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Heartland Payment Systems, Inc. (NYSE:HPY)

Q2 2010 Earnings Call

August 4, 2010 8:30 AM ET

Executives

Bob Baldwin – President and CFO

Bob Carr – Chairman and CEO

Analysts

Bob Napoli – Piper Jaffray

Dave Koning – Robert W. Baird.

Meghna Ladha – Susquehanna

Robert Dodd – Morgan Keegan

Reginald Smith – JP Morgan

Brett Huff – Stephens

Tim Willi – Wells Fargo

Chris Shutler – William Blair

Andrew Jeffrey – SunTrust

Leonard DeProspo – Janney Montgomery Scott

Paul Bartolai – PB Investment Research

Operator

Good day everyone. And welcome to the Heartland Payment Systems Second Quarter 2010 Earnings Conference Call. Today's conference is being recorded.

At this time, I would like to turn the conference over to the President and CFO, Mr. Robert Baldwin. Please go ahead, sir.

Bob Baldwin

Thank you, and good morning, everyone. I'd like to welcome you to our Second Quarter 2010 Earnings call. Joining me is Bob Carr, Chairman and CEO. Today, Bob will begin our discussion with an overview of the quarter, and then I'll return to go through some of the financials in detail before taking your questions.

During the course of this call, we will be providing comments on the processing system intrusion we experienced, our investigation of the processing system intrusion is conventional and ongoing consequently 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 second quarter of 2010, which is available on our website, heartlandpaymentsystems.com.

Now, I'd like to turn the call over to Chairman and CEO, Bob Carr.

Bob Carr

Thanks Bob and good morning, everybody. I'd like to thank you all for joining us today and for your interest in Heartland. By now you should have seen our financial results for the second quarter that we released this morning. On an adjusted basis we reported net income of $9.1 million or $0.23 per diluted share, which after the adjustments Bob will review with you in a minute were in line with our expectations.

Results in the quarter were led by record small merchant processing volume, which reached $16.3 billion, up 8% organically, compared to the second quarter of last year, while we processed a record 800 million transactions in our petroleum vertical in the quarter.

I'm particularly pleased that we've achieved these results in both an unexciting consumer environment and during a period in which we're implementing a number of new growth initiatives. Certainly achieving 8% organic growth in our core business during a period of weak economic growth is an achievement in and of itself but what is more rewarding is achieving that growth while increasing our sales force by 24% ruling out a new sales management strategy and bringing the industry's leading security product to market.

For the first time in over two years, processing volume is benefited from a quarterly increase in same-store sales, which were up 1.1% for the quarter. While we were anticipating improvement in same-store sales this year after the sustained weakness of the last couple of years, it is nice to finally get a little lift from the economy with the improvement coming a little sooner than we had foreseen.

Although installed margin of $12.1 million was up sequentially from the first quarter, new business remains a challenge. Reinvigorating new business growth is one of our primary goals for the second half of this year. We're implementing a multi faceted aggressive growth strategy and in the second quarter we made significant progress on a number of our initiatives.

First and foremost, we filled 273 of our more than 1,000 open relationship manager positions in just three months. We now have a record 1,393 relationship managers up 24% from March 31.

In addition to sustaining our market share leadership in the restaurant vertical, we are making similar in-roads with our other targeted verticals. For instance, in hospitality industry the Texas hotel and lodging association recently became the 38th state hotel and lodging association to endorse Heartland as the official provider of card processing, gift marketing, payroll services, tip management and check management services.

Since receiving endorsement of the American Hotel & Lodging Association, hospitality organizations are coming to recognize our comprehensive suite of business products and services including first ever unified payments processing platform in the lodging industry and how we can help to improve their bottom lines.

We're achieving similar success in the healthcare vertical. We have just partnered with the California Medical Association to provide their membership with access to a full suite of payment solutions, specifically designed to streamline operations and control costs for healthcare practices.

In addition to our comprehensive card processing payroll and check managing services we are integrating with confirm pay a real-time web based eligibility verification and payment solution to bring increased transparency to the point of care.

Confirm pay enables healthcare providers to verify benefit coverage and determine remaining deductibles in real time to better manage patient receivables and cash flow. For the convenience store and petroleum business, our SmartLink telecommunications technology is another unique to Heartland competitive advantage.

Since SmartLink offers a cost effective solution to help operators better manager their multiple communications linkages, we think we can help gain market penetration over time.

On May 24, we have officially launched our industry-leading end-to-end encryption technology. Over 3,000 of our E3 terminals have been purchased by more than 2,500 different business owners, utilizing our extensive knowledge of the small and mid sized marketplace, we have designed the implementation of E3 to be easy, cost effective to help overcome any concerns that owners of small and mid sized businesses may have about the security of cardholder data.

In fact, E3 also helps merchants address PCI compliance regulations including our E3 end-to-end encryption warranty which in the unlikely event of a data breach of a merchant using E3 will reimburse the merchant's breach-related fines. We do not charge additional processing fees or taxes, and there are no changes to a merchant's daily routine or the speed of transactions.

This initiatives has been strongly embraced throughout the organization with the majority of our relationship managers having made at least one E3 terminal sale in the past few weeks.

I feel the growth of our sales organization, our new marketing strategy and our industry-leading security products will all prove to be additive to the inherent growth in our existing small and mid sized merchant franchise.

In addition to the success of our legacy merchant processing business, we are experiencing similar success with our other products. Our campus solutions, our loyalty payroll, micropayments and check businesses are making steady progress, penetrating large markets.

In the quarter payroll revenues were up 12% while our equipment revenues were up nearly 27% including E3 terminals sold in the quarter. Those still a small part of our overall revenue, our solid performance among these growth initiatives illustrates how synergistic products that have margins consistent with our processing business increased the leverage of our relationship manager network.

Complimentary products will continue to play an important roll in our strategy to strengthen the value proposition that we offer our merchants. Our growth strategy remains mindful of the need to generate attractive returns on our investments.

In the second quarter, our operating margin came in at 13.2%. Importantly, general and administrative expenses in the quarter were down relative to both the preceding and year ago quarter. We'll be closely monitoring expenses to make sure we're achieving our efficiency objectives.

Finally, on May 19th, we announced the settlement with MasterCard and on July 15th MasterCard announced that over 99% of their banks had agreed to our offer indicative of continued progress being achieved resolving the issues associated with the 2008 breach.

Let me conclude by noting that the successful resolution of many of the issues associated with the processing system intrusion is a testament to the amazing hard work of our many tremendous employees and the loyalty of our valued merchants.

Heartland is now more clearly focused on serving our merchant customers and strengthening the value of our franchise anytime since we became aware of the incident.

Let me turn the call back over to Bob Baldwin.

Bob Baldwin

Thanks Bob. As I discussed our results, unless otherwise noted, my comments will be exclusive of any expenses our accruals associated with the processing system intrusion. Heartland reported GAAP net income of $1.6 million or $0.16 per share for the second quarter of 2010.

Adjusted earnings for the quarter reported on basis that is consistent with our guidance was $0.26 per share, that number excludes separately identified processing system intrusion costs including $0.01 per share of processing system intrusion-related interest, as well as $0.02 per share of 123R stock compensation expense.

For the quarter, total SME processing volume was $16.3 billion, up 8% compared to a year ago and a slight sequential increase in the rate of transaction processing growth compared to first quarter.

The improvement in transaction processing growth this quarter was helped by the 1.1% increase in same-store sales growth. We saw very consistent if modest growth in most of our SIC categories this quarter and in fact, every segment showed at least one month of positive same-store sales growth.

Retail even broke through into the positive quarter column for the second quarter, leaving restaurants as the only segment that declined and that decline was only 1%. You will see in our statistical supplement that we have broken out QSRs from our food category, where it was previously combined. Now, food is centered on C stores and liquor stores, and both food and QSR showed solid gains in the quarter. We also saw modest increase in our average ticket size in the quarter.

Looking at our Visa and MasterCard activity, for the first time since 2008, we saw our credit volume actually rise in the quarter, although it only amounted to 0.6%. Signature debit remained the driver of our SME Visa MasterCard growth with volumes growing nearly 8% in the quarter.

Network Services transactions count was $800 million in the quarter, a very solid 10% increase from $728 million a year ago. Net revenue for the quarter was $115.1 million, up 8.1%.

This quarter net revenue growth was driven by SME card revenue growth along with good growth in our non-card processing activity, primarily offset by lower net revenue in Network Services due to contract renegotiations.

Total costs of services for the quarter were up 15.7% from a year ago, in large measure due to a 19% increase in processing and servicing costs. Processing and servicing growth was driven primarily by increased processing costs, reflecting our significant systems investments we have made in recent quarters, as well as adds to the cost of goods sold in our non-card processing business lines.

In the quarter, dues assessments and fees were up 53.2%, reflecting the significant fee increases we have seen from Visa and MasterCard in the last year. But I would note that the costs are costs that we passed through to merchants.

Customer acquisition costs were up only 0.5% in the quarter, reflecting weakness in new margin installed and modest growth in same-store sales. General and administrative costs in the quarter were down 3% in the quarter, compared with the second quarter of 2009, reflecting the productivity and efficiency enhancements we've been presenting.

G&A was also down $3 sequentially from the first quarter, primarily due to impact at Heartland summit had on the first quarter cost, but also indicative of improving efficiencies as well as seasonal factors. I would note that we do expect G&A to be somewhat higher in the coming quarters.

For the quarter, interest expense was $1.2 million, double our cost from the year ago. Of the total interest expense in the second quarter, approximately $500,000 or $0.01 per diluted share was directly attributable to funding, the processing, system intrusion settlements. I'll get into this a little more in a minute.

Operating income for the quarter was $15.2 million and the operating margin on net revenue for the second quarter was 13.2%. Except for the second quarter of last year, that's our best operating income since the beginning of 2009. We think we have implemented many efficiency and productivity enhancements that will improve leverage in future quarters, getting margins solidly near the mid teens this quarter is an encouraging sign of progress.

Now let's look at our cash flow. For the quarter we had negative GAAP operating cash flow of $8.3 million, as we used our available cash to increase the amount of interchange we have advanced to our SME merchants.

Management's measure of operating cash takes that income adds back amortization, depreciation, the provision for or recovery of the processing center -- processing system intrusion costs and other non-cash items at the top of the operating cash flow statement. This results in total sources of total cash flow from operations of $30.3 million. We then reduced that figure by signing bonuses and buyout paid.

Using this management metric operating cash was $22.2 million in the second quarter, up from $21.2 million last year. Taking that same debt management definition of operating cash and reducing it by CapEx, our free cash flow amounted to $16.2 million for the quarter, up 20% from $13.5 million in last year's second quarter. We used $380,000 of cash to pay dividends in the second quarter.

We remained very conscious of our liquidity, especially given the need to fund the MasterCard settlement in the coming quarter. Our cash position is currently very healthy. At June 30, our liquidity including $15 million of our current cash position and over $57 million of our cash that we used to fund merchant advances in June totals over $72 million.

On a liability side as of June 30, total long and short-term borrowings were approximately $115 million. $53 million of which has been incurred directly to satisfy the financial obligations, incurred the result of the processing system intrusion.

We believe we will not need to incur any additional borrowings to fund settlement obligations, arising from the processing system intrusion or to fund our present growth strategy.

Given our estimates of remaining outstanding financial obligations associated with the processing system intrusion, for which we have reserved and the timing of when we need those obligations will need to be satisfied. We believe our current cash on hand, effective cash on hand, cash generation capacity, strong balance sheet and access to other sources of liquidity is sufficient to satisfy these obligations.

Because we were unable to reasonably estimate our total financial obligation prior to negotiating our recent settlement agreements, the additional ongoing interest expense attributable to the processing system could not previously be determined.

Therefore although our guidance has specifically excluded cost associated with the processing system intrusion, we could not quantify the additional interest expense. Since, we now believe we will not need to incur any additional borrowings, the additional interest expenses can now be estimated as included as part of the guidance.

We’ll also be exploring the establishment of a set of new financing arrangements this quarter with a focus on replacing current facilities with a combination of term and resolving credit facilities that enhance our financial flexibility going forward.

Let me wrap up with our guidance for 2010. For the full year 2010, we now expect net revenue to grow by 7% to 9% to between $450 and $458 million. For the year, earnings per share are expected to be $0.95 to a $1 excluding $0.11 per share of stock compensation and $0.03 per share of specifically identifiable processing system intrusion related interest expense.

The company’s guidance for 2010 does not include any estimates for potential losses, cost expenses and accruals or recoveries arising from the previously announced processing system intrusion, exposure to various legal proceeding that are pending or may arise and related fees and expenses and other potential liabilities, costs and expenses.

Back to you, Bob.

Bob Carr

Thanks, Bob. Economic conditions have seemed to settle down over these last few quarters, but consumer spending specially a small and mid sized merchants remains below levels of years ago. We can't read the tea leaves any better than the other prognosticators offerings their opinions, so from where we sit, we see equal reasons to believe the economy will or won't improve over the next few quarters.

What we do know is that our industry has received more attention over these past few months that at anytime I can remember. Fortunately, the questions being raised or the same questions we asked when we first got into this business.

What is the fair cost to process a merchant’s card transactions? Ever since that day our goal has been to drive down that cost. I hope everyone on the call will take a minute to revisit the Merchant Bill of Rights on our website and compare our commitments to pricing transparency and merchant advocacy with the latest views on these subjects now appearing throughout the media.

Over the balance of this year, regardless of the direction in which the economy tax we'll be in the field, with the longest and strongest sales organization in our history, implementing a full court press to penetrate the verticals we have identified as well as others we'll soon be launching. And to better capitalize on the growing need for secure card processing transactions with our E3 terminals.

Before closing today's call and opening it up to questions, I’m pleased to announce that your Board of Directors has declared a third quarter dividend of $0.01 per share, payable September 15th, to holders of record on August 25th.

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

Question-and-Answer Session

Operator

(Operator Instructions) And we'll first hear from Bob Napoli of Piper Jaffray.

Bob Napoli – Piper Jaffray

Thank you. Good morning.

Bob Carr

Good morning.

Bob Napoli – Piper Jaffray

I guess, first question would be – I have two questions here. But the – Bob, would you intend to pass through the entirety of any cut and interchange to all of your merchants, depending on whatever that outcome is from the Fed?

Bob Carr

Yeah. We will and then we'll go next door and ask other merchants if they’ve – is we've received the full benefit of the congressional act.

Bob Napoli – Piper Jaffray

Great. Thank you. And the second question, I mean, you have added a lot of sales, but the margin installed, I mean, obviously, you did that at a bunch of them so they're just coming on board. But, I mean, your margin installed is still radically below where you were in 2008.

What kind of – what kind of traction can you get in this market, I mean, do you have the same kind of growth potential in the U.S. that you used to and do you think as you add these sales reps, how much penetration and how effective are you seeing in the early stages?

Bob Carr

We think we have a great opportunity to increase our growth rate with all the initiatives that we have and are looking forward to training these new reps and getting them up to speed.

Bob Baldwin

I think it's fair to say that it's a very tough environment out there in the new sales arena. There's not a lot of new business and so the existing sales forces are out very, very aggressively and obviously in addition a lot of our people are very new and are very much going through changes as we move to the – the new vertical approach, which is different and different is short-term challenging.

But we think that it is the right strategy. We think that the growth in the sales organization is a direct result of the new vertical. It really gave much more focus to the sales leadership and who they were trying to hire and where they were trying to hire them and the results speak for themselves. Now, obviously, we need to translate that into installed margin by that larger sales force.

Bob Napoli – Piper Jaffray

Thank you.

Operator

Dave Koning, Robert W. Baird.

Dave Koning – Robert W. Baird.

Yeah. Hey, guys. Nice job. I guess, first of all the same-store sale through the month. I know same-store sales obviously got a lot better it seems like they might have peaked in March, continued to be pretty positive. But maybe you could just talk about through the month and then into July?

Bob Baldwin

We don't have July yet, Dave, although I’d say that the volume we saw for the month was, you know, my gut would be that it's going to be in the same ballpark of sort of low, very low but positive same-store sales. There really was not any discernible trend.

We did sort of the highest same-store sales, the best same-store sales we’ve seen was in March. But it was 1.9% and the lowest was May at 0.6% but then June was back up to 1.4%. So, there really is and within the categories there really isn't any major trend. I would say that each of the segments was sort of, bouncing around.

Dave Koning – Robert W. Baird.

Okay. That's helpful. And then, you did mention that revenues are down about 10%, transactions are up about 10%. Most of that just has to do with it sounds like competitive pricing dynamic, etcetera, in renegotiation. But how long-term should we view this? Is this something where transactions grow overtime, typically we should have revenue growth or is that a tough market where there's always some pricing pressure?

Bob Baldwin

I think there's always going to be some pricing pressure, but it really will be slightly lumpy in – when contracts come up for renewal. We’ve had a couple of big contracts that have come up for renewal.

They -- the timing of further ones is complicated by the fact that you look and you say, this contract ends three years from now. When is that actually going to be renegotiated is a challenging question. It's often earlier than you might expect.

But overall, we do expect growth in net revenue out of that segment going forward, not only from -- we don't have on the horizon any more changes in -- near-term changes in contract and our focus there is trying to do two things.

One is add new products to some of the large established contracts we have. That, for example, the SmartLink product that Bob mentioned is one that we're aggressively going after our installed base. And the other is, we're achieving some good success in middle market petroleum situations with the Network Services platform.

Dave Koning – Robert W. Baird.

Okay. Good. And then just finally the breach-related costs, they continued this quarter a little bit and I know it's hard to forecast that going forward. But you’re going to pay MasterCard coming up, all the banks related to the MasterCard settlement.

How soon are we pretty much done with the nonrecurring costs? I know it's hard to forecast, because it seem like we're getting pretty close to the end of the nonrecurring costs?

Bob Baldwin

Well, we have not had anything to announce to date with Discover, although we engaged in productive discussions with them. And we do have some ongoing regulatory investigations from the FTC that is, hasn't played out yet.

And then the last thing is the issuer class action, which we believe with 99 plus percent acceptance by MasterCard issuers and the 98% plus by Visa issuers, has done a lot to undermine that as representing a true class.

But for those regulatory and the lone remaining issuer litigations, unfortunately, you have to continue to pay the lawyers. So as far a s we can see right now, the -- there will be in this year and unquestionably into next year ongoing legal costs at a minimum in dealing with these remaining things, which unfortunately we just have trouble making go away and cutting off that legal expense.

Dave Koning – Robert W. Baird.

That sounds good. Good job. Thanks.

Bob Carr

Thanks.

Operator

James Friedman of Susquehanna. Mr. Friedman, your line is open.

Meghna Ladha – Susquehanna

Hi. This is -- can you hear me?

Bob Baldwin

Yeah, Meghna. Thanks.

Meghna Ladha – Susquehanna

Hi. My question was, Bob, if you can give color regarding the merchant and volume attrition. I know you had big merchant loss last quarter, so if you just talk about that -- how that played out this quarter?

Bob Carr

Our attrition has been fairly consistent for the last year. No change one way directionally -- one way or the other.

Bob Baldwin

I'm not sure what you're referring, Meghna, with the -- I mean, we're not happy with our merchant attrition. Our volume attrition with the same-store sales getting better is actually down to levels that we haven't seen since 2008. But our merchant count attrition is not really improving in any material way.

Bob Carr

And if you're looking at attrition sequentially, first quarter is the quarter that many merchants don't have any volume. So if you're looking sequentially from the fourth quarter to the first quarter, you might think that attrition improved, but looking was bad. But when you look – if you look at it year-over-year, looking at it year-over-year taking out the seasonality factors our attrition is fairly consistent. It's too high. Its always too high but its not higher than it was in the past.

Meghna Ladha – Susquehanna

Thank you. That was helpful.

Operator

Robert Dodd of Morgan Keegan.

Robert Dodd – Morgan Keegan

Hi, guys. A couple of (inaudible). Can you give us the payroll and the equipment revenues?

Bob Baldwin

Robert, those are on that supplement.

Robert Dodd – Morgan Keegan

They are? I didn't see it. Sorry. The other question is, the sales – the relationship managers, you have added a lot sequentially. Historically, you haven't had, particularly higher retention from the sales reps. Do you think that's going to be different now with the verticalization of the sales force or do you still expect to be churning a lot of those guys off over the next year?

Bob Baldwin

I wish I could give you a different answer, but, keeping – bringing new people on and getting them adjusted especially in the commission only environment is very difficult. We do a good – we work really hard to recruit people we think are the qualified folks, but we have high attrition rate of people who are coming into the business.

Once they're here a while, we have a better, much better luck in keeping them. We have not found the silver bullet to solve that problem, frankly. It's not worse than it was, but it's also not better than it was.

Robert Dodd – Morgan Keegan

Okay. Got it. And just an extension of that, have you changed the pool – you mentioned the district managers have been working aggressively. Have you changed the pool of the type of candidates you're looking at or is it the traditional kind of business service sales that you have looked at in the past?

Bob Baldwin

It's really -- it's still the traditional group of people who have been successful at business-to-business sales, who in one way or another and also who very – who want to sell the Heartland way which is really important.

But I do think that if you're a division manager and you're looking to hire someone for the restaurant vertical, you are doing – looking a little bit differently than you would have in the past just looking for a good person, now you have a specific geography you're trying to place that person, so that tells you where to go find them. And with the restaurant vertical you're looking more likely perhaps to a former restaurateur than you might have previously.

So it does guide some of your recruiting which I think was a driver to the success that we had in our net adds in the quarter. So it is helpful, I think.

Bob Carr

Well, also, in the healthcare market we’ve had a number of former pharmaceutical salespeople join us because of the termination of a lot of reps in that part of the healthcare world. So that's been a big factor.

Bob Baldwin

Without our having established the medical vertical probably very few of those would have either been targeted by our people or would have been looking at Heartland. So I think that that's a net add.

Robert Dodd – Morgan Keegan

Very helpful. Thanks.

Operator

Next we hear from Reginald Smith of JP Morgan.

Reginald Smith – JP Morgan

Hey, guy. Nice quarter.

Bob Baldwin

Thanks.

Reginald Smith – JP Morgan

And I guess, I have a follow-up on the attrition question from earlier. It sounds like volume attrition has come down to I guess kind of '08 levels. Can you talk a little bit more about maybe give us some percentages there?

And then how you think about that normalizing, it sounds like attrition has been steady for a year, so we should be annualizing some stuff now. How do you think that attrition rate will kind of normalize overtime and how quickly can that happen?

Bob Baldwin

The attrition rate, like volume attrition rates are running a little over 15% right now, Reggie. And in the past back in the good old days '05 to '07 we were running sometimes single digits and often 10% to 12%. That was helped by same-store sales growth in the 7% to 8% area, speak about good old days.

And I don't think – I think that as we look at the coming out of the bubble era, there was no question that there was an oversupply of credit cards and so transactions driven by that. That doesn't seem likely to be the case for the next couple of years at least.

That said, we do think that cards electronic payments more broadly in fact with this week's announcement now or never we better use electronic payments on our cards, the – it is a secular share grower.

Now, we don't know how the regulatory changes might impact that. But is the fundamental value proposition of not using paper at the point of sale, instead using – conducting an electronic transaction, do we think that that trend remains in place ? The answer is, yeah.

So that says to me that if you get back to 3% or 4% growth in the consumer – in consumption and I don't think, I think that the economy is doing better than Main Street America as exemplified by our same-store sales. But I guess Main Street back to 3% or 4% which perhaps is a more normal G&P growth. I think electronic payments can have – can be taking share and so you can get to 5% or maybe 6% same-store sales. I don't think we are going to get back to that 7% or 8% growth anytime soon.

So I think there is room for attrition, volume attrition to come down further. Do I think we'll get to single-digit numbers any time in the foreseeable future? I don't think so. I'd love it, of course, but I do think we can improve further from here.

Reginald Smith – JP Morgan

Okay. And if I could sneak a few more in. SME volume growth for the year I think last quarter or the quarter before you talked about high single digits. Just curious, has that –has your view changed at all for this year?

Bob Baldwin

No.

Reginald Smith – JP Morgan

All right. And then I guess finally, on the new sales force, it's great to see you guys increase headcount there. Just curious, how you guys are thinking about or how your managers, your sales managers are thinking about, managing a bigger sales force, possibly chasing fewer opportunities.

How are people, your legacy sales folks, how do they feel about the new program and the new hires? Is there enough opportunity in this environment for everybody to kind of eat?

Bob Carr

Our vertical strategy really increased the capacity of our sales managers to manage -- manager division in the best way because now we're focused on how many restaurant reps, how many hotel reps, how many health care reps and other verticals that we'll be rolling out.

The big change that we began to make last fall was to restructure the organization, so that it could expand and handle a much larger organization in a way that everybody can make a decent living.

So, we are flushing out our 100 divisions across the country, broken into 15 regions and focusing on the verticals. Our veterans have mixed views of it. They prefer to not be managed the way they are now in terms of being focused on a vertical and not being able to traverse the country and without having some accountability to the local rep.

We allow our veterans and everyone to sell anywhere they want to, unless that particular prospective merchant has already been contacted by someone else. With our size that had become a significant problem where we'd have multiple sales reps trying to sell the same business and trying to offer different deals. It just made us look unprofessional and that was the problem we had solved I think nicely at this point.

But some of our veterans have not been thrilled about it, but we feel -- we knew that was going to happen and we feel that we’re through that pretty much and we're moving on, feeling very comfortable that this is the right direction for us to become much larger organic growing company to get back to the question answered earlier, can we get back to our old growth rate? I'm not sure about that, but we think we can improve it a lot with this new strategy.

Reginald Smith – JP Morgan

Thanks. That's helpful. Great quarter.

Bob Baldwin

Thank you.

Operator

Brett Huff, Stephens.

Brett Huff – Stephens

Good morning.

Bob Baldwin

Good morning.

Brett Huff – Stephens

One question on how the conversations go with the sales folks go, now that they're verticalized? What is the response of folks that are, the merchants that are in the verticals now, are they finding there's more expertise or more value add or is it primarily just driven by you guys want to make sure your sales force is divided up and focused properly or merchants sort of how are merchants responding to that product utilization?

Bob Carr

Well, our legacy merchants aren't impacted very much at all. Our focus is the multiple products in an integrative platforms. For example, in restaurants there's lots of legislation being discuss and in some stage passed. About chip reporting, we made a significant investment in building our chip reporting in our payroll business, integrating that back in to the restaurant POS companies of which we're working with a number of them.

I would say that, our organization is becoming much smarter about the needs of restaurateurs and healthcare providers and lodging. And we're strengthening our relationships with those who do not compete with us directly, in those verticals.

So we are hoping and thinking that we are going to get -- we have a great reputation for our integrity out there. And we want to get that same reputation developed for our knowledge. And the way we're going about it I think is the answer.

And I think it’s going to be difficult for our competitors with commodity products to compete with us going forward in these verticals and that is absolutely our strategy for the next few years.

Operator

Tim Willi of Wells Fargo.

Tim Willi – Wells Fargo

Thank you. Good morning, and two questions. First, if you could just give us maybe a little bit of an update around the selling success of the loyalty products. I think you commented on them from time-to-time in prior quarters, just curious how that continues to progress.

Bob Carr

Our Charleston folks have just done an absolutely amazing job. We introduced a new small mid sized merchant gift loyalty product in September. We’ve already installed over 3,000 merchants, I think 3300 merchants in the last, yeah, September 1st of last year. It's been a fantastic product, it's allowed us to bring out a lot more processing business. It is one of those integrations that I was just talking about. It's been a major success and we're very excited about the future of that product.

Bob Baldwin

And our net revenue in the loyalty and gift marketing area is up almost 50% year-over-year.

Tim Willi – Wells Fargo

Are there any metrics you could share relative to maybe some of the merchants that have been using that for a longer period of time in terms of their average same-store improvement or something that just sort of demonstrates the value that product brings to merchants as a way to gauge its value propostion for future challenges.

Bob Baldwin

That business is so seasonal that I think we have to get a full-year cycle before we can really look at the uplift that our merchants are getting. So that's -- that would be a good question for us to take a look at early next year.

Tim Willi – Wells Fargo

Okay. And second question I had was just around the Network Services business. Given the price compression that has happened in that division over the last couple of quarters and thinking about your overall margin, to what degree has that business weighed on the margins of the company and sort of how do you think about the go-forward margins of Heartland in that context?

Are there things that you can do or products that you're trying to put into that operation that would help alleviate what would seem to have been pretty significant margin pressure given the price declines or sort of how do we think about that whole equation relative to the consolidated margins?

Bob Baldwin

Well, it's a good question and a challenging area. There are no questions that business has lower margins in it. The large merchant category we're trying to enhance that with the added products with those merchants.

We're also looking forward to getting a much more robust, small to mid sized merchant -- petro merchant product, which has been harder to do than we anticipated and that would have better margins, closer to our traditional.

I think that's fair to say that as we look at our longer term margin objectives, we have hair cut those in the last few years in what we think is achievable and that's a combination of the more robust spending we're having related to our platforms, both for security and redundancy, et cetera, but also there's – the pricing pressure on those larger merchants has proven worse than we expected it to be not so great, but it has been worse than we expected. We're hopeful that the people will stop being stupid, but, you've got to work with the market on that.

Bob Carr

Yeah. On the other hand, we have had, you know, long extensions of great agreements with significant partners. And we do think that our SmartLink product and some of our loyalty products are going to be able to help those – help us with new margin.

I think the headline on that business for us is that it was a great acquisition. It's been tougher to make changes in the platform which has its pluses and minuses. Our retention of those accounts has been better than our expectations and I think we'll be able to overcome this margin loss on the renewals with new products and expanded relationships.

We have 760,000 student ID cards out today in our campus solutions market and we're working with some of our petro and C store customers to accept those cards and there's a lot of potential synergy as we get critical mass across the country.

Tim Willi – Wells Fargo

If I can just ask one more question related to margins. Just given all of the sort of complimentary products, you talk about campus card, royalty, et cetera. If we sort of bucket all those together, do those in aggregate make money or are they right now also contributing to a drag on margin that should reverse itself and scale up given what seems to be some pretty nice momentum around some of these products and the market acceptance?

Bob Carr

In aggregate they're definitely dilutive of our margins and as they scale up we – they are good margin businesses that are just in investment and growth phases. So definitely see that as helping us as we go forward.

Tim Willi – Wells Fargo

Okay. Thank you so much.

Operator

(Operator Instructions) Chris Shutler of William Blair.

Chris Shutler – William Blair

Hi, guys. Good morning.

Bob Baldwin

Good morning.

Chris Shutler – William Blair

First question just on the conform payment SmartLink Maybe, Bob, you can just, I know that you talked about a little bit in your prepared remarks but if you could just give us a little bit more detail on those products and any anecdotal evidence so far of success or feedback that you're hearing from merchants and then maybe you can just touch on the sales cycle for each, how long it takes?

Bob Carr

Well, SmartLink we have – we haven’t installed base it's – it's in the pipeline of multiple of hundreds of locations. The value proposition there is to consolidate the communication links into one broadband solution that we take care of on the front-end of the connectivity’s. That's basically a cost savings of product for our customers and we've got a lot of verbal commitments on going into the thousands of locations with that.

Confirm pay, we're launching something that's new to the medical industry and we’ve had success with it. It's still a product though that we have to continue to investment in and build out because healthcare is so different from one provider to another and their needs are so much different.

But we think we're on the right track and it's worth the investment to decommoditize payment processing for the healthcare industry by having some unique solutions that work with the different types of providers. So confirm pay is a longer haul than smart link, but we think they're both very, very good investments to decommoditize payment processing.

Chris Shutler – William Blair

Okay. Great. Thanks for that. And then as a follow up on the different tangent, the 79% revenue growth Bob for 2010 guidance, how much of that increase in revenue growth is attributable to incremental Discovery, AmEx volume?

Bob Baldwin

It's a good chunk. I would say that it's probably three percentage points or so. Three to four.

Chris Shutler – William Blair

Okay. Thank you, guys.

Operator

Andrew Jeffrey of SunTrust.

Andrew Jeffrey – SunTrust

Hi. Good morning. As a follow-up on Tim's question, can you just sort of review or comment on your competitive position in the market from a product offering standpoint and give us a sense of whether you think you have kind of the suite of offerings now that makes you sort of long-term competitive in the market or if there's some other functionality you'd like to be adding over the next couple of years?

Bob Baldwin

We think our leaders in the product set that's being offered to the small and mid sized merchant community. We have lots of work to do this announcement about the contact less payments with the cell phone for, carriers are backing it is going to be very interesting. We think, we believe we're going to be in the leadership position there.

We have a lot of work to do to stay ahead of things. There's so much change in the industry and the back-end requirements -- all the changes in the back-end that are going to come as a result of the new legislation required -- there's a lot of compliance work that has to be done that sucks up the resources for the development. So we're trying to balance that, as well as we can.

The competitive situation that we face is the same as everyone else faces. We think we're better equipped to compete. The toughest competition we have now is basically all these sub-ISOs who are called POS dealers in the various vertical market segments around the country.

That's the big change over the last few years is that the POS business has changed to where the dealers and the manufacturers are looking more as software as a service which has been talked about for a long, long time, but it is there today. It is there. And that's -- so all these POS dealers are all sub-ISOs of ISOs and we're developing competitive strategies to compete with them. That's where the rubber is hitting the road for us primarily and we think that we're in a better position to compete with that than a lot of our bank competitors as an example.

Andrew Jeffrey – SunTrust

Okay. And as a follow-up, can you comment a little bit, I know this question earlier about passing on lower interchange potential and debit, and I remember that that was a big share driver for you after the original Wal-Mart settlement. But it's obviously a different world as you just articulated and I'm thinking specifically about PCI compliance fees which seemed to be driving revenue growth if not share for some of your competition.

Can you just comment on that sort of I know philosophically where you stand in terms of those as you call them junk fees? But can you talk about the prevalence of explicit PCI compliance fees and how that's affecting your competitive position and also affecting pricing generally in the market?

Bob Baldwin

It's a great question. The September 21st meeting in Orlando is something we are really looking forward to at the PCI council, because we hope to get some clarity on the compliance requirements for true end-to-end encryption as well as tokenization.

What is the scope reduction going to be if any with the product? This is all new. We are getting tremendous trash in with our E3 standalone terminal. We are coming out with our ways that integrates in with POS systems now – that's new now.

A lot of folks were saying small merchants won't spend any money to have better security. I think we're proving that wrong. You know, thousands of merchants have already done that and they buy the equipment and that keeps them from having to pay monthly fees, transaction fees, et cetera, et cetera. We recover our costs upfront.

So this is the battle that's being waged and we'll have to see which strategy works out. We think in terms, nobody is talking about how many installations they have except us. I'm not sure how many installations our competitors have and the vaporware solutions of tokenization just aren't competitive with our true end-to-end encryption.

So we are ready to take on the battle. We think we are in the very strongest position, we spent millions of dollars of getting our products to market and we are looking forward to seeing who's going to win. We think we're going to win.

Andrew Jeffrey – SunTrust

All right. Thanks, guys.

Operator

Leonard DeProspo of Janney Montgomery Scott.

Leonard DeProspo – Janney Montgomery Scott

Hi. Good morning. And I just had a question, information but the trends on credit and debit , each month May through June, if you have those figures, Bob?

Bob Baldwin

Yeah, I do. Now, this is just Visa and Mastercard right now, but April, May and June actually debits dollar volume growth declined month over month. The average growth was just under 8% but it was the highest in April and then declined to the lowest in June.

Credit actually, bounced around and was positive in both April and June, very modestly positive in our merchant categories. So but I'd say we remain very modest growth in credit for the quarter, but debit is the driver in the growth.

Leonard DeProspo – Janney Montgomery Scott

Okay. Thanks.

Operator

Paul Bartolai of PB Investment Research.

Paul Bartolai – PB Investment Research

Good morning, guys. Thanks for taking my question. First question just on new margin installed and then obviously the macro conditions are impacting that but just trying to get a sense of how that compares versus your competitors. Are you losing share gain or maybe you’re just having challenges given some of the markets you are targeting and then maybe how pricing is playing into that given the challenges of signing up new business?

Bob Carr

It is really – it's worse than hard, it's impossible to know where we are in terms of share. It's hard to imagine that we're gaining much share. But – and as Bob mentioned, I think that the area where the share shift has occurred is the aggressiveness of the POS dealers in going after the card processing business. And those who are in that business have benefited from it, from that approach.

Beyond that, we think we're very much holding our own, but it's just – there's just no public information out there. I do know that just, if you look at the – a lot of the larger ISO's and the numbers that they have reported, their growth rates in their portfolio has been less than ours and in fact negative in the year ended now last December. And so that would suggest that we’ regaining share relative to them, but it's very hard to generalize.

Paul Bartolai – PB Investment Research

And then just any discernible trends on pricing, giving the challenges of signing new businesses, is it getting a lot tougher?

Bob Carr

Pricing is – perceived price is major driver and there's no question that various forms of teaser rate and lowball sales are as aggressive today, or more aggressive than they have ever been, a lot of hungry salespeople out there who don't know how to price anything else except to compete any other way but sort of putting out a low price.

I think that the – that's always been a tough thing to compete with. But we think that the merchant is now and will in the future be more sensitized to their costs and that our approach to costs, our interchange cost model will be more interesting and valuable to the merchant as we get some of these changes – legislated changes coming through.

So, but when you look at the expected basis points in margin that we’re getting out of our new installs, it is not deteriorating compared to in the SME business it's not deteriorating to compared to where it is. And on a broader scale, our SME net revenue in card processing is dead flat this quarter versus same quarter last year.

So overall, our effective price is hanging in there. But I will say that getting the new installs is perhaps tougher because of some of the – not only the lack of new locations and the challenge from the POS dealers, but also that perceived price offering that competitors have.

Paul Bartolai – PB Investment Research

Okay. Great. That's helpful. And then just a quick follow-up. The rev guidance, it sounds like same-store sales was a little bit better than you expected, but looks like it took down the revenue a little bit. Just curious what the other factor is going on there?

Bob Carr

The real driver is twofold, Paul. One is that we were looking for install margin to be higher in the first half of this year than we’ve achieved and that just has a cascading effect in terms of your business activity in the latter part of the year. That's probably the biggest driver.

To a slightly lesser extent we had expected somewhat more of our installed margin to come from non-card businesses. And those tend to drive up your net revenue because they don't have any, if you sell a $300 terminal or a $400 terminal, that sale price is reflected dollar for dollar in your net revenue.

And so, we are expecting a little bit more share of our revenues becoming from these non-processing activities, and that was driving up the net revenue growth rate and that's really the other piece of it.

Paul Bartolai – PB Investment Research

Okay. Great. If I could sneak one more in real quick, the stock comp was up year-over-year and it looks like you took it up in the guidance. I'm just curious what's driving that? Are you shifting how much you're paying in cash versus stock, or is that maybe to help that with the hiring of the new salespeople? Just curious what's driving that? Thanks.

Bob Carr

Has nothing to do with new salespeople. There was a grant made by our Board, Compensation Committee recently of options and that came in with a pretty high volatility assumption. And the volatility is a big driver of the cost of an option. And so, it was nothing outside of, I think, the Board's -- or the comp committee's grant was approximately the median of the competitors that we have out there.

It's an important way to -- it's an important piece of incentive for our middle and senior management, and it was felt that it was appropriate to give that incentive to that group of people. But the cost came in just a little bit higher that what we were sort of guessing at when we gave guidance at the beginning of the year.

Paul Bartolai – PB Investment Research

Okay. Great. Thank you very much.

Operator

And our final question for today will be a follow-up from Bob Napoli of Piper Jaffray.

Bob Napoli – Piper Jaffray

Thanks. Most questions were asked. If you had the numbers behind the Discover and American Express volume, I think you said last quarter it was $600 million, of which $200 million was American Express?

Bob Baldwin

We do have that and -- let's see. AmEx volume, well, Discover volume was $467 million and AmEx volume was about $200 million, about flat with last quarter.

Bob Napoli – Piper Jaffray

Okay. And just on AmEx, you're one of the few that they have given the ability to market there too and I mean, are you -- are these merchants that generally did not accept American Express? How are you -- how are they splitting the merchants, because they have their own sales force?

Bob Baldwin

Well, they're focusing their sales force on the larger merchant category.

Bob Napoli – Piper Jaffray

Right.

Bob Baldwin

This program, the one-point program is focused on smaller merchants and they're saying they want the sales and the servicing of those merchants to be handled by those acquirers that they've engaged in the program.

And overall, we've seen -- we were I think viewed by AmEx as one of their better producing sales organizations. That should come as no surprise. We focus on the hospitality and we also think we just have a larger merchant, which is typically more interest in AmEx.

Also no surprise, now that we're getting more better economics on AmEx sales, the percentage of our sales that – of our new installs, our new merchants that accepts AmEx has never been higher, about half of our install card merchants now accept AmEx.

When you look at what we're getting paid on though, it is only merchants that are new to AmEx as far as getting those full economics. If a merchant is already accepting AmEx and we take them away from somebody else, we don't get any – we don't get that uptick in the margin. We do get a servicing fee that we didn't use to get, but we only get the full economics if that merchant is new to AmEx, either because they have changed ownership or they're a new establishment to acceptance of AmEx.

Bob Napoli – Piper Jaffray

Are they – are most of your sign-ups new, I mean, the $200 million, is that coming mostly from new to AmEx merchants?

Bob Baldwin

That is, no, that is a combined number of in fact, we've been doing a lot of conversions of the merchants on the -- to our servicing from AmEx during the last quarter. And so a decent percent, more than half of that reported volume is where we're not getting the full economics.

Bob Carr

I think the economics piece we're getting is about $75 million out of that $200.

Operator

At this time, I would like to turn the conference back over to Mr. Carr for additional and closing comments.

Bob Carr

Thank you, [April], and thank you all for joining us and have a great day.

Operator

That does conclude today's teleconference. Thank you all for your participation.

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Source: Heartland Payment Systems, Inc. Q2 2010 Earnings Call Transcript

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