Good day, ladies and gentlemen, and welcome to the Q1 21017 CPI Card Group earnings conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions]. As a reminder, this conference call is being recorded. I would now like to turn the conference over to Will Maina of investor relations. Sir, you may begin.

Thank you, Ashley. And good afternoon, everyone. Welcome to the CPI Card Group first quarter 2017 earnings conference call. Participating on today’s call from CPI Card Group are Steve Montross, President and Chief Executive Officer, and Lillian Etzkorn, Chief Financial Officer. Before we begin, I would like to remind everyone that this call may contain forward-looking statements as they are defined under the Private Securities Litigation Reform Act of 1995. Please refer to the disclosure at the end of the company’s earnings press release for information about forward-looking statements that may be made or discussed on this call. The earnings press release is posted on CPI’s website. Please note there is also a presentation that accompanies this conference call and is also accessible in the IR section of our website. Please review the information along with our filings with the SEC and SEDAR for a disclosure of the factors that may impact subjects discussed on this call all. All forward-looking statements made today reflect our current expectations only and we undertake no obligation to update any statements to reflect the events that occur after this call. Also, during the course of today’s call, the company will be discussing one or more non-GAAP financial measures, including EBITDA, adjusted EBITDA, adjusted EBITDA margin, adjusted net loss or income, adjusted diluted loss or earnings per share, free cash flow and constant currency. Please see the earnings release on CPI’s website for all the disclosures required by the SEC, including reconciliations to the most comparable GAAP measures. And now, I’d like to turn the call over to Steve Montross, President and Chief Executive Officer. Steve?

Thanks, Will. And good afternoon, everyone. Thank you for joining us on today's call. I will begin by covering some highlights from the first quarter and then provide you with an update on market conditions and recent developments. Beginning on slide four, we have a summary of our first quarter 2017 results. Total net sales were $56 million, a decrease of 35.2% from the prior-year period. Adjusted net loss was $3 million or negative $0.05 per share. We generated adjusted EBITDA of $3.9 million, free cash flow was a negative $8.3 million and we returned $2.5 million to shareholders through our quarterly dividend. Overall, our first quarter results were in line with our expectations and we are reiterating our 2017 financial guidance, which Lillian will discuss later in the call. Turning the slide five, I'd like to provide you with some more detail on our first quarter results. Product net sales for the first quarter were $29.8 million, down approximately 46% year-over-year. Our first quarter results compared to the prior year were predominantly driven by a decrease in our EMV card production volume, which was in line with our prior expectations and reflected a continuation of the trend of reduced volume demand in the US EMV card market that began in 2016. More specifically, we produced 18.3 million EMV cards in the first quarter of 2017, which was down from 41.4 million cards in the prior-year period, with the decrease driven primarily by reduced demand from large issuers. Despite this decrease, we believe our market share has remained fairly stable year-over-year. Based upon our first-quarter results, in ongoing conversations with our customers regarding their EMV card demand for the remainder of 2017, we continue to expect to produce about the same number of EMV cards in 2017 as we did…

Thanks, Steve, and good afternoon, everyone. I’ll now provide a review of our first quarter 2017 results. Turning to slide ten, you will see the highlights of our first quarter results. First quarter net sales were $56 million, down 35.2% from $86.4 million in the first quarter of 2016. Product net sales decreased $25.2 million from the prior year, primarily driven by a 55.8% year-over-year decrease in the number of US debit and credit EMV chip cards sold. Services net sales decreased $5.2 million or 16.5% year-over-year to $26.2 million, primarily driven by declines in the US prepaid debit segment sales and lower card personalization and fulfillment services revenue, which I will discuss in more detail shortly. Gross profit for the first quarter was $16.1 million, a decrease of 45.8% year-over-year and representing a gross margin of 28.7% compared with the gross margin of 34.4% in the first quarter of 2016. The decrease in our gross margin from the prior year primarily reflects both the revenue decline and absorption of fixed cost, partially offset by our cost reduction actions, which we initiated during the second quarter of 2016. Loss from operations in the first quarter of 2017 was a negative $1.8 million compared with operating income of $13.7 million in the prior-year period. The change in income from operations primarily reflects the same factors impacting the gross profit margins, in addition to $580,000 of patent and shareholder litigation and related charges in the first quarter of 2017. We reported a net loss of $4.5 million or negative $0.08 per share in the first quarter of 2017 compared with a net income of $5.7 million or $0.10 per share in the prior-year period. We recorded a tax benefit of $2.3 million in the first quarter compared to a tax expense of…

Our first question comes from Brad Berning of Craig-Hallum. Your line is open.

Hi, good afternoon. I thought maybe you could start with a little bit more for the outlook for 2Q specifically across the business lines and help us understand the trajectory through the year. I know you guys said 1Q met your expectations, but I think analyst assessments were a little different than yours. So, maybe you guys can help us get in the right direction on those. And then secondly, just obviously a broader question, can you talk about visibility that you have so far into 2Q, visibility into second half, and then help understand from a guidance process how you’re thinking about guidance versus what you have visibility on? And lastly, if you can just talk about the services margins a little bit this quarter and how those – what you need to see to help get those recover in the second half as well.

Lillian, you want to talk about Q2 guidance.

Yeah. For the second quarter, Brad – thanks for the question and thanks for being on the call with us today. So, really, we’re continuing to see the revenue pickup and really get into more of what I characterize a normal historical cadence. And historically, the cadence for the company was probably 17%, 18% in the first quarter, 20% to 22% in the second quarter depending. So, what we’re seeing really is a return to more of those historical patterns. And as we look towards the second half of the year, we continue to see the buildup of the EMV card manufacturing volume and we also have a lot of initiatives that Steve was talking about during his section in terms of our initiatives such as print on-demand and some of the services and products that we’re offering will continue to be ramping up as we progress through this year.

And then, Brad, you had also asked about visibility. So, talk a little bit about visibility. Our visibility is consistent with what we were – what we've been discussing in our prior call couple of months ago where we've got pretty good visibility out four to eight weeks. And then we have good visibility in terms of where we think we will be for the year and that’s really based on bottoms-up analysis with the customers and we continue to go through that exercise fairly regularly, going through that bottoms-up analysis on our customers. And so, through that process and through the discussions with them, we get a good understanding of where they expect to be for the year and then, therefore, where we expect to be for the year. So, overall, for the year, we believe good expectations or a good level of expectations and understanding of where our customers are going to be and, therefore, where we’re going to be in terms of visibility – hard visibility, have good line of sight over the next four to eight weeks, I’d say it’s more in the medium-term where – not clear line of sight to exact business, but overall we've got expectations around business volumes based upon those discussions with the customers. And then, in terms of services, with the expectations around services revenue or margin, I’d ask Lillian to comment on that.

Sure. So, really, what drove those lower margins on a year-over-year basis, Brad, is that we had lower sales in our prepaid business and that was related to a delay in the rollout of a packaging design refresh that one of our large customers had. And as a result, with lower volume, we had lower absorption and efficiency levels at the facility. Additionally, we are incurring incremental cost as we're ramping up some of our print on-demand – getting ready for our print on-demand and ramping up for that. So, as we look forward, the customer that had the delay, we expect to see that business as we progress through the year and then we’ll also be having incremental volumes coming on with the prepaid and print on-demand will continue to ramp up. So, the margins there will return to more of what we would normally expect.

Just to real quick follow-up on the services, the design package refresh was part of that delay due to the CFPB delay in the rules [ph], so some uncertainty for packaging for this year.

Not really. It was more just the design considerations that they had and it was more internal to them. And it wasn’t really caught up in those regulations.

Got it. Understood. I'll get back in the queue for other questions. Thanks a lot.

Okay. Thanks, Brad.

Our next question comes from David Koning of Baird. Your line is open.

Yeah. Hey, guys. Thanks for taking my call.

Sure, Dave.

I guess, first of all, just on – you kind of mentioned a shift, a little bit towards the bigger banks, which was pretty evident in the ASP going down and in the card personalization also being weak in the quarter. But I guess I'm wondering – I know in the back half, it sounds like you expect those smaller banks to spend more, but I'm just wondering why those would be down year-over-year. I think those were expected to be later like – towards now – years ago, the big banks were going to really ramp the EMV cards, but would be in growth mode for the smaller banks by now. Maybe you can talk a little bit about why they’re down in Q1 and then why you kind of really think they’re going to accelerate the rest of the year.

Yeah. So, overall, what we’re seeing, Dave, is that the migration continues with the small and midsize issuers and as they convert. What we're seeing is that it’s now – with the small and midsize issuers, some of the larger of those players were converting in 2016. Now, we’re seeing the smaller players convert, but there continues to be conversion activity in that small to midsize issuer market. So, that progress. But, overall, for the market, that growth, if you will, around the small and midsize issuers is being offset by reduced demand from the large issuers. The large issuers really went through their conversions in a very significant way back in 2015. And so, what we’re seeing is that those conversions from the large issuers are pretty much done, and so the demand from the large issuers have really slowed quite a bit. So, that slowing demand is really offsetting some of the growth that we’re seeing from the small and midsize issuer market.

Okay, okay. Well, that’s good on that one. And then, I guess, two real small questions. One being, if the ASP bottomed in Q1 and the rest of the year gets better; and the other is how far into the $10 million cost save plan are you because Q1 seemed a little elevated. I’m wondering if you just really haven't started the plan and Q2 starts to be the benefactor of that.

So, ASPs in the first quarter were pulled down a bit by just the concentration or predominance of some large issuer activity. Also, we had a – with the volumes at the levels they were, had a couple of large orders that also skewed a bit the ASPs. So, we think that impact is mitigated as we look forward. But we still expect – with the large issuer market, we still expect we’re going to see pricing pressure in the large issuer market. So, don't want you to lead you to believe that suddenly ASPs in that – with the large issuers are going to pop up, therefore, you ought to start seeing rising ASPs from us. I think the mix will change a bit and that will cause our ASP to move around a bit and we saw that impact in the first quarter where it was really down from the fourth quarter. So, we think that that will cause it to move around a little bit, but it’s – we still believe that we’re going to some pricing pressure from the largest issuers as we go throughout the year. And then the second half of your question, sorry, Dave.

That was related to the cost savings, right?

Yeah.

Yes.

So, we definitely have been implementing and have been receiving the benefit of the cost efficiencies and reductions in the first quarter. Just as we did in the fourth quarter of last year, a lot of the activity that we began, we began in 2016. So, on an ongoing basis, we’re continuing to work to drive those cost improvements and efficiencies. We have full visibility to the $10 million commitment that we have for this year and quite candidly we’ll continue to look for incremental opportunities as we progress in the business because, as Steve just mentioned, as customers continue and the market continues to pressurize the prices, we need to ensure that we’re maintaining and, quite frankly, trying to improve our margins, so that we deliver appropriate returns.

Yeah, that’s great. Well, thanks, guys.

Thanks, Dave.

Our next question comes from Paulo Ribeiro of BMO Capital Markets. Your line is open.

Thank you. Well, I have a lot of questions. I’ll repeat some of the points that have been discussed so far. I still want to get more granularity and understanding of those. In particular, let's start with the smaller issuer market. You’ve talked in the past two things. About a year ago, when you first revised downward your EMV expectation for 2016 pretty dramatically, you mentioned two things. One was, the inventory at the large issuers and second was the delay at the smaller issuers due to bottlenecks and getting their processing ready. How much visibility do you have in both issues? Where are inventories now? Gemalto mentioned three to six months. Is that the normal level? And on the smaller issuers, have they solved the bottlenecks? Are they about to solve the bottlenecks? How well do you understand or have visibility into that issue?

Sure. So, with the large issuers and the inventory issue, we think the inventory issue is largely past. And that’s based upon discussions that we've had with the large issuers. So, we believe the vast majority of the large issuers have worked through excess inventories. We think – generally, the large issuers want to have inventories kind of in that three to four month range, and so we believe, based on the discussions with those large issuers, the vast majority of them have worked through that inventory issue. So, that’s largely past. In terms of the bottlenecks a year ago at this time, that was a real issue for the small and midsize issuers where there was a real backlog of conversions at the processor level for the small and midsize issuers. That was really worked through over the course of 2016. So that isn't an issue impeding the conversions for the small and midsize issuers at this point. Again, we think that – in terms of numbers of institutions, we think that it’s probably about 60% of the small and midsize issuers have converted over, with a lot of those being some of the larger players in that space, but there's still – a lot of these small issuers still to convert. But as we've had discussions with the processors and with the issuers themselves, it doesn't appear that the bottlenecks at the processor level are impeding the conversions.

Perfect. Great. Another point I want to discuss is the delay in the packaging refresh. And you guys gave us a lot of color already, but I'm still trying to get a better sense. What was – to the extent that’s a fair question – the impact this quarter, right? And that's refresh. When it comes, is it a one-time big event enough to move the quarter like we’ve seen this quarter or is it a process that happens spread over a few quarters, how should we think about it? Again, try to quantify as much as you can. What was lost – the delayed revenue this quarter and how we should think of it being recuperated once this client decides to go ahead?

Yeah. Once that business starts moving ahead, we would expect to recoup that over a couple of quarter period of time.

Yeah, okay. I'll get back in the queue. Thanks.

Thanks, Paulo.

Thanks, Paulo.

Our next question comes from Gary Prestopino from Barrington. Your line is open.

Hi. Good afternoon, everyone.

Hey, Gary.

How are you?

Good. How are you doing?

Just fine. I don’t want to beat a dead horse on some of these issues, but in the quarters, on the progression of sales, Q3, Q4, as I’m kind of thinking about it, linearly, we’ll continue to see an increase. So, Q3 will be more than, obviously, Q2, but will Q4 be more than Q3?

I guess on that – Gary, it’s Lillian. Thanks for the question. Thanks for being on the call. We’re not going to break out specific Q3 and Q4 guidance and revenue breakout. I think from the perspective that, as we’re looking at the second half of the year, obviously, that's where the majority of our revenue is going to be for this year, given where our first quarter came out and our expectations for the second. So, we’ll continue to ramp up as we discussed on the services side of the business, the products that we have coming out in addition with the EMV card manufacturing sales. So, those will continue to ramp up as we move into the second half of the year, but I don't want to get into specificity between the third and fourth quarter at this point.

Okay, that’s fine. And then, anything on the dual contact cards you can share with us?

In terms of our outlook and our discussion around the dual interface card, it really is consistent with what we discussed a couple of months ago in our year-end earnings call that we continue to supply a few or several issuers, but at low levels for dual interface cards. And we have discussions with the issuers about it, but there's not any firm plans to launch dual interface as far as we – as far as our discussions go with the issuers, don't see any plans to have a material launch of dual interface cards now. We think it's – as we look at the market, we think it’s an event that happens after 2017 in terms of a meaningful issuance of dual interface. That’s our outlook right now, Gary. We’re not counting on dual interface in 2017.

What about the metal cards now that you’ve received certification? Is that something that is way off in the future as well?

We’re excited about it. We’re excited about the opportunity and we’re excited about getting those certification, and so we are very focused on working with our customers around that. And so, we’re looking forward and we’re optimistic about the long-term potential of that and certainly we’re pushing to make sure that we – as soon as our customers are ready, we’re there to deliver for them.

And then just lastly, in terms of what you said in the quarter with the average prices going down and it was a mix issue, is it historically what happens as the bigger banks come in and put their orders in or get most of their cards from you in Q1 and then it slacks off as you go through the year and then you’re looking at the small and midsize issuers throughout the rest of the year bulking up their orders?

No. I wouldn't characterize the order patterns as something like that. It just happened in the first quarter. We had a preponderance of large issuer business. And there were a couple – a couple of those orders were fairly lumpy. They came in the first quarter that pushed the ASPs around a little bit. But, no, that not a typical order pattern. Typically, we’d see a flow throughout the year.

Okay, thanks.

Thanks, Gary.

Our next question comes from Stephanie Price of CIBC. Your line is open.

Hi. Good afternoon.

Hey, Stephanie.

Hi, Stephanie.

In terms of EBITDA, are you expecting that EBITDA is going to follow the same cadence that you were kind of talking about for revenue for Q2, so 20% to 22% of total for the year?

I wouldn’t necessarily characterize a specific target range on that. We didn’t provide the range for the EBITDA. But how I would characterize EBITDA as we progress through the year is as the revenue is coming in and we’re having better utilization, so we don’t have under-absorption – so, for instance, we’ll have much better efficiencies coming in and as we continue to realize the cost reductions, that will also benefit the EBITDA. So, really, as the business comes in and ramps up, I also expect EBITDA to be coming through and dropping through to the bottom line as well.

Okay. So, I guess, you answered most of my second question, just around where that EBITDA improvement is coming from and how should we be thinking about the drive –the improvement in EBITDA for the rest of the year.

Yes. It really is – as the volumes come in, it improves the efficiency for the operations. You cover your costs better, you have better throughput, better efficiencies. So, that naturally improves the EBITDA. And then also, as we continue with our cost initiatives throughout the year, that will also continue to improve EBITDA.

Okay. And then just finally from me on cash flow, when you think about cash flow for the full year, can you kind of talk a bit about how we should think about that rolling out through the remainder of the year?

Yeah. I think we talked on the last call in terms of cash flow. And we haven’t provided specific guidance for our cash flow for this year. But CPI has historically been a positive free cash flow or positive operating cash flow type of business. We fully expect that to be the case this year. One of the dynamics that is different, though, as we’re looking at 2017 in comparison to 2016 is 2016, with the decline of our revenue, we basically threw off a lot of working capital, and that was a true benefit for the cash flow last year. As you think about the business and as we look through the year and as we’re ramping up throughout 2017, working capital tends to become more of a use versus the benefit. So, that is something that I would expect as we progress through the year. You are going to see working capital usage, but I do fully expect the company, as it has historically been, to be positive free cash flow.

That’s helpful. Thank you.

Thanks, Stephanie.

[Operator Instructions]. Our next question comes from the line of James Schneider of Goldman Sachs. Your line is open.

Good afternoon. This is Lara Fourman stepping in for Jim. Thanks for taking my question.

Sure.

My first question was just on chip prices and if you can just talk a little bit about chip price trends that you’re seeing and even if you’re seeing pricing pressure, if we could expect gross margin expansion over the course of the year.

Yeah. So, in terms of overall prices, I think we had indicated before, and this is something that we had talked about over the last several quarters, that we expected that there would be continuing pressure with the large issuers around prices, and that's certainly something that we've seen throughout that period of time, and that's something that we expect to see through the rest of the year. And that's also something that we have taken into consideration as we put our guidance together in terms of pricing pressure in the market overall and then with the large issuers. And so, it’s something that we look at and we track and certainly have taken into account our expectations around that.

And then what does that mean for gross margins? Because I think the cost of the cards are also – the cost that you have for the cards are also coming down.

We’re seeing chip costs come down and that's one of the things we continue to focus on, is making sure that we’re really pushing to get some cost reductions on the chip cost side as well.

So, when it comes to the actual gross margin, we’re not providing specific guidance on the gross margin and really where we’re focused and where we are providing the guidance is on overall EBITDA and EBITDA margin. As Steve was indicating, pricing has been a pressure and that'll continue just as – we’re working with the chip cost and looking for the efficiencies there, we continue to have the pricing pressure, so we do need to be very focused on our cost structure and ensure that we’re driving as many efficiencies out of that as we can to ensure that we’re hitting those EBITDA targets.

Got it. And then my last question was just in terms of the EMV card pricing pressure that you’re seeing on the ASP side, what are the main pricing pressure points, if you will? Is it coming from other competitors going after the same contracts, more just EMV cards being later in the cycle of getting everyone to transition, your clients pushing back more on the cost side?

I think it’s a combination of both the competition and the customers looking for price reductions. And so, we've had with the large issuers because they have large volumes that then would justify them going through a time-consuming process. A lot of the large issuers have gone or will go through a request for proposal process where they’re soliciting bids from us and others in the industry. And so, as a result, you’re seeing competition around the business that’s there, and so that’s a factor, is the competition and then also the large – especially with the large customers, but all customers are looking to make sure that they’re minimizing the costs that they have to pay, and so we’re seeing the customers really seeking to get some price reductions as well. So, that’s the source of it.

Okay, great. Thank you.

Sure.

And we have a follow-up question from Paulo Ribeiro from BMO Capital Markets. Your line is open.

I want to go back to Stephanie’s question on the cash flow. And Lillian, it was a great explanation. We really saw a big consumption of cash this quarter. Can you just tell us a little more about use of working capital as you’re ramping up? Is it you building inventory in expectation of demand, is it accounting [indiscernible] consuming cash? Could you just give us a little more color on that – how should we think about the uses of cash?

Yeah. So, for this quarter, obviously, part of the drivers were just the earnings result. And when we look more specifically into the cash flow statement, it is really the working capital uses. So, some of it was some inventory as we were producing – quite frankly, work-in-process inventory that we're producing for shipments that are going to happen later in the year and the second quarter in particular, one large customer. And again, just as we’re building up and getting prepared to support the revenue and the volume that we have coming in in the latter parts of the year.

So, the delay, for instance, from the prepaid side of the business, that delay from the packaging issue, that’s not – is that part of it, meaning you are preparing to get that out – the product out of the door and now it got – you’re stuck with it for a little bit longer?

I would say it’s more so as we are supporting the volume in the business that was coming in. And that itself was not a driver.

Around that prepaid, the delay in that business, we didn't start building it because they’re still redesigning it, and so we didn't have working capital tied up in that, Paulo.

Okay, perfect. And kind of a related question about the use of capital, you announced a while ago a buyback program. How do you think about it and how should we think about it? Do you use part of it, but not all of it? What are the metrics that you follow to – you consider when deciding that you should pull the trigger?

I’d say from the overall capital allocation approach and strategy, Paulo, that we've employed, is really focusing on first investing in the business, and that's really where you see us spending our cash and dedicating our cash. The other area that we’re keenly focused on is on reducing leverage. Obviously, that wasn't the case this quarter just given some of the cash consumption, but on a long-term basis, that really is our focus, is to reduce the net leverage. And then to the extent that we have excess cash, so to speak, we’ll look to return it to shareholders. We did do that this quarter with the dividend that we just announced and we’ll continue to look to that. But, again, the top priority for our cash and cash deployment is investing in the business to support the profitable growth and then, secondly, is to ensure that we’re improving our net leverage position.

Perfect. One last question, if I may. In terms of the innovation, the product innovation that you show in the slide, are the margins better on those business versus, let's call, the tiers in their segments, meaning personalization and the print on-demand? So, those all will have – and the metal card versus chip card, are that also a factor in the improvement in margins, the change in mix?

On that, quite candidly, just as we talked about other products, we’re not going to get into specific margin information and provide that. As much as I know that you and others would like us to share that, we’re not going to.

Just generally, if they are better.

Maybe I’ll answer the question a little bit differently. Part of what we’re focusing on is we want to make sure that we’re delivering value to our customers. We want to be the innovative partner with our customers and providing them products and services that meet the needs of both today, but also in the future. So, really, that's where you see the excitement that we have around the innovation and the new product, and it's really focused on delivering that value for the customer and, of course, getting a fair return for ourselves as well. And that’s really how we think about it.

That was helpful. Thank you very much.

Thanks, Paulo.

I’m showing no further questions. I would like to turn the call back to Steve Montross for any further remarks.

Okay. Well, thank you, everyone, for participating in our earnings call. Also, I’d like to thank all of the CPI employees for their contributions and commitment to serving our customers and also want to thank our valued customers who depend on and entrust us to serve their businesses. So, we look forward to speaking with you next quarter. Thanks, everyone.

Thank you.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program. And you may all disconnect. Everyone, have a great day.