Not a lot has changed about Heartland Payments (NYSE:HPY) over the last eight months. When I last wrote about Heartland, I thought the company was a quality growth play on the increasingly cash-less transaction market and was pursuing some quality growth opportunities outside of merchant acquiring and payment processing. The problem then and now is valuation; I thought Heartland was well-valued in November and the market-lagging 1% appreciation since then doesn't change my view. While I like Heartland as a low-teens grower over the next decade, the valuation already seems to anticipate that.
Payment Processing Not Changing All That Much
For all of the talk of Square and mobile payments, not as much is changing in the here and now as bears want to believe. Merchants still rely upon acquirers/processors like Heartland, Global Payments (NYSE:GPN), and Vantiv (NYSE:VNTV) to facilitate their acceptance of credit and debit cards, with the acquirers and processors (often, but not always the same entity) taking a piece of every transaction.
Heartland has built its business by serving small and mid-sized enterprises (or SME) with less than $5 million in annual value with its own direct sales force. Heartland takes on underwriting and merchant fraud-related liability for sponsoring banks and also handles the authorization and processing procedures. What makes Heartland different is not only some of the services it offers, but the unusual transparency with which it provides them - many other acquirers and processors go out of their way to disguise the flow of funds between the card issuers, payment networks, and themselves. Whereas some of the company's rivals have tried to quietly pocket any changes in fees among these groups, Heartland is transparent about these changes.
Heartland remains a relatively smaller player in the bigger picture. Holding about 3% to 4% share of the acquiring and processing market, Heartland is about the same size as Global Payments and both are dwarfed by Bank of America (NYSE:BAC) (16% acquiring share), First Data (13% acquiring share), JPMorgan Chase (NYSE:JPM) (13% acquiring share), and Vantiv (8% acquiring share) and likewise by First Data, JPMorgan, and Vantiv on the processing side (First Data handles the processing for its own merchants, as well as those of Bank of America, Wells Fargo (NYSE:WFC), and Citigroup (NYSE:C)).
Heartland did see attrition tick up in the first quarter to 15%, the highest level since 2010, but new margin installed was also up 24%, so I do not believe that Heartland is gaining or losing significant share.
… But Change Is Coming
Heartland's market isn't changing as fast as the bears thought it would, but that doesn't mean it is not changing. Mobile payments and alternative POS terminals are making an impression, motivating the company to acquire the majority of Leaf, a developer of dedicated POS tablets.
Integrated payment solutions are also becoming more significant, with companies increasing turning toward integrated services to avoid the commoditization of basic acquiring services. Integrated payment solutions is a somewhat vague, buzzword-y concept, but it includes add-ons like servicing mobile solutions, offering loyalty programs and targeted offers, and providing data analytics.
Global Payments has put a lot of emphasis on growing its APT integrated payments business, while Vantiv not only reaps cost advantages from a single processing platform but also acquired Mercury - a leading provider of integrated payment services.
To stay competitive, Heartland is going to have to offer similar services and it is doing so in part through a rebranding of its security offerings as "Heartland Secure". The company is also working more closely with American Express (NYSE:AXP), both as one of the partners for its OptBlue program to increase acceptance of AmEx cards with smaller merchants, and as a distribution partner for a new small business loan program (structured as advance sales of future credit card receipts).
Non-card Growing Nicely
Heartland's businesses outside of acquiring/processing continue to grow nicely; up about 13% in the first quarter to almost 30% of sales. Although payroll customer attrition has been high (26% in the first quarter), revenue was up 11% and the K-12 (up 20%) and campus businesses (up 16%) are doing even better. With the acquisition earlier this year of MCS Software, Heartland now has better than 30% share in the growing K-12 market where schools are increasing turning to card-based programs to reduce theft and loss and better manage their cafeteria programs.
Good Growth, But Largely Expected
I continue to believe that Heartland can grow revenue at a long-term rate of around 6% a year, as slower-growing acquiring/processing revenue is offset by growth in payroll, academic cards, and other types of payment processing or services. I also believe that money being spent to develop these businesses today are masking the inherent profitability of the business and that free cash flow margins will expand into the mid-teens as the company moves from building scale and capabilities into real revenue generation. With that, I see long-term FCF growth in the low double-digits.
Working those back through a discounted cash flow model, though, I do not get to a fair value at or above today's price. Likewise, a 10x multiple on 12-month expected EBITDA (above the company's long-term average and in line with expected EBITDA growth) only leads to a fair value more or less in line with today's price.
The Bottom Line
For me and Heartland, then, the story remains the same. I think Heartland is more likely to remain competitive with the likes of Global Payments and Vantiv than the bears believe, though I do think companies like U.S. Bancorp and JPMorgan Chase are serious about leveraging their card businesses as a high-margin/high-return-on-capital growth opportunity. I also believe that there is significant growth potential in the non-card operations. My only problem is that I think the market already anticipates this and is pricing the shares fairly reasonably (though owning a reasonably-priced stock with above-average growth potential is not a terrible thing).
Disclosure: The author is long JPM. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.