Automatic Data Processing (NASDAQ:ADP), the largest provider of payroll processing & human capital management solutions in the U.S., is about to release its FY 2013 annual results on August 1. ADP derives a lion’s share of its revenues from payroll processing, which is directly impacted by the strength of the labor market in the economy. With the employment situation stabilizing in the US, ADP is likely to report its financial numbers, in line with its guidance. ADP has guided for 6-7% growth in revenues for FY2013 over the previous year and a pretax margin expansion of at least 50 basis points for its Employer Services division, which is its most important business segment.
One of the major determinants of ADP’s stock value is the interest it earns on the client’s funds, which accounts for 20-25% of its operating income. ADP earns this income by investing the client’s funds in U.S. Treasury securities before passing them on either as tax payment to the IRS or payment to the client’s employees. In this way, interest rates in the US economy and the average client’s funds held by the company significantly affect ADP’s earnings. The interest earned on client’s funds has been subdued for the last few years due to the ultra low interest rate environment prevailing in the US economy. However, the recent hike in yields caused by concerns over the Federal Reserve’s plans to gradually taper off its QE program is likely to give an added boost to ADP’s earnings.
Lower interest income due to low interest rates have been partially offset by rising client’s fund balances. Hence we will be closely looking at the ADP’s average investment balances (client’s funds) to see how they are holding up.
Jobs Sentiment Improving
ADP’s major business segments – Employer Services and PEO Services – have a direct relationship with the jobs scenario in the US economy. Fortunately for ADP, job growth has picked up in the last few months, showing renewed hiring interest particularly in the small and medium business segments of the U.S. economy. The latest employment report published by ADP in collaboration with Moody’s Analytics shows that in June 2013, the U.S economy added 188,000 private sector jobs compared to an addition of 134,000 jobs in May.  Most of June’s job additions came from the small business segment (1-49 employees) which added 84,000 jobs. In comparison, medium sized businesses (50-499 employees) and large businesses (more than 500 employees) added 55,000 and 49,000 jobs respectively. According to another report from ADP, the U.S economy added 27,910 franchise jobs in June compared to 19,160 jobs in May, with restaurants contributing 75% of the franchise job growth.  Overall, the employment scenario seems to be improving and is likely to benefit ADP in the form of increased number of client employees.
Impact of Rise In US Bond Yields
A distinctive part of ADP’s business is the interest that it earns on funds held for its clients. Historically, the interest earned on client’s funds as a percentage of ADP’s operating income has been more than 30%. For instance, in FY2008, it accounted for almost 35% of ADP’s operating income. In absolute terms, ADP earned $680 million as interest on client’s funds in 2008. In FY2012, however, ADP earned only $490 million, translating into 22% of operating income. Both the relative and absolute figures for interest on client’s funds have taken a beating in the last few years due to the ultra low interest rates prevailing in the US economy.
However, if the recent reversal in yields is anything to go by, a sustained and steady increase in interest rates over the next few years could significantly increase ADP’s earnings. In June 2013, the U.S. Federal Reserve Bank indicated that it plans to taper off its QE-bond buying program if the U.S economy continues to gain strength. This led to a sudden jump in bond yields which would benefit ADP if interest rates continue to crawl back to their normal levels.  In the last two months alone, yields on 10-year U.S. government bonds have increased from 2.1% to 2.6%. As far as average client’s funds are concerned, ADP has been able to grow them steadily from 2010 onwards with anticipated FY2013 growth of 5-7%.Notes: