Description

DST SYSTEMS

DST Systems's core business trades at a 10.4x P/FCFE which is too low a multiple for a growing company with a strong moat (35% marketshare in core business at end of 2004) that is aggressively repurchasing stock. DST is cheap for a number of reasons, mostly related to the management team:

- They like corporate transactions and avoiding taxes about as much as John Malone, yielding quite a challenge comparing year-over-year results

- They aren't that interested in making things transparent for shareholders. Between $15+/share in value in private non-consolidated subsidiaries and a delibrate lack of disclosure about the core operating businesses, this isn't the sell-side's favorite stock to cover

- While most of the businesses they own are very similar, the company none-the-less is a holding company that may get a corresponding “holdco discount”. Given the capital allocation skill of this management team, the company should probably trade at a premium.

- They take the long view in regards to building value, including suppressing current income via investing through the income statement. In addition, they buy back shares while also feigning ignorance to the value of the company. In fact, they have bought back $2.7 billion (market cap is now $4.1B before considering dilution) in shares over the last 6.5 years at an average price of $41/share and all of that below current prices.

My favorite quote from recent conference calls:

Jim Kissane - Bear Stearns - Analyst

Thanks. Tom, can you discuss your logic behind such a big buy-back? Is it simply just to get in front of the [cocoa] dilution next year, or is it more economical? You just think the stock is pretty cheap here?

Thomas McDonnell - DST Systems Inc. - President and CEO

Well, we're not qualified investment analysts on this end, Jim, so I don't know that I can speculate on the relative price of the stock.

After looking at all the recent private market transactions this CEO has undertaken and the value creation from them, I can only conclude that this remark was less than forthcoming.

-------- Overview --------

DST Systems' primary business is financial services information processing and computer software services (how is that for generic). Their secondary businesses are 1) output solutions: integrated print and electonic statemetns and billing output solutions and 2) healthcare information systems. In plain english, DST Systems provides software to manage customer information and printing/mailing solutions for communicating with customers, primarily within the financial services and healthcare industries. This is obviously a large market that is software engineer and account representative intensive.

The company also has a large portfolio of non-consolidated affiliates and investment securities relative to the company's value.

The quick rundown of the numbers:

96.1mm SOS (assuming convert with strike of $49.08 is converted and all options are converted)
$58 stock price
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$5.56 billion market cap fully diluted.

+$0.55 billion debt net of converts
-$0.46 billion cash (assuming stock options are converted)
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$5.63 billion enterprise value

-$1.54 billion available-for-sale securities (State Street, Computershare Ltd., Euronet Worldwide, “Trading securities”, “Held-to-maturity” and “Other”)
+$0.38 billion deferred taxes (mostly related to these securities)
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$4.47 billion enterprise value net of available-for-sale securities

-$1.76 billion value of non-consolidated affiliates (covered in more detail below)
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$2.71 billion enterprise value of consolidated operating businesses

Non-consolidated affiliates (all have good expected growth, real estate excluded):

-  BFDS + IFDS: These are both JV's with State Street that extend the company's brands and customer solutions. Without digging too deep, $15.3mm net income in 2005 (net of interest earned on cash balance and $11.2mm deferred gain on a business sale). Cash on balance sheet of JV attributable to DST: $475mm (search “interest rate risk” in 2005 10-K for reference).  Strong growth and franchise: 20x on net + cash yields a value of $800 million

-  Argus 50% JV: www.argushealth.com. This is a pharmacy benefit plan processing company 50% owned by DST. In the first 6 months of 2006 DST recognized $3mm net income from their stake compared to $0.3mm in the first 6 months of 2005. Total 2005 earnings from Argus were not broken out in the 10-K. Argus processed 205mm claims in 2004 and 234 million in 2005 (growth of 14%). In 2006, growth will be significantly higher due to major contract wins in the Medicare PDP market. Placing a 20x multiple on their first 6 months earnings, this unit is worth $120mm.

-  Real estate investments not in use by company: very conservatively $50mm

-  Asurion: This private company is the largest wireless roadside assistance and handset insurance company. Strong growth profile. On July 13, 2006, $254mm cash was dividended to DST from Asurion (it was treated as return of capital) based on debt placement at Asurion. Assuming interest rate of 7% on debt, and using a 20x multiple on post-debt-financing earnings (and adding back in amortization), remaining stake in Asurion should be worth at least $535mm. Combined with the cash distribution this yields a value of $788mm+.

-------- Operating Businesses --------

$2.71 billion enterprise value of consolidated operating businesses

Operating businesses:
EBITDA of $460mm over last twelve months on a non-GAAP basis. 
Maintenence capex of $75mm (a little less than half of total spent on capex - I think this is probably conservative given the businesses). 
Taxes of $125mm (assumed 35% fed and 3% state). 
FCF: $260mm.
EV/FCF: 10.4x

Share repurchases:

Fully-diluted shares outstanding now: 96.1mm @ $58/share
Shares bought back in 2001: 5.4mm @ $33.85/share
Shares bought back in 2002: 0.6mm @ $44.17/share
Shares bought back in 2003: 32.3mm @ 34.4/share (janus exchange) and issued converts that when converted dilute for 17.1mm shares @ 49.08/share. Company also bought an additional 3.7mm in the open market @ $34.73
Shares bought back in 2004: 5.7mm @ $48.48/share
Shares bought back in 2005: 14.4mm @ $53.59/share
Shares bought back thus far in 2006: 2.9mm @ $58.1/share
Total bought back in 2001 – 2006: 65mm @ $41/share

I think this FCF understates the “steady state” cashflow that I define as cashflow adjusted for those items on the expense statement that are really invested in growth through sales, marketing, implementation and research and development. I think once adjusting for those, the “steady state” after-tax FCF is closer to $430mm, leaving the company trading at a 6.3x multiple. I believe this company should trade at least at a 15x multiple to my “steady-state” after-tax FCF, as the cash reinvested through the income statement increases the value of the company beyond that of a steady-state company. This gives a fair value for the company in excess of $100/share. A management team that is willing to suppress current income shows, in my opinion, a long-term philosophy that is accretive to the overall value of the company (especially when coupled with aggressive stock buybacks).

The operating businesses are reported in two segments, Financial Services and Output Solutions. Financial Services includes both the investment fund processing/technology services business and the newly acquired healthcare technology business. Output Solutions is currently in the midst of a technology upgrade that has temporarily suppressed margins but long-run should add to the ROIC of the business.

-------- Financial Services --------

The financial services unit has two different components as mentioned above. For the purpose of this valuation, I will ignore the healthcare unit and merely assume that it is worth what they paid for it last year ($100mm net of cash acquired). The financial services component (paraphrasing the 10-K) of the business does a whole host of software-related tasks related to managing information for mutual funds, investment managers, insurance companies, banks, brokers, financial planners and third party administrators. The company' proprietary software systems includes shareowner recordkeeping systems, invesment management systems, business process/customer contact systems, and recordkeeping systems to support “managed account” investment products.

As an aside, a link to industry growth stats:
http://www.ici.org/factbook/pdf/05_fb_table01.pdf

Looking at revenues and operating income over the past three years (and backing out out-of-pocket reimbursement, units that have been sold, one-time charges unrelated to the business and recently acquired healthcare biz):

                  2005    2004    2003
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Revenues ($mm)

US              $874.1  $769.3  $708.2
  rev growth      13.6%    8.6%
Intl            $146.1  $138.7  $123.0
  rev growth       5.3%   12.8%

Shareholder Accounts (mm)
US               102.2    92.2    87.9
  growth          10.8%    4.9%
Intl              12.0    11.5     7.3
  growth           4.3%   57.5%

Oper Inc ($mm)  $300.5  $271.6  $257.2
  inc growth      10.6%    5.6%
D&A             $ 99.9  $108.4  $ 95.1

EBITDA          $400.4  $380.0  $352.3

-------- Output Solutions --------

The Output Solutions unit provides single source, integrated print and electronic statement and billing output solutions. The Output Solutions Segment also offers a variety of related professional services, including statement design and formatting, customer segmentation, and personalized messaging tools as well as providing electronic bill payment and presentment solutions and computer output archival solutions.

The 2003 revenues do not include the OMS revenues or operating income that were lost because of the “Janus Exchange” (see the 10-K for more details).

                                    2005    2004    2003
----------------------------------------
Revenues ($mm)  $487.2  $453.9  $472.7
  rev growth       7.3%   -4.0%

Oper Inc ($mm)  $ 26.0  $ 21.1  $ 8.2
  inc growth      23.2%  157.3%
D&A             $ 26.9  $ 28.2  $ 36.0

EBITDA          $ 52.9  $ 49.3  $ 44.2

This year net income will be suppressed as they have invested significantly in new equipment while re-signing contracts at lower rates but higher volumes. Between accelerated accounting depreciation and the lower rates, it will take a few quarters for the former profitability to reemerge with the new equipment online (excluding D&A differences, operating income declined 51% in the 1H06 relative to the 1H05 while revenue climbed 8.5%).

-------- Investment versus Maintenance Capital Expenditures --------

It is my contention that a great deal of capital expenditures and costs and expenses are actually investment. For instance, from the 10-K: the Company’s research and development efforts are focused on introducing new products and services as well as on enhancing its existing products and services. The Company expended $189.2 million, $251.6 million and $216.0 million in 2005, 2004 and 2003, respectively, for software development and maintenance and enhancements to the Company’s proprietary systems and software products of which $40.0 million, $61.9 million and $61.8 million was capitalized and included in Investing Activities in 2005, 2004 and 2003, respectively.

Given the company's market share and the business it is in (extremely high switching costs), it seems unlikely that much of this software R&D is necessary to maintain the business – these are business investments which should fall under a ROIC framework and should be backed out of the current income statement.

Capex less capitalized software expenses for the years ended December 31, 2005, 2004 and 2003, were $97.1 million, $120.7 million, and $202.5 million. It is likely that a not-insignificant portion of the remaining capital expenditures is spent due to the expanding business and personnel needs. What portion is maintenance capital expenditures? Hard to say, but I think $50 million would be a reasonable estimation.

Finally, while new client implementation and sales and marketing expenses aren't broken out for the Financial Services segment, they are also likely a large portion of the company's cost structure while they only a portion of those expenses would properly be considering ongoing costs of doing business. Out of 5700 employees in the Financial Services segment, some not insignificant portion is likely dedicated to these two tasks. Let's assume the low end is 500, at an average cost of $80k per year (a guess), which would require backing out another $40 million from the expense structure. For a reference point, Sungard (which isn't totally comparable, but is the best I can do) spends 29% of their expenses on “sales, marketing and administration” which would equate to $182 million in DST's case. I feel like this is a good gut check on $40 million being conservative.

Taking these adjustments into account, free cash flow to equity in 2005 would've been $428.4 million for Financial Services. The calculation is:

= pre-tax pre-investment cashflow + expensed R&D + expensed S&M and implementation - taxes

= (EBITDA – maint. capex) + (R&D – capitalized R&D) + income statement investment – oper. inc. * tax rate

= $350.4 + $149.2 + $40.0 - $111.2

= $428.4 million Financial Services free cashflow to equity in a steady state.

This equals $4.46/share. Using the same adjustments for the previous two years, steady state FCFE for financial services growth has been strong due to the steep reduction in sharecount, mostly:

2005: $4.46/share
2004: $4.16/share
2003: $3.45/share
CAGR: 13.6%

One obvious critique of my methodology is that I have subtracted out all R&D as investment spending, when surely there is some that is necessary just to stay afloat. I don't disagree, but I think the $40mm for implementations and sales and marketing is a number that could be as much as a factor of 5x too small, and thus I've allowed some “fudge” room there. That being said, the whole process is probably uncomfortably rough for some potential investors.

Moving on to Output Solutions, it seems this business does not deserve similar treatment as it is not an expanding high moat software business, but rather a printing solutions business. Using the average of 2004 and 2005's operating income as “normalized”, and tax-affecting it, we get a business earning after-tax FCF: $14.8mm. Using Bowne & Co. (BNE)'s forward multiple (18x) as an appropriate multiple for this business, an appropriate value would be $266mm.

-------- Valuation --------
$0.09 billion, or $0.95/share, of net debt assuming full conversion of converts.
$2.92 billion, or $30.4/share, of non-operating businesses.
$0.27 billion, or $2.8/share, of output solutions.
$0.10 billion, or $1.04/share, of the healthcare business at book

Using a $60.5 share price, this leaves $27.21/share allocated to the financial services segment, which earns $4.46/share FCFE in my adjusted steady state for a multiple of 6.1x.

Valuing at 15x steady state (which lines up with 25x the non-adjusted FCFE number of the financial services unit) implies a value of $6.4B, or $66.8/share. Adding this to the rest of the businesses implies an intrinsic value of $100/share for DST for a business where management has reduced sharecount by almost half over the previous five years and shows no signs of slowing down.

Catalyst