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Eaton Vance Corp. (NYSE:EV)

F3Q09 Earnings Call

August 19, 2009 11:00 am ET

Executives

Daniel C. Cataldo – Vice President Finance Planning and Analysis

Thomas E. Faust, Jr. – Chairman of the Board, President & Chief Executive Officer

Robert J. Whelan – Chief Financial Officer

Laurie G. Hylton – Vice President & Chief Accounting Officer

Analysts

Analyst for Craig Siegenthaler – Credit Suisse

Dan Fannon – Jefferies & Company, Inc.

Michael Kim – Sandler O’Neill & Partners, LP

Jeff Hopson – Stifel Nicolaus

Marc Irizarry – Goldman Sach

Ken Worthington – JP Morgan

Cynthia Mayer – Bank of America

Operator

Welcome to the Eaton Vance third quarter fiscal year 2009 earnings release. At this time all participants are in a listen only mode. A brief question and answer session will follow the formal presentation. (Operator Instructions) As a reminder, this conference is being recorded. It is now my pleasure to introduce your host Dan Cataldo, Vice President of Financial Planning and Analysis for Eaton Vance.

Daniel C. Cataldo

Welcome to our third quarter fiscal 2009 earnings call and webcast. Here this morning are Chairman and CEO Tom Faust; CFO Bob Whelan; and Laurie Hylton our Chief Accounting Officer. Tom and Bob will comment on the quarter and then we will address your questions. The full earnings release and charts we will be referring to during the call are available on our website www.EatonVance.com under the heading press releases.

Please be aware that today’s presentation contains forward-looking statements about our business and our financial results. The actual results may differ materially from those projected due to risks and uncertainties in our operations and business including but not limited to those discussed in our SEC filings. These filings including our 2008 annual report and Form 10K are available on our website or upon request at no charge.

I’d now like to turn the call over to Tom.

Thomas E. Faust, Jr.

In our recently completed third quarter Eaton Vance financial results improved sharply on a sequential basis benefitting from the rally in securities prices and resulting favorable impact on our managed assets and revenues. Thanks primarily to better markets, our earnings are up and our outlook is much improved. Going in to the market downturn Eaton Vance set a goal to emerge from this downdraft as a stronger and better company. Today, we can report substantial progress towards that goal.

This quarter’s results highlight the consistency and continuity that have long been hallmarks of the Eaton Vance organization, consistency in our business strategy and investment approach, continuity of our leadership team and core values leading to continued strong internal growth and favorable financial results. As I comment on the quarter please refer to the tables in the press release and the call slides are available on our website as they provide additional color.

In the third quarter we recorded our 14th consecutive quarter of positive net long term flows with $3.9 billion of net inflows for the quarter equating to a 12% annualized internal growth rate. This was driven by gross sales and other inflows of $10.6 billion, up 10% from the prior quarter as well as a meaningful drop in outflows which at $6.7 billion were down 24% from the second fiscal quarter. Looking back at the first nine months of fiscal 2009 which covers a market environment that was certainly challenging by any standards our net inflows of $7.9 billion equate to a 9% annualized internal growth rate, e think a remarkable number given the market environment and the fact that we experienced $2 billion of outflows during the period from debt pay downs on leveraged funds to maintain required asset coverage requirements, a trend that started to reverse in the third quarter.

Consistent with a long term corporate objective, our business is becoming more diversified with our large cap value franchise now accounting for a reduced percentage of gross and net flows. Our large cap value represented a still considerable 29% of consolidated sales in the third quarter. Other major franchises are growing as a percentage including municipal income at 19% of sales, bank loans at 12%, parametric, tax managed, core equity at 10% and emerging market equities at 6%.

Because of our strong net flows and the recent strong markets, our $143.7 billion of managed assets as of July 31st were up 13% from the end of last quarter, up 17% from the beginning of the fiscal year and are down only 8% from a year ago, a period in which the S&P 500 was down 22%. Earnings for the quarter of $0.26 per diluted share, while down 35% from the year ago quarter are up 18% from the second quarter of fiscal 2009 as we enjoyed some of the positive leverage associated with rising markets and asset levels.

The earnings for the quarter did include approximately $0.02 per share in cost associated with the May closed end fund launch. As Bob will discuss in a few moments, we expect to see continued upwards pressure on our margins so long as we at least maintain current asset levels. Helped by the freeing up of the credit markets and the government’s lending programs, we have been active in the developmental launch of new income products. Not only did we offer a new municipal bond closed end fund in the quarter, we also launched an institutional opportunistic credit fund and a private fund to take advantage of government financing offer through the TALF program.

We have on the drawing boards plans to launch a series of fixed term income funds and retail management accounts that are designed to provide relatively stable income over their lives and return of principle upon termination. We expect to start introducing these before the end of the year.

As mentioned earlier, a positive development in the quarter was the easing of asset coverage pressures on our leveraged funds as markets improved. As you may recall, we experienced nearly $3.5 billion of outflows over the fourth quarter of fiscal 2008 and the first two quarters of this fiscal year due to deleveraging of some of our closed end and private funds. I’m happy to say that with the launch of the new closed end and TALF funds and some releveraging in older closed end funds, leverage was a positive factor in this quarter’s flows to the tune of roughly $200 million.

With respect to trends in our flows, there were some very positive developments in the third quarter over the second. Not only were client withdrawals down in total for the complex, they were down in almost every major investment discipline and distribution channel, the only exception being bank loan funds. Sales were up in income products across all investment disciplines and distribution channels. The lower client withdrawals combined with the higher income product sales led to sequential quarterly improvement in net flows across every major long term fund asset class, equity fixed income and floating rate income and each category of separate accounts: high net worth; institutional; and retail managed accounts.

As we have been working hard to achieve, the mix of our funds sales continues to diversify. For the three months ended July 31st we have a record 27 open end funds selling at an annual rate of $100 million or more across the whole spectrum of investment disciplines in which we operate and including funds sold in international markets as well as in the US. Slide 10 lists the 11 Eaton Vance funds whose sales in the third fiscal quarter were at an annual rate of $400 million or more. In future earnings reports I look forward to adding additional funds to this list as the diversity of our funds business continues to expand.

Retail managed accounts made a solid contribution to net flows in the third fiscal quarter as sales were steady with the second quarter and client withdrawals dropped off dramatically. The quarter saw a good balance in sales among Eaton Vance, parametric and TABS managed account products. Since the acquisition of the tax advantage bond strategy business of M. D. Sass on December 31st of last year, we’ve raised over $1.4 billion of gross and $1.0 billion in net in TABS products in the retail managed account channel exceeding our expectations.

Another promising product in our retail separate account lineup is the option overlay strategy we offer in conjunction with our affiliate Parametric Risk Advisors as investors seek to mitigate equity risk and take advantage of high volatility levels to earn premium income. While we expect that the consolidation currently underway under broker dealers will for some time have a disrupting effect on retail SMA sales industry wide, it clearly did not hamper our business this quarter as the almost $1 billion in net retail SMA flows we booked equates to an annual internal growth rate of more than 20%.

In our institutional and high net worth separate account businesses we saw a big improvement sequentially in the third fiscal quarter in both segments which combined for $2.3 billion in gross and $1.2 billion in net flows for the period. In the institutional channel Eaton Vance large cap value and taxable income, Atlantic Capital small and its mid cap growth, TABS and Parametric’s emerging market discipline all raised meaningful assets in the quarter and continue to generate significant interest in the fourth fiscal quarter.

It is worth singling out particularly the improved flow trends and outlook in Atlantic Capital which is experiencing solid investment performance and renewed attention from institutional consultants and investors as their high quality investment style returns to the floor. While our institutional business did improve this quarter we would not describe the current market there as robust. In both the size and timing of new awards, activity in the institutional market remains down. Nonetheless, we are encouraged by our business trends and are hopeful that we’ll see a solid close to the year.

In the high net worth channel there were two notable highlights in this quarter, the first was the offering of the private TALF fund primarily through the Eaton Vance Investment Council Group here in Boston which raised over $130 billion in assets including leverage and second the parametric tax managed core products generated over $600 million in sales. You may recall that last quarter we talked about how the capital losses incurred in the recent bear market seemed to be diminishing investor appetite for parametric style of tax managed core equity investing.

We’re happy to say that this no longer seems to be the case. With the S&P up almost 50% from the lows of early March, family, office and high net worth investors have quickly come back to this product as a favored source of tax efficient equity market data. As we discussed on last quarter’s call the intermediary distribution landscape is changing dramatically as a result of the consolidation that’s sweep through Wall Street over the past year. Merging firms are reexamining managers on their recommend list and starting to consolidate their platforms.

As the list of preferred partners gets whittled down, we believe we stand to benefit from expanded opportunities. As examples, the Atlanta SMID and TABS managed account products recently moved from being recommend products at Smith Barney to featured products on the much larger combined Morgan Stanley Smith Barney platform.

In the competition for shelf space at consolidating broker dealers and other venues where asset managers go head-to-head, we stand to benefit versus the many competitors who were put up for sale or forced in to restructurings to deal with the parent’s company financial distress or change of business direction. The stability and continuity of Eaton Vance are particular competitive advantages in times like these. While many of our competitors scaled back over the past year we continued to invest on distribution organization and continue to expand our product offerings.

Matt Witkos and his team at Eaton Vance Distributors are attuned to meeting the needs of our distribution partners and focused on the opportunity at hand. As consolidation among distributors continues to play out, I’m confident that we will remain one of the winners in the intermediary channel.

In the retirement market, 401k plan sponsors continue to refine their product offerings in ways that play to our strengthens, adding new income products in categories where we have expertise. We are also adapting our product structures to accommodate their requirements, expanding our lineup of class I and R mutual fund shares and adding new collective trusts which should benefit our retirement business.

In May, the Obama administration released additional details on proposed tax law changes with the release of its fiscal 2010 budget proposal. As has been widely noted, the proposed changes included increases in the maximum tax rate for individuals to 39.6% from 35% on ordinary income and short term gains and to 20% from 15% for long term gains and qualified dividends. Even more dramatic increases in individual tax rates have been proposed as a way to pay for healthcare reform. It has also been suggested that tax increases now slated to take effect in 2011 could arrive as soon as next January.

Although the exact nature and timing of pending tax law changes is still up in the air, it’s a near certainty that high net worth investors will be paying appreciably higher taxes on investment income and gains in the coming years. As a leading provider of funds in separate accounts managed with an after tax return objective, Eaton Vance has quite naturally taken a leadership role in informing financial advisors and high net worth investors about pending tax law changes and helping them position their portfolios accordingly.

While no one in a higher tax bracket is looking forward to increased taxes, the impact on Eaton Vance’s tax managed and tax [efficient] product franchises is likely to be very positive. As we have mentioned in the past, a significant factor in determining which firms will win and which will lose in the intermediary channel consolidation is investment performance and ours has been very strong.

Today we offer 20 equity funds with overall four or five start Morningstar ratings for at least one class of shares covering a broad range of investment disciplines including large and small cap, value growth in equity income as well as specialty and emerging market funds. We talk a lot about the consistency of our approach and the consistency of the investment results we’ve achieved. This is evident in the fact that on an asset weighted basis 88% of our equity funds have beat their Lipper peer group averages over the past three years and 95% have beaten their peers over the past 10 years.

We’ve been asked recently whether we are concerned about the fall off in the relative performance in our large cap value funds since the equity market bottomed in March. Of course we care since we are competitive by nature and always strive to beat the competition. But, our performance has lagged for what we consider good reasons, our continued emphasis on attractively priced high quality large cap companies with strong business franchises and the fact that, as often happens, in the early stages of a market rally, leadership has been provided primarily by low quality stocks.

While our investment disciplines don’t guarantee that we will necessarily outperform over short periods in all market environments, we are confident that we have the right team and the right approach to continue to outperform over market cycles as borne out by the stellar long term performance record these funds maintain. As of last night, Eaton Vance large cap value fund class A shares rank among the top 21% of large cap value funds as categorized by Lipper for three year performance, among the 7% of its peer group for five years and in its top 5% of competing funds over the past 10 years.

We continue to be gratified by the continuing enthusiasm shown by consultants, gate keepers and discerning investors for Eaton Vance in the many investment disciplines where we claim expertise including large cap value. I expect our large cap value franchise to remain a core business for Eaton Vance for many years to come.

That covers my comments, I’ll now turn the call over to Bob to review the financial results in more detail.

Robert J. Whelan

As Tom mentioned, we are reporting GAAP earnings for the quarter of $0.26 compared to earnings in the third quarter of 2008 of $0.40 and compared to our second quarter GAAP earnings of $0.22. Also, as mentioned, this quarter’s earnings include $0.02 of costs associated with the May closed end fund launch. Our assets under management were positively impacted by $3.9 billion of net flows in the quarter as well as $11.9 billion market appreciation contributing to the combined $15 billion or 12% increase in average AUM in the quarter relative to the second quarter.

We finished the third fiscal quarter with assets under management of $143.7 billion or $7.7 billion higher than the average of $136 billion in the quarter, a strong starting point for the fourth quarter revenue growth. We achieved positive operating leverage in the quarter as revenues grew 15.1%, expenses 10.4% and operating income 31.1% from Q2 to Q3. In line with that positive operating leverage, our GAAP margin also improved sequentially from approximately 22.7% to 25.9%.

In the third quarter, revenues increased approximately $30 million or 15.1% to $228.4 million as compared to $198.4 million in the second quarter. Investment advisory and administrative revenues increased 14% in line with the increase in our average AUM increase of 14% in the quarter. Our advisory and administrative effective fee rate increased slightly in the quarter to 51.5 basis points from 50.6 basis points in Q2 as a result in a slight change in asset mix due to the strong equity market rally in the quarter and one more fee day in the third quarter relative to the second.

Operating expenses increased 10.4% to $169.1 million from $153.3 million in the second quarter of 2009. Year-over-year total operating expenses declined 11% from $190.7 million. The sequential increase in total operating expenses was largely driven by increases in compensation from $67.2 million in Q2 to $77.3 million in the third quarter. The increase is attributable in part to higher sales base incentive due to strong open end fund sales and separate account sales in the closed end fund we launched in May.

Operating income based bonus accruals were also higher for Eaton Vance and our subsidiaries due to growth in pre-bonus operating income and adjustments in accrual rates to match expectations for the fiscal year as a whole. Despite a decline sequentially in both average and ending headcount, base compensation increased because of a two day increase in the number of payroll days in the period relative to last quarter. Stock-based compensation increased approximately $1.1 million from the second fiscal quarter primarily because of the employee stock purchase plan expense that recurs semiannually.

As we have noted in prior quarters we benefit from a flexible cost structure in which a significant portion of our expense fluctuate with sales, assets or earnings. As assets have fallen in the past due to market action, so have a number of our distribution and service base expenses. In this quarter, with average assets up approximately $15 billion or 12%, we’ve seen an increase in both distribution and service based fees commensurate with that increase.

In our other expense category we realize an overall decline in expenses of $1.1 million or 4% from $29.8 million to $28.7 million. The positive trend was largely driven by a decline in our facilities expenses with the completion of our move to a new corporate headquarters ending certain duplicative expenses that we had been incurring in advance of the move. Our facilities expense in total declined 20.7% sequentially from $13 million to $10.3 million in the third quarter. These savings were partially offset by increases in travel and communications in line with the strong business growth as well as information technology.

Operating income increased sequentially by 31.1% from $45.1 million to $59.2 million or $14.1 million. Net income increased 21.2% from $25.8 to $31.2 million from Q2 to Q3. Our effective tax rate for the third quarter was 39.5% versus 40.5% in the same quarter last year. Our tax rate was 28.6% in the second quarter of 2009 when we benefitted from a favorable state tax ruling that lowered our tax expense in the quarter by $3.4 million.

Total headcount for Eaton Vance and all of our affiliates at the end of the third quarter was 1,052 versus 1,089 last year and 1,056 employees in the second quarter. This is the fourth consecutive quarter in which total headcount has fallen. Excluding the 20 employees we now have who are associated with the TABS business we acquired in December, our headcount at the end of the quarter was down 5% from a year ago.

We think an appropriate measure to analyze our financial results is by looking at adjusted operating income, a metric we use internally to assess our run rate of business momentum, removing the effect of several categories of one-time items that can distort our reported results. As a reminder, we define adjusted operating income as operating income excluding the results of consolidated funds and adding back closed end structuring fees, stock-based compensation and the write off of intangible assets and other items we consider non-operating in nature.

Our adjusted operating income increased $17 million Q3 2009 from $55 million in the second quarter of 2009, an increase of 31.2%. Our adjusted operating margin increased to 31.6% in the quarter from 27.7% in the prior quarter. Lastly, our balance sheet and financial position continues to be strong and allows us to invest in and grow our business. We have cash and short term investments of $333 million all in safe and liquid securities. We have an untapped line of credit of $200 million with an option to increase that to $300 million. Our ending equity and tangible equity levels continue to grow and are now at $319 and $100 million respectively. We continue to maintain our strong investment grade ratings and our $500 million of debt does not come due until 2017.

Now I’d like to turn the call back to Tom Faust for some closing comments.

Thomas E. Faust, Jr.

Over the past year Eaton Vance, like all asset managers, has faced an extremely challenging environment as a result of the turmoil in the equity and credit markets. Hard choices had to be made as managed assets and revenues declined at alarming rates. One choice we made was to continue to invest in our business, our people, our facilities, our distribution organization, our investment management and our client service capabilities.

We’ve looked at this period not only as a challenge but as an opportunity to strengthen our business and our competitive position. We did not make major cuts and faced some criticism because of that. As we sit here today with managed assets approaching year ago levels and our business momentum on the rise, I can say I’m glad we reacted the way we did. Our organization is as strong as its ever been from investment management to distribution, client service and administration.

Our employee morale has been maintained and our financial strength and reputation are intact. Our people are united in pursuit of the business opportunities we see ahead. Good things continue to happen at Eaton Vance. We’d like now to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Analyst for Craig Siegenthaler – Credit Suisse.

Analyst for Craig Siegenthaler – Credit Suisse

One quick question, given the strong flows and uptick in AUM balances this quarter, can you comment on why you didn’t see much comp margin improvement? Also, can you provide the breakout of fixed versus variable comp?

Robert J. Whelan

In terms of the margin improvement, we did see margin improvement both on a GAAP basis and adjusted operating earnings basis. In terms of compensation, this was the quarter in the year where we look at year end projections and make adjustments to where we think our overall compensation relative to bonus accruals should be. We did that both for Eaton Vance as well as all our subsidiaries and that really explains the increase in compensation, largely the $10 million increase from $67 to $77 million in the quarter.

Thomas E. Faust, Jr.

Just to add to that, in this quarter in particular, if you breakdown comp between variable and fixed including stock-based comp in the fixed portion, the breakdown is roughly 40% variable versus 60% fixed. The 40% variable being operating income based bonuses, sales base incentives and revenue based incentive.

Operator

Your next question comes from Dan Fannon – Jefferies & Company, Inc.

Dan Fannon – Jefferies & Company, Inc.

You mentioned Tom that institutional RP activity is still pretty slow. I wanted to talk about that kind of expressed in the quarter and what you’re seeing this far in to August and really what the commentary is from some of the gate keepers when you talk about consultants and others in terms of how that’s progressing and when you think that actually will pick up?

Thomas E. Faust, Jr.

Dan, I spoke yesterday to [Elisha Jones] who runs our institutional business so I can really relay her color on the market. I think she feels like things are slowing getting back to normal. That at the beginning of the year there was really panic among lots of types of institutional investors as asset values were down, as assumptions about market returns were so far off the market in many areas in 2008 and fundamental questions about asset allocation and also big challenges in many cases to liquidity.

In all of that, in some cases the reaction was we should go out and get a different consultant because it was following their advice that got us where we are today. Relatively long down the list, towards the list of what institutional clients were doing was saying we need to look at our choice of managers in this particular box. So, it’s taken a while and I think my comment is meant to convey that we think it’s still continuing that most institutional investors are still working through that process.

One of I think frustrations for many types of institutional investors and how they’re set up and governed is that they have relative and limited flexibility to respond quickly to change in circumstance. Early on I think people felt frozen and then as markets recovered so quickly then they felt like, “Well, we don’t want to react after things have already changed.” So, we’re seeing lots of activity in terms of RFPs. We will I think clearly have a record year in terms of number of RFPs we’ve filed out. That of course doesn’t do a whole lot for our business but we are seeing searches now in the way we didn’t see in the first couple of quarters in the year.

Still mandates are relatively small reflecting largely the fact values, endowments and pension plans have lower values and also because still people are I think afraid to make major changes at this point until there seems to be some stability to the investment situation. Of course, many institutions are going through their own internal changes with changes in personnel and changing in funding levels, etc.

It continues to be a market that’s in some disarray. I think we can say that things are slowly getting back to normal and we did have a pretty good quarter for our institutional flows. But, I’d say the visibility in to the rest of the year is still relatively poor. We think we’ll be okay but things are still slowly coming back to normal in that market. Certainly, we benefit from having a broad array of products both on the equity side and the income side but it’s proving to be a pretty prolonged search process for a lot of mandates and when they come often they are smaller than they would have been 12 or 24 months ago.

Dan Fannon – Jefferies & Company, Inc.

Then Bob, a question on operating margins, we saw certainly some improvement sequentially but remain well below year ago levels. If you look at your AUM levels today and the asset mix, are you happy with where margins are or should we see continued kind of cost control and margin expansion assuming kind of asset levels end of period where they are today?

Robert J. Whelan

The good news going in to the fourth quarter is that we have beginning assets under management almost $8 billion higher than ending assets under management. If you play that out on the revenue line, that should get us all things being equal in terms of flows and markets, close to 240. We continue to look very closely at expenses, we have been managing expenses prudently and as I said on the last call, we think the margin can creep up and should creep up just as a matter of course.

Thomas E. Faust, Jr.

Don’t forget that we had what we said was $0.02 or roughly $3.5 million of expense associated with the closed end fund that we closed during the quarter that won’t recur. Also, as Bob mentioned there were some minor adjustments to our accrual rate for bonuses during the quarter that we don’t expect to recur in the fourth quarter. So, we’ve got a couple of things other than just the fact that we’re ending the quarter at a higher asset and revenue run rate than the average of the third quarter. We’ve got a couple of other factors that make us pretty optimistic that we’re likely to see higher margins in the fourth quarter and beyond assuming markets stay where they are and assets at least maintain current levels.

Operator

Your next question comes from Michael Kim – Sandler O’Neill & Partners, LP.

Michael Kim – Sandler O’Neill & Partners, LP

First, can you just talk a little bit about your outlook as it relates to the closed end fund business both in the near term and over time assuming the markets continue to trend higher?

Thomas E. Faust, Jr.

As you may have observed, discounts in the close end fund markets have closed pretty meaningfully. In the past, that’s been a pretty good indicator of possibly a reopening of the closed end fund window. Although we were generally pleased with the results of the May offering which was the largest listed closed end fund that anyone has done since 2007, really the last time there was a robust close end fund market, we don’t have any traditional closed end funds on the drawing board today.

I think part of it is that there’s been changes in the distribution landscape that traditionally closed end funds were largely sold through the major broker dealer firms and many of those firms of course are in the midst of major changes and the personnel involved in launching closed end funds in some cases people have left organizations. So, there’s a little bit beyond the market factors there’s some specific factors relative to the individual firms that have tended to take the lead in offering closed end funds. But, we do not have certainly in our financial plan, any closed end funds for the balance of 2009. That could change in a hurry but certainly as we sit here today we don’t have anything that we’re expecting for the remainder of this year.

Michael Kim – Sandler O’Neill & Partners, LP

I know you touched on this earlier but can you just give us some additional color on maybe the drivers behind the improvement in RMA redemptions this quarter? Was it more a function of more favorable equity markets, was getting TABS on more platforms perhaps a bigger driver or do you think we’ve kind of reached a point where there’s less volatility now as it relates to kind of the broker consolidation that’s been going on?

Thomas E. Faust, Jr.

Of course it’s a little bit of conjecture, we don’t know why people are redeeming less, I think the biggest factor has to be you can’t forget the fact that the retail managed account market is today still overwhelmingly an equity market. We have growing presence in municipal separate managed account businesses but for the most part retail managed accounts relative to the investment business as a whole is very much an equity driven market. I think my guess would be more so than anything else, nothing like a 50% market movement to help people feel better about their equity investments.

Certainly, some of the factors you suggested in terms of the pace of change within some of the broker dealer firms may be slowing a bit also had to help a little bit. I think another factor I would point to would be I mentioned in my remarks the improved outlook in the institutional business and the high net worth family, office business for parametric tax managed core. That also applies in the retail channel with I think now great visibility, some would say the inevitability of higher tax rates and a fairly quick drying up of tax losses with the equity market rally, it’s not surprising that some of the pressure we had seen on outflows earlier in the year when people simply felt like they didn’t want equity market beta exposure and they didn’t need harvesting of tax losses, which is really the essence of the parametric tax managed core product, as that dynamic shifts and has shifted, I think that’s also been a factor in contributing to a lower withdrawal rate in our retail SMA business.

Robert J. Whelan

That is correct Tom. If you look down in to the details of the managed account business that the PPA withdrawals were down dramatically.

Michael Kim – Sandler O’Neill & Partners, LP

Then just finally, it looks like most of the flows last quarter were skewed towards separate accounts from a distribution standpoint and then on the mutual fund side it was more skewed towards fixed income products. So, I’d just be curious to get your thoughts on how we should be thinking about the overall revenue yield going forward?

Thomas E. Faust, Jr.

I think if your presumption is that we’re likely to have a downward trend in revenue yield, I think that’s probably a fair assumption. Our highest revenue yielding products if you exclude distribution revenues would be equity mutual funds. Generally, as you point out, we’re seeing faster growth today in the fund business in income products versus equities and we’re also seeing faster growth in separate accounts away from funds.

We certainly I would say for modeling purposes you should expect a continuation of what’s been a fairly significantly long term trend, the moderating of overall average fee rates. I think that will continue likely over the next two or three quarters. I guess I would say one thing that works against that to the extent you have a very strong equity market rally, like we saw in this quarter, that’s obviously going to push things in the opposite direction.

Michael Kim – Sandler O’Neill & Partners, LP

Did you give us an average AUM level for the quarter?

Robert J. Whelan

It was $136 billion.

Operator

Your next question comes from Jeff Hopson – Stifel Nicolaus.

Jeff Hopson – Stifel Nicolaus

You noted that you have developed some new products of fixed term income funds and I’m curious what need or trend you responded to in that regard? Also, wondering about closed end fund releveraging, is there more to come eventually there? Then finally, Tom you did address this a little bit but talking about some of the spending you had done during the tougher times so as revenues have increased how do you think about further investments, reaccelerating some spending, etc. from here I guess?

Thomas E. Faust, Jr.

The first question was about what we call managed income term [inaudible]. We filed some, I think three mutual funds, that would follow this strategy and also are talking to potential distribution partners about that type of product in a separate account format. The concept is a pretty simple one, this is a diversified vehicle for investing in income securities that are managed to a date certain. Think about when you buy a bond, it decreases in remaining maturity and decreases in remaining duration over the life of its investment. Where when you buy it what you expect is that over some fixed period of time you will get a steady income stream and return of principle at maturity.

In contrast, when you buy a mutual bond fund or a bond separate account you tend to have a relatively constant maturity or duration over time. A fund or separate account typically is managed to maintain a fairly tight duration standard. The risk you face is that if you – assuming that’s a relatively long duration, the risk you face is that come time when you need your money if the markets have turned down, interest rates have been moving up and income security prices have been falling, you face the risk that you don’t get the principle value that you hoped to get when you need money for retirement or for whatever reason.

This is a product that really seeks to provide in a pooled format that provides diversification and ongoing management the characteristics of individual bonds, that is that have a fixed termination date. The reason that we are devising this is that we have heard from investors that through the downturn an increased desire for products where they know it’s managed towards a specific target. It’s distinct from a target date fund which of course the target date is the target retirement date not the target end date of the vehicle. Here, it’s managed towards a clear end date for the vehicle.

We think this is a product that will be very well received. We’ve had an enthusiastic response among financial advisors and look forward to introducing this. We’ll see what happens, it’s in a financial sense not a major commitment to us. It’s a new product idea, it certainly has the potential we think to be a significant new product for us and potentially a significant new type of income fund as well. That’s the first one.

On the second one, releveraging of closed end funds we mentioned that there were about $200 million of additional net leveraged added in the third quarter after something like $3.5 billion of deleveraging over the course of the prior three quarters. It may happen, there’s nothing in the works, I think people are fairly slow to add leverage until there is maybe a little more visibility to where markets are going from here. We certainly have the flexibility in terms of coverage ratios to add leverage.

I think as you know the cost of debt financing, credit facilities or any other kind of borrowing is certainly higher than it was going in to the credit crisis and that certainly weighs in on our behavior but we’re not expecting big increases. We are certainly hopeful that over time as markets stabilize and credit availability returns and is reflected in lower credit spreads that we can see some releveraging in those products and get back a significant chunk of that $3.5 billion but it won’t come over the next couple of quarters.

Finally you asked about spending trend and where we expect to spend money over the next few quarters. In terms of infrastructure, I don’t think we have a whole lot, we did defer some IT type projects and I have no doubt when it gets to be budget time and we’re looking fiscal 2010 we’ll hear about some of those. But, we recently went through a relocation of our headquarters that was a fairly expensive item, that’s now behind us. We recently relaunched our website, that expense is behind us.

We think our staffing levels in marketing, client service, in investing team are about where they need to be. We’re starting a process of looking at headcount planning for the new year. We’re telling people that although revenues are up and although business conditions are better and the outlook is brighter that fiscal discipline is still the order of the day going in to 2010. So, we’re really not expecting major pressures on cost items in terms of compensation which is our largest cost factor. Certainly, with today’s labor market conditions and our business generally, we don’t expect to see major upward pressures there in terms of base compensation levels.

We think we’re in a period potentially where we should be seeing accelerated revenue growth based on better markets and asset levels that today are well above where they averaged in the third quarter and also certainly the continuing inflows. Where we don’t look to see major increases in costs that should interfere with what we would naturally expect to be a rising margin trend in that environment.

Operator

Your next question comes from Marc Irizarry – Goldman Sach.

Marc Irizarry – Goldman Sach

Just on the large cap value in the retail channel, can you just share with us what you’ve seen over the last several weeks in terms of as the markets a little more choppy in terms of the sales trends there, have they improved relative to where they were tracking for most of the quarter?

Thomas E. Faust, Jr.

I don’t know that they’ve improved. We’ve maintained positive sales momentum in large cap value certainly in recent weeks. I think we’re holding our own, I don’t we’re improving. One of the things that we’re dealing with is August is a time where financial advisors often take vacations so it’s not unusual to see a slowdown in activity in August. But, both large cap value and business generally we’re having I think an okay, certainly net positive experience so far in August. Sales are down a little bit from where they were in the last couple of months. Certainly net sales are also down a little bit but we think trends are generally pretty good although there’s been some noticeable softening since the end of July.

Marc Irizarry – Goldman Sach

Then just in terms of margins, I know you don’t necessarily have a target for them but if you look at your AUM levels, [Universe] has peaked, they’re down about 10% maybe 17% on average but your profitability is probably down about a third on an annualized basis. Your assets aren’t that far away, it looks like your profits are a little further, how should we think about the progression of the margin over time, getting back to closer to peak levels?

Robert J. Whelan

Well, I think in the next quarter given what we mentioned about the beginning starting assets under management being higher, the non-recurring closed end fund expense, when you do the math on that keeping market inflows flat you’re probably looking at a 28% margin and we continue to look for margins to head in to the high 20s, low 30s going in to 2010. Again, with prudent expense management and strong net sales, hopefully that will be the case.

Thomas E. Faust, Jr.

Remember though it’s not our ending assets that really drive revenues, it’s average assets for the period and we were still pretty well down on a year-over-year basis in the third quarter but certainly feel like with the fourth quarter and then we hope in to the turn of the new year that those comparisons versus the prior year quarter become very favorable which should help our margin trends over time.

Marc Irizarry – Goldman Sach

Should you be able to get the comp ratio back more in to the level where it was back in ’08 sort of dipping back in to the high 20s or is the rate of sales such that it’s going to be more difficult to get back there?

Thomas E. Faust, Jr.

It’s a little hard to say. I don’t think there’s any reason to think that it can’t get back to where it was in 2007 and the early part of 2008. But, we’re going to need certainly some help in terms of asset growth I would think driven ideally by just the market going up because those are pretty cheap assets to put on the books. But, certainly with continued sales success that should drive compensation costs down in the long term. Of course, if you sell a lot that puts the short term pressure on costs. I think a rising up trend, assuming that markets continue in a favorable direction is a reasonable assumption in terms of profitability profits in relation to comp expense.

Marc Irizarry – Goldman Sach

Then just Tom, in terms of the impact of retail consolidation on the SMA business, you haven’t seen any impact thus far. How far along do you think these firms are in their decisions as to who’s going to be on the shelf?

Thomas E. Faust, Jr.

I think the big one that is really front and center right now is Morgan Stanley Smith Barney and they’re going through the process now. I think we mentioned in the call script a couple of examples where products we had that had been on the Smith Barney platform have now been selected for broader opportunities. So, things are happening real time in that particular case. In the case of Merrill B of A things are moving more slowly, that’s a little more complicated because of the different cultures and histories and business practices of the two firms that are merging. It’s more complicated and I don’t think we’ve seen a lot of headway, at least not that I’m aware of in terms of bringing those platforms together. But, Smith Barney Morgan Stanley, that’s happening now.

Marc Irizarry – Goldman Sach

Then just in terms of the stock buyback, it looks like you still have some left on the authorization, share count is creeping up a bit, can you just speak to sort of how you’re thinking about deploying your capital?

Robert J. Whelan

We’re constantly looking at what the best use of cash would be. We’re sitting on $330 million worth of cash. If you look at working capital, just taking [cart] assets, [cart] liabilities, working capital is at approximately $315 million which equates to two quarters of operating expenses. That working capital in relation to total operating expenses feels okay. Obviously, the other levers are dividend and if you look at our dividend the yield is in line with competitors, our payout is probably on a last 12 month recent quarter a little bit higher.

Share repurchases, we’ve been quite on share repurchases. Historically, we’ve been pretty active but more likely than not given that this is the first quarter where revenues have rebounded and earnings have rebounded a good posture for capital planning is doing what we have been doing which is sit on cash, be opportunistic and maybe ease back in to share repurchases over time. That’s our current thinking.

Operator

Your next question comes from Ken Worthington – JP Morgan.

Ken Worthington – JP Morgan

Just to hit the compensation again, if I take the comp from the first three quarters, divide by three, it’s averaging $71 million a quarter. You guys mentioned that there were accruals but I think Tom mentioned there weren’t big catch up accruals. What kind of is the rate go forward number for compensation? Was the catch up just like $1 million or $2 million, was it bigger than that, smaller than that?

Robert J. Whelan

I think the rate is probably in that $75 to $80 million. If you take the $10 million change in compensation sequentially, $1 million of that was stock-based compensation, we had obviously incentive comp increases because of strong sale to the tune of $2 million and then we had a bonus pool and subsidiary bonus pool and then a TABS pick up of almost $7 million. Probably $2 million of that was rate related. So, I think that $77 million number could range in a similar range in the fourth quarter given that we’re starting with higher asset levels and hopefully higher earnings levels projected.

Ken Worthington – JP Morgan

I know this doesn’t get a lot of attention but below the line, the unrealized gains, can you just give us a little color on what’s in there? I think you have most of the seed capital and stuff is available for sale but what was the unrealized gain this quarter?

Robert J. Whelan

The unrealized gains, we had an unrealized gain of $3.1 million in our separate account investments and that was offset by an impairment loss of roughly $400,000 in the quarter.

Operator

Your next question comes from Cynthia Mayer – Bank of America.

Cynthia Mayer – Bank of America

I guess just a very quick picky question on the comp, I think I heard you say that there was one more fee day but two more payroll days. Did I hear that right and all else equal will that normalize a little bit?

Robert J. Whelan

There were two more payroll days in the quarter, we went from 64 to 66 and again, that’s the February effect that happens when you go from Q2 to Q3 which also shows up in the fee days which went from 89 to 90. We did see a drop in [FTEs] from 1056 to 1052 ending as well as the average which we thought would bring down base compensation but because of the extra two payroll days that offset that. In the context of the $10 million increase that was not that material.

Cynthia Mayer – Bank of America

In terms of the cost of the closed end fund have there been any change in terms of how the cost is calculated in terms of the payments to the distributors or is it the same formulas as before?

Thomas E. Faust, Jr.

It was really substantially the same as before. I think as you know, different firms have different models but on an overall basis it was essentially the same model, same numbers as in the last go around back in 2007.

Cynthia Mayer – Bank of America

Am I right in thinking that at the lower levels of close end funds the proportion there as in terms of the expense is much higher so there’s a certain asset level at which it becomes more cost effective for you?

Robert J. Whelan

Generally a smaller fund is slightly more expensive to offer just because the incentive comp decreases as the funds grow and we have to potentially apply internal break points to the sales compensation.

Thomas E. Faust, Jr.

That’s internal costs.

Robert J. Whelan

Right, that’s internal costs but not with respect to the structuring costs.

Thomas E. Faust, Jr.

The external costs actually work a little bit the other way that certain firms, not the lead managers, but certain firms, and this was all disclosed in the prospectus, but certain firms are entitled to additional compensation if they exceed the sales thresholds, typically $50 million or $100 million. So, if you get a really big fund and you have second tier firms that are doing $50 to $100 million, that can have a negative effect on your cost per dollar of asset raised. Unfortunately, we didn’t come close to hitting those levels in this offer.

Operator

Ladies and gentlemen I will now turn the conference back over to management for closing comments.

Robert J. Whelan

Thank you for joining us today. We look forward to talking with you next quarter which not only will be the wrap up of fiscal 2009 but will also mark our 50th year as a public company. We look forward to speaking with you then.

Operator

Ladies and gentlemen this concludes today’s teleconference. You may disconnect your lines at this time. Thank you all for your participation.

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