Value Ideas Contest: All Systems Are Go
An investment in DST Systems (“DST”) represents an opportunity to own a market leading, mid-cap data processing firm with a non-core investment portfolio that that is not currently being reflected in the company’s share price despite being worth up to 88% of the company’s entire market cap. Taking into account the value of the company’s core data processing business, its integrated print and mail business, and its large investment portfolio, DST trades at an estimated 57% discount to intrinsic value on a sum-of-the-parts basis.
Business Segments & Overview
Financial Services (67% of sales, 23% operating margins)
DST is principally known for its shareholder recordkeeping or transfer agency service provided primarily to the mutual fund industry, which comprises the bulk of revenues for the financial services segment.
Transfer agents perform an unglamorous but essential function to the investment management industry, including: executing shareholder transactions, maintaining records of transaction, sending account statements and other documents, maintaining records of account ownership and calculating and distributing dividends.
DST is compensated primarily on a per account basis, with revenue differing based on the level of complexity and who ultimately performs the underlying work. The most common service is “remote service,” which generates approximately $4-$5 in annual revenue per account. DST is the market leader with approximately 36% market share of all mutual fund accounts and approximately 65% of the outsourced market. In total, there are approximately 100 million accounts on DST’s platform. The nearest competitor is Bank of America (BAC), with 30 million accounts.
Shareholder record keeping is a great business for a number of reasons. The business exhibits high switching costs and customer captivity and offers a recurring revenue stream. The business also offers attractive margins, has high barriers to entry and features long-term contracts which afford greater visibility.
Over time, DST has demonstrated consistent and predictable revenues, EBITDA and FCF, with EBITDA margins of 30-35% and FCF of approximately $300mm/yr.
In addition to its core transfer agency business, DST also provides other essential technology and software solutions, primarily to the healthcare industry through its DST Healthcare solutions business. This segment provides insurance claims processing, benefit plan management, billing solutions, etc. This business comprises roughly 20% of operating revenue and offers high growth rates thanks to various secular tailwinds (increased access to healthcare, aging population, etc.). Covered lives in this segment are approximately 23mm, or roughly 15% of the market. Due to its attractive growth potential, this business is a likely spin-off candidate given the higher multiple it deserves versus DST’s core business.
Output Solutions (32% of sales, 13% operating margins)
This segment provides integrated print and electronic statement and billing output solutions for the financial, telecommunications, video, utilities and healthcare industries.
Communications created and mailed include statements, monthly bills, marketing products, trade confirmations, dividend checks, year-end tax reports, etc. DST is the market leader with tremendous scale (which provides a barrier to entry) in an industry where customers seldom switch service providers. This business is experiencing somewhat of a decline due to the paperless billing trend but DST is capturing revenue, albeit at a lower margin, from digital conversion. Additionally, margins in the core business are somewhat masked by accounting for out-of-pocket expenses and thus are higher than they initially appear. This segment also offers good cross-selling opportunities with transfer agency and Health Solutions business. DST is compensated on items mailed or on a per image basis and is one of the largest producers of First Class mail in the US, with 2.3bn shipments in 2010.
Over time, DST has demonstrated fairly lumpy revenue, EBITDA and FCF in its Operating Solutions segment, with EBIT margins ranging from 1-7% and FCF of -30 million-45 million. However, there is significant operational improvement potential within the segment and management thinks it can reach consistent double digit operating margins as the business gains further scale.
Investments & Other
Hidden in DST is a non-core investment portfolio for which the market is assigning little if any value to and which represents the most unique part of the DST investment thesis.
The investment portfolio is comprised of an assortment of financial assets including publicly listed equities, equity interest in privately held companies, real estate assets and various profitable joint ventures.
A breakdown of the contents of the portfolio as well as their estimated value is below.
Publicly Listed Equities
Through the buying and selling of various businesses and ownership interests, DST has accumulated sizable stakes in various publicly listed companies, primarily in the financial and data processing industry. A listing of DST’s current holdings is below:
State Street: 10.3 million shares at $34.04/share (approximately $350 million)
Computershare: 15 million shares at $7.28/share (approximately $115 million)
Euronet: 1.9 million shares at $15.7/share (approximately $30 million)
Undisclosed: $214 million of undisclosed equity holdings
Total Value of Equity Portfolio: $710mm
Privately Held Companies
Based on Nashive, Asurion is the largest global provider of wireless handset insurance and wireless roadside assistance programs. DST sold the majority of its 37.5% stake in the business, which it acquired after merging it with another of its insurance units, to a consortium of Private Equity firms for $878 million in 2007. DST detained a 6% stake in the company.
Asurion is the dominant player in high-margin business with 20% share of total cell phone subscribers as users. Customers include virtually all wireless cell phone service providers including AT&T, Verizon, T-Mobile and Sprint. Asurion insures over 100 million handsets and has estimated revenues of $4bn.
The value of DST’s stake in Asurion is grossly understated on the company’s balance sheet. While DST accounts for its investment in Asurion using the historical cost method, which values its 6% stake at $3mm, the company’s investment is probably worth between approximately $120-$175mm, even assuming a conservative haircut (25-35%) to the valuation established with the 2007 sale of the business. The value of DST’s 6% stake in Asurion may be worth considerably more than these conservative estimates given Asurion’s dominant market position, strong growth profile and recession resistant revenues, as consumers are more likely to insure their high-priced smartphones again damage, loss, etc. in a weaker economy.
Total Value of Privately Held Companies: $120-$175 million
DST Systems owns numerous real estate assets of varying types, locations and ownership structures. The company owns apartment buildings, parking lots, raw land, office buildings, (some of which are leased back to the company), and retail and industrial properties. While it is hard to determine exactly what real estate DST owns given the company’s poor disclosure practices, a reasonable estimate can be made using the limited amount of information the company does provide.
An estimated breakdown of DST’s real estate assets is as follows:
- 1.6 million square feet of production facilities; locations: Kansas City, UK, California and Canada,
Estimated Rents: $4-$10/square feet
- 1.2 million square feet of office buildings; locations: Kansas City, UK and South Africa, Estimated
- 271k square feet of data centers; locations: Kansas City, Estimated Rents: $4/square feet
- 46k square feet of retail properties; locations: Kansas City, Estimated Rents: $12/square feet
-Various other properties including parking lots, 120 unit apartment building, undeveloped land, underground storage facilities and a 1.1 million square foot office building leased to the IRS via a JV; locations: Kansas City and California
In total, DST owns an estimated $300 million worth of real estate assets, excluding 200k+ sq feet of production facilities in the UK, 75k sq ft of office space in the UK, 8k sq ft of office space in Johannesburg and an unknown amount of developed and undeveloped land in the Kansas City area, which were omitted from the calculations due to difficulty in obtaining estimated values.
Total Value of Real Estate Assets: $300mm
DST has three unconsolidated affiliate joint venture agreements with State Street which offer full service mutual fund processing and fund administration. All three JV’s generate positive and predictable earnings streams. All JV’s have 50/50 ownership splits.
DST’s joint ventures, along with its portion of equity earnings, are as follows:
Boston Financial Data Services ($15mm)
International Financial Data Services LP ($16mm)
International Financial Data Services UK ($6mm)
Capitalizing these JV’s are 10-15x earnings, I estimate they are worth between $369-$554mm.
DST also owns an assortment of other financial assets, including stakes in private equity funds, as well as trading and held-to-maturity investments worth over $200mm. A listing of DST’s “other assets” is below:
Private Equity Investments: $149mm
Trading Securities: $50mm
Held to Maturity Securities: $11mm
Total Value of Other Assets: $200mm
At approximately 2.8x estimated 2011 EBITDA, adjusted for the company’s investment portfolio, DST currently trades at an extremely cheap multiple on a consolidated basis.
In light of DST’s conglomerate structure and asset holdings, however, a more appropriate valuation methodology is a sum-of-the-parts analysis.
Applying median market multiples from relevant peers to the company’s various businesses, I estimate the following enterprise values for the company primary operating segments:
Financial Services: $1.625bn, assuming 6.5x 2011e EBITDA of $250 million
Healthcare Solutions: $638mm, assuming 8.5x 2011e EBITDA of $75 million
Output Solutions: $315mm, assuming 4.5x 2011e EBITDA of $70 million
Adding in the company’s investment portfolio value of $1.8 billion while subtracting out the company’s net debt of $777 million(adjusted for $125 million accounts receivable securitization and 50% of $125.8 million of related party credit agreements), I estimate an equity value for the consolidated business of approximately $3.3 billion, which translates to a share price for DST of $70 and an upside potential of 57%.
Why This Opportunity Exists
DST is trading well beneath its intrinsic value for a number of reasons.
First, DST is a complicated story with a number of moving pieces. The company’s conglomerate structure creates added difficulty in trying to determine the company’s intrinsic value.
Second, DST offers very limited financial disclosures regarding its investment portfolio and has a very weak investor relations program. DST’s financials statements have historically been somewhat complex and non-transparent. Additionally, the company does not have much of an investor relations presence, has a severely lacking website, no investor presentations and by and large has failed to effectively communicate its story to The Street.
Finally, DST has very limited sell-side analyst coverage. DST is a lightly followed name with only a handful of sell-side analysts covering the stock, which has allowed it float beneath the radar and remain inefficiently priced.
The biggest risk to DST is a trend known as “sub-accounting.”
Specifically, sub-accounting refers to transfer agency services being performed by broker-dealers as opposed to typical traditional agents. Industry trends have led to an increasing amount of mutual fund investments being held by financial intermediaries (broker-dealers, other financial institutions) as opposed to a direct relationships between the fund company and the investor. As a result, broker-dealers have invested in sub-accounting or omnibus platforms that allow them to provide transfer agency services in house, for a lower fee than that charged by DST and other transfer agents.
Within DST’s transfer agency business, growth is slowing and many foresee a long-term erosion DST’s core record keeping business due to secular changes within the mutual fund industry and a negative mix shift stemming from a trend towards mutual fund sub-accounting. However, today the market is pricing in an overly draconian scenario that significantly overstates the risk to DST’s core business.
Currently, approximately 45% of industry total 275 million mutual funds are on sub-accounting platforms, but this can reach 60-70% of total mutual fund accounts in the coming years. Sub-accounting is an inherently lower margin business, with annual revenues of $2-3 per account. DST could lose up 20-25% of its registered accounts over the coming 2 years; management forecasts losses of 12 million accounts in 2011. Account losses from sub-accounting should see stabilization after 2012. How Bad Can It Be?
The sub-accounting threat is real but there is a somewhat of an embedded a cap in terms of the number of accounts likely to convert to sub-accounting platforms. This helps put a floor under the number of accounts DST is could potentially lose. For example, analysts estimate that 10-20% of broker-dealers lack the scale necessary to offer sub-accounting services, while 10-15% of mutual fund accounts are still held directly by investors, not by financial intermediaries. Additionally, certain types of mutual fund accounts are less susceptible to sub-accounting conversion due to features on these accounts that require shareholder consent, etc. (Tax-advantaged plans, other retirement plans, etc.) Roughly 45% of company’s accounts are tax-advantaged or retirement related – accounts which are less impacted by the sub-accounting trend.
In addition, there are multiple offsets DST to the ultimate loss of accounts DST may face in the coming years including: converting fleeing accounts to DST’s internal sub-accounting platform, international account growth and, growth in the 401k/retirement plan record keeping business
In addition, DST has a more diversified revenue stream than investors typically give it credit for, allowing growth in other areas of its business mix to cushion the revenue blow from sub-accounting.
At less than 4x 2011e EBITDA (accounting for the company’s non-core investment portfolio), DST shares fully reflect most even the most severe account loss scenarios.
Applying peer multiples and assuming the unlikely scenario of ZERO growth in any of DST’s other account types, segments or business lines over the coming years AND assuming none of the accounts lost to sub-accounting convert to DST’s platform, the market is pricing in an estimated 25% decline in the number of DST’s registered accounts. This is far too draconian of an assumption, all else equal. Applying peer multiples, if DST were to recapture half of its accounting fleeing to sub-accounting platforms, then the market would be pricing in losses of over 30 million accounts, an even more extreme scenario
Adding in reasonable growth rates in other areas of DST’s business, it looks as though the market is pricing in a losses of up over 40% of DST’s accounts. Clearly, the threat DST faces from sub-accounting is being vastly overstated in the marketplace.
Given that 45% of DST are somewhat protected from the shift to sub-accounting, if 30% of DST’s remaining accounts (or approximately 18mm) end up leaving (a rate that mirrors the likely conversion rate for the broader industry) and assuming zero growth or recapture, DST still look cheap relative to peers.
DST is a mid-cap data processing firm that in many ways looks more like a mini conglomerate. The company operates in two core segments – primarily transfer agency services to the mutual fund industry and print and mail solutions to a number of industries – and also owns a large, non-core investment portfolio consisting of equity securities, privately held companies, real estate, private equity stakes, etc. that I estimate might be worth up to 88% of the company’s market cap. On an adjusted basis, the company trades approximately 2.8x EBITDA and has a breakup value that is meaningfully higher than today's share price.
While DST has long looked cheap on a sum-of-the-parts basis, it seems like other investors are finally starting to catch on; Russell Glass recently offered to buy the company in the mid 60’s and multiple other parties have expressed interest in acquiring DST. While DST has thus far rejected all offers, I think these expressions of interest help to put somewhat of a floor under the stock price.
In conclusion, on a sum-of-the-parts basis, DST currently trades at an estimated 57% discount to intrinsic value and represents the opportunity to own an high-quality, under-followed conglomerate business with significant embedded assets that is under great pressure to breakup itself up and unlock shareholder value.
Recent News / Catalysts
In early June, it was announced that activist investor Russell Glass, along with an unnamed private equity firm, offered to buy DST at a price in the mid-60s. While DST unanimously rejected the bid as inadequate, the bid effectively put the company and play and called to the market’s attention the value of DST’s embedded assets.
Russell Glass subsequently hosted an investor forum with the company’s largest shareholders outlining his views on the company, why he thinks it’s undervalued and what the company can do to close the gap to intrinsic value. Glass has since requested several board seats and offered to buy DST’s holding in State Street, offers which were both ultimately rejected as well.
Finally, on August 5th, DST announced it hired strategic advisors (Bank of America Merrill Lynch and Skadden, Arps, Slate, Meagher & Flom LLP) to help it explore “strategic alternatives.” In short, what was once more of a theoretical breakup value has effectively become a reality as this initiative increases the likelihood that the DST pursues initiatives that will unlock significant value for shareholders either through a sale, breakup or spin-off of non-core assets.
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