Karat Packaging Inc. (NASDAQ:KRT) Q4 2022 Earnings Call Transcript

Karat Packaging Inc. (NASDAQ:KRT) Q4 2022 Earnings Call Transcript March 16, 2023

Operator: Good day! And welcome to the Karat Packaging Inc. Fourth Quarter and Full Year 2022 Earnings Conference Call. All participants will be in 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, Investor Relations. Please go ahead.

Roger Pondel: Thank you, operator. Good afternoon, everyone and welcome to Karat Packaging’s 2022 fourth quarter earnings call. I’m Roger Pondel with PondelWilkinson, Karat Packaging’s Investor Relations firm. It will be my pleasure momentarily to introduce the company’s Chief Executive Officer, Alan Yu and its Chief Financial Officer, 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 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 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 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, I’ll turn the call over to CEO, Alan Yu. Alan?

Alan Yu: Thank you, Roger, and hello everyone. We were able to grow our top line during the fourth quarter of 2022 against a very strong prior year quarter, despite an overall challenging deflationary environment in our industry and multiple price reduction that we’ve implemented. Additionally, thanks to our continued margin improvement efforts, we achieved record full year gross margin of 31.2%, despite a negative out of period inventory write-off of approximately $900,000 and generated a record full year operating cash flow of $29.5 million. With the stabilization of ocean freight costs and the supply chain issues caused by the pandemic now essentially behind us, we are focusing on operating costs, containment and eliminating inventory (ph) built during the supply chain disruption period.

Photo by Tarah Dane on Unsplash

During the fourth quarter we added a number of contract with new national and regional chain accounts, and we expanded product offering to existing customers. We are expecting these new agreements to materialize and add to our top line starting mid-2023, and we are continuing the strong momentum in building our pipelines. In the near term revenue for the 2023 first quarter were likely to be down about 10% compared with our prior year period. We are anticipating revenue to pick up again toward the end of the second quarter. For the full 2023 we are expecting revenue growth to be at the high single digit year-over-year. As a reminder, year-over-year comparisons were impacted by pricing for inventories sold during most of the first half of 2022, which was near peak level.

Also, order volumes during that time period last year were unusually high due to supply shortages. We continue to see solid growth in our environmentally friendly products. This category grew 24% in the fourth quarter over the prior year quarters, and demand remains strong into 2023. Our joint venture in Taiwan, building a state of the art bagasse factory for manufacturing 100% composable food service products is progressing well. We are continuing to receive orders and (ph) an increase that would fill capacity quite quickly, which would be a good problem to have. However, construction of the plan is behind schedule because of power supply issue, which now have been resolved. We currently expect initial shipment to begin in the second quarter.

We are implementing a number of growth strategies in 2023 that we are confident will provide solid long term returns. Among them, we are improving our fill-rate and inventory management and modifying our model to be more asset-light by scaling back manufacturing production in California, while expanding import products which carry higher margins. To accommodate future growth, we are working on increasing our distribution space. In February, we signed a new lease for the approximately 52,000 square foot distribution facility in Chicago and expect to move in by the end of April. We are also getting closer to sign the lease for another distribution facility similar in size in Houston. Additionally, we are working on expanding our existing warehouses by adding approximately 15% of the new rack space.

As part of this initiative, we are targeting geographical expansion in the East Coast and Midwest Regions. To do so, we are increasing the size of our sales team by approximately 35%. Lastly, we are in the process of upgrading our e-commerce platform and expanding online support teams. As well, we are excited to begin offering online sales in Canada and Hawaii. We expect to again generate strong operating cash flow and continue to scale back our CapEx this year, which will give the company flexibility to consider returning excess capital to our shareholders, as we continue to look for strategic growth opportunities. I will now turn the call over to Jian Guo, our Chief Financial Officer to discuss our financial results in greater detail. Jian.

Jian Guo: Thank you, Alan. Our 2022 fourth quarter results reflect continued top line growth, despite a challenging year-over-year comparison, improved margin and continued strengthening of our liquidity position. Now, let me provide more color on our operating results starting with revenue. Net sales for the 2022 fourth quarter increased 1.5% to $92.7 million from $91.3 million a year ago. The 2021 fourth quarter was a particularly strong revenue quarter with COVID re-openings and price increases implemented due to extraordinarily higher ocean freight and other costs. By channel sales to distributors, our largest channel grew 3.1% for the 2022 fourth quarter. Sales to the retail channel increased 4.6%. Sales from the online channel increased 1% and sales to national and regional chains decreased 3% for the quarter.

The decrease in the chain account was due to certain operational issues, which have been essentially resolved. Sales of our eco-friendly products increased 24% for the fourth quarter. During the fourth quarter, we completed a project to reevaluate and classify our inventory to be more aligned with a variety of product categories offered to customers. As a result, some of the product category data, including eco-friendly products in the prior period was recast to allow for a more meaningful comparison. We continue to see accelerated growth from these products as we strengthen our market leadership position and expand our product offering in this category to meet the needs of our customers and the evolving regulatory landscape. Eco-friendly products represented 27% of our total sales in 2022, compared with 21% in 2021.

Gross profit increased 4.8% to $29.7 million for the 2022 fourth quarter from $28.3 million last year. Gross margin expanded 100 basis points to 32.0% from 31.0% in the prior year quarter. Gross margin was favorably impacted by lower and stabilized ocean freight cost for the 2022 fourth quarter and 9.8% of net sales compared with 12.3% of net sales in the 2021 fourth quarter. The gross margin was negatively impacted by a $1.7 million inventory write-off, which represented an out-of-period adjustment for certain inventory items in the previously issued quarterly and annual financial statements, as well as an impact of $2.4 million from freight and duty capitalization. Based on current cost factors, we are expanding our 2023 full year margin goals to be in a range of 32% to 33%.

Operating expenses in the 2022 fourth quarter were $24.9 million or 26.8% of net sales, compared with $21.2 million or 23.2% of net sales in the prior year quarter. The increase primarily reflected higher labor costs of $1.5 million due to workforce expansion, higher production costs of $1 million due to unexpected machinery repair and about $600,000 due to an increase in rental expense from the two additional warehouses added in May 2022. Operating expenses in the 2022 fourth quarter also included a CapEx deposit write-off of approximately $500,000 related to pre-pandemic capital investment project. Net income for the 2022 fourth quarter decreased to $4.5 million from $6.0 million for the same quarter last year. Net income margin was 4.9% for the 2022 fourth quarter versus 6.5% in the prior year quarter.

Net income attributable to Karat for the 2022 fourth quarter was $4.5 million or $0.23 per diluted share compared with $5.6 million or $0.28 per diluted share in the prior year quarter. Adjusted EBITDA, a non-GAAP measure was $9.9 million for the fourth quarter versus $10.9 million in the prior year quarter. Consolidated adjusted EBITDA margin was 10.7% of net sales versus 11.9% in the prior year quarter. Adjusted diluted earnings per common share was $0.30 per share for the 2022 fourth quarter versus $0.32 per share in the prior year quarter. During the 2022 fourth quarter, we generated operating cash flow of $17 million and continue to expect strong cash flow in 2023. We believe Karat is well positioned to execute on its future growth strategies.

We finished 2022 with $84.5 million in working capital, compared with $72.1 million at the end of 2021. We have financial liquidity of $63.0 million as of December 31, 2022 and declared and paid a special cash dividend of $0.35 per share on our common stock. Lastly, we just considered the extension of our $40 million credit line, extending the maturity to March 2025. We expect to continue to further strengthen our financial and liquidity position in 2023. 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. . Our first question comes from Jake Bartlett with Truist Securities. Please go ahead.

Jake Bartlett: Great. Thanks for taking the question. My first one is on the 2023 sales growth, and Alan or Jian can you talk about what the drivers are, so you know high single digits. Does that include negative impact from pricing, so pricing would be a headwind. Just, if you could give us components of that high single digits growth, that would be helpful?

Alan Yu: Sure, Jake. Well first of all, we believe that right now we’re seeing that price construction due to deflationary, especially from ocean freight pricing coming down to back to pre-pandemic. So we have been adjusting our prices ever since September of last year ’20, and then October, November, December, even January. We do see that pricing to be a little bit basically stabilized as well as ocean freights been stabilized. So our growth are part of these several factors. One, our online sales, we’re seeing strong online sales. Also we added, we’re looking to start in Canada. For online sales in Canada we never really tried to approach it in the past years, and this is because we actually modify our platforms and increase our warehouse spaces.

And of course, second is national chain account and regional chain account. As mentioned in the previous discussion that we actually signed in several, over a dozen different regional and national chain accounts that is expected to start shipping starting April, May, June, July of this year and they will add to our existing volume. Right now the obstacle headwinds to service these national chain accounts that we just added is warehouse spaces. We have been short of warehouse spaces ever since the end of last year. So we’ve added some spaces that was still not adequate. So that’s why we have continued to seek for new space, and this is an area that we’re looking to really expedite €“ speeding up the process of getting additional warehouse spaces in different areas.

Even in California we are actually looking for additional space in California. New Jersey – South Carolina, we just expanded an additional 50,000 square feet in South Carolina and we’re racking up the entire warehouse in New Jersey, and we’re moving some of the equipment out of California and using that space, racking space for product that were coming in to service these accounts that we sign up. Also another factor is that we’ll actually be €“ growth will be the eco-friendly product. We’re seeing more and more states, cities are banning Styrofoam, the plastic and the straws. So we’re bringing more higher margin, higher revenue wise product from overseas to sell to our customers and the (ph) on that part.

Jake Bartlett: Great. You know just kind of really just narrowing back on the pricing side, because that seems to be €“ you know obviously it was a headwind in the fourth quarter here. And so I think you mentioned Alan that you thought that the pricing level, the absolute level of pricing has stabilized. I just want to get your confidence on that, that we’re not going to just see continuing decrease in pricing, which is going to kind of squeeze margins, but also limit the sales growth. So in the 10-K as you disclosed kind of the drivers to the change in revenue, I think the implication here if I did the math right, is that pricing was a negative 4% drag in the fourth quarter and so the question is, if you kept prices where they are now, how much of a drag would that be for 2023 as a whole? Should we assume that pricing is going to be a negative impact on growth for ’23 as a whole?

Alan Yu: Well, earlier Jake we mentioned in our €“ earlier in the conference call that the 2022 first quarter was the biggest, the highest ever in history of ocean freight. That’s what we’ve seen and also as well as supply chain disruption was all in the first quarter, mainly in the first quarter of last year, that everyone is rushing to buy whatever they can and stocking up everything and then at the higher price, even ourselves, we did that too. And this year we’re seeing that first quarter, we’re seeing everything’s coming down. All the price is coming down, ocean freight is coming down. Right now ocean freight stabilized. It has been kind off continuing to come down since July of last year to even till the end of the last year.

So in January the ocean freight started to stabilize. And I do see that there’s not much of a price difference anymore in the future for 2023, unless we have sufficient spaces that we’re going after, even more accounts that we’re looking to sacrifice our margin and prices to obtain new accounts, which we already have in those pipelines and also agreements that basically it’s going to fill our capacity in terms of warehouse space. Again, we still have capacity in bringing more additional product and manufacturing capacity, but we’re lacking in warehouse spaces, so that is the key components. We can grow as long as we add more warehouses, and it €“ not increasing too much facility costs.

Jake Bartlett: Okay, great and then. I just wanted – sorry, Jian thanks.

Jian Guo : Hi Jake! This is Jian. If I can just add on to Alan’s comments real quick, I think Alan provided a lot of great color on pricing, so hopefully that answers your questions about pricing. Just as far as what the trend is going to be for 2023, I also just wanted to add that we are continuing €“ we do expect to continue to be able to expand our gross margin even when pricing start to stabilize, right? As mentioned, as Alan mentioned pricing as of last year, if you’re looking at earlier part of 2022, it was at peak level. A lot of that was because of the significantly higher ocean freight costs. Now, even as we continue €“ as we start to take actions to be proactive to pass on savings to our customers, because of the significant job in the ocean freight and because of a lot of the other margin improvement, sort of initiatives that we are implementing, we’re actually guiding higher gross margin on a full year basis for 2023, and we’re very confident that we can continue to expand our gross margin, even with this price action that we’re talking about.

Jake Bartlett: Great. My other question

Alan Yu : Let me add one more thing to price margin wise. Jian mentioned that we are able to keep €“ we’ll actually increase our gross margin, even with the price decrease. That is correct, because we’re actually looking to have a full year guidance of 32% to 33% gross margin and if you look at €“ if we take a look at back in the fourth quarter, we actually took almost over €“ around $2.4 million freight duty capitalization. Same thing with the third quarter. It was like more around, around same area of freight duty capitalization. But starting the first quarter of 2023, I don’t believe we’ll see any more freight duty capitalization that we’ll take down on our margin wise, gross margin wise and revenue wise. So we’re seeing that it’s going to be a favorable thing, with ocean freight stabilized for this year.

Jake Bartlett: Great! And then my other question was just on manufacturing and the decision to I guess take away the manufacturing in the Chino facility. One question is, are you keeping the manufacturing in Texas facility? And you know what is €“ just maybe a little more detail in the decision to make that change. There were some reasons why you did, you had manufacturing capabilities before. So I’m wondering, kind of what change to kind of drive that decision.

Alan Yu: Yes, we’re actually going €“ we actually have started increasing our equipment and moving some of the equipment from California into Texas. So we’re increasing our Texas manufacturing facility of capability, because it has more space and also the warehouse spaces, it costs less. The manufacturing cost is much lesser in Texas versus California. Finding skilled mechanic, labors, it’s much easier in Texas versus California. California, the warehouse facility cost has gone up triple since two years ago. So in terms of €“ as well as labor costs has gone up a lot tremendously, and we’re seeing that, and that has been one of our key headwinds in the third and fourth quarter of last year, as labor continued to go up, different laws changes in California, So we see California as more as a hub that can facilitate product manufacture overseas into California.

And for us to manufacture more in Texas is more favorable for us, because it’s more in the mid – in the inland area and also most of our new accounts, new customers are actually out of the Midwest and Texas, Midwest and East Coast now. We are seeing most of our growth in the Midwest and East Coast versus a decline in the West Coast area market.

Jake Bartlett: Great! Thank you so much. I appreciate it.

Operator: The next question comes from Ryan Meyers with Lake Street. Please go ahead.

Ryan Meyers : Hey guys! Thanks for taking my question. The first one for me, some of like revenue and national regional chain accounts was negatively impacted by some operational issues that you said have since been resolved. I’m just wondering if we can get some more detail on that and what went on there?

Alan Yu: Well Ryan, in the fourth quarter we have some issue of €“ actually have some issues with our equipments. They were shutting down, they were broken. So we have a kind of a decline in production output and we then actually just have to turn over to our oversea partners to help and start producing for us. And basically it was a bit of a delay, because we have to ship them overseas into California versus it was made in California. These products have come in, and we see that this is actually pretty good in terms of it will cost us less to bring the product oversea versus us continue to maintain the CapEx expenditures to fix these equipments, to maintain these equipment, to continue purchase these equipment. So that’s one of the decision that we made in January that we want to reduce manufacturing in California, because we’re losing mechanic, skilled mechanic in California.

It’s challenging to find new one to replace them. So we might as well just start to move our equipment into a Texas and also for the West Coast, we’ve added an oversea partners.

Ryan Meyers : Got it, that’s helpful. And then just kind of switching gears. When we think about the eco-friendly products, you said it was 27% of mix here in 2022. How would you expect that business to grow and what percentage of mix would you expect that to represent in 2023?

Alan Yu: Jian, do have a number, the actual numbers on that part? I can explain the part that €“ what I’ll do, I’ll explain the part, the growth part. The growth aspect is that we see that in 2023 more and more city and states are going to push force, the law into effect, especially like in California. We’re banning the styrofoam completely in California, and in some of the cities. And also we’re adding the €“ like in there’s no more styrofoam in the city of Los Angeles county. So everyone have to go into paper, something more eco-friendly. And more and more are actually €“ now that we’re €“ the COVID pandemic is behind us, we are going back and started looking at eco-friendly packaging, and that’s where we see the growth is as well as our online channels.

We’re seeing more sales in the eco-friendly aspect of the product through our online channels and with the new sales that we were moving into Canada. Canada has completely gone into eco-friendly, and that’s where we see the major huge market in terms of eco-friendly product in the Northern State of Canada.

Ryan Meyers : Got it. And then last question €“ oh! Go ahead Jian.

Jian Guo: Yeah, if can also add on. Just from the numbers perspective, I think as you pointed out over the €“ on average for the entire full year of 2022 eco-friendly products represented about 27% of total sales, which is based on the updated product category that we talked about in our prepared remarks. Just to give you an idea about the sort of the trajectory here. So when we look at Q1 2022, that percentage was 25%. Q4 2022, that percentage was 31%. So you can clearly obviously see the momentum in the close of our eco-friendly product and spend as Alan mentioned with all the strong demand to the regulatory, the change in the regulatory environment and our continued expansion of the products that we are offering in this category, we do see that this momentum is going to continue into 2023.

Ryan Meyers: Got it. That’s super helpful. And then last question for me. I appreciate the commentary on building up the sales force there. Obviously, you’re targeting some new geographies, but I’m curious, are you guys targeting any industries outside of food service?

Alan Yu: I’m sorry, what was €“ the food service area, because we are targeting with the additional sales force. We’re targeting geographic location, as well as we’re adding new food product, yes more beverage items, Bubble tea and boba product supplies. We do see that the demand for boba supply has come back up this year, so that’s the area that we’re targeting. But mainly geographic area in the Midwest and East Coast and Southeast, that’s where we see the biggest drive of our growth in 2023.

Ryan Meyers: Got it. Thanks for taking my questions.

Operator: The next question comes from Michael Hoffman with Stifel. Please go ahead.

Michael Hoffman: Hi! Thank you very much. So Alan and Jian, can we speak to €“ I want to get to the sales growth thing a little. Can you walk us through what we should assume for cadence 1Q, 2Q, 3Q, 4Q to get to a 7% or 9%, so mid-point 8%, that’s high single sales growth for the year. What does the cadence look like over the four quarters?

Alan Yu: Jian, do you have like a breakdown, the forecast on that numbers, because I can go over the process and the strategy, but the actual numbers, I think you have the projected numbers. So Michael, let me go over the strategy in that part. The first quarter of 2023 versus 2022, we see a decline, because the first quarter, that was when the market was short of everything. So everyone was trying to grab a whole container, and they were stocking up, they were worried about everything. So I think we were selling out everything that we had on the floor. So we started to really increase our inventory that which all came in the second quarter of 2022, which really kind of a €“ it’s actually decreased our operational, because we were €“ you couldn’t move anything in our warehouses.

And we immediately, we added new warehouse facilities in California, and that helped a lot for a third and fourth quarter, so we eliminated the warehouse space issues. And in the second quarter, that’s why we’re seeing a decline, year-over-year decline, because we actually normalized this share well with the price coming down. But we see that this is a continuing issue for 2023, that’s why we started to look for additional spaces early in the last year. In January we finalized the Chicago, and we’re looking to finalize Houston, so we wanted to make sure we have them operational by May of this year, because we see a bulk of our new accounts that are coming onboard. They need the product, we need to stock for them by April, May of this year, and that’s where we really see the increasing need of South Carolina space to increase; New Jersey warehouse need to increase the space.

Texas need to increase the space, Seattle. Every one of our facilities need to increase our existing space by racking up the entire warehouse, adding additional 15% to 25% additional spaces, plus the two additional warehouses. That will help us for the growth of facilitating the growth for the new account that we’re signing up, which we already signed up. It’s just that the product will start to come in from overseas, and also domestic we have to increase the stockpile 60 to €“ 30 to 60 days inventory on the floors for them to start to take on the product, and that’s where we’re seeing the number is.

Michael Hoffman: Okay, and then Michael Sorry.

Jian Guo: No, you’re fine. Just maybe to provide a little more color on the €“ from the numbers perspective to answer your question on the breakdown by quarters in 2023, so this is what we have in mind. For Q1 ’23, we already discussed in the previous prepared remarks that we were currently expecting the revenue to be down about 10%, and I think Alan provided a lot of great color on operationally what’s driving that. From overall the percent perspective, I think that’s going to €“ we talked about that trend is going to revert, and then we’re going to see that revenue growth is going to accelerate towards the end of the year. So we do currently expect continued momentum in our revenue growth, primarily in the second half of 2023, probably around 20% or above in the fourth quarter. So over €“ when we’re looking at the full year 2023, that’s how we come up with the high single digit year-over-year growth.

Michael Hoffman: So if I’m playing this out, negative 10% in the first low to mid-single digits in 2Q, you know teens in 3Q, over 20% and 4Q and that’s how you get a blend into that 8%.

Jian Guo: That’s just the overall trend, is we’re going to start a little, but it’s going to continue to accelerate throughout the year, yeah.

Michael Hoffman: Right, right, and the way I sort of characterize it, 1Q negative 10%, 2Q sort of up 5% to 10%, 3Q up 10% to 15%, 4Q up 20% to 25%, that blends you into you know, call it an 8% number, that’s a high single digit. But would you discourage us from thinking about it that way?

Jian Guo: No, I wouldn’t. I think the overall trend makes sense. Obviously part of it depends on the timing of the shipment, especially as we think about quarter end, but I think overall the trend, it makes sense.

Michael Hoffman: Okay. And then your margin outlook 32% to 33% straddles the 32.2% for the year, so it you know a slide down to an 80 basis points and you’re dealing with a negative in the first quarter. So the nature of this question is, are we looking for increased number of skews and better quality of what’s being sold is what helps overcome a headwind in margins in 1Q and then an improving trend to get you to, call it the midpoint 32.5%, which would be up modestly year-over-year on a full year basis at the midpoint. Is that the right assumptions about how that’s happening?

Alan Yu: Michael, Michael, let me answer that question. We’re going to see more of a higher margin in the first quarter and second quarter, and I want to see a lesser margin in the second half of the 2023. That’s one of the strategy that we were seeing is because we are going to go full ahead in terms of competing in the market, starting the second quarter, second half of the year, as we have more capacity in terms of facility space. And yes, and earlier Jian mentioned that in the fourth quarter we’re going to see €“ actually starting in third quarter, fourth quarters, we’re going to see a more of an increase, because historically our increase year-over-year has been around 15% to 22% year-over-year growth, and that’s where we’re going to see the momentum of that part, mainly because of our additional sales rep that we’ve hired, as well as the additional warehouse suite that we have to service the new geographic area customers.

We mentioned that in the past years, our goal is to continue to grow into the area that we have not touched. That is the southeast, Midwest and the east coast, and finally we are having €“ with the additional space that we added, we’ll be able to accommodate growth in that area.

Michael Hoffman: Okay, and just so I make sure I heard this correctly. If I’m looking at the margin trend, you’re higher in the first half than you are in the second half, which means you have a sequential improvement from the year end 4Q into the first half, in order to land at a midpoint of 32.5% for the full year, which is the €“ you know your guide 32% to 33%?

A – Alan Yu: Correct, yeah.

Michael Hoffman: Okay, and then I don’t want to belabor the fourth quarter much. I get some of the dynamics were happening that were out of your control between down equipment and getting product from overseas. But if you €“ and I haven’t had a chance to do this, because I’m on the road and so I confess I should have done it myself, but I haven’t, so I’m asking you. If you account for €“ let me ask it a different way. You gave guidance that would’ve landed us at about 33.2% for the margin for the quarter, and we came in at 32%. So what is €“ what accounts for that 120 basis points? I’m assuming some of it’s the write-offs and some of it is the timing of product that got disrupted because of say the equipment failures, but I would like to hear sort of what’s €“ what made up some of that 120 basis points?

A – Alan Yu: Jian, would you? I mean me, my understanding it’s the write-off, but Jian can go into detail on that part.

Jian Guo: Yeah, I can take that question. So the biggest impact in terms of the €“ in terms of the margin in the fourth quarter, you’re right, it is the write-off. But the out of period which we talked about in the prepared remarks, the impact is $1.7 million for Q4 2022.

Michael Hoffman: Okay, all right. I can do the math on that. So what’s really important is if you would have pitched your margin target, even if the sales were down because of the pricing give backs related to freight, that’s the really important message, is margins are on track ex the write-off?

A – Alan Yu: Yes, margin is actually on track to grow.

Michael Hoffman: But I’m €“ specifically in the fourth quarter, margins were okay ex the write-off. You know I get the dollar amount is lower because of starting on a smaller sales base, because you had to get price back, but the margin actually was €“ you know margin trend ex your write-off for the fourth quarter was on budget or better?

Jian Guo: I can take €“ Michael, I can take that question. So it actually is going to be better. So without the impact of the $1.7 million out of period adjustment, our fourth quarter margins would have been 33.8%, so it would have been better. And then in Q1 we are seeing that operationally that some of the actions that we are taking to improve the margin is actually, we’re starting to see some of those translating into numbers, so we do expect margin to continue to expand from that number into Q1, 2023.

Michael Hoffman: Okay, that €“ I wanted to make sure we had that clarity, because I think that’s important for everybody to understand. You had a good margin quarter. You had to give back some price, but you had a good margin quarter. Okay, that’s Last question for me, capital spending you said was going to be down, but what’s the dollar amount you’re budgeting?

Alan Yu: Jian, can you take that question for the capital side? I know my understanding is that it will be much lower than the previous years. I believe the 2022 and 2021 where you spend over $15 million in capital expenditures, but in 2023 I think we’re looking to spend under $4 million for capital expenditures as we decrease manufacturing in California. So we will reduce the CapEx expenditure for the maintenance expenses. But in terms of €“ yeah…

Jian Guo: Yes, that’s absolutely right. So I would say our round rate CapEx is going to be significantly lower as Alan talked about. That number is excluding for example the continued investment that we are making into the joint venture or if we were to expand €“ continue to invest into the joint venture, but that’s absolutely right. The round rate CapEx is at a much lower level.

Michael Hoffman: Okay, so about $4 million is what I’m hearing?

Alan Yu: That is correct.

Michael Hoffman: Alright, great, thank you for taking the questions.

A – Alan Yu: Thank you, Michael.

Operator: The next question comes from Paul Dircks with William Blair. Please go ahead.

Paul Dircks: Hi! Good afternoon. Thanks for taking my questions. First one for me is, and forgive me if this was covered earlier, but on the destocking behavior, you know obviously I think the thinking was that it would end here in the fourth quarter. So obviously continuing into 2023, can you help us parse out if there are certain customer segments, certain product categories or any other certain you know labeling of what actually is being destocked, and how much confidence do you have that it will wean over the next quarter or two?

A – Alan Yu: I believe the destocking part for most of our client that we service has ended in the end of last year. We continue to emphasize to our customers, do not overstock, we will bring product in. There’s no shortages, there’s no supply chain issue in most cases. Ocean freight are better than last year in terms of the arrival time. The more clear, the easier to get a container out of the port. It’s less congested, and the domestic local carriers are actually faster than before. So there’s less of an issue of supply chain disruption. Only in certain cases that some of the containers might get delayed, but in most cases it’s not going to be delayed, and also as well as the price, we actually kind of alerted most of our customer that price has started to come down since last August, September and October, and they continue to come down, and we will continue to let them know what is the market price on that part.

So our client has been educated and advised on that part. So I don’t see any more of destocking. That’s where I said and mentioned earlier that everything should be normalized in 2023.

Paul Dircks: Okay, so just to be clear, no more to destocking here in the first quarter?

A – Alan Yu: Correct.

Paul Dircks: Okay, got it. Next question for me, in 2022 price was up about 12% for the company. Can you let us know, what was price up for the Karat earth products or maybe if you have it in this way, how much did Karat Earth products contribute to your overall price increase?

Alan Yu: Jian, do you have the numbers?

Jian Guo: Karat Earth in itself in terms of the percentage of the overall price increase is actually not a super significant percent. It should be below 10%.

Paul Dircks: Okay, so you know then maybe into 2023, are we seeing any price deflation on Karat Earth products or are those somewhat saved given the fact that there’s so much of a push globally into eco-friendly products?

Alan Yu: Yes Paul, I am seeing some deflationary pricing on the €“ including the Karat Earth. They are brought in from overseas. When they €“ when the price increased in the ocean freight, it was also added to the Karat Earth. Basically all category lines were added on the ocean freight lines. So we also have announced a price decrease on the Karat Earth product in the fourth quarter and also January of this year as well.

Paul Dircks: Got it, that’s helpful. And then last one for me, you know into 2023, what are your expectations for being able to leverage your SG&A. Do you expect that you’ll be able to do that for the full year or is this something that we should think about only when revenue is growing in the back half of the year?

Alan Yu: I do believe €“ I’m sure Jian can elaborate more, but my understanding is that SG&A is coming down. In the second part of last year SG&A were up sharply. Facility costs, labor costs and also production manufacturing expenses, but SG&A should be starting to come down in terms of 2023 as we reduced manufacturing in California. Mainly the SG&A increase was due to manufacturing in California and trying to repair the equipments and also the hiring the people and skilled labor to maintain these equipment. That was one of the biggest challenge for the past three quarters. We do see that moving into the Texas, that will give us some of a leverage in terms of balancing out and reducing the expenditure and the SG&A on that part.

Paul Dircks: Okay, very well. Thank you for your help.

Alan Yu: Thank you, Paul.

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

Jake Bartlett: Great! Thanks for taking the question. I had just a couple of follow-ups. One was on the CapEx and what you’re talking about kind of for expectations for ’23. But if I include you know just CapEx plus deposits, which I think it seems to be the best way to do it, but it was $14.7 million in ’22. What should that number be in ’23? You mentioned $4 million in CapEx, but that’s not kind of the, maybe the whole picture and especially with what you’re investing into the JV. So what should we €“ if we think about kind of free cash flow as you know a combination of the CapEx and deposits, what should that number be?

Alan Yu: Well Jake, on €“ for the year 2022 and 2023 the equipment that we ordered in 2022 that we pay most of the deposit, and we actually accounted for that as a CapEx expenditure already in 2022. They are coming in €“ basically there is not much coming into 2023 and basically all we have to do is pay the remaining balance of those equipment that we pay for already in 2022. As far as JV, we actually pay a majority of it in 2022 already in terms of CapEx deposit on that part. 2023, as we mentioned that we want to see first how the joint venture in terms of the sales growing and the growth and everything, to see if we do increase the CapEx, the additional investment or actually we’re looking to having, actually having additional parties to join the joint ventures in terms of selling the shares and having more shareholders for the company.

So there’s different area that we’re actually looking to right now on that part. So we don’t see much of an increase in CapEx or deposited in 2023 for the joint venture, as well as for the equipment wise. So that’s why we’re saying that we’re pretty safe in terms of $4 million in terms of maintenance and some of the capital expenditure we are actually looking to expand is on new trucks, new trailers, warehousing, racking and those sort of things that we’re spending in terms of the 2023, more on the logistics side.

Jake Bartlett: Okay. And the Chicago or Illinois factory in Houston warehouse, those wouldn’t be big CapEx expenses, that’s the $4 million includes those.

Alan Yu: Yes. That would not be a big expenditure for CapEx.

Jake Bartlett: And then my other question is about your back to pricing. You know in my other coverage, covering restaurants and their guidance for costs in ’23 and all of them have the packaging costs being up year-over-year. So they’re not seeing this, at least telling us yet about deflation on that line. Is there any nuance that maybe the €“ what restaurants order for to-go packaging is not going to be deflationary, but other items are. Just maybe a little more detail, because I’m seeing a little bit of a disconnect in terms of what the restaurants I cover are talking about, and then you’re kind of commentary on pricing. And maybe if you could just maybe €“ maybe it’s a factor of what is coming down. I know in the past you’ve talked about the plastics, you know plastic based products that are really what’s driving the deflation on your pricing. So any more detail there would be helpful.

Alan Yu: Sure, plastic actually dropped more than anything. Paper has not dropped at all. Paper costs in the U.S. has been €“ actually has gone up a lot in 2022, even to the end of the year. I’ve even seen a price increase in January of 2023 on the paper side. But on the plastic side, it has dropped a lot, more than 40% in terms of risen costs, and that’s basically it’s known to everyone. One thing about the restaurant industry, restaurant doesn’t really – even though they order, they buy direct from manufacturers like us. They actually have to €“ have to have a third party logistics such as a Cisco, Sigma or other national distribution company. They were due to mark-up, and in terms of what is the landed cost, the actual cost is determined not by just by buying the product from us, but also from the logistic side of the business.

Now, in that part of the segment of the business, I’ve seen that increase a lot in terms of facility and labors. So that might be it in the case that the actual landed cost has gone up versus the product cost has come down.

Jake Bartlett: Okay, thanks a lot. I appreciate it.

Alan Yu: Thank you, Jake.

Operator: 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 : Well, thank you everyone for joining the conference call of Karat Packaging, and I look forward to the future conference call. Thank you all, everyone. Goodbye!

Operator: The conference has now concluded. Thank you for attending today’s presentation. You may all now disconnect.