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MagicDiligence (< 20)

Magic Formula Stock Review: Heartland Payment Systems (HPY)

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February 12, 2009 – Comments (0) | RELATED TICKERS: HPY , V , MC

Heartland Payment Systems (HPY) is a bank card payment processor to many small merchants in the United States, mostly restaurants and retailers. By volume, Heartland is the 6th largest in the U.S., and one of the fastest growing. A credit card processor, for those unfamiliar, provides merchants with the ability to accept credit cards as payments, connecting the card terminal with the card issuer to verify the transaction, then moving the funds from the issuing bank to the merchant's bank account.

As I was researching Heartland, it was well on it's way to being named a Magic Formula Top Buy. Taken as a business, Heartland has it all. A focus on transparent fees, with no hidden charges so typical of the industry, has helped Heartland grab market share from the bigger players like First Data (DATA). Sales have grown at a compounded 20% per year over the last 5 years, and were continuing at a similar rate this year. Cards continue to grow as a form of payment, and this trend is set to continue. Payment processing firms benefit from high switching costs... most businesses are very leery about switching processors once they have one in place. And Heartland is in fine financial shape. Net debt is only about $30 million. Free cash flow is strengthening as the company completes it's in-house processing system rollout. And MFI return on capital has been steady and solid, if not spectacular, at around 40%. With strong growth, moat, and financial standing, Heartland seems to fit the bill as a top notch MFI stock

But Heartland's current low valuation (19% earnings yield) is due to a massive security breach at the end of January. Analysts estimated that up to 100 million credit card numbers were compromised, and several banks have had to re-issue Visas (V) and Mastercards (MC). Heartland tried to assure customers that personal information like Social Security numbers or addresses were compromised, but in situations like this perception is often reality. Even if Heartland does not lose the confidence of it's merchants, the company will be on the hook for reimburing the banks for the cost of card reissue. In the worst case scenario, one of the card brands may decide to stop doing business with Heartland, which would be fatal to the company. This is what happened to processor CardSystems after a breach in 2005 - a smaller one than Heartland's at "only" 40 million affected accounts.

Therefore, an investment in Heartland is fairly risky at this point in time. There are some reasons to be optimistic. CEO Bob Carr is a straight shooter, and immediately contacted merchants, released several press releases to investors, and quickly closed the leak. He sees this as an opportunity to improve security in the entire industry by implementing end-to-end encryption. In the week after the breech, Carr informed investors that Heartland had continued to add merchants at a faster rate than last year. Also, this situation has a lot of differences than CardSystems. That company's security problem was the lack basic security measures like a firewall and virus software! I don't it think it's likely Visa or Mastercard will be dropping Heartland.

MFI investors willing to play the odds are likely to make a good profit on Heartland, but the downside risks are rather large.

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