Karat Packaging Inc. Q1 FY2024 Earnings Call

Thank you for standing by. My name is Kat, and I will be your conference operator today. At this time, I would like to welcome everyone to the Karat Packaging Incorporated First Quarter 2024 Earnings Conference Call. I would now like to turn the call over to Roger Pondel of Investor Relations. Please go ahead.

Thank you, operator. Good afternoon, everyone, and welcome to Karat Packaging's 2024 First Quarter Conference Call. I'm Roger Pondel with PondelWilkinson, Karat Packaging's Investor Relations firm. It will be my pleasure momentarily to introduce you to 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 everyone that today's call may include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements are subject to numerous conditions, many of which are beyond the company's control, including those set forth in the Risk Factors section of Karat's most recent Form 10-K as filed with the Securities and Exchange Commission, 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 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. Sales volume for our 2024 first quarter grew 3.5% over the prior year period. Net sales were about the same as last year, but included certain items that impacted year-over-year comparability, which Jian will discuss later in this call. We are encouraged by our first quarter performance as the growth initiatives that we implemented last year are starting to bear fruit. Our new business pipelines continue to grow, and our product offering continues to expand. We are adding new customers and gaining wallet share with existing accounts. Sales for manufactured products in the first quarter were 12.4% of total net sales compared with approximately 23% last year, while keeping with our asset-light strategy in the U.S. and emphasizing imported items. Sales of our eco-friendly products rose 6% in the first quarter over the prior year quarter. This category represented approximately 34.5% of total sales versus 32.6% last year. Eco-friendly products remain a priority for Karat as we continue to develop new and innovative products and build up inventory to meet growing demand from customers. We also achieved a near record high gross margin of 39.3% during the first quarter with better visibility into ocean freight rates and new contract rates locked in through April 2025. Combined with the continued strength of our U.S. dollar, we expect our gross margin to remain at a higher level. Our operating income in Q1 2024 was impacted by a non-cash impairment of $2 million of the right-of-use asset for our City of Industry lease in California. With the shift to optimizing our new Arizona warehouse base and away from California, our future rent expense will be reduced. Our newly established distribution center in Arizona is now fully operational, which will provide meaningful efficiency for Karat in the Southwest region. We are continuing to look for other distribution centers in the Southeast region this year to further penetrate and grow key U.S. markets. Additionally, we are exploring strategic acquisition opportunities to further penetrate the marketplace. We have strong operating cash flow and liquidity, a solid balance sheet, and a positive long-term outlook. Our Board of Directors again authorized an increase in the quarterly cash dividend payment to $0.35 per share on May 7 from $0.37 per share in the preceding quarter. Our regular quarterly dividend policy began in August of last year with an initial payment of $0.10 per 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, and good afternoon, everyone. Net sales for the 2024 first quarter were $95.6 million, compared with $95.8 million for the same quarter last year. Sales volume increased 3.5% over the prior year quarter. As Alan mentioned earlier, the year-over-year comparison of net sales is impacted by certain items. Our Q1 2024 net sales were understated by $0.7 million related to products shipped and recognized as revenue in 2023 but not delivered until 2024. The related impact on cost of goods sold and gross margin was $0.4 million and $0.3 million, respectively, for Q1 2024. In prior periods, we assessed the impact of the lag between shipping and delivery for previously issued quarterly and annual financial statements and concluded it was immaterial. The impact will not be recurring in future quarters. The amount of the revenue deferred for products shipped in March 2024 but not delivered until April 2024 was $1.9 million. Additionally, net sales for the 2024 first quarter included $2.2 million of online sales platform fees. By channel, compared with a year ago, sales to distributors, our largest channel, were lower by 3.3% for the 2024 first quarter. Sales to national and regional chains were up slightly. Online channel sales were up by 9.0%, which benefited from the inclusion of online platform fees of $2.2 million as discussed earlier, and sales to the retail channel increased 5.0%. The distributor channel remains challenging, and the overall pricing environment is still very competitive. However, we are seeing encouraging growth momentum in the other channels, primarily driven by our continued geographic penetration in the East Coast, Northeast, and Midwest regions, and growth in our eco-friendly products. Cost of goods sold for the 2024 first quarter was $58.0 million, compared with $57.7 million in the prior year quarter. The increase was primarily due to higher freight and container rates. Earlier in the year, increased import volume and the inclusion of certain production costs in cost of goods sold partially offset this increase by lower product costs for certain raw materials and finished goods, as well as favorable foreign currency exchange rates. Gross profit for the 2024 first quarter was $37.6 million versus $38.1 million in the prior year quarter. Gross margin was 39.3% in the 2024 first quarter, compared with 39.8% for the prior year quarter. Operating expenses in the 2024 first quarter were $29.5 million, or 30.9% of net sales, compared with $25.4 million, or 26.5% of net sales in the prior year quarter. Operating expenses in the current quarter included a non-cash impairment of $2.0 million of the operating right-of-use asset for the City of Industry lease that Alan mentioned earlier as we entered into an agreement to sublease this warehouse in California. The increase was also driven by the inclusion of online sales platform fees, higher rent from additional leased warehouses, and higher labor costs due to workforce expansion. Such increases in operating expenses were partially offset by a decrease in shipping and transportation costs and the inclusion of certain production costs in cost of goods sold. Net income for the 2024 first quarter was $6.5 million, compared with $9.2 million in the prior year quarter. Net income margin was 6.8% in the 2024 first quarter compared with 9.6% in the prior year quarter. Net income attributable to Karat for the 2024 first quarter was $6.2 million, or $0.31 per diluted share, compared with $9.0 million, or $0.45 per diluted share last year. Adjusted EBITDA, a non-GAAP measure in the 2024 first quarter, was $13.5 million versus $15.3 million in the prior year quarter. Adjusted EBITDA margin was 14.2% in the 2024 first quarter versus 15.9% in the prior year quarter. Adjusted diluted earnings per common share were $0.40 per share in the 2024 first quarter, compared with $0.46 per share a year ago. The first quarter ended with $112.3 million in working capital compared with $110.5 million at the end of 2023. As of March 31, 2024, we had financial liquidity of $49.3 million with another $33.5 million in short-term investments. During the first quarter, we made significant investments to stock up our inventory ahead of our summer peak seasons. With a positive outlook for new business, we expect net sales for the 2024 second quarter to increase by mid-single-digit over the prior year quarter. Our gross margin goal for the 2024 second quarter is approximately 38% to 40%. For the full 2024 year, we expect net sales to grow 8% to 15% and gross margin to be in a range of 37% to 40%. Alan and I will now be happy to answer your questions.

And your first question comes from the line of Michael Hoffman with Stifel.

Alan, Jian, sorry about my voice. I'm not sure where it's disappeared to. Can you bridge for us maybe by the line items, whether it's national distribution on site or online, or retail, versus your own plan? So if I think about the guide you gave us, we were going to land somewhere around $100 million, round numbers. We're about $4.5 million short. Of those four buckets, where's the shortage? And what gives you confidence in this next 90-day view in light of that, where it fell short?

Michael, I just want to clarify the question. Are you talking about the $4 million shortfall for the first quarter, or are you referring to the second quarter's first quarter?

Yes. So you gave us a forward view of up mid-single-digits, which, if we did the math, it would land you at about $100 million, right? And you did $95.5 million, I'm rounding. So we're $4.5 million short. And if I think of the four segments, where does that shortfall come relative to your own plan? And what gives you comfort in the next forward plan that we've got a better handle on that?

Sure. Well, I believe Jian mentioned earlier in the call that there were some changes in accounting practices for revenue recognition. We deducted $2 million that we normally recognized as we shipped the product in the past 12, 15, or even 20 years. But our auditor has decided that we need to adapt a new method of recognizing revenues when customers receive the product. As a result, we had to reduce $2 million from the current quarter, which is something we have never done in the past 24 years of our accounting history. So this is the first quarter they want us to start moving forward to change this practice. That accounts for over $2 million that we couldn't recognize.

Sounds like you ought to get another auditor. How are you supposed to track when a delivery arrives unless you're controlling the last mile? That seems like an unreasonable reach.

Jian is the one that dealt with the auditor. Maybe Jian, you could perhaps kind of explain this, as we had some challenges understanding it. We’ve had to set up a program just to accommodate this new request.

Hi, Michael, this is Jian. Let me chime in on this one. You make a fair point about tracking; it is a challenge, and we are reviewing our internal processes to make sure that we have reliable, accurate data to account for revenue appropriately. We have been tracking this internally for quite a long time. As Alan mentioned, it’s the same accounting practice we've used for 15 to 20 years. We evaluated the lag between shipping and delivery and concluded, along with our auditors, that the impact was immaterial. While we don't track every single shipment, we have a good estimate method to get to a close number. So in Q1, we are seeing increased activities, particularly towards the end of the quarter. That contributed to the revenue deferred from March to April of $1.9 million.

Okay. So I just want to tease out a couple of things on this. Did you look at March of '23 and apply the same treatment of accounted sales as shipped? Did you adjust that number to reflect that?

No, actually, Michael, like I said, this is the first time we are applying this.

Yes, I get that. I was just wondering if you did the work and put the prior year on the like basis. What I'm trying to get to is that underlying structural demand is good. Maybe I'm still repricing some inventory from the above-average inflation in the inventory, but volume is good. So I got this oddball accounting issue. You still think you ought to fire your auditor? And if I had like-to-like comparison, you really did land somewhere between low to mid-single-digit growth. And so none of us should freak out.

Yes. Again, like I said, basically, this is it is what it is. I mean...

Yes. I get that. This underlying business demand is good.

It is very good. I would say the underlying business... this is the best quarter in a year. We've seen volume and pricing decline for the past three quarters, and this is the first quarter we're seeing solid year-over-year growth in volume and revenue. The pipeline that we have is stronger than ever, so I would say that this is the best quarter in a year.

Okay. The market shouldn't freak out, the stock should be fine tomorrow, etc. There was a question in there somewhere, but I'm not sure what it was, but you get where I'm going.

Yes. Again, like I said, basically this is it is what it is.

Yes. I get that. We are not looking at repricing issues anymore at this point.

Yes. Well, actually, we're not looking at any repricing issue. The question mark that we mentioned last quarter was the ocean freight. We were uncertain how it would play out, but it played out well; ocean freight did not increase significantly for the next year’s contract. That's why we’re more confident in raising our full-year gross margin guidance, from initially 35% to 38% or 35% to 37% up to 37% to 40% because we feel confident we signed contracts for ocean freight, which was the wildcard. We feel very strong about the coming year.

Your next question comes from the line of Ryan Meyers with Lake Street Capital Markets.

Just kind of as a follow-up to the last question, I just want to make sure I understand it clearly. So it sounds like you priced through the lower price inventory this quarter, so pricing shouldn't be a headwind for the remainder of the year.

That is correct.

And then, if we think about the eco-friendly business, it came in at 6% growth for the quarter. I know that business has been treading in the double-digit growth rate there. Is there anything to call out about what you guys saw in the quarter for eco-friendly, or is that just kind of related to the pricing as well?

Well, we did see a demand picking up in eco-friendly products. We saw more cities enforcing compostable products, making regulations stricter. We’re seeing new laws on paper bags that will raise prices as early as August or September due to tariffs. This enhanced awareness is creating a higher demand for compostable products, and we're seeing a shift away from conventional plastics. Overall, the strong demand for eco-friendly products is encouraging.

If we think about the 8% to 15% top-line guidance for the year, just kind of want to get a good understanding of what needs to happen for you guys to hit the higher end of that range?

If we were to do just organic growth, we're looking at the 8% range. Last year, the third and fourth quarters were not as strong, but we’ve seen robust growth in our pipeline, especially with national chain accounts, which are turning into revenue. We expect this to support our growth into the range of 8% to 10%. Additionally, we're actively in conversation with potential partners for acquisition, and we hope to have results by the third quarter that may help us reach double-digit growth.

And your next question comes from the line of Ryan Merkel with William Blair.

This is Mike Francis on for Ryan. A little follow-up on the last question regarding the M&A. Was that 8% to 15% at the end of 4Q that you gave, was that also inclusive of the M&A?

If we do not include any M&A, that would be in the range of 8% to 10%. If we include the M&A, that would be in the range of 10% to 15%, yes.

You talked about the distribution area being a little weaker. Can you give a little more color around that? Is it just market softness? Or is there anything happening with any of the players there?

We have seen the California and West Coast market dropping. The overall environment in California, especially for smaller restaurant chains, is declining. We're seeing closures as well. One of my favorite restaurants announced its shutdown recently. The increase in minimum wage and the difficulty in finding labor, especially in California, are causing issues. It's better now, with the drop being only single-digit versus double-digit in previous quarters.

You raised the dividend again. Is there any sort of target capital allocation we should think about longer-term?

Currently, we're sitting on cash from deposits. We're increasing our dividend because our cash flow continues to increase. We don’t have any debt, and if we successfully complete two acquisitions by the end of this year, that will utilize some of our cash, but we will still be in a healthy cash flow position.

I hope you can find a new replacement restaurant. It's too bad.

That concludes our Q&A session. I will now turn the conference back over to Alan Yu for closing remarks.

Thank you, everyone, for joining Karat's first quarter 2024 earnings conference call. And once again, thank you very much, and we'll talk to you next time. Bye-bye.

Ladies and gentlemen, that concludes today's call. Thank you all for joining. You may now disconnect.