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

Guys, I'm Phil Ng, Jefferies billing products analyst. We're delighted to have the AZEK team here. Representing the company, we got Pete Clifford, the CFO; Jon Skelly, who heads up the residential segment. Obviously, the big growth driver for the company.

Well, I guess, you kind of kick things off, guys, the R&R market has been challenged this year, given existing home sales being under pressure and rates are still pretty elevated. You guys have put up pretty impressive growth backdrop with sellout actually growing. Just kind of walk us through what are some of the key drivers in terms of your ability to kind of grow in this environment and perhaps actually even grow a little faster than your peers.

Sure. Thanks for having us. So first and foremost, at a macro R&R level, we've seen more resilience in our category and outdoor living. And so we've seen a more consistent backlog environmental contractors. We've seen a lot more consistent engagement activity with consumers, through our various digital channels. And it seems that the overall investment spend in outdoor living, as part of the R&R category, has been stronger than perhaps, some of the interior sectors. And so we've complemented a slightly better performance than we expected with our end markets, with our growth drivers, our share gain activities. So we've been successful in driving shelf space conversions in the pro channel, in the retail channel. We've been successful with the launch of new products and just continuing to drive wood conversion at an accelerated pace. So between a slightly better performance from a repair model standpoint in our sector and then our proven growth drivers, that's led to the results that we've been talking about on our earnings calls.

Super. On some of these initiatives, that's AZEK-led in terms of increasing your penetration in the channel and some of the new products. Can you expand on: one, how that ramped and where you're just finding some inroads? And what's driving that? I mean what are some of the great things you guys have done to kind of pick up [ share ]?

Yes. So certainly, it starts with the quality and aesthetic of the products. So we're continuing to bring to consumers, products where they don't have to compromise. They can get the low maintenance and long warranty of a composite product versus wood, but they get the natural beautiful would look. A couple of specific areas. During the pandemic, we were -- when we're at capacity, there were parts of the market, particularly entry level, which we weren't able to service. So we've had a good opportunity to go back and take some of that share. We weren't able to service with the additional capacity that we've had in the business. That's certainly been helpful. We've been under-indexed in the retail channel. We've been successful in growing our share in that end market. And then just continuing to execute against our downstream demand initiatives, right? We've been growing our brand in the pro channel. We now have the strongest professional brand in the -- in decking. We continue that expansion in terms of consumer awareness and education to drive wood conversion. So again, it's that the combination of taking additional shelf space, pulling through the product, creating additional demand for the product that's driving the results.

Super. I think recent months, last weeks, we've seen some signs, consumer is weakening. Any intel internally, whether it's digital engagement, what your customers are telling you in terms of any choppiness that you're seeing out there or slowdown?

We would still categorize demand is stable. So again, when backlogs, digital engagement, quote activity at the dealer level, we've seen stability there through season. That stability has continued. So we haven't at this time, seeing any weakening in those factors. So we're still in a position where, again, we're going to categorize demand as stable from what we've seen throughout the beginning of the season.

Okay, super. With recent weeks, concerns that rates are going to stay higher for longer, and your stock has obviously got hit with the broader group. In a higher rate environment, an existing home [indiscernible] perhaps be more challenged. You have enough AZEK company-specific and industry levers to drive growth in 2024.

Sure. I mean, as we've talked about before, Phil, I mean, we think that we can consistently outgrow the market, right? So we've walked through our growth algorithm, starts with repair and remodel growth, repair and remodel historically, highly resilient over a 10-, 15-, 25-, 30-year period. You see pretty stable 4% to 6% R&R growth, that we have seen a weaker environment for that this year. But again, we've been able to outgrow that through wood conversion and through initiatives, right? So that growth stack provides us opportunities to continue to grow this business, regardless of where, while stable wherever R&R shakes out. So that's been beneficial. Within the interest rate environment, we're much more R&R levered as a business. It's the vast majority of what we do. And within that, not a lot of debt purchases. Our data suggests that it's roughly around 10% of where people use financing for an outdoor remodel project. So financing is not a huge driver of activity within our business. So we're not obviously immune to interest rates with our Exteriors business is more of a 50-50 split between new residential and repair and remodel. But again, we're a bit more insulated than if we were completely levered to new housing, which is obviously highly dependent upon interest rates.

Got you. A question for Pete. When we think about this year, you've had some headwinds, whether it's price cost, curtailing production. And when we look out into 2024, what are some of the levers you have that could be a good guy and perhaps, maybe, appreciating some things that we should be mindful of that potentially headwind?

Yes. So as we've talked about on the last 2 calls, we have some kind of known tailwinds to 2024. First one being, look, in the first half of '23, we had a significant amount of underutilization, as well as accounting change impact that collectively was about $20 million that won't reoccur next year, in the first half of the year. And then secondly, we talked about -- we would see about $50 million of deflation in '23, about $30 million of that would roll off the balance sheet and hit the income statement in 2023 and $20 million, which sit on the balance sheet at year-end and roll off in 2024. So there's about $40 million kind of line of sight to upside year-over-year results. Now in fairness, we haven't really finalized yet what our investment profile will be against that $40 million, but clear line of sight to, again, about $40 million worth of one time stuff that should benefit us in 2024. As far as pricing, it's a little early to talk about pricing for '24. But I would say, we're heading back to a more traditional pricing environment after 2 years of pretty significant inflation.

Is your view that -- I mean, once again, you mentioned still early, is your longer-term view in a weaker consumer backdrop, where you guys offer a high-performance product, whether it's your exterior or your composite decking business that you should get a little pricing every year?

Yes. I think we've kind of said, given the strength of our brand, the quality of our products and obviously, the innovation and aesthetics, that this should be a space that you could push a modest price increase through the channel each year.

Great. And from a profitability standpoint, your margins in the back half is really starting to showcase some of the initiatives you guys have done. And I think EBITDA margin is going to shake out and then [ call it ], in the mid-20% range. When we look out, I mean, your longer aspirational target is call it, 27.5% and it seems like you're making a lot of progress there. Could you get there a little sooner? And what are some of the things that you need to still accomplish to kind of get from A to B? Is it mostly on the operation formulation side or you sold need a little more growth?

Yes. I joked with our teams about 6 months ago that the questions would pivot from, can you make 27.5% can you beat 27.5% only post our third quarter results. So look, 3Q gives us a lot of confidence that we're not only on track, we're probably modestly ahead. We feel really good about being able to achieve 27.5% in 2027. I think 3Q, as well, allowed us to kind of demonstrate the progress that's really been made over the last 2 years, that have been masked by a lot of inflation in the PVC markets primarily. And look, the pathway to how do we get to the remaining 250 basis points to 300 basis points here, over the next 2 or 3 years, is still in line with what we outlined at our Investor Day. The portfolio of actions are, look, we've got a lot of runway around recycling, and that's really kind of three-pronged. We can always increase the content of recycling our products. We can continue to move to lower cost, lower grades of recycling and then obviously, our ability and efficiency to convert those materials as well. And then the next biggest bucket is really product configuration and product design and then obviously, other levers like continuous improvement and likely getting some modest SG&A leverage, as we grow the business nearly double-digit.

Got you. You guys set out to get 1 billion pounds of recycled content, I think, target by 2026. Can you remind us where you are on an LTM basis? And what are some of the biggest hurdles from getting here to A to B? Is it just a technology standpoint? Is it a reformulation standpoint? What needs to happen for you to get from A to B at this point?

Yes. So as we finished '22, we were more than halfway there to the 1 billion pounds. In fairness for 2026, achieving that part of that will hinge on sort of what the volume environment looks like in the next 2 years to 3 years. As far as the opportunity, again, in front of us, kind of what's the pathway. Again, I think the simplest way to think about it is we've got opportunities to increase content. So think of our PVC deck boards, we're in the low 60s with the next ambition to get to 70%, as far as moving to lower-grade cheaper forms of recycled materials, think of our cap composite product, where we've got 90% recycled material in it already, but we have an opportunity to move from high density to low density, as a cheaper shift in material costs. And then lastly, as we continue to invest in return polymers and some of our conversion facilities, just the efficiency and cost performance around those are still pretty significant.

But from a technology standpoint, you guys feel pretty good in terms of getting it from A to B?

Yes. Again, I think the benefit for us is it's more about iteration than innovation, and that's what allowed us -- has allowed us the last several years to make really steady progress each year on all fronts.

Pete, since I got you, I care about free cash flow. I think you do as well. You've been investing on growth last few years. Give us a little flavor on how to think about how much headroom you have from a capacity standpoint. And as you kind of grow from here, the capacity ramp and how you're thinking about deploying that free cash flow you're going to be generating.

Yes. And look, I think the priorities still remain the same. Our -- the #1 investment we're going to always continue to make is in organic growth and driving capacity to match that organic growth opportunity that's outsized. Second, we're going to continue to invest CapEx around margin expansion products to help us get to 27.5% or above. Third, hopefully, there's a bit of a normalization here in 2024, and the M&A market start to come back, that we do think we can be an intelligent acquirer and add to our portfolio. And then in the very near term, supporting share repurchase program, is a significant priority for us here, especially in 4Q.

Super. On the M&A front, I mean, what are you seeing as the pipeline higher multiples? Where are some of the opportunities that you look to tap into going forward?

Yes. Look, we cultivate a lot of our own deals. We're not a big auction participants. So that cultivation is done. A lot of these are proprietary deals and family-owned businesses. So the cultivation period takes years sometimes, if you're really positioning yourself that you want to build the relationship, so that when someone is ready to sell a business, you're the first person they call. So I'd say the funnel is active, but I would also say the M&A markets are probably not back to normal yet. I would think that in the back half of fiscal '24 for us, we'd start to see some realignment or buyers valuation assumptions are better aligned to our expectations.

A question for Jon. I think there's a lot of focus in your composite decking business as it rates residential. Your exterior, trim business has actually grown pretty nicely. What's driving that growth? How should we think about that growth profile of that business, the margin opportunities? Just bigger picture of how to think about that business?

Sure. I mean I think the best analog is our decking business, right? It's a material conversion story, where people are choosing us as a replacement for wood. So it's got a lot of the exact same. You've got that long-term aesthetic. You've got the long-term warranty. You've got the low maintenance and you've got the recycling. So that's -- our exteriors business, our trim business is something where I think recycling was less of a focus, but given the capabilities we now have through return polymers and the ability to use a higher, higher percentage of recycled content. That's really been helpful from a margin perspective in that business. For us, specifically, it's downstream execution, continuing to gain share, continuing to educate consumers and contractors and the benefits of the product and driving the wood conversion, the same way we drive in the decking business. And so having the #1 and #2 brands in exteriors and exterior trim is a large benefit to us, and then we use that name recognition to drive downstream conversion.

Super.

I'd just add. I mean, our exteriors business is not dilutive from a growth perspective. It's not dilutive from an EBITDA perspective. As Jon mentioned, we on the #1 and #2 brands. It's a pure wood conversion story, leverages the material science of our PVC decking business, leverages the extrusion technology of our decking business. So it goes through the same channel in 2 steps. So it's a fantastic business.

Great. You've made some acquisitions that are more adjacent in nature. Can you talk about how that is the integration process and how bringing that in-house to the AZEK umbrella has potential to unlock opportunities going forward? And you still see a lot of runway in operating some of these adjacent categories?

So I mean if you start -- if you kind of do a historical look back, I mean, again, from -- we're just talking about exteriors with the Versatex acquisition, which was now several years ago, that gave us the second leading brand and it also gave us a portfolio of value-added products, in that segment we didn't have. And so our growth and their growth post acquisition, outpaces both of our individual growth prior to acquisition. If you look at Ultraox aluminum rail and then if you look at the most recent INTEX PVC Rail acquisition. There again, we're able to get purchasing leverage, channel leverage, sales and marketing leverage across these businesses. So again, we had similar technologies that we understand. It's a similar end user that we understand. So we get to use our brand power and our channel leverage to really accelerate growth, and some of our buying power to reduce our cost of goods sold through purchasing efficiencies. So that's the model, stick to our knitting. You're going to see us continue to pursue things well with technologies that we understand, where we have the R&D and the engineering know-how, where we had the buying power, and it's all outside the home exterior of the home and the outdoor living space. Those natural adjacencies within our Investor Day presentation, we've tried to appropriately size and profile various end markets, where we see continued opportunity.

The railing market is an interesting market. I appreciate you probably don't want to be all things [ rolling ]. But your attachment rate, I don't think it's super high. Is that an opportunity for you to grow organically or maybe tackle that on the inorganic side of things going forward?

Yes. Yes, absolutely. The answer is both. So we're attacking both organically and inorganically, and we see it as a great opportunity. The Railing segment is much more fragmented than Decking and Exteriors. We don't see there being any reason why we can't eventually have a similar share in Railing that in our Decking and Exteriors businesses.

Great. The penetration rate story has been pretty powerful on Decking, certainly, exterior trim. Has that trend shifted, slowed or accelerated in this current backlog?

So I mean, again, from our standpoint, our mission is to drive that. And so our downstream efforts are all around how do we continue to force an acceleration of that. And so we'll continue to do that with feet on the street. We'll continue to do that at the point of purchase. We're doing a lot more of that through our marketing efforts, both digitally and traditionally. Again, I think awareness and education is a key driver here. The more consumers that we can get to touch and feel the product and see the quality, see the aesthetics, then again, I understand they don't have to make a compromise. They can get low maintenance. They don't have to stand and stain anymore, and they can get a beautiful sustainable product with up to a 50-year warranty. We tell that one story at a time, and we continue to drive conversion. And then there's a big network effect in our business. There's definitely -- looking over the fence and seeing what the neighbor put in, and that tends to drive a lot of growth in the neighborhood, once folks have a positive experience with our products, they tell their friends, contractor referrals then come from that. So it's a snowball effect where you kind of win 1 consumer at a time, and continue to see that add benefits to additional conversion in the future.

That's great. I guess a question for Pete. On the commercial side of things, it's been a little noisier. We have some destocking, but the margins have actually still been pretty impressive. Can you talk through where you are with that destocking process? Preaching that business has more of a backlog when we look out to 2024, how you see commercial performing?

Yes. So I think the good news for us is through the third quarter that we just completed, the bulk of the markets that we serve on the commercial side. So graphics, marine and a lot of the general industrial markets were actually already through and complete with their channel reshuffling. The loan market that we expected to continue to see some continued inventory changes in was around semiconductor. And we still do expect to see that completed by our fiscal year end here at the end of this month. I think 2024, the way we would think about the business is kind of returned back to normal growth rates, which are kind of more GDP like. Business has done really well and executed well over the last 2 years in terms of margin expansion. We think this is a business that we can kind of maintain sort of in that 20 to low 20s percent kind of EBITDA profile.

From a channel standpoint, I would say, on your core residential business, it's been kind of noisy as well from a managing inventory, and you guys managing your inventory. Give us an update where we are in that process? Do you have a view whether or not the channel will get back to stocking at a more normal level? Or this is kind of in a new basis going forward just because your service level has really improved?

Yes. Look, I think we've been assertive all year in terms of trying to manage the channel inventory levels to a conservative profile to kind of derisk 2023. Most of this year, we've kind of been down about 10%, in terms of days on hand, with inventory in the channel at our partners as well. We've taken about $80 million of inventory off of our balance sheet since the beginning of the year through the end of the third quarter. I think the new norm is, look, we'd really like to keep our lead times low, and industry lead times low, as that's the best way to kind of make sure that the channel is not disincentivized to buy more than what it needs. So our lead times for most of this year kind of been back to sort of 2 to 4 weeks. The industry prepandemic was kind of think of it as probably around 8 weeks. During the pandemic, it went up to 14 weeks. So if we can continue to execute and manage our capacity well, we really think we can keep our lead times in line to that kind of 2 to 4 weeks through most of the season.

Okay. Great. And from a free cash flow conversion, CapEx is obviously coming down. What about -- is there anything else that you could do on the cash flow conversion side, I mean, perhaps maybe working capital?

Yes. As we kind of outlined on our Investor Day, next target for us is about 18.5% as a percentage of sales for working capital. We think that's very achievable. Most of that is going to come primarily from inventory turn acceleration in velocity. So historically, we've done around 3 to 4 turns. We dropped below that as the business down shifted here about a year ago. We're back up above 4. And at least internally, our aspiration is trying to get to 6 turns plus over the next couple of years.

Super. Last question for me on the commercial side. Does it make sense, strategically, as part of the portfolio just because the growth profile is a little more muted compared to your core residential business, if it's separable?

It is separable. Look, we've done a lot of work to improve, again, the profile of the business. So we're really pleased with a business that's seen sort of in the mid-20s from an EBITDA perspective for most of this year. Look, we are past every year, we're looking at our portfolio, and this year is no different. So we're always open to again, to manage our portfolio effectively.

Okay. That's all for me. I want to thank Pete and Jon for all the great insights. Really appreciate your support here today. Thank you.