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Automatic Data Processing Inc. (ADP - Analyst Report) reported third-quarter fiscal 2014 earnings from continuing operations of $1.06 per share, which missed the Zacks Consensus Estimate by a couple of cents.

Quarter Details

Revenues increased 6.8% year over year to $3.32 billion, which missed the Zacks Consensus Estimate of $3.34 billion. The year-over-year growth was driven by strong results from Employer Services, PEO Services and Dealer Services segments.

Employer Services revenues increased 5.7% year over year to $2.35 billion. The number of employees on clients’ payrolls in the United States grew 2.8% in the quarter on a same-store-sales basis.

PEO Services revenues rose 15.1% year over year to $650.8 million in the reported quarter. Dealer Services revenues increased 6.8% on a year-over-year basis to $494.9 million.

In the quarter, combined worldwide new business bookings for Employer Services and PEO Services grew 14.0% year over year. New business bookings represent annualized recurring revenues anticipated from new orders.

Interest on funds held for clients declined 10.6% year over year to $100.1 million. The decline was primarily due to a 30 basis points (bps) drop in average interest yield to 1.6%, which was offset to a certain extent by an increase of 9% in average client funds balances from $23.2 billion to $25.2 billion.

Total expenses in the reported quarter increased 6.7% year over year to $2.56 billion, attributable to higher operating expenses (up 8.2% year over year), selling, general & administrative expense (up 3.0% year over year) and systems development & programming costs (up 10.0% year over year).

ADP reported pre-tax earnings of $769.8 million from continuing operations, up 6.4% from the year-ago quarter. Employer Services, PEO services and Dealer services pretax income increased 8.0%, 11.0% and 16.0%, respectively, on a year-over-year basis in the reported quarter.

Net income from continuing operations was $510.4 million or $1.06 per share compared with $481.6 million or 99 cents in the year-ago quarter. This excludes one-time gain of $11.2 million, ADP earned from the divestment of a certain business unit during the quarter. Including this gain, the company reported net income of $521.6 million or $1.08 per share.

ADP exited the quarter with cash and cash equivalents of $1.69 billion compared with $1.29 billion in the previous quarter. Long-term debt was $12.1 million versus $12.6 million in the previous quarter.

Dealer Services Spin-off

Recently, ADP announced its plans to spin-off the Dealer Services business into an independent publicly traded company. ADP expects the spin-off to be completed in Oct 2014. The Dealer Services business segment provides marketing solutions to over 26,000 auto retailers, distributors and manufacturers.

The 100% tax-free spin-off will help ADP to focus more on its core Human Capital Management (HCM) business, going forward. Per management, the strong long-term growth prospect of the automotive market will provide significant growth opportunities to the Dealer Services business.

The transaction is expected to provide ADP at least $700.0 million, which it plans to use in buying back shares. ADP expects to keep the current quarterly cash dividend of 48 cents per share constant for the time being. Post the spin-off, the company expects to eventually raise its dividend payout ratio to 55.0–66.0%.

Guidance

ADP expects fiscal 2014 revenues to grow 8.0% (prior outlook 7.0% to 8.0%) on a year-over-year basis. Earnings growth is projected to be 9.0% (prior outlook 8.0% to 10.0%).

Employer Services revenues are expected to grow approximately 7% with a pre-tax margin expansion of approximately 100 bps. PEO Services revenues are expected to improve 14.0% (prior outlook 12.0% to 13.0%). Pre-tax margin is expected to grow slightly on a year-over-year basis.

Combined Employer Services and PEO Services new business bookings are forecasted to be approximately 8.0% for fiscal 2014.

ADP expects Dealer Services revenues to increase 8.0% with a pre-tax margin expansion of approximately 100 bps.

Our Take

We believe that the Dealer-services spin off will remain an overhang on the stock in the near term. Although the plan is shareholder-friendly, it did not go down well with credit rating agencies.

Following the announcement, the Standard & Poor’s lowered ADP’s credit rating from AAA to AA, primarily due to the company’s plan of using the proceeds to buy back shares. Moody’s’ (MCO - Analyst Report) Investor service also decreased its rating to Aa1, citing lower scale and variety of ADP’s product portfolio.

Nevertheless, ADP is expected to perform better on the back of improved execution and higher client retention. Moreover, recovery in the job market will help the company. However, volatile macroeconomic environment and increasing competition from Paychex Inc. (PAYX - Snapshot Report) and Equifax Inc. (EFX - Analyst Report) are the near-term headwinds.

Currently, ADP has a Zacks Rank #3 (Hold).

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