Federated Hermes Inc (FHI) 2005 Q1 法說會逐字稿

Good morning. My name is April (ph) and I will be your conference facilitator today. At this time I would like to welcome everyone to the Federated Investors first quarter 2005 earnings conference call. [OPERATOR INSTRUCTIONS] Mr. Hanley, you may begin your conference.

Good morning and welcome. Today we plan about a 15 minute presentation before getting to your questions. Leading the discussion will be Chris Donahue, Federated's CEO, and Tom Donahue, CFO. Also on the call are Denis McAuley and Rich Novak from the corporate finance group.

Let me say that the 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 2004, on file with the SEC.

And with that, I'll turn it over to Chris to talk about the first quarter.

Thank you, Ray, and good morning. On today's call I will review our vision and performance in the first quarter before turning the call over to Tom to discuss the financials.

Now we continue to participate in settlement discussions with the regulators on the previously disclosed mutual fund trading issues. Therefore, I will be unable to make any further comments on these discussions or on the timing to resolve these issues. Tom will comment on the related expenses from the first quarter.

I'll start with comments on assets and flows in each asset class before looking at the distribution channels.

As regards equity assets, equity assets were down 2% overall from the prior quarter, while up 7% from the first quarter of '04. In mutual funds, over 80% of the decrease from the prior quarter was from market depreciation and the rest was from negative net sales and exchanges.

Among funds, our strongest inflows in the quarter were in the Federated Market Opportunity Flexible Fund and the Kaufmann and Kaufmann Small Cap funds. The Muni and Stock Advantage Fund also continues to have solid inflows. The Kaufmann produced higher sales in the first quarter than in either of the two preceding quarters. While net sales were solid, they were impacted by approximately $40 million in redemptions by two clients due to changes in their investment strategies.

Our Equity Managed Account product added about $270 million in gross sales that are not reported in our mutual fund sales results. This was our highest quarterly sales total for this equity product. Net sales were about $91 million and were impacted by a mandate change from a single client that resulted in a $127 million redemption. We continue to experience strong sales momentum and expansion of distribution for this product.

On the fixed income side, net redemptions continued with Ultrashort Bonds accounting for about half of the net outflows. We had positive flows in Blend, International, Capital Preservation -- which is, of course, our GIC products. Fixed Income Separate Accounts declined primarily due to the unwinding of the CEO product that was nearing the end of its scheduled 5 year term.

During Q1 assets in Federated's money market mutual funds and separate accounts increased slightly from the prior quarter due to seasonal growth on the separate account side. In our money market mutual funds, period-end assets were just about flat from the prior quarter. Average money market fund assets showed the smallest quarterly decrease of the past year and today money market mutual fund assets stand at approximately $113 billion compared to $110 billion at quarter end.

The acquisition of the Alliance Capital's cash management business is moving forwards and on the timeframe that we expected. We had our first conversion as part of this acquisition in March and we added about $820 million. We expect to convert the remaining assets during the second quarter to reach a total of about $22 billion.

We continue to work to add new customers, develop new money market products and applications and pursue acquisitions for growth in the face of the prospect of further short-term interest rate increases. Our initiative with the OCC began in Q1 and we saw some nominal asset flow, which we expect will increase over the coming quarters.

Our market share for money market funds was up for the quarter, due in part to the conversion of those monies from Alliance which I mentioned. Excluding the acquired assets, our share was still up slightly from year end and our yields remain in good shape.

As of April 27th, our managed assets were approximately $181 billion, including $128 billion in money market area, $28 billion in the equity area and $25 billion in the fixed income area.

Through the first 3 weeks of April, equity and bond fund flows showed net redemptions at about the same pace as the first quarter. As usual, we caution against drawing conclusions for the quarter from this early data.

Turning now to investment performance, we had another solid performance quarter in equities. A majority of our actively managed equity mutual funds beat their benchmarks and were in the top half of their peer group rankings for the first quarter. Highlights include very competitive performance in the Market Opportunity Fund, mid and large cap growth products, the Muni and Stock Advantage Fund and our International Small Cap and International Value funds.

Looking at the 3-31 Lipper rankings for our domestic equity funds, just under 40% of our rated assets are in the first or second quartile funds over the last year, 65% over the last 3 years, 67% over 5 years and 61% over 10 years. For taxable bonds, the comparable first and second quartile percentages are 67% for 1 year, 66% for 3 years, 63% for 5 years and 64% for 10 years.

Let's take a look at distribution. In the trust market, equity fund sales decreased 7% from the prior quarter and were up about 3% from the first quarter of '04. Trust and capital markets money market assets declined about $2 billion as higher rates in the direct market likely still had some impact here.

We continue to fare well in bank consolidations where we consistently end up on the short list of cash management providers to our clients.

Bank trust equity assets in the managed account product grew about 17% in the quarter, topping $200 million. We're encouraged by the steady growth of this product, even as market conditions were challenging.

In the broker/dealer channel, money market assets were up about $2 billion, with $820-some million coming from the Alliance acquisition and the rest from conversions and other organic growth. For equity funds, sales were about the same as the prior quarter. We were recently added to a new major bank retail platform for fund sales, as well.

Distribution of the managed account equity product continues to increase in the broker channel. The Strategic Value Mandate was recently added to another major platform and we continue to see growth in distribution and accounts from brokers, including bank broker/dealers. Some of our major platforms include A.G. Edwards, Raymond James, Legg Mason, Lehman, Bank of America, LPL, Wells, Prudential and others.

In the Edward Jones channel our assets were up slightly in the first quarter, driven by gains in money market assets. Our sales of equity funds were higher than in the preceding 3 quarters and we continue to sell a fairly broad mix of equity fund products. Our number of accounts in the Jones system is at an all-time high.

In the institutional channel, money market assets decreased by about $1 billion from the prior quarter. We added 1 new cash management customer with an initial funding of about $50 million during the first quarter. Assets have seemingly stabilized in the $10 billion range in this channel over the last 4 months.

For institutional accounts, we continue to focus on building longer-term records and on developing new strategies that can lead to larger mandates into the future.

Now an update on some new products and initiatives. A new money market fund was started in August. It now has $1.7 billion in it.

We've discussed the managed account product at the channel level and the total assets in this product from both bank and brokers at quarter end were over $1.1 billion. Our target for '05 remains $2 billion.

We recently launched a new strategic value mutual fund based on the successful managed account product and are working on other new products, including an absolute-return-style mutual fund and some new cash management products.

On the M&A side, the bank arrangements -- rollups, we call them -- continue to look attractive and we are looking at several opportunities in this field. At least this point, I would turn it over to Tom to discuss the financials.

Thank you, Chris. As noted in our press release, Federated's earnings were significantly impacted by charges taken related to settlement discussions with regulators on the past mutual fund trading issues. While the ongoing nature of these discussions restricts further commentary, I do want to note that no regulator has passed on the settlement charges and these amounts are subject to further revisions.

The total Q1 pretax charges were $52.9 million, with settlement-related expense of $50.6 million booked in the other expense line item and the rest mainly in the professional fees line. The tax provision for the quarter was impacted by our assumptions on the tax treatment of potential settlement components. Our normalized rate is still around 37%.

Moving to the Q1 business results, the 7% revenue decrease from Q1 '04 was due mainly to lower money market and fixed income assets, partially offset by higher equity assets. Fewer days in Q1 versus Q4 primarily caused this sequential quarter revenue decline of 1%. As we have previously covered, lower administrative-- administered assets from funds sponsored by third parties also negatively impacted these revenue comparisons.

On the expense side, beyond the investigation and related expenses, all other operating expenses decreased by $4.5 million or 3% from Q1 '04 and were about the same as the prior quarter. Compensation and related expense decreased from Q1 '04 due to lower Kaufmann earn-out accruals since the prior year accrual was for 2 years of payment. The current accrual is for 1 year. The increase in comp from the quarter-- from the prior quarter is due mainly to seasonally higher payroll tax and benefit costs.

Marketing and distribution expense decreased from Q1 '04, primarily from lower assets.

On the balance sheet, our cash and short-term investments stood at about $275 million at March 31st.

We purchased 674,000 shares during the quarter and increased our quarterly dividend by 20% to $0.15 a quarter.

As Chris mentioned, the first closing and conversion of business from the Alliance acquisition occurred in March and we expect to convert the balance of the assets in the second quarter. The total assets to be converted will likely reach about $22 billion. Based on converting and retaining this level of assets, our total upfront cash payments will be about $26 million, with an additional $68 million paid over 5 years for a total of about $94 million. Actual amounts paid will depend on assets and related revenues over the next 5 years.

We still expect this business to add $0.02 to $0.035 per share to 2005 earnings and $0.03 to $0.05 on a full-year basis. After the conversions in this quarter, we'll be able to provide more detailed guidance on the specific revenue and expense line items impacted by the transaction.

Another area of impact to 2005 earnings is option expense. At this point we do not plan to adopt 123(R) in 2005, so we will not have the $0.01 per share impact for Q3 and Q4 discussed last quarter. While we have not finalized our methodology, it looks like the earnings impact based on our present outstanding options will be about $0.03 to $0.04 on an annual basis for the next couple of years, beginning in 2006.

Finally, in March the FASB issued FSP EITF 85-24-1, which addresses the accounting treatment for B-share commission funding arrangements as financing or as sales. We are currently evaluating the implications of this new guidance and we will adopt the appropriate provisions in the second quarter.

That completes our presentation and we will now open up the call for questions.

Thank you. [OPERATOR INSTRUCTIONS] Bill Katz, Buckingham Research.

I'm sort of curious if you could give us an update on what's going on on the institutional channel?

Bill, good morning, this is Chris. What's going on in the institutional? Remember that the way we put our organization together, institutional includes our work to direct advisors, our work with government entities and a cash component and then, of course, the efforts on calling direct large mandates. And I think you're probably asking about the latter more than the way we calculate the figures and have reported them. Am I right on that?

That's correct. I apologize for not being more exact.

On the institutional side, as I said in my remarks, what we're-- what we're working on are building records for the long haul. As you know, until you have what amounts to a 3 or maybe even 5 year record you do not screen up to par in those areas. We have several mandates where we can screen on the fixed income side, but we're still working on-- on those in other areas. So to us this is a project for the out years, not for the current timeframe.

OK. And so the second question, I appreciate the acceleration of the retail managed account flows and distribution and you reeled off a number of sort of distributors that you're participating with but conspicuously absent from that are some of the bigger platforms. And I know I ask you this every quarter, but there are others around you that, seemingly, are having very good organic growth in these channels off higher bases and I'm just sort of curious if there's anything stunting your ability to get on Merrill or UBS or some of the other platforms that would-- might accelerate the growth of this line item?

Well, I'm not aware of anything in particular. As you know, Merrill Lynch in one case has gone through several different personnel changes and this has been a source of frustration for us in terms of the products we have, which we think are better than the products that they have on there now. But it remains just a constant effort of calling and presenting and calling and presenting.

And as I've mentioned, I think now for several quarters, we continue that effort and we aren't aware of anything in particular that doesn't enable it to happen, which only enhances the frustration.

Bill, it's Ray Hanley. On-- when you look at the stats, although they're not as precise, perhaps, as the fund stats, the Merrills and Smith Barneys, clearly, are at the top of the asset heap in the product, but the flows have actually broadened out so a number of the platforms that Chris mentioned are, in fact, top 5, top 10, top-tier providers in this product.

OK. And so one final question on organic growth. I'm just sort of curious. There's some other, larger, players that have reported their result and pretty prolific in terms of organic growth and flows and retail managed accounts. I'm sort of focusing on the mutual fund side of the equation.

Your performance is solid but it's not necessarily top-tier and you're still sort of laboring with the market timing issue. Do you think you need to sort of ramp up the advertising spend or the marketing spend to try and recapture some momentum as you sort of exit any settlement, whether it's next quarter or the quarter after that or even tomorrow?

I think that will certainly be a discussion in terms of ramping up advertising in the environment you're talking about for exactly the reasons you're talking about.

OK. You want to quantify what it-- would it be double from where we're at? I mean, it's a relatively low number as it stands now.

No, I haven't really-- We haven't really put enough meat on that bone to do that and I would be very reluctant to try and guess what that expense might be. But the concept is right there.

Cynthia Mayer, Merrill Lynch.

A couple of questions on administrative fees. I know it's being down, but it seemed like it go down-- went down a little bit faster this quarter and I'm wondering what sort of trend you're seeing there, if we should extrapolate that it's-- it's declining a little faster and will continue to decline at that pace.

Cynthia, it's Ray. The decline has been just about exactly what we had forecasted with the assets going down by about 50% from where they were when we first started talking about this, I think, 2 quarters ago. The full run rate wouldn't be in the first quarter, but a good bit of it would be. So on the third-party administered side, you've really seen the bulk of it and our projections for the impact for the full year being in the $0.03 range, $0.03 to $0.04 would still hold there in terms of negative impact.

On the Federated side, it's been driven by the overall decrease of assets year-over-year with the money funds, so that's kind of just more like a straight formula.

So you would expect it to stabilize here, except for the fluctuations in money market assets?

On the third-party administered side, it's heading to a stabilization point. On the Federated side, it'll be dependent on assets.

OK, great. And, let's see, in terms of rolling up other money market assets, I'm wondering if you could just sort of update on what kind of opportunities you're seeing? And do you want to finish consolidating the Alliance assets, really, before you look for anything else? Or what sort of pace are you thinking about and what governs how fast you can go out and buy things?

Well, on the-- on the pace question, we'll answer that one first. The rollup in the Alliance is not putting a pause on our efforts to look or even to conclude to do other deals. So that is not really a pause. That's a lot of work and it's something that has to be done and done properly, but it doesn't put up a roadblock for us.

Some of the other things that we're seeing. Increasingly, almost any institution that has small or not-growing mutual funds and, especially, money market fund assets is looking at the cost of compliance being severe and the cost of non-compliance being nuclear and concluding, "Hey, can we grow this business? Is this a core business for us?" And so there is a rather large component of people taking a look at their strategies here.

Now you say, "OK, what about the timing of these things?" Well, each one of them is related more towards the individual decision making at that institution than something that we could force to make happen. So we remain in the position of calling on all of these people, talking to them and working with them on their timeframe to fold into their strategy.

We think that the pace is definitely accelerating and we're talking to number of people, but it's quite difficult to say, "Oh, well, this will be the number or here's what a peek in the pipeline looks like."

OK, great. And just a sort of a very general question on the industry, when you think about possibly greater disclosure of revenue sharing agreements, what sort of impact do you think that'll have in terms of the competitive landscape? Do you think there will be a greater emphasis on performance?

I don't think that the impact of greater disclosure on those payments will be much at all. I think that that disclosure will occur and overwhelmingly the surveys have indicated that people who are using intermediaries know that they are paying for them and are willing to do it. So the increased disclosure would just be more information along those lines.

On the second part of the question, about the increased focus on performance, there's increased focus on performance regardless of whether there's more disclosure on the cost It's just the way it is and there's nothing wrong with that. I'm not lamenting that fact, but it isn't artificially accelerated by the greater disclosures of the fees and charges.

OK. And final question, just can you update us on CDOs, how many exist at this point and equity exposure?

There's no equity exposure. There's no remaining book value. We have two high-yield CDOs with a couple hundred million assets that will likely run a couple more years and we're looking at other opportunities.

Ken Worthington, CIBC World Markets.

On acquisitions, has your talks with regulators impeded your ability to approach some potential sellers? Like, obviously, you were able to complete Alliance Capital, but has it prevented you from making deals in other areas?

Well, obviously, if someone doesn't call or let us in on a potential trade, we don't know about it. But to date, we have not felt that we have been restrained in being received, especially with people in the bank world who know us and have known us for over a quarter of a century in terms of doing this kind of transaction.

Thank you. Can you also update us on 15c3-3? Has there been any progress there that you're aware of in the last quarter or so?

We consider it progress in the sense that we continue to work on it. There are efforts continuing. We've met with all the SEC commissioners. We're continuing to work with the staff on it and we're just continuing to work it.

But as I've mentioned on this call for quite a lot of time now, we don't control that process. Both the clients, meaning the brokers that would use the money funds and us, are in favor of this and we think it makes a lot of sense, but it takes a lot of time and a lot of work in order to get it to fruition. So we continue to work it and that's about all I can give you at this time.

Great. Thank you. And I know you don't really want to comment on the mutual fund settlement, but is it fair to say that fee cuts are on the table?

It's fair to say that no one has settled with the Attorney General who hasn't had fee cuts.

Perfect.

William Tanona, J.P. Morgan.

Just quickly on Alliance -- I know you guys say that you expect the remainder to close here in the second quarter, but can you give us some type of timing in terms of how we should think about this from a modeling perspective?

Well, we're hoping to have closings in May of a substantial portion of the assets, the biggest portion of the assets, 80-90% of them.

By May?

In May, during May.

OK. And then, with the-- I believe you said the majority of the equity outflows came from a lost mandate. Can you give us a sense as to was that just doing some portfolio rebalancing or was it something to do with performance or did they give you a rationale as to why they withdrew assets from you guys?

Bill, it was one of the mandates within the separate accounts, the SMA product that you were referring to and it was within large cap value and they selected another provider. The growth that we've had there, essentially, has been driven by the strategic value mandate and that just continues to have very strong performance. It continues to penetrate new distribution platforms and, in fact, it's been so successful that that was the basis for launching the new mutual fund product that we-- that Chris mentioned, which has gotten off to a very promising start on the sales side.

The other decrease I mentioned -- and I don't know which one you were referring to -- was in the Kaufmann Fund and 2 clients moved out of that fund and it was $40 million and that was due purely to changes in their investment strategies, not due to performance analysis of the Kaufmann Fund.

Right. That's changing from growth or from-- and/or from small cap.

OK. And then, as you think about value being-- having been in favor for quite some time and people speculating about growth, any thoughts on initiatives to launching any type of new growth funds or some type of liftout to acquire more growth capabilities outside of just, say, the Kaufmann Fund?

Well, you bring up the thing of liftouts, but I don't think that's really the spirit of your question. We continue to look for acquisitions and we would do that, as well. We think we have a pretty good, solid array of product on the growth side with the 2 Kaufmann funds, plus the Mid Cap Growth Strategies Fund, which has an outstanding 3-year record and even in the top decile here in the first quarter. So they've got a pretty strong record.

So we think we're in pretty good shape if the worm turns and leans heavily on the growth side of it. That is not to say, though, that we wouldn't do a little shopping if we saw something available, but it wouldn't be in the form of a liftout.

Yes, Bill, just to elaborate on that a little, I mean, we're solid in small to mid cap growth, obviously, with Kaufmann. Chris mentioned the Mid Cap Growth Strategy Fund, which has been top decile in the recent quarter, 1-year, 3-year. Even beyond that, the record's very solid.

And then the Large Cap Growth Fund has had a pretty good turnaround over the last year and a half under Phil Orlando and it was in the top 5% of its category last quarter. It's kind of median on a 1-year basis, but-- so we think we'd be pretty well positioned for growth.

Chris Meyer, Morgan Stanley.

I just have one question. It's encouraging to see the stability in the money market assets. I just wondered if you could help us understand whether that is a reflection, you think, of clients being comfortable that we're nearing the end of the rate-tightening cycle or whether it's just a lack of desire to invest in the equity or bond markets?

Well, at base what it really is the recognition of money market fund assets as a cash management service as much, if not more than, as an investment, per se. That-- this goes inside the organization of Federated and back for 25 years that substantial portions of the cash of our customers are cash management service-type money that are going to be there no matter what the rates are doing.

And so the top half of the chart, the top that you're talking about has gone out into the market. Those assets that were sensitive to the increases in interest rates have moved and so you've seen, over time, and we've discussed on these calls before, a lessening of the departure of those assets as the most sensitive ones have moved out first.

And that's really the dynamic as it works. So it's very hard to conclude that, "Oh, well, money fund assets have stabilized because people are shy of the equity market." Yes, there's some of that going on, but in many of these cases -- you take the broker/dealer cash -- that money is more or less stable based on how broker/dealers do at raising the share of wallet that their customers have. And in a bank trust scenario, about 20% of a bank trust assets are going to be in cash all the time anyway, whether they're fully invested or afraid of the market.

So, yes, those factors are there but the bigger factor is the cash management service aspect of this business.

So, Chris, the-- the small rise from-- well, maybe it's not that small, from $110 to $113 billion quarter end to today, can you just give us which channel that's been most prevalent in?

Chris, it's actually Ray. The retail continues to be the-- be the fastest-growing into the month. We got past the April 15th period with a minimal disruption which we have had typically with tax payment day. You can see some outflows there, which we had right on that day, but that seems to have recovered pretty quickly.

The interesting thing about being up the couple of billion that Chris mentioned, perhaps a couple hundred million of that are new conversions related to Alliance, but the bulk of it would be organic.

[OPERATOR INSTRUCTIONS] Bill Katz, Buckingham Research.

Sort of going back to the comment on fee-- potential fee concessions as part of a settlement. If you look across some of the other players that have settled, the fee reductions have been pretty broad-based and beyond sort of the funds that have been impacted. Would that be sort of a similar model that we should be thinking about?

Once again, the way I would respond to that, Bill, is that my understanding of previous settlements is that the settlement amounts were allowed to be distributed among the funds based on how the manager, the investment manager, felt about it. Those were not directed by the regulators in terms of how that was done. So that you've got other factors there, as well, in terms of the fund boards have an oar in the water on that one and so it's really tough to make a specific comment about us. So that's why you've heard me making comments about what other settlements have already done.

Right. I'm sorry to paint you into a tough corner here because you're in the process of this, but I guess what I'm asking you is in terms of fee concessions, not so much as a remuneration in the funds, but in terms of price cuts, should we be thinking across the entire platform of the retail or really just geared to sort of the funds that may have been affected by the alleged market timing?

It's my understanding that the way the other settlements have worked is that if there is an overall number of a fee concession that the investment manager has the ability to spread that in any fund that they and the boards of those funds determine it's appropriate to spread it into, whether or not the fund was involved in any of the market-timing issues or not. So that is how the other settlements have gone.

OK. Thank you. I appreciate that.

David Haas, Fox-Pitt, Kelton.

A quick question just on the money market side. If I'm sort of looking back at the end of '02 with $150 billion in money market versus today, can you give us a sense for the-- sort of the margin give-up as a result of the lower assets and what sort of margin extension we could see if we get back to those historical levels?

David, I-- the margin, actually, net of the regulatory and investigation-related charges, our overall margin has stayed pretty consistent that you reference. It would be-- I don't think that we could quantify the precise impact on earnings from the decrease other than to say that there is, obviously, some leverage in that business and it goes both ways, assets up or assets down.

OK. And just on-- in terms of the number of funds that you have outstanding, if I sort of look at your number of funds versus the assets you have versus competitors and we had a competitor suggest that they were going to start merging and bringing down the number of their funds, what are you thoughts there? Are your thoughts to consolidate anything in the near future or maintain the same level and amount as today?

I would say, inside Federated on at least a monthly basis, we look at the array of funds. And we look at it for the purpose of analyzing the life of each fund. And we don't look at it from the perspective you're talking about -- "Oh, well, let's consolidate funds," because each fund has its own life, its own goal, its own shareholders, its own investment objective and has to be analyzed one at a time.

And so within that, we are always consolidating and reviewing. There are a couple of consolidation of funds that we approved last week in one of our internal meetings and so that will be proceeding apace. There are others that we are looking at, but it is a constant effort here so that we never end up with a whole gang of them to do because of some theory like that. It has to be a constant review.

Cynthia Mayer, Merrill Lynch.

Just wondering, quickly, whether the market-timing negotiations have, in any way, impeded share buybacks and generally any shift in thoughts on use of cash?

Well, Cynthia, if we are in possession of material non-public information, we're not allowed to buy shares. So to the extent that we are in the middle of discussions with them, we are not able to do that. If you look, we bought 600,000-some shares and we released information of where we were and when we were not in possession of material information we were able to purchase.

At this time, there are no further questions.

Well, thank you for joining us. That concludes our call.

This concludes today's conference call. You may now disconnect.