It All Adds Up for ADP

The company's greater focus on its Employer Services business has prompted S&P to give ADP its highest rating: 5 STARS

We think that shares of Automatic Data Processing (ADP; $49) are undervalued, given the strides the company has made (and is making) in streamlining its business. By our analysis, last year's sale of its Claims Services business and the planned spin-off of the Brokerage Services business will allow management to better focus on its Employer Services business, which we believe has the potential to increase revenues at a midteens rate.

Also, additional cash should allow ADP the financial flexibility to buy back more shares, increase its dividend, or expand into new geographic areas and service lines that would leverage its strong capabilities around the Employer Services segment, in our view. The stock carries S&P's highest investment ranking of 5 STARS (strong buy).

Automatic Data Processing was incorporated in 1961 and is one of the largest payroll-outsourcing services in the world, based on revenue. Following the planned spin-off of its Brokerage Services business (which will include the Securities Clearing & Outsourcing Services unit), it will be comprised of two main businesses: Employer Services (accounting for roughly 85% of total revenues post spin-off) and Dealer Services (15%).

Paycheck Preparation

The Employer Services business provides payroll processing, human-resource information, and benefits-administration products and services. The unit had roughly 545,000 clients at the end of fiscal 2006, across the U.S. (85% of revenues in fiscal 2006), Canada (4%), Europe (10%), and South America, Australia, and Asia (1%). The division has its own direct sales force, but does derive some sales from indirect channels.

Employer Services markets its products and services to employers of all different sizes through its three groups: Small-Business Services (for companies with 49 or fewer employees), Major Accounts Services (50 to 999 employees), and National Account Services (1,000 or more employees).

This unit offers services including preparation of client employee paychecks and electronic deposits, and preparation of reports for management and associated tax reports for appropriate federal, state, and city agencies. It can also aid in a company's hiring process by performing background checks, reference verification, and operating a human-resources help desk. The division also offers benefits administration services, including open enrollment, COBRA, and flexible spending accounts. On the retirement end of the spectrum, it offers record-keeping and administrative services for corporate retirement and deferred compensation plans.

New Markets Eyed

For clients looking to outsource a large portion or all of these functions, Employer Services also provides business process outsourcing, which allows the client to outsource its HR, payroll, payroll-administration, employee service center, benefits-administration, and time- and labor-management functions.

Overseas, Employer Services offers its GlobalView product, which uses an SAP (SAP) platform for standardized payroll processing and human-resource administration. GlobalView is available in 31 countries. We believe the company's efforts outside the North American market will be a major growth catalyst in coming years, especially as the acceptance of outsourcing non-essential functions grows.

We believe ADP will be able to expand into new product markets and move deeper into the small and midsize market, as well as internationally. One area where we see ADP expanding further is human resources business process outsourcing (HR BPO), which integrates the company's core payroll services with other products such as benefits and retirement-plan outsourcing. We also believe an opportunity exists with companies in the small and midsize segment. While Employer Services already markets to companies of all sizes, penetration rates are relatively low, in our opinion, compared with larger companies.

Brokerage Unit Spin-Off

The Dealer Services business provides dealer management systems to automotive, heavy-truck, and power-sports retailers around the world. At the end of fiscal 2006, 25,500 dealers used this division's system or other offerings it provides. The main system manages activities such as accounting, inventory management, factory communications, scheduling, vehicle financing and insurance, sales, and service. It also offers a suite of Web-enabled services, in addition to computer hardware, hardware-maintenance services, and software support.

In April, 2006, the company completed the sale of its Claims Services business. Net cash from the transaction was about $760 million. With this infusion of cash, ADP ended fiscal 2006 with over $2.3 billion in cash, cash equivalents, and short-term marketable securities on its balance sheet, an increase of roughly 50% over the prior fiscal year. The cash allowed the company to continue its share buyback program and increase its quarterly dividend by 24%, to 92 cents per share annually.

In August, 2006, ADP announced the proposed spin-off of the Brokerage Services unit, subject to regulatory approval. The spun-off company, to be named Broadridge Financial Solutions, would pay a roughly $800 million one-time distribution to ADP, which the company will likely use for further share repurchases. We believe the divestiture of these two units will allow ADP to better focus on its Employer and Dealer Services businesses.

Forecast for Growth

We believe the company's strong balance sheet, with $1.5 billion in cash and a modest $74 million in long-term debt as of the end of December, 2006, gives it a level of financial flexibility that its rivals don't have, and positions ADP to make acquisitions, repurchase shares, and continue to raise its dividend, which it has done for 32 consecutive years.

We look for ADP, as it's currently comprised (including the Brokerage Services business), to increase revenues by about 11% in fiscal 2007 and 10% in fiscal 2008. Within the individual segments, we see low double-digit growth in both the Employer and Dealer Services segments, offset somewhat by a slower advance in Brokerage Services. We expect the proposed spin-off of the latter unit to be completed by the end of March, however, which should aid ADP's growth going forward.

Operating margins in fiscal 2007 could be somewhat constrained, in our view, due to integration costs from the acquisition of Kerridge Computer (see below) and expenses surrounding the upcoming spin-off. Also, the company has been making investments back into the business, including the hiring of more salespeople in Employer Services. We think these costs will be offset by rising revenues from the two divisions and increased income on funds held for clients.

HR-Outsourcing Opportunities

By fiscal 2008, we believe that some of the aforementioned spending will be completed and look for a fully integrated Kerridge to begin to help widen margins. In all, we see an improvement in the annual operating margin next fiscal year.

We see the company's Employer Services division as well-positioned for growth. The use of human-resources outsourcing should continue to grow, in our view, and we believe ADP's deep penetration into the payroll-processing market gives it a twofold advantage. First, it may already be a supplier to a company looking to outsource its HR functions. Second, it has the benefit of being a well-known supplier of HR-related services.

Competition in the HR-outsourcing space is intense, but we believe the barriers to entry are quite high, as a sizable infrastructure is needed to process a large number of employees. We think competition may become more challenging in the future, as companies that currently offer outsourcing of business processing in other areas of the market (such as finance and accounting) may look to expand their service offerings.

Outlook for Earnings

We look for ADP to continue to make acquisitions, reflecting the financial flexibility it has, largely owing to a strong balance sheet. For example, in late 2005, it purchased Kerridge, a leading provider of dealer-management systems in Britain, for $300 million. The purchase bolstered the Dealer Services unit's overseas exposure. At the end of December, 2006, ADP had $1.5 billion in cash and a debt-to-total capital ratio of about 1%.

For fiscal 2007, we expect operating earnings of $2.23 per share. The 20% growth in operating earnings we anticipate this fiscal year reflects our expectation for top-line growth as well as the repurchase of nearly 18 million shares through the first six months of the year. In fiscal 2008, we look for earnings per share of $2.54, based on revenue growth combined with a widening of operating margins.

ADP shares are currently trading at approximately $49, which leaves the shares with appreciation potential of about 20% to our 12-month target price of $59.

No Poison Pill in Place

We base our target price on a blend of relative valuation and discounted cash flow (DCF) metrics. We use a peer-average price-earnings ratio of 25 times applied to our calendar 2007 EPS estimate of $2.36 to arrive at a value of $59. Our DCF model yields an intrinsic value of $58.

We have a generally positive view of ADP's corporate-governance policies. We view favorably that greater than two-thirds of the board of directors is made up of independent outsiders, both the compensation and audit committees are comprised solely of independent outsiders, and that there's no poison-pill provision in place.

Negative factors, in our view, include a lack of annual reviews of individual directors and the fact that the board can amend the bylaws without shareholder approval.

Risks to our recommendation and target price, in our opinion, include the threat of competitors moving into the human resources outsourcing market segment, which could lead to pricing pressure and weaker margins. Other risks include the difficulties ADP could experience in attempting to broaden its reach both overseas and into the market for smaller companies, and a weakening of the employment market.

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