Federated Hermes Inc (FHI) 2003 Q4 法說會逐字稿

Good afternoon. My name is Amy, and I will be your conference facilitator today. At this, I would like to welcome everyone to the Federated Investors earnings conference call. (OPERATOR INSTRUCTIONS).

Good afternoon and welcome. Today we have about a 20 minute presentation before getting to your questions. Leading today's call will be Chris Donahue, Federated's CEO, and Tom Donahue, Federated's Chief Financial Officer. Also on the call are Rich Novak and Stacey Friday from the Corporate Finance Group.

By way of Safe Harbor, let me say that this discussion will include forward-looking statements, and actual results could vary materially. For a 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 annual report on Form 10-K for the year ended December 31st, 2002, on file with the SEC.

With that, I will turn it over to Chris to talk about the fourth quarter and 2003.

Thank you very much and good afternoon all. On today's call, I intend to review our business performance in the fourth quarter before turning the call over to Tom to discuss the financials. Questions will follow. I will comment briefly on our performance in each major asset class before looking at the distribution channels.

Equities. Equities were a source of strong growth in Q4, as well as for much of '03 totally. Equity assets were up 15 percent from the prior quarter and up 42 percent for the year. Once again, in a year that so strong and strong equity market performance, Federated gained market share and equity assets. For 2003, our equity fund assets increased by 41 percent versus the industy's 38 percent.

Also during the fourth quarter, Federated gained equity fund market share as our asset growth was slightly above the industry's asset growth. Federated's equity growth comes from combining competitive funds in a variety of disciplines with successful distribution in multiple channels. Driving both growth and net fund sales were the Federated Kaufmann Fund, which is a multi-cap growth fund; the Capital Appreciation Fund, a large cap blend fund; Market Opportunity Fund, strategic value, and the Federated Kaufmann Small Cap Fund, which is in its one-year anniversary in December and has reached $270 million at year-end. We also had good sales results in the Federated Muni and Stock Advantage Fund, which was launched in September of '03, reached 80 million by year-end, and now sits at 100 million.

Investment performance is beginning to benefit from our new equity research model that emphasizes proprietary fundamental research. The real success here will, of course, be determined by results over the long-term. We see some good results, which I will address later in my remarks.

Money market. Turning to the Money Market Fund, the assets in Federated's Money Market Fund and separate accounts increased slightly from the prior quarter, while the average decreased by about 2 percent. Ending and average assets each declined for the full-year as the rate advantage from Fed easings late in '02 and in the first half of '03 dissipated. While Money Market Fund assets decreased in '03, our market share increased from about 6 percent in '02 to a little over 6.25 percent at the end of '03. So far this year in '04, Money Market Fund assets are up slightly.

On the fixed-income side, our experience was consistent with the market and industry as assets on the margins shifted out of bonds. Our modest net outflows span multiple product categories in durations with lower fee ultra short products showing accelerated net outflows. We experienced net outflows in corporate, government, mortgages and munis. On the plus side, the blended, the global and our dipped products had positive flows.

In January, equity flows were positive and running on about the same pace as Q4, while fixed-income flows were negative with outflows running higher than the Q4 pace. As always, we caution against drawing conclusions for the quarter from this early data. In terms of total assets, as of last week, our managed assets were just over 200 billion, including 144.5 billion in money market, 26.4 in billion in equities, and 29.3 billion in fixed-income.

Turning to investment performance, among funds rated by Morningstar our percentage of assets in our equity funds rated four or five stars increased front 51 percent to 59 percent from Q3, and our percentage of three, four or five-star rated assets increased from 65 percent to 72 percent. Federated had 11 five-star funds with 48 percent of our eligible equity fund managed assets at year-end. As of year-end, all classes of the Federated Kaufmann, Federated Market Opportunity, and Federated Capital Appreciation Funds were five-star rated. These products span important style boxes and position us for continued growth here in '04.

Briefly in the fixed-income area, our fund ratings remained about the same as the prior quarter. At December 31st in our funds ranks by Lipper, 46 percent of our equity fund assets, 84 percent of our global and international equity fund assets, 63 percent of our bond fund assets and 75 percent of our money fund assets were ranked in the first or second quartile based on one year total return. Our domestic equity total return performance levels as measured by the Lipper rankings are strong over both the long and the short-term.

Through December 31st, 55 percent of our domestic equity fund assets were in funds ranked in the first quarter quartile compared to their peers for the 10 year total return. Measured by five-year total return, we placed 43 percent in the first quarter. For three and one year, we placed 52 percent and 35 percent respectively. Finally, more than two-thirds of our eligible stock and bond funds ranked as Lipper leaders in one or more categories at quarter-end. These categories include total return, consistent return, preservation, tax efficiency and expenses.

Let's turn to distribution. In the trust market, our focus remains on finding ways to work with our clients to grow assets. We have reorganized our salesforce in order to provide a special focus on the largest banks. The bank's managed account product continues to grow by adding new distribution, growing accounts and raising equity assets. During the fourth quarter, these equity assets grew 42 percent from 86 million to 122 million, and we expect this total to grow substantially over the coming quarters and years. Interestingly, accounts have increased from 74 accounts to 112 in Q4.

In the broker-dealer channel, we continue to have strong sales momentum. We posted our best year ever for stock and bond fund sales, which grew 28 percent from '02. Equity fund sales increased 39 percent for the year. We had outstanding success in moving up in the lead tables for fund sales in major broker-dealers during '03. In addition to growth in fund sales, we are seeing accelerated sales of our managed account product among brokers, including bank broker-dealers. Assets in this channel grew 73 percent from 182 to 314 million during Q4, and we expect to see substantial growth in this product over the future.

We continue to pursue the addition of our product to the platforms of the major warehouse programs, and this remains an important goal. Here the numbers of accounts increased front 729 to almost 1100 in Q4.

In the Edward Jones channel, we are selling arranger products led by the strong performing equity funds I mentioned previously. Our fund sales share increased about 17 percent during '03 and are running about a 3 percent market share. This was down from the prior year, due largely to the overall increase in equity fund sales where our share is lower than for bond funds. We added six new institutional cash management customers with initial funding about 25 million during the fourth quarter. Assets have been flattened down recently as institutional money fund yields in some categories have slightly lagged the direct market alternatives. In addition, as we discussed last quarter, we expect that approximately $1.5 billion in money market fund assets in this channel will be withdrawn during the first quarter of '04 by companies exiting bankruptcy.

Briefly, an update on new products and initiatives. We have discussed the managed account product at the channel level. The total assets for this product have now reached over $500 million, up 84 percent or 277 million at the beginning of '03. Our target for '04 is $1 billion, which, of course, includes penetrating a warehouse platform.

As we have previously mentioned, our variable annuity relaunch effort is not showing much momentum, and we will be winding down this product during '04. We launched this product into a market that turned very negative for these types of products. With the changes to tax rules and facing well-established products of competitors, we have been able to be as successful as we had expected.

In Germany, our sales continue to grow, and assets in the retail funds in our LVM partnership were over $420 million, up 52 percent in 2003. We continue to emphasize the marketing of our 529 plan product, which is still in a very early stage. We continue to actively seek acquisition opportunities, as I have discussed before, for both the center of excellence and the rollout types.

Finally, I would like to comment on our review of past fund trading issues. As you know, we recently announced a restoration fund, as well as a series of important remedial actions. These are detailed in our February 3rd press release. Our review has been extensive and has taken considerable time and resources. We were determined to conduct a thorough review of our clients, shareholders, regulators, and the media and the investing public could be confident in the integrity of our results. While our review is substantially completed, we continue to work towards its full completion.

We also continue to discuss the issues discovered in the review with various governmental agencies. As such, I will be somewhat limited in my ability to answer questions on this topic, but will do the best we can in these circumstances.

At this point, I will turn it over to Tom before we begin the question-and-answer session.

Thank you, Chris, and good afternoon everybody. We have made two modifications that impacted the presentation of our financial statement. First, we have reclassed certain distribution-related and other items on a consolidated statement of income to better reflect our contractual obligations with third parties.

In the past, we have recorded revenues net of fees paid for certain distribution expenses and services provided by third-party intermediaries to sell the funds and provide services to shareholders and (inaudible). These payments are now presented as operating expenses primarily in the marketing and distribution line.

The second change is related to our B share funding arrangement and follows recent discussions that we have had with the SEC. Federated has recorded $268 million of additional deferred sales commission assets and nonrecourse debt at December 31, 2003 to now reflect financing treatment for all 12- B1Cs (ph) and CDSCs (ph) sold under Federated's B share program. For comparative purposes, deferred sales commissions and nonrecourse debt of 261 million were recorded as of December 31, 2002.

I want to point out that the higher nonrecourse debt does not reflect any additional leverage, liabilities or obligation and remind you that these assets have, in fact, been sold in a legal truce sale to an unrelated third-party. Financing treatment is consistent with our original accounting for this funding arrangement before Q4 of 2001. Using financing treatment, we will no longer recognize gains on the sale of future revenues in the period of sale. We will recognize B share 12B1 (ph) fees as revenue and will have greater amortization of the deferred sales commission expense.

Nonrecourse debt expense will also increase based on the larger nonrecourse debt balances. These revenues and expenses will be larger offsetting.

As we have previously discussed, we completed an agreement during the fourth quarter to extend our B share funding program for another three-year term, and it began on January 1, 2004.

Switching now to a Fin-46 discussion. Based on the guidance provided by the FASB in mid-December, we have concluded that Federated is not the primary beneficiary and is, therefore, not required to consolidate the three CBO (ph) products where we serve as investment and manager for approximately $1 billion of assets.

Now turning to our results. Q4 revenues increased 10 percent compared to 2002 and 3 percent from the prior quarter. These increases were due to growth in average equity and fixed-income assets partially offset by lower average money market assets.

On the expense side, compensation and related expenses increased 3 percent on a full-year basis. On a quarterly basis, the variances reported were driven by finalizing accruals for various incentive plans. Professional service fees for Q4 2003, included 11.4 million of expenses from our review of fund trading practices, which accounted for most of the variance. The other expense line item included the 7.6 million of funds restitution expenses. Going forward, we will incur additional expenses related to these matters, related to legal proceedings and compliance.

On the balance sheet, our cash and short-term investments stood at 234 million at year-end. During the quarter, we used 9.2 million for dividends. We did not reproduce any shares in Q4 due to the review. As noted in the press release, we are now able to begin to repurchase shares subject to the usual restrictions per earnings and other blackout periods.

We would now like to open up the conference call for questions.

(OPERATOR INSTRUCTIONS). Bill Tanona, J.P. Morgan.

Could you guys tell me why the return on assets under management was so high this quarter? Were there any type of performance-related fees or anything else in there, or is that a pretty good run-rate to use going forward?

The first comment I would make is that the run-rate is reflective of the change in how we are booking our revenue, but that is consistent with all of the periods that we showed in the press release.

Secondly, the blended realization rate would be up because of the increase in equity assets generally and the Kaufmann Fund in particular, so that would account for most of the variance on the blended realization rate. But it's probably best to look at those things individually.

So there were no performance fees or anything that would move that to the upside?

No.

Okay. In terms of -- I know you cannot really talk about the settlement -- but does the $12.4 million include an estimate for a potential settlement with regulatory bodies?

No.

No. So that is just expenses that you guys have incurred as a result of your review?

Correct.

In terms of the settlement, Spitzer (ph) and some of the other AGs have been somewhat successful in terms of getting industry players who might have been involved in reducing some of their fees and what they charge their clients. Have you guys been in any type of discussions with the Attorney General on this topic?

It would be unwise and impossible for us to comment on any of the discussions we have had with the regulators. On the subject of fees, however, I think that if you look at our advisory fees and look at them in a way that is comparable to other fund sizes that you will find us within a few basis points of the industry averages looked at this way. And so in terms of the average advisory fee, we think we're in pretty good shape, and so we would be able to make some pretty good commentary. The Kaufmann Fund and its performance and its fees stands on its own, and their fees are obviously higher than the average.

Okay. Lastly in terms of -- can you give us an update with DTC and the options clearing corp?

That has taken longer than we expected to get out of the gate, and it is really not an tissue from Federated's standpoint. They have not thrown the switch on making the money fund, in fact, live on their platform. When they do, our funds will be there, as well as funds of a few other firms, and we continue to expect that to happen soon, but it has not happened to date.

Thank you very much.

Ken Worthington, CIBC.

Actually you just answered the questions I had. Thank you.

Bill Katz, Buckingham Research.

Chris, I was wondering if you could start off and give us maybe some qualitative feedback on what you are hearing from your clients, particularly in the trust channel in light of all the market timing and late trading both before the disclosure and after? Has it been sort of a sense of relief, or is there still sort of a wait-and-see attitude?

In terms of the qualitative evaluation, I would start with the numbers that I think you can look at the flow data and the asset data and look at it as a checkpoint for our belief that the customers have by and large stuck with us throughout this entire investigation. And so that is why we reported the assets and the flows in the press release, and I would characterize it as our clients have been supportive and patient as we have conducted an extensive radio.

Don't forget that especially in the trust area, they have fiduciary obligations that generally cause them to wan thorough reviews. And just as it works when you have changes in the marketplace where people who are diligent and looking forward to getting complete answers, they tend not to pull triggers very quickly going and are going out. You have that same kind of effect here in these cases. I would characterize redemptions that might have been attributable or that we could attribute to this issue as modest. So on a qualitative and qualitative basis, I think our clients have been supportive and patient.

Okay. Thank you. On the second question, just in terms of -- I know you don't disclose it normally this way -- but month-to-month how your asset flows looked in the equity business maybe each of the months in the quarter as compared to your commentary they were running in January in line with the fourth quarter? The November versus December and November versus October if you will.

Okay.

Generally our strongest month of the quarter was October. November was still positive, and December was about breakeven from a flow standpoint, and then obviously now as we mentioned earlier in getting to January, we're running back on a pace where we would be at about the same level as for if you annualized January -- I am sorry -- take January for the whole quarter, you would get to about where we were for the full quarter of '04. So certainly there was a dip in December.

Interestingly, as compared to November, it was moreso some additional redemption. The sales rate was not much different, and I don't think that we would -- those comments are strictly on the equity site. The fixed-income field like it was on its own path is due to market issues more so than anything particular to the review.

Thanks and, Chris, one more follow-up. You have been mentioning in terms of the managed account business and trying to penetrate the major warehouses for several quarters now and I know you talked down your bullishness sometime last year around the managed account more generally, but how many more quarters do you think we will go before you land one of these management accounts?

I wish I knew, Bill, because I look at these same things every quarter, but more important than that, we keep trying on it. It is a very difficult thing, and I think one of the things that happens is there is always another story. But with all of the attentiveness to fiduciary and regulatory process and evaluation, everybody is just making double-triple sure before they put somebody new on one of those programs. We keep pressing it and pressing it and pressing it. So I will keep reporting it until we get it. Perseverance does pay off.

And then just the final question -- sorry to belabor all the questions here -- on the institutional channel, I know it it more an '05 event, but where are you know in terms of pipelines? Has the market timing issue spilled over into the institutional channel, or is that being compartmentalized?

Well, it is hard to assess in terms of any impact from the review. In terms of how we are progressing on the fixed-income side, we are very competitive records, and we find that we are getting further along in the processes, but we don't have a lot to show you up on the scoreboard in terms of mandates actually won.

On the equity side, I think it is fair to indicate that that is some number of orders out there. The good news there is that we are building the kind of records and process that we think will work there, but it is a longer-term proposition.

Robert Lee, KBW.

Good afternoon everybody. A couple of quick questions. The first one you have done a pretty good job of controlling compensation despite the strong market the last two or three months of the year. Comp is up 3 percent, and I guess it is about the same rate as '02 in a much more difficult at least equity market environment. Considering all the investments you have made in your staff there, what can we be expecting for compensation across going further, maybe beyond a normal first quarter pickup because people have 2 or 3 percent increases or something? Should this start to accelerate somewhat?

For the year, the uptick is primarily based on more dollars going into the investment area. That is where the increases in bonuses are showing up. We had better performance I think overall this year versus last year. So we would expect that to continue especially when a whole new plant has another full year to work and (inaudible) thinks we should succeed, and we would expect to have higher comp under that basis.

And on the other side, with the TA outsource, you might see some effect from compensation related to that coming in later part of the year.

One last thing. There will be a stepdown in the rate of accrual related to the Kaufmann earn-out that happens in April, which is the anniversary of the measurement period for those earn-out. So that run-rate will go down from about 3.5 million to about 1 million 7 comparing, say, Q1 to Q2 and Q3.

Okay.

We might as well finish it off with the company does better. A lot of those programs are tied toward paying more if the company is doing better, and why should I forget sales to the extent that if our distribution networks are more successful, there will be more pay there.

Fair enough. And a quick question I had is on the share repurchase. If I am understanding it correctly, as soon as your blackout period lifts tomorrow or the next couple of days, you will essentially as circumstances warrant prepared to sell repurchasing stock again. Some of your competitors have been caught up in the timing scandal seems to have the view that so long as there are even settlement discussions going on, they are precluded from repurchasing stock or what have you?

I was curious if you perceive that to be much of an -- why is that not an issue for you? Why did -- your attorneys got comfortable with it or --? How come you feel comparable doing it -- I mean I know you can't speak for your competitors, but some of your competitors don't feel comfortable doing it?

Well, I like the way you phrased it. First, once we get out of the blackout period associated with the normal blackout period, then we would be eligible to come back in in our mind. This is how we are approaching it. This is not to say that we are going to buy more shares or there is some kind of pent-up demand or we are not, it is just saying that we are then going to go through it each day and evaluate it based on all the facts and circumstances, including lawyers and accountants and valuations and everything like that.

So I would not want to engage in a legal debates with others about how they have come down on facts and circumstances that may be completely different from our own. I just don't know how to do that, especially on a telephone call.

Fair enough. Thanks, guys.

Mark Constant, Lehman Brothers.

I wanted to follow-up first, Chris, on something that you referenced when you were talking about how if you comparably evaluated advisory fees so that you would be within a few basis points, with the exception of Kaufmann.

In light of the fact that mysteriously even the people who should know better -- I guess the Morningstars of the world -- still include advisory fees and compare them as if they were apples-to-apples or I should advice-related fees and spreadout loads and that kind of stuff as if that were apples-to-apples to no load products that might have separate advisory fees accrued to the customer elsewhere? Do you run into that same frustration with the regulators? I guess what I am wondering is do they acknowledge the incomparability of load expense ratios to no-load expense ratios, or should we be concerned that ignorance is a fear factor?

I would not ascent to the notion of frustration with the regulators as you put it, but I would say a couple of things on this point. And that is from our point of view, the methods and the practices that we have on these items are properly disclosed in the prospectuses. That said, we think that perhaps in the media there is some lack of understanding of how all those various fund expenses relate, and the advisory fees, as you dutifully point out, are advisory fees and relate to the investment advice. Then you have, of course, the overlay of distribution, administrative expenses, and other kinds of things based on where the fund is being sold, the fact that it is being sold through intermediaries largely because of Federated's business model. So it is a completely different model than a pure retail model or an in-house model or other types of models.

So I would aim the frustration more at the media understanding of the differences between total expenses, administrative expenses and distribution expenses, which are really expenses for advice and distribution as well.

But you have not gotten blank stares back across the table on the regulatory side?

I believe they understand all of these things very well.

One last topic I know you are sensitive on this, but are there any issues that have been raised by any regulators that are perhaps in addition to those that you have outlined such that something you consider completely appropriate and non-objectionable someone else has potentially raised as objectionable, or have you disclosed what is in the discussions?

I can put my lawyer hat back on for this one. If there were any issues such like that were raised that were material, we would have already had them in the press release or already mentioned them in the call or filed an 8-K.

Whether you agreed or not, okay. Fair enough.

So by the subtraction method, we are saying we have got everything out there. But I am not at liberty to comment on any of the discussions that we have had with the regulators beyond the things that we have determined to be material that we have disclosed.

And finally, two quick numbers things. One, should we think of the TA outsourcing later this year as being effectively P&L neutral even though it does push around light items on the expense side?

Mark, we just not having gotten through to figure out exactly how that is going to work out. So I am not going to really take you anywhere to analyze that. We have an outsourced theme. The outsourced player wants to have an experience where they make some money, so how that is going to work with us, we just really have not worked for us.

In the end, maybe it will give us lower margins, but I don't think by very much because it's a low margin business for us.

Understood. And the last clarification on the expense side, if you will, Tom, the 12.4 million included things you had not run through the P&L before but incurred in the fourth quarter? Is that correct?

It includes fourth-quarter expenses that we actually incurred in the fourth quarter, and it includes the investigation costs in first quarter and beyond the first quarter that we anticipate to pay.

So your earlier comment, you will have course of discussion with regulators type expenses, complaint expenses, but this did include a provision for specifically related costs?

Let me just go through it. The 12.4 included costs that we are already incurred in the fourth quarter and costs that we will incur in the first quarter and probably in the second quarter. And then the other costs that I am talking about -- legal proceedings and compliance items -- that is really a different comment.

Okay. Understood. Thank you very much.

Cynthia Mayer, Merrill Lynch.

Just a couple of line items that have not been covered. The other service fees ticked up slightly, and I guess it is a combination of distribution and different kinds of fees. Was the rise a function of distribution (inaudible)?

That is the 7.6 restitution. Is it the other revenue item or the expense item? We have two similarly named --

I am sorry. Revenue.

Revenue. Well, then we have a different answer. That would have been mainly from distribution-related fees so when you have equity assets going up, that would have driven the variance in that line item.

Okay. Great. And similarly the advertising promotional I guess ticked up slightly all year last year. Are you thinking that trend will continue just a little bit?

The advertising and promotional line ticked down.

Okay. I am sorry about that. (multiple speakers)

(multiple speakers) changed around. We have a marketing distribution line item and an advertising and promotional line item. The advertising and promotional looking at it --

Maybe I should just ask you what you see as a trend there?

In terms of that, we don't have a large media advertising budget relative to people with different distribution models. But even within the confines of what we do, we had scaled that back last year since the impact of the positive markets was really something that built over the year, and a number of those decisions get made early in the year. So that is something we will be looking at that, but I would not be looking for any great big step up there. I think it's reasonable to assume that it trends upward, but not by any real large amount.

Okay. Net flows on separate accounts. Can you give any color on that, particularly on the equity side, and any color on what styles are managed there?

The best story there is on the smaller, the private accounts that Chris mentioned. I mean basically our gain in assets over the course of the year there was heavily weighted to flows, and that would have been in strategic value and the blend strategy.

In terms of true institutional accounts, there would not be a lot of activity really to speak of there. We have had growth in some of the existing products where they have added more assets, but from a flow standpoint, there would not really be any Q4 events of consequence.

Right. That is what you were talking about as possibly a 2005 or 2005 thing or later this year.

Right. From an institutional standpoint, you need the records to firm up over a longer period of time. I think if you look at the results and Chris went through them, you can start to see it in the fund ratings that there is some good things in the pipeline from a performance standpoint. We are hopeful over that longer period that will lead to the bigger separate account wins.

Great. All right. Thanks a lot.

(OPERATOR INSTRUCTIONS). There are no further questions at this time, sir.

Thank you. That concludes our call. Thank you for joining us today.

Thank you for participating in this afternoon's conference call. At this time, you may all disconnect.