Financial Engines Management Discusses Q1 2013 Results - Earnings Call Transcript

May. 8.13 | About: Financial Engines, (FNGN)

Financial Engines (NASDAQ:FNGN)

Q1 2013 Earnings Call

May 07, 2013 5:00 pm ET


Raymond Jay Sims - Chief Financial Officer and Executive Vice President

Jeffrey Nacey Maggioncalda - Chief Executive Officer and Director


Robert P. Napoli - William Blair & Company L.L.C., Research Division

Hugh M. Miller - Sidoti & Company, LLC

Mayank Tandon - Needham & Company, LLC, Research Division

Avishai Kantor - Cowen and Company, LLC, Research Division


Good afternoon, and welcome to the Financial Engines First Quarter 2013 Earnings Call. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Ray Sims, Chief Financial Officer. Please go ahead.

Raymond Jay Sims

Good afternoon, and thank you, all, for being on today's call.

Before we get started, I need to remind everyone that part of today's discussion will include forward-looking statements, such as statements regarding our operating metrics; anticipated costs and expenses; growth and growth opportunities; strategy and timing; trends impacting our business; impact of new laws and regulations; enrollment rates, implementation and potential impact of enrollment enhancements and strategies; anticipated features, benefits, success and impact of Income+; anticipated adoption of our products and services; anticipated benefits and impact of customer experience enhancements; long-term objectives and financial outlook for 2013.

These statements are based on what we expect as of this conference call, as well as current market and industry conditions, financial and otherwise, and we undertake no obligation to update these statements to reflect events, circumstances or changes that might arise after this call.

These forward-looking statements are not guarantees of future performance or plans and therefore, investors should not place undue reliance on them. We refer all of you to our SEC filings for more detailed discussions of the risks that could impact our future operating results and financial conditions, which could cause actual results to differ materially from those discussed in these forward-looking statements.

I also want to inform our listeners that we will make some reference to non-GAAP financial measures during today's call. You will find supplemental data in our press release, which reconciles our non-GAAP measures to our GAAP results.

Now I would like to turn the call over to Jeff Maggioncalda, our Chief Executive Officer.

Jeffrey Nacey Maggioncalda

Good afternoon, everyone. Thank you for joining us today. I'm pleased to report that Financial Engines had a good first quarter. Let's take a look at our numbers for the quarter.

Revenue increased 29% to $53.9 million in Q1, compared to $41.7 million a year ago. Non-GAAP adjusted EBITDA increased 43% to $16.7 million in Q1, compared to $11.7 million a year ago. Non-GAAP adjusted earnings per share increased 50%, to $0.15 in Q1 compared to $0.10 a year ago.

In addition to our financial performance, we report quarterly on some important operating metrics, including assets under management, assets under contract, total members and enrollment rates. Please refer to our SEC filings for definitions of these operating metrics.

We had a solid quarter across all of these metrics. As of March 31, assets under management reached $70.8 million, a 32% increase from $53.7 billion a year ago. Assets under contract increased by 23% to $635 billion from $517 billion a year ago. Total members enrolled in Professional Management grew to more than 681,000 members. Enrollment rates among employer plans where services had been available 26 months or more, averaged 12.8% at the end of the first quarter.

There are a number of fundamental forces driving our growth opportunity. As we have discussed previously, demographic trends continue to drive our business. When Social Security was introduced in 1935, only 6% of Americans were 65 or older. Since 1935, this age segment has more than doubled. And today, 13.3% of Americans are aged 65 and older, a total of 41 million individuals. By 2060, the projected 65 and older population will rise to 92 million, or 1 out of every 5 U.S. residents.

Boomers transitioning into retirement are challenged, not only by the reality of insufficient retirement savings and rising healthcare costs, but also the risk of outliving their savings.

In addition to demographics, we believe another factor driving our growth is the increasing reliance on defined contribution plans. The Baby Boomers transitioning into retirement will be relying less and less on defined benefit pension plans as employers continue to freeze and terminate these benefits. A recent Insured Retirement Institute survey reports that 48% of retirees say a defined benefit pension plan is a major source of income for them in retirement, compared to only 38% of working boomers.

The survey also examined the reliance on 401(k) accounts, and found that only 34% of retired boomers expect to rely heavily on their 401(k), versus 45% of working boomers.

Financial Engines also continues to benefit from legal and regulatory tailwinds. On April 10, President Obama released his budget proposal, setting forth a number of policy priorities for 2014. One proposal would limit an individual's total balance across tax-deferred accounts to an amount sufficient to finance an annuity of not more than $205,000 per year in retirement, or about $3 million for someone retiring in 2013. Less than 1% of Financial Engines managed account members have account balances greater than $3 million, and half of our members have balances less than $47,000. So we do not expect that this provision, even if passed, would have any meaningful direct impact on our business under current market conditions.

Another proposed initiative includes an automatic workplace pension, to encourage employers who do not currently offer a retirement plan to enroll their employees in a direct deposit IRA account, as well as changes to the required minimum withdrawal formula for inherited IRA accounts. It is not clear which of these initiatives will make it into the final budget, but these proposals clearly illustrate that individuals are facing increasingly confusing and changing formulas. Rules and regulations layered on top of an explosion of complex options. Increased complexity gives rise to an increased need for help. And we believe these more complex features will prompt more sponsors and participants to seek services like Financial Engines.

Separately, the Government Accountability Office, known as the GAO, issued a report on April 3 that examined the current rollover practices among the 401(k) plans, and found that the current rollover process favors distribution to IRAs. The GAO's research found that complex guidance and marketing information may make it difficult for participants to understand and compare distribution options, or to appreciate the conflicts of interest that can be inherent in the process. The GAO found that participants are subjected to pervasive marketing of IRAs, in many cases, from their plan service providers steering participants toward the purchase of their own retail products and services, even when they may not serve the participants' best interest. The report provides a number of recommendations to the Secretary of Department of Labor and Commissioner of the IRS, including recommendations to help ensure that plan participants receive adequate, timely and balanced information when they separate from an employer and are deciding what to do with their retirement plan savings.

In response to the GAO's report, Senate Health, Education, Labor, and Pensions Committee Chairman Tom Harken stated, "This report is a wake-up call that we need stronger consumer protection in the growing 401(k) rollover market." He went on to urge the Department of Labor to "move forward with their efforts to modernize the definition of fiduciary under ERISA, and make sure that those giving advice are held to the highest possible standards."

Employers often take their cues from Washington. Standards and common practices emerge. We believe the GAO report benefits Financial Engines by reinforcing the importance of independence and the need for help, especially with respect to IRA rollovers, for plan participants separating from their employers.

We also see a continued trend of plan sponsors providing more help to participants in 401(k) plans. The 2013 Retirement Confidence survey, recently released by the Employee Benefits Research Institute, revealed that 28% of Americans have no confidence that they will have enough money to retire comfortably, the lowest confidence level in the study's 23-year history.

The Mercer workplace survey found that 401(k) participants who use "in-plan advice" like Financial Engines, have a more optimistic retirement outlook by a margin of 10 percentage points, compared to participants who did not use in-plan advice.

So our growth opportunities continue to benefit from demographic trends, the increased reliance on 401(k) plans, legal and regulatory tailwinds and increased demand for investment advice in the workplace.

Now I would like to discuss our strategy to take advantage of these growth opportunities and the progress that we're making. Let's start with assets under contract, which is the value of assets in retirement plans where Professional Management has been made available.

Assets under contract rose to $635 billion by the end of Q1, up from $575 billion at the beginning of the quarter and up 22% over the last year. The growth in the first quarter was driven primarily by new employers making their services available, the positive performance of financial markets over the last year, and the steady contributions that participants and employers made into their 401(k) accounts.

Competitors, including new investment advisory firms and established players alike, appeared to have increased their focus on providing managed accounts to the 401(k) market. We continue to broaden the scope of services we offer, and improve the customer experience in order to further differentiate from target date funds and managed account competitors as we grow our AUC. We believe that improving the customer experience will also drive engagement, enrollment and retention.

We continue to focus our efforts on converting assets under contract into assets under management by improving enrollment. In Q1, we added $3.1 billion of AUM from new enrollment, yielding $1.1 billion net of voluntary and involuntary cancellations. This growth in AUM was due to campaigns in increasing ongoing enrollment. In addition to enrollment campaigns, we're pleased with the ongoing progress from our integrated enrollment efforts and continue to focus on non-campaign enrollment methods.

Our integrated enrollment capability, available through our largest provider partners, now covers 80% of our AUC. We continue to increase the speed and quantity of messaging to participants, and we continue to see steady progress and the effectiveness of this enrollment method. We continue to make progress understanding what drives enrollment, designing more effective communication programs, and deploying these programs more broadly across our installed base.

Enrollment from employers rolled out 26 months or more averaged 12.8% at the end of Q1. An attractive characteristic of our business model is the built-in growth that comes from ongoing contributions from 401(k) participants. Every 2 weeks, a part of most participants’ paychecks is deducted and deposited into their 401(k) account, which is usually partially matched by their employer. We estimate that in addition to the $1.1 billion of AUM from new enrollees, our AUM increased by approximately $1.3 billion more in Q1, due to member and employer matching contributions, an increase of 30% over last year.

The net inflows from contributions have steadily risen as our member and AUM base has grown and Americans continue to increase their savings rates.

We are increasing our focus on retention of Professional Management members. Our increased retention efforts are currently focused on reducing voluntary cancellations. We believe that we can reduce cancellations over the coming years by increasing personalization, flexibility and the breadth of services that we offer.

For the first quarter of 2013, our average quarterly overall cancellation rate was 3%, which is somewhat lower than our historical cancellation rate, in which we believe is favorable -- mostly to favorable financial markets. Sponsor and participant response to broader advisory capabilities continues to be positive and reinforces our unique ability to provide holistic advice that is independent and free from product conflicts, and we will continue to invest in developing these efforts.

Our other primary growth initiative is Income+, a retirement income feature that provides retirees with a steady monthly paycheck from their 401(k) to a checking account that can last for life. We continue to make progress deploying Income+ with our provider partners and plan sponsors. We now have 7 providers who have established or committed to establish, Income+ connections. Provider partners with live Income+ connections now represent more than 50% of our AUC. Income+ went live with plan sponsors at Fidelity in late 2012, and Vanguard has announced to their sponsors its intent to add Income+ as well.

Once the remaining provider connections are live, nearly all of our AUC will have access to Income+. This broad adoption of Income+ by plan providers and plan sponsors, positions Financial Engines to become the standard for retirement income and 401(k) plans. Demand for Income+ by some of the nation's largest employers remains strong. We have more than 70 signed contracts for Income+, with plan sponsors representing over $126 billion in retirement plan assets, and over 1.4 million participants.

As of March 31, 2013, plan sponsors who have made Income+ available to their participants represent $42 billion in assets under contract, an increase of 121% from the first quarter of 2012, and more than 455,000 participants. Beyond the workplace, Financial Engines can now provide IRA management with Income+ capability for members and their spouses on multiple custodial platforms.

We have established connections with 2 leading IRA providers, TD Ameritrade and Charles Schwab. And we intend to establish connections with additional leading IRA providers.

This is consistent with our efforts to provide independent, holistic help to participants that includes open architecture connections with IRA custodians. We believe that plan sponsors, participants, pension consultants, policy makers and thought leaders favor this open-architecture approach, and the independence that Financial Engines provides.

And while independent holistic help may be available today through investment advisers, this is typically limited to high net worth individuals only. Financial Engines provide independent holistic help to members whose median portfolio is only $47,000. For the near term, IRA management will be available only to professional management members in the Financial Engines direct channels. We are proceeding with further validation and testing of a broader management retirement offering, and we will continue to invest over the longer term to expand and deploy this platform.

We believe that extending our offering to include the management of IRA, as well as 401(k) accounts, will better engage members and help drive enrollment. And broadening our services will also differentiate us from competitors and products like target date funds. We believe also that expanding our service offering will help mitigate the pricing pressure prevalent in the industry. And we expect our IRA capability can improve sponsor and member satisfaction, revenue per member and voluntary and involuntary cancellation rates over time.

We expect that the larger benefit of IRA management and Income+ will be realized over the longer term, as the demographic wave of baby boomers retiring continues over the next 2 decades. We continue to expand the number of retirement plan sponsors we serve. At the end of the first quarter, we had 515 plan sponsors where Professional Management was available, representing $635 billion in dollars and assets, and about 6.8 million participants.

At the end of the first quarter, we were managing portfolios for $70.8 billion for more than 681,000 members. And half of those members had less than $47,000 in their accounts.

As of March 31, 2013, 142 of the Fortune 500 have hired Financial Engines to help their employees and our advice is available to over 8.5 million participants.

When I look at the fundamental trends driving our growth, the breadth and strength of our relationships, and the equality, scalability and the uniqueness of our services, I feel that Financial Engines is increasingly well-positioned to take advantage of a significant market opportunity, and to deliver on our promise of providing everyone with the independent, personalized retirement help that they deserve.

Now I'd like to turn it over to our CFO, Ray Sims, to discuss our financial results in more detail. Ray?

Raymond Jay Sims

Thanks, Jeff. As Jeff said, total revenue increased 29% to $53.9 million in the first quarter of 2013 from $47.1 million in the prior year period. This increase in revenue was driven primarily by growth in Professional Management revenue, which increased 38% to $45.5 million in the first quarter of 2013.

Professional Management revenue growth was driven by higher AUM, which reached $70.8 billion at the end of the first quarter, compared with $53.7 billion ending the prior year period. This increase in AUM was the result of increased enrollment from marketing campaigns and other ongoing member acquisitions, as well as contributions and market performance.

Platform and other revenue was down 5% to $8.4 million for the first quarter of 2013, compared with $8.8 million for the first quarter of 2012. This was due primarily to a few sponsor terminations, which resulted mainly from an effort to unify all sponsors onto our full-service platform, and a timing shift for reimbursable, printed fulfillment materials, associated with a large, sub-advisory campaign. We expect platform and other fees to average approximately $9 million per quarter in calendar year 2013.

Cost of revenue, exclusive of amortization of internal use software, increased 30% to $19.9 million for the quarter, compared to $15.3 million in the prior year period. As a percentage of revenue, cost of revenue remained constant at 37% in both the first quarters of 2012 and 2013.

As most of you already know, employee-related costs are our largest expense, and include items such as wages, cash incentive compensation, noncash stock-based compensation and benefits. The expense variances that I will be talking about within each of the functional areas were driven primarily by increases in employee-related wages, benefits and employer payroll taxes from growth in headcount and annual cash compensation increases.

Rent and corporate depreciation expense, which are allocated based on headcount, also increased across each of the functional areas due to the commencement of our lease for the new headquarters facilities in April 2012.

Research and development expense increased to $7.6 million for the quarter, up 24% from $6.1 million in the prior year period, due primarily to increases in employee-related and allocated rent and depreciation expenses.

As a percentage of revenue, R&D decreased from 15% in the prior year period to 14% this quarter, as employee-related expenses grew at a slower rate than revenue. Sales and marketing expenses increased to $10.4 million for the quarter, up 12% from $9.3 million in the prior year. This increase was driven primarily by increased employee-related expenses, allocated rent and depreciation expense, and an increase in the amortization of direct response advertising. As a percentage of revenue, sales and marketing expenses decreased from 22% in the prior year period, to 19% this quarter, as employee-related expenses grew at a slower rate than revenue.

General and administrative expense increased to $4.8 million for the quarter, up 26% from $3.8 million in the prior year quarter, due primarily to increases in employee-related costs, professional services and consulting expenses, and allocated rent and appreciation expense. As a percentage of revenue, general and administrative expense remained constant at 9% in the first quarters of 2012 and 2013.

Income from operations as a percentage of revenue increased to 18% for the first quarter of 2013 from 14% compared to the prior year period. Net income increased to $6.2 million in the first quarter of 2013 compared with net income of $3.5 million in the first quarter of 2012.

As many of you know, we look at non-GAAP adjusted EBITDA as a key measure of our financial performance. Our earnings release has a table that reconciles our GAAP net income to adjusted EBITDA. Adjusted EBITDA in the quarter increased to $16.7 million, up 43% from $11.7 million in the first quarter of last year. Adjusted EBITDA is one of the metrics we use to determine employee cash incentive compensation.

We provide further information about the calculation of our non-GAAP adjusted EPS in today's earnings release. Non-GAAP adjusted EPS was $0.15 in the first quarter of 2013, compared with $0.10 in the first quarter of 2012. In terms of cash resources, as of March 31, 2013, we had total cash and cash equivalents of $192 million compared with $146 million as of March 31, 2012.

On May 2, 2013, Financial Engines' Board of Directors declared a cash dividend of $0.05 per share of the company's common stock. The cash dividend will be paid on July 5, 2013, to stockholders of record as of the close of business on June 14, 2013.

Now on to our outlook of 2013. Based on financial markets remaining at May 2, 2013, levels, when the S&P 500 index closed at $15.98, we estimate 2013 revenue to be in the range of $230 million to $235 million, and 2013 non-GAAP adjusted EBITDA to be in the range of $73 million to $75 million.

We estimate that from May 2, 2013 market levels, a sustained 1% change in the S&P index on May 2 through the end of 2013, would impact our 2013 revenue by approximately 0.43% and our 2013 non-GAAP adjusted EBITDA by approximately 0.8%, all else being equal.

In planning for the growth of our business, we have accelerated hiring into the first 2 quarters of 2013, and it may affect the quarterization of our adjusted EBITDA. While we have historically provided sensitivity based on the S&P 500 for simplicity, we encourage investors to utilize the breakdown of our aggregate portfolios provided in our earnings release to run more accurate sensitivities as international equity and bond market performance may deviate substantially from the S&P 500's performance.

The recommended indices are the S&P 500 for domestic equities, the MSCI EAFE index for international equities and the Barclays Capital U.S. bond index for bonds.

Our outlook for 2013 is consistent with the longer-term objectives we shared with you earlier, which assumes fairly normal market conditions. Revenue growth of 20% to 30% per year, operating margins of 15% to 20%, long-term EPS growth of 25% to 40% per year, assets under management growth of 25% to 30% per year and enrollment rates and plans rolled out for 26 months or more of 12% to 15%.

With that, operator, we would now like to open it up for questions.

Question-and-Answer Session


[Operator Instructions] Our first question comes from Bob Napoli of William Blair.

Robert P. Napoli - William Blair & Company L.L.C., Research Division

The Income+ product, just like if you could -- I was hoping you might be able to give a little color on what we can look for, for the economics off of that portfolio. So you have $42 billion of signed contracts by sponsors for Income+, and you expect to have the majority of your sponsors, I think you said, covered by Income+ as your providers add the product. So can you give us a feel for how you expect that to start to affect your metrics? And how has the -- how many employees are getting checks? Are you -- try -- can you give us some kind of feel for the economic effect of all the investment you've made in Income+?

Jeffrey Nacey Maggioncalda

Yes, so, Bob, this is Jeff. In terms of Income+, I'll give you a sense for it, although probably more in terms of which metrics will be impacted sooner and then which ones will follow. The basic idea here, obviously, is all these baby boomers retire, someone is really going to become a standard. Typically, the industry develops standards around important things like retirement income. So a lot of what we're really focused on is simply penetration of the market and getting sponsors to say, Income+ is the retirement income solution I want in my plan. I think as must more sponsors do that, the early metrics that you'll see move would be AUC metrics. As sponsors say, hey, this is a differentiated offering, I have a target date fund in my plan, but I don't have any way to provide retirement income, I'll hire Financial Engines. Once they do that, and the connection's in place, we get to roll that out. Over 65% of the assets is held by people -- of the AUC is held by individuals with -- who are 50 years old and older, so we have seen slightly higher enrollment rates among plans where Income+ is available. And given the concentration of AUC among people closer to retirement, we think that the next sort of metric people will end up seeing is, a bit of a lift in our enrollment rates. You see a little bit of that starting to emerge in our enrollment rates, not at [indiscernible], I mean, if you think about the amounts of AUC rolled out to that $42 billion is -- it's not that much, and it's still early days. With Income+ on IRA, we think that there is a good opportunity to not only provide a way to facilitate in plan AUM to stay with us and not cancel. But as you know, we lose about 5% of AUM every year due to involuntary cancellations, where people leave the plan. By making Income+ available on IRA accounts, essentially, we're making Income+ portable. So someone who's using it and they rollover, can go ahead and keep on using that service, even if they move over to an IRA plan. So we also see Income+ being helpful on the retention side, both voluntary and involuntary. In terms of the unit economics, in plan, the unit economics on Income+ are basically the same as non-Income+. The only difference being, that you have higher average balances among those individuals who are closer to retirement and typically, the same unit cost. So you see slightly higher margins among Income+ participants. That'll help our gross and operating margins -- on the margin. And on the IRA accounts, at least with the 2 custodial relationships that we have announced so far, we do see unit economics that are at least as favorable as what we were seeing in the 401(k). So we think there's some pretty good leverage on Income+ on the IRA side as well, and that hopefully, will provide us also with a little bit of lift to profitability as more of our assets build in the IRA accounts. And, Ray, I don't know if you want to go into more specific details about the metrics, the order or the general system effect there?

Raymond Jay Sims

I think you were pretty thorough. Just a reminder that obviously, you have them -- typically, you have the most amount of money in your account, whether it's a 401(k) plan or an IRA, the day you roll it out, the day you start drawdowns. And we were losing about 5% of assets a year through involuntary terminations. To the extent those remain, the percentage, or the amount of basis points we get will remain constant because there's no additional charge but the balances are larger. When that becomes a meaningful proportion of our total revenue, it should increase margins modestly, as Jeff mentioned.

Jeffrey Nacey Maggioncalda

Does that cover, Bob?

Robert P. Napoli - William Blair & Company L.L.C., Research Division

Yes, that's very helpful. And just one follow-up, I guess, on the IRA and the announcement of -- I'm still not totally clear how you're working with Schwab and Ameritrade. Are you working with Schwab and Ameritrade only to the extent that one of your current employers -- employees that's using Financial Engines also has a Schwab or a TD Ameritrade account? Or are you working with TD Ameritrade and Schwab separately?

Jeffrey Nacey Maggioncalda

Great. So here's how this works. Since last summer, we have been able to provide investment advice, specific personalized recommendations on any outside tax-deferred account, whether it's a Schwab or TD or Merrill or any place else. And we didn't charge anything extra for that. And a lot of people said, wow, why are you guys doing that, offering that level of service for free? A lot of it was because we want to do a better job, have a bigger, stronger value proposition to maintain our pricing and for customer satisfaction. A lot of it was about asset discovery. If you provide investment advice. And as a valuable service, people are more likely to say, "Hey, I've got an IRA account over here, here or here." Today, with respect to our relationship with Schwab and TD Ameritrade, essentially, you can think of them like a current record keeper in a sense that we have created connections with them so that we can pool balances out of the Schwab record-keeping system. We can send trades into it or TD Ameritrade. We can deduct fees, and we can send Income+ disbursement instructions. And so they are like another record-keeping partner, except they are not affiliated with any employed -- employer plan. In terms of the types of individuals who have access to this, there are a number of individuals today, who -- and we're managing their 401(k) account, and the member has a 401(k) account at a company and they also have an IRA account, say, at Schwab or TD. In some of the cases, the member already had the money either Schwab or TD didn't need to move it. They simply said, "Hey, this is great. Can you please manage it?" We're able to manage it. In some cases, the member said, "Oh, I have an account someplace else. It's not at Schwab or TD." And we said, “Well, we can give you advise on it, if you'd like. Or if you like us to manage it, you'll -- you can move it to 1 of these 2 and actually move the money, either Schwab or TD. We can advise it, regardless. But if you want us to manage it, it's got to be 1 of these 2 platforms." We have customers who were members in a 401(k) and they called us and said, "I'm retiring, and I would like to keep your service." And we said, "That's great. If you roll it over to either Schwab or TD, then we can continue to manage it." So we have already seen retention among current members. And we also have cases where a member called and says, "My spouse has an IRA at such and such place, can you manage my 401(k) but my spouse's IRA?" And we say, "Well, we can give advice regardless of where it is. But if you want us to manage it, you could get Schwab or TD." And we're -- as we said in the scripts, we do plan on building out that network of IRA partners over time. But a lot of what this is really about is just providing good service for our customers and trying to retain customers instead of losing them as they retire.

Raymond Jay Sims

If you like, we'll send you the forms to sign up for the service.

Robert P. Napoli - William Blair & Company L.L.C., Research Division

Sure. I'll consider it. Last question and I'll turn it over. They just -- the number of sponsors -- the growth in the number of sponsors has slowed down over the last couple of quarters. I mean, obviously, the growth in the AUM and the contributions looks good. But -- and I just -- are you running out of runway for adding large sponsors? Do you need to go towards the smaller sponsor market or the RIAs? Or -- what is the -- are you running out of room on the big -- adding new big sponsors?

Jeffrey Nacey Maggioncalda

Right. So the answer is we don't think so. The AUC among our current book of business is about $635 billion. If you look at AUC, the total 401(k) assets among the Fortune 1,000, that's probably $1.5 trillion to $2 trillion. So we are starting to penetrate a reasonable portion. And among our provider partners, some are better penetrated than others. But there's still a large amount of 401(k) assets even in the large market. Of course, there are opportunities to go down market, and we can imagine doing that. There might be a case that with other record keepers available, we might create some additional provider partners. But the answer is, there's still a lot of IRA AUC available. I think our major job is to make sure that we can differentiate our service from target date funds and to continue to add value so that we can justify our current prices, which we have not lowered despite pretty much broad scale price pressure on other types of record-keeping and investment management services. And so I think that's kind of the main objective is to add enough value so that we are relevant and different from other services to those other large plan sponsors.

Raymond Jay Sims

We said we'll be adding $50 billion to $100 billion of AUC here, and we're on track to continue with that rate.


Our next question comes from Hugh Miller at Sidoti.

Hugh M. Miller - Sidoti & Company, LLC

I had one, first, just for the housekeeping question about the tax rate in the quarter. I didn't really hear you guys make any questions about that. But that kind of came in below kind of the prior levels we've seen, and I was wondering if you could give us just some detail on the reasoning for it and how we should be thinking about that going forward?

Jeffrey Nacey Maggioncalda

Well, I think it was Einstein who said that general relativity is pretty easy. It's income taxes that are hard, and there is a certain amount of truth to that. The rate was low in the quarter. And it was low primarily because last year, the R&D tax credit had been suspended. It was reinstated retroactively, so we got the benefit of a full year's worth of credit flowing through the tax rate. And in addition, stock -- the benefits associated with the exercise of stock options up a little bit, too. We internally think of the long-term tax rate at about 38% and probably that's a reasonable way for you to think about it as well.

Hugh M. Miller - Sidoti & Company, LLC

Okay, great. That makes sense. And you made some comments about kind of the efforts to try and improve personalization and kind of the user experience to benefit the cancellation rate for new plan participants. But can you just talk about how those efforts have kind of gone? I know, obviously, we had a slight sequential decline in the cancellation rate but was that primarily because of the efforts within -- with the new participants? And how should we be thinking about kind of some of the costs? As you -- I think you talked about how you want to step up your efforts even further there.

Jeffrey Nacey Maggioncalda

Yes. So with respect to the results that we reported in the quarter, I think that most of that cancellation -- it's hard to say for sure person by person. But typically, what you see is in a historical pattern. When markets go up, cancellation rate -- voluntary cancellation rates typically dip. I think most of what you're seeing in that lower quarter-to-quarter and year-over-year cancellation rate is mostly due to favorable markets and people saying, "Hey, this is a great service. You guys are making me money." With respect to the initiatives, there are a few different dimensions. We are focused initially on retention rate among people in the first 90 days. We have seen that a large portion of our voluntary cancellations happen in the first 90 days and usually, it's because of a disconnect between some of the expectations when they enroll and what the service actually is able to provide. And one of the types of disconnects we hear is, "Hey, I thought that you were able to help me with more than just my 401(k)." And a lot of our effort around total retirement advice, advice on IRAs and also management of IRAs is trying to respond to that feedback that we sometimes get, which is, "I wish your service were broader." Another piece of what people say is, "Hey, it seems like you're going to be really diversifying a lot of my company stock. And I would like to hold more of my company stock. Is there any way that you can facilitate me owning some more of the company stock?" And in the past, we've been pretty rigid about it, and we're actually building in some new ways to more gradually, over time, allow us to diversify someone's company stock position. There are other types of personalization that people are looking for, that we're building into the algorithms, if you will, to simply make it more, like a more customized portfolio. And then there's another element of personalization, which is communication, which is being more clear about the capabilities of the services, being more clear about how to personalize it and helping people really take the -- get the most out of the personalization capability that already exists. And so we're still in pretty early days, and we're seeing some good results. We think that we'll be able to move the needle on this, as we said. I don't think there's going to be a tremendous amount of money that will be associated with lowering the cancellation rates. It's more going to be incremental investment to create incremental enhancement features and things like that over time. So I don't expect either a precipitous improvement in cancellation rates nor any kind of major investment that you'll see show up in a given quarter because we're really going all in on something expensive to reduce cancellations.

Hugh M. Miller - Sidoti & Company, LLC

Got you, very helpful there. Another question I had was with regards to kind of the allocation shift we've seen amongst your client assets slightly gearing more towards equities in the last -- in a quarter or 2. Wondering if kind of that's just simply a function of kind of the market appreciation. Or can you guys tell whether or not you're seeing a shift in risk tolerance among the participants?

Jeffrey Nacey Maggioncalda

It's a great question and one that I wish I got more asked more often. So there are 2 major factors that determine the overall asset allocation. One is the glide path. So we have a target risk level by age over our participant base. And unlike pretty much anybody else, that I know of at least, we derive our glide path empirically. We look at millions of portfolios every month, and we say what are the absurd risk preferences of these individuals and then we create a distribution and we set our risk levels based on the typical risk level of someone in an age cohort. Those risk levels do change over time. And in particular, we saw after 2008, people became more conservative. They experienced some risk and some loss and they said, "I don't like this, and I'm going to hunker down a bit." We do see some people saying, "Hey, I'd like these up markets. So I'm going to take a little bit more risk." And risk references seem to be shifting a little bit up. And because we view our glide path empirically to observe risk preferences, ours have got up a little bit as well. The second factor in addition to risk preference is, is the actual expected returns and variances among the different asset classes. And as the equity markets have appreciated, we have sort of a global market equilibrium model where our holdings generally reflect the overall capitalization by asset class in the market. So as equities become more valuable, we tend to hold more equities. As equities become less valuable, we tend to hold less equities. So it's really the combination of those 2 things, and there's no change in methodologies. It's just the natural calibration of our methodology that we've been implementing for the last decade.

Raymond Jay Sims

What you might find interesting, since you asked the wonky question, is the returns actually vary quite a bit by asset class during the period. I have that language I use about looking at the S&P 500 and the IFA and the Barclays Bond Index. In the quarter, the return on the S&P 500 was 10.6%. The return on the IFA index was 5.1%, much higher in developed countries and lower in emerging markets because of the decline in natural resources and actually negative 0.1% on bonds. So the allocations do follow that empirical common sense in terms of where the returns have been.


[Operator Instructions] And our next question comes from Mayank Tandon at Needham.

Mayank Tandon - Needham & Company, LLC, Research Division

So first question, Jeff, is just any changes on the competitive front you've seen in the past couple of quarters? And at the same time, any changes on the pricing front that you've seen during the same time period?

Jeffrey Nacey Maggioncalda

Yes. So on the competitive front, we have seen, over the last 2 or 3 years, an increasing number of venture-backed, start-up companies getting into the investment advisory space. With respect to traditional RIAs, we don't see a lot of those guys trying to mechanize and trying to make it a big, broad, scalable offering. They pretty much have they're smaller client, wealthier clientele and they're kind of happy with that. So we don't see a lot of competition there. But perhaps, we have some impact on it. It seems like there's a growing number of companies getting funded to go do kind of electronic investment advice. And although there are a lot of them, we have not yet seen anybody really make much of a dent -- any noticeable dent in the 401(k) market. And I think that's partly because -- largely because plan sponsors are pretty risk averse and they don't really want to bet on a start-up company when they're acting as fiduciaries and dealing with benefits that could affect tens of thousands of employees. With respect to target date funds, they are another major competitor and haven't really seen much there. I mean, they are what they are. They're broadly implemented. Where we do see the pricing pressure is more in terms of target date funds getting cheaper and cheaper. And this is not a new phenomenon, but it's one that continues as basically actively managed retail target date funds at the 100 to -- 75- to 100-basis-point range get replaced with index fund target date funds which are in the, say, 25 to 50 basis points, which get replaced by custom target date funds created by consultants, which can be in the 10 to 20 basis points. And so target date funds have been seeing a lot of pricing pressure. That does create more pressure for us because of the -- on a relative basis, if that's in your substitute, the alternative to managed accounts, one could argue, is the target date funds. And when they become cheaper, and we don't, it creates a bigger spread in terms of pricing. The other competitive element would be record keepers who offer their own proprietary offering. Fidelity is the only partner that we work with so far that has their own offering as well as ours. They put out a press release recently showing some of their progress. They're starting to build up a bit of a book of business in terms of managed accounts. They're still substantially smaller than we are. They reported $5 billion of AUM at their Q1 in their Professional Management program, so compared to $70 billion, it's much smaller. But I think that a lot of folks are recognizing that as the investment management parts get commoditized, having differentiated personalized services is a much more attractive type of service offering, both for the participant but also for the provider. And so we have seen more attention being paid to manage accounts, and we feel good about where we stand. But we think the pricing pressure and competitive interest will remain for the foreseeable future.

Raymond Jay Sims

Yes. One of the most important things to sponsors is, are there people -- are their employees using and getting benefits from our services? And we have enrollment rates that we believe are dramatically higher than--- usage rates dramatically higher than those of any of the competitors'. And that's the real selling point when we go to new sponsors, that this is really making a difference in your employee's profile -- portfolios.

Mayank Tandon - Needham & Company, LLC, Research Division

That's very helpful color. And Ray, just one more question on the financials. So I know you don't give specific guidance around margins. But could you give us a sense of how the various expense items may track over the course of the next few quarters?

Raymond Jay Sims

Well, in general, we have almost religious zeal about making sure the expenses in aggregate grow more slowly than revenues. As I mentioned in a variety of forums, we try to manage our investment and future growth to not surprise investors in margins. And one of the early proof points we had to accomplish was showing that we really could take some of the leverage and bring it down to margins. Absent surprise upside in the market, where we can't quite spend as fast as the market goes up at times, I think the objective is generally to keep the margins stable, perhaps growing slightly over time, and reinvest in growth opportunities to continue the very high top line growth rates. I had mentioned in earlier call that we had talked about gross margins being in the range of 60% to 65%. And as we hit various provider ratchets, those came down from the high end of the range to the mid or lower end of the range. I think that still will be true and the ability to improve margins over time will be by increasing the rates of each of our expense categories more slowly than revenues. You might have noticed or will notice when you look at the financials in detail that our sales and marketing went up quite a bit more slowly. And our general and administrative expense went up a little more rapidly in dollars, although it didn't change in percentage. Larry Raffone, up until the end of last year, was in sales and marketing because he was a productive member of society. He's now moved in his role as President to the G&A category. But he's still doing lots of important things but it shows up in G&A, which gave a little bit of a benefit to sales and marketing and a little bit of a burden to general administrative. And he still is actually a productive member of the society.

Jeffrey Nacey Maggioncalda

Mayank, one of the things I'll throw in, obviously, the market has been pretty favorable. And if it were unfavorable, I want to say the same thing, which is that we have a budgeting process that happens every year. For the most part, we set our budgets based on a bottoms-up view of where we think we're going to be in the following year, assuming certain performance in the market, which generally is 1.5% to 2% appreciation in the markets per quarter. We are not really going to be super responsive if the market goes higher than that or if it goes much more lower than that unless its way higher or way lower. We'll just sort of wait to the next annual cycle. And you might see margins fluctuate. We'll let margins fluctuate, either up or down, because we don't want to be hyper twitchy with the market in terms of hiring plans and spending and advertising programs and things like that. If it is sufficiently different in either direction, we might make a change of plans midyear. But generally speaking, we'll kind of hold to our plan on either the upside or the downside. And I think part of what you see in Q1 is the markets were really good, and we're not going to merely turn around and say, "Hey, let's spend that."


Our next question comes from Avishai Kantor at Cowen.

Avishai Kantor - Cowen and Company, LLC, Research Division

It's Avishai Kantor on behalf of Moshe Katri. Can you talk a little about your marketing campaigns, where do you see success, what do you focus on, et cetera?

Jeffrey Nacey Maggioncalda

Yes. So in terms of our marketing campaigns, there are a couple of categories. We have what we call annual campaigns. These are printed retirement evaluations that gets sent out to employees every year. And so the vast majority of these go out to our existing customer base, and they are somewhat expensive, a couple of dollars. But you have to print them and mail them and things like that. And we do generate a reasonable amount of our ongoing AUM from that new end release through these campaigns. What you'll notice with these campaigns is that you'll see it -- you'll typically see an expense in the quarter followed by AUM growth in the next quarter and revenue in the next 2 quarters, as the marketing turns into enrollment, which then turns into revenue. So there's a little bit of a lag effect. We have been increasing our emphasis on non-campaign marketing efforts, and that's really the integrated enrollment that we talked about. This is really taking a lot of the same information, the retirement evaluation information, and building it right into the provider's website digitally so when someone goes to check how much money is in their 401 (k), we can help identify whether they're making a mistake in terms of their risk level or company stock, or whether they may be forfeiting a company MATS [ph], something they might be able to get. They can click directly on the provider's website and can enroll in our program there. Although it took a long time to get these connections, and there was a bit of investment cost upfront, the marginal cost of providing this is very close to 0. And so, we are now getting more and more of our enrollment from this very low marginal costs marketing campaign from an integrated enrollment. And those are the 2 major pieces that we focus on. Of course, the messages that go through those print and online channels varies depending on the services that we have available in a segment of individual that we're targeting.


Our next question comes from Bob Napoli at William Blair.

Robert P. Napoli - William Blair & Company L.L.C., Research Division

Just following up on that thought, if you would. I mean, can you give a feel for the amount of AUM that is currently coming from integrated enrollment versus mailings -- direct mailings? And where your -- kind of what your goals are over the next few years?

Jeffrey Nacey Maggioncalda

Yes. So it varies quarter-to-quarter, but we have certainly seen the share coming from online campaigns increasing. And without getting into too many specifics, I will say that in terms of AUM that came from customers that we're not just rolling out this quarter, in Q1, more than 50% actually came from the digital channel. So we really have been putting some effort into this. And I think that's helping on the cost structure as well as -- in addition to the once-per-year touch point in print. It's kind of an always-there digital presence. And so, this -- as you know, because you've been listening to all these calls, we've been talking about this for a while, and slowly but surely, the AUC coverage grows, the ability to change the messaging grows, we get a little bit smarter, and it's starting to become a real contributor in terms of our AUM growth

Robert P. Napoli - William Blair & Company L.L.C., Research Division

That's pretty substantial, the -- over 50%. And then just last question on the R&D. I was wondering if you could possibly break out the R&D between what might be called maintenance R&D and growth R&D, if you could. And then for the growth portion, is it primarily being spent on the Income+ and the IRA products or improvements to the base product? Or kind of give me a little better feel for the R&D would be helpful.

Raymond Jay Sims

I'll help you without a lot of specific numbers, which can certainly be helped or may not be helped at all. Typically, you don't do R&D on stuff that you already have. So a lot of the R&D is on future enhancements, which we believe will help growth. Certainly, as we get feedbacks, both from sponsors and participants, about enhanced features they would like in the base service and Income+ and IRA. We spent some money where we can, incorporating those features into future releases, which, by the way, will now be happening somewhat more often. And so it's a substantial amount, as well as further out enhancements to the product, which are not currently in the roadmap and we're not currently talking about in much detail. But you could imagine, as we talk about holistic financial management, we're looking beyond the offerings we have today. It's hard to give a really precise breakout, but I would say a substantial minority of the R&D is maintaining what we have now and improving some of the internals. One of the real benefits of the business in the very long term is that there's very high leverage in terms of capital. So we have made, over the years, major changes in our software at the same time that hardware costs per cycle have been coming down dramatically. So that to serve perhaps 10x as many members as we currently have in terms of hardware costs will probably be under $1 million today. So we work on the software in a way to minimize the hardware costs. There's a lot of that kind of internals also to get response times up and, again, make the experience more satisfying.


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