Mixed 2Q at DST Systems

Zacks

DST Systems Inc. (DST) posted second quarter 2012 adjusted earnings per share (EPS) of 77 cents, significantly missing the Zacks Consensus Estimate of 97 cents. The results were 26.7% lower than $1.05 recorded in the prior-year quarter.

Revenue

Total revenue in the second quarter was $632.8 million, up 8.7% from $582.2 million in the year-ago quarter. Excluding out-of-the-pocket reimbursements, consolidated operating revenue increased 9.8% year over year to $465.5 million, which was just above the Zacks Consensus Estimate of $465.0 million.

Financial Services operating revenues (excluding out-of-the-pocket reimbursements) increased 9.4% year over year, primarily owing to broad-based improvements in the brokerage, retirement, healthcare and AWD operating units as well as significant contribution from the ALPS acquisition (in July 2011). However, the results were partially offset by lower mutual fund shareowner processing revenues.

Output Solutions operating revenues increased 10.0%, reflecting favorable contributions from Newkirk Products, Inc. (acquired in May 2011) and Lateral Group Limited (acquired in August 2011). During the quarter, there were new client commitments from North America. DST Systems expects full conversion activities related to these new clients to be completed in the second half of 2012, resulting in revenue growth.

This apart, Investments and Other Segment operating revenues increased 10.2% year over year to $15.5 million, primarily as a result of increased rental activities.

During the quarter, total mutual fund shareowner accounts serviced decreased by 2.3% sequentially to 97.2 million. Registered accounts and sub-accounts serviced by the company during the quarter were 80.2 million and 17.0 million, respectively. The rate of decline was far worse than the 0.2% fall in the previous quarter.

The decline was mainly due to conversion of roughly 800,000 registered accounts to Bank of New York Mellon Corp.’s (BK) platform.

Operating Results

Total cost and expenses increased 14.3% from the year-earlier period to $581.9 million. Consolidated operating income was $50.9 million, down 30.6% from $69.3 million in the year-ago quarter. Margin deceleration was due to weak performances across the board.

Financial Services operating income decreased 23.8% from the year-ago period to $48.8 million. The decrease was due to higher costs pertaining to the ALPS acquisition, new business development and compensation. Output Solutions operating income was $4.6 million, down 48.3% from the year-ago quarter. The decline was attributable to higher costs due to Canadian plant expansion and new client start-up expenses, partially offset by increases in the North America operations.

Net income attributable to DST shareholders in the quarter was $144.9 million or $3.17 per share compared with $55.2 million or $1.17 per share in the year-ago quarter. Despite a lackluster operating performance, the improvement in net income was attributable to higher non-operating income, partially offset by a higher tax rate. Excluding the one-time items included in operating income and non-operating income, adjusted net income in the quarter came in at 79 cents per share, down from $1.05 in the year-ago quarter.

Balance Sheet

DST Systems’ balance sheet appears highly leveraged. The company exited the quarter with $93.0 million in cash and equivalents, up from $52.0 million reported in the previous quarter, and debt of $1.21 billion, down from $1.36 billion reported in the previous quarter. Growing cash balance and declining debt reflects an improving net cash situation.

Share Repurchases

No share buyback was made during the quarter. But 200,000 shares were issued under share-based compensation plans, due to which the company currently has approximately 45.1 million shares remaining under its existing share repurchase authorization.

Guidance

DST Systems expects another 5.8 million subaccounts to convert to Bank of New York platform during third quarter 2012. The company also forecasts 8-10 million conversions of registered accounts to subaccounts in 2012. But the company expects roughly 30.0% of these accounts to convert to DST's subaccounting platform.

Conclusion

DST Systems is one of the leading global providers of sophisticated information processing software and products to the financial services industry, primarily mutual funds. The company has supplemented internal growth with strategic acquisitions.

The company missed the Zacks Consensus Estimates on the bottom line, but just managed to beat the top-line projection. Total revenue improved on strong performances across the segments.

We remain encouraged by DST’s exposure in the insurance vertical. Currently, the company has tie-ups with more than 20 of the top 25 insurance companies in America, which is expected to drive decent revenue growth.

However, we are still of the opinion that, DST Systems’ business volume and massive scale of operation in Financial Services will attract new customers. Moreover, we expect steady contributions from Lateral and New Kirk to provide continued support to Output Solutions’ revenue growth.

We expect the acquisitions to be accretive in the upcoming quarters. The similar lines of businesses will make it easy for DST Systems to speed-up integration.

On the other hand, tough competition from Broadridge Financials Solutions Inc. (BR), and Advent Software Inc. (ADVS) and a high debt burden remain concerns.

Currently, DST Systems has a Zacks #3 Rank, implying a short-term “Hold” recommendation.

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