November 16, 2015 - 3:29pm EST by
2015 2016
Price: 11.00 EPS 0 0
Shares Out. (in M): 57 P/E 0 0
Market Cap (in $M): 607 P/FCF 0 0
Net Debt (in $M): 331 EBIT 0 0
TEV (in $M): 938 TEV/EBIT 0 0
Borrow Cost: Available 0-15% cost

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  • Misunderstood Business Model




SHORT CPI Card group with a price target of $6.


Business Description

CPI has three segments:  UK private label/prepaid gift cards, US turnkey reloadable general purpose cards (think GreenDot), and the US Credit/Debit segment (80%+ of profits). CPI manufactures the physical plastic credit card, printing and milling the card and embedding chips –effectively a job shop printing business. They personalize 1/3 of cards produced, adding personal data to card, mag stripe and chip. The company is a recent IPO from a PE sponsor, has a 180 day lockup, and the sellside just initiated this week. Rumor is Oberthur had previously looked to buy CPI Card for ~$500M EV (i.e., ½ of its current EV)

Investment Thesis

CPI has been overearning due to the EMV migration in the US, which is the migration from mag stripe cards to chip cards. We expect these earnings to normalize, quickly and dramatically

  • CPI is fundamentally a poor business: its position in the value chain is weak, with minimal differentiation and low barriers to competitive supply expansion

    • CPI’s value-add is commodity printing and embedding of the chip: CPI prints the cards and embeds the chip (acquired from third party), a commoditized step in the value chain with low switching costs and minimal barriers to entry. This is a cost of capital return sort of business.

    • Lack of bundled option likely to impair CPI share: CPI’s lack of participation in the full value chain puts it at a disadvantage to competitors who can offer a turnkey solution, driving losses relative to magstripe share

    • CPI weak position is likely unfixable: entering the software/chip business is IP intensive and would take significant capital and expertise, both of which CPI lacks. It is unlikely to expand its value chain positioning upstream.

  • EMV migration caused a temporary spike in margins that is likely to revert: US chip card migration caused temporary shortage of chip milling/embedding supply, causing margins & returns to spike to unsustainable levels that market extrapolates forward

    • Margins/returns have spiked far above historical and peer norms: operating margins have expanded 11% 21%, in-line with gross margin expansion, driving ROIC 10-12% mid-20s, far above better positioned peers

    • Margins should actually fall due to pass through of EMV chip costs: ASP increase due to pass-through chip costs, which results in lower % margin even if per-unit profitability increases meaningfully; this is mis-modeled by sell side

    • Research indicates margin reversion already building: industry is already in overcapacity, and customers focus is turning from reliability of service to price

  • Estimates overestimate the size of the EMV card market: EMV market is likely to be peaking now while market expects growth

    • Meaningful demand pull forward due to EMV rollout: the EMV rollout has pulled forward demand from future years into the current period, leading to an upcoming decline in sales volumes

    • Post-EMV rollout demand lower due to less fraud/longer expiration cycles: less fraud and longer expiration date cycles decrease the number of cards that need to be issued each year, in contrast to the apparent projections that management has provided to the sell side

    • Minimal pre-paid debit card penetration: research indicates that only a small portion of prepaid debit cards are likely to be enabled with EMV chips, limiting the impact this segment could contribute to industry growth

  • High leverage limits management flexibility while CPI comes out of the gate reasonably levered (~3x NTM consensus/4.6x LTM net levered), that leverage obviously increases in our base case, where EBITDA falls from $100M+ to under $70M, resulting in leverage >4x. This should limit FCF generated to debt paydown, taking debt funded M&A, dividends, and buybcaks off the table for CPI.


  • Timing: The main risk is that we are off on our estimates of the EMV volume peak, and hence we are too early to the short, and EMV volumes may not see a large decline, although we expect margins would still normalize

  • Dual-interface adoption: there is another potential technological change on the horizon: contactless, or “dual-interface,” cards. Research indicates this is unlikely to have meaningful uptake, but it could drive a similar tightening cycle.

  • Takeout: Oberthur passed on CPI at $500M; another bidder may be willing to pay more and put a floor under the stock. Of course, with $331M of debt outstanding, this still would put the equity down well over 50% from here

  • Liquidity: the stock and borrow are both illiquid, and the lockup does not expire until April.


Insider Activity
Management sold a small amount in the greenshoe option; they also likely got a good chunk of the $300M dividend paid that the IPO financed. Obviously the PE fund is cashing out here; the IPO was used primarily to paydown the debt taken on to pay a big dividend prior to listing. Tricor Pacific, the sponsor, bought the business in June ’07.


Capital Allocation Review
These guys are pretty levered, so the immediate uses of capital are likely to be deleveraging. They have historically tucked in a number of small acquisitions. The track record there is unclear, but likely immaterial for our investment horizon here. If our thesis plays out, they will end up 5x levered or so, and so the priority will definitely by deleveraging.


Catalysts/Event Path & Signposts

The primary catalysts will be earnings reports as well as industry reports on EMV adoption.


Size up signposts

  • Evidence of gross margin erosion

  • Evidence of market share loss

  • Confirmatory data on EMV penetration rates/market sizing

  • Secondaries / increased liquidity


Size down/exit signposts

  • Meaningful EMV adoption in non-reloadable prepaid cards or closed loop cards

  • Meaningful adoption of dual-interface (contactless) cards, which could cause another tightness cycle




Aside from the general fact that the tree has a highly attractive skew, there are three points worth reiterating. First, is that all of the assumptions derived from the supporting analysis on EMV penetration, share, and margins is actually loaded into the Downside case, not the Base case. This is simply conservatism, given that our analysis indicates such dramatic declines in profitability. Second, the probability distribution reflects that fact, with the downside and base case being equally weighted, and the cases on either side of those cases totaling to the same 20%. Third is the fact that our bear case – down 80% -- largely approximates the purchase price Oberthur, a large and sensible acquirer, was willing to pay for the asset.


CPI Card sits in the most commoditized place in the value chain


The EMV migration has changed the value chain for the physical cards, and CPI is positioned in the weakest links of the chain. Pre-EMV, there were essentially two steps – card manufacturing and card personalization. Manufacturing was simply printing and punching the cards and attaching the mag stripe. Personalization was relatively straight-forward, and included embossing the cards with the name and number and encoding that info on the mag stripe, which was very easily done on industry standard equipment (indeed, this is the whole point of EMV – to make it more difficult to make faked cards where the mag stripe works just fine). It was a job shop printing business with little in the way of differentiation.


With EMV, the dynamic changes – the added pieces are focused on the software that makes the chip run, the hardware of the chip, and then properly encoding that chip (which now has to coordinate with the software used and the physical chip itself). The software is differentiated (largely passed on the ease of personalizing the chips that run the software), and the true value-add and differentiation is in the combination of the software and the chip. Further, since the personalization now is specific to the software/chip combo, there is an added advantage of having the integrated players do the personalization, and at that point most players are simply buying the full suite of services in a bundle (which is how all of Europe operates).


This bundling disadvantages CPI, which operates a more limited suite of steps, notably excluding the software/chip, which is the most differentiated aspect of the value chain. Research indicates that customers are increasingly looking for a bundled, turnkey solution, which should cause share pressure for CPI relative to their share in mag stripe cards.


The physical manufacturing of the card, which is where CPI operates, is still commoditized. The printing companies (plastic manufacturers) did have to add steps to mill and embed the chips, and hence there was a shortage of capacity in this step of the value chain, but it is completely interchangeable and commoditized, and there is substantial evidence that there already exists excess capacity in that market. Hence, while prices/margins/returns where attractive when there was a shortage of capacity in this step of the value chain, now that the bottleneck is cleared it should return to its steady state economics, which is a highly competitive, commoditized business.


Barriers to entry on the other aspects of the value chain, namely chip and software, are meaningful and are effectively insurmountable for CPI. CPI will remain in the weak spot in the value chain. Additionally, there is little value to the integrated acquirers to pick up CPI through an acquisition. Indeed, research indicates that CPI was shopped to Gemalto and Oberthur, and that Oberthur’s bid was only $500M EV (ie, half of the current valuation).


CPI has been overearning, but that should normalize soon

CPI is a weak business, as described above, and should be earning something that approximates its cost of capital. However, they have been earning meaningful excess returns recently due to the bottlenecks in the supply chain as EMV issuance accelerated:



We have confirmed via research calls that contracts were harder to come by a year ago. A year ago, buyers were concerned about a lack of capacity, and, relative to the cost of messing up the EMV migration for a bank, the incremental cost of higher cards was not a focus.


This leads to CPI earning meaningfully higher margins/returns than comparable businesses. Indeed, given the relative value added and barriers to entry, CPI is a meaningfully weaker business than most peers, yet consensus calls for CPI to meaningfully outperform these peers in operating margins and ROIC:

This is true despite the fact that CPI has historically performed close to in-line with peers, on ROIC metrics that seem more sensible for this quality of business. We project the company’s margins and returns to normalize in our base case, but still exceed peer levels:

Part of the reason that CPI is making such high margins is that they are effectively marking up the EMV chip that is the largest cost component of an EMV card. These chips costs $0.35-0.50, and are sourced externally from a variety of sources, where the chips are widely available. CPI should simply not be able to do this in a normal environment. Assuming that increasing competition and price sensitivity pushes down prices, I expect the markup on this chip to fall away (see below). Importantly, the sell-side mismodels margins, expecting continued elevated margins despite the fact that CPI could double profitability per card and still have % margins fall.



Profitability overall for an EMV card for CPI should indeed be double or better than profit per card was in a mag stripe world. However, they are currently earning 10x more per card for adding the simple step of embedding the card in the plastic (not technically hard to do at all). As the pricing process normalizes, I expect profitability/card to decline from 31c to 6c, which should push percentage margins to below the historical levels.


Research indicates that several factors, largely already in motion, should drive pricing down and cause returns to normalize:


  • Fall in EMV issuance, as described below – EMV card issuance volume is likely to fall once we pass through the initial upgrade cycle and volumes return to replacement level

  • The meaningful additions of capacity, which has led to there currently being excess capacity which will only get worse as the EMV peak passes. Research indicates that even here, at/near the peak, there is excess capacity.

  • Banks are no longer “scared” about being caught short of capacity, and hence are more willing to negotiate on price

  • EMV migration projects are winding up, with responsibility for procurement moving to corporate procurement departments that are much more focused on the best price as opposed to ensuring that the overall project works smoothly


Combined, these factors should drive a decline in prices/margins/returns as the industry enters overcapacity. Even allowing for continued elevated EMV volumes, earnings are unlikely to accelerate from current levels, limiting our downside risk.


EMV card issuance pace
EMV card manufacturing is very near its peak, which will occur sometime between 1H15 and 1H16. I modeled out the issuance pace of credit and debit (shown below) and conclude that there will be a pretty dramatic drop-off sometime in FY16 or FY17, and that the trough is roughly 15% lower on pure EMV card issuance volumes (which will be compounded by pricing). As research indicates there is already excess capacity at current (peak) volumes, this indicates that the industry will have a huge amount of overcapacity in the future – and that CPI has amongst the weakest positioning to make it through that trough time.



There are several dynamics that lead to this meaningful drop off. First, the EMV cut over date (which shifts liability to the least prepared party, be that issuer or merchant) was October 1st of this year. Hence, the banks wanted to get the bulk of their portfolios migrated over by or around this time, accelerating the normal amount of issuance (that is, pulling it forward). We believe that significant pull-forward was required to achieve the levels of penetration that is expected by the industry: for instance, to achieve the credit card penetration of 60-70% widely expected to be achieved by the end of this year, approximately 175M cards, or roughly 25% of cards outstanding, had to be replaced ahead of their expiration dates this year.


Second, post the issuance, there will be fewer cards naturally expiring, for two reasons: banks are extending expiration dates (since EMV cards cost more to replace) and they will have just refreshed an abnormal part of the portfolio, so there should be a drop off in following year or two. This basic dynamic is a core of this thesis, and while it is impossible to get this precisely accurate, I think we have done a good job of framing up the majority of the effects that will happen over the next two years or so.


Lastly, research indicates that the vast majority of prepaid debit cards are unlikely to migrate to EMV anytime soon. While open-loop, reloadable prepaid debit cards may migrate, they are tiny – even assuming they converge to 80% penetration by FY18, they add well under 10% to industry production estimates.


I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.


Quarterly earnings reports show margin erosion and slowing topline.

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