Karat Packaging - Q1 2024

Transcript

Operator (participant)

Thank you for standing by. My name is Cass, and I will be your conference operator today. At this time, I would like to welcome everyone to the Karat Packaging Inc first quarter 2024 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question-and-answer session. If you would like to ask a question during this time, simply press star followed by the number one on your telephone keypad. If you would like to withdraw your question, press star one again. I would now like to turn the call over to Roger Pondel of Investor Relations. Please go ahead.

Roger Pondel (Head of Investor Relations)

Thank you, operator. Good afternoon, everyone, and welcome to Karat Packaging's 2024 first quarter conference call. I'm Roger Pondel with PondelWilkinson, Karat Packaging's Investor Relations firm. It will be my pleasure momentarily to introduce you to the company's Chief Executive Officer, Alan Yu, and his Chief Financial Officer, Jian Guo. Before I turn the call over to Alan, I want to remind everyone 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 factor section of Karat'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 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. With that, it is my pleasure to turn the call over to CEO Alan Yu. Alan?

Alan Yu (CEO)

Thank you, Roger. Good afternoon, everyone. Sales volume for 2024 first quarter grew 3.5% over the prior year period. Net sales were about the same as last year, but included certain items that impacted year-over-year comparability, which Jian would discuss later in this call. We are encouraged by our first quarter performance as the growth initiatives that we implemented last year are starting to bear fruit. Our new business pipelines continue to grow, and our product offering continues to expand. We are adding new customers and gaining wallet share with existing accounts. Sales for manufactured product in the first quarter were 12.4% of total net sales, compared with approximately 23% last year, in keeping with our asset-light strategy in the U.S. and emphasis on imported items. Sales of our eco-friendly product rose 6% in the first quarter over the prior year quarter.

This category represented approximately 34.5% of total sales versus 32.6% last year. Eco-friendly products remain priority for Karat as we continue to develop new and innovative products and build up inventory to meet growing demand from customers. We also achieved a near-record high gross margin of 39.3% during the first quarter. With better visibility into ocean freight rate and new contract rates locked in through April 2025, combined with the continued strength of our U.S. dollar, we expect our gross margin to remain at a higher level. Our operating income in Q1 2024 was impacted by a non-cash impairment of $2 million of the right-of-use asset for our City of Industry lease in California. With the shift to optimizing our new Arizona warehouse base and away from California, our future rent expense will be reduced.

Our newly established distribution center in Arizona is now fully operational, which will provide meaningful efficiency for Karat in the Southwest region. We are continuing to look for other distribution centers in the Southeast region this year to further penetrate and grow key U.S. markets. Additionally, we are exploring strategic acquisition opportunities to further penetrate the marketplace. We carry strong operating cash flow, as well as the company's liquidity, solid balance sheet, and positive long-term outlook. Our board of directors again authorized an increase in the quarterly cash dividend payment to $0.35 per share on May 7th from $0.37 per share in the preceding quarter. Our regular quarterly dividend policy began in August of last year with an initial payment of $0.10 per share. I will now turn the call over to Jian Guo, our Chief Financial Officer, to discuss the company financial result in greater detail. Jian?

Jian Guo (CFO)

Thank you, Alan, and good afternoon, everyone. Net sales for the 2024 first quarter were $95.6 million compared with $95.8 million for the same quarter last year. Sales volume increased 3.5% over the prior year quarter. As Alan mentioned earlier, net sales year-over-year comparison is impacted by items. Our Q1 2024 net sales were understated by $0.7 million related to products shipped and recognized as revenue in 2023 and not delivered until 2024. The related impact on cost of goods sold and gross margin was $0.4 million and $0.3 million, respectively, for Q1 2024. In the prior periods, we had assessed the impact of the lag between shipping and delivery to the previously issued quarterly and annual financial statements and concluded it was immaterial. The impact will not be recurring in future quarters.

The amount of the revenue deferred for products shipped in March 2024 but not delivered until April 2024 was $1.9 million. Additionally, net sales for the 2024 first quarter included $2.2 million of online sales platform fee. By channel, compared with a year ago, sales to distributors, our largest channel, was lower by 3.3% for the 2024 first quarter. Sales to national and regional chains were up slightly. Online channel sales were up by 9.0%, which benefited from the inclusion of online platform fees of $2.2 million, as discussed earlier, and sales to the retail channel increased 5.0%. The distributor channel remains challenging, and the overall pricing environment is still very competitive. However, we are seeing encouraging growth momentum in the other channels, primarily driven by our continued geographic penetration in the East Coast, Northeast, and Midwest region, and growth in our eco-friendly products.

Cost of goods sold for the 2024 first quarter was $58.0 million compared with $57.7 million in the prior year quarter. The increase was primarily due to higher freight and container rates earlier in the year, an increased import volume, and the inclusion of certain production costs in cost of goods sold, partially offset by lower product costs for certain raw materials and finished goods, as well as favorable foreign currency exchange rate. Gross profit for the 2024 first quarter was $37.6 million versus $38.1 million in the prior year quarter. Gross margin was 39.3% in the 2024 first quarter compared with 39.8% for the prior year quarter. Operating expenses in the 2024 first quarter were $29.5 million, or 30.9% of net sales, compared with $25.4 million, or 26.5% of net sales, in the prior year quarter.

Operating expenses in the current quarter included a non-cash impairment of $2.0 million of the operating right-of-use asset for the City of Industry lease that Alan mentioned earlier as we entered into an agreement to sublease this warehouse in California. The increase was also driven by the inclusion of online sales platform fees, higher rent from additional leased warehouses, and higher labor costs due to workforce expansion. Such increases in operating expenses were partially offset by a decrease in shipping and transportation costs and the inclusion of certain production costs in cost of goods sold. Net income for the 2024 first quarter was $6.5 million compared with $9.2 million in the prior year quarter. Net income margin was 6.8% in the 2024 first quarter compared with 9.6% in the prior year quarter.

Net income attributable to Karat for the 2024 first quarter was $6.2 million, or $0.31 per diluted share, compared with $9.0 million, or $0.45 per diluted share last year. Adjusted EBITDA, a non-GAAP measure, in the 2024 first quarter was $13.5 million versus $15.3 million in the prior year quarter. Adjusted EBITDA margin was 14.2% in the 2024 first quarter versus 15.9% in the prior year quarter. Adjusted diluted earnings per common share was $0.40 per share in the 2024 first quarter compared with $0.46 per share a year ago. The first quarter ended with $112.3 million in working capital compared with $110.5 million at the end of 2023. As of March 31st, 2024, we had financial liquidity of $49.3 million with another $33.5 million in short-term investments.

During the first quarter, we made significant investments to stock up our inventory ahead of our summer peak season. With a positive outlook for new business, we expect net sales for the 2024 second quarter to increase by mid-single digit over the prior year quarter. Our gross margin goal for the 2024 second quarter is approximately 38%-40%. For the full 2024 year, we expect net sales to grow 8%-15% and gross margin to be in the range of 37%-40%. Alan and I will now be happy to answer your questions, and I'll turn the call back to the operator.

Operator (participant)

Thank you. We will now begin the question-and-answer session. If you have dialed in and would like to ask a question, please press star one on your telephone keypad to raise your hand and join the queue. If you would like to withdraw your question, press star one again. If you are called upon to ask a question and are listening via loudspeaker on your device, please pick up your handset and ensure that your phone is not on mute when asking your question. Again, press star one to join the queue. And your first question comes from the line of Michael Hoffman with Stifel. Your line is open.

Michael Hoffman (Analyst)

Hi, Alan. Jian, thank you for taking the question. Sorry about my voice. I'm not sure where it's disappeared to. Can you bridge for us, maybe by the line items, whether it's national distribution on-site or online, I mean, or retail, versus your own plan? All right. So if I think about the guide you gave us, we were going to land somewhere around $100 million, round numbers. We're about 4.5 short. Of those 4 buckets, where's the shortage, and what gives you confidence in this next 90-day view in light of where it fell short?

Alan Yu (CEO)

Michael, let me just understand the question. Are you referring to $4 million short for the first quarter, or are you referring to the first quarter?

Michael Hoffman (Analyst)

Yeah. So you gave us a forward view of up mid-single digits, which if we did the math, it would land you at about $100 million, right? And you did $95.5 million, I'm rounding. So we're $4.5 million short. And if I think of the four segments, where does that shortfall come relative to your own plan, and what gives you comfort in the next forward plan that we've got a better handle on that?

Alan Yu (CEO)

Sure. Well, I believe Jian mentioned earlier in the call that there was some change in accounting practice, revenue recognition. We actually had to deduct $2 million that normally, in the past 12, 15 years, 20 years, we had been recognizing revenues as we shipped the product. But our auditor has decided that we need to adopt a new method of recognizing revenues that we need to account for when the customers, even if we ship at the last date of every month, they need to understand how long does it take for them to receive the product. And they're asking us to recognize revenue upon the day they receive it. So we had to reduce $2 million from the current quarter, over $2 million, basically. And that's something that we have never done so in the past 24 years of our accounting history.

So this is the first quarter they want us to start moving forward to change this practice. That's over $2 million that we couldn't account for in recognition. The other $2 million, actually, me and Jian, we were actually looking at the guide in terms of approximately $98 million versus $100 million. I believe that we actually would have met the lower end of our projection in terms of the first quarter if we were able to account for the $2 million that we had to change in revenue recognition practice.

Michael Hoffman (Analyst)

Sounds like you ought to get another auditor. How are you supposed to track when a delivery arrives unless you're controlling the last mile? That seems like an unreasonable reach.

Alan Yu (CEO)

Jian is the one that dealt with the auditor. Maybe, Jian, you could perhaps kind of explain to because we were fighting for that. We thought that was really hard to understand, to account for, because it's taking a lot of our time to just trying to find the bill of lading. And when the customer receives it, we have to track down all the tracking. Some of our deliveries are delivered by third-party and UPS. So we had to set up a program just to accommodate this new request on that part.

Jian Guo (CFO)

Hi, Michael. This is Jian. Let me chime in on this one. So I think you make a fair point about tracking. It is a challenge, and we are reviewing our internal process to make sure that we have reliable, accurate data to be able to account for revenue appropriately. I will say, as I mentioned in my prepared remarks, that historically, this is something that we've been tracking internally for a fairly long time. As Alan mentioned, it's the same accounting practice since 15, 20 years ago. We have evaluated, as I mentioned earlier, previously, kind of the lag between shipping and delivery and concluded, and our auditors concurred in the past, that the impact was immaterial. Basically, the lag was immaterial, even though we don't necessarily track every single shipment, know exactly when it's delivered to the customer.

We have a pretty good idea, and we have sort of the estimate method to help us get to a pretty close number. So that said, fast forward to March 2024, I will just add a little color here. In Q1, we are seeing increased activities, the pickup activities, towards the end of the quarter. And that's also one of the reasons why, if you look at the last few days in the quarter, the activity that we saw, the amount of the shipment that went out actually increased quite a bit compared to what we typically see towards quarter end. As I mentioned earlier, the amount of the revenue that we deferred from March to April is $1.9 million. So basically, roughly the $2 million that Alan was talking about earlier.

Compared to typically, on the quarterly basis, we see towards the quarter end, that number is roughly 700,000-800,000. So there's a little bit of an increased activity in the shipments that in the products that we shipped but have not yet delivered to the customer. So that also accounted for a little bit of a year-over-year comparison. I just wanted to point out part of the reason why you are seeing the $1.9 million. Alan talked about the sort of the $2 million. It's also the increased activity, the increased momentum that we're seeing towards the quarter end.

Michael Hoffman (Analyst)

Okay. So I just want to tease out a couple of things on this. Did you look at March of 2023 and do the same treatment of you counted sales as you shipped it, and now you had to count it on the delivery and sort of adjust that number? And then the reality of the like-to-like is you hit your low to mid-single digit growth rate because you reset the prior number to look the same way?

Alan Yu (CEO)

No, actually, Michael. Like I said, this is the first time.

Michael Hoffman (Analyst)

Yeah, yeah. I get that. I was just wondering if you did the work and put the prior year on a like basis. What I'm trying to get to, and I'm not doing a very good job of it, is I think I'm hearing you said almost 4% volume growth. So I'm going, "Okay. Underlying structural demand's good. Maybe I'm still repricing some inventory from the above-average inflation in the inventory. But volume's good. So SKUs are good. I got this oddball accounting thing. I still think you ought to fire your auditor." And if I had a like-to-like comparison, you really did land somewhere between low to mid-single digit growth. And so none of us should freak out. The market shouldn't freak out. The stock should be fine tomorrow, blah, blah, blah. There was a question in there somewhere, but I'm not sure what it was.

But you get where I'm going.

Alan Yu (CEO)

Yeah. Again, like I said, basically, it is what it is. I mean.

Michael Hoffman (Analyst)

I get that. But underlying business, all this noise aside, underlying business demand is good is what I'm saying.

Alan Yu (CEO)

It is very good. I would say that underlying business, personally, I think this is the best quarter since a year for 12 months, basically, for the fourth quarter because we've seen volume decline, pricing decline for the past three quarters. This is the first quarter we're seeing a solid year-over-year growth in volume, in revenue, also in revenue. If we had to use if we were to use the old accounting method, revenue was higher. The volume was higher. The pipeline that we have is stronger than ever. I would say that this is the best quarter in a year.

Michael Hoffman (Analyst)

Okay. Who knows what the market does tomorrow because it hates misses? But I think the big message here is you've got a good underlying fundamental business model still chugging along. You've made business decisions to assure the growth rate by moving the distribution centers. And we've got this oddball accounting issue. Have we repriced all the inventory for the above-average pricing? Is that out? We're not looking at repricing issues anymore at this point?

Alan Yu (CEO)

Yes. Well, actually, we're not looking at any repricing issue. And also, one of the major question marks that we mentioned that last quarter was the ocean freight. We were uncertain how the ocean freight is going to play out. But it actually played out pretty well. That ocean freight did not increase significantly for the next year contract. So that's why we're more confident in terms of raising our full-year profit growth margin guidance. Originally, I believe, it was 35%-38% or 35%-37%. Now we're upping to 37%-40% because we feel confident that we signed now that we have signed the contract with ocean freight, which was the wild card. And that's why we feel very strong that we're going to see a very strong year with the support of ocean freight as well as strong dollar.

Michael Hoffman (Analyst)

Okay. I'll leave it at that. Thank you very much.

Alan Yu (CEO)

Thank you, Michael.

Operator (participant)

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

Ryan Meyers (Analyst)

Hey, guys. Thank you for taking my questions. Just kind of as a follow-up to the last question, I just want to make sure I understand it clearly. So it sounds like you priced through the lower or sorry, you went through the lower-priced inventory this quarter. So pricing shouldn't be a headwind for the remainder of the year?

Alan Yu (CEO)

That is correct.

Ryan Meyers (Analyst)

Okay. Got it. That's helpful. Then if we think about the eco-friendly business, it came in at 6% growth for the quarter. I know that business has kind of been trending in the double-digit growth right there. Is there anything to call out about what you guys saw in the quarter for eco-friendly, or is that just kind of related to the pricing as well?

Alan Yu (CEO)

Well, we did see, though, a demand picking up in eco-friendly product. We saw more and more cities actually enforcing compostable product and making it even stricter. The state of Washington is imposing that to be able to not confuse the consumer. Starting July, they want every compostable plastic item to have some type of green item on it or the lids so that they can see it specifically. It's different than the regular PET non-compostable lids. And we're seeing that there's new laws on the paper bag shopping bag that basically the U.S. Commerce is increasing tariffs on all the imports from overseas, which definitely will raise the price for U.S. domestic user starting, I would say, as early as August or September. Once everyone depletes their inventory, the price can go up as much as 30%-40% on the paper bag shopping bag.

So these new laws in different states and cities is actually creating a higher demand in terms of compostable product. And we're seeing more people moving away from just regular plastic into compostable, regular Styrofoam into plastic, and also other items. So I would say that those manufacturers that continue to sell Styrofoam, it's really seeing really a drop in volume-wise.

Ryan Meyers (Analyst)

Okay. Got it. That makes sense. Then if we think about the 8%-15% top-line guidance for the year, just kind of want to get a good understanding of what needs to happen or what needs to come into the model for you guys to hit the higher end of that range.

Alan Yu (CEO)

Well, if we were to just do organic growth, we're looking at the 8% range. The reason we're saying that is because last year, our third and fourth quarter, we were not as strong as we didn't have as much pipeline that we have today. And all the pipeline that we have is currently with the national chain account, with supermarkets. Those are actually turning into revenues. And we're seeing them in the third and fourth quarters. That will help us to the 8%-10% growth margin. And also, we are aggressively, actually, in conversation with several different companies, potentials to partner or acquisition that we're hopeful that by the end of this year, third quarter, we should be able to have some results in terms of what acquisition or what partnership that we may have by third quarter of this year.

That will help us to the double-digit mark by the end of this year, as I mentioned earlier, last quarter.

Ryan Meyers (Analyst)

Okay. Got it. Okay. Sure. Well, that's helpful. Thank you for taking my questions.

Alan Yu (CEO)

No problem. Thank you, Ryan.

Operator (participant)

And your next question comes from the line of Ryan Merkel with William Blair. Your line is open.

Michael Francis (Analyst)

Hey, guys. This is Mike Francis on for Ryan. Thanks for taking my questions. First, a little follow-up on the last question regarding the M&A was that 8%-15% at the end of 4Q that you gave, was that also inclusive of the M&A?

Alan Yu (CEO)

If we do not include any M&A, that would be the range of 8%-10%. If we include the M&A, that would be in the range of 10%-15%, yes.

Michael Francis (Analyst)

Okay. Perfect. Thank you. And then next for me, you talked about the distribution area being a little weaker. Can you give a little more color around that? Is it just sort of market softness, or is there anything unhappy with any of the players there?

Alan Yu (CEO)

Well, we have been seeing California, West Coast market dropping. The overall environment in California, especially for the mom-and-pop, smaller restaurant chains, they were seeing decline in sales. Not only that, we're seeing closures. One of my favorite restaurants that I've been going to for the past 25 years, they announced shutting down April 30th. And we're seeing more and more restaurants shutting down in California because of an increase in minimum wage. And it's hard to find laborers in California, especially hard to find people that want to work in the kitchen. We're still seeing that. We see it a little bit. It's better now that the drop was only a single digit versus double-digit in the past quarters for California. So that's where we're seeing a softness.

Also, we're seeing this, is across the board from all of our competitors in distribution that they're saying the same thing as well. But we're seeing a strong growth in online as well as potentially a stronger growth for the national chain account. Also in Midwest and East Coast, that's where we're focusing on that part for that.

Michael Francis (Analyst)

Okay. Last one from me. You raised the dividend again. Is there any sort of target capital allocation we should think about longer term, maybe a percent of operating cash flow or anything like that?

Alan Yu (CEO)

Currently, we're sitting on some cash that we actually put on deposit for income actually generating income. Of course, we're increasing our dividend because our cash flow continued to increase because our operation is pretty strong. We don't have any debt on that. That's why we're looking at mergers and acquisition. If we were to successfully complete 2 acquisitions by the end of this year, that should deplete our cash pretty much take some of our cash. I wouldn't say deplete all of our cash because we're still generating more cash every quarter. I would say that we're still in a healthy cash flow position on that part. We are looking at acquisition target definitely not to exceed what we have on hand, cash on hand.

Michael Francis (Analyst)

Okay. I hope you can find a new replacement restaurant. Too bad. I'll pass it on.

Alan Yu (CEO)

All right. Thank you, Ryan.

Operator (participant)

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

Alan Yu (CEO)

Thank you, everyone, for joining us, Karat first quarter 2024 earnings conference call. I want to again say thank you very much. We'll talk to you next time. Bye-bye.

Operator (participant)

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