Description

Given recent activist/private equity interest in DST...

DST Systems, Inc. is comprised of three main segments: Financial Services, Output Solutions and an Investment Portfolio.

DST's Financial services segment (~70% of total net revenue) provides informatino processing and account management software to the financial and healthcare industry.  DST's financial industry solutions (~75% of segment revenue) include mutual fund shareowner, subaccount and unit trust recordkeeping systems for US and international mutual fund companies; a defined-contribution participant recordkeeping system for the US retirement plan market; investment manaegment systems offered to US and international investment managers and fund accountants; and a business process management and customer contact system.  DST's healthcare industry solutions (~25% of segment revenue) include a healthcare claims administration processing system and services offered to providers of healthcare plans, third party administrators and medical practice groups; and pharmacy claims processing systems offered to healthcare plans, insurance companies, third party administrators and pharmacy benefit managers.  DST is typically paid on a per account basis for its industry leading financial industry products and on a per covered life or per pharmacy claim paid basis for its healthcare industry products.

DST's Output Solutions segment (~30% of total net revenue) provides single source, integrated print and electronic statement and billing output solutions.  In 2009, DST produced 12.9 billion images and delivered 2.4 billion items from five operating facilities strategically located throughout North America and the U.K.  DST is among the largest users of continuous, high-speed, full-color inkjet printing systems and among the largest First-Class mailers in the U.S.

DST's investment portfolio is held on the balance sheet at ~$1.5b and consists of publicly traded securities, significant equity stakes in profitable, unconsolidated affiliates (i.e. Boston Financial Data Services), real estate, and private equity investments (held on books at lower of cost or market).

Investment Thesis

High quality Financial Services segment produces attractive and predictable recurring free cash flow stream (~70% of company revenue and 82%+ of company FCF): 

• DST's shareholder accounting software covers approximately 75% of the U.S. mutual fund industry's active accounts. The other 25% is processed by in house systems at Fidelity, Vanguard, Oppenheimer and Franklin.
• DST is paid on a per account basis and its solutions are extremely sticky. Industry contacts have unanimously told us it would take over 3 years for a large customer to migrate off of DST's system. If a customer did want to migrate off of DST's system, the only other alternative is to build an in house system from scratch. The trend over the past decade has been toward outsourcing the software functionality due to significant cost savings.
• The fees per account a mutual fund pays to DST are part of the operating expenses that are charged back to the mutual fund holder resulting in very little pricing pressure upon contract renewals.

 Sub-accounting headwind in the final few innings: 

• Starting in the late 90s, large broker/dealers began to see the transfer agent role as an attractive revenue opportunity by performing the transfer agent function in house (customer service, shareholder accounting, payment of dividend, statements, etc.) vs. at the mutual fund level.
• In order to perform the transfer agent function in house, most of the large broker/dealers licensed a DST-like software from PFPC (a failed competitor to DST). Under this scenario, broker/dealers establish omnibus accounts with each mutual fund product, and perform the shareholder accounting functions on PFPC's software. This resulted in a decrease in a number of accounts serviced at the mutual fund level (i.e. Smith Barney's 10,000 individual accounts that own Janus' Growth Fund will collapse into one omnibus account at the mutual fund level). This shift toward sub-accounting has been a negative headwind for DST given its per account business model and dominant market share at the mutual fund level.
• Based on our due diligence, we believe we are in the final few innings of this sub accounting shift. As stated earlier, this is not a new phenomenon (market only discovered this in 2008 due to M&A activity caused a sudden spike in lost accounts, particularly when AG Edwards shifted to Wachovia's sub accounting platform) but the market continues to obsess over it. All large broker/dealers with enough scale to do in house processing have moved to sub accounting, leaving very little exposure for large, unexpected batches of account losses. We anticipate the sub accounting headwind ($35m impact to revenue and $15-$20m impact to FCF) to taper off in 2012, and growth will likely reaccelerate.
• DST acquired a sub accounting software platform in 2007, which can help mitigate the shift to sub accounting if DST's sub accounting system is chosen.

 Restructuring initiatives taken in 2010 will help drive margin expansion and FCF in 2011 and beyond: 

• DST implement a restructuring plan in 2010 to streamline the operations of both the Financial Services and Output Solutions segments.
• DST is nearly done w/ the restructuring and has achieved $40m in annual savings in 2010 w/ an additional $25 million in annual savings to benefit 2011, for a total of $65m in on going savings per year.

 Favorable long term fundamentals: 

• DST has largely been able to grow through the sub accounting headwinds via organic account growth and by successfully expanding their software offerings to service other adjacent markets (AWD and Healthcare).
• DST's software solutions help customers drive efficiency around the many manually intensive activities involved with account management (account opening/closing, customer service, priority tasking, item processing, etc). Underpenetrated verticals on a global basis are healthcare, telecommunications, insurance, mortgage servicing organizations and pharmacy benefit managers, just to name a few.
• Management guides to long term organic growth in the mid single digit range, which we think is reasonable. Our base case model assumes ~2% organic growth.

 Significant hidden value in investment portfolio: 

• Wall Street consensus price target for State Street (STT) is ~$55. Applying that value would add an additional $2.36 to our base case target price.
• DST owns a 6% stake in privately held Asurion, which is owned by private equity firms Madison Dearborn Partners and Providence Equity. Asurion is the largest provider of white label insurance/warranty programs for the mobile phone and consumer electronics industry. The investment in Asurion is held in "Other Investments" at a book value of $3.1m. DST sold 30% of its stake in Asurion to the private equity group in 2007 at an implied valuation of $3.1b. Using this valuation, DST's 6% remaining stake in Asurion was worth $186m. Based on our due diligence, this investment has been a "complete homerun" for the private equity investors. With the proliferation of high priced smartphones, and 2 year contract lock-ins, we believe demand for phone insurance will be very robust. Marking up the $3.1m book value to $186m valuation, which we believe is very conservative, would add an additional $2.42 to our base case target price.
• The other $233m of investments held in Other Investments consists largely of private equity fund investments conservatively held at the lower of cost or market value. We know from our experience with AAA and KPE that market values were significantly reduced during 2009, and values have sharply rebounded off of their lows (see performance of AAA and KPE). While difficult to quantify, we believe given the conservative accounting methodology used and the sharp writedowns most private equity firms took during the downturn, there is likely upside potential here.
• Unconsolidated affiliates include 50% JV's with State Street, consisting of Boston Financial Data Services (BFDS) and International Financial Data Services (IFDS), which both provide full-service and shared-service shareowner recordkeeping to mutual fund and Open Ended investment Companies around the world. RS is a client of BFDS. Both of these businesses have been somewhat pressured by the downturn and low interest rate environment impacting float income. As a sanity check, book value of $356m triangulates to approximately 8-9x depressed earnings, which seems fairly reasonable.

Warranted Value 

• Base case = $66 (based on SOTP, 10% unlevered FCF yield on FY14 estimates for Financial Services segment; 13% yield on FY14 estimates for Output Solutions segment; and fully taxed value of investment portfolio w/ 20% haircut)
• Downside = $38 (based on SOTP, 12% unlevered FCF yield on FY14 estimates for Financial Services segment assuming continued deterioration in Financial Services segment due to loss of registered accounts and no growth in rest of business; 17% yield on FY14 estimates for Output Solutions segment assuming top line deterioration and significant operating margin compression; and fully taxed value of investment portfolio w/ 40% haircut)

Key Risks 

• Shift to sub-accounting continues indefinitely, resulting in continued loss of registered accounts;
• M&A of small to mid size broker/dealers would likely result in loss of registered accounts;
• M&A in mutual fund industry by any of the 4 large in-house Mutual Fund families (Vanguard, Fidelity, Franklin and Oppenheimer) would likely result in loss of registered accounts;
• Double dip recession results in prolonged high unemployment, resulting in fewer new account creation
• Significant decline in value of investment portfolio vs. our assumptions

ADDITIONAL METRICS

Catalyst

Key Value Drivers / Free Options: 

• Activist intervention and/or private equity takeout unlocks value
• Market value of investment portfolio turns out to be greater than our assumption
• Monetize 6% ownership in Asurion, which is currently held on the books for $3.1m and is likely worth in excess of $180m)
• State Street stock appreciation
• Any one of the 4 large in-house, mutual funds (Franklin, Fidelity, Vanguard and Oppenheimer) decide to outsource shareholder accounting software
• Economic rebound results in return to normalized growth rates...
• Output Solutions segment achieves goal of double digit operating margins...