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DST SYSTEMS INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) The discussions set forth in this Quarterly Report on Form 10-Q contain statements concerning potential future events. Such forward-looking statements are based upon assumptions by the Company's management, as of the date of this Quarterly Report, including assumptions about risks and uncertainties faced by the Company. In addition, management may make forward-looking statements orally or in other writings, including, but not limited to, in press releases, in the annual report and in the Company's other filings with the Securities and Exchange Commission ("SEC"). Forward-looking statements include, but are not limited to, (i) all statements, other than statements of historical fact, that address activities, events or developments that we expect or anticipate will or may occur in the future or that depend on future events, or (ii) statements about our future business plans and strategy and other statements that describe the Company's outlook, objectives, plans, intentions or goals, and any discussion of future operating or financial performance. Whenever used, words such as "may," "will," "would," "should," "potential,", "strategy," "anticipates," "estimates," "expects," "project," "predict," "intends," "plans," "believes," "targets" and other terms of similar meaning are intended to identify such forward-looking statements. Forward-looking statements are uncertain and to some extent unpredictable, and involve known and unknown risks, uncertainties, and other important factors that could cause actual results to differ materially from those expressed or implied in, or reasonably inferred from, such forward-looking statements. If any of management's assumptions prove incorrect or should unanticipated circumstances arise, the Company's actual results could materially differ from those anticipated by such forward looking statements. The differences could be caused by a number of factors or combination of factors including, but not limited to, those factors referred to below in Part II, Item 1A, "Risk Factors." Readers are strongly encouraged to consider those factors when evaluating any forward looking statements concerning the Company. The Company's reports filed with or furnished to the SEC on Form 8-K, Form 10-K, Form 10-Q and other forms and any amendments to those reports, may be obtained by contacting the SEC's Public Reference Branch at 1-800-SEC-0330 or by accessing the forms electronically, free of charge, through the SEC's Internet website at http://www.sec.gov or through the Company's Internet website, as soon as reasonably practicable after filing with the SEC, at http://www.dstsystems.com. The Company undertakes no obligation to update any forward-looking statements in this Quarterly Report on Form 10-Q to reflect new information, future events or developments, or otherwise. The information contained in this Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Condensed Consolidated Financial Statements and Notes thereto included in this Form 10-Q and the audited Consolidated Financial Statements and Notes thereto in the Company's Annual Report on Form 10-K for the year ended December 31, 2013. INTRODUCTION DST Systems, Inc. (the "Company," "we" or "DST") provides proprietary technology-based information processing and servicing solutions to many of the largest financial services and healthcare companies around the world. The Company serves clients in the asset management, brokerage, retirement, insurance, healthcare, telecommunications, utility and other markets. DST's solutions help clients process, communicate and safeguard critical customer information. Services we provide include transaction processing, business process outsourcing, ancillary consulting and professional services, information technology services (such as data and software hosting), integrated print, mail and electronic customer communications solutions and data analytics. These services are provided through a blend of deep industry knowledge, proprietary technology and a scalable infrastructure for clients that operate in complex, highly regulated, and high-volume transactional business environments. The Company manages its business through three operating segments, Financial Services, Healthcare Services and Customer Communications. Investments in the Company's equity securities, private equity investments, real estate and certain financial interests have been aggregated into an Investments and Other Segment. Financial Services The Financial Services Segment is the Company's largest operating segment. Through this segment, DST provides asset management and asset distribution solutions. Asset management solutions include the tracking of purchases, redemptions, exchanges and transfers of shares; maintaining investor identification and ownership records; reconciling cash and share activity; processing dividends; reporting sales; performing tax and other compliance functions; and providing information for printing of investor trade confirmations, statements and year-end tax forms. In the U.S., the Company provides asset management solutions to mutual funds, brokerage firms, retirement plans and alternative investment funds (such as real estate investment trusts ("REITs")). Asset management solutions are provided either under a software as a service ("SaaS") model or on a business process outsourcing ("BPO") basis by DST or its domestic joint venture. Revenues are primarily based on the number of accounts, participants or transactions processed. The Company's asset management BPO solution offerings are enhanced by DST's proprietary workflow software, which is also licensed separately to third parties. In Australia and the 25-------------------------------------------------------------------------------- Table of Contents United Kingdom, DST licenses software solutions to funds and fund managers, who perform participant accounting and recordkeeping for the wealth management and retirement savings market. The Company also provides asset management solutions on a SaaS and BPO basis internationally (United Kingdom, Canada, Ireland and Luxembourg) solely through its joint ventures with State Street Corporation ("State Street"). In addition, DST provides asset distribution solutions through the Financial Services Segment ranging from consulting to active wholesaling and marketing for open-end mutual funds, exchange-traded funds ("ETFs"), closed-end funds and alternative investment funds. The Company also offers distribution support solutions including an aggregating website designed for financial advisors and broker/dealer back-office operations and a centralized data delivery source for investor account detail from mutual fund, variable annuity, and REIT companies. DST also provides asset management services, through the utilization of sub-advisors and index providers. Healthcare Services The Healthcare Services Segment is comprised of the Argus Health Systems ("Argus") and DST Health Solutions ("DSTHS") businesses. Through this segment, DST provides solutions including claims adjudication, benefit management, care management, business intelligence and other ancillary solutions. DST offers solutions to both the medical and pharmacy benefits components of a health plan or managed care organization's business. Argus is a pharmacy claims administrator and provides health care information management services supporting commercial, Medicaid and Medicare Part D plans. Argus derives revenue from pharmacy claims processing services and from the management of pharmacy networks, call center services, pharmaceutical rebate administration, and clinical programs and management reporting for the benefit of their customers. Further, Argus' revenues include investment earnings related to client cash balances maintained in the Company's bank accounts. DSTHS is a medical claims benefit manager providing processing systems, integrated care management applications, analytical solutions and BPO services for payors and providers in the U.S. healthcare industry. DSTHS processing services are offered on a software license, SaaS or BPO basis. Services are offered as stand-alone component solutions to complement health plans, existing operations or systems, or as an integrated core administration package of systems and comprehensive administrative solutions. Customer Communications The Customer Communications Segment offers a full range of integrated print, mail, and electronic solutions to customers in the United States, Canada and the United Kingdom. Through this segment, DST produces individualized communications for client's customers such as investment fund statements, explanation of health benefit statements, and monthly utility bills. DST provides the formatting, printing, mailing, electronic presentment and archiving of these types of communications. As one of the largest First-Class mailers in the United States, the Company also provides a range of postal services to help clients optimize mail efficiencies and streamline postage expenses. Approximately 50% of the services provided by this segment are for customers in the financial services and healthcare industries. Additionally, services are provided to the retail banking, insurance, consumer finance, video/broadband, telecommunications, utilities, retail and other service industries. Revenues in this segment are derived from presentation and delivery (either print or digital), mailing fees and archiving of customer documents, and are based generally on the number of images processed or packages processed and the range of customization and personalization options chosen by the client. Investments and Other The Investments and Other Segment is comprised of the Company's investments in equity securities, private equity investments, real estate and other financial interests. The Company owns and operates real estate mostly in North America, primarily for lease to the Company's other business segments. The Company is a partner in certain real estate joint ventures that lease office space to the Company, certain of its unconsolidated affiliates and unrelated third parties. The assets held by the Segment are primarily passive in nature. Seasonality Generally, the Company does not have significant seasonal fluctuations in its business operations. Transaction processing and Customer Communications volumes for mutual fund customers are usually highest during the three months ended March 31 due primarily to processing year-end transactions and printing and mailing of year-end statements and tax forms during January. The Company has historically added operating equipment in the last half of the year in preparation for processing year-end transactions, which has the effect of increasing costs for the second half of the year. Revenues and operating results from individual license sales depend heavily on the timing and size of the contract. 26-------------------------------------------------------------------------------- Table of Contents RESULTS OF OPERATIONS The following table summarizes the Company's operating results (in millions, except per share amounts): Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 2014 2013 Revenues Operating revenues Financial Services $ 266.9 $ 248.8 $ 789.9 $ 746.3 Healthcare Services 95.5 80.7 280.4 242.7 Customer Communications 159.1 160.5 487.2 498.5 Investments and Other 14.9 14.6 43.8 43.3 Elimination Adjustments (25.9 ) (24.4 ) (76.0 ) (70.3 ) 510.5 480.2 1,525.3 1,460.5 % change from prior year period 6.3 % 4.4 % Out-of-pocket reimbursements Financial Services 11.3 8.8 37.6 31.9 Healthcare Services 1.9 1.5 4.9 4.2 Customer Communications 158.6 163.1 482.8 500.2 Investments and Other - 0.1 0.1 0.1 Elimination Adjustments (2.8 ) (1.9 ) (7.9 ) (5.6 ) 169.0 171.6 517.5 530.8 % change from prior year period (1.5 )% (2.5 )% Total revenues $ 679.5 $ 651.8 $ 2,042.8 $ 1,991.3 % change from prior year period 4.2 % 2.6 % Income from operations Financial Services $ 49.9 $ 54.4 $ 138.4 $ 153.5 Healthcare Services 19.6 11.4 38.0 29.9 Customer Communications 12.0 15.5 41.3 43.0 Investments and Other 3.5 7.2 10.7 13.3 Elimination Adjustments (2.2 ) (2.2 ) (6.2 ) (6.1 ) 82.8 86.3 222.2 233.6 % change from prior year period (4.1 )% (4.9 )% Interest expense (6.4 ) (8.4 ) (20.0 ) (27.3 ) Other income, net 57.5 73.4 282.3 175.0 Equity in earnings of unconsolidated affiliates 10.2 3.8 25.2 18.9 Income before income taxes 144.1 155.1 509.7 400.2 Income taxes 44.1 58.2 171.5 131.6 Net income $ 100.0 $ 96.9 $ 338.2 $ 268.6 Basic earnings per share $ 2.53 $ 2.26 $ 8.30 $ 6.16 Diluted earnings per share $ 2.51 $ 2.23 $ 8.22 $ 6.03 Non-GAAP diluted earnings per share $ 1.54 $ 1.21 $ 3.85 $ 3.24 Cash dividends per share of common stock $ 0.30 $ 0.30 $ 0.90 $ 0.90 27-------------------------------------------------------------------------------- Table of Contents Consolidated revenues Consolidated total revenues (including out-of-pocket ("OOP") reimbursements) for the three and nine months ended September 30, 2014 were $679.5 million and $2,042.8 million, respectively, an increase of $27.7 million or 4.2% and $51.5 million or 2.6% compared to the three and nine months ended September 30, 2013. Consolidated operating revenues for the three and nine months ended September 30, 2014 increased $30.3 million or 6.3% and $64.8 million or 4.4% as compared to the same periods in 2013. The increase in consolidated operating revenues during the three and nine months ended September 30, 2014 was primarily attributable to increased operating revenues in the Financial Services and Healthcare Services Segments, partially offset by a slight decline in operating revenues in the Customer Communications Segment. Consolidated OOP reimbursements for the three and nine months ended September 30, 2014 decreased $2.6 million or 1.5% and $13.3 million or 2.5% as compared to the same periods in 2013. The decrease in OOP reimbursements is primarily attributable to client losses in the Customer Communications Segment. Additional information regarding revenue by business segment is included below following the caption, "Business Segment Comparisons." Income from operations Consolidated income from operations for the three and nine months ended September 30, 2014 was $82.8 million and $222.2 million, respectively, a decrease of $3.5 million or 4.1% and $11.4 million or 4.9% as compared to the same periods in 2013. The decrease in operating income during the three and nine months ended September 30, 2014 was primarily due to declines within the Financial Services, Customer Communications and Investments and Other Segments, partially offset by an increase in the Healthcare Services Segment. As a result of market changes which have impacted DST's service offerings to clients, including lower registered account processing, DST has implemented a restructuring initiative to reduce its workforce and consolidate certain facilities to enhance operational efficiency within the Financial Services and Customer Communications Segments. As a result of this restructuring initiative, the Company incurred pretax charges during the third quarter 2014 of $6.4 million ($5.6 million in Financial Services and $0.8 million in Customer Communications) and anticipates an additional pretax charge in fourth quarter 2014 of approximately $7.5 million ($4.0 million in Financial Services and $3.5 million in Customer Communications) associated with the actions taken during the third quarter. The Company anticipates this restructuring initiative will result in annual pretax operating cost savings of approximately $13.0 million to $15.0 million, of which approximately 75% is expected to be realized in the Financial Services Segment operations and the remaining will be realized within the Customer Communications Segment. Additional information regarding income from operations by business segment is included below following the caption, "Business Segment Comparisons." Interest expense Interest expense for the three and nine months ended September 30, 2014 was $6.4 million and $20.0 million, respectively, a decrease of $2.0 million and $7.3 million as compared to the three and nine months ended September 30, 2013, primarily from lower weighted average debt balances outstanding. 28-------------------------------------------------------------------------------- Table of Contents Other income, net The components of other income, net are as follows (in millions): Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 2014 2013 Net realized gains from sale of available-for-sale securities $ 50.1 $ 50.0 $ 98.0 $ 134.4 Net gain on private equity funds and other investments 6.5 16.3 21.3 27.8 Dividend income 2.6 3.1 42.1 10.1 Gain on sale of private company investment - - 103.6 - Gain on contract to repurchase shares - - 18.1 - Interest income 0.5 0.8 1.2 2.9 Foreign currency gains (losses) (0.5 ) 0.8 (1.1 ) (6.4 ) Miscellaneous items (1.7 ) 2.4 (0.9 ) 6.2 Other income, net $ 57.5 $ 73.4 $ 282.3 $ 175.0 The Company recorded net gains from the sale of available-for-sale securities of $50.1 million and $98.0 million during the three and nine months ended September 30, 2014, compared to $50.0 million and $134.4 million for the same periods in 2013. Included in the $98.0 million of net gains from the sale of available-for-sale securities for the nine months ended September 30, 2014 is a gain of $87.8 million from the sale of approximately 1.4 million shares of State Street Corporation. The Company recognized a net gain of $6.5 million and $21.3 million on private equity funds and other investments for the three and nine months ended September 30, 2014, as compared to a net gain of $16.3 million and $27.8 million for the three and nine months ended September 30, 2013. The Company receives dividend income from certain investments held. Dividend income was $2.6 million and $42.1 million for the three and nine months ended September 30, 2014, as compared to $3.1 million and $10.1 million for the three and nine months ended September 30, 2013. Included in the $42.1 million of dividend income for the nine months ended September 30, 2014 is a $33.2 million cash dividend received from a cost-method investment in a privately-held company received in first quarter 2014. Excluding the $33.2 million dividend received in 2014, dividend income declined during the three and nine months ended September 30, 2014, primarily attributable to lower dividends from State Street Corporation resulting from fewer shares owned. The Company received pre-tax cash proceeds and a related gain of $103.6 million during the nine months ended September 30, 2014 from the sale of DST's remaining investment in a privately-held company. DST repurchased $200.0 million of its common stock from the Argyros Group during 2014. The price paid per share was determined in connection with the secondary offering of the Argyros Group's DST common stock in May 2014. In connection with this share repurchase, DST recorded a non-cash gain of $18.1 million during the nine months ended September 30, 2014 resulting from the change in stock price between the date the share repurchase price became fixed and the settlement date. The Company had unrealized losses on foreign currency translation of $0.5 million and $1.1 million during the three and nine months ended September 30, 2014, as compared to unrealized gains on foreign currency translation of $0.8 million and unrealized losses of $6.4 million during the three and nine months ended September 30, 2013. The Company began hedging against certain foreign currency exposures in May 2013. Miscellaneous items include unrealized gains and losses on marketable securities designated as trading securities, amortization of deferred non-operating gains and other non-operating items. Miscellaneous items resulted in a loss of $1.7 million and $0.9 million for the three and nine months ended September 30, 2014, as compared to a gain of $2.4 million and $6.2 million for the three and nine months ended September 30, 2013. The movements within miscellaneous items are primarily attributable to lower unrealized gains on trading securities during 2014. 29-------------------------------------------------------------------------------- Table of Contents Equity in earnings of unconsolidated affiliates Equity in earnings of unconsolidated affiliates is as follows (in millions): Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 2014 2013 BFDS $ 1.5 $ 1.8 $ 4.5 $ 6.1 IFDS (U.K. and L.P.) 7.2 1.0 10.3 8.9 Other 1.5 1.0 10.4 3.9 $ 10.2 $ 3.8 $ 25.2 $ 18.9 DST's equity in earnings of unconsolidated affiliates increased $6.4 million during the three months ended September 30, 2014 and increased $6.3 million during the nine months ended September 30, 2014, as compared to the same periods in 2013. The increase in equity in earnings during the three months ended September 30, 2014 were primarily from increased earnings from IFDS. Other significant items impacting equity in earnings during the nine months ended September 30, 2014 are a $5.7 million gain recognized upon the sale of an unconsolidated affiliate during the nine months ended September 30, 2014 and the recognition of a $7.4 million gain (DST's share) recorded by IFDS ($6.3 million) and BFDS ($1.1 million) on the sale of IFDS' equity method investment in Cofunds, Ltd. during the nine months ended September 30, 2013. DST's equity in BFDS earnings decreased $0.3 million and $1.6 million during the three and nine months ended September 30, 2014, respectively, as compared to the same periods in 2013. Absent the $1.1 million gain related to the 2013 sale of the Cofunds, Ltd. investment as mentioned above, DST's equity in BFDS earnings decreased $0.5 million during the nine months ended September 30, 2014, as compared to the same periods in 2013. The decrease in BFDS earnings is primarily attributable to lower shareowner processing revenues associated with reduced levels of accounts serviced, partially offset by higher revenues from other ancillary services. DST's equity in earnings of IFDS increased $6.2 million and $1.4 million during the three and nine months ended September 30, 2014, as compared to the same periods in 2013. Absent the $6.3 million gain on the sale of the Cofunds, Ltd. investment in 2013 as mentioned above, of which $1.7 million was recorded during the three months ended September 30, 2013, DST's equity in earnings of IFDS increased $7.9 million and $7.7 million during the three and nine months ended September 30, 2014, respectively, as compared to the same periods in 2013. The increase is primarily the result of revenues recognized related to the ongoing conversion activities of the previously announced new wealth management clients in the U.K. These multi-year implementation efforts for the two new clients are continuing to progress and are expected to be completed in phases. Earnings will continue to be impacted by the rate of progress related to the conversions and therefore may not be consistent period to period throughout the implementation and conversion process. IFDS continues to incur significant costs to develop the new wealth management platform for the U.K. market and expand its infrastructure to prepare for the addition of these new clients and associated services offerings. Total IFDS shareowner accounts serviced were 23.6 million at September 30, 2014, an increase of 0.1 million accounts or 0.4% from June 30, 2014 and an increase of 2.0 million accounts or 9.3% from September 30, 2013. The increase in accounts for the nine months ended September 30, 2014 is primarily attributable to new client conversions, including a previously announced client in Canada that converted approximately 650,000 new accounts during the three months ended March 31, 2014. DST's equity in earnings of other unconsolidated affiliates increased $0.5 million and $6.5 million during the three and nine months ended September 30, 2014, as compared to the same periods in 2013. The increase for the three months ended September 30, 2014 is primarily due to higher earnings from real estate investments. The increase for the nine months ended September 30, 2014 is primarily due to the sale of DST's investment in an unconsolidated affiliate which resulted in a gain of $5.7 million. 30-------------------------------------------------------------------------------- Table of Contents Additional condensed financial information of DST's significant operating unconsolidated affiliates, BFDS and IFDS, is presented below (in millions): Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 2014 2013 Total revenues $ 269.9 $ 212.9 $ 785.9 $ 627.5 Costs and expenses 238.2 201.1 718.3 586.9 Depreciation and amortization 10.3 7.6 29.9 22.2 Income from operations 21.4 4.2 37.7 18.4 Non-operating income 1.3 0.9 2.6 22.4 Income before income taxes 22.7 5.1 40.3 40.8 Income taxes 5.3 (0.7 ) 10.9 10.6 Net income $ 17.4 $ 5.8 $ 29.4 $ 30.2 Income taxes The Company records income tax expense for interim periods based on its best estimate of the annual tax rate as adjusted for discrete items, if any, that are taken into account in the relevant period. The Company's tax rate was 30.6% and 33.6% for the three and nine months ended September 30, 2014, respectively, compared to 37.5% and 32.9% for the three and nine months ended September 30, 2013, respectively. Excluding the effect of discrete period items, the Company expects its annual tax rate to be approximately 35.0% for full year 2014 compared with an annual tax rate of 35.3% for the full year 2013. The full year 2014 tax rate can be affected as a result of variances among the estimates and amounts of full year sources of taxable income (e.g., domestic consolidated, joint venture and/or international), the realization of tax credits (e.g., research and experimentation, foreign tax and state incentive), adjustments which may arise from the resolution of tax matters under review and the Company's assessment of its liability for uncertain tax positions. The Company's tax rate for the three months ended September 30, 2014 was lower than its expected annual tax rate primarily due to the release of certain liabilities for uncertain tax positions upon expiration of the statute of limitations and higher foreign tax credits due to higher earnings from foreign jurisdictions. The Company's tax rate for the nine months ended September 30, 2014, is impacted by a discrete, permanent tax benefit on the $18.1 million gain recorded on the contract to repurchase the Company's own common stock. In accordance with the Internal Revenue Code, a corporation recognizes no gain or loss on the redemption of its own stock for cash. The Company's tax rate for the nine months ended September 30, 2013 was lower than its expected annual tax rate due to the completion of the IRS examination of previously filed federal income tax refund claims for Domestic Manufacturing Deductions under Internal Revenue Code Section 199 and research and experimentation credits for the periods 2006 through 2009. As a result, the Company recognized income tax benefits of $16.1 million during the nine months ended September 30, 2013, resulting from the reversal of previously reserved tax positions related to these matters. The income tax benefit for the research and experimentation credits relates to the resolved claim years and certain post-audit periods that are still subject to examination. The income tax benefit for the Domestic Manufacturing Deductions relates only to the resolved claim years. The law that provided for research and experimentation credits expired on December 31, 2013 and accordingly no research and experimentation credits have been recorded during 2014. 31-------------------------------------------------------------------------------- Table of Contents Comprehensive income The Company's comprehensive income totaled $85.3 million and $276.1 million for the three and nine months ended September 30, 2014 compared to $82.9 million and $312.9 million for the three and nine months ended September 30, 2013. Comprehensive income includes net income of $100.0 million and $338.2 million for the three and nine months ended September 30, 2014 compared to $96.9 million and $268.6 million for the three and nine months ended September 30, 2013, and other comprehensive loss of $14.7 million and $62.1 million for the three and nine months ended September 30, 2014 compared to other comprehensive loss of $14.0 million and other comprehensive income of $44.3 million for the three and nine months ended September 30, 2013. Other comprehensive income (loss) consists of unrealized gains (losses) on available-for-sale securities, unrealized gain (loss) on cash flow hedges, the Company's proportional share of unconsolidated affiliates other comprehensive income (loss), and foreign currency translation adjustments. The principal difference between net income and comprehensive income is the net change in unrealized gains (losses) on available-for-sale securities. 32-------------------------------------------------------------------------------- Table of Contents Business Segment ComparisonsFINANCIAL SERVICES SEGMENT The following table presents the financial results of the Financial Services Segment (in millions): Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 2014 2013 Operating revenues $ 266.9 $ 248.8 $ 789.9 $ 746.3 Out-of-pocket reimbursements 11.3 8.8 37.6 31.9 Total revenues 278.2 257.6 827.5 778.2 Costs and expenses 210.7 187.0 638.2 577.2 Depreciation and amortization 17.6 16.2 50.9 47.5 Income from operations $ 49.9 $ 54.4 $ 138.4 $ 153.5 Operating margin 18.7 % 21.9 % 17.5 % 20.6 % The following tables summarizes the Financial Services Segment's statistical results (in millions, except as noted): September 30, 2014 2013 U.S. mutual fund shareowner accounts processed: Registered accounts - non tax-advantaged 29.8 30.9 IRA mutual fund accounts 22.5 23.2 Other retirement accounts 8.2 8.3 Section 529 and Educational IRAs 8.9 9.3 Registered accounts - tax-advantaged 39.6 40.8 Total registered accounts 69.4 71.7 Subaccounts 28.4 24.3 Total 97.8 96.0 International mutual fund shareowner accounts processed: IFDS U.K. 11.1 10.0 IFDS L.P. (Canada) 12.5 11.6 Total 23.6 21.6 September 30, 2014 2013 Defined contribution participant accounts 6.9 6.7 ALPS (in billions of U.S. dollars): Assets Under Management $ 15.4 $ 10.7 Assets Under Administration $ 173.6 $ 125.2 Automatic Work Distributor workstations (in thousands) 212.0 209.1 33-------------------------------------------------------------------------------- Table of Contents Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 2014 2013 Changes in registered accounts: Beginning balance 70.9 73.3 71.2 75.7 New client conversions - - - 0.3 Subaccounting conversions to DST platforms (0.4 ) (0.4 ) (0.4 ) (1.5 ) Subaccounting conversions to non-DST platforms (0.8 ) (1.0 ) (1.7 ) (3.0 ) Conversions to non-DST platforms (0.6 ) - (0.7 ) (0.2 ) Organic growth (decline) 0.3 (0.2 ) 1.0 0.4 Ending balance 69.4 71.7 69.4 71.7 Changes in subaccounts: Beginning balance 27.6 22.4 25.7 12.4 New client conversions - - - 5.7 Conversions from non-DST registered platforms 0.1 0.3 0.7 0.9 Conversions from DST's registered accounts 0.4 0.4 0.4 1.5 Organic growth 0.3 1.2 1.6 3.8 Ending balance 28.4 24.3 28.4 24.3 Changes in defined contribution participant accounts: Beginning balance 6.7 6.5 6.9 6.1 New client conversions - - 0.3 1.3 Organic growth (decline) 0.2 0.2 (0.3 ) (0.7 ) Ending balance 6.9 6.7 6.9 6.7 Revenues Financial Services Segment total revenues for the three and nine months ended September 30, 2014 were $278.2 million and $827.5 million, respectively, an increase of $20.6 million or 8.0% and $49.3 million or 6.3% as compared to the same periods in 2013. Financial Services Segment operating revenues for the three and nine months ended September 30, 2014 were $266.9 million and $789.9 million, respectively, an increase of $18.1 million or 7.3% and $43.6 million or 5.8% as compared to the same periods in 2013. The increase in operating revenues for the three and nine months ended September 30, 2014 is primarily from higher operating revenues within the ALPS and Brokerage Solutions businesses and higher software license revenues, partially offset by lower mutual fund registered shareowner account processing revenues. These increases were partly offset by a contract termination payment received from a Retirement Solutions client in first quarter 2013 that increased operating revenues for the nine months ended September 30, 2013 by $6.0 million. ALPS operating revenues increased over the comparable prior year periods as a result of net positive funds flow and favorable market conditions which have contributed to the growth of assets under management within the ALPS proprietary funds and increases in other ALPS distribution and services revenues. Brokerage Solutions had increased operating revenues from higher subaccounts processed as a result of organic growth from existing clients and new client growth. Global Solutions operating revenues during the three months ended September 30, 2014 increased as compared to the three months ended September 30, 2013, primarily from higher international investment management software revenues recognized during 2014. Excluding the $6.0 million contract termination payment received in 2013, Retirement Solutions operating revenues increased during the three and nine months ended September 30, 2014 from the same periods in 2013 principally from higher professional services fee revenue and higher participants as a result of the conversion of new clients. Operating revenues also increased from higher professional services revenue from the implementation and configuration of new wealth management clients. Financial Services software license fee revenue was $11.0 million and $31.7 million for the three and nine months ended September 30, 2014, respectively, an increase of $3.1 million or 39.2% and $6.1 million or 23.8% over the same periods in 2013. 34-------------------------------------------------------------------------------- Table of Contents Operating revenues from DST's U.S. shareowner account processing declined primarily as a result of lower registered accounts in 2014. Registered accounts decreased 1.5 million accounts or 2.1% from June 30, 2014 and decreased 2.3 million accounts or 3.2% from September 30, 2013. The decline in registered accounts from June 30, 2014 and September 30, 2013 is primarily the result of accounts converting to subaccounting platforms and to non-DST platforms, partially offset by organic growth at existing clients. Conversions of registered accounts to subaccounts are currently estimated to be at the low end of or slightly below the Company's previous guidance of three to four million accounts in 2014. Conversion of registered accounts to subaccounts during 2015 is currently estimated to be four to five million accounts. DST has been informed that certain broker/dealers may convert certain tax-advantaged accounts to a subaccounting platform, however, the timing and number of accounts is not currently known. The number of accounts estimated to convert from various DST platforms is based upon information obtained from clients. There are a variety of factors that will affect the number and timing of registered accounts converted to subaccounts. U.S. operating revenues for the three and nine months ended September 30, 2014 were $224.0 million and $664.5 million, respectively, an increase of $10.0 million or 4.7% and $23.1 million or 3.6%, as compared to the same periods in 2013. International operating revenues for the three and nine months ended September 30, 2014 were $42.9 million and $125.4 million, respectively, an increase of $8.1 million or 23.3% and $20.5 million or 19.5% as compared to the same periods in 2013. Financial Services Segment OOP reimbursement revenues for the three and nine months ended September 30, 2014 were $11.3 million and $37.6 million, respectively, an increase of $2.5 million or 28.4% and $5.7 million or 17.9% as compared to the same periods in 2013. The increase during the three and nine months ended September 30, 2014 is primarily due to an increase in revenues at ALPS due to higher activities, partially offset by lower mutual fund registered shareowner account volumes. Costs and expenses Financial Services Segment costs and expenses (including OOP costs) were $210.7 million and $638.2 million for the three and nine months ended September 30, 2014, respectively, an increase of $23.7 million or 12.7% and $61.0 million or 10.6% as compared to the three and nine months ended September 30, 2013. Costs and expenses in the Financial Services Segment are primarily comprised of compensation and benefits costs as well as technology-related expenditures and reimbursable operating expenses. OOP costs, included in costs and expenses, were $11.3 million and $37.6 million for the three and nine months ended September 30, 2014, respectively, an increase of $2.5 million or 28.4% and $5.7 million or 17.9% as compared to the same periods in 2013. Excluding OOP costs in 2014 and 2013, costs and expenses were $199.4 million for the three months ended September 30, 2014, an increase of $21.2 million or 11.9% as compared to the same period in 2013. On this basis, costs and expenses during 2014 were impacted by increased processing costs to support the incremental revenues and higher costs associated with new business initiatives associated with the growth of the ALPS asset gathering business and investments to further develop the Applied Analytics and Brokerage Solutions service offerings. The Company also incurred higher employee termination costs during the three months ended September 30, 2014, primarily as a result a $5.6 million charge resulting from the restructuring event implemented during the third quarter to reduce its workforce and consolidate certain facilities to enhance operational efficiency within the Financial Services Segment. Excluding OOP costs in 2014 and 2013, costs and expenses were $600.6 million for the nine months ended September 30, 2014, an increase of $55.3 million or 10.1% as compared to the same period in 2013. On this basis, costs and expenses during 2014 were impacted by increased costs to support higher revenues and higher costs associated with the new business initiatives described above partially offset by lower mark-to-market losses on deferred compensation liabilities and expenses associated with the fund launched by ALPS of $2.8 million in 2013 that did not recur in 2014. Also contributing to the increased costs in the Financial Services Segment during the nine months ended September 30, 2014 were $9.8 million of employee termination costs and $5.6 million of advisory and other transaction costs incurred in connection with the agreement with the Argyros Group in 2014. Depreciation and amortization Financial Services Segment depreciation and amortization expense for the three and nine months ended September 30, 2014 was $17.6 million and $50.9 million, respectively, an increase of $1.4 million or 8.6% and $3.4 million or 7.2% as compared to the same periods in 2013. The increase during the three and nine months ended September 30, 2014 was primarily from higher capital expenditures. 35-------------------------------------------------------------------------------- Table of Contents Income from operations Financial Services Segment income from operations for the three and nine months ended September 30, 2014 was $49.9 million and $138.4 million, respectively, a decrease of $4.5 million or 8.3% and $15.1 million or 9.8% as compared to the same periods in 2013. Financial Services Segment income from operations for the three and nine months ended September 30, 2014 decreased primarily from higher operating expenses to support new business initiatives as well as higher employee termination and advisory and other transaction costs, partially offset by higher operating revenues and lower mark-to-market losses. Additionally, income from operations for the nine months ended September 30, 2013 included a $6.0 million contract termination payment that did not recur in 2014. HEALTHCARE SERVICES SEGMENT The following table presents the financial results of the Healthcare Services Segment (in millions): Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 2014 2013 Operating revenues $ 95.5 $ 80.7 $ 280.4 $ 242.7 Out-of-pocket reimbursements 1.9 1.5 4.9 4.2 Total revenues 97.4 82.2 285.3 246.9 Costs and expenses 73.1 66.0 232.9 202.8 Depreciation and amortization 4.7 4.8 14.4 14.2 Income from operations $ 19.6 $ 11.4 $ 38.0 $ 29.9 Operating margin 20.5 % 14.1 % 13.6 % 12.3 % The following tables summarizes the Healthcare Services Segment's statistical results (in millions): September 30, 2014 2013 DST Health Solutions covered lives 24.1 23.6 Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 2014 2013 Argus pharmacy paid claims 122.7 110.9 359.7 330.0 Revenues Healthcare Services Segment total revenues for the three and nine months ended September 30, 2014 were $97.4 million and $285.3 million, respectively, an increase of $15.2 million or 18.5% and $38.4 million or 15.6% as compared to the same periods in 2013. Revenues for the three and nine months ended September 30, 2014 increased primarily from increased medical claims transaction volume growth from new and existing clients and higher business process outsourcing revenues. Pharmacy claims processing revenue also contributed to the increased operating revenues principally due to Medicare, Medicaid and healthcare exchange members growth at existing clients. Revenues were also higher than in the prior year as a result of increases in discount card services and other ancillary services and some acceleration of seasonal activity which historically has occurred in the fourth quarter. Additionally, operating revenues increased from software services and support associated with the implementation of the Affordable Care Act. Operating revenues include approximately $1.3 million and $4.3 million of software license fee revenues for the three and nine months ended September 30, 2014, an increase of $0.3 million and $0.8 million over the same periods in 2013. 36-------------------------------------------------------------------------------- Table of Contents Costs and expenses Healthcare Services Segment costs and expenses (including OOP costs) were $73.1 million and $232.9 million for the three and nine months ended September 30, 2014, respectively, an increase of $7.1 million or 10.8% and $30.1 million or 14.8% as compared to the same periods in 2013. Healthcare Services costs and expenses are primarily comprised of compensation and benefits costs but also include technology-related expenditures. The increase in costs and expenses for the three and nine months ended September 30, 2014 was primarily attributable to increased staffing costs, higher client conversion and implementation costs and higher claim processing costs due to the increased volume and complexity of transactions processed. Additionally, the three and nine months ended September 30, 2014 were impacted by the resolution of a previously disclosed regulatory inquiry which resulted in the reversal of $4.0 million previously accrued in excess of the final settlement amount of $2.0 million. For the nine months ended September 30, 2014, costs and expenses were negatively impacted by an incremental $5.7 million estimated liability recorded during second quarter 2014 related to processing errors identified for certain pharmacy claim transactions involving a specific set of circumstances. Depreciation and amortization Healthcare Services Segment depreciation and amortization expense for the three and nine months ended September 30, 2014 was $4.7 million and $14.4 million, respectively, a decrease of $0.1 million or 2.1% and an increase of $0.2 million or 1.4% as compared to the same periods in 2013. Income from operations Healthcare Services Segment income from operations for the three and nine months ended September 30, 2014 was $19.6 million and $38.0 million, respectively, an increase of $8.2 million and $8.1 million as compared to the same periods in 2013. The increase is primarily attributable to higher revenues and the $4.0 million liability reversal related to a regulatory inquiry, partially offset by increased staffing costs incurred to complete new client implementations and to service the increased transaction volumes. The increase in operating income for the nine months ended September 30, 2014 was also partially offset by increased costs associated with the $5.7 million estimated liability for processing errors recorded during second quarter 2014. CUSTOMER COMMUNICATIONS SEGMENT The following tables present the financial results of the Customer Communications Segment (in millions): Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 2014 2013 Operating revenues $ 159.1 $ 160.5 $ 487.2 $ 498.5 Out-of-pocket reimbursements 158.6 163.1 482.8 500.2 Total revenues 317.7 323.6 970.0 998.7 Costs and expenses 296.2 297.2 900.8 923.0 Depreciation and amortization 9.5 10.9 27.9 32.7 Income from operations $ 12.0 $ 15.5 $ 41.3 $ 43.0 Operating margin 7.5 % 9.7 % 8.5 % 8.6 % Three Months Ended September 30, 2014 2013 Operating Operating Operating Operating Revenue Income Revenue Income North America $ 111.9 $ 11.8 $ 115.2 $ 12.9 United Kingdom 47.2 0.2 45.3 2.6Customer Communications Segment $ 159.1 $ 12.0 $ 160.5 $ 15.5 37-------------------------------------------------------------------------------- Table of Contents Nine Months Ended September 30, 2014 2013 Operating Operating Operating Operating Revenue Income Revenue Income North America $ 340.2 $ 37.8 $ 357.1 $ 38.3 United Kingdom 147.0 3.5 141.4 4.7Customer Communications Segment $ 487.2 $ 41.3 $ 498.5 $ 43.0 The following table summarizes the Customer Communications Segment's statistical results (in millions): Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 2014 2013 Images Produced North America 2,073.9 2,362.9 6,353.5 7,268.8 United Kingdom 493.3 494.0 1,590.6 1,525.0 Customer Communications Segment 2,567.2 2,856.9 7,944.1 8,793.8 Packages Mailed North America 445.2 546.2 1,385.5 1,686.9 United Kingdom 215.8 191.2 616.8 545.7Customer Communications Segment 661.0 737.4 2,002.3 2,232.6 Revenues Customer Communications Segment total revenues for the three and nine months ended September 30, 2014 were $317.7 million and $970.0 million, respectively, a decrease of $5.9 million or 1.8% and $28.7 million or 2.9% as compared to the same periods in 2013. Customer Communications operating revenues for the three and nine months ended September 30, 2014 were $159.1 million and $487.2 million, respectively, a decrease of $1.4 million or 0.9% and $11.3 million or 2.3% as compared to the same periods in 2013. Out-of-pocket reimbursement revenues for the three and nine months ended September 30, 2014 were $158.6 million and $482.8 million, respectively, a decrease of $4.5 million or 2.8% and $17.4 million or 3.5% as compared to the same periods in 2013 primarily due to lower North America volumes. Customer Communications North America operating revenues decreased $3.3 million or 2.9% and $16.9 million or 4.7% during the three and nine months ended September 30, 2014, respectively, as compared to the same periods in 2013. The decrease was primarily from reduced volumes as a result of organic declines at existing clients and previously announced client losses, partially offset by higher electronic solutions and postal service solutions revenues. During the third quarter 2014, the Company signed a new Customer Communications client in North America which is anticipated to result in approximately 24 million packages on an annual basis once fully transitioned. During the third quarter, DST began processing new volumes for this client and will continue to transition additional applications throughout 2015. Customer Communications U.K. operating revenues increased $1.9 million or 4.2% and $5.6 million or 4.0% for the three and nine months ended September 30, 2014, respectively, as compared to the same periods in 2013 primarily due to the higher volumes from new and existing clients and favorable foreign currency exchange rates movement. Costs and expenses Customer Communications Segment costs and expenses (including OOP costs) were $296.2 million and $900.8 million for the three and nine months ended September 30, 2014, respectively, a decrease of $1.0 million or 0.3% and $22.2 million or 2.4% as compared to the same periods in 2013. Costs and expenses in the Customer Communications Segment are primarily comprised of reimbursable operating expenses (primarily postage and freight), compensation and benefits costs, material costs (principally paper and ink) and other operating costs. Excluding reimbursable operating expenses in 2014 and 2013, costs and expenses increased $3.5 million or 2.6% and decreased $4.8 million or 1.1% for the three and nine months ended September 30, 2014, respectively, to $137.6 million and $418.0 million, respectively. 38-------------------------------------------------------------------------------- Table of Contents Excluding OOP costs, Customer Communications North America costs and expenses decreased $1.4 million for the three months ended September 30, 2014, primarily from lower variable expenses as a result of reduced volumes and attainment of postal operating efficiencies, partially offset by higher employee termination costs. Excluding OOP costs, Customer Communications U.K.'s costs and expenses increased $4.9 million during the three months ended September 30, 2014, as compared to the same period in 2013, primarily due to increased variable costs associated with higher volumes and the reversal of approximately $2.5 million of lease obligation liabilities that were extinguished during the three months ended September 30, 2013 that did not recur in 2014. Excluding OOP costs, Customer Communications North America costs and expenses decreased $13.0 million for the nine months ended September 30, 2014, primarily from reduced costs associated with the operating revenue decline partially offset by higher employee termination costs. Excluding OOP costs, Customer Communications U.K.'s costs and expenses increased $8.2 million during the nine months ended September 30, 2014, as compared to the same period in 2013, primarily due to the impact of foreign currency exchange rates and higher operating costs to support the increased volume of work. Customer Communications North America continues to review its current cost structure in order to identify additional cost savings opportunities. In connection with these efforts, the Company is planning to close certain leased operating locations before the end of 2014 and transfer the operations to other operating locations. As result, the Company incurred $0.8 million of employee related restructuring charges during the third quarter and anticipate additional employee and facility related restructuring charges of approximately $3.5 million will be incurred during the fourth quarter of 2014. Depreciation and amortization Customer Communications Segment depreciation and amortization expense for the three and nine months ended September 30, 2014 was $9.5 million and $27.9 million, respectively, a decrease of $1.4 million or 12.8% and $4.8 million or 14.7% as compared to the same periods in 2013. Depreciation and amortization expense decreased $0.8 million and $3.4 million in North America and $0.6 million and $1.4 million in the U.K. during the three and nine months ended September 30, 2014, respectively, as compared to the three and nine months ended September 30, 2013, primarily due to lower capital expenditures. Income from operations Customer Communications Segment income from operations for the three and nine months ended September 30, 2014 decreased $3.5 million and $1.7 million, respectively, as compared to the same periods in 2013. During the three months ended September 30, 2014, Customer Communications North America income from operations decreased $1.1 million and Customer Communications U.K. income from operations decreased $2.4 million. During the nine months ended September 30, 2014, Customer Communications North America income from operations decreased $0.5 million and Customer Communications U.K. income from operations decreased $1.2 million. The decrease in Customer Communications North America is primarily due to lower revenues, partially offset by reduced operating costs. The decrease in Customer Communications U.K. income from operations is due to higher operating costs, partially offset by increased revenues and lower depreciation. INVESTMENTS AND OTHER SEGMENT The following table present the financial results of the Investments and Other Segment (in millions): Three Months Ended Nine Months Ended September 30, September 30, 2014 2013 2014 2013 Operating revenues $ 14.9 $ 14.6 $ 43.8 $ 43.3 Out-of-pocket reimbursements - 0.1 0.1 0.1 Total revenues 14.9 14.7 43.9 43.4 Costs and expenses 9.2 4.6 27.0 22.1 Depreciation and amortization 2.2 2.9 6.2 8.0 Income from operations $ 3.5 $ 7.2 $ 10.7 $ 13.3 Operating margin 23.5 % 49.3 % 24.4 % 30.7 % 39-------------------------------------------------------------------------------- Table of Contents Revenues Investments and Other Segment total revenues were $14.9 million and $43.9 million for the three and nine months ended September 30, 2014, respectively, an increase of $0.2 million or 1.4% and $0.5 million or 1.2% as compared to the same periods in 2013. The majority of the revenues in the Investments and Other Segment are derived from the lease of facilities to the Company's other business segments. Costs and expenses Occupancy costs are generally the largest costs included in costs and expenses in the Investments and Other Segment. For the three and nine months ended September 30, 2014, Investments and Other Segment costs and expenses were $9.2 million and $27.0 million, respectively, an increase of $4.6 million and $4.9 million as compared to the same periods in 2013. The increase in 2014 costs and expenses is primarily the result of a $3.8 million gain on the sale of real estate which reduced costs and expenses in third quarter 2013. Depreciation and amortization Investments and Other Segment depreciation and amortization expense for the three and nine months ended September 30, 2014 was $2.2 million and $6.2 million, respectively, a decrease of $0.7 million and $1.8 million as compared to the same periods in 2013, primarily attributable to real estate sold or held for sale. Income from operations Investments and Other Segment recorded income from operations of $3.5 million and $10.7 million during the three and nine months ended September 30, 2014, respectively, a decrease of $3.7 million and $2.6 million as compared to the same periods in 2013. The decrease in operating income for the three and nine months ended September 30, 2014 is primarily from the $3.8 million gain on the sale of real estate in third quarter 2013 and higher occupancy costs, partially offset by higher occupancy revenues and lower depreciation expense. The Company expects a decline in the Investments and Other Segment operating revenues beginning in the fourth quarter 2014 as a result of the sale of real estate assets that were occupied by third parties. The real estate sold during the third quarter 2014 represented approximately 40% of DST's wholly-owned U.S. real estate facilities occupied by third parties or vacant as of December 31, 2013 (excluding the underground storage facility). 40-------------------------------------------------------------------------------- Table of Contents USE OF NON-GAAP FINANCIAL INFORMATION In addition to reporting financial information on a GAAP basis, DST has disclosed non-GAAP financial information which has been reconciled to the corresponding GAAP measures in the following financial schedules titled "Reconciliation of Reported Results to Non-GAAP Results." In making these adjustments to determine the non-GAAP results, the Company takes into account the impact of items that are not necessarily ongoing in nature, that do not have a high level of predictability associated with them or that are non-operational in nature. Generally, these items include net gains on dispositions of business units, net gains (losses) associated with securities and other investments, restructuring and impairment costs and other similar items. Management believes the exclusion of these items provides a useful basis for evaluating performance of its business, but should not be considered in isolation and is not in accordance with, or a substitute for, evaluating business unit performance utilizing GAAP financial information. Management uses non-GAAP measures in its budgeting and forecasting processes and to further analyze its financial trends and "operational run-rate," as well as making financial comparisons to prior periods presented on a similar basis. The Company believes that providing such adjusted results allows investors and other users of DST's financial statements to better understand DST's comparative operating performance for the periods presented. DST's management uses each of these non-GAAP financial measures in its own evaluation of the Company's performance, particularly when comparing performance to past periods. DST's non-GAAP measures may differ from similar measures by other companies, even if similar terms are used to identify such measures. Although DST's management believes non-GAAP measures are useful in evaluating the performance of its business, DST acknowledges that items excluded from such measures may have a material impact on the Company's financial information calculated in accordance with GAAP. Therefore, management typically uses non-GAAP measures in conjunction with GAAP results. These factors should be considered when evaluating DST's results. DST SYSTEMS, INC. RECONCILIATION OF REPORTED RESULTS TO NON-GAAP RESULTS Three Months Ended September 30, (Unaudited - in millions, except per share amounts) 2014 Operating Operating Pretax Net Diluted Revenue Income Income Income EPS Reported GAAP results $ 510.5 $ 82.8 $ 144.1 $ 100.0 $ 2.51 Adjusted to remove: Employee termination expenses - Financial Services - 6.8 6.8 4.2 0.11 Employee termination expenses - Customer Communications - 0.8 0.8 0.5 0.01 Loss accrual reversal - Healthcare Services (1) - (4.0 ) (4.0 ) (4.7 ) (0.12 ) Net gain on securities and other investments (2) - - (55.4 ) (34.3 ) (0.86 ) Income tax items (6) - - - (4.5 ) (0.11 ) Adjusted Non-GAAP results $ 510.5 $ 86.4 $ 92.3 $ 61.2 $ 1.54 2013 Operating Operating Pretax Net Diluted Revenue Income Income Income EPS Reported GAAP results $ 480.2 $ 86.3 $ 155.1 $ 96.9 $ 2.23 Adjusted to remove: Employee termination expenses - Financial Services - 1.8 1.8 1.3 0.03 Net gain on sale of real estate - Investments & Other (7) - (3.8 ) (3.8 ) (2.4 ) (0.05 ) Settlement of leased facility obligation - Customer Communications (8) - (2.5 ) (2.5 ) (2.5 ) (0.06 ) Net gain on securities and other investments (2) - - (65.9 ) (40.8 ) (0.95 ) Net gain from unconsolidated affiliates (5) - - (1.7 ) 0.3 0.01 Adjusted Non-GAAP results $ 480.2 $ 81.8 $ 83.0 $ 52.8 $ 1.21 Note: See the "Description of Non-GAAP Adjustments" section for a description of certain adjustments and see the "Use of Non-GAAP Financial Information" section for management's reasons for providing non-GAAP financial information. 41-------------------------------------------------------------------------------- Table of Contents DST SYSTEMS, INC. RECONCILIATION OF REPORTED RESULTS TO NON-GAAP RESULTS Nine Months Ended September 30, (Unaudited - in millions, except per share amounts) 2014 Operating Operating Pretax Net Diluted Revenue Income Income Income EPS Reported GAAP results $ 1,525.3 $ 222.2 $ 509.7 $ 338.2 $ 8.22 Adjusted to remove: Employee termination expenses - Financial Services - 9.8 9.8 6.1 0.15 Employee termination expenses - Customer Communications - 1.1 1.1 0.7 0.02 Advisory and other transaction costs - Financial Services (3) - 5.6 5.6 3.5 0.09 Loss accrual reversal - Healthcare Services (1) - (4.0 ) (4.0 ) (4.7 ) (0.11 ) Gain on contract to repurchase common stock (4) - - (18.1 ) (18.1 ) (0.44 ) Net gain on securities and other investments (2) - - (254.8 ) (157.8 ) (3.84 ) Net gain from unconsolidated affiliates (5) - - (5.7 ) (3.6 ) (0.09 ) Income tax items (6) - - - (6.1 ) (0.15 ) Adjusted Non-GAAP results $ 1,525.3 $ 234.7 $ 243.6 $ 158.2 $ 3.85 2013 Operating Operating Pretax Net Diluted Revenue Income Income Income EPS Reported GAAP results $ 1,460.5 $ 233.6 $ 400.2 $ 268.6 $ 6.03 Adjusted to remove: Employee termination expenses - Financial Services - 3.5 3.5 2.4 0.05 Contract termination payment - Financial Services (6.0 ) (6.0 ) (6.0 ) (3.7 ) (0.08 ) Loss accrual - Healthcare Services (1) - 2.5 2.5 2.5 0.06 Net gain on sale of real estate - Investments & Other (7) - (3.8 ) (3.8 ) (2.4 ) (0.05 ) Settlement of leased facility obligation - Customer Communications (8) - (2.5 ) (2.5 ) (2.5 ) (0.06 ) Net gain on securities and other investments (2) - - (161.3 ) (99.9 ) (2.24 ) Net gain from unconsolidated affiliates (5) - - (7.4 ) (4.6 ) (0.10 ) Income tax items (6) - - - (16.3 ) (0.37 ) Adjusted Non-GAAP results $ 1,454.5 $ 227.3 $ 225.2 $ 144.1 $ 3.24 Note: See the "Description of Non-GAAP Adjustments" section for a description of certain adjustments and see the "Use of Non-GAAP Financial Information" section for management's reasons for providing non-GAAP financial information. Description of Non-GAAP Adjustments (1) Contingent loss accruals are recorded in the Condensed Consolidated Statement of Income within the Costs and expenses line item. An estimated loss accrual was recorded in 2011 for $3.5 million for a previously disclosed regulatory inquiry regarding the processing of certain pharmacy claims during the period 2006 to 2009 in the Healthcare Services Segment. In 2013, an incremental loss accrual of $2.5 million was recorded for this matter. This regulatory inquiry was resolved during third quarter 2014 for $2.0 million resulting in the reversal of $4.0 million previously accrued in excess of the settlement amount. Upon resolution of this matter, a tax benefit was recorded in third quarter 2014 as the majority of the settlement payment will be deductible for tax purposes. (2) Net gain on securities and other investments is comprised of net realized gains from sales of available-for-sale securities, other than temporary impairments on available-for-sale securities and net gains on private equity funds and other investments. These net gains were recorded in the Condensed Consolidated Statement of Income within the Other income, net line item. 42 -------------------------------------------------------------------------------- Table of Contents (3) Advisory and other transaction costs incurred in connection with a matter involving a significant shareholder are recorded in the Condensed Consolidated Statement of Income within the Costs and expenses line item. (4) DST recorded a gain of $18.1 million on the contract to repurchase 2.4 million shares of DST common stock resulting from the change in stock price between the date the share repurchase price became fixed and the settlement date. This gain was recorded in the Condensed Consolidated Statement of Income within the Other income, net line item. There is no income tax expense associated with this income as the gain is related to the repurchase of the Company's own stock. (5) The net gain from unconsolidated affiliates are included in the Condensed Consolidated Statement of Income within the Equity in earnings of unconsolidated affiliates line item. The net gain recorded in 2013 relates to the sale of an unconsolidated affiliate by IFDS ($6.3 million) and BFDS ($1.1 million). During the third quarter 2013, IFDS U.K. adjusted their estimated tax obligation related to the gain on sale which resulted in increased earnings at IFDS U.K., and a corresponding increase in income tax expense at DST. During 2014, the net gain from unconsolidated affiliates relates to the sale of DST's investment in an unconsolidated affiliate ($5.7 million). (6) Income tax items relate to benefits from historical domestic manufacturing deductions, research and experimentation credits and other similar items. These items are included in the Condensed Consolidated Statement of Income within the Income taxes line item. (7) Gains on sale of real estate assets are reflected net of impairments taken on the carrying value of real estate assets. The Company recorded impairment charges of $0.4 million during the three and nine months ended September 30, 2013 related to real estate not currently utilized in the Company's operations. The impairment charges are included in the Condensed Consolidated Statement of Income within the Depreciation and amortization expense line item. The gain on sale of real estate of $4.2 million during the three and nine months ended September 30, 2013 is included in the Condensed Consolidated Statement of Income within the Costs and expenses line item. (8) During 2012, the Company recorded a liability for the estimated leased facilities abandonment costs associated with properties not used in the U.K. Customer Communications operations. Subsequently in 2013, a lease obligation was extinguished resulting in the reversal of a portion of the remaining liability. Management's analysis of non-GAAP results for the three and nine months ended September 30, 2014 and 2013 Taking into account the items described in the tables above, adjusted non-GAAP diluted earnings per share was $1.54 and $1.21 for the three months ended September 30, 2014 and 2013, respectively, and $3.85 and $3.24 for the nine months ended September 30, 2014 and 2013, respectively. Management's discussion of the Company's "Results of Operations" in the sections above are applicable for these changes in non-GAAP diluted earnings per share, when adjusting for the items in the reconciliation tables above. In addition, the increase in non-GAAP diluted earnings per share for the three and nine months ended September 30, 2014 is attributable to lower weighted average diluted shares outstanding. Diluted earnings per share in future periods will be affected by any future share repurchases and the related timing of such repurchases. 43-------------------------------------------------------------------------------- Table of Contents LIQUIDITY AND CAPITAL RESOURCESCompany's assessment of short-term and long-term liquidity The Company believes that its existing cash balances and other current assets, together with cash provided by operating activities and, as necessary, the Company's revolving credit facilities, will suffice to meet the Company's operating and debt service requirements and other current liabilities for at least the next 12 months. Further, the Company believes that its short-term liquidity may be increased by monetizing available-for-sale securities owned by its domestic subsidiaries (which were $543.7 million at September 30, 2014) and other assets, and that its longer term liquidity and capital requirements will also be met through cash provided by operating activities, bank credit facilities and available-for-sale securities and other investments. At September 30, 2014, the Company had approximately $610.2 million of availability under its domestic revolving credit facilities. The Company renewed its $150.0 million accounts receivable securitization program and repaid its $125.0 million term loan facility during the nine months ended September 30, 2014. On October 1, 2014, the Company replaced its existing revolving credit facility which had a scheduled maturity date of July 1, 2015. The new $850.0 million revolving credit facility has a maturity date of October 1, 2019. Sources and uses of cash The Company had $87.5 million and $62.5 million of cash and cash equivalents at September 30, 2014 and December 31, 2013, respectively. The Company's primary source of liquidity has historically been cash provided by operations. In addition, the Company has used returns on the sale of investments to fund other investing and financing activities. Principal uses of cash are operations, reinvestment in the Company's proprietary technologies, capital expenditures, investment purchases, business acquisitions, payments on debt, stock repurchases and dividend payments. Information on the Company's consolidated cash flows for the nine months ended September 30, 2014 and 2013 is presented in the Condensed Consolidated Statement of Cash Flows, categorized by operating activities, investing activities, and financing activities. Operating activities Cash flows provided by operating activities were $223.8 million during the nine months ended September 30, 2014 compared to $333.9 million for the nine months ended September 30, 2013, a decrease of $110.1 million, primarily as a result of a $125.0 million dividend received from BFDS during 2013 that did not recur in 2014. Operating cash flows during 2014 resulted principally from net income of $338.2 million (including $33.2 million of dividend income from an investment in a private company), changes in working capital and adjustments for non-cash or non-operating items included in the determination of net income including net gains on investments of $198.2 million, an $18.1 million gain on the contract to repurchase common stock and depreciation and amortization expense of $97.5 million. Operating cash flows for the nine months ended September 30, 2014 were impacted by the following significant changes in working capital from 2013 to 2014: • Accounts receivable increased $10.0 million during the nine months ended September 30, 2014, as compared to a decrease of $34.9 million during the same period in 2013, a net decrease in working capital of $44.9 million. • Income taxes payable increased $27.0 million during 2014, as compared to a decrease of $7.3 million during 2013, primarily driven by the timing of tax payments on the prior year investment sales and higher operating results. Investing activities Cash flows provided by investing activities were $207.5 million during the nine months ended September 30, 2014 as compared to $286.7 million for the nine months ended September 30, 2013, a decrease of $79.2 million. The decrease is primarily attributable to fluctuations within funds held to satisfy client fund obligations, partially offset by higher proceeds from the sale of properties and lower investments in securities. 44-------------------------------------------------------------------------------- Table of Contents Capital expenditures The following table summarizes capital expenditures by segment (in millions): Nine Months Ended September 30, 2014 2013 Financial Services $ 52.1 $ 44.3 Healthcare Services 7.7 8.9 Customer Communications 24.2 18.6 Investments and Other 1.6 3.3 $ 85.6 $ 75.1 Future capital expenditures are expected to be funded primarily by cash flows from operating activities or draws from bank lines of credit, as required. Investments The Company purchased $56.7 million and $77.6 million of investments in available-for-sale securities and other investments during the nine months ended September 30, 2014 and 2013, respectively. During the nine months ended September 30, 2014, the Company received $292.8 million from the sale/maturities of investments as compared to $300.0 million during the nine months ended September 30, 2013. Financing activities Cash flows used in financing activities were $406.3 million during the nine months ended September 30, 2014 as compared to $579.0 million for the nine months ended September 30, 2013. The lower cash outflows in 2014 are primarily attributable to a $139.2 million decrease in net debt repayments (net debt repayments of $70.7 million in 2014 as compared to net debt repayments of $209.9 million in 2013) combined with lower cashflows on client fund obligations of $133.0 million, partially offset by higher repurchases of common stock of $93.1 million. Common stock issuances and repurchases On January 29, 2014, the Board of Directors of DST authorized a new $250.0 million share repurchase plan, which allows, but does not require, the repurchase of common stock in open market and private transactions. The Company repurchased approximately 1.0 million shares of DST common stock for $92.1 million during the nine months ended September 30, 2014, resulting in approximately $157.9 million remaining under the Company's existing share repurchase plan. The Company repurchased approximately 2.6 million shares of DST common stock for $181.8 million during the nine months ended September 30, 2013 under the previous share repurchase plan. As of March 23, 2014, the Argyros Group beneficially owned 9.2 million shares or 22% of DST common shares. During March 2014, DST entered into an agreement under which DST agreed to a two-step process to assist the Argyros Group with the disposition of a substantial portion of their common stock ownership in DST. To implement the Argyros Group's disposition, DST facilitated the May 2014 registered, secondary common stock offering of $450.0 million (before any overallotment option) of DST common stock beneficially owned by the Argyros Group. Concurrent with the closing of the secondary offering and based upon a price determined in the secondary offering, DST repurchased, and simultaneously retired, 2.4 million shares of its common stock from the Argyros Group for $200.0 million. In connection with this share repurchase, DST recorded a non-cash gain of $18.1 million during the nine months ended September 30, 2014 resulting from the change in stock price between the date the share repurchase price became fixed and the settlement date. The Company received cash proceeds of $10.3 million and $21.8 million from the issuance of common stock from the exercise of employee stock options during the nine months ended September 30, 2014 and 2013, respectively. The value of shares received in exchange for satisfaction of the exercise price and for tax-withholding obligations arising from the exercise of options to purchase the Company's stock or from the vesting of restricted shares are included in Common stock repurchased in the Condensed Consolidated Statement of Cash Flows. The amount of such share receipts and withholdings for option exercises and restricted stock vesting was $6.1 million and $23.3 million during the nine months ended September 30, 2014 and 2013, respectively. 45-------------------------------------------------------------------------------- Table of Contents Dividends For each quarter of 2014, the Board of Directors of DST has declared a quarterly cash dividend of $0.30 per common share. Total dividends for the nine months ended September 30, 2014 were $37.0 million, including cash dividends of $11.8 million paid in September 2014, $11.9 million paid in June 2014 and $12.6 million paid in March 2014. The remaining amount of the dividend represents dividend equivalent shares of restricted stock units in lieu of the cash dividend. On October 24, 2014, the Board of Directors declared a quarterly dividend of $0.30 per common share, payable December 12, 2014, to shareholders of record at the close of business on November 26, 2014. Client funds obligations Client funds obligations represent the Company's contractual obligations to remit funds to satisfy client pharmacy claim obligations and are recorded on the balance sheet when incurred, generally after a claim has been processed by the Company. In addition, client funds obligations include transfer agency client balances invested overnight. The Company had $340.9 million and $366.5 million of client funds obligations at September 30, 2014 and December 31, 2013, respectively. Debt activity The Company has used the following primary sources of financing: its syndicated revolving credit facility; subsidiary line of credit facilities; secured promissory notes; term loan credit facilities; accounts receivable securitization program; privately placed senior notes; and secured borrowings. The Company has also utilized bridge loans as necessary to augment the above sources of debt financing. The Company had $612.1 million and $683.0 million of debt outstanding at September 30, 2014 and December 31, 2013, respectively, a decrease of $70.9 million during the nine months ended September 30, 2014. On October 1, 2014, the Company replaced its existing revolving credit facility which had a scheduled maturity date of July 1, 2015. The new $850.0 million revolving credit facility has a maturity date of October 1, 2019. The Company's debt agreements contain customary restrictive covenants, including limitations on consolidated indebtedness, liens, investments, subsidiary indebtedness, asset dispositions and restricted payments (including stock repurchases and cash dividends), and requires certain consolidated leverage and interest coverage ratios to be maintained. The Company is currently in compliance with these covenants. The Company's debt arrangements are described in Note 7 to the consolidated financial statements included in Item 1 of this Quarterly Report on Form 10-Q. Guarantees The Company entered into an agreement to guarantee up to $8.0 million of a $38.5 million mortgage loan to a 50% owned real estate joint venture. The $38.5 million loan matures on September 30, 2018. At September 30, 2014 and December 31, 2013, total borrowings on the loan were $27.8 million and $28.3 million, respectively, of which the Company guaranteed $1.5 million at both September 30, 2014 and December 31, 2013, respectively. The Company has an agreement for a performance guarantee up to $5.0 million on a 20 year franchise agreement entered into by a 50% owned real estate joint venture. At September 30, 2014, the Company's liability recorded associated with the guarantee was $0.8 million. The Company's 50% owned joint ventures are generally governed by shareholder or partnership agreements. The agreements generally entitle the Company to elect one-half of the directors to the board in the case of corporations and to have 50% voting/managing interest in the case of partnerships. The agreements generally provide that a joint venture owner, if it desires to terminate the agreement, may establish a price payable in cash, or a promise to pay cash, for all of the other's ownership in the joint venture and submit a binding offer, in writing, to the other party to sell to the other party all of its ownership interests in the joint venture or to purchase all ownership interests owned by the other party at such offering price. The party receiving the offer generally has a specified period of time to either accept the offer to sell its interest, or to elect to purchase the offering party's interest, in either case at the established offering price. The Company cannot estimate the potential aggregate offering price that it could be required to receive for its interest in the case of a sale, or to pay for the other party's interest in the case of a purchase; however, the amount could be material. In addition to the guarantees entered into as mentioned above, the Company has also guaranteed certain obligations of certain joint ventures under service agreements entered into by the joint ventures and their customers. The amount of such obligations is not stated in the agreements. Depending on the negotiated terms of the guaranty and/or the underlying service agreement, 46-------------------------------------------------------------------------------- Table of Contents the Company's liability under the guaranty may be subject to time and materiality limitations, monetary caps and other conditions and defenses. In certain instances in which the Company licenses proprietary systems or third party systems to customers, the Company gives certain warranties and infringement indemnities to the licensee, the terms of which vary depending on the negotiated terms of each respective license agreement, but which generally warrant that such systems will perform in accordance with their specifications. The amount of such obligations is not stated in the license agreements. The Company's liability for breach of such warranties may be subject to time and materiality limitations, monetary caps and other conditions and defenses. The Company has also entered into indemnification agreements with its directors and executive officers and certain other officers. In addition, from time to time, the Company enters into agreements with unaffiliated parties containing indemnification provisions, the terms of which vary depending on the negotiated terms of each respective agreement. The amount of the Company's indemnification obligations is not stated in the agreements. The Company's liability under such indemnification agreements and provisions may be subject to time and materiality limitations, monetary caps and other conditions and defenses. The Company has entered into purchase and service agreements with its vendors, and consulting agreements with providers of consulting services to the Company, pursuant to which the Company has agreed to indemnify certain of such vendors and consultants, respectively, against third party claims arising from the Company's use of the vendor's product or the services of the vendor or consultant. In connection with the acquisition or disposition of subsidiaries, operating units and business assets by the Company, the Company has entered into agreements containing indemnification provisions, the terms of which vary depending on the negotiated terms of each respective agreement, but which are generally described as follows: (i) in connection with acquisitions made by the Company, the Company has agreed to indemnify the seller against third party claims made against the seller relating to the subject subsidiary, operating unit or asset and arising after the closing of the transaction, and (ii) in connection with dispositions made by the Company, the Company has agreed to indemnify the buyer against damages incurred by the buyer due to the buyer's reliance on representations and warranties relating to the subject subsidiary, operating unit or business assets in the disposition agreement if such representations or warranties were untrue when made, or due to any breach of the representations, warranties, agreements or covenants contained in the agreement. The Company has entered into agreements with certain third parties, including banks and escrow agents that provide software escrow, fiduciary and other services to the Company or to its benefit plans or customers. Under such agreements, the Company has agreed to indemnify such service providers for third party claims relating to the carrying out of their respective duties under such agreements. The Company has entered into agreements with lenders providing financing to the Company pursuant to which the Company agrees to indemnify such lenders for third party claims arising from or relating to such financings. In connection with real estate mortgage financing, the Company has entered into environmental indemnity agreements in which the Company has agreed to indemnify the lenders for any damage sustained by the lenders relating to any environmental contamination on the subject properties. In connection with the acquisition or disposition of real estate by the Company, the Company has entered into real estate contracts containing indemnification provisions, the terms of which vary depending on the negotiated terms of each respective contract, but which are generally described as follows: (i) in connection with acquisitions by the Company, the Company has agreed to indemnify the seller against third party claims made against the seller arising from the Company's on-site inspections, tests and investigations of the subject property made by the Company as part of its due diligence and against third party claims relating to the operations on the subject property after the closing of the transaction, and (ii) in connection with dispositions by the Company, the Company has agreed to indemnify the buyer for damages incurred by the buyer due to the buyer's reliance on representations and warranties relating to the subject property made by the Company in the real estate contract if such representations or warranties were untrue when made and against third party claims relating to operations on the subject property prior to the closing of the transaction. In connection with the leasing of real estate by the Company, as landlord and as tenant, the Company has entered into occupancy leases containing indemnification provisions, the terms of which vary depending on the negotiated terms of each respective lease, but which are generally described as follows: (i) in connection with leases in which the Company is the tenant, the Company has agreed to indemnify the landlord against third party claims relating to the Company's occupancy of the subject property, including claims arising from loss of life, bodily injury and/or damage to property thereon, and (ii) in connection with leases in which the Company is the landlord, the Company has agreed to indemnify the tenant against third 47-------------------------------------------------------------------------------- Table of Contents party claims to the extent occasioned wholly or in part by any negligent act or omission of the Company or arising from loss of life, bodily injury and/or damage to property in or upon any of the common areas or other areas under the Company's control. Except for the $0.8 million guarantee described above that has been accrued, at September 30, 2014 and December 31, 2013, in accordance with accounting and reporting guidance on guarantees, the Company had not accrued any liability on the aforementioned guarantees or indemnifications as they relate to future performance criteria or indirect guarantees of indebtedness of others. Off balance sheet obligations As of September 30, 2014, the Company had no material off balance sheet arrangements. |