Karat Packaging Inc

NASDAQ:KRT

Earnings Call Analysis

Earnings Call Transcript 2024-Q2

[Operator]

Thank you for standing by. My name is Celine, and I will be your conference operator today. At this time, I would like to welcome everyone to the Karat Packaging Second Quarter 2024 Conference Call. [Operator Instructions]

I would now like to turn the call over to Roger Pondel, Investor Relations. Please go ahead.

[Roger Pondel]

Thank you, operator, and good afternoon, everyone, and welcome to Karat Packaging's 2024 Second Quarter 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 this 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, copies of which are available on the SEC's website at www.sec.gov, along with other company filings made with the SEC from time to time. Actual results could differ materially from these forward-looking statements and Karat Packaging undertakes no obligation to update any forward-looking statements except as required by law.

Please also note that during this call, we 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, I will turn the call over to CEO, Alan Yu. Alan?

[Alan Yu, executive]

Thank you, Roger. Good afternoon, everyone. Net sales for our 2024 second quarter grew 3.5% over the prior year period and sales volume grew 3.2%. Our business pipeline continues to expand with the signing of new national and regional chain accounts. However, initiation of some new orders is taking longer than anticipated during the quarter, mainly due to administrative setup procedures at the larger chain account and software demand in certain categories, which we do not expect to recur in the back end of the year.

We are pleased to see that gross margin held steady in the second quarter at 38.5%, despite pressure from significantly higher ocean freight costs that started in mid-May. Ocean freight rates spiked at that time when increased tariffs for certain imports goods were announced initially to take effect August 1st, resulting in part to higher demand and lower capacity. Freight rates moderated somewhat in late July, which enabled us to ship more product with contracted ocean freight rates that were locked in earlier this year. We expect freight rates to start to normalize after demand softened subsequent to the tariff effective dates.

With better visibility into ocean freight rates, reduced vendor pricing, and continued strength of the U.S. dollar, we expect to be able to meet our full-year goal for gross margin. Our strategic initiative from last year to establish warehouses in new geographic markets and in large existing warehouses is yielding positive results and is contributing to business growth across most of our sales channels, especially for our online sales. Sales for this category, which typically carries the highest margin and included a positive impact from the inclusion of online platform fees of $2.7 million in the second quarter of 2024, grew 26% in the second quarter.

Sales of our eco-friendly products represented approximately 32.3% of total sales in the second quarter, essentially the same percentage as last year. Eco-friendly product remains a priority for Karat. We believe that there will be an increased demand for eco-friendly and compostable single-use disposable products and this should have a positive long-lasting impact on our results. We saw that the growth in eco-friendly products significantly outpaced the overall growth in July.

Sales for manufactured products in the second quarter were 11% of total net sales compared with approximately 20% last year, in keeping with our asset life strategy in the U.S. and emphasis on imported items. From the inventory pipeline perspective, we are positioned to support an even stronger second half of the year in 2024 compared to 2023. Our preliminary sales in July were up by more than 10% year-over-year, and we expect the robust year-over-year performance to continue into the end of this year. Further, we are continuing to exploring strategic acquisition opportunities to further penetrate the marketplace. Lastly, on August 6th, our Board of Directors authorized a regular quarterly cash dividend, payment of $0.35 per share, and a special dividend of $0.15 per share.

I will now turn this call over to Jian Guo, our Chief Financial Officer, to discuss the company's financial results in greater detail. Jian?

[Jian Guo, executive]

Thank you, Alan. Net sales for the 2024 second quarter were $112.6 million, up 3.5% from $108.7 million for the same quarter last year. As Alan mentioned earlier, our sales volume grew 3.2% compared to the 2023 second quarter. Net sales also included the favorable impact of the inclusion of online platform fees of $2.7 million and the unfavorable year-over-year pricing comparison. By channel, compared with a year ago, online sales for the 2024 second quarter were up 26.2%, benefiting in part from the inclusion of online platform fees discussed earlier. Sales to national and regional chains were up about 0.9%, sales to the retail channel increased 1.1%, and sales to distributors was slightly lower. The distributor channel remains challenging with the pricing environment still very competitive.

Cost of goods sold for the 2024 second quarter was $69.2 million compared with $66.9 million in the prior year quarter. The increase was primarily due to increased freight and duty costs and inventory reserve adjustment and the inclusion of certain production costs in cost of goods sold. These increases were partially offset as the prior-year quarter included write-offs of certain expired products and raw materials related to the disposal of certain machinery and equipment in executing the plan to scale back production in certain locations.

Gross profit for the 2024 second quarter was $43.4 million versus $41.9 million in last year. Gross margin was 38.5%, same as the prior year quarter. Gross margin for the 2024 second quarter was impacted by higher inventory reserve adjustment and an increase in freight and duty costs, which as a percentage of net sales increased to 8.6% from 6.2% in the prior year quarter.

At the same time, gross margin for the 2024 second quarter benefited from the adjustments to net sales related to online platform fees and cost of goods sold related to production expenses as discussed earlier. And lower vendor pricing and increased import as a percentage of total product mix, resulting in a decrease in product costs as a percentage of net sales. Gross margin in the 2023 second quarter included a negative impact of 160 basis points from the write-off of certain raw materials as we executed the plan to scale back production in certain locations, which we discussed earlier.

Operating expenses in the 2024 second quarter were $32.3 million, or 28.7% of net sales, compared with $28.5 million, or 26.2% of net sales in the prior-year quarter. Operating expenses in the current quarter included online sales, platform fees, higher rent and warehouse expense, and increase in marketing expense for online sales, and higher stock-based compensation expenses. Such increases were partially offset by a decrease in impairment expense and loss on disposal of machinery, as the 2023 second quarter included $2.5 million of impairment expense and loss on disposal of machinery, primarily due to executing the plan to scale back production in certain locations.

Net income for the 2024 second quarter was $9.2 million compared with $10.7 million in the prior year quarter. Net income margin was 8.2% in the 2024 second quarter compared with 9.8% in the prior year quarter. Net income attributable to Karat for the 2024 second quarter was $9.1 million, or $0.45 per diluted share, compared with $10.5 million, or $0.53 per diluted share last year.

Adjusted EBITDA, a non-GAAP measure in the 2024 second quarter was $15.7 million versus $21.1 million in the prior year. Adjusted EBITDA margin was 13.9% in the 2024 second quarter versus 19.4% in the prior year quarter.

Adjusted diluted earnings per common share was $0.49 per share in the 2024 second quarter, compared with $0.69 per share a year ago.

The second quarter ended with $114.2 million in working capital compared with $110.5 million at the end of 2023. As of June 30, 2024, we have financial liquidity of $55.5 million with another $32.7 million in short-term investments.

We expect net sales for the 2024 third quarter to increase by mid- to high-single digits over the prior-year quarter. Our gross margin goal for the 2024 third quarter is approximately 38% to 39%. For the full 2024 year, we expect net sales to grow mid-single digits and gross margin to be in the range of 38% to 40%.

Alan and I will now be happy to answer your questions and I'll turn the call back to the operator.

[Operator]

[Operator Instructions] Your first question comes from the line of Ryan Merkel with William Blair.

[Ryan Merkel, analyst]

Great. First off, Alan, why is the change in sales growth lower for '24? Is the big issue the new business taking longer? Or are there also macro pressures with maybe restaurant traffic also weighing on the change there?

[Alan Yu, executive]

What are we referring to? Because to what my understanding is that our sales for 2024 is actually going to be higher than 2023. And we have been considering -- continuously reiterating overall growth of 7% to 15% total. That's where we're seeing. And if we were having a merger and acquisition, it would be a 15%, approximate higher range of the estimate. Without the acquisition, it will be at the lower range of the estimate. So I don't believe that. Jian, can you -- do we change our sales guidance lower?

[Jian Guo, executive]

So the sales guidance for the full year of 2024, for right now, we are expecting mid- to high-single digit for the third quarter for 2024. On the full-year basis, we're expecting mid-single digit from the prior year.

[Ryan Merkel, analyst]

Yes. And Alan, you cut out when you started answering the question. I thought the prior guide, correct me if I'm wrong, I thought it was up 8% to 15%. I think that included M&A. So you're going from 8% to 15% for the full year '24 to now mid-single digits. That's kind of a big change. Yes.

[Alan Yu, executive]

Correct. Well, I believe that like Jian mentioned earlier, we were expecting some of the chain accounts to hit it earlier versus later. So right now, we're still pushing for the chain to move faster in terms of converting into our product. But right now at this time, I believe Jian is -- we're being very conservative in terms of making sure that we can meet our guidance on that part.

[Ryan Merkel, analyst]

Got it. Okay. And then, Alan, you mentioned July was stronger and I think you mentioned you thought that would continue. Can you just reiterate those comments? Was that a total business comment? Or is that specific to online or eco-friendly? I'm sorry, I just missed it.

[Alan Yu, executive]

Yes. July, I believe we're seeing double-digit growth in revenue-wise. So year-over-year comparison comp. And it's not -- basically, all segments we're seeing chain accounts are hitting at latter part of July. Our bubble tea supply is growing. Our online is actually going very strong. And online is basically, we're seeing a -- I believe, Jian, we mentioned about this quarter was 17% year-over-year growth online. And last quarter, I mentioned that our goal for this year was $70 million online revenue. Right now, I'm actually pushing for $80 million revenue goal.

So our second part of the 2024, we're seeing a strong push in the online, and how we're about to do that is we added additional staffing into putting more items into Amazon FBA and also changing -- adding a new feature on our Shopify, our LollicupStore.com that customer can buy volume and get volume discount on that part. So we foresee that. Basically, our online sale is very likely to be over 20% year-over-year growth. So up from $70 million initially, we projected to almost $80 million. That is our goal for online sales by the end of this year.

[Ryan Merkel, analyst]

Got it. Okay. That's very encouraging.

[Operator]

And your next question comes from the line of Jake Bartlett with Truist.

[Jake Bartlett, analyst]

Great. My first was just a follow-up on the last comment. Alan, you mentioned, July being up 10%, but the guidance for the quarter is mid- to high-single digits, so implying a deceleration. Is that just being conservative? Or is there something coming down the pike in the next 2 months that you think would be decreasing the sales growth from the July level?

[Alan Yu, executive]

We're trying to be conservative, basically. But like I said, the business is overall is very encouraging. We see the business growing, and we want to make sure that we're able to hit that number, that's one other thing.

[Jake Bartlett, analyst]

Okay. And in the second quarter, you missed your guidance. You mentioned kind of onboarding these new accounts, taking a little longer than expected. But to what extent is the weak pricing or just the pricing environment that was mentioned in the press release, I think on your prepared remarks as well. But how confident are you in the pricing that pricing will sustain? Or is there a risk that the prices will continue to decline given the competitive environment?

[Alan Yu, executive]

Well, we see the pricing stabilizing, and also we have been very competitive in terms of ensuring that we're continuing to move forward in the market -- taking market shares and ensuring that we don't lose any clients. All of our clients are looking for savings regardless of new clients, old clients -- existing clients. So that's what we've been doing in terms of doing that and how we'll be able to pass on saving to our client is basically on several items is one of the strong dollar, it's helping that as well as we have been negotiating with our vendors to also get more support from them to lower their cost. But of course, the ocean freight in the second quarter really increased quite a bit in terms of the situation with the ocean freight, the shortage of containers, that's actually raising the prices. But even with that, we're still able to meet our gross margin goal with that high increase in ocean freight.

[Jake Bartlett, analyst]

Got it. And Alan, could you just -- this is -- for those of us who aren't as close to how the ocean freight rates work and all the dynamics there. On the last call, you mentioned that you had contracted, you had rates locked through April of 2025. So I guess, I'm struggling to understand how the current rate environment impacts you if you're contracted through April of '25. Just help us understand the dynamics there and what makes you go on and off contract? And in the context then, how confident are you in the freight rates for the remainder of the year?

[Alan Yu, executive]

Well, we signed just like most companies did in the -- back in the end of April, our contracted rate -- a certain contracted rate. And because the situation was a shortage, the ocean freight liner added a peak season surcharge. And that's a rate that can add $500 to $800, and they elected to add $1,000 each container that we ship. At the same time because the ocean freightliner, they knew that there is a higher demand in the containers and they reduced their shipping -- ship to the U.S. So they were able to raise the rate in the -- spot rate in the market.

What they've done is even though we have a contracted rate, they're not giving us exactly the container numbers that we needed to ship our product. So if we wanted to get additional container, we have to go out of our rates -- contracted rate with freight forwarder like other people, if they didn't sign the contract. And that rate skyrocketed to $8,000 containers and $10,000 containers to New York, which is almost triple the amount of -- like quadruple the amount of money that we had originally signed the contract with.

Unfortunately, we were able to -- we only needed to use 10% of our containers with out of the contract rate versus some of our competitors or other smaller importers that didn't sign -- elect to sign the contract rate would have to ship more product. They have to go out and find containers at the rate of anywhere from $6,500 to $10,000 a container, almost near the price that they were paying during the pandemic.

[Jake Bartlett, analyst]

Okay. And last question, Alan. In an environment or in the eventuality, the possibility that whatever happens with this Presidential election, there is the possibility of a broad kind of tariff being implemented. Can you just speak to that risk for Karat, what mitigating factors there might be? And what kind of maybe contingency measures you're taking for that potentiality?

[Alan Yu, executive]

Sure. We've noticed that U.S. has been implementing tariffs on different items and not just a regular tariff, but additional tariff, anti-dumping tariff on different categories starting July, August, and October, and December. So what we've done is we've been finding different vendors like we had before moving from our purchase from China into Malaysia, Vietnam, and other part of the Asia world. And that's something that we've been doing in the past years. So our purchase reliance on shipment from China has reduced even more.

And with the additional tariff on aluminum, that's not going to be just us, it meet everyone in the U.S., even the manufacturer, not only the importer, manufacturer that need the raw material are getting from China are going to get hit with a really high tariff, as much as 55% to 100% increase in tariffs. So everyone have to look for alternatives. And definitely not everyone can bring the factory immediately back to U.S. for production. But even domestic manufacturers have announced increase in prices. So we're also working on that and looking for additional new vendors. We've done so. We're working on testing on the quality and everything to ensure that they will have the same match of the item SKU that we have right now. So that's what we've done right now to mitigate.

In the case that a new President comes in and all of a sudden start raising tariffs of every country in Asia and also Europe and Mexico partner country, I think that's going to be an issue that everyone has to deal with. It will be a broad price increase among the categories that basically being increased on tariffs. So it wouldn't just be us, it would be just like everybody. And that -- with that said, everyone has to raise their price at that time.

[Operator]

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

[Ryan Meyers, analyst]

The first one for me is, Alan, I was wondering if you could just comment on maybe what you're seeing across some of your food service customers? Are you seeing any softness there? Or is there any kind of issues in overall traffic levels? Just so we get a good understanding of the overall kind of demand at food service environment and what that looks like?

[Alan Yu, executive]

Sure. We're getting increasing orders from chain accounts, definitely -- especially chain account that is doing well. Very fortunate for us. And that many of the chain accounts are actually doing well and some chains are not doing as well. Fortunately, we have not -- most of our customers are the better part of it.

In the distribution side, we're seeing softness in distribution side, especially in California. California restaurant environment is really not doing well, especially mom and pop shops. They're closing. If not, they're about to close. But that national chain accounts, especially fast-casual chains, surprisingly they're doing better than the fast food chain. That's what we're seeing.

[Ryan Meyers, analyst]

And then it sounds like the original guidance range that you guys had given, the 8% to 15% at the high end there accounts for an acquisition. So maybe can you just kind of comment on how we should maybe be thinking about that for the rest of this year and maybe what you're seeing in the M&A environment?

[Alan Yu, executive]

Well, we're still in discussion with different partners and see what we can do in terms of merger and acquisition. And even as we speak right now, we have some potential partners that we're working with right now on that part. Even potentially partnering bring additional manufacturing into Texas, because of like a previous question that brought up about the tariff. There are certain item categories that we're seeing a high tariff. And actually, I'm looking to discuss with some of the overseas partners to bring their manufacturing capability into U.S., domestic U.S., so that we can do a joint venture in terms of producing items that basically it's being hit with the tariff. So basically, we can increase sales and also revenue by bringing the manufacturing back to the U.S. That's one thing that we're doing right now.

On the revenue side, I mean, we're also discussing with -- partnering with a company or buying shares of a company that would enable us to tap into supermarket industry, different segments, adding SKUs. Our goal is basically increase our revenue by adding additional SKU, as well as increasing our wallet share of customers.

[Ryan Meyers, analyst]

Okay. Got it. That's helpful.

[Operator]

Your next question comes from the line of Brian Butler with Stifel.

[Brian Butler, analyst]

Just, I guess, back on kind of the inferred guidance for the back half of '24. When you think of the mid-single digit growth for the full year and mid- to high-single digits for third quarter. So does that suggest fourth quarter is going to be -- or you're expecting fourth quarter to be very strong, almost mid-teens for growth? Am I thinking about that progression from quarter-to-quarter correctly for the back half?

[Alan Yu, executive]

We're thinking of double-digit growth for the fourth quarter. That is correct.

[Brian Butler, analyst]

Okay. And then when...

[Alan Yu, executive]

Again, in the past, we have been seeing our company double-digit growth. I think we're happy that we're seeing that we're back to the trajectory that starting the third quarter, we're having a strong quarter in third quarter and even a stronger quarter in the fourth quarter.

[Brian Butler, analyst]

And is that benefiting from some of the -- some larger client, the national account signing, finally, kind of getting through the administrative process? And how does that roll into -- how should we think about that rolling into '25?

[Alan Yu, executive]

Yes, that is actually true. Some of the large chain accounts that we were expecting for the third quarter is actually going to roll into the end of the third quarter and into fourth quarter. And that's where we see a segment that we're seeing the growth. It's adding additional national chain accounts. And some of these chain accounts actually switching a different type of product from Styrofoam into plastic, into papers and other things, compostable items. And that's something that we're seeing that right now. And are we going to see a stronger 2025? Definitely, we're going to see a stronger 2025 with an increase in online sales. Additional increase in online sales, that's already starting in third quarter and moving to fourth quarter in 2025.

[Brian Butler, analyst]

Okay. And then thinking about the EBITDA and the kind of the margin compression that we saw in the second quarter, I mean, we were down about 550 basis points. Do you have a bridge between last year and this year, kind of the puts and takes, what's behind that 550 basis point compression?

[Alan Yu, executive]

That I will ask -- Jian Guo would answer that question.

[Jian Guo, executive]

Yes. So if you look at, Brian, if you're looking at the bridge between last year's adjusted EBITDA margin to this year's adjusted EBITDA margin, the biggest gap there is the operating expense. As we talked about earlier, our growth margin remained consistent between the quarters. So really the biggest gap is the operating expense section. Some of the items that we talked about in the prepared remarks in terms of the fixed operating expenses. And then there are also certain categories, certain investments that we're making, for example, the marketing expenses to support our online sales growth. Those are the examples -- some of the examples of the increases in operating expense that would account for the majority of the variance year-over-year.

[Brian Butler, analyst]

And is that showing up in the selling expense because selling expense was up like 56% year-over-year in the second quarter. Is that those things -- is that what you're talking about?

[Jian Guo, executive]

The selling expense, I mean, you are right, that's a great comment. Although I do want to highlight, if you are only looking at the selling expense -- if you're looking at the selling expense line item, there is a little bit of a apple-to-orange comparison in the sense that there was an adjustment of the online platform fee, which Alan mentioned earlier that this year it's being included in this quarter -- well, I should say starting Q4 2023, we're including in selling expense versus previously it was reported as offset against sales. So that's a fairly significant increase in the selling expense that's sort of from an accounting adjustment that we discussed earlier as well.

[Brian Butler, analyst]

Okay. And then on the freight costs, so how should we -- how does that freight cost look in the third quarter and the fourth quarter? Can you provide some maybe, I guess, that trend in the back half as a percent maybe of revenues?

[Alan Yu, executive]

Sure. As I mentioned earlier that the second quarter we're seeing a significant increase in ocean freight due to peak season surcharge, as well as if we were to contract out, out of our contract to getting a container from freight forwarder, 10% of that, that really increased our ocean freight. We have seen the ocean freight prices come down starting July and even more in August. The non-contract rate was as high as $8,000 to California West Coast and $10,000 to East Coast. Now it's down below $5,000. And fortunately, now we're really not using any containers out of our contract rate starting August.

So in July, we were still taking some containers that we needed to without the contract rate, so that we don't run out of product on our customers. But in August, we have stopped taking any non-contracted containers. So that's a good thing. Even though we're paying for the peak season surcharge, but we're not paying for the extra above the peak season surcharge, the $6,000, $7,000 container rate. And this is due to the fact that containers basically have become more available, less people are shipping products, because there was a tariff that was hitting the U.S. and Europe in August 1st, and those companies that needed to ship electric vehicles into Europe, basically they stopped shipping that. So basically there is more containers available for the U.S. customers right now. And the fourth quarter we're seeing that the ocean freight liners should be removing the peak season surcharge that we can go back to the original contracted rate. So the ocean freight will come down even more during the fourth quarter of this year.

[Brian Butler, analyst]

Okay. And then...

[Jian Guo, executive]

So, Brian, just a little more color -- just a little more color there just to get a line on the model. So overall, in terms of net sales, we are expecting ocean freight for the second half of the year to range between 8% to 10% of net sales. Everything Alan talked about, right, just in terms of the ocean freight, the trend, obviously, I think that's a great sort of insight into what we're expecting just in terms of modeling out the second half of the year. I do wanted to just as a reminder, we typically do see about roughly 2 months lag in terms of the real-time rate and how it's getting recorded on the financials just because of inventory turn.

So that said, the spike in the second -- in the late part of the second quarter, we will see primarily that impact getting reflected on the financials in the first half of the third quarter. And as we start, obviously, seeing improvements in ocean rate will get that benefit in the second half of the third quarter as well as the fourth quarter.

[Brian Butler, analyst]

Right. And to be clear, that's built into your 38% to 40% gross margin kind of forecast for the full year.

[Jian Guo, executive]

Correct.

[Brian Butler, analyst]

Right. And if you think about going down to the EBITDA line, are you -- that 38% to 40% would suggest some margin improvement year-over-year on the gross margin. But on the EBITDA line, it seems like we're going to probably see some compression because of the higher cost on operating in those fixed costs and selling. Is that a fair way to look at EBITDA and gross profit for the full year?

[Jian Guo, executive]

On the full-year basis, I think we previously communicated our long-term goal for our adjusted EBITDA margin is to be the high -- mid-teen. And I think we're still on track to meet that goal for full-year 2024.

[Brian Butler, analyst]

Mid-teens. Okay. And then one last one on maybe an update. You had talked in the past about expanding some of the distribution product lines kind of beyond the packaging pieces. Do you have an update on that and maybe where you stand and if that strategy is continuing to be pressed forward?

[Alan Yu, executive]

Yes, we're actually looking to the food segment -- frozen food segment. So we're adding refrigerated truck, we're adding refrigerated containers, and we're also looking to build a cold storage containers warehouse in the state of Texas. So that's what 2025 goal in terms of what other items we can sell. There might be frozen food, frozen dumpling, and other things that we might be able to distribute and also possibly manufacturing domestically.

[Brian Butler, analyst]

Do you have an estimate on the capital requirements for that?

[Alan Yu, executive]

Right now, we don't know how much capital requirements going to be. We have not estimated that yet.

[Operator]

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

[Alan Yu, executive]

Thank you, operator, and thanks to all of you for joining us today. We appreciate your continuing support. We remain confident about Karat's future and we look forward to keeping you up appraised of our progress. Have a great evening, everyone. Goodbye.

[Operator]

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