Thomas A. McDonnell - Chief Executive Officer
Kenneth V. Hager - Chief Financial Officer, Vice President and Treasurer
James Kissane - BAS-ML
David Koning - Robert W. Baird
DST Systems, Inc. (DST) Q2 2009 Earnings Call July 23, 2009 11:00 AM ET
Ladies and gentlemen thank you for standing by and welcome to the DST Second Quarter Earnings Call. This time all participants are in a listen-only mode. Later we will conduct a question-and-answer session, instructions will be given to you at that time. [Operating Instructions]. And as a reminder today's conference call is being recorded.
I'd now like to turn the conference over to President and CEO, Mr. Tom McDonnell. Please go ahead.
Thomas A. McDonnell
Hi good morning. I'm joined this morning by -- with me here in Kansas are Tom McCullough and Ken Hager. Before we start I'd like to make a statement under the SEC procedures and rules.
If in the course of our conference call today we make forward-looking statements respecting DST and its businesses such statements would be based on our views as of today and actual results could differ. There could be a number of factors affecting future results including those that set forth in DST's latest periodic report, which we filed with the SEC.
All such factors should be considered in evaluating any forward-looking statements which we may make today. Our comments today on operating results are based on the results taking into account the items set forth in the press release under the section description of non-GAAP adjustments. A reconciliation of reported GAAP results to income adjusted for certain non-GAAP items accompanies the earnings release.
With that as background, taking in to account the non-GAAP adjustments, net income for the second quarter of 2009 totaled $44.8 million. That was $0.90 per diluted share. That compares to $53.7 million or $0.91 share per diluted share for the second quarter of 2008. That was a decrease of 16.6% of net income, but a decrease of 1.1% in diluted EPS.
Consolidated operating revenues decreased 22.1 million or 5.2% over the second quarter of 2008. So $404.500 million. Consolidated income from operations in the second quarter of 2009 decreased 14.5 million or 17.5% to $68.5 million. Other income increased by $1.3 million or $4.8 million for the quarter, that's from unrealized depreciation on marketable securities, designated as trading. That was partially offset by a decline in dividend income, interest income and higher accounts receivables, securitization programs costs of $800,000 incurred upon entering into that new program in May.
Dividend income declined by $2.9 million during the quarter, principally from the reductions in DST's quarterly dividend to $0.01 per share as compared to $0.24 per share in the second quarter of 2008.
In the Financial Services area, operating revenues decreased 6.8 million or 2.3% to $287.7 million as compared to the second quarter of 2008. Excluding the 22.3 million of incremental revenues resulting from the consolidation of Argus Financial Services -- from the consolidation of Argus, Financial Services operating revenues decreased $29.1 million during the second quarter of 2009 as compared to the same period in 2008.
International revenues decreased, reflecting lower volumes of international professional services and changes in foreign currency exchange rates. Mutual fund share owner processing service revenues declined from a lower level of registered accounts and track participants.
Lower data processing support revenues from DST Health Solutions and professional services were recorded. Software license fee revenues decreased 4.8 million or 30.8% to 10.8 million. The decreases are primarily due to lower AWD and investment management license free revenues.
Excluding reimbursable operating costs, cost and expenses increased by $7 million or 3.5% to 207.6 million. Cost and expenses include the Argus and BlueDoor technologies' consolidations and increase in deferred compensation cost of approximately $5.5 million, the effect of which is offset is unrealized gains on trading securities in the other income section.
In addition, there were $2.7 million of severance costs associated with reductions in international staffing levels. Foreign currency exchange effects between U.S. dollar and other currencies reduced costs by $5.4 million and compensation and benefit related costs were reduced at both international and domestic operations principally from lower staffing levels and lower travel related cost.
Depreciation and amortization cost decreased by $1.2 million in the second quarter of 2009. Financial services segment income from operations for the second quarter of 2009 totaled $61.9 million as compared to 74.5 million in the second quarter of 2008. That was a decrease of $12.6 million or 16.9%. Again 5.5 million of this decrease is attributable to an increase in the deferred compensation cost.
Other significant components affecting income from operation included reduced earnings from international operations, the consolidation of loses incurred by Argus, lower AWD software license revenue, lower data processing support revenues and reduced earnings from mutual funds shareowner processing.
The operating margin for the second quarter 2009 was 21.5% as compared to 25.3% in for the second quarter of 2008. Excluding the effect of the deferred compensation cost f referenced above, operating margin would have been 22.9% the second quarter in 2009 as compared to 24.8% for the second quarter of 2008.
International operations and losses from the consolidation of August were the primary reasons for the decline in operating margins. Turning to Output Solutions, its operating revenues decreased by $13.6 million or 10.4% to 117.5 million and that principally reflected lower items mailed and fewer images produced in the U.S. as well as foreign currency exchange effects of approximately $2.5 million.
Items mailed decreased 1.1% to 568 million. Images produced decreased 8.8% to 3.1 billion. The decrease in images is due to lower volumes from existing clients and certain telecommunications clients reducing the amount of transaction information included on their invoices thereby lowering the total images and pages produced.
During the second quarter of 2009, Output Solutions received four new client commitments representing one fully transition, approximately 300 million aggregate packages annually. Processing for two of the new clients began during the second quarter of 2009 with approximately 21.9 million packages mailed.
Full conversion of these four clients was expected to be completed during the third and fourth quarters of 2009. Excluding reimbursable operating costs, cost and expenses decreased by $12.6 million or 11% to 101.6 million. Lower personnel and material costs from lower processing volume, lower equipment cost from the implementation of owned digital print technologies and lower costs related to the effect of foreign currency exchange rates of approximately $2.3 million contributed to the decrease in second quarter 2009 costs and expenses.
Depreciation and amortization increased by $500,000 attributable to increased appreciation from equipment to support expanded capabilities for the upcoming mail (ph) and presorting of mail.
Output Solutions operating income for the quarter decreased by $1.5 million from the prior year quarter to $5.9 million, primarily from lower revenues. Operating margin for the second quarter of 2009 was 5%, compared to 5.6% for the second quarter of 2008.
The equity and earnings of unconsolidated affiliates was $10.5 million the second quarter of 2009. That was a decrease of $1.1million from the second quarter of 2008. That's primarily a decline in BFDS and IFDS earnings, partially offset by improved results in some other unconsolidated affiliates.
DST's equity and BFDS earnings decreased by $1.6 million and that's primary from a 169 basis point decline in the average interest rates on cash balances maintained by the BFDS on behalf of its customers and certain lease abandonment costs associated with the consolidation of operational facilities.
DST's equity at IFDS decreased by $800,000. The decrease at IFDS primary reflects foreign currency exchange effects between the US dollar, the British Pound, the Canadian dollar and other currencies.
DST's equity and earnings of other unconsolidated affiliates was $3.4 million, an increase of $1.4 million primarily from improved results at certain other unconsolidated affiliates. That was partially offset by the absence of a gain recorded in the second quarter of 2008 related to the early extinguishment of debt at a real-estate joint venture.
Other income was $4.8 million in the second quarter of 2009, an increase of $1.3 million as compared to $3.5 million in second quarter of 2008. The increase in other income as compared to the second quarter 2008 is primarily from unrealized depreciation on marketable securities designated as trading, the effect of which is offset in the Financial Services by an increase in cost expenses, and also offset by $2.9 million decline in dividend income and interest income and the accounts receivables securitization renewal costs that we mentioned earlier.
Interest expense was $9.5 million for the second quarter of 2009. That's a decrease of 4.3 million from the second quarter of 2008. That's primarily from lower average interest rates. The company's income tax rate was 39.7% for the second quarter of 2009 as compared to 36.3% in the second quarter of 2008. The second quarter of 2009 tax rate was negatively impacted from current year tax benefit was provided and from lower dividend income which was taxed at lower effective tax rate.
The company expects to the tax rate of 39.4% for year-to-date (ph) and the full year tax rate assumes the current international tax status and lower dividend income.
Turning to mutual fund shareowner activity, total mutual fund shareowner accounts serviced were 118.9 million at June 30th 2009. That was an increase of 1.3 million or 1.2% since March 31, 2009. And it’s comprised of net increases of existing client accounts of 1.4 million, new client conversions of 1 million accounts, offset by conversions to non DST platforms of 1 million accounts and conversions to DST's sub accounting platform of 100,000 accounts.
Tax advantage accounts serviced totaled 46.3 million at June 30, 2009 and that was an increase of 400,000 accounts or 0.9% at the March quarter end. Tax advantaged accounts represented 42.1% of total registered account serviced at June 30th. Sub accounts serviced totaled 8.9 million at the end of the quarter. That was an increase of 200,000 accounts and so the end of the first quarter that represents conversions of 100,000 registered accounts from TA2000, an increased in sub accounts from existing clients of 100,000 accounts.
Excluding organic increases or decreases in accounts of existing clients, we currently project account serviced at year-end 2009 will approximate 118 million. That would be comprised roughly of 107.2 million registered accounts and 10.9 million sub accounts.
This projection anticipates the conversion of 600,000 new registered accounts in the second half of 2009. Our sub accounting clients have indicated they plan to convert 1 million new sub accounts to TA2000 sub accounting from non-DST platforms during the second half of 2009.
In addition, the company expects 3.4 million registered accounts will convert to sub-accounting platforms, during the second half of 2009 of which 1 million will convert to TA2000 sub-accounting.
The company received three new client commitments in the second quarter of 2009 representing approximately 2,000 registered accounts. They are expected to convert in 2010. The fine contribution participant were 3.4 million at June 30, 2009, that's a decrease of 400,000 or 10.5% from the March quarter end. The decline in participants during the second quarter of 2009 represents a seasonal movement of terminated participants, partially offset by new participant enrolments.
As previously announced DST has new client commitments totaling approximately 1.2 million track participants, of which 200,000 are expected to convert fourth quarter this year and the remaining one million in 2010.
At June 30, 2009 DST had 49.7 million shares outstanding. During the quarter we repurchased 10,000 shares of stock at an aggregate cost of $365,000. At the quarter end, we had approximately 2.4 million shares remaining under our existing share repurchase authorization plan.
The diluted shares outstanding at the end of the quarter were 50 million and that's a decrease of 9 million or 15.3% from the second quarter of 2008 an increase of 100,000 or 0.2% from the first quarter of 2009. Total stock option and restricted stock equity units outstanding at June 30, 2009 were 8.2 million, that's comprised of 5.7 million stock options and 2.5 million shares of restricted stock.
Overall equity units decreased to 100,000 or 1.2% for the March 31 quarter end and decreased 400,000 or 4.7% from June 30th of last year. During the second quarter DST repurchased 61.4 million in principle amount of the original 540 million series A debentures and 12.7 million in principle amount at original 300 million series B debentures.
We recorded 2.1 million gain during the second quarter of 2009 associated with these repurchases purchases. The gain has been identified as a non-GAAP adjustment in the reconciliation to GAAP income. At June 30,2009 the outstanding amount of series A debentures was $418.5 million and the amount of the series B debentures was a 168.3 million.
With that we would now operator like to open up the call for questions.
Thank you. (Operator Instructions). And that first one will come from the line of James Kissane from Bank of America. Please go ahead.
James Kissane - BAS-ML
Thanks. Tom can you give us a sense of the revenue potential on the poor client wins in the Output business and may be the impact on margins been and does it help you get the 10% margins in reasonable time frame?
I think it will help us move there, Jim. As we mentioned, the three plans at Output are all now really on the same technology, all run by the same shop management technology software.
During the fourth quarter last year and the first quarter this year, telecommunications clients, lot of them decided to reduce the call detail that they were producing on the statements so that reduced the number of statements. Generally our billing now the rhythms start with a higher price for the first page and decline with subsequent pages. So some of that capacity that was freed up by printing less pages per bill for those clients is been picked up by the bills from these new clients. So that should improve the margins.
When you deal with any of these big clients basically coming from in house operations, there is not insignificant amount which has been reflected partially already of cost to absorb some of their transition out of equipment cost and so forth. So I think that the assumptions that the margins will improve is valid. It will move us towards that, rather we can get to the double-digits next year.
That's still our target to try and get there, but I think we'll make significant progress toward it. We are trying to break out the revenue. We're basically we're mailing about say actually to 20 some odd million, there is roughly say 540 million mail for the quarter.
So that's 2.1 billion pieces of mail for the year. The 300 million would be about a 7% pick up. So I don't think it would be unrealistic to say that's probably about where the revenue would go, but it should come in at higher margins.
James Kissane - BAS-ML
Great and I think you talked about the pipeline being pretty strong in Output in the past. Is it so strong after these three or four wins?
Well these take a big chunk out of it, but there's still a reasonable amount out there. I think as we've talked about probably for longer than most of you want to hear that the trend is, there is some movement to electronic presentment, which we of course support and more movement towards more sophisticated bill, we are using color and going down to individualized messages at the customer level. In house operations have challenge we're stepping up both to the technology and stepping up with projections, that may show overall reduced volumes and therefore higher fixed cost for images. So there is more activity in these areas then we've seen for some period of time. So I'd say that pipelines are solid. It may not be I won't go so far to say robust, but it's a solid pipeline.
James Kissane - BAS-ML
Okay, on the financial side, do you have a sense of pent-up demand for software, so as things stabilize in these open market. Do you think there'll be a pretty quick recovery in software?
Well, of course the software DST International, that's primarily the, not so much the pickup of the mutual fund business, but really the major financial services organizations. We do have some products in there, that are performance management, risk management products which are starting to see more interest partly because of the state of the marketplaces. But for the mainline software I think until you see the big multinational financials report in other quarter to, hopefully improve results and because they just don't have budgets right now, we'll need to cut them all off.
James Kissane - BAS-ML
Okay and Tom anytime update on renewing the credit facility and maybe thoughts on the pricing or cost of that?
Well, as we mentioned we've redone the securitization. We continue to work with banks on working with the credit facility. I think we feel comfortable that we'll get it renewed but I can't imagine it will come in at less than 2, 3 other basis points so that's where it is.
James Kissane - BAS-ML
Okay and just last question. The long-term margin potential for healthcare, is obviously dragging the margins today. Do you have a margin profile, two or three years out?
Well I think now that we've combined with Argus and Argus is struggling as is the BFDS with virtually no earnings on balance. In fact we will probably maybe experiencing given that those balances incur certain bank processing charges they may actually be negative for a period of time here. So if interest rates correct then we get some positive cross selling and some synergies between the two businesses which we think we definitely will. There's no reason it can't be certainly double-digits I'd say 12 to 15%.
Having said that, I think real question, it's not a question but obviously a situation now given the administration emphasis on healthcare reform, we think there could a lot opportunity there but there it could also be some risk, I don't think necessary risk in tremendous this intermediation of the current systems, but could require a substantial retooling, depending on how reimbursements are handled and what sort of requirements work their way out and what type of technology to support these, what arguably should be an improved interface from the physician office because I think the -- where I know it's like, I think it's $40,000 per officer stipend to get technology and so if they can go to more electronic movement of claims and so forth. So, that we think there is some very legitimate opportunity there but this could take a little while to clarify.
James Kissane - BAS-ML
Okay, thanks Tom.
Our next question comes from the line of David Koning from Robert W. Baird. Please go ahead
David Koning - Robert W. Baird
Yeah hey guys. I guess first of all just on the financial service that you talked about 5.5 million of deferred comp. Is it fair to say the next quarter you'd probably expect that to comeback through the EBITDA line, with 2% higher margin there, there's something in that ball park and then the other income line will be closer to zero instead of 5 million?
Well, I think when we say deferred comp this is not the deferred comp from some current payment or current plan. This is the balance held in deferred plan participants that have build up, in some cases for as long as 10 or 15 years and the nature of the deferred is that the individuals select a investment option and the companies obligation to them varies on the movement in valued added investment. Those investments were all funded. So the companies risk is neutralized, but if the market is down 10% then the company reduces expenses by that.
But then also has a offsetting increases on the other side. So it's a contra movement at all times and that will be what it is. I mean it's from when you look at the overall P&L other than the fact that shows up in two different spots on the landscape, it's basically neutral. But I do want to make it clear that, that's relative to these deferred amounts that have been in place from plans over extended periods where the employees are allowed, officer's bonus plan participants to allow some to differ some portion of their bonus.
So that I don't think you can predict anything what it's going to be. Its just a function of, if the volume goes up it increases expense on one side but then it goes down and accretes income in the other category for the actual value of the securities the company owns, that have increased. So is that addressing the question or...?
David Koning - Robert W. Baird
Yeah, I think that's fair, because it basically is a little bit of tough moving target, because it’s hard to forecast margins and financial services, because that can move around, but it just should be offsetting.
It’s offsetting in the aggregate, but as to margins, it’s in two separate categories on the P&L. So it actually has a disconnected effect from margins, or it has a connected effect for actual EPS.
David Koning - Robert W. Baird
Okay, that's helpful. Secondly, just as we think about growth over the next three to five years, we are selling in the core business, I mean if the market does have to rebound and its done so far in the last I guess few months, but if we get 2 to 4% of comp growth kind of like we how we see in the last five years or so.
Is it fair to assume some sort of pricing decline, maybe low single digit or some thing like that just with the shift to sub-accounts and may be a little core pricing decline or is that too hard to even forecast?
Its hard forecast but I think that there will be price pressure because we are still in a economic environment where everybody is trying to control their costs and our customers just like DST and other companies are going to vendors and whatever and see what improvements we can get in vendor services. So there is that pressure there. I would like to think that growth rates of 2 to 4% can materialize.
We also think that obviously that the available market is not totally lasting, but we'd like to think over next couple of years we will have some market share movement and then certainly we think market share movement in the sub-accounting side, although as you pointed out that has the lower revenue unit. So I think the broad assumption that there'll be some top line, that there be some account growth probably mitigated by some cost structure on the top line also.
David Koning - Robert W. Baird
And you didn't mention any new movements from registered to sub-account this quarter compared to last quarter. Do you still expect some movement over the next couple of years or do you feel like we're at a little bit of a low?
No I think we expected and I think given these market sometimes you do hit lows but the movement of sub-account has been a little bit spiky anyway. It's sort of a function of which firms have adopted, I think we've pretty well identified, most of the major ones have already done that so we would assume maybe a slower rate but we still anticipated to occur.
I think we've seen some in this quarter also. Given that there have been conversions over to non-DST platforms of about a million in the quarter or so.
David Koning - Robert W. Baird
Okay and then just my last question, Tom. Jim asked the question about renewing the debt in the last couple of 10-Qs I think you mentioned that your expect rates of some of refinancing of the debt would be 4% to 7% higher, I think you just talked to Jim about, that it might be 2 to 3% higher. So I'm just wondering if that the rate expectation now are little more favorable than maybe which you thought a few months ago?
Those numbers we put out in February and I think we were more concerned about the credit markets then. But and they are still boiling over but I think if we use 300, that might be reasonable.
David Koning - Robert W. Baird
Great thank you.
Thank you. Our next question comes from the line of Andrew Gunlock from ABS (ph). Please go ahead.
Andrew Gunlock from (inaudible). Good morning. Just couple of quick question. So your cash balances -- first question is on cash flow from operations. So your cash balances are basically the same and you spent close to $95 million, both on CapEx and on repurchases of debt and equity so was that in fact roughly your cash flow from operations or am I missing few things?
Well, generally free cash, flow pretty much equals our after tax earnings. We did have some reduction in CapEx, which would have added to cash flow outside of the earnings. And so that's probably the roll up to that. Probably Ken Hager has got a schedule and let me handle that answer.
Andrew, I would say that, Tom said most of other points. This quarter we had some little stronger receivable collection, which added to cash flow and maintained our cash balances and allowed us to buyback more.
Understand, thank you. And then related to the buyback as the financing picture looks more expensive but certainly available, do you see yourselves going back to your traditional stock repurchases as opposed to debt repurchases or do you see a fundamental change in capitalization of this company going forward?
Well, I think obviously made some pretty aggressive stock repurchases and when we were retiring convertible bonds, we see that as almost sort of a mix that while you are retiring it, if you take the conversion price of the bonds at 49 and a fraction, you're sort of retiring stock at that price, if you do the bonds, which is somewhat of a premium over the current price but then you eliminate the coupon.
And also just to manage some of the refinancing, that will incur our current approach is to concentrate on reducing the convertibles outstanding but applying any proceeds we receive from stock option exercises to directly go to repurchase stock to offset the impact of those option exercises.
So I think you would expect at least for the remainder of this year that balance sheet activity will be in the converts rather than the common.
I understand. Thanks. There in two other operational strategic questions, one on the smaller business. One if your big healthcare comps Trizetto was bought at basically the peak of the private equity bubble by Apax at 10 or 11 times EBITDA, kind of reverse equity with a lot of debt.
And I am just curious if that has comeback to haunt them in the ability to win clients and new business and convince your customers that they're going be around and not go through a restructuring and whether that not helping you on that business at all.
And as you answer that may be you can also give us or give me what the financial services margin would be without the inclusion of Argus which I guess basically has zero EBIT and lots of -- and a bit of revenues there.
Yeah, and actually that's something we won't break that up way today because we've got to review of how we present segments going forward. As to the Trizetto thing, yes it was a pretty, I would guess expensive acquisition at least based on terms today.
In that business, a lot of our focus is moving existing clients from license situations to processing BPO or ASP and we compete with Trizetto and others. We see them I think we compete effectively with them. I have not specifically heard any feedback that there is concerns about restructuring or the levels of debt. But that may be there. We're not just aware of it. But at some point, there was a pretty good amount of financing which thought would be closer to the way we're associated with them.
I see. And then on the more important business or the mutual fund business, you've spoken before about how the changes on Wall Street can affect your business. But you've also spoken about the opportunities it presents and some funds consolidated look for outsourcing opportunities. And are you more comfortable today than the last time you spoke about this publicly on looking forward at the opportunities?
I don't know if comfortable would be the right word, but I think our sense is that given the severe impact on financial services firms, you know either insurance companies with mutual fund operations or broker dealers that have them or even just stand alone funds that are challenged by expense. That we're seeing more opportunity, not only from current in house operations but even from existing clients, who may want to rearrange what they do and what they might want to sub-contract to us to move some of those activities out from under their operation. And it may well be also that you will see a number of divestitures, larger financial organizations that may look to sell their mutual fund operations in order to; one, focus most more on their traditional businesses and two, to raise some capital. So I think we think all those trends will be in place or maybe accelerate a little bit which we think will give us some opportunities, but it's hard to get comfortable in these kind of markets, but those would be our impressions.
Okay. Thanks for the comments and thoughts.
Thank you. Our next question comes from the line of Kathy Smith from KPC (ph). Please go ahead.
Hi, I wanted to see if you could shed some light on what your plans are for refinancing the rest of the Series A convertibles for the next August?
Well at this point we are working with the banks to redo our bank lines and we would anticipate having that firmed up probably by year end. As to financing the converts we'll continue to use free cash flow to reduce the amount that would need to be refinanced and clearly it's a moving target at this point because at least potentially if the markets improve and we make some progress they may not have to be refinanced because they can be put at par but the conversion price is 49 and some thing. So depend upon stock prices that may or may not be put.
So we continue to look at what various scenarios are, but our current approach is to firm up the bank lines and through use of free cash flow, reduce to the extent possible, the need to refinance or the amount to be refinanced, if they have to be refinanced. And then we have as always a back stop of a fair amount of marketable securities that are certainly available for this purpose if other avenues are not attractively available to us.
Okay and just one other thing. You mentioned that you did redo account receivable securitization facility. Are the terms primarily the same? Do you have about same amount sold into that right now?
Let Ken answer that. I think he'll describe it as we go ahead.
The overall size of the facility declined slightly from 200 million to a 175 million. And we've roughly the same amount, roughly the same amount advance as we had previously.
Okay thank you very much.
And at this time I am showing no further questions. Please continue.
Well. We want to thank you for joining us on the call today and we look forward to talking to you at the next scheduled call after the end of the third quarter.
Thank you. And ladies and gentlemen that does concludes your conference call for today. Thank you for your participation and for using AT&T Executive Teleconference Service. You may now disconnect.
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