18 December 2010

ADP: Look Ahead to December 2010 Quarterly Results

This post describes our model of Automatic Data Processing's (NASDAQ: ADP) Income Statement for the December-ending second quarter of fiscal 2011.

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 U.S. companies with a AAA bond rating.  An S&P 500 Dividend Aristocrat, ADP recently announced its 36th-consecutive annual dividend increase

The company has a market value of about $23 billion.

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. 

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

In fiscal 2010, which ended 30 June, ADP's earnings fell to $1.21 billion from $1.33 billion in the prior year.  Revenue increased to $8.93 billion from $8.84 billion.  The company's results in fiscal 2010 were weakened by high unemployment, which reduces the demand for payroll services, and low interest rates, which limits the company's interest income.

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 companies that sell 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.

ADP has recently acquired several other companies, including Italian business software developer Byte Software House, automotive marketing firm Cobalt, human resource solutions provider Workscape, and payroll tax firm MasterTax.
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.

Automatic Data Processing earned $0.56 per diluted share on a GAAP basis in the September-ending first quarter of fiscal 2011.  Earnings per share were unchanged from the same three months of last year. 

Readers wanting to take another look at ADP's September 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 December 2010 quarter.

In the press release on 27 October 2010 announcing its results for the September quarter, ADP updated its guidance for fiscal 2011.  Some changes to the guidance reflect the company's better-than-expected performance during the first fiscal quarter, and other adjustments are reactions to recent corporate acquisitions.

Including the results of the newly acquired companies, ADP now believes it can achieve full-year Revenue growth between 7 percent and 8 percent.  Since Revenue in fiscal 2010 was $8.93 billion, the guidance translates into a Revenue range of $9.56 billion to $9.65 billion for the fiscal year that will end in June 2011.  Let's say $9.6 billion.

In the September 2010 quarter, ADP brought in Revenue of $2.23 billion.  This leaves $9.6 billion - $2.23 billion = $7.37 billion for the final nine months of the fiscal year.

December quarters are not typically biggest producers of Revenue for ADP, so we can't simply divide $7.37 billion divided by 3.  Our specific target is $2.36 billion, 32 percent of the nine-month total.

ADP's guidance indicates that pretax operating margin expansion is expected at the company's Employer Services, but margin declines are expected at PEO Services and Dealer Services.  Acquisition costs will put negative pressure on margins.  However, since Employer Services is much bigger than the other units, the company-wide margin may be flat to slightly positive.

In fiscal 2010, the Gross Margin as a percentage of Revenue was 52.1 percent, but it was closer to 50 percent in each of the last two quarters.  Given this information and the seasonal pattern, we are setting our target for the Gross Margin in the December quarter at 51 percent.  When combined with our Revenue estimate, the margin target leads to a forecast for the Cost of Goods Sold -- what ADP calls "Operating Expenses" -- of (1 - 0.51) * $2.36 billion = $1.16 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 December 2010 quarter. 

Research and Development expenses ("Systems Development and Programming Costs") were $135 million in the September 2010 quarter.  We are looking for a similar figure in the current 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.  The percentages have generally been falling from year to year.   Given this data, we are expecting SG&A expenses in the December 2010 quarter will be 24 percent of Revenue, or 0.24 * $2.36 billion =  $566 million.

Rolling up these estimates yields a target for Operating Income, as we define it, of $442 million.  This is 2.4 percent less than Operating Income in the December 2009 quarter.

As for non-operating items (i.e., other income less interest expense), $15 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 $297 million ($0.60 per share, depending on the share count).  In the year-earlier quarter, Net Income from continuing operations was $316 million ($0.62 per share).

Please click here to see a 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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