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, 2022. 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, 2021 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, 2022 (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,” “continue,” “committed,” “attempt,” “target,” “objective,” “guides,” “seek,” “focus,” “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; 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 inability to recruit, retain and develop qualified personnel, including key personnel; a disruption or other failure in our supply chain, including as a result of the Russia-Ukraine conflict, or labor pool resulting in increased costs and inability to pass those costs on to our customers and extended production lead times and difficulty meeting customers’ delivery expectations; a decline in U.S. and global market and economic conditions and resulting decreases in consumer and business spending, declines in consumer credit worthiness impacting demand for credit cards and ongoing or accelerating inflationary pressure; our failure to retain our existing customers or identify and attract new customers; system security risks, data protection breaches and cyber-attacks, including as retaliation for U.S. sanctions in connection with the Russia-Ukraine conflict; 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; interruptions in our operations, including our information technology (“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; environmental, social and governance preferences and demands of various stakeholders and our ability to conform to such preferences and demands and to comply with any related regulatory requirements; the effects of climate change, negative perceptions of our products due to the impact of our products and production processes on the environment and other ESG-related risks; disruptions in production due to weather conditions, climate change, political instability or social unrest; 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; our limited ability to raise capital in the future; problems in production quality, materials and process; our inability to develop, introduce and commercialize new products; 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; our inability to successfully execute on our divestitures or acquisitions; our inability to realize the full value of our long-lived assets; costs relating to product defects and any related product liability and/or warranty claims; our inability to renew licenses with key technology licensors; the highly competitive, saturated and consolidated nature of our marketplace; the effects of delays or interruptions in our ability to source raw materials and components used in our products from foreign countries; failure to comply with regulations, customer contractual requirements and
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evolving industry standards regarding consumer privacy and data use and security; 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; quarterly variation in our operating results; our failure to operate our business in accordance with the Payment Card Industry Security Standards Council security standards or other industry standards; our failure to comply with environmental, health and safety laws and regulations that apply to our products and the raw materials we use in our production processes; risks associated with the majority 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 majority stockholders; the influence of securities analysts over the trading market for and price of our common stock; failure to meet the continued listing standards of the Nasdaq Global Market; 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; our ability to comply with a wide variety of complex laws and regulations and the exposure to liability for any failure to comply; the effect of legal and regulatory proceedings; 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, 2021 filed with the SEC on March 8, 2022, 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 (as defined below) issued on the networks of the “Payment Card Brands” (Visa, Mastercard ® , American Express ® and Discover ® ). 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 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 solutions market through more than 20 years of experience.
We serve a diverse set of several thousand customers which includes direct customers and indirect customer relationships whereby CPI provides Financial Payment Card solutions to a customer through a Group Service Provider (as defined below). Our customers include some of the largest issuers of debit and credit cards in the United States, the largest Prepaid Debit Card program managers in the United States, numerous financial technology companies (“fintechs”), as well as independent community banks, credit unions and Group Service Providers. We define “Group Service Providers” as reseller or card processor 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.
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 many 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;
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● the U.S. large issuer market, serving some of the largest U.S. debit and credit card issuers; and
● the U.S. fintech market, where we produce and personalize Financial Payment Cards for financial technology companies.
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;
● Prepaid Debit, which primarily provides integrated prepaid card services to Prepaid Debit Card program managers primarily in the United States; and
● “Other,” which includes corporate expenses.
COVID-19 Update
The COVID-19 pandemic and associated counteracting measures implemented by governments and businesses around the world have impacted, and continue to impact, economies and societies globally, including the locations where we, our customers and our suppliers conduct business. We believe the global impacts from COVID-19, along with other macro-economic factors, have contributed to, among other things certain adverse effects on our supply chain, production lead times, labor availability, employee absenteeism and costs. Though we have implemented measures to attempt to mitigate the impacts of the challenges described above, we believe that such impacts, and the associated costs, may continue throughout 2022 and beyond. The long-term implications of COVID-19 on our results of operations and overall financial performance remain uncertain, though the health and safety of our employees remains paramount.
On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security (“CARES”) Act was signed into law. The CARES Act, among other things, included 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. We deferred employer social security payments in 2020 in accordance with the CARES Act, and the first installment repayment was made in the fourth quarter of 2021. The second installment payment is permitted to be paid no later than the fourth quarter of 2022 and had not been paid as of September 30, 2022.
Trends and Key Factors Affecting our Financial Performance
We believe the following key factors may have a meaningful impact on our business performance and may 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, 2022 , the Company incurred increased employee compensation and recruiting expenses in Cost of Sales and Operating Expenses, which we expect to continue throughout 2022 and beyond as the Company continues to actively recruit additional employees, including temporary contractors, and is affected by inflationary pressure. 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 the Company to lose or delay customer opportunities, and are likely to continue throughout 2022 and beyond.
● We have experienced, and continue to experience, inflationary pressure in our supply chain, as well as delays and difficulties in sourcing key materials and components needed for our products. Such issues 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 certain raw materials and components, increased shipping costs, freight and logistics delays, longer lead times, shortages of raw materials we use in our products, such as the on-going global microchip shortage, and unpredictability. Certain of our suppliers have also required us to place orders that commit us to purchase goods as long as a year or more in advance of our anticipated production need, which is
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a significant change from the historical practice of placing non-binding purchase orders for delivery within weeks of the order. While we are taking actions to limit the impact of the dynamics described above, including compiling buffer stock, we expect to experience supply chain impacts on our business and our ability to meet customer demand in future periods. We also believe some of our customers may have anticipated, or may anticipate in the future, supply chain-related delays and correspondingly have increased, or may seek to increase, their own inventory of the Company’s products on hand. Also, geopolitical uncertainties associated with the ongoing Russia and Ukraine conflict, as well as recent COVID-19 impacts in China, are introducing additional supply chain disruptions on a macro-economic level, which may further compound the Company’s supply chain challenges. Additionally, certain microchip manufacturers have indicated they plan to limit the types of microchips that they manufacture, which will affect our ability to continue to provide lower-cost contact microchips for certain of our customers. This could cause us and affected customers to migrate programs to more expensive microchip options or to contactless cards at a faster pace than expected, which may be 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, cost inflation has increased at a faster pace than anticipated, and we expect these factors will impact profitability throughout 2022 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 throughout 2022 and beyond.
● Our Second Wave® payment cards feature a core made with recovered ocean-bound plastic (“ROBP”), which we historically have sourced from Haiti and processed using single source suppliers. Due to political instability and other factors in Haiti as well as the supply chain constraints described above, we have faced challenges in obtaining consistent supply of ROBP from Haiti. We recently began sourcing ROBP from Thailand, and the supply chain for this material includes single source suppliers similar to the materials sourced from Haiti. We have tested this material and believe that cards that incorporate the material meet or exceed applicable quality standards, and we believe we will be able to procure sufficient supply from this new source country. However, if we encounter production challenges with this material or are unable to obtain adequate or consistent supply from the source country, we may not have sufficient supply of ROBP to meet customer demand for our Second Wave cards. The Company continues to actively monitor and manage its supply chain, including compiling buffer stock of materials and evaluating alternative suppliers and sources for ROBP, but it is uncertain how issues in Haiti and other factors in the ROBP supply chain will affect our ability to continue obtaining sufficient ROBP. Additionally, alternative suppliers of ROBP in other source countries may be constrained by local or global geopolitical challenges, instability and unpredictability, and we may be subject to increased shipping and materials costs, which we may not be able to pass through to our customers.
● As of June 30, 2021, the market value 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 with the year ended December 31, 2021. The Company continues to be classified as an accelerated filer in 2022. As a result, our annual assessment of the effectiveness of our internal control over financial reporting must be audited by our external audit firm in compliance with the provisions of Section 404 of the Sarbanes-Oxley Act of 2002 (“the Sarbanes-Oxley Act”). 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, 2022 . We expect these increased costs to continue throughout 2022 and beyond. In connection with our evaluation and testing during 2021, management identified deficiencies that they determined resulted in material weaknesses in internal controls, and the related remediation efforts have also increased such costs. 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,
2022
2021
2022
2021
(dollars in thousands)
Net sales:
Products
$
71,606
$
52,276
$
208,867
$
146,445
Services
52,971
47,326
140,442
135,468
Total net sales
124,577
99,602
349,309
281,913
Cost of sales
76,137
61,917
221,040
171,419
Gross profit
48,440
37,685
128,269
110,494
Operating expenses
24,995
20,983
71,789
60,236
Income from operations
23,445
16,702
56,480
50,258
Other expense, net:
Interest, net
(7,323)
(7,183)
(22,334)
(23,196)
Other (expense) income, net
(63)
(6)
(79)
23
Loss on debt extinguishment
—
—
(395)
(5,048)
Income before taxes
16,059
9,513
33,672
22,037
Income tax expense
(4,149)
(2,887)
(9,609)
(6,769)
Net income
$
11,910
$
6,626
$
24,063
$
15,268
Segment Discussion
Three Months Ended September 30, 2022 Compared With Three Months Ended September 30, 2021
Net Sales:
Three Months Ended September 30,
2022
2021
$ Change
% Change
(dollars in thousands)
Net sales by segment:
Debit and Credit
$
99,512
$
76,121
$
23,391
30.7
%
Prepaid Debit
25,335
23,498
1,837
7.8
%
Eliminations
(270)
(17)
(253)
*
%
Total
$
124,577
$
99,602
$
24,975
25.1
%
* Not meaningful
Debit and Credit:
Net sales for Debit and Credit increased $23.4 million, or 30.7%, for the three months ended September 30, 2022 compared to the corresponding period in the prior year. Products net sales increased primarily due to increased volumes of contactless cards. Contactless cards have additional technology to process contactless transactions and generally have a higher selling price than contact-only EMV ® cards. Services net sales increased due to growth from card personalization, higher CPI On-Demand sales from existing customers and higher Card@Once services.
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Prepaid Debit:
Net sales for Prepaid Debit increased $1.8 million, or 7.8%, for the three months ended September 30, 2022 compared to the corresponding period in the prior year primarily due to increased volumes from existing customers and the benefit of price increases. We historically have generated higher net sales in the third quarter of the year, as our sales of Prepaid Debit Card solutions are more heavily weighted toward the second half of the year when consumers tend to purchase more of these products and services in anticipation of the holiday season in the United States.
Gross Profit and Gross Profit Margin:
Three Months Ended September 30,
% of 2022
% of 2021
2022
Net Sales
2021
Net Sales
$ Change
% Change
(dollars in thousands)
Gross profit by segment:
Debit and Credit
$
38,071
38.3
%
$
28,176
37.0
%
$
9,895
35.1
%
Prepaid Debit
10,369
40.9
%
9,509
40.5
%
860
9.0
%
Total
$
48,440
38.9
%
$
37,685
37.8
%
$
10,755
28.5
%
Debit and Credit:
Gross profit for Debit and Credit increased $9.9 million, or 35.1%, for the three months ended September 30, 2022 compared to the corresponding period in the prior year primarily due to the net sales increase described above, partially offset by the inflationary impact on production costs. Gross profit margin increased to 38.3% during the three months ended September 30, 2022, compared to 37.0% in the corresponding period in the prior year, primarily due to operating leverage from higher net sales, including the benefit of price increases, partially offset by higher production costs, primarily materials .
Prepaid Debit:
Gross profit for Prepaid Debit increased $0.9 million, or 9.0%, for the three months ended September 30, 2022 compared to the corresponding period in the prior year primarily due to the net sales increase described above, partially offset by the inflationary impact on production costs. Gross profit margin for Prepaid Debit increased to 40.9% for the three months ended September 30, 2022 compared to 40.5% in the corresponding period in the prior year primarily due to operating leverage from higher net sales, including the benefit of price increases, partially offset by increased materials costs as a percentage of sales.
Operating Expenses:
Three Months Ended September 30,
% of 2022
% of 2021
2022
Net Sales
2021
Net Sales
$ Change
% Change
(dollars in thousands)
Operating expenses by segment:
Debit and Credit
$
8,653
8.7
%
$
7,677
10.1
%
$
976
12.7
%
Prepaid Debit
1,260
5.0
%
1,017
4.3
%
243
23.9
%
Other
15,082
*
%
12,289
*
%
2,793
22.7
%
Total
$
24,995
20.1
%
$
20,983
21.1
%
$
4,012
19.1
%
Debit and Credit:
Debit and Credit operating expenses increased $1.0 million, or 12.7%, for the three months ended September 30, 2022 compared to the corresponding period in the prior year, primarily due to increased selling, compensation and other costs.
Prepaid Debit:
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Prepaid Debit operating expenses increased $0.2 million, or 23.9%, for the three months ended September 30, 2022 compared to the corresponding period in the prior year.
Other:
Other operating expenses increased $2.8 million, or 22.7%, for the three months ended September 30, 2022 compared to the corresponding period in the prior year, primarily due to a $1.7 million increase in compensation expenses as a result of increased employee headcount and higher labor costs in addition to $0.8 million of increased stock compensation, and a $1.1 million increase in professional services and other costs.
Income from Operations and Operating Margin:
Three Months Ended September 30,
% of 2022
% of 2021
2022
Net Sales
2021
Net Sales
$ Change
% Change
(dollars in thousands)
Income from operations by segment:
Debit and Credit
$
29,418
29.6
%
$
20,499
26.9
%
$
8,919
43.5
%
Prepaid Debit
9,109
36.0
%
8,492
36.1
%
617
7.3
%
Other
(15,082)
*
%
(12,289)
*
%
(2,793)
22.7
%
Total
$
23,445
18.8
%
$
16,702
16.8
%
$
6,743
40.4
%
Debit and Credit:
Income from operations for Debit and Credit increased $8.9 million, or 43.5%, for the three months ended September 30, 2022 compared to the corresponding period in the prior year, primarily due to higher net sales and operating leverage, partially offset by higher production costs. Operating margin increased to 29.6% for the three months ended September 30, 2022 compared to 26.9% in the corresponding period in the prior year primarily due to the factors discussed above.
Prepaid Debit:
Income from operations for Prepaid Debit increased $0.6 million, or 7.3%, for the three months ended September 30, 2022 compared to the corresponding period in the prior year, primarily due to higher net sales, partially offset by higher production costs. Operating margin decreased slightly to 36.0% for the three months ended September 30, 2022 compared to 36.1% in the corresponding period in the prior year.
Other :
The loss from operations in Other increased $2.8 million, or 22.7%, for the three months ended September 30, 2022 compared to the corresponding period in the prior year due to the factors described above under “Operating Expenses.”
Interest, net :
Interest expense increased to $7.3 million for the three months ended September 30, 2022 from $7.2 million in the corresponding period in the prior year, due to higher average debt balances offset by a lower average interest rate and interest income received of approximately $0.2 million in 2021 related to income tax refunds.
Loss on debt extinguishment:
During the three months ended September 30, 2022, we did not record any loss on debt extinguishment.
Income tax expense:
Our effective tax rates on pre-tax income were 25.8% and 30.3% for the three months ended September 30, 2022 and 2021, respectively. The decrease in our effective tax rate for the three months ended September 30, 2022 compared to the corresponding period in the prior year was primarily due to the release of a federal valuation allowance
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for increased deductibility of interest costs due to a tax election made in the current year and a greater proportion of pre-tax income in relation to the impact of permanent items.
Net income:
During the three months ended September 30, 2022, net income was $11.9 million, compared to net income of $6.6 million in the corresponding period in the prior year. The increase was primarily due to higher net sales resulting in higher gross profit, partially offset by higher “Selling, general and administrative” costs and income tax expense.
Nine Months Ended September 30, 2022 Compared With Nine Months Ended September 30, 2021
Net Sales:
Nine Months Ended September 30,
2022
2021
$ Change
% Change
(dollars in thousands)
Net sales by segment:
Debit and Credit
$
285,708
$
218,798
$
66,910
30.6
%
Prepaid Debit
64,010
63,339
671
1.1
%
Eliminations
(409)
(224)
(185)
*
%
Total
$
349,309
$
281,913
$
67,396
23.9
%
* Not meaningful
Debit and Credit:
Net sales for Debit and Credit increased $66.9 million, or 30.6%, for the nine months ended September 30, 2022 compared to the corresponding period in the prior year. Products net sales increased due to increased volumes from existing customers, including the acquisition of new portfolios by an existing customer and the transition to eco-focused and other contactless cards, and higher Card@Once instant issuance sales. Contactless cards have additional technology to process contactless transactions and generally have a higher selling price than contact-only EMV cards. Services net sales increased due to growth from card personalization, as well as higher Card@Once services, partially offset by a decrease in volumes for our existing customers in our CPI On-Demand service, which benefited in the corresponding prior period from COVID-19 related government disbursement work.
Prepaid Debit:
Net sales for Prepaid Debit increased $0.7 million, or 1.1%, for the nine months ended September 30, 2022 compared to the corresponding period in the prior year primarily due to the benefit of price increases. Prepaid Debit net sales in the prior year period benefited from the acquisition of new portfolios by our existing customers and customer replenishment of retail inventory, which had been maintained at lower levels in 2020 due to COVID-19 uncertainties.
Gross Profit and Gross Profit Margin:
Nine Months Ended September 30,
% of 2022
% of 2021
2022
Net Sales
2021
Net Sales
$ Change
% Change
(dollars in thousands)
Gross profit by segment:
Debit and Credit
$
104,389
36.5
%
$
83,988
38.4
%
$
20,401
24.3
%
Prepaid Debit
23,880
37.3
%
26,506
41.8
%
(2,626)
(9.9)
%
Total
$
128,269
36.7
%
$
110,494
39.2
%
$
17,775
16.1
%
Debit and Credit:
Gross profit for Debit and Credit increased $20.4 million, or 24.3%, for the nine months ended September 30, 2022 compared to the corresponding period in the prior year primarily due to the net sales increase described above,
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partially offset by the inflationary impact on production costs. Gross profit margin decreased to 36.5% during the nine months ended September 30, 2022, compared to 38.4% in the corresponding period in the prior year, primarily due to higher production costs, primarily materials, partially offset by operating leverage from higher sales including the benefit of price increases .
Prepaid Debit:
Gross profit for Prepaid Debit decreased $2.6 million, or 9.9%, for the nine months ended September 30, 2022 compared to the corresponding period in the prior year. Gross profit margin for Prepaid Debit decreased to 37.3% for the nine months ended September 30, 2022 compared to 41.8% in the corresponding period in the prior year. The decreases in gross profit and gross profit margin were primarily due to higher production costs, primarily materials, partially offset by higher sales as described above.
Operating Expenses:
Nine Months Ended September 30,
% of 2022
% of 2021
2022
Net Sales
2021
Net Sales
$ Change
% Change
(dollars in thousands)
Operating expenses by segment:
Debit and Credit
$
25,542
8.9
%
$
23,077
10.5
%
$
2,465
10.7
%
Prepaid Debit
3,487
5.4
%
3,446
5.4
%
41
1.2
%
Other
42,760
*
%
33,713
*
%
9,047
26.8
%
Total
$
71,789
20.6
%
$
60,236
21.4
%
$
11,553
19.2
%
Debit and Credit:
Debit and Credit operating expenses increased $2.5 million, or 10.7%, for the nine months ended September 30, 2022 compared to the corresponding period in the prior year, primarily due to increased selling, compensation and other costs.
Prepaid Debit:
Prepaid Debit operating expenses were essentially flat and increased less than $0.1 million, or 1.2%, for the nine months ended September 30, 2022 compared to the corresponding period in the prior year.
Other:
Other operating expenses increased $9.0 million, or 26.8%, for the nine months ended September 30, 2022 compared to the corresponding period in the prior year, primarily due to a $5.7 million increase in compensation expenses as a result of increased employee headcount and higher labor costs in addition to $2.7 million of increased stock compensation, and a $3.0 million increase in professional services and other costs, including costs related to compliance with the Sarbanes-Oxley Act.
Income from Operations and Operating Margin:
Nine Months Ended September 30,
% of 2022
% of 2021
2022
Net Sales
2021
Net Sales
$ Change
% Change
(dollars in thousands)
Income from operations by segment:
Debit and Credit
$
78,847
27.6
%
$
60,911
27.8
%
$
17,936
29.4
%
Prepaid Debit
20,393
31.9
%
23,060
36.4
%
(2,667)
(11.6)
%
Other
(42,760)
*
%
(33,713)
*
%
(9,047)
26.8
%
Total
$
56,480
16.2
%
$
50,258
17.8
%
$
6,222
12.4
%
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Debit and Credit:
Income from operations for Debit and Credit increased $17.9 million, or 29.4%, for the nine months ended September 30, 2022 compared to the corresponding period in the prior year, primarily due to higher net sales, partially offset by increased production costs and operating expenses. Operating margin decreased to 27.6% for the nine months ended September 30, 2022 compared to 27.8% in the corresponding period in the prior year primarily due to the factors discussed above.
Prepaid Debit:
Income from operations for Prepaid Debit decreased $2.7 million, or 11.6%, for the nine months ended September 30, 2022 compared to the corresponding period in the prior year, primarily due to lower gross profit. Operating margin decreased to 31.9% for the nine months ended September 30, 2022 compared to 36.4% in the corresponding period in the prior year, primarily due to the factors discussed above under “Gross Profit and Gross Profit Margin.”
Other :
The loss from operations in Other increased $9.0 million, or 26.8%, for the nine months ended September 30, 2022 compared to the corresponding period in the prior year due to the factors described above under “Operating Expenses.”
Interest, net :
Interest expense decreased to $22.3 million for the nine months ended September 30, 2022 from $23.2 million in the corresponding period in the prior year. Interest expense was higher in the first nine months of 2021 primarily due to $2.6 million of “make-whole” interest premium paid in connection with the termination of our $30.0 million senior credit agreement (the “Senior Credit Facility”) on March 15, 2021. The decrease in interest expense due to the “make-whole” interest premium was partially offset by higher average interest rates on our borrowings during the nine months ended September 30, 2022.
Loss on debt extinguishment:
During the nine months ended September 30, 2022, we recorded a $0.4 million loss on debt extinguishment relating to the $20.0 million early redemption of the 8.625% Senior Secured Notes due 2026 (the “Senior Notes”), as we expensed the associated portion of the unamortized deferred financing costs.
During the nine months ended September 30, 2021 we recorded a $5.0 million loss on debt extinguishment relating to the termination of both our previous 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 the Senior Notes and entry into our new asset-based, senior secured revolving credit facility (the “ABL Revolver”) on March 15, 2021.
Income tax expense:
Our effective tax rate on pre-tax income was 28.5% and 30.7% for the nine months ended September 30, 2022 and 2021, respectively. The decrease in our effective tax rate for the nine months ended September 30, 2022 compared to the corresponding period in the prior year was primarily due to a greater proportion of pre-tax income in relation to the impact of permanent items.
Net income:
During the nine months ended September 30, 2022, net income was $24.1 million, compared to net income of $15.3 million in the corresponding period in the prior year. The increase was primarily due to higher gross profit partially offset by increased “Selling, general and administrative” costs and income tax expense, and a decrease in other expenses due to the impact of debt refinancing costs incurred in the 2021 first quarter.
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Liquidity and Capital Resources
At September 30, 2022, we had $21.5 million of cash and cash equivalents.
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 11, 2022, we used the available borrowing capacity under the ABL Revolver to fund the redemption of $20.0 million aggregate principal amount of the Senior Notes at a redemption price equal to 103% of the principal amount thereof plus accrued and unpaid interest thereon to the redemption date.
On March 15, 2021, we completed a private offering of $310.0 million aggregate principal amount of the Senior Notes and related guarantees at an issue price of 100%. 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.
On March 15, 2021, we entered into a credit agreement with Wells Fargo Bank, National Association providing for an ABL Revolver of up to $50.0 million. On March 3, 2022, we entered into Amendment No. 1 to Credit Agreement (the “Amendment”), which amended the ABL Revolver. The Amendment, among other things, increased the available borrowing capacity under the ABL Revolver to $75.0 million, increased the uncommitted accordion feature to $25.0 million and revised the interest rate provisions to replace the LIBOR benchmark with updated benchmark provisions using the secured overnight financing rate (“SOFR”) as administered by the Federal Reserve Bank of New York. On October 11, 2022, we entered into Amendment No. 2 to the Credit Agreement, which amended the ABL Revolver to adjust certain monthly document delivery terms and to clarify the treatment of certain inventory.
Borrowings under the amended ABL Revolver bear interest at a rate per annum equal to the applicable term SOFR adjusted for a credit spread, plus an applicable interest rate margin. We may select a one, three or six month term SOFR, which is adjusted for a credit spread of 0.10% to 0.30% depending on the term selected. For each quarter through March 31, 2023, the applicable interest rate margin ranges from 1.50% to 1.75% depending on the average unused capacity of the facility for the previous quarter. The unused portion of the ABL Revolver commitment accrues a monthly commitment fee, 0.50% per annum through March 31, 2023, based on the average daily borrowing capacity under the ABL Revolver over the previous month. The interest rate margin and unused commitment fee percentage changes, effective April 1, 2023, to between 1.25% and 1.75% (interest rate margin) and 0.375% and 0.50% (unused commitment fee).
As of September 30, 2022, we have $25.0 million in ABL Revolver borrowings outstanding and $50.0 million available to borrow under the ABL Revolver. Amounts borrowed and outstanding under the ABL Revolver are required to be repaid in full, together with any accrued and unpaid interest, on the earliest to occur of March 15, 2026 and the date that is 90 days prior to the maturity of the Senior Notes (and may be subject to earlier mandatory prepayment upon certain events).
The ABL Revolver includes limitations on our ability to borrow in certain situations, including limitations based on the calculation of a borrowing capacity and further limitations that are triggered if the amount available to borrow under the ABL Revolver is less than $7.5 million. The borrowing capacity represents the net availability under the ABL Revolver and is calculated as the lesser of a) the total of certain eligible assets, including cash, accounts receivable and inventories, further reduced by stated contribution percentages and adjustments or b) the $75.0 million of available borrowing capacity under the ABL Revolver (“Borrowing Base”). The Borrowing Base is further reduced by credit line reserves, letters of credit, as well as the loan ledger balance outstanding on the ABL Revolver. Additionally, commencing with the month immediately following a date on which borrowing capacity is below $7.5 million and until such time that borrowing capacity equals or exceeds $7.5 million for 30 consecutive days, we must maintain a fixed charge coverage ratio (as defined in the Credit Agreement for the ABL Revolver) greater than 1.00, calculated for the trailing 12 months in order to borrow under the ABL Revolver.
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As permitted by the indenture governing the Senior Notes, the Company may from time to time repurchase some or all of the Senior Notes in open market transactions, in privately negotiated transactions or otherwise. Prior to March 15, 2023, the Company may also redeem some or all of the Senior Notes at a “make-whole” redemption price, and on or after March 15, 2023, the Company may redeem some or all of the Senior Notes at a redemption price initially set at 104.313% of the principal amount of the notes to be redeemed, and reducing over time to 100%, in each case plus accrued and unpaid interest. Additionally, prior to March 15, 2023, the Company may redeem, on one or more occasions, up to 40% of the aggregate principal amount of the Senior Notes with the proceeds of certain equity offerings, at a redemption price equal to 108.625% of the principal amount of the notes to be redeemed, plus accrued and unpaid interest. Furthermore, prior to March 15, 2023, but not more than once during each consecutive twelve-month period, the Company may also redeem up to 10% of the aggregate principal amount of the Senior Notes at a redemption price equal to 103% of the principal amount of the notes being redeemed, plus accrued and unpaid interest. The timing and amount of any such redemptions or repurchases will depend upon market conditions, contractual commitments, the Company’s capital needs and other factors.
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 related indenture, with any required payments to be made after the issuance of the Company’s annual financial statements. No such payment was required based on the Company’s 2021 operating results.
In connection with the issuance of the Senior Notes and entry into the ABL Revolver, we terminated our previous Senior Credit Facility and previous First Lien Term Loan. Net proceeds from the Senior Notes, together with cash on hand and initial borrowings of $15.0 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 Senior Credit Facility and the First Lien Term Loan. As of September 30, 2022 , the Company had $290.0 million aggregate principal amount outstanding on the Senior Notes, plus accrued and unpaid interest.
Operating Activities
Cash provided by operating activities for the nine months ended September 30, 2022 was $11.7 million compared to cash provided by operating activities of $14.5 million during the nine months ended September 30, 2021 . Cash generated from earnings for the nine months ended September 30, 2022 was negatively impacted by working capital increases, including an increase in accounts receivable of $ 14.9 million due to higher net sales compared to the previous period. We also increased inventories by $ 13.9 million during the nine months ended September 30, 2022 , to maintain certain levels of inventory to help mitigate supply chain constraints. We also decreased accrued expenses by $ 3.2 million during the nine months ended September 30, 2022 , primarily related to payments on accrued interest and employee performance incentive compensation during the period. Additionally, we benefited from the collection of $9.8 million of income tax refunds during the nine months ended September 30, 2021.
Investing Activities
Cash used in investing activities for the nine months ended September 30, 2022 was $14.3 million, compared to $4.7 million during the nine months ended September 30, 2021. 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 $7.8 million during the nine months ended September 30, 2022, compared to $0.5 million during the corresponding period of the prior year.
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Financing Activities
During the nine months ended September 30, 2022, cash provided by financing activities was $3.5 million. Net proceeds from the ABL Revolver were $25.0 million and in connection with the Amendment to the ABL revolver, we paid $0.3 million of debt issuance costs. A portion of the proceeds from the ABL Revolver was used to redeem $20.0 million of Senior Notes and to pay $0.6 million of early redemption costs. We received $2.1 million under financing leases and we paid $2.5 million of principal on financing leases during the nine months ended September 30, 2022, compared to $1.7 million of principal payments during the corresponding period of the prior year.
During the nine months ended September 30, 2021, cash used in financing activities was $46.6 million. Proceeds from the Senior Notes and ABL Revolver, net of discount, were $310.0 million and $14.8 million, respectively. We paid $9.5 million of debt issuance costs and $2.7 million of debt extinguishment costs, which included an early termination “make-whole” interest premium of $2.6 million on the Senior Credit Facility. We used proceeds from the Senior Notes and initial borrowings under the ABL Revolver, plus cash on hand, to pay in full and terminate the Senior Credit Facility balance of $30.0 million and the First Lien Term Loan balance of $304.7 million on March 15, 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 Senior Credit Facility and First Lien Term Loan.
During the second quarter of 2021, we used $15.0 million of cash on hand to pay down the ABL Revolver to zero and had no borrowings outstanding thereunder as of September 30, 2021.
Working Capital
Our working capital as of September 30, 2022 was $112.7 million, compared to $80.9 million as of December 31, 2021. Our working capital d uring the nine months ended September 30, 2022 was primarily affected by borrowings of $ 25.0 million on our ABL Revolver, principal payments of $20.0 million on the Senior Notes, an increase in inventories of $ 14.2 million, and an increase in accounts receivable of $ 14.8 million. Our working capital needs are typically highest in the first and third quarters due to the timing of payments for employee incentives and interest on outstanding borrowings. A large portion of our employee incentive compensation payments are made in the first quarter, with smaller payments made in each subsequent quarter. The majority of our interest payments are due in the first and third quarters.
Material Cash Requirements
Our material cash requirements include interest payments on our long-term debt, operating and finance lease payments, and purchase obligations to support our operations.
Debt Service Requirements
As of September 30, 2022, the total projected principal and interest payments on our borrowings were $404.8 million, primarily related to the Senior Notes, of which $26.5 million of interest is expected to be paid in the next 12 months. The remaining interest payments are expected to be paid over the remaining term of the Senior Notes, which mature in 2026, and the principal is due upon maturity. We have estimated our future interest payments assuming no additional borrowings under the ABL Revolver, no early redemptions of principal on the Senior Notes, no early voluntary or required repayment of the borrowings under the ABL Revolver within the next twelve months, and no debt issuances or renewals upon the maturity dates of our notes. However, we may borrow additional amounts under the ABL Revolver, redeem principal on the Senior Notes early or refinance all or a portion of our borrowings in future periods.
Leases
We lease real property for production and services, in addition to equipment. Refer to Part II, Item 8, Financial Statements and Supplemental Data, Note 9, “Financing and Operating Leases” for details on our leasing arrangements, including future maturities of our operating lease liabilities.
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Purchase Obligations
A purchase obligation is an agreement to purchase goods or services that is enforceable, legally binding, and specifies all significant terms. As of September 30, 2022, there have not been any material changes to the purchase obligations disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2021.
Subsequent to quarter end, the Company entered into a capacity reservation agreement with one of the Company’s chip suppliers to reserve manufacturing supply capacity due to the current global supply shortage environment. Under the agreement, the Company has agreed to pay certain fees in exchange for the supplier’s commitment to reserve capacity, subject to certain conditions, to produce a set quantity of chips from 2023 through 2025, and the Company has committed to purchase those chips. The total value of the minimum non-cancellable commitment is $194.9 million over the term of the agreement, $69.6 million of which is expected to be paid in 2023. In the event that the supplier is unable to deliver the specified quantity of chips, it will be subject to liquidated damages of 10% of the price of any non-delivered products.
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 for the year ended December 31, 2021, for which there were no material changes as of September 30, 2022, included:
● Revenue recognition, including estimates of work performed but not completed , and
● Income taxes, including valuation allowances and uncertain tax positions.
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.