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Automatic Data Processing Inc. (ADP) reported second quarter 2011 earnings per share of 62 cents, beating the Zacks Consensus Estimate by a penny. Second quarter earnings was primarily driven by strong top-line growth partially offset by higher expenses.

Operating Performance
Earnings per share were flat on a year over year basis but leaped 10.7% sequentially. Excluding a tax benefit of 2 cents a share in the second quarter of 2010, earnings increased 3.3% year over year in the second quarter 2011.

Net income from continuing operations decreased 2.0% year over year to $310.1 million, with net margin falling to 12.9% from 14.3% in the prior-year quarter. Excluding a tax benefit of $12.2 million in the second quarter of 2010, net income increased 2.4% year over year in second quarter 2011.

Total cost of expenses increased 11.7% year over year and 6.7% sequentially to $1.95 billion.

Operating income increased slightly (0.6%) on a year-over-year basis to $452.5 million. Operating income climbed 13.4% sequentially. Operating margin decreased 160 basis points (bps) year over year but increased 90 bps on a sequential basis to 18.8%.

Pre-tax income increased 1.2% year over year and 11.0% sequentially to $484.6 million in the second quarter. Pre-tax margin decreased 170 bps on a year-over-year basis but increased 50 bps sequentially to 20.1% in the quarter.

Employer Services, PEO Services and Dealer Services pre-tax margins fell 0.8%, 0.4% and 2.6%, respectively, in the quarter.

Revenue
Revenues increased 9.4% year over year and 7.9% sequentially to $2.41 billion in the second quarter, comfortably surpassing the Zacks Consensus Estimate of $2.34 billion. Organic growth was 5.0% in the quarter. Unfavourable foreign currency exchange had a negative impact of 1% on revenue growth.

The strong year-over-year growth was primarily driven by new business sales from Employer Services and PEO Services that grew 16% in the quarter.

Employer Services revenue increased 7.0% year over year (4.0% organically) to $1.92 billion. In the United States, revenues from traditional payroll and payroll tax filing business were flat.

Excluding payroll, revenues grew 16% in the quarter, driven by acquisitions. The number of employees on clients' payrolls in the United States grew 2.4% in the quarter, on a same-store sales basis. Worldwide client retention improved 0.8% year over year.

PEO Services revenue was up 15.0% year over year at $355.7 million in the second quarter. Interest on funds held for clients increased 1.0% year over year to $129.0 million owing to a 9.0% rise in average client funds balances, partially offset by a decline of 30 bps in the average interest yield to 3.5%.

Balance Sheet and Cash Flow
As of December 31, 2010, cash and cash equivalents (including short-term marketable securities) were $1.34 billion compared with $1.22 billion in the previous quarter ended September 30, 2010.

Long-term debt decreased marginally to $35.1 million at the end of second quarter from $35.6 million in the prior quarter.

Year to date, Automatic Data Processing acquired nearly 2.4 million shares of its stock for treasury at a cost of about $102 million.

2011 Guidance
Automatic Data Processing expects year over year expense and earnings comparisons to alleviate in the second half of fiscal 2011.

Total revenue is expected to increase 5.0% year over year, up from the prior growth rate of 3.0% to 5.0%. Including acquisitions, the growth is expected to be 9.0% up from the prior forecast of 7.0% to 8.0%. The Zacks Consensus Estimate is currently pegged at $9.55 billion.

Employer Services is expected to achieve 5% revenue growth, up from the prior forecast of a 4% growth on continued positive trends in key business metrics. Including acquisitions, Automatic Data Processing anticipates 6% to 7% revenue growth, up from the prior forecast of about 5% growth.

The company expects pays per control to increase approximately 2.0%, up from the prior forecast of a growth of 1.0%. Client revenue retention is expected to increase over 0.5%, up from the prior forecast of approximately 0.5% for fiscal 2011.

Employer Services pre-tax margin is expected to increase 50 bps. Including acquisitions, management anticipates up to 20 bps of pre-tax margin improvement.

PEO Services revenue is projected to improve 15.0%, up from the previous forecast of 13.0% to 15.0% growth. Management continues to anticipate a decline in pre-tax margin due to increased benefits, pass through revenues and the grow-over impact of $9 million favourable state unemployment tax settlement in 2010.

Employer Services and PEO Services new business sales are estimated to see high single-digit growth as compared with $1.0 billion in fiscal 2010.

Dealer Services revenue is expected to increase 2% to 3%, up from 2% growth projected previously, due to the positive results achieved during the second quarter.

Automatic Data Processing anticipates at least 50 bps of pre-tax margin improvement, up from the prior forecast of a slight improvement. Including acquisitions, management continues to anticipate revenue growth of over 20%.

Interest on funds held for clients is expected to decline 3% to 4% from $542.8 million in fiscal 2010. This is based on an approximate 30 to 40 bps decline in the expected average interest yield to about 3.2% to 3.3%, partially offset by a 7% to 8% growth in average client funds balances.

Automatic Data Processing expects earnings per share to increase 5.0% from $2.37 in fiscal 2010. The Zacks Consensus Estimate is currently pegged at $2.47.

Our Take
We remain Neutral on a long-term basis (6–12 months). We believe Automatic Data Processing’s second quarter results reflect the sluggish U.S. employment market and tough competition from Paychex Inc. (PAYX). However, we believe the strong fiscal 2011 outlook suggests a positive second half, driven by higher client retention and new business sales from Employer Services and PEO Services.

Currently, Automatic Data Processing has a Zacks #3 Rank, which implies a Hold rating on a short-term basis.

Source: ADP Beats Estimates, Raises Guidance