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, 2009 (the "first quarter") and the respective prior year period, and our financial condition as of August 31, 2009. 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, 2009 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, 2009 ("fiscal 2009"). 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, the following risks, as well as those that are described in our periodic filings with the Securities and Exchange Commission ("SEC"):
• general market and economic conditions including, among others, changes in United States ("U.S.") employment and wage levels, changes in new hiring trends, legislative changes to stimulate the economy, changes in short- and long-term interest rates, changes in the fair value and the credit rating of securities held by us, and accessibility of financing;

• 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. 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 benefit 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 primarily 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.

The weak economic conditions, credit crisis in the financial markets, and extremely low investment rates of return on our funds held for clients that we experienced in fiscal 2009 continue to impact our financial results for the first quarter of the fiscal year ending May 31, 2010 ("fiscal 2010"). The weak economy affects our ability to sell and retain clients, reduces our transaction volumes due to fewer employees in our client base, and results in lower average investment balances in our funds held for clients.
Our key indicators for the first quarter reflect deterioration when compared to the first quarter of fiscal 2009; however, we are not seeing further significant deterioration when compared to the fourth quarter of fiscal 2009. The year-over-year change in some of our key indicators for the first quarter of fiscal 2010, for the three months ended May 31, 2009 (the "fourth quarter"), and for full year fiscal 2009 are as follows:

                                                  First quarter             Fourth quarter             Fiscal
(Decrease)/increase:                               fiscal 2010               fiscal 2009                2009

Checks per client                                       (5.0 %)                   (5.2 %)               (2.9 %)
New client sales from new business starts                (13 %)                    (27 %)                (19 %)
Clients lost due to companies going out of
business or no longer having any employees                 1 %                      19 %                  17 %

Highlights of the financial results for the first quarter as compared to the same period last year are as follows:
• Payroll service revenue decreased 6% to $354.4 million.

• Human Resource Services revenue increased 1% to $132.1 million.

• Total revenue decreased 6% to $500.2 million.

• Operating income decreased 14% to $189.9 million, as interest on funds held for clients decreased 43%.

• Operating income excluding interest on funds held for clients decreased 11% to $176.2 million. Refer to the discussion on page 23 for further information on this non-GAAP measure.

• Net income and diluted earnings per share decreased 17% to $123.6 million and $0.34 per share, respectively.

• Cash flow from operations decreased 13% to $186.6 million.

Our service revenue for the first quarter decreased 5% compared to the same period last year. Weak economic conditions negatively impacted our client growth, check volume, and revenue per check. Despite the economic pressures, we continue to focus on providing excellent customer service and invest in our business, while controlling expenses.
The credit crisis in the financial markets caused a flight to quality investments, resulting in lower available yields on high quality investments. The average rate of return earned on our combined funds held for clients and corporate investment portfolio was 1.7% for the first quarter compared to 2.9% for the same period last year. We have seen stabilization here as well, as the 1.7% average interest rate earned is slightly higher than the 1.6% earned for the fourth quarter of fiscal 2009. Our short-term portfolio has been heavily invested in taxable securities and our short-term taxable interest rates earned averaged 0.1% for the first quarter compared to 2.6% for the same period last year.

In addition to reporting operating income, a U.S. generally accepted accounting principle ("GAAP") measure, we present operating income excluding interest on funds held for clients which is a non-GAAP measure. We believe operating income excluding interest on funds held for clients 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. 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 excluding interest on funds held for clients 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 excluding interest on funds held for clients decreased 11% to $176.2 million for the first quarter, as compared to $197.4 million for the same period last year. Refer to the reconciliation of operating income to operating income excluding interest on funds held for clients on page 28 of this Form 10-Q. Financial Position and Liquidity
Unprecedented volatility in the global financial markets in the past year has caused diminished liquidity and limited investment choices. 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. Currently, our primary short-term investment vehicle is U.S. agency discount notes. However, we are seeing gradual improvements in liquidity for high quality money market securities and are beginning to explore opportunities to invest a portion of our short-term portfolio in investments other than the U.S. agency discount notes.
Our exposure from our investing activities has been limited 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 August 31, 2009 are traded in active markets. Despite the macroeconomic environment, as of August 31, 2009, our financial position remained strong with cash and total corporate investments of $634.1 million and no debt.
Our primary source of cash is from our ongoing operations. Cash flows from operations were $186.6 million for the three months ended August 31, 2009, as compared with $214.6 million for the three months ended August 31, 2008. The decrease in cash flow from operations was related to lower net income. Historically, we have funded operations, capital purchases, and dividend payments from our operating activities. It is anticipated that cash and total corporate investments as of August 31, 2009, 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, 2009, and our financial position as of August 31, 2009, refer to the analysis and discussion in the "Results of Operations," "Liquidity and Capital Resources," and "Critical Accounting Policies" sections of this Form 10-Q.

Outlook
Our outlook for the full year fiscal 2010 reflects the impact of current economic and financial conditions, and assumes these conditions will continue through the remainder of the fiscal year. Refer to page 22 for information on some of our key indicators, which provides statistical evidence of the economic weakness in the first quarter of fiscal 2010.
Consistent with our policy regarding guidance, our projections do not anticipate or speculate on future changes in interest rates. Comparisons to the prior year are expected to improve in the second half of fiscal 2010. Projected changes in revenue and net income for fiscal 2010 are as follows:

                                                      Low                High
              Payroll service revenue                 (7 %)     -        (5 %)
              Human Resource Services revenue          3 %      -         6 %
              Total service revenue                   (5 %)     -        (2 %)
              Interest on funds held for clients     (30 %)     -       (25 %)
              Total revenue                           (5 %)     -        (2 %)
              Investment income, net                 (35 %)     -       (30 %)
              Net income                             (12 %)     -       (10 %)

Operating income excluding interest on funds held for clients 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% throughout 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 7% 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 American Recovery and Reinvestment Act of 2009 (the "2009 economic stimulus package") generating lower tax withholdings for client employees. As of August 31, 2009, the long-term investment portfolio had an average yield-to-maturity of 3.0% and an average duration of 2.6 years. In the next twelve months, slightly less than 15% of this portfolio will mature, and it is currently anticipated that these proceeds will be reinvested at a lower average interest rate of approximately 1.2%. 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 remaining respective quarters of fiscal 2010:

                                      Interest on
                                     funds held for     Investment
                   Fiscal 2010          clients         income, net
                   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 the 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. Purchases of property and equipment for fiscal 2010 are expected to be in the range of $55 million to $60 million, in line with our growth rates. Fiscal 2010 depreciation expense is projected to be approximately $65 million to $70 million, and we project amortization of intangible assets to be approximately $20 million to $25 million.

RESULTS OF OPERATIONS
Summary of Results of Operations:

                                           For the three months ended
                                                   August 31,
 $ in millions                                   2009                2008      % Change

 Revenue:
 Payroll service revenue                $       354.4       $       378.5            (6 %)
 Human Resource Services revenue                132.1               131.4             1 %

 Total service revenue                          486.5               509.9            (5 %)
 Interest on funds held for clients              13.7                24.2           (43 %)

 Total revenue                                  500.2               534.1            (6 %)

 Combined operating and SG&A expenses           310.3               312.5            (1 %)

 Operating income                               189.9               221.6           (14 %)

 As a % of total revenue                           38 %                41 %

 Investment income, net                           0.9                 3.0           (70 %)


 Income before income taxes                     190.8               224.6           (15 %)

 As a % of total revenue                           38 %                42 %

 Income taxes                                    67.2                75.9           (12 %)

 Net income                             $       123.6       $       148.7           (17 %)


 As a % of total revenue                           25 %                28 %

 Diluted earnings per share             $        0.34       $        0.41           (17 %)

We invest in highly liquid, investment-grade fixed income securities and do not utilize derivative instruments to manage interest rate risk. As of August 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:

                                                                          For the three months ended
                                                                                  August 31,
$ in millions                                                                  2009               2008

Average investment balances:
Funds held for clients                                                $     2,907.2         $  3,220.1
Corporate investments                                                         618.4              484.5

Total                                                                 $     3,525.6         $  3,704.6


Average interest rates earned (exclusive of net realized gains):
Funds held for clients                                                          1.8 %              3.0 %
Corporate investments                                                           0.7 %              2.6 %
Combined funds held for clients and corporate investments                       1.7 %              2.9 %

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

Total                                                                 $         0.3         $      0.3




As of:                                                              August 31,          May 31,
$ in millions                                                             2009             2009

Net unrealized gain on available-for-sale securities (1)          $       68.6        $    66.7

Federal Funds rate (2)                                                    0.25 %           0.25 %

Three-year "AAA" municipal securities yield                               1.22 %           1.35 %

Total fair value of available-for-sale securities                 $    1,936.4        $ 1,780.9

Weighted-average duration of available-for-sale securities
in years                                                                   2.6              2.5

Weighted-average yield-to-maturity of available-for-sale
securities                                                                 3.0 %            3.3 %

(1) The net unrealized gain of our investment portfolio was approximately $74.8 million as of September 18, 2009.

(2) The Federal Funds rate was a range of 0% to 0.25% as of August 31, 2009 and May 31, 2009.

Payroll service revenue: Payroll service revenue decreased 6% for the first quarter of fiscal 2010 compared with the same period last year. Weak economic conditions negatively impacted our check volume, client growth, and revenue per check. During the first quarter, checks per client declined 5% compared with the same period last year. Our client base declined from May 31, 2009 as our client retention has been affected by clients lost due to companies going out of business or no longer having any employees. In addition, new client sales from new business starts declined 13% for the first quarter compared to the same period last year.
Our payroll tax administration services were utilized by 93% of our clients as of August 31, 2009 and 2008. Our employee payment services were utilized by 74% of all clients as of August 31, 2009, compared with 73% as of August 31, 2008. 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: Human Resource Services revenue increased 1% to $132.1 million for the first quarter of fiscal 2010. The following factors contributed to Human Resource Services revenue growth:

                                                                                                         % Change
                                                                                                             from
As of:                                               August 31,             %       August 31,         August 31,
$ in millions                                              2009        Change             2008               2007

Comprehensive human resource outsourcing
services client employees served                        463,000           4 %          446,000              17 %
Comprehensive human resource outsourcing
services clients                                         18,000          10 %           17,000              18 %
Workers' compensation insurance clients                  78,000           5 %           74,000              15 %
Retirement services clients                              49,000           1 %           49,000               9 %
Asset value of retirement services client
employees' funds                                   $      9,621           2 %     $      9,395               7 %
Health and benefits services revenue               $        6.5          39 %     $        4.7              96 %

The impact from weak economic conditions on our payroll client base has nearly offset the revenue growth from Human Resource Services, as these ancillary services are most often provided to our payroll clients. The most significant impacts have been to retirement services and comprehensive human resource outsourcing services revenue. Although our client bases have grown, it has been at rates lower than we have seen historically, and we are experiencing fewer employees per client. Also, we continue to experience volatility in PEO net service revenue due to fluctuations in workers' compensation claims. The asset value of retirement services client employees' funds increased 34% from the lowest point in fiscal 2009 of $7.2 billion as of February 28, 2009, due to some recovery in the financial markets and more of the retirement plans converting with existing assets. However, the shift in the mix of assets in the retirement services client employees' funds to investments earning lower fees from external fund managers has generated lower revenue than the same quarter a year ago. In addition, we earned revenue in fiscal 2009 from the required restatement of clients' retirement plans that is not recurring in fiscal 2010. Total service revenue: Total service revenue decreased 5% for the first quarter compared with the same period last year. The weak economy continues to have a negative impact on service revenue growth as described above.

Interest on funds held for clients: For the first quarter of fiscal 2010, interest on funds held for clients decreased 43%. The decrease was primarily the result of lower average interest rates earned and lower average investment balances. Average investment balances for funds held for clients decreased 10% for the first quarter compared to the same period last year. This decline was the result of overall economic factors, which have negatively impacted our client base, and the impact of the 2009 economic stimulus package generating lower tax withholdings for client employees.
Combined operating and SG&A expenses: The following table summarizes total . . .