Karat Packaging Inc.

Can you kind of help frame that for us? That would be helpful.

Sure, Jake. Well, thank you. First of all, the fill rates. We are seeing our fill rate out of our Texas facility, which is one of our largest facilities. We're still at most of the purchase order that we received. The second quarter was at 50%. So we had to short customers almost 50% of the item they needed to order. But in California it was much better. California fuel rate was up to 85% except for the item that would basically bury under the, inside the warehouse. We had to emergency release a secondary warehouse in California just to be able to operate and start getting the product out of the warehouse shipped. So that was one of the issues. So in second quarter we did transfer, move more product into Texas. And at this moment right now, we're trying to move product into South Carolina, New Jersey, and Washington to stock up other warehouses because we have a lot of customers in different parts of the states that also need our products. So that's what we have been doing right now. Is there a softness in the market? No, I do not see a softness in the market. Actually, I've seen the market is growing even stronger. And the demand, especially the demand for composable eco-friendly product, it's It's basically growing, growing faster than ever. For example, I've seen that the San Mateo County is requiring every restaurant to be using compostable products starting October 1st, Hawaii starting September 1st. So everyone is clearing up with eco-friendly product line right now. And we spoke to a national chain account last week, and they were saying that prior to pandemic, their takeout was 15% of their overall volume. As of today, they're at 40% of their entire volume. And not to mention that, they've even added four different brands of virtual kitchen. That increased the volume, the usage of the packaging. And this is where we're seeing that the entire industry is going to be looking to grow with the disposable packaging, with this trend moving into more ghost kitchen and virtual kitchen from the existing chain accounts.

Great. Thank you. That's really helpful. And I wanted just to focus in on gross margins for a moment. One is I know in the first quarter there was that big impact of capitalization of freight and duty. Was there any impact in the second quarter? I might have missed that, but whatever impact was in the second quarter. And then you know, we've been tracking, you know, weekly spot ocean freight rates from, you know, East Asia to the West Coast, and they're down about 60%, you know, currently is from what I'm seeing year over year. So the question is, you know, when do you see that sort of benefit flowing through? I mean, is there a quarter or two delay? When should we see the benefit of really dramatically falling ocean freight rates, you know, coming through the gross margin.

Sure. The ocean freight started to increase last year. So in last year's fourth quarter, when we had our earnings conference call, we were mentioning that, everyone was saying that there's going to be a headwind because the ocean freight is growing. And the peak of the ocean freight was the first quarter. And that's where we see a, we had a, in the first quarter earnings, we had a favorable capitalization, freight duty capitalization, in the first quarter because we brought in a lot of product using the higher freight rate. And the freight rate started to drop. When it started to drop, it dropped from early, I would say, early June. That's when it first started to drop, not in May. So basically, June, we wouldn't see a much favorable freight doing capitalization gain the second quarter, but we will see a tailwind starting the end of third quarter and into the fourth quarter. And yes, the freight has dropped tremendously from, I would say, $21,000 spot rate to currently at $5,700 today. Okay, great.

And Jake, this is Jen. Just to add on to Alan's comments to answer your question. During the second quarter, we did have an unfavorable impact from the freight and duty capitalization of about 2.3 million. So it did have a fairly significant impact on our gross margin. And now also to what Alan was talking about, we expect to start to see the benefit from the decrease in the ocean freight rate in the third quarter. The later part of the third quarter, and then probably more so in the fourth quarter of 2022. Great.

And then my last question, the Taiwan, the JV, my impression was that you were going to, that was going to be, you know, a way you could prove the automations to produce bagasse in an effective way. I know it's typically a very labor-intensive process, so you're going to try to, you know, see how that automation works and whether it's cost-effective, and then if successful, you might bring it to the U.S. But it sounds like you're kind of making the decision to bring it to the U.S., but I'm not sure if you've kind of – do you feel like you've proven out the automation at this point?

Well, yes. Earlier this year, our thought was to start in Taiwan and see if it's workable and bring it to the U.S. But at this point, we are seeing progressing very well. The production basically is set up and everything. So we are confident that we should be able to train and hire people in Taiwan and get it operational. That's why we are already jumping into the second phase of the Taiwan investment. Basically, we know the demand for compulsive product is going to be widespread in the U.S. And there has been already other larger manufacturers that have tried to bring in bagasse manufacturing domestically. And so far, I haven't seen it done very well. I always think that our manufacturing facility and our equipment, we compare with different type of other equipment that are out there in the market. We would say that the partnership, the equipment that our partners are developing is actually more advanced and also has higher efficiency rates. And basically because of their experience, we wouldn't see any issues of bringing them over to the United States basically we already spoken to a lot of chain account and they're very supportive of the domestic manufacturing versus buying product from China right now I still see majority of the many company chain accounts in the market that are buying these using these broadcast products are mainly I would say 80% are from China and that's where we want to reduce our reliance from Chinese manufacturer into other part of the world especially if we can manufactured domestically, I would think that I've already spoken to a lot of chain and we are gaining a lot of support that if the price is not too much more, they would actually support the domestic manufacturer like us.

Great, thank you very much. Our next question comes from Michael Hoffman from Stifel.

Hi, Alan, Jen, thank you very much for taking the questions. On the freight side, can we follow through in the commentary of, so there was a couple million dollar headwind in 2Q. If rates are falling and given the inventory turns, you've added $27 million of inventory sequentially, we're going to see probably not as great but still have pressure in 3Q and then a fairly significant reversal is the way to think about that, that capitalized number.

Yes, we have increased our inventory in Q2, and we are looking to significantly decrease our inventory in Q3 compared to Q2. And at the same time, we are going to see some favorable freight and duty capitalization gain in Q3. That's where we're sitting at right at this point because the ocean freight has dropped significantly.

Okay. Just to be clear, though, you've got a whole bunch of inventory that's sitting on a freight and duty that's higher – than the current market is. So that's a drag, isn't it, in the third quarter until you get more inventory turns? You've got to turn this inventory and get the stuff coming in at lower rates.

Yes, Michael. I wouldn't say it's a drag, and I wouldn't say a lot of inventory at a higher cost. The higher cost came in in the first quarter, not necessarily in the second quarter. The second quarter freight has already dropped. The product that we brought in the first quarter had a much higher rate of already being depleted. And it's reflecting in the second quarters. Basically, right now, the reason I said that our inventory is going to drop significantly, especially by the end of the third quarter, is that we have already seen reduction in terms of ocean freight coming in. And basically, all these new inventory that we brought in are at lower cost freight rates and that's where we see that and also starting next month we reduce our inventory for six weeks period and we're adding the inventory back starting this week and all of our basically by the end of the quarter most of our product will be at the normal market rates and currently we have not shown any decrease in prices in the market So it wouldn't be a market drag on our segment at this point.

So just to be clear, the $2.3 million freight and duty drag in 2Q should not repeat. It should be neutral to positive in 3Q.

I would say that it would be neutral in Q3. Okay, and then it should turn positive.

Go ahead, Jen.

Hi, Michael. Thank you for the question. I just wanted to provide a little... color there so I think Alan is exactly right if you look at our inventory turn our average inventory turn is about a little over 60 days as far as total ocean freight and duty cost including sort of the cash base cost as well as the capitalization piece if you look at the second quarter the total ocean freight represented about 18 percent of net sales which, as I said, included the unfavorable impact of a little over 2 million already from this capitalization. When we look at the third quarter, our current expectation for the total ocean freight cost, including the impact from the capitalization, we expect to to see that percentage to decrease to mid-teens. So we do expect probably 200 basis points to 400, roughly, basis point decrease in our total ocean freight and duty as a set of net sales in the third quarter, if that answers your question.

Perfect. That's what I was trying to get at. Did you end up with signing a contract and having to take a contract rate in May like lots of the world did? And if you did, where are you on the mix of spot versus contract in your containers?

Well, that's a very good question. Yes, everybody signed a contract in the end of April starting in May. And as Shipper realized, the spot rate is much lower than contract rate. All the ocean freight liners, have agreed to reduce the contract rate to match the spot rate.

So your mix would have been really high contract earlier in the year. Now it's more spot is what I'm hearing.

Everyone is on spot now, yes.

Okay. And then what percent of sales was eco-friendly? If you said that in the prepared remarks, I'm sorry, I missed it.

Jen, do you have the number?

Yes, it's still in the high teens as a percentage of total sales. Net sales, we are seeing year over year, it probably increased by roughly 1%. It's still in the high teens as a percentage of total sales.

So basically flat sequentially, but up year over year. So we've settled in sort of a current level of demand based on access to the product and things of that nature, but the trend is still to drive it higher.

Yes, that is still the trend. Yes.

And that trend is going to be boosted, obviously, by, as Alan talked about, the joint venture in Taiwan once the manufacturing starts to get the products out of the joint venture in Taiwan.

Right. And if I remember hearing it correctly, this should be in production in 4Q, but what am I looking at? It's really a 1Q before anything gets onshore USA. Right. That is correct. Okay. And then the $2 million fulfillment issue, was this a function of some of the labor challenges you've been dealing with, and you just didn't have enough people to move all of the goods out of Chino to be able to redistribute it into the other distribution centers in order to be able to then deliver it to the customers?

Yes. Actually, in California, during the second quarter, end of May and June, we've seen a much higher increase in COVID-related cases. We've never seen so many staff that are calling off sick for five to seven or eight, even more days. And there's short staff getting product out. There were some challenges. And also we had to call in temp agency people, and that also increased operational costs. But second quarter, we had to face a lot of shortage in labor, and that was one of the challenges. And that's one of the things that we did at open house end of the second, actually early July, And we actually added 5% of our, we hired 5% additional labor force just to cover those shortages.

And is it fair to say that $2 million is not a recoverable revenue? Somebody else fulfilled it ultimately? Or do you think you might actually get that $2 million back?

We will probably get half of that back because of the shortage of everyone out there. We now know that if a restaurant needs a product and can't find it from us, they'll find it from someone else. But One thing is, of course, for the item that we didn't ship out, we had a delay in shipment. That was another thing. We were delaying about 10 days in some of the shipment out of California. So now we're pretty much caught up in terms of shipping product. Even online order, we were delayed for Amazon order and online orders. As of today, we're pretty much caught up. And we're looking to increase more fill rates. So I would say that we recover 50% of that 2 million shortages from last quarter.

And based on the comments you made and your opening remarks about moving product into Texas, South Carolina, and New Jersey, you would expect in 3Q those fulfillment rates out of those distribution centers to be better than they were in 2Q? Yes, that's our goal. Okay.

All right, great. Thank you. Thank you, Michael. Our next question comes from Paul Dirks from William Blair. Thank you. Good afternoon, everyone.

So my first question is on price. Could you maybe quantify for us what price contributed in the quarter? And looking forward, do you expect to see any price deflation, in particular on the plastic product side of the business?

I will leave the price in terms of the effect on the quarter. But on the question, on the remark on the price deflation, we do not see a price deflation in the paper. So I guess you already know that paper product is actually looking to go even higher potentially next year, actually early next year, possibly end of this year. That's what everyone is seeing, a shortage of paper supply. Plastic, on the other hand, Are we looking at a price drop in the plastic? At this moment, I haven't seen any price drop. Domestically, the raw material did drop about 10% in terms of raw material, but all of the manufacturers out there are seeing a higher operation cost in terms of warehouse storage fee, the labor cost has increased, the operational cost, the transportation of the movement of the raw materials. So that, we haven't seen the softness in terms of demand for plastic, and especially when right now we're in the summer season, everyone's still looking to getting plastic cups, and also everyone's looking to switch their styrofoam into plastic containers. So, so far, the demand still outgrow the availability of the product. So I haven't seen much of that softness in that part of the area. Would that continue forward? we'll see how they move because the thing is right now, as I mentioned, the growth in takeout is 40%. There is still some supply issues in the market for most of the product, not all the product, but that's what we're seeing right now.

That's helpful.

I guess my next question is, sequentially, could you maybe talk, Alan, about your conversations with the national chains and also your retail customers. On a sequential basis, sales were only up modestly and thinking about how sales progressed last year, it's quite a bit of a lower growth rate than what we saw moving seasonally into the summer months last year. Can you maybe talk about those conversations that you had? Did the tone of those conversations change or perhaps get a little bit more cautious as we got into June and into July? Sure.

One of the softener we've seen is our T-Zone product, our boba supply product. Now we've seen a drop in terms of sales volume. As last year when the economy opened up, everyone was craving for a drink or high-end or expensive drink in terms of boba supplies. Now we saw a softener this year, but we do see that trend might continue to go upward, trending up, as more chain account, national chain are looking to incorporate Boba Supply into their offering. Now in terms of discussion with the national chain account, now that we're open and we're able to travel and meet our national chain account, we are in discussion with most of our national chain account to increase what they've been purchasing from us. That's one of our strategies, to increase our wallet share for the existing customers, national chains. And we are talking to some meaningful large chain account We are looking to add additional product line into their current usage and back part sense. We will be announcing in the third quarter letting everyone knows which chains actually where we've added new chains or which distributor we have added in the third quarters and also at the same time displaying how our growth with the national chain account will be growing Because with the national chain account, it does take a long time to get approval, get a mock-up, get sample testing. And we've done all that in the – doing the second quarters, and we are looking to close most of the majority of the deal in the third and fourth quarter of this year. So that will trend into an increase in sales for the 2023.

Very good.

And my final question is, you know, on the Bagasse facility in – in Taiwan. Can you share with us how did those product margins compare to the other eco-friendly products that Carrot currently offers and how would those margins be affected with the introduction of the new US facility? Could those US facility margins be yet the most rich that you guys would have in your portfolio? Can you help us understand the profitability of these products?

Well, the key aspect of having a bagasse product is there's a need for it. Regulation says in most places are banning plastic. So they're not even allowing the polypropylene or the reusable plastic. So basically all the restaurant has to change into the compostable products such as bagasse or sugar cane product line. In terms of margin-wise, I would think that the operational expense in U.S. is going to definitely be higher than overseas. But the benefit is that it is made in the USA. It is reliable. It is domestic. Our customer can actually come and visit this facility to see how it is made versus if it's made overseas, what if there is a supply chain disruption? What if there's a ship down or a blockade in a certain part of the port in China? So that aspect, people will see the benefit in terms of not necessarily looking for the pricing-wise, as long as the price is not too far off compared to the product that are coming from overseas. That's where we see it. In terms of margin-wise, I'm not going to say that there's going to be a higher margin because we have to see how the operational expense will be when we first start in domestic U.S. And part of the raw material that we'll be receiving will be from our existing paper plans. that we can recycle the paper pulp into what the existing material is, sugar cane or wheat, and blend it in. That will reduce our raw material cost. So this is where we see how effective we are able to use our recycled raw material to produce a product.

I appreciate the color. Thank you. Thank you, Paul. That does conclude today's questions.

I would now like to turn the call over to Alan Yu for closing remarks.

Thank you, everyone. Well, thank you all for joining the conference call for Victoria Packaging second quarter. We look forward to speaking with you again in the third quarter. Again, thank you very much, and have a nice, wonderful day.

Operator? Thank you, ladies and gentlemen. This does conclude today's call.

Thank you for your participation. You may now disconnect.