Karat Packaging Inc. Q2 FY2025 Earnings Call

Good afternoon, everyone, and welcome to the Karat Packaging Inc. Second Quarter 2025 Earnings Conference Call. Please also note, today's event is being recorded. At this time, I'd like to turn the floor over to Roger Pondel. Sir, please go ahead.

Good afternoon, everyone, and welcome to Karat Packaging's 2025 Second 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 turning 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 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 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 today's call, we will be discussing adjusted EBITDA, adjusted EBITDA margin, adjusted diluted earnings per share and free cash flow, which are non-GAAP financial measures as defined by SEC Regulation G. A reconciliation of the most recently 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 achieved a record second quarter performance marked by a 13% increase in sales volume, 10% growth in net sales, and 20% growth in net income year-over-year despite a significant foreign currency headwind due to a sudden substantial weakening in the U.S. dollar against the New Taiwan dollar. Heading into the third quarter, we continue to diversify our global sourcing and expand into new countries and geographies, and we see the currency pressure starting to ease. Our record quarter performance is a testimony to Karat's nimble business model and resilient global supply chain, which allows us to succeed in navigating the supply chain disruption and trade uncertainties. We are swiftly diversifying our sourcing footprint, reducing reliance on China to just 10% in the second quarter while implementing plans to further expand our sourcing across other Asian countries and Latin America to enhance supply chain resilience and flexibility. In addition to the sourcing diversification, Karat's ability to quickly ramp up existing domestic manufacturing operations enables us to respond rapidly to customers' needs. Together, these actions have further enhanced our agility and competitiveness and are helping us to secure new business and position the company well for sustained growth in a challenging external environment. Business trend remains strong as we proceed into the third quarter and the remainder of 2025 and continue double-digit sales growth across our major markets, including California. Further, recent new business wins from a number of large national chains are scheduled to begin shipping in the third and fourth quarters. Our new distribution center near our Chino headquarters is now fully operational, significantly strengthening our logistic capabilities and enabling even faster delivery times. This facility also supported inventory buildup during the second quarter, positioning us well to accommodate our anticipated growth in the second half of the year. As previously announced, we implemented price increases for select products on April 1, followed by broader price adjustments across most of our product lines in late May. We continue to assess the impact of these changes, along with potential effects from the new tariffs enacted in August. Karat remains focused on accelerating top-line growth and profitability through product innovation, strategic expansion, and a track record of being a dependable supplier to our customers. At the same time, we continue to drive operational efficiency through disciplined cost management. In the second quarter, we improved our operating cost leverage, saving $1 million in online shipping and marketing by switching providers even as shipping volumes increased. We also shifted our online sales focus from third-party platform fulfillment through our own e-commerce storefront, lowering online selling costs and more effectively utilizing online marketing dollars. These efforts reflect our ongoing focus on balancing growth with profitability and building long-term operational resilience. We believe Karat is well-positioned for continued profitable growth. And 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. I'll begin with a summary of our Q2 performance, followed by an update on our guidance. Net sales for the 2025 second quarter were $124 million, up 10.1% from $112.6 million in the prior year quarter. The increase was primarily driven by year-over-year volume growth of 13%, partially offset by $3.3 million in unfavorable pricing as chains and distributors’ growth outpaced online and retail channels. Sales to chain accounts and distributors were up by 11.4%. Online sales increased 6.8% over the prior year quarter, reflecting our continued focus on expanding this high-margin category. Sales to the retail channel turned positive with an increase of 1.9%. Cost of goods sold for the 2025 second quarter was $74.9 million compared with $69.2 million in the 2024 second quarter. The increase primarily reflected $4.0 million of higher product costs resulting from increased sales volume. This was partially offset by more favorable vendor pricing and product mix. Additionally, ocean freight and duty costs rose by $2.1 million due to higher import duty costs impacted by the recent tariffs, coupled with an increase in import volume of 37.0% as we increased inventory ahead of expected business expansion during the second half of 2025. At the same time, average ocean container rates during the 2025 second quarter decreased 4.0% year-over-year. Gross profit for the 2025 second quarter increased 13.1% to $49.1 million from $43.4 million in the prior year quarter. Gross margin increased 110 basis points to 39.6% compared with 38.5% in the prior year quarter. Gross margin benefited from lower product costs as a percentage of net sales, mainly due to more favorable vendor pricing and product mix and reduction in depreciation expense as a percentage of net sales. These improvements were partially offset by higher ocean freight and duty costs as a percentage of net sales increased to 9.5% during the 2025 second quarter versus 8.6% during the 2024 second quarter. Operating expenses for the 2025 second quarter were $32.6 million compared with $32.3 million in the prior year quarter. The increase was mainly due to higher shipping and transportation costs for offline orders from increased shipping volume, increased rent and higher salaries and benefits. These increases were partially offset by a decrease in shipping costs for online orders despite the increase in online orders shipped, online platform fees, lower marketing expense, stock-based compensation, and a gain recognized from disposal of machinery and equipment. Operating income in the 2025 second quarter increased 48.9% to $16.6 million from $11.1 million in the prior year quarter. Total other expense, net, was $2.0 million for the 2025 second quarter compared with other income, net, of $1.0 million in the prior year quarter. The difference was primarily due to a loss on foreign currency transactions of $2.9 million compared with a gain of $0.3 million during the 2024 second quarter. Net income for the 2025 second quarter increased 19.8% to $11.1 million from $9.2 million for the prior year quarter. Net income margin was 8.9% in the 2025 second quarter compared with 8.2% a year ago. Net income attributable to Karat for the 2025 second quarter was $10.9 million or $0.54 per diluted share compared with $9.1 million or $0.45 per diluted share in the prior year quarter. Adjusted EBITDA for the 2025 second quarter was $17.7 million compared with $15.7 million for the prior year quarter. Adjusted EBITDA margin was 14.3% of net sales for the 2025 second quarter compared with 13.9% for the prior year quarter. Adjusted diluted earnings per common share was $0.57 for the 2025 second quarter compared with $0.49 for the same quarter last year. We generated operating cash flow of $9.8 million in the second quarter and ended the quarter with $116.8 million in working capital. Our free cash flow was $9.6 million in the second quarter. As of June 30, 2025, we had financial liquidity of $44.7 million with another $26.4 million in short-term investments. On August 5, 2025, our Board of Directors approved a quarterly dividend of $0.45 per share payable August 27, 2025, to stockholders of record as of August 20, 2025. Looking ahead, we expect net sales for the 2025 third quarter to increase by approximately 9% to 10% over the prior year quarter. We expect our gross margin for the 2025 third quarter to be in the low to mid-30s, and adjusted EBITDA margin to be within 10% to 12% as our cost of goods sold have begun to reflect inventory brought in with the elevated tariffs. Currently, we are maintaining our full-year 2025 guidance for net sales, gross margin, and adjusted EBITDA margin pending potential impact related to additional tariff changes. Alan and I will now be happy to answer your questions, and I'll turn the call back to the operator.

Our first question today comes from Michael Francis from William Blair.

This is Mike on for Ryan. Nice quarter. I wanted to unpack some stuff on the guide, but first, let me start with prices. I was surprised to see price was negative on the quarter, especially with some of the tariff price increases. So I guess two parts. Why was price negative on the quarter? And then what should we be expecting from the impact of price in the second half?

We are currently maintaining our pricing with some slight increases in specific categories. This is because we have greater visibility regarding pricing in the countries we import from. Additionally, we are starting to reduce our costs by shifting some of our sourcing from Taiwan to other Asian and Latin American countries where tariffs are lower, and our cost of goods purchased has been decreasing. We have new vendors who are helping to lower our costs, which will assist us in addressing any potential tariff impacts.

Okay. So if I think about that right with your second half guide that you referred to, should I be thinking sort of a similar volume growth and price impact that we saw in this quarter in the third quarter?

Jian, would you be able to answer that question?

Yes. So to answer your question, Michael, going forward, the second half of the year, we do expect pricing to be close to breakeven compared to about a negative 3% in this quarter.

Okay. Understood. And then with that, I noticed that there's embedded in the guide, there's a sequential decline in gross margin. So I wanted to know what the puts and takes of that? Is it tariffs coming through the P&L? Is it just lower profitability, sourcing from other countries? I just would love to unpack that.

Currently, the positive impact of the new sourcing will be felt in the fourth quarter. In the third quarter, we are still experiencing some of the tariffs we encountered in the second quarter, which have resulted in higher tariff costs. These should be alleviated in the fourth quarter. We are assessing how significant the impact will be. As we indicated during our first quarter earnings call, the products sourced in the second quarter will be sold in the third quarter, leading to a higher gross margin in the second quarter and a lower gross margin in the third quarter. Additionally, a significant factor was the currency FX loss from many products sourced from Taiwan due to devaluation against the U.S. dollar, which has increased some of the cost of goods sold and subsequently decreased our gross margin.

Got it. So if I'm understanding you right, it should be down in the third quarter, but then gross margin should recover some in the fourth quarter?

Yes, that is my understanding.

Got it. And then last one for me. I just wanted to know what you're seeing on July trends? And have you seen any sort of prebuy from your customers ahead of the August tariffs?

We are seeing strong sales from some of our national chain accounts in July. The tariff has led many of our smaller competitors to reduce their inventory. Our volume has increased in a category that was previously sourced from overseas. July has shown strong demand, particularly in California, where we are experiencing greater than double-digit sales increases. This trend began in June and continued into July. We are confident that achieving double-digit revenue growth is within our reach.

And our next question comes from Josh Axel from UBS.

A question for you on the online sales. Can you give a little guidance on what you're thinking for the second half of the year as far as online sales, the kind of growth you're targeting and what you're seeing in that area? And then I have one more question for you.

Sure. No problem. We believe online sales will continue to grow, especially we just added a new platform called Sysco Market. That seems to be doing quite well for us and it is basically fulfilled by our own logistics warehouse. We've moved away from Amazon FBA fulfillment by a third-party because the cost was just too high, and there were a lot of issues in terms of inventory reconciliation. By moving away from Amazon FBA, our revenue dropped a little bit, but our margin has significantly improved. We also have better control of the inventory as well. So we do see our online sales growing continuously, just like we have been in the past months and years.

Do you think you can get back to double-digit online growth in the second half of the year? Or with losing Amazon, is that going to be a little more difficult?

I believe that in the fourth quarter, due to the Sysco Marketplace, which we launched about three months ago and has gained significant momentum, we have around 500 SKUs available and plan to add another 750 SKUs this month. This initiative is expected to generate revenue. We anticipate that online revenue will likely return to double-digit growth in the fourth quarter.

Okay. Great. And then the last question, can you just comment, Alan, on what you're seeing in the M&A landscape, if you're looking at anything? And if so, what or if maybe prices are just not seeming attractive or just where you are?

Yes, we are still exploring mergers and acquisitions. We have been reviewing the past six months, during which there have been a few notable mergers and acquisitions in our packaging sector. It appears that sellers did not receive the expected value for their assets, and I believe current prices are still not aligned with our expectations. Many of our competitors who have made these acquisitions were primarily aiming to expand their product lines and market shares. However, we can achieve similar growth through new stock-keeping units and by enhancing our own offerings. Our strategic goal with mergers and acquisitions is to improve a location, expand our client base, or introduce new items that we don’t currently offer. Therefore, we continue to assess opportunities in this area. Additionally, we are introducing new product lines and are in discussions with several vendors for potential collaborations, similar to our past joint venture with a bagasse manufacturer. We are open to a variety of options and not confining our search to a single area.

And with that, ladies and gentlemen, we'll be concluding today's question-and-answer session. I'd like to turn the conference call back over to Alan Yu for any closing comments.

Thank you, everyone, for joining our Karat Packaging second quarter earnings conference call. I would like to say thank you all, and have a nice day. Bye-bye.

Ladies and gentlemen, with that, we'll conclude today's conference call and presentation. We do thank you for joining. You may now disconnect your lines.