The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the condensed consolidated financial statements and the accompanying notes to condensed consolidated financial statements included elsewhere in this report, and the consolidated financial statements, notes to consolidated financial statements and Management's Discussion and Analysis of Financial Condition and Results of Operations and the risk factors contained in our Annual Report on Form 10-K for the year ended December 31, 2008, as amended.

Forward Looking Statements

Unless the context requires otherwise, references in this report to "the Company," "we," "us," and "our" refer to Heartland Payment Systems, Inc. and our subsidiaries.

Some of the information in this Quarterly Report on Form 10-Q may contain forward-looking statements that are based on our management's beliefs and assumptions and on information currently available to our management. Forward-looking statements include the information concerning our possible or assumed future results of operations, the impact of the systems breach of our processing system, our attempts to settle or successfully litigate claims arising from the systems breach of our processing system, business strategies, financing plans, competitive position, industry environment, potential growth opportunities, the effects of future regulation and the effects of competition. Forward-looking statements include all statements that are not historical facts and can be identified by the use of forward-looking terminology such as the words "believe," "expect," "anticipate," "intend," "plan," "estimate" or similar expressions.

Forward-looking statements involve risks, uncertainties and assumptions. Actual results may differ materially from those expressed in the forward-looking statements. You should understand that many important factors, in addition to those discussed elsewhere in this report, could cause our results to differ materially from those expressed in the forward-looking statements. Certain of these factors are described in Item 1A. Risk Factors contained in our Annual Report on Form 10K for the year ended December 31, 2008, as amended, and include, without limitation, the significantly unfavorable economic conditions facing the United States, the results and effects of the Processing System Intrusion including the outcome of investigations, litigation and claims, the extent of cardholder information compromised and the consequences to our business, including the effects on sales and costs in connection with the system breach, our competitive environment, the business cycles and credit risks of our merchants, chargeback liability, merchant attrition, problems with our bank sponsors, our reliance on other bank card payment processors, our inability to pass increased interchange fees along to our merchants, system failures and government regulation.

Overview

General

Our primary business is to provide bank card payment processing services to merchants in the United States and Canada. This involves facilitating the exchange of information and funds between merchants and cardholders' financial institutions, providing end-to-end electronic payment processing services to merchants, including merchant set-up and training, transaction authorization and electronic draft capture, clearing and settlement, merchant accounting, merchant assistance and support and risk management. Our merchant customers primarily fall into two categories; our core small and mid-sized merchants (referred to as Small and Midsized Enterprises, or "SME merchants") and large national merchants, primarily in the petroleum industry. We also provide additional services to our merchants, such as payroll processing, gift and loyalty programs, and paper check processing, and we sell and rent point-of-sale devices and supplies.

On January 20, 2009, we publicly announced the Processing System Intrusion, which apparently had occurred during some portion of 2008. See "- Processing System Intrusion" for more detail.

At September 30, 2009, we provided our bank card payment processing services to approximately 174,560 active SME merchants located across the United States. This represents a 3.4% increase over the 168,850 active SME merchants at December 31, 2008 and a 4.0% increase over the 167,900 active SME merchants at September 30, 2008. At September 30, 2009, we provided bank card payment processing services to 76 large national merchants with approximately 54,733 locations. Our total bank card processing volume for the three months ended September 30, 2009 was $18.6 billion, a 7.3% decrease from the $20.0 billion processed during the three months ended September 30, 2008. Our SME bankcard processing volume for the three months ended September 30, 2009 included increases for American Express and Discover processing. Our Discover processing volume also benefited from our purchase of an existing merchant portfolio from Discover during the third quarter of 2009. Our total bank card processing volume for the nine months ended September 30, 2009 was $51.9 billion, a 3.0% increase from the $50.4 billion processed during the nine months ended September 30, 2008. Bank card processing volume for the three and nine months ended September 30, 2009 includes $2.7 billion and $7.3 billion, respectively, for large national merchants acquired with Network Services, compared to $4.4 billion and $6.2 billion, respectively, for the three and nine months ended September 30, 2008. Additionally, we provided bank card processing services to approximately 6,300 merchants in Canada.

Merchant attrition is expected in the payment processing industry in the ordinary course of business. We experience attrition in merchant bank card processing volume resulting from several factors, including business closures, transfers of merchants' accounts to our competitors and account closures that we initiate due to heightened credit risks relating to, or contract breaches by, merchants, and when applicable same store sales contraction. We measure total processing volume attrition against all SME merchants that were processing with us in the same month a year earlier. During the nine months ended September 30, 2009, we experienced 23.2% average annualized attrition of our SME bank card processing volume. During 2008, 2007 and 2006, we experienced average annual attrition in our SME bank card processing volume of 17.3%, 12.6% and 11.1%, respectively. Much of our attrition is related to business closures, which accelerated in 2009 and 2008 due to weak economic conditions, and in 2009 and 2008 our volume attrition was significantly impacted by overall contraction in same stores sales. In 2009, attrition was also likely increased modestly due to merchant concern regarding the Processing System Intrusion.

In our SME business, same store sales changes, which represents the change in bank card processing volume for all bank card merchants that were processing with us in the same month a year earlier, contracted 8.6% on average in the three months ended September 30, 2009, compared to contraction of 2.0% on average in the three months ended September 30, 2008. Same store sales growth or contraction results from the combination of the increasing or decreasing use by consumers of bank cards for the purchase of goods and services at the point of sale, and sales growth or contraction experienced by our retained SME merchants. The following table compares our same store sales growth or contraction for the 2008, 2007, 2006 and 2005 full years, and by quarter during 2009 and 2008:

                                             Same Store
                                            Sales Growth
                                            (Contraction)
                      2005 full year                  7.5 %
                      2006 full year                  4.2 %
                      2007 full year                  3.0 %
                      2008 full year                 (2.1 )%

                      2008 first quarter              0.6 %
                      2008 second quarter            (0.1 )%
                      2008 third quarter             (2.0 )%
                      2008 fourth quarter            (6.8 )%

                      2009 first quarter             (7.6 )%
                      2009 second quarter            (9.7 )%
                      2009 third quarter             (8.6 )%

The same store sales contraction we experienced in our SME business during the second, third and fourth quarters of 2008, and the first, second and third quarters of 2009, are attributable to poor economic conditions including impacts from severely contracted credit markets, a weak housing market, historically low consumer and investor confidence and high unemployment rates. Our same store contraction experience tracked the overall economic downturn. Management believes that all of these factors have negatively impacted disposable income, spending and behavior, which has impacted the businesses of our SME merchants. In addition, management believes that the current challenging economic conditions and depressed consumer confidence, as well as the general contraction in credit availability, and a decrease in usage of credit cards by consumers, may continue to negatively impact our business.

Increases in our direct sales force, including our Relationship Managers, historically have led to significant growth in the total SME merchants for whom we process and the gross margin generated by those merchants. Our sales managers are compensated based on their success in growing the sales force and increasing the total SME merchant base in their regions. Our sales force grew from 1,117 Relationship Managers at December 31, 2007 to 1,166 at December 31, 2008 and remained flat at 1,167 at September 30, 2009. We measure the production of our sales force by gross margin installed, which reflects the expected annual gross profit from a merchant contract after deducting processing and servicing costs associated with that revenue. Our newly installed gross margin for the nine months ended September 30, 2009 decreased 13.8% from the gross margin we installed during the nine months ended September 30, 2008. We attribute this decline in newly installed gross margin to the weak economy and negative publicity related to the Processing System Intrusion, which required our sales force to focus on merchant retention instead of new gross margin installs.

As a result of our commission-only compensation system for our sales force, we are able to increase the size of our sales force with minimal upfront costs. However, since we pay signing bonuses and commissions approximating 92% of the gross margin generated by a SME merchant in its first year, growth in SME merchant base consumes significant capital, as it typically takes approximately one year's processing to cover the outlays for signing bonuses, commissions and payroll taxes.

We have developed a number of proprietary payment processing systems to increase our operating efficiencies and distribute our processing and merchant data to our three main constituencies: our merchant base, our sales force and our customer service staff. We provide authorization and data capture services to our merchants through our own front-end processing system, which we call HPS Exchange. We provide clearing, settlement and merchant accounting services through our own internally developed back-end processing system, which we call Passport. Passport enables us to more effectively customize these services to the needs of our Relationship Managers and merchants.

During the three months ended September, 2009 and 2008, we processed approximately 88% and 83%, respectively, of our SME bankcard merchant transactions through HPS Exchange. At September 30, 2009 and 2008, we were processing approximately 99% and 98%, respectively, of our active SME bankcard merchants on Passport. Our internally developed systems are providing substantially all aspects of most of our merchants' bankcard processing needs, excluding Network Services. Previously, we relied on third party vendors for many of these services including bank card authorization and data capture services, settlement and merchant accounting services. We will continue to process our Network Services transactions and a minority of our SME transactions through third party systems.

Our bankcard revenue earned in our SME business is recurring in nature, as we typically enter into three-year service contracts with our card processing merchants that, in order to qualify for the agreed-upon pricing, require the merchant to achieve bank card processing volume minimums. Most of our SME revenue is payment processing fees, which are a combination of a fee equal to a percentage of the dollar amount of each Visa or MasterCard transaction we process plus a flat fee per transaction. We make mandatory payments of interchange fees to card-issuing banks through Visa and MasterCard and dues and assessment fees to Visa and MasterCard. Our SME gross bankcard processing revenue is largely driven by Visa and MasterCard volume processed by merchants with whom we have processing contracts; as such, we also generally benefit from consumers' increasing use of bank cards in place of cash and checks, and sales growth experienced by our retained bank card merchants. In contrast, Network Services revenues are largely driven by the number of transactions it processes (whether settled, or only authorized), not its processing volume, as the larger merchants which comprise Network Services' customer base pay on a per transaction basis for processing services.

We also provide payroll processing services throughout the United States. At September 30, 2009, we processed payroll for 9,232 customers, an increase of 21.6% from 7,591 payroll customers at September 30, 2008. At December 31, 2008, we processed payroll for 7,738 payroll customers.

Processing System Intrusion

On January 20, 2009, we publicly announced the discovery of a criminal breach of our payment systems environment (the "Processing System Intrusion"). The Processing System Intrusion involved malicious software that appears to have been used to collect in-transit, unencrypted payment card data while it was being processed by us during the transaction authorization process. Such data is not required to be encrypted while in transit under current payment card industry guidelines. We had received confirmation of our compliance with the Payment Card Initiative Data Security Standard ("PCI-DSS") from a third-party assessor each year since the standard was announced, including in April 2008, before the discovery of the Processing System Intrusion. Subsequent to the discovery of the Processing System Intrusion, we were advised by Visa that based on Visa's investigation of the Processing System Intrusion, Visa had removed us from Visa' published list of PCI-DSS compliant service providers. In April 2009, we were re-certified as PCI-DSS compliant and the assessor's report attesting to such re-certification has been reviewed and approved by Visa. As such, we were returned to Visa's Global List of PCI-DSS Validated Service Providers. Card data that could have been exposed by the Processing System Intrusion included card numbers, expiration dates, and certain other information from the magnetic stripe on the back of the payment card (including, for a small percentage of cards, the cardholder's name). However, the cardholder information that we process does not include addresses or Social Security numbers. Also, we believe that no unencrypted PIN data was captured. We believe the breach has been contained and did not extend beyond 2008.

For the three and nine months ended September 30, 2009, we recorded pre-tax expenses of $73.3 million and $105.3 million, respectively, or about $1.22 and $1.74 per share, respectively, associated with the Processing System Intrusion. The majority of these charges, or approximately $90.8 million, related to:
(i) assessments imposed in April 2009 by MasterCard and VISA against us and our sponsor banks, (ii) settlement offers we made to certain card brands in an attempt to resolve certain of the claims asserted against our sponsor banks (who have asserted rights to indemnification from us pursuant to our agreements with them), and (iii) expected costs of settling with certain claimants with whom settlement discussions are underway. Notwithstanding our belief that we have strong defenses against the claims that are the subject of the settlement offers and settlement discussions described in (ii) and (iii) above, we decided to make such settlement offers and engage in such settlement discussions in attempts to avoid the costs and uncertainty of litigation. We are prepared to vigorously defend ourselves against all the claims relating to the Processing System Intrusion that have been asserted against us and our sponsor banks to date.

The accrual relating to the settlement offers and the settlement discussions during the nine months ended September 30, 2009 resulted in our creating a $82.9 million Reserve for Processing System Intrusion at September 30, 2009. To date, we have not received acceptance of any of the settlement offers noted in
(ii) above and no definitive agreements have been reached with respect to the settlements negotiations noted in (iii) above. Therefore it should not be assumed that we will resolve the claims that are the subject of the settlement offers or the subject of settlement discussions for the amounts of the settlement offers or the expected costs of settling with certain claimants as discussed above. We understand that the reserve related to the settlement offers is required by SFAS No. 5, "Accounting for Contingencies" (ASC 450-20), based solely on the fact we tendered offers of settlement in the amounts we have accrued. It is possible we will end up resolving the claims that are the subject of the settlement offers and the settlement discussions, either through settlements or pursuant to litigation, for amounts that are significantly greater than the amount we have reserved to date. Moreover, even if the claims that are the subject of the settlement offers and the settlement discussions were resolved for the amount we have reserved, that would still leave unresolved a significant portion of the claims that have been asserted against us or our sponsor banks relating to the Processing System Intrusion. We feel that we have strong defenses to all the claims that have been asserted against us and our sponsor banks relating to the Processing System Intrusion, including those claims that are not the subject of the settlement offers.

While we have determined that the Processing System Intrusion has triggered other loss contingencies, to date an unfavorable outcome is not believed by us to be probable on those claims that are pending or have been threatened against us, or that we consider to be probable of assertion against us, and we do not have sufficient information to reasonably estimate the loss we would incur in the event of an unfavorable outcome on any such claim. Therefore, in accordance with SFAS No. 5 (ASC 450-20) no reserve/liability has been recorded as of September 30, 2009 with respect to any such claim, except for the assessments actually imposed by MasterCard and Visa, the amounts of the settlement offers we made and the expected costs of settling with certain claimants as discussed above. As more information becomes available, if we should determine that an unfavorable outcome is probable on such a claim and that the amount of such probable loss that we will incur on that claim is reasonably estimable, we will record a reserve for the claim in question. If and when, we record such a reserve, it could be material and could adversely impact our results of operations, financial condition and cash flow.

The remainder of the expenses and accruals related to the Processing System Intrusion recorded in the three and nine months ended September 30, 2009 were primarily for legal fees and costs we incurred for investigations, remedial actions and crisis management services. Additional costs we expect to incur for investigations, remedial actions, legal fees, and crisis management services related to the Processing System Intrusion will be recognized as incurred. Such costs are expected to be material and could adversely impact our results of operations, financial condition and cash flow.

Acquisitions in 2008

In May 2008, we acquired the net assets of the Network Services business unit ("Network Services") of Alliance Data Network Services LLC ("Alliance"), for a cash payment of $92.5 million. The acquisition was financed through a combination of cash on hand and our credit facilities. Network Services provides processing of credit and debit cards to large national merchants, primarily in the petroleum industry. From the date we acquired Network Services through December 31, 2008, it settled $8.7 billion of bank card processing volume on 317 million transactions and during the nine months ended September 30, 2009 it settled $7.3 billion of bank card processing volume on 350 million transactions. Additionally, Network Services generated revenues on 1.4 billion and 1.8 billion transactions it authorized through its front-end card processing systems during the period from the date we acquired it through December 31, 2008 and in the nine months ended September 30, 2009, respectively.

In March 2008, the Company acquired a majority interest in Collective Point of Sale Solutions Ltd. ("CPOS") for a net cash payment of $10.1 million. CPOS is a Canadian provider of payment processing services and secure point-of-sale solutions. This acquisition added approximately 6,300 Canadian merchants to our merchant base as of September 30, 2009 and provided us an entrance into the Canadian credit and debit card processing market. We are now able to service merchants that have locations in both the United States and Canada.

In November 2008, we acquired the net assets of Chockstone, Inc. ("Chockstone") for a net cash payment of $4.0 million. The Chockstone acquisition expands our ability to equip merchants nationwide with enhanced gift card and loyalty programs. Chockstone's loyalty platform helps businesses of all sizes identify their most profitable customers and market to their unique needs - thereby increasing the frequency of their visits and the size of their average purchases. Chockstone's loyalty marketing and gift card solutions are used by leading brands in more than 65,000 restaurants, convenience stores, and other retail locations in North America.

Third Quarter of 2009 Financial Results

Our financial results for the three months ended September 30, 2009 continue to reflect the impacts of challenging economic conditions, soft consumer spending, and the costs we incurred related to the Processing System Intrusion. Poor economic conditions have unfavorably impacted both new merchant installs and processing volume at existing merchants. For the three months ended September 30, 2009, we recorded a net loss of $37.1 million, or $0.99 per share, compared to net income of $13.4 million, or $0.35 per share, in the three months ended September 30, 2008. During the three months ended September 30, 2009, we recorded pretax charges of $73.3 million, or about $1.22 per share, for costs we incurred for investigations, remedial actions, legal fees, crisis management services and settlement offers. The following is a summary of our financial results for the three months ended September 30, 2009:

• During the three months ended September 30, 2009, our SME processing volume increased 1.1% to $15.8 billion from $15.7 billion during the three months ended September 30, 2008. We earn percentage-based revenues on our SME processing volume.

• Net revenue, which we define as total revenues less interchange fees and dues, assessments and fees, decreased 0.4% from $110.4 million in the three months ended September 30, 2008 to $110.0 million in the three months ended September 30, 2009. The decrease in net revenue was driven by the declines in equipment-related income primarily due to lower revenues from prepaid card and stored-value card systems at our Debitek, Inc. subsidiary and in the number of new SME bank card merchants installed during the three months ended September 30, 2009.

• Our general and administrative expenses increased 34.3% from $20.7 million in the three months ended September 30, 2008 to $27.8 million in the three months ended September 30, 2009. This increase was primarily due to growth in personnel costs including wages and bonuses, medical benefits and a $1.4 million increase in SFAS 123(R) stock compensation expense, as well as an increase in legal expenses.

• Our income from operations, which we also refer to as operating income, declined to $14.7 million for the three months ended September 30, 2009 from $23.1 million for the three months ended September 30, 2008. This decline was primarily due to the unfavorable impact which challenging economic conditions had on our revenues. Our operating margin, which we measure as operating income divided by net revenue, was 13.4% for the three months ended September 30, 2009, compared to 20.9% for the three months ended September 30, 2008.

See "- Results of Operations - Three Months Ended September 30, 2009 Compared to Three Months Ended September 30, 2008" for a more detailed discussion of our financial results.

Critical Accounting Estimates

The discussion and analysis of our financial condition and results of operations are based on our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. These condensed consolidated financial statements are unaudited. In our opinion, the unaudited condensed consolidated financial statements include all normal recurring adjustments necessary for a fair presentation of our financial position at September 30, 2009, our results of operations, our changes in stockholders' equity and our cash flows for the nine months ended September 30, 2009 and 2008. Results of operations reported for interim periods are not necessarily indicative of the results to be expected for the year ended December 31, 2009. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. Actual results could differ from those estimates. Our significant accounting policies are more fully described in note 2 to our consolidated financial statements included elsewhere in this report and in our Annual Report on Form 10-K for the year ended December 31, 2008, as amended. The critical accounting estimates described here are those that are most important to the depiction of our financial condition and results of operations, including those whose application requires management's most subjective judgment in making estimates about the effect of matters that are . . .