Karat Packaging Inc. (NASDAQ:KRT) Q1 2024 Earnings Call Transcript

Karat Packaging Inc. (NASDAQ:KRT) Q1 2024 Earnings Call Transcript May 11, 2024

Karat Packaging Inc. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Thank you for standing by. My name is Kat, and I will be your conference operator today. At this time, I would like to welcome everyone to the Karat Packaging Incorporated First Quarter 2024 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks there will be a question-and-answer session. [Operator Instructions] I would now like to turn the call over to Roger Pondel of Investor Relations. Please go ahead.

Roger Pondel: Thank you, operator. Good afternoon, everyone, and welcome to Karat Packaging’s 2024 first quarter conference call. I’m Roger Pondel with PondelWilkinson, Karat Packaging’s Investor Relations firm. It will be my pleasure momentarily to introduce you to 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 everyone that today’s call may include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements are subject to numerous conditions, many of which are beyond the Company’s control, including those set forth in the Risk Factors section of Karat’s most recent form 10-K as filed with the Securities and Exchange Commission, copies of which are available on the SEC’s website at www.sec.gov, along with other company filings made with the SEC from time to time.

Actual results could differ materially from these forward-looking statements and Karat Packaging undertakes no obligation to update forward-looking statements except as required by law. Please also note that during today’s call, we will be discussing adjusted EBITDA, adjusted EBITDA margin 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: Thank you, Roger. Good afternoon, everyone. Sales volume for our 2024 first quarter grew 3.5% over the prior year period. Net sales were about the same as last year, but included certain items that impacted year-over-year comparability, which Jian will discuss later in this call. We are encouraged by our first quarter performance as the growth initiatives that we implemented last year are starting to bear fruit. Our new business pipelines continue to grow and our product offering continue to expand. We are adding new customers and gaining wallet share with existing accounts. Sales for manufactured product in the first quarter were 12.4% of total net sales compared with approximately 23% last year, and keeping with our asset light strategy in the U.S., an emphasis on imported items.

Sales of our eco-friendly product rose 6% in the first quarter over the prior year quarter. This category represented approximately 34.5% of total sales versus 32.6% last year. Eco-friendly products remain priority for Karat as we continue to develop new and innovative products and build up inventory to meet growing demand from customers. We also achieved a near record high gross margin of 39.3% during the first quarter with better visibility into ocean freight rate and new contract rates locked in through April 2025. Combined with the continued strength of our U.S. dollar, we expect our gross margin to remain at a higher level. Our operating income in Q1 2024 was impacted by a non-cash impairment of a $2 million of the right-of-use asset for our City of Industry lease in California.

With the shift to optimizing our new Arizona warehouse base and away from California, our future rent expense will be reduced. Our newly established distribution center in Arizona is now fully operational which will provide meaningful efficiency for Karat in the Southwest region. We are continuing to look for other distribution center in the Southeast region this year to further penetrate and grow key us markets. Additionally, we are exploring strategic acquisition opportunities to further penetrate the marketplace. We carry strong operating cash flow as well as the Company’s liquidity, solid balance sheet and positive long-term outlook. Our Board of Directors again authorize an increase in the quarterly cash dividend payment to $0.35 per share on May 7 from $0.37 per share in the preceding quarter.

Our regular quarterly dividend policy began in August of last year with an initial payment of $0.10 per share. I will now turn the call over to Jian Guo, our Chief Financial Officer, to discuss the Company financial result in greater detail. Jian?

Jian Guo: Thank you, Alan, and good afternoon, everyone. Net sales for the 2024 first quarter were $95.6 million, compared with $95.8 million for the same quarter last year. Sales volume increased 3.5% over the prior year quarter. As Alan mentioned earlier, net sales year-over-year comparison is impacted by items. Our Q1 2024 net sales were understated by $0.7 million related to products shipped and recognized as revenue in 2023 and not delivered until 2024. The related impact on cost of goods sold and gross margin was $0.4 million and $0.3 million, respectively for Q1 2024. In the prior periods, we had assessed the impact of the lag between shipping and delivery to the previously issued quarterly and annual financial statements and concluded it was immaterial.

The impact will not be recurring in future quarters. The amount of the revenue deferred for products shipped in March 2024 but not delivered until April 2024 was $1.9 billion. Additionally, net sales for the 2024 first quarter included $2.2 million of online sales platform fee. By channel, compared with a year ago, sales to distributors, our largest channel was lower by 3.3% for the 2024 first quarter. Sales to national and regional chains were up slightly. Online channel sales were up by 9.0%, which benefited from the inclusion of online platform fees of $2.2 million as discussed earlier, and sales to the retail channel increased 5.0%. The distributor channel remains challenging and the overall pricing environment is still very competitive.

However, we are seeing encouraging growth momentum in the other channels, primarily driven by our continued geographic penetration in the East Coast, Northeast and Midwest region and growth in our eco-friendly products. Cost of goods sold for the 2024 first quarter was $58.0 million, compared with $57.7 million in the prior year quarter. The increase was primarily due to higher freight and container rates. Earlier in the year, an increased import volume and the inclusion of certain production costs in cost of goods sold partially offset by lower product costs for certain raw materials and finished goods as well as favorable foreign currency exchange rate. Gross profit for the 2024 first quarter was $37.6 million versus $38.1 million in the prior year quarter.

Gross margin was 39.3% in the 2024 first quarter, compared with 39.8% for the prior year quarter. Operating expenses in the 2024 first quarter were $29.5 million, or 30.9% of net sales, compared with $25.4 million, or 26.5% of net sales in the prior year quarter. Operating expenses in the current quarter included a non-cash impairment of $2.0 million of the operating right-of-use asset for the City of Industry lease that Alan mentioned earlier as we entered into an agreement to sublease this warehouse in California. The increase was also driven by the inclusion of online sales, platform fees, higher rent from additional leased warehouses, and higher labor costs due to workforce expansion. Such increases in operating expenses were partially offset by a decrease in shipping and transportation costs and the inclusion of certain production costs in cost of goods sold.

Net income for the 2024 first quarter was $6.5 million, compared with $9.2 million in the prior year quarter. Net income margin was 6.8% in the 2024 first quarter compared with 9.6% in the prior year quarter. Net income attributable to Karat for the 2024 first quarter was $6.2 million, or $0.31 per diluted share, compared with $9.0 million, or $0.45 per diluted share last year. Adjusted EBITDA, a non-GAAP measure in the 2024 first quarter, was $13.5 million versus $15.3 million in the prior year quarter. Adjusted EBITDA margin was 14.2% in the 2024 first quarter versus 15.9% in the prior year quarter. Adjusted diluted earnings per common share was $0.40 per share in the 2024 first quarter, compared with $0.46 per share a year ago. The first quarter ended with $112.3 million in working capital compared with $110.5 million at the end of 2023.

As of March 31, 2024, we had financial liquidity of $49.3 million with another $33.5 million in short-term investments. During the first quarter, we made significant investment to stock up our inventory ahead of our summer peak seasons. With a positive outlook for new business, we expect net sales for the 2024 second quarter to increase by mid-single-digit over the prior year quarter. Our gross margin goal for the 2024 second quarter is approximately 38% to 40%. For the full 2024 year, we expect net sales to grow 8% to 15% and gross margin to be in a range of 37% to 40%. Alan and I will now be happy to answer your questions and I’ll turn the call back to the operator.

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Q&A Session

Operator: [Operator Instructions] And your first question comes from the line of Michael Hoffman with Stifel.

Michael Hoffman: Alan, Jian, sorry about my voice. I’m not sure where it’s disappeared to. Can you bridge for us maybe by the line items, whether it’s national distribution on site or online, I mean, or retail, versus your own plan, right? So if I think about the guide you gave us, we were going to land somewhere around $100 million, round numbers. We’re about $4.5 million short. Of those four buckets, where’s the shortage? And what gives you confidence in this next 90 day view in light of that, where it fell short?

Alan Yu: Michael, let me get — just understand the question. Are you referring to $4 million short for the first quarter or are you referring second quarter — first quarter?

Michael Hoffman: Yes. So you gave us a forward view of up mid-single-digits, which, if we did the math, it would land you at about 100 million, right. And you did $95.5 million, I’m rounding. So we’re $4.5 million short. And if I think of the four segments, where does that shortfall come relative to your own plan? And what gives you comfort in the next forward plan that we’ve got a better handle on that.

Alan Yu: Sure. Well, we — I believe Jian mentioned earlier in the call that there were some change in accounting practice, recognition, revenue recognition. We actually had to deduct $2 million that normally in the past 12, 15 years, 20 years, we have been recognizing revenues as we ship the product. But our auditor has decided that we need to adapt a new method of recognizing revenues that we need to account for when the customers, even if we ship at the last date of every month, they need to understand how long does it take for them to receive the product. And they’re saying, they’re asking us to recognize revenue upon the day they receive it. So we had to reduce $2 million from — the current quarter, over $2 million, basically.

And that’s something that we have never done so in the past 24 years of our accounting history. So this is the first quarter they want us to start moving forward to change this practice. That’s over $2 million that we couldn’t account for recognition. The other $2 million, we were actually — me and Jian, we were actually looking to guide in terms of approximately $98 million versus $100 million. I believe that we actually would have met the lower end of our projection in terms of the first quarter if we were able to account for the $2 million that we had to change in revenue recognition practice.

Michael Hoffman: Sounds like you ought to get another auditor. How are you supposed to track when a delivery arrives unless you’re controlling the last mile? That seems like an unreasonable reach.

Alan Yu: Jian is the one that dealt with the auditor. Maybe Jian, you could perhaps kind of explain to, because we were fighting for that. We thought that was really hard to understand, to account for, because it’s taking a lot of our time to just try and define the bill of lading. And when the customer receive it, we have to track down all the tracking using — some of our delivery are delivered by third-party and UPS. So we have to set up a program just to accommodate this new request on that part.

Jian Guo: Hi, Michael, this is Jian. Let me chime in on this one. So, I think you make a fair point about tracking. It is a challenge, and we are reviewing our internal process to make sure that we have reliable, accurate data to be able to account for revenue appropriately. I will say, as I mentioned in my prepared remarks, that historically, this is something that we’ve been tracking internally for a fairly long time, as Alan mentioned. It’s the same accounting practice since 15, 20 years ago. We have evaluated, as I mentioned earlier, previously, kind of the lag between shipping and delivery and concluded, and our auditors concurred in the past, that the impact was immaterial. Basically, the lag was immaterial. Even though we don’t necessarily track every single shipment, know exactly when it’s delivered to the customer, we have a pretty good idea and we have sort of the estimate method to help us get to a pretty close number.

So that said, fast forward to March 2024, I will just add a little color here is, in Q1, we are seeing increased activities, the pickup in activities towards the end of the quarter. And that’s also one of the reasons why, if you look at the last few days in a quarter, the activity that we saw, the amount of the shipment that went out actually increased quite a bit compared to what we typically see towards quarter end. As I mentioned earlier, the amount of the revenue that we deferred from March to April is $1.9 million. So basically, roughly the $2 million that Alan was talking about earlier, compared to typically on the quarterly basis we see towards the quarter end, that number is roughly %700,000, $800,000. So there was a little bit of increased activity in the shipments that — in the products that we shipped, but have not yet delivered to the customer.

So that also accounted for a little bit of a year-over-year comparison. I just wanted to point out part of the reason why you are seeing the $1.9 million. Alan talked about this sort of the $2 million is also the increased activity, the increased momentum that we’re seeing towards the quarter end.

Michael Hoffman: Okay. So I just want to tease out a couple things on this. Did you look at March of ’23 and do the same treatment of accounted sales as you shipped it? Now, you have accounted on the delivery and sort of adjust that number. And then the reality of the like-to-like is you hit your low to mid-single digit growth rate and because you reset the prior number to look the same way.

Alan Yu: No, actually, Michael, like I said, this is the first time.

Michael Hoffman: Yes, I get that. I was just wondering if you did the work and put the prior year on the like basis, what I’m trying to get to, and I’m not doing a very good job of it, is I think I’m hearing, you said almost 4% volume growth. So I’m going, okay, underlying structural demand is good. Maybe I’m still repricing some inventory from the above average inflation in the inventory, but volume is good. So SKUs are good. I got this oddball accounting thing. You still think you ought to fire your auditor. And if I had like-to-like comparison, you really did land somewhere between low to mid-single digit growth. And so none of us should freak out. The market shouldn’t freak out, the stock should be fine tomorrow, blah, blah, blah. There was a question in there somewhere, but I’m not sure what it was. But you get where I’m going.

Alan Yu: Yes. Again, like I said, basically this is it is what it is. I mean…

Michael Hoffman: Yes. I get that. This underlying business — if all this noise reside, underlying business demand is good.

Alan Yu: It is very good. I would say the underlying business, I — personally, I think this is the best quarter since the — for 12 months, basically for fourth quarter, because we’ve seen volume decline, pricing decline for the past three quarters, and this is the first quarter, we’re seeing a solid year-over-year growth in volume, in revenue, also in revenue if we had — if we were to use the old accounting method. Revenue was higher, the volume was higher, and the pipeline that we have is stronger than ever. So I would say that this is the best quarter in a year.

Michael Hoffman: Okay. That’s — who knows what the market does tomorrow because it hates misses. But I think the big message here is you’ve got a good underlying fundamental business model still chugging along. You’ve made business decisions to assure the growth rate by moving the distribution centers. And we’ve got this oddball accounting issue. Have we repriced all the inventory for the above average pricing? Is that out? We’re not looking at repricing issues anymore at this point.

Alan Yu: Yes. Well, actually, we’re looking — we’re not looking at any repricing issue. And also one of the major, the question mark that we mentioned that last quarter was the ocean freight. We were not sure — uncertain how the ocean freight is going to play out, but it actually played out pretty well that ocean freight did not increase significantly for the next year contract. So that’s why we’re more confident in terms of raising our full year gross margin guidance. Originally, I believe, it was 35% to 38% or 35% to 37%. Now we’re up to 37% to 40% because we feel confident that we signed — now that we have signed the contract with ocean freight, which was the wildcard. And that’s why we feel very strong that we’re going to see a very strong year with the support of ocean freight as well as strong dollar.

Operator: Your next question comes from the line of Ryan Meyers with Lake Street Capital Markets.

Ryan Meyers: Just kind of as a follow-up to the last question, I just want to make sure I understand it clearly. So it sounds like you priced through the lower — sorry, you went to the lower price inventory this quarter, so pricing shouldn’t be a headwind for the remainder of the year.

Alan Yu: That is correct.

Ryan Meyers: And then, if we think about the eco-friendly business, it came in at 6% growth for the quarter. I know that business has kind of been treading in the double-digit growth rate there. Is there anything to call out about what you guys saw in the quarter for eco-friendly or is that just kind of related to the pricing as well?

Alan Yu: Well, we did see a demand picking up in eco-friendly products. We saw more and more cities actually enforcing composable products and today making even stricter, like the state of Washington is imposing that to be able to not confuse the consumer. Starting in July, they want every compostable plastic items to have some type of green item on it or like the lids, so that they can see it. Specifically, it’s different than the regular PET non-composable lids. And we’re seeing that there’s new laws on the paper bag, shopping bag that basically that U.S. commerce is increasing tariffs on all the imports from overseas which definitely will raise the price for U.S. domestic user starting, I would say, as early as August or September.

Once everyone deplete their inventory, the price can go up as much as 30%, 40% on the paper shopping bag. So, there’s these new laws in different states and cities is actually creating a higher demand in terms of composable product. And we’re seeing more people moving away from just regular plastic into compostable, regular Styrofoam into plastic and also other items. So I would say that those manufacturer that continue to sell Styrofoam, it’s really seeing really a drop in volume wise.

Ryan Meyers: And then if we think about the 8% to 15% top line guidance for the year, just kind of want to get a good understanding of what needs to happen or what needs to come into the model for you guys to hit the higher end of that range?

Alan Yu: Well, if we were to just do organic growth, we’re looking at the 8% range. The reason we’re saying that because last year, our third and fourth quarter, we were not as strong as we had — that — we didn’t have as much pipeline that we have today. And all the pipeline that we have is currently with the national chain account with supermarket. Those are actually turning into revenues. And we’re seeing them in the third and fourth quarter. That will help us to the 8% and 10% gross margin. And also we are aggressively actually in conversation with several different companies potentials that to partner or acquisition that we’re hopeful that by the end of this year or third quarter, we should be able to have some results in terms of what acquisition or what partnership that we may have by third quarter of this year. And that will help us to the double-digit mark by the end of this year, as I mentioned earlier.

Operator: And your next question comes from the line of Ryan Merkel with William Blair.

Michael Francis: This is Mike Francis on for Ryan. And first, a little follow-up on the last question regarding the M&A. Was that 8% to 15% at the end of 4Q that you gave, was that also inclusive of the M&A?

Alan Yu: If we do not include any M&A, that would be in the range of 8% to 10%. If we include the M&A, that would be in the range of 10% to 15%, yes.

Michael Francis: And then next for me, you talked about the distribution, this area being a little weaker. Can you give a little more color around that? Is it just sort of market softness? Or is there anything happening with any of the players there?

Alan Yu: Well, we have been seeing California, West Coast market dropping. The overall environment in California, especially for the mom and pop, smaller restaurant chains that we’re seeing decline in sales, not only that, we’re seeing closures. One of my favorite restaurant that I’ve been going for the past 25 years, they announced shutting down April 30. And we’re seeing more and more restaurants shutting down in California because of the increase in minimum wage. And it’s hard to find laborers in California, especially hard to find people that want to work in the kitchen. We’re still seeing that. We see a little bit — it’s better now that the drop was only single-digit versus double-digit in the past quarters for California.

So that’s where we’re seeing a softness. And also we’re seeing — this is across the board from all the — all of our competitors and distribution that they’re seeing the same thing as well. But we’re seeing a strong growth in online, as well as potentially a stronger growth for the national chain account. That’s why — and also in Midwest and East Coast, that’s why we’re focusing on that part for that.

Michael Francis: Okay, last one for me. You raised the dividend again. Is there any sort of target capital allocation we should think about longer term? Maybe like 1% of operating cash flow or anything like that?

Alan Yu: Currently, we’re sitting on some cash that we actually put on a deposit for income — we’re actually generating income. And, of course, we’re increasing our dividend because we — our cash flow continued to increase because our operation is pretty strong, and we’re not — we don’t have any debt in that. And that’s why we’re looking at merger and acquisition. If we were to successfully complete two acquisitions by the end of this year, that should deplete our cash — pretty much take some of our cash. I wouldn’t say deplete all of our cash because we’re still generating more cash every quarters. I would say that we’re still in a healthy cash flow position at that part. We are looking at acquisition target definitely not to exceed what we have on hand — on cash on hand.

Michael Francis: Okay. I hope you can find a new replacement restaurant. It’s too bad.

Operator: That concludes our Q&A session. I will now turn the conference back over to Alan Yu for closing remarks.

Alan Yu: Thank you, everyone, for joining Karat first quarter 2024 earnings conference call. And once again, thank you very much, and we’ll talk to you next time. Bye-bye.

Operator: Ladies and gentlemen, that concludes today’s call. Thank you all for joining. You may now disconnect.