Karat Packaging Inc. (NASDAQ:KRT) Q4 2023 Earnings Call Transcript March 14, 2024
Karat Packaging Inc. beats earnings expectations. Reported EPS is $0.47, expectations were $0.4.
KRT isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).
Operator: Good afternoon. And welcome to the Karat Packaging Fourth Quarter and Full Year 2023 Earnings Conference Call [Operator Instructions]. 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 2023 Fourth Quarter and Full Year Conference 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 Chief Financial Officer, Jian Guo. Before I turn the call over to Alan, I want to remind all of 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, 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 the 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. Sales volume for our 2023 fourth quarter grew 7% over the prior year period. Although revenue was again impacted by unfavorable year-over-year pricing comparison and by startup delays from several new national and regional chain accounts, we estimated approximately $2 million to $3 million in revenue from new accounts which pushed into 2024. We are starting to work on orders from these new accounts now. As part of our strategic initiatives, we continue to scale back US manufacturing during the fourth quarter, which further enhanced gross margin to a near record high of 35.7%. Sales from manufactured products in the fourth quarter were 16% of total net sales compared with approximately 27% last year.
We expect our gross margin to remain at a higher level because of our initiatives and the continued strong US dollar. Sales of our eco-friendly product grew 11% in the fourth quarter over the prior year period. This category represented approximately 33% of total sales, which exceeded our expectation versus 31% last year. We are continuing to develop new and innovative eco-friendly products to meet increasing customer demand and expand our customer base. In 2023, we opened new distribution center in Chicago and Houston and doubled the size of our Washington State distribution center with the move into a new 100,000 square feet facilities. These new distribution centers are fully operational and contributing nicely to geographic and market penetration.
As part of our growth plans for 2024, we recently signed a new lease for a distribution center in Arizona. We’re taking possession of the warehouse now and are expecting it to be fully operational early in the second quarter. We are planning on opening another distribution center in the Southeast region this year. Together with a sales force expansion, we are further penetrating key US markets in the South, Midwest and Pacific Northwest region and expect the growth in these markets to more than offset the decline in the California market but weaker conditions in the restaurant sector throughout the states. Our operating leverage in Q4 2023 was impacted by a write-off vendor prepayment of $1.1 million to purchase certain PPE product in 2020 during a period of extreme inventory supply shortage caused by the pandemic.
We are focusing on implementing automation and AI technology at all of our facility in 2024 to further enhance efficiencies and productivities. Additionally, we are actively evaluating strategic acquisition opportunities this year as market valuations are showing signs of reality and normalization. With Karat’s strong operating cash flow as well as the company’s liquidity, strong balance sheet and positive long term outlook, our Board of Directors in February again authorized an increase in the quarterly cash dividend payment to $0.30 per share from $0.20 per share last quarter and from $0.10 per share since the regular quarterly dividend policies was initiated in August 2023. I will now turn the call over to Jian Guo, our Chief Financial Officer, to discuss the company’s financial results in greater detail.
Jian?
Jian Guo: Thank you, Alan, and good afternoon, everyone. As Alan mentioned, we delivered another quarter of significant margin expansion and business performance. As I go through the key financial metrics here, I will be talking about certain [misclassification] adjustments made in the fourth quarter of 2023 for the full year amount within the income statement with no impact on net income. The prior year amounts were not adjusted due to the immaterial impact on the overall financial statements. Net sales for the 2023 fourth quarter were $95.6 million, including an adjustment of $6.5 million of online sales platform fees for the full year, which resulted in an increase to both net sales and selling expenses. Net sales were $92.7 million in the prior year quarter.
Sales volume increased 7.3% over the prior year quarter, which was offset by unfavorable year-over-year price comparisons as we have passed on savings from ocean freight and raw material costs to customers primarily in the last quarter of 2022 and first half of 2023. By channel, compared with a year ago, sales to distributors, our largest channel, was lower by 6% for the 2023 fourth quarter. Sales to national and regional chains decreased 3.6%. Sales to the retail channel decreased 5.2%. And our online channel sales were up by 68.2%, including the impact of 60.7% from the adjustment of online sales [platform] fees as discussed earlier. We are encouraged by the volume growth in our business as well as the growth of our eco-friendly products, online channel and the increased geographic penetration in the East Coast, Northeast and Midwest.
Cost of goods sold for the 2023 fourth quarter was $61.5 million, which included an additional import duty reserves of $2.3 million and an adjustment of $3.9 million of certain production expenses from general and administrative expenses compared with $63 million in the prior year quarter, which included an out of period inventory write off of $1.7 million. Gross profit for the 2023 fourth quarter was $34.1 million, which included the additional duty reserve and the impact from the adjustments discussed earlier versus $29.7 million in the prior year quarter. Gross margin expanded 370 basis points to 35.7% in the 2023 fourth quarter from 32% for the prior year quarter. Gross margin in the 2023 fourth quarter included a negative impact totaling 240 basis points from the additional duty reserve and the impact from the adjustment discussed earlier.
Despite the unfavorable year-over-year price comparison, gross margin benefited from our efforts to scale back manufacturing in the US in favor of imports, which carry higher margin and improved operating efficiencies. Operating expenses in the 2023 fourth quarter were $29.5 million or 30.8% of net sales compared with $24.9 million or 26.8% of net sales in the prior year quarter. Operating expenses in the 2023 fourth quarter included the negative impact of a vendor prepayment write-off and the adjustments discussed earlier totaling $3.6 million. The increase was primarily driven by higher labor costs, increased rent from additional leased warehouses and workforce expansion. Such increases were partially offset by lower shipping and transportation costs, stock based compensation and bad debt expense.
Net income for the 2023 fourth quarter was $4.2 million compared with $4.5 million in the prior year quarter. Net income for the 2023 fourth quarter included the negative impact from the additional duty reserve, vendor prepayment write-offs and a tax adjustment of $300,000, totaling $2.9 million. Net income margin was 4.4% in the 2023 fourth quarter compared with 4.9% in the prior year quarter. Net income margin in the 2023 fourth quarter included a negative impact from the duty reserve, vendor prepayment write-off, tax adjustment and the adjustments discussed earlier totaling 350 basis points. Net income attributable to Karat for the 2023 fourth quarter was $3.9 million or $0.19 per diluted share compared with $4.5 million or $0.23 per diluted share last year.
Adjusted EBITDA, a non-GAAP measure, in the 2023 fourth quarter was $8.6 million versus $9.9 million in the prior year quarter. Adjusted EBITDA in the 2023 fourth quarter included a negative impact of $2.3 million from the additional duty reserves as discussed earlier. Adjusted EBITDA margin was 9% in the 2023 fourth quarter versus 10.7% in the prior year quarter. Adjusted EBITDA margin in the 2023 fourth quarter included a negative impact from the additional duty reserve and the adjustments totaling 330 basis points. Adjusted diluted earnings per common share was $0.24 per share in the 2023 fourth quarter compared with $0.30 per share in the prior year quarter. We believe Karat is well positioned to execute on its future growth strategies.
We finished 2023 with $110.3 million in working capital compared with $84.5 million at the end of 2022. As of December 31, 2023, we have financial liquidity of $59.3 million with another $26.3 million in short term investments. I will now close with our 2024 outlook. Net sales for the 2024 first quarter are expected to increase [low] to mid single digit from the prior year quarter based on the current competitive environment and the new business outlook. Our gross margin goal for the 2024 first quarter is approximately 37% to 39%. For full year 2024, we expect net sales to grow 8% to 15% and gross margin to be in the range of 35% to 38%, assuming no significant increases in ocean freight rates. 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
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Operator: [Operator Instructions] The first question is from Jake Bartlett with Truist Securities.
Jake Bartlett: My first is on the sales in the fourth quarter, and backing out or backing out the online sales adjustment, there was — it was lower than guidance. Even I think if you add the $2 million to $3 million that kind of moved forward into the first quarter of 14, it was below guidance. So the question is what is driving that, what — versus expectations, what really drove the lower than expected results in the fourth quarter for sales?
Alan Yu: Jake, let me answer that question. Well, first of all, we did see a slowdown in the customers purchasing product for inventory back in December, especially in the month of December, we saw a significant slowdown in all of our distributors taking orders on that part. And one of our reason is that our main chain account were saying that they were overstocked and the business was not as good as last year. So that was one of the main reason that we had a really slow December.
Jake Bartlett: And I remember the stocking or maybe destocking for distributors is an issue or just a dynamic in the fourth quarter that maybe had gone away. Is this maybe a return to normal kind of behavior from the distributors or was this — are we still in kind of abnormal territory with how they’re behaving right now?
Alan Yu: We understand that every year, especially at the end of the year, in December, our customer goes on vacations and they try to destock whatever and return inventory that are excessive. And that’s kind of normal seasonality things. One way to avert that will be adding additional new account, new businesses to offset that, especially this year, now that it’s different than last — actually, last — the last quarter was different than the prior year. But in the prior year period, people are concerned that there might be a shortage so they tend to stock up during the holiday. But last quarter, especially in December, people understand that there’s abundant inventory out in the market. So they won’t be too concerned about bringing too much inventory into their warehouse.
And I believe that most companies or most of our customer distributors are overstocking the inventory in the warehouse, they’re struggling with the warehouse bases. In the past years, when they’re short of spaces, they actually lease additional spaces. But now the warehouse space have become so expensive, people are trying to reduce their warehouse storage space to reduce their cost of operation.
Jake Bartlett: And then last question on sales. Alan, if you can just describe the pricing environment. It feels like part of why the sales were kind of — expectations and guidance was marched down in 2023 was because of just pricing and your desire to pass along price plus lower costs through price. Have we stabilized there? Do you think that — do you feel more confident that pricing is not going to continue to come down in ’24 that maybe is kind of bottoming and will grow from here?
Alan Yu: Well, yes, in 2023, I would say that in most industries, especially packaging industry, we’re seeing — everyone has seen prices coming down due to overstocking, due to the lower cost of ocean freight, due to lower cost of the raw material. And we’re seeing basically — and not only bottom, we’re seeing a kind of a rebound a little bit in terms of pricing in some of the categories, like the glove, like certain categories that are in shortage that are from overseas. So that’s what we’re seeing right now. We’re seeing — I would say, we’re pretty much — we came to the bottom in the fourth quarter and it started a little rebound in the first quarter of 2024.
Operator: The next question is from Michael Hoffman with Stifel.
Michael Hoffman: Can I have some modeling questions about 2024, so we just get all the details. So could you give us a little thoughts about where SG&A lands, interest expense, taxes? And then lastly, free cash flow and sort of either a dollar amount or a cash conversion ratio of your EBITDA, just so we can complete the model?
Jian Guo: Let me take that question. So we can provide some high level estimate, obviously, would provide [Technical Difficulty] revenue and gross margin, and don’t necessarily go down into all the details. But we can definitely share some of our thoughts here. And again, as we mentioned in the guidance, the full year — the thoughts on the full year performance, a lot of that, especially for the second half, this is just a caveat, the second half of 2024 is going to be assuming we don’t have significant changes in the ocean freight rate. But high level when we’re thinking about, I think, Michael, you’re asking operating expense and interest expense, and cash flow, right? So operating expense, I would say, high level, this is a area of focus for the management team right now and our goal is to continue to improve the leverage there.
I want to say 2024 high level operating expense on a full year basis is probably going to be fairly consistent or a little bit better than 2023. When you take out some of the discrete items that we incurred in 2023, I think overall operating leverage is going to improve a little bit. We do expect to see some improvement, especially related to labor costs, partially offset by increase in rent expense, some of the fixed expenses as we continue to expand our warehouse base. So high level, that’s the operating expense, operating leverage. Interest expense year-over-year, I don’t see significant changes. The term loans, and again, these are the term loans that we have on Global Wells, which is a consolidated variable interest entity, these are the term loans on Global Wells books from not our operating entity.
But again, both term loans are fixed interest rate, we don’t expect significant changes year-over-year in interest expense. Free cash flow, we do believe our free cash flow is going to be — it’s going to continue to be really, really strong in 2024. We talked previously about the pivoting to a more asset light model focusing on the import as opposed to making heavy investment on — CapEx investments here domestically. So we do expect to continue with that model into 2024 and continue to expect strong free cash flow in ’24.
