ADP: In-Depth Analysis for the September 2010 Quarter

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Automatic Data Processing (NASDAQ: ADP) 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.

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 $0.54 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.

The company's market value is currently about $22 billion on a fully diluted basis.

ADP is one of four remaining 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.

In fiscal 2010, which ended 30 June, ADP earned $1.2 billion on Revenue of $8.9 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.

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 September quarter rose 6.4 percent, from $2.10 billion last year to $2.23 billion in the most recent period. Fluctuations in currency exchange rates shaved about 1 percent from revenue growth.

Reported revenue exceeded our $2.14 billion estimate by 4.2 percent.

Employer Services, the company's largest business segment, achieved Revenue growth of 5.6 percent, from $1.48 billion to $1.56 billion. Revenue from the company's "traditional" payroll businesses was up only 2 percent, which indicates healthier growth in new lines of business.

Revenue grew at a robust 15.2 percent at the Professional Employer Organization Services segment, from $296 million to $341 million.

The Dealer Services business reported a surprisingly strong 11.6 percent Revenue increase, from $302 million to $336 million. However, organic growth was only one percent as this unit continues to be affected by dealerships closings.

Operating Expenses were $1.12 billion, or 50.1 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 49.9 percent, a substantial 220 basis points less profitable than last September's 52.1 percent.

The latest Gross Margin was 210 basis points lower than our estimate of 52.0 percent.

Depreciation and amortization expenses were unchanged at $60 million, as expected.

ADP spent $135 million on "Systems Development and Programming Costs," which we treat as analogous to Research and Development. The expense was up $9 million (7.1 percent) from last year's $126 million. The latest figure matched our estimate exactly.

As a percentage of Revenue, R&D increased from 6.0 percent to 6.1 percent.

Sales, General, and Administrative expenses rose 4.9 percent to $516 million. The latest amount was just $2 million more than our $514 million estimate for the quarter. Reported SG&A expenses equaled 23.1 percent of Revenue, down from 23.4 percent last year.

Subtracting the various operating expenses from Revenue yields Operating Income of $402 million, which fell short of last year's $415 million by 3.2 percent. The latest Operating Income amount was only 0.5 percent less than our $404 million target, as higher-than-expected Revenue was offset by a lower-than-expected Gross Margin.
As for non-operating items, Other Income less Interest Expense equaled $35 million, net. This amount was only a little better than last year's $31 million, but it was quite a bit better than the $10 million we expected.

The effective Income Tax Rate was 36.2 percent in the September 2010 quarter. We had estimated the tax rate would be 35 percent.

At the bottom line, Net Income of $279 million was 2 percent less than income of $284 million in the September 2009 quarter. With fewer shares outstanding, earnings per share were unchanged at $0.56.

Reporting earnings were $10 million ($0.02 per share) more than our target for the quarter, in large part because Other Income was better than we anticipated.

In summary, the September quarter was mostly consistent with expectations. Revenue was better, but this was offset by a softer Gross Margin. There were surprises in the expenses, but other income was significantly better.

Full disclosure: Long ADP at time of writing.