Welcome to the CPI Card Group's Q1 2023 earnings call. My name is Bailey, and I will be your operator today. If you are viewing on the webcast, you may advance the slides forward by pressing the arrow buttons. The call will be open for questions after the company's remarks. If you would like to get in queue for questions, simply press star followed by the number one on your telephone keypad. If you would like to withdraw your question, again, press star and one And now I will 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 Q1 2023 earnings webcast and conference call. Today's date is May 9th, 2023, and on the call today from CPI Card Group are Scott Scheirman, President and Chief Executive Officer, and Amintore Schenkel, Chief Financial Officer. 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 a 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 statement 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 March 31st, 2023, will be available on CPI's investor relations website.
Now I'd like to turn the call over to President and Chief Executive Officer, Scott Scheirman.
Thanks, Mike. Good morning, everyone. During today's call, I will discuss CPI's Q1 performance, reiterate our outlook for the full year, and review our long-term strategy. Amintore will review the financial results in more detail, and then we'll open up the call for questions. We will start on slide four. Overall, I'm very pleased with the Q1 performance. We increased sales by 8% despite comparisons with a very strong Q1 in 2022, which benefited from large eco-focused cards orders and significant Instant Issuance printer upgrade sales. Growth in this year's Q1 was led by ongoing strength in sales of contactless cards, and we also delivered good growth from other areas across our debit and credit portfolio.
We grew Adjusted EBITDA 11% to $25 million and increased the Adjusted EBITDA margin 50 basis points to 20.7%, driven by operating leverage. We increased net income by 81% to nearly $11 million, aided by sales growth, operating leverage, a lower tax rate, and lower interest expense as we have utilized cash flow to reduce our average borrowings. We also improved our overall financial position in the quarter, generating nearly $4 million of positive free cash flow, retiring an additional $8 million of our Senior Notes, and reducing our net leverage ratio to 2.9 x at quarter end. As we mentioned in March, this year we are focused on continuing to execute our strategy, grow the business, win share in the marketplace, increase cash flow, and reduce leverage.
We believe the Q1 demonstrated good progress against each of these goals. As we look to the rest of the year, our sales efforts will remain focused on gaining market share with our differentiated portfolio of innovative products and services and end-to-end solutions and leading quality and customer service. Turning to our outlook on slide five. Today, we are affirming the financial outlook we provided in March. We believe continued strong performance from contactless cards, additional sales of end-to-end solutions, and further penetration of instant issuance will drive sales growth for the full year. However, there is more risk and uncertainty in the market. The banking industry stress that emerged following the collapse of Silicon Valley Bank in March has contributed to more cautious spending environments among issuers.
Although we do not have any significant direct exposure to the three major banks that have failed, we have recently seen softening customer demand in our debit and credit segment, and consequently do not expect Q2 results to be as strong as the Q1. Near term, it's difficult to project the extent of the banking industry stress or how long it will continue to impact us. Given the uncertainty, we have implemented various new initiatives to drive sales and manage expenses more tightly in 2023. Based on what we know today and the strong Q1 performance, we have affirmed the full year outlook we provided in March. Despite the near-term challenges, we continue to believe we operate in an attractive long-term growth market.
Secular card trends have remained healthy, as evidenced by the 11% compounded annual growth rate on Mastercard and Visa US cards in circulation for the three-year period ending December 31st, 2022, and the ongoing movements towards eco-focused cards and contactless cards should continue to aid growth. I would also remind you that the card business is reoccurring in nature, with historically approximately 90% of payment cards issuance being for reissuance and replacements, so there is strong support for the market over time. We have successfully gained share in a growing market over the past five years by focusing on our key strategies, and we expect those to continue to be the foundation for our growth. Specifically, turning to slide six, our key strategic priorities remain deep customer focus, market-leading quality products and customer service, continuous innovation, and a market competitive business model.
We believe the Q1 results demonstrated further advances against these priorities. Although eco-focused card sales were down compared to some very large orders in the prior year, we still sold nearly 7 million of our innovative cards made with recovered ocean-bound plastic core in the quarter and continue to be a leader in the U.S. eco-focused card space. We also continue to leverage our high quality end-to-end solutions, driving growth in contactless cards, personalization services, and our Card@Once SaaS-based instant issuance business. Prepaid was down slightly in the quarter, but we did continue to have success with new customer types. We demonstrated a competitive business model. We generated operating leverage despite ongoing inflationary impacts on key material costs and continued to balance pricing with managing long-term customer relationships.
These four key strategic priorities will continue to guide our actions to grow and gain market share, and we also plan to pursue additional opportunities in the market, such as our expansion of prepaid use cases and development of complementary digital offerings. We remain confident in the long-term growth prospects for the market and in our ability to execute against our strategies to win business and grow share. Now I will turn the call over to Amintore to review our Q1 results and our outlook in more detail. Amintore.
Thank you, Scott, and good morning, everyone. I will begin my overview on slide eight. Q1 net sales increased 8% to $120.9 million compared to the prior year quarter, led by the debit and credit segment, which increased 11%. As Scott mentioned, debit and credit sales growth was driven by strong sales of contactless cards, and personalization services also contributed solid sales growth, as did Card@Once instant issuance solutions. Prepaid debit segment net sales decreased 2% compared with the prior year, and we continue to expect full-year prepaid sales to be similar to 2022 levels. Overall, pricing contributed a little less than half of the sales growth in the quarter, primarily due to pricing actions implemented over the course of 2022.
Q1 gross profit of $43.1 million increased 10% from the prior year, while gross profit margin increased from 35.3% to 35.7%, driven by operating leverage from sales growth, including benefits from price increases, partially offset by the impacts of inflation on materials costs and expenses incurred related to a production staffing model change in our prepaid segment. SG&A expenses increased by approximately $1 million in the quarter compared to the prior year, primarily due to increased headcount and related compensation expenses to support our growth and strategic execution, partially offset by a reduction in professional services expenses, primarily related to third-party SOX costs incurred in the prior year.
Our tax rate was 20.7% in the quarter, which compared to 38.3% in the prior year quarter, due to higher interest expense deductibility and a favorable adjustment to reflect a change in state tax law. We would project a normalized rate excluding any adjustment items of between 25% and 30%, but including the Q1 adjustment benefit, we currently expect the overall 2023 rate to be at the lower end of that range. Net income in the Q1 increased 81% to $10.9 million and Adjusted EBITDA increased 11% to $25.1 million. Adjusted EBITDA margin improved from 20.2% in the prior year to 20.7%, driven by operating leverage from sales, including pricing benefits. Net income growth also benefited from the lower tax rate and lower interest expense.
Turning now to our segments on slide nine. I mentioned the segment sales drivers earlier, so I will just discuss segment profitability on this slide. Income from operations for the debit and credit segment increased 25% in the quarter to $30 million, driven by the higher net sales and operating leverage, including the benefits of price increases. Prepaid debit segment income from operations decreased 38% in the Q1 to $3.7 million. Prepaid income was negatively impacted by approximately $1 million of costs incurred related to the conversion from a temporary to a full-time staffing model at our prepaid production facility and was also negatively impacted by the reduction in sales. We expect the prepaid margins to be stronger over the remainder of the year as we gain efficiencies from the labor conversion and benefit from more beneficial mix and operating leverage.
Turning to the balance sheet, liquidity, and cash flow on slide 10. We made substantial progress with our financial position in the Q1. We generated $8 million of cash flow from operating activities in the quarter and invested $4.1 million on CapEx, which resulted in free cash flow of $3.9 million. This compared to the free cash flow usage of $19.1 million in the prior year period, with a strong improvement driven by increased net income and reduced working capital usage. Accounts receivable balances decreased $4 million from year-end as we collected the receivables related to the high sales levels in the Q4. Inventories only increased $1 million or less than 2%.
On the balance sheet at March 31st, we had $14 million of cash and $13 million of borrowings outstanding on our $75 million ABL revolver. We had $277 million of Senior Secured Notes outstanding at quarter end as we repurchased $8 million of notes in the open market in the Q1. Subsequent to quarter end, we repurchased an additional $7 million in the Q2. Our capital structure and allocation priorities remain focused on maintaining ample liquidity, investing in the business, including possible strategic acquisitions, de-leveraging the balance sheet, and potentially returning funds to stockholders. Overall, the Q1 results were strong, and we have affirmed our 2023 full year outlook. Specifically, for 2023, we continue to expect mid-single-digit net sales growth with higher growth in the debit and credit segment and prepaid sales similar to 2022 levels.
Mid to high single digit Adjusted EBITDA growth, free cash flow to more than double from the 2022 level as we grow earnings and optimize working capital in a more stable supply chain environment, and net leverage ratio improvement to between 2.5x and 3 x as we generate strong cash flow and continue to reduce our Senior Notes balance. Our outlook assumes the turmoil in the banking industry affects Q2 results but does not worsen, and we return to a more normalized environment over the course of the year. I will now pass the call back to Scott for some closing remarks on slide 11. Scott?
Thanks, Amintore. Before opening the call for questions, I would like to welcome Jeff Hochstadt to the CPI team. We announced today that Jeff will become our new Chief Financial Officer effective May 15th, replacing Amintore, who had previously declared his plans to resign in 2023 due to family-related personal reasons. Jeff is a proven strategic leader who brings a vast background of diverse business and financial experience to CPI. He most recently had his own company providing strategic and financial consulting services, which followed his career at Western Union from 2006 through 2021, including roles as Chief Strategy Officer and Senior Vice President and Head of Global Financial Planning. Jeff has also held various financial and strategic positions with First Data, Morgan Stanley, IBM, and PricewaterhouseCoopers, among others.
Amintore will stay with CPI full-time through the end of the Q2 and then will continue as an advisor for a period of time. I want to again thank Amintore for his many contributions to CPI and his commitment to ensure a smooth transition. To summarize today's call, we had a strong performance in the Q1, increasing sales, Adjusted EBITDA margins, and free cash flow, and driving further improvements in our net leverage ratio. Although we have seen some new risks arise from the banking industry turmoil of recent weeks, we are taking responsive actions and have affirmed our full year outlook. Overall, we remain focused on continuing to execute our strategies, grow the business, win share in the marketplace, increase cash flow, and reduce net leverage in 2023. Thank you for joining our call today. We will now open up the call for any questions.
We will now open up the call for your questions. If you would like to ask a question, simply press star followed by the number one on your telephone keypad. If you would like to withdraw your question, again, press star and one. We will pause for just a moment to compile the Q&A roster. Your first question will come from Jaeson Schmidt. Your line is open.
Hey, guys. Thanks for taking my questions and congrats on a really nice start to the year. Scott, just want to dig into your caution around Q2. Is this softening demand more related to pushouts, or are you seeing cancellations as well?
You know what I would describe it is as we move through the month of April, just saw a softening in customer demand or customer orders coming in. You know, some customers that might be not placing an order, some customers that might be pushing the order to, say, the Q3 or Q4. It really seems to have tied back to the Silicon Valley Bank and, you know, subsequent, I'm going to use the word banking turmoil, Jaeson, where customers feel, you know, uncertain about the future. We believe they're probably tightening their spending just to see how things will unroll over the, you know, the weeks, maybe the months to come from that standpoint. Again, I have a lot of confidence in the long-term business.
There's a lot of secular trends in place for sure. You know, cards continue to grow. Card payments are growing at the expense of cash. You know, as we shared in the script, you know, Visa, Mastercard, cards in circulation have grown at 11% CAGR over the last three years, you know, ending December 31st, 2022. I believe contactless cards are still a really, you know, good opportunity for us. We think at the end of 2022, the market was 50%-60% converted to contactless. We think that'll be over 80% by 2025. I'll also just emphasize our eco-focused cards, right?
Broadly, banks, end user consumers, the issuers, the networks, you know, everybody's trying to be more sustainable, and we are definitely a market leader with eco-focused cards issuing, you know, over $95 million. I think there are some near-term challenges, but long term, I'm very positive on the business and believe there's continued opportunity to gain share and grow over the long term.
Okay. That makes sense and all really helpful. I think you probably answered sort of what my next question was gonna be on sort of the confidence that Q2 is simply this air pocket, and you would resume to a more normalized environment. Is this really just due to kind of customers noting that these launches have simply been delayed into the H2 ?
Well, I would say there's some of that, right? You know, there's things that are happening in the market where I would say the regulators and the government are continuing to try and do things to provide more confidence to, you know, end user consumers with banks. They've done, you know, in my view, some of the right things to get these banks recapitalized or take them over. Hopefully, this banking turmoil will, you know, subside in the coming weeks or months, if you will. But again, as we called out, you know, in the earnings release or the script comments that, you know, we assume the turmoil in the banking industry affects the Q2 but does not worsen.
You know, we, you know, we believe we'll return to a more normalized environment over the course of the year. you know, we'll have to, you know, play it out from that standpoint. You know, so far in the month of April, customer demand has been soft.
Okay. Got it. Just the last one from me, and I'll jump back into queue. Just curious if you could expand on some of these new initiatives that you've implemented to drive sales.
Sure, sure. No, and you'll probably appreciate, Jaeson, for competitive reasons, I don't wanna get into a lot of detail here. But, you know, over the last week to 10 days, the teams have been meeting, and they've come up with a number of ideas that I believe will be helpful to drive the top line, you know, incent some demand in the marketplace. And then also we are just closely, like probably many companies are right now, just closely managing our expenses and making some decisions on some expenses that maybe can be pushed off to later in the year or into to 2024. So it's a combination of those. But again, for competitive reasons, I don't wanna get into a lot of detail on how we're driving demand.
Okay. Totally understand. That's it for me. Thanks a lot, guys.
Thanks for joining, Jaeson.
Your next question comes from Leanne Hayden. Leanne, your line is open.
Yeah. Hi, this is Ed Najarian and Leanne Hayden at EF Hutton. How are you?
Good. How are you guys doing this morning?
We're doing great. Thank you. Two quick questions. First on the Senior Secured Notes, could you give us some context about just on a couple things? Number one, how quickly you are kind of contemplating paying that down over the next year or two. I guess secondarily on that, what kind of purchase costs you're seeing on the Senior Secured Notes relative to par. It looks like the ABL revolver is sort of replacing some of that debt to some extent. Are you getting some rate arbitrage there relative to the 8.6% on the Senior Secured Notes? Thanks. That's the first question. Thanks.
Yeah.
Okay.
I'll start. Oh, go ahead, Amintore.
Oh, go ahead, Scott. If you wa nna start. Sorry.
Okay. Hey, thanks for joining the call. Thank you for your question. First, I would say we've, you know, we've been committed to deleveraging the balance sheets, you know, both through growing our profitability and using our free cash flow to reduce our debts outstanding. You know, as we think about 2023, without getting into real specifics, you know, so far we've bought back $15 million of our debt. I'm gonna call it's been a tad bit below a dollar or below par, so we think it's a good value, a good thing for the shareholders to do that. Where we think the net leverage ratio will end up in 2023 as we've guided is somewhere between 2.5x and 3 x. We closed Q1 at 2.9x.
You know, broadly, I would say we continue to be committed to deleverage the balance sheet. Amintore, do you wanna speak about the rate between the Senior Notes and the Revolver?
Yes. I mean, there's a little bit of a differential, you know, I'll let you guys kind of do the math by looking at our disclosures in terms of the rate that we've got on the ABL versus the Senior Secured Notes. There is a positive rate differential between the two if we borrow on the ABL versus having those balances still remaining outstanding on the Senior Secured Notes. You know, as it relates to the repurchases, you know, we have been able to do those repurchases below par.
You know, clearly, as we kind of look forward at, you know, what we will do going forward here in the future, you know, we've indicated that, you know, we do want our leverage ratio to be between 2.5x and 3x by the time we hit to the end of the year. Clearly, we'll look at, you know, what makes sense in terms of either repurchasing notes or utilizing cash for other activities out there. You know, we continue to have one of our key mantras as it relates to our capital strategy, deleveraging our balance sheet.
Okay, great. Thank you. You know, you're at 2.9x on the leverage ratio now. I don't wanna, I guess maybe I'm trying a little bit, putting words in your mouth. Would it be reasonable to think we could get to the lower end of that 2.5x-3x range by the end of the year?
Well, I might give you it depends answer. You know, we gave a range, just so that we've got flexibility, if you will. Again, we're committed to deleveraging the balance sheet. As we think about the uses of our cash or capital, we wanna make sure we've got ample liquidity, but also, you know, invest in the business, whether that's through CapEx or working capital. You know, if there's things that will help us grow the business long term, you know, we're actively looking at how do we deploy that cash so it has the best return to our shareholders at the end of the day.
That's why there's a bit of a range there, just so that as we move through the year, if there's opportunities, we can take a hard look at those and make the best decisions for our shareholders.
Right. Okay. Understood. I appreciate that. Thank you. Then just one more quick question. I don't know if you're maybe willing to go here or not, but in terms of the, you know, a bit of weakness, I guess, in the Q2 relative to the, you know, whole broader situation with regional banks, any ability to put any context or parameters around that, from a, you know, a revenue or a sales standpoint, or just to give us any kind of range of how to think about that magnitude?
Yeah, you're right, I don't wanna go there. What I would tell you is that, you know, we've reaffirmed the full year outlook. You know, Q1 results are actuals now. But our color really has been around that we just expect Q2 results to not be as strong as Q1 just due to softening demand. Again, and part of that just depends upon how we progress through the Q2, the timing of orders and so forth. Again, I wanna get our, you know, investors or potential investors really focused on the long-term opportunities here. There's a lot of great secular trends that we spoke about with contactless cards, eco cards. Clearly, cards will continue to grow in our opinion.
In our instant issuance Card@Once business, SaaS-based business, we've got by far the best solution in the marketplace. You know, over the long term, I believe there's a lot of opportunities for us to grow and continue to gain market share, possibly gain market share just as we have historically.
Okay, great. Thank you very much for taking our questions.
Thank you for dialing in. Appreciate the question.
With no further questions, that concludes today's CPI Card Group's Q1 earnings call. Thank you for joining.
Thank you.