Good day and welcome to the Karat Packaging Inc. Third Quarter 2022 Earnings Conference Call. 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 call over to Roger Pondel, Investor Relations for Karat Packaging. Please go ahead.

Good afternoon, everyone and welcome to Karat Packaging's 2022 third 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 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 Karat Packaging'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 third quarter 2022 net sales increased 7% from the prior year period, which was particularly strong quarter from post COVID reopenings. Result for the most recent quarter were impacted by customers destocking of certain inventories. Due to supply chain recovery nonetheless, we continue to see solid long term demand, particularly for our environmentally friendly products which grew 27% over the comparable prior year period. We also are continuing to gain wallet shares with our existing customers and we recently closed numerous new deals with both new and existing chain and distributors customers. We are fully committed to growing our offering an eco-friendly disposable foodservice product as more cities and states in the United States and around the world are enacting regulations to ban styrofoam and single use plastic. Customer increase are increasing, as is demand. And we remain optimistic about our leadership position while we continue to invest in new and innovative composable products. Our joint venture of building a bagasse factory in Taiwan is progressing well. It is expected to begin manufacturing 100% composable food service products in December with first shipment begin early in the new year. We already are receiving orders and entries that could fill capacities. Our initial investment of approximately $6.5 million in this project is on target to produce approximately 648 containers of products annually. And we are in discussion with our Taiwan partner to expand production line to double the manufacturing capacity by mid 2023. Gross margin for the third quarter expanded significantly despite selling through some inventory with higher freight and duty cause absorbed from the first and second quarter. We continue to see solid gross margin improvement into the fourth quarters from normalized ocean freight rates, continue shift to higher margin products and foreign…

Thank you, Alan. We achieved net sales of $110 million for the quarter, up 7% from $102.7 million in the same period last year. With the widely anticipated economic downturn along with the supply chain recovery, net sales for the 2022 third quarter were impacted by customers destocking of certain inventory. The increase from the strong prior year quarter due to COVID reopenings was principally driven by our eco-friendly products, including continued gains in wallet share with our customers. By channel sales to distributors, our largest channel grew 11% for the 2022 third quarter. Sales to the retail channel increased 7%. Sales to national and regional chains increased 5% and sales from the online channel decreased 4% for the quarter. Gross profit increased 15% to $34.2 million for the 2022 third quarter from $29.8 million last year. Gross margin expanded 210 basis points to 31.1% from 29.0% in the same period last year. Gross margin benefited from higher margin eco-friendly products previously implemented price increases to offset inflation, favorable foreign currency exchange rates and improved operating efficiencies and leverage. Although ocean freight rates dropped significantly towards the end of the third quarter, total freight and duty costs remained elevated at 14.8% of net sales during the third quarter of 2022 compared with 14.1% of net sales in the prior year quarter. The 2022 third quarter freight and duty costs included an impact of $5.9 million from freight and duty capitalization as we sold through some inventory with higher freight and duty cost absorbed from the first and second quarter. We expect total freight and duty costs to continue to decrease as a percentage of net sales in the 2022 fourth quarter, and potentially into 2023. We continue to focus on optimizing our eco-friendly products and online sell and improving operating…

Thank you. We will now begin the question and answer session. [Operator Instructions] Our first question comes from Jake Bartlett with Truist Securities. Please go ahead.

Great. Thanks for taking the question. My first one. Alan is that what if just to see -- what your competence is that destocking is what's driving the lower sales. I think your destocking has being more impactful everything to distributors than the change or something like online. But those channels also grew slower than the distributor channel. So first question is really just what's your confidence level that something is temporary as destocking is what's driving the slower sales growth?

Well, first of all, you're right. The change of destocking is mainly the distributors. A lot of distributors are actually overstock. I can tell that by talking to a lot of these distributors, they were so afraid of the supply chain disruption and outages in the past month. All of them bought in truckloads in themselves and those as well as they were buying from us. Some people were buying 30 day 45 days inventory. And all of a sudden, every one of the warehouse, including our warehouse was packed with products that was coming from overseas. We had to emergency lease a secondary warehouse in California just to store the product. And luckily, we were able to also destock some of our inventories. And that's why actually our operations are back to normal. Or in the month of July and August we were just scrambling to find spaces, warehouse spaces to put the product in and it was actually hampering the operation. We had to spend extra money in terms of extra people to move product. Our efficiency was down, operational efficiency was down, because the warehouse was packed with every product that was a blocking every lanes in the warehouse. I think that's the same situation with our customers as well.

So, Alan, what is driving? What do you think the biggest mean, you're below your guidance, the mess on RSS versus in distributors wasn't by that much. So why do you think has such so much slower growth at the chains in online, I think then than you would have been expecting. Is it the pricing issue that's coming through? Or just -- I look at it from our coverage and restaurant that off premise demand has remained fairly robust. So what do you think is driving that slower than expected growth, if it's not destocking the chains and the onlines started the business?

Yes. We have we started price reduction. As you know that we had seven increases last year, and two increases this year, mainly due to the increase in ocean freight costs. As ocean freight has dropped, we actually wanted to take the initiative to allow actually starting to lower the price for our customers. So they can also benefit from the lower costing and to offset some of the inflationary costs that we incur during the end of last year and earlier this year, when ocean freight was at $15,000 a containers. So that is also another issues of our -- it's not a slower sales, but I will say it's lower in the total overall revenue.

Okay. And just onto the pricing. You've obviously taken a lot of price over the last couple of years. Do you expect the pricing, your average prices to be down year-over-year in 2023 as you move forward? Is that a situation where as you've taken [Indiscernible] price last couple of years that it will actually decrease? Thank you.

I do see certain categories in plastic, price will be lower, dropping. But on the paper side, it has hold very strong in it also looking to increase in the paper size. The demand for paper has actually increased significantly, especially with lot of California, other states are banning pass -- not only banning Styrofoam, some places are banning plastics overall. So the demand on paper is still on the rise. And also the -- which cost shortage of paper supplies. So I do see the plastic sides, prices coming down. But the paper side, its going up. And that's where we see the growth is, the eco-friendly product line. The paper shopping bag versus a plastic bag. The paper food container versus compostable paper food container. Paper soda cup will actually even higher costing compostable paper soda versus the traditional plastic cup and styrofoam cup. So that's where I see the separation of the difference in cost and prices. Plastic will come down paper will go up, which kind of offset each other.

So on average, you don't think there's going to be a decrease. You think maybe prices will hold flat in 2023 versus 2022. I'm really just across your whole portfolio of products you should -- to expect flat pricing in 2023 versus 2022. Is that the message?

No. Actually, I do see plastic side, the cost of plastic price and the selling price, it's going to come down slowly. But on the paper side, it might go up. So that's where I see the offsetting. So the average eating out.

The average will be flat. Okay. Thank you very much.

Not a problem.

Our next question comes from Michael Hoffman with Stifel. Please go ahead.

Hi, good afternoon, Alan. If you could talk a little bit about what's going on in 3Q and then sort of carried into the remainder of this year and the next year. The year-over-year growth that happened, how much of that was in physical units or SKUs versus price?

I would think that Jian will answer that question in terms of the year-over-year growth number. Jian?

Yes. Hi Michael. Thank you for the question.

Hi, Jian.

Yes. So in terms of the quarterly year-over-year revenue growth, actually, what we are seeing is the vast majority of the growth actually was driven by pricing. We actually saw a little bit of a decline in terms of volume. So overall, as we talked about in our prepared remarks, our overall year-over-year growth is about a little over 7%. I will point out as you probably recall, that year-over-year comp is actually very challenging for us this year, because last year if you recall Q3 was a really strong quarter with really strong volume from post COVID reopening. Last year's year-over-year growth was over -- in the third quarter with over 30%. So we do as Alan pointed out, we do still feel really confident with the continued long term momentum, long term demand in our revenue growth.

And sort of just aggravate your growth in your model. Are you getting confident about those where the destocking at current across product lines is that -- where do you think you are in the [Indiscernible] in destocking as customer base works through the changing demand side in the marketplace?

I'm sorry. Would you mind repeating your question, Michael? I am not sure if I got your question clearly right. I heard quite a bit of a noise.

Yes. Sorry, I'm in an airport. So you alluded to destocking. When you analyze the types of SKUs that are focus of that destocking. Would you say that there's still more to happen before we're done? Or it all happened in the third quarter?

Let me answer that question, since I'm more familiar with the market. I believe that right now, to my knowledge is from the customer sides. They are -- some of the customers still basically overstock. Their warehouse is still full. But the retail sector, the retail customers are starting to reducing their inventory on their floor -- on their stores. They're starting to reordering, especially this month, particularly this month in November versus last couple of months ago. We're seeing that maybe it's holiday season coming up, and people are getting prepared for the holiday season. But I do see that most of destockings have happened in the end of third quarter and also the beginning of fourth quarter.

When give us what you're projecting for fourth quarter revenue you factored in an incremental level of destocking, as well as whatever the year-over-year price tag would be on the price increases we've done all through the course of the year?

Correct.

And are there specific SKUs or product categories that are seeing a greater pressure on the destocking and are there another real pattern that is just in overall activity?

Yes. I do see that on the inventory side, particularly on the plastic sides, customer are have been destocking inventory on the plastic side, because they see that the price is coming down. So nobody wants to hold on to the inventory that has higher cost, higher value. So they know that they shouldn't be stocking too much on the plastic items. But on the paper size, I would think that no one -- customer not really stocking up. Because even though that's unlike last year, people are afraid of outages since last year. I think even with the higher demand in paper. I think the inventory is just about correct. It hasn't been like last year where there's a scarcity of the inventory on the paper side.

If we were to think about plastics as a percentage of your model, just so we kind of get a sense of what this pressure feels like?

I always think the plastic it's about 30% of our entire model.

And do you think you clear this plastic inventory correction by the end of the fourth quarter?

Yes, yes. I do believe that our inventory that we brought in the higher costs will be cleared out by the end of the fourth quarter.

Okay. Sorry. I'm teasing this out piece by piece. Freight costs down dramatically. How do I think about the sequential impacts, favorable impact of lower freight costs to you? And have this sort of happened in the third quarter? There's a tail for it in the fourth quarter or is going to carry into 2023 given the sort of current known inventory and how freight cost starts close through?

Jian mentioned earlier in the conference call, we have actually, we've seen most, I would say 90% or 95% of the higher freight and duty costs were absorbed mainly in the third quarter. Second quarter, we absorbed some, but majority of 5 point like $5.6 million of out of the $6.6 million were absorbing the third quarters. So in the fourth quarters, we do not think there's much more of a capital actually freight and duty costs in terms of effecting our costing on the gross margin size. That's what we're seeing that fourth quarter gross margin will be significantly higher than the our second and third quarters, so that we're confident comfortable that our entire annual gross margin goal of 31% to 32% will be achieved by the fourth quarter.

And correspondingly, the anniversaring of that would be it would carry into the first half of 2023, so to get that incremental gross margin lever in the first half of 2023.

Yes. That's correct.

Okay. And then you alluded to a new business expansion of wallet. So, when you think about we get through the clearing of the destocking, which are having unit pressure, you would expect to be positive unit growth and then some level of normal pricing in 2023?

Yes. We are -- we do expect a positive unit growth in the fourth quarters year-over-year comp, and also going into the first quarters, as now the, I always think that everyone is back to normal. They're allowing vendors like us to visit the customers. We're able to sit in front of the customers and start to explain to them and also letting them know, what kind of compostable products that we now have available. Especially, we know that in January 1st, both California New York are banding PFAS, a chemical on bagasse item. And that is something that everyone is rushing into, get their hands on the PFAS free bagasse product, because that will be the law starting January 1. So, we are expecting a high -- we have been receiving abundant increase on these new composable products. And that's something that will be our focus for the 2023 years.

Thanks very much for taking my question.

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

Thanks. Good afternoon, everyone. My first question, Alan, could you just comment on the outlook for consumer spending on restaurants? You think about budgeting for 2023, are you thinking about slower demand for your customers, or you're not seeing that yet?

Actually, I'm seeing a slower demand from the Mom and Pop retail stores. But I'm seeing a higher demand in the national restaurant chains, talking to the some of the restaurant chains, their volume, they're growing more, as more and more people are spending the money to the fast food chains versus these restaurants, Mom and Pop restaurants and that's where we see this shifting that part.

And in prior downturns, what your customers typically do? Do you see them looking to save costs? Do they come back, price concessions? Do they try to find lower price products? Just trying to think through some of the implications of a slower consumer economy next year?

This is all I see from talking to the customer perspective on the restaurant side. Right now, the main concern is not in the packaging costs, the main concerns on getting labor, getting people, staff to work in the restaurant, that is the key. And the biggest growth in the expense is actually not on the packaging. It's coming from the labor side. Even as food costs have level, basically. So the packaging, if that's dropping 5%, 10%, to them is basically it's nothing comparable to what the labor costs increase has been in the past two or three months, especially in California.

Yes. Makes sense. Okay. Last one for me. Can you comment on how much revenue you expect from the Green Earth Technology joint venture 2023?

That we -- we were expecting I believe in the past quarter, we mentioned that we're looking to ship around at maximum of capacity, 648 containers a year in 2023. But in terms of overall revenue, I think it's about around $20 million. I think that was about approximately $20 million to $25 million overall revenue from that. And at the same time, we are actually in discussion with them to increase the capacity by mid 2023. Because we are seeing more and more increase in demand in the bagasse product as California and New York banning Styrofoam and other states and cities are banning Styrofoam. So the demand for bagasse product is actually on the rise sharply. But the supply is actually limited, because there aren't that manufacturers making these bagasse product in the world.

Right. Well, it's great to hear. Thanks for the color.

Thank you.

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

Great. Thank you for taking the follow up. Alan, my question is on the pricing. And I think typically you don't just lower prices because you want to pass along for the goodness of your heart, because your competition is offering lower prices too. And so I'm wondering whether part of what's happening here is some of the gains you've made into accounts, the kind of incumbent who used to be supplying that can might be getting more aggressive trying to win the business back. Is that what you're seeing or are you seeing more competition as the supply chain eases in the -- maybe the other suppliers can now supply their customers like they had prior? Are they simply just trying to compete more to win back that business on price?

I think that, I don't see our competitors are going really, going after the price right now. I think it's more about the service issue. Most of our competitors, the bigger manufacturer and domestic ones, they're actually going back to all the customer they didn't know that. They overcome the supply issues. There is really not much of a supply chain disruption issue anymore. But they're not really lowering the price as much and that's one of the things. But on the distribution side, where they tend to buy from import from overseas, those are the ones that are really starting to come back and start lowering their prices to the market. And for us, basically, we do want to maintain our market share in both the distributor -- the national chain account and distribution account. And also, of course, online, what we're seeing -- what we're looking for a sharp growth online next year, with our a lot of implementations, how we start move forward into different sorts of selling channels, including Amazon Canada, Amazon Mexico, and Amazon Hawaii. That's where we see our growth it's going to be. But in terms of price, I don't think our domestic competitors really into the lowering the price in terms of getting the business back. But rather than offering supplies basically, making sure that there's no service disruption. I think that's a key part right now people want. They want stability.

Got it. So you're not -- you don't think you're losing some of the share that you gained during the supply chain disruptions. You think that you're going to hold on to those each of the business that you gained over the last couple years?

Yes. And actually, and also on top of that, we're actually, as we mentioned earlier, we're actually gaining some new accounts, in the Midwest market and southeast market region, that region that we haven't really been tapping into, now that we're able to start going out on sales car, people can fly to customers and start presenting our product, we're seeing more and more new customer coming in to our way that basically, that needed the product didn't realize, didn't really have an opportunity to go out or look for new vendors and suppliers. I think that's something that we're doing right now.

Great. And then last question. We've been tracking freight costs from China, East Asia to the West Coast, and they're down about 85% currently and have been down year-over-year since early July. So, I just want to understand how that flows through? I know there's a delay. You have inventory now that has been shipped at that lower price and that's going to have visibility into higher margins, gross margins in the first half of the year. But maybe just help us understand how that looks -- for the impact on gross margins. It sounds like you're giving your customers a lowering prices partly on passing along the savings from this lower freight. So what should we even prime broad strokes, what should we think about for gross margins in 2023?

I believe that gross margin will be -- we're looking at actually a 31% to 32% gross margin in 2023 or even higher, because the product that we're now, we're looking to bring in are more eco-friendly products, ESG items. And would it carry a higher margin. Why I say that it carry a higher margin? There is still limited capacity producing the right ESG products, the one that has certifications, the one that it's approved by the city. With the lack of supplies, of course, the price goes up. And also these are premium products such as bamboo straws, such as compostable food containers, bagasse product with PFAS free chemicals. These are items that basically carries a higher cost. To make a bagasse product with PFAS free chemicals, actually, that increase the cost in orders to making sure that it can absorb waters or absorb grease, not soaking through it. So I would think that there is going to be some kind of elevation in terms of price on these items that will offset the other products like such as plastic cups, plastic portion cups, that part in essence. So, I do think that the gross margin were looking good on that part, especially with the online sales is growing. We're seeing a great potentials in terms of online sales, because we do see that customers are actually ordering more online looking for these eco-friendly product that they cannot find in the local distribution area.

Okay. And then just lastly on that. So just one more on. We're looking at spot rates here as we understand them as we get them. But you also sometimes are paying contract. And so, maybe just remind us, when you've been paying contracts as we think about the year-over-year change in freight costs. I mean, for instance, in the second quarter of 2022 year, your freight costs were 18% of sales. If I look at that as being -- current prices being down 80% from when they were the prices at that time. It seems like there could be a major impact on gross margins. But again, you might have been not paying -- I think you weren't paying the spot market, you're paying a contract at that time. So just remind us what you were -- when you were paying contract, when you kind of switch to market just so we can understand and try to gauge how gross margins, how the freight costs might flow into gross margins?

Sure. Well last year, most of our importers [Indiscernible] product have a contract rate of approximately $4,500 per container. But the problem is, even though we had a contract rate of $4,500 for containers, the ocean freight shippers, they didn't give us any containers availabilities to use that contract rate. So we have to go out in the market to get spot rate out that $10,000, $15,000 $20,000 per containers. They may give us 20% of what we needed. So perhaps we have, we were able to get 20% of that container, we need to add contract with $4,500. And the rest of the container, we have to go out and get spot rate paying $15,000 for containers. This year on the different side is that most companies signed a contract of $10,000 per containers started in May. But because of price has been dropping down most of the importer like us, we stop using our contract. We went out in the market and got the spot rate of 7,000, 6,000, 5,000, 4,000 up to now is like little over $2,000 for containers. So these ocean freight came back to every one of our importer and says, okay, we're going to change your contract that you signed in April at $10,000. We'll lower it to whatever the spot market rate is. So that's the difference between this year and last year.

Okay. Thanks a lot. I appreciate it.

Thank you.

[Operator Instructions] Our next question comes from [Indiscernible] with UBS. Please go ahead.

Hello. Thank you for taking my question. I was wondering, first of all, if you can, maybe discuss a little bit about your rationale, capital allocation regarding paying a special dividend versus buying back company stock or maybe other options that you have?

Got you. Well, the rationale behind versus buying back stock is that our flow to market is very limited. We don't have that much flow of shares in the marketplace. So, our goal is actually we do want and that's why our stock price is discounted, because we don't have enough flow in the market. Okay. And we do have excess cash. What can we do with it? Well, we're sitting on it, and we're reducing our capital expenditure. We had in the beginning of last year, when we first went public, we mentioned that our expected capital expenditure will be 5% of overall revenue. And this year, we're looking at 3%. And we're looking at next year our capital expenditure, it's approximately less than 2%. And we're actually, we're generating profit, our ocean freight has dropped, our daily operation, cash has increased. So we're sitting -- what will be actually we're seeing, we will be sitting on millions of dollars of cash on hand and we do not want to waste our money go out there, buy company has over value. So what we did is, we actually found that this new technology company partner with in oversea in Taiwan, that they can actually invest in the company with very little money, that we can actually have the availability of what the market not just U.S. what the world needs, is composable products. And that's why we're investing our money into it. Even with that investment and doubling down on that investment next year, we are still going to be sitting on a lot of cash. We have been asking advisors, is it good to repurchase shares. Our advisors are telling us, it's not a good idea to repurchase shares, because our flow is already small out there in the market. Our goal is actually to we need to have more flow in the market so that we can attract more shareholders. That is our rationale.

Great, thank you. I really appreciate. It's very helpful. You give a little bit of detail, but I was wondering if you could maybe expand a little more on your online strategy and your expectations for growth in the coming 2023 and beyond?

Sure. Currently, we're selling our product on Amazon, our own Lollicupstore.com. We just added recently walmart.com, ebay.com And we're looking to other channels. On the Amazon.com, we've been selling products in the U.S. only. And we're seeing that starting January 1, 2023, Canada is banning all plastic. And there's going to be a major need for a compostable eco-friendly product, not only on the straw side, on the food container, on the cup side, on the container sides. And that's where we see we'll be pushing through Amazon Canada. Same thing with Amazon Mexico, also Amazon Hawaii. With that said we need to add more warehouse space. We need to have more products in our East Coast warehouse. In the past, we've been struggling to get product into the East Coast, whereas only California has most of the product, majority of the product and shipping from California into East Coast, that takes about five to seven days. Customer who are our B2B customers that are in Connecticut, in Boston's, in New York, they don't want to wait five to seven days to get the product. So we lose that business. And that's why our strategy is restock or actually stock up as much as we can in New York, South Carolina, our South County distribution facility will be double by the end of this month with the inspection, the fire inspection that we have increased our facility in South Carolina, which we could serve a southeast region. The focus of getting online sales up is how fast can you ship. Well, we can ship within 40 hours. How quickly can you get the product? Do you have multiple DCs that can ship the last mile to the customer faster so they don't have to wait a week. And by ordering like going out driving half a mile, half an hour, 30 minutes or an hour to find their local suppliers. They brought order online. So we're seeing more people sourcing for eco-friendly products online. And that's where we see our growth is going to be, eco-friendly ESG product online next year.

Thank you. And my last question, I appreciate your time. You've been very clear today and over the last several quarters and years about the growth of eco-friendly products. Can you talk about as you look forward well beyond next year, the next several years, what percentage of your revenue you see that being, because it's, I guess it's relatively small today?

Right now I believe our eco-friendly product is approximately 20% of overall revenue. Our new joint venture, it's actually selling 100% of eco-friendly proposal revenue with the additional expansion in 2023. That will be 100% ESG product. And adding other ESG product not only the bagasse product. In U.S. our core business, I do see in 2023 we should be at 35% to 40% our goal in terms of ESG product. As we move for with our growth in revenue. I do see our sales on the paper shopping bag, mainly on the bagasse that would has PFAS free chemical on it will be the top drivers in the 2023 year.

Great. Thank you very much for the color. Really appreciate it. Have a wonderful day.

Thank you.

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

Thank you, operator. And thank all of you for joining us today. We appreciate your support and interest in our company. And I look forward to keeping you appraised of our progress and to speaking with you in the future again. Have a great Thanksgiving and holiday season ahead. Thank you very much. Bye-bye.

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