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

All Right. Well, good morning. I'm Anthony Pettinari, Citi's homebuilding and building products analyst. And we're very pleased to welcome from The AZEK Company, Peter Clifford, CFO; and Jon Skelly, President of the Residential segment. Peter, Jon, thank you for joining us. And I think we'll jump right into questions. And certainly, if anyone in the audience has questions, please jump in.

Peter, can you start off and maybe talk about recent demand trends and maybe the sell-through that you've seen in January, February?

Yes. Consistent with our earnings call in December, the sell-through environment has been really steady in the last 4 or 5 months, and that's been a continuation here into January, and that's just the theme and pattern it's been. On a reported dollar basis, modestly positive. And then on a unit basis, modestly negative, kind of down mid-single digits.

And when you think about sort of dealer destocking that you saw last year and sort of the restocking into the spring season, any way that you sort of characterize the dealer appetite to restock the…

Yes. I think it's kind of bifurcated and Jon can weigh in here as well. But with a lot of the dealers that might be publicly held, you're seeing a focus on cash and folks probably being a little bit more conservative and leaning more on the distributors to hold inventory in the season. And then I would say, for the independents, many of them that have been through many cycles are not bothered and looking at the whole inventory in kind of more traditional levels.

On pricing, I mean, you've had 2, 3 years of strong pricing with a number of pricing actions. Can you talk generally about how you -- the approach to pricing, how pricing has held up in maybe a somewhat more soft demand environment?

Yes. We've put out in our planning assumptions that on a full year basis, we were looking to see probably 4 to 5 points of price realization on the year. Obviously, most of that is really heavily skewed to the first half of the year as it was all carryover pricing from 2022. Out of the gates here, we said on our last call, we really haven't seen anything non-traditional in terms of the pricing activity in the first quarter and nothing that would cause us to think about our planning assumptions any differently on sort of pricing for the year. So we've been resolute. We don't expect list prices to move or change. And again, we're not seeing really anything meaningfully different on what we would call our gross to nets.

And outside of kind of near-term cost fluctuation, which has obviously been pretty intense over the last few years. Is there a way that you think about sort of the long-term price trajectory for your products?

Yes. I mean I think at the end of the day, this is a sector and a space that, on an annual basis, we should be able to push a modest price increase to cover our merit increases and benefits, inflation and those number of things.

Right. And apologies if I missed this, but the level of price cost carryover that you expect for this fiscal year from…

On a full year basis, it's about 4%, 5%.

4%, 5%. Got it. Got it. And then just maybe stepping back, as you think about your full year guidance, can you talk about some of the kind of underlying assumptions for the full year guidance? What could get you to the higher end?

Yes. At a macro piece, our first assumption was, look, we've only got about 15% of our portfolio that's got exposure to new starts, and that's in the exteriors business. So for that 15% that's got new housing starts exposure. Our assumption was roughly down 15% to 20% on that piece of the business. On the rest of the exteriors business that's more R&R exposed. Our assumption was about double-digit down. And then we had our Deck, Rail & Accessories business at kind of down high single-digits. And then really, our commercial business, which is about 10% of the portfolio, we had pegged at about mid-single digits down.

And in terms of the cadence of earnings between the first half and the second half.

Yes. So the full year assumption of sell-through being down 10% on a unit volume basis, that is consistent for the year, but there is some noise created by sort of the inventory lapping with the fourth quarter of '22. So net-net, with the destock in the first quarter, we have kind of articulated about $85 million of negative volume pressure in the first quarter. We gave a range in the second quarter, but the midpoint of about $65 million of headwind to volume. And then we would be modestly negative in the third quarter, and that would be balanced and offset by the fourth quarter volume being positive. And again, the fourth quarter volume being positive is not a market assumption, that's really just a comp to the prior year, where we took out a lot of inventory in the fourth quarter of '22. So back half of the year, volume, both on a production basis as well as sales volume is approximately flat, which again, kind of leads you to almost the entire volume impact for the years in the first half.

Got it. I mean your margins in the back half of the year, exiting the year should be quite strong. I don't know if there's a lot of moving pieces there, but is…

Yes, there's actually only a couple of element. So if we didn't give a full year guide. We gave our planning assumptions, but enough details that most folks would kind of correlate around the implied back half of the year of around $730 million and around $180 million of EBITDA, which is about 25% kind of quality of earnings. The key and the levers to kind of walk from the first half to the back half is 3 things. So first, we've got about $30 million of deflation that begins to roll off the balance sheet really in month 6. So almost all of that $30 million is in the second half of the year that wasn't in the first half of the year due to our balance sheet lag. Second one is production levels in the first half of the year are meaningfully down. I think we said on our call, we were down about 47% in the first quarter and recovered modestly in the second quarter, but will still be down 30-plus percent. So there's a lot of period expense on the manufacturing side due to that underutilization. So that's about $20 million in the first half that doesn't reoccur in the back half of the year. And then the last piece is, we had announced or communicated on our year-end call that the accounting change we made on inventory estimates would bring about $8 million of onetime costs for the first half of '23. So again, that doesn't reoccur in the back half of the year. And then lastly, again, it's not a market piece, but more of the seasonality of the business as there's about approximately $130 million more of revenue in the back half of the year than the first half of the year just given our third quarter being the main season.

Got it. And can you talk about the Boise facility and you brought that on, probably have some spare capacity there in terms of your strategy there and kind of how you go to market?

Yes. I think, obviously, that was a decision that you made 3 or 4 years out when you kind of do a greenfield or a brownfield new facility. So for us, it was a reflection of the confidence in sort of the eventual long-term opportunity in the space. Obviously, coming online at a time where there's a bit of destocking in the sector, has made it a bit more painful. So when I think about Boise and the opportunity, if you think to '24, you think to '25, there's a tremendous opportunity to leverage that facility and get productivity out of it. Obviously, I had the start-up costs in '22, which are about $8 million to $10 million. And you could really think of a lot of that underutilization in the first half of the year and the $20 million is largely the Boise facility. So for me, it's a huge tailwind as I think about 2024 and 2025, if we get modest recovery in volumes in those years, I can probably cut my cost per pound in Boise by at least 1/2, if not 2/3s. So it really gives us a tailwind to '24 and '25. And obviously, some of the areas of the country that are underpenetrated just from a composite perspective are out West and in the Northwest. So it was critical for us to kind of have that manufacturing capability geographically out West.

And can you talk a little bit about your exposure to pro and DIY channels, sort of where you sit versus the industry and maybe the commercial strategy in terms of growing both of those business?

Great. Jon, do you want to?

Yes, sure. So I mean, Pros always been the historic strength of the business, within decking we're equal to or probably a little bit larger from a revenue perspective versus the competition there. From a retail perspective, it's an area where we've been under-indexed historically. We've chosen a methodical investment approach around that business. And so if you kind of look over the last 5 years, retail has gone from about 5% of the business to now 10% or 11%, so steady increase in opportunity there. But we see that continued opportunity in retail, and we'll continue to invest against it and grow that as part of our share while continuing to grow our core pro presence.

And then you talked about the core remodeling exposure is, obviously, much bigger than new residential. But are there any initiatives to grow new residential? Or is there any kind of like mix that you're thinking about or initiatives to?

Yes. We have a number of initiatives with our sales and marketing organization. So we do have a separate team that focuses on what we call the builder channel. And just -- that's a lot of core blocking and tackling on a regional basis. So if you think about these national homebuilders, they don't actually make decisions on a national level, you have to sort of go market by market. So we have dedicated teams focused on growing our share with those. We participate pretty meaningfully around multifamily. So we -- again, we have dedicated efforts around expansion within that channel. And then we have a real dedicated focus around the architect who, again, will service multiple aspects, whether that's a commercial opportunity, a custom build opportunity or even some of the architects who manage, again, the more production style builders. So dedicated focus and efforts around growing our business in each of those channels. And coming out of the pandemic you tend to see, especially with more of the production builders, the good category of decking being more important there as we kind of convert from historically what has been wood decks to our types of materials. That was an area that we had to constrain during the pandemic. We used more of our supply to be more towards our mid-to-upper tier products. Now with the additional capacity with the availability of Boise, we're going to have the capacity to be able to more aggressively use some of those more entry-level products to attract some of that business.

And your biggest competitor, I guess, is wood. But within the composite space, can you talk about competitive intensity? You have a large publicly traded peer and then maybe some second-tier players. Just I wonder how that's changed.

Yes. So competitively, as you stated, the huge price is wood conversion, right? So I mean, we have dedicated focused efforts around driving that conversion and we view that as the largest opportunity. So typically, when we look at where our share gains are coming from, it's from there. In terms of our overall competitive positioning, the first place we're going to differentiate ourselves from a product perspective. We believe and have had external validation in terms of our aesthetics, right? So I think we have a strategic advantage in terms of the look and the beauty of the product being most like wood. And so we're going to sort of lead with that from a product perspective, and then we're going to back it up with warranties and quality that our consumers demand. We have, amongst the competitive set, we're unique in having 2 types of decking technology. We have the capped composite, which is similar to our competitor. And then we have market leadership around our PVC products, which those are the most premium products in the market with the highest aesthetics, they're lighter, they're easier to install. They don't hold as much heat. So there's some inherent product advantages with that technology. And then we have a little bit broader exposure than other competitors in terms of a very nice growth, profitable exteriors business that complements our decking business. And so we're able to service a broader addressable market, both through our decking outdoor living business and our Exteriors business, so that gives us some further differentiation. And then again, we try to couple that with a very focused downstream effort. So one of the things that we do a little bit differently. We invest a lot in feet on the street to drive pull-through demand. So working through the channels, working through distributors, retailers and dealers is important. But ultimately, we have a lot of focused efforts on getting more contractors to use our product and getting sticky with those contractors. That's a really important part of what we call the ground gain in the business, which helps us grow our brand and grow our presence across the U.S. and Canada.

And you mentioned this, but can you touch a little bit more on the recycled content goals and to what extent that could be sort of a tailwind going forward?

Yes. So when we think about the 3 kind of key components to recycling rate. So on the capped composite side, we use nearly 100% recycled product in the capped composite product. So our opportunity there is really to move to lower-cost recycling materials. And you want to think about our content right now is about 50% high density and 50% low density. We expect to exit this year to probably be middle of the fourth quarter for us to kind of take that next step in terms of content of that 70% to 75% LD. So we feel like that's going to provide a nice tailwind additionally to margins in 2024. Then on the PVC decking side is the next kind of element. And it's not really about innovation. It's a continuation of iteration, so we've been really good over the last several years have kind of taken 4 or 5 points of content up each year. So we didn't officially publish a target for '23, but you could think of 4% or 5% is probably a reasonable expectation for us. We entered this year at about 60% recycled content on the deck side for PVC. And again, we would think that, that target or that progress opportunity consistently over the next couple of years. We don't view entitlement as 70% or 80%, it's probably closer to 85% or 90%, and that's where we would eventually be trying to get to. And then the third piece is related to our Exteriors business. And what's unique about the Exteriors business and the product there is it's not capped. So obviously, our decking products are capped. So you don't really have any issues with the color of the recycled material. You can use any kind of PVC pretty comfortably and easily. The nuance for exteriors is it puts a focus on our ability to source Pure White high-quality recycled materials, which we've been doing aggressively. And so that's kind of the key there for us. We're in the 30s from a recycled content. The next milestone, not entitlement is get closer to 60 over the next couple of years, and we're excited about the progress, not only from a margin perspective, but I also say recycling is our best buffer against inflation. And then obviously, it's critical to our sustainability story.

And you've had some partnerships to increase collection rates or getting recycled content on.

Yes. We think recycling in kind of 4 swim lanes. You got to source it, you got to convert it, you got to formulate it and then you got to embed it in your manufacturing. And in all 4 swim lanes and platforms for us, we probably have never been better positioned. We're constantly out finding new sources. I would say the bulk of our -- on the PVC side, we're, I think, probably the only vertically integrated PVC recycler in the United States. And so we've got many, many relationships on post-industrial kind of scrap. And in the last 1.5 years, we've been pretty aggressive on partnering on construction and demolition. And then as well with the most recent partnerships announced, we're willing to find sources wherever we can to bring in high-quality PVC materials. And again, from a capacity perspective on our ability to convert, we're in really good shape. And then obviously, with the capacity that we have now on the manufacturing side, it really supports us to go even faster on both the formulation as well as the manufacturing inclusion.

You talked about wood substitution. And maybe just taking a step back, I mean, you were seeing very strong growth and composite decking we're seeing very strong growth prior to the pandemic. We have the pandemic and maybe pull-forward some demand and you also have record volatility in terms of lumber, swinging high and then coming to back down and going up again. Like how do you think about sort of the underlying demand for composite decking and sort of exiting the pandemic. I guess the 2 questions are. You talked about some of the goals at the Investor Day last year. If you think about trend growth for composite decking and if we're sort of -- if we lapped sort of the pull-forward for the pandemic. And then on the lumber side, like when lumber was $1,500 versus $300, do you see like a real meaningful call? Or is it just too noisy to impact?

Yes. So 2 bites there. First one, well, let's call it, the normalization or we reverted back to the kind of trend line. One of the areas or ways that we've gotten kind of comfort on the business kind of resetting back to kind of more traditional level is, we've looked at the decking business since the end of 2019 through the end of '22. So that would have included the vast majority of the destock. And really, the growth rate ex-price, ex-M&A on the decking side was about 28%. So obviously, a CAGR of about 8%, which is kind of in line with how we've always articulated kind of the growth back and the opportunity from an organic volume perspective. So we do believe we've reset back to the trend line. Obviously, this year is more of a macro issue. And then your second question was on just kind of impact of wood prices as a general statement. So 2 things there, and Jon can weigh in here as well. One, as we've been under-indexed a bit in retail, we've probably also been under-indexed at the opening price point and maybe arguably even a little bit in the good category as our products have always kind of skewed more to the better, best and premium. So that's where your consumer is more sensitive to price and probably the price of wood has played. So I would say we haven't seen that or felt that because of that nuance of our coverage. And then the second thing is -- and the surprises many, I think we feel strongly in the business that actually wood prices being lower are a good thing for our business and a good thing for the industry in general, that 25% of the cost of the project is the infrastructure underneath the deck, which is primarily wood. So as wood comes in, it lowers the total cost of the project, which we think helps do more projects at a minimum or in certain cases, probably allows the consumer to upsell or mix up in terms of the composite deck boards that they might pick on a project.

And then kind of rounding out the portfolio. I mean you have a much smaller commercial business. I don't know if you can talk about sort of the drivers and profitability there and sort of maybe long-term thoughts on the business?

Yes. So it is about 10% of our portfolio. A lot of time has been spent over the last 2 years kind of improving that business. So we're proud of what the business is doing and the results that it's delivering. We've kind of said long-term, we think it's probably about a 20% EBITDA business. It's been a little bit higher than that, but that's probably the right trajectory that's sustainable long-term. In the very near term, some of the industrial markets that they serve are seeing the lag of sort of destocking, hitting them. Now so it wasn't really pronounced in our 1Q results, but we do expect a little bit of choppiness in the second and third quarter. Again, the good thing is, it's 10% of business. So when we talk about channel destocking on the commercial side, it's $2 million or $3 million a quarter, not tens of millions. And we kind of said on our call that if you said anything that's different in the full year planning assumptions, it's one probably that residential is a little bit stronger than we anticipated, 2, have got a little bit more deflation than anticipated. And 3, the commercial business is probably going to be closer to 10% down that mid-single digits. And whatever challenge we have there, I'd probably use my deflation upside to offset.

Can you talk a little bit about the capital needs of the business. I mean, you're coming off with a big project in Boise.

Yes, we're really excited about free cash flow here this year and obviously, you get into next year. So our business is seasonal. So we tend to be consumers of cash in the first half of the year tend to generate all of our cash in the third and fourth quarter. So as you look specifically at '23, we participated modestly in the repurchase program in the first quarter. We are sensitive to our leverage target. So kind of said we'd really like to maintain a sort of 2 to 2.5x. And we certainly appreciate given the macro having a pretty strong balance sheet. So I think in the second quarter, we kind of said, just given the fact that, again, we're a consumer of cash in the second quarter and our leverage ratio is probably going to be at the high-end of that 2.5%, 2.6% that we probably won't participate in a meaningful way in the second quarter. But with the profitability and cash flow in the third and fourth quarter, plus the $40 million of inventory we want to take off the balance sheet year-over-year that we would look to participate a lot more meaningfully in the third and fourth quarter.

Is there kind of a free cash flow conversion target over the cycle or a way to think about that?

I think you'll see us next year when we give our full year guide that we would probably speak to an operating cash target or free cash flow.

In terms of the uses of cash, you had the StruXure acquisition, and I think a few smaller bolt-ons. Can you talk about what that brought to the portfolio and then maybe financial criteria targets?

You want to take the strategic fit?

Yes. So the strategic fit there is, again, if you look at some of those core criteria that we talk about around the business, wood conversion, sustainability, high-performance, high aesthetics, that's what you get with somebody like a structure, right? So they're replacing wood pergolas that right over time with a aluminum, which is up to 50% recycled automated solutions. So you're taking an outdoor space and you can turn it into an indoor space, if you want, by closing the ceiling, all sorts of upgrade options in terms of heaters lighting, televisions. I mean you can really create just a beautiful outdoor living area with that product. So it's incredibly complementary to our Deck, Rail & Accessory portfolio, and it really is best-in-class in terms of their capabilities, their aesthetics, their brand. So it was just a really natural strategic fit for us. The other acquisition we completed last year was INTEX. What that brought to us is a PVC rail solution to complement our existing aluminum and composite rail. And it's made out of the exact same material as the rest of our Exteriors business. So it just provides a really nice match, really nice pair with our exteriors portfolio. Plus, we have the ability to offer a more broad portfolio around exteriors, things. If you look at how you might use our Trim around the garage, they make [ trellises ] out of our PVC material. They make different types of infills, customs infills for our railing solutions, different types of brackets. So there again, if you look at a lot of those exterior accent pieces on a home that historically have been made out of wood, we now get to convert that to our long-lasting material, again, with that high recycled content that we talked about, 30% going to 60%. So outdoor living and exteriors, very, very close to the brand, same technology in the manufacturing plants that we use, whether at the, again, plastic extrusions or aluminum extrusions. So trying to keep it really straightforward, really simple. And it's just a great tool for -- ultimately for our contractors. So our contractor is engaged with the homeowner out on the job, okay, we talked about your deck, we talked about your rail. Would you consider putting a pergola on top? Are there some accent pieces that we could add. So it just gives our contractors the opportunity to have a broader portfolio that they get to offer to that end consumer.

And then just from a criteria perspective, just some of the other keys is, obviously, we're not looking to buy anything that's going to be dilutive to our residential kind of growth rates. We're not naive that there aren't a lot of high growth, 30% plus EBITDA companies out there that are selling at reasonable prices. So that said, we're not looking for fixer uppers. But I think things that are kind of mid-teens or better that we feel like we can actually get to above 20% EBITDA pretty quickly just with our synergies and capabilities or those are things that would be interested.

And one question that we received was, you talked about being maybe under-indexed to good and may be over-indexed to kind of better best with maybe inflation stress consumer, are you seeing some level of sort of trade down within your own portfolio? And then as you think about sort of the broader universe of kind of remodeling products, categories, how is the consumer sort of prioritizing decking in exteriors versus other kinds of projects?

Yes. Just first on sort of any mix down. We haven't seen any meaningful mix down during this year. Strangely, as we mentioned, the entry point products were what we didn't serve very well with capacity constraints. So as we've kind of had that opportunity this year, it's almost like a share pickup than necessarily a mix down. So it's been kind of additive, and I don't know if you can…

Yes. I mean I think it's -- we're -- again, we talked a little bit about the builder opportunity. I think it's also important in the retail environment. So we're pretty excited about the fact that we can actually sell the portfolio with our higher service level and with our capacity. So that's positive for us. And then in terms of what we've seen, what we're seeing at the ground level in terms of prioritization on repair and remodel, consistent with what we talked about, again, we're seeing that steady sort of sell-through rate. We're seeing steady backlogs amongst our contractor base. And so we have not seen, at this point, any sort of reprioritization from the consumer from inside the house back to outside the house inside of the house, we've seen a nice level of consistency in terms of backlog. And from our dealer surveys and from our contractor surveys, again, it was, I would say, slightly more optimistic this quarter than they were last quarter.

And you also look at, I guess, web traffic or web hits on the states, those have been encouraging into the spring.

Yes. Yes, again, we look at both our internal metrics, which are important, but then we just look generally speaking on just how many people type composite decking into Google, right, and unaided and you're continuing to see positive strength and year-over-year growth on those just general parameters, right? So again, we're early in the season here, right? We're up 3 points in the first quarter. There's a lot of year to go. But just in terms of what we see from our surveys, what we see from our dialogue with customers, what we see from our web traffic and overall web traffic. Those kind of leading indicators continue to point towards the stability that we've been seeing in the sell-through.

Great. Any questions from the audience? One question we're just asking all of our companies in terms of -- and I think you've spoken to a few of them, but in terms of your exposure to megatrends or secular trends that could really reshape the consumer over the next decade. What do you think is most important for AZEK, and to the extent that anything is sort of underappreciated about AZEK or above those trends and how they sort of maybe potentially benefit you?

Yes. I mean, a clear one to have this one for us is wood conversion, right? I mean so that's a core part of our strategy. It's a core part of our story. And again, if you just follow siding, you follow exterior doors at proxies, both of those product categories went through the exact same conversion rights. So now they're both sitting there and 10% to 15% of the market is wood and the rest is composite. We're completely flipped over, roughly 75%, 25%. So that's just a core part of our purpose and our mission is to convert that as quickly as possible. But we do -- we also see technology is -- could be a key driver of our business, and we -- that's when we look at somebody like structure and say, okay, they're using technology to make a homeowner's life better, right? They're giving them a better solution. And there's a lot more that we can do around that in terms of having it be connected to the home via technology, right? So today, there's rain sensors and temperature sensors where the ceiling will automatically we're going to close or the heater will come on when it gets down to a certain level. There's a lot of things that people can do with integrated lighting, both in the pergola, around the deck connected to the pool, where you can connect it to an application on your phone or iPad. So we see the opportunity to not only have just beautiful products, but also to get more integrated over time with technology.

I'd just add. I think one of the benefits that's permanent from the pandemic is the way people value their own and their outdoor living space, even as people return to a hybrid model, there's still a lot of people working far more from home, and it's just placed a different value on the outdoor living space that's permanent in my opinion. And I think that's going to be something that we're going to benefit from for a long time.

Great. Great. Well, Peter, Jon, thank you.

Yes. Thank you.

Appreciate it.