Q3 2023 Karat Packaging Inc Earnings Call

Participants

Alan Yu; Chairman & CEO; Karat Packaging Inc.

Jian Guo; CFO & Director; Karat Packaging Inc.

Jake Rowland Bartlett; VP; Truist Securities, Inc., Research Division

Michael Edward Hoffman; MD & Group Head of Diversified Industrials Research; Stifel, Nicolaus & Company, Incorporated, Research Division

Ryan James Merkel; Partner & Research Analyst; William Blair & Company L.L.C., Research Division

Ryan Robert Meyers; Senior Research Analyst; Lake Street Capital Markets, LLC, Research Division

Roger S. Pondel; CEO and President; PondelWilkinson Inc.

Presentation

Operator

Good afternoon, and welcome to the Karat Packaging Inc. Third Quarter 2023 Earnings Conference Call. (Operator Instructions) Please also note that this event is being recorded today. I would now like to turn the conference over to Roger Pondel, Investor Relations. Please go ahead, sir.

Roger S. Pondel

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

Alan Yu

Thank you, Roger. Good afternoon, everyone. We are proud to deliver a strong third quarter, with revenue in line with our expectation and sustained meaningful improvement in margin. Sales volume increased approximately 7% over the prior year period, although total revenue was again impacted by unfavorable year-over-year pricing comparison along with lower revenue from logistics service and shipping charges as anticipated. Sales of our eco-friendly product continue to improve. This category grew 15% in the third quarter over the prior year quarter and represented approximately 33% of total sales.
For the quarter, we achieved a 49% increase in net income from the prior year quarter, and we're able to sustain an elevated gross margin. Even with the industry-wide deflationary environment, gross margin in the third quarter continued to benefit from our strategy of scaling back manufacturing operation and significant lower ocean freight costs versus last year. Sales from manufactured products in the third quarter were 22% of total net sales compared to approximately 27% last year, which generated labor product cost saving of $1.1 million. We expect our gross margin to remain at a higher level because of our initiatives and the continued strong U.S. dollar.
Now into the fourth quarter of 2023 and heading to 2024, we will continue to implement asset-light initiatives in our other U.S. locations, and we'll concentrate more on import and distributions. We see a long runway for margin expansion given our objective of having manufactured products to be at approximately 10% to 15% of total sales. We're also focusing on new product development to further enhance our competitive strengths, fill customer demand and add to revenue growth.
Our new Chicago and Houston distribution centers, which became fully operational in September, are expected to contribute to new geographic market penetration and to enhance our fill rates. Together with the recent expanded national sales force, we are growing market shares in the East Coast, Northeast and Midwest regions. We soon expect to double the size of our Washington State distribution center, with the moving to a new 100,000 square foot distribution center. Additionally, as part of our strategic growth plan, we're looking to open smaller satellite warehouses in 2024 in select regions to support online sales growth as well as deploying new AI technologies to further improve operating efficiencies.
Based on geographic sales from our distribution center, for the third quarter compared with the prior year quarter, the East Coast Northeast region increased 41%, and the Midwest and Texas region improved 7% year-over-year. These improvement were offset by softer sales from California, which declined by 16%, reflecting a weaker conditioning in the restaurant sector throughout the state.
The successful execution of our strategic initiatives is also evidenced by our sustained strong operating cash flow as well as liquidity and balance sheet position. Accordingly, as we announced earlier this week, our Board of Directors authorized an increase in the quarterly cash dividend payment to $0.20 per share from $0.10 per share. The Board's action reflects it's confident in Karat's long-term future and commitment to returning value to shareholders.
I will now turn the call over to Jian Guo, our Chief Financial Officer, to discuss the company's financial result in greater detail. Jian?

Jian Guo

Thank you, Alan, and good afternoon, everyone. Net sales for the 2023 third quarter, as expected, decreased 4.1% to $105.5 million from $110 million in the prior year quarter. Sales volume increased 7% over the prior year quarter, which was offset by unfavorable year-over-year pricing comparison as well as lower logistics services and shipping revenue.
The unfavorable year-over-year pricing comparison reflects the expected impact from the multiple rounds of price reductions implemented primarily around late 2022 and the first half of 2023 as we proactively passed on savings from ocean freight and raw material costs to customers. By channel, as a comparison to the prior year quarter, sales to distributors, our largest channel, was lower by 4.0% for the 2023 third quarter. Sales to national and regional chains decreased 2.3%. Sales to the retail channel decreased 19.3%, and our offline channel sales were up by 1.6%.
We are encouraged by the volume growth in our business as well as by the strong momentum in the growth of our eco-friendly products and the geographic regions that we're starting to penetrate, including the East Coast, Northeast and Midwest.
Gross profit increased 14% to $38.9 million for the 2023 third quarter from $34.2 million in the prior year quarter. Gross margin increased 580 basis points to 36.9% in the 2023 third quarter from 31.1% for the prior year quarter. Despite the unfavorable year-over-year pricing comparison, gross margin benefited from our continued efforts to scale back manufacturing operations, the strong U.S. dollar and a significant decline in ocean freight rates, which amounted to 7.9% of net sales in the 2023 third quarter compared with 14.8% of net sales last year.
Operating expenses in the 2023 third quarter were $27.6 million or 26.1% of net sales compared with $26.3 million or 23.9% of net sales in the prior year quarter. The current quarter operating expenses included approximately $450,000 in transaction costs incurred in connection with the secondary offering, which was completed during the quarter.
Other increases in operating expenses included workforce expansion as we reduced production but increased warehouse headcount, higher marketing expenses to support online sales growth, and higher rental expense from the expansion of our warehouse footprint. The increase in operating expenses was partially offset by savings in shipping and transportation costs due to lower rates.
Net income for the 2023 third quarter rose 48.5% to $9.1 million from $6.2 million for the prior year quarter. Net income margin advanced to 8.7% in the 2023 third quarter from 5.6% in the prior year quarter. Net income attributable to Karat in the 2023 third quarter rose to $9.1 million or $0.45 per diluted share from $6.1 million or $0.31 per diluted share in the prior year quarter.
Adjusted EBITDA, a non-GAAP measure, increased to $15.2 million in the 2023 third quarter from $11.7 million in the prior year quarter. Adjusted EBITDA margin rose to 14.4% of net sales from 10.7% for the prior year quarter. Adjusted diluted earnings per common share rose to $0.47 per share from $0.33 per share in the prior year quarter.
Turning to liquidity. With $12 million of net cash from operating activities in the third quarter of 2023, we finished the quarter with $113 million in working capital, up from $84.5 million at the end of 2022, even after a total of $16.9 million of dividends paid during the first 9 months of the year. As of September 30, 2023, we had financial liquidity of $64.4 million with another $18.1 million in short-term investments.
I will now close with our fourth quarter outlook. We are revising our net sales forecast for the fourth quarter to be up approximately 2% to 5% year-over-year based on our current restaurant conditions in California, including the competitive environment. We expect robust volume growth of 10% to 15%, partially offset by unfavorable year-over-year pricing comparison. Our gross margin projection for the 2023 fourth quarter and into the first quarter of 2024 remains at approximately 36% to 38% with the current projection for ocean freight costs remaining fairly consistent.
As Alan mentioned earlier, we're expanding our market penetration into the East Coast, Northeast and Midwest region. As well, our strong sales pipeline and our growth initiatives are expected to continue to enhance our performance. Alan and I will now be happy to answer your questions, and I'll turn the call back to the operator.

Question and Answer Session

Operator

(Operator Instructions) At this time, we will take our first question, which will come from Ryan Merkel with William Blair.

Ryan James Merkel

Maybe, Alan, can you just talk about fourth quarter and why you guys are lowering the revenue there? It sounds like California maybe price down a little bit more than you thought last quarter? Just unpack that for us.

Alan Yu

Yes. Actually, California has been -- our sales in California has been reducing, dropping. And we're seeing that the restaurant condition, it's not just the price drop in the California area competitiveness. It's -- as I mentioned earlier, our volume growth is looking at 10% to 15%, volume wise, growing. In third quarter, it was only 7%. But in volume, it looked growing more.
But in California, the restaurants, we're seeing more restaurants shutting down. And we're seeing restaurant conditions pretty bad. The overall environment is -- it's not very good. The chains are doing well. The independent restaurants, they're closing early. We don't see much of foot traffic. We talked to the restaurant owner. They don't see people coming in after 7:00 p.m. at nighttime.
They used to -- people used to pack the restaurant and also do takeouts even after 9:00 PM. But right now, there's -- crime is increasing. Crime rate is going up. It's not safe to be out there. People just not dining out right now, so we're seeing California down. And we don't see any revision upward in California for the near term. And that's why we're focusing West and East Coast right now.

Ryan James Merkel

Got it. Okay. And it looks like price will be down roughly 10% in the fourth quarter. Did that surprise you? Or is that consistent with what you thought last quarter?

Alan Yu

This is actually consistent with what we saw because everything is coming down. Ocean freight has been -- has come up a little bit in the third quarter. So third quarter, we saw our gross margin decline a little bit because ocean freight went up for a couple of months and then went back down again. So we're seeing that the fourth quarter, our gross margin coming back normalized.

Ryan James Merkel

Got it. Okay. Maybe just lastly, just talk about the AI that you're going to be including in the warehouses. What are you doing there and what's the benefit going to be?

Alan Yu

Well, we're seeing that the overall payroll has gone up throughout the U.S., especially in California. And what we want to do is we want to reduce our staffing. We want to utilize more AI technology to finish -- complete the work that are redundancies, repetitive rework or simple works like customer service, purchasing, placing POs, placing sales orders or generating sales orders as well as warehousing. We're using AI to monitor each staff efficiency. So far, we've already tested our customer service, online customer service. 98% of our increase are currently handled by our AI technology. And what we're trying to do is reduce our purchasing account payable, accounting department, at least 70% of the workload -- simplify workload. So that -- with the existing staff, we can run actually -- increase our revenue with existing staff or even lesser staff than we have right now.

Operator

Our next question will come from Michael Hoffman with Stifel.

Michael Edward Hoffman

Could you just share a little bit? I know you don't give a lot of detail at the regional mix. But just so we appreciate, what percent of revenues is California versus other major areas like Texas, Northeast or Northwest or Southeast?

Alan Yu

California right now is approximately, I would say, 30% of overall revenue. Jian, would you -- is that (foreign language) We actually carve that out.

Jian Guo

Can you hear me?

Alan Yu

Yes. Go ahead, Jian.

Jian Guo

Yes. That's about right. It's a little over, but that's roughly right, yes.

Michael Edward Hoffman

Okay. And then the next biggest region would be sort of the Texas area, Midwest and then Northeast. Is that how we think about it?

Alan Yu

That's correct.

Michael Edward Hoffman

Okay. All right. And then when you think about -- I know you're not giving guidance yet, but I just want to figure out what I'm taking out, '23 into '24, what I have to sort of consider. So there's been this pricing mix shift based on changes in raw material inventory, freight, all through the latter part of this year and the early part of the next -- latter part of last year into this year. What's my rollover effect of that? What -- how do I think about rolling over the pressures that have been in California versus the opportunity for either new customer wins or expansion of wallet of existing based on things like adding Houston or Chicago or the capacity expansion in Washington State? Can you help us with how to think about the top line in '24?

Alan Yu

Yes. We do feel that we have several new regional chain. That's what we're focusing on in terms of Midwest and East Coast as well as supermarket chains for 2024. And I believe, Jian, do we -- I would say that our 2024, we are looking to increasing revenue wise in terms of what these pipeline -- converting these pipeline and also new distributors because we're adding -- last quarter, I believe we added over -- around 30 new distributors and chain accounts in the last quarter. And now we're seeing that perhaps 35 or more distributors in the fourth quarter and moving forward in 2024 approximately. So we do see an upside in terms of increasing revenues. I believe that our -- we would be -- did we guide our revenue up on 2024, Jian?

Jian Guo

We haven't. We typically will provide the 2024 revenue guidance in our fourth quarter 2023 call. But to Alan's point, we do see some great, Michael, to answer your question, growth opportunities in terms of that top line in 2024. So I know Alan already touched on we are seeing roughly an increase of 10 distributor like in the distributor channel, which is our biggest channel, as you're aware, each month. So -- and then we are getting very close on some of the pipelines in our new business as well as expanded business in our chain channel as well. So we'll be providing an update on our 2024 revenue guidance next quarter.

Michael Edward Hoffman

Yes. Fair enough, and I'm truly not trying to get guidance as much as I just -- we all have to build a model, and I've got to put a number out there. I want to make sure I'm in the right neighborhood as opposed to something silly. So what I think I'm hearing is that you've got enough new business opportunities between the distributors, new business growth and chains that there's a low single-digit-ish organic growth, overcomes any things like weakness in California rolling over. And then you've had -- you've enjoyed -- so my -- is that the right way to think about it? Sort of low mid-single digits without getting it into a hard range?

Alan Yu

Michael, you missed one thing. It's not just new accounts. And also, we mentioned that we're going to be adding new product. There are several items that we'll be adding that will increase our revenue organically for the next year 2024.

Michael Edward Hoffman

But if we're being conservative, sort of mid-to-low single digits is a good place to start without getting too aggressive.

Alan Yu

That is conservative, yes.

Michael Edward Hoffman

Okay. And then you've had a very good gross margin year. You took the gross margin outlook up meaningfully from original 32% to 36%, 38%. But I presume we settle back a little bit. And then you settle back to a higher low than history, so more like a 34%, 36%. Is that the right way to think about gross margins in '24?

Alan Yu

If you're the -- we're working to guide -- we can't guide right now, but we're hoping that we are -- our gross margin stay around 35% to 37%. That is correct. That is our goal.

Michael Edward Hoffman

All right. And then you clearly have demonstrated part of your capital allocation is the dividend. So this has been a meaningful increase in it. How should we think about dividend growth from this point? You've stepped this up quite nicely, the $0.80 a year. But how do I think about how to model dividend growth on a go-forward basis?

Alan Yu

Well, here's what we see. We will be going very light asset in terms of 2024. In 2021, '22 -- '21, '22, year '22, we actually spent a lot of money on CapEx investment. This year, toward the fourth quarter of this year, we're probably seeing 0 or very little CapEx expenditure. In 2024, we're seeing a very, very low CapEx expenditure as well.
So with all the money that we save, we are looking at possibly increasing our dividend or special dividend every semiannual or annually on that part. And also as well as any acquisition that we discussed in the past, we believe in 2024, it's very likely because market condition is actually allowing people to looking to sell their business while they can't right now because their -- a lot of business are actually not struggling. I would say, they're not growing.
And they were -- they have been growing in the past year, and they were not looking to sell at a reasonable price. But I think that in next year, more and more businesses looking to consolidate and also to sell the business. And then more opportunity will be out there for 2024 for strategic wise, basically. We mentioned earlier that we're looking for smaller warehouses, satellite warehouses.
Not necessarily open up our own warehouse, but also acquiring a small business that has a warehouse location that we can just take on additionally and then add on to the business. That will also -- on top of the organic growth, this will be our acquisition growth in terms of 2024.

Operator

Our next question will come from Ryan Meyers with Lake Street Capital.

Ryan Robert Meyers

First one for me, how do you think about the pricing environment in 2024? And do you feel like you've seen enough here through the last couple of quarters that it stabilized a little bit?

Alan Yu

We're seeing the pricing stabilize right now, except for California. California has been very competitive in terms of pricing wise. But one thing is the labor. We're going to see a labor increase across the board, every industry. And that is going to -- we're going to see how that plays out in terms of price decrease or price increase going forward. Warehouse price is going up. Labor is going up. Everything going up in California. Gas is going up. Delivery going up. So far, we're seeing it stabilize, but we'll have to see -- wait until at the first quarter to see what happen for 2024. A lot of changes in 2024.

Ryan Robert Meyers

Got it. Makes sense. And then obviously, during the quarter, you guys announced the expansion of 5 new sales reps. Just wondering if you can talk a little bit about the productivity that you've seen there, how that ramp-up has gone.

Alan Yu

Yes. And I mentioned earlier that in the past, like first 2 quarters this year, we only gained about around a low single-digit new distributor every month. But right now, we're gaining double-digit new distribution adding -- coming onboard every month right now. And these sales rep are basically mainly targeting toward the Midwest and East Coast, and we're seeing meaningful distribution converting to account and start placing orders.
And that's why we're heavily increasing our inventory in those sectors, which are the warehouse of -- let's say, it's fully packed -- backed up right now. So we're looking to open a new warehouse in that area, not in California. We're looking to scale back in California. Also another one of the major method that we're looking to increase or maintain our current gross revenue is scaling back more manufacturing in the U.S.
As we mentioned earlier in our earning releases that 22 -- currently, 22% of the overall revenue were produced by the -- our manufacturing facility in the U.S. Our goal is just to produce 12% to 15% or maybe 10% to 12% overall revenue from U.S. That will increase our gross margin.

Operator

And our next question here will come from Jake Bartlett with Truist Securities.

Jake Rowland Bartlett

I just want to build on the last question about the pricing. You've seen the menu pricing decelerating over the last few quarters kind of even as you start to lap lower prices a year ago. And so I guess the question is, how confident are you, Alan, that you're reaching a point where pricing is stabilizing? Is it a -- I mean how much of a risk do you see that, that just continues in '24 as supply chain has eased and your competitors can maybe better -- more easily compete on price?

Alan Yu

Well, here's what we see. In the past year, historically, we actually do better in an environment like this because we're always competitive against our domestic manufacturers like Pactiv, SOLO, [Dark] and Fabri-Kal and other manufacturers out there in the U.S. where we -- actually, we move faster, quicker. So during this price competitive environment, we're actually gaining new -- more new accounts than versus losing accounts. So we do see this as a positive thing in terms of next year that are -- that's why we're increasing our sales force network that we're able to take out more accounts, more new customers, versus we have no space. We have no capacity. So right now, we're building on new warehouses, so that was going to increase our inventories and also service new customers. And right now, we're already in the pipeline. We do have a pipeline list full of accounts that is about to start opening up and start turning their business over. That's where we see that very strong growth in terms of positiveness into 2024.

Jake Rowland Bartlett

Okay. Great. And the other question is about this kind of this -- where does gross margins land. And I'm trying to kind of parse through that. Obviously, freight costs are very low or shipping costs or ocean freight costs are very low right now. And that should probably go up, but then you'll have a benefit from having less manufacturing. So I heard the 35% to 37% kind of longer-term target. But how do you get there versus what we were talking about kind of maybe a year or 2 ago? And specifically, how much does moving from a mid-20% to kind of, call it, low teens on manufacturing mix, how much does that alone support or boost gross margins?

Alan Yu

Well, what we saw in the first quarter and second quarter this year, especially second quarter this year, we saw our gross margin increase significantly. And that was part mainly due to the fact that we scaled back reduced manufacturing in California. California manufacturing has been very costly, and we saw that. And we actually -- we went from a monthly production output of 145,000 units to just around 45,000 units. And that boost alone boosted our margin by at least 4 basis points -- 3, 4 basis points. And now we're scaling back in Hawaii and also Texas in terms of -- and scaling even more back in California, so that we're importing more product from overseas where it's lower cost versus the U.S. manufacturer. The cost continue to increase here. So we're seeing that this -- and we started just this quarter in the scaling back in other facility -- manufacturing facility. So we're going to see that benefit fully realized in the first quarter of 2024. And that's where I said that we will see, after the first quarter of 2024, where our gross margin is going to really lie on for the remaining of the years.

Jake Rowland Bartlett

Got it. Okay. Great. And then the last question is just on operating costs on G&A. There was a pretty big increase quarter-to-quarter in the G&A kind of even recurring. Is that level of somewhere close to $19 million, is that the right level to build from? Or is there anything kind of abnormal in G&A costs in the third quarter that wouldn't recur? Just trying to figure out whether this is the right run rate to grow from.

Alan Yu

I'm going to leave this question to Jian. Jian?

Jian Guo

Yes, Jake, let me take that question. So if you look at our Q3 SG&A, as we mentioned earlier, we did -- this number does include about $450,000 secondary offering-related transaction costs, which we don't expect to recur in the fourth quarter of 2023. I think we previously talked about -- if we look at our cost structure, I think our -- in terms of the split between fixed and variable OpEx, it's about half and half. So I think the way that we think about the fourth quarter, if you take roughly half of the run rate SG&A of what we incurred in the third quarter and then apply kind of a similar lift -- a similar leverage from the percentage to the variable portion, I think that will get you to very close to what we expect the fourth quarter OpEx number is going to be. We are obviously continue to look into areas to improve our leverage, our OpEx leverage, and there are definitely areas that we're focusing on. So we do hope to come in with a little bit of efficiency in the fourth quarter.

Operator

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

Alan Yu

Thank you, operator, and thanks to all of you for joining us today. We appreciate your continued support. We remain confident about Karat's future, and we look forward to keep you appraised on our progress. Have a great evening and a wonderful thanksgiving. Thank you very much. Bye-bye.

Operator

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