Karat Packaging Inc. Q3 FY2022 Earnings Call

Good day and welcome to the Karat Packaging Inc. Third Quarter 2022 Earnings Conference Call. All participants will be in listen-only mode. After today's presentation there will be an opportunity to ask questions. Please note, this event is being recorded. I would now like to turn the call over to Roger Pondel, Investor Relations for Karat Packaging.

Good afternoon, everyone and welcome to Karat Packaging's 2022 third 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 Karat Packaging'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 third quarter 2022 net sales increased 7% from the prior year period, which was particularly strong due to post-COVID reopenings. Results for the most recent quarter were impacted by customers destocking certain inventories. Due to supply chain recovery, nonetheless, we continue to see solid long-term demand, particularly for our environmentally friendly products, which grew 27% over the comparable prior year period. We also continue to gain wallet share with our existing customers and have recently closed numerous new deals with both new and existing chain and distributor customers. We are fully committed to growing our offering of eco-friendly disposable food service products as more cities and states in the United States and around the world enact regulations to ban Styrofoam and single-use plastic. Customer increases are rising, as is demand. We remain optimistic about our leadership position while we continue to invest in new and innovative compostable products. Our joint venture building a bagasse factory in Taiwan is progressing well. It is expected to begin manufacturing 100% compostable food service products in December, with first shipments beginning early in the new year. We are already receiving orders and inquiries that could fill capacities. Our initial investment of approximately $6.5 million in this project is on target to produce approximately 648 containers of products annually, and we are in discussions with our Taiwan partner to expand the production line to double the manufacturing capacity by mid-2023. Gross margin for the third quarter expanded significantly despite selling through some inventory with higher freight and duty costs absorbed from the first and second quarters. We continue to see solid gross margin improvement into the fourth quarter from normalized ocean freight rates, a continued shift to higher margin products, and foreign currency gains, which already allow us to implement some price reductions to proactively pass on savings to our customers. We achieved record quarterly operating cash flow and ended the quarter with financial liquidity of $54.5 million. We are pleased to announce that our board of directors recently declared a special cash dividend of $0.35 per share on the company's common stock. Karat's consistent solid growth has built a strong financial and liquidity position for the company, giving us the flexibility to return excess capital to our shareholders. As we proceed into the fourth quarter and fiscal 2023, we have implemented several new initiatives to significantly grow online sales. We expect to continue growth from our eco-friendly product line, improvement in our fulfillment rate with recent warehouse expansion, and better operating efficiencies. We are currently targeting net sales for the 2022 fourth quarter to be in the range of $95 million to $98 million, up from $91.3 million for the 2021 fourth quarter. We are confident in achieving our full year average gross margin goal of 31% to 32%. I will now turn over the call to Jian Guo, our Chief Financial Officer, to discuss our financial results in greater detail.

Thank you, Alan. We achieved net sales of $110 million for the quarter, up 7% from $102.7 million in the same period last year. With the widely anticipated economic downturn along with the supply chain recovery, net sales for the 2022 third quarter were impacted by customers destocking certain inventory. The increase from the strong prior year quarter due to COVID reopenings was principally driven by our eco-friendly products, including continued gains in wallet share with our customers. By channel, sales to distributors, our largest channel, grew 11% for the 2022 third quarter. Sales to the retail channel increased 7%. Sales to national and regional chains increased 5%, and sales from the online channel decreased 4% for the quarter. Gross profit increased 15% to $34.2 million for the 2022 third quarter from $29.8 million last year. Gross margin expanded 210 basis points to 31.1% from 29.0% in the same period last year. Gross margin benefited from higher margin eco-friendly products, previously implemented price increases to offset inflation, favorable foreign currency exchange rates, and improved operating efficiencies and leverage. Although ocean freight rates dropped significantly towards the end of the third quarter, total freight and duty costs remained elevated at 14.8% of net sales during the third quarter of 2022 compared with 14.1% of net sales in the prior year quarter. The 2022 third quarter freight and duty costs included an impact of $5.9 million from freight and duty capitalization as we sold through some inventory with higher freight and duty costs absorbed from the first and second quarter. We expect total freight and duty costs to continue to decrease as a percentage of net sales in the 2022 fourth quarter, and potentially into 2023. We continue to focus on optimizing our eco-friendly products and online sales and improving operating efficiencies to offset price reductions of certain products. As Alan mentioned, we are confident in delivering on our gross margin goal for the full year. Operating expenses in the 2022 third quarter were $26.3 million or 24% of net sales, compared with $24.4 million, also about 24% of net sales in the same period last year. The net increase in expenses was primarily due to higher labor costs and workforce expansion and an increase in rental expenses from our expanded warehouse distribution network. Other income totaled $143,000 in the 2022 third quarter, compared with other expenses totaled $24,000 in the prior year quarter. Other income for the 2022 third quarter included a gain on foreign currency transactions of $369,000 compared with a foreign currency loss of $63,000 in the 2021 third quarter. Net income for the 2022 third quarter increased 51% to $6.2 million from $4.1 million for the same quarter last year. Net income margin was 5.6% for the 2022 third quarter compared with 4.0% a year ago. Net income attributable to Karat Packaging for the 2022 third quarter was $6.1 million or $0.31 per diluted share, compared with $3.8 million or $0.19 per diluted share a year ago. Adjusted EBITDA for the third quarter rose 30% to $11.7 million from $9.0 million a year ago. Consolidated adjusted EBITDA margin was 10.7% in the third quarter versus 8.8% for the same quarter last year, and adjusted diluted earnings per common share increased 50% to $0.33 from $0.22 in the prior year quarter. During the 2022 third quarter, we generated record quarterly operating cash flow of $20.2 million and paid off the entire $11.6 million balance of outstanding borrowings on our $40 million line of credit. We believe Karat is well-positioned to execute on its future growth strategies. We finished the quarter with $90 million in working capital compared with $72.1 million at the end of 2021 and financial liquidity of $54.5 million. We continue to explore other options to expand liquidity in support of business growth and to further enhance long-term shareholder value. Alan and I will now be happy to answer your questions.

Thank you. We will now begin the question and answer session. Our first question comes from Jake Bartlett with Truist Securities.

Great. Thanks for taking the question. My first one is, Alan, what’s your confidence that destocking is what's driving the lower sales? I think your destocking has been more impactful on distributors than the change in other channels. So my first question is really just what's your confidence level that something is temporary as destocking is what's driving the slower sales growth?

Well, first of all, you're right. The change in destocking is mainly among distributors. A lot of distributors are actually overstocked. I can tell that by talking to many of these distributors, they were so afraid of the supply chain disruptions and outages in the past months that they purchased excessive amounts of inventory. Some were buying truckloads of products for 30 to 45 days inventory. As a result, every warehouse, including ours, was packed with products coming from overseas. We even had to emergency lease a secondary warehouse in California just to store the products. Luckily, we were able to destock some of our inventories, and that’s why our operations are back to normal. In July and August, we were scrambling to find spaces, and it hampered our operations. We had to spend extra money in terms of additional labor to move products, leading to reduced operational efficiency because the warehouse was cluttered and blocking access to pathways. The same situation applies to our customers.

So, Alan, what do you think is driving the slower growth at the chains and online? I think the messaging from your distributors wasn't significantly below expectations. So, why do you think there's such slower growth at the chains and online if it's not primarily destocking?

Yes, we have started price reductions. As you know, we had seven price increases last year and two this year, primarily due to increased ocean freight costs. As those ocean freight costs have dropped, we took the initiative to allow our customers to benefit from lower costs—offsetting inflationary pressures from the last year and earlier this year when ocean freight was at $15,000 per container. So that is another factor contributing to our overall revenue.

Okay. So, on pricing, do you expect your average prices to be down year-over-year in 2023? Is that possible considering the price increases you have implemented over the past couple of years?

I do see certain categories in plastic having lower prices. However, on the paper side, it has held strong, and we see potential increases there. The demand for paper has actually increased significantly, especially with many places in California and other states banning Styrofoam and plastics. So, while I see plastic prices coming down, paper prices are expected to rise. That’s where we see the opportunity for growth in eco-friendly product lines.

So on average, do you think prices will hold flat in 2023 versus 2022 across your portfolio?

I do see plastic prices coming down, but the cost of paper will likely go up. So that’s the main point of offsetting there.

Hi, good afternoon, Alan. If you could talk a bit about what's going on in Q3 and how that might carry into the remainder of this year and into next year. How much of the year-over-year growth was in units versus price?

I would think Jian will answer that question in terms of the specifics on year-over-year growth numbers.

Yes. Hi Michael, thank you for the question. In terms of the quarterly year-over-year revenue growth, the vast majority of the growth actually was driven by pricing. We actually saw a little bit of a decline in terms of volume. So overall, as Alan pointed out, our overall year-over-year growth is about a little over 7%. I should mention that this year’s year-over-year comparison has been quite challenging for us, because last year, Q3 was outstanding with over 30% growth due to the post-COVID reopening.

Can you assess your confidence on destocking across product lines? How much has already been corrected?

I’m sorry, could you please repeat your question? I didn’t catch it clearly.

You mentioned destocking. When analyzing the types of SKUs being destocked, do you believe there’s still more to go or has it mainly happened in the last quarter?

To my understanding, from customer reports, some of them are still overstocked, particularly in plastic items. Retail customers are starting to reduce their in-store inventories and reordering. We are beginning to see improvements this month, perhaps due to preparations for the holiday season. I expect that most of the destocking has occurred by the end of this third quarter and the beginning of the fourth quarter.

Could you provide projections for fourth-quarter revenue factoring in destocking and expected price dynamics?

Correct.

Are there specific SKUs or product categories experiencing greater destocking pressures?

Yes. Particularly in the plastic categories, customers are destocking inventory because they see prices decreasing. They don't want to hold inventory with a higher cost. Meanwhile, on the paper side, demand remains stable, and inventory levels are correct, without the shortages we experienced in the past.

Looking at freight costs that have decreased substantially, what do you expect in terms of the sequential impact on your costs and margins moving forward?

As Jian mentioned, we have seen that 90% to 95% of the freight and duty costs were absorbed mainly in this quarter. We do not expect these costs to adversely affect our gross margins going forward, especially in fourth quarter gross margin, which we anticipate to be significantly higher than in the second and third quarters.

Can you provide a sense of how freight costs will impact gross margins as we move into 2023?

I believe we will achieve a gross margin of 31% to 32% in 2023 or even higher because the eco-friendly products we are bringing in generally carry higher margins due to their limited availability.

Thanks. Good afternoon, Alan. Can you comment on consumer spending in restaurants as you plan for 2023? Are you anticipating slower demand from your customers?

I see slower demand from Mom and Pop retail stores, but there appears to be increased demand from national restaurant chains. More customers are spending at fast-food restaurants compared to small independent eateries, which is shifting demand.

In previous downturns, what actions do you see your customers typically taking regarding cost savings?

From my discussions with restaurant customers, their main concern is not about packaging costs but rather about staffing and labor shortages, which have become a larger part of their expenses than packaging.

Can you provide expectations for revenue from the Green Earth Technology joint venture in 2023?

We expect to ship at maximum capacity of 648 containers a year in 2023, with overall revenue projected between $20 million and $25 million. Discussions are ongoing to potentially increase capacity by mid-2023 due to rising demand.

Regarding pricing and competition, are you seeing suppliers getting more aggressive as supply chain issues ease?

I don’t see competitors significantly dropping prices right now; it's more about service. Most larger domestic manufacturers are trying to maintain relationships and ensure stability rather than heavily competing on price. However, distributors are starting to lower their prices to try to regain business.

So, you're not losing the share you gained during supply chain disruptions?

Correct. In fact, we are adding some new accounts in the Midwest and Southeast regions as we can begin in-person visits with customers again. Thank you, operator, and thank you all for joining us today. We appreciate your support and interest in our company. I look forward to keeping you updated on our progress and to speak with you again in the future. Have a great Thanksgiving and holiday season ahead.

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