Earnings Call Transcript - KRT Q2 2021

Operator, Operator

Good afternoon, and welcome to the Karat Packaging Second Quarter 2021 Earnings Conference Call. I would now like to turn the conference over to Roger Pondel. Please go ahead.

Roger Pondel, Investor Relations

Good afternoon, everyone, and welcome to Karat Packaging's 2021 Second Quarter Earnings Call. I'm Roger Pondel with PondelWilkinson, Karat Packaging's Investor Relations firm. It is 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 all 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 as filed with the Securities and Exchange Commission and 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'll be discussing adjusted EBITDA and adjusted EBITDA margin within non-GAAP financial measures as defined by the SEC Regulation G. A reconciliation of non-GAAP financial measures to the most directly comparable GAAP 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 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. Earlier today, we reported solid second quarter financial results that reflect strong demand for the company's prowess and its nimbleness as a leading supplier of customized solutions for a diverse and expanding customer base. In addition, the increasing adaptation of environmentally-friendly products and solutions continues to drive demand in the food service industry, particularly for Karat Packaging. For the second quarter, net sales exceeded our expectations, increasing 12% year-over-year with strong performance in our national online and distribution channels. Excluding the personal protective equipment products that we primarily saw in the second quarter last year during the height of the COVID-19 pandemic, our rate of comparative sales growth for the second quarter in our core business was nearly 70%. Online sales rose 22% year-over-year in the second quarter. We continue to shift our sales mix towards high-margin channels. Sales through national and distributor channels also increased at a double-digit rate. Retail sales decreased year-over-year in the most recent second quarter, primarily due to PPE sales in the prior period. Gross margin in the fiscal 2021 second quarter declined year-over-year primarily due to increases in freight and material costs, as well as a comparison to the high-margin PPE products we saw last year. As Ann will explain shortly in more detail, we saw a significant number of PPE products in last year's second quarter. These products carry margins close to 50%, which are higher than margins on our traditional products. Ocean freight rates have risen to the highest levels we've ever seen, and we expect these rates to remain at high levels until early next year. To respond to the current and anticipated increases in freight rates and protect our margins, we instituted multiple price increases in the second quarter. As a result, gross margin increased 110 basis points sequentially compared to the 2021 first quarter. Despite higher freight costs, we continue to take action to pass on these costs in July, implementing the largest price increase in our company's history. Our positive momentum has continued into the third quarter, with the secular tailwinds we're seeing in restaurant openings, consumer spending, and the adaptation of environmentally-friendly products helping to drive demand in support of our business. We're also witnessing high demand for our beverage line of higher-margin bubble tea supplies, which is contributing to our growth and profitability. As a result, we're currently targeting net sales to be in the range of $100 million to $102 million in the 2021 third quarter. Moreover, growth in high-margin online sales and the actions we've taken to offset higher freight costs have given us confidence in our ability to improve our gross margin in the third quarter relative to the first half of 2021. At the same time, we are driving greater efficiency in our operations. We're better leveraging our cost base at our largest facility in Texas while also increasing output. We're also recently expanding our network through the acquisition of a warehouse building and the addition of a distribution facility in South Carolina. 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 second quarter results reflect strong top-line growth, offset by a decline in gross margin and an increase in operating expenses. Net sales increased 12% to $95 million in the second quarter. In last year's second quarter, we shifted to import PPE products to meet a critical need during the height of the pandemic and support our growth. Sales of this product peaked in last year's June quarter at $29 million. Since then, PPE sales, as expected, have declined and represented less than 1% of total sales in this year's second quarter. Excluding PPE products, sales in the 2021 second quarter rose 69% year-over-year. Sales to distributors, our largest channel, grew 14%, and sales to national chains expanded 38%, primarily due to more business with existing customers. Online sales rose 22% in the quarter as we continued to make significant investments in this channel. Sales to the retail channel fell 41% from a year ago, primarily due to sales of PPE products in last year's second quarter. Excluding PPE products, our sales in our retail channel were up slightly year-over-year. We also increased minimum shipping requirements to better manage fluctuating labor conditions, which shifted a portion of our sales mix from retail to distributors and enabled us to better utilize packing resources. For reference, the tables in our earnings release issued earlier this afternoon break out sales of our traditional products, excluding PPE by channel. Gross profit decreased 3% to $28 million in the 2021 second quarter, primarily due to a decline in gross margin, partially offset by higher sales. Gross margin was 29.7% in the 2021 second quarter, a decline of 440 basis points compared with 34.1% in the same period last year. The gross margin decline primarily reflects higher freight and material costs, as well as the high-margin PPE products sold in last year's second quarter. As Alan mentioned, we've taken action to pass through higher costs in a series of price increases. Our progress to date is evident with our gross margin trend, which improved from 27.4% in the fourth quarter of 2020 and 28.6% in the 2021 first quarter to 29.7% just reported in the second quarter. Operating expenses in the most recent second quarter increased 47% to $21 million, principally reflecting higher shipping costs, payroll expenses associated with workforce expansion and labor, an increase in facility costs, and higher professional fees. Costs related to our public offering were approximately $600,000 in the 2021 second quarter. Operating income declined 53% to $7 million in the 2021 second quarter. Operating margin was 7.3% compared with 17.1% in the same period last year, primarily due to pressure from higher freight and shipping costs. Other income increased approximately $5 million year-over-year in the second quarter due to a gain on PPE loan forgiveness, which we borrowed last year. Provision for income tax expense decreased to $2 million in the 2021 second quarter from $4 million in the same period last year. Our effective tax rate was 14% in the second quarter compared with 28% in the same period last year, primarily because the $5 million gain recorded on the forgiveness of the PPP loan is not subject to federal income tax. Excluded in the debt position, our effective tax rate in the 2020 working quarter was 23%. We expect our effective tax rate for 2021 to be in the mid-20% range. Net income amounted to $9 million for the 2021 second quarter compared with $10 million in the same period last year. Net income attributable to Karat Packaging Inc. was $9.6 million or $0.50 per diluted share in the second quarter compared with $10.1 million or $0.65 per diluted share last year. Adjusted EBITDA on a consolidated basis was $10.1 million for the 2021 second quarter compared with $16.5 million a year ago and $6.8 million in the 2021 first quarter. Consolidated adjusted EBITDA margin was 10.7% in the second quarter compared with 19.4% a year ago and 9% in the 2021 first quarter. Adjusted EBITDA attributable to Karat Packaging Inc. was $10.2 million in the 2021 second quarter. Adjusted EBITDA margin attributable to Karat Packaging was 9.7%. Net cash used in operating activities was $2 million in the 2021 second quarter compared with net cash provided by operating activities of $7 million in the same period last year. The decline primarily was due to changes in working capital, in particular, increases in inventory and accounts receivable that principally reflect our growth. Capital expenditures were significantly lower year-over-year, primarily as a result of the purchase of manufacturing equipment and construction of our facility in New Jersey last year. I will now turn the call back to Alan for closing remarks, then we'll be happy to answer any questions you may have.

Alan Yu, CEO

Thank you, Ann. Our business continued to grow as we capture positive secular trends in the food service industry. As a nimble supplier of a wide range of products, Karat Packaging is able to respond more quickly to market conditions than our competitors, which we believe gives us a tremendous advantage. Our 2021 second quarter delivered solid growth in sales as we proactively worked through our cost pressures. We're pleased that demand continued to be strong, which we believe will contribute to another solid sales performance in the third quarter. With that, I'll turn the call over to the operator for Q&A.

Operator, Operator

And the first question will come from Jake Bartlett with Truist.

Jake Bartlett, Analyst

Congrats on some great top line growth here. Alan, my first question is about the upside due to sales that you saw in the second quarter than the strong guidance for the third. Are there any particular channels that are driving the upside? Or is it fairly broad-based?

Alan Yu, CEO

I do see, Jake, well, if you can hear me well. I do see - can you hear me? Jake, are you there? Okay. Well, what I see in the second quarter is the online sales. I see more and more people ordering online. I think there's a disruption in the supply chain throughout the U.S., especially in the cup market. When you go out to a national chain account, it could be any national chain account. You ask them for a cup. Normally, they have a plastic cup. Now they probably tell you that they're out of cups. They may offer a styrofoam cup or, in some places, they may not even have that. What I heard in the market is that every manufacturer is struggling with challenges in terms of producing, whether it's styrofoam, paper, or plastic cups. This is where we see everyone turning to online purchasing. Many people are going online, buying large straws, our bubble tea supplies, and our cups. So, as Ann mentioned earlier during the conference, our biggest sales growth has been in our bubble tea supply category, which has seen almost 100% growth. This is something we've never seen in the past. The demand for boba has increased, showing double-digit, actually triple-digit growth year-over-year. We are also seeing increased demand for cups. Customers in Las Vegas and Florida are traveling and using our cups. Businesses are purchasing cups like crazy. In Las Vegas, everywhere you go is packed with people, each holding a plastic or paper cup. The demand really spiked in the second quarter as the economy opened up. This is where I see all these catalyst for growth, and it has continued into the third quarter. We currently have back orders, and we're behind three weeks in shipping products. Imagine if we were caught up. We just don't have enough people to pack the orders and ship right now. This challenge is faced industry-wide, regardless of whether it's Sysco, US Foods, Bunzl, or even Amazon. Everyone is struggling with hiring enough personnel to ensure timely shipments.

Ann Sabahat, CFO

So, Jake, let me follow up with what Alan just shared. In Q2 of 2021, we saw our food products grow to $21 million or 22% of revenue for Q2 of 2021, which is over 200% year-over-year and over 60% Q-over-Q. The main food growth drivers were syrup, boba, popping pearls, and powder. In terms of cups, our revenue for cups, cup mix holders, and cup jackets came in at a robust $20 million or 27% of total revenue in Q2 of 2021, representing a 30% increase compared to Q1 of this year and significantly up over 200% from the pandemic lows of Q2 of 2020. Another trend that we are seeing is that food containers for us remain roughly at about 15% and custom printing represents approximately 19% for the company in Q2.

Jake Bartlett, Analyst

Great. That's really helpful. Actually, my next question was to build on that, what percentage was environmentally friendly, whether it's Karat Earth or however else you define it? It would be great if you could share both as a percentage of sales in the second quarter.

Ann Sabahat, CFO

Yes. Eco-friendly sales approximated $17 million in Q2 of 2021 or roughly 18% of total revenue, an increase from about $14 million in Q1 of 2021 and $8 million in Q2 of 2020. The company continues to see strong demand for paper food containers, hot cups, cold paper cups, and fold-to-go containers. In terms of Karat Earth, we maintain a steady position at about 5% of total revenue for Q2 2020.

Jake Bartlett, Analyst

Great. And then my next question is on SG&A. It was up fairly significantly in the second quarter compared to the first quarter. How should we think about the back half of the year in '21? Is the second quarter a good run rate? Or should we expect similar growth quarter-over-quarter for the remainder of the year? Just any help on what to expect from G&A going forward.

Ann Sabahat, CFO

Yes. We should expect Q3 to be similar to Q2 this year.

Jake Bartlett, Analyst

Okay. And for the fourth quarter, should we expect a similar trend or any reason why it should deviate?

Ann Sabahat, CFO

That should be a similar expectation as well in Q4.

Jake Bartlett, Analyst

Okay. And then last question...

Alan Yu, CEO

Jake, I want to add to what Ann mentioned earlier in Q3. We did mention that our Q3 earnings are projected to be around $100 million to $102 million, which reflects 30% to 33% year-over-year growth. I expect this to be higher than our Q2 numbers, primarily due to strong headwinds we anticipated continuing into the third quarter based on our second quarter results.

Jake Bartlett, Analyst

Headwind of growth or headwind of what?

Alan Yu, CEO

Oh, tailwind.

Jake Bartlett, Analyst

Yes, that's a tailwind. Got it. Great. Great. If you could frame out what kind of pricing is in the system in the third quarter versus the second quarter? How much has that - you mentioned it was the largest increase in July in the company's history. If you could help us just frame what the year-over-year pricing is at this point and what it was in the second quarter, that would be great.

Alan Yu, CEO

Sure. In the second quarter, we implemented price increases in April and June across different categories. But in July, we imposed a 10% to 18% price increase nearly across the board, except for some national chain accounts. This is by far our largest price increase ever. Ocean freight has skyrocketed since June. In June and July, and even now in August, we've seen ocean freight continue to rise. This has caused many of our competitors to halt importing products. Even with the high cost of ocean freight, most are struggling to secure enough container space for imports. This situation is creating a supply chain disruption in the U.S. It's important to note that even if you pay nearly triple the amount of money compared to last year, there is no guarantee of securing container space.

Operator, Operator

And the next question comes from Michael Hoffman with Stifel.

Michael Hoffman, Analyst

My question centers around the cadence for the remainder of the year. We have seen meaningful improvements in revenues. EBITDA came in about where you all thought it would when you were at the time of the IPO. I guess maybe we, as sell-side analysts, were a little more ambitious, but it came more or less in line with what you were projecting. How do you feel about that original EBITDA target net of global illnesses, which was about $38 million? Are we still on pace to reach that, accounting for these challenges with freight and labor, while maintaining good demand and balancing all of that?

Ann Sabahat, CFO

Michael, that is a great question. In terms of our EBITDA margin, we continue to have confidence that our EBITDA margin will be between 9% to 12%. This should lead us on trend to achieve between $36 million and $38 million roughly for the remainder of the year.

Michael Hoffman, Analyst

Okay. So a little bit low on the lower end. The high end still reflects where we started. And in fairness, there have been unprecedented inflation pressures, and you're working hard to price through it while managing costs.

Ann Sabahat, CFO

Yes, absolutely. We've seen that despite the rising freight costs, we have been proactive in protecting our gross margin. We increased from 27.4% in Q4 of 2020, to 28.6% in Q1 of this year, and then to 29.7% in Q2 of this year. So we continue to maintain and grow our margins during challenging quarters.

Michael Hoffman, Analyst

And again, speaking about gross margins, you've always stated that approximately this is a 30% gross margin business. Given the pricing initiatives, some mix trends, and strong demand, are we headed towards the 30% range for gross margins for the remainder of the year, indicating further sequential improvement?

Ann Sabahat, CFO

That is our expectation, Michael. For Q3 and Q4, we aim to reach that 30% gross margin range.

Alan Yu, CEO

I believe, Michael, Ann mentioned in the last quarter that our goal for 2021 is between 29% to 31%. With the second quarter already at 29.7% and approaching 29.8%, we are still targeting 31% as our goal for the year.

Michael Hoffman, Analyst

Terrific. With many restaurants now opened, we've all heard stories of labor challenges. But my interesting question is about the transition from takeout to on-site dining, as well as menu changes. How have these changes been showing up in your business?

Alan Yu, CEO

Here's the situation: When restaurants were closed, our takeout containers saw a rise in demand, and we experienced a sharp drop in sales for cups, napkins, and unwrapped utensils. However, as restaurants began reopening, we observed an increased demand for cups. Interestingly, when locations were closed, fewer cups were used, but with the reopening, there has been a scramble to restock cups as well as napkins and utensils. Customers have reported that, during the pandemic, their drive-thrus were incredibly busy, yet after reopening indoor dining, they expanded their operations significantly. Many high-volume stores opened new locations as a direct response to demand. So, as restaurants, hotels, and attractions have reopened, the demand has surged.

Michael Hoffman, Analyst

Okay. Last one from me. M&A is something we've discussed previously. You indicated that was a purpose of the IPO—to have a flexible balance sheet to pursue M&A opportunities like Pacific Packaging. How does your pipeline look? Are there chances to find another opportunity similar to Pacific Packaging or something different? Could you elaborate?

Alan Yu, CEO

Yes, we've received interest from several companies. Ann and I have been looking into this and are conducting due diligence. We want to ensure that we make the right decision, focusing on companies with synergy in leadership, management teams, and product offerings. Additionally, location is critical. We are in discussions with several companies and gathering more information on these opportunities.

Operator, Operator

And the next question will be from Ryan Merkel with William Blair.

Ryan Merkel, Analyst

First off, Alan, with the ongoing market shortages, is your import model proving successful in the marketplace? Are your fill rates better than your competitors?

Alan Yu, CEO

Yes, if you monitor the industry closely, you will find that many manufacturers are facing shortages. The primary reason for this is a labor shortage, which is the main issue affecting supply. This problem is prevalent across the market, including restaurants. Many cannot open their indoor dining services due to the lack of staff. Several distribution managers need to perform multiple roles, from operating forklifts to delivering. It's a tough climate out there for everyone. The only alternative for many is import. We've seen seasonal shortages in our products, and we had a 1.5-month shortage. Our fill rates were low, but in June and July, we ramped up our imports significantly. Our warehouses are currently stocked, and I believe our fill rates are better in California, although we are trying to get products into Texas and New Jersey. There's a greater supply problem on the East Coast than the West Coast. Ocean freight issues are causing significant congestion. Additionally, every logistics provider, including UPS and FedEx, is maxed out at capacity, leading to major delays. So far, our delays are definitely better than those of most of our competitors.

Ryan Merkel, Analyst

You touched on that a bit, but could you clarify how you are managing the situation? Given the container congestion and the high freight rates, what are you doing to ensure you maintain high fill rates while managing these shipping and logistics challenges?

Alan Yu, CEO

We proactively placed orders ahead of time. When we anticipated a peak demand for our bubble tea products and cups, we immediately placed additional orders with our overseas partners. We ordered more than twice what we typically order, and these orders are currently arriving. This has enabled us to fulfill many customer needs, especially some larger national chains that ran out of cups, straws, and food containers. If you talk to anyone in the restaurant industry, they'll likely tell you to reach out to us, as we can meet their needs. This is the current situation in the market.

Ryan Merkel, Analyst

That's great. Thank you for the clarification. Lastly, regarding your gross margins for the quarter, did your price increases manage to cover raw material and freight cost increases?

Alan Yu, CEO

Yes, they did. As Ann mentioned, our second quarter gross margin has improved from the first quarter. The largest raw material pricing spikes occurred in April and May, which were not as impactful in Q1. Our gross margins would have dropped below the first quarter numbers if we hadn’t raised prices. As a result, our gross margin improved from 29.2% to 29.7%. This improvement was largely due to our proactive measures to pass on those increases to our customers.

Ann Sabahat, CFO

Yes, and to clarify further, we went from 27.4% in Q4 to 28.6% in Q1, and then to 29.7% in Q2. We have been able to increase cost efficiency to cover the rising ocean freight and higher material costs, which contributed to additional margin expansions sequentially over the past few quarters.

Operator, Operator

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

Alan Yu, CEO

Thank you all for joining our conference call, and we will definitely continue to work hard to increase our shareholder value. We look forward to better results next quarter. Thank you all. Have a nice day.

Operator, Operator

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