Heartland Payment Systems, Inc. Q2 2009 Earnings Call Transcript

Heartland Payment Systems, Inc. (HPY)

Q2 2009 Earnings Call

August 4, 2009 8:30 am ET

Executives

Robert H. B. Baldwin, Jr. – President & Chief Financial Officer

Robert O. Carr – Chairman of the Board & Chief Executive Officer

Analysts

David Koning – Robert W. Baird & Co.

Robert Napoli – Piper Jaffray Companies

Thomas C. McCrohan – Janney Montgomery Scott, LLC.

Brett Huff – Stephens, Inc.

Analyst for James Friedman – Susquehanna Financial Group, LLP.

Robert Dodd – Morgan Keegan & Co.

Analyst for Tien-Tsin – JP Morgan

Andrew Jeffrey – SunTrust Robinson Humphrey

Franco Turrinelli – William Blair & Co. LLC.

Presentation

Operator

Welcome to the Heartland Payment Systems second quarter 2009 call. My name is Chrissie and I will be facilitating your audio portion of today’s interactive broadcast. All lines have been placed on mute to prevent any background noise. (Operator Instructions) At this time I would like to turn the event over to Mr. Robert Baldwin, you may begin your call.

Robert H. B. Baldwin, Jr.

I’d like to welcome you to our second quarter 2009 earnings call. Joining me this morning is Bob Carr, Chairman and CEO. Today Bob will begin our discussion with the overview of the quarter and then I’ll return to go through some of the details before taking your questions. During the course of this call we will be providing comments on the processing system intrusion. Our investigation of the system intrusion is confidential and ongoing, consequently, beyond today’s prepared remarks we want out participants to be aware we do not intend to make any additional comments.

Before we begin I would like to remind you that some of our discussion may contain statements of a forward-looking nature which represent managements’ beliefs 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 report of our financial results we released earlier this morning and the company’s SEC filings.

We undertake no obligation to update any forward-looking statements to reflect events or circumstances that may arrive after this call. Now, I’d like to turn the call over to Bob.

Robert O. Carr

By now you should have our financial results for the second quarter that we released this morning. On an adjusted basis we reported net income of $9.3 million or $0.25 per fully diluted share. Bob will go through the official GAAP results in more details but I believe the adjusted results best reflect the fundamental performance of our business since they are the numbers we use to run the business. Though down from the year ago period these results mark a rebound from the first quarter even though we believe there was some deterioration in the second quarter economic environment facing our merchants.

Transaction processing volume continues to reflect economic weakness. In particular it feels like our small and midsized merchants are suffering more than the broader market as same store sales were negative for the fifth consecutive quarter this quarter down a record 9.7%. Total new margins installed in the quarter was flat sequentially with the first quarter but down 17.2% from the record levels of new margin installed in the second quarter of last year. We have not seen a meaningful change in merchant account attrition over the last three quarters so we do not believe the breach has had a material impact on merchant counts or on processing volumes.

We also have seen no increase of attrition on the sales organization as a result of the breach. While competition is intense, we are sustaining our pricing. It’s clear that the economy that has merchants in survival mode focused on their business serving their customers and not necessarily shopping their processing relationship. Nevertheless, economic weakness of this magnitude is unprecedented in our experience as a company.

On the other hand we are starting to see growth in the processing volume from our new American Express and Discovery agreements. We are one of just a very select group of processors in the industry that can now offer merchants a single platform through which they can process all four of the major card brands. As planned, just this week we purchased the Discover portfolio. The transactions from our merchants we were previously handing off to Discover will now be processed over our network where we will earn our full margin. We expect to see both the Discover and American Express processing volumes to ramp in future quarters from the purchased portfolio and as more merchants are added.

Our payroll micropayments and check businesses are similarly affected by slower economic activity and falling payrolls. Though we saw increase in both our payroll and equipment revenues this quarter, growth rates have slowed. We are making progress on many fronts, in the second quarter 92.1% of new merchants were installed on HPS Exchange, helping improve operating leverage. Although revenue growth slowed in the quarter, margins rose sequentially to 14.7%. We are optimistic the recovery in margins from the first quarter should continue over the balance of the year especially as we anniversary costs assumed in the Network Services acquisition and we reduce the extra costs created by the breach.

For the second consecutive quarter we grew the number of relationship managers with 1,210 as of June 30^th. We also increased our team of account managers who install new merchants and manage ongoing relationships to 327 at June 30^th, up from 308 at the end of the first quarter. Our entire sales organization is certainly being challenged by current economic conditions. They are aggressively marketing our growing suite of products and establishing relationships we expect will lead to better opportunities as the economy recovers.

In addition to being able to offer our merchants a platform that can accommodate all four major card brands, we have enhanced the reporting and analytics we provide to our merchants. The tools we can provide through our new MicroStrategy relationship will give merchants better insight in to their business by turning static data in to a valuable asset for understanding customer behavior, analyzing products, identifying business trends and managing risk.

Our Campus Solutions division has also been a success. This summer we have added 16 new colleges and universities to our program with more on the way. We’ve continued to improve the product having added new campus safety and security enhancements as well as food service capability that enables campuses to tie their back end menu management and nutritional information to customer purchasing data for more effective planning and control of their dining operations.

However, the most exciting new development is our end-to-end encryption project, our technology that we call E3. Just a few weeks ago we successfully completed the first phase of a pilot project by transmitting live advanced encryption standard or AES encrypted card transactions from a merchant to Heartland’s processing platform using our newly developed tamper resistant security module or TRSM terminal. To the best of our knowledge this is the first time encrypted transactions have been sent from a merchants card reader to and through a major processors’ payments network.

We have currently 10 merchants live on this beta. We are on schedule to introduce E3 before the end of the year which we believe will offer merchants the highest level of beta security in the marketplace. We believe a successful roll out should provide a distinct competitive advantage as merchants become increasingly sensitive to their security risks. We believe security is a major issue facing merchants beginning with the larger chains that have the resources and face the biggest risk to their franchise from security issues we believe it is inevitable that merchants will be demanding the highest level of security in their transaction processing as we move forward.

Let me add that our E3 project is just the most visible evidence of our extensive investment in technology to improve security throughout our system and to fortify our entire infrastructure. Since introducing the industry’s first new processing technology for brick and mortar merchants in nearly 15 plus years, we have continued to enhance and expand our technological capabilities including the partial integration of acquisitions such as Network Services, Chalkstone and others. Over the long term we believe these investments will yield attractive returns for our shareholders.

Now, let me update you on the processing system intrusion. Let me preface my remarks by reminding everyone that our position previously articulated has not changed and it is Heartland’s continuing intention to vigorously defend claims asserted against us in our belief that we have meritorious defenses to claims asserted to date. We remain fully engaged in the ongoing investigation and resolution of claims that have arisen from the processing system intrusion. Although we cannot foresee the ultimate outcome at this point, there have been some movements on several fronts that lead us to believe we are making progress.

This quarter, processing system intrusion costs were $19.4 million which includes reserves for an offer Heartland has made to settle certain of the claims. Consistent with FAS 5, such a settlement offer requires the accrual of a reserve in that amount. At this point we do not believe that an unfavorable outcome is probably on the other claims that have been or may be made against us and we do not have sufficient information to reasonably estimate the loss we would incur if we faced an unfavorable outcome on any of those claims.

Accordingly, no costs for those claims are reflected in our financial statements. The other costs included in the processing system intrusion include fines and legal fees. Because the nature of these ongoing matters is confidential including the settlement offer, you can understand the limitations of the disclosure we can share with you.

Let me now turn the call over to Bob.

Robert H. B. Baldwin, Jr.

Heartland reported a GAAP loss of $2.6 million or $0.07 per share for the second quarter of 2009. Excluding separately identified processing system intrusion costs, net income would have been $9.3 million or $0.25 per share. Considering the awful market conditions, same store sales and new margin installed performance, our increased technology investment and the distraction from the breach, we believe this was a very solid quarter.

Bob took you through the same store sales and new installs performance for the quarter, with these growth drivers still suffering, total processing volume was $17.8 billion up 3.8% for the quarter. Organic card processing volume was actually down 0.6%. Total same store sales were down 9.7% in the quarter. Retail, hotels and electronic were down worse than average, continuing recent trends and of course petroleum was weak given price declines relative to last year’s second quarter.

Restaurants remained a bright spot coming in about 2% better than the overall average and entertainment reversed trends by outperforming the averages. Quick service restaurants and convenience stores also continued to perform much better than overall same store sales results. Within the quarter, June represented a trivial improvement from May and it looks like July was perhaps a bit better.

While SME volume was off a bip for the quarter, our transaction count for the quarter grew by 5.6% so the volume is up but the value of each transaction is down. Debit dollar volume grew 8% for the quarter while credit fell by 7% reflecting continued weakness in credit and an ongoing increase in debit share of the payments pie. Network services transaction volume was 728 million transactions in the quarter, up 87 million sequentially from the first quarter and generally in line with our expectations.

Net revenue for the quarter was $106.6 million up 14.1%. About $8.5 of the total $13.2 million revenue increase was attributable to Network Services. Despite the difficult conditions, organic revenue growth was 4.9% as we managed to increase both organic card processing and payroll and equipment revenue. The new Amex and Discover processing arrangements are still ramping up so have negligible net revenue impact.

Total cost of services for the quarter were up 5.2% from a year ago on a 14.1% net revenue increase. The increase in cost of services is primarily the result of a 16.5% increase in processing and services cost and a 57.2% increase in depreciation and amortization. Beginning with the third quarter we should see growth in both of these costs start to normalize as we anniversary the end of the [US] acquisition which caused the large increases. In addition, processing and servicing is one of the categories where costs are up due to the processing system intrusion related expenses and inefficiencies.

Dues, assessments and fees were also up a little faster than overall costs reflecting the significant fee increases we have seen from Visa and MasterCard we have seen in recent months but these are fees that we pass through to merchants. Customer acquisition costs were up 3.9% for the quarter continuing to reflect the lower rate of new margin installs and weakness in same store sales.

G&A costs were up 45.9% in the quarter compared with the second quarter of 2008. The increase is due in part to overhead costs added in the Network Services acquisition and our ongoing new product development investment especially for E3 and other technology infrastructure initiatives. In the second quarter the remainder of the Heartland summit costs totaling $885,000 were also expensed.

As in the first quarter we’ve separately broken out processing system intrusion related costs in our income statement. For the second quarter these costs were $19.4 million pretax and on an after tax basis represented about $0.32 per share. The majority of these charges relate to a settlement offer we made in an attempt to resolve certain of the processing system intrusion claims. The settlement offer was made in an attempt to avoid the cost, uncertainty and time delays of litigation.

To date we have not received any response to the settlement offer and there can be no assurance that these claims will be settled at the proposed levels. By making this offer we believe we are required to accrue for the amount of the settlement offer. The accrual of the settlement offer resulted in a $14.4 million reserve for processing system intrusion at June 30, 2009. It should not be assumed that we will resolve the claims related to the processing system intrusions for the amount we have reserved and it is possible the company will end of resolving these claims from amounts that are significantly greater than the amount we have reserved to date requiring additional future reserves.

The remainder of the expenses and accruals were primarily for the legal fees and for costs we incurred for investigations, remedial actions and crisis management services. Operating income for the quarter was $15.6 million and the operating margin on net revenue for the quarter was 14.7%. Sequentially, that’s a significant improvement from the first quarter that is consistent with prior year’s seasonal pattern although the margin remains at a lower level than a year ago due to the Network Services acquisition. We continue to believe that over the long haul we can drive operating margins significantly higher.

Now, let’s look at our cash flow; operating cash flow for the quarter was $21.2 million. More importantly management’s measure of operating cash take net income, [match] back, amortization, depreciation, the provision for the processing system intrusion and other non-cash items at the top of the operating cash flow statement resulting in total sources of $33.8 million. We then reduce that figure by signing bonuses and buy outs paid. Using this management metric, operating cash grew 30% in the second quarter to $22.9 million from $17.6 million last year.

Capital expenditures for the quarter were $13.4 million of which $5.7 million was for the construction of a new service center in Jeffersonville Indiana with most of the balance used to strengthen our technology infrastructure. Taking that same management definition of operating cash and reducing it by non-service center cap ex, our free cash flow amounted to $15.2 million for the quarter up 29% from last year’s second quarter. Keep in mind however that we are using cash to fund the ongoing cash cost of the intrusion particularly including legal expenses. We also used $375,000 of cash to pay dividends in the second quarter.

We remain very conscious of our liquidity especially given perspective costs arising from processing system intrusion which could potentially be material. Currently we believe that Heartland’s cash generation capacity combined with our strong balance sheet and access to other sources of liquidity to be adequate to give us capacity to absorb future potentially significant costs. These resources include our excess cash position at quarter end, our quarterly operating cash flow, our ability to raise debt and our ability to leverage the unencumbered asset represented by the service center in Jeffersonville.

In addition, we do have insurance coverage that we believe should provide resources for certain of the intrusion related costs and expenses. Of course, at this time we cannot assure you that our financial resources will in fact be sufficient to meet the cash burden we may incur as a result of the breach, we simply do not have the information that will enable us to reasonably estimate the amount of total losses we might incur by reason of such claims and many of these losses are not currently deemed probable. We recognize we may incur losses in connection with the breach. Such losses may be material and could have a material adverse impact on the results of operations and financial conditions.

Let me wrap up with our guidance for the year. A slowdown in the economy faced by our merchants got even worse in the second quarter and it remains unclear as to what the rest of the year holds. It seems that consumer spending has been particularly affected in this recession and seems to fall more harshly on small and midsized main street merchants that we serve in our SME portfolio. This is likely to not only limit same store sales growth but also limit other product growth opportunities as well as new business development activities.

For example, this guidance assumes less of a lift from the Amex and Discover relationships even though we remain enthusiastic about their long term prospects. Overall, our guidance assumes a business environment for the remainder of the year that is essentially unchanged from what we saw in the second quarter. We are also in an environment of additional costs to support our technology plans and to address the processing system intrusion and only a portion of such costs can be separately identified.

All of the above factors necessarily add conservatism to our guidance. The guidance for 2009 did not include any estimates for potential losses, costs and expenses arriving from the system breach including exposure to credit and debit card companies and banks, exposures to various legal proceedings that are pending or that may arise and related fees and expenses or other potential liability costs and expenses. The costs already incurred and accrued for the first half of this year are similarly excluded from this guidance.

In addition, our guidance excludes 123R, stock compensation expenses which has been immaterial over the last few years but it has now become a more significant expense as a result of new options granted during the second quarter of this year. Heartland has not repriced previously issued options. Taking that all together, for 2009 we expect to achieve full year net revenue of between $400 and $425 million which is about a 10% increase compared to 2008 net revenues of $384 million. Our full year guidance is now $0.85 to $0.90 per diluted share with excludes $0.06 of 123R stock compensation expense.

Back to you Bob.

Robert O. Carr

Economic conditions in the second quarter did not improve from the first quarter and while there is optimism the worst may be behind us, there is still a great deal of uncertainty. In the short term this is certain to weigh on processing volumes and revenues. In the second quarter we’ve managed to adjust economic conditions to generate attractive margins and profits and sustain our liquidity.

We are not letting this deter us from our long term thinking. In addition to our strong focus on the needs of the small and midsized merchant, we are committed to a leadership position and ensuring the security of the processing system network. Our E3 initiative is a revolutionary idea that we believe addresses a large and growing issue for our merchants. Beta testing is underway and we are optimistic we will have this product in the market by yearend.

Before closing today’s call and opening it up to questions, I am pleased to announced that the board of directors had declared a third quarter dividend of $0.01 per share payable September 15^th to holders of record on August 25^th. With that, we’d now like to open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from David Koning – Robert W. Baird & Co.

David Koning – Robert W. Baird & Co.

I guess my question is around the gross margin install, with retention being good but it seems like new sales are being impacted maybe mostly by the economy but maybe can you talk just a little bit about if there’s some impact from the breach just on new sales or if you really think it is just all the economy?

Robert H. B. Baldwin, Jr.

I think it’s mostly the economy frankly and there’s some hesitation and some slowdown on account of the breach by some merchants. I think we’re through that, that happened a lot in the first quarter. What we’re finding and this is really sort of not expected is that our veteran reps who have the highest average of install margin month-over-month are suffering the most. We think that’s because new locations are not being added by our customers and we count that as new business in the way we do our metrics.

Also, there’s no business formation hardly at all so we’re not benefitting from that natural growth in the economy and there’s just much more focus on the merchants part to do their knitting and not as much interest in making changes although we’re doing our best to get there. Also, our sales people have rightly been focused on retaining their customers and dealing with questions and explanations, a lot of discussion on end-to-end encryption out there. It’s a combination I think mainly of the economy but also playing defense to a degree that we’ve never had to play it before.

David Koning – Robert W. Baird & Co.

I guess the second question a little bit around that too, I know gross margin install on a quarter-to-quarter basis really doesn’t have a huge impact on revenue and if we isolate a couple of quarters here where gross margin install has been pretty weak it might not have much of an impact longer term but maybe talk through a little bit how you see the rest of the year playing out on gross margin install and then what the impact on the next couple of years from that pattern could be if there really is much of a pattern?

Robert H. B. Baldwin, Jr.

The longer that we remain at this depressed level the more the cumulative effect. So, frankly in terms of the guidance the biggest change from where we were previously to now is that we had assumed a recovery, not dramatic growth in new large install but a recovery to comparable levels to last year and then somewhat above comparable levels in the back half of the year. We don’t have a crystal ball very clearly at this point so the guidance given assumes no recovery.

It not only takes in to account the disappointing performance in the second quarter but factors in something a little bit better than that but not by much. Overall, we remain convinced that our sales model is a super model. There’s a lot of stress out in the industry that we’re hoping to be able to take advantage of so I’m hopeful that this will change itself in the near term but our guidance sort of factors that in.

As you’re rightly saying, it’s really the absolute amount of margin doesn’t really matter it is really that relative to the base of business that we already have because if the base of business is there, you know that’s going to trade off, of course that’s a trade off worse than normal in this tough economy and new installs especially you have to fill up that pool again and then to get growth you have to go beyond that.

The longer we remain at depressed levels of installed margin and the tough attrition that will play right through to what we’ll be able to achieve in overall processing volume or net revenue from our card business. It’s an important question and one we’re working real hard on. We do think that we have really coming out of the summit in April, our focus on new verticals we think has a lot of promising opportunities for us. That said, it’s also taken longer to get people comfortable with it and work out kinks on some of the new products that we’ve been offering so it’s not happening as quickly as we would like.

Operator

Your next question comes from Robert Napoli – Piper Jaffray Companies.

Robert Napoli – Piper Jaffray Companies

A question on the Network Services business, how is that business performing relative to how it was performing before you acquired it and expectations? Can you give me the revenue for that business for this quarter?

Robert H. B. Baldwin, Jr.

The business overall is performing pretty much in line with what we had expected. In terms of revenues, the revenues are not as strong as they had been previously before we acquired it frankly, because there was a certain amount of that business that had good top line revenue but not much bottom line impact so we cut that back. For example, they wrote a lot of equipment income business that was marginally profitable and so we said, “Why are we doing this?”

Overall, I would say that the total revenue for the second quarter was $22.1 million, that’s up from $19.9 million in the first quarter. We don’t really have a year-over-year number because we only had June of last year but, June of last year the revenue was $8.1 million. So, it’s performing in line, I’d say overall our perspective is that when we bought the business we had expected that we would have more impact in terms of new large contract opportunities. That new large contract opportunities has proven to be a pretty tough market, one that has frankly not been helped by the occurrence of the breach in terms of people holding back.

But, the flip side of that is that we are very encouraged by the relationships that we inherited from the Network Services business and have been working very closely with them. We had haircut those expectations quite a bit so those sort of balance each other out and it’s working out pretty well.

Robert O. Carr

One other comment about that is we had not built in to our model that we would be taking cell phone top off in through the retail market place and we’re doing that in one of our new verticals that we’re specializing in. We also have some strength in some verticals that are not petroleum as a result of the acquisitions. So, from my point of view I’m delighted that we were able to do that transaction and think it’s going to put us in good stead for the future.

Robert Napoli – Piper Jaffray Companies

A follow up just on the breach, what level of expenses do you expect to be incurring other than I guess settlement related which you said you can’t really estimate at this point of time? What type of ongoing expenses over the next few quarters do you anticipate?

Robert H. B. Baldwin, Jr.

I would guess that the primarily legal ongoing expenses are running in the $4, $5 and maybe $6 million a quarter area.

Robert Napoli – Piper Jaffray Companies

The last question, American Express and Discover, you said you kind of ratcheted down your expectations for that, what are your expectations? And, what challenges, is it just the economy that has forced you to ratchet down those expectations or is it acceptance?

Robert H. B. Baldwin, Jr.

It’s not acceptance at all, it’s really been timing more than anything else. In particular, the larger long term impact is from the change in the relationship with American Express. We had anticipated that in the second half of this year we would be handling the servicing for the majority of the Amex merchants in our portfolio. We don’t know when that conversion is going to happen. That is a non-trivial revenue source when it comes but it really was trigged by the ongoing development of new account generation activity, core Amex and it is in Amex’s hand.

We’ve taken any benefit from that out of our expectations while we remain fully expected that it will kick in and it could perhaps kick in during this year, it’s just that we don’t control it so we’ve backed it out. So absolutely no change in our enthusiasm for either of the projects, we just over the last weekend did the conversion of the Discover portfolio fully on to our platforms so that was a major accomplishment for our team and for Discover’s team so we’re very pleased with that. Both are important value adds to the merchants going forward, being able to offer one statement and one deposit for all four major cards is a big plus that we will offer to our merchants. It’s just played out in the face of this economy, it just played out more slowly than we would like so we ratcheted back those expectations.

Operator

Your next question comes from Thomas C. McCrohan – Janney Montgomery Scott, LLC.

Thomas C. McCrohan – Janney Montgomery Scott, LLC.

Bob, can you just give us the equipment revenues for the quarter?

Robert H. B. Baldwin, Jr.

Equipment revenues for the quarter totaled $7 million compared to $6.85 million a year ago.

Thomas C. McCrohan – Janney Montgomery Scott, LLC.

In connection with the volume attrition, the processing volume I also thought was relatively strong given the trends in same store sales so I’m just trying to get my arms around that. The volume attrition trends that you’re seeing in the quarter do you have a point number of just directionally can you talk about that?

Robert H. B. Baldwin, Jr.

Well, the volume attrition with the ongoing tough merchant count attrition plus same store weaknesses is somewhere in the, I don’t have the exact number, somewhere in the 20% to 23% I think for the quarter. It’s pretty tough.

Thomas C. McCrohan – Janney Montgomery Scott, LLC.

Directionally is it staying kind of in line with where it was last quarter, getting worse, better?

Robert H. B. Baldwin, Jr.

I think right along in line with where it was for the last quarter. Just to reiterate, if you look at the last nine months of merchant account attrition you cannot see any trend whatsoever in that. It’s been at 22% given or take one or two basis points, a percentage of .1 or so and so that’s what gives us confidence that the overall impact on our merchant account from the intrusion has not been anything material.

Operator

Your next question comes from Brett Huff – Stephens, Inc.

Brett Huff – Stephens, Inc.

Bob, can you just go over the numbers that you gave us from your script May to June and June to July and just a couple of details right after that? I was writing quickly but didn’t get it all.

Robert H. B. Baldwin, Jr.

May to June and June to July?

Brett Huff – Stephens, Inc.

You gave us commentary on how the business was doing or the transactions or the volume was doing from May to June and then June to July.

Robert O. Carr

I think we said that June was mildly better than May and that July was –

Robert H. B. Baldwin, Jr.

Same store sales growth?

Brett Huff – Stephens, Inc.

Right.

Robert H. B. Baldwin, Jr.

Same store sales within the quarter June was a hair better than May and judging just by the volumes in July versus our model it may be that July was a little bit better. Then, the other cuts were over on the quarter we saw debit growing at 8% while credit fell at 7% and actually just to give you a little more elaboration, in July, debit really improved very nicely relative to June while credit continued to slide.

So, in fact that trend which we’ve seen for some time not only associated with the tough economy but also I suspect changes in credit card issuers behavior, credit is not going to be a driver of growth in our business. Fortunately, plastic we think will continue to gain share but it’s clearly going to be much more in the form of debit and prepay and less in credit which who knows how long it’s going to be tough but it’s certainly major changes in that side of the business.

Brett Huff – Stephens, Inc.

One other question, in the $19.4 million accrual, you said part of that $14 million was due to a proposed settlement, is that the class action related thing? Is it not related to the Visa and MasterCard part of the settlement? I just want to make sure I understand that clearly?

Robert H. B. Baldwin, Jr.

I’m sorry we have to remain – it is a settlement offer on certain of the claims is where we have to leave our comments.

Operator

Your next question comes from Analyst for James Friedman – Susquehanna Financial Group, LLP.

Analyst for James Friedman – Susquehanna Financial Group, LLP.

Just wondering about the pricing environment, if you look at it this quarter versus last quarter, the last earnings call you talked about teaser rates being offered by competitors, are they still doing that and how is Heartland responding?

Robert H. B. Baldwin, Jr.

First of all, in everything we look at, our margins have remained very solid. Our net revenue as a percentage of volume has been higher than we were budgeting for this year. In terms of new margin installs we saw a fractional weakness within the quarter compared to the first quarter but it was really marginal and in fact it was really in April, by June the number was back to where we were in the first quarter.

There’s no question that our sales force, Bob was mentioning one of the things they’ve had to deal with is we’ve got a lot of requests for a review of the pricing on a merchant. That’s been a merchant is coming back saying they’ve got an offer from someone and we should look at our price. Actually, by and large when we are actually doing that we are not having to reduce our price, we are really able to use that dialog with the merchant to point out to them the differences between what we are doing.

This wasn’t a phenomena just of last quarter and this quarter, this is a regular thing where one way or another an awful lot of business sales people in our business are trying to use some form of a teaser rate to induce the merchant to switch and that is not the way that we do our business. We do interchange plus so you really can’t offer a teaser rate, there’s isn’t a particular rate. When we go through those details with somebody about how the economics of the proposal that we have or the business that we’ve written with them compares to the proposal they’ve gotten we are usually able to keep the merchant at the same margins that we’ve got. Overall, really no impact on pricing going through this tough period.

Analyst for James Friedman – Susquehanna Financial Group, LLP.

The next question was progress related to the breach, last quarter you also said that the settlement with MasterCard was moving faster, any update there? And, also some commentary on the settlement with Visa?

Robert H. B. Baldwin, Jr.

Just for clarity, what I said last quarter was that the MasterCard process, under their rules, they have a whole process for acting for the issuer to present claims and that process was happening faster than we had expected it too. In the case of both of the major brands, we think that there are things happening in their process, in their adjudication process that are faster than may have been the case in certain of the other large intrusions that have occurred but we really can’t guess on how that is going to impact the overall timing at this point.

Analyst for James Friedman – Susquehanna Financial Group, LLP.

Just one last quick question, are you still maintaining your same store sales guidance of a decline of 6% to 8% for the year?

Robert H. B. Baldwin, Jr.

I think it’s really more in line with what we experienced in the second quarter, that’s one of the elements that we’ve gone to a more conservative expectation on that. I hope I’m wrong but it’s just impossible to have a crystal ball from where we’re sitting right now.

Operator

Your next question comes from Robert Dodd – Morgan Keegan & Co.

Robert Dodd – Morgan Keegan & Co.

A couple of quick ones and then a longer couple maybe, can you give us the payroll revenue in the quarter?

Robert H. B. Baldwin, Jr.

Sure, payroll revenue was $3.5 million, up from $3 million in the second quarter of last year.

Robert Dodd – Morgan Keegan & Co.

Then you said you purchased in the Discover portfolio, can you give us some color on what the cap ex or the expense for that was or will be rather in this quarter? Are we looking at $5 million, $10 million, $20 million?

Robert H. B. Baldwin, Jr.

It’s under $5 million to pay for the Discover, more like $3 million.

Robert Dodd – Morgan Keegan & Co.

Then the other two, on NWS, you mentioned it’s a tough business to try and take share from the other guys out there, I mean are you getting any feedback from prospects in that business about their reaction to E3 and your end-to-end encryption especially given the Visa or PCI guys just pushed back the pay at the pump deadlines to 2012 for having even the modest late security in encryption standards?

Robert O. Carr

There’s been enormous amount of interest in E3. The bigger merchants are very interested in getting card numbers out of their systems internally both on the back end and the front end. Back end I think a lot of us processors are looking at ways to get rid of the card number to handle exception items like graph retrievals and charge backs. I think that move is being made as we speak and will be in place quickly.

The front end taking the card numbers out of the front end is another matter all together. There’s enormous interest in it, we’ve been getting unsolicited telephone calls from some of the big names in the merchant community and have an awful lot of interest in it. The challenge for us is that there’s not one solution that solves every body’s problem. We’re starting off with the stand alone device, we’re building point-of-sale interface wedges, we need a pay at the pump solution, we’re talking to the lead company in that area and we need a card not present solution.

So, there’s a whole family of solutions that need to be created here. We’re well in to our development of those and I believe that we’re going to be able to announce some wins here sometime in the next few quarters that may surprise some people.

Robert Dodd – Morgan Keegan & Co.

The last question going back to the breach which I know you don’t want to talk about but one of your comments which I assume your lawyers wrote for you which was to the extent of the $14.4 million in this quarter is related to a settlement and no other settlements are or no other litigations are considered probable at this point. I don’t know if I’m reading too much in to this but obviously we’ve got to conclude that a settlement with Visa or MasterCard is probable at this point so am I reading too much in to that at this point to assume the $14.4 must be Visa or MasterCard since it’s improbable that it could be them.

Robert H. B. Baldwin, Jr.

There’s an important distinction between what is truly probable and likely outcome and how that needs to be measured and accounted for under FAS 5. We just don’t on any of this right now we cannot say that any particular outcome is probably. On most of the issues we are in a position where we believe that from a legal position our arguments and our defenses are very powerful and that is the driver behind why it is not probable. In other words we think we could prevail in litigation but we have this contradictory situation where we think we could prevail but we really don’t want to go in to litigation.

So, we’ll have to see how that all plays out but right now, unless we’re given a good reason not to litigate then we will be forced to litigate. In one situation we have presented what we think might be something that could allow, that we would be willing to not litigate if that played out as we’ve proposed it. So, that triggered a recognition on the accounting side. As we indicated, we have not had any response to that proposal and so if the response to that proposal was that we should pound sand then I guess that situation would be right back where the other ones are. It’s a tough balance between the legal, the accounting and sort of the real world interactions that we’re having.

Operator

Your next question comes from Analyst for Tien-Tsin – JP Morgan.

Analyst Tien-Tsin – JP Morgan

My first question on the Network Services business, can you remind us how you guys paid there? I think you quote process transactions and settled transactions, how does the revenue kind of works in that segment if you could remind us please?

Robert H. B. Baldwin, Jr.

The revenues there are transaction based and therefore the price of fuel has nothing to do with our revenues. Is that what you were looking for?

Analyst Tien-Tsin – JP Morgan

I guess you’re paid differently for processing versus settling? Can you give us some order of magnitude of which one of those buckets kind of glides?

Robert H. B. Baldwin, Jr.

You should be paying more for processing and settling a transaction than just for providing the authorization although really it’s situational. In other words there are auth only merchants where we get paid more because they’re relatively smaller or more complex needs or smaller locations than our full settlement merchants on that platform. There’s no way to generalize, it is transaction-by-transaction rather than dollar volume but you really can’t generalize about what part of the – I guess I would say the generalization is the larger the merchant the smaller the transaction fee is likely to be.

Robert O. Carr

I’ll add to that, less than half the total transactions that we authorize are not settled and that’s one of our great opportunities going forward with this business is to bring in those non-settling merchants in to our settlement system and we’re working hard to do that as we speak.

Analyst Tien-Tsin – JP Morgan

Now, this might be a tough question but I’m trying to kind of break down the volume growth so if you look back to last year I think you guys did about $15.2 billion, can you talk about the different buckets in notional terms? So, talk about what was your notional attrition? Obviously, I can figure out what the same store sales decline was, what was the notional new adds? I’m just trying to get an appreciation for how we should think about that going forward? I think earlier you talked about new adds need to offset attrition, can you give us an order of magnitude of kind of notional in billions what we’re talking about there?

Robert H. B. Baldwin, Jr.

The short answer is going to be no I can’t but, let me give you a sense. Last year, for second quarter we had about $15.2 billion of SME volume. If we had not added any merchants at all in the interim, that same group of merchants, because that’s what our same store sales is, would have produced about $13.5 billion, in other words the same store sales decline year-over-year was about 10%. Therefore, the merchant add activity that we’ve pursued in the third quarter, fourth quarter, first quarter and now second quarter of this year has essentially been able to just about fill up that hole.

Analyst Tien-Tsin – JP Morgan

Plus the attrition?

Robert H. B. Baldwin, Jr.

That’s in the same store sales.

Robert O. Carr

The new business is offsetting –

Robert H. B. Baldwin, Jr.

The $15.2 billion, two things happen, one is we lost a bunch of those merchants, 20% plus of those merchants went away. I don’t have the volume associated with that group. But, let’s say that the remainder was $12 billion or something on that order, the ones that stayed with us went from $15 billion to $12 billion, let’s say that’s the attrition and then the ones that stayed with us, that’s where the same store sales growth is, that’s down another 10% so that’s down to, using those numbers, $10.8 billion and then the subsequent adds have gotten us back to the $15 billion plus number.

Analyst Tien-Tsin – JP Morgan

To be clear, I guess initially you said you started with $15.2 after same store sales it’s down to $13.5 billion, that $13.5 billion does not include attrition you’re saying or was it already counted in?

Robert H. B. Baldwin, Jr.

I misspoke, that was a wrong explanation on the fly. Same store sales, the merchants that were with us a year ago and are still with us. So, it only counts the ones that were with us in both periods so first you’d have to take out the attrition, the volume associated with the ones that left us either because they left us or because they went out of business and then you’d also subtract the same store sales decline of around 10%. That gets us down to probably of that $15.2 billion that was there last year, probably the number is around $10 billion that is still with us and then we had to fill up that bucket with new installs which just got back to about breakeven.

Operator

Your next question comes from Andrew Jeffrey – SunTrust Robinson Humphrey.

Andrew Jeffrey – SunTrust Robinson Humphrey

Could you elaborate a little on the E3 terminal initiative on a couple of fronts, one sort of how you plan to compete against the established providers and then two, do you think that there is – are you creating a market in your view or do you think there’s sort of intrinsic demand for what I assume are going to be relatively expensive next generation terminals at the point of sale in a pretty difficult merchant environment where you’re kind of noting that merchants are really kind of focused on keeping the lights on than talking processing or I assume terminals. So, maybe a little more color around how you think that program competes, grows, etc.

Robert O. Carr

I’ll take my first cut at it without being too windy here Andrew, I believe there is an intrinsic desire of merchants to stop having card numbers in the clear so that they do not have to be concerned about the liability that comes from a breach. Our approach is to work with all the terminal manufacturers that want to send us encrypted transactions and all the manufacturers. We’ve talked to all the major manufacturers and each of them has a plan of going forward, they’re different, there’s not one single standard. The [inaudible] [AXCS9] Committee is working on that standard, we’re on that committee.

It probably won’t be developed for a year plus. We’re going forward with a solution that we’re having developed but we also expect the existing manufacturers to have products that we’ll be able to resell and the direction we’re moving is to get out in the market quickly and to sort of lead the way for the other manufacturers to get in to the market place so that we can be selling their equipment. It’s natural, it’s intuitively make sense that these devices would be more expensive but in fact, they’re not.

The technology that we’re adopting, the TRSM methodology and approach is exactly what pin debit has been doing for 30 years, all we’re doing is encrypting the track data as the track is read by the reader similarly as the pin is encrypted as you key it in. It’s the same sort of model and the same sort of encryption and decryption back to the card brand. It’s not terribly expensive and the cost of the PCI audits and the liability is a lot more than upgrading a device. We believe these devices will be under $500 for a purchase per point of sale and possibly lower than that. We are going to rent them to merchants who want to offset a recurring expense of PCI compliance and liability exposure with a piece of hardware that takes them out of scope.

Andrew Jeffrey – SunTrust Robinson Humphrey

So your view would be the terminal manufacturers that are the most aggressive in terms of embracing this approach are going to be the biggest beneficiaries?

Robert O. Carr

I think the merchants are going to be the biggest beneficiaries and it’s going to help out the equipment business too. I do believe, and this is just my personal opinion, that over the next few years the majority of the point of sales devices in this country will be upgraded to TRSM model. That’s worth what you pay for it, that’s just my opinion.

Andrew Jeffrey – SunTrust Robinson Humphrey

Then from a higher level on the competitive front, could you give us your view of the First Data B of A JV? I assume from everything we’ve read the bank processors have been hurting even more than the independent processors, do you think this gives B of A a more formable position down market to go up against traditional Heartland merchants?

Robert O. Carr

I think it’s on balance, it’s going to be not that impactful. What is clear though is that there’s going to be a lot of effort needed internally for that conversion to take place from [TSYS] to First Data’s platform. It’s going to cause merchants to take a look that may have not been interested in taking a look at alternatives in the past. So, I think it’s going to continue to distract both of the organizations and I think if it has any impact at all in the market place it will be that we have more opportunities to take merchants away than we did before.

Operator

Your final question comes from Franco Turrinelli – William Blair & Co. LLC.

Franco Turrinelli – William Blair & Co. LLC.

A couple of quick question for you if I may, going back to the E3 for a second, I guess what I’m not sure about is whether or not you see this as a long term differentiated product or whether or not you really see yourselves leading with the formation of a new industry standard that everyone is going to adhere to?

Robert O. Carr

I think we’re developing a new level of security, a higher level of security than is currently called for in the PCI standards which are good standards and they’re required but, we can go beyond those and there’s different approaches to doing it, chip and pin tokenization and encryption. We think we’re the advocates for the end-to-end encryption and there’s lots of discussion about what that means and we’re doing our best to educate folks about what we’re doing it and why we’re doing it. It’s no silver bullet but it’s definitely an improved standard.

I’m not sure that our methodology per say is going to become the standard but we’re going to adopt and use whatever standard does exist out there. We’re not interested in becoming an equipment manufacturer, we’re interested in processing transactions that are as secure as possible. I think we will lead because I think the competition is going to have to compete with us down the road. We think we have an advantage because we’re the first out with it.

Robert H. B. Baldwin, Jr.

The driver here is that the bad guys see the value and opportunity in grabbing card numbers any way they can and we want and need to take that value away from them and it’s just very hard under the current approaches, that’s why we think a higher level of security is needed.

Franco Turrinelli – William Blair & Co. LLC.

I guess what I’m trying to figure out is if this is going to turn in to a long term differentiated product with some opportunity for pricing as well or if this is really just Heartland really just kind of leading the formation of a new industry wide standard.

Robert O. Carr

I think our intrusion has gotten the attention of the entire industry plus all of the intrusion since then, there were 630 other intrusions in 2008 so I think we just happened to be in the wrong place at the wrong time. I think because of our size relative to the other parties that have been breached I think we are looked to for a solution here and we will be leading it. I do think the industry is going to change and it’s going to go to this type of a solution but again, that’s my opinion.

Robert H. B. Baldwin, Jr.

I think also it’s hard to engage what competitors are or will be willing to do, that’s they’re issue. We are working very hard on getting out there with successful products and then we’ll let the market place dictate whether we can get additional margins for it and/or market share. But, I think that being first is good and we know that there is a lot of perceived risk and a lot of concerns on the merchant side that will encourage them to for example spend money on a new terminal that will allow them to get out of PCI scope. So, whether it plays itself out for market share or in pricing or both we think it’s a better thing to be out there first than not.

Franco Turrinelli – William Blair & Co. LLC.

This seems as if it would be also in the strong interest for the card associates for this to happen. Are you able to get any support from them in moving this forward?

Robert O. Carr

We met with all four of the card brands and have had very good cooperation in our opinion about working out solutions. We’re pleasantly surprised with the reaction of the card brands to being willing to accept encrypted transactions. The question is how do we do it and I don’t think there’s going to be a uniformity in the method in the short term but we’re willing to work with each card company with whatever solution they can give to us.

Franco Turrinelli – William Blair & Co. LLC.

One final question, obviously at the heart of the Heartland model, no pun intended is the relationship manager and I’m wondering if you can just give us a sense, you commented that there’s been no attrition but maybe just kind of give us a sense for kind of their mood and what they’re focused on and what they’re encouraged by and worried about?

Robert O. Carr

Our sales organization is very motivated and the veterans are suffering the most here. Of course they have the biggest portfolios and the biggest residuals so they’re in the best position to suffer through this. The lead referrals have dried up, the new locations have dried up. But our organization is focused on two things right now, one thing is learning the new products that we rolled out in our April summit, things like cell phone top up and remote check products and some of the gift marketing and so on that we’re doing and they’re also focusing on maintaining their existing customers and playing defense and that’s taking away from their time to go out and knock on doors so to speak.

I think we’re transitioning to a more vertical market organization and the sales people have a lot to learn and they’re learning it but I believe they’re on the right track and we believe that’s the right approach to take in the market place going forward.

Thank you everyone for joining us and have a great day.

Operator

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

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