Federated Hermes Inc (FHI) 2007 Q2 法說會逐字稿

Greetings, ladies and gentlemen and welcome to the Federated Investors Incorporated Q2, 2007 earnings conference call. At this time, all participants under a listen-only mode. A brief question-and-answer session will follow the formal presentation. (OPERATOR INSTRUCTIONS) As a reminder this conference is being recorded.

It's now my pleasure to introduce your host, Mr. Ray Hanley, President of Federated Investors Management Company. Thank you, you may begin.

Good morning and welcome. Leading today's call will be Chris Donahue, Federated's CEO, and Tom Donahue, Chief Financial Officer, and also with us are Dennis McAuley and Lori Hensler from the Corporate Finance Group.. Let me say that certain statements in this presentation, including those related to money market assets, investment performance, sales, new products and acquisitions constitute forward looking statements which involve known and unknown risk and other factors that may cause the actual results to be materially different from any future results, implied by such forward looking statements. For a discussion of the risk factors see the section titled risk factors and cautionary statements in Federated's annual report on Form 10K for the year ended 12/31/06 and other reports on file with this SEC. As a result, no assurance can be given as to future results, and neither Federated nor any other person assumes responsibility for the accuracy and completeness of such statements in the future. And with that, I'l turn it over to Chris.

Thank you, Ray. Good morning. I will begin by reviewing Federated's recent business performance before turning the call over to Tom to discuss our financials. Starting with the cash business, money market fund assets grew by $8.6 billion during the quarter. The Q2 growth was strongest again in the broker dealer and in the wealth management channels. Cash separate accounts had a decrease of about $1 billion, consistent with expected seasonality.

On the institutional side, we have begun to see a slight steepening of the money market portion of the yield curve. The yields of all our institutional prime funds remain just behind the overnight rate. About 1/2 of the quarter's money market fund growth came from the capital markets and corporate channels, which tend to be more rate sensitive. In terms of market share of assets, we are at about 6.8% as of the end of Q2, up from about 6.7% in Q1 and 6.6% at year end. As we noted before, we believe that short-term metrics on market share are less useful than share over longer periods and we continue to expect to grow our market share over time as we've done over the last 10 to 15 years.

An update on our efforts on functional equivalency for money market funds show that's the CFTC application ended the quarter at about $450 million, while the OCC, options clearing corp, grew to more than $800 million. We continue to work through legislative efforts to enact the changes we've been seeking with the SEC around the 15c33 effort, which is broker cash. On this item, a bill has been introduced in the House, Bill 1171 and we are looking for support in the Senate as well. The cash funds international multi-currency product with PNB, Perry Barr Investment Partners, and Henderson Global Investors, saw some cash flows in Q2, but is still in it's start-up phase. Assets in this product were about $200 million at quarter end.

Turning to equities. Assets have increased about $2 billion from the prior quarter. The growth came from market appreciation and from positive flows in separate accounts, offset by net outflows in mutual funds. Equity Mutual Fund outflows decreased, however, from the prior quarter. Among our actively managed products, outflows remain concentrated in three areas, large cap value, large cap blend and our contrarian market opportunities fun. As we've discussed previously, we continue to work on repairing the records and the blend in large value. In fact, the large blend capital appreciation fund has continued its very strong performance rebound. The fund ranked in the top decile of it's category for Q2, year-to-date '07 and over the trailing one year period. Large value has underperformed during these same time frames.

The market opportunity fund is a unique strategy that's not correlated to the U.S. equity market. Through it's relative performance is not a significant performance measure, it will tend to outperform its assigned category in down markets and underperform in up markets, with predictable impact on rankings and flows. With markets up mostly in Q2, this fund experienced nearly $200 million in net redemptions and this trend has continued into the first part of '03, with the last two days, this is one area where there is happiness in a portfolio manager.

The Kaufman Fund had modest outflows in Q2, consistent with industry results for domestic growth funds, while the Kaufmann's Small Cap Fund continued to produce net inflows. Federated Kaufmann Fund products produced positive net flows on a combined basis during the second quarter. Now with the usual caution about a few weeks of information, we'll mention that net outflows in our actively managed equity funds are running at a higher pace for the first three weeks of July, compared to Q2, with higher outflows from the aforementioned market opportunities fund. Assets in the Federated MDT Equity Mutual Funds increased 42% during the quarter to reach $754 million. Two-thirds of the increase came from merging the Federated Large Cap Growth Fund into the MDT Large Cap Growth Fund. Excluding the merger, fund assets increased about 15%, with more than half of the growth from net sales.

We also continue to have success with MDT in the institutional area, winning four new accounts in the second quarter with initial funding of about $23 million. MDT's SMA strategy had modest net outflows as we continue to work to increase sales from the Q1 '07 reopening of the All Cap Core strategy. MDT total managed assets in mid-July reached $9 billion. That's up $2.2 billion from the acquisition a year ago, when the assets were at $6.7 billion. We also saw continued solid net inflows in our strategic value equity SMA product. Federated's total SMA assets reached $10.8 billion in the second quarter, up about 14% year-to-date. Overall, equity separate accounts, including SMAs and institutional accounts produced just under $200 million in net flows during the second quarter.

On the Fixed Income side, net redemptions decreased to about 1/2 of the level from the prior quarter. We continue to see positive flows in Federated Total Return Bond Fund which has performed well over a long time frame. Fixed Income Fund performance remains strong in most products. For the first couple of weeks of Q3, flows are negative and on a pace similar to Q2. As of July 25th, our managed assets were approximately $261 billion, including $195 billion in money market, $43 billion in equities and $23 billion in Fixed Income. Money market mutual fund assets stand at about $174 billion.

Looking at investment performance, and using the June 30 Lipper rankings for Federated's Domestic Equity funds, the numbers continue to improve. 72% of rated assets are in the first or the second quartile over the last one and three year period. 61% over five years and 63% over 10 years. For Bond Fund assets the comparable first and second quartile percentages are 85% for one year, 83% for three and five years and 78% for 10 years.

Turning to distribution, in the wealth management and the trust market, we added five new institutional cash management customers, with initial assets of $137 million. Money market assets in the channel grew by nearly $4 billion, driven by gains in capital markets an institutional brokerage channel. We also saw growth in the equity managed account product, with assets up 12% during the quarter to reach nearly $1 billion. In the broker dealer channel, growth in the SMA product continued, assets grew 7% in the quarter to $9.8 billion. Money market assets also continued to grow in this channel, gaining about $4 billion during the quarter.

Within Edward Jones, money market assets continued to grow. Our year-to-date monthly average gross and net fund sales have improved at Jones, compared to the last four months of '06. We continue to devote substantial resources to improving these results. In the bank broker dealer channel, we were recently upgraded to the top tier of fund providers in the platform for a major U.S. bank. In the global institutional channel, we continued to have success on the institutional side, winning nine new accounts in the second quarter. We expect to see about $300 million from these wins, with most of the -- most of this money coming in during Q3. These wins occurred if a variety of styles, including MDT small and midcap strategy, strategic value equity, core fixed income, and active cash. We continue to experience elevated RFP activity, and to reach more files presentations for institutional equity account opportunities since the MDT acquisition, and for our stronger fixed income mandate as well as for our cash management.

We are proceeding on schedule with the previously announced acquisition of certain assets of Rockdale Investment Management, related to the management of the $364 million highly ranked Rockdale Atlas portfolio. We expect to close this acquisition in Q3. We also recently announced new leadership for our international equity portfolio management team, as we work to upgrade our product offering in this important area. We remain interested in acquisition opportunities and continue to have discussions for both consolidation and center of excellence deals. Tom? Thank you, Chris. For Q2, revenues increased about 17% compared to Q2 '06 and 5% from the prior quarter. The increases were due mainly to higher money market and higher equity assets. In addition, the MDT acquisition impacted the year-over-year totals. Q2 also has one more day than Q1, which affects both revenue and marketing and distribution expense.

On the expense side, lower compensation and related expense from the prior quarter was due mainly to seasonality and payroll taxes, 401k contributions and to the $1.1 million of severance expense that was recorded in the first quarter. Compared to Q2 '06, the increase was mainly from MDT, as well as higher incentive compensation accruals and stock compensation expense. Marketing and distribution expense increased from the prior quarter, and from Q2 '06 largely due to money market fund growth. Especially in broker dealer channels where products are structured to pay distribution and service fees to the intermediaries. The additional day in Q2 also added expense compared to the prior quarter. We expect to see continued pressure in this line item and expect to see this expense increase from the Q2 levels.

As related assets increase, payments to intermediaries increase. In particular, growth and broker dealer, money market funds will result in higher marketing and distribution expense, as most of the related revenue, revenues are paid to -- through to the intermediaries. Also, additional payment requests from the intermediaries leads to increases in the marketing and the distribution line item. We referred to this in the past as a success item since these expense increases are increased as related assets increase. Professional service fee expense increased from the prior quarter due largely to higher general legal fees, consulting fees and professional search firm fees. Intangible amortization expense decreased from the prior quarter due to the independent appraisals final asset valuation from the MDT acquisition, reflecting a higher allocation to goodwill than in the preliminary draft valuation. In addition, certain other intangible assets rolled off. The expense in Q2 is a good estimate of the run rate for the next couple of the quarters.

The operating margin for the quarter was 32.1%. If significant growth continues in the broker dealer money market asset area, the related marketing and distribution expense makes it more difficult to increase our margins in the future. The Q2 tax rate was 37%, down slightly due to the impact of various state tax changes. We continue to estimate our full year 2007 tax rate at 37% to 38%. On the balance sheet, cash and short-term investments were $129 million, at the end of the Q2. During Q2, we paid $13 million for the second of five earn out payments to alliance from our 2005 money market acquisition.

The first of three potential contingent payments from the MDT transaction will occur in the third quarter. MDT assets have increased over 30% from the $6.7 billion in acquisition, based on the related revenue growth, we will make the maximum year one payment of $43 million, which is fully accrued to goodwill at the end of the second quarter. As Chris mentioned, the Rockdale acquisition should close this quarter. In this transaction, the up front purchase payment will be $5.75 million, we will also pay Rockdale contingent purchase amounts over five years based on revenue growth and investment performance. We expect the acquisition to be neutral to book earnings in year one and two, and will provide more information on line item impact after we complete the acquisition. We would now like to open up the conference call for questions.

Thank you. (OPERATOR INSTRUCTIONS) Our first question comes from Ken Worthington with JPMorgan. Please state your question.

Hi. Good morning. I guess firstly, could we just get an update on your relationship with Pershing, the [Mellon] Bank of New York merger has closed. Any changes there?

Well, in terms of the relationship with Pershing, as we mentioned on the, on the last call, our relationship with Pershing remains very, very strong. And there have been no changes that we are aware of as of, as of right now from that last, that last call.

Okay. Perfect. Thank you. In terms of return of capital, you guys have been very aggressive -- or not very aggressive, but you've been very good about returning capital to shareholders. The buyback in the most recent quarter was smaller than usual. Any, any reason for that? Or any reason why we shouldn't expect more robust repurchases in future quarters?

Hey, Ken, if we look at that during the quarter, we view ourselves opportunistically, and if you look back over the last six quarters, we've purchased over 7 million shares, kind of like you mentioned. And we look at the price and where things are and all the factors. And we're not compelled in any one quarter to hit some target, so we view ourselves opportunistically purchasing the shares, and we will continue to do that.

Okay. Thank you. Yes just fishing a little bit there. And then lastly, on the C rate, we were kind of wrong this quarter. The investment advisory revenue over the average assets was flat for the quarter. And actually, if you take it out a couple of decimal places, it fell. Given that equity markets were so strong and equity assets grew a bit faster than the money market fund assets, why did that fall for the quarter? I would have expected it to kind of creep up.

Ken, this is Ray. There's-- as you know a lot of products that go into those blended numbers that you're looking at for the equity and money market and then there, of course is -- each product has its own financials and accruals and all of that enters into what comes out as the blended C rate. So there's really nothing that we could point you to there. Nothing of consequence other than whatever the resulting mix of, of individual products were under each one of those categories, the end result just comes out there. We've not done anything on the pricing side.

Okay great. Thank you. I was just fishing again. Thank you very much.

Our next question comes from John Fox with Fenimore Asset Management. Please state your question.

Yes, hi good morning. Just wondered if you could go through again the MDT? I mean you talk about the assets being up but, of course the markets up quite strong since last July. So could you break out maybe market appreciation, net flows and then the effects of any combining any funds into the mix?

Well, to go over what happened on the Equity Mutual Fund side, when we bought those funds, they were a little over $300 million. Now they are just a little over $750 million. Okay. Now, during the quarter, they increased 42%. What I said in my comments was that 2/3 of that increase came from the Large Cap Growth Fund merger. And then if you exclude the merger, the fund assets were up about 15%, and about 1/2 of that was from net sales. By the subtraction method, the other 1/2 was from appreciation.

That's from March 31st, '06?

That's for the, for this, for the quarter, right.

Okay. What was the beginning balance at March 31st '06?

'07. It was --

Right, '07. I'm sorry.

$131 million on the funds and they closed the quarter at $753 Q2. So they are up $223 million, of which about a little under $150 million was from the merger. And actually more than 1/2 of the rest was from positive net sales.

Okay. And the second question is I would expected the cash balance to be higher, given the lower amount of buyback this quarter. I guess you made the alliance payment. Were there any other significant cash payments in the quarter?

Taxes. I don't --

So nothing unusual?

No.

Okay. Thank you.

Our next question comes from Craig Siegenthaler with Credit Suisse. Please state your question.

Thanks, good morning.

Good morning.

Just a quick question on the multi-currency cash fund. Just wanted to know how much of the $200 million of assets were provided from the managers versus third parties, and also what fee you're earning on this product?

Well, it's all third parties.

Okay.

The fees are individually negotiated and they're in the single-digit range and it's -- the way you do it over there, it's individually negotiated by, by client.

And so there's no seed capital place, but you guys are (inaudible)?

No. Craig, let me elaborate on the assets. We're also picking up some assets from the relationships with these partners but outside of CFI and that was an additional couple hundred million over the last couple weeks that have come in through working with our partners there.

So is the $200 million purely on your -- with your accounts or is that shared three ways, and is economics with single-digit based and point ROA, is that shared too or is that the break you get?

That would be our remaining portion, but the $200 million is solely in our offshore money market mutual fund product.

Got it. And oh, then on the Fixed Income business. Just wondering, performance there is pretty strong. What do you think it's going to take to turn that into positive flows?

Well, we continue to work on that. What it really takes is, unfortunately, a lot of what happened in the market place in the last couple of days, as people change their attitudes about what they're doing. So I think what you see -- if you look at the sales picture of the Federated sales force over the years, you see them able to switch and take advantage of opportunities on the Fixed Income side, or the equity side where the markets give them the best opportunity. So I can't give you a specific answer as to when those flows on the Fixed Income or for that matter on the equity side would turn, but we're looking forward to it. We made good progress this year with-- or this quarter with the net flows being net -- less worse by half for this quarter versus last quarter. And those continue at a pace so far this year. So it's just continually blocking and tackling. There's no magic bullet out there that's going to do it. It's just a long term continual process of making the sales, presenting the case and keeping the performance up.

Great. Thanks.

(OPERATOR INSTRUCTIONS) Our next question comes from Bill Katz with Buckingham Research. Please state your question.

Okay. Thank you. Good morning, everybody.

Good morning, Bill.

I just wanted to come back to your discussion on the distribution expenses related to the money markets. Is this merely just a mix shift or an acceleration of growth in the channel, or have the economics actually changed?

Well, it -- the acceleration in the broker dealer channel has run now for probably close to two years and it's just a function of the interest rates getting to the point where the returns attract assets. So that channel has grown their money market assets pretty substantially. In terms of the underlying business, it's very competitive, as is the rest of the money market business. And so I -- it's hard to point to any particular change there, other than there's constant distribution fee pressure.

Okay but still, it looks like those expenses rose faster than the related assets. So is it the distribution fee pressure that you're signaling there?

Yeah, and in that quarter too, in Q2, there were some lumpy things in there but as we look forward, out over the next couple of quarters, as Tom mentioned, we see that line item bumping up even with those items notwithstanding.

Okay. And then just a couple of other questions. It seems like some of your peers are de-emphasizing the separately managed account, reflecting some trading and economic issues that they see. And yet that seems to be an area of continued great focus for you. Are you seeing any kind of change in the economics erosion of margins as you build those assets?

No. And we do not have the view that you assigned to others there. We look at the SMA business as an excellent business today, growing into the future. The structure of the sales force that we have under Mike [Bavers] leadership is working well, and as I mentioned, we're working on the All Cap Core the Strategic Value, the Fixed Income side and we like this business and have seen -- we haven't seen the factors that you're talking about, erosions of margins or things like that.

Okay. Just two more. Given the credit dislocation that's been going on in the subprime world. Just sort of curious, are you seeing any ripple effect in the money market channel in anyway?

No, we are not and just for the record, we sure don't believe we have any problems in the subprime holdings in, in any of those money market funds at all. Or in any other product. Or in any other product as well.

Okay and just lastly, I just want to come back to capital management for a second. And if I look at your stock price in the second quarter, it was up a little bit but down a little bit, but on average it doesn't look like it changed much, yet the buyback did slow. Though I appreciate Tom you saying, you don't have to be in the market at any one period of time. Is it just husbanding of capital for other alternatives at this point in time? I'm trying to understand why you would slow down, given that the stock really didn't do much.

Bill, I went back and looked at the last six quarters and we bought -- a year ago, we bought 2.4 million and we paid $31.70. And in the fourth quarter we bought 1.3 million, and we paid $33.50. So the price in the first quarter, when we bought 1.2 million that we paid was $35.77. So this past quarter, to buy only 250,000 shares we paid almost $38. So you're right, during the quarter, the price didn't change much, but it's, it certainly has gone up from the previous quarters of purchasing it. And I say we're -- we look at it and we're opportunistic, and we look at a bunch of other factors and next quarter is a new quarter. And as I always like to say, we will remain active in buying the stock, because we like to score on all three streets, as dividends, share repurchase and acquisitions.

Okay. Thank you.

Our next question comes from Cynthia Mayer with Merrill Lynch. Please state your question.

Hi, good morning.

Good morning.

I apologize if you covered this, but will you be making a payment to MDT next quarter, I think?

Yes. In the third quarter, $43 million.

$43 million.

Already accrued.

And after that, what payments remain to them?

Two more payments if they hit the growth targets of the same level.

Over -- over subsequent years or quarters?

Over next year and the year after.

Okay. And just to circle back to the question of the Pershing, I wondered if you could comment maybe on the other part of the money that you manage, which I guess would be sort of more corporate balance sheet money. Do you have any update on that?

We don't have any update on Bank of New York, [Mellon] assets outside of Pershing. We continue to work with the combined entity and as we said in the past, we work with just about every large U.S. bank. We found that even large banks with proprietary products will have a need for outside providers and so we expect to continue to work with Bank of New York and [Mellon] in this regard.

What is the size of that pool of money?

That gets us into our client balance and that's something we're not commenting on.

Okay. I also had a question on comp. It looked like it was a little lower, even if you take out the one-time stuff last quarter. Is that a sustainable rate?

Yes, the, the, number, that we had a severance number in there of 1.1 million also.

Right.

That and the 401k and the first quarter tax stuff. We mark that -- I'll call it, we mark that the market on our bonus calculations or what we think we're going to hit for the year every quarter, and we make as best estimate as we can. And if things pick up performance wise, that number picks up, things trail off a little bit, it'll, it'll go down. It is really every quarter we look at it and say what's the-- our best expectation on what we're going to pay.

Okay. Great. And last question. I appreciate no, no exposure as you said. Just can you remind us if you have any equity interests in CDOs or CLOs.

Well we had-- we did do a CDO last year in October. And with we launched this, we launched it as a high quality CDO. So it has performed very well to date. It had a very strong quality bias on it and none of the holdings in that CDO have been downgraded or even placed on negative watch, despite all the recent downgrades of other securities. And what it means to Federated, in terms of our equity investment, we put one-- little less than $1.5 million in this, as our -- as our equity investment. So that would be, I guess, our maximum potential loss. But as you know how accounting works, we have not impaired this carrying value at this time, which is a proxy for what is required to make a judgment on impairment on that asset. Well, and Chris, not only have we not impaired it, but the equity flows are higher than we had anticipated nine months into the deal.

Right. Okay. Thanks a lot.

Our next question comes from Robert Lee with KBW. Please state your question.

Thanks. Good morning, everyone.

Good morning.

Chris, I have a question for you. I know you're an active power shopper, I guess as you like to put it. Are you seeing any -- notwithstanding the last couple of days or weeks of market performance, are you seeing -- have you see any change in seller expectations as it relates to pricing, considering that there's so many -- it seems like there's so many potential buyers out there? And do you think -- well, I guess that's the first question.

Well, not -- not really. And the reason is that any one of the deals that we end up concluding is so individual and specialized that it's very difficult to put it on a trend line, at least from my perspective, because I don't look at them as an investment bank that adds up all the deals and then has 20 or 30 or 50 in a book and then says, oh, the prices are moving this way or that way. We look at them as individually as you'd look at your own children, and say, well, this one's different and this one's different. And so the pricing is unique. So it's very difficult for me to put my finger on some trend change, such like you'd be looking for.

Okay. And the second part of that -- the second part of the question is, are you somewhat surprised that you haven't seen more money fund businesses maybe on the block? And clearly there's been a lot of assets flowing into money funds generally, or cash management generally, but it clearly as you point out it could be pretty much a scale business. But it doesn't seem like past your alliance transaction, that there's been much going on in that space? I mean, does that surprise you? And why do you think more people haven't given up the ghost there?

Well, I wouldn't say exactly surprised and part of the reason is that if you have a gang of money funds and you have some control over the redemption profile of those money funds, you can successfully run a money fund at rather small numbers, 1 billion, 10 billion or whatever. It's that when you have the potential, and the variety of clients that can call up and dent significantly your reposed position, that the portfolio manager begins to get queasy. And when that happens, that's when these kind of sales occur.

You also get them when the owners decide, as you say, to throw in the towel or, or whatever in terms of the overall performance. And the legitimacy of the business in terms of its growth profile. But if people are just not -- if they're not impacted by the potential of redemptions and nobody throws in the towel, it's very difficult to move them. So we share your enthusiasm and do a lot of effort in terms of trying to stimulate a wider trend in doing alliance type deals, but they are lumpy in terms of how they get concluded. Rob on the-- on a lot of the broker dealer cash that we've talked about on the call, while it's not acquisitions, the group here that works on it goes out and, and wins the business from, from somebody else. And I say it's not acquisitions because they are just moving it. But you could do, you could do a lot of comparisons there, although we don't pay up front for it. It's a different form of money, money market assets moving to us and moving away from somebody else.

Okay. And one last question. The -- and clearly, it's been a pretty hot environment for closed end funds for a lot of competitors. And I know you've done a couple in the past. I mean given your fixed income orientation, sort of the income orientation of a lot of your equity products, can you maybe talk a little bit about why do you think -- has that been a market you've started to try to get some shelf space on, or is that your plan down the road? Can you maybe address your views towards participating in that market a little bit more?

We like the closed end area. And we're looking at some products right now, and we're pretty optimistic about some of the ideas that we have, but obviously we don't have anything that we can announce in terms of this deal or that deal or get into any detail on, but we like the space.

Okay. That was it. Thank you.

There are no further questions at this time. I will turn the conference back over to Management for closing comments.

Well, thank you. If there are no further questions, that concludes our call. Thank you for joining us.

Thank you. This concludes today's conference. Thank you all for your participation. All parties may disconnect now.