CPI Card Group: Bullish Long-Term Future Despite Challenges (NASDAQ:PMTS)

CPI Card Group (NASDAQ:PMTS) produces Debit, Credit, and Prepaid Debit cards for banks and other customers in the United States. The company has been able to turn its growth around after 2017, improving the company’s bottom line constantly. In 2023, though, CPI Card Group has experienced challenging demand, resulting in a significant stock price fall.

A Great Recovery From 2017

After a weak revenue trajectory in 2016 and 2017, CPI Card Group has been able to increase revenues impressively through organic efforts. From 2017 to trailing figures as of Q3/2023, revenues have grown at a CAGR of 13.7%.

CPI Card Group has achieved great growth as circulating Debit and Credit cards have continued to grow. In the past three years, Visa’s and Mastercard’s United States-based cards have grown at a CAGR of 10% according to CPI Card Group’s Q3 presentation.

With the high growth, CPI Card Group has achieved a good amount of operating leverage – the company’s EBIT margins have gone from slightly negative figures in Q4/2017 to a constant double-digit level. Currently, the trailing EBIT margin stands at 15.7%.

Short-Term Weakness in Q3 and Forward

After a long period of growth, CPI Card Group reported very weak revenues in Q3, with a revenue decrease of -15% after an already weak H1 growth. The company attributes the weak performance to lower card volumes, seemingly driven by a turbulent macroeconomic situation and a pressured purchasing power, along with higher interest rates. In addition, CPI Card Group’s customers bought a large amount of inventory in 2022 and is currently burning through the inventory, contributing to lower year-over-year performance, as told in the company’s Q3 earnings call.

The company expects the soft market to continue at least into Q4, with the market starting to normalize gradually in 2024. For Q4, CPI Card Group guides a similar level in revenues and adjusted EBITDA as for Q3. Year-over-year, the guidance would point to a revenue decrease of around 16.2% and an adjusted EBITDA drop of 22.1%.

The weak sales have also contributed negatively to margins, although the impact is still surprisingly small in my opinion. In Q3, CPI Card Group’s EBIT margin was 12.2%, still proving a good level of profitability with lower sales. The margin is very widely below the Q3/2022 EBIT margin of 18.8%, but I don’t believe that the previous year’s figure is a very good comparison figure, as the margin was CPI Card Group’s record margin in a long period of time. The company’s demonstrated operating leverage from 2017 does still go in both directions; significantly lower revenues than expected could deteriorate the bottom line.

The Stock Seems to Have Significant Undervaluation

The stock seems to be priced very low at the moment – CPI Card Group trades at a low forward P/E ratio of 8.3 despite a good amount of growth in past years. To further demonstrate the incredibly cheap price tag, I constructed a discounted cash flow model in my usual manner.

In the model, I factor in a poor Q4 and a slow recovery in 2024, after which I estimate CPI Card Group to grow modestly for a few years – for 2024, I have a growth of 4%, well below the company’s 2017-Q3/2023 CAGR of 13.7%. As the demand normalizes for 2025, I estimate the growth to accelerate to 8%, after which the growth slows down in steps into a perpetual growth rate of 2% from 2029 forward. For margins, I expect mostly a stable future. For 2024, I conservatively estimate a negative EBIT margin change of half a percentage points, as weak demand persists for at least the first half of the year. After the year, I estimate the EBIT margin to scale back into a figure of 15.0%. I believe that the estimated stable level is fair, as the 2022 level of 16.6% seems slightly boosted by a very strong demand due to supply chain concerns – the 15.0% estimate provides some margin of safety. CPI Card Group has a reasonably good cash flow conversion, as the company’s capital expenditure needs seem quite low.

With the mentioned estimates along with a cost of capital of 10.46%, the DCF model estimates CPI Card Group’s fair value at $28.58, around 63% above the stock price at the time of writing. The company’s management seems to agree with the notation of undervaluation – CPI Card Group has authorized $20 million in share repurchases representing around 10% of outstanding shares with the current stock price, with an agreement to purchase shares from Parallel49, the majority shareholder of the company.

The used weighted average cost of capital is derived from a capital asset pricing model:

In Q3, CPI Card Group had $6.7 million in interest expenses. With the company’s current amount of interest-bearing debt, CPI Card Group’s annualized interest rate comes up to a high figure of 9.84%. The company doesn’t shy away from leveraging debt despite a high interest rate – despite paying some of the company’s long-term debt off, CPI Card Group’s debt-to-equity ratio stays high. I estimate a long-term ratio of 40%.

For the risk-free rate on the cost of equity side, I use the United States’ 10-year bond yield of 4.22%. The equity risk premium of 5.91% is Professor Aswath Damodaran’s latest estimate for the United States, made in July. Yahoo Finance estimates CPI Card Group’s beta at a figure of 1.18. Finally, I add a small liquidity premium of 0.5%, crafting a cost of equity of 11.69% and a WACC of 10.46%.

Takeaway

Despite short-term challenges that seem likely to continue well into 2024, CPI Card Group seems like an intriguing investment opportunity. The company has achieved a great amount of growth from 2017 organically, and any further growth after the weak short-term demand seems to indicate an upside with the currently low valuation. It seems likely that the challenges are mostly a short-term hiccup due to lower issuance volumes and customers’ high inventory levels, but the main risk for the investment case would be a more long-term deterioration in revenues. As I don’t see a long-term earnings fall as a reasonable baseline expectation, I have a buy rating for the time being. With the management’s large share repurchase authorization, CPI Card Group’s management seems to agree about the undervaluation.