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Automatic Data Processing (NASDAQ:ADP)

Q2 Fiscal 2006 Earnings Conference Call

January 25th 2006, 1:30 PM.

Executives:

Karen Dykstra, Chief Financial Officer

Art Weinbach, Chairman and Chief Executive Officer

Gary Butler, President and Chief Operating Officer

Analysts:

Greg Cappelli, Credit Suisse

Greg Smith, Merrill Lynch

Tien-tsin Huang, JP Morgan

Brandt Sakakeeny, Deutsche Banc

Lloyd Zeitman, Bernstein Investment Research

Greg Gould, Goldman Sachs

Adam Frisch, UBS

Mark Marcon, Robert W Baird

Bryan Keane, Prudential

David Togut, Morgan Stanley

Rod Bourgeois, Sanford Bernstein

David Grossman, Thomas Weisel Partners

Pat Burton, Citigroup

Gary Bisbee, Lehman Brothers

Cindy Shaw, Moors & Cabot

Presentation

Operator

Good afternoon. My name is Carol, and I will your conference facilitator. At this time I would like to welcome everyone to the Automatic Data Processing, Inc. second quarter fiscal 2006 earnings conference call. I would like to inform you that this conference is being recorded, and all lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question and answer session. (Operator Instructions) I will now turn the call over to Karen Dykstra, Chief Financial Officer. Please go ahead ma'am.

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Karen Dykstra, Chief Financial Officer

Good afternoon. I'm Karen Dykstra, Chief Financial Officer for ADP, and I'm here today with Art Weinbach, our Chairman and CEO, and Gary Butler, our President and Chief Operating Officer. As you know, we issued our earnings release for the quarter earlier today.

Our results were strong, with 9% revenue growth and 31% growth in earnings per share from continuing operations. And as you can see in our release, we recently completed the divestiture of our Graphics Communication business within our Investor Communications group. The business was the financial print business, which had declined in recent years with the decline in demand for research print. The revenues for that business were about $100 million annually, and it was close to a breakeven business pre-tax. During the second quarter we recorded a onetime charge for the write-down of the assets, and reclassified the business to a category called discontinued operations. Almost all of the charge that we took in the second quarter was related to the write-down of the assets. As I said, the business itself was running at close to a breakeven point. All prior periods now reflect this discontinued operation, and we have provided those reclassified numbers on our Website.

Also I wanted to mention we've been getting a lot of questions over the last few weeks as the SEC issued its proposal on Internet availability of proxy materials, and I'd like to take you through how we look at this, although I'm sure, you're welcome to ask more questions during the call. The comment period runs about three more weeks, and ADP will be submitting a written response in the next few days. The proposed rule is directed at the annual proxy mailings for corporate issuers, with the underlying premise of access equals delivery, and a goal of lowering printing and distribution costs for corporate issuers. ADP will continue to provide voting services; that supposed to change. Access in this case means allowing shareholders to get this information on the Internet versus the historical delivery, the mailing of annual reports and proxies.

The proposed rule impacts our proxy mailing business, which is within our Brokerage Services group. We deliver about 1 billion pieces from our Investor Communications group each year, and of that, about 300 million pieces represent equity proxies. The number of pieces mailed will not change, since ADP would be mailing this postcard notifying shareholders where to go if they elect to receive the material by mail. The weight of the mailings, obviously, would be lower from not mailing the annual report and proxy, lower, resulting in lower postage revenue, which has a large pass-through cost. So think of it as very low-margin business.

The total for the potential revenue impact this year is about $150 million. Now, that's two-thirds postage and one-third fees. But the outcome, and I want to be clear about this, the outcome will likely be primarily postage-related, and a much lower number than the number that I just mentioned. And that also assumes there's no change in the process for shareholders that have already elected electronic mailings. So it's still very early in the process, and no one is clear on what the final rule will be, but we believe that it will be pluses and minuses. For example, just to give you an example, under the proposed rule, a shareholder can request printed copies, and the request must be fulfilled within two business days. ADP would fulfill those requests on a pick and pack basis, which will generate a higher fee per mailing than the current bulk mailing process.

So overall, I think you should hear that there is pluses and minuses; there's still a lot to be determined. There certainly would be an impact to ADP, but likely not a significant impact to ADP, and we will continue to update you as more of this becomes available. So, having said all that, hopefully that provides you some additional clarification on these new topics in the brokerage business. Switching over back to our strong results for the quarter, we are halfway through the year now, and we've narrowed our guidance on earnings per share for continued operations to 23 to 25% growth, basically taking off the bottom of the range. We also improved our revenue growth guidance to 10%, which reflects the strength that we had so far this year, plus the additional Kerridge acquisition revenues in our Dealer Services business.

Art, did you want to add some comments?

Art Weinbach, Chairman and Chief Executive Officer

I really did. Thanks, Karen. I guess my cut at it is we really had a terrific quarter. Our results were, clearly, stronger than our plans; 9% revenue growth, 31% earnings per share growth sounds pretty good to me. So I feel very good about the quarter. I must admit that I was surprised by the softness in our stock today, which just proves to me once again I never would make it as a stock prognosticator. But more important, when we entered this year I talked about momentum, and I talked about the importance of momentum in a recurring revenue model. It should be very clear now, six months into this fiscal year with the results that we've delivered, that we have it.

There are always short-term aberrations in individual results. And unless those short-term aberrations are forewarnings of things to come, and we really don't think any of the numbers today really are forewarnings of anything negative, so we don't really believe any of that exists today. But these short-term aberrations really shouldn't get in the way of the very, very positive direction in which we're heading. I'm very comfortable with where we are six months for the year. And as usual, I'm optimistic, but for very good reason this time. I'm very optimistic about where we are going.

As always, I will look forward to your questions.

Karen Dykstra, Chief Financial Officer

Now we'll turn it back to the conference call operator for your questions.

Questions & Answers

Operator

Thank you. Operator Instructions Our first question will come from the line of Adam Frisch with UBS.

Q - Adam Frisch

Thanks; and good afternoon. If I could ask a clarifying question, and then hopefully something that's a little bit more insightful. Art, I think some of the confusion around, or your surprise around the stock price is confusion around the margins reported in the quarter. And I'm not sure that the press release really deciphered between if it was upside in the core operations or if everything came from interest rates, which, obviously, you wouldn't receive as much credit for if they were coming from the actual business. So when we take out the option expense from SG&A, COGS and R&D, to get an apples-to-apples comp year-over-year, I think the margins improved by about 230 basis points, excluding most of the investment activity. Can you say, can you give us a clue here if that's kind of the right conclusion to draw here? And if so, if you could provide more color around how the core business, how you're generating more leverage and operating profitability from that.

A - Art Weinbach

I think if we look at the overall margin, we had a terrific margin first half. We're up over 200 basis, over 2%, I think, in terms of the numbers. Karen will tell you what the real numbers are in a minute. We had started this year, and we talked about every one of our businesses increasing their margins by 1% during the year. Certainly we're comfortable with that for our services in brokerage today. So I think we're feeling very good. And in addition, we are basically doing better than we had anticipated. Because we're doing better than we had anticipated, especially in Employer Services, we stepped up some investments and some expenses, and we took them earlier than we would have in another part of the year. So again, I'll let Karen cover what the real numbers are, but the direction you should hear is we're feeling very comfortable with where we are on a cost control and a margin basis. And I'm talking within our operating units, having nothing to do with the interest in any of those comments.

A - Karen Dykstra

And as everyone knows, the interest does not play into the Employer Services results, so the margins are, reflect real business growth and nothing to do with interest rates. Yes, the press release has one earnings statement that portrays the comparable periods from last year as if we had stock compensation expense in the number, so that is available to look at both ways. It is true on a year-to-date basis we're up significantly on a pre-tax margin basis, and in the quarter we're up significantly in, very significantly on a pre-tax basis, if you adjust last year for the stock compensation expense. Yes, interest rates do help the overall pre-tax margin, and the quick and dirty as you look at it are interest yields in the quarter was higher than last year's second quarter, and we give those results as well in the press release. But when you add up 7/10 of a point on a $12 billion client balance, obviously, that impacts the results as well.

But I think even when you do the math, you say okay, if they increase their yield by that much in the quarter on that kind of balance, and you back that out of the quarter earnings and revenues, you still get a significant increase in the pre-tax margin. So the margins are improving in all of the businesses, I would say, except at this point Dealer Services, because of the acquisition of Kerridge. Our margin in Employer Services for the first quarter was a very large quarter-to-quarter of last year improvement in pre-tax. This year it was more or less flat, I mean this quarter, I'm sorry. The second quarter was more or less flat as we increased our investment in some sales implementation headcount. But we are still projecting a 100 basis point improvement in Employer Services, and again, having nothing to do with interest rates.

Brokerage Services' margins also have improved, and are close without the, when you adjust for the discontinued operations. But on a full-year basis, we're still projecting about a 100 basis point improvement overall in brokerage as well. So I think we're well along the way to these improved margins, and hopefully with the data that we provide separately on comparable bases adjusting for stock comps, folks can get their in terms of what the real comparisons are year-to-year.

Q - Adam Frisch

Definitely verified my point. Thank you for that. My two questions related to the actual business are as follows. We focus on things like the metrics that you include in the press release, like retention and sales and things like that. Three issues I want to bring up to see what your views on them are, and how they're going to affect your business going forward. The first being wage inflation, the second being tightness or looseness of the labor market, and the third is the apparent easing of healthcare costs. Could that benefit or hurt your business, those three issues?

A - Art Weinbach

Let me try and take each one of them separately. Wage inflation plays into our business all the time, especially, the easiest place for you to see it is in our tax filing business, where the balances go up. It's kind of a built-in growth that we have, just because wages and wage growth make the balances higher, and therefore, makes the amount that we have under investment and yield on it higher. Wage inflation, the numbers that we've been looking at recently look stronger than we had again anticipated earlier in the year. So I'm not an economist to comment on wage inflation, but if I looked at the trends in our numbers, I'd say it's moving up. In terms of the overall labor markets, which I think was the second of the two parts, the number that Karen talks about each period in our Employer Services business is paid for control, and that again plays into our overall growth in a meaningful way. The number was a little over 2%, a little bit over 2% in the U.S. for the, quarter or six months?

A - Karen Dykstra

Both.

A - Art Weinbach

Both the quarter and the six months. So that's there. And if you ask do we see any trend, we certainly have seen a relatively consistent 2% increase throughout the year. The third piece was healthcare. Clearly, we have a benefits administration business that's part of our Employer Services business which provides health and welfare services, and so we are affected by the methodology and by the plans that are in place. But unless there was some massive change, I think it would be an ordinary transition for us from the current healthcare environment to wherever it might go in the future. So I don't think the increase in healthcare expenditures by itself has a significant impact on us.

Q - Adam Frisch

If I could just sneak in one more, Art. At the last analyst day you said your appetite for larger acquisitions was in fact larger. And from this I assumed you would be doing some things in Employer or Brokerage, so I was a little bit surprised to see activity in Dealer and Claims. Do you have powder left to do other things, bigger things in your bigger businesses? How do you plan on allocating capital going forward?

A - Art Weinbach

My prior reference was to Employer Services and to Brokerage primarily, so that you should not interpret the other transactions as in any way answering the question or the direction of where we are. And certainly the amount of resources that we put into these acquisitions is not enough for us to change our direction, in terms of our appetite for larger transactions, especially in Employer Services.

Operator

Our next question comes from the line of Mark Marcon with Robert W Baird.

Q - Mark Marcon

I was wondering if you could talk a little bit about the acceleration that you mentioned in terms of the growth in the sales force and the implementation resources that you put in place. Could you give us a little bit of color on that in terms of how much should you move it up? Because when we look at the Employer Services margins, they were basically down about 20 bips on a year-over-year like-for-like basis, despite the 10% revenue growth. So I'm just trying to understand that to a greater extent.

A - Gary Butler

Our headcount in Employer Services sales is roughly up on a year-to-year basis, call it 5, 6%. We are also in process, not complete, but in process, to ramping up to our '07, at least desired, headcount for sales as we look today. So you will see that headcount increase another 6 to 7% over the remaining portion of this fiscal year, so that we are fully staffed and ready to go into field sales with that group as we enter fiscal '07 and beyond.

Q - Mark Marcon

And the reason for accelerating the growth in terms of the sales force, is that because you're seeing just a better business environment, a better selling environment, and therefore, want to take advantage of the environment? What's the rationale behind the acceleration?

A - Gary Butler

Several things. Typically, the most tried and true method of growing Employer Services, or Dealer, or any of our businesses for that matter, has been through the control of a direct sales force. So to the extent that we add more salespeople and add more quota and deliver more new recurring revenue, then we'll grow our core businesses. We also focus, clearly, on raising the productivity per salesperson in addition to adding headcount. So we have other measures and programs that would support that as well. And then thirdly, we would attempt to grow our new revenues through alternate distribution, like our arrangements with Microsoft or SAP on our GlobalView product.

A - Art Weinbach

We also started the year a little softer than we wanted to be in terms of the size of our sales force relative to our plan, and the size of our implementation force in relation to our plan. So during this quarter, not only did we beef up and get a head start on next year, but we also filled part of that shortfall. So it's the combination of those things that I think really gets to what happened in the increased expenses in Employer Services during the quarter.

Q - Mark Marcon

Even with that acceleration, you continue to be confident that you should be able to show about 100 basis points of margin improvement for the full year, which would imply good improvement on a year-over-year basis during the back half of this fiscal year?

A - Karen Dykstra

Right. And on a year-to-date basis we are still over 100 basis points better than last year in Employer Services. And even with this expense, acceleration of new business expense, we are looking at a 100 basis point improvement.

A - Gary Butler

Normally we would hire those resources in the fourth quarter, but because we are having a strong year and we sense the marketplace being very receptive to additional deployment of direct sales resources, we've taken the liberty of moving those investments further up in the cycle so that we can be even better ready, so to speak, as we begin '07.

Q - Mark Marcon

That means the margin, the year-over-year margin improvement in the first half of '07 should be even stronger than what it normally would be; is that correct?

A - Art Weinbach

We're not ready to go into '07, clearly, at this point in time. So we'll have a number of judgments that we have to make between now and '07, so I'm not getting, too early in terms of '07 prognostications here.

A - Karen Dykstra

I would also give us a little bit of leeway in that we're still only halfway through '06, so we still have time to make decisions about what we might do in the back half of '06 as well. Right now, based on our forecast, this is what we're forecasting. But we have a lot of the year to go to make those kind of decisions on what we're going to invest in.

Operator

Our next question comes from the line of Bryan Keane with Prudential.

Q - Bryan Keane

Art, maybe you can help us, or Gary, with the new business sales. It looked like it was 9% in the U.S. and 8% worldwide. Maybe you can just break it down. It sounds like it was strong in National Accounts and Small Business, but it's still slightly below expectations. Can you expand on that and give us some color? And then, how does that look going forward? Because you guys do seem pretty confident.

A - Gary Butler

As we mentioned in the release, we are forecasting double digits for the full year of '06. So when you take in the fact that we are 9% for the first six months, it would imply a fairly strong second half. The results in SBS and in National Accounts were very strong, and we continued to see a continuation of that result. As we mentioned at the end of last quarter, we did get off to a slow start in our international sales. We had a very strong fourth quarter of '05, but we did get off to a soft start, and we were under manpower in our international sales unit. They did have a very good December, and we are expecting them to have a strong second half as we finish out '06.

A - Art Weinbach

I just want to clarify at the beginning, when Gary was talking about 9%, that was in the U.S. Our overall including international is 7% year-to-date. So we do have to have a pretty good second half in order to get to the double digits.

Q - Bryan Keane

Is it still being carried by the beyond payroll services? Is that where the crux of the pipeline looks like it is going to create the opportunities?

A - Art Weinbach

Beyond payroll continues to grow faster, clearly, than our traditional payroll and tax service. So that will continue to be the primary driver.

Q - Bryan Keane

Karen, I don't know if you have the numbers, the breakout between, for that beyond payroll growth in the quarter versus the core business payroll.

A - Karen Dykstra

Yes, I have the growth. We're distinguishing between the previous conversations where we were talking about sales growth and what has to happen the second half of the year, and I will provide you with the revenue growth. Revenue growth for the quarter was 7% in the core payroll and tax, and then 14% for the beyond payroll category, which gets you to the 10% U.S. revenue growth in Employer Services. I think the good news in that is that 7% in the core payroll and tax is quite good, compared to where we had been in the last couple of years. So we're very pleased with that 7%.

Q - Bryan Keane

Finally, Karen, talking about the e-proxy thing. If we're talking about 150 million, two-thirds of that postage and probably most of that being, we're talking about a couple of pennies at most really. Am I looking at that right? And is it possible even that it could be accretive to your business?

A - Karen Dykstra

We're very hesitant to give out a range of what it could be, because it likely could swing in a lot of different erections. I wouldn't argue with you; it could be a couple of pennies. It depends on what way, assuming that we still do the electronic mailings the way we do them today, it would probably be in that range. It's possible, but I would say unlikely that it would end up to be accretive, but there's so many things going back and fourth at this point, and so early. It is really hard to call, which is why we didn't give a range on the earnings per share. I wouldn't argue with your number. I would say it's as good as anybody else's at this point.

A - Art Weinbach

It's very clear that something is going to happen this proxy season. Whatever we're talking about, we're really talking about in the future. We are in the 60-day period where, for the SEC comment period right now. And once that ends, there will still be a lengthy discussion, the date period, and then we'll all have to see how it comes out. So there's just too much uncertainty to get more specific. I think I totally share what Karen said, we really don't think this is going to be very significant.

Q - Bryan Keane

And it would be '07 at the earliest, fiscal year '07 for you guys, probably more like fiscal year '08? Or is it still too close to call?

A - Art Weinbach

I would say that their intention, as we understand it, is to try and have this in place for the '07 proxy season, which would be companies where the year ends December 31 '06 and later. But again, there is so much between now and then, you sure can't bank that number.

Operator

Our next question comes from the line of David Togut with Morgan Stanley.

Q - David Togut

Karen, can you give us a little bit more granularity on the flow, just the latest duration? And as you look at the reinvestment of instruments in that flow, are you looking at a lot of reinvestment over the next six to 12 months more at the two-year end of the spectrum, or perhaps further out where you might have some yield pressure on reinvestment?

A - Karen Dykstra

Sure. Right now, we're about 2.3 years duration. As we look at the next six months, for example, we have about 1.4 billion rolling over within, so just to finish off the fiscal year, about 1.4 billion rolling over with embedded yields of about 3.4%. And our new purchase rates, assuming we would go in the same, in a similar duration to what's rolling over, would be more like 4.6, 4.7% just for the next six months. In total as we look at a 12-month period, we think of it in terms of about 5 billion to reinvest, some of which is coming from maturities and then additional income and things, and all of those things that we've talked about in the past. So that number still is about the same. David, did you have anything further?

Q - David Togut

On the 5 billion to reinvest, could you give us a sense of what the yield is on that 5 billion, and what the, I guess the duration, if you will, of what you're reinvesting?

A - Karen Dykstra

I don't have the exact embedded yield in the total maturing. The 5 billion to reinvest would not all be rolling over; it would be rolling over plus additional cash flows from operations and so on. So it's not all rolling over. I don't, I'm sure it would be slight, slightly different than the 3.4 that I said for the six months, but I don't think it will be materially different. In terms of where we're going, I think, is the bigger question, is where are we going with the maturities, right now we're intending to keep it about as is. We're about 2.3 years. As the interest rates continue to rise, we could always look at timing of when to go out a little bit longer. But we have not made any of those decisions, so right now you should hear that our investment philosophy remains consistent with where we have been in the past year or so.

Q - David Togut

Just a quick question. If you could remind me what the standard yield is that you assess the Employer Services business, and what the variance was in other income from changes in interest rates in the quarter.

A - Karen Dykstra

The Employer Services gets credited with 4.5% interest rate, and the yield in the difference was $13 million period to period from the second quarter to the second quarter of last year. I don't know what the, I don't have that number in front of me of what that change is from, but the difference that is impacting the other segment is worth 13 million in the second quarter.

A - Art Weinbach

Our average yield was 3.8% in the second quarter.

A - Karen Dykstra

3.9 in total for the second quarter.

Operator

Our next question comes from the line of Rod Bourgeois with Sanford Bernstein.

Q - Rod Bourgeois

I just wanted to inquire on the guidance. You beat the Street this quarter by $0.02. I'm wondering why not take up the upper-end of your guidance range. Is that just a level of conservatism, or does it reflect that the Street was sort of loading the quarterly earnings numbers differently than what was in your plan?

A - Art Weinbach

We have done well. When we gave the range before, it was somewhat lighter than it is right now. What we basically said is we're floating around near the top of the range, and we know with much higher confidence we are not going to be at the low-end of things. That's really what we did this quarter. As always, we will continue to monitor it every quarter and let you know where we are. We also wanted to take advantage of some of these incremental investments and some of the expenditures that we're taking, because we're really convinced it's going to help our long-term growth for all the reasons Gary enumerated when he was talking about the increases in the sales force.

Q - Rod Bourgeois

Great. It's encouraging to see the core and tax business growing 7%. What would you attribute that to? Is it because your bookings number in the last couple of quarters has been somewhat lighter than the ultimate plan, and I guess retention is down a little bit year-over-year. Is the 7% growth just a function of the strong bookings and the better retention that you had a year ago, and the sort of ripple effect from that? Or is it attributable to something else?

A - Karen Dykstra

I think you can look at it as, one, good sales results last year and the beginning of this year. Two, it's the 2% increase in pays per control that we're seeing, 13% growth in client fund balances, which for the quarter $12 billion of client funds which gets credited to ES of 4.5%. Better retention, all of those things add up in yields a 7% growth in the core payroll business.

Q - Rod Bourgeois

Okay. Is there something changing secularly to help that growth rate, or is it really just sort of a function of your sort of investments and better performance in sales productivity and so on? Is there something secularly changing to help that a little bit?

A - Art Weinbach

I don't think there is a secular change. I think the momentum I was referring to at the beginning of the year comes into play in our business. So what we have is all the things that drive growth in the normal time. And it's what are our sales going to be, what is our retention going to be, what's going to happen with pays per control, what's going to happen with client balances? Things like the wage inflation question that came up before certainly factors into it, because it factors into the client balances. But as you continue that, and as we talk about retention and it continues, but it's improving each time. So that as it continues to improve, you get not only that little bit of benefit, but you carry the whole base along with it. And so it's that kind of thing that helps fuel this revenue growth. So no, I don't think there is a major secular change. I think we're riding the current momentum base.

Q - Rod Bourgeois

If you could give a quick update on the Microsoft relationship and the progress of that, as it hopefully is in the early stages of ramping up a little bit. That would be helpful. Thanks.

A - Gary Butler

We continue to be pleased with our partnership with Microsoft. As you happily noted, it is very early in the process and very early in the sales cycle of a new product like their small-business accounting, which includes our payroll product within the product. The results are a little bit slower than we initially expected. We get continued good reviews on the product from the CPAs, as well as from the end users, or our client. Microsoft has announced a marketing campaign starting in January, which includes both media promotion as well as some price promotion. And as you again noted, this is a long-term relationship with them, and the partnership will take some time to deliver big results. But in time, we still have good confidence that it will be what we thought it was going to be.

Operator

Our next question comes from the line of David Grossman with Thomas Weisel Partners.

Q - David Grossman

Karen, could you perhaps highlight the margin drivers as you see it in the second half of the year in Brokerage and Employer Services, and highlight if you can any differences that we may see in the second half of the year versus the first half of the year in terms of what the primary drivers will be?

A - Karen Dykstra

In brokerage, I think the most important thing to remember and to think about as you look at the margins are the huge effects of the proxy season at the end of the year. So if you look at our brokerage margins in the quarter, 15%, year-to-date 15%, we're really forecasting that for the year we'll be 18 or 19%, closer to 19%, which is about a 100 basis points better than last year in brokerage. And that all comes in at the end of the year with the proxy season, because it's an enormous scale that comes into play when we process all of those pieces and deliver all those pieces. So I think that's the unique thing to consider looking at the brokerage forecast. If you look at the Employer Services forecast, we are a little bit over 100 basis points better on a year-to-date basis. Our full-year forecast is higher, call it 23% compared to 22% last year. Our third fiscal quarter is our big quarter. It's the year-end processing. We get high margins on W-2 processing and the like. So that's the thing that comes into play, third quarter being the highest overall revenue quarter and highest overall margin. And that will buoy up to the higher level forecast that we're calling for the full fiscal year.

Q - David Grossman

But in terms of non-seasonal factors, are there any differences between the year-over-year drivers of margin expansion in the second half of the year versus the first half?

A - Karen Dykstra

Not really. I can't think of anything that's not seasonal. Like I talked about, last year we were investing all through the cycle. And this year we already talked about we have already started the investments. But there's nothing big that I would say we should look forward to in the second half of the year. And in terms of our expense levels, that would adjust it one way or the other.

Q - David Grossman

On the PEO side, I think you made an announcement the other day that you had entered California. Can you help us understand what impact both near and intermediate-term we should look for in terms of the overall growth rate of the PEO business, and any color you can in terms of how you view the market opportunity in California?

A - Gary Butler

California is a terrific marketplace for a couple of reasons. One is we have a lot of clients already in California that are good candidates to purchase our PEO services. The regulatory environment and the pricing environment around workers' compensation insurance has also changed over the last year. So we are quite excited about the opportunity there, and are staffing up our headcount to address that accordingly. It certainly will enhance our growth rate in the PEO, because it's additive to where we've been in the past historically. So all in all, I think it will keep us up in the kind of very strong growth rates that we are in today as we look into the future.

Q - David Grossman

So you would view it more as sustaining the current growth rate as opposed to accelerating the current growth rate in the PEO business?

A - Art Weinbach

I think it will give us a short-term tick in the growth rate, and then over time, no business continues to compound out at the 20%-plus rate in the type of business we're at forever. So at some point in time, I would go where Gary was and say it will blend.

A - Gary Butler

But I think the important thing to note is that even in the non-California market, we are certainly not anywhere near penetrated to any significant level in terms of both the sales headcount that we can deploy, as well as the client base that we can upgrade. So we think this is just a great extension of more of the same good thing.

Q - David Grossman

One last question on Europe. It looks like, despite some weakness in Europe for the first time in several quarters, the pays were flat year-over-year. Can you, you can view that as stabilization, or do you think we're closer to a turning point in the European market?

A - Karen Dykstra

I think that we might, I would like to think that it's stabilization. I think really where we sought improvement was in France. And there was some significant seasonal hiring in France at the holiday time. As we dissected our numbers, we noted the clients, and so on. So I'm not sure that France wouldn't go back the other way and bring us perhaps back to the small decline. That was the only noticeable change. We've seen improvement, for example, in Canada and the UK for the last couple of quarters. But we still see weakness and decline in Germany and the Netherlands. And it had been declining more in France, and France turned into a slight positive this quarter. That I'm not sure will sustain.

Operator

Our next question comes from the line of Pat Burton with Citigroup.

Q - Pat Burton

Congratulations on the quarter. My question is for Karen, and it relates to the ramp-up in interest expense. Can you just go through the components of that? Thanks.

A - Karen Dykstra

The ramp-up in interest expense is really related to leveraging our portfolio strategy. So the interest expense is most subject to current interest rates. So as the short-term interest rates have risen, that goes right to the interest expense line, because that's, and we borrow, as you know, more than 200 days per year based on our cycles of when we have high balances and low balances. The second quarter is typically a higher borrowing quarter; won't see as much in the third quarter when our balances are higher. But it's really the fed funds rate movement and the short-term rate movement that caused the acceleration of the interest expense line.

Q - Pat Burton

But on a seasonal basis, you would expect that to go down then, in the third quarter?

A - Karen Dykstra

As we look at our high peak balances month, the third quarter and going into April are really our higher balances. So there's less borrowing days. Now, as funds rates or short-term rates keep growing, that will offset some of it. But yes, I wouldn't expect to see the same growth in the third quarter.

Operator

Our next question comes from the line of Gary Bisbee with Lehman Brothers.

Q - Gary Bisbee

A couple of questions. In response to one of the first questions you had on the margins, can you just clarify? It appears to me that the pre-tax data that's in the press release and on your Website, the year ago numbers do not include option expense. And as a result, the margin this year is a tougher comparison. Am I looking at that the right way? And if so, what are the year-to-year actual like comps, excluding margin, I'm sorry, excluding the option expense in both periods?

A - Karen Dykstra

Let me give that to you. I thought it was in the press release. As a separate statement right after the as-recorded results, we try to put out an adjusted prior year column that has the adjustments for stock comps in. And it should be there or at least on the Website for all of the details, I will give you the numbers. The pre-tax margin this quarter, as we report it, is 20.4%. Compared to last year, without stock comp expense, the number was about 20.2. But if you adjust last year's numbers to take out the stocks to include stock compensation expense, the number would have been about 17.8%. So you're looking at an apples-to-apples 20.4 versus 17.8.

Q - Gary Bisbee

I'm sorry; I must not have clarified. I was wondering of the segment level, if you would be willing to share that data.

A - Karen Dykstra

At the segment level we are not imposing the stock compensation expense in the segment results. The additional stock compensation is all at the other segment as part of the corporate results.

Q - Gary Bisbee

All in the other segment. Okay. Thanks for clarifying that. A couple of other questions. How significant in your mind is the entry into the accounts payable market that you had a release out on earlier this week, and how large a market opportunity do you see there? And lastly on that, how much of this is an easy upsell into the existing client base?

A - Gary Butler

First of all, this is a relatively small initial launch into the accounts payable market. Obviously, we have terrific abilities around money movement and other kinds of electronic reconciliation and so forth in terms of moving data. So the accounts payable marketplace on the surface looks like a good extension of our core capabilities, and certainly, with the large number of accounts that we already have for our payroll services, a likely extension of add-on services. So we've entered into an alliance to kind of test the water with a company called Harbor Payments, to kind of see where it will take us. So it's early, and we'll keep you advised as things develop.

A - Art Weinbach

Part of our strategy has been how do we extend our money movement type activities? And I think Gary expressed it very well; this is an extension which will in part play into that longer-term strategy. It's early. We will see how it plays.

Q - Gary Bisbee

Are you willing to quantify the aggregate revenue contribution of the beyond payroll versus the core payroll and tax within the Employer Services business?

A - Karen Dykstra

Just for example, for last year, for the full year fiscal '05, the beyond payroll category was about 1.7 billion and the payroll category about 1.75 in the United States. I'm sorry; 2.75. 1.7 in beyond payroll and 2.75 in our core payroll and tax in the U.S., for about 4.5.

A - Art Weinbach

Karen, also I think some of that 40% has tax-related or money movement-related products included in it, like total pay.

A - Karen Dykstra

The way we categorize the beyond payroll category has some product which you could certainly look at and say which side do they belong on, or do they have payroll and tax characteristics, or do they belong in the extension category total pay. Money movement would certainly be one of them. That's not tax filing, but it's the payment on an ADP check or direct deposit money movement aspects that's clearly related to processing and payroll.

A - Art Weinbach

The way to think about that if you want to think of it over the conversations we've had for a long time since we first started talking about beyond payroll, we've been consistent in the way we report it. And that percentage is growing to where we think the beyond payroll piece on this consistent methodology we've been talking about is going to approach somewhere around 40%.

Q - Gary Bisbee

One last question. Are there any attractive, or how many do you see types of attractive large acquisition opportunities in Employer Services? That stems from a lot of investor, investor frustration in the last year with the lack of activity there. And given what's been stronger growth, higher profitability and higher return on assets than your other business, why the delay in making a move there and/or investing in the Employer Services business more versus the lower return businesses within your portfolio?

A - Art Weinbach

I think as you go up into really significant size, you could list the, and everyone could list how many companies there are and what the alternatives are. When you start coming down into what I will call the 50 million to $250 million revenue size, I think there are a number of opportunities. I can tell you our appetite is there. I can tell you we have a team that's clearly focused on trying to do transactions in the Employer Services space. I can tell you that Employer Services acquisitions is the highest priority in our acquisition program. And we'll see what happens. We're not in the business of forecasting any transactions before they get announced.

Operator

Our next question comes from the line of Cindy Shaw with Moors & Cabot.

Q - Cindy Shaw

A couple of questions, first around the hires in sales. If you could give us some color as to where you're adding them. You mentioned you were understaffed in international earlier in the year. Also just comment on major accounts versus national versus Small Business Services. And give us a sense for, particularly in Small Business Services, if they might actually be able to impact revenue in this fiscal year.

A - Gary Butler

The price where we would be adding the most headcount would certainly be in our small-business services. The place where we would be adding the second-largest amount would be in the PEO. In majors, that number would be relatively modest in terms of the actual account headcount. And we are trying to raise the headcount in our international unit across the board.

Q - Cindy Shaw

And in Small Business Services and the PEO, do you think they'd kind of impact results fairly quickly? I know the larger accounts it takes a while.

A - Gary Butler

It would certainly have a positive benefit toward the end of this fiscal year, but not in a real significant number.

Q - Cindy Shaw

On the employee, the client retention, you'd had some pretty nice improvements in a string of them. It seems like that stopped in the most recent quarter. If you could give us any sense for is there any particular reason that you can pinpoint it to? Are you seeing employee retention also drop off, or where do you think that might be going?

A - Gary Butler

As it relates to Employer Services, we were slightly behind last year's level in the second quarter. However, on a year-to-date basis, we are in essence even with last quarter. So we think our service levels are strong, and we'll continue to enjoy very excellent client retention.

A - Art Weinbach

Can I have an opportunity to add something if I could. It's important, as you talk about that seasonality and the calendarization that Karen was talking about before, that we recognize how important the January period is to our Employer Services business. First of all, it is the key retention month for us during the year. And all we have at this point is anecdotal evidence. I know Gary was saying to me earlier today that the service levels and the anecdotal reports that we're getting are that we've had a very good year-end, and that our quality and our retention looks pretty good. We will see what the numbers are when we report them at the quarter. But also, on the sales side, January is our largest quota month during the year, and we had a pretty good January. So on both of those indicators, as we try and look at the very small number of retention that Gary was referring to that we were off in the quarter, I think it really goes to the comments I was making at the beginning. But unless there's a real trend out of that, those aberrations, anything can happen in a short period of time. I wouldn't read too much into it.

Operator

Our next question comes from the line of Greg Cappelli with Credit Suisse.

Q - Greg Cappelli

It's Greg and Jeremy. Just back to new order growth for a moment. Internationally, you mentioned you were understaffed to start the year. Did you guys actually have an unusual amount of sales turnover there, or were you just late in making new hires, which are now maybe ramping up to give you the confidence about the second half comment?

A - Gary Butler

In international sales, we have had no unusual sales turnover. As I mentioned earlier, we had very strong fourth quarter in terms of our results, and we didn't achieve the planning levels of growth in terms of headcount that we had hoped to get in the first quarter. So it's purely a matter of a lot of strong sales in the fourth quarter and being below headcount as we finished out the first half of the year.

A - Karen Dykstra

We had planned the first time in a long time a pretty decent headcount growth internationally, somewhere in the 10% range. So when we miss the beginning of the quarter, especially in Europe, it takes, there's a longer leadtime to higher those people. So when we missed early in the year, we realized we would probably be missing for at least the first half. And we're still, where we had hoped to be in terms of headcount.

Q - Greg Cappelli

Karen, I heard your comments with respect to pays per control in different geographies and internationally. What about new order growth just geographically? Was there any specific, are there any specific areas that are causing the weakness?

A - Karen Dykstra

Geographically in the United States, or you mean internationally?

Q - Greg Cappelli

Internationally.

A - Karen Dykstra

I think Europe in general has been causing the weakness.

A - Art Weinbach

Karen was talking about before when she was talking about pays per control. I think our sales in those two have been a little bit weaker.

A - Karen Dykstra

Biggest sales plan and so on, so I think it's also been France and……..

Q - Greg Cappelli

Maybe just one more. What's causing the swing in the profitability of other quarter-to-quarter?

A - Karen Dykstra

Other is comprised of a lot of different components. Basically think of it as there's two businesses in other. One is the Claims Services business, which we talk about pretty frequently. The other is a small processing, international processing business. And then the rest is a whole bunch of corporate allocations and charges and so on, plus, most notably new this year, the stock compensation chart that wasn't in the prior periods. But if you look at other, and if you look at apples-to-apples other versus last year's second quarter, if you included stock compensation expense in last year as well, you're looking at about a $60 million swing year-to-year. There were three basic components of what made up that swing.

The first is in the second quarter of last year we took some onetime charges. There were a fair amount of, a whole lot of different reasons, restructurings and contributions and things like that. We took some onetime charges that did not repeat in the second quarter of fiscal '06. The second is one that I mentioned a little bit earlier on, another question, which is the tax filing offset, which is the difference between the 4.5% we allocate to Employer Services. And our actual interest rate earned actually was better by $13 million this quarter versus second quarter of last year. And the third is actually stock compensation expense, which year-to-year is better, some of the programs and things that we implemented that on a comparable basis was going to drive stock comp expense down. Those are the three reasons why you see the big swing year-to-year on other.

Operator

Our next question comes from the line of Greg Smith with Merrill Lynch.

Q - Greg Smith

Can we get an update on the comprehensive outsourcing solution or that business, and what the trajectory looks like in the competitive environment as well?

A - Gary Butler

That business is, as we look at all of '06, is around a 75 or an $80 million business this year. That will be up some 40% or so, 35 to 40%, versus last year. As we ended '05, we had roughly 15 good-sized accounts in that group. And we should exit this year somewhere around 25-plus clients in that group. We've got a strong backlog of about 30, $35 million of already booked clients, some 14 clients. And we would expect this year to sell another 20 to 25 million in new business, which would represent another 8, 10, 12 accounts that we would add to that list. But clearly, as we look into '07, we're talking about $100 million plus kind of business with pretty good growth rates.

Q - Greg Smith

And are those clients coming mostly from within the existing, or are these deals put out for bid that you're competing against other providers?

A - Gary Butler

I would say it's a combination of both. Our existing clients are excellent prospects for these services, and they're particularly great prospects for a service that we would called internally managed payroll, which is an extension of the service bureau payroll. But with us taking over the payroll department. And in this a space where we mostly compete, which would be under the 15 to 20,000 employee level, we're certainly on the better list and do fine for those companies that are going out to bid.

Q - Greg Smith

Great, thanks for that. One other question if I could, kind of switching gears on the brokerage side. Just wondering if you guys have heard anything from Ameritrade about what they to plan to do with the TD Waterhouse processing?

A - Art Weinbach

We've been communicating with Ameritrade, obviously, since the announcement has occurred. The most recent indications we have are that they intend to take the processing in-house, and that it will probably be a year-plus before they'd be able to execute on that plan.

Operator

Our next question comes from the line of Tien-tsin Huang with JP Morgan.

Q - Tien-tsin Huang

Just a quick question on Dealer Services. It looks like internal growth has settled down to the single digits. Is there any reason to believe that this rate can improve going forward?

A - Karen Dykstra

I think the Dealer Services internal growth rate certainly has slowed down to single digits, and that this business has gone through some cycles before. Right now, with the state of the U.S. auto manufacturers, it certainly has made its way to the dealerships and, therefore, impacts our business in terms of ability to sell into the dealerships and transaction volumes that we get from certain processing. So it certainly is a thought, somewhat cyclical related to the health of the auto industry, and currently dealing with the state of the U.S. manufacturers. Having said that, our strategy is to continue to layer on applications and to grow geographically, and to continue with that application service provider model, which has been going very well. So at what point we get back to the higher growth levels, it's certainly hard to say. And certainly when we're in the typical, period with the manufacturers, it's nothing that I see in the near future. But I think they're still, at the core they're still a solid revenue growth business, and we've been through the cycles before where we have been low and then made it back up into the double-digit range. As long as we continue along with our strategy, and the Kerridge acquisition certainly will help in that strategy, in broadening our product set, particularly internationally, I think that we certainly can see it having a good solid growth rate in the future.

A - Gary Butler

Just to reemphasize the point, and Karen will correct me if I'm wrong here, our internal growth rates for last year in '05 were around 6%. And even though they're down a point or two this year from that year, it's not a dramatic change. So the real crux of the matter is the amount of new accretion that we have in terms of adding clients. And a lot of clients, particularly those who are heavily domestic in terms of their dealerships, are in many ways sitting on their hands waiting for the saga to unfold.

Q - Tien-tsin Huang

What is the growth profile of the Kerridge acquisition?

A - Gary Butler

Kerridge is roughly a $150 million business. We're very happy to add them to our ADP family. They clearly augment our position in Europe, where we already had in excess of $100 million in revenue. So as a combined unit, our international group now is in excess of $250 million, and operating throughout all of Eastern and Western Europe, as well as China, Korea and a number of countries in the Pacific Rim. They've got terrific relationships with the key manufacturers. They already have live clients in China, which we think is a big opportunity here. So in general, we think the consolidated unit is going to be a lot stronger than we were prior to acquiring Kerridge.

Operator

Our next question comes from the line of Brandt Sakakeeny with Deutsche Banc.

Q - Brandt Sakakeeny

Just a couple of quick following questions. Karen, is there any seasonality in that old Cunningham Graphics business, or is it pretty much sort of 20, 25 million per quarter?

A - Karen Dykstra

No seasonality. There's no seasonality. Look at it as even per quarter.

Q - Brandt Sakakeeny

Great. And then, in terms of the ramp-up of the sales force, what is the typical productivity cycle, and should we start to see a material impact from the new salespeople beginning as soon as the March quarter?

A - Gary Butler

The ramp up, depending, depends upon where we hire the people. Obviously, to the extent that we hire new sales associates in our Small Business Services, these folks begin to be productive in the four to six-month kind of time frame. To the extent that we are adding sales force in our GlobalView international product, or in our high-end National Accounts or COF, clearly the startup curve is in the six to nine and, in some cases, even 12 month areas. And the PEO and majors would be someplace in between the two that I described. So to the extent that we are hiring up additional account in SBS, we should start to see a benefit in the fourth quarter. But I would pretty much project that the rest of the headcount ramp up, we would not really see that acceleration until '07.

A - Karen Dykstra

Also clarify, if I could. When we talked about accelerating the hiring of sales and implementation resources, as it relates to the second quarter, a lot of that was just getting us back to the original planned amounts that we had for fiscal '06. So we did not go over with this acceleration any amounts that we were not already anticipating for this year. And now, as we talk about, but we did have some catching up to do, by the way, in the second quarter. So if the expenses grew from the first quarter to the second quarter, now as we're talking about accelerating, we are talking about more hiring in the third fiscal quarter. And then to Gary's point, some of them if we hired them early in the quarter, and they're in SBS, we might get some productivity out of that in the SBS, but obviously not in the majors and national account areas. And it depends on how quickly we can get them on board. It's not going to all happen overnight.

Q - Brandt Sakakeeny

Karen, sorry, one other final question. I think you gave us the split of the equity mailings. Can you give us some further granularity there, specifically the mix within equity of M&A and non-M&A?

A - Karen Dykstra

I'm not sure I understand. M&A and non M&A and….

Q - Brandt Sakakeeny

Right, because I guess the SEC proxy doesn't affect, isn't affected by M&A mailings. And the equity mailings, is that where the M&A mailings are contained?

A - Karen Dykstra

We're talking about annual report and proxy distribution for corporate issuers.

A - Art Weinbach

So if there is an acquisition plan going on or something, that's really separate. That activity would go on independent of this notice issue as it's been laid out so far. Right. I realize that. That's why I'm trying to figure out, as we look historically maybe in that brokerage business, I remember specifically the compact Hewlett-Packard was a big event. I'm trying to ex-out M&A revenue to look at what percent of the business might ultimately be affected by your proxy.

A - Karen Dykstra

I think that you should use the numbers that I gave in terms of parameters, because quite frankly in recent years there hasn't been any big influence like an HP Compaq that we had a couple of years ago, where it drove a significant amount of pieces volume or posted volume. There was always some of that, but I would say it's a noise level in our numbers.

A - Art Weinbach

The bigger issue is actually spin-offs, because if you think an organization which has a certain number of shareholders, and then you spin off that number into multiple entities, we in effect get three times if it's three entities, the number of shareholders that we had in the, not individual shareholders, but shareholders for investment than we had before. So as much, you really have to watch what's happening. And close to the time of it's really big, you'll hear about it from us.

Operator

Our next question comes from the line of Lloyd Zeitman with Bernstein Investment Research.

Q - Lloyd Zeitman

Pretty much all my questions have been answered. Could you just tell us the number of outstanding PEO employees at the end of the quarter?

A - Art Weinbach

118,000, I think.

A - Karen Dykstra

Yes, 118,000.

Operator

At this time we have time for one or two more questions. Our last question comes from the line of Greg Gould with Goldman Sachs.

Q - Greg Gould

Karen, sorry to belabor the margin issue on Employer Services, but I just want to make sure I, there have been a lot of different ways it was asked, I just want to sort of put all the pieces together. The operating margin in Employer Services did not include employee stock options for either this year or last year, but it was flat for the quarter, up 100 bips for the first half. And the reason it was flat in the second quarter was because of investments that were pulled forward. And you're comfortable that the operating margin will the pre-tax margin will expand 100 BIPS for the year. Is that the right way to think about it?

A - Karen Dykstra

Yes. That's the right way to think about it. That's what our current forecast contemplates. And the only caveat I give is something I mentioned earlier, which is we've got six months to go in the fiscal year, and we could always choose to do other investment if we see the need and we see the opportunity. But at the moment, our forecast contemplates a 100 basis point improvement for the full year. We were very slightly down over the second quarter, and a lot of that had to do with this catch-up in some hiring. But still, as you said it, just right.

Q - Greg Gould

The hiring in sales force, the 6 or 7% you want to do right now, when the new fiscal year starts, would you expect another 6 or 7% right away?

A - Gary Butler

No. We're basically, we basically hire in the fourth quarter as we get ready for the beginning of the fiscal year. This year, because we're having a strong year and we see a very receptive market by product, we're choosing to start that hiring at the end of the second quarter and as we enter the third quarter. So we're just getting a head start, call it four months over our traditional pattern, just so that we'll have people in the territory ready to go as we begin the fiscal year.

Q - Greg Gould

And then lastly, the year-over-year comparisons for new sales are tougher in the second half. It sounds like the pipeline is strong enough and the sale folks, or the sales cycles are short enough that you can still hit that double-digit for global Employer Services for the year?

A - Gary Butler

That is certainly our plan and expectation. And we reviewed this pretty extensively, obviously, in preparation for this call. So we had a good January, so we were at our plan in double-digits over last January as, art, I think had reiterated. So we've got a pretty good confidence level in the double-digit number for the full year.

Operator

At this time there are no further questions. I will now turn the conference back to Ms. Dykstra.

Karen Dykstra, Chief Financial Officer

Thank you very much. We'd like to thank you all for participating on the call today. And we appreciated your time and enjoyed talking to you. Thank you.

Operator

This concludes today's Automatic Data Processing, Incorporation second quarter fiscal 2006 earnings conference call. Thank you for participating. You may now disconnect.

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Source: Automatic Data Processing F2Q06 (Qtr Ending Dec 31, 2005) Earnings Conference Call Transcript (ADP)
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