CPI Card Group Inc. — Q3 2016 Form 10-Q
Business context and period. CPI provides financial payment cards and related personalization, fulfillment and other services, principally in North America, with U.K. operations. This unaudited report covers the quarter and nine months ended September 30, 2016; comparisons are with the corresponding 2015 periods. Dollar amounts below are in millions unless stated otherwise.
Financial performance and position
- Q3 revenue: $81.2, down 24.6% year over year. Product sales fell to $37.5 from $65.6; service sales rose to $43.7 from $42.1.
- Q3 earnings and margins: Gross profit was $29.1 versus $43.0, with gross margin of 35.8% versus 40.0%. Operating income was $11.7 versus $26.4, and operating margin was 14.4% versus 24.5%. Net income was $4.0 versus $14.8; diluted EPS was $0.07 versus $0.19.
- Nine-month revenue and earnings: Revenue was $241.3, down 14.0%. Gross profit was $81.5 versus $104.4, and gross margin was 33.8% versus 37.2%. Operating income was $29.9 versus $57.8, and operating margin was 12.4% versus 20.6%. Net income was $9.4 versus $33.2; diluted EPS was $0.17 versus $0.02. The prior-year comparison included preferred dividends that reduced income attributable to common stockholders.
- Cash flow: Nine-month operating cash flow was $39.8 versus $44.4. Capital expenditures were $12.4; cash used in investing was $12.4. Financing activities used $19.5, including $9.0 to repay the Sellers Note, $6.0 in share repurchases and $5.0 in dividends. Cash increased $7.7 to $21.3.
- Debt and liquidity: Long-term debt had a $312.5 principal balance and $301.4 carrying value after unamortized discounts and financing costs. Cash was $21.3, including $3.8 held outside the U.S. No revolver borrowings were outstanding; the filing reports approximately $40.0 of availability, reduced by a $0.05 letter of credit. The term loan matures in August 2022. CPI reported covenant compliance and said cash, operating cash flows and borrowing availability should fund obligations and operations for at least 12 months.
- Balance sheet: Total assets were $270.7; total liabilities were $359.7, resulting in a stockholders’ deficit of $89.0. Current assets were $92.8 and current liabilities $34.1.
Material changes and management commentary
- The main sales and earnings pressure was lower U.S. Debit and Credit card revenue, particularly EMV cards: customers reduced purchases while drawing down inventory accumulated in 2015. Q3 EMV card sales volume declined to 22.6 million from 41.2 million; nine-month volume was 86.5 million versus 115.9 million. Personalization and fulfillment growth partly offset card declines.
- Lower production volumes weakened overhead absorption and margins. In U.S. Prepaid Debit, nine-month sales also declined as a large customer shifted some business to a competitor; lower prices and higher material and labor costs pressured margins.
- U.K. revenue was affected by sterling exchange-rate movements and softer retail gift-card volumes. The Petersfield U.K. operation had closed in August 2015, reducing comparative-period sales and costs.
- Interest expense rose to $15.1 for the first nine months from $8.1, reflecting the First Lien Term Loan entered into in August 2015. Public-company, litigation and related corporate expenses also contributed to higher operating expenses.
- CPI declared dividends of $0.135 per share for the first nine months and had a $20.0 share-repurchase authorization; $14.0 remained available at quarter-end. A further $0.045-per-share dividend was approved in November 2016, payable in January 2017.
- The filing provides no quantified revenue or earnings guidance. Management identified EMV adoption and ordering patterns, customer relationships, competition, technology shifts, security and production risks, substantial indebtedness, foreign-exchange exposure and legal claims among factors that could affect results.
Risks, contingencies and unusual items
- Internal controls: Management concluded disclosure controls were ineffective at September 30, 2016 because of an unremediated material weakness related to finance expertise and accounting for non-routine, complex transactions. Remediation efforts were ongoing.
- Legal matters: A putative securities class action alleges IPO-registration-statement omissions, including about EMV inventory and demand; the company said the claims are without merit. Two Gemalto patent cases were pending. CPI reported that potential losses in these matters were not estimable and recorded no accrual; it also noted potentially material legal expenses and no assurance of a favorable outcome. CPI separately filed a patent suit against Multi Packaging Solutions in October 2016.
- Debt terms: The credit facility includes restrictive covenants and may require excess-cash-flow prepayments beginning with 2016 cash flows. The company reported compliance at quarter-end.
- Other: CPI reported no material off-balance-sheet arrangements and no material changes in market-risk disclosures from its 2015 annual report.
Important facts for investors to verify
- Whether EMV customer inventory normalization leads to a recovery in card volumes, and whether personalization and fulfillment growth can offset product declines.
- Trends in gross and operating margins, especially production-volume absorption and U.S. Prepaid Debit pricing, costs and customer retention.
- Debt-service capacity, excess-cash-flow repayment requirements, revolver availability and compliance with credit-facility covenants.
- Developments in the securities and patent litigation, including potential costs, outcomes and any eventual loss estimates.
- Progress in remediating the material weakness and whether management later concludes internal controls are effective.