The Company’s cash flow from operating activities totaled $72.2 million for the three months ended March 31, 2004. Operating cash flows primarily resulted from net income of $51.6 million, depreciation and amortization of $36.4 million partially offset by a decrease in accrued compensation and benefits of $26.4 million.
The Company has a cash management service for full service mutual fund transfer agency clients, whereby end of day available client bank balances are invested overnight by and in the name of the Company into credit-quality money market funds. All invested balances are returned to the full service mutual fund transfer agency client accounts the following business day. In the first quarter of 2004, the Company initiated a similar cash management service for a portion of its corporate securities processing transfer agency accounts. The Company had $406.2 million and $63.4 of transfer agency investments and deposits at March 31, 2004 and December 31, 2003, respectively. The Company will continue to evaluate implementation of this service for the remainder of its corporate securities processing transfer agency accounts and estimates that the balance may increase by approximately $300.0 million upon full implementation.
The Company collects from its clients and remits to the U.S. Postal Service a significant amount of postage. A significant number of contracts allow the Company to pre-bill and/or require deposits from its clients to mitigate the effect on cash flow.
Cash flows used in investing activities totaled $76.0 million for the three months ended March 31, 2004. The Company expended $39.9 million during the three months ended March 31, 2004 for capital additions, of which $28.4 million related to the Financial Services, Output Solutions and Customer Management Segments and $11.5 million related to the Investments and Other Segment, which primarily related to acquisitions of buildings and building improvements. The Company made $9.7 million of investments in available-for-sale securities and expended $13.9 million for advances to affiliates and other investments. During the three months ended March 31, 2004, the Company received $9.4 million from the sale and maturities of investments in available-for-sale securities and $2.5 million primarily from the sale of other investments.
On March 30, 2001, the Company completed the acquisition of a 75% interest in EquiServe, Inc. (“EquiServe”) by purchasing interests held by FleetBoston Financial (“FleetBoston”) and Bank One Corporation (“Bank One”). On July 31, 2001, the Company completed the acquisition of the remaining 25%, which was owned by Boston Financial Data Services, on essentially the same terms provided to FleetBoston and Bank One.
The EquiServe acquisitions were accounted for as a purchase and the results of EquiServe’s operations are included in the Company’s consolidated financial statements beginning March 30, 2001. The minimum purchase price of $186.7 million was paid in four installments. The minimum purchase price (discounted to $177.7 million for accounting purposes) has been allocated to the net assets acquired based upon their fair values as determined by a valuation. Three installment payments totaling $165.1 million were made through December 31, 2003. The final installment payment was $45.8 million and was paid in March 2004. The final purchase price installment increased pursuant to a formula that provided for additional consideration to be paid in cash if EquiServe’s revenues, as defined in the agreements, for the years ending 2000, 2001, 2002 and 2003 exceeded certain targeted levels. Goodwill was increased by $25.6 million, the amount of contingent consideration paid during the first quarter of 2004.
Cash flows used in financing activities totaled $3.6 million for the three months ended March 31, 2004. For the three months ended March 31, 2004, the Company repurchased $13.2 million of common stock. The Company had payments of $20.0 million for the three months ended March 31, 2004 on its long-term debt. Net borrowings totaled $13.8 million on the Company’s revolving credit facility, which brought the outstanding balance to $490.9 million at March 31, 2004.
The Company has approximately $62.5 million of scheduled debt payments due on or before March 31, 2005, however the Company has classified these amounts as long-term debt due to the Company’s ability and intent to refinance the debt under its existing line of credit agreements.
The Company’s prior stock repurchase program expired on February 29, 2004. On February 26, 2004, the Company’s Board of Directors authorized a new stock repurchase plan. The new plan allows (but does not require) the repurchase of up to 6 million shares of Company common stock in open market and private transactions during the period beginning March 1, 2004 through February 28, 2007.
During the three months ended March 31, 2004, the Company purchased 0.2 million shares of its common stock under this share repurchase program for $8.9 million. At March 31, 2004, the Company had 5.8 million shares remaining to be purchased under this program and had purchased 0.2 million shares since this program commenced.
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 bank and 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 longer term liquidity and capital requirements will also be met through cash provided by operating activities and bank credit facilities.
FIN 45
The Company has 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 on the underlying service agreement, 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 to customers, the Company gives certain indemnities (including infringement indemnities) and warranties to the licensee, the terms of which vary depending on the negotiated terms of each respective license agreement. Such warranties 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 obligations may be subject to time and materiality limitations, monetary caps and other conditions and defenses.
From time to time, the Company enters into service agreements and other agreements with unaffiliated parties containing indemnification provisions, the terms of which vary depending on the negotiated terms of each respective agreement. The amount of such obligations is not stated in the agreements. The Company’s liability under such indemnification provisions may be subject to time and materiality limitations, monetary caps and other conditions and defenses. Such indemnity obligations include those described herein.
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
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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 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.
At March 31, 2004, the Company had not accrued any liability on the aforementioned guarantees or indemnifications as they relate to future performance criteria or indirect indebtedness of others in accordance with FIN 45.
FIN 46
In December 2003, the FASB issued the revised Interpretation No. 46 (FIN 46), “Consolidation of Variable Interest Entities, an interpretation of ARB No. 51.” FIN 46 was effective immediately to variable interest entities created after January 31, 2003. It is effective March 31, 2004 to variable interest entities created prior to February 1, 2003. FIN 46 requires the consolidation of certain types of entities in which the Company absorbs a majority of another entity’s expected losses, receives a majority of the other entity’s expected residual returns, or both, as a result of ownership, contractual or other financial interests in the other entity. These entities are called “variable interest entities.” The principal characteristics of variable interest entities are (1) an insufficient amount of equity to absorb the entity’s expected losses, (2) equity owners as a group are not able to make decisions about the entity’s activities, or (3) equity that does not
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absorb the entity’s losses or receive the entity’s residual returns. “Variable interests” are contractual, ownership or other monetary interests in an entity that change with fluctuations in the entity’s net asset value. As a result, variable interest entities can arise from items such as joint ventures, lease agreements, loan arrangements, guarantees or service contracts.
If an entity is determined to be a “variable interest entity,” the “primary beneficiary” must consolidate the entity. The primary beneficiary is the holder of the variable interests that absorb a majority of the variable interest entity’s expected losses or receive a majority of the entity’s residual returns in the event no holder has a majority of the expected losses. There is no primary beneficiary in cases where no single holder absorbs the majority of the expected losses or receives a majority of the residual returns. The determination of the primary beneficiary is based on projected cash flows at the inception of the variable interests.
With regard to real estate, the Company is the lessee in a series of operating leases covering a large portion of its Kansas City based leased office facilities. The lessors are generally joint ventures (in which the Company has a 50% ownership) that have been established specifically to purchase, finance and engage in leasing activities with the joint venture partners and unrelated third parties. Two of the real estate joint ventures have entered into financing arrangements with the Company’s wholly owned captive insurance company. In each case, the other joint venture partner has guaranteed at least 50% of the joint venture’s borrowings ($39.1 million at March 31, 2004) from the Company’s captive insurance company. The Company is generally not the primary beneficiary of the joint ventures if the lease terms are consistent with market terms at the inception of the lease and do not include a residual value guarantee, fixed-price purchase options or similar features that disproportionately obligate it to absorb decreases in value or entitle it to participate in increases in the value of the real estate. The Company had one real estate joint venture and related lease entered into subsequent to January 31, 2003, that qualified as a variable interest entity due to the Company’s financing arrangement with the Company’s wholly owned captive insurance company. The Company has not consolidated the real estate joint venture upon application of FIN 46 because it is not the primary beneficiary based upon a cash flow analysis. The Company has finalized analyses of real estate joint ventures entered into prior to February 1, 2003 and determined that a large portion of the real estate joint ventures are variable interest entities but the real estate joint ventures will not need to be consolidated because the Company is not the primary beneficiary. The Company entered into two real estate joint ventures during the first quarter of 2004. The Company has determined that these ventures are not variable interest entities.
With regard to operating joint ventures, the Company has formed or entered into operating joint ventures to enter into or expand its presence in target markets. The Company has three significant operating joint ventures; BFDS; IFDS (includes IFDS U.K., IFDS Canada and International Financial Data Services , Luxembourg); and Argus Health Systems. Each of these operating joint ventures was formed prior to February 1, 2003. The Company has finalized its FIN 46 analyses of these operating joint ventures, and its assessment is that none qualify as variable interest entities due to meeting the criteria for the operating joint venture exception in FIN 46.
OTHER
Comprehensive income (loss). The Company’s comprehensive income (loss) totaled $37.8 million for the three months ended March 31, 2004, compared to a loss of $20.3 million for the three months ended March 31, 2003. Comprehensive income (loss) consists of net income of $51.6 million and other comprehensive loss of $13.8 million for the three months ended March 31, 2004, and net income of $51.4 million and other comprehensive losses of $71.7 million for the three months ended March 31, 2003, respectively. Other comprehensive income consists of unrealized gains (losses) on available-for-sale securities, net of deferred taxes, reclassifications for net gains included in net income and foreign currency translation adjustments. The principal difference between net income and comprehensive net income is the net change in unrealized gains (losses) on available-for-sale securities.
Other than temporary impairments. At March 31, 2004, the Company’s available-for-sale securities had unrealized losses of $0.9 million. If it is determined that a security’s net realizable value is other than temporary, a realized loss will be recognized in the statement of operations and the cost basis of the security reduced to its estimated fair value. The Company does not believe that the unrealized losses recorded at March 31, 2004 are other than temporary.
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The Company recognized investment impairments of $1.2 million and $4.3 million for the three months ended March 31, 2004 and 2003, respectively, which the Company believed were other than temporary. The impairments related primarily to investments available for sale in the Financial Services and Investment and Other Segments. A decline in a security’s net realizable value that is other than temporary is treated as a loss based on quoted market value and is reflected in the Other income, net line in the statement of income.
Seasonality. Generally, the Company does not have significant seasonal fluctuations in its business operations. Processing and output solutions volumes for mutual fund and corporate securities transfer processing customers are usually highest during the quarter 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.
Recently Issued Accounting Standards
At a recent meeting, the FASB unanimously voted for proposed accounting standards relating to equity-based compensation to be effective for fiscal periods beginning after December 15, 2004 (January 1, 2005 for the Company). An exposure draft was released in the first quarter of 2004 and the final standard is expected to be issued in 2004. The accounting standard is expected to require all companies to utilize the fair value method of accounting for equity-based compensation in accordance with SFAS No. 123, “Accounting for Stock-Based Compensation.” Companies can currently voluntarily adopt SFAS No. 123, using a variety of adoption methods. DST is currently evaluating the impact of the proposed accounting standards and the adoption alternatives provided under both the current standards and the proposed standards. DST discloses the pro forma impact of stock based compensation on its earnings in its notes to financial statements.
In December 2003, the FASB issued an exposure draft that would amend the computational guidance in SFAS No. 128, “Earnings per Share,” for calculating the number of incremental shares included in diluted shares when applying the treasury stock method. Also, this proposed Statement would eliminate the provisions of SFAS No. 128 that allow an entity to rebut the presumption that contracts with the option of settling in either cash or stock will be settled in stock. In addition, this proposed Statement would require that shares that will be issued upon conversion of a mandatorily convertible security be included in the weighted-average number of ordinary shares outstanding used in computing basic earnings per share from the date when conversion becomes mandatory. This Statement will be effective for fiscal periods beginning after December 15, 2004 (January 1, 2005 for the Company). After the effective date, all prior-period earnings per share data presented shall be adjusted retrospectively (including interim financial statements, summaries of earnings and selected financial data) to conform with the provisions of this Statement. At this time, DST does not believe any prior period adjustments will result from the exposure draft. If this Statement is finalized in its current form, DST will be required to include the shares from the convertible debentures as dilutive in its calculation of earnings per share.
Company-Specific Trends and Risks
Dependence on Certain Industries
The Company derives a substantial proportion of its consolidated revenues from the delivery of services and products to clients that are publicly traded corporations, mutual funds, investment managers, insurance companies, banks, brokers, or financial planners or are in the video/broadband, direct broadcast satellite, wire-line, wireless and cellular, debt protection, Internet protocol telephony, Internet, utility and other businesses. Consolidations which would decrease the number of potential clients in such businesses, events which would reduce the rate of growth in or negatively impact such businesses, or significant declines in the number of accounts or subscribers serviced by clients in such businesses could have a material adverse effect on the financial condition and results of operations of the Company.
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Development of Technology
The Company is implementing and enhancing (a) a new stock transfer system (“Fairway”) that will replace the existing systems used by its wholly-owned subsidiary EquiServe, Inc. to maintain corporate stock transfer records, and (b) a new subscriber management system (“Concorde”) that will replace the existing systems used by its wholly-owned subsidiaries DST Interactive, Inc. and DST Innovis, Inc. to maintain cable and satellite TV subscriber records. Failure to successfully complete Fairway or Concorde development and implementation, to successfully convert existing clients to such systems, or to successfully complete and implement various other current technology projects could have a material adverse effect on the financial condition and results of operations of the Company.
Impact of Technological and Market Changes
The Company’s clients use computer technology-based products and services in the complex and rapidly changing markets in which they operate. The technology available to the Company’s clients, such as methods for the electronic dissemination of documents, is expanding. The Company’s future success depends in part on its ability to continue to develop and adapt its technology, on a timely and cost effective basis, to meet clients’ needs and demands for the latest technology. There can be no assurance that the Company will be able to respond adequately and in advance of its competitors to these technological demands or that more advanced technology, including technology for the electronic dissemination of documents, will not reduce or replace the needs for certain of the Company’s products and services.
Similarly, certain of the Company’s clients provide services related to communications devices and/or the communications industry. The communications industry, and wireless communication devices in particular, are rapidly evolving. The future success of the Company’s business of providing administrative services to clients in the communications industry depends in part on the Company’s ability to continue to develop and adapt its services, on a timely and cost effective basis, to meet clients’ needs and demands for administrative services appropriate to the latest communications technology.
The Company has expended considerable funds to develop products to serve new and rapidly changing markets. If such markets grow or converge more slowly than anticipated or the Company’s products and services fail to achieve market acceptance, there could be a material adverse effect on the financial condition and results of operations of the Company.
The Company significantly invests in available-for-sale equity securities of other companies. The value of such securities depends on the market for such securities and on changes in the markets in which such other companies operate.
Reliance on Facilities
The Company’s processing services are primarily dependent on facilities housing central computer operations or in which information, image or bill and statement processing occur. The Company’s mutual fund full service, corporate stock transfer and insurance, warranty and debt protection administrative service businesses are dependent on call centers in various locations. The Company owns, leases and manages real estate. A natural disaster, terrorist act or other calamity that causes long-term damage to the Company’s facilities, or economic or other events impacting the real estate markets in which the Company owns, leases or manages real estate, could have a material adverse effect on the financial condition and results of operation of the Company.
Reliance on Insurers
Currently, the Company’s business of providing administrative services in connection with the insurance, warranty, and debt protection services of its clients significantly depends upon its business relationships with one or more insurance companies that provide coverage necessary for the clients’ products and services. Termination of the business relationships with such insurance companies could have a material adverse effect on the financial condition and results of operations of the Company if the Company were unable to arrange alternative sources of coverage.
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Importance of Key Personnel
The Company’s operations and the continuing implementation of its business strategy depend upon the efforts of its technical personnel and senior management. Recruiting and retaining capable personnel, particularly those with expertise in the types of computer hardware and software utilized by the Company, are vital to the Company’s success. There is substantial competition for qualified technical and management personnel, and there can be no assurance that the Company will be able to attract or keep the qualified personnel it requires. The loss of key personnel or the failure to hire qualified personnel could have a material adverse effect on the financial condition and results of operations of the Company.
Lack of Control of Joint Ventures
The Company’s business strategy for growth and expansion includes reliance on joint ventures. The Company derives part of its net income from its pro rata share in the earnings of these unconsolidated companies. Although the Company owns significant equity interests in such companies and has representation on their Boards of Directors or governance structures, the Company is not in a position to exercise control over their operations, strategies or financial decisions without the concurrence of its equity partners. The Company’s equity interests in Boston Financial Data Services, Inc. (“BFDS”), Argus Health Systems, Inc., and International Financial Data Services Limited Partnership and International Financial Data Services Limited (collectively, “IFDS”) are subject to contractual buy/sell arrangements that may restrict the Company’s ability to fully dispose of its interest in these companies and that under certain circumstances permit such companies to purchase the Company’s interest.
The other parties to the Company’s current and future joint venture arrangements may at any time have economic, business or legal interests or goals that are inconsistent with those of the joint venture or of the Company. In addition, if such other parties were unable to meet their economic or other obligations to such ventures, it could, depending upon the nature of such obligations, adversely affect the financial condition and results of operations of the Company.
Significant Competition from Other Providers
The Company and its subsidiaries and joint ventures encounter significant competition for the Company’s services and products from other third-party providers of similar services and products and from potential clients who have chosen not to outsource certain services the Company could provide. The Company’s ability to compete effectively depends, in part, on the availability of capital and other resources, and some of these competitors have greater resources and greater access to capital than the Company. The Company also competes for shareowner accounting services with brokerage firms that perform sub-accounting services for the brokerage firms’ customers who purchase or sell shares of mutual funds for which the Company serves as transfer agent. Such brokerage firms maintain only an “omnibus” account with the Company representing the aggregate number of shares of a mutual fund owned by the brokerage firms’ customers, thus resulting in fewer mutual fund shareowner accounts being maintained by the Company. Any of these events could have a material adverse effect on the financial condition and results of operations, including gross profit margins, of the Company. In addition, competitive factors could influence or alter the Company’s overall revenue mix between the various business segments.
Regulation
As registered transfer agents, the Company, its subsidiary EquiServe, its indirect subsidiary EquiServe Trust Company, N.A. (“EquiServe Trust”), its joint venture BFDS and BFDS’ subsidiary National Financial Data Services, Inc. (collectively, “Domestic Transfer Agent Businesses”) are subject to the Securities Exchange Act of 1934, as amended (the “Exchange Act”) and to the rules and regulations of the Securities and Exchange Commission (“SEC”) under the Exchange Act which require them to register with the SEC and which impose on them recordkeeping and reporting requirements. Certain of the operations and records of the Domestic Transfer Agent Businesses are subject to examination by the SEC and, as providers of services to financial institutions, to examination by bank and thrift regulatory agencies. In connection with its transfer agency business, EquiServe Trust serves as a limited purpose trust company subject to regulation of the Office of the Comptroller of the Currency. In addition, companies wholly owned by IFDS (“IFDS Transfer Agent Businesses”) are subject to regulation of similar regulatory agencies in other countries. Any of the Domestic Transfer Agent Businesses or IFDS Transfer Agent Businesses could have its
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regulatory authorizations suspended or revoked if it were to materially violate applicable regulations, which could have an adverse effect on the financial condition and results of operations of the Company.
Similarly, certain of the Company’s subsidiaries involved in the business of providing administrative services in connection with insurance and warranty products are licensed insurance agencies or licensed or registered service warranty providers and, as such, are subject to applicable state insurance and service warranty laws and to related rules and regulations. These laws and regulations impose on them recordkeeping, reporting, financial, and other requirements and generally regulate the conduct of regulated business operations. In the event any of the subsidiaries materially violate any of these applicable laws or regulations, their regulatory authorizations could be suspended or revoked, which could have a material adverse effect on the financial condition and results of operations of the Company.
The Company’s existing and potential clients are subject to extensive regulation. Certain of the Company’s customers are subject to federal and state regulation of investment advisors and broker/dealers. Certain of the Company’s clients are also subject to federal and state regulations governing the privacy and use of the customer information that is collected and managed by the Company’s products and services. Certain of the Company’s revenue opportunities may depend on continued deregulation in the worldwide communications industry. Regulatory changes that adversely affect the Company’s existing and potential clients, or material violation of regulatory requirements by clients, could diminish the business prospects of such clients. If such conditions were to materially, adversely affect the business of a material client or a material group of the Company’s clients, such conditions could have a material adverse effect on the financial condition and results of operations of the Company.
Interest Earnings as a Portion of Revenue
The Company’s transfer agent businesses derive a certain amount of service revenue from investment earnings related to cash balances maintained in transfer agency customer bank accounts. The balances maintained in the bank accounts are subject to fluctuation. A change in interest rates could have a material adverse effect on the financial condition and results of operations of the Company.
Anti-Takeover Considerations
Some provisions of the Company’s Certificate of Incorporation could make it more difficult for a third party to acquire control of the Company, even if the change of control would be beneficial to certain stockholders. The Company has also adopted a stockholders’ rights plan, which could delay, deter or prevent a change in control of the Company. A few of the Company’s client agreements allow the client to terminate its agreement or to obtain rights to use the Company’s software used in processing the client’s data in the event of an acquisition or change of control of the Company. In the event of a change in control of the Company (as defined in the applicable plan or agreement), vesting of awards (including stock options, restricted stock, and rights to receive stock as deferred compensation) under the Company’s Stock Option and Performance Award Plan will be automatically accelerated, certain limited rights related to stock options will become exercisable, and employment continuation provisions will apply under the employment agreements of certain executive officers. Certain of the Company’s joint venture agreements allow other parties to the joint venture to buy the Company’s joint venture interests in the event of a change of control of the Company.
Non-U.S. Operations
Consolidated revenues from the Company’s subsidiaries in Canada, Europe and elsewhere outside the U.S. account for a percentage of the Company’s revenues. The Company’s current and proposed international business activities are subject to certain inherent risks, including but not limited to, specific country, regional or global economic conditions, exchange rate fluctuation and its impact on liquidity, change in the national priorities of any given country, and cultural differences. There can be no assurance that such risks will not have a material adverse effect on the Company’s future international sales and, consequently, the Company’s financial condition and results of operations.
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Variability of Quarterly Operating Results
The Company’s quarterly and annual operating results may fluctuate from quarter to quarter and year to year depending on various factors, including but not limited to the impact of significant start-up costs associated with initiating the delivery of contracted services to new clients, the hiring of additional staff, new product development and other expenses, introduction of new products by competitors, pricing pressures, the evolving and unpredictable nature of the markets in which the Company’s products and services are sold, and general economic conditions.
Client Failure to Renew or Utilize Contracts
Substantially all of the Company’s revenue is derived from the sale of services or products under long-term contracts with its clients. The Company does not have the unilateral option to extend the terms of such contracts upon their expiration. Certain of the Company’s service agreements contain “termination for convenience” clauses that enable clients to cancel the agreements by providing written notice to the Company a specified number of days prior to the desired termination date. Such clauses are sometimes coupled with a requirement for payment by the client of a fee in the event of termination for convenience. The failure of clients to renew contracts, a reduction in usage by clients under any contracts or the cancellation of contracts could have a material adverse effect on the Company’s financial condition and results of operations.
Dependence on Proprietary Technology
The Company relies on a combination of patent, trade secret and copyright laws, nondisclosure agreements, and other contractual and technical measures to protect its proprietary technology. There can be no assurance that these provisions will be adequate to protect its proprietary rights. There can be no assurance that third parties will not assert infringement claims against the Company or the Company’s clients or that such claims, if brought, would not have a material adverse effect on the financial condition and results of operations of the Company.
Security of Proprietary Customer Information
The Company’s business involves the electronic recordkeeping of proprietary information of the Company’s customers, and of the clients of such customers. The Company maintains systems and procedures to protect against unauthorized access to such information and against computer viruses (“Security Systems”), and there is no guarantee that the Security Systems are adequate to protect against all security breaches. Rapid advances in technology make it impossible to anticipate or be prepared to address all potential security threats. A material breach of Security Systems could cause the Company’s customers to reconsider use of the Company’s services and products, affect the Company’s reputation, or otherwise have a material adverse effect on the Company’s financial condition and results of operations.
Potential Dilution of Company Common Stock
In August 2003, the Company issued $840 million aggregate principal amount of convertible senior debentures. The debentures are under specified circumstances convertible into shares of the Company’s common stock at a conversion rate of 20.3732 shares per $1,000 principal amount of debentures, subject to adjustment. Each series of debentures are convertible under any of the following circumstances: (1) during any calendar quarter (and only during such calendar quarter) if the closing price of the Company’s common stock, for at least 20 trading days during the period of 30 consecutive trading days ending on the last trading day of the previous calendar quarter, is greater than or equal to 120% of the applicable conversion price; (2) subject to certain exceptions, during the five business day period after any five consecutive trading-day period in which the trading price per $1,000 original principal amount of the applicable series of debentures for each day of that period was less than 95% of the product of the last reported sale price of the Company’s common stock and the conversion rate on each such day; (3) if the Company call the debentures for redemption; or (4) upon the occurrence of specified corporate transactions. Upon conversion, the Company will have the right to deliver, in lieu of shares of its common stock, cash or a combination of cash and shares of common stock. The debentures, if converted into common stock, would have a potentially dilutive effect on the Company’s common stock.
Under the Company’s Employee Stock Purchase Plan, employees have a right, subject to certain limits, to purchase Company common stock at 85% of the lower of the average market price of the stock on the exercise date or the
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offering date. Under the Company’s Stock Option and Performance Award Plan, the Company issues to directors and employees options to purchase shares of the Company’s common stock. Purchases under the Employee Stock Purchase Plan and exercises of options could have a potentially dilutive effect on the Company’s common stock.
A change of control under the Company’s stockholder’s rights plan would cause the issuance of rights to purchase 1/1000th shares of preferred stock of the Company for each share of Company common stock, or, in some circumstances, other securities of the Company, which could have a potentially dilutive effect on the Company’s common stock.
Miscellaneous
In addition to the factors noted above, there may be other factors that cause any forward-looking comment to become inaccurate. One such factor is litigation and claims involving the Company, including routine litigation and claims involving transfer agency operations in which the plaintiffs or claimants allege that errors or delays in transaction processing cause damages based on factors such as unfavorable changes in the market value of securities processed and including class action claims based upon various regulatory rules and consumer protection statutes with respect to which class action plaintiffs may attempt to assert private rights of action. Other factors include, but are not limited to, accounting or other fraud that may occur with respect to the financial statements or business of a financial service provider or other client of the Company; changes in management strategies; changes in lines of business or markets; failure of anticipated opportunities to materialize; changes in the cost of necessary supplies; and changes in the economic, political or regulatory environments in the United States and/or the other countries where the Company now competes or may compete in the future.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
In the operations of its businesses, the Company’s financial results can be affected by changes in equity pricing, interest rates and currency exchange rates. Changes in interest rates and exchange rates have not materially impacted the consolidated financial position, results of operations or cash flows of the Company. Changes in equity values of the Company’s investments have had a material effect on the Company’s comprehensive income and financial position.
Available-for-sale equity price risk
The Company’s investments in available-for-sale equity securities are subject to price risk. The fair value of the Company’s available-for-sale investments as of March 31, 2004 was $1.2 billion. The impact of a 10% change in fair value of these investments would be approximately $70.3 million to comprehensive income. As discussed under “Comprehensive income (loss)” above, net unrealized gains on the Company’s investments in available-for-sale securities have had a material effect on the Company’s comprehensive income and financial position.
Interest rate risk
The Company and certain of its joint ventures derive a certain amount of their service revenues from investment earnings related to cash balances maintained in transfer agency customer bank accounts that the Company is agent to. The balances maintained in the bank accounts are subject to fluctuation. At March 31, 2004, the Company and its joint ventures had approximately $1.9 billion of cash balances maintained in such accounts, of which $406.2 million is on the Company’s balance sheet. The Company estimates that a 50 basis point change in interest earnings rate would be approximately $4.4 million of net income (loss).
At March 31, 2004, the Company had $1,458.6 million of debt, of which $596.0 million was subject to variable interest rates (Federal Funds rates, LIBOR rates, Prime rates). The Company estimates that a 10% increase in interest rates would not be material to the Company’s consolidated pretax earnings or to the fair value of its debt.
Foreign currency exchange rate risk
The operation of the Company’s subsidiaries in international markets results in exposure to movements in currency exchange rates. The principal currencies involved are the British pound, Canadian dollar and Australian dollar. Currency exchange rate fluctuations have not historically materially affected the consolidated financial results of the
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Company. At March 31, 2004, the Company’s international subsidiaries had approximately $221 million in total assets and for the quarter ended March 31, 2004, these international subsidiaries produced approximately $5.0 million in net income. The Company estimates that a 10% change in exchange rates would increase or decrease the total assets by approximately $22 million and would increase or decrease net income by approximately $0.5 million.
The Company’s international subsidiaries use the local currency as the functional currency. The Company translates all assets and liabilities at year-end exchange rates and income and expense accounts at average rates during the year. While it is generally not the Company’s practice to enter into derivative contracts, from time to time the Company and its subsidiaries do utilize forward foreign currency exchange contracts to minimize the impact of currency movements.
Item 4. Controls and Procedures
As of the end of the fiscal quarter for which this quarterly report on Form 10-Q is filed, the Company’s Chief Executive Officer and Chief Financial Officer evaluated the effectiveness of the Company’s disclosure controls and procedures. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures (i) are effective for recording, processing, summarizing and reporting, within the time periods specified in the Securities and Exchange Commission’s rules and forms, the information required to be disclosed by the Company in reports that it files or submits under the Securities Exchange Act of 1934, and (ii) include controls and procedures designed to ensure that information required to be disclosed by the Company in such reports is accumulated and communicated to the Company’s management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. There has been no change in the Company’s internal control over financial reporting that occurred during the fiscal quarter for which this quarterly report on Form 10-Q is filed that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
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PART II. OTHER INFORMATION
Item 1. Legal Proceedings
The Company is from time to time a party to litigation arising in the ordinary course of its business. Currently, there are no legal proceedings that management believes would have a material adverse effect upon the consolidated results of operations or financial condition of the Company.
Item 2. Changes in Securities and Use of Proceeds
Stock repurchases. The following table sets forth information with respect to shares of Company common stock purchased by the Company during the quarter ended March 31, 2004.
Period | | Total Number
of Shares
Purchased | | Average Price
Paid Per Share | | Total Number of
Shares Purchased
as Part of
Publicly Announced
Plans or Programs | | Maximum Number of
Shares That May Yet
Be Purchased Under
the Plans or Programs |
| |
| |
| |
| |
|
January 1-January 31 | | 29,245(1) | | $42.88 | | 0 | | 2,223,172(2) |
February 1-February 29 | | 3,139(1) | | $42.81 | | 0 | | 2,223,172(2) |
March 1-March 31 | | 262,998(1) | | $44.74 | | 200,000 | | 5,800,000(3) |
(1) | For the quarter ended March 31, 2004, the Company purchased in open market transactions approximately 95,000 shares of its common stock related to employee stock option exercises. These purchases were not made under the publicly announced repurchase plans or programs. Of these shares, 29,245 shares were purchased in January, 3,139 shares were purchased in February and 62,998 shares were purchased in March. |
(2) | The Company’s prior stock repurchase program, which the Company announced on February 26, 2002, allowed the repurchase of up to 6 million shares of Company common stock in open market and private transactions, had 2.2 million shares available to be repurchased at the time the program expired on February 29, 2004. |
(3) | On February 26, 2004, the Company’s Board of Directors authorized a new stock repurchase plan. The new plan allows (but does not require) the repurchase of up to 6 million shares of Company common stock in open market and private transactions during the period beginning March 1, 2004 through February 28, 2007. |
Item 3. Defaults Upon Senior Securities
None.
Item 4. Submission of Matters to a Vote of Security Holders
None.
If a stockholder desires to have a proposal included in DST’s Proxy Statement for the annual meeting of stockholders to be held in 2005, the Corporate Secretary of DST must receive such proposal on or before December 1, 2004, and the proposal must comply with the applicable SEC laws and rules and the procedures set forth in the DST By-laws.
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Item 5. Other Information
The following table presents operating data for the Company’s operating business segments:
| | March 31,
2004 | | December 31,
2003 | |
| |
| |
| |
| | | | | |
Financial Services Operating Data | | | | | | | | |
Mutual fund shareowner accounts processed (millions) | | | | | | | | |
U.S. | | | | | | | | |
Non-retirement accounts | | | 55.2 | | | | 54.0 | | |
IRA mutual fund accounts | | | 24.2 | | | | 23.7 | | |
TRAC mutual fund accounts | | | 6.2 | | | | 6.1 | | |
Section 529 and Educational IRA’s | | | 4.5 | | | | 4.1 | | |
| | |
| | | |
| | |
| | | 90.1 | | | | 87.9 | | |
| | |
| | | |
| | |
| | | | | | | | | |
International | | | | | | | | | |
United Kingdom (1) | | | 4.8 | | | | 4.6 | | |
Canada (2) | | | 2.8 | | | | 2.7 | | |
| | | | | | | | | |
TRAC participants (millions) | | | 3.7 | | | | 3.5 | | |
Security transfer accounts processed (millions) | | | 22.1 | | | | 22.9 | | |
Automated Work Distributor workstations (thousands) | | | 88.1 | | | | 87.0 | | |
lock\line supported consumers (millions) | | | 21.4 | | | | 19.8 | | |
| | | | | | | | | |
Customer Management Operating Data | | | | | | | | | |
Video/broadband/satellite TV subscribers processed (millions) | | | | | | | | | |
U.S. | | | 30.5 | | | | 30.4 | | |
International | | | 6.7 | | | | 8.9 | | |
| | | | | | | | | |
| | For the Three Months
Ended March 31, | |
| | 2004 | | 2003 | |
| |
| |
| |
Output Solutions Operating Data | | | | | | | | | |
Images produced (millions) | | | 2,185 | | | | 2,289 | | |
Items mailed (millions) | | | 429 | | | | 447 | | |
| | | | | | | | | | |
(1) Processed by International Financial Data Services, (U.K.) Limited, an unconsolidated affiliate of the Company.
(2) Processed by International Financial Data Services, (Canada) Limited, an unconsolidated affiliate of the Company.
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Item 6. Exhibits and Reports on Form 8-K
(a) | Exhibits: |
| |
| 31.1 | Certification of Thomas A. McDonnell, Chief Executive Officer of Registrant |
| 31.2 | Certification of Kenneth V. Hager, Chief Financial Officer of Registrant |
| 32 | Certification Pursuant to 18 U.S.C. Section 1350 of Thomas A. McDonnell, Chief Executive Officer of Registrant and Kenneth V. Hager, Chief Financial Officer of Registrant |
| |
| Exhibit 32 shall not be deemed “filed” for the purposes of or otherwise subject to the liabilities under Section 18 of the Securities Exchange Act of 1934 and shall not be deemed to be incorporated by reference into the filings of the Company under the Securities Act of 1933. |
| |
(b) | Reports on Form 8-K: |
| |
| The Company furnished a Current Report on Form 8-K dated January 27, 2004, under Items 7 and 12 of such form, reporting the announcement of financial results for the fourth quarter ended December 31, 2003. |
| |
| The Company furnished a Current Report on Form 8-K dated February 27, 2004, under Items 7 and 9 of such form, reporting an announcement by the Company concerning a new share repurchase program. |
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, and in the capacities indicated, on May 7, 2004.
DST Systems, Inc. | |
| |
| |
/s/ Kenneth V. Hager | |
| |
Kenneth V. Hager
Vice President, Chief Financial Officer and Treasurer
(Principal Financial Officer) | |
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