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Global Payments Inc. (NYSE:GPN)

F2Q08 Earnings Call

January 3, 2008 5:00 pm ET

Executives

Jane Elliot - Vice President of Investor Relations

Paul Garcia - Chairman, President and CEO

Jim Kelly - Senior EVP and COO

Joe Hyde - EVP and CFO

Analysts

Tien-Tsin Huang – JP Morgan

Liz Grausam – Goldman Sachs

Andrew Jeffrey - SunTrust Robinson Humphrey

Adam Frisch – UBS

Kartik Mehta – FTN Midwest

Paul Bartolai – Credit Suisse

David Koning - Robert W. Baird

Mark Sproule – Thomas Weisel

Greg Smith – Merrill Lynch

Robert Dodd – Morgan Keegan

Operator

Welcome to Global Payments second quarter fiscal 2008 earnings conference call. (Operator Instructions) At this time, I would like to turn the conference over to your host, Vice President of Investor Relations Jane Elliot. Please go ahead.

Jane Elliot

Thanks, Connie. Good afternoon and welcome to Global Payments fiscal 2008 second quarter conference call. Joining me on the call today are Paul Garcia, Chairman, President and CEO; Jim Kelly, Senior EVP and COO; and Joe Hyde, EVP and CFO.

Before we begin, I would like to remind you that some of the comments made by management during the conference call contain forward-looking statements that involve a number of risks and uncertainties. For these statements, we claim the protection of the safe harbor for forward-looking statements contained inthe Private Securities Litigation Reform Act of 1995.

While these statements reflect our best current judgment, they are subject to risks and uncertainties that could cause actual results to vary, which are discussed in our public releases, including our most recent 10-K. We undertake no obligation to revise any of these statements to reflect future circumstances, or the occurrence of unanticipated events.

In addition, some of the comments made on this call may refer to normalized results which are not in accordance with GAAP. Management believes that normalized results more clearly reflect comparative operating performance. For a full reconciliation of normalized to GAAP results in accordance with Regulation G, please see our press release filed as an exhibit to our Form 8-K dated today, January 3, 2008 which may be located under the investor relations area on our website atwww.GlobalPaymentsInc.com.

Now I would like to introduce Paul Garcia.

Paul Garcia

Thanks, Jane. Good afternoon, everyone and Happy New Year. We are quite pleased with our second quarter results. For the second quarter, our revenue grew 18% to $308.8 million and our normalized diluted earnings per share grew 14% to $0.48.

Our growth was driven by solid performance in our merchant services segment, while our money transfer segment continued to be impacted by lower year-over-year pricing, both of which I will discuss in just a moment.

Starting with our merchant segment, our ISOs continued to drive strong organic growth in our domestic direct channel. We continued to have success in retaining our customers and in signing new ones, including two new ISOs signed inthe past quarter.

Our credit and debit card transactions grew 28% for the quarter, with revenue growth of 25%. Due to the continued success of our ISO channel, we are raising our expectation for fiscal ’08 revenue growth to thelow 20% range for our domestic direct channel.

In Canada, I am very pleased with the long-term merchant referral agreement with HSBC that we signed and announced during the quarter. This agreement demonstrates our continued success in this market. For the quarter, our Canadian credit and debit card transactions grew 4%, while our revenue grew 20%, driven largely by a favorable Canadian currency exchange rate.

While we anticipate a continued year-over-year currency benefit for the remainder of this fiscal year, our third quarter revenue growth for this channel is expected to bein thelow double-digit percentage range.

This expected growth is lower than our second quarter growth, primarily due to non-recurring card association incentive revenue realized during our fiscal ’07 third quarter. For fiscal ’08, we are raising our revenue growth expectation to thelow to mid-teen range for our Canadian channel.

Our Asia Pacific channel had strong revenue growth of 24% for the quarter. Due to these results, we are increasing our expectation for fiscal ’08 revenue growth for this channel to 33% to 40% on a reported basis; or, thelow to high teen percentage range on a pro forma basis. This growth reflects solid momentum gains from our continued sales initiatives and investments, and a positive turn in our revenue growth from Taiwan, as previously anticipated.

We continued to make operational progress on our goal to be fully converted from HSBC’s back and front end systems platform by calendar 2010. As of today, we have converted both the Macau and Hong Kong back end platforms onto our U.S.-based platform.

Our Central and Eastern European merchant channel had revenue growth of 7% inthe second quarter, with growth in credit and debit card transactions of 10%. Our revenue growth was primarily driven by a favorable year over year Chec currency exchange rate; the impact of our November 2006 Diginet acquisition; and, importantly, solid transaction growth. This growth was partially offset by a deconversion of the previously discussed large customer, and to a lesser extent, price reductions granted on contract renewals.

We continue to expect this deconversion to have a mid single-digit unfavorable impact on our fiscal ’08 revenue growth in this channel. Based on the continued strong Chec currency exchange rate, we are raising our fiscal ’08 revenue growth expectations to the high single-digit to low teen percentage range.

Our domestic, indirect and other revenue declined 7% during the quarter, but as anticipated, primarily due to industry consolidation. We expect a fiscal ’08 revenue decline in the mid single-digit to high single-digit percentage range for domestic, indirect and other.

Moving on to our money transfer segment, inthe U.S. our transactions grew 8% for the quarter, while our revenue declined 5%, which reflects the continuing impact of a competitive domestic pricing environment. Transaction growth was driven by same-store sales growth and branch expansion compared to the prior year.

We ended the quarter with 879 domestic branches compared to 855 locations last year. During the second quarter, we closed a number of unprofitable domestic branches, which caused a sequential decline compared to the first quarter of this year.

In Europe, we ended the quarter with 71 branches compared to 53 locations last year. For the quarter, we achieved 39% transaction growth and 48% revenue growth in this channel. We continue to expect the second half of fiscal ’08 to benefit from the anniversarying of last year’s domestic pricing trends; although this benefit will be less than we previously anticipated, given the continued concerns over immigration domestically, and the sharp decline in new home construction.

For fiscal ’08, we anticipate money transfer segment revenue growth in the mid to high single-digit percentage range.

I will now ask Joe to further discuss our financial results.

Joe Hyde

Thank you, Paul. Our merchant services segment operating margin was 25.9% for the quarter, which reflects a decline compared to last year, primarily due to the continued high growth in our lower margin ISO channel; the ongoing impact of investments in our Asia Pacific channel; the customer deconversion in Europe; and duplicate expenses in connection with our facility consolidation plan.

Additionally, our check guarantee channel experienced higher than expected losses toward the end of the quarter due to higher loss rates coupled with lower collection rates, which we believe is related to the current economic environment.

Although this trend did not have a meaningful impact on our second quarter earnings growth, we anticipate a relatively larger impact on our third quarter growth, especially due to strong collection rates achieved during the third quarter of fiscal ’07.

Our merchant services margin was favorably impacted during the quarter by credits we received from a card association and from our domestic health insurance carrier, both of which related to prior overbillings of certain fees.

Lastly, due to strengthened foreign currencies compared to the U.S. dollar, we received a benefit during the quarter of $11 million in revenue and $0.04 in diluted earnings per share, most of which relates to our merchant services segment.

Looking ahead for this segment, we expect a merchant services operating margin of between 25.1% and 25.4% for fiscal ’08. For the third quarter, we are expecting our merchant services operating income dollar growth to range from alow single-digit percentage decline to alow single-digit percentage increase, primarily due to the non-recurring card association incentive revenues realized during our fiscal ’07 third quarter.

Due to the non-recurring nature of this impact, however, we expect a return to stronger growth in our fourth quarter. To a lesser extent, we also expect our third quarter earnings growth will be impacted by our year over year check guarantee results as previously discussed.

In addition, due to the timing of certain HSBC interchange pricing adjustments last year in our Asia Pacific channel, we expect a modest headwind in our current year third quarter and a similar tailwind in our current year fourth quarter. Lastly, we are also expecting a positive impact in our fourth quarter from anticipated changes in the Canadian market interchange structure.

As a result of these factors, we are expecting third quarter diluted EPS of between $0.39 and $0.42, and fourth quarter diluted EPS of between $0.48 and $0.52.

Moving to money transfer, this segment’s operating margin was 3.6% for the current quarter, which reflects a significant decline compared to the prior year, primarily due to the factors that Paul discussed, combined with our branch-based, high fixed cost model.

For fiscal ’08, we are expecting a money transfer operating margin ina mid to high single-digit percentage range. Our corporate expenses increased 4% during the quarter, and we continue to expect fiscal ’08 expense growth ranging from zero to growth in thelow single-digits.

During the quarter, we completed the facility consolidation plan that we announced in March 2007 and incurred a modest amount of related restructuring charges.

Based on our segment guidance, we expect a fiscal ’08 total company operating margin of 18.8% to 19.1% compared to a normalized fiscal ’07 operating margin of 20.8%. These amounts include the impact of stock option expenses in both years, but exclude the impact of restructuring and other charges.

Moving now to our non-operating line items, we expect $12 million to $14 million in income from the net of our interest and other income, and interest and other expense during fiscal ’08.

Also for fiscal ’08, we expect minority interest net of tax of $8 million to $10 million and an effective tax rate of between 33.5% and 34%. Lastly, we expect average diluted shares outstanding for the fiscal year to bein the range of $80.8 million to $81.5 million.

During the quarter, we completed $19 million in open market share repurchases atan average price of $40.09 per share, including commissions paid. Capital spending for the quarter was $13 million, which primarily related to technology spending, including for our new G2 platform inthe U.S., in addition to merchant terminal spending and our facility consolidation plan.

For fiscal ’08, we continue to expect capital expenditures of $40 million to $50 million. The $9 million on our business acquisitions line for the quarter primarily represented our Discover merchant portfolio acquisition, money transfer branch acquisitions, as well as a customer list and long-term merchant referral agreement in our Canadian channel.

Moving to the balance sheet, our reported cash increased due to strong cash flow generated during the quarter, which included $52 million related to settlement processing. The majority of this $52 million relates to temporary timing differences, partially due to our Hong Kong back end system conversion. These timing differences will likely reverse during the second half of fiscal ’08.

As previously discussed, our cash balances include amounts that we hold related to merchant reserve funds which totaled $127 million atthe end of the second quarter. This reflected an increase of $15 million compared to the end of the first quarter, primarily due to our Hong Kong back end system conversion. Prior to this conversion, HSBC was holding this cash on its balance sheet in connection with our transition services agreement.

In addition to merchant-related reserve funds, our cash balances include other forms of operating cash that is either needed to manage our business or that reflect timing differences such as cash in our money transfer branches or cash related to settlement processing. The remaining non-operating cash that is available for acquisitions, share repurchases or other strategic initiatives was approximately $130 million atthe end of the second quarter. Our primary strategy for this excess cash is to focus on seeking new acquisitions which we believe represents the highest potential return for our shareholders.

Paul will now discuss our fiscal ’08 guidance.

Paul Garcia

Thanks, Joe. Based on current trends and our ongoing growth strategy, we are raising our revenue guidance for fiscal 2008 to a range of $1.231 billion to $1.257 billion, or approximately 16% to 18% growth over $1.062 billion.

We are also raising our fiscal ’08 diluted EPS guidance to a range of $1.89 to $1.96, reflecting 7% to 11% growth over our fiscal 2007 normalized diluted EPS of $1.77. This guidance includes stock option expense but does not include any other significant acquisitions or potential restructuring and other charges.

When I consider the long-term growth prospects of Global Payments, particularly the emerging Asian and Central European markets, and the strength of our ISO channel, I continue to be very optimistic about our future.

Operator, we will now go to questions.

Question-and-Answer Session

Operator

Your first question comes from Tien-Tsin Huang – JP Morgan.

Tien-Tsin Huang – JP Morgan

Happy New Year. Let’s drill down on money transfer, the 4% operating margin was a bit of a surprise. It looks like the implied operating expenses there actually climbed a little bit sequentially. I am just trying to better understand what drove thechange. Was that commission pressure? Were there some branch closing costs there as well?

Joe Hyde

I think most of it, because the model is different than the Asian model where transaction growth rates work to our favor, as the rates of growth have slowed from years prior and we have remained competitive on pricing has a bigger impact on the bottom line, we did close a few more branches – or a lot more branches – than we would have historically.

If anything, we have been reducing expenses, not increasing expenses so this is really a pricing issue in the market, coupled with the factors that Paul outlined in his comments.

Tien-Tsin Huang – JP Morgan

So how has pricing competitively changed here over the last quarter or so?

Jim Kelly

I think over the quarter there hasn’t been as dramatic achange. As we have said on previous calls, we had a large change December prior so we are through that large increase, but as Joe said in his comments, the outlook for the business continues to be uncertain as it relates to the overall market, because pricing continues to bea pressure because of immigration issues together with construction and other factors that again, Paul mentioned.

I wouldn’t say that it has stabilized. I would say that it has slowed in terms of declines, but it has not abated entirely.

Tien-Tsin Huang – JP Morgan

I had a couple of questions on the broader income statement. First, thecost of service line was flat sequentially which was obviously a positive surprise. Any one-time items there worth calling out?

Joe Hyde

Other than the couple of credits that I talked about that we received inthe quarter that would have helped that line, but I think the biggest impact was in the second quarter it grew 10%; in the first quarter it had grown 18%; the biggest difference there is the annualization of the Asia Pacific acquisition, which is heavily concentrated incost of service.

Other than that, there is really nothing else driving that.

Tien-Tsin Huang – JP Morgan

Check and gaming, I am assuming that is in that line as well, did you call out the dollar amount? Also, can you just remind us how big your check and gaming business is inthe aggregate and how that is growing, and how the margins compare to the greater firm average?

Jim Kelly

I will start with your last question first. The check and gaming business is not something that we have broken out. It is a smaller part of our business, it is less than 10% of our revenue. We mention it now because the losses have gotten a little bit higher and it probably will cause a growth impact in the third quarter because the third quarter last year was just an unusually strong quarter; I actually mentioned itin my comments on last year’s third quarter call.

The margin on the business is very good, but it is a type of a business where the revenue kind of stays the same and the earnings is dictated by the success of your collections. Our collections have not been as successful as we have been, and the margin lowers as a result.

We are attempting to manage the situation, go back to some of the merchants that we have and look for higher pricing to compensate ourselves for the lower risk, but it is hard to do that quickly.

Joe Hyde

Just to comment on the revenue side, I think as we have announced inthe gaming in particular we have had a number of strong signings of the growth rates both for the credit card, cash advances, together with the check cash advance business which together comprise our gaming business are doing well from a revenue standpoint and we view this as really a cyclical issue for the economy more than anything else.

Tien-Tsin Huang – JP Morgan

Any way just to quickly quantify the dollar exposure on the potential losses on the check guarantee side?

Jim Kelly

It is not like a reserve that is sitting out there inthe conventional sense of a credit card balance; these are losses that come from, as Joe said, we guarantee checks and if the checks bounce we collect the checks and we provide a reserve in the event that we don’t collect the check. Those rates of collection improve and decline, and they have for the last ten years and they will continue to. This is more of an anomaly than a trend.

Operator

Your next question comes from Liz Grausam – Goldman Sachs.

Liz Grausam – Goldman Sachs

Some questions on the overall merchant services margin. A little bit surprised to see you bring down the expectations for the margin for that group overall from your previous guidance, given how much strength you are seeing on your revenue line and given how much currency benefit you had out in Canada. If you could walk us through, how much of it is the business mix is changing the margin profile of that business? How it is you think about potentially reinvesting some of the gains that you get from currency and managing the margin in that business? And, give us some perspective on where you see that directionally moving, if you can, into ’09?

Joe Hyde

Well in terms of the margin guidance for the year, some of the decline or the pull back from our guidance that we had inthe first quarter was due to just stronger ISO growth, more ISO revenue; the ISOs continued to do very well and that creates more earnings, but ithas an impact on the margin.

The check guarantee losses, as we talked about, was not something that I was anticipating as of the first quarter and that had an impact on the margin.

We are still investing internationally in both Europe and inAsia and that also has an impact on the margin.

Lastly, the facility planned consolidation, we took a little bit higher duplicate expenses inthe course of integrating the two facilities that we had there, and that hasa temporary impact on the margins as well.

I don’t think we arein a position or are just not ready to go into fiscal ’09 guidance. Obviously our intent is to continue to invest internationally and get some gains from those investments; the ISO channel will likely continue to grow and likely will cause some level of margin impact there, but as we get closer to the year we will talk more about that.

Liz Grausam – Goldman Sachs

On your money transfer business, obviously a drag to growth and a drag to the overall firm’s margin and profitability. Is there any inflection point that you see on the horizon? It sounds like you are going to anniversary some pricing changes. Has the underperformance and greater cyclicality of this business brought you to think about more strategic options for this business going forward or are you still fairly committed to the money transfer segment?

Paul Garcia

Let me tackle that one, Liz. We are not pleased with the performance. I mean, 8% transaction growth in this environment domestically is actually not bad. We are quite pleased with our performance inEurope, but overall you are right; it is a drag, particularly on the earnings and the anemic margins we had inthe business clearly hurt us overall.

This was a business that was accretive to our growth rate and produced excellent margins, so this has been a steady deterioration and I think we all know the reasons. Does that result in us doing something with this asset? I think we look at every single asset we have and it is our responsibility to make those decisions. I am not prepared to say anything at this point. We continue to be committed to the management team there, I think they are very smart. I think we still have the best product out there – truly the best product out there – but I would be disingenuous to tell you I am pleased with the results. I am not. It is an active discussion.

Operator

Your next question comes from Andrew Jeffrey - SunTrust Robinson Humphrey.

Andrew Jeffrey - SunTrust Robinson Humphrey

Paul, could you talk a little bit more about Asia, both from a revenue growth standpoint and from an ongoing investment standpoint? Obviously you had a very strong quarter, the guidance you gave for the full year implies not as comparably robust a second half. Maybe you could touch on that.

Then I think in past discussions you have talked about ’08 as being the focal point of your investment inAsia. Is it right to think about the margins expanding as we move our way into ’09, without getting into specific guidance issues there?

Paul Garcia

Andrew, I would say we are clearly running this business for growth, not for margin expansion at this point. While I have said publicly and I will be happy to say again that ultimately I think the Asian business produces accretive margins, and I will stick to that. It is going to be along time. I would think it would be not wise to think we are going to expand these margins aggressively getting into fiscal ’09. It is a longer investment cycle; we are just starting to make some serious investments in Mainland China. Having just come back and seeing that firsthand, it is going to be a while before those investments pay off.

That is one of the reasons that Joe pointed to for deteriorating margin inthe merchant services segment and some of the guidance you are seeing that we are giving going forward.

I would say stay tuned on that. I am very bullish on where that growth is going. I think there area couple gives and takes right now; we are still ridding ourselves of some merchants and that is why you are seeing a little lumpiness in some of the growth, unprofitable merchants are having an impact on some of the revenues, but overall I am very bullish on that and I think you will see some margins. I am just not going to be pinned down right now as to when we will see that expansion.

Andrew Jeffrey - SunTrust Robinson Humphrey

As far as the second half revenue growth is concerned, is the implication that there were some non-recurring revenue benefits inthe second quarter?

Joe Hyde

In Asia, the comment that I made was – well, in the second quarter we did have a small amount of card association incentive revenue that provided a bit of a lift.

Paul Garcia

I think he was unclear as to – Andrew, I think the answer to the question is that you were unclear about why it looks like there is some revenue moving around. It wasn’t, as Joe talked about, headwinds and tailwinds inthe third quarter and the fourth quarter. There were some interchange adjustments as this thing settles in; there were some bucketing issues that we are dealing with.

Joe Hyde

Right. Inthe course of the transition services agreement for HSBC there was some variability inthe interchange that was applied to the business in the third and fourth quarter. Essentially the short story is that the third quarter last year was abnormally high; the fourth quarter was abnormally low. So for the Asia Pacific revenue over the next two quarters, you may seea small slowdown inthe third quarter, a tailwind in the fourth quarter; net result for the full year is a non-impact and we just wanted to give you that sensitivity before we got to those two quarters. But it is not a material impact to the total company, it just may play with growth in Asia for the next couple of quarters, that’s all.

Paul Garcia

One of the things around my favorite subject, Asia, I believe that we are better – this is a strong statement – I think we are better positioned in Asia and China in particular than anyone, truly. We have more of an infrastructure already, we have more of a focus and quite frankly although it is small because of the nature of the beast, I think we probably have a larger portfolio than anybody. Soit is a great business.

Andrew Jeffrey - SunTrust Robinson Humphrey

The domestic merchant business, where you clearly continue to take share, any changes in the competitive environment? Any pricing concessions on these two new ISOs you signed in the quarter? Or are we just seeing the over-execution or out-performance of your book of business?

Paul Garcia

I think it is two things happening. You have the latter; you have our big ISOs, our whole ISO portfolio but primarily driven by our big ISOs, continuing to just go from strength to strength doing extremely well, with a lot of aggressive things they are doing like free terminals, etc. These are very entrepreneurial managers and they are doing a great job.

The two ISOs that we signed, quite frankly, are smaller so they would actually not enjoy the full rate that the bigger guys do. So although they have very competitive rates, our ISOs, the larger they become, the better the rates they enjoy.

So there is a bit of a pressure always as your ISOs grow, but then you offset that with new ISOs, quite frankly at a higher rate until they produce those kind of volumes. It is producing a nice end result.

Operator

Your next question comes from Adam Frisch – UBS.

Adam Frisch – UBS

I wanted to make sure we have the right picture on the merchant side. Obviously check is causing a little bit of volatility with the margins, if it is a quarter here and a quarter there fine, it is no big deal; but I wanted to just make sure on the merchant processing business, which is the business that everyone focuses on because it is your largest, that the formula or the way of thinking is still the same; the U.S. is fairly stable and growing, and you are investing in Europe and Asia who will eventually become more profitable with better growth in future years.

Has anything changed from that general formula?

Paul Garcia

Adam, I couldn’t have said it better. That is exactly what the story is. We have solid growth with a lot of visibility domestically; we have solid opportunities inAsiain Europe; we are ina significant investment mode in both of those. When we say domestically, I really should sayNorth America because we are referring to Canada as well. So that is exactly the story.

Adam Frisch – UBS

And the margin on the U.S. business, fairly stable from the last couple of quarters to where we are looking going forward? Nothing haschanged there either?

Joe Hyde

No, there is really no bigchange other than what I have highlighted.

Adam Frisch – UBS

And the natural follow up then, if check cashing is causing some volatility on the margin side, we’ve seen First Data get out of the business – or attempt to, at certain points – what are you guys thinking about your check cashing business? Would you consider scaling it down or getting out of it?

Paul Garcia

Adam, we have a couple of different businesses within check; we have our gaming business and that, quite frankly, is doing terrifically; although we are seeing a little uptick there, it is a more collectable amount and really, it is a business that we are committed to.

The guarantee business, which is mostly for smaller merchants and it is just what it implies, it is a guarantee on a check, that business dynamic haschanged dramatically over the last 15 or 20 years and the quality of the check writer today, quite frankly, has deteriorated.

So you are having a scenario where a check guarantee was significantly less expensive than a bank card rate; now they are significantly more expensive than bank card rates because of the whole volatility.

Then when you go through an economy, those riders are typically the ones that are impacted by things like mortgage crises. So that is a business, it is small though. I mean, we haven’t given a huge amount of guidance on that, but it is a very small business to us and it is having some impact, but I would tell you, if the whole thing went bad it is not a major deal here for us.

Adam Frisch – UBS

I just want to make sure, the important parts of the business are the same story. Then I just wanted to focus on interchange for a second. Have there been any material changes there in the last few months or any anticipated in your fiscal second half that could help you on the growth and/or margin side?

Paul Garcia

Now that we area global company, interchange is a pretty complicated subject because you have interchange implications in the EU, you have interchange in Canada, interchange inAsia.

Adam Frisch – UBS

Maybe just focus on theU.S. since that is your biggest market.

Jim Kelly

There were changes, both MasterCard and Visa this past summer, nothing inthe fall but for the spring, at least to date, Visa is talking about some increases on their premium cards, the signature cards; MasterCard hasn’t announced anything as of yet and as well, Discover, now that we arean acquirer for Discover consistent with the Visa/MasterCard structure, there are going to be some changes there as well. They are not anything close to what you saw years prior, but they will have some impact. I think it will be immaterial for this fiscal year.

As Joe mentioned, the Canadian market on the Visa side is going through some pretty substantial changes to align more to a U.S. model than the existing Canadian model, and that will likely have some positive impact.

Paul Garcia

Let medo one follow on, to be clear. I said the whole business could go bad in guarantee, that would bea little bit of an over-statement. What I mean is that the business could experience some significant write-offs as a percentage but because it is a relatively small piece of our business, it wouldn’t have a major impact.

Operator

Your next question comes from Kartik Mehta – FTN Midwest.

Kartik Mehta – FTN Midwest

Paul, I just wanted to make sure I understood some of the comments you have made. I think, Joe, you indicated there were four primary reasons you gave for the merchant margins being a little bit lower: stronger ISO growth, the check guarantee losses, investment internationally and I think facility consolidations is what you said.

If I understand right, you had already anticipated investment internationally in facility consolidation, and after hearing your thoughts on the check business, Paul, it seems like the reason the margins are going to bea little bit less than you anticipate is just because the ISOs have been really strong and that would bethe primary reason. Would that be correct, Paul?

Paul Garcia

That is the primary reason. If we had to list them in terms of 1, 2, 3, 4 then ISOs is the primary reason. But as it relates to the facility consolidation, there were expectations of duration, we would complete it and it ran an extra month or so longer than we had originally planned. A host of reasons that have a period expense which would have been higher than what Joe would have originally expected.

Kartik Mehta – FTN Midwest

Would that bethe second then, Joe, the second biggest reason?

Joe Hyde

I don’t know that I can rank it, Kartik –

Paul Garcia

That was a slippery slope I started there, sorry.

Joe Hyde

I would say that it wasn’t – while we forecast, we all have expectations. Sometimes we meet them, and sometimes we were late. We were more focused on the service side of our customers and making sure that it was a smooth conversion, and that is why it ended up running a little higher in terms of expense than we had planned, but I don’t think it would be easy to rank them all just here on the phone.

Jim Kelly

Far and away the largest year over year impact is the ISOs, far and away the largest.

Kartik Mehta – FTN Midwest

Just to understand the guarantee business, I think, Jim, you said this is not an anomaly, the losses. The losses you have already incurred, does that mean inthe coming quarters you could recover those and they will bea positive and this is just somewhat of a temporary loss on the guarantee side of the business?

Jim Kelly

My comment, Kartik, relative to an anomaly is that this will occur from time to time. We record losses based on a historical rate of collections. When those collection rates decline we increase the loss rate that we record in the income statement. I don’t anticipate that we are going to collect at a higher rate inthe next quarter to offset what we have just charged off, largely because the economy has turned and businesses like the check guarantee business are going to feel that.

Paul Garcia

One of the reactions we do have, instead of – and there was a question earlier about are we going to get of the business, or if we were to do something – what we can doin the guarantee side which, quite frankly, we dodo and sometimes it does result in customer loss, is that we approach customers and raise the rates, sometimes dramatically, if you have been experiencing X loss factor and now it is X plus Y, we factor that in and go back to the merchant. They either accept that increase or we no longer provide the service.

Kartik Mehta – FTN Midwest

A final question, Paul. You’ve talked about the gaming business and it is doing well. Obviously abig competitor of yours had some issues here; another competitor is trying to get out of the business. Does that provide opportunity for you to increase market share, or is the market so competitive that might not necessarily bethe case?

Paul Garcia

We actually are picking up some customers. We have been successfully competing for some time, but I think our biggest competitor having some issues is not something that we have been reveling in by any stretch of the imagination, but where that offers market opportunities we will take advantage of them. Quite frankly, we have signed a couple of notable customers recently.

Operator

Your next question comes from Paul Bartolai – Credit Suisse.

Paul Bartolai – Credit Suisse

Thanks and good afternoon. We have talked a bit about the benefits that you received in the quarter. Any chance, given we have an issue with year-over-year comp coming up in 3Q, could we maybe quantify some of the benefits you received in 2Q of this year from the credits you received?

Joe Hyde

They are not large enough to go through one by one and try to quantify it. The point there was only to let you know that they are out there. I think the biggest year-over-year impact is the Canadian Card Association incentives that we got inthe third quarter of last year. I have spoken about ita few times over the past 12 months. It was a multimillion dollar revenue and earnings impact, as I said on the last quarter call. Out of respect for the card association and just for competitive reasons, we are not able to quantify that.

One of the credits we got was actually from a card association and we would prefer not to quantify that. I would like us to do that, but we are just not prepared to break that out at this time.

Paul Bartolai – Credit Suisse

But what about in 2Q of this year? The benefits that you received, any chance you could – I mean not even one by one, but maybe just in aggregate so we could get some magnitude of the impact?

Joe Hyde

No, we are just not prepared to break that out at this time.

Paul Bartolai – Credit Suisse

We have talked a little bit about the check business. Maybe if we could just go a little bit broader and talk about the macro impact in general. It certainly seems like the economy is something that could impact the check business and maybe some of the other businesses over the next few quarters. Any comments on what you are seeing in the business in terms of the macro outlook?

Joe Hyde

We are talking about the U.S. macro outlook?

Paul Bartolai – Credit Suisse

Any change you are seeing in spending habits, volumes or anything like that?

Joe Hyde

Aside from the check business itself, I wouldn’t say that we’ve seen a big impact. Our December was strong growth; it wasn’t as strong as November so maybe we were off just a little bit there. But it is only January 3 and we haven’t reviewed the full set of reports for the month. I am not seeing any major impact or new trend in our domestic business as a result of the economic environment.

Paul Garcia

Paul, let me repeat that because I think that is an important point. We did seea pretty blockbuster Thanksgiving period, and we did have a good Christmas, but not to that level. So we are kind of seeing what you are reading about, a little bit of a consumer slowdown. Still, because there is a lot of conversion from cash and check into credit we are still getting that uplift, and the growth was still really, really good. It was just really good around Thanksgiving and not as strong in December.

Paul Bartolai – Credit Suisse

Okay, great. Then just a last question, I think we’ve beaten this to a dead horse but I am going to do ita little bit more anyway. When you look atthe merchant margins, I understand some of the impacts and there are some give and takes. Just given some of the strong volumes you are seeing and the currency benefit, I am still a little bit surprised at the lowering of the merchant margins. You even mentioned that the gaming business is not that significant. Has anything else changed in the base business? Specifically theU.S. merchant business from when you gave guidance atthe beginning of the year?

It just seemed that with currency and some of the strong volumes, we are not seeing maybe as much leverage as we’ve seen inthe past in that business.

Joe Hyde

Again, the ISOs continued to grow very strong and as they grow strong the margin is impacted by that growth. The non-ISO aspect of the business is actually improved over levels that we had seen in ’07. We are getting a modest amount of growth from those channels and I hope to see continued growth, but there has been no negative trend on the non-ISO side.

The margin hasn’t moved that much in terms of our guidance, but to the extent that there has been some movement, it is largely for the factors that I have described, which is ISO channel, investments in international, the check guarantee and some higher expenses relating to the integration of that facility.

Operator

Your next question comes from David Koning - Robert W. Baird.

David Koning - Robert W. Baird

A couple more questions on Asia Pacific. Over the last couple of quarters I think you did 20% sequential growth last quarter and about 15% sequential growth this quarter. I know you mentioned some non-recurring items, etc., but that would suggest very strong year-over-year growth if that sort of pace would continue. I am wondering if there is any seasonality to maybe the Q1 or Q2 timeframe and that maybe they are just weaker quarters inthe back half of the year.

Joe Hyde

You are talking in Asia? I don’t think there is a huge amount of seasonality differences. I think there area lot of moving parts and as we are investing in the business, the revenue has accelerated.

I think it would be difficult to take a look atit on a sequential basis. That is not the way that I would look at it, but we just look atit on a year-over-year and how the results are trending. I don’t have a clear answer to your question, I am not sure that there is a pattern there.

David Koning - Robert W. Baird

How many sales reps do you have now in Asia Pacific?

Jim Kelly

We last reported a number, but we have increased that. We have actually decreased a little bit in India as we are trying different models. We are notionally in the 300 range with upticks in some areas and downticks in others.

Quite frankly, as I said earlier, you could double or even triple that sales force. Once we build the proper infrastructure and roll out all of our products and get our conversions done, I think these markets can justify massive numbers.

We have added significantly inChina, for example. We have not added – in fact, actually took some away inIndia and the rest of the markets are pretty stable. Adding a little bit pretty much in every other market, but not significantly.

Operator

Your next question comes from Mark Sproule – Thomas Weisel.

Mark Sproule – Thomas Weisel

Last quarter we talked a little bit about the direct sales force and the improvements that you have started to see there and how that might help out a little bit. How has that progressed over the last quarter? Are you still seeing improvement there?

Joe Hyde

I don’t think there is any notable change from what we said previously. It continues to be very positive, new leadership that came in about 18 months ago has revamped the senior management team and a variety of factors have led to growth year over year, as Phil mentioned in his comments, both through our alliance with Comerica and our core direct business are seeing good growth in the base and good growth in new sales across the board.

Mark Sproule – Thomas Weisel

Is that helping to offset some of the ISO pressure that you are seeing on the margin side?

Paul Garcia

It is.

Joe Hyde

It is, but when you put them into context, we are dealing with – I don’t know exact count – but somewhere close to 100 ISOs all of which touch hundreds, if not thousands, of independent sales representatives as compared to our U.S. sales force which is substantially smaller. So we are ata disadvantage but again, the ISOs are focused on a vertical, on a market namely the smaller merchants where our focus is for mid-market merchants. We try to stay away from each other relative to competition and complement each other. I think we are going to consistently see stronger growth out of ISOs just because we have more of them that we are going to be able to support from a direct sales force, at least at this time.

Mark Sproule – Thomas Weisel

As you sign new ISOs, you said the ISOs that you signed to this quarter were on the smaller side. Are you taking on an increased level of risk associated with the transactions that they are doing, or have you been able to stay away from some of the higher risk type of activities and maintain a lower [tone] there?

Jim Kelly

The new business that we’ve added, either through our direct channels or adding new ISOs, we have not changed our risk profile. We are ever vigilant to stay away from problem areas and any new ISO relationship that we engage goes to the same credit review and they are obligated to follow the same procedures as everybody else.

Mark Sproule – Thomas Weisel

On the check cashing side, maybe I will stay away from the continual discussion of at what point does it get large enough that you separate that out from the other merchant platform businesses. I know you sayit is less than 10%; your money transfer business is roughly 10% anyways. How big does it have to be before you start to separate that out and we can focus in on what the core business is?

Jim Kelly

I think the check business has got a long way, it is not a separate business in the company. Joe and others would make that decision, but I don’t seeit inthe near term.

Paul Garcia

It has got a long way before it is 10%.

Mark Sproule – Thomas Weisel

On your cash situation, obviously you continue to build up a lot of cash. From an acquisition perspective, are you still looking aggressively inthe international arenas? Are you seeing a lot more activity out there? Has the pricing become more normalized and rational versus where we would have been this time last year?

Jim Kelly

In terms of the markets, clearly given First Data going private is going to have an impact on international expansion, as I think most people know. I think there is still expectations of strong pricing internationally; I think that is going to take some time to reset itself. But we seea very, as Paul has said many times, a very strong pipeline and we are optimistic that we will continue to be successful on the international acquisition front as we have been inthe past.

Operator

Your next question comes from Greg Smith – Merrill Lynch.

Greg Smith – Merrill Lynch

Following along on the acquisition commentary, is there any chance you might be looking at anything larger? Obviously we have a couple of public companies facing some issues. Is there any chance you may be shifting and possibly looking ata larger potential acquisition?

Paul Garcia

Wow, Greg, how do I answer that? We look at lots of stuff, and just because something is large or public wouldn’t discourage us as long as the fundamentals made sense. We like doing smaller deals; we like doing deals that are strategic markets or potentially open up new markets to us. That is not to say we wouldn’t consider something. So yes, we are looking at lots of things.

I would tell you though that most of our focus is indeed international, as Jim just alluded to.

Operator

Your next question comes from Robert Dodd – Morgan Keegan.

Robert Dodd – Morgan Keegan

On the Discover portfolio inclusion, I know it is small, but can you give us an idea of what your plans are to market that with your direct sales forces, and also how that is flowing through to your ISOs at this point?

Paul Garcia

Robert, we are just delighted to have done that deal, and the first guy to market with that to the ISO community. It is being marketed exactly the way a Visa MasterCard transaction is, and many times, priced exactly the same way. It is typically bundled to a merchant. So if you area merchant target of our direct salesforce or ISO, we would offer you an all-inclusive product and you would get reporting that was inclusive and a common number to call for any customer service enquiry, funding. I mean, it is truly a product that you could accept and not have to go to any additional amount of work to offer that to your customer.

We are seeing a nice uptick; it is another revenue opportunity for our ISOs, it is a revenue opportunity for our direct sales force and we were able to acquire some of that business that Discover had signed where we had the bank card relationship.

Jim Kelly

In terms of your question on ISO relationships, the program that we put in place and we have previously announced, our four major, largest ISOs have already been converted and are participating in the program. In those cases, we purchased from Discover the merchants that were related to the Visa/MasterCard accounts of those ISOs and then simultaneously turned around and sold them to the ISOs so that they enjoyed the full benefit of not just new business, as Paul described, to sign up as a one-stop shop for statement and merchant contracts and the like, but as well they enjoy the full benefit of pricing for their existing portfolios.

They have been all very pleased with the program and we are anxious to convert the rest of our ISOs and hopefully have that done by the end of this summer.

Robert Dodd – Morgan Keegan

Financially on that, I am trying to quantify in my head and I don’t know if I can figure it out, to be honest, what kind of impact could that have on your margins going forward, as well? Because obviously we are talking about a non-organic increase inthe ISO revenue which is lower margin and will have a depressing effect. Is that going to be material or are you going to give us more indications of that ata later date? Can you give us any hints now?

Joe Hyde

It is all positive, both for our direct business, the spread increase from what we were earning on a card fee versus now atthe full rate, or effectively the full rate, is all positive for the company, even taking into account the purchase price of the portfolio.

As well for the ISOs, we charged a fee for switching the transaction to the ISO, we are now charging them a full end-to-end processing fee so that is also additive. The offset to it are really two factors: one, the ISO margin overall would be relatively consistent for a Discover transaction as a Visa, MasterCard transaction for the ISO so that is a drag on it.

Secondly, Discover while ithas got great opportunity to grow, it is still relatively small inthe marketplace. Soin total, it is not big enough to have an impact. It is all positive, but I don’t think it is going to be that noticeable. But it will help margins across the board.

Robert Dodd – Morgan Keegan

Moving on to Dolex, can you give us any hints on, are you looking at any changes on the pricing model or the commission model, rather? Because obviously any adjustments to pricing at your end, as far as I understand, do not affect the commission payouts so that is where you get a margin hit.

Have you had any discussions with any of your agents or your larger payout agents with regard to achange in pricing at their end?

Joe Hyde

No, the short answer is no. I don’t believe we have had any direct conversations. Many of these relationships are multi-year agreements. I think it is a good point, but those are based on the opportunities within the agreement and as I said earlier, we are considering all opportunities to reduce expenses whether it is at the branch level, at the corporate level or at the settlement level.

Operator

Ladies and gentlemen, this conference will be available for replay starting today at7:30 pm and ending atmidnight on January 18, 2008. If you wish to listen to the replay, please dial 1-800-695-4249. International participants can dial 402-220-0322. This concludes our conference for today. Thank you for your participation. You may now disconnect.

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Source: Global Payments F2Q08 (Qtr End 11/30/07) Earnings Call Transcript
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