Federated Hermes Inc (FHI) 2016 Q4 法說會逐字稿

Welcome to Federated Investors' fourth-quarter 2016 analyst call and webcast.

(Operator Instructions)

As a reminder, this conference is being recorded. I would now like to turn the conference over to 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 President; and Tom Donahue, Chief Financial Officer.

During today's call, we may make forward-looking statements. We want to note that Federated's 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. Good morning. I will briefly review Federated's business performance and then Tom will comment on our financial results.

Looking first at equities. While Q4 was the second equity outflow quarter for Federated over the last 13 quarters, full-year net equity sales were a record $5.8 billion. The strategic value dividend strategies, both domestic and international for combined funds and separate accounts, produced positive net sales for the fourth quarter, though at a reduced amount compared to prior recent quarters.

The domestic strategic value dividend strategy produced another year of solid performance in 2016. The fund strategy returned 10.4% for the year, in line with its five-year annual return of 10.8% and substantially higher than its 10-year annual return of 5.2%.

The fund ranked in the top 13% of its assigned Morningstar category on a trailing three-year basis at year-end, while it's one and five-year ranking was in the 89th percentile. Though not a value fund, Morningstar includes it in the large cap value style box category. When many funds that are pursuing much different strategies, it's Morningstar defined peers are often seeking undervalued stocks.

In contrast, our strategy's objective is to provide a high and rising income stream from high-quality dividend paying companies and does not change with fluid markets or investor preferences that can drive short-term market performance. Given the category mismatch, the fund's relative rankings have varied significantly. Over the last eight calendar years, and for its one-year ranking, the fund finished in the top 1% twice, in the top one-third once.

The other five years saw the fund in the bottom quartile, yet the fund produced positive net sales in seven of the eight years and produced cumulative net sales of nearly $10 billion. We believe that the intermediaries and the investors looked beyond style box ranking against many dissimilar funds and were attracted to our solutions strategy, offering the potential for high and growing income from high-quality businesses.

We continue to expand strategic values distribution in the fourth quarter, adding separate account mandates, including two wins for about $50 million, and map overs including $100 million from a broker-dealer. Interestingly, the fund strategy was repeating the same pattern, top 2% of the Morningstar style box in December and in the fourth-quarter so far in January. Also, through the first three weeks of January, the fund's pace of net redemptions are running at about half of the month of December's amount.

Other strategies with positive net sales in the fourth quarter include MDT Small Cap Core, MDT Small Cap growth, and Muni Stock Advantage funds. Using Morningstar data for rank funds at the end of the fourth quarter, four Federated funds, 13% were in the top decile for trailing three-years. We had nine funds or 30% in the top quartile and 43% in the top half for trailing three-years.

In addition to strategic value dividend, other top decile or top quartile trailing three-year equity strategies at quarter-end include MDT Small Cap Core, MDT Small Cap growth, Muni and stock advantage, all of those just mentioned are in the top decile, Kaufmann, top 21% and Kaufmann Small Cap, top 25%. Three weeks into the first quarter, net sales of equity funds and SMA's combined are negative $245 million.

Turning now to fixed income. Overall, Q4 net sales were positive $274 million, while the full-year saw net outflows of $1.7 billion. Net fund sales in the fourth quarter were led by ultrashort funds, the institutional high-yield fund, and the floating rate fund.

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 3, 5, and 10-years. The total return bond fund was top quartile for the trailing 1, 3, and 10-years, 27% for the five-years.

In all, we had nine fixed-income strategies with top quartile three-year records at quarter-end, including floating rate, strategic income, and ultrashort bonds. Fixed-income sales for funds are positive early in the first quarter, $141 million, led by ultrashort bond funds, high-yield funds, and the floating rate fund.

Now looking at money markets. Total assets in funds and separate accounts increased by $4 billion from Q3 and were down $4 billion from the end of 2015. Money market mutual fund assets decreased by $3 billion from Q3 and $15 billion from Q4 of 2015, while separate accounts added $7 billion from the prior quarter and $11 billion for the full year.

The post-October 14 reform driven shift from prime to Muni -- from prime and Muni money funds into Government Money Funds didn't change much through the year. We expect that as spreads widen, investors who exited prime funds will reconsider their options over time, including our newly launched private prime and collective prime funds. We also expect a rising rate environment will be positive for money funds generally and in particular as compared to bank deposit alternatives.

Taking a look now to our most recent asset totals as of January 25. Managed assets were approximately $363 billion, including $249 billion in money markets, $63 billion in equities, and $51 billion in fixed income. The Money market mutual fund assets were $199 billion. The January average money market fund assets are running about $200 billion.

Looking at distribution, Q4 was another solid sales quarter for our SMA business, with over $2 billion in gross sales and $600 million in net sales. Total SMA assets ended the quarter at $23.6 billion, an increase of nearly $7 billion or 40% for the year 2016. SMA assets nearly doubled over the past three years. Federated ranks fifth in the rankings of the largest SMA managers at the end of the third quarter.

In the institutional channel, we began 2017 with about $250 million in separate account wins that are yet to fund. RFP activity continues to be solid and diversified, with interest in value and dividend strategies for equities and high-yield and short duration for fixed income. We continue to prepare for the April 10, 2017 effective date of the new DOL Fiduciary rule, though we would both expect and recommend that it be at least delayed.

We more than doubled the number of funds with R6 pricing to 19 in 2016 and plan to increase to 25 funds in 2017. We have also begun the process of creating T-shares with an initial filing and expect to have them in place for 33 strategies before the rule's current listed effective date. The recent SEC no action letter in regard to so-called clean shares and Section 22-D as outlined in our call last quarter were a welcome development.

We will also highlight our $23 billion SMA business with 14 equity strategies and 8 fixed income strategies. We believe SMA's work well in a level fee-wrapped account structures and provide transparency and potentially tax advantages. As we mentioned before, we believe Federated will have a competitive advantage in working with intermediaries to help them navigate the new fiduciary rules, whatever and whenever they are.

Our long history with banker trust departments and extensive resources, both in-house and with leading industry experts presents an opportunity to add significant value for our clients. On the international side, we continue to roll-out the new Canadian domiciled strategic value dividend fund product, with fourth-quarter combined net sales of just under $100 million in SMA and the new fund, Canadian assets are approaching $2 billion, up from $1.6 billion at the end of 2015. We also continue to seek alliances, acquisitions and other activities to advance our business in Europe and the Asia-Pac region, as well as the US and the rest of the Americas.

Tom?

Thank you, Chris. Revenue was up 19% compared to Q4 of last year due to lower money fund yield waivers. Revenue decreased 2% from the prior quarter due to lower money market assets and related revenue.

Q4 revenues included the impact of approximately $3 million related to a non-recurring fee credit from a fund service provider which resulted in reduced regular fund fee waivers. Revenue increased 23% for 2016 compared to 2015 driven by improvements in money fund waivers and equity related revenue.

Equities contributed 39% of Q4 revenues. Combined equity and fixed income revenues were 56% of the total.

Operating expenses increased 23% compared to Q4 of last year and decreased slightly from the prior quarter. The increase from 2015 was due mainly to higher money market fund distribution expense as a result of lower waivers. The sequential decrease was due mainly to lower costs and related expenses reflecting changes to incentive compensation accruals.

Distribution expense includes a $2 million expense to correct certain underpayments of past distribution costs. The previously discussed change in one of our customer relationships is expected to be completed today. For Q1, the reduction to our pretax income is expected to be about $1 million compared to Q4's run rate and $2 million on a full-quarter basis for future quarters.

The pretax impact of money fund yield waivers of $3.4 million was down from the prior-quarter's number of $4.2 million and Q4 of last year's number of $16.4 million. The decreases were due mainly to higher fund gross yields.

Based on our current assets and yields, and with the expected customer change, we expect the impact of these waivers on pretax income in Q1 to be about $1 million, dropping down to about $350,000 in Q2. If there are further Fed rate increases, these numbers should go to an immaterial level.

For Q1, it is important to remember that the fewer number of days will impact revenue, which is largely earned on a per day basis. Thus for Q1 based on Q4 average asset levels, we expect the impact of fewer days to reduce revenues by about $6.6 million and reduce related distribution expense by about $2.3 million.

Seasonality around payroll taxes and benefit expenses will impact compensation and related expense in Q1. We expect to have higher incentive comp accruals. An early estimate of Q1 comp and related expense is about $75 million, up from the $69 million in Q4. The combined impact of fewer days and higher estimated comp and related expense is about $10 million in lower operating income compared to Q4, all else being equal.

Federated paid a $1.25 per share dividend in Q4, which included a $1 special dividend. This marked the fourth special dividend since 2008, for a total of $6.53 per share in special dividends. The special dividend resulted in a decrease in diluted earnings per share for the fourth quarter of approximately $0.02 due mainly to the application of the two class method of calculating earnings-per-share.

The effective tax rate for Q1 was about 33%. As we've been reporting in our SEC filings, we adopted a new accounting standard update in the second quarter of 2016 that requires all excess tax benefits and deficiencies, including the tax benefits from dividends on unvested restricted stock to be recognized in the income tax provision on the income statement instead of any equity on the balance sheet. While our tax rate was marginally lower in Q2 and Q3 due to this adoption, the special dividend and employee stock vesting that occurred in the fourth quarter reduced our tax provision by approximately $2 million. Looking just at Q1 2017, we do not expect this adoption to have a significant impact on our federal tax rate and anticipate the tax rate will be closer to 37%.

At quarter-end, we had cash and investments of $301 million of which $266 million is available to us. We continue to be active on the share repurchase front, purchasing 706,000 shares in the fourth quarter.

That completes our prepared remarks, Audrey, we'd now like to open the call up for questions.

(Operator Instructions)

Ken Worthington, JPMorgan.

First, on the passport relationship, just to level-set us, if there were no voluntary fee waivers for the low-rate environment, what would the change in the relationship do to quarterly revenue? Previously, I think in the Ks it was 6%; last quarter relative to the third-quarter run rate which included a bunch of fee waivers, it was 3%. I think you said going forward, it's 2%. Maybe just to kind of level-set because, again, fee waivers are moving all around, I think that impacts the numbers you're giving. If there were no fee waivers, what would the quarterly impact be?

Yes, Ken, you have the progression of the numbers right going back over the two years that we've raised this. The only thing I'd correct is that, that's expressed as impact to our pre-tax income, not revenue.

Got it. Okay. Thank you.

Secondly, you've launched a number of the non-40 Act funds; I think, a private fund and separate accounts. What did flows look like this quarter in those newer products? I think 4Q is seasonally a good quarter for the state and Muni pool plans. How much of the increase in the separate account assets were from the text pool and the other pools versus what's going into these newly launched products?

Sure, Ken. The vast majority of the separate account money market inflows would have been from our existing separate accounts, the state pool business that you mentioned. We've talked about seasonality in that business; runs along the tax collection and then state spending cycles. So typically, Q4 and Q1 into the first part of Q2 we see inflows and then outflows over the subsequent two quarters as money is being utilized by the states.

We did have positive flows in the private prime fund. They would have been fairly nominal at this point, but there is a considerable amount of interest. There's a long runway to having our clients adopt the agreements necessary to use that kind of fund. It is structurally much different than a mutual fund. But we did add customer relationships in the fourth quarter to the private fund. We have a good pipeline of interest and agreements in process now.

Ken, I would add to that, that what the clients were doing, as we've mentioned before, and I think that's been true across the industry, is clients were really looking at seeing what the lay of the land was going to be, how things were going to work, play it safe in govis, check out and see how the new products work, how much spread is there going to be, and bide their time as they come into 2017.

I think that's what's going to happen. It isn't going to be any kind of sudden movement. It will be something that occurs over time.

Okay, great. Thank you. Then lastly, Tom, just a clarification: can you go through the fee credit that you mentioned for this quarter? I didn't quite get it.

The fee credit?

You mentioned a credit?

Oh, yes. We had a credit, about $3 million, from a fund service provider that had, had a long-term underpayment to many clients in the industry and that was our portion that came to us. So it's basically a one-time $3 million item.

Where did it hit in the P&L? Was it a boost to revenue? A reduction to expense? I'm sorry, where did it hit?

The $3 million is revenue.

Revenue. Okay, great. Thank you very much.

Michael Carrier, Bank of America.

Chris, just on the long-term flows in the outlook, you gave some helpful color on strategic value dividend. Just when you look at what's going on, on the different distribution platforms in what your wholesalers are saying, just wanted to get some sense on if that is a little bit less in favor? Are there products that are seeing increasing demand? On the fixed income side, just given that the environment is changing, if you can size in a rising rate environment the products that you tend to see more interest versus those that you can see less, maybe on the Muni side, if we get tax reform?

On the fixed income side, the performance in the -- then I'll get to the equity second, reversing your questions. On the fixed income side, the total return bond fund performance has been simply outstanding. So that remains a very good, steady fund. Its average maturity is in the 4.5- to 6.5-year range. So as clients become more interested in what's going to happen with interest rates, that brings about our whole array of shorter-term type products, intermediate funds, et cetera. We have a very excellent array of those funds for clients.

We are seeing the people who want to play it both ways in the Muni Stock Advantage fund, both in terms of performance and in terms of gross sales and net sales. So we think we are in pretty good shape right down the yield curve, all the way down into the ultrashorts, which we're of course seeing some decent flows in there as well.

On the equity side, the reason we go through all that performance jazz on strategic value dividend is to try and repeat the message that this fund is a solutions-oriented product, for those clients looking for growing income. That really isn't going to change a whole heck of a lot. Yes, in the first part of last year, with some very robust style-box oriented performance, other investors were attracted to this product. The core of the product though, is as I have said. So that solutions product still remains very strong. But you are seeing interest in the MDT-type products, which are the Small Cap offerings. People are cheering the fact that the Kaufmann enterprises are back in the top quartile for their performance as well. So, we think we're in pretty good shape there.

When you talk about what broker-dealers are saying, especially the bigger firms, it is always, at today's day and age, punctuated by what's going on or could go on with the DOL. We think that, as some of these broker-dealers go through their selection as to which of the funds into the future they will choose to monitor, our funds, our large funds with large assets and good performance and good relationships and good monies of individual clients, put us in excellent position for the future.

Okay, thanks.

Then, Tom, just a little bit more clarification on some of the items that you mentioned on the P&L. Just on that $3 million fee credit, did you say which line item on the revenues that was in?

It comes in as a reduced waiver line. I don't know the line item up there.

Advisors.

Okay. So, it's a reduced advisory fee net line. Reduced waiver of advisory fee, so therefore more (multiple speakers).

Got it, okay.

Then on the distribution expense, I think you mentioned something about a $2 million of past items. Just wanted to find out on that distribution expense, was that a benefit to the expense line? Or was that an increase in that line?

That was an expense of something that we hadn't paid out, and then we had to pay it out.

Okay, got it. So those somewhat offset each other? Meaning, in the quarter.

Yes.

Okay. All right. Thanks a lot.

(Operator Instructions)

Bill Katz, Citi.

If I look at your average assets year on year, it looks like they are slightly up. Within that, equity has risen as a percentage of total AUM. The fee waiver is down and yet your margins are down by about 200 and some-odd basis points year on year. I noticed a little bit of noise in this quarter, but it looks like it rounds against each other.

Can you talk about as you think about on a go-forward basis the dynamic between fee rates, volumes, and margins for the franchise? Because you would think, all this being equal, margins would be higher, not lower. So I'm just trying to get my hands around what's going on underneath the overall margin print?

Yes, Bill, the first comment is, when we reinstate the last portion of the waivers, we actually reduce our margin. So if you go back in and calculate the changes, it hurts our margins. So it's anomalous position of, we get more operating income and it comes in at a reduced margin. So we are happy with it. Then we get to go back and say how come? We've got to grow our margin again, too. That is the primary driver there.

Okay. Maybe just a follow-up then.

I think -- because you've mentioned a couple different classes of share, I think R and T were in there. As you look ahead between mixed within maybe equity or fixed income, or mutual fund versus SMA, or even in the share class, what you think the trend is for the fee rate for the Company against that?

I will talk about the trend in the assets. Then we can talk about how that gets to the rate, which it obviously does. The trend is going to be increasing SMA. The SMAs are roughly half of what the fund is. The reason for that is that it works, as I mentioned in my remarks, it works very well on a fee-oriented wrap type account and is very consistent with how the DOL is currently structuring things.

In terms of the various share classes, whether it is an R class, an R6 class, a T class, an A share with low waived, or a clean shares per the SEC recent permission slip, our investment advisory fee under all of those circumstances is the same. What you are talking about in all of those circumstances is changing how the distributor, the broker-dealer administrator, et cetera, is being compensated. I think you're well aware of the fact that, that would be tightly analyzed under a fiduciary situation.

So what we are trying to do with all of those is deal with this transition period. Down the road, when you asked about the future, I think the A share is going to basically not exist, being either replaced by a T share or by an R6 or a clean share, which is sold across the board. So there will be a little noise here until we figure out where the market is going and where the regulations are going to fall. But that is what we are looking for.

Okay. Then just one last one. Thanks for taking the question.

Just about the comments around the rising rate backdrop: is there anything different this particular cycle? I guess the reason I ask is, one, it seems like prime as a percentage of governments is lower. Then, two, within governments there has been a shift to the rule changes that narrows the duration a little bit. So would you think you'd have the same uplift of volume, all else being equal this cycle? Or might it be more tempered relative to prior cycles? What's the house view there?

I think that basically, when you have rates going up, when you look at the onslaught that money funds have suffered over these many years, there is a great desire to have the final end product, i.e., daily liquidity, at par. So as rates go up, I think you will see increasing amounts of money coming into the business. Then, as you point out, because they have put a few dents on the prime product, maybe more than dents, those receptacles aren't there, so the spreads are going to be a key factor. Once they get to 50 basis points or so, I think you will see more movement occurring. They're around 40 or so right now. I think people will be digesting that and seeing what to do. I also think there are some -- at least we're working on it, trying to change these products and get them back to the way they were in 2010. There are a lot of different angles on that, as well.

Finally, I would add that, it also depends on when these rates come through. Our house view is that we think two more are likely, and more than not -- more than likely they're coming in March and September rather than June and December. Then that would leave open yet another possibility in December.

Okay. Thank you for taking all the questions this morning.

At this time, there are no further questions. That does conclude our question-and-answer session. I will now turn it back to Mr Ray Hanley for closing remarks.

Okay. Then that will conclude our call. We thank you for joining us today.

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