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Executives

Richard G. Rawson – President

Paul J. Sarvadi – Chairman of the Board, Chief Executive Officer

Douglas S. Sharp – Chief Financial Officer

Analysts

Tobey Sommer - Suntrust Robinson Humphrey

Jim MacDonald - First Analysis Corporation

Jeff Martin - Roth Capital Partners LLC

Mark Marcon - Robert W. Baird

Michael Baker - Raymond James

Administaff, Inc. (ASF) Q3 2009 Earnings Call November 2, 2009 10:00 AM ET

Operator

Good day ladies and gentlemen, and welcome to Administaff third quarter 2009 earnings conference call. My name is [Tawanda] and I will be your coordinator for today. (Operator Instructions) As a reminder, this conference is being recorded for replay purposes.

Joining us on the conference today is Mr. Richard Rawson, President; Mr. Paul Sarvadi, Chairman of the Board and Chief Executive Officer; and Mr. Douglas Sharp, Chief Financial Officer. I would now like to turn the presentation over to Mr. Douglas Sharp, Chief Financial Officer. You may proceed sir.

Douglas S. 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 meanings of the Federal Securities laws. Words such as expects, intends, projects, believes, likely, probably, goal, objective, outlook, guidance, appears, targets 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 third quarter 2009 financial results. Richard will then discuss expected trends in our directed costs including benefits, workers compensation and payroll taxes, and the impact of such trends on our pricing. Paul will then add his comments about the quarter and our ongoing strategy in the current macro environment. I will provide our financial guidance for the fourth quarter. We will then end the call with a question-and-answer session.

Now let me begin today’s call by discussing our third quarter results. Today we reported third quarter earnings per share of $0.23, which was slightly above the mid point of the EPS range implied in our key metrics guidance. As for our key metrics, the number of paid worksite employees averaged 107,625 and as expected remained relatively flat throughout the quarter. Gross profit for worksite employee per month averaged $220, within our expected range of $218 to $222. And effective operating expense management produced $1 million in savings from the mid point of our Q3 forecast.

Our cash flow remains strong and our balance sheet continues to reflect significant liquidity and no debt. EBITDA plus stock-based compensation totaled $16 million in the quarter. Working capital increased by $4 million during Q3 to a balance of $130 million at September 30.

Now let’s review further details of our third quarter results. Third quarter revenues declined by 7% from 2008 to $391 million as a result of a 10% decrease in the average number of worksite paid employees, partially offset by a 3% increase in revenue per worksite employee per month. As for worksite employees, net hires versus layoffs in our client base were relatively flat during the quarter, which was a positive sign considering the significant level of net layoffs from Q4 of 2008 through Q1 of 2009.

Client retention continued to hold up well, averaging 98.3% for the quarter, which was near our historical level. Sales continue to be a challenge in this economic environment, however, were nearly offset those worksite employees through client attrition.

Looking at third quarter revenue contribution and year-over-year change by region, the Southeast region, which represents 11% of total revenue, decreased by 2%; the Northeast region, which represents 22% of total revenue, decreased by 1%; the Central region, which represents 15% of total revenue, decreased by 4%; the West region, which represents 20% of total revenue, declined by 10%; and the Southwest region, which represents 32% of total revenue, declined by 12%. Larger declines in the West and Southwest regions were primarily a result of a disproportionate number of large clients that turned for financial reasons in Q1 of this year.

Moving to gross profit, gross profit per worksite employee per month averaged $220 for the quarter, which was within our expected range as lower than expected workers compensation costs offset higher than anticipated benefit costs. Now as for benefit costs, you may recall that we forecasted additional benefits costs of $2 million per quarter for each of the third and fourth quarters due to increased COBRA participation. Actual third quarter COBRA claim costs came in as anticipated. However, we experienced increased claim costs from higher utilization of health plans by active participants during the quarter, which Richard will address in a few minutes.

Additionally, Q3 benefit costs included the impact of a retroactive tax imposed by the state of New York on health insurance premiums. Workers compensation costs were 0.53% of non-bonus payroll for Q3 of 2009, below our forecasted level of 0.70%, as we experienced stable trends in both the frequency and severity of workers compensation claim costs through September 30, which is the end of our policy period. Actuarial loss estimates resulted in $3.6 million reduction in previously reported loss reserves. Richard will provide further details of these positive developments shortly.

As for our third component of direct costs, payroll taxes as a percent of total payroll costs totaled 6.46% for the quarter, a slight increase from 6.44% in Q3 of 2008.

Now let’s move on to operating expenses which totaled $61.5 million for the quarter, a 10% decline from Q3 of 2008. These results correspond with the decline in worksite employee levels and reflect the execution of our 2009 operating plan, which targeted various areas for cost reductions in response to the impact of weak economic conditions.

As for the details, salaries and wages declined by 12% from Q3 of 2008. Now in accordance with our 2009 operating plan we continued to experience cost savings through the targeted reduction of corporate headcount, a 50% reduction in the company’s 401(k) match and a deferral of merit increases of our corporate employees. Additionally, incentive compensation expense has declined from Q3 of 2008.

General and administrative costs declined by 9% compared to Q3 of 2008. Costs were reduced in various areas, particularly those that are variable with worksite employee and corporate headcount levels.

Sales commission cost has declined by 13% from Q3 2008, consistent with the decline in paid worksite employees and lower sales production. Advertising costs declined by 14% as we’ve been able to take advantage of lower advertising rates while achieving our gross rating point targets. We also eliminated our least productive business promotion effort in 2009.

Depreciation and amortization increased by 5%, due primarily to capital expenditures made throughout the prior year. We have scaled back capital expenditures in 2009, spending just $6.5 million year-to-date. Interest income was slightly higher than expected; however, decreased by approximately $1.3 million from Q3 of 2008 due to declining interest rates.

Due to a revision in our full year effective income tax rate from 40% to 40.5% our effective tax rate for the third quarter included a year-to-date catch up adjustment and was therefore approximately 42% on a stand alone basis. This resulted in a drag on Q3 earnings of approximately $0.01 per share.

Now as for our balance sheet and cash flow, EBITDA plus stock-based compensation totaled $16.4 million for the third quarter. Cash outlays during Q3 included cash dividends of $3.3 million and capital expenditures of $2.1 million. While we did not repurchase any shares during the quarter, our balance sheet continues to remain strong with working capital of $130 million, allowing us to resume buying shares as opportunities arise. We currently have 411,000 shares remaining under our current authorization.

At this time, I’d like to turn the call over to Richard.

Richard G. Rawson

Thank you Doug. This morning I’m going to give you the details of our third quarter gross profit results and then I will update everyone on the current pricing and direct cost trends and how they will affect gross profit per worksite employee per month for the fourth quarter. I will then wrap up my remarks by commenting on factors affecting our 2010 gross profit plan.

As you know our gross profit comes from the service fee component of our mark up combined with the surplus that is generated when the direct cost pricing allocation components of our mark up exceed the corresponding direct costs. Doug just reported that our gross profit per worksite employee per month was $220 for this quarter, which was in the mid point of our expected range. These results came from achieving $195 per worksite employee per month of service fees and generating a surplus of $25 per worksite employee per month or 2.5% of our total direct cost allocations.

The pricing of our service fee for new accounts sold this quarter was $194 per worksite employee per month. The pricing on our renewed business remained the same as Q3 of last year. The service fee on our entire book of business is relatively flat compared to last quarter as we have continued to be sensitive to our clients needs while we all manage our way through these difficult times. These are great results and we continue to be very pleased with our relative pricing strength.

Now let’s review the details surrounding the $25 of gross profit per worksite employee per month surplus that was earned. We had an $11 per worksite employee per month larger than expected surplus in the workers compensation cost center, offset by a combination of a $9 per worksite employee per month worse than expected deficit in the benefits cost center and a $2 per worksite employee per month less than expected surplus in the payroll tax cost center.

Let me give you the details of each cost center beginning with the workers compensation program. You may recall that over the last four quarters I have been reporting the continual improvement in incidents and severity rates that we have experienced for this current policy year, which expired on September 30, 2009. Now that this policy year is over, we know that the number of claims filed during this year was significantly lower than the prior year and resulted in a 17.6% reduction in the number of claims filed compared to last year. This lower incident rate is due to our effective safety service programs, along with the fewer number of worksite employees that file those claims. The severity rate, which is the average cost of the claims, was 16.3% lower than the prior policy year. It is these recent result that caused our workers compensation expense to be 0.53% of non bonus payroll or $11 per worksite employee per month better than our original forecast.

Now on the benefit side of our direct cost the story is quite different. This quarter our benefits cost per covered worksite employee increased 9.3% over Q3 of 2008 to $757, which was $15 per covered employee higher than we were expecting for the quarter. This significant increase was primarily the result of increased utilization by worksite employees and their families, including some large loss claims. This spike in utilization may be due to a fear of loss of health insurance coverage in the midst of a recession combined with an increase in treatments for swine flu. During our last quarterly call we reported a significant increase in the healthcare costs coming from the increase in COBRA enrollees. We estimated that this would cause our healthcare costs to increase about $2 million per quarter above our normal trended costs and that is what we experienced.

Additionally, the state of New York passed a retroactive premium tax on all plans that cover employees living in New York, which resulted in $2 per covered employee of additional expense for the quarter.

Lastly, the payroll tax cost center generated a little less surplus than we forecasted, mainly because the payroll average of worksite employees was slightly lower than previously expected.

In summary our business model continues to demonstrate resiliency as the factors that affect our direct costs continue to counter balance each other.

Now let me update everyone on what our gross profit expectations are for the fourth quarter beginning with benefits. We’re going to forecast a continuation of a 9% increase in benefits cost for Q4 over last year. This increase is due to the ongoing cost of COBRA participants and the recent pattern of higher utilization. As I mentioned last quarter, we had already built in allocation increases to match a 9% to 10% cost increase in benefits, so our deficit in this cost center should begin to improve next year.

As for the payroll tax cost center our surplus should increase in Q4 as most employees have already reached their wage limits and year end accruals always add some extra surplus.

As for the workers compensation center, our allocations have been declining over the past four quarters. We have not seen workers compensation insurance companies raising their rates, so until they do we will not be increasing our allocations.

On the expense side of this cost center, we recently renewed our workers compensation insurance policy again with ACE Insurance Company. They slightly reduced our administrative fees and they also lowered their forecast of our losses for this new policy year. But as you all know we always begin each policy year with a conservative forecast and we let the positive results develop as we actively manage this cost. This year is certainly no different. Therefore we will forecast a cost of 0.67% to 0.69% of non bonus payroll for Q4.

On the pricing side, we typically do not see much variation in Q4 of each year from Q3. Therefore the service fee component of our mark up should remain the same.

In summary, when we consider all of the above factors, our gross profit per worksite employee per month should be in the range of $220 to $222 for the quarter.

Now let’s discuss 2010. As we look into next year there are a number of additional factors that we need to consider. First, in the area of pricing, when we begin to see improvement in the small business marketplace we should then see the mark up component of our service fee begin to increase. Second, the unemployment fund in each state has been severely depleted. Most states are still working on how much of an increase they’re going to assess employers next year. So we will have to wait until we get our new rates before we can complete our forecast. Keep in mind that whenever we do receive the state rates, we will adjust our allocations accordingly.

Third, the uncertainty about healthcare and what it means to employers adds to the difficulty in forecasting this cost for 2010. We do know that our administrative fees with United Healthcare will go down slightly next year. We also know that the minor plan design changes that we are implementing January 1 should have a slightly positive effect on our trend for 2010. But the bottom line is this, it’s just too early to finalize 2010’s gross profit picture.

At this point I would like to turn the call over to Paul.

Paul J. Sarvadi

Thank you Richard. Today I will comment on three primary topics to provide some color on recent results and our outlook going forward. First I’ll discuss sales retention and employment metrics among our small business and mid market clients reflected in our third quarter results. Second I will cover our fall campaign selling and retention efforts underway and the climate we are facing in the marketplace, including the specific impact of healthcare reform. And I’ll complete my remarks with a description of our approach to 2010 from a very high level, considering the backdrop of the economic and political environment.

During the third quarter our key unit growth metric stabilized at expected levels from the decline we had experienced since October of last year. Layoffs and new hires in the client base continued at a very low level, similar to last quarter, and worksite employees paid from sales offset client attrition results. Client retention at 98.3% was just slightly lower than historical norms of 98.5%, which I believe is exceptional considering the economic climate. These results reflect the hard work and dedication of our organization, supporting our clients in very meaningful ways through the recession.

New sales during the quarter were below expectations at 70% of forecasts, similar to Q2, reflecting a foxhole mentality among small business and mid market prospects. This mentality was reflected in the employment statistics from actual data within our system and from our most recent survey results. Business leaders continue to hold the line on compensation, including base pay and overtime. Regular pay was flat on a year-over-year basis and overtime was 7% of base pay, which is at a historically low level. One sign of recovery in the actual data from Q3 was the first increase in commissions paid to the sales staff of our clients that we’ve seen in over a year. This indicator of the new business pipeline of our customers was up 4% over the same period one year ago and was stable compared to the prior quarter. This is a good sign, but certainly not enough for business owners to jump out of the foxhole and advance with hiring and investment.

Our quarterly survey released today provides further insight into the view of the economic climate from the perspective of the small business community. On the positive side, 48% of owners surveyed expect a sales increase for the balance of the year and into 2010. In addition, 65% of those polled believe the recovery has either already started or will happen in 2010, while 21% think it’ll be 2011 and 13% are unsure. However, when it comes to making decisions to move ahead with hiring and compensation increases, there is still caution and reticence among business leaders to take action. 61% expect to keep employment levels the same next year while 28% expect to add employees and 11% expect to reduce staff. 54% expect no change in compensation levels, 24% expect an increase, 18% are still unsure and only 4% expect to reduce pay.

Apparently, long term concerns are weighing quite heavily on hiring and investment decisions in the small business community. Respondents rated the economy as the biggest short term concern, followed by healthcare reform. However the level of concern over potential tax increases, government expansion and the effect on business, and the federal deficit was greater for the long term than concern over the economy. In addition, there’s a significant level of uncertainty in the marketplace driven by healthcare reform legislation working its ways through Congress. This effort to completely overhaul a major sector of the entire economy has provided more cause for pause. Even though it remains to be seen what shape the final version healthcare reform may take, and whether some form will pass at all, there is a considerable level of uncertainty regarding what this will mean to employers and everyone else for that matter.

For Administaff, healthcare reform as currently contemplated is a short term negative due to the uncertainty, but a long term positive due to the complexity. This is because there’s nothing proposed that’s going to simplify choices, make it less complicated to understand, or make it easier for businesses to implement the right solution. In fact, distilling the 200 page bill to understandable, specific options for clients and employees to choose from will be the first challenge Administaff will overcome.

One of Administaff’s core competencies is helping clients comply with complicated government requirements which allows clients to focus on their profit opportunities. We have experienced healthcare reform on a smaller scale when a pay-or-play mandate on employers was enacted in Massachusetts. Our efforts helping clients to analyze options and complete the paperwork necessary to comply added value to our current client relationships. But the stakes are much higher for business owners from some elements being considered in Congress today.

A public plan option with a potential 40% tax on so-called rich plans is a recipe for driving major plan design and cost changes, which will be very complex. In addition, it’s possible hiring and retaining key employees, which is the primary purpose for employer sponsored plans in the first place, may require new inducements or at a minimum new communications emphasizing other distinguishing elements beyond healthcare.

In any event, Administaff has several competencies that we’ll apply in dealing with healthcare reforms. Our benefits and risk management services will help clients decide their best path and get the most for their hard earned dollars. Our compliance services will help them meet requirements, manage risk and avoid costly penalties for non-compliance. Our expansive benefit offerings beyond healthcare will help clients distinguish themselves in the marketplace and compete for the best employees. And we will help clients manage and communicate changes and use our technology to ease implementation. These skills and services will be highly attractive to prospects and more valued than ever by clients in the future.

At this time of year we’re well underway with our critical fall campaign, which is a promotional period focused on selling new accounts and retaining clients at year end. This year for the reasons I’ve already discussed, we find small and mid market prospects in the foxhole. However, the early signs of recovery are appearing and although they are not jumping out yet, many have placed their helmets on a stick and raised it in the year. If the helmet does not get shot off, they’re ready to advance and take advantage of market opportunities, which are great in a down economy. Our challenge in this climate is to reach in and help them out of the foxhole and see the opportunity we provide for them to be ahead of the pack as a recovery emerges.

Our current clients and target prospects are the best small businesses in America. And in our recent data points of survey information, they are distinguishable from other recent small business surveys. This year alone we have helped clients complete and integrate 25 competitive acquisitions with an average of 37 employees per company, nearly an equal number in the process at some stage. Prior to the downturn we had prophesied our client base would respond differently to a recession in three ways; layoffs would start later, cuts would not be as deep and a rebound would occur sooner than other small businesses. The first assumption was true in hindsight. The second is likely but as yet unproven as statistics are not yet available. And the third should be in front of us over the next quarter or two.

As we look ahead to 2010, we believe our approach should be similar to the one we used this year to navigate successfully through a very difficult time. When this year began I explained we were taking a conservative, measured approach balancing the interest of company stakeholders. Even though our company had a very strong balance sheet and no debt, and we felt we would remain profitable through the downturn, we elected to tighten our belt and position our company to support our clients as much as possible and to be prepared if economic conditions got even worse. Fortunately our plan has been effective and we have remained profitable and even strengthened our financial position, increasing working capital by over 30% to $130 million since the beginning of the year. We are in an excellent position to be opportunistic in regard to acquisitions or new product or service additions that are consistent with our mission to help small and mid market businesses succeed.

We’ve been able to continue important technology development that will improve our competitive advantage as we move into 2010. This quarter we’ll be rolling out our online benefits enrollment platform, which provides a state-of-the-art decision support tool that models specific choices available to individuals to enroll in benefit programs. We have also continued to develop our HR tools performance management and job description development and HR information repository reporting tool, which will be launched next year on our softwares and service platform. This will provide powerful new functionality for current clients and be available on a standalone basis to prospective and former full service PEO clients.

We’ve also been able to maintain our trained sales staff throughout this down cycle, with an average of 306 trained reps in the third quarter, even with the number we had a year ago. In addition at this time 55% of our sales professionals have over 18 months experience compared to 42% one year ago. This experience is likely to pay substantial dividends as business owners sentiment improves in tandem with an economic recovery over the next year.

Our recurring revenue business model is driven significantly by the January starting point of paid worksite employees and the associated pricing of those accounts as each new year begins. Every year there’s a considerable change in January due to the influx of new accounts sold in the fall campaign and the concentration of year end renewals of current clients. Normally at this time of year we take a shot at timing the starting point and bracketing the next year outlook based upon our years of experience. However last year we deferred providing specific guidance due to the financial crisis and associated uncertainty. This year for different reasons there’s a similar level of uncertainty in the marketplace that makes that exercise less credible.

In this environment we have determined it’s better to work to obtain the desired result but shy away from providing early guidance with less than meaningful ranges of expectations. So we will repeat what we did last year and defer in providing specific guidance to early next year once we have worked through the year end transition of new and renewing accounts.

As we look ahead to 2010, we are on solid financial footing and we are prepared for a range of possible economic eventualities. At this time we do not see anything exceptionally positive or dramatically negative on the horizon for next year. If the recovery takes hold and the marketplace responds favorably, we will benefit tremendously and the results will be obvious. If however the economy stalls or continues to bounce along the bottom, we are positioned to remain profitable and to be opportunistic in accelerating our long term plan for growth and profitability.

At this time I’d like to pass the call back to Doug to provide our specific guidance for the fourth quarter.

Douglas S. Sharp

Thanks Paul. Now before we open up the call for questions I’d like to comment on our financial guidance for the fourth quarter of 2009. In general we continue to expect worksite employee levels to remain relatively flat over the remainder of the year, particularly if minimal hiring and layoffs in our client base continue to offset each other. We are lowering our gross profit per worksite employee forecast, primarily as a result of hire than anticipated 2009 healthcare cost trends. And we expect a similar level of Q4 operating expenses as we had previously forecasted.

So as for our fourth quarter key metrics guidance, we are forecasting Q4 average paid worksite employees in a range of 107,250 to 107,750. Based upon Richard’s earlier comments, we expect gross profit per worksite employee per month to be in a range of $220 to $222 for the quarter. As for operating expenses we are forecasting a range of $65 to $65.5 million for the quarter or a year-over-year decline of approximately 11% from Q4 of 2008. The sequential increase of approximately $4 million from Q3 of 2009 is primarily attributable to additional business promotion and advertising costs focused around our fall sales campaign. We are forecasting Q4 net interest income between $200,000 and $400,000 which is relatively the same as Q3 results. And we are forecasting a Q4 effective tax rate of 41%. As for average outstanding shares, we are forecasting 25.2 million for Q4.

Now as Paul just mentioned, normally at this time of the year we would provide our guidance for 2010. However, as you are aware, there’s a high level of uncertainties around the current macro environment, including the viability of an economic and labor market recovery and the impact of government regulation including healthcare reform and potential tax increases. Therefore, we will follow a similar approach as last year. We will finalize our 2010 operating plan as we approach year end and have more clarity on the macro issues. We will also incorporate the results of our 2009 fall sales campaign and year end client renewal period. Detailed 2010 guidance will be provided during the next quarter’s conference call to be held in early February.

So at this time I’d like to open up the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Tobey Sommer - Suntrust Robinson Humphrey.

Tobey Sommer - Suntrust Robinson Humphrey

I was wondering if you could give us a sense for what your experience was in terms of worksite employee growth or sales and pricing in the middle of that experience you had in Massachusetts. Just maybe that could serve as an example for how things could play out as the healthcare reform emerges.

Paul J. Sarvadi

Sure. Thank you. The Massachusetts situation you know was a good dry run for us to go through. It allowed us to develop you know quickly response to the legislation and provide a package to our clients and prospects about what the requirements were and what had to be done. It reminded me a lot of you know cottage industries that are established through legislation like COBRA, back when it took place, and even immigration reform when you have to figure out what to do and how to go about it. So you know the first thing we saw was there was a high value in just helping people figure it out, something that we could possibly leverage in the marketplace in the event that there’s a mandate to all employers. There’s even the potential for a new product.

Relative to worksite employee growth and pricing you know we are not that large in the part of the country but net marketplace we did just fine. And you know we didn’t do what I would plan to do for healthcare reform. We didn’t you know market heavily around it and you know build a sales campaign around it, which we would do for a broader reform if that gets passed. So we didn’t really leverage that to any great length but we certainly you know saw sales and pricing operate normally through that period.

Tobey Sommer - Suntrust Robinson Humphrey

I was wondering if you could speak to whatever discrete items we already know about that will either flow you know flow out of the P&L in terms of expenses, perhaps those COBRA expenses you’ve been carrying now for a few quarters, or you know 401(k) contributions increasing. Anything that you know of already that’ll likely kind of change in 2010 to the extent that you can comment on it.

Richard G. Rawson

Tobey, this is Richard. I would say that you know we talked about this increase in the COBRA and we talked about the participant enrollment increasing. And now those have kind of flattened out. We kind of feel like that we’ve got a pretty good handle on what the costs are going to be as we go into the next year.

What we don’t have yet though is the fact that we are going to be able to do an automatic step up in the billing for COBRA participants effective January the first of 2010. And that will hopefully by the end of the first quarter pretty much shut off the squeeze that we’ve experienced in Q2 and Q3 and that we’ll again experience in Q4. And so that certainly will be a positive that we didn’t have this year.

Outside of that, you know if you talk about trends in healthcare, you know we’re hearing stuff on the Street that the large marketplace, large business marketplace, will probably be in the [net] trends in the 9% to 13%. And we heard some information on Friday that it looked like maybe small businesses might have an increase as much as 15%. That’s big dollars. That’s huge. And so we think we can you know fare well as a result of that. But you know we’re sure not ready to start predicting it yet.

Paul J. Sarvadi

Well in any event our costs will be significantly lower than what small businesses will see in their increases. And in fact if you look back at our ten year history, or 11 I guess now that it’s a public company, average increase for large companies on healthcare has been 8.5% while ours has been 6.5%. So we’ll be working hard to beat that 9% to 11% or 12% number that most big companies will have.

Tobey Sommer - Suntrust Robinson Humphrey

I was wondering if you could comment about early sales force activity here in the fall selling season in terms of you know appointments being set and how the response has been here to date.

Paul J. Sarvadi

There’s no question like I mentioned in my remarks about the mentality out there, you know harder to get in the door, but we’re doing it. People are just working harder to get the job done. We’re just having to create more opportunities. You know we’re having to try and figure out what the mindset of that customer is as we go in to you know see how to position our service more effectively for what their needs are at the time. And we are building up a pipeline that we hope to convert. But it’s like you know at this time of year every year, it’s too hard to predict. You know fortunately I think the retention has been continuing to operate at a very effective level. So you know we’ll see how we do. But so far so good.

Operator

Your next question comes from Jim MacDonald - First Analysis Corporation.

Jim MacDonald - First Analysis Corporation

Just following up on that, would you hazard a guess as to whether you can maintain your employee base over the December 31, January 1 timeframe or will be see a decrease?

Paul J. Sarvadi

That is a great question. We don’t know. You know we’re still hoping for an increase. You know I mean like I said in my remarks we’re working and hoping for the very best results, but we’re ready for any eventuality. We know that the year end has you know a significant number of client attrition, but that’s why we have a fall campaign to help offset that. Both of those areas are going you know as expected at this time, but it’s just not possible to tell which way things will go.

Jim MacDonald - First Analysis Corporation

Can you comment on the economy and your Southwestern region, which is a big part of your business, and whether that’s different from the rest of the country. And you know maybe went into the recession later.

Paul J. Sarvadi

Yes. Very interesting. You know obviously the economic downturn did start later here, but it doesn’t seem to have been as severe in the Southwest, mainly in Texas. But I will say that it seems to me that the broader economic and political issues that are on the table have to have pretty much had an across the board impact on small business owners. You know every day they’re saying that you know the potential over the long run for them to pay much higher taxes and have more government intrusion into their operation, it’s putting quite a pause into their mindset. You know when a business owner sits there and decides do I need to hire someone new or do I need to invest in new equipment or do I need to you know move my business forward? Or do I need to just kind of hunker down because I don’t know what’s coming? It makes that equation a tough one right now for them.

But they are starting to see a little bit of light at the end of the tunnel and they’re just hoping it’s not a train about to run them over.

Jim MacDonald - First Analysis Corporation

And a quick technical question, the interest income was you know popped up slightly and then you’re forecasting it going back down. Was there an anomaly this quarter?

Douglas S. Sharp

Well the interest income we’re given fourth quarter guidance is similar to that in the third quarter. So I don’t think there’s a material difference between the two quarters.

Operator

Your next question comes from Jeff Martin - Roth Capital Partners LLC.

Jeff Martin - Roth Capital Partners LLC

I believe last quarter on the call you said that you were planning to implement about $1 a month increase in the service fee component of the model. As I understand it as you speak about it today, that’s on hold until things kind of turn around. Is that correct?

Paul J. Sarvadi

Yes.

Jeff Martin - Roth Capital Partners LLC

And so you know that maybe, let me take a stab at it, middle of next year or just kind of playing it quarter by quarter, month by month? How are you going about the decision on that?

Richard G. Rawson

It’s really all about as we see you know some of the metrics that Paul talked about from the survey of our small business customers, as we see the overtime pay start to increase; as we see commission pay of the employees at our clients who get a commission, as we see that continue to increase; as we see the growth in the existing client base start to increase; those will all be indicators for us that things are moving in the right direction. And it’ll be easy to start increasing the allocations. Easier, let me put it that way.

Jeff Martin - Roth Capital Partners LLC

And then on the client base, are you seeing any change in receptivity from the middle market? You know you haven’t really spoken to that yet on the call. Maybe you can just touch on that.

Paul J. Sarvadi

Sure. I mentioned last quarter that we had gone through another revision in our sales and marketing efforts on the mid market organization. And you know we’ve got a lot of very positive things happening on that front, some of them a little longer term. But our pipeline, you know even as we said here today for mid market clients, even for year end, it looks pretty good. But it’s hard to tell until you reel those in, you know but like I said I’m very happy with the size of the pipeline, especially on the backdrop of this economic climate.

Jeff Martin - Roth Capital Partners LLC

On the unemployment taxes side, New York, could you give us a little bit of background how that progressed? Was it unexpected? How far in advance did you see that coming? What other in general the aggregate other states? I mean what could go positively or negatively from here?

Paul J. Sarvadi

That was not an unemployment tax. That was a healthcare premium tax that the legislature in New York state had retroactively put in place. Actually it went all the way back to last October. And we just heard about it recently. And the reason was because they’ve had a premium tax in that state but they had never had one for employers who had worksite employees in that state but their policy wasn’t resident in that state. And so this tax kind of came out of the clear blue to us. And of course we booked the accrual. I think it was about $550,000 that went into effect for us on April of 2009. And so you know we’ve taken care of that and of course it’ll be in the normal run rate.

On the unemployment tax side, I don’t expect anything favorable. All the funds are way underwater and I expect some pretty significant increases from every state in their unemployment tax rates for 2010.

Richard G. Rawson

And we are building in the New York premium tax increase on the going forward basis, because we have it right in our contract, whether it’s unemployment tax or premium tax. Any tax that our client would have been impacted with before any statutory change that would have impacted their cost is passed on through. This one that had the nature of going backwards we decided not to go back and collect from our clients.

Jeff Martin - Roth Capital Partners LLC

How do you look at the risk in terms of the trend to try and stay ahead of the state unemployment tax situation?

Richard G. Rawson

Well in unemployment tax it’s a little bit easier for us because you know within our system, when the new rates come in, we’re able to load them in immediately and it passes it through on the next payroll. So it’s not like there’s a lag or we have to go back and do some more pricing. It’s just not that hard. So that part works well.

Operator

Your next question comes from Mark Marcon - Robert W. Baird.

Mark Marcon - Robert W. Baird

I was wondering if you could talk a little bit about just for the prior quarter and as you think about the fourth quarter, what sort of sales efficiency rates are you expecting?

Paul J. Sarvadi

Well you know we have been running at about 70% of budget, even though the budget goes up as the year goes along. So we’ve been selling a little more but still at that same level of budget. You know the fourth quarter always has the element of you know clients trying to improve their operation next year. That’s why we hold the fall campaign to begin with. So I’m still expecting you know better results in the fourth quarter than earlier in the year. That’s happened every year. Even last year in the middle of the crisis it was still our best quarter of the year last year with the fourth quarter in sales.

So you know but I think it’s wise for us to you know plan as if there’s no major change in percentage of total budget. So we’re hoping to do much better than that but I’m not going to plan for that or build the expectation at some kind of increase.

Mark Marcon - Robert W. Baird

Normal budget wouldn’t normally be the 1.2 per?

Paul J. Sarvadi

Well you know we’ve had fall campaigns as high as 1.5. You know 1.2 to 1.5 is the normal range. So you know we end up at 70% of that number then that’s what you’d look at.

Mark Marcon - Robert W. Baird

How are you thinking about the pricing environment? Obviously you’re not planning on passing through a service mark up in the near term. But can you talk a little bit about the competitive environment? Has it eased up at all or how should we think about that?

Paul J. Sarvadi

Keep in mind that our pricing for this year has really not been affected much by competitive pricing. What we’ve done this year is we’ve actually had some increase on the renewal pricing, year-over-year on renewing accounts, $2 or $3. We’ve had basically sales of new accounts, pricing on new accounts for the year has been about on par with last year. But the reason our price on entire book did not go up this year was because we went back to clients during the term of their contract, customers that were having difficulties, and we made some adjustments where we could to help them get through this period. And I think that’s been part of helping us you know sustain our renewing rates and so forth.

So we’ve really been able to roll up our sleeves and stand shoulder to shoulder with the customer, not just on pricing but on the actual services we’re providing them and how we’re helping to impact their businesses. So that’s the part that I see waning already. You know we may have a little bit of a price increase at year end. It’s just hard to predict because you know you have the influx of you know the new ones coming in. It depends on which ones leave and which ones stay. So there’s a mix change that’s another factor in pricing at year end. And that’s why we’re not budgeting for an increase although we’re out there you know working to see that move that way you know because we think we can move that up a little bit in the not very distant future. But it depends on how that mix change happens at year end.

Mark Marcon - Robert W. Baird

In terms of the sales force, how are they feeling you know? As the quarter went along and as October came in, was there any change relative to what you ended up seeing in say July and August in terms of receptivity among potential clients, the head poking out a little bit more out of the foxhole? Or is it still about the same?

Paul J. Sarvadi

No, we did see some difference and even more recently. You know the big difference this year in our fall campaign over last year is we were able to have a kick off meeting. You’ll remember last year in the fall campaign we had the hurricane come through Houston and it completely wiped out our fall campaign kick off meeting. So this year we were able to bring our entire sales force together and the rest of our company for that matter to different places and we were able to you know have an effective kick off and make sure everybody’s focused on you know what the goals are, but also what the obstacles are and how to overcome them.

And you know we’ve got a lot of good activity there, but also the attitudes are very good. You know it’s been a tough year for people but we were able to get them all together and look them in the eye and say hey, look, we don’t care what happened so far this year. None of that matters anymore. That’s all behind us. You know it’s time to focus on a recovery that’s coming and you know it’s time to go and help make our recovery happen first.

So people are very focused and they’re encouraged, but they are working very hard to get it done. It’s just that’s the nature of the beast out there today.

Mark Marcon - Robert W. Baird

And then the mid market, how big is that as a percentage of revenue at this point? And what’s the read out out of those clients?

Paul J. Sarvadi

It’s about 10% of the base. It hasn’t moved much over the course of the year. And you know mid market customers, they have a lot of difficulty in this type of climate because they’re not so big as large companies that can just cut a whole layer of fat in their organizations. They really don’t have that. And they’re not as agile as small businesses in being able to be responsive. So you know they’ve had the toughest time I think in trying to deal with the economic climate. But frankly that’s where we did quite a bit of the pricing adjustments to try to help these customers make it through.

But they are now you know planning into next year differently than they were last year. Even though these numbers don’t look like a great labor market recovery, they sure aren’t planning a bunch of layoffs like they were last year at this time. We were you know planning layoffs. We were helping to communicate compensation freezes or reductions, and those activities are not happening. So I think the mid market is showing some recovery as well.

Operator

Your next question comes from Michael Baker - Raymond James.

Michael Baker - Raymond James

I was wondering if you could give us a sense for you know based on some of the proposals that are out there, the elimination of pre-existing condition limitations and you know the rate bans, you know kind of your expectation if you know some of that type of legislation came through as to what you would anticipate in terms of your underlying loss ratios.

Richard G. Rawson

Well I tell you, that’s a great question, Michael. And it’s absolutely, I mean we’ve spent a lot of time you know analyzing what’s going on up there. We’re communicating with our own government affairs people almost on a daily basis. We’re having dialogs with United Healthcare, with our outside benefits consultants, and the fact of the matter is nobody can tell you what it’s going to look like yet.

Michael Baker - Raymond James

I was just wondering more broadly you know what we’ve heard kind of as part of the debate some of the solutions to affordability, we’ve never really kind of heard the PEO model highlighted. I was wondering if you could give some perspective there and whether or not you’re beginning to see a shift in some of the lobby efforts at the federal level to the states, given the fact that under some of the proposals the states may still have discretion and it might be a solution to push forth to them.

Paul J. Sarvadi

I can tell you that the insurance reform component of the healthcare legislation has never been an issue for us. We already don’t eliminate for you know pre-existing conditions, etc. So you know we already operate a big company plan that doesn’t have those types of insurance reform limitations. So you know maybe we haven’t been real clear about that, but that’s never been a worry on our plate because you know we already bring that advantage into the small to medium size business community.

Richard G. Rawson

And every change we get we try to talk about the PEO model as a solution. But we’ve been talking about that now since 1995 in Washington and I guess we’re just not big enough as an industry, Michael.

Operator

And at this time there are no further questions in the queue. I would now like to turn the call over to Mr. Paul Sarvadi for closing remarks.

Paul J. Sarvadi

Okay. Well we’d like to thank everyone for participating today and look forward to getting with your after our year end transition when we have a little bit better picture about what 2010 might look like. Thank you very much.

Operator

Thank you for joining today’s conference. That concludes your presentation. You may now disconnect and have a wonderful day.

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