|Shares Out. (in M):||57||P/E||10||5|
|Market Cap (in $M):||271||P/FCF||9||5|
|Net Debt (in $M):||275||EBIT||63||102|
A credit card upgrade cycle can generate $2.00 EPS by 2020 and a $20 stock price.
CPI Card Group (PMTS) is not well known by investors as the company just went public in October 2015.
CPI is the largest manufacturer of credit and debit cards in North America with 35% market share. Customers include nearly all the card issuers
such as American Express, Bank of America, JP Morgan Chase & Wells Fargo. 80% of EBITDA and 76% of sales in the March 2016 quarter were earned
by the USA debit & credit segment. The remaining 20% of EBITDA is earned from card personalization services.
In 2015 CPI shipped 310 million credit & debit cards and personalized 130 million cards.
Normally this is a predictable business as 88% of annual card demand results from the re-issuance of existing cards as cards expire, break or are lost.
In 2015 half of cards produced were the magnetic stripe variety and about half were EMV.
Investment Thesis - Long-Term Investors Will Win
CPI Card Group (PMTS) is in the middle of a 7 year credit card upgrade cycle that can boost EPS ten-fold from $0.22 to $2.00/share.
Ironically, a major EPS miss due to excess inventory is giving investors a great opportunity to purchase PMTS at a depressed $5/share.
By 2020 PMTS stock price could reach $20 if they earn $2/share and are valued at a 10x P/E. There are two phases to this investment thesis.
Phase 1 will be the end of the inventory destocking process in 2016-2017 that allows PMTS to rapidly earn $1/share.
Phase 2 includes the upgrade cycle to dual interface credit cards which drives average selling price up to $2/card and EPS to $2.00/share by 2020.
Two Upgrade Cycles:
This mundane industry grew about 7% annually till 2013. Then in November 2013 over 40 million Target customers had their credit card information
stolen and the CEO was fired afterwards. To combat fraud and hackers Visa and Mastercard have made greater efforts to encourage retailers to issue
encrypted EMV cards and dual interface cards. The higher price of these smarter cards $2.00 versus $0.20/card, will result in sales at CPI Card Group
rising over 250% from 2013 → 2020. EPS in 2013 were $0.22/share and could reach $2.00/share in 2020 with 100% adoption of dual interface cards.
Take A Look Inside Your Wallet:
If you look inside your wallet you will likely see that your bank debit card has a magnetic stripe on the back. For 50% of consumers one of your credit cards
will have been upgraded to an EMV card that has an encrypted chip on the front of the card. Costco Warehouse customers will likely have the most
advanced card, a dual interface credit card.
Retailers are being forced to accept these more advanced credit cards by Visa & Mastercard. Credit card fraud is a multi-billion dollar problem and all the losses
were born by Visa and Mastercard till recently. As of October 2015 retailers that do not accept EMV cards will be responsible for credit card fraud, NOT Visa & Mastercard.
Not surprisingly retailers have been rushing to upgrade their point of sale terminals to accept the EMV chip cards. As of March 2016 we are about 50% through the
upgrade cycle to EMV cards. New credit card issuance of EMV cards is expected to peak in the middle of 2017. At that point another credit card upgrade cycle
from EMV to dual interface cards will likely begin.
A Gift For Investors → Excess Credit Card Inventory:
CPI management understood that banks were over-ordering credit & debit cards in 2015 ahead of the October 2015 deadline, and factored this into their EPS guidance.
On May 11, 2016 CPI management made it clear that they had been mistaken. The over-ordering was greater than they realized. The bank customers had
excess card inventory and new orders had evaporated. EPS guidance for 2016 was reduced by (44%) from $0.94 → $0.50 EPS. The stock price fell sharply.
CPI management after more in-depth conversations with the banks believes that the banks over-ordered 17 – 35 million cards from CPI Card Group.
A sharp reduction in card orders by the banks should result in the excess inventory being depleted by the September-November 2016 time-frame.
Thus Wall Street analysts should not have reduced their 2017 EPS by (33%) from $1.20 → $0.80 EPS on the same day (see orange bars representing 2017 EPS).
Graph #1 below presents our view that 2017 EPS will more likely be $1.06, and not the $0.80 EPS forecast by the Wall Street consensus.
Price cutting to obtain new orders from the large banks will likely reduce EPS by $0.14 in 2017, but otherwise Wall Street EPS reductions were not justified.
Industry card demand remains healthy. Visa releases data showing how many millions of new EMV cards are being issued on a monthly basis.
EMV card issuance is rising every month to a new record level. Thus manufacturers such as CPI Card Group are suffering from a classic “inventory destocking” event.
Once the destocking is over, card orders should recover to much higher levels. Management assumes that quarterly EPS will return
to normal by the December 2016 Quarter.
Operating Leverage Will Help A lot:
Pre-tax margins for CPI Card Group will trough around 4% in the June 2016 Quarter. The good news is that the blended average card price (magnetic plus EMV) is
about $0.60 per card today and headed towards $2.00 per card in 2020 with 100% adoption of dual interface cards. In addition 90% of SG&A costs are fixed.
Thus sales and Gross margin dollars can triple, while SG&A costs slowly rise. This operating leverage in the income statement allows annual EPS to rise from
under $.50 EPS in 2016 to about $2.00 EPS in 2020 if EMV and dual interface cards are adopted in the timeframe I have forecast through 2020.
EPS Forecasting Assumptions:
The key positive driver for CPI Card Group is that the average price of a credit card they manufacture is expected to rise from $0.60 to $2.00/card over the next 4 years.
SG&A will remain very stable and interest expense is also a fixed cost. The result is that most of the increase in gross margin dollars flows to EPS.
Conclusion - Long-Term Investors Will Win
CPI Card Group (PMTS) is in the middle of a 7 year credit card upgrade cycle that can boost EPS ten-fold from $0.22 to $2.00/share. Ironically, a major EPS miss
due to excess inventory is giving investors a great opportunity to purchase PMTS at a depressed $5/share. By 2020 PMTS stock price could reach $20 if they earn $2/share
and are valued at a 10x P/E.
Our recommendation is to focus on the long term EPS opportunity and ignore the current quarterly EPS weakness.
More About The Upgrade Cycle:
What Is EMV Technology?
EMV stands for Europay, Mastercard, Visa. It is a global credit card technology standard that is accepted by 99.99% of retailers in Europe.
Even 100% EMV adoption has taken place in Canada. The United States is the last of the G-20 nations to adopt EMV cards at retail.
Magnetic strip cards hold your personal information in the stripe itself. Cheap hand held technology has made it possible for a thief to swipe your card,
steal your personal information, and then be able to make purchases with your card information. As a result credit card fraud has grown rapidly in the USA.
Thus EMV cards were invented where it is far more difficult to forge or steal your personal information.
The next improvement was dual interface cards where another layer of authentication was added. A signature was required or inputting a numerical PIN code.
These cards are called “Tap & Go” cards by retailers because consumers only need to hold up the card near the point of sale terminal. There is no need to
insert the card into the terminal as one does with a chip card.
Most credit cards have a 3 year expiration date after their issuance. This has resulted in about a 3 year cycle for the banks to issue EMV cards
as the older magnetic stripe cards approach expiration.
The EMV upgrade cycle in the USA began in 2013 and is expected to be completed in 2017. Sometime in 2017 the next upgrade cycle for dual interface cards
should begin and be completed in 2020. The dual interface cycle will be an easier transition as the current retailer point of sale terminals that accept EMV chip cards
will also accept dual interface cards.
Management at CPI Card Group was surprised by the size of the excess card inventory that has led to the current EPS miss in the June 2016 quarter.
The inventory problem could be even larger than their new assessment. If so, quarterly EPS would remain depressed for a longer time frame.
The company would need to reduce EPS guidance again based on lower unit assumptions.
Nearly all of the excess card inventory is held by large banks such as Bank of America. The banks don’t need more cards but have been willing to order
more cards if manufacturers cut prices for new orders by another $0.20/card. There is a risk that price cutting could get even worse and that
card prices would never recover.
CPI Card Group has $350 million of Gross Debt. If the profits stay depressed for longer than expected then CPI will be at greater risk of breaking
their debt covenants. The good news is that the largest shareholder, Tricor Pacific, is a private equity firm with access to capital beyond banks.
1) Phase 1 - The end of the credit card destocking process in the second half of 2016, will allow quarterly EPS
to step up from $0.06/quarter to $0.16/quarter.
2) Phase 2 - The credit card upgrade cycle continues from EMV chip cards to dual interface cards in the United States.