Description

Heartland Payment Systems (HPY)-Short                       

Background:

Heartland Payment Systems (“HPY”) provides bankcard payment processing services to North American merchants. It is the 9^th largest processor in the United States. Heartland focuses primarily on small to midsized merchants (“SME” merchants) through a nationwide direct sales force of 739 Relationship and Territory Managers. In addition to its core SME business, Heartland performs processing services for several large national and mid-tier merchants through its “Network Services” business. It attempts to cross-sell payroll processing, gift & loyalty programs, and prepaid & stored value solutions to all its merchants. Heartland has recently made several acquisitions in the K-12 School Solutions space.

After suffering a nearly fatal blow following the early 2009 revelation of a 2008 processing system intrusion, the company has rebounded strongly as moderate top line growth has been coupled with extremely robust margin expansion to generate a 60% CAGR in operating EPS from $0.65 in 2010 to $1.70 in 2012. The share price has responded accordingly.

Investment Thesis:

Our short thesis has three or four main drivers.

(1) Intense competition from disruptive entrants will permanently impair Heartland's core SME franchise.

(2) Heartland's compensation-driven focus on short-term EPS targets has led it to engage in short-sighted actions that have undermined its business model. The consequences will be felt shortly.

(3) An ongoing lawsuit by its former HR Director and its checkered history point to possible corporate malfeasance

(4) A recent (Dec. 12) step-up in pace of non-core acquisitions, potentially to offset an anctipated slowdown in organic growth

When compared to a stock price that seemingly discounts none of these risks, Heartland offers a very interesting short opportunity. What follows is a detailed elaboration of our main drivers. 

1.      Secular challenge to its core SME franchise (70% of Net Revenue)

Heartland derives 70% of its Net Revenue from acquiring and processing debit & credit card transactions for small to medium sized enterprises, or “SME merchants”. In FY ‘12, HPY processed $71.7 billion of transaction volume for 171.9k SME merchants (~ $415k per merchant). After deducting interchange fees to card issuing banks and dues & assessments to Visa and MasterCard, Heartland’s Net Revenue from this $71.7  billion in processing volume was $378 million, yielding a “Net Spread” of 52.5 basis points ($378 million/ $71.7 billion).[1]

As shown below, the “US Industry Average Net Spread” has exhibited an extremely steep downward slope. The Net Spreads incurred by smaller merchants are substantially higher than those incurred by larger merchants.

Inefficient distribution is primarily responsible for this disparity. The time and effort to qualify, board, and service a merchant has historically been similar for both small and large merchants. This similarity necessitated the application of significantly higher Net Spreads on a smaller merchant’s volume in order to meet a merchant acquirer’s minimum return objectives. Other, less significant, explanations for the disparity are the higher attrition of smaller businesses (requiring higher premiums) and the inability (or time) of smaller merchants to comprehend the “effective” rate.

Heartland offers limited information regarding the composition of its SME processing volume. However, its 2012 10-K (page 19) specifies that the top 25 SME merchants accounted for 3.56% of SME Visa and MasterCard processing volume. That 356 basis points of total SME Visa and MasterCard processing volume derived from only 1.5 basis points (top 25 SME merchants/ 172,000 total SME merchants) of its SME merchant population strongly points to a distribution inequality between SME processing volume and SME merchants (i.e. a large majority of its total SME processing volume derives from a small minority of its SME merchant population). Applying the most commonly observed distribution inequality (80/20) to this relationship yields the following result:

 An approximate application of the “US Industry Average Net Spread” to this implied distribution suggests the bottom 80% of SME merchants contribute ~ 33% of SME Net Revenue from just 20% of SME processing volume. The Net Revenue contribution from this bottom 80% (comprised of 136k merchants averaging ~ $105k in transaction volume) is the critical variable in determining Heartland’s vulnerability to disruptive new entrants. We anticipate material pricing and attrition pressure as competition intensifies for these merchants. The negative implications for Heartland have not been fully appreciated by the market.

Disruption from New Entrants

In late 2010, Square officially entered the merchant acquiring market.[2] Square began by commercializing its service in the very markets that incumbents considered least desirable. This “micro-merchant” market—babysitters, truck carts, dog-walkers, merchants at farmers markets, etc.—suffered most from the defects of the existing distribution regime.[3]  Such merchants were economically attractive to traditional acquirers only at exorbitant Net Spreads that precluded wide-spread adoption. The “micro-merchants” were themselves deterred by the inconvenience of overpriced single-purpose built POS terminals and the (deliberate) complexity of intricate payment schemes designed to obfuscate economic reality. They also were apprehensive about the lengthy, time-consuming process of applying for a “merchant account”.

Square was founded on the idea that while 7-8 million merchants accepted cards, 26 million did not. The proliferation of mobile devices—smartphones and tablets—had solved much of the POS hardware distribution hurdle. The original conception was that a very simple, intuitive software application coupled with an efficient, innovative mass-marketing campaign (using traditional and social media) that focused on simplicity, transparency, and ease of use would tap into a latent tidal wave of demand. In effect, they bet that spreading the fixed costs of marketing and software development (rather than individual, variable costs of a commissioned sales force) over a large potential market of users  could the solve the distribution problem that had plagued the industry.

Complications did emerge. Some hardware became unavoidable, so they designed and then mass produced “dongles” that could be plugged into audio-jacks of smartphones or tablets. As they intended to give the “dongles” away for free, mass production was necessary to bring unit costs below $1 each, thereby keeping customer acquisition costs low. But the “dongle” was simply a necessary by-product to activate software. Square is, first and foremost, a software driven company.

Additionally, to accelerate mass adoption necessitated streamlining the merchant on-boarding process.  To this end, Square was allowed by Visa and MasterCard to become an “aggregator” for all merchants below $100k in volume. This meant those merchants need not apply for a “merchant ID” as they could ride on Square’s. This reduced the on-boarding process from days to minutes—a huge difference.

So Square has entered the payments space by offering a completely different (and disruptive) set of value attributes to merchants; simplicity vs. complexity, transparency vs. obfuscation; mobility vs. standalone; mass-market  retail distribution vs. “feet on street”; complete ease of entrance and exit vs. upfront fees/termination costs.

As shown below, the growth of Square has been astonishing. Since Square’s entrance, many clones have emerged. While they have not had anything close to Square’s level of success, their presence can only serve to intensify the competitive environment.

Upmarket Migration

Having established a beach-head at the very lowest segment of the market, Square now has its sights set on moving upmarket towards smaller and medium sized businesses. In late August, it introduced a new pricing plan—offering merchants an option of the existing 2.75% on all processed volume or $275 flat fee per month (up to $250k per annum at which point the 2.75% re-applied).

The tables below show a comparison of Square’s total merchant rates to those of Heartland both before and after this change in pricing plan was instituted.[4]

 Just as the smart-phone enabled Square to reach micro-merchants, Square believes the proliferation of tablets as POS devices will facilitate its entrance into the SME market. According to its COO, “the era of standalone devices in retail is over. This commodity hardware (pointing to tablet) is really good, powerful, flexible, and the cost is amazing relative to 80’s and 90’s era machines.” This comment is   surprisingly, Square believes this hardware transformation will play directly into its strengths and talents in software engineering. Its “Square Register” software application offers business analytics, inventory management, loyalty programs and customer relationship management at no incremental expense. Square merchants also get instant inclusion in the “Square Directory”, thereby granting a merchant immediate access to customers using the “Square Wallet” mobile application. In effect, Square aims to provide more value at a similar or lower price. Its more efficient method of distribution enables it to do so.

Over time, Square’s total value proposition (better product at lower cost) should increasingly appeal to a higher % of Heartland’s current (or potential) SME merchants. In response, Heartland will be forced to either cut its Net Spread for the bottom 80% of merchants or risk massive defections. Such massive defections on a largely fixed cost business would prove disastrous, so assuming that Heartland did elect to cut the Net Spread on its bottom 80%, its earnings sensitivity would be as follows. (I assume 50% decremental margins due to reduction in variable commissions, but it is likely the decrementals could be greater).

2.  Recent earnings gains driven by margin expansion and Durbin Amendment derive from a series of actions aimed to meet short term incentive compensation hurdles at the expense of long term value.

In the 2^nd half of 2010, Heartland’s Compensation Committee made two grants to its top 5 executive officers. They were as follows

• 530k options at strike price of $15.22 that would vest in 4 equal installments beginning on July 22, 2011 to July 22, 2015
• 320k RSU’s contingent on hitting diluted EPS “calculated to exclude non-operating gains and losses and excluding the after-tax impact of share-based compensation expense” targets of $1.48 in 2012, $1.74 in 2013, and $2.04 in 2014. 50% of RSU’s would vest in 2013 if the 2012 target was met, 25% would vest in 2014 if the 2013 target was met, and 25% would vest in 2015 if the 2014 target was met.
• On an apples-apples basis (adding back after-tax stock option expense to Street numbers), consensus estimates are $1.81 in ’12 and $2.14 in ’13—substantially north of what is needed to meet the 2012 and 2013 incentive targets

We believe these packages (as well as 2009 package granted to Chairman and CEO Robert Carr discussed later) have focused management’s efforts on narrow EPS targets and short-term price appreciation at the expense of long-term value creation.

It is no co-incidence that the (admittedly) sharp margin expansion and EPS growth trajectory commenced at this time (Q3 ’10). Unfortunately, the means by which this has been accomplished have not been consistent with the best long term interests of the company. Two areas in particular—treatment of its sales-force and treatment of its merchants—demonstrate this short term vs. long term disconnect.

Purging of Sales-force and Servicing Representatives

Heartland operates a commission only sales-force. Regional Directors (RDs) oversee 11 geographic divisions. The RDs recruit Division Managers (DMs). The DMs, in turn, recruit Relationship Managers (RMs). The RMs generate the new merchant accounts. The payment schematic is shown below. (Gross Margin is calculated by deducting interchange fees to card issuers, assessments and fees to Visa and MasterCard, and HPY’s internal costs of underwriting, processing, and servicing an account from Gross Processing Revenues).

Heartland inserted an Account Manager (AM) in 2006. The AM program aimed to cut attrition by "allow(ing) Heartland to offer an Account Manager who is more attuned to the merchants' service and technical needs.” The AM program was paid for by reducing RM residuals (from 20% to 15%). Heartland justified this reduction by claiming the RMs would benefit most from the AMs. The benefits would be lower attrition (longer residuals) and less servicing of existing accounts (freeing time to install new accounts).

Heartland’s compensation practices differ from the ISOs (Independent Selling Organizations) utilized by larger processors to reach small merchant accounts. An agent employed by an ISO receives no upfront signing bonus but retains 50%-60% of the residual gross margin. Assuming both a Heartland RM and an ISO Agent installed $72k in Gross Margin and the account’s life was 6 years, the Present Value of compensation to each party would be as follows.

Note the ISO Agent makes nearly double the Heartland RM for a given level of margin installed. The ISO Agent also “owns” his/her residual commission stream should they elect to leave the ISO. In contrast, the Heartland RM’s residual commission stream only “vests” after $120k in annual gross margin has been installed. Even after “vesting”, Heartland retains the right (and assumes the obligation) to buy-out the vested RM’s “portfolio” at 2.5X TTM commissions.

Given this disparity, how did Heartland ever build a capable sales-force? Heartland shrewdly positioned itself as the “white knight” in a notoriously unscrupulous industry. They trumpeted a “Merchant Bill of Rights” that denounced the industry’s most noxious practices. They backed rhetoric with far-sighted contrarian actions like passing-through 100% of the 2003 debit interchange reductions to merchants. This elevated reputation enabled Heartland to offer RMs less $ per gross margin installed. The RMs believed Heartland’s reputation would enable them to install more gross margin and this would more than offset the lower $ per gross margin Installed.

Heartland also refrained from “forced” buy-outs, and positioned the buy-out as a tool to provide liquidity to vested RMs. Similarly, they let the inevitable attrition of underperforming, unvested, non-salaried, commission sales people remove underperformers and did not arbitrarily force them out. This latter policy helped attract new talent by removing fears that Heartland might abuse its unique compensation structure by terminating RMs after they had installed margin but before they had vested. Such actions would enable Heartland to pocket the terminated RM’s “residuals” at no incremental cost.

However, in Q3 ’10, in an abrupt reversal of policy, Heartland began massively eliminating both Relationship Managers and Account Managers.

In addition, the company made an unprecedented “forced” buyout of “portfolio equity” of vested RM’s during Q3 ’10, as shown below

On their Q3 ’10 call, the company offered that the buyouts in Q3 ’10 would likely add $8 million to earnings for the next twelve months. They did not quantify the impact of the reduction in the “residual commissions” to non-vested RM’s and AM’s, though it was likely as substantial. In 2011, “processing and servicing” costs (where residual commissions are expensed) fell by $16 million while Net Revenue grew by $37 million. As a % of sales, “processing and servicing” fell from 51.5% in 2010 to 44.1% in 2011, thereby explaining the entire step up in OPM’s from 10.4% to 16%.

Durbin Obfuscation-Merchants

In October of 2011, the Durbin Amendment went into effect. The Amendment capped the interchange rates on debit card transaction at 0.05% ($ volume) + $0.21 (per transaction). This reflected a substantial reduction from the average prevailing market rate of 0.95% + $0.20. The “interchange-plus” contracts of medium to large merchants insured they would immediately enjoy the entirety of the savings. The acquirer/processor would neither lose nor gain.

However, the prevalence of “bundled” pricing—pricing not legally tied to interchange—amongst smaller merchants does enable their acquirers/processors to temporarily boost their own Net Spreads by not passing along 100% of the interchange savings to their clients. Both First Data and BofA have said the ability of the acquirers/processors to retain this benefit will be “competed away”, within 12-18 months.  Ultimately, the savings will find their way to the intended recipient, the merchant.

As the self-anointed “honest broker” of the payments industry and the founding supporter of the “Merchant Bill of Rights”, Heartland had traditionally prided itself on its transparency regarding pricing to SME merchants. Indeed, Heartland’s 2003 decision to pass-through all of the reduction in debit interchange that arose from the Wal-Mart settlement set it apart from its less enlightened peers. As Mr. Carr said on the Q3 ’10 call, “After the 2003 Wal-Mart settlement, when debit interchange rates were reduced by 1/3, our new merchant signings grew by 50% in 2004. Unlike our competitors, we chose to pass the entire rate decrease through to our merchants. History has a funny way of repeating itself.”

As Durbin’s 10/1/11 implementation approached, Mr. Carr went on the rhetorical offensive. On the Q4’10 call, he commented, “it is our policy to pass along any changes in interchange to our merchants” and “this (Durbin) is going to be good for Heartland because we’re going to gain market share”. While size meant the % gains would not be the same, he felt Durbin “is going to be similar to ’03.” Mr. Carr even went to YouTube to make his case that “every dime that was intended to go back to merchants by the Durbin Amendment will be passed directly to Heartland’s merchants” and “encouraging all merchants in America to work hard to get this money that was intended for them back.” Again, on the Q2 ’11 call, “we are poised to gain market share once again as we did 8 years ago when Wal-Mart litigation was settled”. On the Q3 ’11 call (after Durbin had just been implemented), Mr. Carr said that “the intent of Durbin was not to temporarily increase profits for processors” and castigated those “who sacrificed their customer’s interests for sake of short-term profitability and 2012 bonus.” On the other hand, he called Durbin an “adrenaline boost to (our) sales organization” that was “helping in recruiting efforts” and implored analysts to have any potential salespeople contact him directly.

What was the truth?

In November of ’11, Heartland announced a $10 per month increase (from $15 to $25) in the Statement Registration Fee (SRM) it would charge merchants, citing the regulatory complexities of Durbin. While not “technically” interchange, the fee no doubt sought to indirectly exploit the interchange reductions created by Durbin. It was, in truth, the exact type of thing that they accused their competitors of doing.

The financial implications of this boost in the SRM fee have been a considerable driver of the last 12 months’ results. Assuming that the fee was levied only on just 173k active SME merchants; the full year impact would be $0.32 per share while the impact from FY ’11 to FY ’12 would be $0.28, as shown below

Given the high probability that Durbin will be competed away, it is a fair assumption that the benefits of such pricing will be transitory. Not only are they unlikely to occur again, but they likely will be reversed; thereby having a negative impact on future earnings.

Growth in New Margin Installed and Stable Attrition Rates?

Management cites the growth in New Margin Installed and the stable attrition that has occurred from Q4 ’10 as evidence that there have not been material effects from their terminations.

Yet further examination reveals some cracks do appear to be surfacing.

• Upfront Signing Bonus vs. Net Adjustments

 When a new merchant is signed at an “acceptable gross margin”, Heartland pays the Relationship Manager an upfront signing bonus based on first 12 months “estimated” gross margin. At the end of 12 months, HPY compares the “actual” gross margin to the “estimate”, and makes an adjustment. In other words, the adjustments made to merchants signed in Q4 ’10 will be made in Q4 ’11. (This explains why I only have the adjustment data through Q3 ’11). A negative number means “estimates” exceeded actual and a positive means the opposite.

Note the material increase in “net adjustment/gross upfront signing bonus” that began in Q3 ’10. The timing coincides with the September ’10 implementation of the WIN program. The WIN program was a means of implementing the huge reduction in Relationship Managers discussed previously. WIN mandates that all RM’s install at least $6k gross margin per month or risk termination. Importantly, WIN applies to those with gross margin installation substantially north of $72k per annum (i.e. a lumpy $150k of gross margin installed is more at risk than a perfectly consistent $72k).  According to an Arizona RM, an unintended consequence of WIN has been that “the Reps simply game the system at the end of the month to put in false installs and run a transaction so that they don’t get fired” as evidenced by the anomaly that “there are so many installs on the last day of the month.”

 The above data would seemingly support this claim and lead to serious questions regarding the validity of Heartland’s new margin installed numbers. Heartland has pointed to the new margin installed as forward looking evidence that the massive reduction in RM’s has not impacted its ability to generate new business. Their basic contention has been that the increase in productivity of existing RM’s has more than offset the impact of a reduction in total RM’s. This calls into question the validity of this argument.

• Merchant Count Flat to Declining

Despite lower attrition and improved new margin installation, Heartland’s Active SME merchant count has declined. Given the reduction in RM’s and AM’s, such a decline is not surprising. As the merchants signed by terminated RMs and AMs defect, Heartland cannot hire the additional RM’s needed to find new SME merchants to replace them.

Mr. Carr’s efforts throughout 2011 to compare the Durbin opportunity to the 2003 debit interchange reduction make the SME merchant count numbers even more surprising. In the twelve months after the ’03 reduction, new merchant signings were +50%. Yet, in the12 months post Durbin, the active SME merchant count has fallen, suggesting that new merchant signings have actually declined.

• Inability to Hire Relationship Managers

In Q3 ’11, management began emphasizing the need to rebuild the depleted RM ranks. In Q4 ’11, this emphasis was increased. According to Mr. Carr, adding RM’s would be easy, “There has been no better recruitment tool for sales than Durbin. Sales professionals are coming to us saying, they want to work for an organization that treats its merchants this way.” In response to a question regarding targets for growing RM’s, Mr. Carr said, “We do have our forecast, of course, and it calls for continued growth along the lines that we've had in the last half of last year. We hope to do better than that, frankly. But that's what our budgeting is based on.” (Note that 60 people were added from Q2 ’11 to Q4 ’11; 731 to 790).

With 790 RM’s at the end of FY ‘11, Mr. Carr’s guidance was for 850 RM’s by the end of FY ’12. Even as recently as Q2 ’12 conference call, Heartland’s President Bob Baldwin stated that “on a rolling basis, we’d like to be achieving growth in the order of 100 people. That—and frankly better than that—remains our objective.”

And yet in the 2^nd half of ‘12, Heartland’s RMs fell by 8% from 810 to 739. Heartland deliberately concealed this decline by stating that they had 768 RM’s at year end, thereby allaying analyst concerns by showing sequential strength. However, the 10-K clarified that 29 sales representatives from a payroll acquisition made on 12/31/12 were erroneously included in the 768 number, and the true RM count was 739. Had this 739 number been made clear in the Q4 ’12 release, we believe management would have come under more analyst pressure for not achieving their targets with respect to RM’s.

We think the Heartland’s struggles to recruit talent derive from the actions committed against its former employees. With Heartland’s reputation damaged, it can no longer offer an inferior compensation package and hope to attract talent.

3.  Questionable Management/Board/ Employer Practices/ Former HR Director’s Lawsuit

We are surprised by the high esteem in which the sell-side holds Heartland’s management. Management’s singular ability to act one way and behave another has served to deter any meaningful inquiry into its internal dysfunction. Yet, a few examples will suffice to show the type of company we are dealing with.

The Breach; Extravagant Executive Compensation for Poor Performance

On May 14, 2008, malware was installed on Heartland’s processing system, enabling perpetrators to steal the credit and debit card data of millions of cardholders. This intrusion occurred from May 14, 2008 to August 19, 2008. The company was alerted to potential abnormalities by Visa & MasterCard in late October. After an extensive investigation, the company did confirm the existence of a breach on January 20, 2009. In the 3 days following the announcement, HPY’s stock fell nearly 50% from $15.45 to $8.15. On 2/24/09 quarterly earnings call, management offered further details of the magnitude of the breach and the uncertainty surrounding future monetary liability. In response, the stock dropped an additional 30% to $5.44 per share.

Several investors filed lawsuits alleging that Senior Management knew something was amiss much earlier than claimed and cited the abnormal insider trading activity of Chairman and CEO Bob Carr. Specifically, on August 1, 2008, Mr. Carr opened up a 10b5-1 plan under which he sold 823k shares for proceeds of $16 million (or $19.50 average) before closing this plan on January 12, 2009,  just one week before disclosing the breach to investors. Of particular interest was that more than 50% of the sales were made in the two months after Visa and MasterCard were said to have alerted Heartland to potential problems. Despite several investigations, the SEC chose not to prosecute Mr. Carr.

What happened after the breach is more revealing. Mr. Carr had been the presiding executive during one of the largest breaches in processing history. This breach occurred at a company that previously prided itself on the security of its transaction platform. He had sold massive quantities of stock during 2008 (pocketing millions). These sales conveniently enabled him to save substantial sums.  This is particularly true because an eventual margin call did force Mr. Carr to sell his remaining 5.2 million shares at $21 million ($4 average) in March ’09. His transactions had triggered an SEC investigation. From a larger perspective, HPY had since its IPO on August 11, 2005 until May 11, 2009 lost 65% of its value vs. a 23% decline for the S&P. All of this had occurred under Mr. Carr’s watch.

Yet, despite this, on May 11, 2009, the board granted Mr. Carr 1.395 million stock options at a strike price of $8.88 and 265k Restricted Stock Units. 1/3 of the options and all of the RSU’s would vest in 4 annual installments from the grant date. 1/3 of the options would vest contingent on a doubling in share price (from $8.88 to $17.76), and 1/3 contingent on share price tripling (from $8.88 to $26.64).  The options had a 4 year expiration date. While ostensibly arduous, the reality was that if Mr. Carr could return the stock to where it had been just 8 months earlier anytime in the next 4 years, he would receive the entire package,

The board did concede that the 2009 compensation decisions marked a “diversion of past practices.”  Yet they justified the package by saying “Mr. Carr was forced in a margin call to dispose of all of his shares in in 2009”, and that there had been “surprising and difficult business conditions.” Left unsaid was that the “conditions” resulted from a breach that occurred under Mr. Carr’s watch. Amazingly, despite his having sold 7.5 million shares for $75 million from 2007-2009, the board did not insist that Mr. Carr himself personally invest alongside any grant.

In July 2010, Mr. Carr was granted 300k options at $15.22 and 220k RSU’s. The options vested in annual installments over the next 4 years and the 220k RSU’s were subject to same EPS targets referenced earlier. In 2011, Mr. Carr was granted another 127k RSU’s, 25% of which were time vesting and 75% based on EPS growth.

And what has Mr. Carr done with the largesse? From 2010-2012, he has sold 1.96 million shares for $45.5 million ($23.22 average). He sold 300k in 2010 for $4.8 million ($15.80 average price), sold 900k in 2011 for $18.4 million ($20.40 average price), and sold 763k in 2012 for $22.5 million ($29.50 average).  No sooner have Mr. Carr’s awards vested than he disposes of his holdings. Regardless of any explanation, such incessant selling does not reflect a strong confidence in the company’s long term future.

Former HR Director’s Lawsuit

Litigation is currently outstanding against Heartland.  In the fall of 2011, Amy Proya, Heartland’s former Director of Human Resources, filed a civil suit against the company. Ms. Proya was employed at Heartland from 2/18/02-5/31/11, a nine year period that saw her rise from HR manager to Director of Human Resources. On 2/1/11, 119 days before she was terminated, Ms. Proya was paid a bonus, given an increase in salary, and given an equity award.

Amongst the claims made in the lawsuit are the following:

• “Heartland Payments has systematically underpaid its commission sales people to create the appearance of higher net income and falsely report better financial results.”
• “Heartland Payment systematically encouraged salespeople to falsify sales to create the appearance of higher sales and falsely report better financial results.”
• “Heartland has systematically intimidated their employees to cover up their illegal internal payroll, tax, and personal practices in denial of rights if those employees.”

The specifics of the case are that Ms. Proya was approached by a leading Heartland Salesperson in December ’10 who claimed they were deliberately being underpaid by Heartland. Ms. Proya later confirmed the claim’s veracity and approached senior management. On February 11, 2011, Ms. Proya alleges Heartland’s Executive Director of Sales “physically intimidated” her, demanding she keep quiet. On May 2, 2011, Ms. Proya’s immediate superior warned that there was a “target on her back”. On May 24, 2011, Ms. Proya was terminated.

She filed in suit in fall ’11 and the case is still ongoing (partly due to a change in Heartland’s legal team during the case). All the facts and dates surrounding the case can be found on the website of the “Court of Common Pleas, Portage County, Ohio”. It is case # CV 2011 CV1489.

4. Step-Up in Non-Core Acquisitions

Following the $92 million purchase of its Network Solutions in ’08, Heartland made only $34 million worth of acquisitions from 2009-2011. However, Heartland spent $108 million in total on 3 acquisitions in 2012. Most interesting is that none of these acquisitions were in the core payment processing business and that 2 of them (worth $82 million) were completed in mid and late December. This raises the question of whether the company might be seeking to offset an anticipated decline in ’13 organic growth with rushed acquisitions that offer no long term value creation, but do offer short term earnings accretion.

Valuation

At 9x ’13 EBITDA and 15.7x consensus ’13 EPS of $2.08 (adding back intangibles but not stock option expense), Heartland’s valuation reflects expectations of fairly robust organic growth (high single digits) at premium returns beyond 2013. In justifying a 20x ’13 EPS multiple, one bullish sell-side analyst cites EPS growth >25% YoY in FY ’12 and FY ’13 and the 400 bps of margin expansion in ’12. In other words, the valuation seemingly reflects the rear-view mirror and not the windshield. Most sell-side analysts share Heartland’s view that the Square genie will go back in the bottle and dismiss any potential threat. As another analyst put it, “large processors and ISOs don’t see Square showing up in their core markets” and the multiple will expand once competitive fears fade. We believe that when Square does conclusively “show up” in core markets, the market will have already discounted it, but certainly do not believe this is the case now.

We believe earnings could potentially decline by late ‘13/ early ‘14 as Heartland’s increasingly aggressive competition meet its increasingly neglected merchants. We believe management would attempt to conceal such a decline by engaging in a series of EPS accretive, value destructive acquisitions. Indeed, that the company spent $82 million on two non-core acquisitions in December ’12 is likely a sign of things to come. In our opinion, such deals are a clear sign of weakness. As investors come to grips with the reality of the secular pressures and re-examine Heartland‘s business model, we believe a substantial multiple de-rating is likely. Even if Heartland does meet/exceed estimates for $2.08 in ’13, we suspect the multiple could decline to10x-11x EPS as franchise erosion becomes increasingly evident. This would suggest price target of $20-$21, or roughly 36% downside from current levels. If earnings due roll over and the multiple contracts, the downside could likely be north of 50%.

Conclusion

We believe Heartland’s current earning power is being overstated, that the medium to long term threat (both in probability and magnitude) to its business model is greater than is widely appreciated, and that this should cause a material degradation in both operating EPS and multiple in the next 12-18 months.

Similarly, we think there is a material probability that certain questionable practices the company has undertaken could have material adverse consequences that are not necessarily on the radar of the company’s investor base.

The largest risk we envision is that management is able to sell the company before operations deteriorate and the questions around its viability begin to gain critical mass. There has historically been a strong bid for processing assets. A bid of 10x ’13 EBITDA (high-end of historical range) would mean $37 (20% downside). The large amount of insider selling in conjunction with the large red flags that due diligence would unearth makes this a low probability event, but not totally remote. Similarly, we could be overestimating Square’s ability to disrupt Heartland’s business model.

Update (Q1 ’13 Earnings)

Acquisitions drove slight “beat”, organic was weaker than expectations

Q1 ’13 saw Net Revenue +$21million from Q1 ’12. +$22 million of this was from acquisitions (1 in June ’12; 2 conveniently made at the end of December), suggesting organic growth was flat to slight decline in the quarter. SME Processing Volumes were +3.7% (lighter than expectations) and, importantly, net spread charged to SME merchants declined as Durbin rolled off and Square’s pricing pressured the low volume, but high net spread merchants. All in, SME Net Revenue grew by an anemic 1.9%.

For the year, the company is targeting 12% Net Revenue Growth (6% organic and 6% acquired). After reviewing the results, I believe that organic growth will be much lower and acquired growth much higher. This is in-line with th view that the company is using the acquisitions to hide the organic weakness.

Relationship Managers and Gross Margin Installed

These two forward looking indicators that we have discussed frequently initially appeared better than expected. In Q4 '12, the company initally reported 768 Relationship Managers, but it was later revealed (in filings and not on the call) that this 768 included 29 salespeople from the Ovation Payroll acquisition closed in late December '12. The actual Q4 '12 figure of 739 Relationship Managers represented a massive sequential (-3.3%) and annual (-6.5%) decline despite management's intentions to actually increase RM's. This decline in RM's also showed up in Q4 '12 Gross Install Margin which, after increasing by double digits in the first 3 quarters, went flat. I have bored you with why I thought this was occuring, but the ramifications were that process volume would slow down as they could not recruit new RM's to install new margin to replace attrition.

At end Q1 '13, they claimed to have 790 RM's (after backing out Ovation Payroll) and Gross Margin Installed increased +10%. These numbers, particularly Gross Margin Install, seemed to allay fears that organic business was in trouble. But it was later revealed on the call (and the President had to correct the CEO) that the Gross Margin Install number now included Ovation Payroll Installed Margin! I would bewilling to bet that the inclusion of Ovatio Payroll Installed Margin was responsible for over half of the 10% increase in Gross Margin Installed. I also have reason to believe (as I laid out in my large write up) that the Gross Margin Install numbers that they report are becoming increasingly less accurate.

On the ability to add RM's, I would only say that they sequentially added people from Q4 '11 to Q1 '12 last year and then the number dropped dramatically. For reasons I have laid out before, I believe they need to constantly terminate RM's in order to eliminate their residual commisions and support margins. This makes it hard for them to steadily ramp RM's without imperiling short term margins - which they are loathe to do.

In short, nothing in the quarter dents the initial thesis.

Catalyst