Good day and welcome to the Karat Packaging First Quarter 2021 Earnings Conference Call. All participants will be in a listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded.

I would now like to turn the conference over to Roger Pondel with PondelWilkinson, Karat Packaging's IR firm, please go ahead..

Thank you operator, good afternoon everyone and welcome to Karat Packaging's first quarter 2021 earnings call, which also happens to be the inaugural quarterly call since Karat completed its IPO on April 15. 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, Ann Sabahat. 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 factor section of Karat Packaging's IPO registration statements 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, which is a non-GAAP financial measure as defined by SEC Regulation G.

A reconciliation of this non-GAAP financial measure to the most directly comparable GAAP measure is included in today's press release, which is posted on the company's website. With that, it is my pleasure to introduce and turn the call over to Alan Yu.

Alan?.

Thank you, Roger. We're pleased to be here with you today our first quarterly earnings call as a publicly traded company. We began trading on NASDAQ under the symbol KRT on April 15. Well, we priced 3.95 million shares at $16 per share.

I'm proud of the Karat Packaging team for their hard work and dedication in completing the IPO process and helping us get to this point. And we'll talk more about the financial aspect of our IPO in a few minutes. To set the stage, let me first tell you a little more about the company.

Karat Packaging is a specialty distributor and manufacturer of a wide range of environmentally friendly, disposable foodservice products and related items primarily used by national and regional restaurants in foodservice setting throughout the United States.

Our products include food and take-out containers, bags, tableware, cups, lids, cutlery, straws, specialty beverage ingredients, equipment, gloves and related products. Our eco-friendly Karat Earth line offers quality, sustainably focused products that are made from renewable resources.

One of the company's distinguished characteristic is that we also offer customized solutions, including new product development and design, printing, and logistics services. Our business has been strong and growing.

We reported solid first quarter financial result that reflect our ability to deliver customized solutions and quality products to a diverse and expanding customer base. Net sales for the quarter grew at a robust rate of 18%, where particularly strong performance in our distributors and online channels.

Our goal is to be deleting single source providers to a broad set of customers for all of their disposal foodservice product.

We aim to do this through a combination of initiatives that includes rolling our base business with incremental revenues from existing customers, expanding our customer base, increasing sales through our online channels and overtime pursuing strategic acquisition.

Our 2021 first quarter results reflect progress in all of these areas, particularly in our online channels, which commands a higher margin and grew 82% during the period.

The positive progress we made in the first quarter was partially offset by the negative impact from a severe winter storm in February that cools our Texas plant for 10 days, as well as by significant increase in freight costs.

Sales rebounded strongly in March and have continued at a robust pace so far in the second quarter, much of these increased demand is being driven by restaurants across the country that are reopening at the same time. As the pandemic winds down, demand for environmentally friendly products also is up as well as demand through our online channels.

Like most companies with international operations, we also experienced a significant increase in freight costs in the quarter. Ocean freight rates have more than doubled over the prior year and expert believes these costs will continue to run at high levels until early next year.

We just took action in the first quarter to pass on these higher costs to our customers through a series of targeted price increase that are continuing into the second quarter. This action gives us increased confidence in our ability to protect our near-term margins.

We also completed the acquisition of Pacific Cup in the first quarter, expanding our manufacturing and distribution footprint in Hawaii. We intend to use a new facility to manufacture paper straws among other products with Pacific Cup.

We have now six distribution centers and three manufacturing plants, and we're continuing to evaluate other acquisition targets. We want to leave adequate time for questions. So I will stop here and turn the call over to Ann to discuss our first quarter results in detail.

Ann?.

Thank you, Alan. Our 2021 first quarter results reflect strong top-line growth and gross margin expansion offset by an increase in operating expenses, principally related to our growth. Net sales increased 18% to $76 million in the first quarter. Sales to distributors, our largest channel grew 18% and online sales advanced 82% in the quarter.

As you know, we've made significant investments in our online channel, because we view this as part of an acceleration and shift in consumer preference towards food delivery. Sales to national chains also grew 18% in the first quarter as we continue to expand business with existing customers.

Sales to retail channel fell 29% primarily reflecting a shift in ordering by retail customers to our online channel. During the pandemic, many retail stores have found it easier to place orders quickly online. Gross profit increased 21% to $22 million in the 2021 first quarter.

Sales through higher margin channels particularly online sales drove a 70 basis point increase in gross margin despite higher freight costs as Alan mentioned.

Operating expenses increased 29% to $18 million in the first quarter, principally reflecting higher shipping cost, expansion in our workforce and facility cost increases as the company continues to grow as well as higher professional fees. Cost related to our public offering were approximately $400,000 in 2021 first quarter.

Operating income declined 8% in the first quarter, primarily due to the increase in operating expenses, partially offset by gross profit. Operating margin declined 140 basis points primarily due to the pressure from higher freight and shipping costs.

Other income increased approximately $4 million year-over-year in the first quarter, primarily due to a decrease in net interest expense that resulted from changes in the fair value of interest rate swap positions. We recorded a gain of $1.3 million in 2021 first quarter versus a loss of $2.4 million in the same period last year.

Provision for income tax expense increased to $1 million in 2021 first quarter, primarily due to a high effective tax rate of 28% in the quarter compare with 26% in the same period last year. We expect our effective tax rate to approximate 27% this year.

Net income amounted to $3 million in the 2021 first quarter, compared with less than $1 million in the same period last year. The increase in net income attributable to non-controlling interest is primarily due to changes in interest rates swap positions at Global Wells, a variable interest entity used to manage certain facilities.

Because interest rate swap positions are primarily held by Global Wells, their associated gains and losses are reported as net income or loss attributable to non-controlling interest in our income statement. Net income attributable to Karat Packaging Inc.

was $1.8 million or $0.12 per diluted share in the first quarter compare with $2.5 million or $0.16 per diluted share in the same period last year. Adjusted EBITDA on a consolidated basis increased slightly to $6.8 million in the 2021 first quarter. Consolidated adjusted EBITDA margin declined 30 basis points to 9% in the 2021 first quarter.

Adjusted EBITDA attributable to Karat Packaging increased 14% to $6.1 million in the 2021 first quarter. Adjusted EBITDA margin attributable to Karat Packaging declined 30 basis points to 8% in the first quarter of 2021.

Net cash provided by operating activities increased to $5 million in the 2021 first quarter, primarily due to improvements in working capital relative to the same period last year. Capital expenditures decline year-over-year, primarily as a result of the purchase of manufacturing equipment and construction of our facility in New Jersey last year.

As Alan mentioned, we completed the initial public offering of our common stock on April 15 of this year, resulting in the issuance of 3.95 million shares at public often price of $16 per share.

The IPO along with the exercise of over allotment option by the company's lead underwriter provided the company with gross proceeds of approximately $73 million. We use a portion of these proceeds to pay down an aggregate a $50 million in principal balance of our loan obligations. I'll now turn the call back to Alan for closing remarks.

That we'll be happy to answer any questions you may have.

Alan?.

Thank you, Ann. Our tough competitive position as a rapidly growing specialty distributors and select manufacturer of environmentally friendly disposable food service product and related items has long served our customers and employees well.

We believe our profile as a publicly traded company only serves to enhance our value proposition in the marketplace. As a nimble supplier of a wide range of products for these food service industry we believe that Karat Packaging has tremendous advantage that differentiate us from our competitors.

Our 2021 first quarter result deliver solid growth in revenue and gross profit. Even as we work through industry disruption and cost pressures, we're pleased our sales demand picked up nicely toward the end of the first quarters, and we expect a strong demand to continue in the month ahead.

Before we begin Q&A section, I wanted to personally thank the entire Karat team for their hard work and dedication to excellence. This is an exciting time for all of us and our commitment to work diligently toward achieving our collective goals and growing our company, and enhancing our value for all of our stakeholders.

With that, I'll turn the call over to the operator. Operator for Q&A..

[Operator Instructions] Our first question will come from Michael Hoffman with Stifel. Please go ahead..

Thank you very much, Alan, and congratulations on your first public company earnings call. I'd like to start with the backdrop on demand and your ability to fulfill.

We understand broadly that the restaurant and food services industry sort of ramped up order activity and I'd like to sort of tease out the strength of your supplier network and how you've been able to continue to meet your fulfillment and in part, because of the quality of that supplier network.

So the customer is getting fulfilled, even if the overall demand is super high, you're still meeting their fulfillment needs?.

Michael, thank you for a question. Well, first of all when the economy opened up in March we did – we were expecting an increase in the demand of packaging, and we added – we did order so-called procure more product oversee in the month of February.

And when the economy really actually opened up in a March and April we actually saw a sharper increase in demand which really drove the entire industry in a distress on the supply and chain matters.

If we were just to supply our existing customers, who would have been the perfect world, but all of a sudden, all of our – not only our existing national chain accounts or chain accounts that we hadn't been working with within the discussion came to us for assistance – ask for assistance.

And that's when our supply chain also got kind of off balance just like everyone else. And we are being ordering more product from overseas to overcome this issue. It has to become better in terms of helping the other national chains and as well as our existing customers.

So that's something that we are doing our best to supply product, to our existing customers, which we have a little problem issue with, but the new customers that are coming to tour us for the assistance, we're doing our best internships, helping them out on that part..

So there's been an opportunity to gain share as well as continue to meet your current customers [indiscernible]?.

That is correct..

Okay.

And then from what you alluded to cost increases between raw material and freight; how do you profile with the sort of the pathway to price increases from a modeling standpoint? Are we looking at these predominantly pass-through, so it's an increase in revenue and offset to expense, and so by its nature would be margin dampening, but that's not necessarily a bad thing.

Just you're offsetting expenses as opposed to gaining any revenue on it?.

Well I would see that we are gaining revenue at the same time by passing through the increase and expenses and also were increasing our margins from the revenue side and also on the margin side by selling our product, offering it online. This is where we see a key driver for our margin.

It's selling a product online, and that is something that we focused last year and we'll continue to focus this year. And this is something that we're very supportive of our e-commerce sectors that we want to make sure that those customers are out there.

They're not able to get their product through local distributors are able to purchase online and get their products to meet their store needs..

Okay. It's the last two for me.

Did you have very big PPE build in 1Q 2020 that you had to overcome or is that real over that tough comparison is really in 2Q 2021 versus 2Q 2020?.

Michael, this is Ann speaking..

Okay..

Michael that was a great question Michael. So in Q1 of 2021, we saw PPE revenue at $800,000 compared to $2.5 million in Q1 of 2020 with the what we saw negative contribution margin in Q1 of 2020 compared to 68% year-over-year.

So we definitely do not see the PPE trend continuing, we'll see it to be less than $1 million or less than $500,000 per quarter for the rest of the year. So the impact would be very minimal..

Okay. And so you have a tougher compare in 2Q, but you've also demonstrated in 1Q that you're offsetting those comparisons. Your expectation in 2Q would be to offset a really strong; you did almost $19 million to PPE in 2Q of 2020.

So your anticipation you'll offset that because of the demand side?.

That is correct..

Okay.

Will you give us some sense of how we should think about, how revenues are going to fall? And aggregate EBITDA ranges for 2Q given the level of price increases you've been doing?.

So, Michael can you please clarify that question? I just want to make sure I address it to the point?.

Yes. I probably didn't ask it very well. Okay.

What is – how would you frame how 2Q 2021 is going to come out from our sales and EBITDA and overcoming PPE and the level of price increases that you've been pushing through to offset freight, labor, and then there's some demand driven pricing because things are so, so there's such strong interest in some of your products.

How do we think about what 2Q earnings are going to depend, sales and EBITDA is going to look like for 2020?.

That is a great question, Michael. So in Q1 to address Q2, I'll share a little bit with Q1. So in Q1, we have grown our revenue 18.1% year-over-year without including PPE. Without PPE we have grown 22% year-over-year. So we will continue to see that in Q2 of 2021, our growth will continue to be exceeding that 18% excluding PPE.

So basically we're going our growing PPE our organic growth above 30%. This is what we're seeing for Q2 of 2021..

Okay. Thank you very much. Translation is on the first quarter..

Thank you..

Our next question will come from Ryan Merkel with William Blair. Please go ahead..

Hey, thanks for taking the questions. First off, I was impressed with your gross margins, and I know Alan, you mentioned online sales, but you also mentioned freight was an offset.

How big was the freight headwind this quarter? And then importantly, do you expect to cover freight costs with price increases in the second quarter?.

Yes, Ryan. In the first quarter we did see freight increased significantly almost nearly a 50% or more increase compared to last year 2020. And what we did was, we actually had a [indiscernible] freight increase in pricing back in January, February and March. So we did numerous price increases in different segment of our product line.

And we also are looking to continue to do price increase in April, May and June just to see how much the freight – because the freight has continued on that in second quarter and we are looking very carefully in terms of proactively marking up prices to offset the freight increased costs..

Okay. So it sounds like you're maybe still in a bit of a chase on freight.

So it's unclear at this point, if freight will be a headwind or more neutral in the second quarter, is that fair?.

Obviously, freight in the second quarter so far in the month of second quarter, it should be neutralized or stabilized at the point we are right now..

Okay. Got it. Okay. And then I wanted to dig in the online sales a bit more, what some of the drivers are? Ann mentioned the shift to e-com due to the pandemic, and that makes sense. But what else is going on? Restaurants are reopening. I think you were planning on increasing your marketing spend adding new products.

Just what else is driving that?.

Well, this is where we see the marketplace. The domestic manufacturer and other importers are competitors are struggling in terms of keeping up the capacity.

Not even national chain accounts, convenience stores, and we've seen some national chain account convenience store placing order online just individual stores just to try – doing whatever they can possibly to make sure that they don't run out of a cup or straws or napkins or any raw material supplies.

And it seems like more and more people are going online because we've seen that other competitor of ours, they're just struggling in terms of keeping the demand because of there's a sharp increase in the demand in the disposal packages when all the restaurants opening at same times. So that's where we see people are going online to find product now.

And we see more and more people and as people can use to order product online, we see that they will most likely stick with it just like ordering take-out when people are more used to ordering take-out rather than going into a restaurant dine-in, we see that trend will continue..

Okay.

And just lastly the retail channel weakness, what's driving that? And do you expect that to turn around next quarter?.

We do see that to turn around the next quarter as more and more retail stores are opening up. We've heard that many retail store are unable to open completely due to a lacking of labor. There is a major shortage in labor in the west coast, and also anywhere that you go in the U.S. So restaurant owners are having a challenge to overcome that.

And we do see it getting – becoming better, some states are easing off with the federal assistance, hopefully that will help the restaurant to get the staff they need to open up, reopened their businesses..

Great. Thanks, Alan. Nice quarter. I'll pass it on..

Thank you, Ryan..

[Operator Instructions] Our next question will come from Jake Bartlett with Truist. Please go ahead..

Great. Thanks for taking the question and congrats on the first earnings call. My first question probably to you, Alan was the mix of products. I am wondering specifically how off-premise to go, product mix is doing as well as the cup business, whether the cup business has been recovering quickly.

What is really – how was that – how was the product mix shifting?.

Thank you, Jake. Well, during the pandemic, we saw cup business dropped sharply and has come back slowly, but the first quarter, at least, because most of the businesses are opening up, we're seeing that the restaurants are opening the cups – really reopening the cup like [indiscernible] with the cup business.

So on the take-out side, we have seen more of a steady in terms of demands on the take-out side but whereas on the cup side, it has really grown sharply, especially when weather is heating up more and more consumers are using the cups and as well as the restaurants opening in dine-in, the fast food chains are allowing customer to use their soft drink fountains, so the demand on cup has really increased.

So, that's one of the things that's pushing the shortages in supply on the cup side..

Jake, let me clarify that question and the perhaps supplement a little bit more, but revenue for cups and related couplets, cup holders and cup jackets, the combination of all of that cup related products came in at approximately $20 million or about 25% of total revenue in Q1 of 2021, still slightly down about 2% from Q1 of last year.

However, staying steady compared to Q4 of 2020. In terms of the take-out containers, we did see that the take-out containers, the hinged containers grew to $11 million or 15% of revenue in Q1 of 2021, basically up from $9.5 million in Q4 of 2020 and $8 million in Q1 of 2020.

So that's some of the trend that we have been seen, Jake, in terms of our product mix. The other thing to – that we see a trend in our product mix is that our food products in terms of syrups and boba grew to about $13 million in Q1 of 2021, up from $10 million in both Q4 and Q1 of last year, Jake..

Great. That's really helpful. And my next question is on your manufacturing. And first part of that is what percentage of your sales were manufactured – that you manufactured yourself? And is that – do you expect that to increase in the near-term given the shortages and given the shortage now and the time it takes for freight to come across from Asia.

How your manufacturing ability kind of help you out here?.

Jake that is a great question. And so, we continue to see our mix between our manufacturing and versus the sales from the goods that we import to be roughly between that 85% to 15% of goods we manufacture.

And so the way we view our manufacturing capability is that to supplement, to be a flexible resource to our customers in terms of having products availability, but we do have limited number of SKUs that we manufacture ourselves at our Chino and our Texas facility.

And so we do still continue to see 15% of our goods, our revenue will come from manufacturing goods and about 85% to continue to come from our goods that we import from overseas..

Okay, thank you..

And just to add that Jake, yes, we are looking to increase our manufacturing to make sure that we do not run out of product for our existing customers rather than just 100% focusing on imports. And also this will reduce the cost of freights as well.

So basically, we're – like Ann says, our revenue is growing and our manufacturers domestically are also going with it..

Got it, got it. That makes sense. And then I got a question about the retail sales and the decline area. I think earlier in the script, Alan, you mentioned that some of that was shifting just into the online channel.

And I'm wondering one maybe how much of the increase in online sales were due to that shift of customers that used to be buying through the retail channel. And then as part of that I believe there is very different margin contribution or margin profiles for the retail and the online retail is less.

So are they now opting to pay more just for the convenience of ordering through the online channel?.

So, Jake, that is another great question. So in terms of our dollar amount for online, we – Q-over-Q we saw online increased by $4.7 million or 70%; in terms of retail, we saw a decrease by $1.1 million or negative of 16%. So in essence there is that shift from retail to online.

In terms of our contribution margin, we continue to see our online to be the highest contribution margin of close to that 60%. And so, we definitely see that there is a shift to online in terms of our dollar amount and also in terms of the fact that we continue to see a contribution margin expansion to our online channels..

Jake, let me ask with your – to answer a question. Yes, we see that customers are willing to pay more online just to make sure they get the product right now..

Yes..

Yes..

Okay. And then, the last question although I do have a few more, but that just the – you've mentioned the cost increases the freight and I believe resin is also higher and you're taking price to offset that.

How do you view gross margins in 2021 relative to 2020? Do you expect just the net impact of those two things to be a drag on gross profits or gross margins or a benefit?.

So, Jake, we continue to see that it's – we're going to be able to maintain the gross margin expansion in 2021. So, we have effectively passed on the increases in our raw materials as well as our increased freight and duty costs to our targeted customers. In January and February, we did see that to be a drag.

However, in March, we rebounded very strongly in March and saw our gross margin above 32% in March. And so, we're very excited about the fact that we're seeing that trend into the next few quarters. And so, we definitely are able to maintain our margin expansion..

Okay. And I actually have one more and then I'll stop hogging the call, but the question was on Karat Earth. I believe the sales mix in the fourth quarter was – was about 8%, I think in 2020 it was 6%.

What percentage of sales was Karat Earth in the first quarter of 2021?.

So eco-friendly – Jake, another great question for eco-friendly products in Q1 of 2021 comprised roughly a 20% of our total revenue compared to Q1 of last year, which was slightly below 20%. So eco-friendly products have increased slightly compared to Q4 of 2020 from roughly about 17%.

In terms of our eco-friendly line, it was roughly about 5%, 5.5% for us in Q1 of 2021, but eco-friendly products comprised roughly about 20%, Jake..

Great. Thank you very much..

Absolutely..

Thank you, Jake..

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

Thank you operator and thanks to everyone for joining us today and for your support and interest in our company. We look forward to speaking with you again soon on our second quarter call..

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect..