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Heartland Payment Systems Inc. (NYSE:HPY)

Q3 2009 Earnings Call

November 3, 2009 8:00 am ET

Executives

Bob Carr - Chairman and CEO

Robert Baldwin - President and CFO

Analysts

James Friedman - Susqhehanna

Bob Napoli - Piper Jaffray

Robert Dodd - Morgan Keegan

Dave Koning - Robert W. Baird

Franco Turrinelli - William Blair

Meghna Ladha - Susqhehanna

Operator

Good day and welcome to the Heartland Payment Systems third quarter 2009 earnings conference. Today’s conference is being recorded.

At this time, I’d like to turn the call over to President and CFO, Robert Baldwin. Please go ahead, sir.

Robert Baldwin

Thank you, operator, and good morning, everyone. I’d like to welcome you to our third quarter 2009 earnings call. Joining me this morning is Bob Carr, Chairman and CEO.

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 before taking your questions.

During the course of this call, we will be providing comments on the processing system intrusion. Our continuing investigation of and settlement discussions related to the processing system intrusion are confidential. Consequently, beyond today’s prepared remarks, we want our participants to be aware we do not intend to make any additional comments.

Before we begin, I’d like to remind you that some of our discussions may contain statements of a forward-looking nature, which represent management’s 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 in the company’s SEC filings. We undertake no obligation to update any forward-looking statements made during this call to reflect events or circumstances that may arise after this call.

Now, I’d like to turn the call over to Bob Carr.

Bob Carr

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

By now you should have our financial results for the third quarter that we released this morning. For the quarter, we reported adjusted net income of $8.7 million or $0.23 per fully diluted share, which excludes expenses associated with the processing system intrusion, but is a net of about $0.03 of stock compensation expense, and Bob will go through the detailed results in a minute.

In many respects our financial performance in the third quarter closely resembled the second quarter as economic conditions for our small and mid-sized merchants were little changed. However, performance within the third quarter showed some signs of improvement that we did not see in the second quarter.

For instance, although, same-store sales were negative for the sixth consecutive quarter, they improved by 110 basis points from the second quarter and September, we represented our best same-store sales comparisons in a year.

And though our new margin installed was also down in the quarter, it ticked up sequentially after falling for basically the past year. Since the fourth quarter of last year is when we first saw same-store sales in new margin installed begin to fall sharply, we should get some help from year-over-year comparisons that will start to get a little easier from this point forward.

We are also making steady progress with a number of our new growth initiatives. Despite rising employment and shrinking payrolls, our payroll new installs were up 11% and revenues were up almost 18% from last year. Both our American Express and Discover processing volume were up substantially from the second quarter with Discover volume benefiting from the purchase of the merchant portfolio on July 31 we mentioned last quarter.

The loyalty platform we acquired last year from Chockstone also grew in the quarter, and we successfully rolled out a gift card marketing program for our small and mid-sized merchant base. To implement gift card marketing, we made significant adjustments to the Chockstone platform to match the SME merchants’ needs, and we feel we now offer a gift card program for smaller merchants that is unmatched in the marketplace.

The new relationships and additional market penetration represented by these initiatives are fundamentally broadening our platform offerings and we believe can be leveraged into more substantial growth when the economy improves.

The challenging economy and stubborn unemployment are most directly affecting our new business success. This has a bearing on our relationship managers, especially our newer employees, where our new business is a significant component of their compensation.

At September 30, we had 1,167 relationship managers, down from 1,210 at June 30. We continue to introduce new products and new marketing strategies that are designed to improve the success of our relationship managers and we are preparing to launch aggressive campaigns and attractive verticals where we believe we have distinct competitive advantages. We are also retooling our restaurant protocol to more effectively leverage our brand and industry expertise for faster growth, which we believe will also enhance our RM count growth.

In addition to the underlying current of improving market conditions felt as we went through the third quarter, our performance was aided by the progress achieved improving our productivity inefficiency. Total cost of services were up only 5% in the quarter with our key processing and servicing cost actually down from the year ago period. Since this is the first full quarter in which Network Services expenses are in both years, it is a good representation of the success of our integration efforts and the leverage opportunity being created by our investments in technology.

General and administrative was the one area where costs were somewhat higher than expected, but more than $1 million of the increase was the result of additional stock compensation with the balance arising from other compensation infringes, as well as outside legal and consulting expenses. And many of these costs are arising directly or indirectly from the impact of the processing system intrusion and the responses we have made in both strengthening our systems and personnel and moving aggressively on new security related initiatives.

So on a fundamental basis, we are improving our core business by improving productivity and efficiency adjusting to a slow growth economy while sustaining our investment in new growth initiatives. But the fundamental business is changing. We think 2010 will be the year of major breakthroughs and enhancing payments security and that could change everything.

We believe that data security is destined to become a more important issue facing merchants. The level of concern about security, which barely move the needle only a short time ago has increased dramatically as a result of our and others intrusions.

The Payments Processing Information Sharing Council, which we helped create, which is tackling the security issue on an industry wide basis now includes eight of the top 10 and 12 of the top 15 processors as participating members. The success of the PPISC is achieving such broad industry representation is indicative of the importance of this problem, and it is an important step in improving overall security.

Yet despite this mounting pressure to improve security, there are few proven tested solutions, and we are now facing a virtual Tower of Babel as different vendors and industry participants announce differing solutions each of which claim superiority.

So I would like to take a moment to give you my take on the challenges and opportunities we face in enhancing payments industry data security. We believe that an effective solution to payment processing data security in addition to the PCI payment processing and device standards must include the following four items.

Number one; encryption of data from the moment of swipe utilizing a secure hardware of magnetic stripe reader. Two; to properly protect consumers, the encryption must be maintained all the way to delivery of the brands and decrypted only in a protected hardware security module.

Three; the merchant should never ever have a digitized card number pass through or restored in any of their communication links or computer systems at any time. And number four, the system must be sufficiently flexible that a merchant will not be faced with major future security related investments. We believe that our solutions satisfy these important criteria.

Our enhanced security technology solutions are on track to move out of beta testing and into live implementations beginning in the first quarter of 2010. As cyber criminals become more pervasive and insidious, we believe sensitivity to security risks will increase with merchants large and small.

Pressure from consumers, regulators and others may eventually compel merchants to make security the highest priority in choosing a processing solution. We believe that having a proven product in the market will provide us with a significant competitive advantage as security concerns create a rising demand for a completely new generation of technology.

Now let me update everyone on the processing system intrusion. Our previously articulated position has not changed, and it is Heartland’s continuing intention to vigorously defend claims asserted against us and our belief that we have meritorious defenses to claims asserted today. We remain fully engaged in the ongoing investigation in a resolution of claims that have arisen from the processing system intrusion.

This quarter, processing system intrusion costs were $35.6 million, which includes reserves for offers we made to settle certain claims, as well as charges for the expected costs of settlement of certain other claims. Because the nature of these ongoing matters is confidential, including the settlement offers and the actual settlements, we believe that may be near, you can understand the limitations of the disclosure we can share with you.

Let me now turn the call over to Bob Baldwin.

Robert Baldwin

Thanks, Bob. As I discuss results, unless otherwise noted, my comments will be exclusive of the various costs associated with the processing system intrusion, which are separately identified. Heartland reported GAAP loss of $13.6 million or $0.36 per share for the third quarter of 2009. Excluding $0.59 per share of separately identified processing system intrusion costs, net income would have been $8.7 million or $0.23 per share. The $0.23 is also net of $0.03 per share of stock compensation.

As Bob mentioned, since we did not see any appreciable improvement in market conditions during the third quarter, results for the period were in line with our expectations and little change from the second quarter.

Small and mid-sized merchant card processing volume of 15.8 billion for the quarter was up 1% from a year ago after being down last quarter. On a sequential basis, SME transaction processing volume was helped by a sequential improvement in same-store sales, which were down 8.6% in the quarter, about 110 basis points better than the second quarter.

Retail, hotels and our electronics were worse than average, continuing recent trends, and petroleum remains weak given lower prices. Restaurant remains solid, coming in about 1% better than the overall average. And auto parts and entertainment were quite strong. Quick service restaurants and convenience stores also continued to perform much better than overall same-store sales.

After very weak and erratic performance April through August, same-store sales improved in the month of September, our best month since October 2008. October 2009 same-store sales results are not yet in, but appear to be consistent with September’s results.

Keep in mind, the fundamental improvement in September and October actually precedes the significant drop in same-store sales that began in the fourth quarter of 2008. So we’re heading into what is a much easier comp, riding the momentum of fundamentally better performance.

While SME volume in the quarter was up only 1%, our SME transaction grew 9%. So, consistent with the industry, while volume is up, the value of each transaction are up, the value of each transaction is down. This is due not only to smaller ticket sizes, but also the continued growth in debit share of our volume.

For Visa, MasterCard volume for example, debit grew by 8.3% in the quarter while credit volume contracted also by 8.3%. Network Services processed 757 million transactions in the quarter, up 29 million sequentially from the second quarter and generally inline with our expectations. Network Services revenues is dependent on transaction count, not dollar volume. Net revenue for the quarter was $110 million, the second best net revenue quarter in our history despite the significant headwinds.

The third quarter of last year was our best revenue quarter ever, so net revenue was just a hair from record levels. Total cost for services for the quarter were up only 5% from a year go with processing and servicing cost actually down from a year ago. Now that we have left the assumption of cost from Network Services acquisition, we are working to keep the growth of processing and servicing costs relatively modest even as we invest in our IT infrastructure and restore transaction processing growth to much greater rates.

Customer acquisition cost were up only 3%, consistent with soft sales volume while depreciation and amortization was up 29% due to increased expenses associated with our various acquisitions and increase in fixed assets. While, we did experience increased costs within general and administrative costs, which were up 34% in the quarter compared with the third quarter of 2008.

For the third quarter, this was primarily due to $1.4 million increase and 123 (NYSE:R) expense as well as additional salary bonus infringe benefits and somewhat higher legal and consulting expenses. The higher levels of personnel and stock comp cost are expected to continue, but we are looking for some of these other costs to fall. As in the second quarter, we separately broken-out processing system intrusion-related cost in our income statement. For the third quarter, these costs were $35.6 million pre-tax and on an after tax basis represented about $0.59 per share.

The majority of these charges in the quarter relate to settlement offers we made in an attempt to resolve certain processing system intrusion claims. And avoid the cost and uncertainty of litigation as well as the expected costs of the settlement of certain other claims.

To-date, we have not received any response to the settlement offers and there can be no assurance these claims will be settled or as the amount of any settlements that may be reached. By making the settlement offers, SFAS 5 requires us to accrue for the estimated exposure to the claims that are subject to the settlement offers.

The accrual of these settlement offers as well as accruals for settlements of certain themes that we deem likely to be settled resulted in the company carrying a $45.2 million reserve for processing system intrusion on its balance sheet at September 30, 2009. It should not be assumed that we will resolve any of the claims related to the processing system intrusion for the amount we have reserved, and it is possible the company will end up resolving these claims for amounts that are significantly greater than the amount we have reserved to-date requiring additional future reserves.

Matters with the various other claimants have not reached the comparable status, we remain uncertain as to the probability of the amount and the timing of any costs associated with those claims. Accordingly, any potential costs are not reflected in our financial statements.

The reminder of the expenses and accruals were primarily for legal fees and for costs incurred for investigation remedial actions and crisis management services. Operating income for the quarter was $14.7 million or 13.4% of net revenue. Margins reflect flat revenues and the increase in general and administrative expenses.

Now, let’s take a look at our cash flow. Operating cash flow for the quarter was $21.3 million; more importantly, management’s measure of operating cash takes net income and adds back amortization, depreciation, the provision for the processing system intrusion and other non-class cash items at the top of the operating cash flow statement, resulting in total sources of $31.6 million.

We then reduced that figure by signed bonuses and the buyouts paid. Using this management metric, operating cash grew 2% in the third quarter to $22.4 million from $22 million last year. Capital expenditures for the quarter were $8.4 million of which $3.4 million was for the construction of the new service center and with most of the balance used to strengthen our technology infrastructure. We also purchased the discover portfolio on July 31 with $3.2 million.

Taking that same management definition of operating cash and reducing it by non-service center CapEx, our free cash flow amounted to $17.5 million for the quarter, up 7% from last year’s third quarter. We used $374,000 of cash to pay dividends in the quarter.

We remain very conscious about liquidity, especially given perspective costs arising from the 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 almost half of our current 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 coverage for certain of the intrusion-related 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 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.

Let me wrap up with our guidance for the year. The economic conditions facing our small and mid-sized merchants did not appreciably improve in the third quarter. And our guidance does not anticipate any meaningful improvement for the rest of the year. Although same-store sales performance in fourth quarter may improve compared to the relatively weaker performance in the year ago quarter. New sales are not expected to similarly to improve.

The above factors necessarily add conservatism to our guidance. Our guidance for 2009 also does not include any estimates for potential losses costs and expenses arising from the system’s intrusion, including exposure to card companies and banks, exposure to various legal proceedings that are pending or may arise and related fees or expenses or other potential liabilities costs and expenses.

The costs already incurred and accrued for the first nine months of the year are similarly excluded from this guidance. In addition, our guidance excludes 123 (R) stock compensation expense, which have been immaterial over the past few years, but has now become a more significant expense as a result of the new options and restricted share units grabbed this year.

We expect this 123 (R) compensation expense to remain at current levels on a go forward basis. For 2009, we expect to receive full year net revenue between $420 million and $425 million, which is about a 10% increase compared to 2008 net revenues of $384 million. And our full year guidance remains $0.85 to $0.90 per diluted share, which excludes $0.08 of 123 (R) stock compensation expense.

Back to you Bob.

Bob Carr

Thanks Bob. While we are cautiously optimistic that the worse maybe behind us, there is still a great deal of uncertainty about the economy and its influence on our markets; especially our core, small and mid-sized merchants. In light of these conditions, Bob gave you a sense of our plan to achieve some modest top line growth to leverage revenue growth into a better bottom line through cost controllers and productivity enhancements and to continue to invest in new product development and merchant growth, so that we can quickly capitalize on any economic improvement, that’s the core story.

But we think there is also an exciting story in the potentially game changing environment in 2010, where heightened security becomes a bigger concern among consumers, merchants and the regulatory authorities. We expect to enter the New Year as the leader in offering enhanced security technology solutions that will provide the transaction processing industry with the highest level of security to be available.

Before closing today’s call and opening it up to questions, I’m pleased to announce that your Board of Directors has declared a fourth quarter dividend of $0.01 per share payable December 15 to holders of record on the 23rd of November.

With that, Audrey we’d now like to answer any questions. Please open the call.

Question-and-Answer Session

Operator

Thank you. The question-and-answer session will be conducted electronically. (Operator Instructions) And our first question today will come from (inaudible) with Goldman Sachs.

Unidentified Analyst

This is [John] in for Julio. I was just wondering if you could give a little bit more color on what you’re seeing from the AMEX and Discover relationships and what you’re expecting going into 2010 from those?

Bob Carr

I think that those are coming along pretty nicely. The Discover, we’re in the process, well at both AMEX and Discover, we’re in the process of going back to existing acceptors in our network and non-acceptors in our network and trying to sign them up to both programs. We’re seeing also good volume increases, particularly on the AMEX side as the one point program has continued to gain momentum.

We’re pleased with the sign-ups that we’ve achieved of new merchants to both programs substantially all of our merchants are being singed up for Discover. All of our new and probably getting towards 50% of our new merchants that we’re signing up are accepting AMEX as well. In that way the merchants gets all four of the brands with one settlement and one statement, which is attractive to them.

As we look into next year, the big event in terms of financial impact is the potential conversion of our existing AMEX acceptors to our servicing the timing of that remains unclear. But we feel we’re making good progress on signing up new merchants and that progress will potentially have an impact of accelerating that conversion process.

Unidentified Analyst

Got it. Are you still feeling somewhat constrained by the, I guess, the unwillingness of the issuers to perhaps issue new cards right now or is that started to maybe turn a little bit?

Bob Carr

I don’t think that issuance of cards is having a very material impact on our volume. It’s really consumers’ use of those cards. They are certainly on the margin people, who are just losing the last cards that they have or who are maxed out on what cards they have and there are a lot of people, who were in those difficult circumstances.

In terms of transactions though, of 60% of our transactions are for debit cards, so that people accessing their bank accounts in a new way and most people and those who drive for ponderings of actual processing activity, do have at least one card that they still have as a go-to card on the credit side.

So I think it is consumers changing their behavior, I don’t think that for our business now or going into the future, there are definitely potential changes in the amount of number of credit cards and the amount of credit made available by the credit card companies and that looks like it maybe a longer term phenomenon, but actually when you look at the transactions that are on cards even on credit cards, it’s driven by people who are using it more as a transactional device, not as a source of credit, that’s where you get the transaction. And then we get the continued growth in share in debit, which is un-impacted by such cut backs.

Unidentified Analyst

Got it. One other quick question. Just given the commentary on what you’re seeing from your small business customers, small and medium-sized business customers; are you seeing any additional pressure just given what’s going on with CIT and how that could potentially impact those markets? Are you seeing any additional, I guess, closures of small businesses or are you not seeing any additional business creation, sort of what you had been saying in the second quarter as well?

Robert Baldwin

It really hasn’t changed. It is at higher levels that it’s been for a while. Certainly, CIT impacts are way too early for us to determine anything. But we’re not seeing any further increase in closures or in merchant count attrition in the last quarter.

Operator

And our next question will come from James Friedman with Susquehanna. Mr. Friedman, your line is open.

James Friedman - Susqhehanna

Hi, thanks for taking my question. I wanted to ask if you have seen any change with regard to the competitive landscape at this point. Are there any new entrants in the space and how your public messaging is going, because you’ve had such success with that in the past?

Bob Carr

I'll take that one. I would say that our competitors are fewer by a little bit. I think a lot of the marginal ISOs are just not able to make it and are consolidating with bigger ISOs. There is a few competitors who really have their act together and are tough competition. I think we are still leading the pack and doing some things that make us pretty tough competition as well.

So I think the industry is absolutely maturing, and this issue of security, the Tower of Babel that I mentioned in the earlier call, is something that's going to get sorted out. We think merchants are smart people and the industry is a smart industry, and we think a lot of the press release war is going to get itself sorted out really quickly and that's going to give us a strong competitive edge.

So I think, it's an interesting time. It's one of the more interesting times of all, because the Wild West Days, I think, are behind us in this industry.

Operator

Next we will hear from Bob Napoli with Piper Jaffray.

Bob Napoli - Piper Jaffray

I know you can't say much on this, but on the settlement and timing, when you said you have no responses and in talking to some people around the card systems, is it possible it could take years to get to the bottom of the total exposure?

And, I mean, do you have any feel for timeframe, or they just have not responded. Have people been responding to you or is there still a lot of information to gather about what the exposure to possibly be? I mean, whatever you can tell me and any color around that would be really helpful.

Robert Baldwin

Well, of course we can't say much. I would say, however, that these things are complicated issues. There are significant amounts of money potentially at stake, and they take therefore a little time to sort out. And litigation can have a way of going forever, but in terms of actually achieving settlements as we’ve indicated, we think we have some potential resolutions coming along not very far from now on certain of the matters. Others, we really have no estimate on timing, but one would not expect it to drag interminably either.

Bob Napoli - Piper Jaffray

Do you have any feel from the other parties on that issue that, kind of trying to come to a resolution sooner rather than later or -- ?

Robert Baldwin

I think that everybody has a certain appetite to move it quicker, but perhaps only when they are getting their way. So it's a process that we’re working through. We certainly would love to get it resolved quickly, but we want to resolve it quickly on terms that we find appropriate for Heartland and its shareholders, which may not match up with the objectives of the people on the other side of the table. So I think that there is an appetite to get it moved along, but there are other major issues that have to be sorted out, too.

Bob Napoli - Piper Jaffray

While the other side hasn't responded to your offer, have they put their own proposal on the table?

Robert Baldwin

I can’t comment on that at all.

Operator

(Operator Instructions). Next we’ll hear from Robert Dodd with Morgan Keegan.

Robert Dodd - Morgan Keegan

Hi, guys. Just on the same subject, just a very quick question and then move on, just passing the words may be more carefully than I should, last quarter was an offer to settle. This quarter it's offers to settle. Am I reading that correctly to say that you’ve now got more offers out in terms of number of parties than you did last quarter?

Robert Baldwin

That is correct, Robert.

Robert Dodd - Morgan Keegan

I got it. Moving onto another subject, kind of on the securities side. Obviously there is a lot of talk, but one of the big vendors out there, VeriFone, has had something of a disagreement with you over strategy, and this morning has come out and said essentially that they’re going to cut off service to your merchants at the end of the year.

Ignoring the legal issues of that, which I'm sure you can't talk about, what's your response to that kind of approach going to be in terms of how you can position or protect your merchant base -- ISO's competitors coming in and saying; hey, you're going to get cut off, you'd better switch to us.

Bob Carr

Well, first of all, we will have a full response to this shortly. That press release came out just before the earnings call. I don't think that was by accident. And I'll just say a tag line on my [e-mails for years] was; recurring revenue good, recurring expenses bad and I think that's the central point of all this, and there will be more, so stay tuned for what's coming.

Operator

Next we’ll hear from Dave Koning with Robert Baird.

Dave Koning - Robert W. Baird

Yeah, hey guys. I wanted to pursue the competitive landscape a little bit more. We hear that the ISOs has been getting better pricing out of First Data and others. Does that cause any sort of pricing pressures that you see, or are you pricing low enough against the ISOs still that that's really not having too much impact on your new sales?

Robert Baldwin

I think it’s a non-event to us.

Dave Koning - Robert W. Baird

Okay.

Bob Carr

I think that there is no direct connection between the pricing that an ISO gets and the price that the merchant gets, because in many cases the price that the merchant can be obfuscated and/or maybe subject to change at a later date. And so, it does say something about the potential profitability of the ISO; or if they want to give away some of their margin, they can perhaps offer a lower initial price, for example. But day in, day out, we believe and we find that our prices are at or better than our competition, and that's not a major issue.

Robert Baldwin

And also remember, there are several layers of entities that have to earn a living, the ISO model. There is the super SO, the ISO, the sub-ISO, the agent, the referral source such as the VAR or the bank or something like that. So there’s one company here handling the sale versus half a dozen through the ISO model and that gives us a major competitive advantage.

Dave Koning - Robert W. Baird

Okay, great. And then same-store sales you mentioned got better in September and October. Can you give us the numbers of year-over-year same-store sales in those months?

Robert Baldwin

I can give you September, Dave, which was 6.5%. So that was a good month. October, was that -- I don’t have those numbers in yet. Looking at our relative volume numbers, it feels about the same as September, but I don’t have that number yet.

Dave Koning - Robert W. Baird

And do you still mean down 6.5%, right?

Robert Baldwin

Yes, unfortunately.

Dave Koning - Robert W. Baird

Okay. And then the sales reps were down about 43 sequentially. What do you think was causing that? And maybe how do you see the next few quarters playing out?

Robert Baldwin

Well, a couple of things. One is that new installed margin, and so the signing bonus is paid, are lower levels than last year; and so it is tougher to make a living, and as a result people are giving up or are just not achieving high enough sales and so they are proactively being let go.

At the same time in this environment, it’s proven slightly tougher to recruit people because of the fact that it’s commission only. We still intend to grow the sales organization aggressively next year, and I think that we’ve mentioned and we’re intentionally vague about, but we’re doing some major new initiatives in and around verticalization, certain verticals, that are right now in early stages.

But can have a material impact on the ability of a sales person to make a good living and on our recruiting efforts as well. So we’ll probably have more on that as we get into next year. Right now it’s very early stages, so we can’t talk a lot about it.

Dave Koning - Robert W. Baird

Okay. Thank you. And then just finally, can you give us equipment revenue and NWS revenue in the quarter?

Robert Baldwin

Equipment revenue was $7.5 million, and Network Services revenues was $27 million of processing revenues, and then you’d add about $1 million of equipment revenues in Network Services.

Operator

(Operator Instructions). We’ll now hear from Franco Turrinelli with William Blair.

Franco Turrinelli - William Blair

Bob, you’ve mentioned in your press release and prepared comments that the equipment revenue was down year-over-year. Is that in fact being affected by the situation with VeriFone or is that really just an end market condition?

Robert Baldwin

No. It really is not at all impacted by VeriFone. We’ve historically had a number of sources of equipments. The Heartland sales model really doesn’t revolve around an equipment sale. It really represents an accommodation to a merchant and the processing solution that they need.

So in other words, if a merchant is interested in moving to IP processing, obviously they need to upgrade their terminal to a modern terminal, and so we would facilitate that transaction. We’ve always used VeriFone and Hypercom as our two main sources, and we’ll obviously have sources of terminals to satisfy any of those merchant demands.

I think it is safe to say that the typical merchant today is not necessarily looking to upgrade to the newest whiz-bang on their terminals if they are probably working on if it aren't broke, don’t fix it kind of mind set, and we can download our solution into an older terminal and it will work just fine as long as they are not trying to do something new with the equipment.

Franco Turrinelli - William Blair

Thank you. And then going back to the verticalization question, you mentioned it was too early to kind of give a report back as to how that’s going. But can you tell us a little bit about what you’re actually doing right now in order to make that happen? Are representatives being assigned to certain verticals? What stage is that whole process at?

Bob Carr

I’ll take that one, Franco. We’ve announced a ninth vertical, and we are going to be announcing a tenth and eleventh one. Basically, we are assigning geographic territories that are protected to our reps who do select to be in one of these verticals. We are making a major push today and over the next four months to verticalize to assign geographic territories to the entire U.S. in the restaurant sector, and we believe that with our focus on that, it keeps our reps from having to learn so many different products.

We have a plethora of products that are very competitive. We’re excited about it, but there’s too much for a rep to really learn. So we are moving even stronger to the verticalization strategy, and I’m hoping that by the end of next year that we have 11 solid markets, maybe a couple more that are verticalized and we have the entire U.S. assigned to a specific rep, and that’s going to help us in recruiting additional reps as well.

Franco Turrinelli - William Blair

Right. I think, Bob, we’re sort of one year on from the beginning or at least the evident beginning of the economic crisis, we are, what? Nine months on from your disclosure of the breach. Can you just kind of give us a sense for really kind of what they are looking at, what they are focused on, how they are feeling about the business and their merchants and what they are doing out there?

Bob Carr

Well, I think there’s the frustration with the lack of the same-store sales being negative rather than positive, as we all got used to for a long time. But I think the results speak for themselves. I haven’t heard of anybody who has had better results in terms of signing new merchants or maintaining their existing volume as we have. I think the morale here is very high. We have sustained some really tough situations over the last nine months.

We’ve come out of them very strong. I think Heartland has a renewed respect in the industry for being a serious player in the security issue versus doing security by press release, and we’ve obviously antagonized some of the players in the industry. The world’s equipment manufactures are our new best friends, and we just don’t think our merchants or any other merchants in the country are eager to take on recurring expenses to buy a piece of equipment. And our sales people are energized by our leadership position, and I think we’re going to have a tremendous 2010 as a result of all that.

Operator

And our final question today will come from Robert Dodd.

Robert Dodd - Morgan Keegan

Hi. Just to follow-up on the relationship manager attrition, the rep attrition. Has anything changed there in terms of attrition by tenure or is the decline sequentially just a function of your first year reps that essentially aren’t cutting it just throwing in the towel?

Robert Baldwin

There’s been no dramatic change in the tenured reps numbers. And it’s important, Robert, we go through periodic episodes of cleaning out our sales force of people who have been underperforming for a while, and so if someone has been at low levels for a while. It’s not a scientific thing at all. If someone is really good at servicing their merchants and works well with the rest of the team, they may well be kept on even if their production isn’t that high.

On the other hand, if they’re very demanding of their manager’s time, they may be pushed out early. I think that we probably went through another one of those sessions during the summer where some people have evaluated whether they want to have such and such person around.

And especially, frankly, I would suspect that on the margin, we did very little of that pushing out during the first and second quarters when we were looking for maintaining our relationships with our merchants as best as we could in the face of the breach now in the third quarter and since the noise level on that has gone down dramatically. And so that as a consideration probably was less important to the manager who is evaluating whether to keep someone around or not.

Operator

And we do have a follow-up from James Friedman.

Meghna Ladha - Susqhehanna

Hi. This is Meghna Ladha on behalf of Jamie. Quick question on merchant and volume attrition. Bob, how was it this quarter versus last quarter? Thank you.

Robert Baldwin

Merchant count attrition has remained just the same, within a couple of tenths of a percent for the last 12 plus months. And so volume attrition really came down some because of the slight improvement in the same-store sales growth, which acts to mitigate the impact of merchant count attrition. So it was modestly better in the volume attrition, not at all in merchant count attrition.

Meghna Ladha - Susqhehanna

And the processing volume of 15.8 billion, that’s the organic volume, right?

Robert Baldwin

That’s the SME, so that is all organic, yes. That does include the Discover volume from that portfolio that we bought in July, so it does include a full quarter of their volume, which amounted to I think it was $400 million?

Bob Carr

That’s right.

Robert Baldwin

I think it’s $400 million.

Operator

And there are no additional questions at this time. Mr. Carr, I’ll turn things back to you for any additional or closing remarks.

Bob Carr

I’d just like to thank everyone and have a great day. Thank you very much.

Operator

Again that does conclude today’s conference. Thank you for your participation.

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Source: Heartland Payment Systems Inc. Q3 2009 Earnings Call Transcript
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