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

All right. Good afternoon, everyone. I'm Matt Bouley, Barclays U.S. Homebuilding and Building Products. Really pleased to continue the day here with the team from the AZEK Company, CEO, Jesse Singh; CFO, Pete Clifford. So everyone's been in these meetings all day so far. So this goes, we're going to start with our audience response questions. So if you could utilize the keypad in front of you, we'll run through these quickly and then jump right into the good stuff into the Q&A. So first question for the audience. Do you currently own AZEK, overweight, marketweight, underweight or...? And for this audience. All right. New investors. Next question, please. General bias towards AZEK right now, positive, negative or neutral? We'll see what that said last year at this time. Okay. Leaning positive, but not as much as I would have thought. Next question, please. Through cycle EPS growth for AZEK will be versus peers, above, in line with or below? Okay. Audience leans towards above peers. Next question please. What should AZEK do with excess cash, bolt-on, larger M&A, share repo, dividends, debt paydown or internal investment? Wide variety, leaning towards internal investment. Next question. What multiple of '24 earnings should AZEK trade, less than 10% to above 21%? So you're going to have builders on stage at one side of that, I think with AZEK, we have to have a different set of ranges.

It's a big range.

Let's see. All right. This is on EPS, not on EBITDA. Okay. Final question, please. Most significant share price headwind facing AZEK today, growth, margins, capital deployment or execution strategy? Okay, a little bit towards growth but not a consensus, I guess. So Jesse, Pete, thank you guys for being here.

Absolutely.

I think we'll start with something just very high level. We just talked about it outside, Jesse, the idea that composite decking is sort of operating in a different world than what we're seeing in other building products categories. So we'll get into all the specifics around AZEK. But just the primary category, focus on composite decking, to your view, what has really caused the decoupling and the strength of that category relative to everything else we're seeing in building products?

Yes. Let me -- first, good to be here. We've been public since 2020, and when we went public, we had a lot of dialogue on the strength of the market and the resilience of the markets in which we play. And as part of that, we said we were a double-digit grower. We had a 10-year track record of double digits. Our 5-year track record right now is 16%, our tenure is 12. And underlying that was the link back to this resiliency. And if you take a look at the last downturn in 2009, which we referenced, the R&R was more resilient than new construction and decking was meaningfully more resilient than R&R. In fact, we mixed up during the last downturn in 2009. And so then if you take that as a backdrop, and you take a look at our growth thesis, in general, we are repair and remodel -- as an industry, we are a repair and remodel, but we are in the segment of repair and remodel, which tends to have the #1 focus. So for the last decade, AIA has listed outdoor living as the #1 area for remodel above bathrooms, above kitchens. And so within R&R, we're a real strong focus. And then within that, we have this conversion of the vast majority of the market being wood and ourselves as an industry taking a higher and higher share. So in 2020, we were saying that the market is 20% composite, we're now saying it's 25% composite and growing. And I think clearly, as you look at the performance of the industry, the underlying growth rate, not the volatility of changes in channel inventory, it's been resilient, and we believe a key part of that is that continuing wood conversion and the focus on -- the continued focus on outdoor living, which was there well before the pandemic, was there through the pandemic and continues to be a main area of focus right now in the house.

Got it. And so just to set the stage for -- not everyone may be familiar, but since you sold part of the commercial business, Deck, Rail & Accessories, is that roughly 80% of revenues or a little less than that?

It's about 2/3, give or take, of revenue.

2/3 and then Exteriors.

And Exteriors is about 1/3, it's a little ballpark.

Okay. So the Deck, Rail & Accessories is the part we're highlighting here first. So we've got this industry that has been growing mid-single digits, far outpacing for all the reasons you just mentioned, the rest of repair and remodel. And then you've got AZEK itself outgrowing the industry, right? So you didn't give a hard number, but you said kind of strong double digits for your own sell-through growth. So maybe kind of get into what are some of the building blocks that drive that difference from mid-single digits in the industry so your own growth being well above that.

Yes, I think in general, if you start to do the math between ourselves and some of the other players in the market over a couple of year stack, you'll arrive at something 400, 500 basis points, some quarters higher, some quarters lower. But in general, over that 2-year stack that would not be far from the numbers. So if you dissect that, we do have multiple product lines. And so one of the key aspects of how we operate is, we always launch new products. And those new products are either in the core or close-in adjacencies. And so if you think about our value proposition, it's using recycled products to repair or to replace wood on the outside of homes. Deck, Rail & Accessories is a key part of that; Exteriors, which is trim, primarily on the outside of homes, but column wraps and those kind of -- things that involve the white accent pieces. So new products are engaged in both those markets. That adds additional growth and has added additional growth for us. On top of that, we have the benefit of channel expansion. We are underrepresented in retail. That's given us some accretive growth. And I think in the pro channel because of our breadth of portfolio, taking those new products, we've been able to consistently expand our position in the market in both of our product lines, right, within our Deck, Rail & Accessories and also in our Exteriors products where we have continued to expand position. And so the question might be, how have you been able to do that? We were capacity constrained for a period of time. We now have additional capacity. And we have new products that are differentiated. And so both of those have been very helpful. In addition, we've got a 200-person sales force that is focused downstream on contractors, and we have incrementally larger investments at the consumer level. So those things are beneficial as you're increasing your position within -- in our case, both the pro and retail market.

So on the retail market, as you just mentioned, you've now got more capacity, the ability to serve the retail channel, category you've probably been or channel you've been, I guess, historically underpenetrated. Just how do you kind of think about where that retail penetration is today? And how much do you want to get that to?

Yes. I mean, first and foremost, our strength has and will continue to be in the pro and with the pro, right? So 88% of what we sell goes through a more professional channel. And we are, as you mentioned, underrepresented on the retail side. And I think the opportunity we have is as our products continue to penetrate consumers and continue to penetrate professionals that becomes more and more relevant as the retail channel wants to continue to grow there. So I would say, we continue to see accretive to our core growth opportunity in retail. So I think that will be additive to our growth equation and that usually comes with a lot of base hits, right? It's -- we're not swinging for the fences here. We see opportunity to continue to drive the special order part of the business and other parts of that business, both in -- in both of our product lines. So I would just say, I don't know that we have a long-term objective except to see that as an additive growth element. So we've gone from 5% of our portfolio in retail to 12%, you could certainly see that continuing the trajectory over the next handful of years.

Got it. So maybe a couple on kind of the guide and the sort of near-term shape of everything, and then we'll get back to the bigger picture. I think the implication from the guide, this was, of course, your fiscal Q1 that you're going to grow residential kind of 6%-ish for the next 3 quarters. And even if you take the Q2 guide out, it sort of implies your second half might even be flattish or up slightly. So just kind of what's the implication of that because a lot of companies that have sort of the opposite cadence of implied improvement versus you guys, it is more of a downslope. So kind of what's the potential for the second half to relative to what's currently implied in the guide -- or was it the conservatism?

Yes. As we had articulated at the end of the first quarter, much of 2023, we managed the channel down about 10% versus sort of pre-pandemic kind of historical days on hand. We ended the first quarter down about 20, which implies we're probably putting about $20 million back into the channel in the second quarter. What's implied in that guide over the 9 months is really that, that $20 million comes back out in the third and fourth quarter. Now that may be a conservative assumption as we think about it here today. But sell-through -- equal sell-through in the last 9 months of the year, and you're right, it's just under 6% is kind of the assumption on the residential basis.

Okay. That's helpful. And I guess it kind of begs the question of just channel inventory and you went through the cycle of channel effectively overstocked and then destocked, now is below normal, yet demand is still okay. I mean is this kind of the way you're thinking about the business for the next multiple years at this point? You're just not going to see the type of stocking you used to see, this industry is going to operate more in kind of a just-in-time basis?

Yes, I think lead times have kind of structurally changed, Matt, and that's really kind of the key. Pre-pandemic, a lot of the industry was sort of at 8 weeks. During the pandemic, a lot of folks went to allocation at 14 weeks. We maintained about 4 weeks for the last 4 quarters. That's our commitment to our channel. That is why, if there -- or later in the year, maybe we wouldn't be talking about putting $20 million more inventory in. But at such a critical time, right into the lead into the season, we think it's the right thing to do. And as we communicated on our last call, maybe one nuance that's different in the past is, we will probably hold a little bit more of our own finished goods on our own balance sheet, a little bit deeper into the season to ensure that we can kind of hit and maintain 4-week lead times as we think that's critical to drive the right kind of efficiency, capital efficiency throughout the channel.

Yes, I would just add that, and this may be the higher level question you have in there, we would prefer to have the least amount of inventory in the system to deliver the highest level of service, right? So that's -- there's a fundamental lean principle on inventory as waste. In our case, given the logistics and the physicality of what we sell, we sell things that are 20 feet long and weigh a bit and are difficult to deliver overnight. So you need to have it staged in the right place. You need some element of that in market, but we would prefer to continue to find ways to manage the inventory at an appropriately low level while we sustain incredibly high service, and we view service as a differentiator. And so hopefully, as we navigate through, we'll be in more of a just-in-time mindset. And I think the capacity that we have added allows us to service demand in season rather than having to stage inventory to service demand. And so I think that gives us opportunities to be more efficient.

Got it. Okay. Well said. So another couple just on the guide and all that. I mean the increase to earnings, the EBITDA was relatively commensurate with the increase in sales. And so I mean, we knew some of the things you had, right, you had deflation carrying over. You had kind of improving production economics. But just any kind of color on that bridge and sort of what really drove that unusually high incremental EBITDA relative to the incremental sales you spoke to?

Yes. I think first and foremost, on the first quarter, it was always going to be the quarter that delivered the largest kind of variance or comp to the prior year. The first quarter came in only modestly better than our internal budgets or our plan. So there wasn't any real big surprises internally. We just felt prudent that in our original guidance because the first quarter was so critical, we wanted to see that land. Second thing being, getting an opportunity to see the entire order book and backlog from the early buy negotiations. Most of that wraps up by the mid-December time frame. So we had really good visibility to what second quarter and how the season is starting to shape up. And then the third thing is just the opportunity to see 4 more months before our call around sort of what was happening with commodities. And with our lag time that just gave us more confidence that we could see that much further into the season around sort of some of the margin drivers.

Yes. And I think if you just step up at a high level, when we went public, we said we thought there was 500 basis points of opportunity. In our 2022, after some noise in supply chain, we said there was 500 basis points of opportunity. We've been working again -- of margin expansion opportunity, I should say. We've been working against that. There was a lot of noise in the system. As that noise comes out, you can see the progress against the initiatives that we had laid out. And so from our vantage point, as we look at it, it is a step-up and guide, it's totally what we expected and what we think we should deliver, and we think there's an opportunity, and we believe that there's an opportunity to continue a pace in the '25 and '26 that hopefully, we'll make our 500 basis point discussion a lot more conservative feeling as we progress.

Yes. Got it. Right. I mean I guess, depending on where you end this year, you'll be a lot closer to your Investor Day guidance of 27.5. I think the other comment you made on the call was -- or you have made is that kind of 100 basis points of annual margin expansion. So presumably, me not putting words into your mouth, but I guess 27.5 is not necessarily a cap.

Correct.

No pun intended. So when you think of 100 basis points per year, how does that kind of split between gross margin, AIMS, productivity, recycling and kind of just ongoing...?

Yes, generically, if you went back to what we laid out on the opportunity set in the 2022 Investor Day, generically, you could think about we probably have executed against about half of that 600 basis points kind of margin opportunities and projects. If you said what's maybe different next year, as you look forward, we really haven't gotten a lot of SG&A leverage in the last 2 years. We've constantly reinvested in the business. I think you'd see us in '25 kind of get back closer to that cadence of delivering '25 basis points potentially from SG&A and 75 basis points from gross margin. So maybe the optics are a little different, but we still are really, really confident in terms of the ability to kind of execute in the near term here 100 basis points a year.

Got it. So if you think about kind of 75 basis points of gross margin a year, I think at the Investor Day, and correct me if I'm wrong, but specifically, the recycling mix was meant over multiple years to drive something like 300 or 350 basis points. So I guess the question is, where are we now on that journey of that [ 300, 350 ] basis points. And sort of where do you see that getting over the next couple of years?

Yes. The quick generic answer as mentioned, I think we're probably about 1/3 of the way in terms of kind of executing that opportunity. Just a little bit of color by kind of the core pieces, we're approximately 60% kind of recycled content on our PVC deck. Target at the Investor Day was 70%. So there's still a lot of headroom there. On trim, we're approaching 40% target and the Investor Day was 50-plus. So we got some headroom there as well. On HD/LD play, we were targeting 90% in the Investor Day. Most of our fleet is going to go to 75% this year. So again, there's still some incremental headway on top of that. And look, we know that by the back half of this year, Boise becomes kind of a productivity tool for us. And we really haven't had as much volume to run through that plan as we would like. So it's a known tailwind for at least the next 2 years beyond in terms of just conversion costs and plant productivity for us.

Got it. Okay. That's helpful. So actually, I'll ask one more on the recycling side. You've made a lot of effort around PVC recycling, sort of a market that really did not exist, I would argue, a few years ago. So kind of, I guess as a 2-parter, where are we on that kind of journey of specifically PVC recycling sourcing. And then just kind of what type of advantage does it give you when you're not really seeing other competitors in that type of -- are you seeing competitors?

Yes. Just high level, we're -- if you know of, and I've asked this question, if you know of other players that are using recycled PVC as a core part of their product or strategy, please let us know. But we have a foundational belief that recycled PVC is a fantastic resource that should not be landfilled. And so we use it in our decking and that will continue to increase and it's both the cost and environmental benefit. Decking is -- has a wrap around it. We use it in our trim, which is all white trim. It has, right now, 35% to 40% recycled content. We believe we can get that higher. But there's also an opportunity for us to continue to use recycled PVC as a raw material to move into other segments. We have a paintable recycled PVC product right now called PaintPro and that allows us to move into wood-look, wood-feel applications where the product drills, cuts, nails like wood, made out of recycled PVC that -- but can access more market. And so we think that's a really important competitive position, to be in that makes us competitive right now, but it also gives us an opportunity to continue to expand. And ultimately, all of this is not about winning now. It's nice that we've got a good quarter to talk about. But really, our focus is to make sure that we set ourselves up for '25 and '26 to have the right new products, the right expansion, the right adjacencies and the right margin structure. And this expansion of recycle and PVC really sets us up really well for the future. And the other thing I'll just highlight is, PVC has some pretty significant advantages on the -- in the decking space. It has a Class A flame spread, which basically means it's really good for fire zones, the flame doesn't propagate and it looks better and it's cooler. So it's a meaningfully differentiated product in the market that also happens to use a proprietary recycle stream for us.

Great. Okay. Shift gears to the pricing side. You're very clear around this year. There was a price increase, but there's rebates. So it's not really contributor to 2024. My question is more around kind of the pricing philosophy in the industry. I guess maybe sticking on the decking side, I mean do you think this is an industry that can kind of get to annual price increases? Or is it still going to be the type of thing where year on, year off, how do you expect that to play out?

First, I think we price to value, right? We have different segmentation in our pricing, good, better, best, premium. And within those ranges, we want to make sure that we are giving a customer a terrific value against that. We think that there's -- in that value equation, there's an opportunity for inflationary-type pricing in basically all of our segments in the future. We've done it in the past, and we fully expect that we'll be able to pass on any inflation in the future.

Got it. So the audience polling question, I think, on the capital deployment gave a rather wide range, didn't seem like there was a consensus. So you're the only answer that matters. So when we think about, you've made efforts around adjacent products and M&A, right, then now you've been more aggressive on the share repurchase and all that. So kind of just update us on kind of the capital deployment priorities and then maybe we can get into the M&A side, too.

So just given time, very high level, we generate an awful lot of cash. We've deployed that cash against a buyback. We will continue -- we've got another $100 million before we reauthorize additional share repurchases. We believe that there's value to be had by continuing to buy our stock, especially given the long-term value that we expect to create. So we would expect to continue to be in the market. We have some floating and expensive debt. Even though our leverage is nearing 1, we'll evaluate debt retirement as it makes sense. And then as you look at the M&A and organic opportunities, 5% to 7% of revenue on capital gives us both maintenance and growth, we're actually adding a new facility within that 5% to 7%. So that gives us plenty of capital. We may go a little higher once in a while, but we've done a lot of the heavy lifting. And then we will selectively deploy capital against acquisitions that fit our investor deck. We're not going to try to move far field and buy something that we have to come out and explain why we bought it, right? We really like our business model. We like the opportunity to drive double-digit growth and close to 30% EBITDA margin over the long term. And we want to make sure that whatever we do enables that. Having said all that, that does leave a fair amount of cash left over, and we're exploring the options too. And depending on the day, maybe we would have put 1 in each bucket also. But I'm joking a little bit. But I do think that, ultimately, we're a growth company, and we see an opportunity to continue to deliver that cash back to shareholders. We'll figure out exactly how we do that.

Question on the competitive environment. There are -- obviously, as your largest competitor is investing in a huge facility, so when you think about just -- and even tertiary players want to be bigger in this category for obvious reasons. So what are you doing and maybe focusing on that big competitor capacity adds, what are you doing to kind of entrench yourselves? And how do you think about what could arise when a large competitor brings a big new plant online? How do you think that could disrupt market dynamics, any of that?

Yes. The simplest way to put it is, over the long term, we have gone through phases of having excess capacity and not excess capacity. But the vast majority of time between us and our competitor, we've had excess capacity. So we're sitting on excess capacity as we speak. We have the ability -- we've already done our large new site. We have the ability to scale it. Throughout all of that, excess capacity doesn't tend to change market dynamics. We're used to it. It's a key part of how we run. We need that surge capacity. We tend to grow into it. So the fact that our largest competitor might be adding capacity is probably a good sign for the industry. We don't expect it to change any competitive dynamics except that they probably need in the future, right? And likewise, our excess capacity puts us in a position where we -- since it's done, we can get scale and leverage on the investment we already have. So we've got some capital efficiency ahead of us given -- or improving capital efficiency ahead of us given that we've already done the multi-hundred million dollar investment that we can scale for years to come.

Got it. Maybe we'll do one more just on the M&A point you made. I think you made an acquisition in the pergolas space recently. You kind of envision a broader set of outdoor products that could fit into the portfolio? Or is it still going to be really kind of closer adjacencies?

I would say, closer adjacencies. We'll be really selective. It has to fit the thesis of double-digit growth, high margin, margin expansion and it has to be an enabler. And in most cases, what we will acquire will fit nicely into the pictures and presentations that we have that allow us to expand our share of wallet.

Got it. All right. Jesse Singh, Pete Clifford, appreciate it. Thank you, guys.

Thank you so much.