CPI Card Group Inc. - Annual Report: 2018 (Form 10-K)

 

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-K

 

Commission File Number 001-37584

 

CPI Card Group Inc.

(Exact name of the registrant as specified in its charter)

 

 

 

Registrant’s telephone number, including area code (303) 973-9311

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to section 12(g) of the Act:  None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes ☐   No ☑

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.

Yes ☐   No ☑

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☑   No ☐

 

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☑   No ☐

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (section 229.405 of this Chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ☑

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☑

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐   No ☑

 

The aggregate market value of the Registrant’s common stock held by non-affiliates was $8.1 million on June 30, 2018 computed based on the closing sale price of the Registrant’s common stock of $2.00 on NASDAQ on that date.

As of February 22, 2019, the number of shares outstanding of the Registrant’s common stock was 11,160,537.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the registrant’s definitive Proxy Statement for its 2019 Annual Meeting of Stockholders are incorporated by reference into Part III of this Form 10-K.

 

 

 

 

TABLE OF CONTENTS

 

 

 

Cautionary Statement Regarding Forward-Looking Information

 

Certain statements and information in this Form 10-K may constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, as amended (the “1933 Act”) and Section 21E of the Securities Exchange Act of 1934, as amended (the “1934 Act”). The words “believe,” “estimate,” “project,” “expect,” “anticipate,” “plan,” “intend,” “foresee,” “should,” “would,” “could” or other similar expressions are intended to identify forward-looking statements, which are generally not historical in nature. These forward-looking statements are based on our current expectations and beliefs concerning future developments and their potential effect on us, and other information currently available. Such statements reflect our current views with respect to future events and are subject to certain risks, uncertainties and assumptions. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those described herein as anticipated, believed, estimated, expected or intended. We are making investors aware that such forward-looking statements, because they relate to future events, are by their very nature subject to many important factors that could cause actual results to differ materially from those contemplated.

 

These risks and uncertainties include, but are not limited to: our substantial indebtedness, including inability to make debt service payments or refinance such indebtedness; the restrictive terms of our credit facility and covenants of future agreements governing indebtedness and the resulting restraints on our ability to pursue our business strategies; our limited ability to raise capital in the future; system security risks, data protection breaches and cyber-attacks and possible exposure to litigation and/or regulatory penalties under applicable data privacy and other laws for failure to prevent such incidents; interruptions in our operations, including our IT systems, or in the operations of the third parties that operate the data centers or computing infrastructure on which we rely; our failure to maintain our listing on the NASDAQ Capital Market; our inability to adequately protect our trade secrets and intellectual property rights from misappropriation or infringement, claims that our technology is infringing on the intellectual property of others, and risks related to open source software; defects in our software; problems in production quality and process; our failure to retain our existing customers or identify and attract new customers; a loss of market share or a decline in profitability resulting from competition; our inability to recruit, retain and develop qualified personnel, including key personnel; our inability to sell, exit, reconfigure or consolidate businesses or facilities that no longer meet with our strategy; our inability to develop, introduce and commercialize new products; the effect of legal and regulatory proceedings; developing technologies that make our existing technology solutions and products less relevant or a failure to introduce new products and services in a timely manner; quarterly variation in our operating results; infringement of our intellectual property rights, or claims that our technology is infringing on third-party intellectual property; our inability to realize the full value of our long-lived assets; our failure to operate our business in accordance with the PCI Security Standards Council (“PCI”) security standards or other industry standards such as Payment Card Brand certification standards; costs relating to the obligatory collection of sales tax and claims for uncollected sales tax in states that impose sales tax collection requirements on out-of-state retailers; disruption or delays in our manufacturing operations or supply chain; a decline in U.S. and global market and economic conditions and resulting decreases in consumer and business spending; costs relating to product defects and any related product liability and/or warranty claims; maintenance and further imposition of tariffs and/or trade restrictions on goods imported into the United States; our dependence on licensing arrangements; risks associated with international operations; non-compliance with, and changes in, laws in the United States and in foreign jurisdictions in which we operate and sell our products; risks associated with the controlling stockholders’ ownership of our stock; and other risks that are described in Part I, Item 1A – Risk Factors and our other reports filed from time to time with the Securities and Exchange Commission (the “SEC”).  

 

We caution and advise readers not to place undue reliance on forward-looking statements, which speak only as of the date hereof. These statements are based on assumptions that may not be realized and involve risks and uncertainties that could cause actual results to differ materially from the expectations and beliefs contained herein. We undertake no obligation to publicly update or revise any forward-looking statements after the date they are made, whether as a result of new information, future events or otherwise.

 

EMV® is a registered trademark or trademark of EMVCo LLC in the United States and other countries.

 

 

CPI Card Group Inc. qualifies as a Smaller Reporting Company in accordance with Rule 12b-2 of the Exchange Act, and has elected to follow certain of the scaled back disclosure accommodations within this Form 10-K.

PART I

Item 1.Business

As used herein, “CPI,” “we,” “our” and similar terms refer to CPI Card Group Inc. and its subsidiaries, unless the context indicates otherwise.

Overview

We are a leading provider of comprehensive Financial Payment Card solutions in the United States. We define “Financial Payment Cards” as credit, debit and Prepaid Debit Cards issued on the networks of the “Payment Card Brands” (Visa, Mastercard ®, American Express and Discover) and Interac (in Canada). We define “Prepaid Debit Cards” as debit cards issued on the networks of the Payment Card Brands, but not linked to a traditional bank account. We have established a leading position in the Financial Payment Card market through more than 20 years of experience. Our customers include leading national and regional banks, independent community banks, credit unions, managers of prepaid debit programs, “Group Service Providers” (organizations that assist small card issuers, such as credit unions, with managing their credit and debit card programs, including managing the Financial Payment Card issuance process, core banking operations and other financial services) and card processors. We serve a diverse set of over 2,000 direct customers and several thousand indirect customers, including some of the largest issuers of debit and credit cards in the United States and Canada, and the largest U.S. Prepaid Debit Card program managers, as well as thousands of independent community banks, credit unions, Group Service Providers and card processors.

We serve our customers through a network of production and card services facilities, including high-security facilities in the United States which are certified by one or more of the Payment Card Brands and, where required by our customers, certified to be in compliance with the standards of the Payment Card Industry Security Standards Council (the “PCI Security Standards Council”). This leading network of high-security production facilities allows us to serve the needs of our diverse customer base.

Driven by a combination of our strong relationships, quality, technology, and innovation, we believe we have strong positions in the following markets:

On August 3, 2018, we completed the sale of the U.K. Limited segment. The historical financial position, results of operations, and cash flows for the U.K. segment have been restated for all periods to conform with discontinued operations presentation. Unless otherwise indicated, financial information within this document relates to continuing operations.

Our business consists of the following reportable segments: U.S. Debit and Credit, which primarily produces Financial Payment Cards and provides integrated card services to card-issuing banks in the United States, and U.S. Prepaid Debit, which primarily provides integrated card services to Prepaid Debit Card program managers in the United States.  Business not considered part of these segments are considered “Other” and include our operations in Canada and corporate expenses.

In the fourth quarter of 2018, we entered into a definitive agreement to sell our Canadian subsidiary to Allcard Limited, a provider of card solutions to the gift and loyalty sectors. The sale agreement did not include customers for which we only manufacture and personalize Financial Payment Cards.  The transaction is expected to close in the first half of 2019.  The agreement to sell our Canadian subsidiary does not meet the criteria to be reported as a discontinued operation. The Financial Payment Card business customers of our Canada operations will either migrate to our

operations in the U.S. or migrate to other service providers before the transaction closes. The divestiture allows us to further optimize our footprint and is consistent with our previously announced plan to better position ourselves to serve customers by focusing on our core businesses. 

During February 2018, we made the decision to consolidate our three personalization operations in the United States into two facilities to better enable us to optimize operations and achieve market-leading quality and service with a market-competitive business model.  This consolidation was completed in 2018.

For information regarding our net sales by geographic location and additional details regarding our segments, see Part II, Item 8, Financial Statements and Supplementary Data, Note 16 "Segment Reporting," and Part II, Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations in this Annual Report on Form 10-K. 

Our Competitive Strengths

Our Strategy

We are a payment technology company that provides end-to-end debit, credit and prepaid payment solutions delivered physically, digitally and on-demand. Our goal is to be our customers’ partner of choice by providing market-leading quality products and customer service with a market-competitive business model. We believe we are well-positioned for success given our diversified business model, history of innovation and ability to evolve with the needs and expectations of our customers. By helping our customers elevate the customer experience, we foster compelling connections between people and technology through traditional and next generation solutions that build brands and enhance people’s everyday lives. 

A Customer-Centric Culture

We aim to inspire and satisfy our customers by redefining experiences that may have traditionally seemed rigid and complex, and offering market-leading quality and service. Based on our core values of customer first, accountability, teamwork, excellence, integrity and results, our strong team of dedicated, passionate employees has helped build CPI into a leading provider of high quality products with a laser-focus on service. With our full and expanding suite of catalytic and competitively differentiated products and services, we offer our customers choice, convenience and control by providing flexibility in timing, design, product options, and overall utility.

Innovation and Growth

We strategically invest in innovation and quality to create a strong foundation for growth.  We continuously work to enhance our offerings and to create and deliver next generation products and solutions that meet the demands of the marketplace and exceed customers’ expectations.

Our Products and Services

EMV® Financial Payment Cards (Contact, Contactless, and Dual-Interface)

We produce both plastic and metal contact EMV cards, which feature an integrated circuit that interfaces with an EMV payment terminal over a contact plate on the surface of the card when inserted into an EMV-enabled payment terminal. We also produce contactless EMV cards, and dual-interface EMV cards, which feature an RFID antenna that utilizes near field communications (“NFC”) technology to allow transactions to process on a contactless basis when the card is brought within the requisite proximity to an NFC-enabled payment terminal.  The dual-interface EMV cards additionally include the contact EMV technology.

Non-EMV Financial Payment Cards and Retail Gift Cards

We produce non-EMV cards that utilize magnetic stripes, contactless cards which utilize NFC technology, and cards that include both magnetic stripes and NFC technology. In addition, we produce non-EMV cards that are issued on the networks of the Payment Card Brands, as well as retail gift cards (which are not issued on the network of the Payment Card Brands).

Card Data Personalization and Fulfillment

We provide data preparation and card data personalization solutions for debit, credit and Prepaid Debit Cards in contact EMV, dual-interface EMV, and non-EMV card formats. Our personalization services are technology-driven and provide a wide range of card customization options, using advanced processes to personalize (encode, program and emboss with data such as cardholder name and account number) and fulfill cards to individual cardholders. Our services provide customers with visibility to manage card stock inventory and fulfillment materials.  In addition, we provide EMV data script development services for our customers and in certain cases generate PIN numbers and mailers on their behalf. We offer patented card design software, known as MYCA™, which provides our customers and their cardholders the ability to design cards on the internet and customize cards with individualized digital images. We also provide consultation and card design services to further assist customers in card customization.

Tamper-Evident Security Packaging Solutions

We offer specialized and innovative tamper-evident security packaging products and services to customers with a Prepaid Debit Card offering that reduce fraud for Prepaid Debit Cards sold through the retail channel. In certain cases, we also manage the fulfillment of fully-completed Prepaid Debit Card packages to retail locations on behalf of our customers utilizing this solution.

Instant Card Issuance Systems and Services

We offer Card@Once ®, our proprietary and patented instant card issuance system and services, which provides our card issuing bank customers the ability to issue a completely personalized permanent debit or credit card within the bank branch to individual cardholders upon demand. Our instant issuance system is enabled by cloud-based software that securely transfers data from our servers to the card branch to encode a magnetic stripe, an EMV card, or a dual-interface EMV card, and personalizes the card on a desktop output terminal in a process which is certified by Mastercard ® and Visa. Our instant issuance system generates both system sales and recurring revenue from software as a service, card personalization and sales of cards and consumables.

CPI On-Demand TM Solutions

Through our CPI On-Demand services, we are able to produce images, personalized payment cards and related collateral on a one-by-one, on demand basis for our customers, enabling individualized offerings and reducing waste and inventory.  Our service offering includes online ordering of a customized payment card through a program manager, with direct fulfillment to a consumer.  While not significant to our 2018 financial results, we believe the CPI On-Demand solution will further differentiate us with our financial institution customers, and we believe it will enable us to further penetrate new, business-to-business and business-to-consumer verticals such as healthcare, transit, payroll, corporate incentives, benefits and insurance. 

Digital Services

While not currently significant to our financial results, we are focusing on enabling digital services and payments, including self-service card customization, on demand fulfillment, order lifecycle management, customer inventory management, EMV® key management, and other innovative solutions, such as digitizing and securely delivering payment credentials as a virtual payment method.

Suppliers

One of the most important components of our products is the EMV microchip. While we have developed constructive relationships with our suppliers and, in general, receive a high level of cooperation and support from them, the objective of our procurement strategy is not to depend on any single supplier. We obtain our components from multiple suppliers located in South Korea, France, Germany, and Singapore, primarily on a purchase order basis. Our main suppliers of EMV microchips are four leading international manufacturers. Approximately 88% of our purchased EMV microchips for the year ended December 31, 2018 came from these four main suppliers. The other key components for our products are substrates (such as PVC), antennas and inlays which we also source from multiple suppliers. We continuously monitor supply chain risks and evaluate alternative suppliers based on numerous attributes including quality, performance, service, scalability, features, innovation and price.

Customers

In the United States, we categorize our customers as follows: large issuers, small to mid-sized issuers, prepaid debit issuers, program managers, Group Service Providers, and card processors. Our diverse customer base includes some of the largest issuers of credit and debit cards in the United States and the largest U.S. Prepaid Debit Card program managers. Our top customer represented approximately 19% of our net sales for the year ended December 31, 2018. Our top five customers represented approximately 39% of our net sales for the year ended December 31, 2018, and we have been serving these customers for an average of greater than 10 years.

We generally enter into master purchase or service agreements that govern the general terms and conditions of our commercial relationships. We then enter into a purchase order or other short-term arrangements that define the quantities of products to be delivered or services rendered, and other terms specific to the order as appropriate. Usually, our contractual arrangements include neither exclusivity clauses nor commitments from our customers to order any given quantities of products on a medium or long-term basis.

Production and Services

Our production and services strategy has several key facets. We have a large network of integrated high-security facilities that we leverage to balance customer orders, expand the array of products and services available to our customers, provide consistent supply and execute short lead times. Our facilities and operating processes are designed to provide a differentiated level of service to each of our key customer sets. For example, we have the processes and capabilities to:

As of December 31, 2018, we operate approximately 446,000 square feet of facilities in the United States and Canada where we focus on Financial Payment Card production and personalization services. See Part I, Item 2, “Properties” of this Annual Report on Form 10-K for information on the operations of each facility.

We rely on secure ground and secure air freight to deliver finished products to our banking customers. Due to the high-security nature of the Financial Payment Card products we provide to our banking customers, certain products must be shipped to these customers via a secure method, such as armored vehicle. With respect to customers for whom we fulfill individual and personalized debit and credit cards, we utilize the U.S. and Canadian postal services to deliver these cards directly to individual cardholders. For other customers, we predominately deliver our products via regular ground and air freight.

Sales and Marketing

We market ourselves as a leader and trusted partner in payments, seeking to meet or exceed the needs of our customers through high quality and meaningful, innovative products at competitive prices. We work to strategize and collaborate with our customers to bring them valuable and innovative solutions. We have approximately 30 sales representatives that give us a wide geographic reach across the United States and Canada. Our sales representatives offer a complete end-to-end solution that incorporates the full spectrum of our products and services from concept to delivery. Our sales and marketing strategy focuses on strengthening our relationships with existing customers through a consultative approach that includes cross-selling expanded services. We leverage the strength of our full-service offerings to attract new customers. Our marketing efforts focus on the needs of our specific types of customers. By tailoring our marketing strategy to different customer segments, we are able to provide relevant targeted solutions to meet their individual needs. We utilize an array of different marketing communications and thought leadership across various industry publications, editorial white papers, case studies, conferences and trade shows, print and digital advertisements, educational webinars, podcasts, and blogs to introduce our existing customers and new customers to

innovations in the payments market. Through these efforts, we drive customer retention and satisfaction, and have been able to attract new customers.

Competition

The market for products and services in the payment card industry is highly competitive. Some of our competitors possess substantially greater financial, sales and marketing resources than we do, and therefore have substantial flexibility in competing with us, including through the use of integrated product offerings and competitive pricing. Competitive factors for our business include product quality, security, service reliability, product line comprehensiveness and integration, timely introduction of new products and features, and price.

Our products and services compete with other card manufacturers and card solutions providers. We believe we are in competition with IDEMIA (formerly known as Oberthur Technologies S.A.), Giesecke & Devrient GmbH,  Valid S.A., Gemalto NV, CompoSecure L.L.C., Multi Packaging Solutions, Inc., and Arroweye. Certain existing and potential customers also have the ability to personalize Financial Payment Cards in-house. In addition, we compete with customers that offer transaction processing products and services to financial institutions. 

Intellectual Property

We own and control various intellectual property rights, such as patents, trade secrets, confidential information, trademarks, service marks, tradenames, copyrights and applications. We have been party to certain patent cross-license arrangements with industry participants and may, from time to time, enter into similar commercial agreements should we consider it necessary or beneficial for our business.

We rely on a combination of statutory (copyright, trademark and trade secret) and contractual safeguards for intellectual property protection throughout the world. As of December 31, 2018, we had 35 U.S. and foreign trademark registrations and applications, 25 existing U.S. patents, 18 foreign patents, as well as 21 pending U.S. and foreign patent applications. Our patents have an average remaining maturity of 12 years, and our trademarks will be due for renewal for additional ten or fifteen-year periods on an ongoing basis.

Environmental Protection

Our manufacturing operations are subject to environmental protection regulations, including those governing the emissions of pollutants into the air, wastewater discharges, the use and handling of hazardous substances, waste disposal, the investigation and remediation of soil and groundwater contamination. We are also required to obtain environmental permits from governmental authorities for certain of our operations.

Regulation

Privacy and Data Security

In the course of our business, we receive personally identifiable information of cardholders from our customers, either from a financial institution or through a card processor on behalf of a financial institution. Such information includes names, email and physical addresses, card account numbers and expiration dates. As a service provider to financial institutions in the United States, we are subject to certain Federal Trade Commission requirements, the privacy provisions of the Gramm-Leach-Bliley Act (the “GLBA”) and its implementing regulations and, as applicable, with various other federal and state privacy statutes and regulations, and the PCI Security Standards Council’s Data Security Standards, each of which is subject to change at any time. Outside of the United States, we are subject to privacy laws and regulations of numerous countries and jurisdictions. The interpretation and application of these privacy and data protection laws are often uncertain and in a state of flux. 

In order to comply with our obligations under applicable privacy laws and regulations and our contractual agreements with our customers, we are required to implement adequate policies and safeguards to protect the privacy of personally identifiable information we receive. As part of their compliance with these requirements, each of our U.S. customers is expected to have a program in place for protecting personally identifiable information and responding to unauthorized access to, or use of, personally identifiable information that could result in substantial harm or inconvenience to consumers, as required by law. A majority of U.S. states have enacted security breach legislation,

requiring varying levels of consumer notification in the event of a security breach, which could result in significant costs to us and significant damage to our reputation.

We are also subject to requirements from the Payment Card Brands, which require us to meet certain security standards in order to achieve certification that allows us to produce and personalize Financial Payment Cards issued on their networks. These standards include extensive requirements with respect to the physical characteristics of our facilities, as well as our electronic treatment and storage of cardholder data. We believe that we have developed significant expertise in acquiring and maintaining these certifications, and have invested significant capital to obtain and retain these designations, which are regularly verified by both the Payment Card Brands and our customers. We believe the long, complex and costly certification process may serve as a significant barrier to new entrants to our market.

The interpretation of pending and existing laws and regulations is evolving and, therefore, these laws and regulations may be applied inconsistently. It is possible that our current data protection policies and practices may be deemed inconsistent with new legal requirements or interpretations thereof, and breaches in the security of our systems and technology could result in a violation of these laws and regulations. Changes to these laws and regulations, as well as any associated inquiries or investigations or any other government actions, may be costly to comply with and may delay or impede the development of new products, result in negative publicity, increase our operating costs, require significant management time and attention, and subject us to remedies that may harm our business, including fines or demands or orders that we modify or cease existing business practices.

Financial Services

We are generally not directly subject to federal or state regulations specifically applicable to financial institutions such as banks, thrifts, and credit unions. However, as a provider of products and services to these financial institutions, our operations may be examined by various state and federal regulatory authorities and representatives of the Federal Financial Institutions Examination Council, which is a formal inter-agency body empowered to prescribe uniform principles, standards and report forms for the federal examination of financial institutions and to make recommendations to promote uniformity in the supervision of financial institutions. Also, state and federal regulations require our financial institution clients to include certain provisions in their contracts with service providers like us and to conduct ongoing monitoring and risk management for third party relationships. In addition, we engage independent auditors annually to review certain of our operations to provide internal control evaluations for our customers’ auditors.

In conducting certain of our card services, we are directly subject to various federal and state laws and regulations including those relating to the movement of money. In order to comply with our obligations under applicable laws, we are required, among other things, to comply with licensing and reporting requirements, to implement operating policies and procedures to comply with anti-money laundering laws, to protect the privacy and security of our clients’ information and to undergo periodic audits and examinations.

In 2010, the Dodd-Frank Act was enacted. The Dodd-Frank Act introduced substantial reforms to the supervision and operation of the financial services industry, including introducing changes that: affect the oversight and supervision of financial institutions; provide for a new resolution procedure for large financial companies; introduce more stringent regulatory capital requirements; implement changes to corporate governance and executive compensation practices; and require significant rule-making. The Dodd-Frank Act has generated numerous new regulations that have imposed compliance costs. The Dodd-Frank Act established the Consumer Financial Protection Bureau (“CFPB”) which is empowered to conduct rule-making and supervision related to, and enforcement of, federal consumer financial protection laws. The CFPB has issued guidance that applies to “supervised service providers” which the CFPB has defined to include service providers, like us, to CFPB supervised banks and nonbanks. The CFPB has in the past and may in the future issue regulations that may require us to make compliance investments. It is difficult to predict with certainty the extent to which the Dodd-Frank Act, the CFPB or the resulting regulations will impact our business or the businesses of our current and potential clients.

Employees and Labor

As of December 31, 2018, our businesses employed approximately 1,100 employees.  We have never experienced any work stoppages or strikes as a result of labor disputes.  We consider our relations with employees to be good.

Available Information

CPI Card Group Inc. is a Delaware corporation.  We were initially formed as CPI Holdings I, Inc. in June 2007 and changed our name to CPI Card Group Inc. in August 2015.  Our principal executive offices are located at 10026 W. San Juan Way – Suite 200, Littleton, CO 80127, telephone (303) 973-9311. The Company's Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to those reports are available free of charge through the "Investor Relations" portion of the Company's website, as soon as reasonably practical after they are filed with the SEC. The SEC maintains a web site, www.sec.gov, which contains reports and information statements, and other information filed electronically with the SEC by the Company.

Item 1A.  Risk Factors

Our outstanding indebtedness may impact our business and our results of operations and may restrict our ability to grow; the covenants and restrictions of our credit facility and other loans could make it difficult or impossible to timely make our debt service payments or refinance our debt when it comes due.

We maintain a substantial amount of debt, and we may incur additional debt in the future to help fund our business.  Our substantial indebtedness and interest expense could have important consequences to us, including:

In addition, the terms of our First Lien Credit Facility restrict, and covenants contained in agreements governing indebtedness in the future may restrict, our ability to operate our business and to pursue our business strategies.  Among other things, our First Lien Credit Facility restricts our ability to:

 

Our failure to comply with any of these covenants could result in an event of default which, if not cured or waived, could result in the acceleration of all of our indebtedness under the First Lien Credit Facility.  Moreover, these restrictions, as well as the limitations described above, could have a material adverse effect on our business, financial condition, results of operations and prospects.  If we are unable to satisfy our obligations under our indebtedness as they become due, or if we are unable to pay our interest obligations we would be rendered insolvent.

Our ability to raise capital in the future may be limited.

Our business and operations may consume resources faster than we anticipate.  In the future, we may need to raise additional funds through the issuance of new equity securities, debt or a combination of both.  As a result of our financial condition, additional financing may not be available on favorable terms, or at all.  If adequate funds are not available on acceptable terms, we may be unable to fund our capital requirements.  Any failure to achieve adequate funding will delay our product and services innovation and development and could lead to abandonment of one or more of our strategic initiatives.  Any of these events could materially harm our business, financial condition and prospects.

System security risks, data protection breaches, and cyber-attacks could compromise our proprietary information, disrupt our internal operations, harm perception of our products, and expose us to litigation and/or regulatory penalties, which could have a material adverse effect on our business and our reputation.

In operating a Financial Payment Card business, we manage large amounts of personally identifiable information of cardholders, including cardholder names, account numbers and similar information.  The reliability and security of our information technology (“IT”) infrastructure and our ability to protect sensitive and confidential information for our customers, which include many financial institutions, is critical to our business.  Our handling of such information makes us a potential target of cyber-attacks or cyber intrusions via the Internet, computer viruses, break-ins, malware, phishing attacks, hacking, denial-of-service attacks or other attacks and similar disruptions from unauthorized use of or access to computer systems (including from internal and external sources).  A breach of our security defenses could result in a loss of our intellectual property, the release of sensitive cardholder information, customer or employee personal data, or the loss of production capabilities at one or more of our production facilities.  These types of incidents have become more prevalent and pervasive across industries, including in our industry.

In addition, our encryption systems are at risk of being breached or decoded.  Smart cards are equipped with keys that encrypt and decode messages in order to secure transactions and maintain the confidentiality of data.  The security afforded by this technology depends on the integrity of the encryption keys and the complexity of the algorithms used to encrypt and decode information.  Any significant advances in technology that enable the breach of cryptographic systems, malicious software infiltration or that allow for the exploitation of weaknesses in such systems could result in a decline in the security we are able to provide through this technology.  Any material breach of our secured systems could harm our competitive position, result in a loss of customer trust and confidence, and cause us to incur significant costs to remedy the damages caused by system or network disruptions, whether caused by cyber-attacks, security breaches or otherwise, which could ultimately have a material adverse effect on our business, financial condition and results of operations.

The protective measures we have implemented to protect against data and security breaches and cyber-attacks may not prevent system or network disruptions and may be insufficient to prevent or limit the damage from any future security breaches.  We regularly evaluate, assess and test our systems and the controls, processes and practices to protect those systems.  The evaluations, assessments and testing identify areas of weakness in, and suggested improvements to, the maturity of our systems, processes, and risk management framework as well as vulnerabilities in those areas that could be attacked and exploited to access and acquire proprietary and confidential information.  Although cybersecurity and the continued development and enhancement of our controls, processes and practices designed to protect our systems, computers, software, data and networks from attack, damage or unauthorized access are a high priority for us, our activities and investment may not be deployed quickly enough or successfully protect our system or network against disruptions and may be insufficient to prevent or limit the damage from any future security breaches.  In addition, as these threats continue to evolve, we may be required to invest significant additional resources to modify and enhance our information security and controls or to investigate and remediate any security vulnerabilities.

In addition, we are subject to significant security and privacy regulations.  Some state and federal laws impose, or in the future may impose, privacy and security requirements on us.  For example, California recently enacted the California Consumer Privacy Act (“CCPA”), which will, among other things, require covered companies to provide certain disclosures to California consumers and allow such consumers to opt-out of certain sharing of personal information, when it goes into effect on January 1, 2020.  The CCPA has already been amended and it remains unclear whether it will be further amended or how it will be interpreted. The prospect of new data privacy laws and ambiguity regarding the interpretation of existing laws has resulted in significant uncertainty and compliance costs.  Congressional committees have recently held preliminary hearings about the advisability of a federal data privacy law, but it is uncertain whether the U.S. government would adopt such a law and whether it would preempt state data privacy laws.  Although we monitor regulatory developments in this area, any actual or perceived failure by us to comply with these requirements could subject us to significant penalties and negative publicity and require changes to our business practices.  Making these changes is, and will likely continue to be, difficult and expensive.  Investigations by the regulators of data security laws could also result in the payment of fines and harm our reputation.  Private actions by affected individuals or our customers could also result in significant monetary or reputational damage.

Interruptions in our operations, particularly in our IT systems, could have a material adverse effect on our business and reputation.

Our business is dependent upon our ability to execute, in an efficient and uninterrupted fashion, necessary business functions, including the operation of complex IT systems.  In addition, a significant portion of the communication between our employees, customers, and suppliers depends on our IT systems.  The reliability of our IT infrastructure and software, and our ability to expand and continually update technologies in response to our changing needs, are critical to our business. 

We depend on data centers and computing infrastructure operated by third parties to serve customers and operate certain aspects of our services.  While we control and have access to applications and data that are hosted in these external locations, we do not control the operation of these facilities or in some cases the hardware and infrastructure within them.  Any disruption of, interference at, or inability to keep up with our needs for capacity by our third-party data center or hosted infrastructure partners could interrupt our business operations.  In addition, any problems faced by our third-party data center operations or hosted infrastructure partners, with the telecommunications network providers with whom we or they contract, or with the systems by which our telecommunications providers allocate capacity among their customers, including us, could adversely affect the experience of our customers.  Any interruption in our business applications, systems or networks, including, but not limited to, new system implementations, server downtime, facility issues or energy blackouts, could have a material adverse impact on our operations, sales and operating results.

Not only could we suffer damage to our brand and reputation in the event of a system outage or data loss or interruption, but we may also be liable to third parties, including our customers.  Some of our contractual agreements with financial institutions require the payment of penalties if our systems do not meet certain operating standards, and failure to operate in accordance with the standards of one or more of the Payment Card Brands could result in a loss of the certification of our facilities, any of which could have a material adverse effect on our business.  In addition, to successfully operate our business, we must be able to protect our processing and other systems from interruption, including from events that may be beyond our control.  We have established certain protective measures in an effort to ensure the continuation of core business operations in the event that normal operations could not be performed due to a catastrophic event.  However, these measures may be insufficient to prevent or limit the damage from any future disruptions, and any such disruption could have a material adverse effect on our business, financial condition and results of operations.

Disruptions in production at one or more of our facilities may have a material adverse impact on our business, results of operations and/or financial condition.

Any serious disruption at any of our facilities could impair our ability to use our facilities and have a material adverse impact on our revenues and increase our costs and expenses.  Our other facilities may not have sufficient capacity, may not have the specialized equipment necessary, may have higher production costs, may take significant time to increase production or may fail to meet our customers’ requirements, any of which could negatively impact our business, results of operations and/or financial condition. Long‑term production disruptions may cause our customers to seek alternative supply which could further adversely affect our profitability.

Additionally, a significant amount of certain specialized manufacturing capacity is concentrated in single-site location.  Due to the specialized nature of the assets, in the event such a location experiences disruption, it may not be possible to find replacement capacity quickly or substitute production from our other facilities.  Accordingly, disruption at a single-site manufacturing operation could significantly impact our ability to supply our customers and could produce severe impact on us.

If we fail to meet the continued listing standards of NASDAQ, our common stock may be delisted, which may adversely affect the market price and liquidity of our common stock.

Our common stock is currently traded on the NASDAQ Capital Market (“NASDAQ”).  As a condition of the continued listing of our common stock, NASDAQ generally requires that, among other requirements, (i) we maintain at least $2.5 million in stockholders equity, or $35.0 million in market capitalization, or $0.5 million in net income from continuing operations, in either the last fiscal year, or two out of the last three fiscal years, and (ii) we maintain a minimum bid price of $1.00 per share.  As of December 31, 2018, we had $149.6 million in stockholders’ deficit.  Our net loss from continuing operations was $14.8 million and $23.1 million for the years ended December 31, 2018, and 2017, respectively. As of March 4, 2019, our market capitalization was approximately $40.2 million.  There can be no assurance that we will be able to maintain compliance with the requirements for continued listing of our common stock on NASDAQ.  If our common stock is delisted and we are unable to list our common stock on another U.S. national securities exchange, we expect our securities would be quoted on an over-the-counter market.  We believe our stock would likely remain listed on the Toronto Stock Exchange (TSX). Any delisting from NASDAQ could result in significant material adverse consequences for our stockholders, including limited availability of market quotations for our common stock and reduced liquidity for the trading of our securities.  Furthermore, if our common stock were delisted it could adversely affect our ability to obtain financing for the continuation of our operations and/or result in the loss of confidence by investors, customers, suppliers and employees.

We may be unable to adequately protect our trade secrets and intellectual property rights against misappropriation or infringement, which may have a material adverse effect on our business.

Our ability to protect our intellectual property is important to our business.  We depend on patents and other intellectual property rights to protect our products, proprietary designs, and technological processes against misappropriation by others.  There is no assurance that our existing or future patents will not be challenged, invalidated or circumvented.  Furthermore, we may have difficulty obtaining additional patents and other intellectual property protections in the future.  The patents and intellectual property rights that we receive may be insufficient to provide us with meaningful protection or commercial advantage.  Moreover, effective patent, trademark, service mark, copyright and trade secret protection may not be available in every country in which we provide services. 

Our efforts to prevent the misappropriation or infringement of our intellectual property or the intellectual property of our customers may not succeed.  We actively seek to protect our proprietary rights and trade secrets by engaging in litigation and by entering into confidentiality agreements with our employees, consultants and strategic partners and controlling access to and distribution of our technologies, documentation and other proprietary information.  Nevertheless, unauthorized parties may attempt to copy aspects of our products or technologies or to obtain and use information that we regard as proprietary and may use such information to interfere with our customers.  Enforcing our intellectual property rights may also cause us to incur significant costs.  These costs and other consequences from the unauthorized use of our intellectual property could have a material adverse effect on our business, financial condition and results of operations. 

Irrespective of our intellectual property rights, we may be required to defend against alleged infringement of the intellectual property rights of others.  Our products may contain technology provided to us by other parties such as suppliers or customers.  We may have little or no ability to determine in advance whether such technology infringes the intellectual property rights of a third party. 

Companies in our industry aggressively protect their intellectual property rights.  From time to time, we receive notices or are named in litigation that claim we have infringed upon, misappropriated or misused other parties’ proprietary rights or that challenge the validity of our patents.  In addition to the costs and distraction that result from intellectual property litigation, an adverse determination in these types of disputes could prevent us from offering some of our products and services or from enforcing our intellectual property rights.  Settlements can involve royalty or other payments that could reduce our profit margins and may have a material adverse effect on our financial results.  Our

suppliers, customers and licensors may not be required to fully indemnify us for the costs of defending against infringement claims.  In addition, we may be required to indemnify some customers and strategic partners related to allegations, regardless of merit, that our products infringe on the intellectual property rights of others. 

We also face risks related to open source software.  Our software may be derived from open source software, which is generally made available to the public by its authors and/or other third parties.  Open source software is often made available under licenses, which impose certain obligations in the event we distribute derivative works of the open source software.  These obligations may require us to make source code for the derivative works available to the public and/or license such derivative works on terms different from those customarily used to protect our intellectual property.  With respect to our proprietary software, we generally license such software under terms that prohibit combining it with open source software.  Despite these restrictions, parties may combine our proprietary software with open source software without our authorization, in which case we might nonetheless be required to release the source code of our proprietary software.  Usage of open source software can lead to greater risks than the use of third‑party commercial software, as open source licensors generally do not provide warranties, controls on the origin or development of the software, or remedies against the licensors.  Many of the risks associated with open source software cannot be eliminated and could have a material adverse effect on our business, financial condition and results of operations.

We may experience software defects, which could harm our business and reputation and expose us to potential liability.

Our services are based on sophisticated software and computing systems, and the software underlying our services may contain undetected errors or defects when first introduced or when new versions are released.  In addition, we may experience difficulties in installing or integrating our technology on systems used by our clients.  Defects in our software, errors or delays in the processing of electronic transactions or other difficulties could result in the interruption of business operations, delays in market acceptance, additional development and remediation costs, diversion of technical and other resources, loss of clients, negative publicity or exposure to liability claims.  Although we attempt to limit our potential liability through disclaimers and limitation of liability provisions in our license and client agreements, we cannot be certain that these measures will successfully limit our liability.

Our business could suffer from problems in production quality and process.

We produce our products using processes that are highly complex, require advanced and costly equipment and must continually be modified to improve yields and performance.  Difficulties in the production process can reduce product yields, reduce product quality or interrupt production altogether.  As a result of such problems, we may not be able to deliver products, or may be able to deliver products, but in a less timely or cost‑effective manner or at a lower than expected quality level, or we may be required to rework or replace products.  As the complexity of both our products and our technological processes has become more advanced, production tolerances have been reduced and requirements for precision have become more demanding.  If we do not advance our production processes at the market rate, we may experience a lower production quality than the market standard.  We may suffer disruptions in our production, either due to production difficulties, such as machinery or technology failures, or as a result of external factors beyond our control, such as delay of, or quality issues with, materials provided by suppliers, interruption of our electrical service or a natural disaster.  Any such event could have a material adverse effect on our business, financial condition and results of operations.

Failure to retain our existing customers or identify and attract new customers could have a material adverse effect on our business.

A substantial portion of our net sales is derived from several large customers.  Our top five customers accounted for approximately 39% of our net sales for the year ended December 31, 2018.  Our ability to provide products and services to these customers and our other customers and meet very high quality standards in a timely manner is critical to our business success.  For example, one of the key services that we offer our customers is the prompt and timely production and delivery of replacement debit or credit cards.  Orders for replacement debit or credit cards often are placed on short notice and may require personalization.  If we are unable to offer these and our other products and services in a timely manner, our relationships with our customers may be adversely affected and we may lose contracts.

In addition, our continued business relationship with our customers may be impacted by several factors beyond our control, including more attractive product offerings from our competitors, pricing pressures or the financial health of these customers, many of whom operate in competitive businesses and depend on favorable macroeconomic conditions.  Because our contractual arrangements include neither exclusivity clauses nor commitments to order specified quantities of products on a medium or long-term basis, there is no guarantee that we will be able to renew or win contracts or purchase orders in a given year.

If we experience difficulty attracting and retaining customers, our business, financial condition and results of operations may be materially and adversely affected.

We face competition that may result in a loss of our market share and/or a decline in our profitability.

Our marketplace is highly competitive, relatively saturated, and increasingly consolidated.  We expect these market dynamics to continue as new product markets develop, companies develop lower-cost production processes, our competitors consolidate, and other competitors attempt to enter the markets in which we operate. 

Some of our competitors have larger global customer bases and significantly greater financial, sales and marketing, manufacturing, distribution, technical and other capabilities than we do.  These competitors may be able to adapt more quickly to new technological requirements and changes in customer and/or regulatory requirements and to leverage their scale to lower production costs and prices.  We also face competition from newly established competitors, suppliers of products and customers who choose to develop their own products and services.

Existing or new competitors may develop products, technologies or services that more effectively address our markets with enhanced features and functionality, greater levels of integration and/or lower cost.  As the technological sophistication of our competitors and the size of the market increases, competing low‑cost producers could emerge and grow stronger.  These dynamics could result in declining average selling prices and reduced gross margins in our businesses.   If we cannot sufficiently reduce our production costs or develop new products, technologies or services, we may not be able to compete successfully and we may lose market share, which could have a material adverse effect on our business, financial condition and results of operations.

The ability to recruit, retain and develop qualified personnel is critical to our success and ability to grow.

Our business functions are complex and require wide‑ranging expertise and intellectual capital.  For us to successfully compete and grow, we must retain, recruit and develop personnel who can provide the needed expertise across the entire spectrum of our intellectual capital needs.  In addition, we must develop our personnel to provide succession plans capable of maintaining continuity in the midst of the inevitable unpredictability of human capital.  However, the market for qualified personnel is highly competitive, particularly in the states in which our operations are concentrated.  This may result in market increases in compensation.  Our efforts to retain and develop personnel may also result in significant additional expenses, which could have a material adverse effect on our profitability.  Even then, we may not succeed in recruiting additional personnel or may fail to effectively replace current personnel who depart with qualified or effective successors.  In addition, our key personnel may not continue to be employed or we may be unable to attract and retain qualified personnel in the future.  Any failure to retain or attract employees or key personnel could have a material adverse effect on our business, financial condition and results of operations.

We may not be able to sell, exit or reconfigure businesses or facilities that we determine no longer meet with our strategy or that should be consolidated.

In executing our strategy, we have experienced consolidation of certain of our facilities and/or the divestiture of certain of our businesses.  We will continue to evaluate such opportunities.  Any such consolidation or divestiture could adversely affect our continuing business and expenses, revenues, results of operations, cash flows and financial position.

We cannot provide any assurance that we will be able to sell non-strategic businesses on terms that are acceptable to us, or at all.  In addition, if the sale of any non-strategic business cannot be consummated or is not practical, alternative courses of action, including relocation of operations or closure, may not be available to us or may be more costly than anticipated.

Our future success depends upon our ability to develop, introduce and commercialize new products, which can be a lengthy and complex process.  We may be unable to commercialize new or improved products we may develop on a timely basis, or at all.

The development of new or enhanced products is a complex and uncertain process requiring the accurate anticipation of technological, market and industry trends, as well as precise technical execution.  The successful development of new products may require us to undertake time-consuming and costly development activities, and we may experience difficulties or challenging market conditions that could delay or prevent the successful development, commercialization and marketing of these new products, including, for example, limited market acceptance of dual-interface EMV technology in the United States.  Before we can commercialize any new products, we may need to expend significant funds in order to conduct substantial research and development.  If we have difficulty producing innovative products, there could be a material adverse effect on our revenue, results of operations, reputation and business.

As we develop products, we may need to make significant investments in product development, as well as sales and marketing resources.  Furthermore, if we are unable to develop and introduce new and innovative products in a cost‑effective and timely manner, our product and service offerings could be rendered obsolete.  In addition, competitors may develop and commercialize competing products faster than we are able to do so.  Any of these factors could have a material adverse effect on our business, financial condition and results of operations.

Our business and financial results may be materially adversely affected by various legal and regulatory proceedings.

We are subject to legal proceedings, lawsuits and other claims in the normal course of business and could become subject to additional claims in the future, some of which could be material.  A future adverse ruling, settlement or unfavorable development could result in charges that could have a material adverse effect on our business, operating results or financial condition.  In addition, litigation can be costly, and the expenses and damages arising from any liability could harm our business.  Furthermore, our insurance may not be adequate to cover claims against us or any liability that may be imposed on us.  See Part I, Item 3, “Legal Proceedings” of this Annual Report on Form 10-K for information on our currently pending legal proceedings.

New and developing technology solutions and products could make our existing technology solutions and products obsolete or irrelevant, and if we are unable to introduce new products and services in a timely manner, our business could be materially adversely affected.

The markets for our products and services are subject to technological changes, frequent introductions of new products and services and evolving industry standards.  In particular, the rise in the adoption in wireless payment systems or mobile payments may make physical cards less attractive as a method of payment.  Although to date we have not seen a meaningful reduction in card‑based payments in the U.S. resulting from the emergence of mobile payment applications, mobile payments offer consumers an alternative method to make purchases without the need to carry a physical card and could, if widely adopted, reduce the number of Financial Payment Cards issued to consumers.  In addition, other new and developing technology solutions and products could make our existing technology solutions and products obsolete or irrelevant.

Our ability to enhance our current products and services and to develop and introduce innovative products and services that address the increasingly sophisticated needs of our customers will significantly affect our future success.  We may not be successful in developing, marketing or selling new products and services that meet these changing demands.  In addition, we may experience difficulties that could delay or prevent the successful development, introduction or marketing of these services, or our new services and enhancements may not adequately meet the demands of the marketplace or achieve market acceptance.  We continually engage in efforts to innovate and upgrade our products and services.  If we do not complete or gain market acceptance of new products, services and technologies, it would likely have a material adverse effect on our ability to retain existing customers or attract new ones.  For example, one of our growth opportunities is the potential adoption of dual-interface EMV cards by U.S. card issuing banks.  Banks may be delayed in transitioning to the issuance of dual‑interface EMV cards due to increased costs and other factors.  If these entities do not deploy dual‑interface EMV technology or do so less quickly and/or completely than we expect, our ability to grow could be significantly affected which could have a material adverse effect on our business, financial condition and results of operations.

Our ability to develop and deliver new products and services successfully will depend on various factors, including our ability to:

 

Additionally, opportunities to combine or package products and service offerings and the ability to cross‑sell products and services are critical to remaining competitive in our industry.  As a result, part of our business strategy is to develop new products and services that may be used in conjunction with or in addition to our existing offerings.  If we are unable to identify adequate opportunities to cross‑sell our products and services, this may have a material adverse effect on our business, financial condition and results of operations.

Our operating results are unpredictable and may vary significantly from quarter to quarter and annually, and may differ significantly from our expectations.

Our operating results are affected by a wide variety of factors that could materially and adversely affect revenue and profitability or lead to significant variability in our operating results.  These factors include, among others, the cyclicality of the financial card and electronic payment industries, capital requirements, inventory management, the availability of funding, competition, new product developments, technological changes, production problems and other factors. 

Furthermore, in periods of industry overcapacity or when our customers encounter difficulties in their end‑markets, orders are more exposed to cancellations, reductions, price renegotiations or postponements, which in turn reduce our management’s ability to forecast the next quarter or full‑year production levels, net sales, profits and cash flows.  For these reasons, our net sales and operating results and cash flows may differ materially from our expectations as visibility is reduced.  This may have a material adverse effect on our business, financial condition and results of operations.

Our long-lived assets represent a significant portion of our total assets, and we may never realize their full value.

Our long-lived assets recorded as of December 31, 2018 were $121.7 million, representing 59% of our total assets, of which we have recorded plant, equipment and leasehold improvements of $39.1 million, as our operations require significant investments in machinery and equipment.

We perform goodwill impairment testing on an annual basis as of October 1 of each year.  Other long-lived assets, such as identifiable intangible assets and plant, equipment and leasehold improvements are reviewed for impairment whenever events, changes or circumstances indicate that the carrying amount of an asset or asset group may not be recoverable.  If we were to conclude that an additional future write‑down of our long-lived assets is necessary, we would have to record the appropriate charge, which could result in a material adverse effect on our results of operations.  A write‑down of our long-lived assets may result from, among other things, deterioration in our performance and a decline in expected future cash flows and could have a material adverse effect on our business, financial condition and results of operations. 

During the second quarter of 2018, we recorded an impairment charge of $7.6 million on the long lived assets in our U.K. Limited segment. During the fourth quarter of 2018, based on the goodwill impairment test performed annually as of October 1, there were no other impairment charges necessary.  See Part II, Item 8, Financial Statements and Supplementary Data, Note 7 “Goodwill and Other Intangible Assets,” and Note 4 “Discontinued Operations and Dispositions” in this Annual Report on Form 10-K for more information.

Our failure to operate our business in accordance with the standards of the PCI Security Standards Council or other industry standards applicable to our customers, such as Payment Card Brand certification standards, could have a material adverse effect on our business.

Many of our customers issue their cards on the networks of the Payment Card Brands that are subject to the standards of the PCI Security Standards Council or other standards and criteria relating to service providers’ and manufacturers’ facilities, products and physical and logical security which we must satisfy in order to be eligible to supply products and services to such customers.  Most of our contractual arrangements with our customers may be terminated if we fail to comply with these standards and criteria.

We make significant investments to our network of high‑security facilities in order to meet these standards and criteria, including investments required to satisfy changes adopted from time to time in their respective standards and criteria.  Further investments may be costly, and if we are unable to continue to meet these standards and criteria, we may become ineligible to provide products and services that have constituted in the past an important part of our revenue and profitability.  For the year ended December 31, 2018, the vast majority of the products we produced and services we provided were subject to certification with one or more of the Payment Card Brands.  If we were to lose our certification from one or more of the Payment Card Brands, Interac (in Canada), or PCI certification for one or more of our facilities, we may lose the ability to produce cards for or provide services to banks issuing credit or debit cards on the networks of the Payment Card Brands.  If we are not able to produce cards for or provide services to any or all of the issuers issuing debit or credit cards on such networks, we could lose a substantial number of our customers, which could have a material adverse effect on our business, financial condition and results of operations.

A disruption in our operations or supply chain could adversely affect our business and financial results.

As a company engaged in manufacturing and distribution, we are subject to the risks inherent in such activities, including disruptions or delays in supply chain or information technology, product quality control, as well other external factors over which we have no control. One of the most important components of our products is the EMV microchip. We obtain our components from multiple suppliers located in South Korea, France, the United States and Singapore, primarily on a purchase order basis. Key components for our products include EMV microchips, substrates (such as PVC), modules, antennas, and inlays, which we source from a few key suppliers.  Changes in the financial or business condition of our suppliers could subject us to losses or adversely affect our ability to bring products to market. Further, the failure of our suppliers to deliver goods and services in sufficient quantities, in compliance with applicable standards, and in a timely manner could adversely affect our customer service levels and overall business. For example, we have in the past experienced delays in our supply chain, which made it difficult to produce our products in a timely manner. In addition, any increases in the costs of goods and services for our business may adversely affect our profit margins if we are unable to pass along any higher costs in the form of price increases or otherwise achieve cost efficiencies in our operations.

Risks associated with reduced levels of consumer and business spending could adversely affect our business, financial condition and results of operations.

Our business depends heavily on the overall level of consumer and business spending. Our revenue is exposed to general economic conditions that affect consumer confidence, consumer spending, consumer discretionary income or changes in consumer purchasing habits. A sustained deterioration in general economic condition, particularly in the United States, or increases in interest rates may adversely affect our financial performance by reducing the demand for our Financial Payment Card solutions or reduce the purchase of our higher margin products. If a downturn occurs, credit card issuers may reduce credit limits, close accounts, and become more selective with respect to whom they issue credit cards. These and other changes in economic conditions could also adversely impact our future revenues and profits and cause a materially adverse effect on our business, financial condition and results of operations.

Costs relating to product defects, and any related product liability and warranty claims may materially adversely affect our business

We offer highly complex services and products and, accordingly, from time to time defects have occurred.  Such defects can give rise to significant costs, including expenses relating to recalling products, replacing defective items, writing down defective inventory, the loss of potential sales and claims by third parties.  In addition, the occurrence of such defects may give rise to product liability and warranty claims, including liability for damages caused

by such defects.  If we sell defective products into the market, our reputation could suffer and we may lose sales opportunities and incur liability for damages, including damage claims from customers in excess of the amounts they pay us for our products, including consequential damages.  In addition, our customers may recall their products if they prove to be defective or make compensatory payments in accordance with industry or business practice or in order to maintain good customer relationships.  If such a recall or payment is caused by a defect in one of our products, our customers may seek to recover all or a portion of their losses from us.  If any of these risks materialize, our reputation would be harmed and there could be a material adverse effect on our business, financial condition and results of operations.

If the U.S. government puts significant tariffs or other restrictions on goods imported into the United States, our revenue and results of operations may be materially harmed.

Most of our chips, as well as certain other raw materials, are imported from companies located outside of the United States.  The U.S. government has already imposed tariffs on imports from certain countries and may impose further tariffs and/or trade restrictions.  The current U.S. administration has also expressed antipathy towards certain existing international trade agreements.  Any of these factors could depress economic activity, restrict our access to suppliers and have a material adverse effect on our business, financial condition and results of operations.

These tariffs are subject to a number of uncertainties as they are implemented, including future adjustments and changes to the products covered by additional tariffs and to the countries included or excluded from such tariffs. The ultimate reaction of other countries, and the impact of these tariffs or other actions on the United States and our business, financial condition and results of operations, cannot be predicted at this time, nor can we predict the impact of any other developments with respect to global trade.

We may become subject to additional sales tax collection obligations and claims for uncollected amounts.

In recent years, a number of states have adopted or considered adopting legislation requiring out-of-state sellers to collect and remit sales tax on sales transactions into those states where they have no physical presence. The United States Supreme Court’s June 2018 decision in South Dakota v. Wayfair, Inc. significantly increased the ability of states to impose sales tax collection responsibilities on out-of-state sellers. The ruling is widely expected to result in an increased number of states seeking to expand the applicability of their own laws regarding sales tax “nexus.” If this occurs, we could become subject to additional costs and administrative requirements to collect and remit sales tax in additional jurisdictions. Further, we may be subject to the retroactive assessment of state or local sales taxes in certain jurisdictions. Such assessments may adversely affect our future cash flow and financial results.

We rely on licensing arrangements in production and other fields, and actions taken by any of our licensing partners could have a material adverse effect on our business.

Many of our products integrate third‑party technologies that we license or otherwise obtain the right to use, including software relating to smart card operating systems used in products such as EMV cards.  As part of our strategy, we have entered into licensing agreements with other leading industry participants that provide us with, among other benefits, access to technology owned by third parties.  For example, we license Java card technology from Oracle and Multos card technology from Multos International, a subsidiary of a competitor, for use in certain of our products, including in EMV cards.  This Java and Multos card technology provides a secure environment for applications on smart cards and other devices with limited memory and processing capabilities, and we rely on our commercial arrangements with Oracle and Multos International for the continued use of these platforms.  Oracle and Multos International may not continue to renew their licenses with us on similar terms or at all, which could negatively impact our net sales.  We have also entered into cross‑licensing agreements with certain of our competitors that provide for an exchange of intellectual property, including the sharing of certain patent rights in our respective portfolios.  If we are unable to continue to successfully renew these agreements, we may lose our access to certain technologies that we rely upon to develop certain of our products, which could have a material adverse effect on our operations.

We are required to comply with complex laws and regulations in the United States and other countries and are exposed to business risks associated with our international operations.

We are subject to numerous evolving and complex laws and regulations which apply, among other things, to financial reporting standards, corporate governance, data privacy, tax, trade regulations, environmental regulations and

permit requirements, export controls, competitive practices, and labor and health and safety laws and regulations in each jurisdiction in which we operate.  There are a number of risks associated with international business operations, including political instability (e.g., the threat of war, terrorist attacks or civil unrest), inconsistent regulations across jurisdictions, unanticipated changes in the regulatory environment, and import and export restrictions.  Any of these events may affect our employees, reputation, business or financial results as well as our ability to meet our objectives.

We may not be in full compliance at all times with the laws and regulations to which we are subject and we may not have obtained the permits, authorizations, or licenses that we need.  Any failure to comply with applicable laws or regulations could result in fines or sanctions.  In such a case, or if any of these international business risks were to materialize, there could be a material adverse effect on our business, financial condition and results of operations.

Environmental, health and safety laws and regulations expose us to liability and any such liability may have a material adverse effect on our business.

We are subject to environmental, health and safety laws and regulations in each jurisdiction in which we operate.  Such regulations govern, among other things, emissions of pollutants into the air, wastewater discharges, waste disposal, the investigation and remediation of soil and groundwater contamination, and the health and safety of our employees.  For example, our products and the raw materials we use in our production processes are subject to numerous environmental laws and regulations.  We are also required to obtain environmental permits from governmental authorities for certain of our operations.  We may not be able to be at all times, in full compliance with such laws, regulations and permits.  If we violate or fail to comply with these laws, regulations or permits, we could be fined or otherwise sanctioned by regulators.

As with other companies engaged in similar activities or that own or operate real property, we face inherent risks of environmental liability at our current and historical production facilities.  Certain environmental laws impose strict and, in certain circumstances, joint and several liability on current or previous owners or operators of real property for the cost of the investigation, removal or remediation of hazardous substances as well as liability for related damages to natural resources.  In addition, we may discover new facts or conditions that may change our expectations or be faced with changes in environmental laws or their enforcement that would increase our liabilities.  Furthermore, our costs of complying with current and future environmental and health and safety laws, or our liabilities arising from past or future releases of, or exposure to, regulated materials, may have a material adverse effect on our business, financial condition and results of operations.

The scientific examination of, political attention to, and rules and regulations on issues surrounding the existence and extent of climate change may result in an increase in our cost of production due to increases in the price of energy and/or the introduction of energy or carbon taxes.  A variety of regulatory developments have been introduced that focus on restricting or managing the emission of carbon dioxide, methane and other greenhouse gasses.  Companies such as ours may need to purchase at higher costs new equipment or raw materials with lower carbon footprints.  These developments and further legislation that is likely to be enacted could negatively affect our operations.  Changes in environmental regulations could increase our production costs, which could have a material adverse effect on our business, financial condition and results of operations.

Our majority stockholders have the ability to control significant corporate activities

Tricor Pacific Capital Partners (Fund IV), Limited Partnership and Tricor Pacific Capital Partners (Fund IV) US, Limited Partnership (collectively, the “Tricor Funds”), affiliated with Parallel49 Equity (formerly known as Tricor Pacific Capital), own approximately 37% and 22% of our common stock, respectively, as of December 31, 2018.  As a result of their ownership, the Tricor Funds, so long as they collectively hold a majority of our outstanding shares, will have the ability to control the outcome of matters submitted to a vote of stockholders and, through our board of directors, the ability to control decision‑making with respect to our business direction and policies.  Matters over which the Tricor Funds, directly or indirectly, exercise control include:

 

Tricor Funds may divest all or some of their ownership of our common stock at any time, either through sale on the open market or through a distribution to the participants in the funds.  If Tricor Funds or the participants in the funds cause a large number of securities to be sold in the public market, the sales could reduce the trading price of our common stock.

Conflicts of interest may arise because directors who are principals of our largest stockholder constitute a substantial portion of our board of directors.

Messrs. Bradley Seaman and Nicholas Peters, who are officers or affiliates of Parallel49 Equity (and its predecessor), serve on our board of directors.  The Tricor Funds, our majority stockholders, are funds controlled by Parallel49 Equity and its affiliates.  Parallel49 Equity and entities controlled by it may in the future hold equity interests in entities that directly or indirectly compete with us, and companies in which it currently invests may begin directly or indirectly competing with us.  As a result of these relationships, when conflicts between the interests of Parallel49 Equity, on the one hand, and of other stockholders, on the other hand, arise, these directors may not be disinterested.  Although our directors and officers have a duty of loyalty to us under Delaware law and our certificate of incorporation, transactions that we enter into in which a director or officer has a conflict of interest are generally permissible so long as (1) the material facts relating to the director’s or officer’s relationship or interest as to the transaction are disclosed to our board of directors and a majority of our disinterested directors approves the transaction, (2) the material facts relating to the director’s or officer’s relationship or interest as to the transaction are disclosed to our stockholders and a majority of our disinterested stockholders approve the transaction or (3) the transaction is otherwise fair to us.  Our certificate of incorporation also provides that any principal, officer, member, manager and/or employee of Parallel49 Equity or any entity that controls, is controlled by or under common control with Parallel49 Equity (other than any company that is controlled by us) or any investment funds managed by Parallel49 Equity will not be required to offer any transaction opportunity of which they become aware to us and could take any such opportunity for themselves or offer it to other companies in which they have an investment, unless such opportunity is offered to them solely in their capacities as our directors.

Certain provisions of our organizational documents and other contractual provisions may make it difficult for stockholders to change the composition of our board of directors and may discourage hostile takeover attempts that some of our stockholders may consider to be beneficial.

Certain provisions of our amended and restated certificate of incorporation and bylaws may have the effect of delaying or preventing changes in control if our board of directors determines that such changes in control are not in the best interests of us and our stockholders.  The provisions in our amended and restated certificate of incorporation and bylaws include, among other things, the following:

We have entered into a director nomination agreement (the “Director Nomination Agreement”) with the Tricor Funds that provides the Tricor Funds the right to designate nominees for election to our board of directors for so long as the Tricor Funds collectively beneficially own 5% or more of the total number of shares of our common stock then outstanding.  The number of nominees that the Tricor Funds are entitled to designate under the Director Nomination Agreement bears the same proportion to the total number of members of our board of directors as the number of shares of common stock beneficially owned by the Tricor Funds bears to the total number of shares of common stock outstanding, rounded up to the nearest whole number.  In addition, the Tricor Funds are entitled to designate the replacement for any of its board designees whose board service terminates prior to the end of such designee’s term regardless of the Tricor Funds’ beneficial ownership at such time.  The Tricor Funds also have the right to have their designees participate on committees of our board of directors, subject to compliance with applicable law and stock exchange rules.  The Director Nomination Agreement will terminate when the Tricor Funds collectively own less than 5% of our outstanding common stock.

We have elected in our certificate of incorporation not to be subject to Section 203 of the Delaware General Corporation Law (the “DGCL”), an anti‑takeover law.  In general, Section 203 prohibits a publicly held Delaware corporation from engaging in a business combination, such as a merger, with a person or group owning 15% or more of the corporation’s voting stock for a period of three years following the date the person became an interested stockholder, unless (with certain exceptions) the business combination or the transaction in which the person became an interested stockholder is approved in a prescribed manner.  Accordingly, we will not be subject to any anti‑takeover effects of Section 203.  However, our certificate of incorporation contains provisions that have the same effect as Section 203, except that they provide that the Tricor Funds, their affiliates (including any investment funds managed by Tricor) and any person that becomes an interested stockholder as a result of a transfer of 5% or more of our voting stock by the forgoing persons to such person are excluded from the “interested stockholder” definition in our certificate of incorporation and are therefore not subject to the restrictions set forth therein that have the same effect as Section 203.

While these provisions have the effect of encouraging persons seeking to acquire control of our company to negotiate with our board of directors, they could enable the board of directors to hinder or frustrate a transaction that some, or a majority, of our stockholders might believe to be in their best interests and, in that case, may prevent or discourage attempts to remove and replace incumbent directors.  In addition, the potential issuance of preferred stock may delay or prevent a change in control of us or discourage bids for our common stock at a premium over the market price.

In addition, these provisions may frustrate or prevent any attempts by our stockholders to replace or remove our current management by making it more difficult for stockholders to replace members of our board of directors, which is responsible for appointing the members of our management.

Any issuance of preferred stock could adversely affect holders of our common stock, which could depress the price of our common stock.

Our board of directors has the authority to issue preferred stock and to determine the preferences, limitations and relative rights of shares of preferred stock and to fix the number of shares constituting any series and the designation of such series, without any further vote or action by our stockholders.  Our preferred stock could be issued with voting, liquidation, dividend and other rights superior to the rights of our common stock.  The potential issuance or issuance of preferred stock may adversely affect the market price and the voting and other rights of the holders of our common stock.

Item 1B.Unresolved Staff Comments

 

None.

 

Item 2.Properties

 

Information regarding each of our facilities is set forth below.

 

 

 

Item 3.Legal Proceedings

In Re CPI Card Group Inc. Securities Litigation, Case No. 1:16-CV-04531 (S.D.N.Y.) (the “Class Action”)

On June 15, 2016, two purported CPI stockholders filed putative class action lawsuits captioned Vance, et al. v. CPI Card Group Inc., et al. and Chipman, et al. v. CPI Card Group Inc. in the United States District Court for the Southern District of New York (the “Court”) against CPI, certain of its former officers and current and former directors, along with the sponsors of and the financial institutions who served as underwriters for CPI’s October 2015 initial public offering (“IPO”). The complaints, purportedly brought on behalf of all purchasers of CPI common stock pursuant to the October 8, 2015 Registration Statement filed in connection with the IPO, asserted claims under §§11 and 15 of the Securities Act of 1933, as amended (the “Securities Act”) and sought, among other things, damages and costs. In particular, the complaints alleged that the Registration Statement contained false or misleading statements or omissions regarding CPI’s customers’ (i) purchases of Europay, MasterCard and VISA chip cards (collectively, “EMV® cards”) during the first half of fiscal year 2015 and resulting EMV® card inventory levels; and (ii) capacity to purchase additional EMV® cards in the fourth quarter of fiscal year 2015, and the remainder of the fiscal year ended December 31, 2015. The complaints alleged that these actions artificially inflated the price of CPI common stock issued pursuant to the IPO.

On August 30, 2016, the Court consolidated the Vance and Chipman actions and appointed lead plaintiff and lead counsel pursuant to the Private Securities Litigation Reform Act. On October 17, 2016, lead plaintiff filed a consolidated amended complaint, asserting the same claims for violations of §§11 and 15 of the Securities Act. The amended complaint was based principally on the same theories as the original complaints, but added allegations that the Registration Statement contained inadequate risk disclosures and failed to disclose (i) small and mid-size issuers’ slower-than-anticipated conversion to EMV® technology and (ii) increased pricing pressure and competition CPI faced in the EMV® market.

On September 21, 2018, the parties executed a stipulation and agreement of settlement (“Stipulation”) to resolve the claims asserted in the amended complaint.  On October 22, 2018, the Court granted lead plaintiff’s motion for authorization to notify the settlement class of the proposed settlement.  After distribution of the notice to the class and a final settlement hearing on February 5, 2019, the Court entered orders on February 6, 2019: (i) approving the proposed settlement; and (ii) granting in part lead plaintiff’s motion for attorneys’ fees and expenses.  On February 25, 2019, the Court entered an order and final judgment dismissing the case, in its entirety, with prejudice.

Heckermann v. Montross et al., Case No. 1:17-CV-01673 (D. Del.) (the “Derivative Suit”)

On November 20, 2017, a purported CPI stockholder filed a stockholder derivative complaint in the United States District Court for the District of Delaware (the “Court”) against certain of CPI’s former officers and current and former directors, along with the sponsors of the IPO. CPI is also named as a nominal defendant. The derivative complaint asserts claims under §§10(b) and 20(a) of the Securities Exchange Act of 1934 and SEC Rule 10b-5 and seeks, among other things, injunctive relief, damages and costs. It alleges false or misleading statements and omissions

in the Registration Statement filed by CPI in connection with its IPO and subsequent public filings and statements. The derivative complaint also asserts claims for purported breaches of fiduciary duties, unjust enrichment, mismanagement and waste of corporate assets.

On March 28, 2018, the Court entered the parties’ stipulated order staying the Derivative Suit pending final determination of the Class Action.  Under its terms, the stay of the Derivative Suit will be lifted 30 days after the entry of final judgment in the Class Action which was entered on February 25, 2019.

The Company believes these claims are without merit and is defending the Derivative Suit vigorously.

CPI Card Group Inc. v. Multi Packaging Solutions, Inc., et al. (2 cases)

First case.  On October 11, 2016, the Company filed a patent infringement suit against Multi Packaging Solutions, Inc. (“MPS”) in the United States District Court for the District of Colorado. The complaint asserts that MPS ultra secure gift card packages sold to at least one customer infringe a Company patent on ultrasecure gift card packages. MPS has answered the complaint and counterclaimed for invalidity and noninfringement. The Company’s preliminary injunction request was denied without prejudice after MPS represented that it had voluntarily ceased using the accused technology and will notify CPI before it re-starts. Discovery is underway. MPS’s early motion for summary judgment was denied in August 2017 and its motion to dismiss on jurisdictional grounds was denied in July 2018. The Company’s subsidiary CPI Card Group-Minnesota, Inc., has been added to the case as plaintiff. The Company’s patent will expire in 2028.

In June 2017, MPS filed an Inter Partes Review (“IPR”) petition with the United States Patent & Trademark Office’s Patent Trial & Appeal Board (“PTAB”) to review the patent at issue in the patent infringement suit. The PTAB instituted the IPR on January 9, 2018. The PTAB entered its final written decision on January 4, 2019, determining that all of the claims in the patent are unpatentable. The Company filed an appeal of this decision to the federal circuit court on March 1, 2019.  The patent infringement suit is administratively dismissed pending the final determination of the patent validity.

The Company intends to vigorously assert its intellectual property rights in connection with this litigation and the IPR.

Second case.  During the summer of 2017, the Company commenced a lawsuit in the District of Minnesota against a former employee, MPS, and two MPS employees (collectively, the Defendants). The former employee was a sales executive who left the Company in 2017 to join MPS. In the lawsuit, the Company alleges that the Defendants misappropriated the Company's trade secrets and confidential information, that the former employee violated his employment agreements with the Company, and that Defendants committed various related business torts. After some early discovery, the Company moved for a preliminary injunction, which the Court granted in December, 2017. The company received a second preliminary injunction in August 2018.  The litigation is ongoing.

In addition to the matters described above, the Company is subject to routine legal proceedings in the ordinary course of business. The Company believes that the ultimate resolution of these matters will not have a material adverse effect on our business, financial condition or results of operations.

Item 4.Mine Safety Disclosures

 

Not applicable. 

PART II

Item 5.Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities

Market Information for Common Stock

Our common stock is listed on the NASDAQ and the Toronto Stock Exchange (“TSX”) under the symbol “PMTS” and “PMTS.TO”, respectively. 

On December 20, 2017, we effected a one-for-five reverse stock split of our common stock, whereby each lot of five shares of common stock issued and outstanding immediately prior to the reverse stock split was converted into and became one share of common stock. In lieu of issuing any fractional shares, any stockholder entitled to receive less than one share of common stock received cash for such stockholder’s fractional share. Share and per share amounts reflect the one-for-five reverse stock split for all periods presented throughout this Annual Report on Form 10-K and the accompanying consolidated financial statements.

The following table sets forth for the indicated periods dividends declared and the high and low prices of our common stock as reported on the NASDAQ and TSX, as adjusted for the reverse stock split discussed above.

 

Holders

There were eight stockholders of record as of February 22, 2019. This figure does not include an estimate of the indeterminate number of beneficial holders whose shares may be held of record by brokerage firms and clearing agencies.

Dividend

During the year ended December 31, 2017, the Company declared quarterly cash dividends of $0.225 per share payable on April 7 and July 7, respectively. The Company discontinued its quarterly dividend during August 2017. 

Issuer Purchases of Equity Securities

There were no shares repurchased under the Company’s stock repurchase plan during the years ended December 31, 2018 and 2017, and the stock repurchase plan expired by its terms during May 2017.

 

Item 6.Selected Financial Data

 

Not required due to small reporting company status

 

Item 7.Management’s Discussion and Analysis of Financial Condition and Results of Operations

You should read the following discussion in conjunction with the consolidated financial statements and the notes to those statements included elsewhere in this Annual Report on Form 10-K. This discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors, including, but not limited to, those which are not within our control. See "Risk Factors" and “Forward-Looking Statements.” 

Company Overview

We are engaged in the design, production, data personalization, packaging and fulfillment of Financial Payment Cards, which we define as credit cards, debit cards and prepaid cards issued on the networks of Payment Card Brands (Visa, MasterCard, American express and Discover) in the United States of America. We have established a leading position in the Financial Payment Card market through more than 20 years of experience and are focused primarily on

this attractive subsector of the financial technology market. Our customers include leading national and regional banks, independent community banks, credit unions, Prepaid Debit Card program managers, Group Service Providers (organizations that assist small card issuers, such as credit unions, with managing their credit and debit card programs, including managing the Financial Payment Card issuance process, core banking operations and other financial services) card transaction processors. We serve a diverse set of over 2,000 direct customers and several thousand indirect customers, including some of the largest issuers of debit and credit cards in the United States of America the largest U.S. Prepaid Debit Card program managers, as well as thousands of independent community banks, credit unions, Group Service Providers and card transaction processors.

We serve our customers through a network of production and card services facilities, including high-security facilities in the United States and Canada that are each certified by one or more of the Payment Card Brands and Interac (in Canada) and, where required by our customers, certified to be in compliance with the standards of the PCI Security Standards Council. We have a leading network of high-security production facilities in the United States and Canada, allowing us to optimize our solutions offerings to serve the needs of our diverse customer base.

In the fourth quarter of 2018, we entered into a definitive agreement to sell our Canadian subsidiary to Allcard Limited, a provider of card solutions to the gift and loyalty sectors. The sale agreement did not include customers for which we only manufacture and personalize Financial Payment Cards.  The transaction is expected to close in the first half of 2019.  The Financial Payment Card business customers of our Canada operations will migrate to our operations in the U.S. or migrate to other service providers before the transaction closes. The divestiture allows us to further optimize our footprint and is consistent with our previously announced plan to better position ourselves to serve customers by focusing on our core businesses.  Our Canadian subsidiary is part of the Other reportable segment.

On August 3, 2018, we completed the sale of our three facilities in the United Kingdom that produce retail cards, such as gift and loyalty cards, for customers in the United Kingdom and continental Europe, and provide personalization, packaging and fulfillment services. The facilities sold included Colchester, Liverpool and Derby locations. The transaction was structured as a sale of all of the outstanding shares of CPI Card Group – UK Limited, for total consideration of approximately $4.5 million. During the third quarter 2018, the Company received net cash proceeds of $0.3 million after the repayment of liabilities associated with the United Kingdom facilities, excluding tax benefits related to the structure of the sale. The historical financial position, results of operations and cash flows for the U.K. segment have been restated for all periods presented to conform with discontinued operations presentation. Unless otherwise indicated, information in Management’s Discussion and Analysis of Financial Condition and Results of Operations relates to continuing operations.  The operations and cash flows were removed from the Company’s consolidated operating results. In connection with the substantial liquidation of the Company’s U.K Limited segment in the third quarter of 2018, we released the related foreign currency cumulative translation adjustment of $4.0 million from accumulated other comprehensive loss into loss from discontinued operations. U.K. Limited incurred a pre-tax loss from operations of $15.4 million for the year ended December 31, 2018, due to the softness in our U.K. Limited retail sector and a decline in sales relating to certain customers. Additionally, we recorded the following charges during the year ended December 31, 2018: impairment charges of $7.6 million associated with goodwill and customer relationship intangible assets, and a $7.2 million loss on the sale.  The major line items constituting the (loss) income of the discontinued operation were as follows:

 

During February 2018, we made the decision to consolidate our three personalization operations in the United States into two facilities to better enable us to optimize operations and achieve market-leading quality and service with a cost-competitive business model.

2018 Summary of Financial Performance

Information below is described on a continuing operations basis.  During the year ended December 31, 2018, net sales increased 14.3% from 2017, to $255.8 million, and we recorded income from operations of $4.6 million compared to $19.3 million loss from operations during 2017.  The operating income margin for the year ended December 31, 2018 was 2%, an increase from operating loss margin of 9% in 2017.  For the year ended December 31, 2018, we recorded net loss from continuing operations of $14.8 million, compared to net loss of $23.1 million in 2017.

Included in loss from operations and net loss from continuing operations during the prior year ended December 31, 2017, were goodwill impairment charges of $19.1 million.  This impairment charge was comprised of $17.2 million related to the U.S. Debit and Credit segment resulting from continued market softness in demand for EMV cards, including price erosion and loss of market share in the United States.  The other impairment for $1.9 million related to Other which resulted from declines in net sales and operating losses incurred in our Canadian business.  See Note 7 “Goodwill and Other Intangible Assets” in Part II, Item 8, “Financial Statements and Supplementary Data” and “Critical Accounting Policies and Estimates” in this Annual Report on Form 10-K for additional information. 

Cash provided by operating activities from continuing operations for the year ended December 31, 2018 was $7.1 million, representing an increase of $3.6 million compared to $3.5 million during the prior year period.

Segment Overview

During the first quarter of 2018, we reorganized our United States business operations and realigned our United States reporting segments to correspond with the manner with which our chief operating decision maker evaluates operating performance and makes decisions as to the allocation of resources. As a result of this realignment, the CPI On-Demand business operations have been moved from the U.S. Prepaid Debit segment into the U.S. Debit and Credit reporting segment, consistent with the other related personalization operations. Segment information for previous periods has been restated to conform with this realignment and current year presentation. The restatement of the prior year segment information was not material.

Our reportable segments were as follows:

U.S. Debit and Credit Segment

Our U.S. Debit and Credit segment primarily produces Financial Payment Cards and provides integrated card services to card-issuing banks in the United States. Products manufactured by this segment primarily include EMV and non-EMV Financial Payment Cards, including contact, contactless, and dual interface cards, and CPI Metals TM, a premium product capability. We also sell instant card issuance systems, and Private Label Credit Cards that are not issued on the networks of the Payment Cards Brands (including general purpose reloadable, gift, payroll and employee benefit, government disbursement, incentive, and transit cards). We provide CPI On-Demand services, where we produce images, personalized payment cards, and related collateral on a one-by-one, on demand basis for our customers. This segment also provides a variety of integrated card services, including card personalization and fulfillment services and instant issuance services. The U.S. Debit and Credit segment operations are each certified by multiple global Payment Card Brands and, where required by our customers, certified to be in compliance with the standards of the PCI Security Standards Council.

U.S. Prepaid Debit Segment

Our U.S. Prepaid Debit segment primarily provides integrated card services to Prepaid Debit Card providers in the United States, including tamper-evident security packaging. This segment also produces Financial Payment Cards issued on the networks of the Payment Card Brands that are included in the tamper-evident security packages. The U.S. Prepaid Debit segment operation is certified by multiple global Payment Card Brands, and is certified to be in compliance with the standards of the PCI Security Standards Council.

Other

Our Other segment includes our corporate headquarter costs and a less significant operations that generate revenue from the production of Financial Payment Cards and retail gift cards, and card personalization and fulfillment services in Canada.

Key Components of Results of Operations

Set forth below is a brief description of key line items of our consolidated statements of operations and comprehensive loss.  All line items below are described on a continuing operations basis.

Net Sales

Net sales reflect our revenue generated from the sale of products and services. Product net sales include the design and production of EMV and non-EMV Financial Payment Cards, including contact, contactless, and dual interface cards, and CPI Metals TM.  We also generate product revenue from the sale of our Card@Once® instant issuance equipment and supplies, Private Label Credit Cards and retail gift cards. Services net sales include revenue from the personalization and fulfillment of Financial Payment Cards, including CPI On-Demand services, tamper-evident security packaging, fulfillment services and software as a service personalization of instant issuance Financial Payment cards. We also generate services revenue from personalizing retail gift cards primarily in Canada.

As of January 1, 2018, the Company adopted ASC Topic 606, Revenue from Contracts with Customers, (“ASC 606”), which requires an entity to recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In accordance with this new standard, certain of our performance obligations are required to be recognized over time as the goods are produced rather than upon shipment, as required under applicable accounting guidance prior to ASC 606,  as those products provide value only to a specified customer, have no alternative use, and we have the right to payment for work completed on such items.  This accelerates the timing of revenue recognition for these arrangements, as revenue will be recognized as goods are produced rather than upon shipment or delivery of goods. See Note 2, “Summary of Significant Accounting Policies” in Part II, Item 8, “Financial Statements and Supplementary Data” and “Critical Accounting Policies and Estimates—Revenue Recognition.” in this Annual Report on Form 10-K for additional information.

Cost of Sales

Cost of sales includes the direct and indirect costs of the products we sell and the services that we provide. Product costs include the cost of raw materials, including microchips in the case of EMV cards and, additionally, RFID assemblies in the case of contactless and dual-interface EMV cards, labor costs, material costs, equipment and facilities costs, operation overhead, depreciation and amortization, leases and rental charges and transport costs. Product costs also include desktop card personalization terminals in the case of Card@Once® instant issuance system sales. Services costs include the cost of labor and the potential rising costs associated with labor, raw materials in the case of tamper-evident security packaging, and equipment and facilities costs, operation overhead, depreciation and amortization, leases and rental charges and transport costs. Cost of sales can be impacted by many factors, including volume, operational efficiencies, procurement costs, promotional activity and employee relations.

Gross Profit and Gross Margin

Gross profit consists of our net sales less our cost of sales. Gross margin is gross profit as a percentage of net sales. We include gross shipping and handling revenue and cost in net sales and cost of sales respectively

Operating Expenses

Operating expenses are primarily comprised of selling, general and administrative expenses (“SG&A”) which generally consist of expenses for executive, finance, sales, marketing, legal, information technology, customer service, human resources, research and development, and administrative personnel, including payroll, benefits and stock-based compensation expense, bad debt expense and outside legal and other advisory fees, including consulting, accounting, and software related fees. Operating expense also includes depreciation and amortization expense, and may include impairment charges on tangible and intangible assets, when necessary.

Income (Loss) from Operations and Operating Margin

Income (loss) from operations consists of our gross profit less our operating expenses and impairments, if applicable. Operating margin is income (loss) from operations as a percentage of net sales.

Other Expense, net

Other expense, net consists primarily of interest expense and foreign currency gains and losses.

Net Loss from Continuing Operations

Net loss from continuing operations consists of our income (loss) from operations, less other expense, net, and income tax benefit.

Results of Operations

Year Ended December 31, 2018 Compared With Year Ended December 31, 2017

The table below presents our results of operations, on a continuing operations basis, for the years ended December 31, 2018 and 2017:

 

Net Sales

 

 

Net sales for the year ended December 31, 2018 increased $32.1 million, or 14.3%, to $ 255.8 million compared to $223.7 million for the year ended December 31, 2017. The increase in net sales during 2018 was due to a 10.1% increase in U.S. Debit and Credit and a 21.4% increase in U.S. Prepaid Debit, partially offset by a 10.5% decrease in Other.

U.S. Debit and Credit

Net sales for U.S. Debit and Credit for the year ended December 31, 2018 increased $16.4 million, or 10.1%, to $178.6 million compared to $162.2 million for the year ended December 31, 2017. The increase was primarily due to higher net sales from our emerging products and solutions, including metal cards, dual interface EMV® cards, and Card@Once®.  Metal cards are a premium product, and dual interface EMV cards include additional technology to process contactless transactions and generally have a higher selling price than other contact-only EMV cards.  Partially offsetting these increases was a decline in  EMV® card net sales, excluding metal and dual interface, and non-EMV card net sales.  Volumes of EMV card net sales, excluding metal and dual interface, increased 5% during the year ended December 31, 2018 compared to the prior year, while average selling prices declined on a year over year basis. 

U.S. Prepaid Debit

Net sales for U.S. Prepaid Debit for the year ended December 31, 2018 increased $12.2 million, or 21.4%, to $69.2 million compared to $57.0 million for the year ended December 31, 2017. The increase was the result of additional sales volumes from new portfolio wins with existing customers and overall higher volumes from our existing customer base.

Other

Net sales in Other decreased $1.2 million, or 10.5%, from the year ended December 31, 2018, compared to the year ended December 31, 2017, as a result of lower volumes with certain customers.

Eliminations

Amounts include the sales between segments and are eliminated upon consolidation. The decrease in eliminations for the year ended December 31, 2018 compared to the year ended December 31, 2017 is due to less sales between segments.

Gross Profit and Gross Margin

 

Gross profit for the year ended December 31, 2018 increased $10.4 million, or 15.2%, to $78.6 million compared to $68.2 million for the year ended December 31, 2017.

U.S. Debit and Credit

Gross profit for U.S. Debit and Credit for the year ended December 31, 2018 increased $4.9 million, or 10.8%, to $50.1 million compared to $45.2 million for the year ended December 31, 2017.  The increase in gross profit for U.S. Debit and Credit was driven by more profitable sales mix as noted in the net sales discussion above, partially offset by the acceleration of depreciation expense and restructuring charges relating to the consolidation of our personalization operations.

U.S. Prepaid Debit

Gross profit for U.S. Prepaid Debit for the year ended December 31, 2018 increased $6.1 million, or 29.8%, to $26.4 million compared to $20.4 million for the year ended December 31, 2017. The increase in gross profit and margin was attributed primarily to higher sales volumes, favorable overhead cost absorption, and cost efficiencies.

Other

Gross profit in Other decreased 20.1% in 2018 to $2.1 million from $2.7 million in 2017.  The decrease is a result of lower sales volumes with certain customers and unfavorable overhead cost absorption.

Operating Expenses

 

Goodwill Impairments

We perform goodwill impairment testing on an annual basis as of October 1 of each year or more frequently when an event occurs or circumstances change that indicates the carrying value may not be recoverable.  For the year ended December 31, 2018, there was no goodwill impairment necessary for the continuing operations.  Based on the goodwill impairment test performed in the prior year, as of October 1, 2017, we recorded an impairment charge of $19.1 million.  This impairment charge included $17.2 million related to the U.S. Debit and Credit segment resulting from continued market softness in demand for EMV cards, including price erosion and loss of market share in the United States.  The other impairment for $1.9 million related to Other which resulted from declines in net sales and operating losses incurred in our Canadian business. 

U.S. Debit and Credit

The decrease in operating expenses is primarily attributed to the goodwill impairment charge of $17.2 million during the year ended December 31, 2017. Partially offsetting this impairment charge were higher costs associated with the consolidation of our personalization operations and increased employee performance incentive compensation.

U.S. Prepaid Debit

U.S. Prepaid Debit increased $0.8 million, primarily due to increased employee performance incentive compensation, and administrative costs.

Other

Other operating expenses increased $1.1 million due to increased employee performance incentive compensation of $3.4 million and consulting and other administrative costs of $1.6 million.  Partially offsetting these costs were decreased legal costs of $2.2 million. Additionally, we recorded a $1.9 million goodwill impairment charge during the year ended December 31, 2017, relating to the Canada business within the Other segment.

Income (Loss) from Operations and Operating Margin

 

During the year ended December 31, 2018 we had income from operations of $4.6 million compared to loss of $19.3 million for the year ended December 31, 2017. Included in the loss from operations during the year ended December 31, 2017 were the goodwill impairment charges discussed above, totaling $19.1 million.  Operating margins for the year ended December 31, 2018 increased to 1.8% compared to (8.6)% for the year ended December 31, 2017.

U.S. Debit and Credit

Income from operations for U.S. Debit and Credit for the year ended December 31, 2018 increased $20.3 million to $22.4 million compared to $2.1 million for the year ended December 31, 2017.  Operating margins for the year ended December 31, 2018 increased to 12.6% compared to 1.3% for the year ended December 31, 2017, primarily due to higher sales volume and more profitable sales mix, partially offset by charges relating to the consolidation of our personalization operations.  Included in income from operations during the year ended December 31, 2017 were the goodwill impairment charges discussed above, totaling $17.2 million related to the U.S. Debit and Credit segment.

U.S. Prepaid Debit

Income from operations for U.S. Prepaid Debit for the year ended December 31, 2018 increased $5.2 million, or 31.5%, to $21.9 million compared to $16.7 million for the year ended December 31, 2017,  primarily due to increased sales volumes and higher overhead cost absorption, partially offset by increased employee performance compensation. U.S. Prepaid Debit operating income margin for the year ended December 31, 2018 increased to 31.7% from 29.3% for the same period in 2017. 

Other

Loss from operations in Other of $39.8 million represented an increased loss of $1.7 million for the year ended December 31, 2018 compared to the year ended December 31, 2017. The larger operating loss was mainly attributable to higher operating expenses, and lower profit in the Canadian business from reduced sales volumes.

Interest, net

Interest expense for the year ended December 31, 2018 increased $2.6 million, or 12.4%, to $23.4 million compared to $20.9 million for the year ended December 31, 2017. The additional interest expense resulted from a higher average interest rate on the First Lien Term Loan during the year ended December 31, 2018 compared to the same period ended 2017.

Income tax benefit

During the year ended December 31, 2018 there was an income tax benefit of $4.3 million compared with an income tax benefit of $16.5 million for the year ended December 31, 2017.  In December 2017, the U.S. government enacted comprehensive tax reform legislation, and the U.S. federal tax rate reduced from 35.0% in 2017 to 21.0% in 2018. The effective tax rate differs from the federal U.S. statutory rate primarily due to the impact of a tax benefit recorded during the year ended December 31, 2018 in connection with the U.K. Limited sale, and to a lesser extent, due to state income taxes and federal tax credits. Partially offsetting the increased tax benefit was the establishment of a partial valuation allowance on certain U.S. deferred tax assets and an uncertain tax position reserve.     

Net loss from continuing operations

Net loss from continuing operations for the year ended December 31, 2018 was $14.8 million, compared to net loss of $23.1 million for the year ended December 31, 2017.  The change was primarily due to more profitable sales mix, higher sales volumes resulting improved gross margin, offset by lower other EMV® card pricing, and higher operating expenses and interest expense as described above. Contributing to the change was the impairment charge recorded during the year ended December 31, 2017.

Fourth Quarter

Our net sales increased 19.2% in the fourth quarter of 2018 compared to the fourth quarter of 2017.  Net sales for U.S. Debit and Credit increased 23.9% in the fourth quarter of 2018 compared to fourth quarter of 2017. The increase in net sales was primarily due to higher net sales from our emerging products and solutions, including metal cards, dual interface EMV cards, and Card@Once® instant issuance systems.  Volumes of EMV card sales, excluding metal and dual interface, increased 17% during the quarter ended December 31, 2018 compared to the prior year, while average selling prices declined on a year over year basis.

Net sales for our U.S. Prepaid Debit segment increased $1.0 million, or 6.0%, to $17.1 million in the fourth quarter of 2018 compared to $16.1 million in the fourth quarter of 2017. The increase was the result of additional sales volumes from our existing customer base.

Selling, general and administrative (exclusive of depreciation and amortization) expenses increased $1.5 million to $19.9 million in the fourth quarter of 2018 compared to $18.4 million in the fourth quarter 2017. This increase was included employee termination charges of $1.0 million, in our Other segment, related to the sale of our Canadian operations which is expected to close in the first half of 2019. 

During the fourth quarter of 2018 there was a loss from operations of $0.4 million compared to a loss from operations of $21.5 million in the fourth quarter of 2017. The decrease in loss from operation was primarily due to the goodwill impairment charges of $19.1 million relating to reporting units within U.S. Debit and Credit and Other, during the three months ended December 31, 2017, as further described above. 

Liquidity and Capital Resources

As of December 31, 2018, we had $20.3 million of cash and cash equivalents. Of this amount, $1.4 million was held in accounts outside of the United States. 

Our ability to make investments in and grow our business, service our debt and improve our debt leverage ratios, while maintaining strong liquidity, will depend upon our ability to generate excess operating cash flows through our operating subsidiaries.  Although we can provide no assurances, we believe that our cash flows from operations, combined with our current cash levels and available borrowing capacity, will be adequate to fund debt service requirements and provide cash, as required, to support our ongoing operations, capital expenditures, lease obligations and working capital needs.

At December 31, 2018, there was $312.5 million outstanding under the First Lien Term Loan.  We have a $40.0 million Revolving Credit Facility, of which $20.0 million was available for borrowing as of December 31, 2018.  Additional amounts may be available for borrowing during the term of the Revolving Credit Facility, up to the full $40.0 million, to the extent our net leverage ratio does not exceed 7.0 times Adjusted EBITDA, as defined in the agreement.  The First Lien Term Loan and Revolving Credit Facility (collectively, “First Lien Credit Facility”) mature on August 17, 2022 and August 17, 2020, respectively. As of December 31, 2018, our net leverage ratio was 10.9 times Adjusted EBITDA.

Interest rates under the First Lien Term Loan, at the Company’s election, are based on either a Eurodollar rate, subject to an interest rate floor of 1.0%, plus a margin of 4.5%, or a base rate plus a margin of 3.5%.  As of December 31, 2018, the interest rate on our First Lien Term Loan was 7.02% and increased to 7.35% for the first six months of 2019, as the interest rate was reset on the First Lien Term Loan during January 2019.  Total cash interest paid during 2018 was $20.7 million, an increase of $2.2 million compared to the prior year 2017.

The First Lien Credit Facility contains customary covenants, including among other things, certain restrictions or limitations on indebtedness, issuance of liens, investments, dividends, redemptions and other distributions to equity holders, asset sales, certain mergers or consolidations, sales, transfers, leases or dispositions of substantially all of our assets, and affiliate transactions. We may also be required to make repayments on the First Lien Term Loan in advance of the maturity date based on a calculation of excess cash flows, as defined in the agreement, with any required payments to be made after the issuance of the Company’s annual financial statements.  We do not have a required excess cash flow payment related to 2018, and we were in compliance with all covenants under the First Lien Credit Facility as of December 31, 2018.

During August 2017, we discontinued our quarterly dividend of $0.225 per share. The dividend discontinuation was part of our plan to utilize a greater portion of available cash to reinvest back into the business and fund growth initiatives and to service our debt.

Operating Activities

Cash provided by operating activities from continuing operations for the year ended December 31, 2018 was $7.1 million compared to cash provided by operating activities of $3.5 million during the year ended December 31, 2017. The year over year increase was due to net working capital fluctuations, including accruals in 2018 for employee performance incentive compensation, and income taxes.  Certain working capital fluctuations were partially offsetting the benefit, including an accounts receivable increase from the prior year.  Additionally, during the year ended December 31, 2018, we recorded a lower net loss from continuing operations than compared to the prior year period.  Included in the net loss from continuing operations during the year ended December 31, 2017, were non-cash impairment charges of $19.2 million, which did not impact cash flows from operating activities.   Cash outflows from operating activities relating to our discontinued operation in the U.K., were a result of the decline in sales and operating losses incurred during 2018, and direct costs relating to the sale.

Investing Activities

Cash used in investing activities from continuing operations for the year ended December 31, 2018 was $5.6 million relating to capital expenditures. In 2018, we financed $1.8 million of machinery and equipment under capital leases. In addition to investments in machinery for our Financial Payment Card production and personalization operations, our capital expenditures in 2018 included investments in information technology.  During the year ended December 31, 2017, capital expenditures from continuing operations were $7.3 million.

Financing Activities

Cash used in financing activities for the year ended December 31, 2018 was $0.5 million related to principal payments on capital leases. Cash used in financing activities for the year ended December 31, 2017, primarily related to dividend payments of $7.5 million.

Working Capital

Our working capital relating to continuing operations as of December 31, 2018 was $43.2 million, compared to $52.1 million as of December 31, 2017.  During the year ended December 31, 2018, our cash balance decreased by $2.9 million, and our inventory balance decreased $4.0 million.  Additionally, we had a net decrease in working capital compared to the prior year due to higher accrued expenses of $11.1 million.  The increase to accrued expenses was primarily due to employee incentive compensation accruals.  Partially offsetting these impacts was an increase in accounts receivable of $11.3 million.   Refer to Note 2 in Item 8, Financial Statements, for further discussion of the impacts on the consolidated balance sheet of new accounting guidance for revenue recognition, implemented January 1, 2018.

Contractual Obligations

Not required due to smaller reporting company status.

Cyclical and Seasonal Nature of Business

Financial Payment Cards and Private Label Credit Cards are generally influenced by broader cyclical changes in the economy, with economic downturns resulting in decreases in the demand for our products and services. In particular, prolonged economic downturns typically have resulted in significant reductions in the demand for general purpose credit cards due to tightening credit conditions. Net sales are also influenced by Financial Payment Card renewal cycles.  Additionally, we generally generate higher net sales in the third quarter of the year, as our sales of Prepaid Debit Card solutions are more heavily weighted toward the second half of the year when consumers tend to purchase more of these products and services in anticipation of the holiday season in the United States.

Off-Balance Sheet Arrangements

We had no off-balance sheet arrangements at December 31, 2018 and 2017.

Critical Accounting Policies and Estimates

Our management’s discussion and analysis of financial condition and results of operations is based on our consolidated financial statements which have been prepared in accordance with accounting principles generally accepted in the United States of America. In preparing our financial statements, we make estimates, assumptions and judgments that can have a significant impact on our reported net sales, results of operations and net income, as well as on the value of certain assets and liabilities on our balance sheet during and as of the reporting periods. These estimates, assumptions and judgments are necessary because future events and their effects on our results and the value of our assets cannot be determined with certainty, and are made based on our historical experience and on other assumptions that we believe to be reasonable under the circumstances. These estimates may change as new events occur or additional information is obtained, and we may periodically be faced with uncertainties, the outcomes of which are not within our control and may not be known for a prolonged period of time. Because the use of estimates is inherent in the financial reporting process, actual results could differ from those estimates.

Impairment Assessments of Goodwill and Long-Lived Assets

We account for business combinations using the acquisition method and allocate the acquisition price of acquired companies to the tangible and intangible assets acquired and liabilities assumed based upon their estimated fair values at the acquisition date. The difference between the acquisition price and the fair value of the net assets acquired is recorded as goodwill.

In determining the fair values in impairment tests, we use one or more of the following recognized valuation methods:

We generally base our measurement of the fair value of a reporting unit on a blended analysis of the present value of future discounted cash flows and the market valuation approach. The discounted cash flows model indicates the fair value of the reporting unit based on the present value of the cash flows that we expect the reporting unit to generate in the future. Our significant estimates in those fair value measurements include identifying business factors such as size, growth, profitability, risk and return on investment and assessing comparable net sales and earnings multiples. Further, when measuring fair value based on discounted cash flows, we make assumptions about future price levels, rates of increase in net sales, cost of sales and operating expenses, weighted average cost of capital, rates of long term growth and income tax rates. We also consider our market capitalization, adjusted for unallocated monetary assets such as cash, debt, a control premium and other factors determined by management.  Valuations are performed by management or third party valuation specialists under management’s supervision, where appropriate. We believe that the estimated fair values used in impairment tests are based on reasonable assumptions that marketplace participants would use. However, such assumptions are inherently uncertain and actual results could differ from those estimates. Changes to or a failure to achieve our projected business assumptions, including growth and profitability, could result in a valuation that would trigger an impairment of goodwill. 

Goodwill and other indefinite-lived intangible assets are not amortized, but instead are tested for impairment at least annually on October 1 or more frequently when an event occurs or circumstances change that indicates the carrying value may not be recoverable. For impairment evaluations, we first make a qualitative assessment with respect to both goodwill and other indefinite-lived intangibles. In 2017, we adopted ASU 2017-04,  Intangibles – Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment (“ASU 2017-04”) in conjunction with our annual impairment testing effective October 1, 2017.  In accordance with ASU 2017-04,  an entity should perform its goodwill impairment test by comparing the fair value of the reporting unit with its carrying amount, and recognize an impairment charge for the amount by which the carrying amount of the reporting unit exceeds its fair value. We completed our annual goodwill impairment testing as of October 1, 2018, which resulted in no such impairment charge.

On August 3, 2018, we completed the sale of our United Kingdom facilities that comprised the U.K. Limited reporting segment. We did not retain significant continuing involvement with the discontinued operation subsequent to the disposal. In connection with the sale, we performed a goodwill impairment test and recorded a charge of $6.4 million in the second quarter of 2018.  The impairment was a result of continued market softness in the U.K. Limited segment, resulting in lower sales and margins and an expected sales price below the carrying value of the segment.  We recorded an impairment charge of $1.2 million to customer relationship intangible assets related to the U.K. Limited segment in the second quarter of 2018, which is reported in discontinued operations.

For the year ended December 31, 2017, we recorded impairment charges of $19.1 million, of which $17.2 million related to U.S. Debit and Credit resulting from continued market softness in demand for EMV cards, including price erosion and loss of market share in the United States.  The other impairment for $1.9 million related to the Other segment which resulted from declines in net sales and operating losses incurred in our Canadian business.  

Goodwill is allocated to our reporting units at the date the goodwill is initially recorded. Once goodwill has been allocated to a reporting unit, it no longer retains its identification with a particular acquisition and becomes identified with that reporting unit. Accordingly, the fair value of the reporting unit as a whole is available to support the

recoverability of its goodwill.  As of December 31, 2018, all of our goodwill is included within reporting units in our U.S. Debit and Credit segment.

Refer to Note 7, “Goodwill and Other Intangible Assets” and Note 8 “Fair Value of Financial Instruments” in Part II, Item 8, “Financial Statements and Supplementary Data” in this Annual Report on Form 10-K for certain additional information on goodwill and intangible asset impairments and for further definition of valuation inputs.

Long-lived assets, such as plant, equipment and software, and amortizable intangible assets, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or asset group may not be recoverable. Plant, equipment, and leasehold improvements are recorded at cost. Accumulated depreciation is computed using the straight-line method over the lesser of the estimated useful life of the related assets (generally 3 to 10 years for equipment, furniture, and leasehold improvements) or, when applicable, the lease term. Maintenance and repairs that do not extend the useful life of the respective assets are charged to expense as incurred. If circumstances require that a long-lived asset or asset group be tested for possible impairment, we first compare the undiscounted cash flows expected to be generated by that long-lived asset or asset group to its carrying amount. If the carrying amount of the long-lived asset or asset group is not recoverable on an undiscounted cash flow basis, impairment is recognized to the extent that the carrying amount exceeds its fair value.  There were no material long-lived asset impairments recorded for the years ended December 31, 2018 and 2017, relating to the continuing operations of the Company. 

Future changes in our assumptions or the interrelationship of those assumptions may negatively impact future valuations. In future measurements of fair value, adverse changes in assumptions could result in an impairment of goodwill or long-lived assets that would require a non-cash charge to the consolidated statements of operations and may have a material effect on our financial condition and operating results.

Revenue Recognition

For periods after January 1, 2018, we account for our net sales as follows:

Products Net Sales:  “Products” net sales are recognized when obligations under the terms of a contract with a customer are satisfied. In most instances, this occurs over time as cards are manufactured for specific customers and have no alternative use and the Company has an enforceable right to payment for work performed. For work performed but not completed and billed, we estimate net sales by taking actual costs incurred and applying historical margins for similar types of contracts. Items included in “Products” net sales are manufactured Financial Payment Cards, including in contact-EMV®, Dual-Interface EMV®, contactless and magnetic stripe cards, private label credit cards and retail gift cards. Card@Once® printers and consumables are also included in “Products” net sales, and their associated revenues are recognized at the time of shipping.

Services Net Sales:  Net sales are recognized for “Services” as the services are performed. Items included in “Services” net sales include the personalization and fulfillment of Financial Payment Cards, providing tamper-evident secure packaging and fulfillment services to Prepaid Debit Card program managers and software as a service personalization of instant issuance debit cards. For work performed but not completed and billed, we estimate revenue by taking actual costs incurred and applying historical margins for similar types of contracts.

Customer Contracts:  The Company often enters into Master Services Agreements (“MSAs”) with its customers. Generally, enforceable rights and obligations for goods and services occur only when a customer places a purchase order or statement of work to obtain goods or services under an MSA. The contract term as defined by ASU 2014-09 is the length of time it takes to deliver the goods or services promised under the purchase order or statement of work. As such, the Company's contracts are generally short term in nature.

Inventory Valuation

Raw materials, and finished goods inventories are valued at the lower of cost or net realizable value, with cost determined using a first-in, first-out, specific identification or weighted-average method. Cost is calculated based upon the price paid for an item at the time it is received by us. Net realizable value is the estimated selling price in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation. The Company monitors inventory for events or circumstances that may indicate the net realizable value is less than the carrying value of inventory, such as negative margins, expiration of material usage, and other forms of obsolescence.  We record

adjustments to the valuation of inventory, as necessary.  For manufacturing work performed but not completed and billed, inventory costs are recognized through cost of sales as the work is completed, consistent with the recognition of revenue.

Stock-Based Compensation

During October 2015, we adopted the CPI Card Group Inc. Omnibus Incentive Plan (“Omnibus Plan”).  During the years ended December 31, 2018 and 2017, we granted stock options to certain employees. We estimate the fair value of option awards using a Black-Scholes option pricing model or other option pricing models, as we deem appropriate.  Option-pricing models require us to estimate a number of key valuation inputs including expected volatility, expected dividend yield, expected term and risk-free interest rate. The most subjective estimate is the expected volatility of the underlying stock when determining the fair market value of an option granted.  Based on the limited amount of trading history of our common stock, we have partially utilized a peer group to estimate the volatility assumption when calculating the fair value of stock options granted during 2018 and 2017. As we obtain more trading history on our own common stock, our specific trading history and associated volatility has been gradually included to replace the peer group volatility assumption.  As such, once our own common stock is fully utilized for the volatility assumption within the Black-Scholes option pricing model, our volatility assumption in the future could be significantly different going forward than what we have estimated for our 2018 and 2017 grants.  This change could impact our stock-based compensation expense in future periods.

A 10% change in our stock-based compensation expense for the year ended December 31, 2018, would have affected pre-tax income by approximately $0.1 million.  We include stock-based compensation expense in selling, general and administrative expenses in our consolidated statement of operations and comprehensive (loss) income.

Income Taxes

We record income tax expense using the liability method for taxes and are subject to income tax in many jurisdictions, including the United States, various states and localities, the United Kingdom, and Canada. A current tax asset or liability is recognized for the estimated taxes refundable or payable on the tax returns for the current year and a deferred tax asset or liability is recognized for the estimated future tax effects attributable to temporary differences and carryforwards. Deferred tax assets and liabilities are measured using enacted income tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect of a change in tax rates is recognized as income or expense in the period that includes the enactment date. A valuation allowance is recorded to reduce the carrying amounts of deferred tax assets unless it is more likely than not that such assets will be realized. In evaluating our ability to realize our deferred tax asset, we considered the following sources of future taxable income:

Our evaluation regarding whether a valuation allowance is required or should be adjusted also considers, among other things, the nature, frequency and severity of recent losses, forecasts of future profitability and the duration of statutory carryforward periods. Our forecast of future profitability represents our best estimate of these future events. After conducting this assessment, the valuation allowance recorded, net of federal benefit, against our deferred tax assets was $6.8 and $4.6 million as of December 31, 2018 and December 31, 2017, respectively. If actual results differ from estimated results, or if we adjust these assumptions in the future, we may need to adjust our deferred tax assets or liabilities, which could impact our effective tax rate.

The amount of income taxes we pay could be subject to possible audits in the taxing jurisdictions in which we operate. In the event of these possible audits, the taxing authorities might challenge items on our tax returns. Because the tax matters challenged by tax authorities are typically complex, the ultimate outcome of these challenges is uncertain. We recognize tax benefits for uncertain positions only to the extent that we believe it is more likely than not that the tax

position will be sustained. Our future results may include favorable or unfavorable adjustments to our unrecognized tax benefits due to closure of income tax audits, new regulatory or judicial pronouncements, or other relevant events. As a result, our effective tax rate may fluctuate significantly on a quarterly and annual basis.

Recent Accounting Pronouncements

Recently Adopted Accounting Pronouncements

As of January 1, 2018, we adopted ASC 606, which requires an entity to recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASC 606 also requires an entity to disclose sufficient quantitative and qualitative information to enable users of financial statements to understand the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. We adopted ASC 606 using the modified retrospective method and recognized the cumulative effect of adoption as an adjustment to the opening balance of “Accumulated loss” on the Consolidated Balance Sheet. Under the new guidance, we recognizes certain performance obligations over time as the goods are produced, since those products provide value to only a specified customer, have no alternative use, and we have the right to payment for work completed on such items. This accelerates the timing of revenue recognition for these arrangements, as revenue is recognized as goods are produced rather than upon shipment or delivery of goods. In addition, as a result of adopting the new guidance, we have recorded decreases to deferred revenue, and work in process, and an increase to accounts receivable.

Recently Issued Accounting Pronouncements

In February 2016, the Financial Accounting Standards Board (the “FASB”) issued ASC Topic 842, Leases (“ASC 842”), which provides guidance for accounting for leases. The new guidance requires companies to recognize the assets and liabilities for the rights and obligations created by leased assets. ASC 842 is effective for annual and interim periods beginning after December 15, 2018 (the Company’s fiscal year 2019) with early adoption permitted. The new guidance requires the recognition and measurement of leases at the beginning of the earliest comparative period presented in the financial statements. The guidance required a modified retrospective approach, with an option to apply the transition provisions of the new guidance at the adoption date without adjusting the comparative periods presented. In July 2018, the FASB issued additional accounting standard updates clarifying certain provisions, as well as providing for a second transition method allowing entities to initially apply the standard at the adoption date and recognize a cumulative-effect adjustment to the opening balance of retained earnings. 

The Company will adopt the new guidance on the effective date of January 1, 2019 and use the adoption date as the date of initial application as allowed under ASC 842. Consequently, financial information will not be updated and the disclosures required under the new standard will not be provided for dates and periods before January 1, 2019.

The new standard provides a number of optional practical expedients in transition. The Company expects to elect the ‘package of practical expedients’, which permits the Company not to reassess under the new standard our prior conclusions about lease identification, lease classification and initial direct costs. The Company does not expect to elect the use-of-hindsight transition practical expedient.

The Company’s adoption process of ASC 842 is ongoing, including evaluating and quantifying the impact on the financial statements, identifying the population of leases and collecting and validating lease data. While the Company continues to assess all of the effects of adoption, the Company currently believes the most significant effects relate to the recognition of new right-of-use assets and lease liabilities on the balance sheet for real estate operating leases, and providing significant new disclosures about the Company’s leasing activities.

The new standard also provides practical expedients for the Company’s ongoing accounting. The Company expects to elect the short-term lease recognition exemption for all leases that qualify, meaning the Company will not recognize right-of-use assets or lease liabilities for existing and new lease agreements that qualify. The Company also expects to elect the practical expedient to not separate lease and non-lease components for all of its leases.

Item 7A.  Quantitative and Qualitative Disclosures about Market Risk

Not required due to smaller reporting company status

 

 

 

Item 8.Financial Statements and Supplementary Data

 

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

 

 

 

Report of Independent Registered Public Accounting Firm

To the Stockholders and Board of Directors
CPI Card Group Inc.:

Opinion on the Consolidated Financial Statements

We have audited the accompanying consolidated balance sheets of CPI Card Group Inc. and subsidiaries (the Company) as of December 31, 2018 and 2017, the related consolidated statements of operations, comprehensive loss, stockholders’ deficit, and cash flows for each of the years in the two‑year period ended December 31, 2018, and the related notes (collectively, the consolidated financial statements). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2018 and 2017, and the results of its operations and its cash flows for each of the years in the two‑year period ended December 31, 2018, in conformity with U.S. generally accepted accounting principles.

Change in Accounting Principle

As discussed in Note 2 to the consolidated financial statements, the Company has changed its method of accounting for revenue in the year ended December 31, 2018 due to the adoption of ASC Topic 606, Revenue from Contracts with Customers.

Basis for Opinion

These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits, we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion.

Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion.

/s/KPMG LLP

 

We have served as the Company’s auditor since 2014.

Denver, Colorado
March 5, 2019

 

CPI Card Group Inc. and Subsidiaries

 

Consolidated Balance Sheets

 

(Dollars in Thousands, Except Shares and Per Share Amounts)

 

 

See accompanying notes to consolidated financial statements

CPI Card Group Inc. and Subsidiaries

Consolidated Statements of Operations and Comprehensive Loss

(Dollars in Thousands, Except Share and Per Share Amounts)

 

 

See accompanying notes to consolidated financial statements