Welcome to the CPI Card Group's Second Quarter 2023 Earnings Call. My name is Chris, and I will be your operator today. If you're viewing on the webcast, you may advance the slides forward by pressing the arrow buttons. The call will be open for questions after the company's remarks. [Operator Instructions] Now, I’d like to turn the call over to Mike Salop, CPI's Head of Investor Relations.

Thanks, operator, and good morning, everyone. Welcome to the CPI Card Group second quarter 2023 earnings webcast and conference call. Today's date is August 8, 2023. And on the call today from CPI Card Group are Scott Scheirman, President and Chief Executive Officer; Jeff Hochstadt, Chief Financial Officer; and John Lowe, Executive Vice President, End-to-End Payment Solutions. 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. These statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those expressed in the forward-looking statements. For a discussion of such risks and uncertainties, please see CPI Card Group's most recent filings with the SEC. 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, but not limited to, EBITDA, adjusted EBITDA, adjusted EBITDA margin, net leverage ratio and free cash flow. Reconciliations of these non-GAAP financial measures to the most directly comparable GAAP measures are included in the press release and slide presentation we issued this morning. Copies of today's press release, as well as the presentation that accompanies this conference call are accessible on CPI's Investor Relations website, investors.cpicardgroup.com. In addition, CPI's Form 10-Q for the quarter ended June 30, 2023 will be available on CPI's Investor Relations website. On today's call, all growth rates refer to comparisons with the prior year period, unless otherwise noted. And now, I'd like to turn the call over to President and Chief Executive Officer, Scott Schierman.

Thanks, Mike, and good morning, everyone. During today's call, I will give a brief overview and highlight our ongoing strategy, John will discuss CPI's second quarter performance and our updated outlook for the full year, and then Jeff will review the financial results in more detail before we open the call for questions. We will start on Slide 4. As you know, in early June, I announced my plans to retire in early 2024. This was a difficult decision for me as I've enjoyed leading CPI since becoming CEO in late 2017, but I need to give priorities to my family. Given the company has a strong foundation with an excellent leadership team that has been executing our strategy successfully, I feel comfortable that the time is right for me to retire. Our Board is currently undergoing a search for the next CEO, evaluating both internal and external candidates and expects to name a new CEO in late 2023 or early 2024. I want to assure you that the company remains committed to the key strategic priorities that have guided our success, specifically deep customer focus, market-leading quality products and customer service, continuous innovation and a market competitive business model. Although we have adjusted our outlook for the year to reflect some near-term challenges in the industry, I remain confident in the long-term secular growth for the market and in CPI's competitive position. As you can see on Slide 5, payment cards issued to consumers continue to grow. The latest figures from Visa and MasterCard show cards in circulation in the US increased at a 10% CAGR, and for the three years ending March 31st and were up 9% compared to the prior year period. Trends towards adoption of higher-priced contactless and eco-focus cards also support long-term market growth expectations.…

Thanks, Scott, and good morning, everyone. Happy to be on the call today. Let me first go through some of the results for the quarter on slide 6 before reviewing our full year outlook. For the quarter, we delivered a 1% increase in net sales, driven by 14% growth in our prepaid business, which is led by Peggy O’Leary and her team. Our dominant credit business declined 1%, which reflects both challenging comparisons with the prior year quarter and cautious spending by some of our customers. As you may recall, our Debit and Credit segment net sales increased 29% in the second quarter of 2022. This was driven by a large card order related to an eco-focused portfolio addition with one of our largest customers. As a result, we sold nearly 15 million more ECO focused cards in last year's second quarter than the current quarter. As a reminder, as of the end of the current quarter, we have sold nearly 100 million eco-focus cards to our customers since late 2019. Aside for Eco focus cards, we delivered increases in debit and credit in this year's quarter, primarily from our other contactless cards, contact cards and services businesses. Comparisons aside, customer demand is softer than we expected coming into the year, which we believe is driven by a couple of factors. As we mentioned last quarter, we started to see some impact on orders following the banking stress that begin in the spring. Although the turmoil that affected small and regional banks has dissipated and the current environment appears to have stabilized, we continue to see cautionary spending among many of our smaller and medium-sized banking customers on cards and a related personalization. We are also hearing from our customers that they were utilizing more existing inventory as supply chain…

Thanks John and good morning everyone. I will begin my overview on slide nine. I Net sales increased 1% in the quarter as strong growth from our Prepaid business offset the expected softness in Debit and Credit. Prepaid sales increased 14%, driven by higher sales to existing customers, while Debit and Credit segment sales decreased 1% as the previously implemented price increases helped offset some of the reduced demand. Looking at our products and services and Debit and Credit, declines in eco-focused card sales were largely offset by increases in sales of other contactless cards, contact cards, personalization services, including our Print on Demand business, Card@Once, instant issuance, processing fees, and sales of non-EMV cards. First quarter gross profit increased 1%, largely in line with sales growth. The gross profit margin decreased slightly from 35.8% to 35.5%. We reduced SG&A expenses by $2 million in the quarter, primarily due to lower expenses in prepaid and lower professional service expenses. Compensation expenses increased slightly in the quarter as the impact of increased headcount and salaries and the Executive Retention package noted in our early June 8-K, were offset by reduced short-term employee incentive compensation expense. Most of the cash and equity expense impacts from the Executive Retention package will be amortized within SG&A through the end of February of next year and recorded as adjustment items to EBITDA. We had a relatively high tax rate of 38.9% in the quarter, which compared to 22.1% in the prior year and brought our year-to-date rate up to 28.6%. The increased rate in the quarter primarily reflects limitations on deductibility of executive compensation related to the CEO retention package. The year-to-date rate is still below last year's level due to higher interest expense deductibility and a favorable adjustment in the first quarter to reflect…

Thanks, Jeff, and thank you to all of our employees for their efforts in delivering our first half results in a challenging environment. I also wanted to note that we are pleased to have had our stock added to the Russell 3000 in June, which should further help us in our efforts to increase liquidity for our shares. To summarize today's call, we faced expected demand challenges in the quarter but delivered good profitability growth and have generated solid results overall for the first half. We expect the short-term customer demand challenges to persist in the near-term and have adjusted our sales outlook to reflect that, but are focused on profitability and free cash flows and have affirmed our adjusted EBITDA and free cash flow outlooks for the year. We expect the market to improve over time, and we continue to remain confident in the long-term secular trends for payment cards and in our ability to continue to gain share. Thank you for joining our call today, and we will now open the call for any questions. Operator?

Thank you. We'll now open the call for your questions. [Operator Instructions] The first question is from Jaeson Schmidt with Lake Street Capital Markets. Your line is open.

Hey, guys. Thanks for taking my questions. Just want to start with sorry – your Q4 outlook, sort of that confidence and a return to growth in Q4, I mean, is this based on recent customer order patterns, or visibility into inventory levels, or what gives you that confidence that you can return to growth here later this year?

Yeah, Jaeson, good morning. This is Scott. Let me give you a couple of thoughts, and I'll let John add some color too as he works even more closely with the customers than I do every day. But I would say based on recent conversations with customers about their project plans, we believe conditions will start to improve later in the year, Jaeson. But obviously, the timing of the market improving could change depending upon a variety of factors, economic conditions, our customers' business objectives and so forth. I think what's really important to note here is the long-term secular trends continue to be intact, contactless cards will continue to transition in the US, eco-focus cards are popular, will be very popular we’re the market leader there for sure. And then 90%, on average, annually, 90% of our revenue is reoccurring. So we have a model that has secular trends, reoccurring revenue in nature. But clearly, we're going through some cautious spending with our customers. And again, these are on -- based on recent conversations, and we have been in the last few months seen some customers push large projects into 2024, I've had no one customer that cancels an order, so they're tightening their credit a bit. But again, these are temporary conditions. But John, I'll let you give some more color on what gives us some confidence in Q4, although not without risk, obviously, for sure.

Yeah. Hey, good morning, Jaeson. Good to talk to you again. I mean, I think Scott covered it well, but the one thing I would say is we're talking to our customers all the time. If you think about what's changed since May, there's really been two drivers. Scott mentioned this, but we've seen the large banks just be a little bit more -- some of them at least focused on inventory, some have moved projects out to next year, some are tightening credit standards, which has impacted their ordering, and in the small to medium space, you've seen the trends that I would say that were occurring in Q2. They've continued to a certain extent in Q3. We do expect those to come back in Q4. And the reason being to answer your question directly is really -- we're talking to our customers all the time. There's a significant amount of what I would say, coding activity, projects we're working on. There's always risk in the outlook, but we feel good about the end of the year and things picking up in relation to where we are now.

Okay. No, that's really helpful color. I appreciate it, guys. And then just looking at the prepaid segment, it seemed to be quite strong in Q2. Just curious if this would impact your normal seasonal patterns that you typically see in the second half of the year?

Jaeson, it may have a bit of an impact in each of our businesses, timing can vary among quarters for sure, we're pleased with the prepaid business. Peggy O'Leary and the team are doing a great job of growing that business. And again, we see that business probably being slightly better than where it ended up in 2022. But there is a bit of seasonality in Q3 for sure, as our customers prepare for the holiday season, the gifting season. But there could be a bit of timing that moves among the quarters. But overall, I'd probably focus you on prepaid is having a solid year for sure and should be a tad bit better in 2023 and that was in 2022?

Jason, the other thing I'd say is the prepaid business, and again, [indiscernible] running that business. She's doing a great job. They've been able to diversify their product set to a certain extent. We moved into HSA cards, some other areas, doing things more than just our typical prepaid open-loop gift cards and that's reduced some of the seasonality in the business overall. So what you'll see from kind of the second quarter to third quarter to the fourth quarter, I think you see a little bit less lumpiness than what you would look at if you look back to our financials historically.

Okay. That makes sense. And then just last one for me, and I'll jump back into queue. How should we think about gross margin here in the second half of the year?

Yes. Hi, Jaeson, this is Jeff. I think for the gross margin for the rest of the year, obviously, when sales dip a little bit, we typically get a little bit of operating leverage with higher sales. So the -- so that will put a little pressure on the gross margin also our pricing is lapsing from last year that we implemented. It's been about a year or so. So, gross margin will be a little bit of pressure. But on the same token, we are managing our expenses pretty effectively. And we don't really give guidance per se on gross margin. But on the adjusted EBITDA, we still affirmed our guidance for the year. There's a lot that we can, again, tighten our expenses in the second half and watch those closely. So we feel good about the adjusted EBITDA guidance in light of lower revenue growth.

Okay. That's really helpful. Thanks a lot guys.

Thanks, Jaeson. Thanks.

[Operator Instructions] The next question is from Bill Charters with Sabal Capital. Your line is open.

Hi, guys. I just wanted to get some clarity on the guidance. Regarding third quarter guidance, you mean third quarter is down year-over-year. And that's up of like $124 million and $28 million last year. And so then you expect Q4 to grow somewhat, and that's how you get to the almost $100 million EBITDA for the year. Am I thinking about that correctly?

Yes, that's correct.

Okay. And then in 2015 and 2016 with EMV traded cyclicality with lower maturities from five years down to three years and lower margins. What cyclicality, if any, do you expect from the contactless conversion?

Yes. Bill, let's talk to you again. Contactless is very different from what we saw in 2015 and 2016, right? I mean I think if you go back, the mandate from Visa and MasterCard, there was a very clear set date. That was October -- you fast forward to the contactless transition really started to pick up slightly in late 2018. If you look at the broader market, we've seen the penetration as of end 2022 at roughly 50% to 60%. We expect that to be in the 80%, mid-80s, if you will, in the next few years. So the transition has been slower. There's no mandate. So I wouldn't say, this particular change in guidance or what's happening in the current year has anything to do with the contactless transition in its totality. I would say that's a much more slow transition, which is good for our customers, it's good for us. And we do expect that to continue in the coming years. So the cyclicality from that, I would say, isn't really comparable to what we saw from the inventory building and the boom in the industry that we saw back in the 2015 and 2016 time period from the Visa and Mastercard mandate.

Okay. Great. And you expect everything to be fully kind of, I guess, or fully implemented by 2025. Is that kind of what you're thinking? A – John Lowe: Well, I mean, you're never going to get to 100% penetration

Right A – John Lowe: so we do believe kind of 2025, 2026 time period during the 80% to 85% range. But keep in mind, our business, one-third of our revenue on the Debit and Credit side comes from our largest issuers, two-thirds of our revenue comes from the small to medium issuers and those small to medium issuers are the ones that are much slower to transition. So we expect, even if you get 80% -- 85%, that's a fairly long tail. And the other thing I would say is, the secular trends, just broadly still remain. The cards in circulation, Scott mentioned this, they're up at a roughly 10% CAGR over the last three years. Overall, card issuance is roughly 90% recurring. And if you're looking at the eco-focus market where we believe we're a leader, we sold nearly 90 million -- or 100 million of those through Q2 and we expect that market to grow at a 50% CAGR over the next few years. So I understand the question about the cyclicality and contactless, but we feel good about where we are in the market.

Yes. Okay. Great. And then the last question I have is on CapEx. What is maintenance CapEx? I noticed like last year was higher than historic. The first quarter was higher, but then this quarter it was lower. What do you feel about CapEx and maintenance? Can you just give us some more color on that? A – John Lowe: Yes, John, again. If you go back several years ago, where we were very tight on cash. I would say we're probably in the $8 million, $10 million range. I think in the current environment, we're probably more in that $15 million to $20 million range. We do have projects that are ongoing, we're always trying to improve our operations from an efficiency perspective, a capability perspective for our customers. In doing that, we expect to continue to spend kind of in that $15 million to $20 million range over the course of the future. And I'd break that down just to your question, there's CapEx for through maintenance for the organization. There's CapEx for projects and improvement. And the maintenance side is probably more in the $5 million to $8 million range, if I had to put a number around it.

Got it. And the rest is growth or efficiencies. A – John Lowe: That's right.

Okay. Great. Well, I have no other questions. Great quarter and great call. Thanks. A – John Lowe: Thanks, Bill

We have no further questions at this time, and this will conclude today's CPI Card Group's second quarter earnings call. Thank you for joining. Have a good day.