TriNet Group Inc (TNET) 2015 Q2 法說會逐字稿

Good afternoon, everyone, and welcome to the TriNet Group's second-quarter 2015 conference call.

(Operator Instructions)

Please also note that today's event is being recorded.

At this time, I would like to turn the conference call over to Mr. Alex Bauer, Investor Relations. Sir, please go ahead.

Thank you, operator.

Good afternoon, everyone, and welcome to TriNet's 2015 second quarter conference call. Joining me today are Burton M. Goldfield, our President and CEO, and Bill Porter, our Chief Financial Officer.

Burton will begin with an overview of our second-quarter operating and financial performance. Bill will the review our financial results in more detail. Bill, Burton and I will then open up the call for the Q&A session.

Before I hand the call over to Burton, please note that we may make forward-looking statements during today's call that are subject to risks, uncertainties and assumptions. In addition, some of our discussion may include non-GAAP financial measures. For a more detailed discussion of the risks and uncertainties that could cause actual results to differ materially from any forward-looking statements, reconciliations of non-GAAP financial measures, please see the Company's public filings, including the most recent Form 10-Q filed with the SEC, and Form 8-K filed today, all available on our website.

With that, I will turn the call over to Burton for his opening remarks.

Thank you, Alex.

I am pleased with the progress we made in a number of important areas during the second quarter. Professional service revenues grew 19% to $98 million. Additionally, professional service fees per WSE grew year over year.

We surpassed a significant internal milestone with respect to WSE count exceeding 300,000. Total WSE count grew to 302,375, up 16.8% year over year, and importantly, up 4.7% from Q1.

We finished Q2 with 486 quota carrying sales representatives, putting us ahead of my commitment of 470 sales representatives as of June 30. As I have stated in the past, this metric and my commitment to 25% year-over-year growth in quota carrying sales reps is a key indicator of future new sales.

Additionally, our worker's comp claims experience came in as expected during the quarter, which was a key concern of mine after Q1. I continue to comfortable with the Worker's Compensation 2015 forecast I gave you at that time.

Now while the fundamentals of our business remain strong, I am disappointed that our second-quarter financial performance was negatively impacted by a higher than usual number of large medical claims. These claims were well in excess of our expected and historical claims volatility. Medical claims volatility was impacted by the frequency of large medical claims and not the severity.

Additionally, there does not appear to be adverse selection. These large medical claims do not appear to be associated with new clients, as the large claims have been driven by clients joining prior to 2013.

The enhanced large claim medical reporting process we put into place with our medical insurance carriers appears to be working. Unlike Q4, there was no significant impact from old claims in the quarter. As a reminder, our net insurance revenue is comprised of three parts, benefits, administrative fees, worker's compensation revenue and benefits performance fees.

Moving forward, I am comfortable that both the benefits, administrative fees and the worker's compensation revenue will continue to grow predictably with my WSE count. I am less comfortable with the predictability of the benefit performance fees, given the high level of volatility in Q2. As a result, our 2015 forecast, which Bill will summarize shortly, now assumes that the higher claims level continues. We do believe this is a prudent path to take at this time.

Make no mistake, my top priority is addressing the medical claims volatility and its impact on the P&L. I will strengthen my internal team. This includes the recruitment of a senior insurance services executive reporting directly to me, as well as additional actuarial and analytical capabilities.

Turning to the market opportunity for TriNet's product and services, the momentum achieved in Q2 is a positive indicator for the remainder of the year and 2016. My team is passionate about our mission, powering our client's business success through extraordinary HR. Whether it's helping small and medium-size businesses navigate Affordable Care Act, or the newly enacted Federal Overtime rules, TriNet is well positioned to be our client's trusted advisor in these areas.

The value of a verticalized solution, which includes local HR expertise, Fortune 500 benefits and a cloud-based technology platform is a unique offering to the vast small and medium business market. Each day 55 million people go to work at companies with between 1 and 500 employees. These employees work for companies that are facing pressures from increased regulatory complexity, and a need for effective HR and attractive benefits.

In order to penetrate this large addressable market, we have organized our sales team by product and by business vertical. Prospective sales representatives are increasingly attracted to TriNet.

Our brand recognition within our target verticals continues to grow, and TriNet is viewed as the premium solution. Because of this dynamic, we are excited about the quality of our new reps. I just returned from our sales kick off event in Phoenix, Arizona, where over 700 attendees in all focused on training, education and mastering the vertical that the reps are selling into. Presentations by existing customers, referral partners and industry experts added color and perspective to each of our core verticals.

Our new reps have been selling into the business verticals we are targeting. After graduating from our training program, these reps are armed with TriNet product knowledge, and are ready to leverage their prior industry experience in preparation for 2016's selling season. Our sales hiring strategy, combined with the training and focus on verticals gives me confidence in new customer acquisition across our product portfolio, continuing the Q2 market momentum.

Turning to our market opportunity, our biggest competitor by far is the unbundled solution, where potential customers are required to piecemeal their HR solution through a web of vendors and brokers. We consistently see this in 75% of the deals we pursue. Our vertical product offerings simplify this exercise for our customers.

With TriNet Passport, we see strength in our technology, life sciences, not for profit and professional services verticals. Passport is characterized by an intuitive, paperless, self-service platform with a comprehensive selection of benefits. Clients cite the product's complete offering, defined by its technology, service model and benefits as the key reason they choose passport.

TriNet Ambrose is characterized by a high-touch service model, with top-tier benefits and direct access to compliance, tax and other specialists. Ambrose remains the premier brand within its selected verticals, including hedge funds, private equity and law firms.

TriNet SOI is characterized by complex multi-state HR and payroll needs. SOI is well suited for verticals that include property management, hospitality and light manufacturing. Coming out of last quarter, we have made significant progress in repositioning the SOI sales force into a vertically-focused channel with sales trending in the right direction. Our vertical focus, combined with our ability to manage multi-state compliance, operating an ACA compliance risks represents an exceptional product offering that is, in fact, resonating in SOI's target markets.

In summary, we continue to see strong momentum in our business, as we penetrate the large, unaddressed SMB market with our unique products and vertically-focused sales and service strategy.

And with that, I would like to turn it over to Bill for the financial review. Bill?

Thanks, Burton.

Our second-quarter net service revenues declined 2% to $122 million year over year. Total WSE count was 302,375, up 16.8% year over year, and up 4.7% since the end of the first quarter. Professional service revenues increased 19% to $97.8 million year over year.

Net insurance service revenues declined 43% to $24.2 million year over year. Net insurance service revenues were affected by a significantly higher number of large medical claims than we had anticipated.

Run rate medical claims and pharmacy claims came in as expected, with premium being slightly under our forecast. The result in Q2 was an approximate $20 million reduction in our net insurance service revenues compared to our forecast.

Our revised 2015 forecast assumes the higher claims level continues and is included in our trend. The result is, in addition to the Q2 impact, we are reducing our net insurance service revenues by an additional $10 million for the remainder of the year compared to our prior guidance.

Total adjusted EBITDA for the second quarter declined 37%, to $24.7 million, compared to $39.4 million for the prior-year period. Our Q2 adjusted EBITDA margin was 20.3%. Adjusted net income for the second quarter declined 40%, to $10.5 million or $0.14 per share, compared to $17.4 million, or $0.24 per share in the same quarter last year.

Our GAAP effective tax rate was 201% for the second quarter, primarily due to a discreet tax charge of $2 million for the reevaluation of the deferred taxes for New York City. We expect our long-term pro-forma effective tax rate to remain at 40.5%.

During the second quarter, we generated $25.4 million in free cash flow, which is defined as operating cash flow less CapEx. Historically, we have spent approximately 3% to 4% of our net service revenues on an annual basis on capital expenditures. During Q2, our CapEx spending totaled $5.7 million, which was 5% of net services revenues.

We closed the quarter with total debt of $510 million. Representing a debt to adjusted EBITDA ratio of 3.3 times trailing 12 months adjusted EBITDA. We spent an additional $5 million in the quarter to repurchase stock. Total cash was $128.4 million at the end of the second quarter, and working capital was $50.7 million.

Turning to our outlook, we now expect Q3 net service revenues to be in the range of $131 million to $136 million, which represents growth of 4.5% year over year. Adjusted EBITDA in the range of $28 million to $33 million, and adjusted net income in the range of $12 million to $15 million, or $0.16 to $0.20 per diluted share.

For 2015, we now expect net service revenues in the range of $555 million to $565 million, which represents organic growth of 9% to 11% over 2014. We expect adjusted EBITDA in the range of $160 million to $170 million for the same period, representing an EBITDA margin range of 29% to 30%. And adjusted net income in the range of $77 million to $83 million, or $1.04 to $1.12 per diluted share.

Now I will turn it back over to Burton.

Thanks, Bill.

In summary, we are capturing market share with 4.7% sequential growth, the strongest in our industry. Our vertically-driven value proposition resonates with prospects and clients. With this continued momentum, my top priority is addressing the issue around the medical claims volatility so we can return to 15% organic revenue growth with 33% to 34% EBITDA margins.

And with that, let me turn the call over to the operator for the Q&A session. Operator?

(Operator Instructions)

Our first question comes from Smitti Srethapramote from Morgan Stanley. Please go ahead with your question.

Hello, this is Daniel Hussein calling in for Smitti. Burton, you mentioned that you had improved the visibility of the medical claims, but clearly the guidance you gave last quarter didn't contemplate these medical claims coming in. So could you just please clarify what aspect of the visibility you've now gotten more comfort with and what is left to do?

Sure, thank you so much for the question. The Q4 issue was around claims that had been made earlier in the year, and they all came through in Q4. The issue that we had this quarter was a large spike in large claims, but they were not from prior periods for the most part. So the increase in medical expenses was largely driven by higher than expected and large claims. So that our system is working, which is getting the reports from the carriers in a reasonable timely fashion.

The other point is the composition of these large claims were largely acute. Meaning they are not chronic conditions that I expect to persist, and the run rate medical claims and pharmacy claims, which we consider trend, came in as expected. So, my issue was a bunching of large claims in Q2. They were not old claims that were flushed through the system. The reports are working.

And ultimately, the final piece, I would say, is that there does not appear to be adverse selection. Because the large claims are not from a bunch of new customers joining us with acute medical conditions. They were from clients that have been with us for a long time. The other thing that I would say is they are primarily from the Passport technology vertical, and majority are from California. Our large carrier in California experienced the same spike in claims. So we do not feel we are either taking on a particularly risky book or there is adverse selection.

The issue is that I haven't seen that type of spike since I have been with the Company over seven years. And we need to find ways to, A, get better visibility and, B, to dampen the spike because it's not acceptable, the variability I saw in Q2.

Understood. But at this point, would you consider reevaluating reinsurance options, for example, that give you -- maybe where you give up some net revenue but dramatically improve the predictability of the revenue model going forward?

So, absolutely, any and all things are on the table. But addressing the issue around this medical claims volatility and impact in the P&L is my top priority. So, I'm going to strengthen the internal team with a senior insurance executive who is right by my side. I'm going to increase the in-house actuarial and analytical capabilities, and I need to explore ways to dampen that.

Up till now, reducing the pooling did not seem like a viable option from a cost standpoint. And, frankly, our pooling levels vary, but they go up to about $1 million for some carriers. Most of these claims were between $200,000 and $500,000, even if I had pooling limits at $500,000, it wouldn't have materially changed the outcome of Q2. So anything and everything is on the table. But if it was an obvious answer, I would tell you the answer today and the fact is that just a simple reduction in the pooling limits would not have impacted this quarter materially.

Understood. And maybe just one quick follow-up for Bill, just clarifying the change to the guidance.

You mentioned basically you are assuming a higher rate for the rest of the year. But clearly, $20 million this quarter and then $10 million for the remainder of the year doesn't seem to assume the same loss rate. So could you maybe just provide a little bit more color there? Thanks.

Sure, Daniel. So we looked at it internally with our advisors, and the best thing we can determine is this higher level of claims will remain. So we are trending that forward at the appropriate rate. And that's why we have got the additional $10 million increase.

We have also done some sensitivity, and it's -- and very possible that we may not see the same level. But we think at this point, it's prudent to leave that higher level in and increase the trend on it. And we'll just determine over the next couple of quarters whether this really does go down, or whether it's a higher level of claims that we now experience and have to build into our business.

Great, thank you.

Our next question is from Tien-tsin Huang from JPMorgan. Please go ahead with your question.

Burton, I caught the lower confidence that you said, the benefits performance feed line, but you are still sticking with your longer term growth target. Does it make sense to slow down the sales engine a little bit just to make sure that you can focus on this with the right resources?

Tien-tsin, it's a great question. If you look at the service revenue line, it's up 19% year over year. And this is before my new sales reps have kicked in. I think the quality of the reps are great. I believe their productivity will be great, and we have an opportunity to capture market.

Having said that, we need to resolve the insurance issues, and I take full responsibility for that. It's unacceptable. I need to get the predictability in the system. I do think they're somewhat tangential issues. I have a great sales engine, the vertical strategy is resonating. The market conditions are helping, particularly with this new wage an hour law, under $50,000, everybody wants a time and attendance system.

There is just a tremendous amount of pressure to get our solution in place for a wide variety of companies and verticals that we are in. But, I need to address this problem. My focus will be on this problem. Frankly, the training was intensive last week. I can turn my attention full time to this issue. The new reps are in place. The training is essentially done.

So look, I will reevaluate it at the end of the year, Tien-tsin, but the reps are in place. I made the 25% growth for this year. I will certainly reevaluate it at the end of the year. My hope is we, get this under control both from a variability and predictability standpoint, and we move forward with the bundled model which is what the clients are clamoring for.

I get that the demand is there. Just curious to hear what you are thinking.

A couple more. The large medical claim issue, can you just go over it again? How is this one different from what you saw in the fourth quarter? And are you changing the way you're rolling that through and the way you guide philosophically?

It is very different in my mind in Q4, Tien-tsin. A, the magnitude is a lot greater. It was about a 5% spike in Q4, which included a significant amount of older claims that were up to 6 months old being washed through the system. We worked with our carriers directly with the senior executives, and said, that was unacceptable. They need to give us the visibility. This quarter, the spike between May and June was closer to 15%, so it was the biggest I had ever seen.

They were not predominantly old claims. There was some from March, but that is acceptable in my mind because it takes 60 days to process, not six months. So these were claims that were incurred in Q2, and at the very tail end of Q1. We got visibility to them in a reasonably timely manner. As I said, they were mostly from Passport, many from California. A lot of people on high-end medical plans. They were acute, things like fractured skulls and things like that. So this was not chronic where we think it will continue. And I'm still digging claim by claim to understand.

There was a statistic, Bill, on the number of large claims to date. Can you point that out to Tien-tsin? Which will give you some idea of the frequency being up so much. And it was not the severity. So it's not that we had a lot of big claims or a small number of big claims. It was a lot of medium size claims.

Got you.

Yes, Tien-tsin, this is Bill. So when we look at just the number of claims greater than $50,000, it really did go up significantly in the second quarter. But plan year to date. So for last year, plan year, we had somewhere in the neighborhood of 500 claims that were greater than $50,000. And through May, which is when we get good paid claim data, we have around 400. So we did see a pretty good increase, and a lot of that happened in Q2.

So it was tracking with our forecast in April, May. And as Burton mentioned, it was a sequentially large increase from May to June, which was the big surprise. And as he also indicated, the sequential increase from November to December was about 5%. So this is a 3X sequential increase. So we're just really trying to understand it.

We took time to go to our carriers to make sure that there wasn't something that changed with their business, or their processing of significance. Or were we seeing something completely different, and where the majority of this occurred, as Burton mentioned, in California, our carrier there did see an increase in claims in the $100,000 to $700,000 range in the April, May and June timeframe.

So it seems to be similar. They did not have a good understanding yet of how it was affecting their book, and we are still going through it as Burton mentioned. We do enough, know enough to know the cohort is below -- or before 2013, they're primarily acute and they are in Passport.

That's helpful to get that. Just one last quick one.

Just on the guidance change. I think it's a $25 million, $28 million difference in revenue and EBITDA. Anything changed on professional services fee line that we need to be aware of?

No, I think you're going to continue to see the progress that Burton mentioned throughout the year. So you will see a slight continued increase there along the trend we have been going. And the negative is just the recognizing what happened with the medical claims. And building those, that $30 million increase, $20 million that hit us in Q2 and $10 million for the rest of the year. To make sure that we think we have got a forecast now that builds in all the information that we know about.

Got it. Thanks for taking my questions.

Thank you so much, Tien-tsin.

Our next question comes from Timothy McHugh from William Blair. Please go ahead with your question.

I just wanted to circle back to dissect this a little bit more. If it was a $20 million impact in Q2 and you're assuming a similar frequency. Why isn't it a $20 million impact or $40 million for the second half of the year?

Tim, I don't think we know enough to say that this frequency is going to continue to go up. I think we, in talking to our advisors and really understanding from internal team, we don't expect that it would necessarily go down to the previous level.

So we are assuming that that increase is there, and we take that higher level and now are trending it forward. Which is normally what we would do with a traditional claims level, we'd trend it forward at a slightly higher rate for those larger claims which is what we have done.

Okay. So, I guess -- I can circle back. I guess I'm not fully clear why that doesn't result in more of an increase in expense or a similar increase in expense and similar impact to Q2 as you go forward.

We are not expecting, Tim, we're not expecting another significant step up like we saw in Q2. But we think that level of claims doesn't necessarily drop down to the previous level. It stays and gets trended forward at approximately 10%. We can talk more.

Okay. And I guess as we -- there a part of -- there was a part of there that you said the premium growth was a little less than you expected. Can you, of the $20 million, how much was premium growth versus just the claims piece?

That's a -- the premium, we saw about $3 million of premium slightly lower than our estimate. And that, for the most part is, we saw some of our clients taking employee only versus employee family, so slightly lower premium in terms of what they were selecting. So that is something we're just going to have to look at.

I think part of that is just our ability to monitor that more closely. That did not come in. And in June, we did see that develop over the three months, but it was within our normal forecast of variance level so we're able to absorb that. It's the claims piece that we weren't able to recover.

Okay. And then, Burton, you talked about the SOI, the sales trending in the right direction. But I guess you talked about productivity in the quarter of the sales force.

Was it fairly universal across the three platforms, was there a lot of variance in how it played out? Any color there would be helpful.

Great, Tim. So Q1 was somewhat disappointing in SOI, and I see it trending up, which is great. I talked about the verticalization of the SOI sales force further, and a bunch of new people coming on board. So, I was happy with the overall productivity of the sales force. I was not particularly thrilled with SOI in Q1. Q2 was trending in the right direction. Frankly, Ambrose had a great quarter in Q2, and Passport did a great job as well. So if I had to rank them, that's they way I would rank them. You can see by the PEPM service fees that it was up considerably year over year. So that gives you some indication of what clients are electing, and what is happening from a service fee standpoint.

We are not getting a lot of pricing pressure. And as I say, a lot of these deals are essentially -- there isn't a competitor in there. So, I didn't talk a lot about particular customers, but there was some really wonderful wins. A professional services company in Huntsville, Alabama, with 193 WSEs that came on board. And they are doing a bunch of government contracts, and they're growing like crazy, and they absolutely love Passport. There was phenomenal examples of different hedge funds that came on board on the Ambrose platform.

So I just see a real opportunity, frankly, for TriNet and others to address the complexity in these small, medium businesses. And it goes back a little bit to Tien-tsin's question. I need to focus on the variability of the insurance, and the team needs to execute on the channel. But I am very comfortable with the direction the channel is going, the sales meeting, 700 people in Phoenix, Arizona in 112-degree weather. Going to these training classes. It's the largest sales kick off obviously in TriNet's history, and it was executed flawlessly. So that ended on Friday. People came back, and now they are in their seats and they're executing. And to have almost 500 quota to carrying front line non duplicative sales reps in the field today, I believe it's the largest sales force on the planet in this arena.

Okay, thank you.

Our next question comes from Edel Garrett from Deutsche Bank. Please go ahead with your question.

I just wanted to look a little bit at your expectation from meeting your sales force growth target. Looking at the WSE growth year over year, it decelerated a bit in the quarter. Should we expect this to recover in the back half of the year, just given how much the sales force has grown?

This is Bill. I think the thing to think about is that the total WSE growth does take some time for the sales force to season, as we have talked. So the new reps, we are not going to really expect them to be productive for six months.

And I think having 19% year-over-year growth and continuing to increase our sales force is not a bad start for that sales force. So we are happy with that, we would always like to see that productivity be completely in line with the growth but I don't know that we will quite get there. I think there will always be somewhat of a lag.

Great. And then also just looking at the sales force initiative you have with SOI, do you have a timeline or just an update as far as how much is completed and when it might be fully done?

So, that is a great question. The answer is, we will always be splitting out new verticals, but the fundamental construct and the change over what it was in the past is done. The fundamental construct when having dedicated territories with verticals, with management that is focused on those verticals, and having referral channels including brokers, trusted advisors, and third parties is pretty much already there.

So, we have formed some third-party relationships. Apparently, they haven't been fully announced yet, but we are looking to trusted advisors to accelerate that growth further. And I am pretty optimistic about both the ecosystem around each of the verticals we serve, as well as the SOI sales force and go to market. It was more churn than I would have liked from a sales rep standpoint. I see that slowing down. I see the new folks coming in.

They are coming into the verticalized model, every new rep that came in came into a verticalized territory. And ultimately, I believe we will be able to feed them a lot of high quality leads through our referral partners, through our brokers, and through relationships like we have with WeWork today.

Great, thanks. And just a couple of last quick ones. Do you have a new target for your sales force, where you want to be in the full year?

And then lastly, it seems that you said CapEx was a little bit higher than the 3% to 4% that you targeted, this quarter, it was around 5%, if I recall correctly. Can you talk about where that additional investment -- what areas you are making additional investments in the quarter?

Great. So from sales rep count, I want to exit on New Year's Eve with the 470 that would be a 25% year-over-year growth. So right now, I need to get the folks out selling, and I need to hold on to those reps so I'll be north of the committed number of 470. And then we will -- assuming no changes as we move into 2016, I will commit to you that by June 30, we will have the 25% increase over the 470.

Why June 30? Because it takes six months for those reps to become productive. They don't have a quota when they come in the door, they go into training, they generate the leads and they learn the business because they're coming out of the verticals. So until I come up with a different model, that would be my commitment. The 470, we met. So I need to hold on to 470 for New Year's Eve, and then 25% by June 30 again.

On the CapEx, I will turn it over to Bill. But suffice to say, that the client experience, as it relates to the platform and services, is being enhanced each and every day. We have releases now monthly, and Bill can talk a little bit more about the CapEx.

Yes. It's really something pretty simple in that, we were spending at the target level of 3% to 4%. Given we had the variability in the medical line, it just took that percentage up to 5%. But it's on the targets in terms of getting our IT and product in place for our clients. So that's where we are spending it. But it's at our target level. We had a little more revenue than we had anticipated, which is why it tipped up just a percent.

Got it. Great, thank you.

Our next question comes from George Tong from Piper Jaffray. Please go ahead with your question.

Burton, can you discuss what might have caused the higher than expected frequency of large medical claims this quarter? Particularly given the groupings of claims on the Passport side.

And secondly, can you describe maybe in a manner understandable to investors how you model and forecast large medical claims frequency? And what analytical actions you might be undertaking to manage volatility and improve visibility of these claims?

Sure, George, and welcome to the call. So the increased medical claims were largely driven by these higher than expected large medical claims. That is number one.

Number two, it's important to understand that my characterization is these large claims were acute, meaning they are not chronic. So this isn't leukemia that goes on for years and years. It was more acute conditions.

The other point I want to make, as you delve into this medical claims issue, is the run rate, medical claims and pharmacy claims came in as expected. I consider that trend. So if you see a big jump in average medical claims, if you see a big jump in pharmacy claims, that would be an ongoing increase in the baseline. And as Bill said, our premium was a little under forecast. We need to get that forecasting a little better.

Additional characterization would be that people are opting in. Obviously it was a large quarter for new clients coming in, and they may opt in at a higher deductible plan or they may opt in without the family or something else. So there was a slight under forecast from what we get in premiums. Because in the end, the performance fee is the premiums less the claims. That is the number we are talking about.

The other point to make is that it wasn't a bunch of old claims being flushed through the system. We do have visibility to the claims for the quarter.

The other point I would make is you want to make sure that you don't have adverse selection, meaning I am bringing on a bunch of sickly clients. The clients that drove these large claims in Q2 were here prior to 2013. And again, they were out of the Passport book of business, which has been around for 25 years in the technology vertical, and the majority were in California. So that's sort of the characterization, the best I can give it to you honestly right now.

To turn to your question, what do I do about this? I need to directly address this medical claims volatility, number one, and I need to address the visibility to those medical claims. So number one is, we need clean data from the carriers. I believe we are well on our way to getting that. This does not seem to be a date issue. Number two is, we rely on outside actuaries and consultants. I need to bring in some expertise in house (inaudible) like TriNet. So that includes a senior executive reporting to me, additional actuarial and analytical capabilities. And ultimately, and the final piece is, I have already engaged with an outside consulting firm, one of the nationally known firms who has done some work with us in the past, to look at how this business model can be explored to take advantage of the opportunity we have here.

So I will give you the answers as soon as I resolve the issues. Obviously there's a couple of outcomes. One is, we have the pricing power. So over time, I can get back to the MORs that we have been interested and promised. So assuming this is now the new trend, we bring on clients every quarter, and we renew medical plans every quarter. So I can increase prices if that is an issue from a trend standpoint.

If the spike abates in Q3 and Q4, I need to look at other ways to lay off some of the volatility through some other construct, I'm not sure exactly what that is. The classic is a pooling construct. But I am looking for things more creative than a straight pooling construct. And then ultimately, to really understand and characterize it better so I can give you very direct answers on the issue. So I hope that helps, and if there is a follow-up, I am glad to try to answer further.

Yes, that's very helpful. Thank you.

Bill or Burton, your new guidance assumes large medical claims frequency stays elevated at current levels. This would suggest something structural has changed as opposed to merely the timing of claims. Can you discuss why or why not something may have changed structurally on the medical side?

Sure. And, George, I think the -- as Burton mentioned, we look at run rates, which should be pretty predictable, and we also look at pharmacy, which has also been predictable. The nature of large claims is that they are somewhat unpredictable. And that is the difficulty we have in trying to really understand what is happening. I don't know that it's structural. It's possible that there will be a higher level, or it's also possible, as we talked to carriers and we've talked to others in the field, who have seen large groups with this type of claims level.

Sometimes these things go back to the previous levels, and other times, they stay at a new plateau. We don't have enough information now to really understand that yet. So that is the piece that we're going to be continuing to look at. But irrespective of that level, I think Burton is also saying we do need to figure out when we do have these unexpected increases, we have to figure out a way to dampen the volatility. Which is a separate but equally important, if not more important, aspect that we are having to look at.

Thank you.

Our next question comes from Jason Kupferberg from Jefferies. Please go ahead with your question.

This is Ahmed Sang for Jason. Coming out of IPO, and the way we thought about this business and the way you had spoken about it, is long term, it's a 15% year-over-year organic growth type of net revenues, and adjusted EBITDA margins in the 33%, 34% range. But in these large claims, you are expecting the level to continue on for the rest of the year.

And if that continues on, assuming it stays at this level going forward. So the way to think about the business in the near midterm is, the adjusted margins closer to the 30% range and the top line organic growth closer to 12%, 13% range. Am I thinking about it right?

Good question. Our long term financial model remains intact. And as you point out, in the short term, we need to understand the impact of any potential changes as we consider these options.

So as we talked about, the service revenue growth was 19% year over year, I expect a strong second half. Obviously, if the performance fees do not come back in line, it's a drag on the growth rate. And I think you are absolutely right at the 29% or 30%.

So the long-term capability to get back to north of 15% top line revenue growth is very much there from my standpoint. But we need to look at how this predictability of our medical revenue and its contribution to net insurance revenues comes out over the next two quarters or so.

All right. Great. And you are talking about strengthening your internal capabilities to get a better handle on these claims, and also hire some outside consulting firms. Should we see any spike in your G&A or any expenses over the next couple of quarters, or is that not material now?

Ahmed, I think we have got enough capacity. I don't think we're going to see a dramatic increase. I think we should be able to absorb the work that Burton is referring to in the normal course.

Thank you very much.

Thank you, Ahmed.

Our next question is from David Grossman from Stifel Financial. Please go ahead with your question.

Most of my questions have been answered. I just have two very quick follow-ups.

First is, Bill, can you repeat the statistic that you provided about claims over $50,000? I didn't quite catch that.

Sure, David. So for our prior plan year for claims over $50,000, we were seeing a number of approximately 500. And plan year to date, so for the eight months that we are in our plan year, it's starts October to May in terms of where we have good statistics. We are seeing approximately 400.

So the level is elevated, and a lot of that has come through in terms of what we just experienced. So we are trying to understand that. Our estimate at the end of last year, as you recall, was we thought that that was an increase. And we built that level into our 2015 planning. And now we have seen it, at least in Q2, go up higher than that. So we are trying to really understand what that means.

Right. So just so I got the numbers right, so you were -- is there a comparison year over year for the quarter? Or are we comparing the eight months that ended May was a certain number, and you are saying the run rate just for June is substantially above that rate?

Well, the run rate that we are experiencing in the second quarter has taken us up significantly. We don't have completely accurate statistics when you get on month-to-month basis in the current quarter.

So I'm giving you the best relative data on paid claims, which is a full year versus plan to date. So it's just indicating that the run rate is up, and we know a little bit of the nature, as Burton described. But that is the best I think I can give you at this stage.

I see. And then the other question I guess gets back to a question that has been asked in a couple of different ways. It gets really to the fundamental business model around offering insurance. And as you know, two of your largest competitors pretty much passed through the health care side of their business.

And I'm just curious why -- first, why you chose this particular model that you have? And then secondly, why there is still some reluctance, given the volatility in these claims, to migrate towards that model, given much bigger companies who have much more room, if you will, for error? Just given their scale and there are other businesses have chosen that route, why you think you can stick with this particular model and make it work.

It's a very valid question, David. The reason why we have chosen to do a portion of our business this way, is because the deductible program does give us flexibility to formulate our plan structures and our pricing with the carriers. I think it aligns us, and that is something that we have found prior to this really large amount of volatility to be pretty useful in how we run the business.

Now that being said, if we have this level of volatility, that is unacceptable risk that we have to try to figure out, as Burton mentioned, to look at various ways that we can try to mitigate that. It may be taking on different insurance constructs, either around the current structure or in addition to it, to limit the volatility. So we are going to keep looking at all of those. I think there is some benefits to it. But we're going to have to manage it against the obviously the risk of volatility.

Right. If I could just ask one follow-up to that. Is there a particular segment that that flexibility becomes particularly important, or is it important in all three segments in terms of your ability to use that to your advantage and garner share?

So, David, it's primarily in Passport which is where we have had the structure. As we talked in the past, the blue and gray business, SOI, doesn't have that many of its work side employees on medical. Only about 25%, given that they, in many cases, don't take it if it's offered.

And it's also not a structure that we have seen historically at Ambrose. So it's really been the Passport structure that we have historically used it, and will we need to refine.

Got it. Okay, guys, thank you.

Thanks, David, appreciate it.

Ladies and gentlemen, that does conclude today's question-and-answer session. And I will also now close today's conference call by thanking everyone for their attendance. You may now disconnect your telephone lines.