Disclosure: I sold DST on Feb/5/2008
I used to love watching cop shows back in the 80’s, cop movies, or more recently Law and Order SVU. You know the scenes where the cop crosses the line by punching the suspect at the station, which is then followed up by the Captain ordering the cop to desk duty with the following quip, “You do that again Sonny and you’ll be pushing paper for the rest of your life!”. Pushing paper is hard work, it’s tedious, and record keeping is a pain. With Sarbanes-Oxley compliance riddling corporate America these days it can be a painstaking process. Businesses want to focus on what they do best to increase their competitive advantages and innovate. However, some people push paper very well and make a lot of money doing it. Which brings me to one of the companies in my ten grand portfolio, DST Systems Inc. They surfaced in one of my screens when I decided to give Joel Greenblatt’s magic formula system a test. One of Mr.Greenblatt’s formula criteria is to scan for companies with a high return on assets (ROA). DST Systems showed up in this screen, but their impressive ROA maybe a bit misleading for this test since I consider DST a service based company. Service based companies rely on their people to drive profits, and those employees are not booked as assets, which can skew the interpretation of ROA
What does DST Systems do?
The company started out in 1969 to develop automated record keeping systems for the mutual fund industry. They are pretty much the largest provider of outsourced shareholder recordkeeping services in the United States
1. Below is just a sample of some of their service offerings for the financial and healthcare industries (their main customers):
- Business Process Management
- Business Process Outsourcing
- Annuity and Mail processing for the Insurance Industry
- Integrated print and electronic communications solutions
- International Asset Management and & Portfolio Accounting
- U.S. Mutual Fund Shareholder Recordkeeping
That’s a lot of fancy words. Breaking this down, their strength is in managing a massive amount of records, moving them, storing them, printing them, and reporting them. The main customer segments in which they provide these services are the financial and healthcare industries. They do offer more services, but this company was hard to break down in terms of business services so I stuck to the main components of the business.
What is the business worth?
This is where things get a little interesting. This company was extremely hard to value because of the various forms of financing the company uses (the company doesn’t list out exact terms of its debt undertaken and provided only interest rate ranges. This makes it very hard to determine the company’s cost of capital). There was also a peculiar entry on the company’s income statement categorized under Revenues as “out of pocket reimbursements”. I had never seen this before and didn’t know what to make of it. These reimbursement revenues represent a substantial portion of the company’s revenues. Digging further into their annual report I came across the footnote explaining these revenues:
The Company’s significant Out-of-Pocket (“OOP”) expenditures include postage and
telecommunication costs which are reimbursed by the customer. OOP expenses are included in costs
and expenses.
So what this means is that all those forms that the company mails out via regular USPS postage and electronic communication are initially paid out by DST. However, the company in turn asks their customers (mutual fund companies for instance) to reimburse this cost back to them. In effect it is a zero sum game, unless the DST is boosting margins to cover this cost and then some. What is a cause for concern is that as we move into digital delivery these costs and revenues will not play a big factor as they do today (how many times has your brokerage or bank asked you to move to electronic statements via email?). In order to value this business going forward you would have to scale this down. The problem is the 10K and annual reports of the company don’t really break down the composition of this component under SG&A. This in turn makes it very hard to properly value the company.
I didn’t really have any solid ground at this point, so I decided to include these “out of pocket” items into Revenue and SG&A estimations going forward. I wish I could give a better reason than that.
The company initially looked relatively attractive with an extremely low P/E of 5.8x (ttm), return on assets of 28%, and steady good revenue growth based on my projections. There are a few problems with the criteria though:
- The company boosted its earnings this year through the sale of one of their business units (Asurion). This is a non-recurring event and threw off the P/E and ROA values by making them look better than they actually were
- I consider DST to be a service based company and running ROA on service based companies doesn’t really provide any value (employees can’t be booked as an asset on the balance sheet, although for service based company’s they are key to generating revenue growth).
It’s now time for my utter mistake including this position in my ten grand portfolio. Owning up to my mistakes is part of the deal, and learning from them all the more important into growing ten grand. The resulting cash flow analysis shows revenue growing at a nice steady rate, but free cash flow to the firm diverging. That is bad, very bad.
Based on my assumptions of 12% continuous annual growth for the next 5 years, tailing off to 5% from that point forward results in a value of approximately $15.47/share. I had acquired DST at $73.60. Ouch.
Lessons Learned
- Using any type of screen criteria is just that. A screen. You need to dig deep to find the details.
- Joel Greenblatt’s magic formula system can work against you if you don’t watch out for those gotchas. In any case, I’m still going to continue testing out his theory, just need to be a bit more careful.
- It looks like the asset sale of Asurion and their planned stock buyback is more of a move to pay down debt and keep the stock price stable, and not indicative of a fundamental change to improve the core aspect of their service business.
- I need to exit this position in the next couple of days. There are better values out there.
- I should bask in the glory of pushing paper as the police captain said. Push and wade through 10-Q’s and 10-K’s like there is no tomorrow.
References
1. DST Systems Inc. company profile, http://www.dstsystems.com/cp/cphm.html
What is the business worth?
This is where things get a little interesting. This company was extremely hard to value because of the various forms of financing the company uses (the company doesn’t list out exact terms of its debt undertaken and provided only interest rate ranges. This makes it very hard to determine the company’s cost of capital). There was also a peculiar entry on the company’s income statement categorized under Revenues as “out of pocket reimbursements”. I had never seen this before and didn’t know what to make of it. These reimbursement revenues represent a substantial portion of the company’s revenues. Digging further into their annual report I came across the footnote explaining these revenues:
The Company’s significant Out-of-Pocket (“OOP”) expenditures include postage and
telecommunication costs which are reimbursed by the customer. OOP expenses are included in costs
and expenses.
So what this means is that all those forms that the company mails out via regular USPS postage and electronic communication are initially paid out by DST. However, the company in turn asks their customers (mutual fund companies for instance) to reimburse this cost back to them. In effect it is a zero sum game, unless the DST is boosting margins to cover this cost and then some. What is a cause for concern is that as we move into digital delivery these costs and revenues will not play a big factor as they do today (how many times has your brokerage or bank asked you to move to electronic statements via email?). In order to value this business going forward you would have to scale this down. The problem is the 10K and annual reports of the company don’t really break down the composition of this component under SG&A. This in turn makes it very hard to properly value the company.
I didn’t really have any solid ground at this point, so I decided to include these “out of pocket” items into Revenue and SG&A estimations going forward. I wish I could give a better reason than that.
The company initially looked relatively attractive with an extremely low P/E of 5.8x (ttm), return on assets of 28%, and steady good revenue growth based on my projections. There are a few problems with the criteria though:
Based on my assumptions of 12% continuous annual growth for the next 5 years, tailing off to 5% from that point forward results in a value of approximately $15.47/share. I had acquired DST at $73.60. Ouch.
Lessons Learned
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