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Operator
Good day everyone and welcome to Investors Financial Services Corp's fourth quarter 2006 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 Ms. Ann Borst, Senior Director of Investor Relations.
Please go ahead.
Ann Borst - Senior Director IR
Thank you for joining us this evening.
We will be making a number of forward-looking statements which are [not] 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, interest rate, shape of yield curve, 2007 net operating revenue, 2007 total operating expenses, balance sheet growth, new business opportunities, increased office space, and operating margin are subject to risks and uncertainties.
The Company's actual results may differ materially from 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 our most recent 10-K and 10-Q filings with the SEC, and in the Form 8-K we filed yesterday, which includes our press release.
I recommend that anyone listening to this call review these reports carefully.
Because this call will be archived on our website, 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, January 17, 2007.
These assumptions may change, but the recording of this call will not be updated.
Joining us on today's call are Kevin Sheehan, Chairman and Chief Executive Officer;
Mike Rogers, President; and John Spinney, Chief Financial Officer.
I will now turn the call over to Kevin.
Kevin Sheehan - Chairman, CEO
Good evening everyone.
While 2006 presented a very challenging yield curve environment, we remained focused on leveraging our core capabilities as the leader in asset processing and grow our business worldwide.
Our success in 2006 is evident by several measures.
First, revenue growth was impressive for 2006, 21% for core services and 33% for value-added services.
Second, in 2006 we reached a significant corporate milestone, processing over $2.2 trillion of assets for our clients as of December 31, 2006.
Third, we ranked number one in client satisfaction in the Global Investors' 2006 Global Custody Survey, an honor we have achieved four out of the last five years.
We received the overall first-place honors in the Global Custodian Magazine's 2006 Mutual Fund Administration Survey.
And fourth, in 2006 we sold our services to new and existing clients that should generate solid top and bottom line growth into 2007.
For example, early in 2006 we extended our iShares and Master Investment Portfolio contracts with BGI for another seven years.
We also broadened our capabilities in Europe with the opening of new offices in London and Luxembourg to support our clients' expansion plans and capitalize on significant opportunities in these markets.
Additionally, we converted new business for new clients, such as a prominent European hedge fund and a global investment bank, which we believe have the potential to develop into substantial business in the future.
In 2006 we aggressively accelerated investment to position the Company for growth in 2007 and beyond.
The largest investment in 2006 was for $70 million in compensation and benefits expense for the approximately 1,000 new employees hired to service new business and to build capacity in areas such as Europe, technology, alternative investments, middle office outsourcing, and fund services.
In 2006 we spent 21% of revenue on technology investments, which is over and above our typical 18 to 20% of revenue.
We continue to drive automation and strive to eliminate many of the industry's manual processes inherent with hedge funds and other complex capital structures.
In addition, we invested $7 million in 2006 for space to accommodate new employees we hired this year, and to build capacity in North America and Europe.
We will continued to take down additional office space in the first half of 2007 to accommodate new employees.
The success of Investors Financial is a result of our dedication to provide the best possible service to our clients.
We are well-positioned to take advantage of new business opportunities in 2007, especially given the recent consolidation in the industry.
I will now turn the call over to John Spinney to review the quarter's financial results in detail, as well as our expectations for 2007.
John Spinney - CFO
I will begin with the year-over-year results for the fourth quarter.
Fourth quarter diluted EPS came in at $0.53, down 12% from the fourth quarter of 2005, as a result of the investments Kevin just outlined.
Net operating revenue for the fourth quarter increased 11% year-over-year due to new business wins and higher client asset values as a result of higher market values and strong client fund flows.
Core service fees for the fourth quarter increased 21% year-over-year due to wins from new and existing clients, as well as higher client fund flows and higher market values.
Value-added service revenue increased 2% year-over-year as a result of strong revenue from cash management.
Cash management sweep fees increased 54% year-over-year due to higher client balances and new business.
Securities lending fees increased 4% year-over-year due to new business and favorable market conditions.
FX fees decreased 25% year-over-year despite higher volumes.
Foreign market investment appeal and added volatility developed in the fourth quarter of '05 and lasted through the first half of 2006.
However, by mid 2006 volatility reversed and diminished right through the fourth quarter of 2006.
Net interest income was up 1% on a year-over-year basis due to strong client funding, offset by the inverted yield curve, tight investment spreads and a smaller balance sheet.
Total operating expenses were up 23% year-over-year due to investments to position the Company for future growth, such as additional personnel, technology and office space.
As we said last quarter, these step variable costs are warranted investments as we continue to expand and enhance our products and services in several high-growth securities processing areas.
Compensation and benefits expense increased 37% year-over-year due to hiring approximately 1,000 employees and management to our North American and European offices.
Annual salary increases, bonus accruals and option expense also contributed to the growth in compensation and benefits expense.
Technology and telecommunications expense increased 30% year-over-year, reflecting both our commitment to our global integrated technology platform, which we view as a significant competitive advantage, and growth in new business and existing customer volumes.
Transaction processing fees increased 9% year-over-year due to increases in transaction volumes, higher market values and new business.
Occupancy expense increased 34% year-over-year due to new office space worldwide.
Now turning to the linked quarter results.
Net operating revenue for the fourth quarter increased 8% linked quarter due to higher core service fees and stronger net interest income.
Core service fees increased 10% linked quarter due to wins from new and existing clients, as well as higher client fund flows, asset values and transaction levels.
Value-added service fees increased 2% linked quarter due to strong cash management fees.
Cash management sweep fees increased 9% linked quarter due to new business and higher client balances.
Securities lending fees increased 10% linked quarter due to new business and favorable market conditions.
And FX fees decreased 8% linked quarter primarily due to lower market volatility, as I discussed earlier.
Net interest income was up 11% on a linked quarter basis due to strong client funding and slower prepayments.
The net interest margin increased by 15 basis points linked quarter to 1.55%.
And interest rate spread increased 14 basis points linked quarter to 1.16%.
As you know, we focus our investments on variable rate short duration securities.
We cannot attempt to generate incremental yield by taking on increased duration of credit risk.
We also continue to run a closely matched balance sheet, with an asset duration of approximately 1.3 years, and a liability duration of approximately 1 year.
Total operating expenses increased 12% linked quarter, primarily due to compensation and benefits.
Compensation and benefits expense increased 19% due to hiring approximately 200 employees during the fourth quarter to service new business.
Bonus accruals also contributed to the growth.
Occupancy expense increased 10% linked quarter due to new space in Boston, Dublin and California.
Now turning to our 2007 guidance.
We expect our 2007 net operating revenue to grow approximately 15 to 18% compared to 2006.
Total operating expenses in 2007 are expected to grow approximately 21 to 24% compared to 2006, which reflect the addition of office space in 2007, and the full year impact of the 2006 investments in additional personnel, technology and office space to position the Company for future growth.
Operating leverage is expected to improve in the second half of 2007 when the full year impact of the major investments is realized.
We expect our effective tax rate to be approximately 33.5%.
We are projecting 2007 diluted EPS to be approximately $2.25 to $2.30 per share.
This guidance assumes the yield curve will remain inverted throughout 2007.
We still plan to keep our balance sheet relatively flat until the interest rate environment improves.
In summary, although we're in the midst of a challenging and unpredictable yield curve environment I'm confident our investments for future growth were at the right time and for the right reasons.
The fundamentals of our business model remain strong and our industry continues to offer robust long-term growth opportunities.
I would now like to open up the call for your questions.
Operator
(OPERATOR INSTRUCTIONS).
Jon Arfstrom, RBC Capital Markets.
Jon Arfstrom - Analyst
John, can you talk a little bit more about the margin?
Is there a way to maybe isolate what was the largest contributor to the margin strength during the quarter, and whether or not that is sustainable?
John Spinney - CFO
I think the biggest contributor during the quarter was better client funding versus using borrowed funds during the quarter.
And then secondarily just lower prepayments activity, which lowers our premium amortization cost.
Jon Arfstrom - Analyst
Also, on the funding costs it looks like it was relatively stable on a sequential basis.
Do you see any emerging pressure there, or is this just as simple as the liability sensitivity of the balance sheet running its course?
John Spinney - CFO
I don't seeing any material changes to liability pricing in the near term.
Jon Arfstrom - Analyst
Then maybe a question for Kevin or Mike.
In terms of the new business environment, Kevin, you mentioned obviously a large merger in your space.
That is one thing I would like you to touch on.
And then the other is just looking at your sales to new clients and sales to investing existing clients, it was about $37 billion for the year.
And the question is, where will we see the results of the higher spending show up?
Is that part of the $37 billion?
Is it coming into fund flows?
Is it going into value-added.
I think everybody is now accepting that you're going to have higher expenses for the first half of the year, but the question is, where do the investors get paid and where do we see it show up?
Thanks.
Kevin Sheehan - Chairman, CEO
I think fundamentally any time there is merger activity it represents an opportunity.
We will obviously, with everybody else, try to act on those, and hopefully are successful in that process.
In terms of our growth, I think it is a balanced amount of growth, and it exists between new business wins.
It exists in terms of fund flows from existing clients.
And it is a function of business that we won in the prior year where we have the full year flows coming onboard in the second year so the benefit is annualized.
Jon Arfstrom - Analyst
Typically you have characterized the strength of the backlog as medium.
Is that still the standard party line?
Kevin Sheehan - Chairman, CEO
Yes.
Operator
Andrea Jao, Lehman Brothers.
Andrea Jao - Analyst
Given the negative operating leverage that is built into your forecast for 2007, what gives you comfort, or what do you think will happen that this negative operating leverage improves in the back half of '07?
And when you do say improved, do you mean you will reach positive operating leverage by the latter part of the year?
John Spinney - CFO
Yes, by the latter part of the year we should be growing revenue faster than expenses.
And what gives us confidence is our visibility to what we have spent thus far, what we need to spend into '07.
And our forecast are showing that we should be positive operating leverage in the middle of the third quarter into the fourth quarter.
Andrea Jao - Analyst
Then just a follow-up.
On the margin for so long as client fund flows are coming in, you see the margin improving.
John Spinney - CFO
All things equal, an incremental dollar asset flow would obviously be incremental to operating margin, that's correct.
Operator
(OPERATOR INSTRUCTIONS).
Brian Bedell, Merrill Lynch.
Brian Bedell - Analyst
Could you just talk a little bit more about the spending initiative?
I know this is -- you have been talking about it the last couple of quarters, but maybe just to isolate what areas they're going into?
And maybe a way to start that would be the 1,000 people that are being added, what portion are in sales, what portion are in operational support?
And then also what type -- to what degree is the spending increase related to the Barclays contract, or if Barkleys asking for more service capacity?
John Spinney - CFO
I think if you look at the new employees, they are directed exactly what Kevin talked about, our initiatives in Europe, technology, alternative investments, middle office.
And all those are part of our fund services or operations.
So those particular headcount are used to grow those practices in Europe.
They are also used to add middle management.
As we said in last call, we have gotten to a size now where we need more middle management capacity to help us run the Company on a day-to-day basis.
We have done that.
And technology is a key driver to our efficiency long term and we need to make investments there to continue keeping up with the products that our clients come up with, and creating ways to become more efficient, especially in areas like alternative investments, hedge funds and venture capital type funds, where the protocols are not as standard as they are in the mutual fund business.
We're making significant investments there because the pipeline gap warrants that type of investments for those types of products.
Brian Bedell - Analyst
When you say pipeline, you mean clients asking you to create this processing capacity?
John Spinney - CFO
I think the general marketplace from what we are seeing from a sales perspective and what our existing clients are putting on the table for new products for us to service.
Brian Bedell - Analyst
And how confident are you that you're on track to end this ramp up?
It sounds like through 2Q the expense growth will continue to ramp.
How confident are you that you're on track to complete these processing improvements, and that they won't last well into the second half of '07?
John Spinney - CFO
I think we are pretty confident right now.
We have put a lot of those resources into the mix in '06.
We have got less to do in '07.
Barring no major client acquisition, I would say we're pretty confident.
If we get the pipeline to just accelerate and close then you will see maybe some expense leading that.
So I am not going to sit here and tell you, if something like that happens you won't say increased expenses, you will.
But absent that, I think we've got pretty good confidence and visibility into the operating leverage improving on the back half as we stated.
Brian Bedell - Analyst
When do you foresee the improvement in organic growth of new business coming from new clients as a result of these expenditures?
Is that something that we will see later in '07 or is more like an '08 timeframe?
John Spinney - CFO
I think fundamentally we're agnostic as to whether it comes from existing clients or new clients.
The fund flows are there.
The new business is there from existing relationships and those have been augmented with new sales.
Brian Bedell - Analyst
But just in terms of the timing, is that something that you guys think that you will be able to leverage pretty quickly, or is it more you're putting your platform out there and then hopefully get new business over time?
John Spinney - CFO
I think these step variables to accommodate fund flows that are coming in the door today regardless of where they are generated.
Brian Bedell - Analyst
Just lastly on the Barclays Fund, is part of this in response to the renegotiation of the contract with Barclays in terms of the expense build?
John Spinney - CFO
No.
Brian Bedell - Analyst
No, it is not related?
Okay.
Thanks very much.
Operator
Rob Rutschow, Prudential Equity Group.
Rob Rutschow - Analyst
Just a quick housekeeping item.
Can you tell us what your foreign assets processed were?
John Spinney - CFO
Yes, they were about $425 billion at the end of the quarter, $430 billion.
Rob Rutschow - Analyst
Can you just talk a little bit more just drilling down on the expenses?
Can you tell us how many more people you expect to add in 2007?
John Spinney - CFO
I think we going to add -- to continue to finish our initiatives, probably 75 to 100 people in '07.
And then all the other headcount that will grow in '07 will be driven off of new business coming in the door from new and existing clients.
Rob Rutschow - Analyst
Okay.
The capacity or the capabilities that you're adding, is any of that related to ETF, foreign ETF, commodity ETF?
And can you just talk generally about the pipeline there?
John Spinney - CFO
In general, I think, all the initiatives we are putting money into would cover the ETF business as well.
We have seen a tremendous amount of growth in that business for our own -- in our own book of business.
And we continue to see activity in the marketplace for future growth of other clients that offer ETF.
Some of that expense will benefit -- so that investment will benefit the ETF processing as well.
Rob Rutschow - Analyst
Just generally, it looks like your foreign custody asset growth is a little bit faster, maybe double, the pace of the U.S.
Should we look for that to continue?
John Spinney - CFO
I think as long as the foreign market returns stay hot and more money flows into those products there will be more foreign assets that we will be custodian and administrator for.
On top of that our Dublin operation continues to grow 40 to 50% of topline growth, as well as assets processed.
So on both front I think we're doing very well.
Operator
This concludes our question-and-answer session.
A replay of this call will be available starting at 8 PM Eastern time today and will run through January 30 at midnight Central time.
To access this replay, please dial 719-457-0820 and enter the pass code of 8301249. (OPERATOR INSTRUCTIONS).
At this time I would like to turn the call back over to Mr. Kevin Sheehan for closing remarks.
Kevin Sheehan - Chairman, CEO
Thank you for joining us on the call today, and we look forward to updating you on our progress in April during our first quarter earnings conference call.
Operator
That concludes today's conference.
Thank you for your participation.