Executives
Robert O. Carr – Chairman and Chief Executive Officer
Robert H. B. Baldwin, Jr. – President and Chief Financial Officer
Analysts
David Cooney - Robert W. Baird & Co.
Anurag Rana - Keybanc Capital Markets
Tim Willis – Avondale Partners
Elizabeth Grausam – Goldman Sachs
Tien-tsin Huang - JP Morgan
James Eric Friedman – Susquehanna Financial Group
Thomas McCrohan – Janney Montgomery Scott
Robert Dodd - Morgan Keegan
Sanjay Sakhrani – Keefe Bruyette & Woods, Inc.
Franco Turrinelli - William Blair & Co.
Robert Napoli - Piper Jaffray
Heartland Payment Systems, Inc. (HPY) Q1 2008 Earnings Call May 1, 2008 8:30 AM ET
Operator
Robert H. B. Baldwin, Jr.
Good morning, and thank you, Amber. I would like to welcome everyone to our First Quarter 2008 Earnings Call. Joining us from Chicago is Bob Carr, Chairman and Chief Executive Officer. Today Bob will begin our discussion with an overview of the quarter and then I will return to go through some of the financials in detail.
Before we begin I would like to remind you that some of our discussions may contain statements of a forward-looking nature which represent our management’s beliefs and assumptions concerning future events. Forward-looking statements involve risks, uncertainties, and assumptions that are based on information currently available to us. Actual results may differ materially from those expressed in the forward-looking statements due to many factors. Information concerning these factors is contained in the company’s SEC filings. We undertake no obligation to update any forward-looking statements to reflect events or circumstances that may arise after this call.
Now I would like to turn the call over to Bob Carr, Chairman and Chief Executive Officer.
Robert O. Carr
Thanks, Bob, and good morning everyone. I would like to thank you all for joining us today and for your interest in Heartland.
I am really pleased with the report we have for you today. We reported a record first quarter with net income up 31% and diluted earnings per share up 35%, thanks to continued strong top line growth and improvements in our operating margins. We are driving solid growth in both revenue and earnings and we expect to maintain our momentum while simultaneously investing to achieve our vision of Heartland as a much bigger and better processing business.
For the quarter our processing was up 18.3% to $13.2 billion despite very soft same store sales growth. This strong volume was the primary driver behind the almost 20% increase in net revenue.
Operating income for the quarter was up 36%, largely due to a 210 basis point improvement in our operating margin compared to a year ago.
New business remained active.
New margin installed in the quarter was up 17.4% as we installed 15,061 new merchants. At March 31 we had nearly 166,000 active card and payroll merchants, an increase of 15.1% from a year ago.
Card merchant relationships are up over 14%, while payroll customers are now over 7,000, up nearly 40% from a year ago.
In the first quarter 81% of total transactions were one our proprietary front end HPS exchange, up 10% from this time last year as we continue to transition merchants onto our technology platform. At May [sic March]31 we had a total of 1,191 relationship managers, up 16% in the past year and on pace to achieve our goal of 2,000 relationship managers in the next 4 or 5 years.
As I remarked in this morning’s release, this is the result of a truly outstanding effort in a tough environment and a clear reflection on the enduring strength of our basic value proposition, the leverage created by our technology investments, and the solid contribution from our new growth initiative. We achieved these results while fighting through one of the most challenging economic climates in recent memory.
Despite one of our lowest quarterly same store sales growth rate of 0.6% we still achieved nearly 20% net revenue growth. And we achieved a record first quarter bottom line at the same time that we were absorbing the cost of investing in new growth initiatives that are expected to start contributing to our performance later this year and in 2009.
At the most fundamental level down on the street, our relationship managers continue to win. New margin installed was up over 17% compared to new margin installed in the first quarter of 2007 and represented an all time quarterly record for new margin installed. New margin installed continues to be one of the best indicators of future growth.
We are making good progress penetrating larger merchants and reaping the benefit of their larger volumes and attractive economies. These are not the mega-merchants that we are now pursuing, those will clearly take more time for us. Instead we are signing more merchants in the over-half-million processing volume category and doing so with attractive pricing.
Though competition remains intense our transparent pricing strategy continues to be well received by the merchant community. Since relationship managers are compensated based upon the margin they install, they are equally motivated to maintain pricing discipline. Our strategy has always been to build and strengthen our sales organization as our growth engine and I am pleased to report that our relationship manager headcount is up 16% from a year ago.
In just the first quarter we added 74 new relationship managers, sequential growth that translates into an annualized rate of better than 26%. We are now working hard to hire the right RMs and then to help them succeed by arming them with new products such as payroll and check management and supporting them with the training and other resources they need to grow their portfolio.
Our payroll business continues to enjoy very strong growth. Payroll revenue was up nearly 41% this quarter as we installed over 1,000 new payroll customers. We have made some more progress with our check products from the smaller base.
A couple of quick comments on some other developments during the quarter. We did complete the acquisition of Collective POS, which gives us about $1 billion dollars of annual Canadian processing volume. More importantly, Collective provides a Canadian processing capability for U.S. merchants with locations across the border. Over time we expect to see substantial growth from Collective, especially given impending industry changes driven by the conversion to EMV-compliant technology in the coming years.
Our campus card program is going well, attracting lots of attention at trade shows and seminars across the country. Building on this success, we have joined forces with Crane company to create an end-to-end credit card and cash solution for the vending machine market, what we have called the Heartland Crane Cash Card Solutions. This comprehensive system applies the affordable use of cellular or Ethernet connectivity and local area machine-to-machine networking to provide vending machine credit card acceptance.
We are pleased to announce today our signing of an acquiring agreement with Discover so that going forward we will offer Discover acceptance to our merchants on exactly the same terms as with Visa and Mastercard. We are already well into the development work that will allow us to provide merchants with consolidated processing, payments, and statementing with both American Express and Discover.
Once this work is complete, in the fall, our payment platform will simplify card acceptance across all brands for our merchants. At the same time, our compensation for both American Express and Discover will improve to more closely approximate standard Visa and Mastercard margins.
I would like to now turn the call back over to Bob, who will go through some more of the detail on the financial results before I provide some concluding comments on our outlook.
Robert O. Carr
Thanks, Bob.
From a financial perspective this is a strong quarter. Diluted earnings per share growth of 35% was led by a combination of strong processing volume growth and expanding margins.
Net revenues for the quarter were up nearly 20% driven by an 18.3% increase in processing volume and factor growth in our non-processing revenues. Both revenues and processing volume in the quarter benefited from one extra processing day in 2008 compared to 2007.
Same store sales growth was weak, as we had anticipated, due primarily to our retail segment, which has been lagging overall same store sales growth by about 2.5% for some time, but ran actually about 4% behind in the first quarter.
Restaurant same store sales have also been poor, coming in about 1% below our overall average.
Despite a significant reduction in same store sales growth, card processing was still up 19.2% in the first quarter of 2008.
Meanwhile, a proxy for our pricing success, card net revenue as a percentage of card transaction volume was unchanged from last year’s level.
Total cost of services for the quarter were up 18.8%. Expense leverage for the quarter was centered in customer acquisition costs, which were only up 10.2% from a year ago. Customer acquisition costs tend to be lower during periods of slower same store sales growth and temporarily elevated attrition levels. These factors reduce the income stream from a merchant relationship, which is the basis of how we calculate our buy-out liability. Consequently, as the growth in the income from existing relationships slows, we book lower additions to the buy-out liability, which in turn reduces the customer acquisition cost in that quarter.
General & administrative expenses rose 20.1% this quarter. As our seasonally weakest quarter, G&A has always been a higher percentage of revenue in the first quarter. As Bob mentioned, G&A costs include the planned investments in new growth initiatives that are expected to generate future revenue improvement opportunities as 2008, and particularly 2009, unfold.
Operating income for the quarter was $14.5 million, an increase of 36% from $10.7 million in the first quarter of 2007. The operating margin for the first quarter was $17.7 percent, up 210 basis points from 15.6% in the first quarter of 2007. Operating margins in the quarter reflect the improving efficiency in our processing and servicing cost as a result of our technology investments, as well as the lower growth in customer acquisition costs.
Processing and servicing cost growth was below both revenue and transaction processing volume growth. 81% of total transactions were on exchange, up 10% fro 71% in the first quarter a year ago and a we move more volume onto our proprietary platforms our efficiency improves.
Net income for the quarter was up 31% and fully diluted earnings per share were up 35% to $0.23.
Now let’s turn to our platform balance sheet. GAAP operating cash flow for the quarter was $31.1 million compared to $12.6 million a year ago. However, a good portion of the increase is attributable to growth in our Visa sponsored bank, as we used cash to fund share repurchases and the Collective POS acquisition.
More importantly, management measure of operating cash takes net income, as adjusted for amortization, depreciation, and the other non-cash sources at the top of the operating cash flow statement, and then reduces that figure by signing bonuses and [inaudible] paid. Using this management metric, operating cash grew 80% in the first quarter to $14.6 million from $8.1 million last year.
Capital expenditures for the first quarter were $3.4 million of which $1.1 million was for the construction of our new service center in Jeffersonville, Indiana, and $2.3 million for other investments to strengthen our technology infrastructure. Taking that same management definition of operating cash and reducing it by non-service center capital expenditures, our free cash flow amounted to $12.3 million in the year’s first quarter, up from $5.8 million in the first quarter of 2007.
We also used $10 million for the Collective POS acquisition, $18 million on stock repurchases, and $3.4 million on dividends. As a result of these outflows, we ended the quarter with modestly less cash than at year end.
Our financial position remains strong. At March 31, 2008, we had approximately $32.5 million in cash, no long-term debt, and $154.3 million in stockholders equity.
In light of the challenging economy we see going forward, we are maintaining our guidance for 2008. For this year we expect to achieve net revenue growth of 16%-18%, operating income as a percentage of net revenue up 20%-21%, and our 2008 earnings per share guidance is $1.13-$1.17 per diluted share.
I would like now to return the call to Bob for some closing remarks.
Robert H. B. Baldwin, Jr.
Thanks, Bob. Let me just quickly conclude so we can open the call for questions.
Heartland’s business is strong in what is generally a weak economy. We are bringing in new relationship managers, improving their efficiency, and they are responding by adding record levels of new margin.
We are investing in a variety of growth initiatives, absorbing the cost of these investments, but expect the return to be attractive.
Our business model and our sales model continue to sustain our organic growth levels at net revenue margins which have remained consistent for many years. Unlike ISO processors, our end customer is the merchant who uses our services. Our merchant contracts with us, our bank partners, and Heartland.
Our model continues to be the superior business model for small and mid-size merchants looking for the best price because we have fundamentally eliminated the middle man from our model.
We have been able to deepen our product offerings and increase our systems performance and reliability to deliver improving margins and rapid growth in a truly rotten economy. Our multiple-product strategy is working. We are gaining more and more traction with our expanding sales organization, offering multiple products and expanding into new vertical markets. In short, our plan is working and we are optimistic about our short-term and long-term prospects.
Finally, our Board of Directors has authorized a $0.09 per share first quarter dividend. Together with our ongoing buy-back program, this is further evidence of our commitment to continually build shareholder value.
And with that, we would now like to answer any of your questions.
Question-and-Answer Session
Operator
(Operator Instructions) Your first question comes from David Cooney with Robert W. Baird.
David Cooney - Robert W. Baird & Co.
I guess first of all, you talked a little bit about the economic weakness continuing and a little bit of caution. Is that more on a same store sales basis that you feel a little caution, or caution in signing up new merchants?
Robert O. Carr
Generally, Dave, more of the former, a hair of the latter. Really, it’s driven and new installs don’t make that much of a difference to our this year volume. Most of it is driven by the results of the merchants that we installed prior to this year. Something like 85% of our revenue this year will be from merchants that were installed prior to 2008.
So the biggest concern is the lousy same store sales growth and we just don’t see any signs of, we think that we are in a consumer recession, regardless of what the economists say about the overall economy. And there’s no signs of any pick up. I don’t think it’s deteriorating from the first quarter levels, but March was quite soft.
In terms of new installs, that was a little lower than we were targeting in the 20% area, but just a very little bit and the shortfalls seem to relate, perhaps, mostly to the Easter being in March this year, which seemed to slow down some installs. Remember, we don’t count a merchant until they’re actually up and installed. Even if we have a big backlog, we don’t count that.
So, I guess I would say finally, anecdotally though, we are running into some more merchants who seem to be putting off sales people by saying, “Listen, I’m worried about keeping my doors open, getting customers in here. I don’t have time to worry about my card processing costs.” So that’s very anecdotal but it’s the first time we’ve heard that kind of comment. So it’s certainly not helping on the new install side, either.
David Cooney - Robert W. Baird & Co.
Secondly, was Q1 around where you had expected? Was it in line with what you thought?
Robert O. Carr
It was not a big surprise to us, no. It was pretty much in line with our expectations.
David Cooney - Robert W. Baird & Co.
Is there any way you could break out payroll equipment in general meter revenue?
Robert O. Carr
Yes. If you’ll bear with me just a second. The payroll-related was $3.8 million, up just under 41%, and equipment-related was exactly $6 million, almost 27%.
David Cooney - Robert W. Baird & Co.
How much was general meter?
Robert O. Carr
They’ve sort of been merged into the dematech operation so we don’t have that disaggregated.
Operator
Your next question comes from Anurag Rana with Keybanc.
Anurag Rana - Keybanc Capital Markets
Bob, could you please give us a little more color on your end market in terms of how you saw same store sales and processing volume grow throughout the quarter, if you could go by January, February, March, and maybe what you’re seeing in the second quarter so far.
Robert O. Carr
We really don’t want to get that granular and to see things bouncing around. As we indicated in the call we had relative weakness in retail and restaurants. Stronger areas were actually automotive related, although that includes petroleum, which gasoline prices going up helps. And fast food/convenience was strong. And services was strong. But I can’t get that granular, and we don’t have any results at this point for April.
Anurag Rana - Keybanc Capital Markets
And any additional details on the timing of various investment you are making this year? Should we see G&A costs go up in the coming quarter or is more of a total fourth quarter event? Or maybe it’s already reflected in processing and servicing costs?
Robert O. Carr
G&A was up a little bit versus last year as a percentage, reflecting some of that spent. A little bit our spend got deferred compared to what we were budgeting just because, you know, as you’re pulling things together some of the marketing programs that we had anticipated getting going in the first quarter didn’t happen. So it’s a little more pushed out but we’re not expecting it to explode at all.
What we have indicated, and I think it’s consistent, is that we’re not looking to the G&A line to contribute any positive operating leverage, so we’re expecting it to grow pretty consistently with our top line growth.
Anurag Rana - Keybanc Capital Markets
And lastly, any additional investments for Discover?
Robert O. Carr
That’s part of it. We have been working on the platform, the [inaudible] platform to integrate both American Express and Discover acceptance. We’ve been negotiating the contract with Discover for quite some time and we’re pleased to get it over the finish line.
But the development work has been going on independent of that because we were confident that we were going to reach agreement with Discover and are excited about integrating Discover acceptance into our overall platform.
Timing on that remains, for the fully-consolidated platform, not until the fall just because of the magnitude of the development that has to be done.
Operator
Your next question comes from Tim Willis with Avondale Partners.
Tim Willis – Avondale Partners
A few questions. One just on the topic of Discover and Amex. You had mentioned improved payouts or something alluding to better economics out of those two associations, with now getting these agreements and sort of one point of sale for a merchant. Any way to give us a relative thought about what that might mean for your net revenue yield versus dollar volume process? Is it incremental, is it fairly notable, going forward?
Robert O. Carr
Tim, we don’t count Discover volume in our volume figures right now. So, as we look forward, really when they’re integrated we will start adding the Discover volume to our reported volume and then the Discover net revenue will be reported, of course, as part of our net revenue. And so we wouldn’t expect our net revenue percentage to change dramatically due to the addition of Discover.
When it comes to reporting we’re going to have some interesting challenges on Amex and I frankly haven’t figured that out yet because, as we’ve indicated, there will be a percentage of our merchants that will be on what we call full-margin acceptance, another percentage where we’re going to be servicing the merchants and getting an increased payout from the relationship, but not full economic, and then some merchants that we’ll see their volume but we won’t get any economics off of. And [inaudible] will migrate over time. So I’m really struggling, frankly, with how we’re going to report that and I guess one way to answer that would be I don’t have to figure that out until the fall so I’ve got some time.
But at a fundamental level we’re going to be generating more economic value from American Express and Discover relationships than we have in the past. It’s going to start in 2008 but really pick up speed in 2009.
Tim Willis – Avondale Partners
My second question had to do with net merchant growth. I guess as we go into this part of the economic cycle the questions about merchants’ business failures, start ups, attrition, etc. I think probably become a little bit more prevalent, at least for a period of time. Have you noticed anything within your franchise, even if it’s just particularly hard-hit geographies like California, Florida, etc. where you’re seeing any change in the rate of business failures or business formations?
Robert O. Carr
First, on the formation side, a new store opening up is a very small part of our added margins. For a variety of reasons our sales people have much stronger incentive to go to the successful merchants that have a significant amount of card processing volume and activity rather than somebody who is a start up where you don’t know what the activity is going to be, and there’s a lot that goes into that. So that’s not a driver.
On the other hand, I did take a look at, and I have not done this geographically, overall our merchant count attrition is up by about 1% in the first quarter of this year compared to the first quarter of last year. So it’s a little bit worse, but actually it’s weaker economic activity at the existing merchants, the ones that stay with us, that’s really having more of an impact on us than loosing merchants due to merchant count attrition.
Operator
Your next question comes from Liz Grausam with Gold man Sachs.
Elizabeth Grausam – Goldman Sachs
[inaudible due to poor transmission] weakening trends. How are you thinking about internally, the impact of the fiscal stimulus plan in the U.S. and how it may impact some of the discretionary spending you see in your portfolio, and if you can compare that increasing net effects?
Robert O. Carr
Liz, I didn’t catch the first part of your questions but I think from the second part, it’s pretty clear that you’re asking us to be smarter than we are. We’re in the position, our merchants business will be what it is. We haven’t built into our plan any further weakening in consumers from deep levels, so I guess implicitly we’re assuming that some of the stimulus, if that’s what’s necessary to stop the consumer from weakening further, then I guess we’re incorporating that by default.
But the kind of fine-tuned analytics that you might do to try to guess what the impact of checks coming in a particular period or something is not something we would attempt to do for our business.
Elizabeth Grausam – Goldman Sachs
Another question on the pricing environment and generally in the restaurants where they’re seeing so much pressure from commodities pricing. Has your low price or cost leadership in this industry been even more notable in this environment, are customers really focused on the basic advantage of lowering their cost of payments or the customers may not be interested in moving at all because of so much volatility?
Robert O. Carr
Well, I have heard some anecdotal reports about merchants sort of doing the latter, saying, “I’ve got other things to worry about, not my processing. Other things, in essence, are broken at the store, my card processing isn’t broken, so I’m not going to chance it.” So we’re getting a little bit of pressure there and it’s a little bit tougher. But we feel very good, and witness our growth in margins, you know that’s a pretty nice growth.
And so we think that the offsetting benefit we’re going to get, and we’ll continue to play on the theme, is that we’re going to take out an element of uncertainty in a merchant’s business, we’re going to tell him what it’s going to cost for the processing and then that’s what they’re going to pay.
You wouldn’t believe the number of letters that we’ve gotten copies of from various merchants, from all ranges of acquirers in the current Visa-Mastercard interchange adjustment, where those adjustments in the aggregate add up to well less than a basis point of changes in interchange. And yet where we’ve seen numerous letters from acquirers saying that they’re going to raise their rates 20 basis points, 30, even 40 basis points. And so we think that our approach will that much better received by the merchant marketplace.
Elizabeth Grausam – Goldman Sachs
And just on the campus card program, you mentioned it briefly in the comments. Can you give us any update on the [inaudible] for that and how you feel about your ROI in that business?
Robert O. Carr
It’s really too early to tell about our ROI. We are very pleased with the reaction. We do have a couple of campuses committed to going to our program this summer and we’re working on many, many others but it’s too early to tell. The economics for us are basically increasing our merchant portfolio in the merchant community around the campus and that part has worked very well up to this point, but it’s still too early to tell how significant a part of the business this is going to become.
Operator
Your next question comes from Tien-tsin Huang with JP Morgan.
Tien-tsin Huang - JP Morgan
If you look back at past cycles, how is the growth in new margins style changed in periods of weaker same store sales? At what point does the lower discount rate that you offer to merchants actually overcome the resistance from merchants to change?
Robert O. Carr
The problem is comparability. This is a very different time in the life, or the history, of the card processing business and 6 or 7 years ago, with the smaller recession of 2001-2002, and certainly different than the 1991-1992 experience. And Heartland also is at a different point in its curve in 2001-2002. Of course, we didn’t exist in 1991-1992 and in 2001-2002 we were a much younger and smaller company. So I don’t have any comments on what merchants do in the tougher economy.
We feel very good about the value proposition and the fact is that our sales people are commission-only sales people so they are highly incentived to sign merchants up. And have done, and will continue to do, we think, a great job of that.
Robert H. B. Baldwin, Jr.
Our net revenue margin just hasn’t deteriorated. Everything I read, always in the industry, is about these terrible deteriorating margins, and we just don’t see that. But on the other hand, we don’t raise merchants’ rates just because we can get away with it, or we think we can get away with it.
So I think there’s an invisible hand in our model that our sales people go out and they get a consistent margin and merchants seem to be comfortable with that and we’ve been able to hold that up very well.
I think that as the economy sours that there are just as many merchants that are more interested in going to a known cost factor for their processing as there are merchants who are worried about the door shutting and therefore don’t care what their costs are for processing.
So I think there are some interesting, Bob cited some anecdotal comments, which are true, I’m sure some sales people say that, but on the other hand I think there are other sales people who feel that they have a great opportunity to add business.
And at the end of the day the results speak for themselves. We had a record quarter, despite Easter ending the quarter, we had a record quarter of new margin installed, with the same net revenue dynamics as we’ve had over the past 5 to 10 years.
Tien-tsin Huang - JP Morgan
Agreed. Then I guess, maybe any change in the type or the size of the new merchant. It sounds like you’ve had some success among the larger merchants.
Robert H. B. Baldwin, Jr.
We’ve had some success. Not the mega-merchants but we are moving upstream a little bit. In some sense competition is tougher than ever, and in my experience over the years, there’s always going to be new competitors coming in doing things that don’t make sense to us. And that certainly is happening now and we would be growing even faster if that wasn’t the case.
But I think the market is a great market and we’re in a very good place. I think our model is much more sustainable than the other guy’s model. And time will tell, but I think our results over a long period of time should count for something.
Tien-tsin Huang - JP Morgan
On the Collective POS acquisition, can we get the revenue run rate, the processing run rate . . .?
Robert O. Carr
Tien-tsin, we’re going to keep their metrics pretty minimal in here. You’ll see some details in the Q. We didn’t for example include their, they’re on a billion dollar portfolio year, so we would not include their volume in ours because their piece of the economics is different from ours and they’re more on the ISO model and their percentage of the overall net revenue of a merchant is smaller as a result. And so I don’t put their statistics in.
And you’ll see that it’s a very modest on any of our statistics. I mean, there was only one month for this quarter but it will remain a very modest number for this year.
Operator
Your next question comes from Jamie Friedman with Susquehanna.
James Eric Friedman – Susquehanna Financial Group
I was wondering if you might have any updates as to the contribution by vertical between the retail/restaurant and other?
Robert O. Carr
The contribution in the sense of earnings?
James Eric Friedman – Susquehanna Financial Group
No. Revenue side.
Robert O. Carr
It’s about the same. Our mix of business, you’ll see in the summer months the restaurant will be up to 43% or something of our net revenue from 39%-40%, but it’s pretty stable.
James Eric Friedman – Susquehanna Financial Group
Did the company disclose the revenue contribution from the acquisition in the quarter? You said it was one month.
Robert O. Carr
It’s around $400,000. Of revenue. So it’s a really small number.
James Eric Friedman – Susquehanna Financial Group
Does your revenue guidance for the year still contemplate flat same store sales as it did when you originally gave the guidance?
Robert O. Carr
Yes, it does. 0%-1%, that’s correct.
Operator
Your next question comes from Tom McCrohan with Janney Montgomery.
Thomas McCrohan – Janney Montgomery Scott
Just a follow up on Collective POS. Can you just give us a little sense of what their primary focus is? Anything on the historical growth rate in the last few years. And are there any contingent payments associated with the acquisition?
Robert O. Carr
Let me take the last part first. We own a majority, but not all of the company. The group that’s running it, led by Michael Bach, we’ve set up a potential buy-out of their position that will be higher based on success in driving both revenue growth and earnings growth. So it’s a formula-base where the more they achieve for the business, the higher value we will pay them at some possible future buy-out date and that’s not locked in stone.
We like that model, we always try to create a decision maker that we feel confidence in, give them the economic benefits of making good decisions and then let them run the business. And we’re feeling great about the opportunity there.
The kinds of growth rates for them to get a meaningful buy-out are well north of 20% on both the top and bottom lines. But again, they’re coming from a very small base, they’ve grown themselves. It’s a company that in many ways reminded Bob Carr of what Heartland was back a decade or more ago but it has a long way to go to see great size.
And I would mention, the good news in the Canadian market is that there is going to be a lot of change coming from the move to EMV compliance. Literally every terminal in that country will have to be changed out and so that’s a great opportunity for us, we think, and for them.
But the cliff-side is that the overall Canadian market is a very competitive market in terms of price. It’s tougher to make a buck there than it is here and so that’s going to play into the outcomes, as well.
Thomas McCrohan – Janney Montgomery Scott
And their primary focus of merchant verticals, do they kind of overlap consistently with what you guys have, about 40% restaurants and a smattering of other?
Robert O. Carr
Not at all. I would say they have a much smaller percentage of restaurant. Our restaurant percentage is the result of an extended period of pretty unique focus on that vertical and tremendous success. The are, like many ISOs at their stage of development, really looking for business wherever they can get it. They haven’t had a particular vertical strategy, nor would that be sensible for them.
And I would say their mix of business would be broadly reflective of the broad range of Canadian small businesses. Obviously they have no large, or very few even medium-size merchants in their portfolio.
Thomas McCrohan – Janney Montgomery Scott
And you ownership of this company, was it 100% financed with the $10 million cash you talked about in your prepared remarks?
Robert O. Carr
Yes.
Thomas McCrohan – Janney Montgomery Scott
In your K you guys talked about, not just in your K but publicly, about going after some of the mega-merchants was the term, Bob Carr, that you used. And in the past you’ve talked about processing a $100 million of processing volume and in the recent K you’ve talked about you can up to a billion, so I’m just trying to understand that. Are you focusing an active dialogue with some mega-merchants today, and if you can take us inside your thinking as far as when are we going to start seeing, hopefully, you winning some of these much larger merchants, now that you have a new processing center in Indiana.
Robert H. B. Baldwin, Jr.
I think active discussions is sort of a matter of opinion. We have nothing in our model or our plans for 2008 to have meaningful revenues coming in from mega-merchants. So that’s part of the answer to your question.
We have signed a number of $100+ million accounts that we’re very proud of and they’re going quite well. And we do expect, over time, to handle a few mega-merchants but there is nothing on the immediate horizon.
Robert O. Carr
And the other thing I would add is that we, I think, do a good job of maintaining pricing discipline. We don’t see the point in doing profitless processing for someone. So while, when you go after these larger merchants you cannot get as many basis points in a deal as you can with smaller merchants. Our minimum basis points on a deal came down very modestly from what it was 2, 3, 4 years ago while we were moving to allow sales people to go after these accounts.
And I think that what we’re seeing in the market place is that unless someone puts value on something unique that Heartland brings, if it’s a pure price gain, we’re probably not going to win. But that’s okay. And what we’re focused on is, in particular, working hard on exploiting the inherent advantages of our database-driven processing platform to create better and better information for merchants.
That’s one thing that the larger merchants do appreciate, if you can develop it. It’s not just something you just sort of wake up one day and say, “Oh, here’s a new way of reporting that’s much better.” You have to really work at it and we are doing that. And you work at it with your larger customers who say, “Hey, I’d like to see this or that or the other.” They have ideas that you don’t usually get from smaller merchants in terms of information.
So, as we go along, I think our success in the larger merchants will, to some extent, be driven by the success we have in creating the better information flow. And that’s left up to us to prove. We have done a lot of work, we’re making good progress, but we’ve got a lot more to do.
Operator
Your next question comes from Robert Dodd with Morgan Keegan.
Robert Dodd - Morgan Keegan
Can we go back to same store sales for a moment. On the last call you told us you were running at 2.5% in January. And obviously you were up ½ roughly for the first quarter and a pretty steep deceleration if February, March. Just trying to get an idea whether that’s leveled out or whether that’s continuing. I realize you don’t want to quantify the numbers exactly but anything you could give us qualitatively would be helpful.
Robert O. Carr
Robert, the number bounces around more than you might expect and so month to month, calling it a monthly trend is dangerous. January was the strongest, March was the weakest. We frankly don’t have April at this point. Nothing in April makes me think that it’s going to be, it’s really hard to judge just from the volume numbers which obviously we have at this point, it’s very hard to be more accurate within a couple of percentage points where the same store sales will come in.
So, March was very soft. It did have Easter in it, which is a soft period for us in our portfolio, and so it was not a surprise to us that it was weak.
Robert Dodd - Morgan Keegan
On the Discover relationship, are you required to buy-out the Discover piece of profit from field merchants and can you tell us is more akin to a regular type merchant relationship or are the mix of services and contract levels the same and in the Amex deal?
Robert O. Carr
I might characterize it as we have the opportunity to buy out that. And as it reflects the Discover merchants that are in our portfolio that we’re processing for Visa and Mastercard and that in essence we will be able to buy the net revenue on those merchants going forward and that will be part of our net revenue. And that will happen but will not happen until later this year. That was part of coming up with an approach to that buy-out was part of the negotiation of this deal.
In terms of your other question, I’m a little unclear what you mean there.
Robert Dodd - Morgan Keegan
I think you’ve already answered that. The Amex deal you’ve got full processing, servicing, and then nothing at all as a variety, depending on the type of merchant.
Robert O. Carr
Discover has changed their model to one where with respect to the acquiring industry and the merchant community, except for the top 100 merchants or something, they kept for themselves, they are just like Visa and Mastercard. They will have an interchange rate, they will allow up to mark-up or charge merchants rates based on what we feel the market allows.
In our model where we’re charging interchange plus for Visa and Mastercard, we will put that same margin onto the Discover interchange rates, which are sort of in between Visa’s and Mastercard’s interchange rates, and many fewer buckets. And so we should get substantially identical profitability from the Discover volume going forward as we have on the Visa/Mastercard.
Amex is really quite different. They continue to own the contract, they determine the pricing. We get to this mix with some merchants with a margin of profitability that’s similar to our Visa/Mastercard, other merchants with a lesser margins where we’re just doing the service thing, and then another group of merchants, the larger merchants, where we don’t get any of the economics.
So Discover is really very different from Amex.
Robert Dodd - Morgan Keegan
One final question. Can you give us a little bit more color on some of the new products? Like you mentioned the campus cards, I think we’ve got good information there. But the check processing, how is that going? And then also, I know it’s very early stages in the community card product, but any updates you’ve got there?
Robert H. B. Baldwin, Jr.
On the check products, we have moved to a different platform so that we could expand the offering to be more competitive in the marketplace. We’re happy with where we are there but it’s too early to really declare victory, it’s still a product that we’re still basically testing out, although we’re very optimistic that it’s going to be a great value proposition for customers and therefore successful.
The community card and the campus card marketplace is exciting. The opportunities are vaster than we thought they would be, but it’s also more complicated because of some entrenched technologies that have been out there for a few years that we weren’t planning on competing with.
We’ve learned that we do need to compete with some other folks and it’s going to take a little bit longer but we think the opportunity is even larger for the community card, and the campus card as well.
But right now, we’re still sort of, to use a term, a science project in a sense. And we have built in the development of this product into our budget for this year and we expect it’s going to work, but it’s a little bit of a gamble, frankly.
Operator
Your next question comes from Sanjay Sakhrani with KBW.
Sanjay Sakhrani – Keefe Bruyette & Woods, Inc.
Most of my questions have been asked. But just one more on American Express and Discover. I was just wondering, have you guys actually sized the opportunity among your client base? Is there a demand to accept those cards, just in your analysis of making that type of investment? And then secondly, I just want to make sure, the merchants loss number? I think you gave us the new merchant additions, which was up about 15,000, so that would work to about 10,000 merchants lost?
Robert O. Carr
On the merchant count attrition and how that all plays, there’s lots of by-plays, and we’re trying to get away from that because we’ve seen lots of inaccurate and misleading analyses over time. So I’m going to pass on that merchant loss question.
On the Discover, Discover acceptance is going to be rolled into Visa and Mastercard. 2/3 accepted today and we would expect that substantially all merchants that we sign up going forward will be signed up for Discover as well as Visa and Mastercard. By the way, we would expect that to be for the competition as well. This is an industry-wide phenomenon where Discover has, by switching its model, we think, will move in the direction of the level of acceptance of Visa and Mastercard. Probably quite quickly.
Amex is obviously a much more complex issue because Amex is controlling the pricing, their pricing is higher than is relative for Visa and Mastercard merchants and so there will be merchants that don’t want it and others that do. Heartland has been one of the best of Amex’s ISOs in signing up new merchants for the acceptance of the American Express card. Not shocking in light of both the kind of sales organization that we have, and our focus on the hospitality industry where Amex is quite strong.
We expect that to continue and we think that adding some economics, we have always paid a commission to our sales people for signing up Amex but this new program will provide greater economics to Heartland on an Amex signup, therefore we will provide greater economics to our sales force for signing up Amex and we would expect a higher percentage of our merchants, like last year one in six of our new installs was put on Amex, and we would expect a higher percentage going forward. But we haven’t quantified it.
Operator
Your next question comes from Franco Turrinelli with William Blair & Co.
Franco Turrinelli - William Blair & Co.
Two questions. The first is I think more for Bob Carr. You know, you talked about the G&A expenses going up this year because of several things that needed to be upgraded in the IT infrastructure, particularly in security. Can you just give us an update on the progress of those initatives.
Robert H. B. Baldwin, Jr.
Sure, Franco. The progress is good. We have been making the upgrades. Our CapEx that Bob talked about in his comments is pretty directly related to that. We have beefed up our facility in Houston. But a lot of our G&A expense that we built into our budget for this year is really around this Discover and American Express expansion of our passport platform. We’re very excited about this.
It’s great to be working in an enlightened environment of the card issuing organization, because now a merchant can make a phone call to us and we can answer all their questions about all their cards. Not now, but when this is up and running. And the economics are better for us, as they should be. And Discover and American Express have moved some of their cost over to us, but there’s been a duplication of cost for many years.
We’re not doing a whole lot of things new, but we had to rewrite and add a substantial amount of code to be able to add Discover and American Express settlements and reporting back to the merchant. So that’s a big segment of our G&A overhead this year, which we can’t capitalize, basically, because it’s an ongoing business segment.
It’s sort of updating an existing set of software. So it’s costing us something this year but we think the results are going to show up very nicely in 2009.
Franco Turrinelli - William Blair & Co.
That’s very interesting to me. I think if we rewind back to the fourth quarter and I guess you were not in a position to talk about it at the time, some of these agreements weren’t in place yet, but looking at the trends for the first quarter, I think the sense we had collectively at the time was that the step-up in G&A expense was remediation, in a sense, of some necessary expenses. I think what you’re telling me now is that some of that G&A expense has an associated revenue benefit as well. And I think that’s new, at least to me.
Robert H. B. Baldwin, Jr.
There is a revenue benefit, Franco, but it doesn’t really show up significantly until 2009.
Robert O. Carr
The expenditures in the fourth quarter were heavily in IT, or a big piece were in IT, but that was some specific remediation things. This year’s expenditures are what is going to show a positive benefit up really next year. And then the other expenditure in growth in G&A is a lot more on the marketing side. The campus and community card programs, for example, where we’re putting a lot of resources into building up our visibility in areas where we haven’t had before. And that requires not just a sales effort, which you pay for it as you go, but also a marketing effort to raise your visibility.
But I would really draw a pretty big distinction between the G&A surprise in the fourth quarter, which was heavily one-time related things that related to work that needed to be done but didn’t have future revenue to it. A lot of what we’re doing now that is leading to no leverage or less leverage from the G&A line is because of long-term economic opportunities and we want to invest in them.
Franco Turrinelli - William Blair & Co.
And just one other point. Not to beat a dead horse here, but could you just kind of give us an update on kind of the competitive landscape, not just for merchants, but for quality sales people, and if you’re seeing any change in environment given what’s happening with the network economy.
Robert H. B. Baldwin, Jr.
The competition on the street is intense. There’s been a lot of investment by private equity folks into new ISO models that is not new right now, it’s over the last couple of years they’ve come out and they’re still out there, so I think the competition is as intense as it’s ever been, on the street.
In terms of sales people, we do seem to be attracting some more qualified industry veterans than in recent times, due to some fairly significant lay-offs by some of our competitors. So I think the environment there, Franco, has changed somewhat and improving for us in terms of hiring experienced people. Which also helps us, I think, to compete better for the larger merchants.
Franco Turrinelli - William Blair & Co.
I just want to make sure that I’m thinking about this the right way. If I think about your net processing revenue growth and I exclude the same store sales growth from those numbers and I kind of looked over the past year or so, I just want to make sure I’m looking at this right because it looks like the newly acquired and newly added revenue was stronger in this quarter than we’ve seen for several quarters. Am I thinking about this the right way?
Robert O. Carr
I don’t know. Give me a little bit more, I’m not following you.
Franco Turrinelli - William Blair & Co.
That’s okay, we’ll follow up off line.
Robert O. Carr
I’m not sure, I would say that the average merchant that we’re installing is clearly bigger than the average merchant we were installing a year ago. And that’s measured really in terms of the margin installed for a location.
But maybe we should take it up off line.
Your last question comes from the line of Bob Napoli with Piper Jaffray.
Robert Napoli - Piper Jaffray
Could you quantify for us the amount that you’re expensing in 2008 for adding the American Express and Discover onto your network?
Robert O. Carr
It’s somewhere not miles away from a high-6 figure kind of number.
But we also have, there’s a whole sector of the IT side, then we have the marketing side of rolling out new applications, new terms and conditions. We’ve got the cost of training people in our service center to take on the questions a we’re going to get as we do the servicing for those merchants. There’s a whole host of things that you take on to do it and it’s hard to break it all down. But it’s a significant overall add to the expense line.
Robert Napoli - Piper Jaffray
Canada. Just a question on strategy and the acquisition that you made, it’s an ISO model, and you have a very unique, differentiated model here in the U.S. Is it your plan over the next several years to take the same model into Canada and use that as a base? Would there be other acquisitions you would add on to it or would you want to grow from that base organically and then add your model to their current ISO model?
Robert O. Carr
That’s really to be determined, Bob. Right now it gives us great advantage. We can take care of a U.S. merchant with a Canadian location. For example, General Meters has a number of colleges and universities in Canada that they provide a campus solution for. We didn’t have any answer for any Canadian location because by the Visa and Mastercard rules we did not have an ability to offer services.
How we play going forward, there are going to be a lot of discussions, a lot of development. Collective POS will develop it’s business in ways that make sense to them, consistent with us trying to help them, and they’re already changing some of the ways they do things. We’re also hoping to move them up the food chain, if you will, because we bring some resources that they didn’t have as a stand-alone.
But, at least right now, we don’t have any intention of trying to just walk in and do this the Heartland way. I think you have to be very thoughtful about whenever you go into a different market and say, “Oh, our model is going to work the same in that different market as it does in our home market.” Obviously we think tremendously about our model here in the States, but we’re respectful of the differences in different other countries.
And getting the foothold, getting actual capital up there, seeing the marketplace and then being able to take care of merchants makes it a win already, and then we’ll see where it goes in the future.
Robert Napoli - Piper Jaffray
What areas of your business would you like to beef up through acquisitions?
Robert O. Carr
We continue to look at things that expand our capabilities of the product set that we can offer through what we think is the best sales force in the industry. And so anything that we have a weakness, we talk to people in niches, like in the rent and utility businesses. We have an obvious shortcoming in the grocery and petroleum spaces. Things like that. We don’t have a lot on the Internet side. Those are all things.
But really, the driving consideration is, first of all, how hard is it to get into that segment on stand-alone. We’re creating a lot of product internally and if you have all the time in the world we think we could build everything for every segment, but the answer there is that you may find it advantageous to short cut that development effort because we have nothing on our plate, from an IT perspective, that goes out 2-3 years already. So there may be benefits to short cutting by buying something or areas where it’s just hard to do it by building a product and then organically grow it.
A lot of things go into the calculation, but the driving factor is what will allow us to offer a bit broader and more complete and more successful product set through our sales force and how that will enable us to keep growing aggressively.
Operator
At this time I would like to turn the call back over to management for any closing remarks.
Robert H. B. Baldwin, Jr.
I would like to thank you all for joining us today and look forward to speaking with you on the next call. Thank you very much for joining us.
Operator
This concludes today’s conference call. You may now disconnect.
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