Azek (AZEK) has seen a successful public offering as investors see the potential for this outdoor brand, with homeowners spending more on their outdoors in a sustainable and ecologically friendly way. While leverage is under control following the public offering, the earnings multiples are very high based on the current performance, in part because some margin work remains to be done.
Reality is that the company requires real sales growth and margin progress to even come close to justifying the valuation. While I like the positioning of the company, this is not a rocket science business and has to deal with real competition, as I am very cautious on the prospects for the company following the offering.
Azek claims to be the innovation leader in outdoor living. The company focuses on beautiful, low-maintenance and sustainable products focused on a rapidly growing outdoor market.
The company believes that homeowners spent more outdoor space, and they recognize that advantages of both long-lasting products, particularly wood, combined with great aesthetics and lower maintenance costs. Products offered by the company include decks, rail, trim and accessories.
The company focuses on integrity and transparency in everything it does include a heavy focus on material technology and US-based manufacturing, including environmentally friendly methods.
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The company operates under its namesake brand as well as TimberTech for the residential segment. The company furthermore has a commercial segment which focuses on engineered sheet products and bathroom practitioners and lockers.
It should be said that the residential segment is the most important business with $655 million in sales, making up more than 80% of total sales with adjusted EBITDA margins close to 30%. The commercial segment makes up the remainder of sales and supports margins just around half that.
The IPO & Valuation Considerations
Azek sold 31.25 million shares at $23 per share in an IPO in which it raised $719 million in gross proceeds, as demand for the shares was solid with the preliminary trading range set at $19-$21 per share.
With 142 million shares outstanding following the offering, equity of the company is valued at $3.3 billion at $23 per share. Note that ahead of the offering, net debt stood at $1.13 billion as the offer proceeds makes that net debt is seen around $450 million. This values the entire company at $3.8 billion. After shares have risen to $30 in the first day of trading, equity is valued at $4.3 billion and the entire business at $4.7 billion.
Truth be told, the company has seen great operating momentum. The company grew sales 8% in 2018 to $682 million, and another 16% to $794 million in 2019. While EBITDA margins are quite impressive, EBIT numbers are not that impressive as operating profits totaled $52 million in 2018 and $59 million in 2019. Absence of any one-time charges, that actually implies some margin pressure and implies that EBIT margins came in at 7-8% last year.
With adjusted EBITDA totaling $180 million in 2019, I peg pro-forma leverage ratios at 2.5 times. Based on EBIT of $59 million and assuming a 4% cost on net debt, equal to interest charges of $18 million and assuming a 20% tax rate, I see net profits at $33 million. That works down to just about $0.25 per share, implying that shares trade at quite a demanding multiple.
Note that the fiscal year of the company ends in September, so the results for the first half of the year which ends in March, are known. The company grew sales by 15% in the first six months of the year to $412 million, but more importantly it doubled operating profits to $32 million. There is obviously some seasonality in the business, and assuming similar EBIT improvements are seen in the rest of the year, EBIT for the year might come in at $100 million.
Based on the same metrics above, I peg net earnings potential at around $65 million, or about $0.45 per share, as such earnings potential still translates into sky-high earnings multiples. The issue is of course that recent growth rates can not be translated into the second half of the year given the Covid-19 crisis, although the company largely sees flattish sales for the months of April and May, with actually modest improvements seen in EBITDA.
Basically the company has a very interesting leadership position in a rapidly growing market and probably has some room to bolster its margins. The issue is that of the valuation of course, as shares now trade at $30 per share and absence of Covid-19 the company at a maximum would earn about $0.50 per share on pro-forma basis, translating into a high multiple around 60 times earnings.
To even come close to fair value, I would require earnings per share of at least a dollar given the position and outlook. This works down to nearly $150 million after taxes, so ahead of taxes and assuming modest leverage it would imply at least $200 million in EBIT. That requires a real combination of sales growth and margins gains and while this could easily be achieved, even solid execution makes that such earnings power might only be seen a year or two or three from now.
Based on the elevated earnings multiples, it is worthwhile to make some comparisons as competitor Trex (TREX) is actually a listed company. Azek is valued at 6 times sales and 26 times last year’s EBITDA. Trex has seen a great run with shares trading at just $10 in 2013, now exchanging hands at an all-time high around $125.
The company generated $745 million in sales last year, in line with Azek, as the 9% sales growth is actually a little slower. With $189 million EBIT, the company is vastly more profitable, as margins come in around 25%, compared to 7-8% for Azek. At $125, the equity value of the company amounts to $7.2 billion, and the business at around $7.0 billion if we account for a modest net cash position. This values Trex at 9 times sales which is higher than Azek, yet Trex is vastly more profitable, and despite the great margins, the company trades at high earnings multiples as well.
So while Azek might have a bright future, at least in terms of the business with real potential for growing sales and margins improving, reality is that valuations are very high and great achievements must be delivered upon, just to justify the current valuation, let alone driven shares higher from here.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.