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DST Systems (NYSE:DST)

Q4 2010 Earnings Call

February 08, 2011 11:00 am ET

Executives

Thomas McDonnell - Chief Executive Officer, Director and Member of Proxy Committee

Analysts

David Togut - Evercore Partners Inc.

David Koning - Robert W. Baird & Co. Incorporated

James Kissane - BofA Merrill Lynch

Operator

Ladies and gentlemen, thank you for standing by, and Welcome to the DST Fourth Quarter Earnings Release Conference Call. [Operator Instructions] And at this time, I will turn the conference call over to your host, CEO, Mr. Tom McDonnell. Please go ahead, sir.

Thomas McDonnell

Good morning. I'm joined this morning here by Steve Hooley, our President of DST; and Ken Hager, our CFO.

Let me make this statement first. 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 set forth in the latest periodic report that we filed with the SEC. All such factors should be considered in evaluating any forward-looking statements that we might make.

Since all the participants have had access to our detailed earnings release, we're going to focus our comments on some of the items that we think are most significant. For the quarter, on a GAAP basis, reported diluted earnings per share were $2. Adjusted for non-GAAP, the diluted earnings per share were $1.07. That $1.07 represents an increase of $0.15 or 16.3% over the fourth quarter of 2009.

The most significant non-GAAP adjustment in the quarter were the receipt of a $49.5 million dividend and net gains of a disposition of securities and other investments. All of the following comments referred to are non-GAAP results.

The consolidated operating revenues for the quarter were $424.9 million. That's an increase of $25.2 million or 6.3% from 2009. That reflects the inclusion of the dsicmm Group revenues. That's the print mail operation that we merged into ours in the U.K. The consolidated operating income increased by $4.5 million or 6.5% over the fourth quarter of 2009.

Some higher software licenses and healthcare processing revenues in the Financial Services segment also contributed to the increase. And the equity in earnings of unconsolidated affiliates increased by $600,000 over the fourth quarter of 2009.

Financial Services' operating revenues increased by $9.2 million and that was a 3.2% increase over the fourth quarter of last year. We had higher revenues at Argus Health Systems, DST Global Solutions, DST Health Solutions and the AWD division.

Income from operations increased by $8.1 million. That's a 12.4% increase that reflects a higher software license and healthcare processing revenues.

During the quarter, 3.3 million registered accounts were converted to subaccounting platforms. 300,000 of those were migrated to DST's subaccounting platform. We also had an organic decline of 500,000 accounts, and that's principally a client who lost the 529 business to one of their competitors who's not a DST client. That was partially offset by 200,000 accounts that were newly converted.

There was a total net decline of 3.6 million registered accounts for the quarter. But if you turn to subaccounting, the net there on subaccounting activities resulted in an increase of 1.4 million subaccounts for the quarter. And that consisted of new client conversions of 600,000 accounts, organic growth of 500,000 accounts and previously mentioned conversion from DST's registered accounts of about 300,000.

Projections for registered accounts converting to subaccounts, it's based on information we obtained from our clients and it can change of course, but the information provided by our clients currently, we expect subaccounting trend to continue in 2011 and convergence of registered accounts to subaccounts are expected to be at approximately the levels experienced in 2010, and that was the order of magnitude of 12 million accounts. Now, some of those will go to our platform and some to others.

The current outlook for '11 of the movement to subaccounting includes the anticipation that a client that is managing a single state Section 529 plan will let one brokerage firm subaccount approximately 800,000 Section 529 plan accounts that are currently in our registered book. As I said earlier, as with all sort of projections and estimates that these can change, not only as to order of magnitude but certainly as to actual timing.

Defined contribution participants increased by 600,000 in the quarter to 4.5 million. That's substantially all new account conversions. Our equity in earnings of BFDS and IFDS increased by $1.9 million to $10.1 million for the fourth quarter of '10. The increased earnings were driven by account growth at IFDS, higher earnings from IFDS as unconsolidated affiliates. As to balances, the average rate earned on balances was 19 basis points for the fourth quarter of '10. That compares to 12 basis points for the fourth quarter of 2009. So the BFDS earnings in particular is still substantially impacted by those lower earnings rates. The average balances for the period increased to $1.2 billion from $950 million for the same period in '09.

At Output Solutions, operating revenues increased by $17.1 million over 2009. If we exclude $27.4 million of revenue from dsicmm, the actual segment operating revenue is decreased by $10.3 million or 8.8% compared to the fourth quarter of 2009. The base revenues and volumes continue to reflect the loss of the large telecom client in the second quarter of last year.

If we exclude dsicmm, Output Solutions reported income from operations for the fourth quarter of 2010 of $2.7 million. That's an increase of $100,000 or 3.8% as compared to fourth quarter of 2009. That's after absorbing, as I mentioned, the loss of the telecom client. Dsicmm incurred a loss of approximately $2.2 million in the fourth quarter of 2010. That included $600,000 of amortization of intangibles from the acquisition, and dsicmm's loss during the quarter also included a number of integration and one-time expenses. Again, if we exclude dsicmm, Output Solutions' operating margin for the fourth quarter was 2 1/2% in 2010 as compared to 2.2% in the fourth quarter of '09. And on the same basis, Output Solutions generated EBITDA of $13.3 million, somewhat of a decrease from 2009 of $1.2 million decrease or about 8.3%, mostly reflecting the lower revenues that I mentioned earlier.

Output has received a new client commitment in North America, which will increase the annual packages mailed by 98 million when fully converted. Full conversion is anticipated to be late this year, early 2012.

Our income tax rate for the quarter was 35.7% and that compares to 36 1/2% in the fourth quarter of 2009. We're currently estimating the 2011 tax rate at 36%. That will vary on a quarterly basis. It really depends on the timing and the sources of taxable income in 2011 from the various jurisdictions and so forth that have varying tax rates.

The share purchases that we made during 2010 reduced the average diluted shares outstanding for the quarter by 3.1 million shares less than that of 2009. We continue to work on the balance sheet. We did repurchase $50 million of the principal amount of the Series C convertible debentures. That leaves $94.1 million of the Series Cs outstanding as of the end of the year.

During the quarter, we also repurchased 100,000 shares of our common stock. That was an average price of $43.31. We have 1 million shares remaining under our current share repurchase authorization. And during the quarter, we paid our second semi-annual dividend of $0.30, that was in November.

I'd like to maybe just recap a couple points for the full year of 2010, and these points or comments reflect the non-GAAP adjustments. So overall, diluted earnings per share increased by $0.84 to $4.43. That was an increase of 23.4%. Operating revenues were $1,640,000,000, and that's an increase of $44.8 million or 2.8%. This includes, of course, the full year of Argus' revenues versus only nine months in 2009, and also the revenue from the acquisition of dsicmm in the third quarter of 2010.

Consolidated income from operations for the year was $308.5 million, and that's an increase of $34.2 million or 12 1/2%, mostly from higher earnings in the Financial Services segment. We did, during the year, complete the announced workforce reduction. Total debt was reduced by $137.5 million as compared to year-end 2009. We retired or repurchased $486 million of our convertibles debentures, and that leaves only the $94.1 million of the Cs outstanding that I mentioned earlier. As part of repurchasing and retiring those convertibles, we did, in effect, renew and put in place our $600 million revolving credit facility. Then, we also did a placement of $370 million of senior secured notes that was accomplished in August, has an average life of eight years and blended interest rate of 5.06%. And that's part of the way we were trying to reposition the balance sheet.

The total dividend for the year was paid on a semiannual basis, $0.30 twice was $0.60, and 2010 was in fact, the year that we initiated the dividend. We did complete the acquisition of dsicmm. That acquisition was accomplished by merging our U.K. print operation and dsicmm. We renamed the resulting entity, Innovative Output Solutions, and we think that has a positive outlook going forward.

And we reduced the total number of shares outstanding to a year-end number of 46.3 million, and that is a reduction of 2.9 million shares for the year of 2010.

So at this point, we would like to open the call to questions, please.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question in queue will come from the line of Jim Kissane with Bank of America Merrill Lynch.

James Kissane - BofA Merrill Lynch

Tom, if you look at 2010 Financial Services segment revenue, what portion is directly tied to mutual fund accounts? Because it seems like your accounts are under pressure but you're still able to grow Financial Services revenue. So if you can give us a little more insight into the break out of the revenues.

Thomas McDonnell

We don't break them out specifically, Jim, as you're aware. But substantial, certainly more than half, comes from mutual funds. But I think in some -- sort of this background, of what I'm sure will be some of the questions about movement of accounts, the revenue on a full-service account, either at DST or BFDS, is our largest revenue unit than remote accounts. And within remote, there are some accounts that are, what are called Level 3 that support the brokers and those who have a lower fee, and then there's subaccounting. So the movement of a lot of these accounts really is at the low end of our fee schedule. And that's part of the reason that even though there appears to be a significant number of accounts moved, that some of the revenue isn't moving proportionally and that it's offset by some of the increases in the other Financial Services segments. We continue to look and see, discuss how we should present Financial Services. But because of all the integration through the data center, all the use of AWD across all the products, some of the stuff that's cross-selling and so forth, internally, we don't break it out in as concise segments as might initially appear given that we do have different lines of business. So we keep them aggregated. But that's some background, Jim, as to how the revenues is moving around there.

James Kissane - BofA Merrill Lynch

I guess up until this quarter, it seemed like tax-advantaged accounts were fairly immune from shifting to subaccounting. Now, it seems like you're moving some -- from the release, it seems like it's isolated. But can you give us a sense that there is not risk or is there a risk that you'll see more tax-advantaged accounts shifting to subaccounting arrangements? And what's changed there?

Thomas McDonnell

All that's really changed is there is one broker-dealer who has, in the overall scheme of things, has disproportioned the amount of 529s with one of our major clients. And they have agreed to let that broker-dealer only move them. Once you get past that broker-dealer, much, much smaller books of business. It is a more complex business and it's not clear to us quite frankly, how when you get to the disbursement side, because you have to monitor what the funds are being dispersed for or whether the [discernible] and room board up, all that. If you've looked at a 529 plan, they're quite complex. So we really -- and Jim, you can never say there's no risk, but we think this is very isolated and a unique set of circumstances.

James Kissane - BofA Merrill Lynch

Based on new client wins in the Output side, when would you expect Output core revenue, excluding dsci (sic) [dsicmm] to grow again?

Thomas McDonnell

Well, I think we would expect the core revenue to start growing from the low base that it's reached to kind of on a quarter-to-quarter basis. The North American revenue includes our Canadian operations and that's had some good growth and clients coming on there. And we think that the IOS business that we put together, the dsicmm, Jim, had been a business that gives us much broader range of clients and a wider range of print products. That particular business had grown by several acquisitions and really needed sort of the critical mass that this brought together to kind of reposition it. The reason I'm going into that details, when we talk about the loss in the fourth quarter, one, there were a number of redundancies in the U.K., and if you're familiar with U.K. employment law, those are complex and expensive. They fall under a collective undertaking called 2B. We have that behind us and also, we took some charges for the consolidation and elimination of some facilities. So if you look at Output overall between client acquisitions in North America, particularly Canada, we fully expect that the what is now called IOS will be profitable throughout 2011. And then we would see that between fee pressures in '10 and the loss of the telecom client, I think we're starting to build back the underlying base revenue in the lower 48s. So I think you should see sequential improvement there, Jim.

Operator

Our next question in queue, that will come from the line of Dave Koning with Baird.

David Koning - Robert W. Baird & Co. Incorporated

Just to follow up a little bit on Jim's question. You break out in the press release that the record-keeping revenue within Financial Services was about flat year-over-year and that's despite about a 10% decline in the registered account base. So I mean, there are definitely things like, we would assume, TRAC and AWD, and some of those things are growing quite well. Is this something that -- this trend, could this continue that you could have another year of throw out 10% or whatever decline in registered accounts and still have the record-keeping revenue remain flattish?

Thomas McDonnell

Well, a little bit of it depends on the exact mix. As I mentioned, a lot of the accounts have moved to subaccounting, well, first it's the question, how many moved to our platform versus somebody else's. Also then, when these move off, they're generally off this category called Level 3 accounts that already transmit data to broker-dealer accounts, and they, by and large, tend to be at the lower end of our revenue spectrum. We've indicated in the press release there's some pretty good TRAC business coming on, and that's at a significantly higher revenue unit. So I don't think you'll see a complete offset only from TRAC and direct mutual fund-related revenue, but we're a little encouraged by some of the results in the healthcare sector. All you got to keep in mind in there in Argus, part of the structure of that revenue base is Argus' access to balances, and there is maybe $300 million to $400 million there that's still a bit of a drag on their numbers. But we would hope to have a mix of business between the decline in the mutual fund side and some improvement in the others, that hopefully, we can offset the revenue and then look at some potential, more significant opportunities, particularly in the TRAC kind of retirement processing area.

David Koning - Robert W. Baird & Co. Incorporated

Sort of along those same lines is despite some of the headwinds from this year margin, I think in Q4, on a normalized basis were the highest in Financial Service they've been at for at least eight quarters or so. And I realize part of that's due to some of the cost-cut plans but maybe you could talk just a little bit about if margins are sustainable even with the subaccounting pressure from here?

Thomas McDonnell

There's a couple things in the fourth quarter: First, the inclusion of license fees helps move the margin up. But aside from that, with the workforce reduction and then a continual focus on overall cost, whether -- every level of operating cost obviously, has a lot of focus, so we certainly are paying a lot of attention to trying to preserve the margins. The fourth quarter would have been a little exaggerated because of the licenses. But I think that we're on top of the costs and we manage them against the other expectations of the business. That said, some of the businesses that we're trying to develop, you're going to see some development expense in those as we go forward, but I think we can keep the margins under control.

David Koning - Robert W. Baird & Co. Incorporated

Just on cash flow, I guess a couple points. First, just that CapEx is been I think about $50 million below D&A, so that drives about a $1 per share benefit relative to EPS from a free cash flow. I guess, I don't see any reason why that's not sustainable unless CapEx starts going up a lot. And then, I guess up alongside that is in Q4, the net-debt came down $136 million sequentially, partly due to the dividend, partly because of core operations. But I mean, is it fair to say, I mean cash flow had to be quite strong in Q4?

Thomas McDonnell

We had good cash flow but going into 2011, we would anticipate CapEx to move up somewhat. The $98 million-package client, which is a long-term contract, actually requires expansion of our facility in Canada. So I think we're going to see circa $10 million, $12 million of CapEx probably to support that business expansion up there. We're going to be looking at which has a longer-term benefit of repositioning some of the data center assets to some more contemporary technologies supporting some of the things that clients are now looking for. Also, we're not unique in this, but accelerating some CapEx into 2011 simply based on the new sort of tax incentives relative to the 100% depreciation that's available. So I think you'll see -- not think, you will see CapEx north of a hundred, I would think, this year.

Operator

And our next question in queue, that will come from the line of David Togut with Evercore Partners.

David Togut - Evercore Partners Inc.

Tom, back to your comment on 12 million registered accounts moving to subaccounting, can you provide more granularity on how many of those accounts might stay on your systems versus moving to competitors' platforms?

Thomas McDonnell

Well, probably not. I don't think -- the way we've estimated that is kind of a continuation of the trend of 2010. David, that's not a number we just have in front of us. As you know, our subaccounting share is less than the competitors'. So I mean, my guess is it's a quarter to a third of those will come to us and the rest will probably go to a different platform. If that's way far off, we'll get back and clarify it, but that's ballpark. Of course, we continue to pursue moving brokers to our subaccounting platform also. These projections only reflect what we believe to be movement from registered to subaccounts. They don't reflect any kind of assessment of our ability to effectively sell into subaccounting clients to move record-keeping onto our system. This is just simply what we think the overall order of magnitude of accounts is going to be. And if they run to the current split, it'd be two thirds to three quarters on another platform, a quarter to a third on ours.

David Togut - Evercore Partners Inc.

And then do you anticipate taking any actions on the cost structure to help offset the possible margin pressure from the loss of these accounts?

Thomas McDonnell

Yes, I think I mentioned we're probably short-term and long-term, we've stayed very much on top of the costs. We did have the reduction in force but we don't anticipate additional actions there, but we obviously, like many organizations, are not rapidly adding to the workforce. We will be redoing some equipment configurations that we think have very favorable long-term cost impacts but actually, in 2011, that will be part of the reason for a little stepped up CapEx. And as you know, we use accelerated depreciation for books as well as tax. So actually, as far as the some of the movements to cost control that would be affected by more efficient operations supported by capital investments, you'll actually see a little step up of that in '11. But then that should produce longer-term improved -- an operating environment from a cost standpoint.

David Togut - Evercore Partners Inc.

Have you quantified the anticipated 2011 revenue from the new Output Solutions client with $98 million aggregate packets?

Thomas McDonnell

Well, to agree, we have, but we don't know exactly what the conversion schedule will be. We anticipate it'll start converting in the third quarter or fourth and be fully converted by first quarter of 2012. It's when you have a client that big that have various different types of output, so it depends on what we move when. We'll have a much better feel midyear. So I guess I would not, well, as I mentioned since we got to expand the plan anyway, I think we can assume this is positive for 2012 but it probably won't produce much net positive, if any, in 2011 given some of the front-end costs that we'll incur and write-off on, to some extent, David, on an accelerated basis. So I don't think you could build anything in for a significant positive for '11.

David Togut - Evercore Partners Inc.

And then the restructuring that you undertook at the beginning of 2010, are there any incremental cost savings from the headcount reduction that we should expect for 2011?

Thomas McDonnell

Beyond what we originally put out, we had $20-some-odd million of severance expense and the annual run rate was $67 million. That's really -- well, actually, that's pretty much exactly where we ended up. Now, actually, severance cost in Q4, which was $3.3 million, the rest of those savings should have been visible in the results in the fourth quarter. So I mean, I guess when you're saying incremental to the fourth quarter net of the $3.3 million severance, probably not.

Operator

At this time, we have no additional questions in queue. Please continue.

Thomas McDonnell

Well, thanks for your participation and look forward to talking again after the first quarter.

Operator

Thank you. And ladies and gentlemen, this conference call will be available for replay after 12 p.m. Central Time, today through February 15, 2011, at midnight. You may access the AT&T teleconference replay system at anytime by dialing (800) 475-6701 and entering the access code 188598. International participants may dial (320) 365-3844. That does conclude your conference call for today. We do thank you for your participation and for using AT&T's Executive Teleconference. You may now disconnect.

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