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Executives

Paul Sarvadi - Chairman and Chief Executive Officer

Richard Rawson - President

Douglas Sharp - Chief Financial Officer and Vice-President Finance

Analysts

James MacDonald - First Analysis Securities Corp.

Michael Baker - Raymond James & Associates

Cynthia Houlton - RBC Capital Markets Corporation

Mark Marcon - Robert W. Baird & Co., Inc.

Tobey Sommer - SunTrust Robinson Humphrey

Bob Bennett – Groundswell Equity Partners

Administaff Inc. (ASF) Q3 2007 Earnings Call November 1, 2007 10:00 AM ET

Operator

Good day, ladies and gentlemen. Welcome to the third quarter 2007 earnings conference call. My name is Ikeda (sic) and I will be your coordinator for today. At this time all participants are in listen-only mode. We will be facilitating a question and answer session towards the end of this conference. (Operator Instructions). As a reminder, this conference is being recorded for replay purposes.

I would now like to introduce your hosts for today’s call. Paul Sarvadi, Chairman and CEO, Richard Rawson, President, and Doug Sharp, CFO. I will now turn the presentation over to Doug Sharp, CFO. Please proceed, sir.

Douglas Sharp

Thank you. We appreciate you joining us this morning. Before we begin I would like to remind you that any statements made by Mr. Sarvadi, Mr. Rawson or myself that are not historical facts are considered to be forward-looking statements within the meaning of the federal securities laws. Words such as expects, intends, projects, believes, likely, probably, goals, objectives, outlooks, guidance, appears, targets, and similar expressions are used to identify such forward-looking statements and involve a number of risks and uncertainties that have been described in detail in the company’s filings with the SEC. These risks and uncertainties may cause actual results to differ materially from those stated in such forward-looking statements.

Now let me take a minute to outline our plan for this morning’s call. First I’m going to discuss our third quarter financial results. Paul will add his comments about the quarter, our outlook for the remainder of 2007, and then provide some preliminary comments on 2008. Richard will then discuss trends in our direct costs, including benefits, workers’ compensation and payroll taxes, and the impact of such trends on our pricing. I will return to provide financial guidance for the fourth quarter and also comment on our preliminary outlook for 2008. We will then end the call with a question and answer session.

Now let me begin by summarizing the financial highlights from the third quarter. We reported third quarter earnings per share of $0.45 at the high end of our expectations. As for our key metrics, we achieved double-digit unit growth as the average number of paid worksite employees increased by 10% over Q3 of 2006 to 112,496 for the quarter.

Gross profit per worksite employee per month averaged $222 for the quarter, above our expected range due primarily to a positive outcome in our direct costs programs.

Operating expenses came in below forecasted levels with the exception of an additional accrual for incentive compensations tied to the achievement of higher operating results.

We’ve repurchased 408,000 shares during Q3 at a cost of approximately $13.4 million and entered the quarter with $110 million in working capital.

Now let’s review the details of our third quarter results. Third quarter revenues increased 13% over 2006 to $383 million as a result of the 10% increase in average paid worksite employees and a 3% increase in revenue per worksite employee per month.

Looking at third quarter revenue contributions and growth by region, the southeast region, which represents 11% of total revenue, grew by 10%. The northeast region, which represents 20% of total revenue, grew by 21%. The central region, which represents 14% of total revenue, grew by 12%. The southwest region, which represents 35% of total revenue, grew by 18%. And the west region, which represents 20% of total revenue, grew by 2% and was impacted by the loss of a large mid-market client during the 2006 year-end client renewal period.

Now moving to gross profits, we had forecasted gross profit per worksite employee per month to be in the range of $216 to $219. This guidance was below the $234 achieved in Q3 of 2006, a period in which we experienced unusually low benefit costs. We exceeded our expectations this quarter, averaging $222. The pricing of our HR services came in as expected, with the upside generated from our direct cost programs.

As for the details, our workers’ compensation program continues to generate positive results. Workers’ compensation costs were 0.52% of non-bonus payroll for the quarter, consistent with the prior quarter and below the low end of our forecasted range. Actuarial loss estimates continue to reflect our favourable claims trend and resulted in a $6 million reduction in previously reported loss estimates. This reduction is generally consistent with that reported in the previous two quarters.

Third quarter benefit costs were generally in line with our expectations as the cost per covered employee per month increased just over 9.5% to $683. Payroll tax costs as a percentage of total payroll declined from 6.7, 6.67% in Q3 of 2006 to 6.55% in Q3 of this year as a result of lower state unemployment tax rates and higher payroll averages and bonuses of our worksite employees.

In a few minutes, Richard will provide further details on this quarter’s positive developments and the expected impact on direct cost trends and pricing for the remainder of 2007 and into 2008.

Now let’s move on to operating expenses, which increased only 7% over Q3 2006 to $59.2 million. This was approximately $700,000 above the midpoint of our expected range and included the additional accrual for incentive compensation tied to our improved operating results, partially offset by expense savings in other areas. The 7% increase in operating expense on a 10% increase in unit growth resulted in a decline in expense on a per worksite employee per month basis from $181 in Q3 of 2006 to $176 this quarter.

As expected, stock-based compensation costs increased by $2 per worksite employee per month as a result of the annual restricted share grants to employees. This was more than offset by lower salaries, depreciation, and G&A costs.

As for net interest income, we reported approximately $2.9 million for the quarter. This is just below the low end of our expected range due primarily to the utilization of invested funds and executing our share repurchases.

Our effective income tax rate for Q3 of 35.1% was slightly less than the forecasted rate of 35.7%, reflecting lower than expected state tax rates.

Now let’s review several balance sheet and cash flow items. We entered the quarter with approximately $110 million of working capital and only $1.2 million of debt. During the quarter we generated $23 million of EBIDTA, cash outlays included cash dividends of $3 million, capital expenditures of $4 million, and share repurchases totally 408,000 shares at a cost of $13 million.

We have now repurchased 1.8 million shares year-to-date or over 6% of the total outstanding shares at the beginning of this year.

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Paul Sarvadi

-- third quarter growth acceleration was the result of solid performance in both of the key drivers to unit growth, sales and client retention. The paid worksite employees added from sales of new accounts increased 22% over the same period last year and this was the primary driver of our 10% unit growth for the quarter.

Our sales success continues to be driven by our growth in the number of trained sales personnel with over 18 months experience with the company. We averaged 264 trained reps for the quarter and 306 total reps, up 4% and 7% respectively, over Q3 of 2006 from 253 trained reps and 285 total reps. The number of sales people with more than 18 months experience increased 22% and reached 150 for the first time in our company history.

Our office opening plan is also on track with six offices open through the third quarter, including our second Boston, Phoenix, and Denver offices, our third Washington, DC, and New York offices, and a new market opened in Jacksonville, Florida. We expect to open our fourth New York office and one more new market in Kansas City in the fourth quarter, bringing total new office openings to eight for 2007.

We’ve also had some early sales success in our recently re-engineered middle market client segment, which we define as clients with greater than 150 worksite employees. In the third quarter we sold five accounts totalling 1,300 employees, most of which will become paid worksite employees in January. We’ve already sold three more middle market accounts during the fall campaign, so we have some nice momentum in this new segment.

Last year at this time our middle market segment had slightly more than 14,000 worksite employees representing just under 14% of our total worksite employee base. As we reported early this year, we experienced a 15% decline in this segment due to a difficult year-end sales and renewal cycle. We have rebounded over the last six months through new sales and growth of existing customers and the segment has recovered and is now slightly larger in absolute number of employees than it was at this time last year.

Our 10% unit growth rate for the third quarter was a combination of this mid-market recover to a slight year-over-year growth rate of 3% and our core business year-over-year growth rate of 11%. Currently the mid-market segment is 13% of our total business.

Our client retention and satisfaction numbers for the quarter were also solid. The number of worksite employees related to terminating clients averaged 1.7% of the employee base per month for the third quarter, which is slightly higher than our target of 1.5%, but better than last year’s 1.9%. Our overall service satisfaction rate for the quarter was 90%, consistent with our year-to-date number of 91%.

Now, this time of year we’re focused on our fall sales and retention campaign, which is designed to take advantage of the natural inclination for prospective small business clients to transition to our services at year-end. Each year we invest in advertising and promotion plans to generate a wave of leads and appointments for sales staff leading to strong Q4 sales. Historically we’ve sold about the same number of accounts in the last four months of the year as we sell in the first eight months.

This year we’ve invested heavily in television and radio advertising featuring our customer spokesperson Arnold Palmer. We have client testimonials from business owners in each of our major markets in our radio ads to localize the message. We’ve also launched personalized direct mail programs to follow up from our corporate call centre to set additional appointments for sales staff. Although it’s much to early to measure the success of the campaign, the first step has been accomplished with a 14% increase over last year in qualified leads supplied to our sales staff.

Another important element of this year’s campaign is the addition of new benefits for client owners and worksite employees to encourage client retention. Clients are receiving personal and business identity theft protection and a new web-based business research tool as a gift from Administaff. Employees are receiving new benefit options, including the Raw 401K, long-term care, cancer coverage, and even pet insurance. The fall campaign began with the sales staff visiting current clients to share the new benefit information and obtain client referrals. This bliss of activity was received well by clients and generated a significant level of energy and, most importantly, sales prospects.

One other element of this year’s fall campaign is a new approach to mid-market renewals. Since this was an area of difficulty last year, and we’ve made major changes to the service model, we are scheduling face-to-face meetings with senior management from both companies. In these meetings we are conducting a financial stewardship review and explaining the changes we are making in our services model. So far these meetings have been productive.

All of these sales and retention efforts under way are directed towards maximizing the number of paid worksite employees in January of 2008. This number has a dramatic effect on the 2008 year-over-year growth rate due to the cumulative effect of our recurring revenue business model.

Last year we had no net gain from December to January in worksite employees for the reasons I mentioned earlier regarding our mid-market segment. The opportunity before us now is to have a successful fall campaign resulting in an increase in paid worksite employees from December to January, thereby accelerating our unit growth rate and stepping up our revenue base for the new year.

So in summary, our outlook for growth for 2008 is positive based upon our growth in the mid-market, I’m sorry, growth in the number of experienced sales personnel, our progress in the mid-market segment, and continuing our market expansion. Our 2008 plan includes an additional eight office openings throughout the year and an increase of approximately 15% in the number of trained sales staff.

The economic environment is also an issue we’re watching closely as we look ahead to next year. Now so far we’re not seeing a negative change in what clients are actually doing in compensation and hiring. However, our client-owner sentiment about the economy going into an election year seems a bit more hesitant and they are somewhat more conservative as a result.

For the third quarter average compensation increases were up just under 6%. Commissions were up over 12% indicating a nice pipeline for new business in the near term. Overtime pay as a percentage of base pay (inaudible) 7%, which is historically high (inaudible).

We continue to believe there is a greater market perception of economic impact on our business model than actually exists. This is due to the last economic down cycle when we had a company specific event which occurred at the same time as the down economy and had more of a significant effect on our growth than the economy did. Our service is equally necessary, maybe more so, in a down economic cycle when employment costs and liabilities rise. We continue to see strong demand for our services as small businesses continue to seek a competitive edge in the marketplace regardless of the economic environment.

Now, our business model is affected when layoffs exceed new hires in our client base, but not to the degree experienced in the last cycle. We believe we will continue to grow units and profitability even if the economy slows, and we expect to continue to generate strong free cash flow.

At this time I’d like to pass the call on to Richard.

Richard Rawson

Thank you, Paul. This morning I’m going to discuss the details of our third quarter gross profit results and the new relationships we have in the workers’ compensation insurance program. I will comment briefly on our expectations for the fourth quarter of 2007, and then I will update you on our pricing strategy and the direct cost trends that will shape our gross profit per worksite employee per month for 2008.

Our gross profit comes from the markup we earn on our HR services combined with the surplus that is generated when our direct cost pricing allocations exceed the corresponding direct costs. For this quarter our gross profit per worksite employee per month was $222, which was above our forecasted range of $216 to $219. These results came from achieving $199 per worksite employee per month of markup and generating a surplus of $23 per worksite employee per month or 2.5% of the total dollars allocated to cover the direct cost. This quarter’s surplus came from better than expected contributions from the workers’ compensation cost centers while payroll tax and the benefit cost centers came in at about what we had expected.

Here are the details, beginning with benefits cost center. In this quarter our expense per covered worksite employee was $683, at the high end of our expected range. We continue to see a migration of employees out of the United Health Care Choice Plus 250 Plan into lower cost plans, which help to reduce our costs. We did have a few more claims over $50,000 than what we had forecasted, but nothing like what we experienced at the end of 2006. So we ended the quarter about where we expected our costs to be.

Our largest contributor to the gross profit surplus in the quarter came from positive results in our workers’ compensation program. The current policy year just ended on September 30th and for this policy year the number of claims reported at 7% lower than last year. Now this decline is particularly impressive when you consider that we have had a 10% growth in the number of paid worksite employees over the year that incur those claims. Obviously the work of our safety professionals in the field is paying off nicely.

Our claims management personnel continue to settle workers’ compensation claims for amounts lower than expected as our back-to-work programs continue to produce favourable results. As a result, we had a nice surplus from our workers’ compensation program as the expense was 0.52% of non-bonus payroll, well below our estimate of 0.60% .

Before we talk about Q4 of 2007 and 2008 I would like to share with you the details of our workers’ compensation insurance program structure beginning October the 1st, 2007. We now have Ace Insurance Company as our new workers’ compensation insurance carrier. They’re coverage is identical to the previous year’s programs that we had with AIG, but at a lower cost and with policy administration function carved out.

Prior to 1998, a workers’ compensation insurance carrier had to issue only one policy which covered all the clients of a PEO. Beginning in 1998, a few states changed their requirement and made the workers’ compensation insurance carrier issue a separate policy in the name of both the PEO and the client doing business in that state. Now, eight years later, most states require the carrier to issue what is called a multiple coordinated policy naming the PEO and the client as policy holders.

Our carrier went from issuing one policy several years ago to several thousand policies this last year. As you can imagine, the administrative costs have gone up rapidly, but more importantly, we discovered that several really good workers’ compensation carriers would not do business with PEOs because their backroom operations could not handle the volume of work required for a PEO.

I am happy to report that we have found a solution to the rising cost and the market limitations through an arrangement with our insurance brokerage firm, Lockton Companies Inc. they are the world’s largest privately owned independent insurance brokerage firm. This new arrangement is with their wholly owned subsidiary called The Lockton Affinity Group. This organization has a successful call center which cross sells insurance products and a policy administration business that issues more than 60,000 workers’ compensation policies each year for its customers. We have partnered with them to issue all of the workers’ compensation policies on behalf of Ace Insurance Company to our clients, which is why our administrative expenses of the program will be lower than last year.

Additionally, this new venture will make these services available to other carriers facing the same PEO policy administration issues. Should there be additional business that comes to the new Administaff-Lockton venture we will get to share in that revenue.

The third feature of this new arrangement is an agreement whereby the Lockton call center operation will set appointments with their clients for Administaff sales personnel to meet and discuss the possibility of becoming an Administaff client.

This new structure creates a distinct and unique advantage for Administaff and we are very excited to open up our long-term options and reduce our cost of our workers’ compensation program.

Now, let me update you on our gross profit expectations for the fourth quarter of this year. The mark up on our service fee is still tracking toward our goal of averaging $200 per worksite employee per month for the fourth quarter and the full year of 2007 as our renewals, completed in the third quarter, were up over $5 per worksite employee per month.

The surplus component of gross profit should add about $30 to $33 of additional gross profit per worksite employee per month based on the following information. We should get a larger contribution to surplus from the payroll tax cost center this quarter because more of the employees with new clients that were added throughout the year will reach their individual wage limits, so our cost will go down as our allocations remain unchanged.

As for the benefits cost center, we have seen our pricing allocations increase from the second quarter. At the same time we have started to see a meaningful shift of employees moving from the higher-cost plans to the lower-cost plans. Also as you may recall from the fourth quarter of last year we had a high number of large loss claims. Therefore, we expect our fourth quarter costs to increase 6% to 7% over Q4 of 2006, which is lower than our full-year forecast for 2007 of 9%.

Our workers’ compensation cost center should continue to add to our surplus. As I mentioned a few minutes ago, the administrative costs will decline from last year since our new structure went into place on October the 1st. Our current incidence and severity rates would indicate a lower cost than Q4 of last year, so an expense of 0.55% to 0.65% of non-bonus payroll for the fourth quarter is certainly in play.

In summary our solid gross profit performance this quarter gives us the platform to finish 2007 with good results.

Now let me give you our up to date outlook for gross profit per worksite employee per month for 2008. Let me explain each component beginning with pricing. We are well on our way to achieving our targeted average mark up on our HR services of $200 per worksite employee per month for 2007. With nominal increases on new and renewing business we should see the average mark up increase by a couple of dollars in 2008.

Our view about the surplus component of gross profit for 2008 has not changed from last quarter. The surplus generated from the payroll tax cost center should increase. From an allocation perspective, we could see a moderate decline at the beginning of 2008 due to lower state unemployment tax rates. The reason for the expected lower tax rates comes as a result of the surpluses that are sitting in many state unemployment tax funds. By law the states are required to lower the rates and/or give credits to employers. The net effect is a projected increase in our surplus for 2008.

We also expect to see the continuation of a nice contribution to gross profit surplus from our workers’ compensation insurance program from the new structure that I discussed earlier. The better than expected incidence and severity rates that we have experienced throughout this policy year, coupled with effective claim settlements, should translate into lower costs as well. We expect little or no change within the allocation side of this cost center. So the bottom line is that we still expect to see a nice surplus contribution to gross profit from in 2008.

The benefits cost center is where we could see some improvement in 2008. A few minutes ago I mentioned that we continue to see migration of covered worksite employees from the United Health Care Choice Plus 250 Plan to a higher-deductible, lower-cost plans. The result is an immediate reduction in our benefits allocation followed by a corresponding expense reduction several months later.

Last quarter I also mentioned that for 2008 we have some additional factors that will affect the benefits cost center. They are: number one, benefit plan design changes that reduce claim costs; number two, lower administrative fees previously negotiated with United Health Care for 2008; number three, double-digit health care cost increases from our fixed-rate plans which cover about 10% of our total book of business; and number four, ongoing allocation increases to match future expected costs. These factors should allow us to mitigate total benefits trend increases and further deficits in this cost center for 2008.

In summary for 2008, we have a very solid game plan for being able to generate a few dollars more of gross profit per worksite employee per month.

Now, I would like to turn the call back over to Doug to give further financial guidance.

Douglas Sharp

Thanks, Richard. Now let’s discuss our guidance for the fourth quarter. We expect average paid worksite employees per month to be in a range of 115,500 to 116,000, reflecting unit growth of approximately 11% over Q4 of 2006. As a reminder, clients sold during the fourth quarter of any year, and in particular during our fall sales campaign, are typically converted to paid worksite employees during the first quarter of the following year.

As for gross profit per worksite employee per month, we expect to be in a range of $230 to $233 for the quarter. An expected sequential increase in this metric over Q3 is consistent with the quarterly pattern that we have experienced in prior years. Specifically, we expect to earn a higher surplus in our payroll tax direct cost center. This is because worksite employees added to our base mid-year typically reach their taxable wage limits by Q4. So for these employees related payroll tax costs diminish while we continue to collect the pricing allocation that was set upon their enrolment.

Fourth quarter operating expenses are expected to be in a range of $63.25 to $63.75 million. This is sequentially up from the third quarter operating expenses by approximately $4 million and includes approximately $2.2 million of additional advertising costs related to our fall sales campaign. We are also expecting a $1.5 million sequential increase in compensation expense associated with the additional sales and service personnel and additional incentive compensation to be accrued only upon achieving forecasted results.

Our Q4 guidance also includes approximately $700,000 of G&A costs associated with the services offered to certain clients and worksite employees in connection with the missing laptop issue. We are currently reviewing our insurance coverage, which may provide up to 90% reimbursement of these costs.

We expect Q4 net interest income to be between $2.9 million and $3.1 million and are forecasting an effective income tax rate of 35.5%.

We are also forecasting 26.8 million average diluted outstanding shares for the fourth quarter and 27.3 million shares for the full year 2007, based upon our current share price.

Now, before we open up the call for questions, I’d like to comment on our preliminary outlook for 2008. We plan to provide detailed guidance during next quarter’s conference call, based upon the results of our 2007 fall sales campaign and the year-end client renewal period. Based upon Paul’s earlier comments, we expect to accelerate from the 10% forecasted unit growth for 2007 to around 12% for 2008.

As Richard mentioned, we currently expect a slight increase in gross profit per worksite employee per month over 2007. Consistent with prior years, we are forecasting about a 1% to 2% increase in the mark up on our HR services. We are also budgeting a slightly higher surplus from our direct cost programs based upon our initial outlook for health care and workers’ compensation cost trends, the expected impact of benefit plan design changes, and a preliminary estimate of lower state unemployment tax rates.

As for the quarterly trend in this key metric, we expect gross profit per worksite employee to be highest in Q1 as we typically earn more surplus in the payroll tax cost center prior to worksite employees reaching their wage limits. Additionally, our benefit plan design changes typically have a greater impact during the first quarter of the year implemented. Thereafter, we would expect a decline in this metric in Q2 and then sequential increases in the third and the fourth quarters, which is consistent with our typical gross profit pattern.

As for operating expenses, while we continue to expect leverage in our core PEO business, we plan to make investments next year in our mid-market initiative, HR Tools software, and other ancillary products. When combined with the continued investment in our national sales and service expansion plan, we expect an increase in 2008 operating expenses slightly above projected unit growth.

Similar to prior years, we are budgeting for a step up in operating expenses from the fourth quarter of 2007 to the first quarter of 2008. This step up in costs is associated with expected hiring of sales and service personnel and certain G&A costs, including our annual sales convention and employee incentive trip. Thereafter, operating expenses are expected to remain relatively flat through the second and third quarters, with the usual step up in Q4 for costs associated with our fall sales campaign.

So, in conclusion, our initial plan for 2008 targets operating income per worksite employee per month at a slight increase over 2007 as an increase in gross profit per worksite employee is expected to be partially offset by investments in our growth and other initiatives. When combined with our projected unit growth, we are currently expecting 2008 earnings growth of somewhere between 15% to 20% over 2007.

As for capital expenditures, we are looking at a base budget of about $20 million, which is up from approximately $13 million projected for 2007. This increase is tied primarily to the planned national sales and service expansion.

We plan to provide detailed 2008 guidance during next quarter’s conference call in early February. This guidance will be largely based upon the results of our 2007 fall sales campaign and the year-end client renewal period, and we will also factor in any changes in the economic climate of the small business community that may occur in early 2008.

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

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Tobey Sommer of SunTrust Robinson Hum. Please proceed.

Tobey Sommer – SunTrust Robinson Humphrey

Thanks. I just wanted to ask a clarification question on, Doug, your preliminary kind of high-level look at 2008. Did you say that you expected earnings growth of 15% to 20% based on the slightly better worksite employee volume growth offset by the incremental investments that you’re planning.

Douglas Sharp

A little clarification there. Yeah, 15% to 20% is what we’re currently targeting in earnings growth and it’s off of about a 12% unit growth number that we’re looking at. And then a slight increase in the operating income for worksite employee over 2007.

Tobey Sommer – SunTrust Robinson Humphrey

Okay. And then, I wanted to ask a question about the mix of marketing versus sales force head count growth going forward. You know, you’ve had a decent amount of opportunity to, I guess, experiment over the years with marketing versus actually just kind of raw brute force increasing the head count and opening up new offices. Any changes philosophically kind of which levers you think you’re going to pull harder in 2008? You know, comparing and contrasting your opportunities in marketing to improve sales force productivity versus actually increasing the head count?

Douglas Sharp

That’s a good question, Tobey, and what we’re looking at for 2008, of course, if you look at this year, we’ve had such a nice increase in the number of trained sales personnel with over 18 months experience that we’re getting the benefit of some better sales efficiency and, you know, what you get from a more experienced sales staff. Relative to the marketing program, next year is an election year, costs go up, we will be spending more money, but we also are going to grow the sales staff faster than we did this year. We’ve got about a 7% increase in the number of total reps right now over a year ago. And we expect to move up to around 15% over the course of next year. So we’re going to invest more in sales person head count, which are backfilling into these offices that we’ve opened. We opened eight, we’re going to open eight by the end of this year and another eight next year. So we’re going to rely a little more for ’09 on sales person head count. In ’08 is more the experience of the sales staff that we have in place and then growing the new sales staff.

Tobey Sommer – SunTrust Robinson Humphrey

As a follow up, regarding the prospective eight new offices next year, any change in the composition? By that I mean, do you plan more Greenfield offices or is the mix of Greenfield to additional offices and markets that you’re already represented in relatively similar to this year?

Douglas Sharp

Pretty similar. I mean, there may be two or three new. We’ll have two this year. We may have one more than this year in next year’s plan. But we make those decisions as we get a little closer to each market or office opening.

Tobey Sommer – SunTrust Robinson Humphrey

And lastly I’ll ask you a question on capital allocation and M&A opportunities. You’ve invested quite a bit of your cash flow recently in stock repurchases. I was wondering if you could comment on what you think your outlook for capital reployment would be in 2008 and if the slowdown in turmoil in the credit markets has brought incrementally, I guess, more attractive acquisition opportunities to Administaff? Thanks.

Douglas Sharp

Sure. Certainly we are more well equipped to evaluate opportunities in the market place and we are doing that. We think there are some things out there that we can do that add ancillary services or add to our opportunities. Sometimes it kind of affects both sides of the fence. It lowers our cost on the PEO side, but then also potential to offer a point solution in the HR tools side of our business, which is kind of a growing new venture for us. So we are keeping our out there, although I don’t see us being in a position to make blockbuster-type of acquisitions or very large acquisitions. They’re more smaller strategic opportunities that we see.

As far as the rest of the use of capital, I think we’re still very bullish about our value of the company compared to how we’re being valued in the market right now, so we’ll continue to buy shares back in a deliberate fashion. And also I think there’s room for us to periodically move the dividends up and to kind of keep our payout ratio and our dividend yield at the levels we’d like to see. So that’s kind of our priority at this point, and of course first priority is investing in the business, growing that sales staff and service staff. That’s all expense through the income statement. But that’s kind of how we see using our capital.

Tobey Sommer – SunTrust Robinson Humphrey

Right. And just as a follow up and then I’ll get back in the cue, there’s no change in your view of actually acquiring other PEOs because most of them probably would not fit with your business model and target customer base. Is that correct?

Douglas Sharp

That’s correct. We’ve not seen any PEO opportunity that made sense to this point.

Tobey Sommer – SunTrust Robinson Humphrey

Thank you.

Operator

Your next question comes from the line of Jim MacDonald of First Analyst. Please proceed.

James MacDonald – First Analysis Securities Corp.

Morning, guys.

All

Morning. Hi, Jim. Hey, Jim.

James MacDonald – First Analysis Securities Corp.

On the economy in general, I’ll start there, you said you hadn’t seen much impact. Are you seeing any regional impact maybe out West or anything that’s maybe different in different parts of your business?

Douglas Sharp

Yeah, a little bit out West, but not so much so that, you know, that it’s significant to our game plan in any way. More the West affects, you know, we were a little light there in the year-over-year growth rate in the west coast, but that was more driven by the loss of a major customer early in the year and how that affects the cumulative effects in our model.

James MacDonald – First Analysis Securities Corp.

And on the middle market you talked about some successes. Could you maybe describe those a little bit further? Which ones have already hit the numbers and what’s yet to come?

Douglas Sharp

Yeah. Of course, we had a few sales early in the year in the first and second quarter and those have all kind of rolled in and come on board. We sold five accounts in the third quarter. One of those is enrolling now. The others are enrolling on January 1st. We sold three more in October. They’re scheduled for January start ups. So we’re starting to build a nice little pipeline of new business there. The exciting part to us is that these accounts in the third and fourth quarter are signing our new two-year agreement and being implemented in our new service model. That we’re really excited about the opportunity to methodically and deliberately impact these client locations and, I think, have much better results for the client and for our service team. So we’re excited about that. We have a pretty good pipeline of prospects that we continue to work on and we’ll just have to see how we do in the campaign.

James MacDonald – First Analysis Securities Corp.

So you think that the changes you made are causing this increase in activity?

Douglas Sharp

There’s no question in my mind that the sales changes have had a positive impact in being more in control of the sales process and knowing more about where we stand with prospects as we go through the process. That’s about all we can measure right now because it’s so early and there’s not that much data yet. But I’ll be excited to get into next year and see how the transition plans and the service model implementations and how that flows into client satisfaction in our larger base.

James MacDonald – First Analysis Securities Corp.

Okay. Just one more area. Could you talk a little bit about any kind of revenue expectations from the Lockton joint venture and just in general the kind of beyond PEO profit centers, like HR tools and other things. When, if ever, do you expect those to be material?

Douglas Sharp

Yeah, we’ve had, I’ll let Richard comment on the Lockton program, but on the rest of the activities, which would be HR tools, our marketplace, and some other new things we’re kind of working on that we’ll probably talk about next time, but when you put all those together, you know, we haven’t broken it out because it’s been in the $1.50 range or there per employee at the gross profit line. But we do expect to see that starting to grow more modestly in ’08, but we are hopeful that that will begin to accelerate some as we get into ’09 because of some of the investments we’re making as I mentioned last quarter about the HR tools game plan.

James MacDonald – First Analysis Securities Corp.

Thanks.

Richard Rawson

On the Lockton side I would tell you that we just put this program in place on October the 1st, so there hasn’t been anything yet. I don’t really expect to see much this year. I think that as we open up their call center, calling into their existing customer base, that’s probably where we’ll see, if we’re going to see anything positive, that’s probably where we’ll see, you know, beginning next year where some appointments get set and maybe that will lead into some closing. I think that is the shortest view that we can see about upsiding that relationship. And then over the next year I think we’ll see how it, what happens in other aspects of that relationship with our back office administration business.

Operator

Your next question comes from the line of Mark Marcon of R. W. Baird. Please proceed.

Mark Marcon – Robert W. Baird & Co., Inc.

Good morning. I’m just wondering if you could talk a little bit about some of the incremental costs that you would anticipate for the mid-market for next year.

Douglas Sharp

Yeah. First of all, we talked about how we’d be enhancing the service offerings. So some of it’s going to be putting some service personnel in place, both to address the different products and services that a mid-market client needs. And also, there will be some scalable aspect to that service growth. If we increase the mid-market client base, which we hope to do, there’ll also be some service personnel that we’ll have to hire to serve those larger clients. A key role being the account executive role that handles the service relationship with those type of clients.

Mark Marcon – Robert W. Baird & Co., Inc.

Have you kind of pinned down the incremental cost for this program?

Douglas Sharp

Yeah. I think Paul had mentioned that in the last conference call, you know, what we expected in the latter half of ’07 and then in ’08. I think it’s about $2.5 million or so in the ’08 period.

Mark Marcon – Robert W. Baird & Co., Inc.

Okay. I was under the impression that that was kind of a preliminary estimate and was still being finalized. But it sounds like that’s pretty much the area where it’s going to settle out.

Douglas Sharp

Yeah, that still looks like a good number to us.

Mark Marcon – Robert W. Baird & Co., Inc.

Okay. Great. And then, Paul, you mentioned that you’re having some face-to-face discussions with some of your existing mid-market accounts and I think the word that was used to describe that was productive. Can you give us a little bit more colour there in terms of exactly what you’re seeing?

Paul Sarvadi

Sure. We’ve essentially, as part of the whole revamping of the mid-market strategy, you know, looked at the process that we’ve gone through in the past renewing these customers. And once again, you know, kind of left over from our previous strategy was more of an incremental approach. We didn’t do a lot of things differently with mid-market customers at renewal than we did with smaller customers. But in recognizing what the needs are and the different influencers and decision makers that are involved in the renewal process, we now are working through holding high-level meetings where I’ve been in several of them or half a dozen of them myself, where we sit down and talk through how the relationship’s going and really look at the economics of it and kind of remind our prospects of what we do day in and day out and how it affects them and their cost structure for the long haul. I think, as anyone might expect, when you have that level of dialogue, you know, senior officer to senior officer, and are able to look at specifics of what we did over the last year from a service perspective and what the game plan is for the coming year, you know, these have been very productive dialogues where they feel good about the relationship and we find out more, and different ways we can meet their needs and find out new needs and so forth. I just found it to be a refreshing, you know, and I think the customer has too in terms of compared to previous renewals.

Now, in the new two-year structure that we have with our clients on our new contract we will be holding this type of meeting one year into the relationship where it’s not centered around the renewal and I think those may even be more productive. So again, we’re learning in this area, but I think the early returns on how we’re dealing with this larger customer has got some pretty exciting possibilities.

Mark Marcon – Robert W. Baird & Co., Inc.

And so your sense from these discussions is that the retention rate of the existing mid-market accounts should be how compared to last year?

Paul Sarvadi

Well, of course compared to last year was where we had, you know, somewhat of a surprise as we got toward the year end and some customers who didn’t give us notice about leaving. To this point we do have 60-day notice on these type of customers, we’re right at that point right now, so it’s kind of hard to tell yet what we’ll see. Of course, we do have a few customers that we already are aware of that won’t be with us in the new year. Some that have been acquired. In fact, a couple of them over the last week or so that we were notified of that there’s been a deal done and they’ve been acquired and are being integrated into a larger firm and won’t need our service anymore.

But this is the part where I don’t want to get too out on a limb because I feel good about it today. I know it’s a pipeline, it’s a new business. I know what we’re doing to renew customers and dialogues are going well. But a year ago I felt pretty good and then over the following month or so we had some surprises. But I think we’ve got a whole different plan in place for this year and hopefully we’ll be successful.

Mark Marcon – Robert W. Baird & Co., Inc.

Yeah. I mean, it sounds good. I guess what I was trying to figure out was, you’re presuming, you know, or the preliminary guns, obviously you’re not really going to know until things really finalize, but it sounds like we’re talking about potentially about 12% worksite employee growth for next year. I was kind of trying to figure out what were you presuming if you have a normal client retention rate of 80% across the entire base or 81% across the entire base. What are you assuming on the mid-market side for this time around?

Paul Sarvadi

I’m assuming, you know, at this point I think we’re being appropriately conservative about the starting point of the paid worksite employees for ’08. I think there’s very significant upside to that if we really have a good fall campaign. Relative to mid-market, you know, like I said in my script, we’ve recovered. We basically had about 3% growth in the mid-market year over year. But I’m not relying on that to be, I’m not relying on any kind of increase in mid-market to be at a 12% up.

Mark Marcon – Robert W. Baird & Co., Inc.

Yeah. So, I mean, your general assumption is probably have attrition that would probably be a little bit greater than the overall core, but you’ve got some new clients coming on board and so at the end of the day that mid-market should be a positive for next year.

Paul Sarvadi

Yeah. I think we should at least, you know, prior to last year-end we were selling enough new business to replace the ones that were going away. As we go to this fall campaign I already see the sales coming in. Don’t know yet about the terms, but I feel pretty good about at least being at that level where it’s an offset. And you know, if it’s better than that, you know, that really becomes a premium. It becomes kind of gravy to the model here and adds a nice step up in the first of the year. But we’re not going to build that until we see it.

Mark Marcon – Robert W. Baird & Co., Inc.

Okay. Great. And then, just a housekeeping question and then I’ll jump back in the cue. What was the percentage of the worksite employees that were actually using the health care benefit?

Douglas Sharp

It’s been running I’d say about 73% or so.

Mark Marcon – Robert W. Baird & Co., Inc.

Okay. Great. I’ll jump back on the cue. Thanks.

Douglas Sharp

Thank you, Mark.

Operator

Your next question comes from the line of Michael Baker of Raymond James. Please proceed.

Michael Baker – Raymond James & Associates

Yeah, thanks. I was wondering, as your sales force has conversations with prospects how important is your health benefit offering in terms of the overall package?

Douglas Sharp

Yeah, it’s definitely an important component of what we do for our customer. Of course, benefits and providing high-quality benefits for employees and keeping the costs under control is a very important issue for small businesses. A lot of times the part of our service that’s most visible to a customer revolves around the benefit programs. So sometimes it operates similar to a proxy for the total service. So it’s important and we highlight it in a way that can demonstrate the benefit that we really bring to small businesses.

Michael Baker – Raymond James & Associates

Now, my understanding is that you kind of use bundled pricing. Are you finding prospects increasingly trying to spike out the underlying costs so that they can compare it to other offerings? Say the Blue Cross/Blue Shield plans out there?

Richard Rawson

Not too much. There’s always some of that and some of that happens more in the larger customer and that’s why on these larger customers we’re having these financial stewardship dialogues where we provide a little bit more information. But for the typical small to medium size company, you know, whether you break it out in our program or not, it all comes together. So it’s kind of like buying a car and saying, hey, I want to know how much the tires are. Well, it doesn’t matter because the tires are going to be on the car and it’s not going to be taken off, so they are, it is what it is. So it’s more of what’s the total all-in price compared to what their cost would be without us. That compares very favourably for small to medium sized businesses and it becomes a relatively easy decision to make.

Michael Baker – Raymond James & Associates

And then I was just wondering if you could provide just one final comment in general about you seen health care pricing out there to date and what you expect in terms of next year. Specifically as it relates to the Blues, which tend to be kind of the strong players in a particular region.

Richard Rawson

Yeah, we’re looking at trend increases next year in the aggregate for the marketplace, and specifically the small business marketplace, are definitely going to be in the 10% to 12% range. Now, for us, because of plan design changes and a number of the other things that I mentioned in my script, you know, we won’t see that kind of an increase. But small businesses are in for a big surprise next year. It’s going to be pretty ugly for a lot of them. And we think that positions us really well in the small business marketplace for this coming year.

Michael Baker – Raymond James & Associates

And what do you think the primary driver of the pickup is? Is it more the competitive dynamics of the Blues were aggressive this year and then are kind of lightening up a bit? Or is there some underlying cost dynamic that’s driving it?

Richard Rawson

It’s, I mean, it’s, you know, I can’t speak specifically for the Blues. I mean, we have a little bit of that out in the west coast and the northwest part of the United States, and I think it’s probably your first remark more so than the latter. It’s just that they were lower and now they’re having to catch up. And that’s what we’ve seen in our pricing with them for next year.

But, you know, I mean, just the demand for health care and the prescriptions and all of those factors, health care inflation is alive and well and it’s not going away.

Michael Baker – Raymond James & Associates

And then just one final question, Richard, in terms of getting a little bit more colour on the benefit design changes, are those pretty much set up to try and drive towards those lower cost plans?

Richard Rawson

There is some of that, absolutely. Of course, you get there a couple of different ways. But you know, our customer base has oddly enough always been a little bit more interested in the richer plains. So when we start talking about those kind of plans and making some tweaks, like going from $15 to $20 for an office visit and things like that, it’s not a huge problem for them to deal with. Because of the richness of our plans what we see is that there are less and less of them available in the marketplace for the small business customer to buy, and that’s what attracts or continues attraction for our relationship.

Michael Baker – Raymond James & Associates

And just one final question. In terms of the relationship with United, obviously it’s kind of out there that United’s having some service issues. I was wondering if any of those were kind of coming through and impacting your client base?

Richard Rawson

You know what, we have not, we have not seen anything, I have not heard of anything on the service side negatively in our book of business. I know that it happens. I know that there are incidents that take place from time to time; they’re just kind of one-offs. But we’re not seeing anything that would adversely affect us right now.

Paul Sarvadi

And we have service standards that are agreed to in our contract and we certainly haven’t been anywhere near the, you know, any of those service standards not being met.

Michael Baker – Raymond James & Associates

Thanks for the commentary, guys.

Operator

Your next question comes from the line of Cynthia Houlton of RBC Capital Markets. Please proceed.

Cynthia Houlton – RBC Capital Markets Corporation

Morning. I just had a question. I think in the preferred comments I think there was a mention of kind of offering I guess existing customers newer services like identities theft, some different retirement packages, etcetera. Could you elaborate on that in terms of any cost associated with that? Is that something that you’re providing in house or you’re working with partners? Could you just discuss that a little bit more in terms of who’s being offered these other services, how broadly, and kind of, you know, are they in-house services or third party?

Richard Rawson

Sure. Let me kind of explain a little bit. We put together some additional benefits for the client owner which involve identity theft protection for the individual client owner and for their company. And then also we made an arrangement with an operation that has what we believe is a one-of-a-kind business research service, web-based business research service, which I’ll probably talk more about next quarter, but it’s a really valuable tool. Kind of a small business destination site that we’re being able to provide to our customers that we think really helps their business and helps them be more informed and get quicker answers to business questions. So that we provided to our customer. We are paying for those. We were able to negotiate tremendously low discounted costs and we think it’s a good investment for us to provide those to our client owners free of charge.

Then there were other benefits provided to employees. For example the Roth 401(k) that was introduced to our retirement services organization, and then we also made arrangements, a relationship with Aflac to provide several of their programs that are options that employees can buy; and then we also even added a pet insurance program through an external provider that employees can buy as well.

Cynthia Houlton – RBC Capital Markets

Again, this is something that you are broadly pushing out to existing customers as a way to incent renewals or again, this is something that is going to be part of all customer packages?

Paul Sarvadi

Yes, it’s something that you keep adding things that keep things fresh for our clients and it really happens on behalf of our client-owners who are going to their employees and saying, “ hey, here are some new benefits we have, some new options.” Some of our clients when they come to renewal sometimes they need to pass on more of the benefits costs to employees. So here is an offset to that where they have got some new things they are providing at the same time. So it’s a benefit to our clients for us to be active in adding to our offerings and making it better year after year.

Operator

Your final question comes from the line of Bob Bennett – Groundswell Equity Partners.

Bob Bennett – Groundswell Equity Partners

Particularly when Jim Macdonald was talking about the softening in the economy, I wanted you to go into little detail in terms of particularly for your middle market clients, what kind of financial underwriting you do for new clients as will as current clients, particularly at the renewal process? Do you do that for each client?

The second thing was, you talked about a 20% attrition rate and I wanted to better understand how many of those clients when they are leaving are clients that you are basically terminating?

From that, how does that tie to, if you think about it, the general business marketplace with companies sort of failing or going south in terms of laying people off and things like that?

Third in summary, your bad debt expense is very nominal -- almost non-existing -- and how does that tie to your underwriting process, as well as to your attrition rates? How can it be so low, is really the question I have for you?

Paul Sarvadi

. Let’s try to address those one at a time. But on the mid market like all of our customers, we get paid by our clients by wire transfer or direct debit prior to submission of payroll. Then we have a very experienced team that manages the credit risk with our client base. Our mid market customers, obviously the dollars are much higher. So we have a process we go through with each customer to make sure we know that we have our relationship secured properly with each customer.

Bob Bennett – Groundswell Equity Partners

Could you go into little bit more detail on the color of that underwriting process particularly on the company that’s been with you for a couple of years?

Paul Sarvadi

We do monitor, we have a watchlist of customers we keep an eye on based on the size and the credit risk that’s associated; we have a group that monitor and keep track of those customers. If there is any indication of any issue -- which a lot of times we will get from a different source -- sometimes within our service organization, we will hear about maybe there is a potential layoff or maybe there are other indications that there may be some issues going on at the client location and that will prompt us to put them out of watch list or contact the financial officer and have a dialog about what’s going on in their operations.

Of course some of them public companies, so we will keep track of the things that are going on there. But this group that we have internally that managed credit is doing a phenomenal job of making sure that we don’t have a risk out there that we are not comfortable with.

The little bit of bad debt we do have, it is unusual, but I think they do a super job there.

Bob Bennett – Groundswell Equity Partners

What percentage of your trade customers – call it 20% on annual basis -- come from clients that you have effectively terminated, because they didn’t hit your criteria or they didn’t do what you wanted them to do in terms of an underwriting process?

Paul Sarvadi

I am trying to think of the rest of the question…

:

No, it was long-winded, I understand.

Paul Sarvadi

No problem. Of the 20% that got away, typically half of those relate to financial related decisions. These are clients that said, hey we have a change in our operations, we can’t make it so they leave or we make the decision that is based on, if they are having any trouble financially making our commitment, we need to separate, unless we could get fully secured on that risk.

Beyond that, we do have the other 10% that ago away typically one-third related to customers that have a compliance-related issue, and if they won’t comply with the requirement, a government requirement whatever, we have to let those go.

About another one-third are what we call kind our success penalty customers that get purchased by another company and become a part of a larger organization. They are in about one-third of the 10%.

Our service issues, where we don’t meet the expectation of the client -- in a down economic climate, the financial difficulties go up some and sometimes even the compliance issues go up a little bit. So that’s why historically we do see that 20% of attrition go up during a down economic period; although we don’t see that we are in a situation right now where we are seeing any indication that there is an increase in terms for those types of reasons.

I appreciate the question and it appears that we are getting near to the end of our time. I just wanted to thank everybody for participating in the call today, and we look forward to having an update for you next quarter.

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