Summary of PAYCHEX INC - Yahoo! Finance

Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Management's Discussion and Analysis of Financial Condition and Results of Operations reviews the operating results of Paychex, Inc. and its wholly owned subsidiaries ("we," "our," or "us") for the three months ended August 31, 2008 and August 31, 2007, and our financial condition as of August 31, 2008. 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 August 31, 2008 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, 2008 ("fiscal 2008"). 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 management 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, the following risks, as well as those that are described in our filings with the Securities and Exchange Commission ("SEC"): general market and economic conditions including, among others, changes in United States employment and wage levels, changes in new hiring trends, changes in short- and long-term interest rates, and changes in the fair value and the credit rating of securities held by us; changes in demand for our services and products, ability to develop and market new services and products effectively, pricing changes and the impact of competition, and the availability of skilled workers; changes in the laws regulating collection and payment of payroll taxes, professional employer organizations, and employee benefits, including retirement plans, workers' compensation, health insurance, state unemployment, and section 125 plans; changes in workers' compensation rates and underlying claims trends; the possibility of failure to keep pace with technological changes and provide timely enhancements to services and products; the possibility of failure of our operating facilities, computer systems, and communication systems during a catastrophic event; the possibility of third-party service providers failing to perform their functions; the possibility of penalties and losses resulting from errors and omissions in performing services; the possible inability of our clients to meet their payroll obligations; the possible failure of internal controls or our inability to implement business processing improvements; and potentially unfavorable outcomes related to pending legal matters. Any of these factors could cause our actual results to differ materially from our anticipated results. The information provided in this Form 10-Q is based upon the facts and circumstances known 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.

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Overview
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, and include:
• payroll processing;

• payroll tax administration services;

• employee payment services; and

• regulatory compliance services (new-hire reporting and garnishment processing).

Our Human Resource Services primarily include:
• comprehensive human resource outsourcing services, which include Paychex Premier® Human Resources and our Professional Employer Organization ("PEO");

• retirement services administration;

• workers' compensation insurance services;

• health and benefits services;

• time and attendance solutions; and

• other human resource services and products.

We mainly earn revenue through recurring fees for services performed. Service revenue is primarily driven by the number of clients, checks or transactions per client per pay period, and utilization of ancillary services. 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 August 31, 2008 as compared to the three months ended August 31, 2007 include the following:
• Diluted earnings per share increased 3% to $0.41 per share.

• Total revenue increased 5% to $534.1 million.

• Payroll service revenue increased 5% to $378.5 million.

• Human Resource Services revenue increased 16% to $131.4 million.

• Operating income increased 5% to $221.6 million.

• Operating income, net of certain items, increased 11% to $197.4 million.

Refer to the discussion below for further information on this non-GAAP measure, operating income, net of certain items.

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Our financial performance during the three months ended August 31, 2008 was due to service revenue growth of 7% over the same period last year, and leveraging of expenses. The growth in service revenue was attributable to client base growth, price increases, and growth in the utilization of our ancillary services. The weak economy continues to impact revenue growth as new client payroll sales have slowed, losses due to clients going out of business have increased, and to a lesser extent, transaction volumes (such as checks per client which have decreased slightly over 1% in the last 12 months) have declined.
In addition to reporting operating income, a generally accepted accounting principle ("GAAP") measure, we present operating income, net of certain items, which is a non-GAAP measure. We believe operating income, net of certain items, is an appropriate additional measure, as it is an indicator of our core business operations performance period over period. It is also the measure used internally for establishing the following year's targets and measuring management's performance in connection with certain performance-based compensation payments and awards. Operating income, net of certain items, excludes interest on funds held for clients. Interest on funds held for clients is an adjustment to operating income due to the volatility of interest rates, which are not within the control of management. Operating income, net of certain items, is not calculated through the application of GAAP and is not the required form of disclosure by the SEC. As such, it should not be considered as a substitute for the GAAP measure of operating income and, therefore, should not be used in isolation, but in conjunction with the GAAP measure. The use of any non-GAAP measure may produce results that vary from the GAAP measure and may not be comparable to a similarly defined non-GAAP measure used by other companies. Operating income, net of certain items, increased 11% to $197.4 million for the three months ended August 31, 2008, as compared to $178.3 million for the same period last year.
As of August 31, 2008, we maintained a strong financial position with cash and total corporate investments of $519.1 million. Our primary source of cash is from our ongoing operations. Cash flows from operations were $214.6 million for the three months ended August 31, 2008, as compared with $253.2 million for the three months ended August 31, 2007. Cash flows from operations were higher for the three months ended August 31, 2007 due to the stock repurchase program. Historically, we have funded our operations, capital purchases, and dividend payments from our operating activities. It is anticipated that cash and total corporate investments as of August 31, 2008, along with projected operating cash flows, will support our normal business operations, capital purchases, and dividend payments for the foreseeable future.
For further analysis of our results of operations for the three months ended August 31, 2008, and our financial position as of August 31, 2008, refer to the analysis and discussion in the "Results of Operations," "Liquidity and Capital Resources," and "Critical Accounting Policies" sections of this review. Investment Portfolio Overview
We maintain a conservative investment strategy within our portfolio of available-for-sale securities to maximize liquidity and protect principal. Our exposure has been limited in the current investment environment as the result of our policies of investing in high credit quality securities with AAA and AA ratings and short-term securities with A-1/P-1 ratings and by limiting the amounts that can be invested in any single issuer.
As of September 22, 2008, we have sold substantially all of our variable rate demand notes ("VRDNs"). The VRDNs are money market securities held at par. No losses have resulted from these sales. We expect to be fully divested of VRDNs by the end of September 2008. Funds from VRDNs are being reinvested in agency discount notes. We have no auction rate securities in our investment portfolio. We had exited the auction rate market in the early fall of 2007 and have never experienced a failed auction. We have no exposure to sub-prime mortgage securities, asset-

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backed securities or asset-backed commercial paper, collateralized debt obligations, enhanced cash or cash plus mutual funds, or structured investment vehicles (SIVs). We have not and do not utilize derivative financial instruments to manage our interest rate risk. As of September 22, 2008, we do not have any position in prime money market funds.
Outlook
Our outlook for the full fiscal year ending May 31, 2009 ("fiscal 2009") is based upon current economic and interest rate conditions continuing with no significant changes. Consistent with our policy regarding guidance, our projections do not anticipate or speculate on future changes to interest rates. We estimate the earnings effect of a 25-basis-point increase or decrease in the Federal Funds rate at the present time would be approximately $4.5 million, after taxes, for the next twelve-month period. Projected revenue and net income growth for fiscal 2009 are as follows:

              Payroll service revenue                  5 %    -       7 %
              Human Resource Services revenue         18 %    -      21 %
              Total service revenue                    8 %    -      10 %
              Interest on funds held for clients     (25 %)   -     (20 %)
              Total revenue                            6 %    -       8 %
              Investment income, net                 (55 %)   -     (50 %)
              Net income                               2 %    -       4 %

Human Resource Services revenue growth is expected to accelerate slightly during the second half of fiscal 2009 as the second half of fiscal 2008 had been impacted by lower revenue from our time and attendance solutions and from the asset values from our retirement services funds.
Growth in operating income, net of certain items, is expected to approximate 11% to 13% for fiscal 2009. The effective income tax rate is expected to be approximately 34% throughout fiscal 2009.
Interest on funds held for clients and investment income are expected to be impacted by interest rate volatility. Based upon current interest rate and economic conditions, we expect interest on funds held for clients and investment income, net, to (decrease)/increase by the following amounts in the remaining respective quarters of fiscal 2009:

  Fiscal 2009        Interest on funds held for clients       Investment income, net

  Second quarter               (30%) - (25%)                      (60%) - (55%)
  Third quarter                (30%) - (25%)                      (20%) - (15%)
  Fourth quarter               (20%) - (15%)                           0 - 5%

Remaining unchanged, purchases of property and equipment for fiscal 2009 are expected to be in the range of $80 million to $85 million, in line with our growth rates. Fiscal 2009 depreciation expense is projected to be approximately $68 million, and we project amortization of intangible assets to be approximately $20 million.

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RESULTS OF OPERATIONS
Summary of Results of Operations

                                            For the three months ended
                                                    August 31,
  $ in millions                                  2008               2007       Change

  Revenue:
  Payroll service revenue                $      378.5       $      361.5            5 %
  Human Resource Services revenue               131.4              113.3           16 %

  Total service revenue                         509.9              474.8            7 %
  Interest on funds held for clients             24.2               32.3          (25 %)

  Total revenue                                 534.1              507.1            5 %

  Combined operating and SG&A expenses          312.5              296.5            5 %

  Operating income                              221.6              210.6            5 %

  As a % of total revenue                          41 %               42 %

  Investment income, net                          3.0               12.2          (75 %)


  Income before income taxes                    224.6              222.8            1 %

  As a % of total revenue                          42 %               44 %

  Income taxes                                   75.9               71.7            6 %

  Net income                             $      148.7       $      151.1           (2 %)


  As a % of total revenue                          28 %               30 %

  Diluted earnings per share             $       0.41       $       0.40            3 %

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

                                                                      For the three months ended
                                                                              August 31,
$ in millions                                                              2008               2007

Average investment balances:
Funds held for clients                                            $     3,220.1         $  3,094.6
Corporate investments                                                     484.5            1,227.6

Total                                                             $     3,704.6         $  4,322.2


Average interest rates earned
(exclusive of net realized gains):
Funds held for clients                                                      3.0 %              4.2 %
Corporate investments                                                       2.6 %              4.0 %
Combined funds held for clients and corporate investments                   2.9 %              4.1 %

Net realized gains:
Funds held for clients                                            $         0.3         $      0.1
Corporate investments                                                         -                  -

Total                                                             $         0.3         $      0.1




As of :                                                             August 31,          May 31,
$ in millions                                                             2008             2008

Net unrealized gains on available-for-sale securities (1)         $       34.4        $    24.8

Federal Funds rate                                                        2.00 %           2.00 %

Three-year "AAA" municipal securities yield                               2.46 %           2.65 %

Total fair value of available-for-sale securities                 $    3,988.9        $ 3,353.5

Average duration of available-for-sale securities in years
(2)                                                                        2.7              2.7

Weighted-average yield-to-maturity of available-for-sale
securities (2)                                                             3.3 %            3.4 %

(1) The net unrealized gain of our investment portfolio was approximately $19.6 million as of September 22, 2008.

(2) These items exclude the impact of VRDNs securities as they are tied to short-term interest rates.

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Revenue: The 5% increase in Payroll service revenue for the three months ended August 31, 2008 compared with the same period last year was attributable to client base growth, price increases, and growth in utilization of our ancillary payroll services. The weak economy continues to impact growth through lower client payroll sales, lower transaction volume (checks per client decreased slightly over 1% in the last 12 months) and increases in clients going out of business.
Our payroll tax administration services were utilized by 93% of all clients as of August 31, 2008 and 2007. Our employee payment services were utilized by 73% of all clients as of August 31, 2008, compared with 72% as of August 31, 2007. Nearly all new clients purchase our payroll tax administration services and more than 80% of new clients select a form of our employee payment services. Human Resource Services revenue increased 16% to $131.4 million for the three months ended August 31, 2008. The following factors contributed to Human Resource Services revenue growth:

As of August 31,                                2008         Change        2007         Change

Comprehensive human resource outsourcing
services client employees served               446,000          17 %      381,000          22 %
Workers' compensation insurance clients         74,000          15 %       65,000          19 %
Retirement services clients                     49,000           9 %       45,000          18 %
Asset value of retirement services client
employees' funds (in billions)               $     9.4           7 %    $     8.8          30 %

For the three months ended August 31, 2008, interest on funds held for clients decreased primarily due to a lower average interest rates earned, partially offset by higher realized gains on sales of available-for-sale securities and higher average investment balances. The increase in average invested balances was driven by client base growth and wage inflation within our current client base.
Combined operating and SG&A expenses: The following table summarizes total combined operating and selling, general and administrative ("SG&A") expenses:

                                               For the three months ended
                                                       August 31,
   $ in millions                                    2008               2007      Change

   Compensation-related expenses            $      201.6       $      190.2           6 %
   Stock-based compensation costs                    6.9                6.3          10 %
   Facilities expense                               15.0               13.7          10 %
   Depreciation of property and equipment           15.9               15.0           6 %
   Amortization of intangible assets                 4.8                4.1          17 %
   Other expenses                                   68.3               67.2           2 %

   Total operating and SG&A expenses        $      312.5       $      296.5           5 %

Combined operating and SG&A expenses for the three months ended August 31, 2008 increased 5% as a result of increases in personnel and other costs related to selling and retaining clients, and promoting new services. As of August 31, 2008, we had approximately 12,500 employees compared with approximately 11,900 employees as of August 31, 2007.

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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. The increase in amortization was mainly due to intangibles from acquisitions during the three months ended August 31, 2007. 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: Operating income growth was 5% for the three months ended August 31, 2008, as compared with the same period last year. The increase in operating income was attributable to the factors previously discussed. Operating income, net of certain items, excludes interest on funds held for clients. Refer to the discussion of operating income, net of certain items, in the "Overview" section on page 19 of this review. Operating income, net of certain items, is summarized as follows:

                                                            For the three months ended
                                                                    August 31,
$ in millions                                                   2008                 2007          Change

Operating income                                        $      221.6         $      210.6               5 %
Excluding interest on funds held for clients                   (24.2 )              (32.3 )           (25 %)

Operating income, net of certain items                  $      197.4         $      178.3              11 %

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 decrease in investment income for the three months ended August 31, 2008 as compared to the same period last year is due to lower average investment balances resulting from the funding of the stock repurchase program commenced at the beginning of August 2007, and lower average interest rates earned.
Income taxes: Our effective income tax rate was 33.8% for the three months ended August 31, 2008 compared with 32.2% for the same period last year. The increase in the effective income tax rate is a result of lower levels of tax-exempt income derived from municipal debt securities held in our investment portfolios. Net income and earnings per share: The decrease in net income was 2% for the three months ended August 31, 2008, as compared with the three months ended August 31, 2007. The decrease in net income was attributable to the factors previously discussed. Additionally, changes in interest rates since the same period last year unfavorably impacted net income by $7.4 million, or 5%. Diluted earnings per share for the three months ended August 31, 2008 of $0.41 per share increased 3% over $0.40 per share for the same period last year. Diluted earnings per share increased at a greater rate than the net income change due to a lower number of weighted-average shares outstanding as a result of purchases under the stock repurchase program completed in fiscal 2008.
LIQUIDITY AND CAPITAL RESOURCES
As of August 31, 2008, we had $519.1 million in cash and total corporate investments. Cash and total corporate investments as of August 31, 2008, along with projected operating cash flows, are expected to support our normal business operations, capital purchases, and dividend payments for the foreseeable future.

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As of August 31, 2008, 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:

    Financial institution                    Amount available   Expiration date

    JP Morgan Chase Bank, N.A.                   $350 million     February 2009
    Bank of America, N.A.                        $250 million     February 2009
    PNC Bank, National Association               $150 million     February 2009
    Wells Fargo Bank, National Association       $150 million     February 2009

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 three months ended August 31, 2008.
As of August 31, 2008, we had irrevocable standby letters of credit outstanding totaling $65.5 million, required to secure commitments for certain of our insurance policies and bonding requirements. These letters of credit expire at various dates between November 2008 and December 2012 and are secured by securities held in our investment portfolios. No amounts were outstanding on . . .