Administaff Q4 2007 Earnings Call Transcript

| About: Insperity, Inc. (NSP)

Administaff (ASF) Q4 2007 Earnings Call February 7, 2008 10:00 AM ET


Douglas S. Sharp - Vice President, Finance and Chief Financial Officer and Treasurer

Richard G. Rawson - President

Paul J. Sarvadi - Chairman and Chief Executive Officer


Tobey Sommer - SunTrust Robinson Humphrey

Mark Marcon - Robert W. Baird

Kevane Wong - JMP Securities

Jim MacDonald - First Analysis

Michael Baker - Raymond James


Welcome to the Administaff fourth quarter 2007 earnings conference call. (Operator Instructions) I would now like to introduce your presenters for today’s call: Mr. Paul Sarvadi, Chairman and Chief Executive Officer; Mr. Richard Rawson, President; and I would like to turn the presentation over to Mr. Douglas Sharp. Please proceed, sir.

Douglas S. Sharp

Thank you. We appreciate you joining us this morning. Before we begin, I would like to remind you that any statements made by Mr. Sarvadi, Mr. Rawson or myself that are not historical facts are considered to be forward-looking statements within the meaning of federal securities law.

Words such as expects, intends, projects, believes, likely, probably, goal, objective, outlook, guidance, appears, target 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 filing 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 fourth quarter and 2007 full year financial results. Richard will then discuss current and expected trends in our direct costs, including benefits, workers’ compensation and payroll taxes and the impact of such trends on our pricing. Paul will recap 2007 year and comment on our outlook for 2008. I will then return to provide Q1 and full year financial guidance and we will then end the call with a question-and-answer session.

Now let me begin by summarizing the financial highlights from the fourth quarter. We reported earnings per share of $0.50 near the high end of our expectations. These earnings were driven by positive results in the following key metrics: We achieved an 11% increase in the average number of paid worksite employees over Q4 of 2006 to 115,451 for the quarter. Gross profit per worksite employee per month averaged $244, up from $239 reported in Q4 of 2006 and significantly above our expectations.

The strong unit and gross profit growth contributed to operating expenses coming in at higher than forecasted level as an additional accrual for incentive composition was tied to the achievements of these better than expected results.

As for our share repurchase activity, we repurchased 582,000 shares during the fourth quarter, resulting in a total of 2.3 million shares repurchased for the full year of 2007. We have repurchased another 295,000 shares during Q1 of this year and as of today, there are approximately 847,000 shares remaining for repurchase under our authorization.

We ended the quarter with $97 million in working capital.

Now let’s review the detail of our fourth quarter results. Fourth quarter revenues increased 14% over 2006 to $402 million as a result of the 11% increase in the average paid worksite employees and a 3% increase in revenue per worksite employee per month.

Looking at fourth quarter revenue contribution and growth by region, the Southeast region, which represents 11% of total revenue, grew by 15%; the Northeast region, which represents 20% of total revenue, grew by 20%; the Central region, which represents 14% of total revenue, grew by 12%; the Southwest region, which represents 34% of total revenue, grew by 18%; and the West region, which represents 20% of total revenue, grew by 5% and was impacted by the loss of a large mid-market client during the 2006 year end client renewal period. We averaged 277 trained sales reps for the fourth quarter, which is a 7% year-over-year increase.

Now let’s move to gross profit, which was obviously a strong contributor to this quarter’s results as we generated a higher than expected surplus in our direct cost program. This higher surplus was primarily driven by our workers compensation program as continued effective claims management has given us the ability to offer lower pricing while also contributing to our surplus.

Workers compensation costs were 0.41% of non-bonus payroll for the quarter, well below our forecasted range of 0.55% to 0.65% and included a $7.4 million reduction in previously reported loss estimates. We also experienced favorable results in the area of benefits. Fourth quarter benefit costs on a per covered employee per month basis came in at $678, a year-over-year increase of only 5% compared to an expected 6% to 7% increase.

Payroll tax cost as a percentage of total payroll of 5.87% remained relatively flat compared to the fourth quarter of 2006. In a few minutes, Richard will provide further detail on this quarter’s positive developments. He will also comment on our positive outlook for 2008 given healthcare plan design changes, lower unemployment tax rates, and continuing favorable trends in our workers compensation program.

Now, let’s move on to operating expenses, which totaled $66.3 million for the quarter or approximately $2.8 million above the midpoint of our expected range. This variance primarily resulted from two items: an additional accrual for incentive compensation of $1.4 million tied to the achievement of better than expected Q4 operating results; and the write off of $1.2 million of capitalized software costs associated with the initial version of our HRTools product, which is in the process of being transitioned to a SaaS model.

Operating expenses on a per worksite employee per month basis totaled $191 for the quarter, including $7 related to these two items. This quarter’s amount compares to $185 per worksite employee per month reported in Q4 of 2006.

As for net interest income, we reported approximately $2.8 million for the quarter. This is just below the low end of our expected range due primarily to the utilization of invested funds in executing our share repurchases. Our effective income tax rate for Q4 of 34.9% was slightly less than the forecasted rate of 35.5%, reflecting a slightly lower than expected effective state tax rate.

Now, I would like to take a few minutes to review our full-year results. Revenues grew 13% to $1.6 billion as a result of the 10% unit growth and a 3% increase in revenue per worksite employee per month. As for full year 2007 revenue contribution and growth by region, the Southeast region, which represents a 11% of total revenue, grew by 11%; the Northeast region, which represents 20% of total revenue, grew by 22%; the Central region, which represented 14% of total revenue, grew by 11%; the West region, which represented 21% of total revenue, grew by 4%; and the Southwest region, which represented 34% of total revenue, grew by 16%.

Gross profit per worksite employee per month declined by 1% from $234 in 2006 to $231 in 2007. Higher than expected healthcare costs earlier in the year were mitigated by improving healthcare trends in the latter quarters and continued favorable trends in our workers compensation and payroll tax areas.

As for a recap of our direct costs, benefit costs for covered employee per month increased 8.3% for the year from $623 to $675, and we ended up in the middle of our initial forecasted range of 7% to 9%. The percentage of worksite employees covered under our health insurance plan increased from 72.7% to 73.2%. Workers compensation cost as a percentage of non-bonus payroll declined from 0.92% in 2006 to 0.51% in 2007 as we experienced declines in both claim and administrative costs. This allowed us to lower pricing allocations to new and renewing clients while also contributing to our surplus. Payroll taxes as a percentage of total payroll declined from 7.27% in 2006 to 7.06% in 2007. This was primarily due to the higher payroll average of our worksite employees and the receipt of an unemployment tax refund from the State of Texas in Q2.

Now, let’s move on to operating expenses, which increased 10% on 13% revenue growth. An increase in cash and stock-based compensation costs made up about 70% of the increase in total operating expense dollars. Cash compensation costs increased by 10% over 2006 due primarily to the hiring of sales and service personnel, including those associated with the initial phase of our mid-market initiative.

Depreciation and amortization increased by $700,000 over 2006; however, included the $1.2 million write-off of capitalized software cost mentioned earlier. General and administrative costs increased by 9%, slightly below our 10% unit growth including costs associated with our sales office openings and additional corporate head count.

Summing up these items, on a per worksite employee per month basis, we experienced an increase of only $1 over 2006 to $184. This increase includes a $3 increase in stock-based compensation costs offset by reductions in other areas.

Now let’s review several key balance sheet and cash flow items. We ended the quarter with approximately $97 million of working capital and only $1.29 million of debt. During the fourth quarter, we generated $25 million of EBITDA. Cash outlays included cash dividends of $2.9 million, capital expenditures of $3.3 million and share repurchases totaling 582,000 shares at a cost of $19.2 million.

For the full year, we generated $90 million of EBITDA, cash outlays included cash dividends of $12 million, capital expenditures of $13 million, and share repurchases totally 2.3 million shares at a cost of $81 million.

Now, before providing our financial guidance, I’d like to turn the call over to Richard.

Richard G. Rawson

Thank you, Doug. This morning I’m going to briefly discuss the details of our fourth quarter gross profit results, and 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. Additionally, I will update you on some new products that we have introduced for 2008.

As many of you know, 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 allocation exceed the corresponding direct cost. For this quarter, our gross profit per worksite employee per month was $244, well above our forecasted range of $230 to $233. These results came from achieving $200 per worksite employee per month of markup and generating a surplus of $44 per worksite employee per month or 3.8% of our total markup. This quarter’s surplus came primarily from better than the expected contributions from the workers compensation and benefits cost centers. Here are the details beginning with the benefits costs center.

This quarter, our expense per covered worksite employee was $678 and below the low end of our expected range. We have continued to see a migration of employees out of the United HealthCare ChoicePlus 250 plan into lower cost, higher deductible plans, which help to reduce our cost.

Compared to Q3, we saw a slight decline in both the number of claims over $50,000 and the dollar amount of those claims. These factors contributed over $2 per worksite employee per month to the better than expected gross profit results. The remaining $11 of better than expected surplus came from positive results in our workers compensation cost center.

This quarter, the number of claims reported is 2% lower than Q4 of last year. This decline continues to be impressive when you consider that we’ve had an 11% growth in the number of paid worksite employees that incur those claims. These positive results are directly related to the great job our safety professionals in the field continue to do.

The severity rate of those claims filed in Q4 is down 26% from Q4 of 2006. Our claims management personnel continue to settle workers compensation claims for amounts lower than expected and our back-to-work programs continue to produce favorable results. Therefore, we had a nice surplus from our workers compensation program as the expense was just 0.41% of non-bonus payroll.

Now before we close the book on 2007, let me share some final thoughts about our full year results. Our initial pricing strategy for both new and renewing business was designed to produce a combined service fee of $200 per worksite employee per month for the full year. We accomplished this goal. We estimated that the surplus component of gross profit per worksite employee per month should add about another $26 to $35 for a total gross profit of $226 to $235 per worksite employee per month.

The surplus for the year came in at $31, producing a total gross profit per worksite employee per month of $231 and right in the middle of our targeted range. This $31 surplus is 3.1% of the $986 per employee per month which was allocated to cover those direct costs. Now these results give me a lot of confidence in our ability to forecast and manage the specific targets for 2008.

So now let me share with you some of the specific game plan for 2008 beginning with the pricing. We plan to increase pricing on new and renewing business by $4 per worksite employee per month by the end of 2008, and average $202 of markup on our HR services for the full year. In addition, we anticipate a slight increase in the surplus component of gross profit over 2007’s results from $31 to a range of $33 to $38 per worksite employee per month.

Here’s how: the surplus generated from the payroll tax cost center should be higher than 2007. As we said last quarter, we expected lower state employment tax rate as a result of surpluses setting in many state unemployment tax funds. By law, the states are required to lower the rate and/or give credits to employers. At this point, we have received nearly all of our state unemployment tax rates for 2008 and they are approximately 15% lower than last year’s rates. In addition, we have been notified that this year we will receive a $1.5 million credit in the second quarter from the State of Texas.

We have reduced our allocation in this cost center to pass on most of the benefit to our clients. However, we have retained some of the benefit due to our success in controlling these costs. Therefore, our expected contribution to gross profit from this cost center will be slightly higher than 2007.

Now, let’s discuss the workers compensation cost center. We also expect to see a nice contribution to the surplus component of our gross profit from this cost center, but not quite as much as 2007. Last quarter, I explained the details of our new workers compensation program and how it would reduce administrative expense. The ongoing improvement in incidents and severity rates that we experienced throughout 2007 coupled with effective claims management in 2008 should also help us on the cost side.

Even though our cost for 2007 was 0.51% of non-bonus payroll, we like to be conservative with our forecasting. So, we will assume the total cost of about 0.6% of non-bonus payroll for the full year. We expect a slight reduction over 2007 to the allocation side of this cost center. Therefore, our spread should be slightly less than last year.

The benefits cost center is another area where we expect to see some improvement in 2008. Last quarter, I mentioned that we had several factors that should positively affect the benefits cost center in 2008. As a part of our historical strategy for managing this costs center, we made a couple of plan design changes beginning January 1, 2008. These changes include a $5 dollar increase in the co-payment for office visits in the ChoicePlus 250 plan and doubling the co-payment charge for office visits to a specialist. The only other plan design change that was made increased the tier II and tier III prescription co-payments from $30 and $50 to $35 and $60 respectively. Now these plan modifications are reflective of the types of plan that we see in the market today.

A few minutes ago, I had mentioned that we continued to see a migration of covered worksite employees moving from the United HealthCare ChoicePlus 250 plan to higher deductible plans. We should begin to see a reduction to our cost, especially when you consider that on January 1, the first of each year that deductible requirement for each covered employee starts over.

Now, the third factor that reduces cost is the reduction net administrative fees, which we had previously negotiated with the United HealthCare to begin in January of 2008. These factors should offset more than half of a normalized 8% to 9% healthcare trend increase in 2008. Therefore, for the full year of 2008, our total benefits cost per covered employee should increase about 4% over 2007.

We have continued to increase our allocations on the pricing side to match normalized trend increases and reduce the deficit in this cost center. This combination of allocation increases in reduced cost should add to our gross profit per worksite employee per month for 2008.

The last topic that I want to share with you today is about the new product offerings that we have made available to new and existing clients. Some are designed to add additional revenues to gross profit and others are designed to enhance our service. You may have seen a press release during the fourth quarter announcing that our current 401(NYSE:K) plan had reached the $1 billion mark in total assets. This puts us in the top 5% of recordkeepers in the United States.

Additionally, the fees that we get from the mutual funds go to offset the cost of providing this benefit to employees and any shortfall gets charged to the participants. Now that we are at a $1 billion in assets, the fees we receive from the mutual funds are covering all of the cost to provide this benefit in the standard Administaff plan except for $1.50 per participant in the quarter.

This means that each participant’s return should be 100 to 200 basis points higher than in a conventional 401(K) plan. We have also added a raw 401(K) option for current clients and former clients that still have us record keep their 401(K) plan. We have also created a non-qualified pre-tax deferred compensation plan for existing clients. Now this plan mirrors our 401(K) plan in that participants use the same easy-to-use technology platform to manage their account and have the same investment options to choose from.

We have also introduced an identity theft insurance policy and the surprisingly popular pet insurance. We believe that these additional offerings will enhance our position in the marketplace and thus add to our gross profit for 2008.

In summation, we see the markup component of gross profit increase $2 per worksite employee per month over 2007 and the surplus component increase $2 to $7 per worksite employee per month to a total gross profit of $235 to $240 per worksite employee per month for the full year of 2008.

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

Paul J. Sarvadi

Thank you, Richard and good morning, everyone. On our third quarter call in November, I stated that small business owner sentiment had become more hesitant and they will beginning to become more conservative in their decision-making. Over the last 90 days there has been considerable uncertainty regarding prospects for the overall U.S. economy. This uncertainty has had some effect on new sales, client retentions and the net hiring within our client base.

Now, we’ve been watching and waiting for this type of reaction that we witnessed over the last few months and in 22 years of business we’ve seen this before and we are aware of the specific effect on our business model that comes from a downturn in the economy. We also know what to change and implement when this happens and we are in full swing with the changing climate. So today we will be describing a plan that trends our unit and revenue growth by 4% and our earnings per share target by 5% from our initial 2008 guidance.

First, I will describe conditions that emerged over the last quarter that have caused us to lower our growth expectations for 2008. Secondly, I will discuss our operating plan in response to these changes and explain how we intend to take advantage of the current environment. Finally, I will finish with our plans for product and service enhancement directed toward extending our competitive advantage over the long term.

Now when business decision makers respond to economic uncertainty we have seen an impact on our sales efficiency at each stage of the sales process. Our census to First Call rate closes for census and time to close reflect hesitancy of the prospect. During this recent fall campaign, our census rate was 43% compared to 50% last year. Our closing rate was 35% compared to 42% last year, resulting in an overall sales efficiency rate of 1.5 sales per sales person per month compared to 1.85 during last year’s fall campaign.

Now, this level of sales efficiency was enough to achieve our threshold objective of 1,200 new accounts sold during the fall campaign, but not our higher target number. So in these periods it is harder to sell and you need more selling opportunities, but we still sell very effectively.

Client retentions since our last call has been a good news, bad news story. Our client attrition rate for the recent quarter averaged 1.1%. This is better than the historical fourth quarter average of 1.3%, which we also experienced in the fourth quarter of 2006. The January client terminations, however, represented 9.6% of the worksite employee base, which is higher than the 8% level we experienced in January of 2007.

This included an increase in the core market client attritions consistent with the changing economic climate and continuing mid-market attrition, which I will discuss in a few minutes. Now, as we look ahead into February and March, termination notices are down indicating normal retention rates are even better than historical average. So we’ve had somewhat of a mixed bag in client retention since our last call.

Now, another factor in our business model and affected by the economic environment is the net of new hires and layoffs within our client base. Over the last 90 days, we’ve seen no growth in the client base as layoffs and new hires had canceled one another out. Although layoffs are not exceeding new hires yet, the slight tail that we had diminished over the quarter and is not apparent in early 2008 hiring plans.

Another sign of slowing comes from the commissions paid to sales staff at client locations. This metric fell from a consistent 6% to 8% year-over-year increase in previous quarters to 3.4% in the fourth quarter. This indicates the pipeline and pace of new business within the client base has slowed somewhat.

Now, when we combine sales retention and net hiring results into our January starting point in paid worksite employees and factor in current economic conditions, we now anticipate unit growth in 2008 of 8% to 9% over 2007.

This is down from the 11% to 12% growth previously forecasted and consistent with growth levels we expect in the struggling economy. The average paid worksite employee count for the full year 2008 is expected to be 4% lower than our initial guidance. In response to these market conditions, we have altered our operating plan to scale back expenses where appropriate while taking advantage of targeted opportunities. Our strong cash position and cash flow characteristics of our business model allow us to be opportunistic during a slower economic cycle.

The first change we made in our operating plan was to scale back corporate hiring in line with worksite employee growth expectations. Next, we decided to save some costs and open only four new offices as opposed to the eight to ten openings originally scheduled for 2008. We still plan, however, to continue salesperson hiring at an aggressive rate and fill the eight offices opened in 2007. We are starting the year at approximately 280 trained sales personnel, which is 11% higher than the same period last year. A weak labor market may actually help us increase this number, which is our leading indicator for future unit growth.

We also see an opportunity to help our clients take advantage of the weaker labor market. Many skilled positions have been difficult to fill over the last couple of years. The current environment represents an opportunity to fill out and upgrade staff at client locations. Our recently improved recruiting operation will have a real opportunity to shine and benefit our clients and mitigate the effect of layoffs in the client base.

We will also keep our eyes peeled for opportunities to acquire companies or develop alliances with companies that have products or services that can complement our PEO services. It is possible to get a double win with strategic acquisition that can lower PEO service costs and offer a new revenue stream for Administaff with prospective or former PEO clients.

Another important decision we have made is to continue product and service enhancements that will improve our client experience and our competitiveness in the marketplace. Fortunately, the cash flow dynamic of our strong business model allows for this opportunity to leap-frog companies that cannot afford such decision when the economy turns.

We will continue to execute our plans for mid-market service enhancement in 2008. In the fall campaign, we were able to test some critical aspects of the reengineering we conducted in this segment during 2007. The new service model was presented to a sample of current clients and was very well received. We sold six accounts out of the 18 opportunities in the fourth quarter with over 2,000 worksite employees and four of those accounts are on the new two-year contract.

The most significant mid-market test is while conducting stewardship meetings with renewing accounts to provide detailed information on the cost and value of their contract with Administaff. These meetings were conducted with 12 accounts with the 11 renewing and 12th extending the contract for six months for further evaluation.

These results have us very excited about extending this practice over the entire segment during 2008 to improve overall client retention. These meetings have also given us some insight into cost and value related discussions that may be beneficial to clients in the 50 to 150 employee range to improve retention as well. This will be a company-wide priority over 2008.

The final area we intend to capitalize on during this slower economic period is the development of our HRTools products into a SaaS model. Our research has revealed that an integrated suite of applications at the right price point that includes job descriptions, performance interviews, policy development and employee data management and reporting, will fill a hole in the small to medium-size business marketplace.

Over the course of this year, we intend to complete this application and use it in three ways to support our business plan. First, we intend to provide this application to current clients as a nice upgrade to self-service capabilities within the employee service center we currently provide. This will fill a perceived product gap in our core service and increase the value received by our clients.

Secondly, we intend to allow exiting clients to maintain this application in the SaaS model on a per employee per month cost basis allowing us to monetize former clients.

Thirdly, we expect to market this application to prospective PEO in other small businesses through various channels to extend our brand and develop PEO leads.

We’ve been continuing to develop marketplace alliances to offer other goods and services to PEO clients. This model has been working and it has potential to be extended to a much broader customer base of small businesses that are prospects for both HRTools and our PEO services. We’ve been working for several years developing these non-PEO revenue sources primarily through our HRTools initiatives and our marketplace alliances.

For most of this period, the revenue and cost were immaterial. However, the HRTools rewrite decision represents a much more significant investment than in the prior years. Since this investment is entirely expensed, we expect these initiatives to produce a slight drag of approximately $0.05 to $0.06 per share on our 2008 results. Both of these initiatives are at a critical juncture to capitalize on previous effort and investment, and we believe continuing on our current trajectory is the right thing to do and will pay off in 2009 and beyond.

So to summarize, we have seen a transition over the last 90 days from uncertainty about the economic climate to validation that the small business community has adjusted their plans for a slower growth outlook. We have adjusted our game plan to control costs and direct our resources at the most important near and long term initiatives and we have adjusted our outlook accordingly.

At this time, I’d like to pass the call back Doug to provide specific guidance for 2008.

Douglas S. Sharp

Thanks, Paul. As most of you are probably aware, we provided our preliminary 2008 outlook during our previous conference call. At this time, I’d like to update our outlook based upon the outcome of our fall sales campaign and year-end client renewal period, and the expected impact on our business by the current economic environment.

Let me begin by saying that we typically start the year by forecasting a wide range for our key metrics. For 2008 our guidance produces an implied range of earnings per share growth of 5% to 15% over 2007.

As for the details, let’s begin with worksite employees. Based upon Paul’s earlier comments, we are now forecasting monthly net unit growth of 1,100 to 1,300 on top of our January starting point. This results in a range of average paid worksite employees of 119,000 to 120,000, or 8% to 9% unit growth over 2007.

As for the first quarter, we expect the average paid worksite employees to be in the range of about 114,000 to 114,500. As for our pricing and direct cost metric, we expect gross profit per worksite employee per month to increase from $231 in 2007 to a range of $235 to $240 in 2008, which is a combination of the $202 in markup on our HR services and a surplus of $33 to $38.

For the first quarter, we are forecasting a range of gross profit per worksite employee per month of $250 to $254, which is considerably higher than that forecasted for the latter three quarters of 2008. This is because we expect to have a greater surplus from our direct cost programs in Q1 when considering the positive upfront impact of benefit plan design changes and payroll tax surpluses, which are typically higher prior to worksite employees reaching their taxable wage limits.

We expect gross profit per worksite employee to decline by 9% to 10% from Q1 to Q2 as we experienced less of an impact from these two items combined with increased payroll tax costs associated with new business. Thereafter, we would expect just a slight sequential increase in Q3 and a sequential increase of 4% to 5% in Q4 as payroll tax costs on new business further decline and price increases continue to roll in.

Now, let’s discuss operating expenses beginning with our full-year forecast. In light of a softening economy and the expected impact on our unit growth, we have made certain reductions to our initial operating expense budget, however, we do intend to continue to invest in our sales expansion and new products and services. Reductions from our initial budget include lowering the growth in our service and support headcount and certain G&A costs that correlate with our revised unit growth outlook.

We plan to open four new sales offices in 2008 on top of the eight sales offices opened in 2007. This will allow for a targeted 15% increase in trained sales reps in 2008. As Paul mentioned earlier, we will invest a total of approximately $7 million additional in our mid-market and non-PEO initiatives, HRTools and midmarket in 2008. When combined with a budget increase of approximately 10% in our core PEO, we are forecasting total operating expenses in a range of $273 million to $276 million. This increase is slightly lower than our forecasted 11% increase in total gross profit dollars.

And as in the prior years, the high end of our full year operating expenses range is tied to additional incentive compensation, which will only be accrued upon achieving higher unit growth and gross profit results.

Taking a look at operating expenses on a per worksite employee per month basis, we are forecasting an increase from $184 in 2007 to about $192 in 2008; however, with the mid-market and HRTools initiatives accounting for $5 of the increase and stock-based compensation costs increasing $1 per worksite employee.

As far our first quarter guidance, we expect total operating expenses to be in a range of $68.75 million to $69.25 million. As is our typical pattern, operating expenses are higher in the first and fourth quarters due to advertising and business promotion costs and at a consistent lower level during the two intervening quarters. We expect net interest income to be between $2 million and $2.5 million for the first quarter and between $9.5 million and $10.5 million for the full year based upon forecasted cash balances and our current environment of lower interest rates. We are forecasting an effective income tax rate of 35.5% and expect average outstanding shares of 25.8 million for the first quarter and for the full year.

Finally, we have budgeted capital expenditures at $18 million. The budgeted increase of approximately $5 million over 2007 largely relates to the relocation and renewal of sales and service offices.

Now, before we open up the call to questions, I’d like to inform you that we will be holding an analyst and investor day on May 8. We look forward to providing an update on both recent developments and our long-term strategy for our core PEO business and new products and services and we will be announcing further details shortly.

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

Question-and-Answer Session


Your first question comes from Tobey Sommer - SunTrust Robinson Humphrey.

Tobey Sommer - SunTrust Robinson Humphrey

A question about the slower outlook on the part of your customers. Can I ask you what your game plan is if that accelerates from here, considering it has changed versus what you saw in the marketplace 90 days ago? What if 90 days from now the situation worsens? What levers do you have at your disposal to pull to alter your game plan? Thank you.

Paul J. Sarvadi

That is a good question. We will be monitoring very closely what clients are doing. But what happens in our business at this time of the year is we are able to kind of get a feel for our clients going-forward plan. There was somewhat of a battening down of the hatches that took place over the year end cycle. But their game plan is pretty much in place for the going forward. So, we are pretty comfortable that we’ve got the right outlook built into our going forward game plan.

I think if we saw further issues like layoffs significantly exceeding new hires and things of that nature we again would look at some tightening up relative to the operating expenses. But we also have built into our operating model that our incentive comp program triggers off of the ongoing results that are generated. So we’ve got a little room in the game plan that way as well.

Tobey Sommer - SunTrust Robinson Humphrey

For additional color I was wondering if you could comment, does your current outlook contemplate zero net worksite employee additions among the existing customer base or do you contemplate perhaps some slight headwind in that regard?

I was wondering if you could comment on the timing of your office openings and the expenses associated with them. I apologize if I missed this in the prepared remarks whether they were first half, second half loaded or just evenly throughout the year?

Paul J. Sarvadi

Let me handle the first part there. As far as building in our forecast we felt like the right thing to do based on the hiring plan that we can see into our client base that it looks like more of a steady state so we built in pretty much a dead on the water scenario relative to new hires and layoffs so there would be no benefit but no major detriment coming from that aspect. So, I’d say it’s more of a steady state that no gain, no loss. So maybe a slight impediment but we did not factor in more of a wholesale major layoff scenario because we don’t see that coming.

Richard G. Rawson

As the new sales offices thus far, fairly front-end loaded. They had those in place for the full campaign so probably spread over the first two to three quarters.

Tobey Sommer - SunTrust Robinson Humphrey

You did suggest I think that in a slowing market you could take advantage of certain situations. I seem to read in to it that in addition to the share repurchases that you have been executing on recently perhaps, there will be an opportunity for you to be opportunistic from an M&A perspective. Firstly did I read that correctly and if so what kind of areas are we looking at?

Paul J. Sarvadi

Certainly I did mention that in my script and we do have an active process internally to look for targeted opportunities that could add components like other HR service components that can either lower our cost in terms of running the PEO and at the same time offer new product to our and other channel strategies. So we are going to be keeping our eye open for companies that are out there that may be the timing of this economic downturn is significantly difficult for them and maybe create an opportunity for us.


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

Mark Marcon - Robert W. Baird

One follow on to Tobey’s question is to what extent do you have flexibility to further reduce expenses if the magnitude of this downturn ends up being a little bit worse than what you are anticipating?

Paul J. Sarvadi

We certainly can adjust the hiring plans and things. We have a good system for being able to try to match that up pretty closely with our expected worksite employee growth. We also have a significant investment set in our game plan for growing the sales staff, for advertising; the advertising costs are higher this year with an election year. So, there is other components in there, but we’d have to make a decision at the time based on whether it makes more sense to pour gas on the fire or whether paring back is exactly the right thing to do


Mark Marcon - Robert W. Baird

When are the new offices scheduled to be opened?

Richard G. Rawson

The plan is to open four sales offices next year and that was spread over the first three quarters of the year fairly evenly.

Mark Marcon - Robert W. Baird

So some are already locked in?

Paul J. Sarvadi

Yes. We will open one this quarter and a couple next quarter, one in the third, stuff like that.

Mark Marcon - Robert W. Baird

If we look at all the geographies, I mean with the exception of California, you continue to experience very strong growth in California it sounded like Northern California, you had a management change. Can you give us an update in terms of how you are seeing California shaping up on a go-forward basis?

Paul J. Sarvadi

I think we are feeling pretty good about the market as it plays out there. We’ve had a couple of things going on in the general marketplace relative to pricing on healthcare and other components that have an affect. But the main reason that the growth rate was down there was early last year there was a large middle market customer with over 800 employees who went way and so it takes a year to kind of flush that through the systems.

So we actually have been doing a little better than it might look like in those numbers.

Mark Marcon - Robert W. Baird

So it sounds like things are generally going well. Are you expecting economic softness to be relatively even across the country or would you expect it to be a little bit more pronounced in California, Florida and the states that we are reading about that are the most challenged?

Paul J. Sarvadi

I expect it to be a pretty even throughout the country with the exception of the Southwest. Down here in Texas we are a little bit counter-cyclical. With the oil prices this high and so forth, even though lot of our base isn’t in the oil business, but that’s certainly a significant part of the economy down here. So and I think we’ve got a little bit of insulation there from the fact that we do still have pretty good share of our business about 30% or so in the Southwest.

Mark Marcon - Robert W. Baird

The really good news in this quarter is the gross profit per worksite employee is expected to go up materially. Are you getting any pushback at all from your clients?

Paul J. Sarvadi

Well, no. We have been passing on cost reductions to our clients. We had a 15% reduction in our unemployment tax rate and passed on most of that back to the customer, but allowed some of it to fall through to increase our gross profit. Because we are out there doing the work that earns that reduction.

So things have lined up pretty much the way Richard predicted last year, which is that we have a little less gross profit coming from the comp program which has performed fantastic. But we have the benefits plan, this is the year that we do the benefit design changes and entered into a new contract to lower the administrative cost. The cost center performed better and then of course the unemployment tax.

So as it relates to our first quarter outlook, our first quarter outlook actually got better than it did in the last quarter at the gross profit line and more than offset the reduction in the per worksite employee cap.

Mark Marcon - Robert W. Baird

From your customer’s perspective -- and I know it varies across depending on which state they are in -- but in general what is their perception of what they’re paying Administaff in terms of the fees that are going through and what sort of decline are they actually sensing that they are getting?

Paul J. Sarvadi

I think this is an area were we can do a better job and I think that’s part of what was revealed in the meetings we held with customers last quarter. I think we can do a better job of explaining what we’re doing and how that flows into the cost and value of their relationship with them.

If you look back over the past years we’ve done a great job on managing one of the most difficult costs to manage, which is the healthcare costs. We’ve had a fairly stable environment there and last year we did have to keep increasing price more in line with trend levels to catch up a little bit even though we were able to control costs down this year with plan design changes. We’ve offered really nice options to customers, it was great to be able to sit in the room and say we do have some new plan options for you this year. Is that a tool that you need to use to help control your costs at the client level?

Of course that translates into some of the migration we’ve seen in the Choice Plus 250 plan, some other options for customers, which lowers our costs going forward. So, it really does depend on the specific situation a given client is in and what they need to do to help manage their costs. But think we’ve done a nice job of creating options to help them in that regard.

Mark Marcon - Robert W. Baird

But in general their perception is that what they are paying is less?

Paul J. Sarvadi

Yes. I mean they’re getting less of an increase than they otherwise would have gotten in the healthcare side. By the way, I misspoke I think I said they were coming into the Choice Plus 250; I meant they are going out of that plan into other plan options. Sorry about that.

Mark Marcon - Robert W. Baird

It’s not that they’re paying less but the increase that they are seeing is going to be less than what was expected?

Paul J. Sarvadi

That’s correct and less than they are hearing about their friends and business associates that they are hearing about in companies that aren’t with Administaff.

Richard G. Rawson

Mark, this is Richard. I will tell you that we have been looking at our trend in healthcare costs now for about ten years. And we have compared that to the Kaiser Family Foundation, who does an annual survey -- they’ve been doing it since 1960 something. Every year since we started tracking this, our trended cost is healthcare for Administaff the full business which reflects all the clients has been lower than that trend. So this is a real value proposition that the business owners get to see and it’s our job to highlight that to them when it comes time especially at renewal.

Again as Paul said, we’ve done a really good job of finding out how they received this and the number of mid-market accounts that 11 out of 12 and then the 12th will decide I better stay on a few more months before I rethink my decision to change.

Paul J. Sarvadi

That’s like I said, we need to do a better job of communicating this to our customers because if you look over the last couple of years, we’ve lowered the workers compensation allocation by one-third within our contracted customers. We’ve lowered the unemployment tax allocation two years in a row for most accounts, the state specifics doesn’t work exactly across the board. But we’ve controlled the healthcare cost increases much better than the average in the marketplace. You add all that up, this is really working for customers, but we need to do a better job of making that known.

Mark Marcon - Robert W. Baird

Last question just on the workers comp that’s obviously been going in your favor. How long do you think that can keep up, particularly if we go into a softening economic environment?

Paul J. Sarvadi

Well the allocation side of that part of our business is pretty much set in stone because it mirrors what is going on in the individual markets because workers compensation is a state by state kind of issue. On the cost side, it’s actuarially loss picks are set at the beginning of the year and then as the actual experience of claims and the number that are incurred and the severity of those claims actually turns into - how they are settled out, of course, then that gives you and our experience has been that gives you a reduction because of the way that we manage safety in the workplace to begin with. We review every single client in certain SIC codes before they even come on. We are actively doing things that would automatically give you some level of comfort that because the actuaries are not going to get to the level of our conservatism out of the box because it’s just hard for them to do.

So it doesn’t guarantee anything is built in, but certainly when you’ve got this many years of this kind of continued success in managing assets, claims, the severity of the claims, the claims administration team that we have to settle those claims. You are going to continue to have positive results in this cost center.

Douglas S. Sharp

I think one of the things we are going to focus on at our upcoming analyst day is to show you each policy period and how it evolves over the seven-year cycle, and then show you in a graphic what happens when you stack those on top of one another. And then when you weigh in what we do from a pricing side, you will see that we are able to manage to a spread on an ongoing basis. I think that will be one aspect of what we cover that day.


Your next question comes from Kevane Wong - JMP Securities.

Kevane Wong - JMP Securities

First, good work on the benefit costs, particularly impressive. I’m trying to get a gauge looking at the adjustments to prior years, it looks like this year was roughly $26 million, which is great. How much of an adjustment to prior years benefit do you have in your estimate for 2008?

Paul J. Sarvadi

Well, actually we have not made any assumptions about 2008 until we see the results come about.

Kevane Wong - JMP Securities

I’m sorry. When you are looking at the workers comp costs that you have forecast, I think it was 0.6?

Paul J. Sarvadi

I am sorry, yes. 0.6 of 1% of non-bonus payroll is what we are forecasting now.

Kevane Wong - JMP Securities

Within that what are the expected adjustments to prior year’s comps?

Paul J. Sarvadi

You can’t make assumptions about that until you actually see the claims get settled. It’s an ongoing process. We don’t really make a lot of assumptions about what that’s going to be.

Kevane Wong - JMP Securities

So you are just looking at net-net what you expected it to be and will adjust as you go through the year?

Paul J. Sarvadi

We look at all the run rate. We let the performance of the team produce the results in any given quarter.

Kevane Wong - JMP Securities

The competitive landscape, there is obviously a lot of interesting moving pieces; I have heard of one particularly large competitor being extremely price competitive particularly in California. There is also it looks like upside with other competitors that might be blowing up and sort of giving opportunity to cherry pick the good clients out of those. Can you touch on those two factors and then other major movements in the marketplace as far as competitive factors that you are seeing happening?

Paul J. Sarvadi

The competitive environment some we keep a good eye on, we’ll have another good assessment of that when we get to our sales convention coming up. We have developed over the last nine months or so a competitive information base that we will be making accessible to our sales staff, but definitely it’s more of a market-by-market issue.

Of course we are the premium service provider in this space and so the only real way someone can try to compete with us is on price and it really becomes, does someone want to pay a lower price for a lot less service? I think we’ve got better ways to validate what we do and the advantages that it brings and the service levels we provide compared to others and that kind of information when we put in the hand of our sales staff, we’re pretty excited about how we think that’s going to play out as we go across the year.

As far as other companies that have problems and maybe companies being available for us cherry pick, we don’t really make it a habit to try and take advantage of someone else’s tough times and in most cases the other PEOs, their client base really doesn’t match up with type of buyer we have because we’re selling a premium service product, premium service offering to premium service buyers, most of the others in our space have sold more of the cost savings, saving money approach on a lesser product.

Kevane Wong - JMP Securities

As it relates to pricing, what is the percentage of when you are looking at renewals or new clients? How many of these discussions tend to have structured RFPs where you have sort of multiple competitors versus the sole-source approach? I know historically it’s been pretty low as far as the numbers of real takeoffs you’ve had, I am curious what that is like now?

Paul J. Sarvadi

That’s a good question. What we find is in the smaller base of our business, not that it happens very often, it is not that kind of environment in fact, remember we’re able to renew most of our base with our internal renewal staff that works with Richard’s pricing group and so that in most cases doesn’t even involve a sales person or anyone else.

As you get to larger customers you do get into more competitive situations or sometimes we’ll have a competitor whisper in the ear of a customer how much money they can save them and then that turns into a more in-depth process where we’ll involve our sales staff or higher level personnel within that group.

Kevane Wong - JMP Securities

Is there a rough percentage that you would be able to throw out. I think before that was not even 30%?

Paul J. Sarvadi

I don’t have that on the top of my head, but it’s still a relatively small group that ends up being escalated.

Richard G. Rawson

I was going to say that when you look at managing the timing of when they are supposed to renew and they do renew, over 90% of the clients renew in the month that they are supposed to renew.

Paul J. Sarvadi

That 10% reflects the one that does take a little more work to bring together.

Richard G. Rawson



Your next question comes from Jim MacDonald - First Analysis.

Jim MacDonald - First Analysis

Are you seeing customers being more price sensitive in this economic environment?

Douglas S. Sharp

Well certainly, I think as over the course of the fourth quarter and the timing of it coming in with the year-end renewal cycle, the attrition at year end really was related I think to cost sensitivity for companies, for which the economic turnaround has already had a pretty dramatic effect and they needed to really batten down the hatches.

So that’s pretty much washed through at this point, it’s kind of like a first layer of those who were maybe in tougher financial situations coming into the reversal.

Jim MacDonald - First Analysis

What are these customers mostly doing, are they going in house or what are they doing to save money?

Douglas S. Sharp

Predominantly it was just to bring it in-house or lower the benefits being offered, some way to weather the storm in their particular operation.

Jim MacDonald - First Analysis

On HRTools, is the investment you’re making all software, is it new services that have some cost associated with them as well?

Douglas S. Sharp

It’s mostly the rewrite of the software into the SaaS integrated application. But there are some ramp-up costs in the latter half of the year related to personnel. We need to manage that initiative as it scales up and to launch the new application as you get into the late, late part of the year.

Jim MacDonald - First Analysis

Switching gears, on your interest rate guidance or interest income guidance, I believe you guided for $2 million to $2.5 million in the first quarter, so if you multiplied that out, it would seem that you wouldn’t get to $9.5 million to $10 million for the year. Could you talk a little bit about what’s in your assumptions in terms of interest rates going forward?

Douglas S. Sharp

The increase over the latter part of the year is really building the cash balances up. As we are generating cash each quarter, we are earning more interest income on that build up of excess cash that we are investing.

Jim MacDonald - First Analysis

How low are you forecasting interest rates by the end of year?

Douglas S. Sharp

I don’t have that figure at the moment, Jim.

Jim MacDonald - First Analysis

Are you forecasting based on forward yield curves?

Douglas S. Sharp

Yes. We considered a scenario or an environment of declining rates in our forecast. I’ll also tell you that our investment policy is more of principal preservation, so our investments are conservative for the most part. Again, unlike some other business models out there we don’t make interest income on float, we’re just investing our excess cash. So, it’s not as large of an impact on our business models as it may be on some of our competitors.

Jim MacDonald - First Analysis

Can you talk at all about the duration of your portfolio?

Douglas S. Sharp

No. We kept it very short; it is primarily auction rate securities with reset rates on a weekly or biweekly basis.


Your next question comes from Michael Baker - Raymond James.

Michael Baker - Raymond James

Richard, I was wondering if we could dig into the worker’s comp a little bit. You’ve obviously addressed the three key pieces from an overall perspective, that being administrative cost claims and actual management. I was wondering with respect to the claims specifically can you give us a sense of historically what you see in a slowing economy? Do you see a pickup? If so, is there a lag aspect to it?

Clearly it sounds like today you have better enhanced management capabilities to deal with that. Maybe you could address in a little bit more detail what you’re doing on that?

Richard G. Rawson

There is certainly this, I would say somewhat of a perception and somewhat of a reality in certain kinds of businesses whereby in a tightening economy people get concerned about being laid off and all of a sudden, gosh, my back hurts.

But we are mostly a white-collar business. I mean we have some gray and we have some blue but in those particular segments of the economy we are not nearly as receptive to that kind of a outcome. Even in the last recession, we looked for that and we really didn’t see much of that happen at all. When I looked at going back six years ago, I don’t recall seeing the severity rate jump out of line because of the fact that we had 8% or 9% in the manufacturing sector and 7% or 8% in the construction sector and we still got the same kind of rate percentages of business today.

So it is different for us and it’s not as pronounced. When I think about our total history in this segment, we’ve only had two claims in our history that has actually ever exceeded an estimate of over $1 million.

So it’s just not as big of a deal for us, number one; number two obviously one of the things that we do on every single account when the day after a claim is reported, we have one of our safety people that goes to that location to investigate the nature of the injury and what took place. If there are issues that are going on in that workplace that aren’t conducive to safety, we are going to send them a report and tell them they have got X amount of time to change it or else we are ending the relationship and we do that.

Paul J. Sarvadi

The other thing that I would add to this dialogue and it is really important, one of the things we bring to the table for our customers that is so helpful in a down economic environment is the way we manage liability. The way we manage through a layoff at a client location, the communication of it and the timing of it and the level of support you provide individual employees is what keeps employees from emotionally reacting and doing something they otherwise shouldn’t do, which is a fraudulent claim et cetera.

So most of the time when companies are going through a layoff scenario, they are fighting a lot of other battles and keeping employees from filing a workers comp claim is way down on their list of what they can pay attention to. But it’s right at the top of the list to what we pay attention to. So as their HR department, we are able to help organize, manage the communication, manage support, out placement function for the employees moving on; maybe even place them at another client location. So we have ongoing activities that mitigate that risk.

Richard G. Rawson

Which is why we continue to say in good times or bad, when you have got an integrated service and we as the co-employer help the business owner manage that relationship, we can actually create positive outcomes for clients where if you disaggregate the service and have a separate health carrier and a separate comp carrier, and a separate this and that, you can’t manage that function together.

Michael Baker - Raymond James

That’s helpful. I had a separate question on the healthcare side. Previously when I asked you guys indicated you really haven’t seen any impact from United Health service issues out there. Clearly United is having some impacts to their business on the unit growth side and I am just wondering if that’s still the case or if you are beginning to see an impact but you have certain intervention dynamics that you are bringing into place. I just wanted an update on that side the benefit equation?

Richard G. Rawson

Sure, I will tell you that we have a tremendously successful relationship with United Healthcare. Their ability to grow their business compared to ours to grow and having them as part of the offerings are two completely different situations. We have seen that on the servicing side, I would say that there are always going to be times that there is a service issue at a particular location but those are just a random events. We haven’t seen anything that would give us what I would call cause for concern about the relationship and about their inability to service our customers.

As a matter of fact, what we have seen in the last 90 day was some very positive outcomes with United Healthcare in one particular market, the Illinois marketplace where they were actually able to renew and create a new long-term relationship with the Advocate Healthcare system in Chicago that had gone awry back in 2003. That was a big one for us.

So we are seeing a little bit different situation.

Paul Jones

We also have service standards negotiated in our contracts. But more importantly, we have such an integrated system between our people who are advocates for our worksite employees in the claim management side. I don’t want to say the squeaky wheel gets the grease and we are the squeaky wheel, but there is some degree of that but more importantly we have at least agreed on how to deal with escalated issues.


In the interest of time, this concludes today’s Q&A session. I would like to turn the call over to Mr. Sharp for closing remarks.

Douglas S. Sharp

Thank you all for attending and we look forward to our analyst day on May 8 and giving you an update on our long-term strategy then. Have a good day.

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