The AZEK Company - Q4 2023

Transcript

Operator (participant)

Welcome to the AZEK Company's Q4 fiscal 2023 earnings call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question and answer session. Please be advised that today's conference is being recorded. I'd now like to hand the conference over to Eric Robinson. Please go ahead, Eric.

Eric Robinson (VP of Finance and Investor Relations)

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 by an 8-K on the SEC's website. I am joined today by Jesse Singh, our Chief Executive Officer, and Peter Clifford, our Chief Operating Officer and 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 the 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. 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 our 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 (CEO)

Good afternoon, and thank you for joining us. The AZEK team once again delivered strong results this quarter, including a 27.6% net sales growth year-over-year, a net profit margin of 11%, and a record Q4 Adjusted EBITDA margin of 27.4%. Our residential business grew 37.6% in the Q4 and approximately 5% year-over-year, delivering an eighth straight year of net sales growth. I'm very proud of how the AZEK team was able to navigate in an uncertain market and consistently deliver against our commitments. The team outperformed by driving above-market revenue growth and by delivering against productivity initiatives, resulting in significant Adjusted EBITDA margin expansion in the second half of the year.

Our focus on cash conversion and capital allocation throughout the fiscal year, including working capital efficiencies and disciplined capital expenditures, delivered strong free cash flow generation of $274 million and returned $115 million to shareholders through share repurchases. AZEK's sales performance was driven by continued double-digit sell-through growth in our residential business overall and in each of our leading deck, rail, and accessories and exteriors categories, which outperformed in an uncertain repair and remodel market. We saw growth in both our residential pro and our retail channels as we benefited from the execution of our initiatives. In addition to our shelf space gains and core decking and trim growth, we saw great results from new products and cladding in our exteriors business and aluminum rail in outdoor living.

Our residential segment's 5% year-over-year net sales growth in fiscal year 2023 is stacked on top of 12% growth in fiscal 2022, and 35% growth in fiscal 2021. On a calendar year basis, we see similar results, with the business growing 31% in calendar 2021 and 4% in calendar 2022 during the inventory unwind within our channel. We expect this growth to continue in this calendar year. Assuming the midpoint of our December quarter end guidance for calendar 2023, we would expect our residential segment to grow approximately double digits year-over-year in calendar 2023. We believe that this highlights not only the resiliency of our subsegment, but also the specific and unique capability of the AZEK growth model.

Our fiscal Q4 margins improved significantly, and we delivered 750 basis points of Adjusted Gross Margin to 45% and 600 basis points of Adjusted EBITDA margin expansion to 27.4%. As we realize the benefits of excellent execution by our operations team, delivering on productivity initiatives and increased production levels while reinvesting in marketing and branding. Cash conversion and disciplined capital expenditures continued to be a focus, and in the Q4, we generated Free Cash Flow of $92 million, growing $83 million year-over-year. Our strong Free Cash Flow generation during the quarter supported approximately $61 million worth of share repurchases. Channel inventories have been conservatively positioned through our fiscal year-end, and we are proactively managing our finished goods inventory levels to maintain high levels of service.

In addition, the business has operated with normalized operating and inventory cadence, with lower lead times and our channel partners continuing to purchase as needed and managing inventory below historical averages. In October, we also announced the sale of our Vycom business, which closed earlier this month. Vycom is a great business and is a leader in industrial plastic sheet manufacturing. We believe that the transaction puts both businesses in a better position to achieve future success. This strategic move simplifies our portfolio and further focuses AZEK on our strategic higher growth and margin opportunities in the repair and remodel and outdoor living markets associated with our residential segment. As stated in our strategy, we also take a portfolio approach to revenue growth and margin expansion.

During 2023, we successfully launched new products, including TimberTech Advanced PVC Landmark in Boardwalk and TimberTech Composite Reserve in Reclaimed Chestnut, along with railing options and an expansion of our exteriors portfolio. We recently hosted hundreds of our contractor and dealer partners at our TimberTech Championship PGA TOUR Champions event, where we had the opportunity to engage in valuable discussions, gather feedback, and preview our new products for the 2024 building season. Among these product launches are the introduction of the new and improved TimberTech Composite Terrain+ collection, new TimberTech aluminum substructure framing, new TimberTech railing, horizontal cable infill, and new AZEK Exteriors bevel siding. We are expanding our position with the homeowner with better style, design, and performance, and strengthening our already strong position with the pro, with an expanded offering of products that increase contractor labor, productivity, and efficiencies.

Our partners are excited about the opportunity created by these new products. During the year, we continued to make progress on our recycle initiatives and increase the amount of recycled content we use in our TimberTech Advanced PVC Decking and our exteriors products. We also expanded the geographic reach of our high recycle content PaintPro Prefinished Siding and Trim solutions, and welcome Lumbermen's and Wausau as new prefinishing partners. The expansion enables us to provide high-quality prefinished siding and trim from the Northeast to Washington State. Overall, we are well positioned to capitalize on the momentum from both our shelf space gains and brand awareness increases in 2023, as well as our slate of new products for 2024. We are also pleased to be recognized for several workplace awards this past quarter.

For the first time, AZEK was named a 2024 Best Company to Work For in the Construction and Materials category by U.S. News & World Report, as well as a top Chicago workplace for the third year in a row. One of our core values is the best team wins, and we're pleased to be recognized for our commitments and actions towards this shared goal, further strengthening AZEK's position as an employer of choice. As we look towards 2024, we are confident in our business strategy and our ability to deliver long-term above-market growth and margin expansion. Key digital metrics highlight continued elevated interest in our TimberTech brand, and we continue to see growing consumer engagement, with website traffic, leads, and sample orders showing year-over-year growth during the Q4.

Outdoor living spaces have been ranked the No. 1 most popular home exteriors remodel for the last 10 years, according to the American Institute of Architects. Our October quarterly pro contractor and dealer surveys indicate they remain busy and have a cautious outlook for growth in 2024. Contractors continue to have backlogs of approximately eight weeks overall, and anecdotally, some have indicated that their sales process is returning to a pre-pandemic normal. In addition to the stability of our existing contractors and dealers, we continue to expand our network, allowing us to access more of the market and drive increased share and wood conversion. In fiscal 2023, we added over 1,000 contractors into our Pro Loyalty program, driven by continued education and awareness of the composite category and the TimberTech brand.

We continue to see positive residential sell-through growth and demand indicators, such as our customer surveys and digital metrics, remain constructive as we begin the fiscal year 2024. While we continue to see favorable demand indicators, we acknowledge the continued macroeconomic uncertainty, mixed consumer confidence, and the potential for a slower repair and remodel market. Our fiscal year 2024 planning assumptions assume a flat to down repair and remodel market, and consistent with our historical track record, we would expect to outperform the market, driven by AZEK's specific initiatives, including material conversion, channel expansion, new product innovations, and customer journey initiatives. We believe that our business model, combined with our margin opportunities, will provide us an opportunity to continue to grow sales and EBITDA for our residential business in fiscal 2024.

For the full fiscal year 2024, we expect that the sale of the Vycom business will reduce commercial segment sales by approximately $77 million and adjusted EBITDA by approximately $17 million on an annualized basis. Taking that adjustment into account, AZEK expects consolidated net sales in the range of $1.335 billion-$1.395 billion, and adjusted EBITDA in the range of $320 million-$335 million. Adjusting for the Vycom sale, our net sales guidance would imply 3%-8% year-over-year growth and 15%-20% year-over-year adjusted EBITDA growth. Peter will provide more context on our guidance as we continue to see the opportunity to drive above-market growth and margin expansion. I will now turn the call over to Peter to provide some additional context on our financial results and outlook.

Peter Clifford (COO and CFO)

Thanks, Jesse, and good afternoon, everyone. As Eric highlighted at the beginning of the call, we have uploaded a supplemental earnings presentation on the investor relations portion of our website. Before we get into the Q4 and fiscal year 2023 results, I wanted to take a moment to reflect on the past year. When we offered our planning assumptions back in November 2022, we were operating in an uncertain environment. At the time, the market was digesting the unknown impact of the Fed's cumulative interest rate hikes on both the repair and remodel spend and consumer sentiment. At the time of our guidance, we were getting questions around: Would material conversion continue in a down market? Would pricing hold in a deflationary environment? Would we see the expected deflation and a slowdown?

Could we manage our plants effectively from both an efficiency and capacity perspective to seize the upside if the market were better than expected? Could we manage our channel inventory conservatively and keep best-in-class service levels? Could we drive strong cash conversion to support a repurchase program to take advantage of dislocations? On all of these points, the AZEK team was able to effectively manage the business and outperform expectations in fiscal 2023. Our new product development and growth initiatives drove continued material conversion. We were able to sustain pricing in a more normalized commodity environment. We appropriately managed capacity and manufacturing costs, and we were able to quickly react to stronger second season by ramping production while continuing to maintain industry-leading service. And finally, our strong results and healthy cash generation allowed us to support our share repurchase ambitions during the year.

To sum it all up, we had set challenging targets at the outset of the fiscal year in a period of uncertainty, and we led the business to exceed those commitments. When we talk about fiscal 2024, we once again encounter a similar economic backdrop. Despite this backdrop, we have confidence and credibility to deliver in fiscal 2024 based on the execution we demonstrated in fiscal 2023. As Jesse mentioned upfront, during the Q4, we continued to see a positive demand environment in the residential business. Sell-through remained equally strong through the season, and contractor backlogs have been stable for the last four quarters at approximately eight weeks. At the same time, our digital KPIs remained strong, and we used our positive sell-through and results to continue to accelerate investment and brand awareness in both the quarter and the year.

We believe we are already reaping the benefits of these brand investments. From an operating perspective, our production returned to normalized levels in the Q4, albeit up substantially year-over-year, due to the lapping of a large fiscal 4Q 2022 channel inventory reduction. We continued to maintain strong service levels during the quarter while executing against our own full-year inventory reduction plan, drawing down inventory year-over-year by $79 million. On the commodities front, key raw materials have remained stable at meaningfully lower input costs, supporting our material savings. The combination of double-digit residential sell-through growth, coupled with strong execution against our material savings, conversion costs, and recycling initiatives, helped us achieve record Adjusted EBITDA margins during the Q4.

For the Q4 of fiscal 2023, we grew net sales by 28% year-over-year to $388.8 million, which was above our guidance expectations. The Q4 growth was driven by the strength in the residential segment, partially offset by declines in our commercial segment.... For Q23, gross profit increased by $77.8 million, or 108% year-over-year to $149.7 million. For Q, adjusted gross profit increased by $60.6 million, or 53% year-over-year, to $174.8 million. Our adjusted gross profit margin percentage increased 750 basis points year-over-year to finish at 45%.

The adjusted gross profit increase was driven primarily by material deflation, manufacturing productivity, execution against material cost productivity initiatives, and a one-time utilities reimbursement of approximately $2 million. SG&A expenses increased by $17.5 million to $85 million. The bulk of the year-over-year increase was driven by our continued commitment to make investments in marketing and brand awareness. Adjusted EBITDA for the Q4 increased by $41.3 million, or up 63% year over year to $106.4 million. The adjusted EBITDA margin rate for the quarter increased 600 basis points year over year to 27.4%. The primary driver of the year-over-year change in adjusted EBITDA was the impact of material deflation, manufacturing productivity, execution against material cost productivity initiatives, and a one-time utilities reimbursement of approximately $2 million, partially offset by continued investment in marketing and branding.

Net income for the Q4 increased by $47.4 million to $42.6 million or $0.28 per share. Adjusted net income for the Q4 increased by $29 million to $53.5 million, or adjusted diluted EPS of $0.36 per share. Now turning to our segment results. Residential segment net sales for the Q4 was $350 million, up 38% year-over-year. Within the residential segment, we saw positive growth in both deck, rail, and accessories and exteriors, while our StruXure Pergola business navigated some destocking during the year. Residential segment adjusted EBITDA for the Q4 came in at $118 million, up approximately 83% year-over-year. Residential segment adjusted EBITDA margins were up 830 basis points year-over-year to 33.7%.

Commercial segment net sales for the quarter were $39.2 million, down 22% year-over-year. These results were in line with our previous quarter's commentary and expectations. Within our commercial segment, Vycom net sales came in at $17.5 million, down approximately $8.6 million year-over-year. Commercial segment adjusted EBITDA for the quarter came in at $9.2 million, a decrease of $5.3 million year-over-year. Within our commercial segment, Vycom adjusted EBITDA was $3.3 million. It is important to note, despite a softer demand backdrop, we were able to hold our EBITDA margins for the segment at 23.6% in the quarter.

From a balance sheet and cash flow perspective, we ended the quarter with cash and cash equivalents of $278 million, and approximately $147 million available for future borrowings under a revolving credit facility. Working capital, defined as inventory plus accounts receivable minus AP, was $223 million, down $118 million year-over-year. We ended the quarter with gross debt of $672 million, which included approximately $79 million of finance leases. Net debt was $394 million, and our net leverage ratio stood at 1.4 times at the end of the Q4. Net cash from operating activities was $127 million during the Q4, an increase of $87 million year-over-year. Capital expenditures for the quarter were approximately $35 million.

For the full year, fiscal 2023, Free Cash Flow increased by $339 million year-over-year to $274 million. As expected, we were active during the quarter with our share repurchase program, repurchasing approximately $61 million worth of shares at a weighted average of $32.70 per share. Given the strength of our cash position, we expect to be active again in the fiscal Q1 with our share repurchase activity. As a reminder, the remaining authorization under our share repurchase program is approximately $202 million. Our capital allocation priorities remain the same. As we previously communicated, we will continue to invest in our business, both organically and inorganically, and to the extent we have excess cash flow, we will look to repurchase shares opportunistically.

As we turn to the outlook, let me provide some context and color on what we are assuming for the upcoming fiscal year. As a reminder, we announced the divestiture of our commercial segment's Vycom business in October 2023. Starting in fiscal 2024, from a reporting perspective, we expect to combine all corporate expenses into the residential reporting segment, and we'll continue to report Scranton Products within the commercial reporting segment. In other words, the new residential segment Adjusted EBITDA definition combines residential EBITDA plus corporate expenses. We believe this change in segment reporting will help investors more easily compare our residential business with fellow building products peers. To assist with modeling, Vycom net sales and Adjusted EBITDA ended the fiscal year 2023 at $77 million and $13 million, respectively.

As a result of the divestiture, we will incur new expenses associated with an arm's-length supply agreement between Vycom and Scranton Products to supply sheet, with a total additional impact of approximately $4 million per year. Adjusted EBITDA for fiscal 2024 as a result of the transaction will be impacted by approximately $17 million, which is reflected in our planning assumptions for fiscal 2024. As previously communicated, the Vycom sale will result in cash taxes of approximately $21 million-$23 million, and an effective tax rate of approximately 53%-56% in the Q1 due to the gain on the sale, and a 32%-33% effective tax rate for the full year. Normalized to exclude the gain on the sale from the Vycom transaction, the effective tax rate is approximately 27%.

I also wanted to revisit the previously communicated known carryover tailwinds that we have headed into fiscal 2024, adding to our confidence and conviction heading into the year. As a reminder about what we've discussed over the past few quarters, we experienced approximately $20 million of negative impact from underutilization in the first half of fiscal 2023, which we expect not to reoccur in fiscal 2024. We also carry approximately $20 million in known deflation currently on our balance sheet, which will flow through the P&L in 2024. The sale of Vycom business modestly reduces some of the underutilization and deflation carryover tailwind by approximately $5 million, and we will continue to expect to invest in marketing growth activities.

Finally, on the revenue side, recall that in prior year, 1Q23, we experienced approximately $30 million-$35 million of net sales headwind from our channel inventory reductions, which we expect not to reoccur in fiscal 2024. With that context, let me move to the planning assumptions for fiscal 2024. We are assuming for the full year that repair and remodel will be flat to down low single digits. For the items in our control, we are confident in our execution skills and ability to continue to drive above-market growth. We are carrying over AZEK specific initiative wins into 2024. We will lap the 1Q23 channel inventory reduction, which gives us confidence in our ability to grow our residential net sales by approximately 5% year-over-year in fiscal 2024 at the midpoint of our planning assumptions.

The sum of these carryover impacts and growth assumptions drives our high-level planning assumptions for the year to $1.335 billion-$1.395 billion in revenue and $320 million-$335 million in Adjusted EBITDA. Adjusting for the Vycom sales, our net sales guidance range would imply 3%-8% year-over-year growth and 15%-20% year-over-year growth in Adjusted EBITDA. Our residential segment planning assumptions for the year is $1.262 billion-$1.318 billion in net sales and $306 million-$319 million in segment Adjusted EBITDA, representing 3%-8% sales growth year-over-year and 18%-23% segment Adjusted EBITDA growth when combining corporate expenses with our residential reporting segment, as mentioned earlier.

A few other assumptions to share include the following: We expect strong gross margin performance, enabling us to continue to invest in growth-oriented marketing and brand awareness initiatives. We're expecting capital expenditures in the range of $70 million-$95 million, consistent with our publicly stated target of CapEx of approximately 5%-7% of revenue. We are expecting depreciation of approximately $87 million-$90 million. We are targeting working capital reduction of approximately $10 million-$20 million for the year. And finally, as detailed earlier, we are expecting a GAAP tax rate for the full year of 32%-33%. For additional planning assumptions to assist with modeling fiscal 2024, please refer to the supplemental earnings presentation we have posted on our Investor Relations website.

Before we turn to our guide on the Q1, I wanted to provide context for the operating environment we expect in fiscal 1Q2024. For the quarter, we are expecting sell-through growth in the mid- to high-single-digit range, which, as we know, is a seasonally smaller quarter as much of the country winds down the building season. From an inventory staging perspective, we expect the channel to remain conservative in line with last year's behavior. As a reminder, this is the period of the year in which the industry negotiates shelf space positions and stages inventory in the channel ahead of the upcoming building season. AZEK historically ships the majority of our channel inventory build, otherwise known as early buy, in our second fiscal quarter, and we are assuming that effectively all of this volume will ship in fiscal 2Q2024.

Channel inventories were positioned conservatively at fiscal year-end, and we are proactively managing our own finished goods inventory levels to maintain high levels of service. As a reminder, we are lapping a fiscal 1Q 2023 channel inventory reduction of approximately $30 million-$35 million. From a margin perspective, we expect to have approximately $20 million of carryover benefits, including approximately $10 million from lapping the prior year's underutilization and $10 million of deflation in the Q1. Taking these factors into consideration, our guidance for the quarter is $230 million-$236 million in revenue and $45 million-$48 million in Adjusted EBITDA. Adjusting for the Vycom sale, our net sales guidance range would imply 17%-20% year-over-year growth and $33 million-$36 million year-over-year growth in Adjusted EBITDA.

We are expecting an effective tax rate of approximately 53%-56% for the quarter, which again, is higher as a result of the gain on the sale of Vycom business. Our team is excited, engaged, and well prepared to tackle the environment in front of us in fiscal 2024. With that, I'll now turn the call back to Jesse for some closing remarks.

Jesse Singh (CEO)

Thanks, Pete. I would again like to thank our dedicated team members, channel and supplier partners, and contractors that support the AZEK Company. Thank you for your contribution and a strong finish to the fiscal year. We remain incredibly excited about the long-term material conversion opportunity ahead of us in the large and fast-growing outdoor living and home exteriors market that AZEK plays in. Our residential segment has continued to show remarkable resiliency and growth capability. The business has delivered a compounded annual growth rate of 11.6% over the last 10 years and 17.7% over the last five years. Our fiscal year 2023 results reflect the strength of our industry-leading position, our focus on strategic growth initiatives, the resiliency of our markets, and the significant margin expansion opportunities ahead of us.

Our strong free cash flow generation puts us in a great position from a capital allocation perspective to invest in growth opportunities and opportunistically participate in share repurchases. Our team's focus on operational excellence to drive above-market growth and margin expansion across any market condition, puts us in a position of strength as we begin fiscal year 2024. With that, operator, please open the line for questions.

Operator (participant)

If you would like to ask a question, please press star followed by the number one on your telephone keypad. If you would like to withdraw your question, again, press star one. We ask that you limit yourself to one question and one follow-up. Your first question comes from the line of Tim Wojs from Baird. Please go ahead.

Tim Wojs (Senior Research Analyst)

Yeah, hey, guys. Good, good afternoon. Nice job. Maybe just kind of starting on the sales guide. So, I guess at the midpoint, you're guiding, you know, about 5%-6% residential growth, in an R&R market that's maybe down, you know, 1%-2%, so 7%-8% outgrowth. Maybe just talk about, you know, the big pieces of that and, you know, kind of what, what's internal, you know, what do you kind of have visibility to? And, you know, if there is outperformance in your eyes in fiscal 2024, does it really come from internal initiatives, or is it really gonna be a better market at this point?

Peter Clifford (COO and CFO)

Yeah, Tim, this is Peter. Yeah, the geography of the 7% there, about two points of that is the inventory lap, and then the other 5% is really our initiatives. And I would say right now, a little more than maybe half of that is carryover from commercial initiatives and shelf space wins from last year at both pro and retail.

Tim Wojs (Senior Research Analyst)

Okay. Okay, good. And then just on shelf space, I mean, was there anything, I guess, unique in fiscal 2023 on some of the shelf space gains? Just double-digit, you know, kind of sell-through growth. I think it's faster than what some of your peers are reporting. I'm just kind of wondering if there's anything in there that's kind of chunky, or is it really just, you know, representative of some of the investments you guys are making?

Jesse Singh (CEO)

Excuse me, by the way, I apologize for my voice. Apparently, I've been talking to customers a bit too much here. So, yeah, you know, relative to your question, most of the pickups we've had, you know, expansions that you talk about were pretty normalized volume feathering in. And so, you know, as Pete pointed out, you should think of it as we expand our position, you know, there's not a huge amount of sell-in. A lot of it is just incrementally being added to a position which then yields benefits, you know, month to month. And obviously, we added it, you know, in some cases at the beginning of last year, in some cases in the middle of last year.

So you start to see the benefit as we move forward. And just as you highlighted, you know, we saw double-digit sell-through growth in both of our core channels, both retail and in the pro channel.

Tim Wojs (Senior Research Analyst)

Very good. Good luck on the year, guys. Thanks.

Operator (participant)

Your next question comes from the line of Keith Hughes from Truist. Please go ahead.

Keith Hughes (Managing Director of Equity Research)

... Yeah, thanks. Building on that, you talked about double-digit sell-through in the quarter, kind of mid-single digits in the fiscal Q1 is coming up. I guess the question is, has something slowed, or is this a function of comps, or take a conservative stance? Can you just talk around what's happening in these periods?

Jesse Singh (CEO)

Yeah, you know, there's a natural question of, you know, where we sit now, have we seen any kind of a slowdown, from what we described in the Q4? And I would say things continue, as we've seen it in the last quarter as we moved into this quarter. We just think it's appropriate, you know, given that December tends to be a light month, to assume a more conservative average as we go through-

Keith Hughes (Managing Director of Equity Research)

Right

Jesse Singh (CEO)

... the end of this quarter. But in general, things have continued pretty consistently for the last six months, last six months with that double-digit sell-through growth. And, if we do happen to see some incremental volume, I mean, we would, we would probably use that as best we can to, you know, to, to manage inventory even more conservatively in the channel.

Keith Hughes (Managing Director of Equity Research)

Okay. And we're at the point that your customers, your distributor customers, are just ordering to replace things that are going out the door. Is that correct?

Jesse Singh (CEO)

Yes. Yeah.

Keith Hughes (Managing Director of Equity Research)

Yeah. Okay. One final question: in the reported quarter, in your guidance, have you seen or are you expecting any price, or is the growth we're describing here all volume?

Peter Clifford (COO and CFO)

You should think of price as kind of negligible, for the year to be modestly positive, but again, negligible, both quarter and-

Keith Hughes (Managing Director of Equity Research)

Okay. Great. Thank you very much. Thank you.

Operator (participant)

Your next question comes from the line of Matthew Bouley from Barclays. Please go ahead.

Matthew Bouley (Equity Research Analyst)

Hey, good afternoon, everyone. Thanks for taking the questions. Staying on the same topic of sort of outperforming the end market growth next year, did I hear you say that a lot of that outperformance is actually just kind of the carryover of some of the wins that you built on last year? And so if that's the case, my question is, you know, do you have line of sight to potential for new business wins, you know, additional new products as you kind of roll out through the year, things like that? Things that are sort of reminiscent of your Investor Day, where you spoke about that kind of annual, you know, internal drivers of above-market growth.

Is there room for additional, you know, beyond just that kind of carryover that, that you're speaking to?

Jesse Singh (CEO)

Yeah, you know, first on the point of carryover, as Pete mentioned, we have a little bit of inventory lapping carryover, pretty modest, and then, and then we've got some additional carryover where we feel confident that the wins we've already secured will give us an opportunity. And then on top of that, we expect to continue to drive our initiatives. I think the way you should think of, you know, our focus on driving above market growth is, you know, we're not trying to land the plane at a specific number or a specific percentage. I think our intent is to always continue to drive over performance.

And in this particular case, we're giving you a range that we feel comfortable that we're able to achieve, given an uncertain market and given the execution that we already see ahead of us. We're gonna constantly, you know, focus on expanding our portfolio. We announced a number of new products, and many of those allow us to access some adjacencies and incremental positions. So, you should assume we're always striving for something bigger. We're just giving you what we think is an appropriate planning assumption as we move into next year.

Matthew Bouley (Equity Research Analyst)

Got it. Thanks for that, Jesse. Second one, just thinking about recycling and the progress there, again, going back to the Investor Day, you guys had outlined, you know, a potential material uplift to margins from mixing towards, you know, greater usage of recycled materials. So my question is: where, where are you on that now? And kind of thinking about that EBITDA bridge for next year, what's implied in the guide around, you know, benefit from, from, you know, mixing towards recycled materials?

Peter Clifford (COO and CFO)

Yeah, Matt, this is Peter. You know, we went back and actually updated here at the end of the quarter, the preview that we gave you guys in the Investor Day and went back to 2009 through 2023, and it kind of said the same thing, that ultimately, we've achieved about 50 basis points of kind of margin expansion, each and every year throughout that period. That's what we would kind of expect as we lean forward. You know, levers are still the same, right? We've got the opportunity to move to cheaper grades of recycle, which is primarily cap composite opportunity, increase recycled content, which is obviously the PVC deck and trim. And as well, you know, across all three product categories, we have the opportunity to reduce our cost to convert those recycled materials down.

So, we feel really good again about, you know, for us, recycling is more iteration than innovation.

Jesse Singh (CEO)

So-

Peter Clifford (COO and CFO)

Right

Jesse Singh (CEO)

... I think the, you know, just to, to put a minor point on that, you know, relative to what we said in the investor deck, you should think that we've added another 100 basis points of benefit, you know, 50 a year, as Pete pointed out. And as we look at our, you know, our margin opportunity, you know, as we demonstrated in our last quarter, you know, we certainly have a number of levers that we can pull, and, certainly, recycling is one of them, but we'll continue to drive the other elements of productivity.

Matthew Bouley (Equity Research Analyst)

Got it. Well, thanks, Jesse. Thanks, Pete. Good luck, guys.

Operator (participant)

Your next question comes from the line of Philip Ng from Jefferies. Please go ahead.

Philip Ng (Senior Equity Research Analyst)

...Hey, guys, congrats on a strong quarter to finish the year. Pete, if I heard you correctly, your, your guidance for 2024, you're assuming 2% inventory lap and with Res's commercial initiative. So that seems pretty conservative. Your sellout, it sounds like Q4 is in the mid- to high-single digits. So implicitly in your full year sales guide, what are you assuming for sellout? And it sounds like it's assuming some moderation. Is that just a function of comps based on the wins that you had on new products, this year, this past year?

Jesse Singh (CEO)

Yeah, I, you know, what, what I would say against the planning assumption is, we're assuming in our planning assumption that there is some potential for market for the market to be a bit slower than what we're seeing now. And, you know, given the data and the macroeconomic environment, we think at this stage it's appropriate to plan for a potential slowdown in R&R to become more negative. So, you know, the way you should just look at all of this is: we're assuming a a modestly less constructive market next year, and that's really how the numbers work.

Philip Ng (Senior Equity Research Analyst)

Okay. On that note, Jesse, you've kind of managed the channel conservatively, right? I think the color you've given us all year was when you've done your survey, channel is generally a little more upbeat. So I'm curious, when you've done your survey, what is your channel partner kind of expecting, anticipating for growth in 2024?

Jesse Singh (CEO)

Yeah.

Philip Ng (Senior Equity Research Analyst)

How are they kind of managing the early buy? Last year, they were a little more conservative, and they kind of bought more through the year. Like, how are they kind of communicating their outlook for next year or for calendar 2024-

Jesse Singh (CEO)

Well-

Philip Ng (Senior Equity Research Analyst)

twenty twenty-four?

Jesse Singh (CEO)

Yeah, obviously, we're in the midst of conversations right now, but I think if you were to, you know, aggregate a wide variety of channel partners, I think what they would tell you is they as they look out next year, they see a flattish year with the opportunity, if we execute together in our categories, to outgrow the flattish year in our products. So that's the macro view. Now, against that, we're working with them to make sure that, you know, they're being well-serviced and that they're in a really good position. So I would think of this as a pretty normal year relative to how folks are gonna look at early buy.

You know, if last year were conservative, you know, I think we're, you know, sitting well on top of that. I'm not saying they're gonna be more aggressive. I'm not saying they're gonna be more conservative. I think it'll be a pretty consistent pattern, and it's really a matter of you know, when they choose to buy and at what level. But I think in general, the feedback from our channel is one of flat with the potential of positive in aggregate and a recognition that we have a unique ability to outgrow that.

Philip Ng (Senior Equity Research Analyst)

Okay. Appreciate the color. Thanks a lot.

Operator (participant)

Your next question comes from the line of Michael Rehaut from JP Morgan. Please go ahead.

Michael Rehaut (Managing Director and Senior Equity Research Analyst)

Thanks. Good afternoon, everyone. Thanks for taking my question. Yeah, I just wanted to first circle back a little bit to the Q1, and if I heard right, you are expecting, you know, a little bit of inventory conservatism in the channel, against the sell-through up mid- to high single digits on the residential side. So is that something that we should be expecting, you know, I guess, in effect, that's a shift into the Q2. And, you know, it sounds like you're kind of looking for sell-through to, you know, for the year to be, you know, maybe a little bit more moderate as the year progresses relative to the, to the Q1.

Is that? Just want to make sure I'm understanding that correctly and you might have a better, you know, growth number in the Q2. Is that, is that the right way to think about the cadence in the first half?

Jesse Singh (CEO)

You know, I would say, Mike, it's probably too early to start to guide the Q2. I think our intent has been, in particular over the last, you know, 6-12 months, to make sure that we're doing a really good job of service so that our channel can operate with an appropriate and, if necessary, conservative inventory level. You know, we're lapping that now as we had that at the end of the Q1 in 2022. We expect channel to be in a good, but, you know, flattish situation with last year, and still able to support growth. And then as we move through the quarters, you know, we'll see how volume progresses.

You know, relative to sell-through assumptions, you know, we've got pretty good visibility, obviously in the quarter that we sit, and we've got good, you know, directional visibility as we look at January and February, just given backlogs. And so beyond that, everything is just a planning assumption. What you're trying to do is, is, you know, gauge the market and, you know, conservatively plan against what the market could do. So I think we're not in the prediction game right now of what's gonna happen in March, April, May, June of next year. What we're just laying out is an appropriate planning assumption that we feel really good about our ability to deliver both on top and, and in particular, our EBITDA against.

Michael Rehaut (Managing Director and Senior Equity Research Analyst)

... Okay. No, I appreciate that, Jesse. I guess secondly, you kind of highlighted for your fiscal full year planning assumptions, continued investment in marketing and brand initiatives from a strong gross margin performance. I'm just thinking about, you know, longer term, and, you know, I'm wondering about, you know, if the investment this year is something that, you know, you would consider a little bit above average as you continue to build out, you know, the platform. You obviously, over the last couple of years, have made a couple different acquisitions, pergolas, for example. And you know, the overall category continues to gain share as well.

Would love to understand, you know, those investments and, you know, if you kind of think over the next two or three years, you might be able to get better leverage out of the SG&A, you know, relative and, and I think ultimately, how to think about incrementally, the drop margins over time.

Jesse Singh (CEO)

Yeah, I will put it in a real simple way. I think this year we have an opportunity, if we have the room to continue to invest in the business. So you're probably not... You know, our current assumption is that you're not gonna see leverage on SG&A. If anything, it might, you know, it might contribute to, you know, 10, 20, 30 basis points of negative leverage. But I think as you move out beyond that, we've made pretty substantial investments in our sales and marketing organization. We've seen a benefit from it. You should expect that, it's really our choice, but I think as we move through 2024 into 2025, we should start being in a position to get leverage off that.

We certainly could get leverage this year if we chose to. It's really a lever that, you know, we'll decide how to pull, but right now, that lever is more in an investment mode.

Michael Rehaut (Managing Director and Senior Equity Research Analyst)

And so therefore, how should we think about incremental EBITDA margins over time for the resi business?

Jesse Singh (CEO)

I think once you move beyond this year, and Pete, please chime in, but I think once you move beyond this year, you should think of SG&A as being positive to leverage.

Peter Clifford (COO and CFO)

Yeah. We said it won't happen every year, but most years, looking forward past 2024, we would expect, you know, possibly as much as 25 basis points as a, you know, leverage opportunity that's there, most years. And look, in the near term here, you know, part of the investment thesis is, look, we're continuing to, you know, clearly outperform the market as well as peers. So, you know, we wanna keep that momentum.

Michael Rehaut (Managing Director and Senior Equity Research Analyst)

Thank you.

Operator (participant)

Your next question comes from the line of John Lovallo from UBS. Please go ahead.

John Lovallo (Equity Research Analyst)

Good evening, guys, and thanks for taking my questions. The first one is, Pete, you mentioned that in the fiscal year 2024 outlook, that pricing is going to be, you know, relatively flat to maybe a slight uptick. I mean, have your thoughts changed on the ability of the business to drive sort of low single-digit price increases, you know, over time? Is that more of kind of a 2025 story? And then, you know, similarly, in the context of the growth algorithm, how are you guys thinking about material conversion in 2024?

Peter Clifford (COO and CFO)

Yeah. First, on the pricing piece, look, we did some traditional product-by-product price increases here. Now, that will be, you know, basically offset by some programming costs on the gross and nets to kind of net to, again, kind of a more modest negligible price for 2024. Look, that's a lot on the backdrop of the pricing that we've taken over the last two or three years. We do expect in 2025, that we'd return to a more traditional kind of annual pricing pattern. As far as conversion, look, I think we feel really comfortable, again, based upon the 2023 performance. It was one of the questions that was open at the beginning of the year, is conversion still happened? Does it still happen at the same pace?

And a down cycle on our sector clearly had a slow start. And, you know, the resolute answer was, it does. And, again, we wake up every morning, we know the levers to pull for conversion. You know, it's all about converting contractors, it's influencing architects, it's making sure we got the right new product launches, that we're fighting for shelf space so people can see the product, and simplifying and educating the consumer in the journey.

John Lovallo (Equity Research Analyst)

Makes sense. Thank you. And then as a follow-up, it sounds like demand in both the pro channel and on retail were both pretty good. Just curious on the mix side, if you've seen any kind of impact on, you know, mix down, if you will, as the economy maybe, maybe has got a little bit more challenging, and consumer confidence has waned to some extent.

Peter Clifford (COO and CFO)

Yeah, generally speaking, our products mix has been really stable. As we called out on the last two falls, you know, we were underpenetrated in the good category, right, due to capacity constraints during the pandemic. As we've relaunched here, Prime and Prime Plus, with ample capacity, we've obviously picked up some share this year in that good category.

John Lovallo (Equity Research Analyst)

Great. Appreciate it. Thank you.

Jesse Singh (CEO)

John, John, I think one of the things just to continue to highlight is, yeah, you know, we are predominantly pro, and we tend to skew more premium. And I think as you see that, you tend to see pretty strong resiliency there, and you know, we see it in all of our data. You know, our good, our more premium products continue to do well. And then as Pete pointed out, we've been able to pick up, you know, some incremental share at the entry level.

But I think in reality, you know, the more premium areas continue to be pretty stable and growing, which is what you might expect in a you know in an economy that you know has a fair amount of wealth, that sits through you know equity holdings and home equity values.

Operator (participant)

Your next question comes from the line of Susan Maklari from Goldman Sachs. Please go ahead.

Susan Maklari (VP and Equity Research Analyst)

Thank you. Good evening, everyone.

Jesse Singh (CEO)

Good evening.

Susan Maklari (VP and Equity Research Analyst)

The first question is, when we think about the range that you gave for sales growth next year of 3%-8%, can you talk about the environment or the factors that would take you to the lower end versus the higher end of that range next year?

Peter Clifford (COO and CFO)

Yeah. I mean, ultimately, it would have to be that R&R is, you know, at the lower end of kind of low to mid single digits negative.

Susan Maklari (VP and Equity Research Analyst)

Okay. All right. And then, in the prepared remarks, when you were talking about some of the new products, the initiatives for next year, it seemed like rail came up quite a bit, maybe perhaps more than it has in the past. Can you talk about how you're thinking of the opportunity there and anything that, we should be thinking about as we think about the next couple of years?

Jesse Singh (CEO)

Yeah, Susan, I'll take that. You know, we highlighted that we play in multiple markets and that we see good opportunity in all of them. Clearly, rail is, you know, a close-in part of our business. We bought an aluminum rail company in at the tail end of 2018. We bought another rail company last year, which is a super premium PVC rail company, and we've seen really, really nice growth from those acquisitions, and we have reinvested and reinvented our core portfolio by both simplifying it, but also upgrading it. So for us, as we look at 2022, you know, we've had really, really nice rail growth that would be accretive to the growth that we've had overall in the company.

And we would expect that to continue, as you know, we're uniquely positioned with having an incredibly broad portfolio. And we would expect to continue to use that portfolio to expand our position in the market.

Susan Maklari (VP and Equity Research Analyst)

Okay. Thank you. Good luck with everything.

Jesse Singh (CEO)

Appreciate it. Thank you, Susan.

Operator (participant)

Your next question comes from the line of Mike Dahl from RBC Capital Markets. Please go ahead.

Mike Dahl (Managing Director of Equity Research)

Hi, thanks for taking my questions. First one on the cost tailwinds. So I think, Pete, you articulated that $40 million in known deflation and production tailwinds, maybe that comes down to $35 million, when you account for the Vycom divestiture. Can you just elaborate more on, you know, what you're seeing on the raw material side? And you talked about this being known deflation on the balance sheet. But is there potential for additional deflationary benefits if raw mats stay where they are today and you cycle into - you continue to cycle into that in your WAC?

Peter Clifford (COO and CFO)

Yeah, Mike. The view on the commodities front, you know, from an expectation perspective of kind of what's embedded in the planning assumptions, is looked at input costs have stabilized and are expected to remain kind of relatively flat all year, with a few modest increases in the back half of the year. So it's kind of steady state, sort of the view from sort of the industry publications, CDI.

Mike Dahl (Managing Director of Equity Research)

Okay. So that the $35 million total, you think fully encompasses where we're at today?

Peter Clifford (COO and CFO)

It does. And if you remember, commodities dropped very sharply right after we started the year. So really, they dropped fast, and then they stabilized, and we've been kind of riding sideways here for the last couple of 6-8 months.

Mike Dahl (Managing Director of Equity Research)

Okay. My second question, okay, maybe I misinterpreted this when the initial release came out, but I think when the Vycom divestiture announced, it-- the idea was to roll up all of the reporting into the residential segment. Now, you're putting corporate expenses into resi, but keeping Scranton Products separate and commercial. You know, anything to read into that in terms of whether your intent has changed on what to do with the remaining Scranton Products business?

Peter Clifford (COO and CFO)

Yeah, I mean, look, I think it was actually a way for us to make it easier for folks to compare us to our peers within the building product space, that most folks that follow us are most interested in residential. So it seemed logical to put those two pieces together.

Mike Dahl (Managing Director of Equity Research)

Got it. Okay, thanks.

Operator (participant)

Your next question comes from the line of Rafe Jadrosich from Bank of America. Please go ahead.

Rafe Jadrosich (Equity Research Analyst)

Great. Hi, hi, Jeff. Thanks for taking my questions. First up, I wanted to just ask, can you talk about the sellout trends in decking versus exterior, the exterior categories, that you saw, well, last quarter, and then what, what are you assuming in, in your outlook for each of them?

Jesse Singh (CEO)

... Yeah, at a high level, both of them were, you know, roughly similar and positive. And I think as, you know, as we look out the next year, we're not parsing out, you know, any specific business. You know, as we've highlighted, we've got conversion opportunity, and new products on the deck rail and accessory side, and we've also got a number of new products that will help us drive wood conversion on the exterior side. So we've seen nice sell-through growth in both of them.

Rafe Jadrosich (Equity Research Analyst)

Got it. And then, just following up with some of the earlier comments on the early buy. You mentioned that normally the majority of the early buy is in the Q2, but some of it has historically fell in the fiscal Q1. But this year, effectively, it's all gonna ship in the Q2. Is there a way you can quantify the rough impact of that assumption? And then what portion of your sales in a typical year would come in the early buy?

Peter Clifford (COO and CFO)

Yeah, I mean, I'll take the first part of the question on sorta, you know, the catalyst for most of it moving to the Q2 now is... Look, it used to happen in the Q1 because capacity wasn't capable of supplying as much product as what was needed in the Q2. Obviously, with the capacity expansions of the last two years, that's really, again, kind of the catalyst for why we really don't feel like there's a need to have any of the shipments in our fiscal 1Q, and that virtually all of it will be in the Q2.

Jesse Singh (CEO)

And then relative to the percentage, we haven't talked about that. You know, I think the most important part of this winter negotiation is that we position ourselves well with our customers to drive growth throughout the year. So, you know, for us, the most valuable part of this is the partnership discussion of how we're gonna work together to grow our mutual businesses with our channel partners. And in that respect, you know, the quarter and the discussions are important to set up the year. What it does do is it gives us pretty good visibility on revenue within the quarter. And so, as we've talked about in the past, and our competitors have too, you know, really, the October quarter and the January quarter are really quarters that end one year and begin another, and they're staging quarters.

And then, you know, we'll see the real impact in season as we move into you know, our fiscal you know, Q3 and Q4.

Rafe Jadrosich (Equity Research Analyst)

Thank you. That's helpful.

Operator (participant)

Your next question comes from the line of Trey Grooms from Stephens Incorporated. Please go ahead.

Noah Merkousko (Senior Research Associate)

Hey, good afternoon. This is Noah Merkousko on for Trey. Thanks for taking my questions. So maybe first, I just wanted to follow up on gross margins. It sounds like, you know, continuing to ramp production from here, you've highlighted the raw material deflation that'll help the front half of fiscal year 2025 and then kinda roll off in the back half. So I guess, you know, would you expect gross margins to be stronger in the front half and then moderate in the back half? Is that kinda the right way to think about it here, or are there other items we should consider as we think about 2024?

Peter Clifford (COO and CFO)

You know, obviously, year-over-year, the performance on gross margin is gonna be meaningfully accretive in the first half of the year, given what we're lapping. And then, you know, I would assume or expect kinda consistency in the back half of the year with this second half of 2023.

Noah Merkousko (Senior Research Associate)

Got it. That makes sense. And then on my follow-up, you know, it sounds like continuing to make investments in SG&A, which would prevent leverage in 2024. But when you think about SG&A as a percent of sales, you know, is 2023 a pretty comparable year, or would you expect that number to move meaningfully higher?

Peter Clifford (COO and CFO)

We're not expecting significantly negative leverage. It'll be flat to modestly negative. As Jesse said, it's probably reasonable to think maybe 20 basis points.

Noah Merkousko (Senior Research Associate)

Got it. That makes sense.

Peter Clifford (COO and CFO)

Yeah.

Noah Merkousko (Senior Research Associate)

Thanks for the time, and good luck with the rest of the year.

Jesse Singh (CEO)

Appreciate it. And you know, the last comment on that really depends on volume. And you know, as we look at you know, our ability to deliver EBITDA margin, we feel really good that in any scenario, you know, we can get into you know, that 24 plus range that we talked about, that puts us on a path towards that 27.5 that we talked about by 2027. And so, So with that, thank you all for joining. We feel you know, as you can tell, we're pretty pleased with how we ended the quarter. And you know, we feel excited about what's ahead of us and look forward to chatting with the rest of you offline as needed.

Take care, and thanks for joining us. Appreciate it.

Operator (participant)

This concludes today's conference call. Thank you for your participation, and you may now disconnect.