DST Systems, Inc. Q4 2007 Earnings Call Transcript

DST Systems, Inc. (DST)

Q4 FY07 Earnings Call

January 22, 2008, 9:30 AM ET

Executives

Thomas A. McDonnell - President and CEO

Kenneth V. Hager - VP and CFO

Analysts

James Kissane - Bear Stearns

Charles Murphy - Morgan Stanley

Gregory Smith - Merrill Lynch

Murali Gopal - Keefe, Bruyette & Woods

David Koning - Robert W. Baird & Co.

Presentation

Operator

Ladies and gentlemen thank you for standing by, and welcome to the DST Systems Fourth Quarter Earnings Release. At this time, all participants are in a listen-only mode and later we will conduct a question-and-answer session with instructions being given at that time. [Operator Instructions]. As a reminder, today's conference is being recorded.

And I would now like to turn the conference over to your host, President and CEO, Mr. Tom McDonnell. Please go ahead, sir.

Thomas A. McDonnell - President and Chief Executive Officer

Thank you and good morning. Before starting, I'd like to make a statement under 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 can be a number of factors affecting future results including those 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 financial 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 these certain non-GAAP items accompanies the earnings release. On that non-GAAP basis, this net income for the fourth quarter of 2007 totaled $67.7 million. That's $0.98 per diluted share, and that compares to $65.5 million or $0.93 per diluted share for the fourth quarter of 2006. That's an increase of 3.4% in total net income and 5.4% in diluted EPS.

Consolidated operating revenues increased $13.2 million or 3.1% over the fourth quarter of 2006 to a level of $432.5 million. Consolidated income from operations in the fourth quarter of 2007 increased by $5.3 million or 5.7% to $99.1 million. Consolidated operating margin increased from 22.4% in the fourth quarter of 2006 to 22.9% in the fourth quarter of 2007.

Turning to Financial Services, Financial Services revenues increased $15.8 million or 5.6% to $297.8 million. That represents higher mutual fund shareowner processing revenues and increased international professional services revenues. Software license fee revenues increased $1.6 million or 9.6% to $18.2 million. And that's compared... that increase is compared to the fourth quarter of 2006.

Financial Services income from operations decreased by $3.4 million or 3.7% from the fourth quarter of 2006 to a level of $88.7 million. The increased contributions from mutual fund shareowner processing were offset by lower international contributions. In addition to that, an item affecting the comparability of the 2007 and 2006 quarter was the recognition in the 2006 quarter of approximately $5.7 million of data processing support and professional services revenues for services that had been performed in prior reporting periods.

Overall, our operating margin declined from 32.7% in the fourth quarter of 2006 to 29.8% in the 2007 quarter.

Output Solutions, by the way in the press release there was a typographic error that referred to the percentage increase in items mailed as 24.1%. And the correct figure should be 2.4%.

Going back to Output Solutions, our operating revenues overall decreased by $2.2 million or 1.6% to $133.7 million for the quarter. The items mailed increased to 2.4% that I just referenced to 654.4 million items mailed and images produced, however, decreased 4.9% to 3.9 billion images.

Output Solutions converted a new telecommunications client during the quarter that contributed to the increase in the items mailed. The decrease in images is a result of certain of the telecommunications clients reducing the amount of transaction information that they print on their invoices. As a result, operating revenue per image actually increased by 2.7% compared to the fourth quarter of 2006, since the decrease in pages printed were lower relative volumes from those customers with lower unit pricing.

Output Solutions operating income for the quarter totaled $6.6 million as compared to a net loss last year in the quarter of $1.5 million. That results from lower material costs and lower leased equipment costs, reflecting the implementation of owned digital printing equipment.

Depreciation and amortization increased $700,000 in the fourth quarter of 2007. That again is from the depreciation for new printers and inserters.

Equity in the earnings of unconsolidated affiliates was $9.9 million in the fourth quarter of 2007. That's a decrease of $7.4 million from the fourth quarter of 2006. In the 2006 fourth quarter, we recorded a $5.5 million of equity in the earnings of Asurion. And no earnings were recorded for Asurion in the fourth quarter of 2007 as our remaining investment is now accounted for on a cost basis.

There were several other items comprising the quarter change. Higher earnings were recorded at BFDS from higher mutual fund shareowner account servicing revenues. The earnings decrease at International Financial Data Services reflects new customer conversion costs, higher income taxes, foreign currency exchange losses and increased depreciation expense.

Subsequent to quarter end in the first week of the year, IFDS Canada converted a new remote client with 3.2 million shareowner accounts. That compares to the 7.5 million shareowner accounts that they had at December 31^st of 2007, so that, that conversion has occurred in early January.

Earnings at Argus decreased from slightly lower operating revenues and higher operating costs in connection with processing Medicare Part D claims. The increase in equity in the earnings of Other is primarily the result of increases in contributions recorded by certain real estate... certain of our real estate joint ventures.

Other income was $8.6 million in the fourth quarter of 2007. That was a decrease of $800,000 as compared to the fourth quarter of 2006. The decrease is primarily due to account receivables securitization program fees and unrealized losses on marketable securities designated as trading, to partly offset by higher dividend and higher interest income.

The increase in interest income was from investing the cash proceeds from the sale of Asurion that we used in December of 2007 to fund the company's income tax obligations that arose from the Asurion sale.

Interest expense was $11.1 million in the fourth quarter of 2007. That's a decrease of $6.4 million from the fourth quarter of 2006. The decrease in interest expense is primarily from the lower average debt balances outstanding in 2007. That's as a result of using a portion of the Asurion sale proceeds and proceeds from the accounts receivable securitization program to reduce other forms of debt.

The income tax rate for the 2007 and 2006 fourth quarter respectively was 36.4%. The increase in the tax rate from the 34% projected at the end of the third quarter 2007 was due to higher than projected domestic and lower than projected international corporate joint venture income occurring in the fourth quarter 2007.

We currently expect DST's tax rate for 2008 to approximate 36%. U.S. mutual fund shareowner accounts processed totaled 119.1 million accounts at December 31st 2007, a net increase of 900,000 or eight-tenths of a percent at the end of the third quarter of 2007.

For the year, account growth came from new client conversions of 7.9 million accounts, accounting for 7.5% of the increase and net growth from existing clients of 5.4 million or 5.1% for 2007 for a total of 12.6% growth.

Tax-advantaged retirement and educational savings accounts serviced totaled 46.2 million accounts at the December 31st year end. That was a net increase of 800,000 accounts or seven-tenths of a percent since September 30th of '07.

Since September 30th of 2007, DST received new client commitments for approximately 100,000 mutual fund shareowner accounts. Currently, we have new client commitments for approximately 530,000 mutual fund shareowner accounts and approximately 7.1 million mutual fund sub-accounts based on the current levels of the clients. Mutual fund shareowner accounts were expected to convert in the first half of 2008, and the sub-accounts are expected to convert at various times throughout the year.

During the fourth quarter of 2007, DST repurchased 1,110,000 shares of its common stock at an aggregate cost of $93.5 million or $84.23 a share. DST had 60.8 million shares outstanding at December 31st, 2007 which includes $2.6 million unvested restricted shares. The net effect of share repurchases and shares issued from stock option exercises resulted in the decrease of shares outstanding of 700,000 shares for the quarter.

Average diluted shares outstanding for the fourth quarter of 2007 were 69.4 million shares. That's a decrease of 700,000 or 1% from the fourth quarter of 2006 and a decrease of 500,000 shares or seven-tenths of a percent from the third quarter of 2007.

At December 31st, 2007 the dilutive effect of the convertible debentures was 7.1 million shares. Effective outstanding stock options was 2 million shares and restricted stock was 1.5 million shares. That aggregates dilution of 10.6 million shares. The aggregate diluted effect increased by 600,000 shares from the prior year quarter as a result in the... of an increase in the company's average share price.

Total stock options and restricted stock equity units outstanding at December 31st, 2007 were 8.6 million. That's a decrease of 600,000 equity units or 6.5% from September 30th, 2007.

At December 31st, 2007 DST had approximately 1.9 million shares remaining to be repurchased under the existing share repurchase plan. On January 18, 2008 DST's Board of Directors authorized an additional 5 million shares to be repurchased under the existing share repurchase plan through December 31st, of 2009.

At this point, we will now turn the call over for questions. Lilly?

Question And Answer

Operator

Thank you. [Operator Instructions]. And our first question will come from the line of James Kissane of Bear Stearns.

James Kissane - Bear Stearns

Hi thanks Tom. Tom, can you give us a little more color on software revenue in the quarter, maybe the relative contributions from AWD Healthcare and Investments and any differential in terms of margins?

Thomas A. McDonnell - President and Chief Executive Officer

Well we don't break out the margins, Jim by those various categories.

James Kissane - Bear Stearns

Just on a relative basis.

Thomas A. McDonnell - President and Chief Executive Officer

Well I think, overall Ken, I think some of the increase was Health Solutions.

Kenneth V. Hager - Vice President and Chief Financial Officer

Yes, it was a slight increase in Health Solutions and that the investment accounting, AWD is relatively flat.

James Kissane - Bear Stearns

Okay. Is it fair to say healthcare is lower margin or also upwards high margin?

Thomas A. McDonnell - President and Chief Executive Officer

Up on licenses Jim. It's pretty much all very, very high margins because in the quarter they recorded the license revenue itself really is generally only impacted by direct commissions or sales expenses associated with it.

James Kissane - Bear Stearns

Okay, great. And then, Tom, is output tracking [ph] your plan for margins. I think you guys had once said double digit was achievable. Is that still?

Thomas A. McDonnell - President and Chief Executive Officer

We believe it is. I mean it's not probably achievable in the next few quarters. We'd like to think over the next couple of years if we can get it back into double digits. I think the... obviously the business there has continued to change. I think the management there... new management's been reacting to that fairly solidly. We were comfortable with the quarter. First quarter as you know tends to be a seasonally good quarter for Output. So we'll probably see some positive impact there, really coming out of the first quarter, Jim. I will have a much better sense whether we are on track for that. That is still our plan in the next couple of years to get up into the double digits.

James Kissane - Bear Stearns

Excellent. Just one last question. A little insight into the foreign currency losses within IFDS during the quarter.

Thomas A. McDonnell - President and Chief Executive Officer

As to order of magnitude or primarily it has to do with the various positions that are held in U.S. dollars and in foreign books. We've altered the way we're holding those currencies now. So we should minimize some of that risk going forward because most of the operations have to some degree a natural hedge Jim, based on the amount of expenses they incur in the local currency. But in this particular quarter, we sort of took action to change the base currency, particularly in Canada that before have been held on Sanmina [ph] Company obligations that were U.S. dollar denominated. So, that's the primary source of the loss in the quarter.

James Kissane - Bear Stearns

That's helpful. Thanks Tom, take care.

Operator

Thank you. And next we'll go to the line of Charlie Murphy of Morgan Stanley. Please go ahead.

Charles Murphy - Morgan Stanley

Thanks Tom. Could you give us some detail on to what type of margin in the Financial Services segment you're hoping to manage toward in 2008? Can that margin increase? And could you give a little bit more detail on why margins in the international piece of that segment appear to be lower year-over-year in the fourth quarter? The revenues appeared to be pretty solid.

Thomas A. McDonnell - President and Chief Executive Officer

What, I think that the nature of some of the revenue in the international side, DSTi has shifted from the mix. We've had more consulting and maintenance revenues, both the license revenue which would have brought that margin down. We don't actually project target margins going forward in the fourth quarter. Some of the discussion we had there, some of the out of period revenues that we're in Q4 '06 would have probably altered that margin up somewhat. And that comparison then would have been less favorable.

Given the way this year's starting out with the market we had experienced reasonable for a change in '07 internal growth rates. I haven't seen the market this morning. I understand it was open down pretty significantly. If the market continues to drift down, two things will impact, there's one that kind of moves back investor confidence or least in many cases paralyzes. And so we may not see some of the growth that we've seen before. And then to the extent that in some of the relationships through joint ventures and so forth we do have some degree of float associated with those, and with the declines in the federal rates we'd expect some pressure there. So I think until this first quarter kind of clarifies the overall market conditions it's going to be pretty hard to talk about which direction margins are going quite frankly.

Charles Murphy - Morgan Stanley

Okay, thanks.

Operator

Thank you. And next we'll go to the line of Greg Smith of Merrill Lynch. Please go ahead.

Gregory Smith - Merrill Lynch

Yes, hi. Good morning guys. Tom just regarding the software sales in the fourth quarter, would you just consider this normal business activity? Or were there some large sales that may be sort of pulled some of your... some potential sales of '08 into '07 into the fourth quarter or again is this just sort of normal business activity from your perspective?

Thomas A. McDonnell - President and Chief Executive Officer

I'd say on a historic basis it's somewhat less than normal. There were no big deals at all. And there certainly was nothing that was brought forward. In fact by policy, we tend to let software sales go where they may, I mean in some software companies that are heavily oriented to others, they're usually pushed to bring stuff into the quarter. A lot of times, price concessions are approaches to maintain price because of the client needs a software, will buy it sooner or later. And we're somewhat indifferent to what quarter that actually occurs in as opposed to having the high quality revenue. But I'd say in the fourth quarter, there were no big deals and clearly nothing was not clearly... but nothing was brought forward from '08 into '07. So if anything, it was maybe somewhat less than normal.

Gregory Smith - Merrill Lynch

Okay, interesting. And then just on IFDS. It sounds like all these different things you called out are potentially one time in nature, negatively impacting the operating profit. Is that a fair characterization?

Thomas A. McDonnell - President and Chief Executive Officer

I believe that's correct. When we say IFDS, we combine IFDS Canada and IFDS UK. And we did have a client commitment at IFDS Canada that we had anticipated would convert fourth quarter of '07 but it actually converted in the first couple of weeks of '08. So that should be positive. They are although for a period of time that still have some residual conversion costs but going into later this year and early next, that ought to be a positive for the Canadian operation and also is positive in positioning in that overall marketplace. As you suggested a number of the others were somewhat one time in nature. On the UK international business, or IFDS UK rather, that business has seen some steady growth benefiting from their participation with coupons in the supermarket segment of the marketplace over there. But I'm not quite sure, and sometime, not sure the distant future there'll be some impact there as that operation starts to reflect positive or starts to reflect tax expense versus tax benefit.

Gregory Smith - Merrill Lynch

Okay, thank you.

Operator

Thank you. And next we'll go to the line of Murali Gopal of KBW. Please go ahead.

Murali Gopal - Keefe, Bruyette & Woods

Good morning and thanks for taking the call. Couple of quick questions. The revenue growth in the Financial Services segment, could you give us an idea how the growth in the segment was if you exclude the healthcare processing business? In other words, I'm trying to get a feel for, you had ASI for a full year now, how that... how the health claim processing business is tracking versus the expectations? I mean is it... is it surprising you on the upside? Or is it more or less what you expected? Just getting a feel for what the Financial Services growth would have been with and without that piece of the business.

Thomas A. McDonnell - President and Chief Executive Officer

Right. I think the Financial Services, the specific numbers we report there are the growth with accounts, where it dropped about 12%. Most of that was remote revenue. So you would have expected the absolute revenue to grow at somewhat less than 12% because you have a combination of remote fees into our service fees, can't give an exact number there. Health Solutions is about tracking where we thought, there were certainly no upside surprises or some modest surprise in some of the fourth quarter licenses. I think that ASI and Health Solutions are now, we believe, successfully integrated. And hopefully we'll all be seeing progress throughout '08, both... and couple of things; one, we have a strategy there to move to the extent we can license customers either remote processing or full service processing. And then we also have reorganized sales to profit [ph] and we think we'll be more effective out there. But we don't actually break out the revenue growth by those two segments.

Murali Gopal - Keefe, Bruyette & Woods

Sure. And in terms of operating margin, would you say that health claim processing business is more or less tracks with the Financial Services segment or it's a lower, significantly lower than the Financial Services segment margin?

Thomas A. McDonnell - President and Chief Executive Officer

Currently it's lower. We anticipate that longer term it can maybe approximate the Financial Services although it's a... maybe not fully reaching it because it's a little more diversified book of revenue with more smaller clients. And you still... when you look it at those numbers, there is still some amortization of goodwill and so forth included in the Financial Services segment which impacts that margin on a GAAP basis.

Murali Gopal - Keefe, Bruyette & Woods

Okay. And in terms of your capital management strategy, I'm just trying to think through... you have the new authorization for $5 million buyback. And you have a comment in the release. I guess you may be entering in an agreement for some kind of accelerated buyback. I'm just trying to get a feel for... obviously the last couple of years you have done acquisition from the health claim processing space. Does that mean, obviously, and I don't expect you to guide on acquisitions. But does that mean what you see out there in terms of opportunities to expand further in that space? You don't see as many opportunities as... is that always or we should be thinking about Tom, the whole capital management strategy there?

Thomas A. McDonnell - President and Chief Executive Officer

Well I think as to Health Solutions in particular, I mean the two companies that we acquired were... in the health side of the rule that's fairly broad between all the insurers and so forth. There's a lot of historic in-house systems and so forth that when you look at the combined business that we now call DST Health Solutions which was the old health solutions and ASI, compared to other competitors like Trizade [ph] and so forth were reasonably sized and well positioned in the marketplace. So it's not in our opinion one that necessarily lends itself to a lot of acquisitions. It's more of penetrating some of those books of business that have traditionally been in-house.

As to the refreshing of the stock purchase one, I don't believe we indicated at all that we're doing anything on accelerated basis and have not committed any accelerated purchase plan. Historically, this runs through the end of '09. Historically we have kept something of this order of magnitude in the repurchase plan. Historically we have completed them over some period. But if I am taking a quick look at the release I am not... I don't believe that we basically the language that you see there is kind of below the plate [ph] that says, if we're authorized to do that if so choose but we have not in any way opted for or engaged in any accelerated repurchase.

Murali Gopal - Keefe, Bruyette & Woods

Sure, thanks. That's helpful. And lastly I was going to ask you, in your third quarter you still had the some tax obligation from Asurion gains that were going to be paid I guess in the fourth quarter. Just looking at the cash balance in the end of the fourth quarter, does that fully reflect all the tax obligation on the Asurion gain or there is still some left out to get to that?

Thomas A. McDonnell - President and Chief Executive Officer

Yes that tax obligation is payable, I think mid December around the 15, so that was paid out then. So the year-end cash would reflect that. However for the whatever that would be about 75 days of the quarter, we did have a several hundred million of cash that was invested. So that would have added to the interest income in the quarter and that obviously will be on the interest side and that will not be there going forward.

Murali Gopal - Keefe, Bruyette & Woods

Sure, thank you very much.

Thomas A. McDonnell - President and Chief Executive Officer

Yes.

Operator

Thank you. And next we'll go to the line of Dave Koning of Robert W. Baird. Please go ahead.

David Koning - Robert W. Baird & Co.

Yes, good morning guys. You mentioned a little about the stock market impact and how the volatility could result a little bit going forward if it continued. I'm just wondering over the six weeks or so when the market has been pretty volatile. If you've seen any impact from your clients whether it be any accounts moving away or anything like that. Maybe you could just talk about that a little bit.

Thomas A. McDonnell - President and Chief Executive Officer

Well,I mean, I think, the comment that I made on the volatility has got to... relative to the last several days and what... at least according to the futures, was going to be a less than attractive day to day. Over the last six weeks or so, you really don't have much of an indicator. Historically, a few weeks around Christmas and the first few weeks of the year are not... do not show a lot of activity. First quarter activity, a lot of it is tied around the individual retirement account and retirement account market, in that usually you see visibility there really March and into April. And there's nothing that we've seen that, that is particularly indicative one way or another, over the last several weeks. But with the severity some of these market moves, you guys know that the fund side of the business. So we just keep track at the shareowners. I mean, I think when you see these kind of moves, it often times gives people pause and may not change their long-term strategies but they may step back for a bit. So it's just kind of unfair to us whether there is going to be some short-term disintermediation or rather if this type of market continues for a lot of... rather people will go into, as I said earlier, more of stage of paralysis for an extended period, we just don't know.

David Koning - Robert W. Baird & Co.

Okay, that's helpful. And I guess just one other, account growth, you mentioned was about 12% to 13%. U.S. revenue growth was about 5%, you discussed a little bit about the variance in which some partly were coming on a remote basis. So I'm just wondering going forward, should we expect that type of variance at least for the next few quarters until Putnam's anniversary that 8% or so difference between account growth and core U.S. revenue growth?

Thomas A. McDonnell - President and Chief Executive Officer

Alright, I just depends on the mix at any point in time. And as the mix of business gets more heavily to remote then you would see the overall gaps narrowing. But it's pretty hard to predict a particular delta between account growth and revenue growth just because... I said because of the mix but I say when you bring on Putnam and other remote clients, the mix shifts a little bit. So that's over time you would expect it not to have as assuming that longer term trends are maybe more towards our remote clients. It's just a question of how that mix occurs and it's pretty hard to predict how... what a delta would be over any particular quarter quote.

David Koning - Robert W. Baird & Co.

Okay, great. Thank you.

Operator

Thank you. And gentlemen there are no further questions in the queue.

Thomas A. McDonnell - President and Chief Executive Officer

Okay, well thanks. It's really great for joining us today and we will look forward to talking to you after the first quarter.

Operator

Thank you. And ladies and gentlemen, this conference will be available for replay after 10.30 a.m. Central Time today until January 29 at midnight. You may access the AT&T Executive Playback Service at anytime by dialing 1-800-475-6701 and entering the access code of 905119. International participants may dial 320-365-3844.

That does conclude your conference for today. Thank you for your participation and for using the AT&T Executive Teleconference Service. You may now disconnect.

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