01 April 2010

ADP: Look Ahead to March 2010 Quarterly Results

This post describes our model of Automatic Data Processing's (NASDAQ: ADP) Income Statement for the third quarter of fiscal 2010, which ended on 31 March 2010.

The purpose of the model is to establish a baseline for identifying surprises, positive or negative, in the quarterly results the company will report.  Estimates for each line of the Income Statement are derived from management's guidance, the company's historical financial results, and other publicly available data.

We begin by reviewing background information about ADP and the business environment in which it is currently operating.

Automatic Data Processing performs payroll, tax, and other personnel-related Business Services for over 500,000 clients, large and small.  ADP pays one of every six private sector employees in the United States.

ADP earned $1.3 billion on revenue of $8.9 billion in fiscal 2009, which ended last June.  The Employer Services segment contributed nearly three-quarters of the total revenue.  ADP has a current market capitalization of about $22.5 billion.

Competitors include Paychex (NASDAQ:PAYX), the now-private Ceridian, and India's Wipro (NYSE: WIT).

ADP is one of four remaining of U.S. companies with a AAA bond rating.  It is also an S&P 500 Dividend Aristocrat, having hiked its dividend for 35 consecutive years.

Fortune Magazine deemed ADP to be Most Admired in the Financial Data Services industry.

As a payroll processor, ADP directly feels the effects of lower Total Non-farm Employment and the higher Unemployment Rate in the U.S.  The weak labor market today is illustrated vividly in the monthly ADP National Employment Report on non-farm private employment, which ADP creates based on payroll data.

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.

Now, we are ready to look ahead to ADP's results for the March 2010 quarter.

In its earnings announcement released in February 2010, ADP updated its Revenue and EPS forecasts for fiscal 2010.

"As we move into the second half of the year we have increased visibility on our key metrics and, as such, have updated our forecasts for revenues and certain key metrics. We anticipate total revenues will be flat to slightly down, compared with our previous estimate of down 1% to 2%. Including the $0.02 from the Reserve Fund as noted above, we expect to achieve the high end of our diluted earnings per share from continuing operations forecast of $2.34 to $2.39 compared with $2.39 earnings per share from continuing operations in fiscal 2009, which excludes favorable tax items in both years.

Given this guidance, we are assuming Revenue in fiscal 2010 will match (i.e., be flat relative to) the $8.87 billion of Revenue in fiscal 2009.  In the first half of the current fiscal year, ADP had Revenue of $4.30 billion, which leaves $4.57 billion for the second half.

In the last few years, the March quarter has been responsible for 52 to 53 percent of second-half Revenue.  This suggests to us that Revenue in the March quarter should be around 0.525 * $4.57 billion= $2.40 billion. 

The Gross Margin has been close to 52 percent of Revenue in each of the last three quarters.  However, the ADP's margin is typically much more lucrative, for whatever reason, in March quarters.  Assuming the seasonal pattern will repeat, we are choosing 54 percent as our Gross Margin target for the latest quarter.  This is equivalent to forecasting that the Cost of Goods Sold -- what ADP calls "Operating Expenses" -- will equal (1 - 0.54) * $2.4 billion = $1.1 billion. 

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 March 2010 quarter. 

Similarly, it seems reasonable to assume Research and Development (R&D) expenses ("Systems Development and Programming Costs") will continue to be about $125 million per quarter.

Sales, General, and Administrative (SG&A) expenses are more variable -- the amount has been as low as 22 percent of Revenue and as high as 32 percent during the last five years --  but March quarters tend to have the least SG&A expense relative to Revenue.  In addition, a declining expense trend is evident.  With these factors in mind, we are expecting SG&A expenses in the current quarter to be 23 percent of Revenue, or 0.23 * $2.40 billion =  $552 million.

Rolling up these estimates yields a target for Operating Income, as we define it, of $559 million.  This is 12 percent less than Operating Income in the March 2009 quarter.

ADP reported that it received $14.8 million (pretax) in the March quarter from the Reserve Fund.  The company had previous written off some or all of this investment.  As for the more run-of-the-mill non-operating items (i.e., other income less interest expense), $25 million would seem to be a reasonable estimate based on recent history. 

If the Income Tax Rate is 36 percent, Net Income will be $383 million ($0.76 per share, depending on share repurchases).  In the year-earlier quarter, Net Income from continuing operations was $403 million ($0.80 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.

Reference:  The chart above of the ADP National Employment Report can be found here.

Full disclosure: Long ADP at time of writing.

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