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, 2021. 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, 2020 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, 2021 (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 “Exchange Act”). The words “believe,” “estimate,” “project,” “expect,” “anticipate,” “plan,” “intend,” “foresee,” “should,” “would,” “could,” “continue,” “committed,” “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, including statements about our strategic initiatives and market opportunities, 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 and responses thereto on our business, including our supply chain, customer demand, workforce, operations and ability to comply with certain covenants related to our indebtedness; a disruption or other failure in our supply chain or labor pool resulting in increased costs and inability to pass those costs on to our customers; our inability to recruit, retain and develop qualified personnel, including key personnel; our transition to being an accelerated filer and complying with Section 404 of the Sarbanes-Oxley Act of 2002 and the costs associated with such compliance and implementation of procedures thereunder; our failure to maintain effective internal control over financial reporting or remediate material weaknesses; 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; the restrictive terms of our indebtedness 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; the effects of current or additional U.S. government tariffs as well as economic downturns or disruptions, including delays or interruptions in our ability to source raw materials and components used in our products; system security risks, data protection breaches and cyber-attacks; interruptions in our operations, including our information technology systems, or in the operations of the third parties that operate the data centers or computing infrastructure on which we rely; failure to comply with regulations, customer contractual requirements and evolving industry standards regarding consumer privacy and data use and security; disruptions in production at one or more of our facilities; our failure to retain our existing customers or identify and attract new customers; our inability to adequately protect our trade secrets and intellectual property rights from misappropriation, infringement claims brought against us and risks related to open source software; defects in our software; problems in production quality, materials and process; a loss of market share or a decline in profitability resulting from competition; our inability to develop, introduce and commercialize new products; new and developing technologies that make our existing technology solutions and products obsolete or less relevant or our failure to introduce new products and services in a timely manner; 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, as well as potential new U.S. tax legislation increasing the corporate income tax rate and challenges to our income tax positions; failure to meet the continued listing standards of the Nasdaq Global Market; 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 Security Standards Council security standards or other industry standards; a decline in U.S. and global market and economic conditions and resulting decreases in consumer and business spending; costs relating to product defects and any related product liability and/or warranty claims; 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
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operate and sell our products and services; the effect of legal and regulatory proceedings; our 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 majority stockholders’ ownership of our stock; the influence of securities analysts over the trading market for and price of our common stock; our inability to sell, exit, reconfigure or consolidate businesses or facilities that no longer meet with our strategy; potential conflicts of interest that may arise due to our board of directors being comprised in part of directors who are principals of our majority stockholders; certain provisions of our organizational documents and other contractual provisions that may delay or prevent a change in control and make it difficult for stockholders other than our majority stockholders to change the composition of our board of directors; 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, 2020 filed with the SEC on February 25, 2021, in Part II, Item 1A – Risk Factors of this Quarterly Report on Form 10-Q 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 or other events 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 provides 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 approximately 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 high-security production and card services facilities in the United States, each of which is audited for compliance with the standards of the Payment Card Industry Security Standards Council (the “PCI Security Standards Council”) by one or more of the Payment Card Brands. Many of our customers require us to comply with PCI Security Standards Council requirements that relate to the provision of our products and services. Our 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, credit unions, and financial technology companies (“FinTechs”); and
● the U.S. large issuer market, serving some of the largest U.S. 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 providers in the United States. Our “Other” segment includes corporate expenses and the loss on debt extinguishment.
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COVID-19 Update
The COVID-19 pandemic has impacted economies and societies globally. The long-term implications of COVID-19 on the Company’s results of operations and overall financial performance remain uncertain. The health and safety of CPI employees remain paramount, and the Company continues 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 have remained open and continue to provide direct and essential support to the financial services industry.
The Company believes the global impacts from COVID-19 have contributed to certain adverse effects on its supply chain, including increased lead times for, and higher costs for, certain raw materials and components, as well as a global chip shortage, which are expected to continue in the future. CPI closely monitors its supply chain and has purchased and may continue to purchase additional inventory to help mitigate supply chain constraints. The current environment has also affected the available labor pool in the areas in which the Company operates, which has resulted in increased labor cost and turnover in our facilities, challenges hiring production employees and shipping delays. On November 4, 2021, the Occupational Safety and Health Administration (“OSHA”) filed an Emergency Temporary Standard (“ETS”) with the Office of the Federal Register that will require employers with 100 or more employees to require their employees to be fully vaccinated with a COVID-19 vaccine or to produce a negative COVID-19 test result on at least a weekly basis, along with certain other requirements. Based on the pre-publication version of the ETS, the Company believes the proposed rule would apply to the Company. Compliance with the ETS could result in increased costs as well as labor disruptions, employee attrition and/or difficulty recruiting new employees which could compound the labor shortage already impacting the Company.
The Company expects the labor and supply chain challenges described above, and the associated costs, to continue to increase through the fourth quarter of 2021 and beyond. The Company may not be able to pass all of these costs through to its customers. The Company has also experienced increased demand for its products and services. The Company is experiencing increased production lead times, which it believes is likely to continue in the fourth quarter of 2021 and beyond, depending on the duration of the staffing and supply chain challenges and the level of demand from its customers. The Company will continue to monitor and respond as the situation evolves. See Item 1A, Risk Factors , in the Company’s Annual Report on Form 10-K for the year ended December 31, 2020 filed with the SEC for further discussion of the possible impact of the COVID-19 pandemic on the Company.
On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”) was signed into law. The CARES Act, among other things, includes provisions relating to refundable payroll tax credits, deferment of employer social security payments, changes in net operating loss carryback periods, alternative minimum tax credit refunds, modifications to the net interest deduction limitation and technical corrections to tax depreciation methods for qualified improvement property. Refer to Part I, Item 1, Financial Statements, Note 11, Income Taxes for a discussion of the CARES Act income tax impacts on the Company. In addition, we deferred employer social security payments in 2020 in accordance with the CARES Act, which are allowed to be paid in two installments in 2021 and 2022. While we are participating in certain programs under the CARES Act, the CARES Act and its guidance are subject to change.
Trends and Key Factors Affecting our Financial Performance
We believe the following key factors may have a meaningful impact on our business performance and negatively influence our financial and operating results:
● We have experienced, and expect to continue to experience, labor availability issues, particularly in the Company’s production facilities. In the nine months ended September 30, 2021, the Company incurred increased employee compensation and recruiting expenses in Cost of Sales and Operating Expenses, which we expect to continue to increase for the fourth quarter of 2021 and beyond as the Company continues to actively recruit additional employees. Also as a result of labor shortages and supply chain constraints, as described below, the Company has experienced extended production lead times in some areas of the business and difficulty meeting some customers’ delivery expectations. We continue to proactively monitor, assess and take steps to minimize disruptions and delays in production; however, these disruptions and delays have caused, and may continue to cause, the Company to lose or delay customer opportunities.
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● Surges in demand for certain raw materials and components, as well as other factors such as staffing challenges, have continued to strain the global supply chain network, which has resulted in increased costs of such raw materials and components, increased shipping costs, freight and logistics delays, longer lead times and unpredictability. In particular, shortages of raw materials and components that we use in many of our products is expected to continue for the foreseeable future and may adversely affect our ability to meet customer demand for our products. Although we strive to place orders for materials and components sufficiently in advance, to compile buffer stock to mitigate the impacts of freight and logistics delays and to bolster our access to raw materials and components, it is difficult to predict the ability of our suppliers to continue to fulfill such orders, and it is likely that such delays as well as costs to obtain such raw materials and components will increase for the fourth quarter of 2021 and beyond. Additionally, certain chip manufacturers recently indicated they plan to limit the types of chips that they manufacture, which will affect our ability to continue to provide lower-cost contact chips for certain of our customers. This could cause us and affected customers to migrate programs to more expensive chip options or to contactless cards at a faster pace than expected, which may be costly and disruptive for the Company and affected customers. While we may be able to pass on some of our increased labor and material costs to our customers, we expect these factors will impact profitability for the fourth quarter of 2021 and beyond. In addition, given that raw materials inventory is recognized on a first-in, first-out basis, we expect the impact of increasing raw materials costs to be realized into our statement of operations in 2022 and beyond.
● Our Second Wave payment cards feature a core made with recovered ocean-bound plastic (“ROBP”), which we source from Haiti and process using single source suppliers. Due to political instability and other factors in Haiti as well as the supply chain constraints described above, there is an increased likelihood that we may face challenges in obtaining an adequate supply of ROBP, which is necessary to meet customer demand for our Second Wave cards. The Company actively monitors and manages its supply chain, including compiling buffer stock of materials and seeking alternative suppliers, but it is uncertain how the current political climate in Haiti and other factors in the ROBP supply chain will affect our ability to continue obtaining sufficient ROBP. Additionally, to the extent we are able to secure one or more alternative suppliers of ROBP, we may be subject to increased shipping and materials costs imposed by such suppliers.
● As of June 30, 2021, the market capitalization of outstanding shares of our Common Stock owned by non-affiliates exceeded $75 million, which triggered the Company being classified as an accelerated filer with respect to SEC regulations and filing requirements effective December 31, 2021. As a result, our annual assessment of the effectiveness of our internal control over financial reporting must be audited by our independent registered public accounting firm, and the result of that audit will be included in our next Annual Report on Form 10-K in compliance with the provisions of Section 404 of the Sarbanes-Oxley Act of 2002. Preparations to comply and continued compliance with this new requirement has significantly increased our compensation expense, professional fees and other administrative costs during the nine months ended September 30, 2021. We expect these increased costs to continue for the fourth quarter of 2021 and beyond. In connection with our evaluation and testing during the third quarter of 2021, management identified deficiencies that they determined resulted in material weaknesses in internal controls. For additional information, see Part I, Item 4, Controls and Procedures .
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Results of Operations
The following table presents the components of our condensed consolidated statements of operations for each of the periods presented:
Three Months Ended
Nine Months Ended
September 30,
September 30,
2021
2020
2021
2020
(dollars in thousands)
Net sales:
Products
$
52,276
$
43,462
$
146,445
$
125,040
Services
47,326
39,240
135,468
103,009
Total net sales
99,602
82,702
281,913
228,049
Cost of sales
61,917
52,095
171,419
148,704
Gross profit
37,685
30,607
110,494
79,345
Operating expenses
20,983
17,125
60,236
53,391
Income from operations
16,702
13,482
50,258
25,954
Other expense, net:
Interest, net
(7,183)
(6,298)
(23,196)
(19,158)
Other income (expense), net
(6)
27
23
(8)
Loss on debt extinguishment
—
—
(5,048)
(92)
Income (loss) before taxes
9,513
7,211
22,037
6,696
Income tax (expense) benefit
(2,887)
(1,402)
(6,769)
2,178
Net income from continuing operations
6,626
5,809
15,268
8,874
Net loss from discontinued operations
—
—
—
(30)
Net income
$
6,626
$
5,809
$
15,268
$
8,844
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 Significant Accounting Policies, for an explanation of the immaterial prior period adjustments.
Segment Discussion
Three Months Ended September 30, 2021 Compared With Three Months Ended September 30, 2020
Net Sales
Three Months Ended September 30,
2021
2020
$ Change
% Change
(dollars in thousands)
Net sales by segment:
Debit and Credit
$
76,121
$
62,710
$
13,411
21.4
%
Prepaid Debit
23,498
20,604
2,894
14.0
%
Eliminations
(17)
(612)
595
*
Total
$
99,602
$
82,702
$
16,900
20.4
%
* Not meaningful
Debit and Credit:
Net sales for Debit and Credit increased $13.4 million, or 21.4%, due primarily to the ongoing transition to contactless cards and new customer growth. Product net sales increased due to higher volumes of contactless cards, including new customer growth, and higher Card@Once instant issuance sales. Additionally, net sales from card personalization services increased due to higher volumes of contactless cards, including new customer growth and higher CPI On-Demand sales. Contactless cards have additional technology to process contactless transactions and
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generally have a higher selling price than contact-only EMV ® cards. Debit and Credit net sales in the prior year third quarter were impacted by lower customer demand than expected, which we believe was primarily attributable to the COVID-19 pandemic.
Prepaid Debit:
Net sales for Prepaid Debit increased $2.9 million, or 14.0%, due primarily to higher volumes from existing customers which included the acquisition of new customer portfolios and the replenishment of inventory by our customers which had been maintained at lower levels in the prior year period due to COVID-19 uncertainties. Prepaid Debit net sales in the prior year third quarter were impacted by lower customer demand than expected, which we believe was primarily attributable to the COVID-19 pandemic.
Eliminations:
This includes the elimination of intercompany sales between segments in the consolidation of our financial statements. The decrease in eliminations is due to lower sales between the segments during the three months ended September 30, 2021 compared to the prior year period.
Gross Profit and Gross Profit Margin
Three Months Ended September 30,
% of 2021
% of 2020
2021
Net Sales
2020
Net Sales
$ Change
% Change
(dollars in thousands)
Gross profit by segment:
Debit and Credit
$
28,176
37.0
%
$
21,720
34.6
%
$
6,456
29.7
%
Prepaid Debit
9,509
40.5
%
8,887
43.1
%
622
7.0
%
Total
$
37,685
37.8
%
$
30,607
37.0
%
$
7,078
23.1
%
Debit and Credit:
Gross profit for Debit and Credit increased $6.5 million, or 29.7%, driven primarily by the net sales increase described above. The increase in net sales was partially offset by higher labor costs in the current year. Gross profit margin increased to 37.0% during the three months ended September 30, 2021, compared to 34.6% in the prior year period, due primarily to operating leverage from higher net sales, partially offset by labor cost increases.
Prepaid Debit:
Gross profit for Prepaid Debit increased $0.6 million, or 7.0%, due primarily to higher net sales and favorable overhead cost absorption, partially offset by increased labor costs. Gross profit margin for Prepaid Debit decreased to 40.5% compared to 43.1% for the three months ended September 30, 2020 due primarily to increased labor costs as a percentage of sales.
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Operating Expenses
Three Months Ended September 30,
% of 2021
% of 2020
2021
Net Sales
2020
Net Sales
$ Change
% Change
(dollars in thousands)
Operating expenses by segment:
Debit and Credit
$
7,677
10.1
%
$
6,986
11.1
%
$
691
9.9
%
Prepaid Debit
1,017
4.3
%
1,059
5.1
%
(42)
(4.0)
%
Other
12,289
*
%
9,080
*
%
3,209
35.3
%
Total
$
20,983
21.1
%
$
17,125
20.7
%
$
3,858
22.5
%
Debit and Credit:
Debit and Credit operating expenses increased $0.7 million, or 9.9%, due primarily to increased selling and compensation costs due to strong business performance.
Prepaid Debit:
Prepaid Debit operating expenses were essentially flat and decreased less than $0.1 million, or 4.0%, compared to the prior year period.
Other:
Other operating expenses increased $3.2 million, or 35.3%, due primarily to $1.7 million of compensation expenses including from employee performance incentive compensation due to strong business performance and from additional efforts associated with new compliance requirements, $1.1 million of executive severance charges, and increased professional fees and compliance costs.
Income from Operations and Operating Margin
Three Months Ended September 30,
% of 2021
% of 2020
2021
Net Sales
2020
Net Sales
$ Change
% Change
(dollars in thousands)
Income from operations by segment:
Debit and Credit
$
20,499
26.9
%
$
14,734
23.5
%
$
5,765
39.1
%
Prepaid Debit
8,492
36.1
%
7,829
38.0
%
663
8.5
%
Other
(12,289)
*
%
(9,081)
*
%
(3,208)
35.3
%
Total
$
16,702
16.8
%
$
13,482
16.3
%
$
3,220
23.9
%
* Not meaningful
Debit and Credit:
Income from operations for Debit and Credit increased $5.8 million, or 39.1 %, due primarily to higher net sales and gross profit as described above. Operating margins increased to 26.9% compared to 23.5% for the three months ended September 30, 2020 due to primarily higher net sales and operating leverage.
Prepaid Debit:
Income from operations for Prepaid Debit increased $0.7 million, or 8.5 %, primarily due to higher net sales and gross profit. Operating income margin for the three months ended September 30, 2021 decreased to 36.1% from 38.0% for the same period in 2020, due primarily to increased labor costs as a percentage of sales.
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Other :
The loss from operations in Other increased $3.2 million, or 35.3%, primarily due to an increase in compensation expenses including from employee performance incentive compensation due to strong business performance and from compliance requirements, executive severance charges, and increased professional fees and compliance costs.
Interest, net :
Interest expense for the three months ended September 30, 2021 increased to $7.2 million compared to $6.3 million for the three months ended September 30, 2020. Interest expense was higher in the third quarter of 2021 primarily due to higher interest rates on the Senior Notes issued in 2021, compared to the interest rates on the debt facilities in the prior year period. This increase was partially offset by less debt principal outstanding in the current year period compared to the prior year period, and from interest income received of approximately $0.2 million in 2021 related to income tax refunds.
Income tax (expense) benefit:
During the three months ended September 30, 2021, we recorded an income tax expense of $2.9 million on pre-tax income of $9.5 million, representing an effective income tax rate of 30.3%. 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%. For the quarter ended September 30, 2021, the effective tax rate differs from the federal U.S. statutory rate of 21.0% primarily due to the impact of state taxes and permanent items. For the quarter ended September 30, 2020, the effective income tax rate differs from the federal U.S. statutory rate of 21.0% primarily due to the reduction of a partial valuation allowance for the limitation on the deductibility of interest expense, offset by permanent items and state taxes.
Net income:
During the three months ended September 30, 2021, net income was $6.6 million, compared to net income of $5.8 million during the three months ended September 30, 2020 . The increase was primarily due to higher net sales and gross profit, partially offset by higher operating expenses, income tax expense and interest expense during the three months ended September 30, 2021, compared to the prior year period.
Nine Months Ended September 30, 2021 Compared With Nine Months Ended September 30, 2020
Net Sales
Nine Months Ended September 30,
2021
2020
$ Change
% Change
(dollars in thousands)
Net sales by segment:
Debit and Credit
$
218,798
$
180,855
$
37,943
21.0
%
Prepaid Debit
63,339
48,680
14,659
30.1
%
Eliminations
(224)
(1,486)
1,262
*
%
Total
$
281,913
$
228,049
$
53,864
23.6
%
Debit and Credit:
Net sales for Debit and Credit increased $37.9 million, or 21.0%, due primarily to new customer growth and the ongoing transition to contactless cards. Product net sales increased due to higher volumes of contactless cards, including new customer growth, and higher Card@Once instant issuance sales. Additionally, net sales from card personalization services increased due to higher volumes of contactless cards, including new customer growth and higher CPI On-Demand sales. Contactless cards have additional technology to process contactless transactions and generally have a
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higher selling price than contact-only EMV ® cards. Debit and Credit net sales in the prior year period were impacted by lower customer demand than expected, which we believe was primarily attributable to the COVID-19 pandemic.
Prepaid Debit:
Net sales for Prepaid Debit increased $14.7 million, or 30.1%, due primarily to higher volumes from existing customers which included the acquisition of new customer portfolios and the replenishment of inventory by our customers which had been maintained at lower levels in the prior year period due to COVID-19 uncertainties. Prepaid Debit net sales in the prior year period were impacted by lower customer demand than expected, which we believe was primarily attributable to the COVID-19 pandemic.
Eliminations:
This includes the elimination of intercompany sales between segments in the consolidation of our financial statements. The decrease in eliminations is due to lower sales between the segments during the nine months ended September 30, 2021 compared to the prior year period.
Gross Profit and Gross Profit Margin
Nine Months Ended September 30,
% of 2021
% of 2020
2021
Net Sales
2020
Net Sales
$ Change
% Change
(dollars in thousands)
Gross profit by segment:
Debit and Credit
$
83,988
38.4
%
$
60,681
33.6
%
$
23,307
38.4
%
Prepaid Debit
26,506
41.8
%
18,664
38.3
%
7,842
42.0
%
Total
$
110,494
39.2
%
$
79,345
34.8
%
$
31,149
39.3
%
Debit and Credit:
Gross profit for Debit and Credit increased $23.3 million, or 38.4%, driven primarily by the net sales increase as described above. Gross profit margin increased to 38.4% during the nine months ended September 30, 2021, compared to 33.6% in the prior year period, due primarily to operating leverage from hi gher net sales.
Prepaid Debit:
Gross profit for Prepaid Debit increased $7.8 million, or 42.0% and Gross profit margin for Prepaid Debit for the nine months ended September 30, 2021 increased to 41.8% compared to 38.3% for the nine months ended September 30, 2020. The increase in gross profit and margin was primarily attributed to higher net sales and favorable overhead cost absorption, partially offset by increased labor costs.
Operating Expenses, net
Nine Months Ended September 30,
% of 2021
% of 2020
2021
Net Sales
2020
Net Sales
$ Change
% Change
Operating expenses by segment:
(dollars in thousands)
Debit and Credit
$
23,077
10.5
%
$
22,767
12.6
%
$
310
1.4
%
Prepaid Debit
3,446
5.4
%
3,286
6.8
%
160
4.9
%
Other
33,713
*
%
27,338
*
%
6,375
23.3
%
Total
$
60,236
21.4
%
$
53,391
23.4
%
$
6,845
12.8
%
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Debit and Credit:
Debit and Credit operating expenses increased $0.3 million, or 1.4%, primarily due to increased selling and compensation costs due to strong business performance, partially offset by a benefit recorded in 2021 relating to estimated sales taxe s, which is further described in Item 1 - Financial Statements, Note 14, Commitments and Contingencies.
Prepaid Debit:
Prepaid Debit operating expenses increased $0.2 million, or 4.9%, due primarily to increased selling and compensation costs due to strong business performance in the current year period.
Other:
Other operating expenses increased $6.4 million, or 23.3%, due primarily to $3.7 million of compensation expenses including from employee performance incentive compensation due to strong business performance and from additional efforts associated with new compliance requirements, $1.1 million of executive severance charges, $0.9 million of increased healthcare expenses, and increased professional fees and compliance costs.
Income from Operations and Operating Margin
Nine Months Ended September 30,
% of 2021
% of 2020
2021
Net Sales
2020
Net Sales
$ Change
% Change
(dollars in thousands)
Income (loss) from operations by segment:
Debit and Credit
$
60,911
27.8
%
$
37,914
21.0
%
$
22,997
60.7
%
Prepaid Debit
23,060
36.4
%
15,379
31.6
%
7,681
49.9
%
Other
(33,713)
*
%
(27,339)
*
%
(6,374)
23.3
%
Total
$
50,258
17.8
%
$
25,954
11.4
%
$
24,304
93.6
%
Debit and Credit:
Income from operations for Debit and Credit increased $23.0 million, or 60.7%, driven primarily by higher net sales and gross profit as described above. Operating margins for the nine months ended September 30, 2021 increased to 27.8% compared to 21.0% for the nine months ended September 30, 2020, due to the higher net sales and operating leverage.
Prepaid Debit:
Income from operations for Prepaid Debit increased $7.7 million, or 49.9% due primarily to higher net sales and gross margin as described above. Operating income margin for the nine months ended September 30, 2021 increased to 36.4% from 31.6% for the same period in 2020, due to higher net sales and favorable overhead cost absorption, partially offset by increased labor costs.
Other:
The loss from operations in Other increased $6.4 million, or 23.3%, primarily due to an increase in operating expenses from employee performance incentive compensation, other compensation expenses and compliance costs, healthcare expenses and executive severance charges.
Interest, net:
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Interest expense for the nine months ended September 30, 2021 increased to $23.2 million compared to $19.2 million for the nine months ended September 30, 2020. Interest expense was higher in 2021 primarily due to $2.6 million of “make-whole” premium interest expense incurred a result of the termination of our Senior Credit Facility on March 15, 2021, as well higher interest rates on the Senior Notes issued in 2021, compared to the interest rates on the debt facilities in the prior year period. This increase was partially offset by less debt principal outstanding in the current year period compared to the prior year, and from interest income received of approximately $0.4 million in 2021 related to income tax refunds.
Loss on debt extinguishment:
During the nine months ended September 30, 2021, we recorded a $5.0 million loss on debt extinguishment relating to the termination of our Senior Credit Facility and First Lien Term Loan as we expensed the unamortized deferred financing costs and debt discount. This was completed in connection with the issuance of new Senior Notes and entrance into the new ABL Revolver on March 15, 2021.
Income tax (expense) benefit:
During the nine months ended September 30, 2021, we recorded an income tax expense of $6.8 million on pre-tax income of $22.0 million, representing an effective income tax rate of 30.7%. During the nine months ended September 30, 2020, we recorded 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%). The effective income tax rate differs from the federal U.S. statutory rate in 2021 primarily due to the impact of state taxes and permanent items. In the prior year period, the effective income tax rate differs from the federal U.S. statutory rate primarily due to the impact of the CARES Act which was signed into law in March 2020 and due to the reduction of a partial valuation allowance for the limitation on the deductibility of interest expense.
Net income:
During the nine months ended September 30, 2021, net income was $15.3 million, compared to $8.8 million during the nine months ended September 30, 2020. The increase was primarily due to higher net sales and gross profit, partially offset by higher operating expenses, the loss on debt extinguishment, and higher interest expense and income tax expense during the nine months ended September 30, 2021 compared to the prior year period.
Liquidity and Capital Resources
At September 30, 2021, we had $20.9 million of cash and cash equivalents. Of this amount, $0.3 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.
On March 15, 2021, we completed a private offering of $310 million aggregate principal amount of 8.625% senior secured notes due 2026 (the “Senior Notes”) and related guarantees at an issue price of 100%. In addition, we entered into a credit agreement with Wells Fargo Bank, National Association, as lender, administrative agent and collateral agent, providing for an ABL revolver of up to $50 million (the “ABL Revolver”), subject to a borrowing base.
In connection with the issuance of the Senior Notes and entrance into the ABL Revolver, we terminated our existing credit facilities, consisting of a $30 million senior credit agreement (the “Senior Credit Facility”), and a $435 million first lien term loan (the “First Lien Term Loan”). Net proceeds from the Senior Notes, together with cash on hand and initial borrowings of $15 million under the ABL Revolver, were used to pay in full and terminate the Senior Credit Facility and First Lien Term Loan on March 15, 2021, and to pay related fees and expenses. During the three months ended March 31, 2021, prior to the termination of the First Lien Term Loan, we paid an excess free cash flow balance of $7.8 million pursuant to the terms of the debt agreements. As of September 30, 2021, the Company had $310 million aggregate principal amount outstanding on the Senior Notes, plus accrued and unpaid interest. As of September
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30, 2021, the Company had no borrowings outstanding and $50 million available for borrowing under the ABL Revolver.
While not impacting the third quarter ended September 30, 2021, the ABL Revolver includes limitations on our ability to borrow in certain situations, including during periods in which the amount available to borrow under the ABL Revolver is less than $5 million. Commencing with the month immediately following a date on which borrowing availability is below $5 million until such time that borrowing availability equals or exceeds $5 million for 30 consecutive days, in order to borrow under the ABL Revolver, we must maintain a fixed charge coverage ratio (as defined in the credit agreement for the ABL Revolver) of at least 1.00 to 1.00, calculated for the trailing 12 months, tested monthly during such period. Borrowings under the ABL Revolver are also subject to limitations based on the borrowing base.
The Senior Notes and the ABL Revolver also contain covenants limiting the ability of the Company, the borrower and the Company’s restricted subsidiaries to, among other things, incur or guarantee additional indebtedness or issue disqualified stock or certain preferred stock; create or incur liens; pay dividends, redeem stock or make other distributions; make certain investments; pay dividends to the Company or make other intercompany transfers; transfer or sell assets; merge or consolidate; and enter into certain transactions with affiliates, subject to a number of important exceptions and qualifications, as set forth in the respective agreements.
The Company has obligations to make an offer to repay the Senior Notes, requiring prepayment in advance of the maturity date, upon the occurrence of certain events including a change of control, certain asset sales and based on an annual excess cash flow calculation. The annual excess cash flow calculation is determined pursuant to the terms of the agreement, with any required payments to be made after the issuance of the Company’s annual financial statements.
The Senior Notes bear interest at a rate of 8.625% per annum and mature on March 15, 2026. Interest is payable on the Senior Notes on March 15 and September 15 of each year, beginning on September 15, 2021. The ABL Revolver matures on the earliest to occur of March 15, 2026 and the date that is 90 days prior to the maturity of the Senior Notes. Borrowings under the ABL Revolver bear interest at a rate per annum that ranges from the LIBOR Rate plus 1.25% to the LIBOR Rate plus 1.75%, or the Base Rate plus 0.25% to the Base Rate plus 0.75%, based on the average daily borrowing capacity under the ABL Revolver over the most recently completed month. The borrower may elect to apply either the LIBOR Rate or Base Rate interest to borrowings at its discretion. The unused portion of the ABL Revolver commitment accrues a commitment fee, which ranges from 0.375% to 0.50% per annum, based on the average daily borrowing capacity under the ABL Revolver over the immediately preceding month.
Operating Activities
Cash provided by operating activities for the nine months ended September 30, 2021 was $14.5 million compared to cash provided by operating activities of $10.2 million during the nine months ended September 30, 2020. The year over year increase was due primarily to higher net income and profitability, and working capital cash improvements including the collection of $9.8 million of income tax refunds during the nine months ended September 30, 2021. These increases were partially offset by cash used in operating activities to increase inventory, including EMV dual interface chips to support our business, and to maintain certain levels of inventory to help alleviate supply chain constraints.
Investing Activities
Cash used in investing activities for the nine months ended September 30, 2021 was $4.7 million, compared to a usage of $3.3 million during the nine months ended September 30, 2020. Cash used in investing activities was related primarily to capital expenditures, including investments to support the business, such as machinery and information technology equipment. 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 $0.5 million during the nine months ended September 30, 2021, compared to $1.6 million during the prior year period.
Financing Activities
During the nine months ended September 30, 2021, cash used in financing activities was $46.6 million. Proceeds from the new Senior Notes and ABL Revolver, net of discount, were $310 million and $14.8 million,
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respectively. We used proceeds from the Senior Notes and ABL Revolver, plus cash on hand from our balance sheet, to pay in full and terminate the Senior Credit Facility balance of $30 million and the First Lien Term Loan balance of $304.7 million on March 15, 2021. During the nine months ended September 30, 2021, we paid $9.5 million of debt issuance costs and $2.7 million of debt exting uishment costs, which included an early termination “make-whole” interest premium of $2.6 million on the Senior Credit Facility. During the nine months ended September 30, 2021, prior to the termination of the First Lien Term Loan, we paid an excess free cash flow balance of $7.8 million pursuant to the terms of the debt agreements.
During the second quarter of 2021 we used $15 million of cash on hand to pay down the ABL Revolver to zero and had no borrowings outstanding thereunder as of September 30, 2021.
During the nine months ended September 30, 2020, we entered into the Senior Credit Facility which provided $29.1 million of cash, net of discount, partially offset by $2.5 million of associated debt issuance costs. We also paid $1.7 million and $1.8 million of principal on finance leases during the nine months ended September 30, 2021 and 2020, respectively.
Off-Balance Sheet Arrangements
We had no material off-balance sheet arrangements at September 30, 2021.
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 Policies and Estimates disclosed in our Annual Report on Form 10-K filed for the year ended December 31, 2020, for which there were no material changes as of September 30, 2021, included:
● Revenue recognition, including estimates of work performed but not completed ,
● Income taxes, including valuation allowances and uncertain tax positions, and
● Sales tax, including an estimated contingent liability.