26 January 2011

ADP: Income Statement Analysis for the December 2010 Quarter

Automatic Data Processing (NASDAQ: ADP) earned $0.62 per diluted share on a GAAP basis in the December-ending second quarter of fiscal 2011, unchanged from the same three months of 2009. 

This post examines ADP's Income Statement for the latest quarter and compares the entries on each line to our "look-ahead" estimates.  Reported earnings were $0.02 more than our $0.60 EPS estimate.

The principal sources for the income statement analysis were the earnings announcement and the associated webcast presentation [pdf].

In a second article, we will report ADP's scores as measured by the GCFR financial gauges.  The follow-up post will also provide the latest figures for the various financial metrics we use to analyze Cash Management, Growth, Profitability and Value.

Before getting into the details, we will take a step back to introduce the subject of today's analysis.

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's market value is currently close to $25 billion, on a fully diluted basis.

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.

Additional background information about ADP and the business environment in which it is currently operating can be found in the look-ahead.

Please click here to see a normalized depiction of the actual and projected results for the just-concluded quarter, as well as the 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.

Revenue in the December quarter rose 9.4 percent, from $2.2 billion last year to $2.4 billion in the most recent three months.  Fluctuations in currency exchange rates shaved about 1 percent from revenue growth.

Reported revenue exceeded our $2.36 billion estimate by 2 percent.  Our estimate was derived from the company's prior guidance (since revised) for fiscal year and seasonal patterns.

Employer Services, the company's largest business segment, achieved Revenue growth of 7 percent, from $1.56 billion to $1.66 billion.  Revenue from the company's "traditional" payroll businesses didn't increase, which indicates Employer Services revenue growth was due to new lines of business and recent acquisitions.

Revenue rose a robust 15 percent at the Professional Employer Organization Services segment, from $311 million to $358 million.  The number of employees paid via PEO Services increased 11 percent.

The Dealer Services business reported a 26 percent Revenue increase, from $299 million to $375 million.  This strong growth rate was primarily due to the acquisition of automotive marketing firm Cobalt.  Organic growth was only four percent as this unit, which continues to be affected by earlier dealerships closings.

Operating Expenses were $1.17 billion, or 48.8 percent of Revenue.  (Note we treat this item as the Cost of Goods Sold for consistency with our other analyses, but the item is only a subset of what ADP classifies as Total Costs of Revenues.)  This ratio translates into a Gross Margin of 51.2 percent, a substantial 120 basis points less profitable than December 2009's 52.4 percent. 

ADP indicated that margins were pressured by investments in sales and service "headcounts" and higher PEO pass-through revenues.

The latest Gross Margin was 20 basis points lower than our estimate of 51.0 percent.

Depreciation and amortization expenses increased to nearly $65 million, about $5 million more than we expected.  The increase may have been due to capital spending and corporate acquisitions.

ADP spent $142 million on "Systems Development and Programming Costs," which we treat as analogous to Research and Development.  The expense was up $21 million (18 percent) from last year's $121 million.  The latest figure exceeded our $135 million estimate by 5 percent.

As a percentage of Revenue, R&D increased from 5.5 percent to 5.9 percent. 

Sales, General, and Administrative expenses rose 9.9 percent to $570 million, about $4 million more than our $566 million estimate for the quarter.  Reported SG&A expenses equaled 23.7 percent of Revenue, up just slightly from 23.6 percent last year.

Operating Income, calculated by subtracting the various operating expenses discussed above from revenue, was $455 million.  This amount is 0.8 percent greater than last year's equivalent value of $452 million.  The latest Operating Income amount was 3 percent above than our $442 million target, as better-than-expected Revenue made up for higher expenses.

As for non-operating items, Other Income less Interest Expense equaled $29 million, net.  This amount was only a little better than last year's $27 million, but it was quite a bit better than the $15 million we expected. 

The effective Income Tax Rate was 36 percent in the December 2010 quarter.  We had estimated the tax rate would be 35 percent.

At the bottom line, Net Income of $310 million was 2 percent less than income of $316 million in the December 2009 quarter.  With fewer shares outstanding, earnings per share remained unchanged at $0.62.

Reporting earnings were $13 million ($0.02 per share) more than our target for the quarter, in large part because Revenue and Other Income was better than we anticipated.

Full disclosure: Long ADP at time of writing.

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