PAYX

Business Context and Reporting Period

Company: Paychex, Inc.
Filing Type: Form 10-K (Annual Report)
Period Ended: May 31, 2007
Business Overview: 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 U.S. and Germany. As of May 31, 2007, the company serviced approximately 561,000 clients with 11,700 employees. The company operates as a single business segment.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Total revenue increased 13% year-over-year, driven by an 11% increase in service revenue and a 33% increase in interest income on funds held for clients.
• Profitability: Net income rose 11% to $515.4 million. Operating income increased 8% to $701.5 million.
• Unusual Items:
  • Litigation Reserve: The company recorded a $38.0 million expense charge to increase its litigation reserve, reducing earnings per share by approximately $0.06.
  • Stock-Based Compensation: Adoption of SFAS No. 123(R) resulted in a $25.7 million expense charge for fiscal 2007.
• Client Base: Client count grew 3.4% to 561,000. Client retention reached a record level of slightly more than 80%.
• Interest Rates: Higher average interest rates (4.0% vs 3.2% in 2006) significantly boosted interest income on client funds.

Guidance, Outlook, and Risks

Outlook for Fiscal 2008

Management projects the following growth ranges for the fiscal year ending May 31, 2008:

• Total Revenue: 11% – 13% growth.
• Net Income: 18% – 20% growth.
• Payroll Service Revenue: 9% – 10% growth.
• Human Resource Services Revenue: 20% – 23% growth.
• Capital Expenditures: Expected to range between $80 million and $85 million.

Management Commentary

Fiscal 2007 marked the 17th consecutive year of record total revenue, net income, and diluted earnings per share. Growth was attributed to client base expansion, higher check volume, price increases, and increased utilization of ancillary services. The company maintains a strong financial position with $1.2 billion in cash and total corporate investments.

Risks and Contingencies

• Legal Proceedings: A significant contingency involves litigation with Rapid Payroll, Inc. licensees. As of May 31, 2007, a reserve of $32.5 million was maintained. A June 2007 jury verdict awarded a plaintiff $26.0 million ($15.0 million compensatory + $11.0 million punitive), which the company intends to appeal.
• Regulatory Changes: Changes in laws regarding payroll taxes, professional employer organizations, and employee benefits could impact service demand and costs.
• Interest Rate Risk: While rising rates benefit interest income, they can decrease the market value of available-for-sale securities. A hypothetical 25-basis-point increase in rates could decrease portfolio market value by approximately $12.0 million.
• Technology and Operations: Risks include failure to keep pace with technological changes, system failures during catastrophic events, and errors in processing client funds.

Investor Verification Checklist

• Litigation Reserve Adequacy: Verify the sufficiency of the $32.5 million litigation reserve given the $26.0 million jury verdict issued in June 2007 and the status of the appeal.
• Interest Rate Sensitivity: Assess the impact of potential interest rate fluctuations on the $5.0 billion investment portfolio and the resulting interest income.
• Stock-Based Compensation Impact: Monitor the $60.7 million in unrecognized compensation costs expected to be recognized over the next 2.7 years.
• Client Retention Trends: Confirm the sustainability of the record 80%+ client retention rate in a competitive market.
• FIN 48 Adoption: Review the impact of the upcoming adoption of FIN 48 (Accounting for Uncertainty in Income Taxes) on June 1, 2007, which is estimated to increase the reserve for unrecognized tax positions by $8.0 million.