CPI Card Group Inc. (PMTS) Q4 2017 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the fourth quarter 2017 CPI Card Group Incorporated Earnings Conference Call. [Operator Instructions] And as a reminder, this conference is being recorded. Now, I will like to welcome and turn the call to Mr. Will Maina, Investor Relations.

Thank you and good afternoon everyone. Welcome to the CPI Card Group fourth quarter and full year 2017 earnings conference call. Participating on today's call from CPI Card Group are Scott Scheirman, President and Chief Executive Officer; and Lillian Etzkorn, Chief Financial Officer. Before we begin, I'd 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 disclosures 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 on SEDAR for a disclosure of the factors that may impact subjects discussed on this call. 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 income and loss, adjusted diluted earnings loss per share, free cash flow and constant currency. Please see the earnings press 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 over the call to Scott Scheirman, President and Chief Executive Officer.

Thanks, Will and good afternoon, everyone. Thank you for joining us on our fourth quarter and full year 2017 conference call. It's great to be here today to discuss our results and I'm excited to share with you our strategy and plan for CPI in 2018 and beyond. I’ll begin the call by briefly summarizing our Q4 and full year 2017 financial results, which can be found on slide 4. Our fourth quarter operating results were broadly in line with our expectations. We generated revenue of $65 million, down 3.6% year-over-year, an improvement to the year-to-date year-over-year decline of 21.3% through the third quarter of 2017. We recorded GAAP net loss of approximately $15 million and adjusted net loss of $400,000. We had adjusted EBITDA of $3 million in the fourth quarter and positive operating and free cash flow of $9 million and $8 million respectively. For the full year, we reported total net sales of $255 million, a GAAP net loss of $22 million and an adjusted net loss of $2 million. We generated adjusted EBITDA of $26 million in 2017. We delivered positive operating cash flow of $2 million for the year. While 2017 was a challenging year for us, looking forward, we remain confident and excited by CPI’s opportunities for growth in the broader payments market. As you recall, during our third quarter earnings call, I shared with you that we would be undertaking a comprehensive review of our business to assess our strategies and opportunities, as we navigate the current challenging US card manufacturing and issuance market. As part of this process, I've spoken with many of our customers and employees and visited each of our US facilities. I've listened to feedback and gained valuable insights on CPI’s strengths, where we need to improve to where there are long-term growth opportunities. Key to these opportunities is the desire and willingness of our customers to actively partner with us and build our collective businesses through ongoing collaboration and innovation. We have developed a strategy and plan that will enable CPI to better serve the needs of our customers, further capitalize on our addressable market and deliver shareholder value. Now, I’d like to spend some time talking about our strategy and plan in more detail beginning with slide 5. Our overarching goal at CPI is to be the partner of choice by providing market leading quality products and customer service with a cost competitive business model. We are committed to getting ourselves fit for growth with an unwavering attention to four key strategic priorities that we believe will support strong company and financial results over the long term. These four strategic priorities include, first, an organizational culture where customers are at the center of all that we do, our relationships with our customers and focus on their needs will inform and direct our new product development and go to market sales, product delivery and customer service strategies. We have recently implemented initiatives that we believe will strengthen our customer relationships. Second is providing market leading quality products and customer service with a high bar for excellence, accountability and continuous improvement. Third, improving productivity and reducing cost while ensuring the highest quality and market competitiveness. And lastly, remaining committed to ongoing innovation to generate new opportunities and fuel future growth. Turning to slide 6, in order to best address our strategy, we have realigned our US business units by product and have named general managers to lead each. The US organizational realignment is focused on enhancing our product and service delivery, driving faster decision making, and improving accountability and speed to market. And each general manager has full end to end customer and P&L responsibility for their business units. The new business units are secured card solutions, which consists of the manufacturing arm of our business including CPI metals, personalization solutions, including CPI On-Demand, Card@Once, our instant issuance business and prepaid. We believe this new alignment will enable us to better serve our customers and address their needs, leverage our employee strengths and talents, facilitate innovation, foster a culture of teamwork, accountability and excellence and deliver outstanding results for our customers and our shareholders. I will now walk you through each of our four key strategic priorities in more detail, beginning on slide 7. Turning to our first priority, our customers. Our customers are at the center of all that we do. Our goal is to help them foster compelling connections and build their brands with their own customers via traditional and next generation solutions that make people's lives every day easier. Our platforms and solutions are being leveraged and enhanced to create choice, convenience and control for our customers. Within our new US organizational structure, we have created customer specific responsibilities and accountabilities to ensure consistent and exceptional customer experience and to best meet and exceed their expectations today and into the future. Additionally, we recently redesigned our website to simplify the experience and make it easier for our customers and potential customers to find information and solutions they need. Our second priority is to provide market leading quality of products and customer service by cultivating an environment with consistent standards of excellence and clear measurements and targets. Our objective is to provide superior quality products, reliability and on time delivery through collaboration, a laser focus on service and accountability. To that end, we have assessed our quality performance and processes across our products and set goals that require step changes in quality and performance. We have identified specific actions for each of our products across a range of initiatives, including standardization, quality specific training, supplier standards, technology upgrades and automation. In addition, we're implementing organizational changes to improve accountability, starting at the production floor and ending with me. We also have recently enhanced our continuous improvement initiatives via rigorous issues identification process, root cause analysis and the implementation of improvement action plans. This includes proactive identification of issues, emphasis on leadership and accountability and training to ensure consistency in what we do and how we do it every day. We're making investments in people, technology, and equipment to ensure a market leading quality and customer service and I personally meet with operations leaders periodically to help ensure we are continuously improving quality and product delivery and any customer issues are resolved timely and the root causes are identified and addressed. As I mentioned, our third priority is ensuring we are operating a cost competitive business model. It is imperative that we evolve our operating model, improve cost efficiencies, enabling us to be market competitive across all of our business lines. Improvements in efficiencies will help our ability to improve profitability, drive cash flow and build a strong foundation for growth and innovation. Our cost initiatives are process improvements and efficiencies, direct and indirect procurement savings, and an optimized footprint. In order to create higher levels of internal effectiveness, heighten our ability to address market demands and customer needs and achieve market leading quality, we will produce and deliver our customers’ products from locations that optimize quality and drive efficiencies. As we analyzed our US based facilities, we concluded that we have the opportunity to optimally serve our customer and future clients with rationalizing our personalization facilities from three to two. As a result, we are in the process of consolidating our Colorado personalization site into our Minnesota and Tennessee facilities. We’re currently working with our clients to seamlessly transition their work in to our Minneapolis, Minnesota and Tennessee facilities and we are also on schedule to close the Colorado personalization site by the summer. We'll continue to manufacture cards in Colorado at our Centennial facility. Finally, our fourth priority is innovation. We will continue to focus on delivering next generation solutions that make our customers and our customers’ everyday lives easier. An example of our customer collaboration and innovation is our involvement in the development of a dual interface biometric payment cards for Visa’s pilot program with Mountain America Credit Union announced earlier this year. During our third quarter earnings call, I you’re your attention to our solutions that are directly addressing customer needs and market demands for choice, convenience and control. Card@Once enables financial institutions and other organizations to instantly issue a card in branch or in-store, delighting customers and delivering more immediate activation and usage. CPI metals, our new and innovative line of metal card products includes our patented encased tungsten fusion card, a heavier alternative with a color core as well as our edge to edge stainless steel fusion card. Both of these cards deliver on our customer's desire to build their brands and top of all [ph] status to create an elevated experience for their customers. CPI On-Demand offers our customers the ability to deliver personalized experience for their customers through customized cards and collateral, imagery and messaging. With quicker lead times and zero inventory model, our customers have increased flexibility and control. And CPI On-Demand is applicable to customers beyond financial institutions and prepaid program managers, including health care, government, insurance, retailers and transit. CPI Digital Solutions provides our customers with the expanded functionality and choice with the ability to deliver secure digital cards or to utilize our templated white label online ordering solutions for physical and digital card delivery. And lastly, our secure packaging and packaging innovation continues to be a strong competency for us, expressly in the prepaid segment and we are expanding our offerings to include high end packaging and welcome kits to complement more premium card products for the financial segment. We are hard at work, executing on our initiatives to better serve the needs of our customers, capitalize on our market opportunities and deliver shareholder value by addressing and improving key areas of our business, while at the same time, consuming to leverage our areas of strength such as our market position and breadth of products and solutions. We believe we have taken the appropriate first steps to help better align our business for long-term profitable growth and we have a detailed plan in place designed to continue to strengthen that position. While we are still in the early stages of our plan, I am encouraged by the solid progress we've made so far and look forward to discussing further progress with our customers, analysts and investors during the course of 2018. I also want to thank all of CPI’s team members for their tireless work and dedication to our company, customers and partners during 2017 and especially over the past few months as we have implemented actions to build a stronger CPI. Now, turning to slide 8, I'd like to spend some time discussing current market conditions and their influence on our business. The market for US debit and credit card manufacturing remains challenging. We continue to see the impacts of a pull forward into the prior years of card reissuance and the extension of card expiration dates for a portion of the market. Based on a review of third party data and forecasts, we currently expect the US industry for card manufacturing volume will be essentially flat in 2018 versus 2017 levels and in 2019, US industry card manufacturing volumes are estimated to grow. We also expect that the average selling prices will continue to decline during the course of the year, similar to what we experienced in 2017. Turning to cards personalization and fulfilment services. With most of our personalization customers having converted the majority of their card portfolio to EMV over the past couple of years, we anticipate 2018 will be characterized by more modest levels of demand, driven by steady state new card issuance, expiration, lost/stolen related card reissuance activity. Turning to US prepaid, in the fourth quarter, we delivered strong year-over-year revenue growth of approximately 40 -- excuse me, approximately 50%, driven by new business including CPI On-Demand and increased volumes. Entering 2018, while still early, we are encouraged by the continued momentum we are seeing in our prepaid business and we expect that CPI will participate in the industry's modest growth this year. Longer term, we continue to see growth potential in prepaid where CPI has strong competitive position. Now moving to slide 9, I will spend some time discussing our emerging products and solutions. Overall, our Card@Once instant issuance metal cards or CPI Metals and CPI On-Demand offerings continue to receive solid customer demand and our outlook for these businesses is positive. Beginning with our Card@Once instant issuance solution, we ended the fourth quarter of 2017 with approximately 7400 installations, up from approximately 6700 installations at the end of the third quarter and 5600 at year end 2016. We continue to see good demand for Card@Once from small and medium sized banks who are looking to differentiate in the market. In addition, the relative under penetration of the solution with US banks combined with the potential to extend instant issuance to other markets beyond the traditional financial services space increases our optimism for the long term growth potential of this solution. For CPI Metals, we continue to see increasing customer interest for this premium product across our customer portfolio. As we discussed with you on our last earnings call, we began shipping our first metal cards in October, including our patented tungsten fusion card. Our metal card pipeline continued to build throughout the fourth quarter of 2017 and while it's still early days, we are encouraged by the level of activity we are seeing in early 2018. For our CPI On-Demand solution, revenue growth in this business continues to progress and we're encouraged by the momentum we're building with this solution. In the latter half of 2017, we were pleased to begin to deploy CPI On-Demand business with wins in the health care and transportation sectors, further highlighting the opportunity for us to provide, further highlighting the opportunity for us to provide outside of traditional bank and financial institution market space. Finally, before closing, I'd like to touch on the dual interface EMV or tap and go card opportunity in the US. We continue to view the potential migration of the US market to dual interface cards as an attractive long-term opportunity. We are pleased to see dual interface highlighted so prominently during recent television advertising campaigns. We are in active conversations today with customers regarding their dual interface product roadmaps and how we can play a role in fulfilling their future needs. But at this time, we're not factoring dual interface into our 2018 plans in a meaningful way. In summary, CPI faced some significant challenges in 2017 due to a soft US card manufacturing market. In 2018, we will not be without some puts and takes, however, we believe there are significant long-term opportunity for CPI in the broader payments market and we've put a strategy and plan in place that will get CPI fit for growth. The EMV migration continues to progress. Prepaid continues to expand and we're seeing good demand for emerging products and solutions such as Card@Once, CPI Metals and CPI On-Demand. Our focus going forward across our entire organization is that every action will be aimed at better serving our valued customers, capitalizing on our market opportunity and delivering value to our shareholders. As I said earlier, I look forward to sharing our progress with you on future calls. I will now turn the call over to Lillian to review our detailed financial and operational results for the fourth quarter and full year.

Thanks Scott and good afternoon, everyone. Turning to Slide 12, you will see an overview of our fourth quarter and full year 2017 results. Fourth quarter net sales were $65 million, down 3.6% from $67.4 million in the fourth quarter of 2016. For full year 2017, we generated net sales of $254.9 million. Product net sales decreased 15.8% year-over-year to $30.3 million in the fourth quarter, primarily reflecting a 23.8% decline in the number of US debit and credit EMV chip cards sold and lower EMV card average selling prices. Services net sales increased 10.4% year-over-year to $34.7 million, primarily driven by growth in our US prepaid debit segment. For full year 2017, product net sales decreased by 25.6% and services net sales declined by 7.6%. Gross profit for the fourth quarter was $18.6 million, representing a gross margin of 28.7% compared with 30.3% in the fourth quarter of 2016. For the full year 2017, gross profit was $75 million or 29.4% of net sales compared with $101.9 million and 33% in 2016. Loss from operations in the fourth quarter of 2017 was $21.8 million compared with an operating loss of $909,000 in the prior year period. Included in our loss from operations during the fourth quarter of 2017 are $19.1 million of non-cash goodwill impairment charges, resulting from our annual impairment test, primarily related to the sales decline in our US card manufacturing business. This non-cash charge is included in our operating loss for the period and full year. For the full year 2017, loss from operations was $18.1 million, or a positive $1 million, excluding the impairment. The year-over-year changes in our gross profit and income from operations for the fourth quarter and full year 2017 primarily reflect the decline in our revenue as well as the aforementioned non-cash impairment charges incurred in the fourth quarter, partially offset by our previously announced cost reduction actions and efficiency initiatives. We reported a GAAP net loss of $14.6 million or $1.31 loss per diluted share in the fourth quarter of 2017. This is compared with net loss of $4 million or a $0.36 loss per diluted share in the prior year period. For full year 2017, the net loss was $22 million compared with net income of 5.4 million in the prior year. As a reminder, all earnings per share amounts have been retroactively adjusted to reflect the 1-for-5 reverse stock split that went into effect in December 2017. Now, turning to our non-GAAP metrics. Adjusted EBITDA for the fourth quarter of 2017 was $3.4 million compared with $8.6 million for the fourth quarter of 2016. Adjusted EBITDA margin was 5.2% compared with 12.8% in the prior year period. The year-over-year changes in our adjusted EBITDA and EBITDA margin primarily reflects higher corporate expenses, primarily related to increased litigation expenses, expenses incurred related to our review of the company's business and strategy and higher costs related to the CEO transition. Also contributing to this decline were lower net sales with the margin reflecting some corresponding negative impact of absorption of overhead costs from the lower volumes, partially offset by cost efficiencies. For the full year 2017, we generated adjusted EBITDA of $25.5 million compared with adjusted EBITDA of $57.2 million in the prior year. Adjusted net loss was $350,000 in the fourth quarter of 2017 or a $0.03 loss per diluted share compared with adjusted net income of $116,000 or $0.01 per diluted share in the fourth quarter of 2016. For full year 2017, adjusted net loss was $2.2 million compared with adjusted net income of $15.7 million in the prior year. Now turning to a review of our segment results for the fourth quarter of 2017, which is on slide 13. US debit and credit segment net sales were $37.9 million for the fourth quarter, a 13.4% decrease from the prior year period. The corresponding segment EBITDA was a negative $10.9 million compared with a positive $8.8 million in the prior year period. The year-over-year decline in our US debit and credit segment result was predominantly driven by a decrease in EMV cards sold as well as lower average selling prices. Segment EBITDA was further impacted by the non-cash goodwill impairment charge, which I referenced earlier. Excluding this non-cash goodwill impairment charge, US debit and credit EBITDA was $6.3 million in the fourth quarter. CPI sold 13.7 million EMV cards in the fourth quarter of 2017, down from 18 million cards in the fourth quarter of 2016. On a weighted average basis, average selling prices were $0.90 in the fourth quarter of 2017, which was down from $0.97 in the fourth quarter of 2016 and up sequentially from $0.86 in the third quarter of 2017. The year-over-year decrease in average selling prices in the fourth quarter was primarily due to lower prices experienced across our customer base, including increased competition in the large issuer market, especially offset by favorable net pricing impacts of customer mix. In our US card personalization and fulfilment business, net sales increased $1.2 million versus the fourth quarter of 2017, predominantly due to reduced EMV card sales. US prepaid debit segment net sales were $19 million in the fourth quarter, up $6.3 million or 50.1% year-over-year. The increase in revenue was primarily driven by sales volume increases across the retail prepaid customer base and higher sales related to our CPI On-Demand solution. US prepaid debit segment EBITDA was $6.5 million, slightly more than double the $3.2 million recorded in the prior year. Our prepaid EBITDA margin was 34.5%, reflects an improvement of 900 basis points over the fourth quarter of 2016, primarily due to the higher sales and cost efficiencies. Finally, our UK Limited segment net sales were $7.5 million in the fourth quarter, representing a decrease of 4.1% from the prior year period. The lower net sales resulted from decreased volumes and some large -- with some large customers during the quarter. UK Limited segment EBITDA was $11,000, down from $998,000 in the prior year period. Now, turning to our cash flow overview on slide 14. Cash flow from operations for the fourth quarter was $9.4 million, down from $20.2 million in the prior year, but up sequentially from $1.3 million in the third quarter of 2017. Capital expenditures in the fourth quarter of 2017 were $1 million, down from $1.9 million in the prior year, yielding fourth quarter 2017 positive free cash flow of $8.4 million. Cash flow from operations for full year 2017 was $2.4 million and CapEx was $8.8 million. Now, moving to slide 15, our ending cash balance as of December 31, 2017 was $23.2 million, up from $14.8 million in the third quarter of 2017. We ended the quarter with a total debt principal outstanding of $312.5 million and a net debt balance of $289.3 million. Netting the deferred financing costs and discounts, our recorded total debt balance was $303.9 million. At December 31, 2017, our net debt leverage ratio was at 11.4 times. As of December 31, 2017, we had an undrawn $40 million revolving credit facility, of which $20 million was available for borrowing. Our term loan has no financial leverage covenants and does not mature until 2022. Total available liquidity was $43.2 million as of December 31, 2017. Finally, before opening the call for questions, I would like to discuss some industry trends and business specific factors that we expect will have an impact on our 2018 results. As Scott mentioned earlier, we expect US industry card manufacturing volumes to remain about consistent in 2018 versus 2017 levels. We expect average selling prices will decline during the course of 2018, similar to what CPI experienced in 2017. Additionally, we expect personalization and fulfilment services will be characterized by more modest levels of demand, driven by steady state new card issuance along with expiration and lost or stolen card related reissuance activity. And finally, we expect that CPI will participate in the prepaid industry's modest growth this year. Looking to 2018, we will continue to invest in our business to enhance our products and solutions and drive efficiencies to improve our overall cost structure. We believe that we have adequate cash and liquidity to support our business plan. Our ongoing focus is on driving profitable growth, returning to consistent positive cash flow generation and delivering shareholder value. So with that, Carmen, please open the call for questions.

[Operator Instructions] And our first question is from the line of Bob Napoli with William Blair.

I guess as you look at 2018, what are your thoughts on free cash flow, the ability to generate free cash flow. I mean, it sounds like you're looking for flattish type of revenue as kind of a reasonable case, flat to down a little bit and I know you've closed one facility. What can you do on the cost side? Do you expect to have positive free cash flow in 2018?

Thanks for the question, Bob. Appreciate that. As you probably realized, as we went through the materials and reviewing the press release and the presentation, we're not actually providing financial guidance as we move into 2018, which would include guidance on the free cash flow or cash in general. But what I can characterize is, we do believe that we have adequate cash and liquidity to support the business and that includes investing into the business, as Scott was describing in his prepared comments and supporting the overall business plan. We are going to be aggressively working on the cost structure. Scott highlighted three key areas that we’ll be addressing as we move through this year. The first is just on ongoing efficiencies, which is the continuation of the discipline that we've instilled and implemented within the organization this past year. So continuing to refine the business with those improvements. Additionally, we're going to be going after very aggressively our procurement spend, both on the direct front, but also on the indirect front. And then the third area that we're focused on from a cost improvement perspective that Scott touched on is the footprint. And as we've announced, we have closed or we're in the process of closing one of our personalization facilities and migrating that business to the other two personalization facilities, one in Nashville, Tennessee and the other in Minnesota and that will help us reduce our cost structure and service our customers more efficiently as we move forward.

Okay. And how much was pricing down in 2017 for EMV cards. I mean, it does seem like it’s stabilized. Has pricing -- you are saying that you expect prices to go down again in 2018.

Yeah. So, prices have gone down in 2017, excuse me. So 2017, I think we're at about $0.97 for the full year and we ended, I’m sorry, 2016, we ended the year at about $0.97 and we're down to about $0.90 for the full year of 2017.

Okay. And you expect a similar decline in 2018?

Well, I mean, it may not be the exact cents decline, but yeah, there is definitely downward pressure on the pricing that we're seeing across the industry. So yes, I would expect to continue to see that pricing pressure continue.

What could go right? Well, how -- on the metal cards, how much is it possible you’re going to see a significant ramp up in metal cards and what is the pricing on metal cards today?

Yeah. There's a number of things that we’re optimistic about, Bob, metal cards could be one of those for sure we've seen good interest from our customers and prospects and those carry a significantly higher average selling price than traditional EMV cards. Another thing that could go on our way is just the mix between large issuers and small issuers, just depending upon what fits that mix sales, and then I'd say we're equally excited about Card@Once. I know we've been talking about EMV cards, but Card@Once, the number of printers or installations we had were up 30% year-over-year and when we feel like there's a lot of demand in the marketplace for that, we can continue to grow that, and then CPI On-Demand. So there's a number of puts and takes as we look forward to 2018, but I think what's key is we have a strategy. We've got four key strategic priorities that center around the customer, market leading quality, cost competitiveness, and continuing to innovate products. I just feel like we've got a business plan that long term we can win and grow this company.

[Operator Instructions] Okay. And I'm not showing any further questions in the queue. I would like to turn the call back to Scott Scheirman for his final remarks.

Thank you, Carmen. Thank you for participating on our earnings call today. I look forward to speaking with you again during our first quarter earnings call. Operator, you can now end the call. Everybody, have a great day. Thank you.