Lower Revenue Hurts DST 2Q

DST Systems Inc. ( DST - Analyst Report ) has posted second-quarter 2011 adjusted earnings per share (EPS) of $1.05 cents, lower than prior-year earnings of $1.23 and the Zacks Consensus Estimate of $1.06.

The quarter’s EPS excludes business development expenses, net gain on the disposition of securities and other investments and net loss on repurchase of convertible debentures.

Revenue

Total revenue in the second quarter was $582.2 million, down 5.2% from $613.9 million in the year-ago quarter. Excluding reimbursements, consolidated operating revenue came in at $424.1 million, down 8.9% from $465.6 million in the year-ago quarter. Lackluster performance in all the three segments dwarfed the overall revenue growth in the quarter.

Excluding reimbursements of $10.2 million, Financial Services’ operating revenues decreased 3.2% year over year to $281.0 million. The drop was due to lower shareowner processing, health claims processing and business process management revenues.

Excluding reimbursements of $148.6 million, revenues from Output Solutions plunged 18.3% year over year to $144.3 million. Higher contribution from dsicmm Group Limited (acquired in July 2010) and Newkirk Limited (acquired in May 2011) was more than offset by lower U.S. operating revenues due to client loss and lower volumes.

Excluding reimbursements of $0.8 million, Investments & Other operating revenues dropped 6.8% year over year to $13.7 million.

During the quarter, total mutual fund shareowner accounts serviced decreased by 0.9% sequentially to 111.8 million. Registered accounts and sub-accounts serviced by the company during the quarter were 95.2 million and 16.6 million, respectively.

Operating Results

Total cost and expenses increased 9.5% from the year-earlier period to $477.6 million. Costs and expenses related to the Output Solutions segment increased 16.6% year over year, mainly due to the integration of dsicmm’s business.

Moreover, costs and expenses related to the Financial Services segment increased 2.6% from the year-ago quarter due to foreign exchange headwinds, higher deferred compensation costs and start-up costs from DST Insurance Solutions, LLC operations. These were responsible for the increase in consolidated costs and expenses.

Consolidated operating income was $73.3 million, down 48.5% from $142.3 million in the year-ago quarter.

Financial Services operating income decreased 14.4% from the year-ago period to $64.0 million. Output Solutions operating income plunged 86.6% from the year-ago quarter to $8.9 million, due to lower U.S. volumes. Investments and Other operating income decreased 22.6% year over year to $2.4 million, due to lower operating revenues.

Reported net income in the quarter was $55.2 million or $1.17 per share compared to $94.0 million or $2.00 per share in the year-ago quarter. Excluding the above-mentioned one-time items, adjusted net income in the quarter came in at $49.4 million or $1.05 per share compared to $57.6 million or $1.23 per share in the year-ago quarter.

Balance Sheet

DST Systems’ balance sheet appears highly leveraged. The company exited the quarter with $91.0 million in cash and equivalents, down from $147.0 million reported in the previous quarter, and debt of $1.16 billion, up from $1.14 billion reported in the previous quarter.

Share Repurchases & Dividend

In the recently concluded quarter, 123,500 shares were repurchased by DST Systems for an amount of $6.1 million, or approximately $49.39 per share. The board of directors has authorized the buyback of 2.0 million of its common stock in the open market. As of June 30, DST Systems had 2.5 million shares remaining under the current repurchase authorization plan.

The company faced a loss of $900,000 while buying back $7.9 million of aggregate principal of the Series C senior convertible debentures, which were priced at $8.8 million.

No cash dividend was paid during the quarter.

Our Take

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’s bottom line missed our expectations. We believe that DST Systems is facing a significant threat to its mutual fund shareholder record-keeping business due to the continuous shift in customer preferences toward subaccounting platforms. Management also anticipates that a few clients may leave DST’s platform in the upcoming quarters.

However, we still believe that DST Systems’ leadership and scale in Financial Services will attract new customers based on the increasing popularity of mutual funds. Moreover, we expect the steady contribution from dsicmm to provide continued support to Output Solutions’ revenue growth.

We expect the five back-to-back acquisitions, made in the past two months, to pay back soon. The similar lines of businesses will make it easy for DST Systems to speed up the integration time, thereby leaving the scope for the acquisitions to be accretive shortly.

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

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