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 each of the three fiscal years ended May 31, 2009 ("fiscal 2009"), May 31, 2008 ("fiscal 2008"), and May 31, 2007 ("fiscal 2007"), and our financial condition as of May 31, 2009. This review should be read in conjunction with the accompanying Consolidated Financial Statements and the related Notes to Consolidated Financial Statements contained in Item 8 of this Annual Report on Form 10-K ("Form 10-K") and the "Risk Factors" discussed in Item 1A of this Form 10-K. Forward-looking statements in this review are qualified by the cautionary statement under the heading "Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995" contained at the beginning of Part I of this Form 10-K.

Overview

We are a leading provider of payroll, human resource, and 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 ("MMS"), which is utilized by clients that have more sophisticated payroll and benefits needs, and include:

• payroll processing;

• payroll tax administration services;

• employee payment services; and

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

In addition to the above, our software-as-a-service solution through the MMS platform provides human resource management, employee benefits management, a time and attendance solution, online expense reporting, and applicant tracking.

Our Human Resource Services primarily include:

• comprehensive human resource outsourcing services, which include Paychex Premierฎ Human Resources and our Professional Employer Organization ("PEO");

• retirement services administration;

• health and benefits services;

• workers' compensation insurance 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 while 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 fiscal 2009 were affected by weak economic conditions in the United States ("U.S."), the severe credit crisis in the financial markets, and extremely low investment rates of return on our funds held for clients. The weak economy affects our ability to sell and retain clients, reduces our transaction volumes related to fewer employees in our client base, and results in lower average invested balances in our funds held for clients. The impacts were reflected in many of our key indicators, with the most significant deterioration occurring in the three months ending May 31, 2009 (the "fourth quarter"), as follows:

• Checks per client decreased 5.2% for the fourth quarter and 2.9% for fiscal 2009, and are projected to decline 3% for the year ending May 31, 2010 ("fiscal 2010");

• New client sales from new business starts declined 27% for the fourth quarter and 19% for fiscal 2009;

• Clients lost due to companies going out of business or no longer having any employees increased 19% for the fourth quarter and 17% for fiscal 2009;

• Average rate of return earned on our combined investment portfolios was 2.1% for fiscal 2009 compared to 3.7% for fiscal 2008; and

• Short-term taxable average interest rate earned was 1.2% for fiscal 2009 compared to 4.2% for fiscal 2008.

Despite the economic pressures, we achieved service revenue growth of 4% over the prior fiscal year as a result of our annual price increase and growth in utilization of our ancillary payroll and Human Resource Services. We effectively managed our expenses as operating income, net of certain items, increased 5% and improved as a percentage of service revenue to 36.4% for fiscal 2009 as compared to 36.0% for fiscal 2008. Refer to the discussion below for further information on operating income, net of certain items.

Our financial results for fiscal 2009 included the following highlights:

• Payroll service revenue increased 1% to $1.5 billion.

• Human Resource Services revenue increased 11% to $523.6 million.

• Total revenue increased 1% to $2.1 billion.

• Operating income decreased 3% to $805.2 million, as combined interest on funds held for clients and investment income decreased 48%.

• Operating income, net of certain items, increased 5% to $729.7 million.

• Net income decreased 7% to $533.5 million.

• Diluted earnings per share decreased 5% to $1.48 per share.

• Cash flow from operations decreased 5% to $688.8 million.

• Dividends of $447.7 million were paid to stockholders, representing 84% of net income.

In addition to reporting operating income, a U.S. 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 and the expense charge in fiscal 2007 to increase the litigation reserve. 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. The expense charge to increase the litigation reserve is also an adjustment to operating income due to its unusual and infrequent nature. It is outside the normal course of our operations and obscures the comparability of performance period over period. Operating income, net of certain items, is not calculated through the application of GAAP and is not the required form of disclosure by the Securities and Exchange Commission ("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 5% to $729.7 million for fiscal 2009 compared to $696.5 million for fiscal 2008 and $605.4 million for fiscal 2007.

Although we have been operating in an unprecedented economic environment during fiscal 2009, we maintained stability in our employee base, allowing us to continue to focus on providing excellent customer service and invest in our business. Some of these investments include the following:

Client base and increased utilization of ancillary services: Our client base was approximately 554,000 clients as of May 31, 2009. This compares with approximately 572,000 clients as of May 31, 2008, and approximately 561,000 clients as of May 31, 2007. Our client base declined 3.1% for fiscal 2009, compared to growth of 2.0% for fiscal 2008 and growth of 3.3% for fiscal 2007. The reduction in our client base for fiscal 2009 reflects the impact of weaker economic conditions on our ability to attract and retain clients. New client sales from new business starts decreased 19% for fiscal 2009 compared to the prior year. Also, an increase of 17% in clients lost due to companies going out of business or no longer having any employees impacted our client retention, which was slightly below historical levels at approximately 77% of our beginning of the fiscal year client base.

Despite the challenging selling environment resulting from the weak economy, we added over 111,000 new clients during fiscal 2009. New sales revenue for MMS clients was strong for fiscal 2009, increasing just under 20% compared to fiscal 2008. The market for MMS has not been as severely impacted by the decline in new business starts.

We believe growth opportunities continue to exist in our target market of small- to medium-sized businesses. Accordingly, we continue to increase the size of our sales force in key areas, primarily MMS and health and benefits services. Reductions are expected in certain areas of our Human Resource Services sales force due to deceleration

in client bases and aggressive sales force increases in prior periods. The following table summarizes the expected composition of our sales force in fiscal 2010 with comparisons to fiscal 2009 and 2008:

                                                       Expected
Year ended May 31,                                       2010        Change        2009       Change       2008

Payroll                                                    1,590           5 %      1,515           1 %     1,505
Retirement services administration and other human
resource services                                            350          (5 )%       370           4 %       355
Comprehensive human resource outsourcing services            210          (5 )%       220           7 %       205
Licensed agents for health and benefits services             160          23 %        130          37 %        95
Licensed agents for workers' compensation insurance           60          (8 )%        65           8 %        60

Total sales representatives                                2,370           3 %      2,300           4 %     2,220

There are also opportunities for growth within our current client base, as well as with new clients, through increased penetration of our payroll and human resource ancillary services and products. Ancillary services effectively leverage payroll processing data and, therefore, are beneficial to our operating margin. The following statistics demonstrate the growth in our ancillary service offerings:

$ in millions
As of May 31,                                              2009           2008           2007

Payroll tax administration services penetration                 93 %           93 %           93 %
Employee payment services penetration                           75 %           73 %           71 %
Retirement services clients                                 50,000         48,000         44,000
Comprehensive human resource outsourcing services
client employees served                                    453,000        439,000        373,000
Comprehensive human resource outsourcing services
clients                                                     18,000         16,000         14,000
Workers' compensation insurance clients                     77,000         72,000         62,000
Health and benefits services revenue                     $    20.9      $    12.3      $     6.4

Service and product initiatives: During fiscal 2009, we made investments in the ongoing expansion of our portfolio of services and products. These included strengthening our software-as-a-service solution for our MMS clients through the following:

• Enhanced the Paychex Time and Labor Online product, an Internet-based, integrated time and labor management system that provides clients with an easy and cost-effective way to automate time and attendance processes.

• Introduced Paychex Expense Manager, an integrated payroll and expense management solution to help clients control discretionary spending while giving their employees the convenience of preparing and submitting expense reports via an easy-to-use, secure, online tool.

In addition, other fiscal 2009 initiatives included the following:

• Enhanced our 401(k) product through the addition of auto enrollment as an optional plan feature. This feature allows employers to automatically enroll their employees in their company's 401(k) plan and increase overall plan participation.

• Continued expansion of our health insurance services nationwide, simplifying the process for our clients to obtain coverage through our network of national and regional insurers. Revenue from health and benefits services increased 70% to $20.9 million for fiscal 2009, and is anticipated to exceed $30.0 million for fiscal 2010.

• Made necessary adjustments to proactively respond to provisions under the American Recovery and Reinvestment Act of 2009 (the "2009 economic stimulus package"), particularly the "Making Work Pay" income tax credit and premium assistance for COBRA recipients. Our preparedness allowed us to educate and assist our clients with these regulatory changes.

Business acquisitions: We may supplement our growth from time to time through strategic acquisitions when opportunities arise. In fiscal 2009, we made immaterial acquisitions to supplement our payroll client base.

Focus on customer service: Integral to our strategy is satisfied customers to achieve maximum client retention. For fiscal 2009, we received high client satisfaction results which was encouraging considering the economic pressures our clients are facing. Client retention was approximately 77% of our beginning of the fiscal year client base. Although customer satisfaction remained strong, increases in clients going out of business or no longer having any employees, and pricing pressures from our largest direct competitor and regional payroll providers kept our client retention rate slightly below historical levels.

Financial position and liquidity: The current credit crisis has resulted in unprecedented volatility in the global financial markets, with diminished liquidity and increased exposure to investment losses occurring in these markets. Despite this macroeconomic environment, as of May 31, 2009, our financial position remained strong with cash and total corporate investments of $574.7 million and no debt. Our cash and total corporate investments have increased approximately $140 million since May 31, 2008.

We also believe that our investments as of May 31, 2009 were not other-than-temporarily impaired, nor has any event occurred subsequent to that date that would indicate any other-than-temporary impairment. We maintain a conservative investment strategy within our investment portfolios to maximize liquidity and protect principal. In the current financial markets, this translates to significantly lower yields on high quality instruments, negatively impacting our income earned on funds held for clients and corporate investments. Our exposure has been minimized in the current investment environment as the result of our policies of investing primarily 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. All investments held as of May 31, 2009 are traded in active markets.

As of May 31, 2009, we had no exposure to variable rate demand notes ("VRDNs") or prime money market funds. In September 2008, we sold all of our holdings in these types of investments as a result of turmoil in the related markets. No losses were recognized on these sales. The proceeds from the sale of these investments were reinvested in U.S. agency discount notes, which is our current primary short-term investment vehicle. We have no exposure to auction rate securities, sub-prime mortgage securities, asset-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 interest rate risk.

Our primary source of cash is our ongoing operations. Cash flow from operations was $688.8 million for fiscal 2009. 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 May 31, 2009, along with projected operating cash flows, will support our normal business operations, capital purchases, and dividend payments for the foreseeable future. During fiscal 2009, dividends paid to stockholders were 84% of net income.

For further analysis of our results of operations for fiscal years 2009, 2008, and 2007, and our financial position as of May 31, 2009, refer to the tables and analysis in the "Results of Operations" and "Liquidity and Capital Resources" sections of this Item 7 and the discussion in the "Critical Accounting Policies" section of this Item 7.

Outlook

Our current outlook for fiscal 2010 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. Comparisons to fiscal 2009 quarters are
expected to improve as fiscal 2010 progresses. Projected changes in revenue and
net income for fiscal 2010 are as follows:


                                                     Low            High

             Payroll service revenue                 (5)%     -      (3)%
             Human Resource Services revenue           3%     -        6%
             Total service revenue                   (4)%     -      (1)%
             Interest on funds held for clients     (30)%     -     (25)%
             Total revenue                           (4)%     -      (1)%
             Investment income, net                 (35)%     -     (30)%
             Net income                             (12)%     -     (10)%

Operating income, net of certain items, as a percentage of service revenue is expected to range from 34% to 35% for fiscal 2010. The effective income tax rate is expected to approximate 35% for fiscal 2010. The higher tax rate for fiscal 2010 is driven by higher state income tax rates resulting from state legislative changes.

Interest on funds held for clients and investment income for fiscal 2010 are expected to be impacted by interest rate volatility. Interest on funds held for clients will be further impacted by a projected 5% decline in average invested balances, with most of the effect in the first half of fiscal 2010. This decline is largely the result of the 2009 economic stimulus package generating lower tax withholdings for client employees. The Federal Funds rate dropped significantly in fiscal 2009 from 2.00% as of May 31, 2008 to a range of zero to 0.25% as of May 31, 2009. As of May 31, 2009, the long-term investment portfolio had an average yield-to-maturity of 3.3% and an average duration of 2.5 years. In the next twelve months, slightly less than 20% of this portfolio will mature, and it is currently anticipated that these proceeds will be reinvested at a lower average interest rate of approximately 1.40%. Based upon current interest rate and economic conditions, we expect interest on funds held for clients and investment income to (decrease)/increase by the following amounts in the respective quarters of fiscal 2010:

                             Interest on funds held   Investment income,
            Fiscal 2010           for clients                net

            First quarter            (45)%                  (70)%
            Second quarter           (35)%                  (40)%
            Third quarter            (20)%                   10%
            Fourth quarter           (15)%                   50%

Under normal financial market conditions, the impact to our earnings from a 25-basis-point increase or decrease in short-term interest rates would be approximately $3.5 million, after taxes, for a twelve-month period. Such a basis point change may or may not be tied to changes in the Federal Funds rate. We estimate the lowest level of combined interest on funds held for clients and investment income over the next fiscal year would be approximately $55 million.

Purchases of property and equipment in fiscal 2010 are expected to be in the range of $55 million to $60 million. Fiscal 2010 depreciation expense is projected to be in the range of $65 million to $70 million, and we project amortization of intangible assets for fiscal 2010 to be in the range of $20 million to $25 million.

Results of Operations

Summary of Results of Operations for the Fiscal Years Ended May 31:


In millions, except per share amounts     2009         Change         2008         Change         2007

Revenue:
Payroll service revenue                 $ 1,483.7            1 %    $ 1,462.7            8 %    $ 1,356.6
Human Resource Services revenue             523.6           11 %        471.8           19 %        396.2

Total service revenue                     2,007.3            4 %      1,934.5           10 %      1,752.8
Interest on funds held for clients           75.5          (43 )%       131.8           (2 )%       134.1

Total revenue                             2,082.8            1 %      2,066.3           10 %      1,886.9
Combined operating and SG&A expenses      1,277.6            3 %      1,238.0            4 %      1,185.4

Operating income                            805.2           (3 )%       828.3           18 %        701.5
As a % of total revenue                        39 %                        40 %                        37 %
Investment income, net                        6.9          (74 )%        26.5          (36 )%        41.7

Income before income taxes                  812.1           (5 )%       854.8           15 %        743.2
As a % of total revenue                        39 %                        41 %                        39 %
Income taxes                                278.6            -          278.7           22 %        227.8

Net income                              $   533.5           (7 )%   $   576.1           12 %    $   515.4

As a % of total revenue                        26 %                        28 %                        27 %
Diluted earnings per share              $    1.48           (5 )%   $    1.56           16 %    $    1.35

We invest in highly liquid, investment-grade fixed income securities and do not utilize derivative instruments to manage interest rate risk. As of May 31, 2009, we had no exposure to high-risk or illiquid investments. Details regarding our combined funds held for clients and corporate investment portfolios are as follows:

                                                                   Year ended May 31,
$ in millions                                              2009           2008           2007

Average investment balances:
Funds held for clients                                   $ 3,323.3      $ 3,408.9      $ 3,275.9
Corporate investments                                        538.2          716.7        1,109.5

Total                                                    $ 3,861.5      $ 4,125.6      $ 4,385.4

Average interest rates earned (exclusive of net
realized gains):
Funds held for clients                                         2.2 %          3.7 %          4.0 %
Corporate investments                                          1.4 %          3.7 %          3.7 %
Combined funds held for clients and corporate
investments                                                    2.1 %          3.7 %          4.0 %
Net realized gains:
Funds held for clients                                   $     1.1      $     6.4      $     1.7
Corporate investments                                            -              -            0.4

Total                                                    $     1.1      $     6.4      $     2.1

$ in millions
As of May 31,                                              2009           2008           2007

Net unrealized gains/(losses) on available-for-sale
securities(1)                                            $    66.7      $    24.8      $   (14.9 )
Federal Funds rate(2)                                         0.25 %         2.00 %         5.25 %
Three-year "AAA" municipal securities yield                   1.35 %         2.65 %         3.71 %
Total fair value of available-for-sale securities        $ 1,780.9      $ 3,353.5      $ 4,975.5
Weighted-average duration of available-for-sale
securities in years(3)                                         2.5            2.7            2.5
Weighted-average yield-to-maturity of
available-for-sale securities(3)                               3.3 %          3.4 %          3.7 %

(1) The net unrealized gain of our investment portfolios was approximately $72.7 million as of July 10, 2009.

(2) The Federal Funds rate was a range of zero to 0.25% as of May 31, 2009.

(3) These items exclude the impact of VRDNs held as of May 31, 2008 and 2007, as they are tied to short-term interest rates. We did not hold any VRDNs as of May 31, 2009.

Payroll service revenue: Payroll service revenue increased 1% to $1.5 billion for fiscal 2009 due to our annual price increase and growth in utilization of our ancillary payroll services. Payroll service revenue increased 8% to $1.5 billion for fiscal 2008 due to client base growth, higher check volume, our annual price increase, and growth in utilization of our ancillary payroll services. The weakening economic conditions in fiscal 2009 negatively impacted payroll service revenue. During fiscal 2009, our client base declined 3.1%, affected by a decline in new client sales from new business starts and clients lost due to companies going out of business or no longer having any employees. Also, checks per client declined 2.9%.

As of May 31, 2009, 2008, and 2007, 93% of clients utilized our payroll tax administration services. Our employee payment services were utilized by 75% of our clients as of May 31, 2009, compared with 73% as of May 31, 2008 and 71% as of May 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.

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