沛齊 (PAYX) 0 Q0 法說會逐字稿

Good morning.

Thank you all for holding.

At this time, I would like to inform all parties that you will be on listen only until the question and answer portion of today's conference.

This call is being recorded.

If have you any objections you may disconnect at this time.

I would now like to turn the call over to Mr. John Morphy.

Thank you, sir you may begin.

It's a pleasure to have you all with us today.

It's a nice sunny day here in Rochester.

With us is Tom Golisano, Chairman, President, and CEO.

Upon the completion of the review of our financial results, and an overview by Tom, we will conduct a Q&A session.

We released our fiscal results for the first quarter ended August 31, 2004, yesterday afternoon after the market closed.

It can be obtained by accessing our website and/or Investor Relations home page.

We have also filed our Form 10-Q for the first quarter ended August 31, 2004.

This filing is available also on our website.

In addition this teleconference is being broadcast over the Internet, and will be archived and available for access on our website until October 22nd, 2004.

Please refer to our website for access to all recent news releases, current financial information, related SEC filings, and investor relations presentations.

Fiscal 2005, is off to a very good start.

We are pleased with our first quarter results, which were right in line with the expectations we established last spring during our budget process.

Following Paychex's tradition, we generated record total revenues, net income and diluted earnings per share.

First quarter earnings release is summarized as follows: Total revenue grew 12% to $345 million, generating net income growth of 9%, to $87.7 million.

Quarterly earnings per share was 23 cents versus 21 cents a year ago, up 9% on an unrounded basis.

Operating income, excluding interest on funds held for clients was up 16% year-over-year in the first quarter.

Looking at the consolidated income statement, total service revenues increased 13% in the first quarter to $334.2 million.

Service revenues include service fees earned from our payroll and human resources benefits product lines.

Payroll services for the first quarter increased 10% to $280.4 million, the increases are related to organic client base growth, increased utilization of ancillary services, and price increases.

Payroll service revenue in the first quarter also benefited slightly from one more calendar billing day, when compared to the first quarter last year.

This positively affected revenue growth by about 1%.

Conversely, the third quarter payroll service revenue will reflect one less calendar billing day, than the third quarter of fiscal 2004.

As of August 31, 2004, 89% of all clients utilized our tax-based services and 63% utilized the employee payment services.

More than 90% of new clients purchase our tax-based services, and more than 70% of new clients purchase employee payment services.

Major market services revenue increased 30% for the first quarter, to 41.0 million.

Approximately one-third of our new major market services clients are conversions from our core payroll service.

Human resource and benefit service revenue increased to $53.8 million for the first quarter of fiscal 2005, a year-over-year increase of 30%.

The increases reflect growth in the number of clients utilizing retirement services products, increases in client employees served by our PAS and PEO bundled services, and the benefit of revenue from the April 2004 acquisition of Stromberg time and attendance products.

Retirement service revenue increased 17% in the first quarter to $20.9 million.

At August 31, 2004, we had over 30,000 retirement services clients.

Paychex administrative services, PAS and the professional employer organization, PEO are comprehensive services that include payroll, employer compliance, employee benefit administration, and risk management outsourcing services designed to make it easier for businesses to manage their payroll and benefits costs.

Sales of PAS and PEO products have been strong, with administrative fee revenue from these products increasing 48% in the first quarter of fiscal 2005 to 16.0 million.

As of August 31, 2004, our PAS and PEO products serviced over 168,000 client employees.

Interest on funds held for clients decreased 19% for the first quarter of fiscal 2005, to $10.8 million which was consistent with the Company's expectations.

The decrease in the first quarter was attributable to lower realized gains on the sale of available 'for sale' securities and lower average interest rates earned in fiscal 2005, partially offset by higher average portfolio balances, resulting from client based growth and increased utilization of the Company's tax-based services, and employee payment services.

Average daily portfolio balances for the first quarter of 2005, were $2.5 billion, compared with $2.3 billion in the prior year quarter.

The funds held for client portfolio earned an average rate of return of 1.7% for the first quarter of fiscal 2005, compared with 1.9% for first quarter of fiscal 2004.

Net realized gains on the sale of available 'for sale' securities included an interest on funds held for clients were 0.2 million for the first quarter of fiscal 2005, compared with net realized gains of $2.7 million for the prior year period.

The Company does not anticipate recognizing a significant amount of gains or losses during the current fiscal year.

Year-over-year growth comparisons for interest on funds held for clients are expected to improve in the second half of fiscal 2005, as a result of improving average interest rate comparisons, and lower impact from year-over-year net realized gain comparisons.

Consolidated operating, selling and general administrative expenses increased 11% for the first quarter over the prior year quarter.

The increases are due to increases in personnel, information technology, and other costs to support the organic growth of the Company.

Higher professional service expenses, related to pending legal matters also contributed to the increase in the first quarter.

There are approximately 9600 employees at August 31, 2004, compared with approximately 8950 at August 31, 2003.

Investment income net decreased 43% year-over-year in the first quarter, which was consistent with the company's expectations.

The decrease is due to lower net realized gains on the sale of available for sale securities and lower average interest rates earned, partially offset by higher average portfolio balances.

Average daily balances invested were $529 million, for the first quarter of fiscal 2005, compared with $386 million in the prior year period.

The corporate investment portfolio earned an average rate of return of 1.8% for first quarter of fiscal 2005, compared with 2.8% in the prior year period.

There were no net realized gains included in investment income in the first quarter of fiscal 2005, compared with net realized gains of $1.5 million in the prior year period.

Again the Company does not anticipate recognizing a significant amount of gains or losses in the current fiscal year.

Our effective income tax rate was 33.0% for the quarter ended August 31, 2004, compared to 32.5% for the same period last year.

The increase in the effective tax rate is the result of lower levels of tax exempt income earned on funds held for clients and corporate investments.

The full-year fiscal 2005 effective income tax rate is expected to approximately 33.0%.

Our financial growth has continued to be impacted by the effect of lower average interest rates on funds held for clients in corporate investment portfolios.

This is the primary reason for the gap between operating income growth, excluding interest on funds held for clients, of 16% in the first quarter, and net income growth of 9% for the quarter.

We expect net income growth in fiscal 2006, will be much closer and possibly the same or in excess of operating income growth, again, excluding interest on funds held for clients, due to the fact that in fiscal 2006, we will no longer be comparing the prior year results that include significant amounts of unrealized gains, as well as the benefit from recent increases in the federal funds rate.

Moving on to the balance sheet.

Cash and corporate investments have grown to $593 million.

Our total available for sale investments including corporate investments and funds held for clients, reflected net unrealized gains of 9.1 million at August 31, 2004, compared with net unrealized losses of $4.2 million in May 31, 2004.

During the first three months of fiscal 2005, interest rates on short-term rates began to increase; however, interest rates on longer term securities actually decreased.

The 3-year AAA municipal securities yield decreased to 2.0% at August 31, 2004, from 2.5% at May 31, 2004.

The recent trend in longer term rates resulted in the increase in the fair value of the Company's investment portfolios.

The volatile up and down long-term interest rate market results in back and forth changes in the market value of our available for sale portfolios, but does not tend to significantly affect our near term results.

Conversely changes to the short-term results affect us immediately, on the short-term rates.

During first three months of fiscal 2005, the net unrealized gain/loss position ranged from a net unrealized loss of 7.5 million, to a net unrealized gain of 9.1 million, the net unrealized gain position was 9.5 million, at September 17th, 2004.

Our net property and equipment balance activity during the three months of fiscal 2005, reflected capital expenditures of approximately $10 million in depreciation of expense of approximately $10 million.

For fiscal 2005, capital expenditures are expected to be in the range of $65 million to $70 million including anticipated purchases for printing equipment, communication system upgrades and branch expansions.

The fiscal 2005, depreciation expense is projected to be in the range of $40 million to $45 million.

The Company reported $406 million of goodwill and 96 million of intangible assets from the acquisitions of Advantage and InterPay in 2003 and Stromberg in fiscal 2004.

Intangible assets primarily represent client lists and license agreements with associate offices which are amortized over periods ranging 5 to 12 years using either accelerated or straight line methods.

Intangible asset amortization is projected to be in the range of $15 million to $16 million for the full year fiscal 2005.

Goodwill balances will not be amortized but instead be tested for impairment on an ongoing basis.

Total stockholders equity increased to $1.3 billion at August 31, 2004, with $45 million in dividends paid during the first three months of fiscal 2005, a payout of 52% of net income.

A return on equity for the past twelve months was 26%.

A few comments on investment rates of return.

Our investment portfolios and the earnings from these portfolios have been impacted by the fluctuations in interest rates.

The federal funds rate, which was 6.5% at the end of fiscal 2000 was decreased many times to 1.0% on June 29, 2003.

On June 30, 2004, the rate was increased to 1.25%, further increased to 1.5% at August 10th of 2004 and yesterday raised to 1.75%.

The decrease in interest rate environment experienced through fiscal 2004, has negatively affected net income growth.

During fiscal 2004 and fiscal 2003, we mitigated some of the impact of the lower interest rates on earnings, by realizing gains from the sale of investments.

During fiscal 2005, the Company does not expect to recognize any significant amounts of gains or losses on the investment portfolios, which will result in operating income growth, excluding interest on funds held for clients, and net income growth for fiscal 2006, being much closer than they have been in recent years.

Exact impact of changing interest rates on the Company is difficult to determine, due to many factors including the recent environment of higher short-term rates and lower long-term rates.

But we estimate that the impact of the 25 basis point change in taxable interest rates, 17 points on a tax exempt basis on earnings for the next 12 month period, would be in the range of 3.5 million to 4 million.

Please refer to our recently filed 10-Q under the market risk factors section for additional discussion of changes in interest rates and related risks.

Legal contingencies.

Paychex is subject to various claims and legal matters that arise in the normal course of business.

Litigation related to Rapid Payroll is still in progress.

Legal reserves total $35.0 million at August 31, 2004 and and are included in other current liabilities on our consolidated balance sheet.

These reserves may change in the future, due to new developments or changes in the Company's strategies or assumptions related to any particular matter.

In light of the reserves recorded, we currently believe that resolution of these matters will not have a material adverse effect on our financial position, or results of operations.

However, they are subject to inherent uncertainties and there exists the possibility that the ultimate resolution of these matters could have a material adverse impact on our financial position and results of operations in the period in which any such effect is recorded.

We refer to you our Form 10-Q for a more detailed explanation of pending litigation.

We would now like to reaffirm our guidance for 2005.

It's pretty much the same as we provided last June, with very few exceptions.

Payroll service revenue growth is projected to be in the range of 8 to 10%.

That's slightly lower than what we talked about.

That's because we reclassified the Time in a Box revenues from payroll service revenues into human resource revenues, so basically there would have been no change without that reclass.

Human resource and benefits service revenue growth is expected to be in the range of 19 to 21%, reflecting the impact of the $6.4 million net incremental PEO revenue benefit recorded in fiscal 2004.

Human resource service revenue growth, excluding total PEO revenue, is expected to be in the range of 28 to 30%.

Total service revenue growth is projected to be in the range of 10 to 12%.

Interest on funds held for clients is expected to decrease approximately 10 to 15%, the recent federal funds rate increase yesterday, probably means we'll be on the lower end of that range.

Total revenue growth is estimated to be in the range of 9 to 11%.

Corporate investment income is anticipated to decrease approximately 30%.

Net income growth is expected to be in the range of 16 to 18%.

Growth in operating income excluding interest on funds held for clients, the 35.8 million of expense charges for pending legal matters in fiscal 2004, and the $6.4 million incremental net income from the PEO revenue in fiscal 2004, is still expected to be in excess of 15%.

These projections are based on current economic and interest rate conditions continuing with no significant changes.

You should be aware that certain written and oral statements made by the Company's management, include or constitute forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995.

These statements should be evaluated in light of certain risk factors which could cause actual results to differ materially from anticipated results.

Please review our Safe Harbor statement on page 3 of the press release, for our discussion of forward-looking statements and the related risk factors.

At this time, I will turn the meeting over to Tom Golisano, who will provide his comments on the first quarter.

Good morning, everybody.

It's Tom Golisano.

First off, I would like to say in the general sales and loss client category, Paychex had a very good quarter.

We seem to be hitting on all cylinders, core, MMS, 401k and particularly the our Paychex administrative services client, customer base.

Nothing unusual happening in the sales environment.

We feel we're very close to our annual targets and certainly very close to our quarterly targets.

Number two, one of the things that we have accomplished in this -- or finished, I should say in this quarter is the total conversion of all the InterPay clients.

As John mentioned, we made the acquisition back in 2003, there were approximately 34,000 clients at the time, and as of the end of October, I think we have about 900 clients left.

And it should be all finished by that point.

Our operations organization did an admirable job with this conversion.

Three, a small item but an item I get a lot of questions on, Europe.

We opened an office in Germany.

About four or five months ago.

We're up to 80 clients, as of last week.

And when I concur that to new office openings in the United States, it is a very, very good job.

So we're pleasantly surprised with that.

Things I always get asked about the economy.

First of all, I would like to mention that one of the things that we monitor is the number of new employees that are hired by our client base, of over 500,000 clients.

During the month of July and August, we actually saw a year-over-year decline in the number of new hires.

Now this is just a two-month period, July and August, but it is negative growth rate over July and August of 2003.

Checks per client remains pretty stable.

Not up or down in the last two quarters but just sort of laying there in a normal state.

The hurricanes.

Obviously very much a question with us, our backup systems and so forth.

We had a number of offices, I believe it was four or five that were out anywhere from a half a day to four or five days.

All of our backup systems performed admirably.

All of our payrolls were taken and as far as I know we did not have a payroll that was late.

The last thing I would add, we've been living with this interest environment for about four years now, and based on John's comments it's apparent that we probably have finally bottomed out on this thing, is it's going to be nice to be able to report operating income and net profit to be approximately the same amount.

So we're excited about that, seem to be running on all cylinders, the InterPay conversion is behind us, and we're looking forward to our expansion in Europe.

So with that, we'll turn it over to the operator for any questions you folks may have.

Thank you.

We will now begin the question and answer session.

If you would like to ask a question, please press star one on your touch-tone phone.

You will be prompted to record your name.

To withdraw your request, press star two.

One moment for the first question.

Cindy Shaw, you may ask your question.

Yes, I have two questions and then a clarification.

First, 90 basis points of operating margin expansion during the most recent quarter, excluding float income.

It seems that that should be pick up in the second half as some of the legal reserve comps get easier, as well as the InterPay acquisition.

If could you comment on that?

Cindy, generally what you are saying is true.

Unusual expense items we'll see more, but every year we generally get most of our margin pickup in the first quarter, it's when the price increase goes in and the budgets get reset.

We'll maintain this the rest of the year, whether it increases much, it would do so for those unusual items but other than that, I expect it to stay about the same.

And then the second question if, in fact, it looks like we finally bottomed on interest rates.

There was a comment in the 10-Q this morning about float income getting better in the second fiscal half.

My estimates are suggesting that we're going to actually see the float income on an absolute dollar basis turn positive and start growing in the second half.

If you could comment on that?

Well, we've given a disclosure.

Whether it will turn totally positive, but the comparisons are going to get closer.

The thing that we really feel the best about is in 2006, we really now are pretty confident this will be behind us.

And then the clarification, you have said, John, during your prepared remarks, float income, the bottom end of the range of down 10 to 15%, would that be down 10%?

Yes.

Great.

Thanks very much.

Thank you.

Our next question comes from Adam Frisch.

Good morning.

I wanted to ask you about organic growth.

I think from your Doc, SEC documents and disclosures, we're looking at organic growth as being somewhat flatish in the past few quarters maybe Tom, you can comment on when you think the improving sales achievements that you have been having lately will actually start accelerating the top line a little bit on an organic basis?

Well, I'm not sure it's been declining.

It's somewhat flatish.

Our revenue growth is in the 13 to 14% range, and that's, excluding interest rates obviously, and expecting a fairly stable economy.

I don't think we'll be far off of that.

Going forward.

And it possibly could be expanded going forward, you know, beyond short term.

So right now, we're quite happy with our internal growth rate, and realize that if we are able to grow that revenue in that 13% range, incrementally to the bottom line, it should be a much higher percentage.

But you expect the new sales that you are talking about that are going well to accelerate the top line?

No, I wouldn't say that.

I would think the expectation that we've communicated to you, I think you should stay right where it is.

Okay.

One thing that happens here, and you are not the only one that raises this question, is we've gotten to the size we're at today, new sales activity, especially for the quarter, doesn't impact us as much.

We have this very large recurring revenue business.

We do a very thorough budget job in the spring.

It's very hard to get any kind of surprise, either up or down.

So we are happy with organic growth.

We had mentioned last June there will be a little bit less year-over-year because of the old acquisition of Advantage InterPay, that's starting to anniversary out.

So we feel actually pretty good about where we are.

Okay on the issue that you just brought up, I know some of it might have been skewed because of the acquisitions, but in the past four quarters excluding the one you just reported, the operating profit growth was lower year-over-year than the revenue growth, and then in the August quarter, it kind of flipped for the first time in, I guess, four quarters -- five quarters, where operating profit growth was actually greater than year-over-year revenue growth.

Can you describe -- and, again some of that might be skewed because of the acquisitions and so forth.

Can you kind of describe, and again some of that might be skewed because the acquisitions and so forth, but can you describe what was going on last year and why it flipped in August and what you are expecting for the rest of the year?

That's because the complete anniversary of the year-over-year comparisons to the acquisitions ended.

In other words the last acquisition of InterPay was in the fourth quarter of 2003.

Right.

And we finally don't have any comparisons on that.

So we've had some very significant increases in revenue before that were all acquisition driven, yet we said that the acquisitions didn't drive profit levels up anywhere to the same amount.

We were incrementally gaining but it wasn't a great number.

So you are finally getting us back to where you have pure number comparisons.

Okay.

Thanks, guys.

Our next question comes from David Grossman.

Thank you.

John, you can maybe help us out on the capital gains side?

Typically if you see a steady and consistent, you know, increase in rates, are you still able to hold the capital gains line/losses flat?

[inaudible] It's that simple.

We -- we use gains to try to mitigate the effect of interest rates.

If I knew what I knew now, I don't know, we might not have taken as many gains last year this.

This year we're going to take the pain, which really is just kind of reporting pain.

It's not anything actual.

The gains are behind us.

There's $9 million in there right now, we are not going to take them, and our goal is really to get 2006 clean and have this gone and not a factor anymore.

So it would be reasonable to think going into '06 that we would assume net gains of zero, or net losses of zero?

Yes, very close.

There was $200,000 in the first quarter that's because we do do some trading but you will not see very much.

Great.

Thank you.

Thank you.

Our next question comes from Josh Rosen.

Yes, thanks.

It's Josh and Greg at CSFB.

Just one quick question, on the -- the sales channel.

One thing that you had talked about last quarter was trying to improve the referral network from the acquisitions that you had made in terms of InterPay and Advantage.

I just wanted to hear if you have made any progress or have any thoughts along those lines?

Well, the number one certain was InterPay because of the ongoing relationship with Fleet bank and the acquisition of Fleet bank by Bank of America.

But we're happy to say that the relationship has continued and the activity level has pretty much maintained itself.

We're constantly working on the arrangement, on the relationship.

Certainly we want to make it a good deal for both the bank and for ourselves, but right now, it's holding pretty true and we're quite happy with that.

And the people from B of A and Fleet have been very, very cooperative with us.

And then the other question that I had was just, you know, if you look back historically at referrals as a source of new business for you guys, has that changed much?

I know have you talked in the past about CPA referrals, client referrals.

The main two we look at are the ones you just mentioned, CPA and client, and on a collective basis they are probably somewhere around 63% to 65% of our new client volume.

As we have gone through this economy for the last three or four years we've not seen any decline percentage wise of our new clients for current referrals.

We've seen a slight decline in the CPA area, and we believe that that's primarily due to the fact that there hasn't been as many new business starts.

New business starts for us as far as selling clients is a significant portion of our new client activity and, of course when we don't have new business starts, we're going to suffer on that end.

And that particularly comes to us through the CPA referral network.

Now, recently, the last six months to a year, we have seen some improvement on it.

Okay.

Thank you very much.

Sure.

Thank you.

Our next question comes from Jim Kissane.

Thanks, Tom just following up on that referral question.

I know people have asked you this before, regarding the ADP wholesale strategy.

Can you discuss the logic of it and are you seeing any of your CPA partners jumping to the wholesale model or putting pressure on you to do a wholesale strategy?

Jim, if there are any, I haven't heard about it.

And I can tell you, this is one thing our sales organization watches very closely.

Very closely.

But I have not seen any kind of impact, nor have I heard of any.

There's certainly some very serious philosophical questions around this type of arrangement and we have those questions.

I'm not sure we have the total answers but we certainly have the questions.

So our stance right now is just to sort of watch it and see what happens.

And we're fortunate we can take that stance because as of this moment, there's been no real impact of any of this type of activity on us.

In any way.

Do you view it as a price cutting strategy by ADP, or is it just something else?

I don't think it is a price cutting strategy, as it is more of an opportunity to enhance their distribution network.

In other words, if -- if they encourage CPAs to get into the payroll processing business, it would impact their sales volume primarily.

The -- one of the issues with the concept, is that most CPAs cannot sell out of their client base, payroll services.

I mean if you are a CPA and I was a CPA and I was selling payroll services and I went to one of your clients, I don't think you will be very happy with me and I don't think you will encourage your client to go with Tom Golisano for his CPA, for his payroll processing.

So it's sort of a limited environment.

Because of that limited-sized portfolio of most CPAs or CPA firms, it's difficult for them to really build a critical mass of clients.

And it ends up being sort of a nuisance and then eventually dissipates.

I mean that's been our history.

That's been my observation is it cast in concrete?

No.

Are we watching ADP?

Yes.

Are we pushing this concept at this point?

No.

Great.

One last question.

You said before that you're going to keep the Advantage platform up and running for the foreseeable future.

Can you give us any color on how long that could be and what the rationale is?

Well, as you know, Jim, or maybe you have forgotten.

Paychex has been in the process of developing a new payroll system for the last couple of years and it's still in the process of development, probably for the next two years.

And we didn't think it would advisable in this particular situation, because of the stability of the Advantage payroll system and the fact that we have the associate relationships that we must continue to process for.

So consequently, we'll leave it on the same platform until our new payroll system is ready and then over time, we'll probably eventually evolve those clients over to that new payroll system.

But the Advantage system is very stable, we have the ongoing obligation to the Advantage associates.

So it will probably stay right where it is for some period of time.

Gotcha.

Thanks, Tom.

Thank you.

Our next question comes from Bryan Keane.

Yeah, hi.

Good morning.

The sales force growth, I see sales force in HR growing at 17% this year, and then I think for the core it grew around 6%.

I guess two questions there: How is the sales force doing mixing with the InterPay and the Advantage folks and then secondly, are those growth rates pretty typical for a given year, that, you know would you would gross 17% in HR and then 6% in core?

First of all, I think those percentages are a little low, even for this year.

They might be closer to 7 or 8%.

The merging of the sales organizations has been behind us for a substantial period of time now.

So that really is no longer an issue.

The ongoing relationship with Fleet bank or B of A now, for payroll referrals that is ongoing, and I mentioned that earlier before.

HR sales, we were pretty aggressive in that sales organization this year for two reasons, one, our continuing confidence in 401k sales; and also our continuing exuberance about our Paychex administrative or PAS product.

By the way, I just made the revelation yesterday or realized the revelation, that it is almost a $50 million/year business for us, considering we've only been involved in it for four or five years, we're delighted with that.

Our major market services division, also had a significant jump in the sales organization.

I think that was between 20 and 22%.

So we've traditionally been very aggressive with our human resource products and major markets, and at least the 15 to 23% growth in salespeople.

Core payroll, 7 to 8%.

That's where we've been and probably will stay there for a while.

What about the cross selling opportunities into InterPay and Advantage clients?

That, of course, with InterPay has been going on because those clients are -- are converted to our system.

It really facilitates it.

For cross selling on 401k with Advantage clients and so forth, we are in the process of making that happen.

Okay.

And just inside of HR, is it going to be PAS and PEO that will grow quicker than some of the other segments.

PAS.

I don't know if I would include the PEO in there.

Certainly PAS and 401k would be the two top leaders in the HR area.

Finally would I be reading it correctly, Tom, you sound a little bit more optimistic about the fundamentals of Paychex given the first quarter or --

You know, it's interesting you ask me that question, because it's only been the last few quarters I realized that I don't know if it's my voice infliction but there seems to be an extraordinary sensitivity to my optimism.

I'm always optimistic about Paychex.

I mean, Why not?

We have a huge market place.

We have a great sales organization.

We have a product that's not faddish.

We don't have inventories, we don't have to build buildings or build factories.

We're in great shape, and if there's an unusual inflection in my voice, positive or negative, I think it's being overread by everybody.

Okay.

Great.

Thanks.

That's helpful.

We think here, it's how many red lights you got on the way in. [ LAUGHTER ]

Thank you.

Our next question comes from Marta Nichols.

Good morning, Marta Nichols with Bank of America.

I wanted to ask about the PAS/PEO business, the growth there obviously has been variable over the last several quarters with the workers comp refund and the change in the loss exposure, and I think have you an acquisition in that line this quarter as well.

Two questions on that.

One, what's the organic growth rate for PAS/PEO right now and for the rest of the year?

And is there -- the second question.

Is there any ongoing workers comp refund impact on that line?

Basically PAS growth, take the PEO out, is well in excess of 30%.

Okay?

Probably over 40%.

But you have to recognize the PEO growth won't be as great, because the market actually in Florida, while it is not heavily penetrated, it's much more penetrated than the rest of the country, and it's not where our growth is focused, because the PEO, while it's a good element, it's not as good as our PAS element.

That's how we look at it.

The workers' compensation piece, we had those comparisons in the last two quarters. we talked about them.

I hoping we may get something favorable, but we won't know until December.

I don't know if that's going to happen.

We continue to be slightly conservative, but we're a little more aggressive at the same time we were a year ago to make sure we're in the right place, and, again, our concern is to make sure that we don't -- we make sure we record workers' comp costs exactly as they should be.

And we will continue to do that.

Right now we continue to be very optimistic about HR, and I think the growth is going to be very good, but some of it just got misconstrued and we had some of those adjustments a year ago.

So some people thought the growth was slowing.

That's not the case.

This is really on the move and it's rather remarkable how large this business is getting in various aspects, compared to how short a period of time ago it was.

And was there enough of an acquisition impact on that line that you got anything meaningful in the growth rate?

Stromberg was not that big in the quarter.

About 1 million.

Sales for the year probably between 8 and 12.

Probably, don't quote me, I'm not sure where it will wind up.

Put that in perspective, though the sales for Stromberg in the year before we bought them were probably less than 2 million.

So, while you might say that's an acquisition, it's our taking a good acquisition and really leveraging it.

So it is really organic growth.

John, can you remind me what the mix of PAS and PEO in there is?

I can't remember.

PAS is bigger than PEO now. 4,000 clients to about 1,000 Tom just said.

4,000 in one and 1,000 in the other?

PAS being the larger one.

Right.

Okay.

And more of a long-term question on growth, I mean you mentioned earlier that new business is obviously less impactful to your results now, than when Paychex was smaller company.

Can we interpret that to mean, that low teens service revenue growth we saw in this quarter is a comfortable long-term growth rate to assume?

I mean obviously, with checks per client rising a little bit in the future you could see a little bit of a lift to that, is there anything else that would cause that growth rate to materially accelerate or decelerate from what we saw this quarter?

We've been pretty consistent now for quite some time that our goal is 15% plus operating income growth, which eventually you get net income growth to be the same when this interest rate thing clears.

Now can the 15 be a little better than that?

Probably.

Is the 15 going to be 20?

I think it's difficult to do, unless you get some help from the economy, which has got to be pretty significant.

That's where our goal is and we want to do this for a long time.

So we generally, as a Company, we get something positive, unless it's so big it just flows right through which normally doesn't happen, we start investing again.

I mean that's what we did in Germany and a lot of people are not quite aware of it.

Right through this recession and this problem, we invested a lot of money in IT, that helped us a lot when these hurricanes came through, because our ability to maintain service levels was great.

We looked at Germany.

We looked at the PAS.

So we'll continue to invest.

When we talk about these returns we generally don't get big surprises and we haven't in the past either.

I'm pretty hesitant to change that formula because the environment will have to change substantially but at the same token we feel pretty good about the formula.

Okay.

And the 15% operating income growth, there's a little bit of margin leverage going forward as well?

I don't think Tom will ever not let us not have operating leverage.

That's not an allowable thing in the budget process.

Okay.

And just a final question on rates.

With interest rates rising now, has there been any change to your strategy as it relates to the investment duration of your client and corporate fund portfolios?

No, it's too early to make that decision.

I assume when rates get to something that is more realistic -- I'm not sure what that is -- we'll take the duration out.

Right now we're down between 2 and 2.3.

We'd like to be at 3.

But, you know, it's kind of unusual.

Short-term rates have gone up lately and long-term rates have gone down.

They went down 20%.

So we'll wait and see, but these things don't always move in sync.

Okay.

Great.

Thanks.

Thank you.

Our next question comes from Pat Burton.

Hi.

Congratulations on the quarter.

Did you see any pickup in small business formation?

I know you mentioned the Pays per control number earlier, but the small business formation?

Pat, not in the last quarter or two.

We saw it start about a year to nine months ago.

And now it's sort of leveled off.

I mean it hasn't deteriorated back down, but it's not continuing to grow.

It's fairly stable right at this point.

We saw a pickup in it, you know some time last year, during the middle of the year.

And probably right through to the end of the year but it sort of tapered off, just like the new hire stuff has.

Okay.

Thank you.

Thank you.

Our next question comes from Steven Weber.

Yes.

Good morning.

One clarification.

Tom, when you said there was a business that was nearly $50 million a year.

Were you referring to PAS at that point?

I was referring to PAS alone without the payroll processing component in it.

That's just all the HR services that make up the entire product.

Okay.

We have over -- you know, over 4500 clients now, around 4500 clients, now and the average revenue without payroll is approximately $8500 to $9000.

If you do that math, you are up over $40 million.

Okay.

We think it's a big accomplishment, considering how long we've been at it.

Two questions: Number one, you alluded to the fact that you're developing this new payroll system.

Can you -- what will this do to your business when you get it?

What kind of attributes will it have that -- to enhance your business?

Well there's a number of them and there are a lot of categories.

If I were to try to scale them, as to impact I would probably say the number one thing we think it will do, is going to make the ongoing maintenance and upkeep of that system an easier project than it is today, with our current systems.

Based on the programming languages, the use of databases, the connectivity between systems and all that type of thing.

The second thing we think it will do is it will have a substantial impact is to make our payroll specialist job easier.

Their ability to communicate with various segments of the company, have data online, their ability to take payrolls in a fashion that's much more expeditious and easier on the client, I think that will be the next part of it.

Third, our ability to deal with desk top and online environments all within one system, rather than in multiple systems.

That's another benefit, huge benefit.

Would I sit here and think that this is going to have any kind of profound impact on our earnings?

I would not go down that route.

I think it will make our operations a heck of a lot better and make our world a lot more controllable going forward, but I would the not look for an impact financially.

Okay, how do you integrate something like and does this existing client, you have half a million clients, will they notice a difference?

The only difference that the clients will notice generally speaking, clients that call in on the telephone or fax their information to us, is if their output reports may have been changed slightly.

It is very easy to deal with.

You send out a schematic to a client, and say, this is where it is now.

This is where it's going to be.

But those changes are really going to be pretty simple.

And not very complex at all for the client.

And it's definitely going to be an enhancement for the client.

Basically everything like the payroll journals, the departmental breakdown, the cash requirements report, the earnings records and the check stubs are not going to be hardly any different at all.

So it will be real easy for the client.

Okay.

My last question is: The 401k business, it seems to be growing less than 20% now.

Is that just the law of big numbers here or are you seeing anything else that's happening in that business?

I think it's two things.

It's certainly the law of big numbers as John mentioned, we're approaching 30,000, or we're already there.

I think the other thing have you to remember is, you know, Wall Street's hit the last few years had an impact on the enthusiasm around 401k plans.

Now, you know, when the market -- if that ever happens -- gets more leveled out and everybody perceives it as an opportunity, I think it will pick up, but I think it is a combination of the two things.

The numbers getting bigger and the perception of 401k's is not as happy as it was five years ago.

Okay.

Thank you very much.

Thank you.

Our next question comes from Mark Marcon.

Good morning.

I'm wondering, you had a sequential uptick in terms of the effective yield as it relates to ENS.

John, can you tell us if interest rates stay where they currently are, what would you anticipate that doing sequentially in this quarter?

I thought we gave the guidance.

I mean, it's -- we talked about the guidance for the year, it will not change much quarter to quarter, float income doesn't change.

So there's no gains.

So I don't think anything has really changed.

The trends you are seeing are what we pretty much predicted would happen as this thing bounced around.

Yeah.

I think we'll get a little more wind out of the short-term rates, but when I did the plan, I didn't build much in and normally I don't build anything in, but we built a little bit in that we thought something would happen, not a huge number, but I probably built 3 or 4 million in, something like that.

So not much is going to change there, Mark.

So maybe -- maybe 10 or 20 basis points of improvement sequentially?

Something like that.

Okay.

Great.

And then as it relates to PAS/ PEO, you know the number in the release was a 48% increase on a year-over-year basis, relative to, you know, prior releases, where, you know, last two quarters 34%.

Is that a like number, the 48%?

Or is there -- is there any change?

That's a like number.

We've accelerated the PAS sales force, they are doing better and better.

We're getting more clients on it.

The PEO really isn't a big impact.

Right.

We have a number of them, PAS alone is probably closer to 50 something.

I mean, it looks like your productivity levels are actually going up with the sales force as well.

It's not just an increase in the sales force, but the productivity level also seems to be increasing.

Is there anything that's changing in the market?

Are you benefiting from the workers comp problems that some of the independents are having?

What -- how would you attribute the improvement in productivity?

Mark, I wouldn't relate it to workers' comp or anything like that.

It's basically two things.

One is we've expected the size of that sales organization significantly, I think in the 35 to 45% range in the last two years.

Mm-hmm.

And the other thing is we're more comfortable with our product, and we have a larger nucleus of salespeople now that know how to sell it and get it installed properly, and we've also been working very hard on the service giving side of this, particularly the customer service rep that goes out and visits the client and is a trained HR professional.

So it is a combination of the three things.

We know it and understand it better.

We've improved our service level, and we've increased significantly the number of salespeople.

Great.

And then this thing on human resources and benefits.

How should we think about the sequential trend in the overall revenue number relative to Q4?

Was there any PEO refund benefit in Q4 of last year?

There's been a little bit.

Can you quantify that, John?

3 million.

Okay.

Great.

And then the last question is in terms of MMS, would you expect that -- the pace of growth there to continue or should it continue to just [lob] large numbers come down a little bit?

Well, obviously, it will become a factor, if it hasn't already but I can tell you that particularly with the addition of our HR online product, the enthusiasm around the sales organization and the productivity is there.

They have been consistently making their numbers.

Their internal sales quota numbers, and we've consistently increased the size of the sales force.

So I hate to sound overenthusiastic, because what you guys accuse me of, but there's certainly enough to be enthusiastic around MMS.

Another factor there Mark, is the geographic expansion of MMS is pretty much complete, being in every city.

Got it.

And that's why that has come down.

So really, the geographic expansion acts as a bigger impact than the size, at the moment.

Got it.

One final question, in terms of this competition on the core side, are you seeing any changes, not necessarily from ADP or Ceridian, but any of the non-traditional players, whether it's Intuit or, you know, some other new sources of competition?

Anything that you are hearing from the field?

I hate to be so succinct on this one because it makes me sound a little -- I don't know what it makes me sound.

The landscape competitively hasn't changed significantly at all.

And particularly, in the arena of Ceridian or Intuit.

ADP continues to remain aggressive.

They've always been aggressive and they've always been a very intense organization.

We have learned to live with that.

But for the rest of the players, just no new issues whatsoever.

Great.

Thank you.

Thank you.

Our next question comes from Craig Peckham.

Good morning.

Just to clarify a bit on the pricing side.

Are the InterPay and Advantage client bases now at parity from a pricing point of view with the core Paychex client base?

No, they are not and quite frankly, there's a significant difference yet.

As you may have remembered, the pricing range was from 20% to 40% less than typical Paychex prices.

Probably with a higher concentration between 25 and 30.

We did not think it was good strategically to move those prices up at that level, all at one time.

So we've made the decision to spread it out over anywhere from 3 to 5 years.

So if the average number that we'll say is 25%, I would say we're probably only about a quarter to a third there.

So when we talk about InterPay being converted 100%, that does not have any effect on the pricing there?

Right, that's strictly the processing.

The pricing has remained where it was initially, plus a price increase, higher than what we would generate for our regular clients, but still a long way from where it is for parity between the InterPay, Advantage and the rest of the Paychex clients.

Thanks, Tom.

And a question for John.

Can you ballpark for us what the legal expense was in this quarter?

About $2 million.

That's related to Rapid Pay.

We left the reserve the same number.

Not much has happened on the legal.

We did a lot of filing of paper, but nothing much.

Okay.

And I guess just one more question, Tom, you mentioned that July and August, I guess are seeing some negative in terms of hiring levels.

Are you saying that the full quarter is about flat year-over-year?

No.

July and August would have a bigger influence than just June.

I would say it's still down.

Okay.

Any thoughts here with three weeks in September behind?

None that I can tell you.

We don't have any data.

I don't know if it was seasonal or what it was.

Okay.

Thanks.

Thank you.

Our next question comes from Greg Gould.

Thanks.

To follow up on the pricing issue or trends.

The price increases that you have implemented across the board not only in Advantage and InterPay, but with the core customers, have they stuck?

As far as we can tell, they've stuck, Greg.

Our client losses are well within our normal limits.

We monitor why we lose them.

Certainly, there's always some that we lose to price, but right now, they're in their very traditional ratios.

Okay.

And then in terms of new business signings, are there any changes in sort of the makeup of the client, whether it's in the size, smaller or larger, or the number of services they are purchasing?

Slightly smaller, definitely the number of services they are buying are up.

I mean, as our penetration in direct deposit and access card and our trust check and so forth, definitely that's up.

So you could look at it, if you want to look at it from a revenue perspective, the average client is slightly lower, but the ancillary service revenue is up and one offsets the other.

Okay.

Thank you.

Thank you.

Our next question comes from Dave Tony.

Hi, Tom and John.

Nice start to the year.

I had a question -- one more follow-up on pricing.

You mentioned in Q1 that you put the normal pricing increase through.

Was that in the normal 3 to 3.5% growth range, and would you expect that to continue kind of given any competitive pricing issues?

Well, we've been doing it for 21 years now.

It's always subject to change but right now, based on what we see today, I don't think there's no reason to suspect that it will be different in next May, 2005.

Okay.

Then just one more question.

Office openings, I think you mentioned last quarter on the conference call that you might open four or so new offices in in the U.S. this year.

Are you planning in that ballpark?

Yes, we are.

Some of them are going to be conversions of sales offices where we have got significant client bases.

So, again, they are not going to have any type of marginal or any kind of impact hardly at all on our financial statements.

Okay.

Well, thanks and good quarter.

Thank you.

Thank you.

Our next question comes from Greg Smith.

Hi.

Good morning.

Just on the thing about acquisitions.

There any new areas you are looking at?

Should we expect to maybe see anything this year?

No.

I don't think so.

I mean, we're still doing a relatively small number of acquisitions of client bases less than 100 or 200 clients.

We don't see any change there, but right now at this moment there's nothing significant on the horizon.

Okay.

And then just on the international front, you talked about some of the early success in Germany.

Has that whet your appetite to expand anywhere in the near term?

Absolutely it has, and my guess is the first expansion will probably be in Berlin.

And I think probably the middle of next year, I wouldn't be surprised if we start thinking about another country.

Okay.

Great.

Thanks a lot.

I appreciate it.

Okay.

Thank you.

Our next question comes from Kartik Mehta.

Good morning.

Tom, a bigger picture question.

Rather than acquisitions, would you ever use consider using the customer base you have, doing a partnership with another company in terms of selling, you know, non-payroll type of products into that customer base?

You know that's an interesting question.

I probably get the question -- I shouldn't say the question.

I probably get a call a week from sales organization or the product -- or organization that has a product, and is looking for a distribution network.

And we probably have looked at every type of conceivable product and service that you can think of.

But I can tell you what the barrier that we run into every time.

One is, do we want to be in a situation where we can't control the quality?

Second, do we want to be in a situation where a sales force gets their attention diverted and not focus and concentrating on the very highly profitable services that we have now?

And that is a very big concern of mine.

And third, what kind of situation would we be involved in if we get involved in a company that doesn't have a long-term history?

What happens when we get involved in selling the product or the service and three or four years later, the product of company disappears?

We don't ever want to have that kind of exposure.

So the combination of controlling, quality, longevity and not diluting our sales force are always the barriers that anybody who comes to with us that type of an idea runs into.

John, a question for you.

What is the financial sensitivity if retention improved by 1% or pays for control improved by 1%?

Obviously both things.

But it's not going to change something dramatically, you might get another percent of growth, but retention -- you know we talk about retention and we say it's in the low 20s the month it's lost.

We think there's a great opportunity there, but the amount that's really controlled is probably about 1 to 5%, 25% of the whole thing, and you can't get all that.

I just don't think that checks per client is going to dramatically change.

I think in this country, and the hiring trend there in the last two months you will not see people adding people like crazy.

The things that would cause that to happen, I don't think it will happen.

It would be nice if they did, but we don't comment on them.

Great.

I'm in that boat too.

Thank you, gentlemen.

Thank you.

Our next question comes from Brandt Sakakeeny.

Thank you.

It's Brandt with Deutsche Bank.

Tom, actually John first, I have a couple of quick questions on modeling.

On the tax rate, should that peak this year and start to drift down as you start to incur more tax exempt income over time, particularly in FY '06?

I believe that's true but I probably wouldn't take it lower than 32 and I might only go back to 32.5, but we'll just have to watch it and model it and see what happens, but it should peak right now.

For this year should we model it at 33 or 32.5?

Well, you know, we compromise here so why don't you go in between the two numbers.

Okay.

And can you just give us an update on the cap ex budget for the year?

Well, the budget is there, the reason it's higher, the printers, we normally get from Xerox, in the past we have leased them.

We are going to buy them because we run these printers into the ground, and we run them for quite a while, and their ability on the product has gotten better.

So that's why there's a little bit of a bubble, but we're behind on spending the money now.

If I had to guess, we won't get to the number which is usually what happens.

But, you know, our key here is we've got cash.

And if somebody can find a better way to do it and can implement it, we'll let them do it.

The question is how much they can implement, and sometimes the capital expenditure teams, what they think they can get implemented is bigger than what they actually can, but the goods news is they are typically of all Paychex people, they don't spend money that they shouldn't spend, and they don't do things until they are ready to do them.

Okay, And on the original guidance on the non-payroll piece, on the HR piece, I think was 12 to 14% if you look at the first quarter growth at 30% and obviously the first half comps were easier.

But it looks like that will turn out to be light.

Is that a fair assessment?

I believe that the growth in HR revenue will be better than we anticipated.

Okay.

Great.

Thank you.

Thank you.

Our next question comes from Rod Bourgeois.

Yes, Rod Bourgeois with Sanford Bernstein.

I wanted to inquire about the profitability in Europe that you are experiencing.

Where that is now, versus your U.S. business and how that might evolve over time.

First of all there's no profitability yet in Europe.

We only have one location and it has about 80 clients.

It started in April.

And the real only substantive comment I have, is going from zero to 80 clients during April to August is pretty darn good and we are quite pleased with it.

I will give you some of the idiosyncrasies of the area, most people get paid monthly, and to a payroll processor that's generally not good news.

But in the case of Germany at least, the revenue per employee per month is still higher there than it is in the U.S., considering the fact that we process a little more than two times per employee per month.

The cost of doing business doesn't seem to be significantly different.

The software that we're using is a licensed product and it's doing a great job and it's allowed to us get into the arena without any heavy initial IT costs, and we like that.

So it's really too early to tell, but right now some of the modeling looks really good.

The thing that's the biggest unknown for us, is what could we ever expect our sales productivity to be on a per person basis and how fast we can expand that.

The other good news that concerned me, sort of subconsciously, about the market over there, and that is how will the CPAs react to us?

And we are pleasantly surprised by their reaction.

Because there was some prior conditioning that payroll processing was more important to the CPAs in Europe than it is here -- or that it is here and we found quite the opposite to be true.

So we are happy about that.

Great.

That sounds like it's a pretty good reaction.

Does that suggest that you feel like over time, the profitability in Europe can evolve to that of the U.S.?

Yes, I do.

And it is based on one key factor, and that's the revenue per employee per month.

It looks like it's going to be higher over there.

Without a correlation and higher overhead costs.

Got it.

And then another question along the lines of long-term opportunities, and it may be Europe, but what would you consider today to be your most important long-term opportunity to be investing in for future growth?

Well, we still got about 11 million companies we haven't sold our payroll services to yet, in the United States.

The opportunity to sell larger clients through MMS, as their smaller clients grow, that's huge, and Paychex administrative services is a great, great opportunity for us.

But it's hard for me to isolate on one, and I hope you get the drift of the message that John has been giving today, and that is we think long-term, that this Company is just positioned so well, and so we kind of focus on stability and consistency and discipline and structure.

I don't see that changing.

And -- because the opportunity is so huge out there, and we're going to focus on consistent results.

The best we can.

So the opportunity isn't a new idea?

It's continuing to invest in areas where you are already making progress?

Absolutely.

All right, thanks, guys.

Thank you.

Our next question comes from TienJen Wong.

Thank you, I'm with JP Morgan.

It sounds like not a lot of change from new business starts.

Any notable change on client bankruptcies or net competitive take aways this quarter?

Not really.

Pretty consistent.

We have not seen a lot of fluctuations in bankruptcies through this whole thing.

No on the low end, it could be different in the upper end but we haven't seen a big difference.

Okay, John, can you remind us, other than the hard workers comp revenue comparison in the third quarter, are there any other non-recurring revenue items that you have to grow over this year?

No, the big -- the big items when you get into the unusual items are obviously the litigation, workers' compensation, which we have talked about, and interest rates.

Got it.

You get rid of those three and life gets simple.

Got it.

Thanks.

Thank you.

Our next question comes from Tim Willi.

Thank you.

Good morning.

A couple of questions.

One, just in your comments about your expectation for pay per control growth, and your comments about not necessarily seeing the kinds of things that would drive that to occur, could you maybe comment anything you hear from your field from -- from customers themselves as to what, you know, is really driving that restraint in hiring?

Is it what we hear about every day in the paper, about benefit costs and concern about the actual strength of a recovery, et cetera?

Or is there something else there that's influencing those kinds of behaviors by your customers?

That is such a specific question.

I really would be hesitant to even answer it.

Even if I had a good idea on what I thought was happening out there.

I just don't feel we're in a position to answer that question.

Okay.

It's lack of knowledge.

Okay.

The second question, sort of on the numbers side.

If you look at total payroll services and separate the major market from the rest of the business, the major market obviously was a 30% grower.

The remaining business was 7%.

Given sort of, I guess you could say a cannibalization of factors as you move customers from one bucket to the other, that 7% growth number I would assume is not necessarily truly indicative of how the rest of that business grows.

Do you have any kind of color, John could you give us on what that kind of growth rate would look like?

The core business grows right around, payroll revenue is up 10%.

You know, it has a little wind on it because of one day.

Core is going to be 8 to 9.

Okay.

And then the cannibalization factor is a percentage point or two?

But it's not a lot.

We have all of these things going and Tom talked about the opportunities, the one we can never lose sight of, it's our most basic thing, get clients that average around 14 to 16 employees and we'll do fine and there's still an awful lot of them out there to get.

Okay.

Great.

Thanks a lot.

Thank you of our next question comes from Sean Keenan.

Yeah, hi, this is Sean from [It] baker.

DSOs picked up up a little bit more than we expected.

Can you provide some color there and your expectations for next quarter?

It's interesting, you track DSO.

I don't know that we track it here at all and that's because we go grab the money, as soon as we can.

So we don't worry about DSO.

But all that is, is timing and how the end of the month happened and I think it was the PEO in Florida that influenced.

We have no receivable issues.

With very the best receivables statistics probably in America, and that's because we take the money from -- I think we're up to almost 70% on -- we take the money automatically.

It might even be higher than that.

So, I can trust you we don't lose much money on receivables.

We are now into the low 70% of our client base that at the end of the month, we deduct the money from the client's checking account for our services.

So bad debts expense is minimal here.

All right.

Thanks.

Thank you.

I'm showing no further questions at this time.

Okay!

Well, it's still sunny here in Rochester.

We went an hour and a half like that, so that's good.

On a more positive note, I want to thank you for joining us here today.

We felt good.

We had a good quarter and we're off to a good start.

Again, we feel real good about the prospects of Paychex in the months, quarters and years to come and we want to produce consistent results.

Thanks again.

I'm sure we'll be talking over the next three or four months or we'll be talking on the next call.

Take care

Thank you.

Thank you.

That concludes today's conference.

You may disconnect at this time.