Karat Packaging Inc. Q3 FY2025 Earnings Call

Good day, and welcome to the Karat Packaging Third Quarter 2025 Earnings Conference Call. Please note this event is being recorded. I would now like to turn the conference over to Mr. Roger Pondel. Please go ahead, sir.

Thank you, operator. Good afternoon, everyone, and welcome to Karat Packaging's 2025 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, 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 this 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 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. Despite ongoing trade volatility, Karat achieved another quarter of record net sales, up over 10% year-over-year, fueled by solid volume expansion, a favorable product mix and effective pricing initiatives. We've experienced double-digit growth across all major markets, especially in Texas and California. Even with significantly higher import costs due to increased duties and tariffs, we successfully sustained a gross margin of 34.5% for the third quarter. We remain committed to our sourcing diversification strategy, and our nimble and flexible operating model continues to enable us to effectively manage ongoing supply chain challenges. During the third quarter, we increased domestic sourcing to approximately 20% from about 15% in the second quarter, and we reduced imports from Taiwan to approximately 42% from 58%. We continue to closely monitor tariff developments and are ready to quickly adjust our sourcing strategy accordingly as we have done in the past to maintain Karat's competitive advantage. Additionally, foreign currency exchange rates between the U.S. dollar and the new Taiwan dollar have shown increased stability since August, which is expected to help improve our operating performance for the current quarter. Earlier this year, we secured a major add-on of business to supply paper bags, a new product category for Karat to one of our largest national chain accounts. Initial shipments to select distribution centers started in the third quarter, and we expect the volume to accelerate in the fourth quarter. With fulfillment expected during Q1 of 2026, this new category of business with this chain account is for a 2-year term and is expected to contribute approximately $20 million in additional annual revenue. Over the next 2 to 3 years, we aim to scale our paper bag business to more than $100 million in additional annual revenue. The anticipated growth from this new category is being driven by national and regional restaurant chains that are transitioning to paper bags from plastic bags. This shift is influenced by evolving state and municipal regulations as well as a growing emphasis on enhancing customer experience and brand images. We expect continued market share growth in this segment, further solidifying our position as a leader in providing sustainable, eco-friendly disposable food service products. In late May and June this year, we implemented broad pricing increases across most product lines to offset rising import costs. Heading into the fourth quarter and 2026, business trends remain strong. We continue to pursue a disciplined pricing approach and partner with our customers while focusing on operating efficiencies. We are actively integrating several meaningful new customer accounts and focusing on increasing online marketing, which will strengthen our 2026 pipeline, building a strong foundation for what we expect to be another record-setting year in sales. Karat announced a first-ever stock repurchase program this week. In addition to the regular quarterly dividend, the announcement underscores our Board confidence in the company's future growth prospects and financial strength. 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 Q3 performance, followed by an update on our guidance. Net sales for the 2025 third quarter were $124.5 million, up 10.4% from $112.8 million in the prior year quarter. The increase was primarily driven by an increase of $9.4 million in volume and a $3.5 million favorable impact from product mix, partially offset by a $0.7 million unfavorable year-over-year pricing comparison. Sales to chain accounts and distributors were up by 13.7%. Online sales increased 3.1% over the prior year quarter, and sales to the retail channel were down 12.5% over the prior year quarter, reflecting the softness of the overall retail sector. Cost of goods sold for the 2025 third quarter increased 17.8% to $81.6 million from $69.3 million in the prior year quarter. Product costs increased $5.0 million due to sales growth, partially offset by more favorable vendor pricing and product mix. Additionally, import costs increased $8.2 million due to higher import duty and tariffs, coupled with a 21.0% increase in import volume as we purchased more inventory ahead of expected business expansion, partially offset by a 13.4% decrease in average freight container rates. Gross profit for the 2025 third quarter was $42.9 million compared with $43.5 million in the prior year quarter. Gross margin for the 2025 third quarter was 34.5% compared with 38.6% in the prior year quarter. Gross margin was negatively impacted by higher import costs, which as a percentage of net sales increased to 14.4% compared with 8.6% in the prior year quarter. The decrease in margin was partially offset by a decrease in product costs as a percentage of net sales due to more favorable vendor pricing and product mix, as well as a reduction in inventory write-offs and adjustments as a percentage of net sales. Operating expenses in the 2025 third quarter were $34.3 million compared with $32.2 million in the prior year quarter. The increase was mainly driven by $2.1 million of higher shipping costs due to higher sales volume, $0.7 million of higher rent expense due to a higher rate on our Chino, California facility lease extension plus the opening of a new Chino distribution center, and $0.6 million of higher salaries and benefit expenses. These increases were partially offset by a $1.4 million reduction in online platform fees. Operating income in the 2025 third quarter was $8.6 million versus $11.3 million in the prior year quarter. Total other income net was $1.3 million for the 2025 third quarter compared with $0.6 million in the prior year quarter. The increase was primarily from a foreign currency transaction gain of $0.7 million, driven by the strengthening of the United States dollar against the new Taiwan dollar during the 2025 third quarter compared with a loss of $0.3 million on foreign currency transactions during the 2024 third quarter. Net income for the 2025 third quarter was $7.6 million compared with $9.3 million for the prior year quarter. Net income margin was 6.1% in the 2025 third quarter compared with 8.2% in the prior year quarter. Net income attributable to Karat for the 2025 third quarter was $7.3 million, or $0.36 per diluted share, compared with $9.1 million, or $0.45 per diluted share in the prior year quarter. Adjusted EBITDA for the 2025 third quarter was $13.1 million compared with $14.7 million for the prior year quarter. Adjusted EBITDA margin was 10.5% of net sales for the 2025 third quarter compared with 13.0% for the prior year quarter. Adjusted diluted earnings per common share were $0.37 for the 2025 third quarter compared with $0.47 for the prior year quarter. We generated operating cash flow of $1.0 million in the third quarter compared with $19.5 million in the prior year quarter. Duty and tariff payments as well as the inventory purchase payments increased. However, such increases were offset by strong collections and, as you will see described in the Form 10-Q filed tomorrow. Despite the significant cash outlays for operations and a $3.5 million early loan repayment on one of our consolidated variable interest entities term loans, we ended the quarter with $91.1 million in working capital. As of September 30, 2025, we maintained financial liquidity of $34.7 million with another $19.9 million in short-term investments. As of September 30, 2025, we reclassified one of our consolidated variable interest entities term loans into current liabilities as the maturity is within 12 months, totaling $20.4 million. We intend to pay down the loan upon maturity with our cash on hand. On November 4, 2025, our Board of Directors approved the quarterly dividend of $0.45 per share, payable November 28, 2025, to stockholders of record as of November 21, 2025. Additionally, our Board of Directors approved our first-ever share repurchase program of up to $15.0 million, under which Karat is authorized to repurchase shares of its outstanding common stock from time to time through open market purchases. Looking ahead to the 2025 fourth quarter, we expect net sales to increase by approximately 10% to 14% over the prior year quarter, with gross margin projected to be within 33% to 35% and adjusted EBITDA margin to be within 8% to 10%. As Alan mentioned earlier, our new business pipeline for 2026 is robust, supported by the new paper bag category offering and the addition of several key customer accounts. We remain focused on accelerating top line growth with disciplined pricing while continuing to enhance operational efficiency and cost management. Alan and I will now be happy to answer your questions, and I'll turn the call back to the operator.

The first question will come from Michael Francis with William Blair.

Alan and Jian, it's Mike on for Ryan. Nice quarter. I wanted to start on paper bags. Did I hear you right that you aim to scale that to $100 million over the next 2 years?

Yes, that is correct.

And what gives you confidence in that number?

It's because there are a lot of chains moving away from plastic bags into paper bags. And this is a segment that we're seeing that, as one of the large chains in the U.S. moves towards this area, more and more similar chains will follow through that. We feel there is an organic growth in that segment. Additionally, it’s not just the paper bags; there are different types of bags. The SOS bag is something that every fast-food restaurant will need. With the growth of fast-food chains and the number of stores that are increasing, we feel that we can be competitive enough to gain market share in that segment as more and more companies look towards this area. There are also bakery bags available. There are many items in that segment that make us feel we can grow swiftly. As we mentioned in our announcement, one chain alone has annual sales projections of $20 million to $25 million just for that one chain. We already have two or three other chains testing our paper bags and SOS bags. That's why we’re confident that this business will grow quickly into an additional $100 million in annual sales.

That's all good to hear. And then I wanted to ask about gross margins, which went lower, I think, as we were expecting, and 4Q is a little lower than we were expecting. Would like to know longer term, do you think that there's an opportunity for you to get back into that high 30% range on the gross margin number? Or is that going to be difficult while tariffs are in the market?

Well, we're trying to be conservative right now at this point because there's still uncertainty. But the good thing is we feel there are tailwinds. One of the issues that reduced our gross margin drastically in the second quarter was the sudden drop in the Taiwanese dollar versus the U.S. dollar, which dropped by 11% in just 3 days. That 11% has come back to about an increase of 4.5% to 5%. Essentially, there has been more stabilization in the U.S. dollar against Asian currencies. This is enabling us to negotiate better pricing with our vendors these past two months. So we're seeing some positive trends regarding gross margin, but we want to be conservative in how we project our numbers. As indicated by September and October, we already see some improvement in October compared to September, which was better than August. We hope to see a more positive trend before issuing an increase in our gross margin forecast.

Okay. And lastly for me, it's good to see the share buybacks. Would love to get an update on your capital allocation priorities between debt paydown, buybacks, and the dividend as well as any potential M&A.

Our strategy is that if we have more than $20 million in short-term deposits, we can allocate it to the dividend, special dividends, regular dividends, or use it for other investments. Even with the increase in tariffs and inventory costs in the second quarter, our deposits have remained stable. Our cash position is strong. Recently, we’ve been reducing our inventory to minimize costs concerning tariffs and related charges. Consequently, we’ve seen cash flow returning to our accounts. This situation has provided us an opportunity to conduct share repurchases while our stock is relatively undervalued, which I believe is a good move. At the same time, we are still exploring merger and acquisition opportunities. We have a few options in the pipeline, including investments, partnerships, joint ventures, and acquisitions. We do not think this will deter us from moving in that direction.

The next question will come from George Staphos with Bank of America.

Can you hear me okay, Alan?

Yes, I can, George.

So listen, maybe just piggybacking on the question about capital allocation. I want to take it from a different approach. Your dividend basically represents the majority of your earnings per share. Why would you consider or contemplate doing more buybacks in light of that? Would you consider borrowing to buy back more stock? It would seem like deleveraging and addressing your debt paydown needs would be more prudent. But how do you think about that?

Here’s the thing. We don’t have any debt on our books right now. The debt you see related to the variable interest entities is tied to real estate ventures.

That $20 million, that current liability, you said you're going to pay that down in the upcoming year?

We can pay it down, either with our current short-term deposits or by borrowing from different banks if needed. As I mentioned, we have no debt on our main books right now, giving us time to allocate our capital wisely. The rate of CD income is dropping as interest rates reduce, so we need to figure out which option provides the best outcome. Paying down debt could generate additional income through intercompany loans. It won't just be straightforward repayment; it will also generate income for the Lollicup side from paying down the VIE company's debt.

And George, this is Jian. I just wanted to add on to what Alan was talking about to answer your question. The main purpose really is to have one additional tool in our toolbox to further enhance our shareholder return while we continue to focus on growing the company either organically or inorganically. As we previously announced, as you probably saw in yesterday’s announcement, the total amount approved by the Board for the share repurchase program is $15 million. This is a fairly small program, left to management's discretion, allowing us to evaluate various factors regarding pricing, performance, liquidity, and the strength of our balance sheet as well as enhancing shareholder returns. You're right; our dividend yield is already robust, so that is certainly something we consider as we move forward with potential execution under this program.

Okay. I appreciate the thoughts on that, and thanks for the reminder on the VIE. One question, back to the question Mike teed up on the bag business. So let's assume you have perfect accuracy on the revenue side on bags, and that's $100 million in whatever time period you said. What kind of margin do you think you're going to get on that business? And you're already starting to see some of that show up in the fourth quarter, you said, correct? So two questions there.

It will be a mix margin. The higher volume could be in the high teens range, while the SOS bag could be in the high 30s. It depends on the product line. The bakery bag could even reach the high 50s. Simultaneously, we are selling these new bags online, which will likely be at a higher margin range. So it will be a mix of each, similar to how we are currently operating. We’re also working on improving our bag manufacturing efficiency to boost margins further, acquiring raw materials more effectively, and potentially shifting some manufacturing into domestic U.S. production, which may save costs and enhance margins. These are the strategies we can implement as we ramp up volume in the next 12 months.

All right. So two quick ones for me, and I'll turn it over to Alan. With that being the case, and we're already in November, the revenue growth range and the margin range is fairly wide. I realize you're trying to be prudent, and I understand there are vagaries in the market, especially with tariffs and sourcing. But I find the range is perhaps a bit wider than I would expect at this juncture in the year. What's causing the caution in terms of narrowing both revenue growth and margin projections for the quarter? And did I hear you say there was an inventory write-off? I apologize; I'm on the road right now, so I don't have your materials in front of me.

I wasn't specifically addressing an inventory write-off, but I know we are reducing inventory for year-end. Sales have been very robust. As noted, we’re midway through the fourth quarter, and we're seeing sales growth in the mid-teen range, but we want to maintain a conservative outlook. The mid-teen organic sales growth we haven’t seen in the past 3 years is encouraging. We are estimating around 12% to 14% growth, but we have seen figures close to mid-teens recently. Our viewpoint remains cautious, which is why we communicate the 12% to 14% growth range, even as we’re witnessing promising sales figures.

And this will conclude our question-and-answer session. I would like to turn the conference back over to Mr. Alan Yu, CEO, for any closing remarks. Please go ahead.

Thank you. Thank you, everyone, for joining our third quarter Karat Packaging earnings conference call. I'd like to say thank you again, and have a nice day. Goodbye.

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