GPGI, Inc. (GPGI) FY 2022 MD&A
This page reproduces the company's own Item 7 MD&A text from the linked SEC filing. It is filer text, not grepcent analysis, scoring, or investment advice.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the Company's audited consolidated financial statements and related notes included elsewhere in this annual report on Form 10-K. In addition to historical consolidated financial information, the following discussion contains forward-looking statements that reflect the Company’s plans, estimates and beliefs. The Company’s actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere particularly in the sections titled “Risk Factors” and “Cautionary Note Regarding Forward-Looking Statements” included elsewhere in this annual report on Form 10-K.
Overview
The Company creates innovative, highly differentiated and customized quality financial payment card products to support and increase its customer acquisition, customer retention and organic customer spend. The Company’s customers consist primarily of leading international and domestic banks and other payment card issuers primarily within the United States (“U.S.”), Europe, Asia, Latin America, Canada, and the Middle East. The Company is a platform for next generation payment technology, security, and authentication solutions. The Company maintains trusted, highly-embedded and long-term customer relationships with an expanding set of global issuers. The Company has established a niche position in the financial payment card market through nearly over 20 years of innovation and experience and is focused primarily on this attractive subsector of the financial technology market. The Company serves a diverse set of over 20 direct customers and over 80 indirect customers, including some of the largest issuers of credit cards in the U.S.
Impact of COVID-19 Pandemic
The global outbreak of the COVID-19 pandemic continues to rapidly evolve. In response to the COVID-19 pandemic, over the past several years, the Company has taken a number of measures to monitor and mitigate the effects of COVID-19, such as safety and health measures for the employees and securing the supply of materials that are essential to the Company’s production process. To date, the impact on the Company’s business and results of operations has not been significant. Any future impact of the pandemic on our operations will depend on future developments, which are uncertain and cannot be predicted and which could result in business disruption.The impact of COVID-19 has created uncertainty regarding the economic outlook for the near term. While governments and central banks continued to be aggressive in providing fiscal and monetary stimulus, the global economic recovery remains fragile. The extent to which the COVID-19 pandemic will continue to affect the Company’s business, financial condition, liquidity and the Company’s operating results will depend on future developments, which are highly uncertain and cannot be predicted.
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Economic Conditions - globally and in the digital asset marketplace
U.S. and international markets and, in particular, the rapidly evolving digital assets industry, are experiencing uncertain and volatile economic conditions, including from the impacts of the COVID-19 pandemic, Russian aggression in Ukraine, sustained inflation, threats or concerns of recession, and supply chain disruptions. These conditions make it extremely difficult for us and our suppliers to accurately forecast and plan future business activities. Additionally, a significant downturn in the domestic or global economy may cause our existing customers to pause or delay orders and prospective customers to defer new projects. Together, these circumstances create an environment in which it is challenging for us to predict future operating results. If these uncertain business, macroeconomic or political conditions continue or further decline, our business, financial condition and results of operations could be materially adversely affected.
The Company's Arculus Platform offers a broad range of secure authentication and Digital Asset storage solutions and enables our consumer Arculus Cold Storage Wallet for digital assets. Recently, some digital asset exchanges have been freezing or limiting consumer withdrawals and some have filed for bankruptcy protection, driving consumer need for enhanced protection of their digital assets. We believe consumers can achieve enhanced protection by controlling their private keys with a cold storage wallet, such as the Arculus Cold Storage Wallet. At the same time, this market cycle has created uncertainty in timing for our anticipated Arculus ramp up, as some of our partners and targets have been impacted. Therefore, we are taking a measured approach to better target the timing of our investments to support near-term and long-term opportunities.
Key Components of Results of Operations
Net Sales
Net sales reflect the Company’s revenue generated primarily from the sale of its products. Product sales primarily include the design and manufacturing of metal cards, including contact and dual interface cards. The Company also generates revenue from the sale of prelams (which refers to pre-laminated, sub-assemblies consisting of a composite of material layers which are partially laminated to be used as a component in the multiple layers of a final payment card or other card construction).which are used by makers of plastic payment and other cards). Net sales include the effect of discounts and allowances which consist primarily of volume-based rebates.
Cost of Sales
The Company’s cost of sales includes the direct and indirect costs related to manufacturing products and providing related services. Product costs include the cost of raw materials and supplies, including various metals, EMV chips, holograms, adhesives, magnetic stripes, and NFC assemblies; the cost of labor; equipment and facilities; operational overhead; depreciation and amortization; leases and rental charges; shipping and handling; and freight and insurance costs. Cost of sales can be impacted by many factors, including volume, operational efficiencies, procurement costs, and promotional activity.
Gross Profit and Gross Margin
The Company’s gross profit represents its net sales less cost of sales, and its gross margin represents gross profit as a percentage of its net sales.
Operating Expenses
The Company’s operating expenses primarily comprised selling, general, and administrative expenses, which generally consist of personnel-related expenses for its corporate, executive, finance, information technology, research and development and other administrative function, and expenses for outside professional services,
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including legal, audit and accounting services, as well as expenses for facilities, depreciation, amortization, travel, sales and marketing.
The Company has experienced an increase in its operating expenses as a result of operating as a public company, including compliance with the rules and regulations of the SEC, legal, audit, additional insurance expenses, investor relations activities, and other administrative and professional services.
Income from Operations and Operating Margin
Income from operations consists of the Company’s gross profit less its operating expenses. Operating margin is income from the Company’s operations as a percentage of its net sales.
Other (Income) Expense
Other (income) expense consists primarily of change in fair value of warrant liability, earnout consideration liability and interest expense net of any interest income.
Net Income
Net income consists of the Company’s income from operations, less other expenses and income tax provisions or benefits.
Factors Affecting the Company’s Operating Results
We believe that our performance and future success depend on a number of factors that present significant opportunities for us but also pose risks and challenges. Please see the factors discussed elsewhere in this annual report on Form 10-K, including those discussed in “Risk Factors” and “Cautionary Note Regarding Forward-Looking Statements” for additional information.
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Results of Operations
Year Ended December 31, 2022 Compared with Year Ended December 31, 2021
The following table presents the Company’s results of operations for the periods indicated:
| Year Ended December 31, | ||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2022 | 2021 | $ Change | % Change | |||||||||||
| (in thousands) | ||||||||||||||
| Net sales | $ | 378,476 | $ | 267,948 | $ | 110,528 | 41 | % | ||||||
| Cost of sales | $ | 158,832 | $ | 123,099 | $ | 35,733 | 29 | % | ||||||
| Gross profit | 219,644 | 144,849 | 74,795 | 52 | % | |||||||||
| Operating expenses: | ||||||||||||||
| Selling, general and administrative expenses | 104,749 | 63,424 | $ | 41,325 | 65 | % | ||||||||
| Income from operations | 114,895 | 81,425 | 33,470 | 41 | % | |||||||||
| Other income, net | $ | 21,280 | $ | 1,132 | $ | 20,148 | 1780 | % | ||||||
| Income before income taxes | 136,175 | 82,557 | 53,618 | 65 | % | |||||||||
| Income tax (expense) benefit | (4,360) | 857 | (5,217) | (609 | %) | |||||||||
| Net income | 131,815 | 83,414 | 48,401 | 58 | % | |||||||||
| Net income attributable to redeemable non-controlling interests (1) | 113,158 | 80,260 | 32,898 | 41 | % | |||||||||
| Net income attributable to CompoSecure, Inc (1) | $ | 18,657 | $ | 3,154 | $ | 15,503 | 492 | % |
(1) Net income attributable to CompoSecure, Inc. for the year ended December 31, 2021 is equal to net income for the period subsequent to Business Combination for the prorated period from December 27, 2021 (the date of the Business Combination) through December 31, 2021. Net income attributable to non-controlling interest for the year ended December 31, 2021 is equal to net income for the period from January 1, 2021 through December 31, 2021. Effective April 1, 2022, the Company had changed its methodology to apply its accounting policy to allocate the net income to redeemable non-controlling interest and CompoSecure, Inc. for the year ended December 31, 2021 and therefore the amounts previously reported have been adjusted to conform to the new methodology. See Note 1 and Note 15 in Notes to Consolidated Financial Statements in this Form 10-K.
| Year Ended December 31, | |||||
|---|---|---|---|---|---|
| 2022 | 2021 | ||||
| Gross Margin | 58 | % | 54 | % | |
| Operating margin | 30 | % | 30 | % |
Net Sales
| Year Ended December 31, | ||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2022 | 2021 | $ Change | % Change | |||||||||||
| (in thousands) | ||||||||||||||
| Net sales by region | ||||||||||||||
| Domestic | $ | 295,423 | $ | 218,441 | $ | 76,982 | 35 | % | ||||||
| International | 83,053 | 49,507 | 33,546 | 68 | % | |||||||||
| Total | $ | 378,476 | $ | 267,948 | $ | 110,528 | 41 | % |
The Company’s net sales for the year ended December 31, 2022 increased by $110.5 million, or 41%, to $378.5 million compared to $267.9 million for the year ended December 31, 2021. The increase in net sales was due to a 35% increase in domestic sales and a 68% increase in international sales.
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Domestic: The Company’s domestic net sales for the year ended December 31, 2022 increased $77.0 million, or 35%, to $295.4 million compared to $218.4 million for the year ended December 31, 2021. This was primarily driven by higher demand for the Company's products in the year ended December 31, 2022 due to higher overall customer acquisition by the Company’s clients as we continue to emerge from the adverse impact of the COVID-19 pandemic.
International: The Company’s international net sales for the year ended December 31, 2022 increased $33.5 million, or 68%, to $83.1 million compared to $49.5 million for the year ended December 31, 2021. This increase was primarily driven by an increase in sales through international distributor channels and the increase in demand in the fintech market.
In addition, the following table presents the Company’s net sales for the three months ended December 31, 2022 compared to December 31, 2021:
| Three Months Ended | ||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| December 31, 2022 | December 31, 2021 | $ Change | % Change | |||||||||||
| (in thousands) | ||||||||||||||
| Net Sales | $ | 93,790 | $ | 75,300 | $ | 18,490 | 25 | % |
The Company’s net sales for the three months ended December 31, 2022 increased $18.5 million, or 25%, to $93.8 million compared to $75.3 million for the three months ended December 31, 2021.
The following table presents the Company’s net sales for the three months ended December 31, 2022 compared to September 30, 2022:
| Three Months Ended | ||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| December 31, 2022 | September 30, 2022 | $ Change | % Change | |||||||||||
| (in thousands) | ||||||||||||||
| Net Sales | $ | 93,790 | $ | 103,305 | $ | (9,515) | (9 | %) |
The Company’s net sales for the three months ended December 31, 2022 decreased $9.5 million, or 9%, to $93.8 million compared to $103.3 million for the three months ended September 30, 2022.
Gross Profit and Gross Margin
The Company’s gross profit for the year ended December 31, 2022 increased $74.8 million, or 52%, to $219.7 million compared to $144.8 million for the year ended December 31, 2021, while the gross profit margin increased from 54% to 58%. The gross margin improvement resulted from a decrease in costs of sales in the period ended December 31, 2022 primarily from improvement in production yields and increased operating efficiencies compared to the period ended December 31, 2021. This was partially offset by higher supply chain costs primarily towards the end of the year ended December 31, 2022.
Operating Expenses
The Company’s operating expenses for the year ended December 31, 2022 increased $41.3 million compared to the year ended December 31, 2021. This increase was driven by salaries, commissions and employee benefits of $26.8 million, increased insurance expense of $5.7 million, increase in stock based compensation of $5.4 million, increase in professional fees of $6.7 million and an overall increase in utilities, supplies and various other costs of $2.3 million due to the growth in operations. This was partially offset by a decrease in marketing expenses of $5.6 million.
Income from Operations and Operating Margin
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During the year ended December 31, 2022, the Company had income from operations of $114.9 million compared to income from operations of $81.4 million for the year ended December 31, 2021. The Company’s operating margin for the year ended December 31, 2022 remained consistent at 30% compared to the year ended December 31, 2021.
Other Income (Expenses) (net)
Interest expense for the year ended December 31, 2022 increased $10.6 million, or 47.1%, to $22.5 million compared to $11.9 million for the year ended December 31, 2021. The additional interest expense resulted primarily from the issuance of Exchangeable Notes in December 2021 resulting in an increase in outstanding debt during the year ended December 31, 2022. The increase in interest expense was more than offset by an overall decrease in other expenses due to the favorable changes in the fair value of earnout consideration and warrant liabilities of $42.2 million, other income of $1.3 million related to employee retention credit (see Note 14 to the consolidated financial statements) and derivative liability of $0.3 million, See Liquidity and Capital Resources below for detail on the existing credit facility.
Net Income
The Company’s net income for the year ended December 31, 2022 was $131.8 million, compared to net income of $83.4 million for the year ended December 31, 2021. The increase was primarily driven by higher sales volume, a more profitable sales mix, favorable change in fair value of earnout consideration liability of $23.3 million and favorable change in fair value of $18.9 million in warrant liability, partially offset primarily by increases in operating expenses as a result of higher sales volume and arbitration charges of $10.2 million.
Year Ended December 31, 2021 Compared with Year Ended December 31, 2020
The following table presents the Company’s results of operations for the periods indicated:
| Year Ended December 31, | ||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2021 | 2020 | $ Change | % Change | |||||||||||
| (in thousands) | ||||||||||||||
| Net sales | $ | 267,948 | $ | 260,586 | $ | 7,362 | 3 | % | ||||||
| Cost of sales | $ | 123,099 | $ | 127,959 | $ | (4,860) | (4 | %) | ||||||
| Gross profit | 144,849 | 132,627 | 12,222 | 9 | % | |||||||||
| Operating expenses: | ||||||||||||||
| Selling, general and administrative expenses | 63,424 | 48,669 | 14,755 | 30 | % | |||||||||
| Income from operations | 81,425 | 83,958 | (2,533) | (3 | %) | |||||||||
| Other income (expense), net | $ | 1,132 | $ | (6,143) | $ | 7,275 | (118 | %) | ||||||
| Income before income taxes | 82,557 | 77,815 | 4,742 | 6 | % | |||||||||
| Income tax benefit | 857 | — | 857 | 100 | % | |||||||||
| Net income | 83,414 | 77,815 | 5,599 | 7 | % | |||||||||
| Net income attributable to redeemable non-controlling interests | 80,260 | — | 80,260 | 100 | % | |||||||||
| Net income attributable to CompoSecure, Inc | $ | 3,154 | $ | 77,815 | $ | (74,661) | (96 | %) |
| Year Ended December 31, | |||||
|---|---|---|---|---|---|
| 2021 | 2020 | ||||
| Gross Margin | 54 | % | 51 | % | |
| Operating margin | 30 | % | 32 | % |
Net Sales
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| Year Ended December 31, | ||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2021 | 2020 | $ Change | % Change | |||||||||||
| (in thousands) | ||||||||||||||
| Net sales by region: | ||||||||||||||
| Domestic | $ | 218,441 | $ | 213,982 | $ | 4,459 | 2 | % | ||||||
| International | 49,507 | 46,604 | 2,903 | 6 | % | |||||||||
| Total | $ | 267,948 | $ | 260,586 | $ | 7,362 | 3 | % |
The Company’s net sales for the year ended December 31, 2021 increased by $7.4 million, or 3%, to $267.9 million compared to $260.6 million for the year ended December 31, 2020. This was due to higher growing demand for its products throughout the year ended December 31, 2021 as we continued to emerge from the adverse impact from the COVID-19 pandemic compared to the year ended December 31, 2020. The increase in net sales was due to a 2% increase in domestic sales and a 6% increase in international sales.
Domestic: The Company’s domestic net sales for the year ended December 31, 2021 increased $4.5 million, or 2%, to $218.4 million compared to $214.0 million for the year ended December 31, 2020. This was primarily due to higher demand for the Company's products primarily in the second half of the year ended December 31, 2021 due to higher overall customer acquisition by the Company’s clients as we continued to emerge from the adverse impact from the COVID-19 pandemic compared to the year ended December 31, 2020.
International: The Company’s international net sales for the year ended December 31, 2021 increased $2.9 million, or 6%, to $49.5 million compared to $46.6 million for the year ended December 31, 2020. This was primarily driven by our efforts to grow our international distributor channels compared to the year ended December 31, 2020.
Gross Profit and Gross Margin
The Company’s gross profit for the year ended December 31, 2021 increased $12.2 million, or 9%, to $144.8 million compared to $132.6 million for the year ended December 31, 2020, while the gross profit margin increased from 51% to 54%. The gross margin improvement resulted from a decrease in costs of sales in the period ended December 31, 2021 from improvement in production yields and favorable product mix compared to the period ended December 31, 2020.
Operating Expenses
The Company’s operating expenses for the year ended December 31, 2021 increased $14.8 million compared to the year ended December 31, 2020. This was primarily due to increases in bonuses and commissions of $4.8 million and marketing and professional fee expenses of $19.0 million primarily related to the launch of Arculus in third quarter of 2021 and an overall increase in other costs of $1.1 million, partially offset by a decrease in transaction costs of approximately $10.0 million.
Income from Operations and Operating Margin
During the year ended December 31, 2021, the Company had income from operations of $81.4 million compared to income of $84.0 million for the year ended December 31, 2020. The Company’s operating margin for the year ended December 31, 2021 decreased from 32% to 30% for the year ended December 31, 2020.
Other Expenses
Interest expense for the year ended December 31, 2021 increased $5.8 million, or 94%, to $11.9 million compared to $6.1 million for the year ended December 31, 2020. The additional interest expense resulted from the refinancing of the Company’s existing debt facility in November 2020 resulting in an increase in outstanding debt during the period ended December 31, 2021. This was offset by a favorable change in fair value of $3.5 million in warrant liability and $9.6 million in earnout consideration liability. See Liquidity and Capital Resources below for more detail on the existing debt facility.
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Net Income
The Company’s net income for the year ended December 31, 2021 was $83.4 million, compared to net income of $77.8 million for the year ended December 31, 2020. The increase was primarily due to favorable change in fair value of $3.5 million in warrant liability and $9.6 million in earnout consideration liability and a more profitable product mix, partially offset by increases in operating expenses as a result of higher sales volume and costs related to the launch of Arculus.
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Use of Non-GAAP Financial Measures
This Form 10-K includes certain non-GAAP financial measures that are not prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) and that may be different from non-GAAP financial measures used by other companies. The Company believes EBITDA, Adjusted EBITDA and non-GAAP earnings per share are useful to investors in evaluating the Company’s financial performance. The Company uses these measures internally to establish forecasts, budgets and operational goals to manage and monitor its business, as well as evaluate its underlying historical performance and to measure incentive compensation, as we believe that these non-GAAP financial measures depict the true performance of the business by encompassing only relevant and controllable events, enabling the Company to evaluate and plan more effectively for the future. In addition, the Company’s debt agreements contain covenants that use a variation of these measures for purposes of determining debt covenant compliance. The Company believes that investors should have access to the same set of tools that its management uses in analyzing operating results. EBITDA, Adjusted EBITDA and non-GAAP earnings per share should not be considered as measures of financial performance under U.S. GAAP, and the items excluded from EBITDA, Adjusted EBITDA and non-GAAP earnings per share are significant components in understanding and assessing the Company’s financial performance. Accordingly, these key business metrics have limitations as an analytical tool. They should not be considered as an alternative to net income or any other performance measures derived in accordance with U.S. GAAP or as an alternative to cash flows from operating activities as a measure of the Company’s liquidity, and may be different from similarly titled non-GAAP measures used by other companies.
The following unaudited table presents the reconciliation of net income to EBITDA and Adjusted EBITDA for the years ended December 31, 2022, 2021 and 2020.
| Year Ended December 31, | ||||||||||
|---|---|---|---|---|---|---|---|---|---|---|
| 2022 | 2021 | 2020 | ||||||||
| (in thousands) | ||||||||||
| Net income | $ | 131,815 | $ | 83,414 | $ | 77,815 | ||||
| Add: | ||||||||||
| Depreciation | 8,575 | 10,428 | 9,916 | |||||||
| Taxes | 4,360 | (857) | — | |||||||
| Interest expense, net | 22,544 | 11,928 | 6,143 | |||||||
| EBITDA | $ | 167,294 | $ | 104,913 | $ | 93,874 | ||||
| Special management bonus expense | — | 4,384 | 15,708 | |||||||
| Equity compensation expense | 11,465 | 6,113 | 1,848 | |||||||
| Mark to market adjustments (1) | (42,533) | (13,060) | — | |||||||
| Other (2) | — | — | 4,071 | |||||||
| Adjusted EBITDA | $ | 136,226 | $ | 102,350 | $ | 115,501 |
(1)Includes the changes in fair value of warrant liability, derivative liabilities and earnout consideration liability for the year ended December 31, 2022 and December 31, 2021 .
(2)Primarily includes the non-recurring transaction expenses relating to the then proposed Business Combination for the year ended December 31, 2020.
The following unaudited table presents the non-GAAP earnings per share and reconciliation of GAAP net income to non-GAAP adjusted net income for the periods indicated:
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| Year Ended December 31, | ||||||
|---|---|---|---|---|---|---|
| 2022 | ||||||
| (in thousands) except per share amounts | ||||||
| Basic | Diluted | |||||
| Net Income | $ | 131,815 | $ | 131,815 | ||
| Add: provision for income taxes | 4,360 | 4,360 | ||||
| Income before income taxes | 136,175 | 136,175 | ||||
| Income tax expense (1) | (22,423) | (22,423) | ||||
| Adjusted net income | 113,752 | 113,752 | ||||
| Less: mark-to-market adjustments (2) | (42,267) | (42,267) | ||||
| Add: stock-based compensation | 11,465 | 11,465 | ||||
| Adjusted net income | $ | 82,950 | $ | 82,950 | ||
| Common shares outstanding used in computing net income per share, basic: | ||||||
| Class A and Class B common shares (3) | 75,697 | 75,697 | ||||
| Common shares outstanding used in computing net income per share, diluted: | ||||||
| Warrants (Public and Private) (4) | — | 8,094 | ||||
| Equity awards | — | 4,183 | ||||
| Total Shares outstanding used in computing net income per share | 75,697 | 87,974 | ||||
| Adjusted net income per share (5) | $ | 1.10 | $ | 0.94 |
1) Calculated using the Company's blended tax rate.
2) Includes the changes in fair value of warrant liability and earnout consideration liability.
3) Assumes both Class A and Class B shares participate in earnings and are outstanding at the end of the period.
4) Assumes treasury stock method, valuation at assumed fair market value of $18.00.
5) The Company did not include the effect of Exchangeable Notes to its total shares outstanding used in diluted adjusted net income per share.
Critical Accounting Policies and Estimates
General:
The discussion and analysis of the Company’s financial condition and results of operations is based upon audited financial statements, which have been prepared in accordance with U.S. GAAP. The preparation of these financial statements involve the management to make estimates, judgments, and assumptions that affect the reported amounts of assets and liabilities and disclosures with respect to contingent liabilities and assets at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Certain accounting policies require the application of significant judgment by management in selecting the appropriate assumptions for calculating financial estimates. By their nature, these judgments are subject to an inherent degree of uncertainty. These judgments are based on the Company’s historical experience, terms of its existing contracts, evaluation of trends in the industry, information provided by its customers, and information available from outside sources, as appropriate. The Company’s actual results may differ from those estimates under different assumptions or conditions. The Company evaluates the adequacy of its expected reserves and the estimates used in calculations on an on-going basis. Significant areas requiring management to make estimates include the valuation of equity instruments, measurement of changes in the fair value of earnout consideration liability, estimates of derivative
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liability associated with the exchangeable notes which are marked to market each quarter based on a Lattice model approach, changes in the fair value of warrant liabilities, derivative asset for the interest rate swap, valuation allowances on deferred tax assets which are based on an assessment of recoverability of the deferred tax assets against future taxable income and estimates of the inputs used to calculate the tax receivable agreement liability. See Note 7, 10 and 12 in Notes to Consolidated Financial Statements in this Form 10-K for further discussion of the nature of these assumptions and conditions. See Note 2 to the Notes to Consolidated Financial Statements for a complete description of the significant accounting policies that have been followed in preparing the Company’s audited consolidated financial statements.
The accounting policies described below are those that the Company considers to be the most critical for an understanding of its financial condition and results of operations and that require the most complex and subjective management judgment. Effective April 1, 2022, the Company changed its accounting policy to calculate the basic and diluted earnings per share as detailed below.
Revenue Recognition
The Company recognizes revenue in accordance with the accounting standard ASC 606 when the performance obligations under the terms of the Company’s contracts with its customers have been satisfied. This occurs at the point in time when control of the specific goods or services as specified by each purchase order are transferred to customers. Specific goods refer to the products offered by the Company, including metal cards, high security documents, and pre-laminated materials. Transfer of control passes to customers upon shipment or upon receipt, depending on the agreement with the specific customers. ASC 606 requires entities to record a contract asset when a performance obligation has been satisfied or partially satisfied, but the amount of consideration has not yet been received because the receipt of the consideration is conditioned on something other than the passage of time. ASC 606 also requires an entity to present a revenue contract as a contract liability in instances when a customer pays consideration, or an entity has a right to an amount of consideration that is unconditional (e.g. receivable), before the entity transfers a good or service to the customer.
The primary judgments relating to the Company’s revenue recognition include determining whether (i) the contract with a customer exists; (ii) performance obligations are identified; (iii) the transaction price is determined; (iv) the transaction price is allocated to performance obligations; and (v) the distinct performance obligations are satisfied by transferring control of the product or service to the client. Transfer of control is typically evaluated from the customer's perspective.
The Company invoices its customers at the time at which control is transferred, with payment terms ranging between 15 and 60 days depending on each individual contract. As the payment is due within 90 days of the invoice, a significant financing component is not included within the contracts.
The majority of the Company’s contracts with its customers have the same performance obligation of manufacturing and transferring the specified number of cards to the customer. Each individual card included within an order constitutes a separate performance obligation, which is satisfied upon the transfer of goods to the customer. The contract term as defined by ASC 606 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.
Revenue is measured in an amount that reflects the consideration the Company expects to receive in exchange for those products or services. Revenue is recognized net of variable consideration such as discounts, rebates and returns.
The Company’s products do not include an unmitigated right of return unless the product is non-conforming or defective. If the goods are non-conforming or defective, the defective goods are replaced or reworked or, in certain instances, a credit is issued for the portion of the order that was non-conforming or defective. A provision for sales returns and allowances is recorded based on experience with goods being returned. Most returned goods are re-worked and subsequently re-shipped to the customer and recognized as revenue. Historically, returns have not been material to the Company.
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Additionally, the Company has a rebate program with certain customers allowing for rebates based on achieving a certain level of shipped sales during the calendar year. These rebates are estimated and updated throughout the year and recorded against revenues and the related accounts receivable.
Net Income (Loss) Per Share
The Company complies with accounting and disclosure requirements of FASB ASC Topic 260, “Earnings Per Share”. Net income per common share is computed by dividing net income attributable to controlling interest by the weighted average number of common shares outstanding for the period. The weighted-average number of common shares outstanding during the period includes Class A common stock but is exclusive of Class B common stock as these shares have no economic or participating rights.
Effective April 1, 2022, the Company changed its methodology to apply the accounting policy to calculate the basic and diluted earnings per share as well as it determined that it would push down the changes in fair value of the mark-to-market liabilities related to the Company's warrants and earnout consideration liability to its operating subsidiary, Holdings, resulting in a change to the net income attributable to the controlling interest and non-controlling interest. Diluted net income per share is computed by dividing the net income allocated to potential dilutive instruments attributable to controlling interest by the basic weighted-average number of common shares outstanding during the period, adjusted for the potentially dilutive shares of common stock equivalents resulting from the assumed exercise of the warrants, payment of the earnouts, exercise of the equity awards, exchange of the Class B units and Exchangeable Notes ("securities") only if the effect is not anti-dilutive.
The Company has prospectively adopted this change in methodology to apply the accounting policy described above to allocate its net income and to calculate its basic and dilutive earnings per share. The Company has provided the appropriate disclosures as required in ASC 250-10. See Note 15 in Notes to Consolidated Financial Statements in this Form 10-K.
Equity-Based Compensation
The Company adopted its existing equity incentive plans in 2021 and 2015. See Note 10 for a detailed discussion of both the plans. The Company estimates the fair value of option awards using a Black-Scholes option valuation model. Option valuation model requires the Company to estimate a number of key valuation inputs including expected volatility, expected dividend yield, expected term, and risk-free interest rate. The expected term assumption reflects the period for which the Company believes the option will remain outstanding. This assumption is based upon the historical and expected behavior of the option holders and may vary based upon the behavior of different groups of option holders. The most subjective estimate is the expected volatility of the underlying unit when determining the fair market value of an option granted. As there was no trading history for the Company’s equity in 2020, the Company had utilized an appropriate index to estimate the volatility assumption when calculating the fair value of options granted during 2020. A nonpublic entity that is unable to estimate the expected volatility of the price of its underlying share may measure awards based on a “calculated value,” which substitutes the volatility of an appropriate index for the volatility of the entity’s own share price. The Company had used the historical closing values of comparable publicly held entities to estimate volatility. The risk-free rate reflects the U.S. Treasury yield curve for a similar expected life instrument in effect at the time of the grant. There were no option grants made during 2022 under 2015 incentive plans. The Company made certain grants under 2021 incentive plan during 2022. See Note 10 in Notes to Consolidated Financial Statements in this Form 10-K.
In connection with the consummation of the Business Combination, the then existing equity holders had the right to receive an aggregate of up to 7,500,000 additional (i) shares of the Company's class A common stock or (ii) Holdings' Units (and a corresponding number of shares of the Company's class B common stock), as applicable, in earn-out consideration based on the achievement of certain stock price thresholds (collectively, the “Earnouts”). There were a total of 657,160 shares subject to ASC 718, or 328,580 shares for each portion of the Earnouts. Upon the transaction date, a valuation was performed which took into consideration all the key terms and conditions of the award, including the fact that, under Topic 718, there is no requisite service period due to the fact that there is no
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service condition prospectively, and as of the grant date there was no service inception date preceding the grant date on which to base historical valuation or expense amortization. As such, the award was considered to be immediately vested from a service perspective, and is solely contingent on meeting the hurdles required for the award to be settled. Since there is no future substantive risk of forfeiture, all expense associated with the awards were accelerated and recognized on December 27, 2021.The valuation of the Earnouts was determined using a Monte Carlo simulation model that utilizes significant assumptions, including volatility, that determine the probability of satisfying the market condition stipulated in the award to calculate the fair value of the award. The following assumptions were used to determine the grant date fair value for the Earnouts that were fully expensed at the closing date, December 27, 2021:
| Year Ended | ||
|---|---|---|
| 12/27/2021 | ||
| Valuation date share price | $ | 9.95 |
| Risk-free interest rate | 0.98% - 1.12% | |
| Expected volatility | 57.92% - 58.88% | |
| Expected dividends | 0 | % |
| Expected forfeiture rate | 0 | % |
| Expected term | 3 - 4 years |
A 10% change in the Company’s equity-based compensation expense for the year ended December 31, 2022 would have affected net income by approximately $1.0 million. The Company includes equity-based compensation expense in selling, general and administrative expenses in its consolidated statement of operations.
Earnout Consideration
As a result of the Business Combination, certain of Holdings' equity holders have the right to receive an aggregate of up to 7,500,000 additional (i) shares of the Company's class A common stock or (ii) Holdings' Units (and a corresponding number of shares of the Company's class B common stock), as applicable, in earnout consideration based on the achievement of certain stock price thresholds (collectively, the “Earnouts”). As such, Earnouts were considered to be derivative liability and the valuation of the Earnouts liability was determined using a Monte Carlo simulation model that utilizes significant assumptions, including volatility, that determine the probability of satisfying the market condition stipulated in the award to calculate the fair value of the award. The Company classifies the Earnouts as liabilities at their fair value on the consolidated balance sheet and adjusts the fair value at each reporting period. This liability is subject to re-measurement at each balance sheet date until exercised, and any change in fair value is recognized in revaluation of earnout consideration liability in the Company's consolidated statements of operations. See Note 10 in Notes to Consolidated Financial Statements in this Form 10-K for a detailed discussion.
Warrant Liabilities
The Company accounts for the warrants in accordance with the guidance contained in ASC 815 under which the warrants do not meet the criteria for equity treatment and must be recorded as liabilities. Accordingly, the Company classifies the warrants as liabilities at their fair value within warrant liability on the consolidated balance sheet and adjusts the warrants to fair value at each reporting period. This liability is subject to re-measurement at each balance sheet date until exercised, and any change in fair value is recognized in revaluation of warrant liability in the Company's consolidated statements of operations. The Private Placement Warrants were valued using a Black-Scholes option pricing model. The Public Warrants were valued using the quoted market price as the fair value at the end of each balance sheet date. See Note 12 in Notes to Consolidated Financial Statements in this Form 10-K for additional information.
Derivative Liability – Redemption Make-Whole Provision Feature
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A derivative liability was initially recorded as a result of the issuance of the 7.00% Exchangeable notes due December, 2026 (see Note 7 in Notes to Consolidated Financial Statements in this Form 10-K). The fair value measurement of the derivative liability is classified as Level 3 under the fair value hierarchy as it has been valued using certain unobservable inputs using Lattice model. These inputs primarily include: (1) share price as of the valuation date, (2) assumed timing of redemption of the notes based on redemption threshold using Monte Carlo simulation (3) historical volatility of share price and (4) the risk-free rate. Significant increases or decreases in any of those inputs in isolation could result in a significantly lower or higher fair value measurement. The fair value of the derivative liability was determined using a Lattice model by calculating the fair value of the notes with the redemption make-whole feature as compared to the fair value of the notes without the redemption make-whole feature, with the difference representing the value of the redemption make-whole feature, or the derivative liability. The conversion feature will be measured at fair value on a quarterly basis and the change in the fair value of the conversion feature for the period will be recorded in the consolidated statements of operations.
Tax Receivable Agreement Liability
As a result of the Business Combination, the Company entered into a tax receivable agreement with Holdings and holders of interests in Holdings. Pursuant to the Tax Receivable Agreement, the Company is required to pay to participating holders of membership units in Holdings, 90% of the amount of savings, if any, in U.S. federal, state and local income tax that the Company actually realizes as a result of the utilization of certain tax attributes. The tax receivable agreement will continue until all such tax benefits have been utilized or expired unless the Company exercises its right to terminate the agreement for an amount representing the present value of anticipated future tax benefits under the tax receivable agreement. The Company will retain the benefit of the remaining 10% of these cash tax savings. The Company recorded $26,842.0 million and $24.5 million in tax receivable agreement liability as of December 31, 2022 and 2021, respectively which is recorded in the Company's consolidated balance sheets. The Company paid $0.1 million in the year ended December 31, 2022 to holders of interests in Holdings pursuant to the savings in U.S. federal, state and local income taxes that the Company realized as a result of the utilization of certain tax attributes for the fiscal year 2021
Income Taxes
Income taxes are applied to the income attributable to the controlling interest (see Note 9 in Notes to Consolidated Financial Statements in this Form 10-K) as the income attributable to the non-controlling interest is pass-through income. The Company complies with the accounting and reporting requirements of ASC Topic 740, “Income Taxes,” which requires an asset and liability approach to financial accounting and reporting for income taxes. Deferred income tax assets and liabilities are computed for differences between the financial statement and tax bases of assets and liabilities that will result in future taxable or deductible amounts, based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized.
We will continue to evaluate the realizability of our deferred tax assets and liabilities on a quarterly basis, and will adjust such amounts in light of changing facts and circumstances, including but not limited to future projections of taxable income, tax legislation, rulings by relevant tax authorities and the progress of ongoing tax audits, if any. we consider all available evidence, both positive and negative, to determine whether, based on the weight of that evidence, a valuation allowance is required to reduce the deferred tax assets to the amount that is more likely than not to be realized in future periods.
The Company was not subject to income taxes prior to December 27, 2021, the date of the consummation of the Business Combination, due to the then equity structure of the Company and was subject to pass through income taxes. Federal, state and local income tax returns for years prior to 2019 are no longer subject to examination by tax authorities. The Company is currently under audit by federal tax authorities for fiscal 2020. There have been no proposed adjustments at this stage of the examination. The examination is expected to be finalized by the end of fiscal 2023. The Company does not expect any material impact to the financial results due to settlement of this audit.
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Holdings is a partnership for tax purposes. Pursuant to Holdings’ limited liability company agreement, Holdings makes pro rata tax distributions during each year to the members of Holdings. These distributions are based on the Company’s estimate of taxable income for each year, and are updated throughout the year. Tax distributions from Holdings are intended to provide each member of Holdings sufficient funds to meet tax obligations with respect to the taxable income of Holdings Company that is allocated to each member. The Holdings limited liability company agreement requires distributions to be calculated based on a tax rate equal to the highest combined marginal federal and applicable state or local statutory income tax rate applicable to an individual resident in New York City, New York, including the Medicare contribution tax on unearned income, taking into account all jurisdictions in which the Company is required to file income tax returns together with the relevant apportionment information subject to various adjustments.
For the year ended December 31, 2022, Holdings distributed a total of $44,4 million of tax distributions to its members, of which $8,1 million was paid to CompoSecure, Inc. (the parent company), resulting in a net tax distribution to all other members of $36,3 million.
Market and Credit Risk
Financial instruments that potentially subject the Company to credit risk consist principally of investments in cash, cash equivalents, short-term investments and accounts receivable. The Company’s primary exposure is credit risk on receivables as the Company does not require any collateral for its accounts receivable. Credit risk is the loss that may result from a trade customer’s or counterparty’s nonperformance. The Company uses credit policies to control credit risk, including utilizing an established credit approval process, monitoring customer and counterparty limits, employing credit mitigation measures such as analyzing customers’ financial statements, and accepting personal guarantees and various forms of collateral. The Company believes that its customers and counterparties will be able to satisfy their obligations under their contracts.
The Company maintains cash, cash equivalents with approved federally insured financial institutions. Such deposit accounts at times may exceed federally insured limits. The Company is exposed to credit risks and liquidity in the event of default by the financial institutions or issuers of investments in excess of FDIC insured limits. The Company performs periodic evaluations of the relative credit standing of these financial institutions and limits the amount of credit exposure with any institution if required. The Company has not experienced any losses on such accounts.
Recently Adopted Accounting Policies
In June 2016, the FASB issued ASU 2016-13, “Financial Instruments – Credit Losses” (Topic 326): Measurement of Credit Losses on Financial Instruments and subsequently amended by ASU 2019-04 and ASU 2019-05 which introduces a forward-looking approach, based on expected losses, to estimate credit losses on certain types of financial instruments, including trade receivables. This new standard amends the current guidance on the impairment of financial instruments. The ASU adds to U.S. GAAP an impairment model known as current expected credit loss (CECL) model that is based on expected losses rather than incurred losses. Under the new guidance, an entity will recognize as an allowance its estimate of expected credit losses. Expected credit losses are determined on the basis of how long a receivable has been outstanding (e.g., under 30 days, 31–60 days) as each customer has its own specific term. This method is used to estimate the allowance for bad debts on trade receivables. A trade receivable is considered past due when its past due one day over its specific payment term. The Company determines the write-offs of the allowance on a customer by customer approach. The Company has not experienced any significant write-offs in the past. The ASU is effective for the Company for fiscal years beginning after December 15, 2022, and interim periods within those fiscal years with early adoption permitted. The Company adopted this guidance effective January 1, 2022. The adoption of this guidance did not have a material impact on the consolidated financial statements.
Liquidity and Capital Resources
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The Company’s primary sources of liquidity are its existing cash and cash equivalents balances, cash flows from operations and borrowings on its term loan revolving credit facility and exchangeable notes. The Company’s primary cash requirements include operating expenses, debt service payments (principal and interest), and capital expenditures (including property and equipment).
As of December 31, 2022, the Company had cash and cash equivalents of $13.6 million and total debt principal outstanding of $363.1 million. The Company believes that cash flows from its operations and available cash and cash equivalents are sufficient to meet its liquidity needs, including the repayment of its outstanding debt, for at least the next 12 months. The Company anticipates that to the extent that it requires additional liquidity, it will be funded through borrowings on its revolving credit facility, the incurrence of other indebtedness, or a combination thereof and offering of its shares in capital markets. The Company cannot be assured that it will be able to obtain this additional liquidity on reasonable terms, or at all. Additionally, the Company’s liquidity and its ability to meet its obligations and fund its capital requirements are also dependent on its future financial performance, which is subject to general economic, financial and other factors that are beyond its control. Accordingly, the Company cannot be assured that its business will generate sufficient cash flows from operations or that future borrowings will be available from additional indebtedness or otherwise to meet its liquidity needs. Although the Company has no specific current plans to do so, if the Company decides to pursue one or more significant acquisitions, it may incur additional debt to finance such acquisitions.
At December 31, 2022, the Company had $233.1 million of total debt outstanding under the Company’s existing credit facility, (the “2021 Credit Facility”). The credit facility comprised a term loan of $250.0 million (with an outstanding balance of $233.1 at December 31, 2022) as well as a $60.0 million revolving loan facility, of which $60.0 million was available for borrowing as of December 31, 2022. Additional amounts may be available for borrowing during the term of the revolving loan, up to the remaining full $60.0 million, as long as the Company’s maintains a net leverage ratio as stipulated in the 2021 Credit Facility. As of December 31, 2022, the Company’s net leverage ratio met the requirement for the available borrowing as defined in the terms of the 2021 Credit Facility. The 2021 Credit Facility will mature on December 21, 2025.
Interest rates for the 2021 Credit Facility was calculated as the fluctuating bank prime rate plus the applicable margin of 2.0% or, for portions of the debt converted to Euro Loans, the quoted LIBOR rate plus the applicable margin of 3.0%. The Company must also pay an annual commitment fee of 0.40% on the unused portion of the $60.0 million revolving loan commitment. As of December 31, 2022, the effective interest rate on the Company’s 2021 Credit Facility was 5.15%. Total cash interest paid during the year ended December 31, 2022 was $20.1 million, an increase of $9.9 million compared to the prior year.
The 2021 Credit Facility contains customary covenants, including among other things, certain restrictions or limitations on indebtedness, issuance of liens, investments, asset sales, certain mergers or consolidations, sales, transfers, leases or dispositions of substantially all of the Company’s assets, and affiliate transactions. The Company may also be required to make repayments on the 2021 Credit Facility 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. The Company made an excess cash flow payment of $13.8 million in the year ended December 31, 2022 per the terms of the 2021 Credit Facility. The Company was in compliance with all financial covenants under the 2021 Credit Facility as of December 31, 2022. See Note 7 in Notes to Consolidated Financial Statements in this Form 10-K for additional information.
On February 28, 2023, the Company amended its 2021 Credit Facility to, among other things, transition from bearing interest based on LIBOR to SOFR or the Alternate Base Rate (as defined in the 2021 Credit Facility), at the election of the Company, plus an applicable margin, and to reflect the waiver of a technical default under the 2021 Credit Facility, related to the delayed delivery of a pledge of its interests in Holdings by the parent Company i.e., CompoSecure, Inc. Holdings had already pledged all of its assets in favor of the lenders as per the terms of the debt agreement. After the amendment on February 28, 2023, the interest rate spreads and fees under the 2021 Credit Facility will be based on a quoted SOFR plus an applicable margin ranging from 2.0% to 3.0% for the revolving and term loan Term Benchmark and RFR Spread debt (as each term is defined in the 2021 Credit Facility). The Alternate Base Rate margin under the old LIBOR rate before the transition would have been ranging from 2.00% to 3.00% for each such portion of debt.
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On April 19, 2021, concurrently with the execution of the Merger Agreement, the Company and its wholly owned subsidiary, Holdings entered into subscription agreements (the “Note Subscription Agreements”) with certain investors ("Notes Investors") pursuant to which such Notes investors, severally and not jointly, purchased on the Closing Date of the Business Combination, senior notes (the “Exchangeable Notes”) issued by the Company and guaranteed by the Company's wholly owned subsidiary, Holdings in an aggregate principal amount of up to $130.0 million that are exchangeable into shares of Class A common stock at a conversion price of $11.50 per share, subject to the terms and conditions of an Indenture entered by the Company and its wholly owned subsidiary, Holdings and the trustee under the Indenture. The Exchangeable Notes will bear interest at a rate of 7% per annum. Interest is payable semi-annually in arrears on each June 15 and December 15, which commenced on June 15, 2022, to holders of record at the close of business on the preceding June 1 and December 1 (whether or not such day is a Business Day), respectively. Additional interest may be payable as set forth in the Indenture. The Exchangeable Notes will mature in five years on December 27, 2026, and be convertible into shares of Class A common stock at a conversion price of $11.50 per share. The Company will settle any exchange of the Exchangeable Notes in shares of Class A common stock, with cash payable in lieu of any fractional shares. See Note 7 in Notes to Consolidated Financial Statements in this Form 10-K for additional information.
Net Cash Provided by Operations
Cash provided by the Company’s operating activities for the year ended December 31, 2022 was $92.8 million compared to cash provided by its operating activities of $77.8 million during the year ended December 31, 2021. The increase in cash provided by operating activities of $15.0 million was primarily attributable to an increase in net income of $48.4 million, equity compensation expense of $11.5 million, amortization of deferred financing costs of $2.3 million, depreciation and amortization expense of $8.6 million, inventory reserve of $1.7 million and deferred tax expense of $3.2 million. This was partially offset by changes in mark to market fair value net changes of $42.5 million and changes in working capital of $23.7 million.
Net Cash Used in Investing
Cash used in the Company’s investing activities for the year ended December 31, 2022 was $9.1 million, primarily relating to capital expenditures, compared to cash used in investing activities of $4.7 million for the year ended December 31, 2021.
Net Cash Used in Financing
Cash used in the Company’s financing activities for the year ended December 31, 2022 was $92.0 million, compared to cash used in the Company's financing activities for the year ended December 31, 2021 of $64.5 million. Cash used in financing activities for the year ended December 31, 2022 primarily related to payment of issuance costs related to the Business Combination of $23.8 million, repayment of scheduled and excess cash flow principal payments on the term loan of $16.9 million, principal payment on the line of credit of $15.0 million, and tax distributions to non-controlling interest holders of $36.3 million. Cash used for the year ended December 31, 2021 primarily related to distributions to then equity holders pursuant to the consummation of the Business Combination on December 27, 2021 and repayments of debt related to the Company’s prior credit facility, partially offset by cash drawn under the 2021 Credit Facility, Exchangeable Notes and capital raised through the PIPE pursuant to the Business Combination.
Contractual Obligations
The following table summarizes, as of December 31, 2022, the Company’s material expected contractual cash obligations by future period (see Notes 7, 8 and 16 of Notes to Consolidated Financial Statements):
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| Payments due by Period | ||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 1 year or less | Years 2-3 | Years 4-5 | After Year 5 | Total | ||||||||||||||
| ($ amounts in thousands) | ||||||||||||||||||
| Long-term Debt (1) | $ | 14,372 | $ | 218,750 | $ | 130,000 | $ | — | $ | 363,122 | ||||||||
| Operating Leases (2) | 2,149 | 4,322 | 2,794 | 1,205 | 10,470 | |||||||||||||
| Tax Receivable Agreement Liability (3) | 2,367 | 2,848 | 3,005 | 17,162 | 25,382 | |||||||||||||
| Total | $ | 18,888 | $ | 225,920 | $ | 135,799 | $ | 18,367 | $ | 398,974 |
(1)Includes principal only. See Note 7 to the Consolidated Financial Statements.
(2)See Note 8 to the Consolidated Financial Statements.
(3)The Company is obligated to make payments under the tax receivable agreement to holders of interests in Holdings. See Note 2 and 16 to the Consolidated Financial Statements.
As of December 31, 2022, the Company had inventory-related purchase commitments totaling approximately $60.0 million.
Financing
The Company is party to the 2021 Credit Facility with various banks and an issuer of Exchangeable Notes to certain holders. For a more complete description of the Company's debt obligations, see Note 7 of Notes to Consolidated Financial Statements in the Audited Consolidated Financial Statements of the Company in this report Form 10-K.