UNITED STATES SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

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

FOR THE QUARTERLY PERIOD ENDED AUGUST 31, 2004

For the transition period from                     to                    

COMMISSION FILE NUMBER 0-11330

PAYCHEX, INC.

(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.

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Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

PAYCHEX, INC.

See Notes to Consolidated Financial Statements.

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PAYCHEX, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands)

See Notes to Consolidated Financial Statements.

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PAYCHEX, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(In thousands)

See Notes to Consolidated Financial Statements.

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PAYCHEX, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
August 31, 2004

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 U.S. 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 U.S. 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 three months ended August 31, 2004 are not necessarily indicative of the results that may be expected for the full year ended May 31, 2005.

The accompanying Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and related Notes to Consolidated Financial Statements presented in the Company’s Annual Report on Form 10-K for the year ended May 31, 2004. Certain prior year amounts have been reclassified to conform to the current year presentation. These reclassifications had no effect on reported consolidated earnings.

The Company reports one segment based upon the provisions of Statement of Financial Accounting Standard (SFAS) No. 131, “Disclosures 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.

Revenue recognition: 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. The Company’s service revenues are largely attributable to payroll-related processing services where the fee is based on a fixed amount per processing period or a fixed amount per processing period plus a fee per employee or transaction processed. 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.

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 for PEO worksite employees were $540.0 million and $404.2 million for the three months ended August 31, 2004 and 2003, respectively.

Interest on funds held for clients is earned primarily on payroll tax filing and payment services and employee payment services funds that are collected from clients before due dates and invested (funds held for clients) until remittance to the applicable tax authorities or client employees. 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,

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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.

PEO workers’ compensation insurance: In fiscal 2003, workers’ compensation insurance for PEO worksite employees was provided under a pre-funded, deductible workers’ compensation policy with a national insurance company. Under this policy, the Company’s maximum individual claims liability was $250,000 and the aggregate claims exposure was based on a percentage of premium rates as applied to workers’ compensation payroll. The fiscal 2004 policy was similar to the fiscal 2003 policy, except that the Company’s maximum individual claims liability was $500,000. The fiscal 2005 policy is similar to the 2004 policy, except that it is no longer pre-funded as claims are paid as incurred.

At August 31, 2004, the Company has recorded $1.8 million in current liabilities for workers’ compensation claims cost based on the estimated loss exposure under the fiscal 2003 policy. In addition, there is recorded $1.7 million in current liabilities and $4.4 million in long-term liabilities under the fiscal 2005 policy. The Company also has recorded an estimated prepayment of $5.4 million under the fiscal 2004 policy in prepaid expenses and other current assets. These estimates may change in the future based on claims experience trends.

Seasonality: There is no significant seasonality to the Company’s business. However, during the Company’s third fiscal quarter, which ends in February, 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 fiscal quarter.

Stock-based compensation costs: SFAS No. 123, “Accounting for Stock-Based Compensation,” establishes accounting and reporting standards for stock-based employee compensation plans. As permitted by SFAS No. 123, 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 the grant.

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The following table illustrates the pro forma effect on net income and earnings per share as if the Company had applied the fair value recognition provision of SFAS No. 123 to stock-based compensation:

For purposes of pro forma disclosures, the estimated fair value of the stock option is amortized to expense over the option’s vesting period. The weighted-average fair value of stock options granted was $9.26 and $8.66 for the quarters ended August 31, 2004 and 2003, respectively. The fair value of these stock options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted-average assumptions:

Additional information related to the Company’s stock option plans is detailed in Note G of the Notes to Consolidated Financial Statements.

Note B: Business Combinations

Fiscal 2004 acquisition: During fiscal 2004, the Company expanded its product offerings to include time and attendance products. Effective April 12, 2004, Paychex acquired substantially all the assets and certain liabilities of Stromberg LLC (“Stromberg”), a provider of time and attendance software solutions for mid- to large-sized businesses, for approximately $13.6 million. The Company paid $12.6 million at the date of acquisition and an additional $1.0 million is expected to be paid in the fourth quarter of fiscal 2005. Paychex had purchased Stromberg’s Time In A Box^® product, a time and attendance solution for small- to medium-sized businesses, in October 2003. The purchase price was allocated to the assets and liabilities of Stromberg based on their fair values as follows:

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The amount assigned to property and equipment primarily represents the fair value of software and is based upon an independent appraisal. The goodwill balance is deductible for tax purposes.

Fiscal 2003 acquisitions: In fiscal 2003, Paychex acquired two payroll processors that serve small- to medium-sized businesses throughout the United States. Advantage Payroll Services, Inc. (“Advantage”) was acquired on September 20, 2002 for $314.4 million and InterPay, Inc. (“InterPay”) was acquired on April 1, 2003 for $182.3 million. The Company has $394.1 million of goodwill recorded on its Consolidated Balance Sheets at August 31, 2004 relating to these two acquisitions.

As a result of these acquisitions, the Company has recorded reserves for severance and redundant lease costs in the allocation of purchase price under Emerging Issues Task Force (EITF) 95-3, “Recognition of Liabilities in Connection With a Purchase Combination.” The purchase price allocation for the Advantage acquisition included reserves of $1.8 million for severance and $3.3 million for redundant lease costs. The purchase price allocation for the InterPay acquisition included reserves of $8.2 million for severance and $2.6 million for redundant lease costs. Activity in the first quarter of fiscal 2005 for these reserves is summarized as follows:

The severance payments for both acquisitions are expected to be substantially complete by the end of fiscal 2005. The majority of redundant lease payments are expected to be complete in fiscal 2007, with the remaining payments extending until 2015.

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Note C: Basic and Diluted Earnings Per Share

Basic and diluted earnings per share were calculated as follows:

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 months ended August 31, 2004, stock options were exercised for .2 million shares of the Company’s common stock, compared with .3 million shares for the prior year period.

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Note D: Funds Held for Clients and Corporate Investments

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 August 31, 2004, all short-term securities classified as cash equivalents and available-for-sale securities held at least an A-1 or equivalent rating, with over 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.

Unrealized gains and losses of available-for-sale securities are as follows:

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The net unrealized loss at May 31, 2004 has changed to a net unrealized gain at August 31, 2004 as a result of a decrease in longer-term interest rates. The $2.5 million gross unrealized loss at August 31, 2004 is comprised of 147 available-for-sale securities, which had a total fair value of $516.1 million. This is reduced from gross unrealized losses of $11.1 million at May 31, 2004, which was comprised of 257 available-for-sale securities with a total fair value of $876.0 million. The Company periodically reviews its investment portfolios to determine if any investment is other-than-temporarily impaired due to changes in credit risk or other potential valuation concerns.

At August 31, 2004, Paychex believes that the investments it holds are not other-than-temporarily impaired. While certain available-for-sale debt securities have fair values that are below cost, the Company believes that it is probable that the principal and interest will be collected in accordance with contractual terms and that the decline in the market value is due to changes in interest rates and not due to increased credit risk. At August 31, 2004, substantially all of the securities in an unrealized loss position held an AA rating or better. The Company currently believes that it has the ability and intent to hold the investments until the earlier of market price recovery or maturity. The Company’s assessment that an investment is not other-than-temporarily impaired could change in the future due to new developments or changes in the Company’s strategies or assumptions related to any particular investment.

Note E: Property and Equipment, Net

Depreciation expense was $10.3 million for the three-month period in fiscal 2005, compared with $9.6 million in the respective fiscal 2004 period.

Construction in progress at August 31, 2004 and May 31, 2004 primarily represents costs for software being developed for internal use.

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Note F: Intangible Assets, Net

Amortization expense on intangible assets was $3.9 million for the three-month period in fiscal 2005, compared with $4.1 million in the respective fiscal 2004 period.

The estimated amortization expense for the full year fiscal 2005 and the following four fiscal years, as of August 31, 2004, is as follows:

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 9.1 million shares of the Company’s common stock, of which 1.6 million 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 7.5 million shares were newly authorized for options.

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The following table summarizes stock option activity for the three months ended August 31, 2004: