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Heartland Payment Systems (NYSE:HPY)

Q1 2010 Earnings Call

May 06, 2010 8:30 am ET

Executives

Robert Carr - Executive Chairman and Chief Executive Officer

Robert Baldwin - President, Chief Financial Officer and Principal Accounting Officer

Analysts

Brett Huff - Stephens Inc.

Robert Napoli - Piper Jaffray Companies

Robert Dodd - Morgan Keegan & Company, Inc.

Tien-Tsin Huang - JP Morgan Chase & Co

Christopher Shutler - William Blair & Company L.L.C.

David Koning - Robert W. Baird & Co. Incorporated

Thomas McCrohan - Janney Montgomery Scott LLC

Timothy Willi - Wells Fargo Securities, LLC

Operator

Good day, everyone, and welcome to the Heartland Payment Systems First Quarter 2010 Earnings Conference Call. [Operator Instructions] At this time, I turn the conference over to President and CFO, Robert Baldwin. Please go ahead, sir.

Robert Baldwin

Thank you, and good morning, everyone. I'd like to welcome you to our first quarter 2010 earnings call. Joining me is Bob Carr, Chairman and CEO. Today, Bob will begin our discussion with an overview of the quarter 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 limited comments on the processing system intrusion experienced. And beyond our prepared remarks, we are advising our participants 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 to reflect events or circumstances that may arise after this call. Additional detailed financial information can be found in Heartland Payment Systems' statistical supplement for the first quarter which is available on our website, heartlandpaymentsystems.com. I'd like to turn the call over to Chairman, CEO, Bob Carr.

Robert Carr

Thanks, Bob, and good morning, everyone. I'd like to thank you all for joining us today and for your interest in Heartland. Performance in most first quarter of key metrics showed continued improvement. SME transaction processing volume was up nearly 7.2% year-over-year while same store sales improved 370 basis points sequentially from the fourth quarter. In fact, March was the first-period in almost two years that we experienced positive same store sales growth. For the quarter, we reported a adjusted net income of $1.5 million or $0.04 per share, net of $0.02 of stock compensation expense, where adjusted net income excludes net insurance recoveries associated with the processing system intrusion. We recognize the bottom line is a departure from recent results, but as we discussed last quarter, our planned increased investment spending including our sales Summit unavoidably compounded the earnings challenges we always face in our first seasonally weakest quarter. Bob will go through the detailed results in a minute.

Clearly, the overall processing environment is improving as it appears the economy is on the mend and consumers are returning to the stores and that's certainly, a welcome relief. In addition, we are making steady progress with both our Payroll and Equipment-related businesses where we reported double-digit revenue growth in the quarter. This contributed to a 5.4% increase in net revenues. Our fundamentals are recovering nicely even though our small and mid-size merchants still seem to be feeling the effects of challenging economic conditions. For instance, merchant attrition for the quarter was better than for all of last year. However, new margin installed remains weak. We believe this was in large part due to the disruption caused by the implementation of our new vertical market strategy, as well as by the time out of the field for training and development at our Sales Summit in March. We believe our new industry specialization model or ISM strategy will enable us to quickly restore new margin installed as well as accelerate overall growth. ISM is a focused selling approach for maximizing productivity and efficiency in targeted vertical markets. Relationship managers are provided a targeted list of prospects in a protected geography in his or her vertical market. Our first three vertical markets are Restaurants, Lodging and Healthcare. Where we have established 1035, 200, and 890 specific geographic territories, respectively. Of these 2125 individual protective territories, we still need to fill over 400 positions in the Restaurant vertical, 120 in Lodging and nearly 700 in Healthcare. Consequently, over the next 24 months, we need to essentially double our relationship managers just to fill the remaining open positions and achieve 100% coverage in these markets. Our Sales Management team is doing a terrific job attacking this challenge with a sense of urgency. As of the end of April, we have already grown relationship managers to over 1200, a significant increase in just the past few months, while head count in our entire sales organization is just three below our all-time high. We are providing our team with the tools and training to become payments in industry, subject matter experts while also strengthening our organization and fine-tuning our marketing strategies to optimize our productivity and achieve our corporate growth objectives. Heartland Campus Solutions had another outstanding quarter. Though the first quarter is seasonally slow, we enrolled in additional six new campuses in our program, including our first three Acceluraid campuses. Acceluraid is a newly released card-enabled financial aid program which together with our existing campus programs, enables us to offer the college and university market one of the most comprehensive programs available in the market. Our agreement with the National Restaurant Association, the Council of State Restaurant Associations and 41 state restaurant associations keeps getting stronger. We just added our Heartland Gift Marketing product to the endorsed solution set for this very large marketplace. We are deeply focused in offering restaurant operators a broad set of products as experience shows that retention goes up as the number of product relation goes up. Heartland Gift Marketing, our Loyalty products is becoming a bigger part of more than just our restaurant vertical. In April, our Gift Marketing program had its best month ever exceeding the results of seasonally strongest November. Loyalty's success exemplifies the strong appeal of our merchant value proposition, far surpassing the traditional processing vendor relationship to become a marketing partner showing how they can use Gift Marketing to acquire new customers. Our job is to help our merchants grow their businesses.

In the first quarter, we installed our first smart link telecommunications technology solution, which consolidates multiple in-store communication lines into one high speed broadband line. The smart link network delivers first of its kind technology that can transmit both transactional data, as well as integral back office information, enabling critical business data to be transmitted quickly over a secure SSL encrypted connection. With this newly released state-of-the-art technology, we can now offer Convenience Store and Petroleum businesses an extremely competitive product that can both streamline their network operations and reduce their telecommunication costs. A large petroleum retailer has recently placed an order for 300 installations, which would ultimately grow to 5000 smart link service connections. And in the first quarter, we also installed our first utility company, Dorchester County Water, using our newly released payment portal. On May 1, we received our first delivery of E3 encrypting terminals, stand-alone terminals will be available in quantity to security conscious merchants later this month. Already price competitive with traditional processing terminals, the Heartland E3 terminal charges no hidden fees or additional fees, unlike some competitors. For essentially the same price as an unencrypting terminal, merchants purchasing a Heartland E3 terminal get the industry's highest level of processing security, backed by a commitment to cover any PCI compliance costs for which a merchant using our device may be found liable. That's a pretty compelling selling proposition and one we think will be extremely successful in the market. By the third quarter, we expect to roll out an encrypting wedge that will provide the same level of security to users of POS systems. With their typical high processing activity levels, merchants using POS systems are even more focused on achieving a superior level of security. To be successful, these growth strategies, as well as our Discover, American Express and other new growth platforms, need to be supported with investment spending. The confluence of significant opportunities we see to grow this year has resulted in spending levels that showed up on our bottom line this first quarter. However, we think the nascent recovery offers an opportunity to leverage our strategic investments in new product development Information Technology and marketing in this strong, renewed topline growth in the coming quarters. And let me now turn the call back to Bob Baldwin.

Robert Baldwin

Thanks,Bob. Heartland reported GAAP net income of $14.2 million or 36% per share for the first quarter of 2010. As I discussed results, unless otherwise noted, my comments will be exclusive of the net insurance recovery associated with the processing system intrusion. Excluding the separately identified net recoveries of $0.32 per share, net income would have been $1.5 million or $0.04 per diluted share. And excluding $0.02 of stock compensation expense, the earnings for the quarter would have been $0.06 per share. Small and mid-sized merchant card processing volume of $14.4 billion for the quarter was up 7.2% from a year ago, a second consecutive quarter of solid year-over-year improvement. Though same-store sales were down 1.5% of the quarter, that's about a 370 basis point in sequential improvement from 5.2% in the fourth quarter. It is also the third consecutive quarter of sequential same-store sales improvement. Even better, in March, we reported our first increase in same-store sales in nearly two years, which is in stark contrast and a new intra quarter rebound from the 4% decline, as recently as January. Same-store sales improvement from January through March represents an encouraging trend, one we believe continued in April. During the quarter, lodging same-store sales continue to lag the recovery at a 6% sales decline, while retail improved, it remained modestly worse than the average continuing recent trends. Restaurants, remain a laggard, coming in 2.4% worse than the overall average. Electronics,, entertainment, quick service restaurants and convenience stores, all performed better than overall same-tore sales as did Petro services and utilities. As you can see, the positive reads were pretty broadly based. And in fact, five SAC code show positive growth for the quarter as you can see in the statistical supplement we have made available on our website.

Overall, SME processing volume was up 7.2% year?over?year with American Express and Discover contributing more than half of that increase. Signature debit volume was up approximately 8%, while credit volume showed significant improvement through the quarter, ultimately turning positive in March. Net revenue from SME card processing was up 5.3%. While we saw a nice quarterly sequential improvement in same-store sales and transaction processing volume growth, new margin installed has yet to bounce back and for the quarter, was down 27.2%. The market for new customers is smaller than it was a year ago due to merchants out of business and remains fiercely competitive. Further, the internal distractions created by the rollout of our ISM strategy and the timeout in the field due to the summit also impacted sales significantly. In the next several quarters, we will be putting most of our energy into our efforts to increase our sales force, as well as our share of the market. Network services processed 685 million transactions in the quarter, up 6.8% from the first quarter of last year, although network services net revenues were down slightly in the quarter, mostly due to more competitive pricing with certain merchants. Both payroll and equipment-related revenues were also up in the first quarter helping with total company net revenue, 5.4% to $103.8 million. For the quarter, we experienced a slight acceleration in our rate of revenue growth compared to the prior quarter.

Total cost of services for the quarter were up 12.9% from a year ago with processing and servicing costs up 18.6%. The processing and servicing increase were primarily reflects costs associated with processing increased SME card volume, increased cost of sales related to higher payroll and equipment-related revenues, cost of investments we have made in enhancing our processing systems, an increase in merchant losses and increases in the cost of our service center. Regarding the higher merchant losses, these historically have peaked right after the holidays. We generally had good merchant loss experience, a result of both a low risk portfolio and a very strong risk department. But given sustained economic weakness over the past two years, we were hit with an increased level of merchant losses this year. These results were exacerbated by some very large individual merchant losses, as well as a failure of management to adequately oversee the performance of our risk department personnel, which resulted in a few pretty significant losses. We've made some changes in that group that we are confident will benefit our merchant loss performance. Among our other cost of services, customer acquisition costs were up 6% in the quarter, in line with better transaction processing volumes which added to our accrued buyout liability. Dues, assessment and fees were up 61% due to the higher costs imposed by the brands which we pass through to our merchants.

First quarter G&A costs were up only 8%, reflecting efforts to control costs after rising 25% in the fourth quarter of 2009. Importantly, of the total $2.1 million first quarter increase, nearly $1.3 million represents incremental 123-R expense and another $400,000 reflects an increase in cost of our Sales and Servicing Summit. We should start to experience better G&A leverage in the coming quarters. Operating income for the quarter was $2.6 million or 2.5% of net revenue, a cyclical trough arising from continued weak end market conditions, higher processing and servicing expenses and incrementally lower net revenue margins. We've separately broken out our net recoveries related to the processing system intrusion on our income statement for the quarter. In the first quarter of 2010, we recognized net recoveries of $20.4 million pretax or about $0.32 per share, primarily due to the settlement of certain processing system intrusion related insurance claims. Insurance proceeds of $26.8 million were reduced by $6.4 million of expenses in the quarter for accruals, legal fees and costs we incurred for defending various claims and actions. At March 31, we have a reserve of $42.8 million on our books for the processing system intrusion. That's down from $99.9 million at December 31, primarily as a result of our $58.6 million Visa settlement. We used $53 million of new bank loans to partially fund the Visa obligation.

As a result of that, interest expense for the quarter rose to $1.1 million from $541,000 in the first quarter of last year, and is likely to remain at these levels due to an increase in borrowings, as well as higher interest rates. As of March 31, total long and short-term borrowings were approximately $118 million. We had over $900,000 of other income this quarter, most of which is attributed to a legal settlement unrelated to the processing system intrusion.

Now let's look at our cash flow. For the quarter, we had negative GAAP operating cash flow, negative $21.6 million, primarily due to the $58.6 million use of cash in the Visa settlement. The incoming cash for the bank loans is of course reflected in financing cash. Management's measure of operating cash takes net income, and adds back amortization, depreciation, the provision for a recovery of the processing system intrusion costs and other non-cash items at the top of the operating cash flow statement. And under this calculation, total sources of cash flow from operations were $35.0 million. We then reduced that figure by signing bonuses and buyouts paid and the 2010 first quarter by tax refunds. Using this management metric, operating cash grew 29% in the first quarter to $22.8 million from $17.6 million last year. Taking that same definition of operating cash and reducing it by $4.2 million of CapEx in the quarter, our free cash flow amounted to $19.2 million for the quarter, up from $11.7 million in last year's first quarter. We used $374,000 of cash to pay dividends in the first quarter.

We remain 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. These resources include almost $50 million of cash in year cash at quarter end, our quarterly operating cash flow and our ability to raise GAAP. Of course, at this time, we cannot assure you that our core net financial resources will in fact be sufficient to meet the remaining cash burden we may incur as the result of the breach.

Let me wrap up with our guidance for 2010. Results for the first quarter were essentially consistent with the forecast behind our previous guidance. In that we were expecting significant investment spending to compound the challenges of our seasonally weakest quarter. Business recovery at our small and mid-sized merchant continue to trail broader indicators of improving economic activity, although same-store sales appear to be turning positive sooner than it's anticipated. New margin installed isn't expected to improve much until the second half of 2010. As previously disclosed, investment spending to support our new sales and marketing strategy for the balance of the year should remain flat with the first quarter. Net-net, therefore, we still expect to achieve full year fiscal 2010 net revenue between $460 million and $475 million, which is about a 10% to 13% increase compared to 2009 net revenues. And our full year guidance remains $0.95 to $1.00 per diluted share, excluding $0.09 per share of 123-R stock compensation expenses. Our 2010 guidance does not include any estimates for potential losses, costs, expense or recovery arising from the processing system intrusion, including 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.

Robert Carr

We're glad the market improved that it first experienced at the end of last year continued into the first quarter. As the economy slowly recovers and consumers gain confidence, we expect processing volume to benefit from both increasing activity, as well as the secular growth of card-based transactions. Though end markets have been weak, we kept investing in our business to improve and expand our growth opportunities and to refine our model to better leverage future growth into stronger returns. With a more targeted sales and marketing strategy and our newly released products, we can capitalize on the increasing complexity and specialization needed by selected merchant vertical markets and with the industry's highest level of data security, we can address the security concerns driving an increasing proportion of business decisions. We think this gives us three very exciting new growth strategies that are ideally positioned to respond to some of our merchants most critical issues. Before closing today's call and opening it 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 June 15 to holders of record of May 25. Operator, we now like to answer any questions.

Question-and-Answer Session

Operator

[Operator Instructions] We'll take our first question from Tom McCrohan from Janney Capital Markets.

Thomas McCrohan - Janney Montgomery Scott LLC

I'm just trying to bridge the gap between the current first quarter run rate at EPS and the trends in new gross margin installed with kind of the firm guidance for the year. So if you can kind of just help us figure out how -- two things, one is the first quarter run rate of $0.04, not a true number because of the merchant losses and maybe you can kind of get some clarity along the one timers? And then how do you expect kind of the EPS to kind of trend and margins to trend for the next few quarters?

Robert Carr

Well Tom, we really don't try to give quarterly guidance. I appreciate the challenges in bridging that. The drivers are, we, see significant seasonal improvement in net revenue. First of all, very solid cost controls in the coming quarters compared to where we were for this quarter and so you're really bringing a lot of that net revenue down to the bottom line. The incremental costs on the losses in terms of credit probably will run relatively high in the second quarter because there's some carryover from some of the merchants that you see, the trailing charge back activity and so you're going to see some more of that, but after the second quarter, we expect that to come back to more normalized levels. And so the story really is one of some significant revenue growth driven by same-store sales which I think we're feeling a little bit better about it. We were building our forecast around negative for the year and I think we're feeling a little bit better on that. And that's essentially offsetting the slight shortfall versus our expectation on the first quarter installed margin. But there's no question that we are looking for some significant improvement, particularly in the third and fourth quarters in the installed margin levels that we're seeing.

Thomas McCrohan - Janney Montgomery Scott LLC

Quick follow-up on the insurance recoveries, Bob, is there any other outstanding claims that we could anticipate, would result in additional recoveries going forward?

Robert Carr

There are some additional claims. But they're I'd say at this point, they are much less significant than what we've recovered. So the substantial majority of our insurance coverage has been paid out at this point.

Operator

Moving on, we'll take our next question from Bob Napoli from Piper Jaffray.

Robert Napoli - Piper Jaffray Companies

Maybe trying to dig into the processing and servicing cost a little bit more to understand because if you bridge that gap to your guidance, I mean can you give us some of the dollar amounts of the items on the losses, on the investments spend. And I would imagine, in order to hit your guidance that you're going to really normalize that processing and servicing line over the –-

Robert Carr

That's correct, Bob. I mean, part of it is the non-card products where that's where there cost of goods sold appears. And since those are growing faster than our card processing, that's showing up there. In this quarter versus a year ago, about $3 million differential was due to the non-card increases and the non-card cost of goods sold. I would say that the losses were running about somewhere north, sort of surprise level or excess losses were somewhere over $0.5 million, about $1.75 million on the quarter. And then the other activity level businesses, which really were sort of platform building and the investment spend in supporting some of the new initiatives probably add up to between $2.5 million to $3.5 million, so those were the major pieces of the increases.

Robert Napoli - Piper Jaffray Companies

What would be the moderation of those items, I mean are the platform building to $2.5 million to $3 million, is that going to drop to a much lower level in the back half of the year? The losses, what is the normalized run rate for losses?

Robert Carr

Normalized in a tough economy, I'd say is closer to one basis point on volume. And in terms of the losses and, yes, those investments spends are going to be coming down in the back half of the year. So while we do expect the absolute dollar amount of the processing and servicing to be higher in the out quarters because of the higher activity levels we expect, the growth is not that substantial compared to the growth in net revenue that we're looking for in the out quarters.

Robert Napoli - Piper Jaffray Companies

American Express and Discover, I was wondering how much volume you're doing out of that and how is the American Express product, in particular, being received? I mean generally, if you go to a small merchant they don't accept American Express occasionally because they say it's too expensive. I mean what kind of response or how are you selling that product and how material is it? And what kind of response do you get?

Robert Carr

Actually with regards to American Express, the reception has been surprisingly strong to us. I think about half of our new installs are signing up with AmEx, which is up from about 20%, 25% prior to the one point program. So that's really gone very well, I think that it's a reflection that merchants are looking for ways to maximize their sales and they know that by embracing all forms of payment they're going to have a better chance of not leaving any sales on the table. In terms of the contribution of American Express to our volume, it was a little over $200 million for the quarter and whereas Discover was a little under $400 million for the quarter. Between them, just a hair over $600 million.

Operator

Moving on, we'll take our next question from Dave Koning from Robert Baird.

David Koning - Robert W. Baird & Co. Incorporated

What was same-store sales in March and April?

Robert Carr

We don't have April yet, Dave. It's really sort of going by a feel for how the numbers are coming in versus our budgeted volume numbers. It feels to me like it was positive, but I've been wrong on that. It's a very inexact process. We were positive 1.5% in March, though. So it was a nice, sequential, we went from negative four to negative two to positive 1.5 during the quarter.

David Koning - Robert W. Baird & Co. Incorporated

I guess one way I'm thinking of this, you need about 12% revenue growth for the last three quarters to hit the low end of your revenue guidance range and I can see, at least 3% improvement, so if you started the year with 5% revenue growth, you can probably get 3%, 4% improvement just from same-store sales getting better, so now we're in the 9% growth range, but I guess, yeah, I'm wondering how do we get from that maybe 9% normalized range all the way up to 12%? Is it some equipment sales that are going to start coming through with the new terminals and what else do you think is really going to improve in the back half?

Robert Carr

Dave, there's no question that we're looking at non-card businesses revenues as a percentage of our total revenues to increase and non-card is sort of more impactful on the net revenue line. And that's the ongoing success of products we've had for a while, like payroll. We're being fairly cautious about it but still feel very good about where we're going to go with our sales of the E3 terminals. That should be a non-trivial boost to our equipment business and other initiatives, whether it is in the Campus business or Gift Marketing are all additive and in a sense, relatively more impactful to net revenue. At this point, we feel very good about the prospects for the net revenue guidance.

David Koning - Robert W. Baird & Co. Incorporated

SME processing volume was up about seven and SME net revenue was up about 5%. Is that just a small pricing gap or is there something else going on?

Robert Carr

Well, there's no question, Dave, the SME net revenue percentage was not where we'd like it to be. This moves around, to some extent, and there's so many elements going into it that it's really hard to parse and say, oh, this is the driver. We do not see any secular shifts, the net revenue, SME net revenue percentage, in fact, for the quarter was just in the Card business, SME card net revenue was 50.4 basis points, that is down from 51.3 basis points a year ago. However, it's up from 50.3 basis points two years ago. That's the first quarter. We don't see any secular shifts but that was a little bit of a surprise for us in the quarter.

Operator

Moving on, we'll take our next question from Tim Willi with Wells Fargo.

Timothy Willi - Wells Fargo Securities, LLC

Just your comment about the Loyalty product that you talked about, sounds like momentum is picking up there. Are you able to just again give any kind of color in terms of the actual utilization or activity that you're seeing from maybe some of the merchants that have been using that product for a longer period of time and just any thoughts around the ramp of merchants that you're selling to now versus maybe sort of the original batch or are we getting better at generating volumes through that. Just some thoughts there and I have a follow-up.

Robert Baldwin

Right, I'll take that. We released our own proprietary Gift Marketing product on September 1 of '09, prior to that time we were reselling a third-party's Gift Card product. When we released our own product, we opened up several different directions to our sales organization to go with gift and it's relatively easy now for a merchant to sign on for Gift Marketing without a large upfront expenditure. Our salespeople are doing -- are offering and taking up promotional cards for our new merchants and distributing them throughout the community and this has created a lot of buzz in our communities and a lot of interaction between our merchant customers to go on to the program. So it's a really it's a new paradigm. I believe that about 2/3 of our installed Gift Marketing customers are active on a monthly basis right now. Which is much higher than it has been historically with our third-party product. So it's certainly a new paradigm, frankly. We're working with some of our association partners to make these association promoted products to help drive business to the members of the association. So it's a work in progress, but the acceptance, up to this point is extremely encouraging. And this is all as a result of our Chockstone acquisition a year and a half ago that's really starting to pay off for us now as of the fourth quarter of last year.

Timothy Willi - Wells Fargo Securities, LLC

Is there any color you could give around sort of maybe like the best group of merchants that have really gone after this program and are doing well? Just anyway that you can sort of -- we can think about the improvement and maybe the revenue stream out of those merchants that are doing a very good, active job with the Loyalty product and just sort of bench mark where your average revenue or contribution for active good merchants would be as you move this product through the system, just how to think about that? Understanding, these are all very new but I'm just trying to what the high water mark might be for people that really go after this and do a good job?

Robert Carr

I'll let Bob speak to the numbers to the extent that we have them available today, but we are focused very strongly on the restaurant and the spa markets. There seems to be a lot of connection with hospitality and tip-oriented services that are receptive to this product. We're not exclusively focused on those areas but those are the primary focuses right now. With our vertical market program, we're going after vertically restaurants, hotels and healthcare. We don't do -- there's not a lot of effort in Healthcare Gift Cards, but in the other two verticals, a lot of effort's going into them. And because those are the verticals we're focusing on, that's why we're getting the traction there. As we expand verticals later in the year and in the coming years, some of those verticals will want Gift Cards and Gift Marketing, and others will not. We'll handle it vertical by vertical.

Robert Baldwin

And unfortunately, Tim, I just can't give you much in way of metrics at this point. It's too new and the range of uses, I mean there's sales that we're making where the merchant is doing the traditional gift card, put it on the little placard up in the store and use it like a gift certificate. Where we're having -- the merchants that are viewing this as a way to a low cost way to acquire new customers, that's what we're driving the product toward. And really has as much to do with the merchant's conviction that this is going to work to specific opportunities they have, to focus their attentions, in other words, a merchant who sees a specific opportunity can get much more aggressive with using gift cards as a way to attract customers than somebody who says, well it just my community. If they see a specific event that's going to happen in a period or a new development that's opened up or something like that and they target that. That's where they get the bigger list. So it's hard to generalize about the ways that merchants will use it, but we are really quite pleased by the response that we're seeing and to the extent that merchants do see better business, that will free them up to make a few more investments in these kind of customer-grabbing activity. So it's a perfect time to be pushing customer acquisition strategy to emerge as we come out in to this recovery.

Operator

Moving on, we'll take our next question from Tien-Tsin Huang from JPMorgan.

Tien-Tsin Huang - JP Morgan Chase & Co

I wanted to ask about the higher merchant losses. Was that a result of a change in your underwriting standards last year or was that an oversight given all the distractions you had last year? I'm just trying to get more comfortable that it's under control now, what may have caused it beyond the macro?

Robert Carr

First of all, we absolutely did not loosen our standards in the last year. In fact, last year, we spent tightening restrictions on certain merchant categories. Did we tighten them enough? Arguably not. It's a pretty tough environment out there and we've definitely gotten hit with some non-trivial merchant losses occurring because you have an appliance store that just goes out of business. On the margin cut, consumers may be more aware of their charge back rights than they used to be. And that doesn't help our financial results. But the other piece was really an unfortunate situation where there was some failures at the risk analysts level and dramatically exacerbated by the manager who was formerly in charge there who, frankly, just neglected some violently waving red flags. And that was the situation that's been taken care off and should not happen again. So while we're expecting some more trailing cost in the second quarter because the charge backs have not all been presented back to us but we do not expect this to repeat.

Tien-Tsin Huang - JP Morgan Chase & Co

So you're comfortable it's under control, the new processes in place and you said you have visibility now in terms of how the some of these other charge backs might run off at this point?

Robert Carr

Yes, I do. And I mean it's not so much new processes as making sure and doing extra things to ensure that the existing good processes are followed and this was absolutely a failure by an analyst. When you get into certain situations, it is a case where the risk person needs to shut down a merchant and say that's enough and there is always a dialogue with a merchant that sometimes people let themselves get sucked in and, oh, I can keep you going. They're going -- things are going to be fixed shortly, that is the job of the manager to not let that happen and, as I say, that was a situation where the manager was not doing her job and, in fact, if anything, obfuscating some of the growing problems. So we've changed that management there and we feel that going forward, that will not be a problem.

Tien-Tsin Huang - JP Morgan Chase & Co

A couple of just clarifying points. Did you provide sales force attrition, curiously, what that would look like particularly among your larger producers and also the new margin installed in the quarter?

Robert Carr

We did say, I think, on the last call, that we lost eight of our top 300 salespeople from last year.

Robert Baldwin

It was 13, I think.

Robert Carr

13. And our attrition for sales, we haven't talked about that but it's about the same. We have not improved it on an overall basis. We still lose way too many of our new hires. We have a lot of focus now on training to try to circumvent that with our new hiring push. In terms of new installs, we were down 27% over the first quarter of '09 in new installs.

Tien-Tsin Huang - JP Morgan Chase & Co

And how did that compare versus plan, the margin install?

Robert Carr

That was definitely like the plan. We're not looking for a very stronger quarter but we were looking for it to be better than this.

Tien-Tsin Huang - JP Morgan Chase & Co

And Bob Carr, I wanted to ask sort of a high level question for you if you don't mind. Just your thoughts on all the regulatory needs flow recently with air change and Vermont, it sounds like it's pushing for some changes at the point of sales, as well. Curious, your thoughts on some of those things, if you don't mind sharing, and maybe just implications for Heartland.

Robert Carr

Well they're so profound, Tien-Tsin. Well With the increases of the assessments by the major card brands and in the face of this economy, the change of the announcement in PIN debit and signature debit, quite frankly, you just wonder how far can these organizations drive costs up for merchants. The merchants are obviously extremely upset about it and to charge a $0.23 transaction fee for some merchant that's selling pack of gum just seems unconscionable. So some of these rules about minimum charges to me are making more and more sense than ever because of the higher cost of acceptance. So firstly, you're asking me sort of a philosophical question there, I think there's something to look at here that there needs to be some way to combat the ever increasing rise in all these costs to merchants. So it's not unreasonable to me for some of these things to be considered. That's my view and I'm not sure what Bob's is.

Robert Baldwin

And I would only add that the problem is that unintended consequences are always very real possibilities in these complex issues. The level of understanding of them by those who are proposing the laws are not high and so we worry about that. Our approach is as always been to just pass through the changes, it remains an industry practice to take advantage of the many changes that are occurring to increase merchants' costs and merchants remain confused about rates. We do our best to help the merchants understand it all but all they know is that their costs are increasing mainly because cards continue to grow as a percentage of their revenues and so those costs continue to rise. It's an understandable reaction and one that I just worry that doing it right is very challenging in a legislative environment.

Robert Carr

I also think that these per transaction costs, $0.20 for interchange, $0.02 for the authorization fee, whatever is called, I forget the names of them. And then a penny plus for the interchange, just think of the fast food, the quick serve restaurant that has an average ticket of $3 to $4, or the convenience store operator or the coffee shop, and you're talking a quarter a transaction, that's more than a margin that's available on some of those sales so I think that's going to push prepaid cards more and some of these state laws that allow a merchant to pick and choose a minimum transaction and the card types that they're going to accept. I think there's going to be some movement caused by this which maybe is the card brand's intent. Maybe the card brands wants to reduce the number of transactions for micro tickets. That's what it seems like. For vending operators, and laundry operators and small ticket operations this is a really humongous change in the marketplace. I think it's coming and we're all eager to see what it is.

Tien-Tsin Huang - JP Morgan Chase & Co

You actually handle a lot of micro ticket? Do you handle a lot of these micro transactions at Heartland?

Robert Carr

We don't handle tons of them but with our MicroPayments business, the vending world has been pretty excited about some new initiatives and it's unknown right now whether or not those initiatives by the Card Brands are going to continue.

Robert Baldwin

Our [indiscernible] is much more that we'd rather that the costs were kept down so that that market could expand more. It's not a very meaningful part of our business now but we think that as we all want electronic payments to supplant currency, the smaller payments is where there's a lot of opportunities for that to happen, to take cash out of the system and it's a little frustrating to see the cost burden of those transactions going the wrong way.

Operator

Moving on, we'll take our next question from Robert Dodd, Morgan Keegan.

Robert Dodd - Morgan Keegan & Company, Inc.

On the credit left side, that issue, because couple of years ago you had some management-supervisory issues in your IT department, as well and now in the credit pipe. Where do you think you stand on the overall quality or supervisory standard in the rest of your business? Is there a material amount of work that needs to be done or a view that needs to be done or are just a couple isolated incidents?

Robert Carr

Well I think we're a full disclosure company and probably talk about these things more than others. I think we have a great management team. It was about 15 months ago that we became a processor that had an intrusion. We're the only to survive. We've been carrying the world on our shoulders here the last 15 months for our market cap to be higher today than it was before the intrusion announcement and for us to have been able to build these product sets and to be having increasing revenue just have made the Fortune 1000 list for the first time. I think our management team has done an exceptional job, they're not perfect, certainly, the CEO is not perfect and nobody else is either. I think we've had very strong results. We are a top-five processor that grew organically to pretty much to get there. So I'm proud of this management team. We can all do better all the time and we are certainly evaluating our staff and trying to improve all the time. So I think it's really not accurate to say that we have not done a good job to get where we are.

Robert Dodd - Morgan Keegan & Company, Inc.

I wasn't actually referring to the breach. About a year before that, you had some personnel changes in the IT department as well, but your point's well made. Moving on to your gross margin, can you give us any color here on I noticed you were down 27% in the quarter but you did have this big sales meeting, was there any material difference between that number in March versus January and February? Was it weaker in March because people were off the street or if you can't give us detail that, any additional color in terms of how you're seeing a big drop-off in specific sales people that are moving into these new verticals, is this just a transitional issue or is it just simply the economy?

Robert Carr

We began to move to this ISM approach in November of '09. And it's a big decision for us to make. We're trying to be tuned to the marketplace. The market place is extremely competitive. Our competitors have gotten much smarter over the years and they know how to deal with our model more successfully. So we felt like we needed to evolve our model and took a step back and we began to feel the impact of that in November. We knew that many of our veteran salespeople were not going to not like this new model because it's more restrictive in some senses. People can't roam all over the country signing people up here and there, they need to focus in a vertical market in a specific geography. So we got through that, we did not lose a lot of our veterans through it and we paid a price. We knew we were going to pay a price and we think that just beginning in the last couple of months, we're starting to get some good traction and I think we're very excited about the possibilities that this approach is going to give us. It's going to give us a lot more exposure into these vertical markets and you are going to see our productivity, I think, increase significantly. There's a major readjustment in our sales model that I think was called for by the market place and frankly, I don't think our competitors are going to match the efforts that we're putting into it because of the nature of what we've done. A publisher of a major magazine was in here a couple of weeks ago and he told me, says your model has proven itself because it's taking the strongest hit that it could ever hit and you're still standing. So we think our model has been very strong and the credibility we have with our people and with our merchants has allowed us to make this change without significant damage and we think it's going to be able to carry us forward with substantial growth for the years to come.

Operator

[Operator Instructions] Moving on, we'll take our next question from Brett Huff with Stephens Investments.

Brett Huff - Stephens Inc.

Just a housekeeping number. Bob Baldwin, did you go through the different net revenue numbers for the non-card revenue, and Payroll and Equipment, and things like that.

Robert Baldwin

Those are on the statistical supplement, Brett, that we put out on our website.

Brett Huff - Stephens Inc.

You mentioned that you're not to the point yet where you're going to give us metrics or net revenue break outs on some of the other new products. How soon will that come. I mean it sounds like a meaningful part of the back half ramp and that revenue will come from some of the newer products and so it seems, more insight to that would be more helpful. What are your thoughts on that?

Robert Carr

A number of them are still relatively small but growth in dollars is there but the absolute dollars is still relatively small. We'll definitely evaluate it as we go through the year.

Operator

Moving on, we'll take our next question from Chris Shutler with William Blair.

Christopher Shutler - William Blair & Company L.L.C.

Where did you end the quarter in terms of sales force and head count?

Robert Carr

It was 1120.

Christopher Shutler - William Blair & Company L.L.C.

And I know, it's too early, but just in general, how would you characterize the productivity of those new relationship managers versus your expectations?

Robert Carr

I'd say it's in line with expectations. Neither surprisingly good nor surprisingly bad. And it's really -- the focus right now is on doing two things. One is growing that sales force aggressively to fill those positions that are open and that the sales leadership is doing that; and then really aggressive training into the vertical and into the different products that sell. So those remain the focuses right now.

Christopher Shutler - William Blair & Company L.L.C.

Maybe you can talk a little bit about the recent agreement with Micros and just how that relationship has evolved over the last couple of years and then maybe more importantly, what kind of additional opportunities you think the expanded relationship might bring?

Robert Baldwin

The Micros settlement was very welcome. We were able to resolve our major issue which was forcing us to pay a transaction fee, which we felt was a toll that didn't have commensurate value. That problem has been addressed and will be resolved going forward. We have had great conversations with Micros, they're a great company. And we have a direct relationship with them in our campus solutions organization and we'll be working with them on encryption and on converting to our exchange platform, directly. So we're excited about the opportunities and we think there's a lot of things that we can do with our hotel and restaurant marketplace to help each other moving forward.

Operator

Moving on, we'll take our last question from Bob Napoli from Piper Jaffray.

Robert Napoli - Piper Jaffray Companies

The stock comp expense, the increase this year versus last year, do you expect that to continue next year or to be back at historical levels?

Robert Carr

It's going to continue more or less at these kind of levels, Bob. We had a significant ramp that occurred in the second quarter of last year so that's playing through and we'll have ongoing stock comp expense but it's more sort of reached a new level that we're annualizing in this period.

Robert Napoli - Piper Jaffray Companies

In your guidance, you gave a little bit of confusion, the way you gave guidance at the end of the year, you excluded from the guidance interest expense incurred on debt to finance any settlement, you didn't use that same language this quarter but I think I thought I heard in your prepared remarks that you are. What is going on? I mean interest expense looks like it could be as much as $0.08 a share, or something like that. Is that in or out or what are you expecting in that regard?

Robert Carr

The guidance is unchanged and so we are basically saying that the end result levels of debt are still unclear because the end result on some of the settlements are still unclear. I'm hopeful that we will be able to give more clarity in the next quarter but we did not, in our guidance, originally and so we're still not including the incremental cost associated with the intrusion related debt.

Robert Napoli - Piper Jaffray Companies

So to come up with kind of an estimate of what that numbers is would take the payments you make, the 60 net less the recoveries and say there's debt associated with that amount and that's the incremental debt that would be excluded from the guidance?

Robert Carr

Yes, that's correct. Yes.

Robert Napoli - Piper Jaffray Companies

The university product, your university product, is that in looking at your statistical supplement, the CPOS is that the...

Robert Carr

That is not the university. CPOS is collective POS, our Canadian affiliate, which has been seeing a very nice ramp of their relatively small business. They've been doing a nice job up there and it shows up in some of the results.

Robert Napoli - Piper Jaffray Companies

The university card is that where is the revenue, what kind of revenue are you generating out of that and at this time and what kind of growth are you looking for in that product?

Robert Carr

I don't want to try to do that on the fly here, Bob. Perhaps we could chat later. It's not a huge number right now and it has some lumpiness associated with the mid-year typical summer rollout of installation so it's not sort of a simplistic thing if we can take it up off-line, I'll appreciate it.

Robert Baldwin

Thanks everyone for joining us today and have a great day.

Operator

That will conclude today's conference. We thank everyone for their participation.

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Source: Heartland Payment Systems Q1 2010 Earnings Call Transcript
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