Karat Packaging Inc

NASDAQ:KRT

Hi, everyone, and welcome to Karat Packaging, Inc. Fourth Quarter 2024 Earnings Conference Call. [Operator Instructions] I'd like to now hand the call over to Roger Pondel, Investor Relations. You may now begin.

Thank you, operator, and good afternoon, everyone. Welcome to Karat Packaging's 2024 Fourth 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 it's 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 this call, we will be discussing adjusted EBITDA, adjusted EBITDA margin, adjusted diluted earnings per share and free cash flow which are non-GAAP financial measures as defined by SEC Reg 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's my pleasure to turn the call over to CEO, Alan Yu. Alan?

Thank you, Roger. Good afternoon, everyone. We ended 2024 with a strong fourth quarter as sales volume grew 14% and net sales grew 6.3% over the prior year quarter. Despite a $4.8 million out-of-period benefit included in the prior year quarter from online sales platform fees related to the first 3 quarters in 2023. We achieved gross margin of 39.2% in the fourth quarter versus 35.7% in the prior year period. As positive momentum continues in 2025, we are prioritizing to further strengthen our supply chain resilience in preparation for tariff uncertainties.

We have reduced our reliance on China for imported goods to approximately 20%. Shifting our sourcing to countries with more favorable trade conditions and minimum tariff like Taiwan. In 2024, we imported over 50% of our global purchases from Taiwan. We continue to actively work on further diversifying our supply chain outside of China and securing additional vendor discounts to mitigate pricing and margin pressures. While we try to protect pricing, we are evaluating product pricing holistically and have implemented pricing increases in certain categories to be effected in March and April. With a strong U.S. dollar and expect stable ocean freight rates this year, we expect the recent imposed tariffs to have minimum long-term impact on margin.

Geographically, for the quarter, we experienced the strongest growth in the Midwest, and we continue to penetrate market in other regions, including the Pacific Northwest and East Coast. Sales in California, our biggest market begin to stabilize in the preceding third quarter, and I'm happy to report that the positive trend continued in the fourth quarter when sales began to grow modestly in December.

Sales of our eco-friendly product in the fourth quarter increased 11% year-over-year and represented 34.5% of total sales. We continue to observe more state and local government legislation requiring recyclable or composable foodservice product. For example, California's ban of styrofoam went into effect on January 1, 2025. We expect demand for our ecofriendly product lines will accelerate, and we continue to actively developing new and innovative products to enhance our competitive position.

Our strategic focus for 2025 are to drive sales growth and improve our operational efficiencies. In January and February 2025, we are seeing robust sales growth and continued strength in our pipeline. We expect the positive momentum to continue into the rest of 2025, and we are closing new businesses expected to convert into revenue in the second half of the year. To support our anticipated growth as recently announced, we signed a new lease on a 187,000 square foot distribution center near our headquarters in Chino, California. This facility almost doubles our current distribution capability in California and provides much-needed capacities to support our anticipated growth and add approximately 500 new SKU of paper products ahead of the peak summer season. We anticipate the new distribution center to be fully operational by about this May.

We are also reevaluating our operating processes and investing in automation and AI support to enhance productivity and maximize operation efficiency with a lean team. As part of our long-term growth strategy, we will continue to explore sales opportunity outside of our traditional channels, such as the supermarket sector, we are in the product testing stage with some of our large supermarket customers to further expand our relationship with them, and we are working on expanding our sales team with experienced representative focus on this sector.

With our strong operating cash flow as well as liquidity and balance sheet and positive long-term outlook, our Board of Directors again approved the increase in the quarterly cash dividend payment to $0.45 per share paid on February 28, 2025, to stockholder of record as of February 24, 2025.

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?

Thank you, Alan. Let me provide an overview of our Q4 performance and I'll close with our guidance for 2025. Net sales for the 2024 fourth quarter were $101.6 million, up 6.3% from $95.6 million in the prior year quarter, which included a benefit of $4.8 million from the adjustment of online platform fees for the first 9 months of 2023. As Alan mentioned, our volume grew 13.9% year-over-year.

Pricing was unfavorable by $5.4 million year-over-year. Online platform fees decreased $3.4 million from the prior year quarter, reflecting the impact of the prior year out-of-period adjustment. By channel compared with the prior year quarter, sales to our distributor channel for the 2024 fourth quarter were up 13.8%, sales to the national and regional chains were up by 1.7%, and sales to retail channel decreased 1.4%. Online sales were down 6.1% or $1.1 million, reflecting the impact of the prior year out-of-period adjustment.

Cost of goods sold for the 2024 fourth quarter was $61.8 million, which included an additional import duty charge of $0.6 million on paper shopping bags. Cost of goods sold for the 2023 fourth quarter was $61.5 million, which included an additional import duty reserve of $2.3 million and the adjustments of $3.4 million of certain production expenses for the first 9 months of 2023. Product costs increased $4.2 million year-over-year, primarily as a result of volume growth, partially offset by a favorable impact from reduced vendor pricing, a stronger U.S. dollar and an increase in imports as a percentage of total product mix.

Gross profit for the 2024 fourth quarter increased 16.8% to $39.8 million from $34.1 million in the prior year quarter. Gross margin expanded by 350 basis points to 39.2% in the 2024 fourth quarter from 35.7% in the prior year quarter. The 2023 fourth quarter included a net unfavorable impact of 290 basis points from the out-of-period adjustments related to online platform fees and production expenses as well as additional import duty reserves. Gross margin benefited from lower vendor pricing, favorable foreign currency impact and product mix, partially offset by higher freight and duty costs.

Operating expenses for the 2024 fourth quarter increased 10.4% to $32.5 million from $29.5 million in the prior year quarter. Selling expenses for the 2024 fourth quarter was $13.9 million compared with $16.0 million in the same quarter last year, which included the impact from an adjustment of $4.8 million of online platform fees for the first 9 months in 2023 and an adjustment of $1.5 million of sales team labor costs for the first 9 months in 2023.

General and administrative expenses were $18.4 million compared with $13.2 million in the prior year quarter which included a favorable impact from the adjustment of $3.4 million of certain production expenses for the first 9 months in 2023 into cost of goods sold and an unfavorable impact of $1.1 million in write-off of a vendor prepayment upon the resolution of a legal contingency. Additionally, the year-over-year increase in general and administrative expenses was driven by an increase in labor costs and rent expense from workforce expansion and additional leased warehouses and higher stock-based compensation and transportation costs.

Operating income for the 2024 fourth quarter increased to 57.8% to $7.3 million from $4.6 million in the prior year quarter. Net income for the 2024 fourth quarter increased 40.3% to $5.9 million from $4.2 million in the prior year quarter. Net income margin was 5.8% in the 2024 fourth quarter compared with 4.4% in the prior year quarter. Net income attributable to Karat for the 2024 fourth quarter increased 44% to $5.6 million or $0.28 per diluted share from $3.9 million in the prior year quarter or $0.19 per diluted share.

Adjusted EBITDA increased to $11.3 million for the 2024 fourth quarter from $8.6 million for the prior year quarter. Adjusted EBITDA margin was 11.1% of net sales for the 2024 fourth quarter compared with 9.0% for the prior year quarter. Adjusted diluted earnings per common share rose to $0.29 for the 2024 fourth quarter from $0.24 for the same quarter last year. We generated operating cash flow of $8.3 million in the fourth quarter and ended 2024 with $114.6 million in working capital compared with $110.5 million at the end of 2023.

Our free cash flow was $7.5 million in the fourth quarter. As of December 31, 2024, we have financial liquidity of $67.8 million with another $28.3 million in short-term investments. As Alan mentioned earlier, our Board of Directors approved another increase of our quarterly dividend to $0.45 per share. We remain committed to a balanced capital allocation strategy between shareholder return and long-term growth investments.

We expect net sales for the 2025 first quarter to increase by 6% to 8% over the prior year quarter. Our gross margin goal for the 2025 first quarter is approximately 37% to 39%. And we expect adjusted EBITDA margin to be between 9% and 11%. On a full year basis, we expect year-over-year revenue to grow 9% to 11% in 2025 and gross margin to be in the range of 36% to 38%. We expect adjusted EBITDA margin to be in the low to mid-double digits.

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

Hi, everyone, and welcome to Karat Packaging, Inc. Fourth Quarter 2024 Earnings Conference Call. Please note that this call is being recorded.

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

So just thinking about what you gave for the first quarter revenue growth guidance, walk me through kind of what you guys are expecting as far as an acceleration of growth goals? Because if you look at the full year guide, obviously, it implies that sequentially throughout the year, the growth is going to accelerate. Just wondering if there's anything to call out there or anything we should be aware of?

Well, first of all, we're seeing -- already seeing California has -- in the past 2 years, California market has been basically a market that we saw -- we have seen decline until the fourth quarter, and that is one of our biggest markets. And we're now seeing that California market stabilize and growing modestly. And our largest market in Texas, we're seeing that market growing big time in the Midwest. That's where we're seeing that. More people are switching out of plastic, styrofoam, into other type of material, could be plastic. It could be composable. And also plastic bag into paper shopping bags.

So we're seeing more and more of that in Midwest. Midwest been a market with a lot of -- heavily on styrofoam. And now they're finally moving away from styrofoam. And basically, if the Trump tariff goes through with the Mexico 25% and also 25% in Canada, we're going to see a major run on our product in the second quarter. So we're ready for the tariff, basically. That's why we leased a double the size of our California warehouse, and we're actually shipping not only -- before previous year, we normally ship 25%, 20% increases from our normal volume in summer peak season. This time of the year, we're asking our overseas production manufacturers to ship 200%, 300% of what we used to sell in the past year.

So ramping up our inventory as the ocean freight is kind of in a good pricing right now, and we know that there's still uncertainties, but we know for sure anything coming out of China, it's -- basically like paper product, it's now being taxed 45%, which whoever is importing from China will stop immediately. There's no way they can afford that. And the reason to import is really helping us, basically, it's not a tailwind -- It's actually not a headwind for us to tariffs. It's actually -- we're seeing as a tailwind for us.

And Ryan, this is Jian. If I can just add on real quick to what Alan was talking about. Also, what we built in this model behind the guidance for full year revenue growth is we are taking into consideration what we are seeing in our pipeline, the new deals that we signed or are very close to get signed that we expect to convert into revenue around mid part of this year.

Okay. Got it. And then just as a follow-up that I will ask a similar question on the adjusted EBITDA margins. Obviously, you guided 9% to 11% in the first quarter, expect to end the year, low to mid-double digits. Is that just a function of you guys are gaining scale kind of on the operating expense line as you ramp revenue? Or is there anything else to think about there as far as the difference between the first quarter and the full year?

Yes. One thing that we're seeing with us in the fourth quarter, we ramp up online sales, and we also sell -- online shipping and also the local shipping cost has gone up. So immediately, starting next week or actually the following week where actually we found actually a different carrier shipper that would save almost a big time basically. We're looking at all these operational savings that we can find in terms of shipping our product, not only the online shipping but also offline shipping.

Recently, the trucking -- truckload shipping from California to everywhere in the U.S. has dropped by 35% as well as the, I would say, the rent, the lease, recently, the operational -- the newly leased warehouse in California is actually down nearly half of what it was 1.5 years ago, the lease rate.

Your next question comes from the line of Jake Bartlett from Truist Securities.

Mine was about the composition of revenue growth or the drivers of revenue growth in '25? Alan, if you can maybe help us understand how much is volume? How much is price? And then I have some follow-ups from that.

I'm going to say the volume is going to be the double-digit in terms of growth. We're already -- I would say that anywhere from 10% to 20% volume growth, pricing because of tariff, we already announced price increase. So there's going to be some type of growth in revenue, but I won't say a lot because we're trying to help our customers, trying to increase as minimum as possible and to reduce our operational expense and with the savings in ocean freight. So we got to work with our clients.

And that's why our clients trust us and continue to give us more business because we're seeing a lot of these existing customers of ours, chain accounts, they're giving us more businesses in terms of the way that we can offer them savings and also different type of savings and also creativity in terms of different type of packaging. Many of them want to switch out of their plastic back into paper bag. And many of them want to switch -- some of them want to switch out of their plastic container into paper corrugated boards. So we're doing a lot of things on that part.

Got it. So just maybe to dial in on the pricing part. It has been negative. It's been a headwind for a little over 2 years now. And it sounds like maybe pricing could remain a bit of something that you kind of use to help drive volumes, right? Is that the right way to think about it, that we should maybe think about slightly negative pricing in '25.

I don't see any negative pricing in 2025. There will be price increase for sure. That's a guarantee. 2025, there's some price increases. We already announced it. And it's just that if there's going to be more announcement of price increase due to tariffs.

Okay. Great. And if you can just build on those -- the comments you just made about the tariffs on Canada and Mexico, just remind us how -- what the dynamic is there? Why is that -- from those 2 markets specifically, why would that be a tailwind for your business?

Well, there is some manufacturers of plastic materials and aluminum items out of Canada. And if the 25% goes in place, basically, their existing clients they will not be able to accept that increase. Same with Mexico. Mexico use has been -- a lot of these distributors are ordering from Mexico on paper products, not necessarily plastic, more of a paper items, paper portion cup, paper bag and paper -- other items, paper goods and janitorial items.

Now if the U.S. tax Mexico, 25% basically, the importer will have to raise the price. And basically, I mean, with us, we're -- like I said, we have been very nimble. We have been importing from different parts of the world. They could be from not just -- we moved a lot out of China already. So our goal is by June of this year, only 10% of the product out of China. That's our goal.

Remember, we were 50% 2 years ago. Now in June, we already know it's 10% or less out of China. So basically, these new tariffs are not going to hit us at all. Basically, there's not a major impact. So we're moving to a different part of the country in Southeast Asia. And that's -- the only item that's basically it's unavoidable, everybody have to increase, it's aluminum because the announcement was that the 25% tariff is globally, including Japan, including Turkey, anywhere. So that basically is a given, that aluminum product has to go up.

Okay. And then the last question is on the freight. We were looking at the -- it looks like the kind of the spot market or the open market here for freight has come down a ton in the last month. What do you have baked in for freight costs in '25? And is it potential to see some upside to that? Or what's the story? Is that a kind of a lever point where it could really help your margins or not?

Well, freight started to drop in the fourth quarter of last year, ocean freight. And there were some additional charges, like peak season surcharge up until end of, I believe, February. So starting March, the ocean freight dropped about, I would say, about 20% on that part. And as they stayed up there -- down there for a while. And we don't expect the 2025 year contract -- there's going to be an increase because the shippers are actually seeing the decline in shipping product from Asia and for the domestic trucking because economy seems to be slowing down a lot. So -- and oil price has come down. So all these truckers are actually looking for businesses and that's giving us an opportunity to save on the operational side.

So as Jian mentioned, fourth quarter our operational expense was higher, and we're seeing that starting in March, our operational expense is coming down and in second quarter it's going to come down even lower than versus compared to fourth quarter and first quarter of this year.

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

First question, just maybe can we talk about the segments across the national accounts, distributors, online and retail? How should we think about that in 2025 and what's driving considering you had such a big outlay or a big performance in distributors in the fourth quarter?

Well, for the distribution channels, we're seeing California distributor, distribution, the major distributors coming to us -- toward us to sign agreement because they have to substitute out styrofoam. So they're buying more of the plastic hinge containers, and we actually forecast a 400% increase in the sales of our plastic container in replacement of styrofoam. This is from the distribution. Also, on the paper bag side, we're seeing a major -- a sharp increase, approximately 100% to 200% increase in the paper bag because they replaces banning plastic bag and some national chain account is actually switching entirely out of the plastic bag into paper bags. And that's where we've seen the growth in distribution also on the chain account. This is for the chain account on the paper bag side.

And also for the chain account, we're seeing some of the chain account moving away from styrofoam into plastic containers as well as some jump into the corrugated boxes like these pizza boxes. They used to just put pizza in it and now they're putting tacos, they're putting actually entrees in the smaller-sized pizza boxes. So that's where we're seeing a sharp increase in the distribution channels. And as some of these chain accounts are coming toward us because they want to consolidate vendor.

Here's the thing with the challenge of having multiple vendors. They have -- they can't get a full truckload per item so their shipping cost is expensive. And so they want to reduce not their FOB pricing on the cost of good itself, they want to actually see an overall saving in the landed cost. So that's something that we're offering to our customers that we can provide at landed cost.

So this year, actually, we're going to be purchasing around 15 to 20 additional trucks and trailers, not just increasing our size of our warehouse. We're actually increasing our fleet, so we can do more delivery ourselves into these chain account, distributors, retail accounts. We're seeing that -- that part, we're going to see -- we can enjoy more savings in the operational side.

Okay. And following up, I guess, on that kind of vendor consolidation. When you think of your revenue growth, that double digit, which is impressive, maybe break that down, what's the market growing at? And then where are you taking share? Clearly, some of that's vendor consolidation, but is there other places you're taking share in '25? And is supermarket -- is there any growth built in there on those trials that you're kind of in there? Is that part of your 2025 guidance as well?

Supermarket growth is part of our guidance. National chain account is part of our guidance and also introducing new paper products, additional 500 SKU on the paper product that is in the bakery bag, in the deli wraps, in the sandwich bags. So these are the sectors that we have never been into. In the past 2 months, we've seen a couple of our competitors being acquired by our competitor also. The acquisition actually caused more of a disruption in that industry, which is favorable to us as well. So we're one company that can ship all the product in one location versus you have to ship multiple locations.

And like I mentioned earlier, customers switching out of plastic bag into paper, that's basically a market share we're taking from plastic bag. And also, we're seeing this is a major issue with the importers. The tariff increase, a lot of these smaller importer without the cash flow they will run into trouble of being able to import product in because of cash flow.

Now that you have to put in more money on the tariff side versus on the -- just on the ocean freight, on the product itself, I mean at Karat Packaging at Lollicup, we're strong, robust in terms of our cash flow. So we can utilize this cash flow to bring in more product as well as having increased storage, investing in trucking. So I mean, we have that leverage now.

Okay. Great. And actually, on cash flow, how should we think about that? I mean you talked about building up inventories in the first quarter. How should we think about cash flow through '25? And what kind of capital spending are you looking at? You talked about adding trucks. So maybe how do we think about free cash flow sequentially through the quarters and a total for kind of where '25 could come out?

We're looking at the -- we actually reduced our -- in the past year -- for the past 24 months, we've reduced our manufacturing in U.S. And that -- also with that reduction, we reduced our maintenance costs, CapEx on that as well. So our maintenance CapEx is down very low to approximately maybe $1 million or less a year. Our major capital investment will be on the truck, brand-new truck and fleet. That reduces our expenses and operational costs because we wouldn't have to lease the trucks and maintenance costs. That -- but the thing is it will increase our EBITDA because that's back on depreciation. I would anticipate our capital expenditure to be around $5 million this year.

Brian, this is Jian, just to answer your question about the free cash flow. The way you think about kind of the free cash flow is, obviously, as you're aware, we were just talking and giving guidance at the adjusted EBITDA margin level. For free cash flow, I would expect the free cash flow conversion ratio to be each of the quarter in '25 to be fairly consistent with 2024 in terms of the cadence.

Next question comes from the line of Michael Francis from William Blair.

This is Mike on for Ryan. First one for me, and you talked about sort of that good growth in the Midwest and some stabilization in California and the new DC there. So I was wondering, looking at '25, what sort of geographies you feel you have the most opportunity in?

I am going to bank on the Midwest. That is where we see the most opportunity in Texas, especially in Texas.

Okay. Any reason why in Texas?

Well, our largest manufacturing facility is located in Texas and a lot of our chain accounts are moving into Texas. And we're seeing -- I mean, I myself moved to Dallas myself last year. And I'm there all the time and see that roads are growing. People are moving to Dallas and Texas everywhere. And the restaurants are booming. They're opening restaurant everywhere. So basically, we're seeing business. I mean, if you -- people see that business is slowing down in California, it's growing greatly in Texas, Midwest.

Okay. And then looking at gross margins for next year, the guidance is down about 200 basis points at the midpoint from where you finished this year at. Can you talk about what's sort of driving that decline? And then are there any sort of positives or offsets that could help there?

Well, right now, we -- the tariff is very uncertain. So for us to set the entire year of gross margin, it's hard to really to anticipate. We don't know if the tariff is going to increase on Vietnam or if there's going to be additional tariff on Malaysia or additional tariff on Thailand or is it going to be globally. So we kind of wanted to anticipate forecast a little bit into it for now because it's -- a lot of things are uncertain right now.

But one thing for sure, the strong dollars, the lower ocean freight, it's helping us a lot in terms of the gross margin. But -- we'll see after -- I would say it should stabilize, there should be more clarity after May of this year. Because right now, this month, we're still seeing one day, there's an increase of 10%, 20% and next 2 days later, there is a withdrawal or a pushback. So right now, we're just waiting to see what's going to happen.

Okay. And then last one for me. You mentioned your operating expenses coming down to the second quarter from the fourth. Can you talk a little bit about what you're assuming on the OpEx side in '25?

Jian, can you go over that with Michael?

Yes. So Michael, just to make sure I'm hearing your question correctly, your question is about what we built in the model for the operating expenses for 2025. Is that correct?

Yes, that's correct.

Okay. Yes, sure. So happy to provide a little more color there. So in our model for 2025, we considered a few things at the operating expense level. One is the continued saving opportunities, as Alan talked about, to be more -- to drive operating efficiency, primarily in the operations, in our operations. Alan talked about potential savings on the shipping side, that's primarily the trucking and shipping of our online orders. The other component of that really also is as we're gaining efficiency, we're trying to -- we're exploring kind of opportunities to get more savings on the labor side.

The third area that we're building kind of in the -- on the operations side, just in terms of saving opportunities, is to look at our online sales, online has been a great, one of our most significant drivers of growth as we, in the past, made significant investments on the marketing side, on the platforms to really drive that growth. We also have opportunities to potentially scale back on some of the investment and maintain momentum on the online sales growth. So those are the major areas that we've considered in terms of building the model for 2025.

I'd now like to hand back the call over to Alan Yu, CEO, go ahead, sir.

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 apprised of our progress. Thank you very much. Have a nice day. Bye-bye.

Thank you for attending today's call. You may now disconnect. Goodbye.