DST Systems Q4 2005 Earnings Conference Call Transcript (DST)

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DST Systems (NYSE:DST)

Q4 2005 Earnings Conference Call

January 25th 2006, 10:00 AM.

Executives

Thomas McDonnell, President, Chief Executive Officer

Ken Hager, Vice President and Chief Financial Officer

Thomas McCullough, Chief Operating Officer

Analysts

Pat Burton, Citigroup

Jim Kissane, Bear Stearns

Greg Smith, Merrill Lynch

David Togut, Morgan Stanley

David Koning, Robert W Baird

Glenn Greene, Think Equity Partners

Bryan Keane, Prudential

Phil Mickelson, JP Morgan

Robert Tung, Citigroup

Tracey McMillin, A.G. Edwards

Morali Gobal, KBW

Herb Buckbinder, Wachovia Securities

Karen Becker, Arian Capital

Operator

Ladies and gentlemen, thank you for standing by and welcome to the fourth quarter earnings release conference. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. Instructions will be given at that time. Operator Instructions As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, President and CEO, Tom McDonnell. Please go ahead.

Thomas McDonnell, President, Chief Executive Officer

Good morning. Before we start, I need to make a statement. If in the course of our conference call today we make forward-looking comments respecting DST and its businesses, such comments would be based on our views as of today and actual results could differ. There could be a number of factors affecting future results including those set forth in DST's latest periodic report which we filed with the SEC. All such factors should be considered and evaluated in any forward-looking comments which we may make today.

We will start with an overview of results for the fourth quarter. As you can tell from the press release, there are a lot of items that occurred in the fourth quarter, some resulting from the transactions throughout the year and some within the fourth quarter itself. So all of our comments today on our financial results initially are going to be based on results excluding certain items that we set forth under the release in the section that was headed up Non-GAAP Adjustments.

There is a reconciliation to the GAAP results including in the press release. We've also reformatted our press release hopefully to streamline it and make it more useful in reporting on our results. On the basis I just outlined, net income for the fourth quarter of 2005 was 58.1 million. That was $0.78 per diluted share. That compared with earnings of 63.0 million, 63 million or $0.74 per diluted share for the fourth quarter of 2004. That was an increase of 5.4% in diluted EPS that represented a decrease of 7.8% in overall net income.

The consolidated operating revenues increased 33.8 million or 9.1%. That number, for comparative purposes we have excluded the revenues of EquiServe and DST Innovis which were sold and we also excluded DST Health Solutions which was acquired in 2005 in order to get the comparable numbers for some of the baseline businesses. Increased revenues that were reported from DST International, from mutual fund shareowner processing, from Output Solutions, and lock/line and its related services. Lock/line will not be included beginning January 1, 2006, but as a result of our ownership in Asurion, earnings will be reflected in the unconsolidated affiliate section.

Consolidated income from operations increased $2.7 million or 2.9% to 95.4 million, and that was from increased financial services revenue, certain cost efficiencies in the financial services area. Included in the numbers above is our Output Solutions, but reviewing just their income from operations, it declined by 3.4 million. That had, that reflected some increased expenditures for the implementation of new printing technology to support future business growth.

Overall, the consolidated operating margin for the quarter was 22.4%. That represents an increase of 1.8% over the comparable period. Equity in earnings of unconsolidated affiliates declined by $600,000 from the 2004 quarter to a level of 8.3 million. While higher earnings were recorded at BFDS. BFDS from increased accounts serviced. That increase was offset by lower earnings at International Financial Data Services, which were impacted by higher Canadian personnel costs. But a significant component to 2004 was significant UK foreign exchange gains that were recognized in 2004 and the gain on a sale of a business unit that was recognized by Wall Street Access, which is a 20% owned joint venture of DST.

Interest expense increased by 3.1 million to a level of 17.6 million in the fourth quarter of 2005, and that's primarily reflective of the higher interest rates from the period. The effective income tax rate for the quarter was 37.5%. That's an increase over the effective rate at the end of September. The increase was a result of a change in the proportion and the fact that we had more domestic taxable income than international taxable income, and there's a rate differential there. Currently, we expect our effective tax rate for 2006 to be 37.5%, exclusive of the effect of any discrete items such as income recognized from the lock/line merger. We thought it would be useful to talk a little more about the capital structure of the Company. The diluted out shares, the diluted shares outstanding for the purposes of the quarter were 74.6 million. If you take into account the effect of the accounting treatment of the convertible debentures, there was an increase in diluted shares outstanding by 2.6 million. Increase is higher than previous quarters and that was a function of the increase in DST stock price.

During the fourth quarter, we repurchased 1.4 million shares of our common stock at a cost of 81.6 million. During 2005, we repurchased a total of 14.5 million shares. Under the existing share repurchase authorization that we had, there's 5.3 million shares remaining. If you look at the point in time at December 31, 2005, the shares outstanding was 69 point, or 69 million shares. And that excludes 2.7 million shares of restricted stock, which are excluded under accounting rules from shares outstanding for the basic earnings per share. So overall, this is a decline for the year of 11.2 million shares outstanding or 14% from the level of December 31, 2004.

Reflected in some of these numbers, and we thought it would be useful on ongoing basis, to give a status of the Company's option and restricted stock outstanding. If you look at the combination of options and restricted stock outstanding at December 31, 2005, the total was 13.3 million shares. And that's a decrease of 3.8 million shares for the year, or in percentage terms, 22.2% from year-end 2004. During 2005, a significant number of options were exercised in connection with the sale of EquiServe and DST Innovis.

As we reported last year, the Company changed its equity compensation approach to using restricted stock was put in place with five-year grants. So while, during the period that those grants cover, we anticipate minimal new grants only in connection with new hires, promotions, and so forth. So we'll continue to report the outstanding option and restricted stock position. We think that's useful in getting a handle on where the outstanding stock in the Company will go over the next several years.

Talking about mutual fund shareholder activity, U.S. mutual fund open share owner accounts that we were processing totaled 102.2 million at December 31, 2005. And for the quarter over the third quarter, that was a net increase of 700,000 or 0.07%. And for the full year, we had an increase of 10 million or 10.8%. That is from a level of 92.2 million at December 31, 2004. If you break that down, 7.1 million accounts or 7.10, 7.7% were converted for new clients, and 2.9 million 3.1% represented net account growth from existing clients.

In the fourth quarter, we did convert a new 401(k) insurance client with about 200,000 participants of that total also. Breaking it down a little further, the tax advantaged retirement and educational savings accounts that we service totaled 39 million at December 31, 2005. That was an increase of 400,000 or 1% for the fourth quarter of 2005 and an increase of 2.7 million or 7.4% from the 36.3 million serviced at December 31, 2004. The tax advantage account increase is primarily IRAs and Section 529 savings plan accounts. As reflected in the press release, once again, we have not finalized any negotiations with clients. A number of them are still in process. We are in discussions or negotiations with approximately 11 potential new clients, with a combined total of approximately 22 million accounts.

Turning to the lock\line merger, it was completed on January 1, 2006. It was a tax free merger of lock\line with Asurion, results in DST now owning approximately 35% of the combined company. As a result of the transaction, we'll recognize a book gain in the first quarter of 2006, and also in that quarter we'll recognize compensation charges related to vesting of DST restricted stock that was triggered by the transaction and the closing of the transaction.

Breakout lock/line, in the lock/line and its related operating revenues, which include premiums to our captive insurance company, for the fourth quarter of 2005 there were 43.1 million and for the full year they were 164.8 million. Included in that for the quarter and for the year were underwriting revenues to the captive insurance company of 12.1 million and 40.8 million. Those underwriting revenues as part of the lock/line related revenue discussed above will be recorded in the future at Asurion.

DST would expect the earnings to be, the merger to be dilutive to earnings per share. We haven't fully assessed the order of magnitude. It really is a function of the amortization of identified intangibles that was discussed at some greater length in the press release. But because of the way the transaction was affected, there will be an intangible amortization at Asurion, and we will then pick up our pro rata share in effect of that amortization through their inclusion of earnings in unconsolidated affiliates. But in addition to that, because the transaction was effective, a sale at a purchase for accounting purposes, DST will also have to identified certain intangibles and amortize those on our books in addition to the amortization that will be reflected at Asurion.

Once that, we have a better sense of the specifics of those numbers, once they have been determined in our going forward reporting relative to Asurion, we will try identify the intangible amortization both at the Asurion and detail level so that there will be a clearer picture of the contribution of that particular unconsolidated affiliate. At this point, we would be, we will turn over the call, open it up for questions.

Questions & Answers

Operator

Operator Instructions Your first question comes from the line of Pat Burton with Citigroup.

Q - Pat Burton

My question relates to the financial services pipeline, Tom. Have there been any industry factors, anything you could account for what appears to be a delay in the client decision-making process? Thanks.

A - Thomas McDonnell

I wouldn't point to any industry factors. We have discussed this many times. I think the, in an attempt to try and give some visibility to the fact that there are mutual funds out there seriously considering changes in the way they do business; they operate at their own pace. Of that 22 million there are some significant clients in there and the process can be quite extended. I don't see any particular factors. At last call, I fully would have expected at least one decision to be announcable by year end. However, it wasn't. I think the best position I can give you is that there is activity. None of them are concluded. We believe that they are serious enough that we do reference them in the backlog or the pipeline whatever you prefer to call it, and can only say once again that I anticipate that there will be some of the backlog moving in the next 60, 90 days.

I recognize that is a response you have heard from me several times, but unfortunately, it's as much clarity as I can provide on that. Having looked some of the preliminary reports and then looked at some of the information that was available in the industry last year relative to the Citigroup analysis of alternatives, it's our understanding although it's not clear to us that there has been an announcement by Citigroup, that they, for all practical purposes, have opted to continue their current relationship and leave future evaluations to the merged organization after the Legg Mason transaction is completed.

Operator

Your next question comes from the line of Jim Kissane with Bear Stearns.

Q - Jim Kissane

Thanks, Tom. Just following up on the question about the pipeline, I think last quarter you had 15 complexes in the pipeline. Now you have 11, but there's still 22 million accounts there. Can you kind of reconcile that and give a little background?

A - Thomas McDonnell

Not one by one, but a couple which were obviously maybe at the smaller end just decided to do nothing, so there's been a little bit of a shuffling around, a little bit of growth in a couple of the underlying account bases, but three or four of them just decided to continue to do what they are doing. But the overall number hasn't materially changed, but there net four less in the number that we count as a pipeline.

Q - Jim Kissane

Did you lose any business to the competitor or is it…

A - Thomas McDonnell

No, just did nothing.

Q - Jim Kissane

Got you. And just a little more background on the Smith Barney business, is there still an RFP out there or has it been taken off the table?

A - Thomas McDonnell

My understanding, and again, this is, I can't speak for them because they've obviously, evidently have not made an announcement. They went through the process; it was quite an involved process. They concluded that from the Smith Barney side given that they had this transaction coming up, they were better to keep the status quo and leave any other decision then stay in status quo to a future point in probably a different organization.

Q - Jim Kissane

I thought it was a mandated decision by the SEC.

A - Thomas McDonnell

Well, again, I don't know that I can interpret the SEC's position. It was mandated that they review what they were doing. I don't think that they were required to make a change.

Q - Jim Kissane

Got you. And just, can you give a little color on the lock/line Asurion deal? What was your motivation and when would you do expect a liquidity event?

A - Thomas McDonnell

It's the motivation. I think that we have, as you would be in businesses that have relatively discrete numbers of competitors, you generally run into them and are familiar with them. Lock/line's business was very much focused on providing the service components to service insurance policies in place. Most of our clients wrote their premium through their own captive insurance companies. The broad base of potential clients and other clients out there is a little bit mixed. Some want to write their own insurance. Some want an outside carrier. Asurion's business is much more correlated to Asurion actually carrying the significant component of the insurance as well as doing the administration.

In addition to that, there is a component of the business, the fulfillment or in effect the replacement of telephones that falls under the broad category that we would call logistics. That is an important element to the service and can be an important element to the profitability. We had at lock/line opted to outsource that component. Asurion on has a very sophisticated and effective logistics operation and we felt that component integrated into the combined book of business that the two companies had the potential to making a material positive impact.

In addition, we at lock/line had pretty much been focused in North America domestically and felt longer-term that growth opportunities outside the U.S. would be important. And Asurion have already established initiatives, particularly in Asia, so when we looked at the two businesses and looked at what we thought would create a much more effective competitor in that space, bringing in the additional services on the logistics side and some additional breadth of product in warranty and roadside service, as well as the initial steps to globalize the business that this was a very effective way to do it. And we believe the combined company will be pretty attractive. As I tried to indicate earlier, were probably going to have to work a little bit to explain the sort of two-tier level of intangible amortization, but we'll try to be as clear on that as we can. Currently, as we say, liquidity, I assume you mean any monetization of that particular position. We think there's an awfully positive future for Asurion, and currently we have no intention or plans that would run to the monetization of the business.

Q - Jim Kissane

Okay, can you just give us a little insight into the margins of Asurion so we can try to model it and value it?

A - Thomas McDonnell

I really can't at this point. It would be premature and we'll have to see how we are going to handle it. You will of course see earnings showing up in our unconsolidated affiliates. Whether or not, since Asurion is a private company, whether or not they will be good visibility of revenues going forward, we haven't clarified that yet. So I would think a lot of the Asurion on questions could be more effectively addressed after the first quarter because we will have a good sense of, I hope by then, of what the accounting treatment of the intangibles and the identification of those are. So think we can address that much more appropriately after the first quarter.

Operator

Your next question comes from the line of Greg Smith with Merrill Lynch.

Q - Greg Smith

Can you talk about Output Solutions? The fact that it was just breakeven, that was a little surprise. Was this investment spending that you're doing anticipated? And were the revenues kind of in line with your budget? Just some more color there, please.

A - Thomas McDonnell

Well, I think when you say anticipated, we have said for some time that we believe that we've got output going the right direction. Part of that right direction and part of the, some of the revenue growth you see now, and I believe revenue growth that you will see incoming quarters, is a function of introducing some more effective, newer technology in the clients, very high-speed four-color presses. Presses that we in fact, laser printers, basically, that we initially experimented with and were using in the UK division. They now have been installed in a couple of our locations here in the U.S., are in production for some of our very high-volume clients. We have taken the position that the way we're going to differentiate that business is with a differentiated product and technology, so I think that the investments were anticipated. Whether we had sort of built them all in to late third and fourth quarter this year, probably not some months back, but you make them when they're appropriate. We wanted to get some of that equipment in before year-end, and some of that equipment in connection with the growth of the volume of several of the clients.

Also, I think that blended in even though there were increases in revenues on the very large contracts that have been in negotiation or the contracts awarded in those businesses have had probably lower pricing than we would have seen a year ago, but we think that's stabilized. And also, we think the investments we made in equipment and clients and so forth will continue to bring down our relative cost to allow us to be more competitive there. So I think that, hopefully the fourth quarter sort of numbers that you see there will start to produce different results in 2005. But again, talking about that when we see the first quarter 2005, you've got to kind of keep in mind, which we'll obviously repeat then, that the first quarter is always a strong quarter for output because of all the production of year-end work in the financial services industry, whether it's year-end confirms, tax forms and so forth, but I think the investments were appropriate. We still believe we're making very significant progress there. As I mentioned before, I think we have a strong management team. I think we have seen much better sales results in a last 90 days, so I would hope that after the first quarter that the numbers in and of themselves will start to speak a little more effectively for the progress.

Q - Greg Smith

Thanks. And then can you talk about the outlook for account growth at existing clients? It looks like we are not seeing too robust growth. Just any color there on what you anticipate for the year ahead.

A - Thomas McDonnell

Well, again, we've had pretty anemic growth for several years. The growth that has occurred has been oriented to some of the tax preferenced accounts, IRAs and 529s. And within the account book, the growth has obviously, not obviously, but the growth has occurred in a relatively small number of the overall clients as marketshare has been moving around a bit in the industry. When we talk to a lot of our clients, we ask them what we think the growth prospects for the mutual fund industry are and we think that with employment numbers improving, it should help on the 401(k) side. That should have some impact on IRAs also.

The 529 plans still are strong. I think really to see upper single digit or higher growth, we're going to have to have a sustained enough positive market experience for people to start to regain confidence to put a broader range of their investments back into mutual funds. So I think fund flows have been improving. It's hard for us to predict the markets, but I would think unless we see reasonably constructive markets for the year, I wouldn't think the organic growth we had last year would be unrealistic, 3, 4%. But to get much above that, we're going to have to see a more positive market I think.

Q - Greg Smith

Okay. And then lastly, just your international software sales continue to be pretty strong. How's the pipeline look there?

A - Thomas McDonnell

Well again, they have a lot of potential clients out there and that is a segment of the business that is, does have software licenses which we have discussed before. When you look at other software companies out there, it's not an unusual pattern to see a lot of business closing around year-end. And within quarters, a lot of revenue occurring late in the quarter, we are generally indifferent to when it occurs. We are more interested in effective revenue recognition, so sometimes we are indifferent of its slips from quarter to quarter. But I think if you focus on the full-year results as opposed to the quarters on DST International in particular, that, we think that they're in pretty good position to kind of achieve overall sales results similar somewhat of above 2005. But quite frankly, a lot of that is really going to, usually will occur, be dependent on late third quarter and fourth quarter.

Operator

Your next question comes from the line of David Togut with Morgan Stanley.

Q - David Togut

Thanks, Tom. Just revisiting the questions around output for a minute, can you quantify what the higher investment expense was in Q4 for printer technology, either from a CapEx standpoint or from pure income statement standpoint?

A - Thomas McDonnell

I don't have it on the top of my head. Let me ask Ken, see if he's got the number handy.

A - Ken Hager

David, I don't have that number in front of me. I can try to get that back to you later.

Q - David Togut

Okay. And secondarily, you started the call talking a little bit about capital structure. Can you give us a sense of your thoughts going forward? You still have a large block of State Street stock which you have held for many years. You divested a number of businesses in the last couple of years, sold the CSC stock, bought back a lot of your own. Where do you see things going from here with the balance sheet? And do you have a long-term commitment to holding the State Street stock?

A - Thomas McDonnell

Well, as we said before, we have no contractual commitment to holding the State Street stock. We're certainly comfortable with it. They are strong partners and we think that their business is good and improving. I think the relevant comments, what we're trying to do, David, is show you particularly with the reporting, it's, you can pick these numbers out yourself of course, but I think if we concisely report on where the outstanding options are over the next several years you should see, I guess the popular term is overhang decline. You should see continual open market purchases of the stock. But were also positioning the balance sheet to settle the first tranche of the convertible instruments in August of 2008 I believe.

Our intention, as we have always said, is to settle the principal amount of those for cash and any accretive amount in shares, and so we want to make sure we are in a position to do that. So think over the next whatever that would be, 32 months, you will see us with consistent and ongoing buybacks, a function of what we believe to be the available cash flow for that. It's generally our policy to reinvest the cash generated from option exercises and retiring stock, and then managing the balance sheet to ensure that we either have cash available or have created a financing structure through our lines of credit or other debt instruments to replace and/or retire the principal amount, as I discussed, on the 2008 tranche for cash and issuing shares for the incremental amount.

Q - David Togut

Well, if there were a tax efficient way to sell the State Street stock and use the proceeds to settle the first tranche of the cocoa, would you consider that?

A - Thomas McDonnell

I think anytime there's a very tax efficient transaction relative, which I think we demonstrated; we have taken advantage of what we believe to be tax efficient structures before. We always reconsider it or, with the other security positions we have, which are not as significant, but they're not de minimus either, relative to what the alternative would be in repurchasing our stock or in deleveraging the balance sheet. But to date, we haven't seen an effective way to do that on a tax efficient basis. And lacking a tax efficient basis, we do have not the strongest case on relative pricing that you would have significant leverage by doing so.

Operator

Your next question comes from the line of David Koning with Robert W Baird.

Q - David Koning

Good morning. I wanted to pursue the margin profile of the two segments. First of all, in financial services, given that you sold the lock/line business which I think you said in the past was at a little bit of a higher margin in than the overall segment, would you still expect that segment to have some margin expansion in 2006?

A - Ken Hager

Dave, this is Ken. I think when you look at the margins for 2006, you have to take into account all of the moving parts, not just lock/line. There's two components of the lock/line business. One is the processing services, which I don't think we've ever said were greater than our other margins, but I thought we said they were more or less consistent with our margins. And then there was an element of underwriting revenue which in itself generally has a lower margin associated with that. And then you have to look at the fact that EquiServe won't be in the picture for the, for 2006 whereas it was in the first half of 2005. And we have the inclusion of Health Solutions which is probably still somewhat in a bit of a ramp up stage from our purposes, so I think all of those factors have to go into account when you look at what you think margins are going to be for the financial services segment for 2006.

A - Thomas McCullough

Maybe State is slightly differently, the exclusion of lock/line will not necessarily result in a decline in margins, but going to Ken's point again, one of the things that maybe is not totally understood in the margins, for instance, where we have joint ventures in the mutual fund processing business, we don't include revenues. The profit from those shows up down in a joint venture line. That probably clouds the margin discussion a little bit. But going back to Health Solutions, it will, again, we're working on the best way to clarify this, I mention the amortization of intangibles at Asurion at two levels. We also have a significant amortization of intangibles at Health Solutions. That amortization of intangibles comes in and certainly dampens the underlying, for lack a better term, cash operating margins within financial services. As to all of the amortization of intangibles, since I think they will be relatively significant both in the inclusion of Asurion and unconsolidated affiliates and their impact in financial services sector because of the amortization of Health Solutions, will try and make that clearer in future quarters.

Q - David Koning

Great. And secondly, within output, I think you did about a 5% margins this year. Given some of the investments that you now made, will those be leveraged in, would you expect, I guess margin expansion in 2006?

A - Thomas McDonnell

I hope so. The margin you saw reflected some of the expenses that were incurred and reported late in the year. We thought and would think that the margins there are more in the 7.5, 8% range normalized. And it's been our intention to continue to improve those margins to get them, the first step would be to get them to a double-digit level, and we think that's achievable in the next year, year and a half or so. So I do think the answer, simple answer is yes, you should expect margin expansion. But again, when you're looking at output, you will probably see a margin expansion in the first quarter because of the strength of the first quarter, but I think it's going to take a couple of quarters to demonstrate that the underlying relative economics of cost to revenues have significantly improved.

Operator

Your next question comes from the line of Glenn Greene with Think Equity Partners.

Q - Glenn Greene

First question relates to the Output Solutions. Just looking at what I'll call the average yield per item mailed, it dropped sort of significantly sequentially and year-over-year. And I guess you alluded to some new contracts came on, but I don't know if they came on this quarter. I was wondering if you could shed some color on sort of the average yield.

A - Thomas McDonnell

Some of them were not new contracts, but significant extensions and renegotiations of existing clients, so you would have seen an impact where the average yield per unit would have declined. But on the other hand, in some cases, a number of units went up substantially, although we don't break those out client by client. We had some clients with very significant increases in volumes so that the net overall impact was positive, but it would have had, the number that you're referring to net yield per item would have had a decline and would also have had a short-term impact on the margins until we get some of the new technology fully implemented.

Q - Glenn Greene

These sort of implicit yields that were added, this is sort of a good stepping off point going forward?

A - Thomas McDonnell

I would like to think so.

Q - Glenn Greene

Okay. And that I know you, there is the issue with the amortization of intangibles and the impact on Asurion, but is there any way to sort of give us some frame of reference for the profitability contribution or at least your share of the profitability contribution of Asurion going forward?

A - Thomas McDonnell

Well, I hate to sound obscure on that. But with the completion of the merger, the combined management team is really working with, to put together their budgets, operating strategy and everything else, we're still working with the accounting treatment of the intangibles. But even without the intangibles, we're not in the position probably until after the first quarter where we actually have a published number for Asurion to give you any legitimate feel for what that earnings component will be. And I apologize for that, but I think we're going to have to wait until after first quarter to give you that.

Q - Glenn Greene

Finally, I was wondering if Ken could just to give us his sense for the fully diluted share account for 1Q, all else being equal, based on the share count, based on the share price today.

A - Ken Hager

As far as, you're talking about the impact of the convertible?

Q - Glenn Greene

Yes.

A - Ken Hager

Well as of the, I don't see it being much different than it is right now with the share price where it was at the end of the year. So if the share price were to decline, then the impact of the converts lessens.

Operator

Your next question comes from the line of Bryan Keane with Prudential.

Q - Bryan Keane

Just a couple of follow-up questions on some of the questions I asked earlier. The Output Solutions margin was I think 10.2% in the first quarter of last year. I guess what I'm, I heard some of your comments, but I'm still a little bit unclear. Does that margin significantly deteriorate from that point of last year's margin? Or is it, or should we go back up to that? In other words, I'm confused on if these fourth quarter expenses are carrying over into the first quarter, or did they seem kind of onetime in nature and we should go back to the existing kind of profile of the margins and output with the high double-digit kind of margin in 1Q?

A - Thomas McDonnell

I think you will see a much better margin than the 5% for output in the first quarter. Some of the costs will carryover, so whether or not it will get to the 10.2% level in the first quarter again, I'm not positive at this point. But there will certainly be an improvement because by nature, a very significant amount of revenue, particularly in financial services side, is oriented to the first quarter of the year.

Q - Bryan Keane

Okay. On the Asurion deal, when that deal broke, you guys kind of said it was slightly dilutive or you thought it would be slightly dilutive. And just on the language here, you're saying it's going to the dilutive and it might be more dilutive than slightly dilutive? I am just trying to get an angle because we obviously, I know we'll know more in 1Q, but I've got to model it or we've got to model it going forward. And I've got to try to guess at it, so it, does it seem like it's, you guys have learned something now that with the intangibles that it's going to be a little more dilutive than you originally thought?

A - Thomas McDonnell

I think maybe the word we used was somewhat dilutive. I don't know what the percentage definition of somewhat or slightly is. I think the dilution is going to be primarily a factor of the intangible amortization. And that's why I hope we can break that out in such a way that you can see how much comes from that and what the Asurion real operating earnings are going forward. I just don't how to quantify that for you at the moment. I think that we obviously feel the transaction is very positive. We certainly have to reflect that given the accounting treatment, it will be dilutive. To what order of magnitude I can't tell you, but I don't, I wouldn't want to imply by what we said here all of a sudden we think it's a very, very big number. Quite frankly, until we work with the accounting treatment of this, and I'm not sure that initially we anticipated the sort of two level of amortization, or have been able to effectively quantify it, again, I am sorry I can't give you a more specific answer. But I think will do everything we can to make the amortization relative to that because you'll end up seeing a discrete number in the unconsolidated affiliates, and we should be able to break out of that number what portion is intangible amortization so that you can treat that however you feel appropriate.

Q - Bryan Keane

Okay. No, that is still helpful. But strategically, if you're, if this acquisition becomes dilutive, I guess down the line here, you think the power of Asurion together is going to be more accretive than if you would have kept lock/line itself, because some questions are coming out as why even sell lock/line then if it might be dilutive for the first year. Is it, the sum of the parts that much better going forward?

A - Thomas McDonnell

Well, I guess it's, if we did not have the intangible amortization, I think you would view this very positive on reported earnings however you want to view it. We made most of our decisions based on the underlying economics of the transaction, not necessarily on how to get reported in the earnings. That's why think it will be relevant for us to point out what the intangible amortizations are. I believe that this is a very solid economic transaction. Now, anymore is sort of luck of the draw with the accounting pronouncements and how it ends up in your P&L, but it is a good economic transaction and that's the basis we made it on. And as I say we will try and point out what we would say, maybe the noneconomic prospects, the intangible amortization and hopefully you will reach the same conclusion. But if it ends up on a GAAP basis by virtue of those, amortization being quote, unquote somewhat dilutive for a period of time, that's unfortunately the way it will be, but that in our opinion does not alter the decision from an economic basis.

Q - Bryan Keane

Okay, and then finally, Ken, the SFAS 128 just reading up on that, it seems like that dilution or the share dilution will take place into 2Q or will that end up being in 3Q of 2006?

A - Thomas McDonnell

Our understanding is to, it will be, it will become issued in the second quarter and will require retroactive restatement, which means at that point we'll go back and restate all prior periods as if they were, if converted, which is why we've been trying to tell people what the if converted numbers are each quarter so that when we do convert I have to apply this pronouncement, you'll have a historical basis of what the numbers were.

Operator

Your next question comes from the line of Phil Mickelson with JP Morgan.

Q - Phil Mickelson

Just going to pick away at a couple different topics. First of all, with the account pipeline once again, has pricing been a big issue or a sticking point between yourselves and some of your potential clients? And could you also comment on kind of the, your kind of thoughts on the existing pricing environment of current accounts and new accounts going forward into this year?

A - Thomas McDonnell

Well, pricing is always an element of any transaction and the mutual fund servicing business is extremely competitive. I would not categorize the delays as price related. Maybe the business that we converted last year, the American Express which was in a pipeline probably for two years, once you get to a certain size mutual fund organization depending on whether there standalone or part of a larger organization, there's incredible complexity with ancillary technology. Whether it's interfaces to other systems, conversions. Many cases it's as a function of the ability to assimilate some portions of their workforce, some portions of their space. These are extremely complex transactions and very significant not only to us, but to the potential client. And again, I can only tell you that they are very complex and therefore they draw out. While the business has been competitive price-wise for several years, I don't think it's any more competitive now than it's been for the past 24 months. And price by and large is not a sticking point in acquiring commitments.

It's determining ramifications of all of the elements I just attempted to describe, and in some cases, it can take a client a year to decide and then it can take us another year to get them converted, given the necessary to elements around as I said interfaces, potential movement of people and so forth. So I don't think you should take from the fact that this pipeline hasn't, portions of it haven't converted more rapidly that there is a disproportionate emphasis on the pricing of transactions. But of that pipeline, just the fact that there's 11 in the 22 million, you can pretty much infer from that a couple of them are fairly substantial size clients. And they are the most complex and the most attractive as far as evaluating a change and as far as us responding to and evaluating, determining gaps, all those things that need to be in place before you can finalize a transaction. So that's really where the complexity comes, not in where the timing is involved, not really in pricing issues.

Q - Phil Mickelson

And then kind of, once again, another little question regarding Output Solutions this time, the vesting the Innovis, the Customer Management business, I was thinking there would be some sort of positive revenue event just from intercompany kind of revenue additions from that. Is that, or eliminating intercompany reductions, am I not thinking of that correctly or should that not have been, is there a positive impact from that?

A - Thomas McDonnell 64

I think that's an accounting treatment question. Let me let Ken respond to that.

A - Ken Hager

Phil, the effect on, of the sale of Innovis had the effect of no longer requiring us to eliminate certain revenues that, for revenues at Output build to Innovis for the work they did for them. When you looked at Output's revenues, they were unaffected because we report them on a segment standalone basis. But what happens now is we have less consolidation eliminations so that the consolidated revenues, in effect, did not reduce by the full amount of the revenues of the Customer Management division because to the extent, and there was, say it's roughly $12 or $13 million a quarter of revenues that Output would build to Innovis, those revenues which used to get eliminated because they were in effect in two places now don't. So while Output's revenues are the same, when we add the consolidated revenues, the effect was that not 100% of the revenues of Customer Management go away on a consolidated basis because a portion of it remains due to the lack of an elimination.

Q - Phil Mickelson

Got you. And then just one last question on the health business, I think you guys have kind of been in kind of a learning mode as far as kind of what to expect growth. I was wondering if you could comment on strategically what you think of that business for 2006. Is that a business you want to make some acquisitions to build it up, or is it investing within that business? Is this a growth business? Can you give us some color on the health business?

A - Thomas McDonnell

We believe it's a growth business. We looked at it very closely before we engaged in the transaction with CSC. We believe they have good, well-placed technology both in the claims adjudication side and the provider side. We believe that has been enhanced by a commitment to a higher level of investment in that technology which we think has been well-received by the current client base, we think will be important to expanding the client base. We have integrated or are in the process of integrating our a AWD technology with the various applications systems Health Solutions has, and we think that's going to be positive both from adding revenue and efficiency within the existing operation. We are providing now combined proposals including output for Health Solutions customers. So we believe all of those fit very nicely with DST's overall business plan of delivering multiple products to a targeted client set.

At this point, we believe that we have a good set of technology. We have not run across anything that would incline us to think that it takes acquisitions to grow that business. You never exclude that possibility, but right now, the idea is invest in the business, improve its presence in that marketplace. And we do think it is a business that can growth grow, particularly with the inclusion of a higher investment rate in the underlying technology, the integrating of the AWD technology and providing a wider range of services including Output. And then over time with our joint venture Argus, which is in the prescription claim processing business, we think there's a viable possibility to integrate more clients for a combined deliverable of both health and prescription claims.

Operator

Your next question comes from the line of Robert Tung with Citigroup.

Q - Robert Tung

It looks like the fourth quarter operating earnings in the financial services segment benefited at least in part from cost-containment. Just wanted to get a sense for what those cost-containment initiatives were in the fourth quarter, and are they expected to recur and what sort of benefits do you expect from it going forward?

A - Thomas McDonnell

I think initiatives we have take on the cost side can't be isolated to a particular quarter. They're ongoing and some of them carried over from the third quarter and so forth. I think like most organizations, we continue to focus on whether or not we can reduce costs from an evaluation of where we are incurring them. Most of our cost initiatives are based on implementation of technology to improve efficiency and operating leverage, so I think you can continue to see that. I don't think we can quantify it quarter by quarter. With us, it's just an ongoing challenge day to day and week to week and quarter to quarter to continue to focus on the costs side of the business, so hopefully you will continue to see improvement there even relative to Output where the costs were increased for certain aspects in this quarter. We anticipate those technology investments to result in lower unitized costs for the business going forward, so it's, I can't really quantify for you what initiatives occurred in the fourth quarter because I said they're not discrete to a quarter. It's just an ongoing process we continually engage in.

Q - Robert Tung

And just a question on how you report the segments out, have there been any proposals internally to perhaps break the financial services segment out into more than one piece from a reporting standpoint?

A - Thomas McDonnell

We continue to review the most effective way to report. Obviously, there certain aspects that are clearly financial services, mutual funds, investment management systems and so forth. We have continued to include Health Solutions and AWD all in the same segment because they're so much, so many integrated components starting with the data center through AWD through cross selling of other product lines that when we look at it, we see it as a business that has so much crossover from both of the technology delivery at the data center, integration of AWD and so forth that it would be not necessarily appropriate at this point to try and separate them out. Because I think we would end up then spending and off a lot of time saying we separated it out, but here's this intercompany revenue that has to then be recognized in a different way. So at this point, in the answer is no, we're going to keep them kind of combined the way we think about operating the business, which is to try and get as much value from the underlying infrastructure in assets across all product lines and get as much reuse and technology like AWD and other components as we can.

Q - Robert Tung

Okay. Then just my last question is on DSTI. And it's not a question about, I understand the quarterly results will differ and it might be stronger in the third and fourth quarter, but looking longer-term, internationally, what, how, what do you see as the growth drivers in that business? And we saw it grew something like 5% in 2005. You mentioned in 2006 it should be at similar levels. What is the qualitative driver of that growth? Are foreign mutual, or European mutual fund complexes just looking to use your software? And who are the other players in those markets?

A - Thomas McDonnell

Well, I guess, if you, first DSTI, probably the smallest portion of its business are the collective investment businesses, whether that's unit trust in the UK or mutual funds elsewhere, their business really is broadly described as investment managers. That could be insurance company portfolios, bank portfolios, private manager portfolios, hedge fund portfolios and on down the line. They have a heavy concentration of clients in the UK, Australia, Hong Kong, and some of those markets and are starting to see some in the emerging Asian markets. We have some presence on the continent, the Netherlands and France and Germany, but not significant at this point. The drivers really are going to be investment managers continuing to expand their business and needing more sophisticated solutions and more integrated solutions.

So when you talk to investment managers, they talk front office, middle office, back office and the preferences is to bring a lot of those systems together, and we have systems across that spectrum. So I think it's just the overall growth of the investment management industry, individual growth within organizations that drive incremental revenue because that, those businesses are generally licensed by relative utilization within a customer, so the more users they put on, the more revenue it generates. You will see if we have continued licensing and sales success, the licenses have subsequent revenues associated with them from the standpoint of maintenance and consulting revenues, so that book should continue to build there. And hopefully, we can be more effective in penetrating some of the European markets.

We've had also some sense that it, without have any significant success yet, but a few clients for the international software are now U.S.-based because they use it for international portfolios, in some cases hedge fund portfolios and so forth. So whether there is any significant market within the U.S. at this point is unclear. So I think really the drivers there are product differentiation, growth in the investment management business and potential penetration of geographies where we have, we have small marketshares currently like in continental Europe, and then in emerging markets, primary in Asia.

Operator

Your next question comes from the line of Tim Willi with A.G. Edwards.

Q - Tracey McMillin

Actually Tracey McMillan standing in for Tim. I had a couple of questions. Sort of a follow-on on the last one. As you look at the delay or the decision-making process, is, could you characterize it that larger fund complexes may possibly be considering more full service offerings where in the past they have been generally been remote customers?

A - Thomas McDonnell

I don't think you could universally categorize of that, Tracey, but you most everybody that, let's say an in-house operation when they're looking at an alternative, they start out by saying what if we went and took everything out. What if we did part, whatever. More of the transactions that we're seeing or the potential transactions we're seeing are more what I would call hybrid, where a client says well, when looking at this, we still want to do a significant portion of this, but by the way, we would like to have either DST or BFDS pickup certain functions that we don't believe are necessarily relevant. And yes that does add some complexity to the evaluation. And that is, I think in many cases, the final outcome may be what we would generally think of as a remote client, but there's more evaluation of well, how much should they really put out. And a lot of the transactions, if they are finalized, at least the ones we're discussing now, will have what I would call a hybrid component where they will be a remote component and then there will be more of the business that will be subcontracted either to ourselves or BFDS as part of the new bringing into play the solution that is most effective for the client.

Q - Tracey McMillin

Related, does there still appear to be a trend in the industry towards more full service?

A - Thomas McDonnell

Yes. When I said more full service, it's certainly more hybrid and to some extent remote clients evaluating, certainly subcontracting a lot of the functions. Most times they do want to keep some aspects for contact with sales forces and certain shareowners and so forth, but that's still an operative situation out there today.

Q - Tracey McMillin

Okay. A couple of little items. I'm not sure if you covered this one. The number of fund complexes that you currently have that have committed in the accounts, where does that stand? I don't think I heard that.

A - Thomas McDonnell

Well, when we say committed, we keep referring to this pipeline of about 22 million and no contracts were finalized in this last quarter, indicating we hope to, as I said many times, we really believe that some of them are going to close or make decisions in the next 90 days. But I can certainly recognize that there might be some skepticism on everybody's part out there because that is what we said 90 days ago. But the book that's, or the number of clients that are still in some stage of discussion or evaluation is about 11 and it's about 22 million accounts. Other than the ones that were referenced, couple hundred thousand that were converted in the annuity side or in the 401 track side in fourth quarter we really don't have any signed agreements. That doesn't mean we don't have substantive negotiations, but we don't have any signed agreements.

Q - Tracey McMillin

Okay. Now a couple of quarters ago you mentioned you had 4 complexes that had committed with roughly 6.2 million accounts.

A - Thomas McDonnell

Those have been converted.

Q - Tracey McMillin

Those have been converted. Okay. And so right now, no commitments. Okay also, just two little items. BFDS, percentage of financial services revenue, I know that is something that's typically broken out in the K. Do you have that available?

A - Ken Hager

We don't have it available.

A - Thomas McDonnell

BFDS revenues?

Q - Tracey McMillin

As a percentage of financial services, you typically offer that in the K.

A - Thomas McDonnell

You mean intercompany revenues from BFDS?

Q - Tracey McMillin

Right.

A - Thomas McDonnell

Ken does not have that handy.

A - Ken Hager

We don't have that available.

Q - Tracey McMillin

Okay. And finally, number of workstations currently in place?

A - Thomas McDonnell

For AWD?

Q - Tracey McMillin

Yes.

A - Thomas McCullough

About 110,000.

Q - Tracey McMillin

Great. Thank you.

A - Thomas McCullough

Tom McCullough responding.

Operator

Your next question comes from the line of Morali Gobal with KBW.

Q - Morali Gobal

Just strategically thinking, in the last several quarters, you rationalized your businesses, sold some businesses, monetized the passive investments and you bought back shares. And obviously that's helped unlock some value, but just in terms of where you are in the process, how should we think about the process of rationalization? You think you're pretty close to being done? And if so, with a much more focused business model do you think you're going to see a significant pickup in your topline growth going forward?

A - Thomas McDonnell

Well, I guess, we have not in our own minds been thinking of this as a rationalization process per se. I think we have seen a couple opportunities that we've taken advantage of because we felt it was an appropriate time to address those businesses for one reason or another. The business lines we have in our international businesses, U.S. mutual funds, AWD, Output, Health Solutions and our joint venture positions, we think is a pretty solid group of businesses at this point and we will be focusing on growing them. I think any acceleration of topline growth, you kind of have to go back to a lot of what we discussed here this morning, which includes the outlook for revenue growth in the mutual fund side, comments about Output Solutions and kind of its investment in technology.

We believe good sales prospects and incremental growth and some incremental growth in existing clients, modified somewhat by the pricing environment, and with Health Solutions. I think it's, we reached a point now where we've had a lot of integration of technology and so forth. We think we've improved the positioning of that product both for the potential of the in-line applications product, AWD related revenues and output related revenues, but that is going to play over the next several quarters to see if the way we positioned that will produce the kind of results we are looking for. So it's hard to quantify at this point any particular step up in revenues because a very significant portion of the business is still pretty well correlated to how successful we are on the mutual fund side. And I think our discussion there indicated that we really haven't seen that spring up in organic growth. But that's going to be a function of, do we get some of these clients signed? And is there a more robust growth in the 3% plus we had last year that will occur in 2005? But I do think we are comfortable and we have a solid set of businesses.

They're businesses that we have long experience with, and we think through our historic approach of differentiating all of those products with technology investments, and hopefully selling affectively into the marketplaces, that we will improve revenue growth. But at this point, we're, don't have any particular reason to believe that in the short-term there will be a material difference given the factors that are dependent particularly on the mutual fund component.

Q - Morali Gobal

Thanks. And also just curious, the software licensing revenues, what extent, can you provide any color on what's been your historical experience in terms of what is the drop-off in the first quarter of software compared to fourth quarter?

A - Thomas McDonnell

Well there is, unfortunately, there is, that is more of a random walk. Sometimes you have a strong fourth quarter and strong enough that stuff carries over to the first quarter. Sometimes it all gets used up in the fourth quarter. I don't, there's no, we can't give you a formula for it. I think I will say that we had an awful lot of activity in the fourth quarter of 2005 and not all of it got completed, so we would not, I don't think we would expect a huge drop at least in the first half. Now, again, some of those are large negotiating contracts and whether they all come to fruition in a 90 day a period, but there is sufficient activity that would reinforce what we said earlier that we think DSTI can have a solid 2006. Some of that is carryover from 2005, but whether it shows up for the first quarter or not is not clear.

Operator

Your next question comes from the line of Herb Buckbinder with Wachovia Securities.

Q - Herb Buckbinder

Just two quick questions. Do you think you could quantify the impact of the ETF and if it had some negative impact on the growth of your fund accounts? And the other question is if we are getting closer to maybe doing something to try to maximize the value of Argus, can you just give us a status of where you are with Argus at this point?

A - Thomas McDonnell

Herb, we have no way to really evaluate ETF, so we can give you our sense as to, that ETFs are not a major dampening effect on open-ended mutual fund accounts, because we think most of the ETFs are more in the realm of brokerage clients and people who would tend to be using them for specialized purposes like trading and so forth. I don't think we see a lot of them really showing up in IRAs and long-term accounts, but that's our opinion. I haven't seen any real studies that would address it, but at least it's our sort of impression that that's not a significant negative factor. I'm sure there are some people who say I'm going to buy an ETF and don't do an open-end fund, but we don't believe it's that relevant at the moment. As to Argus, it is, as you're quite familiar in the prescriptions claim processing business, their volumes continue to grow. They do have, they have added to their technology support of Medicare Part D and that, we believe, should produce some enhanced clients, pardon, enhanced numbers of clients. And we also hope we can come up with an effective cross selling and integration strategy with the Health Solutions division. But Argus is, on a relative basis, not that significant to our overall numbers at this point. But if some of the volumes that have been predicted in Medicare Part D which you have seen a lot of PR on, or a lot of press on I should say, we could see a much improved and a little bit different take on Argus six, nine months down the line.

Operator

Your next question comes from the line of Karen Becker with Arian Capital.

Q - Karen Becker

I had a bigger picture question, which is you guys have bought back stock aggressively over the past year and you don't sell stock personally. So I'm curious if you can share with us what you see as sort of the secular trends in the business over the next two or three years that gets you so excited. Thanks.

A - Thomas McDonnell

Karen, I may be so excited might be a little bit of a stretch, but I think we're very confident in the business. I guess when you look at secular trends, maybe take those in three or four broad categories. One, we talked a lot about the mutual fund industry, but longer-term we all recognize, maybe everybody but the administration recognizes that there's issues with Social Security and there has to be more movement towards privatization of retirement savings. I think as limits on IRAs have continued to grow, you see more people now becoming interested, because they think their more meaningful. Employment growth should drive more 401(k) growth and conversions, not too many days go by when you don't see a major U.S. corporation freezing their defined benefit plans and moving more to defined contribution plans. We think all that is positive. And again, I think that the kind of rebuilding of confidence of U.S. investors in overall investment vehicles that would bring them back to the mutual fund industry, we think all that is positive. On the Output side, not only are we investing in technology, but over time, some of the business we see there is not dissimilar to what we see in the mutual fund business where large organizations, whether they are Telecom organizations, whether they are cable operations, or they're utilities, that have in-house print operations are reevaluating whether they can, on an effective cost basis, really keep up with the technology and manage the ongoing the mix between paper and electronic delivery.

They're still in the output business. If you took the largest five, I doubt it's 6 or 7% of the overall output in the U.S., so it's still a very fragmented business out there. We think that lends itself to sort of a consolidation over time, and we think that the evaluation of in-house versus vendor-provided services will accelerate. Health-care, we think a lot of money of going to be spent on health-care and health-care administration. We think a lot of systems that our division has in place will facilitate more of the consumer driven health-care components. We think those are very positive aspects of the technology that we have. A lot of that technology is deliverable as discrete components without necessarily having to move the underlying claims adjudication engine. So we just think with the health-care segment of this economy is so big and growing, and it is going to be demanding changes. And any time with the growth and change, historically, that is where we have been able to most effectively apply our technology.

So I think if you look at those broad categories, and the fourth one I would have mentioned would have been, hopefully we will continue to expand our footprint internationally because we have now international operations in shareowner accounting. We have international operations in Output. We have international operations in investment management. And we periodically receive some inquiries as to whether components of the health-care technology are exportable outside the U.S. So I think there's additional sort of longer-term, I don't know that I would call it a secular growth, but certainly growth opportunities for high-quality U.S. technology to be represented more effectively in international marketplaces.

Q - Karen Becker

My next question would be Asurion, can you talk about the capital structure there? Is there debt?

A - Thomas McDonnell

We really can't talk about the capital structure yet until we see how this works out over the next 30 days.

Operator

There are no further questions at this time. Gentlemen, please continue.

Thomas McDonnell, President, Chief Executive Officer

Well, with no further questions, we want to thank you for joining us today and hopefully at the next meeting we'll be able to report something on the pipeline. Thanks for joining us.

Operator

Ladies and gentlemen, this conference will be available for replay after 1:30 PM Central time today running through Wednesday, February 1, 2006 at midnight. You may access the AT&T teleconference replay system at any time by dialing 1-800-475-6701 and entering the access code 813-443. International participants please dial 320-365-3844. Those numbers again are 1-800-475-6701 and 320-365-3844, and then entering the access code 813-443. That does conclude our conference for today. Thank you for your participation and for using AT&T executive teleconference. You may now disconnect.

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