Good day, and welcome to the Karat Packaging Inc. First Quarter 2022 Earnings Conference Call. Please note, this event is being recorded. I would now like to turn the conference over to Roger Pondel. Please go ahead.

Good afternoon, everyone, and welcome to Karat Packaging's 2022 First Quarter Earnings Call. I'm Roger Pondel with PondelWilkinson, Karat Packaging's Investor Relations firm. It will be my pleasure momentarily to introduce the company's Chief Executive Officer, Alan Yu and its Chief Financial Officer, Jian Guo. Before I turn the call over to Alan, I want to remind all listeners that today's call may include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements are subject to numerous conditions, many of which are beyond the company's control, including those set forth in the Risk Factors section of the company's most recently Form 10-K as filed with the Securities and Exchange Commission, copies of which are available on the SEC's website at www.sec.gov, along with other company filings made with the SEC from time to time. Actual results could differ materially from these forward-looking statements, and Karat Packaging undertakes no obligation to update any forward-looking statements, except as required by law. Please also note that during today's call, we will be discussing adjusted EBITDA, adjusted EBITDA margin and adjusted diluted earnings per share, which are non-GAAP financial measures as defined by SEC Regulation G. A reconciliation of the most directly comparable GAAP measures to the non-GAAP financial measures is included in today's press release which is now posted on the company's website. And with that, it is my pleasure to turn the call over to CEO, Alan Yu. Alan?

Thank you, Roger. Good afternoon, everyone. We're pleased to be here with all of you today. Our first quarter 2022 results again demonstrated excellent operational execution, achieving record sales and strong margin expansion. Our positive sales performance was broad-based across all categories, including national and regional chain accounts, distributors, online and retail channels. Sales were boosted to some extent by Karat's Tea Zone branded products, particularly bubble tea supply, and our newly expanded logistics services. We continue to gain wallet share with our existing customers and added many new customers through wholesale distribution and through e-commerce, direct-to-consumer channels. Our online presence is an important initiative. In addition to selling Karat products, we plan to expand the selling platform of our sites, enabling other foodservice purveyors to showcase and sell their products and creating a convenient one-stop shopping option for our customers. The company achieved a gross margin of 32.5% in the year 2022 first quarter, increasing 390 basis points over the same quarter last year. Despite continued supply chain challenges and higher freight costs, this demonstrated our ability to improve operational efficiencies and cost leverage. Gross margin also benefited from freight and duty capitalization. Demand for compostable and biodegradable products is on the rise, as more cities and states are enacting regulations to ban single-use plastics and Styrofoam products. Karat's long-standing commitment to providing environmentally friendly disposable products has empowered us to grow into a leader in the industry. As we continue to provide new and innovative offerings, just subsequent to the close of the quarter, we entered into a joint venture agreement to build a 180,000 square feet state-of-the-art automated factory in Taiwan to manufacture 100% compostable foodservice products from bagasse, which is a derivative of sugarcane pulp. The new plant, which will feature state-of-the-art robotics, is expected to produce approximately 7,600 tons, or 650 containers of takeout boxes, plates, bowls, tableware, and other bagasse products in the year 2023. About half of the product produced at this plant will be earmarked for Karat's customers. This will further enhance Karat's vertical integration in its supply chain and minimize dependence on imported goods from China, which is where most bagasse products in the United States currently come from. Longer term, it is our objective to establish a similar plant in the United States and become a dominant domestic manufacturer in the near future. I am also happy to mention that as of this month, we expanded our warehouse capacity, adding a total of 90,000 square feet of new leased warehouse space in California and Hawaii. We also expanded our South Carolina warehouse space by 50,000 square feet to meet the continuously increasing demand. This much-needed additional warehouse space will give us more room to grow and allow us to further increase our fulfillment rates and support additional sales growth. As we proceed into 2022, we believe we will see continued business growth further accelerated by the expansion of our warehouse base and continued operating efficiencies. We are currently targeting net sales for the 2022 second quarter to be in the range of $116 million to $118 million, up about 24% at the midpoint of the range over the same period last year. Accordingly, for the full 2022 year, we are increasing our guidance with net sales expected to be in the range of $445 million to $449 million versus $360 million in the year 2021 and up from last quarter forecast of full-year growth guidance of 17% to 19%, or $426 million to $433 million. Our gross margin goal for the year 2022 full year remains 31% to 32% on average. The ocean freight costs are challenging to predict. We currently expect the freight rate to remain elevated for the remainder of 2022. While some of our higher first quarter ocean freight costs will be absorbed in the second or possibly the third quarter of 2022, we reiterate the full year average gross margin goal of 31% to 32%. We currently expect some tailwind from foreign currency gains and continued operating efficiencies to offset most of our expected unfavorable impact on freight and duty capitalization in the second quarter. I want to leave adequate time for questions. So with that said, I will turn over the call to Jian Guo, our Chief Financial Officer, to discuss our financial results in greater detail. Jian?

Thank you, Alan. As Alan mentioned, we delivered another quarter of impressive sales growth and a significant increase in adjusted EBITDA. We reported record quarterly net sales in the 2022 first quarter, rising 39% to $105.4 million from $75.7 million in the same period last year, reflecting strong growth from existing and new customers. Our new product offerings, greater product penetration, and price increases implemented throughout the second half of 2021 and the first three months of 2022 all contributed to the strong sales growth. By channel, sales to distributors, our largest channel, grew 48% for the 2022 first quarter. Sales to national and regional chains advanced 36%, and online sales increased 18%. Sales to the retail channel rose 32% for the quarter, fueled by our bubble tea suppliers. Gross profit increased 59% to $34.3 million for the 2022 first quarter. Gross margin for the 2022 first quarter rose to 32.5% from 28.6% for the same quarter last year. The margin expansion was primarily a result of the strong sales growth in our higher-margin products, improved operating efficiencies and fixed cost leverage, along with favorable foreign currency impact. Also benefiting gross margin was strong pricing to offset increased products, ocean freight, and labor costs. Although some of the higher first quarter freight costs will not be absorbed in the cost of goods sold until the second or possibly the third quarter of 2022, overall, freight costs as a percentage of net sales increased from 8.6% in Q1 2021 to 14.4% in Q1 2022. While we currently expect the ocean freight rates to remain elevated for the remainder of 2022, as Alan mentioned, we are confident that we will continue to effectively manage the freight costs and deliver on our gross margin goal for the full year. Operating expenses for the 2022 first quarter were $24.8 million, or 24% of net sales, compared with $17.9 million, also 24% of net sales in the prior year quarter. Our operating cost leverage remained consistent with the prior year quarter as the operating efficiencies achieved were offset by higher shipping transportation and production costs and stock-based compensation. Heading into the second quarter of 2022, we are seeing some abatement in the shipping cost increases and expect stock-based compensation to be more comparable year-over-year. Other income net was $1.1 million for the 2022 first quarter compared with $465,000 in the prior year quarter. We recognized an interest income of $1.3 million in both quarters from the change in the fair value of our interest rate swap. The interest expense on our line of credit and term loans decreased by $572,000 year-over-year, primarily due to the decrease in our average debt outstanding from the first quarter of 2021 to the first quarter of 2022. Provision for income taxes was $2.7 million or 25% for the 2022 first quarter compared with $1.2 million or 28% for the prior year quarter. The higher tax rate in the prior year quarter was attributable in part to the inclusion of certain nondeductible costs related to Karat's initial public offering, which was completed in April 2021. Net income more than doubled to $7.9 million for the 2022 first quarter from $3.1 million for the same quarter last year. Net income attributable to Karat Packaging Inc. was $6.7 million or $0.34 per diluted share for the 2022 first quarter compared with $1.8 million or $0.12 per diluted share for the same quarter last year. We delivered record first quarter consolidated adjusted EBITDA of $13.0 million, an increase of 90% from $6.8 million a year ago. Consolidated adjusted EBITDA margin improved 330 basis points to 12.3% in the first quarter from 9.0% for the same quarter last year. Adjusted diluted earnings per common share more than doubled to $0.36 from $0.15 in the prior year quarter. Net cash used in operating activities was $11.4 million for the 2022 first quarter versus net cash provided by operating activities of $4.5 million for the same quarter last year. The difference primarily reflected changes in working capital, including inventory buildup to accommodate higher demand in our peak season and an increase in accounts receivable from higher sales, partially offset by higher accounts payable and accrued expenses. We finished the quarter with $93.7 million in working capital compared with $72.1 million at the end of 2021. We believe Karat is well positioned to execute on its future growth strategies. As of March 31, 2022, the company has $10.2 million of borrowing outstanding under the line of credit and additional availability of $29.8 million under this line. We invested $4.8 million in CapEx during the 2022 first quarter, principally for manufacturing automation. Alan and I will now be happy to answer your questions, and I'll turn the call back to the operator.

And the first question will be from Jake Bartlett from Truist Securities.

And congrats on a great quarter. Good start to the year. My first question is on the increased guidance for sales in 2022. If you could maybe just give us some detail as to what the main drivers of the increased guidance are? It seems like demand for a while now has been really stronger than you can accommodate. So it feels like the demand has already been strong. So I'm wondering, is it the increased capacity that you've added in the quarter? Is it just the increased staffing that you're seeing? And then also if you can touch on whether there's more pricing assumed in that guidance. I think the pricing, at least what I had, was about 5% to 7% was going to be running through in 2022. Maybe any update there?

Sure, Jake. Well, one thing that we've seen is that the increase is coming from demand. For example, you heard that we are adding additional warehousing space, both in California and Hawaii. This is because we've seen the demand in Hawaii has actually exploded more than what we anticipated. There's more tourists going to Hawaii and, basically everywhere, there's demand for packaging. The same goes for California, where we're shipping to Las Vegas and Arizona; there's a strong demand increase on the packaging side for those states. More and more tourists are coming into Vegas and California. Another factor is our Boba Tea supply. We are seeing huge demand in the growth of Boba Tea supply during this first quarter, now that we're entering our peak season in the second quarter. Lastly, of course, more and more people are looking to go into the eco-friendly lines. We're seeing high demand in the bagasse products and compostable utensils; our full line is growing. I would say there are particularly a few categories growing really strong, but other categories are growing as well. Another thing is our fill rates are going up; last quarter, I mentioned that our fill rate was only 60%, but we actually increased our fill rate to approximately 70% to 75% now. That automatically increases our revenue. So I wouldn't attribute much of the increase in guidance towards the price increase.

That's really helpful. Could you share how much the first quarter benefited from the capitalization of freight and duty? You mentioned in the guidance that this aspect is included. Can you clarify how this might affect the rest of the year? It was beneficial in the first quarter. Will it be a disadvantage in the following quarters? Please help us understand how to model the quarterly trends.

Sure. Jake, thank you so much for the question. So in terms of the impact from the capitalization in Q1, the total dollar amount of the impact was approximately $6 million. As we mentioned in our remarks, even with the $6 million benefit in our cost of goods sold in the first quarter, overall, ocean freight cost remains, as a percentage of sales, much higher year-over-year. Last year, Q1, we were at 8.6% of sales versus Q1 this quarter, it was 14.4%. A lot of that was primarily because we were really starting up. We brought a lot of the shipments from Asia to stock up our inventory in anticipation of our peak season starting with the second quarter. To answer the second part of your question in terms of expectations for the remaining quarters in 2022, we expect to absorb a significant portion of the benefits that we've realized in Q1 in Q2. That said, I will highlight a few factors as we think about our gross margin for the second quarter as well as for the full year 2022 holistically. Even with a little bit of headwind from the ocean freight capitalization in Q2, we are seeing some favorable impacts, and we do expect to be able to offset at least partially or mostly some of the negative impact from the ocean freight capitalization in Q2. For instance, we are seeing a significant positive impact from foreign currency exchange rates, reflecting a strong USD against some of the currencies in Asia. We continue to see improvement in our product mix as we shift into higher-margin products and continue to improve some of our operating efficiency. So we are experiencing various positive factors that are trending toward offsetting the expected negative impact in Q2. Hence, we reiterated our full year 2022 gross margin goal of 31% to 32% on average.

Great. That's really helpful. And then my next question is on the JV that you're entering into in the facility. You mentioned, Alan, some tons of packaging and some containers. Can you help us understand what that might mean for sales in 2023? And do you expect that facility to be open kind of early in the year and that this could be a benefit for the whole year? That's my next question. And I have one more quick follow-up.

Sure. As you've stated, we expect 2023 will be the year when many states and cities will be transitioning from Styrofoam, paper, and plastics into 100% compostable packaging products. We've already received news that Los Angeles County starting May 1 is going to ban all single-use plastics, such as Styrofoam and plastic utensils, plastic straws, and plastic takeout containers. Hawaii already implemented that last year, and New Jersey is also banning them. More and more states are likely to follow suit. However, as we all know, the majority of bagasse products are still coming out of China. This is what we've been communicating to our investors; we are trying to move away from China into other parts of the world, Asia, or potentially via the joint venture we started in Taiwan. Our goal is to test out the automation of the robotic system and see if we can bring it into Texas to manufacture domestically. Yes, our goal is to produce these domestically, which would have a favorable impact on our revenue. Now we can actually control the cost of our product instead of worrying about ocean freight; all we need to consider are the raw materials, which can be sourced domestically. I would say we can produce 650 containers from the first phase of our joint venture. We do have a second part of the joint venture, which will also be able to produce another 650 containers from the same location. Regarding the total revenue for 2023, we're still working it out.

Got it. And then real quickly, is that more of a certainty of supply costs move? Or is that more of a driver of sales, you think, with that JV?

I would say it's driving our sales and also the ability to test the new equipment and see if they are suitable for domestic manufacturing in the U.S.

Let's just start on the eco and environmental products. Can you just update everyone kind of what percent of revenue that is now? And then what the expectation is for that percentage for 2022 guidance? And where it could go once the new facilities ramp up in '23?

Jian, can you provide Brian with the current numbers and I'll go over with the future goals of the company on that part?

Yes, sure. I can take that question. Brian, in terms of our eco-friendly products, overall, the percentage of total sales has gone up just a little bit from Q4. It remains in the high teens. I think Q4, we indicated close to 20%, high teens. So it's still in that range, having gone up just a little bit less than 1% in terms of the current quarter. As we consider the remainder of 2022 and 2023, we think the percentage will continue to increase as we are seeing development in certain regions. We expect the trend to continue into 2023, especially with additional capacities on our end as the joint venture production starts in the second half of this year.

And Brian, our goal for 2023 is to hit approximately 30% of our overall revenue from the eco-friendly product line, ESG, and green products. That is our goal.

Can you remind me, is the eco-friendly product materially higher in margins? Or is it pretty similar to your other products?

It is higher margin than our traditional products.

My next question was kind of on the overall growth. Can you break that down between price and volume between the strong growth you saw? And then maybe are you getting prices that offset the inflation in each business line?

Can you rephrase that question?

Well, I guess just at the very highest level, can you break down the organic growth between price and volume?

Yes, I can take that question. So when you look at the overall revenue growth year-over-year, I would say approximately half of that came from pricing and the remaining from primarily volume and mix. Regarding the pricing, to add additional context, we implemented multiple price increases primarily in the second half of 2021 and a bit in the first quarter of this year. That's really where we're seeing the benefit during our year-over-year comparison.

So if I heard that correctly, about 50% of the growth was from the increased pricing that you had put in place?

Correct. A little over 50%.

Okay. And on the cash flow side, on the inventory build, how should we think about that inventory through the remainder of the year? Does that come back down, and do we end up with a working capital number that's either flat or slightly negative? Or is that going to remain at an elevated level for a while?

I would think that inventory will remain elevated for a while because to support our growth, we expect our growth to continue to be strong. Last year, there were significant shortages of our products, which was one of the reasons our fulfillment rate was only at 60%. We realize that it takes us 2 to 3 months to get product from overseas to the U.S., and if a customer wants the product, they want it now. So we have to have products on hand sitting in our warehouse. This is one of the reasons we increased our warehousing space in California and Hawaii. By having the product in place, we can fulfill the demand that will automatically increase our sales. We are actually looking for more warehousing space in Texas and California to grow that. Accordingly, we'll be bringing more inventory in to support our growth.

Okay. So with that kind of change in higher inventory to support growth, I mean, is the expectation that free cash flow is going to be flat to negative this year?

I would say free cash flow will be positive this year, with us generating more net profit from the operations.

Okay. So even with the additional investment in inventory, you expect free cash flow to remain positive for 2022. That's fair?

That is correct.

Okay. And then last one for me. Any color on or update regarding the M&A environment and outlook for 2022 and 2023?

Well, last year, it was challenging when the market was booming and everyone was doing well. We saw a lot of M&A activities in the market. I guess now, with the market coming down, I've seen less M&A activities in recent months. However, I think this will be a good opportunity for us to really explore partnerships or which companies would be suitable for us to partner up with in the next 6 to 9 months as economies shift downward in most cases. I would say that there are more opportunities down the road than there were 6 months ago.

And the next question will be from Paul Dircks from William Blair.

So first one for me, I just wanted to ask, Alan, over the last 30 to 60 days, how has the tone of the conversations that you've had with national account customers changed as we've seen the rapid inflationary pressures across the economy take greater hold?

Well, in the past 30 to 90 days, we've seen that most of our national account customers are looking to work even more closely with us. There's still a concern about supply chain disruptions in the marketplace, primarily on the paper side. The paper shortage is still ongoing, and it could be concerning paper food containers, cups, trays, or other items. We have talked to many of the national chain accounts, and they want to work closely with us to ensure continuity of supply, just in case their primary supplier cannot accommodate them. This shift in mindset suggests the importance of having backup suppliers in a market where disruptions are a reality.

Got it. So perhaps stated differently, your response suggests that there isn't much change in demand from those national account customers. They seem to be looking to maintain it as a solution for their own supply chain challenges. We aren't really observing an economic impact in terms of a decline in demand related to you; would that be a reasonable conclusion?

Yes, I haven't heard much in terms of declines in demand.

Okay. I appreciate that. Switching to the online channel, you mentioned during the prepared remarks that you guys were planning to open up the website to become more of a one-stop shop. Can you maybe talk about, one, does this require a step-up in expenditure? And two, how would this change the growth potential and maybe even the margin profile of the online channel, which, as you know, is your highest margin channel for your business?

Well, I don't see any change in margin for our online sales. We've been utilizing Amazon to sell our products, but we are now utilizing our Lollicup store and our own website to sell directly to the end user. We feel that we need to expand our product offerings, not just what we have to carry ourselves, but in terms of sauces or other items that our customers may need. Our focus is on partnering with different vendors so that they can use us as a platform, leveraging our client base to sell their products, earning commissions, or affiliate commissions for us as an additional revenue stream. We want to better utilize our 40,000 online customers to provide more options for them.

That's helpful. And I guess quickly to follow up on that. Is it your expectation that there would be a major step-up in your expenditure in terms of your website? Or how quickly should we expect to see some of these new ideas implemented online?

I don't foresee a significant expenditure now because most of our expenditures were allocated last year and the year before. In the past two years, our operational expenses have been considerably higher due to investments in technology and warehouse management systems. We spent millions upgrading our online system. Currently, I would say that the investments we will make will be in personnel required to manage and expand our product offerings and partnerships on our platform. So, the focus for this year is on people rather than the website itself.

That's helpful. Last one for me. You had mentioned that you expect ocean freight rates to remain elevated over the course of 2022. But recently here, we're starting to see rates come down a bit. So my question is, can you remind us if those rates do continue to come down, how quickly we should see those affect your P&L? Are we likely to see some margin tailwind from this later in the year if we continue to see the current change persist?

Sure. The reason I indicated that we expect the ocean freight to remain elevated is based on last year; we saw it come down briefly for 3 weeks, 4 weeks, 5 weeks, then it went back up again. Currently, we notice that while ocean freight has decreased in the past 4 to 5 weeks, this is mainly due to the lockdowns in the ports of China. When the port reopens, will we see rates go back up again? So we are cautious. For now, we remain steadfast on our projections regarding significant drops in rates. If the situation continues positively, we may see some improvements in our margins during the second half of the year. That said, I want to reiterate that domestic freight truckload rates have come down due to a lack of products arriving from overseas, but at the same time, the LTL carriers have raised their domestic shipping rates significantly.

And the next question will be from Michael Hoffman from Stifel.

Okay, so you can tell from my voice. It's why Brian asked the questions, but we had some follow-up, if I could. With regards to the ocean freight, how much is your freight cost, a contracted rate versus a spot rate?

Yes. We have contracted rates, which last year averaged about $4,500. Our current year contracted rate is about $10,000. This is one reason we expect ocean freight to remain elevated. The market rate from freight orders is about $9,000 now, which is still higher than our contract rate from last year.

What percent of total freight is contracted versus spot?

Last year, I would estimate about 40% to 50% of our freight was contracted versus spot rate. Starting May 1, we have taken about 10% to 20% of our contracted rate. The remaining 80% will use market rates.

Okay. So if the trend is favorable, you might actually get the freight as a tailwind because you can lean on the spot rate for some of that?

Correct.

So the next question is about capitalizing freight costs. Within the full year guidance, how much have you assumed you're capitalizing freight as a dollar amount versus the $6 million in 1Q? And within the capitalization, what's the timeline to amortize that off?

Yes, I can take that question. Michael, if I understand correctly, your first question is about how much benefit we have capitalized from ocean freight costs in Q1. We capitalized approximately $6 million in Q1. As I previously mentioned in my remarks, despite the benefit of around $6 million, our total ocean freight cost was about $15.2 million or 14.4% of net sales in Q1. Regarding how soon we expect to amortize that benefit on the P&L, our current estimate depends on the volume of purchases that we make in the second and third quarters. Based on our current estimates, we do expect to absorb most of the benefits from Q1 in the second quarter. There may be a small portion we recognize in the third quarter this year. Again, I want to emphasize that even with the expected hit from ocean freight capitalization in Q2, we all reiterated our gross margin goal of 31% to 32% on average for the full year.

To clarify, the full year guidance does not rely on having capitalized freight for the entire year; instead, you will effectively reabsorb it. This situation presents more of a timing difference regarding when that expense is recorded, as part of that expense is recognized within the framework of considering capitalization as a 5- and 10-year amortization cycle. I believe this is an important point. Am I mistaken?

Our full year guidance on gross margin does include the anticipated impact from ocean freight capitalization across all quarters.

Yes. But if I understood you correctly, Jian, what you're saying is you capitalized in 1Q, you're going to reabsorb most of it in Q2 and a little bit in Q3. So that you will have absorbed it within the P&L, and you're still going to make your numbers.

That's correct.

I think that's an important point is you're not getting to your numbers by capitalizing an expense for the full year; it's more of a timing issue.

Yes, you're correct. The margin expansion was not really driven by capitalization. The capitalization just led to some fluctuations between the quarters.

Yes. But I mean it did help your reported number.

Yes, our fulfillment is definitely better than last quarter and also compared to last year's same quarter. We had a major fulfillment issue last year. I would say first quarter is better, and second quarter will be even better.

Okay. And lastly, labor has been a challenge for you, but you didn't really bring it up this time. So making decisions like adding warehousing or what have you, you can staff add and you're feeling better about labor availability on a relative basis?

I would say labor is definitely better than the beginning of the year. More people are looking for jobs now. I would say that it's improved; we are in a better situation than the previous quarter and last year.

And the next question will be a follow-up question from Jake Bartlett from Truist Securities.

Great. My question is about pricing. You mentioned that pricing contributed about 20% to the first quarter and accounted for half of the approximately 40% revenue growth. Considering this was implemented throughout 2021 and you've already adjusted it a bit more in 2022, how much of the expected 22% to 23% revenue growth in 2022 is due to pricing?

I believe Jian mentioned that 50% of that 23% will be contributed by the price increase we initiated last year, particularly towards the end of the year. The current prices reflect the new rates we raised in October, November, and January this year. This means that nearly half of that projected growth will stem from pricing.

So just to clarify, I initially thought the first question about pricing was specifically regarding the first quarter, but it wasn't. Are you saying that you expect an average pricing increase of about 11% to 12% for the entire year of 2022?

The growth this year is expected to be 22% year-over-year, with approximately 10% of that attributed to price increases.

Okay. And then maybe just to ask the question about what in the first quarter, how much of the 39% revenue growth was from pricing?

Jian, do you have that number?

Yes. As we discussed earlier, Jake, just over 50% of the first quarter year-over-year revenue growth was attributed to pricing increases. I also want to mention that as we head into the second half of this year, the year-over-year impact from pricing will lessen, as much of our price increases were implemented in the second half of 2021.

Great. That's helpful.

Thank you, operator, and thank you all for joining us today. We appreciate your support, interest in our company. I look forward to speaking with you again. Thank you very much. Have a nice day.

And thank you, sir. The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.