Heartland Payment Another Company Poised To Rebound With Small Business

By Stephen D. Simpson, CFA | June 28, 2012 AAA

Setting aside the ceaseless news media squabbling over whether the private sector is getting stronger (and doing so fast enough), there is a large ecosystem of publicly traded companies leveraged to a recovery in small and mid-sized businesses (SMB). As a large payment processor oriented towards the SMB category, Heartland Payment (NYSE:HPY) is one such company.

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Honesty and Service, What a Concept!
Heartland has something of a leg up on its competitors in that many of them are not keenly focused on the same market segment. Heartland puts most of its focus on merchants, with $5 million or less in annual card volume, while rivals like First Data, Bank of America (NYSE:BAC) and Fifth Third (Nasdaq:FITB) target higher-volume customers. Given the expense of servicing numerous small customers, some payment processors compensate by simply offering less service.

Heartland not only stands apart by offering better service, but also taking a very open and honest approach with its customers. Payment processing can be a murky business, as processors often use opaque and/or complicated pricing formulas and will try to tack on otherwise "hidden" charges and service fees. Heartland doesn't necessarily try to compete on price, but at least its customers know what they'll be paying and customers seem to appreciate that.

SEE: The Truth about Credit Card Swipe Fees

Putting a Bad Breach Behind It
Heartland was devastated by the announcement in 2009 that its system suffered a deliberate security breach. From peak to trough, the stock lost more than 70% of its value and there were legitimate concerns as to whether the company would either be sued out of business or face a mass customer exodus.

As it stands now, it looks like the worst is likely over. The company has settled with Visa (NYSE:V), MasterCard (NYSE:MA), Discover (NYSE: DFS) and American Express (NYSE:AXP) and the company has set aside over $100 million to deal with class action and other consumer suits. At this point, the company believes it has reserved adequately for these actions, and though there is still some risk here, the company is very likely to survive very much intact - particularly as it still holds the #5 position in payment processing transaction volume.

SEE: Litigation: Are Your Investments At Risk?

Waiting for the Recovery
Heartland saw its processing volume rise 8% in its last reported quarter, and underlying same-store sales were up more than 3%. While the restaurant and retail spaces (Heartland's largest customer categories) are not yet fully healthy, they do appear to be getting better.

However, that may not be the only way in which Heartland can grow. Lower interchange fees are a challenge for Visa and MasterCard, but an opportunity for Heartland - particularly if their competitors try to capture some of those benefits by virtue of their opaque pricing systems. Elsewhere, a data breach at Global Payments (NYSE:GPN) could help shift some incremental share toward Heartland.

The Bottom Line
Heartland has set up a good record here of late for outperforming analyst expectations. At the same time, there is an economic recovery underway (albeit a slow one) and an ongoing transition towards more and more credit and debit card usage at smaller businesses. Don't forget, too, that Heartland could be a worthwhile acquisition candidate for a bank looking to grow its less-regulated fee income business.

Heartland has room to increase its share (it holds less than 3% of its available market), and yet it already posts very solid returns on capital. Assuming Heartland can grow its free cash flow at a high single-digit clip, these shares are about 15-25% undervalued. That's not quite enough to entice me to buy, but it's close enough that these shares merit ongoing monitoring.

At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.

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