Heartland Payment Systems, Inc.

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Heartland Payment Systems, Inc. - Credit Card Processing & Merchant Services - Category Directory

47 Hulfish Street, Suite 400
Princeton, New Jersey 08542
(609) 683-3831

www.heartlandpaymentsystems.com

Sales

$377.5 million

Business Description

We are a leading provider of bank card payment processing services to merchants in the United States; according to The Nilson Report, a leading publication covering consumer payment systems worldwide, in 2003 we were the eighth largest bank card acquirer in the United States ranked by purchase volume (which we refer to as processing volume). We facilitate 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. We also provide additional services to our merchants, such as gift and loyalty programs, paper check authorization and payroll processing, and we sell and rent POS devices and supplies. As of May 31, 2004, we provided our payment processing services to approximately 77,000 active small- and medium-sized merchants in all 50 states. In 2003, we processed approximately 340 million transactions. We estimate that the annualized processing volume of merchant contracts we owned or serviced at May 31, 2004 was approximately $23.0 billion.

Our revenue is recurring in nature, as we typically enter into multi-year service contracts that require minimum volume commitments from our merchants in order to qualify for the agreed-upon pricing. Most of our gross revenue is payment processing fees, which are a combination of a percentage of the dollar amount of each Visa and MasterCard transaction we process plus a flat fee per transaction. We pay interchange fees to card issuing banks and dues and assessments to Visa and MasterCard, and we retain the remainder.

We sell and market our payment processing services through a direct sales force of over 700 sales professionals, known as Relationship Managers, in all 50 states. We establish a local sales and servicing presence, which we believe provides for enhanced referral opportunities and helps mitigate merchant attrition. We pay our sales force through commissions only, based solely upon the performance of their merchant accounts. We believe that our sales force and our experience and knowledge in providing payment processing services to small- and medium-size merchants gives us the ability to effectively evaluate and manage the payment processing needs and risks that are unique to these merchants. In 2003, our sales force generated over 29,000 merchant applications and installed over 27,500 new merchants.

Our sales efforts focus on small- and medium-sized merchants that typically generate annual Visa and MasterCard processing volume between $50,000 and $5,000,000. The local sales and servicing presence of our nationwide direct sales force is well received by small- and medium-sized merchants, as we believe that larger payment processors do not typically service them with local sales professionals that have industry-specific knowledge and a focus on educating their merchants on processing methods and costs. These merchants have typically paid higher payment processing fees than larger merchants.

We maintain high standards regarding the creditworthiness of the merchants to whom we provide services, and have developed systems and procedures designed to minimize our exposure to potential

losses. In 2003, we experienced losses of less than 0.4 basis points of payment processing volume and in the first quarter of 2004 these losses remained low at 0.67 basis points (0.0067%). We have developed significant expertise in industries that we believe present relatively low risks as the customers are generally present and the products or services are generally delivered at the time the transaction is processed. These industries include restaurants, brick and mortar retailers, lodging establishments, automotive repair shops, convenience and liquor stores and professional service providers. As of March 31, 2004, over 32% of our merchants were restaurants, and we believe that the restaurant industry will continue to provide us with growth opportunities. According to a report by the National Restaurant Association, restaurant industry sales are expected to exceed $440 billion in 2004, which will represent the thirteenth consecutive year of real sales growth, as adjusted for inflation. This steady growth profile, combined with the industry's low seasonality, makes restaurant merchant processing volume very stable and predictable. In addition, the incidence of chargebacks is very low among restaurants, as the service is provided before the card is used. Our industry focus not only differentiates us from other payment processors, but also allows us to forge relationships with key trade associations that attract merchants to our business. Our industry focus also allows us to better understand a merchant's needs and tailor our services accordingly.

Since our inception, we have used a number of proprietary Internet-based systems to increase our operating efficiencies and distribute our processing and merchant data to our three main constituencies: our sales force, our merchant base and our customer service staff. In 2001, we began providing authorization and data capture services to our merchants through our own front-end processing system, HPS Exchange. During the year ended December 31, 2003 and the quarter ended March 31, 2004, approximately 26% and 37%, respectively, of our transactions were processed through HPS Exchange, which has decreased our operating costs per transaction. We rely on third parties to provide the remainder of our bank card authorization and data capture services, as well as all of our settlement and merchant accounting services. We are developing our own back-end processing system for the clearing and settlement of transactions, which will enable us to customize these services to the needs of our Relationship Managers and merchants.

Based on The Nilson Report, in 2003 we were the eighth largest bank card acquirer in the United States ranked by purchase volume (counting all First Data Corporation companies and alliances as one acquirer), which we refer to as processing volume. Since inception, we have grown rapidly, with our merchant processing volume increasing, on average, 39.5% annually from approximately $4.7 billion for the year ended December 31, 1999 to approximately $17.9 billion for the year ended December 31, 2003. During the same period, our total net revenues increased, on average, 35.5% annually from $112.0 million for 1999 to $377.5 million in 2003. We have achieved this growth entirely through organic expansion rather than through acquisitions or buying merchant contracts from others.
Services and Products

As noted above, we derive the majority of our revenues from fee income relating to Visa and MasterCard payment processing, which is primarily comprised of a percentage of the dollar amount of each transaction we process, as well as a flat fee per transaction. The percentage we charge varies and depends upon several factors, including the transaction amount and whether the transaction processed is a swipe transaction or a non-swipe transaction. On average, the gross revenue we generate from processing a Visa or MasterCard transaction equals approximately $2.38 for every $100 we process. We also receive fees from American Express, Discover, Diners Club and JCB for facilitating their transactions with our merchants.

We receive net revenues as compensation for providing bank card payment processing services to merchants, including merchant set-up and training, transaction authorization and electronic draft capture, clearing and settlement, merchant accounting, merchant support and chargeback resolution, as well as payroll services. We arrange for certain of these services, particularly merchant accounting, clearing and settlement and a majority of our authorization and electronic draft capture services, to be performed by third-party processors (primarily Vital), while we perform the remaining services in-house. In addition, we sell and rent POS devices and supplies and provide additional services to our merchants, such as gift and loyalty programs, paper check authorization and chargeback processing. These services and products are described in more detail below:

Merchant Set-up and Training

After we establish a contract with a merchant, we create the software configuration that is downloaded to the merchant's existing, newly purchased or rented POS terminal, cash register or computer. This configuration includes the merchant identification number, which allows the merchant to accept Visa and MasterCard as well as any other bank cards, such as American Express, Discover, JCB and Diners Club, provided for in the contract. The configuration might also accommodate check verification, gift and loyalty programs and allow the terminal or computer to communicate with a pin-pad or other device. Once the download has been completed by the Relationship Manager, we conduct a training session on use of the system. We also offer our merchants flexible low-cost financing options for POS terminals, including installment sale and monthly rental programs.

Authorization and Draft Capture

We provide electronic payment authorization and draft capture services for all major bank cards. Authorization generally involves approving a cardholder's purchase at the point of sale after verifying that the bank card is not lost or stolen and that the purchase amount is within the cardholder's credit or account limit. The electronic authorization process for a bank card transaction begins when the merchant "swipes" the card through its POS terminal and enters the dollar amount of the purchase. After capturing the data, the POS terminal transmits the authorization request through HPS Exchange or the third-party processor to the card-issuing bank for authorization. The transaction is approved or declined by the card-issuing bank and the response is transmitted back through HPS Exchange or the third-party processor to the merchant. At the end of each day, and, in certain cases, more frequently, the merchant will "batch out" a group of authorized transactions, transmitting them through us to Visa and MasterCard for payment.

We introduced HPS Exchange, our internally developed front-end processing system, in August 2001. In 2003 and in the first quarter of 2004, we processed approximately 26% and 37%, respectively, of our transactions through HPS Exchange. The remainder of our front-end processing is outsourced to third-party processors, primarily Vital, but also including First Data Merchant Services Corporation, Paymentech Network Services, Inc. and Global Payments, Inc. Although we will continue to install new merchants on Vital's and other third-party processors' systems, we anticipate that the percentage of transactions that are outsourced to third-party processors will decline as we install a majority of new merchants on HPS Exchange.

Clearing and Settlement

Clearing and settlement processes represent the "back-end" of a transaction. Once a transaction has been "batched out" for payment, the payment processor transfers the merchant data to Visa or MasterCard. This is typically referred to as "clearing". After a transaction has been cleared, the transaction is "settled" by Visa or MasterCard and the merchant is compensated for the value of the purchased goods or services. We currently outsource these clearing and settlement services to Vital. We have begun to develop the technology necessary to perform these services internally since a majority of the data provided to merchants by back-end providers already resides in our databases. We anticipate offering these services to some of our merchants in 2005.

Merchant Accounting

We organize our merchants' transaction data into various files for merchant accounting purposes. Merchant accounting services allow merchants to monitor sales performance, control expenses, disseminate information and track profitability through the production and distribution of detailed statements summarizing their bank card payment processing activity. We also provide exception item processing. We use this data to provide merchants with information, such as volume, discounts, fees, chargebacks, qualification levels and funds held for reserves to help them track their account activity. Merchants may access this archived information through our customer service representatives or online through our Internet-based customer service system.

Merchant Support Services

We provide merchants with ongoing service and support for their processing needs. Customer service and support includes answering billing questions, responding to requests for supplies, resolving failed payment transactions, troubleshooting and repair of equipment, educating merchants on Visa and MasterCard compliance and assisting merchants with pricing changes and purchases of additional products and services. We maintain a toll-free help-line 24 hours a day, seven days a week, which is staffed by our customer service representatives and during 2003 received approximately 60,000 customer calls per month. The information access and retrieval capabilities of our Internet-based systems provide our customer service representatives prompt access to merchant account information and call history. This data allows them to quickly respond to inquiries relating to fees, charges and funding of accounts, as well as technical issues.

Chargeback Services

In the event of a billing dispute between a cardholder and a merchant, we assist the merchant in investigating and resolving the dispute as quickly and accurately as possible with the bank card associations or card issuers, which determine the outcome of the dispute. In most cases, before we process a debit to a merchant's account for the chargeback, we provide the merchant with the opportunity to demonstrate to the bank card association or the card issuer that the transaction was valid. If the merchant is unable to demonstrate that the transaction was valid and the dispute is resolved by the bank card association or the card issuer in favor of the cardholder, the transaction is charged back to the merchant. We typically charge our merchants a $25 fee for each chargeback they incur. However, in 2004 we initiated a new policy in which we do not charge our merchants a fee for their first three chargebacks in a year. We believe this policy has been well received by merchants who are unhappy with their occasional chargeback fees.

Payroll Services

Through our wholly-owned subsidiary, Heartland Payroll Company, we operate a full-service nationwide payroll processing service. Our payroll services include check printing, direct deposit and related tax payments. In addition, we offer a "Payday" card, which provides employees who do not have bank accounts with the opportunity to have their payroll deposited to a Visa debit card account. In order to improve operating efficiencies and ease-of-use for our customers and to decrease our own processing costs, we have implemented electronic and paperless payroll processing that allows an employer to submit its periodic payroll information to us via the Internet or through a PC-based, direct-connect option. If a customer chooses either of these online options, all reports and interactions between the employer and us can be managed electronically, eliminating the need for cumbersome paperwork. Nearly 40% of our payroll clients currently submit their information electronically. However, if a merchant chooses not to submit its payroll data online, it may submit such information via phone or facsimile. We recently enhanced our payroll processing service offerings by adding a time-and-attendance application, which enables employees to clock in and out using a POS terminal. This added functionality facilitates our collection of a merchant's payroll data.

Portfolio Servicing

In 1999 and 2000, we sold merchant contracts representing approximately $5.4 billion of annual processing volume to National Processing Company and Certegy, Inc. Most of the merchants whose contracts were sold to National Processing have been converted to its platform. However, less than 10% of the sold merchant contracts are still being serviced by us under a five-year transaction processing agreement entered into by National Processing and us in 2002. In connection with the sale of merchant contracts to Certegy, we entered into a 10-year servicing agreement, which, as amended, provides for us to service those sold merchants' processing needs in exchange for a servicing fee.
Industry Overview

The payment processing industry provides merchants with credit, debit, gift and loyalty card and other payment processing services, along with related information services. The industry has grown rapidly in recent years as a result of wider merchant acceptance, increased same store sales, increased consumer use of bank cards and advances in payment processing and telecommunications technology. According to The Nilson Report, total expenditures for bank card transactions by U.S. consumers was $1.8 trillion in 2002, or 32% of all consumer payments, and is expected to grow to $3.1 trillion by 2007, or 42% of all consumer payments. From 1990 to 2002, the compound annual growth rate of card payments was 13%, but this rate is expected to slow modestly to 11.5% for 2002 to 2007. The proliferation of bank cards has made the acceptance of bank card payments a virtual necessity for many businesses, regardless of size, in order to remain competitive. This use of bank cards, enhanced technology initiatives, efficiencies derived from economies of scale and the availability of more sophisticated products and services to all market segments has led to a highly competitive and specialized industry.

We believe that the card-based payment processing industry will continue to benefit from the following trends:

Growth in Bank Card Transactions

The proliferation in the uses and types of bank cards, rapid technological advances in payment processing and financial incentives offered by issuers have contributed greatly to wider merchant acceptance and increased consumer use of such cards.

Sources of increased bank card payment volume include:

• continued displacement of cash and checks at the point of sale;

• increased same store sales;

• increasing consumer acceptance of alternative forms of electronic payments; and

• increasing acceptance of electronic payments by merchants who previously did not do so, such as government agencies and businesses that provide goods and services to other businesses.

Increased Bank Card Acceptance by Small Businesses

Small businesses are a vital component of the U.S. economy and are expected to contribute to the increased use of bank cards. The lower costs associated with bank card payment methods, as opposed to checks, are making payment processing services more affordable to a larger segment of the small business market. In addition, we believe these businesses are experiencing increased pressure to accept bank card payments in order to remain competitive and to meet consumer expectations. As a result, many of these small businesses are seeking to provide customers with the alternative to pay for merchandise and services using bank cards, including those in industries that have historically accepted only cash and checks.

Bank Card Acceptance by Government and Business-to-Business Industry

State and local governments and the business-to-business industry have recently begun to provide customers with the ability to pay for merchandise and services using bank cards. For example, state and local governments have begun accepting bank cards for government payments, such as motor vehicle fees, recreational services, parking fees and taxes, in order to reduce their costs of collecting and processing payments and to expedite the deposit of these payments into their own accounts. We believe that the growth in bank card payments between businesses and the historically low acceptance of bank cards as a payment method by governments and the business-to-business industry represent an attractive market opportunity for us.

Technology

At present, many large payment processors provide customer service and applications via legacy systems that are difficult and costly to alter or otherwise customize. In contrast to these systems, recent advances in scalable and networked computer systems, such as distributed application architecture and relational database management systems, provide payment processors with the opportunity to deploy less costly technology that has improved flexibility and responsiveness. In addition, the use of fiber optic cables and advanced switching technology in telecommunications networks and competition among long-distance carriers further enhance the ability of payment processors to provide faster and more reliable service at lower per-transaction costs than previously possible.

Advances in PC and POS terminal technology, including integrated cash registers and networked systems, have increasingly allowed access to a greater array of sophisticated services at the point of sale and have contributed to the demand for such services. These trends have created the opportunity for payment processors to leverage technologies by developing business management and other software application products and services.

Segmentation of Merchants and Service Providers

The payment processing industry is dominated by a small number of large, fully-integrated payment processors that handle the processing needs of the nation's largest merchants. Large national merchants (i.e., those with multiple locations and high volumes of bank card transactions) typically demand and receive the full range of payment processing services at low per-transaction costs.

Payment processing services are generally sold to the small- and medium-sized merchant market segment through banks and ISOs that generally procure most of the payment processing services they offer from large payment processors. It is difficult, however, for banks and ISOs to customize payment processing services for the small- and medium-sized merchant on a cost-effective basis or to provide sophisticated value-added services. Accordingly, services to the small- and medium-sized merchant market segment historically have been characterized by basic payment processing without the availability of the more customized and sophisticated processing, information-based services or customer service that is offered to large merchants. The growth in bank card transactions and the transition from paper-based to electronic payment processing have, however, caused small- and medium-sized merchants increasingly to value sophisticated payment processing and information services similar to those provided to large merchants.