Management's Discussion
and Analysis of
Financial Condition and Results of Operations
The
following discussion should be read in conjunction with, and
is qualified in its entirety by, the Company's Consolidated
Financial Statements and Notes thereto included elsewhere
in this Annual Report. Historical results are not necessarily
indicative of trends in operating results for any future period.
This document contains forward-looking statements within
the meaning of Section 27A of the Securities Act of 1933 and
Section 21E of the Securities Exchange Act of 1934. You can
identify such forward-looking statements by the words "expects,"
"intends," "plans," "projects,"
"believes," "estimates," and similar expressions.
In the normal course of business, Administaff, Inc. ("Administaff"
or the "Company"), in an effort to help keep its
stockholders and the public informed about the Company's operations,
may from time to time issue such forward-looking statements,
either orally or in writing. Generally, these statements relate
to business plans or strategies, projected or anticipated
benefits or other consequences of such plans or strategies,
or projections involving anticipated revenues, earnings or
other aspects of operating results. Administaff bases the
forward-looking statements on its current expectations, estimates
and projections. Administaff cautions you that these statements
are not guarantees of future performance and involve risks,
uncertainties and assumptions that Administaff cannot predict.
In addition, Administaff has based many of these forward-looking
statements on assumptions about future events that may prove
to be inaccurate. Therefore, the actual results of the future
events described in such forward-looking statements in this
Annual Report, or elsewhere, could differ materially from
those stated in such forward-looking statements. Among the
factors that could cause actual results to differ materially
are the risks and uncertainties discussed in this Annual Report,
including, without limitation, factors discussed under the
caption "Factors That May Affect Future Results and the
Market Price of Common Stock."
Overview
Administaff provides a comprehensive Personnel
Management System which encompasses a broad range of services,
including benefits and payroll administration, health and
workers' compensation insurance programs, personnel records
management, employer liability management, employee recruiting
and selection, performance management, and training and development
services. The Company's overall operating results are largely
dependent on the number of worksite employees paid and can
be measured in terms of revenues or costs per worksite employee
paid per month. As a result, the Company often uses this unit
of measurement in analyzing and discussing its results of
operations.
In addition to the ongoing sales of the Company's principal
PEO services and the servicing of its client base, the Company
currently has several strategic initiatives in progress, which,
while supporting the Company's long-term plans, have increased
the level of operating expenses for the near term. The Company
believes that these initiatives will provide long-term benefits
to the Company, including the ability to maintain steady and
predictable growth, enhanced client retention, new and incremental
revenue streams and increased internal operational efficiencies.
The initiatives include:
Sales and Service Expansion.
The Company is currently executing a long-term
national expansion strategy targeting approximately 90 sales
offices located in 40 markets. The plan calls for continuous
expansion with approximately one new sales office opening
each quarter. To support this expansion, the Company plans
to open additional service centers as warranted by the growth
in the number of clients and worksite employees in different
regions of the country. In addition, the Company is expanding
its service capacity by placing service personnel in its sales
markets as the number of clients and worksite employees grows
in each market.
As of December 31, 1999, the Company had 25 sales offices
located in 15 markets, three service centers, located in Houston,
Texas; Dallas, Texas and Atlanta, Georgia; and 200 service
personnel located in 13 markets, including approximately 150
located in the three service centers.
Telecommunications and
Network Upgrade. The Company has significantly
upgraded and modified its telecommunications and network infrastructure
to allow for enhanced communications among its sales offices,
service centers and corporate offices.
eBusiness Strategy.
The Company is in the process of implementing a comprehensive
eBusiness strategy, which is comprised of three primary components.
First, the Company is continuing the development of its Internet-based
service delivery platform, Administaff Assistant, which is
designed to provide clients and worksite employees access
to human resources information, transactional data and other
components of the Company's PEO services 24 hours-a-day and
seven days per week. Second, the Company is developing a business-to-business
eCommerce portal for its client companies. Third, the Company
plans to develop and share content with various community-of-interest
sites targeting small and medium-sized businesses.
Software Development.
During 1998, the Company began to develop the next generation
of its proprietary PEO information system and other software
development projects associated with this system. Development
activities on these projects continued in 1999, and are expected
to continue in 2000.
In addition to the expenses associated
with these strategic initiatives, the Company continues to
be affected by the ongoing IRS audit of the Company's 401(k)
plan and IRS Employee Leasing Market Segment Study, although
certain aspects of these issues were settled during 1999.
For a discussion of these issues, see Note 9 of the Notes
to Consolidated Financial Statements.
Revenues The Company's
revenues are derived from its comprehensive service fees, which
are based upon each employee's gross pay and a mark-up computed
as a percentage of the gross pay. The comprehensive service
fees are invoiced along with each periodic payroll. The Company's
revenues are dependent on the number of clients enrolled, the
resulting number of employees paid each period, the gross payroll
of these employees and the number of employees enrolled in benefit
plans.
Direct
Costs The Company's
primary direct costs are (i) the salaries and wages of worksite
employees ("payroll cost"), (ii) employment-related
taxes ("payroll taxes"), (iii) employee benefit
plan premiums and (iv) workers' compensation insurance premiums.
Payroll costs of worksite employees are affected by the composition
of the worksite employee base, inflationary effects on wage
levels and differences in the local economies of the Company's
markets. Changes in payroll costs generally have a proportionate
impact on the Company's revenues.
Payroll taxes consist of the employer's portion of Social
Security and Medicare taxes under FICA, federal unemployment
taxes and state unemployment taxes. Payroll taxes are generally
paid as a percentage of payroll. The federal tax rates are
defined by the appropriate federal regulations. State unemployment
tax rates are subject to claims histories and vary from state
to state.
Employee benefit costs are comprised primarily of health
insurance costs but also include costs of other employee benefits
such as life insurance, vision care, dental insurance, disability
insurance, prescription card, education assistance, adoption
assistance, a dependent care spending account and a worklife
program.
Workers' compensation costs include premiums, administrative
costs and claims-related expenses under the Company's workers'
compensation program. Since November 1994, the Company has
been insured under a guaranteed cost program under which premiums
are paid for full insurance coverage of all accident claims
occurring during the policy period.
The Company's gross profit per worksite employee is determined
in part by its ability to accurately estimate and control
direct costs and its ability to incorporate changes in these
costs into the comprehensive service fees charged to clients,
which are subject to contractual arrangements. Gross profit,
measured as a percentage of revenue, is also affected by the
comprehensive services fees and direct cost structure; however,
due to the large portion of the Company's revenue being directly
related to worksite employee payroll cost, changes in the
level of payroll cost per worksite employee can cause fluctuations
in this statistic which are not necessarily indicative of
relative performance from period to period. As a result, the
Company uses gross profit per worksite employee per month
as its principal measurement of the relative performance at
the gross profit level.
Operating
Expenses As a result
of the strategic initiatives referred to above, operating
expenses have increased significantly during the last several
years. The types of operating expenses affected by each of
the initiatives are as follows:
Sales and Service Expansion.
• general and administrative expenses associated with establishing
and
maintaining sales offices and service centers;
• compensation expense for additional sales and service
staff;
• travel expense associated with maintaining a national
sales and service
presence; and
• depreciation expense associated with capitalized costs
of facilities,
furniture and equipment and computer hardware and
software.
Telecommunications and
Infrastructure Upgrade.
• compensation expense of additional technology staff;
• consulting expense associated with design and selection
of technology
products;
• ongoing maintenance costs of network hardware and software;
• ongoing data and voice transmission service costs;
and
• depreciation expense associated with capitalized costs
of network
hardware and software.
eBusiness Initiatives.
• compensation expense of service, technology and support
staff for
Administaff Assistant;
• consulting expense associated with the planning and
development of
Administaff Assistant, the eCommerce portal and
the overall eBusiness
strategy;
• travel, legal and compensation expenses associated
with obtaining
alliance partners to participate in the eCommerce
portal;
• depreciation and amortization expenses associated with
computer
hardware and software used for, and the development
costs of,
Administaff Assistant and the eCommerce portal;
and
• ongoing maintenance costs of hardware and software
associated with
Administaff Assistant and the eCommerce portal.
Software Development.
Capitalized software costs that did not significantly affect
operating results in 1999, but will begin to affect operating
expenses through amortization expense as the new system is
placed into service in 2000.
In addition, the Company has incurred travel and legal expenses
associated with the IRS 401(k) plan audit and the IRS Employee
Leasing Market study.
Income
Taxes
The Company's provision for income taxes typically
differs from the U.S. statutory rate of 34% due primarily
to state income taxes and tax exempt interest income. Deferred
income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities used
for financial reporting purposes and the amounts used for
income tax purposes. Significant items resulting in deferred
income taxes include depreciation and amortization, software
development costs, accrued state income taxes, client list
acquisition costs, and the allowance for uncollectible accounts
receivable. Changes in these items are reflected in the Company's
financial statements through the Company's deferred income
tax provision.
Results of Operations Year Ended
December 31,1999 Compared to Year Ended December 31, 1998
The following table presents certain information
related to the Company's results of operations for the years
ended December 31,1999 and 1998.
Revenues The
Company's revenues increased 34.3% over 1998 due to a 22.0%
increase in the average number of worksite employees paid
per month accompanied by an 8.7% increase in the fee revenue
per worksite employee per month. The Company's continued expansion
of its sales force through new market and sales office openings
was the primary factor contributing to the increase in the
average number of worksite employees paid. Revenues from markets
opened prior to 1993 (the commencement of the Company's national
expansion plan) increased 14% over 1998, while revenues from
markets opened after 1993 increased 63%. Revenues from the
state of Texas represented 61% of the Company's total revenues
and Houston, the Company's original market, represented 36%
of the total.
The 8.7% increase in fee revenue per worksite
employee per month directly related to the 9.0% increase in
fee payroll cost per worksite employee per month, reflecting
(i) compensation increases within the Company's existing worksite
employee base; (ii) the addition of clients with worksite
employees that had a higher average base pay than the existing
client base; (iii) the attrition of clients with worksite
employees that had a lower average base pay than the existing
client base; and (iv) the penetration of markets with generally
higher wage levels, such as San Francisco, New York and Washington,
D.C.
Gross Profit
Gross profit increased 30.5% over 1998 due primarily
to the 22.0% increase in the average number of worksite employees
paid per month accompanied by a 7.3% increase in gross profit
per worksite employee per month. Gross profit per worksite
employee increased from $164 per month in 1998 to $176 per
month in 1999, reflecting effective execution of the Company's
pricing strategy. The Company's pricing objectives attempt
to maintain or improve the gross profit per worksite employee
by matching or exceeding changes in its primary direct costs
with changes in the gross markup per worksite employee.
Gross mark-up per worksite employee per
month increased 7.6% from $673 in 1998 to $724 in 1999. Approximately
43% of the $51 increase in gross markup per employee was the
result of increased service fees designed to match the increased
payroll tax expense associated with the higher average payroll
cost per worksite employee. The remaining increase in gross
markup per employee was related to other increases in the
Company's comprehensive service fees, which were designed
to match or exceed known trends in the Company's primary direct
costs, including approximately $4 per worksite employee related
to a change in the method used to calculate service fees for
clients who experience turnover within their workforce.
Payroll taxes increased $23 per worksite
employee per month, primarily due to the increased average
payroll cost per worksite employee. The overall cost of payroll
taxes as a percentage of payroll cost was 7.2% in 1999 versus
7.3% in 1998.
The cost of health insurance and related
employee benefits increased $12 per worksite employee per
month over 1998 due to a 3.1% increase in the cost per covered
employee and a slight increase in the percentage of worksite
employees covered under the Company's health insurance plans
from 66.4% in 1998 to 67.8% in 1999.
Workers' compensation costs increased
$5 per worksite employee per month, and increased slightly
from 1.20% of payroll cost in 1998 to 1.25% in 1999, primarily
due to higher bonus and other year-end compensation of worksite
employees, some of which is subject to workers' compensation
insurance premiums.
Gross profit, measured as a percentage
of revenue, declined from 4.08% in 1998 to 3.96% in 1999.
This decline was due primarily to the increase in average
payroll cost per worksite employee. Because payroll cost is
the largest single component of both revenues and direct costs,
an increase in the average payroll cost per worksite employee
creates a mathematical downward pressure on the calculation
of gross profit as a percentage of revenue.
Operating Expenses
The following table presents certain information related to
the Company's operating expenses for the years ended December
31, 1999 and 1998.
Operating expenses increased 37.6% over
1998 as a result of the 22.0% growth in the average number
of worksite employees paid per month by the Company, combined
with the effects of the previously mentioned strategic initiatives,
all of which comprise investments in the Company's sales,
service and technology infrastructure. Operating expenses
per worksite employee increased 13.1% from $137 in 1998 to
$155 in 1999.
Operating expenses in 1999 include a non-recurring $1.4 million
($920,000 net of tax) write-off of certain capitalized software
development costs. This write-off was the result of a periodic
evaluation of all software development projects, which included
a review of costs incurred to date, estimated costs to complete,
estimated maintenance costs, and the availability of alternative
software packages. Upon completion of this evaluation, the
Company determined that two projects would be terminated and
that the costs associated with these projects should be written
off. The majority of the costs written off related to efforts
to customize an electronic document management system to meet
the Company's physical records management needs. Excluding
the impact of this charge, operating expenses increased 35.1%
over 1998, and increased from $137 per worksite employee in
1998 to $152 in 1999.
Salaries, wages and payroll taxes of corporate and sales
staff increased from $63 per worksite employee per month in
1998 to $72 in 1999. Approximately $6 of this increase was
the result of a 25.9% increase in corporate and sales staff,
combined with an 8.0% increase in the average salary per employee.
The remaining increase was related to higher payroll tax rates
and the adoption of an employer matching contribution feature
in the Company's 401(k) retirement plan. The 25.9% increase
in corporate and sales staff was devoted largely to supporting
the Company's strategic initiatives, including a 23% increase
in sales and sales support staff in the district sales offices,
a 23% increase in service personnel, predominantly located
in the Company's service centers and sales markets, a 90%
increase in technology staff, and newly formed departments
devoted to the Company's eBusiness initiatives.
General and administrative expenses increased $3 per worksite
employee per month over 1998. The increase resulted from (i)
hardware and software maintenance fees and communications
costs associated with the Company's Internet development,
national technology platform and other technology initiatives;
(ii) higher legal and accounting fees associated with corporate
activities such as the ongoing 401(k) plan audit, corporate
entity changes and eBusiness alliance contract negotiations;
and (iii) higher rent expense due to recent openings of sales
offices in St. Louis, San Francisco and New York, and the
new Dallas and Atlanta service centers.
Depreciation and amortization expense increased $5 per worksite
employee as a result of the increased capital expenditures
placed in service in 1998 and 1999, including (i) the implementation
of a national technology infrastructure; (ii) the implementation
of certain new components of Administaff Assistant, primarily
the web payroll and web reporting capabilities, which include
both internal software development costs and externally purchased
software; (iii) the opening of new sales offices; (iv) the
expansion and relocation of the Dallas service center and
opening of the Atlanta service center; and (v) the expansion
of corporate headquarters.
Commissions expense declined slightly on a per worksite employee
per month basis due to lower sales agency commissions. Advertising
costs also declined slightly per worksite employee, as the
Company was able to increase its advertising coverage while
incurring lower rates for much of its radio advertising. In
addition, the Company utilized resources available through
its marketing agreement with American Express to generate
leads and appointments for its sales representatives.
Other
Income
Interest income decreased 23.3% from $3.3 million in
1998 to $2.6 million in 1999, due to a lower level of cash
and marketable securities resulting from the repurchase of
shares of the Company's common stock under the repurchase
program approved by the Company's Board of Directors in January
1999. In addition, the average interest rate related to interest-bearing
investments declined slightly as the Company shifted a higher
portion of its marketable securities into tax-exempt securities.
During the fourth quarter of 1999, the Company entered into
a Closing Agreement on Final Determination Covering Specific
Matters with the Internal Revenue Service, settling nondiscrimination
testing issues involving the Company's 401(k) plan for certain
prior plan years. The actual amount of the settlement was
substantially lower than the original estimate and accrual
made in 1996, resulting in a non-recurring gain of $932,000
($852,000 net of income tax effect) in the fourth quarter
of 1999. This gain includes the impact of an adjusted amount
recoverable from the Company's former third-party record keeper
pursuant to a 1996 agreement, under which the record keeper
agreed to reimburse the Company for a portion of its settlement
of the nondiscrimination testing issues.
The Company's provision for income taxes, which includes
the effects of the non-recurring gain from settlement of the
401(k) testing issues, differs from the U.S. statutory rate
of 34% in 1999 due primarily to certain portions of the final
settlement and original accrual being non-deductible for income
tax purposes. In addition, the Company's provision for income
taxes differs from the U.S. statutory rate due to state income
taxes and tax-exempt interest income in both years.
Net
Income Net income for
1999 was $9.4 million, or $0.68 per diluted share compared
to $9.1 million, or $0.62 per diluted share in 1998. The 1999
results include the effects of two unrelated, non-recurring
items: (i) a $932,000 gain ($852,000 net of income tax effect)
associated with the settlement of nondiscrimination testing
issues related to the ongoing audit of the Company's 401(k)
plan for amounts less than the amount originally accrued for
such issues in 1996; and (ii) a $1.4 million ($920,000 net
of income tax effect) write-off of software development costs
incurred on projects which are not expected to be completed.
Excluding the effects of these items, the 1999 net income
and diluted earnings per share were also $9.4 million and
$0.68.
Year
Ended December 31, 1998 Compared to Year Ended December 31,
1997
The following table presents certain information related to
the Company's results of operations for the years ended December
31, 1998 and 1997.
Revenues
The Company's revenues increased 38.7% over 1997 due to a
29.4% increase in the average number of worksite employees
paid per month accompanied by a 7.6% increase in the fee revenue
per worksite employee per month. The Company's continued expansion
of its sales force through new market and sales office openings
was the primary factor contributing to the increase in the
average number of worksite employees paid. Revenues from markets
opened prior to 1993 (the commencement of the Company's national
expansion plan) increased 27% over 1997, while revenues from
markets opened after 1993 increased 59%. Revenues from the
state of Texas represented 72% of the Company's total revenues
and Houston, the Company's original market, represented 43%
of the total. Revenues for the Texas markets as a whole and
the Houston market both increased 29% over 1997.
The 7.6% increase in fee revenue per worksite employee per
month directly related to the 8.0% increase in fee payroll
cost per worksite employee per month, reflecting the continuing
effects of the net addition of clients with worksite employees
that had a higher average base pay than the existing client
base, primarily through the penetration of markets with generally
higher wage levels, such as Los Angeles, Chicago and Washington,
D.C. In addition, wage inflation within the Company's existing
worksite employee base contributed to the increase in payroll
cost per worksite employee. During the fourth quarter of 1998,
the Company experienced a reduction in the rate of growth
in the average payroll per worksite employee. For the quarter,
the average payroll per worksite employee increased 5.5% over
the same period in 1997 compared to a 9.0% increase for the
nine months ended September 30, 1998.
Gross
Profit Gross profit increased
33.8% over 1997 due primarily to the 29.4% increase in the
average number of worksite employees paid per month accompanied
by a 3.1% increase in gross profit per worksite employee per
month. The increase in gross profit per employee was due to
an increase in gross markup per worksite employee of $36 offset
by an increase in benefits and payroll taxes per worksite
employee of $31. The Company's pricing objectives attempt
to improve the gross profit per worksite employee by matching
or exceeding changes in the overall cost of its primary direct
costs with increases in the gross markup per worksite employee.
Gross markup per worksite employee per month increased 5.7%
from $637 in 1997 to $673 in 1998. Approximately half of the
$36 increase in gross markup per employee was the result of
increases in the Company's comprehensive service fees, which
were designed to match or exceed known trends in the Company's
primary direct costs. The remaining increase in gross markup
per employee was related to increased service fees designed
to match the increased payroll tax expense associated with
the higher average payroll cost per worksite employee.
The $31 increase in benefits and payroll taxes per worksite
employee per month was due to higher payroll taxes and health
insurance premiums per worksite employee, partially offset
by lower workers' compensation costs per worksite employee
per month.
Payroll taxes increased $22 per worksite employee per month
versus 1997. Approximately $16 of the increase was due to
the increased payroll cost per worksite employee. The remaining
increase was due to a net increase in the weighted average
state unemployment tax rate paid by the Company, which increased
the overall cost of payroll taxes as a percentage of payroll
cost to 7.3% in 1998 from 7.1% in 1997.
The cost of health insurance and related employee benefits
increased $16 per worksite employee per month versus 1997
due to a 4.9% increase in the cost per covered employee and
an increase in the percentage of worksite employees covered
under the Company's health insurance plans. Approximately
66.4% of the Company's worksite employees were covered by
these plans during 1998 versus 64.6% in 1997.
Workers' compensation costs decreased by $9 per worksite
employee per month, and declined from 1.6% of payroll cost
in 1997 to 1.2% in 1998, due primarily to a lower rate on
the Company's fixed premium policy. In addition, the Company
received $475,000 of proceeds in 1998 from the settlement
of a class action lawsuit related to premiums paid in a prior
year.
Gross profit, measured as a percent of revenue, declined
from 4.22% in 1997 to 4.08% in 1998. This decline was due
primarily to the increase in average payroll per worksite
employee, which had the corresponding effect of increasing
revenue and applying mathematical pressure on the gross profit
margin.
Operating Expenses
The following table presents certain information
related to the Company's operating expenses for the years
ended December 31, 1998 and 1997.
Operating expenses increased 36.9% over
1997, which compared to an increase in revenue and gross profit
of 38.7% and 33.8%, respectively. The overall increase in
operating expenses can be attributed to the 29.4% growth in
the average number of worksite employees paid by the Company
and the continuing investment in infrastructure, technology
and service capacity. Operating expenses per worksite employee
per month were $137 in 1998 versus $130 for 1997, an increase
of 5.4%.
Salaries, wages and payroll taxes of corporate and sales
staff increased from $57 per worksite employee per month in
1997 to $63 in 1998. Approximately half of this increase relates
to a 45% increase in sales office staff, which includes district
sales management, office administrators and sales representatives.
The remainder of the increase is due to a 35% increase in
corporate staff and a 3.6% increase in average payroll per
corporate employee.
General and administrative expenses increased $3 per worksite
employee per month over 1997; however, the 1997 results included
an unusual bad debt charge. Excluding the effects of this
charge, general and administrative expenses increased $7 per
worksite employee per month over 1997. Approximately $5 of
this increase can be attributed to professional and consulting
fees incurred in relation to ongoing technology projects,
higher telecommunications costs, and the cost of maintenance
contracts on new computer hardware and software. The Company
incurred approximately $1.5 million in consulting fees related
to technology initiatives, including its Internet service
delivery platform and improving and enhancing its local area
and wide area networks. The remainder of the increase is related
to the opening of four district sales offices and the new
Dallas service center.
During the second quarter of 1997 the Company recorded a
$1.3 million (approximately $800,000 after tax) bad debt charge
for the uncollectibility of an account receivable from a significant
former customer. This charge resulted from the customer's
inability to pay the invoices related to a single payroll
period in April 1997. The Company attempted to collect the
amounts due or obtain a secured position on the amount owed
by the customer; however, the Company was unable to collect
the amounts or obtain such a position. In late June 1997,
the customer filed for bankruptcy protection and the Company
subsequently learned that the customer's ability to pay the
amounts owed had become severely impaired. The Company has
not collected, and does not expect to collect, any of the
amounts owed by the customer.
Depreciation and amortization expense increased $2 per worksite
employee per month as a result of the increased capital expenditures
placed in service in 1997 and 1998.
Commissions expense was slightly lower per worksite employee
per month versus 1997 due to lower sales agency commissions.
Advertising costs declined $3 per worksite employee per month
as the Company incurred lower rates for much of its radio
advertising and utilized resources available through its marketing
agreement with American Express to generate leads and appointments
for its sales representatives.
Net Income
Net interest income increased 29.8% from
$2.6 million in 1997 to $3.3 million in 1998, due to the investment
of the proceeds from the Company's initial public offering
for the entire year in 1998 and the investment of the proceeds
from the sale of common stock to American Express received
in March 1998. The Company incurred no interest expense in
1998, while the 1997 period included the write-off of deferred
financing costs relating to long-term debt that was repaid
using a portion of the proceeds from the IPO.
The Company's provision for income taxes differs from the
U.S. statutory rate of 34% primarily due to state income taxes
and tax exempt interest income. The effective income tax rate
for 1998 was consistent with 1997.
Operating income and net income per worksite employee per
month were $27 and $22 in 1998, versus $29 and $23 in 1997.
The Company's net income and diluted earnings per share for
the year ended December 31, 1998 increased to $9.1 million
and $0.62, versus $7.4 million and $0.53 for the year ended
December 31, 1997.
Liquidity and Capital
Resources The Company
periodically evaluates its liquidity requirements, capital
needs and availability of resources in view of, among other
things, expansion plans, debt service requirements and other
operating cash needs. As a result of this process, the Company
has, in the past, sought and may, in the future, seek to raise
additional capital or take other steps to increase or manage
its liquidity and capital resources. The Company currently
believes that its cash on hand, marketable securities and
cash flows from operations will be adequate to meet its short-term
liquidity requirements. The Company will rely on these same
sources, as well as public and private debt and equity financing,
to meet its long-term liquidity and capital needs.
The Company had $56.2 million in cash
and cash equivalents and marketable securities at December
31, 1999, of which approximately $21.5 million was payable
in early January 2000 for withheld federal and state income
taxes, employment taxes and other payroll deductions. The
remainder is available to the Company for general corporate
purposes, including, but not limited to, current working capital
requirements, expenditures related to the continued expansion
of the Company's sales, service and technology infrastructure,
capital expenditures and the Company's stock repurchase program.
At December 31,1999 the Company had working capital of $35.8
million compared to $52.5 million at December 31,1998. The
decrease in working capital was due primarily to the use of
$16.1 million to repurchase shares of the Company's common
stock, as cash flows from operations of $17.8 million funded
a large portion of the Company's capital expenditures of $19.0
million, including $5.2 million in capitalized software development
costs.
Cash Flows From Operating
Activities The Company's
cash flows from operating activities in 1999 increased $3.9
million to $17.8 million due to a $3.9 million increase in
net income adjusted for non-cash items from $16.6 million
in 1998 to $20.5 million in 1999.
Cash Flows From Investing
Activities Capital
expenditures, including software development costs, totaled
$19.0 million in 1999 and $20.4 million in 1998. The level
of capital expenditures incurred in the past two years is
significantly higher than the periods prior to 1998 and relates
directly to several of the strategic initiatives the Company
currently has underway. For the two-year period, capital expenditures
can be summarized as follows (in millions):
Capital expenditures for computer hardware
and software include the costs of application software directly
related to the ongoing development of Administaff Assistant,
the costs of network and telecommunications infrastructure
required to support the national technology platform, the
costs of desktop workstations for new employees in the corporate
offices, sales offices and service centers and the cost of
software for various corporate needs.
Software development costs include approximately $0.8 million
to develop the initial release of Administaff Assistant, and
approximately $2.0 million on subsequent enhancements to Administaff
Assistant, including the web payroll and web reporting applications,
which have recently been deployed. In addition, software development
costs include approximately $3.1 million for a substantial
upgrade of the Company's proprietary PEO information system,
which is expected to be deployed during the summer of 2000.
Software development costs also include $1.4 million related
to two projects, a records center automation system and a
web content management system. In the fourth quarter of 1999,
the Company determined that these two projects would not be
completed, and the costs were written off.
Capital expenditures for furniture and fixtures, land, building
improvements and vehicles are largely related to equipping
and furnishing seven new sales offices, new service centers
in Dallas and Atlanta, and expansion to accommodate growth
in the number of employees at the Company's corporate offices.
The Company expects a continued high level of capital expenditures
with a budget of approximately $21 million for 2000, which
is primarily composed of continued software development, hardware
and software costs related to Administaff Assistant, initial
development related to the Company's eBusiness strategy, including
the eCommerce portal, and continued expansion of corporate,
sales and service centers to accommodate the ongoing growth
of the Company.
Net sales of marketable securities during 1999 primarily
represent funds used to repurchase shares of the Company's
common stock. Net purchases of marketable securities during
1998 primarily reflect the investment of the proceeds from
the Company's Securities Purchase Agreement with American
Express in highly liquid marketable securities with maturities
ranging from 91 days to five years from the date of purchase,
consisting primarily of corporate and government bonds.
Cash Flows From Financing
Activities Cash flows
from financing activities for 1999 primarily include the repurchase
of 1.1 million shares of the Company's stock under the stock
repurchase program approved by the Company's Board of Directors
in January 1999 and expanded in May 1999.
Cash flows from financing activities for
1998 consist primarily of items relating to the sale of units
consisting of 693,126 shares of common stock (293,126 shares
from Treasury Stock) and common stock purchase warrants for
an additional 2,065,515 shares to American Express for a total
cost of $17.7 million. Other significant cash flows from financing
activities during 1998 included the exercise of warrants to
purchase 140,508 shares of common stock by a third party warrant
holder at a price of $4.52 per share, the repurchase of 140,508
shares of common stock from the third party warrant holder
at a price of $21 per share, and the repurchase of 150,000
shares of common stock from three stockholders at a price
of $21 per share.
Year 2000
As the Company's operations rely on several internal computer
systems and third party vendor relationships, the Company
prepared for the Year 2000 issue under the assumption it could
cause potentially significant operational issues if not properly
addressed. The Year 2000 issue generally describes the various
problems which might have resulted from the failure of computer
and other mechanical systems to properly process certain dates
and date sensitive information.
In preparing for the Year 2000 issue, the Company followed
a methodology widely used in various industries to prepare
for this event. Those steps included:
sanctioning of the preparation efforts by management and
the Board of Directors;
assessing the potential risks associated with both its
proprietary PEO system and its reliance on several critical
third party vendors;
testing the hardware and software application components
of this system in various scenarios;
obtaining written information from critical third party
vendors on their state of readiness;
communicating the status of the Company's preparations
to its customers, employees and shareholders; and
developing contingency plans including staffing the conversion
time period and alternatives for customers during the period
surrounding January 1, 2000.
Through March 1, 2000, the Company has not experienced any
adverse effects from the Year 2000 conversion and does not
currently expect that it will experience any adverse effects.
In addition, the Company has not experienced any adverse effects
with any of its third party vendors or customers. While the
Company does not expect that it will experience any adverse
effects related to this issue, it will continue to monitor
for Year 2000 specific issues on an informal basis using existing
staff.
The Company did not incur any significant costs related to
preparations for the Year 2000 issue other than the time of
internal personnel required to adequately prepare for the
event, and does not expect to incur any material costs in
the future.
Other Matters
The Company had net deferred tax liabilities of $4.5 million
at December 31, 1999, versus $2.9 million at December 31,
1998. This increase is due primarily to differences between
the book and tax basis of software development costs, prepaid
commissions and depreciation.
Seasonality, Inflation
and Quarterly Fluctuations Historically,
the Company's earnings pattern includes losses in the first
quarter followed by improved profitability in subsequent quarters
throughout the year. This pattern is due to the effects of
employment-related taxes which are based on the individual
employees' cumulative earnings up to specified wage levels,
causing employment-related taxes to be highest in the first
quarter and then decline over the course of the year. Since
the Company's revenues related to an individual employee are
generally earned and collected at a relatively constant rate
throughout each year, payment of such tax obligations has
a substantial impact on the Company's financial condition
and results of operations during the first six months of each
year. Other factors that affect direct costs could mitigate
or enhance this trend.
The Company believes the effects of inflation have not had
a significant impact on its results of operations or financial
condition.
Factors That May Affect
Future Results and the Market Price of Common Stock
Audit of the Company's
401(k) Plan; IRS Employee Leasing Market Segment Group
The Company's 401(k) plan is currently under audit
by the IRS for the year ended December 31, 1993. Although
the audit is for the 1993 plan year, certain conclusions of
the IRS could be applicable to other years as well. In addition,
the IRS has established an Employee Leasing Market Segment
Group for the purpose of identifying specific compliance issues
prevalent in certain segments of the PEO industry. Approximately
70 PEOs, including the Company, have been randomly selected
by the IRS for audit pursuant to this program. One issue that
has arisen from these audits is whether a PEO can be a co-employer
of worksite employees, including officers and owners of client
companies, for various purposes under the Internal Revenue
Code of 1986, as amended (the "Code"), including
participation in the PEO's 401(k) plan. With respect to the
401(k) plan audit, the IRS Houston District has sought technical
advice (the "Technical Advice Request") from the
IRS National Office about whether participation in the 401(k)
plan by worksite employees, including officers of client companies,
violates the exclusive benefit rule under the Code because
they are not employees of the Company. A copy of the Technical
Advice Request and the Company's response have been sent to
the IRS National Office for review. The Technical Advice Request
contains the conclusions of the IRS Houston District with
respect to the 1993 plan year that the 401(k) plan should
be disqualified because it covers worksite employees who are
not employees of the Company. The Company's response refutes
the conclusions of the IRS Houston District. The Company also
understands that, with respect to the Market Segment Group
study, the issue of whether a PEO and a client company may
be treated as co-employers of worksite employees for certain
federal tax purposes (the "Industry Issue") has
been referred to the IRS National Office.
The Company does not know whether the National Office will
address the Technical Advice Request independently of the
Industry Issue. The Company is not able to predict either
the timing or the nature of any final decision that may be
reached with respect to the 401(k) plan audit or with respect
to the Technical Advice Request or the Market Segment Group
study and the ultimate outcome of such decisions. Should the
IRS conclude that the Company is not a "co-employer"
of worksite employees for purposes of the Code, worksite employees
could not continue to make salary deferral contributions to
the 401(k) plan or pursuant to the Company's cafeteria plan
or continue to participate in certain other employee benefit
plans of the Company. The Company believes that, although
unfavorable to the Company, a prospective application of such
a conclusion (that is, one applicable only to periods after
the conclusion by the IRS is finalized) would not have a material
adverse effect on its financial position or results of operations,
as the Company could continue to make available comparable
benefit programs to its client companies at comparable costs
to the Company. However, if the IRS National Office adopts
the conclusions of the IRS Houston District set forth in the
Technical Advice Request and any such conclusions were applied
retroactively to disqualify the 401(k) plan for 1993 and subsequent
years, employees' vested account balances under the 401(k)
plan would become taxable, the Company would lose its tax
deductions to the extent its matching contributions were not
vested, the 401(k) plan's trust would become a taxable trust
and the Company would be subject to liability with respect
to its failure to withhold applicable taxes with respect to
certain contributions and trust earnings. Further, the Company
would be subject to liability, including penalties, with respect
to its cafeteria plan for the failure to withhold and pay
taxes applicable to salary deferral contributions by employees,
including worksite employees. In such a scenario, the Company
also would face the risk of client dissatisfaction and potential
litigation. A retroactive application by the IRS of an adverse
conclusion resulting in disqualification of the 401(k) plan
would have a material adverse effect on the Company's financial
position and results of operations.
Expenses Associated
with Expansion
The Company's past operating results have been affected by
the Company's long-term national sales and service expansion.
In many cases, the costs of this expansion have been incurred
in advance of the anticipated growth in worksite employees
(the primary driver of the Company's revenues). The Company
expects to continue to incur substantial additional operating
expenses in the foreseeable future as a result of continuing
national expansion. See "Operating Expenses - Sales and
Service Expansion" for a discussion of the types of expenses
incurred in this expansion.
Estimated
Costs and Effectiveness of Capital Projects and Investments
in Infrastructure
The Company currently has several strategic initiatives in
progress, which have significantly increased the level of
capital expenditures and related depreciation expense incurred
over the past several years. The Company has incurred approximately
$39.4 million in capital expenditures in the past two years,
and expects to incur approximately $21 million during 2000.
These capital expenditures have been, and will continue to
be, primarily associated with the expansion and upgrade of
the Company's technology and telecommunications infrastructure,
Internet service delivery capabilities, and corporate headquarters,
sales and service facilities. There can be no assurances that
the Company's cost to complete these projects will be as estimated
or that the ultimate effectiveness of such projects will provide
the necessary operating efficiencies required to offset the
resulting increases in depreciation and amortization expense
which accompany these expenditures. In addition, the Company
may require additional capital resources to fund these and
future capital expenditure requirements.
Estimated
Costs and Effectiveness of eBusiness Strategy
The Company is
implementing a comprehensive eBusiness strategy, which includes
(i) the continued development of Administaff Assistant, the
Company's Internet-based service delivery platform, with a
focus on providing automated, personalized PEO services to
the Company's clients and worksite employees; (ii) the development
of a business-to-business eCommerce portal designed to deliver
a wide variety of value-added products and services to the
Company's clients, worksite employees and their families;
and (iii) the development and exchanging of human resource
content with various community-of-interest sites targeted
at small and medium-sized businesses to extend the Company's
brand and attract additional customers to its core PEO service.
While
the Company believes that this comprehensive strategy will
ultimately lead to increased profitability through new revenue
streams, operating expense savings and higher client retention,
there can be no assurances that losses or diminished profitability
will not be incurred in future periods as a result of these
initiatives.
Among the factors
which could affect the success of the Company's eBusiness
strategy are (i) the Internet connectivity and computer literacy
of the Company's clients; (ii) the willingness of clients
to accept an electronic service delivery platform; (iii) the
Company's ability to identify, negotiate and integrate agreements
with strategic partners; (iv) the timely rollout of the Company's
eCommerce portal; (v) the attraction of clients and worksite
employees to the eCommerce portal; (vi) the effective generation
of revenues from the eBusiness initiatives, particularly eCommerce
portal; (vii) unanticipated development costs related to the
eBusiness initiatives; and (viii) the Company's ability to
control or reduce operating expenses as a result of the eBusiness
initiatives, particularly the development of Administaff Assistant.
Increases
in Health Insurance Premiums, Unemployment Taxes and Workers'
Compensation Rates
Health insurance
premiums, state unemployment taxes and workers' compensation
rates are in part determined by the Company's claims experience
and comprise a significant portion of the Company's direct
costs. The Company employs extensive risk management procedures
in an attempt to control its claims incidence and structures
its benefits contracts to provide as much cost stability as
possible. However, should the Company experience a large increase
in claim activity, its unemployment taxes, health insurance
premiums or workers' compensation insurance rates could increase.
The Company's ability to incorporate such increases into service
fees to clients is constrained by contractual arrangements
with clients, which could result in a delay before such increases
could be reflected in service fees. As a result, such increases
could have a material adverse effect on the Company's financial
condition or results of operations.
Failure
to Manage Growth
The Company has
experienced significant growth and expects such growth to
continue for the foreseeable future. As described under the
above caption "Expenses Associated with Expansion,"
the costs associated with the Company's sales and service
expansion have been significant. Accordingly, the Company's
expansion plan may place a significant strain on the Company's
management, financial, operating and technical resources.
Failure to manage this growth effectively could have a material
adverse effect on the Company's financial condition or results
of operations.
Liability
for Worksite Employee Payroll and Benefits Costs
Under the CSA,
the Company becomes a co-employer of worksite employees and
assumes the obligations to pay the salaries, wages and related
benefit costs and payroll taxes of such worksite employees.
The Company assumes such obligations as a principal, not merely
as an agent of the client company. The Company's obligations
include responsibility for (i) payment of the salaries and
wages for work performed by worksite employees, regardless
of whether the client company makes timely payment to the
Company of the associated service fee, and (ii) providing
benefits to worksite employees even if the costs incurred
by Administaff to provide such benefits exceed the fees paid
by the client company. If a client company does not pay the
Company or if the costs of benefits provided to worksite employees
exceeds the fees paid by a client company, the Company's ultimate
liability for worksite employee payroll and benefits costs
could have a material adverse effect on its financial condition
or results of operations.
Federal,
State and Local Regulation
As a major employer,
the Company's operations are affected by numerous federal,
state and local laws relating to labor, tax and employment
matters. By entering into a co-employer relationship with
employees assigned to work at client company locations, the
Company assumes certain obligations and responsibilities of
an employer under these laws. However, many of these laws
(such as the Employee Retirement Income Security Act ("ERISA")
and federal and state employment tax laws) do not specifically
address the obligations and responsibilities of non-traditional
employers such as PEOs, and the definition of "employer"
under these laws is not uniform. In addition, many of the
states in which the Company operates have not addressed the
PEO relationship for purposes of compliance with applicable
state laws governing the employer/employee relationship. If
these other federal or state laws are ultimately applied to
the Company's PEO relationship with its worksite employees
in a manner adverse to the Company, such an application could
have a material adverse effect on the Company's results of
operations or financial condition.
While
many states do not explicitly regulate PEOs, 19 states (including
Texas) have passed laws that have licensing or registration
requirements for PEOs and several other states are considering
such regulation. Such laws vary from state to state but generally
provide for monitoring the fiscal responsibility of PEOs,
and in some cases codify and clarify the co-employment relationship
for unemployment, workers' compensation and other purposes
under state law. While the Company generally supports licensing
regulation because it serves to validate the PEO relationship,
there can be no assurance that the Company will be able to
satisfy licensing requirements or other applicable regulations
for all states. In addition, there can be no assurance that
the Company will be able to renew its licenses in all states.
Loss
of Benefit Plans
The maintenance of health and workers' compensation insurance
plans that cover worksite employees is a significant part
of the Company's business. The current health and workers'
compensation contracts are provided by vendors with whom the
Company has an established relationship, and on terms that
the Company believes to be favorable. While the Company believes
that replacement contracts could be secured on competitive
terms without causing significant disruption to the Company's
business, there can be no assurance in this regard.
Need
to Renew or Replace Client Companies
The Company's standard CSA is subject to cancellation on 60
days' notice by either the Company or the client. Accordingly,
the short-term nature of the CSA makes the Company vulnerable
to potential cancellations by existing clients, which could
materially and adversely affect the Company's financial condition
and results of operations. In addition, the Company's results
of operations are dependent in part upon the Company's ability
to retain or replace its client companies upon the termination
or cancellation of the Client Service Agreement. Historically,
approximately 20% of the Company's clients have remained clients
for less than one year and there can be no assurance that
the number of contract cancellations will not increase in
the future.
Marketing
Agreement with American Express
The Company has entered into a Marketing Agreement with American
Express to jointly market the Company's services to American
Express' substantial small and medium-sized business customer
base across the country. Under the terms of the Marketing
Agreement, American Express is utilizing its resources to
generate appointments with prospects for the Company's services.
In addition, the Company and American Express are working
to jointly develop product offerings that enhance the current
PEO services offered by the Company. The Company believes
that the agreement will enhance its ability to increase its
base of worksite employees and clients; however, there can
be no assurances to that effect. Among the factors that could
cause the effectiveness of the Marketing Agreement to be less
than anticipated are the ability of American Express to set
qualified appointments, the Company's ability to make timely
presentations to all of the appointments set by American Express,
and the Company's ability to convert those appointments into
sales.
Liabilities
for Client and Employee Actions
A number of legal
issues remain unresolved with respect to the co-employment
arrangement between a PEO and its worksite employees, including
questions concerning the ultimate liability for violations
of employment and discrimination laws. The Administaff CSA
establishes the contractual division of responsibilities between
the Company and its clients for various personnel management
matters, including compliance with and liability under various
governmental regulations. However, because the Company acts
as a co-employer, the Company may be subject to liability
for violations of these or other laws despite these contractual
provisions, even if it does not participate in such violations.
Although the CSA provides that the client is to indemnify
the Company for any liability attributable to the conduct
of the client, the Company may not be able to collect on such
a contractual indemnification claim and thus may be responsible
for satisfying such liabilities. In addition, worksite employees
may be deemed to be agents of the Company, subjecting the
Company to liability for the actions of such worksite employees.
Geographic
Market Concentration
While the Company
has sales offices in 15 markets, 11 of these represent expansion
markets pursuant to the Company's national expansion plan.
The Company's Houston and Texas (including Houston) markets
accounted for approximately 36% and 61%, respectively, of
the Company's revenue for the year ended December 31, 1999.
Accordingly, while a primary aspect of the Company's strategy
is expansion in its current and future markets outside of
Texas, for the foreseeable future a significant portion of
the Company's revenues may be subject to economic factors
specific to Texas (including Houston). While the Company believes
that its market expansion plans will eventually lessen this
risk in addition to generating significant revenue growth,
there can be no assurance that the Company will be able to
duplicate in other markets the revenue growth and operating
results experienced in its Texas (including Houston) markets.
Competition
and New Market Entrants
The PEO industry
is highly fragmented. Many PEOs have limited operations and
fewer than 1,000 worksite employees, but there are several
industry participants which are comparable in size to the
Company. The Company also encounters competition from "fee
for service" companies such as payroll processing firms,
insurance companies and human resource consultants. In addition,
several of the Company's PEO competitors have recently been
acquired by large business services companies, such as Automatic
Data Processing, Inc. Such companies have substantially greater
resources and provide a broader range of services than the
Company. Accordingly, the PEO divisions of such companies
may be able to provide more services at more competitive prices
than may be offered by the Company. Moreover, the Company
expects that as the PEO industry grows and its regulatory
framework becomes better established, well-organized competition
with greater resources than the Company may enter the PEO
market, possibly including large "fee for service"
companies currently providing a more limited range of services.
Potential
Client Liability for Employment Taxes
Pursuant to the
CSA, the Company assumes sole responsibility and liability
for the payment of federal employment taxes imposed under
the Code with respect to wages and salaries paid to its worksite
employees. There are essentially three types of federal employment
tax obligations: (i) income tax withholding requirements;
(ii) obligations under the Federal Income Contribution Act
("FICA"); and (iii) obligations under the Federal
Unemployment Tax Act ("FUTA"). Under the Code, employers
have the obligation to withhold and remit the employer portion
and, where applicable, the employee portion of these taxes.
Most states impose similar employment tax obligations on the
employer. While the CSA provides that the Company has sole
legal responsibility for making these tax contributions, the
IRS or applicable state taxing authority could conclude that
such liability cannot be completely transferred to the Company.
Accordingly, in the event the Company fails to meet its tax
withholding and payment obligations, the client company may
be held jointly and severally liable therefor. While this
interpretive issue has not, to the Company's knowledge, discouraged
clients from enrolling with the Company, there can be no assurance
that a definitive adverse resolution of this issue would not
do so in the future.
Qualitative
and Quantitative Disclosures About Market Risk.
The Company
is primarily exposed to market risks from fluctuations in
interest rates and the effects of those fluctuations on the
market values of its cash equivalent short-term investments
and its available-for-sale marketable securities. The cash
equivalent short-term investments consist primarily of overnight
investments, which are not significantly exposed to interest
rate risk, except to the extent that changes in interest rates
will ultimately affect the amount of interest income earned
on these investments. The available-for-sale marketable securities
are subject to interest rate risk because these securities
generally include a fixed interest rate. As a result, the
market values of these securities are affected by changes
in prevailing interest rates.
The Company attempts to limit
its exposure to interest rate risk primarily through diversification
and low investment turnover. The Company's marketable securities
are currently managed by three professional investment management
companies, each of whom is guided by the Company's investment
policy. The Company's investment policy is designed to maximize
after-tax interest income while preserving its principal investment.
As a result, the Company's marketable securities consist primarily
of short and intermediate-term debt securities.
As of December
31, 1999, the Company's available-for-sale marketable securities
include an investment in a mutual fund, which holds corporate
debt securities with maturities ranging up to 18 months. The
amortized cost basis, fair market value and 30-day yield of
this investment was $1,763,000, $1,749,000 and 5.95% at December
31, 1999. The following table presents information about the
Company's remaining available-for-sale marketable securities
as of December 31, 1999 (dollars in thousands):
