The AZEK Company Inc. (AZEK) Earnings Call Transcript & Summary

Hey, everybody. I'm Matt Bouley, Barclays home building and building products. Thanks, everyone for coming to Miami this year for the 40th Annual Industrial Select Conference. For this next meeting, happy to have the team from AZEK here, Pete Clifford, CFO; and Jon Skelly, President of the Residential Segment.

So before we dive into the questions, we'll start with our ARS questions. So hopefully, many of you have seen how that works. So we're just going to run through these 5 or 6 questions quickly. So number one, do you currently own AZEK overweight, market weight, underweight or no? So we have an audience of new investors, but a few on the stock. Next question. General bias towards the stock right now, positive, negative or neutral? It's a little weighted towards positive. Next question, please. In your opinion, through cycle EPS growth for AZEK will be above in line with or below peers? And the crowd thinks above peers. Next question, please. Suspense is killing, yes. In your -- yes, well, we'll re-ask these in 20 minutes. In your opinion, what should AZEK do with excess cash, bolt-on, larger M&A, share repo, dividends, debt fee paydown or internal investment? All right, a little bit more towards share repurchases. Next question. What multiple of '23 earnings should AZEK trade? All right. The crowd thinks a premium, higher than '21. Next question. Most significant share price headwind facing AZEK today, core growth, margins, capital deployment or execution strategy? Core growth at the moment. And the last question, does ESG play an active role in your decision-making for AZEK? Yes, positive; yes, negative; no or no but plan to. All right. A little bit weighted towards yes and a positive factor and no one thinks a negative consideration. So Pete, Jon, thank you guys for being here. Maybe we'll just start with kind of an overall question on the demand environment. Maybe if you can kind of walk us through how the second half of last year played out from a sell-through perspective, some of the commentary you guys gave on your Q1 call a couple of weeks ago was encouraging around kind of how sell-through is progressing at the beginning of the year. So maybe just kind of talk through what you're really seeing from a consumer demand perspective?

[indiscernible] So but from a sell-through perspective, the environment for us over the last 4 months [indiscernible].

Just going to get the mic on. Just a second here.

Okay. Perfect. Hopefully, that's better. Our sell-through has been incredibly stable over the last 4-plus months. It's been a continuation on a reported basis -- a positive on a reported basis and modestly negative on a unit volume basis kind of classically anywhere from 0% to 5%, so mid-single digits down. We've done a lot of outreach, obviously, more channel partners. We did our last survey in January at both our contractors as well as our dealer partners. Results for January were encouraging in the sense that most folks were modestly more optimistic in January than they were the 90 days previously. So that, coupled with a lot of our sample and digital marketing information, kind of points to still pretty healthy interest in the category. Jon I'll...

Yes. I think that's well said, Pete. I mean, I think we had that steady demand, which enabled us to get the excess inventory out of the channel via demand, which was really, really positive. The sentiment is still really stable in terms of backlogs, quoting activity, things of that nature. And then we're taking a much more proactive role in managing demand as to where we can get that 1:1 ratio of sell-to equals sell-through. And we are working with our channel partners to get the right inventory to the right locations where there's that real steady demand that we're seeing.

Yes. Yes. And that's exactly what I wanted to ask about, kind of how you're working with the channel partners? What can you kind of tell around their inventory levels at this stage? I know you mentioned the destocking is largely over from your perspective. How are you kind of managing and sort of planning the year of 2023 in terms of working with them from an inventory perspective?

Yes. So we've moderated inventory levels to now be from a days-on-hand perspective equal to what you would see in a 2017 to 2019 average, right? So we've kind of gone back pre-pandemic and said, what's a typical healthy level of days-on-hand, and we're managing to that. And we're doing that by skew by location, right? So it's not just on a macro basis, but we're kind of going geography by geography. And so then as we get pulses weekly and then once a month, we get the full data dump of sell-through. And then we match that against what's on order board to say, okay, it looks like you don't have enough here or maybe you have too much there. So we can actively work with distribution partners and then more specifically with the dealers, too, because the dealers, we want them to continue to pull through the channel. So we want to make sure that we're managing their inventory levels as well. So it's a lot more proactive than it was. We got a lot better in terms of our data access and data management over the last couple of years. And so that will allow us to prevent a buildup and a drawdown like we saw sort of in the last year earlier this year.

I'd just add, with our lead times where they're at, with our capacity where it's at, as well as where our finished goods inventory levels are at, I'd say there's a real focus, especially here in the second quarter. Second quarter is traditionally when inventory is built in the channel. And I would just say we're being pretty thoughtful in terms of how we reinflate inventory. And again, using the data that Jon just described to make sure that we're being conservative in terms of how we feel.

Got it. And then one last one on that topic. You mentioned the dealers. How far down into the channel can you see? Does it feel like there's still kind of any excess inventory down at that level of the channel? Or does it feel kind of lean throughout?

So it depends, Matt. I think if you look at some of the larger organizations, particularly some of the publicly traded dealers, you can see a pretty aggressive working capital drawdown and those -- so I mean, they've -- we've seen them be certainly aggressive. And then on the flip side, you see some sort of more locally owned mom and pop say, "Hey, I'm going to load up my wagon. I'm going to be the individual in the market that has a stronger inventory position as I see some competitors pulling back." But net-net, definitely the same type of drawdown in terms of the days on hand perspective, both at the dealer channel and at the distributor level. So it's -- it kind of evens out across the board, but you do see some regional differences if somebody -- if a local dealer decides to take a more proactive inventory position.

And again, about 20% of our revenue is actually dealer direct, and we can kind of get a pulse on how much that's up or down year-over-year based upon what we think throughput is to kind of get some insight in the inventory at the dealer level.

Got it. Okay. That's helpful. So moving beyond just channel inventories. Higher level, you guys spoke to some share gains, some shelf space wins, Pro and Retail. I guess, the near-term question is, how does that shake out between Pro and Retail, where were you able to add space and shelf space? And the higher-level question is, maybe you can kind of walk us through your Retail exposure at this point? And where do you think that can get to over time?

So we're not giving the split between Retail and Pro share gain, but it was at both levels. And it was pretty consistent across product categories. So that's the main thing. I mean, I think in summary, what we would say about our Early Buy process would be, we saw most of our customers take a smaller position, but we added a lot of net new customers, right, new shelf gains across both Pro and Retail. And that's what we want to see. We want to see broad participation and we want to see a broad breadth of product across Deck, Rail & Accessories, Exteriors, which we saw. And with Retail, that was more deck specific in terms of share gain. So we're in a good position. And as Pete mentioned, we managed the directs very, very closely to make sure that we can get that pull-through out of distribution. And so that allows the channel to be able to again, function. We can manage that much more to that 1:1 ratio, the sell-to to sell-through. So we're in a good position there.

Got it. So in terms of winning shelf space at both channels, how do you think about like a competitive response, right? Is there an implication on pricing? Or do you feel like there would be more competition in other pieces of your channel? How do you think about kind of [indiscernible]?

So I mean, Retail is a list price business. I mean more or less when -- the retailer themselves will set that price. So that's -- and they're pretty disciplined with that. You may see them run a spring selling promotion, something like that, but the lists are pretty set there. On the Pro channel side, they also have list price. But if they've taken an inventory position during Early Buy, writing down that inventory position by cutting price is usually not the most economical decision for them. So we feel pretty good in terms of the pricing and the load-in that we've done across the channel. And there's been a long history of cheaper products available. So if you walk into deeper lows, you'll see a lower-priced private label product. If you walk into a professional dealer, you'll also see that. It's been around for decades. And yet, if you look at the growth of ourselves and the other market leaders, you see us continuing to take share and continuing to grow our piece of the business while not pursuing a price-driven strategy.

So it sounds like, therefore, pricing has been stable to begin this year. How do you guys think about the longer-term pricing strategy from your perspective? Is it -- this industry has gone through periods of no price and then kind of slightly moving towards annual price, things like that. How do you think the pricing within both decking and exteriors will progress over several years?

Yes. I think as you get beyond '24, I think pricing returns back to, I'll say, pre-pandemic of what this should be a space in an industry where you can pass your 2 to 3 points of inflation on through pricing as kind of a stable baseline. We've kind of left that out of our growth stack as kind of a hedge, but I think it's a rational market. And as you think about the near term, we had talked about on our year-end call that we expected to see potentially a modest increase in our backside pricing, sort of what we call gross to net anywhere from about 100 basis points based upon our first quarter results, saw nothing -- any actions to say that that assumption was not appropriate for the full year, if anything, we are modestly favorable.

Got it. And to clarify, when you say gross to net 100 basis points, that is effectively a discount you are giving?

Rebates program.

Got it. Okay. Perfect. And so how do you think about, I guess, moving down the P&L. I mean there's clearly been some reductions in PVC, polyethylene. How are you guys thinking about that potential upside to the deflation benefit that you have outlined?

Yes. So as we said on our last call, we've got upside to both our 2023 deflation impact as well as carrying over larger deflation on the balance sheet to 2024. Some of that '23 upside, we didn't monetize simply because, look, our outlook a little bit on the commercial business is a little choppier. So I'm probably going to use that inflation upside to pay for any modest choppiness on the commercial segment. But ultimately, prices seem to have stabilized in 1Q at price points that obviously more than support our full year assumptions. I think there's a chance in the back half of the year. One of the areas that hasn't moved in our favor yet is more of the specialty materials and additives, which have been pretty kind of stubbornly high throughout most of the last kind of 4 to 6 quarters. I'm hopeful that that's an area where we start to see some incremental opportunity for inflation, candidly, because of the balance sheet lag. It's probably more of the '24 inflation impact, but those are things that I still think that are out in front of us. But again, the key takeaway is we've been vouchering lower cost all year. It's gone on for the balance sheet. We have about a 5-month lag that impact starts rolling off in month 6, and it's meaningful to both third and fourth quarter. And some people have asked, why is there a step up in 4Q versus 3Q. One of the answers is, look, we've bought a lot less just in terms of purchases in 1Q '23. My production levels were down 47%. As I increase my share purchase dollars in 2Q, I generate more deflation, which comes off the balance sheet in 4Q just in a more monetized way.

Got it. Okay. And so on the topic of recycle, I guess, number one, I want to sort of hear where you guys are and where you expect to be by the end of the year. But then just because it's topical, maybe you saw the headline in Barron's this past week, and it said recycled HDPE is actually more expensive than virgin. And so I'm curious if, number one, you can comment on any inside baseball? How does it -- what do you actually see in your recycled resins versus what's available virgin? And then just kind of update us on your progress on the recycled side.

Yes. So just in general, on 3 buckets of recycling. So let's just start with PVC. So as you know, we're probably the largest kind of vertically integrated recycler PVC. So it's a market that we're building, so it's less mature. So the prices for recycled PVC are pretty low. Similarly, LD behaves in a similar fashion. It's just early days. There's not that many people that know how to use LD. Conversely, HD is sought after, it's easy to use. It's a mature market. So HD recycling behaves or follows virgin prices really quickly. So I think one of the things that we've learned over time here over the last kind of 6 quarters is recycling is a fantastic way to expand margins. But it's also our best buffer against inflation. So it really has 2 catalysts to it as to why we want to go faster. So as it relates to our current state and near-term strategy and what we're working on, if you think about on our composite decking business, we're at about 50% HD and 50% LD. We expect in the fourth quarter to get and exit the year about 70% to 75%. So it will be much of an impact to '23, but it will be a tailwind and a carryover benefit to 2024 as we set the sustainability of margins. But obviously, important to get further away from HD, which behaves more like a virgin resin and take the inflation data off the table. On PVC decking, we entered last year at about 55% to 56%. We exited at 60%. Wouldn't technically publish a target for '23, but you should think of it as 4% to 5% increase again, so sort of 64%, 65%. And that's certainly not entitlement at all on that business. And then on the trim side, we really have a target for this year. We put it in our Investor Day, we're at about 30% the goal, not entitlement, but let's just say the next phase over the next several years to get trimmed to about 60%. So those 3 things all together, I think we have laid out, it's about 350 basis points margin expansion and approximately $50 million of EBITDA over the time frame.

Got it. Okay. That's helpful. So a question on the capacity side. Maybe you can kind of update us where you are with the Boise facility. I believe you effectively didn't fully ramp that up. So just curious kind of what's there, at what point would you consider turning that back on and sort of what are your views and where you want to be from a capacity utilization perspective?

Yes. So if you said a second thing about 2024 margins and what are things that would be tailwinds the next year, Boise is one of those, obviously, in 2022. For the most part, I incurred sort of the start-up costs without any real manufacturing going on. We started the commission lines in the fourth quarter of '22. Look, we probably only commissioned about 20% of what we expected in Phase 1. So we've tried to match commissioning with what the external demand environment was. And as we were obviously going through the channel destocking. We've kept production very, very low there, which means most of that $20 million of first half of the year underutilization. You could think of as the vast majority of that is Boise facility. So conversely, if you are ambitious and think that 2024 even has a modest bounce back in volume, the more I can ramp my production, I can honestly probably cut my cost per pound in Boise in half next year. So there is a real productivity play. We would have expected to have gotten that in '23 to recover the start-up costs. But obviously, with the production challenge, volume challenges this year, it's really a 2024 opportunity. It's not insignificant as a margin tailwind.

Yes. Got it. Okay. Super helpful. Question on the Exteriors business because big business probably doesn't get as much airtime as it should. I guess within your down 10% overall sell-through guide for the year, just how is exterior sort of contemplated within that? And then just kind of how do you think about the longer-term share gain opportunity with your PVC trim?

I'll start. Jon, you feel free to pile on here. But when you think about the Exteriors business, I think one thing to note is it never really had the inventory build that the Deck, Rail & Accessories side of the business had. So there was a very modest channel correction, but it literally started like the last 2 weeks of June and was complete by the third week of July. So we've kind of been on a pace where sell-to has equaled sell-through for the last several months. It's probably one of the bright spots when we look at what's different from our planning assumptions and again, acknowledging that commercial might be a bit softer, but residential being a bit stronger. I would probably say the residential being a little bit stronger, it's kind of Exteriors being a little bit more resilient than probably what we even expected in terms of so far out of gate this year. And then, long term.

Yes. I mean, long term from a share perspective, I mean, we're the market leader in that business. And we continue, like some of the shelf space gains we talked about earlier, we're with the Exteriors business. We're also in Retail with that business, and we've recently launched some new SKUs in Retail there. And we're continuing to look at more value-added solutions, things that save contractors time and money. And while there's decent penetration in certain markets like the Northeast, when we talk about market expansion and channel expansion, there's terrific opportunities with that business. So we're investing, we're growing, and it's got the same material conversion opportunities we see in our decking business and just a long-term runway for conversion in the future.

Got it. And then from a portfolio perspective, we saw your largest competitor divest their commercial businesses, probably more addition than subtraction for them. You guys have a bit bigger commercial footprint. How do you think about where that fits in the portfolio and whether it's going to be there for the long term?

Yes. Look, we've put a lot of time and energy and over the last 2 years to kind of get the quality of earnings in that business to be much closer to the corporate average. So I think we're proud of what we've done with the business over the last 2 years. We believe it could and should stay at sort of 20% kind of plus EBITDA kind of profiles. That said, from a capital deployment perspective, where we're going to deploy capital is in the residential segment. That's going to be the focus. Every year, as we're supposed to -- we look at our portfolio and ask the question if we're the best owner and if that answer, we're going to come back someday that we want the best owner, we would do what we have to.

Got it. I want to check with the audience as we have a big crowd. Does anyone want to ask the AZEK team a question? Okay. So sticking with the balance sheet. I'm going to take this into overtime slightly. How are you guys thinking about sort of the -- where you are from a leverage perspective and at what point you might consider more towards share repurchase?

Yes. So as you know, our business is pretty seasonal. So our cash flows in the first quarter and second quarter, we tend to consume cash and generate all of our cash in the back half of the year. So what does that mean? Look, our leverage ratio, we are serious about trying to generally stay in close proximity to 2x to 2.5x, which will probably be at that at the end of the second quarter, kind of around 2.5x to 2.6x maybe. So I think you'll see us be very measured and do not a ton here in the second quarter. But obviously, if the macro gets better, if we're in line with where we think we're going to be plus executing well on inventory reduction, I think you'd see us be much more participated in the third and fourth quarter of this year on the share repurchase.

Got it. All right. Perfect place to end. Pete Clifford, Jon Skelly, thank you guys for coming.

Thank you.