Karat Packaging Inc. Q3 FY2023 Earnings Call

Good afternoon, and welcome to the Karat Packaging Inc. Third Quarter 2023 Earnings Conference Call. All participants will be in listen-only mode. After today's remarks, there will be an opportunity to ask questions. Please also note this event is being recorded today. 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. And welcome to Karat Packaging's 2023 third quarter conference call. I'm Roger Pondel with PondelWilkinson, Karat Packaging's Investor Relations firm. And 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, and copies of which are available on the SEC's website 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 now 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. We are proud to deliver a strong third quarter, with revenue in line with our expectations, and sustained meaningful improvement in margin. Sales volume increased approximately 7% over the prior year period. Although total revenue was again impacted by unfavorable year-over-year pricing comparison, along with lower revenues from logistics services and shipping charges, as anticipated. Sales of our eco-friendly products continue to improve. This category grew 15% in the third quarter over the prior-year quarter and represented approximately 33% of total sales. For the quarter, we achieved a 49% increase in net income from the prior-year quarter. And we're able to sustain an elevated gross margin. Even with the industry-wide inflationary environment, gross margin in the third quarter continued to benefit from our strategy of scaling back manufacturing operations, and significantly lower ocean freight costs versus last year. Sales for manufacturing products in the third quarter were 22% of total net sales, compared to approximately 27% last year, which generated labor product cost saving of $1.1 million. We expect our gross margin to remain at a higher level because of our initiatives, and the continued strong U.S. dollar. Now, into the fourth quarter of 2023, and heading into 2024, we will continue to implement asset-light initiatives in our other U.S. locations, and will concentrate more on import and distribution. We see a long runway for margin expansion given our objective of having manufactured products to be approximately 10% to 15% of total sales. We're also focusing on new product development to further enhance our competitive strength, fuel customer demand, and add to revenue growth. Our new Chicago and Houston distribution centers, which became fully operational in September, are expected to contribute to new geographic market penetration, and to enhance our fill rates. Together with the recently expanded national sales force, we are growing market shares in the East Coast, Northeast, and Midwest regions. We soon expect to double the size of our Washington State distribution center, with the move into a new 100,000 square foot distribution center. Additionally, as part of our strategic growth plan, we're looking to open smaller satellite warehouses in 2024 in select regions to support online sales growth, as well as deploy new AI technologies to further improve operating efficiencies. Based on geographic sales from our distribution center for the third quarter compared with the prior-year quarter, the East Coast Northeast region increased 41%, and the Midwest and Texas region improved 7% year-over-year. These improvements were offset by softer sales from California, which declined by 16%, reflecting a weaker condition in the restaurant sector throughout the states. The successful execution of our strategic initiatives is also evidenced by our sustained strong operating cash flow, as well as liquidity and balance sheet position. Accordingly, as we announced earlier this week, our Board of Directors authorized an increase in the quarterly cash dividend payment to $0.20 per share, from $0.10 per share. The Board's action reflects its confidence in Karat's long-term future and commitment to returning value to shareholders. I would 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, and good afternoon, everyone. Net sales for the 2023 third quarter, as expected, decreased 4.1% to $105.5 million, from $110 million in the prior-year quarter. Sales volume increased 7% over the prior-year quarter, which was offset by unfavorable year-over-year pricing comparison, as well as lower logistics services and shipment revenue. The unfavorable year-over-year pricing comparison reflects the expected impact from the multiple rounds of price reductions implemented primarily around late-2022 and the first half of 2023, as we proactively pass on savings from ocean freight and raw material costs to customers. By channel, as a comparison to the prior-year quarter, sales to distributors, our largest channel, were lower by 4.0% for the 2023 third quarter. Sales to national and regional chains decreased 2.3%. Sales to the retail channel decreased 19.3%, and our online channel sales were up by 1.6%. We are encouraged by the volume growth in our business, as well as by the strong momentum in the growth of our eco-friendly products, and the geographic regions that we're starting to penetrate, including the East Coast, Northeast, and Midwest. Gross profit increased 14% to $38.9 million for the 2023 third quarter, from $34.2 million in the prior-year quarter. Gross margin increased 580 basis points to 36.9% in the 2023 third quarter, from 31.1% for the prior-year quarter. By the unfavorable year-over-year pricing comparison, gross margin benefited from our continued efforts to scale back manufacturing operations, the strong U.S. dollar, and a significant decline in ocean freight rates, which amounted to 7.9% of net sales in the 2023 third quarter, compared with 14.8% of net sales last year. Operating expenses in the 2023 third quarter were $27.6 million or 26.1% of net sales, compared with $26.3 million or 23.9% of net sales in the prior-year quarter. The current quarter operating expenses included approximately $450,000 in transaction costs incurred in connection with the secondary offering, which was completed during the quarter. Other increases in operating expenses included workforce expansion as we reduced production but increased warehouse headcount, higher marketing expenses to support online sales growth, and higher rental expense from the expansion of our warehouse footprint. The increase in operating expenses was partially offset by savings in shipping and transportation costs due to lower rates. Net income for the 2023 third quarter rose 48.5% to $9.1 million, from $6.2 million for the prior-year quarter. Net income margin advanced to 8.7% in the 2023 third quarter, from 5.6% in the prior-year quarter. Net income attributable to Karat in the 2023 third quarter rose to $9.1 million or $0.45 per diluted share, from $6.1 million or $0.31 per diluted share in the prior-year quarter. Adjusted EBITDA, a non-GAAP measure, increased to $15.3 million in the 2023 third quarter, up from $11.7 million in the prior-year quarter. Adjusted EBITDA margin rose to 14.4% of net sales, from 10.7% for the prior-year quarter. Adjusted diluted earnings per common share rose to $0.47 per share, from $0.33 per share in the prior-year quarter. Turning to liquidity, with $12 million of net cash from operating activities in the third quarter of 2023, we finished the quarter with $113 million in working capital, up from $84.5 million at the end of 2022, giving us a total of $16.9 million of dividends paid during the first nine months of the year. As of September 30, 2023, we have financial liquidity of $64.4 million, with another $18.1 million in short-term investments. I will now close with our fourth quarter outlook. We are revising our net sales forecast for the fourth quarter to be up approximately 2% to 5% year-over-year based on our current restaurant conditions in California, including the competitive environment. We expect robust volume growth of 10% to 15%, partially offset by unfavorable year-over-year pricing comparison. Our gross margin projection for the 2023 fourth quarter and into the first quarter of 2024 remains at approximately 36% to 38%, with the current projection for ocean freight costs remaining fairly consistent. As Alan mentioned earlier, we're expanding our market penetration into the East Coast, Northeast, and Midwest regions, as well as our strong sales pipeline and our growth initiatives are expected to continue to enhance our performance.

Thank you. We will now begin the question-and-answer session. At this time, we will take our first question which will come from Ryan Merkel with William Blair. Please go ahead.

Hey, afternoon everyone, and thanks for taking the question. Maybe Alan, can you just talk about fourth quarter and why you guys are lowering the revenue there? It sounds like California, maybe prices are down a little bit more than you thought last quarter. Just unpack that for us.

Yes, our sales in California have been declining. The restaurant conditions there are poor, not only due to price drops and increased competition but also because of a significant number of restaurant closures. While we're experiencing overall volume growth of about 10% to 15%, the growth in California has slowed down, with only 7% reported in the third quarter. Independent restaurants are struggling and closing earlier, and foot traffic has diminished significantly. Restaurant owners have noted a lack of customers after 7 p.m., whereas it used to be crowded even later. The rise in crime is contributing to people feeling unsafe going out to eat. As a result, we do not anticipate any improvement in California in the near future, which is why our focus is on the Midwest and East Coast.

Got it, okay. And it looks like price will be down roughly 10% in the fourth quarter. Did that surprise you or is that consistent with what you saw last quarter?

This is actually consistent with what we saw because everything is coming down. The ocean freights went up a little bit in the third quarter. So, in the third quarter, we saw gross margins decline a bit because ocean freight increased for a couple of months, and then went back down again. So, we're seeing that for the fourth quarter, our gross margin normalizing.

Got it, okay. Maybe just lastly, just talk about the AI that you're going to be including in the warehouses, what are you doing there and what's the benefit going to be?

Well, we're observing that overall payroll has gone up throughout the U.S., especially in California. What we want to do is reduce our staffing. We want to utilize more AI technology to complete work that is redundant or simple, such as customer service, purchasing, placing POs, generating sales orders, and monitoring each staff's efficiency in warehousing. So far, we have already tested our online customer service, where 98% of our inquiries are currently handled by our AI technology. We're trying to reduce our purchasing and accounts payable workload significantly, so that with the existing staff we can actually increase our revenue with the current or even fewer staff that we have right now.

Got it. Okay, very good. I'll pass it on. Thanks.

Thank you, Ryan.

Hi, Alan, Jian. How are you?

Hey, Michael.

I have a few questions. Could you just share a little bit? I know you don't give a lot of detail at the regional mix, but just so we appreciate, what percent of revenues is California versus other major areas like Texas, Northeast, or Northwest or Southeast?

California right now is approximately, I would say, 30% of overall revenue. Jian, can you validate that?

Yes

We actually didn't cut that out.

Can you hear me?

Yes, go ahead, Jian.

Yes, that's about right, it's a little over. But that's roughly right, yes.

Okay. And then the next biggest region would be the Texas area, Midwest, and then Northeast, is that how we think about it?

That's correct.

Okay, I understand. While you're not providing guidance yet, I want to determine what I should carry over from 2023 into 2024. Specifically, I’m considering the pricing mix shift due to changes in raw material inventory and freight costs during the latter part of last year and into this year. What will be the rollover impact of that? How should I evaluate the pressures in California alongside the opportunities for new customer acquisitions or growth with existing customers, especially with developments like Houston, Chicago, or capacity expansion in Washington State? Can you assist me in understanding how to approach the top line for 2024?

Yes, we believe we have several new regional chains to focus on in the Midwest and East Coast, as well as supermarket chains for 2024. In terms of revenue for 2024, we are looking to convert this pipeline and add new distributors. Last quarter, we added around 30 new distributors in chain accounts, and we expect to see at least 35 more in the fourth quarter and into 2024. Therefore, we anticipate an increase in revenue. Did we provide guidance on our revenue for 2024?

We haven't. We typically will provide the 2024 revenue guidance in our fourth quarter 2023 call. But to Alan's point, we do see some great, Michael, to answer your question, growth opportunities in terms of that top line in 2024. So, I know Alan already touched on we are seeing roughly an increase of 10 midsized distributors in the distributor channel, which is our biggest channel, as you are aware, each month. And then we are getting very close on some of the pipelines in our new business as well as expanded business in our chain channel as well. So, we'll be providing the update on our 2024 revenue guidance next quarter.

Yes, I understand. I'm not specifically looking for guidance; I'm just trying to build a model and need to put a number out there. I want to ensure I'm in the right ballpark and not far off. From what I gather, it seems you have sufficient new business opportunities with distributors and growth in chains, suggesting a low single-digit organic growth that offsets any challenges in California. Is that a reasonable way to think about achieving low to mid-single digits, without pinning it down to a specific range?

Well, Michael, you missed one thing. It's not just new accounts. And also, we mentioned that we're going to be adding new products. There are several items that we'll be adding that will increase our revenue organically for the next, yes, 2024.

Right. But if we're being conservative, sort of mid-low single digits is a good place to start without getting too aggressive?

That is conservative, yes.

Okay. And then you had a very good gross margin here. You took the gross margin outlook up meaningfully, from original 32% to 36%-38%. But I presume we settle back a little bit, then you settle back to a higher low than history, so more like a 34%-36%, is that the right way to think about gross margins in '24?

If we are going to provide guidance, we cannot do so at the moment, but we are optimistic that our gross margin will remain in the range of 35% to 37%, which is our objective.

Okay, all right. All right, and then you clearly have demonstrated part of our cap allocation is the dividend, so this has been a meaningful increase in it. How should we think about dividend growth from this point? You've stepped this up quite nicely, about $0.80 a year. But how do I think about how to model dividend growth on a go-forward basis?

Well, here's what we see. We will be going very light asset in terms of 2024. In 2021-2022, we actually spent a lot of money on CapEx investment. This year, for the fourth quarter of this year, we're probably seeing zero or very little CapEx expenditure. In 2024, we're seeing a very, very low CapEx expenditure as well. So, with all the money that we save, we are looking at possibly increasing our dividend or special dividend every semiannual or annually on that part. And also, as well as any acquisition that we've discussed in the past, we believe, in 2024, it's very likely because market conditions are actually allowing people to sell their businesses while they can right now, because many businesses are not struggling, I would say they're not growing. And they haven't grown in the past year, and they are looking to sell at a reasonable price. But I think that, in next year, more and more businesses will look to consolidate and also to sell their business. More opportunities will be out there for 2024 for strategic-wise, basically. We mentioned earlier that we're looking for smaller warehouses, satellite warehouses, not necessarily opening up our own warehouse, but also acquiring a small business that has a warehouse location that we can take on in addition and add to the business. That will also, on top of the organic growth, provide acquisition growth in 2024.

Okay, great. Thank you very much for taking my questions.

Thank you, Michael.

Hey, guys, thanks for taking my questions. First one for me, how do you think about the pricing environment in 2024? And do you feel like you've seen enough here through the last couple of quarters, that it stabilized a little bit?

We're observing that pricing is stabilizing currently, with the exception of California, which remains highly competitive in terms of pricing. One factor to consider is labor; we are not noticing an increase in labor costs across all industries. This will influence whether prices decrease or increase in the future. In California, warehouse prices, labor, gas, and delivery costs are all rising. While we're seeing some stabilization now, we will need to wait until the first quarter of 2024 to understand the situation better, as we anticipate many changes in 2024.

Got it, makes sense. And then, obviously during the quarter you guys announced the expansion of five new sales reps. Just wondering if you could talk a little bit about the productivity that you've seen there, how that ramp-up has gone?

Yes. As I mentioned earlier, in the past, like the first two quarters of this year, we only gained about a low single-digit new distributor every month. But right now, we're gaining double-digit new distribution accounts each month. These sales reps are mainly targeting the Midwest and East Coast. We are seeing meaningful distribution converting to accounts and starting to place orders. And that's why we're heavily increasing our inventory in those sectors, which our warehouse is fully stocked right now. We are looking to open new warehouses in that area, not in California. We're scaling back in California. Also, another one of the major methods we are looking to increase or maintain our gross revenue is scaling back more manufacturing in the U.S. As we mentioned in our earlier releases, currently, 22% of the overall revenue is produced by our manufacturing facility in the U.S. Our goal is just to provide 10% to 15% of overall revenue from the U.S. That will increase our gross margin.

Great, thank you for taking my questions.

And our next question here will come from Jake Bartlett with Truist Securities. Please go ahead.

Great, thanks for taking the question. I just want to build on the last question about the pricing. You've seen many pricing decelerating over the last few quarters, even as you've lapped lower prices a year ago. And so, I guess the question is how confident are you, Alan, that you're reaching a point where pricing is stabilizing? How much of a risk do you see that that just continues in '24 as supply chain eases, and your competitors can maybe more easily compete on price?

Well, here's what we're seeing. In the past year, historically, we actually do better in an environment like this because we're always competitive against our domestic manufacturers. Historically, we have gained more new accounts than we have lost during this price competitive environment. So, we do see this as a positive thing in terms of next year. That's why we're increasing our sales force network, so that we're able to take on more accounts, and effectively service new customers. Right now, we already have a pipeline full of accounts about to open up and start doing business. That's where we see very strong growth in terms of positivity in 2024.

Okay, great. The other question is about where does gross margins land. And I'm trying to parse through that. Obviously freight costs are very low or shipping costs or ocean freight costs are very low right now. That should probably go up, but then you'll have a benefit from having less manufacturing. So, I heard that the 35% to 37% kind of longer-term target, but how do you get there versus what we were talking about maybe a year or two ago? Specifically, how much does moving from a mid-20% to, call it, low teens on manufacturing mix, how much is that alone support or boost gross margins?

In the first quarter and especially the second quarter of this year, we saw a significant increase in our gross margin. This was primarily due to reducing manufacturing in California, which has been quite expensive. We cut our monthly production output from 145,000 units to about 45,000 units, leading to a boost in our margin by approximately three to four basis points. We are now also reducing manufacturing in Hawaii and Texas and further decreasing operations in California. We plan to import more products from overseas where costs are lower compared to U.S. manufacturing, as costs continue to rise here. We initiated these changes this quarter, and the benefits will be fully realized in the first quarter of 2024. This is when we expect to see the actual impact on our gross margin for the rest of the year.

Got it, okay, great. And the last question is just on operating costs on G&A. There was a pretty big increase quarter-to-quarter in G&A, kind of even recurring. Is that level of somewhere close to $19 million, is that the right level to build from or is there anything abnormal in G&A costs in the third quarter that wouldn't recur? Just trying to figure out whether this is the right run rate to grow from.

I'm going to leave this question to Jian. Jian?

Yes, Jake, let me take that question. So, if you look at our Q3 SG&A, this number does include about $550,000 in secondary offering-related transaction costs, which we don't expect to recur in the fourth quarter of 2023. I think we previously talked about if we look at our cost structure, in terms of the split between fixed and variable OpEx, it's about half-and-half. So, I think the way that we think about the fourth quarter, if you take roughly half of the run rate SG&A of what we incurred in the third quarter, and then apply kind of a similar leverage percentage to the variable portion, I think that will get you very close to what we expect the fourth-quarter OpEx number to be. We are, obviously, continuing to look into areas to improve our leverage, our OpEx leverage. There are definitely areas that we're focusing on, and we do hope to come up with a little bit of efficiency in the fourth quarter.

Got it. Okay, thank you so much, I appreciate it.

Thank you, Jake.

And 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, Operator. And thanks to all of you for joining us today. We appreciate your continued support. We remain confident about Karat's future. We look forward to keeping you apprised of our progress. Have a great evening, and a wonderful Thanksgiving. Thank you very much. Bye-bye.

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