Good day, and welcome to the Karat Packaging Inc. Second Quarter 2023 Earnings Conference Call. All participants will be in listen-only mode. Please note, this event is being recorded. I would now like to turn the conference over to Roger Pondel with PondelWilkinson, Investor Relations for Karat Packaging. Please go ahead.

Thank you, operator, and good afternoon, everyone. Welcome to Karat Packaging's 2023 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 this 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 posted on the company’s website. And with that, I will turn the call over to CEO, Alan Yu. Alan?

Thank you, Roger. Good afternoon, everyone. Despite revenue being impacted by anticipated price reductions and lower revenue from logistics services and shipping charges, we achieved excellent second quarter results. Sales for our core disposable foodservice products grew during the quarter, with volume increasing 5% over the prior year period; demand for our eco-friendly products remains strong. Sales for the category grew 22% in the second quarter over the prior year period. Our 2023 objective for the eco-friendly product category is to be about 35% of total sales. We were able to sustain record levels for the gross margin despite the industry-wide deflationary environment and multiple price reductions that were implemented, as well as write-offs of raw materials associated with the disposal of certain machinery and equipment. We continue to implement our asset-light growth initiatives to focus more on import and distribution, drive margin expansion, and improve inventory management and fill rates. We are working through some operational challenges in the opening of our Chicago and Houston warehouses, and we currently expect both warehouses to be fully operational before the end of September 2023. We are also looking for additional warehouse space in strategic locations, such as Arizona and Florida. Together with the scaling back of manufacturing footprints in certain U.S. locations now substantially complete, combined with the expansion of import items, we were able to achieve and maintain greater margin. I also want to mention that we completed a transaction of selling our portion of a joint venture project in Taiwan and received payment of our full investment of $6 million plus interest. Our current operating model and strategic initiatives are producing strong operating cash flow. Accordingly, as we announced earlier today, our Board of Directors declared a special dividend of $0.40 per share. The Board also approved the initiation of a regular quarterly cash dividend policy and declared a dividend of $0.10 per share. These distributions demonstrate the Board’s confidence in Karat’s future and commitment to returning value to our shareholders. 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 revenue comparison, second quarter 2023 results demonstrated our ability to implement our business strategies, and we were again able to uphold enhanced margins and strengthen the company’s liquidity position. Net sales for the 2023 second quarter, as anticipated, decreased 5.3% to $108.7 million from $114.9 million a year ago. The decrease was primarily due to pricing reductions as well as lower logistics services and shipping revenue, partially offset by the increase in volume and change in product mix. By channel, sales to distributors, our largest channel, were lower by 5.7% for the 2023 second quarter. Sales to national and regional chains decreased 5.7%. Sales to the retail channel decreased 13.7%. And sales from the online channel increased modestly. As Alan mentioned, our core disposable foodservice product volume grew 5% over the prior year period, and our eco-friendly products increased even more at 22% for the second quarter. Karat is a leading provider in this category based in part on our enlarged sourcing network and expansion of our product offering. Eco-friendly products represented 32% of total sales in the 2023 second quarter compared with 25% a year ago. Gross profit increased significantly by 23.3% to $41.9 million for the 2023 second quarter from $34.0 million in the prior year quarter. Our gross profit in this quarter includes a write-off of $1.7 million of raw materials as we disposed of certain machinery and equipment in the U.S. Gross margin increased to 38.5% in the second quarter of 2023, which included a 160 basis point impact of raw materials write-off. The gross margin for the prior year second quarter was 29.6%. Gross margin expansion benefited from a significant decline in ocean freight costs, which amounted to 6.2% of net sales in the 2023 second quarter compared with 18.0% of net sales last year. Operating expenses in the 2023 second quarter were $28.5 million or 26.2% of net sales compared with $26.2 million or 22.8% of net sales in the prior year quarter. Operating expenses in the current quarter included impairment expense and loss on disposal of machinery of $2.5 million, of which $2.4 million was due to our scaling back manufacturing in certain locations. Excluding this impact, our run rate operating expenses in the 2023 second quarter were $26.1 million or 24.0% of net sales, which reflected reduced shipping and transportation costs and bad debt expense, partially offset by workforce expansion, higher marketing expenses to support online sales growth, and higher rental expenses from the additional leased warehouses. Net income for the 2023 second quarter rose 48.3% to $10.7 million from $7.2 million for the same quarter last year. Net income margin advanced to 9.8% in the 2023 second quarter from 6.3% a year ago. Net income attributable to Karat in the 2023 second quarter rose to $10.5 million or $0.53 per diluted share from $6.3 million or $0.32 per diluted share in the prior year quarter. Adjusted EBITDA, a non-GAAP measure, increased to $21.1 million in the 2023 second quarter from $11.8 million in the prior year quarter. Consolidated adjusted EBITDA margin expanded to a company record of 19.4% of net sales from 10.3% for the 2022 second quarter. Adjusted diluted earnings per common share rose to $0.69 per share from $0.34 per share a year ago. We finished the quarter with $110.3 million in working capital, up from $84.5 million at the end of 2022, and financial liquidity of $56.0 million with another $28.0 million in short-term investments. Moving further into 2023, we’re forecasting net sales for the third quarter to be down approximately 3% to 4% year-over-year, and we are anticipating strong top-line growth of 10% to 15% for the fourth quarter. The overall market condition for our industry remains deflationary, but we believe we are towards the tail end of the price cuts. The year-over-year expected decline in revenue in the third quarter primarily reflects the delayed operation of our two new warehouses and unanticipated implementation delays by certain new chain account agreements that were signed earlier this year. That said, we anticipate a strong fourth quarter with shipments starting to the delayed chain accounts and additional warehouse capability being fully operational. Accordingly, we expect net sales to be up by approximately 10% to 15% over the prior year quarter. We’re also raising our 2023 full year gross margin goal to be around 36% to 37% versus 31.2% for 2022, as our current operating and growth initiatives continue to benefit our performance. Alan and I will now be happy to answer your questions, and I’ll turn the call back to the operator.

The first question today comes from Michael Hoffman with Stifel. Please go ahead.

Hi, Alan, Jian. Just to be clear, the down 3Q is about delays and then incremental price pressures related to resetting of raw materials and freight. It’s not a decline in activity; it’s a delay in an upside in activity?

Yes. We do see the sales momentum is very strong, especially in the East Coast, in Atlanta, Florida region, Texas region, Oklahoma, and Chicago. People are waiting for us to get the warehouse up and running, same as Houston. We were looking to have it operational mid-July, but with the permitting delays and racking delays and training. So we’re shooting for September. And we’re telling the customer, hang on tight, and we’ll get it ready. Because we don’t have enough – every one of our warehouses currently, it’s overloaded already. South Carolina warehouse, we even have to stop shipping product because it’s just overloaded.

Okay. So I’ll just repeat myself. You’re not seeing a reduction in demand. This is a timing issue related to your ability to fulfill because of the warehousing startup delay?

Michael, I want to reemphasize, there is no reduction in demand in the Midwest and East Coast, but we have seen softening in the West Coast.

Okay. All right. Fair enough. And then – just to do the quick math, are we – and just so it helps us sort of level set models, are we settling in somewhere around $435 million to $440 million in sales, that gets you to that sort of low single-digit? And then if gross margins play out the way you’re describing it, that sort of $155 million to $160 million. I’m assuming G&A, there’s nothing unusual going on for the rest of the year. So all of that upside in gross margin should come through in EBITDA as well.

Jian, can you answer this question?

Yes, I can take that, Michael. So from the modeling perspective, if I hear your question correctly, the top line, what we did on that, the total full-year revenue is we will probably see a modest low single-digit decline compared to last year. I think overall, from the SG&A leverage perspective, our expected full year SG&A leverage is going to be fairly consistent with last year, although we are expecting – obviously, we’ve provided in our prepared remarks the updated guidance on the gross margin. We significantly upped our guidance on gross margin for the full year. So that said, we are seeing – we are expecting our adjusted EBITDA margin to be higher than that.

Right. So just to be clear, there’s about $10 million or $11 million of incremental gross margin coming through the model based on the sales outlook. And we should expect most of that to translate into EBIT and EBITDA, so it’s not a big step up in SG&A is what I think I heard you say. And I apologize for the background voice.

That’s correct.

I’m in a public setting. Okay. Okay. All right. That’s what I needed those two things. Thanks.

Thank you, Michael.

The next question comes from Ryan Meyers with Lake Street Capital. Please go ahead.

Hi guys. Thanks for taking my questions. First one for me. I know investment in the sales team has been a priority in the past. So just kind of curious what the sales team looks like right now and how that ramp-up has gone as we look to accelerate growth here in Q4?

Yes. We have recently hired a new – actually three sales reps in the Midwest, and we are looking for two to three more in the East Coast and also the Northwest. So we are on track with the additional sales rep recruitment.

Got it. That’s helpful. And then some of the weakness that you’re seeing on the West Coast, just wondering if you could unpack that a little bit more. Was that kind of broad-based across the business? Is eco products performing well in the West Coast? Just kind of help us understand what you guys are seeing there.

What I’m seeing and through the street, in the West Coast, we are seeing some softness in the distribution channel, especially those catering to the mom-and-pop restaurants. We walked the streets in Los Angeles, and we heard that in San Francisco, Northern California, restaurants are closing at 8:00 p.m. versus they were closing at 10:00 p.m., 11:00 p.m. After 6:00 p.m., people are not going out eating anymore and dining. And also, there are many restaurants that have basically shut their doors in the West Coast region, especially California; we’re seeing a lot of decline in activity in that part. But the chain stores have remained strong. So basically, this is what we’re seeing in support of that. Even in the West Coast, as the mom-and-pop restaurants are closing, they’re raising prices, their cost of goods sold has gone up, the rent has gone up, but the chain stores have been able to maintain strength in terms of growing their sales numbers.

Got it. That’s super helpful. Thanks for taking my questions.

Thank you, Ryan.

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

Yes. Hi, thanks. I wanted to ask about the change in sales in the second half. Alan, is the delay at the national chain accounts and your warehouse delay, are those the same things? Or are those separate issues?

These are separate issues. Normally, we understand dealing with national chain accounts, there’s always the setting up of item codes. The timing also, if there is a switching over from another vendor, there might be some leftover inventory they need to deplete. So there’s always an issue like that for these chains. So even if we were anticipating the – like, for example, an August 1 start date, it might be pushed back to October 1 or September 15. Now, with the warehouse, that is another key problem we’re seeing because the warehouse is so overloaded. This is the same issue we had last year. That’s why we increased our warehouse space in California and also we're adding new spaces in other locations. When the warehouse is overloaded, we tend to be shorting customer items and delaying shipment to the product because – or we have to move – like change the location of the product to ship them originally versus South Carolina or to Texas, or we might have to shut down shipments for a couple of days because we have to move around the product and organize it and also transfer our product into different warehouses. So right now, we're using Chicago and Houston as storage facilities for the overloaded warehouses in South Carolina, California, and New Jersey. We're waiting for the racking to be implemented in the entire warehouse for the existing warehouses, as well as the new warehouse. Chicago is just fully racked, and they’re getting started to begin operations next week. But in Houston, we have racking delays because of ocean freight from the vendors; they have delays in that. So this is what I see. That's why we're rushing into getting another warehouse in Florida and Arizona; we know that even though this was originally part of the end of the year objective, we're pushing forward because we know that even if we start looking now, it might be the end of the year when that really happens.

Yes. Okay. Got it. And then you mentioned that expanding import items has helped gross margins. Are you primarily talking about California and shutting down the facilities there and just replacing it with imports, is that how we should be thinking about it?

Well, in California, we scaled back in manufacturing, with the increase in labor, increasing electricity costs, and rental facilities. So we scaled back in California already. And we moved a lot of these products overseas, as well as we will bring actually new items, eco-friendly items. For example, people are looking for a different type of bagasse product. They're searching for a different type of PLA lids. And also, we are just about to introduce our one and only, first and only paper lids in place of PLA. A lot of cities are considering PLA still part of plastic; you can't decompose it unless you have a commercial compost site. So with the paper lid, it can basically decompose – just put on the ground, and they will decompose. So we're focusing on new items that are compostable and eco-friendly. We're also looking at going through – even with plastics; we're looking to start using recycled content plastic added to our existing virgin plastic so that the cups or the hinged containers are made with at least 25% recycled content. So these are the things that we're focusing on moving forward to new items.

Okay. All right. Thank you.

Thank you, Ryan.

The next question comes from Jake Bartlett with Truist Securities. Please go ahead.

Great. Thank you so much for taking the question. Mine is on the gross margins and the guidance. I believe – just kind of backing into it here, I think that implies about a little over 34% gross margins in the back half of the year. I want to just – and correct me if I'm wrong on that. But also, is that the right level to expect going forward? Or is that still benefiting from unusually low freight costs, for instance, or ocean freight costs? Trying to figure out kind of what the – gross margins have sort of diverged so much from kind of original expectations; trying to figure out what the right normalized gross margins are kind of going forward? And then I have a follow-up.

Well, Jake, here's the thing. We mentioned earlier in our report that we are benefiting from super low ocean freight in the past, in the second quarter. But we're seeing ocean freight coming back up pretty fast, but not as much as it was back in 2022; it has gone up 30%. We're anticipating ocean freight to go up even more starting August 15. That's what we've been told. For example, we were paying $1,100 ocean freight, and it is going to go up to $2,000, $2,500, nearly double in certain areas. So basically, we don't know how long that's going to sustain because three to four months ago, the cost of ocean freight went up, and for just two weeks, it was not sustainable; it fell down again. So we're still in a really sensitive manner of timing things that we don't know where the ocean freight is going to be, which also is a big chunk of our cost of goods sold. So there's really not much we can say about the normalization right now.

Got it. Okay. And I think given that commentary, we should expect higher gross margins in the third quarter, and then it comes down in the fourth from that level. Is that the right way to think about the cadence here?

At this current moment, yes, third quarter, we should see a higher gross margin. Fourth quarter, it's unknown.

Okay. And then I wanted to dig in on the comments about volumes. And I think you mentioned that the core foodservice disposable packaging volumes were up 5%. What was the overall volume just across the business? I'm trying to kind of figure out what else might have been dragging the volume down.

Well, our core business is our packaging, disposable packaging as well as food items. That segment has gone up 5%. The segment that has dragged our number down is the shipping and also logistic service. The service that we had in the past, pulling containers from the port for other nearby neighbors. That has dropped significantly in the past quarters.

Okay. Okay. And you've talked about – I think for a couple of quarters now, we've had – you've had visibility on the chain accounts that you've signed on, and this is a matter of kind of getting those up and running and some delays there, but it's going to happen, which is encouraging. My question is whether there's more in the pipeline, like you've signed additional chain accounts that we might expect in 2024? Just trying to understand the pipeline of new business that you've been generating.

Yes. We have a list of pipeline that we generated, beginning of this year and also at the end of the second quarter. We are seeing more and more in our pipeline, not just in national chain accounts, but also supermarkets. We are targeting convenience stores after – during the – starting the fourth quarter this year. The first thing we need to do is increase our capacity in terms of warehouse storage. We understand that without the warehouse storage, we will not be able to service our customers in the correct manner.

Okay. And then the last question is, you initiated a dividend. You are a growth company as well. So is this kind of maybe an indication that you're not actively seeking to acquire another company, maybe generate capacity that way? How should we look at your returning of cash to shareholders while being a pretty fast growth company?

Yes. We're returning dividends to the shareholder. One is that we're accumulating a lot of cash. One of the reasons we're accumulating cash is that we have decided not to invest more in the equipment to manufacture products. In the past two years, we invested over $50 million or more the past two years consecutively. This year, we mentioned earlier in the first quarter that our CapEx expense is going to drop significantly. But even with returning dividends – cash to the shareholder, we're still holding substantially cash on hand that we're putting into our deposit account, as well as we have a line of credit we can utilize any time if there is a strategic partner that becomes available that we can acquire, could be a warehouse distribution center or that we need in a strategic location or clienteles or something, but definitely not a manufacturer.

Got it. Thank you so much. I really appreciate it.

Thank you, Jake.

This concludes our question-and-answer session. I would like to turn the conference back over to Alan Yu for any closing remarks.

Thank you, everyone for joining our Karat Packaging Conference Call – second quarter, and we look forward to sharing with all of you again in the third quarter conference call. Again, thank you very much for your participation. Have a nice day. Bye-bye.

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