Automatic Data Processing, Inc



|Automatic Data Processing, Inc. |(ADP-NASDAQ) |$130.65 |

Note: This report contains substantially new material. Subsequent reports will have new or revised materials highlighted.

Reason for Report: 3Q FYQ18 Earnings Update

Prev. Ed.: 2Q FY17 Earnings Update

Brokers’ Recommendations: Neutral: 78.8%↑ (14 firms); Positive: 22.2% (4); Negative: 0.0% (0) Prev. Ed.:14; 4; 0

Brokers’ Target Price: $126.14↑ ($6.98↑ from the last edition; 6 firms) Brokers’ Avg. Expected Return: 3.6%

Executive Summary

Automatic Data Processing Inc. (ADP) provides business outsourcing solutions, which include human resource, payroll, tax and benefits administration services. The company’s services also include securities transaction processing, investor communications, computing solutions for auto retailers/manufacturers, and automated solutions for the property/casualty insurance industry. The company reported revenues of $12.38 billion in FY17.

Key factors for determining an investment strategy for ADP are as follows:

• The company has made significant investments in new services, which include time and labor management, benefits administration, retirement recordkeeping and administration, and HR administration services that are beginning to perform impressively.

• The company continues to return cash to shareholders via dividend payments and share repurchase activities.

• ADP’s balance sheet is strong.

• The payroll processing sector had limited competition in the past, but several potential entrants and existing competitors (e.g., Paychex, Insperity) are rapidly gaining traction.

Of the 18 firms covering the stock, 14 firms provided a neutral rating; four firms assigned a bullish rating, while no firms rated the stock negatively. Target prices range from $85.00 to $138.00, with the average price being $119.16. The firms’ average expected return over the current share price is 6.7%.

Neutral Stance (Neutral or equivalent rating) – 14 firms or 77.8%– These firms are on the sidelines as they believe that ADP’s current valuation already reflects prospects of a rising interest rate environment, higher job growth and lower taxes. Moreover, slowdown in bookings and declining retention rate will hurt top-line growth. Most of them believe that the company faces significant competition in the human capital management (HCM) market from new entrants, that is hurting market share. Nevertheless, some firms believe that healthy demand for the company’s HCM solutions will drive growth. Further, ADP continues to launch innovative new solutions that effectively address client needs and differentiate it from competitors. Moreover, the company’s solid liquidity position gives it the flexibility to pay dividends and make share repurchases as well as acquisitions.

However, most of these firms don’t believe that activism from Pershing Square will enhance the company’s overall growth prospects or attractiveness among investors at least in the near term. In fact, some of the firms believe that the company is already working on many of the issues raised by the activist investor. However, major clients are resistant to change. Amid stiff competition, rapid change could increase attrition rate, which would hurt client retention rate.

Bullish Stance (Buy or equivalent rating) – 4 firms or 22.2%

Bearish Stance (Sell or equivalent rating)

Feb 12, 201

Overview

Automatic Data Processing Inc. (ADP), based in New Jersey, provides computerized transaction processing, data communication and information services worldwide.

Key investment considerations as identified by the firms are as follows:

|Key Positive Arguments |Key Negative Arguments |

|ADP has solid growth potential due to increasing complexity and legal |As the company generates revenues from interest on funds held for clients, |

|liability of administering human resources. |fluctuations in interest rates could cause volatility in ADP's revenues and |

|A solid balance sheet and impressive cash flow have improved the liquidity|earnings. |

|position of the company. |Competitors are fast gaining traction in the payroll/ HCM market, which |

|High dividend yields will likely improve shareholders’ value, which in |could have an adverse impact on ADP’s top line growth. |

|turn will drive EPS growth. | |

The Employer Services segment includes human resource information, payroll processing, human resources tax and compliance management, retirement services, time and attendance management services and benefit administration products and services.

The Professional Employer Organization (PEO) Services segment provides approximately 7,800 clients with employment administration outsourcing solutions, including payroll, payroll tax filing, HR guidance, 401(k) plan administration, benefits administration, compliance services, health and workers' compensation coverage and other supplemental benefits to the employees.

For further information, please visit: .

Note: ADP’s fiscal year ends on Jun 30; fiscal references differ from the calendar year.

Feb 12, 2018

Long-Term Growth

ADP has solid financials, enjoys a leadership position in core businesses, has a proven recurring revenue model, generates strong free cash flow and undertakes shareholder-friendly actions. At its Analyst Day last year, the company stated that it expects long-term growth in booking rates to be 8% to 10%, revenues to grow in a range of 7-9% and EPS to grow 12-14%. Currently, long-term EPS growth for ADP is pegged at 10.3%.

In a latest presentation (related to proxy fight with Pershing Square) filed with the Securities and Exchange Commission (SEC), ADP stated that margins have expanded 580 basis points (bps) over the past six years. Total research & development (R&D) spending has amounted to $859 million at a CAGR of 8%, while R&D spending for innovation over the same time period has increased to $450 million at a CAGR of 20%.

Management stated that 84% of small and mid-market clients have been migrated to its cloud-based platforms, but they represent only 51% of ES revenue. The remaining 49% of revenues to be migrated represents enterprise, multinational and HRBPO clients. ADP noted that a 1% increase in client attrition among this group would require a 400 bps increase in bookings to offset.

Per management, ADP is working to reduce service office footprint from 110 non-sales locations in the beginning of FY17 to 81 locations by the end of the fiscal year. This is further anticipated to reduce to 48 locations by the end of FY19.

ADP still expects revenue growth at a CAGR of 7-9% through FY20. HRBPO is expected to be the fastest growing segment (12-14% CAGR) but with lower margin profile. High margin HCM business is expected t at 5-6% CAGR, while global solutions are expected at 6-7% CAGR.

Moreover, ADP expects core margins to expand almost 500-600 bps through FY20.

Management believes that cross-selling opportunities, expansion into under-served international markets, acquisitions, and improvement in operating efficiencies could enable ADP to generate mid-teens earnings growth over the next three to five years.

Most firms believe that increasing complexity and legal liability of administering human resources bode well for ADP. They expect the company to gain from its dominant position in the payroll processing and human resources outsourcing market. They believe that the long-term growth targets are achievable, despite an intense competitive environment, due to the cross-selling opportunities and continued migration of existing clients to newer platforms.

The firms believe that the strength in PEO reflects a favorable fundamental backdrop. Moreover, investments throughout the downturn and accelerated sales force hiring will improve ADP's competitive position. The company has been investing in a broad range of solutions ─ both for improving core payroll offerings, as well as developing its Beyond Payroll and GlobalView offerings, which provide it a significant opportunity to leverage its broad, valuable client relationships.

Moreover, diversification of its core payroll offerings (RUN and Workforce Now) provides ADP with a long-term growth opportunity. Additionally, the introduction of Vantage HCM, a SaaS-based solution is expected to provide the company a competitive edge over its peers.

Overall, despite the near-term pressure from increased investments, the firms believe that the investments ADP is making to boost its sales force and innovative products should enable it to deliver consistent revenue and earnings growth over the long term. Feb 12, 2018

Target Price/Valuation

Provided below is a summary of valuation and ratings as compiled by Zacks Digest Research:

|Rating Distribution |

|Positive |22.2% |

|Neutral |77.8% |

|Negative |0.0% |

|Average Target Price |$126.14↑ |

|Digest High |$140.00↑ |

|Digest Low |$100.00↑ |

|No. of Firms with Target Price/Total No. of Firms |14/18 |

Potential risks to the target price include weakness in the U.S. economic environment, a declining interest rate trend, and ADP’s failure to deliver margin expansion.

Recent Events

On May 2, 2018, ADP reported 2Q18 results. The highlights are as follows:

• Revenues increased 8% y/y to $3.69 billion.

• Adjusted EPS increased 16% y/y to $1.52.

• Worldwide new business bookings increased 9%.

On Apr 11, 2018, ADP’s board of directors declared a regular quarterly dividend of 69 cents per share payable on Jul 1, 2018 to shareholders of record on Jun 8, 2018. This dividend increase of 10% came on the back of the benefits from the new tax (Tax Cuts and Jobs Act – enacted in December 2017).

Revenues

According to the 3Q18 press release, revenues of $3.69 billion grew 8% on a y/y basis. Organically, revenues rose 6% y/y. Worldwide new business bookings increased 9%. The company raised its new business bookings guidance, which was in the range of 6-7%.

Segment Details

Employer Services revenues of $2.80 billion increased 7% year over year on a reported basis and 4% on an organic constant-currency basis. The number of employees on ADP clients' payrolls in the United States rose 2.9% on a same-store-sales basis. Client revenues retention increased 170 basis points (bps) on a year-over-year basis.

PEO Services revenues were up 10% year over year to $1.1 billion. The upside was driven by 9% increase in average worksite employees. Average worksite employees paid by PEO Services were roughly 512,000.

Interest on funds held for clients in the fiscal third quarter increased 21% to $135 million. The company’s average client funds balances climbed 6% year over year to $28.8 billion, while average interest yield of 1.9% was up 20 bps on a year-over-year basis.

Provided below is a tabular representation of sources of revenue as compiled by Zacks Digest:

Guidance

ADP anticipates FY18 revenue growth in the range of 7-8%. Acquisitions and the impact from foreign currency translation are projected to add approximately two percentage points of growth to revenues.

ADP expects pays per control to increase 2.5% for FY18. For the PEO Services segment, management anticipates revenue growth of 12%.

Interest on funds held for clients is projected to increase about $65 million or about 16%. This is based on anticipated growth in average client funds balances of approximately 5% from $23.0 billion in FY17 and an average yield which is projected to increase about 20 bps to 1.9%. The total contribution from the client funds extended investment strategy is expected to be up $50 million over FY17.

Outlook

Firms believe that ADP’s continuing investment on mobile and cloud-based technologies and solutions has improved its footprint in the payroll processing market. They also believe that the data captured from these solutions enables the company to provide deep insight analytics to better serve their employees. This is also providing ADP a competitive edge.

Some firms expect retention to remain solid for the rest of FY18. However, lumpiness is expected 4Q18 due to the transition of all remaining mid-market clients to current platform by the end of CY18.

Most of the firms believe that ADP will benefit from solid growth in the PEO business, international growth and positive impact from rising interest rates in the medium-term

Please refer to the Zacks Research Digest spreadsheet on ADP for more details on revenue estimates.

Margins

According to 3Q18 press release, adjusted EBIT margin contracted almost 20 bps to 24.4% primarily due to higher pass-through revenues and expenses related to acquisitions.

Employer Services segment margin fell approximately 20 bps on a y/y basis. PEO Services segment margin improved approximately 40 bps in the quarter.

Guidance

Adjusted EBIT margin is anticipated to be more or less flat for FY18 compared to the prior anticipation of a decline of almost 50 bps. Currently, ADP expects an adjusted effective tax rate of 26.2% compared with previous forecast of 26.9% for FY18.

Employer Services segment revenues is expected to grow in the range of 5%. Margin is expected to be flat with the year ago quarter.

Firms’ Outlook

Few firms with neutral rating believe that profit margins will improve over the next few years due to increasing interest rates. However, unfavorable revenue mix (due to faster PEO growth), significant sales force growth and higher spending on the changes to the company’s client service business model will hurt margin expansion in the near term.

Please refer to the Zacks Research Digest spreadsheet on ADP for more details on margin estimates.

Earnings per Share [NOTE: Only highlighted material has been changed]

ADP reported 3Q18 adjusted EPS of $1.52, which increased 16% on a y/y basis.

Guidance

ADP expects adjusted EPS to grow in the range of 16-17%, up from 12-13%.

Firms’ Outlook

Most firms believe that the raised guidance reflects Global Cash Card acquisition, a lower tax rate, favorable exchange rates and better interest income. Some firms believe that the company is aiming to return to its long-term model for low- to mid-teens EPS growth, as reflected by the revised guidance.

Please refer to the Zacks Research Digest spreadsheet on ADP for more details on EPS estimates.

|Analyst |Shuvra Shankar Dey |

|Copy Editor | |

|Content Ed. | |

|QCA |Maharathi Basu |

|Reason for Update |3Q FY18 Earnings Update |

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