Insperity Inc (NSP) 2010 Q3 法說會逐字稿

Good morning. My name is Michael and I will be your conference operator today. I would like to welcome everyone to the Administaff third quarter earnings conference call. After the speakers remarks, there will be a question-and-answer period. (Operator Instructions). At this time, I would like to introduce today's speakers. Joining us all our Paul Sarvadi, with the Chairman of the Board and Chief Executive Officer, Richard Rawson, President and Douglas Sharp, Senior Vice President of Finance, Chief Financial Officer and Treasurer. At this time I'd like to turn the call over to Douglas Sharp. Mr. Sharp, please go ahead.

Thank you. We appreciate you joining us this morning. Before I 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 the details of our third quarter 2010 financial results. Richard will discuss recent and expected trends in our direct cost, including benefits, workers compensation benefits and payroll taxes and the impact of such trends on our pricing. Paul will then add his comments about the quarter and the formal launch of our adjacent business development strategy. I will provide our financial guidance for the fourth quarter and some preliminary comments on 2011. We will then end the call with a question-and-answer session.

Now let me begin today's call by summarizing the financial highlights from the third quarter. Today we reported Q3 earnings of $0.28 per share, a 22% increase over Q3 2009 on continued positive trends and our growth and profitability metrics. Paid worksite employees averaged 108,440 for the quarter, a sequential increase of 3% over Q2 2010 and near the high end of our forecasted range of 108,500. Gross profit for worksite employees per month averaged $227, an increase of 3% over Q3 2009 and within our expected range. Operating expenses totaled $61.6 million for the quarter, below our forecasted range of $62 million to $63 million. Our cash flow remains strong in Q3 as we generated $18 million of EBITDA plus stock based compensation. During the quarter we repurchased 250,000 shares at a cost of $5.5 million and completed an acquisition with an upfront cash payment of $7.4 million. We ended Q3 with $137 million of working capital.

Now let's review further details of our third quarter results. As I just mentioned, paid worksite employees averaged 108,440. This was a 2.9% sequential increase over Q2 of this year, an acceleration from the 2.3% sequential increase in the prior quarter. Client retention was once again at our historical highs as we have now averaged 99% for two quarters in a row. A second component of worksite employee growth, net hiring in our client base was also positive during the quarter. But, even more importantly, worksite employees paid from sales have shown continued improvement. Third quarter revenues increased by 6% compared to Q3 of 2009 as a result of a 5% increase in revenue for worksite employee per month and a 1% increase in average number of paid worksite employees.

Looking at third quarter revenue contribution and growth by region, you will see we had increases across the board. The Northeast region, which represents 24% of total revenue, grew by 14%. The West region which represents 20% of total revenue grew by 6%. And the Southeast region which represents 11% of total revenue, the central region which represents 15% of total revenue and the Southwest region which represents 30% of total revenue each grew by 2%.

Moving to gross profit. The mark up on our HR PEO services remain stable and surpluses from our direct cost programs came in within our range of expectations. This resulted in an average gross profit for worksite employee per month of $227 which was an increase of $7 over Q3 of 2009.

Richard will discuss the details of our pricing and direct cost programs in a few minutes. So I'll just provide some brief comments. As for our benefits program, pricing allocations came in slightly lower than expected while costs of $807 per covered employee per month were also slightly below forecasted trends. Excuse me. As for our workers compensation program, we continue to experience favorable claim trends. Workers compensation costs were 0.58% of nonbonus payroll for Q3 of 2010, above Q3 2009 cost of 0.53%. But below this quarter's forecasted level of 0.64%. Actuary loss estimates resulted in a $2 million reduction in previously reported loss reserves in the third quarter of 2010. This compares to a $3.6 million reduction in Q3 of the prior year. Payroll taxes as a percentage of total payroll remains relatively flat at 6.5% in Q3.

Now let's move on to operating expenses which totaled $61.6 million for the quarter or $189 per worksite employee per month. Excluding $5 of incremental expenses associated with this year's acquisitions, operating expenses per worksite employee per month would have declined from $191 in Q3 of 2009 to $184 in Q3 of this year.

As for some of the details, salaries and wages increased just 1% over Q3 of 2009 as February's reduction in corporate head count more than offset incremental headcount from the 2010 acquisition and higher incentive compensation expense. Stock-based compensation expense declined by approximately $214,000, commissions increased by 3% consistent with a higher sales production and an increase in paid worksite employees. Advertising costs remain relatively flat. Remember that we focused more marketing efforts during our fourth quarter sales campaign each year to boost lead and sales activity.

General and administrative costs increased by 3% over Q3 of 2009, however were managed below forecasted levels. Depreciation and amortization expenses decreased by 10% due to a lower level of capital expenditures throughout 2009 and the first three quarters of this year.

As for our balance sheet and cash flow, year-to-date EBITDA plus stock based compensation totaled $43 million through the end of the third quarter. Cash outlays for the nine months included capital expenditures of $4.5 million, repurchases of 369,000 shares at a total cost of $8 million. Cash dividends of $10 million and upfront cash payments related to our two acquisitions totaling $13 million. Since the beginning of the year, working capital increased by $10 million to $137 million at September 30. At this time, I would like to turn the call over to Richard.

Thank you, Doug. Today I first like to update you on the details of our gross profit results. Then, I'll comment on the successful completion of our renewal contract negotiations for both the health and workers compensation insurance programs. And finally, I will share with you our outlook for the balance of the year as it relates to gross profit. As many of you know, our gross profit comes from the service fee component of our markup combined with the surplus that is generated when the direct cost pricing allocation components of our mark up exceed the corresponding direct cost. This quarter, the service fee component of our markup average $194 per worksite employee per month and the surplus was $33 per worksite employee per month, which produced the $227 gross profit per worksite employee per month that Doug just reported. Both the service fee and the surplus were right on our forecast. We did average a $1 per worksite employee per month increase on our service fee for reviewing business this quarter. However, we are still experiencing some pricing pressure on new business sold resulting in the average markup of the $194.

Now let me give you some of the details of the $33 surplus beginning with the benefits cost center. The deficit in this cost center was $3 per worksite employee per month higher than we had expected, which was the result of lower increases in our allocations offset by slightly lower benefits cost. The lower pricing allocations are the result of planned participants continuing to select the lower cost, higher deductible plans, which should help reduce our total benefits cost in later periods. On the cost side, the slightly better than expected cost came from both a reduction in the number of COBRA participants and a slightly lower cost per COBRA participant. We did have a spike in large loss claims this quarter and without that, our results would have been significantly better. Payroll tax cost center generated a surplus but it was $1 per worksite employee per month lower than forecast and was the result of slightly higher expense due to higher growth in worksite employees, which by the way we can all live with.

Now let's discuss the workers compensation cost center surplus results, which was $4 per worksite employee per month better than expected. The additional surplus in this cost center came from lower cost which were driven by both lower incidents and severity rates. For the policy year that ended September 30th, the number of workers compensation claims filed was 2.86% lower than the last policy year. The lower incidence rate is due to a lower number of worksite employees combined with a continuation of our effective safety service programs. The severity rate, which is the average cost of these claims, dropped 1.82% from the same period last year. In summary, our pricing is stable and our continued effective direct cost management produced solid gross profit results for this quarter.

Now I want to comment briefly on the results of our new workers compensation policy which went into effect on October 1. Over the last year we have worked very successfully with Ace Insurance Company to refine the type of coverage that should work even better for both companies. You probably saw the press release a few weeks ago that outlined the details of a new three-year policy structure. So I'm not going to take time to discuss it now. But I do want to say that this new structure will save us about $1.6 million a year in premiums. This savings comes because we will be taking a slightly higher amount of financial risk on claims that exceed $1 million, up to an aggregate loss of $5 million. Since the inception of this program in 2003, we have had only a few claims that exceeded $1 million and none have exceeded $1.5 million.

You may also recall seeing a press release announcing our new three year contract with United Healthcare for both our medical and dental insurance. These new policies will be effective January 1, 2011 and reflect a premium structure that aligns the goals of both companies. As a number of covered worksite employees increase, our administrative fee will decrease, which is exactly the kind of structure that we wanted. We estimate the savings to be approximately $8 million over the three years period. In summary, we will see administrative cost reduction in both of these programs for the next three years.

Now let's talk about our gross profit expectations for the fourth quarter. The success of our renewal department is continuing to add dollars to our average service fee but there is still isn't any improvement in the economy to support higher fees on new business right now. Therefore we will forecast $193 to $194 per worksite employee per month of service fee for the balance of the year.

Looking at the surplus component of gross profit, here's what we see for the fourth quarter beginning with payroll taxes. You may recall that our payroll tax cost center surplus declined as the employees reached their specific wage limits. In addition, as we start to grow, the allocation that we get on new business has to be prorated and the spreads are not as much as they are in the first quarter of each year. However, in Q4 of each year we benefit from year end accruals on the allocation side of the payroll tax cost center. Therefore our surplus should be a couple of dollars per worksite employee per month better then Q3.

Moving to the workers compensation cost center, here is what we see. On the pricing side of this cost center, I have reported to you for the last few quarters that our allocations had been very stable and they were again in Q3. Workers compensation insurance marketplace is still soft so we still plan to keep our allocations at the current level and hopefully will be able to start increasing them next year. On the expense side of this cost center, we just ended another good quarter at 0.58% of nonbonus payroll because of a continuation and low incidents and severity rates. We believe that we can continue to manage our expenses to a level of about 0.62% of nonbonus payroll, which is slightly better than our previous guidance and as a result of the new contract with Ace Insurance Company. However, if claims develop out better than the actuarial estimate, the ultimate cost will be lower and the surplus would be higher than our new forecast.

Now switching to the benefits cost center, let tell you how we see our deficit changing beginning with the allocations. I mentioned earlier that we had been seeing quite a shift in covered employee selecting the lower cost higher deductible medical plans. This automatically reduces the allocation amounts we receive. I think it's safe to assume that we will continue to see this flight to lower cost plans in Q4 and beyond. On the cost side of the equation, we have previously said that our trend for the full-year 2010 should be between 6% and 6.5% higher than the 2009 expense. Now we see that the trends should be closer to the 6% rather than the 6.5% for the following reasons. Federal government subsidy period for newly eligible COBRA participants expired May 31 and our participation has finally started to decline and should continue to decline each quarter for the next several quarters. Our previous range had assumed that the cost for COBRA participant would remain at about 1.8 times the cost of a regular health care participant's cost, and it has. Utilization by non-COBRA plan participants has improved this year but it is not completely returned to historical levels. And as I mentioned earlier, we have continued to see substantial migration of planned participants moving to the lower cost higher deductible plans which should also did reduce our expenses. If we experienced a 6% trend increase over 2009, that would mean that our fourth quarter benefits cost per covered employee would increase about 0.6% over Q4 of last year, which had unusually high claim levels primarily caused by the COBRA issue.

Last but not least, our adjacent business services are adding a few dollars to our gross profit line. After merging the results of our last acquisition in July, we are seeing a contribution of about $7 of gross profit per worksite employee per month to the gross profit, which is up from the $3 earlier in the year. In summary our gross profit per worksite employee per month should be in a range of $237 to $241 for the fourth quarter. At this point, I'd like to turn the call over to Paul.

Thank you Richard. My objective today is to provide insight for investors regarding our ongoing plan that's driving our growth and profitability. First I'll discussed our recent sales and service success and resulting growth momentum were seeing in our PEO business. Secondly, I'll offer some color on our formal companywide launch of our adjacent business development strategy, which occurred at our fall campaign kickoff in September. And lastly, I'll provide some high-level thoughts about continuing our growth and profitability acceleration in 2011 and beyond.

Since the first of this year, we have reversed a downward unit growth trend caused by the recession and have begun a growth pattern we've seen in previous economic recoveries. Even though the economic recovery has been tepid and intermittent, we have reestablished some growth momentum through record level client retention and improving sales. Since the low point in paid worksite employees in February, we have averaged a net gain of nearly 1,100 employees per month for around 1% or month unit growth. More recently since June after we retooled our sales engine, we experienced a net gain of over 1,400 employees per month in four out of five of those months. So we have, in fact, regained some growth momentum.

However we certainly are not hitting on all cylinders, as reflected in our sales results. For Q3, we were at 88% of budgeted sales with the sales efficiency ratio of 0.71 sales per sales person per month. Still below our minimum expectation of 0.8 and substantially below our target of 1.0, however a solid improvement over a year ago at 0.57. This third quarter level of new sales was a 12% increase in worksite employee sold over the same period last year and was accomplished with 12% fewer trained sales personnel. We averaged 303 total reps and 273 trained reps during the quarter. These trained reps drove this 24% sales efficiency increase over the same period last year.

In addition to the sales efficiency gains, we've also seen a higher conversion rate from sold worksite employees to paid worksite employees. Typically sales from one month come into the paid worksite employee count over the following couple months as accounts are oriented and employees are enrolled. Also there is some level of shrinkage from the sold number to the paid worksite employee count. Of course, only paid worksite employees flow into our financial model and a decrease in the shrinkage number is important as the sales conversion efficiency gains. New paid worksite employees in Q3 from previous periods sales was up more than 15% over the same quarter last year. This improvement is further evidence that the retooling we did on the sales engine earlier this year is paying off.

The primary reason this level of sales has restarted our growth engine ahead of schedule is the historically high level of client retention we have experienced throughout the year. Our monthly client retention rate of approximately 99% does not sound like that much of an improvement over the 98.5% historical level. However, this represents a 33% reduction in attrition and fewer employees to replace through sales allowing us to experience growth below our historical sales efficiency threshold of 0.8 sales per sales person per month. This is very meaningful to growth in our business model and to the immediate opportunity to grow into next year.

The third contributor to growth is the net gain or loss from hiring and layoffs within the client base from one period to the next. Fortunately, our client base produced a small net gain each month in Q3 and in all but two months since the first of this month. If all three of these trends continue through the yearend selling and retention season, we may be headed for quite a nice change going into next year from what we've seen the last few years. In our residual income business model, the starting point in paid worksite employees in January is a key metric driving both growth and profitability in the new year. The number of paid worksite employees in January in each of the last three years was a step down of more than 2,000 paid worksite employees from the prior December. We may be in a position to reverse that trend and if we are successful, the effect is a big positive instead of a big negative.

Each of the prior years to step down was for a different reason. Three years ago it was mid market terminations outpacing mid market sales. Two years ago it was layoffs and terminations directly linked to the financial crisis. Last year was the persistent economic uncertainty and the effect on our sales results. This year we have a strong pipeline and much improved mid market sales, a slight positive from the struggling labor market and improving core market sales. In this environment, we have a pretty good chance to maintain the year-end number of paid worksite employees due to heavy year-end sales and renewal periods. If retention continues at the same level of improvement we have been experiencing, we may even express an increase paid worksite employee count to start the new year.

If we are successful in just maintaining the level of worksite employees in January that we expect to end with in December and grow next year within the current range of 1,100 and 1,400 net gain in worksite employees per month, our unit growth rate would return to double-digit unit growth in the 10% to 11% range for 2011. To factor in a wider range of possibilities, we consider the possibility of 2,000 employee net loss or net gain in January and a unit growth range for 2011 becomes 8% to 13% for our PEO business as 1,100 and 1,400 monthly employee growth level we are experiencing.

Then, as I mentioned last quarter, we are embarking on a new and exciting growth strategy as a result of implementing our adjacent business development plan. Our plan is to develop profitable adjacent business units with recurring revenue streams, strong growth potential and substantial cross-selling opportunities to grow our core PEO business. We have been and will continue to develop an array of business performance improvement offerings through a build, buy or partner strategy.

As part of our fall campaign kickoff in September, we formally launched eight adjacent business offerings. Two were from within the PEO recruiting and retirement services representing our build strategy. Four businesses came from our buy strategy including two very recent acquisitions and to developed from previously acquired assets. These offerings include employment screening services from a company we bought called US DataLink and we have three companies now offering software as a service product including performance management from Perform Smart, expense reimbursement from [Expensible] and time and attendance from Galveston. These three offerings represent the core of our HR cloud application bundle which we will continue to develop to create a one-stop shop for small and midsized companies that want to operate their business without any technology infrastructure.

We have other applications we expect to add that I believe will allow Administaff to greatly benefit from the rapid growth we expect in the staff business. In addition, these offerings are perfect for prospects not ready for the PEO or those for whatever reason leave our PEO service. The final two adjacencies in loss in September are from partnering relationships with Locked In Affinity Group to offer business insurance and Copy Comp to provide technology support. These two are in response to client demand and further leverages our resources and our small and medium sized business channel.

We intend to leverage our 300 professional sales personnel, our substantial marketing expertise and our 25,000 PEO prospects that we see face-to-face each year to grow these new businesses. This strategy will also allow us to develop a much wider net of small and medium-sized businesses that become customers of one or more services that may eventually qualify for our premium PEO service offering. This launch was the first step expanding the identity of Administaff beyond the PEO and evolving into a business performance improvement company with the ability to help businesses succeed in a wide variety of ways. Our core PEO service remains the pinnacle and the way we can help businesses the most that are interested in improving their performance. However, from now on, we will be looking for some way to help every business we call on in order to help them improve, even if only a small step.

We've identified and prioritized a list of business performance improvement products and services that have the potential as a successful standalone business and as a feeder for the other adjacencies and the core PEO. Some of these already exist within and will spin out of our PEO . Some we will acquire in the future and some we will partner with successful providers to deliver to our target markets. This new strategy is nothing short of explosive and its potential to grow our core PEO and the overall revenue and earnings of the Company. The growth of the PEO contributes to the adjacent businesses through the nine of out ten prospects that are not ready for the full service offering. And each adjacent business becomes an incubator and feeder for the PEO.

The entire Company was introduced into the adjacent business development plan and our cross-selling efforts began in late September. The first step was to take a new look at the Company as a whole beyond just the PEO. Historically since the lion's share of our revenue and profits comes from the PEO, we have described that Company and client base accordingly with approximately 5,700 PEO clients comprised of small and midsized companies and approximate 110,000 associated worksite employees. However, when you aggregate the customer base and employees served by the collective entities including our adjacent businesses, you see quite a different picture. Administaff currently serves 110,000 small to midsized companies not just 110,000 worksite employees. In fact, when we include our broader client base we currently reach over 2.3 million employees. This is a client base we are now nurturing and cross-selling into. In addition when you look at the collective prospect base for all of our businesses, the 180,000 PEO prospects within our sales force automation system becomes over 500,000 business performance improvement prospects. Both the customer and prospect databases will be approached in a new way from now on is an integral part of our cross-selling system.

The second step in the transition was to begin the education process on the offerings and introduce them to the corporate staff, sales staff and then to our entire customer base. To accomplish this, we developed a brochure which looks like an iPhone with the aps on the screen depicting 10 offerings. The PEO, both core and mid market, and the eight adjacent businesses. As part of the campaign, the PEO sales staff has been equipped to go out and see the current PEO client base and explain the new offering and obtain PEO referrals at the same time. The same brochure is used to introduce current clients of our adjacent businesses to the PEO and the other adjacent businesses.

The final step for the stage is a transition to extend the fall campaign beyond the PEO and integrate this referral and cross-selling effort. We established new roles, tracking systems and campaigns to get stated and we also added an objective for the fall campaign to pass out referrals across the customer base. At this point, we are just over a month into the campaign and the energy level is high. We are having successes every day generating referrals and learning a tremendous amount across the Company. Of course the change of this nature is not without risk and new habits take time to develop. But we are on a very positive track, which I believe will be highly beneficial for the overall enterprise.

As we look to 2011 and beyond, I believe we will find this new strategy to be transformational and will take Administaff to an entirely new level of success. In March of next year, we will reach our 25th anniversary since our inception in 1986. Over this period, we established a new industry and developed the most successful business model in the business. We built a national sales and service infrastructure and replicated processes and programs that resulted in predictable and consistent growth and profitability. Through our experience, we've developed two highly leveragable core competencies. We know HR and we know how to help small and midsized companies overcome the obstacles they face everyday to succeed. This combination has positioned Administaff to become a powerful business performance improvement Company.

2011 will be a year of implementing this new strategy to accelerate our growth and profitability into the future. Obviously executing this plan is not without additional risk and costs in the short term. But the beauty of this plan is the lower risk and the leverage costs in the future. Our single most significant risk in our business model to date is the short-term volatility and healthcare claims in our core PEO business. Most of this risk is isolated in the smallest clients with a large claim potential far outweighs the associated profitability on a given client in a given period. These small clients are valuable to the Company, however because our history shows many of them grow into profitable emerging growth clients over time. This new adjacent business development strategy opens up an opportunity to connect with many more small business clients without using healthcare as a loss leader in taking on that risk. This also positions the Company's favorably when and if the new healthcare legislation reaches the stage of implementation of the insurance exchanges which most likely to affect the smallest clients.

The cost leverage of this new strategy is also significant. We are adding many ways to benefit in growth and profitability from the major investment we are already making everyday to get in front of small and midsized business owners. The relatively small add-on investments to make other products and services available through our current sales operations The relatively small add-on investments to make other products and services available through our current sales operations pales in comparison to the overall cost for this sales infrastructure. There are many other reasons we are convinced we are on track with both the specific strategy and the timing of this change that we don't have time to discuss here. We are also convinced our opportunities are greater than ever and so is our capability to take advantage of them.

This transformation is born out of a desire to grow the core business faster and more consistently and capitalize on the many strengths and assets we have developed in the last 25 years. We believe we have the right plan and the right people to execute this new strategy. As shareholders, we believe we are looking ahead to the greatest period of value creation in our history. This will be our focus and our goal. At this point I'd like to pass the call back over

Thanks, Paul. Now before we open up the call for questions, I'd like to provide our financial guidance for the fourth quarter of 2010 and some preliminary comments on 2011. As for Q4 2010, we continue to expect sequential growth and paid worksite employees based upon the positive trends discussed in our earlier comments. We expect Q4 gross profit for worksite employee and operating expenses to be at a similar level as that implied from our previous full-year forecast. So as for our fourth quarter key metrics guidance, we are forecasting Q4 average paid worksite employee in a range of 111,250 to 111,750 slightly higher than our previous forecast and a 4% to 4.5% increase over Q4 2009. As a reminder worksite employees sold in the fourth quarter, which is historically our high selling season, are typically paid in the first quarter of the following year.

As Richard just mentioned, we now expect gross profit for worksite employee per month to be in a range of $237 to $241 for Q4. As per operating expenses, we are forecasting a range of $67.5 million to $68.5 million for the quarter. The sequential increase of approximately $6 million from Q3 of 2010 is primarily attributable to additional business promotion and advertising costs focused around our fall sales campaign and costs associated with our adjacent business services. We are forecasting Q4 net interest income between $200,000 and $300,000 and a Q4 effective tax rate of 42%. As for our average outstanding shares, we are forecasting 25.6 million for Q4.

And I'd like to provide some high-level comments regarding our outlook for 2011. As Paul just mentioned, we believe there are several scenarios in which we could achieve high single-digit to double-digit growth in the average number of paid worksite employees in 2011. When combined with the pricing trends related to our direct cost programs and HR services, we would then expect even further top line revenue growth. As for gross profit per worksite employee, we would expect some incremental increase over the levels experienced during 2010 particularly since an expected continued decline in the level of COBRA participants should favorably impact healthcare costs and a surplus generated by our workers compensation program has remained stable. Additionally, the markup on our HR services has are remained stable during the last half of 2010 and we would expect to be moving this back up beginning in 2011.

As Paul mentioned, we will be making certain investments in our adjacent business services strategy in the upcoming year, which will impact the level of operating expenses. We will finalize our operating plan as we approach yearend when we will have more clarity on the results of our 2010 fall sales campaign and year-end client renewal. Detailed 2011 guidance will be provided during next quarter's conference call to be held in early February.

At this time, I would like to open up the call for questions.

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

Thank you. Paul, I had a question for you about the adjacent business initiative. You've assembled a portfolio of services now and I'm just wondering what pushed you over the top to kind of launch a big initiative? Do you feel like you had assembled a wide enough array? And then secondly do anticipate adding to that over time as you have historically?

Thank you, Tobey. Yes, that was precisely we put our game plan together we've been developing several things over the last couple of years. This spring, we organized differently to deliver on that strategy and planned for a launch in the fall where we put all eight of these new businesses together and introduced them formally and brought everybody up to speed and have been introducing to customers. So, this was the right time. We finally kind of reached a critical mass where we had enough to talk about to any prospect that we call on. We are much more likely now to be able to find some connecting point with every customer we call on. So it was time to extend that. Now we do though have a few areas that we want to expand into, a few holes if you will that we intend to fill over time and like I said in my prepared remarks we will use build, buy and partner strategy to do that.

Thanks and then two other questions and then I'll get back in the queue. Could you comment on I think you mentioned mid market sales were improving -- wondering if you can give us little bit more color on that? And then Richard wondering if you could describe with a little bit more detail the spike in large claims? And what kind of impact that had on the quarter? Thanks

Sure I'll take the mid market question first. As you all who have been with us for awhile know, we've worked diligently on our investment into the mid market segment over the last several years. And completely rebuilt our service model and completely rebuilt our sales model and taken several runs had it. And we really are just reaching a level now where we are hitting on all cylinders, both in service and now finally in sales. I say finally only in that it's been an tough nut to crack but we have a very strong pipeline of mid market prospects. We have much better key indicators in terms of how we are actually moving through the sales process and we very much have a unique sales model with a tremendous value add that just goes through the sales process. And also we kind of built a pipeline just like we did in the small and medium-sized customers where you build a pipeline over several years where customers come back through that even though they weren't ready maybe a year or two years ago, they are ready now. So with that pipeline developed, we feel strongly that mid market is more likely to contribute to growth as we go through the yearend process in the net effect of new sales versus client attrition, as opposed to being a negative effect which it was a few years back. So we feel good about our mid market efforts and look forward to a successful year end transition.

Yes Tobey, I think your question was about the spike in the large loss claims. We look at claims over that are over $50,000 and this quarter we actually had a step up in the number and in the dollar amount of those claims, which is kind of a randomness of it all. Nothing sustainable. But it was about $4 million higher than our norm. So as you can see from our results, we certainly had a good quarter in the whole health care cost center area and it would have been significantly higher without those large loss claims. So we are not really expecting those to recur in the fourth quarter.

Thank you very much.

Your next question comes from the line of Jim MacDonald with First Analysis.

Yes, good morning guys. Focusing on the healthcare a little longer, could you talk about the impact of your COBRA pricing and the COBRA participants and how that's gone from Q2 to Q3 and how you expect it to move forward?

Yes, sure, Jim. We mentioned I think it was at the beginning of the second quarter we talked about the fact that we were going to be increasing our allocation for the effect of the COBRA from 2000 -- back in 2009 that we saw going to be increasing our expenses in 2010. And of course we did initiate the increase, all the customers have now taken that and gotten that increase. And what we have seen is two glimpses of positive, which we expected to see we just didn't know when we would see them. The first one is that the subsidy period ended in May and now were starting to see some of those COBRA participants drop off. As their time on COBRA comes to an end. And so with the subsidy ending, a lot of them are no longer taking it. That number will continue to decline each quarter over the next probably four to five quarters. And so by this time next year we should be back to a normal percent of COBRA participants on our plan. So we expect to see improvement every quarter there.

The other thing that I think is positive is that even with some of the large loss claims this quarter, our average cost per COBRA participant has actually gone down a little bit in the third quarter over the second quarter. So we hope that that will continue as well.

And you said was a still though 1.8 of normal?

Yes

Less than that?

No, it still about 1.8 times normal participants claims and of course historically that number has averaged about two times that of a regular participant claim. So it's good.

And could you give us the total percentage of your employees that are health taking employees on COBRA. It was 7.2% or something a couple quarters ago?

Yes it's down to 6.4% now.

And you expect that to get back to 3.6% or something?

Yes, we sure do.

And then just one more and I'll get back in. For the new adjacency strategy could you talk a little about your sales approach for each of those services. I guess one of the risks I see would be distracting your PEO sales force and having them spend too much time selling the adjacent services rather than the core service?

That's exactly right Jim, that's a risk we also see and the way we structure this is that the PEO sales staff are not involved in actually selling any of those adjacent services. They are involved and just referring those prospects across two in most cases an inside sales operation that sells the other services. So their focus is certainly toward closing PEO accounts but this is a way for them, once they refer them into the operations for any adjacency it's a way for them to put their name on that account. And that becomes their account that they are able to help with and continue to communicate with. As they add on other services or move towards further engagement with the Company, that becomes a customer in their database that they can keep moving and helping become a PEO customer one day. So I think we are definitely on top of that risk, that risk is there. But we found that our sales staff is very happy to be able to engage the customer in some way and offer some help even if they don't become a PEO client.

Okay, thanks very much.

Your next question comes in the line of Jeff Martin with ROTH Capital Partners.

Thanks. Good morning, guys

Good morning

Just want to make sure I've got this correct, your quarter would have been roughly $0.10 higher if it weren't for the spike in the large loss claims, is that right, with a tax effect of $4 million?

Yes that's about right

Okay And then in terms of the adjacent services, do you have any idea what kind of incremental spend in operating expenses next year tied to those adjacent services when we're just trying to think in terms of modeling it out?

Well you know we're still modeling it out ourselves. Because there's a wider variety of potentialities for next year that we're in the depths of working through in our budgeting process. And we also though have a wider range of possibilities on the revenue side in each of those businesses. So we have not looked at this as material in the next year in terms of those adjacent business services. And that's kind of the goal I don't think it would be to material in a positive way or in a negative way. But rather a development year for them to really come out of the water in a positive way in 2012. But the details of that we really need to work through . And there is some potential out there still depending on how much we want to capitalize on certain opportunities. There are opportunities for some relatively substantial level of expansion but it's hard to pin down right now especially we don't want to really provide specific guidance on that. So were looking at both sides of the equation revenue and

Sure

The fact of the matter is our long-term one of our long-term objectives has always been to balance growth and profitability so we are not going to be abandoning that to deploy this new strategy.

Is there any way to talk in broader term looking out a little further what your target model would be in terms of revenue and gross profit percentage is from adjacent services? Are you looking at it that way? Do you have any insight you could share with us this early on?

Yes we talked a little bit last quarter you can see it coming to fruition in this quarter. We look at a contribution in the gross profit for worksite employee line which was about $3 in the first and second quarter and now it's up to about $7 for the third and fourth quarters and we expect that to grow and has really not a lot of limitation to it. We can grow that substantially. The question that you are rightfully kind of focused on is okay how much of that is going to flow to the bottom? We have basically said not much for a while. And are trying to target that spend to be at the right level but we believe very quickly relative to implementing such a strategy to see a contribution that comes from both growing the PEO faster and each of these adjacencies beginning to contribute to the bottom line

Right, right. And then final question on client retention, what are you doing to execute as such a strong level of retention and what could sway it positively or negatively over the next 12 months?

Well, we've really tried to zero in on that and what it appears to us looking back over the last two years during the down -- the depths of the recession or from the financial crisis in late 2008 through all of 2009 we have made some improvements throughout 2008 that we're really out of blocking and tackling level looking at not just why clients leave but why they stay and how committed they are to stay once they renew. We start researching how committed that renewal was. We start working with customers who were in the category of what I'd call a noncommitted renewal. They barely renew just because they didn't have time to look at something else. Or just weren't really committed. We start looking at ways we could move them up to a more what we call a client loyalty measurement.

So we started measuring more client loyalty as opposed to just client satisfaction and started looking at drivers of client loyalty. Those are real kind of in the weeds type of things but over the 2009 our service organization really engaged clients at that level. And I believe that our improvement in client retention was masked by the normal attrition that goes on with economic recession. And that's why we kind of had our historical normal client retention throughout the recession. Now as things stabilized in 2010 even though it's been a tepid economic recovery, our improvement started to show up as even better than historical levels of client retention. So that was kind of the root causes a lot of blocking and tackling which I think is a good thing it wasn't a silver bullet.

That I think also means that it would take something pretty significant to shake us loose here and have things deteriorate. Although were doing everything we've been doing and everything we can think of to have a really good year end client retention level. So nice improvement on the mid market size that I mentioned earlier and then improvements in the blocking and tackling in our core business on customer loyalty. That in a nut shell has us in a nice position going forward. I think the other thing that is a factor for this fall is keep in mind that healthcare pricing which is kind of a proxy for the total price of our service. In the marketplace, healthcare costs are going up faster than they are within our PEO model. That is primarily driven because healthcare costs are going up driven by the healthcare reform where new benefits have to be included in policies from October 1 on like no maximum and no previously conditioned limitations etc. And those are attributes that were already included in our plan and costs that were already in our plan. So where most small business plans are going up anywhere from 3% or 6% or 7% above trend, our cost increases for these changes is around 0.5%. And so when you take 0.5% on top of our trend, the 6% or 7% level compared to 12% to 13% of small businesses are going up, that puts us in yet a further advantage over the marketplace and as we are able to communicate that should help us with retention through the year end.

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

Good morning and it's nice to see the worksite employees trending up. I was wondering if you could talk a little bit about just the differences you are seeing in the various regions in terms of your growth? Is there a reason for that? Or are they trending sequentially about the same?

Now we are looking at some pretty good across the board growth with there are a couple of things we've had some exceptional efforts going on in the Northeast. I think pretty strong sales effort up there. A lot of the year-over-year numbers are based on kind of where we had customer terminations last January. So that kind of reflected in the size of the base in the Southwest region and the West Coast. But generally speaking from an economic climate, it's a little stronger in the Southwest then the rest of the country. Texas is performing better than most places. Across the board we are seeing in terms of identifying trends, you'd say it's pretty much across the board there's layoffs and new hires. New hires are overcoming layoffs by a small amount it's not a big tailwind. But it's certainly not a headwind like it was in 2009 that's very favorable for us. And the improving sales metrics to go from 0.57 sales per sales person per month to 0.71 that's good progress but it's still not near back to where we need to be and were working on that and hopefully that fall campaign will bring us numbers. And we've got new approaches to through the adjacent business development strategy into next year that we hope will make the pipeline stronger and bring on an ongoing basis have more prospects that are ready to come on board to the PEO. So that's kind of the game plan and hopefully we'll see that come to fruition.

Great and then can you talk a little bit about what you would expect the turnover rate to be as you transition from Q4 into Q1? What's the traditional attrition rate?

Yes remember historically in January we've been around 9% of attrition or 91% retention, however you want to look at that -- that's a big number to overcome. You've got to sell all that number and if you want to grow some, you have to sell beyond that. So that's why the fall campaign is so significant. Last year we saw some improvement in that number I don't remember exactly the number off the top of my head but I think it was eight point something like 8.3 or 8.4 I think. So we saw some improvement. If we can improve upon that number than obviously it will take fewer sales in the fall campaign to not only replace those but to maybe see some growth. So that's why we kind of looked at a range of 2,000 employee decline into next year from the transition to 2,000 employees net gain that's how you get the 8% to 13% in a growth for next year. Assuming that we continue to grow just at the rate we have this year which is 1,100 to 1,400 employees per month growth. Really we should improve on that, we should do better than the 1,400 we should do better than last year to not have a decline. So I'm pretty enthusiastic about it. But it's always a big wildcard but 8% to 13% is not a bad place to start for next year's unit growth.

Your next question comes from the line of Michael Kim with Imperial Capital

Hi, good morning, gentlemen. Just touching on the issue of pricing, you talk a little about new business being a more aggressive than the renewal business. Are you seeing some moderation in the pricing trends? And as we go into Q1 is it your sense that maybe some of your renewal customers will compare with some of your alternatives and maybe a shift in the pricing environment?

Well, we have seen our new business sold over the last quarter is a little bit lower than what it was say a year ago. But that's just the economic environment we live in and the uncertainty that's still going on in the small business market place. As far as our renewing business is concerned, we are able to get a step up on every account that renews. Because we've got allocations for healthcare costs, payroll taxes and all of that, that are built into the pricing as well. So every customer gets an increase. The markup component of the increase is up, it was up $1 per employee per month in the third quarter. And I think some of that is still due to us being sensitive to the client base as we come out of this recession. So I don't see that number really going down any and we think that through the renewal time this year we should be able to increase that going into next year a little bit but not a lot.

And then just switching gears are you looking to continue to expand the sales force as you drive into this adjacent business strategy? Or are you seeing maybe more preference or a stronger emphasis on increasing the sales efficiency?

This year we focused on pretty much like I mentioned a retooling of the sales effort. So when you're kind of getting things reestablished, you are not going to grow the sales staff to get the efficiency numbers right . And you get some of these other metrics right that even affects pricing on new business that something that hasn't been a focus because we are focusing on some of the other blocking and tackling we have to do in the sales effort. As those efficiency numbers move up we will start focusing on pricing again as well.

But in terms of sales growth, I do expect that early next year we will start growing both core sales staff modestly because we do have room in our offices to backfill and grow some more sales staff without having to expand any new offices. And I also think that we are probably looking next year for the first time in a long time to growing the mid market sales staff now that we are hitting what I think is acceptable sales metrics, it will be time to a ramp that effort up. So those are just things in the back of our mind ,we haven't really roll that into are forecasting at but that gives you a little bit of insight into what we are thinking about

Okay and lastly can you talk a little bit about the strategic environment in terms of valuations? You talked a little bit about buying versus building versus partnering can you comment on the valuations you are seeing and how that is shaping your strategy in developing the adjacent business?

Yes I would say that there are two things probably affecting more or less the timing of some of these things. One of course is valuation, we've seen that as the economy and the recovery's been slow, I think we found some good opportunities with fair valuations. I think a lot of times you buy these private companies that are pretty wide range of possibilities on what you run into in terms of valuation. But we found I think are very good companies that fit in our strategy and fit in our culture and we've been able to integrate them very quickly and has seen progress very quickly and helping them move their business along and the valuations we think were favorable.

But also you have the potential tax change going on for next year with tax cuts expiring and that kind of heated up the and the M&A activity and I think that probably helps with the valuation its probably moved us along a little faster in terms of what we've been looking at and kind of have in the pipeline. But I think it's generally been very favorable for us to execute the strategy that we have now the timings has been real good for us.

And do you have a certain scale of business in mind I guess can you a range of what your target opportunities look like in term of the lower end are upper boundary that you would be comfortable with? Or is a privately based on fit and how it would meet your adjacent business strategy?

As you watch our Company over time we are pretty conservative on that front. And we've done acquisitions that have been fairly modest in terms of the total dollar amount. That's not to say we wouldn't do something more dramatic if you will. But you it would have to be a game changer for us. It would have to be something that really fills a gap or something that could really attract the right client base or become a tremendous feeder for the PEO business or something that really fit dead center into our overall strategy. So there are a few of those things out there. But I think I would keep in mind that we are conservative and the way we go about these things and if we were to do something larger it would obviously fit into the overall game plan and it would be very well understood.

Okay great. Thank you very much

Your next question comes line of Michael Baker with Raymond James.

Thanks. Paul, I was wondering if you could comment on whether or not health reform is influencing the sales process? And if so can you give us a sense for whether there's any variance by size employer?

Sure I think definitely health reform is affecting the mindset of the business owners in the marketplace. A lot of it is just downright confusion. Health reform introduce more complexity higher risk for business owners and higher costs. That's kind of the net assessment of it. That's a good thing on one hand and I think larger businesses -- we've seen more mid market companies they hate get me out of this I don't want to deal with this anymore. Smaller businesses there kind of saying well isn't there something that going to come eventually that might help me either a tax credit? Or other options on how we I can go about this? Those are still a ways off. I think the other thing that really is a hard pill to swallow is the tax increase for earners above a certain amount that is going to add 3.8% tax rate on all types of income. That is a real hard pill to swallow for business owners because that affects them personally. So we hear a lot of talk about it and we are able to try to shift gears to why we exist which is to help businesses deal with such things. And do it in a positive way and help them navigate to their best opportunities to help their business through attracting and retaining key people which is the whole point of having benefits in the first place. So we don't see it as a long-term negative for us, in fact, I see many ways that we can turn it into a positive. But uncertainty or confusion is never a row positive thing in the selling process. So it's something we've had to work through.

That's helpful and then I had a question for Richard. I was wondering if you could give us a sense then your PEO book what the health care uptake is currently versus same time last year?

I'm sorry the healthcare what?

The uptake in those opting to actually take health insurance?

Oh yes it's about the same as it was last year it's about 73% -- 73.5% -- 74% of the total worksite employee base.

And I was wondering if you took out those kind of large claims that you had in the quarter, there's a lot of debate in terms of the influence of higher deductible plans and how that might impact utilization, I was just wondering if you could give us your thoughts along those lines?

Yes well certainly we have seen what I would call a significant migration from employees taking like the hundred percent to 50 plan all the way up to $1500 high deductible plans and $3000-high deductible plans and as that happens obviously the employee is kind of thing I do want to spend as much for the premiums and I want to take the risk that I'm not going to be as sick or need to go to a hospital. So the effect on us is obviously a lower cost on a per participant basis over time. So we think that that's -- we've seen this before and we believe the demand right now is as customers renew especially, they are saying hey what can we do differently in 2011 to help manage this cost that is going through the roof? So we think that our cost trends for 2011 probably will be better than 2010.

Thanks a lot.

And that is all the time we have today for questions. I'd like to turn the call back to Mr. Sarvadi for any closing remarks.

So we just like to thank everyone for participating today and we look forward to the fall campaign and the successful year-end. So thank you very much.

Thank you ladies and gentlemen this does conclude today's conference call you may now disconnect.