沛齊 (PAYX) 2006 Q2 法說會逐字稿

[OPERATOR INSTRUCTIONS] Now at this time, I'd like to turn the conference call over to your speaker Mr. John Morphy.

Thank you sir, you may begin.

Thank you for joining John Judge, our President and CEO and me today for our second quarter earning release.

The teleconference call will be comprised of three sections.

A review of second quarter fiscal 2006 financial results, including comments and guidance for full year fiscal 2006.

An overview from John.

And lastly a Q&A session.

Yesterday afternoon after the market closed we released our financial results for the second fiscal quarter ended November 30, 2005.

This press release can be obtained by accessing our Website at the Investor Relations page, www.paychex.com.

We have filed our Forms 10(Q) and 8(K) with the SEC, which provides additional discussion and analysis of the results for the quarter.

These filings are also 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 23, 2006.

Please refer to our Website for access to our recent news releases, current financial information, SEC filings and the investor relations presentation, which will be updated in the next week or so.

The second quarter was another excellent quarter for Paychex.

Not quite as strong as the barn burner first quarter but very good by all measurements.

And right in line with the higher expectations we established for 2006 performance at the end of the first quarter.

Both net income and diluted earnings per share increased 30% to 112.6 million and $0.30 respectively.

Total revenues were up 15%.

Payroll service revenue was up 9% to 303.9 million.

Major market services revenue increased 26% to 53.4 million.

Retirement services revenue grew 15%.

Administrative fee revenue from Paychex Premier increased 66%.

Quarterly cash dividend per share increased to $0.16 per share from $0.13.

We will now refer to the consolidated income statement.

Payroll service revenue increased 9% and 10% for the three months and six months ended November 30, 2005, to 303.9 million and 612.5 million respectively.

This growth was attributable to client based growth, increased utilization of ancillary services, price increases, check volume growth and new higher activity for the three and six months ended November 30, 2005, compared with the respective periods last year.

As of November 30, 2005, 91% of all clients utilized our tax filing and payment services and 67% utilized the employee payment services.

Major market services revenue increased 26% and 27% for the three months and six months ended November 30, 2005, to 53.4 million and 105.7 million respectively.

Approximately 1/3 of our new major market services clients are conversions from our core payroll services.

Human resource services revenue increased 32% and 36% for the three months and six months ended November 30, 2005, to 75.1 million and 150.9 million respectively.

The increases in human resource services revenue are comprised of the following four key areas of revenue focus.

Retirement services revenue increase 15% and 16% during the three months and six months ended November 30, 2005, to 25.8 million and 50.4 million respectively.

As of November 30, 2005, we serviced more than 36,000 retirement services clients, as compared with approximately 32,000 clients at November 30, 2004.

Again, we expect to sell more 401K accounts than anyone else in America.

Sales of the Paychex Premier product have been strong, as administrative fee revenues from this product increased 66% for the three months and 69% for the six months ended November 30, 2005, to 12.8 million and 25.0 million respectively.

As of November 30, 2005, our Paychex Premier products serviced over 193,000 client employees, as compared with over 133,000 client employees at November 30, 2004.

Our PEO product provides essentially the same services as Paychex' Premier, except we serve as a co-employer of the clients' employees, assume the risks and rewards of workers' compensation insurance, and provide more sophisticated healthcare offerings to PEO clients.

The PEO product is available primarily for clients domiciled in Florida where the utilization of PEO is much more prevalent than other areas of the United States.

Revenues from the PEO product increased 37% for the three months and 56% for the six months ended November 30, 2005, to 14.3 million and 32.5 million respectively.

As of November 30, 2005, our PEO products serviced over 56,000 client employees, as compared with over 53,000 client employees at November 30, 2004.

Due to the characteristics of the PEO product, the revenue and profits from the PEO product fluctuate significantly between quarters.

Since entering the PEO business about ten years ago we have always generated a profit and margins over the longer term approximate our total Company margins.

The fluctuations in PEO revenues primarily relate to the assumption of the risk and reward of workers' compensation insurance and to a lesser extent other offerings unique to the PEO.

Prior to fiscal 2003, Paychex did not assume any workers' compensation risk, as we fully outsourced the PEO workers' compensation insurance to outside carriers.

In fiscal 2003, workers' compensation insurance companies became reluctant to offer PEO's workers' compensation insurance at a reasonable price and we decide to self insure the workers' compensation product we offered to our PEO customers.

In response, we implemented extensive risk control procedures and accompanied by strong management we assumed additional workers' compensation insurance risk.

And were awarded with higher profits on our PEO workers' compensation products.

However, this income often varies significantly from quarter to quarter and is not at predictable as our other revenue streams.

Fiscal 2005 and 2006 were good examples of significant variances.

As the third quarter and fourth quarters were the strongest quarters in fiscal 2005, whereas we expect the first and second quarters to be the strongest in fiscal 2006.

We expect the full fiscal year 2006 growth in revenue from our PEO product be in the range of 10% to 15% over PEO revenues of 53.7 million in fiscal 2005.

The factors that caused the significant variances are disclosed in our Form 10(Q) for the quarterly period ended November 30, 2005.

Quarterly revenue information for the PEO from June 1, 2003, through November 30, 2005, is now available on our Website in the Investors section.

Interest on funds held for clients increased 68% and 73% during the three months and six months ended November 30, 2005, to 20.8 million and 4.1 million respectively.

The increases in interest on funds held for clients are primarily due to higher interest rates earned and higher average portfolio balances.

Our investment portfolios and the earnings from these portfolios have been impacted by the increasing interest rate environment.

The Federal funds rate, which was at 1% at June 1, 2004, and 2% at November 30, 2004, steadily increased to 4% through November, 2005, and is currently at 4.25%.

The increase in interest rate environment has positively affected net income growth.

The average interest rate earned on funds held for clients increased to 3.0% for the first three months and 2.9% for the first six months of fiscal 2006, compared with 2.0 purchases for the first three months and 1.9% for the first six months of fiscal 2005.

The higher average portfolio balances were driven by client based growth, check volume growth within our current payroll base and increased utilization of our tax filing and payment services and employee payment services.

The average investment balance for funds held for clients for six months ended November 30, 2005 increased 12% over year ago, compared to a 7% increase for the same period ended November 30, 2004.

This is a good time to put some additional perspective on float income.

We have frequently referred to being with the wind neutral and into the wind regarding the impact of changing interest rates.

In the early 2000's we were clearly into strong headwinds.

And today the wind is clearly at our back.

We should be with the wind at least through fiscal 2007.

With the periods after that dependent upon future changes and interest rates.

From 1995 through 2000, the Federal funds rate hovered around 5% for most of the time.

With a short duration low of 4.75% and a short duration high of 6.5%.

Since then, the Federal funds rate moved from a peak of 6% to a low of 1%.

We view the movement toward the 5% rate as a return to normal levels of float income versus extraordinary levels.

The predictability of float income becomes much more certain when we are not in periods of rapidly changing rates in either direction.

For most of the 90's, we are neutral to rates and hopefully we are headed again in that direction.

We refer you to the management discussion and analysis of financial conditions and results of operations in the section, Market Risk Factors, for a more detailed explanation of the effects of fluctuations in interest rates and related risks.

Consolidated operating and selling, general and administrative expenses increased 9% and 10% for the three months and six months ended November 30, 2005, to 241.2 million and 482.1 million respectively.

These expenses increased primarily as a result of our investments in personnel, information technology and other costs incurred to support our revenue growth.

There were approximately 10,600 employees at November 30, 2005, compared with approximately 9,700 at November 30, 2004.

Operating income, excluding interest on funds held for clients, increased 20% and 21% for the three months and six months ended November 30, 2005, to 137.8 million and 281.3 million respectively.

Investment income net increased 102% and 108% for the three months and six months ended November 30, 2005, to 5.5 million and 10.4 million respectively.

These increases are due to increases in average interest rates earned and increases in average portfolio balances, which resulted from investment of cash generated from our ongoing operations.

Our effective income tax rate was 31.4% during the three months and six months ended November 30, 2005, compared with 33.0%, in each of the respective periods last year.

The decrease in our effective tax rate is attributable to higher levels of tax-exempt income derived from municipal debt securities held on our funds held for clients and corporate investment portfolios and a lower effective state income tax rate.

Moving to a discussion of the balance sheet.

Cash and corporate investments were approximately 800 million in November 30, 2005.

Our cash flows from operations were again strong at 235 million for the six months of fiscal 2006, an increase of over 34 million from 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 19.9 million at November 30, 2005, compared with net unrealized losses of 9.9 million at May 31, 2005.

The change in unrealized loss position is due to increasing yields that decreased the fair value of the Company's investment portfolio.

The three-year AAA municipal securities yield increased to 3.33% at November 30, 2005, from 2.85% at May 31, 2005.

Our net property and equipment balances activity during the six months of fiscal 2006 reflected capital expenditures of approximately 38.6 million and depreciation expense of approximately 24.9 million.

Client fund deposits as of the end of quarter declined to 2.4 billion from 2.7 billion due to the calendar timing at the end of the quarter.

Total stockholders' equity increased to 1.5 billion at November 30, 2005, with 110 million in dividends paid during the first six months of fiscal 2006.

Our return on equity for the past 12 months was 30%.

Fiscal 2006 guidance.

Our current outlook for the full fiscal year ended May 31, 2006, is the same as provided in our Form 10(Q) for the quarter ended August 31, 2005.

Except for the inclusion of the effect of the Federal funds rate increases on November 1, 2005 and December 13, 2005.

The Federal funds rate increases affect interest on funds held for clients and corporate investment income.

Our guidance for net income has remained unchanged because the effect of the two latest Federal funds rate increases were not significant enough for us to increase the expected range of net income for fiscal 2006.

Our current outlook is as follows.

Payroll service revenue growth is projected to be in the range of 9% to 11%.

Human resource services revenue growth is expected to be in the range of 25% to 28%.

Total service revenue growth is projected to be in the range of 12% to 14%.

Interest on funds held for clients is expected to grow in the range of 50% to 55%.

Total revenue growth is estimated to be in the range of 13% to 15%.

Corporate investment income is anticipated to increase approximately 80% to 85%.

We expect the full fiscal year 2006 effective income tax rate to approximate 31.5%.

And most importantly we expect net income growth to be in the range of 22% to 24%.

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

Equity based compensation.

Under the new accounting rules for equity based compensation, all stock based compensation arrangements are treated for accounting purposes as other forms of compensation.

The cost of the award must be recognized in the income statement.

We anticipate adopting FAS 123R in the first quarter of fiscal 2007.

We continue to evaluate the new standard and the alternate methods of adoption.

Contained in Note A to the financial statements for three months and six months ended November 30, 2005, is the pro forma disclosure of the effect on net earnings and EPS as if we had applied fair value accounting for stock based accounting under SFAS #123.

However, the calculation of compensation costs for share based payment transactions in accordance with SFAS #123R may be different from the calculation of compensation under SFAS #123.

Based upon our current review of the new rules and anticipated equities awards we expect the adoption of FAS 123R will reduce income by approximately 5% in fiscal 2007.

Safe Harbor.

You should be aware that certain written and oral statements made by 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 statements on page two of the press release for our discussion of forward-looking statements and related risk factors.

At this time I will now turn the meeting over to John Judge who will provide his comments and then we will open for questions.

Thanks, John.

Nice job.

Well, good morning everyone and Merry Christmas and happy holidays.

We appreciate you spending time with us this morning to talk about Paychex.

I would like to begin my comments with a couple of observations about where we are.

And then expand some on John's comments about our performance.

Fiscal '06 is shaping up to be another great year for Paychex.

Better than our expectations as we ended the year and right on our improved expectations that resulted from a great first quarter.

And you remember we began the year with optimism.

We saw the economy start to change in our favor in the second half of fiscal '05.

We had a good selling year and a great client retention year.

So we booked a pretty aggressive internal plan and set about planning for our success.

You remember some of the steps we took to get off to a fast start.

We moved operational planning earlier in the calendar.

We got budgets done and quotas out by the first day of the new fiscal year.

We re-released early hires for the sales team so they could hire and train and get their new sales reps into the territory for the beginning of the year.

And as a result we had virtually no open territories on June 1.

Well, by the time the first quarter was over we knew we had a very good year on our hands.

So much so, that we changed for the first time in ten years our guidance to reflect an even better full year performance.

Well, as you heard from John, our good performance continued into the second quarter.

And I would like to add some color to John's descriptions of our performance.

You heard all the revenue numbers.

Clearly, we are proud of the 9% payroll services revenue growth.

The 15% total revenue growth.

The 26% major markets growth.

The 32% HRS growth.

The 34% combined Premier and PEO growth.

But it wasn't just the quantity of the revenue growth that excited us.

It was the quality of the revenue growth.

Payroll service revenue growth is the strongest it's been since 2001.

And you know that's the biggest part of our revenue stream.

New client growth through November is noticeably up versus the same period a year ago.

Revenue from ancillary products continues to grow even though tax pay and direct deposit have very high penetration rates.

And our long term growth engines of HRS and MMS continued at very high year to year growth rates.

So, the quality of the revenue was very encouraging.

On the expense side, the numbers were very good and we are proud of them but so is the character of the expense story.

We have an excellent process we put in place to ensure that we both drive continuous improvements in our expense-to-revenue ratios.

And that we spend the money that we do allocate on the right things.

We are formula driven on the amount of expense that we allow in our budgets.

It's based on projected revenues and the mandate that every new dollar be more profitable than the last.

And we are process driven on how expense dollars get allocated to projects.

We prioritize based on a rigorous business case scrutiny.

Combined, it's how we get margin expansion while continuing to invest in the right projects that move our business forward.

And then finally, on the income side the number is great. 30% growth is terrific but so is the quality of the income growth.

It's repeatable and it's mostly from excellent execution.

Let me talk for a minute about excellent execution because if there's one area of our business strategy that we focus on above all others, it's execution.

It's what allows us to have confidence not only in the current period but in the out periods as well.

Let me start with sales.

Our sales team had a very strong quarter again.

They exceeded their revenue targets and once again all major units performed at or above plan.

They did an excellent job of bringing in new clients.

New client growth for the quarter and the first half significantly outpaced last year for the same periods.

They made excellent progress in employee retention and keeping their territories covered and producing.

And as you heard from John they sold all of our offerings well.

Basic payroll, ancillary services, human resources services and especially Premier at 66% growth.

It was great execution, which sets us up for a good revenue growth next year and beyond.

Then we also got terrific execution from our operations and service delivery teams.

Customer satisfaction is up.

And that's up from a year where we had near record levels.

I believe we have an excellent chance to set a new customer sat record this year.

Client retention, which was a new record last year, is very strong again and on pace to break last year's record.

Employee retention and especially the payroll specialists has improved at a very nice rate.

And I believe that explains why we are doing so well at customer satisfaction and client retention.

And our operations team achieved all of this through some pretty troubling times.

Namely the hurricane season and specifically Katrina and Wilma, where they never had a single business interruption.

Now our ops teams are focused on flawless execution of the year end processing for our clients.

And they are ready and able.

I'm really proud of the work these teams are doing and more importantly with the results that they are getting.

So, let me end my comments on that note.

In summary, we came into the year bullish on what we could achieve.

We had a very strong first quarter and for the first time in ten years raised our guidance.

We followed it with a very strong second quarter and reaffirmed that we are right on target to achieve our adjusted guidance.

And finally, we are really pleased with the quality of our financials and the execution of our teams.

With that, John and I would be happy to answer any questions you might have.

[OPERATOR INSTRUCTIONS].

Your first question comes from Cindy Shaw with Moors and Cabot.

Thank you, two questions.

One, the 10(Q) on your discussion today suggests that the HR benefits revenue growth is going to be slowing in the second half due to the workers' comp.

You mentioned from the overall business there in the PEO the margins are similar to Paychex' overall margins.

How should we think about worker comp variations from quarter to quarter?

Has that got a lot of margin variability or is that pretty consistent?

First off, we decided that we were having things bounce around the PEO.

So, we changed our disclosure and gave you all of the pieces of the HR revenue stream.

So, when we look at what PEO is expected to do in the last half, that is right on with what we expected it to do when we were talking last September.

And we gave you a little more data so you could see the impact.

So, you could really get a good awareness of what's going on exactly in HR.

What we have is a PEO business.

It's not necessarily growing rapidly.

It's a good business, we make good margins.

And over the longer term those margins are almost equal to payroll.

Now, you can get a short term hit or miss because of the fluctuations that changes it.

But a lot of that increased volume winds up in the income statement and it does vary.

Now unfortunately for us, we've come to recognize there is no way to get that to vary less.

Workers' comp just works that way when you self insure, that's the only piece we have.

So looking forward, we think we have a pretty good idea of what the next half is going to be.

And usually we're pretty close on the year, it's just what I call lumpy.

So, I think we've given you enough information so you can see that we are actually going to have a good second half on the other HR revenue areas but unfortunately the PEO was not.

And that was caused - - some of that lumpiness was caused by some legislation, I don't want to get into all detail, by the State of Florida that basically caused the last 12 months to be better than normal and then go back to a little more normal period starting on January 1.

John, in terms of contribution margins as that revenue varies quarter to quarter, does - - I don't really understand how the costs get accrued on workers' comp.

Is that pretty steady or does it align pretty well with the revenue?

No, the costs are pretty steady and that fluctuation on the workers' comp affects the profits.

So what's happened here, in the past the fluctuations weren't very significant.

So, what's happened here we've - - it's taken us a little bit out of and not by much.

It might be by $0.005 to $0.01 a quarter.

It's taken us out of the normal way the quarters go this year.

Which I think next year will return right back to normal.

Normally, the first three quarters are pretty close to the same and the fourth quarter is a few pennies higher.

So, I think what we have here is a little of income in the first half compared to the second half.

But again we are thrilled with the year.

We are thrilled with the second quarter.

All the things we are looking for are banging right in the right place and we think we have a great year going.

Well, that leads to my second question on the guidance.

It still seems - - I know you said that the changes in the Fed funds rate weren't enough to impact the net income guidance, the range of that is $0.02.

I estimated that the increase in the 10(Q) last night in the interest and investment forecast is $0.02.

So, would that say maybe there are enough pressures from Katrina or something else or the economic outlook is just not getting better; that it took you from the low end to the high end of the guidance or are you being conservative here?

It seems to me that even with the workers' comp thing it's conservative guidance.

No, I would not agree with those things.

First off, the change in the rates that took place did not give us $0.02.

If it did I would have changed the guidance.

The interest rates didn't give us that much first off because the long term rates haven't changed very much.

So, we didn't get enough.

Right now I believe to get $0.01 out of interest we almost need two more Fed's funds rate change.

If I got two more, I probably would change the guidance slightly.

But what happened was we got a little more interest income.

We were in the range.

And when we provide you a range I want you to understand I don't give you - - I don't low ball the whole thing.

When I give you a range, I'm in the range.

I could be at the low end of the range, I could be at the high of the range.

I hope to be there.

So what happened was, when we look at the Fed funds rate changes that wasn't enough to move it.

When I look at our expectations from the rest of the business, as John said earlier, they are virtually unchanged from where we thought they would be at the end of the first quarter.

Great.

Well, Happy holidays.

Thank you very much.

Your next question comes from David Togut of Morgan Stanley.

Thanks.

The core payroll services revenue growth slowed a bit within the November quarter to 6% from 7 in August, which certainly was above trend.

Could you give us a sense what have drove some of that slow down?

Perhaps elaborate on some of the underlying metrics?

Okay.

It's probably almost time, as we head towards putting all of our payroll back on one platform, that's going to happen over the next 18 to 36 months.

We look at MMS and it's really just a platform, David.

You can't look at core payroll and say; take it separately from MMS and look at it.

I now look at them combined all the time and I will come back to that little bit of a slight difference in a second.

The reason I do that is we have been improving and improving the MMS product.

Marty and his operations team and IT people have done a great job of getting that product to be absolutely we think the best software for that market niche that's on the market.

Some great efforts.

As a result of that, more and more of the clients use MMS.

So despite the fact we've gotten to a maturity across the geographic area.

The growth in MMS has stayed very strong, as more and more clients take advantage of the extra features that are in that product.

So, I no longer really believe you can say MMS is growing this much and you will think that's the 50+ market but MMS has many clients under 50.

So, to me you have to look at that together.

Now on payroll, you could say it's slowed down slightly from the first quarter.

But again the first quarter was a barn burner.

You look at the 9% plus growth in payroll revenue, we are thrilled with that.

And as John, that's the highest organic growth we've had since 2001, except for the first quarter this year.

So, we look at payroll growth and we feel pretty good.

John, you talked about or - - John Judge you talked about a reduction in client turnover, improving metrics around payroll services specialists and so forth.

Can you put some numbers around this to give us a sense of what the magnitude of the improvements are?

We don't publish those numbers.

It's more to just give you a feel for some of the key areas that drive our overall performance and directionally whether they are improving or whether they are flat or whether they're not improving.

Well perhaps, could you perhaps score in some way whether it be a scale of one to ten or whatever metric you choose, how strong demand was in the quarter, new design signings in payroll services?

What we've decided to do was what we told you.

So, we gave you the overall flavor of it and our preference is to leave it at that.

David, when we look at this, we think the economy is in a good place.

We probably saw acceleration in the first quarter, right now we see stabilization at a nice level.

Thank you.

Your next question comes from Bryan Keane of Prudential.

It's Bryan Keane from Prudential, good morning.

Client based growth, I think you guys were saying was driving some of that nice increase in the payroll services.

What should we expect for client growth this fiscal year?

Is that going to average about 5% or will it be a little higher than?

I don't believe it will be at 5.

We will hope it will be better than last year by a reasonable amount.

It's too hard to say because we are entering into the selling season.

So, if I could tell you how many we would sell in January, it's thousands of clients that we sell, I'd have a better answer there Bryan.

We right now, feel right now very good about where client growth is.

Remind me, what was client growth last year?

I can't remember the exact number.

I can remember the one without the acquisitions was 6%.

That's not the number you are looking for.

I think the other one was below 4, I want to say 3.5 to 4, I can't remember the exact number.

Just to the previous question about client retention, I think you used to say around 88%, 89%.

Is that - - I guess you stopped quoting that number but has it been a little bit better, worse than that old quoted number?

Basically, I will go to what percentage we lose.

Because that's how usually talk about it, instead of the number used.

We have been between 20 and 23 for a long time.

And when we talk about record levels we are bouncing at the bottom end of that.

We are bouncing right around that 20 number.

Right.

Now, some people think there's tremendous room for improvement.

Moving that number even a few tenths represents a lot of work on the part of operations because a very significant portion of the lost clients, we can't control.

Over half is bankruptcies.

And about a half of that half is because people got so small they just don't simply feel they can afford the service anymore.

What I mean by that is because we are on the low end, it really isn't that we are down to one or two - - three or four employees, we are down to one, the owner.

Right.

That's helpful.

Thanks.

And then finally John, I just noticed the cash flow from operations seems like it's lagging the net income growth over the last six months.

I have net income almost up 30%.

But cash flow from on ops, only up about 17.5.

What's causing that differential?

That's just a calculation where the balance sheet could be moving on various things, cash flow hasn't been impacted negatively at all.

Receivables right now are in the best shape they've ever been in.

Did DSO's actually go up slightly in the quarter?

You can't calculate the DSO's that way.

It depends on when I sent the billings out.

I assure you, cash flow is fantastic.

And anything that you see that shows it's off a little is just the timing of the balance sheet.

Next question comes from Adam Fritz of UBS.

Hi, Guy, this is Allison Heikkinen for Adam.

I was just wondering, looking at your SG&A break out in the Q, it seems like facility and amortization cost declined year over year.

Could you tell us a little more about those reductions and then any other areas of the business where you maybe able to cut costs?

Well, we continue to leverage all the time.

I think probably it would be more appropriate to lump the facilities with depreciation.

Because what's happening, there's been changes in how we have to account for costs.

So, things that used to be rebates from the person leasing us the property, now are capitalized in some of that.

So, put them together.

But we are happy with where we are on lease costs.

The -2% would be something up.

But when you talk about how we leverage and we get our 12% revenue growth goal to 15%, a lot of that comes off really leveraging our fixed costs in facilities versus people because we have to keep rendering excellent service to our clients.

Okay.

And then if you could also just comment on any additional costs that you see that may be less in fiscal 2006?

Nothing unusual.

Okay, great.

Thanks, guys.

Happy holidays.

Your next question comes from Rod Bourgeois of Sanford Bernstein.

Yes, Ron Bourgeois here.

I wanted to talk about the drivers of margin expansion, uptick that you've seen over the last two to three quarters, when you cancel for the effect of float.

It looks like the margin expansion you are generating here is more than just normal scale leverage, judging from the revenue growth trends that you are reporting.

John, is there any way you can roughly quantify the key drivers of the margin expansion that you are seeing and sort of break it out a little bit more for us on that?

Generally the margin expansion, it happens in the first quarter because that's when the price increase goes in.

The next quarter is usually pretty good.

This could change a little bit in the third quarter and I will come back to that in a second.

Nothing unusual.

We just keep pushing our costs all time.

At the same time we have lots of measures and things in place that John was kind of referring to that talk about better customer service.

We just have an attitude here.

You don't get money easily but we have to service the clients.

Now, when you go back this quarter has worked out pretty good.

But now, when I get to the third quarter what happens in there; is that's a quarter where we have more year end revenue.

But and gladfully we have more year end expense.

But on top of that the selling expense goes up because we expense the whole commission for a new client sale, in accordance with GAAP, at the time we make the sale.

So, the selling season is pretty well impacted in the next quarter.

So the margins could change a little.

So, the thing I look at generally is; what's the year over year doing?

We also have some benefit in the first six months obviously from what the PEO is doing, not significant but that's a piece.

But right now, I think the way to look at margins is; we are going to pretty significantly get from 12 to 15.

Sometimes we might get a little bit more, sometimes we might get a little bit less.

But that's what it's going to average out to be over anything that's over more than a quarterly period.

Is there - - if you could break your margin expansion then?

If it's - - if you exclude the scale leverage that naturally occurs, if you could break the rest into sort of positive mix shift versus cost controls?

Because you are clearly indicating that you are seeing some of both.

Is it more cost controls or more positive mix shift that's helping the margins over the last couple of quarters?

Positive mix change.

Okay.

And would you expect that to continue as being the main driver over the next year?

That depends on what the economy does.

Obviously, when the revenue per check increases a little bit, the checks per client increase that helps that metric a little bit.

But that's not most of the noise in the number.

Most of the noise is the normal stuff.

Got it.

Thanks for your help on that.

Your next question comes from Craig Peckham of Jefferies.

Good morning.

John Morphy, I wondered if you could elaborate a little bit more on roughly how much of the growth in year to year PEO revenue is work comp related?

In other words, is a there a way to decompose that so we can see what the core service levels growth looks likes?

Almost all of it is workers' comp.

I think if you look at the statistic on worksite employees, that's only up 6%.

One thing we've done with our PEO, is first off we really like the Premier model better.

But to be successful in the State of Florida and a little bit in some other areas, you really have to be in the PEO model.

So, we go there.

We took a little bit of the risk that the insurance companies forced upon us.

In our typical Paychex history we put some great people in place.

We have some great people down there managing costs.

We put some great controls in.

We turned what could have been a tough situation into a very good one.

The unfortunate part was it didn't come to us in the form of typical Paychex revenue, which is very predictable and very consistent.

So, we are doing the right things down there.

And that's just kind of the way it is but a lot of that was workers' comp.

And now the reason that's going to change; is next half we're not going to see it.

Now, I will go through one example.

I wasn't going to do it.

But I think it's worth doing.

Back in 2003, Florida changed the statute on workers' comp.

What they did was, they eliminated some things to try to get some of the abuse out of it, as well as not pay certain types of claims or certain types costs.

When that went in, they didn't really know what the effect was going to be.

So, the actuaries on accidents stayed conservative and everybody did.

Well, it turned out that worked out very well.

So, then the actuaries started bringing their estimates down some, primarily last half of last year and impacted into the beginning of this year.

But now they are a little bit more accurate at this, so that helped us.

Now, the State realizes that they did a good job in lowering the costs.

So now the State has chosen to lower what you can charge for that service.

So, there are some things going on that we really don't have any control of.

We run a great business.

And we do it great but we just have to operate in that environment.

Which we are glad to be in and we wish was more consistent but unfortunately it's not.

Is Premier operating or available in every state?

Yes.

Okay.

Thanks.

Your next question comes from Greg Gould of Goldman Sachs.

Thanks.

John, I wanted to understand a little bit more about the HSA alliance with Affiliated Computer Services.

Couldn't you tell us what you think the opportunity there is?

Well basically, that is the same arrangement as we have on our 401K account.

Okay?

So, basically with render a service and somebody else - - because in those HSA accounts, they can put money in and it gets invested like a 401K.

And that investment opportunity is what they are doing.

So, it's the same thing.

Now, this is similar to anything that would be around health accounts or savings accounts, if these become popular that's great for us.

And we will be there and we should be one of the best providers of these services in the low end market of anybody in the world.

And right now you look at 401K, we do a great job.

There are not many areas where we would get very much differentiation on ADP but 401K is one.

So, it looks good.

When we see how many there are, we just don't know.

And then just one other question on pricing.

Anything new or different you are seeing in the core payroll product and MMS?

No.

This is John Judge, no.

We are pretty much on a business as usual.

The pricing strategy has remained the same for a number of years.

It will in all likelihood continue to remain the same.

The only thing that's a little different, is we've put emphasis on controls around discounting, which has gotten us some better yields.

And are you having success normalizing the pricing for the acquisition, the clients who came in from the acquisitions?

We continue on the policy that we are going to raise them more aggressively than others but we are not in such a big hurry.

Right now we've got great retention on those clients.

The InterPay clients are all commingled, so that one doesn't change too much.

They are kind of like a normal client.

And the Advantage ones, great retention.

We're raising the prices but our goal is to keep them and make good money off them.

And how fast the prices get to normalcy is not really a stated goal.

Okay.

Thank you.

Your next question question comes from David Grossman of Weisel Partners.

John, just a couple of questions on the float.

The first is, it looks like the float balances were up perhaps a little bit more than I would have thought.

And I'm not sure if there's anything there.

But if you can perhaps just address that and what your expectations are for the year?

And then secondly on the short term portfolio, if I'm looking at the Q right, it looks like it was down sequentially quite a bit.

And perhaps I'm not understanding if or if there's something going on there if you could address that as well?

Good questions.

First one you have to realize, float is seasonal to some degree.

The best quarter for float is our third.

The next best is our first.

The second is our weakest.

Okay?

And that's because of the way money flows, In the third you have all the year end bonuses.

You have all the heavy checks.

You have higher check volume.

You have those things.

You have those Social Security taxes, all those payroll taxes.

And that wings off as you go through the year.

So don't - - we don't look at very many things sequentially because it doesn't mean very much.

Now, in the balance going up, I think that's again some indication the economy is staying strong.

The other area that's in here, which is hard for me to evaluate but I know it's impacting us, we put in the Readychex product awhile ago.

And what Readychex is, basically the check is drawn on our bank account.

And we can actually better float on that than we do off of a direct deposit check where we only do get it for one day.

And more and more people are choosing Readychex because they don't want to do the bank reconciliation process.

And we do that for them.

It's a great product for us.

And I think that's influencing balances.

Plus normal client growth.

Plus there is wage inflation, a little more than people would expect.

The real productivity changes that we see in the U.S. are really coming from what people pay for goods.

I think employees who do a good job throughout the U.S. are seeing wage increases in the 3.5% to 4% range.

I guess I was looking at it on a year over year basis.

So, as I look at the year should I think more in the 12% to 13% range for - -?

I think right now it will stay at 12.

The only thing I would say that might change that and I just don't have any way of knowing; is last year the year end was a real burn burner on bonuses.

So we might be up against a tougher comparison.

But right now it's hard for me to say.

Okay.

And then on the short term portfolio?

That's simply a matter of the fact that the short term portfolio fluctuates based on the direct deposit employee pay balances.

And this is the poor quarter on float volumes usually.

I see.

And then just going back to a couple of questions that were asked about margins.

So when you roll all of that up, the commentary about the lumpiness, the workers' comp., et cetera, and I know you have this stated in a range.

But is the kind of year for fiscal '06 a reasonable proxy to think about for fiscal '07.

Close.

It wouldn't be enough to change it dramatically.

But again our stated goal is 12% revenue growth and 15% increase in operating income without float.

That's what we are shooting at.

This year we have the wind with us.

It's nice and we had the wind against us for awhile.

And I still think we are going to have some wind next year that's going to help us on that statistic.

And what the Fed funds continues to do is going to affect it, which I think is going to be a few more changes.

I don't know that I know anything on that issue.

And the other factor is if long term rates improve we get a little kick out of that.

So, kind of as these rates have changed, we feel pretty good how they've done it.

They've really kind of extended the impact to us a little bit more than if they had done it even more rapidly.

And with the changing rate - - or the more stable environment does that change your target mix at all in terms of long versus short term?

No, the increase in short term is completely related to the fact that tax pay is more mature.

And the growth in the float balances is coming from employee pay.

Employee pay, I only had the money for a day.

And it doesn't allow me to - - and it fluctuates more, so it doesn't allow me to put as much into long term, which is what I would prefer to do.

Great.

Thanks very much.

Thank you.

Your next question comes from Pat Burton of Citigroup.

Happy holidays.

John Morphy, my question for you is; on the workers' comp. business if you reserve for the self insured plan where do those reserves show up on the balance sheet?

Thanks.

Well, there is an accrual there.

I'm not sure exactly where it is.

I can't remember.

And the earlier question about the accounts receivable increase, that was just due to the timing of billings?

Just the timing of billings.

As you all know our, EIP percentage is over 60, it might be over 70, where we just simply take the money.

It's a nice way to do business.

Thanks.

Your next question comes from Gary Bisbee of Lehman Brothers.

Good morning.

A couple of questions.

You said earlier that Paychex Premier is being offered in all 50 states.

But can you give a sense over the last 12 months how much of the growth from that and the PEO has come from entering new geographic markets versus just building up your presence in those markets?

Basically none.

When you look at these two products we are heavy in Florida with the PEO as a result of buying a PEO back in 1996.

And the growth in that PEO has been reasonable.

I wouldn't call it unbelievable.

I wouldn't put it in the 25% plus range continually.

Okay?

For about two years now we've had the past - - they it the Paychex Premier product and that's been across the country.

We kind of had that in place about eight or nine years ago with the software and everybody was positioned.

And we were waiting to learn more and more about the market.

Well, in typical Paychex fashion, we started off small.

We kind of dabble a little bit and we do a lot of things.

And then all of the sudden we decide it's time to light the fire.

Well, that happened about three years ago.

And that's when we realized that this product was going to become well accepted throughout the country.

A real good place is California because people out there have got a few more laws to deal with.

And they're more willing to be worry-free and outsource.

So, right now this is throughout the country.

It's - - the growth everywhere is great.

And we've got a really excited bunch of salespeople in it because they think they are selling the best product to sell in the Company.

So, and not that you are going to comment on how quickly that can keep growing.

But the sense is that the penetration in most of your big markets are still big opportunities.

The penetration of this product is the lowest of any product we have.

It's hard to exactly say how big the market will be.

Some people talk about ADP be getting a little more aggressive.

We would love to see that.

So, we will do a little more education in the marketplace.

But no, it's too early.

It will be good now.

At the same time, I do know as you get the size growing anything 60% plus, that will change.

But we will still be at levels that we feel great about.

Any updates in the last six months in terms of where you might be looking to invest the growing cash balances you have?

I know that the story has been small lock on acquisitions that might add additional product lines and maybe small some small lock on payroll.

Any thoughts of doing any bigger?

We keep looking but we can't find them.

I just have a tough time saying generating the cash is a bad idea.

But obvious, when that balance reaches a point where we think we absolutely should do something, we will.

But I think we keep looking at that.

With did increase the dividend from $0.13 to $0.16.

And I'm sure we will continue those trends as long as the situation remains similar to what it is.

And we will continue to look at it.

But I think the most important thing on this cash is that we not go do something that is big and lose it.

Any thought - - or change in the thoughts on share repurchases?

We keep looking at it.

And the problem I have is can we adjust looking out three or four years something by a small amount of money by doing it?

Yes.

I don't give up $700 million or $800 million purchasing power for the little effect we would get on that.

Now, I think as time goes on we are going to have to keep looking at that.

But until it makes more sense, I don't think we will do that.

Okay.

Thanks.

Your next question comes from Brandt Sakakeeny of Deutsche Bank.

Good morning.

Can you discuss, I guess and give us an update on the Germany business and also Stromberg?

And I guess two, see any signs e of the Microsoft/ADP relationship out there?

We will start with your first quarter.

Both Stromberg and Germany are having very good business results.

We will start with Stromberg.

Stromberg has finished out its first half.

It's one of the most aggressive growth plans that we have in all of our business lines is the plan that we have on Stromberg.

I think you'll remember from our prior discussions, the first year that we acquired Stromberg they were doing $1 million in revenue.

And we got them up to 6 or so, 6+ in the first that they were under our umbrella.

Obviously, our plans are to grow that expand that fairly aggressively.

They were on target both in billings and bookings through the first half.

So, they've done a very good job of expanding the sales teams that they have out in the field.

And so we are pretty pleased with what's happening with Stromberg.

And continue to expect great things from Stromberg for some period to come.

On the Germany side, you know I'm sure, that we expanded into our second city.

We went into Berlin.

All the results we are getting back both from original city of Hamburg and the new city of Berlin are excellent.

November, as it turns out was the best selling month that we've had ever in our Germany experience.

So, that whole thing continues to run well.

They've made very good progress in the couple, three few months in two significant areas for the future.

One, is in its infrastructure.

There's a lot of work that's been done on the technical infrastructure.

And secondly in the area of skills transfer and relationships with the existing accounting professionals.

We sent some American people over there that are very skilled people in the Paychex business model.

They will be there for a limited period of time.

A year or two probably at most.

But they are there to transfer all the knowledge and skill about how we go about this market, both with our end user clients as well as how we work with the accountants from a referral model.

And both of those activities are progressing extremely well.

So we're pretty - - we are very, very happy about what's happening in both of those, we call them growth initiative areas.

And we still continue to expect really great things out of them in the future.

And just on the Microsoft/ADP relationship.

Microsoft/ADP relationship has continued to not have an impact or shown itself from an impact standpoint with our sales teams and with our clients.

So, we've sort of watched that somewhat carefully.

That's as, I'm sure you know, is a bigger issue for other companies, software type companies, than it is for us.

But to date it has not really caused much difficulty at all.

We watched some of the public statements that were made by both Intuit and Microsoft.

And we looked at what their view of the world is relative to either customers captured by Microsoft or ADP and customers lost potentially from Intuit.

And it looks like it's a nonstory so far.

Great.

Thanks so much.

Your next question comes from Jeremy Davis of Credit Suisse First Boston.

Hi, guys, it's Jeremy and Josh.

Just wondering outside of Germany if you are focusing any more seriously on any other geographies right now?

We are not from the standpoint of doing anything yet.

We've - - our strategic planning is looking beyond Germany.

But the decision that we've made and the way that we are going against these growth initiative investments; is first and foremost it's according to a financial model.

We have to do both, provide excellent results in our current period as well as cordon off some money and invest it in things for the future.

But we are pretty careful about how much money we put into these investments given the - - how fast the returns can be expected.

And so in the case of Germany, the thing that makes the most sense to us right now is to continue to stay focused on Germany.

And work as hard as we can to try and capture that flag if you will.

There's lots of growth available to us inside Germany.

And the incremental - - the yield off of incremental investment dollars inside Germany is far better than it would be if with opened up another country as an example.

And so again, we are relatively new into Germany.

And so we are going to continue on our path to penetrate Germany and try and get significant both penetration and results out of Germany.

Once we get to a point where we feel more comfortable that we are well on the way of performing in Germany where where we want to, then we will start to look at the second and third country.

Now, what I meant earlier when I said we have done some work on it; we have a pretty good understanding internally as to where we would go next.

But for the time being though, all of our international investment dollars are going to be targeted to Germany because that's where we are going to get the maximum return on that investment.

Okay.

And you've made some commentary on the pricing environment in some of your other segments.

But wondering if you could characterize the pricing trends that you are seeing for the Premier product specifically?

It doesn't vary all that much differently from the way we price all of our products.

You start with the basic premise that we have an offering that is required, needed and wanted in the marketplace.

And because of our size and our ability to get leverage off of our infrastructure, we are able to create an environment where a client can get a substantial amount of value for a very, very small investment.

And I will give you a simple example.

If you were to hire a bookkeeper to go and do your payroll and tax accounting and so on, there's no way in a world that a client, take our average client of 14 employees who pays us about $2,200 a year.

There's no way in the world they could hire somebody to do what we do for them.

So it's a - - we have a value proposition that's great for our clients and it's great for us.

Everybody wins.

That scales all the way up to the Premier product.

And if you think about it, in it's the simplest form the Premier product provides clients with everything they would get from an in-house personnel department.

They get an HO - - a human resources rep from us, essentially an HR consultant.

They get access to payroll, tax pay, employee pay or direct deposit, 401K programs.

And so the whole plethora of offerings that we have.

And they get it at a price that they couldn't possible do by themselves internally.

So, the same type of leverage that we are seeing from a pricing environment on the low end is also available on the high end.

And are those Premier clients similar employee client size as you are seeing in your standard and traditional business?

No, if you took the average client for all the Paychex against the average client for Premier, it wouldn't be the same.

The average client for Paychex tends to be, as I said earlier, about 14 clients.

Premier offering by its nature would tend to be attractive more for a larger client than that.

With that said, there are lots smaller clients that use the product.

They maybe - - they may have a small number of employees but they may be at the high end of a professional services world.

And so they have all very strong earning white collar types employees.

And so the types of offerings might be more valuable to them.

Or they might be a smaller firm that is run by somebody who came out of a large corporation and is used to all of the help and caring that comes out of a personnel department.

So it's - - but the general nature of the Premier client is larger than the nature of the average Paychex client.

Would you say that goes up to a few hundred client employees or beyond that?

If you go up - - if think about what our major markets clients are today, we have major market clients that go up to 1,000 employees, 2,000 employees.

So, there's nothing in the nature of the offering that would stop it from going to any client that is a Paychex client.

And those clients, as I said go up, in some cases above 1,000.

Thank you for the color

[OPERATOR INSTRUCTIONS] Your next question comes from Tien-Tsin Huang of J.P. Morgan.

This is David Cohen for Tien-Tsin.

A question on the 401K.

Would you talk about the - - a couple of questions.

Would you talk about the market opportunity as well as the penetration rates and existing client base and the fee and margin profile on that business?

The fee arrangement is generally about $100 per person and $100 per person sign up fee.

The margins are good.

But we don't look at margins too much by product.

Because we really benefit on this product from the fact that a lot of the cost is already into the core payroll client and the clients that does it.

So, the margins are obviously very good.

When I look at the market, the market on the 50 and over employee market, the percentage of penetration on that hasn't changed much over the last three to five years.

Now, the thing that we are looking forward to is next spring or probably towards June; we are going to be able to offer a lot more funds.

Where we've been limited in the past to only being able to offer our four major fund managers.

We are going to be able to offer, I won't call it an unlimited number, but expanded a lot, which is going to allow us to us have a better chance to get planned conversions.

Which right now is difficult for us to do.

The reason you don't get many planned conversions is; people don't want to tell their employees they've got to change where the money is invested.

If you can to allow it to change without having to do that it's easier.

So, that's what we are going to have the ability to do.

Now in our marketplace we have about 35,000 or so 401K's.

There's probably another 70,000 that we have that basically aren't ours.

So, we've got some good hopes for that but only time will tell.

Okay.

Thanks.

With the breakout of the PEO, on a historical basis, if we were to look at the paths in PEO that you've given in the past and back out the PEO historical.

Is what's left of the Premier over a historical basis is it that simple or is it something else in there?

It's probably that simple.

But whether you'd have - - first all what I gave you the back out, the historical data you are going to find on the Website is simply the revenue.

So, the revenue will probably work.

Now, the other reason we broke this out; when you do Premier and this is where we have apples and oranges.

Now, on the Premier product the payroll revenue or the regular Paychex stuff is allocated back to those products.

In other words, in the Premier, that's simply the Premier administration fees that we are generating.

In the PEO we don't do that.

PEO is the PEO.

So, the delivering of payroll to a client that revenue sits in the PEO.

So, they are really not apples and apples.

And that's another reason why we decide to do break it out.

Okay.

Thank you.

Your next question comes from Mark Marcon of RW Baird.

Good morning.

I was wondering with regards to the PEO change in legislation, John, can you go through that one more time, just in terms of specifically what changed?

It sounds like - -?

Workers' comp. is a moving target all the time.

You've got, what are you going to pay?

So the State of Florida basically put in some tort reform in 2003, October, I believe, that would apply to all accidents after that date.

Not ones before it.

So, there's certain things they won't pay.

Somebody told me what they were, I can't remember what they were.

And basically that lowered workers' compensation claims.

Right.

And then what they did when they saw the claims actually got lowered, then they lowered their rates.

But they didn't lower their rates until they saw the claims went down.

So they lowered the rates and that went into effect when?

It's going into effect January 1.

On January 1.

And then because they are lowering the rates that basically means that you obviously won't be able to charge as much to your clients for workers' comp. because the overall rates are down?

That's right.

But that wouldn't impact your margins per se would it?

Yes, it means I get less - - well, if you take the cost out, no.

I think the margins will stay about the same.

So the margins will stay about the same.

And then staying on the topic of margins, your incremental margins excluding float income were basically 50% on a year over year basis.

And your operating profits x-float were up 20%.

And obviously your business mix continues to shift more towards HR and ancillary services that have higher margins.

Can you go through it again in terms of why the profit growth x-float should slow - - why isn't this more of a permanent shift as opposed to coming back down towards 15% growth on - -?

Partly it's because I've got - - in the first half I got unusual profits from the PEO.

That's - -.

That affected that percentage.

You've got everything going with it.

I didn't think we would ever have a year we'd go much above 15%.

And we got it because the year started off better than we expected.

And you've got everything kind of going for you in the economy now.

And it's stabilized a little bit now.

So, I don't think it's going to change dramatically.

And you've got some money that's there in the PEO.

And the funny part about this is, I don't have to move - - it's funny, you've got a Company that generates 600+ million pretax but the amount of money it takes to change that 20% year over year is just a few million dollars.

Right.

And so you are talking about a business that's doing 1.6 billion in revenues and that number just changes.

So, I think when you look at the year and last year we are going to have much tougher comparisons in the last six months on that.

Because I not only benefited in these six, I am going to benefit in the next six.

So, I've just got a few things in different places than norm.

But still the business is fantastic and any year I'm above 15% without float I'm thrilled.

Yes.

But the PEO is that much of a difference.

The PEO is small but you take $4 or $5 million in the quarter and it changes that number.

Okay.

And then can you - - and unfortunately I wasn't on the call the whole time.

So, I apologize if this is redundant and we will follow up off-line if it is.

But did you talk about where we are with the - - with regards to the initiatives in terms of bolstering the sales force and payroll specialist retention rates?

We are doing fine.

We are seeing modest improvement.

Nothing significant yet because it would be too early to the get that kind of improvement if you can do something that's lasting.

But all indicators look good.

But we're still working on it and we'll be working on it.

Because I'm not sure we will ever be satisfied in these areas.

But payroll specialist has been a little bit more than the salespeople but we're seeing good results there too.

So, on both fronts they are improving?

Yes.

Thank you.

[OPERATOR INSTRUCTIONS]

I think we don't have any more questions.

So first, I would like to thank everybody for taking part in this.

I really appreciate your interest in Paychex and I hope you all have a very happy and safe holiday season.

So, thank you from both of us.

Take care.