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Executives

Thomas A. McDonnell - Chief Executive Officer and Director

Analysts

David J. Koning - Robert W. Baird & Co. Incorporated, Research Division

James F. Kissane - Crédit Suisse AG, Research Division

DST Systems (DST) Q1 2012 Earnings Call May 1, 2012 8:00 AM ET

Operator

Good morning, and welcome to the DST Systems Incorporated Q1 2012 Earnings Conference Call. [Operator Instructions] Now, I would like to turn the conference over to our host, Mr. Tom McDonnell. Please go ahead.

Thomas A. McDonnell

Good morning. I'm joined here in Kansas City by Steve Hooley, President, COO; and Ken Hager, our CFO.

But before beginning, I'd like to remind everyone that in the course of our conference call today, we will make forward-looking statements regarding DST or some of its businesses. Such statements are based on our views of today, and actual results could differ materially from forecasted results. Could be a number of factors affecting future results, including those risk factors set forth in our latest annual and quarterly reports, which we file with the SEC. All such factors should be considered in evaluating any forward-looking statements that we make. Since participants on the call have access to our detailed earnings release, we'll focus our comments on those items that we think are most significant.

As a reminder, all of our comments on our financial results refer to our non-GAAP results. A reconciliation to the most comparable GAAP measures have been provided in the first quarter earnings release.

On an adjusted non-GAAP basis, diluted earnings per share for the quarter were $1.05. That compared to $1.08 for the first quarter of 2011. Consolidated operating revenues came in at $475.9 million. That was an increase of $49.9 million or 11.7% from the 2011 period. And that reflects the inclusion of ALPS, the Lateral Group and Newkirk. This is the first full quarter of inclusion of ALPS revenues.

Consolidated operating income decreased by $8.1 million, and that was an 11.1% decline from the first quarter of 2011. We continue to make increased investments in new business development for brokerage, retirement and insurance verticals. And we also had business expansion costs incurred in the quarter for DST Output Canada, where they're expanding the plant. And those are the primary reasons for the decline from last year.

Financial Services operating revenues increased by $30.3 million. That was a 10.8% increase over the first quarter of 2011. $23.8 million of that increase was the inclusion of ALPS. We also recorded revenue increases for brokerage, retirement, healthcare and the AWD product.

Mutual fund shareowner account fees declined. That was a result of lower registered accounts being serviced. However, software license revenues were $2.6 million or 29.5% more than the first quarter of 2011, primarily from higher AWD license fees.

The Financial Services cost and expenses increased by $34.1 million or 17% over the first quarter of 2011. That reflects the inclusion of operating cost of ALPS and the other businesses acquired during '11. And also, business development and start-up costs for insurance, brokerage and retirement, those businesses, the start-up costs actually increased by $6 million to a total of $11.6 million for the quarter. Depreciation and amortization was up by $3.4 million. $2.3 million of that was attributable to the 2011 acquisitions.

Financial Services income from operations decreased by $7.2 million, or 11.5%. We had $3.1 million registered accounts that converted to sub-accounting. $1.7 million of those converted to DST's sub-accounting system, and the balance went to other platforms. We did have 300,000 accounts of organic growth and 500,000 new account conversions, so that the net reduction in registered accounts was 2.3 million. The sub-accounts processed actually increased by 2.1 million for the quarter. That included the conversion of DST's registered accounts of 1.7 million and a combination of organic growth and conversions of 400,000 accounts to our platform, and that comes to the increase of 2.1 million for the quarter.

In line with our previous projections, we expect that 8 million to 10 million registered accounts will convert to sub-accounting for 2012. We estimate approximately 30% of those accounts will convert to DST's sub-accounting platform. We think a majority of the accounts will probably convert in the first half of 2012, although we can't determine the exact timing of conversions.

Turning to defined contribution participants. They increased by 100,000 in the quarter. When you look at defined contribution plans, they need to maintain the accounts of participants who terminate their employment during a given year until the second quarter of the following year to support tax and other reporting requirements. We actually see annually a reduction of the terminated participants processed during the second quarter. We have new client conversions, however, scheduled at 1.3 million participants for late 2012 and '13. And of that total, we anticipate the conversion of 600,000 participants in the fourth quarter of this year and the remainder throughout 2013.

During the first quarter of '12, the pharmacy claims processed by Argus Health Systems increased 8.2% to 99.2 million claims. That was pretty much driven by new client conversions. Health Solutions revenues, they increased principally from software-related revenues.

Our equity in BFDS earnings was unchanged from the 2011 quarter. Their average balances for the period declined slightly to $1.2 billion from $1.3 billion last year. The interest rates that BFDS earned on those balances decreased from 16 basis points to 10 basis points, and as we continue to reiterate, that negatively impacts BFDS results.

DST's equity and earnings of IFDS International Financial declined from the prior-year quarter by $4.3 million. However, IFDS U.K.'s accounts actually increased by 100,000 during the quarter, but the earnings decline results from higher costs related to a lot of new business development and client conversion activity. IFDS U.K. is establishing its Percana software that's for insurance and pension recordkeeping in the U.K. and it's actually in the process of converting to insurance/pension clients. IFDS U.K. is also in the early phases of converting 2 new shareowner processing clients with approximately 800,000 accounts. These conversions should be complete by December 31 of this year. So new business development and client conversion cost will continue to have a negative impact on earnings for the remainder of this year, and the positive side should materialize in 2013.

IFDS Canada came into '12 with 10.1 million accounts, and it's received a client commitment, which will increase its accounts by 10% to 15%. That's a conversion that should occur in the fourth quarter. But in preparation for that, IFDS Canada has and will continue to incur upfront cost to convert this client, and that'll be a drag on their earnings for '12 also.

Turning to Output. The North American operating revenues increased by $6.2 million in the quarter. That reflects the Newkirk acquisition and new client revenues. The North American income from operations declined by $800,000 to $9.6 million, and that resulted in an operating margin of 8.4%. In the quarter, we had a cost for the Canadian plant expansion, we're about doubling the capacity up there, new client conversion costs. And Newkirk's first quarter is one of their seasonally lowest, and all of those contributed to the decline from last year. Newkirk's business is more seasonal than the rest of Output North America given their customer set. And so a significant portion of its profits have historically been earned in the fourth quarter. EBITDA for North America declined by $1.3 million to $16.9 million.

Output U.K., their subsidiary, IOS, had operating revenue increase of $12.9 million, and that principally reflected the acquisition of the Lateral Group, although we did experience some lower volumes from several existing clients. IOS reported an operating loss of $1 million for the quarter. It reflects somewhat lower-than-expected sales, but also facility consolidation costs involved with both real estate and redundancies.

In January of '12, this -- we acquired the remaining shares of IOS, so that it's now a wholly owned subsidiary. That will assist us in achieving what our goals are for IOS, facilitate ongoing cost reduction from the consolidation of facilities and the redistribution of work to the remaining locations. But those, of course, will have upfront onetime real estate disposition and staff reduction costs, and we anticipate that will be with us over the next 3 quarters.

Our real estate holdings, reporting those on 2 bases here. We had $0.03 per earnings per diluted share of the quarter. That's $0.02 higher than '11. And that real estate generated $5.3 million of operating EBITDA, and that's an increase of $500,000 over the prior-year quarter. If you look at the funds from operation, or FFO, they were $5.8 million or $0.13 a share for the quarter. That's an increase of $1.1 million or $0.03 per share from the same quarter of '11. On our consolidated real estate debt, plus the prorated share of joint ventured debt, stood at $301 million at March 31. And substantially all the joint venture debt is nonrecourse.

The income tax rate for the quarter was 32.5%. That compared to 35.7% the first quarter of '11. The lower 2012 rate reflects increased dividend income and higher international earnings, which both attract lower rates. We're currently estimating our income tax for 2012, the income tax rate for 2012 will be approximately 34.5%.

The average diluted shares outstanding for the quarter were 45.2 million. That's an increase of 500,000 shares or 1.1% from the fourth quarter of '11. Those are primarily shares issued under equity compensation plans. The average diluted shares outstanding decreased 1.8 million shares or 3.8% from the first quarter of last year, however. And that reflects the shares that we repurchased in the second half of '11.

Contributing to the increase, we had stock option exercises and take those in combination with stock option expirations. That resulted in a decline in total equity units, which are comprised of unexercised stock options, restricted stock and restricted stock units of 1.4 million units, so that was a 28% decline from the end of the year. We also expect to receive a cash dividend of approximately $47 million from a minority investment in a private company in mid-May.

Anticipate that we may also be selling a portion of our investment in a transaction arranged by that company, and that if we do, that would generate approximately $140 million of pretax proceeds. However, both the dividend and the sale are contingent on the closing of certain recapitalization events by the company. If they do occur, our intention would be to pay down debt with the after-tax proceeds.

So with that, operator, we'd now like to open up the call to questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes of the line of Dave Koning with Baird.

David J. Koning - Robert W. Baird & Co. Incorporated, Research Division

My -- I guess my first question is just on, the Financial Services segment was quite good in terms of organic growth. It was about flat year-over-year for the first time in several quarters. Is the expectation now that, that can continue to be around flat or maybe even start to grow again organically?

Thomas A. McDonnell

Well, I think if -- we still fully expect the 8 million to 10 million registered accounts to move to sub-accounting, if you neutralize that, so to speak, we think there's some underlying growth there. And of course, part of it moves over to the -- from the registered to the sub-accounting. And we are viewing really the several sources of revenue that come off what's really the underlying mutual fund system. There's the registered accounts, the sub-accounts and the retirement accounts. Because all of those systems, the TA2000, which is the registered mutual fund account system, the sub-accounting system and the TRAC, which is the retirement system, their underlying architecture is all the mutual fund systems. So it has similar operating characteristics both from the way we can move staff around and use the data center resources. So I think we're seeing, within the accounts side, a little bit of growth, but obviously offset by the shift. But with the pickup in revenue in sub-accounting and retirement, I think we're looking at more, the 3 of those combined should be pretty stable throughout the year and if our projections are correct, that this should be -- there should be a significant decline in sub-accounting conversions from registered account next year. I think you can generally get a sense that, that combined revenue, at least, is stable to -- with some opportunity to move up late in the year and into the first part of next.

David J. Koning - Robert W. Baird & Co. Incorporated, Research Division

Okay, great. And then I guess secondly, ALPS was a little better than what we expected. I'm just wondering, is there seasonality? I know it started the year at about $24 million. Is that a pretty stable revenue stream or is Q4 -- I'm sorry, is Q1 seasonally strong and then it drops off in Q2?

Thomas A. McDonnell

It's not necessarily seasonally stronger, but I mean I think, obviously, a certain portion of their revenue is tied to market movements. So you had a pretty strong first quarter in the markets overall, so we would hope we could at least sustain the gains in the first quarter. I'm not sure what you'll see for the rest of the year. You kind of have to look at a portion of their results based on what your expectations for total returns for the market are for the year. But it's not seasonal per se. It just happened to be linked to a pretty strong first quarter in the equity markets.

David J. Koning - Robert W. Baird & Co. Incorporated, Research Division

Okay, great. And then my final question, what portion of that investment are you planning to sell to get the $140 million of pretax? I guess I'm just wondering what might be left -- kind of valuing what might be left?

Thomas A. McDonnell

Well, we haven't -- because of the agreements we have in our private equity and other things, we're not really in a position to disclose that at the moment until everything becomes final. So really can't help you too much there, I apologize for that.

Operator

[Operator Instructions] Our next question comes from the line of Jim Kissane with Credit Suisse.

James F. Kissane - Crédit Suisse AG, Research Division

Just following up on the last question. Your thoughts maybe on paying down debt versus buying back stock with the proceeds?

Thomas A. McDonnell

Well, I think we increased debt beyond what our normal targets would've been last year, Jim, when we acquired ALPS, because ALPS was an opportunity that came up in the second half of the year. So -- and we put some not technically interim, but another piece of financing in to accommodate that. So we'd like to get it back down to sort of pre-ALPS levels. And this would be one reasonable step to that, plus the application of cash flows for the year.

James F. Kissane - Crédit Suisse AG, Research Division

And just going back to David's question on ALPS, it did seem like it had good performance. Can you give us a sense of the year-to-year growth in ALPS? I didn't catch it, if you did.

Thomas A. McDonnell

Well, when you -- we had them for just -- we didn't have them for the full year last year.

James F. Kissane - Crédit Suisse AG, Research Division

If you look at their performance in 1Q last year versus its performance this year.

Thomas A. McDonnell

We don't have that number in front of us, Jim. It's -- they've been growing 20-change percent, and that's what we -- when we bought it, that's some of the projections. So we anticipate that's probably what'll be realized this year. So I think you can think in terms of 20% ups.

James F. Kissane - Crédit Suisse AG, Research Division

Got you, okay. And then it seemed like the U.K. Output losses moderated somewhat from the fourth quarter. And what the outlook for U.K. Output earnings?

Thomas A. McDonnell

Well, it's moderated somewhat from the fourth quarter, but I will tell you some of the onetime expenses slipped from Q1 into Q2. Because when we acquired Lateral, we picked up what we've now concluded is one of the more attractive production sites in Nottingham. So that delayed a couple of the closures, although our sense is that the disposition of real estate's coming in more positive than we thought, so I don't think you can -- I wouldn't suggest that, that's an absolute run rate because we will probably have a -- somewhat increased redundancy and plant closings in the second quarter. But the business with the new Lateral management and so forth has stabilized, so I think from an operating standpoint, it should continue to prove throughout the year. But the remaining costs will be incurred, I think, substantially all this year for plant closings, consolidation and staff reduction. But it's a little hard at this point to predict exactly which quarter.

James F. Kissane - Crédit Suisse AG, Research Division

If you look out to 2013, will it still be a drag on Output margins?

Thomas A. McDonnell

We would hope not. I think it should -- now of course, we're stating the margins separately here, the 8.4% does not include the U.K. And the drag on that margin, it was the plan expansion in Canada. We picked up a sizable piece of business there and literally had to double the plant, so you had some front-end costs associated with that. But I would hope that by 2013, that IOS U.K.'s at least neutral to positive.

James F. Kissane - Crédit Suisse AG, Research Division

Okay. Just a couple of more questions. Update on your insurance initiative? We haven't heard too much about it in a while, and how quickly do you see revenue and earnings developing there?

Thomas A. McDonnell

Well, the 3 major development businesses we have are retirement. Retirement, of course, is an in-place business with a system there. It's really -- a lot of the investment there is in adapting the system to some very large customers, because usually what you find no matter how complete your system, large customers have incremental requirements. And the conversion costs for retirement are high, but the business then is very sticky. So that's really the nature of the cost associated with the retirement. On the brokerage side, it's kind of a 2-phase business. That's where sub-accounting is embedded. And the investment really is more in the peripheral products to expand the offerings to brokers, and those are a series of smaller investments. On the insurance side, we re-platformed the system for domestic use in the U.S. And what we're looking at very closely now is one, its applicability to the marketplace and the timing of entry there. So it's a little premature to predict when you would see revenues. The product, I'd say it's been re-platformed just because the Java language is preferable in the U.S. marketplace. But also there's some elements of the system like a pay-out system that are in place, but there's some other elements that would be necessary to make it applicable to a broader segment of insurance, Jim. So I would think by the end of Q2, we'll have a good answer for you on that.

James F. Kissane - Crédit Suisse AG, Research Division

Okay. And my last question. The $0.60 to $0.65 of business development and start-up expenses this year, where do you see that falling in 2013? Any sense of what kind of drop-off we might expect?

Thomas A. McDonnell

No, I don't today. I mean typically what happens, particularly -- probably the more difficult one to predict there would be insurance because it's usually, in the early stages of bringing a system up, you incur similar costs when you're bringing on the first several customers. You might re-categorize it from development to conversion or whatever. I think they will moderate. But certainly, these -- the sense is if the run rate of expense continues, there would be a incoming amount of revenue to offset it. But again, I think once we have a little bit better handle on insurance, that's this point, Jim, the most difficult one to predict. But we do think the $0.60, $0.65 for this year is a good number. I would fully expect it to decline somewhat next year, but I wouldn't want to try and give you an order of magnitude today.

Operator

[Operator Instructions] Thank you. That concludes our question-and-answer period. I would now like to turn the call back over to Mr. McDonnell for closing remarks.

Thomas A. McDonnell

Well, thank you guys for joining us this morning. And we look forward to talking with you at the end of the second quarter. Thanks again.

Operator

Thank you, all, for joining us today and for your continued interest in DST. We look forward to speaking to you next quarter.

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