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

Hi, guys, I'm Phil Ng, Jefferies' Building Products Analyst. We're delighted to have the AZEK team here. Representing the company, we've got Pete Clifford, CFO and COO; and Jon Skelly, who heads -- President of North America on the Residential side.

So guys, I mean, I think AZEK's in a pretty unique position and environment where the consumers weakening, R&R is still pretty challenged. And you seem to kind of power through that. So just kind of give us the recipe of what's driving that outperformance and how sustainable is that going forward?

Yes, I'll start Jon, you can pile on. I mean, look, we have a secular story that's unique, right, the composite decking, that 75% of the market is still wood today with typically 1% to 2% converting to composites each year on a new deck build and one point of conversion in our space generically is about 4 points growth for the whole industry. So one thing, secular story unique. Second piece to that secular story is I think that many times, folks assume that, that 4 points of growth for the whole industry comes across at legacy share positions. And frankly, we really think that our downstream capabilities and processes in most years, yielding us more than that, let's say that 4% for the market. Obviously, that means someone else is getting less. Secondarily, look, we're just uniquely positioned by our starting point in our baseline that about 1/3 of the industry goes through retail to purchase their composite decking. For us, it's approaching about 15% of our sales with the Lowe's win that we've communicated for next year. So almost certainly, over the next couple of years, retail is going to remain an accretive growth opportunity for us. And it's difficult at times we talk about sort of how do you differentiate or how do you separate conversion activities from commercial initiatives. But for us, we kind of tend to really focus on the tactical piece of it. And for us, conversion is really about 4 things. It's number one, it's getting now downstream, and Jon's team's fighting out street-by-street to get contractors who build wood decks to convert to build composite decks. Two, we're going to continue to be on time and on point with the right colors and the right collections for new products. Third, we've got to continue to battle to make sure we're getting the product placement and the shelf position with both the pro and retail partners. And then lastly, we got to continue to influence the influencer. So making that customer journey as simple as possible for people to make their decisions on decking projects.

Right? I mean, you guys were very underpenetrated in retail when you first went public. You've made some great strides there. How should we think about that opportunity, call it, 3 to 5 years as well as new construction, which isn't as big? Are those opportunities going forward, call it, 3, 5 years?

Yes. We certainly think so. Again, I think as we've talked about with retail, we like to hit consistent singles and doubles, right? So if we can just continue to execute. As we execute well, it gives us really good data that we can go back to our partners with and show them the power and the growth that they're able to generate with our brand and with our downstream efforts. So we'll continue to execute against that while roughly 1/3 of the market, we'll go through retail. We don't have to be 1/3 of the market, if we can, again, just continue to hit singles and doubles and take that 15% to 20% plus, we view that as a success. And certainly, on the builder side, while they're national builders, it's a very fragmented space. You have to kind of go market by market, region by region to win that business. But we think some of the new product introductions that we have and then some of our ground game execution will allow us to gain additional share in the building market as well.

Got you. And how have you approach your go to market? I mean you built out your downstream sales effort and then the product offering has been a little different as well. Just give us a little more color on how you kind of approach that in recent years to kind of drive some of the share gains?

Sure. So Pete did a terrific job of, again, defining the growth algorithm, right? And so it's execution against that. So first and foremost, converting that contractor, installing wood to convert them to our type of materials that's going to be downstream sellers who are literally in front of that contractor in front of that builder on a daily basis driving that conversion, right? Once you start to make some of those connections too, and you capture that new wallet, then we can start trying to expand our share of wallet with that contractor. So if they're a deck builder, maybe they're just going to be able build decks. But a lot of times, we have a lot more general contractors who they might be doing decking one day, they might be doing siding and trim the next day, right? So we have the opportunity with the breadth of our portfolio to grow our share with that individual over time. As we've talked about before, our penetration is very different depending on which part of the country, which markets you're in. So we're going to have targeted downstream efforts in underpenetrated markets not just in underpenetrated channels. So that's going to give us an opportunity to get above market growth when we're able to grow faster than the market in a geography where we don't have the same level of penetration. So those are a couple of examples of situations where we're utilizing our downstream efforts and momentum to drive additional share gains.

And what part of the country are you underrepresented on a penetration standpoint?

Yes. So historically, I think the strength of Composite Building Materials has really resided where we sit today. If you kind of look at from Maine on down through what we call the lower Mid-Atlantic, you're going to see stronger penetration than you kind of get from Coastal Carolinas, Florida through Texas up into California, that's much less penetrated for our types of products or our types of materials. So we're playing the long game in those markets. One other thing we've done from an execution standpoint is we've put a lot of additional marketing focus on some of those core target areas. So in the past, we might have done a much more sort of national investment from a marketing standpoint. Now we're picking some spots and saying these are some core geographic areas we want to penetrate. And so we're turning up the volume on our sales and marketing efforts in those markets to make a differential impact.

Okay. When we look at some of the retailers out there, whether it's Home Depot or Lowe's, we've talked about a weakening consumer, some of the bigger ticket discretion, you guys have seen in as well. Give us a little color on what you're seeing in the marketplace right now. I mean, I think you guys skew more towards the high end, but any increased choppiness in recent months?

Yes, a couple of points there. So from a product mix perspective in our business, generically, the opening price point is about 5% of our sales. So it's pretty limited. But at that OPP, we have seen POS sort of moderate over the June-July time frame. For us, it's still positive. Generically speaking, the special order business has been resilient, has kind of been high single digits as a general statement. So again, I think our indexing to the premium has really helped us here through this season.

On your last call, you were talking about -- I think you and Jesse and team were talking about how some of these companies today idiosyncratic drivers should put you in a pretty good spot even if R&R is flattish. Can you help unpack what are some of those levers for 2025? And is that a mid-single-digit opportunity at some points? Just help us contextualize some of those self-help levers next year?

Yes. I mean, I think first and foremost, something that's kind of here that we've kind of built into our culture is genuinely, our teams are not standing around all day trying to figure out what the macro is going to be. We spend our time focused on what we can control. And we wake up every morning with the same mission, how do we figure out, how to grow 5 to 7 points, 5 to 7 points on top of whatever R&R, if it's flat, if it's down 4, if it's up 4. So in most years, traditionally, we've had a solid carryover, but what's unique maybe about 2025 is there's 2 things. So first and foremost, we talked about a recent win with a retailer where we picked up a stocking position. It's called the [ Blue Retailer ], and kind of monetize that as sort of a double. So it's about $30 million is how we've talked about sort of an expectation. A little bit of that will be in the month of September, but the lion's share of that is really going to be in 2025. And as we announced with our last earnings call, we picked up a distributor in Canada. It should bring, let's call it, high single-digit kind of million dollar kind of opportunity. So I would say our carryover opportunity walking into 2025 is probably as good as it's been in the last couple of years.

Super. And then Pete, since you are the COO, actually were as well on the operations front, the big part of the AZEK story was on the self-help and continuous improvements out of things. I think you identified about 500 basis points. Where are you with that journey and what's left?

Yes. So I think you're referring to Page 149 in the 2022 Investor Day presentation where we laid out in a pretty granular way sort of how we see the levers for margin expansion within the business. Generically, I would say we've executed about half of that opportunity. We still got plenty of headroom, really in all kind of 3 or 4 phases of the recycling kind of opportunities. And again, just to remind the opportunities we've got an ability to move to cheaper lower grades of recycled material. It's primarily a cap wood opportunity. So a fair amount of our fleet has started transition next year earlier from 50% LD to 75% LD. We paused a bit of that here to get through the Lowe's fill-in opportunity and make sure that, that goes flawlessly. Late in our first quarter, we'll be back at converting the rest of our fleet to 75%. Again, generically, we've kind of said aloud that a pound of LD is about half of the pound -- cost of pound of HD. On the PVC deck side, we're approaching kind of mid-60s from a recycling content. That's not entitlement. So there's more room, more headroom to grow there. And on the exterior side, we look to exit probably this year approaching 30% recycled content. And probably with more of an outsized opportunity there simply because we're starting from a lower baseline of content on the exterior side, coupled with the fact that we continue to launch more new products that are paintable. And when they're paintable, it's much easier for us to crank up the recycling content in those products. And then the fourth wheel in there in recycling is just us looking at our conversion costs. So really our time and cost to convert scrap materials that we source back into resin pellets that can be used in the extrusion process. So we've got room on all 4 phases of the recycling effort. We still have product configuration as well as continuous improvement, and we really haven't tapped SG&A leverage over the last couple of years. And I think with R&R getting back, hopefully here soon to 4% to 5% when we are growing to double digit, we really think we can still fully invest and fund the business from an SG&A perspective and still get about 25 basis points of leverage in most years.

Pete, that sounds like a really long list. So 250 basis points seems like you're selling yourself short. So hopefully, we're going to update in the not-so-distant future on that front. From a recycling standpoint, what are some of the gating factors at this point? Is it just timing? Are there -- you need more capacity in recycling side? Is it more know-how? Can you just kind of help us think through what are the next steps?

Yes. So on the LD, HD side on the cap wood, it's pretty straightforward. We need time. Again, I don't know if we've got quite 1/3, but earlier this year, we had converted a meaningful amount of the extrusion lines in Ohio, again, paused that a bit to get through our fill in here. That will restart. I know we would be disappointed if we don't have the full fleet to 75% as we exit next year. So that's kind of an immediacy in front of us. On the recycling side, it's always been more about the PVC side. It's been more about iteration than innovation. So we've been pretty consistent on the deck side to get 3% or 4% kind of content increase each year. It's got a similar profile to when we talked about LD versus HD over the commodity cycle, generically speaking, a pound of recycled PVC is about half the cost of virgin. And so there, it's about continued iteration.

With Boise up and running, you kind of talked about product reconfiguration. What are some of the opportunities there in terms of unlock in terms of cost savings? And then, I guess, more importantly, from a cash flow conversion, how should we think about your ability to ramp up capacity and then the capital intensity of that?

Yes. So let's talk about capacity and CapEx and cash flow. I know we can maybe talk about sort of product configuration. But generically speaking, we said CapEx would normalize over the last 2 years. It has, it's kind of been back to that 5% to 7% of sales after being pretty elevated to build out Boise for 2 years. We just finished commissioning our last extrusion line at Boise to complete Phase 1. So really, that's about 2 years past the original time line. So we've really been in a position in the last 2 years where we've been a bit suboptimal in Boise. But now we're coming out the other side where this will be the first quarter as we exit, where we'll have probably the original planned production volume to stand up against those assets. So obviously, when I think about next year, I've got -- even if production volumes were -- for pounds we're flat next year at [indiscernible] on 1Q, 2Q and 3Q and next year obviously we expect to grow. So whether it's 2 years or whether it's 3 years, I really think we have an opportunity to likely reduce our conversion cost per pound maybe by half as we think about Boise, and that's just fully utilizing kind of Phase 1. I don't think we'll be spending any CapEx in 2025 on Phase 2. There's probably some modest CapEx spend in '26 because of the lead times for extrusion lines and some of the equipment that I suspect we'll need some of that maybe in 2027. But a reminder on Phase 2 for Boise, it is going to be very asset light. I don't need any more buildings. We've built a space that basically can allow us to double our extrusion lines without any new rooftops, [ real color lines ] are in, blending systems are in, conveying systems are in. So the CapEx price tag is going to be much lower. And obviously, that will be another secondary way to get a lot of conversion cost reduction that I'm not going to need a second plant manager. I'm not going to need a second blending team. So we will leverage that site for at least the next half a decade to help us drive really good incrementals, if you want to call it that. And from a cash flow perspective, we've put up very good numbers last year, expect to follow that up this year as well. We said at our Investor Day, you should think of us as kind of high teens, probably very high teens kind of percentage of sales for free cash flow from operations, that 5% to 7% for CapEx kind of points to a sort of 10% plus free cash flow as a percentage of sales.

And as you kind of ramp up capacity at Boise, it sounds like it's -- you still got a lot of runway, whether it's 2026, 2027, would you still be able to run at 5% to 7% on a CapEx standpoint?

Yes, I do. I mean, the only thing we've kind of talked about is that we might be irregular, let's call it that, is we don't own one of our facilities in Scranton over some of the disposition activities we had, we may choose to do something different there.

Okay. From a capital deployment standpoint, Pete, how are you thinking about balancing it between buybacks and M&A?

Yes. I guess one of the things I'm probably most excited about of late is, look, the last 120 days it finally feels like the M&A market has kind of returned to normal. There's a lot of better assets in terms of -- in the funnel. The quality of the assets is better. People are past the valuation gap of sort of if you didn't sell your business at the end of COVID, it probably took the last 2 years to kind of get people grounded back to valuations that make sense. So our priority is going to continue to be if we can find the right bolt-on acquisitions that are not dilutive from a growth perspective, right down the middle, go through our channel, wood conversion stories. Hopefully a plan or material science knowledge and extrusion capabilities that we can pay reasonable prices for and get synergies as well as -- and arbitrage on sort of the multiple we pay with where we trade. We're going to make that the first priority after supporting the business organically. And then from a buyback perspective, I would categorize the philosophy as, look, we're going to be programmatic in one sense that we're always going to have some flow just based upon the strength of cash flows. But I think in most quarters, we'd like to allow ourselves like this past quarter to be opportunistic; if we see a dislocation that we might do a larger ASR in a quarter than maybe it wasn't planned initially.

Are there any product categories that stand out from an M&A standpoint? And then at your Investor Day, you also highlighted a drive and push to grow your railing business. Where are you on attachment rate side of things? And is that going to be driven by inorganic opportunities? Or are you going to try to grow it internally?

So both, so good team there, Phil. So from an M&A perspective, we definitely view rail as an attractive category. It is fragmented. There are a number of players of relative size in that area that aren't transformational acquisitions, they'd be tuck-in acquisitions. So we definitely view that as a great consolidation opportunity in the future. Also organically, we're addressing that market. We talked on our last call about entering steel rail marketplace. And so if you think about what we've been able to do across the decking portfolio with a full development of a good, better, best premium portfolio in decking, we now see the opportunity to do it organically and also the acquisition on the railing side to where again, our leaning today is a bit more on the best premium. And so we see a nice opportunity to provide a balanced portfolio across railing organically. You'll see some more product introductions from us in the future on that and then selectively via M&A.

Where are you from an attachment rate standpoint? And where would you like to be?

I think other than a pure railing company, there is no deck company that has an attachment rate anywhere near the share of our decking rate. So we're part of that club. And so it's -- we've been able to increase it. Railing this year has grown faster than our decking business. And so we've added an attachment rate here this year. Our expectation is we're going to be able to continue to do that in the next couple of years.

Okay. Your Exterior business, from what I can tell, is growing pretty similar to your Deck, Rail & Accessories business. I wanted to show a little more love on that Exterior business. Just walk us through the strategy there and some of the drivers going forward and perhaps the market structure.

Yes. I'll give you my infomercial on the Exterior business here. So it's about 25% of our revenue as a company and it has probably been grossly underappreciated over the last half a decade. But if you look back over the last 5 years as a general statement, it has grown in line with our decking business, which is saying a lot. It is not dilutive from a gross margin perspective. It's not dilutive from an EBITDA perspective. It goes through the same 2 steps of distribution, and completely leverages our PVC recycling technology that supports half of our decking business, which is PVC. It's PVC extrusion material science at its core as well. And I would argue it's probably modestly a bit more asset-light than even the decking side of the business. In the near term, we've kind of said that this is the primary exposure for the company in terms of new starts is within this. We've kind of said that, of that 25% of sales, about half is new starts exposed and half is R&R. So this is where we are gaining some modest impact from interest rates. So we have seen the business moderate a bit. We were kind of flat to modestly positive in the first half of the year and the back half of the year, we expect to be flat to modestly down single digits within the space. But again, this is an area of the business, we said, hey, if there are rate cuts, where would you possibly see a tailwind? This would be one of those parts. It's kind of front and center that we would expect to benefit from.

Okay. Perfect segue. We're all expecting rates to come down at some point. I mean it seems like your business is very agnostic, but what do you need to see to kind of reaccelerate that R&R backdrop that's been a good guy for you in the years past?

Again, we can't control the marketplace. We can't control what the R&R spend will be. What we do feel good about is our execution to deliver growth above and R&R has improved, right? So we feel a lot more confident about, as Pete mentioned, that 500 basis points of growth above whatever the R&R market is. We feel much better about our ability to execute there. So we're not going to sit around and wait. We do believe that R&R has been down for a while. We're hopeful it will come back, but we're planning for if it doesn't come back, we're still going to deliver our above-market growth. So probably not a direct answer to your question, but again, we can't predict that. Even the experts can't predict it. You look at 4 different estimates of what R&R is going to be next year, you have 4 different answers. So we're just going to clinch on to our execution and try to deliver that above-market growth.

And I'd just -- I'd add in at the end is, look, we've said, we don't have a lot of HELOC exposure. The view is sort of 15%, but that 15% is probably almost completely on away over the last 1.5 years, and obviously, even on the decking side, that would be a piece of the business you would hope that would probably give us a modest tailwind.

Super. From a portfolio construction, are there any odds and ends in the portfolio that you're still thinking about whether it's a good fit to keep long term? You've obviously done a lot on the Commercial side, but help us think through that.

Yes. I mean, we've kind of said we want to be a residential business, and we want to be a business that's heavily weighted towards R&R and we like the ratio we have now, it's 80% plus kind of R&R and the rest being primarily new starts. We did the work we had to do on Vycom. We didn't feel like we were the best owner for that asset. We still have Scranton Products, that's part of the portfolio. I would just say, again, all of our capital and our commitment and resources is continuing to go into becoming almost exclusively a residential business that's R&R focused.

Okay. Well, guys, thanks for all the great insights. Thank you. Really appreciate your time.

Thank you.

Thanks very much.