19 September 2010

ADP: Look Ahead to September 2010 Quarterly Results

This post describes our model of Automatic Data Processing's (NASDAQ: ADP) Income Statement for the first quarter of fiscal 2011, which will end on 30 September 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.

First, we present some background information about ADP and the business environment in which it is currently operating.

Automatic Data Processing performs payroll, human resource, data processing, and outsourcing Business Services for well over 500,000 clients, large and small, in the United States and other countries.  ADP pays one of every six private sector employees in the U.S.

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.

According to its latest 10-K, ADP earned $1.2 billion on Revenue of $8.9 billion in fiscal 2010, which ended 30 June.  The company has a market value of about $20 billion.

ADP has three main businesses:  Employer Services, Professional Employer Organization Services, and Dealer Services.  Employer Services processes payrolls, administers benefits, and performs other services to enable firms "to staff, manage, pay and retain their employees."  PEO Services, by establishing co-employment relationships with customers and their employees, enables businesses to outsource various functions.  In this arrangement, an ADP entity becomes the employer of record for the affected employees.  Dealer Services helps dealers of vehicles and machinery manage their business activities.

The Employer Services business segment contributed 72 percent of total revenue in fiscal 2010.  Competitors include Paychex (NASDAQ:PAYX), the now-private Ceridian, and India's Wipro (NYSE: WIT).

Dealer Services revenue has been adversely affected by the downturn in vehicle sales and the closing of many dealerships.

As the processor of many payrolls across the U.S., ADP quickly senses macroeconomic changes in Employment.  ADP uses the data it collects to issue the monthly ADP National Employment Report on non-farm private employment.

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.)  In accordance with an outsourcing agreement between the two companies, ADP has been providing data center services to Broadridge.  In 2010, Broadridge notified ADP it would not extend the agreement beyond its 30 June 2012 expiration date.  ADP does not anticipate that end of this relationship will have a material impact.

ADP earned $0.42 per share in fiscal 2010's fourth quarter, which ended 30 June 2010.  Earnings per share were 41 percent less than the $0.70 ADP made in the same quarter of 2009; however, the prior-year result was boosted by a tax benefit of $0.24 per share.  Excluding this one-time benefit, diluted quarterly earnings from continuing operations declined from $0.45 in June 2009 to $0.42 per share in June 2010.

Readers wanting to take another look at Automatic Data Processing's June 2010 quarter might wish to review our Income Statement and Financial Gauge analyses.

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

In the press release on 29 July 2010 announcing fourth quarter results, ADP issued the following guidance for the new fiscal year.
  • Total revenues – increase 1% to 3%
  • Diluted earnings per share – increase 1% to 3%, compared with $2.37 earnings per share from continuing operations in fiscal 2010 which excludes favorable tax items
  • Employer Services – revenue growth of 1% to 3%; pretax margin expansion of up to 50 basis points
  • Pays per control – flat to up 0.5% for the year
  • Client revenue retention – flat to up 0.4 percentage points
  • PEO Services – low double-digit revenue growth; pretax margin decline due to increased benefits pass through revenues
  • Employer Services and PEO Services new business sales – high single-digit growth compared to $1.0 billion sold in fiscal 2010
  • Dealer Services – revenues and pretax margin flat to slightly up

Since Revenue in fiscal 2010 was $8.93 billion, the one-to-three percent growth guidance translates into a Revenue range of roughly $9.0 billion to $9.2 billion for the fiscal year that will end in June 2011.  Let's say $9.1 billion.

Revenue in September quarters is typically less than 25 percent of annual Revenue for ADP.  The average over the last decade is closer to 23.5 percent, give or take about 1.5 percent.  If we use this average with the fiscal 2011 Revenue estimate, we get 0.235 * $9.1 billion = $2.14 billion as a target for the September 2010 quarter.  The range of uncertainty around the estimate is around $200 million.

The guidance includes some limited operating margin expectations for each of ADP's three businesses.  Since Employer Services is much larger than the other businesses, the margin expansion forecast for this business should predominate. 

ADP's Gross Margin as a percentage of Revenue was 52.1 percent in fiscal 2010.  In September quarters, the Gross Margin has tended to be at, or slightly below, the year's average.  For this reason, we are assuming the Gross Margin will be about 52.0 percent in the September 2010 quarter.  This is equivalent to forecasting that the Cost of Goods Sold -- what ADP calls "Operating Expenses" -- will equal (1 - 0.52) * $2.14 billion = $1.03 billion. 

Depreciation and amortization expenses have been around $60 million per quarter for nearly three years.  We have no reason to expect a different figure in the September 2010 quarter. 

Research and Development expenses ("Systems Development and Programming Costs") have been between $120 million and $130 million in most quarters during recent years.  However, the $138 million reported expense in the June 2010 quarter broke out of the range.  The increase might reflect one-time costs or a push to complete upgrades prior to the end of the fiscal year.  However, it seems more likely that ADP is stepping up its investments in business modernization.  The 10-K mentions investments required for the "migration to new computing technologies and the development of new products and maintenance of our existing technologies."  These product improvement activities usually require a sustained effort, so we are assuming a $135 million expense in the September 2010 quarter.

Sales, General, and Administrative expenses are more variable.  In the last five fiscal years, the amount per quarter has ranged from $436 million to $697 million.  As a percentage of Revenue, SG&A has varied between 20.7 percent and 32.5 percent.  Looking just at September quarters, the ranges are much narrower:  $436 million to $534 million and 23.4 percent to 28.3 percent.  The percentages have generally been falling from year to year.   With these circumstances in mind, we are expecting SG&A expenses in the September 2010 quarter will be 24 percent of Revenue, or 0.24 * $2.14 billion =  $514 million.

Rolling up these estimates yields a target for Operating Income, as we define it, of $404 million.  This is 3 percent less than Operating Income in the September 2009 quarter.

As for non-operating items (i.e., other income less interest expense), $10 million would seem to be a conservative estimate based on recent history. 

We're assuming the effective Income Tax Rate will match fiscal 2010's 35 percent.  This assumption leads to an estimate for Net Income of $269 million ($0.54 per share, depending on the share count).  In the year-earlier quarter, Net Income from continuing operations was $284 million ($0.56 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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