UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

 

FORM 10-Q

 

 For the quarterly period ended March 31,June 30, 2017

 

or

 

For the transition period from                          to                         

Commission File Number 1-14036

 

DST Systems, Inc.

 

 

DST Systems, Inc.

Form 10-Q

Table of Contents

 

 

The brand, service or product names or marks referred to in this Report are trademarks or service marks, registered or otherwise, of DST Systems, Inc. or its consolidated subsidiaries.

 

The accompanying notes are an integral part of these financial statements.

 

The accompanying notes are an integral part of these financial statements.

 

The Condensed Consolidated Financial Statements of DST Systems, Inc. and consolidated subsidiaries (“we,” “our,” “us,” the “Company” or “DST”) included herein have been prepared by the Company, without audit, pursuant to the rules and regulations of the United States Securities and Exchange Commission.  Certain information and note disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) have been condensed or omitted pursuant to such rules and regulations, although we believe that the disclosures are adequate to enable a reasonable understanding of the information presented. These Condensed Consolidated Financial Statements should be read in conjunction with our audited financial statements and the notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016.

 

In March 2017, we acquired State Street Corporation’s (“State Street”) ownership in both Boston Financial Data Services, Inc. (“BFDS”) and International Financial Data Services Limited (“IFDS U.K.”), which resulted in control of the entities. As such, they were consolidated in our financial results from the date control was obtained.

In addition, beginning in 2017, DST established a new reportable segment structure that separates the previously reported Financial Services segment into two new segments, Domestic Financial Services and International Financial Services, based upon the geographical location of the revenue-generating business. The activity within the previously reported Investments and Other segment has now been included in either the Domestic or International Financial Services segments based on the business supported. The Healthcare Services segment remains unchanged. The new segment presentation is reflective of how management is now operating the business and making resource allocations following the acquisitions of the remaining interests in IFDS U.K. and BFDS in the first quarter 2017, as well as the recent reductions in non-core investment assets resulting from monetizations and the use of State Street stock in the BFDS exchange transaction. The Company’s operating business units are now reported as three operating segments (Domestic Financial Services, International Financial Services and Healthcare Services).  Certain amounts in the 2016 financial statements have been reclassified to conform to the 2017 presentation and prior periods have been revised to reflect the new reportable operating segments.

In May 2017, our Board of Directors declared a two-for-one stock split of DST’s outstanding common stock effected in the form of a stock dividend, which was paid on June 8, 2017 to shareholders of record at the close of business on May 26, 2017.  In connection with the stock split, 16.5 million treasury shares were used to settle a portion of the distribution.  All share and per share data, excluding treasury shares, have been retroactively adjusted for all periods presented to reflect the stock split as if the stock split had occurred at the beginning of the earliest period presented.

In the opinion of management, the accompanying unaudited Condensed Consolidated Financial Statements contain all adjustments (consisting only of normal recurring adjustments) necessary to fairly state the consolidated financial position and the results of operations, comprehensive income, changes in stockholders’ equity and cash flows for the periods presented. The results of operations for the three and six months ended March 31,June 30, 2017 are not necessarily indicative of the results to be expected for the full year 2017.

Recently Adopted Accounting Pronouncements

 

In March 2016, the Financial Accounting Standards Board (“FASB”) issued guidance which simplifies several aspects of the accounting for employee share-based payment transactions, including the accounting for income taxes, forfeitures, and statutory tax withholding requirements, as well as classification of related amounts within the statement of cash flows. The guidance was adopted on January 1, 2017 and resulted in approximately $1.9$0.1 million and $2.0 million of excess tax benefits being recognized in Income taxes in the Condensed Consolidated Statement of Income for the three and six months ended March 31, 2017.June 30, 2017, respectively. We also elected to account for forfeitures as they occur rather than using an estimated forfeiture rate. The impact to our consolidated financial statements was not material.

Accounting Pronouncements Pending Adoption

In February 2016, the FASB issued guidance which requires lessees to reflect most leases on their balance sheet as assets and

In January 2016, the FASB issued guidance which updates the reporting model for certain financial instruments, including the

In May 2014, the FASB issued guidance which requires companies to recognize revenue to depict the transfer of promised

On March 27, 2017, we entered into a series of definitive agreements to acquire State Street’s equity interest in our BFDS joint venture, which provides shareholder recordkeeping, intermediary and investor services, and regulatory compliance solutions to financial services clients in the United States. We also acquired an investment in a privately-held company and the equity interest in IFDS Realty, LLC, which holds the real estate assets used in BFDS’ operations, through a distribution from International Financial Data Services L.P. (“IFDS L.P.”), our 50/50 joint venture with State Street.  The BFDS transaction, which closed on March 30, 2017, was structured as a non–taxable exchange under Section 355 of the Internal Revenue Code. At closing, DST delivered to State Street approximately 2.0 million shares of State Street common stock with a closing date fair value of $163.4 million (with a cost basis for tax purposes of approximately $1.1 million) in exchange for State Street’s equity interest in BFDS. The number of shares delivered at closing was calculated using the negotiated fair value of $157.6 million and the closing price of State Street'sStreet’s stock at signing. BFDS is included within the Domestic Financial Services segment.

The acquisition of State Street’s 50% equity interest in BFDS was accounted for as a step-acquisition. Accordingly, we remeasured our previously held non-controlling equity interest in BFDS to the estimated fair value of $151.1 million, resulting in a gain of $56.0 million recorded at the acquisition date, within Other income, net in the Condensed Consolidated Statement of Income.

The factors described above, combined with the synergies expected from combining our operations with the acquired entity and the resulting enhanced clarity in the service offerings available to our clients, are the basis for the acquisition price paid resulting in $68.5$68.7 million of goodwill recorded, none of which is expected to be deductible for tax purposes.

The transaction was accounted for using the acquisition method of accounting, and as such, assets acquired, liabilities assumed, and consideration transferred were recorded at their estimated fair values on the acquisition date. During the second quarter 2017, our initial purchase price allocation and estimate of fair value for certain intangible assets and related income tax effects were adjusted based on facts and circumstances existing at the acquisition date. Future adjustments to the purchase price allocation could be significant as valuations for tangible and intangible assets are finalized and associated income tax impacts are determined.

The following table summarizes the aggregate acquisition-date fair value of the consideration transferred for the acquisition of BFDS and the amounts recognized as of the acquisition date for the assets acquired and liabilities assumed (in millions):

The following table summarizes the intangible assets acquired and estimated weighted-average useful lives as of the acquisition date (in millions):

The operating results of BFDS were combined with our operating results subsequent to the acquisition date. Approximately $1.4$75.4 million and $76.8 million of revenues and $0.3$1.6 million netand $1.9 million of pretax income of the acquired business is included in the Condensed Consolidated Statement of Income for the three and six months ended March 31, 2017.

On March 27, 2017, we acquired State Street’s ownership of our IFDS U.K. joint venture, an investor and policy holder administrative services and technology provider to the collective funds, insurance, and retirement industries, for $141.0 million. Additionally, we acquired from our IFDS L.P. joint venture both the equity interest in IFDS Realty U.K. LLC (“IFDS Realty U.K.”), which holds certain real estate utilized by the U.K. business, and the equity interest in IFDS Percana Group Ltd. (“IFDS Percana”) for total cash consideration of $68.0 million. As a result of DST’s 50% ownership in IFDS L.P., approximately half of the cash consideration DST paid to IFDS L.P. was distributed to DST in the form of a distribution, resulting in net cash paid for the acquisition, after cash distributions of approximately $175.0 million. The acquisition was funded through cash on hand and our existing debt facilities. In addition, concurrent with the acquisition of the remaining interests in IFDS U.K., we also purchased State Street’s notes receivable from IFDS U.K. for cash consideration of $25.9 million, which approximated the fair value of the note at the acquisition date. We will continue to service offshore and cross-border markets in Canada, Ireland and Luxembourg through IFDS L.P., our 50/50 joint venture with State Street. IFDS U.K., IFDS Realty U.K. and IFDS Percana are included within the International Financial Services segment.

The acquisition of State Street’s 50% equity interest in IFDS U.K. was accounted for as a step-acquisition. Accordingly, we remeasured our previously held non-controlling equity interest in IFDS U.K. to the estimated fair value of $136.8 million, resulting in a loss of $12.5$12.2 million at the acquisition date, which is included in Other income, net in the Condensed Consolidated Statement of Income.

The factors described above, combined with the benefits expected from the opportunities for enhanced efficiencies in our delivery model, are the basis for the acquisition price paid resulting in $197.9$195.9 million of goodwill recorded, of which $23.0$18.9 million is expected to be deductible for tax purposes.

The transaction was accounted for using the acquisition method of accounting, and as such, assets acquired, liabilities assumed, and consideration transferred were recorded at their estimated fair values on the acquisition date. During the second quarter 2017, our initial purchase price allocation and estimate of fair value for certain intangible assets and related income tax effects were adjusted based on facts and circumstances existing at the acquisition date. Future adjustments to the purchase price allocation could be significant as valuations for certain tangible andassets, intangible assets and contingent liabilities are finalized and associated income tax impacts are determined.

The following table summarizes the aggregate acquisition-date fair value of the consideration transferred for the acquisition of the remaining interests in IFDS U.K. and the amounts recognized as of the acquisition date for the assets acquired and liabilities assumed (in millions):

The following table summarizes the intangible assets acquired and estimated weighted-average useful lives as of the acquisition date (in millions):

The operating results of IFDS U.K. were combined with our operating results subsequent to the acquisition date. Approximately $6.0$200.2 million and $206.2 million of revenues and $0.1$60.8 million netand $60.7 million of pretax lossincome of the acquired business is included in the Condensed Consolidated Statement of Income for the three and six months ended March 31, 2017.June 30, 2017, respectively.

The following table summarizes the unaudited pro forma results of operations for the three and six months ended March 31,June 30, 2017 and 2016 as if the BFDS and IFDS U.K. acquisitions had occurred on January 1, 2016 (in millions, except per share amounts):

The pro forma financial information adjusts the actual combined results for items that are recurring in nature and directly attributable to the acquisitions of the remaining interests in BFDS and IFDS U.K., including intangible asset amortization and fair value adjustments for property, plant and equipment, deferred revenue and other transaction related items. Pro forma financial information for the threeThe six months ended March 31, 2017 and 2016 include adjustments for intangible asset amortization of $3.9 million and fair value adjustments for deferred revenue of $7.4 million. The financial information also is adjusted for the increase in Costs and expenses resulting from changes in fixed asset policies of $18.4 million and $23.8 million and the exclusion of acquisition related costs of $1.5 million and $0.8 million, for the three months ended March 31, 2017 and 2016, respectively. Additionally, the three months ended March 31,June 30, 2017 pro forma information was reduced by the net gains resulting from the transaction of $188.6 million and the related tax impacts.million. The unaudited pro forma amounts have been prepared based on estimates and assumptions, which we believe are reasonable, and are not indicative of what actual consolidated results of operations might have been if the acquisitions had been effective at the beginning of 2016, nor is it reflective of our expected actual results of operations for any future period.

We incurred approximately $5.1 million of pre-taxpretax costs from 2015 through the firstsecond quarter 2017 in connection with our acquisitions of the remaining interests in BFDS and IFDS U.K., which are included in Costs and expenses in our Condensed Consolidated Statement of Income.

In April 2017, we signed an amendment to completionan existing servicing agreement which extends in excess of the acquisitions, in May 2017,ten years with one of IFDS U.K.’s existing wealth management platform clients, which we were in the processclients. As part of completing a multi-year development and implementation effort for, terminated for convenience certain of its servicing agreements with us. We are currently evaluating the financial effect this termination will have on our future operating results. The pro forma information provided above is based on actual results for the periods presented and, accordingly, has not been adjusted to reflect the impact of the customer termination. Additionally, in April 2017amendment, we made an up-front payment of approximately $37.5£30.0 million to one of IFDS U.K.'s clients in connection with the signing of an amendment toclient during the existing servicing agreement.second quarter 2017. We also agreed to pay them an additional $37.5£30.0 million during the fourth quarter of 2017. These payments are expected to be recovered over the term of the revised contractual arrangement.

On July 1, 2016, pursuant to the Purchase Agreement dated June 14, 2016, we completed the sale of our North American Customer Communications business for cash consideration of $410.7 million after giving effect to a $0.7 million adjustment

agreed upon in December 2016 to settle working capital and other matters under the terms of the agreement. We recorded a pretax gain of $341.5 million on the sale during 2016, which has been presented as a component of discontinued operations.2016. Additionally, on May 4, 2017, we completed the sale of our United Kingdom Customer Communications business for cash consideration of approximately $43.9 million, subject to customary post-closing working capital adjustments. We recorded a pretax gain of $2.9 million on the sale during the second quarter 2017. We have classified the results of the two businesses sold as well as the gain realized upon sale as discontinued operations in our Condensed Consolidated Statement of Income and Statement of Cash Flows for all periods presented. Additionally, the related assets and liabilities associated with theour discontinued operations arewere classified as held for sale in our Condensed Consolidated Balance Sheet.Sheet at December 31, 2016 prior to the sale of our United Kingdom Customer Communications business.

Pursuant to the terms of the North American transaction, we will continue to provide certain information technology and operations processing activities to the North American Customer Communications business for an estimated period of 12up to 18 months from the transaction date. Additionally, we will continue to incur costs for certain print-related services provided by the disposed business for an estimated period of 3 to 5 years following the transaction. The information technology and operations processing activities we performed after the sale of the business resulted in approximately $7.6$4.9 million and $12.5 million of continuing cash inflows from the business sold and the costs incurred for certain print relatedprint-related services provided by the business sold resulted in continuing cash outflows of approximately $9.4$14.3 million and $23.7 million for the three and six months ended March 31,June 30, 2017.

The revenues previously eliminated in consolidation that have continued post-transaction were approximately $7.1$7.4 million and $14.5 million for the three and six months ended March 31,June 30, 2017, respectively, as compared to $4.1$4.0 million and $8.1 million for the three and six months ended March 31, 2016.June 30, 2016, respectively. The expenses previously eliminated in consolidation that have continued post-transaction were approximately $15.3$13.4 million and $28.7 million for the three and six months ended March 31,June 30, 2017, respectively, as compared to $5.5$3.0 million and $8.5 million for the three and six months ended March 31, 2016.June 30, 2016, respectively. The revenues and expenses associated with these continued activities have been classified within continuing operations for all periods presented. The offsetting costs and revenues previously recorded within Customer Communications and eliminated in consolidation have been reclassified to discontinued operations for all periods presented.

As of June 30, 2017, all assets and liabilities previously classified as held for sale in our Condensed Consolidated Balance Sheet had been sold. The following table summarizes the assets and liabilities classified as held for sale in our Condensed Consolidated Balance Sheet (in millions):

The following table summarizes the comparative financial results of discontinued operations which are presented as Income from discontinued operations, net of tax on our Condensed Consolidated Statement of Income (in millions):

In April 2016, we completed the sale of our United Kingdom Customer Communications’ Bristol production facilities for pretax proceeds totaling approximately $16.0 million. Concurrent with this sale, we leased back approximately two-thirds of the facilities under a 12-year lease. The rent payments and associated rent expense of the Bristol production facilities arewere approximately $0.7 million per year over the 12-year lease term. This lease obligation was sold in conjunction with our sale of the United Kingdom Customer Communications business on May 4, 2017.

 

Investments are as follows (in millions): 

 

 

We consolidate the investments of open-end funds in which we own a controlling interest as a result of our seed capital investments. At December 31, 2016, we had a controlling interest in seed capital investments of $53.6 million which was comprised primarily of equity securities as well as $8.4 million of cash collateral deposited with a broker for securities sold short. In March 2017, we reduced our ownership interest in a substantial portion of our seed capital investments, resulting in the deconsolidation of the respective fund. We held non-controlling interests in certain seed capital investments of $27.5$11.4 million and $7.4 million at March 31,June 30, 2017 and December 31, 2016, respectively. At December 31, 2016, our controlling interest in seed capital investments of $53.6 million was comprised primarily of equity securities as well as $8.4 million of cash collateral deposited with a broker for securities sold short.

Our investments in private equity funds meet the definition of a variable interest entity (“VIE”); however, the private equity fund investments were not consolidated as we do not have the power to direct the entities’ most significant economic activities. The maximum risk of loss related to our private equity fund investments is limited to the carrying value of our investments in the entities plus any future capital commitments. At March 31,June 30, 2017 and December 31, 2016, our maximum risk of loss associated with these VIE’s, which is comprised of our investment and required future capital commitments, was $108.1$107.4 million and $115.0 million, respectively. 

 

Investments in unconsolidated affiliates are as follows (in millions):

(1) DST’s ownership percentage in IFDS U.K. and BFDS was 50% prior to the respective acquisitions in March 2017, at which time the businesses became wholly-owned subsidiaries.

 

In connection with the acquisitions of the remaining interests in BFDS and IFDS U.K,U.K., as well as the receipt of IFDS L.P.’s distributions of real estate and its investment in IFDS Percana during March 2017, the corresponding investments in unconsolidated affiliates balances were reduced. Additionally, in connection with the acquisitions, DST also effectively settled IFDS U.K.’s note payables to State Street by acquiring State Street’s outstanding note receivables due from IFDS U.K., which is considered part of the total cash paid to acquire State Street’s equity interests in IFDS U.K. See Note 2, Significant Business Acquisitions,Transactions, for further details.

  

 

Authoritative accounting guidance on fair value measurements establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value.  These tiers include: Level 1, defined as observable inputs such as quoted prices in active markets; Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions.

 

 

At March 31,June 30, 2017 and December 31, 2016, we held approximately $7.6 million and $11.5 million, respectively, of investments in pooled funds, which are measured using net asset value as a practical expedient for fair value and therefore excluded from the tabletables above. The investments in pooled funds are included within the $152.8$152.6 million and $128.0 million of cost method and other investments at March 31,June 30, 2017 and December 31, 2016, respectively, disclosed within Note 4, Investments.

 

Intangible assets