Heartland Payment Systems' CEO Discusses Q4 2010 Results - Earnings Call Transcript

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Heartland Payment Systems (HPY) Q4 2010 Earnings Call February 16, 2011 8:30 AM ET

Executives

Robert Baldwin - President, Chief Financial Officer and Principal Accounting Officer

Robert Carr - Executive Chairman and Chief Executive Officer

Analysts

Brett Huff - Stephens Inc.

Robert Dodd - Morgan Keegan & Company, Inc.

Reginald Smith - JP Morgan Chase & Co

Thomas McCrohan - Janney Montgomery Scott LLC

Meghna Ladha

David Koning - Robert W. Baird & Co. Incorporated

Kartik Mehta - Northcoast Research

Operator

Good day. And welcome to the Heartland Payment Systems Fourth Quarter and Fiscal Year-End 2010 Earnings Conference Call. [Operator Instructions] At this time, I would like to turn the conference over to President and CFO, Robert Baldwin. Please go ahead, sir.

Robert Baldwin

Thank you, Jenny. And good morning, everyone. I'd like to welcome you to our fourth 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 these factors is contained in the report of our financial results we released earlier this morning and in the company’s SEC filings. We undertake no obligation to update any forward-looking statements made during this call to reflect events or circumstances that may arise after this call. Now I'd like to turn the call over to Bob Carr.

Robert Carr

Thanks, Bob. And good morning, everybody. I'd like to thank you all for joining us today for and for your interest in Heartland. As you saw on our financial results for the fourth quarter released this morning, we reported adjusted net income, excluding breach-related expenses of $7 million or $0.18 per share, which is also net of $0.04 of non-operating items. Bob will go through the detailed results in a minute.

Our performance in the quarter was driven by continued steady growth across our business together with significant benefits from several of our recently implemented efficiency initiatives. Our major revenue categories, payment processing, payroll and equipment sales, all registered double-digit growth and that's indicative of healthy fundamental core growth. On the cost side, processing and servicing costs were up 3%, reflecting the efficiency initiatives of reduced sales commissions that resulted from our third quarter residual portfolio buyouts, a reduction of salary account managers and other personnel cost-containment measures. This combination of top-line growth and improved productivity drove a 36% increase in operating income, a good start to the improvement in operating margins that we are targeting.

However, the really encouraging results in the fourth quarter were the progress we are seeing in our numerous growth metrics. For the quarter, same stores sales were up 3.8%, a 180 basis point sequential improvement compared to the previous quarter, and our third consecutive quarter of positive same store sales performance. And after declining for far too long, new margin installed was up 6.4%, our first year-over-year increase in new margin installed in two years. Though we certainly recognize that we are benefiting from an improving economy, we believe our new business success is the result of our focus on accelerating new installed growth by improving the productivity of our sales organization.

In August, we made some changes in our leadership of our sales organization and in the ensuing five months, we have seen a significant reduction in our headcount, but have improved our sales productivity to the highest it has ever been in Heartland. In fact, our productivity per sales professional has improved by 60% from just nine months ago. Equally important, while the new focus caused many unproductive relationship managers to leave the company, retention of our 200 highest earning salespeople remained high at 88.5% on a year-over-year basis. We have taken the best and most effective practices of our best divisions across the country and implemented their sales process and management techniques.

While this has not been easy, we have a new energy and commitment from our sales team to significantly improve new installations in 2011. We have a lot of wind at our back and have been successful in achieving our objectives through the first weeks of the New Year. We now have a solid core of our highest performing relationship and account managers capable of generating the kind of new business growth achieved in the fourth quarter. They go to market with the wealth of products, industry leading security technology and transparent pricing that we believe provides the most competitive combination in the market. From this solid foundation of productive, successful salespeople, we will expand the sales organization consistent with our commitment to maintain and improve overall productivity.

Right now, about 20% of our divisions and territories are preparing to hire new relationship managers, utilizing an approach of hiring and training that is proven successful and quickly bringing the new RM to a high level of production. Our job is to help the rest of the teams quickly reach their productivity objectives, so they, too, can make new hires. We think this is a great time for goal-oriented salespeople to join our company. For the third consecutive year, Selling Power Magazine has named Heartland Payment Systems the number one service company to sell for in the United States. According to Selling Power's founder and publisher, Heartland is only the second company to top their list for three straight years, and they’ll be competing for new business with one of the industry's broadest and strongest product portfolio.

For instance, Heartland is one of the largest payment processors in the convenience store and petroleum industry, and we've strengthened our offerings to provide an even more compelling selling proposition. This past quarter, CITGO Petroleum Corporation began offering our SmartLink network services product to its nearly 6,500 CITGO branded gas stations in the United States. SmartLink technology consolidates multiple in-store devices under one high-speed broadband line, enabling business owners to lower telecommunication costs, save time and resources and manage their business more efficiently. This new service currently is being used by 800 satisfied customers, and we expect this to increase significantly this year and into the future.

We also have a growing presence in the large healthcare market. In January, the 20,000 strong Ohio State Medical Association chose Heartland to provide its members with access through a comprehensive suite of payment solutions expressly created for healthcare practices, including best-in-class card processing, gift card marketing, payroll and check management services.

More broadly, our industry-leading E3 security technology is [indiscernible] widespread adoption. Our new wedge, which is now getting certified in a number of POS Systems, will greatly expand our market opportunity. In fact, Coalfire Systems, a leading independent PCI Qualified Security Assessor, found that our properly deployed E3 wedge solution is one of the most effective data security controls available today and provides significant scope reduction for merchants and POS developers. The wedge offers a variety of security options to merchants using computer-based point-of-sale systems and addresses the epidemic of data breaches in the retail and hospitality industries, two of the big three industries affected by data breaches because of the frequent use of POS Systems.

In the most recent quarter, approximately 1/2 of all of our new card processing merchants, also purchased a new E3 terminal. We now have over 12,000 E3 terminals deployed, with more than 10,000 owners making the decision to invest in the highest quality security offering available today. We are also pleased to announce that in the last two months, we have entered the K-12 school program market through three small acquisitions. Put together, these acquisitions represent about 9,000 K-12 schools, making Heartland one of the top-five participants in this market. Our focus in entering this market is to bring modern payment processing solutions to these schools. And while these acquisitions will have only a very modest impact on this year's results, successful penetration with our solutions will offer significant revenue and earnings growth in 2012 and beyond.

Let me conclude with just a brief statement on the Durbin amendment. Heartland has always subscribed to a transparent, cost-plus pricing model where merchants clearly see their interchange costs. There are a lot of uncertainties regarding implementation and we are hopeful that the Fed will not overburden the industry with excessively complex regulations. In fact, the simplest change on our menu, taking large bank interchange to $0.12, would offer very substantial savings to merchants large and small and could be implemented in 2011. It has always been our policy to pass along any changes in interchange to our merchants. The last time we saw something similar to Durbin, we had our most successful growth year in the company's history.

Now let me turn the call back over to Bob Baldwin.

Robert Baldwin

Thanks, Bob. Heartland reported GAAP net income of $6.6 million or $0.17 per share in the fourth quarter of 2010. Excluding $0.01 per share of Processing System Intrusion costs, net income would have been $7 million or $0.18 a share. Excluding a number of non-operating items I'll enumerate later, earnings would have been $0.22 per share. Small and Mid-sized merchant card processing volumes of $15.1 billion for the quarter was up 6.8% from a year ago, a nice sequential improvement from 5.9% growth in the third quarter. Processing volume benefited from a 3.8% increase in same-store sales in the quarter, a 180 basis point sequential increase from the third quarter, as well as the third consecutive quarter of positive growth. Volume attrition was also further reduced to a recent low, just 12.7% for the quarter. As a result of the strength of the back end of the year, I'd note that same-store sales were up 1.3% for the year after being down for the two previous years.

January same store sales rose 0.5%, softness that was undoubtedly weather-related in part, but also consistent with our cautious view on 2011 in that we are not building in expectations for further same-store sales improvements in the year ahead. Our statistical supplement, which is available on our website, provides more detail on vertical industry, same-store sales performance but in broad strokes, our best performing industries were petroleum, utility, electronics and furniture, quick-serve restaurants and auto-related retailers.

For the quarter, all of the segments that we follow were in positive territory and all of our geographies showed positive same-store sales growth. This quarter, we saw a consistent average ticket and a continued shift to more signature debit spending. Overall, SME, Visa, MasterCard volume grew 5.7% for the quarter and transactions grew by 5.7%. But within these totals, credit volume grew about 3.1% and credit transactions grew 1.2%, while signature debit volume in the quarter was up about 8.9% and transactions up 7.6%.

It's certainly rewarding to see a continuation of the sequential improvements in same-store sales and transaction processing volume growth that we've achieved throughout 2010. What's more encouraging is the growth of new margin installed which has been lagging some of our other growth metrics. New margin installed was up 6.4%, while new SME merchants installed in the quarter were up 5.5% from a year ago.

Network Services processed 790 million transactions in the quarter, up 11.2% from the fourth quarter of last year. However, due to prior-contract renewals from large merchants, NWS card processing net revenue was down 4.3% in the quarter. This was the best relative performance of any quarter in 2010 and sets the stage for a return to NWS processing net-revenue growth in 2011.

As Bob mentioned earlier, both payroll and equipment-related gross revenues were up double digits in the fourth quarter, with payroll up 21.5% and equipment related up 11.1%. Together with transaction processing growth, this drove net revenue up 5.1% to $110.5 million for the quarter. While total cost of services for the quarter were up 14.1% from a year ago, the bulk of the increase was concentrated in interchange and dues assessments and fees which are costs we pass through. Our largest controllable cost of service, processing and servicing expense, was up only 3.2% from a year ago. Fourth quarter general and administrative expenses were up just 1.9% compared with the fourth quarter of 2009. Both increases reflect the effect of cost containment initiatives we have undertaken.

Operating income for the quarter was $14.3 million, up 36% year-over-year, while the operating margin expanded to 12.9% of net revenue, which is up both sequentially and year-over-year. Our plan to achieve further margin expansion is based on continued progress with consolidations, the move of back-end petroleum and processing off of Fifth Third platform and onto Passport, a lower compensation expense from the reductions of account managers and residual buyouts and a disciplined 2011 budget process.

This quarter, in addition to the cost of the Processing System Intrusion, we had a number of items in non-operating income expense. Non-operating expenses were comprised of the costs associated with the exit of the Johnson City servicing facility, an intangible asset impairment charge and $3.8 million pretax to settle potential class-action litigation over the treatment of reimbursable employee expenses. On the other hand, during the quarter, we sold most of the remaining merchant accounts that had not been converted onto HPS Exchange, and we're still processing on third-party front-end platforms. The sale amounted to 636 merchant locations that were processed on three third-party platforms. This was a strategic sale undertaken to eliminate administrative and servicing inefficiencies associated with what amounts to random legacy accounts on non-Heartland platforms which also enabled us to simultaneously exit the contracts with those processors.

The net effect of all of the aforementioned items was to reduce earnings by $2 million pretax or $0.03 a share in the 2010 fourth quarter. Costs associated with the Processing Systems Intrusion further reduced earnings by $0.01 in the quarter and another $0.01 arose from PSI-associated interest expense. Therefore, looking at earnings, excluding the net effect of the intrusion and non-operating items, earnings would have been $0.22 a share. Calculated on the same basis, earnings for the full year were $0.69.

Now let's look at our cash flow. Management's measure of operating cash takes net income and adds back amortization, depreciation, the provision for the Processing System Intrusion and other noncash items at the top of the operating cash flow statement, resulting in total sources of cash flow from operations of $30.3 million. We then reduced that figure by signed bonuses and buyouts paid. Using this management metric, operating cash was $19.4 million in the fourth quarter, up from $17.4 million last year and consistent with our year-over-year growth in operating income. Taking that same management definition of operating cash and reducing it by capital expenditures of $6.3 million, our free cash flow amounted to $13 million, about equal to last year's fourth quarter. We used $382,000 of cash to pay dividends in the fourth quarter.

In November, we strengthened our financial condition and increased liquidity with our new credit facility, which includes a new five-year $100 million term loan and a $50 million revolving credit facility. In January, we put on a fix-pay interest rate swap for half of the term loan at an attractive all-in fixed rate. The revolver includes an accordion feature that allows it to be increased to $100 million. The facility is committed through November of 2015.

Let me wrap up with our guidance for 2011. For the full year of 2011, we expect net revenues to increase 7% to 9%, and fully diluted EPS to be between $0.92 and $0.96, after deducting $0.15 a share of 123R stock compensation expense. As always, our first quarter will be seasonally our weakest. The company's guidance does not include any of the ongoing costs related to the Processing System Intrusion. Back to you, Bob.

Robert Carr

Thanks, Bob. Much as it was from any other businesses that saw their core markets severely damaged by the recession, 2010 was a transitional year for Heartland. Over the course of the past 12 months, we have made tremendous progress both dealing with lingering issues, as well as adjusting to what many have termed the new normal. Despite these challenges, we grew the business and ended the year on a high note, with the strong fourth quarter that is generating good momentum headed into 2011. On the economic front, we are optimistic that GDP growth will remain solid, if unexciting, for our Small and Mid-Sized merchants. As a stronger more efficient organization, we are confident we've made the right decisions, difficult as they may have been, that will enable us to more productively leverage our resources.

Before closing today's call and opening up to questions, I would like to announce that the Board of Directors has raised the dividend to $0.04 per share from $0.01 per share with the new higher dividend payable March 15 to holders of record on the 4th of March. With that, we would now like to answer any questions. Please open the call, Jenny, for questions.

Question-and-Answer Session

Operator

[Operator Instructions] And we will take our first question from Tom McCrohan with Janney.

Thomas McCrohan - Janney Montgomery Scott LLC

Just a quick question on EPS guidance of $0.92 to $0.90 or $0.92 and $0.96, does that, the word “deducting” has thrown me off, does that include options or not exclude options?

Robert Baldwin

That is after our expensing of $0.15 of options. In other words, that will be the GAAP number, excluding of course only the Processing System Intrusion.

Thomas McCrohan - Janney Montgomery Scott LLC

And so the comparable number will be the $0.66?

Robert Baldwin

$0.69, I think.

Thomas McCrohan - Janney Montgomery Scott LLC

$0.69 adjusted for the non-operating stuff?

Robert Baldwin

Yes.

Thomas McCrohan - Janney Montgomery Scott LLC

Can you talk a little bit more about the improvement in the sales force productivity? I just want to make sure that the 60% increase you talked about was more than just simply reducing the numerator or the number of salespeople. So if you can give a little insight into how you monitor and track sales for productivity, that will be helpful.

Robert Carr

Well, we divide the number of selling people by the production and a large part of that is a reduction in the headcount. We had a substantial number of people that were hired that just never just got off the ground, and we stopped doing that. We have implemented some procedures to bring new people on and have them be immediately productive. That was never our model in the past. That's been working very well. We have our -- our margins have -- our average sales rep production has gone up from the low $2,000s into the $5,000s. So it's been pretty significant. We have what we call a win philosophy in Heartland now. A win means putting a certain threshold of sales each month and sales people that don't do that in three out of four months are removed from the organization. And the theory is, that we're much more efficient, and our managers are spending their time much more productively managing people who are out there working every day, trying to bring in business. And we wound up having a lot of people, for some reason, that love to carry a Heartland business card and apparently tell their spouse that they had a job, but they really weren't working here very hard. Those people are all removed from the organization at this point.

Thomas McCrohan - Janney Montgomery Scott LLC

And any other comments on the regulatory environment? You talked about Durbin. How about the routing aspect of Durbin? Do you have any insight into what implications will be for folks like yourself on the various permutations of that?

Robert Baldwin

Well, and that's exactly right, Tom. It's a little bit premature to talk about it. I think that, however, that our view is that these are incredibly complex systems and that if the Fed, in its implementation, chooses to undertake some of the more thoroughgoing changes that have been suggested, they will have to build in some very substantial delays in implementation because there's too many moving parts, too many systems that have been built using certain assumptions about the way the world works. And if you turn that world upside down, you just cannot do it quickly. And remember, we're only one part of a value chain that has both the networks and the issuers, and all of us would have to make changes. So it really will come down to how aggressive they choose to be in implementing the legislation. But I am sure that if they try to do, reach too far, that it's going to be -- will involve significant delays in implementation, if anything.

Operator

And we'll go to our next question from Reggie Smith with JPMorgan.

Reginald Smith - JP Morgan Chase & Co

So you guys did a very good job, I guess, of reducing processing costs this quarter. I was wondering, hoping that you guys can maybe talk a little bit about that, maybe parse out the different components? I guess I'm trying to figure out what's a good run rate to assume going forward? How much of the sequential savings is permanent? But any color around that would be great.

Robert Baldwin

Well, a significant portion of the phase in processing and servicing arose from, to a certain extent, the platform consolidation that we have achieved. Remember, we moved to Fifth Third, back end, to Passport that involves some savings that started to hit in the fourth quarter, more relevant in the first quarter. Then we bought out the residuals in August, the significant buyout, that's an ongoing save. We restructured and slimmed down our account manager force. That was an effort we had undertaken for a number of years to have a field servicing team that was out there very widespread, and we struggled with how to get that to be very effective and efficient and, in the end, have chosen to focus that much more, and we drove out a lot of costs that way. So a large portion of the saves are -- in many of them are in people and will be on go or people-related costs like the commissions that will be ongoing. You're going to have some further savings in platform consolidations that we're undertaking this year, although those are really going to hit home much more aggressively next year. But we feel good about keeping our overall processing and servicing costs in line. The one thing that's a little bit of an x factor is that included in that line is the cost-of-sales of some of our non-card processing businesses. And if, for example, we sell a lot of equipment, while the cost of the equipment we sold is in that processing and servicing. So that's something that adds a little bit of potential variability. But overall, I would describe the saves we've achieved in processing and servicing to be pretty fundamental to the way we're doing, running the business.

Reginald Smith - JP Morgan Chase & Co

You kind of alluded to, in your prepared remarks, about the last time there was a big interchange movement you guys gained share. I'm just curious, your sales folks, in their conversations with merchants, since the Durbin proposal was put out, have they gotten any sense -- do they have a view on whether merchants understand it? Does it seem like people are going to be more interested in moving, changing processes or acquirers? Any color you can provide there?

Robert Carr

Well, there's a lot of discussion going on across the industry about who's going to do what. And I think all of us are eager to see what the final Fed regs are going to be before we put anything in stone about what we're going to do. So I'm not sure. There's definitely a lot of confusion out there, and so I think it's premature to put too much out there. And so we're telling our salespeople just this is going to be good for Heartland because we're going to gain market share, but we need to see the final outcome of the Fed.

Robert Baldwin

And the only other thing I'd add is that, that I think it's dangerous to overestimate how much time our typical Small and Mid-Sized merchant is focused on this. There's been a lot of lobbying noise, but we are all deeply focused on, the investment community is deeply focused on it. But if you're out there trying to make a living in your store it remains not a great, not an easy time in the economy for that Small and Mid-Sized merchant. And so I would surmise that the great majority of them have -- they really don't know what they think, and we'll know an awful lot more about where things are going the next time we speak to this group because that will be after the April 17 release of the Fed's rules.

Reginald Smith - JP Morgan Chase & Co

I guess on mobile payments, there's been a lot of talk recently. I'm just curious how Heartland sees themselves in that food chain? And is this something you're thinking about longer term?

Robert Carr

Rey [ph] we're absolutely thinking about it. We have a new E3 reader that will plug into the audio jack of a smart phone or an iPad. So we are on top of it as much as we can. We are eager to see what Durbin -- what's going to happen with Durbin and what's going with ISIS. We are using, we have been using cell tags for several years in our campus market place, so we know there's a lot of interest in it from consumers. We like to see what the direction is going to be with ISIS because that's going to be a determining factor. But in terms of POS, what Apple is doing in their stores, I think is the wave of the future. There are going be mobile devices that are going to be used to make payments, wireless devices, and that's the future versus hardwired POS systems. So we think we're all over that particular topic and we'll be an industry leader in rolling out solutions for that.

Operator

And we'll move to our next question from Dave Koning with Robert W. Baird.

David Koning - Robert W. Baird & Co. Incorporated

I guess first of all, gross margins installed, if you could talk a little bit about the monthly transfer in the quarter. I realized that's lumpy, but I'm trying to link it to how that moved and maybe the timing of when a lot of the reps were let go, and if there is any correlation. And then kind of on top of that, can 2011 margin installed grow quite a bit even if reps are down maybe 25% on average through the year?

Robert Carr

We started implementing the changes actually in early August in a couple of regions. We have 15 regions, and we didn't really get them rolled out to all the regions until November. November, December, January and February are the slowest sales months of new installations, always have been just for seasonal reasons. So we're really eager to get into the warmer weather in March, which is typically one of our better months, so where we think we're coming into our best times. The increases in sales over the prior year were a little bit stronger in October, in November than they were in December, but we still beat last year's December that may have been weather-related. It's hard to tell. The productivity of our people who are successful is really sort of striking to us because the people who are getting their wins are actually getting their wins by almost 45% over the minimum target. And we've never really focused on anything but the minimum target in the past. So the average salesperson at Heartland today is generating just a significant amount of business more than in the past and we think that because of the reduction of headcount and the reduction of the management time spent with people who just aren't out there working full-time, we think that efficiency is going to allow us to beat last year's installs by a pretty decent margin, quite frankly.

Robert Baldwin

And the other element that goes into that is the hiring. We're making sure that each of the geographic areas has people who are productive first, and then, that set them free to do some hiring. But it is important that, that same productivity focus is being implemented on the hires and so our very strong objective when we're making hire is to get that person producing a substantial amount of business right out of the chute. So I think implicit in your question, Dave, is do we need to have more people to continue to grow? We can grow from the low levels of last year with the force that we have now, but looking forward, yes, we are looking forward to getting a larger sales force, but I think it's fair to say that it will be a much more measured and careful process to make sure that when we bring someone on, they are really making a good living for themselves, so that they can sustain themselves.

Robert Carr

And we also know from past experience that a successful salesperson is much more likely to recommend a job at Heartland to another successful salesperson. And we've lost some of that over the last couple of years and that's coming back now as well. We do not let a manager hire a new person now unless 75% of their people were successful in the prior month, and that's a big change at Heartland.

David Koning - Robert W. Baird & Co. Incorporated

You mentioned that the few, little acquisitions you did, I mean, are these going to contribute much more than 1% of revenue? I guess that one. And then, the terms of the new loan, is interest expense going to be up a little from where we've been running in the last couple of quarters?

Robert Baldwin

In terms of the aggregate revenues on the K-12, it's going to be over 1% of net revenues but not dramatically over 1%. We carryover sort of a recurring book of business there, but the drive is to take those platforms and those established customers and add more payment processing functionality which will enhance the revenues of those businesses probably kicking in, in the second half of the year within the new school year is the likely timing. And in terms of -- the other question was?

Robert Carr

On the loan interest.

Robert Baldwin

The loan interest. The aggregate loan interest is going to be in the area that -- really not very different from the latter part of this year. It's going to be about the same as the run rate we had in the fourth quarter.

Operator

And moving on, we have a question from Kartik Mehta with Northcoast Research.

Kartik Mehta - Northcoast Research

Bob, you talked about the Durbin amendment. I realize there's still a lot of unknown factors, but you clearly had success the last time, there was such a significant change in the market related to interchange. And I'm wondering if you could talk about the success you had during that time? Maybe a lot of market share you picked up during that time or maybe how ahead of quota you were? Just to get a sense of the benefit that this could really provide Heartland.

Robert Baldwin

While they are a much bigger company now than we were in 2003, so but in 2003, I believe we grew 40% primarily as a result of that. There was a lot of energy in our sales organization as a result of it. We're expecting to get a nice bump in our growth, though, by gaining market share, but it's not going to be anywhere in that range.

Kartik Mehta - Northcoast Research

So do you anticipate, Bob, making any kind of changes to your prices to the merchant? I realize you're not -- you're going to pass through the interchange. But would you anticipate changing any kind of statement fees or anything else that could potentially help in terms of margin, and maybe overall pricing for the company?

Robert Baldwin

We are going to be doing -- we have some new costs that we never had before because of government regulation and some of those will be passed on to our customers. So the answer to your question is yes. We are looking at some things that -- to recover some of our costs.

Kartik Mehta - Northcoast Research

And I'm assuming, Bob, that would be in terms of fees to your merchants?

Robert Carr

Correct.

Kartik Mehta - Northcoast Research

And finally, I think, Bob, you said 2011, you are estimating about 1.5%

same-store sales in 2011, would that be correct?

Robert Baldwin

Well, we are assuming the number in that ballpark. In other words, consistent with the average for this year, but that is not a forecast. We are not smart enough to know where the economy is going. But that's what we've built into our budgeting process.

Kartik Mehta - Northcoast Research

Well, I guess, Bob, what I was trying -- I wanted to find out was, is there any way to look at sensitivity to mid-year margins or earnings for every 50 basis point or every 100 basis point improvement in that ratio?

Robert Baldwin

Well, same-store sales is one element in looking at your overall attrition rate in the portfolio. And a 1% decline, a 50 basis point decline will be very hard to see, a 1% decline in our attrition rate from, let's say, 13% to 12%, or something, is going to enhance your net revenue by a sort of 70% or 80% of that because about 80% of our business is coming from merchants that have been with us over a year. And so you're really talking about, on a quarterly basis, I would estimate, less than 1% change in your net revenue. Now net revenue, bump like that, goes through to the bottom line very nicely. As we've talked about the first quarter is always seasonally weak and part of that is just we only have a 90-day quarter and that we have less net revenue. So there's a fair amount of operating margin that comes out of a bump in net revenue. But it's hard to give a more specific answer than that.

Kartik Mehta - Northcoast Research

And I guess in that vein, do you have enough data to determine if your new E3 terminal is helping reduce attrition? I know you said that attrition has been, reduced, and I'm wondering if how much of that you could attribute to the new E3 terminal?

Robert Baldwin

I don't think enough-- we have 11,000 customers that have gone to the E3 terminal at this point, which is pretty decent since the end of May. But that's still a pretty small percentage of our business and it's too early to tell. We measure attrition year-over-year, in any case, and it hasn't even been many years since we released that product. We think it's going to help a lot, though.

Operator

And we will hear next from Robert Dodd with Morgan Keegan.

Robert Dodd - Morgan Keegan & Company, Inc.

Just three questions. First on the guidance, the $0.92 to $0.96, does that exclude interest expense related to the breach, and if so, can you give us a ballpark on how much that is?

Robert Baldwin

No, Robert, we excluded and called out the interest rate related to the breach because when we gave our guidance since the beginning of last year, we, of course, had no idea how much our interest was going to be. So this reflects what we -- and we're going into the year. We ended the year a little bit high in our borrowings under the revolver because we paid for the acquisition of one of the K-12 schools on the 30th of December. So we are at $110 million, $115 million of borrowings between the term loan and the revolver right now and are not, excluding acquisitions, expecting that to grow as the term loan is going to amortize. So if anything, that's going to tend to come down during the course of the year, and we're reflecting the full interest cost for the year which is going to be, as I think, sort of in, directionally, the run rate of the fourth quarter. And that does include, in essence, processing systems cost but we'll just take that as -- the fact is that we had to pay out all that money, and it's changed a little bit of our debt load as a company, but we still remained very conservatively capitalized and a lot of flexibility for accessing capital, if we need to, going forward.

Robert Dodd - Morgan Keegan & Company, Inc.

On the K-12, can you give us a little bit more color about what the product actually is? Is it kind of akin to your college campus product with access controls and maybe a food card for the cafeteria or something? Can you give us a little bit more color on that? And whether it's going to lead to the same kind of expense ramp? I mean, it's the wild card, obviously, with your campus card which initially required a fair amount of upfront investment to kind of drive the sales effort.

Robert Carr

I'll take that one, Robert. It's a very conventional lunch account program to start with. That's what we acquired and the development is all done. And one of these companies had a really great platform, and we're going to use that platform. So the development is not -- we're not going to have that development overhead that we had with the campus program. We expect to be able to expand because of our sales organization. We can go to see 9,000 schools, and there's lots of other activities at schools that can be paid for with an account program, so that's where we're going to integrate it into some of our other tools, Web service tools. And that's why we think we can expand it substantially. And also, the schools have lots of community leaders involved with them and it just gives our local salespeople some additional networking opportunities as well.

Robert Dodd - Morgan Keegan & Company, Inc.

And last question, if we go back to either what you expect this time or if you compare it to the interchange change last time, is there a risk that the ISIS or your other competitors in this space who, in most cases, probably are not going to pass on all of the savings to their merchant base, is there a risk that they get much more aggressive as we get through, if the Durbin rules stay as they are right now, in order to gain share so that they can, lack of a better term, price gouge after the interchange change? Do you think that's going to affect your attrition maybe in the middle of the year and then you benefit later? I mean, is there any color you can give us on that?

Robert Carr

I don't think that we're going to be in a -- I think it'll be a strong competitive position. I'm not sure how ISO's could be more competitive than they are now in terms of bait and switch techniques for merchants. So I think we're under a very strong competitive position, and there will be lots of markups in the future just like they are now. I think it’s going to be very similar to 2003, the main difference being that we're a much larger organization, and to get the percentage of growth we got back then is going to be impossible. But I think we're going to be very well positioned because the combination of transparent pricing on something this complicated, along with our E3 solution, is a pretty powerful solution. And our people are pretty excited about those differentiators in the marketplace. They are very significant.

Operator

And moving on, we have a question from Meghna Ladha with Susquehanna.

Meghna Ladha

Can you point out some of the main growth drivers that will help you achieve the 7% to 9% guidance for fiscal '11?

Robert Baldwin

Sure. The first is just continued growth, as we said, we turned around the SME volume growth in by the end of the year. The fourth quarter was sequentially better than the third quarter. And we're looking to push that further with successfully increasing the margin we install. So that's going to help. The second factor is in NWS. During the year, we are growing our transactions reasonably nicely. Unfortunately, due to re-pricings earlier in the year, the profitability for transaction was not as good in 2011. We don't face that same headwind in terms of re-priced contracts. So NWS card processing net revenue was down year-over-year, and that's going to turn around. It's not going to be an anchor on us. And then we have good growth going in our non-card businesses, whether its payroll, express funds, the campus and micropayments solutions, are all growing nicely. And we expect also to grow our Equipment business especially tied in with the E3 and, as Bob mentioned earlier, the SmartLink equipment. So a lot of growth drivers, nothing that's radical or dramatically different, just better than last year without a couple of drags that we had, that we faced in 2010 .

Meghna Ladha

And can you provide some color with respect to your operating margin guidance for fiscal '11? I know last quarter, you said that you expected to approach 15% of net [ph], any update on that?

Robert Baldwin

No, we are going to work hard to get it as high as we can. As you know, there's quite a bit of seasonal variation within the operating margin. And so we expect a pretty attractive, a peak operating margin, in likely the third quarter which is our typical pattern. But I think that the numbers will speak for themselves. The focus will remain not just -- this is not a one-year focus, this is a multi-year focus. We're trying to drive ourselves to greater efficiency as an operation, while still growing the top line significantly. The better success we have in growing the top line, as I mentioned, the more operating margin that we get out of an incremental dollar of top line is pretty significant, so that will also have an impact. I think there's sort of implicit numbers speak for themselves as far as what we're giving guidance on for operating margin. But suffice it to say that we're aspiring to do better.

Meghna Ladha

And just three very quick questions. When was the tax rate, it was 36% in the fourth quarter, what do you expect in 2011? Second was contribution from AmEx on Discover in terms of volumes, and what was the count of relationship managers at the end of the quarter?

Robert Baldwin

It's 38.4% is sort of our base number for tax rate. The last question was relationship managers, this is available in the statistical supplement, but it's 917 at the end of the year. We're counting a little bit differently because unlike previously, when we had territory managers, they could just manage if they wanted to, now we're saying that territory manager has to be productive just like the people who work for them, so really treating them just like another relationship manager in that regard. The other question you had, I missed about Discover.

Meghna Ladha

AmEx and Discover processing volume? It was about $740 million last quarter. What was it this quarter?

Robert Baldwin

AmEx and Discover between them were about $740 million, and this quarter would be $780 million. This is AmEx piece where we're getting, we call it, full economics. In other words, not the servicing-only piece of AmEx.

Operator

And moving on, we have a question from Brett Huff with Stephens.

Brett Huff - Stephens Inc.

On G&A, I know you guys have your conference phasing in some of the quarters coming up. Could you give us just the sense of how that will phase and impact G&A? But then also, any other enumeration of any cost take-outs that you're anticipating there and when they might phase in during the year?

Robert Baldwin

Well, we're not doing a summit this year. Our intention is do them every 18 months. And last year, we did one early. So this year, this time, we're doing it late to get back on the cycle, and we're going to be doing it in the first quarter or early second quarter of next year. As a result, we have some pretty modest costs build into -- we will have some pre-conference planning costs in the fourth quarter of this year. Overall, G&A is not going to be -- we're going to end up with a lot of days on the processing and servicing line. G&A is not going to be as low a growth as the processing and servicing. In some large part, because of, as I mentioned, the platform consolidations that we're doing, they are going to offer some very significant saves as we move to a cloud-based environment in 2012. This involves a lot of G&A costs in 2011. So while in the aggregate, our costs of making the donuts, if you will, in terms of the processing costs, really aren't growing this year. The way it's going to play out in our financials is very constrained on the processing and servicing line, but some incremental costs in G&A as we build out the new cloud-based platform. And then there were other costs as well that we're growing in the G&A line this year as a result of, overall, not being very happy with the financial performance that we achieved. This year's bonuses were quite low. They were budgeting for a return to a normal performance-based budget bonuses this year, that's not 2011. Obviously, that will be dependent on achieving success as we defined it. So G&A will grow a good amount in 2011, but the operating margin improvement is going to be driven, as we indicated, primarily in the processing and servicing line, as well as some of the other customer acquisition costs and G&A lines where you still have the wash through of relatively low expenditures, investments, if you will. And so resulting, low depreciation and amortization in both G&A and in customer acquisition costs.

Brett Huff - Stephens Inc.

And then if that G&A is going -- it sounds like the planning and the effort to consolidate some of the platforms would be an '11, is the way you're characterizing that, would that then -- is that a temporary thing in '11 and then it declines that management or the planning phase? Does that decline or does that remain in G&A going into '12?

Robert Baldwin

That declines. Now of course in '12 we do have the summit which is going to bump things up. But that piece is the very specific costs that we are incurring and would go away as you successfully roll out the new platform.

Brett Huff - Stephens Inc.

And then can you give us any color on the portfolio buyback that you're looking for going forward? I mean, you obviously had some significant ones recently. Any thoughts on that or color?

Robert Baldwin

Well, we're not planning any large buyouts like August of this year. That could change, but we're not planning on that right now. We are still seeing a decent activity in terms of buyouts in the fourth quarter, and so we're thinking that the numbers, for planning purposes, we're using I think $8 million of buyouts this year, and the fourth quarter, we are right on that run rate maybe even a little above it even after the large buyout in August. So it's not something that, in general, we are responsive to our salespeople, to those who are productive, who are staying with us, we will buy them out if they want us to and usually that's for life events and that will continue.

Brett Huff - Stephens Inc.

And then last question, any forward-looking view on CapEx? Any changes to last year, et cetera?

Robert Baldwin

This year, our CapEx will be higher, somewhat, because of the expense associated with the move, consolidation of the Johnson City platform into our service center. In our service center in Jeffersonville, we have not finished out the one floor with fixtures and such likes because we weren't going to use it for a while. Well, with shutting Johnson City, we will be using that and that's going on right now. We also had to grow our deployment centers substantially. So basically, last year's run rate, 2010 run rate, will continue on CapEx, but then you'll throw in another $4 million or $5 million for incremental for Johnson City expenditures in 2011.

Operator

And our next question comes from Sanjay Sakhrani with KBW.

Unidentified Analyst

This is actually Stephen [ph] filling in for Sanjay. Just a quick question with regards to, I guess, the same-store sales mentioned that January was a little bit lighter because of the weather, have you seen any bounce back in February?

Robert Baldwin

We don't have any way to measure intra-month same-store sales. On a very judgmental feel basis, actually, it feels a little bit better and I'd say that it's just based on looking at the daily volume numbers compared to a year ago volume numbers, it feels a little bit better even with the tough weather we've had in the early part of this month. But it's really hard to judge and for that matter, we're waiting today, we find out how Valentine's Day was, Valentine's Day is a very big day at Heartland because of our significant focus on restaurants, and I don't have that number yet. I'll have it a little later this morning. So it's very hard to tell.

Unidentified Analyst

And then I guess, like now, given largely the processing system [ph] is behind, and I know that you guys increased the dividend this quarter. Are there any potential chances to maybe repurchase back shares at some point in the future?

Robert Baldwin

I think it's fair to say that the subject of repurchased shares has been not a subject of discussion in the last couple of years' board meetings. I would expect that to be something that we would take up this year. We have some significant cash flows that we are anticipating, that we can use in a variety of ways. We're going to be using it in -- there is some CapEx that we have. We have raised the dividend, and we are always looking for attractive acquisitions. But certainly, I would expect the board to consider repurchases in the coming months.

Operator

And with no further questions in the queue at this time, I'd like to turn the call back over to Robert Carr for any additional or closing remarks.

Robert Carr

Thank you. And thank you, everybody for joining us, and have a great day.

Operator

And again, that does conclude today's conference. We do thank you for your participation.

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