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Paychex, Inc. (NASDAQ:PAYX)

F2Q2011 Earnings Conference Call

December 21, 2010 10:30 a.m. ET

Executives

John Morphy – SVP, CFO and Secretary

Martin Mucci - President and CEO

Analysts

Julio Quinteros – Goldman Sachs

Jason Kupferberg – UBS

Rod Bourgeois – Bernstein

David Togut - Evercore Partners

David Grossman – Stifel Nicolaus

Nathan Rozof – Morgan Stanley

Ashwin Shirvaikar – Citigroup

Jim Macdonald – First Analysis

Tim Willi – Wells Fargo

Kartik Mehta – Northcoast Research

Jim Kissane – Bank of America -Merrill Lynch

Mark Marcon – R.W. Baird

Gary Bisbee – Barclays Capital

Joseph Foresi – Janney Montgomery Scott

Glenn Greene – Oppenheimer

David Parker – Lazard Capital Markets

Tien-Tsin Huang – JPMorgan Chase

Giri Krishnan – Credit Suisse

Operator

Welcome and thank you for standing by. (Operator instructions) I would now like to turn over the meeting to John Morphy, Senior Vice President and Chief Financial Officer.

John Morphy

Thank you for joining us today for our second quarter earnings release. Also with us is Martin Mucci, our President and CEO. During this teleconference call we will review our second quarter 2011 financial results, guidance for the full year fiscal 2011, and Martin will provide an overview of the business perspective as well as we will concluded with a Q&A session.

Yesterday afternoon, after the market closed, we released our financial results for the second quarter, ended November 30, 2010. We have also filed our Form 10-Q with the SEC, which provides additional discussion and analysis of the results for the quarter. These are available by accessing our investor relations page at www.paychex.com. In addition, this teleconference is being broadcast over the Internet and will be archived and available on our Web site for approximately one month.

We were pleased with our favorable financial results for the second quarter. Results were very consistent with our first quarter results and given another quarter of positive results, we have improved our outlook for fiscal 2011 accordingly. I will discuss this in more detail in a few minutes.

Our key business indicators of checks per client, revenue per check and client retention continued to improve. Checks per client, the number of checks issued during the period divided by the average client base represents our most meaningful barometer of how the economy is doing. Our checks per client reflect an increase of 2.5% for the second quarter and 1.8% for the six months compared to the same periods last year.

We saw checks per client gradually stabilize the last fiscal year with positive growth of 1.1% for the fiscal 2010 fourth quarter and 1.2% for the first quarter of fiscal 2011. Fiscal 2011 has generated increases in revenue per check. The increase is consistent with the annual price increase we implemented in May of 2010 and also reflects some positive results related to decreases in discounting.

Our client base in the quarter has benefited from better client retention as our client losses for the first half of fiscal 2011 were 12% lower than for the same period last year. Our client base has improved slightly since May 31, 2010.

On December 9, 2010, we announced that we have entered into an agreement to acquire SurePayroll, Inc., a leading provider of software as a service payroll processing for small businesses for approximately $115 million. SurePayroll serves approximately 30,000 small businesses with its online payroll product. The transaction is expected to close by the end of Calendar 2010 and revenue for SurePayroll for the 2010 calendar year is expected to be approximately 23 million.

The diluted earnings impact on fiscal 2011 is expected to approximate one penny per share with most of the one penny related to the amortization of acquired and tangible assets and deal expenses occurred in expense in the year of acquisition.

In summary, our second quarter was a very good quarter, quite similar to our first and our six months results were slightly better than we anticipated at the beginning of the fiscal year. One of the many benefits of our filing of Form 10-Q on the same day as the press release is that we get to wake up early and get a preview of how Wall Street is responding to our results.

Through some early morning comments on guidance, our guidance policy remains unchanged since well before the recession entered our lives. Normally the guidance we give at the beginning of the year remains unchanged except for actual change in interest rates. The recurring revenue nature of our business provides for a predictability very few other company's enjoy.

The improved guidance for fiscal 2011 relates primarily to better than expected checks per client and sooner than expected operations productivity related to the implementation of our core advanced payroll platform in fiscal 2010.

We do not include a revenue growth or slight earnings dilution for SurePayroll on our guidance since the transaction is not yet closed. If we had included anticipated results for SurePayroll the change to guidance, if any, would have been minimal.

There were also some comments on operating margins. Operating margin improvements of Paychex are a way of life as all of our employees recognize the need and desire to continually improve operating margins. We experienced some backward movement during the recession, as our cost reduction efforts could not outpace the excessive reductions and checks per client and negative client growth. It's very good to be back on our normal trend of improving operating margins in the first half of the year, watching some erosion in the second half of the year related to normal investments in the business with the expectation of new operating margin improvements will appear in the first half of the next fiscal year.

We will now move on to a discussion of our results as presented in the consolidated income statement. Payroll service revenue increased 1% for both the second quarter and the six months to 355 million and 716 million. The primary reason for the payroll service revenue growth, aforementioned increase in Checks per client, increase in revenue per check and better retention.

Offsetting some of these positive factors was our lower client base compared to a year ago. We have seen a slight increase in our client base since the end of fiscal 2010 with the more meaningful period for changes in the client base coming up in the next six months.

Human resource services revenue increased 10% for both the second quarter and six months to 145 million and 291 million. HRS revenue growth reflects modest improvements in economic conditions, coupled with our annual price increase. Some additional highlights of contributions to HRS revenue growth were; Paychex HR Solutions client employees served increased 14% to 532,000 employees as of November 30. We have seen positive results from expanding our PEO offering throughout the country. In addition, improving economic

Conditions has resulted in growth in number of employees per client for HR Solutions.

Health and benefits services revenue increased 29% to $10 million for the second quarter and 35% to 20 million for the six months of fiscal 2011, driven primarily by a 29% increase in the number of applicants as of November 30, 2010 compared to a year ago.

Somewhat offsetting the impact of the previously mentioned factors is fluctuations in PEO workers compensation, which negatively impacted PEO net service revenue. Our workers compensation cost will often fluctuate quarter to quarter.

Combined interest on funds held for clients and investment income decreased 8% for the second quarter and six month. Yields available on high quality securities continue to remain low. Expenses increased 1% for the quarter and 2% for the six months due to costs related to continued investment in our sales force, customer service and technological infrastructure.

Improvements in productivity within operations with related lower headcount has somewhat offset this increase.

Sales up represented headcount is at the expected level going into the third quarter or main selling season.

Operating income increased 6% for both the second quarter and six months to 204 million and 405 million. Operating income, excluding interest on funds held for clients, increased 7% to both the second quarter and six months to $192 million and 381 million respectively. We continue to manage expenses, contributing to this growth.

We do anticipate that expenses in the second half of fiscal 2011 will be slightly higher, bringing our operating income, net of certain items as a percent of service revenue, down a little bit. And the 37.8% seen during the first six months of the year. Net income and diluted earnings per share increased 6% to $134 million and $0.37 per share respectively for the second quarter. The six month net income increased 7% to 266 million while diluted earnings per share increased 6% to $0.73 per share.

High quality investments continue to earn very low yields. Starting in November 2009, we began to invest in select A-1, P-1 rated variable rate demand notes and have gradually increased our investment in variable rate demand notes to 700 million as of November 30, 2010 from 226 million as of May 31, 2010.

For the first six months of fiscal 2011, we earned an after tax rate of approximately 24 basis points on variable rate demand notes as compared to approximately 8 basis points in U.S. Agency discount notes which are our primary short-term investment vehicle. Our long-term portfolio was also invested predominantly in municipal bonds, general obligation bonds; Pre-refunded bonds, which are secured, by U.S. government escrow and essential service revenue bonds. We have maintained our conservative investment strategy and have not recognized or realized any impairment losses on our investments. Our investments are high quality credit securities with AAA and AA ratings and short-term securities with A-1 and P-1 ratings, with more than 95% of our portfolio rated AA or better.

We limit the amounts that can be invested in any single issuer. Our priority has been and will be to ensure we can meet all of our cash commitments to clients that took place as we transferred cash balances from their accounts.

Our financial position remains strong with cash and total corporate investments of 690 million and no debt. Our cash flows from operations were 319 million for the six months of 2011, up 14% from a year ago as a result of higher net income and changes in operating assets and liabilities.

Funds held for clients, as of the end of the quarter were $3.3 billion, compared to $3.5 billion as of May 31. Funds held for clients varied widely on a day-to-day basis, and averaged $2.9 billion during both the second quarter and six months representing increases of 3% and 2% over the prior year periods. This growth in balances was due to an increase in State Unemployment insurance rate, the 2010 calendar year and the increases in checks per clients, offset somewhat by the lingering effect of the difficult economic conditions.

We expect the recent tax legislation will reduce funds held for clients by approximately 3% over the next 12 months. A total available for sale investment including corporate investments and funds held for clients reflected net unrealized gains of 61 million as of November 30, 2010 compared with net unrealized gains of 67 million as of May 31, 2010.

Our stockholders equity increased to 1.4 billion as of November 30, 2010. Our return in equity for the last 12 months was 34%.

Guidance; our outlook for fiscal 2011 is based upon current economic and interest rate conditions continuing with no significant changes. Consistent with our policy regarding guidance our projections do not anticipate or speculate on future changes to interest rates. Our guidance is consistent with the net income trends we've experienced in fiscal 2007 through fiscal 2010 when net income for the second half of the fiscal year was slightly less than the first half of the year. This relates primarily to the timing of the annual pricing increase in May, timing of additions to our sales force, the year-end payroll processing occurring in our third fiscal quarter and higher levels of selling expense in the second half of the year.

Our favorable second quarter financial results were a continuation of the first quarter and our outlook for the full year, 2011 has improved accordingly. Our fiscal 2011 guidance does not reflect any anticipated results from SurePayroll as the anticipated revenue impact is less than 1% of the balance of the year and the anticipated earnings dilution is expected to be approximately one penny per share, due to the amortization of acquired and tangible assets, and one time transaction costs expensed in the year of acquisitions.

Our 2011 guidance is as follows: We project payroll service revenue to increase in the range of 1% to 2%. Human Resource services revenue growth is expected to be in the range of 10 to 13%, total service revenue is expected to be in the range of 3% to 5%, interest on funds held for clients is expected to decrease by 12 to 17%, investment income net is projected to increase by 29 to 32%, net income is expected to improve 4% to 6% for fiscal 2010.

Operating income, net of certain items is expected to increase at a rate close to the first half of the year but as a percentage of total service revenue declined slightly to approximately 36% for fiscal 2011. The effective income tax rate is expected to approximate 35% for fiscal 2011.

Interest on funds held for clients and investment income for fiscal 2011 are expected to be impacted by the low interest rate environment. The average rate of return on combined funds held for client and corporate investment portfolios is expected to be 1.4% for fiscal 2011.

As of November 30, 2010 the long-term investment portfolio, which excludes variable rate demand notes and an average yield to maturity of 2.7% and an averaged duration of 2.5 years. In the next 12 months slightly less than 20% of this portfolio will mature and it is currently anticipated that these proceeds will be reinvested at a lower interest rate of approximate 1.1%.

Investment income is expected to benefit from ongoing investment of cash generated by operations. Under normal financial market conditions the impact to our earnings from a 25 basis point increase or decrease and short-term interest rate would be approximately 3.5 million after taxes for a 12-month period. Such as a basis point change may or may not be tied to changes in the federal funds rate. It is not possible to quantify the after-tax effect with 25 basis point change in the current investment environment.

Purchase of property and equipment for fiscal 2011 were revised to the expected range of 95 million to 100 million as we continue to invest in technology and infrastructure.

Fiscal 2011 depreciation expense is expected to be in the range of $65 million to $70 million and we project amortization of intangible assets for fiscal 2011 to be approximately $20 million.

You should be aware that certain written and oral statements made by management constitute forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. These statements should be evaluated in light of certain risk factors, which could cause actual results to differ materially from anticipated results. Please review our Safe Harbor statements in the press release for our discussion of forward-looking statements and related risk factors.

At this time I'm very happy to turn the meeting over to Martin Mucci.

Martin Mucci

Thank you John. I am pleased to join you with you today and talk about our results. I have been in the new role for just about three months and we are very focused on executing on our plans to continue to be the leading provider of Payroll, Human Resource and Benefit Outsourcing to small and medium size businesses.

My focus is on driving growth in terms of clients, revenue and profits while continuing to provide great service to our clients and employees. We are pleased with our financial performance in the first half of fiscal 2011; checks per client, revenue per check and client retention have all demonstrated consistent improvement.

Checks per client have improved for each of the last three quarters and client retention has improved in all categories for five quarters. Improving client metrics and benefits from implementing our new core advanced payroll platform are enabling us to improve our operating margins as well. And we continue to invest in our employees, our products and our services.

We are also pleased with the efforts or our employees on many fronts. Client satisfaction results are at the highest levels ever in our history in both core and major market products. Our employees remain dedicated to our client satisfaction and being an essential partner with our clients and all of us are well prepared for our year-end processing coming in just a few weeks.

As you know we converted our core clients to a new application over a year ago that contains significantly greater functionality and we continue to build from there releasing new enhancements approximately every six months. Recent enhancements have included a new design for our online reports back in June and new online W2's and online paystubs just last month. We have also introduced new smart time clock solution for our clients with less than 20 employees.

Our major market business is heading toward 400 million in annual revenue and offers a complete one source solution for our mid size clients including online HR administration, time collection and management, and benefit enrollment. We are very competitive in this space and continue to make major investments in this product set including recently enhancing the integrated user experience allowing our clients to navigate between applications and integrating the data behind these applications with web services.

Over 532,000 client employees, up 14% utilize our Paychex HR Solution services through both a national PEO and ASO model for HR outsourcing. This is more than our largest three competitors combined. We also service one in ten 401(k)'s in the country with assets now over $12 billion.

During the first quarter call we discussed some new core sales initiatives that were implemented on October 1, 2010. At that time we introduced new pricing and packaging of our core products and we have made some changes in our training programs to expand the knowledge and selling skills of our new sales representatives. We have also made a number of changes to bolster our field sales management team, we are fully staffed in all sales positions, and our currently deploying the latest in technology tablets to support our sales team and improve their efficiency and production.

It is really too early to tell the report on the progress of some of these initiatives until we get through January, as you know an important selling month for all of us.

Looking at some of the other areas of importance that I have discussed in the past few months, I am actively pursuing, interviewing for executive positions leading sales and marketing. We are separating the marketing from sales by establishing a new Vice President position that reports directly to me and allows us to capitalize on our brand strength and accelerate the work with Channel partners and lead generation for our sales teams. We expect both positions to be filled in the next 45 to 60 days.

And of course we announced our merger agreement with SurePayroll on December 9 and expect this transaction to close in just the next few weeks. SurePayroll, with their 30,000 clients provides us an entry into a new segment of the payroll online market. A segment we think is positioned to grow as the five million small businesses who calculate their payroll manually move to the web.

Paychex already has 40,000 clients using online input but SurePayroll, with it's software as a service model will offer another alternative to those clients looking for more of a self service alternative. Both company's offer quality service and from a client control standpoint Paychex will now be able to offer a full range of payroll, outsourcing alternatives. Clients who want more control have SurePayroll. Clients who want high level of personal interaction with a dedicated payroll specialist have the Paychex model.

We are excited about this SurePayroll employee team, talent and leadership in this marketplace. The leadership team that has led SurePayroll since it's start in 2000 will remain in place and focus on growing their business within the Paychex family.

It has been an extremely busy and productive time since taking the helm a few months ago and I'm proud to be the CEO at Paychex and lead an outstanding team of employees in sale and operations. We're excited about taking Paychex to our next level of performance.

With that I would like to open it up for questions for John and I. Angela?

Question-and-Answer Session

Operator

Thank you. We will now begin the Question-And-Answer session. (Operator Instructions) The first question comes from Julio Quinteros with Goldman Sachs.

Julio Quinteros - Goldman Sachs

Sure. Hey guys. Real quickly, John Morphy for you real quickly on the two metrics. Just want to make sure we have the new client sales metric for the November quarter? I might have missed that one. And then once you're done with the anniversary of the easier comps on the checks per client, where do you expect the checks to clients number to essentially stabilize once we get past the, looks like by the third quarter of this year, you anniversary the clients?

John Morphy

What was the first question again?

Julio Quinteros - Goldman Sachs

Sorry, the new client sales numbers.

John Morphy

We don't give new client sales numbers but the sales were up slightly but not much and this is the sixth month that is really the most important six months anyway so it's the next one. As far as easier comps I don't even think of it in terms of easier comps because normally checks per client doesn't go up so I would say that the comps didn't have much to do with it because the comp was only worse than the last recession by 1% of five versus four. I think one of the things that's affecting checks per client slightly on a positive basis is the fact that new business formation isn't as good as anybody would like it to be so as a result we're not introducing some of the smaller based clients at the bottom, not with that change 2.5 to zero, no.

The checks per client to me were stronger than what I would have anticipated and I could ride this horse for as long as it will run and it's surprising it's gone this far but we don't see any weakness in it. And when we look at the economy the part that we see that's encouraging is the businesses that are in place seem to be pretty good right now. Bankruptcies are definitely down, falling off, retentions getting better in every area. They are definitely hiring people, maybe not like crazy and they're not letting that many people go so we're seeing some real good stability and we've seen this for nine months.

Julio Quinteros - Goldman Sachs

Great. Thanks.

Operator

Our next question comes from Jason Kupferberg with UBS.

Jason Kupferberg - UBS

Thanks guys. Just a couple of questions here. I wanted to talk about some of the bank partner relationships that SurePayroll looks to be brining to the table here. Can you talk about how you might plan to leverage those relationships? Not just on the SurePayroll side but also for the core of Paychex business going forward?

John Morphy

I think the positive piece of that is they do have the sales bank, these bank relationships through Share. We have bank relationships through Paychex that we've had from outsourcing the referrals to our fallouts product and I think we can leverage by combining those. I think the banks can understand that they can either stay with the Share product or they can go with the full-outsourced product. Whatever their clients want at the time. And all the agreements that are in place we're sure bank partners now will remain in place.

Jason Kupferberg - UBS

Okay. And I think on the call in October you guys suggested that you would look to provide some new long-term guidance before the end of the current fiscal year? Is that still the plan and are there any more specifics on expected timing there when the (inaudible) should expect that?

John Morphy

We basically said next June.

Jason Kupferberg - UBS

Okay, so your Q4 call?

John Morphy

Yes I think if we go look at what it should be for the following year we'll know a little bit more but I think most people are settling. I don't think when we come out it's going to be a surprise.

Jason Kupferberg - UBS

Okay. All right. Thanks guys. Good luck. Happy Holidays.

John Morphy

Okay. Thank you.

Operator

Your next question comes from Rod Bourgeois with Bernstein.

Rod Bourgeois - Bernstein

Okay. Great, so three months ago you guys talked about a different approach to the pricing in the market and I wondered if we could get an update on the kind of traction that new pricing strategy is getting in the market? And whether it's helping you recapture some share?

John Morphy

I think it's a little early to tell at this point. We just put it in October. There was a number of sales in the pipeline coming in so we saw most of that happening in October from the previous months. I think once we get past January we'll have a better sense of how that's going. I think things are generally pretty good. We've made some tweaks to it already but I think we feel pretty good about it and we're waiting to kind of see how January goes. We're watching it very closely but certainly the sales reps have all been trained and pretty supportive of what we're doing and we're out there selling as best as we can. We'll let you know after the next quarter I think.

Rod Bourgeois - Bernstein

Okay and Martin, I just wondered if you could lay out your top one or two priorities as you take the helm as CEO in terms of improvements you'd like to see at Paychex, either changes to your strategy or enhancements to prior strategies where you think there's big room for opportunity?

Martin Mucci

Well I'm feeling very good about the level of services. I said that they are the highest levels we've had in the past. I feel good about the product set that we've rolled out, both in the small and mid market, very strong competitively. The focus is all on growth. How do we get the sales engines going again? We've taken already some steps through making sure that we have the right people in place in the field leadership positions. We've got new training that we've rolled out already and we're giving them the best technology through tablets. And online they can basically load a client on their tablet today and send it back through the process to do that faster and more productive.

I think the next big piece of that growth focus is going to be getting a new leader at the head of sales, that I told you I'm actively interviewing for now and expect to have in the next 45 to 60 days. And a new separate position in marketing, which will generate more leads and better brand recognition. I think sometimes one of the biggest frustrations for me over the years has been that we had marketing as part of sales and we have a very strong presence in product and knowledge, and certainly a leader in this space but we're not always known for, is as complete an outsourcer as we are for benefits and HR outsourcing. So, it's all about growth and it's getting the leadership in place, the very top and focusing a lot more on the marketing side of it to generate, to help generate that growth.

Rod Bourgeois - Bernstein

And Martin, just real quick, on the effort to hire a new sort of sales leader, are you looking for somebody that can bring sort of a new approach to sales or somebody who can jest mange the current approach in a really disciplined way?

Martin Mucci

Well, I think it's a little bit of both. We have a great sales engine here that we've had for many years. We've got 2,200 sales reps out there that continue to probably provide the best productivity in the industry. So it's a little bit of both. You need someone whose going to fit into the culture well and drive the organization. But I also think from even from a more marketing position, it's bringing a little bit new disciplines. We're good on the web. We could be better and we could get our brand out there stronger and generate more leads. So I think the sales leadership is probably more about executing really well and driving some of the things that we're doing now. Maybe looking at things like Lead Generation and so forth and supporting the sales forces. But the marketing will be a bit of a new strategy there. Certainly an enhanced strategy.

Rod Bourgeois - Bernstein

All right. Good luck with those hires. Thanks guys.

Martin Mucci

Thanks.

Operator

The next question comes from David Togut with Evercore Partners.

David Togut - Evercore Partners

Thanks and good morning. Could you comment on your recent headwind rates in the small business payroll versus market against your principal national competitor?

John Morphy

We've never disclosed that. They would love for us to tell them. I'd love for them to tell us.

David Togut - Evercore Partners

Well can you give us a sense of whether your win rates are trending up or down?

John Morphy

I think the win rates actually over time don't change very much at all.

David Togut - Evercore Partners

Okay. They've highlighted their new run product down market as being a significant (inaudible) advantage for them. Have you seen any impact from this?

John Morphy

I haven’t seen anything significantly. I'll let Martin comment on that.

Martin Mucci

No, I don't think so. The impact I would say we're getting from the sales reps, I've talked to an awful lot of them in the last few months. I don't think we're seeing a big impact one way or the other. As John said it hasn't changed much over time. I think we're both pretty aggressive with our sales forces and we obviously have very quality service and we haven't seen a big change there.

David Togut - Evercore Partners

Great. Thanks and just finally, John with EPS now starting to grow again. Would you anticipate growth in the dividend over the next 12 to 24 months?

John Morphy

Not really as a board decision and let me say it this way. We comfortable with where the dividend is, when we established that dividend level we knew that paying 75% greater earnings was okay. I don't think you'd have to get back to 75% of earnings to basically say there'd be a dividend increase but it really will be up to them. I think some of that we base on what fiscal '12 looks like when we get to the July meeting. I'd be hesitant to say because I'm really not sure.

We're very dividend friendly. That hasn't changed but it'll be interesting, a lot of it we've based on what maybe we saw, with some acquisition opportunities. I think that the factors that could cause that decision to be made will be what's there at that time and right now it would be too early.

David Togut - Evercore Partners

Okay. Thank you.

Operator

The next question comes from the line of David Grossman with Stifel Nicolaus.

David Grossman - Stifel Nicolaus

Thank you. It sounds like you're pretty optimistic going into the selling season. I'm wondering if you could just help us understand how much of that optimism is cyclical versus confidence and some of the actions that have been taken over the last several months? And part and parcel with that perhaps you could comment on some of the early activity that you've seen in the month of December?

John Morphy

One thing, I think we are optimistic but cautious and you won't know until you get there. One thing we don’t' read into is when you look at guidance for the year, we've reached the stage of the year where what they sell doesn't affect this year too much. So we're optimistic that we're going to have a good selling season but we're also to the point where guidance at this stage, unless you get a pretty significant economic event, the guidance should stay pretty consistent. I'll let Martin talk about how he feels about the selling season.

Martin Mucci

Yes I think it's still early, the initiatives we took in October and continue to take. I do feel good that we have a very pumped up sales team that's out there. Certainly we've got the right products and services. We've got quality service. Certainly great value for our clients and good field leadership. I think it's just a matter of time to make it all gel and come together and while I'm optimistic, as John said it's a big selling season for us in December and January and it's still a little too early to tell.

John Morphy

The only thing we don't know David is we've seen a lot of improvement in the marketplace, what's existing and a lot of this new business formation, these payrolls pickups happen in January, like it or not. And you really don't know until you get right on top of it because when you're selling core payroll most sales are sold in one visit, so there isn't a lot of queuing up of the business. Now MMS we feel really good about. They're off to a good start and that business queues up probably six to eight weeks ago. We feel good about that. You've just kind of got to go in there and play the game and see what happens.

David Grossman - Stifel Nicolaus

Okay and just kind of looking at your comments John about rates, excuse me about rates and balances, when you roll all the different elements together because it sounds like you're expecting some head wins to balances because of this new legislation and you’ve got 20% of long-term portfolio rolling off next year. Does that seem to suggest that if rates stay relatively flat everything kind of put together, that we've got to a head win to funds for clients or could that balance perhaps grow next year given all those parameters?

John Morphy

I think when you look at it, interest on funds held for clients, all the parameters in place, I think you can see a drop of about 10% but we're getting down to a number, that isn't a big number. Right now it might even be a penny. So I think when you look at interest on funds held for client the impact of that going forward until rates go up really isn't going to be very significant.

David Grossman - Stifel Nicolaus

So everything else being equal, investment income for clients would actually be down next year?

John Morphy

It will be down a little bit but not a lot.

David Grossman - Stifel Nicolaus

I see. Do you have any idea what kind of rate level we need to see before that starts growing again?

John Morphy

I'd have to ask my treasury people. I mean the reinvestment rates 1.2 in the long-term portfolio. I don't think that can go any lower. The short-term rates, we've got a little bit of the bites back. When they come back up I don't know they're going to come up 25 basis points a crack, I've no idea what they'll do but if they picked up 100 basis points that would be a pretty big bite. I think they're going to keep rates down as long as they can keep them down.

David Grossman - Stifel Nicolaus

Okay and just one last thing on the investment. It sounds like you've got a plan for the second half of the year and is there any more specifics you can provide over and above what you've already said about how those investments translate into incremental growth and profitability going forward?

John Morphy

Well when you look at the margin expansion some of it's related to investments, some of it's just we've got a philosophy that's been in place for a long time that when you ask for expense growth you're not going to get it equal to revenue growth. Now unfortunately, when the recession happened you got the two negative impacts that we can plan to but we're not willing to let people go or do layoffs, which we won't, that's very hard to offset. That's checks per client coming down which that last check is the most profitable. Some of the margin expansion and negative client. Well hopefully negative client growth now is behind us but we won't know until we get to the selling season but we were flat for the six months. We were flat a year ago but we know retentions better so hopefully that will get a reasonably good answer. I don't think we're going to get a surprising answer but we'll get one and the checks per client keeps going up.

But now we continue to make investments. Now one thing we haven't said too much about, we are really spending a lot more money on product development; this is that the core advanced platform is really product development. Now we're on the MMS products so our IT expenses are up dramatically. I mean I'm talking pretty significant double-digits as we try to get this product portfolio stronger and stronger. So we balance all those things with what we're doing with the other costs because we believe margins have to keep going up. Now it might now go up quite as strongly as they did this year because it got some good benefit out of checks per client but I've learned never to say never because you don't know what's going to happen.

But we're going to continue to focus on those things and see what we can get. The core advanced platform now has been fully in place for a year and what's happening is the people are responding. The training is easier. We've got a lot of experienced payroll specialists but the other thing is the response time in the machine are getting better and better and they aren't finished yet.

We knew we'd get some things out of this and maybe we didn't target specifically as much as maybe we should have but some of that was a little bit of trust that if we got it we would get it. So to me things are moving in the right direction. We're getting what we need to get and most of it should continue.

Martin Mucci

The good news is those productivity enhancements, we've poured that money back into the investments for more technology in both the small and mid size and that's not going to stop. We'll continue to do that but that's baked in to the numbers that you're seeing in the guidance.

David Grossman - Stifel Nicolaus

Okay. Got it. Great guys. Thanks very much.

John Morphy

You're welcome.

Operator

Our next question comes from the line of Adam Frisch with Morgan Stanley.

Nathan Rozof – Morgan Stanley

Good morning. This is Nathan Rozof on for Adam Frisch. I'd like to ask what you guys are hearing from the field about recent changes to the tax rates or the tax extensions that we had recently coming out of Washington D.C. Are clients starting to signal any increased confidence from that that could translate to a willingness to invest and hire?

John Morphy

Well you know one problem we have in our business because we have so many clients. We have the (inaudible) touching them but people don't when they're talking lower (inaudible) organization. I wouldn't say we have a lot of color on that subject. I think we can look at the tax rates, I don't know if it's as much as a boon. I think the social security thing could be because people have a little more money to spend but all we're really doing is continuing what was in place. So I think, to me it's not so much you headed a positive but you got rid of some unsureness is you didn't drag something out that probably would have been negative but the social security thing, that money, it's the same amount of money basically goes to everybody so the lower income people are going to get the same amount so it will be interesting to see what happens with all that but we have not heard a lot and I think it's a little too early to see and we'll just have to watch what they tell us about consumer spending and those things in the next three to six months.

Martin Mucci

Yes I think the good news is that obviously we've seen checks per client grow so they are hiring a little bit and the business values

business values for going out of business is improved for five quarters now, so obviously something is kicking in whether it's business tax credits and other things happening or not. The bottom line is they're going to hire more when they've got demand for their services and products but I don't think it's hurting any but we haven't seen a lot of positive coming from just the tax changes.

Nathan Rozof - Morgan Stanley

Switching gears to the investment portfolio, we realize you guys take a lot of care there investing in AAA and AA quality securities? But with the recent concerns that have sprung up in the meetings market is that causing you to take or look into any additional safeguards?

John Morphy

Well we're always looking at more and more safeguards and I think, we keep talking about this. We haven't seen a reason to change our position yet based on where we are but at the same token it doesn't mean we can just sit here and say, oh life is perfect. No we've got to keep looking at that.

Nathan Rozof - Morgan Stanley

Okay and then lastly, just on the SurePayroll acquisition, kind of two lines of thought here. Number one is, is there SAS technology something you're going to integrate into your existing online product and then can you give us any insight kind of how the financial and growth metrics compare between the SurePayroll product and growth rates in your existing online product? Thank you

John Morphy

Yes. You're welcome. I guess the first one, we're not looking necessarily to integrate it into the online technology because they're very different products. One much more self-service than the Paychex online product. We will look to leverage and integrate into our back office through our tax calculation payroll calculations and so forth. But the front end from the client perspective, we're not looking to do that at this point because they're very different.

From the metrics standpoint, I mean obviously they're seeing pretty strong growth there, about 30,000 clients and they've grown pretty well. And we continue to think that they will grow very strongly in that marketplace, particularly as some of these five million businesses that are doing it maybe doing their payroll manually will come over. So we're expecting higher numbers than our normal growth because they're still relatively new, about 10 years old.

This really participates in a segment that we think is going to be growing and actually it's a replacement segment. We believe right now that approximately five million businesses or over half the market are at the low end is doing payroll basically using a pen and a government pamphlet. Hard to believe but that's what they're doing. They're not in QuickBooks. There's no computer anywhere in the process. Pen and a pamphlet. Well if you look at how the world is evolving and I don't think it's going to happen overnight but the kids of today are not going to use a pencil, they're going to use some type of a handheld device. And they're not going to really care all the time whether a salesman calls on them so we believe this market that we're going into, this product will be what replaces manual payroll over the longer haul and we've got to make sure we've got something.

So we don't see much cannibalization here. This is a product that will grow faster than our products because it's smaller. The revenue characteristics will be much smaller. At the same token the service requirement will be much less. Our goal on something like this would be out of 100 payrolls, only touch about three of them. So it's a whole different concept and the customers looking for a different concept. This really is the person the do it yourselfers that wants to do it himself. Doesn't want a lot of help except when he needs it. He wants to be able to call somebody. So it's an exciting opportunity but it really doesn't have all the same characteristics of our other business which is really worry free and we think you'll get the margins off for the fact to get to many, many clients you won't be touching this stuff very often.

Nathan Rozof - Morgan Stanley

Thanks again and happy holidays guys.

John Morphy

Thank you.

Operator

The next question comes from Ashwin Shirvaikar with Citigroup.

Ashwin Shirvaikar - Citigroup

Hi John. Hi Martin. So I wanted to follow-up on that SurePayroll comment that you had with the lower revenue per client and then down to lower cost per client. Does the SurePayroll product support the pyramid approach of selling more stuff to the payroll client or is this going to be more low touch always?

John Morphy

Well they are low touch but they also do have a model that is similar to ours in selling 401(k) and insurance and so forth. But again more of a low touch approach to it but they do link other products to their payroll service and have been doing that for some time and have the relationships built. I'd still say it's set up pretty low penetration rate but it's something that we hope to further expand as needed in that marketplace.

Martin Mucci

It's going to be dependent on what their needs are. For example and they way they've got it structured right now tax pay and employee pay are a requirement for everyone to plan. And an interesting thing, on the way in today they're talking about social security checks, I think by 2013 a person has to take either direct deposit or a debit card. So maybe that's a move towards direct deposit being able to be recorded in this country. I don't know.

Ashwin Shirvaikar - Citigroup

Great and I guess speaking of debit cards, could you and there's been I guess a lot of comment already recently about debit cards, prepaid cards and so on, can you comment on where you stand with regards to rolling out payroll cards?

John Morphy

We were the first in the industry to have them. We've had them almost 10 years and need and desire to have them just hasn’t been that strong but we have a product that's as good as anybody’s. We've been doing it a long time and we've got the whole thing covered. There's a lot of talk about this but when you get down to people asking for it there hasn't been much need yet.

Martin Mucci

It's more for the unbanked, I guess what we would call unbanked employees and it has kind of limited growth. To some degree, as John said we've had it out there for a long time. If they have a debit card most employees of our clients already have debit cards because they just use the one account. If they don't have an account and they want to pay through the card that's the kind of client that will request it but we have had it out there for a long time. It's still a pretty small penetration and does not seem to be growing a great deal even though we market it quite a bit even to the employees directly.

John Morphy

Now that could change dramatically if you told somebody you can do direct deposit and if you don't do that you've got (inaudible) card. We're not going to send you a check anymore and if that happened you would see the utilization of those cards go up dramatically. So this thing with social security needs to be followed closely to see what happens.

Ashwin Shirvaikar - Citigroup

Okay. Switching gears, last question on margins. Could you maybe address the idea of peak margins so in your view are there structural changes in the business that happened during the last down term that affected peak margins in the recovery? I mean can you sustain, let's call it 15,00 basis point kind of year-over-year margin improvement and get to a low 40s level?

John Morphy

I don't know what's possible exactly because all I know since 1990 the margins of paychecks have gone up almost every year. We continued operating this philosophy that we can continue to leverage the model. I assume that when you get to 100% gross margin you probably have peaked. Where it peaks between there and then I don't know. Just when I might say to myself boy can this go any higher it goes higher. So our goal is to keep them going higher or you've got to find some way that revenue growth that's greater than what we've got so some of that's a trade off. I mean I'm sure if we were willing to totally cave in on price you'd have more business but you wouldn't make any more money. I don't think we've reached the point at what you would say that margin expansion is not possible.

Ashwin Shirvaikar - Citigroup

Fair enough. Happy Holidays guys.

John Morphy

Thank you.

Operator

The next question comes from Jim Macdonald with First Analysis.

Jim Macdonald - First Analysis

Yes. Congrats on the SurePayroll acquisition. You talked about the operational side a little bit. How about on the sales side? Do you see that being pretty separate or any integration there?

John Morphy

I think Jim it's a little too early to tell. We haven't closed yet and we're still kind of working through that. They obviously sell through a telesales and not on the street and that's part of the model given the lower revenue per client. So, we're continuing to look at that. We also want to maintain strong territory integrity for our reps but we're still kind of balancing that out. We'll wait until after we close to make a final determination of how that's going to go.

Jim Macdonald - First Analysis

And how about web sales, you were doing some more web sales and they're doing web sales. How do you avoid a mixed message there?

John Morphy

I think it's all in how you portray the brand of the product. That's one of the reasons we left the SurePayroll. We're going to leave the SurePayroll brand out there as either powered by Paychex or provided by Paychex. It is very important that they are very different products and so we will market them differently and look to certainly gain a different client.

Martin Mucci

As John said we don't expect a lot of cannibalization. It's really about client control. The client who wants more control and self-service will go to SurePayroll and it will be advertized and sold as such. And those who want a more full service, kind of dedicated person to them, whether it's online or not, it will come to Paychex. And so I think it's all in how we present it and brand it for the client, which we think will help by having the two separate names.

Jim Macdonald - First Analysis

Great and one last minor question on the quarter. You mentioned that the workers comp and the PEO impacted revenue a little bit. Can you quantify that at all for the quarter?

John Morphy

No, we don't quantify. It's less than $5 million. It bounces around but sometimes up, sometimes down.

Jim Macdonald - First Analysis

Okay. Thanks very much. Have a great holiday.

John Morphy

Thank you.

Operator

The next question comes from Tim Willi with Wells Fargo.

Tim Willi - Wells Fargo

Thanks. Good morning. I just had one question going back to I think Rod's question about strategy and any sort of thoughts. Could you talk about on the M&A front Martin, is there anything that you think about from M&A where there might be more of a focus than in the past and then just in general sort of thinking about the environment for non payroll business like healthcare or retirement and sort of how you think about that in the environment around selling prices right now?

Martin Mucci

I think from an M&A, we're constantly and have been for years looking and always searching, investigating possible M&A opportunities. When you look back at our products, particularly for the mid market the HR Administration online product that we have was through an acquisition to Time and attendance. TLO what we call Time and Attendance online, we purchased as well and of course SurePayroll. We're always looking at where we can either add through acquisition. It's just it's always tough when you're looking for something that we think reasonably priced and will add value to our product set. We do look well beyond payroll and of course we're always doing small payroll acquisitions all the time. But we're always looking for product additions and anything that will add value to our product set.

We feel pretty good about the environment, as we see the checks per client from the business losses looking better. We certainly feel better about the 401(k) business and certainly in the HR Solutions, which is our PEO and ASO. As John mentioned earlier, we moved the PEO nationally. That's been doing well. We're now able to do the same sales force and same service group, which we combined to offer either of the PEO or ASO model and that continues to grow. I think we're 14% in the number of employees served by those two solutions so that continues to go well.

We see a definite environment where more clients of all sizes are looking to outsource their HR support to us either through the PEO or ASO. And on the insurance market, workers comp has been around a long time, continues to do well there. And health insurance had good growth and revenues and we think as the healthcare reform, depending on where that kind of quiets down, clients will continue to purchase health insurance.

There is always and I think we're getting better and better at being able to take health insurance from a broker that's already there in the market where a client already has health insurance. I think we were good at starting them up in insurance and we're getting better at hiring and training our insurance reps to be able to compete more effectively with an agent position already placed.

Tim Willi - Wells Fargo

Okay. Thank you very much.

Operator

The next question comes from Kartik Mehta with Northcoast Research.

Kartik Mehta - Northcoast Research

Hey, good morning John and Martin. John and Martin, I wanted to ask you, in the past you've talked about potentially leveraging your sales force to sell other products and one of your examples you gave was the merchant processing business. And I was hoping you could provide an update to where that stands and if you found any other areas where you could use your sales force and leverage them to sell other products into your customers?

Martin Mucci

Yes Kartik. This is Marty. It's continuing to move along. I think we'll have some information on that shortly where you on the merchant service side. We still think that's a nice opportunity for us. It's not huge but we think it's a nice opportunity to use our distribution model. Our sales team meeting these businesses for the first time as they just start up and be able to help them through that process. More of a partner than an acquisition type model and on other things we're looking to sell we're always careful not to dilute the sales team. We have again the most productive sales team, I think, in the industry and we're always careful not to have them get diluted with too many projects but we do a great job of, I think passing referrals between sales forces. So we'll always look for other things that can leverage that sales force without diluting them from the basic goal, which is to sell more payrolls and get those new clients signed up so we can sell them other products as well.

Kartik Mehta - Northcoast Research

And John you stated that you increased your investment into variable notes to $700 million. Obviously you're feeling more comfortable about that investment class and I was wondering if you're looking to change at all the structure of the portfolio now that maybe the environment is changing a bit?

John Morphy

Well I think we'll still move back in these investment choices that one time we thought were very save that we could a little worried about for a while but we'll continue to. I don't see a major change in what we're going to do in the portfolio but I do think you've go to keep looking at it. Look at it a little more gust or a little more thoughtfulness. I think we hit a strategy that's worked for a long time but I think when I talk to my investment people we sit here and say yes, we think it still works but you know what we've really got to rethink the whole thing. It doesn’t mean we'll change it but I think you've got to look at it from every aspect that you can think of.

Kartik Mehta - Northcoast Research

And then this last question John. I think you said SurePayroll might be about a penny dilutive in fiscal 2011. So if you looked at 2012 would you expect that dilution to somewhere about $0.03 to $0.04?

John Morphy

No, because I think a lot of it's going to be the amortization from the expenses. They've got to be expensed in the first year. I think if I looked out I'd still say it might be a penny but it's not $0.03 or $0.04.

Kartik Mehta - Northcoast Research

All right. Thanks John and Martin. I hope you guys have a great holiday.

John Morphy

Thank you. You too.

Martin Mucci

Thank you. You too.

Operator

The next question comes from Jim Kissane with Bank of America - Merrill Lynch.

Jim Kissane - Bank of America - Merrill Lynch.

Hey Martin and John. Great job. On SurePayroll, will you be offering that through the CPA referral network in the future?

John Morphy

I think we're still working through that Jim. It's certainly is an offering that just like the banks I think will appear to some CPA's and the fact that a CPA can handle whatever a client wants through one company will be very strong both through the banks and the CPA's so we're still finalizing how we're going to do that waiting to close in the next few weeks here but we're working through that right now. And certainly see it as an opportunity to give the CPA's choice for their clients.

Jim Kissane - Bank of America - Merrill Lynch

Okay. Not to get into much of the detail but I sort of have an iPhone App. Will you be putting that app on top of your core payroll service?

John Morphy

Right now that would be on the SurePayroll service and if there's anything that goes on the Paychex side it would come much later.

Jim Kissane - Bank of America - Merrill Lynch

Okay and not to put you on the spot, but can you give us a long-term target for where you think you can get net new client growth back up to? Is it 3%, 4%, 5%?

John Morphy

I think we set the goal at 3%. That does not ensure payroll in it. In other words we either have to get the 3%. The reason I put SurePayroll is it isn't always a client to client because they'll be smaller clients, smaller revenue. But now we feel we've got to get back to 3% and we're doing everything we can to do that

Jim Kissane - Bank of America - Merrill Lynch

Okay. Great. Have a great holiday. See you.

John Morphy

Thank you. You too.

Operator

The next question comes from Mark Marcon with R.W. Baird.

Mark Marcon - R.W. Baird

Good morning Martin and John. Just wondering If you could talk a little bit about the benefits we've seen from the new core payroll platform combined with how we should think about the incremental expenses that layer on during the new calendar year, specifically 401(k), what's the incremental change that we're going to see from Q2 to Q3 in terms of the expenses that you're adding back?

John Morphy

Well I think if you look at the guidance you can figure it out.

Mark Marcon - R.W. Baird

Yes. I did that. Just double-checking.

John Morphy

I'd say I already told you. We've got some expenses. It's not that big. The bigger impact in the second half of the year is selling expenses, which are always higher. The operating characteristics off the core advanced system, the first half of the year were great. We actually, operating expenses went down a little bit. We still continue to invest and it's people and it's working faster so I think the beauty of this right now is we could have a lot of good things happen but by no means is it over.

Mark Marcon - R.W. Baird

That's exactly what I was trying to get at. I mean we're going to see some incremental expense growth above and beyond the normal sales commission pickup that we're going to see in Q3 but it sounds like the core platform still yields some benefits above and beyond those incremental expenses going forward?

John Morphy

Well that' what we're continuing to see. I mean the platform itself is, helped the payroll specialist to be more productive, even a little bit better than we expected from an improvement standpoint because the performance is good. It's easier to train on. It's got a lot more functionality for them to be able to pop up screens and so forth. To be able to help them through the calls faster.

And so they're seeing a lot more productivity from it and that was a little bit better. Where we will, we continue to think that we'll see that and at some point obviously it's going to level out but we're not sure that we're there yet or not. We don't have a lot more to do to improve the speed, there's a few things but it seems to be working extremely well and we're certainly getting great feedback from the payroll specialists who are using it. As well as the clients, we use it from the online system, feel very good about it as well.

Mark Marcon - R.W. Baird

Great and then you mentioned client satisfaction scores are near record levels. Client retention has been improving. The environment is getting better. The company's that are still around have been stress tested. Do you think the client retention rate on a seasonally adjusted basis, going from this calendar year to next calendar year may end up being higher than what it has been historically?

John Morphy

What do you mean by? You mean get worse?

Martin Mucci

No, client retention.

Mark Marcon - R.W. Baird

No client, get better.

John Morphy

It will get better.

Martin Mucci

We're definitely going to be better than last year. I don't think we'll get, we wont' get to the historic high but we've made a pretty big dent in it from what we can see at this point. January is obviously a big month.

Mark Marcon - R.W. Baird

That's exactly what I was getting to. Could this December to January trend be materially better than we've seen over the last couple of years.

Martin Mucci

Better but I don't think. I think this is going to be something that keeps gradually improving. In other words you gave the range like 19.5 to 23.

John Morphy

Yup. We aren't. I don't think we'll be under 21 yet.

Mark Marcon - R.W. Baird

I don't have you there yet.

Martin Mucci

I think that will come down gradually.

Jim Kissane - Bank of America - Merrill Lynch

Okay. Great and then can you just mention a little bit what you're going to spend specifically in terms of, you mentioned CapEx is going up.

John Morphy

We put nine million into a building in Rochester that, we had a lease on it. It's one of those things I probably should have bought four years ago but I missed it. We had a long-term lease on it and the people came to us and said they wanted to sell. We had to write a first refusal. The lease is going to run long enough that it didn't make any sense not to buy it.

The only place we really buy buildings is Rochester where we know we've got a long-term presence, we've got multiple buildings. We're not moving in and out of them and as we mentioned we're continuously trying to match the size of the branch requirement also with new service type requirements. So you really don't want to be owning buildings that you've got to sell.

Mark Marcon - R.W. Baird

Great so it sounds like this was kind of a one-time bump?

John Morphy

It was a one-time bump. About 10 million of it and the Rochester, I don't think we've ever sold a building.

Mark Marcon - R.W. Baird

Great. Happy holidays.

John Morphy

Okay.

Martin Mucci

Thanks a lot, Mark.

Operator

The next question comes from Gary Bisbee with Barclays Capital.

Gary Bisbee - Barclays Capital

Hi guys. Good morning. I guess just two quick questions. First one, on the payroll revenue growth, I guess I'm wondering why it decelerated a little bit from last quarter, particularly with checks that are in retention and revenue per check?

John Morphy

You can't, quarter over quarter doesn't mean anything for us. You've got to really look over the prior year.

Gary Bisbee - Barclays Capital

That's what I mean, versus the prior year it was 1.8.

John Morphy

You're cutting it too close. The checks per client, you've got to remember the checks per client goes up, I don't get dollar for dollar because the check (inaudible) goes up. The average revenue per check goes down. So the price increase has also had to balance against the client base drop that was in the prior year, 3%. So (inaudible) here, we look at the revenue growth we felt was pretty consistent. It got a little bit of noise. One other thing we didn't do, we didn't put a W2 price increase in. When you put a W2 increase in it generally (inaudible) that affects the quarter. That wasn't in there. There's nothing that I would call systemic but we always have a few differences so if you want to look at something to the accuracy that you're looking at it, it's often as not going to be a misleading assumption.

Gary Bisbee - Barclays Capital

Okay and then the second question. Regarding the SurePayroll, it sounds like a real good addition to the portfolio of offerings but is there and I understand how this could expand the market so the really small people doing it themselves but is there also a defensive component here to the extent that have you witnessed any share loss or people trading down to a cheaper offering around the economy and is that part of the angle as well or do you see this much more as?

John Morphy

We haven't witnessed anything but you sure got to have some concerns so I look at this as definitely an offensive move but also a very defensive one. I mean we believe and I can't tell you exactly when, and I don't think it's five years from now but if you don't have a pretty much hands free notes touch product, that's a market you can't participate in and whether you're going down or coming up like into it that would not be a good place for us to be.

Martin Mucci

Well you certainly saw with the economy over the last couple of years that there was more pressure on price but that's not really. We didn't see this as a defensive move in that way. We saw it more just as John said, we see this as a growing market where those doing it manually will move to this and that's a pretty big, it's a hard group to move to a full outsource sometime but we know there'll be a number of them that will want to go to self serve but it will be web based not calculator based.

John Morphy

See one advantage of this over time would be, right now the do it yourselfer (inaudible) that's doing it with a pencil and a manual is not connected to anything. He's just out there by himself but if you could get him for that person into a mode where they were basically doing it this way that would start to get them connected to you where you would have a chance to sell them more or to move them up. So it really is, it's both offense and defensive. I think if you look forward, the way that this world is going to not have a product in this product offering would be a real mistake if you were a payroll outsourcer.

Martin Mucci

Yes, it keeps us solid right from the self service right through the full outsource and the small right to the midsize where we're feeling good about filling out the whole product set from start to finish.

Gary Bisbee - Barclays Capital

Great. Thanks a lot.

Operator

The next question comes from Joseph Foresi of Janney Montgomery Scott.

Joseph Foresi - Janney Montgomery Scott

Hi. My first question is I was just curious. How do you balance the margin profile with the pricing changes, do you really make it up in any kind of market share gain or increase in checks?

John Morphy

Well it's a combination of a lot of factors. You know the pricing change we made we haven't seen all the dynamics. There still is discount in the marketplace and we're just trying to put controls on the margin to expand it. So you know everything is and remember we're on high margins so you take the gross margin of branch level because you get the other stuff. We're (inaudible) less than 75% margin.

Joseph Foresi - Janney Montgomery Scott

All right. So is it really about gaining market share and then the incremental checks will push the margins or is it a volume gain, just trying to get a good feel for it?

John Morphy

I'd say it's all of it. Hard to say it's any one piece of it.

Joseph Foresi - Janney Montgomery Scott

Okay. Any changes that you guys are hearing early on in the characteristics of the sales cycle or the pipelines? Is there any behavior changes on the part of clients?

John Morphy

No. I mean in the core it's going to be one or two sale visit, in (inaudible) it's probably a two or three month visit.

Joseph Foresi - Janney Montgomery Scott

Okay and then just lastly I know you've talked a little bit about new business accelerating or potentially maybe getting better. I'm just wondering on the timing of the new business coming back and any expectations that you guys have for the upcoming sales cycle?

John Morphy

We haven't seen enough yet to know. We're watching it closely but we haven't seen anything really change in this. Maybe a little bit better but not enough to be able to measure.

Joseph Foresi - Janney Montgomery Scott

Okay so just to characterize it. Really what you're saying is there's stability out there and you're waiting to see if there's going to be (inaudible)?

John Morphy

Yes.

Joseph Foresi - Janney Montgomery Scott

Okay. Great. Thanks guys.

Operator

The next question comes from Glenn Greene with Oppenheimer.

Glenn Greene - Oppenheimer

Morning. I guess just the first question back to SurePayroll. Any plans to change how it's been marketed given that it still has a relatively small customer base and you're talking about the five million small businesses doing manual, my guess is that they haven't marketed it as aggressively as they could under the Paychex umbrella? Any thoughts there?

John Morphy

Yes I think we will definitely see more investment going there. I think they marketed well online in the way they've presented themselves but I do think going after the five million users who are doing it manually will be a new initiative and we'll be able to invest in SurePayroll to be able to do that. I'm not sure exactly the best way to do that yet but that's certainly part of the job of the new head of marketing that will come in and take the lead on that.

Glenn Greene - Oppenheimer

Okay and then John just on the revenue per check, and the checks per client, obviously they've been improving but do you sort of expect the same sort of continued improvement in the back half? What are you sort of thinking about in the back half in terms of those trends?

John Morphy

Well we were tracking and we think checks per client should stay about 1% positive. Now this second quarter jumped up a little more than I thought, whether that will continue I don't know. It won't dramatically change what we're forecasting but we'll wait and see. I wish I knew. Already it's, I never thought it would go to 2.5% but I should never say never. It even happens to me too. So I would have thought the 1.0, 1.5 would have been sustainable for a while and we'll see what happens. Now the kind of mixed thing is going to be, the mixed blessing is going to be, I think when new client sales pick up, which eventually they do, then you'll see checks per client affected somewhat by the smarter client size being added in but I'll be glad to get the new sales.

Glenn Greene - Oppenheimer

Yes but at this point you're thinking, probably 1.0, 1.5 for the back half?

John Morphy

Yes.

Glenn Greene - Oppenheimer

And on the revenue per check?

John Morphy

No that was slight. It's off pricing and discounting and got a little bit better but we put this new pricing model in which changed the discount a little bit. Actually you've got to look at it hard because we changed the pricing model. I don't see all the discounting right now but we've got ways to look at that. But that wasn't the biggest change, the biggest change is checks per client but the revenue project did get better and right now the pricing increase that we put in in May was we've got it. Last year we gave it all back.

Glenn Greene - Oppenheimer

Any way to frame how much you've tightened the discounting?

John Morphy

Not yet.

Glenn Greene - Oppenheimer

Meaning you just don't want to share it at this point with us?

John Morphy

No I don't want to share it and I don't quite know yet. Some of it (inaudible) the price so really got to look at the net net.

Glenn Greene - Oppenheimer

Great. Okay. Great. Thank you very much guys.

John Morphy

Okay. Thank you.

Operator

The next question comes from David Parker with Lazard Capital Management.

David Parker - Lazard Capital Markets

Marty. I was wondering. You've talked about the differences between the online Paychex product and the SurePayroll product. Can you just provide some more color on the thought process behind the decision to acquire rather than build from what you had previously?

Martin Mucci

I think when you look at the resources that we have on building, we have a really full slate of products already that we're building on including the mid market. We're making constant improvements there and feel we have a very competitive product and we have a lot of focus on it. And so when you looked at this opportunity that came up with SurePayroll it was, do you want to take upwards of a couple of years to 2 1/2 years to build something like that or do you take some of the experience that they have inn the product that they had and build on top of that and we found that that was a much better approach to take.

I did not want to wait long to have it and I also think there's some experience that over the 10 years that they had in building that product and focusing very much on self service, which is really not our model. Our model has always been that full-outsourced expert that's there to answer anything and set you up and so forth. And we just felt that the combination of their experience and the product that they had over the last 10 years would be a much faster way to get into this market and actually invest in them and support them to build an even better product as that market grows.

David Parker - Lazard Capital Markets

Great and then just in terms of the sales force. Are you doing anything differently on the recruiting side and just with that process and trying to distem the sales turnover that you've seen in the past historically?

Martin Mucci

Yes, I think the recruiting was another piece of the changes that we've put in. We're doing a lot more recruiting in-house now. We were using a lot of external agencies spread out across the country. We've modeled that now into coming inside. We have a new head of recruiting that is handling the recruiting side of it and we're working with the sales managers and leadership in the field on again, what's the best method to find the right person in what you're looking for.

We have made a number of changes in how we're looking at it, how we're recruiting, who we're using to get those candidates and then maybe making sure we're reinvesting in an on boarding tool. By boarding meaning here's what their first six months look like, here's what their first 12 months look and be sure that they're fully supportive because once you get them in an kind of past that first 12 to 18 months, it's a lot easier to retain them. It's in that first six to 12 probably that they struggle the most and I think we could, we reinvested now and revamped our on boarding so we help them be successful from the very beginning.

David Parker - Lazard Capital Markets

And then John, any one time costs associated with the departure of the former CEO that was in the quarter.

John Morphy

No. No they were all in the first quarter.

David Parker - Lazard Capital Markets

In the first quarter. Okay.

John Morphy

That was what that agreement was so if you wanted to look for it you could find it.

David Parker - Lazard Capital Markets

Okay. Great. Thanks guys.

John Morphy

Yes.

Operator

The next question comes from Tien-Tsin Huang of JPMorgan.

Tien-Tsin Huang - JPMorgan

Hi, thanks just wanted to ask a couple of quick questions. On SurePayroll, I like that acquisition a lot. I'm curious, what kind of metrics would you provide on an ongoing basis to help us track the performance there? Any ideas, John Morphy?

John Morphy

We haven't decided.

Tien-Tsin Huang - JPMorgan

Yes because I think it would be recognize by the SEC.

John Morphy

25 meaning revenue, I mean but we'll see what happens. We'll decide that in the future.

Tien-Tsin Huang - JPMorgan

I recognize it's small but obviously schematically it seems like there's some real potential there. That's why I asked.

John Morphy

It's probably like everything else in America. If it does great we'll tell you. If it doesn't we won't.

Tien-Tsin Huang - JPMorgan

Yes. We've noticed that.

John Morphy

Joshing you. Kidding you.

Tien-Tsin Huang - JPMorgan

I know. I know. On the 401(k) match can you remind us what the impact on the P&L will be?

John Morphy

The P&L is about, it's about $6 to $7 million.

Tien-Tsin Huang - JPMorgan

$6 to $7 million starting in January.

John Morphy

January we'll have it the following year but you won't hear us talk about it anymore.

Tien-Tsin Huang - JPMorgan

Okay. That's good, from a following standpoint I just want to know when that -

John Morphy

(Inaudible) being there and from my frame reference now it's, we put it back in. It is what it is. An expense like everything else. It's not like we don't allow expenses. It's just there so it might explain some of the metrics how it's moving but obviously in the first half of next year you'll get it a little bit in your wind but (inaudible)

Tien-Tsin Huang - JPMorgan

Okay. Fair enough. Last one and then I'll let you guys eat lunch. I know Jim and David asked about Ron and Mobile. I think you guys were talking about a tablet for your sales force but I'm curious just in terms of the self-help or online mobile tools for some of your customers above the SurePayroll threshold. What's the status on when we might see some of those things come to market?

Martin Mucci

I don't think we'd say at this point. It's not something that I'd want to say publicly. Our clients, our whole model in the way we sell is we'll take care of everything for you so we're not looking for our client base much to be able to use those tools other than for input. If they want it we've always been able to have, you can do it by phone, fax or online. We have over 40,000 clients that use online for input today but we still like them to be able to rely on us for the full package of expertise and so forth and so we're looking at that but that's not as critical to our client base as it is to the SurePayroll client base. But it's not something I would probably talk about publicly at this point.

John Morphy

(Inaudible) so that everybody understands. Our MMS product, the client does a lot of that themselves so we talk about having this no touch at the bottom and then you think of other people that really want a used software, like the ultimate software model. Our MMS is not really far from their model. It's just they sell a software. We don't. But at the end, you've got maintenance one-way or the other so it really is the same thing so we have products that if the client wants to do an awful lot themselves, they want to do a lot, we have solutions for them.

Martin Mucci

Or sure there's the online, as John said the whole mid market, major market product or one source solution, everything is basically online and packaged and fully integrated and the client knows the input.

Tien-Tsin Huang - JPMorgan Chase

I see. That's a good overview. I appreciate it.

John Morphy

Thanks.

Operator

The next question comes from Giri Krishnan with Credit Suisse.

Giri Krishnan - Credit Suisse

Thanks just a couple of quick questions. Could you update us on what you've seen recently or what you expect to see this week selling season in respect to your pricing in your large national (inaudible)?

John Morphy

Well he'll be out there everyday and he'll do what he's doing and we'll react to it but right now fortunately his pricing activities haven't changed too much over the last six months.

Giri Krishnan - Credit Suisse

Okay so it's not less or more action just about the same?

John Morphy

[Inaudible)

Giri Krishnan - Credit Suisse

And then within your four year guidance what sort of implied revenue from your health and benefits product?

John Morphy

All consistent with what we had with 29% gross. What's in there but again it's not a big enough number where if it misses it's going to make much difference.

Giri Krishnan - Credit Suisse

All right.

John Morphy

It will eventually but not this stage.

Giri Krishnan - Credit Suisse

Right. Okay. Thank you.

Operator

We have no further questions.

John Morphy

Well thank you all very much. Again, we really appreciate your interest in Paychex. We think we have a good process here and wish all of you, your friends and your families a wonderful holiday season and a safe one. So thank you very much.

Martin Mucci

Thank you.

Operator

This concludes today’s conference. Please disconnect at this time.

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