|Shares Out. (in M):||40||P/E||0.0x||0.0x|
|Market Cap (in $M):||3,430||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||321||EBIT||0||0|
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
Non-Core Asset Monetization
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
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
Operating Costs Peaked in 1Q14
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 30th, 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 3rd 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.
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.