Description

DST provides processing services to the financial and healthcare industries. Its core business has stabilized and shows signs of acceleration and, in addition, the company has non-core assets equal to 24% of its market cap which should be monetized over the next 18 months and used to repurchase stock. Fair value of $125 is based on a SOTP valuation and a 9.2x EV/EBITDA multiple versus peers at 11x. The recent share price declined over the last month has been on no news, creating a good entry point.

Core Business Stable and Starting to Grow

• DST’s core shareholder recordkeeping business has been under pressure since 2007 as registered accounts have converted to subaccounts which generate lower revenue. The trend toward subaccounting has been driven by brokers looking for revenue growth and increased sales of mutual funds through brokers. However, the remaining registered accounts are sticky and cannot be easily converted. The shareholder recordkeeping business is around 60% of DST’s financial services segment and should grow 0-1% over the next few years while DST’s ETF, retirement, and other financial services businesses (40% of rev) should continue to grow 15% which drives ~6.5% topline growth in financial services versus consensus 3% growth. 2Q saw 6.8% y/y growth in the financial services segment which was the highest since pre-crisis driven by stabilized recordkeeping and acceleration in other businesses. DST’s financial services revenue growth should remain around 6.5% versus consensus for 3%.
• DST’s costs have increased over the last few quarters due to new client growth and higher costs to support regulatory, compliance, and security programs which management had messaged going into the year. These costs reached a peak and should be stable to lower  in 2H14 and 2015 as revenue growth remains ~6.5% which should result in operating leverage and margin expansion which drives 10-12% net income growth.

Non-Core Asset Monetization

• DST owns $800mm of non-core assets including shares of State Street, shares of other publicly traded companies, private equity investments, non-core real estate, and other non-core assets which the new management team is systematically monetizing and returning cash to shareholders via buybacks. Importantly, new management has not purchased any non-core assets and has messaged that they will be disciplined in capital allocation and have acted accordingly.
• Between DST’s FCF and its monetization proceeds, the company can repurchase at least 10% of outstanding shares each year resulting in EPS growth of greater than 20% for the next several years. Since 2000, DST has reduced the share count from 125.3mm to 39.7mm and the pace is set to accelerate now that DST’s leverage is below its target and any potential acquisitions would be small.
• DST’s balance sheet is underleveraged at 1.3x debt/EBITDA versus management’s target of 2.00-2.15x leverage so has $400mm of capacity for share buybacks or acquisitions, both of which would be highly accretive.

Valuation

• On a SOTP basis, DST is worth $106 on 2014 EBITDA and $125 on 2015 EBITDA. This includes 10x EV/EBITDA for financial services (processor peers at 11.5x), 10x for healthcare (peers 11.4x), and 6x for customer communications (peer 6.2x). In addition, DST has $794mm of after-tax non-core assets and should generate $300mm of FCF in 2015.
• Often companies do not get full credit for non-core assets and are valued on traditional metrics such as P/E, EV/EBITDA, and FCF yield. 75% of DST’s non-core asset will be converted into cash and returned to shareholders via buybacks over 18 months so the business can be valued using traditional multiples as this occurs. Valuing DST at 20x P/E, 9.0x EV/EBITDA and 6.0% FCF yield versus peers at 20.7x, 11.0x , and 5.3%, DST is worth $105 on 2014 numbers, $130 on 2015 numbers, and  $160 on 2016 numbers. From 2004-2007, DST’s topline was flat and EPS grew 12% and DST traded at 12x EV/EBITDA and 20x P/E over the period.
• Investors can win in several ways with DST, including continuing the current trajectory. Accelerated monetization and share repurchases, a strategic acquisition, or sale to private equity or a strategic partners such as STT or BK would accelerate value realization.

Background

• Steve Hooley became CEO in 2012 and began rationalizing costs and monetizing non-core assets. The new CEO was put in place by the largest shareholder at the time, George Argyros, to improve operational performance and monetize non-core assets. 
• Argyros Group had owned 22% of DST’s outstanding shares and the business was run like a private company, providing limited disclosure and rarely talking to investors. Argyors’s wife took over the trust because George is 77 years of age and in marginal health. She sold the position down to 7% in May 2014 in which DST repurchased $200mm of stock and $450mm was in the secondary offering.
• Since the deal, management has tried to improve shareholder communications (which were historically poor) through better segment reporting, hiring an IR person, planning to attend more conferences, being available for calls, and redoing their investor slides. However, management still has a ways to go including sharing details of capital allocation plan, giving guidance, telling a clear story.

Segments

DST has three segments: financial services 66% of EBIT, healthcare 17%, and customer communications 17%. Financial services segment includes several different businesses which is key to understanding why the segment is stabilized and starting to grow.             

Financial Services 50% rev, 66% EBIT

The shareholder recordkeeping businesses are about 60% of DST’s financial services segment and growth in subaccounting is now offsetting declines in registered accounts on a revenue basis, so revenues for this part of the business will be flat to up 1%. DST’s other financial services businesses are growing around 15% resulting in ~6.5% sustainable revenue growth versus consensus 3%. 

Shareholder Recordkeeping Businesses – 60% of financial services segment, 0-1% growth

DST provides shareholder recordkeeping services to mutual fund companies and brokers that sell mutual fund products. DST’s proprietary TA2000 recordkeeping system includes transaction processing, compliance, systems reporting and statements, settlement services, mail processing, and distribution and dealer services for 70.9mm registered accounts and 27.6mm subaccounts. DST’s system has over 50% market share in registered accounts and around 25% market share in subaccounts, with BoNY controlling most of the remainder. DST generates an annual fee around $5.50/year per registered account and $2.50/year per subaccount.

DST is the largest provider of registered account recordkeeping with an estimated 50% market share with the biggest competitors being in-housed systems. In subaccounting, DST and BK are the only large players with a combined 75% market share of the vended market. BK started offering subaccounting systems before DST and thus is about 3x the size of DST. However, DST is playing offense and steadily taking share in a growing end market. DST has grown the business to 27.6mm accounts from 2mm over seven years. Half of the subaccounting market is still in-house with approximately 150mm accounts. DST’s product offering is estimated to be 20% lower cost than in-house, reduces and diversifies risk, and ensures compliance with changing regulatory landscape.

Trend Toward Subaccounting

Since 2007, brokers looked for new sources of revenue growth. One of those sources has been growth in broker subaccounting. The brokers can in-house the transfer agent and some of the recordkeeping services, but typically do not have adequate systems to meet high compliance, disclosure, and documentation standards so they use DST’s TA2000 system for a lower fee, $2.50/year per account. DST’s margin on subaccounting is higher because incremental software sales have lower assocated costs. DST’s subaccounting business has grown 20-30% over the last year.

From the Risk Factors section of DST’s 10-K:

An increase in subaccounting services performed by brokerage firms could adversely impact our revenues.

Our mutual fund clients may decide to allow a broker/dealer who has assisted with the purchase or sale of mutual fund shares to perform subaccounting services. A brokerage firm typically maintains an “omnibus” account with the fund's transfer agent that represents the aggregate number of shares of a mutual fund owned by the brokerage firm's customers. The omnibus account structure results in fewer mutual fund shareowner accounts on our systems, which adversely affects our revenues.

We offer subaccounting services to brokerage firms that perform mutual fund shareowner subaccounting. As the recordkeeping functions in connection with subaccounting are more limited than traditional shareowner accounting, the fees charged are generally lower on a per unit basis. Brokerage firms that obtain agreements from our mutual fund clients to use an omnibus accounting structure cause accounts currently on our traditional recordkeeping system to convert to our subaccounting system, or to the subaccounting systems of other service providers, which generally results in lower revenues.

Ring Fencing the Risk

Non-tax advantaged (NTA) registered accounts have seen the biggest impact from subaccounting with registered accounts falling from 71.0mm in 2007 to 30.7mm in 2Q14. Within NTA accounts, accounts invested directly with the mutual fund families cannot be subaccounted because there is no broker in between DST and the account. Only those accounts invested through a broker can be subaccounted. DST does not disclose the number of accounts invested directly with a mutual fund family, but there are a few indicators that the remaining accounts are sticky and cannot switch. 40mm of 71mm NTA accounts have converted since 2007 (were all broker accounts) and remaining accounts have been sticky over the last year, declining by only 1mm accounts LTM (versus 14.4mm in 2011), and management lowered subaccounting customer conversion guidance to 3-4mm in 2014 from 4-5mm accounts when they reported 2Q results. Further, DST is tracking better than the 3-4mm with just 1mm conversions in 1H14. In addition, DST added 0.7mm new registered account customers in 1H14, making the net loss in registered accounts only 0.3mm in 1H14.

Tax-advantaged (TA) registered accounts (IRAs, SAR-KEP, Section 529) have been more stable, falling from 46.2mm in 2007 to 40.2mm in 2Q14 because brokers are required to get signatures and authorization from each individual account holder which makes compliance requirements prohibitively high. Management has not seen any signs of pickup in conversion activity in these accounts.

DST’s other financial services businesses – 40% of financial services segment, 15% growth

• ALPS – an ETF management and distribution company. ALPS is the exclusive distributor and administrator of the iShares SPDR funds, among other funds. In addition, ALPS owns several ETFs including SDOG, IDOG, EQL, EDOG, and ENFR. ALPS earn fees based on assets under administration and assets under management. This business benefits from the secular trend toward low cost ETFs.
• TRAC – provides participant recordkeeping and administration for defined contribution plans (401(k), 403(b), 457, ESPP). The business generates revenue based on number of accounts under administration and based on transactions.
• AWD – offers BPO services to clients including claims processing, client on-boarding, complaints management, exception management.
• Other – includes Bluedoor, Argus, and DST’s new big data business (unnamed). Also includes DST Vision which was an in-house startup because REIT customers had complained about the existing Maverick platform for REIT recordkeeping. DST launched DST Vision a few years ago and now serves 80% of U.S. REITs.

Summary of Financial Services

The shareholder recordkeeping businesses are about 60% of DST’s financial services segment and growth in subaccounting is now offsetting declines in registered accounts on a revenue basis, so revenues for this part of the business are expected to be flat to up 1%. DST’s other financial services businesses are growing at 15% resulting in around 6.5% sustainable revenue growth versus consensus 3% and 1-3% over the last few years.

The closest comps for DST’s financial services segment are processing companies including: ADP, FIS, FISV, PAYX, JKHY, and SEIC which trade at an average 11.5x EV/EBITDA and revenue growth is estimated at 6.5%.

Healthcare Services – 18% rev, 17% EBIT

This segment provides processing systems, integrated care management applications and BPO services for payers and providers in the U.S. healthcare industry. The business is growing topline 10-15%, benefiting from the increasing complexities of the U.S. healthcare industry. The closest comps are TriZetto (private equity sold to Cognizant at 14.2x EBITDA), CTSH 10.7x, ESRX 9.6x, CTRX 12.2x.

Customer Communications – 32% rev, 17% EBIT

Customer Communications provides digital print, electronic solutions, direct marketing, and fulfillment services directly to clients and through relationships in which its services are combined with or offered concurrently through providers of data processing services. The business has been growing mid-single digits as increased compliance at financial institutions has resulted in increased disclosure to customers and a trend of outsourcing communications. The margins in this segment are the lowest in the company at 7.5% operating margin. The closest comp is CSG Systems, CSGS, which trades at 6.2x EV/EBITDA.

Revenue Growth Accelerating

• DST’s business is a scale business with high incremental margins so organic revenue growth is the key to driving organic earnings growth. DST’s registered accounts are stabilized and the remaining businesses are growing at 15% for non-recordkeeping businesses, 10-15% for healthcare, and 5% for customer communications.
• DST’s 2Q financial services segment revenue growth was 6.8% y/y, the fastest growth since the financial crisis due to stability in recordkeeping and accelerating growth in non-recordkeeping businesses. Also, the faster growing business continues to become a larger part of the segment which is a tailwind for growth. 
• Also, comps for registered accounts get easier in 3Q, as the y/y decline in registered accounts lessens from -3.3% in 2Q to -2.5% in 3Q.
• DST’s businesses benefit from favorable industry trends including: aging population, increased complexity and regulatory oversight, ETFs and alternatives increasing in volume, demand for top-tier data security, increasing demand for data analytics, and increased outsourcing of processed services.

Operating Costs Peaked in 1Q14

• DST has been investing in new systems and bringing new customers online in 1H14 which has increased opex costs ($20mm sequential increase in 1Q14) and been a drag on financial services margins in 1H14, giving limited operating leverage for the recent revenue growth. Some of these costs are regulatory-related and are now built into the cost structure and some are related to bringing new customers onto DST’s platform which will roll off.
• Customer contracts are 1-3 years long and management plans to increase pricing in the coming renewals to cover the increased compliance costs which suggests margin expansion in 2H14 and 2015 from current levels because the cost buildout is largely complete. Even without pricing increases, DST’s revenues have begun to accelerate so as costs stabilize, the company should see good incremental margins.

2014 Peak Capex Year

DST has averaged $100mm of capex over the last seven years versus $130mm capex guidance in 2014. The additional $30mm capex is designated for a refresh of their generator plant at one of their datacenters plus the acquisition of new equipment to support a new customer that will be coming online at the end of 2014. Capex should normalize to $100mm in 2015. Normalizing capex drives an additional $0.75/share of FCF in 2015.

High Quality Core Business

DST is a high ROIC, capital light business with high barriers to entry, a leading market position, and strong FCF generation. 90% of DST’s revenue is recurring and DST has long relationships with customers (34 years with top 5 financial service customers, 17 years with top 5 healthcare, 12 years with top 5 customer communications). Given the complexity and regulation around recordkeeping, customers are unlikely to change because of the transition risks involved and recordkeeping is a small total cost of doing business. This dynamic gives DST pricing power to protect its margins, creating durable earnings. DST’s trailing ROIC is 30.7% and forward ROIC is 34.5%. ROIC tends to be closely correlated to earnings multiples because a higher ROIC drives a higher sustainable growth rate. DST’s business requires around $100mm in annual maintenance and growth capex versus operating cash flow of $390mm, leaving $290mm of FCF for repurchases, dividends, debt reduction, or M&A. 

Non-Core Asset Monetization

DST’s prior management team accumulated non-core assets over the last decade including shares of State Street, shares of other publicly traded companies, private equity investments, non-core real estate, and other non-core assets. DST’s new CEO has been systematically monetizing non-core assets at the pace of at least $100mm per quarter for the last nine quarters and still has $800mm of after-tax non-core assets remaining which should be mostly completed over the next six quarters. Importantly, the new CEO and management team has not made any incremental non-core investments and continues to monetize and use proceeds to repurchase shares and reduce outstanding debt.

Marketable securities. DST owns 6.42mm shares of STT stock (held AFS for accounting purposes) and shares of other publicly traded companies and other publicly traded debt (held AFS and HTM). The after-tax fair value of these assets is $488mm and could be fully monetized quickly if management chose to accelerate the monetization. Management has used sales of marketable securities to smooth the monetization proceeds which can be lumpy due to private equity distributions, real estate sales, and sales of other illiquid non-core assets for which the timing is tough to predict. Since June 30^th, STT stock has risen by 8% which is worth about $30mm or $0.75/share for DST and reflected below. 

Private equity. DST’s largest private equity investment was an LP commitment to a 2008-vintage fund for which all capital has been called and the fund has begun monetizing investments (in year 6 of a 10 year fund). For all of DST’s private equity investments, there is only $6.5mm remaining unfunded capital so the investments are approaching maturity. All of DST’s private equity investments are marked at book value. Given the 2008 vintage, most of the capital was invested near the bottom of the cycle when asset prices were attractive, implying that there could be large embedded gains. Over the last 6 quarters, DST has harvested $159mm from private equity while the book value has only declined by $73mm, implying embedded gains of $86mm or 2.18x multiple-on-invested-capital (MOIC). Valuing the remaining private equity investment at a 2.0x MOIC arrives at $244mm of fair value.

Real Estate. DST owns 3.1mm SF of real estate including offices, data centers, production facilities, and retail space. In addition, the company owns a number of surface parking facilities and an underground storage facility with 0.5mm SF in Kansas City and 200 acres of undeveloped land adjacent to its buildings in El Dorado Hills, California. Most of DST’s real estate is located in Kansas City, London, and El Dorado Hills. Some of the real estate is occupied by DST’s businesses while other properties are leased to 3^rd party tenants and held as investments. An optimal capital structure would probably involve selling all real estate including that occupied by DST and using capital to repurchase shares, the base case is that DST only monetizes those assets that are not occupied by DST’s businesses. Management noted that the unconsolidated real estate line item is the best proxy for the book value of non-core real estate. Given DST has owned most of its properties for many years, I estimate the fair value is 1.5x the book value which equates to $47mm of after-tax fair value of non-core real estate. In addition, DST includes $413mm of assets classified as “properties”; however, I assign no incremental value to these as management may view most of these properties as core to the business.

Hidden Non-Core Assets. In addition to the assets highlighted above, DST has other assets which may not be included on its balance sheet or in footnotes in its financials. For example, in 2Q, DST realized a $103.6mm gain from the sale of DST’s remaining investment in a private company. Management said because of confidentiality agreements, they could not provide details, but this transaction appears to be from the sale of DST’s 5% stake in Asurion which was a co-private equity investment from years ago. Other examples include sale of private company in 2Q12 for $139mm, cash dividend from a private company in 2Q12 of $47mm, and cash dividend from BFDS of $125mm. There may be other such undisclosed assets that DST can monetize. Since 4Q11 when DST began monetizing non-core assets, the company has realized $1.22b of proceeds from monetization while estimated net fair value of investments has only declined by $456mm (from $1.25b to $794mm). Part of this was driven by STT’s appreciation, but also partially because of off-balance sheet non-core assets being monetized and assets being realized at better than expected prices. DST gets no credit for these hidden assets in the fair value, but could drive additional upside.

Share Repurchases

• The new CEO who has been running the business since Sept 2012, has shrunk the share count by 14% and reduced net debt by 41% through monetization proceeds and FCF generation from 3Q12 to 2Q14.
• The company’s target leverage is 2.00-2.25x debt/EBITDA which is $1.0b of net debt at the mid-point of their target leverage versus current leverage of $588mm. Management opted to deleverage because they planned to make tuck-in acquisitions ($100-200mm max) and wanted dry powder on their balance sheet. However, they are selective on price and no deals have met their hurdles. They have indicated that the currently have enough debt capacity for any opportunities they might find.
• Incremental FCF and monetization will likely all be used for share buybacks or acquisitions given management realizes that the balance sheet is underleveraged.
• In 1Q14, management was negotiating with Argyros Group regarding the exit of their 22% stake, so was restricted from share repurchases. With $60-75mm of FCF/quarter and $100mm of monetization proceeds and dividends of $12mm/quarter, DST has the capacity to repurchase $148-163mm of stock each of the next six quarters while keeping net debt unchanged. This would be roughly $900mm of share repurchases or 27% of DST’s current market cap by the end of 2015. If DST increased its leverage to its target, it could do an incremental $400mm which would be $1.3b of repurchases on a $3.3b market cap or 39% of the current market cap.
• The company was blocked out of share repurchases 90 days following the Argyros Group transaction (until August 8^th), but should be back in the market now.

Valuation

On a SOTP basis, DST is worth $106 on 2014 EBITDA and $125 on 2015 EBITDA. This includes 10x EV/EBITDA for financial services (processor peers at 11.5x), 10x for healthcare (peers 11.4x), 6x for customer communications (peer 6.2x), and $794mm of after-tax non-core assets.

While a SOTP valuation is nice, often companies do not get full credit for non-core assets and are valued on traditional metrics such as P/E, EV/EBITDA, and FCF yield. Over the next 18 months, 75% of DST’s non-core asset should be converted into cash and returned to shareholders via buybacks or deployed in acquisitions, so by 2016, the business can be valued applying a P/E, EV/EBITDA, or FCF yield multiple (no need for a SOTP). As the assets are monetized, DST should start to get full credit for its non-core assets. Valuing DST at 20x P/E, 9.0x EV/EBITDA and 6.0% FCF yield versus peers at 20.7x, 11.0x , and 5.3%, DST is worth $105 on 2014 numbers, $130 on 2015 numbers, and  $160 on 2016 numbers. It is reasonable to discount these numbers/multiples and arrive at slightly lower fair value, but still one with material upside.

Multiple Ways To Win

There are several ways to win with DST including growing earnings as a standalone company and continuing the $100mm/quarter measured pace of monetization. An aggressive buyback, a strategic acquisition, or a sale of the company, all provide 50%+ upside over an accelerated time frame.

Standalone. Fair value is $105 in 2014 and $125 in 2015.

Accelerated buyback: $137. Increase target leverage to 3x debt/EBITDA and use $800mm of debt to repurchase stock. In addition, monetize liquid non-core assets immediately and use the $488mm of net proceeds for a total buyback of $1.3b. Announce a $1b ASR and $300mm ongoing buyback. Continue to monetize additional $305mm non-core illiquid assets at a measured pace, using proceeds for ongoing buybacks. Commit to returning 70% of operating FCF to shareholders through dividends and buybacks. Under this scenario, share count would shrink to 25mm shares and EPS would grow to $8.60 in 2015 assuming a 5% interest rate on new debt. Even at the current discounted 16x P/E, the stock would trade to $137.

Strategic acquisition $140. If DST were to make a $1.0b acquisition, they could deploy their non-core assets into earnings-generating assets. DST has $793mm of non-core assets and $412mm of debt capacity at their 2.00-2.15x debt/EBITDA target. If they paid 12x EBITDA, that would add $50mm to net income or $1.25/share to EPS and the stock may give credit for $1.25 x 16 = $20 incremental upside above base case.

Sale of the company. A PE sponsor could take leverage to 5x which would free up $1.7b of cash, plus $793mm of non-core assets which is $2.5b that could be extracted from the business immediately. In addition, management could sell the healthcare business for nearly $1b at TriZetta’s 14x multiple. DST’s current market cap is $3.3b compared to the potential $3.5b that could be extracted from the business within the first few months. DST previously had received bids from private equity in 2011. DST could also make a strategic acquisition for STT (large JV with DST) or BK (major competitor). BK owns 4.4% of DST’s shares and increased their position by 50% in 2Q and STT owns 2.6% of outstanding shares and increased their position by 5% in 2Q.

Catalysts

• Next several quarters of earnings which should show see revenue growth remain around 6.5% in financial services and margin expansion.
• Resuming share repurchase program following Argyros repurchases. 
• Potential dividend increase in next couple quarters.
• Better messaging around capital management plans.
• Upside cases: accelerated buyback, strategic acquisition, or sale of company to PE or competitor.
• For every 100 bps in short rates, DST adds $0.14 to EPS because they have custody of client assets.

Risks

• If tax-advantaged accounts conversion to subaccounting began to occur, that would introduce a new risk and possibly change the thesis.
• Account loss in healthcare business or customer communications. DST lost a customer in healthcare which will hit revenues starting in 1Q15. In addition, customer communications lost a customer in 1H14, but they also won a larger customer contract which starts in 4Q14.
• Management becomes complacent about buybacks and lets cash build on balance sheet rather than deploying it. Or worse, management reverses course and starts buying more non-core assets. However, management has been clear they are on a one-way track of monetizing non-core assets.
• Management makes a poor acquisition or significantly overpays. They have a good track record – last purchase was ALPS which has been a great growth driver.

Consensus view

• Still viewed as an event-driven play for monetizing non-core assets. The street thinks 3% core revenue growth and some operating margin expansion can drive ~5% EBITDA growth. They acknowledge recordkeeping business is stabilizing, but are taking a conservative “wait and see” approach.
• Consensus view is that management will continue slow monetization and buy back stock at a measured pace. However, management understands balance sheet is underleveraged. They do not get credit for the additional dry powder on their balance sheet which can alone drive $1/share of EPS.
• Consensus is bullish on DST with an average $110 pt and the five analysts all buy-rated. However, given limited liquidity and excitement around the stock recently, there has been limited interest.

Catalyst