Karat Packaging Inc.

Thank you for standing by. My name is Celine and I will be your conference operator today. At this time, I would like to welcome everyone to the Carat Packaging Second Quarter 2024 Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press star followed by the number one on your telephone keypad. If you would like to withdraw your question, press star one again. Thank you. I would now like to turn the call over to Roger Frendel, Investor Relations. Please go ahead.

Thank you, Operator, and good afternoon, everyone, and welcome to Carrot Packaging's 2024 second quarter conference call. I'm Roger Pondell with Pondell Wilkinson, Carrier to 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, Jan Goh. Before I turn this 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 factor section of the company's most recent 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. The care of packaging undertakes no obligation to update any forward-looking statements 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 gap measures to the non-gap 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?

Thank you, Roger. Good afternoon, everyone.

Net sale for 2024 Second quarter grew 3.5% over the prior year period, and sales volume grew 3.2%. Our business pipeline continues to expand with the finding of new national and regional chain accounts. However, initiation of some new orders is taking longer than anticipated during the quarter, mainly due to administrative setup procedures at the larger chain accounts and software demand in certain categories, which we do not expect to recur in the back end of the year. We are pleased to see that gross margin held steady in the second quarter at 38.5%, despite pressure from significantly higher ocean freight costs that started in mid-May. Ocean freight rates spiked at that time when increased tariff for certain imports goods were announced initially to take effect August 1st, resulting in part to higher demand and lower capacity. Freight rates moderated somewhat in late July, which enabled us to ship more product with contracted ocean freight rates that were locked in earlier this year. We expect freight rates to start to normalize after demand softens subsequent to the tariff effective dates. With better visibility into ocean freight rates, reduced vendor pricing, and continued strength of the U.S. dollar, we expect to be able to meet our full-year goal for gross margins. Our strategic initiative from last year to establish warehouses in new geographic markets and enlarge existing warehouses is yielding positive results and is contributing to business growth across most of our sales channels, especially for our online sales. Sales for this category, which typically carries the highest margin, included a positive impact from the inclusion of online platform fees of 2.7 million in the second quarter of 2024. Grew 26% in the second quarter. Sales of our eco-friendly products represented approximately 32.3% of total sales in the second quarter. Essentially, the same percentage as last year. Eco-friendly product remains a priority for Carrot. We believe that there will be an increased demand for eco-friendly and compostable single-use disposable products and this should have a positive long-lasting impact on our results. We saw that the growth in eco-friendly products significantly outpaced the overall growth in July. Sales for manufactured products in the second quarter were 11% of total net sales, compared with approximately 20% last year, in keeping with our asset-buy strategy in the US and emphasis on imported items. From the inventory pipeline perspective, we are positioned to support an even stronger second half of the year in 2024 compared to 2023. Our preliminary sales in July were up by more than 10% year-over-year, and we expect a robust year-over-year performance to continue into the end of this year. Further, we are continuing to explore strategic acquisition opportunities to further penetrate the marketplace. Lastly, on August 6th, by Board of Directors authorize a regular quarterly cash dividend payment of 35 cents per share and a special dividend of 15 cents per share. I will now turn this call over to Jian Guo, our Chief Financial Officer, to discuss the company financial result in greater detail. Jian.

Thank you, Alan. Net sales for the 2024 second quarter were $112.6 million, up 3.5% from $108.7 million for the same quarter last year. As Alan mentioned earlier, our sales volume grew 3.2%. Compared to the 2023 second quarter, net sales also included the favorable impact of the inclusion of online platform fees of $2.7 million and the unfavorable year-over-year pricing comparison. By channel, compared with a year ago, online sales for the 2024 second quarter were up 26.2%, benefiting in part from the inclusion of online platform fees discussed earlier. Sales to national and regional chains were up about 0.9%. Sales to the retail channel increased 1.1%, and sales to distributors were slightly lower. The distributor channel remains challenging, with the pricing environment still very competitive. Cost of goods sold for the 2024 second quarter was $69.2 million compared with $66.9 million in the prior year quarter. The increase was primarily due to increased freight and duty costs and inventory reserve adjustment and the inclusion of certain production costs in cost of goods sold. These increases were partially offset as the prior year quarter included write-offs of certain expired products and raw materials related to the disposal of certain machinery and equipment in executing the plan to scale back production in certain locations. Gross profit for the 2024 second quarter was $43.4 million versus $41.9 million in last year. Growth margin was 38.5%, same as the prior year quarter. Growth margin for the 2024 second quarter was impacted by higher inventory reserve adjustment and an increase in freight and duty costs, which as a percentage of net sales increased to 8.6% from 6.2% in the prior year quarter. At the same time, gross margin for the 2024 second quarter benefited from the adjustments to net sales related to online platform fees and cost of goods sold related to production expenses as discussed earlier, and lower vendor pricing and increased import as a percentage of total product mix, resulting in a decrease in product costs as a percentage of net sales. Growth margin in the 2023 second quarter included a negative impact of 160 basis points from the write-off of certain raw material as we executed the plan to scale back production in certain locations which we discussed earlier. Operating expenses in the 2024 second quarter were $32.3 million or 28.7% of net sales compared with $28.5 million or 26.2% of net sales in the prior year quarter. Operating expenses in the current quarter included online sales platform fees, higher rent and warehouse expense, an increase in marketing expense for online sales, and higher stock-based compensation expenses. Such increases were partially offset by a decrease in impairment expense and loss on disposal of machinery as the 2023 second quarter included $2.5 million of impairment expense and loss on disposal of machinery primarily due to executing the plan to scale back production in certain locations. Net income for the 2024 second quarter was $9.2 million compared with $10.7 million in the prior year quarter. Net income margin was 8.2% in the 2024 second quarter, compared with 9.8% in the prior year quarter. Net income attributable to TARIT for the 2024 second quarter was $9.1 million, or 45 cents per diluted share, compared with $10.5 million of 53 cents per diluted share last year. Adjusted EBITDA, a non-GAAP measure in the 2024 second quarter was $15.7 million versus $21.1 million in the prior year. Adjusted EBITDA margin was 13.9% in the 2024 second quarter versus 19.4% in the prior year quarter. Adjusted diluted earnings per common share was 49 cents per share in the 2024 second quarter compared with 69 cents per share a year ago. The second quarter ended with $114.2 million in working capital compared with $110.5 million at the end of 2023. As of June 30th, 2024, we have financial liquidity of $55.5 million with another $32.7 million in short-term investments. We expect net sales for the 2024 third quarter to increase by mid to high single digits over the prior year quarter. Our gross margin goal for the 2024 third quarter is approximately 38% to 39%. For the fall 2024 year, we expect net sales to grow mid-single digits and gross margin to be in the range of 38 to 40%. Alan and I will now be happy to answer your questions and I'll turn the call back to the operator.

Thank you. We will now begin the question and answer session. If you have dialed in and would like to ask a question, please press star 1 on your telephone keypad to raise your hand and join the queue. If you would like to withdraw your question, simply press star 1 again. If you are called upon to ask your question and are listening via loudspeaker on your device, please pick up your handset and ensure that your phone is not on mute when asking your question. Your first question comes from the line of Ryan Merkel with William Blair. Please go ahead.

Great. Thanks for taking the questions. First off, Alan, why the change in sales growth lower for 24? Is the big issue the new business taking longer or are there also macro pressures with maybe restaurant traffic also weighing on the change there?

What are we referring to? Because

To my understanding is that our sales for 2024 is actually going to be higher than 2023. And we have been continuously reiterating overall growth of 7% to 15% total. That's what we're seeing. And if we were having a merger and acquisition, it would be a 15% approximately higher range of the estimate. Without the acquisition, it will be at the lower range of the estimate. So I don't believe that, Jen, did we change our sales guidance lower?

So the sales guidance for the full year of 2024, for right now, we are expecting mid to high single digit for the third quarter. for 2024. On the four-year basis, we're expecting mid-single digits from the prior year.

Okay. Yeah, and Alan, you cut out when you started answering the question. I thought the prior guide, correct me if I'm wrong, I thought it was up 8% to 15%. I think that included M&A. So you're going from 8% to 15% for the full year of 2024 to now up mid-single digits. That's kind of a big change.

Correct. Well, I believe that, like Jen mentioned earlier, we were expecting some of the chain accounts to hit it earlier versus later. So right now we're still pushing for the chain to move faster in terms of converting into our product. But right now at this time, I believe Jen is being very conservative in terms of making sure that we can meet our guidance on that part.

Got it. Okay. And then, Alan, you mentioned July was stronger, and I think you mentioned you thought that would continue. Can you just reiterate those comments? Was that a total business comment, or is that specific to online or eco-friendly? I'm sorry, I just missed it.

Yes, July, I believe we're seeing double-digit growth in revenue-wise. So, you know, with your comparison comp, And it's not, basically it's all segments that we're seeing. Chain accounts are hitting a later, latter part of July. Our bubble tea supplies is growing. Our online is actually growing very strong. And online is basically, we're seeing a, I believe, Jen, we mentioned about this quarter was 17% year-over-year growth online. And Last quarter, I mentioned that our goal for this year was $70 million online revenue. Right now, I'm actually pushing for $80 million revenue goal. So our second part of the 2024, we're seeing a strong push into online. And how we're about to do that is we added additional staffing into putting more items into Amazon FBA and also adding a new feature on our Shopify, our lollipopstore.com that Customer can buy volume and get volume discount on that part. So we foresee that basically our online sale is very likely to be over 20% year-over-year growth. So up from $70 million initially, we projected, to almost $80 million. That is our goal for online sale by the end of this year.

Got it. Okay. That's very encouraging. Thank you. I'll pass it on. Okay. Thank you, Randy.

And your next question comes from the line of Jake Barlett with Truth. Please go ahead.

Great. Thanks for taking the questions. My first was just a follow-up on the last comment. Alan, you mentioned July being up 10%, but the guidance for the quarter is mid to high single digits, so implying a deceleration. Is that just being conservative, or is there something coming down the pike in the next two months that you think would be decreasing the sales growth from the July level?

We're trying to be conservative, basically. But like I said, the business overall is very encouraging. We see the business growing. And we want to make sure that we're able to hit that number. That's one of our things.

Okay. And, you know, in the second quarter, you missed your guidance. You know, you mentioned kind of onboarding these new accounts online. you know, taking a little longer than expected. But to what extent is the weak pricing or just the pricing environment that was mentioned in the press release, I think on your prepared remarks as well. But, you know, how confident are you in the pricing, the pricing will, you know, sustain or is there a risk that, you know, the prices will continue to decline given the competitive environment?

Well, we see the pricing stabilizing and also we have been very competitive in terms of the ensuring that we're continuing to move forward in taking market shares and ensuring that we don't lose any clients. All of our clients are looking for savings, regardless of new clients, old clients, existing clients. So that's what we've been doing in terms of doing that. And how we'd be able to pass on savings to our client is basically on several items. One of the strong dollars is helping that, as well as we have been negotiating with our vendors to also get more support from them to lower their costs. But, of course, the ocean freight in the second quarter really increased quite a bit in terms of the situation with the ocean freight, the shortage of containers. That's actually raising the prices. But even with that, we're still able to meet our gross margin goal with that high increase in ocean freight.

Got it. And, Alan, could you just – this is – for those of us who aren't as close to – you know, how the ocean freight rates work and all the dynamics there. You know, on the last call, you mentioned that you had contracted, you had rates locked through April of 2025. So I guess I'm, you know, I'm struggling to understand how, you know, the current rate environment, freight rate environment impacts you if you're contracted through April of 25. Just help us understand the dynamics there and, you know, what makes you go on and off contract. And, you know, in the context, you know, then, How confident are you in the freight rates for the remainder of the year?

Well, we signed, just like most companies did back in the end of April, a certain contractor rate. And because of the situation with the shortage, the ocean freight liner added peak season surcharge. And that's a rate that can add $500 to $800, but they elected to add $1,000 each container that we ship. At the same time, because the ocean freight liner, they knew that there's a higher demand in containers, and they reduced their ship to the U.S., so they were able to raise the rate in the spot rate in the market. What they've done is, even though we have a contractor rate, they're not giving us exactly the containers numbers that we needed to ship our product so if we wanted to get additional container we have to go out of our rates contracted rate with free for order like other people if they didn't sign the contract and that race skyrocketed to eight thousand dollar containers and ten thousand dollar container to new york uh which is almost triple the amount of uh like quad tripled the amount of money that we had the sign originally signed the contract with like unfortunately we only needed to use 10% of our containers out of the contract rate versus some of our competitors or other smaller importers that didn't elect to sign that contract rate or had to ship more product. They had to go out and find containers at the rate of anywhere from $6,500 to $10,000 a container, almost near the price that they were paying during the pandemic.

Okay. And last question, Alan. You know, in an environment or, you know, in the eventuality, the possibility that, you know, whatever happens with this presidential election, you know, there's the possibility of a broad kind of tariff being implemented. Can you just speak to, you know, that risk for carrot? What mitigating factors there might be and, you know, what kind of maybe contingency, you know, measures you're taking for that potentiality? Sure.

We've noticed that U.S. has been implementing tariffs on different items and not just a regular tariff, but additional tariff, anti-dumping tariff on different categories starting July, August and October and December. So what we've done is we've been finding different vendors like we had before moving from our purchase from China into Malaysia, Vietnam, and other parts of the Asian world. And that's something that we've been doing in the past years. So our purchase reliance on shipment from China has reduced even more. And with the additional tariff on aluminum, that's not going to be just us. It's going to be everyone in the U.S., even the manufacturer, not only the importer, manufacturers that need raw material are getting from China are going to get hit with a really high tariff, as much as 55% to 100% increase in tariff. So everyone has to look for alternatives. Definitely not everyone can bring the factory immediately back to the U.S. for production, but even domestic manufacturers have announced increase in prices. So we're also working on that and looking for additional new vendors. We've done so. We're working on testing on the quality and everything to ensure that they will have the same match of the item skew that we have right now. So that's what we've done right now to mitigate. In the case that a new president comes in and all of a sudden starts raising tariffs on every country in Asia and also Europe and Mexico partner country, I think that's going to be an issue that everyone has to deal with. It will be a broad price increase among the categories that are basically being increased on tariffs. So it wouldn't just be us. It would be just like everybody. And with that said, everyone has to raise their price at that time.

Okay. Thank you so much. I appreciate it.

Not a problem.

Your next question comes from the line of Ryan Mayers with Lake Street Capital Markets. Please go ahead.

Hey, guys. Thanks for taking my question. First one for me is Alan. I was wondering if you could just comment on maybe what you're seeing across some of your food service customers. Are you seeing any sauces there? Is there any kind of issues in overall traffic levels? Just so we get a good understand of the – the overall kind of demand at food service environment and what that looks like?

Sure. We're getting increasing orders from chain accounts. Definitely, especially on a chain account that is doing well. Very fortunate for us. And that many of the chain accounts are actually doing well and some chains are not doing as well. Fortunately, most of our customers are the better part of it. In distribution side, we're seeing softness and distribution side, especially in California. California restaurant environment is really not doing well, especially mom and pop shops. They're closing. If not, they're about to close. But the national chain, especially fast casual chains, surprisingly, they're doing better than the fast food chain. That's what we're seeing.

And then, you know, it sounds like the original guidance range that you guys had given, the 8% to 15% at the high end there, accounts for an acquisition. So maybe can you just kind of comment on how we should maybe be thinking about that for the rest of this year and maybe what you're seeing in the M&A environment?

Well, we're still in discussion with different partners and see what we can do in terms of merger and acquisition. Even as we speak right now, we have some potential partners that we're working with right now on that part. Even potentially partnering, bringing additional manufacturing into Texas because of a previous question that brought up about the tariff. There are certain item categories that we're seeing high tariff. Actually, I'm looking to discuss with some of the overseas partners to bring their manufacturing capability into the rest of the U.S. so that we can do a joint venture in terms of producing items that basically is being hit with the tariff. So basically we can increase sales and also revenue by bringing the manufacturing back to the U.S. That's one thing that we're doing right now. On the revenue side, I mean, we're also discussing partnering with companies or buying shares of companies that would enable us to tap into the supermarket industry, different segments. adding SKUs. Our goal is basically to increase our revenue by adding additional SKU as well as increasing our wallet share customers.

Okay, got it. That's helpful. Thanks for taking my questions. Thank you.

Your next question comes from the line of Brian Butler, which is the first. Please go ahead.

Hi, afternoon. Thank you for taking the questions. Just, I guess, back on kind of the inferred guidance, for the back half of 24. When you think of the mid-single-digit growth for the full year and mid-to-high-single-digit for third quarter, that suggests fourth quarter is going to be, or you're expecting fourth quarter to be very strong, almost mid-teens for growth. Am I thinking about that progression from quarter to quarter correctly for the back half?

We're thinking of double-digit growth for the fourth quarter. That is correct. Okay.

Again, in the past, we have been seeing our company double-digit growth. I think we're happy that we're seeing that we're back to the trajectory that starting the third quarter, we're having a strong quarter in the third quarter and even a stronger quarter in the fourth quarter.

And is that benefiting from larger clients, the national account signing finally kind of getting through the administrative process? And how does that roll into – how should we think about that rolling into 2025?

Yes, that is actually true. Some of the large chain accounts that we were expecting for third quarter is actually going to roll into the end of third quarter, into fourth quarter. And that's where we see a segment that we're seeing the growth. It's adding additional national chain accounts. And some of these chain accounts are actually switching different types of products from styrofoam into plastic, into papers and other things, compostable items. And that's some of the things that we're seeing that right now. And are we going to see a stronger 2025? Definitely we're going to see a stronger 2025 with an increase in online sales, additional increase online sales. That's already starting in third quarter and moving to fourth quarter 2025.

Okay. And then thinking about the EBITDA and the kind of the margin compression that we saw in the second quarter, I mean, we were down about 550 basis points. Do you have a bridge between last year and this year, kind of the the puts and takes, what's behind that 550 basis point compression?

That, I would ask Chanty to answer that question.

Yeah, so if you look at, Brian, if you're looking at the bridge between last year's adjusted EBITDA margin to this year's adjusted EBITDA margin, the biggest gap there is the operating expense, as we talked about earlier. our growth margin remained consistent between the quarters so really the biggest gap is the operating expense section some of the items that we talked about in the prepared remarks in terms of the fixed operating expenses and then there are also certain categories certain investments that we're making for example the marketing expenses to support our online sales growth those are the examples some of the examples of the increases in operating expense that would account for the majority of the variance year over year.

And is that showing up in the selling expense? Because selling expense was up like 56% year over year in the second quarter. Is that those things? Is that what you're talking about?

The selling expense, I mean, you are right. That's a great comment, although I do want to highlight If you're looking at the selling expense line item, there is a little bit of an apple to orange comparison in the sense that there was an adjustment of the online platform fee, which Alan mentioned earlier, that this year it's being included in this quarter, well, I should say starting Q4 2023, we're including in selling expense versus previously it was reported as a offset against sales. So that's a fairly significant increase in the setting expense that's sort of from an accounting adjustment that we discussed earlier as well.

Okay.

And then on the freight costs, so how does that freight cost look in the third quarter and the fourth quarter? Can you provide some maybe, I guess, you know, that trend in the back half as a percent maybe of revenues? Sure.

I mentioned earlier that the second quarter, we're seeing a significant increase in ocean freight due to peak season surcharge, as well as if we were to contract out of our contract to getting a container from freight quarters, 10% of that, that really increased our ocean freight. We have seen the ocean freight prices come down starting July and even more in August. The non-contract rate was as high as $8,000 to California West Coast and $10,000 East Coast. Now it's down below $5,000. And fortunately, now we're really not using any containers out of our contract rate starting in August. So in July, we were still taking some containers that we needed to without the contract rate so that we don't run out of product on our customers. But in August, we have stopped taking any non-contracted containers. So that's a good thing. Even though we're paying for the peak season surcharge, we're not paying for the extra above the peak season surcharge, the $6,000, $7,000 container rates. And this is due to the fact that containers basically have become more available. Less people are shipping product because there was a tariff that was hitting the U.S. and Europe in August 1st. And those companies that needed to ship electric vehicles into Europe, basically they stopped shipping that. So basically there's more container available for the U.S. customers right now. And the fourth quarter, we're seeing that the ocean freight liners should be removing the peak season surcharge that we can go back to the original contract array. So the ocean freight will come down even more during the fourth quarter of this year. Okay.

Just a little more color there just to get a line on the model. So overall, in terms of net sales, we're expecting ocean freight for the second half of the year to range between 8% to 10% of net sales. Everything Ellen talked about, just in terms of the ocean freight, the trend is Obviously, I think that's great sort of insight into what we're expecting. Just in terms of modeling out the second half of the year, I do want to just as a reminder, we typically do see about roughly two months lag in terms of the real-time rate and how it's getting recorded on the financials just because of the inventory turn. So that said, the spike in the late part of the second quarter, we will see primarily that impact getting reflected on the financials in the first half of the third quarter. And as we start, obviously, seeing improvements in ocean rate, we'll get that benefit in the second half of the third quarter as well as the fourth quarter.

Right. And to be clear, that's built into your 38% to 40% gross margin kind of forecast. for the full year? Correct. Right. And if you think about it going down to the EBITDA line, that 38% to 40% would suggest some margin improvement year over year on the gross margin. But on the EBITDA line, it seems like we're going to probably see some compression because of the higher costs on operating and those fixed costs in selling. Is that a fair way to look at EBITDA and gross profit for the full year?

On a four-year basis, I think we previously communicated our long-term goal for our adjusted EBITDA margin is to be the mid-teen, and I think we're still on track to meet that goal for four-year 2024. Mid-teen.

Okay, and then one last one on maybe an update. You had talked in the past about expanding some of the distribution product lines kind of beyond the packaging pieces. Do you have an update on that and maybe where you stand and if that strategy is continuing to be pressed forward?

Yes, we're actually looking to the food segment, frozen food segment. So we're adding refrigerated truck. We're adding refrigerated containers. And we're also looking to build a cold storage containers warehouse in the state of Texas. So that's what 2025 goal in terms of what other items we can sell. There might be frozen food, frozen dumplings, and other things that we might be able to distribute and also possibly manufacturing domestically.

Do you have an estimate on the capital requirements for that?

Right now, we don't know how much capital requirements are going to be. We have not estimated that yet.

Okay. Okay.

That was all my questions. Thank you very much.

No problem.

That concludes our Q&A session. I will now turn the conference back over to CEO Allen, you for closing remarks.

Thank you, Operator, and thank you to all of you for joining us today. We appreciate your continued support. We remain confident about CARES' future, and we look forward to keeping you appraised of our progress. Have a great evening, everyone. Goodbye.

Ladies and gentlemen, that concludes today's call. Thank you all for joining. You may now disconnect.