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HPY > SEC Filings for HPY > Form 10-K on 28-Feb-2014All Recent SEC Filings

Show all filings for HEARTLAND PAYMENT SYSTEMS INC

Form 10-K for HEARTLAND PAYMENT SYSTEMS INC


28-Feb-2014

Annual Report


ITEM 7. 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 consolidated financial statements and the accompanying notes to consolidated financial statements and the risk factors included elsewhere in this report.

Overview

General
Our primary business is to provide card payment processing services to merchants throughout the United States. This involves providing end-to-end electronic payment processing services to merchants by facilitating the exchange of information and funds between them and cardholders' financial institutions. To accomplish this, we undertake merchant set-up and training, transaction authorization and electronic draft capture, clearing and settlement, merchant accounting, merchant assistance and support, and risk management. We also sell and rent point-of-sale devices. Our card-accepting 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 merchants, predominately petroleum industry merchants of all sizes (referred to as "Network Services merchants").

We provide additional services such as:

School nutrition, point-of-sale solutions, and associated payment solutions, including online prepayment solutions, to K-12 schools through Heartland School Solutions,

Full-service payroll processing and related tax filing services through Heartland Ovation Payroll,

Payment processing, higher education loan services and open- and closed-loop payment solutions to colleges and universities through Campus Solutions,

Prepaid and stored-value card solutions through Micropayments, and marketing solutions including loyalty and gift cards, which we provide through Heartland Marketing Solutions.

Card Payment Processing
At December 31, 2013, we provided our card payment processing services to 166,697 active SME merchants located across the United States. This compares to 169,994 active SME merchants at December 31, 2012. At December 31, 2013, we provided card payment processing services to approximately 1,024 Network Services merchants with approximately 42,669 locations, compared to 396 Network Services merchants with 47,064 locations at December 31, 2012.

We sold our interest in Collective POS Solutions Ltd. ("CPOS") in a transaction settled in January 2013. CPOS has historically represented an insignificant component of our financial position and results of operations. However, as further disclosed elsewhere in the notes to consolidated financial statements, we recognized a gain on the sale of CPOS in the first quarter of 2013. As a result, we presented the net assets of CPOS as held for sale at December 31, 2012 and presented the results of operations for CPOS as a discontinued operation for all periods presented.


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Our total card processing volume for the year ended December 31, 2013 was $102.3 billion, a 2.0% increase from the $100.4 billion processed during the year ended December 31, 2012. Our SME card processing volume for the year ended December 31, 2013 was $74.6 billion, a 4.0% increase over $71.7 billion in 2012. This increase in processing volume reflects same store sales growth and the addition of SME merchants whose processing volume exceeded that of merchants who attrited during the year. Our card processing volume for 2013 also includes $27.7 billion of settled volume for Network Services merchants, compared to $27.9 billion for 2012. Network Services' merchants are primarily in the petroleum industry and the slight decline in settled volume reflects lower average petroleum prices in 2013. The increase in settled volume in the 2012 period over 2011 primarily reflects the expansion of a contract with a large petroleum merchant to include back end settlement. Card processing volume for the years ended December 31, 2013, 2012 and 2011 was as follows:

                                         Year Ended December 31,
                                      2013         2012        2011
                                              (In millions)
SME merchants                      $  74,578    $  71,724    $ 67,499
Network Services merchants            27,710       27,894      15,533
Canada (a)                                59          770         666
Total card processing volume (b)   $ 102,347    $ 100,388    $ 83,698

(a) Canadian operations were discontinued as result of the sale of CPOS in January 2013.

(b) Card 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 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. We measure SME processing volume attrition relative to all SME merchants that were processing with us in the same month a year earlier. During the year ended December 31, 2013, we experienced 12.9% average annualized attrition in our SME card processing volume compared to average attrition of 12.8% and 13.5% for the years ended December 31, 2012 and 2011, respectively.

In our SME business, we measure same store sales growth, or contraction, as the change in card processing volume for all card merchants that were processing with us in both the same month a year earlier and the current month. In 2013, same store sales grew 2.0% on average, compared to 2.2% and 2.6% same store sales growth in 2012 and 2011, respectively. 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 merchants. Historically, our same store sales experience has tracked overall economic conditions. The following table compares our same store sales growth or contraction during 2013, 2012, 2011 and 2010:

Same Store Sales
Growth (Contraction)   2013   2012   2011    2010
First Quarter          2.2%   3.4%   3.2%   (1.5)%
Second Quarter         1.9%   2.2%   2.5%    1.1%
Third Quarter          1.6%   1.8%   2.3%    2.0%
Fourth Quarter         2.4%   1.5%   2.5%    3.8%
Full Year              2.0%   2.2%   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 card marketing businesses. In 2013, our newly installed gross margin for the year increased 22% from the gross margin we installed during the year ended December 31, 2012 compared to increases of 12% and 5% in 2012 and 2011, respectively . We attribute this increase in newly installed gross margin to growth in the number of salespersons in our sales force and improved individual productivity achieved by our salespersons. Our combined Relationship Managers and Territory Managers count amounted to 844, 739 and 790 at December 31, 2013, 2012 and 2011, respectively. In addition, as of December 31, 2013, we employed an additional 58 Senior Product Advisors ("SPA"), primarily payroll specialists, who have augmented our generalist SME sales force. We expect to drive increases in year-over-year installed margin in future periods primarily by increasing our Relationship and Territory Managers, and SPA count.

The card processing 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 card processing volume minimums. Our SME revenue is generated primarily 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,


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assessments and other network fees to Visa, MasterCard and Discover. Our SME gross card 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. The number of Network Services transactions decreased in 2013 primarily due to a decrease in the number of locations we serve at one large retail merchant. Network Services' increase in the number of transactions processed for the 2012 period is due to 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 years ended December 31, 2013, 2012 and 2011 were as follows:

                                    Year Ended December 31,
                                 2013         2012         2011
Network Services merchants:              (In thousands)
   Settled                      967,230      957,756      553,078
   Authorized                 2,347,776    2,481,174    2,720,595
   Total Network Services     3,315,006    3,438,930    3,273,673
American Express (a)             32,016       32,306       31,704
   Total                      3,347,022    3,471,236    3,305,377

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

Our ability to manage our front-end authorization systems, HPS Exchange, VAPS and NWS, provides us greater control of the electronic transaction process, allows us to offer our merchants a differentiated product offering, and offers economies of scale that we expect will increase our long-term profitability. During the years ended December 31, 2013, 2012 and 2011, approximately 96%, 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.

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 December 31, 2013 and 2012, substantially all of SME merchants were processing on Passport and all Network Services settled transactions were processed on Passport.

Heartland School Solutions
We provide school nutrition, point-of-sale solutions, and associated payment solutions including online prepayment, to kindergarten through 12th grade ("K to 12") schools through-out the United States. At December 31, 2013 and 2012, our Heartland School Solutions business provided services to over 29,000 public and private schools, compared to over 19,000 public and private schools at December 31, 2011. Our Heartland School Solutions business has been built through a series of five acquisitions in 2010, 2011 and 2012. 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 in 2012 and 2013.

Heartland Ovation Payroll
We provide payroll processing services throughout the United States. On December 31, 2012, we acquired Ovation Payroll, Inc. ("Ovation") adding over 10,000 customers to our existing payroll business. At December 31, 2013, we processed payroll for 24,088 customers, an increase of 6.8% from 22,553 payroll customers at December 31, 2012. In 2013, 2012 and 2011, we installed 5,797, 3,399 and 3,723, respectively, new payroll processing customers. Installs for 2013 included Ovation installation activity. We operate a comprehensive payroll management system, which we refer to as HOP (formerly PlusOne Payroll), that streamlines all aspects of the payroll process to enable time and cost savings. HOP was made available to new and existing customers beginning in 2010. We fully converted all of our existing payroll customers to HOP in 2011. The HOP platform enables us to process payroll on a large scale and provide customizable solutions for businesses of all sizes. The acquisition of Ovation added scale to our HOP platform, leveraging operating costs, and also added management, a new sales approach including an affinity partner network, and enhanced product and servicing capabilities.


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Campus Solutions
We provide open and closed loop payment solutions and higher education loan services to campuses throughout the United States and Canada. At December 31, 2013 and 2012, our Campus Solutions business served more than 2,000 colleges and universities, compared to approximately 200 at December 31, 2011. The increase reflects our acquisition of Educational Computer Systems, Inc. ("ECSI") on December 14, 2012, expanding our Campus Solutions business into higher education and post-graduate school/student services, including student loan servicing.

2013 Financial Highlights
Our financial results for the year ended December 31, 2013 as compared to the year ended December 31, 2012 benefited from 13.0% year-over-year growth in net revenue, partially offset by increases of 9.4% in processing and servicing costs and 24.0% in general and administrative expenses. We define net revenue as total revenues less interchange fees and dues, assessments and fees. For 2013, we recorded net income from continuing operations attributable to Heartland of $74.7 million, or $1.96 per share compared to net income of $64.4 million, or $1.60 per share, in 2012. The following is a summary of our financial results for the year ended December 31, 2013.

Net revenue increased 13.0% to $599.0 million during 2013, from $529.9 million during 2012. The increase in net revenue was driven by organic growth in Card Payment processing and Heartland School Solutions and increases in net revenue for Heartland Ovation Payroll and Campus Solutions, primarily reflecting the 2012 acquisitions of Ovation and ECSI, respectively, and the acquisition of NutriKids in Heartland School Solutions.

SME card processing volume increased 4.0% to $74.6 billion, compared to $71.7 billion in 2012. We earn percentage-based revenues on our SME processing volume. The year-over-year increase reflects same store sales growth and the addition of SME merchants whose processing volume and net revenue exceeded that of merchants who attrited in the same period.

Processing and servicing expenses for 2013 increased by $20.4 million, or 9.4%, compared with 2012. The increase in processing and servicing expenses for the year ended December 31, 2013 was primarily due to increased costs associated with processing and servicing higher SME card processing volume, increased residual commissions, and increased cost of sales and servicing related to higher Heartland School Solutions, Campus Solutions, and Payroll processing revenues. Partially offsetting these increases was a decrease in service center costs.

Our general and administrative expenses for the year ended December 31, 2013 increased by $33.6 million, or 24.0%, from $139.9 million in 2012 to $173.6 million in 2013. This increase is primarily due to personnel and other expenses added through the 2012 acquisitions of ECSI, Ovation and NutriKids. General and administrative expenses in the year ended December 31, 2013 also included $2.9 million for our periodic sales and servicing organization summit which was held in October 2013, and reflected increases in personnel costs for other headcount increases and costs of investments in various growth initiatives. General and administrative expenses as a percentage of net revenue for the year ended December 31, 2013 was 29.0%, up from 26.4% for the year ended December 31, 2012.

Our income from operations, which we also refer to as operating income, increased 14.8% to $126.1 million for 2013 from $109.8 million in 2012 and our operating margin, which we measure as operating income divided by net revenue, was 21.1% for 2013, compared to 20.7% for 2012. These year-over-year improvements reflect maintaining aggregate spending increases below the rate of growth in net revenue.

See "-Results of Operations -Year Ended December 31, 2013 Compared to Year Ended December 31, 2012" for a more detailed discussion of our full year operating results.

Components of Revenues and Expenses

Revenue. We classify our revenues into five categories: Card Payment Processing, Heartland School Solutions, Heartland Ovation Payroll, Campus Solutions and Prepaid Card/Other.

Our Card Payment Processing revenue primarily consists of discount, per-transaction and periodic (primarily monthly) fees from the processing of Visa, MasterCard, American Express and Discover transactions for our SME merchants and per-transaction fees for the authorization and settlement of transactions for our Network Services merchants. Also included in this category are American Express and Discover servicing fees, merchant service fees, fees for processing chargebacks, termination fees on terminated contracts and fees from selling, renting and deploying point-of-sale devices. Interchange fees, which are our most significant expense, are set by the card networks and paid to the card issuing banks. For the majority of our


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SME card processing revenue, we do not offset processing revenues and interchange fees 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 merchants on the first business day of the next month. For SME merchants to whom we do not advance interchange, we record card processing revenues net of interchange fees. As Network Services does not advance interchange fees to its merchants, we record its card processing revenues net of interchange fees. Revenues are recorded at the time of shipment or service is provided.
Heartland School Solutions revenues include fees from sales and maintenance of cafeteria point-of-sale solutions and associated payment solutions, including online prepayment solutions, back office management and hardware and technical support. Revenues are recorded at the time of shipment, over the maintenance period, or at the provision of services.
Heartland Ovation Payroll revenue includes fees charged for payroll processing services, including check printing, direct deposit, related federal, state and local tax deposits and providing accounting documentation and interest income earned on funds held for customers. Revenues are recorded at the time service is provided.
Campus Solutions revenue includes fees associated with providing solutions to support administrative services for higher education institutions including student loan payment processing, delinquency and default services, refund management, tuition payment plans, electronic billing and payment, tax document services, and business outsourcing. Campus Solutions revenue also includes fees from the sale and maintenance of open- and closed-loop payment hardware and software solutions for college or university campuses to process small value electronic transactions. Revenues are recorded at the time of shipment, over the maintenance period, or at the provision of services.
Prepaid Card and Other revenues include Micropayments fees from selling hardware and software for unattended wireless credit card based payment systems, and unattended value top-up systems for off-line closed-loop smart (chip) card based payment systems. Also included in this category are Heartland Marketing Solutions fees from selling mobile and card-based marketing services, gift cards and rewards services. Revenues are recorded at the time of shipment, over the maintenance period, or at the provision of services.

Net Revenue. We define net revenue as total revenue less interchange fees and dues, assessments and fees. Management uses net revenue to assess our operating performance, including operating margin.

Expenses. In addition to interchange fees, we also pay Visa, MasterCard and Discover, as well as certain PIN networks, dues, assessments and fees, which are a combination of a percentage of the dollar volume processed and per-transaction fees. Interchange fees and dues, assessments and fees are recognized at the time transactions are processed. It is our policy to pass along to our merchants any changes in interchange fees and card network dues, assessments and fees. Since the card networks regularly adjust those rates, our gross card processing revenue will increase or decrease, but all the impact of such changes will be paid to the card issuing banks and our net revenue and income from operations will not be affected.

Costs of services also include processing and servicing costs, customer acquisition costs, and depreciation and amortization. Processing and servicing costs include:

processing costs, which are either paid to third parties, including our bank sponsors, or represent the cost of our own authorization/capture and accounting/settlement systems. During 2013 and 2012, costs we paid to third parties represented about 39% of our processing costs;

residual commission payments to our Relationship Managers, sales managers, trade associations, agent banks and value-added resellers, which are a percentage of the gross margin we generated from our merchant contracts during the accounting period;

the costs of operating our service center and other customer support locations, including telecommunications costs, personnel costs, occupancy costs, losses due to merchant defaults, depreciation and amortization, and other direct servicing costs; and

the costs of merchant supplies, bankcard terminals, POS systems, hardware and software deployed in our businesses.

Customer acquisition costs reflect the amortization over the initial three-year contract term of the cash signing bonus paid, and the deferred acquisition costs accrued for vested Relationship Managers and sales managers, as well as changes in the accrued buyout liability, which reflect the impact of buying out residual commissions and volume attrition (see "-Critical Accounting Estimates -Accrued Buyout Liability") .


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Depreciation and amortization expenses consist of depreciation on our investments in property, equipment and software, and our amortization of acquired intangible assets. Depreciation and amortization expenses are primarily recognized on a straight-line basis over the estimated useful life of the asset.

General and administrative expenses include personnel and other administrative expenses related to our information technology infrastructure costs, our marketing expenses and other administrative functions.

Critical Accounting Estimates
The discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. 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 consolidated financial statements included elsewhere in this report. 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 and balance sheet, which are impacted by management's estimates, are described below.

Revenue
Our card 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 card processing, we do not offset card 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, processing 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 advance receivables, we record the associated revenues on a gross processing revenue basis in our consolidated Statements of Income. We have merchant portability, credit risk, and the ultimate responsibility to the merchant and, as such, revenue is reported at the time of settlement on a gross basis. Payment processing services are transaction based and priced either as a fixed fee per transaction or calculated as a percentage of the transaction value. The fees are charged for the processing services provided and do not include the gross sales price paid by the ultimate buyer to the merchant. 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.

We evaluate our contractual arrangements for indications that multiple element arrangements may exist. For contracts with multiple deliverables, we record revenue based on vendor specific objective evidence of selling price where applicable, or based on the best estimate of the selling price.

Capitalized Customer Acquisition Costs . . .

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