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Executives

Douglas S. Sharp - Chief Financial Officer

Richard G. Rawson - President

Paul J. Sarvadi - Chief Executive Officer

Analysts

Tobey Sommer - SunTrust Robinson Humphrey

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

Jim Macdonald - First Analysis Corp.

Administaff, Inc. (ASF) Q2 2008 Earnings Call August 1, 2008 10:00 AM ET

Operator

Welcome to the Administaff second quarter 2008 earnings conference call. (Operator Instructions) Now on today’s call we have Richard Rawson, President of the company; Paul Sarvadi, Chairman of the Board. And I would now like to turn the call over to Douglas Sharp, the Chief Financial Officer.

Douglas S. Sharp

Before we begin, I would like to remind you that any statements made by Mr. Sarvadi, Mr. Rawson, or myself, that are not historical facts are considered to be forward-looking statements within the meaning of the Federal Securities laws. Words such as expects, intends, projects, believes, likely, probably, 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 filings with the SEC. These risks and uncertainties may cause actual results to differ materially from those stated in such forward-looking statements.

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

Now let me begin by summarizing the financial highlights from the second quarter. We reported second quarter earnings per share of $0.43, compared to $0.50 in the 2007 period. For purposes of comparison, you may recall that a health care administrative fee credit contributed $0.08 per share to earnings in the 2007 period. This year’s earnings were driven by positive outcomes in unit growth, pricing and direct cost management.

The average number of worksite employees paid increased just over 7% for the quarter to 116,149, above the high end of our expected range. Gross profit for worksite employee per month averaged $241 for the quarter, also above our forecasted range.

We have now generated $45.0 million of EBITDA year-to-date and have returned $22.0 million to shareholders through share repurchases and cash dividends.

Now let’s review the details of our second quarter results. As I just mentioned, the average number of paid worksite employees per month increased just over 7% compared to the second quarter of 2007, from 108,336 to 116,149, above the high end of our expectations. In a few minutes Paul will provide the details behind our second quarter unit growth, including sales, client retention, and net change within the existing client base, and also comment on our outlook for the remainder of 2008.

Second quarter revenues increased 12% over 2007 to $420.0 million, as a result of the 7% increase in the average paid worksite employees and a 4% increase in revenue per worksite employee per month.

Looking at second quarter revenue contribution in growth by region, the Southeast region, which represents 11% of total revenue, grew by 12%; the Northeast region, which represents 21% of total revenue, grew by 20%; the Central region, which represents 14% of total revenue, grew by 15%; the West region, which represents 20% of total revenue, grew by 5%; and the Southwest region, which represents 33% of total revenue, grew by 9%.

Now moving to gross profit, gross profit for worksite employee per month for the quarter was $241, above the high end of our forecasted range of $235 to $238. These results were consistent with Q2 of 2007, however, last year’s period included the administrative fee credit negotiated with United Health Care equating to $10 per worksite employee and a Texas payroll tax refund that was $5 per worksite employee more than that received this year. So this year’s results actually show nice improvement.

As for the specifics, we generated a higher than expected surplus in the payroll tax area in Q2. Payroll taxes as a percentage of total payroll costs declined from 7.14% in Q2 of 2007, to 7.09% in Q2 of this year, as a result of lower state unemployment tax rates and a higher payroll averages in bonuses of worksite employees.

Additionally, these results include an expected $1.5 million unemployment tax refund received from the State of Texas during the quarter, which compares to a $2.9 million refund received in Q2 of 2007. Workers’ compensation costs were 0.57% of non-bonus payroll for the quarter. This was below our forecast of 0.65% as we continue to successfully manage both the frequency and severity of claims. Actuarial loss estimates continue to reflect these payroll claim trends and resulted in a $3.7 million reduction in previously reported loss estimates.

Benefit costs per covered employee per month increased 5.7% year-over-year to an average of $693 for the quarter. As mentioned earlier, the prior period included a $3.3 million administrative fee credit. Excluding this credit, benefit costs per covered employee increased by just 3.5%. Richard will discuss further details in a few minutes, including our outlook for gross profits for the remainder of the year.

Now let’s move on to operating expenses. You may recall that our plan for this year included a continued investment in our sales expansion and in new products and services, such as HRTools and our mid-market initiative. Additionally, we are currently integrating the operations of our recent acquisition of US Datalink, an employment screening services company. With this in mind we forecasted a 12% increase in Q2’s operating expenses over the prior year to approximately $67.5 million. Operating expenses for the quarter exceed this forecast by about $1.0 million due primarily to the hiring and retention of sales reps ahead of plan, which is a positive development for future unit growth.

The following year-over-year comparisons reflect the execution of this year’s plan. Salaries and wages increased by 13% and included an increase in trained sales reps to our highest level yet, averaging $292 for the quarter. The increase in salaries and wages also includes personnel costs associated with our April acquisition of US Datalink and our mid-market initiative.

Field service head count is up about 9%, as we managed this area close to our forecasted unit growth.

Stock-based compensation increased by $473,000, due to the full effect of the three-year vesting of annual restricted share grants.

Sales commissions increased by 21% off of a lower than normal level in the 2007 period. On a per worksite employee per month basis, commissions were similar to Q1 of this year, at approximately $9.

Advertising increased by just 5%, as we had accelerated certain marketing initiative in Q1 of this year as compared to 2007. This was consistent with our plan to increase sales lead activity at the outset of 2008 to offset slightly lower closing rates in a weaker economy.

General and administrative expenses increased 19% and were in line with our expectations, when considering costs associated with our sales office expansion and development costs related to our HRTools initiative.

Depreciation and amortization remained relatively flat.

Interest income declined by approximately $1.1 million from Q2 of 2007 and came in about $500,000 less than our forecast. As you may recall from last quarter’s conference call, our investments have included some municipal auction rate securities. Due to some uncertainties surrounding the liquidity of this market, our plan was to attempt to sell these securities. We were successful in liquidating a large portion of the securities during the quarter. However, the reinvestment of these funds and a lower yielding tax -exempt money market fund resulted in lower interest income. As of today, we have only $8.7 million in auction rate securities, down from $34.0 million at the end of Q1 of this year.

Now, this activity had another impact on our Q2 financials, as the lower tax-exempt interest income increased our effective income tax rate for the quarter from an expected 35.7% to 37%. I will address our forecast of both interest income and our estimated income tax rate for the remainder of the year in a few minutes.

Now let’s review several key balance sheet and cash flow items. EBITDA plus stock-based compensation totaled $24.2 million for the second quarter. Cash outlays included share repurchases of $1.5 million, cash dividends of $2.9 million, capital expenditures of $3.1 million, and acquisition costs of $3.8 million.

Working capital, which is also a good measure of our liquidity, was $85.0 million at June 30, 2008.

As for our year-to-date share repurchase activity, as of today, we have repurchased 693, 000 shares and currently have approximately 1.45 million shares remaining for repurchase under our authorization.

So in summary, we are very pleased with our second quarter activity and results as we continue to balance our long-term growth strategy and profitability.

At this time I would like to turn the call over to Richard.

Richard G. Rawson

This morning I am going to discuss the details of our excellent second quarter gross profit results. Then I will update you on the pricing and direct-cost trends we are seeing and how they will affect gross profit for worksite employee per month for the balance of the year.

Our gross profit comes from the mark-up that we earn on our HR services, combined with the surplus that is generated when our direct cost pricing allocation exceed the corresponding direct cost. Doug just reported that our gross profit for worksite employee per month was $241, which is above the top end of our forecasted range of $235 to $238. These results came from achieving $198 per worksite employee per month of service fees, and generating a surplus of $43 per worksite employee per month, or 4.3% of our total direct cost allocations.

Pricing on both new and renewing business in the second quarter increased more than $4 per worksite employee per month over the second quarter of last year. I believe this fact continues to demonstrate the value proposition that we bring to prospects and current clients. This quarter’s better than expected surplus of $5 per worksite employee per month came from better than expected results from our payroll tax and workers’ compensation direct cost centers.

Let’s begin with payroll taxes. A better than expected surplus in this cost center came as a result of having a greater spread between our allocation and the actual payroll tax expense, which was applied to a larger amount of taxable payroll, than what we had originally forecasted. This cost center contributed approximately $2 of the additional surplus to the gross profit of per worksite employee per month.

The balance of the better than expected surplus of approximately $3 came from out workers’ compensation program, which continues to produce superior results. The number of claims reported this policy year-to-date is up only 1.26% over the same period of last year. As I have said in the past, this incidence rate is particularly impressive when you consider that we’ve had a 7+% growth in the number of worksite employees that incur those claims. The severity rate of these claims filed through the end of the second quarter is up about 8.5% higher than the second quarter of last year. Now, these positive results are directly related to the great job our safety and claims management professionals continue to do.

Now let me give you the details for the benefits cost center. As Doug mentioned a few minutes ago, our benefits per covered employee per month was $693, which was just slightly above our estimate. However, on the pricing side of this cost center, we saw a slight increase in our allocations from what we had expected. Therefore, our deficit in this cost center is in line with our expectations, and actually declined this quarter compared to the second quarter of last year. The bottom line is this: we had another very good solid quarter of performance.

Now, let me share with you what we see for gross profit per worksite employee per month for the balance of the year, beginning with pricing. We believe that renewals for the balance of the year will continue to add mark-up dollars to our service fee. Additionally, we do not plan to reduce our mark-up from the current level on new business sold. Therefore, we are forecasting our average mark-up for worksite employee per month for the full year to be about $199, which is quite impressive in this economic environment.

In addition, we anticipate the surplus component of gross profit to increase from our beginning of the year forecast of $33 to $38 per worksite employee for the full year to a new range of $43 to $45 per worksite employee per month for 2008. Here’s how: the surplus generated from the payroll tax cost center typically declines each quarter throughout the year. However, the better than expected results year-to-date should carry forward throughout the balance of 2008 and add an additional $2 per worksite employee per month to the surplus.

Now let’s discuss the workers’ compensation cost center. As for the pricing allocations for this cost, we have continued to get the same levels of pricing as we did last quarter and we don’t see any pressure to reduce this allocation going forward. On the cost side, we will continue to estimate the workers’ compensation cost to be about 0.65% of non-bonus payroll for the rest of the year. Therefore, we are not expecting any change to our previously forecasted level of surplus for the balance of the year in this cost center.

Now for the benefits cost center, this is where we expect to see further contribution to gross profit for 2008. We are continuing to increase our allocations on the pricing side to match normalized trend increases and further reduce the deficit in this cost center. On the cost side, last quarter I had mentioned that we had three factors that should positively affect the benefits cost center in 2008. The first factor was a couple of planned design changes that took effect January 1. The second factor was migration of covered worksite employees moving from the United Health Care Choice Plus 250 Plan to a lower cost, higher deductible plan. And the third factor that would reduce our cost was the reduction in administrative fees from United Health Care that also took effect in January of this year.

The good news is that all three factors are still contributing to the lower cost of benefits compared to last year. So, for the full year we believe that total benefit per covered employee should only increase about 2.7% over 2007. This combination of allocation increases and reduced costs should add an additional $4 to $6 per worksite employee per month to our surplus for 2008.

Last but not least is the extra contribution to gross profit from our non-PEO offerings, including the recent acquisition of US Datalink and the reduced premiums on our unemployment practices liability insurance policy. These items should add a couple of dollars more to gross profit per worksite employee per month for the balance of the year than our previous forecast. In summation, we should see gross profit per worksite employee per month increase to a new range of $242 to $244 for the full year of 2008.

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

Paul J. Sarvadi

My comments today will focus on our sales and service expansion and our continuing solid execution of our 2008 operating plan. I will highlight the drivers of our consistent financial performance in spite of the challenging economic environment and I will summarize the initatives that are paving the way for growth acceleration and greater profitability as we look ahead to 2009.

Our excellent first half results demonstrate our ability to grow profitably with a surprisingly modest impact from the turbulent economic environment. 12% year-over-year revenue growth and a 19% increase in operating income in the first half of this year drives home the point that the Administaff business model and strategy can produce consistent, predictable growth and profitability even when there is little or no economic growth.

The cash flow dynamic of our business model also allows for continued investment when many other companies have to batten down the hatches. We have been able to continue to invest in sales expansion, service enhancements, and new products and services to leverage the PEO business. We have achieved 8% unit growth over the first half of the year and exceeded the high end of our unit growth range in the second quarter by fighting through the difficult sales climate, renewing our focus on client retention, and benefiting from our strategic client selection.

The sales climate has been more difficult and as anticipated, our closing rates have been lower than historical levels experienced in favorable economic conditions. As a result, sales for the quarter in our core business were 89% of budget and year-to-date sales were at 84% of budget. We are continuing to make progress in our mid-market initiatives as we train sales staff and transition current accounts to the new service model. At the end of the second quarter we were approximately 60% complete with this transition and expect to finish in the current quarter.

Sales in the mid-market segment are generally weighted toward year end, however, we have enrolled approximately 1,100 employees in the first half of the year, which is 33% more than the first half of last year.

At the beginning of 2008 we anticipated a challenging sales environment and our game plan to deal with was to offset the effect of lower closing rates with more sales opportunities. These opportunities come from investing more in marketing and growing the sales force. Now the availability of qualified sales candidates over the first half of the year has presented a significant opportunity for us. We are ahead of plan for the number of trained sales personnel, which is our key indicator for future growth.

Our original 2008 plan was to ramp up to 15% year-over-year growth in trained sales personnel by year end. We’ve been able to achieve this level already in the second quarter and now anticipate reaching a 16% to 17% level toward year end.

Now, although sales were below budget, our client-retention improvement initiative, which began in February, has produced some nice early returns. Second quarter attrition averages 1.4% of the base of worksite employees per month, which is below the historical 1.5% level and well below last year’s second average of 1.7%. Success in this area is especially exciting since many of the improvements are expected to be implemented over the last half of the year with the goal of impacting year-end attrition. We are on the right track here and an improvement in client retention is the most significant factor in the business model to affect both growth and profitability.

Client satisfaction levels have also been at or above historical highs throughout the first half of the year. The second quarter 93.4% of clients surveyed rated their satisfaction with the Administaff services to be completely or mostly satisfied. This was a healthy increase from 90.2% in the same quarter last year.

Now another factor leading to successfully growing the business in the recent quarter is the net gain in employment within our client base. Now although the contribution to worksite employee growth has been nominal, it is in stark contrast to the contraction in employment experienced in the overall economy.

Our company strategy to target the best small- to medium-sized businesses from across a wide range of industries and geographies paid off nicely over the first half of the year. Employment in small businesses has outpaced large companies year-to-date and leading small businesses are the most likely to continue to flourish in tough times.

So the combination of an acceptable level of new sales, improved client retention, and nominal employment growth in the client base resulted in the recent unit growth, which was slightly above our expectations in the second quarter.

Now as we look ahead to the second half of 2008 our focus is clear. We have the largest sales force we have ever had and the sales organization is energized and poised for a successful fall selling campaign, which will kick off in September. As you heard from Richard, our direct cost programs are performing well and creating distinct advantages for our client and adding nicely to our profitability.

We have a dedicated team of service providers that are satisfying clients at record levels and we have the entire organization aligned with specific goals for improving client retention, especially at year end. Also, our investment in product and service enhancement are on track to increase the value to our clients and add income streams for Administaff.

So in conclusion, Administaff continues to perform extremely well and compare favorably in the current economic environment and we are positioned very nicely for acceleration and growth and profitability as we move into 2009.

At this point I will pass it on to Doug to go over the guidance.

Douglas S. Sharp

At this time I would like to provide financial guidance for the third quarter and an update to our full year forecast.

We are essentially reiterating our full-year worksite employee growth guidance, although we have narrowed the low and high end of our range, which is typical at mid-year. Our gross profit for worksite employee forecast has been increased to the high end of our previously forecasted range due to favorable trends and pricing in direct cost management. Our revised operating expense guidance includes the impact of hiring and retention of our sales staff ahead of our initial plan. We have lowered our forecast of interest income and increased the estimate of our effective income tax rate due to the impact of a declining interest rate environment on our tax-exempt investments.

Now let’s discuss the detailed metrics, beginning with unit growth. Based upon Paul’s remarks, our updated forecast assumes an increase in the average paid worksite employees of $700 to $1,400 each month for the remainder of the year, with the exception of December. This produces a range of $117,500 to $118,500 average paid worksite employees for the full year, and a range of $119,750 to $120,250 for the third quarter.

As Richard mentioned, we now expect full-year guidance for gross profit per worksite employee per month to be in a range of $242 to $244, an increase from our previous range of $239 to $243 based upon an improved outlook in our direct cost program. As for the third quarter, we expect gross profit per worksite employee per month to be $233 to $235. This is sequentially down from the second quarter due primarily to the unemployment tax refund received from the State of Texas in Q2, equating to $4 per worksite employee.

As for operating expenses, we now expect to be in a range of $277.0 million to $279.0 million for the full year, or an increase of approximately $2.5 million from our previous guidance. As I just mentioned, this increase is primarily related to costs associated with the hiring and retaining of our sales staff ahead of plan. And remember that the high end of the full year forecasted range includes additional incentive compensation tied to achieving higher unit growth and gross profit goals.

As for the third quarter, operating expenses are expected to be in a range of $68.0 million to $68.5 million. This is fairly consistent with Q2 operating expenses, as our typical sequential decline in advertising is expected to be offset by higher G&A costs associated with our annual fall sales campaign travel.

For reasons discussed earlier, we have lowered our forecast of net interest income to a range of $8.0 million to $8.5 million for the full year and a range of $1.9 million to $2.2 million for the third quarter. Primarily as a result of this lower tax-exempt income we are now assuming an income tax rate of 36.3%, up from 35.7% in our previous forecast. And we are now estimating average outstanding shares of 25.8 million for Q3 and the full year.

So, in summary, we are basically reiterating our full-year guidance at the operating income line, as we plan to invest higher gross profit dollars in to our sales expansion. The impact of lower interest rates from the end of last year on workers’ comp discount factors, interest income, and our effective rate is about $0.17 per share, which represents the difference between that implied by the mid-point of today’s guidance and the top end of our original guidance, which was about $2.01 per share.

Now at this time I would like to open up the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Tobey Sommer with SunTrust Robinson Humphrey.

Tobey Sommer - SunTrust Robinson Humphrey

I wanted to ask a question about what you’re seeing in payrolls and bonuses and overtime, if you have some sort of an update. I think last time we heard from you on a conference call you were on the heels of one of your surveys, but maybe you have an update of what June and July trends, kind of more recent data, suggest is going on in your small-business customer base.

Paul J. Sarvadi

Sure, I can do that for you, Tobey. Like I said in the script, we are seeing some nominal net gain in employment, which is the key factor. But behind that, when you look at some of the other factors, for example average pay or compensation is up about just under 6% year-over-year in our client base.

Commission, which is really our leading indicator, has been lower than it was a year ago. I mentioned it dropped off dramatically in the fourth quarter, it rebounded a little bit in the first quarter, in the second quarter it was down a little, but we’re around 4% year-over-year increase in commissions.

Which to me means companies are still doing business, they’ve still got sales but they’re not robust like they were a year ago. But they are also not falling out of bed so I think kind of a steady state going forward is what we anticipate out of that number.

Also, the overtime as a percentage of base pay is still running at 10%, so businesses, at least in our client base, are being pretty smart about this. They’re operating kind of at capacity but the degree to which they’re using overtime is still on the high end, because the commissions aren’t high enough to say that growth is really coming back strong yet, so they’re not hiring more people to lower that overtime number. But we think we’re pretty much in the steady-state mode, at least in the third quarter.

Tobey Sommer - SunTrust Robinson Humphrey

And I wanted to ask you a question about your levers that you get to look at internally to drive the unit growth. It looks like you’re going to step on the gas a little bit more relative to sales people and try to take advantage of the talent that’s available to you, given the economic conditions. And I wanted to get a sense for how you approach the balance between additional marketing dollars in additional kind of feet on the street.

Paul J. Sarvadi

We’re up year-to-date considerably on both the marketing dollars that we’ve spent and obviously the investment in our sales force, which is the biggest factor in increased operating expenses. But we think it is perfectly appropriate because we’ve been able to make those investments and still be at the top of our original range in terms of our operating income targets for the year. You know, when you add in the out-performance in the first half of the year and our guidance for the balance of the year.

So, the balance, like we’ve said many times, is our balance between growth and profitability. When we can still meet our profitability targets and invest further in growth, that’s what we like to do. Because I can’t overemphasize how well positioned we are going into this fall campaign and having the number of trained reps up well ahead of schedule. I think that means that if the economy continues to kind of move along kind of the way it, hey, we’re in great position to out-perform. And if the economy comes back at all, I mean, you’ll see this thing come out of the water in a big way.

So, we’re excited about where we are and I think we’ve found and struck that balance between growth and profitability. That was really the key question at the beginning of the year, was how much would sales be affected by the economic environment and what would we have to do to at least stay close to our budget number and be able to continue to grow. And I think we found that balance quite well.

Tobey Sommer - SunTrust Robinson Humphrey

Last question for me will be on working capital, kind of where you are in that in the quarter and maybe, Paul, if you could address what opportunities you may see to continue to drive the contribution from non-PEO business, maybe in the form of acquisitions, if you’re seeing anything interesting out on the horizon.

Douglas S. Sharp

On the working capital, it’s still very healthy. It was $85.0 million at the end of the second quarter. If you remember, we had a discussion back in the first quarter about some of the auction rate securities which we had re-classed down into long-term because they were dealing with a bond fund that was more liquid than some of the others, however, there is some good news on that front in that they are making progress in redeeming that fund.

So, I think we’ve taken a conservative position on that, but that could, in the future, also be added to that working capital position. So, therefore, probably north of $90.0 million as we see it today.

Paul J. Sarvadi

Now, on the acquisition front, you will notice that we did make a small acquisition that’s having a nice impact on the operation. We purchased US Datalink, which is a very strong kind of boutique shop for employee screening, background checks, etc, and we’ve been able to transition our own corporate background checking to that service and then are in the process now of moving our client base to that service.

That will save a lot of dollars and improve the service to the customer all in one whack, so we’ll add to our bottom line relative to our non-PEO initiative.

And in fact, when you add up the market place that we have with our customer base and HRTools and the progress we’re making there, and add in the US Datalink, you know, Richard mentioned in his script that we’re starting to see a contribution from these things.

And I’ve talked about this for a couple of years now, that what’s going to be exciting, as we start to talk about three components to our gross profit: the mark up for the HR services, the surplus component from managing the pricing and cost of the direct costs; and then this third component, which now has kind of gone up from about $1.30 or so a year ago to closer to around $3.00.

So, as we start to see that move up, there is some tremendous potential to increase our gross profit per employee as we add services and actually get some more momentum and some more traction within these current programs.

Operator

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

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

I was wondering if you can talk a little bit about what you’re seeing regionally. Looks like the Western portion is finally starting to up-tick after a number of challenging quarters. Are you seeing improvement there with regards to your Northern California branch? What are you seeing over there?

Paul J. Sarvadi

Well, you notice the West, which represents about 20% of our base, increased only 5% year-over-year. A lot of that was due to we had a large mortgage-related client out there that obviously had the expected effect of what happened in the mortgage business. And so that was the primary reason.

But we still have some challenges in Northern California but I think we’ve got that well underway now, of turning things around up there. We feel good about that, especially as we go into this fall selling season.

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

I thought the 5% was an improvement relative to the year-over-year growth we ended up seeing last quarter.

Paul J. Sarvadi

It was an improvement but we’re certainly not happy at that level and expect to make a difference going forward.

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

It’s getting better so I just wanted to know, do you think the momentum is going to continue to get better over there?

Paul J. Sarvadi

I do. I think we’ve got a lot of fundamental things in place right now, in California, both from a pricing and direct cost side and in the actual sales management and sales organization out there, so we’re pretty excited about where we’re going.

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

How about fighting competitive inroads? ADP mentioned yesterday that they have been expanding aggressively, obviously no secret to anybody who has been paying attention, in California. Looks like whatever storm that created, you’re more than weathering it.

Paul J. Sarvadi

In the long run we’re happy to see folks spend some more money building the market out there. Because we do very well, compare very favorably, and for our target customer, no one does what we do for them, so we like to see that going on.

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

What about the mid-market initiative. Can you talk a little bit about what you’re seeing in terms of client retention on that front and the success that you may be having?

Paul J. Sarvadi

The 1.4% attrition we had in the second quarter was exactly the same in both mid-market and core business. So we are really excited.

These stewardship meetings that we’re having are going very well. We’ve worked some issues with clients that relate to a better understanding of our pricing and invoicing and that seems to be received extremely well.

We are now in the process of, like I said, transitioning the rest of our mid-market clients to our service model, but also transitioning to them to some of this new information. And it looks like we’re probably going to let that move down a little bit toward what we call our emerging growth client, which are the 51-150 range.

We think we’ve got some things we’ve figured out with the mid-market that are really going to help retention in that group, so that’s part of what we plan to implement over the last half of the year that we hope will affect January 1 renewals.

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

So that lower attrition rate was a function of just the partial implementation of the programs and it hasn’t been fully implemented as yet.

Paul J. Sarvadi

Absolutely. We started in February just organizing and getting everyone focused on what we can do to improve and we incentived ideas and formed committees to focus on specific aspects and those groups have been working to devise changes and put them in place. And I would say we’re probably not 20% to 25% implemented on the changes that we’ve come up with.

So we’re pretty excited about attacking that retention issue. Because like I said in my script, the most significant thing we can do to impact both growth and profitability is to improve client retention.

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

In terms of the actual mark up for the service, so not the surplus, but just the fee mark up, is the $198 down relative to what it was before?

Richard G. Rawson

It is. From the end of last year, we averaged $200. And then when we came into the first quarter, because of attrition and year-end attrition that took place, we actually started the year, in the first quarter we were at $198. And so we’ve maintained that now, that $198 number, so far through the first half of the year and you know, that was by design because if you’re unsure about the economic climate, you don’t need to be pushing margin. So we kept it at the same level.

We’re not seeing the kind of pressure that we saw in the first quarter and so we think that that number will actually go up to $199 for the average for the full year. We are pleased about that, we think that’s really solid stuff.

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

So if it goes to $199 for the full year, that implies $200 for the second half.

Richard G. Rawson

That’s correct.

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

And then do you think that could go up next year?

Richard G. Rawson

Yes, I think so. Right now we’re just focused on the balance of this year, but by the time we get through the third quarter into renewals for January, which will start in November, we’ll start to see what that looks like for 2009. And I think as we see what happens in the rest of the economy, that will also give us another indicator as to how much we can go up in 2009.

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

And during the first half, what sort of yield were you averaging on your corporate investments?

Douglas S. Sharp

Probably 2.0% to 2.5%. That’s tax-exempt

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

And now it’s going to be?

Douglas S. Sharp

We’re probably looking at more around 2.0% at this point, based on today’s environment.

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

Do you think as we look out towards next year, if things settle down, that we could move back into the old structure and that the old tax rate could come back or should we think that this is kind of a permanent change?

Douglas S. Sharp

I think for the moment we’ve taken the approach that we’re going to focus more on the liquidity in our investments and so therefore we’ve moved out of the higher yielding into these tax-exempt money market funds just due to the volatility in the market out there.

Should things settle back down, we would hope to make more money on our investments. And we’ll have to see whether it makes sense to go the route of tax-exempt going forward or taxable, on our investments. So it’s a little early to tell, Mark.

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

One last question. Any thoughts in terms of if there’s a change in the administration and the parties that control all three, or at least the legislative and the executive branch, there’s been a proposal for increasing payroll taxes. Can you talk a little bit about how that might impact you?

Paul J. Sarvadi

Well, I’ll tell you what, the impact on us I don’t think would be significant. We do make a surplus in the payroll tax area. So it might be a little bit of a benefit. But more importantly is the effect that would have throughout the economy would be, I think, dramatic. You know, if you just take off the limits, you know, the FICA limit, you just take a lot of spendable income out of the economy and hand it to the government.

I think it would be bad for the economy but I don’t it would necessarily be bad for us. We’re in a business that basically, whenever the government gets involved, that’s a reason you have up, but we translate and interpret what the government’s requiring on employers and we’re able to help them manage it and deal with whatever the government is requiring.

Operator

Your next question comes from Jim Macdonald with First Analysis Corp.

Jim Macdonald - First Analysis Corp.

We’ve heard a lot about the sales force but I can’t find a number anywhere. What was the average number for the quarter?

Richard G. Rawson

292 for the quarter. Up 15% year-over-year.

Jim Macdonald - First Analysis Corp.

What kind of attrition are you seeing of the sales force? Any change in that in this environment?

Paul J. Sarvadi

The growth sooner than expected was impacted by both our ability to hire new and also having some pretty good success on retention.

Jim Macdonald - First Analysis Corp.

Are you hiring any kind of different type of person in this environment?

Paul J. Sarvadi

Our recruiters and our sales management would say that we’ve been able to hire a better, a higher quality, there have been more quality people available. We do recruiting a lot out of the financial services world. You know better than I do what kind of turmoil there has been out there. So we have been able to bring some really great people into our operation.

Richard G. Rawson

And you know the caliber of people in your industry anyway, Jim. They’re just first class.

Jim Macdonald - First Analysis Corp.

One other question. On the repurchase activity, it was a little bit less than we would have expected. What are your thoughts on share repurchases here?

Paul J. Sarvadi

I think we did want to hold our powder a little bit, kind of see what happened throughout the second quarter. We knew we had an acquisition coming down and some other things with the US Datalink. Not a bit number, but we though it was best to kind of hold the powder a little bit.

But at this point, we’re pretty confident about where things are going and we’re going to continue to be active repurchasing shares. And the Board will meet on that again in August and we’ll kind of get a flavor for how aggressively we’re going to be. I really don’t know the answer to that at this point.

Operator

Your next question is follow-up from Tobey Sommer with SunTrust Robinson Humphrey.

Tobey Sommer - SunTrust Robinson Humphrey

Paul, I wanted to get your perspective on some news out in the space, but not necessarily your own. A competitor out there said they’re going to look for extra strategic alternatives and I know historically you’ve kind of shied away from looking at competitive PEOs’ books of business that don’t really line up all that well with your own. But I wanted to get your perspective on the opportunity there, on the PEO side, kind of outside of the Datalink type opportunities in the market.

Paul J. Sarvadi

We continue to look at PEO acquisition opportunities when they come up. But like you said, we typically find that the client base doesn’t really line up, the pricing doesn’t line up. And most importantly, the service offering doesn’t really line up. Therefore, we’ve not been able to find PEOs to acquire that would really be a net add, or least appreciable enough to make it worth our while.

So we still are hopeful that there are some out there. We know there are companies out there that kind of patterned their business after our model and as we locate those we would certainly be open to integrating those in if it really makes sense. But that’s not certainly even central or even on the edge of what our real strategy is.

Tobey Sommer - SunTrust Robinson Humphrey

And I wanted to ask a specific question on Texas, your home state and home market. Have the results of the book of business, in terms of net job growth and kind of things that would impact the existing customer base, has that been noticeably better than the rest of the country.

Paul J. Sarvadi

A little. Of course, you know, Houston is obviously counter-cyclical and driven by the energy business. I will remind you that we don’t have a lot of client base directly in the energy business and that’s why we’re not seeing a big bump in net employment in that group. But the Houston economy in general, and Texas largely, is affected by the higher energy costs of pricing and so we’re getting some benefit there.

More than other parts of the country but not as much as you might think, with the weighting of how heavily the energy sector is to the total economy in Texas.

Operator

This concludes our Q&A session. I would like to turn the call over to Paul Sarvadi for closing remarks.

Paul J. Sarvadi

We would like to thank everybody for joining us today and we look forward to continuing the kind of performance we had over the first half of this year and we’ll be in touch with you next quarter.

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Source: Administaff, Inc. Q2 2008 Earnings Call Transcript
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