Federated Hermes Inc (FHI) 2002 Q3 法說會逐字稿

Good morning. My name is Laura (ph), and I will be your conference facilitator today. At this time I'd like to welcome everyone to the Federated Investors third quarter earnings conference call. All lines have been placed on mute to prevent background noise.

After the speakers' remarks, there will be a question and answer period. If you would like to ask a question during this time, simply press star, then the number one on your telephone keypad. If you would like to withdraw your question, press the pound key.

Thank you. Mr. Hanley, you may begin your conference.

Thank you and good morning. Today we have about a 20-minute presentation, and then we'll get to your questions.

Leading today's call will be Chris Donahue, Federate's CEO; Tom Donahue, CFO; Dennis McAuley (ph) and Rich Novak (ph) from the corporate finance group are here as well.

By way of Safe Harbor, let me say that this discussion will include forward-looking statements and that actual results could vary materially. For discussion of the factors which could cause actual results to vary from these forward-looking statements, see the section titled risk factors in the company's registration statement on annual report Form 10-K for the year-ended December 31, 2001 on file with the Securities and Exchange Commission.

With that, I'll turn it over to Chris.

Thank you, Ray. Good morning, and welcome to our fellow shareholders, analysts, media representatives who have joined us today to discuss the third quarter results.

Q3 presented a challenging operating environment for investment managers. This is not news to you. Against the backdrop of difficult market conditions, Federated once again has demonstrated the value of its varied business mix. Gross and net sales of Bond Fund products were strong. Average money market fund assets -- excuse me -- exceeded the prior quarter's average, and we continued to add new accounts in this area. Despite a tough equity market, we had a number of bright spots which I'll comment on in a moment.

Now, taking a look at each asset class in more detail, let's begin with money markets. Money market average assets in both mutual funds and separate accounts increased by about 1.5 billion compared to the prior quarter. Focusing on money market mutual funds, we entered the quarter managing 128 billion. We averaged 135 billion during the quarter and ended the quarter at 126 billion. Money market mutual fund assets have increased to 130 billion as of October 21st.

Federated's money market assets continue to fluctuate, reflecting the underlying customer's use of these products for large-scale cash management. With September being a corporate tax payment month, fluctuations tended to be more pronounced. In addition to tax payments, some corporate customers have tended to withdraw funds at the end of the month and then replace these funds early in the following quarter. And at the end of the quarter, there were rate anomalies that affected some overnight activities.

For example, our clients in the institutional corporate market began Q3 with $16 billion with us. These people averaged 21 billion during the quarter and ended with 18 billion. By the end of last week, these assets were back to 21 billion to begin another cycle of building up and drawing out cash.

We also see this cycle in our large bank customers who have an institutional client base. In our bank capital markets group, part of our bank trust channel, our clients entered Q3 with 20 billion in money fund assets, averaged 21 billion, and ended the quarter at 18 billion before rebounding to nearly 20 billion last week. Since these fluctuations have tended to be short-lived, we tend to want to look at the average asset levels as an important indicator.

Our outlook remains positive for our cash management business. Because of the nature of Federated's client base, cash management is as much a service as it is an investment product. Over the last 25 years, we have successfully pioneered the use of money funds into new applications and continue to do so today. And we continue to have success in expanding our customer relationships, and we'll give you the numbers on that in a second.

We believe that the overall market for cash management is enormous, and that our position for growth in this business is very strong. According to the Federal Reserve, there's about 8.3 trillion in M3 (ph). That's where they consider and count all of the various money market funds.

Since 1994, when we began to actively pursue corporations and other non-bank institutional customers for cash management, our money market fund assets as a percentage of M3 (ph) has more than doubled from 0.7% to 1.6%. We expect to continue to be successful in increasing our share of the broad market for cash management by continuing to broaden and deepen our extensive customer relationships, by continuing to find new applications for money fund products, by expanding our separate account cash management as we've done with Textpool and others, and by looking for opportunities to consolidate business to leverage our scale advantage.

Turning to the fixed income side. Asset growth remains strong at 9% during this quarter, and 27% over the last 12 months. Gross and net Bond Fund sales accelerated from already strong levels. Government mortgage back and municipal Bond Funds drove the increases in sales and flows. Short duration products continue to attract the attention of investors looking to extend out the curve for higher yields.

Our Capital Preservation Fund, which invests largely in (inaudible), also produced strong net and gross sales. Sales of Federated's total return Bond Fund grew by about 50% from the prior quarter, and net sales were about three times greater than Q2.

Taking a look at the equity, third quarter equity fund gross and net sales decreased from Q2 as continued equity market volatility took its toll. For the quarter, equity fund net sales were minus 224 million. Another 177 million transferred from a Federated equity fund to a Federated fixed income fund. Most of the outflow took place in July. August net outflows declined significantly, and net sales were positive in September.

In terms of the participants, our capital appreciation blend fund, Federated Kaufmann Fund, and market opportunity mid-cap value fund were the leaders in equity fund sales. All three have produced strong relative performance and had positive net sales during each month of the quarter.

Now, through the first three weeks of October, Bond Fund flows are down from Q3's pace, while equity fund flows are slightly negative. Once again, we caution against drawing conclusions from -- you know, for the quarter from this early data.

Turning to investment performance -- among the funds rated by Morningstar, our percentage of assets and equity funds rated four or five stars increased slightly from 40% to 42% from Q2 and our percentage of three, four, and five star rated assets increased from 73% to 83%. On the fixed income side, four and five star rated assets decreased slightly from 29 to 27, while assets in funds rated three, four or five remained at 65%.

During the third quarter, we announced a new global structure for investment management under the leadership of Kim Schappert. The goal is to further refine the Federated investment process to deliver strong performance based on proprietary research and quantitative analysis. To this end, we are elevating the research analysts' function to have an eye-to-eye view with portfolio managers. In this regard, the analysts' function develops its own career path in addition to operating as a potential feeder system for portfolio management.

We recently announced the filling of two key posts, James Gordon (ph) as director of quantitative analysis and Chris Karappi (ph) as head of equity research. With these steps, we are putting in place the building blocks to take our already strong research effort to a higher level.

Let's talk a little about distribution. In the trust channel, we are seeing outstanding results from our efforts to extend our relationships and broaden the bank's use of our stock and Bond Fund products. Equity fund sales in this market are up 11% year to date, with Q3 sales up 12% from Q3 in '01. Bond Fund sales through the end of Q3 are 37% higher than the full-year '01.

In the broker/dealer market, equity fund sales decreased from the prior quarter, but have increased 15% year to date from 2001. Bond Fund sales, as you might suspect, are up 41% year to date. We're having increased success among bank/broker dealers this year with long-term fund sales already about 20% higher than the full 2001 total.

We have launched our new Retirement Ally (ph) variable annuity product with Nationwide Financial. We're focusing on increasing our distribution of this product with major variable annuity sellers and expect to raise significant new retirement assets with this product over the next several years.

In the Jones network, we launched the new variable annuity product in late July and saw August and September sales increase in a difficult variable annuity sales environment. In the Jones System, our top-selling products recently have been the equity funds. The top three funds in August and September were the American Leaders large cap value, Market Opportunity mid-cap value and the Capital Appreciation Blend fund. Our sales there continue to run at about 4% market share inside that system.

We continue to grow our customer base for cash management. We received funding from an Illinois government entity to manage $400 million cash separate account this month in partnership with a client adviser firm. The timing of our mandate to manage cash from the state of Florida defined contribution program has been pushed back, as the education effort for the state employees is continuing. We expect that any funding this year will be relatively low, but we expect to see more meaningful flows next year as the plan gets rolled out.

We continue to grow our corporate and public entity institutional cash management account business, with 11 accounts bringing 625 million in Q3. This brings total new accounts in this area to 36 year-to-date.

We continue to have success from the CFTC-related customers, with assets averaging about 1.8 billion during Q3, up from about 1.5 billion at the end of Q2. In the investment adviser segment, we are developing new distribution opportunities and expanding the use of our products in existing relationships. For example, during the third quarter, a large Midwestern investment adviser selected the Market Opportunity mid-cap value fund for a $50 million retirement product application.

Beginning October 1st, working with BB&T, our Capital Appreciation Fund was added to the state of North Carolina's 401(k) program. This program has 175,000 participants, over 2 billion in assets, and we are one of only three equity products inside that system.

We're also having success with our Capital Appreciation Fund in the insurance channel. We mentioned last quarter that, when we entered into a new relationship with Great West Life (ph) , they will use the fund in their 401(k) product. Initial funding was 15 million, and assets have increased to 60 million during Q3.

The Principle Group (ph) hired us to manage a separate account, clone of Capital Appreciation Fund, which has now grown to 100 million.

Briefly, an update on other key initiatives you heard us talk about before. We are continuing to develop a new distribution opportunity for our managed account product. This is the product that's structured for accounts between 100,000 and 10 million. Our first new accounts are funded with approximately $15 million, and our focus is expansion of our distribution into the major programs.

We were recently accepted into the managed account program at Raymond James for our mid-cap value discipline. Raymond James is one of the leading sellers of managed account products. We continue to work through the process of selling through the major wirehouse (ph) programs.

We introduced this managed account product to our bank trust clients during the summer and have signed up our first bank. We are in the process of developing contracts with a large group of banks and expect to begin to see more meaningful assets over the next several months.

On the international front, we're developing additional business through our London-based wholesaler, which we added in Q1. He's raised a couple hundred million dollars so far, and we're having discussions in developing operational links with multinational banks and other organizations that can use our liquidity and other fund products.

Our sales in Germany so far this year are running ahead of last year's. Assets in the retail funds with our partnership with the LBM insurance company are about 240 million. We look for more success on the institutional side, having recently added two accounts with about 140 million.

We are continuing to develop our 529 product, offering in partnership with Schoolhouse Capital (ph), which is State Street's program. This launch is increasingly looking more like a Q1 '03 event as we look into the future.

With that, I will turn it over to Tom for commentary on the financials.

Thank you, Chris. From a financial standpoint, as Chris said, Q3 was very challenging. The substantial market based decrease in equity managed assets significantly impacted our revenues.

As I comment on the Q3 results, the comparisons to Q3 2001 will take into account the previously discussed changes from our B share program and the change in the accounting treatment for goodwill in order to have a proper comparison to the current period's results. Once again, these adjustments to last year's results are detailed in the press release.

Measured year-over-year, our revenues were about the same as Q3 2001, adjusted for the B share change. While revenues increased slightly from bond and money market assets, it was not enough to offset the market's impacts on equities, resulting in a decline in revenues from the prior quarter.

In addition, previously discussed changes in third party fund administration business that occurred late in Q2 resulted in lower revenues for Q3.

Looking at specific line items for Q3, investment advisory fees grew 2% year-over-year. Increases in revenue from money market and fixed income assets more than offset equity revenues that decreased mainly from market activity.

Investment advisory fees decreased from the prior quarter due to the impact of lower equity market values. Administrative service fees increased year-over-year as growth in fixed income and money markets more than offset lower fees from equity assets. These fees decreased from Q2 due to the fund administration customer changes we discussed last quarter.

Other service fees decreased from adjusted Q3 2001 and from the prior quarter due to lower equity fund assets and the changes in fund administration customers.

On the expense side, compensation and related decreased year-over-year and from the prior quarter due largely to lower incentive compensation accruals. The lower accruals were the result of recalibrating for market activity in Q3.

Our guidance for Q4 is to use an average of the year-to-date quarterly compensation expense for Q4 and not the Q3 run rate. Remember, incentive compensation as one of our success items can continue to fluctuate, given market conditions.

Professional service fees decreased from Q3 2001 and from prior -- and from the prior quarter, due mainly to a lower number of funds resulting in lower fees paid for portfolio counting. We expect going forward that these fees will increase for two reasons.

First, the net fees we pay for portfolio counting will increase $250,000 per month beginning in November as a credit we have been receiving expires. Second, the professional fees will increase from the outsourcing of our legal function, which we recently announced. However, this is not a net increase, but simply moving categories. The amount of the increase in this category should be about 1.25 million per quarter.

Advertising and promotional expense increased year-over-year and from Q2 due to higher marketing allowance expenses from higher money market and fixed income fund assets. Year to date, our operating margin was 47% compared to 44% for the full year 2001. We continue to expect to be able to maintain margins in the mid-40s going forward.

In terms of non-operating income, we recognized a pretax impairment charge of 1.8 million on our mortgage-backed CDO (ph) investments. For forms of corporate and manufacturing housing, asset-backed bonds were the drivers in the drop in value during the quarter.

We have approximately $650,000 remaining in book value for the CDO (ph). This $650,000 is based on credit support from a major bank that supports the remaining value of the investment. Our management fees will decrease by about $500,000 per year going forward due to the decrease in portfolio value.

On the balance sheet, our cash levels stand at 124 million during the third quarter. We used 11 million for share repurchases and 6.5 million on our recently increased dividends.

In summary, the third quarter again demonstrated the value of having a varied business mix. While the downdraft from equity market valuation was severe, we were able to offset part of the market's impact by growing our fixed income and money market business and by continuing our diligent expense management. We have continued to make investments for the future growth while producing significant year-over-year earnings growth in a difficult environment.

With these results, our ongoing share repurchase and dividend, we continue to produce exceptional shareholder value.

Thank you very much, and we will now open up the conference call to questions.

At this time, I would like to remind everyone, in order to ask a question, please press star, then the number one on your telephone keypad.

We'll pause for just a moment to compile the Q&A roster.

Our first question comes from William Katz (ph) of Merrill Lynch.

William Katz (ph): Thank you. A couple of questions. Chris, I'm curious. It sounds like you have plenty of good backup here in terms of new business and you're pretty confident in terms of your pretax margins. Just curious if you want to go out on a limb here as you look out to '03 and talk a little bit about your expectations, you know, versus your 15% or 20% EPS growth goal and what would be a risk for you not to achieve that?

As we have said since July, we are unwilling to give crisp (ph) guidance into '03 until we see where the stock market ends up. If you tear into our financial statements and the effect of, you know, just during the quarter seeing the equity numbers on average assets drop by 4 billion, and you look at what that means on a revenue basis of about 100 basis points or so, on an annualized basis, that's $40 million worth of revenues that's no longer in the fort due to no fault of our own.

And so that kind of impact causes us to be reticent about commenting on '03 at this stage of the game. The question is, well, what would cause us in '03 to not meet any kind of standard like 15% to 20%? I think the answers revolve around how the equity markets perform, where we end this year in order to begin next year, and our ability to do the kinds of new things we're doing in a cost-effective way -- the new things meaning the changes I talked about in the investment management and the potpourri of new products and new initiatives that I don't have to catalog today.

On the -- another factor would be, as I think you are all aware, if you have a rip-snorting, quick, fast, and high run-up in interest rates, that's generally not a good time for money market fund assets that are not the very sticky type. And we've been through that before as well. We don't foresee that looking ahead in the marketplace right now. But those would be the principle factors.

William Katz (ph): Just to come back to your commentary on margins - does your pretax margin goal sort of inclusive of what you've done in terms of building up the investment management process? I guess the corollary question would be, if revenues can persist to be somewhat choppy to downward pressure, do you have any room to really take costs down further beyond what you might have done in this past quarter?

Do we have the expenses of the -- you know, Schappert's plan in our mind when we're looking at fourth quarter and next year? The answer is yes. We have that factored in, at least in our minds, in the margin. And the answer is yes.

Now, what's going to happen in the next quarter and next year on basically compensation, you know, it's one of our success items and it really does fluctuate, as you see, from this quarter. And we are supposed to go through and recalculate it and put our best estimate on what we think it's going to be.

Can it go down? Yes. Can it go up? Yes.

Chris Donahue (?): Bill, addressing the issue that you used a polite euphemism, I forget what it was, are there any other opportunities for expense contraction or something like that in your question. We have no sights on one of those big hairy layoffs or one of those kinds of deals. On the other hand, we are always looking at ways of doing business that have to change into the future, and we're always trying to improve the thing. We think that constantly looking at these things is the way to go.

An example of that was the announcement we made a few months ago, I guess about six weeks ago now, on the legal department and our alliance with the Reed Smith (ph) law firm. And these are ways to, what we believe, is to improve the legal service and to improve the focus of Federated on investment management and distribution powerhouse.

So we are always looking at ways, turning over more rocks and seeing if there are other kinds of alliances and changes that can improve the overall profile of the company. Are there other of those kinds of things? Like I say, we're always looking.

William Katz (ph): Okay. Last question is, in reference to capital management, sounds like, from all the new business opportunities, that you are pretty much fully slated from a product perspective. A lot of things are seasoning. Why not be more prolific in terms of share repurchase, given that the stocks are weak and you're trading at such a discount to your peers?

I'm -- you know, we look at that every day -- what's the price and what are we doing and what's the volume and what's going on? I don't disagree with that.

William Katz (ph): Are you signaling that you might be more aggressive going forward? Obviously you've been consistent in buying back stock since the IPO, but given the rising cash flow here, less product development and so forth, good balance sheet, why not step up a little bit more?

Chris Donahue (?):I would be happy to do exactly what you're saying. What people don't recognize exactly is, when the share price is what it is and we are foreclosed from buying and -- you're not supposed to get into too much of the details of all of this, because then you let other people know when it is you can do things. But everybody knows that there are quiet periods ahead of our announcements and quiet periods shortly following our announcements because of legal requirements. And the frustration from my point of view is that, when the buying opportunities are the best, our ability to buy is zero.

And, you know, it mesmerizes me in terms of the sellers of big portions of the stock why they continue to want to sell at times when we are not able to participate. But, you know, you just roll with the punches.

William Katz (ph): Okay. Thanks very much, guys.

Your next question comes from Henry McVey (ph) of Morgan Stanley.

Henry McVey (ph): Good morning, can you hear me?

Yes.

Henry McVey (ph): OK. A couple questions. One, Tom, I missed what you said about the expenses and the net. You said the 250,000 and it was 1.25. Can you give us those numbers again?

On the professional fees?

Henry McVey (ph): Yes. You were talking about the expenses.

Tom Donahue Yeah, we had a credit from -- on our portfolio accounting arrangement that expired. And so starting in November they will go up per month $250,000.

Henry McVey (ph): All right. Okay.

It shows up in professional service fees.

Henry McVey (ph): Okay. Next thing is, just on the compensation, you said that you had a reversal because performance had come off, but then you said that the Morningstar ratings were up. Is there something in terms of Lipper benchmarks that went down that we should factor?

Let me answer that first and then Chris can address the performance numbers.

When we go through to determine what the incentive compensation accrual should be, we look at every different area. It isn't just performance. It's sales. It's how is the company doing? And it is performance, too. You run all of those numbers. Basically, it's across the board where we change things. It wasn't like investment management was a leader of that at all.

Henry (ph), we don't comp off of Morningstar. It's a proxy to talk about performance in growth for all the funds so that we don't have to go through each fund one at a time. You guys can push, point, and click your way to find out every piece of fund information you want. We're comping off of benchmarks in some relative Lipper and relative competitor-type situations.

And so it is a slightly different bandwidth, but also, it isn't only investment manager comp, it's salesman's comp, executive comp, that are built into that that are related to sales, net sales, incremental income, and other factors.

Henry McVey (ph): Right. Okay. So it sounds like there was more just in terms -- despite you had good bond sales and it sounds like you're making penetration, but it sounds like it was across the board in terms of revisiting those issues and not just investment management?

Tom Donahue (?): Right. Go back, Henry (ph), and look at the first two quarters and how performance was -- performance, I mean how the company was doing, how sales were doing and how the funds were doing. You had to run at a higher number. Things have changed.

Henry McVey (ph): A couple others - just, Chris, you talked about a lot of different opportunities. It sounds like there's a lot on the plate. If you had to narrow it down to two or three things we would focus on, is it the separate accounts, the variable annuity? You gave us a host of things. If you were to look toward year-end over the next few months, what do you think would be the two or three things that we could see tangible evidence of?

First of all, having eight children, and not wishing to say I love one child any more than the other, I will attempt to answer that question in terms of size. The variable annuity product is a biggie product. I've talked about it in terms of it being 15% of the industry, and therefore, being something like a five plus -- $5 billion to $6 billion-type project for us.

Therefore, the variable annuity has to be a winner. So you're going to want us to say, hey, here are some sales, we're improving them, and we've done this before. How do the sales compare? That's one over the shorter term, assuming you get any kind of variable annuity type market that we're going to want to see some action on.

The other one is the separate account program. This is another one that is approximately 15% of the industry. When I say 15% of the industry, exclude the money funds and take the total of separate account business and what is that as a percent of the fixed income and equity business in our industry? Okay, it's around 15%. Therefore, you've got another $5 billion-plus that we're trying to develop. So you're going to want to look for to us see a couple of things.

First, that we're getting on more of the bigger platforms -- you know, how are we doing at Merrill, how we doing at Smith Barney, we have Raymond James, 11 or 12 of the others. How are the assets going? And then what's happening in bank trust because that's a new area for people. That's not generally tread upon by others.

So those would be the two leading ones in terms of size, even though I love all of the children.

Henry McVey (ph): Okay. One final one -- in terms of the asset productivity, we've come down from those 24 basis points to prior year it was at nearly 27. We're at 23. When you're talking about these margins that you think you can sustain, is that factoring in no change in asset yield productivity?

Henry, it's Ray Hanley. In terms of factoring it in, yes it's factored in all the time. Obviously with the Bond Funds, the interest being at the shorter end product, those fees are lower than the spread products, but they're higher than money market fund products, which is where at least some of that demand is coming from. So the answer is yes, it's factored in and, you know, we remain hopeful that the higher spread, higher fee products sell more, but you have to take what's available in the market.

Henry McVey (ph): Okay. Good enough. Thanks, guys.

Thank you.

Your next question comes from Mark Constant (ph) of Lehman Brothers.

Mark Constant (ph): Good morning. Actually a couple things wanted to follow up, Ray, with what you were just talking about with respect to the Bond Fund sales. I think Chris alluded earlier to the idea of people moving off the curb to some degree. I wondered, in the way you compensate the sales force on those products, understanding they are higher fee than money fund, but lower than traditional spread fixed income product. Do you have a potential churn problem there? Is there an asset philosophy velocity that's inconsistent with the most fixed income, or is that something we should generally look at as being more profitable than money fund (inaudible)?

Chris Donahue (?): You should not worry about that. The basic overall concept is one of incremental income. That's kind of the guide. The fact that someone is in a money fund and goes to an ultrashort or then goes into an equity fund, there's not a sales component there that's going to generate three tickets in outside bonuses because the money is only in one place at any one time generating whatever the income it's generating, and therefore generating a calculation with which to pay a bonus.

Mark Constant (ph): Even if we're seeing the higher sales end redemptions on the bond side, that's not what's driving, say, the marketing allowances, advertising, promotion, et cetera?

Chris Donahue (?): What I was talking about was the salesman's -- the actual salesman's compensation. Now, when you get into marketing allowances, every single deal with everybody is different. And we do not -- we're not into a game of paying marketing allowances on churning, as you might suspect. So - but I can't characterize all the of the various marketing allowance arrangements in one sentence. Every one of them is uniquely negotiated with various aspects of sales, net sales, changes, assets and the like.

Mark Constant (ph): Okay. If I can change gears a little bit to the money fund side, you had in your earlier comments, Chris, talked about some of the yield anomalies that we've seen, I guess, in the last couple of quarters in the money market and direct market. Do you see that as being a sustainable sort of systemic development that we're going to have to deal with going forward? Just, you know, accepting higher asset velocity in or around quarter end or is there a function of the yield environment? Or is that something you see as being ( Inaudible)?

Chris Donahue (?): It's interesting that the comment I get is, yes, they are anomalies and yes, they are unique, and yet they occur at the end of every quarter. Not being a bond or money management specialist myself, I take this to mean that we have to learn to deal with increased quarter end and quarter beginning volatility and anomalies at the end of the quarter in interest rates based on what the repo is doing, because you can't control any of this. So everyone calls them anomalies, yet when they occur just about at the end of every quarter, you begin to get the message.

Mark Constant (ph): Is it fair to suggest that they are happening more often at the ends of recent quarters than in prior quarters?

It's been consistent over the last couple quarters, but it's not just the rate anomaly with the spot market. It's also corporations moving money around. It's the buildup and draw-down related to assess-backed securities.

Mark Constant (ph): I'm trying to get a sense of what if we've seen the last couple of quarters is a true and sustainable phenomenon, vis-a-vis prior years?

I think that, because of that combination that we're talking about, more institutional business with us and the pattern that has existed of those month-end -- quarter-end anomalies and rates that we are going to have to deal with increased volatility. Whether that's sustainable or not -- and that will happen every quarter into the future, or many quarters into the future -- it's hard for me to have a legitimate opinion on that, Mark, I just don't know.

Mark Constant (ph): Thanks.

Your next question comes from Penn Worthington (ph) of CIBC.

Penn Worthington (ph): The market is still pricing in the potential for another Fed rate cut in November. Can you talk about how another 25 basis point cut will impact the money business as it relates to profitability and potential for consolidation or outsourcing in the money fund business?

Chris Donahue (?): Well, in terms of profitability, if the Fed cuts rates, that doesn't do anything to profitability of money funds at all. If they cut rates again, that will tend to lower the rate in the spot market and put money funds in a relatively advantageous position, which should relatively attract more funds into money market funds. And so you will have relatively more dollars and, you know, I guess in that sense it helps profitability if they were to, you know, reduce rates like that.

What was the second part of your question?

Penn Worthington (ph): I'm going to rephrase the question a little bit.

Consolidation.

Chris Donahue (?): Yeah. Okay. This kind of move really doesn't have much to do with consolidation. Consolidation is on different factors. It's really on the factors of how others who have money funds have built their business, and are they diversified enough, do they have enough product, enough size, to be able to consistently offer daily liquidity as part of their clients. And there are pods of money fund managers who, like First Merit in Akron, find it better to jump up onto a bigger ship of state for handling their money fund business.

So -- it is not, though, directly related to what the Fed does, up, down, across, flat, or whatever. It's really related to the essence of the business. Second point is that smaller competitors in the money market area will find it increasingly difficult to grow. You know, so you have a 25 basis point change either way, it's difficult for the smaller players to get bigger because the bigger players want real liquidity. They look at a $10 billion government fund and say, I know I can get my 200 million or 300 million in and out and not blow up the fund. Just the size alone tends to stimulate a kind of consolidation opportunity.

Penn Worthington (ph): Thank you. I'm actually going to try to rephrase that question. I'm not sure I was clear enough. It seems like some of your competitors are seeing pressure to either cut fees or initiate fee rebates because the yields are so low to keep their total returns competitive. You know, are you seeing that having impact -- any impact in the profitability of the money market fund business in general, or as that relates to the potential to force some of the smaller players to outsource or consolidate?

Chris Donahue (?): We have seen none of that reducing fees in order to keep rates at some given level. And the reason for that is, the question in the money fund is always, what else can you do with the money? And then the second question is, how much of this is a cash management service as compared to a rate gain with a computer?

So this tells you pretty straight up that, in our large money funds that have, you know, the 20 basis point family, they're very competitive. And so we're able to play the game. And on the stickier assets that are used overwhelmingly as a cash management service, they're still good services giving competitive yields, and with appropriate marketing allowances and sharing, as I like to term it. So we're not seeing those kinds of pressures.

Some of the terms that you use, I would demur from using. I use the terms marketing allowances and sharing. And at the beginning of your question, you started to head down this road. I would agree that there are increasing pressures and demands and requests for more sharing or more market allowances. But that's a lot different than fee pressure or price pressure or net yield pressure. It's exactly what it is -- a request or a pressure to share more of your investment management fee with the -- you know, the person through whom we're distributing.

Penn Worthington (ph): Thank you very much. I'll follow up offline.

Your next question comes from Brian Budell (ph) of Salomon Smith Barney.

Brian Budell (ph): Just some (ph) more questions about the money market business. But you had ending assets of 142, was it, in September? No, I'm sorry, 147 in the money market funds?

Yes.

Between the funds and the separate uncounts?

Brian Budell (ph): Yes. You said it was 142 as of October 21, right?

Right.

Brian Budell (ph): Okay. So should I take a simple average for the first three weeks? I guess the real question is, what's your expectation about the average assets in this quarter being higher or lower than the prior quarter?

Chris Donahue (?): The guidance we're giving on this quarter is going to be general and broader than your question, which is that we're still happy with the fourth quarter added together, making the year 2002 15% to 20% in EPS growth over last year. Okay?

Now, within that, we don't give guidance on what we think the average assets in the money fund component or any of the other components will be for the quarter. Historically, the fourth quarter has tended to be a positive quarter for us on money funds. If you look back over the years, money fund assets have tended to increase in the fourth quarter. Will that happen this year? You know, we can't say for certain that it will, but that's what's happened historically.

If the Fed, as the previous questioner mentioned, drops rates by 25 basis points, that would assist and you would have, you know, relatively more assets come in for that.

One of the reasons we go through all of these various numbers on money funds is to get you the sense that the point-to-point numbers are all over the place and you can't draw straight lines between them and make up averages and things like that, which is why we say, look back and see what they were for the quarter on average because that's, in effect, what generates the fees. So we aren't going to draw straight lines between two numbers.

Brian Budell (ph): All right. What portion of the money base now is what you would term interest rate sensitive? I guess that would be if you add together the corporate institutional market with the portion of the bank trust market that's interest rate sensitive.

Chris Donahue (?): Overall, about half of the money fund assets are in bank trust. So we consider that to be relatively sticky money. Another big chunk of the other half is broker/dealer retail. And that's about a $30 billion-type business and, you know, that's very sticky money. Then the other two pods that you mentioned, which at the end of September, the institutional was at 18 billion and the bank capital markets was at 19 billion. Then those numbers over the last several days have built up to where they're each over 20, that would be the most interest rate sensitive money.

In the bank capital markets, something approaching half of that area also is involved in various types of sharing arrangements, where there are various numbers of basis points going back to the client of ours who is distributing the money fund to their client or using it in their cash management service, which tends to dampen the volatility of those assets.

So, you know, you've basically got half of the assets in bank trust that we consider relatively sticky, another 30 billion in broker/dealer that we consider very sticky, and then the other two pods, which are roughly 20 each, the institutional, would be relatively more interest rate sensitive and the bank capital markets has sections of it that are just like the institutional, but a whack of it has got some sharing arrangements which make it less interest rate sensitive.

Brian Budell (ph): Great. So, going back to my earlier question about looking at what you're trying to predict average assets for this quarter, of course, the seasonality effect is one of the potentially more predictable patterns, but in terms of new accounts coming on board -- you mentioned 11 new accounts last quarter in the business -- what does the environment look like this quarter? I know -- I'm not asking you to predict a specific number, but are we looking at similar type of trends?

Chris Donahue (?): Yes. That's what we would -- we've been running, call it 10 of those new type accounts for each quarter for a considerable amount of time. And so we pressure the sales guys to make sure that kind of thing happens. They're incented on their own to want to do it. If you asked me what I'd be looking forward to, that's what I'd be looking forward to -- the same type of number in new accounts in the fourth quarter. How much money they'll have is really jump ball.

Brian Budell (ph): Right. Then for some of these new accounts, I guess for the bigger ones, what type of fee rates are they coming in?

Chris Donahue (?): All of these accounts that we're talking about come into our regular funds. So it just depends on which fund they're in. We have a whole bunch of funds at 20 basis points and another few at 18. And then you're dealing with the regular Federated price (ph). Those aren't separate accounts. Those are large institutional Fortune 500-type companies that are coming into our regular fund.

Brian Budell (ph): Okay. So in the 18, 20 bits range?

Chris Donahue (?): That's the fund expense ratio. That's not what we get. We get -- there are fund expenses, and then we would receive somewhere on the order of 15 basis points, call it, in revenues out of the blend of those products, counting both administrative fees and investment advisory fee.

Brian Budell (ph): Okay. And - let's see here. Just on the marketing fees, in terms -- the marketing allowances, essentially, in looking at the different distribution channels, are you getting essentially more pressure in the broker/dealer channel as opposed to other channels, and is that causing you to shift resources to some of the other channels in viewing them as being perhaps more profitable, or are you willing to stick it out in the broker/dealer channel ...

Brian Budell (ph): To us, all of these channels are good, solid, and excellent businesses that, no matter where the latest information of marketing allowance pressure was, we wouldn't do what you're saying, redirect resources because you get the pressure over here, now you go somewhere else.

In all of these areas the businesses are good enough that we can withstand the pressure and would stay inside all of them, but frankly, I don't really see huge differences in any of these groups. These things come sporadically, and they come based on competitive pressures when people are changing what they're doing. So I don't have in my mind what you have in your mind that somehow it's one particular group that's driving the machinery on the marketing allowances.

Brian Budell (ph): Right. Okay. Great. Thanks very much.

Your next question comes from Robert Lee (ph) of KBW (ph).

Robert Lee (ph): Thanks. Good morning, everyone.

Good morning.

Robert Lee (ph): A couple quick questions. The first one, maybe going back to an earlier question, looking at Bond Funds. In addition to the ramp-up in sales, you've had a pretty big ramp-up in the redemption rate in those. I guess that's partially because of the short duration product.

But number one, is there a particular segment that's -- of your client base that's really driving that redemption rate? And does that raise any concern that, if you get (inaudible) rate, it makes the income book look more rate sensitive in terms of assets leaving quicker than they would otherwise, if rates start to back up much? And I have two other questions.

Tom Donahue (?): Rob, in term of where the sales and the redemptions are occurring in particular, the redemptions, the higher redemption rates on the fixed income products and equity, for that matter, occur in the channels where we sell products no load (ph), essentially.

So in the trust channel, in the -- among registered investment advisers, we are seeing higher redemption rates. That would be true both for longer term and the shorter term Bond Funds.

Now, overall, when you look at our fixed income redemption rates, certainly the increased use of the shorter-term products has resulted in higher absolute redemption rates, really across all of the channels. And here we are seeing customers use those funds as substitutes for money market funds in some cases. So there is, in fact, more money going in and more money coming out.

Having said all that, in the third quarter, we did -- the flows did broaden out from the ultrashort funds. They're still weighted toward the short ends, but we were picking up increased flows on total return fund, on our Capital Preservation Fund. So it wasn't just an ultrashort phenomena.

Robert Lee (ph): Thanks. The other two questions, looking at the admin business, you really don't talk about this too much, you've done a pretty good job over the years of getting rid of, I guess the expense centers, whether it's portfolio accounting or legal, just basically having them outsourced and looking at how to make your own business more efficient.

But where does the administrative business sort of fit in the game plan? A lot of competitors. I would assume it takes a fairly hefty technology budget to keep up with what's out there. Is there really a core business for you still? Do you think that's something you would look at maybe it makes more sense to sell that business or wind it down in some way?

And then second question, just try and refresh my memory, at your securitization (ph) facility, that has another year -- that comes up again in the next six months or so?

Chris Donahue (?): Rob, on the securitization facility, that runs through the end of 2003. We'll start to look at that sometime next year.

Okay. On the administrative business, if you recall how we got into the administrative business -- and this is where we perform administrative services for various bank mutual fund families. We got into it in the late '80s because it was a service to our bank trust customers. We consider our bank trust customers core, absolutely core, more than core, whatever phrases you want to use. And so, providing them services apropos of their relationship with us is a very good and important thing for us to do.

You saw with the First Merit how these things sometimes go full cycle from when they were exclusively using the money, using our funds, then they, over a decade, developed some of their funds. Now we expect here, as we move into the 2000s, that there will be more of these banks deciding that maybe this business isn't growing as fast as it should. Maybe the expenses for some of those banking institutions are higher than what they think is appropriate, and maybe they can improve the offerings to their clients by offering a different array of product. And so we do this because these are good clients who have good relationships with us that are very much core to our activities.

And in terms of things like big technology commitment, yes, there is commitments of resources to it, but the kinds of services that we're offering to our bank trust clients who have their own mutual funds are very, very, very similar to the kinds of services we offer to our own selves.

So it is not a new technology commitment. It may be additional things that we do, but it's right down the middle of the plate for us. So we look at that and then we look at the balances that those clients have with us. And it's in the multi-billions of dollars. And so we think it's an important customer service to offer to our client.

Robert Lee (ph): Okay. If I could actually ask you just one more quick question. Chris, you guys are, I guess, pretty much in the flow of the M&A activity in the industry. Could you give us some update on -- are you seeing more people -- are you seeing potential sellers start to loosening up on what they're looking for, given the pain of the last couple of years? Are you seeing any sort of change in pricing at all?

Tom Donahue (?): Well, this is Tom. Generally, the way that you look at this, it depends which group you're talking to. If you're talking to people that have mutual funds that are inside another, bigger institution, they have one way of talking about it. If you are talking about people that started their mutual funds, filled it up and got it to critical mass and are still entrepreneurs, they have a different way of looking at it.

The first one is the owned by a big -- you know, a big financial institution. And I think they look at it and say, what's our growth prospects? What are we doing here? How much money are we spending? And should we maybe outsource this? I think that those opportunities for us are becoming more available, given the market conditions the last couple of years.

On the entrepreneurs, I think they are no change, and it's always an individual thing for each entity and where are they going and where is their mindset. I don't think market conditions have anything to do with them deciding what they're going to do. It's really where they are in their decision process. We do have a lot of things that we're looking at. But we'll see what happens.

Robert Lee (ph): Thanks.

Your next question comes from Stephen Schwartz (ph) of Raymond James.

Stephen Schwartz (ph): Good morning, guys. Can you hear me?

Yes.

Stephen Schwartz (ph): Hi there. Just a number of follow-ups. I am interested in going back and talking about compensation and where that should be. And let's just assume - and maybe carrying that on to earnings for 2003. Let's assume kind of normalized market returns and, say, assets between 2002 and 2003 were to grow by 8% to 10%. Would we still see compensation for the year-to-date average in 2003 or would that be more to the levels we saw in the first two quarters?

Tom Donahue (?): If the market grew next year and the firm grew next year and the performance was up to par, would we have higher compensation next year than this year? Yes.

Stephen Schwartz (ph): I mean as a percentage of revenues. Clearly would be higher. Would it be higher as a percentage of revenues?

Tom Donahue (?): I have to do calculations. I do not think about it in terms of percentage of revenue. We build it from the bottoms up to what is in each area. We don't look at it as what is the percentage of revenue and would it grow? I would have to figure that out.

Stephen Schwartz (ph): Okay.

Tom, while you're speaking, could you touch upon investment income in the quarter and the drop from 2Q?

Yes, a combination of a couple things. One, rates are down, so our yield on that is down. Then we had a couple trading errors that, you know, caused us to pay for those trading errors and not make as much money in that line item. $600,000 of trading errors type thing.

Stephen Schwartz (ph): That sounds like it's a euphemism for something.

For instance, we missed a corporate action on something and we had a relationship with our client where we were supposed to get out of something if it got downgraded, we missed the corporate action to get it registered and, once the thing got downgraded, we had to get out of the security with our client and we had to take the loss because we had not followed through properly.

Stephen Schwartz (ph): Okay. Chris, you gave a list, I think it was 11 separate accounts added in the third quarter.

No, no. That's 11 new accounts of a Fortune 500-type style institutional biggie account that come into our funds. It was not 11 new, separate accounts.

Stephen Schwartz (ph): Okay. Then this is going to be a vague question, but I'm kind of -- you know, you gave a laundry list of stuff which I tried to write down, but I was interested in -- and hopefully I got them all, but were those funded in the quarter or to be funded?

Chris Donahue (?): ... something ahead of 600 million.

Stephen Schwartz (ph): But they were funded?

Chris Donahue (?): Yes.

Tom Donahue (?): What we're dealing with here is a company essentially opening the account with us. A lot of times they start at zero and it depends on the ebbs and flows of their cash flow. Those 11 corporate customers at the end of Q3 had about 650 million, but obviously that number, we look at that as a starting point.

Stephen Schwartz (ph): Okay. And then I want to follow up on a competitor's conference call when touching on cash management, which admittedly is a smaller part of their business than yours, talked about the flat yield curve in the very, very short end. And that had created, I guess, an opportunity or had made it more interesting for corporations in particular to use the spot market as opposed to the money market fund. Did you see any of that?

I ...

Stephen Schwartz (ph): Exclusive of that anomaly which happened the last day of the quarter.

Scott Donahue (?): Right. My knowledge and ability to comment relates to the use of the word "anomaly." Maybe it was double-digit basis points that caused people to want to be in the direct market over the end of the quarter. But as to what you're talking about with yield curves and all, I'm not in a good position to give you a good response on that.

Tom Donahue (?): Steve, the numbers in our corporate business would not indicate any systemic use of change in how they're using money market funds. We have continued to have all the same accounts. We haven't lost any accounts in the year. The balances on average are up. We continue to add new accounts. So, from our standpoint, we're not experiencing -- the numbers aren't showing us spurning anything like that.

Stephen Schwartz (ph): One last question for Tom. Tom, you mentioned that legal is going to increase the professional service fees, but it was going to come out of another area. Which line item?

It's a bunch of areas. We have -- compensation would be the biggest one. We have rent, which would be a smaller one and the other, you know, computer things and service things. But the biggest one is the comp line.

Stephen Schwartz (ph): Okay. Thanks, guys.

Okay.

Your next question comes from Lynn Savage (ph) of Fox Pitt Kelton.

Lynn Savage (ph): ... comments on M3 and money market funds share of M3. Recently there's been some issues in the commercial paper market. I think you've indicated that maybe institutions for cash management may look to money market funds, given their diverse fiction - use money market funds over commercial paper more. Have you seen any indications of that occurring?

Chris Donahue (?): Yes, I'll take you way back. I remember the first pitches I made on money market funds back in the mid-'70s where (ph) the same point that, through good credit analysis and diversification, you know, you can do much better.

Do you see things like that? Well, what happens is, at the point of impact, do people primarily say, in the bank trust world, really want to go direct, and what is the amount of basis point spread that will cause them to go direct? This is one of the points that allows them to stay in a diversified, professionally managed product. And you see it every minute in every decision that people are making.

But I can't draw a straight line around a bunch of clients and say, Oh, here are the actual ones who decided to make a move into a fund out of the commercial paper because of this point. So the most we can say is a generalized point. Beyond that, it's very hard to track it.

Tom Donahue (?): Anecdotally, we've heard from treasurers that even if rates were to rise, that past patterns of jumping into the direct market, there may be a pause on that. But my sense would be, until we really see a sustained rate increase, it would be hard to know how much of that, in fact, transpires.

Lynn Savage (ph): Okay. Thanks very much.

At this time, there are no further questions. Sirs, are there any closing remarks?

Ray Hanley (?): No, that concludes our call. Thank you.

This concludes today's Federated Investors third quarter conference call. You may now disconnect.