Item 2. Management’s Discussion and Analysis
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operation s
References to the “Company,” “our,” “us” or “we” refer to CPI Card Group Inc. and its subsidiaries. For an understanding of the significant factors that influenced our results, the following discussion should be read in conjunction with our unaudited condensed consolidated financial statements and related notes appearing elsewhere in this Quarterly Report on Form 10-Q for the quarter ended September 30, 2020. This management’s discussion and analysis should also be read in conjunction with the management’s discussion and analysis and consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2019 filed with the Securities and Exchange Commission (“SEC”).
Cautionary Statement Regarding Forward-Looking Information
Certain statements and information in this Quarterly Report on Form 10-Q for the quarter ended September 30, 2020 (as well as information included in other written or oral statements we make from time to time) may contain or constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. The words “believe,” “estimate,” “project,” “expect,” “anticipate,” “plan,” “intend,” “foresee,” “should,” “would,” “could,” “guides,” “provides guidance,” “provides outlook,” or other similar expressions are intended to identify forward-looking statements, which are not historical in nature. These forward-looking statements are based on our current expectations and beliefs concerning future developments and their potential effect on us, and other information currently available. Such forward-looking statements, because they relate to future events, are by their very nature subject to many important risks and uncertainties that could cause actual results or other events to differ materially from those contemplated.
These risks and uncertainties include, but are not limited to: the potential effects of COVID-19 on our business, including our supply-chain, customer demand, workforce, operations and ability to comply with certain covenants in our credit facilities; a decline in U.S. and global market and economic conditions and resulting decreases in consumer and business spending; our lack of eligibility to participate in government relief programs related to COVID-19 or inability to realize material benefits from such programs; our substantial indebtedness, including inability to make debt service payments or refinance such indebtedness; costs and impacts to our financial results relating to the obligatory collection of sales tax and claims for uncollected sales tax in states that impose sales tax collection requirements on out-of-state businesses, and challenges to our income tax positions; the restrictive terms of our credit facilities and covenants of future agreements governing indebtedness and the resulting restraints on our ability to pursue our business strategies; our limited ability to raise capital in the future; system security risks, data protection breaches and cyber-attacks; failure to comply with regulations, customer contractual requirements and evolving industry standards regarding consumer privacy and data use and security, including with respect to possible exposure to litigation and/or regulatory penalties under applicable data privacy and other laws for failure to so comply; interruptions in our operations, including our IT systems, or in the operations of the third parties that operate the data centers or computing infrastructure on which we rely; disruptions in production at one or more of our facilities; our inability to adequately protect our trade secrets and intellectual property rights from misappropriation or infringement, claims that our technology is infringing on the intellectual property of others, and risks related to open source software; defects in our software; problems in production quality, materials and process; a disruption or other failure in our supply chain; our failure to retain our existing customers or identify and attract new customers; a loss of market share or a decline in profitability resulting from competition; our inability to recruit, retain and develop qualified personnel, including key personnel; our inability to sell, exit, reconfigure or consolidate businesses or facilities that no longer meet with our strategy; our inability to develop, introduce and commercialize new products; the effect of legal and regulatory proceedings; failure to meet the continued listing standards of the Toronto Stock Exchange or the rules of the OTCQX® Best Market; a continued decrease in the value of our common stock combined with our common stock no longer being traded on a United States national securities exchange, which may prevent investors or potential investors from investing or achieving a meaningful degree of liquidity; developing technologies that make our existing technology solutions and products obsolete or less relevant or a failure to introduce new products and services in a timely manner; quarterly variation in our operating results; our inability to realize the full value of our long-lived assets; our failure to operate our business in accordance with the Payment Card Industry (“PCI”) Security Standards Council security standards or other industry standards; costs relating to product defects and any related product liability and/or warranty claims; maintenance and further imposition of tariffs and/or trade restrictions on, or slow-downs or interruptions in our ability to obtain, goods imported into the United States; our dependence on licensing arrangements; risks associated with international operations; non-compliance with, and changes in, laws in the United States and in foreign jurisdictions in which we operate and sell our products; our
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ability to comply with a wide variety of environmental, health and safety laws and regulations and the exposure to liability for any failure to comply; risks associated with the controlling stockholders’ ownership of our stock; potential conflicts of interest that may arise due to our board of directors being comprised in part of directors who are principals of our largest stockholder; and other risks that are described in Part I, Item 1A – Risk Factors in our Annual Report on Form 10-K for the year ended December 31, 2019 filed with the Securities and Exchange Commission (the “SEC”) on March 6, 2020, Part II, Item 1A – Risk Factors in this Quarterly Report on Form 10-Q for the quarter ended September 30 , 2020, and our other reports filed from time to time with the SEC.
We caution and advise readers not to place undue reliance on forward-looking statements, which speak only as of the date hereof. These statements are based on assumptions that may not be realized and involve risks and uncertainties that could cause actual results to differ materially from the expectations and beliefs contained herein. We undertake no obligation to publicly update or revise any forward-looking statements after the date they are made, whether as a result of new information, future events or otherwise.
Overview
We are a payment technology company and leading provider of comprehensive Financial Payment Card solutions in the United States. We define “Financial Payment Cards” as credit, debit and Prepaid Debit Cards issued on the networks of the “Payment Card Brands” (Visa, Mastercard, American Express and Discover in the United States and Interac, in Canada). We define “Prepaid Debit Cards” as debit cards issued on the networks of the Payment Card Brands, but not linked to a traditional bank account. We also offer an instant card issuance solution, which provide card issuing bank customers the ability to issue a personalized debit or credit card within the bank branch to individual cardholders. We have established a leading position in the Financial Payment Card market through more than 20 years of experience. We serve a diverse set of over 2,000 direct customers and several thousand indirect customers, including some of the largest issuers of debit and credit cards in the United States, and the largest Prepaid Debit Card program managers, as well as thousands of independent community banks, credit unions, “Group Service Providers” (organizations that assist small card issuers, such as credit unions, with managing their credit and debit card programs, including managing the Financial Payment Card issuance process, core banking operations and other financial services) and card processors.
We serve our customers through a network of production and card services facilities, including high-security facilities in the United States which are audited for compliance by one or more of the Payment Card Brands. Many of our customers require us to comply with the standards of the PCI Security Standards Council. This leading network of high-security production facilities allows us to optimize our solutions offerings and to serve the needs of our diverse customer base.
Driven by a combination of our strong relationships, quality, technology, and innovation, we believe we have strong positions in the following markets:
● the U.S. prepaid debit market, serving several of the top U.S. Prepaid Debit Card program managers;
● the U.S. small to mid-sized issuer market, which includes independent community banks and credit unions; and
● the U.S. large issuer market, serving some of the largest debit and credit card issuers.
Our business consists of the following reportable segments: Debit and Credit, which primarily produces Financial Payment Cards and provides integrated card services to card-issuing banks primarily in the United States, and Prepaid Debit, which primarily provides integrated card services to Prepaid Debit Card program managers primarily in the United States. Businesses not considered part of these segments are considered “Other” and included our operations in Canada prior to the sale and disposition of our Canadian operations and corporate expenses.
In the fourth quarter of 2018, we entered into a definitive agreement to sell our Canadian subsidiary. The sale did not include the portions of the business relating to Financial Payment Cards, as that business migrated to our operations in the Debit and Credit segment or to other service providers in 2019. The transaction closed on April 1, 2019, and we received cash proceeds of $1.5 million. After the payment of liabilities and transaction costs, including employee termination costs (the majority of which were expensed in 2018), the sale did not have a significant impact on cash, and no significant loss on the sale was recorded. In connection with the disposition of the Canadian subsidiary, the
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Company released the related cumulative translation adjustment of $1.3 million from “Accumulated Other Comprehensive Loss” on the condensed consolidated balance sheet into “Foreign Currency Loss” on the condensed consolidated statement of operations during the nine months ended September 30, 2019. The Canadian subsidiary was not a significant operating segment and the financial results of this business through the transaction closing date were presented as part of the Other reportable segment.
COVID-19 Update
On March 11, 2020, WHO characterized COVID-19 as a pandemic. Further, on March 13, 2020, the President of the United States declared the COVID-19 pandemic a national emergency, invoking powers under the Stafford Act – the legislation that directs federal emergency disaster response. The broader and long-term implications of COVID-19 on our results of operations and overall financial performance remain uncertain. The adverse effects of the COVID-19 pandemic have become widespread, including in the locations where we, our customers and our suppliers conduct business. The health and safety of our employees remains paramount, and we continue to follow response protocols based on precautions and other appropriate measures recommended by the Centers for Disease Control and Prevention as well as various state and local executive orders, health orders and guidelines. All of CPI’s operations remain open and continue to provide direct and essential support to the financial services industry. We may experience constrained supply, curtailed customer demand or impacts on our workforce that could materially adversely impact our business, results of operations and overall financial performance in future periods. While CPI’s net sales in the third quarter and first nine months of 2020 increased over the prior year, we experienced lower customer demand than expected (which we believe is primarily attributable to the COVID-19 pandemic), and we may experience further effects in the Company’s results of operations and overall financial performance in future periods. There can be no assurance that the Company’s strategies will be successful in effectively managing the Company’s resources and mitigating the negative impact of the COVID-19 pandemic on our business and operating results. See Part II, Item 1A – Risk Factors in this Quarterly Report on Form 10-Q for the quarter ended September 30, 2020 for further discussion of the possible impact of the COVID-19 pandemic on the business.
On March 27, 2020, the President of the United States signed the Coronavirus Aid Relief, and Economic Security (CARES) Act into law. The CARES Act, among other things, includes provisions relating to refundable payroll tax credits, deferment of employer side social security payments, changes in net operating loss carryback periods, alternative minimum tax credit refunds, modifications to the net interest deduction limitations and technical corrections to tax depreciation methods for qualified improvement property. CPI is continuing to evaluate and apply certain provisions of the CARES Act that may benefit the Company. Refer to Note 12, Income Taxes – Continuing Operations, for a discussion of the CARES Act income tax impacts. In addition, we have deferred employer side social security payments starting with the second quarter of 2020. While we are participating in certain programs under the CARES Act, the Act and its guidance are subject to change.
The Company evaluates goodwill for impairment at least annually on October 1, or more frequently when an event occurs or circumstances change such that the carrying value may not be recoverable. The potential negative implications of COVID-19, and a related potential decline in the Company’s total fair value of invested capital and financial performance for reporting units with goodwill, could require the Company to perform a quantitative test for goodwill impairment in future quarters. As of September 30 , 2020, all of the Company’s $47.2 million of goodwill is included within reporting units in the Debit and Credit segment.
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Results of Continuing Operations
The following table presents the components of our condensed consolidated statements of continuing operations for each of the periods presented:
Three Months Ended
Nine Months Ended
September 30,
September 30,
2020
2019
2020
2019
(dollars in thousands)
Net sales:
Products
$
43,462
$
33,963
$
125,040
$
99,845
Services
39,240
37,718
103,009
105,603
Total net sales
82,702
71,681
228,049
205,448
Cost of sales
52,095
46,324
148,704
136,314
Gross profit
30,607
25,357
79,345
69,134
Operating expenses
17,125
17,617
53,391
54,080
Litigation settlement gain (1)
—
—
—
(6,000)
Income from operations
13,482
7,740
25,954
21,054
Other expense, net:
Interest, net
(6,298)
(6,085)
(19,158)
(18,847)
Foreign currency gain (loss)
23
(40)
(10)
(1,320)
Other income (expense), net
4
14
(90)
25
Income (loss) from continuing operations before income taxes
7,211
1,629
6,696
912
Income tax benefit (expense)
(1,402)
(2,258)
2,178
(3,618)
Net income (loss) from continuing operations
$
5,809
$
(629)
$
8,874
$
(2,706)
Note: The Company revised its prior year financial statements to adjust immaterial items, relating to estimated sales tax expense and depreciation expense. Refer to Note 1, Business Overview and Summary of Accounting Policies, for an explanation of the immaterial prior period adjustments.
(1) Refer to Note 15, Commitments and Contingencies, for further information regarding the cash litigation settlement gain recorded in the second quarter of 2019.
Segment Discussion
Three Months Ended September 30, 2020 Compared With Three Months Ended September 30, 2019
Net Sales
Three Months Ended September 30,
2020
2019
$ Change
% Change
(dollars in thousands)
Net sales by segment:
Debit and Credit
$
62,710
$
51,502
$
11,208
21.8
%
Prepaid Debit
20,604
20,452
152
0.7
%
Eliminations
(612)
(273)
(339)
*
%
Total
$
82,702
$
71,681
$
11,021
15.4
%
* Not meaningful
Net sales for the three months ended September 30, 2020 increased $11.0 million, or 15.4%, to $82.7 million compared to $71.7 million for the three months ended September 30, 2019, due to an increase in sales from the Debit and Credit segment.
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Debit and Credit:
Net sales for Debit and Credit for the three months ended September 30, 2020 increased $11.2 million, or 21.8%, to $62.7 million compared to $51.5 million for the three months ended September 30, 2019. The net sales increase was primarily due to higher volumes of dual-interface EMV card sales, including Second Wave cards featuring a core made with recovered ocean bound plastic . In addition, net sales increased from CPI On-Demand card personalization due to new customer wins and higher volumes from our existing customers, and from COVID-19 related government disbursement work. Dual-interface EMV cards have additional technology to process contactless transactions and generally have a higher selling price than contact-only EMV cards, which benefitted the current year sales increase compared to the prior year period. Partially offsetting these increases were reductions in volumes of Card@Once instant issuance product sales and card personalization sales in the third quarter of 2020. The decline in volumes was primarily as a result of ongoing impacts from COVID-19 including reduced hours of operation, lack of access or closure of certain bank branches, and fewer new accounts and requests for replacement cards.
Prepaid Debit:
Net sales for Prepaid Debit for the three months ended September 30, 2020, increased $0.2 million, or 0.7%, to $20.6 million, compared to $20.5 million for the three months ended September 30, 2019. The increase was primarily due to timing of certain customer sales, partially offset by reduced sales volumes primarily associated with COVID-19 impacts, including lower retail store traffic.
Gross Profit and Gross Profit Margin
Three Months Ended September 30,
% of 2020
% of 2019
2020
Net Sales
2019
Net Sales
$ Change
% Change
(dollars in thousands)
Gross profit by segment:
Debit and Credit
$
21,720
34.6
%
$
16,441
31.9
%
$
5,279
32.1
%
Prepaid Debit
8,887
43.1
%
8,916
43.6
%
(29)
(0.3)
%
Total
$
30,607
37.0
%
$
25,357
35.4
%
$
5,250
20.7
%
Gross profit for the three months ended September 30, 2020, increased $5.3 million, or 20.7%, to $30.6 million compared to $25.4 million for the three months ended September 30, 2019. Gross profit margin for the three months ended September 30, 2020 increased to 37.0% compared to 35.4% for the three months ended September 30, 2019, due to an increase in gross profit margins in the Debit and Credit segment.
Debit and Credit:
Gross profit for Debit and Credit for the three months ended September 30, 2020, increased $5.3 million, or 32.1%, to $21.7 million compared to $16.4 million during the three months ended September 30, 2019. The increase in gross profit for the Debit and Credit segment was driven primarily by higher sales volumes and pricing of dual interface EMV cards, including Second Wave cards. In addition, higher sales from CPI On-Demand card personalization and COVID-19 related government disbursement work contributed to an improvement in gross profit compared to the prior year. Gross profit margin increased to 34.6% during the three months ended September 30, 2020, compared to 31.9% in the prior year period, due primarily to operating leverage from higher dual interface card sales including Second Wave and CPI On-Demand net sales .
Prepaid Debit:
Gross profit for Prepaid Debit during the three months ended September 30, 2020 was flat at $8.9 million compared to the three months ended September 30, 2019. Gross profit margin for Prepaid Debit for the three months ended September 30, 2020, decreased to 43.1% compared to 43.6% for the three months ended September 30, 2019. The decrease in gross profit and margin was primarily attributed to product mix.
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Operating Expenses, net
Three Months Ended September 30,
% of 2020
% of 2019
2020
Net Sales
2019
Net Sales
$ Change
% Change
(dollars in thousands)
Operating expenses, net, by segment:
Debit and Credit
$
6,986
11.1
%
$
7,817
15.2
%
$
(831)
(10.6)
%
Prepaid Debit
1,059
5.1
%
1,100
5.4
%
(41)
(3.7)
%
Other
9,080
*
%
8,700
*
%
380
4.4
%
Total
$
17,125
20.7
%
$
17,617
24.6
%
$
(492)
(2.8)
%
* Not meaningful
Operating expenses, net, for the three months ended September 30, 2020, decreased $0.5 million, or 2.8%, to $17.1 million compared to $17.6 million for the three months ended September 30, 2019.
Debit and Credit:
Debit and Credit operating expenses decreased $0.8 million to $7.0 million in the three months ended September 30, 2020 compared to $7.8 million in the three months ended September 30 , 2019. The decrease was due primarily to cost reductions during the three months ended September 30, 2020.
Prepaid Debit:
Prepaid Debit operating expenses decreased slightly for the three months ended September 30, 2020 when compared to the three months ended September 30, 2019 primarily due to certain cost reductions.
Other:
Other operating expenses during the three months ended September 30, 2020 increased $0.4 million compared to the three months ended September 30 , 2019. The increase in operating expenses was due to certain costs including self insurance medical expense, partially offset by cost reductions.
Income from Operations and Operating Margin
Three Months Ended September 30,
% of 2020
% of 2019
2020
Net Sales
2019
Net Sales
$ Change
% Change
(dollars in thousands)
Income (loss) from operations by segment:
Debit and Credit
$
14,734
23.5
%
$
8,628
16.8
%
$
6,106
70.8
%
Prepaid Debit
7,829
38.0
%
7,815
38.2
%
14
0.2
%
Other
(9,081)
*
%
(8,703)
*
%
(378)
(4.3)
%
Total
$
13,482
16.3
%
$
7,740
10.8
%
$
5,742
74.2
%
* Not meaningful
Income from operations for the three months ended September 30, 2020 was $13.5 million compared to income from operations of $7.7 million for the three months ended September 30, 2019. The Company’s operating income margin for the three months ended September 30, 2020 increased to 16.3% compared to 10.8% for the three months ended September 30 , 2019.
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Debit and Credit:
Income from operations for Debit and Credit for the three months ended September 30, 2020 increased $6.1 million, to $14.7 million compared to $8.6 million for the three months ended September 30, 2019 due primarily to higher sales volumes and pricing of dual interface EMV cards including Second Wave cards, and CPI On-Demand card personalization including COVID-19 related government disbursement work. In addition, lower operating expenses during the three months ended September 30, 2020 contributed to an improvement in income from operations. The lower operating expenses were a result of cost reductions in the third quarter of 2020. Operating margins for the three months ended September 30, 2020 increased to 23.5% compared to 16.8% for the three months ended September 30 , 2019 due to the higher net sales and decrease in operating expenses.
Prepaid Debit:
Income from operations for Prepaid Debit for the three months ended September 30, 2020 was $7.8 million, an increase of 0.2% compared to $7.8 million for the three months ended September 30 , 2019. The minor increase was the result of lower operating expenses. The Prepaid Debit segment had reduced sales volumes primarily from COVID-19 impacts from lower retail store traffic during the three months ended September 30, 2020. Operating income margin for the three months ended September 30, 2020 decreased to 38.0% from 38.2% for the same period in 2019, due to lower operating expenses.
Other :
The loss from operations in Other was $9.1 million for the three months ended September 30, 2020 compared to a loss from operations of $8.7 million for the same time period in 2019. The loss from operations was higher in the third quarter of 2020 by $0.4 million, primarily due to an increase in operating expenses from certain costs including self insurance medical expense, partially offset by cost reductions .
Interest, net :
Interest expense for the three months ended September 30, 2020 increased to $6.3 million compared to $6.1 million for the three months ended September 30, 2019. Interest expense is higher in the third quarter of 2020 as a result of interest incurred on the new $30.0 million Senior Credit Facility entered into on March 6, 2020. Partially offsetting this additional expense is a decline in the interest incurred on our First Lien Term Loan due to lower average interest rates for the three months ended September 30 , 2020 compared to the same period in 2019.
Income tax benefit (expense):
During the three months ended September 30, 2020, we recorded an income tax expense of $1.4 million on pre-tax income of $7.2 million, representing an effective income tax rate of 19.4%. During the three months ended September 30, 2019, we recorded an income tax expense of $2.3 million on pre-tax income of $1.6 million , representing an effective tax rate of 138.6%. For the quarter ended September 30, 2020, the effective tax rate differs from the federal U.S. statutory rate of 21.0% primarily due to the impact of a partial valuation allowance for the limitation on the deductibility of interest expense in 2020, offset by permanent items and state taxes.
Net income (loss) from continuing operations:
During the three months ended September 30, 2020, net income from continuing operations was $5.8 million, compared to a net loss of $0.6 million during the three months ended September 30 , 2019. The change was primarily due to higher net sales and gross profit in the Debit and Credit segment.
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Nine Months Ended September 30, 2020 Compared With Nine Months Ended September 30, 2019
Net Sales
Nine Months Ended September 30,
2020
2019
$ Change
% Change
(dollars in thousands)
Net sales by segment:
Debit and Credit
$
180,855
$
151,517
$
29,338
19.4
%
Prepaid Debit
48,680
53,162
(4,482)
(8.4)
%
Other
—
1,679
(1,679)
(100.0)
%
Eliminations
(1,486)
(910)
(576)
*
%
Total
$
228,049
$
205,448
$
22,601
11.0
%
* Not meaningful
Net sales for the nine months ended September 30, 2020 increased $22.6 million, or 11.0%, to $228.0 million compared to $205.4 million for the nine months ended September 30, 2019.
Debit and Credit:
Net sales for Debit and Credit for the nine months ended September 30, 2020 increased $29.3 million, or 19.4%, to $180.9 million compared to $151.5 million for the nine months ended September 30, 2019. The net sales increase was primarily due to higher volumes of dual-interface EMV card sales, including Second Wave cards featuring a core made with recovered ocean bound plastic . In addition, net sales increased from CPI On-Demand card personalization due to new customer wins and higher volumes from our existing customers, and from COVID-19 related government disbursement work. Dual-interface EMV cards have additional technology to process contactless transactions and generally have a higher selling price than contact-only EMV cards, which benefitted the current year sales increase compared to the prior year period. Partially offsetting these increases were reductions in volumes from card personalization and Card@Once instant issuance product sales. The decline in volumes was primarily as a result of impacts from COVID-19 including fewer new accounts and requests for replacement cards, and reduced hours of operation, lack of access or closure of certain bank branches.
Prepaid Debit:
Net sales for Prepaid Debit for the nine months ended September 30, 2020 decreased $4.5 million, or 8.4%, to $48.7 million, compared to $53.2 million for the nine months ended September 30, 2019. The decrease was primarily a result of reduced sales volumes primarily from COVID-19 impacts, including lower retail store traffic.
Other:
There were no Other net sales for the nine months ended September 30, 2020, compared to $1.7 million for the nine months ended September 30, 2019. In April 2019, we sold the Canadian subsidiary, which was the only operation contributing to Other segment net sales.
Gross Profit and Gross Profit Margin
Nine Months Ended September 30,
% of 2020
% of 2019
2020
Net Sales
2019
Net Sales
$ Change
% Change
(dollars in thousands)
Gross profit by segment:
Debit and Credit
$
60,681
33.6
%
$
47,460
31.3
%
$
13,221
27.9
%
Prepaid Debit
18,664
38.3
%
21,771
41.0
%
(3,107)
(14.3)
%
Other
—
—
%
(97)
*
%
97
*
%
Total
$
79,345
34.8
%
$
69,134
33.7
%
$
10,211
14.8
%
* Not meaningful
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Gross profit for the nine months ended September 30, 2020 increased $10.2 million, or 14.8%, to $79.3 million compared to $69.1 million for the nine months ended September 30, 2019. Gross profit margin for the nine months ended September 30, 2020 increased to 34.8% compared to 33.7% for the nine months ended September 30, 2019.
Debit and Credit:
Gross profit for Debit and Credit for the nine months ended September 30, 2020 increased $13.2 million, or 27.9%, to $60.7 million compared to $47.5 million during the nine months ended September 30, 2019. The increase in gross profit was driven primarily by higher sales volumes and pricing of dual interface EMV cards, including Second Wave cards. In addition, higher sales from CPI On-Demand card personalization and COVID-19 related government disbursement work contributed to an improvement in gross profit compared to the prior year. Gross profit margin increased to 33.6% during the nine months ended September 30, 2020, compared to 31.3% in the prior year period, due primarily to operating leverage from higher dual interface card sal es and CPI On-Demand net sales.
Prepaid Debit:
Gross profit for Prepaid Debit during the nine months ended September 30, 2020 decreased 14.3% to $18.7 million compared to $21.8 million for the nine months ended September 30, 2019. Gross profit margin for Prepaid Debit for the nine months ended September 30, 2020 decreased to 38.3% compared to 41.0% for the nine months ended September 30, 2019. The decrease in gross profit and margin was attributed to lower sales primarily from COVID-19 impacts which resulted in unfavorable cost absorption.
Other:
There was no gross profit for the nine months ended September 30, 2020 compared to gross loss of $0.1 million for the nine months ended September 30, 2019. In April 2019, we sold our Canadian subsidiary and no longer have any operations contributing to Other segment net sales or gross profit.
Operating Expenses, net
Nine Months Ended September 30,
% of 2020
% of 2019
2020
Net Sales
2019
Net Sales
$ Change
% Change
(dollars in thousands)
Operating expenses, net, by segment:
Debit and Credit
$
22,767
12.6
%
$
23,423
15.5
%
$
(656)
(2.8)
%
Prepaid Debit
3,286
6.8
%
3,266
6.1
%
20
0.6
%
Other
27,338
*
%
27,392
*
%
(54)
(0.2)
%
Other-litigation settlement
—
—
(6,000)
*
6,000
*
%
Total
$
53,391
23.4
%
$
48,081
23.4
%
$
5,310
11.0
%
* Not meaningful
Operating expenses, net, for the nine months ended September 30, 2020 increased $5.3 million, or 11.0%, to $53.4 million compared to $48.1 million for the nine months ended September 30, 2019. The increase was primarily due to the cash litigation settlement gain of $6.0 million recorded in the second quarter of 2019, which was a reduction to net operating expenses.
Debit and Credit:
Debit and Credit operating expenses decreased $0.7 million to $22.8 million in the nine months ended September 30, 2020 compared to $23.4 million in the nine months ended September 30, 2019, primarily due to cost reductions.
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Prepaid Debit:
Prepaid Debit operating expenses were $3.3 million for the nine months ended September 30, 2020, a minor increase of 0.6% when compared to the nine months ended September 30, 2019.
Other:
Other operating expenses were down $0.1 million for the nine months ended September 30, 2020, when compared to the nine months ended September 30, 2019. The reduction in operating expenses was primarily due to certain cost reductions and expense savings from the sale of our Canadian subsidiary, partially offset by restructuring severance charges and other costs incurred in 2020 . During the nine months ended September 30, 2019, we received $6.0 million cash, which was recorded as a reduction to net operating expenses, related to a litigation settlement.
Income from Operations and Operating Margin
Nine Months Ended September 30,
% of 2020
% of 2019
2020
Net Sales
2019
Net Sales
$ Change
% Change
(dollars in thousands)
Income (loss) from operations by segment:
Debit and Credit
$
37,914
21.0
%
$
24,037
15.9
%
$
13,877
57.7
%
Prepaid Debit
15,379
31.6
%
18,505
34.8
%
(3,126)
(16.9)
%
Other
(27,339)
*
%
(21,488)
*
%
(5,851)
(27.2)
%
Total
$
25,954
11.4
%
$
21,054
10.2
%
$
4,900
23.3
%
* Not meaningful
Income from operations for the nine months ended September 30, 2020 was $26.0 million compared to income from operations of $21.1 million for the nine months ended September 30, 2019. The Company’s operating profit margin for the nine months ended September 30, 2020 increased to 11.4% compared to an operating profit margin of 10.2% for the nine months ended September 30, 2019. In the prior year period, we reached a litigation settlement and received $6.0 million cash which was recorded through income from operations within the Other segment.
Debit and Credit:
Income from operations for Debit and Credit for the nine months ended September 30, 2020 increased $13.9 million, to $37.9 million compared to $24.0 million for the nine months ended September 30, 2019. The increase in income from operations was driven primarily by higher sales volumes and pricing of dual interface EMV cards including Second Wave cards, and CPI On-Demand card personalization and COVID-19 related government disbursement work . Operating margins for the nine months ended September 30, 2020 increased to 21.0% compared to 15.9% for the nine months ended September 30, 2019.
Prepaid Debit:
Income from operations for Prepaid Debit for the nine months ended September 30, 2020 decreased to $15.4 million compared to $18.5 million for the nine months ended September 30, 2019. The decrease in income from operations was due to reduced sales volumes primarily due to COVID-19 impacts from lower retail store traffic. Operating income margin for the nine months ended September 30, 2020 decreased to 31.6% from 34.8% for the same period in 2019, primarily as a result of unfavorable cost absorption from lower sales, impacting gross profit and operating expenses.
Other:
The loss from operations in Other was $27.3 million for the nine months ended September 30, 2020, compared to a loss from operations of $21.5 million for the same time period in 2019. The 2019 loss benefited from the $6.0 million cash litigation settlement gain, and was partially offset by lower net current year operating expenses.
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Interest, net:
Interest expense for the nine months ended September 30, 2020 increased to $19.2 million compared to $18.8 million for the nine months ended September 30, 2019. Interest expense was higher in 2020 primarily as a result of interest incurred on the new $30.0 million Senior Credit Facility entered into on March 6, 2020. This additional expense was partially offset by a decline in the interest incurred on our First Lien Term Loan due to lower average interest rates for the nine months ended September 30, 2020 compared to the same period in 2019.
Income tax benefit (expense):
During the nine months ended September 30, 2020, there was an income tax benefit of $2.2 million on pre-tax income of $6.7 million, representing an effective income tax rate of (32.5)%. During the nine months ended September 30, 2019, we recorded an income tax expense of $3.6 million on pre-tax income of $0.9 million, representing an effective tax rate of 396.7%. The effective tax rate differs from the federal U.S. statutory rate in 2020 primarily due to the impact of the CARES Act which was signed into law in March 2020. The CARES Act allows companies with net operating losses (“NOLs”) originating in 2018, 2019, or 2020 to carry back those losses for five years and temporarily eliminates the tax law provision that limits the use of NOLs to 80% of taxable income. The CARES Act increases the Internal Revenue Code Section 163(j) interest deduction limit for 2019 and 2020, and allows for the acceleration of refunds of alternative minimum tax credits. For the nine months ended September 30, 2020, the Company estimated a tax benefit for certain provisions in the CARES Act including the carryback of losses and the increase to the interest deduction limitation, resulting in a tax rate benefit of 54.7% . In addition, the effective tax rate differs from the federal U.S. statutory rate of 21.0% due to the impact of a partial valuation allowance for the limitation on the deductibility of interest expense, permanent items, and state taxes. In the prior year period, the effective tax rate differs from the federal U.S. statutory rate primarily due to the impact of the partial valuation allowance for the limitation on the deductibility of interest expense.
Net income (loss) from continuing operations:
During the nine months ended September 30, 2020, net income from continuing operations was $8.9 million, compared to a $2.7 million loss during the nine months ended September 30, 2019. The change was primarily due to higher net sales and gross profit, and the income tax benefit for the nine months ended September 30, 2020, partially offset by the cash litigation settlement gain recorded in the prior year.
Liquidity and Capital Resources
At September 30, 2020, we had $50.3 million of cash and cash equivalents. Of this amount, $0.5 million was held in accounts outside of the United States.
Our ability to make investments in and grow our business, service our debt and improve our debt leverage ratios, while maintaining strong liquidity, will depend upon our ability to generate excess operating cash flows through our operating subsidiaries. Although we can provide no assurances, we believe that our cash flows from operations, combined with our current cash levels, will be adequate to fund debt service requirements and provide cash, as required, to support our ongoing operations, capital expenditures, lease obligations and working capital needs.
The Company is party to a First Lien Credit Facility, dated as of August 17, 2015, that includes a First Lien Term Loan that matures on August 17, 2022. On March 6, 2020, the Company entered into a new $30 million Senior Credit Facility which matures on May 17, 2022. The Senior Credit Facility ranks senior in priority to the Company’s First Lien Term Loan, which had $312.5 million outstanding as of September 30 , 2020. The Company’s Revolving Credit Facility was terminated concurrently with the new Senior Credit Facility on March 6, 2020. The Revolving Credit Facility had no borrowings outstanding as of the termination date.
The Senior Credit Facility and the First Lien Term Loan contain customary representations, covenants and events of default, including certain covenants that limit or restrict the Company’s and certain of its subsidiaries’ ability to incur indebtedness, grant certain types of security interests, incur certain types of liens, sell or transfer assets or enter into a merger or consolidate with another company, enter into sale and leaseback transactions, make certain types of investments, declare or make dividends or distributions, engage in certain affiliate transactions, or modify organizational
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documents, among other restrictions and subject to certain exceptions. In accordance with the Senior Credit Facility, the Company is also required to have adjusted EBITDA, as defined in the agreement, of $25 million for the previous four consecutive fiscal quarters in total at the end of each quarterly period ending on or after March 31, 2020.
The Senior Credit Facility and the First Lien Term Loan also require prepayment in advance of the maturity date upon the occurrence of certain customary events, including based on an annual excess cash flow calculation, pursuant to the terms of the respective agreement, with any required payments to be made after the issuance of the Company’s annual financial statements. The Company was not required to make any prepayments of the First Lien Term Loan with respect to our 2019 annual financial statements.
Interest rates under the Senior Credit Facility are based, at the Company's election, on a Eurodollar rate subject to an interest rate floor of 1.0%, plus a margin of 8.5% or a base rate plus a margin of 7.5%. As of September 30, 2020, the interest rate on our Senior Credit Facility was 9.5%. Interest rates under the First Lien Term Loan, at the Company’s election, are based on either a Eurodollar rate, subject to an interest rate floor of 1.0%, plus a margin of 4.5%, or a base rate plus a margin of 3.5%. As of September 30, 2020, the interest rate on our First Lien Term Loan was 5.5%.
Operating Activities – Continuing Operations
Cash provided by operating activities – continuing operations for the nine months ended September 30, 2020 was $10.2 million compared to a usage of $3.0 million during the nine months ended September 30, 2019. The year over year improvement was due primarily to net income during the nine months ended September 30, 2020 of $8.8 million compared to a net loss of $2.7 million in the prior year period. For the nine months ended September 30 2020, we had a working capital cash usage of $16.2 million relating to an increase in accounts receivable due primarily to higher sales in the period and timing. For the nine months ended September 30, 2019, we had a working capital cash usage relating primarily to payments for employee performance incentive compensation earned in 2018 and increases in inventory to support the growth of our business.
Investing Activities – Continuing Operations
Cash used in investing activities – continuing operations for the nine months ended September 30, 2020 was $3.3 million, compared to a usage of $1.8 million during the nine months ended September 30 , 2019. Cash used in investing activities – continuing operations was related primarily to capital expenditures, including investments to support the growth of the business, such as machinery and information technology equipment. In the prior year period, partially offsetting the capital expenditure outflows, we received cash of $1.5 million for the sale of our Canadian subsidiary. As presented in our supplemental disclosures of non-cash information on the statement of cash flows, finance leases were executed for the acquisition of right-of-use machinery and equipment assets totaling $1.6 million during the nine months ended September 30, 2020, compared to $5.2 million during the prior year period.
Financing Activities
During the nine months ended September 30 , 2020, cash provided by financing activities was $24.8 million. The Senior Credit Facility provided $29.1 million of cash, net of discount, partially offset by $2.5 million of associated debt issuance costs during the nine months ended September 30 , 2020. The Company paid $1.8 million and $1.2 million of principal on finance leases during the nine months ended September 30 , 2020 and 2019, respectively. For working capital purposes, we borrowed and repaid $11.5 million on the Revolving Credit Facility during the nine months ended September 30 , 2019.
Off-Balance Sheet Arrangements
We had no material off-balance sheet arrangements at September 30, 2020.
Critical Accounting Policies and Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts and disclosures in the financial statements and accompanying notes. Actual results could differ from those estimates. Our Critical Accounting
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Policies and Estimates disclosed in our Annual Report on Form 10-K filed for the year ended December 31, 2019, for which there were no material changes as of September 30, 2020, included:
● Impairment Assessments of Goodwill and Long-Lived Assets,
● Revenue Recognition, including estimates of work performed but not completed ,
● Inventory Valuation,
● Income Taxes, including valuation allowances and uncertain tax positions, and
● Lease accounting, including incremental borrowing rate estimates.
Text extracted from the filing as submitted to EDGAR. Formatting, tables and exhibits are simplified for reading; the original document is authoritative for anything you rely on.