沛齊 (PAYX) 2005 Q2 法說會逐字稿

Good morning, and thank you for standing by.

At this time all participants are in a listen-only mode.

After the presentation we will conduct a question and answer session. [Operator Instructions].

Today's conference is being recorded.

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

Now I will turn over the meeting to Mr. John Morphy.

Mr. Morphy, you may begin.

Thank you for joining us for our second quarter press release.

Also with us today is Jon Judge, our President and CEO.

The teleconference call will be comprised of three sections: first, a review of the financial results, appropriate comments and guidance for fiscal 2005; then Jon will give us an overview as well as some comments on his experiences over the past few months as he assumed the role of President and CEO; lastly, we will conduct a Q and A session.

Yesterday afternoon, after the market closed, we released our financial results for the second quarter ended November 30, 2004.

This press release can be obtain by accessing our website at our Investor Relations home page.

We have also filed our Form 10(Q) for the second quarter ended November 30, 2004.

This filing is available 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 January 21, 2005.

Please refer to our website for access to all recent news releases, current financial information, related SEC filings, and the Investor Relations presentation which will also be updated in the next week or so.

As usual we are quite pleased with our second quarter results.

They were in line with our expectations and followed the Paychex tradition of continually generating record total revenues, net income, and diluted earnings per share.

The second quarter earnings release is summarized as follows: for both the second quarter and first six months of fiscal 2005 total revenue growth was 11 percent, which in turn generated net income growth of 8 percent.

Quarterly earnings per share were 23 cents versus 21 cents a year ago, up 8 percent on an unrounded basis.

Year-to-date earnings per share were 46 cents versus 42 cents a year ago, up 8 percent on an unrounded basis.

All of these were right in line with our expectations.

Operating income, excluding interest on funds held for clients, was up 14 percent and 15 percent year-over-year in the second quarter and six-month period to 114.5 million and 232.4 million, respectively.

Some very good news.

We expect the recent increases in short term interest rates, although long-term rates remained relatively constant as the yield curve flattens, will mean that our results will no longer be negatively impacted by interest rates commencing in the fourth quarter of a fiscal 2005.

Moving to the consolidated income statement.

Total service revenues increased 13 percent in both the second quarter and six months to 334.9 million and 669.1 million respectively.

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

Payroll service revenue increased 9 percent in the second quarter and 10 percent in the six-month period to 278.7 million and 559.1 million, respectively.

The increases are related to organic client base growth, increased utilization of ancillary services, and price increases.

Looking forward to the third quarter of this fiscal year, payroll service revenue will be impacted slightly by one less calendar billing day compared to the prior year third quarter.

This will affect year-over-year revenue growth in the quarter by approximately 1.5 percent.

As you recall in the first quarter this year, we benefited from one additional calendar billing day than the fiscal 2004 first quarter.

The number of days in the fourth quarter is the same as the prior year, as is the full fiscal year for 2005.

So this basically is just a movement of one day into the first quarter out of the third and affects revenue slightly.

As of November 30, 2004, 90 percent of all our clients utilized our tax payment and filing services and 64 percent utilized our employee payment service.

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

Major market service revenue increased 28 percent and 29 percent for the second quarter and six-month period of fiscal 2005 to 42.5 million and 83.5 million, respectively.

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

Human resource and benefit service revenue increased 32 percent for the second quarter and 31 percent for the six-month period of fiscal 2005 to 56.2 million and 110.0 million, respectively.

The increases reflect growth in clients for retirement services, growth in client employees served by the Company's comprehensive Paychex Administrative Services, PAS, and PEO bundled services, and the benefit of revenue from the April 2004 acquisition of Stromberg time and attendance products.

The growth in human resource and benefit service revenue will be approximately 20 percent for the last six months of fiscal 2005, as fiscal 2004 benefited from one-time favorable workers' compensation adjustments related to the PEO.

Exclusive of the revenues from the PEO, the growth in these revenues would be expected to be in the range of 29 to 31 percent for the last half of fiscal 2005.

Retirement services revenue increased 17 percent in both the second quarter and six-month period of fiscal 2005 to 22.5 million and 43.4 million, respectively.

At November 30, 2004, we served approximately 32,000 retirement services clients.

PAS and the 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 cost.

Sales of PAS and PEO products have been strong, with administrative fee revenue from these products increasing 42 percent in the second quarter and 45 percent in the six-month period of fiscal 2005 to 16.5 million and 32.5 million, respectively.

As of November 30, 2004, our PAS and PEO products serviced over 187,000 clients' employees.

Interest on funds held for clients decreased 15 percent for the second quarter and 17 percent for the six-month period of fiscal 2005 to 12.4 million, and 23.2 million, respectively, which was consistent with our expectations.

The decreases are attributable to lower net realized gains on the sale of available for sale securities, partially offset by higher average interest rates earned in fiscal 2005 and higher average portfolio balances resulting from client based growth.

Average daily portfolio balances for both the second quarter and first six-months of fiscal 2005 were 2.4 billion compared with 2.3 billion in the respective prior year periods.

The funds held for clients portfolio earned an average blended rate of return of 2.0 percent for the second quarter and 1.9 percent for the first six months of fiscal 2005, compared with 1.8 percent for both those periods in fiscal 2004.

There were no new net realized gains included in interest on funds held for clients for the second quarter of fiscal 2005, and 0.2 million for the six-month period of fiscal 2005, compared with net realized gains of 4.4 million, and 7.1 million for the respective prior year periods.

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.

Lower interest rates have negatively affected net income growth since fiscal 2002.

As we mentioned earlier, this trends is expected to reverse itself in the fourth quarter of fiscal 2005.

Consolidated operating, selling, general and administrative expenses increased 12 percent in both the second quarter and six-month period of fiscal 2005 over the prior year periods.

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

There were approximately 9,700 employees at November 30, 2004, compared with approximately 9100 at November 30, 2000 -- I'm sorry, that was November 30, 2004, to November 30, 2003.

Consolidated expense growth year-over-year is expected to be lower in the second half of fiscal 2005 as a result of expense charges taken in fiscal 2004 of 9.2 million and 26.6 million in the third and fourth quarters respectively, to increase the reserve for pending legal matters.

Operating income increased 11 percent in both the second quarter and six-month period to 126.9 million, and 255.6 million, respectively.

Investment income net decreased 46 percent for the second quarter and 44 percent for the six-month period to 2.8 million, and 5.0 million respectively, which was consistent with our expectations.

The decreases are due to lower net realized gains on the sale of available for sale securities and lower average interest rates earned offset somewhat by higher average portfolio balances.

The average portfolio balances for the corporate investment portfolio were approximately 557 million, and 544 million for the second quarter and first months -- first six months of fiscal 2005, compared with average balances of 415 million and 400 million in the respective prior year periods.

The corporate investment portfolio earned an average blended rate of return of 2 percent for the second quarter and 1.9 percent for the first six months of fiscal 2005, compared with 2.5 percent, and 2.7 percent in the respective prior year periods.

There were no net realized gains included in investment income in the second quarter or a six-month period of fiscal 2005 compared with 2.7 million, and 4.2 million in the respective prior year periods.

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

The Company expects investment income to decrease by 30 percent in fiscal 2005.

Our effective income tax rates were 33.0 percent for both the second quarter and six-month period of fiscal 2005, compared with 32.7 percent and 32.6 percent for the respective prior year.

Moving to the balance sheet, cash and corporate investments have grown to 598 million.

Our total available for sale investments including corporate investments and funds held for clients reflected net unrealized losses of 0.6 million at November 30, 2004, compared with net unrealized losses of 4.2 million at May 31, 2004.

This reflects the fact that while short term rates have gone up, long-term rates have remain relatively stable and down slightly.

During the first six months of fiscal 2005, interest rates on short term securities did begin to increase.

However, interest rates, as we mentioned, on long-term securities have decreased, the three-year AAA municipal securities yield decreased to 2.34 percent at November 30, 2004, from 2.50 percent at May 31, 2004.

During the first six months of fiscal 2005, the net unrealized gain position ranged from a net unrealized loss of 7.5 million to a net unrealized gain of 10.6 million.

Our investment portfolios reflect a net unrealized gain position of approximately 2.3 million at December 17, 2004.

Our net property and equipment balance activity during the first six months of fiscal 2005 reflected capital expenditures of approximately 27 million, depreciation expense of approximately 21 million, and a net book value of disposal of capital assets of approximately 4 million.

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

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

The Company has 406 million of goodwill on the balance sheet, resulting from the acquisitions of Advantage and InterPay in 2003 and to a lesser extent Stromberg in fiscal 2004.

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

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

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

Total stockholders' equity increased to 1.3 billion, with 95 million in dividends paid during the first six months of fiscal 2005, a pay out of 54 percent of net income.

A return on equity for the past 12 months was 26 percent.

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

The litigation related to Rapid Payroll is still in progress.

Originally, 32 lawsuits were brought by the licensees.

As of December 15, 2004, 11 cases have been settled for approximately 7.0 million, and 21 remain open.

We continue to aggressively defend our position in the RPI litigation.

As mentioned previously, the resolution of the RPI litigation will have no significant impact upon the future operations of the Company, as the revenues derived from the licensees are less than 2 million per year.

Legal reserves total 35.0 million in November 30, 2004, 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 affect on our financial position or results of operations.

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

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

We will now summarize our fiscal 2005 guidance, which is extremely close to what we provided last June and reaffirmed in the first quarter close.

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

Human resource and benefit service revenue growth is expected to be in the range of 21 to 23 percent, reflecting the impact of the 6.4 million net incremental PEO revenue benefit recorded in the third quarter of fiscal 2004.

Human resource service revenue growth excluding total PEO revenue is expected to be in the range of 29 to 31 percent.

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

Interest on funds held for clients is expected to be relatively flat year-over-year.

This is a slight improvement from what we mentioned earlier in the year due to the increase in rates.

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

Corporate investment income is anticipated to decrease approximately 30 percent.

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

Growth in operating income, excluding interest on funds held for clients and the one-time events of the Rapid Payroll litigation and favorable PEO's Workers' Compensation, is expected to approximate 15 percent.

As usual, these projection 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 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 would turn the meeting over to Jonathan Judge, who will provide his comments on the second quarter before we take any questions.

Great, thanks, John.

Great job.

I'd like to take a few moments to reflect on 3 topics that I think you might be interested in.

First, how the senior management transition is going.

Second, some additional observations on the quarter, and then third, what you can expect from us going forward.

Let me begin with the senior management transition.

As most, if not all, of you know, I replaced Tom Golisano on October 1 as the CEO of Paychex.

Tom founded this company, built it from a dream to a major U.S. corporation with his bare hands and those of a few close friends and colleagues, and then ran it for over 30 years.

Then on October 1, he turned the reins over to me.

So it's a fair question to ask, How is the transition going?

And in four words or less, I would say it's going very well.

Let me talk about it for a second.

First, Tom has been terrifically helpful to me, very giving of his time and his philosophies and his knowledge of the business, and so I'm very grateful to the work that Tom's done with me to help me in the transition.

Second, I spent the first month on the job spending time looking at all of the different major functions of the Company and working very closely with the senior management team so that I could get a chance to get to know them, and they could get a chance to know me, and perhaps more importantly, that will I could get a feel for how they ran each of their areas.

What I would say about the senior management team and I are that we're on the same page right now.

We are on board with one another and I think more importantly we are on the same page.

The second month I spent a fair amount of time in the field visiting our operations in 14 or 15 cities in the U.S.

In those visits, I met with all of our management teams and most of the people in the branches.

I put the branch through a review of their operation so I could get a good understanding of both the people in the branches, but then more importantly, how their branches are running.

What's going well, and what are the things that they are working on.

I got a very good feel from this process of the business model of our company, of our management systems and measurement systems, and more importantly to me, the business processes around the U.S. and how our business functions.

I had a chance in the same period to talk with several of our customers and business partners; and all in all, it's been a very productive few months and a very pleasantly surprising few months for me because our people, our processes, our business model and our prospects are that good.

My transition is surely not done.

There's lots of thing to learn still and lots of thing to assimilate.

But I would say it's off to a very good start.

Second, I wanted to make a couple of comments and observations on the quarter.

Now, John did his normal excellent job of reviewing the financial highlights with you.

It was an excellent quarter for us.

Perhaps more importantly, it was quarter as predicted by us and forecasted by you.

I share the Paychex senior management philosophy put forth over many years by Tom and John that we owe it to you in our guidance to give you the most accurate picture we see and at all times call out any significant chances -- changes to that as soon as we know them.

You can count on me, not only subscribing to that philosophy, but actively promoting it.

On the quarter itself the top line and bottom line numbers were excellent as you heard, but for me the real story was not just the quantity of the revenue and profits but the quality of it.

It was an across the board successful quarter.

We hit all of our sales target, core payroll, MMS and the ancillaries, and began getting good signals on interest rates.

We also watched several economic factors that we're able to see because of the type of business that we are in.

We get to see all of the new hires that are done by our clients, mostly in the 0 to 50 range, but as you know we serve clients all the way up to 2,000 and in a few selective cases, above that.

So we get to see all of their new hires because we do the compliance reporting for them on about 95 percent of our clients.

We also get a chance to see with the customers that we bring on board how many of those are new starts, new companies versus existing companies that either were using another vendor or were coming to a payroll vendor for the first time.

Across the board, the economic factors look good to us.

If we look at all the new hire data that we've looked at since, say February through November, for 4 months in the spring it was up 2 to 4 percent.

A couple of months in the late summer it was down about 2 percent.

And we came out of the summer in September, October, November, it was -- those months saw slight increases, in one case flat.

Again if you look over that full 9 months or 10 months of data that we've looked at so far, the numbers are all pretty positive.

The new hires are up roughly at about the 2 percent range.

Same is true for new starts.

The businesses that we see coming on board with Paychex, the number of businesses that we have taken on this year that are new versus last is up, and that's a positive sign for us as well.

And, of course, John talked about the interest rate change that we saw in the quarter as being positive as well.

Third, going forward, what can you expect from us?

Four areas that I wanted to focus on.

First, you can expect that we will protect our core franchise and our core capabilities.

We are world class at serving the payroll and HR service needs of small and medium-size companies in the U.S. and we will continue to devote the majority of our resources in that arena.

There is still lots of growth to be had in this segment, and we are excited about our prospects there.

Second, that we will selectively invest in growth initiatives that build off our core competencies, but in new markets for Paychex.

Now you know about 2 or 3 of those already.

You know that we've started a pilot in Germany.

You know that we have taken on some larger customers over time and you know that we acquired a time and attendance company called Stromberg.

In all three of those cases, our investments are looking quite good.

Our Germany model has gone well.

In the first 4 months, we were able to acquire 80 to 100 customers.

We just -- I just had a review of our Germany operation yesterday, and it looks like we are going to have a very positive January, taking on some 30 percent or more customers in the January time frame.

So again the Germany piece looks good to us.

The larger accounts.

I just mentioned we brought in some new larger accounts.

That piece looks fine as well; and then Stromberg has been a very good story for us in the time and attendance, the products have gotten great reception from our clients and we expect that that's going to be a very successful acquisition over time.

So those are the two -- the growth, there the major ones that you know about.

In the future, you can expect that we will continue to look at future -- excuse me, at growth initiatives, and that we will invest in those and put our money where our mouth is relative to funding the ones that we find to be promising.

And then third, we will continue to be open to acquisitions that fit strategically, financially, and culturally to our model.

You know I believe that we've just completed the integration of InterPay into the Paychex family.

That's 30,000 clients in the entire operation supporting them, now fully integrated.

That was an acquisition that we did in April of '03 and our team is very excited about how successful that integration went.

Acquisitions in general, the right acquisitions can be an excellent growth vehicle for us, but only where would they fit; and so you should know that we are open to acquisitions.

That we are not going to go on an acquisition binge by any stretch of the imagination, but where we see acquisitions that make sense to us, again, strategically, financially, and culturally, you should expect to see that we will continue down that path.

And then finally, the thing I would say is that you can expect that the management team in Paychex will stay focused and dedicated to serving the key constituencies, our customers, our business partners, our shareholders, and our employees.

Paychex is a terrific company.

We intend to make it better.

Thank you for your attention.

John and I would now be happy to entertain your questions.

Thank you. [Operator Instructions].

Sir, did you want me to announce the company as well as their name?

Yes.

Thank you.

Josh Rosen, CSFB.

Yes, thanks.

It's Josh and Greg at Credit Suisse First Boston.

We would just love to follow up on the comments you made there at the end regarding getting yourself fully entrenched into the business, and would be curious as to where you've seen the biggest -- or you've had the biggest surprises, excuse me, on the -- both the opportunity side in terms of where you see the greatest opportunities with this business as you've gotten up to speed on it, and then where you might see some threats that might be a surprise.

It's an interesting question.

It actually came from the board in the first meeting that I had and I wasn't able to give them a terrifically detailed answer, but I could give them one that was reasonably detailed.

This company is one that I studied quite a bit before I decided to come on board and was lucky enough to be asked to come on board.

It is -- you will take this, I'm sure, as being a biased statement but having worked for many years at IBM and looking at multiple companies of our clients and so on, this is one of the best business models of a company that I've I ever seen.

So the response that I gave to the board on that question was, if there were any surprises that I saw when I was talking to the board it was after the first 30 days or so, it's now the same statement after close to 90 days, the surprises have been positive.

The quality of our people, again, I visited 14 or 15 branches, so I haven't seen all 75 or 80 of the branches, which I will get to before too long, but the quality of our people is outstanding, the quality of our measurement and management systems is outstanding.

The quality of our business processes is outstanding.

So the surprises that I've had so far have all been positive.

And by the way I would say the same exact thing with more gusto about our senior management team.

I don't expect that you will see any changes in our senior management team.

It is one very focused, very terrific senior management team.

So I'm quite, quite happy with what I've seen so far.

In terms of prospects, it was something that I knew was there before I came in and it turned out to be absolutely true.

You know, we are a business that is focused and firing against a segment of the economy that very few people absent retail have been able to get to and certainly been able to get to profitably and that's the small businesses, the 0 to 50 or 0 to 200.

That segment is not penetrated well.

We've done a good job as a business and made some pretty good strides in it, but there's still lots of growth just in the segment itself without any organic growth in the segment.

So there's plenty of room for to us grow there.

So the opportunities are terrific.

And I think the other things that we will be spending time on now and into the future in terms of other growth initiatives, ancillary markets or segments or offerings that we could put into the marketplace in conjunction with the ones we already have, I really don't see an end to the terrific record this company has had so far.

I've said this before, 21 years since this company went public, it's never had a year where it didn't grow revenue and I don't see that string breaking.

So I can't forecast for the rest of time.

I can certainly tell you that in the upcoming year with the guidance we've given you, we are going to have another good year this year, and I can't see a place where we are either saturated or we don't have a place to go.

All right.

Well, thank you for all the color.

Thanks, I appreciate it, Josh.

Greg Gould, Goldman Sachs.

Thanks.

John and Jon, I wanted to understand, the interest rate outlook is stronger -- interest revenue outlook is stronger, it will be flattish for the fiscal year.

At the same time, you commented that net income -- or operating profit growth would approximate 15 percent, which is, I guess, tempered a little bit from the -- in excess of 15 percent in the prior earnings release.

Is there higher expense than what was originally planned in the second half of the year?

Basically, first off, we are a little more favorable on rates.

We are going to see in the fourth quarter where funds -- the return on funds held for clients, the growth rate there will clearly be above the net income rate or the operating income without float rate.

It won't happen in the third quarter, but will change in the fourth.

Now when you take the question you're asking, Greg, the 15 percent, remember, doesn't have float income in it.

So the improvement in float income doesn't affect that number.

I changed it slightly, could have probably left it the same.

We think we are going to be right around 15 percent, but we look at some of the expenses we've got, we're investing a little more in Stromberg than we thought.

Europe is still going pretty well, not a major investment, and we've had a little more in legal expenses related to the litigation, although I don't really forecast that to be very significant the rest of the way, so it's just minor stuff.

I think what you've got to realize here it's kind of mind-boggling is that while revenues for the year are going to be in excess -- well in excess of 1 billion, we are talking about numbers that 3 or 4 million change these percentages somewhat dramatically.

But, no, we feel pretty much the same way we did before.

Interest rates a little more confident and I feel real good about where we are in the year.

So it's the incremental expenses, 3 to 4 million, is that what we should take out of this?

About that, but actually I wouldn't change much of anything.

I think where you are is still pretty close to what it is.

Okay.

And then on the new hires, it seems very volatile.

Is there any particular insight into why?

No, I think you have some seasonality but as Jon mentioned, we saw the turn in January.

February, March, April, May, and June were up 2 to 4.

Then I think people got a little worried about the economy, terrorism, all that stuff, the summer was down a little bit, and then we saw it get up a little better in September, and it's been a little better the last 2 months.

I think it's good that it's a little better the last 2 months.

I think what you have to remember we talk about this as kind of a job less recovery.

We see the needle pointing in the right place.

We feel pretty good about the economy, but the world is a different place than it was before and more people are cautious.

Okay.

Great. and sorry, let me sneak one last question in.

In terms of acquisitions, what is your philosophy on dilution for future acquisitions?

Well, we don't like them when they are dilutive but I think you also recognize that we are a company that believes in the long-term growth picture, that means we know we have to make each and every quarter, but if we saw something that was really beneficial to the long-term future of this company, I don't think we would be afraid to take some dilution to do that.

We would be up front about it and we would explain it.

But the deal would have to be in front of me for me to tell you, but I wouldn't say we wouldn't do any deal that was dilutive.

Okay.

Thank you very much.

David Farina, William Blair & Company.

Good morning, John, the -- when you look at the break out your SG&A expenses, your compensation is up 14 percent year-over-year which is probably the highest number I've seen in years.

I know you talked about people and things like that, what exactly is in that?

And should we -- you were talking pretty fast when you were giving your guidance in that area.

Can you kind of go back through what you expect for compensation and overall SG&A expense, and why it's that high, and what it should be going forward?

Going forward I think it's going to remain about the same as it is on a percentage basis.

Right now, probably a little less than the second quarter and a little higher than the first.

We just got some legal expenses there in the first half which might not be there, but we are investing in Stromberg.

We were hoping that Stromberg was going to get off and running profitably and immediately.

And I looked back and when I reviewed the budget, and I will put as much blame on myself, I looked at the number and we were just too optimistic.

It is not a staggering number but it could be 2 or $3 million which moves us a little bit.

Europe continues to do very well.

We now have over 100 clients.

It's a real learning experience.

I'm sure Jon can give his comments on that too in a minute, because he's had a lot of experiences over there.

So we've got a little bit of investment in some things going on that might be a little bit higher than normal.

But I think also the leverager in here is really not that significant or that big a deal, and I can assure you when we go for the budget next year we are going to go right back on these things that the leverage will be right where we are accustomed to, but the other thing we've had in the last couple of years, we've got a few unusual items.

A lawsuit, some workers' comp stuff, so we haven't been quite as clean, I guess as you would look at it, as normal; but I expect us to return to that next year.

And, John, kind of on a secular -- I mean, obviously your growth isn't as high as it once was, but you've always generated a lot of leverage.

Over time, should we expect your expense growth to be kind of in the high single range?

Is that a fair -- you know?

I would think that's about where it's going to be, high single digits, might be 9 to 10.

This year it's a little higher than we like, but I kind of gave you some of the reasons for that.

If it changes higher than that high single digits, then you're going to see us -- we've got to be investing, because if we are going to make the formula work -- if you are going to have 12 percent revenue growth to get to 15 percent profit growth, the expenses can't go up much more than 9.

Just as a general principle, I will add to that, which I'm sure you know what I'm about to say, but as a general principle we will not grow expenses faster than we grow revenue so you will not see that happen.

You will see us selectively allocate expense dollars to growth initiatives.

I'm a very big believer that you always have got to have some percentage of your resources dedicated to this quarter this year and some percent of your resources dedicated to things that will bring -- come into fruition in the following years.

But at all times you will see us be religious to a financial model and you will see us very, very religious towards improving our productivity year-in and year-out.

Okay.

Thank you very much.

Brandt Sakakeeny, Deutsche Bank.

Oh, actually, thanks.

I'm all set.

They've all been asked.

Stephen Weber, SG Cowen.

Yes, good morning.

A couple of things.

John, you mentioned in the last call that you would know at the end of December whether had you some upside in your Workers' Comp formula.

I'm not sure I understand that, but I know there's some volatility there.

It's pretty close to the end of December.

Is there anything that you can tells there?

Secondly, at -- you mentioned in an earlier call that the float balance would grow like 5 or 6 percent for the full year because of some calendarization effects.

Has anything changed on that score?

No, basically I think the float balance when we get down to the end of the year will be in the 4 to 7 percent range.

The lowest quarter for float is the one we just completed.

The highest quarters for float is the first quarter -- or the third quarter of the year and the fourth.

The reason that's true is you got all the bonus be direct deposit payments that happen in the quarter we are going to go into with the month of December, and then in the next quarter you've still got a lot of Social Security taxes and everything else they haven't rolled off.

We still believe that's going to be the situation.

Whether that will change slightly, I don't know.

And that's usually based upon -- you've got client growth, plus there is wage inflation of some degree and we are doing better penetration.

So that should happen, okay?

When I look out, I don't see any issues on float income.

As far as the December Workmen's Comp, we do expect some favorability but I kind of built that into the guidance.

At the same time, we built in a little bit more investment into the guidance so they were kind of an offset.

So not a big number.

The Workers' Comp continues to be a good thing for us and we continue to monitor quite well.

We've had to move into a little more what we call self insurance the last time.

We are still very conservative on how we build the reserves so we don't have a quarter where we say we a had a prior quarter misstatement.

We know the -- we don't want to have that under any circumstances.

Right now, workers' comp is going pretty well.

If I could just follow up on that latter point.

The -- when you said HR services revenues you were going very quickly as usual, up 20 percent in the second half, I assume that you -- and I was trying to square that with the 21 to 23 percent that you put in your outlook, I'm assuming you left out that 6.4 million out of the second half of last year for the 20 percent, otherwise it doesn't work.

The 6.4 is why it's only 21 percent in the last half.

Okay.

Take the PEO out.

I guess -- I'll say it simpler.

There is no problem with growth in HRS if we rate close to the 30 percent.

We just have some workers' comp between years that caused some aberration.

Okay.

Fine.

Thank you.

Randy Mehl, Robert W. Baird.

Good morning, John and Jon.

Well done on the quarter.

I wanted to pursue a couple items.

First was the PAS product, it looks like the combination of PAS PEO is up 40 percent in the second quarter.

Can I assume that that was largely skewed by PAS, or are you seeing really good growth in the PEO that's kind of keeping pace?

Oh, no, it's PAS.

The PEO growth is a little higher than half of that and the rest is PAS.

Florida is a good market for us.

We probably have the best PEO in the country, but Florida if you talk about any saturation --I don't want to -- saturation's the wrong word, but penetration in Florida is a lot higher than the rest of the country and the PAS growth really isn't going to be significant in Florida -- or the PEO growth, but the rest of the country is going great, especially in California.

So given that and given how early we are in the development of that product, I mean, should we expect 40 percent plus at least into the foreseeable future, is that part of the growth strategy here?

The growth strategy is the number would be very high.

Whether it's going to stay at 40 percent really is based on how much sales force growth we can swallow, because what happens is to push this, you got to push salespeople.

And to push salespeople means in the year you push them you break even and sometimes you lose a little bit.

So it's -- again, it's going to look at the year and say, okay, how much can we expand that sales force and afford, and how much client growth can we take on in service, so there's a lot of factors.

I expect this growth rate to stay high.

Whether it stays right at 40, I don't know.

The situation is a little bit similar to MMS in the early years when we were penetrating.

Eventually the growth rate will come down some, but right now this is probably going to be the best product we've ever had in the race to 100 million.

I was a real skeptic on this product at one time, but this product is going quite well, great acceptance and the revenue opportunities here are very, very significant.

Okay.

And then on the time and attendance, you had made some couple comments -- a couple comments about Stromberg.

When you bought Stromberg I know they addressed a lot of the clients that were larger than your typical core payroll clients.

I'm wondering with the combination of the latest acquisition of Stromberg and the Time In a Box that you had, number one, how many clients you have there and what kind of growth in clients you would expect, or what kind of client penetration you might expect from T and A at this point?

This is way too early to the even know that, but we think we have the potential here to take a business -- actually, what's -- it's interesting is, Stromberg only did about $2 million last year in the upper end.

This is where you know I got a little aggressive.

I think we were looking for over 10 which we are not going to get.

We will probably get orders that's going to be there, but it's taken this long to get the clients -- the clients satisfied.

Now that's going to continue to move.

I can't tell you what penetration is going to be.

And client counts I don't think are as indicative there.

And when this gets going, we will probably get more data.

One thing that's happened is the product on the upper end has been very good and MMS has started using more of that product, but by using that product it changes it to a little bit lower sales volume, so it's helping MMS, but it hurts Stromberg a little bit.

Right now, over all, we are very pleased with what Stromberg and Time In a Box are doing.

And our usual, we got a little too optimistic on what we could get from them.

Great work environment down there and I continue to see good things, and we think we've got a business that over time will go over 50 million.

It might take a little while, but we feel real good about it.

It's one of the those great little expansions of the product line that Jon referred to a little bit earlier.

These are the thing that we have to look for.

Is there any major reconstruction that needs to happen with the product or is this just a matter of adoption and sales?

No, this is John Judge.

There's no major thing that's to be redone in the product.

The product is in good shape.

The acceptance of the product is in very good shape with our sales teams.

So it's just a matter of taking the a company with a relatively small company compared to Paychex with an offering that is -- I think is a terrific adjunct offering and getting it ramped up both from the ability to install it and service and support it.

Fantastic.

Thank you very much.

Pleasure.

Jim Kissane, Bear Stearns.

Thanks.

John, can you reconcile new hiring trends with your checks per clients, which I think were flattish in the quarter?

You guys are great.

We really want to get off this check per client subject and you just -- you know, you guys can't let it go, I guess.

All we're going to say -- look, when checks per client was a real driving force in the business, we disclosed and we talked about it, because it was going down like the interest rates were.

Today we don't talk about it for a couple of reasons.

One, in the 90s that statistic didn't change despite a lot of hiring.

The reason that statistic isn't very important right now is -- and we've gone on record and some of you want to -- we can agree or disagree and I hope you guys are right, because it would make it better if you are, but I've got to be a little bit conservative, is we put on new clients in a smaller size than what our average base is.

That's because the opportunity is at the lower end.

And as a result of that, the checks per client may decrease a little or be about the same, and unless you can factor all those things in, you don't know what it just said.

EDP still looks at theirs.

But all I can say is we spent a lot of time trying to understand how they calculated theirs.

And my belief is that we calculated ours the same way they do, and we don't exactly, but we are a little more client upheaval or moving, and basically it would be about the same, it would be up a little bit.

We don't believe we are going to get momentum off growth in checks per client.

New hire reporting indicates it's not going to be tremendous hiring expansion here.

And that's the way it is.

Now, I talked about upheaval.

I used a bad word there.

So it's really -- now we have more sales and loss activity going in because we are on the low end.

If you look at the average customer size added in the last 12 months in the core payroll business, can you give us a sense what have that was?

It's going down some because there's more business starts.

In the recession, that number was up around 9 to 10.

Right now it's probably in the 7 to 8 range, and that's good news.

Versus your historical number, like 14, right?

Our average is 14, not the average new one.

Actually, our overall average if I put core and MMS together, which I really need to do, is 16.

Then your average -- if you can break out MMS, what's the average customer size there.

60 to 70 but, again, you do that and it's -- you are on a statistic that's kind of narrow because a lot of the core business that used to be above 50 is now in MMS.

Okay.

Just one last question, John, the Rapid Payroll situation, based on the commentary in the queue seems to be breaking your way.

Is that the right conclusion?

Rephrase that.

The Rapid Payroll situation based on the commentary in the queue --?

Okay, I don't want to think about the lawsuit.

Okay.

Lawsuits are like a roller coaster.

We've had our moments where we didn't like it and we've had our moments where we liked it a whole lot better and right now I feel pretty comfortable so I guess it says I like it where I am right now.

That's always subject to change but we feel pretty good.

We got some bad rulings early and we've gotten some good rulings recently.

Great.

Thanks, John.

Pat Burton, Smith Barney.

Hi, congratulations on the quarter.

My question, John -- is for John Morphy.

John, within the 9 percent revenue growth number in payroll, could you just tell us what percentage of that is roughly price and what percentage of that is coming from new client additions as opposed to the pace per control number?

Thanks.

You guys -- you guys are creative.

We don't give the client growth number and we told you the price increase was in the 3.5 to 4 percent range.

We said that last May.

That's what we put in.

And most of that price increase stuck as usual.

Okay.

And as a follow up, the organic growth rate within the HR and benefit business was what this quarter, if you strip out the Stromberg acquisition?

Stromberg was -- it wouldn't change it hardly at all.

Stromberg revenues, we are hoping to get over 10 in the quarter.

I don't think we are at 3 or 4 year-to-date, so we are okay.

About two per quarter, something like that?

Yeah.

Thank you.

Mark Marcon, Wachovia Securities.

Good morning.

I'm wondering if you could comment a little bit about the growth rate in core payroll stripping out MMS?

What you are seeing, how you think it's going to trend longer term and productivity levels within the sales force, how are things going?

Things are going fine.

The sales force is definitely meeting their goals.

They are more revenue based at the moment than client based.

They are doing a great job in the ancillaries which take more time.

As we become more of a price leader than kind of a low-cost provider which we believe we are the quality provider today, and we are the price leader in the industry, that takes a little more time to sell.

So I think productivity at the sales force level is fine.

Somebody might say, well, it went down slightly but that's how you look at it.

We know our productivity is as much as 50 percent higher than our best competitors.

So it's hard for me to look at that stat and worry about it.

Core payroll growth, I think, Mark, you can't just look at that by itself, because MMS has just become such a big part of the blend and at times I wonder whether I should just stop giving you the MMS number by itself because 30 percent to 33 comes out of core.

What we really wanted to show was our ability to participate in those markets and over time as clients need more things, sometimes more of it goes into MMS.

But right now, we feel real good about the core.

The opportunity at the low end is excellent.

That's where the under penetrated market is.

The sales force is off to another real good year.

When I was at conference in September, people were very excited.

So right now, we are having a good year.

So your expectation is that -- the long term trend there, John, is going to continue.

Yes.

Terrific.

And can you talk a little bit about the client retention rate?

I missed that.

You didn't miss anything.

We didn't talk about it yet.

Okay.

Basically we are close to record levels.

Doing that inside of the integration of InterPay is wonderful.

You take 30 thousands clients, you take them off a platform and put them on a new one, that doesn't look the same and the reports are different.

The operations people just simply did a phenomenal job to do that, they did it in 18 months, but they didn't really have 18 months because they lost about 4 because you can't do it through the selling season.

Advantage retention has been real good, and our retention is good.

So right now, we feel really good about it.

Our customer surveys are at the highest levels, or pretty close to highest levels they've ever been.

This is something that is looked on in the branches every minute, day, hour.

That's terrific.

So the client -- and the client retention being at close to record levels includes InterPay and Advantage?

Yes.

Terrific.

Thank you.

Bryan Keane, Prudential.

Hi, good morning.

Let me ask one of those questions another way.

I guess for new client growth, I think we were at 505,000 at the end of fiscal year '04.

What is the target rate that we should expect for fiscal year '05, is that still around 5 percent?

It is going to be 4 to 5.

4 to 5.

Again, we've talked about the impact that we have on Advantage and InterPay, those large acquisitions.

That impact still is there.

Now the InterPay one starts to go away a little bit stronger than it did, but we still have about 40 to 50,000 clients that are on a perform that we don't get referrals off of and we don't get anything else off of and again the sales force is a little more focussed on revenue.

Right now we are comfortable with where our client growth is and the sales force knows it's important, but the biggest thing is to bring in the revenues and we have a lot of cross-selling now more than ever with PAS, workers' comp, 401(K), little bit of the Time In a Box and the Stromberg revenue so, no, we are very comfortable with where we are.

Okay.

And, Jon Judge, I just wanted to get back to some of your comments, kind of about the growth versus expense issue.

What's your philosophy on that?

Should we expects more kind of top-line acceleration as you develop maybe a little higher expense or should we expect more margin expansion and kind of keep the base revenues the same?

How do you think about that?

I think about first of all looking at where we've been, where we are, where we are headed, so you are not going to see a set of dramatic changes here.

We are going to continue to perform in the quarter and in the year.

But we are going to also put more focus on cordoning off some finance -- some expenses to be able to make investments that will help grow the future.

So with that said, though, I was at IBM for 25 years, and I've been sort of classically trained in terms of the whole budgeting process.

We will not enter into a budget for a year where we are not improving productivity.

We will not enter into a budget for year where we are growing expense faster than revenue unless there's an extraordinary situation there.

So there are lots of ways that a business can self-fund -- inside of a calendar year, can self-fund some growth initiative moneys by just getting more productive in your current business and cordoning off some of those funds to invest in some things that will help you out in the out years.

So -- but you are not going to see a dramatic switch in terms of the financial philosophy of this company.

It's had 21 years as a public company of outstanding results and we are going to continue on the path that we've been on.

Okay.

And then finally, John Morphy, I guess just long-term operating income growth, should that still be around 15 percent and then plus or minus I guess a little bit depending upon rates?

Plus or minus a little bit depending on rates, but that's our stated goal; and I can assure you are we are going into some longer term planning process working at that, and at the same token, we're starting to work on next year's plan and I know for the two Johns sitting here, it will be a cold day in hell before we decide we are not hitting that number.

Okay, great, thanks, guys.

Cindy Shaw, independent.

For John Morphy, two questions, first probably pretty straight forward, DSOs were up to 50 days.

That's an unusually high number if you can tells what's going on there.

And then after that, one on interest rates,

I will be very frank, Cindy.

I don't even look at DSOs.

That whole thing fluctuates based upon when the billing cut off was at the end of the month.

We, for over 60 percent of our clients we simply take the money out of their bank accounts.

Losses on ancillary services are now less than 5 million a year, that's when the stars are all in the wrong place.

Receivable write-offs and clients are probably less than 1 million a year.

So receivables are something that I just don't worry about because we have some great people collecting the money.

Okay.

Great.

And then on interest rates, you've said in the past that you wouldn't take or realize any losses on the investment portfolio unless it was growing faster than that 15 percent operating income target you just discussed.

I'm looking at forward rates here in my model and expecting interest income -- and that would be both the corporate and the client portfolios to hit about 25 percent for this fiscal year, and that's based on the rising interest rates and RIL [ph], and for next fiscal year, about 33 percent.

So that's about 20 percent of your bottom line starting to grow a lot faster than that 15 percent.

Would you start to realize losses so that you don't wind up with kind of a tough comp in the out period?

Well, we'll look at it, but right now, I couldn't recognize losses that I don't recognize.

The portfolio is actually slightly positive.

I don't know exactly how you came up with your rate scenario, but right now looking forward we see floating income this year is going to be very close to what it was last year.

It might be slightly more, so it might have a little wind with us in the fourth quarter, but not enough to really change anything.

What's going to happen next year on this position, we don't know yet, and I haven't discussed it with Jon here yet, because we just don't know enough about what's going to happen.

We will know more about that when we get probably into the first -- first part of next year.

Now, our goal isn't to let that get too uncomfortable, but right now you've got a very unusual situation.

Short term rates are moving and long-term rates went down.

You can actually get a mortgage today at a lower cost than you could have got it last August.

That yield curve is really flattening.

So we'll just have to watch and see what happens.

Personally, I don't believe the long-term rates can stay where we are, so I think eventually they will go up and we will get some losses in the portfolio, but remember our long-term goal is to keep growth in net income and growth in the float income would be -- the float income growth would be about what our net income growth is.

That's our long-term goal.

You can get some aberrations but right now it's too early for me to say what we would do, because I don't know what's going to happen.

It sounds -- if it did -- if it did get extreme at the 30 some percent growth there versus about 15 for the services income growth that you would start to take them losses to try and maybe bring that more in line?

If the portfolio had them in it and it was the right thing to do.

Great.

Thanks very much.

Craig Peckham, Jefferies.

Hi.

First a question for John Morphy.

John, can you hazard a guess on your legal expenses in the second quarter?

I could but we are not going to disclose them.

Okay.

But you talk about the 2 to $3 million of total expenses, it would fit within that kind of spectrum?

I would rather not say.

The litigation that we've got going, one of the reasons we've gotten into a better place is we've been aggressive, we've been tough, and we haven't revealed much of our position.

Okay.

Fair enough.

And for Jon Judge.

Jon, thanks for the comments about what you see as some of the opportunities out there for the Company.

Maybe you could spend a minute or two talking about where you think maybe the Company is under performing and has the most room for improvement?

It's hard to call -- it's hard to call out the Company under performing when you look at the financials on this company.

And if it is, I wish I had gotten here sooner.

But in terms of opportunities in the future, a couple of thing to think about.

One, today we derive all of our income and all of our revenue from the United States predominantly.

We have the one pilot we are running in Germany, but all of our success to date has been from the United States.

When you think about how we derive our revenue, we are in different taxing municipalities, and different municipalities that have different HR and payroll rules and regs, as we go state by state, county by county, city by city and we do it quite easily inside the United States.

It would lead me to the conclusion that even though you are dealing with different languages and different governments and different regs, there really isn't anything that I see at least in the early stages that would say that dealing in the international front would not be something that could hold great promise for us.

As I mentioned in my comments as I went through the review of where we are in Germany, without getting overly flowery about it, there are lots of things that we see in our experience in Germany so far that reminds us of the things that we saw in Paychex in the United States several years ago.

So I told you earlier, we think that there's a pretty good opportunity for us in Germany, and we believe that Germany is a pretty good pilot for what could happen in other major countries in Europe.

So I would say to begin with one of the areas is certainly in the -- is in the international front.

Second, I mentioned earlier that even with the great success that we've had we are still relatively under penetrated in the base markets that we are dealing with, so there's lots to be done there before you have any growth in new starts or growth in small businesses, and as I mentioned earlier as well, we've seen some pretty good economic trends in terms of both new starts and new growth in that sector of the economy so there's plenty of growth there.

You saw that we did a pretty good job, or we have had good early feelings about Stromberg acquisition.

That's where we've added some capability to our current offerings.

And there's no question in my mind but that there are other areas where either improvements to the offerings that we have in place today or the addition of new offerings to the suite that we currently bring to market would also give us some more lift in the markets we're in.

And if you just thinking about the strategy that the Company's currently on and the role that ancillaries has played in our growth relative to the core payroll clients, you start to get the flavor that by adding additional products and offerings you can get a pretty significant impact out of the markets that you're in.

So I don't see anything that tells me that we are getting close to hitting a wall.

I think there's great opportunity in our base business and I think there's lots of places for us to go and do some quality exploration in terms of new growth initiatives and new investments that we might make to continue Paychex's long history of growing its revenues and its income way beyond what would be the traditional rates for the U.S. economy or even the Dow.

Okay.

And Europe seems like it's essentially an emerging market with respect to this product, but are there acquisitions that are available there that you'd look at?

In Europe?

Correct.

The interesting thing about -- at least what we've -- our initial studies of the European market are that the majority, and this is certainly true for Germany, the majority of the payroll that's being done by a provider outside of a company doing it itself is being done by CPAs.

There are very few large payroll companies around the world, certainly in Germany that's the case and in the other major markets in Europe that we've just started to look at.

So acquisition's probably not going to be the first action that will cause us to get into those markets.

That also, by the way, is relatively true for the U.S.

Although we've had a lot of acquisitions, they tend to be -- of payroll companies, they tend to be of smaller companies.

I don't think it's going to be acquisition that's going to be the major way we get our entree into the European market.

Thanks.

Pleasure.

Greg Smith, Merrill Lynch.

Hi, first on what's left as far as the integration of Advantage and InterPay?

Basically InterPay is done, ceases to exist basically as of right now.

Advantage is a different situation.

First off, when you talk about these two acquisition, Advantage was a much better company than InterPay.

That doesn't mean we wish we didn't buy InterPay, it's just Advantage was a much better company.

The product was a little bit better.

They had some sales force.

They had distribution across the country.

They also had several other revenue opportunities that turned out to be reasonably good for us.

One is New England Business Systems, which basically is a private branded system, and then we also have some associates, there's about 15 of them that basically have territory rights, et cetera, and they do reasonably well also.

So we cannot just simply convert these clients and eliminate the need for the platform.

So that's why we chose to do InterPay first.

We will now start to address Advantage and what to do with their platform although it's not a real big issue to maintain it.

Over time we probably won't, but in the meantime, we've got to come up with good solutions for the associate network as well as a good solution for nebs before we do that.

So right now I don't see us in a big hurry to complete that.

Okay.

Then on the PAS product, where are those clients -- the new clients typically coming from?

A fair number I think it's 40 to 50 percent, I could be wrong on that, I'm giving you my off-the-cuff, is the -- comes out of our current client base where somebody has payroll.

A big change in the selling environment today is, it used to be the core guys just kind of went in and tried to sell.

We are much more into team selling now where the core guy, depending on the situation, he may bring 1 or 2 HR people with him, he might even bring an MMS person with him.

It's really team selling and then finding out what's the best solution for that client and what works for them.

Now it might be they don't want to be a lot of ancillaries, it might be they want the full thing.

So I'd say about 40 percent comes out of there and then the rest is brand new.

Okay.

And then last question.

You talked about maybe some acquisitions and you've been successful cross-selling.

Is there any kind of corporate -- or is there any reason you wouldn't look to partner with somebody that maybe has a product that you could sell into the customer base or would you really want to own all those products?

I will give you my opinion and let Jon give you another opinion and it might be totally different.

Our problem with partnering is we like to makes lots of money.

And usually, we want so much of the profits the partner doesn't want to do any business with us, okay?

We have high margins.

We like to control our client base.

And the other thing is, we just haven't seen many partnerships that work long-term.

We are not looking to educate somebody in the payroll business.

Sometimes they are not looking to educate us in whatever they do, because we have such critical mass that we can do it ourselves.

We tend to not do partnerships because we haven't found a way to make them to be lucrative enough for both people or make sure they are going to be long-term enough for both people.

Now, I don't think that means we wouldn't do one, but we've never been able to find one that fit our definition.

I will set Jon give his comments on this.

It's pretty similar.

There's a little bit of a different twist in the way I look at it, but relatively similar.

And what I would say is that I am always open to partnerships.

Through my work career, I've had lots of experience dealing with partnerships, and so clearly there's nothing about it that would cause me to not be open.

I would be very open.

The place where I end up -- mostly the same place I think John does. but with a little bit of a twist is, when we think about the markets that we want to go into, we have a philosophy here and it's one that I had before I came here, so it was easy to for me to subscribe to it.

We have a philosophy of sticking to our knitting.

Staying where we have good core competencies, and so you'd have to find for a place for us to be interested in partnering, you start out with the thought that it would have to be relatively close to our core competencies and if that's the case we probably would be more interested in either growing it ourselves or acquiring the company that might be interested in partnering with us versus pure partnering.

With that said I am not -- it's not that I'm opposed to it.

I am very open to it.

It's just not clear to me at least in the first 90 days that a scenario will come about where a partnering approach would be a better approach for us than either growing it ourselves inside or acquiring a company that had the offering that we wanted.

That's good stuff.

Thank you.

Kartik Mehta, Midwest Research.

Good morning, a couple of questions.

First on the Stromberg acquisition.

It sounds like the time and attendance area is full of opportunity.

Is Stromberg enough for you to build scale or do you need to make more acquisitions in that area to have enough scale for it to make a difference?

Stromberg is absolutely enough in terms of us getting into the market and what they bring to us is they bring an excellent understanding of the time and attendance market.

They bring an excellent set of platforms and products.

The scale will come from us, and that's why these two companies coming together was such an attractive proposition.

We have the market access.

We have the long legacy of performing well and at very high customer satisfaction levels with our clients.

And then they bring to bear the subject matter expertise in time and attendance and the product platforms.

So the 2 of those happen to be a very good marriage.

But in terms of scaling, if you think about the Stromberg offering being a combination of software and some hardware, scaling software is easy, and that's where I came from.

Scaling hardware is relatively easy as well, particularly in an integrated solution like this.

So I don't see any issues with us scaling it.

It's just a matter of making sure that we do it properly both for ourselves and for our clients.

And a question on the new hire side.

I think you said new hires were up 2 percent.

I was wondering, one, if that's a year-to-date number?

And if so, would you be able to give a number for this quarter?

Month over month.

I'm sorry, John, you said?

Month over month.

Okay, that was month over month.

And one final question on the PAS product, John, how much of that sale is re-occurring (sic) and how much of it would you say is a one time sale?

What do you mean when you say re-occurring?

What I mean is products that -- such as your payroll product where the customer is consistently buying it month to month whereas you might buy a product just one time and not have a need for it again.

The PAS product -- think of it as a bundle.

And the PAS product is something where it's geared at a customer who has got -- has got the needs that are more sophisticated than just cutting payrolls for their clients.

And if you think about it, it's almost -- the easiest way to think about it is it's a bundle of all the things that we do on behalf of our clients in the human resources area, as well as in the payroll area.

So once a client comes to us on PAS, typically they will stay with us over time.

So it's a -- I don't see -- when you say recurring -- it's a recurring revenue stream, if that's what you mean.

But I don't know about recurring --

The model's the same [inaudible].

Thanks, John, I appreciate it.

Pen Jian Wong [ph], JP Morgan.

Did you give the sales force turnover metric in the quarter?

I'm sorry, could you repeat the question.

Sure, the sales force turnover, did you provide that metric?

I don't know that we provided it or not.

John, why don't you give it.

Basically, we hadn't said it yet, but it's slightly under 30 percent so it's the best it's been in a long time and we are happy with that.

Okay.

Good to hear.

And also can you comment on the ADP and Microsoft partnership?

Did you compete for that business and how do you expect it's going to change the competitive landscape?

I don't believe we competed for it, but sometimes people participate and I might not have known about it.

But this is big enough I would have probably.

ADP right now is trying lots of ways to increase its penetration in the payroll business.

And maybe they will be successful, maybe they won't, but we think way down in the low end, we are dealing with people who do not want to do it theirself and we have great contacts with these CPAs, and we've seen lots of new things come at us over the years.

It doesn't mean we don't look at them and address them.

This one here is far too early to even know enough about to know exactly what would happen, but we believe it takes a lot to change this landscape, because Tom goes back 30 years on this landscape.

PCs coming in, lots of things -- the Internet, and a lot of it a stays the same because what people want to do remains the same.

But we'll keep watching it and we'll see what happens, but it's too early to know anything now.

We haven't heard the sales force complaining yet, which is always a good sign.

The one piece I'd add to that, if you think about a company like Microsoft where for the first time in 20 years it started about 1999, 2000, where PC physical volumes flatten out or are actually even went down a little bit, so where they got the majority of their growth in their operating systems it comes from units.

They've got need to grow, and ADP has obviously got need to grow.

You can't look at a company like Paychex and the success it's having, and if you have a need to grow, not try to figure out a way to get into that market.

So it's a different way of telling you, you are going to see new entrants attempt to come into this marketplace all the time, driven largely because of the size of the marketplace and the success that Paychex is having.

So it's -- to me, on every call I'm sure you are going to have another person who is trying to get into this marketplace, and we are going to stick to our knitting, as I said earlier.

We are going to stay focused on what we do well and we expect there are going to be other people trying to get in there, and the thing that will keep us in the position that we're or growing our position is how well we perform, not who else is showing up in town hoping to get at this area that we've done so well in.

Understood.

Anything new from Intuit, since we are on the topic?

No, if anything we think they've realized this isn't easy.

Very good.

Thanks, happy holidays.

Thank you.

Marta Nichols, Banc of America Securities.

Good morning, thanks.

On the interest income line, we are now I think below 4 percent of revenue and the peak was obviously a lot higher than that.

Other than the big decline in rates that you've seen, is there anything else in terms of the structure of your fees to payroll clients that's lowered the contribution of interest income to your revenue?

No, it's -- well there's a few factors going on that you need to be aware of.

First off, the float money was mostly affected by rate.

But now most of the float money comes off tax pay.

So tax pay is pretty close to maturity.

You could argue it's at maturity, so the growth in float income related to tax pay is simply going to be average balance in client base growth, so it's not going to equal our 12 percent growth.

Direct deposit float income is no where near as big as tax pay, but that business continues to grow in the use of the ready checks product, which gives more float to us because the checks are drawn on our bank account versus the clients'.

That increases.

That's one reason why our short term/long-term component is adjusted to 60/40 short versus long is the float part of the direct deposits increasing.

But my belief is that float income may become slightly important to us, but it's not going to change dramatically, but it isn't going to grow dramatically either where the interest rate fluctuations cause significant issues.

Okay.

And then just a follow on to some of the earlier strategic questions for Jon Judge.

I understand your strategy sounds very much like if it isn't broke, don't fix it, and given that you're pretty comfortable as it sounds like you are with management and strategy and so forth, are there any areas where you think given your background that you can really add value?

That shouldn't sounds as mean as it did, but is there something that you think you bring that's different that Paychex didn't have previously?

I have a lot of experience in the international markets and Paychex has made -- has had most of its experience in the U. S. I've had a lot of experience in larger enterprise clients.

All of Paychex experience and success is in smaller.

And that doesn't mean, by the way, that we are going to either go to international or go to large clients, but those are areas where we are not participating today, where there are fairly significant spends going on and I have got a lot of experience in both of those areas.

Just in general management experience that I've had in almost across the board I've got a lot of experience in sales and marketing, I got a lot of experience in senior executive level management.

All of those things, the disciplined advantage of measurement systems, management systems, business process management, all of those things can't help but help my ability and Paychex's ability to continuing to do good performance going forward.

On the part about if it ain't broke, don't fix it, while I know when there's change in a company, particularly at the senior levels of management, everybody wants to understand quickly as to whether or not there are going to be major strategic shifts and I would even argue that there are some senior executives who feel it's important that when there's a new sheriff in town, they got to go make dramatic changes so that the world knows there is somebody new in place.

I have never had those feelings.

I've always felt like you ought to mange a company to where it is and where it needs to be.

This company is a very well run company that went through a normal CEO succession, and in my personal opinion, trying to jerk this company around into a new way of doing things with the experience that it's had would be exactly the wrong thing to do.

That's really helpful.

Thank you very much.

Tim Willi, A.G. Edwards.

Thank you, good morning.

A question for John Morphy.

Looking at the core processing operating margins, and if you look out several years could you give some kind of qualitative assessment between payroll versus the HR versus the retirement services, where the biggest incremental gains in the margins will come from and I guess just any color as well on a relative basis, whether the HR and 401(K).

As you look at those businesses and the market opportunities, where their margins relative to the payroll could eventually sort of shake out?

Basically everybody wants to look at it kind of the way you just described and it really doesn't quite happen that way because what you do is all our products obviously have very high margins or we couldn't have this absolutely wonderful pretax percent of revenue, which is approaching 40 percent.

Basically, what happens though is when we take a payroll client on, that like produces a core base of data that we now have in our system.

The beauty of these ancillaries is we are able to offer an outstanding cost value proposition to the client, meaning we give them more services at a selling price that is very attractive to them, but at the same time provides us with an absolutely wonderful profit opportunity because we already have the data.

In other words, there are very few record keepers, maybe none in the 50 and under market in 401(K) that make money.

We make money because when my 401(K) guy goes and sells this client, we don't have to go get any data, we've got it, and we can pass that data.

We also can make the service better because we can go move money.

Not only one of those record keepers is excellent at moving money.

We don't have to fight for the owner.

How are we going to get the money from them and all that.

The system has some built-in advantages.

The same thing, tax pay, one person can satisfy about 3,500 clients because we are centralized in Rochester.

Direct deposit, one person satisfies about 8,000 clients.

So you can see the revenue per person on those ancillaries, sometimes it's in the millions of dollars.

So that's how our margins go up.

They go up by us taking a good core payroll system and adding more things to it that because of what we already have we can do it at a phenomenal profit level, yet offer at a price that's very favorable to the customers.

So that's what happens.

I really don't look at them and try to say, do we make more money on 401(K) versus core.

Well, we do in a way, but that's because I don't allocate any cost to the 401(K) for getting the data.

So our margins don't go up really based on cost reductions, they go up based on continuing to offer these products that expand off our offerings.

Okay.

So would it be, I guess, a safe assessment on our end that the -- as we look at growth rates of payroll versus the ancillary that there is an increased likelihood of margin expansion as the growth rates of the ancillary stay strong?

If we were to, for some reason, believe or see those growth rates slow for whatever reason, the likelihood of incremental margin improvements for the entire company would begin to abate?

That's a true statement if you thought that was going to happen, but that's the challenge that we have as a management team is to make sure we keep taking this product portfolio and we don't leap it outside, but we gradually enhance it with things that we can do what we are talking about, or you find things -- now I can give you a scenario where margins actually could go down and you would be thrilled.

PAS margins are a little bit less because of the workers' comp component as well as the consultant component, but the revenue growth there could be bigger.

So I could give you a scenario in 5 years where PAS is just so big the margins went down, but we made a whole lot more money.

What we are into is growing profit at a certain level.

We want to grow it faster than revenue unless we have some environmental switch that means we can still get the profit growth we need without that happening.

But based on where we are right now, I feel comfortable with margin expansion continuing for 3 to 5 years.

Beyond that it's hard to predict anything in this world, but we feel real good about the growth of ancillaries and our ability to leverage.

Great.

Thank you very much.

David Grossman, Thomas Weisel Partners.

Thanks.

John, you mentioned several times on this call about the opportunity within the existing small business market and penetration rates.

Could you maybe help us understand some of the things you are doing there to access that market opportunity?

The same things we've always done.

I wouldn't say there's anything unbelievably new.

We really chase CPAs hard.

We track calls to CPAs, visits, closing percentage, all those things.

We push hard our national account programs with banks, whether they are with the subways of the world, we push the telemarketing end of it with people that make calls and get appointments.

I think we are pretty much on a full frontal attack in all the ways that we can.

That does mean there won't be new ways, and maybe the guy I got sitting next to me will think of a few more, and or he'll challenge Walter to find a few more.

Walter is always working on this.

Walter is a major shareholder in the Company, the sales guy, and we keep doing those things.

The thing about payroll is, there's nothing magical about this.

And people say we'll try this new thing, most of these new things don't change much.

This is a business where it's feet on the street and it's making sure your operational people are committed every day to servicing that customer in the best manner possible.

So then your comments are really directed at just sustaining the current growth rate?

No, we always like to make it better.

But you've got an economy that moves around.

You've got new business starts that move around.

We always like to do better.

Okay.

Thank you.

Sean Keenan, Raymond James.

Yeah, hi.

This is Sean Keenan in for Mike Baker.

What is the size of your dedicated sales force for just the PEO?

I don't know the PEO by itself.

If you want to look at the website you can find it for--

The PAS and PEO are together, right?

Yes.

Okay.

Because actually at the first quarter, it was 105.

It hasn't changed--

It hasn't changed.

-- we upped the sales force once a year in the May, June time frame.

Okay.

And what about turnover in that segment?

Sales force turnover.

Probably less than the 30 percent.

Less than 30 percent.

And last question is, can you talk about the pricing outlook and the competitive environment in the PEO segment?

Thanks.

First off, the PEO segment isn't that material to us, but outlook is that we are the best PEO there and we have the highest quality clients and that's based on not taking risk on workers' comp.

Pricing is pretty much in the market.

They bid each job because they're bigger jobs.

I would imagine we still get our 3 to 4 percent.

We are competitive and while it is competitive down there because we are the best, we are the leader on doing certain things.

We are at the hour and a half point here so we are willing to take 1 or 2 more questions, but I think in the interest of moving forward we would like to end it.

Adam Frisch, UBS.

Hi, guys.

This is Steve Stout for Adam.

Have you seen any incremental discounting here at the year-end, particularly from ADP, or pricing pressure that is unusual?

ADP always has price pressure on this time of year.

I don't think it's any worse this year than it's been. 2 years ago it was -- 2 or 3 years it was pretty extreme.

We then kind of countered by not so much raising -- lowering price, but obviously I know some of our clients, I know some of them we aggressive went after that found some of the clients that were unhappy with them.

Pricing is pricing but you got to remember the pricing pressure here is in two places.

We have the recurring base where we put the increase in in May.

Those people if they are happy with you, they do not leave.

Then we have the new sale environment where we can be just as competitive as they are.

No one client matters big time to either one of us, so we keep pushing it.

But I don't think the discounting is that dramatically different.

Just to clarify, I think you said that pricing increases added about 3 to 4 percent to revenue, is that right?

Yes.

And you've talked a lot about the ancillary services and I know you touched a little bit upon the on-demand product and the joint venture between Microsoft and ADP.

Can you talk about any specifics in terms of adding maybe new products or ancillary services that we would see over the next six months [inaudible] to add to revenue?

We have talked about all the products that we can at the moment.

We -- now don't lead that to believe we've got something that's hot that's sitting here ready to announce.

Most of our new products start a little bit slow and then they get rolling as we get the systems going.

We tend to experiment in the client base a little bit.

Right now, some of the new ones we've put in obviously are Time In a Box and that one we'll continue to look at more, and I'm sure our marketing department's got ideas, but we are not ready really to reveal any more of those at this time.

Do you think that the majority of your ancillary products come from the payroll business, or maybe HR, or is it just a blends of both?

Do you see a particular -- better opportunity in ancillary in one or the other?

We focus on the employee and all the administration around a paycheck and employee benefits.

That's our focus.

I wouldn't call it just payroll, and I wouldn't say we try to look at payroll versus human resource opportunities as one as better than the other.

They are grouped in, and that's what -- Jon referred to staying in our knitting.

I think we will stay close to the payroll part as well as employee benefits.

A good example, if they put in a medical retirement savings plan we would jump on that so fast and be right there and be a leader in it.

If you start talking about some things we tried in the past, we are trying to leverage purchasing power because we've got 500,000-plus clients.

We tried that with phone cards and other things, they're commodities that doesn't work too well.

So we're looking for things that are right close to our knitting, but they're really around that employee benefit and the employee himself.

Last thing, did you guys mentioned your utilization rates for tax pay?

Yes, it's 90 percent.

Okay.

Thank you very much.

At this time I would like to thank everybody for their participation.

Jon got through his first one here I think pretty well.

It was fun.

For me it was a little different.

I didn't the other guy next to, but then I didn't have him glaring at me either.

Tom, I don't know where you are today, I'm sure you are on the call someplace and you gave us a great company to continue some great traditions, and I can assure you the management team here is well committed to doing that and I wish all of you a very happy and enjoyable holiday season.

Thank you