Federated Hermes Inc (FHI) 2017 Q2 法說會逐字稿

Greetings, and welcome to Federated Investors Second Quarter 2017 Analyst Call. (Operator Instructions)

I would now like to turn the conference over to your host, 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 CEO and President; and Tom Donahue, Chief Financial Officer.

During today's call, we may make forward-looking statements, and we want to 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, and Federated assumes no duty to update any of these forward-looking statements.

Chris?

Thank you, Ray, and good morning all. I will briefly review Federated's performance, and Tom will comment on our financial results.

Looking first at equities. We closed the second quarter with record high assets of over $65 billion. Total assets in the domestic and international Strategic Value Dividend strategies increased to a record high of nearly $40 billion. The domestic Strategic Value Fund returned 3.1% in the second quarter, which placed it in top 8% of this what we consider not meaningful Morningstar-assigned Large Cap Value Style Box for the quarter, and that put it in the top 7% year-to-date.

Our fund's objective is to provide a high and growing dividend stream from high-quality companies. Its 12-month distribution yield of 3.4% ranked in the top 2% of its assigned category at quarter-end. Furthermore, our fund pursues a dividend strategy that most funds in this category do not follow and has regularly moved between the first and fourth quartiles over history as we've discussed before.

For combined domestic and international mutual funds and separate accounts, strategic value outflows decreased from $680 million in the first quarter to $40 million in the second quarter. The $14 billion domestic mutual fund had second quarter net redemptions of $336 million. Net redemptions have decreased each month in the second quarter, dropping from $157 million in April to $114 million in May and $65 million in June. The $23 billion domestic SMA strategy returned to net positive flows in the second quarter with $147 million in net sales, and institutional separate accounts added $156 million.

Net sales for all equity funds and separate accounts in the second quarter were negative at $966 million, down from about $1.4 billion in the first quarter. However, funds with positive net sales in the second quarter included MDT Small Cap Growth and Small Cap Coreand the Muni and Stock Advantage Fund. We have 6 additional funds with modest flows in the second quarter.

Using Morningstar data for trailing 3 years at the end of the second quarter, 3 Federated funds were in the top decile, 6 funds or almost 25% were in the top quartile and 42% were in the top half. Trailing 1-year rankings showed 5 funds in the top decile, 9 funds in the top quartile and 17 funds, almost 2/3, above median. Top quartile trailing 3-year equity strategies at quarter-end included MDT Small Cap Core, top 1%; MDT Small Cap Growth, top 3%; Kaufmann Small Cap, top 7% and Kaufmann, top 15%. 3 weeks into the third quarter, net sales of equity funds remain negative approximately $200 million, which is a lower rate than during the first quartile -- quarter.

Equity SMA net flows are slightly positive. In particular, the Strategic Value Dividend Fund had net redemptions of about $53 million through the first weeks of July, while the SMA had about $30 million of positive flows. We have seen early Q3 positive net sales in the MDT Small Cap Core and Small Cap Growth, in the Muni Stock Advantage, International Strategic Value Dividend and International Leaders.

Turning now to fixed income. Overall net flows were slightly positive in the second quarter with net fund inflows of $138 million offset by a separate account net redemption of $124 million.

Net fund sales were led by the Sterling Plus Short Bond Fund in the U.K., the Total Return Bond Fund, high-yield funds and the floating rate fund. Net redemptions for separate accounts were primarily due to a decrease of about $150 million in subadvised mandates, partially offset by the addition of a $41 million high-yield accounts.

Our fixed income business has a variety of strategies that are performing well. At quarter-end, using Morningstar data, the Institutional High Yield Bond Fund was top 3% for the trailing 3 years, top 13% for the trailing 5 years and top 5% for the trailing 10 years. Our Total Return Bond Fund was top quartile for the trailing 1, 3, 5and 10 years. In total, we had 7 fixed income strategies with top quartile 3-year records at quarter-end.

Fixed income net sales for funds are negative early in the third quarter at about $248 million, which includes an institutional client redemption of about $200 million from a government bond fund.

Turning now to money markets. Total assets and funds and separate accounts decreased by $3 billion from Q1. Money market mutual fund assets decreased by about $2 billion from Q1 and separate accounts were down $1 billion, both reflecting seasonality around taxes. Our money market mutual fund market share, which includes our subadvised funds at the end of the second quarter was 7.4% compared to the prior quarter of 7.5%.

While money fund assets remain concentrated in government funds, we did see a slight uptick in prime assets -- prime money fund assets in the second quarter. We believe investors will begin to reconsider their options over time, including our newer private prime fund and collective prime fund, which preserve the use of amortized cost accounting and do not have the burden of redemption fees and gates. We also believe that a rising rate environment will be positive for money market funds and will encourage investors to shift cash from bank deposits.

Now looking at our most recent asset totals as of July 26. Managed assets were approximately $356 billion, including $238 billion in money markets, $66 billion in equity and $52 billion in fixed income. Money market mutual fund assets were $169 billion on that date and have averaged $171 billion so far in July.

Looking at distributions. The second quarter was another solid sales quarter for our SMA business with $1.7 billion in gross sales and $167 million in net sales. Total SMA assets ended the quarter at an all-time high of $26 billion, an increase of about $4 billion or 18% since the second quarter of 2016. Federated continued to rank fifth in the Dover rankings of the largest SMA managers at the end of the first quarter, which is the most recent data available.

In the institutional channel, we began the third quarter with about $205 million in wins yet to fund: roughly $80 million in separate accounts and $125 million in the project and trade finance tender fund. We also had our fixed income SMA strategies approved for one -- to an additional major wirehouse platform and anticipate sales beginning late in this year. RFP and related activity levels continue to be solid and diversified with interest in MDT and dividend income for equities and high yield and short duration for fixed income.

On the international side, we are proceeding with our efforts for growth in Asia-Pac. This initiative is in its early stages. The new business development team will focus on the regional distribution of Federated investment strategies and growing strategic relationships with large financial institutions. This new effort complements our European, U.K. and Canadian operations where U.K. assets reached an all-time high of $5.2 billion counted in U.S. dollars. In Canada with last year's rollout of a new Canadian-domiciled Strategic Value Dividend Fund, assets reached $2 billion, up from $1.6 billion at the end of '15. Assets overall in Europe, which we still include England in Europe, are about $12 billion. We continue to seek alliances and acquisitions to advance our business in Europe and the Asia-Pac region as well as in the U.S. and the rest of the Americas.

Tom?

Thank you, Chris. Revenue was down 5% compared to Q2 of last year due to lower money market-related revenues from lower assets and from the previously discussed change in the customer relationships, which occurred near the end of January. These decreases were partially offset by an increase in revenue due to lower money fund yield-related waivers and higher equity and fixed income-related revenues.

Revenue was down slightly from the prior quarter, reflecting a full quarter of the customer relationship change and lower money market assets, offset by a decrease in money fund yield-related waivers and an additional day in the quarter and higher revenue from equity assets.

Equity revenues increased about $9 million in Q2 compared to Q2 2016 and $3 million compared to the prior quarter. Equities contributed 43% of Q2 revenues, and combined equity and fixed income revenues were 60% of the total.

Operating expenses decreased 5% compared to Q2 of last year and decreased 4% from the prior quarter. The decrease from Q2 of 2016 was driven by lower money market assets and the impact of the customer relationship change, partially offset by higher distribution expense as money fund yield-related waivers decreased. In addition, we had lower comp and related expense reflecting lower incentive comp accruals.

The decrease from the prior quarter was due mainly to the same factors as well as the seasonal decrease in payroll tax. In addition, an insurance-related recovery of about $618,000 drove the decrease in professional service fees from the prior quarter. An early estimate of Q3 comps and related expense is about the same as the rate in Q2.

As we noted last quarter, the Q2 impact of money fund yield-related waivers was immaterial. Based on current and expected yields, we expect the impact of the waivers on pretax income going forward to remain immaterial.

Our effective tax rate for the quarter was about 37%, and we expect about the same rate for Q3.

During Q2, we amended and extended our credit facility. The structure converted an amortizing term loan with $178.5 million outstanding and an unused $200 million revolver to a $375 million revolver with an option to increase it by $200 million during its term. The term was also extended from 2019 to 2022, and the pricing remained the same. In addition to extending the term, the new structure gives us additional flexibility around loan draws and repayments.

At quarter end, we had cash and investments of $283 million of which about $253 million is available to us. We continue to be active on the share repurchase front with 580,000 shares bought in Q2.

Sherry, we would now like to open the call for questions.

(Operator Instructions) Our first question is from Bill Katz from Citi.

This is Ben Herbert on for Bill. Just seeing some higher spending guidance from some of your peers this quarter, wanting to get your outlook, particularly against a decline in gross sales.

Well, if you notice that the distribution line came down, and that's primarily because of the money fund reduction in assets and our commensurate distribution payments go up -- go down if that goes down. So the main -- and then compensation line, incentive compensation many times goes down if assets go down, and the sales aren't as robust as they have been in the past. So those are the 2 main drivers of our expense line. If those goes back up, distribution and the compensation lines will follow right back up. In terms of all the rest of the line items, we company-wide had pretty diligent expense management, and I expect that to continue.

Okay. Maybe taking just a step back and talking more from a strategic standpoint where you think maybe the best opportunities are to drive gross sales going forward?

This is Chris. Overall, in longer term, that's one of the reasons we're going into the Asia-Pac region. Now that's not going to get you guys a quarterly number in the near term because that's at its early stages, as I mentioned. But that has to be one of the first things that we go for. So when you look at where you can gather more sales, it's the ones I've mentioned in my opening remarks, where you have a good handful of equity and a good handful of fixed income product that have top quartile 3-year records, and those are the funds where we have positive sales. Another interesting one which we announced on July 24 was we did reduce the expense ratio in the Kaufmann Small Cap Fund from 100.5 to 90. And we expect with this good performance in this $738 million fund to generate good sales there as well. We've also put a SMA program together for the large cap Kaufmann fund, which again has a good record, and we would expect things to be happening there as well. So what really happened in this industry strategically is as a result of the DOL, as a result of the proliferation of products over history, people are focusing more on those enterprises and those mandates and those areas of excellence that are able to offer those kinds of performance records that we're talking about and focus expenses, resources and development in those areas. And that's what I think you'll see us doing and others as well.

Our next question is from Ken Worthington from JPMorgan.

First, I was hoping to talk about the pricing of money market funds. You've mentioned in the past that there were competitors who sort of regularly were willing to cut price and try to take share, and that Federated has had a strategy of remaining pretty disciplined on pricing. So what are you seeing in today's market? Are you seeing more aggressive pricing at all? And if so, is there a certain part of the money fund market where it's focused? And maybe how intense is pricing competition today versus what it's been in recent years?

You have understood our approach to this quite crisply, Ken. And overall, I don't think it's any more intense than it has been before. People take turns doing it. And one firm will do it for a while, then another firm will do it for a while. Some will stick to it longer. And we haven't seen ourselves lose any clients over this time frame. We have seen the assets more or less level off. I think the decrease from -- during that quarter is the usual seasonality. And recall that the oligopolization of this business means that clients like to diversify among the people -- among the various people that are actually active in this field, and that supplies a pretty good bottom for someone with our strategy and the strong relationships we have with the clients. There's also another thing we're working on. I've mentioned it here before. And that's H.R.2319, which is a bill floating through Congress, and you can put whatever percentage chance you want on a bill coming out of Congress. But this is a bill which would basically restore money market funds to the 2010 amendments, i.e., restore prime funds with amortized cost, no fees and gates and no natural person, which would enable the municipal funds to regain their once $500 billion that they had. And so that's another strategic way of getting at the same kind of question that you're looking at. Overall, in the money market fund area, the assets remain about the same, where they've been. Yes, they go up and down a little bit, but you still have got $2.7 trillion in that area. And so if -- what that tells you is that the clients love the utility of the product. Yes, $1 trillion plus moved over to government, but it moved over into a vehicle that retained the utility that was loved so much by these clients.

Got you. And then just turning to SMAs. Can you talk about what you're seeing in equity SMAs? Maybe start by saying, like what types of distribution had been the primary drivers of the growth last year when Strategic Value Dividend was gathering so many assets there? And maybe why the flows have fallen off? I mean, which distribution channels the flows have fallen off from? And if so why?

Ken, it's Ray. The growth there would be through all of the kind of platforms that you see, primarily broker platforms. And then as we've talked about before, the SMAs work well in a level fees type of post-DOL environment. So that's where most of the footings have been. And in terms of the relative demand, it's really -- it follows the same overall pattern that you saw driven by Strategic Value Dividend and -- but the swings were more severe, both plus and minus, for the mutual fund than they were for the SMA, but they did follow a similar pattern last year after an extraordinary period of performance in the beginning of the year. And then as the year went on and as the market sort of shifted, even though the strategy continued to do what it was supposed to do, the SMA flows dipped down to where they very briefly touched negative and they've been rebuilding now. And as we mentioned before, they're edging back into solidly positive territory. So it's been driven by strategic value, but we do have other strategies in there, the MDT strategies, and they've had some positive flows. And I know you are coming at this from the equity side, but we think that on the fixed income side, we mentioned the addition on one of the big -- on another one of the big wirehouse platforms. The fixed income strategy for us is a little under $1 billion today, and we look at this as a significant development to open up some meaningful new distributions toward the latter part of this year.

Our next question is from Michael Carrier, Bank of America Merrill Lynch.

I just had a question. You guys mentioned, I think on one of the Kaufmann funds, some of the changes on the fees. Just across the platform when you're looking at the lineup and competitively where the products stand, just how much of that have you kind of gone through? I know you kind of go through it from time to time, but just wanted to get a sense on is most of that behind you? Or are there still some tweaks that could be done?

Well, Michael, it is a constant, never-ending effort. And the way we look at it here is that all of those funds are like your children. You look at them one at a time to decide what to do. There is no macro decision, "Oh, the fee should be at or about median, the expenses should be thus or so." Those are all important touch points to analyze. But you have to have a confluence of events of the capacity to sell the fund, its investment record, the resources that are devoted to it, and what is the best thing to then do. And that's why I mentioned those 2 items, the large cap Kaufmann SMA and the reduction in the Kaufmann Small Cap Fund. We tend not to make big announcements about these things. We tend to just do them on the fly. And if you look over our history, we're doing a few of these every year, altering the prices, changing the packaging in order to improve the presentation to the investment community.

Okay. And then just as a follow-up, I guess, both on the money market side and the fixed income. As rates have risen and then on top of that if we get into second half of the year, the Fed shift in terms of the balance sheet policy. Any new expectations on demand from products, talking to clients, across either the money markets or fixed income, meaning whether there will be some potential opportunities? Or you expect like the competitive environment to pick up and become more challenging?

I will address this at the beginning. And I think Debbie has phoned in. So she will be able to comment a little more after I finish. The first thing would be that as rates increase, it was a big event to get all of the funds more or less at or above 100 basis points. And now your question is -- one of the questions is, how big this spread have to be in order to move people? And we, Debbie included, don't think there's going to be a rate increase until December in any event, and then there will be one. So you can tell what that's going to do to the rates in fact. So the slow inexorable increase in rates will have a positive impact on this business. But it's very difficult for us to detect when people will switch back to Prime, if they don't have the utility of the product they want as against the given spread. Right now that spread is about 29 or 30 basis points. And in the old history days, it used to be 12 to 15, and people aren't moving back. And I think the reason is the utility of the product. Will it get higher, and will they move? Will they get more comfortable over time with the existing product structure? That remains to be seen. I'd love to hear Debbie's comments on this, and I think you all would as well.

So thanks, Chris. And I agree 100% that 30 basis points seems like a lot, almost double -- more than double what the history has shown us has been acceptable between prime and government, But that's when the two had a profile that were the same from a usership standpoint, and that's different now. So if 30 isn't enough, maybe it's 40. But what I really think is happening and what we're getting from a client feedback perspective on a day-to-day basis is that they are putting a tiny bit of their cash in Prime right now. So they may used to have had all of their cash in the prime sector, now they've got, let's say, 80% in the government sector with a 20% of that on new cash that's coming into their business is going into the Prime sector. And because it is higher spread, it's not seeing much volatility. We're not getting the seasonal flows in and out of prime that have historically been larger than what we would see in our government funds. Instead, that day-to-day cash that you needed on a daily operational basis is staying in the government space. I think the other place where we're starting to gain assets and certainly starting to get a lot of interest, specifically into the Prime space, is out of the bank deposit market. In a rising rate environment, which as Chris mentioned, we do believe will continue, although with a slightly slower speed, we do think that the money funds make a whole lot more sense versus bank deposits that are kind of sticky and don't go up as quickly. And certainly, when you look at the average deposit rates, both government and prime money market funds are above them substantially now from a yield and a return standpoint. So I think it's again taking time. People have to get used to this product, but there are various reasons why it looks awfully attractive versus both the traditional government money fund product as well as other cash vehicles that are out there.

Our next question is from Kenneth Lee with RBC Capital Markets.

Just want to follow up on that institutional prime. You mentioned that in conversations with treasurer some of them are putting a portion of the money into the prime versus the government. I mean, why wouldn't they put more into the prime because it sounds as if they have systems and the accounting to handle the floating NAVs and stuff like that? Just wondering is this something else that we're missing?

Debbie can have the first swing at guessing that. Go ahead.

I think a lot of it has to do with the 5:00 timing. So with the floating net asset value, mark-to-market pricing that occurs, all funds basically on a cut-off basis in the prime space at this point are at 3:00. And with many institutional clients, they need capacity to transact out till 5:00. So I believe that's a good reason why a portion of them are keeping a substantial amount of that cash in that government space.

One of the other features to this though is they are going to test this. And they want to make absolutely sure that everything works, how all that 4 decimal place works, how the other customers in the fund work, how the fund works, and it's really hard to crawl in behind their brain to figure out when they are going to break loose from their test mode into their all-in mode.

Got you, got you. So would it be fair to characterize that the conversations from treasurers have changed somewhat, that they are looking at that spread, the 29 to 30 bps additional spread, and they are trying to figure out ways to try to capture that additional spread rather than just sitting still?

Well, they are to some modest, modest extent. But you can feel them struggling with their desire to get it and being conflicted by the lack of the utility in the way the products are constructed as against the government fund. And that's their rub.

I think one other factor to consider is the size of the prime funds at this point. The prime funds universe at its peak from an industry perspective was about $1.9 trillion. And there were, I'd say, at least 20 products that were over $10 billion to $20 billion in size. There are currently 3 in the market that are of that size. So what used to be an easy trade for somebody, a corporate treasurer that had short-term cash of, let's say, $1 billion in a single fund now can't be done in a single fund. It has to be broken up into smaller and several funds because of the smaller nature of those products.

Got you. Okay. That's helpful. And just one more question in terms of the rising rates. Obviously, some potential impact in terms of demands and flows. But wondering that in a scenario of gradually rising rates, is there any change in terms of the economics for Federated, either in terms of either widening margins or some kind of lag effect in terms of the fees versus the rates you're giving to the clients?

No, no.

And our next question is from Robert Lee with KBW.

This is actually Andy McLaughlin on for Rob Lee. We just had a question about capital management. Now that earnings have come back, it's been a while since you've raised your regular dividend, recognizing you've paid some specials along the way. Any kind of change in that policy versus considering raising it versus continuing to kind of pay special?

Thank you. We did pay a special dividend not all that long ago. And as the cash builds up, you'll notice we said we had $253 million available to us. And looking at our needs, I think that we will have to look at that and consider what we do to see what's appropriate to give back to shareholders as we've continued in the share buyback program. And the way we look at the use of cash is acquisitions that fit our criteria is kind of our first desire and that's because our criteria gives us excellent return on our acquisitions. And of course, the regular dividend and then considering increases in dividend and special dividend and then the share buybacks, which we have continued to think are attractive. So we balance all 3 of those, and we'll continue to look at it in a pragmatic fashion.

Great. And if I could just follow up on a little bit of a different topic. As distributors, there's kind of been headlines in the news about distributors narrowing their fund and manager list. Have you felt any kind of positive or negative impact from that?

We have felt impact from that. And the way I would describe it is, it forces naturally desired co-ing in any event. As I mentioned in the answer to a previous question, when the big firms go from analyzing or having on their platform 4,000 funds to having 2,000 funds, and many of them have done exactly that, then that causes you an impact. Now we have been very fortunate in that the funds that are big leaders for us, good flows for us, good performance for us and that we have devoted significant resources towards, all got through the grand alembic of that change. And so we came out in pretty good shape. How others did, I can't really assess that. So we have very good relationships with them, and we think that our shelf space situation is really very, very good. And we also think that we'll have the ability to put new things on there as well, like adding to the SMA shelf with our large cap Kaufmann offering. So it does have an impact. And perhaps all it really does is accelerate that which the marketplace and inside business judgment would have had to have done anyway.

Ladies and gentlemen, we have reached the end of the question-and-answer session. I would like to turn the call back to management for closing remarks.

Well, that concludes our comments for today, and we thank you for joining us.

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