沛齊 (PAYX) 2005 Q3 法說會逐字稿

Good morning and welcome to today's Paychex third-quarter earnings release teleconference.

Following today's presentation, there will be a formal question and answer session. (OPERATOR INSTRUCTIONS) At the request of Paychex, today's conference is being recorded for replay purposes.

Should you object, you may disconnect at this time.

I would now like to turn the meeting over to today's host, Mr. John Morphy.

Sir, you may begin.

Thank you for joining us today for our third-quarter press release.

Also with us is Jonathan Judge, our President and CEO.

The teleconference call will be comprised of three sections -- a review of the financial results, including comments and guidance for the remainder of fiscal 2005; an overview on comments from Jon Judge; and lastly a Q&A session.

Yesterday afternoon after the market closed, we released our financial results for the third quarter ended February 28, 2005.

This press release can be obtained by accessing our website at our Investor Relations homepage, www.Paychex.com.

We have also filed our Form 10-Q for the third quarter ended February 28, 2005, and this filing is now 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 April 22nd.

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

As usual, we are quite pleased with our third-quarter results.

They are in line or slightly ahead of expectations and follow the Paychex tradition of record total revenues, net income and diluted earnings per share.

The third-quarter earnings release is briefly summarized as follows.

Total revenue growth was 9% for the third quarter and 11% for the first nine months of fiscal 2005, which in turn generated net income growth of 15% and 11% for respective periods.

Total revenues for the first nine months of fiscal 2005 were 1.1 billion.

Quarterly earnings per diluted share were $0.24 versus $0.21 a year ago, up 15% on an unrounded basis.

Year-to-date diluted earnings per share were $0.70 versus $0.64 a year ago, up 11% on an unrounded basis.

Moving to the consolidated income statement, payroll service revenue increased 8% in the third quarter and 9% in the nine months of fiscal 2005.

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

In the past, we have discussed the fact that we do not always have comparable billing days quarter to quarter.

This was the case in fiscal 2005 as we had one extra day in Q1 and one less day in Q3.

One day affects year-over-year growth by approximately 1%.

Thus the growth rate for payroll service revenue in the third quarter was slightly less than normal.

Major Market Services revenue increased 25% and 27% for the third quarter and nine months of fiscal 2005.

Approximately one-third of our new Major Market Services clients are conversions from our core payroll service.

Human resource and benefits service revenue increased 13% for the third quarter and 24% for the nine months of fiscal 2005 to 65.1 million and 175.2 million respectively.

The increases reflect growth in clients for Retirement Services, growth in client employees served by our Paychex administrative services and professional employer organization, bundled services and the benefit of revenue from the April 2004 acquisition of Stromberg time and attendance products.

The lower than normal revenue growth for the quarter relates to recognizing favorable PEO worker's compensation adjustments related to prior years in fiscal 2004.

Excluding total PEO revenue, human resource and benefits service revenue increased 25% and 28% for the three and nine months of fiscal 2005 respectively.

Fiscal 2004 growth rates, excluding the PEO, would have been 25% and 22% for the nine months.

Retirement Services revenue increased 17% in both the third quarter and nine months of fiscal 2005.

At February 28, 2005, we served over 32,000 Retirement Services clients.

Sales of PAS and PEO products have been strong with administrative fee revenue from these products increasing 32% in the third quarter and 40% in the nine months of fiscal 2005.

As of February 28, 2005, our PAS and PEO products serviced just under 200,000 clients’ employees.

Our financial growth continues to be impacted by fluctuations in interest rates earned and net realized gains and losses on sales of available for sale securities in the funds held for client and corporate investments portfolios.

We do not anticipate recognizing a significant amount of gains or losses during the remainder of fiscal 2005.

The third quarter reflected our first significant increase in interest on funds held for clients since fiscal 2001.

Looking ahead we expect this trend to continue based upon current and anticipated interest rate levels.

We refer you to our Form 10-Q for a more detailed explanation of the effects of fluctuations in interest rates.

Consolidated expenses, excluding the 9.2 million charge for pending legal matters recognized in Q3 of fiscal 2004, increased by 10% and 11% respectively for the third quarter and nine months of fiscal 2005.

These increases are primarily due to increases in personnel, information technology, and other costs incurred to support organic growth and the additional expenses incurred as a result of the acquisition of Stromberg in April of 2004.

There were approximately 9,900 employees at February 28, 2005, compared with approximately 9,300 at February 29, 2004.

Investment income net decreased 2% for the third quarter and 33% for the nine-month period.

The decreases are primarily due to lower net realized gains on sales of available for sale securities, partially offset by higher average portfolio balances.

The nine months of fiscal 2005 was also impacted by longer-term interest rates which were lower through much of the nine-month period.

We do not anticipate recognizing a significant amount of gains or losses during the remainder of fiscal 2005 in this category either.

Our effective income tax rate was 33.0% for both the third quarter and nine months of fiscal 2005 compared with 32.7 and 32.6 for the respective prior-year periods.

The full-year fiscal 2005 effective income tax rate is expected to approximate 33%.

We will now move to a discussion of our balance sheet.

Cash and corporate investments have grown to 693.4 million.

Our cash flow from operations increased 42.5 million to 367.5 million for the nine months ended February 28, 2005, in the same period a year ago.

Our total available for sale investments, including corporate investments and funds held for clients, reflected net unrealized losses of 7.4 million at February 28, 2005, compared with net unrealized losses of 4.2 million at May 31, 2004.

The higher net unrealized loss position at February 28, 2005, was driven by a recent increase in longer-term interest rates.

The three-year AAA municipal securities yield increased to 2.6% at February 28, 2005, from 2.5% at May 31, 2004.

Our net property and equipment balance activity during the first nine months of fiscal 2005 reflected capital expenditures of approximately 41.0 million, depreciation expense of approximately 31.7 million, and the net book value of disposals of capital assets of approximately 4.1 million.

For fiscal 2005, capital expenditures are expected to be in the range of 55 million to 60 million, including anticipated purchases for printing equipment, communications system upgrades and branch expansions.

This number is a little bit less than what we announced previously as we have pushed off some of our capital expenditures since there was not really (ph) time to implement all of them.

The fiscal 2005 depreciation expense is projected to be in the range of 40 million 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 Stromberg in fiscal 2004.

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

Intangible assets are amortized over periods ranging from five to 12 years, using either accelerated or straight line methods.

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

Total stockholders equity increased to 1.3 billion at February 28, 2005, with 143.8 million paid in dividends in the first nine months, a payout of 54% of net income.

Our return on equity for the past 12 months was 26%.

In February 2005, we increased our borrowing capacity under our uncommitted secured short-term lines of credit from 600 million to 900 million.

Legal contingencies.

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

The litigation relating to Rapid Payroll remains in progress.

To date 32 lawsuits have been commenced with 12 settled for approximately 7.5 million.

During February of 2005, we received favorable rulings from the Los Angeles Superior Court and the Federal District Court.

Legal reserves totaled 27.4 million at February 28, 2005, and are included in the other current liabilities on our consolidated balance sheet.

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

Fiscal 2005 guidance.

The guidance for fiscal 2005 is summarized as follows and continues to be very close to the guidance we provided last June.

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

Human resource and benefits service revenue growth is expected to be in the range of 21% to 23%.

Obviously that is lower than normal because of the PEO worker's compensation adjustments that we previously mentioned in fiscal 2004.

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

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

Interest on funds held for clients is expected to grow in the range of 4% to 6%, reflecting the benefit of increasing interest rates.

Total revenue growth is estimated to be near the upper end of the range of 9% to 11%.

Corporate investment income is anticipated to decrease approximately 25%, whereas net income growth is now expected to be in the range of 17% to 19%.

As usual, 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 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 three 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 Jonathan Judge who will provide his comments on the third quarter before we open the meeting for questions.

Great, John.

Thanks.

I just have a couple of comments to add to that I think excellent review that John took you through.

I will start by the way in publicly congratulating John.

He was just selected as the second-best CFO in the technology sector by Institutional Investor Magazine in the new list that came out, and I think it's terrific that he has received this public recognition for the terrific job he is doing.

On the Company, we will start with a review of the quarter.

I wanted to do three things I guess -- talk to you a little bit about the quarter and some comments that I had on the quarter; and then secondly a couple of comments on the economy and sort of how we see the macro model that we are operating in; and then lastly, just give you a little insight on some of the things that we are working on.

So we will start with the quarter.

Obviously I was very pleased with the performance that we had this quarter.

We saw across the board strength in our businesses, and I think the results show it as John just took you through.

In the payroll side of our business, if you look at the Core Payroll piece, which is by far and away the largest part of our business, that continues to grow.

It grows well, and perhaps more importantly for us, it is growing almost exactly according to the plans that we have laid out.

That is the growth that we see in that business that comes from the clients, the growth that we see in that business that comes from the success of selling our ancillary products, and the growth in that business that comes from the appreciation that we get in terms of price increases for the work that we do to consistently improve the offerings that we have.

MMS, which is the payroll business that we do for our larger clients, pretty much same is true there, only their growth rates are even higher.

John talked about a growth this quarter of 25% for our MMS business, and again that continues to be a very strong growth area for us.

That business recently -- we put a press release out this quarter -- recently passed its 25,000 client mark.

So it continues to be strong.

If you look at our ancillary businesses, Taxpay and direct deposit, worker's comp, health insurance, flexible spend accounts, retirement services and so on, all of those businesses had a good quarter.

Just a couple of numbers to drive a point home.

Taxpay and direct deposit, which are two of our very large and very strong businesses well penetrated, continue to improve.

On the Taxpay side, we now have over 90% of our clients using Taxpay; and of the new clients that we land, 97.7 or almost 98% of them include Taxpay in the initial offerings that they take from us.

On direct deposit, we are now over 65% of our base that have direct deposit.

And of the new clients that we are signing on board, the rates are now in excess of 76% that take this offering as well.

So it's a good way I think to see not only the success that we have had in the past, but the fact that even in some of our more penetrated products that our success continues and our growth continues in those areas.

On the outsourcing side of the house, both PAS and PEO continue to drive very strong results for us.

PAS is now over 5,000 clients.

PEO is over 2,700 clients.

In the combined outsourcing business, we are dealing with over 200,000 employees.

And then the last piece I wanted to mention was a relatively new offering we have, something called HR Online.

It is only about a year old.

The way to think about that is a series of forms and tools and techniques that allow our clients online to manage critical data about their employees and then give access to both the employees and the managers to that data.

Things like vacation days, sick days and so on.

That product has had terrific take-up.

We now have over 30 clients that have 1,000 employees or more.

It is becoming one of the leading offerings that we use when we are dealing with larger clients because of the strength of that offering and the value that it has obviously shown to these clients.

So again another very significant growth area for us and doing real well.

On some other areas of our business that I wanted to sort of touch on, some things that happened in the quarter that we found very positive, year-end, as you know, is extremely important to our clients and, therefore, to us.

All of the year-end processing, particularly W-2s, we went through this year's year-end with near flawless execution.

A terrific job done by our operations team.

And an example of that would be the fact that in our Core Payroll business, which again is one of the largest -- well is the largest piece of our business -- we had the majority, the overwhelming majority of all the W-2s in our clients' hands by January 11th.

So one of the best closes that we have had ever and that continues.

As well, we do a lot of work on client satisfaction, and our client satisfaction rates are now at record levels for the Company.

So we have really got a lot of positive things going there.

And John obviously talked about our balance sheet.

It remains extremely strong.

No debt, excellent cash balances, and obviously a very good and positive cash flow generation.

So the overall, I guess when I step back and think about the quarter -- I'm very happy with the way the quarter went.

I was very pleased with the execution that was done by our teams and obviously the results that we got.

Second, on the thing I wanted to talk about was just economy.

We get asked often about what our view of the economy is because we have some unique insight into some of the key drivers for the economy, and I thought I would just touch on that quickly, because that macro model obviously is important to us.

Our view of the economy is that it continues to look strong based on a couple of important drivers.

One, new-hire reporting.

New-hire reporting for the quarter was up 4% versus a year ago, driven by pretty good Decembers and February months, both just out about 2%, and an extremely strong January, which pulled the whole quarter up 4%, which is a terrific indicator.

Second, because of the nature of our business, we get a chance to see a lot of the bonuses, year-end bonuses, that our clients are paying out; and the bonus checks were very strong, evidenced by a 12% increase in the average funds held for clients in that period of time.

So that was another indicator for us that said the economy is running strong.

And then finally, new business starts, and those remain good.

And so we have coupled that with what's happening with the interest rate environment, and we walk away saying that the economy is pretty strong, particularly those drivers of the economy that have a direct impact on our business, and so our outlook remains pretty positive going forward.

The last thing I wanted to touch on and then we will open to questions is some of the things that we are working on, just to sort of give you a flavor for what we are focused on inside the Company and what we're trying to drive.

The first part would be our next year budget and operating plan.

We are in that cycle right now.

We are getting close towards the end of it, so we've done a lot of work on our whole planning process.

We have tried to reinvigorate that planning process and scrutinize literally all elements of our business to understand where there are areas where, if we provide more investment, will we drive enhancements to those particular elements, so it will give us a chance to be able to drive more aggressively for growth in next year's plans.

So there is a lot of work going on around that, and the work has all been extremely positive and a really good team effort by all of the key players on our team.

Second, we are doing the same thing with all of our offerings portfolios.

We are going in and looking at every one of our offerings.

Again, where there are areas where investments or enhancements would have a positive impact into the marketplace, we are making those decisions as a team to make those investments, as well as looking at areas where we don't currently have offerings, but would be areas that would be positive for our business if we develop those offerings and release them.

So there's a fair amount of work going on in that area.

Obviously we continue to evaluate other opportunities, be they geographic or from an M&A standpoint.

We will continue to do that.

You can imagine in a company like ours, or a business like ours, where we have as many clients as we do currently, over 500,000 clients, and a distribution network to get to those clients, there are lots of opportunities that are presented to us -- unsolicited I might add -- of people who are looking for a chance to hook into our distribution channel to be able to get at those clients.

Now we are fairly stingy about how we deal with those things, but we end up getting a chance to look at a lot of different alternatives, and obviously we will continue on that path.

And then finally, we are working on some execution areas that will continue to drive the superb execution of our Company.

Two or three areas that I would tell you that we are working hard on right now are in the areas of attrition.

That would be mainly focused on our sales attrition and our payroll specialist attrition.

We are focused on client losses.

Because if you think about the net new client gain that we get year in and year out, that is really two pieces that fill that equation.

One are the clients that we capture and two are the losses of clients that we have that we had captured in years past, so we are working on that.

I mentioned to you earlier we also have got a lot of work going on in the client satisfaction arena as well.

So lots of good things going on inside the Company.

Again I will reiterate, I think the quarter was a very good quarter for us.

I think the results speak for themselves, and I am pretty enthused about both our position today and what we have to look forward to in the future.

With that, I will end my comments and then open it up to questions.

(OPERATOR INSTRUCTIONS) Bryan Keane, Prudential.

We are through the key selling and retention period, but I just wanted to know what you guys now are expecting for fiscal year '05 client growth or new client growth?

We said it is going to be less than 5.

You know it is going to depend on what the next couple of months do.

We are not totally alarmed by that.

It is not quite where we would like it to be, but we have had a very good year on revenue, which is where our sales force is primarily focused.

The one difficult side is the effect of Advantage and InterPay on client growth has continued a little bit longer than we thought it would.

But we feel very comfortable with our long-term goals and the guidance on revenue that we have briefly have given for next year.

Okay.

And just an update on Advantage and InterPay, where we are on moving those customers on to the Paychex platform?

In both cases, they are fully integrated.

In one, in the case of InterPay we have integrated them onto the Paychex -- most of the -- onto the Paychex platform.

In the case of Advantage, their platform was a good platform, and so we've left most -- many of their clients on their compute platform, but they are fully integrated into our business, into our branches and so on.

In fact, it is an area that I have found pretty interesting because I know that whenever you go through a major integration effort -- in this case, we are talking about close to 80,000 clients -- there is always -- whenever a company announces that they are doing an acquisition, everyone gets a little bit skittish about how well will they be able to do the integration of those clients?

In the case of both the InterPay and Advantage integration, my view of it, having watched the tail end of it and then all of my visits into the branch offices, this integration has been superb.

Okay, great.

And then just, finally Microsoft and ADP are teaming together to offer accounting and payroll services in this small business.

Do you guys see that at all as a competitive threat?

Obviously, you know, anything that any one of our competitors do or announce you have to take it as a competitive threat.

There are some threats that I would say are major threats, and there are others threats that are -- I guess at best you could say they are interesting, and we will see if anything comes of it.

In this particular case, there is not any question but that that is something that we have to watch, but it is not one that either have seen any immediate results on in terms of our client base or any of our accounts that we are competing for.

Of course, you know with my background, I have been around Microsoft for many many years.

I know quite a bit about their company.

They have done lots and lots of partnerships.

In this particular case, I guess I would say it remains to be seen whether or not this will actually materialize into being a significant threat.

But at the moment, it does not appear to be.

Okay, great.

Congratulations on the quarter.

Cindy Shaw, Moors & Cabot.

Congratulations on the quarter.

A couple of questions.

The HR Online, it sounds like it is more targeted at midmarket, and that is a segment that really does not have more than one strong competitor.

Is that an opportunity to help take the MMS to a new level?

And then the second question, I would like to dig in a little bit on the SG&A.

Okay.

On the first one, your observations are correct.

It is not that it is an offering that is not applicable to smaller companies.

But you are right in the fact that the actual take-up tends to be more in larger companies.

It is sold through our MMS team, and it has gotten to a point where in many of our client engagements they actually lead with HR Online.

So it has got great functionality for the client.

It's got immediate bang for the buck for the client.

It's got immediate applicability, and of course, you know I talked to you about some of the numbers with it.

So it is early on in the game obviously, but we are pretty enthused about the results that we have seen so far.

We are very enthused about the customer response to the offering, and the fact that it fits so well into our family of products that we target against the midmarket.

I guess I just conclude that your observations are correct, and I think the assumptions that you have made or the conclusions you have drawn are also correct.

Is that something that can also help take costs out to serve those clients?

It is actually more of a functional enhancement than it is a cost reduction, and most of the clients -- and on the cost reduction side, I presume you meant for the client?

Both you and the client.

Yes.

On that side, in part it would depend on whether or not they even had an offering or not.

But clearly if they did not have an offering, and you went to an online version of this, and put all of the forms and tools in one place, and managed all the data in one place, it would have to be a cost savings.

Right.

And then on the SG&A, in the past I thought I heard we are going to get mid single digit to high single digit growth in SG&A expenditures in fiscal '05.

It looks like it is tracking a little higher than that, and I noticed in the 10-Q this morning that previously there has been some guidance around operating income minus float.

There was no comment there.

I'm wondering if we are having a change in thought around the SG&A and operating income growth?

Well, I think on the SG&A, Cindy, as we typically do, when we get a year that gets a little bit better than we anticipated, we start investing.

So you've got some of the things in Germany.

We've got the Stromberg things.

We also, which to a lesser degree, but actually (inaudible) those two, we implemented a new tax environment by setting up a captive, and that required us to book some accruals that normally we would not have been booking because of the insurance rules on captives.

That affected it a little bit.

But we're going to continue to see SG&A grow I think around 10%.

As the revenue number gets a little more exciting, we are going to invest.

But I don't think it's a major change from where we were, and I can assure you Jon has not come in and given us any new tradition where we can just spend more money.

So you will see us watching this money very closely, but again our biggest goal is to get year-over-year improvement at the bottom line and to continue it in the years to come.

Are you still targeting operating income growth minus flow to 15%?

Approximately 15.

This year we will be very close to that when I take out some unusual items.

Some of those unusual items are the worker's compensation adjustment, the lawsuits obviously, and then we had a couple of other minor things this year.

But we're very close to that number.

Josh Rosen, CSFB.

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

I just wanted to follow up on two items.

First, you had talked about focusing in on attrition both on the sales side and on the client side.

If you could offer just additional color in terms of what steps that might entail and what type of progress that you hope to get out of those steps, that would be helpful.

Sure.

The thinking behind this is actually relatively simple, but obviously the execution is always a little more difficult.

But if you break the two jobs up, and one being the payroll specialist and the other the sales rep, the payroll specialist in my way of thinking is Paychex to the outside world.

They manage the relationship between us and our clients.

They are who our clients talk to day in and day out.

They are sort of the institutional knowledge of our firm relative to that client.

So they are, in my way of thinking, they are an incredibly important part of our business because they are both the service delivery aspect of our business and they are the actual management of the relationship between us and our clients.

So that job is important for that reason.

On the sales side of the house, there is the same types of reasons.

They are the revenue generators for our Company.

They are the people who are solely charged with the responsibility of capturing all of our new clients and setting the expectations for those new clients, so that when we actually deliver service to them we do it at their expectations or greater, which is the key to retaining them over a long period of time.

The other side of the sales part that is also important to us is high attrition rates on the sales side leave us with open territories.

High attrition rates with our sales teams leave us with a much higher degree of new salespeople on our roster of the sales team versus experienced salespeople.

So when I look at both of them, on the one hand, I worry about the attrition rates because -- and this would be the payroll specialist -- because of the effect it can have on our operational efficiency and on the relationships that we have with our clients, particularly as it relates to long-time tenure, to long-term relationships.

And on the sales side, I worry about attrition because of things like open territory, lower productivity coming out of new salespeople that are coming on board, being trained and so on.

So in both cases, my personal view is high attrition rates there will have effects on our ability to manage our business and certainly on our ability to improve the business.

So in both cases, I have been working with the management teams and setting the expectation that attrition rates in the 20% range on payroll specialists and in the 30% range on sales specialists are unacceptable and must be improved.

We're now at the process of going through all the root cause analysis and what are the things that we can change and do better, and as you would imagine, they fall into a lot of the sort of normal suspects.

It is how you hire.

It is who you hire.

It is how you on-board them.

It is how you support them from a first-time manager standpoint and so on.

We are looking at all of those areas, and hopefully -- you know this is obviously something that does not get fixed overnight -- but hopefully you will see us move our attrition levels in those two key jobs to numbers that are much lower -- 5 points, 6 points, 7 points lower in both categories over time.

So that is sort of what we are working on and a rough idea about why we are working on them.

I believe, though, if we get this resolved, it will be -- it will have dramatic improvements in our productivity on the sales force side, in our client retention on the operations side, and quite frankly, culturally it will have a very good effect in terms of proof points for Paychex being a great place to work.

I appreciate all the color on that.

The second question I had related to the PAS product, which really continues to demonstrate great growth at this point.

At what point when you guys look out do you see that reaching a size where you might at least see revenue growth decelerate a little bit?

We still continue to see such rapid revenue growth on that product.

You could see some of that next year because a lot of it in the beginning -- look, we have a product here that can definitely grow very strong.

But as the sales force gets sizable and you can only add so much to it, that actually becomes a limiting factor.

We are still promoting good growth because we have been able to grow the sales force on an accelerated basis.

We have not fully announced what the sales growth next year will be, but the slowdown in revenues will be almost at the same time that the sales force growth does not stay way accelerated.

Okay.

Thank you for the color.

Mark Marcon, Robert W. Baird.

Good morning and congratulations on the quarterly results; and congratulations to you, John Morphy, on the recognition.

Where is Randy?

Randy has moved on.

I know.

I am only kidding you.

Glad to have you with us, Mark.

Thanks, John.

With regards to the discussion about lowering the attrition rates, how much of that is going to necessarily entail an increase in comp?

It looks like you have been getting some good G&A leverage here.

Is that something that we can expect in the following year, or are the retention efforts going to mitigate that?

They are not necessarily comped.

Obviously when you have an area you focus on, you look at all comers in comp.

I have not been in a position yet as a manager where, when you are trying to improve an attrition area, that somebody does not suggest that one of the things you could do is comp.

So I'm sure that that will be one of the areas that will be looked at.

But in terms of anything meaningful from your standpoint as you look at our Company's financials, you are not going to see anything in that that is going to put a blip on the radar screen in my estimation.

Great.

How would you judge the latest group of sales hires in terms of performance and productivity levels?

I don't have any data on the latest group, so whatever I would say to you would be completely anecdotal.

So it's probably best not to say anything.

Okay.

How would you just judge the overall sales-force productivity?

I think the productivity is good.

The productivity has been declining in our sales force over the past couple of years, and I would say that some of the reasons for that are attrition.

Some of the reasons for that are younger people in the sales force.

You know some of the reasons are open territories.

So some of the things that I mentioned earlier.

I fully expect that once we get improvement on the attrition rates that we will see immediate improvement in our productivity.

One thing we should remind everybody that I think we all do know is that our productivity still is significantly higher than anybody else in the industry, and we really learned about that when we bought InterPay and Advantage.

Last question.

What are you seeing in terms of pricing out there in the field?

We are in a new calendar year.

And also specifically, how is it going with InterPay and Advantage in terms of getting them up to normal rates?

We're going to have our same price increases that are probably going to go in consistently on May 1st.

We have started that process.

Obviously it has been approved and ready to be implemented.

Pricing really has two areas.

You have the recurring client pricing, which as long as the service is exceptional, pricing is not that big an issue because it isn't that big an amount of a change.

In a new environment, a new unit environment, you have some competition there.

Sometimes discounting is there, but I don't think it's any worse than it has been in the last three or four years.

InterPay and Advantage, we will continue to accelerate their price increases, but we are more interested in making sure we don't rock the boat and retain them, than trying to just make a surge to get pricing back exactly where ours is.

So we are making good progress on that.

Retention on InterPay clients and Advantage client, although the InterPays we don't see anymore because they are fully integrated, has been better than we anticipated.

We continue to be satisfied with what we're doing there.

Patrick Burton, Smith Barney.

It is Rob Summ (ph) for Pat Burton.

Could you guys give us an update on how the expense and revenue ramp-up is going in Germany and Europe?

Well, remember Europe is really small now.

We are approaching 150 to 200 clients.

I would not say we've ramped anything up.

The investment commitment there is probably something less than $2 million a year.

We are probably getting to the point now when we go into the plan to decide how are we going to accelerate that.

I'm sure John is pretty close to giving them the okay to go to another city.

It is probably going to be Berlin, but there could be others.

And I think if we see a little more success there, then I think the push is going to be to see if we can look at some other countries.

But we have got some very good things going on, but we just have to make sure we understand they are still very small at this time.

But then I think the good news is it is possible you can look out five, 10 years and see something that would be pretty good.

But we've still got to do a little more proof in the pudding and see what happens.

Baked into your plans, what’s kind of the breakeven period, after how many years?

Well, that is a hard question to answer because it won't get past breakeven until you have enough mature territories or stable territories compared to growth ones.

So I think this is going to be an investment for at least three to five years, and it is going to take a while to be significant.

Which is why when you look at this, it is an outstanding opportunity.

It is one that really requires a long view.

Yet at the same time if you don't have the long view, you would never do it.

We have done this before in the U.S., and it is going to take a while.

But I kind of call it like a stock option.

It is (indiscernible) yet, but we've got -- this is something we should do or we are not taking care of the future generations of Paychex.

On the M&A front, I guess you mentioned something about distribution, people wanting to get into your distribution capabilities, and could you kind of elaborate a little bit on what kind of companies you're really looking at in the funnel?

You know you start out with what is it that they are interested in.

And to do that, you sort of have to step back and think about the sector.

Small business represents one of the largest opportunities in the U.S. economy.

And for the most part, most players are unable to get into the small business world absent retail because the access, the market access costs are so high that you essentially lose any profit that you might gain just by putting sales forces or other distribution methods into targeting that environment.

So most people sit back and they say, God, I wish I could figure out a way to get the small business, but I make one sales call and I've lost my profit for the year.

Then they take a look at a company like us that has 505,000 or 510,000 clients and a stable existing distribution mechanism, and they say, well, what a great partnership that would be.

We have this great offering, and they have this great distribution method.

Let's put the two together.

The offerings could be anything.

They could be software offerings.

They could be service offerings.

It literally is anything that you can think of that would be targeted at the payroll or the HR world of small business, and they come to us mainly because they have no mechanism to get to these businesses.

We look at all of them.

Some we will look at certainly longer than others, but normally there are very few that will pass the test.

We think about our clients, and we think about our access to those clients as literally part of the family jewels, and we are not going to give those up under any circumstances to anyone.

Partnerships are things that we do from time to time, but we tend to like to do things ourselves because we really care about the value proposition that we offer the clients and our reputation in this market.

So interestingly enough, typically what will happen is if we see something that is of interest to us, the first thing we will think about is buying it as opposed to partnering with it.

But the nice thing from our standpoint is it is more the deal flow that is sort of interesting to us than anything else, because it gives us a chance to really stay tuned as to what is out there and to see a lot of different offerings.

Even if we only took one or two out of 1,000, they could be significant drivers for us as a business.

What are some of the areas that you're looking to add onto your capabilities?

Well, the easiest way to say that without showing too many cards is, anything that you can think of that has to do with employer/employee relationships in a company would be interesting to us.

We are also from a strategic standpoint, we are very committed to sticking to our knitting.

So it is not likely you're going to see us varying too far from the model that we are in today and the types of offerings that we put in the market today.

But in general terms, if you want to think about where it is likely we will go, anything that has to do with the complexity of taxing authorities and rules and regs as it relates to employers is good for our business.

Anything that has -- that an employee -- that could be handled through an employee deduction is good for our business in general terms.

So if you think about the Roth 401(k) work being done right now in the government or if you think about things like flexible health accounts, anything -- if you think about the privatization of Social Security -- any of those things that affect areas that are between an employee and an employer or could be affected by a deduction on a paycheck, those are interesting things for us.

And just finally, just getting back to your comments earlier in the call on the ADP and the Microsoft Office small business accounting alliance, I mean that -- you're not going to see it in effect right now, but it is expected to be launched later this fall in calendar '05.

I mean kind of in a worst-case scenario, what are your kind of fears about that in terms of the self-service market?

And what kind of contingency plans do you have kind of in the back of your mind there?

There are plenty of self-service offerings out there today.

If you think about -- when I think about us, the part of the market that we are the strongest in is not the self-service market.

The part of the market that we are the strongest in are clients who want to focus on their business and want to have a partner help them with the payroll and HR processing side of their world.

In some cases, you might even say that they think of it as a necessary evil.

Those are the clients that we are the strongest with and the clients that we do the best with and the clients that we will stay focused on.

It's not, and again on this particular, on the self-service of the world, we are watching it closely.

You may even see us put offerings out there at some time in the future.

But at the current time, it's not an area that we are spending a lot of time on, nor do we see this particular area as a threat to our base business.

You know when you look at this, the real -- if this is going to be worth anything to ADP, Microsoft is going to have to be very successful in challenging (technical difficulty).

That is a big challenge, and we will have to wait and see what happens.

Okay, no, that is very helpful.

Thanks a lot.

Glenn Greene, ThinkEquity Partners.

Just a couple of questions.

Obviously you just finished your important sort of sales selling season.

I was wondering if you could give us some color on sort of competitively what you saw this season, whether it's the typical usual competitors, if they did anything differently?

Or if anyone sort of emerged or someone you watched noticed anything different?

And also just some color on how successful your sales activity was relative to your expectations for the quarter?

I would say that on the -- did we see anything dramatically different, the answer would be no.

There was nothing that came to the forefront in any of our officers’ meetings or any of the reviews that are done in the sales side of the house that would suggest that there is a major shift in the market as we see it.

And on the sales results side of the house, some of which you know were obvious in the comments that we made earlier, we remain pretty optimistic about the performance that our sales teams have put forward both in the past and in the present.

We're pretty happy with where we are.

Okay and then just one quick question for John.

You know looking at the average fund balances, the 3 billion or so in the quarter, obviously you know you get the seasonal lift, but it was even more so than sort of we were contemplating.

And it sounded like part of it was explained by the bonuses being up.

I was wondering if you can shed some light on the fund balance level?

It was primarily bonuses.

Bonuses were very heavy at year-end, which you know for us that includes we are going to get the Taxpay part of that, as well as the net pay (ph) of it.

I would expect the 12% growth is not normal and will get back down to somewhere between 6 and 10, probably closer to 8.

We will just have to monitor it.

It was a pleasant surprise, and it showed that the economy picked up.

I think what is happening in the U.S. a little bit today is employers are very reluctant to add new people.

They are not so reluctant to reward the ones they have.

Thatcher Thompson, CIBC World Markets.

A quick question.

What percentage of the new clients you add in a year come on stream in this third quarter?

More than 25%.

I would say a third.

A third?

And you are paying out a lot of those sales -- the commissions to your sales force in this quarter without a full benefit of the revenue?

Yes.

That is why -- the third quarter, Thatcher, has lots of things in it that (inaudible) distortion because they kind of work out year-over-year.

Now a couple of those things are first off W-2 income.

We spread W-2 income over basically 13 months.

We double up the one month in January because we believe we earn the revenue throughout the year.

We have clearly demonstrated that we get the money, because most people do pay for the W-2s.

As a matter of fact, one of our collection strengths is a client that might not have paid during the year, to get the W-2s, they have got to pay.

So W-2s hit a little bit.

You've got the expense.

You have got a lot of year-end reports that have transaction fees on some of them, and then you've got this great selling season where we expense the commissions I think around about a one-month lag, so most of the sales take place in January.

So by the end of February, we have a pretty big commission expense thing in there, too.

Okay.

You mentioned new-hire reporting up 4% for the quarter.

Can you give us that same stat for some other recent quarters?

I think the year would have been up about 2 or slightly less most of the way, and last summer obviously we had the reductions in July and August where it went the other way.

Okay, and then you mentioned you saw good bonuses.

Any wage inflation, any changes in salaries you're seeing out there?

I think there was some wage inflation.

Adam Frisch, UBS.

A couple of quick questions for you guys.

One, outside of the anniversary of legal expenses recorded last year, what is kind of driving the margin improvement that we saw and how much margin improvement do you think we can generate heading into next year?

You know I think the thing to come back to is we have the formula that basically that talks about 12% revenue growth and 15% operating income without float.

And the interest rates, they can put us a little bit above the 15.

They probably will; not a lot, though, at this point.

We're going to keep driving for that.

That is kind of baked into what we need to do.

And if revenue growth is only 11, then that's going to force us to try to get some more margin improvement.

We are very fortunate in view of the fact that we continually introduce products that have higher margins on them.

So this really is not so much about cost reduction efforts as it is about balancing how much have we got with how much do we invest.

And we want to be a company that invests.

We want to invest in the future.

By the same token, we are very responsible for the short and near-term targets which we try to meet.

So in this past quarter, what is happening is the Ops Job and InterPay integration was really completed going into this quarter, so we got some advantages there.

They have done a good job at interfacing the Advantage in.

The salespeople have done some good things.

So we just keep pushing on all burners about this.

It is kind of in our culture.

It is something that I am sure is not easy for us to do, but I cannot tell you that we sit here and we just talk about it every day; because our people's expectations, they understand it and we make it happen.

But it is going to stay pretty much in that range of 12% revenue against 15% on the operating income.

Switching gears to pricing increases for a second, how much of your revenue growth and margin expansion was driven by that?

And maybe if you could point to kind of excluding the changes in pricing, what was payroll growth and how does this compare to previous quarters?

Price increases generally are in the 3.5% to 4% range.

They go in in May.

There is no real pricing increases after that, so it's hard for me to say exactly what pricing was.

But you've also got to remember that we do have some wage expansion because our most prolific expense is wages and compensation, and we have pressure on that to raise them as we challenge the people and they do a good job for us.

So we don't look at it -- I would say 3.5% of revenue growth comes out of price increases; and then you've got the ancillary, 3.5; and then client growth hopefully around 5.

Okay.

And then last question here on changes in demand that you have seen separately at both the small business markets and the MMS markets, and how, if any, has this environment changed over the past three to six months or so?

We have not seen much change.

The marketplace is pretty consistent right now.

I don't see anybody that is really moving up in the market or aggressively being there than where they were.

It is really an ADP/us situation at MMS; and on the low end, it has kind of been the same way it has been for the last 12 to 18 months.

I was talking about the changes in demand from the potential client base, not so much on the vendor side.

Demand is about the same.

When you get reasonable new client formation, it is there.

But this is a business that just does not have a lot of volatility in it.

Okay.

Great.

Thanks, fellas.

Greg Smith, Merrill Lynch.

I was just wondering; you talked a lot about the price increases, but assuming the economy were to continue to pick up, any chance you would increase the absolute level or the percentage of those price increases a year from now?

I doubt it.

Okay.

We have been consistent, about the same in good times and bad.

Okay.

And then on the MMS side, is the client split there moving more towards new clients just as you picked some of the low hanging fruit within the current customer base?

Slightly.

We say approximately a third.

We used to be a little bit above a third.

Now we are a little bit below a third.

That is really the result of the maturity of MMS in the branches.

So that when you first go into a branch, there is a real high demand to convert to MMS out of the existing pool.

We are starting to get more clients from the outside, but the statistic has not changed dramatically yet.

Steve Weber, SG Cowen.

Could you go through sort of the accounting on this worker's comp thing for your PEO clients?

And tell us whether that had any -- what kind of revenue effect it might have now that you are self-insured in the third quarter?

Well, you certainly asked a complicated question.

Basically on worker's comp, very conservative.

A lot of companies, and we don't need to mention the names, had a lot of problems with their worker's comp accruals.

The reason we are self-insured is the insurance companies don't want to cover PEOs any more.

So we have adopted that we will take the insurance on.

We have upper limits so the balances cannot go above.

We track claims unbelievably diligently.

We have several people telling us what we think the actuarial liability is, so we are not even relying on just one.

We basically book what we think is a realistically conservative number.

We have probably been slightly too conservative over the last 18 months.

When I say too conservative, you are still talking about not being conservative about it; you're still talking about a number that is less than $5 million, okay?

So it is not significant.

We're going to book this a little bit closer.

I don't think you'll see enough to see a difference.

I would not change margins for it.

You are probably talking again about a number that is less than $5 million a year, so it's not even equal to a penny.

The real key here, that I think the real good part of it is, our PEO people in Florida do an absolutely wonderful job of controlling worker's comp claims.

Our experience is much better than anybody else of similar client mix.

They work hard at it.

We have told them why we want growth.

We don't want growth in clients that are high risk, and we will continue to manage this quite well.

So basically the effect in this quarter was less than a year ago as we've gotten better at this; and as we get more experienced in the self-insurance line, it's going to get closer and closer.

But by the same token, I don't want to be on this call explaining why we had a lot more expense than we thought.

So we're going to continue to be near the line but a little bit conservative.

Did you imply you were going to sort of true this up by the end of the year?

Was that what you intended to say?

It is trued up now.

Okay.

Could you just give us some feel for us some of the other -- you disclosed how you did it in the 401(k) and the PAS -- how are these other ancillary services doing?

I assume Stromberg is still doing extremely well.

How is Section 125, the worker's comp offering, etc.?

We are pleased across the board.

I touched on that a little bit earlier.

But to use Stromberg as an example, Stromberg is a business that we acquired a little over a year ago, about a year ago now.

And at the time we acquired them, they were doing roughly 1.5 million a year, something in that neighborhood.

They will finish the year probably closer to 10, 9 or 10, something like that.

In ledger revenue, bookings will be higher.

So that is a perfect example on this theme of what are the types of acquisitions that we would find attractive?

That is an example of a great one.

It fits really well into our offerings.

It can leverage our existing infrastructure, both sales and operations.

It is of high demand in our client base.

I mean that is an example where you can take a smaller company that had a good offering and a good idea, and then put it into a larger company that has you know deep financial pockets, great distribution network, great sales network, and get almost an immediate improvement to it.

So Stromberg and time and attendance in general doing well, and by the way, we're just at the front end of that.

We're expecting great things to come from that area of the business and from that acquisition.

In all of the other areas that you mentioned, you know our results have been good, and our outlooks for those areas remain very positive.

So you know I cannot think of a single offering that we have today that you know we are unhappy with or that we are thinking about jettisoning.

I gave you the numbers earlier on Taxpay and direct deposit, which are pretty mature but they continue to move on.

You just talked earlier about worker's comp.

Health insurance has been going well.

Flexible spend has been going well.

Retirement services, 401(k) and the like going well.

We obviously spend a lot of time on PAS and PEO.

So the portfolio that we have of our offerings right now I think is extraordinarily strong, and the demand for them is quite good.

Greg Gould, Goldman Sachs.

John and Jon, on the sales-force retention and the client retention, with the increased focus on both of those going forward, what kind of targets do you think are realistic for improvement over, let's say, the coming year or two?

I think in the payroll specialist side of the house, we are currently sitting just above 20.

We have been as low as 17, so I would start off with saying that we ought to be able to get it back into that neighborhood.

In that area, it is pretty tight.

I think there are going to be some arguments that it is going to be hard to get there, but I think it is reasonable to assume that we ought to be able to get that back into the teens.

On the sales side, the sales team has made great -- good progress over the years.

I mean those numbers I am told were in the 40s not very long ago.

Those numbers I think that we ought to be able to get much stronger improvement in the near term.

I'm not prepared to quote any numbers to you, but we should be doing materially better than we are doing.

I am going to certainly put a lot of pressure on trying to figure out what is wrong and get it fixed immediately so that we can do a better job on the attrition on sales.

Client retention, while we put a lot of effort -- we have been putting a lot of effort into that, are right near record good levels of that.

We are going to continue to push that, but that one is very hard to change very dramatically.

But even if we can just pick up a half-point a year, that would be good.

Are you still here?

Rod Bourgeois, Sanford Bernstein.

You commented that payroll services revenue growth was less than normal in the quarter.

Can you give us some more sort of background on what is driving that trend in the quarter?

Number of days.

One day off is 1%.

Okay.

So that comment had solely to do with the billable day issue?

Yes.

You had one extra day in the first quarter.

We talked about it.

You gave it back in the third quarter.

We try to get the days to perfectly match up, but we are not always able to do so.

Got it.

I just wanted to make sure there was not something beyond that.

That makes sense.

No.

Payroll is moving nicely, and it is steady and it's not volatile either.

Great.

And when you exclude the float and the fiscal '04 onetime items, your core margins expanded 70 basis points year-over-year.

So margins, ex the float, are not showing as much as operating leverage as in sort of prior years.

Do you expect core margin expansion to move much from the current level either on the high side or the low side?

Go back to our long-term guidance, 12% revenue growth and 15% operating income growth.

And when we get a little bit better than that we tend to invest, unless we don't have something to invest in that makes sense.

But we've got some good investment opportunities in Europe, in Stromberg, and we are going to continue to try to take care of that.

I think we're very committed to predictable results, and the only way we are going to get predictable results for a long period of time is to continue to invest and make sure those out years are as good as we can make them.

So having core margins accelerate from this level will probably be offset by future investments, which will keep the margin expansion at this fairly consistent base.

Is that accurate?

Pretty close.

David Saunders, Legg Mason.

I just had a quick question on the pick up in yield year-over-year versus interest on funds held for clients versus your corporate investments.

What was the differential there in the pickup for the investment on funds held for clients versus your corporate investments?

It is a very simple answer to that.

Basically what happens is in the whole portfolio we are about 60% short-term and 40% long-term.

What we invest long-term has a lot of controls and restrictions on it, but the average yield or the maturity is going to be about 2.3 years now with a target normally of up around 3.

We lowered that as rates decreased.

I think as rates get more comfortable, we will probably start to take that out.

The corporate portfolio is almost all long-term because that is our money and there is not much volatility on it.

The other portfolio has the volatility of the client funds, and that is where all the short-term investments are.

And right now short-term rates are higher than long-term in the portfolio because you’ve got the weighted average.

At this time, I show no further questions.

I would like to turn the meeting back over to Mr. Morphy for any final statements or closing remarks.

Okay.

I want to thank you very much for joining us, and we felt it was a very good quarter.

We are always happy to get year-ends behind us and feel good about them, which we generally do.

We are looking forward to a good fourth quarter.

Jon and I are looking out the window here in Rochester.

We have got sunshine.

There is a little bit of snow left, and at least we know the next time we are talking to all of you, it better be warm enough to play golf or we are really in trouble.

So thanks a lot, take care, and all of you have a good few weeks here.

Bye.

Thank you for participating in today's teleconference and have a nice day.