Karat Packaging Inc. (NASDAQ:KRT) Q3 2023 Earnings Call Transcript

Karat Packaging Inc. (NASDAQ:KRT) Q3 2023 Earnings Call Transcript November 10, 2023

Operator: Good afternoon, and welcome to the Karat Packaging Inc. Third Quarter 2023 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today’s remarks, there will be an opportunity to ask questions. [Operator Instructions] Please also note this event is being recorded today. I would now like to turn the conference over to Roger Pondel, Investor Relations. Please go ahead, sir.

Roger Pondel: Thank you, operator, and good afternoon, everyone. And welcome to Karat Packaging’s 2023 third quarter conference call. I’m Roger Pondel with PondelWilkinson, Karat Packaging’s Investor Relations firm. And it will be my pleasure, momentarily, to introduce the company’s Chief Executive Officer, Alan Yu; and its Chief Financial Officer, Jian Guo. Before I turn the call over to Alan, I want to remind our listeners that today’s call may include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements are subject to numerous conditions, many of which are beyond the company’s control, including those set forth in the Risk Factors section of the company’s most recent Form 10-K as filed with the Securities and Exchange Commission, and copies of which are available on the SEC’s Web site at www.sec.gov along with other company filings made with the SEC from time to time.

Actual results could differ materially from these forward-looking statements, and Karat Packaging undertakes no obligation to update any forward-looking statements, except as required by law. Please also note that, during this call, we will be discussing adjusted EBITDA, adjusted EBITDA margin 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 Web site. And with that, I will turn the call over to CEO, Alan Yu. Alan?

Alan Yu: Thank you, Roger. Good afternoon everyone. We are proud to deliver a strong third quarter, with revenue in line with our expectation, and sustained meaningful improvement in margin. Sales volume increased approximately 7% over the prior year period. Although total revenue was again impacted by unfavorable year-over-year pricing comparison, along with lower revenues from logistics service and shipping charges, as anticipated. Sales of our eco-friendly product continue to improve. This category grew 15% in the third quarter over the prior-year quarter, and represented approximately 33% of total sales. For the quarter, we achieved 49% increase in net income from the prior-year quarter. And we’re able to sustain an elevated gross margin.

Even with the industry-wide inflationary environment, gross margin in the third quarter continue to benefit from our strategy of scaling back manufacturing operation, and significantly lower ocean freight costs versus last year. Sales for manufacturing products in the third quarter were 22% of total net sales, compared to approximately 27% last year, which generated labor product cost saving of $1.1 million. We expect our gross margin to remain at a higher level because of our initiatives, and the continued strong U.S. dollar. Now, into the fourth quarter of 2023, and heading to 2024, we will continue to implement asset-light initiatives in our other U.S. locations, and will concentrate more on import and distributions. We see a long runway for margin expansion given our objective of having manufactured product to be approximately 10% to 15% of total sales.

We’re also focusing on new product development to further enhance our competitive strength, fuel customer demand, and add to revenue growth. Our new Chicago and Houston distribution centers, which became fully operational in September, are expected to contribute to contribute to new geographic market penetration, and to enhance our fill rates. Together with the recent expanded national sales force, we are growing market shares in the East Coast, Northeast, and Midwest regions. We soon expect to double the size of our Washington State distribution center, with the move into a new 100,000 square foot distribution center. Additionally, as part of our strategic growth plan, we’re looking to open smaller satellite warehouses in 2024 in select regions to support online sales growth, as well as deploy new AI technologies to further improve operating efficiencies.

Based on geographic sales from our distribution center for the third quarter compared with the prior-year quarter, the East Coast Northeast region increased 41%, and the Midwest and Texas region improved 7% year-over-year. These improvements were offset by softer sales from California, which declined by 16%, reflecting a weaker condition in the restaurant sector throughout the states. The successful execution of our strategic initiative is also evidenced by our sustained strong operating cash flow, as well as liquidity and balance sheet position. Accordingly, as we announced earlier this week, our Board of Directors authorized an increase in the quarterly cash dividend payment to $0.20 per share, from $0.10 per share. The Board’s action reflects its confidence in Karat’s long-term future and commitment to returning value to shareholders.

I would now turn the call over to Jian Guo, our Chief Financial Officer, to discuss the company’s financial result in greater detail. Jian?

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Jian Guo: Thank you, Alan, and good afternoon, everyone. Net sales for the 2023 third quarter, as expected, decreased 4.1% to $105.5 million, from $110 million in the prior-year quarter. Sales volume increased 7% over the prior year quarter, which was offset by unfavorable year-over-year pricing comparison, as well as lower logistics services and shipment revenue. The unfavorable year-over-year pricing comparison reflects the expected impact from the multiple rounds of price reductions implemented primarily around late-2022 and the first-half of 2023, as we proactively pass on savings from ocean freight and raw material costs to customers. By channel, as a comparison to the prior-year quarter, sales to distributors, our largest channel, was lower by 4.0% for the 2023 third quarter.

Sales to national and regional chains decreased 2.3%. Sales to the retail channel decreased 19.3%, and our online channel sales were up by 1.6%. We are encouraged by the volume growth in our business, as well as by the strong momentum in the growth of our eco-friendly products, and the geographic regions that we’re starting to penetrate, including the East Coast, Northeast, and Midwest. Gross profit increased 14% to $38.9 million for the 2023 third quarter, from $34.2 million in the prior-year quarter. Gross margin increased 580 basis points to 36.9% in the 2023 third quarter, from 31.1% for the prior-year quarter. By the unfavorable year-over-year pricing comparison, gross margin benefited from our continued efforts to scale back manufacturing operations, the strong U.S. dollar, and a significant decline in ocean freight rates, which amounted to 7.9% of net sales in the 2023 third quarter, compared with 14.8% of net sales last year.

Operating expenses in the 2023 third quarter were $27.6 million or 26.1% of net sales, compared with $26.3 million or 23.9% of net sales in the prior-year quarter. The current quarter operating expenses included approximately $450,000 in transaction costs incurred in connection with the secondary offering, which was completed during the quarter. Other increases in operating expenses included workforce expansion as we reduced production but increased warehouse headcount, higher marketing expenses to support online sales growth, and higher rental expense from the expansion of our warehouse footprint. The increase in operating expenses was partially offset by saving in shipping and transportation costs due to lower rates. Net income for 2023 third quarter rose 48.5% to $9.1 million from $6.2 million for the prior-year quarter.

Net income margin advanced to 8.7% in the 2023 third quarter, from 5.6% in the prior-year quarter. Net income attributable to Karat in the 2023 third quarter rose to $9.1 million or $0.45 per diluted share, from $6.1 million or $0.31 per diluted share in the prior-year quarter. Adjusted EBITDA, a non-GAAP measure, increased $15.3 million in the 2023 third quarter, but $11.7 million in the prior-year quarter. Adjusted EBITDA margin rose to 14.4% of net sales, from 10.7% for the prior-year quarter. Adjusted diluted earnings per common share rose to $0.47 per share, from $0.33 per share in the prior-year quarter. Turning to liquidity, with $12 million of net cash from operating activities in the third quarter of 2023, we finished the quarter with $113 million in working capital, up from $84.5 million at the end of 2022, giving us a total of $16.9 million of dividends paid during the first nine months of the year.

As of September 30, 2023, we have financial liquidity of $64.4 million, with another $18.1 million in short-term investments. I will now close with our fourth quarter outlook. We are revising our net sales forecast for the fourth quarter to be up approximately 2% to 5% year-over-year based on our current restaurant conditions in California, including the competitive environment. We expect robust volume growth of 10% to 15%, partially offset by unfavorable year-over-year pricing comparison, our growth margin projection for the 2023 fourth quarter and into the first quarter of 2024 remain at approximately 36% to 38%, with the current projection for ocean freight costs remaining fairly consistent. As Alan mentioned earlier, we’re expanding our market penetration into the East Coast, Northeast, and Midwest regions, as well our strong sales pipeline and our growth initiatives are expected to continue to enhance our performance.

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: Thank you. We will now begin the question-and-answer session. [Operator Instructions] At this time, we will take our first question which will come from Ryan Merkel with William Blair. Please go ahead.

Ryan Merkel: Hey, afternoon everyone, and thanks for taking the question. Maybe Alan, can you just talk about fourth quarter and why you guys are lowering the revenue there? It sounds like California, maybe price down a little bit more than you thought last quarter. Just unpack that for us.

Alan Yu: Yes, actually California has been — our sales in California has been reducing, dropping. And we’re seeing that the restaurant condition, it’s not just the price drop in the California area competitiveness, actually, as I mentioned earlier, our volume growth is looking at 10% to 15% volume-wise growing. In third quarter it was only 7%, but in volume [we’re] (ph) growing more. But in California, the restaurants, we’re seeing more restaurants shutting down. And we’re seeing restaurant conditions pretty bad. The overall environment, it’s not very good. The chains are doing well. The independent restaurants, they’re closing early. We don’t see much of foot traffic. We talked to the restaurant owner, they don’t see people coming in after 7 p.m. at night time.

People used to pack the restaurant, and also do takeouts even after 9 p.m., but right now crime is increasing, crime rate is going up; it’s not safe to be out there. People are just not dining out right now. So, we’re seeing California down, and we don’t see any revision upward in California for the near-term. And that’s why we’re focusing on Midwest and East Coast right now.

Ryan Merkel: Got it, okay. And it looks like price will be down roughly 10% in the fourth quarter. Did that surprise you or is that consistent with what you saw last quarter?

Alan Yu: This is actually consistent with what we saw because everything is coming down. The ocean freights have gone up a little bit in third quarter. So, third quarter, we saw gross margins decline a little bit because ocean freight went up for a couple months, and then went back down again. So, we’re seeing that the fourth quarter, our gross margin coming back normalized.

Ryan Merkel: Got it, okay. Maybe just lastly, just talk about the AI that you’re going to be including in the warehouses, what are you doing there and what’s the benefit going to be?

Alan Yu: Well, we’re seeing that the overall payroll has gone up throughout the U.S., especially in California. And what we want to do is we want to reduce our staffing. We want to utilize more AI technology to finish — complete the work that are redundancies, repetitively work or simple works, like customer service, purchasing, placing POs, placing sales orders or generating sales orders, as well as warehousing, by using AI to monitor each staff efficiency. So far, we have already tested our online customer service, 98% of our increase are currently handled by our AI technology. And what we’re trying to do is reduce our purchasing account payable, accounting department, at least 70% of the workload, simplify workload. So that with the existing staff we can run — actually increase our revenue with exiting staff or even lesser staff that we have right now.

Ryan Merkel: Got it. Okay, very good. I’ll pass it on. Thanks.

Alan Yu: Thank you, Ryan.

Operator: And our next question will come from Michael Hoffman with Stifel. Please go ahead.

Michael Hoffman: Hi, Alan, Jian. How are you?

Alan Yu: Hey, Michael.

Michael Hoffman: I have a few questions. Could you just share a little bit, I know you don’t give a lot of detail at the regional mix, but just so we appreciate, what percent of revenues is California versus other major areas like Texas, Northeast, or Northwest or Southeast?

Alan Yu: California right now is approximately, I would say, 30% of overall revenue. Jian, is that — can you validate that?

Jian Guo: Yes —

Alan Yu: We actually didn’t cut that out.

Jian Guo: Can you hear me?

Michael Hoffman: Yes, go ahead, Jian.

Jian Guo: Yes, that’s about right, it’s a little over. But that’s roughly right, yes.

Michael Hoffman: Okay. And then the next biggest region would be the Texas area, Midwest, and then Northeast, is that how we think about it?

Alan Yu: That’s correct.