Earnings Call Transcript - KRT Q4 2021

Operator, Operator

Good day, and welcome to the Karat Packaging 2021 Fourth Quarter and Year-End 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, Karat Packaging Investor Relations firm. Please go ahead, sir.

Roger Pondel, Investor Relations

Good afternoon, everyone, and welcome to Karat Packaging's 2021 fourth quarter and year-end conference call. I'm Roger Pondel with Karat Packaging's Investor Relations firm. It will be my pleasure momentarily to introduce the company's Chief Executive Officer, Alan Yu; and Karat's new 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 IPO registration statement and its most recent Form 10-Q 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 this 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?

Alan Yu, CEO

Thank you, Roger. Good afternoon, everyone. We're pleased to be here with all of you today. Our business continued to grow at a robust pace as we gain wallet share with our existing customers and expand our customer base. Earlier today, we reported record fourth quarter net sales and continued margin expansion. Despite ongoing global supply chain challenges and tight labor conditions, fourth quarter 2021 results reflect exceptionally strong demand for our product and market trends remain favorable. As we continue to provide innovative offerings, our sales were somewhat constrained by the delay of certain shipments to customers from December to January due to inventory shortages resulting from port congestion and labor challenges. We continue to manage the labor environment through increased recruiting efforts and shifting distribution to other facilities in our supply chain. Online sales again posted the highest percentage increase, 56% year-over-year in the fourth quarter as we are placing greater emphasis on this category of our business, which commands higher margins. In addition to sales from our own online channels, we experienced excellent growth through eBay, Walmart, and Amazon. Our distributor channel and national and regional chains also posted very strong results. During the year, we added more than 50 new regional restaurant chain accounts as well as national chain accounts. As noted in the press release, we've achieved our gross margin goal in the 2021 fourth quarter, increasing 360 basis points to 31% over the same quarter last year despite higher inventory and ocean freight expenses. This demonstrated our ability to improve productivity and operational efficiency, as well as successfully passing through inflation-related cost increases. Gross margin also benefited somewhat from higher land costs capitalized in the fourth quarter compared to the third quarter, mainly freight, duty and customs brokerage fees. Our positive business momentum is progressing in 2022. The food service sector is continuing to experience a steady increase in consumer spending. Moreover, demand for environmentally friendly products continues to grow which bodes well for Karat as a leading industry provider. As a result of a favorable outlook, we are currently targeting net sales for the 2022 first quarter to be in the range of $101 million to $103 million, up about 35% at the midpoint of the range over the same period last year. For the full 2022 year, we expect sales to grow by 17% to 19% over 2021. Lastly, as part of our plan to expand our third-party logistics services, we have just leased 14 trucks and trailers. This is in addition to the previously announced orders of 10 Tesla semi-trucks that we expect to arrive in 2023. We want to leave adequate time for questions, so I will stop here and turn the call over to Jian Guo, our new Chief Financial Officer, who joined Karat in February, to discuss our financial results in greater detail. Jian?

Jian Guo, CFO

Thank you, Alan. I am very pleased to have joined the Karat team at this exciting time in the company’s growth and development. Our 2021 fourth-quarter results reflect strong top-line growth from existing and new customers and improved margins as we continue to enhance our operating efficiency. We delivered $10.9 million of adjusted EBITDA or 11.9% adjusted EBITDA margin. Now, let me provide more color on our operating results starting with revenues. Net sales for the 2021 fourth quarter increased 30% over the same quarter last year to $91.3 million. Net sales for the full year 2021 increased 23% over 2020 to $364.2 million. Net sales in 2020 included $38.1 million of PPE products, principally during the height of the pandemic in the second quarter of 2020. Net sales of PPE products decreased to $2.7 million in 2021 or less than 1% of net sales. Sales to distributors for the 2021 fourth quarter, our largest channel, grew 33% and sales to national and regional chains expanded 27%. Online sales rose 56% for the quarter, reflecting strong demand and our continued investment in this critical channel. Sales to the retail channel decreased to 4% from the same quarter last year with some sales having shifted to other channels, and the fourth quarter typically being slower on the retail side. We implemented minimum shipping requirements in the second half of 2021 to better manage tight labor conditions, which shifted a portion of our sales mix from retail to distributors and enabled us to better utilize staffing resources. Gross profit increased 47% to $28.3 million for the 2021 fourth quarter due in part to the strong sales growth in our higher-margin channels and products along with improved operating efficiencies and better management of freight expenses. Gross margin for the 2021 fourth quarter expanded to 31.0% from 27.4% for the same quarter last year and 29.0% in the 2021 third quarter. Operating expenses for the 2021 fourth quarter were $21.2 million or 23% of net sales compared with $17.2 million or 24% of net sales in the prior year quarter and $24.4 million or 24% of net sales in the 2021 third quarter. The reduction in operating expenses as a percentage of net sales from both the prior year and the sequential quarter demonstrated the company’s improvement in cost leverage. Specifically, we are gaining efficiencies in facilities, shipping, and labor costs. Provision for income taxes was $1.1 million for the 2021 fourth quarter versus a benefit of $224,000 for the same period last year. Net income increased more than threefold to $6 million for the 2021 fourth quarter from $1.6 million for the same quarter last year. Net income attributable to Karat Packaging, Inc. was $5.6 million or $0.28 per diluted share for the 2021 fourth quarter compared with $922,000 or $0.06 per diluted share for the same quarter last year. Adjusted EBITDA on a consolidated basis advanced to $10.9 million for the 2021 fourth quarter from $4.5 million a year ago. Consolidated adjusted EBITDA margin was 11.9% in the fourth quarter compared with 6.4% for the same quarter last year. Adjusted diluted earnings per common share rose more than fivefold to $0.32 from $0.06 per share in the prior year quarter. Net cash provided by operating activities increased to $9.9 million for the 2021 fourth quarter from $2.2 million for the same quarter last year, reflecting the higher net income and favorable changes in working capital and non-cash adjustment. We finished the quarter with $72.1 million in working capital compared to $36.6 million at the end of 2020. In October 2021, we refinanced our line of credit with improved pricing and more flexibility in financial covenants. We believe we are better positioned to execute our future growth strategies. Alan, and I will now be happy to answer your questions. And I’ll turn the call back to the operator.

Operator, Operator

Thank you. Our first question will come from Jake Bartlett with Truist Securities. Please go ahead.

Jake Bartlett, Analyst

Thanks for taking my question. My first is for you, Alan or others. The question is fourth-quarter revenue came in a bit below the guidance that you had provided in early November. And you mentioned the supply chain bottlenecks, as well as, I think in the script, you mentioned staffing. That was in December and January. So I just want to make sure I understand kind of what happened there? And also, most importantly, how confident you are that those bottlenecks are now easing or have eased or will ease?

Alan Yu, CEO

Thank you, Jake. Well, yes, the fourth quarter we experienced a lot of shortages in product due to containers arriving late from the port and due to a shortage in labor during the holidays. We had many employees who were sick or calling in sick. So the warehouse was short-staffed; even if we had product on the floor, we were not able to ship everything in a timely manner, and the containers were trying to get from the port to the warehouse. We also had to shut down for almost two days toward the end of the year for inventory counting. One of the main causes of that issue was our fulfillment rate. Our fulfillment rate, especially in December, was around 50%, but we see that fulfillment rate improve significantly in the first quarter. To your question, do I see bottlenecks getting better? Yes, the port is getting a lot better. It used to take a container about three months from the factory to our warehouse. Right now, I’m seeing it take about two months, sometimes a little more, over two months to get containers into California. So it is much faster. The delays at the port are also reduced; right now, the delay could be no more than two weeks, whereas back in December and November, it was sometimes over 45 days just to get containers into our warehouse. We see a lot of these issues from the fourth quarter resolving, and in the first quarter, we also improved our efficiency by hiring more people, especially after January. We were able to hire more people and also work over the weekend to get our orders filled. I think the biggest challenge in the fourth quarter was trying to get the orders fulfilled; we had no problem receiving purchase orders from our customers. The demand was high; it was just that we couldn’t fulfill as much as we wanted due to labor shortages and supply shortages.

Jake Bartlett, Analyst

Great, great. And it sounds like you mentioned sick time, and that would coincide with the spike in Omicron that we’ve heard others talk about. Would that be the right way to think about it that the Omicron spike impacted your staffing and those sick days in your productivity as well?

Alan Yu, CEO

Yes. I would say that not only us; we’ve spoken with a lot of customers. I mean, COVID started back in 2020. We have been well controlling the employees that have COVID. But during the spike in Omicron, we experienced the most significant labor shortage with employees catching COVID. At one point, 50% of each of our departments were out sick. So it was really a challenging time during that period to get people to come to work, especially when everyone was gathering and then calling in sick after.

Jake Bartlett, Analyst

Great. No, that makes a lot of sense. And I was just – the next question is about the outlook for sales in 2022, the 17% to 19% growth. I’m hoping you can maybe break that down into a few different buckets in terms of the contribution to that growth. One is the price increases that you’ve taken throughout 2021. So how much is just increased pricing of what you’re selling contributing to that 17% to 19% growth? The other part is, how much of that growth do you think is going to be coming from existing customers? And then how much is dependent on getting new customers? Maybe some of those new customers as I understand you’ve signed on some, but haven’t really turned them on. So I’m just curious to understand the main drivers of this 17% to 19% growth?

Alan Yu, CEO

Sure. I would say 5% to 7% will come from increasing prices. The reason being, we raised prices on certain products, and also there are certain products where we decreased our prices, so it kind of offsets each other. I think that the majority of our increases, such as 5%, will come from an increase in new customers and also new product lines that we’re bringing in. We have been adding more product lines. Last year we added approximately 100 to 200 SKUs. This year, I expect to add an additional 100 to 200 SKUs mainly for online sales, where we see online will be a big driver that could give us additional $10 million to $50 million, possibly even more in revenue because we foresee that our online sales could possibly increase by 50% to 75% year-over-year this year.

Jake Bartlett, Analyst

Great. And then last question for me. The missing piece in terms of 2022 guidance, the missing piece to get to EBITDA is the operating cost. I’m just wondering if you could give us some of the big moving pieces there and whether we should expect leverage on operating costs in 2022? Perhaps if you can kind of just help us understand how much leverage we should expect. I know there’s shipping, there’s labor costs potentially, maybe lapping some of the one-time costs you incurred in 2021. But just any help on the operating cost and how we should think of that in 2022 would be helpful.

Alan Yu, CEO

Sure. I would say we are seeing the operating cost to be fairly increased, not insignificantly compared to our revenue growth. We are starting this month—starting next month—we will actually stop all the outside brokerage sales force that we have. So we terminated all of the outside sales agreements, and everything will be done in-house by our corporate salespeople. We’ve seen that on the inventory side, we’ve seen an increase in the dollars that is favorable to our cost of purchase overseas, as well as we’ve been utilizing more on the shipping side. We’re maximizing our shipments; previously, we shipped 28 pallets per truckload, and now we can ship 30 to 32 pallets. We’ve also seen the domestic local shipping truckload prices recently drop versus an increase in LTL. So we’re pushing our customers to ship more in bulk with the increased SKU offerings we’re bringing in. That also increased our efficiency in operational costs. Same with labor; we are hiring more people, seeking to achieve more efficiency out of our staffing that is another increase in our efficiency in cutting our operating costs.

Jake Bartlett, Analyst

Got it. So the message is that you do expect operating costs to contribute to margin expansion overall in 2022?

Alan Yu, CEO

Correct.

Jake Bartlett, Analyst

Great. I’ll pass it on. Thank you so much.

Alan Yu, CEO

Thank you, Jake.

Operator, Operator

Our next question will come from Ryan Merkel with William Blair. Please go ahead.

Ryan Merkel, Analyst

Good afternoon, everyone, and congrats on the quarter and a strong guide. My first question is on gross margin for 2022. Alan, is the primary driver of higher margins, is it the mix? Or what are the other puts and takes that we should be thinking about?

Alan Yu, CEO

We see the primary driver of gross margin is, one, a strong dollar; two, we’re selling more eco-friendly products that we are offering. Hawaii has—we have actually really better utilized our Hawaii operation and also we’re expanding our Hawaiian operation, which has a high demand for eco-friendly products composed of our ESG product line. We do see that with the economy opening up, and more cities and restaurants calling for environmentally friendly packaging, such as gas plate for gas hinge containers, PLA straws, or compostable straws. More importantly, we’re able to increase our online sales through Amazon, eBay, Walmart, not only on e-commerce stores. We also aim to double our staffing on the e-commerce side to push those online sales, which is crucial for revenue growth. Our goal for online sales in 2022 versus last year is 50% to 75% or even more on the growth side. Online sales generate a much higher gross margin than our traditional retail channels. This is how we see a strong driver for our gross margin in 2022.

Ryan Merkel, Analyst

Yes. Okay, makes sense. And then the share gain in 2021 was really impressive, with 50 new accounts. Can this continue in 2022? Or was 2021 a unique year because of the shortages and you were able to outservice your peers? Or do you think you can continue with the share gains at this sort of accelerated pace?

Alan Yu, CEO

We believe—in 2021, our sales actually really didn’t go out to look for customers. So we believe in 2022, we will be able to increase even more than 50 new accounts, especially in the Midwest market. This market is where we see, like I said, we have been strong in the West Coast, but very weak in the Southeast, Eastern part of the U.S., and even in the Midwest. There are a lot of opportunities out there that we haven’t tapped into, so we do see even bigger opportunities in 2022 versus 2021 for new customer growth in the regional chain accounts.

Ryan Merkel, Analyst

Got it. Okay. That’s great to hear. And then just lastly for me, Alan, I think your domestic OEM competitors were out of capacity. I think that was the case in 2021. Where do we stand now? I assume they’re expanding capacity. Are they starting to ramp up a bit? Could that competition heat up?

Alan Yu, CEO

I do—I have been hearing that the domestic manufacturers have expanded their operations. In 2021, the shortage was not caused by the lack of capacity; it was more a lack of labor for everybody, including ourselves. At a certain point, there were certain days in a month where we could have had less than 10% of our staff coming in due to the Omicron variant. That’s what I’ve heard from the competitors as well; everyone is having a hard time finding labor. Even today, it’s not that they don’t have the equipment; they just can’t find enough people to come to work consistently, and too many employees are quitting.

Ryan Merkel, Analyst

Okay. Well, thanks for the color. I’ll pass it on.

Alan Yu, CEO

Thank you.

Operator, Operator

Our next question will come from Brian Butler with Stifel. Please go ahead.

Brian Butler, Analyst

Thanks for taking my questions. You guys hear me?

Alan Yu, CEO

Yes. We can hear you, Brian.

Brian Butler, Analyst

Okay, great. So just at a high level, how do you view the risk of hyper or very high inflation in food costs with the current Russia-Ukraine situation? What kind of risk is that to your model?

Alan Yu, CEO

Well, we’ve seen the raw material increases on the plastic side and resin side by nearly 50%. The paper side increased even more by almost 70%, and we’ve seen even the raw materials, the food ingredients that we import have also increased a little. Everything has spiked up. What we’ve done is we have to protect our margins and ensure that we’re operating profitably. So we pass on most of these increases to our customers, and our customers are basically passing those increases to their end consumers as well. We’ve seen that consumers seem to be accepting these inflation costs fairly well. Even this year, I don’t see many more increases coming along. I think everything has stabilized; however, we remain cautious regarding any future increases due to uncertainty in raw material shortages, especially in aluminum and paper. So we're more cautious about that part. If it happens, we'll just have to do what we can to protect our margin.

Brian Butler, Analyst

Okay. And then on the ESG products or the environmental products, can you give us some color on the mix that was in 2021 and your expectation for 2022?

Alan Yu, CEO

Sure. In 2021, for example, the state of Hawaii mandated all restaurants to use compostable take-out packaging, not only in straws, lids, and cups but also in take-out containers. That has kind of been delayed and is now moving into 2022. I have been hearing a lot of national chain accounts looking for these compostable products because they have missed that deadline. We anticipate significant growth in that area. We also see that even in our neighboring countries like Mexico and Canada, customers are asking for compostable products. Many states and local regulations are now requiring restaurants and businesses to use 100% compostable products, not just recyclable products. We started our compostable line back in 2007, and we're one of the leading manufacturers and importers of that product line. We've seen a significant increase in sales in this aspect of the product line, and we expect it to continue growing even faster in 2022. However, this poses a challenge in finding more sources as making compostable products is more complex compared to regular plastic or paper containers, and most of them are produced overseas, which poses supply chain risks.

Brian Butler, Analyst

On those years, how much more profitable are the environmental compostable products than your standard plastic products or regular paper?

Alan Yu, CEO

I would say it's about 15% to 25% more profitable than our standard products.

Brian Butler, Analyst

Okay. That's helpful. On the freight costs, and those coming down in 2022 versus 2021, any color on how that trends through the quarter? I mean, are we going to see a big difference in the first quarter and then it kind of evens out the rest of the year? Or is there some other volatility in there?

Alan Yu, CEO

The information that we receive shows that ocean freight has actually gone up 35% from last year starting in May 1 rather than coming down. The freight for domestic shipping is coming down, at least on truckloads. That has come down a little bit with the truckload orders. But for LTLs, it has actually gone up. So it kind of offsets each other.

Brian Butler, Analyst

Okay. And what—when you think about kind of the demand that you're seeing for 2022, is there a rebuild of inventory for your customers? And what does that do for your working capital needs to meet that 17% to 19% revenue growth?

Alan Yu, CEO

For our company, we have been investing in more inventory. This is one of the reasons we see a stronger first quarter compared to the fourth quarter last year; we built up a lot more inventory this quarter than last quarter. Our fulfillment rate is much better now, which we believe will lead to improved revenue. We’ve also ordered more equipment this year versus last year, which will also increase our capacity. Regarding our financial needs, we’re currently in a good position because of our profit margins.

Brian Butler, Analyst

So is working capital going to be a use of cash again in 2022? Is that the right way to think about it, you're going to be up or spending?

Alan Yu, CEO

Yes.

Brian Butler, Analyst

And what about CapEx? Do you have any outlook on what the CapEx number should be?

Alan Yu, CEO

We're still looking at about 5% as we previously announced for CapEx.

Brian Butler, Analyst

5% revenue? Okay. And a couple more on the modeling side. What's the right tax rate to think about for 2022 as well as what's going to be the interest expense?

Alan Yu, CEO

I'm going to leave that to Jian for this question.

Jian Guo, CFO

Yes, sure. In terms of the income tax rate, I think in 2022 it will be fairly comparable to what we have seen in 2021.

Brian Butler, Analyst

What's the right interest expense to be looking at? I mean, assuming rates don't change materially from where we are right now.

Jian Guo, CFO

Yes, sure. In terms of the interest expense, if you’re looking at the core Karat business without the interest rate swap, it will be fairly comparable to the second half of 2021. On the overall consolidated Karat Packaging as a group, we are looking to see some significant gains from the change in the fair value of the interest rate swap we have. High level, we haven't had much change in our outstanding debt due to paydown from the proceeds in 2021, but that should be the overall outlook for 2022.

Brian Butler, Analyst

Okay. That's helpful. And then one last one. Just what's the outlook for M&A in 2022? What thoughts of growth there?

Alan Yu, CEO

Well, we've made several requests and we are seeking M&A opportunities in 2021. It has been very challenging due to the hot market with many acquisitions going on, and we have seen valuations ranging from 13x to 17x EBITDA. That's definitely not something we're looking to do right now. We're also waiting to see if there are any manufacturers out there that could complement our needs in terms of acquisition or joint ventures. I would say something will definitely be in the pipeline; we have a couple of prospects that should be finalized in the next 30 to 60 days.

Brian Butler, Analyst

Okay, great. Thank you very much for taking my questions.

Operator, Operator

Our next question is a follow-up from Jake Bartlett with Truist Securities. Please go ahead.

Jake Bartlett, Analyst

Thanks for taking the follow-up. Just a couple of quick ones. My first was just on the gross margin outlook for 2022. I think the drivers you mentioned seem to be somewhat long-term and could be considered long-term. So the question is, should we be moving that long-term model up, or is 2022 somewhat abnormal?

Alan Yu, CEO

With the current situation that we're progressing with—the increase in online sales and also the eco-friendly ESG product line—I see this leading to an overall average for 2022 around 31%, definitely higher than 2021 and previous years. We have found ways to increase our gross margins, especially through online sales channels that have been lucrative alongside our ESG product line. The goal for 2022 is a strong dollar that will help offset some increases in costs overseas due to inflation. Thus, I would suggest a long-term gross margin guidance of 31% to 32%.

Jake Bartlett, Analyst

Got it. So the model could be higher margin given the mix shifts you’re targeting; is that the right way to think about it?

Alan Yu, CEO

Yes, it is.

Jake Bartlett, Analyst

Okay. And then I just had a question on the environmentally friendly products. It was asked, Alan, but I'm not sure if you answered, but the percentage of sales in 2021 that you consider environmentally friendly would be helpful because it's such a big part of the story to be able to track that.

Jian Guo, CFO

Yes, overall, it's about 20%. So in the high teens of the overall total sales for 2021.

Jake Bartlett, Analyst

Great. And then the last question is your exposure to or how much you're importing from China? I know that you've been diversifying your supply sources. As we think about production shutdowns and disruption from COVID case spikes, how should we think about the risk there? It would be helpful to understand what percentage of your imports are coming from China these days.

Alan Yu, CEO

Sure. We mentioned previously that we have been moving imports from China to other regions like Vietnam, Malaysia, and Taiwan. Most of our products are now shipping out of Taiwan, even with the eco-friendly product line that was primarily produced in China. Now, more companies are moving those into Vietnam and Indonesia as well as Taiwan. I would say, in the past, we mentioned over 30% to 40% dependency in China, but we have reduced that to about 25%. Our goal is to keep our imports from China at 20% or less out of China versus other countries.

Jake Bartlett, Analyst

Okay. And is the production halts or disruption currently happening, will that affect your ability for the 20% to 25% you get from them now? Is that a material risk to your outlook?

Alan Yu, CEO

No. Most of the vendors we order from China have set up manufacturing out of Vietnam as well. In case there’s a disruption in China, like earlier this year when there were some shutdowns at the port, we needed to rely on our network in Vietnam and Taiwan. Almost everything we purchase in China has a backup plan in Taiwan or Vietnam, and we're even looking at Indonesia.

Jake Bartlett, Analyst

Great. And then lastly, gas prices and diesel prices. Just remind us where they are. How much is your exposure as diesel prices have gone up? Is that material for the model? I want to make sure we understand that.

Alan Yu, CEO

I don't believe we have much exposure to gas prices. Our fleet has locked into a good price for the past three months versus diesel prices out in the market. So we do not see much risk due to gas prices. The increased gas prices have led to increased LTL shipping costs, as well as UPS and FedEx implementing fuel surcharges. However, for truckloads, we are actually gaining margin by encouraging customers to order by the truckload, and those costs have come down. Independent trucking companies have absorbed the increase in gas prices recently.

Jake Bartlett, Analyst

Great, thank you so much.

Alan Yu, CEO

Thank you, Jake.

Operator, Operator

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

Alan Yu, CEO

Well, thank you, everyone, for joining us today. I hope we were able to answer everyone's questions. I look forward to your next conference call next quarter. Have a nice day, everyone. Thank you.

Operator, Operator

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