Insperity Inc (NSP) 2003 Q2 法說會逐字稿

Hello. Good morning, ladies and gentlemen, and welcome to the Administaff second quarter 2003 earnings conference call. I would like to remind you that any statements made by Mr. Sarvadi or Mr. Rawson are not historical facts and are considered to be forward-looking statements within the meaning of the Federal Securities Laws. Words such as expects, intends, believes, estimates, likely, goals, assume and similar expressions are used to identify such forward-looking statements and involves a number of risks and uncertainties that have been described in detail in Administaff's filings with the SEC. These risks and uncertainties may cause actual results to differ materially from those stated in such forward-looking statements.

With us today are Richard Rawson, EVP and CFO, and Mr. Paul Sarvadi, President and CEO.

Mr. Rawson, you may begin.

Thank you and good morning everyone. We appreciate you joining us this morning for the call.

Let me outline our plan for the call this morning. First, I'm going to discuss our second quarter results. Then Paul will add his comments about the quarter and provide details about our game plan for the balance of the year. Then I will come back and talk briefly about financial guidance for the third and fourth quarters and then we will end the call with a question-and-answer session.

Now let me begin by summarizing the most significant financial highlights from the quarter. Revenue per Worksite employee was $973 for the quarter, an increase of 9% or $80 over Q2 of 2002. This improvement was due to our pricing increases that we continue to have over the past year. Benefits, expense per covered employee increased less than 1% over Q1 of 2003 and significantly less than our expected sequential increase of 4 to 4.5%. These results were driven by the effective benefit plan design changes that we implemented in January of this year.

Improved pricing combined with lower than expected benefits cost resulted in a 31% increase in gross profit per Worksite employee per month over the second quarter of last year to $208. These results exceeded our expected range, even though we took a $2.5 million charge related to our workers' compensation dividend, which I will explain in further detail in just a minute.

Operating expenses for second quarter increased 5.5% to $44 million, which was the top end of our expected range. We reported second quarter earnings from continuing operations at 7 cents per share, compared to net loss of 10 cents per share for the second quarter of 2002.

These results include number one, the $2.5 million or 6 cents per share after-tax charge related to the write-off of the dividend receivable on our workers' compensation policy; and number two, a gain of $457,000 or 2 cents per share on the sale of eProsper, an investment we had previously written off. These results continue to exclude the operations of financial management services, a division which is currently for sale.

Now, let me explain the details. Worksite employees, the average number of Worksite employees that we paid in the second quarter declined by 2% from the second quarter of last year and declined sequentially from $76,425 that we paid in Q1 of 2003 to $75,103 we paid this quarter. Paul will be discussing the reasons for this decline and progress toward regaining our growth momentum in a few minutes.

Second quarter revenues grew by 7% over Q2 of last year to $219 million, primarily as a result of increased pricing which offset slight decline in paid Worksite employees. As you may recall, last quarter we experienced a $13 per Worksite employee per month increase in revenue due to the acceleration of the payroll tax component of our comprehensive service fee for clients on the new billing system beginning January 1, of this year. This quarter, as expected, we experienced $2 per Worksite employee per month reduction in revenue related to the same clients consistent with the decline in the payroll tax cost as the wage limits of those employees associated with those clients have been met.

Total payroll tax per Worksite employee per month, which remains a key driver of our revenues, was $4179 in the second quarter, including bonus payroll of $216 per Worksite employee per month.

Now looking at revenue growth by regions. The Northeast region, representing 13% of total revenue, grew by 21%. The Southeast region, which represents 11% of total revenue, grew by 5%. The Central region, which represents 15% of total revenue, grew by 8%. The West region, which represents 21% of total revenue, grew by 17%. And the Southwest region, which represents 40% of total revenue, remained flat. We have averaged 225 trained sales reps for the first half of the year and average 219 for the second quarter.

Approximately 62% of our sales reps have more than 18 months of Administaff sales experience and this percentage has remained relatively constant since the beginning of the year.

Moving to gross profit, as I mentioned a few moments ago, gross profit per Worksite employee per month increased significantly from the $159 in Q2 of last year to $208 for the second quarter of this year. Net of the write-off of our workers' compensation dividend of approximately $11 per Worksite employee per month. This significant increase in gross profit was primarily a result of lower than expected benefits costs.

Benefits cost per covered employee, which is currently 71% of total Worksite employee base was $537 for the quarter, an increase of only 9% over the second quarter of last year and a sequential increase of slightly less than 1% over the first quarter of this year.

The reduction in benefit costs resulted from plan design changes which were implemented effective January 1 of this year and were fully confirmed in the second quarter. Workers' compensation costs were 1.67% of total payroll for the quarter, compared to 1.26% in the second quarter of last year. This increase is attributable to our decision to write-off a previously earned dividend of $2.5 million.

At the end of this quarter, the second quarter, our workers' compensation claims experience supported an increase in the dividend to approximately $3.6 million. However, deterioration in the financial condition of our insurance carrier during the quarter as demonstrated by lowering of the carrier's credit rating to a D has resulted in some uncertainty as to the carrier's ability to ultimately pay this dividend. Therefore, while we will continue to make every effort to collect the dividend, we have decided to take the conservative approach and write-off the previously recorded asset.

Our payroll taxes, including FICA, FUDA (ph) and state unemployment taxes as a percentage of total payroll cost was 7.36% in the second quarter, as compared to 7.4% in Q2 of 2002.

Now, let's talk about operating expenses. As expected, operating expenses increased $2.3 million over the second quarter of last year. This increase was primarily due to an increase in legal cost related to our lawsuit with Aetna and an accrual for incentive compensation. On a per Worksite employee basis, operating expenses increased from $182 in Q2 of last year to $196 this quarter.

This increase in operating expenses included the following. Compensation cost increased by $8 per Worksite employee per month of which $6 was due to accrual related to our 2003 incentive compensation plan that's payable only upon the achievement of certainly annual goals. While we have experienced a 1.8% decline in Worksite employees from the second quarter of last year, we have also had a corresponding 2% reduction in corporate headcount over the same period.

Advertising costs increased $1 per Worksite employee and commission cost declined by $1 per Worksite employee per month. Depreciation and amortization costs increased by $115,000 over the second quarter of last year or $1 per Worksite employee per month. However, these costs are declining now on a sequential quarterly basis.

General and administrative cost increased by $5 per Worksite employee per month due to increase in legal cost related to our lawsuit with Aetna. While we continue to believe that our fiduciary liability insurance policy allows for the reimbursement of a significant portion of these legal fees, we have taken an appropriately conservative position and are continuing to expense all cost associated with this litigation.

For this quarter, the total Aetna-related legal costs were approximately $1.1 million. Since the inception of this lawsuit in the fourth quarter of 2001, we have expensed $5 million in legal costs, of which $3.5 million has been submitted for reimbursement to our insurance carrier.

In the second quarter of this year, we incurred net interest expense of approximately $289,000 due primarily to the mortgage on our new corporate headquarters. This compares to net interest income of $442,000 in second quarter of last year.

Now, I'd like to make some comments about our balance sheet. Total assets are $289 million, including current assets of $185 million. We ended the quarter with approximately $75 million in cash, cash equivalents and marketable securities and $48 million of working capital, up $14 million from the end of last quarter.

Prepaid expenses and other current assets total $23.7 million, and is composed of the following items. $7.7 million is funded surplus to United Healthcare in excess of actual costs, which is an increase of $6.1 million over the first quarter of this year. Our second quarter funding rates set in December of last year prior to the implementation of the plan design changes that I spoke about a few minutes ago, significantly exceeded our ultimate costs. This funded surplus combined with recent favorable cost trends were major factors in United Healthcare's decision to lower funding rates for the third and fourth quarters of this year.

The next component is $7.5 million related to the security deposit with United Healthcare, which as previously announced, will be refunded in January of 2004. This amount had been previously reported as long-term deposit. The next component of the $23.7 million is $2.8 million of prepaid workers' compensation insurance, which will be applied to our August premium. And finally, $1.7 million is related to estimated refund of overpaid unemployment taxes from the state of Texas.

You may recall this amount was approximately $6 million at the end of Q1. During the second quarter, the Texas Work Force Commission allowed us to apply this overpayment to the estimated Q1 and Q2 tax liabilities, which totaled approximately $4.3 million.

Last week we received our initial 2002 and 2003 unemployment tax rate computations from the Texas Workforce Commission.

We are currently reviewing these computations with the Texas Workforce Commission and I can tell you that we do not expect any negative impact to the estimates used to record our payroll taxes. We limited capital expenditures in the first half of the year to $3.2 million, which includes $661,000 in capitalized software development costs.

Last, but not least, is the $19 million of deposits that consist primarily of the $17.5 million balance that we have with United Healthcare.

Now, at this point, I would like to turn over to Paul.

Thank you, Richard. Today my comments will focus on three areas. First, I'll provide mid-year update on the most important elements of our 2003 operating plan. I will then provide details regarding our emphasis for the balance of 2003 and I will finish with some preliminary thoughts on 2004. We made excellent progress through the first half of the year in executing the five critical elements of our 2003 game plan that I outlined for you at the beginning of this year.

Let me identify each objective I discussed and update you on our progress. First, the most important element of our plan was to recover our profitability through matching cost per benefit. Our second quarter and first half financial results clearly demonstrate the success we've had in this area.

The second priority was to further refine healthcare cost and pricing strategy to slow our overall healthcare cost escalation in order to provide more attractive pricing of our services to clients going forward. We updated and included new insurance risk factors such as age and gender and Cobra rating into the pricing model to align each client or prospect allocation for benefit more closely with the marketplace.

We successfully improved client selection through risk management standards relating to client size, employer contribution and Cobra takeovers. This included a decision to non-renew an unprofitable segment comprised of smallest accounts.

Now the early return on these strategies are encouraging. We appear to be attracting and retaining clients that are most likely to fit our business model for the long run.

Two specific facts provide evidence of this improvement in client selection. First, many new clients sold in the second quarter were prospects that earned favorable pricing allocation due to profile of their account.

Secondly, analysis of client retention in the first half of the year confirmed that the average gross pay per Worksite employee per month for clients that renewed their contracts was 15% higher than accounts that were terminated. This is positive in that lower average pay clients have historically had lower margins, as well. The next priority I outlined was need to aggressively pursue cost-saving opportunities with our major health carrier and to achieve more balanced financial relationship.

Our recent announcement of our new contract with United, including reduction in deposit, lower administrative cost and an agreement on rate setting methodology is the direct evidence of our success in achieving this objective. Another priority I mentioned early in the year was the expansion of our retirement services offering to take advantage of the opportunity presented to Administaff by last year's Internal Revenue Service decision.

I am pleased to report we are on track on this initiative, as well. I expect to be in compliance on the IRS decision on a timely basis. I continue to be excited by the opportunity to offer more retirement plan options at favorable participant and client cost with nominal new cost to Administaff in the short term and significant potential financial benefit in the long term. The final priority I discussed at the beginning of the year was the objective of regaining our sales momentum and beginning to grow our core business. As the year began, we were forecasting flat paid Worksite employee growth for the first part of the year and nominal growth over the second half. In this area, we have not been able to achieve desired result and in fact experienced 4.5% decline in Worksite employee since January. I believe this is due to a couple of factors.

First, this objective proved to be more challenging early in the year, as I discussed last quarter, as the war-related economic malaise affected prospect buying decisions and layoffs within the client base in the first quarter. Since sales from a given quarter generally become paid Worksite employees in the subsequent quarter, the new employees were not enough to offset employees lost to attrition.

Secondly, both sales and client retention have been more difficult due to continued emphasis on conflicts, but appropriate higher priorities for first half of the year, namely pricing and client selection.

So, in summary, three of the five major priorities established for 2003, recovering our profitability, refining our healthcare cost and pricing strategy and achieving more balanced financial relationship with our major health carrier have all been completed successfully. A fourth priority, expansion of our retirement services offering is right on track and one priority, regaining our sales momentum and growing our core business has been more challenging than expected and although progress has been made, we still have our work cut out for us.

Therefore, the central emphasis for the balance of the year 2003 will be to turn the corner in sales and client retention, the two major drivers of our unit growth. So, I'd like to provide some detail regarding the latest results in our near-term outlook in these areas.

We made substantial progress in the second quarter in sales and I believe we are gaining momentum. Actual sales for the second quarter were 45% ahead of Q1 driven by 24% improvement in the closing rate and 31% increase in average size of caps sold. These are healthy improvements, but we still have a way to go in this area. Each successive month in the quarter was better than the prior month, but we are still not up to our historical sales metrics for our business model to produce the level of unit growth we want. In order to achieve these metrics, we need to increase the number of sales opportunities and improve closing rate by another 10%. This will be our focus over the last half of the year.

Now, client attrition continued to be higher than normal throughout the second quarter, as I expected. I believe this is related to the past due of healthcare allocation that are higher than historical levels. Fortunately, we are very close to the end of that cycle and we are seeing the first sign of daylight in this area in our forward-visibility in client termination. Our contracts require 60-day notice of cancellation, which gives us some idea of future attrition although not all clients provide the required notice.

As we sit here today, September notices are substantially below the numbers we previously had in hand one month out. For the third quarter, however, Worksite employees lost due to client attrition will be impacted by termination of a single large account of over 1000 employees. This client was very pleased with our services, however, they are terminating because they have decided to sell their business. I'd like to take the last few minutes today and briefly look ahead to 2004.

I'm already getting energized by the possibilities next year for Administaff. First, we currently have more than half of our client base on our new billing system. After monitoring the results on the 20% of our base that have been on the system all year, I can already see how much more consistent and predictable our business will become when the rest of the client base are on the new system.

I expect all of our clients to be on the system beginning in January of 2004. When this happens we'll no longer experience the quarterly earnings pattern we've had in the past. We will no longer have losses in the first quarter of each year followed by increasing profitability in each subsequent quarter due to payroll taxes.

This means sequential quarterly metrics will be meaningful and our business will be easier to understand, monitor and drive. We've also been able to validate the certainty of gross profit built into price of the accounts on the new system. We will no longer be affected by changes in payroll or benefit elections that occur within a client.

I'm also cautiously optimistic about the economic outlook for next year. Although we are certainly still in a jobless recovery today, growth in Q2 does appear to have been at levels that is have stemmed a tide of significant layoffs that we've seen over the last couple of years. If trends continue, we will see less headwind next year.

I'm also encouraged by outlook for operating cost going forward. We are in a position to grow significantly without the need to add infrastructure or other significant cost. This is evident in our greatly reduced capital spending this year and decline in our depreciation and amortization cost associated with our previous investments.

In conclusion, I'm pleased with the overall results for the first half of the year and I'm also excited to be in a position to focus our energies back on growing the business. I'm looking forward to 2004 and the opportunity to drive volume over our infrastructure in the dynamic change represented by our new billing system.

At this time, I'd like to pass back to Richard to discuss guidance for the balance of the year.

Thanks, Paul. As a reminder, we talk about guidance, we're excluding the results of financial management services from our guidance as this division is currently for sale and is being reported as a discontinued operation in 2003. We're forecasting the paid Worksite employee count to decline from an average of 75,100 paid in second quarter to approximately 74,000 paid Worksite employees in each of the third and fourth quarters.

While the loss of a single account will largely contribute to this decline in Work site employees, the termination of this account is actually expected to have a positive impact on the average pay of Worksite employees and our gross profit metric.

Excluding bonus payroll, we expect the average payroll per Worksite employee per month to be approximately $4000 in each of the third and fourth quarters, which is increase of about 1% over the second quarter of this year.

Gross profit per Worksite employee per month for the third quarter is expected to increase to a range of 230 to $234, based on pricing strength and an expected 3 to 4% sequential increase in benefit costs per covered employee over the $537 that we experienced this quarter.

Gross profit per Worksite employee for the fourth quarter is expected to increase to a range of 245 to 253 dollars per employee per month and includes an expected 2 to 3% sequential increase in benefit cost per covered employee over the third quarter of this year.

Now, these estimates also include the effects of our transition to the new billing system that we had at the beginning of the year. We expect operating expenses to be in a range of 42.5 to $43 million in each of the third and fourth quarters. And we are continuing to include approximate a million dollars of legal costs associated with our law suit with Aetna and these estimates for both quarters. New interest expense should be in a range of two hundred and fifty to three hundred thousand dollars for the balance of the year and our effective tax rate should be 39.5%.

Now, I would like to open the call up for questions.

OK, thank you, sir. Ladies and gentlemen, if you wish to ask a question at this time, please key star, then one on your touch-tone phone. All questions will be taken in the order in which they are received. Once again if you would like to ask a question, key star, then one. Sir, give me a moment while I gather your first question.

Sir, your first question comes from Thomas Geovine of Geovine Capital Group.

Hi guys. Excellent job on the cost side. Just a capital structure question. But, I was wondering if you can articulate a capital plan? With the recent dividend tax benefit you could put in something like a 20 cent dividend, it would be 1.5% nominal yield, which would hopefully lay return regarding visibility of cash flow which is only about a $5.5 million cash usage a year. I am curious as to what the board has discussed on this front or further buybacks?

Yes, Tom, we can give feedback on that. We actually haven't had a opportunity for our Board to fully discuss that issue. But, we expect to discuss that at our next board meeting which is later in August.

Great. Thank you.

OK. Thank you, sir. Your next question comes from Randy Mehl of Robert W. Baird & Company.

Good morning, Paul and Richard. Couple questions. One, you mentioned a -- I think you said surplus of $6.1 million on healthcare. How did you come up with that number and how is -- you had mentioned United assumption for the next couple of quarters for funding rates has changed. How has that changed?

The $6.1 million is increase from the second quarter to the first quarter. But, in terms of what we have paid in compared to what our actual cost for the benefits were during the quarter. So, you know, it was evident by the press release that we announced in June that there was going to be a surplus because of the fact that United Healthcare was going to be reducing the security deposits. So, they had already seen the results that the requirements they had for us that were set last year to fund in the second quarter on a monthly basis were actually higher than what our actual experience has turned out to be.

Would you expect that surplus to be wiped out by the end of the year or as we get into the first quarter? What would the expectations be?

Well, I think certainly we expect that that surplus will decline because the idea is not to have a huge surplus. And United Healthcare certainly is onboard with that because they have in fact reduced our funding rates for the third and fourth quarter compared to what they told us at the beginning of this year. So, you know, our game plan, our strategy is always to have a little bit of a surplus there. But, you know, it's not as big as $7 million.

OK. On the payroll tax side, I was a little surprised at the I think your payroll tax per Worksite employee was flat year-over-year. Can you walk me through the contribution there? Because I would assume the Suita (ph) contribution is higher on a year-over-year basis. I'm wondering how that didn't go up.

Geez-

Maybe you could give -

I don't have the information here in front of me on a per Worksite employee basis for payroll tax.

I used it for the information you put in the press release. It could be mine are not precise either, it looks like it was roughly flat.

I would be happy to call you back.

That would be fine. There wasn't -- I think I understood what you said about the Texas Workforce Commission, but was there a credit then applied in the quarter at all on the -- for Suita or how did that work?

No, what we did, we continue to book our expense at what we think the actual rate is going to be. But, because there is so much excess the Texas Workforce Commission said that we could start applying -- because they didn't have the rates back in April, May and June. We just got them last week. They told us to go ahead and start applying our -- instead of paying in at the end of the quarter, just apply that against the deposit. So, we've done that, so we haven't paid any dollar amounts in for both the first and the second quarter. So, the deposit has gone from $6 million now down to $1.7 million.

Right, but there was no change in your expense assumptions?

No, we haven't changed. Until we have the final rates and the process is complete on the rate evaluation and conclusion, we will not be making any adjustment to that expense line item until it is all said and done and then we will tell everybody what it was.

Thanks a lot, Richard and Paul. I appreciate it.

Thank you, sir. Your next question comes from Jim Janesky of Janney Montgomery Scott.

Your workers' compensation carrier, because of the issues you are having with the current one, you do expect to replace that carrier and what type of assumptions are you making in your operating expense numbers for the third and fourth quarter with respect to workers' compensation, if you could get a better understanding around that?

Sure. Our current policy expires at the end of September of this year. We are very close to finalizing the negotiations to secure a new carrier. So, when we -- when that happens, we will in fact make an announcement about that. And in terms of the cost side of what we have built in our estimates all year this year, we have continued to assume kind of somewhere in the range of 20% increase. And I wouldn't be in any position to want to increase that at this point.

OK. 20% increase off of -- you know, your cost jumped this quarter, of course, because of the $2.5 million?

Sure. You would back that out obviously.

Back that out on the 1.62% would that be more appropriate, Richard?

Yes, it would.

Since you used the word "finalize", I assume since you made projections that you know, you are down to the wire and costs are -- you're pretty sure as to what those would be with the carrier. Is that correct?

Yeah, if I wasn't I wouldn't be saying that.

OK. Great. As we look into 2004 and I know that you didn't give formal guidance, but kind of play bigger than the bread basket-type of question, you know obviously the top line growth is going to depend upon a number of issues that some are within your control and some are outside of your control. But, do you see any reasons why operating margins, the implication for operating margins that you have coming out of the 2003 should not continue into 2004 ?

Yeah, I see no reason why they shouldn't continue.

OK. Do you still expect -- I know with the new billing system, remind us, do you still expect a loss in first quarter of 2004 because of the new -

No, that will be gone next year.

So, that will be gone. So, if -- when does your fall campaign kick into full gear?

Mid-September.

OK, any change, Paul, with respect to how you will approach this fall campaign?

We need to allow other people to ask some questions. Let me answer that one and we will go from there. We intend to have emphasis on client retention during that period. We are energized about this years fall campaign. We've got everybody kind of focused on that period, and we intend to have a very strong emphasis both on the sales and our client retention during that period and we are energized about giving it our best shot as we go through the fall.

OK thanks.

OK, thank you, sir. Your next question is from (inaudible).

Yes, Paul and Richard, first of all I would like to ask a few questions about costs. They continue to spiral upward. And it now costs you 42% more to administer a single Worksite employee that it did six years ago. In a business where there is a lot of repetition and data processing costs have come down, I don't understand why costs are increasing, instead of decreasing. Are you all planning any major initiatives to bring Worksite employee costs down?

Our costs over the last couple of years now, total operating cost have been relatively flat other than the $5 million that we spent on the Aetna litigation.

Even if I took out the Aetna litigation -

Let me answer the question, CJ. You are correct if you look back over the period, we have moved operating cost up dramatically during that period while we moved the gross profit per employee up dramatically. Those two are related. They are related indeed that we were investing heavy in infrastructure and technology and adding services and continuing to stay on the cutting edge in terms of what we do for our customers. Those are related.

The good news is we are at the end of this cycle. You've going to see that stuff going the other way in the not-very-distant future. We are very energized about that, as well, we are at the end of the cycle and will see positive things in that area. In this most recent period, CJ, the numbers are affected more by the -- because we look at these things on a per Worksite employee basis.

Of course, when the employee count went down over that period since a year ago, that had a dramatic effect. But, we did have a corresponding reduction in headcount that matched the degree that those costs have gone down and we reallocated significant resources internally to management of direct cost and the increase in financial reports requirements that have gone out over the last year and a lot of other things. So, you can't see it all from the surface of what we've done underneath there. But, we're excited about where we're going on that front, as well. And you know, as we go forward, we expect not to see anything like the last five years.

One thing you said you increased gross profit. But, on a operating income level, the second quarter this year was the least profitable, excluding last year, since 1997, yet you have three times as many Worksite employees as you did in 1997. It just seems as though even though you increased pricing, operating expenses must have increased much more rapidly.

You know, huge portion is amortization and depreciation that I just explained. We can spend more time talking about that, the but the important thing is we are on the right track going forward on that front.

Thank you.

OK, thank you, sir. Your next question is from Josh Rosen of Credit Suisse First Boston.

It is Josh and Greg at First Boston. Just wanted to follow-up on the benefit cost of things and the design plan you have gone through given they are better than expected experience you had from the second quarter sequential to the first. Is that sort of -- would you view that only 1% sequential increase as a one-time thing just as you roll into the new benefit design plan or is that something where you have a little better control on benefit cost increases over time?

It's both, actually. What happens, you put benefit plan design changes into managed cost over the long haul. You know have a reduction in that cost that comes in place and then stays in place over time. But, you do get a one-time hit from that or benefit from that which we saw in the first quarter and saw again in the second quarter, just as we planned and hoped for. Then, you will see that's the what we're looking for the third quarter is back in the normal trends for increases with what's happening in the marketplace from that lower level.

OK. That makes sense. Then, just to follow-up on the new pricing model that you guys have instituted this year. Continue to take (inaudible) of the business, what has been the client acceptance of that? Have you had strong resistance to doing that where you need to keep a few people on that older system?

No, it has been really exciting and well received by clients, by the sales staff. You know, it makes sense to them. It works the way the underlying costs work. So, it's no surprise or shock. It means we can more tightly price each customer. It means both of us know what's built into the rate and what's -- what we're expected to make and they are expected to pay. It responds to the changes they make throughout the year. So, it's been very, very good. It's a tremendous systematic improvement for the business both from the customer perspective and our perspective internally.

Thanks, Paul.

OK, thank you, sir. Your next question is from Tony Tristani of Halpern Capital.

Hi, congratulations on a nice quarter. A couple of questions. Your guidance for Q3 and Q4 obviously assumes more and more Worksite employees move to the new billing system. By the fourth quarter is it correct to assume that maybe 80% will be moved to that new system which you will have smoothed out the historical earnings pattern?

Actually, Tony, what happens is that as we go through this year, we are moving about 5 or 6% each month. It is pretty even. We are halfway through the year and we are halfway converted. But, only the ones that were with us at the very beginning on the new system, the 20% on the new system in January, no seasonality, I mean, no quarterly earnings pattern on that 20%.

All the others have been converting every month. There's still -- they still have a peroration component in the way their rate works until January. Then at January, they look like the ones we had at the beginning of this year at the 20%. As we go forward, the only ones that will have a peroration will be new sales, like next year in March or April, we sell a new piece of business. Their rate will be relatively flat over the balance of this year on that customer. But, everyone else who was with us on January within didn't take out the seasonality in the business.

Right. I mean, can you kind of distill to that, I mean the guidance in Q3 and Q4 is pretty dramatic. I mean, it's a very strong step up in profitability. Can you try and determine what the carry-over is into next year? You need an idea of roughly as you end the year in Q4, is it like 70% on the new system, economically or 50 or 80, will help us get an idea of how much for third and fourth quarter improvement in profitability is pricing increase and moderated benefit costs and how much is the new billing system?

Good question, but the reality is that over the balance of this year the improvement is based on the pricing change and the margin that's built in on each customer. It's really not affected by the new billing system. In fact, the $13 benefit we got in the first quarter you actually lose over the rest of the year that group. So, our profitability is really based on improvement that's gone in pricing and managing cost.

Yeah, it's the lower than annualized expected increase in healthcare cost coupled with the decline in payroll taxes on the 80% of the business that wasn't on the new billing system. You know, from February to where we are now and through the balance of the year. In terms of looking at next year at this stage of the ballgame, you have got to annualize all four quarters and that will give you kind of a basis to look at for sequentially going forward beginning in 2004.

OK. I will talk to you after the call. Second question and final one is could you talk about where you are on the Aetna lawsuit? What are some key milestones? When does it go to trial? What is the jurisdiction?

We can give you an update. We can report on the Aetna lawsuit, all discovery has been completed and that we at this point our only expectation is that we could go to trial in the fall.

Hmmm. So, pretty quickly. What is the jurisdiction, again, on where this is being held?

Here in Houston.

Hometown advantage. Thank you.

OK. Thank you, sir. Your next question comes from Jim MacDonald of First Analysis.

Quick follow-up and growth questions. On the workers' compensation side, based on your statements, does that mean little chance you will go self-insured like you were possibly considering?

I didn't say that.

OK.

Actually, what I said was that we are in the final stages of negotiating a relationship with a new carrier and we will be finalizing all of that and then discussing whatever we have when we're completed with all of that. I think what we have said, but didn't say it this quarter, last quarter. What is happening in the marketplace in terms of what is available when the market gets tight, you see more of what you would call high deductible plans, things of that nature, where there is some risk taking that goes on. That's normal, normal for everybody in the marketplace. And that's what is kind of available out there today.

OK. And still is likely you will have some kind of self-insurance aspects, at least, in the new contract?

I wouldn't call it self-insurance, but I would says its participating in a way that deductibles would be pretty high and you'll have to fund those underlying claims under that deductible. But, those amounts are anticipated in the plan anyway. It is just a matter of how you move them from our pocket to the insurance company.

On growth, could you talk about hires and fires for the quarter and when the thousand person client was lost and client turnover in the quarter, those kind of metrics?

Sure. Kind of interesting for the second quarter. First quarter layoffs excluding new hires every month. We got in the second and I mentioned in my remarks it appears that growth GDP growth, economic activity was enough to kind of stem the tide of layoffs. We didn't get any benefit to speak of from new hires, but we weren't hurt badly by it either, so its kind of back into net zero kind of thing. Now, the large contract we terminated comes out of our count in August, which is why we've forecasted generally flat employee growth for the balance of the year.

OK, thank you, sir. Your next question comes from Chris Gutek of Morgan Stanley.

Good morning, Paul and Richard. Richard, to make sure I understand correctly regarding the workers' compensation policy, I believe you said if it hadn't been for the financial challenges of the carrier, you valid accrued additional dividend of $3.6 million, is that correct?

Not an additional $3.6 million, we would have accrued additional 1.3 -- excuse me, $1.2 million for a total of 3.6.

(inaudible) factor that the carrier hadn't been impaired would have been the $3.6 million.

That is correct. Yes.

The diluted share count was down sequentially even though stock price is up. Did you repurchase shares in the quarter? Is that true.

It is roll-forward from the first quarter. We purchased I can't remember the exact amount in Q1, Chris. I want to say 800,000 shares in the first quarter.

OK. From American Express?

Yes.

With the attrition of this large client, may be its just a one-off pledge, have you guys reconsidered the possibility of aggressively going after larger-type clients (inaudible) employees? Is that still part of the game plan?

Yeah, that is still part of the game plan. Service is a good fit for customers in the range. You like to have a nice flow of them. Customers will leave at times and it always hurts when a big one leaves. My hope is we end up having a nice, steady flow of these size customers coming on. So, we have really no change there.

Thanks.

OK, thank you, sir. Your next question comes from David Farina of William Blair.

Good morning. On your growth by region, look at Southwest, should we be concerned it has been several quarters since we have seen much movement out of that region?

Typically what happens is wherever you put sales people, that is where you are going to grow. We had made the decision a long time ago that we were going to diversify outside of the state of Texas. So, if you're not adding sales people in Texas then that growth in the state will continue to decline as you add sales people in other parts of the country.

Is there another way to look at that perhaps on a sales person basis? Are we seeing growth on apples to apples comparison basis way of doing that, like same-store sales thing per sales person?

We used to give it by sales market, but it got to the point we've got 21 major markets now. So, I think that's the only other way you could go back to doing it. It doesn't seem to make any sense because it is about the number of sales per sales person per month. Over this last year and-a-half or two years, David, the real driver of that region in terms of the net effect has been layoffs exceeding new hires, not enough sales individuals to offset the number of layoffs because 40% of our business was in that region. So, actually the sales efficiency in that region is still better than anywhere else. It's just that when asked how big the base is, it is how big the base is compared to the number of sales people in the region.

One other quick question on workers' compensation. Given what is going on in the workers' compensation universe, do you anticipate having multiple carriers covering different states and not doing business in other states and so forth or do you think you can have one national carrier like you have had in the past?

I believe we will have one national carrier across the country.

OK, thank you.

Ok, thank you, sir. Your next question from Jim Wilson of JMP Securities.

Good morning. My question is one that really relates to competition and growth. I know your major competitor is (inaudible) or ADP haven't seen any growth either of late. What are your other marketing in the sales quarter increased on getting new clients, what are the key things attracting people these days and conversely what is your biggest issue in discouraging people from choosing PEO or choosing Administaff?

Sure. I think our offering and the attractiveness of it has remained the same as it has been over the last several years. You have to juxtapose that against kind of the economic climate and the mindset of buyers in the marketplace. Our customers come to us for a variety of reasons. It's to reduce administrative burden. It's to manage all the cost associated and all the administrative hassle of dealing with insurances and so forth. It's also managing the liabilities that go along with being an employer. For us, compared to the marketplace, it's because they see a opportunity for gain in their own business by putting high-performance human resource practices implementing those in their business. That's where our core strength is. We have tremendous experience at implementing human resource practices in small to medium-sized businesses to make a difference in that business to really affect (inaudible). We are a premium service for premium-service buyers. We are not really in the same -- we are not in (inaudible) total source. Most of our competitors still total, its really competition against tradition and how they have done business in the past and whether or not they are in a position to invest to become more systematic and strategic in the people playing in the business so they can have the benefit of that in their business.

Now, we've been affected some certainly the last couple of years simply by the foxhole mentality, if you will, you know the same kind of resistance you see in capital spending and so forth. In fact, we've always seen our sales efforts seem to track with what is happening on the capital spending front and the mentality of the business owner because that is who buys our service. Whether they are in an investing mindset or not to improve and go to the next level. So, it does get harder when the economy is tougher. But, we're seeing that really begin to turn since the end of the war we've definitely seen some relief out there for sure. You know, it's not robust or going crazy or anything, but it's sure back to something more comfortable.

OK. And anything you can think of or characterize compared to last recession in '90 or '91 that is tougher to sell-through today now than it was then?

From our corporate perspective, of course, we went through a period of really rapid price escalation because of the cost escalation we went through. So, that's been the biggest obstacle is that for a period there we needed to be aggressive enough in pricing the service to be certain that we were going to recover and match that underlying cost. Obviously, we're there now. We are definitely have the whole base priced in a way that matches cost nicely and puts us back in a position to be more competitive in the way we price business. I expect that to play in our favor in both new and renewing business as we go through the fall.

OK. Very good. Thanks.

OK. Thank you, sir. Ladies and gentlemen, thank you for your questions. Unfortunately, this brings our time to an end. I would like to turn the conference back over to Mr. Richard Rawson from Administaff.

Again, thank you all for joining us today and appreciate it. Bye-bye

OK. Thank you, sir. Thank you, ladies and gentlemen. If you have follow-up questions direct your questions to Richard Rawson at Administaff. This brings your conference to a close. Please feel free to disconnect your lines at any time.