Blackhawk Network Holdings (HAWK) Talbott Roche on Q1 2016 Results - Earnings Call Transcript

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Blackhawk Network Holdings, Inc. (NASDAQ:HAWK) Q1 2016 Earnings Call April 27, 2016 8:30 AM ET

Executives

Patrick Cronin - Vice President-Finance & Investor Relations

Talbott Roche - President and Chief Executive Officer

Jerry N. Ulrich - Chief Financial & Administrative Officer

William Y. Tauscher - Chairman, Head of International and Corporate Development

Analysts

Sara Rebecca Gubins - Bank of America Merrill Lynch

Bryan C. Keane - Deutsche Bank Securities, Inc.

Paul Condra - Credit Suisse Securities (NYSE:USA) LLC (Broker)

Christen Chen - Jefferies LLC

James Schneider - Goldman Sachs & Co.

Timothy Wayne Willi - Wells Fargo Securities LLC

Wayne Johnson - Raymond James & Associates, Inc.

Ashwin Shirvaikar - Citigroup Global Markets, Inc. (Broker)

Operator

Welcome to the Blackhawk Network's First Quarter 2016 Earnings Conference Call. For those on the audio dial-in, your lines have been placed on listen-only until the question-and-answer session. This call is being recorded. If you have any objections, please disconnect at this time.

I would like to turn the call over to Mr. Patrick Cronin, Blackhawk's VP of Finance and Investor Relations. Please go ahead.

Patrick Cronin - Vice President-Finance & Investor Relations

Okay. Thank you, operator, and good morning, everyone. Yesterday, we published our first quarter 2016 earnings results along with a supplemental slide presentation which contains additional detail on Blackhawk's quarterly results, business highlights, and financial guidance for fiscal 2016. A copy of the presentation and earnings release can be accessed from our Investor Relations website at ir.blackhawknetwork.com.

Before we begin, we do want to apologize for any confusion caused by an error in the 2016 updated guidance section of the earnings release that was filed on Form 8-K as compared to the accurate 2016 guidance in the earnings release that hit the Wire at 2 p.m. Pacific time yesterday. You should refer to the release that hit the Wire and the earnings presentation posted on our IR website which are correct. Yesterday evening, we filed an amended Form 8-K with the corrected guidance, which is now available on EDGAR.

Joining me this morning to discuss Blackhawk's first quarter results are Talbott Roche, our Chief Executive Officer and President; Jerry Ulrich, Chief Financial and Administrative Officer; and Bill Tauscher, Chairman of the Board.

To get started, we should spend a minute on forward-looking statements. I'd like to remind everyone that management will make statements during this call that are forward-looking within the meaning of federal securities laws. Forward-looking statements contain information about future operating or other financial performance. Forward-looking statements are based on our current expectations and assumptions and involve risks and uncertainties that could cause actual results or events to be materially different from those anticipated. Further, such forward-looking statements speak only as of the date of this presentation. We undertake no obligation to update or revise any such statements as a result of new information, future events or otherwise. For a list and description of those risks and uncertainties, please see the Safe Harbor statement on slide two and the Risk Factors section in our filings with the SEC.

Before I turn the call over to Talbott, I want to walk you through a definition change to our adjusted operating revenue metric and introduce a new cash tax benefit for 2016. In our ongoing effort to simplify our key financial metrics, we communicated in yesterday's earnings release a revised definition of adjusted operating revenues or AOR. As we've mentioned in the past, we receive marketing funds primarily from our closed gift loop partners, which under U.S. GAAP are required to record – we are required to record as marketing revenues.

Now, 100% of these revenues from these partners is spent inside of our distribution partner network to promote the in-store gift card program. We record the marketing expense in the sales and marketing line of our income statement. Also, in a few countries such as Japan where we use a sub-distributor, we've experienced significant fluctuations in marketing revenues with no net impact to adjusted EBITDA.

Beginning with Q1 2016, we have now defined adjusted operating revenues to exclude pass-through marketing revenues and have restated historical results for comparability. The restatement for the past nine quarters is posted on our IR website. We'll also use our new definition of AOR to measure operating expense lines as a percentage of revenues rather than using a separate pro forma definition of revenues that we've used in the past. For your modeling purposes, we expect full year 2016 marketing revenues in the range of $90 million to $100 million, which have been excluded in our updated AOR guidance. For 2015, for reference, marketing revenues totaled $105 million.

Moving on to slide four. For 2016 we've adopted Accounting Standards Update 2016-09 published in March, and that standard changes how certain tax benefits from stock compensation deductions are recognized in the financial statements effective for all companies beginning in 2016. Specifically, certain realized tax benefits that previously were treated as increases in paid-in-capital are now treated as a reduction in tax expense.

In our adjusted metrics we will include the new cash tax benefits as a component of reduction in cash taxes payable from amortization of acquisition intangibles, utilization of acquired NOLs, and now deductible stock-based compensation. Historical results have been revised for comparability, as shown in the table on the slide, and a full nine quarters with the revision have been posted to the IR website. We estimate the cash tax benefit related to stock compensation for full year 2016 will be approximately $14 million as compared to $13 million for 2015. Both years, the EPS impact is about $0.24.

I will now turn the call over to Talbott Roche.

Talbott Roche - President and Chief Executive Officer

Thank you, Patrick, and good morning, everyone. Moving to slide five. For Q1, financial results came in at the high end or exceeded the guidance range provided during our February earnings call.

Adjusted operating revenue, excluding marketing revenues as Patrick mentioned earlier, were $185 million or a 23% increase over the revised 2015 figure. Adjusted EBITDA growth of 7% and adjusted net income growth of 8% exceeded guidance due to strong performance from International and Incentives. Overall growth was lower as a result of the EMV headwinds in 2016.

On slide six, beginning with U.S. Retail, an increase in measures taken by certain non-EMV compliant distribution partners to manage their liability for fraudulent credit purchases of gift cards had a larger impact on our U.S. Retail segment results in Q1 than we originally predicted. I will provide additional detail on the EMV outlook for the remainder of the year in a few minutes.

In our Incentives segment, adjusted operating revenues grew 18% organically and 72%, including the acquisitions of Achievers and Giftcards.com. Achievers was EBITDA positive for the quarter and ahead of plan and Giftcards.com exceeded our expectations in the quarter as well.

International adjusted operating revenue growth of 33% also exceeded expectations, driven by strong sales in Germany and Asia-Pac as well as contribution from Didix, the Europe-based content provider which we acquired in the second half of 2015.

Finally, we were pleased this quarter with performance across our various digital distribution channels in both the Retail and Incentives segments. Transaction dollar volume totaled $184 million, up 140% year-over-year with organic growth of approximately 50%. Within the U.S. Retail segment, Digital Channels represented 8% of total gift card TDV for the first quarter.

Turning to slide seven and our segment results. The 1% year-over-year decline in U.S. Retail transaction dollar volume was driven by several factors. First, U.S. closed and open gift card transaction dollar volume reflected the shift in Easter into Q1 of 2016, compared to the first week of Q2 in 2015, which was more than offset by EMV headwinds.

Second, U.S. Retail TDV growth was reduced by the termination of two low-margin programs in our general purpose reloadable business. The key mobile private label program was discontinued during Q1, as was a program to link tax refunds to our PayPower GPR card. This decline in overall TDV limited U.S. Retail AOR and adjusted EBITDA growth to the low single-digits in the first quarter. Excluding our estimated impact of EMV, U.S. Retail AOR grew 10%, and adjusted EBITDA grew 14%.

International continued to see large transaction dollar volume growth in Japan and Germany in the first quarter. The FX impact to AOR during the quarter was only $1 million, an impact of 6% on year-over-year growth compared to an impact of 14% in Q1 of 2015.

The Incentives segment showed strong AOR and adjusted EBITDA growth driven by the addition of Achievers and Giftcards.com Incentive business. Further, a contract amendment for program fees contributed to the favorable results for the quarter. Unallocated expense growth was driven primarily by higher information-security and compliance costs, as well as occupancy costs.

On slide eight, we've provided an update on the EMV-related impact to our Gift Card business. We have continued to dialogue regularly with our non-EMV compliant distribution partners on measures they have taken to mitigate their liability for fraudulent credit card activity in their stores. A few partners decided to take restrictive measures and a few important partners have taken increasingly restrictive measures around the sale of higher denomination open loop cards during late Q1 and into Q2.

Some EMV-impacted retailers have established lower limits on credit card purchases of gift cards or removed higher denomination products from the displays in impacted markets. We are seeing forecasted compliance dates slip at multiple retailers due to the complexities around testing and certification of their point of sale EMV upgrades, creating risks that dates could move out.

As of today, our top-25 accounts, seven, going to eight later this week are now compliant; four are tracking toward their compliance date; two have moved up their date; and 11 have moved back their date. Our updated forecast assumes some delays. We continue to actively monitor the situation, and based on the information currently provided by our partners we are estimating that stores representing approximately 95% of open loop gift TDV will become EMV-compliant by the end of September 2016.

Our previous estimates of EMV-related financial impact provided on our February 23 call were based on measures our non-EMV-compliant distribution partners had taken and the plans they had communicated to us up to that point. We coupled this with the sales impact we had observed between mid-January 2016 when we were first notified of EMV actions taken in our February earnings release.

With the additional restrictive measures taken and observation of more current sales impact, we have increased our estimate of the full year 2016 impact related to EMV by approximately $29 million on adjusted operating revenues and $30 million on adjusted EBITDA. Our current estimates do allow for a sales ramp period following compliance.

The updated guidance reduces overall consolidated full year 2016 growth by 6% on the adjusted operating revenue line and 23% on the adjusted EBITDA line. While EMV-related headwinds are significant, we continue to believe this issue is limited to 2016. Distribution partners are motivated to become compliant, and our internal consumer research and third-party research conducted by the National Retail Federation indicates the ongoing popularity of gift cards remains high for retailers and consumers.

Moving on to slide nine. While we acknowledge EMV-related headwinds are significant in 2016, we have many positive developments to share in both our U.S. Retail segment as well as internationally and across our Incentives segment.

In U.S. Retail, we're rolling out new category cards and new cash-back Visa products. While some marketing has been curtailed in non-compliant chains as they work towards becoming compliant, we expect to restock and market closed and open products to increase awareness with consumers once a broader selection returns to the stores. And we continue to see strong digital growth and expect to sign several more important digital distribution deals over the course of the year.

In Incentives our Achievers employee engagement solutions continue to gain momentum through enterprise account cross-selling. We are introducing the Achievers platform to some of our largest distribution partners and are finding employee engagement to be one of the hottest topics in HR departments today.

Consumer incentives received a boost with the acquisition of extrameasures in the second quarter, which adds to our leadership position in the consumer incentive space. And Giftcards.com incentive business has been exceeding expectations so far in 2016 and, with CardLab, establishes us as a leader in the e-commerce channel for Incentives. The pipeline of opportunities to continue to build on our Incentives business remains robust.

In International we see new distribution partner opportunities in Germany, and we are expanding the open loop gift product offering in Europe. The acquisition of Didix allows us to sell higher margin content across Europe. There are additional international acquisition opportunities for Didix-like content providers. We're also seeing growth in the Asia-Pac region, driven by new content, continued momentum in Japan, and the new growth in Korea.

And finally, across Digital Channels we continue to sign up new digital distribution partners, and we are integrating all e-commerce capabilities into the feature-rich Giftcards.com platform. We're also integrating and expanding NimbleCommerce capabilities for offers and egift services. These digital channels have become meaningful contributors to our Retail and Incentives business in the U.S. with significant growth rates.

With that I'll turn it over to Jerry to cover 2016 guidance and other key financial metrics.

Jerry N. Ulrich - Chief Financial & Administrative Officer

All right. Thank you, Talbott. I am going to provide, as Talbott said, some additional details on both the second quarter 2016 and the full year 2016 guidance, and from there I'll cover some enhanced free cash flow analysis that we've provided, and finally overview our key revenue and expense ratios.

Turning to slide ten, as a reminder, the second quarter is our second-largest gift card transaction dollar volume quarter of the year due to Mother's Day, Father's Day, and graduation season falling within the quarter. We don't expect our largest non-EMV-compliant distribution partners to become compliant until after the second quarter. So we believe the additional restrictions that Talbott described earlier will have a significantly larger negative impact on our key financial metrics during the second quarter than previously expected.

The adjusted guidance ranges are presented here on slide 10. Also, at the bottom of the slide we're showing our current estimated impact of the EMV measures on the second quarter; adjusted operating revenues and adjusted EBITDA, and the metrics, adjusted, to exclude this estimated impact.

So excluding EMV impact, the year-over-year profit comparisons are challenging. We expect organic growth for the Incentives business to be flat to down in the second quarter, as some programs ended and other new programs won't launch until the second half. Retail organic growth is lower due to Easter falling in the first quarter, which also reduces profitability.

Also, as mentioned with the first quarter results, we're incurring some incremental spend on technology, security and compliance initiatives, including work towards ISO certification. This excess growth will moderate in the second half of the year.

Moving on to our full year guidance. We will continue to see the EMV impact in the second half of the year, as we've assumed, as I said earlier that two of the largest non-EMV-compliant distribution partners won't become fully EMV compliant until the end of the third quarter. In addition, our guidance does not assume an immediate rebound in sales following EMV compliance, as we've assumed it will take some time for consumer behavior and sales volumes to improve.

The full year guidance does reflect an improved sales picture by the end of the year in U.S. Retail, higher than originally expected growth in contribution from Incentives and International, and the resulting profit leverage we typically realize in the fourth quarter.

So again, at the bottom of slide 11, excluding the estimated EMV impacts, we would show AOR growth for 2016 of 19% to 27%, adjusted EBITDA growth of 24% to 34%, and adjusted EPS growth of 14% to 21%. These estimated pro forma growth figures are above our long-term growth targets of 20%.

Okay. On slide 12, since the last call, we have tightened our – or expanded our free cash flow – I'm sorry, tightened our free cash flow projection to between $110 million and $125 million for the year. We've lowered our CapEx target to $54 million, which would represent about 5.6% of adjusted operating revenues, down from 6.4% in 2015.

We ended Q1 with a debt-to-EBITDA leverage ratio of 2.65 times, and we do still plan to raise a new round of debt sometime in the next two quarters while maintaining a maximum total debt to EBITDA pro forma leverage ratio of 3.5 times to 1 times. The additional availability under our credit facilities would be used for acquisitions and we continue to have a robust pipeline of opportunities.

All right. Turning to slide 13, some expanded disclosure here on free cash flow. We've expanded the disclosure to show kind of a full view of free cash flow that's reconciled to adjusted EBITDA and to our free cash flow disclosure in our earnings release. The primarily difference in the cash flow amount versus the accounting disclosure previously in our earnings releases is the addition of cash flows associated with flows on increased transaction volume. We've added this figure going forward since we adjust out the cash flow from operations – or we adjust out of the cash flow from operations a 100% of the settlement timing differences that occur at the end of each quarterly period.

Looking at our key revenue ratios in the first quarter, Prepaid and Processing Revenues as a percentage of transaction dollar volume increased 90 basis points year-over-year due to a lower proportion of open loop gift sales in U.S. Retail, again the result of EMV, and a higher proportion of incentives on the overall business. Our Incentives segment, including the addition of Achievers and Giftcards.com carries a much higher revenue yield on the transaction dollar volume.

Partner Distribution Expense declined in the first quarter 2016 compared to the prior year, also related to the growth in the Incentives segment, which has a high proportion of direct sales. For the full year 2016 we expect Partner Distribution Expense as a percentage of Prepaid and Processing Revenues to be flat to 2015 based on the overall mix within Retail and between Retail and the Incentives segments.

The adjusted operating revenue ratio, similar to PPR, improved year-over-year due to the higher proportion of Incentives volume, which again has a higher revenue yield as compared to our Retail segments. For the full year, we expect this ratio to come down primarily due to the high weighting of U.S. Retail and International Retail sales volume in the fourth quarter.

And moving on to slide 15, we demonstrated expense leverage in Processing & Services as a percentage of adjusted operating revenues due to acquisition expense synergies and the addition of Achievers, which has lower Processing & Services cost. Conversely, Achievers does incur higher sales and marketing expense based on their enterprise sales model, which causes deleverage in this line during the quarter.

G&A expense as a percentage of AOR increased year-over-year, primarily due to the slower revenue growth due to EMV. Since we gain a lot of expense leverage in the fourth quarter, given the seasonal spike in U.S. and International Retail revenues, the full year expense ratios are lower than each of the first three quarters of the year. In spite of the lower revenue growth in 2016, we expect full year 2016 total operating expenses, excluding product cost of sales will be flat to slightly down as a percentage of adjusted operating revenues as compared to last year.

If we are to adjust these expenses to exclude the impact of EMV and look at EBITDA margins on a pro forma basis excluding this temporary impact, we believe we would show margin expansion of at least 100 basis points. Now, mathematically, by simply adding back our estimated AOR and adjusted EBITDA EMV impact, you'd see a 240 basis point increase in margin over 2015, but this would be overstated in part due to temporary cost containment measures we've taken this year included delayed hiring and reduced salary increases and incentive compensation for 2016.

And on slide 16, looking at product margins, product sales of course include Cardpool sales, telecom handset sales, our ancillary card printing and processing business, and product sales at Achievers. Recall that the portion of Achievers revenues related to points redemption for merchandise or prepaid closed loop cards are recorded in the product sales line. The expense offset to product sales skews the cost of the product sold. The year-over-year margin improvement in Q1 was driven again primarily by the addition of Achievers.

And of course there is additional information including reconciliation of GAAP and non-GAAP measures and walks in year-over-year earnings per share in the appendix.

And with that, I'd like to turn it over to the operator to open it up for questions.

Question-and-Answer Session

Operator

Thank you. The first question is from Sara Gubins of Bank of America. Your line is open.

Sara Rebecca Gubins - Bank of America Merrill Lynch

Hi. Thank you. Good morning. Just to start off on EMV, as we're trying to understand more about the impact, could you give us a sense of how much of your revenue today comes from open loop gift cards?

Jerry N. Ulrich - Chief Financial & Administrative Officer

Sara, we typically don't break it out by group, but it's going to be roughly 15% to 20%.

Sara Rebecca Gubins - Bank of America Merrill Lynch

Of overall revenue?

Jerry N. Ulrich - Chief Financial & Administrative Officer

Yes.

Sara Rebecca Gubins - Bank of America Merrill Lynch

Okay. Great. Thank you. And then it may be too early to tell, but is there any reason to think that what is happening with open loop right now and grocer and retailers' behavior is – might suggest a longer-term change as opposed to the short-term reaction while they try to implement EMV?

Talbott Roche - President and Chief Executive Officer

Sara, I can answer that. We are working very closely with our partners and talking to them on an ongoing basis, meaning biweekly, about the situation. And as we mentioned, we now have seen some retailers move from non-compliant to compliant, are in-process today, and we are restocking the cards, working with them to round out the displays with any of the products that were eliminated during their non-compliant period. So we don't have reason to believe that retailers won't want to carry a complete selection of product and return to having a complete offering for their shoppers. And in terms of retailers who have taken other measures to restrict certain forms of tender for higher value transactions involving gift cards, we know that they want to stop doing that as soon as possible because it is very inconvenient for their consumers. So we see these impacts on these measures that they're taking to address the situation during the transition not persisting afterwards.

Sara Rebecca Gubins - Bank of America Merrill Lynch

Okay, great. Thanks. And then just a question on store upgrades. You upgraded 500 stores in 2015. If you could talk about what your expectations are for 2016 and give us a breakdown of grocery partners that are basic versus best practices versus loyalty and how that's been trending, it'd be great. Thanks.

Talbott Roche - President and Chief Executive Officer

Yeah. Good question. We are forecasting this year to achieve the same number of migration to best practices as last year; so the same 500, but obviously in different chains. We have been making progress even while retailers are in a non-compliant state, meaning EMV-non-compliant. We have been partnering with retailers, for instance, to install new displays and add more pegs even during this transition, signaling their intent to continue supporting this very attractive, high traffic-driving destination category going forward.

We're also adding – we're forecasting approximately 50 new cards this year and that will be rolling out – some of them will be rolling out and launching in the R1 timeframe, which is spring, and usually as is typical in any given year, the preponderance of them are released in R2. It will be the same this year. And those will be added to the displays to drive additional sales. So yes, we continue to migrate. We're focusing on that ongoing migration of basic to best practices, and we expect the same number of retailers as year-ago to make that migration.

Sara Rebecca Gubins - Bank of America Merrill Lynch

Thank you.

Operator

Thank you. The next question is from Bryan Keane of Deutsche Bank. Your line is open.

Bryan C. Keane - Deutsche Bank Securities, Inc.

Hi. Good morning. So on the EMV issue, last quarter we talked about six retailers. Sounds like there's a lot more now. How many retailers are we seeing now are impacted by this EMV issue?

Talbott Roche - President and Chief Executive Officer

So Bryan, let me break it down. There are more retailers than six that are non-compliant. In the February call, we had identified six of our top 25 that had taken measures to mitigate their risk. That number has expanded now to 10 out of our top 25; so four more retailers now have taken some measure that they weren't taking previously. I'd say though, more importantly, of those six, a few important partners have had to take enhanced measures. So we outlined some of that in one of the slides that we went through during the deck.

Let me give you an example. So an account may have previously required a manager override for a certain transaction dollar amount on – of gift cards sold. That would require a checker calling over the manager, doing a visual check of some form of ID before permitting the sale to go through. Certain retailers may have – or a few may have moved to restricting or hard-declining certain credit card transactions above a certain value for gift cards in their store. So that's a very different approach. You may also have seen – or we have seen an account take down a few more cards than they had previously taken down, which will restrict sales. So it's the enhanced measures in a few key accounts that has been a big driver of adjusting our numbers.

The final issue would be the delays that we have seen. Now, while we have, I noted, seen some accounts pull forward their dates because they are anxious to becoming compliant and not have to have these measures in their store, we mentioned we've seen 11 accounts actually slip, and that can mean, slip a couple weeks, that could mean slip a month or more.

That is based on the fact that they have a tremendous amount of dependencies on third parties to become EMV-compliant, including hardware providers at the point of sale, software providers to upgrade the software that runs the EMV protocols, and then processers that they have to certify all the different transactions that's with. And it's the certification process that seems to be taking the longest. So we are also baking into our revised forecast the time it takes to get through that process, which in some cases has been longer than originally anticipated.

Bryan C. Keane - Deutsche Bank Securities, Inc.

And when you see so many become EMV-compliant, are they outselling open loop gift cards right away? I mean, you are seeing it come back more to normal yet? Or how does it work, once they do become EMV-compliant?

Talbott Roche - President and Chief Executive Officer

Yeah. So when they become EMV-compliant, as I mentioned, we're in the process of that happening with some. A few of our accounts had already become EMV-compliant the beginning of the year, but those that are going through it right now, we are partnering with them to restock those cards as the stores become EMV-compliant.

In some cases, that's a rolling process for the chain. So they may be putting a target in place of 40 to 60 stores per week and we're addressing it as they go. In other cases, they are asking to wait to put all those cards back until the complete division or the chain has completed the EMV compliance and the certification testing. And in those cases, we are waiting until all stores are done. And then we are partnering with them to restock those cards.

But for the most part, they're getting them back in as soon as they can. And then there is a burn-in process, right. So the consumer now realizes, okay, I can go buy a variable load open loop card there. I can find a $200 Visa card there that I previously couldn't find. And so we've accounted for the fact, there's some burn-in process for the consumer to become aware. We're also partnering with our accounts to run attendant marketing programs that would help increase consumer awareness of the category and drive traffic to the displays post EMV compliance as a way to accelerate that consumer awareness.

Bryan C. Keane - Deutsche Bank Securities, Inc.

Okay. And then, last quarter the impact was much smaller than – that now that you guys are outlining $51 million in adjusted revs and $44 million now in adjusted EBITDA. Are you guys comfortable that you have your arms around this situation and then it's not going to get worse? – Because it got a lot worse from last quarter. Thanks.

Talbott Roche - President and Chief Executive Officer

Yeah. We acknowledge it did get a lot worse or – we have a lot more information than we had in the February timeframe and we are trying to inform our forecast based on that additional information. We have made a careful and thoughtful bottoms-up forecast based on all the information available to us to-date. And having seen a few more weeks since that call and seeing how this is playing out in the marketplace, we try to accommodate for the delays and these additional measures that we've taken.

So, yes, we feel we have – based on the information we have today, we have offered a – developed a very solid forecast for the impact of this. And we remain – we believe based on the information we have today, again, the preponderance of this is contained within the timeframe we've discussed and these retailers are pushing to get compliant by the end of Q3.

Bryan C. Keane - Deutsche Bank Securities, Inc.

Thanks.

Operator

Thank you. The next question is from Paul Condra of Credit Suisse. Your line is now open.

Paul Condra - Credit Suisse Securities (USA) LLC (Broker)

Hey, thanks and good morning. I guess what I'm trying to think about is, when you guys are thinking about 2017 and let's say we get to a point where all your distribution partners are back online, I mean how does that play out then? Is your expectation that you'd recoup all that lost EMV revenue in 2017? And then would there be some kind of growth component on top of that just because now you have increased distribution? Is it correct to think about it that way? Is that how you are thinking about it? Can you give us any details?

Talbott Roche - President and Chief Executive Officer

Well, I think one inherent belief we have is that EMV and the compliance EMV has in no way changed the consumer's appetite for gift cards. They remain one of the most, if not the most popular gifts, as measured not just by Blackhawk, but by many other third parties. So retailers also are embracing this category as they always have as a destination category that not only is profitable and it drives traffic to their stores. So we have no reason to believe that those trends are going to change. There's nothing inherently different about the category or the consumer appeal of gift cards because we've moved to EMV.

So yes, we believe that this continues to be a growth category in 2017. We are going to continue to add – execute against our best practices, and execute in terms of bringing new content and driving additional marketing. So we are very bullish on growth in 2017.

William Y. Tauscher - Chairman, Head of International and Corporate Development

Paul, this is Bill Tauscher. I would only add one thing. While you are right to be focused on a post-EMV world in our U.S. Retail, just to remind you of what we said in the body of the presentation. All the rest of the elements of our business are actually exceeding our expectations today, and we think for this year. So there's just really nice things happening in our business as we look forward to 2017, whether they be the performance of our acquisitions, our International, Incentives business, the pipeline of new acquisitions that we think could be very beneficial.

So there is a business here when we get past EMV that's actually performing better today. We think it will perform better this year and that has great potential, obviously, as we look at 2017.

Paul Condra - Credit Suisse Securities (USA) LLC (Broker)

Yeah. That's helpful. The other business lines did do really well. Just for modeling perspective, as I'm trying to get comfortable with how this business comes back in 2017 if we just grow off of 2016 base? Or is there some kind of step function up as you recoup a lot of this lost distribution?

Jerry N. Ulrich - Chief Financial & Administrative Officer

Yeah. Hey, Paul. This is Jerry. It's obviously early in this cycle to absolutely calculate the U.S. retail open loop rebound, 2017 versus 2016. We do need to see it kind of play out here as we get towards the end of the year. But you would expect some above "normal" growth just because you've got cards back on shelves. So we're not going to sit here today based on information we have to say, gee, do the math. And if we're down 20%, we're going to be up 30% because of that. We just have to see this play out. But you would expect, obviously, a higher than "normal" growth rate that we've historically talked about.

William Y. Tauscher - Chairman, Head of International and Corporate Development

Yeah. I don't think in any circumstance a model should be built where you take our current 2016 retail with EMV results and then say, we're going to grow as we have before. That's just way too conservative. So, as Jerry said, whether you want to look at it as growth off of this base that's bigger, or the business rebounds and then our base growth continues in our business. The mistake would be to just say, oh well, they have this 2016 and now they are going to start growing again off of that. We're going to have a rebound for sure.

Paul Condra - Credit Suisse Securities (USA) LLC (Broker)

Okay. Okay, thanks. That's helpful. And then just on the Incentives biz, good AOR growth, but the TDV didn't seem to grow at all. Just wondering what happened there?

Jerry N. Ulrich - Chief Financial & Administrative Officer

I think one of the things about TDV – and we've been talking about it; it becomes less directly connected to the AOR growth, particularly with the growth in Incentives. Also, Cardpool growth, which we don't record a TDV figure for. So if you look at the Incentives business, TDV is not as representative. So in the future we may focus primarily on the traditional retail channel TDV.

We also, of course, mentioned that we have exited a couple of categories in the prepaid – in the GPR, General Purpose Reloadable PIN services. So we didn't do a tax refund program this year. And T-Mobile discontinued their program. So going forward, you're going to get muted TDV growth. And again, that was a category that had a lower ratio of adjusted operating revenue to TDV. So you start to see a little disconnect on some of that ratio and the TDV growth itself.

Paul Condra - Credit Suisse Securities (USA) LLC (Broker)

Okay. Thank you.

Operator

Thank you. The next question is from Ramsey El-Assal of Jefferies. Your line is open.

Christen Chen - Jefferies LLC

Hi. Good morning. This is Christen Chen calling in for Ramsey. Thanks for taking my question. So I first wanted to ask about the cadence in the guidance. So the Q2 guide was below our expectations and was just wondering if there is a disproportionate impact on – are we expecting the brunt of the EMV impact to be felt in Q2? And maybe also just on the tax benefit is that supposed to be evenly distributed throughout the quarter?

Jerry N. Ulrich - Chief Financial & Administrative Officer

So I'll take the first part of that question on the proportion in Q2. It does have a significant impact in Q2. As we mentioned, we've got several holidays that we typically sell well in. But we've also factored in that a couple of our largest partners aren't going to be compliant until toward the end of Q3, so there's still a significant impact, Q3, and some spillover in the assumptions around getting back to kind of a fully-stocked shelf and so forth. So there is impact even in Q4. If you did the math and looked at the estimated total impact on our full year guidance and subtracted what we said the impact for first quarter and the impact for second quarter, you'd still see a significant amount in the second half of the year.

On your second question, the tax benefit from the stock compensation change in accounting will not necessarily be evenly dispersed throughout the year. Patrick, correct me if I'm wrong, but we have $6 million, the first quarter impact and the full year is $14 million. So a little disproportionate in the first quarter related to the timing, typically of awards of stock and the vesting. So you typically would get exercises and the related stock comp benefit heavier in the first quarter because that's our annual refresh grant. And so little heavier in the first quarter and then spread throughout the year. But this tax benefit does depend on timing of exercises as well of stock options, so it will be a little bit lumpy on quarterly basis.

Christen Chen - Jefferies LLC

Okay, great. And also, can you just provide an update on Whole Foods? Are there any changes in your expectations, so when the revenues will roll on?

Talbott Roche - President and Chief Executive Officer

So we do – Whole Foods is continuing to come onboard. They are moving through the EMV compliance work that needs to be done. And we'll continue to bring them up in the Q3 timeframe.

Christen Chen - Jefferies LLC

All right. Great. And then just last one before we hop off. So on the CapEx guide, can you provide some reasoning or rationale behind what was the thought behind bringing that down by $10 million?

Jerry N. Ulrich - Chief Financial & Administrative Officer

Well, I think we – with the EMV impact, we tended to look at all aspects of what's going on in the business and we just deferred some things that we didn't think would have as much impact nearer term. We don't feel like we are sacrificing anything significant longer term. We also have a slightly higher proportion of some of our development team working on, what I mentioned earlier, on the OpEx side some of the security enhancements and compliance work being done. So that just shifted a bit out of CapEx and into the expense line.

Christen Chen - Jefferies LLC

All right. Great. Thanks for taking my questions.

Operator

Thank you. And the next question is from Jim Schneider of Goldman Sachs. Your line is open.

James Schneider - Goldman Sachs & Co.

Good morning. Thanks for taking my question. I was wondering if you could maybe comment again on EMV about the intensity of the marketing and distribution spend you're going to see on the back end of this as your clients start to become compliant. How much do you expect either as a percentage of revenue basis or maybe in terms of fixed dollars – is required for restocking and remarketing of those displays?

Talbott Roche - President and Chief Executive Officer

Well, really what we've been able to do is think about this in terms of timing of spend. So rather than trying to – or rather than significantly increasing our overall spend around merchandising and/or restocking efforts, we can shift some of those dollars in accordance with EMV compliance dates by partner and be strategic about how we take those dollars and make them work best in terms of a return for the partner, as well as a return for business.

So it's really not a huge enhancement. It's a very careful management of those dollars that are allocated down to the store level to make sure we get the peak returns and we spend the dollars post-EMV, or as they become compliant by store and/or by division, restock as quickly as possible.

Jerry N. Ulrich - Chief Financial & Administrative Officer

And we typically would go back to our partners and ask them to participate in some of that activity later this year. And on the open loop Visa product that we program manage, we, as Talbott said have pulled back current advertising or promotional activity rather, just because it would be foolish to spend that given the restrictions in place. So we would retain some of those funds into the fourth quarter to promote when the cards come back online.

James Schneider - Goldman Sachs & Co.

Thanks. And then as a related follow-up, just in terms of your margin commentary and the overall expansion of roughly 100 bps on an EBITDA basis or a little bit more than that, as we look into the fourth quarter, is that what we should expect for that quarter specifically as you kind of ex out all the expense and cost save nettings in the first three quarters? Should we expect that the EBITDA margins in Q4 end up in the zip code of a 100 bps above where they were last year?

Jerry N. Ulrich - Chief Financial & Administrative Officer

Yeah, on an adjusted basis. So again, this is pro forma work when you add back the impact of EMV. As I said earlier, we do expect to feel some roll-over impact into the fourth quarter. We'll have a better handle of course next quarter on where we see the end of the year coming in. But yeah, we would definitely see in the fourth quarter, which traditionally is our leverage quarter that margin expansion.

James Schneider - Goldman Sachs & Co.

Thank you.

Operator

Thank you. The next question is from Tim Willi of Wells Fargo. Your line is open.

Timothy Wayne Willi - Wells Fargo Securities LLC

Thank you and good morning. I had a housekeeping question and then two others. But on the housekeeping side, you talked about the tax and the T-Mobile contracts pressuring the North American TDV. Is there any way you could just sort of frame for us like what they were, either on a dollar basis or how it impacted that 3% growth rate that you quoted, just again, sort of get a better feel for the modeling as we look out through 2016 and into 2017, and Bill's comments about growth.

Jerry N. Ulrich - Chief Financial & Administrative Officer

Yeah. First of all, the tax program of course has heavier TDV impact in the first quarter and into the first part of the second quarter. So it'd be a disproportionate impact of probably in the range of 5% to 7% on U.S. Retail TDV, including the T-Mobile continuance. So ballpark, that's what I would say.

Timothy Wayne Willi - Wells Fargo Securities LLC

So we should think about that 3% that you quoted and then another 5% to 7% to sort of get to apples-to-apples versus last year. Correct?

Jerry N. Ulrich - Chief Financial & Administrative Officer

Yeah. I'd say.

Timothy Wayne Willi - Wells Fargo Securities LLC

Okay. Perfect. That's okay. So – great. And then – so just on Digital, two things; one is, Talbott, maybe you could just talk a bit about the distribution strategy and some of the comments around new content or just give us a feel for how you guys are approaching that market and creating content opportunities for yourself and distribution.

And also, if I could just slide into that as well, a lot of people believe, and I think it's been proven out in places like Europe that post-EMV, lot of fraud goes digital and stays away from the offline. So just any observations, thoughts, comments, proactive steps you're taking as you build out these digital channels to ensure that there's not some kind of issue that would repeat itself 12 months to 18 months from now that the frauds' migrated online.

Talbott Roche - President and Chief Executive Officer

Right. No, Tim. It's a good question, obviously. We have been very aware that a card in our present environment becomes more of a target by fraudsters than a post-EMV environment. We've been watching the fraud rates in the segment of our Digital that is – where we serve as merchant of record which is only a segment of Digital. So we have our own proprietary business in which we do take the payment risk and we're very closely monitoring that. We have enhanced our controls and best practices around fraud management in that segment. But of course a large and growing – that's a large and growing segment, but we also have an attendant another segment that's large and growing, which is where e-commerce providers, big guys like a staples.com or an Amazon or eBay are accessing our content through APIs, activating that, and they are then the merchant of record. So in that case we don't have exposure to the fraud risk. But again, we are working closely with them and making sure they are enacting best practices. Of course, many of these guys are the leaders in the market.

And Digital is also growing through another area that we should make sure you're aware of. Over half of the volume we do in Digital is in the incentives and rewards space. And in that market the cards are typically prepurchased. It's a corporate account – not always, but in many cases it is.

I'll give you an example. So with large financial institutions who contract with us to allow their credit card points to be converted into e-gift, that's all done through a corporate relationship, a contract we have with that FI (50:07). And those funds, again are settled between the two and there isn't a – we're not taking a payment risk in that environment. But they are all fast-growing, as we mentioned; triple-digit growth. And we're feeling good about all of the segments and we're watching the frauds activity very closely.

Timothy Wayne Willi - Wells Fargo Securities LLC

Great. And thanks very much. I'll just catch you offline for the remaining questions. Thanks.

Operator

Thank you. The next question is from Wayne Johnson of Raymond James. Your line is open.

Wayne Johnson - Raymond James & Associates, Inc.

Hi. Yes, good morning. Two questions, first, on the EMV topic. So one of the things I'm wondering about is, what is the timing of information flow from your retail distribution partners back to Blackhawk, not just on the EMV compliance which obviously has become a big issue here, but on all the information that you get on all your prepaid products? So if you could provide some color on that, I would appreciate it.

Talbott Roche - President and Chief Executive Officer

Well, we have regular meetings with our accounts in that the cadence of that communication has increased – started increasing in the Q1 timeframe when the EMV situation became known to us. And, frankly, now we are talking to our top-25 and tracking our top 100 on a weekly basis. And there's regular communications between the sales and account management team and the account, not only at the merchant level, but often through the loss prevention teams and/or even with Treasury.

And so we are working very closely and that the – the communication flow has become almost virtually real-time. And the situation though is fluid. So what will happen is an account may have enacted certain measures and then they'll see how those go, and then they'll communicate with us that they are going to take additional measures. And that information is flowing on a very timely basis, on a real-time basis.

Wayne Johnson - Raymond James & Associates, Inc.

Okay. Good. And so I appreciate that. So just for further clarification on my part, so there's no like electronic window that you guys can just look at at any given moment in time and say, geez, things aren't going our way here on this. So they have to tell you how things are going on the EMV side? There's no, like automated electronic link where you know instantly?

Talbott Roche - President and Chief Executive Officer

No, it's handled through communications. I mean they are communicating this to us through meetings and dialogue.

Jerry N. Ulrich - Chief Financial & Administrative Officer

The certification process is not publicized. Some of the payment processors for example are even using third parties to try to get through the retail certification process.

William Y. Tauscher - Chairman, Head of International and Corporate Development

But to be clear – this is Bill – if you're talking about us watching or seeing what's going on in the margin (53:18) in any given store at any given moment. Since we activate real-time all the point of sale transactions, we literally see instantaneously if we choose to, all the activity that's going on, up, down, sideways or whatever; sales that are going away that could indicate some card has been pulled, etcetera. And so we have a massive, instantaneous window down to the store and the product about sales, because we are the point of sale activator. So in terms of that amount of data, that's all automated.

That's a window, if you will, or a portal, if you will that we obviously have that we track and look at. And we use that constantly of course to look at trend data, to look at what's up, what's down, to even originate questions where we might not be hearing something verbally and the data says something else.

Talbott Roche - President and Chief Executive Officer

Yeah. So elaborating on what Bill's saying. Now – if that's where you're asking the question. We use that data actually and often feed that back to the account so that they can monitor – we can monitor and share with them information about any outside velocities that would indicate they could have a problem in the store. And that's actually a fraud tool that we've developed and implemented and are using to help them not take more drastic measures that could impede customer experience at checkout.

Wayne Johnson - Raymond James & Associates, Inc.

Okay. That is what I'm – that is the spirit of my question, and I'll follow-up later on that topic more thoroughly. On a second topic, on the core close loop prepaid business, could you flesh out just some of those trends, how they are tracking in terms of TDV? Any kind of unit volume, average load volume? I apologize if you mentioned that earlier. I'm juggling a couple things this morning. I'd appreciate that.

Jerry N. Ulrich - Chief Financial & Administrative Officer

Yeah, Wayne. We're not typically breaking it down to the individual product level. We would see probably modest increase year-over-year in the average load volume. But there were a few closed loop cards. The predominant impact of EMV has been on open loop. But there were a few higher denomination variable load cards. So that probably temporarily stems what we've seen as a steady increase in average load value in closed loop. So growth in closed loop is as we expected for the most part. The impact – or additional impact is primarily around the open loop product.

And I wanted to circle back on the question about the impact of – I think it was Tim had earlier on TDV for U.S. Retail – because we've previously done some analysis. And as reported, the TDV was down 1%. And also, as we said in the slide, if you adjusted for our estimated EMV impact in Q1, it would have grown 3%. But also, if you adjusted out the financial services TDV figures, that growth for U.S. Retail, essentially the gift card business is in the range of 13% to 14% for the quarter. So that would indicate, given that the impact is not open loop, that closed loop is solid.

Wayne Johnson - Raymond James & Associates, Inc.

Great. I appreciate that. I'll get back in the queue. Thanks.

Operator

Thank you. And the final question is from Ashwin Shirvaikar of Citigroup. Your line is open.

Ashwin Shirvaikar - Citigroup Global Markets, Inc. (Broker)

Thanks, guys. So you already had that comment with regards to adjusting spend as far as CapEx is concerned, given the poorer results than planned this year. Any thoughts on what you can do with regards to OpEx? As well as, does this change anything with regards to the M&A pipeline, those sorts of asynchronous investments that you might be making or thinking of?

Jerry N. Ulrich - Chief Financial & Administrative Officer

Yeah. There's two parts to that. I'll take the first one and then let Bill talk about the M&A pipeline. With regards to OpEx, I did mention that we've delayed hiring. We took some measures around compensation for this year. We've obviously selectively looked at other areas of expenses. There are some areas that we felt, hey, we have to continue to spend. We're not going to impact long-term growth because we've got a temporary EMV challenge here. It's a significant challenge, as we admit. But we've taken we think some pretty aggressive measures to stem the operating expense growth.

And that's why, earlier I indicated that if you did these pro forma adjustments you actually back into a calculation that says the three key operating expense lines would actually be 240 basis points better than last year, but that would be a little bit of a misnomer going forward. So that's why we said, hey, probably a 100 basis point expansion in EBITDA margin if you adjust out both the impact of EMV but also some of the expense measures that we would view as specific to this year.

One of the other things, again that we wanted to talk specifically about and remind people, that in the second quarter the guidance includes a number of factors. Easter fell in the first quarter this year versus the second quarter of last year. The overall volume, therefore, of U.S. Retail does impact "profitability". So when we did on our second quarter guidance the kind of adjusted EMV impact figures, we got decent adjusted operating revenue growth in the 12% and 23% range. But there's kind of a question; gee, adjusted EBITDA though, you're in a decline midpoint basis. Why would that be? Part of it is just U.S. Retail volume being impacted; Easter switch, and then we had as we mentioned a little bit more challenging Incentives business in the second quarter. We've got for example a telecom carrier program that was strong in the first quarter of 2015 and 2016 but has ended. And we've got a new carrier program, but it was delayed out into Q3.

We've kind of talked before that the overall Incentives business can be a little bit lumpy quarter-to-quarter. It's an enterprise sale. You've got large deals, programs that might end – a rebate program before another one picks up. We are very bullish on the second half overall for the year. As Bill said, we're running ahead of plan in the first quarter. We see the full year being better than expected. We've got the benefit of the extrameasures and Giftcards.com acquisitions that will accelerate in the second half.

And we did talk about some of these investments in information-security and compliance. We did kick those off late last year. They are having kind of an impact on the expense growth in the first half year-over-year, but that growth is going to moderate year-over-year in the second half. So you really have to turn to the kind of full year guidance that we gave to see the real profitability picture and the leverage that we're getting. So kind of long-winded answer, but wanted to reinforce a couple of those points. And then, let Bill talk about the M&A pipeline.

William Y. Tauscher - Chairman, Head of International and Corporate Development

Well, as we've talked about before, we have some very clear guidelines as we analyze the opportunities. First of all, the good news is that we have more opportunities than we need or want to take care of. So we are in a nice position of getting to choose what are the best ones. We have restricted our thought process to be businesses that are essentially add-ons to what we're doing. So if you've watched what we've done, we've done e-commerce businesses that fit right on top of what we have; we've done incentive businesses that fit right on top of what we have after we built the foundation with our first acquisitions that laid the structure for the incentive business. So you'll see more of the same where these are businesses that are add-ons.

These are businesses where we are not paying premium multiples, and the end result is they become highly accretive quickly. And we're not stepping out into some new space or paying for something that we hope to be developing. We did a little bit of that with Achievers, but it was the foundation play for us, and we've been rewarded with great performance in Achievers that we see continuing. But in the future, we have now got the foundation for our incentive business built. And as we did with extrameasures and as we did with gift cards, those are really things that lay nicely on top of what we're doing, and therefore really have the potential and are adding currently and have the potential in the future to add to what we're doing. And we've got a nice list of some more of those that we're working on.

And then the second thing we do that's very important is that we spend – not just a great deal of time – everybody does in due diligence, but we do all of our planning for how we're going to integrate these acquisitions before we do them. And it allows us to move fairly quickly in the way these acquisitions come onboard and the way the contributions come onboard.

Ashwin Shirvaikar - Citigroup Global Markets, Inc. (Broker)

Okay. So between the two answers, I'd say that from a variable comp perspective, feels like you are doing what you can to control variable comp. And from a M&A perspective, it's incremental acquisitions. Where appropriate, you're not in some sort of a cash conservation mode, given the results this year. You still selectively continue to make acquisitions. That be fair?

Jerry N. Ulrich - Chief Financial & Administrative Officer

No, in fact we absolutely view the EMV issue as this issue that we didn't foresee coming into the year. It's gotten a little bit worse, but it will manage by the end of the year. So we're not shorting our future, so to speak. We are continuing to invest in our growth as we head into 2017.

Ashwin Shirvaikar - Citigroup Global Markets, Inc. (Broker)

Got it. And then question on Digital Channels growth. I mean, obviously healthy here, but the relative economics of a digital card being purchased versus a physical card being purchased, could you potentially walk through the relative economics? Just remind us of what that digital growth does to your profitability, to your cash flow?

Talbott Roche - President and Chief Executive Officer

Yeah, we've talked about this before. It is generally similar. In the digital world, we may not have certain costs like card fulfillment – or rather card shipping to stores and DSD Management, those types of in-store cost issues. But we have other forms of costs such as payments where we are the merchant of record. So it all though nets out to be similar economics to the physical retail business that we're in.

Ashwin Shirvaikar - Citigroup Global Markets, Inc. (Broker)

And that's not changing with what seems to be maybe incremental competitive nature of digital?

Talbott Roche - President and Chief Executive Officer

No. No, we're not seeing material changes today.

Ashwin Shirvaikar - Citigroup Global Markets, Inc. (Broker)

Got it. Thanks, guys.

Operator

Thank you. And there are no further questions in the queue at this time. I'll turn the call back over for closing remarks.

Patrick Cronin - Vice President-Finance & Investor Relations

Okay, everybody. Well, thanks for joining us today and we will be in touch soon. Bye now.

Operator

Thank you. And ladies and gentlemen, this concludes today's conference. You may now disconnect. Good day.

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