ADP Earnings Preview: Increasing Employment And Treasury Yields Seen As Conducive To Growth

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ADP: Automatic Data Processing logo
ADP
Automatic Data Processing

Automatic Data Processing (NASDAQ:ADP), the largest provider of payroll processing and human capital management solutions in the U.S., is slated to release its results for the first quarter of fiscal year 2014 on Wednesday, October 30. The company posted healthy top line growth (7% y-o-y) in FY 2013, as new business bookings grew by 11% y-o-y and client retention reached all-time highs in Employer Services. [1]

ADP derives the majority of its revenues from payroll processing, which is directly related to the employment scenario in the economy. With the employment situation stabilizing in the U.S., ADP is likely to report its financial numbers in line with its guidance. The company has guided for a 7% increase in revenues in FY 2014, with broad-based growth across Employer, PEO and Dealer services. [2]

The interest earned on client funds is also one of the major determinants of ADP’s stock value as it accounts for 20-25% of the company’s operating income. ADP invests client funds in U.S. Treasury securities and takes a small percentage of the interest earned as commission. In this way, interest rates in the U.S. economy and average client funds held by the company significantly affect its earnings.

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The interest earned by ADP on client funds has been falling year-over-year due to the low interest rate environment prevailing in the U.S. economy. Hence, the recent hike in yields caused by concerns over the Federal Reserve’s plans to gradually taper off its Quantitative Easing  program is likely to give a much needed boost to ADP’s earnings.

Our current price estimate of $70 for ADP stands at a discount of over 5% to the market price.

See our complete analysis of ADP here

Improving Job Market To Support Payroll Processing Division

Employer Services and PEO Services, ADP’s major businesses in payroll  processing, have a direct relationship with the job market in the U.S. economy. The job market has picked up in the last few months across all segments of the U.S. economy, including small, medium and large businesses.

According to ADP’s monthly national employment report, over 70,000 jobs were added in the small business (1-49 employees) segment in both August and September; the medium business segment (50-499 employees) and the large business segment (>500 employees) added more than 100,000 jobs each in the two months combined. [3] Overall, the employment scenario seems to be improving and is likely to benefit ADP in the form of increased number of client employees.

Client Interest Revenue Drag To Slowly Reduce

The consistent decline in interest earned on client funds over recent years has been the most significant drag on ADP’s earnings. The company earned $684 million as interest on client funds in FY2008, which declined to $421 million in FY 2013, even as average client fund balances increased from $15.5 billion to $19.2 billion over the same period. As mentioned earlier, this was the result of the low interest rate environment in the U.S.

ADP sees the decline in interest earned on client funds to be bottoming out in terms of the size of the year-on-year decline, thanks to the rising yields on U.S. Treasuries. [4] The company estimates a total pre-tax impact of $50-$60 million in FY 2014 due to lower interest, which is lesser than the $88 million in FY 2013. Almost half of this is expected to occur in the first quarter, with reduced negative impact as the company progresses through the year. [5]

We will update our $70 price estimate for ADP based on the upcoming quarterly results.

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Notes:
  1. ADP 10-K FY 2013, www.sec.gov, August 19, 2013 []
  2. Fiscal 2013 Earnings Webcast & Conference Call, ADP Investor Relations Website, August 1, 2013 []
  3. ADP National Employment Trends, ADP Website []
  4. U.S. bond yields hit two-year high; emerging currencies slide, Reuters, August 19, 2013 []
  5. Automatic Data Processing Management Discusses Q4 2013 Results – Earnings Call Transcript, Seeking Alpha, August 1, 2013 []