AUTOMATIC DATA PROCESSING INC quarterly report, Q2 FY2011

ADP 10-Q Summary

Business context and reporting period

Automatic Data Processing, Inc. (ADP) filed its unaudited quarterly report for the quarter ended December 31, 2010, the second quarter of fiscal 2011. ADP operates Employer Services, PEO Services and Dealer Services. Comparisons are with the three and six months ended December 31, 2009; balance-sheet comparisons are with June 30, 2010. Dollar amounts below are in millions except per-share data.

Financial performance and position

Metric	Three months	Six months
Total revenue	$2,405.7; up 9%	$4,635.2; up 8%
Pre-tax earnings from continuing operations	$484.6; up 1%	$921.0; down less than 1%
Pre-tax margin	20%, versus 22%	20%, versus 22%
Net earnings from continuing operations	$310.1; down 2%	$588.6; down 2%
Diluted continuing-operations EPS	$0.62; unchanged	$1.19, versus $1.18
Operating cash flow	Not reported for the quarter in the supplied filing text	$647.3, versus $672.9

• Revenue growth reflected all three segments: Employer Services revenue rose 7% for the quarter, PEO Services 15%, and Dealer Services 26%. ADP said total revenue would have grown about 5% for the quarter and 4% for the half-year excluding recently completed acquisitions.
• For the six months, investing activities used $6,138.1 and financing activities provided $5,130.3. Cash and cash equivalents declined $337.6 to $1,305.7. These cash flows include substantial client-fund investment and obligation movements and should not be read as corporate operating cash needs alone.
• At December 31, cash and marketable securities were $1,441.3; working capital excluding client funds and related obligations was $1,342.2, down from $1,568.6 at June 30. Stockholders’ equity was $5,775.6.
• Long-term debt was $35.1, and the long-term-debt-to-equity ratio was 0.6%. No commercial paper, reverse-repurchase obligations or borrowings under revolving credit agreements were outstanding at period end. ADP reported $6.25 billion of committed revolving credit facilities and a $6.25 billion commercial-paper program.
• Funds held for clients were $24,218.5, against client-fund obligations of $23,682.1. These restricted client-related balances are distinct from ADP’s corporate cash and debt.
• Dividends declared were $0.36 per share for the quarter and $0.70 for the half-year. ADP paid $335.6 in dividends and repurchased $102.1 of common stock during the half-year.

Changes versus prior comparable periods

• Revenue grew faster than pre-tax earnings: expenses increased 12% in the quarter and 10% in the half-year. Operating costs included higher PEO pass-through costs, acquisition-related expenses, and increased sales and service staffing.
• Employer Services’ pre-tax earnings rose 4% in the quarter and 3% in the half-year, while its margins declined. PEO Services’ quarterly pre-tax earnings rose 10%, but half-year earnings fell 6%, partly because the prior-year period included a $9.2 benefit from settling a state unemployment tax matter. Dealer Services’ pre-tax earnings rose 7% and 10%, respectively.
• Dealer Services’ reported growth included acquisitions; the filing estimates organic growth of approximately 4% for the quarter and 2% for the half-year. Dealer client losses from dealership closures and service cancellations continued to offset growth.
• Lower prior-year tax expense benefited comparisons: the 2009 periods included a $12.2 tax-provision reduction from resolution of tax matters. The 2010 effective tax rates were 36.0% for the quarter and 36.1% for the half-year, versus 34.2% and 35.3%.
• ADP acquired six businesses, including Cobalt for approximately $405.0 net of cash acquired. Acquisitions contributed to increases in goodwill and intangible assets; goodwill rose to $2,878.8 from $2,383.3 at June 30.

Outlook, commentary, risks and unusual items

• Management described improving trends in client retention and pays per control in Employer Services, continued PEO worksite-employee growth, and stabilization in the automotive sector. It also cited increased Dealer Services transaction activity, while noting ongoing dealership-related client losses.
• ADP did not provide a specific earnings or revenue forecast in the supplied filing text. It expected acquisitions to have no material impact on fiscal 2011 earnings and forecast fiscal 2011 capital expenditures of $160–$180, compared with $90.2 in fiscal 2010.
• Client-fund interest income is sensitive to rates: the average yield on client funds fell to 3.5% in the quarter and 3.6% in the half-year, from 3.8% and 3.9%. ADP estimated that a 25-basis-point change in both short- and intermediate-term rates could affect pre-tax earnings by about $8 over the following 12 months; a 25-basis-point short-rate-only change could affect them by about $4.
• ADP reported $69.8 of unrealized losses on available-for-sale securities, attributed primarily to interest-rate changes rather than credit losses; all were in loss positions for less than 12 months. Approximately 86% of available-for-sale securities were rated AAA or AA, and all were investment grade.
• Unusual items included an $8.6 impairment charge on two buildings held for sale in the half-year, partly offset by $1.8 of gains on building sales. The prior-year half-year included a $5.3 securities impairment charge.
• A purported California class action alleges unlawful handling of certain client calls and seeks statutory damages. ADP intends to defend the matter and says it believes it has indemnification from the third-party vendor involved; it considers a material adverse effect unlikely, but states it is too early to determine potential exposure. Other ordinary-course claims were not expected to materially affect results.
• Other cited risks include employment and wage levels, economic conditions and interest rates, foreign exchange, competition, regulation, technology, acquisitions, and automotive-industry conditions. ADP said there were no material changes to the risk factors in its fiscal 2010 Form 10-K.

Important facts for investors to verify

• Whether revenue growth excluding acquisitions translates into improving margins and earnings, given expenses grew faster than revenue.
• How client-fund yields and interest rates affect revenue and earnings, and whether client-fund liquidity remains adequate under stressed financing conditions.
• Acquisition performance, including Cobalt’s contribution, purchase-price allocation, and the substantial goodwill and intangible-asset balances.
• Progress on Dealer Services’ organic growth and the effect of continuing dealership closures and client losses.
• Developments in the class action, the asserted vendor indemnification, and the recorded building impairment and disposal plans.
• Execution of the $160–$180 fiscal 2011 capital-expenditure plan and continued dividend and share-repurchase spending.