2023-05-22 12:44:25 ET
Summary
- Management reiterated guidance that implies PMTS is trading at 8x (EPS) vs S&P 22x, but the market does not believe the guidance.
- We believe the guidance because the business is a consumable product meaning customers can delay but not eliminate purchases.
- PMTS cautioned the second quarter is witnessing a delay in buying driven by bank turmoil, which we believe abates due to the idiosyncratic nature of the recent bank failures.
- The company’s business is driven by the number of bank accounts, not number of banking institutions.
- PMTS has made it into the preliminary round for Russell 2000 inclusion, which should generate considerable share demand.
Summary
CPI Card Group Inc., (PMTS) is one of the largest credit and debit card manufacturers in the United States. The company's financial performance has improved due to market share gains, industry growth, and ASP expansion. The company's fundamentals are stable with 90% of its revenue recurring due to lost, stolen, damaged, or renewal card demand. The credit card industry experienced a 11% CAGR over the past 3 years driven by secular changes from cash to card usage. Over the past three years, PMTS's revenue has increased organically by nearly 100% outpacing industry growth due to market share gains.
Q1 2023 Results
The company beat its first quarter expectations relative sell-side consensus estimates with YOY revenue growth of 10%, which is twice the annual expected growth rate and earnings of $.91 vs consensus of $.65. However, the company mentioned the second quarter would be weaker than the first quarter due to some customers pulling back on card purchases but reiterated annual guidance. The market overacted with a decline in stock price of more than 35% as investors doubted the company's ability to achieve guidance.
Why Believe Guidance
PMTS makes credit and debit cards for well over 1,000 clients compared to approximately 8,000 credit unions and banks in the United States. Credit cards are a consumable product that have an expiration date of 5 years. Ever year about 90% of the company's product demand comes from maturity of existing cards, lost, stolen, or switched due to competitive offerings by card issuers. Said differently, the vast majority of a bank's credit card portfolio must be replenished every year. The banks can pull back for a month or two, but they are required to issue cards 1 month before their customers cards mature. Additionally, end customers routinely lose, damage, or have cards compromised that must be replaced.
Banking Turmoil
The recent banking sector turmoil has investors concerned about PMTS' customer's buying patterns. Silicon Valley and First Republic failed because very wealthy customers and businesses held deposits more than government insurance levels, and quickly withdrew deposits causing a bank run. These two banks were uniquely positioned for wealthy private bank clients, and their demise does not lead to a systemic banking crisis.
Over 50% of PMTS clients are small credit unions and community banks. These bank clients are not the ultra-wealthy and most of their deposits do not exceed FDIC or NCUA insurance limits. The company also has 30% of its customers that consists of the top ten banks that have benefited from the deposit flight. The remaining 20% of the company's clients are small regional banks that are pulling back in what we believe will be a temporary pause as the market realizes the banking sector is not going through a 2008-2009 consolidation event.
Most people choose their bank based on fees and convenience of location . In the event of a massive bank consolidation cycle, if fees and location don't change customers stay with the new bank. A large consolidation event will stimulate card manufacturing demand. For example, every First Republic Bank customer will now need a Chase credit and debit card. In other words, a banking crisis increases card production for the industry.
The Perceived Credit Card Cycle
In 2015, the government mandated card issuers to adopt EMV or chip cards to reduce fraud. This arbitrary date pulled forward demand and then extended card maturities from 3 to 5 years. However, approximately 30% of the cards in circulation are either lost, stolen, damaged or switched annually. From a portfolio perspective, if the average card expires in 5 years the average credit card vintage is less than 4 years. Since the 2015 deadline the "cycle expiration cliff" has been smoothed out to normal demand levels. To assess this claim, the company's peak quarterly revenue before the 2015 deadline occurred on Q3 2015. Its anniversary from a portfolio perspective should have been Q2 or Q3 2019, but revenue has grown steadily since 2019. In fact, product revenue is up over 100% in the three years after 2019.
The other cyclical concern is around the contactless conversion. Our first report in late 2020, was partially based on our belief that PMTS was a lesser known COVID play. COVID increased adoption of contactless credit cards that carry an approximately $.70 greater ASP driving revenue growth as new customer issue contactless cards. There is a concern that the incremental pricing of $.70 could be eliminated as contactless cards are commoditized through time. However, contactless cards have been around for over 9 years and have been commoditized with prices declining from $7 to today's approximate price of $.70 incremental price difference between contactless and EMV. PMTS and the industry are not experiencing supernormal profitability presently and margins should hold in the coming years.
Why Cards Are Not Going Away Anytime Soon
We believe for a technology to disrupt consumer behavior the offering needs to be either cheaper or more convenient for the end user. Some people believe that digital transactions such as Apple Pay (AAPL) will make credit cards obsolete. However, the consumers do not pay for the physical card itself and it is only $1.50 use for the issuers.
Apple is the largest company in the world and launched its Apple Pay in 2014. Yet, the adoption has not been overwhelming at only 5% penetration (and 39% of Americans never heard of Apple Pay). In fact, penetration slowed from its first launch and today Apple issues its own physical metal card. Even the Fintechs including PayPal (PYPL) have contributed significantly to cards in circulation as the cards are a cheap effective way to further connect with customers.
Catalysts
Russell 2000 inclusion - after the close on May 19th PMTS made the preliminary list for inclusion into the Russell 2000 index. We believe this should create significant buy interest in shares.
Strategic M&A - the company has disclosed it could pursue strategic acquisitions. We believe a deal that could consolidate the industry could have significant synergies, creating a larger company, strengthening the industry with greater pricing stability, and increasing share liquidity with increased shares outstanding. A well-structured deal could send the stock significantly higher than our ultimate $75 price target.
Additional Market Share Gains - the company disclosed it increased capital investments that expanded capacity by 50%, sending a strong signal to its customers and competitors for their intent to take additional market share.
Returning Capital - the company should generate over $3.70 of cash earnings in 2023. The reduction of the company's buffer inventory accumulated because of capacity concerns and reduction in capex could allow the company to generate $5 per share of ((FCF)) in 2023, allowing for a dividend or share buy backs.
Risks
FinTech Funding - Fintech's are a growth driver for the company and as the Fed raises interest rates, investments into VC firms could slow, thereby slowing their investments into FinTech companies. However, FinTech companies already have significant war chests to spend on customer acquisition.
Recession Risk - According to the company, the last significant recession of 2007-2009 saw cards in circulation fall by about 10%. We believe the Great Recession was especially difficult on the industry because it was a credit and liquidity fueled recession with several banks collapsing.
Stock Illiquidity - there seems to be a few large institutional holders and several quant related funds. The lack of a broad diversified investor base creates significant idiosyncratic volatility to shares.
Conclusion
PMTS is a very mispriced stock given historical and anticipated results with a below market multiple. Investors who purchase stock now are getting a significant value discount to hold an illiquid stock. The company has many drivers including pricing, market share increases, and contactless conversion that should drive revenue growth for years to come. Sell-side coverage should improve the company's visibility, and if the company can execute, we will see a stock worth $75 once the market realizes earnings will be greater than $5 per share.
Lastly, the company has been discussing potential acquisitions. One potentially interesting situation has emerged with Idemia's private equity owner rumored to be considering selling or breaking the company up. According to the most recent news article on Idemia sales process , the first round of bids for Idemia have been submitted and are indicative of splitting up the company. If a deal whereby PMTS buys part of Idemia could be structured, it could increase operational scale and efficiency, promote greater industry pricing stability, and increase share float, which would alleviate the illiquidity discount for PMTS shares allowing for our target price of $75 to be exceeded. Our long term price target is based on the company earning $5 per share and carrying a 15x multiple, which is below the average market multiple. We believe the company will earn $5 per share in 2024 or 2025.
For further details see:
CPI Card Group: Mispriced Equity Explained