Karat Packaging Inc. Q4 FY2023 Earnings Call

Good afternoon and welcome to the Karat Packaging Fourth Quarter and Full Year 2023 Earnings Conference Call. Please note, this event is being recorded. I would now like to turn the conference over to Roger Pondel, Investor Relations. Please go ahead.

Thank you, operator. Good afternoon, everyone. And welcome to Karat Packaging's 2023 Fourth Quarter and Full Year Conference 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 Chief Financial Officer, Jian Guo. Before I turn the call over to Alan, I want to remind all of 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 the 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. Sales volume for our 2023 fourth quarter grew 7% over the prior year period. Although revenue was again impacted by unfavorable year-over-year pricing comparisons and by startup delays from several new national and regional chain accounts, we estimated approximately $2 million to $3 million in revenue from new accounts pushed into 2024. We are starting to work on orders from these new accounts now. As part of our strategic initiatives, we continue to scale back US manufacturing during the fourth quarter, which further enhanced gross margin to a near-record high of 35.7%. Sales from manufactured products in the fourth quarter were 16% of total net sales compared with approximately 27% last year. We expect our gross margin to remain at a higher level because of our initiatives and the continued strong US dollar. Sales of our eco-friendly products grew 11% in the fourth quarter over the prior year period. This category represented approximately 33% of total sales, which exceeded our expectation versus 31% last year. We are continuing to develop new and innovative eco-friendly products to meet increasing customer demand and expand our customer base. In 2023, we opened new distribution centers in Chicago and Houston and doubled the size of our Washington State distribution center with the move into a new 100,000 square feet facility. These new distribution centers are fully operational and contributing nicely to geographic and market penetration. As part of our growth plans for 2024, we recently signed a new lease for a distribution center in Arizona. We're taking possession of the warehouse now and are expecting it to be fully operational early in the second quarter. We are planning to open another distribution center in the Southeast region this year. Together with a sales force expansion, we are further penetrating key US markets in the South, Midwest, and Pacific Northwest region and expect the growth in these markets to more than offset the decline in the California market due to weaker conditions in the restaurant sector throughout the states. Our operating leverage in Q4 2023 was impacted by a write-off vendor prepayment of $1.1 million to purchase certain PPE products in 2020 during a period of extreme inventory supply shortage caused by the pandemic. We are focusing on implementing automation and AI technology at all of our facilities in 2024 to further enhance efficiencies and productivity. Additionally, we are actively evaluating strategic acquisition opportunities this year as market valuations are showing signs of reality and normalization. With Karat's strong operating cash flow as well as the company's liquidity, strong balance sheet, and positive long-term outlook, our Board of Directors in February again authorized an increase in the quarterly cash dividend payment to $0.30 per share from $0.20 per share last quarter and from $0.10 per share since the regular quarterly dividend policy was initiated in August 2023. 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, and good afternoon, everyone. As Alan mentioned, we delivered another quarter of significant margin expansion and business performance. As I go through the key financial metrics here, I will be talking about certain adjustments made in the fourth quarter of 2023 for the full year amount within the income statement with no impact on net income. The prior year amounts were not adjusted due to the immaterial impact on the overall financial statements. Net sales for the 2023 fourth quarter were $95.6 million, including an adjustment of $6.5 million of online sales platform fees for the full year, which resulted in an increase to both net sales and selling expenses. Net sales were $92.7 million in the prior year quarter. Sales volume increased 7.3% over the prior year quarter, which was offset by unfavorable year-over-year price comparisons as we have passed on savings from ocean freight and raw material costs to customers primarily in the last quarter of 2022 and the first half of 2023. By channel, compared with the year ago, sales to distributors, our largest channel, were lower by 6% for the 2023 fourth quarter. Sales to national and regional chains decreased 3.6%. Sales to the retail channel decreased 5.2%. And our online channel sales were up by 68.2%, including the impact of 60.7% from the adjustment of online sales fees as discussed earlier. We are encouraged by the volume growth in our business as well as the growth of our eco-friendly products, online channel, and the increased geographic penetration in the East Coast, Northeast and Midwest. Cost of goods sold for the 2023 fourth quarter was $61.5 million, which included an additional import duty reserve of $2.3 million and an adjustment of $3.9 million of certain production expenses from general and administrative expenses compared with $63 million in the prior year quarter, which included an out-of-period inventory write-off of $1.7 million. Gross profit for the 2023 fourth quarter was $34.1 million, which included the additional duty reserve and the impact from the adjustments discussed earlier versus $29.7 million in the prior year quarter. Gross margin expanded 370 basis points to 35.7% in the 2023 fourth quarter from 32% for the prior year quarter. Gross margin in the 2023 fourth quarter included a negative impact totaling 240 basis points from the additional duty reserve and the impact from the adjustment discussed earlier. Despite the unfavorable year-over-year price comparison, gross margin benefited from our efforts to scale back manufacturing in the US in favor of imports, which carry higher margin and improved operating efficiencies. Operating expenses in the 2023 fourth quarter were $29.5 million or 30.8% of net sales compared with $24.9 million or 26.8% of net sales in the prior year quarter. Operating expenses in the 2023 fourth quarter included the negative impact of a vendor prepayment write-off and the adjustments discussed earlier totaling $3.6 million. The increase was primarily driven by higher labor costs, increased rent from additional leased warehouses, and workforce expansion. Such increases were partially offset by lower shipping and transportation costs, stock-based compensation, and bad debt expense. Net income for the 2023 fourth quarter was $4.2 million compared with $4.5 million in the prior year quarter. Net income for the 2023 fourth quarter included the negative impact from the additional duty reserve, vendor prepayment write-offs, and a tax adjustment of $300,000, totaling $2.9 million. Net income margin was 4.4% in the 2023 fourth quarter compared with 4.9% in the prior year quarter. Net income margin in the 2023 fourth quarter included a negative impact from the duty reserve, vendor prepayment write-off, tax adjustment, and the adjustments discussed earlier totaling 350 basis points. Net income attributable to Karat for the 2023 fourth quarter was $3.9 million or $0.19 per diluted share compared with $4.5 million or $0.23 per diluted share last year. Adjusted EBITDA, a non-GAAP measure, in the 2023 fourth quarter was $8.6 million versus $9.9 million in the prior year quarter. Adjusted EBITDA in the 2023 fourth quarter included a negative impact of $2.3 million from the additional duty reserves as discussed earlier. Adjusted EBITDA margin was 9% in the 2023 fourth quarter versus 10.7% in the prior year quarter. Adjusted EBITDA margin in the 2023 fourth quarter included a negative impact from the additional duty reserve and the adjustments totaling 330 basis points. Adjusted diluted earnings per common share were $0.24 per share in the 2023 fourth quarter compared with $0.30 per share in the prior year quarter. We believe Karat is well positioned to execute on its future growth strategies. We finished 2023 with $110.3 million in working capital compared with $84.5 million at the end of 2022. As of December 31, 2023, we have financial liquidity of $59.3 million with another $26.3 million in short-term investments. I will now close with our 2024 outlook. Net sales for the 2024 first quarter are expected to increase low to mid-single digits from the prior year quarter based on the current competitive environment and the new business outlook. Our gross margin goal for the 2024 first quarter is approximately 37% to 39%. For full year 2024, we expect net sales to grow 8% to 15% and gross margin to be in the range of 35% to 38%, assuming no significant increases in ocean freight rates. Alan and I will now be happy to answer your questions. And I'll turn the call back to the operator.

The first question is from Jake Bartlett with Truist Securities.

My first is on the sales in the fourth quarter, and backing out the online sales adjustment, it was lower than guidance. Even if you add the $2 million to $3 million that kind of moved forward into the first quarter, it was below guidance. So the question is, what is driving that? Versus expectations, what really drove the lower-than-expected results in the fourth quarter for sales?

Jake, let me answer that question. Well, first of all, we did see a slowdown in customers purchasing products for inventory back in December, especially in the month of December. We saw a significant slowdown in all of our distributors taking orders during that part. One of our reasons is that our main chain accounts were saying that they were overstocked and the business was not as good as last year. So that was one of the main reasons that we had a really slow December.

I remember the stocking or maybe destocking for distributors is an issue or just a dynamic in the fourth quarter that maybe had gone away. Is this maybe a return to normal behavior from the distributors, or are we still in kind of abnormal territory with how they're behaving right now?

We understand that every year, especially at the end of the year, in December, our customers go on vacation and they try to destock whatever and return inventory that is excessive. That's kind of a normal seasonal thing. One way to avert that will be adding additional new accounts, new businesses to offset that, especially this year. Now that it's different than last year, the previous quarter was different from the prior year. Last year, people were concerned that there might be a shortage, so they tended to stock up during the holiday. But last quarter, especially in December, people understood that there's abundant inventory out in the market. So they weren't too concerned about bringing too much inventory into their warehouses. I believe that most companies or most of our customer distributors are overstocking their inventory in the warehouse; they're struggling with the warehouse space. In past years, when they were short on space, they actually leased additional spaces. But now warehouse space has become so expensive, people are trying to reduce their warehouse storage space to lower their operating costs.

And then last question on sales. Alan, if you can just describe the pricing environment. It feels like part of why the sales were below expectations and guidance in 2023 was because of pricing and your desire to pass along prices plus lower costs. Have we stabilized there? Do you feel more confident that pricing is not going to continue to come down in '24, that maybe it is bottoming and will grow from here?

Well, yes, in 2023, I would say that in most industries, especially the packaging industry, we are seeing prices coming down due to overstocking, lower ocean freight costs, and lower raw material costs. We're not only seeing a bottoming; we're actually seeing a bit of a rebound in terms of pricing in some categories like gloves and certain categories that are in shortage from overseas. That's what we're seeing right now. We’re pretty much at the bottom in the fourth quarter and starting to see a little rebound in the first quarter of 2024.

The next question is from Michael Hoffman with Stifel.

Can I have some modeling questions about 2024, so we just get all the details? Could you give us a little thoughts about where SG&A lands, interest expense, taxes? And then lastly, free cash flow and sort of either a dollar amount or a cash conversion ratio of your EBITDA, just so we can complete the model?

Let me take that question. So we can provide some high-level estimate. Obviously, we would provide revenue and gross margin, and don’t necessarily go down into all the details. But we can definitely share some of our thoughts here. Again, as we mentioned in the guidance, the full-year thoughts on the full-year performance depend significantly on the second half of 2024 assuming we don’t have significant changes in ocean freight rates. High level, when we think about, I think, Michael, you're asking about operating expense and interest expense, and cash flow, right? So operating expense, I would say, high level, this is an area of focus for the management team right now and our goal is to continue to improve the leverage there. I want to say 2024 high level operating expense on a full-year basis is probably going to be fairly consistent or a little bit better than 2023. When you take out some of the discrete items that we incurred in 2023, I think overall operating leverage is going to improve a little bit. We do expect to see some improvement, especially related to labor costs, partially offset by increases in rent expense and some of the fixed expenses as we continue to expand our warehouse base. So high-level, that's the operating expense outlook. Interest expense year-over-year, I don’t see significant changes. The term loans, and again, these are the term loans that we have on Global Wells, which is a consolidated variable interest entity, these are the term loans on Global Wells' books from not our operating entity. But again, both term loans are fixed interest rate; we don’t expect significant changes year-over-year in interest expense. Free cash flow, we do believe our free cash flow is going to be really strong in 2024. We talked previously about pivoting to a more asset-light model focusing on import as opposed to making heavy investment on CapEx here domestically. So we do expect to continue with that model into 2024 and continue to expect strong free cash flow.

Could you provide us an overview of the cash conversion of your EBITDA? To provide some context, you're converting around 70% of your EBITDA into cash. Should we anticipate that this trend will extend into 2024 as well, considering the cash flow from operations minus all capital expenditures?

I would think it will be in that range.

Alan and Jian, could you provide some insights on the year-over-year sales changes in the segments? Specifically, for those that showed a decline, what is the balance between price and volume? Is there a situation where volume was positive but price drops led to an overall negative result? I'm trying to understand if there was a solid underlying volume that was impacted by reduced prices for raw materials and lower freight costs. How should I consider this across the various segments?

In the fourth quarter 2023, the volume did increase. I believe, Jian, what is the percentage of volume increase overall versus the …

In the fourth quarter of 2023, the volume did increase. I believe, Jian, what is the percentage of volume increase overall versus the …

And how was that distributed across the four segments, the operating lines, when you think about that? Is there positive or negative for distributors, national retail versus online?

I would say that the mainly online sales volume was more positive, and into the retail segment that was positive. In the distribution segment, I would say it kind of evened out a little bit. But mainly, our growth in volume is more on the online as well as the national chain account.

You mentioned cadence earlier, Jian. Could we discuss how you plan to start the year with a much stronger gross margin and then finish lighter to reach the average of your guidance? How should we think about that cadence? Is there anything uneven about it, or should I just expect a gradual decline throughout the year to achieve the midpoint of the range?

Well, here's the thing. I think if you're referring to 2023…

Yes, starting the year, you see a gross margin of 37% to 39% in the first quarter, but it will be lower for the full year. Is there a gradual decline each quarter, or how should I approach this? I'm trying to model the steady decline each quarter to arrive at an average for the full year outlook.

There is significant uncertainty regarding contract renewals for ocean freight in May 2024. We have some clarity for the first two quarters, but the major unknowns include the potential weakening of the US dollar and whether ocean freight costs will hold steady or rise, and if they do increase, by how much. We've accounted for this uncertainty in our projections for the last two quarters of the year. We expect strong volume growth, targeting a 15% increase in volume for this year. Additionally, changes in how we classify capital expenditures will affect our gross margin. Previously, we accounted for CapEx at the operating level, but starting in 2023 or 2024, we will include it at the top level, which will also influence the gross margin. This change is one of the key factors expected to impact margins.

So just to clarify, you were cautious about the outlook for ocean freight in your guidance. However, as a potential opportunity, if ocean freight remains stable at current levels, is that what I understood correctly? I might be misunderstanding your message.

Yes, that is correct. If the ocean freight maintains stable, then basically, I would say that this is definitely beneficial for our third and fourth quarters.

The next question is from Ryan Meyers with Lake Street Capital Markets.

First one for me. So if we think about the revenue guidance range, the 8% to 15% growth. What would you need to see to come in at the high end of that range? Is that more of a stabilization in pricing, or even a little bit of improvement in pricing? Just want to get a good understanding of how we potentially could see that 15% top line growth for 2024?

Well, in the past year, prior to the pandemic, our company has been growing double digits every year. Last year was a much different environment because in 2022 there was a major spike in ocean freight, and we had to add the price of cost of goods sold and the reselling prices based on that. There was a deflationary factor during 2023. But in 2024, as everything stabilizes, our selling volume is going to increase with adding new sales reps who have been out there selling to more new chain accounts. We are already seeing that, adding several dozen new accounts in the past few months. So we’re adding about 20 to 40 accounts every quarter’s distribution and chain accounts. With that said, that’s going to significantly enhance our top line, in addition to our existing customers. We are also adding additional new items such as napkins and other new categories, bringing in an additional 300 to 400 SKUs that will also contribute to our top line. On top of that, we're looking at acquisitions this year. As we mentioned during our IPO, one aspect of our growth strategy is to start exploring acquisition targets. In the past years, we've been looking at it, but the price was not reasonable. Now, we see that sellers are becoming more realistic about what their businesses are worth, which we can take advantage of this year. If we were to hit the 15% range, I would say that would involve a small acquisition. We're not considering large acquisitions but looking at small ones.

And then if we think about the softness that you commented on in the distributor and national channels in the fourth quarter, just wanting to get a good understanding of how much of that was driven by just the California market versus how much of it was the overall system as a whole?

In the California market, we saw a decline of almost double digits in terms of year-over-year decline in the fourth quarter. The restaurant environment in California is really struggling in this industry, especially for mom-and-pop restaurants that are serviced by distributors. The chain accounts, however, are doing much better than the distributors that cater to mom-and-pop shops. We are seeing a lot of restaurant closures and bankruptcies occurring, which we observed in the fourth quarter in California.

The next question is a follow-up from Jake Bartlett with Truist Securities.

My first was just on that discussion on guidance, Alan. You mentioned volume expectations of 15%, but the guidance is 8% to 15%. So is that just a follow-on of the lower pricing that we had by the end of the year? Just helping us understand the dynamics. I know there’s a mix that goes on as well impacts sales growth. So maybe just help us mesh the 15% volume growth and the 8% to 15% revenue guidance.

We're calculating volume wise based on the case count. The case counts could be something that's worth $3, $4 a bottle or something that is $80 a case. That's where we’re seeing the volume growth. We're comparing the number of bottles and number of cases that we're selling in year-over-year comparison. We saw the growth starting in the fourth quarter, especially in November and December last year. We’re already observing strong growth this year already in the first two months of 2024. With the new customers we recently acquired and the potential customers that are in our pipeline, we expect this number to continue to grow. So, 15% is more of a conservative number based on the number of customers in our pipeline, but this can vary. Of course, we understand that the second quarter and third quarters will always be stronger than the first and fourth quarters in terms of volume growth. So we're looking for the 15% growth in terms of operational growth quarterly. Revenue, we have a strong base already in 2023, and the combination of volume growth and new accounts leads us to believe revenue growth will be in the range of 8% to 15%. We want to be conservative with this revenue guidance because in 2023, we had a noticeable decline compared to 2022. We want to rebuild in 2024 to surpass what we had in 2022.

But just so I understand, the offset to volume growth is negative mix or negative price, or else revenue would be higher than volume, I would assume. So why is revenue growth slower than volume growth?

The pricing. You're right. We are competing with other vendors for pricing. So we're both competing with other vendors as well as selling more higher-priced volume online.

And then, Jian, the question on operating expense or G&A growth. I just want to make sure your comment, you said you want to improve versus '23; that's on a percentage of sales basis. You don't expect the absolute G&A or operating expenses to be lower year-over-year. So I just want to make sure that that's the right message.

That's correct, Jake. It's the leverage, the percentage.

Regarding the adjustments for the online sales platform fees shifting into selling expenses and retail sales, as well as the production expenses moving from general and administrative to cost of goods, how should we approach this for modeling? While you're not providing specific quarterly amounts for '23, should we simply divide those adjustments by four to estimate their quarterly impact as we consider '24 and beyond?

That should be pretty close, although a couple of covers there is the online platform fee with a significant growth of our overall online sales. I would expect that amount to increase in 2024 compared to 2023. On the production expense, I would expect the '24 amount to be slightly below the '23 amount due to continued reductions in overall domestic production activities.

Regarding the import duty reserve, should we consider that it might have been higher in the past? It seems like it was accounted for all at once. How will taking this reserve now affect the cost of goods sold over the next three quarters? Would it result in higher costs since if the reserve had been set more appropriately over time, the cost of goods sold would also increase? Is that the right way to approach this?

Can I just make sure I understand your question correctly, Jake? You're talking about the reserve for the duty, import duty?

Yes.

So this year, we actually don't expect significant changes in 2024, currently based on the best information that we have. The reason we had an increase in the reserve in this charge, which you're right, did impact Q4 cost of goods sold. The impact was an estimate change. This was a loss contingency; we previously reserved, took charge reserves based on our best estimate at that time. In the second quarter of 2023, we had an investigation ongoing, and so we took a reserve back in Q2 2023. Fast forward to Q4 2023, we had some updates in estimates that helped us better estimate this reserve, this loss contingency. That’s the reason we recorded an adjustment to this charge. As of right now, based on the information and assistance provided from counsel, we do not expect significant changes in 2024 related to this charge.

Jake, let me add to what Jian just mentioned. This reserve is a special duty reserve. It originates from an item that we imported from overseas. All investigations have confirmed and finalized. So in 2024 and onward, we should not experience any type of import issue concerning this particular product. The reserve amount we set is the highest we expect, and it's unlikely to result in a cash payout soon. It may take a couple of years since we plan to appeal. However, this $2.3 million or $3.5 million is the highest reserve we have calculated, and we anticipate this reserve may adjust to a different amount as we expect a lower liability.

The next question is a follow-up from Michael Hoffman with Stifel.

The M&A, just to be clear, given the quality of the cash flow, I presume you would be able to fund the small M&A that you're thinking about all from sources that you generate. So it's self-funded?

Correct. We have over $110 million in cash flow in terms that we can utilize; we're not going to utilize all of it. But for sure, that's something that we can do it from our own funds.

A big statement being is that there's nothing on the rate of it. You're going to drive the leverage up. This is going to be self-funded off of cash and the leverage stays relatively stable.

Yes. Also, we expect to generate even more cash this year.

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 2023 fourth quarter earnings call. I would like to say thank you all, and have a nice day. Thank you very much. Bye-bye.

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