CompoSecure, Inc.

Ladies and gentlemen, thank you for standing by, and welcome to Composecure's third quarter 2023 earnings call. I would now like to hand the call over to Composecure's external investor relations advisor, Sean Mansouri with Elevate IR. Please go ahead.

Good afternoon, and thank you for joining us. With me on the call is John Wilk, Composecure's chief executive officer, and Tim Fitzsimmons, chief financial officer. They will begin with prepared remarks, and then we will open the call for Q&A. During the call, we will make statements related to our business that may be considered forward-looking, including statements concerning our plans to execute on our growth strategy and our ability to maintain existing and acquire new customers, as well as other statements regarding our plans and prospects. Forward-looking statements may often be identified with words such as we, expect, we anticipate, or upcoming. These statements reflect our views only as of today and should not be considered our views as of any subsequent date. We undertake no obligation to update or revise these forward-looking statements. Forward-looking statements are not promises or guarantees of future performance and are subject to a variety of risks and uncertainties that could cause the actual results to differ materially from our expectations. For a discussion of material risks and other important factors that could affect our actual results, please refer to the information in our annual report on Form 10-K and other reports filed with the SEC, which are available on the Investor Relations section of our website at composecure.com and on the SEC's website at sec.gov. Please note that the discussion on today's call includes certain non-GAAP financial measures, including adjusted EBITDA, adjusted net income, and adjusted EPS. The company believes these non-GAAP financial measures provide useful information to management and investors regarding certain financial and business trends impacting the company's financial condition and results of operations. These non-GAAP financial measures should not be considered as an alternative to net income or any other performance measures delivered in accordance with U.S. GAAP and may be different from similarly titled non-GAAP measures used by other companies. A reconciliation of GAAP to non-GAAP measures is available in our press release and earnings presentation available on the investor relations section of our website. Thank you, and with that, let me turn the call over to John to discuss our third quarter results.

Thank you, Sean. Good afternoon, everyone, and thank you for joining us for our third quarter conference call. During the quarter, our domestic business once again achieved record results, exceeding our all-time net sales from the third quarter of last year, demonstrating the resiliency and demand for our premium metal payment cards, However, global economic uncertainty weighed on results across our smaller international business, which we will review later in the call. Despite this, we are on track to achieve the most successful year in our company's history in terms of net sales, adjusted EBITDA, and operating cash flow. Now to summarize the quarter on slide three, net sales in the quarter were 97 million, compared to 103 million in the year prior. As I mentioned a moment ago, the decrease was primarily attributable to lower international sales, which offset the record results we delivered domestically. Year to date, our net sales are up 2% to 291 million compared to the prior year. Adjusted EBITDA increased 9% to 35 million compared to 33 million in our prior year, in part due to our operating expense control. Looking at card issuer trends, customer feedback and broader industry sentiment indicate that the demand for premium metal cards remains strong, and they continue to communicate a positive outlook despite the economic uncertainty. That said, select customers are more tightly managing their inventory levels, which has impacted order volumes in both Q3 and Q4. Given these factors, we are adjusting our full year sales guidance for 2023 to a range of $386 million to $392 million and expect adjusted EBITDA to range between $141 million and $146 million which captures the low end of our original guidance for adjusted EBITDA issued earlier this year. Regarding ARCULUS, we projected the net investment to improve from last year, which was 21 million. Due to the combination of revenue growth and optimizing operating costs, we're pacing ahead of that goal and now anticipate the net investment for 2023 to be approximately 15 million. Turning to slide four, on that note, I want to take a moment and highlight a few key developments in the business. For the quarter, several of our customers launched new premium metal card programs, including Amex with Hilton Aspire, Amex with SAS Elite, and Axis Magnus Bank in India, to name a few. We also continued our B2B marketing initiatives and product enhancements for both Arculus Cold Storage and Arculus Authenticate with a focus on lead generation through industry conferences and digital marketing. Our efforts have recently begun to show promising developments while our sales team worked through a growing pipeline of prospective partnerships. Turning to slide five for some further details on Arculus enhancements. We have two things I want to highlight. Arculus Authenticate hardware pass keys received official designation as a Microsoft FIDO2 security key vendor and is now compatible with the Microsoft ecosystem, offering users a reliable and user-friendly passwordless authentication solution. Arculus Cold Storage now supports 95% of crypto by market cap and has added several key enhancements, including support for custom tokens across three additional chains, Ethereum, Polygon, and Binance Smart Chain. We expanded Arculus integration with MetaMask, improving security by enabling the Arculus card as a signing device for safe offline private key storage. And cross-chain DeFi capabilities were enhanced via Wallet Connect across major chains as well.

On slide six, I referred to card issuer trends earlier.

I'd like to provide some more insight. You can see that our largest customers continued to experience purchase volume growth. While the trend has moderated over the past several quarters, it still remains very healthy and well above pre-pandemic levels. On the right-hand side of the slide, you can see that American Express once again reported strong card acquisition numbers this quarter with 2.9 million new proprietary cards during the quarter. In addition, they've indicated they'll continue to spend on marketing given the quality of new card acquisitions and great demand for their products. Keep in mind, this is all publicly available information. We're providing the chart to give some additional insight and understanding based on what our customers are saying publicly. On slide seven, looking at the overall payment market, we highlighted several customer and partner quotes and the themes that we're seeing. First, we're hearing positive sentiment related to market growth. including consumer demand for products and continued marketing investment to drive customer acquisition. Second, a cautious optimism remains despite global economic uncertainty, in part due to a relatively strong U.S. labor market and inflation levels moderating slightly domestically. These factors point towards continued growth for the premium payment card market. I'll now hand it over to Tim to review our financials before returning for closing remarks.

Thanks, John, and good afternoon, everyone. I'll provide a more detailed overview of our Q3 2023 financial performance and then turn it back to John before we open the call for questions. Unless stated otherwise, all comparisons and variance commentary are on a year-over-year basis. Net sales were 96.9 million compared to 103.3 million. Domestic sales increased modestly compared to the record year-ago period, which was offset by lower international sales, which is a more variable market due to global economic uncertainty, customer mix, and a smaller sales base. Gross margin for the quarter was 51% compared to 60% in the prior year. The decrease was primarily due to lower production efficiencies from new card constructions, as well as an impact from inflationary pressures on wages and materials. Income for the quarter increased 74% to $38 million compared to $21.9 million in the prior year. The increase was driven by prudent operating expense controls as reflected by a reduction of selling general and administrative expenses, as well as changes to the fair value of the warrants, earner consideration, and derivative liabilities. Adjusted EBITDA in Q3 increased 9% to 35.5 million compared to 32.7 million in the prior year, and our adjusted EBITDA margin increased approximately 500 basis points to 37% compared to 32% in the third quarter of 2022. The increase in adjusted EBITDA was driven by the aforementioned operating expense controls. On slide 10, you can see our year-to-date performance. Net sales are up 2%, to $290.7 million driven by our strong sales execution and the resilience of our domestic market, partially offset by lower international sales. Our year-to-date gross margin was 54% compared to 60% in the prior year due to the lower production efficiency and inflationary pressure from labor and materials. Net income for the first nine months was $81.5 million compared to $109.5 million in the prior year. The low net income was driven primarily by the non-cash changes to the fair value of the warrant earn-out and derivative liabilities. Adjusted EBITDA for the first nine months increased 2% to $107.9 million compared to $105.6 million in the prior year. Adjusted EBITDA margin for the first nine months of 2023 was 37%, which was flat compared to the prior year. On slide 11, we'll take a closer look at the split between domestic and international sales. You can see that our domestic sales are holding strong despite comping record results from last year and increased modestly to $84.4 million in the third quarter of 2023 compared to the third quarter of 2022. International net sales for the quarter of 2023 were $12.6 million with a decrease primarily due to the global economic uncertainty. Moving on to the balance sheet. We had cash and cash equivalents of $23.8 million and total debt of $345 million, which includes $215 million of term loan and $130 million of exchangeable notes. This results in a total net debt of $321.2 million. As always, we want to provide both our overall debt leverage and our bank agreement secured debt leverage as our bank agreement is calculated with slight differences. At September 30, our overall leverage ratio was 2.31 times based on a net debt of $321.2 million and a trailing 12-month adjusted EBITDA of $138.9 million. This compares to 2.83 times at September 30, 2022, with the improvement driven by paying down debt and increased TTM adjusted EBITDA. At September 30, 2023, we had a bank agreement secured debt leverage ratio of 1.48 times based on a total secured debt of 215 million and trailing 12-month bank-adjusted EBITDA of 145.5 million. This compares to 1.9 times at September 30, 2022. I want to turn now to the earnings per share. As a reminder, Our method under GAAP for calculating basic and diluted EPS allows us to allocate changes and adjustments of mark-to-market instruments among the public company and the operating subsidiaries to better reflect the actual economic impact on the conversion of such instruments on our net income and our per share basis. GAAP EPS for the three months ended September 30, 2023 was $0.39 per basic share and $0.34 per diluted share. This compares to $0.18 per basic and diluted share in the year-ago period. The increase was primarily driven by changes to the fair value of the warrants, earn-out consideration, and derivative liabilities, primarily driven by the change in our stock price. You can read through the footnotes on the slide that take you through the complexities of the allocation of the net income due to the up-sea structure and the shares that are included in the basic and diluted calculation. Turning to slide 14, you can see how we are tracking with GAAP EPS for the year to date, which now puts us at 86 per basic share and 75 cents per diluted share. This compares to $1.02 and 94 cents per basic and diluted share, respectively, in the year-ago period. Again, this was impacted by the same factors I outlined on the previous slide, as non-cash adjustments can have either a positive or a negative impact on net income. On slide 15, we're also providing a non-GAAP adjusted net income and adjusted EPS, which excludes the impact of the non-cash fair value adjustments for the warrants, earn-out, revaluations, and stock comp. We believe this provides a clearer picture of the economics of the company's operating results. With that background, our non-GAAP EPS for the third quarter 2023 was 27 cents per basic share and $0.24 per diluted share. This compares to $0.26 per basic share and $0.22 per diluted share in the year-ago period. In the appendix, you will find a reconciliation between the GAAP and the non-GAAP net income used in these calculations. Turning to slide 16, adjusted EPS for the nine months ended September 30, 2023, puts us at $0.83 per basic share and $0.72 per diluted share. This compares to 86 cents and 74 cents per basic and diluted share, respectively, in the year-ago period. I'll now turn it back to John to discuss our guidance and give closing remarks.

Thanks, Tim. Now, turning to slide 17, as I previously stated, We are revising our 2023 net sales guidance and now expect it to range between 386 and 392 million. And we expect adjusted EBITDA to range between 141 million to 146 million, which still captures the low end of our previously issued adjusted EBITDA guidance. In closing, I want to reiterate a few key takeaways from our call today. We're on track to achieve the most successful year in our company's history in terms of net sales, adjusted EBITDA, and operating cash flow, even following a record year that saw 41% revenue growth and 33% adjusted EBITDA growth. During the third quarter, our domestic business once again achieved record results, demonstrating the resiliency and demand for our metal payment cards, And although select customers have begun to manage tighter inventory levels and macro uncertainty has weighed on the international results, customer sentiment regarding consumer demand remains positive. We continue to expand our marketing and sales capability of both our payment card and Arculus offerings while investing to deliver unique innovations to the market. We remain focused on optimizing our balance sheet, as reflected by another reduction in debt this quarter. And I remind you of our long-term contract renewals that we put in place with our two largest customers that we discussed in the last quarter. With all of that, we believe we are well positioned to execute on our growth and profitability objectives as we move forward. With that, I'd like to open up the call to Q&A.

Thank you. Ladies and gentlemen, if you'd like to ask a question at this time, you will need to press star 1-1 on your telephone and wait for your name to be announced. To withdraw your question, please press star 1-1 again. Please stand by while we compile the Q&A roster. And our first question coming from the line of John Todaro with Needham Yulan is open.

Great. Thanks for taking my question. Congrats, guys, on a record year. So, John, obviously you've been in the business for quite some time. Just wondering on the macro uncertainty and weakness, if we could get a bit more color on, you know, kind of how far ahead card issuers typically manage their inventory, any kind of sight line or thoughts on 2024 trends. And then I have one more question on the authentication side.

Sure. So, typically, Customers can keep anywhere from, let's say, three to six months of inventory, John. And at certain times, they'll tweak that up slightly. At certain times, they'll tweak it down slightly. And that has the potential to impact any given quarter. We think that is, call it transitional type impact as that happens over time. They'll adjust levels up or down. On the international front, we've talked about two things. One, just generally that part of our business is made up by a number of customers, smaller customers, but more of them. And generally that has more variability. With some of the economic uncertainty on a global basis right now, we just see a modest slowdown in that business. but it will still, you know, we think perform well for the year coming in right around 20% of total revenue for the year, which is our long-term guide. And that's where we ultimately think it comes in, but it'd be slightly down from last year.

Got it. And then just one more on digital authentication. So, you know, in the past thing is last year, you specifically called out some of the non-crypto opportunities on that side is being quite a large opportunity set. So just curious kind of how that's shaped up quarter over quarter, any kind of update in how you're framing the cold storage versus the digital authentication non-crypto.

Continue to remain very excited about the opportunities in the authentication space. having meaningful conversations across large institutions and fintechs domestically and internationally right now. The movement or implementation of these, as I've mentioned in prior quarters, takes longer. It requires sort of technology change within institutions. It is taking some time. But I'd say those conversations continue to go very well. And, you know, in our view, we're starting to see that in the overall sort of net investment numbers for Arculus, which are heading in the direction that we want.

Great. Thanks, Dave. Thank you, John.

Thank you. One moment for our next question. And our next question coming from the line of Reggie Smith with J.P. Morgan. Your line is open.

Hey everyone, this is Charlie on for Reggie. Thanks for taking the question. I'm curious if we can dig in a little bit more on the international slowdown. Was there any specific geographies that pulled back and are there any large money center banks out there that could be an opportunity moving forward or is that not so much an option out there? Thanks.

Yeah. So Charlie, thanks for the question. I'd say we saw some of those impacts really across Europe and a little bit in Asia. To answer the second part of the question, yes, we think we opened up new business with a couple of money center banks in Europe last quarter and expect those kinds of opportunities to bear fruit in our international business over time. So it is just a more variable base for us given, you know, it's more spread out, more customers dealing with, you know, different economic conditions within different countries and regions.

Got it.

That's helpful. And if I can sneak in one more.

Sure.

Is there any, like, Do you see any risk to that sentiment spreading to the U.S.? And looking back, were there any cracks or maybe subtle signs that could have predicted this lowdown? I mean, you mentioned the variability, but any color there would be helpful. Thanks.

Yeah, Charlie, we're not seeing it domestically as evidenced by kind of what we announced today, which was third quarter of last year was our strongest domestic quarter ever. We beat that this year. you know, with, in our view, a really strong domestic quarter. We, as I mentioned, you know, renewed contracts with our two largest customers. That was one of the big outstanding questions for us as we moved into this year. And as I mentioned earlier, we couldn't be more pleased with that. As we look at, you know, whether or not we could have predicted it I think you're seeing across a variety of industries, you know, not you know, we're still seeing consumer spending. We're still seeing resiliency there. You're just seeing a little bit of cautiousness in this point about inventory management. I think you're seeing across a variety of industries, not necessarily specific to card manufacturing, which is not a major pullback, but just, you know, improving cost controls in an uncertain world. So, no, we don't see that impact domestically. And, you know, hindsight is 20-20. But we think we're seeing this impact not just specific to card manufacturing. That's great. Thanks for taking the questions. I appreciate it.

Thank you. I'm on for our next question. And our next question coming from the line of Our coach would be Riley Yelena-Silken.

Hey, John. Give us your thoughts on maybe what you think inventories in the channel are now after some of this cautiousness. I mean, the quarter for you guys was good domestically. The channel inventories were high. That's probably why it was not meeting your expectations, this inventory drawdown. But what do you think inventories are right now? Thank you.

We don't have visibility into inventory levels across all of our customers. It's data that they generally hold tight across a few. We do have some visibility, but I think ranges in the areas that I talked about could be three to six, three to seven months of inventory that they can dial up or down. depending on how they're feeling going into end of year.

Okay. Thank you very much.

Thank you, Hal.

Thank you. One moment for our next question. And our next question, coming from the lineup, Chase White with Compass Point Research and Trading LLC, Yolanda Sopin.

Thanks for taking the question, guys. So on the updated guidance, what factors would drive you to the top end of the range in revenues and EBITDA versus the bottom end?

For us, you know, it's largely locked from, you know, orders and production. There are sort of a few things that we need to close out that would take you to higher end of the range and then uh just from a production standpoint you know being able to run without uh uh without challenges and and one of the things that you know we talked about here briefly and i just i just want to mention is as we innovate so as we deliver new products to the market that we're excited about you know we we will see some up and down in our margin as you know, times when we launch new products, you know, we'll see, you know, small bumps down in that. Other times you'll see small bumps up. But we will continue to deliver innovative new products. That is, you know, the lifeblood of this company. It helps drive our future growth. And so, you know, making sure that is, you know, those products are ramping up they're running through efficiently in the factory. So closing out a few orders here and then making sure that we run efficiently between now and the end of the year would deliver us closer to the high end of the ranges.

Got it. That's helpful. And can you just remind us what needs to happen before you're able to return capital to shareholders, whether it be buybacks or dividends or both?

Chase, I appreciate the question. On capital allocation, we've said specifically our two priorities are organic growth and paying down debt. And beyond that, we have conversations at the board, as you could imagine, regarding capital allocation and what we might do and when. And as the board were to make decisions that would alter those priorities, we'll certainly let you and the market know. But at this point, those are still our priorities.

Got it. Thank you.

Thank you.

Thank you. And as there appear to be no further questions in queue, this does conclude today's conference call. Thank you all for participating. You may now disconnect.