Good day and welcome to the Karat Packaging Inc. First Quarter 2023 Earnings Conference Call. Today, all participants will be in 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, Investor Relations. Please go ahead sir.

Thank you, operator, and good afternoon everyone. Welcome to Karat Packaging's 2023 first quarter earnings 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 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 most recently Form 10-K as filed with the Securities and Exchange Commission, copies of which are available on the SEC's website at www.sec.gov, along with other company filings made with the SEC from time to time. Actual results could differ materially from these forward-looking statements, and Karat Packaging undertakes no obligation to update any forward-looking statements except as required by law. Please also note that during today's call, we will be discussing adjusted EBITDA, 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. Our first quarter performance reflects a strong execution of our 2023 business strategy. We were able to achieve a record gross margin of 39.8% and record adjusted EBITDA results since the company's IPO in 2021; despite the industry-wide deflationary environment and multiple price reduction that we implemented. Moving ahead with our growth strategy on improving inventory management and fill rates, we recently signed a lease for an 83,000 square feet distribution center in Houston, following the addition of a Chicago warehouse earlier this year. Our plans for geographic expansion on the East Coast and the Midwest region are progressing well. With the recent expansion of the sales team and additional marketing activity together with the new contracts that were signed during the fourth quarter last year, we are expecting revenues to pick up again during the second half of this year. As a reminder, revenue for the first half of 2023 is expected to be lower than the same period last year, when pricing for inventory sold was at the peak level. In addition, order volumes during that time period last year were unusually high due to supply shortages. We continue to execute our asset-light business plan, and are now scaling back manufacturing production in California, while increasing import items focusing on higher-margin products during the past few months we have significantly enlarged our sourcing network in Asia giving us greater flexibility without additional overhead. To me our growing demand for eco-friendly and compostable products this category grew 17% in the first quarter over the prior year quarter. And demand remains strong. Our 2023 growth goals for the eco-friendly product category is to be around 35% of total sales. Due to the multiple construction and regulatory approval delays in Taiwan and our recent strategy to shift toward imports and diversifying eco-friendly product sourcing we decided to sell a proportion of the joint venture bagasse factory to Kerry [ph] Global Group. We are expecting the transaction to close within a three-month period or soon thereafter. With the selling price equal to our initial investment of about $6 million plus 5% interest. Lastly, we made a significant upgrade to our e-commerce platform and expanding our online support team. Sales to Canada and Hawaii are underway and proceeding well. We are now seeing some of the benefits of our online efforts with the business going in a positive direction. We again generated strong operating cash flow during the first quarter and continue to project positive cash flow throughout 2023, which is allowing Karat to generate excess capital and seek new opportunities. Accordingly, as announced on Tuesday, our Board of Directors declared another special dividend of $0.35 per common share. I will now turn the call over to Jian Guo, our Chief Financial Officer to discuss the company's financial results in greater detail. Jian?

Thank you, Alan. Despite a challenging year-over-year comparison first quarter 2023 results demonstrated our ability to adapt to the external business environment as we were able to significantly enhance margins and strengthen the company's liquidity position. Net sales for the 2023 first quarter as anticipated decreased 9.1% to $95.8 million from $105.4 million a year ago. This was slightly better than our original expectation. Last year's first quarter was a particularly strong revenue quarter with inventory price increases at the peak due to extraordinarily higher ocean freight and other costs and strong volume resulting from overall supply shortage in the industry. By channel, sales to distributors our largest channel was lower by 7.6% for the 2023 first quarter. Sales to national and regional chains decreased 14.2%, sales to retail channel decreased 21.7% and sales from the online channel increased almost 1%. As Alan mentioned earlier, our investment and marketing efforts to support our e-commerce platform have begun to bear fruit. Sales of our eco-friendly products increased 16.8% for the first quarter. We continue to further strengthen our leadership position as Karat experiencing strong growth from these products based in part on our enlarged sourcing network and expansion of our product offering as well as the evolving regulatory landscape. Eco-friendly products represented 33% of total sales in the 2023 first quarter compared with 25% a year ago. Gross profit increased 11.2% to $38.1 million for the 2023 first quarter from $34.3 million last year. We achieved record gross margin of 39.8% in the first quarter, an improvement of 730 basis points over the prior year quarter. Gross margin expansion benefited by a significant decrease in ocean freight costs, which amounted to 5.9% of net sales in the 2023 first quarter compared with 14.4% of net sales last year. Also costs for…

We will now begin the question-and-answer session. [Operator Instructions] Today's first question comes from Jake Bartlett with Truist Securities. Please proceed.

Great. Thank you so much for taking the question. My first was on gross margin and the gross margin guide. I want to make sure that -- so I think from your last comment that the 32% to 33% reiteration of the gross margin that includes what roughly $2 million in expenses. And were those expenses or were that write off inventory write-off get backed out of adjusted EBITDA? I'm just trying to make sure what's going to be kind of flowing through to your adjusted EBITDA.

That is also included. Yes, also it has been included. Yes.

Okay. But as you report your adjusted EBITDA will -- you won't back out those kind of impairments?

Jian can you answer that question? I can answer the question that our gross margin it's basically 32% 33% or higher. It's included in the adjusted the impairment. But the other question, I would think that, Jian to be better to answer that question.

Yea. Hi, Jake. This is Jian. Thank you for the question. Yes. So we obviously, will be working with our auditors on the second quarter adjusted EBITDA presentation but we are thinking, this is a nonrecurring charge related to the scaling back of our production in California. So we'll consider the add back to adjusted EBITDA as well as adjusted EPS for the write-off in the second quarter.

Okay. Okay. So adjusted gross margin a little bit higher than I think maybe we -- you in prior guidance implied is my read on that. And just to that point, it's such a strong gross margin expansion in the first quarter. It seems like you could have no gross margin expansion year-over-year for the rest of the year and be within that range. I mean, I guess, help us understand you're still going to be benefiting from lower freight price freight costs. Is it just a matter of -- till you're lowering prices that much that you wouldn't see a gross margin improvement year-over-year for the rest of the year?

We do see gross margin improvement. And -- but our goal is as we mentioned in the earnings announcement that in the third and fourth quarter we want to go out aggressively. So we will be able to balance out with the higher margin and lower margin chain account that was -- able to increase the volume and the revenues with some of the chain accounts that are looking for a much lower pricing. We're able to do so. We weren't able to do so, because we didn't have warehouse base in the -- initially. But now that we're able to set up new additional warehouse space and making space in the existing warehouse what we're doing right now is we're racking up all the existing warehouses or move it to a larger warehouse and at the same time adding additional spaces. And with that, when it's done basically we can go out -- first of all, we can increase our inventory levels so we can increase the fill rate. At the same time, we can go out and go after the new accounts with a lower margin. We're just being a little bit somewhat conservative stating 32%, 33% at this point.

Got it. And maybe just a little more detail on the drivers to the back half of the year. Guidance, obviously, includes a very strong growth in the back half of the year. Maybe if you can describe how fill rates have improved, maybe quantify, maybe where some of that new business how confident are you that that new business is coming online. Just give us some comfort that you're going to be able to kind of hockey fit the growth trajectory here even as you're kind of -- even as pricing remains aggressive as you mentioned.

Well, where -- one thing is our online business is definitely doing well and we've realized that more and more people are looking for eco-friendly product online. We're looking to add additional 200 to 300 SKU on the fine line, more of an elegant expensive line of bagasse and eco-friendly paper product, that's coming-in in the third quarter. At the same time, we're focusing more on the high-margin items such as custom printing product. It's not just the custom printing cup anymore. It's the take-out box containers and even paperless and also the custom bagasse plate and custom bagasse hinge containers as well as we're looking to bring in pizza boxes, corrugated doughnut boxes. There are so many items that we're focusing just on the eco-friendly side, because we've seen recently, especially in the past 30, 45 days, more companies are coming to us. They're saying that they're being forced to by the cities to move faster in terms of moving into eco-friendly products. So, when we set our -- right now our annual goal to be 35% of our revenue coming from the eco-friendly product, I would think that would be a conservative number; with the amount of additional products we're going to bring in at a higher margin versus the traditional product that we sold the portion cup, the plastic cup. All the plastic items are -- they're basically saturated the market and the margin is limited, because there's a lot more importer bringing the product cheap versus the eco-friendly items that we're not competing. There's really not much competition out there.

Okay. And then, sorry, last question is on the…

Hey Jake, can I -- maybe just to chime in real quick. I think you were wondering how confident we feel about the sales trend pick up right in the second half of this year. And I would say, I think Alan provided a lot of great color already. Maybe just to summarize, I think our level of confidence is pretty high and that comes from primarily a couple of things. One, we already signed some new warehouses. We are getting ready to move in towards around the -- some of the warehouses -- in the second quarter or towards the end of the second quarter. So we know that's coming along and we're also adding to Alan's point, racking spaces in some of the existing warehouses. So that infrastructure is going to be ready pretty soon here. And then just one other thing I will point out, I think we touched on this in some of the earlier discussions as well is, a lot of -- a big chunk of our business we do have great visibility into what our volume is going to be from our pipeline, right? So some of the new contracts that we previously signed that were sitting in our pipeline, we know we're going to start shipping towards the end of -- around the end of the second quarter, starting also in the beginning of the third quarter. So we do have some great visibility into what our volume is and that gives a lot of comfort, a lot of confidence right in our overall sales guidance.

Got it. And then lastly, kind of pulling out of the bagasse joint -- the JV in Taiwan or selling it, does that -- I mean how much does that hurt your ability to go into eco-friendly. I think that -- you had some excitement around that. Doesn't that -- I mean isn't that a headwind for those plans? How do you kind of think about the exit of that JV?

Jake, yes. We went into the joint venture last year when people couldn’t travel, I couldn't travel overseas. And this year, I went -- I was able to go abroad overseas. And also of course, with the joint venture, we were able to get the market intel that domestic manufacturer, who has already started manufacturing bagasse product in US, are looking to shut down the production plant and going to sourcing overseas, because they came to our factory to source. And during the time that we started the bagasse factory joint venture, we -- I was not aware of so many bagasse plants that are out there in Asia. And also, that are coming around in Asia with more product, better product and better pricing, and newer equipment. And when I was able to do so and find out that originally, when we went on a joint venture with overseas partners is that where you -- we didn't know that there was abundant of these suppliers out there in the market. Second, we know that this bagasse product is going to be a highly demanded product in the US, and we know that we want to also be one of the one manufacturer to start production in the US, but we didn't know how challenging it was to start a manufacturing bagasse plant in US, which most of these larger manufacturer, our competitors, are looking to shut down this year. And one thing I heard that is the reason for them to shut down with -- pouring millions of dollars and they've lost money and it's hard to maintain these equipment finding the people domestically to produce these products with a higher quality. So, now that of course because we signed a contract agreement that we can back out of course there is regulatory issues that they couldn’t -- the factory couldn't get permit. And that's one thing that made us decided to not only to back out at the same time we're scaling back manufacturing in California because the cost of manufacturing in California has risen year-over-year comparably. And we heard that it's going to go even higher with the electricity costs going up with the labor cost going up with more regulation toward manufacturing in California. It is actually going to be beneficial for us to reduce our manufacturing and just use the space warehouse space, which their space has become more expensive. So, now with that said, without being committed to the factory in Taiwan, the joint venture, we're able to find even lower cost higher premium products from different vendors. And that's what I mentioned in our earlier release that we're able to find additional sources in Asia throughout Asia because even India they're starting to produce bagasse and use bagasse domestically. That's how widespread the Asian countries are going after in terms of eco-friendly product reducing plastic versus US.

Great. Thank you so much. I appreciate it.

Thank you, Jake.

The next question comes from Ryan Meyers with Lake Street Capital Markets. Please proceed.

Hi guys. Thanks for taking my questions. First one for me. As you've taken price down pretty aggressively, do you feel like you've been able to gain market share versus some of your competitors?

Yes.

Got it. Straight forward. Not easy enough. As we think about the sales team and the ramp here in the second half, how long typically does it take a new sales rep to get up to speed add new customers, or how should we think about the investments you guys are making in sales right now and kind of your level of confidence how new sales people online can help accelerate growth in the second half?

Well, right now we're looking for experienced sales staff. With our competitors looking to scale back in terms of operations with the demand scaling back in certain area territory. So, basically, we're able to pick up new sales reps. People are looking for a new job. And we're actually picking up people in the similar industry. And also one thing is that the key difference between us and our competitors is that we have everything where we have different ways of selling product and most of these new sales reps that we're interviewing are stating that basically they couldn't compete with us because they're limited they're restricted to sell a certain price and they're only -- limited to certain product. And the product might be stored and manufactured in different facility. They can't consolidate. Versus the flexibility that we're offering in our company that enables the sales rep the o sell quickly faster. Most of these companies that have their structure in terms of regional, a city, a small territory. But for us, basically our sales can go anywhere. They're very flexible. We're giving a lot of authority to our sales rep to go out and flexibility in terms of selling the product the customers and also pricing. So, with that said, we see that it only takes about a couple of months for the sales staff to bring revenue in new sales rep.

Okay, that’s helpful. And then obviously we added the warehouse in Chicago a warehouse in Houston. Do you feel like that will be it for FY 2023 and then you'll look to evaluate more warehouse space in 2024, or how should we think about that for the rest of the year?

Our lease is up in Seattle end of August. We've already negotiating with the different facility to double our space in Seattle Northwest area. We're also looking to add different territorials in throughout the US because our goal is to increase our online visibilities to service different type of customers. And also we're looking to go into the B2C commerce party supplies. That basically we're able to sell to the consumers directly. Lately we all heard that Party City went out -- went bankrupt and there is a high demand of birthday plates, cups, and napkins and different type of anniversary type of consumer goods. That's something we're looking to get into as we grow our online team and which just in the first quarter of this year, the past three months, we actually enlarged our online team members more than doubled. And we're looking to double in terms of additional having additional staff to help us grow that business segment.

Got it. Thank you. Thanks for taking my questions.

Thank you, Jake -- Ryan.

Our next question comes from Ryan Hoffman with Stifel. Please proceed.

I'm not sure who Ryan Hoffman is, but this is Michael.

Hey Michael.

Don’t even have a Ryan in the family. So, whatever. I hope you have a good day. Can we get into a little bit about cadence. Jian, what's the -- ocean freight was 14.4%, a year ago 5.9% this year. How do I think about that trend two, three and 4Q? What am I comparing against?

Yes. Ryan, thank you for the question.

It's, Michael. Jian, it's Michael.

Sorry I don’t know why I have – now I have Ryan stuck in my head. Sorry.

That’s okay.

It’s my job.

Yes, call me late for dinner.

Sorry , yes. you're absolutely, right. So for the rest of the year we actually think ocean freight as a percentage of sales is actually going to be pretty stable. It might come down, even a little bit from first quarter we were at 5.9%. So I think it's probably going to be in the 4% to 6% range for the rest of the year.

And I'm comparing 2Q through 4Q, it was averaging, what?

I would say, averaging maybe roughly 5% give or take.

From last year. So this is against last year, I mean you were 14.4% last year in the 1Q. What's the trend? I wasn't saying that very clearly. It's the Ryan, thing got me all confused.

So, it's going to come down. When you're doing the year-over-year comparison, you'll see a significant job. Last Q2 -- Q2 2022, we're at 18% of sales. So -- and then that came down to about 15% in Q3 and almost 10% in Q4. What I'm saying is, for the rest of the quarter -- or for the rest of the year, right Q2, Q3, Q4 we think that this percentage is going to be pretty stable. It's probably going to be very close to the 5% -4% to 6%, in that range for the rest of the year.

So, that leads you then to an interesting -- I get being conservative, but it seems like it's really conservative you stay with 32% to 33%. So, how do I think about what's creating margin -- I mean, effectively sequential margin compression to stay inside 32% to 33%, because at 39.8% if I take the midpoint at 32.5%, and then do an average of what the remainder of the year would look like that's like 30%. And yet, it's a really steep savings in freight, which helped drive the 39.8%. So help me get comfortable, how much cushion have we built in here?

We tried to build cushion. Yes. I mean me and Jian, we try to. We don't know, how the market condition is because we've seen the market in the -- the overall market channel it's, -- with the increase in interest rate and restaurants shutting down and more input product coming through the US. And I don't know, how competitive -- we don’t know how competitive down the road it's going to be. So we just want to build some cushions maybe, a lot of cushions. So that we're competitive in the market, in the third and fourth quarter. That's all.

And then Michael, also just -- I do echo everything that Alan mentioned. Just a couple of additional items. I wanted to mention. I think Alan touched on some of this already. So in the second quarter, we were also talking about we were expecting currently some write-off of inventory related to our scaling, back of the production in California, right? So that's part of the overall picture, when we think about the second quarter margin. And then, we also previously discussed, starting primarily from the third quarter going into the fourth quarter, as we have the infrastructure in place the warehouse, sales team, new sales members coming on board and we start to really focus on pushing the volume. We do expect to see the margin to come down, as we might take additional price out -- price reductions to gain additional market share. So, all of those are being considered in providing the full year guidance of 32% to 33%.

And I want to add something Michael, just FYI like for starting April -- actually May 1, we reduced our highest moving item portion cup plastic cup by 10%. And June -- and we just announced that we're looking to do another announcement in different categories in June 1, also high moving volume categories. So we are looking to -- we know, that we understand that our customers looking for savings, and they see that price should be coming down. And we are actually -- we have been done doing so ever since last September, but not like a onetime decrease where we've been doing it every monthly. So we have done at least four price reduction already since last September.

Okay. So just to understand how the market environment may play out. If you have this current business climate that you lived in, in 1Q by all -- what I'm hearing is by all logic you're going to end up at better than 32% to 33% margin. If the business climate deteriorates, which is what you've built in is this super conservatism in the numbers, you can stay in the 32% to 33% range, gain share -- grow the business 5% to 8%, gain share stay at 32% to 33%. But if I have a stable business environment, I'm probably going to be better. Is that a reasonable conclusion? I'm not trying to push your numbers out. I just want to understand if the business environment is like it is right now and probably have upside to the margin.

Actually I feel the business environment for our company is great. We're going out there. We're winning every bid that we go after. In NRA actually this month and we're expecting to increase additional 100 new chain account business coming aboard. We've been waiting to go out. We've asked our sales reps to hold back not to go out and go poach, because we have limited space. And now we're asking our sales that we're ready to go. So we do see overall market environment is not good but for our company it's good.

And Michael I would say your statement is fair.

Okay, all right. So I get we're being conservative, but if we could -- we -- there's more room for upside than there is downside.

There is a lot of room I can say. There's a lot of room. Yes a lot.

Good. So back in -- I think I can't remember if it was the third quarter or the fourth quarter, but we reintroduced the idea of maybe starting to do some M&A again and you thought about that as something that might trickle into the second half. Where is your head around M&A versus organic and adding, like, you're adding warehouse through the organic method instead of buying things. Where are you on that?

Right now at this point after visiting the overseas manufacturing plant comparing to domestic manufacturing, I do not think it is worth it to buy -- to merge with a company that has old equipment domestically. A lot of these manufactured domestically I have seen that they will have a challenging year in terms of competing overseas vendors as manufacturer also at the same time, the most challenging will be hiring the technician to maintain the equipment and also maintaining these older equipments. We will see opportunity. So far we've been approached by different company capital investment group looking to represent certain company that they're looking to sell the company. Maybe two years ago they weren't looking to sell, but now they're looking to sell manufacturers or some competitors and even some distributors that they were looking to sell last year, but this year they're open minded now. But we believe that right now it's not the time yet. Of course, as I mentioned that one of the key drivers that will enable us to look into a certain company is will that give us strategic access to a particular location and clientele. That is something we're looking at. And, of course, given all of our PE ratio, EBITDA multiples are low we don't see companies out there looking to sell at low -- at the current rate of low EBITDA margin EBITDA. Yeah, they're still looking at 10 times multiple, which is not realistic.

Yeah, okay. That’s fair enough. Thank you very for taking the questions.

Thank you, Michael.

The next question comes from Ryan Merkel with William Blair. Please proceed.

Hi, everyone. Haven’t heard my name, you’ve got many chance in the conference call in quite awhile. I like it. My first question is on second quarter revenue guidance coming in a little bit below the street. Are you saying that the reason that it's coming in a little bit light is because you're having to cut price more, or is there also maybe some underlying demand weakness from your customers? Just want to be clear on that.

I wouldn't -- there is no underlying demand in -- lower demand in our -- from our customers. We're seeing that because we lowered our prices by 10% to 20% and we're seeing that possibly that the volume will go up very likely but the revenue may come down. But of course, at the same time I mentioned that, we do want to be a little bit conservative in terms of the revenue guidance and profit margin guidance now they for. We do feel that there is a lot of room to grow and both in revenue and gross margin, but we just want to be a little bit comfortable in terms of conservative.

Understood. Make sense. Okay. And then I wanted to follow-up on gross margin. Alan, I think you said you want to be aggressive with the national accounts because you have inventory now. Are you saying that you're going to cut prices below market to take market share, or is it more of a mix impact that impacts the gross margins in the second half?

No. I wouldn't say that would have cut prices. We just want to be fair with the prices because everyone knows that the raw material has come down. And it's not fair for the customers to not receive any benefit at all. That's something we believe that at least they should be receiving the market pricing information, market intel on that part. And also at the same time, we're offering a different type of product. A lot of the customers that we're approaching are people that are switching it from Styrofoam into paper or plastic as well as switching from paper plastic into compostable product. And that's something that we're able to go after these customers, creating new ideas, brainstorming with them, new packaging. One of the things that our competitor has been doing selling more is Styrofoam. And that is -- you're hitting basically they're hitting a wall on that part. There is really no room to grow in the Styrofoam business. And with that, all of a sudden we see a demand driven toward the eco-friendly side of the business. And traditionally, most of the company out there are buying, just bringing in the traditional product. But there are a lot of new smaller chains, midsize chains. They're looking for a higher-end compostable product. That's something we're looking to go into more even though we're going to continue to bring in the traditional product we're also looking to bring the higher end different unique type of compostable product. Such as out in the market I don't believe there is a paper lid in the market for your soda cup or a paper lid for your food containers. That's something we've just started to bring in. And then we'll display it at that NRA Show. A 100% compostable paper lid, not a plastic, not a bagasse, but a paper product.

Got it. Thanks for the color.

Thank you, Ryan.

At this time, we are showing no further questioners in the queue and this does conclude our question-and-answer session. I would now like to turn the conference back over to Alan Yu for any closing remarks.

Thank you everyone for joining the earnings call and Q&A session. And I look forward to all of you on the next earnings call. Thank you very much and have a wonderful day. Bye-bye.

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