Karat Packaging Inc. Q3 FY2024 Earnings Call

Hello, and thank you for standing by. At this time, I'd like to welcome everyone to the Karat Packaging, Inc. Third Quarter 2024 Earnings Conference Call. As a reminder, this call is being recorded. I will now turn the conference over to Roger Pondel. Please go ahead, sir.

Thank you, operator. Good afternoon, everyone, and welcome to Karat Packaging's 2024 Third Quarter 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 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 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. We are encouraged by our third quarter performance with net sales up nearly 7% and volume up approximately 10%. Despite some pricing pressure, we experienced growth in most of our sales channels. Our online business, which benefited from the inclusion of $3 million online platform fees in the current quarter, achieved a 33% increase over the prior year period. Karat's recent expansion into the supermarket chain category is starting to generate positive results. After successful product sampling and trial orders, we began shipping customized bakery packaging containers for a major grocery chain customer in late September, followed by the initiation of shipments on utensils to another major grocery chain in mid-October. We are now developing additional product offerings and intensifying our sales efforts in this sector. Sales of our eco-friendly products increased 9% year-over-year and now represented 33.4% of total sales in the third quarter. We believe demand for eco-friendly and compostable single-use disposable products will continue to increase and will contribute positively in the long term. We are focusing on new eco-friendly product development to further enhance our competitive edge. By the end of the fourth quarter, we expect to launch a new line of rPET cups and lids to meet the rising demand that we're seeing in the marketplace. This new line of rPET products is made with more than 25% recycled PET material. Geographically, we continue to experience strong growth in the Midwest, Northwest, and East Coast compared with last year. Additionally, we see sales stabilizing in California, which is our biggest market, following a sharp decline in the past few quarters. At the gross margin level, we achieved a gross margin of 38.6% in the third quarter versus 36.9% in the prior year period despite the impact from high ocean freight rates in the first half of the quarter. Heading into the fourth quarter, we are encouraged by the positive momentum and our focus on optimizing inventory sourcing and management, controlling expenses, and enhancing warehouse capabilities. From an inventory perspective, we implemented procedures to optimize sourcing and inventory management. Even with reduced domestic production and increased sales, we expect to be able to reduce inventory import volume in the fourth quarter of 2024 compared to the prior year. Additionally, with decreased ocean freight rates and reduced vendor pricing in certain categories, we expect fourth quarter margins to remain at a higher level. Additionally, we recently implemented measures to further reduce labor and certain other operating costs, and we expect such measures to yield benefits in the fourth quarter. We are also actively looking for a new distribution center in the Southeast region to support anticipated business growth. With Karat's strong operating cash flow as well as the company liquidity, solid balance sheet, and positive long-term outlook, our Board of Directors again approved an increase in the quarterly cash dividend payment to $0.40 per share on November 5 from $0.35 per share in the preceding quarter. 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. Net sales for the 2024 third quarter were $112.8 million, up 6.9% from $105.5 million for the same quarter last year. As Alan mentioned, our sales volume grew nearly 10% compared with the 2023 third quarter. Net sales also included a favorable impact from inclusion of $3 million in online platform fees, partially offset by a $5.7 million unfavorable year-over-year pricing comparison. By channel, compared with a year ago, online sales for the 2024 third quarter were up 32.8%, benefiting in part from the inclusion of online platform fees mentioned earlier. Retail and distributor channel sales increased 9.2% and 3.3% respectively from the prior year quarter as our investments in the sales force started to come to fruition. Sales to national and regional chains were essentially flat. Cost of goods sold for the 2024 third quarter was $69.3 million compared with $66.6 million in the prior year quarter. The increase was primarily due to higher ocean freight and duty costs driven by elevated ocean freight rates, primarily in the first half of the quarter, coupled with increased import volume, along with the inclusion of production expenses related to machinery repair and maintenance. Gross profit for the 2024 third quarter increased 11.7% to $43.5 million from $38.9 million last year. Gross margin for the 2024 third quarter increased 170 basis points to 38.6%, which included a net benefit contribution of 110 basis points from adjustments to net sales related to online platform fees and production expenses in the cost of goods sold as discussed earlier. Gross margin also benefited from lower vendor pricing and increased imports as a percentage of total product mix, partially offset by higher ocean freight costs. Operating expenses in the 2024 third quarter were $32.2 million compared with $27.6 million in the prior year quarter. Operating expenses in the current quarter included online sales platform fees, higher rent and warehouse expense, increased shipping and transportation costs, and higher online marketing expense. Such increases were partially offset by the inclusion of production expense in cost of goods sold, as discussed earlier, and a decrease in professional expenses due to transaction costs in connection with the secondary offering during the 2023 third quarter. Net income for the 2024 third quarter increased to 1.3% to $9.3 million from $9.1 million for the prior year quarter. Net income margin was 8.2% in the 2024 third quarter compared with 8.7% a year ago. Net income attributable to Karat for both the 2024 and 2023 third quarters was $9.1 million or $0.45 per diluted share. Adjusted EBITDA was $14.7 million for the 2024 third quarter compared with $15.2 million for the prior year quarter. Adjusted EBITDA margin was 13.0% for the 2024 third quarter versus 14.4% in the prior year quarter. Adjusted diluted earnings per common share was $0.47 for both the 2024 and 2023 third quarters. We generated operating cash flows of $19.5 million in the third quarter and ended the quarter with $115.6 million in working capital compared with $110.5 million at the end of 2023. As of September 30, 2024, we had financial liquidity of $75.1 million with another $21.5 million in short-term investments. As Alan mentioned earlier, our Board of Directors just approved another increase of our quarterly dividend to $0.40 per share. This is on top of the $23 million we returned to shareholders in the current year in regular and special dividends. We remain committed to a balanced capital allocation strategy between shareholder return and long-term growth investments. We expect net sales for the 2024 fourth quarter to increase by mid to high single digits over the prior year quarter. Our gross margin goal for the 2024 fourth quarter is approximately 39% to 40%. We are also reaffirming our full year 2024 guidance today. Alan and I will now be happy to answer your questions. And I'll turn the call back to the operator.

Jian, I just wanted to follow up and get a good understanding of what you said in regard to the guidance. So thinking about the Q4 guide, you guys called out an increase in sales of mid to high single-digit percent. But if I believe back to last quarter, sort of the implied Q4 number with the full year guidance, I think, was looking for a double-digit growth rate. Just want to make sure I understand that correctly. If there's anything that I'm missing, it would be kind of helpful to walk through that.

Yes. So Ryan, thank you for the question. Yes, that's correct. So at this point, we do expect the fourth quarter sales growth to be mid to high single digits. We are also reaffirming our full year guidance, as we mentioned in the prepared remarks. I do also want to call out, if you recall, Ryan, last Q4 2023 last year, our Q4 net sales amount actually included an accounting misclassification adjustment of a full year amount of a little over $6 million. So that was a benefit to Q4 2023. So that's going to cause a little bit of apple-to-orange comparison this year. But with that impact, we are still expecting to see mid to high single-digit year-over-year growth in Q4.

Okay. Got it. That makes sense. And then just thinking about the national and regional chain segment, it looks like revenue was flat year-over-year. Is most of that pricing? Or is there anything else to call out there? It looks like volume across the business is pretty strong, but just to get an understanding of that segment itself would be helpful.

You're talking about the chain segment? Yes, correct. Because I know over the past handful of quarters, you guys have obviously made some emphasis of rolling out into new regional chains, whether it's with salespeople or additional products, but just kind of get a good feel for that line item. Yes, sure. I can start. I'm sure Alan can add additional detail there. So for some of the chain accounts, I mean that is right what you said, Ryan, as far as the pricing adjustments. We wanted to make sure that we remain competitive in our value propositions with our customers. So we did have some price adjustments in the past quarter. I also wanted to point out, as we mentioned in our prepared remarks, we started shipping to a major supermarket chain customer in the very last week of September, which was a little later than what we previously anticipated. However, we are at a full annualized volume with this particular customer now, and we do expect to get a benefit in the fourth quarter in the chain segment. Alan, anything else you want to add?

Sure. First of all, regarding your question about the double-digit growth we anticipated, if you exclude the $6 million from last year's fourth quarter, our total revenue would have been $89 million. With the added $6 million, it's $95 million. When comparing $89 million to our current guidance, it represents a little over 14%, which indicates double-digit growth year-over-year. Jian pointed out that if we make an apple-to-apple comparison, our actual growth would indeed be 14%. Additionally, as Jian mentioned, we've recently started shipping to a well-known supermarket chain in Texas, as well as another national chain we're focusing on. We are optimistic about beginning shipments to other national chains in the fourth quarter or possibly early in the first quarter. Our goal is to achieve that. In terms of further growth, online sales are strong, showing a 33% increase year-over-year in the fourth quarter. We plan to rely heavily on online sales as we will be enhancing our marketing efforts in that area. We invested significantly in online advertising in the third quarter, which is expected to bear fruit in the fourth quarter.

Okay. Got it. That makes sense. Yes, the commentary on the guidance and that $6 million impact from last year is helpful and kind of gets us in a good spot.

My first question is about the supermarket opportunity. Alan, you mentioned the new account and two new accounts you've brought on. How significant is this opportunity? You're clearly highlighting it in the press release and in today's call. What is the potential for Karat in both the near and long term? Additionally, why is Karat well positioned for this business? It appears to be a sector you previously did not pursue or had limited success with. What makes this a good time for Karat to enter this market?

With the initial number and forecast from our customers, we expect our annualized revenue to be around $5 million, possibly reaching between $5 million and $6 million. We are also pursuing additional projects with the same accounts that could increase our annualized revenue to $15 million for this one account. For another supermarket chain, we anticipate starting with about $0.5 million to $1 million, which could also grow significantly. The unique aspect of targeting supermarket chains is that they have fewer SKUs and operate with higher volumes, particularly in the bakery product section. Previously, our focus was on the cup business, including sectors like restaurants and beverages. Now, our focus is shifting towards the bakery business and also expanding into the deli sector. There are numerous opportunities in delis and supermarkets for products like paper containers and bags. We aim to pivot towards areas we haven't concentrated on before. In the past, we mainly dealt with hot and cold cups, but as we transition into this new business sector, we recognize that the opportunities and potential are much larger than what we have achieved in the cup business previously.

Okay. Great. And on the eco-friendly side, nice to see the continued growth there. I'm trying to understand what the implications are for the new product or products that you're going to be launching in the fourth quarter. How big a deal is that? How much could that be adding to the eco-friendly product growth in '25 and beyond?

We are beginning to expand into the corrugated box takeout container sector. Many bakery stores and chains are transitioning from plastic takeout containers to corrugated board boxes. You'll notice various types of corrugated boxes, bakery containers, and paper containers with plastic openings. Previously, it was predominantly plastic or Styrofoam. We're also interested in different sizes of SOS bags, not just shopping bags. Regarding our rPET business, we've received requests from some chains to minimize the use of virgin materials and increase the use of recycled materials to reduce plastic consumption. In Europe, there is a ban on most plastic unless it includes at least 25% recycled content. This mirrors how we started the PLA cup business back in 2007. Companies that still need to use plastic, due to its functionality, are being encouraged to use less virgin material in favor of more recycled content. Additionally, our corrugated box business is expanding beyond just packaging to also include food container takeout applications.

Okay. And then for my last question, I might come back with another one later. The gross margins have clearly exceeded expectations from a couple of years ago and remain strong, especially with the guidance for the fourth quarter. My question is about their sustainability. What portion of the margin expansion, compared to the 31% you were operating at two years ago, is expected to reach 39% in 2024? Among the gains, what should we consider as a long-term benefit? What margins are sustainable for this business in the long run?

As Jian mentioned earlier in our call, we are projecting our gross margin guidance for the fourth quarter to be between 39% and 40%, compared to 38.5% from last quarter. We anticipate maintaining our margin in the high 30s to low 40s. We believe this is sustainable because we are increasingly focusing on online sales, which typically carry higher profit margins. Currently, our online revenue has grown by 33%, accounting for about 17% to 18% of our total revenue. We expect this to rise to the low 20s overall, possibly reaching 25% or more for online sales relative to our total revenues, which will help enhance our overall margin. Additionally, we see stability in ocean freight rates, with a decline expected for the remainder of the year and likely into the first quarter, contributing to reduced costs and improved gross margin. We are committed to boosting online sales, which will yield higher margins, while also addressing pricing pressure in the distribution segment that is benefiting our sales volume. We are looking at a potential year-over-year volume increase of 20% in the fourth quarter.

Sorry, regarding your last comment, do you expect the volume from the distributors in the fourth quarter to be significantly high in terms of what is driving sales?

Overall volume to be 20% higher.

In the fourth quarter?

In the fourth quarter, yes. Last comment, Jake, while I have you on the phone. We have not seen a double-digit growth for the past 18 months. And basically, we're seeing that as a very hopeful sign that our goal is we do want to continue this to be the double-digit growth in the future.

I just wanted to follow up on the potential for double-digit growth in the future. It appears that there is strong momentum, and the markets seem to be improving with California stabilizing rather than declining further. Additionally, your expansion into supermarkets and new products is promising. How should we consider the fourth quarter's projection of mid-single-digit revenue growth? Looking ahead to 2025, what are your initial expectations? Is there a chance for double-digit growth again, or should we anticipate more of a mid-single-digit growth until we see some supportive macroeconomic trends?

Well, Brian, as I mentioned earlier to address today's question, in the fourth quarter, if we are making a fair comparison, there is already double-digit revenue growth. If we exclude the $6 million from the online platform fee added from January to December, we are expecting to see double-digit growth in the first quarter of 2025 based on our current trajectory. Historically, in the year prior to COVID, we experienced double-digit growth year-over-year, and it appears we are on the right path to returning to that organic growth rate.

Okay. Great. Regarding operating costs, which include the platform fees, when will we reach that anniversary? Additionally, how quickly do you expect costs to grow in 2025 if you are anticipating double-digit growth in revenue?

We are going to invest. I would describe this as an investment in advertising aimed at boosting future online sales. To continue growing our online business, we are spending on advertising to acquire new customers, encouraging them to make repeat purchases. Our objective is to grow our business from $70 million this year to $75 million and then to $125 million next year. We anticipate increasing our advertising expenses in the online sector. However, this strategy is expected to accelerate our revenue growth compared to the past 12 months.

Okay. And then on kind of generating that growth, what type of capital expectations do you have from a spending perspective on what has to be outlaid to support kind of that double-digit growth? Can you give some color there?

In terms of capital expenditure, we will not be spending as much. We have a budget for online growth and advertisement spending. While we have increased our spending slightly, we are not going to significantly overextend ourselves. Therefore, I do not anticipate a substantial capital expansion in this area, except for our intention to expand additional warehouse space. This will be the main focus of our capital expenditure, particularly in the Southeast region, where we aim to build a major center to support our growth. This could involve millions of dollars, but we already have sufficient cash flow to support this investment.

Okay. And then my last one, just you had reported a data breach in the third quarter. Do you have an update on where that kind of stands and what that impact might have been or might be in the future here?

Based on our initial investigation, there was no material data breach. We were more cautious regarding a situation where a couple of employees clicked on an attachment that allowed the hacker access to our email system. We also hired a third-party investigator to look into the matter. The initial findings indicate there were no material data breaches. We will continue to monitor the situation for any potential issues. In terms of monetary damages, there were none, and the amount spent is very nominal and non-material.

There are no questions at this time. I will turn the call back over to Alan Yu for 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, and we look forward to keeping you appraised of our progress. Have a great evening and a wonderful Thanksgiving holiday season. Thank you all. Bye-bye.

And this concludes the meeting. We thank you all for your participation. You may now disconnect.