The AZEK Company Inc. (NYSE:AZEK) Q4 2022 Earnings Call Transcript

The AZEK Company Inc. (NYSE:AZEK) Q4 2022 Earnings Call Transcript November 29, 2022

Operator: Good afternoon. My name is Emma and I will be your conference operator today. At this time, I would like to welcome everyone to the AZEK Fourth Quarter and Full Year 2022 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. Eric Robinson, you may begin your conference.

Eric Robinson: Thank you and good afternoon, everyone. We issued our earnings press release and a supplemental earnings presentation this afternoon to the investor relations portion of our website at investors.azekco.com. The earnings press release was also furnished via 8-K on the SEC’s website. I’m joined today by Jesse Singh, our Chief Executive Officer; and Peter Clifford, our Chief Financial Officer. I would like to remind everyone that during this call, we may make certain statements that constitute forward-looking statements within the meaning of federal securities laws, including remarks about future expectations, beliefs, estimates, forecasts, plans and prospects. Such statements are subject to a variety of risks and uncertainties as described in our periodic reports filed with the Securities and Exchange Commission that could cause actual results to differ materially.

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We do not undertake any duty to update such forward-looking statements. Additionally, during today’s call we will discuss non-GAAP financial measures, which we believe can be useful in evaluating performance. These non-GAAP measures should not be considered in isolation or as a substitute for results prepared in accordance with GAAP. Reconciliations of such non-GAAP measures can be found in our earnings press release, which is posted on our website. Now let me turn the call over to AZEK’s, CEO, Jesse Singh.

Jesse Singh: Good afternoon and thank you for joining today’s call. We hope everyone had everlasting Thanksgiving and we appreciate you taking the time to join us. The AZEK team delivered solid fourth quarter performance and despite a challenging macro environment, we delivered strong growth in revenue and adjusted EBITDA for fiscal 2022. I’m proud of what the entire AZEK team has been able to accomplish as we navigated through a constantly changing external environment, while continuing to provide strong service to our customers and drive meaningful innovation in the marketplace. During our Investor Day in June of this year, we highlighted that we play in large growing and resilient markets with strong tailwinds, operate leading brands with category leadership and have multiple levers to drive growth and margin expansion.

We remain confident about our markets, our strategy and our ability to deliver on our long-term objectives and goals. As we enter fiscal 2023, we believe that our business is well positioned to navigate through any macroeconomic situation and to continue the next phase of our strategic growth and margin expansion plan. For the fiscal year, we delivered $1.36 billion in net sales, generated $301 million in adjusted EBITDA, representing increases of 15% and 10% year-over-year and delivered $0.97 in adjusted diluted earnings per share. Our fiscal fourth quarter results and execution are all in line with our guidance and expectations share the last time we spoke. As previously highlighted, we expect that our Q4 to be meaningfully impacted by the lapping of inventory build 2021 and significant channel inventory drawdown.

Q4 was consistent with our expectations with customer demand remaining steady and the channel drawing down inventory levels. The destocking we saw in the channel was primarily in our deck rail and accessories business, where we generally saw consistent positive sell through growth on a dollar basis and modest declines on a unit basis. This resulted in a meaningful drop in our net sales to our channel partners. We were able to hold our balance sheet inventory steady by lowering production levels in Q4 to the levels required to meaningfully draw down the necessary inventory from the channel. We have plans for continued lower production volumes in fiscal Q1, 2023, before we expect to increase our production levels starting in fiscal Q2. Because of our aggressive actions to move quickly past this period of under-utilization, we expect to see the greatest financial impact in Q1 and early Q2.

From a demand indicator perspective, our recent contract survey highlighted continued backlogs for the remainder of the year with many of our contractors booking into 2023. However, over the last few quarters their concerns have shifted away from material availability toward economic uncertainty and labor availability. We also saw consistent consumer engagement with leads and samples continuing to show year-over-year growth within the quarter and a continued modest year-over-year decline in web traffic. Our strategic initiatives are on track with strong growth in new products, pro-dealer channel expansion and positive retail channel point of sale trends. Our recycling expansion continues to progress as expected and we exited Q4 having achieved a key milestone in our expanded use of recycled PVC for our advanced PVC decking lines.

These decking products are now made up approximately 60% recycled materials, an increase from approximately 55% at the beginning of fiscal 2022. We also saw strong performance from our commercial segment with sales and segment adjusted EBITDA growth driven by the combination of net price realization and operational discipline. In fiscal 2022, the rapid increase in inflation during the year created a lag in our ability to deliver desired margin and deferred our margin expansion as pricing lagged raw materials. As highlighted on our last quarterly earnings call, our price cost margin coverage has moved to a net benefit and we have been running with higher recycled rates, which will provide us a cost benefit as we move through coming quarters.

We have also taken steps over the last two quarters to bring down our overall SG&A expenses, while continuing to invest in customer activity and market expansion. And we have made the conscious decision to prioritize certain customer investments in Q1, while reducing activity in Q2. As we look back on the quarter and the fiscal year, we have made significant progress in executing against the plan we laid out at the beginning of the year and against our long-term goals that we highlighted at our Investor Day in June of 2022. We operate with a clear strategy to drive above market growth through market conversion, new product innovation, multichannel expansion and a best-in-class customer journey and market expansion through adjacencies. We have a clear operational strategy of expanding the use of recycle and leveraging our AIMS program to drive increased profitability.

And our focus on ESG is a core part of how we operate and who we are. We once again received multiple awards for our culture and focus on ESG. Most notably, we were recognized by CohnReznick in their inaugural Gamechangers in ESG award, highlighting AZEK’s leadership in driving positive change for our people, our customers, our communities through ESG. We are also proud to be need to the list of America’s most trusted companies by Newsweek based on fair treatment of employees, opportunities for career development and employee compensation and trust in the company’s values, leadership and customer facing communications. In addition, we continued our history of innovation in new product development by launching multiple new products in the year.

In our exteriors segment we took home the HBSDealer Golden Hammer Award for AZEK’s Exteriors Captivate, Prefinished Siding and Trim for its innovation and value. In decking, we received Architizer A Plus product award for TimberTech’s Landmark Collection for decking in the sustainable design category. Finally at our acquired structure business unit, we are proud to have officially launched Cabana X, a non-permanent, high quality, high-tech cabana to AZEK’s pro channel and to commercial applications. This new product expands structures already robust product portfolio. Moving to our outlook. Our business is overwhelmingly focused on the repair and remodel market, with strong long-term tailwinds driven by the combination of favorable demographic trends and an aging housing stock.

AZEK is also experiencing the positive impact of a sustained focus on outdoor living in a material replacement from traditional wood products towards our long lasting and sustainable products. Industry data suggests that there are around $60 million decks in the US and approximately half are estimated to be beyond their useful life. A meaningful part of our decking business is driven by this need to replace wood decks. The large installed base and natural obsolescence for materials such as wood, helps drive our material conversion opportunity. These strong tailwinds combined with company-specific strengths around new product innovation, portfolio breadth and best-in-classes esthetics, collectively, we believe AZEK is positioned to drive above market growth and margin improvement.

While we continue to see solid contractor demand and continued interest in our category. We expect the macro-economic environment will likely impact our business in 2023. For planning purposes, we are assuming that approximately 50% of our business that is new construction focus will see high teens decline from a volume perspective. We are also assuming repair and remodel activity will be down mid to high single digits. These assumptions are based on a number of industry projections that include the impact of recent interest rate moves on new construction and the broader economy. The combined impact of new construction and R&R leads to our planning assumption of a 10% decline in volume excluding the contribution from acquisitions and pricing in fiscal 2023.

Using this assumption, we would expect to deliver $250 million to $265 million of adjusted EBITDA in fiscal year 2023. As a reminder, we are exiting 2022 with a number of positives on the margin front, including positive price, recycled benefit, productivity and a moderating raw material environment. We expect the majority of our underutilization to impact Q1 and part of Q2. In fiscal 2023, we expect an approximately $8 million impact from an update to the process by which we estimate the value of our inventory. This incorporates our increased use of recycle materials. A significant part of the impact is expected to occur in Q1 and early Q2. We expect to see the benefit of our margin and sourcing programs in Q3, as we work our way through higher cost inventory in the first half of 2023.

Our assumptions for the back half of the year include continued price realization, commodity deflation that we are already experiencing, completed productivity actions and our current recycle rates. Pete will provide more detail in a moment, but with the visibility we have in our costs in the balance of the fiscal year, we are confident that we are in a strong position to navigate the next few quarters and expand our margins as we move past the first quarter. We’re also confident in our ability to execute our business model to drive incremental market penetration and growth. Now, let me turn the call over to Pete to provide some additional context on our financial results and outlook.

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Peter Clifford: Thanks Jesse and good afternoon everyone. As Eric highlighted upfront, we have uploaded a supplemental earnings presentation on the Investor Relations portion of our website. First, I wanted to provide some color on the operating environment during the quarter. As Jesse mentioned, the demand environment has remained relatively stable. The sell through profile was positive on a dollar basis and modestly negative on a unit volume basis. This backdrop has allowed us to make real progress in taking inventory out of the channel with our partners. The 4Q inventory reduction in the channel was in line with expectations. From an operating perspective, the focal points for 4Q were around getting our conversion costs down as much as possible to match the significant drop in production levels without hurting the future.

It is important to note that we held our balance sheet inventory levels flat, sequentially quarter-to-quarter. Production levels were down more than 40% in the period. On the commodities front, we saw the bulk of our purchases portfolio remained stable in the quarter, with the exception of PVC resin, which saw a decline during the last 10 days of September. Since the close of 4Q, we’ve also seen softening in other key commodity inputs. This is a positive news for the business in the long run as it sets us up to recapture lost margin during 2022, while we were playing catch up on inflation versus pricing. There is an approximately a 4.5 month lag on purchase price variance positively impacting our income statement. Therefore, we will not fully realize the impact of that deflation until late 2Q and into the second half of 2023.

For the full year fiscal 2022, I’d like to reiterate Jesse’s point that we’re proud of the results we delivered in a very disruptive environment. To quickly recap, full year net sales were $1.356 billion, up 15% year-over-year, while our adjusted EBITDA was $301 million, up 10% year-over-year. For the fourth quarter of 2022, we saw net sales of $305 million, modestly above our guidance. Net sales declined 12% year-over-year, driven by the previously communicated channel inventory reduction and we are well on track to achieving normalized channel inventory levels by the end of the current quarter. During the quarter, we updated our process by which we estimate the value of our inventory. The primary update was made to include more consistent and predictable recycling introduction rates into our inventory valuation.

The resulting impact reduced our inventory valuation by $19.3 million during the quarter. It is important for us to do this given the significant progress we’ve made in our recycling introduction rates, which are now more consistent and the stability of our operations has made delivering the impact more predictable over time. Our business will benefit from the improved clarity and predictability around our margins. 4Q ’22 gross profit decreased by $40.4 million or 36% year-over-year to $71.9 million inclusive of the previously mentioned update and process, by which we value our inventory. 4Q ’22 adjusted gross profit decreased by $16.2 million or 12% down year-over-year to $114.2 million. The adjusted gross profit drop was in line with the decline in net sales.

Note, there is approximately at two-month lag on our labor and overhead, which will push some of the cost pressure into fiscal 1Q ’23. Selling and general administrative expenses increased by $7 million to $67.5 million or approximately 22.2% of net sales. The bulk of the year-over-year increase was the impact from the contribution from acquisitions and transaction related expenses, partially offset by one-time lower incentive compensation as a result of the reduced outlook in fiscal 2022. Adjusted EBITDA for the fourth quarter was $65.1 million, in line with guidance. Adjusted EBITDA declined 20% year-over-year, driven by lost volume leverage with the decline in both production and net sales levels. Net income for the quarter was a loss of $4.8 million or approximately negative $0.03 per share driven by the previously mentioned inventory valuation process update.

Adjusted net income for the quarter was $24.5 million for adjusted diluted EPS of $0.16 per share. Note that our effective income tax rate in fiscal 2022 was negatively impacted by increased state tax expense recognized in the current period, which reduced our earnings per share by approximately $0.02. Now turning to our segment results, residential segment net sales for the quarter were $254 million, down 16.7% year-over-year, driven by the previously mentioned channel inventory calibration impact, which was largely in our deck, rail and accessories business. The exteriors business saw positive growth year-over-year and the acquisition of structure contributed approximately $24 million in the fourth quarter. Residential segment adjusted EBITDA for the quarter came in at $64.5 million, which was down 30% year-over-year.

Commercial segment net sales for the quarter were $50.4 million, up 23% year-over-year. We saw double-digit growth at both our Vycom and Scranton Products businesses. Commercial segment adjusted EBITDA for the quarter came in at $14.6 million, an increase of $8.5 million year-over-year. Margin expansion was driven by favorable price commodity coupled with productivity. The Commercial segment team continues to exceed expectations. From a balance sheet cash flow perspective, we ended the quarter with cash and cash equivalents of $120.8 million and approximately $147.2 million available for future borrowings under our revolving credit facility. Working capital defined as current assets minus current liabilities was $348.1 million. We ended the quarter with gross debt of $678.1 million, which included approximately $78.1 million financial leases.

Net debt was $557.3 million and our net leverage ratio stood at 1.9 times at the end of the fourth quarter. Net cash from operating activities was $40.1 million during the quarter versus net cash from operating activities of $89 million in the prior year period. Capital expenditures for the quarter were approximately $31 million. During the quarter, we executed share repurchases of $23 million or $1.1 million shares. The remaining authorization under our share repurchase program is approximately $319 million and we will continue to look to act opportunistically to make repurchases. Our capital allocation priorities remain the same, as we previously communicated. As we turn to the outlook, let me provide some context and color on what we are seeing and assuming for the balance of the fiscal year.

Let me first take you back to our Investor Day back in June 2022. We articulated a sensitivity analysis in June that if our volumes were down approximately 5% in 2023, we can hold our adjusted EBITDA approximately flat on a dollar basis. The outlook that we’re providing today has two specific adjustments to the sensitivity shared at our Investor Day in June. First, our fiscal year 2023 planning assumption is volume down 10%. Second, on the incremental 5% volume drop from the 5% to 10%, we are assuming 50% decrementals driven by the first half of the year. The planning assumptions we are providing on this call should not be considered formal guidance. We are simply being transparent on our assumptions that we are planning the business around.

Our planning assumption of a 10% decline in volume, drives us to a target range of approximately $250 million to $265 million of adjusted EBITDA for the full year fiscal 2023. A few other planning assumptions to share, we expect lower capital expenditure spending in fiscal 2023 in the range of approximately $70 million to $80 million, which is approximately $100 million less than fiscal 2022 as we enter a period of more normalized capital spending. Similarly, we expect to generate significant year-over-year free cash flow in fiscal 2023. The strong free cash flow defined as operating cash flow, less capital expenditures will allow us to support our repurchase program in 2023. Additionally, we expect full year SG&A, excluding the carryover impact from acquisitions and more normalized management incentive compensation will be flat to down year-over-year.

For additional planning assumptions to assist with modeling full-year 2023, please refer to the supplemental earnings presentation that we posted on our Investor Relations website. Before we turn our guide for the first quarter, I wanted to provide context for the operating environment that we expect in fiscal 1Q 2023. Sales volume is expected to be down approximately $85 million in volume year-over-year or a 30% plus decline in sales volume driven by an inventory correction in the channel and the lapping of inventory fill from 1Q ’22. This has affected landline with what we highlighted on our last earnings call. We are well on our way to achieving normalized channel inventory levels at the end of the quarter. Similarly, production volumes are expected to be down approximately 30% year-over-year.

Just to reinforce these factors, we are making intentional decisions to deal with the impact of right sizing our channel inventory and lower production volumes in the near term. As a result we will have under-utilization flowing through in both 1Q and 2Q and labor and overhead. During the quarter, we will continue to burn through our higher cost inventory layers and we are lapping the impact from recycled costs being period expense in the prior year to being capitalized in 1Q 2023. Within SG&A, we have prioritized investments in certain sales and marketing activities in 1Q that will not reoccur and the balance of the year. For 1Q 2023, we expect consolidated net sales between $200 million to $215 million. We expect adjusted EBITDA between $8 million to $12 million.

In closing, it’s important to highlight some of the key elements that our implied outlook for the balance of 2023 between 2Q and 4Q, which include channel inventory normalization of 4Q, 2022 and 1Q, 2023 will be behind us. We had material input cost deflating in 1Q ’23 that will impact our results meaningfully in the third quarter post our lag. We expect production volumes to normalize in the second half, positively impacting utilization and setting the stage for productivity. We anticipate sales volumes will recover significantly from the 1Q 2023 seasonally low and channel inventory impacted profile. We expect the whole price in our core markets. And lastly, given the environment we think that we might see more commodity started to play. I’ll now turn the call back to Jesse for some closing remarks.

Jesse Singh: Thanks, Pete. I would like to take a moment to thank our dedicated team members, channel and supplier partners and contractors that support the AZEK company. Thank you once again for your continued focus, dedication and your contribution to the results in the fourth quarter and for all of 2022. The fundamentals of our business are strong as is our confidence in the future. We are well on our way to restoring normalized channel inventory levels and the actions we have taken position us well to realize the benefits of our recycling and sourcing initiatives late in Q2 and into Q3. Given our visibility to cost, we are in a strong position to navigate the next few quarters and expand our margins as we move past our fiscal first quarter.

Our award winning new product not only solidify our position in the core, but give us an opportunity to continue to drive material replacement. Our acquisitions, our expanded exteriors line and our constant innovation and decking and rail have put us in a position to continue to gain market presence and share. We have a clear strategy an AZEK-specific initiatives to drive above market growth and we believe that we are well positioned to win and deliver on our long-term goals. With that, operator, please open the line for questions.

Q&A Session

Operator: Thank you. Your first question comes from the line of Keith Hughes with Truist Securities. Your line is now open.

Keith Hughes: Thank you. First question on the raw material commentary helping out in the second half of fiscal year, can you give us any sort of indication how big a number this is playing in the EBITDA guidance for the year highlighted earlier?

Peter Clifford: Yes, Keith, this is Peter. I think I’ll start just generically on how we’re thinking about deflation. First and foremost, we’re comfortable and confident that we can start to recapture some of the margin that was delayed last year, what the price commodity lag starting in 2Q 2023. As far as what we’re seeing so far quarter-to-date in 1Q 2023, as I mentioned in my prepared remarks, we are seeing significant lower purchase input costs in 1Q, 2023. Keep in mind with our balance sheet lag of the 4.5 months, some of that won’t start to roll off until March of 2023. But obviously that implies and means that we will also have some carryover deflation into 2024. From an assumption perspective of what’s embedded, the way we’re thinking about and how you should think about, what’s embedded in the EBITDA profile as we expected about $50 million of annualized deflation, of which about $30 million of that will actually hit fiscal 2023 EBITDA with the remainder being a carryover favorable deflation to 2024.

Keith Hughes: And to be clear that $30 million assist here in ’23 just said is that, is that based on what you’ve seen so far, are you assuming some more deflation?

Peter Clifford: I think what gives us a lot of confidence is based upon the prices were seeing quarter-to-date 1Q. We don’t need prices to go down much further to support the $50 million and the $30 million. So obviously if the commodity markets to continue to turn in our favor, then obviously there’s potentially some upside.

Keith Hughes: And then one final thing to this, I assume in the guidance you’re assuming selling prices for products remain flat other than the roll through pricing actions you did this calendar year, is that correct?

Peter Clifford: Yeah, we’re not assuming any change the list prices.

Keith Hughes: Okay, great. Thanks. That’s very helpful. Thanks.

Peter Clifford: Yes.

Operator: Your next question comes from the line of Matt Bouley with Barclays. Your line is now open.

Matthew Bouley: Hey, good evening, everyone. Thanks for taking the questions. So given the guidance for margins, you’ve alluded to for Q1 and then the step up beyond Q1. I mean it sounds like you pointed to a few things, the production levels should increase, you’re burning through some of the higher cost inventory. I mean, should we think that the cadence of margins is going to be kind of consistent in terms of that sequential increase beyond Q1 or is there going to be a more meaningful step up in the second half. Just given where you’re starting in Q1, it’d be helpful if you kind of walk us to some kind of framework for the second quarter there? Thank you.

Peter Clifford: Yeah, at a really high level, Matt is, look, we’ll obviously see sequential improvement from 1Q to 2Q. We still have a little bit of pressure in 2Q. As you are aware, our labor and overhead lag is about two months. So some of the inefficiency in 1Q will push to 2Q, but our production levels, we really expect to start to normalize in the back half of the second quarter and recover to a much healthier level. And then we would expect an even more meaningful step up from 2Q to 3Q and that again probably a more modest step up from 3Q to 4Q. So obviously with 1Q guide and the full-year outlook, you get back into the nine-month profile. And again the second quarter will be below that average and the third and fourth quarter would be above that, if that helps give some context.