Welcome to CPI Card Group's Third Quarter 2023 Earnings Call. My name is Chris, and I'll be your operator today. [Operator Instructions]. Now I'd like to turn the call over to Mike Salop, CPI's Head of Investor Relations.

Thanks, operator, and good morning, everyone. Welcome to the CPI Card Group third quarter 2023 earnings webcast and conference call. Today's date is November 7, 2023, and on the call today from CPI Card Group are Scott Scheirman, President and Chief Executive Officer; Jeff Hochstadt, Chief Financial Officer; and John Lowe, Executive Vice President, End-to-End Payment Solutions. Before we begin, I'd like to remind everyone that this call may contain forward-looking statements as they are defined under the Private Securities Litigation Reform Act of 1995. These statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those expressed in the forward-looking statements. For discussion of such risks and uncertainties, please see CPI Card Group's most recent filings with the SEC. All forward-looking statements made today reflect our current expectations only, and we undertake no obligation to update any statements to reflect the events that occur after this call. Also, during the course of today's call, the company will be discussing one or more non-GAAP financial measures, including, but not limited to, EBITDA, adjusted EBITDA, adjusted EBITDA margin, net leverage ratio and free cash flow. Reconciliations of these non-GAAP financial measures to the most directly comparable GAAP measures are included in the press release and slide presentation we issued this morning. Copies of today's press release as well as the presentation that accompanies this conference call are accessible on CPI's Investor Relations website, investor.cpicardgroup.com. In addition, CPI's Form 10-Q for the quarter ended September 30, 2023, will be available on CPI's Investor Relations website. On today's call, all growth rates refer to comparisons with the prior year period, unless otherwise noted. And now I'd like to turn the call over to President and Chief Executive Officer, Scott Scheirman.

Thanks, Mike, and good morning, everyone. During today's call, I will give a brief business and strategic overview. John will discuss CPI's third quarter performance and our updated outlook for the full year, and then Jeff will review the financial results in more detail before we open up the call for questions. We will start on Slide 4. As we stated in our second quarter earnings call, we expect the third quarter results to be lower than prior year as customers remained cautious in their spending and continue to work down their inventory levels after stocking up in 2022 due to the significant supply chain challenges across the industry last year. We are also facing very challenging comparisons with the prior year third quarter when net sales increased 25%. Given this backdrop, third quarter sales this year declined 15%, driven by a reduction in card volumes in our Debit and Credit segments and some timing impacts in prepaid. As we assess the rest of the year, we believe sales and adjusted EBITDA in the fourth quarter will be at similar levels as the third quarter as it is taking longer than expected for customer spending to rebound and for our new sales initiatives to have an impact. Consequently, we now expect net sales as well as adjusted EBITDA to decline in the mid-single digits range for the year. The market for card production has certainly turned out to be more difficult than expected in 2023. But if we step back and look at the bigger picture, we believe the overall card industry appears healthy. Most importantly, cards in circulation have continued to grow and large issuers have continued to report strength in their card programs which John will discuss more in a few minutes. Consequently, we remain confident in the long-term health of the market, and we believe we're well positioned for future with our innovative, high-quality products and services, and strong customer focus. As one indicator of our belief in the business, this morning, we announced a $20 million share repurchase program. We believe repurchasing shares is a great investment for our shareholders, and this authorization will run through the end of 2024. Before turning the call over to John, I would like to highlight our ongoing strategic focus on Slide 5. As discussed, we believe the softness we are experiencing is temporary in nature. The strategies we have successfully employed to grow sales and gain market share since 2017 continue to be our cornerstone, and we remain committed to having deep customer focus, market-leading quality products and customer service, continuous innovation, and a market competitive business model. Over the long term, we believe our market will return to solid growth, and we believe we will gain share by focusing on these strategic priorities. I'd now like to turn the call over to John Lowe to further discuss the current environment, our third quarter results, and our outlook for 2023. John?

Thanks, Scott, and good morning, everyone. I will start on Slide 6, which is a good indicator of the overall health of the market. As Scott mentioned, payment cards issued to consumers continue to grow. The latest figures from Visa and MasterCard show cards in circulation in the U.S. increased at a 10% CAGR for the three years ending June 30, and were up 9% compared with the prior year quarter. Additionally, recent earnings reports from the big U.S. banks also point to healthy card issuance and usage trends with consumers. As a few examples, Chase noted that cards outstanding increased 16% year-over-year in this third quarter, driven by strong account acquisition. Citi's new account acquisitions increased 5%. And Wells Fargo's new account growth increased 22%. So the card issuance to consumer side of the market where banks and other issuers participate has been strong in 2023. But the production side where we participate has been relatively soft. However, if you look at our last two years together, CPI sales are more broadly in line with the issuance trends to consumers. Looking back to 2022, we delivered well above average growth with our Debit and Credit segment increasing 32% and as customers had high demand for cards given the limited supply in the market. As the supply chain stabilized and lead times came down in 2023, in combination with economic uncertainty and banking industry stress, customers have pulled back on ordering this year more than we expected and are targeting lower months of supply for their inventory, resulting in our updated outlook of a mid-single-digit sales decline for the year. Relative to 2021, though, this year's projected sales would still be about 20% higher than the 2021 levels and the combined 2-year trends would be more consistent with the ongoing…

Thanks, John, and good morning, everyone. I will begin review on Slide 10. Net sales decreased 15% in the quarter with Debit and Credit sales declining 16% and prepaid sales declining 12%. Within our Debit and Credit segment, as mentioned, the primary driver of the decline is reduced card sales. Third quarter gross profit decreased 25% and the gross profit margin decreased from 38.9% to 34.1%. The lower sales levels negatively affected margin due to the impact on fixed costs within cost of sales and margin was also impacted by higher material costs, primarily chips, partially offset by lower freight costs. SG&A expenses, including depreciation and amortization declined by $1.8 million in the quarter, primarily due to lower professional services costs. Compensation expenses decreased as lower employee short-term incentive compensation offset $3 million of accruals related to the previously announced executive retention awards and higher headcount and salaries. Our tax rate increased to 37.7% compared to 25.8% in the prior year quarter and brought our year-to-date rate of 30.5%. The increased tax rate expected for 2023 primarily reflects limitations on deductibility of executive compensation related to the executive retention package. Net income in the third quarter decreased 68% to $3.9 million adjusted EBITDA decreased 25% to $21.2 million. Adjusted EBITDA margin declined from 22.7% in the prior year to 20.1% due to the reduced sales levels and related lower gross margins. The net income decline also reflects the impacts of the executive retention award accrual, which is not included in adjusted EBITDA and a higher tax rate, partially offset by lower interest expense. Turning now to our year-to-date results on Slide 11. For the first nine months of the year, net sales decreased 2% with the Debit and Credit segment down 2%, and prepaid debit down 1%. Debit and Credit…

Thanks, Jeff, and thanks to all of our employees for your hard work and dedication in serving our customers well. I would also like to welcome Ravi Mallela, who is joining our Board of Direct as an Independent Member. Ravi is Chief Financial Officer of National Mortgage Holdings, Inc. and we look forward to the financial and business experience he will bring to our Board and Audit Committee. To summarize today's call, 2023 has turned out to be more challenging than we expected, as economic uncertainties and banking industry stress have contributed to customers being more cautious with their spending as well as more focused on working down inventory levels after the substantial purchases in 2022. Although exact timing is not cleared, we expect customer demand to improve over time, and we continue to believe in the long-term secular trends for payment cards and in our ability to gain share over the long term. We are pleased to put in place a $20 million share repurchase program announced this morning and believe it will be beneficial for shareholders. Thank you for joining our call today, and we will now open up the call for any questions.

[Operator Instructions] First question is from Jaeson Schmidt with Lake Street. Your line is open.

Hi, guys. Thanks for taking my questions. Just looking at the updated full year guidance, I'm just curious if you're seeing any cancellations? Or are these just mainly due to push outs?

Hi, Jaeson, it's Scott. Thank you for joining the call. I would say some of it's pushouts. For example, we've had a customer that's in the subprime that are tightening a bit. So there's a bit of a cancellation there. But I would say largely, I think what's important is the secular trends are intact in our business. We operate in attractive and growing markets. As John mentioned on the call, the cards in circulation from Visa and MasterCard are growing at a 10% CAGR. We also are very much in a reoccurring business in that, on average, year-on-year out, there's about over 600 million cards produced. We think about, on average, 90% of those are reoccurring, meaning it's card reissuance, if it's lost or it's stolen. So we feel good about the long-term trends in the business. The secular tailwinds are there, contactless cards continue to win in the marketplace. They're higher-priced eco-focus cards are out there for sure. Both banks and consumers want to be more environmentally sound. We're the market leader with over $100 million since 2019. So I think what we're seeing is just a bit of a timing difference, temporary difference between card issuance, card usage. Cards are winning at the expense of cash for sure. The large issuers are continuing to grow that. The production market has just been softer than we expected with cards, cautious spending, some robust purchases in 2022 as a result of a tight supply chain. But clearly, we believe in the long-term health of the business, we believe we have opportunities on a long-term basis to continue to win share. And we announced a $20 million share repurchase program which represents over 10% of our market cap. So I very much believe in the long-term business. But again, let me have John. John spent some more time with customers than I do, so he can give you some more color on as far as pushouts or cancellations of what we're seeing.

Jaeson, good to talk to you this morning, and Scott covered most of it. The only color I'd add is in the example of a customer where they're credit tightening, where they're in the subprime space. Things like that are going to happen, flow over time. But for the most part, if you take a large issuer as an example, they're kind of cutting back their spending in the current year, but they still have the same book of business. They're still growing their account base. We still feel good about our position from a share perspective. That's just one example. And we see that across our book of business. So we feel really, really good about where we're positioned in the market. Continue to execute on our strategy, continue to hear good things from our customers. And I would say the only other thing is probably there is some delayed reissuances in the market, our small to medium space, they're still cautious in their spending. So you definitely see some slowdowns that are continuing into Q4. But the overall card market, as Scott said, right, you're growing at a 10% CAGR over the last three years. We saw a 9% growth quarter-over-quarter from Visa and MasterCard. So we still feel very strongly about the position we are in the market and the market self-growing at a decent CAGR.

Okay. That's really helpful. And then just curious if you think the current environment coming out of the supply chain constraints, do you think it has any lasting impact on how customers handle their inventory levels?

I'll take that one. I think if you go back to 2021, 2022, and there were a ton of industries that were impacted by this, right? The supply chain was tight. Our lead times are really long. The visibility in our business has come down as lead times have come down but what I would say is we're getting back to more historical times. Our lead times are a little bit tighter than history. But we don't necessarily see whether it's the large banks, the small to medium banks, changing their broader historical patterns. I think what we see is they built up inventory over the last 1.5 years, and they're starting to normalize that optimize that back down to what I would say normal course patterns. But what we don't see is banks in general, taking on more risk where they're only going to hold a really, really small amount of inventory and risk not issuing a card to one of their consumers. Their goal at the end of the day is to be top of wallet and everything they do and so they will hold the right amount of cards to make sure they always meet their customers' needs.

Okay. Appreciate that color. I'll jump back in the queue. Thanks guys.

Thanks Jaeson.

[Operator Instructions]. The next question is from Hal Goetsch with B. Riley Securities. Your line is open.

Hi. Good morning. I'll stay on this topic. 2022 was a very, very big growth year. I mean it was up 27%. And if you look at maybe your guidance for the full year now, it looks like over a 2-year basis, the revenues are going to be up about 20%. And if the card market is growing roughly what you said kind of at least high single-digit. My question is like how much inventory in the channel was there that needs to be drawn down? Is it -- can you help us figure out how long this is going to take? Because it would seem that if the -- looking on a two year basis now you're -- you exit the year kind of where we think you're going to exit that. It would seem like the consumption over maybe a 2-year period was pretty much in line and like inventories may be get rightsized by Q1. But like I wanted to get your thoughts on that. And also I wanted to get your thoughts on like, how can we anticipate not getting that kind of channel fill pretty strong again? Thank you.

Yes. Hal, John again. You're right. If you look at the two year period, right, the growth of '22 and then take that over '22, '23, compare that to the overall market, things are more in line. From a standpoint of when inventory will fully normalize. Right now, based upon what we're seeing lead times still continue to be low. Our customers, I think, are continuing to optimize. That said, I think we're going to give a lot more guidance in early next year. I don't think we could sit here today and tell you exactly when it will fully normalize and the production market matches up to the card issuance market. But we still feel strong about where we are and your analysis is spot on. That's exactly the way we've thought about it, except for exactly when it will come back. I will say that banks in general, if you go back to where we're in August, they are carrying less months of supply than we expected, but that can't go to zero, right? You think of the 1 billion cards in circulation, the 600 million to 700 million that are produced every year, cards are turning over in every one's wallets roughly every three years, regardless of what the expiration date is. So we feel -- it's going to -- the market overall will gradually improve over the course of '24 but we'll give more guidance in early next year.

All right. Great. Thank you.

There are no further questions at this time. And this will conclude today's CPI Card Group third quarter 2023 earnings call. Thank you for joining. And have a good day.