CPI Card Group Inc. — Q2 2016 Form 10-Q
Business and period: CPI provides payment-card products and services, including card production, personalization and fulfillment, through operations in North America and the U.K. This unaudited report covers the quarter and six months ended June 30, 2016; comparisons are with the corresponding 2015 periods.
Financial performance
| Metric | Q2 2016 | Q2 2015 | Six months 2016 | Six months 2015 |
|---|---|---|---|---|
| Net sales | $73.7m | $95.5m | $160.1m | $172.8m |
| Gross profit / margin | $22.7m / 30.8% | $35.8m / 37.5% | $52.4m / 32.7% | $61.3m / 35.5% |
| Operating income / margin | $4.5m / 6.1% | $19.7m / 20.6% | $18.2m / 11.4% | $31.4m / 18.2% |
| Net income (loss) | $(0.3)m | $12.2m | $5.4m | $18.4m |
| Net cash provided by operations | Not stated for quarter | Not stated for quarter | $33.2m | $18.9m |
- Revenue mix: Q2 product sales fell 40.8% to $40.1m, while services sales rose 21.1% to $33.6m. For the first half, product sales declined to $95.1m and service sales increased to $65.1m.
- Profitability and interest: Q2 net loss attributable to common stockholders was $0.3m, or $(0.01) per share; first-half diluted EPS was $0.10. Net interest expense rose to $5.1m for Q2 and $10.1m for six months, versus $1.6m and $3.5m, respectively, reflecting the term loan put in place in August 2015.
- Cash flow and investment: First-half operating cash flow increased to $33.2m, driven largely by working-capital changes, especially lower receivables, despite lower net income. Capital expenditures were $7.0m. Financing used $8.1m, primarily for $6.0m of share repurchases and $2.5m of dividends.
- Liquidity and debt: Cash was $31.5m at June 30, including $4.2m held outside the U.S. Reported debt carrying value was $310.0m, including $9.0m of current maturities; principal outstanding was $312.5m on the first-lien term loan and $9.0m on the sellers note. The $40.0m revolver had no borrowings, $0.1m of letters of credit and $39.9m available. The company was in covenant compliance.
- Balance sheet: Total assets were $277.1m, total liabilities $368.1m and stockholders’ deficit $91.0m. The company repurchased 1.44m shares for $6.0m under its $20.0m authorization and declared dividends of $0.09 per share for the first half.
Changes and management commentary
- Q2 sales declined 22.8%; first-half sales declined 7.4%. Management attributed much of the U.S. Debit and Credit decline to reduced EMV card orders as customers worked through inventories built up in 2015. Q2 EMV card volume fell to 22.5m from 49.8m; first-half volume was 63.9m versus 74.7m. Management also cited pricing pressure from increased competition among large issuers.
- Lower production volumes reduced overhead absorption, contributing to margin compression, especially in U.S. Debit and Credit. U.S. Prepaid Debit’s first-half sales also faced a difficult comparison with elevated prior-year sales tied to a large customer’s packaging redesign.
- Operating expenses rose 12.6% in Q2 and 14.2% in the first half. Increases included public-company costs and patent-litigation-related charges; the first-half discussion identifies $2.9m of public-company costs and $1.9m of litigation-related charges.
- The U.K. Limited segment recorded modest sales growth, but currency movements reduced reported U.K. sales. The company also cited the August 2015 closure of its Petersfield U.K. facility as a reason for lower “Other” sales versus 2015.
- Management said cash, operating cash flows and available borrowing capacity were expected to be adequate for debt service and operating needs for at least the next 12 months. The filing provides no quantified earnings or revenue guidance.
Risks, contingencies and unusual items
- Legal matters: Gemalto patent litigation was stayed on July 11, 2016 pending Patent Trial and Appeal Board consideration of CPI’s challenge. A second Gemalto case was pending, with a motion to stay not yet decided. CPI said loss was reasonably possible but not estimable and recorded no accrual. Two purported IPO-related shareholder class actions were filed in June 2016; CPI intends to defend them.
- Controls: Management concluded disclosure controls were ineffective at June 30, 2016 because of an unremediated material weakness involving finance expertise and accounting for complex or non-routine transactions. Remediation efforts were ongoing.
- Other risks: CPI highlighted potential effects of the U.K.’s vote to leave the EU, including economic, regulatory and currency uncertainty. Broader disclosed risks include slower EMV adoption, customer concentration and retention, competition and price erosion, operational/security failures, intellectual-property claims and substantial indebtedness.
- Debt obligations: The $9.0m sellers note principal and unpaid interest were due in September 2016. The first-lien facility includes customary covenants and potential excess-cash-flow prepayments beginning with fiscal 2016.
- Subsequent dividend: In August 2016, the board approved a further $0.045-per-share dividend payable in October.
Investor verification priorities
- Verify whether EMV inventory digestion, shipment volumes and competitive pricing continued to pressure sales and gross margins after June 30.
- Review the company’s ability to sustain operating cash flow, given its reliance on working-capital movements, and its capacity to service debt and meet the sellers note obligation.
- Track the Gemalto matters and shareholder class actions, including any change in estimated exposure, accruals or legal costs.
- Monitor remediation of the material weakness and whether management later reports effective disclosure controls.
- Assess ongoing repurchases and dividends against liquidity, debt covenants, capital spending and potential excess-cash-flow repayments.