The Value Guys are two veteran Wall Street analysts that produce a podcast of their candid stock picks every week. Using screens to cull through a list of stocks, The Value Guys narrow the list to three or four stock ideas and highlight their favorite.
After my McKesson Corporation case study where I used DuPont analysis, I was excited to listen to The Value Guys DuPont Formula Edition. They screened for companies generating a high return on assets as a function of margin and asset turnover. They presented some interesting companies including Heartland Payment Systems, Inc.
Heartland Payment Systems, Inc. (NYSE: HPY) provides bankcard payment processing services to merchants in the United States and Canada. The company specializes in end-to-end electronic payment processing including merchant set-up and training. Over 70% of their business is with small and mid-sized enterprises which is recurring in nature as their clients use Heartland to process Visa, MasterCard, Discover and American Express credit and debit cards. Bankcard revenues consist primarily of a combination of percentage of dollar amount of each transaction and a flat fee per transaction. The company also provides electronic transaction services for secondary and college education markets and runs a payroll processing division.
Co-founded in 1997 by Robert Carr, Heartland employs 2,667 people and is based in Princeton, NJ. The company has a $1.2 billion market cap with Carr serving as the Chairman and CEO while owning 1.3% of shares outstanding.
As pointed out by fund manager Chuck Akre during a Value Investing Congress, there is an international war on cash. This is the underlying secular trend supporting his thesis for a long position in MasterCard Inc (NYSE:MA). While MasterCard provides the network in the war on cash, Heartland provides the pipes.
A typical $100 bankcard transaction cost the merchant $2.50. The $2.50 is split among the card issuer, the network and the payment processor as seen in the graphic below from the company’s most recent annual report.
What Happened in 2009?
Taking a look at a summary of the financials for Heartland, 2009 stands out like a sore thumb. What the heck happened there? Clearly it’s the only year in the past six years that the company has lost money.
The $51.7 million loss in 2009 looked like it came out of nowhere. Assets weren’t written down from an impairment and operating cash flow was positive. With free cash flow of $19.9 million, it was some type of non-cash charge.
For Heartland, the loss did come out of nowhere. On January 20, 2009 Heartland announced the company was a victim of a security breach of their processing system sometime in 2008. According to the Federal indictment of Albert Gonzalez, Mr. Gonzalez was the ring-leader of a hacking scheme allegedly called “Operation Get Rich or Die Tryin” that stole 130 million card numbers beginning on December 26, 2007. It seems that Heartland’s systems were compromised for nearly a year. The sentries guarding Heartland’s moat were compromised and the enemy was living in the castle. How could the castle be saved?
It appears that Heartland management took swift action. In April 2009, within months of their announcement, Heartland was returned as complaint service providers with Visa and MasterCard. In December 2009, they settled with American Express. For the 2009 fiscal year, they expensed $132.9 million and slashed their dividend to free up cash. In January 2010, Heartland settled with Visa and their sponsor banks. In May 2010 they settled with MasterCard. In August 2010 they settled with Discover. By the end of 2010, 98% of the financial liability was behind Heartland and they posted recoveries for the processing system intrusion expense from 2009. This shows that management conservatively estimated the liability.
Competitive Analysis and Return on Equity
Even more interestingly, the company exhibited evidence of having a competitive advantage as return on equity immediately recovered along with net margins.
The loss in 2009 looks like a blip. Heartland immediately went back to 20% returns on equity and it looks like they may even improve on it. However, the security breach certainly took at least two years of profitability away from the company if you count not only the loss but also the opportunity cost of not earning normal profits for the year. Equity took an even harder hit with a loss of three years of returns. Security breaches are a very real risk to Heartland.
Market Share Dynamics
Over the past twenty years, the processing industry has been consolidating as the larger players take more market share on a dollar volume basis. The top ten merchant acquirers captured 79.7% of the market in 2008 versus 39.0% of the market in 1988. Founded in 1997, Heartland has been able to go from zero market share to 3.1% in 2008 and a top ten competitor. Heartland’s entry into the bankcard processing industry was prescient. They were able to gain a foothold in the industry prior to significant consolidation that has created some barriers of entry for new entrants to take large market share. Heartland’s niche market of restaurants and small acquisitions has allowed the company to gain market share since 2003. There is evidence that barriers of entry exist in the industry with the purchase transactions market share for the top ten acquirers ranging from a high of 89.2% in 2006 to a low of 85.1% in 2011. Additionally, the position of the companies in the top ten and their market share has remained relatively stable indicating the ability of these companies to defend their turf.
The question of concern is the market shift downturn from 87.0% in 2010 to 85.1% in 2011 for the top ten U.S. acquirers. Is this the beginning of substitute payment methods like PayPal, Square and mobile payments encroaching on the traditional players or just typical variability in the industry? These data points will be important to watch as 2012 information comes in.
In 2011, 34.8% or $1.9 billion of Heartland’s processing volume was for restaurants. According to the National Restaurant Association, restaurant sales are expected to grow 3.5% to $631.8 billion in 2012. Thus, 2011 restaurant sales were approximately $609.7 billion and Heartland’s $1.9 billion in processing volume gives them a 0.32% restaurant market share. However, Heartland states in their 10-K that they provide services to 45,219 independent restaurants. In 2010, The NPD Group puts U.S. restaurant locations at 578,353. On a location basis, Heartland has a 7.8% market share. It appears they have some niche market advantages with a long runway of growth ahead of them. A feature of this niche is it provides lower risk business since restaurants have a low chargeback rates as service is typically provided prior to card use.
In 2011, top 25 merchants represented only 3.2% of Heartland’s processing volume. This gives their customers little bargaining power as a group. On the other hand, Heartland is unaffiliated with a Visa or MasterCard issuer and must be sponsored by an issuing bank in order to be a merchant acquirer. Heartland has three sponsor banks they work with. There is some risk in having such concentrated vendor relationships. A good litmus test regarding this risk is Heartland’s journey through its 2009 security breach. Heartland maintained all it’s relationships with its sponsor banks. The value of sponsoring a merchant acquirer as a customer to the sponsor banks could be seen as Heartland secured lending from one of their sponsor banks in the aftermath of the security breach.
The largest risk to Heartland is its services being substituted by new competitors like PayPal and Square that lie just outside of the traditional payment processing industry. This is a risk to monitor closely for investors in the bankcard processing industry. Even with these risks, Heartland’s positioning gives the company some competitive advantages. I like the Heartland at the right price.
Disclosure: No position in HPY