Heartland Payment Systems CEO Discusses Q3 2010 Results - Earnings Call Transcript

| About: Heartland Payment (HPY)

Heartland Payment Systems (NYSE:HPY)

Q3 2010 Earnings Call

November 3, 2010 8:30 a.m. ET


Bob Baldwin – President and CFO

Bob Carr – Chairman and CEO


Tien-Tsin Huang – JP Morgan

Dave Koning – Robert W. Baird

Sanjay Sakhrani – KBW

Bob Napoli – Piper Jaffray

Tom McCrohan - Janney Capital Markets

Chris Shutler – William Blair & Company

John Williams – Goldman Sachs


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

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

Bob Baldwin

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

Before we begin, I'd like to remind you that some of our discussions may contain statements of a forward-looking nature which represent management's beliefs and assumptions concerning future events. Forward-looking statements involve risks, uncertainties, and assumptions that are based on information currently available to us.

Actual results may differ materially from those expressed in the forward-looking statements due to many factors. Information concerning those factors is contained in the report of our financial results we released early this morning and in the company's SEC filings. We undertake no obligation to update any forward-looking statements to reflect events or circumstances that may arise after this call.

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

Bob Carr

Thanks Bob and good morning everybody. I'd like to thank you all for joining us today and for your interest in Heartland. By now you should have seen our financial results for the third quarter that we released this morning.

For the quarter, we reported adjusted net income of $8 million, or $0.20 per fully diluted share, which excludes expenses associated with the breach. Bob will go through the detailed results in a minute.

I believe the third quarter may represent an important inflection point where we have finally reached the point where more of our resources are being focused on growing the business and improving operations than are being used to fight economic headwinds and breach-related battles.

Our settlement with Discover concluded our dealings with the brands, and most legal claims have been dismissed, so that while we are still engaged with some regulators and the issuer class action, we can devote most of our energies to achieving greater success in a still-challenging marketplace.

The numbers tell the story. Both transaction processing volume and transactions processed were quarterly records, up 6% and 9% respectively. By all accounts, our small and mid-sized merchants are not growing nearly as fast as this, meaning we are still gaining market share.

Same-store sales were up for the second consecutive quarter, and new margin install, though down relative to a year ago, was still the best since the fourth quarter of last year. New margin installed has been growing nicely, with September the best month of 2010 and October close to the best month since 2008.

Merchant volume attrition in the quarter was also at the best level it has been over the last two years. Similarly, performance in our payroll, loyalty, campus solutions, and other ancillary products has improved. Combined with our strong volume, the result was record quarterly net revenues.

Our success is rooted in our fair deal transparent pricing strategy. Over the past few months we've made significant progress penetrating like-minded organizations to plant the seeds of growth with their membership. Recently, we have been selected as the exclusive endorsed provider of payroll services and endorsed provider of card processing services by the 900-member independent organization of Little Caesar's franchises and the exclusive endorsed provider of credit and debit card processing services by the U.S. Hispanic Chamber of Commerce.

We also are the exclusive endorsed provider for electronic payment solutions for the National Restaurant Associations, more than 40 state restaurant associations, as well as the American Hotel and Lodging Association, and more than 200 trade associations and member-based organizations.

Since its launch on May 24, more than 7,000 small and mid-sized business owners across the country have purchased and deployed Heartland's E3 terminals to protect their businesses and their consumers. We now have the largest number of merchants in the United States actively using truly effective end-to-end encryption technology to secure their transactions and momentum is building. September was our best month. We sold more than 1,700 E3 terminals, over half of them to new merchants.

The widespread adoption of E3 by business owners in the first few months demonstrates that merchants of all sizes, not just the big merchants, want to protect card owner data and lower their risk of payment card industry data security standard fines and fees.

And in October we expanded our product line and entered additional markets by launching our new E3 magnetic stripe reader wedge, or PC-based, payment applications. Working with multiple P.O.S. developers, this allows us to offer and add security to those larger merchants using P.O.S. systems that are increasingly the target of criminal attacks.

Throughout our history, we have invested in a strong sales organization as the main vehicle to carry our message to the market, and over the past two years we have been focused on dealing with the slowing economy and other distractions that caused us to be less intensive in the management of our sales organization than we would otherwise have been.

Earlier this year, we had recruited heavily to focus on filling exclusive areas with our vertical market approach, but after an intensive review this summer, we have abandoned the exclusive area part of this approach because it was not working as well as we had forecast.

We have implemented a higher level of accountability throughout our organization, and the result is that a significant number of underperforming salespeople have left the company. While this may appear to be counterintuitive, the fact is that our sales effectiveness has improved dramatically as evidenced by our install results.

August installs represented the best month of the year, until they were followed by significant increases in September and again in October. And our November pipeline is the deepest we have seen in more than two years. We appear to be back to our 2008 level of merchant installations and we think this is significant.

By focusing on the productivity of our entire sales team, we have required and achieved a new commitment of hard work and effort from all levels of our sales team. Our new merchant installation results have improved by more than 40% in the past 90 days, while the number of people on our sales team has decreased to 1,144 from 1,393 at June 30.

We expect our merchant installations to increase again this quarter, and at the same time expect the number of relationship managers to further decrease. We are focusing strongly on developing successful relationship managers.

At this point I am deeply involved with the direction of the sales organization, with the help of four other sales managers who have recently been promoted to leadership roles. We are now laser-focused on increasing the productivity of our entire sales team through day-to-day accountability for sales production.

While I have done this before, I can tell you, I have never been as excited as I am now to get more deeply involved in helping our relationship managers increase their new margin installed and generate more income for their families. It is very satisfying to see so many of our people become more successful than ever before.

I have essentially been on the road the entire time since the last quarterly conference call, out talking to the sales managers in all of our regions. It is clear that our sales leaders and relationship managers are extremely proud of our company's business model and our approach to developing end-to-end encryption to help improve the security of our merchants and to reduce the cost of PCI compliance.

We are very focused on consistent performance across the board in each of our 98 divisions and 15 regions. We have instituted some fun contests and rewards programs, and initiated an all stars program for hundreds of consistent producers from one month to the next.

At the same time that we are driving sales improvements, we are taking a much harder look at our entire cost structure. Because of our focus on economic and other challenges over the past few quarters, we were not as focused on cost-containment as we would otherwise have been. However, this has been a major focus in the past few months and will continue to be a higher focus of management over the next few quarters.

In the past few weeks and months, we have implemented actions to reduce costs by making significant cutbacks in our expense areas. These cutbacks were in areas that are no longer needed due to our focus on developing the success of each relationship manager who is willing to follow the best practices we are implementing across the organization.

We see some clear wins ahead in 2011. Previously discussed processing platform investments will begin to generate returns including benefits from the conversion of NWS merchants to our own back end and some significant rationalization of our processing data centers. Further, we believe there are opportunities to improve operational efficiencies to generate additional improvements in margins in 2011.

A quick comment on the Durbin Amendment. After the 2003 Walmart settlement, when debit interchange rates were reduced by one-third, our new merchant signings grew by 50% in 2004. Unlike our competitors, we chose to pass the entire rate decrease through to our merchants. And history has a funny way of repeating itself. We are seeing results and in a similar decrease in interchange, we intend to pass the savings through to our merchants and to move aggressively to take market share from competitors whose policies are not as merchant-friendly.

Let me now turn the call over to Bob Baldwin.

Bob Baldwin

Thanks Bob and good morning, everybody. I'd like to thank you all for joining us today and for your interest in Heartland. By now you should have seen our financial results for the second quarter that we released this morning. For the quarter, we reported adjusted net income of $8 million, or $0.20 per fully diluted share, exclusive of the various costs associated with the processing system intrusions, which are separately identified.

Heartland reported GAAP net income of $7.5 million, or $0.19 per share for the third quarter of 2010, excluding $0.01 per share of separately identified processing system intrusion costs. Net income would have been $8 million, or $0.20 per share. The $0.20 is net of $0.03 per share of stock compensation expense and $0.01 of processing system intrusion related interest expense.

Small and mid-sized merchant card processing volume was a record $16.6 billion for the quarter, up 5.9% from a year ago. SME transaction processing volume reflects an improvement in same-store sales, reduced volume attrition, and modest new margin installed improvements. Same-store sales were up 2% in the quarter, or about 90 basis points better than in the second quarter.

SME transaction processing volume growth primarily continues to be driven by increased SME Visa/MasterCard debit volume, though credit volume also improved modestly in the quarter. We also saw a modest increase in our average ticket size in the quarter.

Our statistical supplement, which is offered on our website, provides more detail on vertical industry same-store sale performance, but in broad strokes, our best performing industries were utility, petroleum, quick-serve restaurants, and hotel, with the retail and restaurant industries lagging. For the quarter, all of the segments that we follow were in positive territory, and in September, excepting only the Southwest, all of our geographies show same-store sales growth.

Network services processed a record 825 million transactions in the quarter, up 9% from the third quarter of last year, a little better than the growth we saw in the first half. Driven by the growth in transactions in volume, as well as growth in our non-card products, net revenue was a quarterly record of $115.4 million. Though transaction count was up, NWS represented a net drag on net revenue growth in the quarter due to contract renegotiations.

Total cost of services for the quarter were up 14.8% from a year ago, primarily due to a 17.7% increase in processing and servicing costs. I would note, however, that third quarter processing and servicing costs were marginally lower than in the second quarter.

I'll go through the cash flow in a second, but I want to mention the impact of exercising our right to buy out a sizable portion of residual commissions owned by our sales force, about $18 million this quarter. In our financial statements this will appear as a reduction to our approved buyout liability on the balance sheet, and as a use of cash in the cash flow statement.

These buyouts immediately produce reduced processing and servicing costs, with quarterly savings of approximately $1.8 million beginning in the fourth quarter of 2010 with future quarterly savings dependent primarily on the rate of merchant attrition.

We have periodically purchased residual commissions from our relationship managers, so this is nothing new. The purchases have been limited in the last few years as we managed liquidity. With the effective resolution of the card brand claims, this option became available to help drive down our ongoing cost structure. As payroll taxes are owed on the buyout, the benefit to the third quarter expenses was very modest.

General and administrative costs were down 8% in the quarter. While this is a very satisfying result, we are closely looking at additional cost saving opportunities in order to improve the operating margin, which came in at a disappointing 12.3% of net revenue for the quarter.

As Bob mentioned, we have come through some difficult challenges in great shape, but our focus on these challenges meant we may have missed some opportunities in other areas. In particular, we are now taking a much closer look at controlling costs and improving productivity and efficiency. Purchasing residuals and reducing headcount has provided a good start.

In addition, in 2011 we will see significant benefits from another of the initiatives that we've had underway for a year or more, driving out costs from our processing and servicing line item. We also see opportunities to reduce overhead in a number of areas, including the costs associated with our former strategy of pursuing aggressive sales force growth and creating the protected territories. Our budget process is not yet complete, but we are very focused on managing our cost structure throughout the company's operations.

The effect of the $18 million buyout of the accrued buyout liabilities skews our cash flow for the quarter, especially in comparison with prior periods. Our GAAP operating cash flow was $8 million for the quarter, reflecting reductions for the $18 million of residual buyouts and nearly $40 million we paid for settlements of claims related to the processing system intrusion.

Management's operating cash was also impacted. This measure takes net income and adds back amortization, depreciation, the provision for or recovery of the processing system intrusion costs, and other non-cash items at the top of the operating cash flow statement.

This calculation results in total sources of cash flow from operations of $50 million. We then reduced that figure by signing bonuses, buyouts paid, and tax refunds. Using this management metric, operating cash was $15.5 million in the third quarter, down from $36.4 million last year, due to the extra buyouts and the settlement of claims.

Our ability to buy the residual commissions, pay the settlement claims, and end the quarter with $38 million of liquidity, which includes $15 million of excess cash on hand and $23 million of our cash that we have used to fund the [dues sponsor bank] in September is a better indication that our cash flow remains healthy.

With Discover settled, and MasterCard paid during the quarter, all the card brand claims have been resolved. Though there remain claims of certain regulatory authorities, we believe we have effectively satisfied the bulk of our obligations, removing this economic uncertainty from our capital planning consideration. This also fixes the amount of interest expense that can be directly attributed to the processing system intrusion.

Consequently, we are now able to explore more permanent financing arrangements with the intention of replacing the current facilities with a combination of term and revolving credit facilities that enhance or financial flexibility going forward.

Let me wrap up by updating our guidance. Based on current business trends, we expect fourth quarter earnings to be equivalent to third quarter earnings, including stock compensation and specifically identifiable processing system intrusion related interest expense.

The ability to focus increased resources on growth opportunities, along with a more stabilized economy, has enabled the company to improve recent performance across a range of key metrics, including same-store sales, new margin installs, and volume attrition.

In particular, as Bob has noted, we are deeply focused on driving improved net revenue growth through improving installed margin results. As a result, the company expects net revenue to grow in fiscal 2011 at a faster rate than the anticipated 6%+ growth in 2010.

At the same time, we have already taken a number of actions to reduce costs, including the buyouts and reductions in other processing and servicing costs that will start to show up in the fourth quarter, but will be even more meaningful in 2011 and thereafter. As a result of these and other planned cost management actions, the company expects to approach a 15% operating margin on 2011 net revenue.

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

Back to you Bob.

Bob Carr

The third quarter's record transaction processing volume, positive same-store sales growth, and improving new margin installations and volume attrition are all signs that our fundamental business is healthy and growing, and in October we sustained our momentum across these key metrics. Our challenges are clear. Build our sales efforts to record levels and seek out cost savings.

Certainly economic uncertainty remains a wildcard for everybody. We've adjusted to this new economic reality with resolving the various disputes that have been a distraction for all of us. Considering that we go to market with the most compelling value proposition in the industry, unsurpassed pricing transparency, unmatched security, and an unbelievable group of talented and dedicated employees who live the Heartland promise, you can understand why we think our future holds great promise. As you have just heard, we're off to a pretty good start.

Before closing today's call and opening it up to questions, I am pleased to announce that your board of directors has declared a fourth quarter dividend at $0.01 per share, payable December 15 to holders of record on November 23.

And with that, operator, we would like to now answer any questions. Please open up the call.

Question-and-Answer Session


Thank you sir. [Operator Instructions.] We'll take our first question from Tien-Tsin Huang from JP Morgan.

Tien-Tsin Huang - JP Morgan

Bob, I didn't quite catch the relationship manager strategy shift. It sounds like you are streamlining there. Can you rehash that for us quickly in terms of what exactly is changing, and also did you see any voluntary attrition from key producers on top of the actions you took?

Bob Baldwin

Primarily, the change was that we were going to protected territories in our vertical markets. That was not working well, and we abandoned that strategy. We are continuing to focus on the vertical markets, but not restricting our people in any way in terms of their geographical coverage. We lost a small percentage of our top performers, but most of the people who have exited the company have been people that had very low production.

Bob Carr

I think it's fair to say that it's - and this really started in September - a very, very heavy emphasis on inspection at all levels of the sales organization. What have you done today to drive an increase in your installed margin? And in a variety of ways the message is very clear to the individual RM, which is to say that we are expecting you to be producing a significant amount of business every month, and if you do that you'll do very well. If you don't, you're better off leaving. And we've driven out a good number of the people that came on to, as Bob mentioned, that protected territory strategy that really just were not selling effectively. So the approach we were taking, still the emphasis on verticals is very important. It's a very effective way to go to market, but the process that we undertook to get involved more in the sales process and define a calling pattern and all that really seems to have distracted people from the main end result of getting installed margin. And so we've refocused everybody on that all-important objective.

Tien-Tsin Huang

I guess as my followup, just the operating margin target next year. Can you give us some more examples of some of the cost-savings initiatives you're talking about? I heard the buyout - and I'm mostly curious to hear where you see the greatest leverage in the expense base.

Bob Carr

The greatest leverage piece right now that we can separately identify is in the processing and servicing line item. That's where the buyouts will appear. That's where some cost savings that we've driven in some of our account manager channel will appear, and we've eliminated two of our nine processing platforms already this year. We have also brought in house the fifth third back end on the network services business. That's the final conversion of a merchant there is happening next week.

So that conversion is happening. And we've also been able to renegotiate some outsource contracts related to network services that will drive benefits in the coming quarters. So that's where we have the most visibility and that gets us a substantial amount of the way. Those alone get us a substantial amount of the way toward the objective that we've laid out.

The additional side is going to come in the G&A costs. There are some overhead that we introduced related to recruiting and training that was specifically tied to this protected territory approach that is no longer needed. But clearly we're also going to be very mindful of driving results for the shareholders. A non-trivial portion of our G&A expense relates to future initiatives and we're going to be taking a very hard look at those.

It's always a balance of how much you spend for that versus returns to shareholders, but clearly this year the revenue shortfall that we experienced really meant that we were overspending in some of those initiatives and at the same time that we're very focused on getting the revenue back up, that's a building process. You can't turn that around in a second.

We've had some very great progress in the last few months on installed margin and we're very focused on continuing that and that will have a great momentum in the second half of next year we think. But it also does not turn on a dime and so we just need to be that much tougher on some of those initiatives, if you will the "nice to haves", to make sure that we're getting ourselves back to an operating margin that's more appropriate for a business such as we're in.


We'll take our next question from Dave Koning with Baird.

Dave Koning – Robert W. Baird

I wanted to pursue some of the metrics that are getting better. It's encouraging that same-store sales are getting better, gross margin install declines getting smaller, and attrition seems to be getting a little bit better. But at the same time it looks like SME volume decelerated a bit and the revue guidance was taken down a little bit. So I just want to connect the dots between some of the improving metrics and your original expectations and maybe what's either gotten worse relative to your expectations. Really just connecting those dots.

Bob Carr

I think on the margin it's been a couple of things. First of all, in terms of the net revenue, one area that did not come through as strongly as we had expected is some of the non-card businesses. Those businesses don't have interchange and dues assessments to them, and so in a sense a dollar made on a piece of equipment that we sell or a payroll sale doesn't have any deduction from it. And no individual great disappointments but in aggregate our equipment sales revenue was lower than we expected.

Payroll has remained subdued, primarily because of lousy checks per control. That's down and September was down to around 16, whereas a year ago at that time we were up close to 19. So that's been tough in the payroll business.

And some of our other new business initiatives were not taking off as well as we had anticipated. Remote deposit capture being an example of that. So that's a piece of it. Network services net revenues, as I mentioned, remain depressed, and that's been a challenge for us all year, and that has sort of offset the benefit of some of the other initiatives.

And the last thing is unfortunately, while we are seeing near-term some very strong improvements in the installs the fact is that you don't get much benefit in the quarter in which you improve the margin installed. You see it later on. So that being a lagging indicator sort of compresses your results.

Dave Koning

That makes sense. So really a lot of these metrics are really just laying the groundwork for better trends into next year really.

Bob Baldwin

That's absolutely right. And obviously we've got to keep that going, maintain the momentum on the revenue side. The revenue side is very impactful. A dollar incremental of net revenue flows very quickly to the operating income line. Unfortunately a dollar shortfall in net revenue also flows very quickly to the detriment of that operating income line. And so we are, and will remain, a company that's very focused on driving the top line growth.

We've been cautious in what we've said about the next year's success because we're pretty new in this productivity focus on the sales organization, but we feel very good about that and I'd be hopeful that when we have fourth quarter results to announce, and have been able to get more time under our belts, that we can be more granular about what we had hoped to achieve in terms of net revenue growth as well as the cost saves that we're looking for.

Dave Koning

And then just two real short ones. Gross margin install, would you expect that to be up year-over-year in Q4? And then what's your same-store sales expectation in your 2011 guidance? Does it need to be at least, say, 2% or something like that?

Bob Baldwin

The same-store sales assumption is in the 1%-2% area. In other words, no improvement from where we are. In terms of installs for the fourth quarter, fourth quarter last year was our weakest quarter of last year, and was about $1 million greater than the third quarter we just finished. So we are targeting to exceed last year's fourth quarter in this year's fourth quarter. As Bob indicated, October was a very good start to that, and our November pipeline is good, so we feel good about exceeding that $13.5 million of the fourth quarter of last year, but obviously two of the three months in the quarter remain to be seen.


We'll move on to Sanjay Sakhrani with KBW.

Sanjay Sakhrani – KBW

Just a quick question on the operating margin expectations. Is that 15% expected at the end of the year on average, and you'd probably see a ramp in the operating margin throughout the year next year? And then second question, I appreciate the fact that you need a little bit more time on the net revenue side in terms of what the long-term trajectory is, but could you conceptually give us a sense of how you guys are thinking about long-term on average earnings growth and maybe if you can hit the top line conceptually? That would be great.

Bob Baldwin

I'd say that first of all, let's not forget that the first quarter is seasonally always our worst operating margin quarter. That will remain the case next year as well. I think the way we'd focus it is on increasing momentum throughout the year on our operating margins, with the degree of success that we achieve driven in some large part by that delta in the net revenue side that we can drive through installs, getting back to that significant leverage that's in each incremental dollar of net revenue. We're looking to turn that around. We've been whipsawed on the downside this year by that. We're looking to turn that around through success in new installs.

As we look out we're not in a position to try to predict the level of improvement in net revenue next year, but this is a company that we believe can absolutely achieve double digits net revenue growth. Whether that occurs next year or not I'm just not in a position to comment on, but that is very much our focus.

As Bob alluded to, there is potential help to that growth through the potential repercussions of whatever the Fed does in the Durbin Amendment. Let's keep that in mind. Our approach to market is very differentiated, and that will be only highlighted by the changes that we expect to see, and we should actually be getting the first indication of where the Fed's coming out I think in the next few weeks is what many have felt. So that could be an interesting thing to look at.

But longer term, where we want to take the company is first of all get back to double digits net revenue growth and then secondly continue to improve that operating margin. We do not see that 15% number that we've put out to approach next year as at all an endpoint. We are absolutely shooting for much higher numbers than that. So it's going to be sort of a double whammy is what we're looking for, both improving net revenue and improving operating margins going forward.


Moving next to Bob Napoli with Piper Jaffray.

Bob Napoli – Piper Jaffray

People have hit the big questions pretty well, but the net revenue margin, that's obviously one of the bigger challenges in driving that operating margin up to the 15% level. You know, 23% this quarter, down a couple hundred basis points. Is that driven primarily by network services? What is the operating margin, if you will, for network services? Or how much is the margin compressed on that piece of business?

Bob Carr

That's absolutely a part of it, and the operating margin - I'm not sure I have that right here. But it is definitely lower than the average for the company, and fortunately a number of the things that we're putting in place in terms of the processing and servicing cost saves I mentioned are specifically related to that side of the operation. We're consolidating platforms. The fifth third conversion is happening. There are some other contracts specifically related to network services that we have renegotiated and will achieve savings next year. And actually a little bit in 2011 but very much in 2012, some significant processing platform almost rethinking that we will get more granular on another time, services, and that will take that from being a drag on our margins to much more consistent with the rest of the company.

So I think that is a part of it, and the other part of it is just sort of the net revenue percentage, which did slip a little bit compared to our expectations this quarter. An important point is, and a very relevant question is, is it because of a decline in your expectation of margin on new business originated. And we've looked at that and in fact that is not the case.

This year our average basis points - now this is not in net revenue, this is in the basis points of margin that we're estimating - is actually the highest it's been in the last four years. So we're not seeing that margin compression in terms of new accounts signed, so how do we end up with that slight shortfall on the net revenue percentage and really what it means is some of our better, higher margin, typically smaller, merchants are attriting at a faster rate than we had anticipated.

And I call that out probably to the competitive nature of the marketplace. It is, and remains, a highly competitive market, and there are a lot of very aggressive offers out there by various players and we think we day in and day out do very well against that. But on the margin it seems to have hurt us a little bit this quarter.

Bob Napoli

It is a pretty big divergence versus your guidance, and if I heard you correctly - so the pieces would be runoff of some of the higher margin merchants and then lower revenue on some of the non-card businesses. And those are the two drivers that caused the divergence versus the outlook you had for 2010 versus what we see today and for the fourth quarter?

Bob Baldwin

I think that's correct. Yes. And the magnifying effect it has in essence on the operating income line. That's correct.

Bob Napoli

And when did you realize - I mean it's a pretty dramatic reversal in strategy on the sales force, because you went from doubling the sales force to a totally different strategy. When did you realize - at the end of last quarter it seemed pretty clear you guys were pretty gung ho about growing the sales force, and what changed?

Bob Baldwin

We were gung ho about growing the sales force, but we weren't getting the productivity out of that growth that we needed, and so we made a change and decided to focus more on the productivity of the individuals and many of the people we brought on we brought them on too fast, frankly, and we couldn't train them properly. So we slowed down the recruiting significantly and the results speak for themselves. I think we're on a really good track to get back to the best months we've ever had and we will begin to grow our organization again once we get the productivity levels up to an acceptable level.

Bob Napoli

Thanks. My last question - the university business? The campus card? What was your revenue in that business this quarter versus a year ago and last quarter? What's the outlook for that piece of business?

Bob Carr

The university side is - there's two pieces and they're not easily broken out here but I would say that overall we were up probably about 30% in our revenues in the third quarter on the campus and micropayments business.

Bob Napoli

And the outlook for that business? Are you seeing more or less opportunities in that area?

Bob Baldwin

We're seeing more opportunities. We've got some new products that we're very excited about. We've launched a card to compete with the HigherOne model, and have a couple of schools on that program and expect that to be a high growth area for us in the future.


And on to Tom McCrohan with Janney Capital Markets.

Tom McCrohan - Janney Capital Markets

I'm trying to get my head around the path back to operating margins in the 20% range, which you had back in 2008, and I know the world has changed a lot. But can you help us think that through? How long would it take to get back there in the context of net revenue growth potentially growing at a slower rate than it did in '08 when you were growing at 27%. So if things don't get back to 27% top line growth, can you achieve 20% operating margins?

Bob Carr

The answer is yes we can. We're not going to do it by growing at 27%. That, at our current size, we have a long ways to go to get to there. At the same time, as we get to be a larger organization, the amount of incremental resources we need to devote to adding to our capabilities is not that substantial. We already have people who are doing new things now that when they finish those they can move on to other new things, and so growing that aggressively is not going to be as necessary going forward. I think doing it in the context of single-digit net revenue growth is very difficult. It involves a different kind of model than we've got.

And it's sort of a circular thing. If you expect to get low growth then you really don't need all the new stuff, therefore you don't spend money on that. But that's not the approach we're going to take. It's going to be much more tightly managed expenditures while we're going through this lower growth than we'd like period to use the sales effort to drive that net revenue growth first up to the double digits. And we think we can go well into the double digits. Can we get back to 15% net revenue growth? That's tougher with the size that we're at today, but that's absolutely an objective that we can hold out for ourselves.

Meanwhile, managing our costs down we think that we can make very substantial progress next year. We see, as I mentioned, some of the processing and servicing changes that we have on track now really don't help us that much even in 2011 where there's some substantial benefits in 2012. So we can already see some operating margin improvements beyond 2011 in things that we have underway right now. So we absolutely do think that we can, and we'll be focused on, getting our operating margins up toward that 20% level, recognizing that in 2008 we got over that level on a quarterly basis, but that was also the year we bought Network Services.

The network services business as a whole is focused on the larger merchants, and that is a very tough, price competitive business. We've been facing in the network services business some absolute margin contraction as we've renegotiated some major contracts, we've extended them for a long time, but at the cost of some price concessions. As we look out, really right now for the first time we're going back to the offensive on the network services business.

And what does that mean? Well, with the back end platform improvements that we've made, that opens us up to do a more effective job in first the mid-market petroleum area, we're focused there. Second, we're also focused on opening up our SME merchant base, our sales force to the petroleum product again.

The problem there has been we haven't had an ability to install a merchant that's time effective for the sales person. So we haven't gotten the traction there, but with our back end running now that can help us on that score. And on the larger merchant side, we're doing two things. One is we're competing - the former strategy at Network Services was to focus primarily on providing front-end authorizations, not doing the back end. Our focus now is on doing front and back end services, and we're seeing the first contract coming up that involves that, and we're hopeful of succeeding in those.

And we're also focused with those larger merchants on introducing some additional product sets and we have a very interesting solution there that helps each of the individual station operators manage all of their interactions with the outside world, their network services, which is a very nice business that we can add on to those existing clients.

So all of those ways we see as improving the network services margins and get them out of being a drag on ours, which will help substantially in getting back toward that 20% operating margin goal.

Tom McCrohan

And just a quick follow up on the SME. Are you still going to market as the low price leader?

Bob Carr

I believe so, yes, but it's a very tricky thing because every merchant that signs up believes that they're getting a better deal than they have now. As we've talked many times, the complexity of this business is such that there are lots of ways that a merchant can believe they're paying one price, but in fact end up paying another price. And our response to that is transparency and customer education.

It's been a hallmark of the way we hire people, the way we want our people to act, and we remain committed to that. But when we lose a merchant to another player, sometimes it's because they've got a better price. Sometimes it's because they perceive they have a better price and we'll just have to deal with that reality going forward.

I think that, getting back to the Durbin changes, that's going to be a very specific area where we will be absolutely highlighting our passing that through and everything I've heard from our competitors in the SME business is that they intend to capture some of that savings for themselves. We will pass it through and go aggressively after market share.


Taking our next question from Chris Shutler with William Blair & Company.

Chris Shutler – William Blair & Company

You talked about raising expectations for the sales force and increasing day to day accountability, so I was hoping you could just maybe get a little more granular in terms of what you've been doing in recent months. And then maybe more specifically, have you implemented quotas for the sales team? And have you changed the day to day reporting requirements that were in place under the ISM model?

Bob Baldwin

Several questions there. I'll take those. We have always had a contractual agreement with our salespeople that they would produce a certain amount of business, but we were very lax about enforcing that. That is what has changed primarily. But also we've gone into some of our most successful parts of the country and have some best practices that we are now deploying across the company.

We never did that before. We've always let our entrepreneurial sales force figure it out themselves, but with a tough economy and what we've been through the last couple years our sales managers were very receptive to doing what's working in other parts of the country. So it's pretty straightforward, fundamental stuff. We're taking what's working in parts of the country and deploying it across the rest of the company. And we're requiring people to produce.

And that's probably the biggest single impact, that if people are not willing to make their appointments and go visit accounts, then they need to move on. And we have an awful lot of people who weren't doing much of that. And they have moved on. We have relaxed the reporting requirements for our winners, people who are hitting their goals. But if they're not hitting their goals we've increased their reporting requirements. I think that covers the points you asked about.

Chris Shutler

And then my only other question is just around the capital allocation going forward. Specifically do you have any thoughts about buying back stock?

Bob Carr

We definitely can consider buybacks. Right now we're in the process of adding to our financial flexibility through creating some revolving credit capacity, which doesn't exist at this moment. And so that's an ongoing discussion with the board as to what's appropriate. That will be considered over time.


We'll take our last question from John Williams with Goldman Sachs.

John Williams – Goldman Sachs

Just wondering about the current background for pricing and competition, and obviously First Data comes up a lot when we talk to investors, and obviously with the acquisitions in the space recently on the ISO side, just wondering if you're seeing any stepped up competition on pricing or seeing anything different in the environment that you've seen before, three or four months ago.

Bob Carr

First of all, with respect to First Data, what they might be doing to their relationships or prices to their ISOs or to their bank partners is not necessarily something we know about or care about. It really is what is the salesperson in the street, who may be buying their services from First Data, or Global or someone else, how are they pricing?

As I mentioned earlier, the average basis points of margin that we're looking at in 2010 has been consistently higher than any of the last prior three years, and specifically in 2010 our average margin basis points is up about 30.3 basis points from 2009 levels, about 0.8 basis points from 2008 levels, and about 0.9 basis points from 2007 levels.

Now this is on our margin install, which is an estimate, but if you look at our true ups, our true ups are very modest, so we think that this is a very robust indication that the price we're getting in the marketplace is not being impacted by the competition.

That said, it's tough out there for everybody, and I think that we are seeing as many, or more, of the aggressive tactics taken by the competition. A good example is PCI fees, which is not something that someone will mention to a prospect when they're signing them up.

I was recently at the mid-year ETA convention, and any number of people made reference to the fact that the industry would have shown declining revenues were it not for the PCI fees, which a lot of players are levying on their merchants, -ranging $100 to $140 a year. That's not something that a salesperson is necessarily going to mention to the merchant, but that's a case where there really isn't any value added being offered. It's just an opportunity to extract a fee, one that we choose not to avail ourselves of.

Over time, the merchant comes to realize that. To varying degrees our industry specializes in statement obfuscation, and so that limits the visibility, but you can be sure that the Heartland salesperson is out there trying to focus the merchant on some of those costs that they're paying.

But net net, we're keeping our price. It's remained that way for many years, and we expect to be able to achieve that primarily because our distribution channel is a more efficient channel than a lot of the others that are out there. Our costs as a vertically integrated player are on the whole lower, and that allows us to compete effectively while maintaining our price.

John Williams

Just one other thing. With regard to the expense leverage that you're expecting to see play out over the next call it a year, in terms of the drivers within specifically the processing and servicing line, it seems as though, just based on your commentary, a lot of what is going to be dropping out should just drop out in one shot most of the time. So in terms of margin trajectory throughout next year is it going to look more like a typical year in terms of the distribution and the ups and downs within margin look more like '07 or '08? Again, obviously not at the same level. But how should we think about the distribution for next year as we look at 2011?

Bob Carr

That's a tough question in the context that we're still going through our budget process with some of that, but I'd say yes. Some of the changes that we're putting through don't have an immediate benefit to us, and will hit during the course of the year, but a number of them have already taken place, an example being the buyouts. Those will be available through the whole year and so should be reflected in the normal seasonal pattern that you saw in 2007 and 2008, and not in the magnified way that we saw in 2010.


We have no further questions at this time. Mr. Carr, I'll turn the conference over to you for any closing or additional remarks.

Bob Carr

Thank you, and just want to thank everybody for participating in today's call, and hope you all have a great day.

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