23 September 2009

ADP: Look Ahead to September 2009 Quarterly Results

The GCFR Overall Gauge of Automatic Data Processing (NASDAQ: ADP) was unchanged at 59 of the 100 possible points in the June 2009 quarter, which was the fourth quarter of ADP's fiscal year.  Our income statement, financial gauge, and gauge update analyses explained in some detail how the score was attained.

Revenue in the June quarter fell 4.5 percent because of the weak economy and unfavorable currency exchange rates.  However, a $120 million income tax benefit caused quarterly earnings to soar from $0.45 to $0.70 per share.  If this one-time benefit due to favorable settlements had not been realized, earnings per share would have been more or less flat.

We have now modeled ADP's Income Statement for the September 2009 quarter, which is the first of fiscal 2010.  The intent of this exercise was to produce a baseline for identifying deviations, positive or negative, in the actual data the company will announce in early November.  GCFR estimates are derived from trends in the historical financial results and guidance provided by company management.

First, we set the stage with some background information about the company and the business environment in which it operates.

Automatic Data Processing, Inc. (NASDAQ: ADP), with over 500,000 clients, is one of the largest firms providing payroll and other personnel-related information technology services.   The company is also known for the monthly ADP National Employment Report on non-farm private employment.

ADP competes for clients with numerous large and small, public and private, business software and services companies.  In the U.S., the IRS lists 24 payroll service providers that have satisfied its requirements for electronic submissions.  Paychex, Inc. (NASDAQ:PAYX) and the now-private Ceridian are probably the most well-known firms.  India's Wipro (NYSE: WIT) is also a competitor.

As a payroll processor, ADP directly feels the effects of decreased employment in the U.S., as shown in the accompanying charts from the Bureau of Labor Statistics of Total Non-farm Employment and the Unemployment Rate.

ADP is one of five remaining of U.S. companies with a AAA bond rating.  It is also an S&P 500 Dividend Aristocrat, having hiked its dividend for 34 consecutive years.  (The well-respected Dividend Growth Investor recently published a comprehensive dividend analysis for ADP.)

Pershing Square Capital Management, a hedge fund managed by William Ackman, bought a 7.3 percent stake in ADP in the second quarter. Ackman, according to Reuters

"told investors ... "As the economy stabilizes, we believe the headwinds facing ADP will become tailwinds. Given the operating leverage inherent in ADP's business model, ADP's earnings should accelerate as it approaches its normalized earnings potential."

In 2007, ADP divested its Brokerage Services Group business, which became Broadridge Financial Solutions (NYSE: BR).  GCFR articles related to Broadridge can be found here.

We're now ready to look ahead.

In a press release announcing June's results, ADP provided a very cautious forecast for fiscal 2010.

"Our fiscal 2010 forecasts anticipate that severely negative economic conditions continue. As such, our forecasts assume a worsening of our business metrics in the first half of the year as compared with the first half of fiscal 2009, with particularly tough year-over-year comparisons expected in the first quarter

-- Total revenues - decline 1% to 4%
-- Diluted earnings per share - $2.29 to $2.39, compared with $2.39 earnings per share from continuing operations in fiscal 2009, excluding favorable tax settlements in the fourth quarter.
-- Employer Services - decline in revenues of 1% to 3%

* Pays per control - decline of 5% to 6%
* Client revenue retention - flat to down 1 percentage point
-- PEO Services - revenue growth of up to 4%
-- Employer Services and PEO Services new business sales - about flat compared to $982 million sold in fiscal 2009
-- Dealer Services - decline in revenues of 4% to 8%
-- We anticipate no improvement in pretax margins given the continued
difficult economic environment anticipated for fiscal 2010

[emphasis added]

We've noted previously that guidance in terms of Earnings per Share (EPS), instead of Net Income, enables management to satisfy or exceed expectations by increasing share repurchases.

Since Revenue in the now-concluded fiscal 2009 was $8.9 billion, a decline between 1 and 4 percent  would translate into a fiscal 2010 Revenue range between $8.51 billion and $8.78 billion.  We chose a mid-range figure of $8.65 billion as the Revenue projection for the entirety of fiscal 2010. 

Over the last five years, the September quarter's contribution to annual Revenue has averaged 22.8 percent.  This ratio yields a $1.97 billion, which we have round up to $2.0 billion, Revenue estimate for the first quarter of fiscal 2010.

The Gross Margin was 53.7 percent of Revenue in fiscal 2009.  ADP indicates it is not expecting any margin improvements in the new year.  We will use 53.5 percent as our target for the September 2009 quarter.  This is equivalent to forecasting that the Cost of Goods Sold (CGS) -- what ADP calls "Operating Expenses" -- will equal (1 - 0.535) * $2.0 billion = $930 million. 

Depreciation and amortization expenses have been around $60 million in each of the last eight quarters.  We have no reason to expect a materially different figure in the September 2009 quarter. 

Similarly, Research and Development (R&D) expenses ("Systems Development and Programming Costs") have been about $125 million per quarter.

Sales, General, and Administrative (SG&A) expenses are variable, but the amount tends to be somewhat lower in September quarters than the others.  Our expectation for the current quarter is $525 million. 

Rolling up these expense estimates yields a target for Operating Income, as we define it, of $360 million.  This is 14 percent less than Operating Income in the September 2008 quarter.

For net non-operating income (i.e., other income less interest expense), $20 million would seem to be a reasonable estimate based on recent history. 

If the Income Tax Rate is 36 percent, Net Income will be $243 million ($0.49 per share, depending on share repurchases).  In the year-earlier quarter, Net Income from continuing operations was $278 million ($0.54 per share).

Please click here to see a full-sized, normalized depiction of the projected results next to ADP's quarterly Income Statements for the last couple of years.  Please note that our organization of revenues, expenses, gains, and losses, which we use for all analyses, can and often does differ in material respects from company-used formats.  The standardization facilitates cross-company comparisons.

Full disclosure: Long ADP at time of writing.

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