DST Systems, Inc. (NYSE:DST) Q3 2016 Results Earnings Conference Call October 20, 2016 8:30 AM ET
Steve Hooley - Chairman of the Board, President, Chief Executive Officer
Gregg Givens - Chief Financial Officer, Senior Vice President, Treasurer
David Ridley-Lane - Bank of America Merrill Lynch
Brian Essex - Morgan Stanley
Peter Heckman - Avondale
Good morning and welcome to the DST Systems third 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 its 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 would like to turn the conference over to our host Mr. Steve Hooley, Chairman. President and Chief Executive Officer of DST. Please go ahead.
Great. Thank you very much. Well, good morning and thank you for joining DST Systems third quarter 2016 earnings call. With me today is our Chief Financial Officer, Gregg Givens. I am going to start by going through some of the highlights of the quarter and after that I will discuss some industry factors that are impacting our business and then I will turn the call over to Gregg for additional detail on our financial results.
Overall, we are pleased with the third quarter results which demonstrate the capability and strength of our teams around the world and the benefit of our streamlined focus on our health and wealth strategy. We delivered positive operating results this quarter with both our healthcare and financial services segments delivering revenue growth and expanded margins over prior year.
Our earnings per share from continuing operations were $1.53 per diluted share for the third quarter of 2016 as compared to $1.83 per diluted share for the third quarter of 2015. On an adjusted basis, our non-GAAP earnings per share from continuing operations were $1.53, an increase of $0.20 or 15% from the third quarter of 2015. Third quarter 2016 consolidated operating revenues increased $12.1 million or 3.4% to $365.5 million as compared to the same period in 2015.
Looking at our segment results for the quarter. Financial services segment operating revenue increased $2.5 million to $270.2 million as compared to third quarter of 2015, primarily driven by acquisitions, which contributed $9 million of incremental operating revenues during the third quarter of 2016. These incremental revenues were partially offset by an organic decline in both the mutual fund and brokerage businesses.
We are very pleased to note the renewal of a number of client contracts within our mutual fund and brokerage businesses, which have extended the terms of these contracts for an additional five to seven years. As part of these negotiations, we experienced fee compression which is reflective of the long-term nature of these contracts and the current competitive market conditions we are facing.
As previously announced, we have a significant new customer coming onto both our mutual fund and subaccounting platforms. In September 2016, we achieved a significant milestone with the completed conversion of approximately 10 million accounts on to our subaccounting platform and based on current volumes, we continue to expect to convert approximately 2.3 million registered accounts on to our mutual fund platform by the end of 2017 from this new client.
During the third quarter, healthcare services operating revenues increased $12.1 million or 12.9% to $106.1 million as compared to third quarter of 2015. This increase is primarily due to new medical claims processing clients implemented this year, organic growth and the expansion of high-value services we are offering to existing clients in both the medical and pharmacy businesses.
During the quarter, two of our healthcare services customers notified us that they would be transitioning their services off of our systems effective in the first quarter of 2017. We continue to expect our healthcare segment to achieve strong revenue growth through a combination of new client wins and organic growth. However, we now expect this growth will derive from a smaller revenue base, the net effect of which will result in lower overall segment revenue growth going into 2017.
Moving to unconsolidated affiliates. Our third 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 coupled with higher operating costs as IFDS expands its infrastructure and responds to regulatory, security, risk and compliance demand across its business.
As we discussed in previous quarters, IFDS U.K. began processing on our wealth management system during the fourth quarter of 2015 and the implementation and development effort is continuing to progress as additional books of business are converted. While IFDS earnings will be somewhat variable in the short-term as key projects are completed, we continue to expect the overall earnings to trend lower due to the increasing amortization of the capitalized software costs and the decline in implementation revenue.
Share purchases and dividends continue to be an important element of our capital strategy. In June, our Board of Directors authorized a new $300 million share repurchase plan. From July to October, we repurchased more than one million shares of DST common stock. We now have approximately $180 million remaining under the current share repurchase plan.
Before concluding my remarks, I want to spend some time focusing on some key factors that we expect will impact our results for 2017 and beyond. Regulatory changes, competition and consolidations within the healthcare and financial services industries continue to create opportunities and challenges for us. We are extensively reviewing the products and services we offer to our clients and the IT infrastructure we use to serve them.
For example, we have recently completed a very successful 18 month development effort to enhance our systems to assist our clients in meeting the new requirements of the money market perform regulations. We continue to rationalize the products and services we offer and have identified certain of our current offerings in which the increased risk and required investment resulting from recent regulations outweighs the benefit we expect to receive. Therefore, we made the strategic decision to exit certain non-core products and services as we continue to refine our business portfolio.
In order to position the company to take advantage of new and emerging technologies, we are embarking on an IT transformation effort, which will increase our operating expenses for the next three to four years. We expect the results of these investments to be lower centralized IT costs and a more agile platform on which to deliver future capabilities. We believe this investment will pay long-term dividends in lowering the overall cost of our IT delivery, provide access to emerging technologies and position us well to take advantage of market opportunities.
Overall, we remain highly confident in our strategic plan and our ability to deliver at a high level for our customers and create value for investors. We remain focused on growing our business through organic initiatives and targeted acquisitions, investing in our business to position DST for the future, driving efficiencies throughout our global operations, assisting with our clients' regulatory compliance, managing our balance sheet to provide appropriate financial flexibility and returning capital to shareholders.
Looking ahead, our entire organization is motivated and focused on achieving our objectives on behalf of our customers and shareholders. We remain highly confident in our health and wealth strategy and the future success of our business.
With that, I would like to turn the call over to Gregg.
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 discontinued operations. Our prior periods have been adjusted to be consistent with this presentation as well.
Now moving to our results. On a GAAP basis, this quarter we reported consolidated net income of $273.3 million or $8.28 per diluted share compared to $75.1 million or $2.08 per diluted share for the third quarter of 2015. The increase in net income is principally from the $340 million pretax gain from the sale of our North American Customer Communications businesses on July 1, which has been reflected in discontinued operations.
Our third quarter 2016 GAAP earnings per share from continuing operations were $1.53 as compared to $1.83 in the same period last year. The decrease in net income from continuing operations is due to less gains on investment sales and less tax benefits in 2016. On an adjusted basis our non-GAAP earnings per share from continuing operations were $1.53, an increase of $0.20 or 15% from third quarter of 2015. The remainder of my comments will focus on our adjusted non-GAAP results from continuing operations.
Consolidated operating revenues for the quarter were $365.5 million, an increase of $12.1 million when compared to third quarter of 2015. The increase in consolidated operating revenues was primarily due to new and existing client growth across a number of our service offerings and year-over-year growth from businesses acquired during 2015 and 2016. This was partially offset by lower mutual fund and brokerage revenue within the financial services segment. Consolidated operating income increased 10.8% or $7.2 million to $73.6 million. Consolidated operating margins were 20.1% in the quarter as compared to 18.8% in the third quarter of 2015.
Within the financial services segment, operating revenues increased $2.5 million to $270.2 million. The operating revenue increase was primarily driven from the businesses acquired during 2015 and 2016, which contributed $9 million of incremental operating revenues during the third quarter of 2016. The operating revenue increases were mostly offset by decline in mutual fund registered shareowner account processing revenue due to lower registered accounts, primarily as a result of subaccounting conversions and lower revenues as a result of extending certain long-term contracts with reduced pricing.
Financial services income from operations increased $3.3 million or 6.4% to $54.6 million as compared to third quarter of 2015. The increase in operating income during the quarter was primarily due to higher revenues and increased cost savings resulting from our previously implemented restructuring and other cost containment initiatives. Financial services operating margin was 20.2% in the quarter, which is an increase from the 19.2% operating margin in the third quarter of 2015.
Turning to our healthcare services segment. Our operating revenues were $106.1 million, an increase of $12.1 million or 12.9% from third quarter 2015. The increase is primarily attributable to new medical claims processing clients implemented during 2016, organic growth and the expansion of the services we are offering to existing clients in both the medical and pharmacy businesses. During the third quarter, healthcare services income from operations increased by $4.9 million or 33.1% to $19.7 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. As a result, operating margin for third quarter 2016 was 18.6% as compared to 15.7% in the third quarter of 2015.
DST's equity and earnings of unconsolidated affiliates was $7 million this quarter, a decrease of $4.8 million when compared to third quarter of 2015. As we have discussed, the continued decrease has been expected as a result of lower revenues recognized related to ongoing client conversion activities and higher operating costs as IFDS expands its infrastructure to address increasing regulatory, compliance and security needs.
Our multiyear implementation efforts for the two wealth platform clients continue to progress, while the scope and timing continues to be adjusted as client requirements evolve. We continue to expect IFDS earnings to decline sequentially due to the amortization of capitalized software costs coupled with a decline in implementation revenue.
Our income tax rate for the third quarter was 34.6%. We expect our income tax rate from continuing operations for 2016 to be approximately 36%.
Turning to our share count. During the quarter, the company spent $75 million to repurchase approximately 630,000 shares of DST common stock. Average diluted shares outstanding for the quarter were 33 million shares, a decrease of 8.8% from the third quarter of 2015. Additionally, during October 2016, we repurchased an additional 400,000 shares of common stock for $45 million, resulting in approximately $180 million remaining under our existing share repurchase plan.
We closed the third quarter with a strong balance sheet that was comprised of $180.9 million of cash and $428.7 million of debt. The sequential increase in cash of $108 million and the sequential reduction in debt of $284 million from the previous quarter is primarily driven by proceeds received from the sale of our Customer Communications North American operations. We continue to maintain a strong balance sheet and believe that our ongoing liquidity gives us the flexibility to be opportunistic in the marketplace.
I will now turn the call back to Steve for concluding remarks.
Thanks, Gregg. While we are pleased with the quarter, we continue to navigate a competitive and changing environment that is pressuring our outlook. We will make investments in our infrastructure to ensure our long-term success, support our customers with superior solutions and services while utilizing our strong balance sheet to support and enhance near-term value and long-term growth.
With that, I would now like to turn the call over to questions. Operator, you can go ahead.
[Operator Instructions]. Your first question comes from the line of David Ridley-Lane with Bank of America Merrill Lynch.
Sure. Good morning. I wanted to ask about the two healthcare clients that will be transition off your platform in the first quarter of 2017. Could you give us a rough sense of the number of covered lives those will represent?
Yes. David, the number of covered lives, I would tell you, isn't necessarily reflective of the impact that we are going to feel and the reason is, one of these is a fairly large BPO client, right. So as you would know, a covered life in a BPO environment has a higher revenue component and the margins generally tend to be a little bit lower on those businesses. So as you think about that and we try to think about what would be most helpful to our investors, you should be thinking about revenue growth rates being depressed in the 2017 in the healthcare services segment into probably the mid-single-digit kind of range.
Got it. Congratulations on completing the 10 million subaccount conversions. Was curious though, in terms of the actual revenue contribution, I noticed in the press release that happened in September, so I am wondering was there a full month of revenue contribution from that large new client win?
Well, first of all, thank you for your congratulations and I will accept it on behalf of the team, both here at DST and at the customer who made that conversion happen. I would tell you, they have been doing this for a long time. It was one of the cleaner conversions that I have been involved with and, again, I think that the impact of that is both our team at DST and a superior team at the client really working together over a long period of time to make that happen. So we did have a full impact. We converted on Labor Day weekend. So there would be a full impact for the month reflected in the earnings.
Got it. And then last question for me. The debt leverage now around 0.6 times, cash balance pretty high relative to history. Is there anything you are marking the cash for? Has your acquisition pipeline increased? Anything? Any color on potential for use of the balance sheet? Thanks.
David, we look at the balance sheet in terms of our overall capital plan and those are discussions we have with our Board, as you are aware of the two principal areas that we would allocate capital to long-term, would be returning capital to shareholders and opportunistic acquisitions. The run rate of our P&L already reflects the investment we are making in the company and as you noted, our debt levels are already low. So overall, the capital plan is really a balance between returning capital to shareholders and opportunistic acquisitions. We continue to monitor those items and I think we have a good track record in terms of returning capital to shareholders as well.
Thank you very much.
Your next question comes from the line of Brian Essex with Morgan Stanley.
Great. Thank you. Good morning and thank you for taking the question. I was wondering if you could address the contract renewals on the financial services side? And what some the key drivers of that renewal process and duration were? And how am I to think about that when I think about the remainder of your installed base? And what might be coming up for renewal going forward?
Sure. So as you know, a vast majority of our business is contracted for on a long-term basis. But these contracts do have anniversary dates. In both of the instances, both of the customers where we had the renewals, both long-term customers of ours, both had contracts. One had a contract that had been auto renewing. The other had a contract that was due. And so in working with the customers, we jointly came to an agreement to extend the contracts in the range of five to seven years and as is typical in that kind of environment and quite honestly in the competitive environment that we operate in, there were fee concessions were baked in as part of that.
So we saw a bit of that in the third quarter. We will see the full impact of it in the fourth quarter and through 2017. So again, very excited to renew two really important customers and long-term customers of ours on a long-term basis and there will be some short-term downward pressure on revenue and earnings because of that. But again in the long-term, really a terrific outcome.
Great. And maybe if I can follow up on that. From a longer-term perspective, as you engineer the renewals of these contracts, do you have any levers that you can work towards to drive better efficiency in those contracts where you might see the profitability contracts improve over time as you gain efficiency?
Yes, absolutely right. So look, we are really pleased with the profit margin expansion in both healthcare and financial services, right, third quarter of 2016 versus third quarter of 2015. And I think what you are seeing there is the constant kind of efficiency gains that we are driving for in the business.
And I mentioned in my prepared comments, an IT transformation program that we are undertaking. And I would tell you, that's really focused on a number of factors, right. It is about lowering our run rate costs on a go forward basis. It's also about improving our agility in the market and our ability to quickly respond to customer needs. But part of the benefit to this, right, is to get us on to platforms where quite honestly we will see more centralization, more modernization and quite honestly drive more efficiency.
And so part of the business that we are in, right. And it is not unusual in the processing business, year-over-year we are looking for efficiencies in the business. And then, there are opportunities, like we have now, to make an investment in the company. And I will just give you one quick example.
The work that we are doing will position us to be able to take all of our open systems into a public or a private cloud environment, right. Now that's not something that happens overnight, but when we get to that point, there are real efficiencies that can be gained there and we think you can see a step function change in your cost and efficiencies overtime.
I appreciate the color. Is there anything that we can wrap our heads around? As you move into a cloud environment, is that going to let you leverage analytics or agile development or maybe how you cluster the processing off of a cloud provider? What are the key drivers, for example, that example specifically that we can point to?
Yes. So well, look, one thing it does is, it will take us from higher cost platforms to lower cost platforms., right. And whether it's a public or private cloud, there is benefit there. You also talked a bit about analytics. One of the other things that this IT transformation program is focusing on is implementing a data strategy that has a common approach to metadata across our company, which again will drive a lower cost and easier access to the platform. So you should think about that as a big data kind of solution for the data that we hold on behalf of our clients. And so we think there is significant kind of not only cost opportunity, but opportunity to provide more services to our customers and position us to just quite honestly be more agile.
Great. Very helpful. Thank you very much.
Yes, you bet.
Your next question comes from the line of Peter Heckman with Avondale.
Good morning, gentlemen.
So with the impact of the fee concessions on the renewals plus the addition of the new subaccounting client and then the other dynamics that are going on in the business, do you believe that the financial services segment can generate positive organic growth in 2017?
I think it's going to be a challenge, Pete. The top line operates in a very tight range. We had nice organic growth this year, but recall, we did a number of acquisitions over the last 24 months, all of which have come through this year. We haven't done any acquisitions this year, not because we haven't been active in the market, but just because we have not found anything where we thought we were getting good value with products and services that would be attractive to our customers.
And so we are not going to have the benefit of acquired revenues, if you will, next year. And we have got some short-term downward pressure. But again, I would point out, I will trade long-term contracts with really important clients for some short-term pain on the revenue and profit side.
Sure. Okay. And then just clarifying your comment on the healthcare segment. I believe you said the deconversions will depress growth but growth will probably run in the mid single-digits in 2017. Was that correct?
That's a good way to think about it, Pete.
Okay. And then on those deconversions, without giving away too much, where are those clients going? Are they taking this in-house? Are they headed to competitors?
There is two main clients. One is taking it in-house and the other is going to a competitor. So the larger of the two runs on multiple platforms. We are one of three platforms they run. They have an in-house solution and they have decided to in-source all of the processing. And so I am obviously disappointed. I am disappointed any time a customer decides to move but I understand their strategic rationale and we will work hard to make sure that we have a clean conversion out for them because it's a long game.
Got it. Okay. And then on the IT transformation, can you talk a little bit about how we should think about sizing the spend there and when we might see the ramp?
Yes. So, Pete, this is Gregg. You will see the spend increase in 2017. Look, I think it could reach up to 50 basis points of operating margin on a consolidated basis, but it will ramp up to that level. And then as Steve indicated, as we get through that we expect to see better cost dynamics out of the IT platform.
Okay. And then just one more, if you will. The fiduciary rule, the whole financial service industry is struggling with it. A lot of conclusions are still not made. But are you seeing any early impacts or changes in behavior from the fiduciary rule that you can talk about?
Yes. It's a good question, Pete. It's getting plenty of play in the press. I would tell you, our customers are still kind of feeling their way through exactly what it means for them and what the impact is going to be. And until my customers know how it's going to impact them, it's hard for us to give you firm guidance on how it will impact us. I think for now, it's caused a lot of things to slow down as people are stopping and evaluating their business, right. Their distribution model, the products that they are distributing, what the form of those products should be. Look, on a very kind of small scale, I talked about us looking at our portfolio of products and services.
We had a relatively small 401(k), a small plan, direct to consumer business that was a nice little business, but we took a look at it in the context of the DOL regulation and some changes that we were going to make there and we kind of looked at the cost of being compliant and the impact that that would have on our view of the future potential for that business and decided to exit that business. So we found a successor servicer and we are in the process of moving that business along. And so again, I think everybody is looking at what they do just like we are and are making some decisions. Now again, that's a relatively small impact at the DST level, but the DOL ruling certainly impacted our thinking.
Okay. That's helpful. I will get back in the queue.
Great. Thank you.
At this time, there are no further question. I will turn the conference back to Mr. Steve Hooley.
Great. Well, thank you very much for listening in today and we look forward to updating you on the first quarter of 2017.
This concludes today's conference call. You may now disconnect.
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