Description

Long:                   CMPO equity

Current Price:    $7.35

Target Price:      $15.00

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About a year ago, we pitched CPI Card Group with the argument that contrary to popular opinion, the credit card manufacturing business was a decent industry and that 6x FCF was far too low a multiple for this under-the-radar stock.  The stock has gone up by about 200% since the.  We think that CompoSecure (CMPO) is a very similar investment. 

We think CompoSecure is an above-average business that is trading for a deeply discounted valuation with a fair value more than double the current share price.  Catalysts for a re-rating include 1) increased investor awareness, 2) a renewal of its agreement with customer Chase, 3) deleveraging and potentially refinancing its debt, 4) a profit contribution from its Arculus cold-wallet technology and 5) an eventual sale of the company. 

Our thesis is:

1. The US payment card manufacturing business is a reasonably good industry with moderate growth – and the premium metal card industry is even more attractive

2. CompoSecure is the leader in the industry – and its competitive position seems secure

3. CompoSecure is very off-the-radar with very few investors focusing on it, partly because it is lumped in with the 2021 SPAC cohort that performed so badly

4. CompoSecure’s valuation is attractive, even in the most conservative scenarios

5. Contract renewals, crypto wallet profitability or sale, debt refinancing and an eventual sale could be catalysts

Card manufacturing industry

We will refer back to our write-up on CPI Card on why we think the credit card manufacturing industry is attractive and why we think the industry will grow at a low-to-mid-single-digit rate for many years:

https://www.valueinvestorsclub.com/idea/CPI_CARD_GROUP_INC/5930792130

The premium metal card submarket is even more attractive given its cache and its use as a marketing tool by banks, “neobanks” and Fintechs for the attractive younger cohort that seeks the status of heavy metal cars. As such, the company expects the business to grow at a 15% through-cycle CAGR, while we assume it will be lower for the sake of conservatism. CompoSecure is best known for making the Chase Sapphire and Amex Platinum cards (these are the 2 most important relationships, which we will discuss later) but it has a wide portfolio:

CompoSecure is the leader in the industry – and its competitive position seems secure

We were initially concerned that CompoSecure’s very high margins (40% EBITDA margins) made it vulnerable to competitive risk, but for a variety of reasons, its relationship with its customers seems secure:

• Growing industry, but not an enormous TAM:  The payment card manufacturing business grows steadily, but it is not the explosive TAM market that would attract many new entrants
• Existing competitors can’t or won’t compete: CPI Card (the primary competitor in non-metal cards) has been prodded often as to why they don’t compete in the metal card market and they repeatedly say that the investment needed to dislodge these customers is not something they are interested in.  From CPI Card’s most recent transcript:

• Length of relationships:  CompoSecure has been working with American Express for 20 years and with Chase for 15 years – it will take a lot to break that relationship, especially when the cost to Amex or Chase ($12 per card when the annual fee is $500 - $750 and the card member spends tens or hundreds of thousand dollars annually) is immaterial relative to the potential disruption to the customer relationship
• Large volume capacity: While there are some competitors who produce metal cards, CompoSecure is the only one who appears to be able to produce high-volume runs, for customers who need that, such Chase and Amex, as well larger issuers whose business may be on the come

CompoSecure is very off-the-radar with very few investors focusing on it, partly because it is lumped in with the 2021 SPAC cohort that performed so badly

Despite being very profitable and increasing its guidance throughout 2022 (when most companies struggled), CMPO is still very off the radar.  It is only covered by 4 analysts, it has never been mentioned on VIC and has only one article on SeekingAlpha.  It’s clearly not a household name.  To the extent that people have heard of it, we have found the perception to be very negative and associated with “some crypto SPAC” – which is both true and misleading. 

CompoSecure is guilty of hyping up their crypto cold wallet (Arculus) during the repugnant SPAC mania of 2021.  At the time, they downplayed the solid metal card segment to make exaggerated claims about crypto.  Guilty as charged:

https://www.sec.gov/Archives/edgar/data/1823144/000110465921051686/tm2113351d1_ex99-2.htm

As the air came out of the crypto and SPAC balloon, we think what is lost is that the metal card business actually did *better* than expected: 

SPAC Presentation April 2021:                    $138 million in 2022 EBITDA for Metal Card segment

2022 Actual EBITDA for Metal Card           $157 million ($136 million reported + $21 million in Arculus segment losses + $10 million arbitration charge minus $10 million stock based comp)

Normally, we think this would be very well received, but we believe that the starting shareholder base at CMPO was much more interested in the “explosive” growth in crypto assets rather than the boring profits in card manufacturing, so CMPO stock price fell by about 50% in 2022. 

Adding to the selling pressure was the fact that the sponsor that put the SPAC together (Don Basile at Roman DBDR) sold its entire 6 million share stake, mostly in the 4Q and is now entirely out of their stock position:

We welcome their exit because Don Basile is exactly the type of clown that excelled during the bubble:  bullsht snake-oil con artist with checkered track record who tried to peddle the next hot thing to retail investors.  Don Basile’s resume includes being the CEO of Violin Memory, which came public in 2013 at $9 and filed for bankrupty 3 years later, and for creating some crypto token for which he is now being sued:

https://www.forbes.com/sites/cyrusfarivar/2022/11/30/a-cryptocurrency-named-after-the-fictional-money-in-star-trek-is-worthless-and-a-scam-new-lawsuit-alleges/?sh=4ddc1f8817b7

We think the exit of Roman DBDR is a positive for the company and its selling pressure has created a positive entry point for the stock.  Good riddance. 

CompoSecure’s valuation is attractive, even in the most conservative scenarios

Similar to our PMTS write-up last year, we think that 6x FCF is far too low a valuation for this business.  We think something closer to 13x-15x FCF is more appropriate, while FCF should grow as well

Upside drivers:

• 2023 guidance could be sand-bagged:  the last 4 quarters of top line growth have been 32% in 1Q22, 54%, 56% and 25% in 4Q22 – 2023 topline growth is 9%, which I think could be conservative
• Arculus:  We have spent almost zero time discussing the Arculus cold wallet/authentication device for non-crypto use cases.  We value it at zero, but it does have some revenues today (it’s sold on Amazon and elsewhere: https://www.amazon.com/Arculus-Key-Card-Hardware-Ethereum/dp/B09RYVHFVY) and the leading crypto cold wallet (Ledger) was recently valued at $1billion + (https://www.bloomberg.com/news/articles/2022-07-30/crypto-wallet-maker-ledger-seeks-new-funding-at-higher-valuation).  To the extent this is worth something, even better.
• Debt refinancing:  the company issued a 7.0% convertible note with an $11.50 strike price.  People may disagree but I feel that the cost of debt for this company should be lower, and could eventually get there with EBITDA growth and debt paydown
• Conversion of Class B shares:  CompoSecure has Class A and Class B shares where the insiders/Class B shares get beneficial tax distributions.  If/when the Class B holders sell, the effective “drag” on Class A public holders will improve. 
• Given that the private equity sponsor (LLR Partners) is the largest Class B holder and has previously looked to sell the company, we think this is a reasonable possibility
• https://www.barrons.com/articles/llr-backed-composecure-goes-on-the-block-seeking-1-5-billion-51578086292:  Luxury credit-card maker CompoSecure is up for sale, four people familiar with the transaction said. CompoSecure produces $125 million in earnings before interest, taxes, depreciation and amortization, the people said. It is seeking bids of $1.5 billion, the people said. FT Partners is advising on the process. The Somerset, N.J., company, which is backed by LLR Partners, is currently conducting chats with potential buyers, the people said. CompoSecure may expand to a full-blown process later in the first quarter, they said.

Contract renewals, crypto wallet profitability, debt refinancing and an eventual sale could be catalysts

The elephant in the room here is the customer concentration.  As the two largest issuers of the two most popular metal cards, it shouldn’t be surprising that Amex and Chase are the two largest customers of CompoSecure, making up a combined 67% of revenues.  While this is clearly a risk, we think it is an analyzable and acceptable one for the following reasons:

• It may not make economic sense for Chase or Amex to switch:   
1. CompoSecure makes $12.62 per card manufactured
2. Chase and  Amex likely make somewhere between $400 to $1300 per premium card member, by our estimates
3. It is unlikely that competitors can manufacture metal cards in the volume that Chase and Amex need
4. Even if they could cut the price of each by half, it may not be worth the $6 per card saving if you have to risk a potential disruption to this valuable customer base with a card that doesn’t work or some other issue:

We made general assumptions about how much a typical premium cardholder spends, the interchange that the issue charges, and the portion retained.  Readers are free to make their own assumptions about interchange, network fees, merchant acquirer fees, credit provisions, etc, but we think this is very attractive business for Amex and Chase.

• Competitors like CPI Card are not eager to / can’t compete with CompoSecure so there may not be anywhere to go:  as we highlighted earlier, the one other publicly traded card manufacturer has made little to no effort into trying to compete for this business, despite being prodded by its investors
• Amex and Chase have seen CompoSecure’s financials and margins and have still extended repeated
1. As we mentioned, CompoSecure has been manufacturing cards for Amex for 20 years and Chase for 15 years
2. These contracts are generally for a 2-3 year term and have always been renewed up until now
3. Interestingly, it does not appear that the economics of the contracts have gotten worse with renewals, even when CompoSecure’s financials became public

1. 1. 1. For example, in April 2021, CompoSecure issued its SPAC presentation, showing it’s 40%+ EBITDA margins: https://www.sec.gov/Archives/edgar/data/1823144/000110465921051686/tm2113351d1_ex99-2.htm
      2. Shortly thereafter, Amex amended its contract with the company
      3. Whatever happened in those negotiations, the price per card and the EBITDA margins of the company were higher in 2022 than in 2021

4. Positive data-point from this week:  Amex agreed to an early extension of its contract with CompoSecure, pushing the expiration date out to July 2026

1. 1. 1. The stock price reaction was rather muted, which either means people weren’t paying attention, they don’t care or they are more focused on the Chase contract which expires at the end of this year
      2. That could mean that a Chase renewal to 2026 could be a catalyst for a re-rating of the stock:

Amex Agreements

2004.08.04 original                 https://www.sec.gov/Archives/edgar/data/1823144/000110465921154308/tm2135648d1_ex10-22.htm

2016.09.09 amend                 https://www.sec.gov/Archives/edgar/data/1823144/000110465921154308/tm2135648d1_ex10-23.htm

2018.07.27 amend                 https://www.sec.gov/Archives/edgar/data/1823144/000110465921154308/tm2135648d1_ex10-24.htm

2018.12.26 amend                 https://www.sec.gov/Archives/edgar/data/1823144/000110465921154308/tm2135648d1_ex10-25.htm

2019.10.10 amend                 https://www.sec.gov/Archives/edgar/data/1823144/000110465921154308/tm2135648d1_ex10-26.htm

2020.03.19 amend                 https://www.sec.gov/Archives/edgar/data/1823144/000110465921154308/tm2135648d1_ex10-27.htm

2020.09.24 amend                 https://www.sec.gov/Archives/edgar/data/1823144/000110465921154308/tm2135648d1_ex10-28.htm

2021.07.14 amend                 https://www.sec.gov/Archives/edgar/data/1823144/000110465921154308/tm2135648d1_ex10-29.htm

2023.03.29 renew                 https://www.sec.gov/Archives/edgar/data/1823144/000110465923038007/tm2310757d1_ex99-1.htm

JPM Agreements

2008.01.04 original                 https://www.sec.gov/Archives/edgar/data/1823144/000110465921154308/tm2135648d1_ex10-30.htm

2014.05.01 amend                 https://www.sec.gov/Archives/edgar/data/1823144/000110465921154308/tm2135648d1_ex10-31.htm

2019.06.06 amend                 https://www.sec.gov/Archives/edgar/data/1823144/000110465921154308/tm2135648d1_ex10-32.htm

2019.10.17 amend                 https://www.sec.gov/Archives/edgar/data/1823144/000110465921154308/tm2135648d1_ex10-33.htm

• Over time, Amex and Chase will become smaller as other issuers grow faster from a smaller base
1. For the foreseeable future, each Amex and Chase are going to be very important customers
2. However, if Amex/Chase grow at slower rates than the rest of the customers (which is likely given that these two issuers were the early adopters and may be closer to their “mature” state), then by definition their revenue concentration will decrease
3. It is possible that by the end of 2026 (when the new Amex contract terminates, if not renewed), Amex will be a 28% customer, down from a 38% customer in 2020.
4. The loss of a 28% customer still would hurt . . . but we think there is a chance that this number keeps getting smaller with time

Appendix & Misc

Management

• Despite the dubious decision to go public with a dumb SPAC sponsor, management and the board otherwise seems very good
• CEO Jon Wilk:  been CEO for 7 years, 3 years at Chase and 9 years at BAC before that, MBA from Kellogg
• Chief Strategy Lewis Rubovitz: 4 years at CMPO, 15 years at Amex, MBA from NYU
• CTO Adam Lowe:  9 years at CMPO, PhD and MBA from Cornell, was a professor for a bit
• CFO Tim Fitzsimmons: 7 years at CMPO, MBA from Drexel
• Board includes the daughter of the founder (who owns $150 million of stock), Jane  Thompson (Harvard MBA), Brian Hughes (Wharton MBA), Niloofar Howe (Harvard Law degree) and the former CEO of Verifone (Paul Galant) who just joined: https://www.sec.gov/Archives/edgar/data/1823144/000110465922101933/tm2226212d4_ex99-1.htm
• I’m not saying that these credentials mean that the stock will work, but I am saying that this is a very different group of people than the typical 2021 SPAC that was filled with journey-men con artists who run from one scam to the next
• Verifone is also the case study for where I think payments hardware businesses belong:  in private equity hands, at 10x EBITDA, where private equity can make money because of the consistent but low growth and strong cash flow while public market investors never give these companies full credit because of terminal value fears (no pun intended):  https://www.businesswire.com/news/home/20180409006418/en/Verifone-to-be-Acquired-by-Francisco-Partners-for-3.4-Billion

Short interest

• There are 1.5 million shares short with average daily volume of 139k shares = 11 days to cover
• I suspect that most people are short because they think either Amex or Chase will terminate their contract or because they hear “Crypto SPAC” – but if we are right, there will be 1.5 million shares that need to be bought

Risks

Contract termination – far and away the most important risk – we discussed our views above, but if Chase does not renew by year—end, this stock is going by at least 33%

Crypto is toxic and destroys almost everything is touches

Ugly share count – the company needs to clean up all these dilutive securities – in our analysis, we have not adjusted the share count for the warrants and earn-outs, given the $11.50 strike, but if the stock does double, you will need to factor this dilution in. 

Disclaimer:  I, my firm, or my firm’s clients may have a position (long or short) in the securities discussed herein and may change such position without further notice.  This is not a recommendation to buy or sell any security.

Catalyst

• Chase contract renewal 
• Profitability at Arculus cold wallet subsidiary
• Sale of company