Good day, and welcome to the Karat Packaging 2021 Fourth Quarter and Year-End 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, PondelWilkinson, Karat Packaging Investor Relations firm. Please go ahead, sir.

Good afternoon, everyone, and welcome to Karat Packaging's 2021 fourth quarter and year-end 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 Karat's new 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 IPO registration statement and its most recent Form 10-Q 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 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, it is my pleasure to 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 as we gain wallet share with our existing customers and expand our customer base. Earlier today, we reported record fourth quarter net sales and continued margin expansion. Despite ongoing global supply chain challenges and tight labor conditions, fourth quarter 2021 results reflect exceptionally strong demand for our product and market trend remains favorable. As we continue to provide new innovative offering, our sales were somewhat constrained by the delay of certain shipments to customers from December to January due to inventory shortages, resulting from port congestion and labor challenges. We continue to manage the labor environment through increasing recruiting efforts and shifting distribution to other facilities in our supply chain. Online sales again posted the highest percentage increase, 56% year-over-year in the fourth quarter as we are placing greater emphasis on this category of our business, which commands higher margins. In addition to sales from our own online channels, we experienced excellent growth through eBay, Walmart and Amazon. Our distributor channel and national and regional chains also posted very strong results. During the year, we added more than 50 new regional restaurant chain account as well as national chain accounts. As noted in the press release, we've achieved our gross margin goal in the 2021 fourth quarter, increasing 360 basis points to 31% over the same quarter last year despite higher inventory and ocean freight expenses. This demonstrated our ability to improve productivity and operational efficiency, as well as successfully passing through inflation-related cost increases. Gross margin also benefited somewhat from higher land costs capitalized in the fourth quarter compared to the third quarter, mainly freight, duty and custom brokerage fees. Our positive business momentum is progressing in 2022. The food service sector is continuing to experience a steady increase in consumer spending. Moreover, demand for environmentally friendly products continue to grow which bodes well for Karat as a leading industry providers. As a result of a favorable outlook, we are currently targeting net sales for the 2022 first quarter to be in the range of $101 million to $103 million, up about 35% at the midpoint of the range over the same period last year. For the full 2022 year, we expect sales to grow 17% to 19% over 2021. Lastly, as part of our plan to expand our third-party logistics services, we have just leased 14 trucks and trailers. This is in addition to the previously announced orders of 10 Tesla semitruck that we expect to arrive in 2023. We want to leave adequate time for questions, so I will stop here and turn the call over to Jian Guo, our new Chief Financial Officer, who joined Karat in February, to discuss our financial results in greater detail. Jian?

Thank you, Alan. I am very pleased to have joined the Karat team at this exciting time in the company’s growth and development. Our 2021 fourth quarter results reflect strong top line growth from existing and new customers and improved margin as we continue to enhance of our operating efficiency. We delivered $10.9 million of adjusted EBITDA or 11.9% adjusted EBITDA margin. Now, let me provide more color on our operating results starting with revenues. Net sales for the 2021 fourth quarter increased 30% over the same quarter last year to $91.3 million. Net sales for the full year 2021 increased 23% over 2020 to $364.2 million. Net sales in 2020 included $38.1 million of PPE products, principally during the height of the pandemic in the second quarter of 2020. Net sales of PPE products decreased to $2.7 million in 2021 or less than 1% of net sales. Sales to distributors for the 2021 fourth quarter, our largest channel grew 33% and sales to national and regional chains expended 27%. Online sales rose 56% for the quarter, reflecting strong demand and our continued investment in this critical channel. Sales to the retail channel decreased to 4% from the same quarter last year with some sales having shifted to other channels and the fourth quarter typically being slower on the retail side. We implemented minimum shipping requirements in the second half of 2021 to better manage tight labor conditions, which shifted a portion of our sales mix from retail to distributors and enabled us to better utilize staffing resources. Gross profit increased 47% to $28.3 million for the 2021 fourth quarter due in part from the strong sales growth in our higher margin channels and products along with improved operating efficiencies and better management of freight expenses. Gross margin for the…

Thank you. [Operator Instructions] Our first question will come from Jake Bartlett with Truist Securities. Please go ahead.

Thanks for taking my question. My first is for you Alan or others. The question is fourth quarter revenue came in a bit below the guidance that you had provided in November – in early November. And you’ve mentioned the supply chain kind of bottlenecked, as well as I think in the script you mentioned staffing. And that was in December and January. So I just want to make sure I understand kind of how – what happened there? And also, most importantly, how confident you are that those bottlenecks are now easing or have eased or will ease?

Thank you, Jake. Well, yes, the fourth quarter we’ve experienced a lot of shortages in product that we have due to container arriving late from the port and due to shortage in labor due to holidays. We have a lot of employee that were sick or calling sick that didn’t come in and show up. So warehouse with we’re short staffed, even if we have product on the floor, we were not able to ship everything in timely manner and the containers – trying to get the container from the port to the warehouse. And also we had to shut down a day – almost two days toward the end of the year for inventory counting. One of the main causes of that would be the fulfillment rate. Our fulfillment rate, especially in December were near not – it was close to around 50% and we see that fulfillment rate improved significantly in the first quarter. To your question, do I see the bottleneck it’s getting better? Yes. The port is getting a lot better. It used back in December, November of last year it took a ship, a container about three months or even four months from the factory to our warehouse. Right now I’m seeing two months, 45 days a little bit more over two months to get containers into California. So it is much faster. And also we don’t have this kind of a delay at the port as we had before in December. Right now the delay could be only about no more than two weeks, back in December and November the delay could have been over – even the container came in offloaded in the dip area it would take us about 45 days to get the container into our warehouse. So we do see a lot of these issues that we had in the fourth quarter away and also in the first quarters, we improved our efficiency in terms of hiring more people, especially in the after January, we were able to hire more people, also work over the weekend to get our orders filled. I think the biggest challenge back in last fourth quarters was trying to get the order fulfilled, which we have no problem getting purchase order from the customers. The demand was high, it just that we couldn’t fulfill as much as we want to due to labor shortages and shortage of supply.

Great, great. And it sounds like you mentioned sick time and that would coincide with the spike in Omicron that we’ve heard others talk about. Would that – is that the right way to think about it that Omicron spike impacted your staffing in those kind of sick days in your productivity as well?

Yes. I would say that not only us, we’ve spoken with a lot of customers. I mean, the COVID started back in 2020. We have been very well control of the employee that have COVID. But during the spike in Omicron, we’ve experienced the most amount of labor shortage of employee catching the COVID. At one point 50% each one of our department were out sick. So it’s really a challenging time during that period to get people come to work, especially when everyone’s having a gathering and then after the gathering, they actually just called it.

Great. No, that makes a lot of sense. And I was just – the next question is about the outlook for sales in 2022, the 17% to 19% growth. And I’m hoping you can maybe break that down in a few different buckets in the contribution to that growth. One is the price increases that you’ve taken throughout 2021. So how much is just increased pricing of what you’re selling contributing to that 17% to 19% growth? The other part is, how much of that growth is going to be – you think is going to be coming from existing customers. And then how much is dependent on getting new customers? Maybe some of those new customers, as I understand that you’ve signed on some, but haven’t really turned them on. So maybe you have very good visibility on that. But I’m just curious to understand kind of what the really the main drivers of this 17% to 19% growth is?

Sure. I would say 5% to 7% will be coming from increasing prices. The reason being, there are some prices on certain product, we raised our prices and also there are certain products, where we decrease our prices. So it kind of offset each other’s. And I would think that the majority of our increases such as, I would say 5%, it would be coming from increase in new customers and also new product line that we’re bringing in. We are seeing that we have been adding more product line. Last year we added approximately 100 to 200 SKUs. This year I would see that adding additional 100 to 200 SKUs mainly for online sales where we see online would be a big driver that would give us additional $10 million to $50 million possibly even more in revenue because we do foresee that our online sales should – could possibly increase by 50% to 75% year-over-year this year.

Great. And then last question for me. The missing piece in terms of 2022 guidance, the missing piece to get to EBITDA is the operating cost. And I’m just wondering, if you could give us some of the big moving pieces there and whether we should expect leverage on operating costs in 2022? And perhaps if you can kind of just help us understand, how much leverage – if we expect leverage. But just some of the moving pieces there, I know there is shipping, there’s labor, costs potentially maybe lapping some of the one-time kind of cost you incurred in 2021. But just any help on the operating cost and how we should think of that in 2021 – 2022 would be helpful.

Sure. I would say, we are seeing the operation cost to be fairly increased, not insignificantly compared to our revenue growth. Mainly that we starting this month – starting next month, we actually stop all the outside brokerage sales force that we have. So we terminated all of the outside sales agreement, everything will be done in in-house corporate by our corporate sales people. And also that we’ve seen that on the inventory side, we’ve seen increase in dollars that as it’s favorable to our cost of purchase to overseas as well as our – we’ve seen that – we’ve been utilizing more on the shipping side. We’ve used to ship the 28 pallets on the truck load, now we can ship 30 to 32 pallets on the truckload. So we’re maximizing the shipment. And also we’ve seen the domestic local shipping truckload price recently just dropped versus an increase in LTL. So we’re pushing our customers asking them to ship more in the food truckload with a more SKU that we bring in. That also increased our efficiency in the operational cost. Same with the labors. We are hiring more people that we’re seeking more efficiency out of our staffing that is another increase in our efficiency in cutting our operating costs as well.

Got it. So the message is, is that you do expect leverage margin – the operating costs to contribute to margin expansion overall in 2022.

Correct.

Great. I’ll pass it on. Thank you so much.

Thank you, Jake.

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

Good afternoon, everyone and congrats on the quarter and a strong guide. My first question is on gross margin for 2022. Alan, is the primary driver of higher margins, is it mix? Or what are the other puts and takes that we should be thinking about?

We see the primary driver of the gross margin is, one, a strong dollar; two, we’re selling more ecofriendly product that we are offering. Hawaii has – we actually really better utilized our Hawaii operation and also we’re expanding our Hawaiian operation, which has a high demand for ecofriendly product composed of ESG product line. And we do see that with the economy opening up, and more and more cities and restaurants are asking, calling for the environmentally packagings, such as gas plate – for gas hinge containers, PLA straws or compostable straws. And also, more importantly, we’re able to increase our online sales in Amazon, eBay, Walmart, not only on e-commerce stores. We are looking to increase our staffing in our e-commerce side by double in terms of pushing our – that will definitely help our online sales. Our goal for the online sales for this year 2022 versus last year is 50% to 75% or even more on the growth side for the online sales. Online sales generate a much higher gross margin than our traditional sales to the distribution channels or retail channels. So this is where we see a strong driver for our gross margin in 2022.

Yes. Okay, makes sense. And then the share gain in 2021 was really impressive, 50 new accounts. Can this continue in 2022? Or was 2021 a unique year because of the shortages and you were able to outservice your peers? Or do you think you can continue the share gains at this sort of accelerated pace?

We believe – in 2021, our sales actually really didn’t go out to look for customers. So we believe in 2022, we will be able to increase even more than 50 new accounts in the – especially in the Midwest market. This market where we see, like I said, we have been strong in the West Coast. We have been weak, very weak in the Southeast, in the Eastern part of the U.S., even in the Midwest. So we’ve seen there’s so many opportunities out there that we haven’t tapped into. So we do see a very even bigger opportunity in 2022 versus 2021 on new customer size on the regional chain accounts.

Got it. Okay. That’s great to hear. And then just lastly for me, Alan, I think your domestic OEM competitors were out of capacity. I think that was the case in 2021. Where do we stand now? I assume they’re expanding capacity. Are they starting to ramp up a bit? Could that competition heat up a little bit?

I do – I have been hearing that the domestic manufacturer, they have expanded their operation. In 2021, it’s not – the shortage, it was not caused by the lacking of the capacity. It was more of lacking of the labor for everybody, including ourselves. At a certain point, I mean, there are certain days in a month that we can only have less than 10% of our staff can come to work due to the Omicron, the height of the Omicron. And that’s what I heard from the competitor as well, everyone is having a hard time finding labours. Even until today, it’s not they don’t have equipment. They just can’t find enough people to come to work. And consistently, instead of working for a 10 day and quit, so that is the challenge. And we still see that challenge as of today. That challenge has not gone away.

Okay. Well, thanks for the color. I’ll pass it on.

Thank you.

[Operator Instructions] our next question will come from Brian Butler with Stifel. Please go ahead.

Thanks for taking my questions. You guys hear me?

Yes. We can hear you Brian.

Okay, great. So just at a high level, how do you view kind of the risk of hyper or very high inflation in food cost with the current Russia-Ukraine situation? What kind of risk is that to the model is that for you guys?

Well, we’ve seen the raw material increase on the plastic side, resin side by nearly 50%. The paper side increased even more by almost 70%, and we’ve seen even the raw material, the food ingredients, that we import have also increased, a little increased. Everything has spiked up. What we’ve done is we have to protect our margin and protect our – making sure that we’re in a profitable business. So we pass on most of these increases on to our customers and our customers basically also pass on the increases to their customers as well. So we’ve seen, basically, the consumer seems to be taking these passing of inflation cost fairly well. Well, even this year, I don’t see much more of increases coming along. I mean, I think everything has stabilized. But we are a skeptical holding in terms of making sure that if there’s any even more increases because there’s a lot of uncertainties with the work going on and the shortage of raw material, especially in aluminum and paper. So we're more cautious on that part. If it happens, we'll just have to do what we can to protect the margin.

Okay. And then on the – you mentioned the ESG products or the environmental products. Can you give us some color on the mix that was in 2021 and what the expectation is for 2022?

Sure. In 2021, for example, the state of Hawaii mandated all restaurants to use compostable take-out packaging, not only in straws, in lids and cups and also take out containers. That has kind of got delayed and then moved into 2022. So I do – I have hearing a lot of these national chain accounts looking for these compostable products because they have – they're out of the deadlines. And we see that's going to grow in that area. And also, we've seen even in our neighboring country like Mexico and Canada, customers are asking for a compostable product. Seattle, San Francisco, California, New York, Maryland, most of these areas they are – the states and local regulations are actually requiring restaurants and businesses to use 100% compostable product. Now like just a recyclable product, but compostable product. So we have been – we started the compostable line in – back in 2007, and we're one of the leading manufacturer of importer of that product line. So we've seen a really large increases on the sale of this aspect of the product line. And we do see in 2022, it will continue to grow even faster pace than 2021. And this is where we see the challenge is, finding more sources. I would say that this is a challenge for every – even our competitors is trying to finding more sources for these compostable products because it's not that easy to make these compostable product versus a regular plastic container or a paper containers. It is much harder to make one. And also, they're not produced – most of them are producible overseas, none from domestic manufacturing. So this is our challenge, and we're looking to do everything we can to find more sources to ensure that our customers are able to get these products from us.

On those years, how much more profitable is the environmental compostable products versus your standard plastic products or just regular paper?

I would say on 15% to 25% more profitable than our standard product.

Okay. That's helpful. On the freight costs, and those coming down in kind of 2022 versus 2021, any color on how that trends through the quarter? I mean, are we going to see a big difference in the first quarter and then it kind of evens out the rest of the year? Or is there some other volatility in there?

The information that we receive and the contract we just recently signed indicated that freight – ocean freight, is actually going – has gone up 35% from last year starting in May 1 versus coming down. The freight coming down is domestic shipping. So far, that is the over the road from, for example, California to Dallas or to Texas to Las Vegas, Arizona. That domestic shipping has come down a little bit with the truckload orders. But for the LTL, it has actually gone up. So it kind of offset each other.

Okay. And what – when you think about kind of the demand that you're seeing for 2022, is there a rebuild of inventory for your customers? And what does that do for your working capital needs to meet that 17% to 19% revenue growth?

For our company, basically, we've not only invested in more inventory. And this is one of the reasons that we see a stronger first quarter than versus the fourth quarter last year is we built up a lot more inventory this quarter than last quarter. So our fulfillment rate is much better, which we see that actually will give us a better result in terms of revenue-wise. And in terms of equipment-wise, we've also ordered a lot more equipment this year versus last year, which they’re all coming in. So that will also increase our capacity-wise. On our financial needs, currently, we're actually – we're pretty good in terms of financial needs right now with our net margin – proceeds from our profit margins.

So is working capital going to be a use of cash again in 2022? Is that the right way to think about it, you're going to be up or spending?

Yes.

And what about CapEx? Do you have any outlook on what the CapEx number should be?

We're still looking at the 5% as we previously announced before on the CapEx.

5% revenue? Okay. And a couple more on the modeling side. What's the right tax rate to think about for 2022 as well as what's going to be the interest expense?

I'm going to leave that to Jian on this question.

Yes, sure. This is Jian. So in terms of the income tax rate, I think high-level 2022 income tax rate, effective tax rate will be fairly comparable to what we have seen in 2021. And then the other question – I'm sorry, the other question is about the...

What's the right interest expense to be looking at? I mean, assuming rates don't change materially from where we are right now.

Yes, sure. In terms of the interest expense, it's – if you're looking at the core Karat business without the interest rate swap, it's probably going to be fairly comparable to the second half of 2021. On the overall consolidated Karat Packaging as a consolidated group, we are looking to have some fairly significant gain from the change in the fair value of the interest rate swap that we have. High level, we haven't had – we paid down because of the pay down from the proceeds in 2021, we've significantly reduced the amount we – we significantly reduced the amount of the outstanding debt, but that should be the overall outlook for 2022.

Okay. That's helpful. And then one last one. Just what's the outlook for M&A in 2022? What thoughts of growth there?

Well, we've – I've actually – we've actually made several requests and also seeking for M&A in 2021. And it has been very challenging because the market has been very, very hot in terms of there's a lot of acquisition and the price basically we've seen 13x to 17x EBITDA, it's just definitely not something that we're looking to do. So we're also waiting to see is there any manufacturing out there that could complement our needs in terms of what we can acquire or we can work with them jointly. I would say that something will be, definitely in the pipe, we have a couple of things in the pipeline. And definitely, within the next 30 to 60 days, this should be something that we've actually finalized on that part.

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

Our next question is a follow-up from Jake Bartlett with Truist Securities. Please go ahead.

Thanks for taking the follow-up. Just a couple of quick ones. My first was just on the gross margin outlook for 2022. And I think the drivers, Alan, you mentioned the reasons why that's so seem to be kind of somewhat long-term, could be considered long-term. So the question is, before I think we're thinking about 29% to 31% long-term gross margins for the model, is there – should we be moving that up long-term? Or is 2022 kind of just somewhat abnormal?

With the current situation that we're progressing with the increase in online sales and also the eco-friendly ESG product line, I do see that the overall average of the 2022 is it's still going to be around 31%, definitely be higher than the 2021 in the previous years. We found different ways of increasing our gross margins, especially we've seen that online sales channel, selling channel has been very lucrative. And also the ESG product line. And also the new product that we were currently bring in, they have offered us – giving us the higher profit margin. And also for the year 2022, we see a strong dollar. With the key thing about strong dollars is the product that we import will have a higher margin even with the increase from overseas because we have seen cost of product overseas have risen significantly in the past three months because every country has raised the price due to inflation. But the past two weeks of the gain in dollars really offset some of those increases. So we do expect the dollars to continue to grow and be strong or even stronger for the next six to nine months. So as of 2022, we think this is a good model for the 31% to 32% gross margin. In terms of the long-term, we're still thinking that if we can continue, that's our goal, online is increasing our online sales, we would say – I would say that this will be a long-term gross margin guidance in terms of going forward.

Got it. So it would move up, the model could be higher margin given the mix shifts that you're targeting. Is that the right way to think about it?

Yes, it is.

Okay. And then I just had also a question on the environmentally friendly products. It was asked, Alan, but I'm not sure if you answered. But the percent of sales in 2021 that you consider environmentally friendly that would be helpful because it's such a big part of the story is to be able to track that.

I'll leave this to Jian to answer the question, which she has the numbers.

Yes, sure. So overall, it's a state about this close to 20%. So in the high teens of the overall total sales for 2021.

Great. And then the last question is your exposure to or how much you're importing from China? I know that you've been diversifying your kind of import, your supply sources and geographies where you're supplying from. As we think about production shutdowns and disruption from COVID case spikes, how should we think about the risk there? And just it would be helpful to understand what percentage of your imports are coming from China these days?

Sure. I believe in our previous conversation or previous conference calls that we mentioned that we have been moving from import from China into other parts of the country like Vietnam, Malaysia and Taiwan. And actually, most of our products are now shipping out of Taiwan – even with the eco-friendly product line and product that was mainly produced out of China. Now there's more companies are moving those into Vietnam and Indonesia as well as Taiwan. I would say that, in the past, we mentioned that it was about over 30%, 40% dependency in China. And then we went down to all the way to 25%. Our goal is still to import only 20% or less out of China versus the other countries.

Okay. And is the kind of the production halts or kind of disruption that's going on right now, will that affect you and your ability for that 20% to 25% that you get from them now? Is that a material risk to your outlook?

No. This is a good thing. Most of the vendor that we order from China, they set up manufacturing out of Vietnam as well. And this just in case that there's a disruption in China, like a few months ago, there were some shutdown in the Nepal port. We have to rely 100% out of Vietnam and Taiwan. And currently, I think almost everything that we purchase on China we have a backup plan in Taiwan or Vietnam and Malaysia, and even now we're looking at Indonesia as well.

Great. And then really the last question, gas prices, diesel prices. Just kind of remind us where they are. How much is your exposure as diesel prices have gone up? Is that material for the model? I want to make sure we understand that.

I don't believe we have much exposure to the gas prices. I know that our truck – our fleet have locked into a really pretty nice, pretty good price for the past three months versus diesel gas out in the marketplace. So from our perspective, we do not see there's a really high risk in terms of gas prices. That's what I mentioned earlier. The increase in gas prices, the increased LTL shipping costs, the UPS and FedEx, they have implemented surcharges, fuel surcharges, same with the LTL carrier. But the truckloads, this is where we actually gain margin in terms of pushing the customers to order by the truckload. Those costs have come down. The independent trucking company or the trucker have absorbed the increase in gas prices due to a reduction in demand in the truckload request on the marketplace recently.

Great, great. Thank you so much.

Thank you, Jake.

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

Well, thank you, everyone, for joining us today. And I hope that we were able to answer everyone's questions. And I look forward to your next conference call next quarter and have a nice day, everyone. Thank you.

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