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Executives

Philip Tomlinson – Chairman of the Board and Chief Executive Officer

James Lipham – Senior Executive Vice President and Chief Financial Officer

Shawn Roberts – Director of Investor Relations

Analysts

Bryan Keene – Credit Suisse

Adam Frisch – Morgan Stanley

Ramsey El-Assal – UBS

John Williams – Goldman Sachs

Brett Huff – Stephens, Inc.

Greg Smith – Duncan Williams

Glenn Greene – Oppenheimer & Co.

Paul Bartolai – PB Investment Research

Craig Maurer – Calyon Securities, Inc.

Total Systems Services, Inc. (TSS) Q2 2010 Earnings Call July 21, 2010 5:00 PM ET

Operator

Good afternoon, ladies and gentlemen, and welcome to the TSYS Q2 2010 earnings conference call. At this time all participants have been placed in a listen only mode; we’ll open the floor for your questions and comments after the presentation. It is now my pleasure to turn the floor over to your host, Shawn Roberts. Sir, the floor is yours.

Shawn Roberts

Thank you, Anthony, and welcome everyone. In the call today our Chairman and CEO Phil Tomlinson will provide highlights on the Q2 events, and then turn it over to Jim Lipham, our CFO, who will review our Q2 financials. And after that we’re going to open it up for Q&A.

I’d like to call your attention to the fact that we’ll be making forward-looking statements about the future operating results of TSYS. These forward-looking statements involve risks and uncertainties, factors that could cause TSYS’ actual results to differ materially from the forward-looking statements, as set forth in TSYS’ reports filed with the SEC. At this time I’d like to introduce TSYS CEO, Phil Tomlinson.

Philip Tomlinson

Thank you, Shawn, and thank you to everybody on the phone for being with us toady. We’ve got a lot to cover and I’m happy to say that most of it, we feel, is positive and shows improvement.

I’d like to take a few minutes to talk a little bit more about our merchant acquiring joint venture with First of Omaha, and we call that FNMS – First National Merchant Services, which we closed on April 1st of this year. Frankly, we consider this to be a really significant step towards TSYS becoming a real full-service payment solution provider. It broadens the entire scope of TSYS much beyond providing the core card processing services that we’ve become so well known for over the years. We can now create and package end-to-end payment solutions for users, acquirers and merchants. And I certainly understand that FNMS represents less than 10% of our revenues today, that’s before reimbursables. But it certainly does not represent business as usual. I’m sure we’ll look back at this transaction in a few years and think of it as a watershed event as it does get us closer to the merchant and ultimately the end customer.

Out of the 407,000 merchant locations served, 70,000 are owned by FNMS with the rest being processed by FNMS. They focus on creating solutions to reduce expenses and complexity of accepting electronic payments. It uses direct sales to focus on small businesses, national sales for the mid-market and national companies, and we also do business with third-party companies or referrals through banks, associations, VARs or value added resellers, ISO sales as well as backend core processing acquiring services.

FNMS has services that complement and enhance niche areas that TSYS has defined as targets of focus, particularly in this healthcare and prepaid market that we’re very excited about. The great thing is we’re now able to refer merchant leads and will ultimately create efficiencies and synergies between our TAS operation (Total Acquiring Solutions) and First National Merchant Services that are still somewhat in the discovery stage. As you know, we’ve only owned this quarter now, but we are delighted with what’s happened so far and with the team and their strong leadership group, and all the efforts that they’ve put forth in this first quarter of ownership.

Now I just wanted to direct a few comments on TSYS and other reporting segments and the current economic and regulatory environment. On a positive note I’m really happy to report that during the Q2 2010 versus the same quarter in 2009 that our same client transactions increased 4.9% and that the TAS point of sale transactions increased 8.5%. On a year-to-date basis same client revenue growth increased 3.6% and the same client account on file growth increased 8.1%, which we are very impressed with.

We also have some good news from the new business side of the house. During the Q2 we began processing for two very well-known retail brands in Canada – President’s Choice and Wal-Mart of Canada, and we have not put out press releases on those yet but I just wanted you to be the first to hear that. Those have been converted and they are customers today. Also we’ve signed a contract directly with Tesco Financial in the UK. We've been processing that business through Royal Bank of Scotland and Tesco decided to go out on their own, and we bid on it and we will continue to process that very, very good piece of business.

We continue to make good progress on the Carrefour conversion in Brazil. We still have several key milestones and decision points facing us over the next few days, and we’re working very diligently to meet Carrefour’s needs. We believe we’ll have this conversion completed pretty quickly. This success will give us the opportunity to add additional clients in the Brazilian market as we go forward, which is one of the world’s top five markets for cards.

Remember, you’ve heard us talk about clustering when we enter new markets, and that is as we add one customer it’s easier for us to add additional customers and we do a good job of selling into additional customers. As the latest example we now have signed our fifth client in Germany over about the last year and a half, and we’re very excited about that.

I know that you have some questions regarding our relationship with Bank of American Merchant Services, or BAMS, and we are actively engaged in discussions with BAMS to extend our relationship beyond 2010. However a definite agreement has not yet been reached. They have been and continue to be a valued TSYS client. We don’t anticipate any change to our current earnings forecast for 2010, and really beyond that we won't have anything to add to the BAMS discussion today.

I know that a lot of you are very aware that the President signed the Financial Reform Bill today, and that regulation along with the regulations that we have seen in the past will place more challenges in the US-based banks and card issuers to adopt to another round of regulations. And if you'll recall, the Card Act which we’ve talked about a lot here before was considered to be really the most sweeping reform in the card industry’s history. By the way, we’ve retooled for the Card Act and for all practical purposes it’s done. We’ve closed this chapter in our history. The software has been rewritten, tested, installed, and is now being used on a daily basis by our clients. There are still a couple of pieces that have not become effective yet, but like I say we’re closing the book on this chapter in our history and we’re glad to have this behind us, and I know our customers are, too.

In addition we’ve got new regulations for the card business that’s becoming underway in Canada and some parts of Europe. And you know, when we stop and think about what we believe that this heightened industry regulatory environment in the card business that we now find ourself in, our value proposition for outsourcing is even more enhanced. And we have believed this for a long time but we are now energized about it. We believe we can do it faster, better, and cheaper than any in-house operation and we’ve confirmed that we can do that with several large issuers. And I’m comfortable that we’ve added even more value to our proposition as a result of these ongoing and past regulations. It’s just hard to do and it takes a lot of time, a lot of effort, and basically you get no real payback for it unless you’re someone like us who can do it for multiple clients.

But let me be clear – we don’t feel that any more regulation is in any way good for our industry. We think the industry has had and seen enough regulation. I’m thrilled to death to see everything you read indicates that banks are back in the hunt for card customers, as the US credit card acquisition mail offers surged for the first time in more than a year. Offers were down 1.53 billion for the same quarter in 2008, but were up 136% from the volume from the year earlier. Personally, I don’t know about you but I received five offers over the past four days in my mailbox at home.

I don’t need to waste your time today reminding you of the economic issues that we all continue to face. We think the economy is showing signs of a slight improvement but we’re certainly far from jumping up and down with excitement over the short-term and the prospects for the average card-carrying consumer out there. And until we can get people back to work, banks lending more and businesses investing in the growth, the economy, we believe, will continue to be sluggish. It is however, in our side of it we do feel like it is picking up, and we hope this trend will continue.

Now with that I’m going to turn it over to our CFO, Jim Lipham, who’s going to review the numbers. Jimmy?

James Lipham

Thank you, Phil. I want to start on slide 7 for those that have the slides in front of them, and give you a little commentary on the numbers here as to a few things that are included in these statements that you don’t see. You can tell that our Q2 revenues are up 5.3% and also revenues before reimbursables are up 4.2%, and that’s real good in spite of the loss of net revenues from deconversions of $16.7 million for the Q2 as well as we had a $1.3 million loss in currency exchange.

Expenses were flat pretty much if you remove FNMS, and you’ll see it in a few minutes as I talk about them, that they’ve had about $25 million in expenses. But during this Q2 we ended up with $6 million worth of one-time, non recurring expenses that set us back a little bit. As you can see, operating income is down 4.2% for the quarter. If you put the $6 million back it would be up 3% which in fact is very good.

Also in the quarter you can see down there on the bottom the total cardholder transactions are up 3.8% which is a good economic trend that it shows; also our same client transactions were up 4.9%, so that’s good also. And if you remember back in the Q1 that total cardholder transactions were only up 1.5%, so we’re actually seeing better growth during this Q2 from transactions.

When you look over at the full year numbers, of course revenues are still up. The year-to-date loss from deconverted customers and net of termination fees is $20 million. And then the currencies, as far as year-to-date we’re positively at around $4.5 million. And you can see, too, down on the transactions year-to-date up 2.2%. Operating income by the way is down 1.6%. Our margins are now 22.3% for the six month period; last year they were 23.1%. Now if you took FNMS out and the $6 million that we had in one-time changes we would have a margin of 23.1%, which would be in line with what we had last year.

With that I’ll go slide 8, which is the net acquisition impact of FNMS, and we say net impact because of the third line down, the third party acquisition fees as part of our one-time charges for the quarter or for the six-month period of $3.6 million, and that’s recorded in our GMA section, or corporate overhead section. But you can see that the revenues for FNMS came in at $29.8 million. That was a little better, a little over $1 million better than what we had anticipated they would do. Their operating profit of $4.851 million shows a margin of 16.2%. This does include $2.7 million of amortization of intangibles. And if you restated the number of net income without that they’d have a margin of 25% which is still, it’s a good margin but a little bit below where we were with TAS. But all in all it was a god first quarter with FNMS and we were pleased. They exceeded their guidance that we had for the quarter. Dollar volumes as far as transactions, transactions up 8.5% for FNMS year-over-year, and then their dollar volumes are up 10.2%, so good growth there from their merchants.

Next slide, 9, is just the chart that shows you how, what really made up the 2% growth in revenues for the six-month period, and you can see internal growth at 3% and new clients and then the acquisition of FNMS. But we still get hurt pretty bad with lost revenues from customers, pricing concessions and then they’re offset a little bit with termination fees. But all in all it’s a pretty good quarter, and I think as we get on into next year we’re looking right now at really only the firs two quarters, if we’ve got any type of deconverted revenues or stuff that we have to overcome, which is the termination fees that we had in these first two quarters here of 2010.

The next page is a chart on the portfolio and a summary of where our account growth is compared to last year, to June of 2009. You’ll see we lost 16.7 million accounts or 4.8% down. And Phil mentioned some of the new clients awhile ago, but the clients lost, just to refresh your memory, is Nordstrom, Wachovia, Charmashops (sp), Barclays SKY CARD, and First Equity. So we did have internal growth during this period of time of 22.5 million. That’s roughly 6% internal growth, and new clients added about 31 million.

We did have a lot of purges during this period of time and they mainly came from Target was the big one, and we mentioned before a lot, we don't have a lot of revenue associated with these purges. And so, but it just looks bad on the number of accounts. On the right hand side you’ll see sequentially we actually grew 9.5 million accounts for the Q2, which is up 3% sequentially. So that’s some good growth there.

Flip over to the next slide, 11, and we’ll talk a little bit about North America. And you can see revenues - $236.8 million. They’re down 9.4%, and then the revenues excluding reimbursables at $202 million are down $10.6 million. The big contributor there is the lost revenues of $22.7 million from the deconverted customers. We were able to improve our operating margin. As you can imagine we went through the year really trying to control expenses, and operating expenses before reimbursables decreased $23.8 million, which helped offset that revenue shortfall, and it also enabled us to move our margin up a little bit as you can see here.

Same transactions are up 5.1%, which is good growth; and then year-over-year the total cardholder transactions are up for the quarter, the Q2, 1.563 million, an increase of 2.7%.

On the next slide, which is the international segment, $78 million in revenue. That’s up 2% and so is the constant currency basis revenues, up 2%. We did mention awhile ago we had some negative currency impact during the quarter. Their revenues, we did have a decrease in revenues of about $3 million on the SKY CARD that we mentioned before. New clients added about $2 million; we had a great quarter for Japan and GP net revenues, and the base one and two volumes were really up about $1.5 million. And then our same client revenue growth was 1%, and then if you took out price concessions it’d be about 3% just like it is in the US. So it was a pretty good month other than the deconversions and price concessions.

Operating expenses, they increased 4.3% here and that again is mostly due to our increase in technology spend along with other expenses in support of our expansion in Brazil and elsewhere. Operating income was down 9.1 from last year and our margin before reimbursables of 15.61% is in line with our expectations, and ahead of Q1’s margin of 14.2%. Total cardholder transactions - 279.9 million, an increase of 9.9%; same client transactions are up 4%, which is good also.

On our next slide, the merchant segment, $126.8 million in revenues and then revenues excluding reimbursables of $94.7 million. You know, the big difference between those two numbers is Visa access fees. But if you look at those revenues, they’re both up over 50% respectively over the prior period, and that's mainly due to FNMS’ $29.8 million in revenues. If you back those out you've still got revenues of, growth of 20.6% and revenues before reimbursables would be up 4.4%.

When you look at the same client revenue growth, it was up 4.7% for the merchants, so the volume growth that we’re seeing here is good. I mean if you look at the point of sale transactions they increased 8.5% and I mentioned awhile ago what FNMS’ growth has been. So all in all it was a good quarter in the merchant segment. We were proud of the acquisition of FNMS and how they ended up. We did renew five clients in the merchant segment during the Q2 and signed up two new ones, so things are moving pretty good in the acquiring arena.

On the next slide we have corporate administration, and it’s up $4.2 million. And I mentioned the acquisition costs. We did have $2.6 million during the Q2 on top of the $900,000 that we had in the Q1, so over half of this increase had to do with that acquisition cost.

Then the last slide, on slide 15 I was just going to touch on the EBIDTA is $496 million. Our cash flow from operations of $400 million is down $23.4 million, and we did have some changes in our balance sheet as far as receivables with FNMS and some other accounts that caused our cash to go down. Free cash flow - $268 million. It’s down $34 million, and a big part of that is the international expenditures, expansion that’s going on internationally with the equipment expenditures, software and the like. And our trailing 12 months net income of $223 million, pretty much in line with what we’ve been showing.

With that, Phil, I’ll turn it back to you.

Phil Tomlinson

Thank you, Jimmy. Anthony, we’d like to open it up for questions now.

Question-and-Answer Session

Operator

(Operator instructions). Our first question comes from Bryan Keene. Your line is live.

Bryan Keene – Credit Suisse

Hi, good afternoon, guys.

Philip Tomlinson

Hey, how are you, Bryan?

Bryan Keene – Credit Suisse

Doing well. Just thinking about the guidance, it sounds like you guys are reentering guidance of 1% to 3% and $0.96 to $0.98.

Philip Tomlinson

That’s right.

Bryan Keene – Credit Suisse

I just want to make sure that’s right. And we were talking a little bit ahead I think in this quarter, so I’m wondering if we should expect maybe the higher end of the range in revenue. And then the second piece on the earnings part, already we’re at $0.51 for half of the year and that would mean that we’d have to actually have declines sequentially in the next two quarters in earnings in order to hit the target. So I just want to make sure I’m understanding that as well.

Philip Tomlinson

Bryan, on the guidance issue we are a little bit ahead through two quarters as far as where ya’ll were in getting to our numbers, but I think we are looking more at the $0.98 per share number. I think what you’ve got to remember is when we started the year with our guidance we had no promotions in there, we had no expenses for merit, we had no bonuses in our guidance at all. We just were pretty much bare there. And as we’ve gone through this quarter with the BAMS discussion and they’ve hung around for a little bit longer than leaving at the end of April, so we actually booked some merits and some promotional expenses, and are preparing to do that through the remainder of the year. And that’s going to most likely eat up what the revenues are that we would probably maintain with BAMS. So I would think that the termination fees are over, and as we go forward we’re going to be pretty close I think to what ya’ll are seeing.

Bryan Keene – Credit Suisse

Just a question on the BAMS relationship. It sounds like they want to continue the relationship so there won’t be any loss of revenue compared to the current run rate, or is it a different relationship that will have some impact on the annual revenue run rate?

Philip Tomlinson

Well, I think we’ll continue it in some form or fashion. We’re trying to work that out right now, Bryan. And I’m not trying to be cute about it - we just haven’t worked it out yet. But as you can see they have not gone anywhere and we’re certainly excited about that.

Bryan Keene – Credit Suisse

Okay, and the term fee – how big was it in the quarter?

James Lipham

$9.8 million.

Bryan Keene – Credit Suisse

$9.8 million. Okay, and then my last question is is there a target number of accounts on file that we should think about next quarter? I know sequentially we had almost a positive 10 million in accounts. Is that a good run rate to think about going forward or are there some other things, you know, maybe purges or deconversions that would change that number?

James Lipham

We’ve had a slight decrease a little bit. We finished up here at about 332. I think we might have some more purges and be down to about 5, bring it down about 5 million accounts, something like that. It’ll be back up around 330 by year end.

Bryan Keene – Credit Suisse

Okay, that’s helpful. Thanks, guys.

Operator

Our next questions come from Adam Frisch. Your line is live.

Adam Frisch – Morgan Stanley

Thanks, good afternoon, guys. I wanted to ask you, you gave a lot of detail on your business but I’ll get to that in a second. I wanted to start my first question relating to the Durbin Amendment, and obviously you guys have a lot of contact with some of the biggest issuers in the world but certainly in the US. Have there been any initial discussions yet on how they plan to respond to the Amendment?

Philip Tomlinson

Well, you know, I think the rules have certainly not been written yet. We talked about this a little bit at our Board meeting today. We’re not quite sure when those rules will be written and how much the debited interchange could possibly be reduced. And you know, optimistically maybe it won’t be reduced, just somebody will manage it other than Visa and MasterCard. But I mean obviously, and we also worry about whether it will migrate over to credit at some point in time. We spend a lot of time in Washington talking to the powers that be up there, and it’s all over the board frankly. And I don’t think there’s any doubt in my mind that should, it’s a direct point of income to card issuers and you know, if they do make a dramatic reduction in that fee it’s going to hurt. It’s just another thing that in my opinion would be piled onto a lot of the regulations that the card industry has had over the past couple of years.

But I think what you’re going to see, frankly, is I think you're going to see higher pricing, more fees, higher fees. You’re going to see some more creative products come on board and we’re working on some of those right now. I think that credit, you know, credit card credit will be a little bit more difficult to come by because you will not be able to take the risk that people have been willing to take in years past. So I think there’s a lot of unintended consequences here as a result of the Durbin Amendment. I don’t think a lot of people in Washington really frankly understood it as well as we would have liked for them to have understood it. But you know, it’s done and we’ve got to live with it, and hopefully sometime between now and maybe the end of the year we’ll find out exactly what it means to the industry, how many dollars it means.

But you’ve seen the same things that I’ve seen in the press. I forgot either Citi or B of A, one of them the other day said they thought it might cost them $600 million. Now we’re not a big debit processor as you know, but you know, we don’t think things like that are good for our industry and we certainly are adamant that we don’t think the government ought to be setting pricing for the industry.

Adam Frisch – Morgan Stanley

Right. Thanks for that, Phil – I just wanted to get your view on it. On the, first of all on your side, you’ve had a bunch of signings over the last several months. Two questions related to that: One, can you help us quantify the timing of the contributions to revenues from these accounts and what kind of order of magnitude are we looking at here? And then secondly, are they causing any changes to the margin outlook as you bring them on board?

Philip Tomlinson

Well, I don’t know that I can-

Operator

Our next questions come from Jason Kupferberg.

Philip Tomlinson

Wait a minute, Anthony. I don’t know that I can give you that information off the top of my head here. I was trying to- I’ll tell you what, Adam – let us do a little figuring on this and before this is over we’ll come back to you on that question, if that suits you. You still there? He must have dropped off somehow. Anthony?

Operator

Our next questions come from Jason Kupferberg. Your line is live.

Ramsey El-Assal – UBS

This is Ramsey El-Assal for Jason Kupferberg. Last quarter you talked about your pipeline loosening up a bit, especially in the US. Has there been any change to that dynamic, due to either macro concerns on the issuer side or because your customers are now focusing on maybe adapting to the Financial Reform Bill just as they finished work on the Card Act?

Philip Tomlinson

Well, I think that when I say it’s loosened up, we talked about earlier the growth and particularly when you start thinking about the same client accounts on file growth. We're seeing some good movement there. That’s the first time in probably a year or so that we’ve seen any real growth to speak of. We think that people are interested in getting back into the business on an aggressive basis. We just, you know, there’s a process that they’re going through to figure out how to stay in this business and remain profitable. And again, a lot of it’s about what I talked about earlier, is unintended consequences when you- As the regulations come into play you know, it’s kind of like a water balloon – you push in one side and it pops out the other.

So I do think that people are becoming more aggressive. As I said earlier, I probably have received, these solicitations at home are starting to pick up – I’ve had five in the last four days with pretty good deals, really. What’s been amazing to me is I really thought I would have some with annual fees attached to them and I haven’t seen one yet, but I know that’s coming.

Ramsey El-Assal – UBS

One other follow-up or one other quick question, rather. The Wal-Mart announcement that you just made, that’s processing their house brand, co-brand product, rather, that they're issuing themselves. So that’s not a conversion, per se, but more just over time that will impact your business as they add accounts?

Philip Tomlinson

They’ll be adding accounts and it is a branded card.

Ramsey El-Assal – UBS

I see. Thank you very much.

Philip Tomlinson

And they’re in the processes of bringing that up. We think that’ll, could be significant. And as you know, we did virtually the same thing last year in Mexico with Wal-Mart.

Ramsey El-Assal – UBS

Mm-hmm. Thanks a lot.

Philip Tomlinson

Thank you.

Operator

Our next questions come from Adam Frisch. Your line is live.

Philip Tomlinson

Adam?

Operator

Adam, your line is live.

Philip Tomlinson

Adam, you there? I think we’re having a problem with his line.

Operator

Okay, Adam, are you there? Your line is live.

Philip Tomlinson

Anthony, we can’t hear anything from Adam.

Operator

Our next questions are coming from John Williams. Your line is live.

John Williams – Goldman Sachs

Good evening, guys. We were wondering if maybe we were on, I didn’t realize. Thanks for taking our questions here. First question was regarding the accounts on file portfolio. It looks like you’ve had pretty substantial pressure on the retail side over the last few years, which is understandable and it makes some sense. I’m curious if you could give some color on what was responsible for the dip you saw just now from March to June, and what your general thoughts are regarding the retail side. Because obviously year-over-year it’s been down actually.

Philip Tomlinson

Well, we don’t process a lot of retail as you know, and certainly the biggest one is Target. And that’s what Jimmy was talking about a littlie earlier, is they have regular purges and they have enough accounts, when they have regular purges the purges are pretty big. He also talked about the fact that if this is an inactive account on file, we’re not making any money to speak of on it in any way and neither are they; we just charge a very slight storage fee for it.

And our systems, you can come in and you can ask for a special purge program or we have automatic purge programs that happen every month, and we’ve done that for years and year and years. It’s only become an issue over the last couple of years when clients were really struggling as a result of this economy, and were looking for virtually any way to cut expense. Historically, clients have wanted to keep older accounts out there with the hopes that they would figure out a way to reactivate them at some point.

John Williams – Goldman Sachs

Okay. Question on the stored value side. This is obviously something that year-over-year has actually been pretty positive. What are the pricing dynamics in that particular segment versus the others, particularly versus sort of a traditional credit card? And in terms of the mix is it more sort of prepaid cards or store brand prepaid cards, gift card type products?

Philip Tomlinson

You've seen what’s happening with Green Dot, and they’re by far our largest customer. We do have some other customers that are doing very well, but most of what we’re doing is reloadable cards where you go into a Wal-Mart or a CVS and you buy a card. And you can reload it, and they’re typically sold to folks who don’t have banking relationships, the 25% to 30% of this country who are unbanked. And they’re using it just like a regular consumer Visa or MasterCard, like you would use it.

John Williams – Goldman Sachs

And on your side of things are the pricing dynamics on those cards different just because…

Philip Tomlinson

Well, there are some different pricing points, but as they start reloading these cards the pricing, you know, you’d basically charge for a lot of the same things. You may not have statements but you’re charging for activity and reloading, and transactions, authorizations – a lot of the same types of transactions but certainly not all of the… There’s more pricing points than there is say with a debit card.

John Williams – Goldman Sachs

Right. And one last thing. On I think page 9 of the slide deck you talked about the price compression you’re seeing. And I know over time you’ve talked about that 2% to 3% compression. Is that still generally what you’re seeing, or is there some other factor at play? Because it looks like, just in the waterfall that you’ve constructed there, it’s a little bit of a big-sized drop from what you’re getting on the left to what you’re seeing on the right.

Philip Tomlinson

I don’t know that that’s- I mean, I wouldn’t say that’s all pricing compression. That’s lost business, it’s about 2% of that 8. You’ve got 9 recurring items. We have, you know, hopefully, and I’m feeling pretty good about this, I think that things have settled down and I don’t really know of any clients that we have today that are close to failure or in big, big trouble with the regulators. I’m sure some are dealing with regulators on a regular basis, but we went through that period there where we lost several top-five clients and it's taking some time to replace that revenue. But we still think it’s a 2% to 3% on an annualized basis.

Now that varies with the size. One year you’re going to have really big customers, and we’ve had one in the last twelve months that we’ve re-upped and the dollars are bigger, but the percentages stay about the same.

John Williams – Goldman Sachs

Okay, that’s helpful. I appreciate the color, guys, thank you very much.

Philip Tomlinson

It’s not an exact science, though, John.

Operator

Thank you. Our next questions come from Brett Huff. Your line is live.

Brett Huff – Stephens, Inc.

Good afternoon, and thanks for taking my questions, guys.

Philip Tomlinson

Hi Brett, how are you?

Brett Huff – Stephens, Inc.

Good. Jim, I wanted to go through and make sure I understood merchant, the merchant operating margins, x reimbursables, came down and that was primarily because of the one-time fees that were associated with the FNMS that you called out – what was it, $3 million? Is that right?

James Lipham

Yeah. You had all of the one-time adjustments, well not all of them. We had $3 million of the $6 million one-time adjustments hit in the merchant section. We had FNMS come in with really a 25% margin. The $3.6 million acquisition costs are all in corporate overhead, so they’re not in the merchant sector.

Brett Huff – Stephens, Inc.

Okay, that was my next question. I wanted to make sure.

James Lipham

Yes, but the real deal is you had $3 million one-time charges that hit in there that brought that margin down, along with FNMS – you know, you had $4.8 million of operating income. You’ve got $2.7 million of acquisition costs, amortization that came in there. And their margins would run, well, they’re running 16 when you consider the amortization of the intangibles. So that would bring the total margins down.

Brett Huff – Stephens, Inc.

Okay, that makes sense. And then I wanted make, the comments you made on guidance were helpful in response to a prior question. Just to make sure I understand it, the fact that BAMS is sticking around longer than you’re thinking is largely going to be offset by the relaxing of a more stringent standard you had when you gave original guidance, meaning you’re going to give some more bonuses out and you’re going to do some more promotions for your business. Is that the right way to think about it?

Philip Tomlinson

And it’s merit, and as you know when we started out the guidance year, we didn’t feel like BAMS could move their front-end business very fast at all. We were concerned about the, you know, the backend which could be moved pretty quick. So we took out $13 million I think in the beginning of the year in our original guidance. We put 3 back in the March guidance when we changed it. We had 10 left, and I told you that we would, we would regularly take it out over the three quarters. Now, if we gave 100% bonus, we gave promotions, we gave merits, we gave the whole thing that’s $15 million, so we’re not going to be able to do it all.

I think one thing on the guidance that you need to keep in mind is that during the Q3 and Q4 we’re going to be showing lost revenues from deconversions without termination fees; where we had $16 million this quarter you’re going to be looking at roughly $24 million to $25 million a quarter for the next two quarters that we’re going to be trying to overcome.

Brett Huff – Stephens, Inc.

I see, so you’re talking net when you talk about those revenues. You’re talking net revenues, netted term fees.

Philip Tomlinson

Right. There’s no termination fees in the last two quarters.

Brett Huff – Stephens, Inc.

Okay.

James Lipham

And it’s going to all pretty much amortize, I mean we’re going to anniversary all that stuff this year so next year will be a little bit better, except overcoming the big termination fee we had in the Q1, you know – it was around $25 million.

Brett Huff – Stephens, Inc.

Okay. And then last one. Can you give us an update on Carrefour? I apologize, Phil, if you talked about it in the first couple minutes. I was late getting on. But did you give us an update on that? And if not, could you?

Philip Tomlinson

I did talk about that.

Brett Huff – Stephens, Inc.

Okay. I’m sorry. I apologize.

Philip Tomlinson

Oh, no problem. We’re moving forward with that. We’ve got a couple milestones that we’ve got to get through. We, you know there’s two more segments left –t he big one is coming up and we’re expecting that to happen here in, well, next thirty days or so. And we’ve obviously got to do a great job and make it happen. And I talked about you know, the fact that we believe that that will be our next area of clustering assuming all goes well, and we think it will. Just like what I was talking about, Brett, is you look back at Germany – we now have signed five customers in Germany and it wasn’t about 18 moths ago we were talking about our first client in Germany and the fact that we were having to gear up to deal with the German functionality.

Same thing we’re having to do with Carrefour in Brazil. The big difference there is we’re using a different software in Brazil. We’re using the Kartek (sp) Prime software, and we've had to make it multi-bank functional as opposed to single-bank functionality. And that has been, that’s been a challenge. And anytime you go into a totally new country it’s challenge, because there's a lot of changes. There're always typically language issues that you have to overcome. And we think we’re about there.

Brett Huff – Stephens, Inc.

Okay. And then last question: Can you talk about capital allocation? I know you have been focused, you did an FNMS deal and I suspect you’re looking at other things. But also the cash is, you know, building up on the balance sheet. Can you talk about buybacks? I know you had an authorization put in place last quarter. Just give us your current thoughts on that.

Philip Tomlinson

Well, I don’t think our thoughts have changed any. We have always said that we would much rather invest as opposed, in something that’s going to help the company grow as opposed to buying it back. We did spend $151 million in this past quarter. We do have some opportunities out there, and as I said last time, I think when we get to the point where we don’t think there’s some live targets out there we’ll have to look hard at some significant buy backs or a dividend increase.

Brett Huff – Stephens, Inc.

Okay. That’s what I needed. I appreciate your time.

Philip Tomlinson

You bet, thank you.

Operator

Our next questions come from Greg Smith. Your line is live.

Greg Smith – Duncan Williams

The equity income in joint ventures perked up a fair amount; it’s been fairly volatile. Is that just cupped data in there?

James Lipham

That’s correct. It’s cupped, it’s doing really well and they really cranked up their process. And as you know in the past, they started out with a lot of investments as they were signing up these banks and getting started. But they’re making some good progress now.

Greg Smith – Duncan Williams

Okay, so we can expect sort of profitability near these levels going forward?

James Lipham

I think so.

Greg Smith – Duncan Williams

Okay. And then I’m a little confused. Jim, you said there’s $6 million total of one-time expenses in the quarter?

James Lipham

That’s correct.

Greg Smith – Duncan Williams

And $3 million of that was related to FNMS. What was the other $3 million?

James Lipham

It was in TAS. It was a reserve.

Greg Smith – Duncan Williams

Oh, okay. Okay. I missed that, thank you. And then did you guys see any notable difference in volumes during the quarter? There just was sort of a sense that things might have slowed later in the quarter, in the month of June perhaps? I mean it doesn't sound as if you’re hedging on that at all but did you see any appreciable difference as the quarter progressed?

Philip Tomlinson

Yeah, we did. We started out April, we had pretty good volume growth when you looked at the transactions per billing date. And then it dropped off in May and then came back in June, and actually was growing at a faster rate than it was in April.

Greg Smith – Duncan Williams

Wow, okay.

Philip Tomlinson

So actually it dipped down in May and came back in June.

Greg Smith – Duncan Williams

Okay. That’s very helpful, I appreciate those comments. Thank you. That’s it for me.

Operator

Our next questions come from Glenn Greene. Your line is live.

Glenn Greene – Oppenheimer & Co.

Thanks, good afternoon, guys. Phil, can you just give us some color on the pipeline prospects that you’re seeing at a high level, both domestically and internationally, that sort of contrasted maybe to how you sort of felt maybe at the beginning of the year?

Phil Tomlinson

Well, I think that our prospect activity has gone up. As I told you in the last quarter I made a mistake talking about letters of intent. As you can see, some of those letters of intent that we were talking about have started to come to the contract sage, and even eh conversion stage. We talked about three of them earlier, which is Tesco and President’s Choice which is- I don’t know if you’re familiar with President’s Choice but they're a large retailer in Canada, and certainly Wal-Mart in Canada. Lat time we talked about another small bank, a smaller bank in Canada. But our prospect list is very good and it’s, it’s gotten, I think it’s gotten very good in the US, which is a pretty big change.

We’ve signed letters of intent with several folks in the US and we are having some very strong conversations with some people in the US who could make a difference. You know, some are startup deals and some might be conversions, but they’re large enough to make a real difference. We haven’t seen that in a couple of years. The US market has been really just about as dead as a hammer. The international market has really continued to do well and I think you’ll see some good announcements coming out of that area over the next couple of months.

I talked last time about how it’s gotten harder, frankly, to get a contract signed. People have gotten for obvious reasons more cautious; everybody is trying to cover all their bases. And it just takes a little longer to get it done. There’s no fast deals done in this business anymore that I’m seeing. But we do, we’re continuing to win in the marketplace. I would say we’re winning 70%, 80% of the time. We feel good about the activity that we have going on around the world. I mean it’s in virtually every place that has a major credit card presence.

So you know, we long-term we feel very good about the activity. The prospecting business has picked up, and it’s picked up in the US which is a really big thing for us, because we, as I said earlier that just has not been going on. I don’t know if that helps you any.

Glenn Greene – Oppenheimer & Co.

No, that’s very good color. You know, just going back to the pricing, and I know you sort of alluded to 2% to 3% annually. Obviously there’s a lot of uncertainty related to the Durbin Amendment, regulatory whatnot. And I think it was Bank of America that sort of had the most draconian sort of scenario, but I think it was almost a 70% fee reduction. But the question really is do you get any sense that once we get resolution, and let’s say it’s a very conservative, sort of draconian scenario where the debited fee interchanges are slashed pretty hard, that you're going to see increased pressure, fee pressure from issuers?

Philip Tomlinson

You know, I’ll be honest with you – I don’t know- We’ve been in this business for 35 years. We have always seen aggressive fee pressure. We have long-term contracts. We always have somebody who’s trying to renegotiate early, certainly we make a choice there. But the fact of the matter is it’s something that we live with on a day to day basis. I don’t know how we can have any more pressure than we’ve had over the past couple of years.

Glenn Greene – Oppenheimer & Co.

Okay. And then finally just to clarify, the $25 million a quarter lost revenue gogni forward in Q3 and Q4, will that sort of do it? Or is there a little bit of spillover affect in 2011 from lost client revenue?

James Lipham

That’ll pretty much do it for lost revenues. We’ll have to overcome the termination fees we got this year in the Q1 and Q2.

Glenn Greene – Oppenheimer & Co.

Got it, and that was $25 million in Q1 and $9 million in Q2?

James Lipham

That’s correct.

Glenn Greene – Oppenheimer & Co.

Great, thanks a lot, guys.

James Lipham

Thank you.

Operator

Our next questions come from Paul Bartolai. Your line is live.

Paul Bartolai – PB Investment Research

Thanks, good afternoon, guys. First question, just what were the term fees last year in the Q2?

James Lipham

Last year in the Q2, I don’t think we had any. All we had was, let’s see. I’m trying to think here. I know we had some in the Q1. I don’t think we had any termination fees in the second.

Paul Bartolai – PB Investment Research

Okay. And just to clarify on the last question in terms of the revenue loss being $24 million, $25 million in Q3, Q4 – there’s no incremental loss. You’re just talking that you had $16 million net given the $9 million termination fee? So there’s no incremental revenues rolling off in Q3 is there, versus Q2?

Philip Tomlinson

I missed that question.

James Lipham

Sorry, I was looking up something. Will you repeat that again?

Paul Bartolai – PB Investment Research

Sure. The $24 million, $25 million revenue grow over that you have in Q3 given the deconversions, that just is compared to the $16 million you had in Q2 because of the $9 million termination fee? I just want to make sure there’s no incremental revenue rolling off the conversions in Q3 versus Q2.

Philip Tomlinson

No. In the $16 million we had in the Q2 we did have a termination fee in there.

Paul Bartolai – PB Investment Research

Right.

Philip Tomlinson

And going forward you won’t have one so it’ll be, it’ll get back to the $25 million.

Paul Bartolai – PB Investment Research

Okay, perfect. And then the higher comp you talked about, just what’s going on in the business, was there any of that in Q2 or is that going to be something that's going to really start in Q3?

Philip Tomlinson

We had a little bit in Q2 but it will really start in Q3 and Q4.

Paul Bartolai – PB Investment Research

And will that be spread throughout most of the businesses or will there be any segments that’ll be disproportionately hit from that?

Philip Tomlinson

It’ll be across all of them.

Paul Bartolai – PB Investment Research

Okay, great. And then just the last one. Just looking at the margin improvement you had sequentially in North America - I mean I think if you backed out the term fees that revenues would be flattish - but you had a jump in op income. Just wondering if you could give us any more color on that? Thanks.

Philip Tomlinson

Well, the drop in expenses is really in two areas. Obviously it’s headcount, and we are down around 500 people I think in North America year-over-year, excuse me, from year end. And then you’ve got some equipment that we obviously had a struggle this first half of the year ahead of us, so we kind of postponed additions, and we’re not quite sure how much of that is going to get back in this year. But we do expect to show some increases in the in technology expenses as we go through Q3 and Q4. But that’s pretty much the two areas that it came from.

Paul Bartolai – PB Investment Research

Okay, great. Thanks, guys.

Operator

Our final questions come from Craig Maurer. Your line is live.

Craig Maurer – Calyon Securities, Inc.

Yeah, good evening. I wanted to follow-up and ask you a hypothetical on the regulatory question. So should you see the draconian cut in interchange on debit that is being suggested by B of A, nowhere in regulations is it suggested that merchant acquirers then have to pass on an equivalent cut. Do you, what’s your opinion on the merchant acquirer's ability to retain a material piece of the interchange cut to recapture some margin they’ve lost over the years?

Philip Tomlinson

Well, historically they have not done, at least in my opinion have not done a great job at holding onto anything that’s cut when you start talking about fees from Visa, MasterCard. And they’ve also done a good job of passing along additional feel – they’ve had to. Now I think this interchange deal is, you have to be careful about it. I mean, when you stop and think about it as I said earlier, most all of the larger merchants acquirers are priced at interchange plus, and there are some smaller ones out there that just have flat discount rates that include interchange. And those are the guys that are going to get hurt, and they’re going to have to go back and reprice, and it’s going to cost them money to do that plus it’s probably going to cost, I think there’s no doubt it’ll cost them revenue.

But I don’t know. I mean I just cannot imagine a draconian cut. I mean one of the things that we spent a lot of time talking about while we were in Washington was the fact that you do have to consider the infrastructure of this business including people like us and really around the world, that allow this activity and this type of payment transaction to occur. It’s not something that is cheap – it’s got a huge backbone behind it, and it has to run 24/7 on a worldwide basis. And the fact that there’s a tremendous amount of fraud and losses in credit and debit, and it’s picking up in debit. Mainly, it’s picking up in debit, mainly beucas there's just so many more debit cards that have been issued in the past few years.

So somebody's going to have to pay for it. And historically it’s been shared and I think if the folks in Washington can get educated well on this they’ll see that the truth is we , you know, you want people to use these cards more. And you don’t want them making too many exceptions to the rules, because that’s been the beauty of particularly the Visa and MasterCard systems. They’ve been so well accepted that they, in some people’s minds, have almost become commodities. And you know, we should all be so lucky. It’s not a commodity – it’s a great product and the banks have done a good job and so have the merchants. But it certainly is not free.

And there are a lot of costs associated with it, and somebody's going to have to pay. That's why I just have faith that the Federal Reserve, you know, those guys, if they’ll maintain a hold of this they probably understand it better than you know, anybody else in Washington.

Craig Maurer – Calyon Securities, Inc.

To that point, B of A’s comment was interesting in that they felt the Fed would have very little leeway to stray from the letter of the Amendment, which would indicate that it’s going to be hard to count any other costs related to the traditional other than moving the bits and the bytes and fraud. And if that is the case, and yo look at the, and B of A’s assumption is right, you have to assume they’re the most efficient player. Then you’re looking at a lot of banks who would be operating at a loss.

Philip Tomlinson

Well, I think under a draconian deal, and of course this is all just supposition, as we’ve talked about before that the key piece of income on a debit card is interchange. And I don’t think there’s any getting away from that fact. It’s a great way to move a transaction. I think it’s cheaper, it’s got to be more efficient than a check, but at the same time it’s- If you take away that interchange it’s going to in a big way, it’s going to hurt it dramatically.

Craig Maurer – Calyon Securities, Inc.

Okay. Thanks for the thoughts.

Philip Tomlinson

I wish I, you know, I just can’t believe they’ll just slash it. But I don’t know.

Craig Maurer – Calyon Securities, Inc.

We’ve seen stranger things in other places.

Philip Tomlinson

You’re absolutely right. And it scares me to death.

Craig Maurer – Calyon Securities, Inc.

Okay. T Hanks for the thoughts.

Philip Tomlinson

Anthony, was that the final question?

Operator

Yes, there are no further questions in queue. Do you have any closing comments you’d like to make?

Philip Tomlinson

I do have a couple things I’d like to say. One is thanks for being with us today. You have seen hopefully some trends that, we’re starting to see some improvement. We still think the economy has got a way to go so we're not exactly jumping up and down, but it's progress. And we’re happy to start seeing some internal growth.

As I said earlier we can finally quite saying “When we become an acquirer” because we are an owner in a top-ten acquirer, and we’ll continue to look for additional opportunities to expand our hold in the merchant acquiring business. FNMS is not going to be our last acquiring acquisition – it’s just our first. So we’re aggressively looking at other opportunities in this area.

You know, we have the financial capacity to do that. There’s a lot going on out there and you can count on us to continue to prudently manage and leverage our balance sheet, but also continue to capture greater domestic and international market share in the traditional card processing business. We’re pleased with our results – we’re not as I said jumping up and sown. And w think we’re poised for growth as this economy improves. We do need the consumer to get on board. We’re, like a lot of people we’re, most cards are driven by the consumer. And like I say, we think we’ll continue to win.

Our prospect opportunities are looking better and so we are feeling better than we have been now in quite some time about our business. And I think what you’ll see out of TSYS is you’ll see it emerge out of this great recession, you’ll see a leaner, a stronger, a more aggressive TSYS. So again, thank you for your time and interest today, and if you have any more questions or if we weren’t clear with an answer – and I know there was a couple there we probably didn’t have quite as much information as you would have liked – don’t hesitate to call Shawn Roberts. Shawn told me just a second ago he’s going to be up all night to answer any phone calls.

So all of our best to you and thank you, and hope you have a good day.

Operator

Thank you ladies and gentlemen. This does conclude your teleconference. You may disconnect your phone at this time and have a wonderful day. Thank you for your participation.

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Source: Total System Services, Inc. Q2 2010 Earnings Call Transcript
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