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Operator
Good day everyone and welcome to the Investors Financial Services Corporation third quarter 2005 earnings conference call.
Today's call is being recorded.
At this time for opening remarks and introductions, I would like to turn the call over to Mr. Joe Dechristofaro.
Please go ahead.
- IR
Thank you for joining us on today's call.
We will be making a number of forward-looking statements which are based on management's assumptions and predictions as of today.
These statements including but not limited to statements regarding the company's expected diluted earnings per share, effective tax rate, financial performance relative to competitors, projected net operating revenue, core service fees, ancillary service fees, foreign exchange service fees, net interest income, securities gains, new customers, client renewals, balance sheet growth, reinvestment focus, expenses, including compensation in investments and technology, operating margin and pipeline and the impact of and activity under a share repurchase program are subject to risks and uncertainties.
The company's actual results may differ materially from any of our current predictions due to any one of a number of factors.
Information regarding the factors that may affect our actual results is set forth in ND&A sections of our most recent 10-K and 10-Q filings with the SEC and in the press release filed today on form 8-K.
I recommend that anyone listening to this call review these reports carefully.
Because this call will be archived on our web site, www.ibtco.com, I want to emphasize again for anyone listening at a later date that the statements made today are based on our assumptions as of today, October 19, 2005.
These assumptions may change but the recording of this call will not be updated.
In addition, on this call we will discuss non-GAAP measures as defined by the SEC.
We believe that these measures provide a more useful depiction of the company's results of operations.
A reconciliation of GAAP information to non-GAAP measures can be found on our web site at www.ibtco.com.
Joining us are Kevin Sheehan, Chairman and Chief Executive Officer, and John Spinney, Chief Financial Officer.
I will now turn the call over to Kevin Sheehan.
- CEO
Thanks.
On today's call we'll discuss our results for the third quarter of 2005 and update you on our progress toward meeting our earnings growth targets.
The third quarter was an important step in meeting our 2005 earnings growth target which we revsed on our last quarterly conference call.
Net income grew 14% year over year, driven by core service fee revenue growth of 25% and ancillary service fee growth of 42%.
Impressive gains in foreign exchange fees, cash management sweep fees, and securities lending fees drove this growth.
Diluted EPS for the quarter came in at $0.53 which was flat with last year's third quarter results.
As of September 30th, we processed approximately $1.7 trillion of assets for our clients, up $200 billion or 13% from June 30th, 2005 and up almost $500 billion of 42% from September 30th, 2004.
During the quarter we converted on $157 billion from a number of new clients including over $120 billion in assets in our European outsourcing client, and over $30 million in assets from the conversion of a major U.S. life insurance company that we announced in the second quarter conference call.
We also won an additional $17 billion in assets from numerous existing clients.
Client fund flows and market movements accounted for approximately $64 billion of our increase in assets proceseed during the quarter.
Turning to the sales environment, we continue to experience higher volumes of RFP activity and new product launches by our clients.
Our pipeline is still characterizeed as medium representing adequate opportunities to meet our revised earnings guidance.
We've also been actively repurchasing our stock during the third quarter.
We bought back approximately 2.1 million shares from July through September.
We will continue to repurchase our stock in an opportunistic fashion in the future.
I'll now turn the call over to John Spinney who will review the quarter's financial results as well as our expectations for the future in more detail.
- CFO
Good afternoon.
As Kevin mentioned, third quarter diluted EPS came in at $0.53 per share, flat with our third quarter 2004 EPS results.
The $0.53 in third quarter diluted EPS includes security gains of $1.4 million or $0.01 per share.
Related to the company's strategy of replacing lower after-tax yielding municipal securities with higher after-tax yielding municipal securities.
We may take a moderate amount of additional securities gains prior to 2005 as we continue to realign our municipal securites portfolio.
I'll now discuss the significant income and expense components for the third quarter in more detail.
Core service fees for the third quarter increased 25% year-over-year due to continued wins from new and existing clients as well as higher client asset values compared to a year ago.
Core service fees rose 6% linked-quarter due to new business wins and higher asset values.
Ancillary service revenue increased 42% year-over-year as a result of increases in foreign exchange fees, cash management sweep fees and securities lending fees.
Ancillary service fees increased 3% linked-quarter due to increases in foreign exchange and cash management sweep fees, offsetting the expected third quarter decline in securities lending fees.
Regarding FX, we recorded approximately 15 million in fees in the third quarter of 2005.
These results represent a 67% year-over-year increase and a 26% linked-quarter increase.
The increases were due to new business, higher volumes and increased FX volatility.
Sweep fees increased 31% year-over-year and 2% linked-quarter due to increased cash balances held by our clients.
Securities lending fees increased over 160% year-over-year due to new business and improved market conditions.
Securities lending fees declined 35% in linked-quarter due to the end of the international dividend season.
Net interest income was down 21% on a year-over-year basis as our balance sheet growth was offset by a flatter yield curve and tighter reinvestment spreads.
Net interest income declined 10% linked-quarter also due to a flatter yield curve and tighter reinvestment spreads.
The linked-quarter net interest margin decreased by 15 basis points to 1.32% while the linked-quarter interest rate spread decreased by 18 basis points to 1.09% due to the factors I just mentioned.
We continued to invest in the same asset class as we have in the past.
We are focusing our investments on variable rate short duration securities.
We are not attempting to generate incremental yield by taking on increased risk such as duration and credit risk.
We also continue to run a closely matched balance sheet with an asset duration of approximately 1.2 years and a liability duration of approximately one year.
A high amount of variable rate securities in our portfolio has allowed us to continue to maintain low asset duration.
Total expenses were up 23% year-over-year and 3% linked-quarter.
Compensation and benefits expense increased 45% year-over-year due to increased head count, annual salary increases, and bonus accruals consistent with our 2005 GAAP diluted EPS performance.
Compensation and benefits expense is up 3% linked-quarter due to an increase in head count offset by slightly lower bonus accruals reflecting third quarter year-to-date GAAP diluted EPS performance.
We expect compensation and benefits to be approximately flat in the fourth quarter 2005 compared to the third quarter of 2005.
Transaction processing fees increased 30% year-over-year and 7% linked-quarter due to increases in transaction volumes in higher market values.
I would now like to discuss our 2005 and 2006 diluted earnings per share guidance.
For fiscal 2005 we continue to expect to achieve approximately 10% growth in GAAP diluted earnings per share.
From a core perspective, we continue to expect 2005 core diluted earnings per share to be approximately flat with our 2004 GAAP results of $2.09 per share.
As we have previously discussed, core diluted earnings per share for 2005 excludes the impact of securities gains totaling $0.11 per share to date in 2005 and approximately $0.10 per share related to ABP 23.
We expect net operating revenue to grow approximately 10% in 2005.
Core service fees are expected to grow by 16 to 18% due to wins from new and existing clients and continued client fund flows, offset by the lackluster performance of the capital markets in the first nine months of the year.
Ancillary service fees are expected to increase approximately 10 to 12% from 2004 levels with solid growth in both securities lending and sweep fees driven by the factors I previously discussed.
Foreign exchange fees are expected to be approximately flat due to lower volumes in volatility in 2005 compared to 2004.
We expect cash management sweep fees and security lending fees to account for the growth in ancillary service fees offset by weaknesses in investment advisory fees.
We now project net interest income to be down approximately 12 to 14% from $188 million in 2004 driven by flatter than expected yield curve environment and tighter than expected reinvestments spreads.
We still expect to keep our balance sheet relatively flat until the interest rate environment improves.
We assume that our net interest income forecast for 2005 and 2006 that short term interest rates will rise until the end of '05 and 2006, and that the yield curve will remain flat.
During 2005 total expenses are expected to grow by approximately 12 to 14% driven by continued investments in head count and technology to support new and existing clients.
We expect to achieve a pretax operating margin fro 2005 of between 32 and 34% and an effective tax rate for 2005 of approximately 32% as a result of the adoption of the APB 23 during the second quarter of 2005.
We are maintaining a cautiously optimistic outlook for 2006 as we expect to continue to see headwinds driven by a challenging environment for net interest income, volatile equity markets, and contract renewals.
We also expect to continue to invest in our infratstructure which may impact our operating leverage.
Ffor 2006 we expect GAAP diluted earnings per share to be approximately flat compared to 2005 GAAP diluted earnings per share.
From a core earnings per share perspective we are projecting annual growth in 2006 diluted EPS of approximately 8 to 10% over expected 2005 core results.
Again, core 2005 diluted earnings per share excludes the impact of securities gains totaling $0.11 per share to date in 2005 and $.10 per share related to the recognition of the indefinite reversal provision of APB 23 with respect to our Irish subsidiaries.
We are basing our 2006 earnings guidance on expected net operating revenue growth of approximately 8 to 10% compared to 2005 net operating revenue excluding security gains. 2005 net operating revenue includes approximately $11 million or $0.11 per share on securities gains taken year-to-date which we do not expect to reoccur in 2006.
We expect our 2006 net operating revenue growth to be driven by the sustained strength of our core service business, continued sales of core and ancillary services to new and existing clients, continued 6% client fund flows, a sustained flat yield curve and tight reinvestment spreads.
We expect approximately 8 to 10% growth in expenses in 2006 in moderate diluted earnings per share impact from our share repurchase program.
We expect to achieve an effective tax rate of approximately 34.25% in 2006.
For 2007 and beyond we are continuing to project long-term annual growth and net operating revenue of 12 to 14%, in annual operating leverage of approximately 50 to 100 basis pointst resulting in annual diluted earnings per share of approximately 13 to 15%.
We remain confident and are committed to our business model and our ability to deliver industry-leading customer service levels, and financial performance including long-term earnings growth in excess of industry averages.
I'd now like to open up the call to your questions.
Operator
Thank you, the question-and-answer session will be conducted electronically.
If you would like to ask a question please do so by pressing the star key followed by the digit one on your touchtone telephone.
If you are using a speaker phone, please make sure your mute function is turned off to allow your signals to reach our equipment.
ONce again that is star one to ask a question and we will pause for just a moment to assembel our roster.
Operator
I'd like to go first to Jon Arfstrom, RBC Capital Markets. .
- Analyst
Good afternoon, guys.
- CFO
Hi, Jon.
- Analyst
Thanks for the guidance.
Makes the job easier.
Question for you on maybe an optimal revenue mix in if you look at net interest income come down as a percentage of revenue.
I'm just curious in our mind if you think at all about what an optimal revenue mix would be?
- CFO
I think it's historically to be between 75-25 and 70-30, and I think somewhere in there is probably the long-term guidance of where it should fall over time.
In terms of you talking about
- Analyst
In terms of you talking about reinvestment yields and tigher spreads, where do you think those spreads have to go before you feel comfortable drawing the balance sheet.
- CFO
We're not going to give specific guidance on spreads per se.
We're going to kind of guide toward the top-line numbers, Jon, and where we think the Fed's going with interest rates and the The shape of the curve.
- Analyst
Okay, I guess the last question in terms of deposits, you had good deposit flows in the quarter and I'm just -- if you're reluctant to grow the balance sheet and deposits continue to come in from your clients, where do they eventually go?
Might we see cash management sweep fees occur over time? and is there maybe a percentage of the balance sheet in terms of the liability side that you need to keep in borrowings to manage the asset side?
Can you comment on that a bit?
- CFO
Sure.
Yeah, there's still some more borrowings that could be paid back with client fund flows and if necessary we could go with off balance sheet with our clients as we wait out the steepening of the yield curve, and then lastly to your point above, to borrowings in general I think you'll always see some level of borrowings on our balance sheet to accomodate client fund flows that happen at period end.
And actually at the end of this quarter was a good example of that where we got a lot of cash and we were able to bring down our borrowings and actually had excess cash that we sold fed funds.
- Analyst
Thank you.
Operator
We'll go next to Joel Gomberg with William Blair.
- Analyst
Good afternoon.
You bought back about half your authorization, your share buy-back authorizition I believe it was 150 you brought back about 70 million, and that was targeted for the next year.
Could you talk a little bit about your strategy of buying back stock?
- CFO
I guess the strategy, Joel, is we're going to be in the market when it's opportunistic.
We've got an authorization for open market purchases.
Some days we'll be in and other days we don't be and we'll buy it when we think it's the right time to buy it.
- Analyst
And then on the expenses, they are -- if you take out the gains sequentially, they're growing faster than the revenues.
Could you flesh that out a little bit more in terms of the growth and expenses relative to revenues?
And then could you also give us the growth and the head count year-to-date?
- CFO
On the expense growth, I think what you're seeing, if you looking especially year-over-year and it looks like a big number, we brought on some significant clients towards the end of last year and through this year, we ramped some of that head count coming into the fourth quarter, so you didn't get any of that head count in the third quarter and all the new business we've added this year, you get the full impact of that in the third quarter so .
The comp numbers are pretty significant.
Also in the third quarter of '05, we had higher bonus accruals relative to the third quarter of '04 because of the really strong performance of the ancillary services in the third quarter of '05.
So as we move further into this year and the revenues start converting on some of the clients that came on for the head count costs, we should be able to see revenue growth offset some of that expense growth.
And then with respect to your head count question, we ended the period with 3,080 employees.
- Analyst
You're at 2700 at your end?
Is that right?
- CFO
That's at 2778.
I think the more important number is back at the beginning of the third quarter of '04, which was around 2500, so we've put on over 500 employees.
- Analyst
In terms of your 2006 guidance, it's similar to last quarter in terms of revenue and expense growth.
Last quarter you indicated it assumed contract renewals.
Is that still the case and any update on Barkley's?
- CFO
What we said is it includes all the contract renewals that are coming up.
As far as the Barkley's contract, when it gets renewed, it gets renewed.
We're constantly talking to all our clients they're up for renewal, and when it gets done we'll announce it.
- Analyst
Thank you.
Operator
We'll go next to Carla Cooper with Robert W. Baird.
- Analyst
Good afternoon.
I wonder if you can talk about the -- I believe you had an opportunity out there in terms of getting the custody piece for the 150 -- roughly 150 billion European clients.
I wonder if you could talk about where you stand with that opportunity.
- CFO
This is John.
There's really nothing to report there right now.
- Analyst
Okay.
And then and I guess the other thing is when you're thinking about your yield curve, your interest rate guidance in terms of the yield curve being flat, what does that contemplate in terms of the yield curve actually moving to an inverted position?
What would be your sensitivity to that occurring? .
Operator
Anything further, Miss Cooper?
- Analyst
I asked about the yield curve.
Can you hear me?
- CFO
You got to turn your mute off so you can hear us.
- Analyst
All right is that better?
- CFO
Yeah, that's better.
- Analyst
My other question was the shape of the yield curve.
You talked about the expectation that your yield curve remains flat, do you mean truly flat and what would be the sensitivity if the yield curve actually inverted?
- CFO
As I said a second ago, I think we're going to keep to our guidance of rates going up, pretty much a flat yield curve.
Could it go one way or the other?
It could, but we're not going to give specific movements in terms of what could actually happen one way or another from day-to-day and month-to-month.
- Analyst
Thank you.
Operator
And once again, that is star one if you would like to ask a question.
We will go next to Brian Bedell with Merrill Lynch.
- Analyst
Hi, good afternoon.
Just on a followon on that one for the flat yield curve, do you mean directionally flat or do you mean precisely completely flat?
- CFO
Pretty much directionally flat.
It could get a little flat from where it is today I guess.
- Analyst
Right, so that [inaudible] your guidance?
Okay.
On the business you converted in the third quarter, the $150 billion, was that done over the course of the quarter or was that skewed towards the beginning or the end of the quarter?
- CFO
It was towards the end of the quarter, for the most part, weighted towards the end so you'll get the full effect in the fourth quarter for most of those assets.
- Analyst
Okay. and I think you said before same with head count associated with that, the compensation?
- CFO
Yep.
- Analyst
Okay and then just on the average balance sheet, looks like you -- at the end of the period your borrowings were way down, $650 million, is that a sustainable pace or is that more really about end of period? [inaudible] the balance sheet?
- CFO
There was a little like I said in my answer to Jon, there was a big slug of liabilities at the end of the period.
We have seen improved liabilities in general, but all that money at period end did not stick.
We have improved in terms of our average final liabilities.
- Analyst
On the average in terms of those deposits.
Those are coming into savings and repo securities?
- CFO
Yep yep.
- Analyst
And then what would you say in terms of the main driver going forward for your net interest margin sensitivity, do you think it's more related to the yield curve or your ability to track lower cost deposits or lag the pricining on your deposits?
- CFO
I think our sensitivity is going to be primarily driven on the shape of the yield curve.
If we go steep we'll get improved net interest income.
- Analyst
Just on on the FX trading revenue, you gave -- thanks for the guidance on that.
Was that due to any one particular client, such as the [inaudible] that you brought on?
Was it really spread across the broad array of clients?
- CFO
Across all of our clients, Brian.
- Analyst
Great, just one last thing on the tax rate, you've got 32% guidance for 2005, right?
- CFO
That's for the full year, right.
- Analyst
For the full year, so that would imply 35% tax rate in the fourth quarter?
- CFO
That's pretty adequate.
- Analyst
Thank you.
Operator
We'll move next to David Chamberlain with PIMCO.
- Analyst
My question's been answered, thanks.
Operator
We'll move next to Kyle.
Cerminara with T. Rowe Price.
- Analyst
Hey, guys thanks for taking the call.
As I look through the numbers, the fees were a lot stronger then I was expecting.
But on the net interest income side as you think about your guidance was very detailed and I appreciate that, as you think about longer term beyond '06, what shall we be thinking in terms of the about the normalized net interest margin for the business.
Is it higher or lower than this?
My sense is that it's much higher looking back over the past few years.
I'm trying to get a sense for has anything materially changed in the business that your net interest margin can't get back to that 1.8 - 2.1 range?
- CFO
I think longer term, Kyle, you'll see it north of 1.3 where it is today.
Once we start coming out of this trough of flat yield curve, we'll return it to higher net interest margin.
I'm not going to put a point on it.
But it should be better longer term.
- Analyst
As we think about the things that we can observe, whether it's fed funds or the 10-year treasury, what are the things that we should be analyzing to get a better sense for when that's going to occur?
Like if the fed stops raising rates, should we expect an immediate increase or will it take time?
Or are there other factors to consider like the 10-year treasury?
Maybe we could walk through a few of those.
- CFO
I think the key points are steepness to to the yield curve and the overnight to that 2 - 5 - 10 across the curve.
Once you see steepness there that will improve, not immediately but over time.
Once the fed stops raising rates, that will take some time because of lags in the asset repricing but that'll improve after that.
And I think those are the two key ones, really.
- Analyst
Last question, you've characterized the pipeline as medium, yet it seems like there's a lot of activity both at IFIN and at some of your competitors.
Are you feeling pretty good about the new business activity or, you know, maybe we could talk a little bit more about the new business environment.
- CFO
The new business environment in terms of the pipeline and the velocity of items, it's pretty strong.
We've got our existing client base adding new funds almost weekly.
There's some good-sized opportunities in there that are going to take some time to work threw and when we close those, if we win those we'll report on those.
- Analyst
I appreciate it.
Thanks a lot!
Operator
We go next to [Brian Lewshinski] with Riversource.
- Analyst
Hi, good afternoon, gentlemen, Thanks for taking my call.
Just a quick question.
Can you talk a little bit about what happened during the quarter in terms of making you reduce your net interest income guidance for '05?
I think last quarter you talked about down 10% year-over-year and now it's down 12 to 14%.
It seems like things played out as you were expecting, in terms of what the fed was going to continue to do and the flatness of the curve so I'm curious what happened in the quarter to make you revise your thinking there.
- CFO
I think we saw a few things happen a little bit faster, prepayments than we originally projected and a little tighter reinvestment spreads and a little higher liability costs in the third quarter than we expected.
- Analyst
Okay.
Anything to do with the sort of consensus moving that the fed will continue to raise rates through 2006?
Did that have anything to do with it as well?
- CFO
No.
- Analyst
Thanks for taking my call.
- CFO
Sure.
Operator
Once again that is star one if you would like to ask a question.
We will go next to Robert Rutschow with Prudential Equity.
- Analyst
Hi guys.
I guess in thinking about the leverage in your model, it looks like the fees-to- expenses were about as high as they've been in some time.
Looking forward, you mentioned some investment for future growth.
How should I think about that expenses in terms of fees going forward?
- CFO
Off the top my head I can't come up with that metric.
It's not something I really track from period to period, per se Rob.
If we continue to put on the assets we put on, and convert the clients we continue to convert, you probably see us obviously add more people, more space, and more technology costs, and transaction processing costs, that's really how the model lays out.
- Analyst
Okay, and then secondly, in asset management were there any givebacks of fees this quarter?
I think you mentioned that last quarter.
- CFO
No, the third quarter was the full quarter with no reimbursement. the second quarter had roughly two months of -- I mean one month of reimbursement, excuse me.
- Analyst
Okay, thank you.
Operator
We'll go next to a follow-up question from Brian Bedell with Merrill Lynch.
- Analyst
Hi thank.
Just a follow-up.
Do you have any conversions of new business schedules for fourth quarter?
- CFO
Not that we haven't already announced other than clients adding funds and things like that that are much smaller than $160 billion in assets.
- Analyst
Like the 17 billion you mentioned earlier?
- CFO
That stuff is always going to happen.
That's not things we're going to talk about in this call, Brian, they just happen in the normal course of the quarter.
- Analyst
Sure.
Then on the expense -- on the investment in the business, can you talk about some of the investments you may be making that are not related to directly to new contract wins, if there are any?
I guess what I'm getting at is is it really just expense related to bringing on new business, and adding head count and technology related to that, or is it built out of a different capability that you're hoping to win new contracts with?
- CFO
I think the majority of it is related to new contracts.
The other thing we've done is part of the comp benefits increase was adding more people as we've added all these assets and clients this year, you have to have more infrastructure and more people around that, so we've done that.
As we continue to grow in terms of our fee revenue growth and asset revenue growth, I think you'll see some more space in '06 to accommodate these new clients and new funds and new people we're adding.
- Analyst
Great, thanks very much.
Operator
There are no further questions at this time.
I'll turn the conference back over to the speakers for any additional or closing remarks.
- CEO
Thank you.
In closing today, thank you for joining us on today's call.
We'll look forward to updating you on our progress toward our new goals in January during our fourth quarter earnings conference call.
Operator
That concludes our conference for today.
A replay for this call will be at 8:00 PM Easter time today and will run through October 25th at midnight, Central time.
To access this replay, please dial 719-457-0820 and enter in the pass code of 6894360 .