14 February 2011

ADP: Financial Gauge 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. 

A previous article examined ADP's Income Statement for the September quarter.  Reported earnings were $0.02 more than our $0.60 EPS estimate.

We have now updated the various financial metrics we use to analyze Cash Management, Growth, Profitability and Value.  This post reports on the metrics for ADP and the associated financial gauge scores.  The metrics were calculated using data from ADP's current and historical financial statements, including those in the latest 10-Q.

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 EmploymentADP 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.

Now we turn to the financial gauges.  The latest quarterly results produced the following changes to the scores:
  • Overall: 25 of 100 (down from 33)

The current and historical values for the financial metrics that determine the gauge scores are listed below, with some brief commentary.  Readers are encouraged to verify these figures and calculate others as they see fit using the filings available at the SEC's web site and elsewhere.

Cash Management31 Dec 201030 Sep 201031 Dec 20095-Yr Avg
Current Ratio (1)
LTD to Equity0.6%0.6%0.7%0.9%
Debt/CFO (years)
Inventory/CGS (days)N/AN/AN/AN/A
Finished Goods/InventoryN/AN/AN/AN/A
Days of Sales Outstanding (days)44.544.344.547.3
Working Capital/Revenue (1)17.0%18.0%17.3%20.3%
Cash Conversion Cycle Time (days)34.834.835.234.9
Gauge Score (0 to 25)1191012
1. Excludes Funds held for clients and Client funds obligations.

The Cash Management gauge score picked up a couple of points due to some minor variations in the underlying financial metrics.

ADP has $1.3 billion in cash and cash-equivalents.  ADP has only $35 million (a pittance for a big firm) of Long-term Debt.  The debt-to-equity and debt-to-cash-flow ratios are near zero.

Working Capital -- the difference between Current Assets and Current Liabilities, but excluding client funds and obligations  -- is also approximately $1.3 billion.  The amount of Working Capital relative to Revenue is stable-to-decreasing, which is good.

The Current Ratio, also excluding client funds, is under the classical 2.0 threshold.  However, the latest figure is within its normal range for ADP.

Days of Sales Outstanding has been static for the last year.  The figure is below (albeit slightly) its long-term average, which is signal of improved cash efficiency.  We'd like to see the Cash Conversion Cycle Time move down, for the same reason.

Growth31 Dec 201030 Sep 201031 Dec 20095-Yr Avg
Revenue Growth5.8%3.3%-2.8%5.3%
Revenue/Assets (1)104.3%101.5%103.2%97.1%
Operating Profit Growth3.5%5.3%13.2%8.3%
CFO Growth6.6%17.9%-16.3%3.4%
Net Income Growth-11.1%-9.8%11.5%-5.9%
Gauge Score (0 to 25)515510
Revenue, CFO, and Net Income growth rates compare the last four quarters to the four previous quarters.  The Operating Profit rate is the annualized rate of growth in Operating Profit after Taxes over the last 16 quarters.Growth
1. Assets excludes Funds held for clients.

The Growth gauge jumped abnormally with September's results because the growth metrics were so much better than they had been in September 2009.  The numbers moderated in December, and the score gave back its gain.

Revenue in December 2010 quarter was 9.4 percent greater than in the comparable year-earlier period.  This performance, which was boosted by recent acquisitions, pushed trailing-year revenue growth to 5.8 percent.  While we wouldn't call this a robust growth rate, it is certainly an improvement on the negative rate of 12 months earlier.

The upward trend in Revenue/Assets may be moderating.  Note that we exclude Client funds from Assets when making the Revenue/Assets calculation. 

The negative (and worsening) Net Income trailing-year growth rate is one drag on the Growth gauge score.  Although macroeconomic factors such as U.S. employment and interest rates probably has the most prominent effect on income, one-time items have also weakened ADP's results.  For example, ADP recorded an $8.6 million impairment charge on assets held for sale.  Similarly, in the June 2010 quarter, ADP recorded a $9.1 million impairment charge on securities.

In addition, ADP's income in the prior year benefited for a tax settlement, which makes the more recent results look comparatively worse. 

Cash Flow from operations during the first six month of the current fiscal year is 3.8 percent less than in the same six months of the previous fiscal year.

Profitability31 Dec 201030 Sep 201031 Dec 20095-Yr Avg
Operating Expense/Revenue81.0%80.6%79.1%80.4%
Free Cash Flow/Invested Capital36.0%35.9%37.9%35.3%
Accrual Ratio16.7%10.5%-10.2%0.2%
Gauge Score (0 to 25)12131715

The Profitability Gauge score barely budged in the latest period.

A decreasing Operating Margin (albeit slightly) is not helping the score.  The decrease indicates that expenses are taking a bigger bite out of each revenue dollar.

The ROIC and FCF/IC ratios are healthy and consistent with their historical averages.

The increase in the Accrual Ratio could be a concern.  However, one-time items that have affected Cash Flow and Income have made this metric especially erratic.  We'd like to see the Accrual Ratio decrease and get back under 0 percent.

Value31 Dec 201030 Sep 201031 Dec 20095-Yr Avg
P/E vs. S&P 500 P/E
Enterprise Value/Cash Flow (EV/CFO)13.111.812.814.1
Gauge Score (0 to 25)0378
Share Price ($)$46.28$42.03$42.82-

The Value gauge score, weak after September, had nowhere to go but down when the share price increased 10 percent and Net Income fell 2 percent in the December 2010 quarter.

The results on a per-share basis are somewhat better because ADP has been repurchasing its shares.

The company's earnings growth would not seem to justify the current P/E multiple.  However, it seems likely that ADP's share price has increased because investors are more confident that improving employment trends will ultimately benefit ADP's payroll business.  The GCFR gauges won't register this improvement until after it actually occurs.

Overall31 Dec 201030 Sep 201031 Dec 20095-Yr Avg
Gauge Score (0 to 100)25334245

The Overall gauge score tumbled mostly because of weakness in the Growth and Value gauges.  The score will remain under pressure until key parameters such as Operating Income, Net Income, Cash Flow from Operations perform better.

As mentioned above, one-time items have skewed some of the numbers.  The effect of these factors should become clearer over time.

Full disclosure: Long ADP at time of writing.

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