CPI Card Group Inc. and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(Dollars in Thousands, Except Share and Per Share Amounts or as Otherwise Indicated)

(Unaudited)

1. Business Overview and Summary of Significant Accounting Policies

Business Overview

CPI Card Group Inc. (which, together with its subsidiaries, is referred to herein as “CPI” or the “Company”) is engaged in the design, production, data personalization, packaging and fulfillment of Financial Payment Cards, which the Company defines as credit cards, debit cards and prepaid debit cards issued on the networks of the Payment Card Brands (Visa, Mastercard®, American Express and Discover) in the United States. To a lesser extent, the Company is also engaged in the design, production, data personalization, packaging and fulfillment of retail gift and loyalty cards.

As a producer and provider of services for Financial Payment Cards, each of the Company’s secure facilities must be certified by one or more of the Payment Card Brands and is therefore subject to specific requirements and conditions. Noncompliance with these requirements would prohibit the individual facilities of the Company from producing Financial Payment Cards for these entities’ payment card issuers.

In the fourth quarter of 2018, the Company entered into a definitive agreement to sell the Company’s Canadian subsidiary to Allcard Limited, a provider of card solutions to the gift and loyalty sectors. The sale agreement did not include the portions of the business relating to Financial Payment Cards, as that business migrated to the Company’s operations in the U.S. or to other service providers in 2019. The transaction closed on April 1, 2019, and the Company received cash proceeds of $1,451. After the payment of liabilities and transaction costs, including employee termination costs, the sale did not have a significant impact on cash, and no significant loss on sale. In connection with the disposition of the foreign entity, the Company released the related cumulative translation adjustment from “Accumulated Other Comprehensive Loss” on the Balance Sheet into income from continuing operations during the nine months ended September 30, 2019. This adjustment was $1,329 and is included in “Foreign Currency Loss” on the Statement of Operations. The Canadian subsidiary was not a significant operating segment and was part of the Other reportable segment.

During February 2018, the Company made the decision to consolidate three personalization operations in the United States into two facilities to better enable the Company to optimize operations and achieve market-leading quality and service with a cost-competitive business model. In conjunction with this decision, the Company accelerated the depreciation of certain related assets, which totaled $266 for the three months ended September 30, 2018 and $2,398 for the nine months ended September 30, 2018. The Company recorded severance charges of $0 and $552, and recorded lease termination charges of $0 and $432 in the three and nine months ended September 30, 2018, respectively. The charges were recorded in the U.S. Debit and Credit segment and were included in “Cost of Sales” and “Selling, General, and Administrative Expenses” on the Statement of Operations.

Basis of Presentation

Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) have been condensed or omitted pursuant to Form 10-Q and Article 10 of Regulation S-X. In the opinion of management, these financial statements reflect all adjustments (consisting of normal recurring adjustments) considered necessary for the fair statement of the results of the interim periods presented. The Condensed Consolidated Balance Sheet as of December 31, 2018 is derived from the audited financial statements as of that date. The accompanying condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2018.

On August 3, 2018, the Company completed the sale of its 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 Company reported the U.K. Limited reporting segment as discontinued operations and restated the comparative financial information for all periods presented in conformity with GAAP. Unless otherwise indicated, information in these notes to the unaudited condensed consolidated financial statements relate to continuing operations. See Note 3 “Discontinued Operation” for further information.

Use of Estimates

Management uses estimates and assumptions relating to the reporting of assets and liabilities in its preparation of the condensed consolidated financial statements. Significant items subject to such estimates and assumptions include the useful lives of property and equipment, the valuation of goodwill and intangible assets, valuation allowances for inventories and accounts receivable, deferred tax assets, uncertain tax positions, discount rates used to determine right-to-use assets and lease liabilities, and revenue recognized for period-end work in process. Actual results could differ from those estimates.

Adoption of New Accounting Standards

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 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 adopted the new guidance on the effective date of January 1, 2019 and used the adoption date as the date of initial application as allowed under ASC 842. Consequently, historical financial information has not been updated and the disclosures required under the new standard have 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 elected the ‘package of practical expedients’, which permits the Company not to reassess under the new standard its prior conclusions about lease identification, lease classification, and initial direct costs. The Company did not elect the use-of-hindsight transition practical expedient.

The new standard also provides practical expedients for the Company’s ongoing accounting. The Company elected 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 as applicable. The Company also elected the practical expedient to not separate lease and non-lease components for all of its leases.

Right-to-use (“ROU’) represent the right to use an underlying asset for the lease term and lease liabilities represent the Company’s obligation to make lease payments arising from the lease. Operating lease ROU assets and liabilities are recognized at commencement date based on the present value of lease payments over the lease term. As most of the leases do not provide an implicit rate, the Company used its incremental borrowing rate based on the information available at commencement date in determining the present value of lease payments. If applicable, the Company used the implicit rate when readily determinable. The operating lease ROU asset also includes any lease payments made and excludes lease incentives.

A lease is deemed to exist when the Company has the right to control the use of identified property, plant or equipment, as conveyed through a contract, for a certain period of time and consideration paid. The right to control is deemed to occur when the Company has the right to obtain substantially all of the economic benefits of the identified assets and the right to direct the use of such assets.

As a result of the adoption of ASC 842 the Company recorded $8,025 of operating ROU assets, and corresponding operating lease liabilities of $8,813 on January 1, 2019, relating to existing real estate operating leases.

The components of operating and finance lease costs for the three and nine months ended September 30, 2019 were as follows:


	Three Months Ended			Nine Months Ended
	September 30, 2019			September 30, 2019
Total operating lease costs	$	659	$	1,967

Finance lease cost:
Amortization of right-to-use assets	$	273	$	574
Interest on lease liabilities		98		160
Total financing lease costs	$	371	$	734

The following table reflects balances for operating leases and financing leases:



	September 30, 2019
Operating leases
Operating lease right-to-use assets, net of amortization	$	6,796

Operating lease liability (current)	$	2,218
Long-term operating liability		5,657
Total operating lease liabilities	$	7,875

Financing leases
Property, equipment and leasehold improvements	$	7,014
Accumulated depreciation		(782)
Total financing leases in property, equipment and leasehold improvements, net	$	6,232

Financing lease liability (current)	$	2,207
Long-term financing liability		3,427
Total financing lease liabilities	$	5,634

Finance and operating lease right-to-use assets are recorded in “Plant, equipment and leasehold improvements, net”. Financing and operating lease liabilities are recorded in “Accrued expenses” and “Other long-term liabilities”.

Components of lease expense were as follows:


			September 30, 2019
Weighted Average Remaining Lease Term
Operating Leases			3.61
Financing Leases			2.80

Weighted Average Discount Rate
Operating Leases			8.95%
Financing Leases			9.22%

Future cash payments with respect to lease obligations as of September 30, 2019 were as follows:


		Operating		Financing
		Lease		Leases
Year Ending
2019	$	696	$	740
2020		2,854		2,332
2021		2,646		1,716
2022		1,371		1,238
2023		1,097		178
Thereafter		602		-
Total lease payments		9,266		6,204
Less imputed interest		(1,391)		(570)
Total	$	7,875	$	5,634

Future cash payments with respect to lease obligations as of December 31, 2018 were as follows:


	Operating		Capital
	Leases		Leases
2019	$	2,927	$	521
2020		2,771		474
2021		2,512		243
2022		1,243		256
2023		971		71
Thereafter		652		—
Total	$	11,076	$	1,565

Cash paid on operating leases was $514 and $1,448 during the three and nine months ended September 30, 2019, respectively.

As of January 1, 2018, the Company adopted Accounting Standards Update Codification ASC 606, Revenue from Contracts with Customers, 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. The Company applied ASC 606 as of January 1, 2018 to all its contracts using the modified retrospective method and recognized the cumulative effect of adoption as an adjustment to the opening balance of “Accumulated loss” on the Condensed Consolidated Balance Sheet. Under the new guidance, the Company 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 the Company has 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. See Note 2 “Net Sales” for revenue recognition timing and methodology under ASC 606.

Recently Issued Accounting Standards

In June 2016, the FASB issued ASU 2016-13, Measurement of Credit Losses on Financial Instruments ("ASU 2016-13"). This ASU changes the model for the recognition of credit losses from an incurred loss model, which recognized credit losses only if it was probable that a loss had been incurred, to an expected loss model, which requires the Company to estimate the total credit losses expected on the portfolio of financial instruments. This standard is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. The Company does not anticipate the adoption of this standard will have a material impact on the Company’s consolidated financial position, results of operations, and cash flows.