PAYX

Business Context and Reporting Period

Company: Paychex, Inc.
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: August 31, 2006 (First Quarter of Fiscal 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 United States. The company operates as a single segment.

Key Financial Metrics

Margins: Net income margin was 29.4% for the quarter. Operating income margin was 40.6%.

Material Changes vs. Prior Period

• Revenue Growth: Total revenue increased 14% year-over-year. Service revenue grew 12%, driven by a 9% increase in payroll service revenue and a 21% increase in human resource services revenue.
• Interest Income: Interest on funds held for clients surged 55% to $29.8 million, and net investment income increased 94%. This was primarily due to higher Federal Funds rates (5.25% vs. 3.50% prior year) and increased average portfolio balances.
• Profitability: Net income rose 17% to $135.1 million. Diluted EPS increased 17% to $0.35.
• Expense Growth: Total expenses increased 13% to $273.0 million. This includes a new $6.5 million charge for stock-based compensation costs resulting from the adoption of SFAS No. 123(R).
• Cash Position: Cash and cash equivalents increased significantly from $137.4 million at the end of the prior fiscal year to $343.9 million.

Guidance, Outlook, and Risks

Outlook for Fiscal 2007

• Revenue Growth: Total revenue growth is estimated at 12% to 14%. Payroll service revenue is projected to grow 9% to 11%, while Human Resource Services revenue is expected to grow 20% to 23%.
• Interest Income: Interest on funds held for clients is expected to increase 30% to 35%. Corporate investment income is anticipated to increase 55% to 60%.
• Net Income: Growth is expected in the range of 13% to 15%.
• Stock-Based Compensation: Expected to impact pre-tax and net income by 4% to 5%.
• Tax Rate: Effective income tax rate is expected to be approximately 31.0%.

Risks and Contingencies

• Legal Proceedings: The company is involved in multiple lawsuits related to the discontinuation of support for payroll processing software owned by its subsidiary, Rapid Payroll, Inc. A legal reserve of $20.3 million has been recorded. Management believes resolution will not have a material adverse effect, though uncertainties remain.
• Interest Rate Risk: The company is exposed to interest rate fluctuations. While rising rates increase earnings on short-term investments, they decrease the market value of longer-term available-for-sale securities. A 25-basis-point increase in rates could decrease the market value of the portfolio by approximately $11.0 million to $11.5 million.
• Accounting Changes: The company adopted SFAS No. 123(R) effective June 1, 2006, requiring fair value recognition of stock-based compensation. Future adoption of FIN 48 (uncertainty in income taxes) and SFAS No. 157 (fair value measurements) is pending.

Investor Verification Checklist

• Stock-Based Compensation Impact: Verify the $6.5 million expense impact of SFAS No. 123(R) adoption and the $68.3 million in unrecognized future costs.
• Legal Reserve Adequacy: Monitor the $20.3 million legal reserve regarding Rapid Payroll litigation and potential for additional liabilities.
• Interest Rate Sensitivity: Assess the impact of rising interest rates on the $2.7 billion available-for-sale securities portfolio and potential unrealized losses.
• PEO Revenue Recognition: Confirm that PEO revenue is reported net of direct costs (wages, taxes, benefits), which totaled $629.6 million for the quarter.
• Dividend Policy: Note the quarterly dividend increase to $0.16 per share and the company's reliance on operating cash flow to fund dividends.