Description

Long SSNC – Recommend a long SSNC trade at the current price of $54 – price target of $74 represents 37% upside, driven by synergy realization from the transformative DST acquisition, which closed 4/17/18.  Although the accretion of the transaction is understood as is SSNC’s business quality (90%+ recurring revenue, 90%+ retention rates), the Street is meaningfully underestimating the magnitude of potential cost synergies given the company’s conservative guidance.  As a result, SSCN’s earnings power for 2020 is slightly above $4, and fair value is 18x P/E. This multiple reflects a weighted average of SSNC’s historical NTM average 20x multiple and DST’s 15x multiple, or a 10% discount to SSNC’s historical average P/E of 20x.  There is the potential for multiple upside if SSNC is able to successfully execute its cross-selling strategy to accelerate organic growth at the combined company, but there is ample upside to consensus earnings estimates predicated on cost synergies.

The biggest misunderstanding is the margin profile at DST and how much opportunity exists in closing the margin gap with peers.  Based on our diligence, there is no reason DST cannot run at a sector-average margin in the mid-30s vs. pre-deal margins of 20% (per Jan ’18 deal presentation).  This implies SSNC can achieve $350mm+ of synergies, nearly double the stated target of $175mm – driven by a mix of public company costs, overhead and facility rationalization, increased offshoring (SSNC has 52% of employees located internationally while DST is only 28%).  DST’s historical margin profile is due to mismanagement by the previous CEO and an incomplete turnaround by the current CEO prior to the company’s sale to SSNC.

The biggest risk to the combined company is market fluctuations and HF redemptions – SSNC’s fund administration business charges based on assets under administration (“AUA”) and AUA fluctuates with the overall equity market – fund admin revenue directly exposed to equity market fluctuations is 6% of SSNC standalone revenue (<3% of combined company).  However, given all of SSNC and DST’s products sell into the asset management industry, industry health matters – any meaningful market pullback or active manager redemptions will impact long-term earnings. For example, organic revenue declined 9% in 2009 with a rapid rebound afterwards. Further, in periods of market stress, SSNC has traded cheap relative to its historical average of 20x NTM P/E; for example, the multiple troughed at 13x during the 2011 Europe panic.  Over a 1-2 quarter time horizon, SSNC may fluctuate with the market, but over a 1-2 year time horizon, its business model and superior capital allocation will drive meaningful outperformance.

In addition, SSNC’s business model is dependent on capital allocation – as such, M&A pipeline and cost of financing (SSNC multiple, interest rate) impacts transaction accretion and feasibility.  SSNC’s pro forma debt balance is ~100% term loans and mostly floating, so continued rate hikes will dilute the earnings benefit from debt paydown.

Valuation and PT

In a bull case, modeling $350mm of synergies realized by 2020, SSNC should be able to generate over $4 of EPS – at 18x (10% discount to the 5-year average NTM P/E of 20x), target of $74.  In a bear case, if SSNC only achieves its synergy guidance of $175mm (which I believe is a very low-probability outcome as they have realized ~$145mm run-rate synergies already), 2020 EPS is $3.60.  At a downside case multiple of 14x (organic growth slows and there are a resurgence of worries about HF redemptions), fair value is $50. The absolute trough NTM multiple in late 2011 was 13x – I believe SSNC should trade at a premium given its history of execution and higher software mix (in 2011 SSNC was still a recent IPO with a short public track record, and they bought Advent in mid-2015, which increased their software mix and therefore should increase the multiple).  Therefore, the up/down is nearly 5:1 at these levels.

The stock is undervaluing the high likelihood SSNC will meaningfully outperform its synergy guidance

• The current synergy guidance is $175mm in 2-3 years, up from $150mm as of the deal announcement.  Our diligence suggests the actual achievable figure could be in excess of $350mm, bringing DST margins to 35% (in-line with peer set and slightly lower than SSNC’s 40% margins).

• SSNC is already running at $140-150mm cost synergies out of a $175mm 2-3 year target after recently announced cuts.  This excludes any benefit from IT spend reduction, facilities consolidation and offshoring mix improvement

• SSNC recently announced the layoff of 900 employees in the Kansas City area – this should drive roughly $100mm in synergies

• DST’s corporate average opex / employee is $96k, but 21% of employees are international / offshore at likely lower cost.  $100mm synergies reflects $110k cost / laid off KC employee

• DST’s 6 NEOs were paid roughly $20mm in salaries and stock comp per the March 2017 proxy, with another $25mm in estimated public company costs

• Moreover, DST margins have historically almost always been lower than peers.  EBITDA margins were 16-17% historically and moved to 19% in 2017 as they divested the investor reporting business (margin accretive) and bought in their JVs with STT (margin dilutive).  Most peers (FIS, FISV, MSCI, SEIC, SSNC) who are engaged in software-enabled outsourced services operate with margins in the 30s (FIS’ comparable segment’s margins are 40%, but DST’s financial services business has more customer concentration which could reduce its structural margin level).  We believe the under-earning is the result of serial management distraction and is not structural, and therefore represents significant upside to SSNC’s conservative guidance. SSNC has a long track record of operating its software-enabled outsourced services assets in the mid-30s margin range, and for nearly every transaction they have done, improved margins in the target entity to the 40%+ level    

• $350mm synergy bridge:

• Existing cost savings plan of $43mm achieved by DST but not fully reflected in LTM 9/30 margin figures in the Jan ’18 acquisition presentation (already achieved)

• A combination of public company costs / senior management salaries and stock comp of roughly $45mm (already achieved)

• SSNC cut ~$100mm personnel expenses which is likely DST’s shared services and other overhead – already achieved June ‘18

• $50mm of IT spend / facilities rationalization

• DST spends $217mm annually on software – industry contacts estimate that some portion of this can be rationalized by using SSNC’s own internal software

• SSNC operates 4 datacenters and DST operates one class-1 datacenter near Kansas City that is operating at half-capacity with a backup in St. Louis

• During a recent conference, Bill Stone alluded to an opportunity to reduce the real estate footprint at DST

• CFO disclosed $50mm opportunity from contractor rationalization in India in a mid-June conference ($25k savings x 2,000 contractors)

• In addition, it is reasonable to expect another $60-70mm of offshoring / right-shoring savings.  DST spends ~$100k / employee – if we assume offshoring savings amount to $50k / employee and DST’s international employee mix approximates SSNC, gross savings can be $200mm.  Am using $70mm for conservatism and recognition that in general, synergy estimates without being on the inside are inherently difficult to ascertain

SSNC CEO from DST acquisition call in Jan ‘18:

“Well, I think that, obviously, we want to surprise you positively versus surprise you negatively. But Steve has had a number of initiatives going on at DST. We think that looks like $40 million, $50 million worth of savings. And then, we have a pretty low-cost model for our offshoring. We think that we can put some of those tenets into this process, and that's probably going to save us tens of millions. You get public company cost.  You get a number of facilities consolidations, right?”

When asked about SSNC’s ability to close the DST margin gap, he responded: “Well, I don't think anything precludes us from thinking that way.”

Importantly, DST has had long history of cost un-conscious CEOs and inconsistent execution, further suggesting the margin gap is self-inflicted

• After the previous CEO (Tom McDonnell)  – who viewed DST as a vehicle to provide employment to the Kansas City area left in 2012 – the new CEO (Steve Hooley) was distracted by divesting DST’s large portfolio of non-core assets and underinvestment in platforms and wasn’t able to meaningfully attack a clearly bloated cost structure

• Tom McDonnell was CEO from 1987-2012 and Steve Hooley took the helm from 2012-2018.  Steve took over in 2012 with a plan focused on selling non-core assets and returning capital to shareholders, as well as to improve operational performance

• DST spun off from Kansas City Southern in 1997 – McDonnell had been CEO since the late 1980s and departed in 2012.  Anecdotally, he had twin goals of supporting the local Kansas City economy and running DST

• He never embraced offshoring (as of 2017, only 28% of employees based internationally vs. SSNC at 52%)

• The Winchester datacenter is operating at half capacity – which was never rationalized (and they had a backup near St. Louis)

• Hooley was brought onboard in 2012 after a mid-2011 clash with an activist investor (Russell Glass) in order to streamline costs and reduce DST’s non-core assets

• Following Hooley’s appointment, he worked with the Argyros family (owners of USCS, acquired by DST in an all-stock deal in 1998 and as a result, DST’s largest shareholder) in selling the company’s significant non-core investments in real estate, PE and other assets.  In a 2/15/12 report, CS estimated that the non-core real estate, minority investments and excess cash / PE was worth $32 / share after-tax. These sales were still in process in late 2017. As of 12/31/17, DST had $200mm of cost-method non-core investments on its balance sheet (about $3.40 / share), with sell-side analysts at the time of the SSNC deal estimating ~$5 of after-tax market value ($300mm)

• After spending several years divesting non-core assets, Hooley began focusing on rationalizing the cost structure.  However, he announced several unexpected investment programs that spooked investors and distracted management from implementing a material cost savings plan

• In Q2 ’15, CEO announced $60mm investment behind security, regulatory compliance (stock down 14%, investors worried about a potential data breach)

• In Q3 ’16, CEO announced unexpected investments focused on putting DST’s technology on the cloud (stock down 13%)

• Finally, during 1Q ’17 they announced a $20mm synergy plan associated with buying in their joint ventures with State Street, followed by a small layoff representing another $23mm in 3Q ‘17 – seemingly, no effort made to close the offshore employee gap or reduce capacity in the Winchester datacenter

Cross-selling opportunity (non-quantified upside):

• SSNC has highlighted significant cross-selling into DST’s mutual fund customer base.  DST has only 30 salespeople (and $2.3bn in revenue) vs. legacy SSNC’s 150 salespeople (for $1.6-1.7bn in revenue), presenting a very strong opportunity to sell SSNC’s middle and back-office software and services to a customer base that hasn’t been well-covered by DST’s salesforce.  SSNC management has also articulated an emphasis on cross-selling high-margin software in particular

• Industry conversations suggest opportunities to sell DST’s capabilities into hedge funds that want to roll out traditional 1940-Act mutual fund products

Management quality and incentive structure:

The core team consists of SSNC lifers – the Chairman and CEO was the founder of the company and owns 13% of the stock.  Directors and executive officers (including Stone) own 37.3mm shares or 15% of total diluted shares outstanding

Incentive comp

In 2017, bonus pool set at 5% of adj. consolidated EBITDA – credit agreement metric

LT incentive comp in the form of time-vesting options.  Rahul Kanwar received options grant in Sep 2017 at a strike of $38.66 – 25% vesting on first anniversary and pro-rata monthly for 3 years afterwards for remainder.  On Dec 2017, other NEOs received LT options with a similar time-based vesting structure, but at a slightly higher strike of $40.44.

What do these companies do?

Latticework in March 2016 spent a lot of time on the SSNC business overview and fundamentals, so will give a shorter description of the business and summarize his key points.  This section focuses more on DST as that asset was much less known by investors and thinly covered by the sell-side.

SSNC overview

SSNC is a leading provider of mission-critical software and software-enabled services to the asset management industry.  Company has 1-5 year non-cancellable contracts subject to automatic renewal, with >90% revenue retention rates and a large pool of 11k clients with the largest client representing 2% of revenue (top 10 roughly 11% of revenue).  Its fund administration business is the industry’s largest with 20% market share, and through the acquisition of Citigroup’s fund admin business, they have been steadily moving the business mix to PE and other alternatives away from the more market-correlated HF AUA business.  Fund administration is 54% of total revenue and software is the remainder (2017 analyst day p9).

• 94% recurring revenue (p4 of May 2018 investor deck)

• Pricing

• Licensing and maintenance contracts have CPI escalators built in

• Pricing scales as function of client AUM, complexity and transaction volume (they also charge a per-investor fee)

• #1 market share in third-party fund administration with 20% share.  #1 market share in PE fund admin (May 2017 investor day). Industry consolidating as banks exit due to regulatory oversight (SSNC just bought Credit Agricole’s fund admin business in early June).  SSNC charges 8-10 bps on AUA on average, subject to minimums

• SSNC uses its own internally-developed software which helps them rapidly respond to customer needs through adding features and customization, creating a competitive advantage

• Business is very sticky, organic growth in 2008-2009 was down 9% (p7 of 2015 investor day transcript) while Advent total reported revenue actually grew 9%

• 95%+ retention rate in software – SSNC spends a peer-leading 9% of revenue on R&D (FISV at 2-5%, FIS product dev is 8-9% of revenue)

• Software business is primarily portfolio management and portfolio accounting tools (Advent Geneva)

• Largest peer is Sungard, bought by FIS in 2015

• Run software and transaction processing on their own fleet of datacenters

• CEO Bill Stone owns >13% of company

• SSNC has a strong track record of driving margin expansion to at or above corporate-average margins – virtually every deal done in recent years has met or beat the company’s target 40-45% margin threshold (see below from SSNC May ’18 investor presentation)

DST overview

DST ($2.2bn PF ‘17A revenue) also provides software-enabled outsourced processing services.  DST operates in two segments, financial services and healthcare services. The financial services segment (80% of revenue) provides sales and transaction support to the mutual fund industry.  This work includes transaction processing, account opening, reconciliations, cash balances, corporate actions, regulatory reporting and tax reporting – these services are provided through a BPO model using proprietary workflow software.  This is a very similar operating model to SSNC’s fund administration business (which SSNC operates at ~35% EBITDA margins – assuming SSNC operates its software business in the 50% margin range, per CFO’s disclosure from a recent conference in mid-June).

• Financial services (80% of revenue, ~75% of adj. EBIT)

• 90% recurring revenue tied to LT contracts, 90% client retention.  Average client tenure of 19 years

• 3-7 year avg contract duration and most have evergreen clause

• Like SSNC, DST owns its own datacenters – one class 1 center in Winchester (outside of Kansas City) with a backup in St. Louis – this provides opportunity for consolidation as SSNC has four datacenters

• Pricing are charged to the client based on number of accounts and number of transaction processes

• Unlike SSNC, DST has more customer concentration – top 5 customers were 28% of FS revenue and largest customer is 10.5% of segment revenue (2016 10-K)

• The core mutual fund shareholder recordkeeping business is essentially a duopoly between DST and BoNY – DST has ~ 50% share in registered accounts and ~25% in subaccounts (market is moving towards subaccounts, creating structural topline pressure).  BoNY is at >135mm subaccounts (https://www.bnymellon.com/us/en/what-we-do/investment-services/asset-servicing/subaccounting.jsp)

• DST’s market share in 2011 was ~10%.  However, since DST made a push to invest behind its subaccount platform, it has gained market share vs. BoNY – DST subaccounts have grown from 28.6mm in 2014 to 46.2mm in 2017 (>60% growth)

• Sub-account revenue / customer is lower than transfer accounts, but profit margins are the same

• DST also has an ETF processing business called ALPS, which they acquired in 2011 – this segment’s growth is partially offsetting declines in the mutual fund processing business.  This business was growing at 30% before DST acquired it. Had $140bn AUA in Dec 2015 which grew to $226bn by December 2017 (DST 10-K) – implying a 30% CAGR over that time horizon as well.

• As a result, we believe organic growth in the FS space should be LSD – continual pressure on the RA business offset by growth in ALPS and continued modest market share gains in subaccounting.  SSNC FY guidance for DST in ‘18E reflects slightly positive organic growth for DST overall

• Healthcare segment (20% of revenue, 25% of adj. EBIT)

• Business uses software to provide healthcare organizations with pharmacy, healthcare administration and healthcare outcome optimization.  Marketed to health insurance companies, health plans, benefits administrators

• Revenue earned on per-transaction basis.  Unclear if there is like-for-like pricing, but unlikely there is meaningful pricing power given customer concentration

• Top  customers are 50% of segment and largest customer was 18% of segment

• From discussions with industry contacts, DST is an embedded supplier and tied to Medicare advantage, where volumes are growing M-HSD

• PBM business is more bare-bones processor and trying to add additional services.  Similar model as Catamaran, which was acquired by United Healthcare

• Largest customer is Humana – feedback from them and another large insurer is that DST is tough to rip out.  Humana and DST co-built the system

• However, the lost a couple of customers in 2016 – one to in-sourcing and another to competitive pricing.  This dynamic negatively impacted organic growth through 2017 – business was growing solidly in the low-teens beforehand

• The most recent DST mgmt. guidance (reiterated by SSNC) was for a rebound in organic growth to the low-teens – am underwriting to M-HSD for conservatism

• Competitors are TriZetto (owned by CTSH), CNDT’s healthcare business, UNH, CVS Caremark

• Roughly half the business is a comp to TriZetto (acquired by CTSH in 2014 for 14x EBITDA, provides billing, claims processing and other services to insurers, hospitals and state-run exchanges) and the other half is tech-enabled PBM.  Our industry contacts suggested that WelldyneRx (bought by Carlyle in 2016 at a double-digit multiple) is a worse asset than DST’s healthcare business

• Healthcare is non-core to SSNC.  SSNC could ultimately decide to sell this asset (accelerating the de-leveraging story after the transaction), or operate it as a new vertical given the attractive market opportunity

Exhibits

Catalyst

Upcoming earnings / guidance, capital return of excess cash through M&A or repurchase