DST Systems' (DST) CEO Stephen Hooley on Q2 2016 Results - Earnings Call Transcript

| About: DST Systems (DST)

DST Systems Inc. (NYSE:DST)

Q2 2016 Earnings Conference Call

July 21, 2016 8:30 AM ET

Executives

Stephen Hooley - Chief Executive Officer and President

Gregg Givens - Chief Financial Officer

Analysts

Peter Heckmann - Avondale Partners LLC

David Ridley-Lane - Bank of America Merrill Lynch

Dave Koning - Robert W. Baird & Co.

Brian Essex - Morgan Stanley

Operator

Good morning and welcome to the DST Systems Second Quarter 2016 Earnings Conference Call. At this time, all lines have been placed on a listen-only mode to prevent any background noise. After the speakers’ remarks there will be a question-and-answer session. [Operator Instructions].

In the course of this conference call today forward-looking statements may be made regarding DST and it's businesses. Such statements are based on the Company's views as of today and actual results could differ materially from the forward-looking statements. There are a number of factors that could affect the Company's future results including those risk factors set forth in DST's latest Annual and Quarterly Reports filed with the SEC. All such factors should be considered in evaluating any forward looking statements that may be made.

Now, I’d like to turn the conference over to our host Mr. Steve Hooley, Chairman. President and Chief Executive Officer of DST. Please go head.

Stephen Hooley

Good morning and thank you for joining DST Systems second quarter 2016 earnings call. With me today is our Chief Financial Officer, Gregg Givens. I'm going to start by reviewing our progress in the execution of our strategic plan, and will then go through some of the highlights of the quarter. After that, I'll then turn the call over to Gregg for additional detail on our financial results.

As we've discussed in the past, our strategic plan is focused on several key areas, including investing in our business to position DST to best serve customers within a highly regulated healthcare and financial services industries. Growing our businesses through organic initiatives and targeted acquisitions.

Driving efficiencies throughout our global operations, ensuring compliance with applicable regulations and providing a secure environment in which we transact business, managing our balance sheet to provide adequate financial flexibility, and returning capital to shareholders. This quarter underscores the strength of our strategy and its successful execution and evolution, including the implementation of our long-term goal for DST to become a more highly focused company with two core segments, being financial services and health care.

We significantly advanced this objective in the second quarter completing the sale of our North American customer communications business for $410 million, subject to customary working capital and other closing adjustments. We also disclosed that we are conducting a process to divest our United Kingdom customer communications business.

Additionally, during the second quarter 2016, we completed the sale and leaseback of our UK customer communications Bristol production facilities for pretax proceeds totaling approximately $16 million. The sale of the customer communications business allows us to improve our targeted growth profile, and provides additional flexibility to capitalize on new opportunities in healthcare and financial services.

We expect use the proceeds from these events to continue advancing the strategic priorities I outlined at the opening of my remarks, including ongoing investments in the growth of our business, acquisitions, and shareholder returns. The divestiture of customer communications further solidifies our commitment to the financial services and healthcare segments.

These segments share a number of challenges that DST is uniquely positioned to address, including complex regulatory environments, privacy requirements, data-driven analytics, and significant capacity and scale requirements. We believe we possess valuable market insights, capabilities, technology, and the talent necessary to meet the demanding needs, and expand our solution set to address these market segments.

Further, with a more streamlined portfolio, we will now be able to focus our resources, including our ongoing investments, to enhance the security, technology, and compliance needs of new and existing customers in both segments. We are also continuing to focus on driving efficiencies across our business lines.

During the quarter, we announced a reduction in our workforce within our financial services segment of approximately 1% of global headcount as well as the consolidation of certain facilities. We expect these actions to result in annual pretax operating cost savings of approximately $22 million to $24 million. These activities, along with our growth initiatives, could help drive significant improvement in our year-over-year margin comparisons.

Overall, we're confident that we are uniquely positioned to serve our customers, and we strongly believe that this strategy will allow us to continue enhancing value for our shareholders. We believe our second-quarter results demonstrate the ability of our team to execute. I'm pleased with the work being performed to implement our initiatives and support the transformation and growth of our Company.

Before moving to our results, I want to note that, as disclosed in our press release this morning, our results for the quarter in prior periods reflect the transition of the entire customer communications segment, as well as certain businesses affiliated with customer communications to discontinued operations.

Now looking at our results. In the second quarter of 2016, consolidated net income attributable to DST was $53 million or $1.58 per diluted share. On a non-GAAP basis, consolidated income from continuing operations was $47.6 million or $1.42 per diluted share compared to $42.2 million or $1.14 per diluted share in the second quarter of 2015.

Consolidated operating revenues increased to $24.6 million or 7% to $373.9 million as compared to second quarter 2015. These improved results are primarily due to new and existing client growth across a number of our service offerings as well as year-over-year growth from businesses acquired during 2015 and 2016.

Looking at our segment results for the quarter, financial services segment operating revenues for the second quarter of 2016 increased $15 million or 5.6% to $280.7 million compared to the second quarter of 2015. The increase was primarily driven by businesses acquired during 2015 and 2016, which contributed $11.6 million of incremental operating revenues during the second quarter of 2016.

The increase was also driven by professional services revenues associated with our wealth management platform business, and organic and new client growth within our brokerage solutions business. The increase in revenues for financial services was partly offset by a decline in mutual fund registered shareowner account processing revenues due to lower registered accounts and negative market conditions impacting our asset management business. The higher revenues in financial services also drove increased operating income, as we continued to drive efficiencies and implement cost initiatives across the segment.

Moving to our Healthcare Services segment, operating revenues increased $11.9 million or 12.9% during second quarter of 2016 to $104 million as compared to second quarter of 2015. The increase is primarily attributable to new medical claims processing clients implemented in January of 2016 as well as organic growth and the expansion of high-value services we are offering to existing clients in both the medical and pharmacy businesses. Partially offsetting these increases is a $1.4 million decline from lower software license revenue in second quarter 2016 as compared to second quarter 2015.

Regarding our healthcare business in general, we are encouraged by the positive momentum we experienced during the second quarter and the expanded margins we delivered over the prior year. We continue to believe in the potential of broader growth opportunities within the healthcare industry, and are confident that our ongoing strategy and investments will continue to expand the value we provide to the marketplace and to our clients, and has positioned us well for the future growth and profitability.

Moving to our unconsolidated affiliates, our second quarter equity and unconsolidated affiliates decreased primarily from lower IFDS earnings. The decrease in IFDS earnings is predominately due to lower revenues recognized related to the ongoing client conversion activities and higher operating costs at IFDS to expand its infrastructure and respond to regulatory, security risk, and compliance demand across its business.

Equity and earnings of BFDS increased from second quarter 2015 primarily due to a combination of higher ancillary revenues and reduced operating costs. As we discussed last quarter, IFDS UK began processing on our international wealth management system during the fourth quarter of 2015. We continue to expect that IFDS earnings will be lower than 2015 due to the amortization of capitalized software costs, coupled with the decline in implementation revenue.

Share repurchases and dividends remain important components of our capital strategy, and on July 14, 2016, our Board of Directors authorized a new $300 million share repurchase plan. During the quarter, we repurchased approximately 660,000 shares of DST common stock for $75 million under previous plan. And during July, we spent an additional $75 million to repurchase approximately 630,000 shares resulting in $225 million remaining under the new plan.

Looking to the second half of the year, we believe that our focus on the healthcare and financial services markets will present a number of opportunities for the Company. While headwinds and challenges associated with both industries continue to exist, we believe we remain well-positioned and look forward to continuing to execute on our strategic objectives.

With that, I would now like to turn the call over to Gregg for detailed discussion of 2016 second quarter results.

Gregg Givens

Well. Thanks, Steve. Before I begin, I would like to remind everyone that in the second quarter of 2016, we began reporting the customer communications segment as a discontinued operation. We've also adjusted prior period results to be consistent with the current quarter's discontinued operations presentation. The sale of our North America customer communications business was completed on July 1, 2016, for total cash consideration of $410 million.

The net proceeds are subject to customary working capital and other closing adjustments pursuant to the terms of the transaction. In addition, during the second quarter 2016, we also completed the sale and leaseback of our UK customer communications Bristol production facilities for pretax proceeds of $16 million.

Now moving to our results, on the GAAP basis, this quarter we reported consolidated net income of $53 million or $1.58 per diluted share, compared to $107.5 million of net income or $2.91 per diluted share for the second quarter of 2015. The year-over-year decline is primarily due to lower realized gains on the sale of investment securities in 2016.

On an adjusted basis, our non-GAAP earnings per share from continuing operations were $1.42, an increase of $0.28 or 24.6% from second quarter 2015. The remainder of my comments will focus on our adjusted non-GAAP results from continuing operations. Consolidated operating revenues for the quarter were $373.9 million, an increase of $24.6 million when compared to the second quarter of 2015. The increase is primarily due to new and existing client growth across a number of our service offerings and year-over-year growth from the businesses acquired during 2015 and 2016. This was partly offset by $1.8 million of negative foreign currency movements.

Consolidated operating income increased 21.9% or $12.4 million to $68.9 million. The increase in operating income is primarily due to growth within the health services segment and from the financial services segment restructuring and cost savings initiatives. Consolidated operating margins were 18.4% in the quarter, as compared to 16.2% in the second quarter 2015.

Within the financial services segment, operating revenues increased $15 million or 5.6% to $280.7 million. The operating revenue increase is primarily driven from businesses acquired during 2015 and 2016 which contributed $11.6 million of incremental operating revenues during second quarter 2016.

Additionally, we had increased professional services revenues associated with our international wealth management platform business, and organic and new client growth within our brokerage solutions business. The operating revenue increases continue to be partially offset by decline in mutual fund, registered shareholder account processing revenue due to lower registered accounts.

In addition, we had negative market conditions impacting our asset management business and approximately $1.8 million of negative foreign currency movements. During the quarter, we reduced our workforce and consolidated certain facilities to enhance the operational efficiency within the financial services segment. As a result, the Company incurred $10.4 million of pretax charges for the restructuring. We anticipate the restructuring will result in $22 million to $24 million of annual pretax operating cost savings.

Financial services income from operations increased $5.9 million or 13.2% during the second quarter of 2016, as compared to second quarter 2015. The primary drivers for the increase in operating income were higher operating revenues and lower expenses from cost containment initiatives including $1.3 million of cost savings resulting from the restructuring activities.

These were partially offset by increased costs incurred to enhance our network infrastructure, maintain security and regulatory compliance, and service our new and existing customers. Financial services operating margin was 18% in the quarter, which is an increase from the 16.8% operating margin in the second quarter of 2015.

Our Healthcare Services segment operating revenues were $104 million, an increase of $11.9 million or 12.9% in the second quarter of 2015. The increase is primarily attributable to new medical claims processing clients implemented in January 2016, organic growth, and the expansion of the services we are offering to existing clients in both the medical and pharmacy businesses.

During the second quarter Healthcare Services income from operations increased by $7.7 million or 65.3% to $19.5 million primarily due to higher revenues. While costs and expenses increased from higher staffing costs associated with supporting the new and existing client growth, enhanced economies of scale were achieved as new clients were converted and we were able to leverage our operating platforms. As a result, operating margins for second quarter 2016 was 18.8% as compared to 12.8% in the second quarter 2015.

DST's equity and earnings of unconsolidated affiliates decreased by $2.5 million to $10.2 million in the second quarter driven by lower IFDS earnings. IFDS earnings decrease by $3.4 million to $6.3 million in the second quarter, primarily from lower revenues recognized related to the ongoing client conversion activities and higher operating costs at IFDS to expand its infrastructure.

Our income tax rate for the second quarter was 35.1%. We expect our income tax rate for 2016 to be approximately 36.5%. During the quarter we monetized $31.8 million of assets. Primarily consisting of $16 million from the sale of the Bristol UK production facility. $10.2 million from private equity investment distributions and $5.1 million in the sale of other non-operating real estate assets.

Turning to our share count, during the quarter the Company spent $75 million to repurchase approximately 660,000 shares of DST common stock. Average diluted shares outstanding for the quarter were 33.6 million, a decrease of 9.2% from the second quarter of 2015. Additionally, during July 2016 we spent $75 million to repurchase approximately 630,000 shares of DST common stocks, resulting in $225 million remaining under our existing share repurchase plan.

We close the second quarter with $72.7 million of cash and $712.2 million of debt. We continue to maintain a strong balance sheet and believe that our ongoing liquidity gives flexibility to be opportunistic in the marketplace.

I will now turn the call back to Steve for concluding remarks.

Stephen Hooley

Great, thanks, Gregg. We're moving forward and will continue taking steps to perform and execute on our strategic plan, and creating long-term value for our shareholders. We're confident that our focus on health and wealth will allow us to deliver on our objectives and continue driving results.

While we are a more focused company, the core components of our strategy that have served us well to date will continue, including organic and acquisitive growth, investing in our platforms to meet regulatory and customer needs, maintaining efficient cost structure and operations, leveraging the strength of our balance sheet, and returning capital to our shareholders.

With that, I would now like to turn the call over to - for questions. Operator, you can go ahead.

Question-and-Answer Session

Operator

Thank you, sir. Our first question comes from the line of Peter Heckmann of Avondale.

Peter Heckmann

Good morning gentlemen nice results.

Stephen Hooley

Thanks Pete.

Peter Heckmann

I wanted to get a clarification within the assets under management assets under administration? Can you talk about the separation of market action versus flows a pretty good sequential increase, but acknowledging that the markets were strong? Can kind of separate those for us and how we can think about that?

Gregg Givens

Peter, if you look at the assets under management, we closed the first quarter with $14.1 billion of assets under management and we ended the second quarter with $15.5 billion of assets under management. So the change from the end of the first quarter to the end of the second quarter we had $1.6 billion of market appreciation and directionally $200 million of net outflows for net $1.4 billion increase in AUM.

Peter Heckmann

Got it. Okay. Great. And then in terms of just thinking about a better comparison, we have not excluded or we have not moved in customer communications to discontinued items, it looks like that business would have contributed about $0.45 in non-GAAP EPS. So assuming you had not moved it to discontinued operation, is it appropriate to kind of think of a $1.87 as an apples-to-apples number that you would have reported?

Gregg Givens

That's right. We had a $1.42 from continuing operations, the discontinued operations contributed $0.45 of non-GAAP earnings per share for a combined consolidated non-GAAP earnings per share of a $1.87 across the total Company.

Peter Heckmann

Got it. That's helpful. And then could you just give us the end of period basic share count?

Gregg Givens

Yes. We close the quarter with 33.2 million shares outstanding.

Peter Heckmann

Great. Thanks. I'll get back in the queue.

Operator

Our next question comes from the line of David Ridley-Lane of Bank of America.

David Ridley-Lane

Sure. Good morning. The cost savings actions you've taken in the financial services segment, I'm wondering it’s $22 million to $24 million in gross savings, but the trends you are seeing in the registered accounts is an offset, so any help you could give us in thinking about a net savings number?

Stephen Hooley

Yes. David, it’s Steve Hooley. I don't want to give you a net number. You've identified one trend, right, which is the decline in registered accounts which we expect, so there will still be some sub-accounting decline. We're also looking closely at the Department of Labor changes that were announced last quarter and what impact that might have on the business going forward and we're working through that with our customers.

I think the other offset is the continuing investment in our infrastructure in security, compliance, and regulatory which continues to be a demand in both the healthcare and the financial services segment. So certainly we took some actions to address the second half of this year and 2017, but as you point out there will be some cost offsets to that, so they won't be - we won't see the full benefit of that reduction.

David Ridley-Lane

Got it. And then on the investments you're making in the financial services segment, could you give us a sense of the overall scale of those gross investments?

Stephen Hooley

Yes. That’s not a number that we break out and I would tell you that we're generally pretty consistent, what we've seen over the last recent 24 to 36 months and we certainly will see going forward is those increased costs from our regulatory compliance security perspective.

David Ridley-Lane

Got it. And then it's been almost a year since the acquisition of Wealth Management Systems. I just wanted to get a quick update on the integration and if you've had any success which you highlight on [cross-selling winds], in the defined contribution plans side?

Stephen Hooley

Yes. I think first of all on the integration side, I’d say the integration is gone very well and in fact the management team that we acquired from Wealth Management is actually now running our retirement business, so John Geli is doing a nice job there. We have seen benefit in some level of cross sell. I think the number that we talked about last quarter in terms of kind of total benefit from all of the acquisitions is we expect to see about 2.5% revenue growth year-over-year 2016 from 2015. Again that's from all of the acquisitions that we did, and that was part of the benefit that we saw this quarter in terms of revenue growth specifically in the financial services sector.

David Ridley-Lane

Got it. Thank you very much.

Stephen Hooley

You bet. Thank you.

Operator

Our next question comes from the line of Dave Koning of Baird.

Dave Koning

Hi, guys. Nice job. And I guess first of all, in the health business, a couple things. The covered lives have been declining sequentially the last couple quarters. I think they were down 6% year-over-year, it doesn't seem to make any difference, really, on the revenue stream, but maybe just wonder what's happening there and why it's not affecting revenue more.

Stephen Hooley

Sure. Good question, and there's two very straightforward answers. The first is mix of business, David. So one of the things that’s happening is we're selling more BPO business and in addition more high value solutions, so high value solutions would be things that we would describe as additional services which are helping our customers to manage their clinical and financial outcomes.

So, you're right. Financial I mean lives covered, we think it's an important metric, but one of the things that we're seeing is quite honestly we're selling more high value services to our existing customers and we’ve seen some movement to BPO operations as opposed to software-as-a-service, and so from that we generate a higher revenue growth, but it’s an excellent observation.

Dave Koning

Okay. Great. And then the other thing that the healthcare, the margins have been so good. Has there been anything the last couple of quarters that's been a little one off, or are you just running at a really nice place now and it's just kind of around where you would probably continue?

Stephen Hooley

I think what you are seeing is the benefits of the investments that have been made over the last three to four years. So the gentleman Jonathan Boehm that runs that business for us and his team have done a terrific job of deploying technology across all sectors of that business, and as we're seeing the increased revenues we're getting the benefit of scale right, and so I think we're very pleased with the results this quarter. We've talked about trying to get to a run rate in the mid-teens from a margin perspective and quite honestly, we think there could be some upside from that mid-teens number.

Dave Koning

Okay. Great. And then the financial business with the cost cuts, I think Gregg mentioned about $1.3 million of cost benefit in the quarter from the cost cuts that you announced. So is it fair to say that $1.3 million annualizes to ballpark $5 million, so is it basically you already have basically dealt $5 million of the annualized benefit that eventually becomes $22 million to $24 million, is that the right math?

Gregg Givens

Well, we implemented the restructuring activity in the second quarter, so directionally you would be thinking there would be $5 million benefit per quarter to get to the $22 million to $24 million of total annual savings, but in the second quarter the impact was directionally $1.3 million.

Dave Koning

So you actually saved during the quarter $1.3 million, but that annual - if you base the annualized, you're like $5 million - am I just think in dollar terms you saved $1.3 million during Q2?

Gregg Givens

That's right. $1.3 million in Q2 and we expect $5 million in Q3 and another $5 million in Q4.

Dave Koning

Gotcha. That makes sense. And then finally, just on the tax rate, you said 36.5% for the full-year. Should we just put 36.5% the last two quarters of the year? It seems like maybe it has to be a little higher than that, but I just want to make sure I understand the difference between the full-year and the quarters.

Gregg Givens

Yes. We are expecting that the rate for Q3 and Q4 to be 36.5%, and what's happening to the rate there, David is that because we sold off customer communications North America, we had a certain amount of income those coming out of Canada that was at a lower tax, all right, and lower tax rate compared to the U.S. tax rate, so that's what's causing kind of the blend there.

Dave Koning

All right. Well, great job. Thank you.

Gregg Givens

Thanks.

Operator

Our next question comes from the line of Brian Essex of Morgan Stanley.

Brian Essex

Hey, good morning and thank you for taking the question. I was wondering I guess if I could dig in particular in the healthcare side. Are you seeing any traction in the markets there due to the disruption I guess on behalf of your competitors? What I mean by that is, there's certainly a lot of M&A consolidation restructuring on a competitor front. Any traction there because of that disruption?

Stephen Hooley

So good observation, Brian. At a very high level, we would say that there’s kind of four things going on in a healthcare industry which are creating significant amount of uncertainty right. One is the merger activity that you spoke about with four of the top five entities talking about potential mergers.

There's a significant question in our mind and I think in the marketplace about the exchanges and who's going to play in the exchanges and where they're going to play. We think there's a relatively big question about which states will expand their Medicaid programs.

And then of course we have a presidential election going on which we think will may have direct impacts on the future of healthcare. So there's a lot happening. Here is what I tell you I think that we have been a net that's been a benefit to us. Mostly because we have got a terrific list of blue-chip clients who have done extremely well in the marketplace and so we've seen kind of nice organic growth.

And as I said we've developed some clinical solutions which again allow us to sell more to that existing customer base. So again we're pretty comfortable with our line of sight through the end of the year, we are significantly less comfortable with our line of sight for 2017 and beyond. And again we just think there’s a significant number of activities happening in that marketplace.

The final point I'd make is that we kind of like to think that whenever there's disruption going on in the marketplace and the potential for you know regulatory change or program change. We tend to be in a really good position to help our customers figure that out and benefit from it. So we're very bullish on the marketplace but as you point out there's a significant amount of disruption going on right now.

Brian Essex

Great. Maybe if I can put that as a follow-up I guess on the M&A side in particular, as you sell non-core assets and bring cash under the balance sheet, obviously, you've got your strategic initiatives, but from the M&A perspective, is there anything there that you would focus on and maybe give us some insight in terms of strategically, how you look at enhancing your business to pursue those initiatives?

Stephen Hooley

Yes. We obviously not going to comment on any M&A activity what I would say is that we're seeing this quarter the benefit of acquisitions that were done during 2015 and 2016 and we think that as it relates to revenue growth in the Company, doing some of these tuck-in acquisitions have been helpful. Again we've seen the benefit this quarter.

And as Gregg pointed out during his comments, we've got an extremely solid balance sheet which gives us plenty of flexibility in the event we see something that we think would benefit our customers and our shareholders.

Brian Essex

Is there a way, and again not asking for specifics, but that you look at that as it relates to what your existing business looks like with regard to market share of customer [penetration] leads your breadth of offerings?

Stephen Hooley

Yes, I think - listen I think our actions this quarter I think really solidify the fact that we are very focused in the financial services and healthcare sectors and so anything that that we can do which would expand the solution offering that we can bring to the marketplace we think is positive. And so those are the quarters that we're focused on.

Brian Essex

Very helpful. Thank you.

Stephen Hooley

You bet.

Operator

At this time, there are no further questions. I would like to turn the floor back over to Mr. Hooley for any additional or closing remarks.

Stephen Hooley

Great. Well thank you all very much. We look forward to updating you at the end of third quarter.

Operator

Thank you, ladies and gentlemen, this does conclude today's DST Systems second quarter 2016 earnings conference call. You may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!