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Paychex (NASDAQ:PAYX)

Q2 2012 Earnings Call

December 21, 2011 10:30 am ET

Executives

Martin Mucci - Chief Executive Officer, President, Director and Chairman of Executive Committee

Efrain Rivera - Chief Financial Officer, Senior Vice President and Treasurer

Analysts

Rayna Kumar - Evercore Partners Inc., Research Division

Nathan A. Rozof - Morgan Stanley, Research Division

Julio C. Quinteros - Goldman Sachs Group Inc., Research Division

Rod Bourgeois - Sanford C. Bernstein & Co., LLC., Research Division

Gary E. Bisbee - Barclays Capital, Research Division

Glenn Greene - Oppenheimer & Co. Inc., Research Division

Joseph D. Foresi - Janney Montgomery Scott LLC, Research Division

James Macdonald - First Analysis Securities Corporation, Research Division

Ashwin Shirvaikar - Citigroup Inc, Research Division

David Grossman - Stifel, Nicolaus & Co., Inc., Research Division

Jason Kupferberg - Jefferies & Company, Inc., Research Division

Timothy McHugh - William Blair & Company L.L.C., Research Division

Tien-Tsin T. Huang - JP Morgan Chase & Co, Research Division

Anthony McCready - Northcoast Research

Vishnu Lekraj - Morningstar Inc., Research Division

Mark S. Marcon - Robert W. Baird & Co. Incorporated, Research Division

Operator

Welcome, and thank you for standing by. [Operator Instructions] Today's conference is being recorded. [Operator Instructions] I would now like to turn the meeting over to Mr. Martin Mucci, Chief Executive Officer.

Martin Mucci

Thank you, Christie, and thank you, everyone for joining us for our Second Quarter Fiscal 2012 Earnings Release Call. And joining me today is Efrain Rivera, our Chief Financial Officer. Efrain will review our financial results for the quarter and our guidance for the full year after my opening comments, and then we'll open it up for your questions.

Paychex delivered solid results for the second quarter. We are focused on our strategy to remain the leading provider of payroll and human resource and benefit outsourcing to America's businesses. We continue to drive growth in revenue and profits while providing industry-leading service and products to our clients and their employees.

Investing in our business remains a priority. We recently launched an expansion of our software-as-a-service product offerings with our new Paychex mobile iPad application. This will permit our clients and their employees to have full access to the products and do anything that they could do now over the Web on a PC or a laptop.

We also unveiled a newly expanded single sign-on landing page and message center that users see when they sign in. This landing page puts all immediate information about the products that a user has in one place and with the full features and functionality of Paychex online services. We continue to invest in product development and supporting technology, which is a key building block to our future success, and we're excited about these new products that we've unveiled.

We were also pleased that several key business indicators continued to show improvement, including the following: Our checks per client have improved for 7 consecutive quarters, with growth for the second quarter at 1.5%. Growth for the first quarter was at 2%, and this moderation in growth was expected and anticipated, and we talked about it on the last quarterly call. Payroll client retention continues to demonstrate improvement, with fewer client losses year-over-year. Client satisfaction results continue to be at exceptionally strong levels, and we find this a particularly telling metric in light of the increasingly complex payroll and Human Resource Services rules and regulations that our clients are required to adhere to.

While we see an increase in sales from our CPA and web referrals, our sales from new businesses are on par with last year. Our main selling season is about to get underway, and we have -- we will have a better read on the selling environment in the next quarter.

Having the sales leadership in place, our new compensation plan, revised training programs and next-generation sales force tablets with improved lead generation position us well for the selling season, and I believe our sales force is doing an exceptionally good job at communicating the strength of our national brand and product and service quality. In addition, in the first 6 months, we have experienced a decline in the payroll sales rep turnover, a statistic that had increased in the same period just a year ago.

While continuing our product development investment in the Paychex next-generation applications, we were able to achieve strong operating margins by improving productivity and leveraging expenses. We have reaffirmed our expectations on full-year guidance provided in June. We expect that increases in checks per client will continue to moderate through the remainder of fiscal 2012 as quarterly comparisons become more challenging. We also expect to continue planned investments in our business, which will impact our operating income margin.

Our 2 acquisitions in 2011 are creating excellent opportunities in both of their markets. SurePayroll continues on track in the do-it-yourself online SaaS market, and we continue to make inroads in the financial advisor marketplace with ePlan Services, which further expands our successful 401(k) services business, where we continue to sell and service more plans than anyone else in the industry.

Both SurePayroll and ePlan offer quality service and from a client standpoint allow Paychex to offer the full range of payroll and 401(k) outsourcing alternatives. Clients who want more control have SurePayroll on the payroll side, where clients who want a high level of personal interaction with a dedicated payroll specialist have the fully outsourced model we're known for.

I would now like to turn the call over to Efrain Rivera, who will review the financial information. Efrain?

Efrain Rivera

Thanks, Marty. Yesterday afternoon after the market closed, we released our financial results for the second quarter and 6 months ended November 30, 2011 and filed our Form 10-Q. It provides additional discussion and analysis of the results for the year. These are available by accessing the IR page at Paychex.com. This teleconference is being broadcast over the Internet and will be archived and available on our website for about one month.

As Marty said, Paychex delivered solid results for the second quarter of fiscal 2012. Some of the key highlights are as follows: Checks per client increased 1.5% for the second quarter and 1.8% for the 6 months. The growth has moderated slightly from the 2% we saw in the first quarter. But as we stated in that quarter, growth in checks per client was expected to moderate through the year, impacting quarterly comparisons in our payroll and HRS revenue.

Total service revenue grew 7% for the second quarter and 8% for the past 6 months. If we exclude SurePayroll and ePlan, this growth would've been 5% for the quarter and 6% year-to-date. Operating margin, which is our operating income net of certain items compared to our total service revenue, came in at 38.7% for the second quarter. Our year-to-date margin was 39.2%. We'll discuss this more later on. The interest rate environment remains at historically low levels. Our combined portfolios have earned an average return of 1.3% for both the second quarter and 6 months, down from 1.5% last year.

Now I'll take you through our results as presented in the consolidated income statement with some additional highlights for the second quarter and first 6 months. Payroll service revenue increased 5% both for the second quarter and year-to-date periods. Organic growth in payroll service revenue excluding SurePayroll was 3% for the second quarter and 4% for the 6 months. We benefited from strong checks per client and improved revenue per check.

Revenue per check increased as a result of price increases and improvements in discounting in our overall client base. Human Resource Services revenue increased 12% for the quarter and 15% year-to-date. Excluding ePlan, HRS revenue growth would have been 10% and 12%, respectively. This growth in HRS revenue reflects the increase in check volume, price increases and growth in clients and client employees, particularly in our Paychex HR solutions offerings. In addition, our insurance services continued to benefit from growth in health and benefits revenue of 27% for the quarter and 25% for the 6 months, as the number of applicants continues to increase.

Combined interest on funds held for clients and investment income decreased 8% for both the second quarter and 6 months. Yields available on high-quality securities continue to remain low. Expenses increased 6% for both the quarter and 6-month periods, largely due to expenses from SurePayroll and ePlan. We continue to invest in product development and supporting technology.

Our operating income net of certain items, which excludes interest on funds held for clients, increased 8% for the second quarter and 12% for the 6 months. As discussed previously, operating margins were at 38.7% for the second quarter and 39.2% for the 6 months. These margins were up from their respective prior year periods, and the increases were driven by leveraging personnel costs and expenses and the timing of spending on [indiscernible] projects.

If you recall, it is not unusual for our margin to drop in the second quarter from the first quarter, as our first quarter typically reflects the highest operating margin of the year, and this year was no exception. Operating margin is expected to be in the range of 36% to 37% for the full year.

Our financial position remains strong, with cash and total corporate investments of $676 million as of November 30 and no debt. Our cash flows from operations were $297 million for the 6 months, a 7% decrease compared to the prior year, resulting from fluctuations in operating assets and liabilities, primarily due to timing, partially offset by higher net income adjusted for net cash -- net non-cash items. Working capital fluctuated with the timing of collections from clients and payments per compensation and PEO payroll. Non-cash items increased due to additional depreciation and amortization from our business acquisitions and an increase in the deferred tax provision.

Funds held for clients as of November 30, 2011 were $3 billion compared to $3.6 billion as of May 31, 2011. Funds held for clients vary widely day-to-day and averaged $3.1 billion for the second quarter and $3.2 billion for the 6 months. This amount represents a year-over-year increase of 8% and 9%, respectively. Higher average invested balances resulted from several factors: SurePayroll client funds, wage inflation, increases in state unemployment insurance rates contributed about 2.5 basis points for the 2011 calendar year and the increase in checks per client. Our total available for sale investments, including corporate investments and funds held for clients, reflected net unrealized gains of $54 million as of November 30, 2011. Net unrealized gains as of May 31, 2011, were $59 million.

Our investment strategy is conservative, and we have not recognized or realized any impairment losses on our investments. Our investments are high-credit quality, with more than 95% of the portfolio rated AA or better. Our priority has been and will continue to be to ensure we can meet all our cash commitments to our clients.

Total stockholders' equity was $1.6 billion as of November 30, 2011, up from $1.5 billion as of the end of May, resulting from earnings and reflecting $228 million in dividends paid during the first 6 months. In October, we increased our quarterly shareholder dividend 3% to $0.32 per share. Our return on equity for the past 12 months was 35%.

I'd like to remind you about a couple of our policies regarding guidance. Our outlook is based on current economic and interest-rate changes -- rate conditions continuing with no significant changes. Our projections don't anticipate or speculate on future changes to interest rates.

We expect fiscal 2012 results to be consistent with the outlook we provided back in June and reaffirmed in September. We expect checks per client will moderate through the fiscal 2012, impacting quarterly comparisons in both payroll revenue and HRS revenue. We have planned spending, which will impact our operating margin.

We continue to project payroll service revenue will increase in the range of 5% to 7% compared to fiscal 2011. HRS revenue growth is expected to be in the range of 12% to 15%. Total service revenue is expected to increase in the range of 7% to 9%.

Interest on funds held for clients is expected to decrease in the range of 12% to 14% due to longer-term investments maturing and being reinvested at lower rates. Investment income net is projected to be in the range of flat to 2% growth. This is lower than what we normally experience due to the cash outlays in fiscal 2011 for business acquisitions. Net income is expected to increase in the range of 5% to 7%. Operating income net of certain items as a percentage of service revenue is expected to be in the range of 36% to 37%.

The effective tax rate for fiscal 2012 is expected to approximate the tax rate experienced in the first 6 months. Interest on funds held for clients and investment income are expected to be impacted by a continuing low interest rate environment. The average rate of return on our combined portfolios is expected to be 1.2% for fiscal 2012.

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 result. Please review our Safe Harbor statement in the press release for our discussion of forward-looking statements and the related risk factors.

Operator, we will now open up the meeting and the conference call to questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question is from Rayna Kumar with Evercore Partners.

Rayna Kumar - Evercore Partners Inc., Research Division

Calling in for David Togut. What was your sales force turnover for the quarter?

Martin Mucci

We don't really give that number out specifically, but it's back in the range of the low 30% range, which is similar to where we were historically. We were down a little bit in the first quarter. Then, second quarter, we were still holding pretty well. We're down where we have been more traditionally. Last year, we peaked up closer to 40%, and so we're down around the low 30s.

Rayna Kumar - Evercore Partners Inc., Research Division

Great. And finally, you recently increased your dividend by 3%, but your earnings growth outlook is double that. Why didn't you raise your dividend the same as your earnings growth outlook?

Efrain Rivera

We look at that carefully and compare it to where we see our earnings increase and try to target a payout ratio that is in the 80% range.

Operator

Our next question is from Nathan Rozof with Morgan Stanley.

Nathan A. Rozof - Morgan Stanley, Research Division

You guys have been -- or you continue to make investments in your SaaS offerings and the iPad app and the single sign-on, I think are positive outcomes from that. So as you prioritize your future investments, is there going to continue to be an emphasis on the SaaS products or your more traditional full-service product? Or can you give us some kind of insight into how you're thinking about your opportunities for investments in one platform versus the other?

Martin Mucci

Yes, sure, I think it's -- SaaS certainly will continue to get investment, but so many of our clients, I think we have about well over 120,000 clients on some SaaS-based cloud model. So we feel very good and very strong in that respect of our online products. And then on the full outsourced, we will continue to invest because the majority of our clients are still on a fully outsourced. And we made a big investment a few years ago, converted all the clients over to a new platform and have been working on that now for a couple of years. That really assists the internal client -- our internal service providers, and we'll continue to invest in both. I think it's always going to be -- you got to stay on top of the technology, and we feel we're actually a little bit of a leadership on that piece on the online clients for our space and with what we've just introduced. And you got to stay on top of the service. So we feel very good that between the technology and the very high service satisfaction numbers we're showing and continue to show that we'll just keep investing in both and making sure that we have what the client wants.

Nathan A. Rozof - Morgan Stanley, Research Division

And then just one follow-up on the same theme. You obviously indicated that SurePayroll added about 2 points of growth to the payroll revenue in the quarter. But can you give us any sense of how that business grew on a year-over-year basis relative to the payroll service segment as a whole?

Martin Mucci

I think what I would say, Nathan, is it's been right on track with what we had expected. We're pleased with what they've been doing and in the business cases we looked at. So they're continuing to grow well. It's certainly strong double-digits and client-based, and we'll know more after the selling season. But they're right on track with what we had expected.

Operator

Next question's from Julio Quinteros with Goldman Sachs.

Julio C. Quinteros - Goldman Sachs Group Inc., Research Division

Marty, this question is for you real quickly. Just in the way that the sales season is sort of set up, obviously, the new applications and the iPads and your sales force improved turnover. When you look at this upcoming sales season, what would you expect to see in order to declare it a successful season? Any benchmarks or metrics that you're really looking for to turn favorably in order for you guys to really feel like this was a good season and you would yield the investments that you made in the last couple months here?

Martin Mucci

Well, certainly, we're looking for an increase over last year. And what we're seeing overall is more flattish, I think. And I think, as I said, we've seen referrals -- the good news is we're seeing referrals -- sales closing from the referrals on CPA -- from CPAs and Web marketing up, and that's very good. What we're still seeing very kind of mixed is the new business formation. They're really more on the flat side and that kind of hold things down. And I think there's some good signs, there's some mixed signs on the new business formation, right? There's consumer confidence, which has been up for a few months, which hopefully will drive more people to start their new businesses. But then you see things like small business lending, which is at an all-time low. So I think what we'd like to see is obviously just an improvement more on the new business side because we think the other pieces are actually going pretty well.

Julio C. Quinteros - Goldman Sachs Group Inc., Research Division

Okay. And just as a quick follow-up. With the debate going on in Congress regarding the payroll tax situation, how should we think about that in terms of impact to your business? Is it opportunity? Is it risk to people? Could it freeze people as Congress goes through this debate? Any thoughts around that would be helpful.

Martin Mucci

Yes, I think it's always a mixed message. I think one, I do think the more that there's gridlock like there is and there's concern with people who are starting new businesses, maybe I shouldn't start it right now because I don't know what's going on with tax credits or taxes to small business or anything like that. On the other hand, I think those that may be in business and have not outsourced their payroll look to someone like us to say, "I can't keep up with all those changes and things that are going on." So I think it's a mixed bag right now. I think that no matter what happens on the current payroll tax piece, we're ready to handle it and we can make those changes very quickly. So it's not going to impact, certainly, the day-to-day business. But overall, I think it may drive a few more people to say, "I'm just going to outsource this. I can't keep up with all of the administrative changes, tax credits, hiring credits and so forth that are going on."

Operator

Our next question is from Rod Bourgeois from Bernstein.

Rod Bourgeois - Sanford C. Bernstein & Co., LLC., Research Division

Okay. Can you tell us the organic year-over-year growth or the shrinkage in your number of clients? And then also if you have any updates on other metrics like growth in your bookings or your sales out of businesses and any growth from business starts? Any update on any of those metrics would be helpful.

Efrain Rivera

Rod, what I'd say is over -- from year end, we're up modestly in clients. Yes, on an organic basis.

Rod Bourgeois - Sanford C. Bernstein & Co., LLC., Research Division

Is that on an organic basis? Okay then.

Efrain Rivera

Excluding SurePayroll.

Martin Mucci

Yes, that excludes SurePayroll, so we're up moderately. I'll jump in on the losses, where out of business continued to improve, although that's moderating because we saw the best improvement over the last year. But that's still getting better. Losses overall are better. Retention -- let me put it that way -- retention is better year-to-date versus last year. So we continue to see that improve, and that's certainly in out of business as well. So it kind of plays into the current client base continues with the checks up, fewer businesses going out of business. That continues on a path that has now been 7 quarters of improvement. The tricky part is still when will more new businesses start up, which is more flat to last year, at least the sales from there, anyway.

Rod Bourgeois - Sanford C. Bernstein & Co., LLC., Research Division

Right. Okay. And just you had quarter-to-quarter growth deceleration in both HRS and payroll. And I guess, I'm wondering, do you feel like execution of late has been less than desired, particularly in the area of sales or customer service? And if so, are there any initiatives planned to try to make improvements in those areas? I know you've had a number of management changes. Should we be expecting more from an execution standpoint in the upcoming quarters as new management team members sort of get their feet more in place?

Martin Mucci

Let me start on that one, Efrain, and then I'll let you jump in. I think from an execution standpoint, I feel very good. The operations side, the service numbers, the service satisfaction results have never been higher. And so we maintain a very high number there that we monitor very closely, and we're real excited about that. So that execution is great. On the sales side, I also think they're really doing a good job selling the national brand that we have, the strength that we bring to the markets, the new technology and so forth. So -- and we continue to show growth, particularly in 401(k), insurance and HR outsourcing. The payroll is a little bit tougher because of the new business starts. But when you see CPA referral, sales from CPA referrals and things picking up, to me, it all shows that execution is going pretty well.

Efrain Rivera

Rod, the other thing I'd say about both HRS and payroll is that we had a really strong first quarter in HRS. There were a number of factors there that were unique to that quarter that we knew were not going to repeat in the second quarter, particularly in the 401(k) business. So I think our HRS results were in line with what we expected. And it's not atypical for the first quarter to be stronger in payroll revenue than the second quarter, that just is gating in the way our business works certainly in recent years.

Martin Mucci

And I think from the leadership team perspective, everybody is in place. I'm sorry, Rod, everybody's in place and feeling really good that the team has come together very well. And everything's filled, including we just announced the hiring of a VP of IT Operations that filled a retirement slot. And we feel very good about the strength of the team and how they're all kind of jumping right in. So very engaged in working well together, and particularly the Head of Sales who's been on now a few months and is extremely engaged now with his team of kind of the seasoned professionals that have been out there.

Rod Bourgeois - Sanford C. Bernstein & Co., LLC., Research Division

Yes. Let me just ask it this way. I mean, when the year-over-year growth rate decelerates, it's not due to seasonality. And we know your business starts, you've indicated, have slowly improved. Your net pricing is up, your checks per client is still up year-over-year, and your retention, you just said, is also improved. So I guess, I'm wondering what other factor is contributing to the deceleration if business starts, pricing, checks and retention are all up?

Martin Mucci

I think what Efrain was saying is in the first quarter, if you're looking at payroll service growth, it was up 4% and then up 3% now. It was more of some kind of one-time things in the first quarter that benefited some of that. It wasn't a big difference. And there were some one-time things there that happened. We really don't see from an execution standpoint any concern at this point. It's really that new business formation that's probably the biggest question mark.

Operator

Our next question is from Gary Bisbee with Barclays Capital.

Gary E. Bisbee - Barclays Capital, Research Division

Let me add on to that. I guess I just want to push back at this line that was in the press release and the 10-Q and each of you said in your comments that checks per client growth will moderate in the remainder of the year. When I look at the employment data, it's strengthened modestly on an overall basis. The year-to-year growth in total employment in the U.S. is faster now than it was a quarter ago. And if you believe the small business segment of the ADP employment report is a good proxy, that's actually grew in this past quarter 1.9% year-over-year and seems to be gaining momentum. So first of all, I guess, I don't understand why checks per client would decelerate. The comp gets slightly tougher next quarter, but I think that's sort of irrelevant if the overall health of the employment market has improved a bit. And then, secondly, any thoughts as to why your checks per client would be growing somewhat slower than that small business employment segment within ADP's data? Because adding onto what Rod was asking, it just feels like you've lost some momentum somewhere here in the business.

Efrain Rivera

Well, first of all, if you look at last year's last quarter compared to this one, we're 2.5% increase to 1.5%. And I think what we're saying is it's hard for us to call that precisely. But what we're seeing is some level of deceleration from the growth rates that we had in previous quarters. That's our best estimate at this point. We can't get any more granular than that.

Martin Mucci

Yes, I think it's just -- it's tougher comparisons, and what we see that it will moderate now. It's always hard to tell, but that's what we feel at this point. I don't know why it would be -- those are big -- the big indexes that someone like ADP uses. And so it could be larger businesses doing better. Sometimes you see that in their hiring versus the smallest, when we have 80% of our clients under 20.

Efrain Rivera

And this is the longest extended streak certainly in the last decade in terms of increases in checks per client. So at some point, we just think that runs its course.

Gary E. Bisbee - Barclays Capital, Research Division

But I mean, I guess, in a normal growing economy, you've got growth. And I know historically, 1%, 2% has not been an unreasonable number. So it's not like it's below that. I can't figure, though, why it would decelerate further. Is there just some level of conservatism in that? Or are you seeing something from your employees that's different from the overall job market, which seems to be gaining a moderate amount of momentum right now? If it's conservatism, then that's fine. I just -- I'm trying to understand if there's something...

Efrain Rivera

Yes. Well, look, we don't have any better data to suggest it's going to -- not going to moderate, I guess, I would say, one. And second, our history tells us that at some point, it will start to slow down, and our assumption is we're now 7 quarters into increases in quarter-over-quarter checks. And we're thinking as the comps get harder throughout the year, that rate's going to come down. Now we don't think it will go to 0, but we think it moderates.

Martin Mucci

Yes, I think the other thing, when you look at the economy, it's not that robust. It seems to be pretty mixed. And so you think the hiring does pick up for a while, and at some point, what you saw a year ago or so was productivity had kind of reached its peak and the small businesses started to hire back. But again, I'm not sure there's a tremendous demand from a consumer standpoint for all their services, so how long will they continue to hire more than last year? So I think it's just, as Efrain said, a historical trends, what we can see and that's kind of our best guess. Obviously, don't have a crystal ball there; just trying to look at it from our historical trend.

Gary E. Bisbee - Barclays Capital, Research Division

Okay. And then just one shorter follow-up. Can you quantify or give an order of magnitude about the margin benefit you've been achieving from the efficiencies from putting in the new payroll platform a couple years ago? And the context I'm asking around is that you've done such a good job over time, growing cost more slowly than you grow revenue. And I guess, given the technological change that's going on, I sometimes fear that maybe that's leading to lower levels of investment than you might otherwise be making this supreme focus on the margins. Maybe if you could help us understand how much efficiency gains you've gotten that may be masking a much higher level of investment. That would be helpful.

Martin Mucci

Yes, it's a good question. I think what we've continued to say is our IT, our investment in product development and IT delivery of the services is up double digits. And it's from an expense standpoint, and that's one of the few things that is and probably will continue to be. We've never stopped investing. And so we really have gotten good efficiencies out of the new platform and continue to keep looking for other efficiencies. And as you know, as you said, we're very good at that. And so the operations side has continued to do what it's always done, which we keep trying to drive out cost whatever we can and invest that over in the other side into the IT and the product development. And we're pleased that, that now has some fruit by showing the iPad and the single sign-on and new platforms and so forth. So we never take our eye off of a significant investment in the IT and the product development.

Operator

Our next question comes from Glenn Greene with Oppenheimer.

Glenn Greene - Oppenheimer & Co. Inc., Research Division

Just wanted to drill down a little bit more on the attrition. I know you talked about fewer client losses year-over-year. But I was wondering if you could tell us where you are in attrition and just sort of update us on sort of the composition of it, how much is coming from failures, et cetera?

Martin Mucci

It really hasn't changed too much, Glenn. It's been -- we're down, in total losses we're down, so better attrition year-over-year. Out of business is still down a little bit. And the relationship that I think we've given before is probably 60% to 2/3 come from out of business, and so that's continuing to help us. And then there's some for price or combination, where they become -- some business takes them over and has a different payroll provider. But the mix of losses has not changed much and attrition and the...

Glenn Greene - Oppenheimer & Co. Inc., Research Division

Are you still sort of a 21%, 22% overall, as I recall?

Martin Mucci

Oh, I'm sorry. In total, yes, yes.

Glenn Greene - Oppenheimer & Co. Inc., Research Division

So that's still about the same place?

Martin Mucci

Yes. Yes.

Glenn Greene - Oppenheimer & Co. Inc., Research Division

Okay. And then just on the pricing side, not so much the rate card increases that go on every year. But what are you sort of seeing out in the market as you try to go after new business, whether it is the small business that’s just been formed? Obviously, a lot of competitive factors whether it's from the big national player or regional players or even sort of online payroll players. But what are you seeing out in the market for competing for new business?

Martin Mucci

Pretty much the same. It's competitive. But I wouldn't say it's changed a lot. There's always discounting that goes on. But we feel like we've held our price increase pretty well, and that's an indication that we still have some pricing power there. So I'd say it's pretty much the same. I think we're winning a little bit more on the regional or local competitor kind of frame and about the same on the national provider, probably the same thing. And I think on the local, it's because of the technology and so forth that the national providers can provide a better technology than the local.

Glenn Greene - Oppenheimer & Co. Inc., Research Division

And then just finally, quickly I just want to go back to the margin question, more specifically related to this year. I mean, you sort of upticked your margin expectations a bit. Wondering what that was attributable to. Is it maybe more cost takeout on the acquisitions? Maybe slower investment this year? Just wanted to get a little more color on what you were thinking in terms of the margins for this year.

Martin Mucci

Yes, I think one, when we look at the second half of the year -- first of all, we obviously have been stronger in the first half of the year. And so we kind of see the second half of the year as we normally do. Some expenses, like selling expenses will probably pick up as there's more sales, and we add sales people usually in the fourth quarter that picks up. But we're not under-investing the technology. It's just as we're seeing some of the savings from the first half of the year continue on from the operations side. They’ll still be offset, but it leaves us a little bit higher than we had expected.

Glenn Greene - Oppenheimer & Co. Inc., Research Division

So it's just -- if it’s coming out of the first quarter, so I think you sort of suggest the timing of investment spending would sort of pick up throughout the year, is...

Martin Mucci

Yes.

Glenn Greene - Oppenheimer & Co. Inc., Research Division

Are you sort of saying that may not necessarily be the case at this point?

Efrain Rivera

No, no, no. IT investment ramps as the year progresses. It's tracking now about where we'd expect it to be. What Marty was saying is we've had very good productivity on the operations side. That will continue.

Operator

Our next question is from Joseph Foresi with Janney Montgomery Scott.

Joseph D. Foresi - Janney Montgomery Scott LLC, Research Division

I wonder if you guys could frame for us just the difference in the business, maybe compare the margins between the technology side of the business and the services one, now that you have these 2 acquisitions. And then maybe you could give us some color on how that's affected your sales cycle. In other words, what's your go-to-market? Has it changed? Are you leading with technology instead of services now?

Efrain Rivera

This is Efrain. On those 2 businesses, it's too early to tell because they're not at scale. So if we go back a year, we said when you added in the cost of those 2 businesses, we're going to end up with $0.01 dilution, that’s still going to be the case for the year. So a little early to call. On the SurePayroll side, you really have to be at scale to understand what their margins will be, and we're still early in that cycle in terms of calling precisely what the margin will be. They're both small enough at this point, and we don't anticipate certainly in the intermediate term, 24 to 36 months, to see them have a significant impact on overall business margins.

Martin Mucci

And I think from a leading -- from a sales perspective, we're still leading with service. That's what we're known for, is an outsourcer of HR and payroll and benefits. I mean, service is number one and our sales team still leads with a great service that we'll provide for the clients and the value. But you got to have the technology with it, so they're certainly showing the technology options that are out there, but they're number one, still selling on service.

Joseph D. Foresi - Janney Montgomery Scott LLC, Research Division

Do you feel like there's -- the dynamic is starting to change in the industry just in general on -- are you seeing more competition that maybe sells technology first or just solely technology? Have you seen any shifts, given where we are on the economic cycle?

Efrain Rivera

Not really. I don't think so. I think it's still, because of the small business environment, it's still more the service piece of it that you're going to take care of everything for them, you're going to keep track of all of the changes and the tax filings and so forth. That's number one. But the technology is certainly coming along as a benefit that the client uses. We have a lot more clients. We have -- the majority of our clients use our online reports, for example. And so you have to have that as part of your portfolio that you're out there selling, that you have online reports, and you have online access, and you have an iPad offering that you can do anything from, that you can do on your PC, but you have to have the service. The technology won't sell it. It's the service and then the technology kind of rounds it out.

Joseph D. Foresi - Janney Montgomery Scott LLC, Research Division

Okay. Just I’m going to squeeze maybe 2 more in quickly. But do you think -- I mean, let's take 5 years from now, do you think that you'll see something or do you think that technology can potentially lead over a longer period of time? And then I just have one last final follow-up.

Martin Mucci

Yes, I think it's always going to be on a -- there's always going to be some kind of a sliding scale of the service and the technology. And I think, certainly, over 5 years, you would assume based on particularly younger people starting businesses and being used to the technology, that it’ll lean toward the technology. But in the end, the technology -- you've got to make it easy for the small business. And if it's the technology, we're going to offer that. If it's the service only or in combination with a technology, that's what we're going to offer. The focus is always going to be adding value to that small business to let them focus on what they do and free them up to what they do. And whatever way they want to see it, we're going to be able to sell it. So technology will play a more important role. But in the end, if you're not a big service provider who can really take care of all the changes and things that they need done, it's not going to sell.

Joseph D. Foresi - Janney Montgomery Scott LLC, Research Division

Okay. And the last one, if I could just squeeze it in. Maybe you could just talk about the HR offering. In general, it seems like clients are more apt to do more outsourcing in that particular vertical, especially with what's going on in the economy. Maybe you could just talk about the client decisions, how it's looking going forward and what you’ve seen historically and any kind of comparison.

Martin Mucci

Yes, I mean, we're still seeing very good growth in the HR outsourcing, whether it's the PEO or the ASO model. And we introduced a new product on the low-end called HR Essentials, which allowed you to just have telephonic support as well if you want to kind of just break into this. But we're certainly seeing still a big market for HR outsourcing. And the benefit of us is obviously having 564,000 clients or more, we can go into that client base that already knows pay checks, using us for payroll and say, "Hey, we can now take and support you from an HR outsourcing perspective," and that service has continued to grow very well. We have over 400 HR generalists that are out in the field supporting probably 40 clients a piece or so. And this is a service we see continuing to grow. It's a great market. And I do think, as you've mentioned or questioned, it's continuing to grow because more businesses just need to outsource the HR and it's easier to do.

Operator

Our next question comes from Jim Macdonald with First Analysis.

James Macdonald - First Analysis Securities Corporation, Research Division

I noticed your PEO direct costs are down double digits this quarter. Has there been any kind of strategy to downplay PEO or why would that be?

Martin Mucci

No. Actually, we had a bit of a bump that we talked about with the PEO. We had a pretty high insurance rate change last year. And so it kind of carried in that it slowed some of the sales in the PEO to start with. We got that back on track about 2 quarters ago. And I think it's just kind of -- it still hasn't picked up necessarily the speed. But we're seeing a lot more sales submissions and things. The products in much better shape now, the insurance rates and so forth. PEO business is kind of spiky. It kind of jumps around with how your rates are and so forth, and we feel we're very much back on track. But in this quarter, there were fewer sales than we would've seen last year. But we feel that's picking back up again. And the ASO basically kind of balanced that out, to be honest with you. But the PEO is a little bit slow. We feel it's now turning back stronger.

James Macdonald - First Analysis Securities Corporation, Research Division

Just a quick follow-up. I think you hinted previously -- you might consider share repurchases. Any update on that possibility?

Efrain Rivera

Well, it's ultimately a Board decision. We have a continuing conversation on that. We had very, very modest dilution in the quarter, frankly, really at the noise level for us. But any decisions would occur at the end of the year when we've had a sense about what opportunities are out there from an acquisition standpoint and other potential uses of cash.

Operator

Our next question is from Ashwin Shirvaikar with Citi.

Ashwin Shirvaikar - Citigroup Inc, Research Division

My question, my first question is on cash flow. It's been now 2 quarters in a row that the cash flow has been down on a year-over-year basis, and the working capital trend seems to be unfavorable. And I just want to delve into that and ask you.

Efrain Rivera

Yes, 2 things. If you look at cash flow, you got 2 things going. One is an increase in AR, and second is a decrease in payable. Ashwin, that' sheer timing. Because our quarter ended on November 30, the day that quarter ends can impact when AR is collected or not. It just happened to fall in such a way that it impacted the collections.

Ashwin Shirvaikar - Citigroup Inc, Research Division

Was it timing the previous quarter also?

Efrain Rivera

Yes. It's a somewhat unusual year in that respect.

Ashwin Shirvaikar - Citigroup Inc, Research Division

Okay. And then going back to the selling season question. Is there going to be sort of a differential in your initial pricing expectations on the SaaS side versus the traditional side? How are you pushing each of those?

Martin Mucci

Well, on the SaaS side, being mostly SurePayroll, they're obviously -- and there is different pricing there that they've had in place and we've maintained, and so that's there. On our side there's not that much difference in the pricing at this point for the online clients, the SaaS-focused clients. And in the core payroll business, than when you go to the mid-market, major market business for us, there is certainly more pricing flexibility there that they use on the larger accounts, and about 60% of those now are on a Saas-based hosted model. So I wouldn't say it's too much different on the traditional paycheck. It's certainly different on the SurePayroll SaaS.

Ashwin Shirvaikar - Citigroup Inc, Research Division

Okay. And just to understand, has the way you calculate your checks per client changed since the acquisition of SurePayroll?

Efrain Rivera

No, no. And we exclude, by the way, SurePayroll from that calculation.

Ashwin Shirvaikar - Citigroup Inc, Research Division

It is excluded and it doesn't...

Efrain Rivera

It is excluded, yes. Yes.

Ashwin Shirvaikar - Citigroup Inc, Research Division

So it's not the same-store sales metric, either?

Efrain Rivera

Yes, it's not.

Operator

Our next question is from David Grossman with Stifel, Nicolaus.

David Grossman - Stifel, Nicolaus & Co., Inc., Research Division

Marty, you talked pretty openly about new business formation being challenged, and obviously, that's been an issue for some time, and a lot of that kind of tied to this financing that's available. Is there anything percolating, either in Congress or otherwise, in the private sector that may change that independent of kind of the macro environment improving?

Martin Mucci

I think I don't see anything necessarily in Congress, although they're certainly focused on it and trying, right, to increase small business strength and startups and so forth. So maybe they'll come up with something. I haven't seen it yet. I don't think necessarily payroll taxes do that or hiring credits. Because you're only going hire if somebody's buying the services. I think the most positive thing we've seen is that consumer confidence being up for a quarter or so now. And I think that's positive because if people are spending more, that's going to drive more small businesses to get started. The lending piece is a little bit discouraging only because if they can't borrow, if it's tough to get the money, then they won't. But there's people that also say that banks were always hesitant to lend to brand-new small businesses, and mostly it was family and home equity. So then you go to home equity, and of course, that's not bouncing back quite yet, but it certainly looks a little more positive. So I'm not really sure to answer your question, David, that there's much that Congress can do. I wish I had an answer for them. But I do think that there are some signs that it's starting to come back just moderately and so we're still hopeful.

David Grossman - Stifel, Nicolaus & Co., Inc., Research Division

So with that said, how dependent is your revenue guidance for the second half of the year depend on new client growth in the second half of the year?

Martin Mucci

Not much in the second half of the year because when you think about it, if a client starts January 1, there's not a lot of revenue there for the rest of the year for us. So there's not a big impact this year. It's more of an impact next year, honestly. And that's what we're looking at. But what we go after is, okay, if new business, and as we've been doing, if new businesses isn’t starting up quite as fast, what are the other channels? How do we get more CPA referrals, how do we get current clients to give us more referrals? We've used the Web more, those other kinds of -- how do we win over more business from a competitor. And we certainly see that as training of the sales force to attack that a little bit more aggressively and for technology, things that will encourage clients to move from one competitor to the other. And I think we're doing that, and we've been doing that for a while to say, "Okay, if it starts up, that's going to be a great plus for us. If it kind of stay flattish, which is what it's been doing, the new business, then we'll attack the current clients that are out there."

David Grossman - Stifel, Nicolaus & Co., Inc., Research Division

And I know you're not going to want to comment beyond the fiscal year. But just at a high-level then, given the pricing and retention dynamics and all the comparisons that we've talked about, is the growth rate in the core business in the second half of the year a good starting point for next year, assuming just an economy that's bouncing around and the credit environment stays relatively flat?

Martin Mucci

Well, I think, hopefully, it's going to be better. I mean, you see -- there’s certainly better signs than if you went a year ago or even 2 quarters ago. The signs are better that things will improve. And we still have -- I mean, the good news is, we still look like we have pricing power, right discounting hasn't changed much, so that's there. You got the current client base, you got more products and technology that we're offering. So I don't know. I mean, new business starts always being flat. Again, they're not down, they're flat. So I think it's hopefully from what we could see, we should expect a pick up a little bit over time. It's just a slow recovery. It's not no-recovery, but it's a slow, moderate kind of recovery that's going to take a little time.

Operator

Our next question is from Jason Kupferberg from Jefferies.

Jason Kupferberg - Jefferies & Company, Inc., Research Division

Wanted to take your temperature a bit. Just on new sales. I know you guys aren't disclosing the specific metrics there. But just relative to your expectation, we're sitting here a little bit more than halfway into your fiscal year. Are you comfortable what you've accomplished fiscal year to date in terms of new sales? Has it been any better, materially better or worse than you would have envisioned at the outset of the fiscal year?

Martin Mucci

Well, Jason, I always want more sales no matter what the number is. But I think it's hard to tell in the first half of the year. Selling season, we always get more clients the last half historically. So I think it really -- we're right into that time now that will always give you a better sense at the end of the third quarter is to how kind of December, January, when January in particular. So it's a little hard to tell. I mean, obviously, when you don't have as much of the new business starts out there, it makes it a little bit more challenging. But as Efrain mentioned earlier, the client base is up moderately from the start of this year, down from the previous year, of course. But this fiscal year, we're up a little bit. And certainly, we'd like to see it stronger. But you know, the other thing that's encouraging to us is the other products are selling well into the base, and a thing that's an encouraging signal for us. 401(k) still growing, HR growing and insurance growing 20%. That means client are spending. To me, that's hopeful that things are coming back.

Jason Kupferberg - Jefferies & Company, Inc., Research Division

Right, right. And just to pick up on that point on the new business formation. Obviously, it's been a recurring theme on this call, that it does remain to some degree, a headwind. Does that make you look to be more aggressive in trying to get competitive takeaways? I mean, when you think about your new sales bogie going into a given year some of it’s going to come from new business and some of it's going to come from a competitive takeaway. Do you tilt more towards the competitive takeaway side when you're in this kind of cycle as this part of the cycle in terms of new business formation? And to the extent that is true, is there more opportunity for you to accomplish these competitive takeaways against the national players or more with the smaller local guys.

Martin Mucci

Yes, I think, certainly, if you're not getting it from the new business, or as much from the new business as you wanted, you absolutely go after. The sales force is never going to fail. They're going to go after whenever they can. And so there's going to be more emphasis on the competitive takeaways. And I think our continued investment in technology and the service results really help with that. Particularly, I think on the local competitor aside, the more regional player, the technology helps a lot. On the national player, I think it's our service that we've been known for. It's always kind of sets us apart, in my opinion. So you definitely go after that a little bit more, and we watch closely that doesn't lead to more discounting and so forth. And at this point, we're not seeing that. It's just being a little bit more aggressive on current clients, and the sales force is certainly up for it.

Jason Kupferberg - Jefferies & Company, Inc., Research Division

Okay. And then just last one for me. A bit of a couple months ago, there was an announcement from Bank of America and Intuit they have a new full-service payroll product to go along with their pre-existing self-service offerings. I'm sure it's kind of early days for that new product, but have you guys heard anything about that out in the field? Is it any kind of incremental competitive force out there that you're paying attention to? And any sense of how its price point compares with your comparable offerings, both on the full-service and the self-service side?

Martin Mucci

Really have not seen very much of it yet. I'm sure it's probably still early, but different, Intuit has worked on full-service before. And I think we've always competed very well against them and don't really see it being an issue. Certainly haven't heard much about at this point. And I think, pricing-wise, it's probably in there from a competitive standpoint between SurePayroll and the full-service offering. So there's not a lot of differentiation. The differentiation would be that the 40 years that we've been in business and the service we provide to the small business, I think, will still be very competitive against something like that.

Operator

Our next question comes from Tim McHugh with William Blair & Company.

Timothy McHugh - William Blair & Company L.L.C., Research Division

Yes. First I want to ask about your comment about the CPA referrals and Web is showing a little better signs of life than the new business formation. Can you talk about with that is? Evidently the small business markets not robust yet. So what's driving them from it? Is that just more outsourcing? Is that market share? Is it execution to the best you kind of understand it? Why are you seeing better trends there versus the new business?

Martin Mucci

I think we're doing -- even this is something that we've done very well over the years, I think we've done even better in taking more of those -- getting more of those referrals. I think, to me, if the execution of dealing with the CPAs, we've always -- that's always been something we've been good at, but we tried to up that over the last year or so as new businesses were kind of flat. That we went after the relationship with the CPAs, finding more ways to add value for them, finding more information we can give them, how we can work better with them and encourage them to give us more of the referrals. And so I think that's a lot on execution and some of the marketing and so forth as we've gone after that CPA community for the referrals. So I think it's more execution there than it probably is anything else.

Timothy McHugh - William Blair & Company L.L.C., Research Division

Okay. And then just to think about the full year here, your service revenue grew 7% year-over-year in Q2 here and your guidance for the year, 7% to 9%. So you’re towards the lower end of that range and you're also talking about tougher or moderating growth because of tougher comps for checks per client. And I think in Q4, SurePayroll from a year-over-year perspective drops off. So is it that you expect, you're hoping for new business or the client growth to improve across the year? Is that the offsetting factor to keep us in that 7% to 9% range? Or I know comparisons get easier for client growth as we go through the year, but I guess I'm just trying to make sense relative to that 7% in the 7% to 9% range for the year that you've guided to.

Martin Mucci

I think where we see is we're still in that range, or we're towards the lower end of that range, probably you can see that from having 2 quarters behind us. But we still feel like we're in that range. I think that we're still hopeful that some of the checks as we say, are still above, they're moderating, but they're still above. And we still think that we'll see it. It's early in the selling season, too. You have to see how that's all going. Even though it doesn't have a huge impact in the second half of the year, it does have some impact. And so we still feel we're within that guidance, but probably on the lower end of it.

Operator

Our next question is from Tien-Tsin Huang with JPMC.

Tien-Tsin T. Huang - JP Morgan Chase & Co, Research Division

You guys covered a lot, so I'll be quick. Just thinking about some of the answers that you guys have had. I was curious if you're more open to doing acquisitions of maybe some of the regional players just for the sake of scale. Especially now that you have a better IT and overall platform, it seems to be more synergies to justify acquiring for scale assuming that your business starts stay stagnant.

Efrain Rivera

This is Efrain. We have a pretty active program of looking at opportunities if we see a regional player that we think would make sense at the right price, we certainly would look at it. So there's no impediment to looking at it. We're pretty disciplined, though, in terms of what we pay because we have a long history of understanding what's a good and accretive acquisition and what's a not so good acquisition. But yes, we look at it and certainly, we'd be open.

Tien-Tsin T. Huang - JP Morgan Chase & Co, Research Division

Given the more challenging sort of macro backdrop, I mean, I'm assuming here that there are more players that are available for sale or more willing to sell themselves out. Is that a fair assumption?

Efrain Rivera

I don't think there's been much of a change, frankly, in terms of availability of opportunities.

Tien-Tsin T. Huang - JP Morgan Chase & Co, Research Division

Okay, okay. I figured I’d ask. Last one for me. Just from the expense growth side. I think it's up 6% year-to-date. How much of that 6% is tied to some of the IT investments? I know that obviously it's your payroll and the amort tied to that. Is...

Efrain Rivera

We don't give a precise figure. But as Marty said, we've been growing IT expense in the teens.

Operator

Our next question is from Kartik Mehta with Northcoast Research.

Anthony McCready - Northcoast Research

This is Anthony in for Kartik. Just to follow-up to the question about the sales force. Have you made any changes to the makeup or compensation structure with the hiring of the new VP of Sales?

Martin Mucci

Well, we put a lot of those things in place before Mark Bottini came in, the Senior VP of Sales. So we have a new comp plan this year for the reps. That is actually been received very well. That's been in place since the June 1. And we also put a lot of other things in place, like the new sales tablet, the new tablet PCs or laptops that they carry with them, and better lead generation tools on those in tracking of leads. So a lot of the things we have put in place around the first of the year and new training programs and so forth. And Mark coming in has really not looked to change of that at this point because I think, actually, the comp plan is pretty well received from the reps, particularly on the payroll side, where we made the changes. So not looking, have not made more changes to it since he came in and really not planning to at this point.

Anthony McCready - Northcoast Research

Okay, great. And just one more. With the release of the single sign-on and the iPad app, how do your new products compared to the competition?

Martin Mucci

I think they compared very well. And in fact, I believe that from a standpoint of the iPad, it's a better app than a national provider or competitor provides. Because what we did was we came out a little bit later but made sure that the iPad is -- that the app is optimized for the iPad. So what that means is basically that our competitor has a smartphone app, which we haven't released yet, we went for the iPad first. And the smartphone app basically is the same app that's used on the iPad. So it's not really optimized for the iPad. It's optimized for the smartphones so you basically expand it to a larger size, but it's not -- you can't get as much out of it. Our iPad app, you can do anything on the iPad that you can do on the PC or a laptop, and that puts it above what our competitor is doing right now.

Operator

Our next question is from Vishnu Lekraj from Morningstar.

Vishnu Lekraj - Morningstar Inc., Research Division

Just a question here on your operating margins. In the past, it seems as though those have grown at a robust rate. Now given some of the investments in terms of your operational structure, some of the product mix changes in terms of the other HR services and the SaaS model, can you talk a little bit what those are going to do moving forward maybe past 2012 and 2013, 2014, given the kind of maybe a moderate economic growth scenario?

Martin Mucci

Well, the margins are always very important to Paychex. They've always been something -- obviously we're very proud of the high margins that we have and the fact that we've been able to still invest while driving productivity in other areas of the company. So we focus a lot on the margins. Whenever we have our growth, our top line growth, it is always got to be leveraged and we'll look to continue to do that. So I think you can continue to see good margins from us and we'll continue to leverage the top line.

Efrain Rivera

Yes, and we target north of 35%. Certainty, this year has been strong. And I don't think that the mix of products and other investments is going to significantly change that.

Vishnu Lekraj - Morningstar Inc., Research Division

So nothing in terms of leveraging maybe your SaaS model a little bit, adding on products from your other HR services in combination with maybe some of your operational investments.

Efrain Rivera

We do all of that. We do all of that. I think it's early in the cycle from some of the SaaS products to change the margin outlook at this point.

Operator

[Operator Instructions] Our next question is from Mark Marcon with R.W. Baird.

Mark S. Marcon - Robert W. Baird & Co. Incorporated, Research Division

Earlier in the session, there was some discussion about one-time factors that impacted and boosted the Q1 year-over-year growth rates. And I'm familiar with that dynamic occurring multiple times on the HR Services side. What was the factor that impacted the core payroll?

Efrain Rivera

It wasn't -- I don't think we've discussed core payroll, specifically. It was on...

Martin Mucci

Yes, a little bit, I think it was more the comparison year-over-year. On the HRS side, it was more asset values and things like that. So I think core was more -- we're talking about the 4% or the 3%. I think it was more comparison year-over-year and probably just a slightly stronger quarter comparison over the first quarter of the previous year.

Mark S. Marcon - Robert W. Baird & Co. Incorporated, Research Division

Okay, I'm not sure that my numbers sync up with that in terms of the year-ago.

Martin Mucci

Let me -- let us get back to you on that one on the one-time core payroll specifically.

Mark S. Marcon - Robert W. Baird & Co. Incorporated, Research Division

Because if there was something one-time, I think it's fairly explainable, simply from the standpoint that in Q4 of '11 on core payroll, you grew 4.6%, then you had this unusually strong first quarter in terms of the sequential growth, and you ended up increasing 6%. And then we go back to the second quarter, and we're back to 4.8%, which is more consistent with what you ended up seeing during the fourth quarter. So just trying to understand if there's anything unusual from a seasonality perspective or anything along those lines that's occurring now relative to then. And we'd be glad to follow up.

Efrain Rivera

As we looked at it, Mark, we didn't see anything significantly. There are occasions when the point at which a particular quarter ends the day can affect, have a small impact. But we didn't see any dramatic one-time events that stood out.

Mark S. Marcon - Robert W. Baird & Co. Incorporated, Research Division

Okay. And what we're the factors, this specific time around in Q1 on the HRS side?

Efrain Rivera

On the HRS side, we had a pretty strong quarter in terms of quarter-over-quarter asset values and basis points. The model of that business is changing more towards an asset fee rather than a basis point of model. It can change in terms of the mix of plans that we acquire or convert. So we had a strong quarter and ended up having pretty good revenue growth in 401(k).

Mark S. Marcon - Robert W. Baird & Co. Incorporated, Research Division

Okay. So that was the primary driver, nothing unusual in terms of workers comp or those...

Efrain Rivera

Workers comp adjustments within the PEO can fluctuate from quarter-to-quarter. That's something that we plan for, and that creates a certain amount of what I'd call the overall lumpiness in the PEO business. So in the first quarter, we had adjustments to the workers comp reserve that a -- yes, right there were benefits but that's going to fluctuate quarter-to-quarter and I would just lump that in with the overall volatility of PEO results as we add and we delete employees in that business.

Mark S. Marcon - Robert W. Baird & Co. Incorporated, Research Division

Okay. That's par for the course. And then just going into the selling season. Just to be clear, you would anticipate that there's going to be fewer companies that would go out of business this fourth quarter than a year ago, right?

Efrain Rivera

That's correct.

Mark S. Marcon - Robert W. Baird & Co. Incorporated, Research Division

Are you anticipating that there are going to be a similar number or even a higher number of new businesses being formed this quarter than a year ago?

Efrain Rivera

Yes, that's the question, Mark. And right now, what we see is the flat environment. And that's what we can't call at this point. We won't know that because the data is reported on a lag. Our expectation certainly is that it will be somewhat better, slightly better. We're not expecting it to increase significantly, but that's what we don't have a crystal ball on.

Mark S. Marcon - Robert W. Baird & Co. Incorporated, Research Division

And the number of sales people that you have going after the new businesses, is that up or down relative to a year ago?

Efrain Rivera

Very comparable.

Mark S. Marcon - Robert W. Baird & Co. Incorporated, Research Division

And then they have better tools, better technology. So most factors aside from the new business environment and potentially the competitive environment would be favorable?

Martin Mucci

I agree.

Efrain Rivera

Compared to last year, yes.

Mark S. Marcon - Robert W. Baird & Co. Incorporated, Research Division

And then with regards to the increase in terms of the expenses, most of that's going to fall into the SG&A side, right?

Efrain Rivera

That's correct. Yes, and it's not all that difficult to see. You'll see it in our results. And if you looked at previous Q3s and also Q4s, we simply sell more and have more selling expense and have other associated operating expenses.

Operator

There are no further questions.

Martin Mucci

Okay. At this point, I want to thank you for your interest in Paychex and for participating in the call. If you're interested in replaying the webcast of this conference call, it will be archived until January 20. And thank you again for your time, and we wish you all a very happy holiday season. Thank you.

Efrain Rivera

Thank you.

Operator

Thank you for participating on today's conference. The conference has concluded. You may disconnect at this time.

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