Azek Company Inc (AZEK) 2020 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by, and welcome to The AZEK Company Third Quarter 2020 Earnings Conference Call. (Operator Instructions)

I would now like to hand the call over to your speaker today, Jon Skelly, Senior Vice President of Strategy and Execution. Thank you. Please go ahead.

Thank you. Good morning, everyone. We issued our earnings press release this morning to the Investor Relations portion of our website at investors.azekco.com as well as via 8-K on the SEC's website. I'm joined today by Jesse Singh, our Chief Executive Officer; and Ralph Nicoletti, our Chief Financial Officer.

Before we begin, I would like to remind everyone that during the call, AZEK management may make certain statements that constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These include remarks about future expectations, anticipation, beliefs, estimates, forecasts, plans and prospects. Such statements are subject to a variety of risks, uncertainties and other factors that could cause actual results to differ materially from those indicated or implied by such statements. Such risks and other factors are set forth in the company's earnings release posted on the website and provided in our final prospectus with respect to our initial public offering as filed with the Securities and Exchange Commission. The company does not undertake any duty to update such forward-looking statements.

Additionally, during today's call, the company will discuss non-GAAP measures, which we believe can be useful in evaluating our performance. The presentation of this additional information should not be considered in isolation or as a substitute for results prepared in accordance with GAAP. A reconciliation of adjusted EBITDA to net income and net loss calculated under GAAP and adjusted gross profit to gross profit calculated under GAAP as well as reconciliations for other non-GAAP measures discussed on this call can be found in our earnings release, which is posted on our website and will be included on our Form 10-Q for our third quarter of fiscal 2020.

I would now like to turn the call over to Jesse Singh.

Good morning. It's great to be speaking with you today on our first earnings call as a publicly traded company. I hope you all are safe in managing through these challenging times. As you know, we completed our initial public offering in June, which was a result of the significant hard work and dedication of our employees who help build AZEK into a leading manufacturer of beautiful, sustainable, low-maintenance building products. I'd like to thank all involved in the process for a successful outcome. We look forward to partnering with our new shareholders as we focus on expanding the business and creating value in the years to come.

I'd also like to recognize our team for their leadership in our response to the pandemic and its impact. Consistent with our core value of do the right thing, our first priority has been and will continue to be the safety of our employees, our customers and our communities. At the onset of the pandemic, we made a number of proactive safety and operational changes across our business and offered enhanced benefits, such as employee bonuses and extended sick leave, among others. The AZEK team responded quickly and efficiently, working closely with our channel partners. This has enabled us to execute our plans in a difficult and uncertain environment. Thank you to the entire AZEK team and our channel partners for your commitment and dedication.

Hopefully, by now, each of you has had the opportunity to review our earnings press release and read that we had a strong June and are seeing an acceleration in the business as consumers continue to focus on their homes and invest in outdoor living. Let me begin by reiterating our strategic priorities and the opportunities we see ahead of us.

We believe that we are a unique company with a compelling long-term growth story. We have leading brands that are known for their innovation. We manufacture in the U.S. using an increasing amount of recycled materials. We are committed to diversity and sound governance. And we are focused on large growing markets that are benefiting from strong trends and the continued conversion from wood to our types of materials. Our long-term goals are to deliver 8% to 10% revenue growth annually and to operate with leverage between 2 and 3x. In addition, we see a long-term opportunity to increase adjusted EBITDA margins by 500 basis points from the fiscal year 2019 level.

We have been and will continue to focus on key initiatives to achieve these long-term goals. These initiatives include: first, deliver revenue growth. We have multiple levers to drive above-market growth and accelerate material conversion, including investing in new product introductions and expanding and leveraging our downstream-focused sales and marketing team. Second, expand margins. We will further expand our margins through the use of recycled materials in our manufacturing processes and through our continuous improvement programs, known as the AZEK Integrated Management System or AIMS. Third, do the right thing. We will continue to improve our social and environmental impact and corporate governance by continuing to invest in doing the right thing. Fourth, invest in our strengths. We will continue to build out our core strengths, which include brand, material science, integrated manufacturing and our strong customer connection.

Our execution is on track and consistent with what we shared during the IPO process. During the quarter, we made solid progress against each of our strategic initiatives, and I'll share some specifics shortly.

Turning to our third quarter results. Despite a volatile and challenging market, our team continued to execute and deliver sales and adjusted EBITDA growth. Our Residential business grew 5.5% compared to the third quarter a year ago, while our Commercial segment declined approximately 20%.

Adjusted EBITDA grew almost 10% year-over-year, and adjusted EBITDA margins expanded 200 basis points from the same period the year before. These results are on top of very strong sales and adjusted EBITDA growth during this quarter in 2019.

Our Commercial business, which represents 6% of our year-to-date segmented adjusted EBITDA, experienced declines in the third quarter. As a reminder, this business tends to track more closely to GDP and the broader economy. The Scranton Products portion of the business has historically been driven by commercial repair and remodel, and during the quarter had a modest downturn in sales. The Vycom portion of the business has a broad domestic customer base with over 20% of the business exposed to retail and trade show end markets where volumes have drastically slowed and in some cases effectively shut down.

Our Commercial business has some great products that include high-privacy bathroom partitions that could become increasingly necessary along with additional barrier products. Although we saw some improvement in the quarter, this business, like the broader economy faces a difficult market environment in the near term.

With respect to the Residential business, early in the quarter, the industry slowed as shutdowns and stay-at-home orders adversely impacted the pro channel -- adversely impacted part of the retail channel and impacted end customer activity. However, as the quarter progressed, conditions began to improve, and by June, we saw a sharp acceleration in demand across our residential channels. Repair and remodel and new construction experienced continued favorable tailwinds after the brief slowdown. The retail channel saw relative strength throughout the quarter as home improvement centers were open and accessible, while the pro channel got off to a slower start during the quarter in specific geographies and came back very strong in the second half of the quarter.

Sales within our exterior business declined in April and May as our strongest geographies were disproportionately impacted by closures but then rebounded strongly in June, and that momentum has continued through July. Sales within our deck, rail and accessory category increased over 9%, and sell-through for the Residential segment overall, that's what our distributor partner sells to our dealers, was up in the mid-teens versus a year ago. As market conditions improve, the focus on our growth drivers has served us well. We improved our interaction with our customers in multiple ways throughout the quarter. Our sales teams on the ground aggressively engage with customers and consumers digitally to drive demand.

We launched our Better Tech, Better Deck campaign meant to inspire homeowners on the technological superiority and design versatility of our TimberTech products. We made investments in our digital and customer experience capabilities to improve how consumers engage and learn about our products online. Importantly, both web traffic and sample orders saw tremendous growth and nearly doubled during the quarter relative to the same quarter of last year.

We expect new products to deliver growth on an ongoing basis, and we have seen strong acceptance of our new product introductions for 2020. Our value-added exteriors products that are designed to drive material conversion and increased contractor productivity continue to support above-market growth. And our simplified and improved railing offerings have experienced very positive market reception.

The launch of our TimberTech PRO Reserve decking line and the TimberTech EDGE Prime+ decking line has solidified our position in 2 key segments and have made a material contribution to our results.

Operationally, during the quarter, our team worked tirelessly to respond to the volatile environment, which began with a slowdown and then quickly reversed course due to rapidly increasing demand while continuing to execute against key operational initiatives. These initiatives are on track with what we shared with you during the IPO process. They include the expansion of our manufacturing capacity, the increased use of recycled raw materials and the execution of our continuous improvement programs.

During the quarter, we started the first stage of our decking capacity expansion with further additions coming online later this year. The recent strategic acquisition of Return Polymers has put us in a strong position to continue to expand our recycling efforts. We continue to evaluate new ways to leverage their strong capability. The combination has yielded many new opportunities, including expanded uses of recycled PVC and the development of new customer-focused initiatives, such as our post-construction waste recycling. The integration is on track, and we are achieving our synergy targets.

Taken together, our market opportunity, growth drivers, operational execution and margin execution during the quarter clearly demonstrate the resiliency of our business model. While the success of our initiatives and the strong demand we are seeing is encouraging, it has also placed a strain on our capacity and resulted in shortages in certain decking and railing categories. As we exited the quarter, we were unable to fully meet demand, and we are operating our plants at full capacity. We expect decking demand to continue at a high level for the remainder of the fiscal year, and our fourth quarter deck, rail and accessory sales will be limited by our ability to meet the full amount of demand.

We have taken the prudent step to accelerate the deployment of our next 2 phases of our previously announced expansion and expect additional capacity to come online during the second and third quarters of our fiscal year 2021. We continue to be confident in our business model and the long-term opportunity for growth and are expanding our capacity plan from the original $100 million investment to approximately $180 million to support future market demand and the large wood conversion opportunity. The strategic capacity expansion plan includes an incremental decking production capacity of approximately 70% and a new manufacturing facility over the next 18 to 24 months.

Our current outlook is based on a number of factors, indicators and macroeconomic variables. We integrate and share data with our channel partners and regularly survey our dealer and contractor customers to understand their activity levels and backlogs, which today continue to show considerable strength. We conduct detailed analysis on our sell-through and our inventory in the channel, which is currently below levels at the same time last year. We also evaluate consumer engagement activity such as web activity, sample orders and quote requests, which, as mentioned earlier, have accelerated. Finally, we also utilize forecasts that correlate to our business, such as repair and remodel and new housing data combined with traditional macroeconomic variables for short and long-term visibility on potential demand and demographic trends.

While we see many positives, including an expanded focus on the home and outdoor living, we also recognize that we are in the midst of a pandemic that is influencing the broader economy and has the potential to impact our markets and consumer sentiment in 2021.

Taken in their totality, these factors influence our favorable near-term outlook for our Residential business and a cautious approach to 2021. We remain highly confident in the long-term market opportunity for the business, driven by secular trends, material conversion and our own execution.

With that, I'd like to turn the call over to Ralph, who will discuss our financial results and the outlook in greater detail.

Thank you, Jesse. As mentioned earlier, we are pleased with our fiscal third quarter results and our ability to manage our business effectively in a difficult operating environment. All comparisons will be made on a year-over-year basis compared to the same quarter ending June 30, 2019.

For the fiscal third quarter of 2020, net sales increased by $2.4 million or 1.1% to $223.7 million. The increase was attributable to higher sales growth in our Residential segment, on top of strong growth of 27% or mid-teens organically in last year's third quarter. Deck, Rail & Accessories grew 9.4% and after a slow start due to the market shutdowns early in the quarter, our Exteriors business grew almost 20% in the month of June, and most recent sale trends continue to be strong.

Net sales for our Residential segment increased by 5.5%, but the Residential segment's contribution to consolidated net sales was partially offset by a decrease in our Commercial segment of 19.7% as compared to the prior year period.

Gross profit for the third quarter of fiscal 2020 decreased by $300,000 or 0.4% to $75.1 million. Adjusted gross profit for the third quarter of fiscal 2020 increased by $700,000 or 0.9% to $91.2 million from $90.5 million in the third quarter of fiscal '19. Adjusted gross profit margin was 40.8%, down 10 basis points from last year including approximately a 90 basis point negative effect from COVID-19-related costs.

Selling, general and administrative expenses increased by $15 million or 29.8% to $65.2 million, about 29% of net sales for the third quarter of fiscal 2020. The increase was primarily attributable to IPO-related expenses of $22 million including the recognition of stock-based compensation expense, partially offset by lower marketing-related expenses and personnel costs as we took steps to adjust our cost structure in light of the initial COVID-19 disruption.

We recorded a net loss of $52.1 million for the third quarter of fiscal 2020 compared to net income of $1.5 million for the third quarter of fiscal 2019, primarily due to the loss on extinguishment of debt and increased selling, general and administrative expenses related to the IPO, which combined totaled approximately $60 million.

Adjusted EBITDA for the third quarter increased by $5 million or 9.6% year-over-year to $57.8 million, mainly driven by higher sales as well as lower selling, general and administrative costs, partially offset by higher COVID-19-related production costs, which included shutting down some of our factories for approximately a week. Adjusted EBITDA margin expanded 200 basis points to 25.8% from 23.8% a year ago.

Now turning to our segment results. As we noted during our IPO process, our Residential segment had a slow start to the quarter, particularly in Exteriors, as several geographies had construction either shut down or disrupted significantly. Our Deck, Rail & Accessories business was also affected, but as the quarter unfolded, more homeowners continue to invest in their outdoor living spaces and many states deemed residential construction essential. In addition, restrictions were eased in certain regions, allowing activity to resume. This resulted in a significant demand increase in both Deck, Rail & Accessories as well as exteriors as we saw sell-through for the quarter increase mid-teens with June significantly above that level. This resulted in the Residential segment net sales for the third quarter to increase by $10 million or 5.5% to $192.6 million. We are seeing strong acceptance of our new deck, rail and exterior trim products, and we are benefiting from the downstream sales force investments we have made in our exteriors and retail channel teams.

Adjusted EBITDA for the third quarter increased by $8.2 million or 15.2% to $62.3 million, mainly driven by higher sales as well as lower SG&A costs as a result of lower marketing and travel expenses, partially offset by higher COVID-19-related production costs.

Commercial segment net sales for the third quarter decreased by $7.6 million or 19.7% to $38.7 million. As Jesse discussed earlier, this business was affected by the slowdown in commercial repair and remodel as well as certain challenged end markets such as retail and trade shows.

Looking at our balance sheet and cash flow. As of June 30, 2020, we had cash and cash equivalents of $215.1 million and approximately $97 million available for future borrowings under our revolving credit facility. Total debt as of the end of June 2020 was $506.7 million, including $467.1 million under the term loan agreement and $44 million outstanding under our revolving credit agreement, which we paid off in July.

We successfully completed our 38 million share IPO of Class A common stock on June 16, which raised an aggregate $819.4 million of proceeds. We used approximately $783 million of the proceeds to reduce our debt.

Our net debt to adjusted EBITDA leverage is 1.5x as of the end of the quarter. The IPO proceeds have significantly strengthened our balance sheet and enabled capital structure flexibility for the future. As a reminder, our long-term financial model target is to operate with leverage in the 2 to 3x EBITDA range with our capital priorities of supporting the core business, strategic M&A and debt repayment.

Net cash provided by operating activities was $11.3 million and $20.3 million for the 9 months ended June 30, 2020, and 2019, respectively. The $9 million decrease is primarily a result of increased working capital usage to support higher production and demand levels.

As we enter our fourth quarter, demand remains very strong with our key residential end markets and has resulted in shortages in certain decking and railing products. We are in the process of adding additional capacity to satisfy the long-term growth opportunity that we see. As Jesse mentioned earlier, we are accelerating and expanding our capacity expansion plan from an original $100 million investment to approximately $180 million.

This is a multiphase program. We're in our first phase, which we partially implemented in the third quarter and will complete in the fourth quarter will add approximately 20% more decking capacity. The second phase will be implemented in our fiscal second and third quarters of 2021. And then the third phase in the early part of fiscal '22 as we ramp up a new facility in the western part of the U.S. The full capacity expansion is expected to result in approximately 70% incremental decking capacity over the next 18 to 24 months.

In terms of capital spending pacing, we now expect total capital expenditures of $85 million to $90 million in fiscal 2020, reflecting a step-up in capital spending of about $15 million, resulting from the accelerated capacity investment. The remaining $65 million increase is expected to largely be spent in 2021. We expect to add the additional 20% decking capacity during the second half of fiscal '20 while improving margins, and we remain on track with achieving our long-term adjusted EBITDA margin expansion objective of 500 basis points.

Now moving to our outlook. Our outlook is based on current strong demand within our Residential segment and balanced by the economic uncertainty caused by the pandemic, including high unemployment and the potential for more market disruption. According to industry forecasts, the home improvement and repair and remodel outlook for 2020 has improved since May, but such forecasts continue to suggest negative to low single-digit growth for the full year. Specific to AZEK, we are encouraged by our current demand trends and internal signals like web traffic and sample orders growth. Over the next quarter, we expect continued robust demand with our Residential segment across both our Deck, Rail & Accessories and Exteriors businesses, partially offset by continued weakness in our Commercial segment.

We are providing guidance for the fourth quarter of fiscal 2020 for net sales growth in the range of 12% to 17% year-over-year and adjusted EBITDA growth in the range of 14% to 19% year-over-year. Additionally, while we don't plan to provide forward-looking guidance multiple quarters out on a regular basis, given that we provided a forecast during the IPO process in this volatile environment, we are providing a directional update. Our net sales growth for our Residential segment for the first quarter of fiscal '21 is low double-digit growth.

We expect the current trends in the Commercial segment will continue through the end of the calendar year. Finally, for modeling purposes, we assume approximately 152.2 million weighted average diluted shares outstanding for the fourth quarter and 123.5 million weighted average diluted shares outstanding for the full fiscal year 2020, and a full year tax rate of 6.7%. Going forward, we plan to issue full year sales and adjusted EBITDA guidance that we'll update quarterly as needed.

I'll now turn the call back to Jesse for closing remarks.

Thanks, Ralph. In closing, I'd like to reiterate my belief that AZEK is a truly unique company that is well positioned to succeed in an attractive and growing market. We've got a strong culture and a broad portfolio and are poised to benefit from multiyear secular trends in outdoor living and wood conversion. We are a proven leader in innovation. We have multiple levers to drive above-market growth, and we see a runway to improve our margins with our focus on expanding the use of recycled materials.

We see additional opportunity through our continuous improvement programs. We remain confident in our ability over the long term to grow the business 8% to 10% on an annual basis and in our ability to drive 500 basis points of adjusted EBITDA margin expansion. We look forward to partnering with our new shareholders as we strive to create value in the years to come.

With that, operator, please open the line for questions.

(Operator Instructions) Your first question is from Matthew Bouley with Barclays.

Congrats on the first results out of the gate here. Firstly, I wanted to ask about the decision to accelerate the capacity additions and the incremental addition. So I guess in the short term, to what degree is the Q4 guide dependent on some of that new -- or the accelerating capacity coming on schedule in Q4? And longer term, are you actually taking a more constructive view on the conversion from wood decking accelerating here?

Thanks, Matt. Let me start with your second question, which is our longer-term view. As we've talked about, we see a tremendous opportunity to continue to drive conversion in the market, and we've seen a lot of really positive secular trends. And this most recent -- those were trends coming into the pandemic. As a reminder, we grew almost 16% coming into the pandemic. And as we see more people staying at home, we believe that the trends are intact for the long term and that as people focus more on the home, that there might be an opportunity for those trends to accelerate. So having said all that, we think it's prudent that we continue to look at staying ahead of the curve relative to our growth opportunity. So that really addresses the second question.

I think as you look at the short term, I'll have Ralph make some very specific comments. But we've been adding capacity, and as Ralph pointed out, we're bringing capacity online as we speak. And we expect to accelerate that through the fall. So as we look at our guidance, we're aware of those capacity adds. And so Ralph, I'll turn it over to you to see if there's any additional color on that.

Sure. Thanks, Jesse. Yes. As I mentioned in my remarks, we started the first phase of the capacity expansion in the third quarter, and we're finishing it now in the fourth quarter here. We're not dependent on that expansion of capacity to meet what we talked about for Q4. And so we're comfortable with the capacity relative to the guidance that we provided. But it is a multiphase program, again, with the first phase being finished in Q4. And then in our fiscal second and third quarters of '21, there'll be another expansion, and then later on as we go into calendar '22 to finish the program in the third phase.

Got it. Okay. I guess secondly, on the same topic, I have to ask about the margin side impact from all that. So any way to quantify kind of what's baked into the Q4 guide from a start-up cost standpoint as this comes online? And certainly, with your plans into '21 and '22, how should we think about modeling these costs from the additional capacity over that time frame?

Yes. The -- as we think about the start-up costs and the transitions of capacity, if you recall from our discussions back in the IPO process, too, we certainly contemplated that we would be expanding capacity and also moving ahead on the cost reduction agenda principally in recycling. And we factored all that into our guidance and we're on target. We continue to believe we have the 500 basis points of opportunity in EBITDA margin growth over the next several years. And I won't quantify specifically the number in the fourth quarter, but it certainly does contemplate our start-up of the first phase in the third and fourth quarter here. And you can tell from our guidance that we're improving our margins, both in the third quarter and the fourth quarter, while we're adding about 20% capacity.

Your next question is from John Lovallo with Bank of America.

The first one, maybe we could just dig in a little bit more on the July trends. I know you said that they were favorable. I mean were they sort of mid-teen year-over-year like June? And then is there any update you could potentially give us on what you're seeing in August?

Just at a very high level, we're -- I think Ralph touched upon the strength of June. We continue to -- as Ralph pointed out in his comments, we continue to see nice and favorable momentum as we progress through July into August. And obviously, given our guidance we expect that to continue through the quarter. Specific month-to-month, we're just seeing strong trends throughout, without getting into any more detail.

Okay. Great. And then I think one of the things that you had contemplated in the prior outlook was some potential distributor destocking over the winter. I mean has your view on that changed at this point given where demand has been?

We -- during both of our comments, we mentioned that the inventory position within our channel is -- and it's one of the areas we track, and it's below where it was the previous year. Given that and given the stability of the economy, we are -- we believe it's a significantly lower probability that there would be destocking as we go into the fall.

Your next question is from Susan Maklari with Goldman Sachs.

First off, I just wanted to dip a little bit more into the demand trends. Can you talk about any shift that you're seeing in terms of mix that are coming through? And maybe along with that, I know you noted some of the very positive trends you're seeing in terms of your web traffic. Can you just give us any more details on that, too?

With respect to mix, we have -- our growth has sustained across the portfolio. And so similar to earlier discussions we might have had, our mix is consistent with what we projected and continues to show the strength of the broad base of the portfolio.

And forgive me, Susan, I forgot your second question, so if you could repeat it.

Yes, sure. I just wondered, you commented on the strength that you're seeing in terms of traffic to the website. Can you just give us a little more color there? Like is it people spending more time on the site? Is it more traffic to the site? Some combination they're in? Are there certain products or categories people seem to be more or less interested in? Any kind of details on that?

Sure. Our TimberTech site is focused on the consumer and, by definition, is focused on the consumer that's looking at outdoor living. And we -- so with respect to the data I shared earlier, it's really around the deck, rail and accessory consumer. And what we see there is an increase in website visits. We see an increase in engagement once they're on the website. And we also see an increase in sample orders placed. And as you may have heard, that's one of the industry indicators of interest in the category. And it's certainly one that we use to understand where our consumers are. And so we have -- the numbers I mentioned are really in reference to all of those variables where we've seen and continue to see really strong interaction with ourselves and doing that digitally.

I'll bring up one other point. As we look at long-term market conversion, we tend to get excited, the more consumers interact with the category. And we believe that as they get better educated, the market will continue to move away from wood into our types of products. So we also view that as a positive for the long term.

Okay. That's helpful. And can you also talk a little bit in terms of raw material costs, what that was like during the quarter and how the -- how you're thinking about that looking out? Obviously, there's been probably some deflationary tailwinds that you've seen, but what are you thinking about the sustainability of that?

Susan, it's Ralph. I'll take that one. First, on raw materials, if you go back a couple of months, when -- I'll call it, in the April, May period, as the COVID-19 situation was really unfolding, we saw declines in resin prices. I would tell you though that, that was fairly short-lived. As the economy, particularly on the construction side picked up, we're starting to see those prices stabilize and tick up.

In terms of our P&L, there's some benefit from that short decline. It really will flow through in our first quarter of fiscal '21, just the way it flows through inventory. So what we're seeing now -- only after a very short decline, what we're seeing now is some stabilization of prices and potentially even some ticking up of prices. Polyethylene looks to be around flat to prior year, PVC moving up a little bit more.

Your next question is from Philip Ng with Jefferies.

Congrats on a really impressive quarter out of the gates. Ralph, can you give us a little more sense of how much capacity you're adding in Phase 2 and Phase 3? And assuming everything comes on very smoothly, what type of growth can you sustain in the next 12 to 18 months just looking past to maybe fourth quarter? Because the industry broadly is sold out, so your ability to kind of deliver that capacity will kind of dictate how much growth you're going to be able to see.

Yes. So Philip, again, as we look at the total program, we're estimating about adding 70% capacity increase. That's obviously very significant from where we are. First phase is adding 20%. I'm not going to get specific by phase. And what we'll do is give you updates as we move through the quarters. The next phase of capacity add is as significant or more than the current one in the Phase 1 that we're doing. So there's meaningful capacity coming on in our fiscal second and third quarter of '21, okay? And I am sorry, the other part of your question, I might have missed.

It sounds like you're adding a lot of capacity. So it doesn't sound like it's going to limit your ability to grow -- I think you said it's 20% and then another 20% plus. That's helpful. And yes, and then thinking next 12 to 24 months out, longer term once again, you kind of reiterate this $500 million of margin expansion opportunity from self-help initiatives so that's great. But appreciating the start-up costs for some of this capacity, especially the greenfield side of things, does that push out some of that timing? And more importantly, do you have the recycling capacity given this uptick and capacity you're adding more broadly for decking?

Yes. On…

Let me -- I'll just give -- let me -- and we said it earlier, we feel really good -- I just want to correct on the 500 basis points, we're a little smaller that $500 million might be a little much for us right now, but 500 basis points -- relative to the 500 basis points, the areas that we outlined were -- that we're executing -- execution items against that, namely recycle, our AIMS program and the long-term SG&A leverage as we lap public company costs, we feel really good about the execution. Those are on track and we feel good about the execution of that. And when we laid out that execution, as you might recall, during the process, we also highlighted that, that execution included various start-up costs as we migrated forward. So at a high level, we're -- we feel really good about that opportunity. Relative to specifics on next year, we're obviously not in a position right now to talk specifics on '21.

Our next question is from Mike Dahl with RBC Capital Markets.

First one, sticking with the capacity side. So I think there's broad buy-in around kind of the secular nature of growth and people understand the current dynamics in terms of seeing very strong demand trends as things settled out post the initial COVID disruption. But the pushback we hear is more around the magnitude of additions when looking at what your largest competitor has announced and now what you're announcing and thinking about kind of the cumulative capacity adds for the industry being announced at a time when there's still potentially a little difficulty discerning what the sustained demand trend will be since you've got some potential stimulus effect now. You've got some shift in terms of wallet share and spending in-home versus out-of-home. How do you respond to that, Jesse?

Yes. I -- first off, as we look at the history of the market, this is an industry that has operated and has operated well with flat capacity in the system. And so we feel really good about the opportunity of the capacity coming online. And as it relates to the long-term trends, we believe that the capacity is needed to be able to meet our long-term trends. So we're really comfortable with our ability to continue to execute and to have favorable market dynamics given the combination of a historical track record of managing through that and also given the significant opportunity we see ahead of us.

The other thing I'll highlight is just as we're able to rapidly accelerate our capacity adds, if it seems appropriate, we would also have the ability to stage it in the future in a different way. And just as a reminder, as we add capacity, we typically do it in a modular way. So we have an ability to scale how fast we deploy it and at the pace we scale that up. And we said that when we talked about the $100 million, and we also believe that as we look at the $180 million. I'll add one additional point. The capacity expansions are to benefit our Deck, Rail & Accessory lines. But they're all -- but we also see ongoing opportunity in our Exteriors business. And we -- as part of the $100 million and as part of the $180 million, we're going to continue to take steps to facilitate the growth in those businesses. The Versatex acquisition, and that team continues to drive really strong innovation working -- and the AZEK team continues to drive market penetration. So we have 2 very strong businesses there. And part of what we're deploying will also facilitate their growth.

That's great. Very helpful. And then the second question, I may have missed it, but kind of a follow-on to Phil. I think there was a question around, given the stronger demand outlook, given the increase, the RNA capacity here, how are you thinking about the recycling capacity that you've got? Are there plans to accelerate your capacity adds in recycling? Or could that be an avenue similar to Return Polymers that you look at to pursue bolt-on M&A to backward integrate?

Yes. Well, obviously, as you point out, Return Polymers has been a terrific acquisition for us and really sets us up not only for now, but is a very scalable operation. And we view our recycling capability as something that we'll also be able to scale in the future. The specifics of what we're going to do, obviously, we'll share when appropriate.

Our next question is from Ryan Merkel with William Blair.

Two questions from me. First off, I think you mentioned low double-digit revenue growth for first quarter '21. So just clarify that if you would. And then does this assume the first 20% phase is fully online? And then are you assuming any channel loading in that? Or is it just matching sell-through?

Ryan, it's Ralph. Yes, as it relates to Q1 of '21, again, we felt given the volatile environment, and it was now a couple of months ago when we -- during the process of the IPO, we gave an outlook. We felt that it was important to provide some update there. And clearly, a couple of months ago, we thought there was the potential for destocking. As we look at the strength of demand and the inventory in the channel that's low, our assumption is that we're going to see continued solid sell-through and given the current inventory levels, there'll be some restoration of inventory in the quarter. We have -- with our capacity plans, we have ample capacity to meet the level of guidance that we gave you and as we're putting 20% more on in this quarter here finishing out.

Okay. That's helpful, Ralph. And then second question, guidance implies EBITDA margin down about 100 basis points sequentially in 4Q despite the higher revs. So can you just talk about the driver sequentially, just so we know the pieces?

Yes. I think the -- probably the biggest piece to point out is we're going into the fourth quarter, and we're incurring about $2 million of incremental public company-related costs, which really weren't in the third quarter. I think that's one. The second is just in the third quarter, as you recall, early in the quarter with the onset of the COVID-19 situation, we pulled back on marketing early in the quarter. And we're going to return to kind of more normal levels in the fourth quarter. So we're very confident in our ability to get SG&A leverage. But we're stepping into higher public company-related costs and a normalization of marketing spend. Those are the 2 differences sequentially. We're going to continue to have good productivity out of the factories and alike. And we'll have some COVID-19-related expenses in Q4 but to a much lesser degree than what we saw in Q3, where we actually had the factory down.

Your next question is from Seldon Clarke with Deutsche Bank.

Just given the impressive demand that you're seeing in decking and the capacity constraints that the industry is seeing more broadly. How are you thinking about the pricing environment going forward? Do you think increased conversion away from wood presents an incremental opportunity for pricing here? Is there anything as it relates to pricing baked into that margin target as well?

Let me start, and I'll let Ralph give you a little bit more granularity and it's more of the latter question you had. As we look at conversion, just as a reminder, we look at conversion in all segments, and we see conversion in premium woods, we see conversion in mid-tier woods and we see conversion in entry level. So I believe that we should -- or I believe that we'll continue to see that conversion opportunity. And that really sets us up well for a broad mix.

And then specific on the earlier question, I'll throw it over to Ralph.

Yes. Seldon, yes, and on pricing, pricing specifically, it's something we always look at. And we'll continue to evaluate that. I would just say for the direction that we gave on our Q1 '21, that doesn't include or contemplate pricing. Typically, if we were to price like we did this past year, we wouldn't see realization in the first -- in our first fiscal quarter just the way the timing and the execution would work. But that's something we're evaluating, and we'll continue to evaluate.

Okay. Got it. And then just sticking on that, your 500 basis points of EBITDA margin improvement target. Is there any way to quantify some of these dynamics either from a percentage or a timing standpoint, whether it'd be underlying operating leverage, the SG&A savings or the benefit from increased recycled material or even just how much of that 500 basis points is controllable versus macro dependent? And like I said earlier, I know you're not giving 2021 guidance, but if there's any way to just think about the timing of some of these buckets over the next couple of years, that would be helpful.

Yes. I think it's important as you think about the 500 basis points just to step back to the components that we talked about. It's largely driven by 2 areas, gross margin improvement. And within gross margin improvement, the majority of that benefit is going to come from our recycling initiatives and our AIMS initiatives. And then on the operating side, there's not a lot of volume leverage. You get a little bit of benefit from that, but not a lot in the gross margin line because 90% of our costs are variable. So the majority of the 500 basis points will come through that -- the operations side, and then there is SG&A leverage. That will pick up once we lap our public company costs. And I think we've also shown that we have the ability to manage our margins -- our EBITDA margins as volumes fluctuate. Because there are levers that we could pull in the SG&A side that would mitigate any decremental-type margin, which we've talked about in the past.

I think in terms of timing, we're really not wanting to lay that out specifically. The 500 basis points is clearly a long-term goal. Having said that, we have specific programs and actions to support it and execute against it. And internally, we do it. And we'll give you updates, as I mentioned, about guidance. We'll give you a view of our annual guidance for '21 later on after the end of this fiscal year.

Yes. Seldon, just a macro -- a very quick macro, as I mentioned earlier. And we've laid out some milestones, and we're on track. So for example, this particular quarter, as we speak, we're ramping up a specific formulation in our PVC facility that really sets up the next year plus the cost savings for us to be able to continue to utilize higher levels of PVC recycling and utilize different streams of PVC recycling. And so I think what Ralph is referring to is when we get into '21, we'll be able to provide a little bit more color on specific milestones like that. And those also include expanding our capability with the third recycle line that we talked about.

Congrats on a good first quarter as a public company.

Thanks.

Your next question is from Keith Hughes with Truist SunTrust.

It's Keith Hughes from Truist. Just a question on commercial real quick. It's got all the pressures that you highlighted in the intro, the EBITDA number was a nice positive in the quarter. Is that kind of EBITDA level possible the next several quarters given that these pressures are going to continue?

As we pointed out earlier, that particular business has some real positives to it and the team has done a terrific job of managing through, as you pointed out, a difficult macroeconomic climate. It's got some differentiated products and a nice market position. Specifics to EBITDA margins, et cetera, for that particular business in the future, we're not disclosing it, except that we have confidence in that team to continue to execute at the levels, if not better, levels in the future.

Your next question is from Adam Baumgarten with Crédit Suisse.

Just curious if in the quarter or in the near term here, if you've seen much of an impact from the shortage of decking lumber that's out in the market, and you guys may be seeing some incremental sales because of people's inability to source that.

As you pointed out, certainly, in certain geographies, there are shortages of different types of materials or longer lead times. The way I would put it is we saw an increase in pricing, I believe, in around 2018 of lumber, and then we saw a subsequent decrease in that. And the conversion rate has continued to sustain. And so we continue to see the opportunity for conversion and don't view that as something that is a quarter-to-quarter thing. We view it as a longer-term trend. And so we continue to see opportunity kind of independent of some of the volatility we've seen in wood.

Got it. And then just on inventory levels, broadly, it seems like they're pretty low. Is there any discernible difference between the dealer channel and retail?

We don't disclose specifics between the 2 channels. I'll just leave it at that.

Our next question is from Alex Rygiel with B. Riley.

A fantastic quarter, gentlemen. As it relates to the web traffic and sample demand growth, what's the lag to when this eventually works its way through the channel and results in shipments at your facilities?

We have -- I would say, I can give you a range of what our market research says. I would say it varies on the shorter side, closer to 2 months, maybe even 1 to 2 months all the way to the longer size, it can be over a year. And the reason why that range is so broad is really driven by the fact that the decision-making process for this particular category, it can be a more extended decision-making process. So I'd consider that range in there. It's a pretty broad range, I understand, but that's what the data shows.

And then circling back to the CapEx expansion decisions. Can you characterize that if that's due to improved market share gains that you picked up during the quarter? Or is it really just broadly more demand just all across the business?

I would say for us, as we look at the long-term opportunity that we see, we believe it's prudent to make the investments now to really set us up to be able to better service the market and also have an opportunity to continue to participate and potentially drive the market growth in the future. And so we certainly -- as we talked about on this call already, are seeing short-term positives. And as we look to the midterm, we've got macroeconomic uncertainty. But this focus on the home, this incremental benefit we might see that's extended really put us in a position to feel comfortable with the decision to expand our view of what we need to execute in the next 24 months.

And the comment in your answer there to drive market growth in the future was interesting. Does that suggest that maybe you missed out on some growth in the current quarter because of being at full capacity?

Yes. I think Ralph highlighted in his comments that we were unable to service all the demand that we saw within the quarter.

Our next question is from Trey Grooms with Stephens Inc.

First one is on -- kind of following up on some of the questions around Commercial. On the Commercial business, I mean, clearly, it's -- it was a -- it's continued to be soft. I mean everybody on that side of the aisle is facing some headwinds here. But I guess looking at the quarter down about 20% or so. And Ralph mentioned continued softness even through the calendar year. But just as far as magnitude, I mean, have you guys seen any signs of improvement there? Or is it kind of still running in that range? Or just trying to get a feel for how we should be modeling out that side of the business a little bit more detail.

Trey, we thought it'd just be prudent to, at this point in time, guide to the trends that we're seeing. There are some pockets of stabilization within that business, and some of the fundamentals, including some of the new products that we're offering both on the outdoor side as well as in bath and partitions and those kind of areas are very good and there's always strong interest. But we're in this window where it's a tough environment to exactly say when things will fully recover. We're starting to see some things stabilize. And we just thought it would be prudent to -- from our own guidance standpoint, to assume that through at least the end of the calendar year that the trends would continue. But there are some pockets of improvement, but it's not something that we'd say today we should be banking on and modeling. Long term, as we've talked about, this is a business that largely will track with GDP over time.

Yes. If I could -- and I'm sorry, Trey, just to maybe add briefly. And it's a bit of a contextual element. It's -- they're good businesses in the segments that they play. But just to give you a sense, in the last 9 months, their EBITDA contribution as we look at segment EBITDA is about 6%. So it's important that we continue to service those customers. But in a relative sense, it's still a pretty modest part of our business.

Yes, totally get that. And thanks for the update on the mix. So my follow-up is just maybe in the weeds, just a little bit more around the capacity increase. You talked about a 70% incremental decking -- an increase of 70% incremental decking capacity. And I think the initial plan was with the $100 million was that there was -- you were going to see increases, both on the composite decking side as well as PVC.

And Jesse, I know you talked about this just a little bit with continued expansions in trim and exteriors, things like that. But can you give us any idea of how the new expansion is kind of broken up into those categories? I think the initial plan was a little bit more on the composite side versus PVC. Just any color there as we look at kind of the types of products you'll be increasing that incremental?

I would just say directionally that we -- you should consider that both sides will benefit. And both sides will benefit roughly equally both on our cap polymer side and our cap composite side.

Your final question comes from Kurt Yinger with D.A. Davidson.

Just one quick one. Could you talk about some of the initiatives you have going on to deliver above-market growth on the residential side and how you're kind of thinking about future opportunities to increase your penetration in the retail channel and how you balance new product introductions while trying to keep some consistency within the channel?

Yes. First, thank you for the question. So let me start at the high level, and hopefully, I'll be able to get to your second question also. As we look at growth, we feel we're fortunate in that we have multiple levers to drive growth. And so at one level, we've made pretty significant investments in sales and marketing and downstream activities. That's both primarily within the Residential side and within the 3 components there. So we've made pretty significant investments in that downstream activity. So for example, on the exterior side, we bought Versatex, and we've expanded the AZEK sales force. So that's an opportunity and it's really an opportunity to continue to drive penetration. So that's one bucket.

The second bucket is really around execution around the consumer. And it falls under that marketing bucket, just making sure that we continue to engage the consumer appropriately and help them along the journey.

And then the third component, as you pointed out, was around new products. And we've got a commitment both to ourselves and the marketplace that we want to continue to have a strong new product pipeline that helps them fill their needs and drive productivity. So for example, in our Exteriors business, and we've talked about Deck, Rail, Accessories, but on the Exteriors business, we continue to drive products that help contractors with productivity as they're repairing and installing new exteriors.

And so as we look at the balance, we look to make sure that we're planting seeds for the future. And we pace things based on both our operational changes and based on what we think is appropriate for the market. And so we -- that's -- it's good insight. It's always a conversation that we have on making sure that we're adequately -- put it this way, we have greater capacity to launch new products than we feel the market could absorb. And so we're always in process of pacing that. So hopefully, that gives you a perspective. And I hope I answered your second question also.

We have no further questions at this time. I turn the call back to management for closing remarks.

Thank you all for taking the time this morning to engage us on our first earnings call. We're committed to doing the right thing. We're committed to the safety of our team members and our consumers and our channel partners and we're committed to continue to execute the strategic objectives that we've laid out.

So with that, thank you very much, and we look forward to further conversations over the next weeks and months. Have a great day.

This concludes today's conference call. You may now disconnect.