Karat Packaging Inc. Q2 FY2022 Earnings Call

Thank you all for joining us today for the Karat Packaging Second Quarter 2022 Earnings Conference Call. I will now hand it over to Roger Pondel from Investor Relations for Karat Packaging. Please proceed.

Thank you, operator, good afternoon, everyone. Welcome to Karat Packaging's 2022 second 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 our 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 recent 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.

Thank you, Roger. Good afternoon, everyone. Our second quarter 2022 results continue to reflect strong demand for our products, particularly our environmentally friendly offering, which grew 50% over the comparable prior year period. The positive sales performance was broad-based across all categories, paced by a 30% growth in the distributor channels. We continue to gain wallet share with our existing customers, and we added several new wholesale distributors to our customer roster. Sales were negatively impacted by approximately $2 million in fewer order fulfillment caused by shipping delays between our China manufacturing plant and other Karat warehouses, including two new facilities in Southern California and Hawaii, that we leased in May. The shipping delay issues were transitional, due to inventory overflow received in May and June, and have been resolved. I thank the entire Karat team for working diligently through it. As more cities and states in the United States and around the world enact new regulations to ban Styrofoam and single-use plastics, demand for compostable and biodegradable products is rapidly growing. We are experiencing an increase from national chains and grocery accounts for our compostable product. Karat is committed to its leadership position in eco-friendly disposable food service products. As we continue to provide new and innovative offerings, our joint venture announced in April, Green Earth Technology in Taiwan, is progressing well. The 180,000 square foot state-of-the-art automated bagasse factory to manufacture 100% compostable food service products is expected to be completed ahead of schedule, with production and shipping to begin before the end of this year. The plant is expected to produce approximately 648 containers of product annually. We are in discussions with our Taiwan partner to extend production lines to double the manufacturing capacity by mid-2023. Additionally, we plan to accelerate our initiative to build a bagasse plant in the US in 2023, using the proprietary manufacturing processes of the new Taiwan facilities. As we proceed further into 2022, we expect continued growth from our eco-friendly product lines, improvement in our fulfillment rates, with the recent warehouse expansion, and continued operating efficiencies. We are currently targeting net sales for the 2022 third quarter to be in the range of $117 million to $120 million, up from the $102.7 million for the 2021 third quarter. For the full 2022 year, we are reiterating our guidance, with net sales expected to be in the range of $445 million to $449 million versus the $364 million in 2021. Despite the significant increase in total freight and duty capitalization costs in the 2022 second quarter, we've achieved a gross margin of 29.6%, consistent with the 29.7% in the same period last year. Gross margin benefited from higher margin eco-friendly products, as well as favorable foreign currency exchange rates. Our gross margin goal for the 2022 full year remains 31% to 32% on average. We are currently seeing some meaningful drops in ocean freight rates. As we absorb the higher ocean freight costs, we are confident that we can still accomplish our full year average gross margin of 31% to 32%. I want to leave adequate time for questions, so with that, I will turn the call over to Jian Guo, our Chief Financial Officer, to discuss our financial results in greater detail.

Thank you, Alan. As Alan mentioned, we delivered another quarter of solid sales growth and increase in adjusted EBITDA on top of the exceptional growth achieved last year due to post-COVID reopening. We reported record quarterly net sales for the 2022 second quarter rising 22% to $114.9 million from $94.5 million in the same period last year, reflecting strong growth from existing and new customers. The increase was driven by our eco-friendly products and price increases implemented to partially offset higher product, freight, and labor costs, as well as increased revenue from our expanded logistics services. By channel, sales to distributors, our largest channel, grew 30% for the 2022 second quarter. Sales from the online channel increased 13%, sales to national and regional chains increased 12%, and sales to the retail channel increased 5% for the quarter. Gross profit increased 21% to $34.0 million for the 2022 second quarter from $28.1 million last year. Gross margin was 29.6%, consistent with 29.7% in the same period last year, despite the significant increase in total freight and duty costs. Overall, freight costs as a percentage of net sales increased to 18% in the second quarter of 2022 from 10.3% in the second quarter of 2021. Gross margin benefited from a shift to higher margin eco-friendly products and favorable falling currency exchange rates, along with improved operating efficiencies and leverage. With some abatement in the current ocean freight rates, we expect total freight and duty costs to continue to decrease as a percentage of net sales in the second half of 2022. We also continue to focus on optimizing our product mix and improving our operating efficiencies, and we are confident to deliver on our gross margin goal for the full year. Operating expenses in the 2022 second quarter were $26.2 million or 23% of net sales, compared with $21.2 million also about 23% of net sales in the same period last year. The increase included incremental warehouse transfer costs to manage inventory overflow, higher demurrage fees, additional temporary labor costs, including for COVID-related illness, and higher rent and stock-based compensation expenses. Other income net was $1.1 million for the 2022 second quarter, including a gain on foreign currency transactions of $850,000 compared with $4 million in the same period last year. The decrease primarily reflects a gain of $5 million from the PPP loan forgiveness, partially offset by interest expenses of $1.1 million in the 2021 second quarter. Provision for income taxes was $1.7 million or 20% for the 2022 second quarter compared with $1.5 million or 14% for the prior year quarter. The lower tax rate last year was primarily attributable to the gain of $5 million from the forgiveness of debt. Net income for the 2022 second quarter was $7.2 million compared with $9.3 million for the same quarter last year, which included the gain on debt forgiveness. Net income attributable to Karat Packaging for the 2022 second quarter was $6.3 million or $0.32 per diluted share compared with $9.6 million or $0.50 per diluted share a year ago. Adjusted diluted earnings per common share increased 17% to $0.34 from $0.29 in the prior year quarter. Adjusted EBITDA for the second quarter was $11.8 million, an increase of 15% from $10.3 million a year ago. Consolidated adjusted EBITDA margin was 10.3% in the second quarter versus 10.9% for the same quarter last year. Net cash provided by operating activities was $3.7 million for the three months ended June 30, 2022, compared with net cash used in operating activities of $7.2 million for the same quarter last year. The difference primarily reflected the increase in net income year-over-year, excluding a one-time gain of $5 million from debt forgiveness included in the prior year quarter, and more effective working capital management. During the 2022 second quarter, we invested $4.4 million in regular CapEx, principally for manufacturing machinery, and another $4 million to set up our joint venture in Taiwan. We finished the quarter with $96.7 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 June 30, 2022, the company had $11.6 million of borrowing outstanding under the line of credit and additional availability of $28.4 million under this line. With Global Wells refinancing of one of its term loans in June 2022, we gained additional liquidity of $8 million. We continue to explore other options to further expand our liquidity to support the business growth and enhance shareholder value. Alan and I will now be happy to answer your questions. And I'll turn the call back to the operator.

Our first question comes from Jake Bartlett from Truist Securities.

Thanks for taking my question. Alan, my first question is about fill rates. You mentioned that improving fill rates are aiding sales. Could you provide an update on how the fill rate has improved or changed since the first quarter? Additionally, how do you see this trending for the remainder of the year? Also, can you confirm whether fill rates are currently limiting your sales growth or if there is any softness in demand? It seems that demand is significantly higher than what you can fulfill, indicating that volume demand is a low risk. Any clarification on this would be helpful.

Thank you, Jake. To start, we are seeing our fill rate from our Texas facility, which is one of our largest, holding steady. In the second quarter, our fill rate was at 50%, meaning we had to short customers nearly half of the items they ordered. However, California performed much better with a fill rate of 85%, aside from a few items affected by warehouse conditions. We needed to lease an additional warehouse in California to manage operations and expedite shipping. Recently, we have been moving more product into Texas and are currently working on stockpiling in South Carolina, New Jersey, and Washington to meet the demands of our customers across various states. Regarding market demand, I do not observe any softness; in fact, the market is strengthening, particularly the demand for compostable and eco-friendly products, which is growing rapidly. For instance, San Mateo County will require all restaurants to use compostable products starting October 1st, and Hawaii will follow suit on September 1st. There’s a significant shift towards eco-friendly product lines. A national chain we spoke with last week reported that their takeout volume has surged from 15% pre-pandemic to 40% now, and they have even launched four branded virtual kitchens, further increasing their packaging needs. The industry is clearly expanding with the growing trend of disposable packaging, especially with the rise of ghost kitchens and virtual kitchens among established chain accounts.

Thank you for the information. I want to concentrate on gross margins for a moment. In the first quarter, there was a significant effect from the capitalization of freight and duty. Was there a similar impact in the second quarter? I may have missed that, so I would appreciate any insights on that. Additionally, we've been monitoring weekly spot ocean freight rates from East Asia to the West Coast, and I see they have decreased by about 60% year-over-year. When do you expect to see the benefits of this reduction reflected in gross margins? Is there usually a delay of a quarter or two before we notice the impact?

Sure. Ocean freight began to rise last year, and during our earnings conference call in the fourth quarter, we noted concerns about a headwind due to increasing ocean freight costs. The peak occurred in the first quarter, where we experienced favorable freight duty capitalization because we imported many products at the higher rates. However, freight rates began to decline in early June, not May. Consequently, in June, we did not expect significant favorable freight duty and capitalization gains for the second quarter, but we anticipate a tailwind starting at the end of the third quarter and continuing into the fourth quarter. Freight rates have dropped significantly, from around $21,000 in spot rates to about $5,700 today.

Okay, great. Jake, just to add on to Alan's comments to answer your question, during the second quarter, we did have an unfavorable impact from the freight and duty capitalization of about $2.3 million. So it did have a fairly significant impact on our gross margin. And now also to what Alan was talking about, we expect to start to see the benefit from the decrease in ocean freight rates in the third quarter, the later part of the third quarter, and then probably more so in the fourth quarter of 2022.

Great. For my last question regarding the Taiwan joint venture, I understood that this would demonstrate the automation for producing bagasse efficiently, considering it is usually a labor-intensive process. You intended to evaluate how the automation performs and if it is cost-effective. If it proves successful, there might be plans to introduce it to the US. However, it seems like you are leaning towards bringing it to the US now, but I’m unsure if the automation has been fully validated at this stage.

Yes, earlier this year, we planned to start in Taiwan and evaluate whether it's feasible before expanding to the US. Currently, we are seeing significant progress. Our production setup is essentially complete, and we are confident in our ability to train and hire staff in Taiwan to get operations running. This is why we are already moving into the second phase of our investment in Taiwan. We anticipate a strong demand for compostable products in the US. Other large manufacturers have attempted to establish bagasse production domestically, but none have succeeded very well thus far. We believe our manufacturing facility and equipment are competitive with what's currently available. The partnership and equipment our collaborators are developing are more advanced and offer greater efficiency. Furthermore, due to their experience, we are confident in their transition to the US market. We have had discussions with several chain accounts, and they are very supportive of domestic production over purchasing products from China. Currently, a large percentage of bagasse products—around 80%—come from China, and we aim to lessen our dependence on Chinese manufacturers by producing locally. From my discussions with various chains, there seems to be considerable support for a domestic supplier like us, especially if our pricing remains competitive.

Great. Thank you very much.

Our next question comes from Michael Hoffman from Stifel.

Hi, Alan, Jian, thank you very much for answering the questions. Regarding freight, can we expand on the commentary? There was a few million dollar headwind in the second quarter. If rates are declining and considering the inventory turns, you've increased inventory by $27 million sequentially. We can expect some pressure in the third quarter, although not as intense, followed by a notable reversal which is how we should consider that capitalized figure.

Yes. We have increased our inventory in Q2 and we are looking to significantly decrease our inventory in Q3 compared to Q2. And at the same time, we are going to see some favorable freight duty capitalization gain in Q3. That's where we're seeing it right at this point, because the ocean freight has dropped significantly.

Okay. Just to be clear though, you've got a lot of inventory that's subject to freight and duty costs that are higher than the current market rates. So, that's a burden, isn't it, in the third quarter until you can turn over more inventory? You need to move this inventory and bring in new stock at lower rates.

Yes, Michael. I wouldn't characterize it as a burden. There isn't a significant amount of inventory at elevated costs. The increased costs were primarily in the first quarter, not so much in the second quarter. Ocean freight rates have already decreased in the second quarter. The products we brought in during the first quarter were at much higher rates, and they have been depleted. This is reflected in the second quarter results. I expect our inventory to drop notably by the end of the third quarter because we've already observed a decrease in ocean freight coming in. All the new inventory is being brought in at lower cost freight rates. Next month, we will also reduce our inventory for a six-week period, and we will begin replenishing inventory this week. By the end of the quarter, most of our products will be at standard market rates, and we have not seen any decrease in prices in the market internally. Therefore, it won't be a market burden on our segment at this time.

So just to be clear, the $2.3 million freight and duty drag in 2Q should not repeat it should be neutral to positive in 3Q?

It will be neutral in Q3.

Okay. And then it should turn.

And Michael.

Go ahead, Jian.

Hi, Michael. Thank you for the question. I just wanted to provide a little color there. So I think Alan is exactly right. If you look at our inventory turns, our average inventory turn is about a little over 60 days. As far as total ocean freight and duty costs including sort of the cash-based cost, as well as the capitalization piece, if you look at the second quarter, the total ocean freight represented about 18% of net sales, which as I said included the unfavorable impact of a little over $2 million already from this capitalization. When we look at the third quarter, our current expectation for the total ocean freight costs including the impact from the capitalization, we expect to see that percentage decrease to mid-teens. So we do expect probably a 200 basis points to 400 roughly basis points decrease in our total ocean freight and duty as a set of net sales in the third quarter, if that answers your question.

Perfect. That's what I was trying to get at. Did you sign a contract and take a contract rate in May, like many others did? If so, what is your current mix of spot versus contracts in your containers?

Well, that's a very good question. Yes, everybody signed a contract in end of April, starting in May. And as shippers realized the spot rate is much lower than contract rate, all the ocean freight liners have agreed to reduce the contract rate to match the spot rate.

So your mix would have been really high, contracting earlier in the year. Now it's more spot, is what I'm hearing.

Everyone is on spot now.

What percentage of sales was eco-friendly? I’m sorry, I missed that in the prepared remarks.

Jian, you have the number?

Yes, it's still in the high teens. As a percentage of total net sales, we are seeing year-over-year it probably increased by roughly 1%; it's still in the high teens as a percentage of total sales.

So basically flat sequentially, but up year-over-year. So we've settled in sort of a current level of demand based on access to the product and things of that nature, but the trend is still to drive it higher.

Yes, we see a trend much higher.

And that trend is going to be boosted, obviously, by the joint venture in Taiwan, once the manufacturing starts and we begin to get the products out of the joint venture in Taiwan.

Right. And if I remember hearing it correctly, this should be in production in 4Q, but what am I looking at? It's really a 1Q before anything gets onshore USA.

That is correct.

Okay. And then the $2 million fulfillment issue, was this a function of some of the labor challenges you've been dealing with? And you just didn't have enough people to move all of the goods out of Chino to be able to redistribute it into the other distribution centers in order to be able to then deliver it to the customers?

Yes. In California, during the second quarter, particularly in late May and June, we experienced a significant rise in COVID-related cases. We faced an unprecedented number of staff calling in sick for five to eight days or more, leading to understaffing and difficulties in getting products out. This situation presented various challenges, including the need to hire temporary agency staff, which further elevated operational costs. Labor shortages were a major issue we confronted during the second quarter. To address this, we increased our labor force by 5% at the open house in early July to help cover those shortages.

And is it fair to say that the $2 million is not recoverable revenue? Somebody else fulfills it ultimately, or do you think you might actually get that $2 million back?

We anticipate recouping about half of that amount due to the shortage. If a restaurant needs a product and can't source it from us, they will seek alternatives. We experienced a delay in shipments from North America, particularly around 10 days from California. However, we have now mostly resolved our shipping issues, including those affecting Amazon and online orders, and we expect to improve our fill rates. Therefore, I would estimate that we will recover around 50% of the $2 million in shortages from last quarter.

And based on the comments you made in your opening remarks about moving products into Texas, South Carolina, and New Jersey, you would expect in 3Q those fulfillment rates out of those distribution centers to be better than they were in 2Q?

Yes, that's our goal.

Okay, great. Thank you.

Thank you, Michael.

Our next question comes from Paul Dircks from William Blair.

Thank you. Good afternoon, everyone. So, my first question is on price. Could you maybe quantify for us what price contributed in the quarter? And looking forward, do you expect to see any price deflation in particular on the plastic products side of the business?

I will address the impact of pricing on the quarter. Regarding price deflation, we do not observe any in paper products. In fact, paper products may see an increase in price early next year, possibly by the end of this year, due to a shortage of supply. Conversely, for plastics, while I have not yet witnessed any price drops at this moment, domestically, raw material costs have decreased by about 10%. However, manufacturers are experiencing higher operating costs due to increased warehouse storage fees, labor costs, and transportation expenses. Demand for plastics remains strong, especially during the summer season as many are looking to purchase plastic cups and transition from Styrofoam to plastic containers. Currently, demand continues to exceed product availability. Although we will monitor future trends, the growth in takeout is notable at 40%, and there are still some supply challenges in the market for various products, though not all. This is our current observation.

Yeah. That’s helpful. I guess, my next question is sequentially, could you maybe talk Alan about your conversations with the national chains and also your retail customers? On a sequential basis, sales were only up modestly. And thinking about how sales progressed last year, it's quite a bit of a lower growth rate than what we saw moving seasonally into the summer months last year. Can you maybe talk about those conversations that you had? Did the tone of those conversations change or perhaps get a little bit more cautious as we got into June and into July?

Sure. We have observed some softness in our Tea Zone product, specifically with Boba supplies, as sales volume has decreased. Last year, when the economy reopened, there was a strong demand for high-end drinks like Boba. However, this year we are seeing a decline. Nevertheless, we believe this trend may start to improve as more national chains look to include Boba supplies in their offerings. Currently, we are in discussions with our national chain accounts to increase their orders. This is part of our strategy to expand our market share among existing customers. We are also engaging with some significant large chain accounts to introduce additional product lines. We plan to announce in the third quarter which new chains and distributors we have added. It's important to note that while our growth with national chain accounts is expected to rise, this process takes time due to the need for approvals, markups, and sample testing. We completed these steps in the second quarter and aim to finalize most of the deals by the third and fourth quarters of this year, which should lead to an increase in sales for 2023.

Very good, and my final question is on the bagasse facility in Taiwan. Can you share with us how did those product margins compare to the other eco-friendly products that Karat currently offers? And how would those margins be affected with the introduction of the new US facility? Could those US facility margins be yet the richest that you guys would have in your portfolio? Can you help us understand the profitability of these products?

The key aspect of the bagasse product is its necessity. Many regulations are prohibiting plastic use, which includes polypropylene and reusable plastics. As a result, restaurants are transitioning to compostable options like bagasse or sugarcane products. Operational expenses in the US are likely to be higher than those overseas, but manufacturing in the USA brings reliability and domestic benefits. Customers can visit the facility to see production firsthand, alleviating concerns about potential supply chain issues, such as disruptions in China. Customers may prioritize these benefits over price, as long as our prices are competitive with overseas products. I cannot guarantee higher margins just yet, as we need to assess operational expenses as we begin production in the US. Additionally, part of our raw materials will come from our existing paper plants, allowing us to recycle paper pulp with sugarcane or wheat, which will help lower our raw material costs. This demonstrates how effectively we can utilize recycled raw materials in our production.

I appreciate the color. Thank you.

Thank you, Paul.

Thank you everyone. Well thank you all for joining the conference call for Karat Packaging's second quarter. We look forward to speaking with you again in the third quarter. Again, thank you very much and have a nice wonderful day. Operator? Thank you, ladies and gentlemen. This does conclude today's call. Thank you for your participation. You may now disconnect.