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Total System Services Inc. (NYSE:TSS)
Q3 2006 Earnings Call
January 17, 2007 8:30 am ET

Executives

Phil Tomlinson - Chairman & CEO
Jimmy Lipham - CFO

Analysts

Tim Willi - A.G. Edwards
Stephen Stout - UBS
Paul Bartolai - Credit Suisse
Tony Wible - Citigroup
Craig Maurer - Soleil Securities
David Parker - Merrill Lynch
Jeff Davis - FTN Midwest Research
Jefferson Harralson - KBW

Presentation

Operator

Good morning, ladies and gentlemen, and welcome to the TSYS fourth quarter 2006 earnings conference call. (Operator Instructions) It is now my pleasure to turn of floor over to your host, Phil Tomlinson, Chairman and CEO. Sir, the floor is yours.

Phil Tomlinson

Thank you so much and welcome to everyone that's on the phone. We appreciate you being with us early this morning. I think we have a good report for you.

As usual, before we get started, I want to call your attention to the fact that we will be making forward-looking statements about the future operating results of TSYS, and that these forward-looking statements do involve risk and uncertainties. Factors that could cause our actual results to differ materially from the forward-looking statements are set forth in our reports filed with the SEC.

2006 is closed out, and frankly, we are glad it's done. We have just finished one of the more remarkable -- and in many ways difficult -- years in the history of our company. We closed out the year with our 23-year record for increased earnings. If you will recall, this time last year I talked about being the captain of that cruise ship that had tilted and I felt like we were in a bit of a fog because of the B of A announcement. And, we were bracing for the departures of two of our very largest clients and struggling on how to increase our revenues and reduce expenses and continue to grow at the same time. I absolutely believe it has really been one of the more difficult challenges our team has ever been through.

I do believe, however, that we've made really, really great progress and we're closing that chapter and we're looking ahead to what I think is a very bright future. I think we have demonstrated impressive discipline and good, old-fashioned hard work in achieving our goals for 2006. In addition to doing a lot of internal work, our team executed some of the most complex and difficult conversions ever in the payments industry. We really did it virtually flawlessly and with minimal risk and disruption to anyone else, any of our clients.

We added a total of a little over 91 million new accounts with nine new clients in 2006, and we also resigned 14 of our current clients to new contracts. We closed 2006 with a total of 416 million cardholder accounts at year end, which really surpassed our expectations, and in large part, compensated for some of the departures that we experienced.

As an example, processing volumes, we were very excited about our processing volumes for the peak holiday spending period. In North America, they were up about 13% and approximately 20% in Europe. Obviously that was boosted by the new clients like Cap One, Toronto Dominion and Banco Populare in Puerto Rico, to name a few. This better than expected year end result was one of the key factors in our financial performance for the year.

In looking at our financials on a GAAP basis, for the fourth quarter, EPS increased 75.8% to $0.44 a share. Obviously that was helped along by the termination payment. Total revenues increased 19.8% to $504 million; and for the year, EPS increased 28.3% to $1.26 per share. Total revenues increased 11.5% to $1.7872 billion.

Now I'm going to talk a little bit about GAAP and non-GAAP, so I hope to get this right. These results, according to GAAP, included the financial impact of the $69 million termination fee which had been anticipated since late '05 and we have talked about extensively over the year in 2006.

However, I think it's really important to understand our financial performance excluding that termination, which is non-GAAP. So if you disregard the effect of that termination payment, our net income increased 11% in 2006 versus 2005. I think the big deal is our guidance on a non-GAAP basis for 2007 is to increase net income in the 14% to 17% range. I think it is really, really impressive when you think about that we have lost two clients in 2006 to total 130 million plus accounts. As you know, in the third quarter we expect Chase to take their accounts and move from a processing contract to a software licensing deal, and you know the size that Chase is. So it is pretty amazing that we have been able to recover as well as we have.

Our operating margin in 2006 was 24.9%, up from 22.3% in '05 and it was 21.5% on a non-GAAP basis. However, we do expect that operating margin to move into the 24% to 26% range in 2007. I think when you look in that perspective, it is a truer look at what our results are and some very favorable comparisons. We have weathered the storm and the setbacks and I think we have learned an awful lot. We've certainly learned how to better generate value for our clients and shareholders, even in the face of challenges like we have had in 2006.

Our team has worked every day to achieve our financial goals and I think we've accomplished impressive results in our efforts to find new revenue opportunities and operating efficiencies.

I think we have done a great job of continuing to increase our internal revenue growth. Internal, or organic, revenue growth is in the 10% range and it's really important to understand the selling of these additional products to our existing clients, and this is evidenced by our value-add products in our International group. We have talked about our value-add products over the years, but that has continued to be a great contributor to our revenues and that piece of business, the revenue and value add increased 9.7% in 2006 versus 2005 and it is a great example of our ability to sell more products into existing clients.

I cannot say enough about TSYS International. We added significantly to our international revenue growth. Our international revenue growth was up 22.7%. We have made significant investments in technology and infrastructure in the prepaid segment in 2006, and it has resulted in several important pilot programs that are currently underway in the international arena. We're doing a travel card for a major UK bank, the Bank of Ireland; a travel card for the UK Post Office prepaid voucher program. So we have a lot going on in the prepaid business, particularly in Europe.

We also are doing a travel money VISA card, which is a reloadable prepaid product available in three currencies: euros, dollars and sterling. It offers the consumer a truly global payments capability.

Since the acquisition of TSYS Card Tech, which was back in July, I think we have better positioned ourselves to enter the acquiring business in Europe and we are on a fast track for our first customer or client launch in the second quarter of 2007. We're not going to give you the name of who that is, but we feel very, very good about it and we will announce it when the time is appropriate. I think it does show that we are making progress there.

Also, Card Tech recently signed four letters of intent that includes several leading consumer finance and banking brands in Europe. One thing I did want to mention to you, as you know, we have a prepaid office in Manhattan. We have announced we're going to close down that operation and we're going to move it to Alpharetta, Georgia. We have looked at it, we understand that we have got to be faster, better and cheaper at everything we do and we believe we can save $7 million or $8 million by moving that operation and be much more efficient.

One thing I wanted to tell you about -- and you saw it in our press release -- we have named Bob Philbin as the new president of Total Acquiring Solutions. Bob is certainly an industry veteran. He has been with our company now four or five years as our CFO, has done a great job, and we think this is a great opportunity for Bob. We know that he's going to do a wonderful job for us. We congratulate Bob on that big promotion for him.

Now with that, I want to turn it over to Jim Lipham, who is going to give you more details on the numbers.

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Jimmy Lipham

Thank you, Phil. As Phil mentioned, we are pleased to announce that we finished '06 in the upper end of our range at net income growth of 28% and our earnings per share on a GAAP basis of $1.27. I will be making some comments based on the P&L that was in the press release, if you will take focus on that.

The first thing, I want to make an overall statement for the year-to-date numbers. You'll remember, that Vital, or TSYS Acquiring Solutions, only has ten months worth of numbers in the '05 comparison to '06, so we do have two more months of Vital's full operations in '06. It does make up a pretty good chunk of these variances year over year.

But if we look at the fourth quarter and the electronic payment processing line, which is our main core processing services and licensing arrangements, you will see that we ended the quarter at $303 million, up 35.8%, and then for the year up 13.7%.

Phil mentioned earlier about the termination fee of Bank of America. Obviously, that was a big portion of this increase in the fourth quarter and year to date. The other revenues came in from the addition of new customers he previously mentioned and the Cap One, Toronto Dominion.

Solid growth from our medium to small-sized customers. Revenues from these new clients and the internal growth, also the inclusion of TSYS Card Tech, all of this helped offset the loss of revenues for the two big deconversions that we had in '06.

We continue to experience some solid organic growth in our account on file numbers with a rate of about 12.7% for the year. As you know, our accounts on file are down for the year due to the loss of the 130 million or so accounts that Phil mentioned earlier.

International revenue is strong for the year and increased $56 million, including the revenue generated by TSYS Card Tech. The international revenues, especially Europe, were positively impacted in the currency translation adjustment by a little over a couple of million dollars.

Value-added services, Phil mentioned, is growing. It was up $20 million or 9.7% and continues to show good size of some very high margin products.

Merchant acquiring, if you look at the quarter, we're down in revenues. The decrease, when you compare it to '05, has to do with the closing of the San Diego sales office of the VOVTMS business, and that was about $7 million reduction in revenue. If you remember, this business had little to no margins and it has been a very good move for us to shut that operation down.

We were also impacted in the acquiring world by the deconversion of a couple of our large customers, knocked the revenues down about $2.5 million. But this revenue drop was offset again by internal growth of our other customers. For the quarter, the internal growth was around $6 million and for the year to date it was a little over $23 million.

Sequentially, revenues are down about close to 1% but going forward, we expect that to reverse. Our front-end transactions saw good growth in the fourth quarter, grew 16% and for the year, the transaction volumes were up 15%. Also during the quarter, TSYS Acquiring renewed long-term agreements with two of their top 20 clients, and for the year that brought the total to six of their top 20 that they had done.

From an operating performance, profit performance TSYS Acquiring saw a 41% improvement in the fourth quarter. This was mainly created by operational efficiencies in the lower transaction delivery expenses, coupled with a one-time charge in '05 where we took an inventory writedown of $2.5 million in the fourth quarter of '05; but strong improvements in the operating profit for the quarter and for the year as the operating profit was up 16% year over year.

Our margins in TSYS Acquiring for the year is 24.2%. This is versus 19.1% for '05, so it's some very strong improvement there and we are expecting them to continue that improvement. TSYS Acquiring, as you know, continues to develop products, including the Merchant Cash Advance Services, Enhanced Merchant Statement Capabilities and the Contact Us and Gift Card areas. So we are continuing to expect great things from them as we go forward.

Dropping down to the other services revenue for the fourth quarter, it increased 13.3%, or $6 million and this is mainly a result of greater growth in our redemption revenues from our ESC Loyalty subsidiary, as well as some increased revenues from our profit product. On a year-to-date basis, we are up 1.4%, or $2.5 million. If you will remember, also in this category we have entered this new agreement with Total Debt Management, its largest customer, whereby revenues have been taken out and reclassed as passthrough revenues now, so that has caused part of this low revenue growth looking number here.

Revenues for other reimbursable lines is actually down 4% for the quarter and increased 12.6% for the year as a result of mainly the postage for billing additional statements for some large clients that we lost and the treatment of the court costs, as I mentioned before, for Total Debt Management.

Total revenues for the fourth quarter increased 19.8% at $503.9 million, that's up 24.8%. I might mention also in the fourth quarter revenues, an increase of approximately $4.2 million related to the effects of currency translation on all of the foreign subsidiaries and the office branches. As we continue down the page to look at expenses, our expense growth in employment was 10.5% or $13.4 million for the quarter; for the year that was 13%, or a $60 million increase.

Included in the fourth quarter results was the effect of adopting FAS 123, which obviously requires companies to expense the fair value of stock options. Our expense in the quarter was $1.7 million; year-to-date was around $6.7 million. We also had normal salary increases, merit increases. As a result of the acquisition of TSYS Card Tech and TSYS Managed Services, we had approximately $3.5 million of additional employment expenses.

On a sequential basis, employment expenses are up approximately $2 million. Also contributing sequentially was the employment expenses for the Managed Services unit. As a consequence of the revised earnings estimates for '06 exceeding our original plan, we revised some estimates around our at-risk base pay, performance incentives, and it increased expenses for the quarter. Then again, for the year the remainder of the increase, or the majority of it came from TSYS Acquiring being in there two more months than what they were in '05.

A good note this year and it will affect what goes forward in '07 is we did make a concerted effort to make efficient use of our people and redeploy resources. When you exclude the employees gained through the Card Tech acquisition and TSYS Managed Services, we're down approximately 210 people since December of '05.

We made some hard decisions during the year, closing the Jacksonville office in November and Phil mentioned the planned closing of our Prepaid Services office in New York, but we continue to review our allocation of people and resources to ensure that we're managing those efficiently.

On the occupancy and equipment expense line, it increased 28.1% or $20 million for the fourth quarter. We continue to add leased equipment/software necessary for the new conversions in '06. As you recall, some of our software licenses are under processing capacity or [WIP] agreements and are amortized using the units of production method. This had the tendency, with these deconversions, to increase our software amortization during the quarter as we dropped our [WIPS] when these people deconverted.

Also during the fourth quarter as a result of the deconversion, we discontinued the use of one of our mainframe operating software systems and this resulted in a one-time acceleration of the remaining useful life, and about $11 million of expense hit in the fourth quarter that won't be there next year.

On the other expenses, we're down 9.3% for the fourth quarter. TSYS Acquiring is the main reason there for lower transaction delivery fees, as well as the reclassification of court costs and attorney fees associated with Total Debt Management.

Excluding reimbursables, operating profit margin for the quarter was up 30.6% which includes the B of A fee. As Phil mentioned before, we do expect our margins to remain in the 24% to 26% range as we go forward and continue to improve during the year '07.

Drop down to the other income, it increased $3.7 million for the fourth quarter compared to '05 and $10 million for the year to date. The big differences there was increased cash that we had available to invest, along with increased rates to improve our income there.

Income taxes for the quarter was up 9%. Obviously that's because of the termination fee, but our effective tax rate for the year was 33.8% and for the quarter was 35.5% compared to 33.9% last year. The effective tax rate was actually lower as a result of favorably settling various tax audits that we had mentioned during the year. We do anticipate going forward the effective tax rate to stay around 35%.

Net income for the quarter increased 75.2% and then our earnings per share, as we stated before at $0.44, up 76% over the fourth quarter of last year. All in all, a very strong fourth quarter and year-to-date number.

I would like to make a few comments now, if you can take a look at the balance sheet, about some of the changes in our assets. Cash at $387 million, it has increased $149 million since December of last year, represents approximately $2 of cash per share that we have now. With the acquisitions of TSYS Card Tech and TSYS Managed Services, as well as the increased investment in Comp Data, we experienced some increases in our associated goodwill, intangible assets, and as well as our equity investments. From the computer software, you can see we have taken a pretty large drop there in the amount of the amortization that we took in, in '06.

Flip to the cash flow statement, you will note significant contribution again from our cash generated from operating activities of $385.6 million. For the year, we continue to generate a significant amount of cash to fund investing and financing activities. We invested roughly $27.1 million in property and equipment which is mainly hardware; and $25.1 million in software, $10.5 million of it for purchased and around $14.6 million for developed.

We also used $22.9 million to repurchase a little over 1.1 million in shares of stock under our share repurchase plan. We had roughly around 900,000 shares remaining under the plan. We also had an increase in our dividends and paid $11.9 million more in dividends.

Our free cash flow number is around $291 million and there again, this speaks well for what kind of growth we have in our cash business.

One final note I would like to leave with you again concerning our '07 guidance, as Phil mentioned before, when you exclude the termination fee and take out the excess amortization and the income tax effects, we do have net income going up 14% to 17%, and that is especially pleasing in light of the loss of the in excess of 130 million accounts on file in '06. You all know how many accounts Chase has, is going to be leaving next year. So it speaks well for the operating efficiencies we are achieving with the downsizing in our account growth.

With that, Phil, I will turn it back to you.

Phil Tomlinson

Thanks, Jimmy. I hope that all that helps you understand why we feel so good about our 2006 performance and our outlook for 2007. We do need to continue to control expenses very aggressively. Our overall goals for 2007 are not a lot different than previous years. We will continue to meet our growth expectations. We're going to have to operate more efficiently and continue to develop new products and provide world-class service to our existing and future clients, and continue to try our very best to create shareholder value.

With that, I want to open it up to questions and we will see if we can’t answer them for you.

Question-and-Answer Session

Operator

Your first question comes from Tim Willi – A.G. Edwards.

Tim Willi – A.G. Edwards

Good morning. A great year, congratulations on working through it as well as you did. Two questions, one around J.P. Morgan. Phil or Jim, if you could just maybe help us understand a bit better what the changes in the income statement might look like with the move of J.P. Morgan to the license? Will you create a new revenue line for licensed revenue, or will it just be an adjustment to the electronic processing revenue? What kind of movement may we see on the expense side of the income statement when that happens?

Jimmy Lipham

As it goes forward, we'll obviously have a decrease in our revenue line from the processing fee dropping down to what the license fee is, but you will have also a decrease in the expense line. When it's all said and done, we should have a net income that is as good or better than what we have today.

Tim Willi – A.G. Edwards

Understanding that eventually as you had moved through that transition, the profitability should be as good or better, but will there potentially be, in that back half of '07, should we be aware of maybe some minor disruption to profitability and operating margins as you do that -- albeit it will just be temporary?

Jimmy Lipham

The profit margins are going to improve up to the 25% range as we talked about, or 24% to 26%. All along during the year, we will be making some changes to prepare for that deconversion. I don't anticipate any abrupt changes as we go forward.

Phil Tomlinson

On that, we have been preparing for this event since day one so all of our lease obligations are timed to this event. We feel very good about our ability to pull this off with no real financial disruptions.

Tim Willi – A.G. Edwards

Good, that's great. The second was just on the international. Phil, you talked about some interesting opportunities and stuff going on with prepaid and a merchant customer. Could you maybe just talk about the overall environment that you're seeing in Europe? Obviously, everybody's sort of trying to understand the impact of SEPA and what that might mean. Can you just give us your sense on what the activity in the marketplace looks like now versus a year ago, and to what degree SEPA may or may not be an issue there?

Phil Tomlinson

As we have said before, I think SEPA is probably a good thing for TSYS long term. It will help us be more palatable as an option to financial institutions in that part of the world. I think we're seeing activity in our business pick up in that region. There are a lot of issuers looking around, there are a lot of service bureaus and companies that are in this business or around this business that are looking at selling or that have at least explored the opportunity to do something different. So we are pretty excited about what's going on in the UK and Europe.

We are also, as you know, really excited about what is going on in China. We're continuing to make really good progress in China. Hopefully, this will be the year of some strong announcements there. As we have said before, that is a three to five-year project before it becomes meaningful, but we are pleased with the process and the progress that's going on as we speak. So I think there's a lot of fertile ground outside of the U.S. and we are planting seeds everywhere.

Tim Willi – A.G. Edwards

Do you think the margin lift that you talk about will predominantly be driven by the domestic business, or actually will there be a notable contribution from growth internationally?

Phil Tomlinson

Yes, our margins outside the U.S. are about as good as our margins in the U.S., very similar.

Tim Willi – A.G. Edwards

So you think they will both equally drive the margin improvement next year?

Phil Tomlinson

I think so, yes.

Tim Willi – A.G. Edwards

Wonderful, thanks a lot.

Operator

Your next question comes from Stephen Stout - UBS.

Stephen Stout - UBS

Congrats on the quarter and the great '07 outlook. Phil, can you talk a little bit about the reasons why you decided to raise guidance and what factors went into that?

Phil Tomlinson

As we have been talking over the last year and once we got past the shock of losing Bank of America, we really asked our people to dig down deep and deal with the issue like it was their own money. Frankly, I think we have done a good job. As we have gotten into that, it has continued to get better and we've made some hard decisions. Closing the Manhattan office was a hard decision. Closing Jacksonville was a very hard decision. We'll keep a lot of those people, but you've heard me say before, we have to be faster, better and cheaper.

Those are three mantras that we have to live by and I think it's a great example of getting better everyday. We went through a very, very strenuous budget process that has recently ended and frankly, we were delighted at the outcome of it. It has been good for us. Certainly we struggle losing any customers but in some ways, it has really made us look a lot deeper than we have had to.

We have new business coming on board, we have the merchant's acquisition, the Card Tech acquisition. We're excited about those. They are going to add value to what we're doing. So it is improving and we're going to continue to try to improve it even more.

Stephen Stout - UBS

Do you feel like there are any other cost initiatives that you can take during the year if you need to?

Phil Tomlinson

I don't think there are any big ones. There are certainly some smaller ones that will add up to some real numbers. What we are trying to do, Steve, is cut fat and not muscle. We're trying to make sure that we have plenty of muscle to continue to be successful and not do anything that's just really dumb.

We are taking hard looks at everything. Every affiliate that we have from prepaid to Vital to even our European operations, we're asking people to dig deep. We want to do it in a smart and sensible way. So we feel good about that. We're very excited about the improvement in our guidance. We have worked harder than most people would note to get there. What I kept pressing our folks for was, pull a miracle out of the hat and let's be flat. It's hard to be flat with the trauma that we have gone through, but we're pretty close so we're excited about that.

Stephen Stout - UBS

Phil, is there any M&A included in these numbers? Can you talk briefly about that?

Phil Tomlinson

There is no M&A that you don't know about. There are some things that we would like to be able to look at.

Jimmy Lipham

I would just add that from the M&A activity in '06, we should see a contribution of $27 million to $29 million in revenues above '06 and '07.

Stephen Stout - UBS

Lastly, have you had time to discuss any additional structural changes or potential liquidity event Synovus' new management?

Phil Tomlinson

We have discussed it a lot and I think they are certainly discussing it. You might want to listen to their earnings call this afternoon at 4:30, I believe. But I don't really have any kind of update there of any substance. Certainly it is one of those things that continues on and we have great faith that they're going to make the right decisions and do the right things. It would just be me guessing what it would be right now. We are optimistic that that thing will get resolved here, hopefully in the near future.

Stephen Stout - UBS

I'm sorry, if I could circle back to the previous question one last time. With the success of the Prime platform, can you give us some color on what your M&A plans may be for this year?

Phil Tomlinson

I don't know if we can give you much color on that, but we do have several things that we're looking at currently. As you know, we have some limitations on what we can do. We have two or three that we're looking at and one or two that we would really like to do something with. But they are not far enough along; really, the process has just started and I wouldn't even say that I am optimistic at this point. We will continue to look at that, particularly in the U.S. and in Europe. There's a lot going on in Europe.

Operator

Your next question comes from Paul Bartolai - Credit Suisse.

Paul Bartolai - Credit Suisse

Thanks, good morning. The first question, Phil, you talked a little bit about the international market, but curious if you could give us an update on what you are seeing in the domestic card market, both in terms of pricing and just activity out there?

Phil Tomlinson

Well, our pricing seems to be fairly steady. In new business, pricing has always been under heavy pressure. We always get a little pressure as we renew contracts. That is one great thing about the economies of scale that we do happen to enjoy. Pricing in this business, we are always going to be under pressure. I don't look for that to get any better any time soon. I think that is the nature of the beast. As I said earlier, everybody wants it faster, better and cheaper, and that is why we have to continue to push to be much more efficient and do it at less cost. Particularly the core pricing, the basic things that we do. Now, that is one reason we love this value-added business because we can do a little bit better margin-wise with value added. But it is under heavy pressure everyday.

Paul Bartolai - Credit Suisse

But not a lot of change, you are seeing?

Phil Tomlinson

No, I don't think it's any worse.

Paul Bartolai - Credit Suisse

And then just in terms of the pipeline domestically and what you're seeing out there?

Phil Tomlinson

Well, we have some very strong prospects. We have several that we would hope to have in the bag here before too long. We don't have a huge pipeline now. I think we're somewhere in the 10 million to 15 million new accounts, as we speak right now. We have just finished that massive pipeline that we had built up last year. As you know, this thing goes in cycles and we have several very, very large players that we continue to talk to, but it is a long sales cycle. About all I can say there is when it happens, it happens. I promise you, you guys will be the first to know.

Paul Bartolai - Credit Suisse

Jim, what were the acquired revenues in the quarter for 4Q?

Jimmy Lipham

The acquiring revenues?

Paul Bartolai - Credit Suisse

No, the acquired from acquisitions.

Jimmy Lipham

Let's say around $6 million for the quarter.

Paul Bartolai - Credit Suisse

$6 million?

Jimmy Lipham

Yes.

Paul Bartolai - Credit Suisse

Then last question, Phil, just any update you want to give on Comp Data, what you're seeing there and what the early objectives are as you work on that initiative?

Phil Tomlinson

It's like I was saying a minute ago. We are very excited about some opportunities that are going on now. We're talking to some very large banks and the issuing process is picking up. As you know, all of that is semi-government controlled, and our optimism is as strong as it has ever been about what is going on in China. We are very optimistic about what is happening there. I believe we are talking to the right people, to the right banks and I think we're making good progress.

I hope that this year we will have some strong announcements coming out of China. I will be disappointed if we don't.

Paul Bartolai - Credit Suisse

Okay, thanks.

Operator

Your next question comes from Tony Wible – Citigroup.

Tony Wible – Citigroup

I was hoping to start off by just getting a couple of housekeeping questions out of the way. How many J.P. Morgan accounts did you have as of the end of this quarter?

Phil Tomlinson

Tony, we try not to talk about how many accounts our clients have. I think you could go to Nielsen or some of those trade publications and get a pretty good number. They are probably, if not the largest, the second-largest issuer in the world. So it is a big number.

Tony Wible – Citigroup

If I heard correctly, you said from relocating your prepaid operations, that you were expecting $7 million to $8 million. Would that start immediately, and where would that show up?

Phil Tomlinson

We don't think we'll have that completely done until about mid-year. On an annualized basis, it will be in the $7 million, $8 million. '08 will be 100%.

Tony Wible – Citigroup

If I understood correctly, there was a little bit of a hit on the Bank of America loss with the licensing of the software and the occupancy line. Is that something that now goes away because of Capital One coming onboard and increasing volume?

Jimmy Lipham

Yes it does. The hit from the Bank of America, that was the deconversion, it was just the timing that we got off of the operating system. It was a one-time hit of around $11 million.

Tony Wible – Citigroup

But the [WIPs] pricing, is that something that now dissipates because of Capital One?

Jimmy Lipham

A big portion of the expense hit this year, and Cap One will add more [WIPs] back to it, so that's correct, and that will decrease it a little bit.

Tony Wible – Citigroup

Last question, as far as a year ago you guys talked about new opportunities to grow between value-added, analytics and then more generalized outsourcing. Is there any one of those areas that you feel is less important today than it was a year ago? In other words, are you honing in on a new strategic area?

Jimmy Lipham

I don't know that we would be willing to talk about a new strategic area today, but certainly those are still important. One thing I did want to mention was the fact that when you talk about J.P. Morgan Chase, that we are keeping their commercial card business, which they are very large in that business. Bank of America, we'll continue to do their merchant acquiring business and their commercial card business. As we've talked about earlier, our commercial card business has about a 90% market share of the branded VISA and MasterCard in the U.S., and we are being very aggressive with that and starting to push on that internationally.

We still would like to increase our footprint in the merchant business. We would like to be able to carry that to Canada. You heard me talk about, we believe that in the second quarter, we'll announce something in Europe, which will be a watershed event for us.

Data Analytics, we are making progress there. We have a group of about 25 to 30 people that are just really laser focused on that, if you will, and we think it's a very hot product and something that is going to sell very well.

We continue to look for value-added products. As I mentioned earlier, our loyalty business has really been drinking out of a fire hose with the addition of several very large clients. Profit, which is our GUI front-end customer service management system, is doing much better, and we've continued to open that up and add new clients. So we feel very good about some of these strategic areas. We would like to do a couple of acquisitions that seem to fit in that make sense and we have our eye on a couple. Whether or not that will work out or not, certainly as you know, only time will tell.

Tony Wible – Citigroup

Actually, I wanted to throw one more in, which is I'm encouraged to hear that it sounds like J.P. Morgan will be a nonevent from the bottom line. What expenses should we anticipate offsetting the drop in revenue? Should it be across the board, or will it be one of the line items that will carry a little bit more of the weight?

Phil Tomlinson

Jimmy can answer that, but the let me state that those guys leaving is a big event to me, and I'm the eternal optimist. I don't expect them to walk in here next week and say we've changed our mind, but you never know what might happen. We do expect them to leave and we're planning on that, and we have always said that you should plan on that.

Jimmy Lipham

I think that obviously the bigger drop is going to come in equipment when it happens, and the operating capacities with the drop in [WIPS] and disk drives and this type of thing that we have. Like Phil said earlier, it has been planned, but that is the line item you will probably see the most drop in expense.

Phil Tomlinson

We have a schedule for moving the people out of that operation. It is very detailed and it is moving forward on track.

Tony Wible – Citigroup

Thank you very much guys.

Operator

Your next question comes from Craig Maurer – Soleil Securities.

Craig Maurer – Soleil Securities

Two questions for you. First, you were discussing the continued negotiations with some very large players in the States, and I was wondering if you could characterize what is being discussed these days? Is it still strictly a pricing issue, or are there other factors going into these decisions these days, as I'm sure it's basically TSYS versus FTC in these discussions.

The second question is just a quick housekeeping question of whether or not the Capital One portfolio conversion was fully completed in the fourth quarter. Thanks.

Phil Tomlinson

I think obviously, when I say that we're having discussions, they would obviously be the traditional type of discussions. I will say this: we have had some discussions here over the past year with different prospective clients that indicate that people might be looking for additional services that frankly we don't offer it this time. We have some questions internally as to whether we want to try to get into some of those businesses. I'm not going to get into that because I think it is too sensitive at this point.

But certainly on the core services, as I said earlier, price is always a big issue. The functionality, the feature, the service levels, the service agreements, the timeliness, the conversion, can you convert, can you do it without putting me out of business. I think if you talk to Cap One or Toronto Dominion or anybody else we have converted, they will tell you, while it is not a non-event if it is done right it can be done very, very well and nobody gets hurt in the process.

So a lot of the very traditional things we'll continue to talk about, and that certainly being price and core functionality. We continue to try to enhance our value-added products and make sure that we have something extra to give. We are looking hard at what enhancements we need to be putting into TS2 and our other software products and what other investments we need to be making to ensure that we win in this business.

Craig Maurer – Soleil Securities

Thank you. And the Capital One question?

Jimmy Lipham

Substantially completed, in the high 90%.

Craig Maurer – Soleil Securities

Thank you very much guys.

Operator

Your next question comes from David Parker – Merrill Lynch.

David Parker - Merrill Lynch

Just building off some of the prior questions, I was hoping that you would talk about the growth expectations in the U.S. business, ex-B of A in 2006 and then as we move into 2007.

Phil Tomlinson

You have those numbers, Jimmy.

Jimmy Lipham

I don't have it right handy with me, but I know that in the guidance we gave, when you take that termination fee out you're seeing some flat growth in revenues on the U.S. side. I think the addition of Cap One has helped offset the loss of revenues that you saw with Bank of America, and then the other business that we put on with Sears being gone, we are able to go through '07 offsetting what we have lost and getting some growth out of our core business as well. I don't have those numbers right off.

Phil Tomlinson

I don't think, unless we sign somebody of some substance, that you're going to see anything jump off the page at you in 2007.

David Parker - Merrill Lynch

Looking at the accounts on file overall and taking the internal growth of existing customers net to purchase, it looks like growth has fallen down from the high single-digits down to the mid single-digits. Should we expect to model it that way going forward?

Jimmy Lipham

I think our internal growth, as we've said, on the account on file from customers that obviously were here at the end of '05 or they're still here now, is 12.7%. Now you have had the drops for, like Phil mentioned, 130 million accounts for two deconversions, but we were able to pick up a lot because we ended up around 413 million accounts at year end, and that is pretty good growth. I would say going forward that I would still use in the 10% to 12% range on account on file growth.

David Parker - Merrill Lynch

Great. Looking at the merchant acquiring business, it's down again sequentially. I know you gave a number of reasons, but can you just talk about that business? It sounds like transaction growth was positive for the business, but the revenues were down sequentially. You expect it to move back into the positive range going forward? What leads you to be optimistic on that end?

Jimmy Lipham

Well, the lost revenues that we had during the year was, like we said, in the terminal deployment business, which we're getting out of. We've shut the San Diego office. We saw a drop in revenues there, around $25 million for the year. This will not be repeating next year. Like I said before, it's a very low margin business. So we are optimistic about that.

We did have two deconversions this year with mainly the big one being Hartland, and that will be anniversaried. We did have a great conversion this year with [Zurich] Bank and we will pick up some additional revenues this year through that.

Then, just their core growth on volumes. It was a big number. It was up to $22 million, $23 million year over year, so we made vast improvements in our profit margins with the efficiencies we got in transaction delivery fees. Bob and his staff are doing a great job in bringing that thing into a more efficient mode of delivering the service, and so we feel pretty good about it.

Phil Tomlinson

We did have to spend a couple of million dollars out there in Tempe at Total Acquiring to bring them up to SOX compliance, and that won't happen again. We will certainly continue to add to that, but that was a one-time margin expense last year.

David Parker - Merrill Lynch

What are your expectations for earnings in the first quarter and specifically your expectations for the expense run rate as we move into the first quarter and move past the B of A deconversion?

Jimmy Lipham

I don't really have the quarter numbers out here in front of me, but I would just have to say we'll get back with you on it.

David Parker - Merrill Lynch

Should we expect the usual ramp through the year, with the first quarter being the lowest quarter and the back end more?

Jimmy Lipham

You're obviously going to have fourth quarter be down because of this termination fee, but you will have probably a ramp up during the quarters from first to third, then we will drop off in the fourth quarter because of termination fees. That is the way it's going to shake out.

David Parker - Merrill Lynch

Great, thank you.

Operator

Your next question comes from Jeff Davis - FTN Midwest Research.

Jeff Davis - FTN Midwest Research

Good morning and great quarter and great year, Phil, given all if your challenges. You referenced that processing volumes in North America were up strongly in Europe, and part of that I take it was from new accounts. Is it safe to say from the processing volumes that you all watch week by week that we can conclude that there is not really any slowdown in the consumer economy?

Phil Tomlinson

That is what we would think. We're certainly not the Federal Reserve or anybody, but we may be a little bit closer to the common man out there who is actually spending the money, but we don't see any slowdown.

Jeff Davis - FTN Midwest Research

Great, very good. Thank you.

Operator

Your next question comes from Jeff Harralson - KBW.

Jeff Harralson - KBW

Do you know how much Bank of America revenues and expenses were in 4Q and how much Capital One revenues and expenses were in 4Q?

Phil Tomlinson

We don't give individual numbers on our clients. Now we did publish a chart when the Bank of America announcement was made that really laid out the revenues that they paid us on an annualized basis. Can you recall what that was?

Jimmy Lipham

No, I think I would be guessing.

Phil Tomlinson

Maybe $120 million or something like that, $140 million. We're trying to look that up now. It is in our annual report.

Jeff Harralson - KBW

I can find that, but maybe it's better just to say, what date did the B of A revenues stop flowing into total this quarter, and what date did Capital One revenues begin flowing in?

Phil Tomlinson

Mid-October on both of them.

Jeff Harralson - KBW

Okay, thank you very much.

Operator

(Operator Instructions) Gentlemen, there are no further questions in the queue. Do you have any closing comments you'd like to finish with?

Phil Tomlinson

I do. We do appreciate your questions and your interest and you being on the phone with us this morning. I know you have a lot going on and we appreciate your support and look forward to hearing from you in the future. If you have any follow-up questions, Shawn is available. He's available 24 hours a day, he tells me. So please don't hesitate to call. Thank you for your interest and we look forward to talking to you next quarter.

Operator

Ladies and gentlemen, this does conclude today's conference call.

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Source: TSYS Q4 2006 Earnings Call Transcript