Good afternoon, and welcome to the Karat Packaging Second Quarter 2021 Earnings Conference Call. [Operator Instructions]. I would now like to turn the conference over to Roger Pondel. Please go ahead..

Good afternoon, everyone, and welcome to Karat Packaging's 2021 Second Quarter Earnings Call. I'm Roger Pondel with PondelWilkinson, Karat Packaging's Investor Relations firm. It is 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 all 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 IPO registration statement 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'll be discussing adjusted EBITDA and adjusted EBITDA margin within non-GAAP financial measures as defined by the SEC Regulation G. A reconciliation of non-GAAP financial measures to the most directly comparable GAAP measures is included in today's press release, which is now posted on the company's website.

And with that, I will turn the call over to CEO, Alan Yu.

Alan?.

Thank you, Roger. Good afternoon, everyone. We're pleased to be here with all of you today. Our business continued to grow at a robust pace earlier today.

We reported solid second quarter financial results that reflect strong demand in the company's prowess and its nimbleness as a leading suppliers of customizing solutions for a diverse and expanding customer base.

In addition, increasing adaptation of environmentally-friendly products and solutions continue to drive demand for the food service industry and particularly for Karat Packaging. For the second quarter, net sales were ahead of the expectation, increasing 12% year-over-year with strong performance in our national online and distribution channel.

Excluding the personal protective equipment products that we primarily saw in the second quarter last year during the height of the COVID-19 pandemic, our rate of comparative sales growth for the second quarter on our core business was nearly 70%. Online sales rose 22% year-over-year in the second quarter.

And we continue to shift our sales mix towards the high-margin channels. Sales through national and distributor channels also increased at a double-digit pace. Retail sales were lower year-over-year in the most recent second quarter, primarily due to PPE sales in the last period - in the prior period.

Gross margin in the fiscal 2021 second quarter declined year-over-year primarily due to increases in freight and material costs as well as a comparison to the high-margin PPE product that we saw last year. As Ann will explain shortly in more detail, we saw a significant number of PPE product in last year's second quarter.

These products carry margin closely to 50%, which is higher than margins on our traditional products. Ocean freight rates have risen to the highest rate we've ever seen. And we expect this rate to remain at high level until early next year.

To respond to the current and anticipated increases in freight rates and to protect our margin, we instituted multiple price increases in the second quarter. As a result, gross margin increased 110 basis points sequentially over the 2021 first quarter.

Despite higher freight cost, we continue to take action to pass on higher cost in July, with the largest price increase in our company's history.

Our positive momentum has continued into the third quarter with a secular tailwind we're seeing in the restaurant opening, consumer spending and services and the adaptation of environmentally-friendly products, helping to drive the demand in support of our business.

We're also seeing high demand for our beverage line of higher margin bubble tea supplies, which is adding to our growth and profitability. As a result, we're currently targeting net sales to be in the range of $100 million to $102 million in the 2021 third quarter.

Moreover, growth in high margin online sales and the actions we take in to cast off higher freight cost has given us confidence in our ability to improve our gross margin in the third quarter relative to the first half of 2021. At the same time, we also are driving greater efficiency in our operation.

We're better leveraging our cost base at our largest facility in Texas. While also increasing output, we are also recently expanding our network through the acquisition of a warehouse building and the addition of a distribution facility in South Carolina.

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 second quarter results reflects strong top line growth, offset by a decline in gross margin and an increase in operating expenses. Net sales increased 12% to $95 million in the second quarter.

In last year's second quarter, we shifted to import PPE products to meet a critical need during the height of the pandemic and support our growth. Sales of this product peaked in last year's June quarter at $29 million. Since then, PPE sales as expected has declined and represented less than 1% of total sales in this year's second quarter.

Excluding PPE products, sales in the 2021 second quarter rose 69% year-over-year. Sales to distributors. Our largest channel grew 14%, and sales to national chain expanded 38%, primarily due to more business with existing customers. Online sales rose 22% in the quarter as we continued to make significant investments in this channel.

Sales to the retail channel fell 41% from a year ago, primarily due to sales of PPE products in last year's second quarter. Excluding PPE products, our sales in our retail channel were up slightly year-over-year.

We also increased minimum shipping requirements to better manage tax labor conditions, which shifted a portion of our sales mix from retail to distributors and enabled us to better utilize packing resources.

For reference, the tables in our earnings release issued earlier this afternoon break out sales of our traditional products, excluding PPE by channel. Gross profit decreased 3% to $28 million in the 2021 second quarter, primarily due to a decline in gross margin, partially offset by higher sales.

Gross margin was 29.7% in the 2021 second quarter, a decline of 440 basis points compared with 34.1% in the same period of last year. The gross margin decline primarily reflects higher freight and material costs as well as the high margin PPE products sold in the last year's second quarter.

As Alan mentioned, we've taken action to pass through higher costs in a series of price increases. Our progress to date is evident with our gross margin trend, which was improved from 27.4% in the fourth quarter of 2020 and 28.6% in the 2021 first quarter to 29.7% just reported in the second quarter.

Operating expenses in the most recent second quarter increased from 47% to $21 million, principally reflecting higher shipping costs, payroll expenses associated with workforce expansion in timber and labor, an increase in facility costs and higher professional fees.

Costs related to our public offering were approximately $600,000 in the 2021 second quarter. Operating income declined 53% to $7 million in the 2021 second quarter. Operating margin was 7.3% compared with 17.1% in the same period of last year, primarily due to the pressure from higher freight and shipping costs.

Other income increased approximately $5 million year-over-year in the second quarter due to a gain on PPE loan forgiveness, which we borrowed last year. Provision for income tax expense decreased to $2 million in the 2021 second quarter from $4 million in the same period last year.

Our effective tax rate was 14% in the second quarter compared with 28% in the same period last year, primarily because the $5 million gain recorded on the forgiveness of the PPP loan is not subject to federal income tax. Excluded in the debt position, our effective tax rate in the 2020 working quarter within 23%.

We expect our effective tax rate for the 2021 to be in the mid-20% range. Net income amounted to $9 million for the 2021 second quarter compared with $10 million in the same period last year. Net income attributable to Karat Packaging Inc.

was $9.6 million or $0.50 per diluted share in the second quarter compared with $10.1 million or $0.65 per diluted share last year. Adjusted EBITDA on a consolidated basis was $10.1 million for the 2021 second quarter compared with $16.5 million a year ago and $6.8 million in the 2021 first quarter.

Consolidated adjusted EBITDA margin was 10.7% in the second quarter compared with 19.4% a year ago and 9% in the 2021 first quarter. Adjusted EBITDA attributable to Karat Packaging Inc., $10.2 million in the 2021 second quarter. Adjusted EBITDA margin attributable to Karat Packaging was 9.7%.

Net cash used in operating activities was $2 million in the 2021 second quarter compared with net cash provided by operating activities of $7 million in the same period last year. The decline primarily was due to changes in working capital, in particular, increases in inventory and accounts receivable that principally reflects our growth.

Capital expenditures were significantly lower year-over-year, primarily as a result of the purchase of manufacturing equipment and construction of our facility in New Jersey last year. I will now turn the call back to Alan for closing remarks, then we'll be happy to answer any questions you may have.

Alan?.

Thank you, Ann. Our business continued to grow as we capture positive secular trends in the food service industry. As a nimble supplier of a wide range of products, Karat Packaging is able to respond more quickly to market conditions than our competitors, which we believe give us a tremendous advantage.

Our 2021 second quarter delivered solid growth in sales as we proactively work through our cost pressures. We're pleased that demand continued to be strong which we believe will contribute to another solid sales performance in the third quarter. With that, I'll turn the call over to the operator for Q&A..

[Operator Instructions]. And the first question will come from Jake Bartlett with Truist..

Congrats on some great top line growth here. Alan, my first question is about the upside due to sales that you saw in the second quarter than the strong guidance for the third.

Are there any particular channels that's driving the upside? Or is it fairly broad based?.

I do see, Jake, well, if you can hear me well.

I do see - can you hear me?.

Yes..

Jake, are you there? Okay. Well, this is why I see the tireless - what I see in the second quarter is the online sales. I see more and more people ordering online, I think there's a disruption of supply chain throughout the U.S., especially in the cup market. Everyone - if you go out to a national chain account, it could be any national chain account.

You ask them for a cup. Normally, they have a plastic cup. Now they probably tell you that we're out of cups. We have a styrofoam cup. In some places, they don't even have styrofoam cup. What I heard in the market is that every manufacturer is struggling, having a challenge, in terms of producing, regardless of styrofoam cup or paper cup or plastic cup.

This is where we see everyone - when people can't find the product in their normal distribution channel or the restaurant people, they go to online. We see a lot of people going online, buying large straws, our bubble tea supplies and our cups.

So what Ann just mentioned earlier in the conference that she described, one of our biggest sales growth as we've seen is almost a double, like 100% growth in our bubble tea supply demand. This is something that we've never seen in the past year. The bobas, double digit, actually triple-digit growth year-over-year, cups demands, upside increase.

I guess what - when people like - I was talking to customers in Las Vegas and Florida, people are traveling. They're going everywhere. They take their own flights and they're using cups. They're going to their favorite restaurant. They go into the hotels. Hotels are buying cups like crazy.

In Las Vegas, everywhere you go is packed with people, and they're holding a plastic cup or paper cup. So the demand has really gone up. And especially in the second quarter, when the economy opens up. So this is where I see all these catalysts of the growth. And it's actually - it's carried over to the third quarter.

Why? Just on our back orders, we're behind 3 weeks of shipping products. Imagine, if we're caught up it's - we just don't have enough people to pack the orders and ship right now. But we're - this is a challenge that I do see everywhere in the market is facing, regardless it's a Sysco, a US Foods or a Bunzl or anybody - Amazon.

Even Amazon is having a challenge hiring people to get the product shipped in timely manner..

So, Jake, let me follow up with what Alan just shared. In Q2 of 2021, we saw our food products grew to $21 million or 22% of revenue for Q2 of 2021, which is over 200% year-over-year and over 60% Q-over-Q. The main food growth drivers were syrup, boba, popping pearls and powder.

In terms of cups, our revenue for cups, cup mix holders and cup jackets came in at a robust, approximately, $20 million or 27% of total revenue in Q2 of 2021, and this has been up about 30% for us compared to Q1 of this year and significantly up over 200% from the pandemic glow of Q2 of 2020.

Another trend that we are seeing is your - the food containers for us remain roughly at about 15% and custom printing remains approximately at 19% for the company in Q2..

Great. That's really helpful. Actually my next question. But just to build on that, what percentage was with the environmentally friendly, whether it's Karat Earth or just how else you define maybe if you could share both as a percentage of sales in the second quarter..

Yes. Eco-friendly sales approximated $17 million in Q2 of 2021 or roughly 18% of total revenue, increase from about $14 million in Q1 of 2021 and $8 million in Q2 of 2020. The company continues to see strong demand for paper food containers, hot cups, cold paper cups and fold-to-go containers.

In terms of Karat Earth, as a percentage of sales, we continue to see it steady at about 5% of total revenue for Q2 2020..

Great. And then my last one, my next question is on SG&A. It was up fairly significantly in the second quarter from the first quarter.

How should we think about the back half of the year in '21? Is the second quarter a good run rate? Or should we expect a similar kind of growth quarter-to-quarter as we move throughout the year? Just any help on what we should expect from G&A going forward..

Yes. So we should expect for Q3 to be similar to that of Q2 of this year..

Okay.

And for fourth quarter, kind of similar as well or any reason that, that should be - deviate?.

That should be similar expectation as well in Q4..

Okay. And then last question....

Jake I want to have a - Jake, I want to add to what Ann mentioned earlier in Q3. In our conference call, we did mention that our Q3 earnings is going to be around $100 million to $102 million, which is 30% to 33% year-over-year growth. I would think that is - it's going to be higher than our Q2 numbers.

And this is one of the reasons as we see a strong headwind continue into the third quarter that - based on the second quarter numbers..

Headwind of group or headwind of what?.

Oh, tailwind. Tailwind..

Yes. That's a tailwind. Got it. Got it. Great. Great. And then just if you could frame out what kind of pricing is in the system in the third quarter versus the second quarter? How much has that - you mentioned it was the largest increase in July in the company's history.

If you could help us just frame what the year-over-year pricing is at this point and what it was in the second quarter, that would be great..

Sure. In the second quarter, we took some price increase in April and also in June in the different categories. But in July - end of July, we actually imposed a 10% to 18% price increase nearly across the board with the exception of some of the national chain accounts. But this is like our largest price ever increase.

Because we've seen the ocean freight has gone up tremendously since June. In June and July and even August, this month, we've seen ocean freight continue to go up. And it's actually deterring a lot of our competitors on stop importing the product.

And even with the high cost of the ocean freight, most people are still unable to get enough container space to bring the product here. This is what's causing a supply chain disruption in the U.S. is that even if you pay more like, almost triple the amount of money that you used to pay last year, there is no guarantee of getting a container space..

And the next question comes from Michael Hoffman with Stifel..

My question center around the cadence for the remainder of the year. So we've got a meaningful improvement in revs. EBITDA actually came in about where you all thought it was at the time of the IPO. I guess maybe we as sell-side analysts were a little more ambitious, but it came more or less in line with you were thinking.

So how do you feel about that original EBITDA net of global wells, that was about $38 million.

Are we still on a pace to be able to do that, accounting for these challenges with freight and labor, but really good demand and sort of balancing all that out?.

Michael, that is a great question. So in terms of our EBITDA margin, we continue to have confidence our EBITDA margin will be between 9% to 12%. In terms of - yes, so that should lead us on trend to be between $36 million to $38 million roughly for the remainder or for the rest of the year..

Okay. So a little bit low on the lower - on the low end. The high end still sort of reflects where we started. And in fairness, there's been some unprecedented inflation pressures and you're working hard to price it through and manage costs..

Yes. I mean absolutely. I mean what we have seen is that in spite of the rising freight and freight costs, what we have been able to do is we have been able to protect our gross margin. We went from 27.4% in Q4 of 2020 to 28% in Q1 of this year and then 29.7% in Q2 of this year.

So we have been very proactive in protecting and also expanding our margin in a very tight past few quarters for us. And so we do continue to - again our EBITDA margin to be within that 9% to 12% range, which would lead us to be at 36% to 38% total EBITDA for 2021..

And again, speaking about gross margins, you've always talked about that approximately, this is a 30% gross margin business.

So would we - given the pricing initiatives, some mix trends the strong demand, are we headed towards the 30% for the remainder of the year, so a further sequential improvement?.

That is our expectation, Michael, in the remainder of the year for Q3 and Q4, our expectation is we're going to be at that 30% gross margin range..

I believe, Michael, Ann mentioned in last quarter, our goal for the 2021 is 29% to 31%. And we've already seen second quarter at 29.7%, 29.8% already. So we're already near to 30% already. So we are still shooting for the 31%. That's our goal, basically. So when we first started, we were discussing in the IPO. Yes..

Terrific. So lots of restaurants have been able to get opened. We've all heard the same stories of challenges with labor and all those things. But the interesting question I have is moving from takeout to on the curve to indoor dining, menu started changing.

And how has some of those menu changes been showing up in your business? That's sort of part one. And then there's this increasing announcement of expanding number of ghost - I always wanted to say ghost chickens. I mean to say ghost kitchens, ghost kitchens also impacting the business..

Well, here's the thing, when restaurant was shut down, but mostly we're using takeout, we've seen a rise in demand on the takeout containers, any type of takeout containers, a sharp drop in the cup business in the napkin and the unwrapped utensils and the compostable line of product.

But when the restaurants started to open up, we saw an even - a larger increased demand in the cup. Whether for drinks when they were closed, people are using less cup now. But when they opened up, everyone starts scrambling to restock their cups that they use as well as napkins, utensils.

The item that we basically were not moving during the pandemic started to really move when restaurants started to open up.

And we've seen one of our customers was telling us that when the pandemic - when there was a pandemic, when they shut down the indoor dining, their takeout, the drive-through was basically car would wrap around the seat in the shopping mall for the drive-thru.

When they open up the indoor dining, they basically added double their store size around the business. So most of these high-volume stores where there's more drive-throughs and when they opened the indoor dining, in fact they opened 2 more - new stores for every one of the locations they have.

That's all from the scenario that a customer has been telling us. And I guess, like I said earlier, when restaurants opened up, when the hotels opened up, when the resorts opened it up, and also the tours of actions start to open up, the demand just skyrocketed..

Okay. Last one from me. M&A is something we've - You talked about that was one of the purposes of the IPO was to create a balance sheet that would allow you to start looking at M&A, Pacific Packaging you led off with.

What - how would you frame where your pipeline is, the prospects of possibly finding another opportunity like a Pacific Packaging or even something different.

Can you talk to us about that?.

Yes. We have received some - Ann and I have been looking and discussing with several companies. And we're looking - we're doing the due diligence. And also we want to do the right thing and making sure that there's a right mix.

As we mentioned in the IPO, we're looking for a company with a synergy that the leadership, the management team and also the product offering. And another thing is the locations. So these are the things that we're looking at. And we have been in discussion with a couple of these companies. We're just - we're gathering more information on that part..

And the next question will be from Ryan Merkel with William Blair..

So first off, Alan, in this market with major shortages, is your import model, is that winning in the marketplace? Are your fill rates better than your competitors?.

I have to say, yes, if you cover the industry well, and I'm sure you can talk to any one of our industry sector manufacturer, everyone is having shortages. And there's one main reason the shortage is it could be a supply issue, raw material supply issue and mainly it's a labor issue, the major shortage of labors.

That is one of the main reasons that there's a supply shortage that's in the market. It's just really hard to get people to come to work in now the environment. Everyone is hiring, but it's really tough. It's a challenging market in labor. It's not just to the manufacturer, it's with the restaurants. I've spoken to a lot of restaurants.

They have to shut down their indoor dining because they can't find enough people to work and clean the indoor area, dining area. Some of the managers in our distributors, they have to drive the forklift and know the trucks and then out make deliveries. I think everyone's accepting that challenge. So basically, the only alternative is import.

Now when we saw - actually, we - I kind of knew every year that when the summer comes, there's a short - always a shortage. So we had 1.5 months of shortage in our products. So our fill rate was low. And then we started ramping up our import in June and July.

So right now, our warehouse are packed and I believe our fill rate is better in California, but we're trying to get the product into the Texas and New Jersey area. And that's one of the challenges everyone is facing.

There's more supply issues in the East Coast than the West Coast, is that the ocean line, the ocean freight - container freights are unable to get to the New York area, the East Coast area. So everything is coming to the West Coast and rail was struck into the East Coast, which is - that's why it's causing a great congestion in the logistics.

Also, I would say that every logistics, including UPS, FedEx for the ground carriers, they are maxed out at their capacity. There's major delays. You can see that - every website is telling you that there's a delay in shipping, there's a delay in delivering, just expect delays.

But I would say our delay today is definitely better than most of our competitors right now..

Okay. And you sort of hit on my follow-up, which is you've got ocean freight rates going crazy. You got the congestion, you got containers coming in late and delayed.

How are you managing that? How are you importing products effectively and having these high fill rates when there's a lot of other people that are facing challenges?.

Well, we actually took the initiative of placing the order in advance. So we actually - like in our conference call, we're nimble that's how we're able to compete in the marketplace. We're small and we're nimble. So we move fast.

When we saw there's a height, a peak, a rising demand in the bubble tea line product with the cup business, we immediately placed additional orders with our overseas partners, the manufacturers, and they started shipping. And we actually ordered more than twice the amount of what we normally would order.

And also, at that time, basically, they're all actually arriving now, and that's one of the reasons we're able to fulfill a lot more of our customers. And actually, we're helping out a lot of these national chain accounts that ran out of cup and ran out of straws and ran out of food containers. We're basically helping a lot of people out.

If you cover the restaurant industry and you would talk to these national chains, you would - people will actually tell them, come to Lollicup. They might be able to help you. I mean that's what's going on out there..

Yes. That's great. Okay. That helps.

And then just lastly, we hit on this a little bit, but I just want to be clear, in the quarter for gross margins, did your price increases cover your raw material cost increases and freight increases?.

I believe it did. As Ann mentioned, our second quarter gross margin was actually higher than our first quarter. Because the largest increase in the raw material was in April and May, it was - the increase was - the largest increase - and the raw material is not in the first quarter, it was in the second quarter.

So basically, if we have not implemented the price increases, our gross margin will fall below the first quarter number. But in essence, we actually were able to increase it from 29.2% to 29.7%, I believe. And that's due to the fact that we were proactively passing on the increase to our customers, on to our products..

Yes. Yes. And to clarify, we went from 27.4% in Q4 to 28.6% in Q1 and then to 29.7% in Q2. To Alan's point, yes, we have been able to increase cost efficiency to cover the rising ocean freight and the higher material costs and then contribute to the additional margin expansion sequentially over the past few quarters..

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

Well, thank you all for joining our conference call, and we will definitely continue to work hard to increase our shareholder value, and we look forward for a better next quarter. Thank you all. Have a nice day..

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