KRT - NASDAQ

Good afternoon. And welcome to the Karat Packaging Fourth Quarter and Full Year 2023 Earnings Conference Call [Operator Instructions]. Please note, this event is being recorded. I would now like to turn the conference over to Roger Pondel, Investor Relations. Please go ahead.

Thank you, operator. Good afternoon, everyone. And welcome to Karat Packaging's 2023 Fourth Quarter and Full Year Conference Call. I'm Roger Pondel with PondelWilkinson, Karat Packaging's Investor Relations firm. It will be my pleasure momentarily to introduce the company's Chief Executive Officer, Alan Yu; and Chief Financial Officer, Jian Guo. Before I turn the call over to Alan, I want to remind all of our listeners that today's call may include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements are subject to numerous conditions, many of which are beyond the company's control, including those set forth in the Risk Factors section of the company's most recent Form 10-K as filed with the Securities and Exchange Commission, copies of which are available on the SEC's Web site at www.sec.gov, along with other company filings made with the SEC from time to time. Actual results could differ materially from these forward-looking statements. And Karat Packaging undertakes no obligation to update any forward-looking statements, except as required by law. Please also note that during the call, we will be discussing adjusted EBITDA, adjusted EBITDA margin and adjusted diluted earnings per share, which are non-GAAP financial measures as defined by SEC Regulation G. A reconciliation of the most directly comparable GAAP measures to the non-GAAP financial measures is included in today's press release, which is now posted on the company's Web site. And with that, I will turn the call over to CEO, Alan Yu. Alan?

Thank you, Roger. Good afternoon, everyone. Sales volume for our 2023 fourth quarter grew 7% over the prior year period. Although revenue was again impacted by unfavorable year-over-year pricing comparison and by startup delays from several new national and regional chain accounts, we estimated approximately $2 million to $3 million in revenue from new accounts which pushed into 2024. We are starting to work on orders from these new accounts now. As part of our strategic initiatives, we continue to scale back US manufacturing during the fourth quarter, which further enhanced gross margin to a near record high of 35.7%. Sales from manufactured products in the fourth quarter were 16% of total net sales compared with approximately 27% last year. We expect our gross margin to remain at a higher level because of our initiatives and the continued strong US dollar. Sales of our eco-friendly product grew 11% in the fourth quarter over the prior year period. This category represented approximately 33% of total sales, which exceeded our expectation versus 31% last year. We are continuing to develop new and innovative eco-friendly products to meet increasing customer demand and expand our customer base. In 2023, we opened new distribution center in Chicago and Houston and doubled the size of our Washington State distribution center with the move into a new 100,000 square feet facilities. These new distribution centers are fully operational and contributing nicely to geographic and market penetration. As part of our growth plans for 2024, we recently signed a new lease for a distribution center in Arizona. We're taking possession of the warehouse now and are expecting it to be fully operational early in the second quarter. We are planning on opening another distribution center in the Southeast region this year. Together with a sales force expansion, we are further penetrating key US markets in the South, Midwest and Pacific Northwest region and expect the growth in these markets to more than offset the decline in the California market but weaker conditions in the restaurant sector throughout the states. Our operating leverage in Q4 2023 was impacted by a write-off vendor prepayment of $1.1 million to purchase certain PPE product in 2020 during a period of extreme inventory supply shortage caused by the pandemic. We are focusing on implementing automation and AI technology at all of our facility in 2024 to further enhance efficiencies and productivities. Additionally, we are actively evaluating strategic acquisition opportunities this year as market valuations are showing signs of reality and normalization. With Karat's strong operating cash flow as well as the company's liquidity, strong balance sheet and positive long term outlook, our Board of Directors in February again authorized an increase in the quarterly cash dividend payment to $0.30 per share from $0.20 per share last quarter and from $0.10 per share since the regular quarterly dividend policies was initiated in August 2023. I will now turn the call over to Jian Guo, our Chief Financial Officer, to discuss the company's financial results in greater detail. Jian?

Thank you, Alan, and good afternoon, everyone. As Alan mentioned, we delivered another quarter of significant margin expansion and business performance. As I go through the key financial metrics here, I will be talking about certain [misclassification] adjustments made in the fourth quarter of 2023 for the full year amount within the income statement with no impact on net income. The prior year amounts were not adjusted due to the immaterial impact on the overall financial statements. Net sales for the 2023 fourth quarter were $95.6 million, including an adjustment of $6.5 million of online sales platform fees for the full year, which resulted in an increase to both net sales and selling expenses. Net sales were $92.7 million in the prior year quarter. Sales volume increased 7.3% over the prior year quarter, which was offset by unfavorable year-over-year price comparisons as we have passed on savings from ocean freight and raw material costs to customers primarily in the last quarter of 2022 and first half of 2023. By channel, compared with a year ago, sales to distributors, our largest channel, was lower by 6% for the 2023 fourth quarter. Sales to national and regional chains decreased 3.6%. Sales to the retail channel decreased 5.2%. And our online channel sales were up by 68.2%, including the impact of 60.7% from the adjustment of online sales [platform] fees as discussed earlier. We are encouraged by the volume growth in our business as well as the growth of our eco-friendly products, online channel and the increased geographic penetration in the East Coast, Northeast and Midwest. Cost of goods sold for the 2023 fourth quarter was $61.5 million, which included an additional import duty reserves of $2.3 million and an adjustment of $3.9 million of certain production expenses from general and administrative expenses compared with $63 million in the prior year quarter, which included an out of period inventory write off of $1.7 million. Gross profit for the 2023 fourth quarter was $34.1 million, which included the additional duty reserve and the impact from the adjustments discussed earlier versus $29.7 million in the prior year quarter. Gross margin expanded 370 basis points to 35.7% in the 2023 fourth quarter from 32% for the prior year quarter. Gross margin in the 2023 fourth quarter included a negative impact totaling 240 basis points from the additional duty reserve and the impact from the adjustment discussed earlier. Despite the unfavorable year-over-year price comparison, gross margin benefited from our efforts to scale back manufacturing in the US in favor of imports, which carry higher margin and improved operating efficiencies. Operating expenses in the 2023 fourth quarter were $29.5 million or 30.8% of net sales compared with $24.9 million or 26.8% of net sales in the prior year quarter. Operating expenses in the 2023 fourth quarter included the negative impact of a vendor prepayment write-off and the adjustments discussed earlier totaling $3.6 million. The increase was primarily driven by higher labor costs, increased rent from additional leased warehouses and workforce expansion. Such increases were partially offset by lower shipping and transportation costs, stock based compensation and bad debt expense. Net income for the 2023 fourth quarter was $4.2 million compared with $4.5 million in the prior year quarter. Net income for the 2023 fourth quarter included the negative impact from the additional duty reserve, vendor prepayment write-offs and a tax adjustment of $300,000, totaling $2.9 million. Net income margin was 4.4% in the 2023 fourth quarter compared with 4.9% in the prior year quarter. Net income margin in the 2023 fourth quarter included a negative impact from the duty reserve, vendor prepayment write-off, tax adjustment and the adjustments discussed earlier totaling 350 basis points. Net income attributable to Karat for the 2023 fourth quarter was $3.9 million or $0.19 per diluted share compared with $4.5 million or $0.23 per diluted share last year. Adjusted EBITDA, a non-GAAP measure, in the 2023 fourth quarter was $8.6 million versus $9.9 million in the prior year quarter. Adjusted EBITDA in the 2023 fourth quarter included a negative impact of $2.3 million from the additional duty reserves as discussed earlier. Adjusted EBITDA margin was 9% in the 2023 fourth quarter versus 10.7% in the prior year quarter. Adjusted EBITDA margin in the 2023 fourth quarter included a negative impact from the additional duty reserve and the adjustments totaling 330 basis points. Adjusted diluted earnings per common share was $0.24 per share in the 2023 fourth quarter compared with $0.30 per share in the prior year quarter. We believe Karat is well positioned to execute on its future growth strategies. We finished 2023 with $110.3 million in working capital compared with $84.5 million at the end of 2022. As of December 31, 2023, we have financial liquidity of $59.3 million with another $26.3 million in short term investments. I will now close with our 2024 outlook. Net sales for the 2024 first quarter are expected to increase [low] to mid single digit from the prior year quarter based on the current competitive environment and the new business outlook. Our gross margin goal for the 2024 first quarter is approximately 37% to 39%. For full year 2024, we expect net sales to grow 8% to 15% and gross margin to be in the range of 35% to 38%, assuming no significant increases in ocean freight rates. Alan and I will now be happy to answer your questions. And I'll turn the call back to the operator.

[Operator Instructions] The first question is from Jake Bartlett with Truist Securities.

My first is on the sales in the fourth quarter, and backing out or backing out the online sales adjustment, there was -- it was lower than guidance. Even I think if you add the $2 million to $3 million that kind of moved forward into the first quarter of 14, it was below guidance. So the question is what is driving that, what -- versus expectations, what really drove the lower than expected results in the fourth quarter for sales?

Jake, let me answer that question. Well, first of all, we did see a slowdown in the customers purchasing product for inventory back in December, especially in the month of December, we saw a significant slowdown in all of our distributors taking orders on that part. And one of our reason is that our main chain account were saying that they were overstocked and the business was not as good as last year. So that was one of the main reason that we had a really slow December.

And I remember the stocking or maybe destocking for distributors is an issue or just a dynamic in the fourth quarter that maybe had gone away. Is this maybe a return to normal kind of behavior from the distributors or was this -- are we still in kind of abnormal territory with how they're behaving right now?

We understand that every year, especially at the end of the year, in December, our customer goes on vacations and they try to destock whatever and return inventory that are excessive. And that's kind of normal seasonality things. One way to avert that will be adding additional new account, new businesses to offset that, especially this year, now that it's different than last -- actually, last -- the last quarter was different than the prior year. But in the prior year period, people are concerned that there might be a shortage so they tend to stock up during the holiday. But last quarter, especially in December, people understand that there's abundant inventory out in the market. So they won't be too concerned about bringing too much inventory into their warehouse. And I believe that most companies or most of our customer distributors are overstocking the inventory in the warehouse, they're struggling with the warehouse bases. In the past years, when they're short of spaces, they actually lease additional spaces. But now the warehouse space have become so expensive, people are trying to reduce their warehouse storage space to reduce their cost of operation.

And then last question on sales. Alan, if you can just describe the pricing environment. It feels like part of why the sales were kind of -- expectations and guidance was marched down in 2023 was because of just pricing and your desire to pass along price plus lower costs through price. Have we stabilized there? Do you think that -- do you feel more confident that pricing is not going to continue to come down in '24 that maybe is kind of bottoming and will grow from here?

Well, yes, in 2023, I would say that in most industries, especially packaging industry, we're seeing -- everyone has seen prices coming down due to overstocking, due to the lower cost of ocean freight, due to lower cost of the raw material. And we're seeing basically -- and not only bottom, we're seeing a kind of a rebound a little bit in terms of pricing in some of the categories, like the glove, like certain categories that are in shortage that are from overseas. So that's what we're seeing right now. We're seeing -- I would say, we're pretty much -- we came to the bottom in the fourth quarter and it started a little rebound in the first quarter of 2024.

The next question is from Michael Hoffman with Stifel.

Can I have some modeling questions about 2024, so we just get all the details. So could you give us a little thoughts about where SG&A lands, interest expense, taxes? And then lastly, free cash flow and sort of either a dollar amount or a cash conversion ratio of your EBITDA, just so we can complete the model?

Let me take that question. So we can provide some high level estimate, obviously, would provide [Technical Difficulty] revenue and gross margin, and don't necessarily go down into all the details. But we can definitely share some of our thoughts here. And again, as we mentioned in the guidance, the full year -- the thoughts on the full year performance, a lot of that, especially for the second half, this is just a caveat, the second half of 2024 is going to be assuming we don't have significant changes in the ocean freight rate. But high level when we're thinking about, I think, Michael, you're asking operating expense and interest expense, and cash flow, right? So operating expense, I would say, high level, this is a area of focus for the management team right now and our goal is to continue to improve the leverage there. I want to say 2024 high level operating expense on a full year basis is probably going to be fairly consistent or a little bit better than 2023. When you take out some of the discrete items that we incurred in 2023, I think overall operating leverage is going to improve a little bit. We do expect to see some improvement, especially related to labor costs, partially offset by increase in rent expense, some of the fixed expenses as we continue to expand our warehouse base. So high level, that's the operating expense, operating leverage. Interest expense year-over-year, I don't see significant changes. The term loans, and again, these are the term loans that we have on Global Wells, which is a consolidated variable interest entity, these are the term loans on Global Wells books from not our operating entity. But again, both term loans are fixed interest rate, we don't expect significant changes year-over-year in interest expense. Free cash flow, we do believe our free cash flow is going to be -- it's going to continue to be really, really strong in 2024. We talked previously about the pivoting to a more asset light model focusing on the import as opposed to making heavy investment on -- CapEx investments here domestically. So we do expect to continue with that model into 2024 and continue to expect strong free cash flow in '24.

So when you -- just give us a sense of cash conversion of your EBITDA. I mean you had -- just to put it in perspective, I mean you're in the 70s percent of your EBITDA converted into cash. Should we assume that, that carries into 2024 as well, the cash flow from ops less all capital spending?

I would think it will be in that range, it will be in the range.

And then Alan and Jian, can you help us a little bit about -- thank you for the details on the sales year-over-year change in the segments. When you look at the ones that were negative, what's the balance between price and volume? Like is there positive volume but really negative price and so the whole thing is negative? And so what I'm trying to get at is that there was a decent underlying volume number, but I'm overshadowed by the resetting of price for raw materials, lower freight, all that stuff. How do I think about that across those segments?

In the fourth quarter 2023, the volume did increase. I believe, Jian, what is the percentage of volume increase overall versus the…

[Technical Difficulty]

And how was that distributed across the four segments, the operating lines, when you think about that, directionally, positive, negative distributors, national retail versus online?

I would say that the mainly online sales volume was more positive and into the, I would say, the retail segment that was positive. In the distribution segment, I would say it kind of even out a little bit. But mainly, our growth in the volume is more on the online as well as the national chain account.

And then you alluded to this a little bit, Jian, about cadence. But can we talk -- because you're going to start the year at a much stronger gross margin and finished the year lighter to get to the average of the guidance. Talk to us a little bit about how to think about that cadence. Is there anything lumpy about it or do I just sort of gradually bring it down all year long to work out to get to the midpoint of the range?

Well, here's a thing. I think if you're referring to 2023…

4...

If we -- 2024 or 2023?

Yes, 4. With the guidance, you start the year at 37% to 38%, 39% gross margin in the first quarter, but the full year is below that. So is it a gradual decline in every quarter or is there -- how do I think -- I'm just trying to -- our modeling, thinking about the cadence very steady decline each quarter. So I get to a blended average for the full year outlook.

Well, this is how -- what Jian mentioned earlier that there's a very big uncertainty of contract renewal for the ocean freight in May of 2024. So we kind of know exactly what's going -- what might occur in the first quarter and second quarter. But big uncertainty is what is the US dollar, is it going to be weakened or maintain as strong as we are today, as well as ocean freight, is it going to maintain the current level or it's going to increase? If it increase, how much it increases? So kind of put a cushion in terms of the last two quarters of the end of the year. But we know that our volume is going to be strong. Our expected volume this year, we're hoping -- we're looking for a goal of 15% growth margin -- not growth margin, 15% growth in volume wise,that is our goal that we're looking to shoot for. And in terms of, of course, the gross margin, we're also adding in -- there's some change in terms of calculation classification. We used to have the CapEx at the operating level but now starting 2023 or 2024 we’ll bring the CapEx into the -- on the top of the levels. So basically, that will affect the gross margin also. That would be one of the big aspects that will affect the margin.

So just so I think -- I understand you, you were being conservative about the direction of ocean freight in your guidance. But as a point of opportunity if, in fact, if the ocean freight proves to be consistent at current levels, is that what I'm -- did I hear that correctly? I may be misunderstanding what you're trying to tell me.

Yes, that is correct. If the ocean freight maintains stable, then basically, I would say that this is definitely beneficial for our third and fourth quarter.

The next question is from Ryan Meyers with Lake Street Capital Markets.

First one for me. So if we think about the revenue guidance range, the 8% to 15% growth. What would you need to see to come in at the high end of that range, is that more of a stabilization in pricing or even a little bit of improvement in pricing? Just want to get a good understanding of how we potentially could see that 15% top line growth for 2024?

Well, in the past year, prior to pandemic, our company has been growing double digit every year, year-over-year. And last year was a much different environment because in 2022 there's a major spike in ocean freight and that we have to add the price of cost of goods sold and the reselling prices based on that and there was a deflationary factor during the last year 2023. But in 2024, as everything stabilized, our selling volume is going to increase with adding new sales rep that's going out -- has been going out there in the street selling to more new chain accounts. And we're already seeing that, we're adding several dozens of new accounts in the past few months basically. So we're adding about 20, 30, 40 accounts, I would say, 40 accounts every quarter's distribution and chain accounts. And with that said, that's going to add a lot to our top line as well as our existing customers. We're adding additional new items such as napkins and other new categories that we're selling in that we're looking to bring in this year additional 300 to 400 SKUs that will also add to our top line. On top of that, we're looking at acquisition this year. As we mentioned during our IPO, one of the things that for our growth strategy is started looking at acquisition target. And in the past years, we've been looking at it but the price was not that reasonable. And we're seeing that people that are looking to sell their business that were potentially we can acquire are becoming more realistic numbers that we can see that we can look into now. So if we were to hit the 15% range, I would say that would have a small acquisition. I'm not going to -- we're not going to talk about large acquisition but we're looking at the small side acquisition.

And then if we think about the softness that you commented on in the distributor and national channels in the fourth quarter. Just want to get a good understanding of how much of that was driven by just the California market versus how much of it was the overall system as a whole?

California market, in the fourth quarter, we saw a decline of almost like a double digit decline in terms of California year-over-year. The restaurant environment in California, it's really bad in this industry and also as well as competitiveness. There's a lot more importers in California. Restaurants are not doing well, especially the mom and pop that are serviced by distributors. The chain account, however, is doing much better than the distributor that's mom and pop shops, which we're seeing a lot of restaurant closing and going out of bankruptcy. That's what we're seeing in fourth quarters in California.

The next question is a follow-up from Jake Bartlett with Truist Securities.

My first was just on that discussion on guidance, Alan. And you had mentioned volume expectations of 15%, but the guidance is 8% to 15%. So is that just a follow-on of the lower pricing that we had by the end of the year? Just helping us understand the dynamics. I know there’s mix that goes on as well impacts sales growth. So maybe just help us mesh the 15% volume growth and the 8% to 15% revenue guidance.

We're volume wise, it's per case count. The case counts could be something that's worth $3, $4 a bottle or something that is $80 a case. So that's where we're seeing the volume growth is. We're calculating by the numbers of bottles and number of cases that we're selling, the year-over-year comparison. And we're already seeing -- we've seen the growth starting in fourth quarter, especially November and December of last quarter last year. And we're seeing -- already seeing some strong growth this year already in the first two months -- first three months of this 2024 already. And with the new customer that we just acquired recently and also the potential customers that are in our pipeline, we're seeing this number to continue to grow. So 15% is, I would say that it's more of a conservative number that we -- I'm going to say in terms of volume growth based on the number of customers that we have in pipeline, but this can be average. Because, of course, we're looking at second quarter and third quarter is always a stronger quarter versus our first quarter and fourth quarter in terms of volume growth wise. So we're going to be looking at 15% is our target in terms of ops growth quarterly wise. And in terms of revenue, revenue, we have kind of a strong base already in the 2023. And we're seeing that with these volume growth and new account added and that's where we see the revenue growth at 8% to 15%. Of course, that is a revenue guidance that we want to be conservative because in 2023, we have a very -- we kind of have a decline in our revenue growth from 2023 compared to 2022. So we're trying to catch back in terms of 2024 to grow beyond the revenue we had in 2022.

But just so I understand, the offset to volume growth is negative mix or negative price, or else revenue would be higher than volume, I would assume. So why is revenue growth slower than volume growth?

The pricing. You're right. We are having to compete with our other vendors for pricing. So we're doing both competing with other vendors as well as selling more higher price volume wise and online.

And then Jian, the question on operating expense or G&A growth. I just want to make sure your comment, you said it was -- you want to improve versus '23, that's on a percentage of sales basis. You don't expect the absolute G&A or operating expenses to be lower year-over-year. So I just want to make sure that that's the right message.

That's correct, Jake. It's the leverage, the percentage.

Percentage of sales. And then just on the adjustments for the online sales platform fees kind of moving from, I guess, going into selling -- increasing selling expenses and retail sales. Also the production expenses moving out of G&A to cost of goods. How should we think of that just for modeling? You're not telling us how much they were per quarter in '23, but should we just divide those adjustments by 4 and assume that that's the right kind of impact on a quarterly basis as we look to model '24 and beyond?

That should be pretty close with only target -- well a couple of covers there is the online platform fee with a significant growth of our overall online sales, I would expect that amount to increase in 2024 compared to 2023. On the production expense, I would expect '24 amount to be slightly below the '23 amount because of the continued scale back of the overall domestic production activities here.

And then lastly, on the import duty reserve. Is it the same kind of way to think about it there that it maybe should have been higher earlier, it was taken all at once here or is that not how that works? So just how would -- by taking this reserve now, how would it impact the next three quarter COGS? Would it be higher because you would have -- if that was a reserve was -- if you reserved more appropriately on an ongoing basis, you'd have higher cost of goods sold. Is that how we should think about it?

Can I just make sure I understand your question correctly, Jake? You're talking about the reserve for the duty, import duty?

Yes.

So this year, we actually don't expect a significant change in 2024 currently based on the best information that we currently have. The reason why we had an increase in the reserve in this charge, which you're right, it impacted Q4 cost of goods sold. The reason why we had the impact was there was a change of estimate. It was a contingency -- it was a loss contingency we previously reserved, took a charge reserves, based on our best estimate at that point in time that in the second quarter of 2023 we had an investigation going on. So we took a reserve back in Q2 2023. Fast forward to Q4 2023, we had some updates in -- estimate updates in events and circumstances that helped us better estimate this reserve, this loss contingency, that's the reason why we recorded an adjustment to this charge. As of right now, based on the information and assistance provided from the counsel, we do not expect significant changes in 2024. That being said, as we think about this reserve amount as of 12/31/2023, this is best based on the best estimate that we currently have. There might be future options that we would look into. But as of right now, we don't expect significant changes in 2024 related to this charge.

Jake, let me add to what Jian just mentioned. This reserve is a special duty reserve. It's based on an item that we have imported from overseas. And this -- basically, all the investigation has confirmed and finalized. So in 2024 and onward, we won't have to deal with this any type of importing issue on this particular product. But for the amount that we reserve, are we going to see a cash payout anytime soon? No. It might be a couple of years down the road since we are going to appeal. And this is -- this $2.3 million or $3.5 million is the highest reserve we're putting. And then we're very likely this reserve would change to a different amount, which is we're looking at a lower amount, the amount -- dollar amount that would change. But this is the highest, the most we will see in terms of the duty that we're liable for, basically.

The next question is a follow-up from Michael Hoffmann with Stifel.

The M&A, just to be clear, given the quality of the cash flow, I presume you would be able to fund the small M&A that you're thinking about all from sources that you generate. So it's self funded?

Correct. Unless -- I mean we're -- basically, we have over $100 million -- like Jian mentioned in our report, over $110 million in cash flow in terms that we can utilize, which we're not going to utilize all of it. But for sure, that's something that we have -- we can do self fund it.

A big statement being is that there's nothing on the rate of it, you're going to drive the leverage up. This is going to be self funded off of cash and the leverage stays relatively stable.

Yes. And also, we are going to generate even more cash this year.

That's what I was trying to get at.

This concludes our question-and-answer session. I would like to turn the conference back over to Alan Yu for any closing remarks.

Thank you, everyone, for joining our 2023 fourth quarter earnings call. And I would like to say thank you all, and have a nice day. Thank you very much. Bye-bye.