Blackhawk Network Holdings' CEO Discusses Q3 2013 Results - Earnings Call Transcript

Oct.10.13 | About: Blackhawk Network (HAWK)

Blackhawk Network Holdings, Inc. (NASDAQ:HAWK)

Q3 2013 Earnings Conference Call

October 10, 2013 10:00 AM ET

Executives

Patrick Cronin - Vice President, Finance and Investor Relations

Bill Tauscher - Chairman and Chief Executive Officer

Talbott Roche - President

Jerry Ulrich - Chief Financial Officer & Chief Administrative Officer

Analysts

Sara Gubins - Bank of America

Bryan Keane - Deutsche Bank

Ramsey El-Assal - Jefferies

Tim Willi - Wells Fargo

David Chiaverini - BMO Capital Markets

Ashwin Shirvaikar - Citi

Operator

Good day, ladies and gentlemen and welcome to the Q3 2013 Blackhawk Network Inc. Earnings Conference Call. My name is Jasmine and I will be your operator for today. At this time, all participants are in listen-only mode. Later, we will conduct a question-and-answer session. (Operator Instructions) As a reminder, this conference is being recorded for replay purposes. If you have any objections please disconnect at this time.

I would now like to turn the conference over to your host for today, Mr. Patrick Cronin, Blackhawk’s VP of Finance and Investor Relations. Please proceed.

Patrick Cronin

Alright, thank you operator and good morning everyone. Quick correction there actually Blackhawk for those of you heard black rock, Blackhawk Network’s earnings call. And with me today to discuss Blackhawk’s third quarter 2013 earnings results is Bill Tauscher, our Chairman and CEO; Talbott Roche, our President; and Jerry Ulrich, our Chief Financial & Administrative Officer.

Before I turn the call over to Bill, I’d like to remind you that management will make statements during this call that include forward-looking statements within the meaning of federal securities laws. Forward-looking statements contain information about future operating or financial performance, and forward-looking statements are based on our current expectations and assumptions that involve risks and uncertainties that could cause actual results or events to be materially different from those anticipated. However, we undertake no obligation to update or revise any such statements as a result of new information, future events, or otherwise. For a list and description of those risks and uncertainties, please see our filings with the SEC.

And with that, I’d like to turn the call over to Bill Tauscher.

Bill Tauscher

Well, thank you Patrick and good morning everybody. I would like to begin by highlighting a few items from our third quarter earnings release and then commenting on our progress on our fiscal 2013 goals. For the third quarter, revenues totaled $206 million, which was an increase of 25% over the third quarter from last year. The increase was the result of three factors.

First, load value increased 18% for the quarter. Second, we had a 58% increase in program, interchange, marketing and other fees. Now, this was primarily the result of increased marketing revenues from both U.S. and international card partners promoting their gift card programs as well as additional backend fees from open-loop gift products. Just as a reminder, the majority of marketing revenues are pass-through that offset the sales and marketing expense line. In fact, marketing expense for the third quarter, net of marketing revenues, declined 300K year-over-year. The third factor in our revenue growth was a 53% increase in product revenues with half the increase coming from Cardpool and the remainder from our telecom handset and card printing businesses.

Turning to load value, third quarter loan value growth was a significant improvement over Q2 driven by continued strong growth in open-loop gift card sales and a rebound in closed-loop gift card sales in the U.S. International load value continued to grow at just over double the U.S. growth rate. As a reminder, we did exit the prepaid telecom wholesale business just after the end of the third quarter last year. Excluding the impact from this exit, load value sales actually grew 22% in the third quarter.

Adjusted operating revenues, which are total revenues net of commissions and fees paid to our distribution partners, grew 34% for the quarter to $101 million. On a GAAP basis, net income for the third quarter declined year-over-year from $3.1 million to $2.4 million due primarily to the inclusion in 2012 results of a $2.6 million after-tax non-cash credit adjustment to the liability for the contingent portion of the Cardpool acquisition purchase price. In the third quarter this year, the contingent liability adjustment resulted in a $200,000 after-tax, non-cash credit or $2.4 million less than last year. Excluding this impact and the impact of other non-cash charges that Jerry will review later on the call, adjusted net income was $4 million for the quarter, up from $1.7 million in the third quarter of 2012.

GAAP diluted earnings per share was $0.04 in the third quarter of 2013 compared to $0.06 for the third quarter of 2012. Year-to-date GAAP diluted earnings per share was $0.12 as compared to $0.23 for the third quarter of 2012 year-to-date. Excluding the impact of non-cash items, however, adjusted diluted earnings per share increased by $0.05 from $0.03 in the third quarter of 2012 to $0.08 for the third quarter of 2013. For the third quarter, year-to-date adjusted diluted earnings per share was $0.28 compared to $0.25 in 2012.

We continue to make really good progress on our growth initiatives. I would like to quickly highlight accomplishments in our international regions, and then I will turn it over to Talbott, who will provide an update on progress in the U.S. Many of you saw the announcement on the sale of Safeway’s Canada division to Sobeys. Blackhawk is also the gift card provider for Sobeys and we are coordinating to ensure a smooth transition to Sobeys operations. This also provides us with an opportunity to integrate certain Safeway best practices into Sobeys overall. Last quarter, we announced Home Depot as a new U.S. distribution partner and now we have signed Home Depot in Canada. We expect to have 180 stores launched by the end of October.

We continue to make progress on adding digital content across all of our international regions. While iTunes remains an anchor partner and a significant contributor to our international growth, we have been expanding with several other digital content brands including Amazon, Google, Microsoft, Sony, Nintendo, and Facebook. Our total international selling locations now exceed 70,000, which is up over 60% compared to last year due to expansion in Japan, where we added 10,000 locations, expansion in Continental Europe, 9,000 locations versus a year ago, and the launch this year of Korea, which has started with 4,000 locations. As a reminder, many of our international distribution partners are convenience chains with less content and lower productivity levels than our U.S. grocery distribution partners, but still provide good customer reach in many international markets. Across all international regions, we have now growth of over 200 distribution partners and over 300 card partners.

With that, I will turn it over to Talbott, who will share progress on all of our U.S. initiatives. Talbott?

Talbott Roche

Thank you, Bill, and good morning everyone. In the U.S., our number one priority remains increasing productivity of existing distribution partners. Towards that end, Safeway’s expansion of its fuel loyalty program utilizing third-party fuel location continued to have a positive impact on load value sales growth of closed gift product into the third quarter.

As Bill mentioned earlier, our marketing expenditures increased substantially over Q3 of last year, and the additional spend proven successful in driving load value growth across open-loop gift, digital, and fuel loyalty programs. We remain on track to add an estimated 1.7 million PEGs across our top domestic distribution partners by late November in preparation for the upcoming holiday season. These additional PEGs allow us to add more points of interruption throughout the store and provide additional space for new content, including local and regional brands, and we are on track to migrate approximately 1,100 of our store locations from what we referred to as the basic category of execution to best practices in time for the holiday season.

In terms of renewal of our existing distribution partner relationships, this is a key indicator of our success, and across our top 50 U.S. distribution partners, we have had a 100% renewal rate year-to-date. Turning to adding our new distribution as another growth driver, the launch of Home Depot as a new distribution partner is ramping with approximately 600 selling stores currently installed and nearly 2,000 locations expected by the end of November. We will continue to focus on other large format specialty retailers with high frequency of shops as new distribution expansion opportunities. Our new relationship with Shell is progressing nicely with 500 stores scheduled to launch in the fourth quarter. And in addition, by year end, we will have launched approximately 2,000 stores between the Casey’s and [racetrack] (ph) chains this year reflecting our renewed focus on the U.S. convenience channel.

Now, turning to telecom, as we mentioned during our Q2 earnings call, we have been adding dedicated telecom displays at several distribution partners with an increased selection of handsets. These investments together with the focus on the convenience channel have resulted in low-double digit load value growth for prepaid telecom across our retail channel during the third quarter.

In terms of digital, we continue to make strong progress on signing more eGift content and expect to end the year with over an estimated 200 card partners offering a digital solution through our network. We have also partnered with Coinstar to power their eGift offering in their coin redemption machines. This partnership makes our eGift product available in Coinstar machines at more than 15,000 domestic retail locations. Financial services remains the fastest growing product category at Blackhawk. We have continued to expand the product offering through our retail distribution channel and are pursuing private label partnerships.

Turning to Cardpool, our card exchange business we have launched successfully with ACE Cash Express and will continue to rollout across their 1,600 locations over the remainder of this year. We have also partnered with Coinstar on this business to power their new card exchange kiosks, which allow consumers to exchange unused gift cards for cash. So far, Coinstar has installed approximately 150 kiosks with further expansions expected in 2014.

Now, to look at the holiday, as we look forward to the fourth quarter, we have seen a range of forecasted growth for consumer gift spending. From a 3.9% estimate by the NRF, National Retail Federation to a study by American Express Publishing forecasting a 7.7% increase in holiday gifting. Of course, if not resolved, there is concern the current budget standoff could impact consumer spending or diminish some of the ongoing improvement in the overall economic picture. However, in preparation for holiday, we have worked with our card and distribution partners to plan over 140 in-store marketing promotions and 45 digital marketing campaigns. We have also secured themed holiday shippers and palette displays which will go into over 10,000 retail locations. We have had an encouraging first four weeks of Q4 and are cautiously optimistic for this year’s holiday.

So with that, I will turn it over to Jerry.

Jerry Ulrich

Alright, thank you Talbott. I am going to go ahead and provide a little additional color on the financials for the third quarter and then share our outlook for the fourth quarter and the full year 2013.

So first on the load value increase, $256 million in the third quarter compared to a year ago and about an 18% overall increase and 22% as Bill mentioned adjusted for the exit of the wholesale telecom business just about a year ago. As we look forward to the fourth quarter, Talbott mentioned some of the prognostications of the gifting markets and consumer spending. We see in the gift card business seasonal promotions becoming the central focus and fuel loyalty programs typically tapered back later in the quarter. This tends to result in a little bit lower overall load value growth in the fourth quarter. So compared to the 22% pro forma growth for the third quarter, our current forecast for fourth quarter load value growth is between 19% and 20%.

Looking at the revenue lines, of course, besides load value there are several other significant drivers including marketing funds from content providers, open-loop gift growth, increasing international sales, and the ramp of product sales including Cardpool. So I am going to touch on each of those as we go through here. First, commissions and fees, the revenue from the commissions and fees line increased $24 million or about 18% year-over-year, which of course was in line with the load value sales growth and also consistent year-over-year at 9.2% of load value.

The second line of our revenues, program, interchange, marketing and other fees increased by $9 million or 58% for the quarter, that was driven primarily by a significant increase in marketing revenue from both U.S. and international card partners. So again a reminder that the marketing revenue is a pass-through, which shows up in the sales and marketing expense lines in addition to the revenue line as we spend the marketing funds. Also contributing to our growth in this revenue line are program fees and interchange income resulting from a continued strong performance of our U.S. Visa product.

For the fourth quarter, we don’t expect year-over-year increases for marketing revenues as we had a very robust marketing program in the fourth quarter of 2012. So our corresponding marketing expense of course would also show no growth in the fourth quarter. So on a profit basis no real net impact. In addition, while we do expect continued growth in fees from our U.S. Visa product sales, we have realized significant fees from our Visa card program in Asia in last year’s fourth quarter whereas most of those fees were realized in the second quarter this year. So on a global basis, the Visa fee income in the fourth quarter will have lower growth than in recent quarters due to the timing of these fees. Overall for the year, the program, interchange, marketing, and other line of revenue should show about 20% growth.

Turning to product sales, the third line of our revenues, it grew $7.8 million or 53% over last year’s, but half of that growth came from Cardpool and the remainder from our telecom, handset and card printing businesses. While Cardpool is growing nicely year-over-year, the growth has slowed somewhat and it’s a little bit short of expectations, which is the driver – one of the drivers rather behind the adjustments to the contingent consideration liability recorded on a quarterly basis over the past year. For the full year, we would expect product sales will grow well over 30%.

Turning to the expense lines, first of all, distribution partner commissions, we had a short blurb on that in our earnings release. I just want to give you a little bit more detail. It increased $16 million or 18% year-over-year and it was 66.6% of commissions and fees for the third quarter, which was similar to the level on the first and second quarters. However, if you look at it compared to last year’s third quarter, it declined by 20 basis points. Last year included extra commission expense based on or as the result rather of a contract amendment with a key partner that did provide some additional tiered commissions for higher per store productivity.

If we excluded the impact of that contract amendment in last year’s third quarter, this line item would have increased about 160 basis points. 80 basis points of that related to the amendment earlier this year at the beginning of this year of our distribution partner agreements with Safeway in the U.S. and Canada and as a reminder that amendment was done to essentially eliminate previous differential and commission rates that we shared with Safeway as compared to our other distribution partners. The remaining portion of the increase for the quarter was due to the change in mix of sales from international regions which again as a reminder tend to have higher fees and commissions as a percent of load value than also a higher share going to the distribution partners.

Okay, looking at profits and services, the expense increased $5 million, or 18% in the third quarter and it was 35% of adjusted operating revenues as compared to 39% of adjusted operating revenues in the third quarter of 2012. Most of the volume leverage in this line really gets realized in the fourth quarter during the peak gift card season. Looking at sales and marketing, for the third quarter, the increase was $7.6 million or 33% and again that was due primarily to the increased marketing expenses that corresponded to the increase in marketing revenue that I talked about earlier. Excluding the increase in marketing expenses, the growth was 6% year-over-year. The year-over-year change in mark-to-market and other amortization expense related to the partner equity instruments, which also rolls up into the sales and marketing line was negligible in the third quarter.

And finally, looking at G&A expense, it grew $5.9 million or about 142% in the third quarter of 2013. Now, remember that the G&A line includes the fair value adjustments on a GAAP basis related to the Cardpool contingent acquisition liability that Bill described earlier in the third quarter of 2013, the pre-tax credit that was recorded in this line item was $350,000 compared to $3.7 million in the third quarter 2012. So if we exclude those credits in both 2013 and 2012, G&A for the quarter grew about 31%. It does of course reflect the higher cost associated with being a public company as well as some increases in legal and compliance cost related to our regulated open-loop businesses and a support of international expansion.

Our income tax lines showed an effective tax rate for the third quarter of 41%. That brings the year-to-date effective tax rate to approximately 40%, which is the current estimated rate for the full year. That’s a little bit higher than last year’s 39% due primarily to the increase in the portion of non-deductible mark-to-market expenses that were incurred or recorded for 2013, particularly in the second quarter related to the IPO activity.

So in summary, I want to remind everyone that our mid to long-term financial objectives that we did communicate during the IPO process are to grow adjusted operating revenues and adjusted net income at 20% plus with adjusted EBITDA margins in the low 20% range. On a reported basis, in other words, not adjusted for the impact of the Safeway commission adjustment that I referred to earlier, which will have about a $9 million impact for the full year, we expect our 2013 operating revenue growth to be in the high-teens and adjusted net income growth in the mid-teens. And of course starting in 2014, the Safeway adjustment would not have an impact and we would be hitting the targets we believe on an adjusted basis. Just to kind of wrap up that point, on a pro forma basis, our adjusted diluted earnings per share for the quarter will be an increase of 32% to $0.33 for the third quarter as compared to last year.

I am going to turn now to some comments on the balance sheet and cash flow. Our year-to-date statement of cash flows and the balance sheet of course reflects the significant reduction in cash that’s simply due to the buildup in our settlement payables around the end of the holiday season each fiscal year end. So in the earnings release, we do provide a pro forma free cash flow table that starts with the cash flow from operations and then removes the impact from the change in gift card settlement receivables and payables and subtracts capital expenditures. The difference year-to-year in the change in settlement receivables and payables is strictly due to the timing of Christmas as compared to our fiscal year end. For the year-to-date 36-week period ended September 7, we showed pro forma cash use of approximately $21 million or $12.4 million if we add back restricted cash related to partner equity purchases that was released at the time of the IPO.

Now even excluding the change in settlement payables following year end, we would use cash during the first three quarters to fund the ongoing investments in the technology platform development and expansion of partner programs including the headcount expansion in displays, the other program development funds. And ultimately, that is made up of course in the fourth quarter due to the seasonality of sales and the resulting earnings leverage in that quarter.

For the rolling four quarters, which I think is a helpful metric, ended with the third quarter of 2013 excluding the special dividend that was paid prior to the IPO our pro forma free cash flow was $28.3 million. Capital expenditures on a year-to-date basis for Q3 were $21.3 million compared to $15.1 million in the 2012 nine-month period, half of that increase coming from a retrofit of our corporate offices to better utilize existing space and the remainder of the increase from technology spend. For the full year 2013, we expect total capital expenditures of approximately $29 million or about 2.5% of total operating revenues and an increase of 22% over 2012.

Before I turn it back to the operator to open up the line for questions, I just wanted to address one question we have received frequently over the past couple of weeks. Given we are coming up on just about six months post-IPO and the lockup period is about to expire, some of you have asked about Safeway’s intent to sell additional shares. We are not going to address that question on this call. However, it might come up on Safeway’s earning call later this afternoon and feel free to either dial-in or refer to their website to get a transcript of that call. By the way, non-Safeway holders include certain Blackhawk distribution partners and Blackhawk employees. Both of these groups were able to fell shares in the IPO and in addition our employee plans did provide a put feature prior to the IPO, so our feeling is that there is not necessarily a big pent-up demand to sell the shares post lockup. However, we don’t control of course the commitment to sell or not sell shares, but nevertheless just wanted to bring to your attention that those opportunities were in place previously.

So with that, I will turn it back to the operator for questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Your first question comes from the line of Sara Gubins from Bank of America. Please proceed.

Sara Gubins - Bank of America

Hi, thank you. Good morning.

Bill Tauscher

Good morning.

Sara Gubins - Bank of America

Could you talk about your expectations for distribution partner commission expense going forward, I know it was up year-over-year, but it was a bit adjusted out, but it was a bit below what we were expecting, and I am wondering if we should expect that to continue to increase?

Bill Tauscher

And I guess, as we look forward Sara, the primary driver has to do with both international versus domestic mix. As we said, international is growing a bit faster, so we would expect it to trend upward slightly. Now for the fourth quarter, we see it at kind of current levels, so we are comfortable that where it’s been so far this year would be kind of where it finishes up for this fiscal year.

Sara Gubins - Bank of America

Okay. And then as we think out to next year, any comments on that?

Jerry Ulrich

Yes, I think without going into lot of specifics, again trend on international will cause it to pick upwards slightly. It can be impacted by mix of sales at certain partners in the U.S. Again, we have talked before that some partners have tiered commission schedules based on productivity per store if they have implemented loyalty programs behind the gift card program, so in any case, I think we see a very modest uptick next year.

Sara Gubins - Bank of America

Okay. And…

Jerry Ulrich

I think just as a way to comment, next earnings release of course will be the year end, and we will provide more specific guidance for 2014 at that time.

Sara Gubins - Bank of America

Great. I don’t know if I missed it, but could you give us the number of store locations you are in currently, and maybe how you are thinking about that for the end of this fiscal year?

Bill Tauscher

Yes, I think -- Patrick help me out, I think we are approaching 200,000 on a worldwide basis, probably 160,000 or 170,000.

Patrick Cronin

And Sara, you asked specifically about store, [selling] (ph) store locations, actually we are…

Sara Gubins - Bank of America

Yes.

Patrick Cronin

Just over 100,000 closer to 110,000, and we will provide an update on that at year end.

Bill Tauscher

I think at year end that number tends to go up based on fourth quarter end.

Sara Gubins - Bank of America

Okay.

Patrick Cronin

And as we said the last time, again as Bill pointed out, we’ve had a lot of increase in international store locations. They don’t perform on per store basis at the same levels as the U.S., of course much more mature program and also the fact that there is grocery with high-traffic locations here that are more productive as well as greater content. So in general, we are kind of de-emphasizing the selling store count as a critical metric.

Sara Gubins - Bank of America

Great. And then…

Bill Tauscher

I would just add, I think our store count will continue to go up. There is clearly -- we are going on international, we will continue to add to that, and as Talbott pointed out, both in the convenience and the specialty big-box area, we see continued opportunities. We just need to be careful, because a convenience store chain of thousands of stores that might add to the overall count could be misleading if one assume to have the same productivity and it does not.

Sara Gubins - Bank of America

Fair enough. Last question, Jerry, I think I heard you and I want to make sure that I got this right. I think that you gave a number for your expectations for adjusted earnings for the fourth quarter, could you repeat that?

Jerry Ulrich

Well, I think what I said was our targets for the full year are in line with our targets that we talked about on a roadshow, so that adjusted earnings number of 20% neighborhood is where we are projecting the full year outcome.

Sara Gubins - Bank of America

Got it. Okay, thank you.

Operator

And your next question comes from the line of Bryan Keane, Deutsche Bank. Please proceed.

Bryan Keane - Deutsche Bank

Yes, good morning. Just wanted to talk about visibility into that key fourth quarter, I think you guys talked about load values being 19% to 20%. What kind of visibility do you have and how do you model that? Is that just looking at the current trends or knowing promotions? How do we think about that?

Jerry Ulrich

I think the process is based on many years of seasonality analysis. Of course, we take into account current programs, new partner expansion. Talbott mentioned the robust calendar for marketing promotions going into the fourth quarter. So, that’s the visibility we have. We of course are somewhat dependent on consumer sentiment and spending, that’s why we talk about some of the forecast that other organizations put out. The National Retail Foundation Forecast that Talbott mentioned is a pickup from last year in terms of growth in consumer spend during the holiday season. So, all the signs at the moment give us some level of confidence in our forecast that’s based on prior seasonality as well as current trends with each of our partners.

Bryan Keane - Deutsche Bank

Okay. I was just hoping you guys could talk a little bit about some of the productivity improvements you have seen and what to expect for that going forward as well?

Talbott Roche

Well, that’s an ongoing effort. I think as we have mentioned, we are pleased with the results of this year the ability to migrate over a thousand of our store locations to best practices, and that will continue into 2014, and there is no reason that those efforts would abate. So we feel – we continue to put effort into that. We continue to see results from those activities.

Bill Tauscher

I would add to that, while this was one, 2013 will be one of our largest years of adding PEGs and PEG count which is fundamental to our retail footprint and does have a direct effect on our sales growth. Given the continued performance of our program at retail and the acceptance of that performance by all of our retail distribution partners, I think we would believe that we could continue to expand our PEG count as we go forward as well. So, as we talked about that when we did the original IPO, we think there is quite a bit left, if you will, in productivity growth as we developed the multiple drivers of that, which of course include both our marketing programs, the increase in our displays and PEG count, the additions of new content, and some of the fundamentals around the way we merchandise and operate the program and moving people into best practices. So I think we certainly believe sitting here today we are not at all at the end of that road.

Bryan Keane - Deutsche Bank

Okay. And then just last question for me, Jerry, I might have missed it, but I think I heard international growth rate – revenue growth rate is still double the company average, what percentage of revenue now does international makeup of total revs?

Jerry Ulrich

Approximately 15%.

Bryan Keane - Deutsche Bank

Okay. Alright, thanks so much.

Operator

And your next question comes from the line of Ramsey El-Assal from Jefferies. Please proceed.

Ramsey El-Assal - Jefferies

Hi, guys. I wanted to start with a housekeeping question. Can you kind of remind and/or summarize for us the Cardpool contingent liability? What are the milestones left there? When does the final payout get calculated?

Bill Tauscher

So that purchase price had two years of contingencies with a third-year earn-out and that earn-out is completed next September, so third quarter next year.

Ramsey El-Assal - Jefferies

Okay. Q3 of next year, okay. On CapEx, you mentioned that this year, fully half of the CapEx went to retrofitting your offices, can we assume that, that won’t, go ahead.

Jerry Ulrich

Let me clarify it Bryan, when I was kind of reading the script, I realized that’s slightly confusing, it’s the increase compared to last year in terms of the expenditures. So I think the increase was year-over-year compared to this time last year was approximately $7 million and half of that was because we did a retrofit spend this year on the facility versus last year. The other half of the increase year-over-year related to increased technology spend.

Ramsey El-Assal - Jefferies

Okay, that…

Jerry Ulrich

The bulk then of the spend year-to-date is in fact technology of course not on building retrofit.

Ramsey El-Assal - Jefferies

Okay. Okay, that helps a lot. Thanks. One last one for me, have you guys ever thought about getting into the business of providing the program management services for the issuing retailers on the gift card side similar to what like an SVS or ValueLink does. I mean, it seems like you would have a really compelling bundled offer to say we can do the third-party distribution, we will manage your program for you. Is that a strategic direction you guys have ever contemplated or?

Talbott Roche

It’s a capability that we have. You are correct we found the business that we are focused on today a lot more attractive. So I don’t take that as a big strategic focus for us. We also have the deep partnerships with many of the players in the marketplace who do provide those services. So we work to maintain those partnerships and recognize our complementary strengths in the marketplace.

Ramsey El-Assal - Jefferies

Okay, thanks a lot. That’s the last one for me.

Operator

And your next question comes from the line of Tim Willi from Wells Fargo. Please proceed.

Tim Willi - Wells Fargo

Thanks and good morning. I have two questions. The first one just going back around eGifting, any color you could give us when you look at your progress here, you are arguing eGifting as well as traditional card, is there any evidence of cannibalization or is it actually opening up some incremental volume opportunities or is it just too early to tell? I would be curious about your thoughts on that.

Talbott Roche

Sure. Great question and it is very early.

Bill Tauscher

Maybe you should repeat the question, because it’s a little hard to understand.

Talbott Roche

Yes. I think the question just I will repeat it for everybody for clarity. Is eGift essentially cannibalized in the sale of physical product or is it providing incremental sales? And while I would qualify my comments as it is very early stages recognizing eGift is less than 1% of our total business today. In the places where we have introduced it in addition to physical card sales, we have seen a lift in overall sales. So we are not seeing cannibalization today. We are – early stages, it appears that it’s being purchased for either incentive and reward occasions that were incremental purchases to just consumer gifting and/or micro-gifting opportunities, which are just we believe incremental occasions, but it is early stages.

Bill Tauscher

I just add to that for a minute. I think as Talbott said it, but to say a little differently, the area that’s likely to move a little quicker in terms of converting physical to eGift is likely to be incentives and we are seeing some new and incremental opportunities there for us as a result of in a world that we have not historically had a big presence in the opportunity with eGifts allows us to change that where we can add some significant value. So far as Talbott said if you measure any statistics, it’s just not yet meaningful though there is just a lot of talk and a lot of activity. And of course as we reported before, we are spending a lot of energy and a lot of investment to make sure that we are prepared for any new distribution of eGift or any new distributors of eGifts and we are having some success in that regard, but it’s really in preparation for something that still looks to be in the future.

Tim Willi - Wells Fargo

Okay.

Talbott Roche

And to Bill’s point, it certainly does provide incremental sales opportunities and net new channel that will be sharing eGift. Today, what I was referencing was the actual side-by-side sales of product next to physical, because that gives us a cleanest view on whether there is incrementality when it’s sold side by side, but certainly in the new reward and incentive channels that will be incremental.

Jerry Ulrich

And you can see different instantiations I guess of electronic gifting, you could see it in physical locations, which opens up another avenue of much more localized merchants being able to offer gift cards in high traffic locations. I mean, so there is a lot of variations on the theme of hey, can I get a gift card on my mobile phone. And we see it as positive in terms of market expansion as we go forward.

Tim Willi - Wells Fargo

Just a follow-up actually you hit on it a bit, just maybe you could give us an update or thoughts on your efforts to generate more regional and I think local content to hang on to the PEGs. I was just sort of curious how that’s progressing, how you are thinking about that?

Talbott Roche

We are really happy about our progress in that area. It is a steep learning curve in terms of curating the right content and building the most effective way to integrate that into our physical displays in-store and merchandise in market after new digital channels that were opening up. So it’s still early, but it’s also that the learning curve is quite steep which is good. So we are expanding to more markets with that approach. We are supporting some of our larger distribution partners with its new local and regional content and where we are doing that, we are seeing increases in sales of approximately 10% to 15%, but we are taking a market by market approach that we ensure we have the best coverage and the best content when we go to market with this offering.

Tim Willi - Wells Fargo

Great, thanks very much.

Operator

And your next question comes from the line of David Chiaverini from BMO Capital Markets. Please proceed.

David Chiaverini - BMO Capital Markets

Thanks. Good morning. So I have a follow-up on the productivity improvement, could you give us an update on framing the opportunity, for instance, how many locations are in the basic offering versus best practices versus enhanced loyalty?

Jerry Ulrich

Yes, I think when we just about six months ago when we are on the roadshow, we trended up as about 50% of our locations. And again, this is referring to U.S. grocery distribution partners, about 50% of the locations are in a basic category, 25% in the best practices, and 25% had adopted a loyalty program to support gift cards. Talbott talked about some of the movement towards the best practices. We certainly would see that continuing as we go forward. Again, our projection was over a several year period, we would attempt to move about half of those stores from that basic category across the best practices. And it remains a focus of both our sales account managers as well as the team that supports operations and merchandising and so forth that ends up in the best practice operations at those store locations.

David Chiaverini - BMO Capital Markets

Got it. And the 1100 that moves to best practices, was that a year-over-year number?

Jerry Ulrich

Well, that would have been this year. So comparing to earlier this year, where we see it ending up this year.

David Chiaverini - BMO Capital Markets

Okay. So six months ago – from six months ago to September is the 1100?

Jerry Ulrich

Yes, yes, correct, correct.

David Chiaverini - BMO Capital Markets

Okay. And do you have a figure for how many went from best to enhanced loyalty?

Jerry Ulrich

We haven’t got any additional partners so far this year moved on to fuel although we have gone back and address the fuel program as it was in place for a couple of partners. So one of the things we talked about is within any of those categories you have different levels of maturity and/or how they execute, there is a wide range of productivity even within the categories. So again, a couple of partners that have reinforced or gone back and made some changes to the program to enhance it.

Bill Tauscher

We have two people testing the fuel loyalty, one testing it for their whole business, which of course is a major marketing shift for any retail business and the other who has a fuel loyalty program and is testing putting its gift cards on the program, which preliminarily looks like good results, but that’s really where the – that’s the most color we can give you at this point.

David Chiaverini - BMO Capital Markets

Got it. Thank you.

Operator

And your next question comes from the line of Ashwin Shirvaikar from Citi. Please proceed.

Ashwin Shirvaikar - Citi

Thank you, guys. I guess my first question is with regards to digital investments and Tim asked a part of this I think, but could you remind us of the roadmap over the next couple of years, what the intent is and the level of investment you are putting in?

Jerry Ulrich

Yes, I think we talked last quarter about significant investment in the digital services arena, so mobile and digital that kind of ties our platforms into the mobile and digital interfaces both e-tailers as well as mobile interfaces on smartphones. As we go forward, we expect to grow capital expenditures at roughly half the rate of the revenue growth. So in the next year or so, that would be our projection. Again, we will refine that as we talk in February about the forthcoming 2014 numbers, but generally that guidance still stands that the growth will slow on year-over-year basis and we will see about half the growth rate of CapEx compared to revenue growth.

Bill Tauscher

Just to add to that with a little different flavor. Just to remind our approach here, we really have two things that we are putting in place. The first is of course we have this huge amount of gift card content that is also now becoming eGift capable and every month, every week that number expands as we work with our various retailers to be able to provider eGifts. And that content and our connectivity with all those retailers and relationships with all those retailers essentially gives a catalog offering for digital distribution just like we have for physical distribution.

And then secondarily, which is where we are spending the capital expenditure that Jerry referred to. We are developing a series of services or we have developed a series of services that are able to be consumed by various people who have either mobile or online applications whether they be e-tailers or a long list of potential people who are today engaging or planning to engage in various kinds of mobile or online commerce, we have the ability to offer to those folks a series of digital services that enhance the gifting experience in a way you can’t do physically. So that’s the second part of the puzzle. Of course, while that’s capital, we also have an expanded business development group working across the board with various people who are emerging to be potential or real providers of gift cards and gift card services within their offerings. And we are spending a fair amount of time, effort, resources in that effort which really isn’t capital, but it’s the same kind of business development effort we have spent historically and continue to spend in getting new retail distribution.

Ashwin Shirvaikar - Citi

Got it. That’s very useful. Thank you. Is there a further update from last quarter on the regulatory side either with regards to the Judge Leon decision or anything else that might be brewing that you can update us on?

Talbott Roche

We really haven’t seen any change in the regulatory environment since last quarter that we believe is meaningful to our business. So we look for the CFPB still has not made their specific ruling around non-bank supervisory role, but again, we think that may come out in the fourth quarter, but again don’t see that as having a major impact to our business. So no, I would say there is really not a lot of change in the regulatory environment that is meaningful to our business.

Ashwin Shirvaikar - Citi

Thanks. Okay. Last question is on the operating leverage, can we take – Jerry, can we take your comments as sort of on a go-forward basis the operating leverage that you are getting is sort of in the numbers, not just in the near-term, but heading into 2014 and beyond or are there elements of operating leverage that are more temporary in nature?

Jerry Ulrich

Well, I think as we talked about, we are getting leverage on certain aspects of our P&L meaning processing and services we have said before that we would expect to continue to get leverage across that infrastructure and transactional processing to support of our revenues. The sales and marketing we talked about being variable depending on the level of marketing revenue. So excluding that, you did see some nice leverage in this quarter. You won’t necessarily see that level of leverage quarter-in quarter-out, but we would see again some leverage there as we go forward excluding the impact of fluctuations in marketing revenue and the corresponding expense.

On the G&A side, we probably have another year of I guess what you call lapping, where you have a little bit more increases because of the increased infrastructure to support public company and some of the regulatory and compliance stuff. So that line we won’t necessarily get leverage in the next few quarters, but we can see it at some point lapping. Now, you have to look at the overall P&L, we have talked a little bit about the commissions paid to our distribution partners ticking upward. So you would lose a little bit of leverage there. And then product sales versus the product cost of sales depending on that margin structure and the relative impact on the overall expenses and you have to take that into account, but as I said a couple of lines, we definitely would see leverage, but offset by a couple of the other lines.

Ashwin Shirvaikar - Citi

Great, thank you guys and look forward to seeing you in a couple of weeks here.

Jerry Ulrich

Okay, thanks.

Operator

And your next question comes from the line of James Friedman from SIG. Please proceed.

James Friedman - SIG

Hi.

Bill Tauscher

Hello, go ahead.

Operator

It seems that Mr. Friedman line has disconnected. There are no remaining questions at this time.

Patrick Cronin

Okay, well we want to thank everybody for dialing in this morning and we will look forward to the next quarter. Thank you. Thank you, operator.

Operator

Thank you. This concludes today’s conference. Thank you for your participation. You may now disconnect. You all have a great day.

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