Earnings Call Transcript - KRT Q1 2021

Operator, Operator

Good day and welcome to the Karat Packaging First Quarter 2021 Earnings Conference Call. All participants will be in a listen-only mode. After today's presentation, there will be an opportunity to ask questions. Please note this event is being recorded. I would now like to turn the conference over to Roger Pondel with PondelWilkinson, Karat Packaging's IR firm. Please go ahead.

Roger Pondel, Investor Relations

Thank you, operator. Good afternoon everyone and welcome to Karat Packaging's first quarter 2021 earnings call, which also happens to be the inaugural quarterly call since Karat completed its IPO on April 15. 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, Ann Sabahat. 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 factor section of Karat Packaging's IPO registration statements 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 any forward-looking statements except as required by law. Please also note that during today's call, we will be discussing adjusted EBITDA, which is a non-GAAP financial measure as defined by SEC Regulation G. A reconciliation of this non-GAAP financial measure to the most directly comparable GAAP measure is included in today's press release, which is posted on the company's website. With that, it is my pleasure to introduce and turn the call over to Alan Yu.

Alan Yu, CEO

Thank you, Roger. We're pleased to be here with you today for our first quarterly earnings call as a publicly traded company. We began trading on NASDAQ under the symbol KRT on April 15. We priced 3.95 million shares at $16 per share. I'm proud of the Karat Packaging team for their hard work and dedication in completing the IPO process and helping us get to this point. To set the stage, let me first tell you a little more about the company. Karat Packaging is a specialty distributor and manufacturer of a wide range of environmentally friendly, disposable foodservice products and related items primarily used by national and regional restaurants in foodservice settings throughout the United States. Our products include food and take-out containers, bags, tableware, cups, lids, cutlery, straws, specialty beverage ingredients, equipment, gloves, and related products. Our eco-friendly Karat Earth line offers quality, sustainably focused products that are made from renewable resources. One of the company's distinguished characteristics is that we also offer customized solutions, including new product development and design, printing, and logistics services. Our business has been strong and growing. We reported solid first quarter financial results that reflect our ability to deliver customized solutions and quality products to a diverse and expanding customer base. Net sales for the quarter grew at a robust rate of 18%, with particularly strong performance in our distributors and online channels. Our goal is to be the leading single-source provider to a broad set of customers for all of their disposable foodservice product needs. We aim to do this through a combination of initiatives that includes rolling our base business with incremental revenues from existing customers, expanding our customer base, increasing sales through our online channels, and pursuing strategic acquisitions over time. Our 2021 first quarter results reflect progress in all of these areas, particularly in our online channels, which command a higher margin and grew 82% during the period. The positive progress we made in the first quarter was partially offset by the negative impact from a severe winter storm in February that closed our Texas plant for 10 days, as well as a significant increase in freight costs. Sales rebounded strongly in March and have continued at a robust pace so far in the second quarter, much of this increased demand is being driven by restaurants across the country that are reopening at the same time. As the pandemic winds down, demand for environmentally friendly products has also increased, along with demand through our online channels. Like most companies with international operations, we also experienced a significant increase in freight costs in the quarter. Ocean freight rates have more than doubled over the prior year, and experts believe these costs will continue to run at high levels until early next year. We took action in the first quarter to pass on these higher costs to our customers through a series of targeted price increases that are continuing into the second quarter. This action gives us increased confidence in our ability to protect our near-term margins. We also completed the acquisition of Pacific Cup in the first quarter, expanding our manufacturing and distribution footprint in Hawaii. We intend to use this new facility to manufacture paper straws among other products with Pacific Cup. We have six distribution centers and three manufacturing plants now, and we're continuing to evaluate other acquisition targets. We want to leave adequate time for questions, so I will stop here and turn the call over to Ann to discuss our first quarter results in detail.

Ann Sabahat, CFO

Thank you, Alan. Our 2021 first quarter results reflect strong top-line growth and gross margin expansion offset by an increase in operating expenses, principally related to our growth. Net sales increased 18% to $76 million in the first quarter. Sales to distributors, our largest channel, grew 18% and online sales advanced 82% in the quarter. As you know, we've made significant investments in our online channel because we view this as part of an acceleration and shift in consumer preference towards food delivery. Sales to national chains also grew 18% in the first quarter as we continue to expand business with existing customers. Sales to retail channels fell 29%, primarily reflecting a shift in ordering by retail customers to our online channel. During the pandemic, many retail stores have found it easier to place orders quickly online. Gross profit increased 21% to $22 million in the 2021 first quarter. Sales through higher margin channels, particularly online sales, drove a 70 basis point increase in gross margin despite higher freight costs, as Alan mentioned. Operating expenses increased 29% to $18 million in the first quarter, principally reflecting higher shipping costs, expansion in our workforce, facility cost increases as the company continues to grow, and higher professional fees. Costs related to our public offering were approximately $400,000 in the 2021 first quarter. Operating income declined 8% in the first quarter, primarily due to the increase in operating expenses, partially offset by gross profit. Operating margin declined 140 basis points, primarily due to the pressure from higher freight and shipping costs. Other income increased approximately $4 million year-over-year in the first quarter, primarily due to a decrease in net interest expense that resulted from changes in the fair value of interest rate swap positions. We recorded a gain of $1.3 million in the 2021 first quarter versus a loss of $2.4 million in the same period last year. Provision for income tax expense increased to $1 million in the 2021 first quarter, primarily due to a higher effective tax rate of 28% in the quarter compared to 26% in the same period last year. We expect our effective tax rate to approximate 27% this year. Net income amounted to $3 million in the 2021 first quarter, compared with less than $1 million in the same period last year. The increase in net income attributable to non-controlling interest is primarily due to changes in interest rate swap positions at Global Wells, a variable interest entity used to manage certain facilities. Because interest rate swap positions are primarily held by Global Wells, their associated gains and losses are reported as net income or loss attributable to non-controlling interest in our income statement. Net income attributable to Karat Packaging Inc. was $1.8 million, or $0.12 per diluted share in the first quarter, compared with $2.5 million, or $0.16 per diluted share in the same period last year. Adjusted EBITDA on a consolidated basis increased slightly to $6.8 million in the 2021 first quarter. Consolidated adjusted EBITDA margin declined 30 basis points to 9% in the 2021 first quarter. Adjusted EBITDA attributable to Karat Packaging increased 14% to $6.1 million in the 2021 first quarter. Adjusted EBITDA margin attributable to Karat Packaging declined 30 basis points to 8% in the first quarter of 2021. Net cash provided by operating activities increased to $5 million in the 2021 first quarter, primarily due to improvements in working capital relative to the same period last year. Capital expenditures declined year-over-year, primarily as a result of the purchase of manufacturing equipment and construction of our facility in New Jersey last year. As Alan mentioned, we completed the initial public offering of our common stock on April 15 of this year, resulting in the issuance of 3.95 million shares at a public offering price of $16 per share. The IPO, along with the exercise of the over-allotment option by the company's lead underwriter, provided the company with gross proceeds of approximately $73 million. We used a portion of these proceeds to pay down an aggregate of $50 million in principal balance of our loan obligations. I'll now turn the call back to Alan for closing remarks. We'll be happy to answer any questions you may have.

Alan Yu, CEO

Thank you, Ann. Our competitive position as a rapidly growing specialty distributor and select manufacturer of environmentally friendly disposable food service products and related items has long served our customers and employees well. We believe our profile as a publicly traded company enhances our value proposition in the marketplace. As a nimble supplier of a wide range of products for this food service industry, we believe that Karat Packaging has tremendous advantages that differentiate us from our competitors. Our 2021 first quarter results deliver solid growth in revenue and gross profit. Even as we work through industry disruption and cost pressures, we're pleased that our sales demand picked up nicely toward the end of the first quarter, and we expect strong demand to continue in the months ahead. Before we begin the Q&A section, I wanted to personally thank the entire Karat team for their hard work and dedication to excellence. This is an exciting time for all of us, and we are committed to working diligently toward achieving our collective goals, growing our company, and enhancing our value for all of our stakeholders. With that, I'll turn the call over to the operator.

Operator, Operator

Our first question will come from Michael Hoffman with Stifel. Please go ahead.

Michael Hoffman, Analyst

Thank you very much, Alan, and congratulations on your first public company earnings call. I'd like to start with the backdrop on demand and your ability to fulfill. We understand broadly that the restaurant and food services industry ramped up order activity, and I'd like to tease out the strength of your supplier network and how you've been able to continue to meet your fulfillment needs. In part, because of the quality of that supplier network, the customer is getting fulfilled, even if the overall demand is super high, you're still meeting their fulfillment needs?

Alan Yu, CEO

Michael, thank you for the question. Well, first of all, when the economy opened up in March, we anticipated an increase in demand for packaging. We did order to procure more products overseas in February. When the economy actually opened up in March and April, we saw a sharper increase in demand that really drove the entire industry into a distress on supply chain matters. If we were just to supply our existing customers, it would have been the perfect world, but all of a sudden, all of our not only existing national chain accounts but also chain accounts that we hadn’t been working with came to us for assistance. That’s when our supply chain also got a bit off balance, just like everyone else. We are ordering more products from overseas to overcome this issue. We're doing our best to supply products to our existing customers, which we have had a bit of a problem with, but we're doing our best to assist new customers that are coming to us.

Michael Hoffman, Analyst

So there's been an opportunity to gain share as well as continue to meet your current customers?

Alan Yu, CEO

That is correct.

Michael Hoffman, Analyst

From what you alluded to regarding cost increases between raw material and freight; how do you profile the pathway to price increases from a modeling standpoint? Are we looking at these predominantly as pass-throughs, so it's an increase in revenue and an offset to expense, and so by its nature would be margin dampening, but that's not necessarily a bad thing because you're offsetting expenses as opposed to gaining any revenue on it?

Alan Yu, CEO

Well, I would see that we are gaining revenue at the same time by passing through the increase in expenses, and we are also increasing our margins from the revenue side and also on the margin side by offering our products online. This is where we see a key driver for our margin. Online sales are something that we focused on last year and will continue to focus on this year. We are very supportive of our e-commerce sectors to ensure that those customers out there who are unable to get their product through local distributors are able to purchase online and receive their products to meet their store needs.

Michael Hoffman, Analyst

Did you have a very big PPE build in Q1 2020 that you had to overcome, or is that tough comparison really in Q2 2021 versus Q2 2020?

Ann Sabahat, CFO

Michael, this is Ann speaking. That was a great question. In Q1 of 2021, we saw PPE revenue at $800,000 compared to $2.5 million in Q1 of 2020, which we saw negative contribution margin in Q1 of 2020 compared to 68% year-over-year. So, we definitely do not see the PPE trend continuing. We expect it to be less than $1 million or less than $500,000 per quarter for the rest of the year. Hence, the impact would be very minimal.

Michael Hoffman, Analyst

Okay. And so you have a tougher comparison in Q2, but you've also demonstrated in Q1 that you're offsetting those comparisons. Your expectation in Q2 would be to offset a really strong performance; you did almost $19 million in PPE in Q2 of 2020. So your anticipation is you'll offset that because of the demand side?

Ann Sabahat, CFO

That is correct.

Michael Hoffman, Analyst

Will you give us some sense of how we should think about revenues and aggregate EBITDA ranges for Q2, given the level of price increases you've been implementing?

Ann Sabahat, CFO

In Q1, we grew our revenue 18.1% year-over-year, without including PPE. Without PPE, we grew 22% year-over-year. We will continue to see that in Q2 of 2021, our growth will exceed that 18% excluding PPE. We expect organic growth to exceed 30%. This is what we're seeing for Q2 of 2021.

Ryan Merkel, Analyst

Hey, thanks for taking the questions. First off, I was impressed with your gross margins. Alan, you mentioned online sales, but you also mentioned freight as an offset. How big was the freight headwind this quarter? And then importantly, do you expect to cover freight costs with price increases in the second quarter?

Alan Yu, CEO

Yes, Ryan. In the first quarter, we did see freight increase significantly by almost nearly 50% or more compared to last year, 2020. We had to implement freight increases in pricing back in January, February, and March. We did numerous price increases across different segments of our product line. We are also looking to continue price increases in April, May and June to see how much freight costs can be offset.

Ryan Merkel, Analyst

So it sounds like you're maybe still in a bit of a chase on freight. It’s unclear at this point whether freight will be a headwind or more neutral in the second quarter, is that fair?

Alan Yu, CEO

As of now, freight in the second quarter should be neutralized or stabilized.

Ryan Merkel, Analyst

I wanted to dig into online sales a bit more; what are some of the drivers? Ann mentioned the shift to e-commerce due to the pandemic, and that makes sense. But what else is driving that? Restaurants are reopening, and I think you were planning on increasing your marketing spend and adding new products. Just what else is driving that?

Alan Yu, CEO

In the marketplace, domestic manufacturers and other importers are our competitors and they are struggling to keep up with capacity. We've seen national chains and convenience stores placing orders online just to ensure they don't run out of supplies like cups or straws. More people are going online because competitors are struggling to keep up with demand. As restaurants open at the same time, more people will likely continue to order products online, similar to how people get used to ordering take-out instead of dining in.

Ryan Merkel, Analyst

What's driving the retail channel weakness? And do you expect that to turn around next quarter?

Alan Yu, CEO

We expect a turnaround in the next quarter as more retail stores open up. Many retail stores are unable to fully open due to a lack of labor, which is a major shortage nationwide. We do see improvements as states ease off federal assistance, which should help restaurants find the staff they need to reopen their businesses.

Jake Bartlett, Analyst

My first question was about the mix of products. I'm wondering specifically how the off-premise to-go product mix is doing as well as the cup business. Has the cup business been recovering quickly? How is the product mix shifting?

Alan Yu, CEO

Thank you, Jake. During the pandemic, we saw the cup business drop sharply. However, as most businesses reopened in the first quarter, we observed restaurants beginning to reorder cups. The take-out side has shown steady demand, but the cup side has really grown sharply, especially as the weather warms up. More consumers are using cups as dining options expand, so demand has significantly increased, contributing to the supply shortages in the cup market.

Ann Sabahat, CFO

Jake, to clarify, revenue for cups and related products came in at approximately $20 million or about 25% of total revenue in Q1 of 2021, which is slightly down about 2% from Q1 of last year but steady compared to Q4 of 2020. In terms of take-out containers, we did see the hinged containers grow to $11 million, or 15% of revenue in Q1 of 2021, up from $9.5 million in Q4 of 2020 and $8 million in Q1 of 2020. Our food products in terms of syrups and boba also grew to about $13 million in Q1 of 2021, up from $10 million in both Q4 and Q1 of last year.

Jake Bartlett, Analyst

What percentage of your sales were manufactured by you? Do you expect that to increase in the near-term given the shortages and the time it takes for freight to come across from Asia? How is your manufacturing ability helping you out here?

Ann Sabahat, CFO

We continue to see our mix of goods manufactured versus imported at roughly between 85% to 15%. Our manufacturing capability serves as a flexible resource to ensure product availability. We continue to aim for about 15% of our goods to come from manufacturing.

Alan Yu, CEO

We are looking to increase our manufacturing capacity to ensure we don't run out of products for our existing customers and not solely rely on imports. This also helps reduce freight costs.

Jake Bartlett, Analyst

You've mentioned the cost increases, particularly for freight and resin, and you're taking price actions to offset that. How do you view gross margins in 2021 relative to 2020? Do you expect the net impact of those two to be a drag on gross profits or gross margins?

Ann Sabahat, CFO

We believe we will maintain gross margin expansion in 2021. We effectively passed on increases in raw materials, freight, and duty costs to targeted customers. While we experienced some drag early in the quarter, we saw a strong rebound in gross margin above 32% in March, and we are optimistic about this trend continuing into the next few quarters.

Jake Bartlett, Analyst

What percentage of sales was from Karat Earth in the first quarter of 2021?

Ann Sabahat, CFO

Eco-friendly products comprised roughly 20% of our total revenue in Q1 of 2021, compared to slightly below 20% in Q1 of last year. Eco-friendly products have increased slightly compared to Q4 of 2020 from roughly 17%.

Operator, Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Mr. Alan Yu for any closing remarks.

Alan Yu, CEO

Thank you, operator, and thanks to everyone for joining us today and for your support and interest in our company. We look forward to speaking with you again soon on our second quarter call.

Operator, Operator

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