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FORM 10-Q

SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

     
(X)   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED FEBRUARY 28, 2003

     
  OR
 
(   )   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the transition period from ____________________ to ____________________

COMMISSION FILE NUMBER 0-11330

 
PAYCHEX, INC
(Exact name of registrant as specified in its charter)
     
DELAWARE   16-1124166
(State or other jurisdiction of   (I.R.S. Employer
incorporation or organization)   Identification No.)
     
911 PANORAMA TRAIL SOUTH, ROCHESTER, NEW YORK   14625-0397
(Address of principal executive offices)   (Zip Code)

(585) 385-6666
(Registrant’s telephone number, including area code)

(Former name, former address and former fiscal year, if changed since last report.)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes[X] No[   ].

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [X] No[   ].

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

     
Common Stock, $.01 Par Value   376,427,750 Shares
 
CLASS   OUTSTANDING AT FEBRUARY 28, 2003

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PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
CONSOLIDATED BALANCE SHEETS
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE OF MARKET RISK
ITEM 4. CONTROLS AND PROCEDURES
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
SIGNATURES
CERTIFICATIONS
Exhibit 10.1 Form of Indemnification Agrmt
Exhibit 99.1 Consent of CEO
Exhibit 99.2 Consent of CFO


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PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

PAYCHEX, INC.

CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
(In thousands, except per share amounts)
                                   
      For the three months ended   For the nine months ended
     
 
      February 28,   February 28,   February 28,   February 28,
      2003   2002   2003   2002
     
 
 
 
Revenues:
                               
 
Service revenues
  $ 274,303     $ 227,964     $ 769,376     $ 661,649  
 
Interest on funds held for clients
    13,486       14,836       39,895       48,953  
 
   
     
     
     
 
 
Total revenues
    287,789       242,800       809,271       710,602  
Operating costs
    68,794       56,739       188,356       165,226  
Selling, general, and administrative expenses
    117,576       98,844       317,825       273,314  
 
   
     
     
     
 
Operating income
    101,419       87,217       303,090       272,062  
Investment income, net
    3,760       8,427       23,546       24,145  
 
   
     
     
     
 
Income before income taxes
    105,179       95,644       326,636       296,207  
Income taxes
    33,658       28,671       104,524       90,343  
 
   
     
     
     
 
Net income
  $ 71,521     $ 66,973     $ 222,112     $ 205,864  
 
   
     
     
     
 
Basic earnings per share
  $ .19     $ .18     $ .59     $ .55  
 
   
     
     
     
 
Diluted earnings per share
  $ .19     $ .18     $ .59     $ .54  
 
   
     
     
     
 
Weighted-average common shares outstanding
    376,356       374,922       376,161       374,460  
 
   
     
     
     
 
Weighted-average shares assuming dilution
    378,081       378,096       377,982       377,809  
 
   
     
     
     
 
Cash dividends per common share
  $ .11     $ .11     $ .33     $ .31  
 
   
     
     
     
 

See Notes to Consolidated Financial Statements.

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PAYCHEX, INC.

CONSOLIDATED BALANCE SHEETS
(In thousands)
                   
      February 28,   May 31,
      2003   2002
      (Unaudited)   (Audited)
     
 
ASSETS
               
Cash and cash equivalents
  $ 169,603     $ 61,897  
Corporate investments
    382,673       663,316  
Interest receivable
    18,891       25,310  
Accounts receivable, net
    98,839       109,858  
Prepaid expenses and other current assets
    12,347       10,106  
 
   
     
 
Current assets before funds held for clients
    682,353       870,487  
Funds held for clients
    2,522,082       1,944,087  
 
   
     
 
Total current assets
    3,204,435       2,814,574  
Other assets
    7,154       7,895  
Property and equipment, net
    153,815       121,566  
Intangible assets, net
    66,453       9,040  
Goodwill
    243,317        
 
   
     
 
Total assets
  $ 3,675,174     $ 2,953,075  
 
   
     
 
LIABILITIES
               
Accounts payable
  $ 21,627     $ 14,104  
Accrued compensation and related items
    57,149       46,819  
Deferred revenue
    4,885       4,137  
Accrued income taxes
    16,460       3,140  
Deferred income taxes
    5,516       9,503  
Other current liabilities
    20,573       14,810  
 
   
     
 
Current liabilities before client fund deposits
    126,210       92,513  
Client fund deposits
    2,492,505       1,930,893  
 
   
     
 
Total current liabilities
    2,618,715       2,023,406  
Other long-term liabilities
    13,148       5,688  
 
   
     
 
Total liabilities
    2,631,863       2,029,094  
 
STOCKHOLDERS’ EQUITY
               
Common stock, $.01 par value, 600,000 authorized shares
               
 
Issued: 376,428 at February 28, 2003 and 375,859 at May 31, 2002
    3,764       3,759  
Additional paid-in capital
    193,811       185,006  
Retained earnings
    816,283       718,192  
Accumulated other comprehensive income
    29,453       17,024  
 
   
     
 
Total stockholders’ equity
    1,043,311       923,981  
 
   
     
 
Total liabilities and stockholders’ equity
  $ 3,675,174     $ 2,953,075  
 
   
     
 

See Notes to Consolidated Financial Statements.

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PAYCHEX, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(In thousands)
                       
          For the nine months ended
         
          February 28,   February 28,
          2003   2002
         
 
OPERATING ACTIVITIES
               
Net income
  $ 222,112     $ 205,864  
 
Adjustments to reconcile net income to cash provided by operating activities:
               
   
Depreciation and amortization on fixed and intangible assets
    29,968       21,867  
   
Amortization of premiums and discounts on available-for-sale securities
    15,098       12,563  
   
Provision for deferred income taxes
    (2,095 )     (1,406 )
   
Tax benefit related to exercise of stock options
    3,635       15,450  
   
Provision for bad debts
    1,428       974  
   
Net realized gains on sales of available-for-sale securities
    (12,583 )     (12,818 )
   
Changes in operating assets and liabilities:
               
     
Interest receivable
    8,353       7,879  
     
Accounts receivable
    12,566       13,242  
     
Prepaid expenses and other current assets
    (1,333 )     (2,898 )
     
Accounts payable and other current liabilities
    28,632       16,668  
     
Net change in other assets and liabilities
    4,419       (37 )
 
   
     
 
Net cash provided by operating activities
    310,200       277,348  
 
   
     
 
INVESTING ACTIVITIES
               
 
Purchases of available-for-sale securities
    (607,785 )     (854,121 )
 
Proceeds from sales of available-for-sale securities
    732,229       722,844  
 
Proceeds from maturities of available-for-sale securities
    78,265       41,594  
 
Net change in funds held for clients’ money market securities and other cash equivalents
    (302,291 )     (161,733 )
 
Net change in client fund deposits
    380,943       224,175  
 
Purchases of property and equipment
    (48,530 )     (32,708 )
 
Proceeds from sales of property and equipment
    5       10  
 
Acquisition of Advantage Payroll Services, Inc., net of cash acquired
    (312,693 )      
 
Purchases of other assets
    (3,791 )     (1,268 )
 
   
     
 
Net cash used in investing activities
    (83,648 )     (61,207 )
 
   
     
 
FINANCING ACTIVITIES
               
 
Dividends paid
    (124,021 )     (116,141 )
 
Proceeds from exercise of stock options
    5,175       13,811  
 
   
     
 
Net cash used in financing activities
    (118,846 )     (102,330 )
 
   
     
 
Increase in cash and cash equivalents
    107,706       113,811  
Cash and cash equivalents, beginning of period
    61,897       45,784  
 
   
     
 
Cash and cash equivalents, end of period
  $ 169,603     $ 159,595  
 
   
     
 

See Notes to Consolidated Financial Statements.

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PAYCHEX, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
February 28, 2003

Note A: Significant Accounting Policies

The accompanying unaudited Consolidated Financial Statements of Paychex, Inc., and its wholly owned subsidiaries have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, the Consolidated Financial Statements do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, the information furnished herein reflects all adjustments (consisting of items of a normal recurring nature), which are necessary for a fair presentation of the results for the interim period. Operating results for the nine months ended February 28, 2003 are not necessarily indicative of the results that may be expected for the full year ended May 31, 2003.

The accompanying Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and related Notes presented in the Company’s Annual Report on Form 10-K for the year ended May 31, 2002. Certain prior year amounts have been reclassified to conform to the current year presentation.

The Company reports one segment based upon the provisions of Statement of Financial Accounting Standard (“SFAS”) No. 131, “Diclosures about Segments of an Enterprise and Related Information.” The Company is a national provider of payroll, human resource, and employee benefits outsourcing solutions for small- to medium-sized businesses in the United States.

Service revenues are recognized in the period services are rendered and earned under service arrangements with clients where service fees are fixed or determinable and collectibility is reasonably assured. Certain processing services are provided under annual service arrangements with revenue recognized ratably over the annual service period. Professional Employer Organization (PEO) revenues are included in service revenues and are reported net of direct costs billed and incurred for PEO worksite employees, which include wages, taxes, benefit premiums, and claims of PEO worksite employees. Direct costs billed and incurred were $398.0 million and $282.8 million for the three months ended February 28, 2003 and 2002, respectively, and $1,068.5 million and $764.8 million for the nine months ended February 28, 2003 and 2002, respectively. Paychex provides delivery service for many of its clients’ payroll checks and reports. The revenue earned from delivery service is included in service revenues and the costs for the delivery are included in operating costs on the Consolidated Statements of Income.

Interest on funds held for clients is earned primarily on funds that are collected before due dates from clients for payroll tax filing and employee payment services and invested (funds held for clients) until remittance to the applicable tax agency or client employee. These collections from clients are typically remitted between one and thirty days after receipt, with some items extending to ninety days. The interest earned on these funds is included in total revenues on the Consolidated Statements of Income because the collection, holding, and remittance of these funds are critical components of providing these services. Interest on

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funds held for clients also includes net realized gains and losses from the sale of available-for-sale securities.

There is no significant seasonality to the Company’s business. However, during the Company’s third fiscal quarter, the number of new payroll clients, Retirement Services clients, and new PAS and PEO worksite employees tends to be higher than in the rest of the fiscal year primarily because a majority of new clients start using services in the beginning of the calendar year. In addition, calendar year-end transaction processing and client funds activity are traditionally higher during the third fiscal quarter due to clients paying year-end bonuses and requesting additional year-end services. As a result of these factors, historically the Company’s total revenue has been slightly higher in the third and fourth fiscal quarters and the Company has reported greater sales commission expenses in the third quarter, which ends in February.

Statement of Financial Accounting Standard No. 123, “Accounting for Stock-Based Compensation,” (SFAS No. 123) establishes accounting and reporting standards for stock-based employee compensation plans. As permitted by the SFAS, the Company accounts for such arrangements under Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Accordingly, no compensation expense is recognized for stock option grants because the exercise price of the stock options equals the market price of the underlying stock on the date of grant.

In December 2002, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure.” SFAS No. 148 amends SFAS No. 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition for a voluntary change to the fair value method of accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures about the method of accounting for stock-based employee compensation and the effect of the method used on reported financial results. SFAS No. 148 amends APB Opinion No. 28, “Interim Financial Reporting,” to require these disclosures in interim financial information. The Company continues to account for their stock-based employee compensation under APB Opinion 25, but has adopted the new disclosure requirements of the SFAS 148 in the third quarter of fiscal 2003. Additional information related to the Company’s stock option plans is detailed in Note G of the Notes to the Consolidated Financial Statements.

Newly Issued Accounting Standards:

In August 2001, the FASB issued SFAS No. 143, “Accounting for Asset Retirement Obligations,” which requires companies to record a liability at fair value for asset retirement obligations in the period in which they are incurred. The associated asset retirement costs are capitalized as part of the carrying amount of the long-lived asset. This Statement is effective for the Company for the fiscal year beginning June 1, 2003. The Company is currently evaluating the provisions of this Statement, but does not believe adoption of this Statement will result in a material impact to its results of operations or financial position.

In October 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” which provides a single accounting model for long-lived assets to be disposed of. The Company adopted this Statement in the first quarter of fiscal 2003 with no material impact to its results of operations or financial position.

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In April 2002, the FASB issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections.” SFAS No. 145 clarifies guidance related to the reporting of gains and losses from extinguishment of debt and resolves inconsistencies related to the required accounting treatment of certain lease modifications. This Statement is effective for fiscal years beginning after May 15, 2002. The Company adopted this Statement in the first quarter of fiscal 2003 with no material impact to its results of operations or financial position.

In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS No. 146 nullifies Emerging Issues Task Force (“EITF”) No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity,” under which a liability is recognized solely based on an entity’s commitment to a plan. SFAS No. 146 requires a liability for these costs to be recognized and measured at its fair value in the period in which the liability is incurred. This statement is effective for exit or disposal activities initiated after December 31, 2002.

Note B: Business Combination

On September 20, 2002, Paychex, Inc. acquired Advantage Payroll Services, Inc. (“Advantage”), a comprehensive payroll processor that serves small- to mid-sized businesses throughout the United States utilizing a national network of 41 offices, including 15 independently owned associate offices. The acquisition of Advantage provides Paychex with more than 49,000 clients and the opportunity to offer those clients the broad array of Paychex Human Resource and Retirement Services products. In addition, the combination of the two companies allows Paychex to expand geographic coverage into areas that were previously not served by the Company and become more efficient in offering services to our clients. Results of operations for Advantage since the acquisition date are included in the Consolidated Statements of Income.

The purchase price for the acquisition was $240.2 million in cash. In addition, Paychex paid $74.2 million in cash for the redemption of preferred stock and the repayment of outstanding debt of Advantage. The cost to acquire Advantage has been allocated to the assets acquired and liabilities assumed according to estimated fair values and is subject to adjustment when asset and liability valuations are finalized. The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition.

         
    Estimated fair
    value at
    September 20,
(In thousands)   2002

 
Current assets
  $ 7,779  
Funds held for clients
    180,905  
Deferred tax asset, net
    7,786  
Property and equipment
    8,086  
Intangible assets
    59,450  
Goodwill
    243,317  
Accounts payable and accrued expenses
    (12,276 )
Client fund deposits
    (180,669 )
 
   
 
Total purchase price
  $ 314,378  
 
   
 

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The $180.9 million of funds held for clients represents investments in marketable securities, primarily money markets and other cash equivalents as well as mutual funds and debt securities, which are classified as available-for-sale securities. These investments were recorded at fair value obtained from an independent pricing service as of the acquisition date. The client fund deposit liability of $180.7 million represents the cash collected from clients for payroll and tax payment obligations, which had not yet been remitted to the related client employees or tax agencies.

The Company recorded $2.4 million of severance and $3.6 million of redundant lease liabilities in the preliminary allocation of the purchase price under EITF 95-3, “Recognition of Liabilities in Connection with a Purchase Combination.” Approximately $1.0 million and $1.1 million, respectively, was paid in the third quarter and nine-month periods of fiscal 2003 for severance and redundant lease costs.

The amount assigned to intangible assets primarily represents client lists and license agreements with associate offices and was based on an independent appraisal. The intangible assets will be amortized over periods ranging from 7 to 12 years using either accelerated or straight-line methods, based on the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets.” Amortization expense related to these intangible assets was $2.1 million and $3.7 million, respectively, for the third quarter and nine-month periods of fiscal 2003.

Advantage provides all centralized back-office payroll processing and tax filing services under license agreements for independently owned associate offices. This includes the billing and collection of processing fees and the collection and remittance of payroll and payroll tax funds pursuant to Advantage’s contract with associate customers. Commissions earned by associates are based on the volume of payrolls processed. Revenue generated from customers as a result of these relationships and commissions paid to associates are included in the statement of income as payroll service revenue and selling, general, and administrative expense, respectively.

The amount of goodwill allocated to the purchase price was $243.3 million, which is not deductible for tax purposes. SFAS No. 142 requires that goodwill not be amortized, but instead tested for impairment on an annual basis and between annual tests if an event occurs or circumstances change in a way to indicate a potential decline in the fair value of the reporting unit. Impairment is determined by comparing the fair value of the reporting unit to its carrying amount, including goodwill. As the Company operates in one segment and as a single reporting unit, it will be evaluated as a single reporting unit for goodwill impairment testing.

The table below contains unaudited pro forma financial information summarizing the results of operations for the periods indicated as if the Advantage acquisition had occurred at the beginning of each of the three and nine-month periods presented. The pro forma information contains the actual combined operating results of Paychex and Advantage, with the results prior to the acquisition date adjusted to include the pro forma impact of: the amortization of acquired intangible assets, the elimination of Advantage’s interest expense and preferred stock dividends, and lower interest income as a result of the sale of available-for-sale securities to fund the Advantage acquisition. The Company realized $7.0 million of gains related to the sale of corporate investments to fund the acquisition. The $7.0 million realized gain is included in each pro forma period presented as if it occurred at the beginning of that period. These pro forma amounts do not purport to be indicative of the results that would have actually been obtained if the acquisition occurred as of the beginning of each of the periods presented or that may be obtained in the future.

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    For the three months ended   For the nine months ended
(Proforma, unaudited,  
 
in thousands, except   February 28,   February 28,   February 28,   February 28,
per share amounts)   2003   2002   2003   2002

 
 
 
 
Total revenues
  $ 287,789     $ 260,483     $ 833,380     $ 762,146  
Net income
  $ 76,282     $ 68,108     $ 219,893     $ 201,358  
Diluted earnings per share
  $ .20     $ .18     $ .58     $ .53  
 
   
     
     
     
 

Note C: Basic and Diluted Earnings Per Share

Basic and diluted earnings per share were calculated as follows:

                                   
      For the three months ended   For the nine months ended
     
 
(In thousands, except per   February 28,   February 28,   February 28,   February 28,
share amounts)   2003   2002   2003   2002

 
 
 
 
Basic earnings per share:
                               
 
Net income
  $ 71,521     $ 66,973     $ 222,112     $ 205,864  
 
   
     
     
     
 
 
Weighted-average common shares outstanding
    376,356       374,922       376,161       374,460  
 
   
     
     
     
 
 
Basic earnings per share
  $ .19     $ .18     $ .59     $ .55  
 
   
     
     
     
 
Diluted earnings per share:
                               
 
Net income
  $ 71,521     $ 66,973     $ 222,112     $ 205,864  
 
   
     
     
     
 
 
Weighted-average common shares outstanding
    376,356       374,922       376,161       374,460  
 
Net effect of dilutive stock options at average market prices
    1,725       3,174       1,821       3,349  
 
   
     
     
     
 
 
Weighted-average shares assuming dilution
    378,081       378,096       377,982       377,809  
 
   
     
     
     
 
 
Diluted earnings per share
  $ .19     $ .18     $ .59     $ .54  
 
   
     
     
     
 
 
Weighted-average anti-dilutive stock options
    3,940       1,365       3,734       1,500  
 
   
     
     
     
 

Weighted-average anti-dilutive stock options to purchase shares of common stock were excluded from the computation of diluted earnings per share. These options had an exercise price that was greater than the average market price of the common shares for the period; therefore, the effect would have been anti-dilutive.

For the three and nine months ended February 28, 2003, stock options were exercised for 131,000 and 568,000 shares of the Company’s common stock, respectively, compared with 362,000 and 1,455,000 for the prior year periods.

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Note D: Funds Held for Clients and Corporate Investments

                                     
        February 28, 2003   May 31, 2002
(In thousands)   (Unaudited)   (Audited)

 
 
Type of issue:   Cost   Fair value   Cost   Fair value

 
 
 
 
Money market securities and other cash equivalents
  $ 1,500,855     $ 1,500,855     $ 1,101,721     $ 1,101,721  
Available-for-sale securities:
                               
 
General obligation municipal bonds
    719,685       745,589       772,388       786,435  
 
Pre-refunded municipal bonds
    214,795       222,147       249,332       254,166  
 
Revenue municipal bonds
    410,221       423,139       446,168       453,854  
 
Other debt securities
    10,167       10,067       8,139       8,180  
 
Other equity securities
    20       47       20       64  
 
   
     
     
     
 
Total available-for-sale securities
    1,354,888       1,400,989       1,476,047       1,502,699  
Other
    3,643       2,911       3,357       2,983  
 
   
     
     
     
 
Total funds held for clients and corporate investments
  $ 2,859,386     $ 2,904,755     $ 2,581,125     $ 2,607,403  
 
   
     
     
     
 
Classification of investments on the Consolidated Balance Sheets:
                               
   
Funds held for clients
  $ 2,492,505     $ 2,522,082     $ 1,930,893     $ 1,944,087  
   
Corporate investments
    366,881       382,673       650,232       663,316  
 
   
     
     
     
 
Total funds held for clients and corporate investments
  $ 2,859,386     $ 2,904,755     $ 2,581,125     $ 2,607,403  
 
   
     
     
     
 

The Company is exposed to credit risk from the possible inability of the borrowers to meet the terms of their bonds. In addition, the Company is exposed to interest rate risk as rate volatility will cause fluctuations in the market value of held investments and the earnings potential of future investments. The Company attempts to limit these risks by investing primarily in AAA and AA rated securities and A-1 rated short-term securities, limiting amounts that can be invested in any single instrument, and by investing in short- to intermediate-term instruments whose market value is less sensitive to interest rate changes.

At February 28, 2003, all short-term securities and available-for-sale bond securities held an A-1 or equivalent rating, with 99% of the available-for-sale bond securities holding an AA rating or better. The Company does not utilize derivative financial instruments to manage interest rate risk.

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Note E: Property and Equipment, Net

                 
    February 28,   May 31,
    2003   2002
(In thousands)   (Unaudited)   (Audited)

 
 
Land and improvements
  $ 4,205     $ 3,155  
Buildings and improvements
    63,820       37,909  
Data processing equipment and software
    152,173       115,512  
Furniture, fixtures, and equipment
    88,551       81,959  
Leasehold improvements
    17,004       15,995  
Construction in progress
          18,941  
 
   
     
 
 
    325,753       273,471  
Less: accumulated depreciation and amortization
    171,938       151,905  
 
   
     
 
Property and equipment, net
  $ 153,815     $ 121,566  
 
   
     
 

Construction in progress at May 31, 2002 primarily represented purchases of data processing equipment and software and related building improvements for the Company’s data center, which was placed in service during the second quarter of fiscal 2003. Depreciation expense was $8,769,000 and $24,314,000 for the three and nine-month periods in fiscal 2003 compared with $6,770,000 and $20,012,000 in the respective fiscal 2002 periods.

Note F: Intangible Assets, Net

                 
    February 28,   May 31,
    2003   2002
(In thousands)   (Unaudited)   (Audited)

 
 
Client lists
  $ 66,398     $ 18,681  
Associate license agreements
    12,250        
Other intangible assets
    3,100        
 
   
     
 
 
    81,748       18,681  
Less: accumulated amortization
    15,295       9,641  
 
   
     
 
Intangible assets, net
  $ 66,453     $ 9,040  
 
   
     
 

Amortization expense on intangible assets was $2,817,000 and $5,654,000 for the three- and nine-month periods in fiscal 2003 compared with $607,000 and $1,855,000 in the respective fiscal 2002 periods.

The estimated amortization expense for the full year fiscal 2003 and the following four fiscal years, including the amortization from intangible assets purchased in the Advantage acquisition, as of February 28, 2003 is as follows:

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    Estimated
(In thousands)   amortization
Fiscal year ended May 31,   expense

 
2003
  $ 8,575  
2004
  $ 10,939  
2005
  $ 9,948  
2006
  $ 8,692  
2007
  $ 7,570  
 
   
 

Note G: Stock Option Plans

On July 11, 2002, the Board of Directors of the Company adopted the Paychex, Inc. 2002 Stock Incentive Plan (“2002 Plan”), which became effective upon stockholder approval at the Company’s Annual Meeting of Stockholders on October 17, 2002. The 2002 Plan authorizes the granting of options to purchase up to 9,108,000 shares of the Company’s common stock, of which 1,608,000 shares were authorized by the stockholders for the Paychex, Inc. 1998 Stock Incentive Plan (“1998 Plan”), but were not optioned under the 1998 Plan, and 7,500,000 shares were newly authorized for options.

The following table summarizes stock option activity for the nine months ended February 28, 2003:

                   
      Shares subject   Weighted-average
(In thousands, except per share amounts) to options exercise price



Outstanding at May 31, 2002
    8,700     $ 22.16  
 
Granted
    1,306     $ 28.04  
 
Exercised
    (568 )   $ 9.11  
 
Forfeited
    (321 )   $ 33.42  
 
   
     
 
Outstanding at February 28, 2003
    9,117     $ 23.43  
 
   
     
 
Exercisable at May 31, 2002
    4,515     $ 12.75  
Exercisable at February 28, 2003
    5,161     $ 16.45  
 
   
     
 

Options outstanding at February 28, 2003 had a weighted-average remaining contractual life of 6.3 years and exercise prices ranging from $1.78 to $51.38 per share.

In applying APB Opinion No. 25, no expense was recognized for stock options granted. SFAS No. 123 requires that a fair market value of all awards of stock-based compensation be determined using standard techniques and that pro forma net income and earnings per share be disclosed as if the resulting stock-based compensation amounts were recorded in the Consolidated Statements of Income.

In the third quarter ended February 28, 2003 there were no stock option grants. The weighted-average fair value of stock options granted was $8.78 for the nine months ended February 28, 2003 and $12.12 and $11.72, respectively, for the quarter and nine months ended February 28, 2002. The fair value of these stock option grants was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted-average assumptions:

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    For the three months ended   For the nine months ended
   
 
    February 28,   February 28,   February 28,   February 28,
    2003   2002   2003   2002
   
 
 
 
Risk-free interest rate
          4.1 %     3.6 %     4.2 %
Dividend yield
          1.2 %     1.6 %     1.2 %
Volatility factor
          .34       .35       .35  
Expected option term life in years
          5.0       4.9       4.7  
 
   
     
     
     
 

     The table below depicts the effects of amortizing the estimated fair value of stock options over their respective vesting periods:

                                   
      For the three months ended   For the nine months ended
     
 
(In thousands, except   February 28,   February 28,   February 28,   February 28,
per share amounts)   2003   2002   2003   2002

 
 
 
 
Net income, as reported
  $ 71,521     $ 66,973     $ 222,112     $ 205,864  
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects
    2,257       3,339       7,925       9,390  
 
   
     
     
     
 
Pro forma net income
  $ 69,264     $ 63,634     $ 214,187     $ 196,474  
 
   
     
     
     
 
Earnings per share:
                               
 
Basic-as reported
  $ .19     $ .18     $ .59     $ .55  
 
Basic-pro forma
  $ .18     $ .17     $ .57     $ .52  
 
Diluted-as reported
  $ .19     $ .18     $ .59     $ .54  
 
Diluted-pro forma
  $ .18     $ .17     $ .57     $ .52  
 
   
     
     
     
 

Note H: Comprehensive Income

Comprehensive income is comprised of two components: net income and other comprehensive income. Comprehensive income includes all changes in equity during a period except those resulting from transactions with owners of the Company. The unrealized gains and losses, net of applicable taxes, related to available-for-sale securities is the only component reported in accumulated other comprehensive income in the Consolidated Balance Sheets for the Company. Comprehensive income, net of related tax effects, is as follows:

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    For the three months ended   For the nine months ended
   
 
    February 28,   February 28,   February 28,   February 28,
(In thousands)   2003   2002   2003   2002





Net income
  $ 71,521     $ 66,973     $ 222,112     $ 205,864  
Unrealized gains/(losses) on securities, net of reclassification adjustments
    10,348       4,394       12,429       7,472  
 
   
     
     
     
 
Total comprehensive income
  $ 81,869     $ 71,367     $ 234,541     $ 213,336  
 
   
     
     
     
 

Note I: Contingencies

In the normal course of business and operations, the Company is subject to various claims and litigation including various employee and licensing matters. Management believes the resolution of these matters will not have a material adverse effect on the financial position or results of operations of the Company.

Note J: Related Party Transactions

During the nine-month periods ended February 28, 2003 and February 28, 2002, the Company purchased approximately $1.8 million and $11.2 million, respectively, of data processing equipment and software from EMC Corporation. The President and Chief Executive Officer of EMC Corporation is a member of the Board of Directors of Paychex.

Note K: Subsequent Event

On March 17, 2003, Paychex, Inc. announced it entered into an agreement to acquire InterPay, Inc., a wholly owned subsidiary of FleetBoston Financial Corporation (“Fleet”). The purchase price is $155 million in cash. InterPay is a national payroll and human resource administrative services provider that serves more than 33,000 small- to medium-sized businesses throughout the United States. In addition, Paychex has agreed to enter into a client referral relationship with Fleet, which allows Fleet to continue to offer payroll processing and related services to its small and medium-sized business clients on a co-branded basis with Paychex.

This acquisition is expected to close in early April 2003. Paychex expects InterPay to contribute approximately $50 million in revenue during the first 12 months after the acquisition. Paychex anticipates the acquisition will be slightly dilutive in the fourth quarter ended May 31, 2003, as the expenses of assimilating the acquisition and amortization of intangible assets will not be fully offset by anticipated gains realized in the corporate investment portfolio that will be liquidated in order to fund the acquisition. Paychex expects future earnings will be accretive as a result of this acquisition.

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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 for the three months and nine months ended February 28, 2003 (fiscal 2003) and 2002 (fiscal 2002), and the financial condition at February 28, 2003 for Paychex, Inc. and its subsidiaries (the “Company”). The focus of this review is on the underlying business reasons for significant changes and trends affecting revenues, net income, and financial condition. This review should be read in conjunction with the accompanying February 28, 2003 Consolidated Financial Statements and the related Notes to Consolidated Financial Statements contained in this Form 10-Q. Forward-looking statements in this review are qualified by the cautionary statement included in the “Other” section of this review under the sub-heading “Safe-Harbor Statement under the Private Securities Litigation Reform Act of 1995.”

CRITICAL ACCOUNTING POLICIES

Note A to the Consolidated Financial Statements included in this Form 10-Q and Note A to the Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended May 31, 2002 discuss the significant accounting policies of Paychex, Inc. The Company’s discussion and analysis of its financial condition and results of operations are based upon its consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires the Company’s management to make estimates, judgments, and assumptions that affect reported amounts of assets, liabilities, revenues, and expenses. On an ongoing basis, the Company evaluates its estimates, including those related to investments, allowance for doubtful accounts, fixed assets, goodwill and other intangible assets, income taxes, contingencies, and our clients’ inability to meet their payroll obligations. The Company bases its estimates on historical experience and assumptions believed to be reasonable under the circumstances. Actual amounts and results could differ from these estimates. Certain accounting policies that are deemed critical to the Company’s results of operations or financial position are discussed below.

Service revenues are recognized in the period services are rendered and earned under service arrangements with clients where service fees are fixed or determinable and collectibility is reasonably assured. Certain processing services are provided under annual service arrangements with revenue recognized ratably over the annual service period. Professional Employer Organization (PEO) revenues are included in service revenues and are reported net of direct costs billed and incurred, which include wages, taxes, benefit premiums, and claims of PEO worksite employees. Direct costs billed and incurred for PEO worksite employees were $398.0 million and $282.8 million for the three months ended February 28, 2003 and 2002, respectively, and $1,068.5 million and $764.8 million for the nine months ended February 28, 2003 and 2002, respectively. Paychex provides delivery service for the distribution of certain client payroll checks and reports. The revenue earned from delivery service is included in service revenues and the costs for delivery are included in operating costs on the Consolidated Statements of Income.

Interest on funds held for clients is earned primarily on funds that are collected before due dates from clients for payroll tax filing and employee payment services and invested (funds held for clients) until remittance to the applicable tax agency or client employee. These collections from clients are typically remitted between one and thirty days after receipt, with some items extending to ninety days. The interest earned on these funds is included in total

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revenues on the Consolidated Statements of Income because the collection, holding, and remittance of these funds are critical components of providing these services. Interest on funds held for clients also includes net realized gains and losses from the sale of available-for-sale securities.

As part of providing payroll, direct deposit, and tax filing and payments services, Paychex is authorized by the client to initiate money transfers from the client’s account for the amount of tax obligations and employees’ direct deposits. Electronic money funds transfers from client bank accounts are subject to potential risk of losses resulting from clients’ insufficient funds to cover such transfers.

The Company’s investments in debt securities are reported at fair value. Unrealized gains related to increases in the fair value of investments and unrealized losses related to decreases in the fair value are included in comprehensive income. However, changes in the fair value of investments impact the Company’s net income only when such investments are sold. The Company is exposed to credit risk in connection with these investments through the possible inability of the borrowers to meet the terms of the bonds.

On September 20, 2002, Paychex acquired Advantage Payroll Services, Inc. As a result of this purchase, the Company has recorded $243.3 million of goodwill on its Balance Sheet at February 28, 2003. SFAS No. 142, “Goodwill and Other Intangible Assets” requires that goodwill not be amortized, but instead tested for impairment on an annual basis and between annual tests if an event occurs or circumstances change in a way to indicate a potential decline in the fair value of the reporting unit. Impairment is determined by comparing the fair value of the reporting unit to its carrying amount, including goodwill. As the Company operates in one segment and as a single reporting unit, it will be evaluated as a single reporting unit for goodwill impairment testing.

The Company’s intangible assets are primarily comprised of client list acquisitions and license agreements with independently owned associate offices. Intangible assets are amortized over periods ranging from 7 to 12 years using either accelerated or straight-line methods. The Company periodically reviews its intangible assets for potential impairment.

SUBSEQUENT EVENT

On March 17, 2003, Paychex, Inc. announced it entered into an agreement to acquire InterPay, Inc., a wholly owned subsidiary of FleetBoston Financial Corporation (“Fleet”). The purchase price is $155 million in cash. InterPay is a national payroll and human resource administrative services provider that serves more than 33,000 small- to medium-sized businesses throughout the United States. In addition, Paychex has agreed to enter into a client referral relationship with Fleet, which allows Fleet to continue to offer payroll processing and related services to its small and medium-sized business clients on a co-branded basis with Paychex.

This acquisition is expected to close in early April 2003. Paychex expects InterPay to contribute approximately $50 million in revenue during the first 12 months after the acquisition. Paychex anticipates the acquisition will be slightly dilutive in the fourth quarter ended May 31, 2003, as the expenses of assimilating the acquisition and amortization of intangible assets will not be fully offset by anticipated gains realized in the corporate investment portfolio that will be liquidated in order to fund the acquisition. Paychex expects future earnings will be accretive as a result of this acquisition.

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RESULTS OF OPERATIONS

For the first nine months of fiscal 2003, the Company generated record total revenues, net income, and diluted earnings per share. The Company’s growth continues to be adversely impacted by the effect of lower interest rates on its funds held for clients and corporate investments portfolios and difficult economic conditions.

On September 20, 2002 Paychex completed the acquisition of Advantage Payroll Services, Inc. (“Advantage”), a comprehensive payroll processor that serves small- to mid-sized businesses throughout the United States. The purchase price was $240 million in cash. Paychex also paid $74 million in cash for the redemption of preferred stock and the repayment of outstanding debt of Advantage. The acquisition provided Paychex with 49,000 new clients. The results of operations for the nine-month period ended February 28, 2003 include the results of Advantage since the date of acquisition.

                                   
(In thousands, except per share amounts)                                
For the three months ended February 28,   2003   Change   2002   Change

 
 
 
 
Revenues:
                               
 
Payroll
  $ 235,255       20.2 %   $ 195,762       10.1 %
 
Human Resource and Benefits
    39,048       21.3 %     32,202       26.2 %
 
   
     
     
     
 
 
Service revenues
    274,303       20.3 %     227,964       12.1 %
 
Interest on funds held for clients
    13,486       -9.1 %     14,836       -42.7 %
 
   
     
     
     
 
 
Total revenues
    287,789       18.5 %     242,800       5.9 %
Consolidated operating, selling, general and administrative expenses
    186,370       19.8 %     155,583       9.3 %
 
   
     
     
     
 
Operating income
    101,419       16.3 %     87,217       0.4 %
Investment income, net
    3,760       -55.4 %     8,427       16.5 %
 
   
     
     
     
 
Income before income taxes
    105,179       10.0 %     95,644       1.6 %
Income taxes
    33,658       17.4 %     28,671       3.3 %
 
   
     
     
     
 
Net income
  $ 71,521       6.8 %   $ 66,973       0.9 %
 
   
     
     
     
 
Diluted earnings per share
  $ .19       5.6 %   $ .18        
 
   
     
     
     
 
Operating income as a % of total revenues
    35.2 %             35.9 %        
Operating income (excluding interest on funds held for clients) as a % of service revenues
    32.1 %             31.8 %        
Operating income (excluding interest on funds held for clients) as a % of service revenues (excluding Advantage)
    33.8 %             31.8 %        
Income before income taxes as a % of total revenues
    36.5 %             39.4 %        
Net income as a % of total revenues
    24.9 %             27.6 %        
 
   
             
         

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(In thousands, except per share amounts)                                
For the nine months ended February 28,   2003   Change   2002   Change

 
 
 
 
Revenues:
                               
 
Payroll
  $ 660,797       15.2 %   $ 573,683       12.6 %
 
Human Resource and Benefits
    108,579       23.4 %     87,966       23.8 %
 
   
     
     
     
 
 
Service revenues
    769,376       16.3 %     661,649       14.0 %
 
Interest on funds held for clients
    39,895       -18.5 %     48,953       -19.3 %
 
   
     
     
     
 
 
Total revenues
    809,271       13.9 %     710,602       10.8 %
Consolidated operating, selling, general and administrative expenses
    506,181       15.4 %     438,540       11.8 %
 
   
     
     
     
 
Operating income
    303,090       11.4 %     272,062       9.2 %
Investment income, net
    23,546       -2.5 %     24,145       28.9 %
 
   
     
     
     
 
Income before income taxes
    326,636       10.3 %     296,207       10.6 %
Income taxes
    104,524       15.7 %     90,343       11.9 %
 
   
     
     
     
 
Net income
  $ 222,112       7.9 %   $ 205,864       10.0 %
 
   
     
     
     
 
Diluted earnings per share
  $ .59       9.3 %   $ .54       8.0 %
 
   
     
     
     
 
Operating income as a % of total revenues
    37.5 %             38.3 %        
Operating income (excluding interest on funds held for clients) as a % of service revenues
    34.2 %             33.7 %        
Operating income (excluding interest on funds held for clients) as a % of service revenues (excluding Advantage)
    35.5 %             33.7 %        
Income before income taxes as a % of total revenues
    40.4 %             41.7 %        
Net income as a % of total revenues
    27.5 %             29.0 %        
 
   
             
     

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Details regarding the Company’s combined funds held for clients and corporate investment portfolios are as follows:

                                   
      For the three months ended   For the nine months ended
     
 
      February 28,   February 28,   February 28,   February 28,
($ in millions) 2003   2002   2003   2002





Average investment balances:
                               
Funds held for clients
  $ 2,374.9     $ 1,949.6     $ 2,067.1     $ 1,798.6  
Corporate investments
    495.3       696.8       585.5       668.8  
 
   
     
     
     
 
 
Total
  $ 2,870.2     $ 2,646.4     $ 2,652.6     $ 2,467.4  
 
   
     
     
     
 
 
Average interest rates earned (exclusive of net realized gains/(losses)):
                               
Funds held for clients
    2.1 %     2.6 %     2.4 %     3.1 %
Corporate investments
    3.2 %     3.6 %     3.3 %     3.9 %
Total combined funds held for clients and corporate investment portfolios
    2.3 %     2.8 %     2.6 %     3.3 %
 
Net realized gains:
                               
Funds held for clients
  $ .7     $ 2.3     $ 3.0     $ 7.6  
Corporate investments
          2.4       9.6       5.2  
 
   
     
     
     
 
 
Total
  $ .7     $ 4.7     $ 12.6     $ 12.8  
 
   
     
     
     
 
                 
    February 28,   May 31,
    2003   2002
   
 
Unrealized gain on available-for-sale portfolio (in millions)
  $ 46.1     $ 26.7  
Federal Funds rate
    1.25 %     1.75 %
Three-year “AAA” municipal securities yield
    1.60 %     2.75 %
Total available-for-sale securities (in millions)
  $ 1,401.0     $ 1,502.7  
Average duration of available-for-sale securities portfolio in years
    2.3       2.3  
Weighted average yield-to-maturity of available-for-sale securities portfolio
    3.4 %     3.6 %
 
   
     
 

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Total service revenues are comprised of revenues from the Payroll and Human Resource and Benefits product lines. Payroll service revenues are earned primarily from payroll processing, tax filing and payment service, employee payment service, and other ancillary services. Human Resource and Benefits service revenues are earned primarily from Retirement Services, Workers’ Compensation Insurance Administration, Section 125 Plan Administration, and Paychex Administrative Services and Professional Employer Organization bundled services.

The increases in Payroll service revenue in fiscal 2003 compared with the prior year are attributable to the acquisition of Advantage, organic client base growth, increased utilization of ancillary services by both new and existing clients, and price increases. Payroll service revenue continues to be impacted by year-over-year decreases in checks per client. The Company has adjusted the calculation of checks per client to eliminate the impact of client payroll frequency. The Company believes this calculation provides a more accurate indicator of underlying economic demand for its services. The year-over-year changes in checks per client (excluding Advantage) are as follows:

                 
    Year-over-year change in checks per client
   
    Fiscal 2003   Fiscal 2002
   
 
First quarter
    (1.7 %)     (1.9 %)
Second quarter
    (.3 %)     (3.8 %)
Third quarter
    (.1 %)     (4.1 %)
Fourth quarter
    N/A       (2.6 %)
Full year
    N/A       (3.0 %)
 
   
     
 

As of February 28, 2003, 87% of all clients utilized the Company’s tax filing and payment services, compared with 84% at February 28, 2002. The Company believes the client utilization percentage of the tax filing and payment services is near maturity. The Company’s employee payment services were utilized by 59% of its clients at February 28, 2003 compared with 56% at February 28, 2002. Approximately 90% of new clients purchase the Company’s tax filing and payment services and 70% of new clients purchase employee payment services. Major Market Services revenue increased 42% for both the third quarter and nine-month periods to $27.3 million and $73.3 million, respectively. Approximately one-third of new Major Market Services clients are conversions from the Company’s Core Payroll service.

The increases in Human Resource and Benefits service revenue in fiscal 2003 compared with the prior year are primarily related to increases in clients for Retirement Services and increases in Paychex Administrative Services (PAS) and Professional Employer Organization (PEO) client employees serviced.

The increase in Retirement Services clients reflects the continuing interest of small- to medium-sized businesses in offering retirement savings benefits to their employees. Retirement Services revenues increased 15% and 20% in the third quarter and nine-month periods to $17.6 million and $49.5 million, respectively. At February 28, 2003, the Company serviced over 26,000 Retirement Services clients.

The Paychex Administrative Services (PAS) product is a combined package of payroll, employer compliance, employee benefit administration, and risk management outsourcing services designed to make it easier for small businesses to manage their payroll and benefit

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costs. The Company’s PEO product provides the same bundled services as the PAS product, but with Paychex acting as a co-employer of the client’s employees. The PEO service is available primarily in the states of Florida and Georgia, where PEOs are more prevalent. Sales of the PAS and PEO products have been strong, with administrative fee revenue from these products increasing 41% and 42% in the third quarter and nine-month periods of fiscal 2003, respectively, compared with the respective prior year periods. As of February 28, 2003, the PAS and PEO products serviced over 95,000 client employees.

The decreases in interest on funds held for clients are primarily the result of lower average interest rates earned in fiscal 2003 and a decrease in net realized gains on the sale of available-for-sale securities offset somewhat by higher average portfolio balances. The higher average portfolio balances were driven by the acquisition of Advantage and the growth in the utilization of the Company’s tax filing and payment services and employee payment services.

The increases in consolidated operating, selling, general and administrative expenses are due to the acquisition of Advantage and increases in personnel, information technology, and facility costs to support the growth of the Company. At February 28, 2003, the Company had approximately 8,250 employees compared with approximately 7,300 at February 28, 2002.

For the third quarter ended February 28, 2003, Advantage revenues included service revenue of $18.6 million and interest on funds held for clients of $1.4 million. For the nine-month period, Advantage revenues were comprised of $32.7 million of service revenue and $2.6 million of interest on funds held for clients. Operating, selling, general and administrative expenses for Advantage totaled $17.0 million and $31.3 million, respectively, for the third quarter and nine-month periods. Included in these expenses was amortization of intangible assets of $2.1 million and $3.7 million for the respective quarter and year-to-date periods.

The acquisition of Advantage resulted in $.01 earnings per share accretion since acquisition and is expected to result in $.01 of earnings per share dilution in the fourth quarter of fiscal 2003. The Company expects the results of Advantage to be accretive in the next fiscal year.

The integration of Advantage began in the second quarter of fiscal 2003, and by the end of that quarter the Advantage sales force had been combined with the sales force of Paychex. While some Advantage clients are being converted to Paychex software platforms, the focus has been on client service and retention with minimal change in the service model for Advantage clients.

Investment income primarily represents earnings from the Company’s 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 revenues. The decreases in investment income are primarily due to a decrease in average daily invested balances, lower average interest rates earned in fiscal 2003, and the timing of net realized gains on sales of available-for-sale securities. The company realized $7.0 million of gains in the second quarter of fiscal 2003 from the sale of corporate investments to fund the acquisition of Advantage. The use of corporate investments to fund the acquisition reduced investment income by approximately $2.4 million and $4.4 million during the third quarter and nine-month periods of fiscal 2003, respectively.

The effective income tax rate was 32.0% in both the third quarter and nine-month periods of fiscal 2003 compared with 30.0% and 30.5% in the respective prior year periods. The increase in the effective income tax rate is primarily the result of lower levels of tax-exempt income, which is derived primarily from municipal debt securities of the funds held for clients and

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corporate investment portfolios. The full year fiscal 2003’s effective income tax rate is expected to approximate 32.0%.

Outlook:

The Company first experienced the effects of the difficult economic conditions in the United States in the first quarter of fiscal 2002, and these effects have continued through the third quarter of fiscal 2003. In response to economic conditions, the Federal Reserve has lowered the Federal Funds rate twelve times since January 2001 to 1.25%, which represents a cumulative 525 basis point reduction. The Company’s combined interest on funds held for clients and corporate investment income in the first nine months of fiscal 2003 decreased 13% year-over-year, primarily as a result of interest rate decreases and lower average balances in the corporate investment portfolio, offset somewhat by higher net realized gains.

In addition to the effects of volatile interest rates, difficult economic conditions have resulted in a lower number of checks per client as existing clients reduce their work forces. During the first nine months of fiscal 2003, the Company experienced a 0.7% year-over-year decline in checks per client (excluding Advantage). In fiscal 2002, the twelve-month year-over-year decline in checks per client was 3.0%.

Despite the above factors, income before taxes was 37% and 40% of total revenues during the third quarter and nine-month periods of fiscal 2003, compared with 39% and 42% for the respective prior year periods. In addition, operating income (excluding interest on funds held for clients) increased 21% in the third quarter and 18% in the nine-month period to $87.9 million and $263.2 million, respectively.

The Company has based full year fiscal 2003 expectations on current economic and interest rate conditions continuing with no significant changes and excluding the impact of the acquisition of InterPay. Accordingly, for fiscal 2003, the Company projects Payroll service revenue growth in the range of 14% to 16% and Human Resource and Benefits service revenue growth in the range of 19% to 21%. Total service revenue growth is anticipated to be in the range of 15% to 17%. The Company expects interest on funds held for clients and corporate investment income combined to be down approximately 15% to 18%.

Taking the factors mentioned above into consideration, the Company anticipates achieving record total revenues and net income for fiscal 2003 and estimates total revenue growth to be in the range of 13% to 15%, including approximately $50 to $55 million from Advantage, with net income growth in the high single digits.

LIQUIDITY AND CAPITAL RESOURCES

The Company has funded its operations, capital purchases, purchases of corporate investments, and dividend payments through cash generated from its operating activities. At February 28, 2003, the Company had $552 million in available cash and corporate investments. Current cash and corporate investments and projected operating cash flows are expected to support normal business operations, purchases of property and equipment, and current dividend payments. The Company has two available, uncommitted, unsecured lines of credit from various banks totaling $140 million at market rates of interest. The Company also has an available, uncommitted, secured line of credit from a bank totaling $350 million at a market rate of interest. No amounts were outstanding against these lines of credit during the

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first nine months of fiscal 2003 or at February 28, 2003. The Company anticipates funding the $155 million acquisition of InterPay through available cash and corporate investments.

Operating activities

                                 
(In thousands)                                
For the nine months ended February 28,   2003   Change   2002   Change

 
 
 
 
Operating cash flows
  $ 310,200       11.9 %   $ 277,348       8.2 %
 
   
     
     
     
 

The increase in operating cash flows for the first nine months of fiscal 2003 reflects achievement of higher net income and cash provided by working capital. The higher cash provided by working capital was related primarily to the timing of payments for payroll-related, income tax, and other liabilities, and the timing of payments for PEO and PAS payroll liabilities in the respective periods.

Investing activities

                                 
(In thousands)                                
For the nine months ended February 28,   2003   Change   2002   Change

 
 
 
 
Net funds held for clients and corporate investment activities
  $ 281,361           $ (27,241 )     -67.1 %
Purchases of property and equipment
    (48,530 )     48.4 %     (32,708 )     12.9 %
Proceeds from the sale of property and equipment
    5       -50.0 %     10       -75.6 %
Acquisition of Advantage Payroll
Services, Inc., net of cash acquired
    (312,693 )                  
Purchases of other assets
    (3,791 )     199.0 %     (1,268 )     -81.3 %
 
   
     
     
     
 
Net cash used in investing activities
  $ (83,648 )     36.7 %   $ (61,207 )     -48.4 %
 
   
     
     
     
 

Funds held for clients and corporate investments: Funds held for clients are primarily comprised of short-term funds and available-for-sale debt securities, and corporate investments are primarily comprised of available-for-sale debt securities. The portfolio of funds held for clients and corporate investments is detailed in Note D of the Notes to the Consolidated Financial Statements.

The reported amount of funds held for clients will vary significantly based upon the timing of collecting client funds, and the related remittance of funds to the applicable tax authorities for clients of the Company’s tax filing and payment services and employees of clients utilizing the employee payment services. Cash provided or used by net funds held for clients and corporate investment activities primarily relates to the timing of purchases, sales, or maturities of corporate investments. During the second quarter of fiscal 2003, corporate investments were sold to fund the acquisition of Advantage Payroll Services, Inc. Additional discussion of interest rates and related risks is included in the “Market Risk Factors” section of this review.

Purchases of property and equipment: To support the Company’s continued client and ancillary product growth, purchases of property and equipment were made for data processing equipment and software, and for the expansion and upgrade of various operating facilities. Purchases of property and equipment in fiscal 2003 are expected to approximate $65 million. This total includes the purchase of a 220,000-square-foot facility in Rochester, New York,

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which was completed in the first quarter of fiscal 2003. Fiscal 2003 depreciation expense is projected to approximate $35 million.

Financing activities

                                 
(In thousands, except per share amounts)                                
For the nine months ended February 28,   2003   Change   2002   Change

 
 
 
 
Dividends paid
  $ (124,021 )     6.8 %   $ (116,141 )     29.8 %
Proceeds from exercise of stock options
    5,175       -62.5 %     13,811       20.3 %
 
   
     
     
     
 
Net cash used in financing activities
  $ (118,846 )     16.1 %   $ (102,330 )     31.2 %
 
   
     
     
     
 
Cash dividends per common share
  $ .33       6.5 %   $ .31       29.2 %
 
   
     
     
     
 

Dividends paid: During the quarter ended February 28, 2003, the Company’s Board of Directors declared a dividend in the amount of $.11 per share, which was paid February 17, 2003 to shareholders of record as of February 3, 2003. Future dividends are dependent on the Company’s future earnings and cash flow and are subject to the discretion of the Board of Directors.

Proceeds from exercise of stock options: The decrease in proceeds from the exercise of stock options is primarily due to a decrease in the number of shares exercised from 1,455,000 in the nine months of fiscal 2002 to 568,000 in the nine months of fiscal 2003. The Company has recognized a tax benefit from the exercise of stock options of $3.6 million and $15.5 million for the nine months ended February 28, 2003 and 2002, respectively. This tax benefit reduces the accrued income tax liability and increases additional paid-in capital, with no impact on the expense amount for income taxes.

MARKET RISK FACTORS

Interest Rate Risk: Funds held for clients are primarily comprised of short-term funds and available-for-sale debt securities, and corporate investments are primarily comprised of available-for-sale debt securities. The Company’s available-for-sale debt securities are exposed to interest rate risk as interest rate volatility will cause fluctuations in the market value of held investments and the earnings potential of future investments. Increases in interest rates normally decrease the market value of the available-for-sale securities, while decreases in interest rates increase the market value of the available-for-sale securities. The Company’s available-for-sale securities and short-term funds are exposed to earnings risk from changes in interest rates, as rate volatility will cause fluctuations in the earnings potential of future investments. Increases in interest rates quickly increase earnings from short-term funds, and over time increase earnings from the available-for-sale securities portfolio. Decreases in interest rates have the opposite earnings effect on the available-for-sale securities and short-term funds. Earnings from the available-for-sale securities do not reflect changes in rates until the investments are sold or mature, and the proceeds are reinvested at current rates. The immediate impact of changing interest rates on earnings from short-term funds may be temporarily offset by realized gains or losses from transactions in the Company’s available-for-sale portfolio.

The Company directs investments towards high credit-quality, tax-exempt securities to mitigate the risk that earnings from the portfolio could be adversely impacted by changes in interest rates in the near term. The Company invests in short- to intermediate-term, fixed-rate

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municipal and government securities, which typically have lower interest rate volatility, and manages the securities portfolio to a benchmark duration of 2.5 to 3.0 years. The Company does not utilize derivative financial instruments to manage interest rate risk.

The following table summarizes recent changes in the Federal Funds rate:

                           
              Fiscal year   Fiscal year
      Fiscal year   ended   ended
      2003   May 31,   May 31,
      year-to-date   2002   2001
     
 
 
Federal Funds rate – beginning of period
    1.75 %     4.00 %     6.50 %
Rate increase/(decrease):
                       
 
First quarter
          (.50 )      
 
Second quarter
    (.50 )     (1.50 )      
 
Third quarter
          (.25 )     (1.00 )
 
Fourth quarter
    N/A             (1.50 )
 
   
     
     
 
Federal Funds rate – end of period
    1.25 %     1.75 %     4.00 %
 
   
     
     
 
Three-year “AAA” municipal securities yield – end of period
    1.60 %     2.75 %     3.44 %
 
   
     
     
 

Calculating the future effects of changing interest rates involves many factors. These factors include, but are not limited to, daily interest rate changes, seasonal variations in investment balances, actual duration of short- and intermediate-term investments, the proportional mix of taxable and tax-exempt investments, and changes in tax-exempt municipal rates versus taxable investment rates, which are not synchronized or simultaneous. Subject to these factors, a 25-basis-point change generally affects the Company’s tax-exempt interest rates by approximately 17 basis points.

The total investment portfolio is expected to average approximately $2.7 billion for the full year fiscal 2003. The Company’s normal and anticipated allocation is approximately 50% invested in short-term securities with a duration of less than thirty days and 50% invested in intermediate-term municipal securities with an average duration of three years. The Company estimates that the earnings effect of a 25-basis-point change in interest rates (17 basis points for tax-exempt investments) at this point in time would be approximately $3.0 million for the next twelve-month period.

The combined funds held for clients and corporate available-for-sale investment portfolios reflected unrealized gains of $46.1 million at February 28, 2003 compared with unrealized gains of $26.7 million and $32.1 million at May 31, 2002 and February 28, 2002, respectively. During the first nine months of fiscal 2003, the unrealized gain position ranged from approximately $22.3 million to $46.3 million. The unrealized gain position of the Company’s investment portfolios was approximately $39.7 million at March 19, 2003.

As of February 28, 2003 and May 31, 2002, the Company had approximately $1.4 billion and $1.5 billion, respectively, invested in available-for-sale securities at fair value, with weighted average yields to maturity of 3.4% and 3.6%, respectively. Assuming a hypothetical increase in both short-term and intermediate-term interest rates of 25 basis points, the resulting potential decrease in fair value for the portfolio of securities at February 28, 2003 would be approximately $8.0 million. Conversely, a corresponding decrease in interest rates would result in a comparable increase in fair value. This hypothetical decrease or increase in the fair

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value of the portfolio would be recorded as an adjustment to the portfolio’s recorded value, with an offsetting amount recorded in stockholders’ equity, and with no related or immediate impact to the results of operations.

Credit Risk: The Company is exposed to credit risk in connection with these investments through the possible inability of the borrowers to meet the terms of the bonds. The Company attempts to limit credit risk by investing primarily in AAA and AA rated securities and A-1 rated short-term securities, and by limiting amounts that can be invested in any single instrument. At February 28, 2003, all available-for-sale and short-term securities classified as cash equivalents held an A-1 or equivalent rating, with approximately 99% of the available-for-sale securities held an AA rating or better.

OTHER

Integration of Acquisitions: The effective integration of acquisitions may be difficult to achieve. It is also possible that the Company may not realize any or all expected benefits from recent acquisitions or achieve benefits from acquisitions in a timely manner. In addition, the Company may incur significant costs and impact existing internal resources in connection with the integration of acquisitions. Failure to effectively integrate recent and future acquisitions could adversely affect the Company’s results of operations.

“Safe Harbor” Statement Under the Private Securities Litigation Reform Act of 1995: Certain written and oral statements made by Paychex, Inc. (the “Company”) management may constitute “forward-looking statements” as defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements are identified by such words and phrases as “we expect,” “expected to,” “estimates,” “we look forward to,” “would equate to,” “projects,” “projected to be,” “anticipates,” “we believe,” “could be,” and other similar phrases. All statements addressing operating performance, events, or developments that the Company expects or anticipates 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 or those which are described in the Company’s SEC filings: general market and economic conditions, including demand for the Company’s products and services, competition, price levels, availability of internal and external resources, effective execution of expansion plans and effective integration of acquisitions; changes in the laws regulating collection and payment of payroll taxes, professional employer organizations, and employee benefits, including 401(k) plans, workers’ compensation, state unemployment, and section 125 plans; delays in the development, timing of the introduction, and marketing of new products and services; changes in technology, including use of the Internet; the possibility of catastrophic events that could impact the Company’s operating facilities, computer systems, and communication systems; 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; potential damage to the Company’s business reputation due to these and other operational risks; the possible inability of clients to meet payroll obligations; stock volatility; and changes in short- and long-term interest rates, changes in the market value of available-for-sale securities, and the credit rating of cash, cash equivalents, and securities held in the Company’s investment portfolios, all of which could cause actual results to differ materially from anticipated results. The information provided in this document is based upon the facts and circumstances known at this time.

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE OF MARKET RISK

The information called for by this item is provided under the caption “Market Risk Factors” under ITEM 2 — MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures: The Company’s Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of disclosure controls and procedures as defined in Rules 13a-14 and 15d-14 of the Securities Exchange Act of 1934, as amended, within 90 days of the filing of this Quarterly Report on Form 10-Q. Based on such evaluation, they have concluded that as of such date, the Company’s disclosure controls and procedures are effective.

Changes in Internal Controls: There were no significant changes in the Company’s internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

In the normal course of business and operations, the Company is subject to various claims and litigation including various employee and licensing matters. Management believes the resolution of these matters will not have a material adverse effect on the financial position or results of operations of the Company.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a)   Exhibits:

  (1)   Exhibit 10.1: Form of Indemnification Agreement for Directors and Officers
 
  (2)   Exhibit 99.1: Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
  (3)   Exhibit 99.2: Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

(b)   Reports on Form 8-K:

  (1)   The Company filed a report on Form 8-K on December 19, 2002 that included the Company’s press release dated December 19, 2002 reporting the Company’s results of operations for the second quarter of fiscal 2003.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

PAYCHEX, INC.

     
Date: March 20, 2003   /s/ B. Thomas Golisano

B. Thomas Golisano
Chairman, President and
Chief Executive Officer
 
Date: March 20, 2003   /s/ John M. Morphy

John M. Morphy
Senior Vice President, Chief
Financial Officer and Secretary

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CERTIFICATIONS

I, B. THOMAS GOLISANO, certify that:

1.   I have reviewed this quarterly report on Form 10-Q of Paychex, Inc.;
 
2.   Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;
 
3.   Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;
 
4.   The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

  a)   designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
 
  b)   evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and
 
  c)   presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5.   The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent function):

  a)   all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
 
  b)   any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

6.   The registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

     
Date: March 20, 2003   /s/ B. Thomas Golisano
 
    Chairman, President, and Chief
Executive Officer

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I, JOHN M. MORPHY, certify that:

1.   I have reviewed this quarterly report on Form 10-Q of Paychex, Inc.;
 
2.   Based on my knowledge, this quarterly report does not contain any untrue statement of material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;
 
3.   Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;
 
4.   The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

  a)   designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
 
  b)   evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and
 
  c)   presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5.   The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent function):

  a)   all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
 
  b)   any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

6.   The registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that

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    could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

     
Date: March 20, 2003   /s/ John M. Morphy
 
    Senior Vice President, Chief
Financial Officer, and Secretary

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