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Inventory destocking headwind

The inventory destocking in the commercial segment of Azek's (AZEK) business should impact the company's revenues in FY23. In the long run, the company should benefit from wood material conversion opportunities and favorable trends in the R&R market.

AZEK’s segment distribution (Created by DzD Analysis using data from AZEK)

In the first half of the fiscal year 2023, the residential segment's channel partners had excess inventory, leading to a decline in volumes. However, as we move into the second half, we should see a normalization in inventory levels, which should result in a lower volume decline. The channel destocking in the Commercial segment’s end markets, including marine, graphics, and semiconductors, is expected to continue in the near term. I believe the revenue in the second quarter should be impacted by the volume decline, partially offset by the pricing actions taken over the last few quarters. The recently took a price hike in May 2023, which should support revenue growth in the coming quarters.

The Commercial segment should continue to face weakness in the second half of FY23 due to the challenging environment resulting from a combination of channel destocking and softer demand in certain commercial end markets. On the other hand, the volume declines in the Residential segment should be less affected, mainly because 85% of the segment's revenue comes from the repair and remodel business (R&R), which is less cyclical compared to new construction. Residential channel inventory levels are below last year and approximately 15% below the 2017–2019 historical average days on hand. I believe that the channel inventory correction in the residential segment is nearing an end, and AZEK is well-positioned for the second half of 2023. However, in the second half of FY23, the lower levels of inventory in the channel and the lapping of the previous year's channel destocking should benefit volume growth. This should result in improved volume performance in the second half of the year.

Overall, the company’s revenue growth in FY23 should be between negative low and negative mid-single digits due to the lower volumes resulting from the weak residential market. This should be partially offset by the pricing actions taken by the company in 2022 and 2023 to offset the inflationary cost pressures.

Long-term opportunities for the company

In the long term, the company should benefit from its strategic initiative and the secular trends around outdoor living and wood material conversion. Furthermore, favorable trends in the Repair & Remodel (R&R) end market, such as the rising average age of houses in the U.S. and an increase in home equity, should benefit the company. AZEK’s strategic initiatives include new product innovation, channel penetration and expansion in geographies, and tuck-in M&As. The company recently simplified and upgraded its railing portfolio by adding high-end PVC railing options, i.e., Statement Rail and Pinnacle Rail. This year AZEK introduced its TimberTech outdoor furniture collection, a premium product produced from high-performance materials. These new product introductions collectively are a strong complement to AZEK’s deck, rail pergolas, and accessories platform offered through its TimberTech, StruXure, Ultralox, and INTEX brands and position it to drive incremental growth in core markets and access additional adjacencies in outdoor living.

AZEK is also picking up incremental shelf space across its professional and retail channels. The company has approximately 90% of its sales distribution from the professional channel and 10% from the retail channel in its Deck and Rail business. These wins will position the company well to take advantage of the coming spring selling season. The company acquired INTEX Millwork Solutions in August 2022, which is a manufacturer of high-quality railing solutions, column wraps, and pergolas. This acquisition, when combined with AZEK’s previous acquisition of StruXure in 2021, positions the company well to drive core and adjacent growth in outdoor living. StruXure manufactures customizable pergolas and cabanas.

AZEK’s material conversion opportunities (AZEK’s Investor Presentation)

The company should also benefit from the shift in trends away from traditional wooden outdoor products and towards products made of composite materials. These products include pergolas, decks, railings, columns, etc. Wood represents approximately 40% to 75% of AZEK’s core markets, which provides tremendous material conversion opportunities for the company. This shift is due to increased lumber prices, the hassle of maintaining wooden outdoor products, and the higher lifecycle costs. The composite material helps address these problems given its superior aesthetics, durability, low maintenance, ease of installation, and lower lifecycle costs. Additionally, the trends in outdoor living have increased over the past few years as people were stuck at home during the COVID period.

Capital Allocation Priorities

At the end of Q2 FY23, AZEK had a net debt of $590.8 million, and the net debt to LTM adjusted EBITDA ratio was 2.3x. The leverage ratio is between the 2.0x and 2.5x target range set by the company. At the end of the quarter, cash and cash equivalents totaled $86.9 million. The strong leverage ratio should benefit the company as it continues to carry out mergers & acquisitions and expand its business.

Conclusion

The inventory destocking at the channel partners in the residential segment should be completed in 2H FY23, which should reduce the volume declines. However, the destocking should continue in the commercial segment due to weak demand in various end markets such as retail, food & beverage, and others. This should impact the company’s revenue in FY23. In the medium to long term, the company’s revenue should benefit from strategic initiatives, favorable trends in the R&R market, and secular trends in material conversion. Despite good long-term prospects, I have a hold rating on the stock due to the expensive valuation.

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