Administaff, Inc. (ASF) Q4 2008 Earnings Call Transcript February 9, 2009 10:00 AM ET
Good day, ladies and gentlemen, and welcome to the Administaff fourth quarter 2008 earnings conference call. My name is Shawnel, and I will be your coordinator for today. (Operator instructions) I would now like to turn the presentation over to, Mr. Paul Sarvadi, Chairman of the Board and Chief Executive Officer; Mr. Richard Rawson, the President; and Mr. Douglas Sharp, Financial Officer. Please proceed.
Good morning. This is Doug Sharp. Thank you. We appreciate you joining us this morning. Before we begin, I would like to remind you that any statements made by Mr. Sarvadi, Mr. Rawson, or myself that are not historical facts are considered to be forward-looking statements within the meaning of the Federal Securities Laws. Words such as expects, intends, projects, believes, likely, probably, goal, objective, outlook, guidance, appears, target, and similar expressions are used to identify such forward-looking statements and involve a number of risks and uncertainties that have been described in detail in the company’s filings with the SEC. These risks and uncertainties may cause actual results to differ materially from those stated in such forward-looking statements.
Now, let me take a minute to outline our plan for this morning’s call. First, I’m going to discuss the details of our fourth quarter and full year 2008 financial results. Richard will discuss expected trends in our direct costs, including benefits, workers’ compensation, and payroll taxes, and the impact of such trends on our pricing. Paul will recap the 2008 year and then discuss our 2009 operating plan. Then I will provide our financial guidance for the first quarter and full year of 2009. We will then end the call with a question-and-answer session.
Now, let me begin today’s call by discussing our fourth quarter results. Today, we reported fourth quarter earnings per share of $0.39. These results were below expectations set forth in our Q4 key metrics guidance due to the continued deterioration in the macroeconomic environment, which went from bad to worse over the course of the quarter.
As for the Q4 year over year comparison, EPS was negatively impacted by $0.06 due to the declining interest rate environment and its effect on our investment income, discounting of workers’ compensation reserves and our effective income tax rate.
Now as for the impact of the weakening economy on our key metrics, the average number of paid worksite employees increased by 3% for the quarter to 118,748, below our expected range. While our client prospect base held up well through the initial stages of the economic downturn, conditions deteriorated to the point where their businesses were impacted. This was evident through an increase in net layoffs of worksite employees in our client base and a decline in our sales efficiency. Additionally, we lost one large account in December due to the client’s weakened financial condition.
Gross profit per worksite employee per month averaged $246 for the quarter, at the low end of our forecasted range. Interest income fell below the low end of our expected range by approximately $450,000, due to declining interest rates and a higher concentration of lower yielding, more conservative investments. Helping to partially offset the Q4 shortfalls in growth unit and interest income, operating expenses totaled approximately and $73.1million, which was $1 million below the low end of our forecasted range.
Now, in spite of the very difficult economic environment our cash flow remained strong through the quarter, and our year end balance sheet continues to reflect significant liquidity and no debt. EBITDA plus stock-based compensation totaled $22 million in Q4 and $98 million for the full year 2008. We ended the year with $98.4 million of working capital.
Now let’s review further details of our fourth quarter results. Fourth quarter revenues increased 6% over 2007 to $426 million as a result of a 3% increase in the average paid worksite employees and a 3% increase in revenue per worksite employee per month.
Looking at fourth quarter revenue contribution and growth by region – the Southeast region, which represents 11% of total revenue, grew by 5%; the Northeast region, which represents 21% of total revenue, grew by 12%; the Central region, which represents 15% of total revenue, grew by 10%; the West region, which represents 20% of total revenue, grew by 5%; and the Southwest region, which represents 33% of total revenue, grew by 2%, and was impacted by the loss of a large midmarket client due to their weekend financial condition.
Moving to gross profit; gross profit per worksite employee per month for the quarter was $246, at the low end of our forecasted range of $246 to $249, but above the $244 reported in the 2007 period.
As for our direct costs, benefit costs per covered employee per month averaged $700 for the quarter, a year-over-year increase of only 3.2%, and just slightly above our forecasted costs.
Workers’ compensation costs were 0.68% of non-bonus payroll for the quarter, also just slightly above our forecasted level of 0.66%. Actuarial loss estimates resulted in a $1.9 million reduction in previously reported loss estimates.
Payroll taxes as a percentage of total payroll costs declined from 5.87% in Q4 of 2007 to 5.72% in Q4 of this year, primarily as a result of higher payroll averages and bonuses of worksite employees.
Now let’s move on to operating expenses, which totaled $73.1 million for the quarter. This was below our expected range of $74 million to $74.5 million, primarily as a result of lower incentive compensation expense, sales commissions, and certain G&A costs. The year-over-year increase of 10.3% over Q4 of 2007 was due primarily to investments we made in the earlier half of 2008, including our sales expansion, new products and services, such as HRTools and our midmarket initiatives, and the integration of the recently acquired employment screening company.
As for the details, salaries and wages increased 14%, and included costs associated with the growth of our sales force throughout 2008. Trained sales reps averaged 322 for the quarter, an increase of 16% over Q4 of 2007. Stock-based compensation increased by 24% due to the full effect of the three year vesting of our annual restricted share grants, which we began issuing in 2005. Sales commission costs remained relatively flat, advertising costs increased by 33%, due to both a shift in the timing and the amount of marketing efforts in the fourth quarter.
As you are probably aware, a deteriorating economic environment negatively impacts our sales closing ratio; therefore, it was important for us to generate a higher level of sales leads, and corresponding sales activity. Additionally, higher advertising rates were incurred during the presidential election period.
Depreciation and amortization declined by 15%. You may recall that we wrote of $1.2 million of capitalized software costs associated with the initial version of our HRTools products in the 2007 period. General and administrative costs increased by just 2% as certain increases such as rent associated with our sales office expansion were partially offset by savings in other areas, such as travel costs.
Interest income declined by approximately $1.6 million from Q4 2007, due to the declining interest rates and a higher concentration of invested funds and lower-yielding taxable government backed funds. This was also a factor in a higher than expected effective income tax rate for the quarter.
Now I would like to take a few minutes to review our full-year results. We reported full-year 2008 earnings per share of $1.79, a 3% increase over 2007. This increase was a net of a $0.19 per share negative impact from declining interest rate on our investment income, discounting of workers’ compensation reserves, and our effective income tax rate. Excluding this non-operational factor, 2008 earnings per share would have increased 14% over 2007. Revenues grew 10% to $1.7 billion as a result of achieving 6% unit growth and a 4% increase in revenue per worksite employee per month.
As for full year 2008 revenue contribution and growth by region – the Southeast region, which represents 11% of total revenue, grew by 10%; the Northeast region, which represents 21% of total revenue, grew by 17%; the Central region, which represents 15% of total revenue, grew by 13%; the West region, which represents 20% of total revenue, grew by 6%; and the Southwest region, which represents 33% of total revenue, grew by 7%.
Gross profit per worksite employee per month increased by 6% from $231 in 2007 to $245 in 2008.
As for recap of our direct costs, benefit costs per covered employee per month increased only 2.5% for the year from $675 to $692, as we managed these costs through plan design, lower administrative costs, and effective pricing to encourage migration of covered worksite employees into lower cost plans. The percentage of worksite employees covered under our health insurance plan increased slightly from 73.2% to 73.5%.
As expected, workers’ compensation costs as a percentage of non-bonus payroll increased from 0.51% in 2007 to 0.63% in 2008. Payroll taxes as a percentage of total payroll declined from 7.06% in 2007 to 6.94% in 2008, primarily due to the higher payroll average of our worksite employees.
Now let’s move on to operating expenses, which increased 14% over 2007. An increase in cash and stock-based compensation costs made up about 70% of the increase in total operating expense dollars. Cash compensation costs increased by 17% over 2007, due primarily to the hiring of sales reps, additional personnel associated with our midmarket initiatives, and employees of the acquired company USDatalink.
Interest income declined by approximately $4.6 million from 2007 due to declining interest rates and a higher concentration of invested funds and the lower-yielding taxable government backed funds. This also contributed to an increase in our effective income tax rate of 35.3% in 2007 to 36.4% in 2008.
Now as for our balance sheet and cash flow; EBITDA plus stock-based compensation totaled $98 million for the full year 2008. Over the course of the year, we returned $50 million to shareholders through dividends and share repurchases. As for our share repurchase activity, we repurchased 1.7 million shares in 2008, including 974,000 shares during the fourth quarter. We currently have 411,000 shares remaining for repurchase under our authorization.
At this time I would like to turn the call over to Richard.
Thank you, Doug. This morning, I am going to share the details of our fourth quarter gross profit results. Then I will update you on the pricing and direct cost trends we are now seeing and how we believe they will affect gross profit per worksite employee per month for 2009.
As you know, our gross profit comes from the mark-up that we earn on our HR services combined with the surplus that is generated when our direct cost pricing allocations exceed the corresponding direct costs. Doug just reported that our gross profit per worksite employee per month was $246 for the fourth quarter, and was within our forecasted range. These results came from achieving $199 per worksite employee per month of service fees and generating a surplus of $47 per worksite employee per month or 4.7% of our total direct cost allocations.
The pricing on our service fee for both new and renewing accounts increased $3 per worksite employee per month over the fourth quarter of last year. Now these results continue to demonstrate the value proposition that prospects and current clients see in our service. In fact, our average markup was $1 per worksite employee per month above our forecast; however, this increase was more than offset by a $2 per worksite employee lower surplus and our workers' compensation cost center due to lower interest rate not higher clients. The total number of claims reported for this quarter was 16% lower than the fourth quarter of 2007. This incident rate is very meaningful when you consider that we had over a 3% growth in the number of worksite employees that incurred those claims. While the average cost of these claims is 30% higher than last year’s average claims cost it was driven primarily by one large claim. However, this quarter's $2 increase in the cost per worksite employee per month was due to the further reduction in the discount rate applied to our workers’ compensation reserves as interest rates declined further in the fourth quarter. The surplus in the payroll tax cost center came in $4 per worksite employee per month better than expected because the actual payroll tax expense was lower this quarter than we have forecasted.
The benefits cost center deficit offset the payroll tax cost center surplus. Total benefits cost for the quarter averaged $700 per covered worksite employee per month, which was at the high end of our expected range, but still only increased 3.22% over the fourth quarter of last year. The plan design changes and migration that we saw in 2008 limited our annual benefits cost increase to only 2.5% for the full year over 2007. These results continue to demonstrate the value proposition that the Administaff PEO model brings to small business clients.
In summation, we had another very solid quarter of performance at the gross profit line, which contributed to a 6% year over year improvement in gross profit per worksite employee per month.
Now let me update everyone on what we expect the gross profit pictures would like for 2009 beginning with the pricing on the market component of our service fee. Considering the economic environment that we are in, we believe that new business sold in 2009 will be similar in pricing to 2008. We are planning to hold the line on increases for renewing customers this year as we help them work through this difficult economic environment. Therefore, we will assume that our average markup per worksite employee per month for 2009 should remind at a $198 per worksite employee per month, which is the same as our 2008 full year results.
Now let me explain our assumptions for the surplus component of gross profit for 2009, beginning with the payroll tax cost center. We have now received almost all of our state unemployment tax rates for 2009. The allocation changes that we have made to match these costs increases would normally allow us to have a similar surpluses in 2008; however, we do not expect to receive the $1.5 million credit from the state of Texas like we did last year. Therefore, our surplus in this cost center will be slightly lower than in 2008.
Now let's discuss the workers’ compensation cost center. At the beginning of each policy year, we get an estimate from our outside actuary as to what the cost of claims could be based on our size and mix of business. Since we maintain a higher allocation than this estimate, we have a built-in surplus to start the year. Then each quarter our actuaries revise the estimated claims cost based on the number and severity of claims filed in the current period plus they make adjustments to the cost of prior policy period claims as they get settled. So as the year goes by, if our incident and severity rates are better than forecasted due to effective safety programs and our claims personnel settle claims faster and at lower forecasted reserves, then our quarterly expense would be lower than forecasted.
We had a five year history of producing better than expected results in this cost center, but we do not build it into our forecast at the beginning of the year. This year, our strategy will be the same as in the past years. So we would conservatively forecast our workers’ compensation cost to start out at 0.74% of non-bonus payroll for the year and let any upside develop throughout the year. Another factor to consider that could produce additional surplus in our workers’ compensation cost center deals with increases in interest rates in 2009. Last quarter, I reported that because of a decline in interest rates, our discount factor applied to reserves was reduced, which increased our expenses by $2.1 million for the year. So if interest rates increase in 2009, we would see our workers compensation expense decline. But we are not going to assume that upside in our forecast.
Now, our last cost center to discuss is the benefits cost center. As I mentioned a few moments ago, we did a superior job last year in managing our healthcare cost increases to only 2.5% over 2007. Much of that success came because we had made some plan design changes at the beginning of 2008. Here is what we see for 2009. While we are not making any plan design changes for 2009, United Healthcare did. They filed for an amendment to their master policy (inaudible), which included modifications to a few of their coverage charges. These changes should help reduce our costs for 2009.
Also last quarter, I had mentioned that we had previously it negotiated a slight reduction to our administrative fees beginning in January of this year. When you combine these two factors, our 2009 cost trend should be about 1% to 1.5% lower than the 6% to 9% trend increases Dan talked about in the marketplace.
Another factor that could help us have lower cost increases in 2009 comes from the continued migration of covered worksite employees moving from higher cost lower deductible plans to lower cost higher deductible plans. To illustrate my point, we introduced the United Healthcare $1500 high deductible health plan in the second quarter of last year, and today we have almost 2% of our covered worksite employees enrolled in that plan. Additionally, we now have another 2% plus of our covered worksite employees enrolled in the United Healthcare $3000 high deductible health plan.
However, to maintain our conservative approach this year, we are not going to factor the effects of much migration into our guidance just yet. So for now, we are going to assume a 5 to 6% trend increase over 2008. From a pricing perspective in the benefits cost center, we have been continuing to increase our allocations for new and renewing business to match the trend that we are forecasting. However, we are seeing our total allocations increase at a slower rate due to the effect of the migration. Therefore for now, we will forecast a slightly lower contribution to gross profit from the benefits cost center.
In summary, when we look at our entire gross profit picture for 2009 and factor in some extra conservatism, we see our gross profit per worksite employee per month for the full year averaging $232 to $236. If you compare this forecast to the 2008 actual results by cost center, you would see about three dollars of the difference coming from the payroll tax cost center, about two dollars of the difference in the benefits cost center and the balance of the difference coming from the workers compensation cost center.
At this point, I would like to turn the call over to Paul.
Thank you, Richard. I will begin my comments today with a few thoughts about our overall results for 2008. I will also discuss the economic conditions and the labor market deterioration we witnessed in the fourth quarter, and the affect on our small business client business base. I will finish by providing details on our outlook for 2009 and the conservative approach we're taking to planning and operating our business in this environment.
(inaudible) bottom line of $1.79 in earnings per share was just under the low end of our $1.80 to $2.00 range provided at this time last year, when the world was quite different than it is today. However, with all the turmoil last year, the single most significant factor affecting our financial results was lower interest rates, which reduced our interest income and increased workers compensation reserves and tax rate. This factor alone reduced EPS by $0.19. Otherwise, we would have come in at $1.98, near the top end of our original range.
Our financial performance was exceptional, as we grew revenues, gross profit, operating income, and EPS in the face of some daunting circumstances. Our operational achievements were equally impressive as we improved client retention, set record level client satisfaction rates, and grew our sales staff substantially. We invested in new products and services and improved our offering to mid-market clients, extending our competitive advantage; and we returned over $50 million to shareholders, while maintaining nearly $100 million in working capital. These results against the backdrop of one economic crisis after another throughout 2008 are truly remarkable. Administaff had an outstanding year by any measure. It is a testimony to our exceptional clients, our amazing employees, our valuable service offering, and our proven business model.
Last quarter, I highlighted the resiliency of our client base, representing the best small businesses in America. During the fourth quarter, as the economic crisis widened and deepened, the challenges facing the rest of the economy spread to this small-business segment, across nearly every business segment sector in every region of the country. As the human resource department for our clients, we had the benefit of a direct view into employment and compensation, and we were able to watch the client base respond accordingly.
The small-business community reaction to the apparent economic crisis included an operating expense tightening, reflected in a round of layoffs within our client base; and a spending pullback that affected our new sales. Prior to the fourth quarter, new hires exceeded layoffs every month of 2008, except for September. After a rebound in October with a net gain of 1,200 employees, the layoffs exceeded new hires by 1,800 in November, 900 in December, and 1,000 in January. These 3,700 layoffs represent a 3.2% decline in the size of our clients’ work force in three months. However, a deeper look at the data indicates many clients have responded quickly and decisively as the economy worsened.
Since October, approximately 1,900 clients, representing 31% of our client base, reduced their staff by an average of 14%. These companies have adjusted their workforce to a new reality and for now are less likely to contribute to the layoff number in the near term. This data also reveals that bad news is not bad for everyone. Doing the same three month period, approximately 1,400 clients or 22% of our base, increased their employment by an average of 12%. These clients are not candidates for near-term layoffs either because they are either unaffected or may even be benefiting from some aspect of the economic turbulence. Another 12% of our client base has turned over at year end. Many of the clients that left were the ones experiencing financial pressures and may have layoffs in the near term, but they are no longer a part of our base at all. The new clients that replaced them just made an investment decision to add our service and are likely to actually grow their workforce as new clients. This leaves 35% of our current client base that remain constant in employment levels over this period. They need or have not yet reacted to the downturn or did so earlier last year, or (inaudible) in weathering the storm. In any event this data indicates that we have seen a round of layoffs in 31% of the base, 34% are likely employment gainers in the near term, and 35% could go either way.
The other reaction we saw during the fourth quarter was the hesitancy of business owners to make significant buying decisions by joining Administaff. Our sales staff did an admirable job through the fall campaign, reaching activity target. The closing rates were at historic lows, resulting in a 1.05 sales per salesperson per month. This is below our 1.2 to 1.5 historical range for sales efficiency in the fall campaign. Sales typically require extra cost to close; they did require extra cost to close and many prospects just could not pull the trigger do to the economic uncertainty. The efforts of our sales organization did produce 7,700 new paid worksite employees in January and a pipeline of 3,500 employees to be paid over the next couple of months.
The other major factor at year end for Administaff is our client retention of renewing accounts. Thankfully, we had a tremendous companywide effort throughout 2008 to improve in this area. This initiative resulted in a 12.6% improvement for the full year and a reduction in the employees lost from client attrition in January from 11,100 in 2008 to 10,100 in 2009.
Now another sign of the times was the failure of one of our large banking clients, which was taken over by the FDIC. This account had approximately 700 employees and left Administaff at the end of November. We reached our high water mark in paid worksite employees in October exceeding 120,400 employees. However, the combination of 3,700 layoffs and the 2,400 net difference between new sales and client attrition, and the one 700 employee client failure resulted in a starting point for January 2009 of approximately 113,600 paid worksite employees.
One other important activity in the fourth quarter turned out to be a management team retreat in November that was focused on an operating plan for 2009 in the event of a lower starting point for paid worksite employees for the new year. This provided a framework around decisions to be made and ranges for operating expense controls. What started as a hypothetical scenario in November emerged as a reality in January. Now with our 23-year history as a growth company, we have had a setback on occasion, experiencing a reduction in the paid worksite employee count. This metric is the primary driver to growth and profitability of our recurring revenue model and any effective plan to respond to a drop in the employee count includes adjusting operating expenses to the new base and restarting sequential unit growth. In lot of the unprecedented economic conditions as we enter the new year, we have planned and will operate Administaff in 2009 by taking a conservative approach which balances the interest of the various constituencies of the company.
I will leave details of the operating expenses to Doug in a few minutes and focus our on our plan for resuming sequential unit growth as 2009 unfolds.
The most important factor to drive unit growth is the number of trained sales personnel. We are very fortunate to have the largest sales force we have ever had, with over 335 trained sales reps as we enter 2009. This is a 20% over the 278 salespeople we had at this time last year. In this environment, we are taking a conservative view of the sales metrics going forward and using a 0.75 sales efficiency rate for the year in our low case and a reduction of the average same salesperson count, an average of 320. To get to the high end of our range, we have assumed a 0.9 sales efficiency and maintaining the trained rep count we have today.
Our visibility in the client retention shows the continuation of excellent results experienced last year, but we feel it is prudent to anticipate a headwind to our unit growth coming from potential layoffs and/or business failures throughout the first quarter. We also feel it is appropriate to assume layoffs will exceed new hires to some degree throughout the rest of the year, and to leave any improvement in the labor market as upside to our operating plan.
Therefore, we do not anticipate an increase in the worksite employee base this quarter from the January starting point, as we expect the pipeline for new sales to offset client attrition and layoffs. In subsequent quarters in 2009, we expect a range of 1% to 3% sequential unit growth as new worksite employee sales more than offset layoffs and client attrition and produce a net gain of 500 to 1,200 employees per month.
So the beginning of this year has presented an interesting and considerable challenge. We have responded quickly and decisively with the plan to continue our history of growth and profitability and our commitment to the clients, employees and families we serve. Administaff is in a unique position to help our clients through this difficult period and I am confident our corporate staff will step up and meet this challenge.
At this point, I would like to pass the call back to Doug to provide specific guidance for 2009.
Thanks, Paul. Now before we open up the call for questions, I would like to provide our financial guidance for the first quarter and full-year 2009.
As Paul discussed earlier, our forecasted unit growth takes into account an expected range of possibilities from the impact of a weak economy on our sales efficiency, client retention, and layoffs within our client base. We are forecasting a level of worksite employees in Q1 flat with our January starting point, then sequential growth between 1% and 3% for the remaining quarters of 2009. This results in expected average paid worksite employees in a range of 113,400 to 113,800 for the first quarter; and 115,500 to 118,000 for the full year. As for gross profit per worksite employee per month, based upon Richard’s earlier comments, we expect to be in a range of $245 to $249 for the first quarter and $232 to $236 for the full year. As for the quarterly pattern in this key metric, it is typically higher in Q1 because of the surplus we generate on a higher level of payroll taxes prior to the worksite employees reaching their wage limits. Thereafter, new business coming on creates a drag on the payroll tax surplus. When combined with pricing increases rolling in throughout the year, we typically see a decline in this metric from Q1 to Q2, sequentially flat from Q2 to Q3, and a sequential increase in Q4 over Q3.
Now as Paul mentioned earlier, we have made adjustments to our initial 2009 operating plan based upon continued deterioration in the economy and its impact on our January starting point of worksite employees and unit growth outlook for the remainder of the year. We are forecasting operating expenses to be in the range of $273 million to $276 million for the full year, a reduction of approximately $25 million from our initial 2009 internal budget, which was formulated in the fall of 2008. This initial 2009 budget included increases over our actual 2000 operating expenses due largely to our run rate levels carried over from the end of 2008, rather than new incremental expenses.
Therefore, the following actions have been taken to result in significant reductions from those existing run rates. Although we did not contemplate a broad-based layoff plan, a reduction in corporate headcount is planned through no new hiring and only limited and targeted replacements of termed employees. Additionally, corporate compensation will be reduced through a deferral of merit increases of our corporate employees, a reduction in the level of stock-based compensation, a reduction in the company’s 401K match, and reduced incentive compensation.
We have also reduced the level of marketing and business promotion expense. As you would expect, sales commission expense will be tied to the level of paid worksite employees. We have targeted various G&A items for reduction, including travel, training, postage, (inaudible) and other costs. Currently, we do not plan to open any new sales offices in 2009.
Now a component of our 2009 incentive compensation plan will be tied to achieving a predetermined level of operating expense reductions, with further reward to our corporate employees for any incremental reductions. As in prior years, the high end of our full year operating expense guidance is tied to additional incentive compensation, which will be accrued upon achieving higher unit growth and gross profit results and operating expense reductions. Now as for the first quarter, operating expenses are expected to be in the range of $72.8 million to $73.3 million. As is our typical pattern, operating expenses are higher in the first quarter as compared to the second and third quarters, due to the restart of payroll taxes on our corporate employees, the timing of our advertising, and expenses associated with our annual sales convention and incentive trips. Additionally, planned operating expense reductions are expected to take significant effect beginning in Q2, and result in a sequential decline of approximately $6 million from Q1. Third-quarter operating expenses are typically flat compared to Q2, with a sequential increase in Q4 due to advertising surrounding our fall sales campaign.
Now for interest income and our effective income tax rate. While we feel it is prudent to maintain a conservative investment strategy in this volatile economic environment, unfortunately it results in lower interest income and a higher effective tax rate. We are forecasting net interest income in a range of $2.5 million to $2.8 million for the full year 2009 and a range of $500,000 to $700,000 for the first quarter. With our recent shift from tax exempt to more conservative taxable investments, we are estimating an effective income tax rate of 39% for both the first quarter and the full year. The effect of lower interest rates on these two components, combined with the discounting of our workers compensation reserves is expected to reduce earnings per share by $0.18 per share in 2009 compared to 2008. As for average outstanding shares, we are forecasting $24.7 million for Q1 and for the full year.
As far as capital expenditures, we have taken the approach to defer certain discretionary items. We are budgeting 2009 capital expenditures at $10 million. In addition to having a positive affect on our net cash flow, this lower level of expenditures will have a favorable impact on our depreciation and amortization.
In summary, we have implemented an operating plan which addresses the expected impact of today's economic environment, while preserving the investments we have made to date. We have built our plan based upon the expected impact of a weak economy on our unit growth and what we see are pricing and direct cost assumptions going into the year. Our key metrics guidance results in an implied EPS with a midpoint of about $1.39 per share and a range of $0.25 from the low to the high end. Once again, it is important to point out that our 2009 forecast includes an $0.18 per share reduction from the 2008 EPS, due strictly to the unprecedented low interest rate environment, a factor outside of our operations.
At this time I would like to open up the call for questions.
Ladies and gentlemen, if you wish to ask a question (Operator instructions). Your first question comes from the line of Tobey Sommer of SunTrust Robinson Humphrey. Please proceed.
Tobey Sommer – SunTrust Robinson Humphrey
Thank you very much. Thank you for all the detail, very helpful prepared remarks. I wanted to ask a question about the sales force. You had a tremendous amount of growth in the trained salespeople. I wanted to see if in the course of the fall campaign or maybe in 2009, how you think about the mix of advertising versus kind of feet on the street, what has been successful for you and maybe any changes you would have looking at how you would allocate that kind of effort in 2009 versus kind of more stable growing years in the economy.
Thank you Toby, appreciate the question. Really, I'm very enthused about what is in front of us in 2009 from a sales standpoint, because as you know we grew the sales staff dramatically, a 20% increase last year; and the fall campaign, although the closer rates were not good, the activity remained high, which means all the new sales staff got a lot of good experience through the fall campaign. And that is what you really look for, those sales opportunities so they can hone their skills through that time period. Now on the advertising front, even though we are lowering our advertising spend and some of our business promotion expenses, we actually think we are going to be able to buy the same or maybe even higher number of gross rating points through this period because you don't have an election year and really the economy has dramatically lowered advertising rates. So we think we are positioned well to support our sales staff in the lead process of providing qualified leads and although and again more experience than they were last year, we are still going to be conservative and actually estimate a lower efficiency rate even than we experienced last year.
Tobey Sommer – SunTrust Robinson Humphrey
Thanks. And let me ask a follow-up of perhaps Richard, if you could help. Several of the things that you discussed in terms of the markup and the difference variance of surplus, sounds like you built in some conservatism. If you were to net those different metrics out in terms of the opportunity for continued development, how would you quantify that looking forward in 2009?
Well, Toby, to your point, we did build in what I would call a little bit more conservatism. You know, as we think about in the payroll tax cost center, we had already built in the beginning allocation rates in the very end of last year for 2009, and then we got in the state unemployment tax rates. So that would seem to match with what our expectations were, the only difference as I said in my prepared remarks was the $1.5 million credit that we won't be getting in 2009 from the state of Texas. So that surplus I believe we just kind of nailed. I don’t think it is liberal or conservative, I think it is just kind of where we expect to be. Obviously, on the workers compensation cost center, our expense there were forecast in some increase over 2008 at this point. But in the very first quarter of this policy year, which starts in October and runs through September, the first quarter's results were really pretty strong. I mean, we had a 16% reduction in clients.
Now that should translate into a lot lower cost. But we just can't tell how much that could be. It could be quite a bit over the next three quarters. On the healthcare side, the migration we believe can produce some upside there. You know, we are raking in the lower allocation right now and usually what happens is it takes a few months for the cost to decline. So we can see quite a few dollars per worksite employee per month additional surplus coming from both the workers compensation and the healthcare cost centers for the year. And actually, instead of them being a drain, they could actually become a contributor. It is just hard to pin the number right now, so that is why we said we just got to go with what we know.
Tobey Sommer – SunTrust Robinson Humphrey
Thank you very much. I will get back in the queue.
Your next question comes from the line of Jim MacDonald of First Analysis.
Jim MacDonald – First Analysis
Hey guys. Continuing on the workers comp discussion, if interest rates were to rise, how quickly would that impact your discount rate decisions (inaudible) October?
No, it is actually readjusted every quarter. So if they went up this quarter, we would start to see the effect of that next quarter.
Jim MacDonald – First Analysis
Okay. And then you mentioned that there was a big claim that increased your severity by 30%. Presumably, if it was that big, it tripped over your $1 million cap. So is 30% the right number to think about or was it capped out really?
No, I mean the reserve hadn't hit the cap yet, but it was pretty close in the total reserve. Obviously if it goes over $1 million it is not our issue to deal with, so we are only responsible up to $1 million. So yes, the 30% is abnormally high for us in a given quarter. Certainly is and this was just one of those unfortunate incidents. But then it is actually comparing the first quarter of two different policy periods, so that one claim would have an inordinate effect but it can't have that effect on both.
Jim MacDonald – First Analysis
Thanks. And then just one more quick one on interest rates, could you talk about kind of where you are invested now and kind of a similar question, how quickly, if interest rates were to rise would that impact you, have you been able to invest in a longer term higher rate type of instruments or kind of what is your total sensitivity on interest rates?
Well, currently, e have apportioned our investments between taxable and tax-exempt, although over the course of the past two years, it has been much more highly concentrated in the taxable government-backed, the Treasury, the agency funds and it has been very short term based on the yield curve. But it is something that we will be looking at very closely over the course of this year and figuring out whether it makes sense to take a little bit more risk, but a measured risk to earn a higher yield depending upon the environment. So I would say at this point, we are fairly heavily into the Treasury and the agency funds which are earning, as you know, very little at this point in time. But I think there – again, depends on the economy and the climate out there but I think at this point there is only room for upside in the yield based upon where we are. So we have kept things very short term for the moment.
Jim MacDonald – First Analysis
So you don't even have 10% or 20% in kind of any long-term estimates?
No. For the current moment, we have kept things fairly short term rather than clatter into the long term.
That is an item, Jim, that our Finance Risk Management Audit Committee is going to review in our next meeting and make a new assessment based on where we are today compared to where we were a quarter ago, when the crisis was a little bit more severe.
Jim MacDonald – First Analysis
Okay, thanks very much.
Your next question comes from the line of Michael Baker of Raymond James. Please proceed.
Michael Baker – Raymond James
Thanks a lot. I was wondering if there is any potential change to your pricing approach, that being the bundling, or if you are finding ways to convey information to your prospects and existing customers around somehow – how some of the components are changing.
Yes Michael first of all, the bundled approach is still our approach to explaining the pricing of our service being, in our point of view, you either have an HR department or you don't and so we are really showing the cost of adding a sophisticated HR function to a company's business. But we have over the last – I think I mentioned a quarter or two ago that with our mid-market customers, we are able to provide some information about the components of our service needs, indicating how much our cost is for the payroll side of the business, how much our cost is for benefits administration or safety services, basically all the kind of break out of the markup component of our service. The $198 that Richard talked about, when you break that out as to how much we spent for the different aspects of the HR function, that information is really providing some insight for our clients to be able to see that wow, if you add up all those components, what a great bargain, because you can go compare those components to other payroll services or benefits administration services or those kind of things and I think that is giving some help to clients who are digging in in a tougher economic environment and really want to watch every penny.
Michael Baker – Raymond James
Okay, that is helpful. Another question I had was
over the years you’ve broadened your service offerings so that if you did have a client decided on some given point that they may not want the full offering that there were some potential trade down opportunity, and I'm just wondering given the attrition that you’ve seen, can you give us some sense to how many have traded down to a lower fee element?
We have not had a lot of that yet. We are getting a little more in our retirement services area. But the bigger impact on that front will come when we complete the HRTools rewrite which will be at the end of the summer or so. In the fall of this year, we will be testing and probably doing the beta test. And when that happens, then there will be a layer of technology functionality that operates as a software to the service component that I think will be very sticky for keeping customers, but also when they leave, you know, we should be able to have a fairly significant portion of our operating income per worksite employee that stays in place.
Michael, this is Richard. I was also going to add that in terms of what we've seen customers do this year, especially as they come in to the renewal cycle we are seeing them look at the total cost of the service, and saying, while I still want the total package that you have we are going to change our benefits plan for this next year. We are going to increase the deductibles, that and go to a plan with a higher deductible and a lower cost to meet the business owner. And so we expect to continue to see that trend taking place to the scale that it is right now kind of throughout 2009 because it does help the business owner make the decision to stay with us even though they are not going to have quite as rich of a health plan.
Actually, that’s part of a broader program to help our customer control cost through the down turn. And we are able to actually consult with them. This is when you need HR consultant. If you're doing a layoff, you need to make sure you keep the right folks and have the others – the right ones leave. Sometimes, you will need to look at your organization design and figure out new ways to do things, we have folks that can do that. Also it’s very – some practical things that you can do, you can lower your actual base pay level but introduce a variable pay component with incentives around key metrics of your business that will drive your growth and profitability and actually create some upside for employees even though you're reducing the base pay levels. So there's ways to keep people aligned, or even energize employees around cost savings environment. And there is other things that we kind of preparing to go do with our customers as they renew that help them think through being in a cost-saving mentality.
But those are all kinds of the things that you get when you have a bundled service offering. If you are buying the payroll from here and buying the benefits from there and buying this, that, and everything else separately you wouldn't get this kind of a cohesive game plan like we provide.
Yes, you just have to figure it out on your own.
Michael Baker – Raymond James
That's helpful. I just had one other question for you, Richard; given the impact of the economy I was wondering if you have a sense of how that's impacting utilization on the healthcare side, or is it still too early to assess that given normal claims like lags?
Sure, actually I do have an answer to that question. We were looking at it from several perspectives, and one of the ways that we talked about it was in terms of higher health care kinds of activities, where their planned surgeries and stuff like that. So we went back and asked UnitedHealthcare to give us a little bit of history since they’ve been doing this for a long, long time. And I don't remember exactly but I think it was about 40 years they went back and looked to kind of their results, and certainly in an economic downturn the incident rate of health claims goes down because people postpone activities, postpone surgeries. That also works on the workers’ compensation site as well; we found that out when we had a report in December from our company that manages all of the workers’ compensation claims. So, we do see a potential reduction in the cost, because of a lack of incidents.
Michael Baker – Raymond James
Thanks for the updates.
Your next question comes from the line of Mark Marcon from R.W. Baird.
Mark Marcon – Robert W. Baird
Good morning. Obviously a really difficult economic environment. I was wondering if you could talk a little bit about the client retention rate that you saw, if you could split it out for the fourth quarter in terms of what you ended up seeing between your traditional smaller clients relative to your midmarket clients. And then I have some follow-ups.
Sure. First of all, we had for the year, a dramatic improvement in our midmarket retention, driven by the investment we made in our midmarket services. And we actually had over 30% improvement in our retention over that period. So, those were pretty dramatic results.
Mark Marcon – Robert W. Baird
It went from what to what?
I’ll see if I got that number right in front of me, but for the full year, I think from between 4,000 and 5,000 employees the year before, and we lost 35 or 600 over year. So, you know, we really saw some great results there. We had, in the fourth quarter, though we saw in the midmarket customers some decline in employment, from layoffs and new hires, and we had one large customer go away, the bank that was taken over by the FDIC. So that is one we kind of couldn’t do much about. But in the small business community as well we just across the board had some clearly great results last year, to have a 12.6% improvement in client retention in a year that we were experiencing last year, I think it's pretty amazing. Even in the month of January we had a 1,000 fewer go away on 11,000 base, so 9% or whatever improvement in the month of January. Those are outstanding results, and I really think we have quite a bit of upside going forward because a lot of the changes that we made, we made as the year progressed more towards the latter part of the year. And we are going to be able to extend those things across the base this year and hopefully continue to make some improvement. This year, we will have our incentive compensation plan focused on three items at the corporate level, and that would be our normal operating income per worksite employee. So, we will have another component tied to client retention, like we did last year because we think there is more room to gain, to leverage the changes we made last year. And then we will probably have about 25% of our incentive comp plan focused on meeting operating expense budgets and improving on those targets.
Mark Marcon – Robert W. Baird
Okay. And so were you running at kind of 80% kind of retention rate for Q4 or –?
We don't usually look at it as a rate within the quarter, but we had – in the quarter, we had let's say –
Mark Marcon – Robert W. Baird
I meant just year over year?
Year-over-year rate? I didn’t look at that yet. But I would say it was a little lower than that, but not much, and it was a great year.
Mark Marcon – Robert W. Baird
Okay. And then in terms of the assumptions going forward, would you expect your client retention rate to stay steady relative to the ’08 with improvements in servicing, offsetting the weakness that we are seeing economically or given the magnitude of this downturn, would you expect that may be the client retention ends up dropping a little bit in ’09 just because of unprecedented –
To be conservative, Mark, we actually budget in a little worse retention than what we’ve experienced last year.
Mark Marcon – Robert W. Baird
Yes, that sounds wise.
Factor in some potential for business values, etc. And we've also factored in layoffs exceeding new hires more considerably as we finish off this first quarter and then still maintaining a headwind, but not quite as much as we've seen in the last few months.
Mark Marcon – Robert W. Baird
So are you assuming that as we look out towards Q2 and Q3, you are assuming lower layoff rates?
Yes, we are still assuming layoffs exceeding new hires, but not as much as they did over this past three months in the next or in February, March in our forecast.
Mark Marcon – Robert W. Baird
And what are you seeing out of the commissions – out of the commission payments out of your clients?
Yes, we haven't released our quarterly survey information yet. But I can't comment on that component. If you recall, in the third quarter last year, we saw a dramatic decline, over 8% reduction in commissions paid year-over-year on our base. And I look back at the dialog we had last quarter, we were talking about whether that would produce a round of layoffs, well, it did, as we are certainly seeing. Now in the fourth quarter the commissions were not off as bad, nearly as severe as they were in third. They were down a little over 2%, between 2% and 3% for the quarter, which is still down, it may have been a little closer to 3%. I don't have that number in front of me, but it was around 3%, and obviously better than the 8% decline. But I'm not sure if it is enough to encourage a lot of folks.
Mark Marcon – Robert W. Baird
And I will jump back in queue. Can you talk a little bit about just the pricing environment that you are currently seeing out there. There is one large player in the space that has admittedly become just a little bit more aggressive. And so I'm wondering if you can just talk a little bit about what's happening from a pricing perspective? And what percentage of your new sales, would you say are state kind of the missionary single bit situations as opposed to you kind of a more competitive situation?
Yes, it is still pretty significant that we are still mostly Greenfield, but there has been more of what I call price based competition. We have to focus more on the value proposition that we provide. This reality is most of the players out there when they come in and compete on price, are really just talking about a base rate, and then when customers need services, or need more services than what's in that base rate, they end up paying, they get nickel and dimed, and cost goes up a lot. So, we just have to demonstrate that and be able to level that playing field with the facts.
But in terms of just our overall strategy for this year, in the market component, we are just planning on kind of a steady state, we did see an increase in the mark-up from new business in 2008 over 2007, because we put some pricing increases there. We're not putting any pricing increase for the markup component for 2009. And we are going, the game plan is to renew existing customers at similar rates that they currently have. Of course some will get an increase, some will get a decrease. So the game plan is to try to maintain that $198 per worksite employee per month average for the whole book of business every month throughout the year.
Mark Marcon – Robert W. Baird
Great. Thank you for the color.
I would now like to turn the call back over to Mr. Paul Sarvadi.
Thank all very much for participating today, and we look forward to getting back together next quarter after we hopefully see some improvement in the marketplace. Thank you very much.
Ladies and gentlemen, that concludes the presentation. Thank you for your participation. You may now disconnect. Have a great day.
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