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HPY > SEC Filings for HPY > Form 10-Q on 6-Nov-2012All Recent SEC Filings

Show all filings for HEARTLAND PAYMENT SYSTEMS INC | Request a Trial to NEW EDGAR Online Pro

Form 10-Q for HEARTLAND PAYMENT SYSTEMS INC


6-Nov-2012

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
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, 2011 (the "2011 Form 10-K"). 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, 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. Some of these factors are described in Item 1A. Risk Factors of the 2011 Form 10-K and include, without limitation, our competitive environment, the business cycles and credit risks of our merchants, chargeback liability, merchant attrition, problems with our Sponsor banks, our relationships with third-party bankcard payment processors, our inability to pass increased interchange fees along to our merchants, economic conditions, systems failures and government regulation.

Overview
General
Our primary business is to provide bankcard 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 Network Services' large national and mid-tier merchants, primarily in the petroleum industry (referred to as "Network Services Merchants"). We also provide additional services to our merchants, such as payroll processing, gift and loyalty programs, paper check processing, and we sell and rent point-of-sale devices and supplies. In addition, we provide closed and open-loop payment solutions, and other transactional services to the college market, and school nutrition and point-of-sale solutions to K to 12 schools.

At September 30, 2012, we provided our bankcard payment processing services to approximately 172,430 active SME merchants located across the United States. This compares to 171,801 active SME bankcard merchants at December 31, 2011, and 173,944 active SME bankcard merchants at September 30, 2011. At September 30, 2012, we provided bankcard payment processing services through Network Services Merchants to 332 merchants with 48,007 locations. Additionally, at September 30, 2012, we provided bankcard payment processing services to over 11,800 merchants in Canada through our 70% owned subsidiary Collective POS Solutions Ltd. ("CPOS"). According to The Nilson Report, in 2011 we were the 6th largest card acquirer in the United States ranked by transaction count and the 9th largest acquirer by processed dollar volume, which consists of both credit and debit Visa and MasterCard transactions, as well as credit card transactions on American Express,


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Discover, Diners Club, and JCB. These rankings represented 2.8 billion transactions and 4% of the total bankcard processing market, respectively. Our total bankcard processing volume for the three months ended September 30, 2012 was $26.5 billion, a 21.3% increase from the $21.8 billion processed during the three months ended September 30, 2011. Our total bankcard processing volume for the nine months ended September 30, 2012 was $75.9 billion, a 22.5% increase from the $61.9 billion processed during the nine months ended September 30, 2011. Our SME bankcard processing volume for the three and nine months ended September 30, 2012 was $18.8 billion and $54.1 billion, respectively, increases of 5.8% and 6.7%, respectively, over the three and nine months ended September 30, 2011 reflecting increases for same store sales growth, new SME merchants installed, and lower merchant attrition. Our bankcard processing volume for the three and nine months ended September 30, 2012 also includes $7.4 billion and $21.2 billion, respectively, of settled volume for Network Services Merchants, compared to $3.8 billion and $10.8 billion, respectively, for the three and nine months ended September 30, 2011. Network Services' increase for the 2012 periods primarily reflects the expansion of a contract with a large petroleum merchant to include back end settlement. Bankcard processing volume for the three and nine months ended September 30, 2012 and 2011 was as follows:

                                       Three Months Ended September 30,     Nine Months Ended September 30,
                                             2012               2011              2012               2011
                                                                   (In millions)
SME merchants                         $          18,818     $   17,788     $          54,089     $   50,696
Network Services Merchants                        7,434          3,842                21,238         10,755
Canada                                              205            178                   563            487
Total bankcard processing volume (a)  $          26,457     $   21,808     $          75,890     $   61,938

(a) Bankcard processing volume includes volume for credit and signature debit transactions. Merchant attrition is expected in the card payment processing industry in the ordinary course of business. We experience attrition in merchant bankcard 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 SME processing volume attrition against all SME merchants that were processing with us in the same month a year earlier. During the three months ended September 30, 2012, we experienced a 12.9% average annualized attrition in our SME bankcard processing volume and for the 2012 nine month period we experienced attrition of 12.6%. During 2011, 2010 and 2009, we experienced average annual attrition in our SME bankcard processing volume of 13.5%, 15.3% and 22.6%, respectively. Historically, much of our attrition has been related to business closures, which accelerated in 2009 due to weak economic conditions.

In our SME business, we measure same store sales growth, or contraction, as the change in bankcard processing volume for all bankcard merchants that were processing with us in the same month a year earlier. During the three months ended September 30, 2012, same store sales grew 1.8% on average, compared to 2.3% in the quarter ended September 30, 2011 and 2.6% on average in the 2011 full year. Same store sales growth or contraction results from the combination of the increasing or decreasing use by consumers of bankcards for the purchase of goods and services at the point of sale, and sales growth or contraction experienced by our retained SME bankcard merchants. Historically, our same store sales experience has tracked overall economic conditions. The following table compares our same store sales growth or contraction during 2012, 2011, and 2010:

Same Store Sales Growth (Contraction) 2012    2011     2010
First Quarter                         3.4 %   3.2 %   (1.5 )%
Second Quarter                        2.2 %   2.5 %    1.1  %
Third Quarter                         1.8 %   2.3 %    2.0  %
Fourth Quarter                                2.5 %    3.8  %
Full Year                                     2.6 %    1.3  %

We measure the overall production of our sales force by new gross margin installed, which reflects the expected annual gross profit from a merchant contract after deducting processing and servicing costs associated with that revenue. We measure installed margin primarily for our SME card processing, payroll processing and loyalty and gift marketing businesses. Our newly installed gross margin for the three months ended September 30, 2012 increased 11.2% and for the 2012 nine month period our gross margin increased 15.6% from the gross margin we installed during the three and nine months ended September 30, 2011, respectively. We attribute this increase in newly installed gross margin to higher volumes and margins at newly installed merchants and improved individual productivity achieved by our salespersons. We expect to drive increases in year-over-year installed margin in future periods primarily by increasing our Relationship Manager and Territory Manager count. Our combined Relationship Managers and Territory Managers count amounted to 743, 790 and 764 at September 30, 2011, December 31, 2011 and September 30, 2012, respectively.


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The bankcard revenue we earn in our SME business is recurring in nature, as we typically enter into three-year service contracts with our card processing SME merchants that, in order to qualify for the agreed-upon pricing, require the merchant to achieve bankcard processing volume minimums. Most of our SME revenue is from payment processing fees, which are a combination of a fee equal to a percentage of the dollar amount of each transaction we process plus a flat fee per transaction. We make mandatory payments of interchange fees to the card issuer through the card networks and dues, assessments and other network fees to Visa, MasterCard and Discover. Our SME gross bankcard processing revenue is largely driven by the Visa and MasterCard volume processed by our merchants. We also realize card processing revenues from processing transactions for our SME merchants accepting American Express and from processing Discover transactions.

In contrast to SME card processing revenues, revenues from our Network Services Merchants are largely driven by the number of transactions we process (whether settled, or only authorized), not our processing volume, as the merchants which comprise Network Services' customer base pay on a per transaction basis for processing services. Network Services' increased number of transactions processed for the 2012 periods primarily reflects the expansion of a contract with a large petroleum merchant to include back end settlement. Additionally, we provide authorization, settlement and account servicing services on our front and back end systems for American Express transactions for larger merchants, and merchants signed to American Express by other processors; for those services we receive compensation from American Express on a per transaction basis. The number of transactions we processed for Network Services Merchants and American Express for the three and nine months ended September 30, 2012 and 2011 were as follows:

                             Three Months Ended September 30,     Nine Months Ended September 30,
                                   2012              2011              2012              2011
                                                        (In thousands)
Network Services Merchants:
Settled                              254,977         147,506             724,610         412,224
Authorized                           668,310         725,238           1,895,496       2,054,537
American Express (a)                   8,275           8,305              24,282          23,694
Total                                931,562         881,049           2,644,388       2,490,455

(a) Includes only those transactions not eligible for residual compensation

Our internally-developed front-end authorization systems, HPS Exchange, VAPS and NWS, provide us greater control of the electronic transaction process, allow us to offer our merchants a differentiated product offering, and offer economies of scale that we expect will increase our long-term profitability. During the three months ended September 30, 2012 and 2011, approximately 95% and 93%, respectively, of our SME transactions were processed through HPS Exchange. All of our Network Services transactions were processed through VAPS or NWS. During the three months ended September 30, 2012 and 2011, 97% of all SME merchant accounts established were placed on HPS Exchange.
We provide clearing, settlement and merchant accounting services through our own internally developed back-end processing system, Passport. Passport enables us to customize these services to the needs of our Relationship Managers and merchants. At both September 30, 2012 and 2011, approximately 99% of total SME bankcard merchants were processing on Passport and all Network Services' settled transactions were processed on Passport.
We provide payroll processing services throughout the United States. At September 30, 2012, we processed payroll for 12,301 customers, an increase of 1.0% from 12,181 payroll customers at September 30, 2011 and an increase of 3.9% from 11,841 payroll customers at December 31, 2011. In the nine months ended September 30, 2012 and the full year 2011, we installed 2,410 and 3,723 new payroll processing customers, respectively. We developed a new comprehensive payroll management system, which we refer to as PlusOne Payroll, that streamlines all aspects of the payroll process to enable time and cost savings. PlusOne Payroll was made available to new and existing customers beginning in 2010. The PlusOne Payroll platform enables us to process payroll on a large scale and provide customizable solutions for businesses of all sizes.

We also provide school nutrition and point-of-sale solutions to K to 12 schools throughout the United States. At September 30, 2012, we provided Heartland School Solutions to over 29,000 public and private schools, compared to over 19,000 public and private schools at December 31, 2011. On June 29, 2012, we acquired the K to 12 school solutions business of Lunch Byte Systems, Inc. accounting for the increase in the number of schools served. See "- Liquidity and Capital Resources - Acquisitions" for detail on our Heartland School Solutions acquisitions.

Third Quarter of 2012 Financial Results
Our financial results for the three months ended September 30, 2012, as compared to the three months ended September 30, 2011, benefited from a higher operating margin, reflecting 17.3% year-over-year growth in net revenue and a


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moderate increase of 4.4% in processing and servicing costs. For the three months ended September 30, 2012, we recorded net income of $19.4 million, or $0.48 per share, compared to $12.6 million, or $0.31 per share, in the three months ended September 30, 2011. The following is a summary of our financial results for the three months ended September 30, 2012:

         Net revenue, which we define as total revenues less interchange fees
          and dues, assessments and fees, increased $21.2 million, or 17.3%, from
          $122.2 million in the three months ended September 30, 2011 to $143.4
          million in the three months ended September 30, 2012. The increase in
          net revenue was driven by the increased card processing net revenue
          from our SME merchants and increases in revenues for Heartland School
          Solutions, Payroll processing, and equipment-related revenues.


         During the three months ended September 30, 2012, our SME processing
          volume increased 5.8% to $18.8 billion from $17.8 billion during the
          three months ended September 30, 2011. We earn percentage-based
          revenues on our SME processing volume. The year-over-year increase
          reflects same store sales growth, improved merchant volume attrition,
          and increased processing activity from new SME merchants installed.


         Our processing and servicing expenses increased $2.3 million, or 4.4%,
          from $53.3 million in the three months ended September 30, 2011, to
          $55.6 million in the three months ended September 30, 2012 primarily
          due to increased costs associated with processing and servicing higher
          SME bankcard processing volume, increased residual commission expense
          and increased costs of sales and servicing related to the higher
          Heartland School Solutions, payroll processing, and equipment-related
          revenues. The increase in processing and servicing expense also
          reflects refined allocations of certain information technology related
          expenses, previously reported in general and administrative expense, to
          processing and servicing starting in 2012. Partially offsetting the
          increases in processing and servicing expense was a decrease in costs
          at our service center.


         Our general and administrative expenses increased $5.9 million, or
          18.3%, from $32.2 million in the three months ended September 30, 2011
          to $38.1 million in the three months ended September 30, 2012. The
          increase in general and administrative expense for the three months
          ended September 30, 2012 was primarily due to a $5.3 million increase
          in personnel costs, including a $2.2 million increase in share-based
          compensation. Personnel costs from the Heartland School Solutions
          acquisitions are the primary drivers of the remaining increase. General
          and administrative expenses for the three months ended September 30,
          2012 benefited from refined allocations of certain information
          technology related expenses, previously reported in general and
          administrative expense, now recorded in processing and servicing
          expense. General and administrative expenses as a percentage of total
          revenue for the three months ended September 30, 2012 was 7.1%, up from
          6.1% for the three months ended September 30, 2011.


         As a result of the 17.3% growth achieved in net revenue, a moderate
          increase in processing and servicing expenses and controlled general
          and administrative expense increases, our income from operations, which

we also refer to as operating income, increased $12.0 million to $33.6 million for the three months ended September 30, 2012, from $21.6 million for the three months ended September 30, 2011. Our Operating Margin, which we measure as operating income divided by Net Revenue, was 23.5% for the three months ended September 30, 2012, compared to 17.7% for the three months ended September 30, 2011.

See "- Results of Operations - Three Months Ended September 30, 2012 Compared to Three Months Ended September 30, 2011" for a more detailed discussion of our third quarter 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, 2012, our results of operations, our changes in stockholders' equity and our cash flows for the nine months ended September 30, 2012 and 2011. Results of operations reported for interim periods are not necessarily indicative of the results to be expected for the year ending December 31, 2012. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses. Actual results could differ from those estimates. Our significant accounting policies are more fully described in Note 2 to our Condensed Consolidated Financial Statements included elsewhere in this report and in our Annual Report on Form 10-K for the year ended December 31, 2011. 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 inherently uncertain. The line items on our income statement


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and balance sheet, which are impacted by management's estimates, are described below.

Revenue
Our bankcard processing revenue is derived from processing and settling Visa, MasterCard, American Express and Discover bankcard transactions for our merchant customers. Our most significant expense related to the generation of those revenues is interchange fees, which are set by the card networks, and paid to the card issuing banks. For our SME merchant bankcard processing, we do not offset bankcard processing revenues and interchange fees in our income statement because our business practice is to advance the interchange fees to most of our SME merchants when settling their daily transactions (thus paying the full amount of the transaction to the merchant), and then to collect our full discount fees from our merchants on the first business day of the next month. We fund interchange advances to our SME merchants from a combination of our operating cash and advances from our sponsor banks. We believe this policy aids in new business generation, as our merchants benefit from bookkeeping simplicity. However, this practice results in our carrying a large receivable from our merchants at each period-end, and a corresponding but smaller payable to our sponsor banks, which are settled on the first business day after the period-end. As we are at risk for the receivables, we record the associated revenues on a gross processing revenue basis in our consolidated income statements. Certain of our competitors report their processing revenue net of interchange fees. This is because the card issuing banks make their payments to these competitors net of those interchange fees, and these acquirers pay this reduced amount to their merchants. For our Network Services merchants, we also record a portion of our processing revenues net of interchange fees because the daily cash settlement with Network Services' merchants is net of interchange fees.

Capitalized Customer Acquisition Costs
Capitalized customer acquisition costs consist of (1) up-front signing bonuses paid to Relationship Managers and sales managers, referred to as the "salesperson" or "salespersons," for the establishment of new merchant relationships, and (2) deferred acquisition cost representing the estimated cost of buying out the commissions of vested salespersons at some point in the future. Capitalized customer acquisition costs represent incremental, direct customer acquisition costs that are recoverable through gross margins associated with SME merchant contracts. The capitalized customer acquisition costs are amortized using a method which approximates a proportional revenue approach over the initial three-year term of the merchant contract.

The amount of the up-front signing bonus paid for new SME bankcard, payroll and loyalty marketing accounts is based on the estimated gross margin for the first year of the merchant contract. The gross signing bonuses paid during the nine months ended September 30, 2012 and 2011 were $24.8 million and $21.9 million, respectively, and for the full year ended December 31, 2011 were $30.5 million. The signing bonus paid, amount capitalized, and related amortization are adjusted at the end of the contract's first year to reflect the actual gross margin generated by the merchant contract during that year. The net signing bonus adjustments made during the nine months ended September 30, 2012 and 2011 were $(2.3) million and $(0.8) million, respectively. Negative signing bonus adjustments occur when the actual gross margin generated by the merchant contract during the first year is less than the estimated gross margin for that year, resulting in the overpayment of the up-front signing bonus, which overpayment would be recovered from the relevant sales person. Positive signing bonus adjustments result from prior underpayments of up-front signing bonuses, and would be paid to the relevant salesperson. The amount of signing bonuses paid which remained subject to adjustment at September 30, 2012 was $33.0 million.

The deferred acquisition cost component of capitalized customer acquisition costs is accrued for vested salespersons over the first year of SME bankcard merchant processing, consistent with the build-up in the accrued buyout liability, which is described below.

Management evaluates the capitalized customer acquisition costs for impairment by comparing, on a pooled basis by vintage month of origination, the expected future net cash flows from underlying merchant relationships to the carrying amount of the capitalized customer acquisition costs. If the estimated future net cash flows are lower than the recorded carrying amount, indicating an impairment of the value of the capitalized customer acquisition costs, the impairment loss will be charged to operations. We have not recognized an impairment loss for the nine months ended September 30, 2012.

Accrued Buyout Liability
We pay our salespersons residual commissions based on the gross margin generated from the monthly processing activity of SME merchants signed by them. We refer to these residual commissions as the ''owned'' portion of such commissions, or ''portfolio equity.'' The salesperson has no obligation to perform additional services for the merchant for so long as the merchant continues processing with us. We accrue the buyout liability, which represents the estimated current settlement cost of buying out all vested and expected-to-vest salespersons for the owned portion of such commissions. We also record a deferred acquisition cost asset related to those buyouts, and amortize that asset as an expense over the initial three-year contract term. Beginning in June 2012, our salespersons earn portfolio equity on their newly installed payroll and loyalty marketing merchant accounts based on the residual commissions they earn on those accounts. The accrued buyout liability and


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