Good day and welcome to the Karat Packaging Inc. First Quarter 2023 Earnings Conference Call. Today, 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 conference over to Roger Pondel, Investor Relations. Please go ahead sir.

Thank you, operator, and good afternoon everyone. Welcome to Karat Packaging's 2023 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. Our first quarter performance reflects a strong execution of our 2023 business strategy. We were able to achieve a record gross margin of 39.8% and record adjusted EBITDA results since the company's IPO in 2021; despite the industry-wide deflationary environment and multiple price reductions that we implemented. Moving ahead with our growth strategy on improving inventory management and fill rates, we recently signed a lease for an 83,000 square feet distribution center in Houston, following the addition of a Chicago warehouse earlier this year. Our plans for geographic expansion on the East Coast and the Midwest region are progressing well. With the recent expansion of the sales team and additional marketing activity together with the new contracts that were signed during the fourth quarter last year, we are expecting revenues to pick up again during the second half of this year. As a reminder, revenue for the first half of 2023 is expected to be lower than the same period last year, when pricing for inventory sold was at the peak level. In addition, order volumes during that time period last year were unusually high due to supply shortages. We continue to execute our asset-light business plan and are now scaling back manufacturing production in California while increasing import items focusing on higher-margin products during the past few months. We have significantly enlarged our sourcing network in Asia, giving us greater flexibility without additional overhead. Our growing demand for eco-friendly and compostable products this category grew 17% in the first quarter over the prior year quarter, and demand remains strong. Our 2023 growth goals for the eco-friendly product category is to be around 35% of total sales. Due to the multiple construction and regulatory approval delays in Taiwan and our recent strategy to shift toward imports and diversifying eco-friendly product sourcing, we decided to sell a proportion of the joint venture bagasse factory to Kerry Global Group. We are expecting the transaction to close within a three-month period or soon thereafter, with the selling price equal to our initial investment of about $6 million plus 5% interest. Lastly, we made a significant upgrade to our e-commerce platform and expanded our online support team. Sales to Canada and Hawaii are underway and proceeding well. We are now seeing some of the benefits of our online efforts with the business going in a positive direction. We again generated strong operating cash flow during the first quarter and continue to project positive cash flow throughout 2023, which is allowing Karat to generate excess capital and seek new opportunities. Accordingly, as announced on Tuesday, our Board of Directors declared another special dividend of $0.35 per common share. I will now turn the call over to Jian Guo, our Chief Financial Officer to discuss the company's financial results in greater detail. Jian?

Thank you, Alan. Despite a challenging year-over-year comparison, first quarter 2023 results demonstrated our ability to adapt to the external business environment as we were able to significantly enhance margins and strengthen the company's liquidity position. Net sales for the 2023 first quarter as anticipated decreased 9.1% to $95.8 million from $105.4 million a year ago. This was slightly better than our original expectation. Last year's first quarter was a particularly strong revenue quarter with inventory price increases at the peak due to extraordinarily higher ocean freight and other costs and strong volume resulting from overall supply shortage in the industry. By channel, sales to distributors, our largest channel, was lower by 7.6% for the 2023 first quarter. Sales to national and regional chains decreased 14.2%, sales to retail channel decreased 21.7% and sales from the online channel increased almost 1%. As Alan mentioned earlier, our investment in marketing efforts to support our e-commerce platform have begun to bear fruit. Sales of our eco-friendly products increased 16.8% for the first quarter. We continue to further strengthen our leadership position as Karat experiences strong growth from these products based in part on our enlarged sourcing network and expansion of our product offering as well as the evolving regulatory landscape. Eco-friendly products represented 33% of total sales in the 2023 first quarter compared with 25% a year ago. Gross profit increased 11.2% to $38.1 million for the 2023 first quarter from $34.3 million last year. We achieved record gross margin of 39.8% in the first quarter, an improvement of 730 basis points over the prior year quarter. Gross margin expansion benefited by a significant decrease in ocean freight costs, which amounted to 5.9% of net sales in the 2023 first quarter compared with 14.4% of net sales last year. Also, costs for certain raw materials were lower and operating efficiencies and productivity are continuing to improve. Operating expenses in the 2023 first quarter were $25.4 million or 26.5% of net sales compared with $24.8 million or 23.5% of net sales in the prior year quarter. The increase was primarily due to workforce expansion and increase in rental expenses from the two additional warehouses added in May 2022 and higher marketing expenses to support online sales growth. The increase in operating expenses was partially offset by decreases in shipping and transportation costs and bad debt expenses. Net income for the 2023 first quarter increased 15.6% to $9.2 million from $7.9 million for the same quarter last year. Net income margin was 9.6% in the 2023 first quarter compared with 7.5% a year ago. Net income attributable to Karat for the 2023 first quarter was $9.0 million or $0.45 per diluted share compared with $6.7 million or $0.34 per diluted share in the prior year quarter. Adjusted EBITDA, a non-GAAP measure was $15.3 million for the 2023 first quarter compared with $13.0 million in the prior year quarter. Consolidated adjusted EBITDA margin expanded to 15.9% of net sales compared with 12.3% for the 2022 first quarter. Adjusted diluted earnings per common share rose to $0.46 per share from $0.36 per share a year ago. Karat's consistent solid growth has built a strong financial and liquidity position for the company. The company is well-positioned to execute on its future growth strategies. We finished the quarter with $97.4 million in working capital compared with $84.5 million at the end of 2022 and have financial liquidity of $62.1 million with another $10 million in short-term investments. Moving further into 2023, we are forecasting revenue for the second quarter to be down about 5% year-over-year. Moreover, we are reiterating net sales for the full year expected to increase by high single digits, from new contracts, increased inventory fill rate with additional warehouse space, benefits from additional marketing efforts and better pricing comparisons. As Alan mentioned, we are now scaling back manufacturing production in California, selling and disposing of equipment and raw materials that no longer will be needed, to create more warehouse space for import products and to further improve inventory management and efficiency. Accordingly, we're currently expecting to record an impairment charge in the range of $2.7 million to $3.5 million in the second quarter of 2023, including approximately $1.5 million to $2 million write-off of inventory with the remaining write-off in operating expenses. We expect to benefit from this shift of strategy to more than offset the impairment charge. At the gross margin level, we believe the gross margin for the first quarter was exceptionally high and is not indicative of future quarters. We are reaffirming our 2023 full year margin goal to be in the range of 32% to 33%, even with the expected impairment charge in the second quarter as we expect to continue to benefit from the stabilized ocean freight, and our efforts to increase import, shift towards high-margin items and improve operating efficiencies. Alan and I will now be happy to answer your questions, and I'll turn the call back to the operator.

We will now begin the question-and-answer session. Today's first question comes from Jake Bartlett with Truist Securities. Please proceed.

Thank you for taking my question. My first inquiry is regarding gross margin and the guidance provided. I want to confirm that the reiteration of the gross margin at 32% to 33% includes approximately $2 million in expenses. Were those expenses, or the inventory write-off, excluded from adjusted EBITDA? I am just trying to clarify what will be included in your adjusted EBITDA.

That is also included. Yes, also it has been included. Yes.

Okay. But as you report your adjusted EBITDA, you won't back out those kinds of impairments?

Jian, can you answer that question? I can answer the question that our gross margin, it's basically 32% 33% or higher. It's included in the adjusted the impairment. But the other question, I would think that Jian would be better to answer that question.

Yea. Hi, Jake. This is Jian. Thank you for the question. Yes. So we obviously will be working with our auditors on the second quarter adjusted EBITDA presentation, but we are thinking this is a nonrecurring charge related to the scaling back of our production in California. So we'll consider the add-back to adjusted EBITDA as well as adjusted EPS for the write-off in the second quarter.

Okay. So the adjusted gross margin is slightly higher than what was previously implied. Considering the strong gross margin expansion in the first quarter, it seems possible to have no gross margin expansion year-over-year for the rest of the year while staying within that range. Can you clarify if you will still benefit from lower freight costs? Is it simply a matter of lowering prices to the point where you wouldn’t see a gross margin improvement year-over-year for the remainder of the year?

We are seeing improvements in gross margin. Our goal, as stated in the earnings announcement, is to aggressively pursue growth in the third and fourth quarters. We aim to balance higher and lower margin accounts by increasing volume and revenue, particularly with some chain accounts that prefer lower pricing. We were previously unable to do this due to a lack of warehouse space, but we are now setting up additional warehouse space and optimizing our existing facilities. This allows us to increase our inventory levels, which improves our fill rate and enables us to target new accounts with lower margins. At this point, we are being somewhat conservative by projecting margins of 32% to 33%.

Got it. Could you provide more detail on the factors influencing the second half of the year? Our guidance reflects strong growth during this period. It would be helpful if you could explain how fill rates have improved, possibly with some quantitative insights, and share your confidence regarding the new business opportunities. Please reassure us that you are on track to maintain a robust growth trajectory despite the competitive pricing environment you've mentioned.

Our online business is performing well, and we've noticed an increasing demand for eco-friendly products online. We plan to introduce an additional 200 to 300 SKUs in our upscale line of bagasse and eco-friendly paper products, which will launch in the third quarter. Additionally, we're concentrating on high-margin items like custom printing products. This now includes take-out box containers, paperless options, custom bagasse plates, and custom bagasse hinge containers, as well as pizza boxes and corrugated doughnut boxes. We are focusing heavily on eco-friendly products because, in the last 30 to 45 days, many companies have approached us, stating they're being urged by their cities to transition to eco-friendly products more quickly. Therefore, we've set an annual goal for 35% of our revenue to come from eco-friendly products, which I believe is conservative. With the range of new products we're launching at higher margins compared to traditional offerings, like plastic cups and portion cups, the market for plastic items feels saturated, with limited margins due to numerous low-cost imports. In contrast, the eco-friendly segment has significantly less competition.

Okay. And then, sorry, last question is on the…

Hey Jake, I just wanted to add a quick note. You were asking about our confidence regarding the sales trend improvement in the second half of this year. I believe Alan already provided some great insights. To summarize, our confidence level is quite high, and that's mainly due to a couple of factors. Firstly, we've signed new warehouse agreements and are preparing to move into some of these warehouses by the end of the second quarter. This is in progress, and we're also increasing racking space in existing warehouses. Our infrastructure will be ready soon. Additionally, as mentioned in earlier discussions, we have good visibility into our business volume from our pipeline. We know that some of the new contracts we've signed will begin shipping by the end of the second quarter and into the beginning of the third quarter. This visibility gives us significant comfort and confidence in our overall sales guidance.

Got it. Lastly, regarding the bagasse joint venture in Taiwan, does the potential sale of it impact your ability to pursue eco-friendly initiatives? I think there was some enthusiasm around that aspect. Doesn't this create a challenge for those plans? How do you view the exit from that joint venture?

Yes, last year we entered into the joint venture when travel was restricted, and I couldn't go overseas. This year, I was able to travel abroad. With the joint venture, we gained market insights indicating that a domestic manufacturer, which has begun producing bagasse products in the US, may shut down its plant and start sourcing products internationally, as they approached our factory for supplies. Initially, when we launched the bagasse factory joint venture, we weren't aware of the numerous bagasse plants available in Asia that are emerging with superior products, competitive pricing, and advanced equipment. During my recent visits, I discovered that when we partnered with overseas affiliates, we didn't realize there was a significant number of suppliers in the market. Additionally, we recognize that the bagasse product will have high demand in the US, and we intend to be one of the manufacturers producing it domestically. However, we underestimated the challenges involved in establishing a bagasse plant in the US, especially as larger manufacturers among our competitors are planning to cease operations this year. I learned that their decision to shut down stems from losses totaling millions of dollars, difficulties in maintaining equipment, and challenges in sourcing skilled labor for high-quality production. Moreover, due to our contractual agreement, there are also regulatory hurdles preventing the factory from obtaining necessary permits, which contributed to our decision to pull back and reduce manufacturing in California. The escalating costs of manufacturing in California have made it less viable—electricity prices, labor costs, and stricter regulations are all contributing to increasing expenses. It has become advantageous for us to scale back manufacturing and utilize warehouse space, which has become pricier. Consequently, we are now free from our commitment to the factory in Taiwan and can explore lower-cost, premium products from various suppliers. As I mentioned in an earlier announcement, we have identified additional resources across Asia, including India, which is also starting to produce and utilize bagasse domestically. This highlights how widespread efforts are across Asian countries to promote eco-friendly products and reduce plastic, contrasting with the situation in the US.

Great. Thank you so much. I appreciate it.

Thank you, Jake.

The next question comes from Ryan Meyers with Lake Street Capital Markets. Please proceed.

Hi guys. Thanks for taking my questions. First one for me. As you've taken price down pretty aggressively, do you feel like you've been able to gain market share versus some of your competitors?

Yes.

Got it. Straight forward. Not easy enough. As we think about the sales team and the ramp here in the second half, how long typically does it take a new sales rep to get up to speed to add new customers, or how should we think about the investments you guys are making in sales right now and kind of your level of confidence how new salespeople online can help accelerate growth in the second half?

Well, right now we're looking for experienced sales staff. With our competitors looking to scale back in terms of operations with the demand scaling back in certain area territory. Basically, we're able to pick up new sales reps. People are looking for a new job. We're actually picking up people in the similar industry. One thing is that the key difference between us and our competitors is that we have everything where we have different ways of selling product and most of these new sales reps that we're interviewing are stating that basically they couldn't compete with us because they're limited they're restricted to sell at a certain price and they're only limited to certain products. The product might be stored and manufactured in different facility. They can't consolidate. Versus the flexibility that we're offering in our company that enables the sales rep to sell quickly faster. Most of these companies that have their structure in terms of regional, a city, a small territory. But for us, basically our sales can go anywhere. They're very flexible. We're giving a lot of authority to our sales reps to go out and flexibility in terms of selling the products to the customers and also pricing. So, with that said, we see that it only takes about a couple of months for the sales staff to bring in revenue in new sales reps.

Okay, that’s helpful. And then obviously we added the warehouse in Chicago and a warehouse in Houston. Do you feel like that will be it for FY 2023 and then you'll look to evaluate more warehouse space in 2024, or how should we think about that for the rest of the year?

Our lease is up in Seattle end of August. We've already been negotiating with different facilities to double our space in Seattle Northwest area. We're also looking to add different territorial throughout the US because our goal is to increase our online visibility to service different type of customers. We are looking to go into the B2C commerce party supplies. That basically we're able to sell to the consumers directly. Lately we all heard that Party City went bankrupt and there is a high demand for birthday plates, cups, and napkins and different type of anniversary type of consumer goods. That's something we're looking to get into as we grow our online team and which just in the first quarter of this year, in the past three months, we actually enlarged our online team members more than doubled. We're looking to double in terms of additional staff to help us grow that business segment.

Got it. Thank you. Thanks for taking my questions.

Thank you, Ryan.

Our next question comes from Ryan Hoffman with Stifel. Please proceed.

I'm not sure who Ryan Hoffman is, but this is Michael.

Hey Michael.

I don't have a Ryan in the family, so whatever. I hope you have a good day. Can we discuss cadence? Jian, ocean freight was 14.4% a year ago, and 5.9% this year. How should I think about that trend for the second, third, and fourth quarters? What am I comparing against?

Yes. Ryan, thank you for the question.

It's, Michael.

Sorry I don’t know why I have – now I have Ryan stuck in my head. Sorry.

That’s okay.

It’s my job.

Yes, call me late for dinner.

Yes, you're absolutely right. So for the rest of the year we actually think ocean freight as a percentage of sales is actually going to be pretty stable. It might come down, even a little bit from first quarter we were at 5.9%. So I think it's probably going to be in the 4% to 6% range for the rest of the year.

And I'm comparing 2Q through 4Q, it was averaging, what?

I would say, averaging maybe roughly 5% give or take.

From last year. So this is against last year, I mean you were 14.4% last year in the 1Q. What's the trend? I wasn't saying that very clearly. It's the Ryan, thing got me all confused.

So, it's going to come down. When you're doing the year-over-year comparison, you'll see a significant drop. Last Q2, we were at 18% of sales. That decreased to about 15% in Q3 and almost 10% in Q4. For the remainder of the year, we believe that this percentage will remain relatively stable, likely staying close to the 4% to 6% range for Q2, Q3, and Q4.

So, this brings up an interesting point. I understand the need to be conservative, but it feels like staying within 32% to 33% is quite cautious. How should I interpret what is causing sequential margin compression to remain in that range? Considering we had 39.8% and if I average that with a midpoint of 32.5% for the rest of the year, it suggests we might end up around 30%. However, there have been significant savings in freight which contributed to the 39.8%. Can you clarify how much buffer we have built in here?

We tried to build cushion. Yes. I mean me and Jian, we try to. We don't know how the market condition is because we've seen the market in the overall market channel, with the increase in interest rate and restaurants shutting down and more import products coming through the US. And I don't know how competitive down the road it's going to be. So we just want to build some cushions, maybe a lot of cushions, so that we're competitive in the market, in the third and fourth quarter. That's all.

I agree with everything Alan mentioned and want to add a few more points. Alan has already covered some of this. In the second quarter, we anticipated some inventory write-offs due to our reduction in production in California. This is part of the overall outlook for our second quarter margin. Additionally, we discussed that starting mainly in the third quarter and moving into the fourth quarter, as we establish our infrastructure with the warehouse and new sales team members, we will focus on increasing volume. We expect our margin to decrease as we may implement further price reductions to capture additional market share. All of these factors are being taken into account for our full year guidance of 32% to 33%.

I want to add something, Michael. Starting on May 1, we reduced the price of our highest moving item, the portion cup plastic cup, by 10%. In June, we are planning to announce additional price reductions in other high volume categories. We understand that our customers are looking for savings and expect prices to decrease. We have been implementing price reductions regularly since last September, not just a one-time cut, and we have already made at least four reductions since then.

Okay. So just to understand how the market environment may play out. Given the current business climate in Q1, it seems logical that you could achieve margins better than 32% to 33%. If the business climate worsens, which you've accounted for with a conservative approach in your projections, you can still maintain margins in the 32% to 33% range, grow the business by 5% to 8%, and gain market share. However, if the business environment remains stable, I would expect better results. Is that a reasonable conclusion? I'm not trying to push your numbers; I just want to understand if the current business environment is likely to improve margins.

Actually, I feel the business environment for our company is great. We're going out there. We're winning every bid that we go after. In NRA actually this month and we're expecting to increase additional 100 new chain account business coming aboard. We've been waiting to go out. We've asked our sales reps to hold back not to go out and go poach because we have limited space. And now we're asking our sales that we're ready to go. We do see overall market environment is not good but for our company it's good.

And Michael, I would say your statement is fair.

I understand we are being cautious, but there is more potential for growth than there is for decline.

There is a lot of room I can say. There's a lot.

Good. I can't recall if it was the third or fourth quarter, but we brought up the possibility of engaging in M&A again, considering that it might extend into the second half of the year. What are your thoughts on M&A in relation to organic growth, especially since you're expanding your warehouse capabilities organically rather than through acquisitions? Where do you stand on this?

At this moment, after my visit to the overseas manufacturing plant and comparing it to domestic manufacturing, I don't believe it's beneficial to merge with a company that has outdated equipment domestically. Many of these domestic manufacturers will face a tough year competing against overseas vendors, and one of the biggest challenges will be hiring technicians to maintain the older equipment. We see potential opportunities ahead. Several capital investment groups have approached us about representing companies they want to sell. Some of these companies weren't looking to sell two years ago, but now they are considering selling manufacturers or competitors, including distributors that were previously off the market. However, we feel that the timing is not right yet. A crucial factor in our evaluation of any potential acquisition will be whether it provides us strategic access to a specific location and customer base. This is an area we are analyzing. Additionally, given our low PE ratios and EBITDA multiples, we don't see companies willing to sell at these low current EBITDA margins. They still seem to be expecting around a 10 times multiple, which isn't realistic.

Yeah, okay. That’s fair enough. Thank you very for taking the questions.

Thank you, Michael.

The next question comes from Ryan Merkel with William Blair. Please proceed.

Hi, everyone. Haven’t heard my name, you’ve got many chances in the conference call in quite a while. I like it. My first question is on second quarter revenue guidance coming in a little bit below the street. Are you saying that the reason that it's coming in a little bit light is because you're having to cut price more, or is there also maybe some underlying demand weakness from your customers? Just want to be clear on that.

I wouldn't say there is no underlying demand or that we're experiencing lower demand from our customers. We're observing that after reducing our prices by 10% to 20%, there is a possibility of an increase in volume, but revenue may decrease. However, I want to emphasize that we prefer to be somewhat conservative with our revenue and profit margin guidance at this time. We believe there is significant potential for growth in both revenue and gross margin, but we want to approach this cautiously.

Understood. Make sense. Okay. And then I wanted to follow-up on gross margin. Alan, I think you said you want to be aggressive with the national accounts because you have inventory now. Are you saying that you're going to cut prices below market to take market share, or is it more of a mix impact that impacts the gross margins in the second half?

No, I wouldn't say that we would cut prices. We want to ensure that our prices are fair, especially since raw material costs have decreased. It's important that customers benefit from this change. We believe they should have access to market pricing information. At the same time, we are introducing a different kind of product. Many customers we are targeting are transitioning from Styrofoam to paper or plastic, as well as moving from paper and plastic to compostable products. We are focusing on these customers by collaborating with them on new ideas and packaging. Our competitor has been selling more Styrofoam, but they are reaching a limit in that area. Meanwhile, we are seeing increased demand for eco-friendly products. Traditionally, many companies have only offered standard products, but there are numerous new and mid-sized chains seeking higher-end compostable options. We aim to enhance our offerings in this space while continuing to provide traditional products. Additionally, we are looking to introduce unique compostable items, such as a 100% compostable paper lid for soda cups or food containers, which we are starting to bring into the market and will showcase at the NRA Show.

Got it. Thanks for the color.

Thank you, Ryan.

At this time, we are showing no further questioners in the queue and this does conclude our question-and-answer session. I would now like to turn the conference back over to Alan Yu for any closing remarks.

Thank you everyone for joining the earnings call and Q&A session. I look forward to all of you on the next earnings call. Thank you very much and have a wonderful day. Bye-bye.

The conference is now concluded. Thank you for attending today's presentation and you may now disconnect.