Federated Investors: Using Options to Win

Federated Investors (NYSE:FII) September 11, 2009 - $25.78

52-week range: $15.80 (Dec. 29, 2008) - $36.63 (Sep. 19, 2008)

Dividend = $0.24 quarterly = 3.72% current yield

Federated provides investment-management services to institutions and individuals. The company offers 158 funds as well as management of separate accounts. Of the company's managed funds, 50 are money market funds, 51 are fixed-income funds, and 57 are equity funds. Its money market and fixed-income funds represent about 87% and 6% of its managed assets respectively. Equity mutual funds were about 7% of assets with its largest equity fund, the Federated Kaufmann Fund, generating about 13% of Federated’s revenues in 2008.

Because Federated focuses on money market funds, it fared better than most asset management companies in 2008’s bear market. Earnings per share actually hit a new record of $2.20 versus $2.12 before dipping a bit in 2009’s first half. Zacks sees EPS of $1.90 and $2.05 for 2009 and 2010 respectively. Those numbers are similar to expectations from Value Line and other sources.

Federated is healthy. Standard and Poors and Value Line eachrate FII’s financial strength as ‘A’ and Value Line notes Federated’s ‘earnings predictability’ as being in the top 1% of all 1700 companies in their research universe.

Today’s well-covered dividend rate provides a very nice 3.72% current yield in a world where bank CDs and Treasury notes pay much lower rates. The payout has been increased in each of the past eleven years.

Here are the per share numbers from continuing operations as reported by Value Line:

[Dividend data excludes 2008’s special dividend of $2.76 /share]

Year	Sales	C/F	EPS	Div.	Avg. P/E
2002	6.32	1.98	1.74	0.22	17.3x
2003	7.58	2.07	1.83	0.30	15.0x
2004	7.92	2.03	1.77	0.41	17.0x
2005	8.49	2.08	1.84	0.58	17.0x
2006	9.42	2.07	1.80	0.69	19.3x
2007	11.08	2.39	2.12	0.81	17.8x
2008	11.97	2.41	2.20	0.93	14.8x

At today’s quote of $25.78 these shares are offered at 13.6x this year’s and 12.6x 2010 estimates. Those are the lowest valuations on FII shares since 1999. Buyers of Federated shares back then saw their investment rocket from a (split-adjusted) $10 /share to $32.80 within two years.

I think a return to at least a fifteen multiple is a good bet based on all historical precedents. That would put FII’s target price above $30 again. Is that a reasonable expectation? Sure. These shares peaked at $31.70 - $45.00 at some point during each calendar year from 2000 right through 2008. Sales and dividends are higher now than in all previous years and EPS are not far off their peak levels from past periods.

Morningstar sees ‘Fair Value’ as $30/share. Standard and Poors now carries a 12-month target of $29 /share.

Here’s my buy/write combination play with Federated to make an excellent total return with less risk than outright purchase of the shares.

	Cash Outlay	Cash Inflow
Buy 1000 FII @ $25.78 /share	$25,780
Sell 10 FII April $25 Calls @ $3.10 /share		$3,100
Sell 10 FII April $30 Puts @ $5.70 /share		$5,700
Net Cash Out-of-Pocket	$16,980

Here’s the break-down on this trade under two different scenarios:

If FII shares rise to at least $30 (+ 16.4%) by April 16, 2010:

• The $25 calls will be exercised.
• You will sell your shares for $25,000.
• The $30 puts will expire worthless.
• You will likely have collected $480 in dividends.
• You will have no further option obligations.
• You will end up with no shares and $25,480 in cash.

This best-case scenario would represent a net profit of $8,500/$16,980 = 50%

achieved in less than 7.5 months on shares that only needed to go up by 16.4% or better.

If FII shares finish exactly unchanged at $25.78 on April 16, 2010:

• The $25 calls will be exercised.
• You will sell your original shares for $25,000.
• The $30 puts will be exercised.
• You will be forced to buy another 1000 FII shares.
• You will need to lay out an additional $30,000 in cash.
• You will likely have collected $480 in dividends.
• You will have no further option obligations.
• You will end up with 1000 shares of FII and $480 in cash.

What’s the risk?

Break-even on this trade would be figured as follows…

On the original 1000 shares it’s their $25.78 purchase price less the $3.10 /share call premium = $22.68 /share.

On the ‘put’ shares it’s the $30 strike price less the $5.70 /share put premium = $24.30 /share.

Your break-even would be the average of $22.68+$24.30/2 = $23.49 /share (excluding dividends) and $23.01 /share (including yield).

Federated shares could drop by up to $2.77 /share or (-10.7%) without causing a loss on this trade.

Summary:

Federated Investors is a profitable, financially strong company with a nice yield and a bargain valuation. It could easily rebound to $30 or better before next April 16^th. That 16.4% (or greater) move up would translate to a 50% total [cash-on-cash] return.

If Federated shares merely stay unchanged from today’s price of $25.78 you would still see a nice profit. You would end up with the same 1000 share quantity you started with and have $480 in dividend payments from two quarterly payouts of $0.24 /share.

Your net cash flow would have looked like this:

	Cash Outlay	Cash Inflow
Buy 1000 FII @ $25.78 /share	$25,780
Sell 10 $25 calls @ $3.10 /share		$3,100
Sell 10 $30 puts @ $5.70 /share		$5,700
Collect Dividends (2 X $240)		$480
Buy 1000 ‘put’ shares @ $30 /share	$30,000
Sell 1000 ‘called’ shares @ $25 /share		$25,000
Net Cash Out-of-Pocket	$21,500

You would end up owning 1000 Federated shares worth $25,780 (at the unchanged price) for your net outlay of $21,500 (over the full course of the 7.5 month trade).

That would be a $4,280 net profit from start to finish on shares that did not go up!

You would have had a margin of safety of 10.7% (from trade inception) as any price above $23.01 /share on the April 16, 2010 expiration date would allow for liquidating your 1000 shares at a profit.

Disclosure: Author is long Federated shares and short Federated options.

Comments

[MILESCFA:]

"Because Federated focuses on money market funds, it fared better than most asset management companies in 2008’s bear market..."

YE07 close $36.99 YE08 close $17.44 down 53%

I wanted to disagree with the author's statement above, but from a cursory glace at IBD's "Investment Mgmt" industry, he's right. Still, being ONLY cut in half doesn't seem wonderful.

The "small" reason I wanted to disagree is that I use to work for a firm that was bought by Eaton Vance (EV), a money manger I know to be of very high quality. It declined slightly less that FII (~47%). Also, FII only started trading from late 1999 according to my charting services, and from 2001-2007 it has essentially traded flat. EV almost tripled during the '01-'07 time frame. Thus I would tend to be indifferent to FII as a stock play by itself, but what about this option play....

The "big" reason I wanted to disagree with the author is...

"Here’s my buy/write combination play with Federated to make an excellent total return with less risk than outright purchase of the shares..."

This is WRONG. The option position is in fact TWICE AS RISKY as the outright purchase of stock, and to wit, has less upside. Why? It's a buy/write plus a naked short of a put. A buy/write limits your upside and has downside risk to "0" (few stocks actually go to zero, but then can!). A short put limits your upside and has downside risk only limited by the fact the stock can't go below zero.

In case you don't realize, if FII finishes below $25, you're long stock that WON'T be called away AND you're short a naked put. Simply stated, for every $1 decline you would be losing $2.

Many authors on Seeking Alpha recommend this strategy (a buy/write and a naked short put) and they act like it's something different. In fact, it's just "doubling down" your bet, a bet that is limited on the upside and "unlimited" on the downside (except stocks don't go below zero). I would recommend you ignore these authors unless you understand the "doubling down", "limited upside" nature of these recommendations. Personally, I'd ignore them anyway.

Sep 13 05:27 PM

[Paul Price:]

MILESCFA,

The possibility for being 'put' on another 1000 shares is clearly spelled out in my write-up.

The 10.7% margin of safety includes this in the calculations.

If FII declines to no less than $23.01 you could liquidate all 2000 shares for either a gain or no loss (depending on the exact price on expiration date).

I believe the shares will remain above $25 to give this trade its best-case scenario result. Outright buyers of FII at $25.78 would be down 10.7% if the expiration date close was $23.01.

Thus... if the shares drop 10.7% the buy/write combination is clearly supeior.

If FII finishes exactly unchanged at $25.78 on expiration date the outright share buyer would have made only the two dividends or +1.86%. The combination would have shown the 50% cash-on-cash return. Once again, the buy/write is far superior.

Only if the shares go well below $21 does the outright purchaser of shares lose less. If you think FII will go below that price point you shouldn't be owning the shares or buying and writing with FII.

Sep 13 06:51 PM

[User 462153:]

"If you think FII will go below that price point you shouldn't be owning the shares or buying and writing with FII."

Paul, I disagree with MILESCFA's conclusions. Although his assessment of the risk in a vacuum is fairly accurate, he's obviously one of those "what if the stock goes to zero" hypothetical option theorists who doesn't know how to do a real trade. However, if the trade is premised upon the above contingency not happening how can a novice do this trade (or any of your covered write strategies) safely since nobody knows whether the stock will go "below that price point" when the trade takes a full seven months to develop? Stated otherwise, how do you manage a trade like this if it starts to go badly? Do you liquidate if the stock reverses? If so, where? Does it have to hit the break even point before you take protective action? Market risk alone could cause the stock to close below 20.00 (as it did in 2008). I have my own methods for handling this, but since it's your trade, I'd like to hear yours. Thanks.

Sep 14 12:31 AM

[Paul Price:]

I manage these buy/write combinations the same way I manage pure stock plays.

If the shares decline due to market action (rather than weaker than expected fundamentals) I typically will do nothing or even add to my holdings.

If the company's earnings picture weakens you deal with it the same way you'd do if you just owned the shares. You could sell the stock and/or close out the puts, roll down to a lower strike or even liquidate the whole position and move on to something else that looks better to you.

No matter what the expiration date, you are always free to change your mind and close out options or sell shares at any time you choose.

Sep 14 07:29 AM