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Heartland Payment Systems (NYSE:HPY)

Q3 2008 Earnings Call

November 4, 2008 8:30 am ET

Executives

Robert Baldwin, Jr. – President and Chief Financial Officer

Robert Carr – Chairman and Chief Executive Officer

Analysts

Patrick Burton - Citigroup

David Parker - Merrill Lynch

Robert Napoli - Piper Jaffray

Robert Dodd - Morgan, Keegan & Company, Inc.

Julio Quinteros - Goldman Sachs

James Friedman - Susquehanna Financial Group

Thomas McCrohan - Janney Montgomery Scott

Tim Willi - Avondale Partners LLC

Sanjay Sakhrani - Keefe, Bruyette & Woods

Anurag Rana - KeyBanc Capital Markets

Franco Turrinelli - William Blair & Company, LLC

David Koning - Robert W. Baird & Co., Inc.

Tien-Tsin Huang - J.P. Morgan

Operator

Good morning and welcome to the Heartland Payment Systems third quarter 2008 earnings conference call. My name is [Jessica] and I will be facilitating the audio portion of today's interactive broadcast. (Operator Instructions)

At this time I would like to turn the call over to Robert Baldwin.

Robert Baldwin, Jr.

Thank you, Operator. Good morning, everyone. Welcome to our third quarter 2008 earnings call. Joining me this morning is Bob Carr, our Chairman and Chief Executive Officer. Today Bob will begin our discussion with an overview of the quarter and then I'll return to go through some of the financials in detail, and we'll include some Q&A.

Before we begin I'd like to remind you that some of our discussions may contain statements of a forward-looking nature which represent our management's belief and assumptions concerning future events. Forward-looking statements involve risks, uncertainties and assumptions that are based on information currently available to us. Actual results may differ materially from those expressed in the forward-looking statements due to many factors. Information concerning these factors is contained in the company's SEC filings. We undertake no obligation to update any forward-looking statements to reflect events or circumstances that may arise after this call.

Now I'd like to turn the call over to Bob Carr, Chairman and Chief Executive Officer.

Robert Carr

Thanks, Bob, and good morning, everyone. I'd like to thank you all for joining us today and for your interest in Heartland.

As you read in this morning's release, Heartland reported record earnings for the third quarter of 2008. Net income for the quarter was a record $13.4 million, up 14%, and earnings were $0.35 per fully diluted share, up 17%. Despite a weakening economy, we grew both new and existing business as new margin installed client by double digits and transaction volume was up 42%. Let me review some of the highlights for the quarter.

Total processing volume was up 42% to $20 billion and organically processing volume grew 11% to a record $15.6 billion.

Net revenue was up 48% on growth in card volume, the Network Services acquisition, and strong growth in Payroll and other revenues. Net revenue was up 14% excluding Network Services.

Operating income for the quarter was 19.4%, so that we successfully maintained our operating margin at 19.4% for the second consecutive quarter while integrating Network Services.

New margin installed in the quarter was up 11%, with our sales force continuing to have success signing up new card merchants and rapidly adding new customers for our Payroll, Check Management and other products.

In the third quarter, over 89% of new merchants were installed on HPS Exchange, a record high penetration and a key to our strategy to use our proprietary technology to improve margins.

At September 30 we had a total of 1,188 relationship managers, up 10% in the past year and continuing grow in these difficult economic conditions.

We feel very good about our performance in the face of a very challenging economy. Just about every measure of our continued success and progress showed improvement in the third quarter.

Organic transaction processing volume was up at double-digit rates to a record high despite the largest drop in same-store sales in the company's history. New business also grew at double-digit rates as we increased our share of the electronic payments pie.

Our acquisition strategy is also working as Network Services added to both our top and bottom line while our investment in technology and increased scale are helping improve overall operating efficiency and achieve better leverage in our model. And our new business initiatives are gaining traction as seen in the rapid growth of our Payroll, Check Management, MicroPayments, and Campus Solutions products.

We expect our transaction processing volume to continue to rise, driven by an increase in the size and effectiveness of our sales force and the introduction of additional products and services.

This quarter our sales force was up 10% from a year ago as we stay on course for 2,000 relationship managers a few years out. We are seeing steady improvement in the quality of our new hires while maintaining the effectiveness of our experienced RMs as a result of our new training and development programs. As the heart and soul of our organization, we plan to grow our sales force over both the balance of this year and well into the future while supporting their efforts with new marketing programs and additional products and capabilities such as petroleum processing.

We are preparing to roll out a new marketing program, the Burger campaign, that once again highlights our base selling premise - that small and midsized merchants are entitled to know their processing costs. With our transparent pricing and merchant bill of rights, our marketing reinforces Heartland as the champion of merchant rights. This is a selling proposition that we believe still has a long runway and is especially valuable as merchants look to squeeze high-cost middlemen out of their processing expense line.

Though competition remains stiff, we continue to generate new business while holding the line on price. We are still seeing a gradual increase in the average size of our new merchant installed, but the primary driver behind the double-digit increase in new margin installed remains market share gains.

Our Payroll business continues to enjoy strong growth as Payroll revenue was up 22% and new Payroll margin installed rose by more than a third this quarter. We are gearing up for a big Payroll push heading into 2009. Our relationship managers are really learning the product and discovering that it opens a large new market for them - businesses that do not necessarily have a card processing need.

Our Check Processing product is enjoying similar success as we continue to improve our efforts to better educate our sales force about the competitive features and benefits of these new Heartland products.

The third quarter was our first full quarter with Network Services. We were very pleased with the progress we made integrating their business and with the underlying performance of our new petroleum vertical. Volumes beat our expectations modestly and expense synergies were realized in our telecommunications and in other areas where we had duplication or could use our increased scale to gain leverage. In part, the progress achieved with our integration efforts helped up maintain operating margins at the same level as the second quarter while absorbing three full months of the lower margin Network Services business.

I personally have met with most of our large Network Services clients and have been pleasantly surprised by the desire of these sophisticated businesspeople to understand the value of our modern integrated technology platforms with less customized card coding and a move to more open and standard formats and systems. Our new large clients want what Heartland is offering to the rest of the merchant community - transparent business relationships driven by the desire to give more value at the same or lower costs.

We also recognize the need to move beyond the lowest common denominator of data security, currently the PCI DSS standards. We believe it is imperative to move to a higher standard for processing secure transactions, one which we have the ability to implement without waiting for the payments infrastructure to change. We believe that standard to be true end-to-end encryption, and we are committed to launching this new standard in the fourth quarter of '09 or early 2010 with several forward-looking clients and industry partners. We believe that the payment world is at risk, relying on virus protection software to protect us from determined criminal organizations.

The development of the new Discover and American Express products is also progressing. We expect to be boarding new American Express installs by January 1, with Discover to follow in the first half of next year.

Finally, I am pleased to announce that yesterday we agreed to purchase the assets of Chockstone, Inc., which we believe is one of the nation's premiere providers of gift card and especially loyalty solutions. Heartland has historically outsourced its gift card solution, and we are excited to have the opportunity to bring that in-house, which should enhance our penetration in this still-growing aspect of a merchant's payments.

However, it is the addition of a strong loyalty solution that has us the most excited. Loyalty represents a true value add to the merchant, improving upon their interaction with their customer. Both gift and loyalty solutions tend to reduce merchant attrition, which adds to Chockstone's attraction.

Chockstone's customer base tends to be focused on larger food service and retail clients and so it complements both the Network Services and the legacy Heartland customer base. This acquisition is another example of our strategy to use M&A to enhance the company's payment processing capabilities while maintaining a strong discipline on the use of our capital.

I'd like to turn the call back over to Bob, who will go through some of the details in the results before I provide some concluding comments.

Robert Baldwin, Jr.

Thanks, Bob. We're pleased once again to report record quarterly earnings with diluted earnings per share rising 17% to $0.35 per share behind strong processing volume growth, disciplined pricing, steady margins, and the contribution from our Network Services acquisition.

Total processing volume for the quarter was $20 billion, up 42%, and excluding acquisitions, organic card processing volume was $15.6 billion, up 11%. For Network Services, transaction-based merchant tickets totaled $836 million for the quarter, somewhat ahead of our plan.

Same-store sales were down 2% in the quarter, with entertainment and retail showing the greatest weakness, much as we have seen throughout this year. In our two largest verticals, restaurants were down only slightly more than the overall average while petroleum was better than planned, which is our only available measure since year ago performance is not in our database.

Within the quarter we did see sequential weakness with September the worst month of the quarter. October did not show any signs of recovery in merchant activity.

Primarily as a result of this organic and acquired processing volume growth, net revenues were up 48% for the quarter. Excluding Network Services, net revenues were up 14%. Organic net revenue growth exceeded processing volume growth primarily due to a 22% increase in Payroll and 63% increase in equipment revenues. Since Network Services revenue is virtually all net revenue and with the proportion of Payroll and other revenue increasing, net revenue has become a better measure of relative performance than the gross revenue measure that GAAP requires.

Total cost of services for the quarter were up 17.7%. Processing and servicing costs were up 64% and D&A up 89%, both due to Network Services lower gross margins and the additional amortization attributable to the acquisition.

As Bob mentioned, outside the normal bumps that can be expected, the integration of Network Services is on schedule. For the third quarter the primary impact was some cost synergies such as with our telecommunications providers. Through further Network Services integration, volume growth, and increases in the proportion of merchants processing on our proprietary technology platforms, we have charted a path for steady improvements in our margins in the coming years.

Customer acquisition costs were up 10.4% in the quarter, continuing to reflect softer new margin installed and same-store sales growth.

General and administrative costs were up 75% in the quarter, again a function of a full quarter of Network Services overhead and our investment in new business initiatives. G&A this quarter was only 5.1% of total revenues, in line with historical proportions.

Operating income for the quarter was $23.1 million, an increase of 19.4% from $19.3 million in the third quarter of 2007. The operating margin on net revenue for the third quarter was 19.4%, the same as the second quarter but down compared to the third quarter of 2007, primarily reflecting the effect of lower Network Services margins as well as our ongoing new business investment.

Interest expense in the third quarter was $1.2 million, up almost $1 million from the third quarter of last year as a result of the borrowings used for the Network Services acquisition.

The tax rate in the quarter was also a little bit higher due to the truing up of some accruals.

The result was record quarterly net income of $13.4 million, up 14%, and record fully diluted earnings per share of $0.35, up 17%.

Now let's turn to our cash flow. GAAP operating cash flow for the quarter was essentially unchanged at $19.2 million this quarter compared to $20.5 million a year ago. More importantly, management's measure of operating cash takes net income as adjusted for amortization, depreciation and the other non-cash sources at the top of the operating cash flow statement and then reduces that figure by signing bonuses and buyouts paid. Using this management metric, operating cash grew 59% in the third quarter to $22 million from $13.8 million last year.

Capital expenditures for the third quarter were $10 million, of which $4.3 million was for the continued construction in our service center in the second phase and $5.7 million for the other investments to strengthen our technology infrastructure.

Taking that same management definition of operating cash and reducing it by non-service center CapEx, our free cash flow amounted to $16.3 million for the year's third quarter, up 42% from $11.5 million in the third quarter of 2007. We also used $4.4 million of cash to pay dividends in the quarter.

Our financial position remains strong. At September 30, 2008 we had approximately $47 million in cash and $176 million in stockholders' equity. Our relationships with our lending institutions are very strong and we maintain an excellent dialogue with them. In addition, we are adding SunTrust as another sponsor bank for the Network Services business.

Let me wrap up with our guidance for the year, where we have made some minor adjustments as same-store sales appear likely to finish considerably below the level we had anticipated when we first issued 2008 guidance. For this year we expect to achieve full year organic net revenue growth of 15% to 16%, which represents net revenues between $349 and $352 million. Including Network Services, we expect net revenue to increase approximately 35% for the year. And our 2008 full year earnings guidance is now $1.12 to $1.15 per diluted share.

And turning it back to you, Bob.

Robert Carr

Thanks, Bob. Let me quickly conclude so we can open the call for questions.

We delivered solid growth on both the top and bottom line once again this quarter, rewarding investors with record volume and earnings in a most challenging economic environment. While we have posted consistent quarterly growth, Heartland has always managed to balance near-term results with long-term opportunity. Right now we have as many or more programs in development with significant long-term transformational implications for the company than at any time in our history.

I feel very fortunate to be surrounded by a wealth of talented, dedicated and motivated managers and employees who are rising to these new challenges and opportunities with creative new strategies and solutions, and we are fortunate to have the capital and financial resources to support their ideas and make the investments that help us achieve our long-term vision and goals.

Our entire management team is completely aligned with the interests of our shareholders. As announced in August, the Board of Directors has approved a new performance-based option program. Among the plans are many long-term oriented objectives, performance-based options, [best] only if fully diluted EPS grows at a compound annual rate of 25% through the years 2011, 2012 and 2013. We hope our shareholders feel confident that we are intensely focused on building value in Heartland now as well as over the long term.

Finally, our Board of Directors has authorized a $0.09 per share third quarter dividend, maintaining our commitment to use our strong results to reward shareholders.

And with that, we'd now like to ask for any of your questions. Operator, you can now open the call.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Patrick Burton - Citigroup.

Patrick Burton - Citigroup

My question will be: Did you guys see another turndown in the customer base in October and, if so, have you factored that into the forward-looking fourth quarter guidance?

Robert Baldwin, Jr.

It's hard. We just have the volumes numbers relative to last year, and it was pretty consistent with the September figure, September growth. But September, as we mentioned on the call, sequentially was the worst month of the quarter, so we were down 2% for the quarter. Same-store sales were down about 3.9% for September, and it's hard to judge precisely but I would say October was in the same ballpark. And yes, that deceleration has been factored into our expectations for the fourth quarter.

Obviously, it is extraordinary difficult to figure that out given the current environment, but we think we've been pretty cautious on it.

Patrick Burton - Citigroup

On the Payroll product, could you talk maybe a little bit about the opportunity there, how you're going to go against some of the entrenched market players? Is it going to be on price or leveraging your merchant relationships? How are you going to move into that market and what's the growth opportunity over the next couple years?

Robert Baldwin, Jr.

It's a great growth opportunity. We've put together a very strong team based in Cleveland. We are right now writing our own platform. We've been operating on a third-party platform which has constrained us in some respects, but during 2009 we expect - or really in the beginning of 2010 - expect to roll that out.

But the driver is having our sales force across the country selling. We are directly competitive with ADP and Paychex. Of course, we're dramatically smaller than they are and, in fact, we benefit a lot from opportunities to come in under, in essence, their price umbrella. So it is a price competitive product offering. They generally do a good job, but even if they turn off 3% or 5% of their existing customers, that represents a lot of growth opportunity for us.

So it broadens the product that our salespeople can sell. About half of our customers in the Payroll business are also card customers. We think in that case it enhances our retention of merchants when we have two products. But it definitely also allows the salesperson, as with our Check product, to go to a merchant who may not accept plastic and have a robust product set to handle some of their major cash flows of their business, in that case perhaps payroll and their check payments. So the opportunity there really is to broaden the target for our sales force.

Operator

Your next question comes from David Parker - Merrill Lynch.

David Parker - Merrill Lynch

Just a follow up on the previous question and just to get a clarification. MasterCard last night talked about declining volume growth in the U.S. in September and then that actually falling off steeply in October to negative growth, so are you assuming in your fourth quarter guidance that we see negative 4% same-store sale growth for the full quarter or is it going to be greater than that?

Robert Baldwin, Jr.

David, it's arguably a little bit more than that. It's a little hard to translate into expected volumes, which there are some pushes and pulls as far as new account expectations as well. So it's not a direct relationship with same-store sales declines.

But I'd say overall that our guidance suggests something that's no better than that negative 3.9% in September; it probably contemplates somewhat worse than that.

David Parker - Merrill Lynch

And then on the sales force, I think you mentioned that it was up 10% and that you expect to continue to grow it over the balance of the year. Would you at any point tone that growth down just if the economic conditions get worse, and how much of your growth is dependant on the sales force continuing to grow?

Robert Carr

Our plan is definitely to grow the sales organization. We've had record installs in the recent months. So that's really driving our growth and that's been our story for a long time. It continues to be. We have no plans to ramp down our growth in our sales organization, although we are much more focused on bringing in quality hires and also on our training program. We're focused a lot on that, so the percentage of growth has decreased in '08 but we expect the growth to continue in '09.

Robert Baldwin, Jr.

And it's important to note that hiring a salesperson, because of the way we pay our sales force  which is driven strictly by the installed margin that they're installing - the incremental cost of a hire is really quite modest. They'll process a lot only if they succeed at driving new installed margin growth.

And we're not changing our view that our business and opportunity is to continue to take share from the other players in the business. Each contract that we sign, the dollars of margin represents a very positive NPV and IRR for us and our shareholders. So we continue to try to maximize the margin we install in any period. Obviously, it's tough now, but you don't stop that or slow that down based on what's clearly a very difficult but nonetheless clearly a cyclic phenomenon because the long-term value is absolutely there in the new accounts.

David Parker - Merrill Lynch

And then you mentioned that you acquire Chockstone. Could you just give us some financial details - when did the deal close, how much did you pay for the company, how much do you anticipate it contributing in the fourth quarter and also in 2009.

Robert Baldwin, Jr.

We have not yet closed. We actually signed the agreement last night. We'll close in a couple of weeks. And so it's pretty premature - let me just say, it's going to be immaterial to our fourth quarter and, frankly, in all likelihood, to our 2009 results.

We think it's strategically an excellent opportunity and we're very excited to make the acquisition, but it is somewhat of a longer-term play in terms of having a material financial impact.

David Parker - Merrill Lynch

I assume that the loyalty platform that you're getting from Chockstone, I mean, that's the old Peppercoin business, and I believe that that also includes some micropayment, small ticket processing functionality. Can you just talk about some of the synergies that you might have with those businesses as you integrate them with your current businesses?

Robert Baldwin, Jr.

Well, first of all, Peppercoin was acquired - good catch by Chockstone - but their real focus was in aggregation of really small micropayments, and that's not a solution that's worked out very well for much of anybody. So I'd call it a trivial aspect of the value of Chockstone.

Chockstone has some very major contracts and is in play in an awful lot of the major retail and food service organizations' thoughts on loyalty. One major account that's out there is Subway, on which they provide currently all of the gift cards across the country and are rolling out their loyalty solution to an increasing number of the franchises; being a totally franchised operation, that sort of takes time.

There are multiple other, if you will, name brand clients that they have. They are deeply focused on QSR opportunities long-term and C-store, both of which tie in with both the legacy Heartland business but also particularly the Network Services customers. And we really feel very good about the quality of the platform. That was a driving consideration, that it's going to bolt on to our technology very nicely, and we're excited about the opportunities in this area.

Operator

Your next question comes from Robert Napoli - Piper Jaffray.

Robert Napoli - Piper Jaffray

The margin installed for the quarter growth of 11%, can you give a little more clarity, I guess, in line with same-store sales, how that growth trended through the quarter and in October, if you have it.

Robert Baldwin, Jr.

We don't have final numbers for October yet. The strongest month relative to last year was July. The weakest was August because we had a blow-out month in August a year ago. And then it was middling in September. So there's really no trend to report in terms of our success in the marketplace and, really, October was fine.

Robert Napoli - Piper Jaffray

The American Express, I was hoping, now that you're getting close to actually implementing the American Express product, if you can give a little bit more color on that and, I think, the potential materiality of that business for you in '09 and beyond and what's different about that product? They're more robust, as you put it, I think, in your press release.

Robert Baldwin, Jr.

Well, we now have Merchants Live. I think our first day's settlement was $28 a few weeks ago. And we'll be installing an increasing percentage of our merchants onto that platform during the coming months and then really, by January 1, we would expect all new merchants to be offered the AMEX settlement as part of their VISA/MasterCard settlement so that we would be providing the statementing, we would be providing the funding - obviously reimbursed by AMEX - and we would be handling their customer service.

What we said is that about 20% to 25% of all new merchants that we sign up go with AMEX and so, round numbers, it's going to be 1,000 to 1,200 that are going to be going on a month. And on all those merchants we get economics that are - a margin that is very similar to our existing net revenue margin. So financially it starts out very small but continues to build.

The second piece of the economic opportunity is different in that we have agreed with AMEX that during the course of 2009, assuming all proceeds as planned, we're going to do a couple of conversions of merchants that will remain under contract - and all this, by the way, is a contract that AMEX will continue to own - but we're going to take over the servicing from American Express for an increasing percentage of our merchants and also the statementing.

So that's going to be paid on a pennies per transaction basis, and that actually has a more material impact. We'll be giving more granular guidance on that when we give our guidance for next year, but it's in the order of a few cents a share for 2009.

Robert Napoli - Piper Jaffray

On the tax rate, is 38% still the right tax rate, do you think, for you guys or is it a little bit higher than that?

Robert Baldwin, Jr.

Yes, that's a good number. It will be a hair higher than that in the fourth quarter, but it's really some adjustments. It's [inaudible] local adjustments and things like that that are playing through a little bit, but 38% is a pretty good number going forward.

Operator

Your next question comes from Robert Dodd - Morgan, Keegan & Company, Inc.

Robert Dodd - Morgan, Keegan & Company, Inc.

On the equipment revenue, you had two very strong quarters in [a low] on that revenue number. I mean, is there anything extra going on there that you can tell us about?

Robert Carr

Yes, Robert. We've been installing a number of schools with our Campus Program and there are a material number of readers that we have to replace, laundry readers and vending readers, plus installing the normal equipment that goes with the one-card program.

Robert Dodd - Morgan, Keegan & Company, Inc.

Is there any visibility on kind of, you know, like a backlog kind of number or anything you can give us there? I mean, should we expect that to continue at these elevated rates for the foreseeable future or is this going to be very choppy and you've just had two goods in a row?

Robert Carr

I'm glad you asked that question because this is very seasonal business. This is second quarter and third quarter business, primarily. While some campuses do convert in the middle of the winter, there's very few, so this is going to be lumpy from year-to-year in the second and third quarter. We expect next year to be very strong growth in the campus market just as it was this year over last year.

Robert Baldwin, Jr.

And the other factor I'd mention is that Network Services does have a nontrivial equipment component in their revenues, and that's going to be coming down somewhat during the fourth quarter and into 2009. It's really a strategic shift. They were doing some business that really didn't involve recurring revenues. Our deep focus is on recurring revenues business, so there's a deemphasis on certain aspects of their business going forward. So that'll moderate it as well.

Robert Dodd - Morgan, Keegan & Company, Inc.

And then one on the customer acquisition costs in the quarter - up sequentially, but with same-store sales, I mean, I would have thought, with same-store sales being weaker sequentially so the accrued buyout liability would have been valued down and the signing bonuses from the cash flow were down, I would have thought that that would perhaps have dropped sequentially, but it didn't. Can you give us a bit of color on what's driving that in addition to those factors and any indications on where it's going to go would be helpful.

Robert Carr

I think the new sales installed trumps the reduction in same-store sales growth.

Robert Baldwin, Jr.

I think that's right. I mean, the biggest driver of the number was the increase in amortization of the signing bonuses which, of course, continues to accumulate. But it was - about $1.8 million of the increase from a year ago was due to the amortization of signing bonuses.

The other factors, you know, I don't have the second quarter numbers, but the increase in the accrued buyout liability was less than a year ago. I don't have the second quarter number with me, but I'd express it more in the form of it flat lining sequentially rather than up or down a little bit, as it was.

Operator

Your next question comes from Julio Quinteros - Goldman Sachs.

Julio Quinteros - Goldman Sachs

I jumped on a little bit late so I just wanted to go back through a couple of quick points on the NWS commentary. Can you just give us a sense on the contribution that NWS made. It obviously looks like you guys are saying that it was accretive in the quarter. Any disclosure there that you can add in terms of the merchant growth excluding NWS and then the accretion to the actual quarter?

Robert Baldwin, Jr.

The last part of your question, Julio, rephrase that please?

Julio Quinteros - Goldman Sachs

Merchant growth excluding NWS, if you can give that.

Robert Baldwin, Jr.

Well, first of all, NWS is, as we've mentioned, large contracts that are very lumpy, so we're doing some RFPs right now that would be installed in 2009. We haven't added any merchants in 2008 since the acquisition, and there were no new merchants in the pipeline. So really it's going to be a sort of steady state for awhile, depending on the actual volume of the existing customers, before we start ramping that up, targeted later part of 2009.

And they were modestly accretive there. It's really driven by there was a one-time payment from a customer that was departing. We had known; it was built into the plan. But as a termination fee, it sort of all flows to the pre-tax line, so that helped some. And otherwise it really came in very much as expected.

Julio Quinteros - Goldman Sachs

And I guess if you kind of look back on what you originally had planned and kind of the environment where it is now, any change in terms of your expectations for the contribution from NWS relative to your previous guidance for sort of the accretive impact of the acquisition here?

Robert Baldwin, Jr.

It's a little better than we had given original guidance. We said it was not accretive for this year. It will be modestly for this year. And looking out into next year, no material changes; it absolutely will be accretive and we feel good about the opportunities on the cost side there. They're coming in very much in line with what we had anticipated.

Operator

Your next question comes from James Friedman - Susquehanna Financial Group.

James Friedman - Susquehanna Financial Group

Bob, I was wondering if you might be able to walk through some of the economic contribution you'd anticipate from Discover similar to the way you described it for American Express.

Robert Baldwin, Jr.

Okay, sure, Jamie. The Discover deal is different in that it really is a purchase by us at some point, once we've finished the platform changes that will allow us to also add Discover processing to the statement and to the daily cash flows. We will buy out contracts that are owned by Discover at a pre-agreed multiple.

And from that point forward - in essence, what we had last year was about $1.75 billion of dollar of merchants that we do the VISA/Mastercard for that did their Discover. That pre-existing portfolio is sort of attriting because over the last year we've been adding, under the new Discover IMAP program, all the new merchants have been on the same kind of economics as we expect to experience going forward, in other words, sort of our full margin on transactions.

So as time goes on, we are each month adding. Almost all of our merchants are signing up for Discover as well as VISA/Mastercard and, whatever their Discover volume, we're getting economics that are the same as ours. But then we'll have a bump and the bump, as of right now, we're expecting to be during the first half, hard to fine-tune. Really, it's a question of the many priorities that we have for transition in our platforms and when that factors in.

But clearly a major first step was getting the AMEX done. That really was the template for what we're going to do with Discover. And so far that's gone well, so we're pleased with that. And that Discover conversion will happen some time probably in the first half of next year.

James Friedman - Susquehanna Financial Group

And since we're talking about next year, would you have any updated thoughts about same-store sales for 2008 and a conjecture on 2009?

Robert Baldwin, Jr.

None beyond what we've said, which is clearly we anticipated, when we gave our original guidance, zero to 1% same-store sales. I think in the quarters we were at plus 0.7%, minus 0.1%, minus 2%, so clearly we're going to be below the bottom end of our expected range. We're still going to be looking hard as time passes. We're not giving guidance now. We're going to look to do that when we give our fourth quarter results. But obviously, this is a tough economy. And people are using cards in more and more places as time goes on, but obviously the overall level of activity at retail is very slow.

Actually, I ought to point out that, again, it is retail and entertainment that are strikingly weak. Restaurants and hotels in the last quarter were very modestly worse than our overall averages. And just to give you a sense, the dollar amount of decline from existing merchants in retail was almost as high as the dollar amount from restaurants, even though restaurants obviously are a much bigger part of our portfolio. So that's really where it's tough out there in Main Street America.

And right now we're going to obviously be prepared for a tough year next year because it looks like that's going to be, but we're still working on what our guidance is going to be.

Operator

Your next question comes from Thomas McCrohan - Janney Montgomery Scott.

Thomas McCrohan - Janney Montgomery Scott

Bob, can you just talk about margin trends in the context of slowing same-store sales growth so if, you know, we're in for a period of - well, it looks like we are - possible negative same-store sales growth through 2009, can you kind of reconcile that with your comments in your prepared remarks that you can see margin improvement next year?

Robert Baldwin, Jr.

Well, Tom, the driver there is do we keep our expense growth lower than our revenue growth? And if we come to a conclusion that revenue growth will be slower, then that will force us to drive our expense growth lower.

We haven't nailed that down; we're in the middle of our budget process now. But clearly we've communicated with our people that it's going to be a question of prioritization, of making sure that we make great use of more scarce resources, and we feel that that dynamic can play out even in the tougher growth environment we're in now. I'd also point out that for the full year we're still guiding to 15% to 16% net revenue growth, so you can still grow your expenses and get operating margin growth when you have that kind of top line growth.

So I think that it's absolutely possible. It's just a question of maintaining the discipline. And remember that a lot of our expenses for G&A in particular are not really related to making the donuts now. And even in our, you know, there's a certain amount - of course, most of our processing and servicing is, but there we're getting scale economies and the G&A is really driven toward building for the future. And obviously there you have to be good stewards of the shareholders' money and be disciplined in your cost growth.

Thomas McCrohan - Janney Montgomery Scott

The implicit margin in your fourth quarter guidance, assuming you hit kind of the midpoint of the EPS guidance, assuming the low end of your organic revenue growth guidance and the $410 million overall gross revenue guidance, you'll do $0.26 a share in Q4 and that kind of implies a pre-tax margin a shade under 15%. So I'm just, you know, compared to the healthy margins in this quarter, can you just kind of talk about - maybe my math is wrong.

Robert Baldwin, Jr.

I can't do math like that on the fly, Tom, sorry. We can talk offline, but I can't go there on the fly like that.

Operator

Your next question comes from Tim Willi - Avondale Partners LLC.

Tim Willi - Avondale Partners LLC

Bob, I was wondering if you could talk about what you're seeing in the M&A environment and how just sort of that relates to your cash flow and capital structure. And I'm particularly curious, you know, given the sort of deal like Chockstone was and some of the other acquisitions you've done recently, are you seeing smaller targets that have some kind of very exciting or innovative product but maybe they don't have as much access to capital anymore as they would have liked and are increasingly looking at a sale of the company in this environment? And just again, how you think about that and Heartland maybe over the next 12 to 18 months.

Robert Carr

I'll comment on that first. The times are definitely different today than they were. There are lots of opportunities out there. Most of them are portfolios of LISOs and ISO organizations. We are not interested in rolling up, you know, the industry and playing a role in that, just because it's not in our business model.

What we are working hard on at Heartland - and I think doing a pretty darn good job lately - is expanding our product base and expanding the verticals that we can be competitive in. And we have identified several different markets that we want to do acquisitions in. Gift card was the largest outsourced part of our business and that was very motivating to us to do the Chockstone deal.

So we're looking. We think there's some good opportunities out there and my expectation is that over the next 15 months we're going to be doing a number of other smaller acquisitions that are going to be directed to broadening our product set and to allow us to be more competitive in more verticals.

Robert Baldwin, Jr.

And I'd only add that it's hard to predict when people are going to run into financial stresses, but clearly you have to be - it's important to maintain your capital base and your liquidity, your access to the capital markets, and we're very sensitive to that. That means that you're going to be very disciplined in your pricing.

On the Chockstone deal we haven't gone into details, but of the total amount that's payable, well less than half of the total possible consideration is being paid upfront. And so if things go very well for Chockstone working with Heartland and as part of Heartland, their shareholders are going to do fine. But it's all backend loaded and reliant on the success of that unit, which we're very excited about. So that was a way to leverage our capital and make sure that we have dry powder for other platform-enhancing transactions.

Robert Carr

I think our sales organization is going to be very excited about Chockstone because now we're going to be - we have control of our destiny having our own platform and we can integrate lots of different functionality into our own platform when we have control. We have not had that, and Bob mentioned that we're developing our own Payroll platform as well. This is all very exciting to our organization because it lets us build competitive advantages in our products. Most of our competitors aren't able to do that.

Operator

Your next question comes from Sanjay Sakhrani - Keefe, Bruyette & Woods.

Sanjay Sakhrani - Keefe, Bruyette & Woods

Bob, I think you mentioned that you guys had record merchant installs. I was wondering, who are you guys typically taking share from and kind of the industry verticals that you've having the most success in? And then maybe you could also touch on merchant attrition rates.

Robert Baldwin, Jr.

Really, we don't discriminate in our efforts to take share away from the industry. If you look at the share, it is held by the banks and so a lot of merchants come to us from banks. But the driver is really are they getting fairly treated by their existing processor and can we come in with a package that's more attractive for them. And there's no particular group that we're going after.

It terms of verticals, restaurants has been coming down a hair in terms of the share of our overall business. As a percentage of our new business, restaurants are not growing. It's running a quarter to a third of our new installs but 30% of our merchants are now restaurants, which is down from 31% or so a year or two ago, so there's no generalizations. But we're also broadening the products. We're broadening in terms of Payroll, the Express Funds product, so it's a little bit less on the card side.

And in terms of attrition, the driver of our volume attrition this quarter was the weak same-store sales growth. We are running about 1 percentage point worse in terms of merchant account attrition this year compared to about a year ago. So it is a little bit worse in terms of merchant account attrition. But the driver is that those merchants that stay with us are shrinking in terms of their volume, and so the volume attrition gets worse as a result of that.

Operator

Your next question comes from Anurag Rana - KeyBanc Capital Markets.

Anurag Rana - KeyBanc Capital Markets

Bob, just wondering about large customers. You talked awhile ago about the sales force going out to larger merchants, and I just wanted to see if there's been any success in that area and how you perceive that opportunity at this point.

Robert Carr

We think that's a great opportunity. It's been very interesting talking to the large customers that we acquired with Network Services. We're a one-stop shop in the fact that we can do front end, back end, and now gift and loyalty - big merchants like that - so that everything's integrated into one.

I think we're going to be a significant player in the years coming ahead. There's not going to be anything coming down in the next few months that I know about that's going to shock the world, but I think we're going to be able to add a lot of value to many large merchants and we can do it in a way that's profitable because of our integrated platforms. I think you're going to see a lot of activity there.

And I also mentioned security. Security is a major driver of the interest of the - not just the payment departments of large companies, but of the corporate risk officers who are very concerned about the risk to the brand in the event of a TJ Maxx or an [Annafer] type problem. And the current platforms out there are not really, in my view and in the view of a lot of the large merchants I talk to, they're not really adequate to counter the criminal organizations that are hacking through in various ways.

So I think there's a lot at play going forward. I think the world's going to change a lot over the next few years with large merchants.

Operator

Your next question comes from Franco Turrinelli - William Blair & Company, LLC.

Franco Turrinelli - William Blair & Company, LLC

Could you start by talking a little bit more about the competitive environment, maybe particularly pricing as well as? Obviously, this is a time when everyone's going to be a little bit more desperate for growth, and I'm just kind of wondering what the environment's like out there.

Robert Carr

The biggest thing I see - and I'll let Bob speak, too - Franco, is that there are just so many oppressive price increases being dumped onto the merchants right now. Companies that have never done it before are raising rates arbitrarily 25 basis points just because they can get away with it. I saw a fee this morning, a $30 personal property tax fee for a machine that cost $135; increases of $140 a year just because compliance issues need to be dealt with. So this is where we're picking up a lot of business, merchants who don't have the Heartland model of fair dealing, not throwing out pricing increases.

So from my point of view from where I sit, it looks to me like the competitive landscape is good for us because so many of our competitors are out doing these price increases now so they can hit their numbers, apparently, this quarter.

Robert Baldwin, Jr.

It's tricky, though, because at the merchant the competitive landscape is always the local - whether it's a bank or ISO - who's really the most aggressive, and you rarely if ever win with a higher price than the merchant is paying now. What happens, though, is after the sale the merchant ends up paying often much more or much more than they think they are. So the key thing is getting through to them and having them recognize that.

Bob made reference to the Price of a Burger campaign. We're going to be pushing this very, very aggressively in the coming months. The industry is looking to the existing base of merchants to maximize their yield on them by jacking up their rates, and we're going to be out there with our different model and we think it's going to be very successful while maintaining good pricing discipline. Our model does not reward a salesperson for signing up a merchant on lousy margin. They won't get paid very much if it's lousy margin.

So we think we can continue to maintain our pricing, but really by offering the merchant that we're not going to jack things up later on. That's really where the value piece is going to come in.

Robert Carr

And to just sort of summarize both of our comments, Franco, I think the world has become increasingly a bait-and-switch model of going with a low price and then raise it up by a lot a few months later, and that's the game that the industry's in right now with small and midsize merchants.

Operator

Your next question comes from David Koning - Robert W. Baird & Co., Inc.

David Koning - Robert W. Baird & Co., Inc.

First of all, it looks like Q4 organic growth is going to be somewhere in the ballpark of 9% to 10%. And I'm just wondering, next year, as we do kind of look out, are the two things that really can make that better that next year an improvement in same-store sales and an improvement in gross margin install? So that's the first question.

Then the quick second question is just normally I think Q1 EPS is down a little from Q4 on a normalized basis and maybe you can just comment if that's still kind of a normal trend.

Robert Baldwin, Jr.

I think that I guess, so far as the guidance goes, Dave, it could be that low. I'd say we widened the band of what we're guiding toward in a sense relatively because of the level of uncertainty out there. We're not predicting things, but we're trying to suggest what might be possible. And I think that that number is what might be possible on the downside.

In terms of next year, it does require - it's a combination of installed margin growth and then getting some form of recovery of same-store sales in the equation to drive growth into the future, and a lot of things that we're doing are exactly focused on achieving those outcomes.

The second part of the question was - oh, the first quarter. We're going to be - you will see the same pattern, Dave, of the first quarter being soft.

And the only thing I'd note in that regard - and we're still working on our budget, so we don't know the exact numbers - but, as you know, from time to time - and we used to call them annual meetings; we don't call them annual meetings because they aren't annual anymore - but our sales summit, which is going to occur in April of this year because we chose to have it in April of this year, will mean that we'll be accruing all of that cost, which is nontrivial, into - most of it will go into the first quarter. So that's going to, if anything, take a little bit more wind out of the first quarter's results than you'd otherwise expect.

It's an absolutely critical cultural and educational opportunity for our sales organization as well as the rest of the organization, so we think it's a very, very good use of the shareholder's money to do it. But from an accounting standpoint, a heavy piece of it's going to hit in the first quarter of next year.

Operator

Your next question comes from Tien-Tsin Huang - J.P. Morgan.

Tien-Tsin Huang - J.P. Morgan

I had a follow up to Dave's question, actually. So I guess, if we assume that low double-digit margin installed persists and we continue to see same-store sales to be down in the low single digits, what would this equate to in terms of organic growth next year? Is double-digit growth still achievable organically?

Robert Baldwin, Jr.

We would expect so, yes, Tien-Tsin. But when you say - if you want to assume lousy growth in installed margin and terrible same-store sales growth, you get bad enough on both of those it's going to be tough. But we expect to improve upon this 11% to 12% growth in installed margin for next year and don't - right now haven't figured out what we're going to anticipate in terms of same-store sales growth next year. The tougher it is, the tougher it is to generate double-digit growth.

Again, I would mention, though, that same-store sales for us is an upwardly biased number. It's the card payments that are made. And, in fact, just an important statistic is that in the debit world that debit is over 40% - this is check card or offline debit; PIN debit is about 2.5% of our volume and this is all legacy Heartland, not including Network Services - but offline debits remain very solid for the third quarter. Our growth in that was at around 16% in aggregate. The weakness was more in the credit side. And interestingly, offline debit growth year-over-year in September was just a hair under that 15.9%, so not deteriorating the same way that credit did in September.

So debit is an important and growing part of our business and highlights the fact that individuals continue to move toward electronic payments in various forms and so it should tend to upwardly bias that same-store sales number, showing how tough the environment is out there right now.

Operator

Your next question comes from Robert Napoli - Piper Jaffray.

Robert Napoli - Piper Jaffray

I didn't quite get the performance-based option targets and I was hoping you could maybe go through that.

Robert Baldwin, Jr.

Yes. Bob, we're going to be measuring it as of March of each year, but including the run rate of Network Services revenues, we need to grow our net revenue by a cumulative 15% per annum to vest in the options and we also have to grow our cumulative EPS by 25% per annum, so the Board gave out a fair number of options to the people who can make the Network Services deal a success. We think if we make that a success that those numbers are achievable, both 15% compound net revenue growth and 25% earnings per share growth. If we achieve those, then those options will vest in equal parts in 2011, 2012 and 2013.

Operator

Your next question comes from Robert Dodd - Morgan, Keegan & Company, Inc.

Robert Dodd - Morgan, Keegan & Company, Inc.

On the performance-based options, what's the base year that those are going to be based from for that growth rate? And then, secondly, are you seeing any increase in attrition in your merchant base from teaser rates?

Robert Baldwin, Jr.

It's through March of 2008 was the base, the last 12 months - the last full quarter without Network Services is the base. And we'll be measuring it in the 12-month periods ending in March of each year going forward.

In terms of - it now is and has been that a healthy portion of our attrition is going to competitors. In the marketplace, the merchant has just a tremendous amount of things that are thrown at them. They are typically focused on building their business, whether it's taking care of their customers and the product that they're selling, so someone walks in and looks them in the eye and says, for example, I'll charge you 1.6%.

The whole point of the Price of the Burger campaign will be to say basically if someone's offering you 1.6%, they are not telling you the truth. They're going to charge you 1.6% on part of your processing, but then there's going to be downgrade fees and other fees that bring it up above that because interchange is above 1.6%. It has been and will be these teaser rates.

But, as Bob was mentioning, we are seeing people being more aggressive about jacking merchants up on the back end, and that is what's going to come to our benefit as we're going in and saying have you seen your recent processor's statement that looks like this? What does this $139 fee represent? What are they promising to do for you and why is that something that you ought to pay?

So we think it's going to be very effective, but the reality is a year from now, two years from now, we will still lose merchants to other pricing techniques. Unfortunately, teaser rate sales work. Long-term, the opportunity for Heartland is to build the reputation for fair dealing in the local community in all kinds of payment mechanisms, and I think that's a fantastic opportunity to build a bulletproof product offering over the long term. But we're going to take, you know, it's going to be two steps forward and one step back now and next year and the year after that, too. But we'll keep progressing.

Operator

This concludes today's Q&A session, and I would now like to turn the call back over to Mr. Carr for any closing remarks.

Robert Carr

Thank you all once again for joining us on this historic morning for our country and have a great day. Thank you.

Operator

This concludes today's conference call. You may now disconnect.

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Source: Heartland Payment Systems, Inc. Q3 2008 Earnings Call Transcript
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