Heartland Payment Systems, Inc. Q4 2009 Earnings Call Transcript

Feb.18.10 | About: Heartland Payment (HPY)

Heartland Payment Systems, Inc. (NYSE:HPY)

Q4 2009 Earnings Call

February 18, 2010 8:30 am ET

Executives

Robert Baldwin – President & CFO

Bob Carr - CEO

Analysts

Tim Willi – Wells Fargo

Tom McCrohan – Janney Montgomery Scott

Reggie Smith – JPMorgan

Dave Koning - Robert W. Baird

Robert Dodd - Morgan Keegan

John Williams – Goldman Sachs

Bob Napoli - Piper Jaffray

Ram Seshadri – Welsh Capital

James Friedman - Susquehanna

Operator

Good day everyone and welcome to the Heartland Payment Systems fourth quarter 2009 earnings conference. At this time, I’d like to turn the call over to President and CFO, Robert Baldwin. Please go ahead, sir.

Robert Baldwin

Good morning, everyone. I’d like to welcome you to our fourth 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 as 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, Chairman, and CEO.

Bob Carr

Thanks Robert and good morning everybody. 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 fourth quarter that we released this morning.

For the quarter we reported adjusted net income of $5.9 million or $0.16 per share net of $0.03 of stock compensation expense. Adjusted net income excludes expenses associated with the processing system intrusion and Bob will go through the detailed results in a minute.

Performance in the fourth quarter showed a sequential improvement relative to the third quarter, transaction processing volume was up 5% after rising just 1% in the third quarter and same store sales showed steady monthly improvement through the quarter resulting in a 340 basis point sequential improvement compared to the third quarter.

Compared to the 10% reductions we were seeing early in 2009, the 2.2% monthly decline reached in December compared to last year is a fairly dramatic improvement that would appear that January was a little weaker and February’s terrible weather may slow the rate of recovery.

New market installs is lagging these other indicators which we see as symptomatic of the cautious attitude of small and mid sized businesses regarding the strength of the economic recovery. Most importantly merchant attrition for the entire year was up only 0.1% compared to 2008 and for that we wanted to thank our many loyal merchants as well as our relationship and account managers who worked very hard to achieve this result.

Both our payroll and equipment related revenues were also up in the quarter driving net revenues up 5% in the fourth quarter after being essentially unchanged in the third quarter. We have completed significant IT development efforts to adapt our Chockstone Loyalty platform for our small and mid sized merchants, and have branded a new solution, Heartland to Gift marketing.

This initiative goes beyond offering a simple gift card. Our preloaded cards are also a marketing tool that enables merchants to draw a new customer to their store. It was a great success in our fourth quarter trials signing up approximately 1300 locations.

We think Heartland campus solution is changing the landscape for academic institutions nationwide with unique campus card programs, state of the art access control and security systems, and cost effective payments processing.

Campus solutions just announced a new agreement to provide 30,000 combined identification and prepaid Hawk debit cards to the students, faculty, and staff of Hillsborough Community College in the Tampa, Florida area. In addition we have now rolled out our first campus card program with a branded card.

Discovery is our partner on this innovative product which allows us to have financial aide loaded directly to the student account in a single card that works on or at off campus with our give something back network and off campus throughout the entire Discover network. This is now the most versatile card in the industry for college students and we think it positions us to move us up the ranks in the campus marketplace over the next few years.

On January 19 we entered into a long-term agreement with the National Restaurant Association. The NRA, the Counsel of State Restaurant Associations, and 40 of the state restaurant associations have contracted with Heartland to endorse and support our core product offerings of payments processing, payroll processing, check processing, and tip reporting.

We believe that this relationship will become the centerpiece of the growth and continuing success of our sales organization. Our progress continues to revolve around the success of our relationship managers and for the second consecutive year Heartland has beaten companies such as FedEx, Icon, Aeromark, and Google, and has been named the top service company to sell for in the United States by Selling Power Magazine.

In 2009 we retained 98 of our top 100 producers and 287 of our top 300 producers from 2008, one of the best sales retention rates among top producers in our history and a testament to the strong loyalty engendered by the Heartland way. Nevertheless it remains a very tough environment in the merchant marketplace.

Consequently during the fourth quarter we launched a number of initiatives to help our great sales organization overcome our new business challenges and achieve an even greater level of success. These initiatives include establishing a new vertical industry focused selling strategy where we leverage an industry specific payment processing product suite and a saturation sales effort, providing RMs armed with vertical industry expertise, exclusive rights to call on those merchants within an assigned territory.

And consciously calling our sales organization so that we can provide additional support to our most dedicated relationship managers. As a consequence at December 31 relationship manager count was 1,069 compared to 1,167 at September 30. We think this new strategy is going to be the foundation of our growth over the next few years.

Our first major vertical is the restaurant industry where Heartland has long maintained an outstanding reputation and established a strong presence. Historically RMs at Heartland were free to call on any merchant anywhere and this remains a viable alternative for an individual. However RMs who sign up for the restaurant protocol will be given exclusive marketing rights to approximately 500 target restaurant owners in a given territory.

To maintain the exclusivity they commit to maintaining an ongoing marketing effort on the target merchants in their territory and to update the database every week. Importantly the creation of these verticals will be the driving factor behind our targeted growth in RM count this year. These new positions offer the potential sales professional an enticing package of target clients, a tremendous set of vertical specific products, and the creditability that comes with representing the industry’s most successful sales organization.

We’ve already added many highly qualified new sales professionals to our ranks and we’ve identified 13 different industry verticals into which we intend to introduce this strategy. In addition to restaurants, we’ve already begun to rollout our medical vertical which effort has helped considerably by the recent endorsement of the California Medical Association.

Pharmacy and lodging will be rolled out in the next few months. We’ve set some pretty ambitious goals especially in the face of the current challenging economic conditions. However we owe our success to our commitment to invest in our sales organization in new product development and in technology. To achieve the levels of growth and success to which we aspire, we must continue to innovate and to invest.

This has been an increasingly competitive industry and to maintain our leadership position we need to leverage the value in our brand especially within the sales and merchant communities. In the short run these initiatives require an investment in recruiting and training, as well as investing significantly to develop the tools to manage the rollout of a very different business model.

One in which we maintain a much deeper ongoing interaction with our RMs and our customers. The near-term impact can be seen in the fourth quarter’s margins and G&A expenses. While not without its risks we believe we are positioning Heartland to take even more share in 2010 and the year’s ahead.

In similar fashion we remain committed to leading our industry enhancing the security of the card data that we and our merchants handle. Next quarter we will be taking our first major delivery of E3 technology devices. We initially intend to rollout our standalone terminal to security conscious merchants.

As our E3 strategy gains momentum throughout the year, we will be introducing additional products for additional markets. We are excited to embark on this new journey which we believe in some respects is already having a positive impact enhancing the security in our industry.

Now let me update everyone on the processing system intrusion, I will preface my remarks by reminding everyone that 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 to date.

We remain fully engaged in the ongoing investigation and resolution of claims that have arisen from the processing system intrusion. Since our last report we have made significant progress with a number of disputes. We have reached settlement agreements with card brands VISA and American Express as well as with the consumer consolidated class action litigation. The shareholders litigation was dismissed with prejudice. While we have certainly made progress in resolving claims related to the processing intrusion, several matters have yet to be fully resolved.

Because the nature of these ongoing matters is confidential including the settlement offers and the settlement discussions we believe may be near, you can understand the limitations of the disclosure we can share with you.

Let me now turn the call back to Robert Baldwin.

Robert Baldwin

Thanks Bob, as I discuss results unless otherwise noted my comments will be exclusive of the various cost associated with the processing system intrusion which are separately identified.

Heartland reported GAAP net loss of $9.6 million or $0.26 per share for the fourth quarter of 2009. Excluding $0.42 per share of separately identified processing system intrusion costs, net income would have been $5.9 million or $0.16 a share.

Excluding $0.03 per share of 123R stock compensation expense earnings would have been $0.19 per share. Small and mid sized merchant card processing volume of $14.8 billion for the quarter was up 5% from a year ago, a nice sequential improvement from 1% growth in the third quarter.

Same store sales were down 5.2% in the quarter, about 340 basis points better than the third quarter and the second consecutive quarter of sequential improvement. Although this quarter did benefit from an easier comparison with the weak 2008 fourth quarter sales volume. Within the quarter the trend of monthly improvement we first saw in the third quarter continued peaking with a 2.2% decline in same store sales for the month of December.

However it appears that momentum has stalled as January same store sales fell 4%, although that is still better than the average performance for the fourth quarter and unfortunately we don’t expect the terrible weather in the first half of February to help matters for this month.

During the quarter hotel same store sales were fully 7% worse than the averages, while electronics and retail were 1% to 2% worse than the average continuing recent trends. Restaurants reversed the trend that had prevailed through the recession, also coming in about 1% worse than the overall average.

Auto parts, entertainment, quick service restaurants, and convenience stores all performed better than overall same store sales. We also continue to see decrease in the value of transactions and a shift to more signature debit spending.

Overall SME VISA, MasterCard volume was flat for the quarter while transactions grew by 3.6%. Within those totals credit volume and transactions were down about 5% while signature debit volume and transactions in the quarter were up about 8%.

While we saw a nice sequential improvement in same store sales and transaction processing volume growth, new margin installs in the fourth quarter did not keep pace falling 23.3% from the prior year fourth quarter and 6.5% sequentially.

Clearly new margin installed is lagging our operating metrics and continues to reflect the cautious nature of merchants still evaluating the strength of the economic recovery. Our verticalization and saturation selling initiatives are intended to directly address these new business challenges.

Network services processed 710 million transactions in the quarter, up 4% from the fourth quarter of last year. Network services revenues are dependent on large national merchant transaction count not on dollar volume. As Bob mentioned earlier both payroll and equipment related gross revenues were also up in the fourth quarter helping with net revenue 5% to $105.1 million for the quarter, again a nice improvement in the year over year growth rate from the third quarter.

Total cost of services for the quarter were up 9.2% from a year ago. Our largest controllable expense processing and servicing, was up 5.2% from a year ago, about in line with our growth in net revenue. Customer acquisition costs actually fell 1% in the quarter, consistent with the weak volumes we saw while acquisitions, technology investments, and the Jeffersonville service center drove depreciation and amortization up 18%.

Fourth quarter G&A costs were up 25% compared with the fourth quarter of 2008 moderately better than the 34% increase in the third quarter. The fourth quarter increase was due to $1.25 million increase in 123R expense, as well as additional salary, payroll taxes, and fringe benefits, and higher legal costs. Notably our fringes increased by 2.5 times and given that we self insure on our medical benefits, resulted from much higher claims that we saw at the end of the year.

In addition our legal fees more than tripled in the quarter versus a year ago quarter. Operating income for the quarter was $10.5 million or 10% of net revenue, primarily due to the increase in G&A expenses relative to the weak revenue growth this quarter.

We separately broken out processing system intrusion related costs on our income statement. For the fourth quarter these costs were $23.7 million pre-tax and on an after-tax basis, represented about $0.42 per share.

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

By making the settlement offers SFAS 5 requires us to accrue for the estimated exposure to the claims that are the subject to the settlement offers. The accrual of these settlement offers as well as accruals for settlements of certain claims that we deem likely, resulted in the company carrying a $99.9 million reserve for processing system intrusion on its balance sheet at December 31, 2009.

To date we have publically disclosed a $3.6 million settlement with American Express, a $60 million settlement with VISA that should close today, and a proposed up to $2.4 million consumer consolidated class action settlement for an aggregate of about $66 million of disclosed or impending settlements.

It should not be assumed that we will resolve any of the claims relating to the processing system intrusions 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 certain other claimants have not reached a comparable status so we remain uncertain as to the probability, the amount, and the timing of any costs associated with those claims. Accordingly any potential costs are not reflected in our financial statements.

The remainder of the expenses and accruals were provided primarily for legal fees and for costs incurred for investigations, remedial actions, and crisis management services. Now let’s look at our cash flow, GAAP operating cash flow for the quarter was $3.2 million.

More importantly management’s measure of operating cash takes net income, adds back amortization, depreciation, the provision for the processing system intrusion and other noncash items at the top of the operating cash flow statement, resulting in total sources of cash flow from operations of $34.8 million.

We then reduce that figure by signing bonuses and buyouts paid, using this management metric operating cash grew 34% in the fourth quarter to $23.8 million from $17.7 million last year. Capital expenditures for the quarter were $8 million, of which $3.6 million was for the construction of the service center in Jeffersonville, Indiana, with most of the balance used to strengthen our technology infrastructure.

Taking that same definition of operating cash and reducing it by non-service center CapEx our free cash flow amounted to $19.4 million for the quarter, up 46% from last year’s fourth quarter. We used $374,000 of cash to pay dividends in the fourth quarter.

For the full year management’s measure of operating cash grew 44% in 2009 to $103.3 million from $71.9 million last year. After reducing this by non-service center CapEx, our free cash flow amounted to $80.3 million for the year, up 50% from last year.

We used $2.1 million of cash to pay dividends for the full year of 2009. We’ve remained very conscious of our liquidity, especially given current and prospective costs arising from the processing system intrusion which are 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.

There 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 costs. 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 are satisfying our VISA settlement by using current cash plus $53 million of proceeds of loans being made by Key Bank and Heartland Bank. Let me wrap up with our guidance for 2010, we do not anticipate the economic conditions facing our small and mid sized merchants to appreciably improve over the next 12 months.

Which means that same store sales are unlikely to turn positive for the year. Further, current trends in new market installed probably won’t improve until the second half of 2010. At the same time we will continue to invest significant sums to support our new sales and marketing strategy which will require that spending be sustained virtually unchanged from current levels over the year.

The effect of our growth expectations and spending plans will be felt acutely early in the year, especially in the first quarter where normal seasonal weakness in both revenues and margins will be exacerbated by higher spending patterns.

But flat quarter over quarter spending and the gradual recovery in new margin installs should help the balance of the year show market improvement. For 2010 we expect to achieve full year net revenue of between $460 and $475 million which is about a 10% to 13% increase compared to 2009 net revenues.

And our full year guidance is now $0.95 to $1.00 per diluted share which excludes $0.09 per share of 123R stock compensation expenses. Our 2010 guidance does not include any estimates for potential losses, costs, and expenses, arising from the previously announced processing system intrusion, [excluding] exposure to credit and debit card companies and banks, exposure to various legal proceedings that are pending, or may arise, and related fees and expenses and other potential liabilities, costs and expenses including the interest expense on debt incurred to finance any settlements.

Back to you Bob.

Bob Carr

Thanks Robert, our core small and mid sized merchants have suffered tremendously throughout this economic downturn and we are glad that some of our key leading indicators showed encouraging improvement in the fourth quarter.

We believe we have moved aggressively to leverage our franchise in the near-term through our new vertical industry focus, our growing loyalty business, and our new alliance with the National Restaurant Association.

These are all important advances with exciting growth prospects and the benefits that we will realize from the significant investments we are making, will be increasingly evident through 2010 and beyond. Longer-term, it is clear that security will become an increasing concern of merchants, and our customers, and we are pleased to be in the midst of this historic introduction of the processing industry’s only complete end to end encryption technology.

Over the long-term we believe this foresight will be greatly rewarded. And after more than a year of tremendous legal and related distractions we are optimistic that we are close to returning to more normalized operations. Before closing today’s call and opening up to questions, I would like to announce that your Board of Directors has declared a first quarter dividend of $0.01 per share payable March 15 to holders of record on the 5th of March.

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

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Tim Willi – Wells Fargo

Tim Willi – Wells Fargo

Two questions, first one was on the loyalty platform that you talked about, it sounds like I think your comments were some pretty strong results in the initial data, I was just wondering if you could give us just a little bit more color around exactly how that’s being delivered and implemented by merchants, if there are specific verticals where you’re really going to focus it sort of tying it in to your vertical specific sales organization that you’ve created here, and just any kind of if you can loosely quantify the positive impact merchants are seeing, whether it be same store or revenue growth or transaction you’ve seen from merchants that betaed this.

Bob Carr

When we acquired Chockstone in the fourth quarter of 2008, the company was basically focused on large merchant customized operations. And we had the platform reread to accommodate small and mid sized merchants. We rolled it out September 1 and with a standard gift card program that we expanded to use in a marketing direction called Heartland Gift Marketing.

That’s the only program that we’ve rolled out. We now have 1600 live merchants on the product. They like it a lot because it drives business to their locations and that’s what we’re trying to do as a company is to build more and more solutions that will drive business to our customers.

We are rolling out a coalition gift card, and working on an electronic punch card products in the gift marketing area. Its too early to tell what the uptick is for our customers and their increased sales but the product is very well received and there’s a lot of talk among our customers about the success of this program.

So we’re pretty excited about it. Other than the number of merchants, I don’t have the metrics to give you but we will have them as we continue to roll this out.

Tim Willi – Wells Fargo

Is there incremental cost to the merchant in terms of technology or administrative expenses to accept this product or is it essentially free for them.

Bob Carr

We have two models, one model is pay as you go where they only pay if they have a transaction, and that’s a good way for them to start with very little risk. The primary model is a monthly fee which generates margins to the company plus a smaller transaction fee. We have all levels of customization or standard card stock that they can use depending how much money they want to spend.

So its sort of a choice that the merchant can sort of choose which way they want to get started.

Tim Willi – Wells Fargo

And then about the vertical sales efforts and just as you implemented this, just curious to the degree of you’ve seen in the competitive landscape if anybody else is moving this way, or if you feel that you’re sort of truly out there on the cutting edge of how to approach what may be the new reality of merchant acquiring, just any sort of due diligence or can you share with us around how you came to the conclusions about the strategy and I think you said 13 specific verticals you’re looking at.

Bob Carr

Well actually last March we started talking about but we didn’t get into assigned areas until November. We began betaing that in November. I think we’re the only company that has the scale in terms of the number of our sales people to be able to do a vertical assignment rollout the way we’re doing it.

There are 600,000 restaurant owners in America for example, and in order to touch all those owners once every nine months, which is our goal, we’d literally need 1000 sales reps out in the field calling on these restaurants and the real spark here was the National Restaurant Association endorsement plus having 40 of the states behind us.

It gives us a lot of energy to go out there and I do think we have a competitive advantage for the time being. Its going to be difficult for many of our competitors who use ISO’s, sub ISO’s, 1099 folks, and sub 1099 folks, who’d have no clue of what their sales people are doing. That model is going to be very difficult to compete with our model that we’re rolling out.

We also have the American Hotel and Lodging Association relationship that’s going to support us in the lodging industry. We have a number of medical associations, the largest being the California Medical Association, that we’re building around for the medical opportunity and we have some pharmacy organizations as well behind us.

So, our approach is to align with the industry organizations with the thought leaders in those industries and to offer their membership great products and vertical market focused solutions that go beyond traditional payment processing.

Operator

Your next question comes from the line of Tom McCrohan – Janney Montgomery Scott

Tom McCrohan – Janney Montgomery Scott

Can you give us the volume net revenue excluding equipment sales, payroll sales, and NWS revenues.

Robert Baldwin

The overall net revenue was, the SME net revenue was $73.2 million compares to $67 million in the fourth quarter of last year.

Tom McCrohan – Janney Montgomery Scott

And how should we be thinking about net revenue spread on volume based revenues going forward and should we assume that Heartland still has a price advantage in the market relative to those processors that sell card services through intermediaries and have kind of more mouths to feed.

Robert Baldwin

We think that we’re first of all maintaining our margins, if you look at the SME net revenue percentage for the fourth quarter it was up actually about two basis points compared to the year ago same quarter so we’re maintaining margin but I think that you’re hearing pretty loudly in this tough environment about in general in the ISO industry about compression in pricing.

We have been and remain a low cost provider in the industry so we’re maintaining our margins. Its been tougher for other players who are part of a different distribution chain with some higher costs associated with it.

Tom McCrohan – Janney Montgomery Scott

And on the new campus card can you help us kind of quantify at all kind of the revenue opportunity there and if you can break out any revenue contribution to date that would be helpful too.

Bob Carr

It’s a little bit difficult to do that because our model with the campus program is to sign up merchants around the campus to take that card and that’s our traditional core business. The revenues that we generate from the card per say are from the merchants who accept those transactions and so our model is basically to break even on the installation and operation of the on campus transactions and to make our money on the off campus transactions.

Operator

Your next question comes from the line of Reggie Smith – JPMorgan

Reggie Smith – JPMorgan

My first question looking at your guidance for next year, I guess the net revenue is a little higher than what I would have expected, I’m just curious what kind of processing volume assumptions are baked into that guidance as far as growth.

Robert Baldwin

SME volume growth is in the high single-digits and then the remainder of the growth in net revenue is from non card volume related activities, payroll, and other loyalty etc.

Reggie Smith – JPMorgan

And digging into SME have you started to see an increase or some noticeable volume from Discover and Am Ex yet.

Robert Baldwin

Yes, you’re seeing, I mean Discover really became a one-time plus that with the acquisition of the portfolio from them in the summer last year, Am Ex is more of a building process and in the quarter the dollar volume from Am Ex and Discover came to just under $600 million, that compares to in the third quarter about $400 million.

So its building pretty nicely with as I mentioned Am Ex being sort of a steady increase whereas Discover kicked in with, that didn’t have a full quarter in the third quarter but then with the fourth quarter we had a full three months with that volume.

Reggie Smith – JPMorgan

And if I can get an update on data encryption and how its being priced. I know that you initially your plan was to kind of give it away to merchants and I’m wondering I’ve seen some other acquirers try to charge for it, just wondering how that market is evolving and where you think its going and then if you could comment a little bit on any impact you might have seen from what VeriFone has done last few months.

Bob Carr

We do have a number of merchants up and running on our second generation E3 hardware. We are waiting a shipment of several thousand devices that we don’t expect to get now until the second quarter due to parts issues. Our model is to recover our costs of the development and build of these devices so that its not a loss leader, if you will.

We do plan on selling the equipment or renting it to merchants as we do in our normal business. The fact is is that the cost of these devices because they’re coming from a great vendor that doesn’t have the big brand, we’re using the Heartland brand here, the cost of the devices is equivalent to the prices that are out there. They’re not more expensive actually.

So our model is to recover our costs and add more merchants because they will have a more secure method of processing. We’re using the same technology as pin debit, and to the best of my knowledge there’s been no merchant ever compromised where they’ve had pins that have been stolen from their system because they never enter the merchant system in the clear.

That’s the exact approach that we’re using in our technology so we’re getting a lot of interest from merchants who want to decrease the cost of worrying and the risk that they have with the PCI model and we have high hopes that this solution is going to be a great interim solution until the US moves to chip and pin in five to 10 years.

Robert Baldwin

If I could just add, when we look at the medium and larger merchants which are not focused around the free standing terminals that we have now, we’re going to be introducing the wedges that are plugged into a POS system much more typically, and those merchants are very security conscious, they’re also of course very cost conscious.

We are optimistic that offering this superior product will allow us to maintain a solid margin in that larger merchant category but obviously we think that those merchants will be tremendously resistant to paying any significant premium for the encryption and sort of at a philosophic level, this is where the product ought to be and the product that we ought to offer for our merchants and for consumers.

And it sort of represents a challenge to the rest of the industry to catch up to that level of security which is we think appropriate.

Operator

Your next question comes from the line of Dave Koning - Robert W. Baird

Dave Koning - Robert W. Baird

On the guidance, Reggie asked the revenue question because it was a little better than what we expected as well, but margins were a little below our expectations. It looks like flat to up a little bit probably in 2010 and maybe you can just talk a little bit about revenue growing 10% to 13% on a model that seems pretty leveragable, why margins wouldn’t be up a little more.

Robert Baldwin

That’s what we were trying to lay out in terms of the costs that we’re facing in 2010. There are a whole host of initiatives that are just costing a lot of money. This verticalization really involves us getting much more actively engaged with monitoring not only what our sales force is doing but also in developing and understanding of the merchant base out there.

It has tremendous value to us we think long-term, but the tools we have to develop if you pull back and say what is Heartland tried to do, its been we’ve tried to offer tools to our sales people and then said to them implicitly we’ll give you lots of support but go out and figure out who your merchants are and who to sell to and figure out how to sell it and we’ll pay you if you successfully sell it.

In this model we’re asking them to be much more engaged with us in terms of information on a daily and weekly basis and we think that that’s going to drive a lot of very positive behavior but in the short-term its involved substantial investment in costs that really won’t play out until later in the year or 2011.

Another example is that we just this year rolled out a brand new payroll platform which we’ve been developing for over a year. That was a necessary and desirable investment in not only creating a better platform then that which we were licensing from a third party but also one that we can scale up. In January we passed the 10,000 customer milestone which we view as just a step on the way but its not a trivial one and we needed to have a platform that can scale successfully to many more thousand merchants.

This year, that’s just going to cut our margins in the payroll business because you’re amortizing the costs of the new system and actually we have some more consulting time expenses as we roll it out to our existing and new merchants while we actually carried most of the cost of the outsourced system as well because we have a lot of customers that we’re not going to be converting until later in the year.

So that’s an example where the challenge to improving our margins this year was a lot of necessary infrastructure investments that we think and are very focused on leveraging in really starting in the back part of the year and then in particular in 2011.

Dave Koning - Robert W. Baird

And then VISA loan, or the settlement related loan that you talked about, the $53 million, first of all maybe the rate you expect on it that you expect and then secondly you did say it looks like in the press release that your guidance excludes that so we should try to add that back to our GAAP number to be in line with your guidance, is that right.

Robert Baldwin

Yes, the cost is going to be, the interest expense line during the course of this year is going to develop into a higher interest expense line there’s no question about that. This $53 million is in two pieces, one is in the drawdown on an accordion of the existing revolving credit so that’s at the same kind of rates that we’ve been paying.

And then there’s a bridge loan in addition to that that we’re paying. That’s going to be in place, its really hard to give you much guidance here because obviously we’re working toward achieving settlements across the full range of claimants that we have. As we get those settlements further nailed down that will also enable us to go back out to the marketplace with a, for a take out financing that will be a permanent financing for us.

But we really can’t do that until we’ve nailed down more pieces of the expense that we’ve got to incur. So this is, to be viewed as sort of a bridge financing to that take out which will be dependent on the timing of achieving further settlements and so its hard for us to give you much guidance on that because we don’t have the amounts and we obviously don’t have the rates that those will be financed at.

So I can definitely, you need to expect higher interest costs in 2010 than in 2009 by a non trivial amount but giving you more guidance on that really presupposes knowledge about both what the aggregate settlements are going to be and then how much, what the market is going to be like for take out financing and I just don’t have visibility on that right now.

Operator

Your next question comes from the line of Robert Dodd - Morgan Keegan

Robert Dodd - Morgan Keegan

If I could just, looking at the new margin installed, is there any more color you can give us on that in terms of productivity in your top 100 or productivity during the course of the quarter. Have you seen any improvements there, was there an impact from obviously the reduction in relationship managers. Any additional color you can give us on that would be helpful.

Robert Baldwin

The productivity issue is sort of a tricky one but there’s no question that while we’re delighted with the retention rates that we have of our people, of our more experienced and successful people, which we think is pretty extraordinary for this kind of commissioned sales organization, there is a underlying challenge there and let’s take an individual who was having great success a couple of years ago in better environment and generating 20,000 a month of installed margin.

That represented 10,000 a month of signing bonuses to that individual. Probably a substantial portion of his or her business was coming from various forms of referral as they build up their business and that is a great way to run a business. Unfortunately in the tough current environment you’re [inaudible] which were installing point of sale systems aren’t doing very much. You’re established merchants who were adding locations are not doing that, maybe subtracting locations. And so its hard, you’re finding your revenue or your margin installed coming down.

Let’s say it comes from 20 down to 14,000. Well that means take home income on signing bonuses goes from $10 to $7,000. Disappointing but not disastrous for the individual and they’re looking around and people out of jobs, well I’m doing okay still and the alternative is that what we’d like them to do is to have that burning passion to keep that revenue going and change their behavior by going as I like to say, going back to their first love cold calling.

Most people don’t really want to do that and to be fair Heartland’s deal with those sales people is if you’re producing whether it’s at 20,000 or at 14,000 you’re considered to be a very valuable producer for the company. So we’re not going to say, you’re missing your quota when you’re coming down that much. So in fact our productivity out of our more successful people has come down fairly significantly in 2009 and we really don’t have any kind of particular sticks to drive that to a higher productivity.

One of the reasons we’re going to this vertical strategy and the saturation selling model is really to change behaviors. We want people out making the calls. Unfortunately in a tough business environment its easy to sort of roll over and stay in bed, not be out aggressively and what we’re doing in this model is requiring that a certain level of calling effort be maintained.

As Bob mentioned such that your target base would be each called on within about a nine month period and so we think that we’re going to be driving much more sort of showing up activity than we’ve been able to drive in the past and in many cases as I say just showing up is half the game. We think that that’s going to be an opportunity to improve that productivity metric.

But right now we have nothing in the way of proof of that.

Robert Dodd - Morgan Keegan

Have you notified your customer base yet of the assessment increases coming or is that notification still to go out and then can you recap kind of what’s typical customer response to that kind of thing versus competitive opportunity exists when that happens.

Bob Carr

We’re going to announce the 1.5 basis point MasterCard increase on the March statement because it goes into effect in April. We do not mark those up, that’s sort of our merchant bill of rights and when we get the first statements from our competitors that show, that say basically the card [inaudible] went up, you’re new price is 15 basis points higher, we take those out and probably go sign up their customers, so we think the big increases that will be done by our competitors will help us get a nice flood of new business in April and May.

Operator

Your next question comes from the line of John Williams – Goldman Sachs

John Williams – Goldman Sachs

In looking across the rest of our universe we’ve seen I guess what you could call some degree of cautious optimism, and it looks like just in your commentary it hasn’t necessarily been that way and just wondering is there something specific within segments that you might have seen in January and February that are, that have really left you a little bit more cautious than you might have been based on what you had seen at the end of December.

Robert Baldwin

Its tough to, I’m not going to characterize why other people get themselves more optimistic. Our mix of merchants is SME merchants, we are I think clearly in this recession there has been a market share shift to larger box retailers. We don’t benefit from that in our primary business. We’re looking at the numbers. We saw a nice improvement in the same store sales numbers but they all had negative signs in front of them which means that in December looking at all the merchants that were with us a year ago in December and still were with us this December they were down 2.2%.

That same statistic for January was down 4%. So every time I try to grab the rose colored glasses, but its just hard to see how I project an improvement in what the consumer is going to do if you will at main street merchants. We’re not seeing any dramatic changes in the mix of business. As I mentioned hotels were terrible in the fourth quarter but they’ve been terrible for over a year.

I think they may be seeing improving occupancy, you read about that, but I think prices are still down. Retail has been just looking at, relative to our overall same store sales numbers, retail has been down for the, over the last 24 months about three percentage points worse than that average, last 12 months, two percentage points worse, and then the last three months one basis point worse.

So its still worse. Its an improving trend, but its still worse than an overall average and the only shift we really saw in the fourth quarter was that restaurants actually deteriorated from what had been a slight outperformance in same store sales over the rest of the recession.

So I wish I was seeing better results. We’re not contemplating further declines but I think if you pull back and look at the overall economy, they’re talking about improvements in the economy but its just hard as we look at the consumers, the people who are facing substantial challenges in paying their mortgages, and in paying their credit cards, as we look at the reduced availability of credit card credit, which is unquestionably going to be an outcome of both the charge-offs that the issuing companies have faced and the legislated changes in the card act, its just hard to see how the consumer is going to be the leader of growth in this recovery.

John Williams – Goldman Sachs

One other thing on the expense side, I know a couple of the previous questions have talked about your revenue guidance being a little higher and there looks to be some degree of unexpected pressure on margins but specific to the breach, I know some of the expenses related to that have flowed through and I was hoping you might be able to give an update on where that stood at the end of the year and maybe a little bit about what you’re expecting for the early part of this year.

Robert Baldwin

Its very hard to nail down those expenses. The pieces that we worked fairly hard to identify the pieces that we can pull out and identify for you. Those other pieces are just parts of whether its accounting charges and other legal bills, etc. but its still running in the low seven digit quarterly number and I would expect that to continue at least for the first half of this year and then start easing off.

Does not disappear though by any means, the lawyers who are reviewing our 10-K and Q this year very much more closely than they did a year and a half ago, will have to later this year as well. So it’s a slow improvement or a slow shedding of that incremental cost burden.

Operator

Your next question comes from the line of Bob Napoli - Piper Jaffray

Bob Napoli - Piper Jaffray

I wanted to make sure I got a number right, relationship managers, was it 1,069.

Robert Baldwin

That’s correct.

Bob Napoli - Piper Jaffray

So that was a pretty good drop quarter over quarter, like 8%, what caused that and is it some of the less productive relationship managers just getting unhappy with the compensation levels and looking for something else, did you intentionally downsize, and what’s the outlook because I know you want to grow that line, the number of relationship managers pretty significantly I think over the long-term.

Bob Carr

We had a call to action of all of our hiring managers in November and we said that we want to, folks that weren’t producing and weren’t committed 100% to the company needed to move on and so most of that reduction is the result of us terminating non productive reps that should have frankly been terminated before November.

Robert Baldwin

And looking forward are definitely, we are very actively hiring. We have hundreds, literally hundreds of spaces available for the restaurant vertical alone. So we are very actively recruiting.

Bob Napoli - Piper Jaffray

And just back to the margins, the operating margin, if you think about the operating margin its changed a lot with the acquisition of the network business, [inaudible] WS and the, now your expenses are up part of it related to the breach, part of to some of these initiatives but what is the right operating margin for this company over the medium term.

Robert Baldwin

Over the medium term we want to take that back into that high teens number and longer term we don’t see anything in the business, change in the business that can prevent us having a 20%-plus operating margin but medium term and that’s not too long we do very strongly want to target that to get up into that higher teens operating margin number.

Bob Carr

A lot of the new product development that we’ve been doing over that last couple of years, we do have good visibility and frankly I feel encouraged in not too far down the road we’re going to be able to flatten the development costs and really see some nice revenue gains as a result of these new products that are integrated with one another and allow us to be a [decommoditized] offering versus our competitors.

Bob Napoli - Piper Jaffray

And medium term is 2011 or is that 2012.

Bob Carr

We’re thinking, we wish it was 2011 right now. The last year has been tough, this year is not going to be quite so tough and then hopefully we’ll have some clear sailing after we get into the second half of this year.

Bob Napoli - Piper Jaffray

And then on your campus card, you signed is it Hillsborough Community College, when was that and is that a significant new signing, it sounds like it.

Bob Carr

Its very significant because we beat out our two larger competitors in the industry for the business and it’s a very large campus so its very significant in our minds. We just are carding the campus over the last few weeks so the benefits of the new business we’ll begin seeing primarily in the second quarter of this year.

Bob Napoli - Piper Jaffray

Is your campus card a MasterCard or VISA.

Bob Carr

Our campus card, we have two flavors. We have an unbranded card, that’s been our product up until now. We have our first college installation with the Discover card which is pretty unique because on campus we do not use the Discover brand. For the laundry, for the Coke machines, for the cafeterias, they’re all transactions that are processed sort of as a close loop transaction.

But when the student goes off campus, and uses that card, when the transaction comes into us if that merchant is accepting the campus card we treat is as a closed loop transaction but the merchant is not our customer such as Wal-Mart, then we process it through the Discover network.

It’s a really great new product that’s going to really revolutionize the campus card space because we are allowed now because of the Discover bug to put financial aides onto that card. And so the one trick ponies out there that only do financial aides and don’t do any on campus transactions are going to have a tough time competing with us going forward because of this product.

Operator

Your next question comes from the line of Ram Seshadri – Welsh Capital

Ram Seshadri – Welsh Capital

When I look at the net margin installed what kind of, since I’m kind of new to the story what kind of an impact does it have, does it have on revenues in the future or its more on the margin side, or could you just give us some insight into that.

Robert Baldwin

It is all a prospective measure so it’s a measure of the first year’s expected margin net revenue less our expenses but and so it’s a very much an indicator of future volume but probably we’re tight on time so maybe we ought to take that up offline. Don’t hesitate to give me a call at the office on that.

Operator

Your final question comes from the line of James Friedman - Susquehanna

James Friedman - Susquehanna

Quick question, can you just remind me again what kind of seasonality you expect for the [inaudible] revenue and operating expenses and the second one is on the tax rate for the year.

Robert Baldwin

On the second question in terms of our planning we’re using 38.1% for the year. That is going to get quite complicated and its complicated this year with all the losses and things that, but for apples to apples comparison we use 38.1%. We’re actually going to obviously realize very substantial tax benefits from the unfortunate costs that were bearing from the intrusion.

The seasonality is going to be quite pronounced this year. Always our first quarter is our lowest revenue quarter. Its actually one day shorter quarter and it also has two of the worst months, January and February in our business. So that normal pattern and we also have lower margins, in essence an incremental dollar of revenue in our business is not quite free, but its quite inexpensive and so those stronger months have higher margins associated with it.

And you’ve seen it, seasonal pattern of that. I would say this year its going to be exacerbated by the carry on of costs in the first quarter. We are doing another summit which is, we view as these company wide meetings as critical, culture building and training exercises. We think of them as every 18 months kind of expenditure because it is a very substantial expenditure.

However this year because of the tough and challenging 2009 we decided to go ahead and have another one and to roll out the verticalization and saturation selling, we decided to have another in March so the cost of that is in the first quarter. So a number of factors are going to be going into leaving the first quarter margins unusually weak and then a very solid rebound in the second quarter and on out.

Bob Carr

Thank you all for joining us and we’ll talk to you next time.

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