Paychex - 10-Q quarterly report FY

 

 

911 Panorama Trail South
Rochester, New York 14625-2396
(585) 385-6666
A Delaware Corporation

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ   No o.

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large Accelerated Filer þ     Accelerated Filer o    Non-Accelerated Filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o    No þ.

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

 

PAYCHEX, INC.
CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
In thousands, except per share amounts

See Notes to Consolidated Financial Statements.

PAYCHEX, INC.
CONSOLIDATED BALANCE SHEETS (UNAUDITED)
In thousands, except per share amounts

See Notes to Consolidated Financial Statements.

PAYCHEX, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
In thousands

See Notes to Consolidated Financial Statements.

Description of business: Paychex, Inc. and its wholly owned subsidiaries (collectively, the “Company” or “Paychex”) is a leading provider of comprehensive payroll and integrated human resource and employee benefits outsourcing solutions for small- to medium-sized businesses in the United States (“U.S.”). The Company also has a subsidiary in Germany.

Paychex, a Delaware corporation formed in 1979, reports one segment based upon the provisions of Statement of Financial Accounting Standard (“SFAS”) No. 131, “Disclosures about Segments of an Enterprise and Related Information.” Substantially all of the Company’s revenue is generated within the U.S. Revenue is also generated in Germany, which was less than one percent of total revenue of the Company for the nine months ended February 28, 2007. Long-lived assets in Germany are an insignificant portion of the total long-lived assets of the Company as of February 28, 2007.

Basis of presentation: The accompanying Consolidated Financial Statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions to the Quarterly Report on Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statement presentation. The Consolidated Financial Statements include the consolidated accounts of the Company with all significant intercompany transactions eliminated. In the opinion of management, the information furnished herein reflects all adjustments (consisting of items of a normal recurring nature), which are necessary for a fair presentation of the results for the interim period. The accompanying Consolidated Financial Statements should be read in conjunction with the Company’s Consolidated Financial Statements and related Notes to Consolidated Financial Statements presented in the Company’s Annual Report on Form 10-K as of and for the year ended May 31, 2006 (“fiscal 2006”). Operating results and cash flows for the nine months ended February 28, 2007 are not necessarily indicative of the results that may be expected for other interim periods or the full fiscal year ending May 31, 2007 (“fiscal 2007”).

PEO revenue recognition: Professional Employer Organization (“PEO”) revenue is included in service revenue and is reported net of direct costs billed and incurred for PEO worksite employees, which include wages, taxes, benefit premiums, and workers’ compensation costs and claims of PEO worksite employees. Direct costs billed and incurred for PEO worksite employees were $653.6 million and $628.3 million for the three months ended February 28, 2007 and 2006, respectively, and $1.9 billion and $1.8 billion for the nine months ended February 28, 2007 and 2006, respectively.

PEO workers’ compensation insurance: Workers’ compensation insurance for PEO worksite employees is provided under a deductible workers’ compensation policy with a national insurance company. Claims are paid as incurred and the Company’s maximum individual claims liability is $750,000 under both the fiscal 2007 and fiscal 2006 policies.

The Company has recorded the following amounts on its Consolidated Balance Sheets for workers’ compensation claims:

The amount included in prepaid expense on the Consolidated Balance Sheets relates to the policy for the fiscal year ended May 31, 2004, which was a pre-funded policy.

Estimated losses under the workers’ compensation policies, based on historical loss experience and independent actuarial loss projections, are subject to change based on changes in claims experience trends and other factors that management monitors on a regular basis. Any adjustment to previously established reserves is reflected in the operating results of the period in which the adjustment is identified. Such adjustments could possibly be significant, reflecting any variety of new and adverse or favorable trends.

Stock-based compensation costs: Effective June 1, 2006, the Company adopted SFAS No. 123 (revised 2004) (“SFAS No. 123(R)”), “Share-Based Payment,” which replaces SFAS No. 123, “Accounting for Stock-Based Compensation” and supersedes Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees.” This statement requires that all stock-based awards to employees, including grants of employee stock options, be recognized as compensation costs in the Consolidated Financial Statements based on their fair values measured as of the date of grant. These costs are recognized as an expense in the Consolidated Statements of Income over the requisite service period and increase additional paid-in capital. The Company adopted this standard using the modified-prospective transition method, and accordingly, results for prior periods have not been restated. See Note B of the Notes to Consolidated Financial Statements for further discussion of the Company’s stock-based compensation plans.

Income taxes: The Company accounts for deferred taxes by recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the Consolidated Financial Statements or tax returns. Under this method, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. With the adoption of SFAS No. 123(R), the Company records a deferred tax asset related to the stock-based compensation costs recognized for certain stock-based awards. At the time of exercise of non-qualified stock options or vesting of restricted stock awards, the Company accounts for the resulting tax deduction by reducing its accrued income tax liability with an offset to the deferred tax asset and any excess tax benefit increasing additional paid-in capital. The Company currently has a sufficient pool of excess tax benefits in additional paid-in capital to absorb any deficient tax benefits related to stock-based awards.

Newly issued accounting pronouncements: In June 2006, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109,” to create a

Note A: Description of Business and Significant Accounting Policies– continued single model to address accounting for uncertainty in tax positions. FIN 48 clarified the accounting for income tax by prescribing a minimum recognition threshold a tax position is required to meet before being recognized in the Consolidated Financial Statements. FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company will adopt FIN 48 as of June 1, 2007, as required. The Company has not yet determined the effect, if any, the adoption of FIN 48 will have on its results of operations or financial position.

In April 2006, the FASB issued FASB Staff Position (“FSP”) FIN 46(R)-6, “Determining the Variability to Be Considered in Applying FASB Interpretation No. 46(R).” This FSP provides additional guidance on the determination of and accounting for variable interests under FASB Interpretation No. 46(R). This FSP was effective for reporting periods beginning after June 15, 2006, and the Company implemented its guidance beginning in the second quarter of fiscal 2007 relative to our limited partner investments in low-income housing projects. The adoption of this FSP did not have a material effect on the Company’s results of operations or financial position.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” This statement clarifies the definition of fair value, establishes a framework for measuring fair value, and expands the disclosures on fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. The Company has not yet determined the effect, if any, the adoption of this statement will have on its results of operations or financial position.

In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Post-Retirement Plans.” This statement requires an employer to recognize the over-funded or under-funded status of a defined benefit post-retirement plan and to recognize changes in the funded status in the year of change through comprehensive income. The statement is effective as of the end of the fiscal year ending after December 15, 2006. The Company currently does not have any benefit plans subject to this new statement and, therefore, expects no impact on its results of operations or financial position.

In October 2006, the FASB issued FSPs related to SFAS No. 123(R) as follows:

Both FSPs are effective in the first reporting period beginning after the date the FSP is posted to the FASB website, which for the Company was the three months ended February 28, 2007. The adoption of these FSPs did not have a material effect on the Company’s results of operations or financial position.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities – Including an amendment to FASB Statement No. 115.” This statement allows a company to irrevocably elect fair value as a measurement attribute for certain financial assets and financial liabilities with changes in fair value recognized in the results of operations. The statement also establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. The Company does not expect this statement to have a material effect on its results of operations or financial position.

As discussed in Note A of the Notes to Consolidated Financial Statements, effective June 1, 2006 (the “adoption date”), Paychex adopted SFAS No. 123(R). This statement requires that all stock-based awards to employees, including grants of employee stock options, be recognized as compensation costs in the Consolidated Financial Statements based on their fair values measured as of the date of grant. These costs are recognized as an expense in the Consolidated Statements of Income over the requisite service period and increase additional paid-in capital.

The Company adopted this standard using the modified-prospective transition method, and accordingly, results for prior periods have not been restated. Under this transition method, the Company recognized for the nine months ended February 28, 2007 compensation costs for (1) stock-based awards granted after the adoption date based on grant date fair value in accordance with the provisions of SFAS No. 123(R); and (2) the unvested portion of any grants issued prior to the adoption date based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123.

Prior to the adoption date, the Company accounted for stock-based compensation arrangements under the intrinsic value method described in APB 25 and related interpretations, as permitted by SFAS No. 123. Accordingly, no compensation costs were recognized for stock option grants because the exercise price of the stock options granted was equal to the market price of the underlying stock on the date of the grant.

Prior to the adoption of SFAS No. 123(R), the Company presented all tax benefits from the exercise of stock options as cash flows from operating activities in the Consolidated Statements of Cash Flows. SFAS No. 123(R) requires tax benefits in excess of compensation costs recognized in the Consolidated Financial Statements (“excess tax benefits”) to be presented as cash flows from financing activities. In accordance with SFAS No. 123(R), excess tax benefits recognized in periods after the adoption date have been properly classified as cash flows from financing activities. Total tax benefits recognized in periods prior to the adoption date remain classified as cash flows from operating activities.

As a result of adopting SFAS No. 123(R), the Company recognized $7.0 million and $19.3 million in stock-based compensation costs and $2.0 million and $5.6 million in income tax benefits in its Consolidated Statements of Income for the three and nine months ended February 28, 2007, respectively. Capitalized stock-based compensation costs related to the development of internal use software for the nine months ended February 28, 2007 were not significant.

The following table illustrates the impact of the adoption of SFAS No. 123(R) on the Company’s results of operations:

The following table illustrates the previously disclosed pro-forma effect on net income and earnings per share as if the Company had applied the fair value recognition provision of SFAS No. 123 to stock-based compensation:

Stock-based compensation costs for any awards granted subsequent to the adoption date are recognized on a straight-line basis over the requisite service period to better align the costs with the employee services provided. Compensation costs for stock-based awards granted prior to the adoption date will continue to be recognized according to an accelerated amortization schedule related to the graded vesting terms of the grant, as they were for the pro-forma disclosures above.

The Company’s 2002 Stock Incentive Plan, as amended and restated, effective October 12, 2005 (the “2002 Plan”), authorizes the granting of stock-based awards for up to 29.1 million shares of the Company’s common stock. Outstanding stock-based awards under the 2002 Plan as of February 28, 2007 consisted primarily of grants of stock options. In July 2006, restricted stock awards were issued under the 2002 Plan to officers and outside directors of the Company.

As of February 28, 2007, the total unrecognized compensation cost related to all unvested stock-based awards was $66.5 million and is expected to be recognized over a weighted-average period of 2.9 years.

Stock option grants: Stock option grants entitle the holder to purchase, at the end of the vesting term, a specified number of shares of Paychex common stock at an exercise price per share set equal to the closing market price of the common stock on the date of grant. Stock option grants have a ten-year contractual term and the vesting schedule is established by the Board of Directors (the “Board”). Stock options granted during the nine months ended February 28, 2007 vest ratably over periods ranging from three to five years. The Company issues new shares of common stock to satisfy stock option exercises.

Stock option grants are normally approved in July by the Board, with a current annual grant guideline of approximately 1% of total common stock outstanding. The grant guideline, reviewed annually by the Board, does not include broad-based incentive stock options granted to virtually all non-management employees with at least 90 days of service. On October 4, 2006, the Board approved a broad-based grant of 2.0 million stock options. The Board previously issued a broad-based grant in April 2004.

The following table summarizes stock option activity for the nine months ended February 28, 2007:

Other information pertaining to stock option grants is as follows:

The fair value of stock option grants was estimated at the date of grant using a Black-Scholes option pricing model for grants prior to and subsequent to the adoption date. The weighted-average assumptions used for valuation under the Black-Scholes model for the nine months ended February 28, 2007 (under SFAS No. 123(R)) and for the nine months ended February 28, 2006 (pro-forma impact under SFAS No. 123) are as follows:

Risk-free interest rates are yields for zero coupon U.S. Treasury notes maturing approximately at the end of the expected option life. The estimated volatility factor is based on a combination of historical volatility using weekly stock prices and implied market volatility, both over a period equal to the expected option life. Prior to the adoption date, the Company had used historical volatility based on monthly stock prices. The expected option life is determined from historical exercise behavior.

The Company has determined that the Black-Scholes option pricing model, as well as the underlying assumptions used in its application, is appropriate in estimating the fair value of its stock option grants. The Company periodically assesses its assumptions as well as its choice of valuation model, and will reconsider use of this model if additional information becomes available in the future indicating that another model would provide a more accurate estimate of fair value, or if characteristics of future grants would warrant such a change.

Restricted stock awards: In July 2006, the Board approved a grant of restricted stock awards to the Company’s officers and outside directors in accordance with the 2002 Plan. All shares underlying awards of restricted stock are restricted in that they are not transferable until they vest. The recipients of the restricted stock have voting rights and earn dividends, which are paid to the recipient at the time of vesting of the awards. If the recipient leaves Paychex prior to the vesting date for any reason, the shares of restricted stock and the dividends accrued on those shares will be forfeited and returned to Paychex.

For restricted stock awards granted to officers, the shares vest upon the fifth anniversary of the grant date provided the recipient is still an employee of the Company on that date. These awards have a provision for the acceleration of vesting based on achievement of performance

targets established by the Board. If the established targets are met for a fiscal year, one-third of the award will vest. For directors, the shares vest on the third anniversary of the grant date. The fair value of restricted stock awards is equal to the closing market price of the underlying common stock as of the date of grant and is expensed over the requisite service period on a straight-line basis.

The following table summarizes the Company’s restricted stock activity for the nine months ended February 28, 2007:

Employee Stock Purchase Plan: The Company offers an Employee Stock Purchase Plan to all employees under which the Company’s common stock can be purchased through a payroll deduction with no discount to the market price. The plan has been deemed non-compensatory subject to the provisions of SFAS No. 123(R) and, therefore, no stock-based compensation costs have been recognized for the nine months ended February 28, 2007.

Basic and diluted earnings per share were calculated as follows:

Weighted-average common share equivalents that have an anti-dilutive impact are excluded from the computation of diluted earnings per share.

For the three and nine months ended February 28, 2007, stock options were exercised for 0.8 million and 1.6 million shares of the Company’s common stock, respectively, compared with 0.1 million and 1.1 million shares for the respective prior year periods.

Funds held for clients and corporate investments consisted of the following:

Classification of investments on the Consolidated Balance Sheets is as follows:

The Company is exposed to credit risk in connection with these investments through the possible inability of borrowers to meet the terms of their bonds. In addition, the Company is exposed to interest rate risk, as rate volatility will cause fluctuations in the market value of held investments and in the earnings potential of future investments. The Company attempts to limit these risks by investing primarily in available-for-sale securities with AAA and AA ratings and short-term securities with an A-1 rating, limiting amounts that can be invested in any single issuer, and by investing in short- to intermediate-term instruments whose market value is less sensitive to interest rate changes. The Company does not utilize derivative financial instruments to manage its interest rate risk.

The Company’s available-for-sale securities reflected a net unrealized loss position of $6.1 million as of February 28, 2007 compared with a net unrealized loss position of $22.0 million as of May 31, 2006. The gross unrealized losses as of February 28, 2007 were comprised of 346 available-for-sale securities, which had a total market value of $1.3 billion. The gross unrealized losses as of May 31, 2006 were comprised of 441 available-for-sale securities with a total market value of $1.6 billion.

The Company periodically reviews its investment portfolios to determine if any investment is other-than-temporarily impaired due to changes in credit risk or other potential valuation concerns. The Company believes that the investments it held as of February 28, 2007 were not other-than-temporarily impaired. While certain available-for-sale securities had market values that were below cost, the Company believes that it is probable that the principal and interest will be collected in accordance with contractual terms, and that the decline in the market value was due to changes in interest rates and was not due to increased credit risk. As of February 28, 2007 and May 31, 2006, substantially all of the securities in an unrealized loss position held an AA rating or better. The Company currently believes that it has the ability and intent to hold these investments until the earlier of market price recovery or maturity. The Company’s assessment that an investment is not other-than-temporarily impaired could change in the future due to new developments or changes in the Company’s strategies or assumptions related to any particular investment.

The cost and market value of available-for-sale securities that had stated maturities as of February 28, 2007 are shown below by contractual maturity. Expected maturities can differ from contractual maturities because borrowers may have the right to prepay obligations without prepayment penalties.

Variable rate demand notes (“VRDNs”) and auction rate securities are primarily categorized as due after five years in the table above as the contractual maturities on these securities are typically 20 to 30 years. Although these securities are issued as long-term securities, they are priced and traded as short-term instruments because of the liquidity provided through the auction or tender feature.

The components of property and equipment, at cost, consisted of the following:

Depreciation expense was $14.7 million and $42.3 million for the three and nine months ended February 28, 2007, respectively, as compared with $13.2 million and $38.1 million for the three and nine months ended February 28, 2006, respectively.

Within construction in progress, there were costs for software being developed for internal use of $37.2 million and $29.4 million as of February 28, 2007 and May 31, 2006, respectively. Capitalization of costs ceases when the software is ready for its intended use, at which time the Company begins amortization of the costs.

The Company accounts for certain intangible assets with finite lives in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets.” The components of intangible assets, at cost, consisted of the following:

Amortization expense relating to intangible assets was $4.7 million and $11.9 million for the three and nine months ended February 28, 2007, respectively, as compared with $3.7 million and $11.1 million for the three and nine months ended February 28, 2006, respectively.

The estimated amortization expense relating to intangible asset balances for the full fiscal year 2007 and the following four fiscal years, as of February 28, 2007, is as follows:

As a result of business acquisitions made during the fiscal year ended May 31, 2003, the Company recorded reserves for severance and redundant lease costs in the allocation of purchase price under Emerging Issues Task Force 95-3, “Recognition of Liabilities in Connection With a Purchase Combination” in the amounts of $10.0 million for severance and $5.9 million for redundant lease costs. Activity for the nine months ended February 28, 2007 for these reserves is summarized as follows:

The remaining severance payments will be completed during the fiscal year ending May 31, 2008. Redundant lease payments are expected to be completed during the fiscal year ending May 31, 2016. Payments of $0.9 million extend beyond one year and are included in other long-term liabilities on the Consolidated Balance Sheets as of February 28, 2007.

Comprehensive income is comprised of two components: net income and other comprehensive income. Comprehensive income includes all changes in equity during a period except those resulting from transactions with owners of the Company. The unrealized gains and losses, net of applicable taxes, related to available-for-sale securities is the only component reported in accumulated other comprehensive loss in the Consolidated Balance Sheets.

Comprehensive income, net of related tax effects, is as follows:

As of February 28, 2007, the accumulated other comprehensive loss was $4.0 million, which was net of taxes of $2.1 million. As of May 31, 2006, the accumulated other comprehensive loss was $14.3 million, which was net of taxes of $7.8 million.

Commitments: The Company has unused borrowing capacity available under four uncommitted, secured, short-term lines of credit at market rates of interest with financial institutions as follows:

The primary uses of the lines of credit would be to meet short-term funding requirements related to deposit account overdrafts and client fund deposit obligations arising from electronic payment transactions on behalf of clients in the ordinary course of business, if necessary. No amounts were outstanding against these lines of credit as of or during the nine months ended February 28, 2007.

As of February 28, 2007, the Company also had standby letters of credit outstanding totaling $59.8 million, required to secure commitments for certain insurance policies. These letters of credit expire at various dates between May 2007 and December 2007. The letters of credit are secured by investments held in the Company’s corporate portfolio, including a $50.9 million letter of credit for which funds have been segregated into a separate account. No amounts were outstanding on these letters of credit as of or during the nine months ended February 28, 2007.

The Company enters into various purchase commitments with vendors in the ordinary course of business. As of February 28, 2007, the Company had outstanding commitments to purchase approximately $5.1 million of capital assets.

The Company guarantees performance of service on annual maintenance contracts for clients who financed their service contracts through a third party. In the normal course of business, the Company makes representations and warranties that guarantee the performance of its services under service arrangements with clients. In addition, the Company has entered into indemnification agreements with its officers and directors, which require it to defend and, if necessary, indemnify these individuals for matters related to their services provided to the Company. Historically, there have been no material losses related to such guarantees and indemnifications.

The Company currently self-insures the deductible portion of various insured exposures under certain employee benefit plans. The Company’s estimated loss exposure under these insurance arrangements is recorded in other current liabilities on the Consolidated Balance Sheets. Historically, the amounts accrued have not been material. The Company also has insurance coverage in addition to its purchased primary insurance policies for gap coverage for employment practices liability, errors and omissions, warranty liability, and acts of terrorism; and capacity for deductibles and self-insured retentions through its captive insurance company.

Contingencies: The Company is subject to various claims and legal matters that arise in the normal course of its business. These include disputes or potential disputes related to breach of contract, employment-related claims, and other matters.

In August 2001, the Company’s wholly owned subsidiary, Rapid Payroll, Inc. (“Rapid Payroll”) informed seventy-six licensees that it intended to stop supporting their payroll processing software in August of 2002. Thereafter, lawsuits were commenced by licensees asserting various claims, including breach of contract and related tort and fraud causes of action. As previously reported in the prior periodic reports, these lawsuits sought compensatory damages, punitive damages, and injunctive relief against Rapid Payroll, the Company, the Company’s former Chief Executive Officer, and its Senior Vice President of Sales and Marketing. In accordance with the Company’s indemnification agreements with its senior executives, the Company has agreed to defend and, if necessary, indemnify them in connection with these pending matters.

On February 20, 2007, the Company resolved pending litigation related to Rapid Payroll through settlement agreements resulting in the dismissal of all but two remaining cases, one of which is pending in the California Superior Court, Los Angeles County, and one of which is pending in the United States Court of Appeals for the Ninth Circuit. The Company intends to vigorously defend the two remaining cases.

The Company has recorded a reserve for pending litigation matters. The litigation reserve has been adjusted in fiscal 2007 to account for settlements, increases in reserves, and incurred litigation expenditures. During the three months ended February 28, 2007, the Company increased its litigation reserve by $13.0 million to account for settlements and for anticipated costs relating to pending litigation matters. The Company’s reserve for all pending litigation totaled $13.2 million as of February 28, 2007, and is included in current liabilities on the Consolidated Balance Sheets.

In light of its reserve for all pending litigation matters, the Company’s management currently believes that resolution of outstanding litigation matters will not have a material adverse effect on the Company’s financial position or results of operations. However, legal matters are subject to inherent uncertainties and there exists the possibility that the ultimate resolution of these matters could have a material adverse impact on the Company’s financial position and the results of operations in the period in which any such effect is recorded.

Income taxes paid were $162.0 million and $135.9 million for the nine months ended February 28, 2007 and 2006, respectively.

During the three and nine months ended February 28, 2007, the Company purchased approximately $1.2 million and $2.0 million, respectively, of data processing equipment and software from EMC Corporation, compared with approximately $0.2 million and $2.7 million purchased in the respective prior year periods. The Chairman, President, and Chief Executive Officer of EMC Corporation is a member of the Company’s Board.

Management’s Discussion and Analysis of Financial Condition and Results of Operations reviews Paychex, Inc. and its wholly owned subsidiaries (“we,” “our,” “us”) operating results for the three and nine months ended February 28, 2007 and February 28, 2006, and our financial condition as of February 28, 2007. The focus of this review is on the underlying business reasons for significant changes and trends affecting our revenue, expenses, net income, and financial condition. This review should be read in conjunction with the February 28, 2007 Consolidated Financial Statements and the related Notes to Consolidated Financial Statements contained in this Quarterly Report on Form 10-Q (“Form 10-Q”). This review should also be read in conjunction with our Annual Report on Form 10-K (“Form 10-K”) for the year ended May 31, 2006. Forward-looking statements in this review are qualified by the cautionary statement included in this review under the next sub-heading, “Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995.”

“Safe Harbor” Statement Under the Private Securities Litigation Reform Act of 1995: Certain written and oral statements made by us may constitute “forward-looking statements” as defined in the Private Securities Litigation Reform Act of 1995 (the “Reform Act”). Forward-looking statements are identified by such words and phrases as “we expect,” “expected to,” “estimates,” “estimated,” “current outlook,” “we look forward to,” “would equate to,” “projects,” “projections,” “projected to be,” “anticipates,” “anticipated,” “we believe,” “could be,” and other similar phrases. All statements addressing operating performance, events, or developments that we expect or anticipate will occur in the future, including statements relating to revenue growth, earnings, earnings-per-share growth, or similar projections, are forward-looking statements within the meaning of the Reform Act. Because they are forward-looking, they should be evaluated in light of important risk factors. These risk factors include, but are not limited to, those that are described in our filings with the Securities and Exchange Commission (“SEC”), including our most recent Form 10-K filed on July 21, 2006. Any of these factors could cause our actual results to differ materially from our anticipated results.

The forward-looking statements in this document are based upon facts and circumstances known to us at this time. We undertake no obligation to update these forward-looking statements after the date of filing of this Form 10-Q with the SEC to reflect events or circumstances after such date, or to reflect the occurrence of unanticipated events.

We are a leading provider of comprehensive payroll and integrated human resource and employee benefits outsourcing solutions for small- to medium-sized businesses. Our Payroll and Human Resource Services offer a portfolio of services and products that allow our clients to meet their diverse payroll and human resource needs.

Our Payroll services are provided through either our Core Payroll or Major Market Services, which is utilized by clients that have more sophisticated payroll and benefit needs. Our Payroll services include:

Our Human Resource Services primarily include:

We mainly earn revenue through recurring fees for services performed. Service revenue is primarily driven by the number of clients, utilization of ancillary services, and checks or transactions per client per pay period. We also earn interest on funds held for clients between the time of collection from our clients and remittance to the applicable tax or regulatory agencies or client employees. Our strategy is focused on achieving strong long-term financial performance by providing high-quality, timely, accurate, and affordable services; growing our client base; increasing utilization of our ancillary services; leveraging our technological and operating infrastructure; and expanding our service offerings.

Our financial results for the three months ended February 28, 2007 as compared to the three months ended February 28, 2006 include the following:

During the three months ended February 28, 2007, we recorded an expense charge of $13.0 million to increase our litigation reserve. Refer to Note I of the Notes to Consolidated Financial Statements for additional information on pending legal matters. On June 1, 2006, we adopted the new accounting standard related to stock-based compensation costs, and recognized $7.0 million of expense for the three months ended February 28, 2007.

In managing and evaluating the results of our day-to-day operations, we believe that operating income excluding certain items is an appropriate measure. We also use this measure in evaluating management’s performance in generating those results. Operating income excluding interest on funds held for clients, stock-based compensation costs, and the expense charge to increase the litigation reserve increased 18% to $155.3 million for the three months ended February 28, 2007. Further details are included in “Operating Income” under the “Results of Operations” section of this review.

Our financial performance during the three months ended February 28, 2007 was largely due to strong service revenue growth of 11% over the same period last year. This growth in service revenue was attributable to higher check volume growth, client base growth, price increases, and growth in the utilization of our ancillary services.

Our financial performance was positively impacted by the effects of increases in interest rates earned on our funds held for clients and corporate investment portfolios. The Federal Funds rate was 5.25% as of February 28, 2007 compared with 4.50% as of February 28, 2006. For the three months ended February 28, 2007, our combined interest on funds held for clients and corporate investment income increased 38% and earned an average rate of return of 4.0%, compared with an average rate of return of 3.2% for the same period last year. The impact of changing interest rates and related risks is discussed in more detail in the “Market Risk Factors” section of this review.

As of February 28, 2007, we maintained a strong financial position with cash and total corporate investments of $1.2 billion. Our primary source of cash is from our ongoing operations. Cash flow from operations was $532.2 million for the nine months ended February 28, 2007, as compared with $457.9 million for the nine months ended February 28, 2006. Historically, we have funded operations, capital expenditures, purchases of corporate investments, and dividend payments from our operating activities. It is anticipated that current cash and corporate investment balances of $647.8 million, along with projected operating cash flows, will support our normal business operations, capital expenditures, and dividend payments for the foreseeable future.

For further analysis of our results of operations for the three and nine months ended February 28, 2007, and our financial position as of February 28, 2007, refer to the analysis and discussion in the “Results of Operations,” “Liquidity and Capital Resources,” and “Critical Accounting Policies” sections of this review.

Effective June 1, 2006 (the “adoption date”), we adopted Statement of Financial Accounting Standard (“SFAS”) No. 123 (revised 2004) (“SFAS No. 123(R)”), “Share-Based Payment.” This statement requires that all stock-based awards to employees, including grants of employee stock options, be recognized as compensation costs in the Consolidated Financial Statements based on their fair values measured as of the date of grant. These costs are recognized as expense in the Consolidated Statement of Income over the requisite service period. We adopted this standard using the modified-prospective transition method, and accordingly,

results for the prior periods have not been restated. Comparisons between the results of operations for the three and nine months ended February 28, 2007 and the same periods last year are impacted by this method of adoption. Refer to Note B of the Notes to Consolidated Financial Statements for additional information regarding stock-based compensation arrangements.

Prior to the adoption date, we accounted for stock-based compensation arrangements under the intrinsic value method described in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations, as permitted by SFAS No. 123, “Accounting for Stock-Based Compensation.” Accordingly, no compensation costs were recognized for stock option grants because the exercise price of the stock options granted was equal to the market price of the underlying stock on the date of the grant.

The impacts to the results of operations for the three and nine months ended February 28, 2007 from recognition of stock-based compensation costs under SFAS No. 123(R) are as follows:

As of February 28, 2007, the total unrecognized compensation cost for all unvested stock-based awards was $66.5 million and is expected to be recognized over a weighted-average period of 2.9 years. The impact on future periods may change based on the issuance of additional stock-based awards as allowed under the Paychex, Inc. 2002 Stock Incentive Plan, as amended and restated, effective October 12, 2005.

For grants of stock options, we estimate the fair value at the date of grant using a Black-Scholes option pricing model. For grants of restricted stock, which were first granted in July 2006, the fair value is equal to the closing market price of the underlying common stock as of the date of grant. Stock-based compensation costs for any awards granted subsequent to the adoption date are recognized on a straight-line basis over the requisite service period to better align the costs with the employee services provided. Compensation costs for stock-based awards granted prior to the adoption date will continue to be recognized on an accelerated amortization schedule related to the graded vesting terms of the grant.

As part of the adoption of SFAS No. 123(R), we did an in-depth review of all of our assumptions used in calculating the fair value under a Black-Scholes option pricing model. For grants subsequent to the adoption date, we calculated the estimated volatility factor based on a combination of historical volatility using weekly stock prices and implied market volatility. We incorporated implied volatility as it is generally more reflective of both historical volatility and

expectations of how future volatility will differ from historical volatility. Prior to the adoption date, we used historical volatility based on monthly stock prices. The expected option life of our stock option grants is determined from historical exercise behavior.

Upon adoption of SFAS No. 123(R), we are required to estimate forfeitures and only record compensation costs for those awards that are expected to vest. Previously, in our pro-forma disclosures under SFAS No. 123, we accounted for forfeitures as they occurred. Our assumptions for forfeitures were determined based on type of award and historical experience.

The assumptions of volatility, expected option life, and forfeitures all require significant judgment and are subject to change in the future due to factors such as employee exercise behavior, stock price trends, and changes to types or provisions of stock-based awards. Any change in one or more of these assumptions can have a material impact on the estimated fair value of an award and on stock-based compensation costs recognized in our results of operations.

Our current outlook for our results of operations for the full year ending May 31, 2007 is unchanged from the guidance provided in our Form 10-Q for the quarter ended August 31, 2006.

Purchases of property and equipment for fiscal 2007 are expected to be in the range of $70 million to $75 million. Fiscal 2007 depreciation expense is projected to be approximately $55 million, and we project amortization of intangible assets to be approximately $16 million.

Our projections are based on current economic and interest rate conditions continuing with no significant changes.

Details regarding our combined funds held for clients and corporate investment portfolios are as follows:

Revenue: The increases in Payroll service revenue of 8% and 9% for the three and nine months ended February 28, 2007 from the same periods last year were attributable to higher check volume growth, client base growth, price increases, and growth in the utilization of our ancillary services.

As of February 28, 2007, 92% of all clients utilized our payroll tax administration services, compared with 91% as of February 28, 2006. We believe that the client utilization percentage of our payroll tax administration services is near maturity. Our employee payment services were utilized by 70% of all clients as of February 28, 2007, compared with 68% as of February 28, 2006. Approximately 95% of new clients purchase our payroll tax administration services and more than 75% of new clients purchase employee payment services.

Human Resource Services revenue increased 25% and 24% for the three and nine months ended February 28, 2007 to $102.2 million and $289.5 million, respectively. The growth was generated from the following: retirement services client base increased 15% to 43,000 clients; comprehensive human resource outsourcing services increased 30% to 350,000 client employees; and workers’ compensation insurance client base increased 16% to 59,000 clients. Additionally, the asset value of the retirement services client employees’ funds increased 24% to $7.6 billion.

For the three and nine months ended February 28, 2007, interest on funds held for clients increased 31% and 41%, respectively. The increases in interest on funds held for clients were due to higher average interest rates earned and higher average investment balances. The current effect of higher average interest rates is expected to diminish as there have been no increases to the Federal Funds rate since June 29, 2006. See the “Market Risk Factors” section of this review for further information related to the effects of changing interest rates.

Combined operating and SG&A expenses: The following table summarizes total combined operating and selling, general and administrative (“SG&A”) expenses:

Stock-based compensation costs from the adoption of SFAS No. 123(R), included in compensation-related expenses, were $7.0 million and $19.3 million for the three and nine months ended February 28, 2007, respectively. During the three months ended February 28, 2007, we recorded an expense charge of $13.0 million to increase our litigation reserve which is included in other expenses. Refer to Note I of the Notes to Consolidated Financial Statements for additional information on pending legal matters.

Excluding stock-based compensation costs and the expense charge to increase the litigation reserve, total expense growth would have been 8% and 10% for the three and nine months ended February 28, 2007, respectively. The growth was a result of increases in personnel and other costs related to retaining clients, promoting new services, and creating more efficient systems for selling and servicing through new and enhanced technology.

As of February 28, 2007, we had approximately 11,500 employees compared with approximately 10,700 employees as of February 28, 2006.

Depreciation expense is primarily related to buildings, furniture and fixtures, data processing equipment, and software. Amortization of intangible assets is primarily related to client list acquisitions, which are amortized using either straight-line or accelerated methods. Other expenses include such items as delivery, forms and supplies, communications, travel and entertainment, professional services, and other costs incurred to support our business.

Operating income: The increases in operating income for the three and nine months ended February 28, 2007, as compared with the same periods last year are attributable to the factors previously discussed. Operating income excluding interest on funds held for clients, stock-based compensation costs and the expense charge to increase the litigation reserve is as follows:

Investment income, net: Investment income, net primarily represents earnings from our cash and cash equivalents and investments in available-for-sale securities. Investment income does not include interest on funds held for clients, which is included in total revenue. The increases in investment income for the three and nine months ended February 28, 2007 as compared to the same periods last year are due to higher average interest rates earned and growth in average portfolio balances resulting from investment of cash generated from our ongoing operations.

Income taxes: Our effective income tax rate was 31.0% for both the three and nine months ended February 28, 2007 compared with 31.4% for both the respective prior year periods. The decrease in our effective tax rate is attributable to higher levels of tax-exempt income derived from municipal debt securities held in our funds held for clients and corporate investment portfolios, and a lower effective state income tax rate, partially offset by the nondeductible compensation related to incentive stock option grants.

Net income: The increases in net income for the three and nine months ended February 28, 2007, as compared with the three and nine months ended February 28, 2006 are attributable to the factors previously discussed.

As of February 28, 2007, we had $1.2 billion in cash and total corporate investments. Current cash and corporate investments of $647.8 million and projected operating cash flows are expected to support our normal business operations, capital expenditures, and dividend payments for the foreseeable future.

We have unused borrowing capacity available under four uncommitted, secured, short-term lines of credit at market rates of interest with financial institutions as follows:

The primary uses of the lines of credit would be to meet short-term funding requirements related to deposit account overdrafts and client fund deposit obligations arising from electronic payment transactions on behalf of our clients in the ordinary course of business, if necessary. No amounts were outstanding against these lines of credit as of or during the nine months ended February 28, 2007.

As of February 28, 2007, we had standby letters of credit outstanding totaling $59.8 million, required to secure commitments for certain of our insurance policies. These letters of credit expire at various dates between May 2007 and December 2007. The letters of credit are secured by investments held in our corporate portfolio, including a $50.9 million letter of credit for which funds have been segregated into a separate account. No amounts were outstanding on these letters of credit as of or during the nine months ended February 28, 2007.

We enter into various purchase commitments with vendors in the ordinary course of business. As of February 28, 2007, we had outstanding commitments to purchase approximately $5.1 million of capital assets.

We guarantee performance of service on annual maintenance contracts for clients who financed their service contracts through a third party. In the normal course of business, we make representations and warranties that guarantee the performance of our services under service arrangements with clients. In addition, we have entered into indemnification agreements with our officers and directors, which require us to defend and, if necessary, indemnify these individuals for matters related to their services provided to us. Historically, there have been no material losses related to such guarantees and indemnifications.

We currently self-insure the deductible portion of various insured exposures under certain employee benefit plans. Our estimated loss exposure under these insurance arrangements is recorded in other current liabilities on our Consolidated Balance Sheets. Historically, the amounts accrued have not been material. We also have insurance coverage in addition to our purchased primary insurance policies for gap coverage for employment practices liability,

errors and omissions, warranty liability, and acts of terrorism; and capacity for deductibles and self-insured retentions through our captive insurance company.

As part of our ongoing business, we do not participate in transactions with unconsolidated entities such as special purpose entities or structured finance entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other limited purposes. We do maintain investments as a limited partner in low-income housing projects that are not considered part of our ongoing operations. These investments are accounted for under the equity method of accounting.

The increase in our operating cash flows for the nine months ended February 28, 2007 reflects higher net income adjusted for non-cash items, and decreased cash from operating assets and liabilities. The increase in non-cash adjustments to net income is primarily attributable to stock-based compensation costs of $19.3 million for the nine months ended February 28, 2007, and the expense charge of $13.0 million to increase the litigation reserve. The fluctuation in operating assets and liabilities between periods was primarily the result of timing of accounts receivable billing and collections and timing of payments for compensation, PEO payroll, income tax, and other liabilities.

Funds held for clients and corporate investments: Funds held for clients are primarily comprised of short-term funds and available-for-sale securities. Corporate investments are primarily comprised of available-for-sale securities. The portfolio of funds held for clients and corporate investments is detailed in Note D of the Notes to Consolidated Financial Statements.

The amount of funds held for clients will vary based upon the timing of collecting client funds, and the related remittance of funds to applicable tax or regulatory agencies for payroll tax

administration services and to employees of clients utilizing employee payment services. Fluctuations in net funds held for clients and corporate investment activities mainly relate to timing of purchases, sales, or maturities of corporate investments. Additional discussion of interest rates and related risks is included in the “Market Risk Factors” section of this review.

Purchases of long-lived assets: To support our continued client and ancillary product growth, purchases of property and equipment were made for data processing equipment and software, and for the expansion and upgrade of various operating facilities. Construction in progress totaled $43.2 million as of February 28, 2007 and $36.3 million as of May 31, 2006. Of these costs, $37.2 million and $29.4 million represent software being developed for internal use as of February 28, 2007 and May 31, 2006, respectively. Capitalization of costs ceases when software is ready for its intended use, at which time we will begin amortization of the costs.

We purchased approximately $2.0 million and $2.7 million of data processing equipment and software from EMC Corporation during the nine months ended February 28, 2007 and 2006, respectively. The Chairman, President, and Chief Executive Officer of EMC Corporation is a member of our Board of Directors (the “Board”). Other assets increased for the nine months ended February 28, 2007 mainly due to the termination of our client-servicing arrangement with New England Business Services, Inc. and the purchasing of the right to service the related clients.

Dividends paid: During the nine months ended February 28, 2007, our Board declared quarterly dividends aggregating $0.58 per share. The most recent quarterly dividend of $0.21 per share was paid February 15, 2007 to stockholders of record as of February 1, 2007. The payment of future dividends is dependent on our future earnings and cash flow and is subject to the discretion of our Board.

Exercise of stock options: The increase in proceeds from the exercise of stock options is due to an increase in the number of shares exercised from 1.1 million shares during the nine months ended February 28, 2006 to 1.6 million shares during the nine months ended February 28, 2007. We recognized an excess tax benefit related to the exercise of stock options of $7.5 million for the nine months ended February 28, 2007 that is reflected in cash flows from financing activities in accordance with SFAS
No. 123(R), as adopted on June 1, 2006. For the nine months ended February 28, 2006, we recognized a total tax benefit related to the exercise of stock options of $7.5 million which was reflected in cash flows from operating activities.

Changes in interest rates and interest rate risk: Funds held for clients are primarily comprised of short-term funds and available-for-sale securities, and corporate investments are primarily comprised of available-for-sale securities. As a result of our operating and investing activities, we are exposed to changes in interest rates that may materially affect our results of operations and financial position. Changes in interest rates will impact the earnings potential of future investments and will cause fluctuations in the market value of our longer-term available-for-sale securities. In seeking to minimize the risks and/or costs associated with such activities, we generally direct investments towards high credit quality, fixed-rate municipal and government securities and manage the available-for-sale securities to a benchmark duration of two and one-half to three years. We do not utilize derivative financial instruments to manage our interest rate risk.

During the nine months ended February 28, 2007, the average interest rate earned on our combined funds held for clients and corporate investment portfolios was 3.9% compared with 3.0% for the same period last year. While interest rates were rising, the full benefit of higher interest rates was not immediately reflected in net income due to the interaction of long- and short-term interest rate changes as discussed below.

During a rising interest rate environment, the increases in interest rates increase earnings from our short-term investments and over time increase earnings from our longer-term available-for-sale securities. Earnings from the available-for-sale-securities, which as of February 28, 2007 had an average duration of 2.5 years excluding the impact of VRDNs and auction rate securities tied to short-term interest rates, would not reflect increases in interest rates until the investments are sold or mature and the proceeds are reinvested at higher rates.

The cost and market value of available-for-sale securities that had stated maturities as of February 28, 2007, are shown below by contractual maturity. Expected maturities can differ from contractual maturities because borrowers may have the right to prepay obligations without prepayment penalties.

VRDNs and auction rate securities are primarily categorized as due after five years in the table above as the contractual maturities on these securities are typically 20 to 30 years. Although these securities are issued as long-term securities, they are priced and traded as short-term instruments because of the liquidity provided through the auction or tender feature.

The following table summarizes recent changes in the Federal Funds rate: