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Federated Investors, Inc. (NYSE:FII)

Q4 2009 Earnings Call

January 29, 2010 9:00 am ET

Executives

Raymond J. Hanley – President Investor Relations

J. Christopher Donahue – President, Chief Executive Officer & Director

Thomas R. Donahue – Chief Financial Officer, Vice President, Treasure & President FII Holdings, Inc.

Deborah Cunningham – Chief Investment Officer Money Market Group

Lori A. Hensler – Corporate Finance

Stacy Friday – Corporate Finance

Analysts

Michael Carrier – Deutsche Bank Securities

Michael Kim – Sandler O’Neill & Partners

Roger Freeman – Barclays Capital

Kenneth Worthington – JP Morgan

Michael Hect – JMP Securities

Marc Irizarry – Goldman Sachs

Cynthia Mayer – Bank of America Merrill Lynch

Robert Lee – Keefe, Bruyette & Woods

William Katz – Buckingham Research

Roger Smith – MacQuarie Research Equities

Operator

Welcome to Federated Investors Q4 2009 quarterly earnings call and webcast. At this time all participants are in a listen only mode. A question and answer session will follow the formal presentation. (Operation Instructions) As a reminder, this conference is being recorded. It is now my pleasure to introduce your host Raymond J. Hanley, President for Federated Investors Management Company.

Raymond J. Hanley

Today we’ve planned some brief remarks before opening up for your questions. Leading today’s call will be Chris Donahue, Federated’s CEO; Tom Donahue, Chief Financial Officer. We also have Debbie Cunningham, Chief Investment Officer for Money Market Group and we have Dennis McAuley, Lori Hensler and Stacy Friday from the corporate finance area.

Let me start by saying that certain statements in the presentation including those related to assets, investment and financial performance constitute forward-looking statements which involve known and unknown risk that may cause actual results to be materially different from future results implied by such forward-looking statements. For a discussion of risk factors please see our SEC filings.

No assurance can be given as to the future results and neither Federated or any other person assumes responsibility for the accuracy and completeness of such statements in the future. With that, I’ll turn it over to Chris.

J. Christopher Donahue

I will start with a brief review of Federated’s recent business performance before turning the call over to Tom to discuss our financials. Looking first at the cash management portion of our business, money market assets decreased by about $5 billion or 2% from the prior quarter. Money market funds decreased about $6 billion and were partially offset by an increase in cash separate account assets.

We are seeing significant asset movements in our money funds over the last several weeks. We saw about $5 billion of inflows during the last week or so of December followed by outflows during January to date of approximately $22 billion. These outflows were concentrated in the middle of the month, a period where we generally see cash movement related to tax payments and other uses of cash. During the week ending January 15th outflows totaled about $15 billion. Money fund assets have been essentially flat since mid month.

Now, in addition to regular uses of cash, the outflows included the withdrawal of assets that came in late in the year which we expected. We also had some client specific actions that were planned for this period. In addition, market condition including rates and yields, regulatory uncertainty and competition from our bank products were factors. Importantly, our client base remained intact.

Low interest rates continue to impact yields and fee waivers for money funds in Q4 and the waiver impact is likely to increase in Q1 as rates fell further in January. However, we believe that we will begin to see some upward movement in rates over the next couple of months initially within the current zero to 25 basis points fed funds target range. As such, we believe that we will begin to see less impact from money fund fee waivers in the second quarter. Tom will provide more specific information in his remarks.

Our cash management business continues to be very well positioned. We expect this business to continue to grow over time with higher high and higher lows during particular cycles. Looking at this most recent cycle, our money funds grew by about $173 billion in ’07 and ’08 combined. In ’09 and here so far in ’10 we have seen about $68 billion leave our money fund.

Now, the SEC’s adoption of new money market rules was a welcome development. We believe that the changes announced will strengthen the regulatory framework that money funds operate within and do what all of the regulators and governmental officials have said is their goal, enhance the resiliency of money funds. It was clear to us that the SEC carefully considered the comments made by Federated and others at arriving a these changes. We anticipate that these changes will not materially alter the way we manage our funds or even the yields of our products as we have generally applied these standards already.

We are encouraged by the process and expect that any future changes follow the path of preserving the key characteristics of money funds the enable those products to play a vital role in our capital markets. Beyond cash, we have a broad array of solid products in both bonds and equities. Our sales growth in ’09 of 64% for combined bond and equity mutual fund gross sales was a result of a combination of solid performance and successful product distribution. We gained market share in ’09 of gross sales for bond funds and for equity funds utilizing the industry’s most recent data.

Now, looking more specifically at equity assets, they increased slightly during Q4 to just under $30 billion at year end. Equity flows were positive. We continue to have success with alternative strategy mutual funds with good results in particular from the prudent bear fund. The strategic value dividend oriented fund continues to show solid flows as does the Kaufman small cap fund.

Bond fund sales continue to dominate industry results in the fourth quarter. Federated’s fixed income products again showed strong sales results gaining share against strong industry flows. The composition of our fourth quarter bond fund flows improved compared to the third quarter. Though gross bond fund sales decreased from the prior quarter the drop was due mainly to lower sales of ultra short products. Gross sales of all other bond products increased 6% and net sales of these products were up 25%. Ultra shorts were about 40% of the fourth quarter gross bond fund sales and 24% of net sales. Comparatively, in the third quarter ultra shorts were 48% of gross sales and 58% of net.

Total net bond funds sales were strong at $1.3 billion for the quarter and reached $6.8 billion for the entire ’09 season, more than four times higher than ’08 sales. For the fourth quarter all categories of bond funds showed net inflows. As announced on Wednesday we launched a new closed end bond fund that raised $178 million in a differentiated strategy utilizing treasury instruments. We are pleased to add another closed end fund and expect to be active in this area going forward.

We also added $241 million in fixed income separate account net flows in the fourth quarter and believe that our consistent performance over the full cycle has positioned us for further growth in this area. So far in January bond fund flows remain solidly positive while equity fund flows are modestly negative. As always, we caution about drawing conclusions from limited data.

Turning to investment performance and looking at the yearend Lipper rankings for Federated’s equity funds, 22% of rated assets are in the first or second quartile over the last year, 62% three years, 81% five years, 79% 10 years. For bond fund assets the comparable first and second quartile percentages are 28% for one year, 68% three years, 76% for five years and 80% for 10 years. The decrease in one year equity assets in the top quartiles from prior periods was largely due to the defensive positioning of certain funds relative to the large market upswing in 2009.

Within fixed income, the decrease in one year Lipper rankings reflects in large part the success we had in ’08 with the high quality of our products. Returns in ’09 favored lower quality products. Our three and five year records are strong and we are above the benchmarks in most of our taxable income strategies on a one, three and five year basis.

As of January 27th our managed assets were approximately $370 billion including $294 billion in money markets, $29 billion in equities, $47 billion in fixed income which includes our liquidation portfolios. Money market mutual fund assets stand at about $260 billion. Now, so far in January our money fund assets have ranged between $259 billion and $281 billion and our averaging about $268 billion.

Regarding acquisitions, with the integration of Clover Capital and Prudent Bear largely completed during ’09, we are not looking for acquisitions targeted to specific investment expertise though this type of deal always remains a possibility. We continue to evaluate multiple acquisition opportunities to add assets and clients including money market consolidation deals. We’re actively seeking acquisitions or partnerships outside of the United States as a part of developing our strategy to expand a global distribution. As always, we really can’t predict the probability or timing of any potential deal.

Thomas R. Donahue

Federated’s total revenues decreased by about $48 million or 4% in 2009 due largely to the impact from money fund yield waivers. These waivers reduced revenues by about $121 million in 2009 compared to the $4 million reduction in 2008. Revenue growth excluding the impact of waivers was due to our diversified business mix as higher money market and fixed income revenue partially was offset by lower equity revenue.

The Q4 revenue impact of money fund waivers to keep deals positive or zero was $57.5 million largely offset by $42.6 million in related lower marketing and distribution expenses. The impact to operating income from these waivers was $14.9 million compared to $8.6 million in Q3. For Q1 volatility in the rates for overnight repo complicates waiver calculation. After averaging about 10 basis points for Q4 treasury backed overnight repo rates were literally zero for the first couple of days in the first quarter and averaged just about five basis points through January 15th.

Since then these rates have been between 10 and 14 basis points. We believe that these rates will move up a bit more over the rest of Q1. In this rate scenario and with recent asset levels and mix the operating income impact in Q1 from these waivers would be approximately $17.5 million. Lower rates on T bills and prime paper compared to Q4 also impacted Q1 potential waiver impact calculations as older paper continues to reset at lower rates.

Looking at the rest of the year, we expect rates to move in to the upper half of the current zero to 25 basis point [hedged] funds target range over the next several months and expect the feds to begin increasing the target rate during the later part of Q2. Under this scenario we expect money fund yield waivers to decrease in each the second, third and fourth quarter.

As we have consistently emphasized with a wide range of outcomes including higher impact for these waivers as possible. Factors that impact the waivers include yield levels available in the market, changes in assets within the funds, actions by the fed, Treasury, SEC and other governmental entities, changes in the expenses of the funds and our willingness to continue to weigh. In terms of sensitivity, we estimate that a 10 basis point increase in yield would reduce the wavier impact by about one third while a 25 basis point increase would reduce the impact by about two thirds.

Turning to operating expenses; 2009 levels decreased 2% from 2008 due largely to lower marketing and distribution expenses related to money market fund yield waivers. We were successful in managing expenses in 2009 and exceeded our targeted range of savings. When comparing ’09 and ’08 keep in mind that the Clover and Prudent Bear acquisitions closed in December ’08 so very little expense was booked during 2008.

For Q1 remember that the launch of our new closed end fund will impact earnings. We anticipate approximately $2 million to $2.5 million pre-tax or $0.01 to $0.02 impact from the deal related expenses in Q1. From a revenue standpoint we expect our net management fee realization rate to be in the mid 40s. We announced a special dividend of $1.26 in addition to the $0.24 regular quarterly dividend. We look at this special dividend as a way to reward shareholders for the success of the company in navigating difficult conditions in 2009. For Q1 the special dividend will reduce EPS by approximately $0.04 per share due to the impact of the two class method required for calculating EPS.

On the balance sheet cash and short term investments were $122 million at the end of the year and recourse debt was $126 million. We also repurchased 50,000 shares in Q4 and 829,000 shares during 2009. We continue to generate strong free cash flow and expect to continue to use cash and loan facilities to fund acquisitions, dividends, share repurchases, capital expenditures and debt repayments.

We would now like to open the call for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Michael Carrier – Deutsche Bank Securities.

Michael Carrier – Deutsche Bank Securities

Just first on the fee waivers, when we do start to get rising rates I just want to make sure that the revenue and expense sharing with the distributors, nothing should change on the way down versus the way up in terms of the potential positive relief that you’ll see? Then, I guess some in the industry have been talking about trying to recapture some of the loss fee waivers over the past year. Any sense of that or do you think competition will be too intense that you won’t be able to really recapture it?

J. Christopher Donahue

We don’t think about recapturing past waivers and we see the fees or the reduction in the waiver going up in the same methodology that it went down.

Michael Carrier – Deutsche Bank Securities

Then just on the special dividend, given where your guys cash levels are and still some uncertainty around regulation of the money markets and then also the macro environment, I just wanted to get a sense how the thought process went because I think it was a little bit surprising given that the dividend is a little above where the cash balances are? Granted, you’re going to be generating cash throughout the year but just a sense because it seemed a little unusual in terms of timing?

J. Christopher Donahue

Well it’s a special dividend so it is unusual. We kind of take a long term perspective on this and this will bring us to having returned and used our capital in terms of dividends about $1 billion since we went public. In terms of share buybacks we’re almost up to $1 billion and in terms of acquisitions we’re at about $750,000 million so we kind of have a three pronged approach there and don’t have the belief that we need to hold on to our cash. We look at the share price and aren’t really believe that reflects the value of the company so how can we reward shareholders with what we believe they should be rewarded with and paying a dividend to them is one of the answers.

Operator

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

Michael Kim – Sandler O’Neill & Partners

First I apologize but I missed what the $0.04 item was. Could you just go over that again?

Thomas R. Donahue

Sure. When we pay a dividend accounting rules tell us that we have to use a two class share methodology because we have restricted stock and so it’s a non-cash charge that we have to reflect, basically a onetime based on the special dividend of $0.04.

J. Christopher Donahue

Obviously a Q1 item Mike.

Michael Kim – Sandler O’Neill & Partners

Then in terms of the fee waivers, does the $17.5 million estimate for this quarter assume that rates stay flat from here or are you baking in some kind of higher rates for the rest of the quarter?

J. Christopher Donahue

It starts with where the rates are now. We expect two things to happen, as the paper and the funds now matures we’re typically buying new paper at slightly lower yields than we were say in the fourth quarter as the rates kind of gradually ticked down and we saw more of that early in January. We have seen since the middle of the month the repo rate has come back up anywhere from five to nine or 10 basis points to get up between 10 and 14 basis points and there are some technical reasons why we have a fair degree of confidence that the repo rates are going to go up further beginning in February and Debbie can speak better to that.

Deborah Cunningham

There’s supply coming in to the marketplace from the Treasury in particular. They have been in a net pay down situation for short term debt over the course of the last four or five months, that will reverse itself in February. There’s a good amount of planned short term treasury issuance that will occur. That additional supply in the marketplace should in and of itself if everything else doesn’t hold true but if that comes to fruition as it’s expected, it should cause rates to come back up a few basis points.

Michael Kim – Sandler O’Neill & Partners

Then more broadly on kind of the institutional side of the business, do you feel like you’re big enough to win some of these fixed income replacement mandates where some of the more entrenched managers have underperformed and are at risk of being replaced? How much of an opportunity is this area given your strong performance track records?

J. Christopher Donahue

We think we’re in pretty good shape on those and have collected a series of mandates in the $100 million type size. So we’re pretty optimistic about our chances there. It is the long term consistent performance over cycles that puts you in that spot.

Michael Kim – Sandler O’Neill & Partners

Then just final question on kind of the SEC meeting earlier this week. It did seem like they indicated that they will continue to evaluate some of the more controversial proposals out there so I would just be curious to get your take on how you’re maybe handicapping the likelihood that we do see some type of transformational reform particularly now that maybe Volker is back on the scene to some extent.

J. Christopher Donahue

Considering sin is not the same as committing sin, Jimmy Carter to the contrary notwithstanding. I think Mary Shapiro has made it clear they are going to continue to look at an array of issues. We don’t place much likelihood at all on changing the NAD to a fluctuating NAV. No matter how often someone talks about doing it, you have to face the reality of the importance of these funds in the capital markets in terms of the securities that are owned by a $3.3 trillion industry.

You also have to acknowledge that fact that about $325 trillion has gone through money funds since the SEC successful integration of Rule 2A7. This is a systemic liquidity enhancement. You also have to note that there’s been over the last say 24 years about $450 billion paid to investors, more than they would have gotten in the MMDA.

So yes, you can consider all of these things and that’s fine but we don’t place much weight on the idea that they’re going to change the NAVs. What we have seen is a regulatory, especially the SEC and especially on 2A7 that over decades has consistently gotten in right because of aggressive study back and forth and considered judgment in the end and that is what we would look forward to here in to the future.

Operator

Your next question comes from Roger Freeman – Barclays Capital.

Roger Freeman – Barclays Capital

I guess just back on the special dividend, how do you evaluate doing a dividend versus say a stock buyback because it seems at this valuation that that could have been a reasonably accretive transaction?

Thomas R. Donahue

We run all the models on buying shares in terms of our forecasts and potential risk and like I said we kind of look at it on a long term you and say that we’ve done about $1 billion after we do the dividend of each so it’s kind of comparable and different times we’ve made different decisions and it looks like buying the shares back hasn’t, at least in the last quarter – what’s that going to do for shareholders? It seems like returning the money to them directly through dividends is a more tangible thing. At least, that’s our view of it at this recent time.

Roger Freeman – Barclays Capital

I guess the other question, do we take this and coming sort of back to regulatory question that you have a lot of confidence that we won’t end up with any sort of capital requirements supporting money markets that you’d want to hold on to cash at this point?

J. Christopher Donahue

The answer to that is yes, we do have a lot of confidence that that will not happen despite [inaudible] and commentaries by other in the marketplace. Part of the reasons for that is you have to ask yourself does this business supportable by a 10% or real bank capital on it? Go ask JP Morgan what their situation would be with $400 billion in money market funds as to how that business would function if they put real bank capital requirements on them.

The need for it is a little odd when you consider that the money funds don’t do the leverage thing and they surely don’t fail the way banks fail. Even in a reserve situation they got $0.99 at the end. That wasn’t a pleasant result because of the delay but don’t forget in the Putnam situation it was all able to be resolved within the context of other money funds and some cooperation from various regulators. So when Mary Shapiro is summarizing the very things that she’s looking at, capital wasn’t one of the things she listed during her call earlier this week.

It’s again one of those things that gets mentioned out in the marketplace a lot and you can have a lot of fun with it but we don’t think that it’s going to come about. Now, a footnote, Mary Shapiro did mention of course the private liquidity facility to provide liquidity to money market funds in times of stress, that’s a quote. So there may be some modest capital requirements in however that ends up being structured but that’s all I can say about that so called liquidity bank.

Thomas R. Donahue

One more comment, from a company access to capital the amount of debt that we have for our earnings and cash flow is pretty small. Our interest coverage ratios are huge and our EBTIDA to debt is very small and obviously we can borrow a lot more money if we want to.

Roger Freeman – Barclays Capital

That’s a fair point and in fact just judging from the special dividend here it sounds like you’re not adverse to running with some leverage.

Thomas R. Donahue

The amount of leverage we have I don’t really view as running with leverage. When we were a leverage buyout company 15 years ago we had some leverage then.

Roger Freeman – Barclays Capital

Last question, can you just explain just in terms of sort of flow dynamics, as you point out there were outflows in the ultra short fund during the quarter as you had money coming back in to money markets in November and December, what are the different dynamics there because presumably cash goes from money markets in to the bond ultra short funds to capture a little bit of extra yield is that money then going out to other riskier assets? Then, what’s coming back in to cash? Can you sort of help me think about that?

Raymond J. Hanley

One clarification, the ultra shorts had inflows in the fourth quarter.

Roger Freeman – Barclays Capital

I think it was in December it out flowed?

Raymond J. Hanley

It may have been during the month of December but for the whole quarter there were in flows. Yes, there is some relationship between the money moving around there and you can look at the last low rate cycle in ’01 through ’03, our ultra shorts went from about $1 billion up to about $4 billion and then shrunk back down to a billion. So we expect some volatility in the flows there both up and down and yes, we do see some of the money shift from cash to ultra short to pick up a bit of yield but also edging out a bit under the risk spectrum and interestingly moving in to a product with a fluctuating NAV in order to do that. So investors understand that trade off and they use that when they’re willing to do it in order to pick up more yield. However, you can see the vast majority of the cash managed assets still stays in the money market fund.

Operator

Your next question comes from Kenneth Worthington – JP Morgan.

Kenneth Worthington – JP Morgan

Maybe first the outlook for investing in the business for 2010, do you kind of feel that you’re kind of returning to investment mode or will return to investment mode or is it still prudent to be kind of in a belt tightening mode for the next 12 months?

J. Christopher Donahue

Well, I don’t know exactly what you mean by investment mode because during ’08 the fourth quarter we closed on two deals right at the same time when we were looking in our budgets for ’09 which involved some significant belt tightening which we’ve articulated before. So, here as we look at ’10 as I mentioned we’re looking to do some shopping internationally and would be open for business on things domestically as well and haven’t hit the pause mode on that side of the investment at all and yet we’re still pretty persnickety on the expense side but unlike last year there may be some relief in terms of some very, very modest hiring here and there if that’s what you meant by investment.

Kenneth Worthington – JP Morgan

So like investments in technology, ratcheting up marketing spend, that is really where I was going in terms of the investment.

J. Christopher Donahue

Ken, our look at technology it is the one area that we continue to invest in and did not cut back even last year and we have the same thought process they’re just things we have to do to move ahead and continue to improve. So on the technology side, we will still continue to invest as we did last year.

Kenneth Worthington – JP Morgan

In terms of the fee waiver I assume the fee waivers are hitting both the investment advisory fees as well as the service fees. If that is correct, can you give us the breakout in terms of the waivers to those lines this quarter?

Thomas R. Donahue

Ken, it was weighted just a little bit more to investment advisory fees. If you take the waiver amount, about 55% of it would have been investment advisory fee and about 45% would have been in the other service fee line item.

Kenneth Worthington – JP Morgan

Then lastly, I’m going to beat the dead horse on the special dividend. If you’re taking a long term view on the stock and you want to reward investors, it seems like is the fact you’re paying a dividend it almost seems like you’re not endorsing the stock right now. Why is my rational wrong?

J. Christopher Donahue

I think you look at different types of shareholders that are in different spots in their ownership of the stock. Some shareholders gain a nice advantage when you buy stock and we’ve done $1 billion worth of that. Other shareholders who choice not to sell precisely because they are in it for the long haul are very well received an additional dividend. So it’s different shareholders in different spots and it’s obvious that if you choose to hold your shares, yes you think the reduction in total shares outstanding etc., is a positive but it’s also a positive to actually receive a dividend. Of all of the shareholders that I talked to, generally speaking they are very positive about receiving a dividend especially if they are long term holders.

Operator

Your next question comes from Michael Hect – JMP Securities.

Michael Hect – JMP Securities

I just want to go back and maybe this is for Debbie, just some thoughts on the outlook for structural form of the money fund industry in particular implications I guess from the recent proposed legislative reform and tax levies on the large banks and maybe the impact you expect that to have on the repo and reverse repo markets which are obviously closely tied to the money fund industry?

Deborah Cunningham

We’re actually working with the Federal Reserve Bank in New York in a tri-party retail working group and this special financial crisis responsibility fee or tax that was announced flies in the face of everything that we’ve been doing over the last three or four months with the fed in attempting to stabilize and continue to allow the repo market to go forward in a positive fashion. Also, I think if you looked at yesterday or maybe it was the day before news items the Treasury came out and basically said they are not at all happy with this potential fee especially in the context of the repo market and were looking to find carve outs in the proposals to remove repo from that particular fee.

They have a very invested interest in doing exactly that given the amount of funding that occurs in the repo market with Treasury collateral. So our thought process is that at this point of time if it does come to fruition obviously it reduced the amount of paper that’s available in the marketplace for certainly prime funds to buy and potentially for government funds to buy also in the context of the repo side of the equation. It would narrow the differentiation between the two types of products governments and primes.

But, in an overall response at this point from the market as well as from other regulators in the marketplace we don’t really think it’s going to hold up in the form that it was initially previewed to the marketplace.

Michael Hect – JMP Securities

Maybe just one more to follow up on the guidance which I guess relates to the fee waivers but just generally in terms of your thoughts on interest rates, it sounds like you’re saying we’re going to be closer to the upper end of the zero to 25 current range that we’re at today in the second quarter and what gives you the confidence that we’re going to have that kind of lift in rates in Q2?

Deborah Cunningham

Two things in particular, number one would be the fact that there is Treasury supply coming during the month of February and just adding supply in to the marketplace when demand remains to be high tends to lift the rate a bit. Secondly, with the FOMC statement on Wednesday, although they did not indicate an end to their purchasing program for their government agency mortgage backed mandate on to the fed balance sheet they in fact said they are reviewing not going to their maximum levels that they had announced previously.

Our thought is they are going to stop the purchasing of those securities number on out of the marketplace and as soon as they do that begin very shortly after that the reverse repo process where they take that collateral that is sitting on their balance sheet and start to reverse it back in to the marketplace so that funds again have usage of it again, increasing supply bringing us back in to that marketplace where rates, even though you’re in that zero to .25 range, end up on an overnight basis up near the 20 to 25 basis point range where they were for most of 2009 and not in the single digit to low teens where they have been in the later part of the fourth quarter and the early part of this first quarter of 2010.

Michael Hect – JMP Securities

Maybe one for Chris, just in terms of the outlook for the money funds space and in terms of consolidation as you’re out talking to different people on the money funds side that may have their money fund business up for sale, what are some of the critical issues? Is it just lack of scale, is it some of the potential regulatory changes? It sounds like your business is already in line with some of the proposals from the SEC but I’m guessing others aren’t. Or, is it a fear of potential capital charges is kind of driving some of the potential consolidation?

J. Christopher Donahue

I would say it isn’t fear of capital charges so much as it is are they focused on this business as a core element of their strategy and are they really willing to devote the resources that are necessary for the long haul? This is the overwhelming way that people end up separating themselves from their money market fund business. We have noted that it can be issues of size, however as I’ve mentioned on these calls before, if a purveyor of a money fund controls the redemption process then they can successfully run a money market fund indefinitely. Then, it has to be something else that is really at work.

When you have a confluence of the CFOs, the CEOs and the people running the business that determine that this is not a core element of their strategy then you have a trade and you’ve seen some big people decide, “Well maybe we’re going to sell this,” and then decide, “No, we’re going to keep it because we’re willing to commit the resources to make it a successful and competitive business.”

Michael Hect – JMP Securities

Can we get just an update on I guess the mix of the money funds across bank trust, the capital markets, broker/dealer and kind of corporate other channels? I’d also be interested in that same mix across foreign govies and tax free buckets?

Thomas R. Donahue

Mike, we don’t have that at hand. I can follow up with you for that. But, what we’ve seen in terms of looking at the decreases it’s really been across channels and we’ll see if we can pull those numbers while we’re still in the Q and A. If we can we’ll give them to you now if not we’ll follow up with you.

Michael Hect – JMP Securities

I just have a couple more on the expense side. In terms of comp expense, I guess for next year what is the best way to think about the outlook for comp? Is it returning to revenue as a percentage increase and what’s the expectation for headcount growth next year and where did you end the year in terms of heads?

Thomas R. Donahue

The outlook for comp they’re in anything like the full realization of the approximately 50 people that came on board in mid December ’08 with our acquisitions. That was fully in the ’09 run rate but there’s not that kind of a step up which was really what drove the ’09 variance that you saw versus ’08. Obviously in Q1 you’ll get a reset of payroll tax and 401k employee benefit cost and historically that’s been a couple of million. But, beyond that is just typically seasonality.

Beyond that, there really isn’t anything that we would point to in terms of an unusual expectation of change in comp. Headcount went down a little bit in ’09. It’s around 1,381 people down 10 or something like that simply because it was less in terms of replacement hiring.

J. Christopher Donahue

Back on the prior question of the breakdown of assets as it regards to bank trust, etc., in Q4 we ended Q4 with $124 billion in bank trust and that compares to $121 billion in Q4 of ’08. In what we call capital markets, I’ll give you the numbers and then I’ll tell you what capital markets is. It was $58 billion at the end of Q4 in ’09 and $86 billion at the end of Q4 ’08. What capital markets is, is basically half bank trust and half corporate. It is that department of the bank that has larger clients inside of it. Broker/dealer was $75 billion at the end of ’09 and $88 billion at the end of ’08. Then, the category we call corporate and some others was $24 billion at the end of the year off of a peak of $31 billion from the year before.

Thomas R. Donahue

Mike, on your other part of your question by type, at the end of the year we were about $46 billion of Treasury, $105 billion of government agency, $97 billion of prime and $34 billion in municipal. Now, that would just be for money market mutual funds.

Michael Hect – JMP Securities

Then just the last housekeeping one for me, on the tax rate it’s been pretty consistent around 37% plus or minus. Is that a good expectation for next year?

Thomas R. Donahue

It’s actually been around 36% and that’s a good rate to use going forward.

Operator

Your next question comes from Marc Irizarry – Goldman Sachs.

Marc Irizarry – Goldman Sachs

Chris, a question just back on the SEC proposals and how the rulings compare to the industry’s stance. It looks like electronic processing at prices other than $1, the industry which I assume you support that that was denied and also the shadow NAV came I guess as a little bit of a surprise to some industry participants. So I guess the question is, were you surprised by those moves and do those indicate further progression towards floating NAVs?

J. Christopher Donahue

I think the first part of your question the proposal that the SEC put out was that the industry has to be capable of actually computing to the third decimal place. This is obviously to make a situation like reserve work a lot better if you can’t do a Putnam situation which basically was baked in to the rules that the Putnam situation is now okay with the rules as written. So the fact that you have the capability of moving in to a third decimal point for times when the NAV is cracked does not mean that they do not allow you to continue to run the $1 NAV when that’s appropriate.

In fact, part of the reasoning that the SEC gave for the second part of your question which is the shadow work to date money funds have been filing on a twice of year basis their shadow price and it’s public in a certain way but you had to know how to work [inaudible] in order to figure it out. So the new requirement of a 60 day delay on publishing it monthly the SEC said the purpose of that was to get people familiar with the fact that these funds are not guaranteed and that they are run out of [inaudible] under 2A7 and amortized costs and that they are investment products.

That was part of the learning experience or teaching experience that the SEC wanted to do. The reasoning of the 60 day delay is they don’t want people playing games with it so this was their way to teach what they thought was important to teach. So teaching people that to me, does not mean they are going to go to a variable NAV which is not going to enhance the efficacy or strength of money funds.

Deborah Cunningham

Can I add one thing to that too? I also believe that historically the SEC as Chris mentioned, received mark-to-market data or shadow pricing data for each fund in the industry twice a year. They did so in a format that was not easily transferred in to any kind of comparative mechanism from their perspective. By collecting monthly data for every fund going forward what I think that allows them to do is build their own database of NAV across funds, types across fund families, across historic time periods in relation to changes in interest rates and changes in market conditions and in their own mind build a database that verifies that the $1 NAV is in fact justified.

Because of over the course of the 35 years of the industry, essentially they’re building in one or two institutions on one or two occasions where that $1 NAV on a mark-to-market basis has been compromised. So, I think this will help them in their argument against why a fluctuating NAV in fact is not needed going forward.

Marc Irizarry – Goldman Sachs

Then some of the other proposals changed, some of banned illiquid securities and banned tier-2 securities, it looked like the industry had hoped for less restrictive terms. Can you tell us what percent of funds holdings are illiquid securities across all the funds? Then also, what percent of your funds are currently in tier-2 securities? If you can breakdown the types of securities across the fund complex that would be helpful.

Deborah Cunningham

From an illiquid security perspective across the board we have about 1% in illiquid securities at this point so the SEC going from 10% to 5% is something that we actually advocated and thought made a lot of sense especially in the context of what their original proposal was which was to cut it out completely. Importantly although 1% doesn’t sound like very much historically there have been times when that number has been 4% or 5% and generally speaking what we used from an argument perspective against why it should not be eliminated is that occasionally what comes to the market initially as an illiquid private placement type of security often times then grows in to something that becomes very liquid and very much accepted in the context of the overall market.

A couple of different examples of those on the taxable side of the equation would be asset backed commercial paper and on the tax free side of the marketplace would be tender option bonds. That was the argument that was used and although 1% doesn’t sound like very much now we didn’t want to completely take it away as something that might find the next part of the marketplace that eventually turns from an illiquid security in to something that is very well accepted.

For the second part of the question with regard to tier-2 we currently only have four funds that have the ability to use tier-2, most of our funds are first tier funds. They are restricted by their prospectus in that regard. But, for the second tier funds that we manage generally speaking we hold them at 4.5% to 5%, so near the limit as it existed two days ago. We will go forward in those same funds obviously with a reduction that takes us down to 3% on an overall basis in second tier holdings in those products and that will be done just by the natural course of maturities of most of the second tier paper that we buy within the products is one month and under type of maturities. So that is very easily achieved to go from 5% down to 3%.

But, our expectation is that as long as that marketplace and the issuers that we follow that is in that sector offer good value in the marketplace we will continue to maximize our allowances in those funds that can use it and be very close to that 3% threshold.

Marc Irizarry – Goldman Sachs

Then just a follow on, what’s your weighted average maturity for your funds?

Deborah Cunningham

On average it’s probably about 45 to 50 days right now.

Marc Irizarry – Goldman Sachs

Then Chris, what do you think the changes in liquidity and changes in the types of securities in the funds means for your ability to compete on yield? Particularly, if you’ve got some of these funds where you’re at the higher end of tier-2 limits right now? What does it mean for competition in terms of competing for yield if some of those securities are taken out?

J. Christopher Donahue

First of all, if you’re talking about competition because of the money funds everybody is playing by the same rules so that’s that. Now, obviously the competition comes from the direct marketplace however, with our client base overwhelmingly these clients are looking to these money funds at these low or even zero interest rate as cash management vehicles so that the precise number of basis points doesn’t drive the truck for them.

They are cash management systems and cash management reasons why individually clients are utilizing these products and they all remain. So yes, there may be some impact from going from 4.5% in tier-2 in certain funds to 3% but it isn’t going to be big enough in our mind to distract a client who is otherwise using these money funds for cash management purposes.

Operator

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

Cynthia Mayer – Bank of America Merrill Lynch

Just to go back one more time to the SEC proposed rules, do you think they will have any impact on consolidation in the industry either by making the products more uniform or requiring more compliance than the little players want to do or do you really see no impact on consolidation?

J. Christopher Donahue

I think the impact on consolidation will be additive but will not act like a spark or an avalanche. The reason is the business reasons why people would be wanting to get out of their money fund business I have already commented on which has to do fundamentally with their commitment to devote the resources to make it a successful business. This is additive because it makes it very clear that you have to do some things that we’ve been doing for a long time. Just to give you an example of one that no one talks about a lot but is important which is the know your customer procedures.

Here is one that we’ve been doing every since we started in to this business 35 years ago we thought it was part of the life blood of how you run a money fund. Well now, that’s going to be required so others are going to have to look at that and say, “What resources do we need to devote to get to this type of requirement of know your investor?” That’s why I say it won’t really be a shock and awe kind of thing on consolidation but it will be additive to those people who are looking at devoting resources to this business.

Thomas R. Donahue

You could also have people look at it and say, “Will the rules they just came out with make money market funds less risky?” If the purveyor of that is how much they way risk in their decision with all the factors that Chris mentioned it could tip them one way or the other.

Cynthia Mayer – Bank of America Merrill Lynch

Just one more I guess on 4Q money market outflows, did you see any shift in terms of outflows to bank deposits versus the previous quarter? And, what kind of rate environment do you think it would take to stop that process?

CCC

We don’t follow the money obviously once it moves out but I think in particular on the retail side of things through say the broker/dealer channel there is obviously competition with the bank deposit products and in 2009 the rate differential would have been such that that certainly explains some of the outflows. We can’t really measure how much of that would be attributed to bank products. Over long periods of times of course bank deposits and money funds have coexisted and typically the money fund rates have been higher than the bank deposits rates and for those customers who are looking at it through that lens the money fund typically is ahead but in this period the bank deposit rates have been higher.

Operator

Your next question comes from Robert Lee – Keefe, Bruyette & Woods.

Robert Lee – Keefe, Bruyette & Woods

I apologize for going back to this, I had to jump off the call but, just to make sure I understand it correctly the incremental fee waiver expectation is $17 million incremental pre-tax in Q1, is that correct?

Thomas R. Donahue

That’s the net amount. [Inaudible] is comparable to $14.9.

Robert Lee – Keefe, Bruyette & Woods

The $17.5 is the incremental net increase?

Thomas R. Donahue

No. $14.9 in the fourth quarter and we expect it to be $17.5 in the first quarter under all those set of assumptions.

Robert Lee – Keefe, Bruyette & Woods

In looking at the balance sheet, I’m assuming you intend to drill down as you said on your credit facility to fund the special dividend, are there any other contingent payments from last year’s transactions that either you just paid or are coming due? I’m just trying to get a sense of maybe how much you have to draw down?

Thomas R. Donahue

We have the lines payment that will come in the second quarter and we expect to have a Prudent Bear payment and a Clover payment and possibly a Alliance payment so we have all of those factored in with our thought process and paying a special dividend and ability to fund it and also maintain availability of at least $100 million in borrowing capacity.

Robert Lee – Keefe, Bruyette & Woods

When do the Prudent Bear, Clover payments? Are those late in the year?

Thomas R. Donahue

Earlier in the year. Alliance is in the second quarter and the other two are in the first quarter.

Operator

Your next question comes from William Katz – Buckingham Research.

William Katz – Buckingham Research

Just sort of coming back to the capital discussion for a moment [inaudible] saw it come out a little differently. I think one of the lessons learned from Legg Mason’s experience with their portfolio is that you can never have enough capital against the money market business in the short term. I just sort of listened to your discussion about tier-1, tier-2, liquid and illiquid and sort of looking at the map that portfolio has 1% of illiquid assets. It’s still a pretty sizeable number compared to your equity base.

I’m just sort of curious with that plus your comments about the fact that you still think there is a slow grind here in terms of the fee waivers through the rest of this year and your earnings power I just don’t understand how you made the decision to do the dividend at this point in time. Are you inherently taking some franchise risk here by running so lean on the balance sheet?

J. Christopher Donahue

We don’t believe so and the reason is that for 35 years we have developed a lot of confidence that we’re not running the risk of blowing up because of a 1% illiquid position, a 3.5% in given funds or 4% or 4.5% tier-2 position in those funds. It is because we have a lot of confidence in the credit work and the resources that we’ve devoted to that business. That’s what gives us the confidence to do something like pay this special dividend.

We’ve look at the cash flow analysis over the next couple of years and feel we have plenty to do what we need to do given all the requirements that we have and we still think we have excess borrowing capacity and we believe we have the ability to finance any deals that we would do in and of itself or with our additional borrowing capacity.

William Katz – Buckingham Research

Are there any leverage restrictions that you’d get up against in any of those initiatives?

Thomas R. Donahue

Our current loan facility has an interest coverage ratios and debt ratios that we are not going to bounce up against at least in our expectation.

William Katz – Buckingham Research

The second question I have is one of your major competitors out there started talking about the long term prospects for the money market business having deteriorating margins. I’m just sort of curious what your thoughts are to that motion?

J. Christopher Donahue

Well, it’s hard to deteriorate from zero. We have a lot of funds where we’re waiving substantially if not all of the fees so yes, in many of the cases we’re paying the administrative fee but what we would look forward to is any move inside the band of zero to 25 is going to be a good thing for the income statement of the advisor to a money fund. Over the long haul if you think that interest rates are moving up at some point or you’re part of the crowd that thinks maybe they’re cooking up some inflation for the longer term then money funds are a heck of a good thing.

William Katz – Buckingham Research

Just two last questions, you may have said it I apologize, did you size the absolute level of the ultra short portfolio at the end of the year?

Thomas R. Donahue

No, we didn’t.

William Katz – Buckingham Research

Do you have a sense of how big that is?

Thomas R. Donahue

Go to your next one and we’ll try and look it up for you.

William Katz – Buckingham Research

Tom, can you tell me what you use in your discounting rate in the cost of your capital discussion between share repurchase and dividend?

Thomas R. Donahue

We change that regularly and I’d say we use 12.5%.

Operator

Your last question comes from Roger Smith – MacQuarie Research Equities.

Roger Smith – MacQuarie Research Equities

If you do look at the new SEC rules on the enhanced disclosure and I know you said that you’ve been providing this shadow NAV twice a year, can you give us a degree of the volatility or how much that range is in those filings and what you might expect people to see once this comes out on a more regular basis?

Deborah Cunningham

We report on a five digit basis and we’re not sure what we’ll be reporting on with the new rules. Our expectation is that next week we’ll have further release of the rules themselves in which will contain the details to such questions as to are you releasing this mark-to-market on a three digit basis, four digit basis, five digit basis so we don’t know for sure exactly what that is. But, for the current time period what we have historically released is a five digit number. That number rarely exceeds anything that is .0015 different than your NAV, than your $1, the two digit one. In terms of a four digit NAV that would mean .0085 to 1.0015 is the band which the reporting of that number and our calculations, we do this on a regular basis, it’s not done semiannually internally, it’s done weekly. I would say with 99% certainty that dollar calculation is within those two bands.

Roger Smith – MacQuarie Research Equities

From a regulatory perspective and I know people keep asking about this capital charges but could you just let us know what the next steps are? Is the SEC planning to hold additional hearings on the money market funds or where do we really stand on that front?

J. Christopher Donahue

We don’t know if they are going to hold additional hearings. What Mary Shapiro says is that they will continue to pursue looking at the structure of the money fund. I know they are waiting on the publication of the President’s working group on this but obviously the whole working group thing has been altered by some political changes in Washington as to what they think they can do, what is possible and what they would want to do. It’s tough for us to figure out what the next step exactly will be, it will be a better question direct towards them but I think the next thing to look forward to is the President’s working group publication.

Roger Smith – MacQuarie Research Equities

Just so I understand sort of the guidance around fee waivers, it sounds like if we’re at the high end of the 25 basis point range in the second quarter I’m assuming that’s really a 10 basis point increase and should we assume one third of the fee waivers go away? How does that sort of trail through the quarter? Do we expect that we’ll be at that 25 basis points closer to the beginning of the second quarter in those numbers? And, did you say you think the Fed is actually going to raise rates in the third quarter?

J. Christopher Donahue

We’ll break this question up there are a couple in there. Ray will take the first part and Debbie will address the Fed view.

Raymond J. Hanley

What we expect to happen over the rest of this quarter is that the overnight repo rate not just up a handful of basis points over the second half of the quarter beginning sometime in mid February and that’s a part of our calculation of a $17.5 million waiver number for Q1. Obviously, to the extent that happens it would be in place for the full second quarter would be our belief and we would expect further movement up towards the higher end of the zero to 25 basis point range during Q2 and during Q3 as we get closer to the point where we believe the Fed actually would move the target rate.

Deborah Cunningham

When we’re actually looking from an outlook perspective at that timing, obviously strength in the economy and what’s happening overall is something that we look at and changes on a day-to-day basis but at this point in time our expectation would be that sometime late summer or early fall is when we’re looking to the first Fed rate hike and in anticipation of that, we think the market will start to react at some point earlier than that exact timing.

Operator

It appears we have no further questions. I’ll turn the floor back over to management for closing comments.

Raymond J. Hanley

That will then conclude our call and we thank you for joining us today.

Operator

Ladies and gentlemen this does conclude today’s teleconference. You may disconnect your lines at this time and we thank you for your participation.

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Source: Federated Investors, Inc. Q4 2009 Earnings Call Transcript
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