Europe is ahead of the curve when it comes to the implementation of eco-friendly practices and environmentalism. However, the United States is on track to follow suit over the next few years. Karat Packaging (KRT) is a micro-cap company that is in a strong position to capitalize on an incoming American green wave.
To IPO or to not IPO
This post could be considered a second iteration of my post “Breaking the Rules and Pajamas: Ag Growth International (AFN)” because KRT is not a typical security I would consider.
Karat Packaging IPO’ed in 2021 amongst a slew of other IPOs. In most value investing books such as the Intelligent Investor, Margin of Safety, and Random Walk Down Wall Street, the authors mention to stay away from IPOs. IPOs are highly risky and tend to trade at ridiculous valuations. The lack of previous information can be seen as unattractive.
Charlie Munger said this at a 2014 Annual meeting of Shareholders:
“Young investors who come into the game early, learn the most basic rule, which is that if the business is selling at X and you can buy it at X minus 20 percent, it’s probably a good idea. That is a rule of thumb that works wonderfully well, particularly in smaller companies.
Then comes the second rule, which is that if everybody else has come to that conclusion, it’s not so good anymore. That’s the inversion of the basic rule of fishing where you fish where the fish are, but the first rule of fishing is still to fish where the fish are. So, you learn these rules and you get them pretty well in your gut. And then you have to learn to hang in when you’re absolutely right. What you really need is, in investing, is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.”
Which translates to:
“Young investors learn the rules; experienced investors know when to break the rules.”
In the current macro-climate, Karat is well positioned to deviate from well-established value investing practices.
The Screen
Unusually, I did not uncover KRT in a Warrior Stock screen. In my student managed fund at the University of Illinois (Illinois Investment Management Academy), we cover a variety of industries and screen for companies in the Russell 2000. Earlier in the semester I covered Semiconductors, Macro-Analysis, and Utilities, now I am working on Industrials. If you could not tell from the bulk of my posts, I am drawn to Industrials.
Going into the screen, I planned to look for growth, consistent/expanding margins, low debt, and low valuations. Out of the 265 companies that I looked at, around 50 looked interesting. Most companies that fit my criteria were already trading near their 52-week highs. I adjusted my standards to look for companies trading nearer 52-week lows.
After several rounds of cuts, I had about 30 companies that I would commit to a ten-minute test. A ten-minute test refers to taking a deep dive into a stock for around 10 minutes. However, sometimes I would become uninterested after reading the company description.
My ten minute test includes reading the basic company description and scanning ratios (ROE, ROA, ROIC, Current Ratio, Leverage Ratio, Altman Z-Score), income statement (positive net income, consistent share count, growing earnings per share), cash flow statement (positive free cash flow, nothing crazy in financing), balance sheet (accounts receivable > accounts payable, no big goodwill spikes), and a quick check of how multiples have changed over the past few years.
The Ten-Minute Test
Company Description:
Karat Packaging manufactures and distributes disposable plastic, paper, and compostable products used in restaurants and food service places. Products include food and take-out containers, bags, cups, tableware, cutlery, among others, and eco-friendly versions of each under the Karat Earth brand. Customers include other domestic and regional distributors, restaurants, fast food chains, and online customers. In addition, KRT offers customizable options for customers.
Analysis: I liked how the company was not in the Building Products or Professional Services industrial subsectors. Both industries looked attractive on paper, but I am weary of the construction environment and skilled based labor situation in the next 6 to 18 months. When I was researching Utilities companies, I read about how many construction jobs were cancelled or halted in the face of the uncertain economic climate ahead. With heightened wage inflation and a tighter labor force, professional service companies are at risk to lose experienced personnel.
KRT’s eco-friendly component was intriguing to me because of my experience in Europe. I do not think that I used plastic silverware or packaging once while I was in the EU. When I came back home, I realized that this movement had not reached the United States in a meaningful way yet.
As I read the company description, I was both excited and worried about this story because retail investors tend to overpay for story stocks. For example, think about clean energy, cannabis, crypto-mining, and electric car companies. There are a bunch of publicly traded companies that operate in these different, exciting industries, but those companies are most likely overcovered, unprofitable, and avoidable for prudent investors.
So my question headed into the rest of the ten-minute test was whether this was just another eco-friendly story stock.
Ratios:
| 12 Months – December 31, 2018 | 12 Months – December 31, 2020 | 12 Months – September 30, 2022 | |
| YoY Rev Growth | 25.3% | 31.4% | 22.8% |
| Gross Margin % | 24.8% | 30.2% | 31.0% |
| EBITDA Margin % | 3.5% | 12.3% | 10.1% |
| Net Income Margin % | 0.0% | 5.9% | 5.9% |
| ROA | 1.7% | 11.0% | 9.1% |
| ROE | (0.8%) | 52.2% | 19.5% |
| Total Asset Turnover / Inventory Turnover | 2.2x / 4.5x | 1.9x / 4.9x | 1.9x / 4.4x |
| Current Ratio | 0.8x | 1.8x | 3.6x |
| Net Debt/EBITDA Ratio | 8.0x | 2.8x | 0.8x |
Analysis: Growth is headed in the right direction, margins expanded and held, as a distributor, asset turns and inventory turns looked productive, and the debt situation looks solid.
Income Statement:
Same periods as above:
| Diluted EPS | $0.00 | $1.13 | $1.24 |
| Weighted Avg Diluted Shares Outstanding | 14.8 | 15.4 | 19.9 |
Analysis: The income statement looked pretty normal except for the jump in number of shares. This concern was my largest headed into a deeper company dive. Will future jumps in shares exist?
Cash Flow Statement:
Same periods as above (in millions):
| Cash from Operations | 2.7 | 14.5 | 22.4 |
| Capital Expenditure | 31.9 | 36.5 | 18.1 |
Analysis: In 2022, the Company was able to generate free cash flow and it looked like it returned some of that cash to share holders in the form of a cash dividend. Normally, I prefer a company that has generated positive free cash flow consistently.
Balance Sheet:
Same periods as above (in millions):
| Accounts Receivable | 15.1 | 23.8 | 36.7 |
| Accounts Payable | 18.5 | 25.1 | 18.9 |
| Gross Plant, Property, and Equipment | 54.3 | 125.9 | 142.3 |
| Goodwill | – | 3.1 | 3.5 |
| Long Term Debt | 11.8 | 89.4 | 41.8 |
Analysis: Same sort of story for 2022, accounts receivable became greater than accounts payable. Investment in PP&E is evident. No unnecessary spikes in goodwill exist. Additionally, a clear effort has been made to pay down long term debt. KRT looks relatively healthy.
Multiples:
| LTM | 12/31/21 | 3/31/22 | 6/30/22 | 9/30/22 | 12/30/22 | 3/10/23 |
| EV/Revenue | 1.40x | 1.12x | 1.11x | 1.03x | 0.82x | 0.83x |
| EV/EBITDA | 1.14x | 0.93x | 0.94x | 0.89x | 0.73x | 0.76x |
| P/E | 22.07x | 18.33x | 15.42x | 15.11x | 12.32x | 12.26x |
| P/BV | 3.65x | 2.92x | 2.93x | 2.68x | 2.05x | 2.09x |
| NTM | 12/31/21 | 3/31/22 | 6/30/22 | 9/30/22 | 12/30/22 | 3/10/23 |
| EV/Revenue | 1.14x | 0.93x | 0.94x | 0.89x | 0.73x | 0.76x |
| EV/EBITDA | 9.95x | 7.92x | 7.88x | 7.56x | 6.27x | 6.59x |
| P/E | 15.9x | 12.46x | 11.92x | 11.27x | 9.32x | 9.60x |
Analysis: This section is where things get interesting. When I think about most IPOs, I envision 10x EV/Revenue, negative P/Es, and wacky valuation. When I think about most story stocks, I envision the exact same things.
It does not seem like KRT is a normal IPO situation.
Here is a comparison between the price action of KRT vs a very popular 2021 IPO, Rivian Automotive (RIVN):
KRT (in orange) and RIVN (in green) both IPO’ed in 2021. However, RIVN looks like the typical techy, green energy IPO. It initially jumped in price and precipitously fell. On the other hand, KRT has fallen, yet its held up well in comparison.
There are a variety of reasons why this is the case, and the variety of reasons is what makes Karat Packaging worth investigating.
Karat Packaging, Inc. (KRT)
Key Financials (as of 3/12/2023)
- Market Cap: $291.1 mm
- Enterprise Value: $336.5 mm
- Current Stock Price: $14.62
Variety of Reasons
Karat Packaging is well positioned amidst a backdrop of macroeconomic tailwinds in a shaky environment, strong business model, and significant growth prospects.
Macro Tailwinds
Karat Packaging is a leading provider of high quality and eco-friendly disposable single use products associated with restaurant take-out and other food services. KRT is favorably situated to grow with the online food delivery market, which is projected to increase at a 18% CAGR to $96 B by 2026. The online food delivery market will continue to be driven by shifting consumer preference to at-home dining.
In addition, single-use plastics and Styrofoam regulation will increase the demand for KRT’s paper and compostable products. Currently, 12 states have passed legislation concerning plastic bags, and 9 states have banned the use of Styrofoam. Moreover, Canada outlawed the use of plastic bags and Styrofoam take-out containers. As regulation continues to spread and KRT begins its penetration into the Canadian market place, the Company is set to benefit immensely.
Competitive Business Model
Aside from the eco-friendly product mix, Karat’s business model is well-paced for sudden and rapid growth.
KRT’s sales mix includes distributors (58%), national and regional chains (22%), retail (12%), and online (8%). Distributors buy Karat’s products and resell them at a higher price. Some of the Companies’ national chain customers are PF Chang’s, Applebee’s, Chipotle, Panda Express, and In-N-Out Burger. The retail segment serves regional bubble tea establishments and boutique coffee houses. The Company sells products online on its website and via Amazon.
75% of Karat’s products are sourced from other manufacturers and 25% are produced in its six United States manufacturing facilities, which allows the Company to maintain its high margins in comparison to its competitors (reference Competitor Analysis below).
The Company has six manufacturing, warehousing, and distribution facilities spread across the United States to have direct access to population centers and provide real time fulfillment. In Q4 2022, Karat is completed a deal to lease a distribution facility in Chicago to expand its reach into the Midwest. Moreover, KRT possesses a strong logistics infrastructure that utilizes third party service providers and 45 of its in-house truck drivers. The combination of a growing distribution footprint and strong logistics infrastructure will allow KRT to achieve its growth goal of high single digit growth in 2023.
Since KRT is smaller in size, the Company can respond flexibly to different macro-economic situations. Management announced in the fourth quarter earnings that it was moving its manufacturing capabilities out of California to Texas because of rising labor costs. Now that freight costs are lower, KRT will fulfill its California demand with more imports. This ability to make strategic adjustments will benefit the Company in a fluid economic environment.
Competitor Analysis
| Competitor | GM% | EBITDA% | EBIT% | NI% | Debt/EBITDA | EV/EBITDA | P/EPS |
| SLGN | 16.3% | 15.0% | 10.9% | 5.32% | 3.5x | 8.5x | 16.5x |
| BNZL | 25.1% | 7.6% | 6.3% | 3.94% | 3.0x | 11.3x | 24.0x |
| PTVE | 16.1% | 13.1% | 7.7% | 5.11% | 4.8x | 5.8x | 9.0x |
| GDNP | 25.7% | 0.7% | (1.7%) | (10.79%) | 41.4x | 75.2x | NM |
| BERY | 16.8% | 14.9% | 9.1% | 5.37% | 4.8x | 7.9x | 12.8x |
| KRT | 31.2% | 9.6% | 7.1% | 5.59% | 1.3x | 6.9x | 14.6x |
Growth Prospects
Karat is planning on doubling manufacturing capacity by mid-2023. It is engaged in a joint venture with a Taiwanese based company, Happiness Moon, to build a new manufacturing facility for environmentally friendly products. The facility should be operational by early 2023. Management announced that it will probably expand this entity in the future.
In the next few years, the Company will enhance its strong customer base. In the third quarter 2022 earnings call, management mentioned how they were seeing greater traction in the Midwest and Southeast United States. Furthermore, KRT will proliferate its offering to non-foodservice industries such as airlines. As mentioned earlier, the Canadian market provides an untapped marketplace for Karat’s products, which will be accessed as KRT amplifies its presence on Amazon, Canada.
Risks
Consumer Preferences
In the event that consumer preferences divert more towards in-person dining, KRT could suffer. Although unlikely, this outcome is possible. However, it is more likely that an overall decrease in consumer spending will have a greater impact on take-out dining. In my opinion, United States consumers do not necessarily operate in the most rational ways. Even if spending budgets decrease, I do not foresee a huge decrease in spending on food.
Halt in Regulation
While there is a clear movement across the United States to regulate single use plastics and Styrofoam, legislation priorities can change under different regimes. The increase in plastic and Styrofoam bans will boost Karat Earth product revenue but to solely rely on intensified regulation is foolish.
Share Dilution and Illiquidity
The rise in share count in 2021 was due to the IPO. That being said, the Company is young and could utilize equity funding for further expansion. I could not find a specific instance where management guided future equity issuance. This issue would be my first question to management given the opportunity.
Since CEO, Alan Yu, and Co-Founder, Marvin Cheng, own approximately 71% of shares outstanding, I infer that they will allocate capital with shareholder interest in mind. Management decided to issue a special dividend in Q32022 rather than repurchase shares, which could be seen as questionable. However, given the lack of liquidity, it was more prudent to issue a dividend than a share buyback because there are so few shares outstanding.
Hopefully, over the next few quarters the Company decides to actually release more shares to be publicly traded. Even though share dilution could be bad, the security might gain more attention if it has more float. Hedge funds are typically limited to stocks that possess more liquidity to be able to move in and out more freely.
Unrealistic Management Guidance
According to the Q3 2022 earnings call, management was bullish on pricing power, customer base growth, and margin strength. Despite customer inventory normalization, Yu was not worried about pricing pressures on plastics. Moreover, he believed that paper prices would be able to compensate for any pricing loss on plastics. Throughout the call, management guided for strong customer retention and wallet share expansion. Management projects a 31% or 32% gross margin “or better”. The Company achieved a gross margin in 2022 of around 31%, but I would be okay with more conservative guidance.
Miscellaneous Attractiveness
Insider Buying > Insider Selling
Between November 14, 2022 and December 16, 2022, insiders including Alan Yu, Marvin Cheng, and Jian Guo (CFO), bought 82,850 shares on the open market worth around $1.15 mm. Yu was responsible for 81,000 shares purchased (a 108 bps increase in his shares held).
On the other hand, between August 18, 2022 and September 14, 2022, Marvin Cheng sold 10,125 shares, which only accounted for a 15 bps decrease in his shares held.
The recent insider buying could be a signal for good things to come over the next few quarters.
Continue the Research
Originally, I wrote this post before Q4 2022’s earnings. I added a couple of important facts throughout the post from the earnings call since I waited until after the Illinois Investment Management Academy pitch process to announce the post.
That being said, I am excited for Q1 2023 earnings and more to come. I plan on keeping a close eye on how this Company performs over the next few years.
If you are interested in learning more about this company, I recommend reading the fourth quarter earnings call, most recent 10-K, and taking a look at the financial statements. As with most of my posts, this write-up is a general summary of what I am looking at with the Company.
There is plenty more to uncover about Karat Packaging. I have not been this interested in a Company since I first dove into Hub Group, Inc (HUBG). The parallels between KRT’s and HUBG’s strong demand and ESG driven growth is particularly cool to see for me.
As always, if you have more questions or want to talk all things KRT, do not hesitate to reach out on twitter, instagram, or shoot me a text.
Employ your curiosity.
-Maximus Beach
Learn more about Maximus Beach’s background here.
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