Karat Packaging Q3 2023 Earnings Call Transcript

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November 9, 2023

There are 8 speakers on the call.

Operator

Good afternoon, and welcome to the Karat Packaging, Inc. Third Quarter 2023 Earnings Conference Call. All participants will be in a listen only mode. After today's remarks, there will be an opportunity to ask questions. Please also note that this event is being recorded today.

Operator

I would now like to turn the conference Over to Roger Pondell, Investor Relations. Please go ahead, sir.

Speaker 1

Thank you, operator, and good afternoon, everyone, and welcome to Carrot Packaging's 2023 Q3 conference call. I'm Roger Pondell with Pondell Wilkinson, Carrot Packaging's Investor Relations It will be my pleasure momentarily to introduce the company's Chief Executive Officer, Allen Yu and its Chief Financial Officer, Jan Go. 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 ks has 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 Carrot Packaging undertakes no obligation to update any forward looking statements except as required by law.

Speaker 1

Please also note that during this call, we will be discussing adjusted EBITDA, 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?

Speaker 2

Thank you, Roger. Good afternoon, everyone. We are proud to deliver a strong 3rd 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 As anticipated, sales of our eco friendly product continue to improve.

Speaker 2

This category grew 15% in the 3rd quarter over 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 3rd quarter Continue 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 3rd quarter were 22% of total net sales compared to approximately 27% last year, which generated labor product cost saving of $1,100,000 We expect our gross margin to remain at a higher level because of our initiatives and the continued strong U. S. Dollar.

Speaker 2

Now into the Q4 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 strength, fill customer demand And add to revenue growth.

Speaker 2

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 move into a new 100,000 square foot distribution center, additionally, as part of our strategic growth plan, we're looking to open smaller satellite Based on geographic sales from our distribution center, for the Q3 compared with the prior year quarter, the East Coast Northeast region increased 41% The Midwest and Texas region improved 7% year over year. These improvements 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 initiative is also evidenced by our sustained strong operating cash flow as well as liquidity and balance sheet position.

Speaker 2

Accordingly, as we announced earlier this week, our Board of Directors authorized an increase in the quarterly cash dividend $0.20 per share from $0.10 per share. The Board's action reflects its confidence in Kure's long term future and commitment To returning value to shareholders, I will now turn the call over to Jan Gao, our Chief Financial Officer, to discuss the company financial results in greater detail. Jan?

Speaker 3

Thank you, Alan, and good afternoon, everyone. Net sales for the 2023 Q3, as expected, decreased 4.1 percent to $105,500,000 from $110,000,000 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 runs of price reductions implemented primarily around late 2022 and the first half of twenty twenty three, 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 percent for the 2023 Q3.

Speaker 3

Sales to national and regional chains decreased 2.3%. Sales to the retail channel decreased 19.3% and our online 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 Eagle Friendly products and geographic regions that we're starting to penetrate, including the East Coast, Northeast and Midwest. Gross profit increased 14% to $38,900,000 for the 2023 3rd quarter from $34,200,000 in the prior year quarter. Gross margin increased 580 basis points We're 36.9 percent in the 2023 3rd quarter from 31.1% for the prior year quarter.

Speaker 3

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 2020 3 third quarters compared with 14.8 percent of net sales last year. Operating expenses in the 2023 Q3 were $27,600,000 or 26.1 percent of net sales compared with $26,300,000 or 23.9 percent 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.

Speaker 3

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 Q3 rose 48.5 percent to $9,100,000 From $6,200,000 for the prior year quarter, net income margin advanced to 8.7% In the 2023 Q3 from 5.6% in the prior year quarter, net income attributable to carat In the 2023 Q3 rose to $9,100,000 or $0.45 per diluted share from $6,100,000 or $0.31 per diluted share in the prior year quarter. Adjusted EBITDA, a non GAAP measure, increased $15,200,000 in the 2023 Q3, About $11,700,000 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 dollars per share from $0.33 per share in the prior year quarter.

Speaker 3

Turning to liquidity. With $12,000,000 of net cash from operating activities in the Q3 of 2023, we finished the quarter With $113,000,000 in working capital, up from $84,500,000 at the end of 2022, Even after a total of $16,900,000 of dividends paid during the 1st 9 months of the year, As of September 30, 2023, we had financial liquidity of $64,400,000 with another $18,100,000 in short term investments. I will now close with our 4th quarter outlook. We are revising our net sales forecast for the 4th 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.

Speaker 3

Our gross margin projection for the 2023 Q4 and into the Q1 of 2024 remains at approximately 36% to 38%, with the current projection for ocean freight costs remaining fairly consistent. As Alan mentioned earlier, we are 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.

Operator

Thank you. We will now begin the question and answer session. At this time, we will take our first question, which will come from Ryan Merkel with William Blair. Please go ahead.

Speaker 4

Hey, afternoon, everyone, and thanks for taking the question. Maybe, Alan, can you just talk about 4th 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 untapped that for us.

Speaker 2

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 Our volume growth is looking at 10% to 15% volume wise growing. In 3rd quarter, it was only 7%, but in volume wise, we're growing more. But in California, the restaurants, we're seeing more restaurants shutting down and we're seeing restaurant conditions pretty bad.

Speaker 2

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.

Speaker 2

They don't see people coming in after 7 pm at nighttime. They used to people used to pack the restaurant and also do takeouts Even after 9 p. M, but right now, there's crime is increasing, crime rate is going up. It's not safe to be out there. People are just not dining out right now.

Speaker 2

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 Midwest and East Coast right now.

Speaker 4

Got it. Okay. And it looks like price will be down roughly 10% in the 4th quarter. Did that surprise you or is that consistent with what you thought last quarter?

Speaker 2

This is actually consistent with what we saw, because everything is coming down. Ocean Freight has gone up a little bit in Q3. So Q3, 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 4th quarter, Our gross margin coming back normalized.

Speaker 4

Got it. Okay. Maybe just lastly, just Talk about the AI that you're going

Speaker 2

to be including in the warehouses. What

Speaker 4

are you doing there and what's the benefit going to be?

Speaker 2

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 Purchasing, placing POs, placing sales orders or generating sales orders as well as warehousing are using AI to monitor Each staff efficiency. So far, we've already tested our customer service, online customer service, 98% of our increase are And what we're trying to do is reduce our purchasing account payable accounting department at least 70% of the workload, So that with the existing staff, we can run actually increase our revenue with existing staff or even lesser staff

Operator

And our next question will come from Michael Hoffman with Stifel. Please go ahead.

Speaker 5

Hi, Alan, Joan. How are you?

Speaker 2

Hey, Michael.

Speaker 3

Could you just share a

Speaker 5

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

Speaker 2

California right now is approximately, I would say 30% of overall revenue? Jan, would you is that can you validate that? We actually didn't carve that out.

Speaker 3

Can you hear me?

Speaker 2

Yes. Go ahead, Jen.

Speaker 3

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

Speaker 5

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?

Speaker 2

That's correct.

Speaker 5

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 'twenty three into 'twenty four, what I have to sort of consider like, so there's been this pricing mix shift based on changes in Raw material inventory, freights 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? How do I think about rolling over the pressures that have been in California First is 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.

Speaker 5

Can you help us with how to think about the top line in 2024?

Speaker 2

Yes. We do feel that we We have several new regional chain that's where we're focusing on in terms of Midwest and East Coast as well as supermarket chains For 2024. And I believe, Jan, do we I would say that our 2024, we are looking 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 account in the last quarter and now we're seeing that perhaps 35 or more distributors in the 4th quarters And moving forward in 2024 approximately. So we do see an upside in terms of increase in revenues. I believe that Our guide are we would be do we guide our revenue up on 2024, Jan?

Speaker 3

We haven't. We typically will provide the 2024 revenue guidance in our 4th 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 Increase of 10 midsized distributor like in the distributor channel, which is our biggest And now 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 update on our 2024 revenue guidance next quarter.

Speaker 5

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 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?

Speaker 2

Well, Michael, you missed one thing. It's not just new accounts. And also 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 2024.

Speaker 5

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

Speaker 2

That is conservative, yes.

Speaker 5

Okay. And then you had a very good gross margin here. You took the gross margin outlook up meaningfully from original 32% to This is 36, 38, but I presume we settle back a little bit, then you settle back to a higher low The histories are more like the 34%, 36%. Is that the right way to think about gross margins in 2024?

Speaker 2

If you're at We're going 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.

Speaker 5

Okay. All right. 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?

Speaker 5

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?

Speaker 2

Well, here's what we see. We will be going very light asset in terms of 2024. In 2021, 2022 2021, 2021, 2022 year 2022, we actually spent a lot of money on CapEx investment. This year, Q4 of this year, we're probably seeing 0 on very little CapEx expenditure. In 2024, we're seeing a very, very low CapEx expenditure as well.

Speaker 2

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've discussed in the past, we believe in 2024 it's very likely because marketing condition is actually allowing people Looking to sell their business while they can't right now because there a lot of business are actually not struggling. I would say they're not growing And they were being they have been growing 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 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 own warehouse, but also acquiring a small business That has a warehouse location that we can just take on additionally and not add on to the business. That will also on top of the organic growth, this will be acquisition growth terms of 2024.

Speaker 5

Okay, great. Thank you very much for taking the questions.

Speaker 2

Thank you, Michael.

Operator

And our next question will come from Ryan Myers with Lake Street Capital. Please go ahead.

Speaker 6

Hey, guys. Thanks for taking my question. First one for me, how do you think about the pricing environment in 2024? And do you feel like you've seen enough here So the last couple of quarters that it's stabilized a little bit?

Speaker 2

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, 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 prices going up, labor is going up, everything is going up in California, gas is going up, delivery is going up. So, so far we're seeing it stabilize, but We'll have to see wait until the Q1 to see what happened for 2024.

Speaker 2

A lot of changes in 2024.

Speaker 6

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

Speaker 2

Yes. And I mentioned earlier that in the past like 1st 2 quarters of this year, we only gained about around a low single digit New distribute every month. But right now we're gaining double digit new distribution, add and coming aboard every month right now. And these sales reps 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 Right now, so we're looking to open a new warehouse in that area, not in California.

Speaker 2

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 in manufacturing in the U. S. As we mentioned earlier in our earning releases that currently 22% of the overall revenue were produced by Our manufacturing facility in the U. S, our goal is just to produce 12% to 15% or maybe 10% to 12% of our revenue

Operator

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

Speaker 7

Great. Thanks for taking the question. 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?

Speaker 7

Is it a I mean, how much of a risk do you see that that just continues in 2024 as supply chain is eased and your competitors can maybe Better more easily compete on price.

Speaker 2

Well, here's what we see. In the past year, historically, we'd actually do better in an environment like this Because we're always competitive against our domestic manufacturers like Pactus and Solo, Dark and Fabricals and other manufacturers out there in the U. S, We actually move faster, quicker. So doing this price competitive environment, we're actually gaining more new account than versus losing account. So we do see this actually as a positive thing in terms of next year that are that's why we're increasing our sales force network that Increased our inventories and also service new customers.

Speaker 2

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 in the 2024.

Speaker 7

Okay, great. And the other question is about this kind of this, where 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 that 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 Just moving from a mid-twenty percent to kind of call it low teens on manufacturing mix.

Speaker 7

How much does that alone support or boost gross margins?

Speaker 2

Well, what we saw in the Q1 and Q2 of this year, especially Q2 this year, we saw our gross margin increase significantly and that was 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 alone boosted our margin by at least 4 basis points, Three, four 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.

Speaker 2

Manufacturer. The cost continue to increase here. So we're seeing that this, and we started just this quarter and the scaling back in other manufacturing facility. So we're going to see that benefit Fully realized in the Q1 of 2024. And that's where I said that we will see after the Q1 of 2024 Where our gross margin is going to really lie on for the remaining of the years.

Speaker 7

Got it. Okay, great. And then the last question is just on operating costs on G and A. There was a pretty big increase quarter to quarter In the G

Operator

and A kind of even recurring,

Speaker 7

is that level of somewhere close to 19,000,000 Is that the right level to build from or is there anything kind of abnormal in G and A costs in the Q3 that would recur? Just trying to figure out whether this is the right run rate to grow from?

Speaker 2

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

Speaker 3

Yes. James, let me take that question. So if you look at our Q3 SG and A, as we mentioned earlier, we did this number Does include about $550,000 secondary offering related transaction cost, which we don't That's to recur in the Q4 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 is about half half. So I think The way that we think about the 4th quarter, if you take roughly half of the run rate SG and A of what we incurred in the 3rd quarter And then apply kind of a similar leverage of the percentage To the variable portion, I think that will get you to very close to what we expect the 4th 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.

Speaker 3

So we do hope to come in with a little bit of efficiency in the 4th 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.

Speaker 2

Thank you, operator, and thanks to all of you for joining us today. We appreciate your continued support. We remain confident about Carrot's future, And we look forward to keep you apprised on our progress. Have a great evening and wonderful day, Sibi. Thank you very much.

Speaker 2

Bye bye.

Operator

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

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Karat Packaging Q3 2023
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