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

Good morning and welcome to the AZEK fireside chat. Very excited to be joined by Jesse Singh, the CEO; and Chris Russell, the Head of Corporate Development, IR and Capital Markets at AZEK. If you don't know AZEK, it means you probably have a wood deck and you should transition quickly. Otherwise, you're going to be have a busy summer sanding. And so -- yes, so with that -- so just to start, we're going to do a fireside chat, and then we'll have some time for Q&A at the end.

I think just to open up if, Jesse, I would just love to hear, how do we think about the long-term drivers to material conversion? What makes AZEK better? What's -- what has driven the amount of material conversion that we've seen in the category?

Great. Appreciate the question, thanks. So let me start by stepping back just a bit. We -- 90% of our company is what we define as our Residential business. Within that 90%, about 2/3 is Deck, Rail & Accessories, consider that more traditional outdoor living, and 1/3 is Exteriors. And in our case, the Exteriors business is wood replacement in more vertical applications on the outside of home, so trim, corners on homes and more recently, kind of selective niche siding. And so across those businesses, in aggregate, depending on the business, we're someplace between 40% and 75% wood. Decking in particular is one of the highest wood penetrations that's out there. When I started 7 years ago, it was 84% wood, it's now 75% wood. So we've been on this kind of trajectory of wood replacement. It's been similar in our Exteriors business. And as we -- if I focus then on the largest segment, Deck, Rail & Accessories, you think about what drives wood replacement. A key characteristic and part of what we benefited from is -- I think people, in general, understand the low-maintenance equation. But what they're concerned about is having the right aesthetics, the right look, the right feel. And so for us, as we look to continue to drive increased penetration, first and foremost, it has to be something that works on the outside of homes that people want to live on. And to that end, we continue to drive more and more investment in things that mimic and are, in many cases, indistinguishable from their natural counterpart in particular things like Ipe or mahogany or cedar. And that has been a key driver of wood replacement. And then on the Exteriors side, it's -- if you think about siding, there's very little wood. There is wood but, call it, teens percentages of wood used in siding, and yet there's 40% plus in trim. And so the question is, why do people use wood in trim? It's because it's easier to work with, it gives you enormous flexibility. And so we continue to drive wood conversion there by driving more productive solutions for our contractors. And so both those sides interrelate: aesthetics, productivity. And then, of course, that's underpinned by increasing use of recycling, which also has a carbon environmental benefit versus some of their natural alternatives.

Great. So can you sort of talk about -- and you touched on this, just the awareness of composite materials in AZEK and how it's changed over time? And then when you think about the long-term penetration opportunity, are there regions or categories where we've already seen this conversion that kind of gives you confidence that this is going to continue? Like how do you think about how high this could go?

So I'll start with the latter. So if you had a map, and we had a map in our investor deck last year without the data. But if you have a map, what you'd see is the area that we're in now, Long Island all the way through into New Hampshire, the East in particular has higher penetration of both alternative decking and alternative trim. And then as you move further west, there's -- the Midwest is pretty good, and then parts of the West and parts of the South have some of the lowest penetration. And so if you just start -- and by the way, we still believe there's enormous penetration in the Northeast in some of the coastal areas where it's still predominantly wood, so there's a tremendous opportunity there. But just that equation of getting close to where we are here and the rest of the country unlocks enormous growth opportunity. And then in terms of brand awareness, we continue to make on the TimberTech side, which is our decking product line, the timber and the tech, we continue to make enormous strides in terms of brand awareness, brand penetration. So if you look at some of the most recent surveys, even of some of the companies that spoke yesterday and today, you would see that we've made pretty meaningful progress in terms of our brand awareness. And we'll continue to invest and drive that. But once again, the most important thing is educating consumers that they don't have to stand on a [ fisher-price ] deck, that you can get the right aesthetics, you're not having a trade-off. And that requires a lot of downstream engagement, consumer engagement, showrooms and that kind of activity.

A tougher question is, what are the key learnings, you think, over the last year? The industry added a lot of capacity kind of post the COVID demand boom. We went through a pretty severe destocking period. The positive side is it looks like everybody help pricing stayed rational and really held. And it does seem like conversion trends are sort of accelerating and they're still growing again. Like what have you learned about how to run your business, track sell-through, work with distributors? And then what do you think we're learning now about the industry and the long-term conversion opportunity?

Yes. I -- fundamentally, everything -- we went public 3 years ago -- almost 3 years ago to the day. And fundamentally, everything we laid out has -- in terms of the market opportunity, the conversion, the need for capacity and all that, that foundationally -- that thesis has held. And just as a reminder, the trailing 12 months prior to March of 2020, we grew 16%. We've got a 10-year CAGR on the Residential side of the business of '19, the business overall of 15%. So we've had kind of structural growth for a long period of time, and we grew through the pandemic. I think, first and foremost, the capacity is necessary, has been necessary, and we're benefiting from it as we speak now. We're able to get after more growth opportunity as we move into the next couple of years by having that capacity. So on the capacity side, you're -- if you've been around business enough, you never try to time capacity perfectly. You do, but it never works out that way. But the fact that we have it, it's built, it gives us an enormous opportunity moving forward. Relative to the inventory side, we ask ourselves that question. We looked at sell-through, we looked at demand trends. We circulated a Harvard business review article called the bullwhip effect, which is basically small changes in demand lead to meaningful changes in channel inventory. We circulated that almost monthly, and it still caught us a bit, right? And I think we -- if there is a learning, it just -- it is that we need to continue to prioritize working with our channel as far downstream as possible to make sure that we are not getting ahead of ourselves. We thought we were doing that a year ago, and then a relatively small change in demand and a bad month or so of sales kind of stacked up a lot of inventory, right? And we've always had -- we've always worked with our channel partners downstream. We have point-of-sale data. We work to make sure that they have the right channel positioned. But when you're fighting a 12-month or a 12-week lead time, which is kind of where we ended up, it's hard to fight the channel on just what they have inventory. And I think it's not just our industry. Every industry that's had extended lead times is going to go through it. I think having our increased capacity allows us to weather that better because we can sustain low lead times in almost any environment right now.

And then following up on that, where are we sort of in this channel inventory correction process? It seems like we've done most of the work there.

Yes. As we've said on our calls, we brought inventory down, we worked with our channel to bring inventory down. And so by the end of our fiscal Q1, which is calendar 2022, inventory was at a below historical levels on a days-on-hand basis in the channel. Now for us, that's our -- the first step of our distribution, we don't necessarily have total visibility to the dealer channel. We have sustained that through March. So there's a reinflation that occurs January, February, March in our industry of just getting more product on the ground to stage for the season. We ended March at historically low levels on a days-on-hand basis. And we also started engaging our dealer base to make sure that we understood what was on the ground there, and they were more conservative as they took inventory on. And it's something that we monitor on a monthly basis. And obviously, when you're looking at days on hand, it -- what matters is your projection of growth, and we're trying to be conservative moving forward. So we feel that we're in a really good position right now. Our guidance for the end of our fiscal Q4 included making sure that we are conservative on where we end with inventory in the channel at the end of the fiscal year. And I think the theme in general is we're trying to make sure that we've gone through this correction, that we have derisked the business as best we can so that we -- as we move into '24, we can perform as well as we can in any environment.

You mentioned sort of the sell-out trends. Can you talk about what you're expecting for the year and then what you see -- sort of seen year-to-date?

Yes. We set what we thought was an appropriate and conservative planning assumption of close to down double digits on a volume basis, not on a revenue basis. We have positive, give or take, mid-single digits of price. And then we have acquisitions on top of that. But we set that assumption based on some of the industry data that we saw, right? So down almost 20% on new construction, which is 15% of our business and down high single digits on [ R&R ]. And I think what we've seen is against that, in general, kind of flattish on revenue sell-through through the end of March. So you should then read if you have price, that means a modest step back on volume offset with price. And so it has been better than our, what I would describe as our conservative planning assumption. And I think if you step back, if you look at, I was just looking at the numbers yesterday, kind of July, August of last year, right around the summer, we started seeing a step back -- it could have been as early as June. We started seeing a step back from the peak of, give or take, down 5% on kind of unit volume starting last summer. We basically continued at that same basic level, taking out the channel movements really through to the point that we're at now. So think of it as we had really strong growth and then sometime over the summer last year, as some of the macro took place, we saw a modest step back. And the way we described that is there was new entrants into the category, different contractors, different DIY, doing a lot of stuff. As they exited, it kind of came back to our standard contractor base, which is full. And they've continued to be full as we cycle now.

So when you think about kind of, oh, the lumber costs have declined pretty significantly, but it's a question that we get a lot is how does that impact demand for composite materials? What have you seen with conversion trends? As we've moved past some of these comps that you're talking about, what are you seeing in terms of composite relative to wood?

First, in general, for us, having wood prices lower, we think, is really beneficial because if you think about the construction of a deck or really any repair and remodel, there is so much wood that's used that in our case, at the low end, maybe 20% of an aggregate deck job is the decking could be as high as 30%. But the rest is labor and other structural areas, and that structure is still primarily wood. So as wood comes back, it makes projects more affordable. And so I think that's a -- it takes -- there's a natural pullback on affordability. And then as a direct replacement for wood, as I highlighted and I should highlight, our company, in general, if you think about good, better, best, premium, we tend to skew more on the premium side. We've got the most advanced technology and the best-looking products on the market. And part of it is because we have a PVC portfolio that is really unique in terms of its characteristics. For us, that movement of is it $1.20 a foot or $1.10 or $1.40 really isn't impacting the vast majority of where we play. I think where you might see some of that is on the shelf at kind of the entry level of low end, where maybe it was $2 a foot for wood and a composite was -- or maybe it was $1.60 and a composite was $1.60, you may see that choice move away. But for us, that's a minority part of our business, it makes up -- we're only 10% retail and -- or 11% retail, and half of that is special order. So in general, we haven't seen that change, but that's where you might see it.

And then kind of going back some, your market share now that you have capacity and you've made that investment, can you talk about what the trends are you're seeing there? Where do you see -- are there additional channels or categories that you'll be able to go after now that you couldn't the last couple of years? And then thinking about when you see consumers switch over to AZEK, what's driving that change? And when you see contractors and dealers switch over, what drives that change?

Yes. We track -- so we track an awful lot of data. We track digital data. We track the samples we ship. We track the number of contractors that engage with us. And the nice trend we've seen over the last couple of years and really since we brought capacity online is we have expanded our contractor base, we added 1,000 last year. Chris, I don't remember the numbers year-to-date, but let's say we've added at least 500-plus contractors year-to-date. We've engaged architects. Having capacity has allowed us to continue to get back on that set of activities that expands our position in the marketplace. We have 200-plus downstream salespeople and -- or salespeople that are direct employees of ours. And a lot of what they do is engage the market, work with contractors on both sides of our business to spec our products and architects and builders. And so we've seen really nice growth there. So the question is, why us? As I mentioned, we have unique products that really give a consumer what they want. We also have a PVC -- what we call Advanced PVC, which is 60% recycled right now -- recycled PVC product line. It's easier to install, it's lightweight and it's cooler. It has aesthetics that are really unique in the market. And so that allows us to continue to penetrate the market at the high end where, in many cases, it's an important alternative to a consumer. So then if you look at the kind of our share position, now that we've had capacity, we've had the opportunity to engage on those growth opportunities that we were not able to look at over the last couple of years. And so we break that between pro and retail. We've been able to incrementally increase on both sides. And I think as you -- if you look at the numbers of what we have reported, what we will report, and you can draw your own conclusion on how we're doing from a numerical standpoint. We think it will show up in the numbers. But we feel pretty good about the fact that we're able to gain share using our capacity against wood and gain incremental shelf space against wood and other competitors.

Switching to Commercial. I think you lowered the Commercial outlook last quarter. There's obviously been a big change in the market there that I'm sure everybody's aware of. Just what has changed in that business this year? Have you seen any kind of stabilization since? And then how should we just think about Commercial business longer term as part of your portfolio?

Yes. So as I mentioned, give or take, 90% of the company is our Residential business. We do have a business that is defined as Commercial. Within that business, it really has 2 sides. One is bathroom partitions, which is education, schools and commercial interiors. And that business has been okay, I would say. There's a lot of tax revenue going into schools and -- at the state level, which supports that business. And then on -- specifically on the Vycom side, it's more of a general industrial business. And our Commercial business grew 40% last year. And similar to the earlier conversation we had on Residential, we knew that there would be some inventory correction, but we guided down against our initial planning assumptions about $40 million. Think of half of that is inventory correction out of the system. The other half of that is demand. That business plays in multiple industrial applications. So think of -- it's actually in semiconductor capital, it's in outdoor furniture, it's in marine. And those industries had both had that combination of excess inventory and a step back in demand. We believe from what we can see right now that the inventory -- that we'll be through the inventory correction there in the back half of the year, which means we'll lap it in '24. And from what we can see now, as we talked about, we believe the markets are kind of at a stable level. There are some parts of that business that continue to grow. But in aggregate, we've guided that, that's a GDP-type business overall. And 40% was clearly higher than the GDP, and I think it's kind of stepping back and normalizing.

And how do you just think about Commercial longer term relative to your Residential business? Is that something you -- that there's options to sell or is that something you'd want to keep?

Yes. The way to think of that business is it's a legacy business, right? So it -- if our Residential business is -- started in the mid-90s -- mid- to late '90s, the Commercial business started a decade-plus earlier. And so it's a legacy business. It has been a diminishing part of the portfolio. We would expect it to continue to be a diminishing part of the portfolio, and that's really based on differential growth rates. And then if you layer -- and then as you look at that business, we're always open to evaluating our portfolio. And if it ever made sense, we would consider options there. But right now, they perform really well in the businesses that they're in. And it's hard to talk about a 20% EBITDA margin business and a -- in these industrial businesses in a -- as something that is a nonstrategic business because it's a great business. But just the differential growth rates will naturally have it become a smaller and smaller part of the portfolio.

Right. And then on your margins, can you just talk about the progress you've had in terms of increasing recycled content? What is the opportunity longer term? And then can you just give us sort of a little bit of a sense of like what type of margin lift do you get from using recycled materials versus virgin?

So if you look at the -- if you consider the margin stack over the last 2 years, we've had -- we've disclosed that we've had over $220 million of raw material inflation really starting in '21. Now we've been able to offset that with price and other actions. The problem is there's been a lag. And so we've made really good progress on recycle, we've taken appropriate pricing actions, and yet it hasn't yet shown up in the margin structure of the P&L. Add to that, we took very aggressive actions on inventory drawdown in the first half of this year, not only externally with our channel, but I think we were -- we decided to, for lack of a better term, pull the Band-Aid off and take our own inventory down really aggressively, which has led to meaningful underutilization in the first half of our fiscal year. So the reason why I do that as a setup is, as we have guided to the back half of our fiscal year, Q3 and Q4, if you look at our guide, you'll start to see some of the benefits of some of the activities we have had as the underutilization is less pronounced as we start to finally see raw materials normalizing and we start to see some of the benefits of recycle. So a way to think of where we could be is just look at our guide for the back half of the year, and you can start to see that we've taken some incremental actions there. Relative to -- so some of that's embedded. We still have a large opportunity. And I think what we've said is by 2027, we'd be at 27.5% EBITDA margins. And the way to think of that is a portion of that is going to come from our transition from recycle so -- or transition to recycle. And in general, you should think of recycle is less than 50% of the cost of the virgin alternative, right, if you just roll up high-level numbers. So in our decking -- in our PVC decking product, we're using 60% recycled right now. We've guided that there's an opportunity to get north of 90% over a period of time. I think our next stage gate is probably in the 70s, which should occur over the next couple of years. That creates a meaningful opportunity to drive margin. And of course, it's a fantastic environmental play also. And we're the largest vertically integrated recycler of PVC in the U.S., maybe in the world, but we don't have good data. And we're probably one of the few companies you're going to hear about that is vertically integrated in PVC recycling, and we're using it in an extremely aggressive way in our products.

Great. Can you talk a little bit more about that, the PVC inflation headwind over the last 2 years? And obviously, PVC prices have come off a lot from that. How do we think about -- with price kind of holding at that current levels, or going a little bit higher, how do we think about that benefit going forward and when we'll start to see the timing that actually flow through your P&L?

So we -- in November, when we gave our planning outlook for the year, at that point, this price raw material that we have been chasing for 2 years, we could see where we were on pricing and we could see where we were relative to sourcing our raw materials. And what we said at that point is we saw a $50 million benefit during 2023 from that kind of price raw material productivity sourcing discussion. We didn't realize any of that in the first fiscal -- first half of the fiscal year. So in the first quarter, the second quarter, because we had a 5- to 6-month lag, we had inventory, we had to work off the balance sheet. So what we've said is of that $50 million, $30 million will hit in the back half of our fiscal year that we're in right now, this quarter and the next quarter. And we'll have $20 million of carryover into 2024. As a reminder, October 1 is the beginning of our 2024. And then we haven't -- and that's really based on what I would say were November numbers -- November, December numbers. We haven't really altered our discussion there. There's been some movement relative to a number of different raw materials. There's been puts and takes. We haven't guided anything larger except to say that, that $20 million is just a carryover of what's going to be on the balance sheet in '23 into '24. There could certainly be additional benefits above and beyond that.

And then the delay is just working through the high-cost inventory?

Yes. Yes, you buy PVC or any other raw material, polyethylene, even recycle, at a certain point, there's a lag of how that flows through the balance sheet.

And how do we think about that, the inventory correction for your own balance sheet that you talked about? Is that -- where are we in that process? Do you still have more to go?

We've taken a meaningful portion out, as we talked about, above what we guided. I think what we've said is there's -- there might be another $10 million or $20 million more of opportunity. And for us, it's really important because we're unlocking cash off the balance sheet, we're driving down our own inventory. And it's -- the way to think of it is we're not only generating cash, we're derisking the future, especially in the potential for a deflationary environment. And it's really important to manage our balance sheet appropriately. So there's probably, say, $10 million to $20 million more.

That's right. That's right.

Yes.

Okay. We can open up the room to Q&A. I don't know if there's a mic we can circulate or you can just yell.

I can phrase the question, too, if you want to.

You just want to raise your hand. Yes. Okay.

Can you just talk a little bit, just given the inflationary environment and the volatility in lumber prices, about like elasticity of demand relative to lumber and what you're seeing and sort of like how that's tracked historically?

We don't -- it may not be the most logical answer, but we don't really see -- as I mentioned earlier, the area where you may see that is in that -- on-the-shelf pure opening price point product. Remember, 75% of the market is wood. So it's already self-selected to be composite, right? And we don't really -- in our business, we haven't seen any impact to our own revenue or our own what we believe is conversion opportunity based on the price of wood. And I know that seems a little lot, but it might just be that we're not selling a low-end product that's trying to compete on price with wood. I mean our products -- I've gotten questions in the past on what's your -- what's the price of your product as a multiple of wood. I don't know. I could calculate it and say it's 5x wood, 4x wood, but it's not something -- if you think about it, if you're a consumer -- and it's typically my demographic or an older demographic is our core customer. You've already owned a wood deck, you've already gone through that cycle, you're not doing the math in your head of -- and you just want something that's going to look right and you don't have to deal with. And that's a lot of the -- and it's aesthetically got to be right. And so if you think about if you bought windows, you may not know your window compared to the absolute lowest price of a window because you're choosing what's right. What we do is very similar to that.

Yes. I mean, I think if you think about the total cost of a decking project, about 1/4 of that is the actual decking materials. 1/4 is the substructure, and then half is contractor profit and labor, right? So one of the bigger determinants and one of the bigger variables is probably really around contractor availability and labor, right? If you think about the total cost of the project. So that's kind of how we think about it.

Sorry, there was...

You can just go ahead and yell. I'll repeat the question.

So I love your product, by the way.

Yes.

We have a fan of our product, for those listening on the web stream.

It's a production builder there is an alternative that I might use. The TimberTech product, is that to compete against that alternative? I mean I don't necessarily want to mention the name but...

Yes. Yes. What we've done, we put everything under the TimberTech umbrella. So TimberTech is, from a consumer standpoint, we did have 2 decking lines: AZEK decking and TimberTech decking. What we've done is we basically simplified the branding for the consumer, which has allowed our market awareness to go up meaningfully. So everything is under the TimberTech brand. And then within that, we've got a composite line and a PVC line. And then within the composite line, we do have the good, better, best. And we've got some very, very -- that good product line is kind of that entry level. I used to have a Board member that would describe it as cheap and cheerful. But it's appropriately priced in that window for a composite decking that's kind of in that, call it, $2 range or lower.

And compared to Trex, it cuts through really well. So it's a beautiful product. But -- so I got 2 more questions real quick. So -- and I'll just say Trex has a system of connectors, ways to put together the deck, which is -- seems to be a preference for a lot of subs out there. Is that something you guys are looking at or thinking about?

Yes. We have -- it's really -- the way I would describe it is you have -- depending on the geography, in the pro channel, I would say we have higher share in some geographies, and they have higher share in some geographies. It's very geographic-dependent. We've got a full systems implementation, so we have fasteners and lighting...

That clip together like theirs.

Yes. Hidden fasteners, the entire system is there. And this is kind of the -- I'm broadening the answer to the question. I think what you find is certain contractors have decided they like company A and certain contractors have decided they like company B. And for -- then they just kind of continue with that business model. Incrementally, we're -- because of our uniqueness of the product that you just described, we're able to pick off company A's contractors sometimes at the more premium segment. But what -- but anyway, we do have the system.

Right. One last thing. So we use a lot of Maritech and in place of -- and it's in place of [ hardie ] because the trim and [ hardie ] is, I think, where they make all their money, right? So we prefer AZEK as -- is there ever going to be a product that goes up price-wise against Maritech?

We -- so one of the benefits of being a vertically integrated PVC recycler is we have the capability to develop much higher recycled products, which we have been doing. And we've got a product called PaintPro, which is incrementally higher recycled products, and it's a painted product rather than being white. And we have pre-finishers that are pre-finishing that product now, similar to some of the other companies kind of color type. I'm not going to name a brand, but you know what I'm talking about, right? So it's a pre-finished model. We certainly will continue to expand our position in the marketplace. And that's a bit of what I'm talking about when I say wood and other replacement is that we have the technology to move to different price points, different application sets. And that really is -- really comes out of having that high recycled content.

Does corner trim softer from hardy? I would do anything to replace that price. So thank you. I don't have to call you or try to call you again.

Yes.

So I think that's -- we're running up against the time here. I want to thank you both, Jesse and Chris. Really appreciate it.

Thank you, Ray.

Really appreciate it. Thanks for having us.

Yes. Thanks, Ray.

Thank you.