Karat Packaging: Eco-Friendly Materials To Revolutionize FCF Generation

Karat Packaging Inc. (NASDAQ:KRT) will most likely benefit from new lines of products made of eco-friendly materials. I also believe that recent investment in e-commerce capabilities and manufacturing plants distributed throughout the USA will likely enhance future FCF margins. Even considering potential supply chain risks or new tax rates on imports of raw materials, I believe that the company remains undervalued.

Karat Packaging

Karat Packaging is a company oriented to the production and distribution of disposable products, which include products for fast food outlets as well as bags, gloves, napkins, disposable cutlery, beverage device ingredients, and other such products.

The company has Karat Earth, a brand through which it offers its products with eco-friendly materials. Its products are commonly made from plastic and paper. In addition to its scale productions, Karat offers its clients the possibility of customized designs and manufacturing, as well as the management and planning of logistics services.

Karat has manufacturing plants distributed throughout the USA, allowing it to satisfy the regional demands of its customers. Karat expects its statistics to remain at numbers similar to those for 2022 and 2023, but it is confident in having productive capacities in order to scale its business internationally in the future through its sales segments. Currently, it offers services to well-known brands in the United States, such as In-N-Out Burger, TGI Fridays, Jack In The Box, and The Coffee Bean.

To meet the demand of small and medium-sized customers, Karat has recently invested in developments for its online store. This allows Karat to automate its production and distribution, which the company itself considers as one of the differentials in terms of competitiveness over other companies in the market.

Along with this ability to respond to its customers, we must also take into account the offer of a wide variety of products that are generally purchased in packages – such as napkins, cupholders, and cutlery – with a personalized design and without printing. In addition, the company has experience and recognition in its logistics and distribution service, which includes 26 trucks and 34 trailers, as well as a number of smaller vehicles, allowing it to operate without dependence on third parties.

Balance Sheet

As of September 30, 2022, Karat reported $7.53 million in cash, inventories of $73 million, and total current assets of $124.8 million. Property stands at $94 million, with deposits of $15 million and total assets of $239 million. The assets/liabilities ratio stands at more than 2x, so I do believe that Karat has a good financial position.

Karat’s liabilities include accounts payable worth $18.9 million, accrued expenses of $8.46 million, and total current liabilities of $34 million. Total current assets are equal to more than three times the total amount of liabilities, so I don’t see liquidity issues here.

Long-term debt stands at $41.7 million, with total liabilities worth $85.3 million. I really don’t believe that Karat has a substantial amount of leverage. My EBITDA expectations seem sufficient to justify the current amount of debt.

Karat Appears To Be Moving More Rapidly Than Competitors With Regards To Recyclable Products And Environmental Objectives

The market for food service disposables is currently experiencing growth and a transition that has been accelerated by the effects of the COVID pandemic, which produced a huge increase and a change in habit with regards to food delivery and the ways of conceiving these services. In addition, along with this growth has also come a change in the type of regulations – due to the emergence of new forms of work and companies dedicated exclusively to delivery services – as well as discussions about future legislation in relation to recyclable products or the fulfillment of environmental objectives. Karat has been ahead of the game in this regard, rapidly developing a line of products made from recyclable materials that currently do not offer great commercial advantages over the competitors, but may eventually play a key role in the process of adapting the general market in this regard. In my view, as more investors have a look at these competitive advantages, Karat may receive more financing, which would lead to lower cost of equity and fair price increases.

Under Conservative Conditions, I Believe That The Fair Price Would Stand At $21 Per Share

Under this scenario, I am quite optimistic about Karat for two reasons. First, I believe that take-out dining and the growth of the e-commerce business model will likely push the company’s revenue growth. Karat offered a few words in this regard in a recent quarterly report.

There is a growing trend towards at home dining and mobility-oriented e-commerce, food delivery and take-out dining. We believe this trend will have a positive impact on our results of operations, as more of our customers will require packaging and containers to meet the demands of their increased food delivery and take-out dining consumers. Source: Quarterly Report

Secondly, I believe that Karat will likely enjoy increased demand for eco-friendly and disposable products. Management reported beneficial expectations about future net revenue of disposable products. Market experts out there believe that the eco-friendly food packaging market could grow at a CAGR of close to 7.2% from 2022 to 2032.

Environmental concerns regarding disposable products broadly have resulted in a number of significant changes that are specific to the food-service industry, including regulations applicable to our customers. We believe this trend will have a positive long-lasting impact on our results of operations, as we expect there will be an increased demand for eco-friendly and single-use disposable products. Source: Quarterly Report

Eco-friendly Food Packaging Market Outlook (2022-2032) The global eco-friendly food packaging market is projected to progress at a CAGR of 7.2% from 2022 to 2032. Eco-friendly Food Packaging Market Size, Growth

In addition, I am also optimistic about the company’s ability to generate disruption with the traditional models of product supply in the market. In my view, if Karat can provide a complete supply in the lines of production, distribution, design, and advice, the EBITDA margin will likely trend north. Besides, expansion of the company’s production capacities, new production plants, or acquiring more vehicles for transportation could enhance FCF growth even more.

My numbers for 2026 include revenue of $607.91 million, EBITDA of around $77.81 million, and EBIT close to $62.26 million. I also assumed an effective tax rate of 36.15%, EBIAT of $39.75 million, and a depreciation of $15.55 million. Changes in accounts receivables would be -$3.48 million, with changes in inventories of -$6.98 million and changes in accounts payable of $4.04 million. Besides, I took into account capital expenditure of $24 million, which would imply free cash flow of $73.2 million.

If we assume FCF close to $12 million for 2023 and $73.2 million from 2023 to 2026, with a WACC of 9.30%, the sum of net present value of future FCFs would be close to $89 million.

Now, with an EV/EBITDA multiple of 6.6x, the terminal value would stand at $513.546 million, and the net present value would be $359.83 million. My results would also include an enterprise value of $448.83 million, and with cash of $7.5 million and debt of $42.6 million, the equity valuation would be $413.73 million. Finally, with a share count of 19.908 million, the implied price would be $20.78 per share with an internal rate of return of 9.24%.

Under Bearish Conditions, I Believe That The Fair Price Could Imply A Valuation Of $12.25 Per Share

We must point out that the fast food and food delivery industry has experienced an extraordinary situation in the last two years, and this growth trend may not have yet found an end. In my view, making market projections clearly is a bit complicated. In my view, if management fails to forecast the demand, and invests too much in new capacity, in the near future, free cash flow margins could decline.

Some of Karat’s suppliers are also suppliers of some competing companies, and a future exclusive contract between suppliers and competitors could mean a shock to the current operation of their businesses. Also, the dependence on imports and the possibility of cuts in the supply chain as well as new tax rates for the entry of raw materials could negatively affect the company’s operations.

Finally, Karat has a situation of rising costs due to its expansion of operations, and the inability to manage this growth as well as to retain skilled personnel in the execution of its strategies can lead to an imbalance in its numbers and generate more complications than long term benefits.

Under the previous conditions, 2026 net revenue would be $355 million, accompanied by an EBITDA of $55 million and an EBIT close to $25 million. I also assumed an EBIAT of $16.5 million, depreciation of $8.86 million, changes in accounts receivable of $0.24 million, and changes in inventories of $0.49 million. Also, with capital expenditure of $13.86 million, I obtained free cash flow close to $40 million.

If we assume a WACC of 10%, the present value of 2026 FCF would stand at close to $25 million. Finally, the sum of PV of FCF would stand at close to $35 million.

Also, with an EV/EBITDA of 6.5x, the terminal value would be $357.5 million, and the NPV would be close to $245 million. My results would also include an enterprise value of $280 million, equity close to $245 million, a fair price of $12.25 per share, and an IRR of -7.5%.

Conclusion

Karat operates in a market that could be growing at a CAGR of more than 7% in the coming years. In addition, with manufacturing plants distributed throughout the USA, it appears to be well positioned. I also believe that recent investments in its e-commerce business model and a new line of products made from recyclable materials will most likely have beneficial effects on the company’s revenue growth. I do see supply chain risks, or new tax rates on imports of raw materials could affect the FCF line. With that, Karat appears undervalued at its current market price.