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

All right, we are going to continue with the program. Good morning, everyone. We're going to finish off our morning session with the AZEK company. We have with us Pete Clifford as well as Jon Skelly, President of Residential and Commercial. My name remains Mike Rehaut. I cover the homebuilding and building product space for JPMorgan. So again, I appreciate everyone for being here. We're excited to be back in person after 3 years virtual and happy to say it's been a great turnout so far. So I appreciate that. I'm going to conduct another fireside chat, and we will have time at the end for Q&A. So with that, I'll kick it off. But again, Pete and Jon, thanks for your time.

So first off, maybe just jump right into it on kind of first half, second half. Maybe first -- on the first half, the double-digit sell-through that you've seen, you noted on your recent earnings call that the driver of this year's sell-through has been kind of the typical drivers of the business that you've seen over the past few years, material conversion, channel expansion efforts, new product development, shelf space wins. So looking at those different drivers, I'd be curious in terms of perhaps if you could break down, if possible, the order of magnitude, how those different drivers have contributed to growth? And how should we think about those drivers and levels of contribution going forward?

Sure. So I think just to start, as a reminder, again, the growth algorithm is sort of a base of repair and remodel market growth. On top of that, you had wood conversion. And then on top of that, we would add our initiatives, our growth drivers. So first half, we would say that the R&R was flat to maybe negative. We do believe that conversion continues. Again, a -- the typical rate of conversion is 1% to 2%. That 1% of conversion is actually worth about 3 to 4 points of growth to us. So we would say that conversion gets you to sort of mid-single digits. And then our outperformance, the reason we've been able to go double digit is through our growth initiatives. And those key drivers have continued to maintain themselves through great execution. So NPD, new product development, first and foremost, we introduced new products every year. They performed quite well. We continue to take share in both the Pro channel and the Retail channel. And so in the first half of the year, you saw the benefit of some of the new shelf space gains that we achieved at the end of last year. And then we've also accelerated our investments and our execution around sales and marketing, right? So downstream selling plus additional marketing investments. So that combination, rough numbers, right, if you're looking at a double-digit, you would say roughly half came from sort of market/conversion with not a lot of market this year. And then the balance, we kind of over -- our target is to deliver around 2%, 3% from initiatives. We did better than that in the first half, delivering about 5% from initiatives.

Right. That's helpful. So that kind of brings us then to the second half outlook. And I think you've gotten questions on this. They had been on the earnings call, just kind of thinking about, okay, first half double digit. Now you're kind of thinking still back half mid-single digit. There was an answer to a question on the call that even through April, you kind of saw that strength in the first half continue on that double-digit rate. So just kind of walk us through the moderation, so to speak, is that you're still kind of guiding to? Is it purely conservatism? Or do you actually see any elements of deceleration or moderation driving that back half outlook?

Yes. So as we mentioned on the call, I would think of it as a planning assumption and just being transparent about sort of how we're thinking about the modeling for the back half of the year and less so from a prediction of a demand environment perspective. As you're aware, we look at a lot of indicators at the beginning of the quarter and one of the things that we do is we generally connect with just under 1,000 dealers in the field as well as approximately 1,000 contractors. And most of the feedback first quarter before our call, the sentiment is sequentially modestly more positive than 90 days prior backlogs at the contractor level. We're still sort of in that 7 to 8 weeks, so very steady and holding. And basically, all of our digital metrics that we follow, whether it be web traffic to [ sample ] orders, et cetera, has all remained really strong heading to the back half of the year. So we haven't seen anything from a key indicator that would suggest any moderation in the back half of the year yet.

Right. Share gains and channel exposures, again, you talked about growth initiatives and some of the wins that you've had in both Pro and Retail, maybe just kind of take a step back, kind of give us a sense around where your market share is today versus 3 to 5 years ago? And how do you see the path to future share gains? And either that kind of answer, if we can get in a little more detail in terms of by channel or by price point? How do you see that playing out?

Sure. So I think if you start, again, the biggest platform for the business is that it's a wood conversion opportunity, right? So in the decking space, it's still a 75% wood on an annual basis and only 25% composite. So we've been definitely taking share through that conversion that we talked about. And so -- and that will continue, right? There's a long runway left for us to just continue to convert wood across price points. It's not just, again, converting at the entry level in terms of trading out composite for pressure-treated, we're also converting things like cedar, redwood, [indiscernible] at the more premium level. So then you look at the opportunity in the various channels. As we've talked about before, we've been under-indexed in retail. So there's -- definitely continues to be upside there. So when you win a share position there, that actually is pretty much a zero-sum game, right? Somebody loses a position, somebody gains a position. So you can see some of the share shift there. And the way we talk about that is as we regularly disclose retail as a percent of our sales. And if you look back 5 years ago, that was mid-single digits. We're now in the teens in terms of that position. So that's kind of the share we've had -- share gains we've had in Retail. And then the Pro channel, we have pretty consistent performance in terms of beating the market by 300 basis points, as we mentioned earlier. So if you back out the Retail share gain, the balance of that gain is going to be from professional share gain. So we have a pretty proven algorithm around overall share gain, again, through -- on top of that conversion, we're getting the gains from our initiatives. And again, sometimes it's going to be a little lumpy. Other times, it's going to be more and more smooth, but we feel pretty confident year after year after year. We're going to continue to outgrow the market and outgrow conversion by around 300 basis points.

Great. On the conversion opportunity, your competitor late last week kind of talked about a view of maybe 150 to 200 basis points of annual conversion opportunity. I recall maybe a few years ago, the annual gains being more close to like 1%, you kind of just said earlier 1% to 2%. So just kind of curious on your thoughts on that, if maybe we're at the higher end of that range currently versus previously? And if that's the case, could there potentially be any upside to the growth algorithm, if -- prior you've been talking about, okay, 100 bps, 3% to 4%, then the added growth initiatives we're talking closer to 200 that kind of changes some of the numbers?

Yes. I think from a data perspective, in terms of conversion, it's an annual process. It's hard to correlate in real time, and our view has been kind of firmly more at kind of 1% versus 2% from planning and expectations perspective. Keep in mind, our portfolio is a little bit different, right? Trim, Siding and Pergolas are all at a little bit different kind of conversion baseline perspective. And then I think just to follow on to even the last conversation is I think there's an assumption out there that all conversion is the same, right? That meaning conversion happens and it comes over at the legacy share positions. And I think with our initiatives, we're doing better than our legacy share positions on new conversion.

Okay. Would also love to hit on new product cadence and investment cycle. Obviously, a big part of the growth initiatives and algorithms to get that -- to keep those share gains running in place. I was wondering if you could describe any goals you might have around product vitality. In other words, even looking at it from a percentage of sales generated by new products introduced over the last 3 years or 5 years, what the costs are in terms of resources, R&D, CapEx with new product innovation. And if that intensity has -- or cost has increased or decreased over the last few years?

I'll kind of start on the product side. So innovation is core to who we are. It's a key growth driver an underpinning of the company, right? So every year, we launch new products. So if you followed us and you watched us year after year after year, launching something new each and every year is kind of core to who we are. So we're really focused on aesthetics, performance and quality. And again, it's going to range across the portfolio. So we're -- if you look at our business kind of good, better or best, we're probably a quarter in the good and 3 quarters in the better and best, whereas a few years ago, we really weren't a player in the good market. So that's a whole new growth channel for us that we've unlocked in being able to service that market. In addition, we've strengthened our position in the premium side of the market through product innovation across decking. So then you get some additional growth channels. We've been a market leader in exteriors. And now we've begun offering niche siding products. So that opens up a $5 billion adjacency that we can go attack. And then we also are able to launch new products to solve problems. We get a lot of feedback from contractors that your deck boards are amazing, but I'm installing them on top of less mature pressure-treated wood, and so that leads to launch of an aluminum substructure product that, again, is a new -- we used to not sell anything that went underneath the deck. And so now we can address that kind of $1 billion plus segment of the marketplace with a better mousetrap, right, with a product innovation, a powder-coated aluminum product. So it really depends on the feedback we're getting from our customers, whether it's a consumer in terms of a [ set ] preference, a contractor in terms of performance or ease of install, and then we're going to bring the best-looking highest-quality product to market to attack that. I don't know if you want to get on this.

Yes. I think we've launched just under 30 products over the last 4 years. So I think that kind of cadence and tempo kind of continues on the path forward. Over the last 2 years, our investment in R&D has kind of outpaced our revenue growth. So it's an area that we're focused on expanding and funding differently in the future. And I think, again, it all comes back to -- we pride ourselves on the fact that we think we have the best-looking product in the industry.

So is it fair to say that, I mean, what you're describing is a pretty, if I'm interpreting it right, a pretty consistent but intense cadence, it doesn't sound like it necessarily has increased or decreased. You're just trying to keep a pretty steady cadence out there. I'm just trying to -- because ultimately, what I'm trying to get a sense of is has the industry itself become more competitive from a new product standpoint and if you had to make any adjustments, but if I'm hearing it right, it sounds more like you've kept a certain level of intensity and you found that to be effective.

Yes. I don't think the competitive dynamic has changed there. I mean, our pathway is, again, to remain a leader from an innovation perspective. And again, it starts with having the best looking products. So we're going to be active every year to stay in front.

Right. You hit on also, Jon, some of the adjacent products, opportunities there, pergolas, siding. Maybe again, just to step back, the size of that opportunity, your strategy for penetrating those markets and to the extent that those also could contribute to growth over time.

Yes, sure. So I mean, again, our core opportunity is about $10 billion. So think of our kind of traditional decking, railing exteriors products. And then you move into some of these adjacencies and that unlocks another $5 billion to $10 billion of additional opportunity that we can go after. And again, these are not ideas. These are -- we're in these markets, right? So we're in the market with a siding product. We're in the market with our aluminum substructure. We are the market leader in aluminum pergolas. So it just -- it gives us an opportunity to do a couple of things. One, we're more important to our key contractors. So they go come to your house and help you build an outdoor space, and they have a broader portfolio that they can offer you, which it's great for them. It gives them a bigger job, a bigger ticket. They make more money. It's obviously good for us in terms of having a broader addressable market that we can go attack. We're pretty disciplined in terms of we know what we know. Our material technology [indiscernible] R&D are around polyethylene PVC plastics and aluminum. So we've -- we're able to provide some scale and some industry knowledge and know-how to drive good growth and good margins because we kind of stick to the technologies we understand and that gives us a lot of leverage kind of behind the scenes and I think it's a great opportunity also to build lifetime value with the customer. And so again, if we -- I'll use myself as a poster child put in the deck and then it was time to get to the porch, fix the porch, just had the house painted, took down all the riding wood trim and put up AZEK Trim in its place. So once we have a first opportunity with a customer and they realize the benefits of the great aesthetics, the quality, the low maintenance, then we -- as they continue to do projects around the home, we get to attack those projects with them with a broader portfolio.

And kind of thinking about those adjacencies, you talked about the growth initiatives in 2% to 3%, adding to the growth algorithm. And that appears to be a little bit more, but maybe correct me if I'm wrong, more kind of siloed into the core decking, railing, accessories, exteriors. Do those adjacent products add any upside to your growth algorithm? Or is it more kind of considered part of what you've laid out already?

Well, I mean, I think the answer is not now it could, right? I mean, again, a lot -- some of these -- we just launched the substructure product this year based on that performance when Pete and Jesse come to you next year and talk about outlook, we'll have a better understanding there. Same thing with Siding. We're new in the marketplace. It's a niche product. We're not trying to be a siding company, right? We're trying to replace wood like cedar. And so it's a more premium wood replacement product that we're trying to achieve there. So again, our history and our planning assumptions that we gave you around that 2% to 3% for now that holds, I just told you earlier about with some share gain, we did better so far in the first half. We're always going to strive to do better. I'm always going to push my team to do better. But again, we feel confident in the data that we can deliver that 2% to 3% consistently. And hopefully, some of these adjacencies do allow us to outperform the way we had this year.

Right. Great. One of the topics that came up on the call last week was around potentially achieving the 2027 EBITDA margin goal early, that 27.5%, I think you kind of exclude maybe some of the added investment spend or costs in the back half -- more or less there in the back half of this year. At the same time, we highlighted that recycling product configuration initiatives, you're at best halfway through, those initiatives combined about 550 basis points you laid out at the Analyst Day. So more broadly, how should we think about the longer-term and where the margins can go? I know at one point along this way, in the past, you've talked about the goal of 100 bps of expansion annually. So I don't know if that's just the way to think about it or other ways that you'd kind of direct us given that, again, it does appear that you're going to be hitting some of these numbers a lot earlier than planned?

Yes. So first, we've not updated the long-term targets yet that's something that we're working on. I'm not giving a guide for 2025. But obviously, we're very confident about getting to 27.5% early. Really, our proxy for 2Q is about 27%. And again, the back half of the year ex the investment on some of the shelf space gain really has us at 27% in almost 3 quarters in a row. Look, we're confident the levers that we have to pull that we can see in front of us. We still have, as you mentioned, a lot of recycling activity, still more iteration than innovation continuing to happen. We're still very early days on the product configuration opportunities that we've kind of laid out. We've got an opportunity with our Boise facility, which we're just finishing the last extrusion line in that facility here this quarter that will finally kind of bring us to a conclusion on kind of Phase 1 that's almost 2 years past due, just given sort of the demand environment that plant over the next 6 to 18 months probably cuts its conversion cost per pound at half just by now having real volume to run through it and optimize kind of the fixed cost structure in it. We still see a lot of sourcing savings. And obviously, as we've said in the past, I think in most years, we'd like to be able to be a modest price taker. So adding those things all up, I think we would aspire in most years to get about 100 basis points of margin lift, classic formula. I think in most years, again, if we're hitting 10% plus kind of organic growth, then we should be able to get 25 bps of SG&A leverage and 50 to 75 basis points on the gross margin line just from the things that we talked, so I think those are all kind of fair high-level assumptions.

Right. That's great.

And I'd just say, I don't think any of us believe that there's anything structurally preventing us from going above 27.5%.

Right, right. I mean the point on the Boise plant coming online and if you could again remind us if that's more of a '25 event, it sounds like. So sometimes, there are ramp-up costs, start-up costs when a plant comes online. At the same time, you're talking about some good amounts of savings coming through. How should we think about that? I mean a lot of times, management will kind of break out and say, okay, this year, we're going to be hit by x number of dollars on the startup side. At the same time, it sounds like you have some benefits that might accrue maybe earlier than normal just given some of the dynamics. Any way to think about that?

Yes. I don't know what I put time line on it per se, but we were open and transparent when we started the plant that there was probably about $8 million to $10 million of kind of initial start-up inefficiency. And that's -- I don't know that we get all of that back next year, but certainly over '25 and '26, that gives you magnitude of what kind of efficiency or productivity, I think we would get out of that facility just by running at full tilt.

Right. So the $8 million to $10 million is actually what you've seen in' '24.

It's kind of been a consistent kind of drag on each of the last 2 years running at kind of optimal volume levels.

Okay. That's helpful.

And keep in mind, as we said as well. And look, I don't know that we'll be tapping into it in '25, but '26, we have the ability to basically double the number of extrusion lines in that facility. And obviously, most of the expensive infrastructure CapEx has already been spent. So we're going to be really efficient in that facility, not just running what we have now with higher volumes, but just even the fact that we can add additional capacity and leverage that fixed cost structure even more in the future is going to be a multiyear tailwind for us.

Right. Great. I'm going to pause here. I have a couple of more questions for myself, but maybe I'll pause here if there's any questions from the audience. All right. Let me -- I'll continue and sometimes -- let the questions percolate. Capital allocation and share repurchase, $125 million year-to-date on the share repurchase side. How should we think about that longer term? And I mean it appears that operating cash flow should easily exceed CapEx in the next 2 or 3 years. So outside of bolt-on acquisitions, I mean, is share repurchase kind of the more likely use of that free cash flow? Or how should we think about that?

Yes. It is. Priority wise, look, we're going to first focus always on organic growth and margin expansion followed by kind of tuck-in M&A. But to your point, I don't know that we're going to be a large enough acquirer to consume more operating cash. So share repurchases are going to be an important part of the future. We expect CapEx levels to be normalized here over the next kind of 2 to 3 years. Free cash flow should be strong. We've got $75 million left on the approved share repurchases program that we're on right now. We would expect to be very active against that in the back half of this year and trust that there's conversations happening this summer to figure out the next program to be approved from a share repurchase perspective.

Can you speak to the share gain you alluded to on the earnings call, I think it was $4 million to $5 million, you're spending this year ahead of that. I think it was the first time you guys have called out that amount of spend. So what is that for? And will we see sell-in for that in this fiscal year? Or is that all pushed [indiscernible].

Yes. Just to give some perspective on. So first, it's actually going to be a reduction in sales. So it's actually not going to show up in SG&A. And it has to do with some retail wins that we've had, and you should think of it as sort of a onetime margin impact as you win space at some of the retailers. Many times you have to help move the inventory from the legacy OEM out. And I think in the past, we kind of talked about with one of our retailers, we've kind of hit a couple of singles over the last couple of years. And I think we described this as sort of maybe a double in terms of impact.

So that's a [ contract ] of sales.

Yes. So think of it as a discount gross to net. Yes.

And when this is sell-in.

Sell-in, we won't really start shipping product. I think the legacy OEM is there through the season in August, and we might see some modest impact in September. So most of this is kind of bankable organic growth for 2025.

And just off of that point, what is -- I think you said mid-teens for retail right now as your mix? Like what -- 5 years out, what is the number we should think about?

That's share, not mix. So their estimated market share, not the percent of their business, correctly.

Yes. I think fundamentally, your question is around the mix for us. And so obviously, we started a few years back, it wasn't a focal point. It was about 5% of revenue. So over the last 4 or 5 years, we've almost tripled kind of our presence on the retail side. About 1/3 of the industry goes through retail. I don't know that, that's necessarily our ambition, but I think it'd be conservative to say something in the 20s is probably an enviable or appropriate target. And to that point, look, it is part of our growth initiatives kind of every year looking forward, right, because of our under-indexed profile in retail, it's going to naturally want to be an accretive growth driver for us organically in the next couple of years.

I'll throw out one last one, unless there's anything else.

I'm just going to ask at retail. Can you talk about the individual products? Is this more so a wood flat composite because obviously you run the [ game ] at good, better to best and does bringing in more decking, is that bringing more trim next years Or was that already at retail where you guys had a good share?

Yes. So starting with the latter. We've already had exteriors in the stores, and that's something, again, we'll continue to look to expand, but the most recent win that Pete's talking about was a decking placement. And if you look at, it would fall in our good and better category in terms of the shelf positions we [ won ].

[indiscernible] getting some singles and doubles with one of the [indiscernible] and not other ones, why is that and why [indiscernible] such, I guess, increasing [indiscernible].

So the last year was a single with orange. This year was a double with blue, if that helps clarify. And again, these are -- typically, these line reviews are conducted once every 3 years. And then you have the opportunity in between, obviously, to try to -- you do some tailoring in terms of if you have certain outperformance in an area, obviously, we're going to be talking to our partners and seeing if there's opportunities to get into additional placement.

What about the new res channel? Obviously, Boise continues to come more and more online and a lot more capacity than you've had in the past. How should we think about either partnerships with some of the larger builders. There's production builders, obviously, a [ ton ] of custom. I don't know if this really fits in a first-time entry-level type of house. But at the same time, there's a broad market out there. So any thoughts around kind of a more strategic or organized approach to that market that certainly, it appears that there's a good opportunity there as well.

Yes. I think -- so if you look historically, our heritage has really been around the custom builder, right? So the more premium custom home, that's a very important part of our business, it has been and continues to be. So our predominant new home exposure is going to be to the architect-designed, more and more custom built home. Having said that, we also -- it's a -- so you see some of these announcements where we have a national relationship or a partnership, it's really a hunting license, right? The ground game is really important in the homebuilding sector. You have to kind of go region by region. And so that's what we've done to a certain extent at some of what I'll call the -- not at the entry-level production but at the more kind of call it semi-custom level. In certain geographies, the builder business is more important. And so we do have relationships there. We have agreements and arrangements in place in certain regions with a lot of those, again, more upper tier production players. And it's like retail for us. We're under-indexed. We'll look at it carefully. What Pete would tell you is the same way we don't want to wake up and be in every Home Depot store overnight. We don't want to wake up and be in every homebuilder overnight. Your margin opportunity at a custom builder is going to be different, obviously, than your margin opportunity at entry-level production. So we have a presence there. We'll continue to execute against it. And as you see more wood conversion, then you're going to see the consumer push the builder to say, "Hey, well, if I'm going to buy this home, I'd like to have a composite deck, not a wood deck". And so I think you'll probably see some evolution in the future as more and more builders convert from wood to our types of products that might create a better opportunity for us to continue to exploit that market.

I'd just add on the Boise piece. A couple of the things that, that plant has strategically given us is; one, I don't think that we have as many wins over the last 2 years in retail. If we don't have that capacity that we could demonstrate and show our partners that we can service the business adequately. So I think it's been fundamental to us winning that business. And then two, we've talked a lot about channel inventory and want to take a conservative position with that. And really the key to inventory levels in the channel remaining conservative is, in a lot of ways, lead time, right? And so that facility is going to allow us to really keep lead times on the decking side at 4 weeks or less, and that's critical to keep channel conservative.

Right. Great. Well, that does it with time. So we'll cap it off there. Thanks so much, Pete, Jon. Appreciate it. And thanks, Eric, for all the help. We will break for lunch. This afternoon, we have D.R. Horton, Trex, Installed Building Products, Century Communities and Stanley Black & Decker. So appreciate it, enjoy lunch, and we'll come back at 1:15.