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

Good afternoon. I'm Anthony Pettinari. I'm the building products analyst here at Citi. And we're very pleased to kick off our afternoon session with Jesse Singh, CEO; and Peter Clifford, CFO, COO of the AZEK company. Jesse, Peter, thanks for joining us.

Thanks to you.

And I think from a format perspective, Jesse, if you want to maybe give some introductory comments, and then we'll just go into Q&A.

Yes. I thought it'd be helpful just to give a quick overview of the company. I'll share just a couple of slides. They are available on -- right about now on our website. And I think they provide a nice summary of both a Analyst Investor Day we did in 2022, along with some recent data. So if you step back and you look at who we are as a company, we basically are focused on outdoor living products. We take recycled products and turn them into sustainable products that replace wood on the outside of homes. And it breaks into 2 categories: deck, rail and accessories and exteriors. This particular picture really capture both. If you take a look at the decking material and the rail above [Technical Difficulty] rail, that falls under deck, rail accessories, and rest of the [Technical Difficulty] on this half for the most part would fall under our Exteriors business as white trim. And then you can see shingle siding and certain other accents column wraps and those types of things. That all falls under what we would define as the exterior category. One of the common characteristics that's in a subsequent slide that I'm not going to share is that we play in markets where the majority of the market is wood and our materials are replacing the wood on outside of homes. And so there's different macro trends that are out there. In our particular case, our analog to digital conversion is replacing natural materials that rote and need to be paint, stained and maintained with recycled materials. And so the macro tailwinds we deal with as an industry are the repair and remodel market which has characteristics that are driven by pretty significant demographic shifts, underbuilding, more housing formation. And the R&R market over an extended period of time has grown some place between 3% and 4%. On top of that, we are focused on what we define as outdoor living more and more investment is going on the outside of homes. And then within that, we deal with material replacement. Now within that, our -- these happen to be our 5-year CAGRs that are updated with our trailing 12 -- from our most recent announcement, which includes calendar Q4, fiscal Q1. As you can see, the core and fundamental premise of our business is double-digit growth with expanding margins. We've got a very long track record of doing that over a decade at 12% growth in the last 5 years at 16% growth. And I think the key characteristic and what differentiates us as a "Industrial" is this idea of double-digit growth and high EBITDA margins. This is a summary page really on the characteristics. I'll just give you a couple of other things in our 2022 Investor Day. We said we would achieve 27.5% EBITDA margins by 2027. Our most recent guide this year has us between 25.5% and 26% (sic) [ 26.1% ] EBITDA margin. So clearly, we're well on track there. So I won't go through any more slides, but I just thought it'd be helpful to give you an overview. In the materials, you'll see our growth stack, which is why we believe we have and will consistently grow above market, and it's driven by that material conversion and then our own specific growth initiatives, and we have a number of clearly defined initiatives that relate to new product expansion that relate to channel expansion, and we've got the largest sales force in the industry that we believe with 200 salespeople. And for a company of our size, that's a meaningful direct employee investment. So with that, if you -- I don't know if you could back it off or turn off to slides or I can just leave that up there, maybe -- it's a good preference. So.

Yes, yes. Great. Great. Thank you, Jesse. So if we look at R&R, outdoor living as a category has outperformed R&R, composite decking has outperformed outdoor living and then AZEK has kind of outperformed peers. So there's a lot of good stuff to unpack there. I'm wondering if we can start off with the growth in composite decking. And if you could talk a little bit more about some of the drivers there around wood substitution. And specifically, sort of what the runway is for that and then the kind of the value proposition that's driving that?

Yes. I -- when I started this job in middle of 2016, we were talking about 16% of the market was composite decking. When we went public in 2020, our S1 and the investor roadshow talked about 20% of the decking market being composite. And as we sit today, the most recent dialogue this last year has been 25% of the market is composite. So in that horizon, we've been converting 1% to 1.5% of the market a year. I think as this particular growth stack shows, when 25% of the market -- when 75% of the market is not you, and you're converting 1% of that market. It adds 3 to 4 points of growth every year, which I think has been a key part of the growth of the segment. I think as we look moving forward, we believe that we can go from 25% to 50% of the market being our types of materials. And our research shows that of the remaining 75% of the market that's not our materials, more than half of that is ready to be converted, we just have to educate and engage them. And what I mean by ready to be converted is they're not looking at price. They're looking at the right sort of a look and feel not too dissimilar from the house I just showed you. But it's really about extending the living space outside. So we think there's a tremendous runway not only in the decking products, but all of our products that are similar to continue to drive conversion of the market.

You touched upon this a little bit, but in terms of consumer use case, cost, ease of use, kind of visual appeal, can you just talk about how composites stack up against...

What the research shows is for the most part, right, the negative research perception on composite decking and it really relates to historically, companies having products in the market that were plasticy is the negative is I don't want to stand on a plastic deck. I don't want to feel like I'm on a fisher-price deck, right? So that's the -- that's really the -- for lack of a better term, the negative that has been overcoming. So then if you look at what's driving the conversion, which is I think where your question gets to, first and foremost, it has to look right. And if you think about our materials around $20 million, $30 million, $40 million homes all the way down to a $600,000 home, when someone goes outside, they want a living space that looks right and is consistent with the look of the house. So you need the right -- you need the right aesthetic that feels natural. So that is, first and foremost, the most important thing. Second is really around the idea that it's not going to change. And there's low maintenance, which means you don't have to spend much to take care of it, you just have to clean it. But there's this other aspect that is being more and more recognized that we just look right the whole time, like the look of the product doesn't change. And I think it becomes really important as even the most expensive woods that are best maintained, don't look right after a period of time. And then I think the third is really around the -- an appropriate value. So we have 4 different price point categories. So it has to fit the $600,000 home, in some cases, by the way, may take our most expensive product. And then -- but you want the right categorization. So people aren't shopping on price -- but they do have zones of value, not too different than a 3 series or a 5 series or a 7 series BMW or any other version you want to talk about, they're looking for the right kind of value in use. What's interesting is what I didn't say, but it's on our website that real consumers don't talk much about is what's the annual cost benefit. They look at it, but most of our consumers have already owned the deck in the past. Our ideal consumer is someone who's already frustrated. They -- you don't have to explain to them that owning a wood Deck is a hassle, right? And I could probably go with show of hands, who's on the house with a wood deck? And I think I could get plenty of customers very quickly in this room, so.

One question we still get is you're substituting for wood, obviously, lumber prices are historically pretty volatile and have been especially over the last 3, 4 years? Does the price of lumber matter?

Yes. For the most part, no. I think during the height of the elevated lumber prices in the pandemic. Lumber got to the point where it was at price parity or above in some cases, the price of an entry-level composite. At that point, the price shoppers start coming in. But in general, we're not dealing with someone who is shopping purely on that first price. So what we've seen in the data is despite the volatility of lumber, we haven't seen any change in terms of the material conversion from wood to our types of materials.

Can you talk a little bit about AZEK's own share gain and the strategies that you've undertaken to implement that? Maybe touch upon the pro channel and then the retail channel.

So at a high level, and I'll use decking as a proxy, but it's a similar characteristic in both sides of our business, right? So 2/3 of our business is deck, rail and [Audio Gap] channel in a way where we can continue to support the Pro that shops there and support the retailers and accessing the Pro. So in the last few years, we've gone from about 5% of our business to 12% of our business, give or take, coming out of retail. We would expect that to be accretive. We will always focus on the Pro significantly. That will be the dominant share of what we do, but there's an opportunity there. The second is, as we grow in the Pro, we have a differentiated product portfolio. We have certain products that our competitors don't have, and we have a very strong focus on downstream activity, we advertise the consumer in a meaningful way. There's 100,000 contractors, give or take that we interact with. We have our 200-person sales force dealing with them. And so that activity combined with differentiated products has allowed us over an extended period of time to continue to gain shelf within the Pro yards. And there's this -- and you might hear it from some of the other more industrial companies. There's a virtuous cycle of dealing with this fragmented contractor base, engaging them and having them pull through and request our product. And then likewise, the better position we have at dealers, the more contractors we access. So these are long sales processes. Some of the stuff we're benefiting from now, we started working on, in many cases, 3, 4 years back. So these are long sales processes. In many cases, family-run businesses that take a very long-term approach to who they work with.

I'm wondering, can you talk a little bit about the strength of demand that you've seen into the spring season and what your pros are telling you, what you're seeing from consumers.

Yes, do you want to touch on some of the data we've seen...

Obviously, we touch our contractors and our dealers every 90 days, sort of the key takeaways from surveys here in January were sentiment with both the dealers and the contractors improved moderately from 90 days ago. What was more meaningful was the growth expectations for the balance of this year, move more markedly. And another thing that we look at pretty rigorously is contractor backlogs. And for the most part, it's been about 78 weeks for most of the last kind of 1.5 years, and those remained steady again this quarter at just a little over 7 weeks, which is up modestly from sort of pre-pandemic levels.

And would you differentiate between retail point of sale and kind of the pro channel sell-through that you see?

Yes. I think the takeaway on the POS data we shared was that same-store sales were kind of in line or better than our Pro channel kind of sell through. And then obviously, our share pickups on the retail side were additive to that. So as Jesse mentioned, we really feel like because of we're indexing, the retail growth opportunity is going to be accretive for us for the next couple of years as we look forward.

And then I guess, a related question. I mean, there's typically sort of a seasonal destock, restock. How has that trended versus kind of a normal year, understanding we haven't had a normal year...

I would say we're back to normal. The last couple of years were probably not completely normal. So there's plenty of capacity in the system. So what's different this year versus last year. Last year, we shipped a modest amount, maybe about $10 million in December. This year, we shipped none, we really shouldn't need to. Again, if you've got proper capacitors, there's no real need to ship people product in December. Generally speaking, order patterns for early by are pretty consistent behavior early this year to last year which again would call kind of normalized. Cost of money was expensive last year. It's expensive this year. I think people are cautious being optimistic about the season. But I think we've shown people over the last 5 quarters or so that we meant that we would keep lead times in line. And when you demonstrate that, it's given us more credibility and there's probably less pressure felt by the channel to want to hold more inventory. And our philosophy in the last 5 quarters has been, we want to manage the channel inventory pretty conservatively, and we've continued to do that.

Yes. One of the -- Pete and I were just talking over lunch. The -- some of -- so if you look at our revenue volatility starting from 2020 to the end of 2023. If you took a straight line from the end of '20 to the end of 2023, you would say, all right, the company is roughly -- growth is on trend, maybe a little bit more price organic growth is tracking about right? And it would seem pretty normal. It's when you take the interim years that you see some volatility in quarter-to-quarter sales. And if you look at our underlying sell-through, which is what the last stage, our dealer sales to our contractor, it's been relatively steady for an extended period of time. Now there might be a couple of -- some quarters, there might be 20%, some that I think there was 1 or 2 quarters that were negative, maybe minus 5%, minus 6%. But in general, it has been a relatively steady sell-through rate. A lot of the volatility has just been this changes in inventory in the channel. We believe all of that is behind us, and we're back to what we sell to our -- what is sold to a contractor is what we're selling to our customers. That's the goal. There will be quarter-to-quarter variations depending on seasonality. But we've kind of gotten through what we believe is that volatile change in inventory in the channel.

Is there a way to think about channel inventories now versus pre pandemic? And are we in sort of a structurally new normal or...

Yes. I think lead times have kind of driven the need per share inventory dollars down. If you went back to kind of pre-pandemic, generically, lead times are probably 8 weeks during the pandemic. A lot of folks were on allocation at kind of 14 weeks. And we held steady through the last 4 quarters at about 4 weeks, and that's our commitment to our channel is 4 weeks through the season this year. So just on share changes and lead times, there just isn't -- there's a structural dollar difference in sort of what channel inventory needs to be.

So we've said over the last year, we're about -- we're down 10% on a days on hand versus 17% to 19% average and -- which was pre-pandemic average. Right now, we sit at down 20%. I don't know what the exact right number is, except that we do believe that less inventory in the channel is better. We believe in lean principles. And -- so we're trying to work with our channels and our service model to make sure that we have an ability to hold inventory at more conservative levels than coming into the pandemic, it's certainly well below the pandemic, but even pre-pandemic at, call it, 10-plus percent lower.

And you recently raised full year guidance for sales, EBITDA margin. Just wondering if you talk about what gave you the confidence to do that? And then on the margin side, what are some of the assumptions from a cost perspective contribution from price, just help folks understand the kind of cost.

Yes. I think if you said what did we learn or what did we want to see in the first quarter. First and foremost, the first quarter in terms of comp or prior year comp was going to be the most significant to the year. So we kind of wanted to see the first quarter. Candidly, we said on the call, our internal budget basically was in line with what we executed. We were modestly better on the top line, and rate was modestly better. But generally speaking, we weren't surprised by the first quarter as kind of what we are targeting, but wanted to see that land. Second thing is, obviously, we got a chance through the first quarter. You get the bulk of your early buyer, those negotiation orders through December. So we had a very good view of what the backlog and what sales look like in the second quarter and the margin of what we were selling in the second quarter. Obviously, another 90 days closer to the season, and then I would say just being able to see another 90 to 100 days of material input costs and consistencies and the commodities market is ultimately what gave us confidence as well as candidly with what we could see in front of us in the second quarter, it would have been very hard to tell a story on the back half of the year, candidly. And then lastly, just as far as kind of margin elements, but pricing, as we said at the beginning of the year is going to be negligible. It will be positive but less than a point. And there really isn't one lever. I mean we're executing right now across the opportunity basket set really well, whether it be recycled, whether it be conversion cost leverage to -- we've gotten additional sourcing savings above beyond commodities. So we're doing pretty well right now. And we kind of said, look, we're in a virtuous cycle right now where every incremental dollar, I mean incremental pound of production, which I'm getting a lot of leverage on, which has given me another pound to buy that's giving me deflation. It's another pound that's giving me a chance to get more recycling benefits. So hence, why we communicated 40% as kind of a way to think about the incremental margins right now in near term.

Yes, the -- as you know from our track record so far as being a public company, our intent is to always be conservative, especially earlier on in the year relative to our guide. As Pete pointed out, the margin side, I mean, we ended Q4 of our fiscal year, which is the quarter that ends at the end of September at 27%, I think it was 27.2% EBITDA margins. And so we were very conservative and actually assumed some inflation in the back half of the year to get to our original guide. So when -- it was -- it -- I think our current guide makes a lot more sense given the way we exited last year.

And Jesse and Peter, you both touched on it. But in terms of recycled content, can you talk about the importance of that for AZEK? I think you're the largest integrated PVC recycler in the U.S. and just where can that go?

So I'll just step back at a high level. During the various cycles we've gone through, being able to use recycle has been incredibly helpful. So during the run-up of raw material, we were able to increase our use of recycle and during the shortage of raw materials at some point, our use of recycle allowed us to continue to have our supply chains move forward. And as we have increased the use of recycle really, since then, it's allowed us to bring our cost structure down. But I think as important, it's allowing us to diversify our supply base such that the faster and broader we increase our recycle, the less -- the more we control our own destiny relative to raw materials, right? Because the recycled market, in particular, recycled PVC is very steady. And so now as we move forward, we're going to continue to expand the use of recycle. It puts us in a great position to be our own supplier. And -- but there's still a ton of opportunity for us to cost reduce the recycle we use. So part of it's sourcing recycle but recycle goes through its own manufacturing process to be usable. There's a lot of opportunity for us to take costs out in terms of the -- reducing the amount of cost that goes into the actual recycling process.

And where are you versus target for recycle content? I mean...

It varies by product line. I'll just give you a high level. Historically, we've given the number as -- in aggregate, call it, 56% of all of our raw material as a company was recycled materials. We've sold Viacom. We need to update that. That will go up. Viacom was one of our smaller businesses that was 100% virgin, basically 100% virgin materials. And so I think as we look at it now, we look at it within product categories. So cap -- one of our decking lines is basically 100% recycled plastics in the core. It nets out to 85% overall. Another one is 60% going to 70%. We're very much on track there. And then our -- that exteriors business, the trim business is in the 30s getting closer to 50%. And so I would say we're on -- we're very much on track on most of them. You make modifications to your conversion schedule based on various other business priorities. But in general, we're very much on track. The good news is, I mean, if you think about our margins, we're coming in pretty good relative to probably ahead of the game relative to what we guided to hit in '27. The good news is we still expect, and I said this on the call, an opportunity of 100 basis points of margin expansion in our future from where we end 2024. That's our expectation.

And for folks...

100 basis points per year, I'm sorry.

And for folks maybe less familiar with the different segments. In terms of your core markets, could you kind of talk a little bit about profitability and growth for decking versus exteriors versus Pergolism structure?

Yes. Yes. So we basically talk about the 2 segments within residential. So we have a very small segment, call it, 5% of our business, which is a legacy business. We sold one of our legacy businesses at the beginning of this fiscal year. We have one legacy business called Scranton products, which makes bathroom partitions. So it's a small part of our business, but very good at what they do. But for simplicity's sake, I'll talk about the other 95%. Within that 95%, we have that exteriors business and the decking business they operate at very similar gross margins, very similar profitability. And over the last few years, very similar growth rates. And then the rail business is part of that deck rail and accessories business. It's attached in many cases to the decking business. It's a more fragmented market that actually gives us in many ways, more growth opportunity because there's an opportunity to either consolidate through acquisitions or continue to launch new products that would give us access to more of that space. So roughly that business, in particular in the last year has maybe grown a little bit better than decking, but it's all roughly in the same domain.

And would you have any interest in sort of adjacent markets like siding or cladding or outdoor furniture?

Yes. I mean all of that is in our investor deck. I think if you think about the exteriors market, I showed you the picture earlier, that trim sits on top of siding. And there's some great siding players out there. Our intent is not to become a $5 billion siding player. But there are niche applications where our materials naturally fit and we're already selling to that contractor. So when we talk about siding adjacencies or those types of applications, it's really using our technology to access wood look or underserved opportunities in and around siding. And so that's the way to think of it. It's additive to that business. You can see that the page is still up here, our growth initiatives, new products is always going to add 1 to 2 points of growth a year. So those are examples of new products that allow us to access adjacencies. But for the most part, our core is going to be focused similarly. But within that core, there's opportunities to continue to modestly expand the portfolio.

Just to add on, on the exterior side, a couple of points worth calling out is just, look, one it is half of our decking business, as you know is PVC based, the exteriors business is almost exclusively PVC based. So it leverages our PVC by leverages our extrusion PVC technology...

And we're really the only player that uses recycling that... Yes.

Yes. So it's besides you're in the same channel.

You talked about the growth and the profitability. I'm wondering if you can talk about the kind of capital intensity of the business, cash generation and then ultimately sort of uses of cash and source.

Yes. So first question there, I'm sorry, was on?

Basically, the CapEx...

CapEx. Yes. So. Again, we're kind of back to a more traditional profile of 5% to 7%. Dynamics on that, how you should think about it is about half or approximately 50% of that 5% to 7% is kind of maintenance to support the business. The other half being both support of margin expansion as well as capacity expansion for growth. If you said what's nuanced or different maybe this year or next year, versus the last couple of years, last couple of years were pretty heavy investment in decking capacity and largely not a lot of capacity expansion in exteriors. And so this year, we've started to put up a small facility across the street from our campus in Aliquippa to add some extrusion lines and a siding line as well. So that's all kind of being funded within that kind of traditional 5% to 7% of sales. Cash generation has been very strong. We've continued to lean into our share repurchase program that was approved. We're coming off a past quarter here where we just finished in February, $100 million ASR, which brings our remaining approval authorization at about $100 million. We expect to be kind of programmatic and share repurchase activity over the balance of the year. All that said, I still think our cash generation is going to be pretty strong next year. We may even exceed expectations internally, which I think would allow us in the back half of the year for the first time to possibly be additive to share repurchases and potentially look at some debt retirement in the back half of the year.

Is there a way you think about sort of optimal leverage for the business? And then from an attractiveness of M&A, I mean, you talked about it at the Investor Day, but...

Yes. On the -- when we went public, we said in the low 2s would be good leverage. I think right now, I mean, since then, the cost of money has gone up. I think we're probably taking a more conservative view on that right now. I don't know that we've guided an exact number, but if you look at the variable part of our debt, it's not outside the realm of possibility. As Pete mentioned, that we would start retiring some of that potentially. And so -- and then even if we don't, you start looking at pretty large cash generations and net cash position that we have. So a long-winded way of saying we might probably be more in the 1s rather than the 2s. Even though right now, there's probably a high probability will drop below one, given our cash generation.

And then in terms of M&A targets, are you seeing...

Yes. I'm sorry, I forgot to answer. On the M&A side, we've done a handful of acquisitions. We've had a nice cadence of doing it. In general, we're paying -- I think our most recent one was probably close to 6x. Give or take, just if you net everything out -- and it's an additive product. It was good for the company. They have grown a nice product line that needed a home. We can plug it into our structure and then grow it out. And so we do see the potential for those kinds of acquisitions that I would define as tuck-ins. I think the key for us is we have an investor deck. We really like our portfolio. I just showed you a high level of both. I think our intent is to make sure that what we do sustains that investor deck that we're not going far field from the business model that we have. We really like high growth. We really like high 20s EBITDA margin, and we want to continue to convert wood and grow the market and keep the track record going that we have. And so we've got a pretty high bar and threshold on what we invest in. We clearly have enough cash, but the last thing I think anyone wants is for us to be having to explain a fixer upper or explain how this acquisition, everything should be about enabling the core business and moving it forward.

Any questions from the audience? I guess, Jesse, we're coming up on the shot clock here. But if you would leave us with one thing, can you just talk about sort of the importance of the AZEK brand and kind of growth that you've seen over the last 5 years?

Yes. So we have -- we've got the top 2 brands in exteriors with AZEK and Versatex. So we happen to have the fortunate situation of having 2 very strong brands there. If you're on the East Coast, or you're walking around, you're talking about exterior trim, there's no one that doesn't know AZEK in the building community. That is a very powerful brand that allows us to continue to pull products behind it in that space. I think similarly, the TimberTech brand has been the second brand in the market in terms of consumer awareness. It's really well known as a Pro brand. Part of the opportunity we've taken over the last, call it, 12 months or so and in particular, the last 6 months, well, actually, over the last 4 years, we've continued to invest in it. But we've stepped up investment in both of our brands. And I think it's really important for us if you look at what drives our differential margin, it's differentiated products, it's integrated manufacturing, including recycling. It's our strong customer connection, and it's the power of the brand. And so both these platforms, they work well together. They're in all of our dealers together on the shelf. They're at the retailers together, but they give us a platform under which we can continue to drive differentiated growth. And so brand's really, really important. And we'll continue to expand the visibility.

Jesse, Peter, thank you. Thank you.

Thank you so much.