Federated Hermes Inc (FHI) 2016 Q3 法說會逐字稿

Greetings and welcome to Federated Investors third-quarter 2016 analyst call and webcast.

(Operator Instructions)

As a reminder this conference is being recorded.

It is my pleasure to introduce your host, Mr. Raymond Hanley, President 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 President, and Tom Donahue, Chief Financial Officer. And joining us for the Q&A will be Debbie Cunningham, our Chief Investment Officer for the Money Markets.

During today's call we may make forward-looking statements and we note that Federated's actual results may be materially different than the results implied by such statements. We invite you to review the risk disclosures in our SEC filings. No assurance can be given as to future results. Federated assumes no duty to update any of these forward-looking statements.

Chris?

Thank you, Ray, and good morning, all. I'll briefly review Federated' s business performance and then Tom will comment on our financials. Looking first at equities.

Q3 was another quarter of positive net equity flows for Federated. Total Q3 equity net flows were $1.8 billion, which represents an annualized organic rate of about 12%. We have had positive equity net flows in 11 of the last 12 quarters.

Federated ranked in the top 8% in the industry for Q3 net equity fund flows as measured by strategic insight. Net sales in Q3 were led by strategic value dividend strategies, both domestic and international, and in SMAs. Other strategies with positive net flows include Muni Stock Advantage, two of the MDT Small Cap Funds and strategic value dividends net sales, though, were lower in the third quarter than in the first part of the year.

Now this strategy seeks a high and rising income stream from high-quality assets. The Fund's sectors and stocks were not in favor in Q3 as market leaders were low-yielding, high-beta, low-quality stocks. With examined periods like this before and have seen solid demand for the product even as dividend paying stocks were out-of-favor in the marketplace.

For example, in 2013 the Fund closed the year in the bottom decile of relative performance for that year. The next year the fund had net sales of $1.3 billion. Over the longer term, the Fund has been successful in achieving its primary mandate.

At quarter end, the Fund ranked in the top 10% of its Morningstar category even though that is not the best fit for this fund. And it ranked there for the trailing one year and in the top 2% for the trailing three years. We believe that the success that these time frames offer is important to our sales results. Just to continue the story, the five-year ranking within the 75th percentile and the 10-year ranking was in the 30th percentile.

Our equity business features a variety of strategies that have produced solid performance. Using Morningstar data for ranked funds at the end of Q3, six Federated Funds, almost 25%, were in the top decile for trailing three years. We had 11 funds, or 42%, in the top quartile and about two thirds in the top half for the trailing three years.

In addition to strategic value dividend other outstanding trailing three-year equity strategies at the quarter end included MDT Small Cap Core, top 1%; MDT Small Cap Growth, top 4%; Kaufmann Small Cap, top 4%; Kaufmann, top 6%; Muni Stock Advantage, top 12% and MDT Stock, top 15%.

Now, three weeks into Q4, net sales of equities and SMAs combined are slightly positive, with positive net sales in strategic value dividend, MDT Small Cap Core, Prudent Bear, Muni Stock Advantage, MDT Small Cap Growth and International Strategic Dividend. Now we're turning to fixed income.

Overall net flows were positive about $750 million. Fixed Income Fund net sales grew at an annualized rate of just under 7%. Net Fund sales were diversified with Total Return Bond Fund and our High Yield Funds each netting more than $300 million.

Sterling Cash Plus Funds netted over $100 million and Muni Funds were net positive nearly $100 million. Our fixed income business has a variety of strategies that are performing well. At quarter end, the Institutional High-Yield Bond Fund was top decile for trailing one, three, five and 10 years and the Total Return Bond Fund was top quartile for the trailing one, three and 10 years. 36% on the five year.

In all, we had eight fixed income strategies with top quartile three-year records at quarter end including Floating Rate, Mortgage Back and Ultrashort Bonds. Fixed income net sales for Funds and SMAs are positive early in the fourth quarter, led by Total Return Bond Fund, High-Yield Funds and Ultrashort Bond Funds.

Now let's look at Money Markets. Total assets in Funds and Separate Accounts decreased by $7 billion from the second quarter and were up $1 billion from the third quarter of 15. Our Money Market Mutual Fund assets decreased by $9 billion from the second quarter and $7 billion from Q3 of 15.

Our Money Market Mutual Fund share in October has been about 7.7% down from about 8% at the end of 2015. About half of that decrease was due to about $4 billion shifting from a Federated Prime Money Market Mutual Fund to a Federated Managed Separate Account. As money moved into Separate Accounts and other non-'40 Act Money Market products, such as our new Prime Collective and New Prime Private Funds. It will not be captured in the Money Market Mutual Fund data for calculations of market share.

In 2016, we saw approximately $11 billion move out of Federated Prime Money Market Mutual Funds into bank deposits. A significant portion of these redemptions were transitioned into a bank affiliate. In certain cases relating to M&A activity among brokers and banks.

With the 2014 money fund rules fully in place as of October 14th we saw a significant shift from our Prime and Muni Funds into our Government Money Funds in Q3 and here into Q4., During Q3 and through October 26th, Government Funds increased $48 billion. Prime Funds decreased by $53 billion and Muni Funds decreased by $10 billion.

We have launched our Prime, Collective and Prime Private Funds. These funds -- these products have about $580 million at the end of Q3, with about $400 million shifting from Federated Money Market Mutual Fund products. With these product additions, extensive changes made to our existing Money Fund product line, our Separate Account capabilities, we believe that our cash management business is well poised for growth.

Taking a look at our most recent asset totals, as of October 26th, managed assets were approximately $357 billion, including $242 billion in money markets, $63 billion in equity, $52 billion in fixed income. Money Market Mutual Fund assets were $203 billion and the average assets were about the same number.

Looking at Distribution, now our SMA business continued to grow in the third quarter with nearly $3 billion in gross sales and $1.8 billion in net sales. Total SMA assets ended the quarter at $23.7 billion, an increase of $1.6 billion in the quarter. SMA assets have more than doubled over the past three years.

Federated ranked fifth in the rankings of the largest SMA managers at the end of the second quarter, which is the most recent data available. In the Institutional Channel, we have about $450 million in wins expected to fund in Q4 or Q1 of 2017, and this is both in Funds and Separate Accounts, and these include mandates in High Yield, Trade Finance and Core Broad. RFP activity continues to be solid and diversified with interest in value, dividend strategies for Equities and High Yield and Short Duration for fixed income.

We are in active dialogue with our intermediary distribution clients in advance of the April 10, 2017, effective date of the DOL fiduciary rule. We're working towards a solution that would enable brokers to use our funds and add their make desired commission structure. In this model each broker could construct its own commission structure and overlay it to all of the funds it sells across multiple fund families in order to achieve level pricing.

This would avoid the necessity of sponsors to create many multiple share classes to reflect different choices brokers are making with regard to their commission structures. Without this change, the number of share classes in the industry would increase significantly and this proliferation of share classes would create a lot of unnecessary complexity, cost, confusion and uncertainty among investors, sponsors, intermediaries and regulators.

We are taking steps to adjust our product line in advance of the new rules. We expanded the number of funds with R6 pricing, i.e., no 12b-1, no shareholder service, no sub-TA, to 19 this year and plan to increase it to 23 funds in early 2017. Our $23 billion SMA business is well suited to the DOL fiduciary rule. We offer14 equity SMA strategies and 8 fixed income SMA strategies.

SMAs work well in a level-fee, wrapped-account structure and provide transparency and potential tax advantages. Finally, as it goes to fiduciary duties in general, we believe that Federated will have a competitive advantage in working with intermediaries to help them navigate these challenges. Our long history with bank trust departments, our extensive resources, both in-house and with leading industry experts, represents an opportunity to add significant value for our clients.

On the International side, we continue to rollout new Canadian-domiciled Strategic Value Dividend Fund product, which saw its first new accounts and assets during the first -- during Q2 and Q3. With Q3 net sales of $82 million, this is for both the SMA and the Fund combined, the Canadian assets are now approaching $2 billion, up from $1.6 billion at the end of last year. We have had success in Europe, Asia and the mid-East from a sub-advised, high-yield product working with a large private bank.

We have raised about $350 million in this effort and are working with this client to launch a new high yield fund this quarter. We added $125 million euros from a European pension client in our fixed-income, multi-sector strategy in Q3, and we continue to seek alliances and acquisitions to advance our business in Europe in the Asia PAC region as well as in the US and the rest of the Americas. Tom?

Thanks, Chris. Revenue was up 26% compared to Q3 of last year and 3% from the prior quarter. Improvement in money fund waivers drove the gain from 2015, higher equity-related revenue and to a lesser extent, higher fixed income revenue led to the sequential quarter increase, which included the benefit of one additional day.

Equities contributed 39% of Q3 revenues and combined equity and fixed income revenues were 55% of the total. Operating expenses increased 29% compared to Q3 of last year and 3% from the prior quarter, due mainly to higher Money Market Fund distribution expense as a result of the lower waivers. The sequential increase was also due to the recognition in Q2 of proceeds from an insurance claim which reduced expenses by $3.5 million, mostly in professional service fees.

An earlier estimate for Q4 comp and related expense is about $75 million. As we've previously discussed the impact of the change in one of our customer relationships will reduce pretax income when fully implemented in late 2016. As we have consistently said, the actual reduction would vary based on asset levels and yields at that time.

Looking ahead to Q1 and assuming that the changes occur by year end as expected, the reduction to our pretax income would be about $3 million compared to Q3's run rate. The pretax impact of Money Fund yield-related fee waivers of $4.2 million was down from the prior quarter's $5 million and from Q3's last year's number of $20 million. The decreases were mainly due to higher fund gross yields.

Based on current assets and yields, we expect the impact of these waivers on pretax income in Q4 to be just under $4 million. For Q1, 2017, assuming the customer relationship change is completed, an increase in yields of 25 basis points could nearly eliminate the remaining waivers. Multiple factors affect yield-related waiver levels and the ability to capture related income going forward.

These factors are covered in the press release and in our SEC filings and we expect these factors and their impact to vary. As noted in the press release, the Board approved a $1.25 per-share dividend, including a $1 special dividend. This marks the fourth special dividend since 2008 for a total of $6.53 per share in special dividend. We will pay the dividend from cash on hand and it will be considered an ordinary dividend for tax purposes.

At quarter end, we had cash and investments of $381 million, of which $347 million is available to us. The $1.25 per-share dividend payment will return about $128 million of this cash to shareholders. The special dividend is expected to decrease diluted earnings per share for the fourth-quarter 2016, by approximately $0.015 due to the application of the two-class method of calculating earnings per share.

We continued to be active on the share repurchase front with just over 900,000 shares bought in Q3. As noted in the press release, a new 4 million share repurchase program was approved by the Board and will be added to the approximately 537,000 shares remaining in the current program.

That concludes our prepared remarks. Rob, we would like to open the call up now for questions.

(Operator Instructions)

Surinder Thind, Jefferies.

I just wanted to start with the Strategic Value Dividend product. You mentioned that gross sales were down quarter-over-quarter versus earlier in the year. Any color around the magnitude of that?

Yes. The magnitude of that was -- it was about $1.25 billion in the first quarter come about $1.3 billion or $1.4 billion in the second quarter, and it is now, let me see. Here, it's -- the net flows were -- first quarter was $1.4 billion, second quarter was $1.5 billion, the third quarter was $1.25 billion. Those are the net flows of that Fund in 2016.

I apologize. I was asking about gross sales. So did I --

Surinder, it's Ray. The gross sales actually increased in Q3 versus Q2. They there were up about $100 million. The redemptions increased as well, resulting in the lower net that Chris mentioned.

Okay. So it was more of a redemptions issue than a gross sales issue.

Both were up.

Fair enough. Maybe just changing the question around little bit. Given the size of that product, I want to say it should be roughly $35 billion, $36 billion in AUM, or actually even a little bit larger than that. Are you guys becoming overly reliant on that product or is it maybe too easy to sell that product versus trying to push the sales of other products?

As you know from my previous answers, we love all our children, especially those that are doing quite well. And so, overly reliant, I would not say that. But easy to sell. There are a lot of products with a lot of good records that do not have good positive sales. I think the real story is that when people in this economy are looking for some participation in the market and a continuing growing dividend that no matter what the Morningstar value category is doing inside the sectors, people are still going to be looking for this kind of a mandate.

The next point I would make is that if you are going to have a big fund, of all the different big funds that I can think of, this would be about the best one to have where you have high-quality, dividend-paying companies that you are relying on. It is not a black box magic thing or trying to get the market right at various times.

That having been said, as you can see from my remarks, we have peppered the story with a lot of other good product, a lot of other good performance and a lot of good other funds that have positive sales as well, but certainly not on the scale of the Strategic Value Dividend Fund. When you say the fund is $35 billion or $36 billion, that is the total of both the SMA and the Fund.

The fund is about $15 billion and then the SMAs are the rest of that number. Just wanted to make sure you got that little point.

Fair enough. And then one quick question on Money Markets here, it seemed like you provided a good amount of color in terms of the flow picture leading up to -- and when we look at the implementation deadline for reform in mid-October, it seemed like flows were generally weak but then post that, it seemed like within the retail funds -- or the open end funds, flows turned sharply positive. Any color around the dynamic around there?

I do not know about the weak part. We had some movement during the course of the year and we went through -- some of that was one-offs related to specific actions that clients took that had some relationship, over a long horizon, to the reform. But the other point I would make is we were among the later companies in terms of shifting to the floating net asset value. We had our funds stay in the old model right up until the deadline. So again the timing of transitions that our clients made may have been different than what other clients have made. Since October 14, yes, we have gained a couple billion dollars back into our money funds.

I actually think -- this is Debbie. I think that the fourth quarter will be a period of variability. There are so many clients that ultimately did not want to be in the product as it was shifting and making it's changes because these were pretty big operational changes to be undertaken by the fund companies as well as the clients themselves.

And I think the fourth quarter will be a period of transition where people watch and make sure that all the plumbing is correct and that everything flows and works the way it is supposed to. I would expect that you will continue to see some movement in the fourth quarter but 2017, with that calendar flip, will be the time when people start to re-address where they are and what they are using, from a money market standpoint.

Very helpful. I'll get back in the queue for more questions. Thank you.

Patrick Davitt, Autonomous Research.

I have a follow-up on the market share question, I understand a lot of what we see in the mutual fund data is related to Separate Accounts. But it does look like, at least year-to-date, that the really, really large diversified players, be it banks or diversified asset managers, are taking a lot of share, even last week in the reversal back to positive. What are they doing competitively to take that share and are you worried that is it a longer-term trend?

First off all, sometimes as owner operators, we like to look at the share numbers in terms of share of revenue. I know the marketplace only looks at it as market share but I always like to make that comment first. What is distorting some of this share data is that you had a lot of forced conversions where you had people move money from their own Prime Funds into their own Government Funds so that was one factor that was going on.

Now when you look at the overall business, yes, we have lost share and I tried to explain in my remarks that about half of that was made up of clients who are moving to Separate Accounts and to some of our other products. Your question is, what are they doing competitively?

I would say, I cannot remember a time, during the decades we have been doing Money Funds, wonder isn't at least one player out there who is chopping at yields in order to gain market share. And there are guys always doing this and there are guys doing this today. And so we evaluate that as we move along and it is just part of life.

All right. Thank you.

Ken Worthington, JPMorgan.

I wanted to dig into fee rates, maybe excluding the impact of rate-driven fee waivers. What is the net fee rate on Prime Funds versus the net fee rate on Government Funds? And I think, Chris, you mentioned there was some movement between money market funds and separate accounts in the money market area. How do the fee rates compare between those?

Ken, it's Ray. In terms of Prime and Government, without waivers the net fee would be right around 12 basis points and there wouldn't be much variability between the two, a little bit but not much. In terms of Separate Accounts, as I think you know, irrespective of asset category, Separate Account advisory rates tend to be about half of what the mutual fund rates are.

Ours, probably even a little bit lower than that. You recall, our Separate Account businesses is dominated by our industry-leading presence with some of the large state pools and so those would not be typical Separate Accounts in the tens of billions. At the end of the day, the separate account rates are really determined on a client-by-client basis.

In terms of Edward Jones, I think you guys had mentioned before, I know it's in the K, about a $6 million quarterly impact from the change in that relationship. Did you guys mention that the change going forward is $3 million a quarter? I did not quite get it. And if the impact of that has changed, why is it changing?

Ken, yes, we did say $3 million when you compare what we think Q1 looks like now compared to what actually happened in Q3. And that is really -- you may recall, we have mentioned the $6 million almost two years ago based on -- and that would have implied that waivers had been fully recovered. They have not, even though we're getting down to low numbers and so really the yields would account for the difference.

If your waivers were fully recovered, is the $6 million still valid or is it the $3 million if waivers were fully recovered?

Between now and late December, even if the Fed moves in December we are not have a situation where the yields would be fully recovered. Hypothetically, yes, if the $6 million implied full waiver recovery, back when, as we use that number over the last several quarters.

Right. But, Ken, today in my comments we're saying in Q1 it is $3 million off of Q3's pretax earnings number. So the $6 million is gone, it is $3 million.

Okay. Thank you very much.

Robert Lee, KBW.

My question is, just going to capital management. I think, certainly to me at least, the special dividend was a bit of a surprise. How should we be thinking, now that most of the fee waivers have been eliminated -- not completely but mostly. You've got a lot more cushion on your normal dividend payout ratio, and it looks like there was a little bit of a pop up in your share repurchase, similar to last quarter, last couple quarters maybe running a tad higher than it had for a while. Should we expect that you may be getting back to a more regular pattern of annual regular dividend increases and that maybe share repurchase from here could, a little bit more consistently run at what the recent trends have been?

We would tend to look at the so-called regular dividend next year in terms of making moves on that. The special -- I am glad to hear that it was a surprise, which means it was kept quiet, but it cannot possibly be viewed as a shock, given our heritage of having done this in the past. The way we looked at it was, we said -- hey, October 15 is past and we think we're in very good shape with the future, with our Money Fund business. If you look through the cash flow pictures internally, we felt we could steer a very good course to maintaining substantial availability and yet returning money to shareholders that currently wasn't being called for. That is how we came to that.

In terms of future activity, we have put in another share buyback program because we more-or-less completed or are in the process of completing the first one. And we want to remain ready, willing, and able to take advantage of that when our internal numbers, which I am not going to tell you about, tell us that buying the stock we think is a good deal based on how we look at the cash flow returns.

One more thing, we approved the last program, I believe last January or February of 2015, and as Chris said we are wrapping that program up so that is completing 4 million shares in a roughly two-year period, so it is another 4 million shares.

Thanks. Maybe just a follow-up. And this probably really a little bit more of a broad industry question. You mentioned about the DOL rule, possibly the industry coming up with more kind of a fund structure where, if I understood it correctly, the advisor can put their commission on it and others have suggested things like that.

I guess I'm trying to understand, my -- what SEC rule allows you to do that? My understanding was, there was a long-standing SEC rule, I don't -- forget the number, that didn't really allow that kind of customized pricing on mutual funds and that somehow the SEC was going to have to waive that rule or change it. Am I understanding that correctly? Or is the SEC actually indicating that they would be willing to address that issue?

If I can quibble with some of your words but not with the substance of what you said. For example, you should be using the word broker not advisor in order to fit directly under how we are seeing Rule 22. Basically, the practice in my whole lifetime has been as you described but there are a series of no-action letters where certain exceptions were granted and there are some efforts to enable brokers to treat these mutual funds simply as brokerage transactions and not take a position as a dealer and therefore perhaps not be subject to the rule.

I know that people are talking to the regulators about this. And the overall point here is, that the puck has moved. The DOL has moved the puck and the game over to another area and so something, though it has worked well for -- since the 1940-act came out, it may be time to change it rather than proliferate thousands and thousands of new classes and give the individual brokers the ability to meet the DOL requirements of a level commission structure and proceed with their business.

And one other factor here too, that -- most people's businesses, at least 40% or something like that, related to retirement, whether it is IRA rollovers or the 401(k) themselves. And then you have your other business that is not exactly retirement. Well, a lot of firms are going to look at it and think that they want to have one overall methodology and pricing structure for their clients.

And so this could impact the business even broader than simply in the retirement world. So to me the poetry is in using the R-6 share class, which is stripped-down, and enable the brokers with any fund group to put the commissions on and the charges that they have determined themselves to be reasonable, which is the standard under the DOL rule.

Great. That's helpful. Thank you.

There are no further questions. At this time I would like to turn the call back to Mr. Raymond Hanley for closing comments.

That will conclude our remarks for today and we thank you for joining us.

This concludes today's conference. Thank you for your participation. You may disconnect your lines at this time.