Karat Packaging Inc

NASDAQ:KRT

Earnings Call Analysis

Karat Packaging Reports Solid Q3 Growth and Positive Q4 Expectations

In the third quarter of 2024, Karat Packaging achieved a 6.9% increase in net sales to $112.8 million, driven by a 33% rise in online sales. The gross margin improved to 38.6%, and net income grew to $9.3 million. Looking forward, the company anticipates mid to high single-digit revenue growth for Q4, with gross margins expected between 39% to 40%. A focus on eco-friendly products and new supermarket partnerships are set to bolster future growth, with expectations of 20% volume growth in Q4, highlighting a strong recovery trajectory.

Strong Revenue Growth Amid Challenges

In the third quarter of 2024, Karat Packaging reported a notable revenue increase, with net sales reaching $112.8 million, up 6.9% from the previous year’s $105.5 million. This growth is attributed to a nearly 10% rise in sales volume, although faced with pricing pressures that had a negative impact of approximately $5.7 million on year-over-year comparisons. The company benefited from the inclusion of $3 million in online platform fees, emphasizing a strategic pivot towards online sales which saw a significant growth of 32.8% compared to the prior year.

Diverse Channels and Product Expansion

Karat's growth was not uniform across all sales channels. Online sales were a standout with a remarkable growth rate, while retail and distributor channels also saw increases of 9.2% and 3.3%, respectively. However, revenue from national and regional chains remained flat, reflecting challenges in that segment. Nevertheless, the recent initiation of shipments to major grocery chains, particularly in the bakery packaging space, signifies an important shift that could enhance revenues in the future.

Optimistic Guidance and Margins

Looking ahead, Karat expects fourth-quarter sales to increase at a mid to high-single-digit percentage rate year-over-year. The company's guidance is cautious, noting that quarter-over-quarter, the prior year’s substantial sales figures included a $6 million accounting adjustment, making comparisons complex. For Q4 2024, Karat aims for gross margins of 39% to 40%, building on the improvement seen in Q3 where the gross margin increased to 38.6%, up 170 basis points from last year.

Commitment to Shareholder Returns

The Board of Directors has approved an increase in the quarterly dividend to $0.40 per share, a step highlighting the company's balanced approach to capital allocation between returning value to shareholders and investing in long-term growth. In 2024, Karat has returned approximately $23 million in dividends, reinforcing its commitment to shareholder value amid ongoing operational investments.

Operational Strategies and Challenges

Karat is focusing on optimizing its inventory sourcing and enhancing warehouse capabilities, in addition to controlling expenses across various operations. As ocean freight costs stabilize and vendor pricing declines, the firm anticipates improved margins. Notably, the company is investigating a new distribution center to support growth, reflecting a proactive approach to logistics amid rising demand.

Sustainable Future with Eco-friendly Initiatives

Karat's investments in eco-friendly products are starting to gain traction, with these items now comprising 33.4% of total sales, experiencing a 9% year-over-year increase. The company plans to launch a new line of rPET cups and lids by the end of Q4, catering to a growing market for compostable materials. This aligns with long-term sustainability goals and addresses increasing consumer demand.

Encouraging Long-term Growth Outlook

Despite the challenges faced in the national and regional chain segment and pricing pressures, Karat remains optimistic about achieving double-digit growth in revenue moving forward. The company's focus on online sales and new distribution channels positions it well for future success, especially considering the strong momentum towards e-commerce and sustainable products.

Earnings Call Transcript 2024-Q3

[Operator]

Hello, and thank you for standing by. At this time, I'd like to welcome everyone to the Karat Packaging, Inc. Third Quarter 2024 Earnings Conference Call. [Operator Instructions] As a reminder, this call is being recorded.

I will now turn the conference over to Roger Pondel. Please go ahead, sir.

[Roger Pondel]

Thank you, operator. Good afternoon, everyone, and welcome to Karat Packaging's 2024 Third 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 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 directly comparable GAAP measures to the non-GAAP financial measures is included in today's press release, which is now posted on the company's website.

And with that, it is my pleasure to turn the call over to CEO, Alan Yu. Alan?

[Alan Yu, executive]

Thank you, Roger. Good afternoon, everyone. We are encouraged by our third quarter performance with net sales up nearly 7% and volume up approximately 10%. Despite some pricing pressure, we experienced growth in most of our sales channels. Our online business, which benefited from the inclusion of $3 million online platform fees in the current quarter, achieved a 33% increase over the prior year period. Karat's recent expansion into the supermarket chain category is starting to generate positive results.

After successful product sampling and trial orders, we began shipping customized bakery packaging containers for a major grocery chain customer in late September, followed by the initiation of shipments on utensils to another major grocery chain in mid-October. We are now developing additional product offering and intensifying our sales efforts in this sector.

Sales of our eco-friendly products increased 9% year-over-year and now represented 33.4% of total sales in the third quarter. We believe demand for eco-friendly and compostable single-use disposable product will continue to increase and will contribute positively in the long term.

We are focusing on new eco-friendly product development to further enhance our competitive edge. By the end of fourth quarter, we expect to launch a new line of rPET cup and lids to meet the rising demand that we're seeing in the marketplace. This new line of rPET product is made with more than 25% recycled PET material.

Geographically, we continue to experience strong growth in the Midwest, Northwest and East Coast compared with last year. Additionally, we see sales stabilizing in California, which is our biggest market, following a sharp decline in the past few quarters.

At the gross margin level, we achieved gross margin of 38.6% in the third quarter versus 36.9% in the prior year period despite the impact from high ocean freight rate in the first half of the quarter. Heading into the fourth quarter, we are encouraged by the positive momentum and our focus on optimizing inventory sourcing and management, controlling expenses and enhancing warehouse capabilities.

From an inventory perspective, we implemented procedure to optimize sourcing and inventory management. Even with reduced domestic production and increased sales, we expect to be able to reduce inventory import volume in the fourth quarter of 2024 compared to the prior year. Additionally, with decreased ocean freight rate and reduced vendor pricing in certain categories, we expect fourth quarter margin to remain at a higher level.

Additionally, we recently implemented measures to further reduce labor and certain other operating costs, and we expect such measures to yield benefit in the fourth quarter. We are also actively looking for a new distribution center in the Southeast region to support anticipated business growth.

With Karat's strong operating cash flow as well as the company liquidity, solid balance sheet and positive long-term outlook, our Board of Directors again approved an increase in the quarterly cash dividend payment to $0.40 per share on November 5 from $0.35 per share in the preceding quarter.

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

[Jian Guo, executive]

Thank you, Alan. Net sales for the 2024 third quarter were $112.8 million, up 6.9% from $105.5 million for the same quarter last year. As Alan mentioned, our sales volume grew nearly 10% compared with the 2023 third quarter. Net sales also included a favorable impact from inclusion of $3 million in online platform fees, partially offset by a $5.7 million unfavorable year-over-year pricing comparison.

By channel, compared with a year ago, online sales for the 2024 third quarter were up 32.8%, benefiting in part from the inclusion of online platform fees mentioned earlier. Retail and distributor channel sales increased 9.2% and 3.3% respectively from the prior year quarter as our investments in sales force started to come to fruition.

Sales to national and regional chains were essentially flat. Cost of goods sold for the 2024 third quarter was $69.3 million compared with $66.6 million in the prior year quarter. The increase was primarily due to higher ocean freight and duty costs driven by elevated ocean freight rate, primarily in the first half of the quarter, coupled with increased import volume, along with the inclusion of production expenses related to machinery repair and maintenance.

Gross profit for the 2024 third quarter increased 11.7% to $43.5 million from $38.9 million last year. Gross margin for the 2024 third quarter increased 170 basis points to 38.6%, which included a net benefit contribution of 110 basis points from adjustments to net sales related to online platform fees and production expenses in cost of goods sold as discussed earlier. Gross margin also benefited from lower vendor pricing and increased imports as a percentage of total product mix, partially offset by higher ocean freight costs.

Operating expenses in the 2024 third quarter were $32.2 million compared with $27.6 million in the prior year quarter. Operating expenses in the current quarter included online sales platform fees, higher rent and warehouse expense, increased shipping and transportation costs, and higher online marketing expense. Such increases were partially offset by the inclusion of production expense in cost of goods sold, as discussed earlier, and a decrease in professional expenses due to transaction costs in connection with the secondary offering during the 2023 third quarter.

Net income for the 2024 third quarter increased to 1.3% to $9.3 million from $9.1 million for the prior year quarter. Net income margin was 8.2% in the 2024 third quarter compared with 8.7% a year ago. Net income attributable to Karat for both the 2024 and 2023 third quarters was $9.1 million or $0.45 per diluted share.

Adjusted EBITDA was $14.7 million for the 2024 third quarter compared with $15.2 million for the prior year quarter. Adjusted EBITDA margin was 13.0% for the 2024 third quarter versus 14.4% in the prior year quarter. Adjusted diluted earnings per common share was $0.47 for both the 2024 and 2023 third quarters.

We generated operating cash flows of $19.5 million in the third quarter and ended the quarter with $115.6 million in working capital compared with $110.5 million at the end of 2023. As of September 30, 2024, we had financial liquidity of $75.1 million with another $21.5 million in short-term investments.

As Alan mentioned earlier, our Board of Directors just approved another increase of our quarterly dividend to $0.40 per share. This is on top of the $23 million we returned to shareholders in the current year in regular and special dividends. We remain committed to a balanced capital allocation strategy between shareholder return and long-term growth investments.

We expect net sales for the 2024 fourth quarter to increase by mid to high single digit over the prior year quarter. Our gross margin goal for the 2024 fourth quarter is approximately 39% to 40%. We are also reaffirming our full year 2024 guidance today.

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

[Operator]

[Operator Instructions] And your first question comes from the line of Ryan Meyers with Lake Street Capital Markets.

[Ryan Meyers, analyst]

Jian, I just wanted to follow up and get a good understanding of what you said in regard to the guidance. So thinking about the Q4 guide, you guys called out an increase in sales of mid to high single-digit percent. But if I believe back to last quarter, sort of the implied Q4 number with the full year guidance, I think, was looking for a double-digit growth rate. Just want to make sure I understand that correctly. If there's anything that I'm missing, it would be kind of helpful to walk through that.

[Jian Guo, executive]

Yes. So Ryan, thank you for the question. Yes, that's correct. So at this point, we do expect the fourth quarter sales growth to be mid to high single digit. We are also reaffirming our full year guidance, as we mentioned in the prepared remarks.

I do also want to call out, if you recall, Ryan, last Q4 2023 last year, our Q4 net sales amount actually included an accounting misclassification adjustment of a full year amount of a little over $6 million. So that was a benefit to Q4 2023. So that's going to cause a little bit of apple-to-orange comparison in this year. But with that impact, we are still expecting to see mid to high single digit year-over-year growth in Q4.

[Ryan Meyers, analyst]

Okay. Got it. That makes sense. And then just thinking about the national and regional chain segment, it looks like revenue was flat sort of year-over-year. Is most of that pricing? Or is there anything else kind of to call out there? It looks like volume across the business is pretty strong, but just to get an understanding of kind of that segment itself would be helpful.

[Jian Guo, executive]

You're talking about the chain segment?

[Ryan Meyers, analyst]

Yes, correct. Because I know over the past handful of quarters, you guys have obviously made some emphasis of rolling out into new regional chains, whether it's with salespeople or additional products, but just kind of get a good feel for that line item.

[Jian Guo, executive]

Yes, sure. I can start. I'm sure Alan can additional detail there. So for some of the chain accounts, I mean that is right what you said, Ryan, as far as the pricing adjustments. We wanted to make sure that we remain competitive in our value propositions with our customers. So we did have some price adjustment in the past quarter.

I also wanted to point out, as we mentioned in our prepared remarks, we started shipping in some of the -- for a major supermarket chain customer, we started shipping to this particular customer in the very last week of September, which was a little later than what we previously anticipated. However, we are at a full annualized volume with this particular customer now, and we do expect to get a benefit in the fourth quarter in the chain segment.

Alan, anything else you want to add?

[Alan Yu, executive]

Sure. First of all, Ryan, to your first earlier question about the double-digit growth that we expected, if you look at the -- as Jian mentioned that if you were to take out the $6 million from last year fourth quarter, our revenue would have been $89 million total. But we added $6 million, so it is $95 million. Now if we were to take out the $6 million with $89 million compared to what we're guiding right now, it's a little bit over 14%, which is double-digit growth year-over-year. And that's what Jian said, if we were to compare apple-to-apple, our real growth will be double digit in 14%.

Now in terms of what Jian just mentioned to you in terms of additional national chain account, yes, we just started the supermarket chain accounts, which is very -- it's a very recognizable reputable company in Texas as well as another national supermarket chain that we're focusing and we started shipping. Of course, there are other national chain that we're working on that we are hopeful that we'll start shipping in the fourth quarter, maybe later of the fourth quarter of this year or earlier first quarters. That is our goal.

And in terms of additional growth that we're seeing is online sales, we're seeing strong online sales. As I mentioned earlier in our conference call, we're already seeing a 33% growth year-over-year, which -- in the fourth quarter, which we will rely heavily on online sales because we're going to be promoting more marketing towards that. In the third quarter, we actually invested a lot more in terms of online marketing advertisement, which will come to fruition in the fourth quarter.

[Ryan Meyers, analyst]

Okay. Got it. That makes sense. Yes, the commentary on the guidance and that $6 million impact from last year is helpful and kind of gets us in a good spot.

[Operator]

Next question comes from the line of Jake Bartlett with Truist Securities.

[Jake Bartlett, analyst]

My first one is just on the supermarket opportunity. Alan, you mentioned this new account that you've -- or 2 new accounts you've brought on. My question is how big an opportunity this is? You're obviously focusing on it on the press release and the call today. But how much of an opportunity really is it for Karat maybe in the near and also the long term? And then also what makes Karat well suited for this business? It seems to be a business you hadn't pursued in the past or maybe you hadn't -- just hadn't had success with it. But what makes this a good business for Karat to be getting into at this point?

[Alan Yu, executive]

Well, with the initial number and forecast projected by the customers, our initial annualized revenue will be around $5 million or a little bit over $5 million to $6 million. And we are currently working on additional projects with the same accounts that should bring us to an annualized revenue of $15 million for this just one account. And also for another supermarket chain, it's about around $0.5 million to $1 million to start with, and it can grow even larger.

What is special about the going after the supermarket chain is that we realized supermarkets have -- they have less SKUs and they use higher volume. And this is more catering towards the bakery product section. I mean in our past, our focus would have been in the cup business, in the restaurant business, in the drinking business. But now our focus is going to the bakery business. So it's from the supermarket, we're also wanting to get into the deli business. There's a lot of paper opportunities in the delis and supermarket and bakeries, like the paper containers, the paper bags. So these are the things that we really want to move -- shift into a business that we haven't been focused in the past.

In the past, it's always the hot cup, the cold cup, the paper cold cup, the PET cup, the portion cup. Now as we shift into this business, we see that the opportunities are much greater and the potential is a lot higher than what we have been doing -- selling in the past with the cup business.

[Jake Bartlett, analyst]

Okay. Great. And on the eco-friendly side, nice to see the continued growth there. I'm trying to understand what the implications are for the new product or products that you're going to be launching in the fourth quarter. How big a deal is that? How much could that be adding to the eco-friendly product growth in '25 and beyond?

[Alan Yu, executive]

Well, we're actually starting to add the corrugated box takeout container business. If you were to go out into bakery stores and some of these chains, they're trying to switch away from the plastic takeout container into the corrugated board box and as well as the bakeries. They have -- you can see all these little corrugated boxes, bakery container, paper containers with the plastic openings. Before it was all plastic or Styrofoam.

Paper bag, SOS bag, those are the things that we want to get into. And there's different sizes of SOS bag. It's not just the shopping bag we're looking to. The rPET business is that we've been asked by a lot of our -- some of our chains that they want us to reduce the use of virgin material, how can we utilize the use of the recycled material so that it's -- we use less plastic as well as more recycled material.

In Europe, basically, they ban all plastic except if you were to mix with 25% or more of the recycled content material. So this is more of a future, just how we started the PLA cup business back in 2007. If we have to -- if companies still have to use plastic, which is more functionable, they want us to -- at least they want the company to start using less virgin material and more recycled content material. That's part of that. As far as the corrugated box business, it's not just for the packaging, it's now for the food container takeout as well.

[Jake Bartlett, analyst]

Okay. And then my last question, maybe I'll jump back in with another later. But is the gross margins -- obviously, the gross margins have been much stronger than initially expected maybe a couple of years ago. My question is -- and then also continue to remain very strong, obviously, with the guidance in the fourth quarter. My question is how sustainable that is? What portion of this margin expansion versus the 31% you were running 2 years ago, now you're looking on pace for 39% in 2024. So of the gains, what should we think about as a long-term gain? What's sustainable for this business long term from a gross margin perspective?

[Alan Yu, executive]

As Jian just mentioned earlier in our call, we're seeing our -- I'm not sure if we mentioned that our gross margin guidance for the fourth quarter, we're looking at 39% to 40% versus our last quarter 38.5%. So we're still seeing this margin in the high 30s and the low 40s. Is this sustainable? Well, we believe it is because we're -- as we mentioned earlier, we're focusing more on online sales, online revenue. Online revenue generally has to carry a larger, higher amount of the margin, basically profit margin. And we're already at 33% growth, which is about 17% to 18% of our overall revenue.

We do -- I do expect that to continue to grow into the 20s or the low 20s overall revenue on the online sales, possibly 25% or more for the online sales compared to our overall revenues. That's going to help us to boost our overall margin. As well as ocean freight, we do continue to see that ocean freight is not going to spike up. We're seeing it stabilizing. It's dropping for the remaining of the year and very likely the first quarter. So these will also help in terms of reducing our cost and increase our gross margin.

So we're doing everything we can in terms of selling online, which online will generate more -- higher margin for us. That is going to offset us in terms of growing our volume in the distribution side of the business. There is pricing pressure on the distribution side of the business, but that is helping us with the sales volume. We're looking at volume potentially up to year-over-year 20% growth in volume-wise, overall volume-wise in the fourth quarter.

[Jake Bartlett, analyst]

Sorry, the volume -- just with that last comment, the volume from the distributors in the fourth quarter or overall you expect the mix to be very high for volume in terms of what's driving sales?

[Alan Yu, executive]

Overall volume to be 20% higher.

[Jake Bartlett, analyst]

In the fourth quarter?

[Alan Yu, executive]

In the fourth quarter, yes. Last comment, Jake, while I have you on the phone. We have not seen a double-digit growth for the past 18 months. And basically, we're seeing that as a very hopeful sign that our goal is we do want to continue this to be the double-digit growth in the -- going to future.

[Operator]

Next question comes from the line of Brian Butler with Stifel.

[Brian Butler, analyst]

I guess, Alan, just to kind of follow up on that double-digit growth kind of in the future, you have -- it looks like very good momentum, and it seems like the markets improves with California kind of flattening, at least not being down more. And then your move into supermarkets as well as new products. How do we think about fourth quarter being high -- or mid-single-digit revenue growth? When you look at '25, what's the early thoughts on where that can be? Could that be double digits again? Or is it really more of a mid-single digit until maybe some of the macro kind of gets more of a tailwind?

[Alan Yu, executive]

Well, Brian, as I mentioned earlier to answer today's question, fourth quarter, if we're comparing apple to apple, it's already double-digit growth revenue-wise. If we take out the $6 million that was -- we added the $6 million from online platform fee from the January to December. So that's why we're expecting to see -- hopefully, we're expecting to see -- actually, we are expecting to see a double-digit growth in the first quarter of 2025 based on that trajectory right now. And our goal is historically, in the past year prior to the COVID, we have been growing double digit year-over-year. And this is basically -- it seems like we're on the right track back to our trajectory, double-digit growth organically.

[Brian Butler, analyst]

Okay. Great. And then on the cost side, operating cost, again, you had -- the operating costs included the platform fees. When do we anniversary that? And when you think about 2025, how much -- how fast should that grow if you're growing top line kind of double digits?

[Alan Yu, executive]

We are going to invest. I would call that this is more of an investment in terms of advertisement for future additional sales online. For online business, in order to continue growth, we're basically acquiring paying -- spending advertisement to acquire new business for that -- so they can continue to recur and buy our product on a recurring basis. So basically, our goal is to grow our business, increase by 50% from currently this year of $70 million to $75 million to $125 million next year. We are going to see more expenses spend on the advertisement for the online expense. But at the same time, it's definitely going to help us increase our revenue faster than it was in the past 12 months.

[Brian Butler, analyst]

Okay. And then on kind of generating that growth, what type of capital expectations do you have from a spending perspective on what has to be outlaid to support kind of that double-digit growth? Can you give some color there?

[Alan Yu, executive]

In terms of capital expenditure, we won't be spending that as much. Basically, we do set a budget in terms of how much online growth and how much we spend on the online advertisement. We've been pushing a little bit higher, but we're not going to go crazy on that. So that's why I don't see a big capital expansion on that part, except for the exception that we are looking to expand additional warehouse space. That is where we're going to see the capital expenditure on additional warehouse space in the Southeast region where we definitely want to build a mega center for the -- to support our growth. It could be in the millions on that part. But definitely, we have the cash flow on hand to support that already.

[Brian Butler, analyst]

Okay. And then my last one, just you had reported a data breach in the third quarter. Do you have an update on where that kind of stands and what that impact might have been or might be in the future here?

[Alan Yu, executive]

We actually -- based on our initial investigation, there were no material data breach. We were a little bit more cautious in terms of some -- it was more of an employee or a couple of employees, they click on the attachment, which were the hacker were able to hack into our e-mail system. And at the same time, we hired a third-party investigator to investigate. Initial investigation came out that there were no material data breach. We'll continue following through and see if there's any issue on that part. In terms of monetary damages, there were no monetary damages and the amount spent is very nominal, very non material.

[Operator]

[Operator Instructions] There are no questions at this time. I will turn the call back over to Alan Yu for closing remarks.

[Alan Yu, executive]

Thank you, operator, and thanks to all of you for joining us today. We appreciate your continued support. We remain confident about Karat's future, and we look forward to keeping you appraised of our progress. Have a great evening and a wonderful Thanksgiving holiday season. Thank you all. Bye-bye.

[Operator]

And this concludes the meeting. We thank you all for your participation. You may now disconnect.