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Federated Investors, Inc. (NYSE:FII)

Q2 2010 Earnings Call

July 23, 2010 09:00 am ET

Executives

Raymond J. Hanley - President for Federated Investors Management Company

Chris Donahue - President and CEO

Tom Donahue - President, FII Holdings, Inc., CFO and Treasurer

Debbie Cunningham - EVP and CIO

Analysts

Michael Kim - Sandler O'Neill

Roger Freeman - Barclays Capital

Mike Carrier - Deutsche Bank

Robert Lee - Keefe, Bruyette & Woods

Ken Worthington - JPMorgan

Cynthia Mayer - BofA Merrill Lynch

Craig Siegenthaler - Credit Suisse

Marc Irizarry - Goldman Sachs

Will Katz - Citigroup

Presentation

Operator

Greetings, and welcome to the Federated Investors second quarter 2010 quarterly earnings call and webcast. 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, Raymond J. Hanley, President for Federated Investors Management Company. Thank you. Mr. Hanley, you may begin.

Raymond J. Hanley

Good morning and welcome. We'll have some brief remarks today before opening up for your questions. Leading today's call will be Chris Donahue, Federated's Chief Executive Officer; and Tom Donahue, Chief Financial Officer, and also with us are Debbie Cunningham, our Chief Investment Officer for Money Market; and from the Corporate Finance Department, Denis McAuley, Lori Hensler and Stacey Friday.

Let me start by saying that certain statements in the presentation will constitute forward-looking statements which involve risks that may cause the actual results to differ from future results implied by such statements. For a discussion of the risk factors, please see our SEC filings. No assurance can be given as the future results and Federated assumes no responsibility for the accuracy and completeness of such statements in the future.

And with that, I'll turn it over to Chris to talk about the second quarter.

Chris 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 $12 billion or 4% from the prior quarter. Money market mutual funds decreased by $9 billion and money market separate accounts decreased by $3 billion, which was due largely to tax seasonality.

Money market asset changes are best understood within the context of the unprecedented cycle we are experiencing. All our clients added $182 billion to their money fund balances in '07 and '08, and in '09 and through the end of Q2 here in '10, we've seen about $95 billion flow out, meaning, by the famous subtraction method that we are up $87 billion from the beginning of this cycle.

During Q2, we saw our money market fund assets decrease in April due largely to expected tax seasonality. These assets then increased in both May and June and average assets so far in July are higher than the June 30 period end level. Growth from clients outside of the US has helped with these results.

While market conditions continue to be challenging, our clients have remained strong, stable and growing. Our clients have appreciated the strength, the stability and the availability of our products. We remain confident that our cash management business is well positioned and we expect this business to grow overtime with higher highs and higher lows during particular cycles. We also expect further growth through consolidation.

The transaction we announced last week with SunTrust is expected to result in the transition of about $17 billion in money market assets in the Federated money market products during Q4. This is an example of our ability to work successfully with long-term clients as they make changes in their approach to cash management, and we expect to see more of these arrangements, as banks and other organizations are attracted to our long-term commitment to this business and our long-term record of providing high quality products and service that they can rely on for their client.

Turning to the money market fund yield waivers. Q2 saw some relief in the impact from these waivers. As we expected, repo rates moved in to the upper portion of the zero to 25 basis point target range. In addition, LIBOR rates further increased reflecting market condition that developed, following uncertainty in Europe. This helps to decrease the waivers more than anticipated. We expect these waivers to decrease going forward though at a slower rate than we saw in Q2 and Tom will comment further on these in his remarks.

Our money market fund share increased in the second quarter to about 8.2%, up from approximately 8.1% at the end of first quarter. For reference recall that in 2009 and2008, our market share was about 8.5%, up from about 7% in '07 and 5% at the turn of the millennium.

As we turn to other products, it is worth noting that in the midst of the difficult market conditions in Q2, Federated was able to use its broad product lineup to offer products geared to challenging equity market. A prime example is the set of alternative strategy equity mutual fund products that we have developed featuring the Prudent Bear Funds which we acquired in December of '08. This fund returned just under 10% for the quarter and produced solid gross sales of $573 million and net sales of $212 million.

It has surpassed $2 billion in assets and as of mid-July had more than doubled in size from the end of 2008. Flows in this product changed quickly with changes in the equity market. While we stressed to clients we believe this type of product should be a part of every portfolio, its value becomes most apparent during tough equity markets.

Other funds with net inflows in Q2 included the InterContinental, Strategic Value, Kaufman Large Cap and Clover Small Value funds. With these and other funds we have a solid equity fund product in growth value income, international and alternative. And we believe that these products will be attractive as equity markets improve and flows pickup.

Our overall equity fund net flows were negative in the second quarter. Growth sales year-to-date 2010 were up 16% compared to the same period in 2009. Equity fund flows are positive for the first half of July driven by the strategic value and Prudent Bear funds. Within equity separate accounts, outflows were negative due largely to net redemption in our SMA products.

Now looking at bond funds, our sales continue to be solid in the second quarter with gross sales of $3.6 billion and net sales of $310 million. Our total return on bond funds showed another quarter of solid inflows above $385 million. Ultra short products however were slightly negative, about a $136 million, but have returned to positive here in the early flows of the third quarter.

Bond fund flows remain positive in the first two weeks of July. Fixed income separate accounts, we had about $1.8 billion in net new funding of institutional accounts in the second quarter. We won another handful of mandates in the second quarter and the early part of Q3 that we expect will fund for approximately $400 million in the mutual funds and separate accounts.

We expect to continue to see significant wins in this area, given our solid performance over the cycle and higher profile after a series of wins. Moving back to the first quarter of '09 we won about 15 institutional fixed income and equity mandates ranging in size up to $1.9 billion. They include core Ag, core fixed some even into our total return government bonds fund, corporates, short-term governments, short-intermediate government, MDT Small Cap and Strategic Value, certainly an array of product offerings.

Turning to fund investment performance and looking at the quarter end Lipper Rankings for Federated's equity fund, 14% of rated assets are in the first or second quartile over the last year, 34% three years, 77% five years, 82% ten years. For bond assets, the comparable first and second quartile percentages are 28% one year, 69% three years, 71% for five years and 86% for ten years.

Interestingly, 77% of international equity-rated assets are in the top two quartiles. For year one, 24% three years, 72% five years and 72% for ten years. Taking a look a Morningstar rated funds, 35% of rated equity fund assets are four and five-star products as the 6/30 and the 82% are three, four or five-star products.

As of July 21st, our managed assets were approximately $338 billion, including $260 billion in money markets, $28 billion in equities and $50 billion in fixed income which includes our liquidation portfolio. Money market, mutual fund assets stand at about $231 billion. So far in July, our money fund assets have ranged between $231 million and $235 billion and have averaged at about $233 billion.

Regarding acquisition, we continue to conduct an active search for an alliance to further advance our business outside of the United States, as an important component of our strategy to expand global distribution. We remain active in looking for consolidation deals, including money market business. As always, we cannot predict the probability or timing of any potential deal.

At this point, I will turn it over to Tom to discuss our financials.

Tom Donahue

Thank you, Chris. As expected, we saw less impact from money market fund yields waivers in Q2 and this impacted related revenue and expense items as detailed in the press release. The reduction in operating income from these waivers grew up to $13 million, compared to $17.8 million in Q1. Based on current market conditions and asset levels, we expect these waivers to reduce operating income by $11 billion to $12 billion in the third quarter. We do not expect the impact from waivers to decrease material from this level until the Fed begins to increase the interest rates. Debbie will comment on our great outlook at the end of my comments.

In terms of sensitivity, we have estimated that a 10 basis point increase in gross money fund yield would decrease waivers by about one-third, and this is essentially what we experienced in the second quarter. Looking forward, we estimate they are gaining another 10 basis points during gross yield, we will likely reduce the impact of these waivers by another one-third from our current levels, and a 25 basis point increase would reduce the impact by about two-thirds. We caution that a wide range of outcomes with possible factors that impact these waivers include yield levels available in the market, changes in assets within the funds, actions by the Fed, Treasury, the SEC and other governmental entities, changes in the expenses of the funds and our willingness to continue the waivers.

Looking at operating expenses. The press release detailed by line item, the impact of the insurance recovery on expenses we had booked in earlier periods. Compensation and related expenses decreased from the prior quarter due largely to lower incentive compensation expense; seasonality in payroll taxes and benefit expense and credit from the insurance recovery. Q1 had also included a reversal of previously accrued incentive comp expense.

We expect Q3 comp expense to be approximately $64 million. Q2 also saw an impairment charge of $7 million to certain assets from our acquisition of MDT Advisers in 2006, which became our quantitative equity team. We have approximately $7.5 million and remaining book value in the amortizable assets from this acquisition.

On the balance sheet, Q2 was the first quarter to include the impact from the $425 million term loan stability put in place on April 9. As we discussed last quarter, proceeds were used to initially pay existing debt. No net proceeds have been invested in various Federated equity and bond funds with additional investments made to see potential new products.

Long proceeds and availability on our $200 million revolver, as well as earnings and cash flow are available for general corporate purposes, including acquisition and related continued payment, share repurchases, dividends, new product seeding and other investments, capital expenditures and debt repayments.

We announced last week, the definitive agreement reached with SunTrust to acquire money market business, sending approval process, we expect to transition the $17 billion through a series of closing is expected to occur during the fourth quarter. Beginning in Q1 of 2011, we expect to add approximately $0.01 to $0.015 cents per share to our quarterly earnings. Actual incremental earnings will vary and will depend on asset levels, transitioning waivers, the final valuation for related intangible assets and other factors.

That completes my comments and I would like to ask Debbie to give some comments on our great outlook.

Debbie Cunningham

Thanks Tom and good morning everyone. I thought I would list maybe a couple positives and negatives for why interest rates should go up and why they should stay where they are. On the positive side of the equation, currently you have a deeper curve. That deeper curve has been based on wider spreads, as well as expectations of our near-term Fed tightening. Fed has remained wider during the quarter and has started to come in, in July based on some European debt concerns in the marketplace and that also has caused that deeper curve to be beneficial, especially to our plan and government plan.

Other countries are also tightening, you've got Australia, Canada very close to Denmark and other two have been in the tightening mode now for the better part of the last nine months. On the same kind of the equation, you do have a slowdown in a lot of the economic statistics as we've been receiving over the course of the last three to four weeks. Notably, both housing and employment with our key statistics on that economic side of the equation have slowed down markedly. You also have had a bit of mitigation of some of the European debt spread increases that occurred. We get a little bit more news on that front today as the European debt stress test for 91 of banking institutions are going to be released at noon today.

Overall, when we processed all of this information, we have pushed our tightening expectation from a Fed perspective into the 2011 time period just recently. I think it will be a first half event of 2011. We don't think that we will be going into any sort a double-dip recession which would push it out even further. But we do think that because of some of factors that I have listed on the negative side of the equation, this tightening process will not occur in 2010, but will rather start in the 2011 time period with a measured 25 basis point per clip days Federal Reserve action that will be precipitated by a stronger growth in economic statistics in the market place.

Raymond Hanley

Thanks Debbie. And we like to open the call up for questions now.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is from Michael Kim with Sandler O'Neill.

Michael Kim - Sandler O'Neill

First Chris, maybe if you could talk a little bit about the outlook for money market fund business. It seems like the spread between bank deposits and money market fund yields has narrowed more recently that combined with fact that the equity markets remain pretty volatile. So just wondering how you are thinking about flows in the near term?

Chris Donahue

In the near term, those factors are correct and we have see it and that's why I mentioned in my remarks that the July average assets are up over and higher than the Q2 average assets in money funds, and that is a factor, but the biggest factor remains our belief in higher highs and higher lows which means that the base of this business really is as a cash management service. And so I know your question Michael with respect to the flows over the short term, and we expect to see them are leveling off here. But over the longer term, we still expect this to be a good, solid, strong business because of the need for cash management service by our clients, and we don't have to get into the consolidation we already mentioned that point as well.

Michael Kim - Sandler O'Neill

Okay and then maybe moving on to the equity side of the business. You've got the performance track records to really kind of benefit from this move back into equities at some point when retail investors get more comfortable, taking on more risk?

Chris Donahue

No, we wish the one-year records were better. The long-term records of the key products are exceptional, and are well positioned to pick up the flows, and I am talking here about net flows. We've seen over the last three years excellent improvement in gross sales of our product which is the way of looking at the acceptance of those products in the market place. Now of course redemptions are a fact of life and so, on a long-term basis, we are very happy with our project.

Michael Kim - Sandler O'Neill

Any change in how you are thinking about expenses in general, now that the markets have come under pressure more recently, are there may be areas where you might start to pull in the reins a bit just assuming the environment remains challenging?

Tom Donahue

We have been continuing to look at things and think that way exactly as you talking about it and one of the things I mentioned, incentive proposition went down and the discretionary side of that, we were able to do that.

Operator

Our next question is from Roger Freeman of Barclays Capital.

Roger Freeman - Barclays Capital

Just sort of following up on the money market outlook, maybe from a longer -term perspective and thinking about higher highs and higher lows from an industry perspective. Given the potential decline in available assets investing, given that the banks are likely issuing less commercial paper going forward and therefore maybe more competition for the smaller asset base and of course banks also having to fund more from deposits and maybe more being competitive against money market rates, is that a concern of yours that money market is a competitive product versus bank deposits over the long run?

Debbie Cunningham

Definitely, we have seen a decrease in supply on the CP side of the equation. That market has almost halved inside from its peak which was in the summer of '07. Having said that, CD deposit type investments have increased by three times their size during that same time period. So, although our available supply is coming in a more concentrated form from an industry perspective, it's more related to financial services, banks and other types of financial services companies than it had been historically the availability for supply is still very good and it's still out there. Some of the things that have been a little bit challenging over the course of last several quarters in the retail marketplace has been from a supply perspective, and that is starting to loosen up a little bit also.

The potential for the Fed to come into marketplace and begin reversing some of their collateral back into the market and creating additional supply there, it will be a welcome relief. So, there are things that are happening that are mitigating some of what has been supply pressures in the marketplace, and overall although we would wish for more diversification in the supply. The supply itself remains pretty good.

Roger Freeman - Barclays Capital

Okay. That interesting, so it sound like the increase in bank funding through CDs has a rough offset to what they decreased from a commercial paper standpoint, is that roughly fair to say?

Debbie Cunningham

Yes, that's true.

Roger Freeman - Barclays Capital

And I guess, while I have you there just on that outlook around sort of rates and then the fee waivers, some of the stats I look at like effective tax fund rate, 4-week Treasury yield, et cetera. I mean they are running kind of roughly where they were for all of last quarter. The effective tax funds rate is 18 basis points right now and 4-week Treasury is at 15. And I guess given your outlook and it doesn't sound like they are going to move up from your point of view. So, I'm trying to figure out why the pressure is come off a little bit more in the quarter?

Debbie Cunningham

Quarter-to-quarter comparisons are absolutely to the point where we're leveling off or flattening out. Having said that, when you look at the increases that we experienced during the second quarter, we talked about it in the context of how the market has steepened out and the yield curve has steepened out. In fact, our product's yield depending upon what category you are talking about, whether it was munis, governments or prime, increased anywhere from 2 to 10 basis points.

And that was direct report to that steeper yield curve, although that curve is not steepening further and in fact may have flattened a few basis points at the end of June and beginning into July. When you compare that to what we say is especially great momentum in April, it got better, but the steepening part of the curve occurred mostly in May and June. That's where we expect your progress be made in the context of overall fund yields which then also makes progress on the fee wavier side of the equation. What we experienced on a velocity basis to that steepening of the curve and increase in fund yields, in the second quarter won't be experienced again in the third quarter, but we don't really see them going down either.

Roger Freeman - Barclays Capital

And then, another 10 basis points increased, you are talking about another one-third benefit, wouldn't it a little bit higher at this point because one-third is also the smaller base, really got a one-third reversal?

Tom Donahue

Well, you also have the mix of the underlying products, and so, remember you have a sharing factor here with the distribution fees. So, when your first move that the underlying math is simply a bit different on the product mix as you get further into a different mix of products as the rates go up.

Roger Freeman - Barclays Capital

That's kind of what I was wondering about. It sounds there is no more sharing of the benefit with the distributors on a second point?

Tom Donahue

And remember too, Roger, These are just rough guidelines. We are just trying get people directionally correct.

Operator

Thank you. Our next question is from Mike Carrier with Deutsche Bank. Please proceed with your question.

Mike Carrier - Deutsche Bank

Thanks. First, just a question on the long-term side of the business. Obviously the fixed income flows across the funds and the separate accounts doing well, and the equity separately managed account, we've had outflows in there for quite a while. Is there any update on what's driving that, what can be done to maybe try to just do that? And then just some of the products that may be working versus the products that you are still having some issues with.

Chris Donahue

On the SMA, I'll quickly mention first that the fixed income SMA continues to grow though they are small and coming off a small base. The negative flows as I mentioned were in the equity side and that continues to be driven overwhelmingly by redemptions from our MDT SMA purchase. And these things just continue because of the relative performance of MDT quant model, both in the downdraft in '08 and the updraft in '09. And although they are doing better now, the redemptions still continue.

Well, maybe six out of seven of their mandates are ahead from inception, but on a current basis, it's still a challenge because of the '08, '09 performance. Historically, when they have had a tough performance before, they have bounced back; these model's been around for 15 years and has worked well. So like other quant managers, we are working with them and believe in their long-term viability, but I can't hearsay that we are going to see a reversal in that trend of negative flows on the MDT separate account equity business.

Mike Carrier - Deutsche Bank

And then just one more on the P&L, we just look sequentially and obviously one quarter doesn't really trend. But we just look at the revenues being down a percent and you got the benefit from the reduced fee waivers. If we are looking at the expenses, those dropped to 3% almost entirely driven by the sharing with the distributors. So I guess just going forward, given where the asset base is, is there anything else that can be done on the expenses or during the quarter, where there any expenses that were just elevated given where asset levels ended from an average to period end. Just trying to understand, if that expense base can go lower given the new level of assets?

Tom Donahue

If you take out the distribution line item, which is what sounds like we're trying to talk about, because if waivers were down, that line item will go up if assets stay the same. You can see that's what happened sequentially. But there's lots of things that we can do and are trying to do and it's following up from the comments earlier. We instituted a lot of expense savings efforts here in end of '08 and through '09 and we're trying to maintain those.

We reduced a lot of products that weren't making it and we didn't see that they were going to continue to be viable, but we are also starting new products so there is a balance there. Overall we are not seeing the huge amount of increases across the board in any areas and we don't expect to. We are trying to maintain basically the level that we are running now. Chris, you have anything else to add to that?

Chris Donahue

No, I think we feel like the expenses are, if you were to look at margins excluding distribution, our margins would be pretty competitive. I mean basically it's a top line thing that we would expect growth in the top line to be the thing that would push the margins not so much reducing the expense base.

Operator

Thank you our next question is from Robert Lee with Keefe, Bruyette & Woods.

Robert Lee - Keefe, Bruyette & Woods

I am just curious Chris, in the equity SMA business, could you maybe give us a sense of kind of the size of the book that is still at risk there?

Chris Donahue

When we purchased the MDT business, it occasioned our total SMAs getting to about $10.5 billion and they are running at about $5 billion now. So the MDT strategies are about $2 billion of that $5 billion right now.

Robert Lee - Keefe, Bruyette & Woods

And may be shifting gears a little bit to capital management. Obviously you put the debt on the balance sheet and as usual talking about, in the market for us if you can find the right property doing consolidation deals and what not, given your willingness in the past to pay special dividend and given the kind of uncertainty as to where tax rates on dividends may end up, starting in 2011. Is it off the table at this point, given your interest in the international acquisitions that another special dividend couldn't be possible as it gets to yearend and tax rates change or is that just something you think about in the mix of things?

Chris Donahue

I would go on the last part in the mix of thing. We don't really take any of these ideas off the table. On the other hand, the idea of the international acquisitions is surely in the top position and depending on what it is or how are they structured, what it costs or how it works, it would willingly and enthusiastically crowd out other ideas, if that were deemed appropriate. But we don't really take anything exactly off the table and you can tell that looking at our charts on how we've done as acquisitions, dividends and share repurchase and you've heard me say for 45 phone calls that I like to score on all three. So by this time you figured, you are going to get the same answer and here I repeat it again.

Robert Lee - Keefe, Bruyette & Woods

I am sure you guys haven't had a chance to absorb it, but I will ask it anyway. Again, I think it was yesterday morning you had the new proposals on the 280-page report on 12(b)-1 fees of proposals coming out. Just initial sense, glancing at it, if you think there is any thing that you think is a meaningful change that really would affect the way you do your business, kind of first take?

Chris Donahue

There could be some meaningful changes in that. The real question though, that you have to look at is nomenclature. In other words, categories and names matter. And our view is that, when the 12(b)-1 fees are running at a billion dollars a month. Last year they were less than that, maybe like a total of none or something. Those fees are for legitimate and proper services. So now comes the question of how you structure them in a way that makes sense not to the regulator.

Point two is, don't forget that the origin of 12(b)-1 is in SEC hall pass to the industry, which, P.S. we opposed when it came out, because it represented using fund assets for distribution. And so now, the challenges that put the genie back in the bottle, and that is becoming a bit of a challenge. So what we are looking at is, how do you preserve legitimate business expenses and charges and add to the SECs legitimate desire to have a transparency understanding disclosure on what's going on. So within that context, we are not thinking that it's going to injure our business at this point. Remember that, within the context of the overall 12(b)-1, the first 25 basis points is acceptable through the SEC in that arrangement. I have not read the whole thing yet. When they first came out, whether it was just the three page item that they put on their website, but nonetheless, those are some initial look at it.

Next thing is that I think there is going to be a 90-day common period, and believe me, they are going to be comments on this that I think will accurately and appropriately reflect what is going on legitimately in the market place, and I believe there is a sound way to get everybody what they want, transparency, understanding and legitimate expenses being covered in a legitimate way.

Operator

Thank you. Our next question is from Ken Worthington with JPMorgan. Please proceed with your question.

Ken Worthington - JPMorgan

Maybe first for Debbie. How are you thinking about, or what are you doing on your money market fund in terms of duration and investments, with LIBOR up, how are you thinking about financial services paper coming out of Europe? Does the higher yield offer good value for your funds or are you really trying to avoid that kind of risk at this point?

Debbie Cunningham

From a duration perspective, we have been neutral for the last two quarters at this point. We had had longer duration targets in most of 2007, 2008 and even into most of 2009. We pulled that back a little bit and it's served us well in the context of the steepening yield curve that occurred in the second quarter of 2010.

Our expectation is that that's sort of on hold again at this point. So for now, again we are still in that neutral phase but the potential for going a little bit longer given what we think is a longer period of time before the Fed actually starts tightening, and the curve has already done part of the job for them. That still is a debatable and discussed item at this point. But right now we are neutral across all of our products.

From a European debt perspective, we own European banks within all of our money funds, taxable, tax free, they are counterparts to repo within our government funds. So, we have exposure to European institutions, banking institutions. None of the sovereigns, but banking institutions across the continent during the '07 and '08 credit crunch time period. What we effectively did was shorten the duration on many of those products. So, if we had historically been comfortable using one of those names, at six months we tightened it down to three months. If we had historically been comfortable using it at three months, we tightened it down to one month.

Over the course of this year, year-to-date 2010, that process has begun to be reversed. And for the institutions that we are dealing with, what we've seen over the course of last three months in the European debt situation really hasn't changed that. The ones that we are dealing with are very global in nature. They are not the Spanish saving bank. They are not the smaller German Londis banks. They are the very large global players in the marketplace, and as such, spreads have widened out in sympathy with some of the others and we've taken advantage of that. We don't find this to be truly a setback in the context of their overall credit profile and our metrics of how we are viewing that.

Ken Worthington - JPMorgan

And then I know you gave more of a short-term outlook on fee waivers, maybe thinking about fee waivers a little bit longer term, is the worst over or is there the potential that we get an increase in fee waivers before the recovery is complete? And what I was thinking there is LIBOR is up on some of the stress in Europe as you get closer to a recovery. You would think that that risk would diminish and LIBOR would fall, therefore potentially necessitating a drop in yields and an increase in fee waivers again. What are you guys thinking there as you look out over maybe a couple quarters towards the eventual recovery?

Chris Donahue

Well Ken, it is always possible and that is why we go through the litany of factors that can affect it, , so if yields were to come in meaningfully and not the offset by increases in other portfolios, then sure that is possible. But to really get to your question, you are into where we think the rates are going to go.

And in Debby's answer before we talked about not expecting them to come in meaningfully, but of course that's the possibility.

Debbie Cunningham

I think at this point in 2010, if you do have reduction and the concern about the credit metrics in the marketplace. And as that spreads tightens, based on more comfortability that that's on a solid footing and good path going forward. That effectively comes hand-in-hand with a better economic set of factor. And as such maybe what the yield curve looks like is the same, but with more of the steepness due to positive economic metrics than the thought that the Fed will tighten sooner rather than later, rather than concern from a credit market perspective and spread being the chief reason for steepening.

Operator

Thank you our next question is from Cynthia Mayer with Bank of America Merrill Lynch..

Cynthia Mayer - BofA Merrill Lynch

Just wondering if you could maybe talk a little about the SunTrust deal and how much competition you saw and in general how much competition are you seeing for deals like that?

Tom Donahue

Well you never know who else parties are talking to, we try deal with mostly our clients we've had long term relationship with them. There were lot of rumors on the SunTrust deal that you've read about it in the paper where they were talking to other parties. We just work along methodically in what we are trying to do. And so, in the end I really don't know what was going with somebody else. We came to our conclusion and then signed the deal and are looking for more of them. And there is no really not very many transactions where the other side says, it's only you and you're the only player who is getting to look at it. It is just not the way that it works.

Cynthia Mayer - BofA Merrill Lynch

And why do you think there haven't been more of them given the pressure of fee waivers and all the regulatory uncertainties? What do you think is holding people back?

Chris Donahue

One of the keys I mentioned on these calls before, maybe control is too strong word, but when you are up and concerning and have your fingers on the ability to redeem, you can therefore not redeem and therefore if you are in control of the redemption process you can run money funds through some extended period of time without a problem if you don't blow the credit.

And so the jobs continue, the income continues and everything marches along even though the CFO or whomsoever decides that this isn't a strategic type business. So it takes a long time. Point two, we started putting banks into these businesses in the late 80s and we have been unraveling it over the last several years. So, it took a long time to get banks into the business and I think it goes at a similar pace on the way up and as each regulation comes in, then it adds another piece of weight to the decision to exit. That's why we look for more. But, to answer your question about why people haven't done it, I think those are the two principal reasons that if you are running the redemptions you don't have a problem and it took a long time to get in and it takes a long time to get out.

Tom Donahue

I would just add one more compliment and a pat on the back for us, it is difficult to go through a complex like SunTrust. It's difficult for them to figure out all the nuances and we are willing to put the time and effort in to work with them in order to maintain their clients being treated properly.

Cynthia Mayer - BofA Merrill Lynch

And maybe just in terms of the other acquisitions you mentioned, more transformative potential acquisitions, you mentioned that the net cash from your recent financing leaves you some room for that. Can you maybe quantify what you view as available and talk about whether it's enough for what you have in mind?

Chris Donahue

We pretty much view that the entire proceeds are available in addition to the revolver that we have and that we could borrow more on top of it, we have 22 or so banks that were in that group and they would readily pop their positions for a figure deal.

Cynthia Mayer - BofA Merrill Lynch

And maybe just a follow-up on the MDT, I know you had nagging outflows there for a while. What are the fees on those versus the rest of your equity products?

Tom Donahue

The fees generally on SMAs are in the 30 basis point range.

Cynthia Mayer - BofA Merrill Lynch

Okay. Maybe just one more on money market balances. I think you used to mention sort of the seasonality to money market balances, with the sense of the cash management product with some companies building up balances toward the end of the year. Do you see that anymore or has all of the turbulence in terms of the yield really disrupted that?

Tom Donahue

I mean you see that the statistics on the cash incorporations are of course very high, but I am not sure that we would expect that kind of seasonality necessarily. It feels like the macroeconomics has trumped seasonality over the last couple of years.

Operator

Thank you. Our next question is from Craig Siegenthaler with Credit Suisse. Please proceed with the question.

Craig Siegenthaler - Credit Suisse

Most of my questions are answered, but just had one on kind of aggregate money market levels. And I know it's going to depend a little bit on the level of interest rate. When you think about the $2.8-ish trillion of AUM out there which is really, I think down from a little under $4 trillion. Debbie, where do you think this probably bases out? I'm assuming you think the slope of the next 12 months is probably a lot more narrow as in the slope we saw over the last 12 months.

Debbie Cunningham

Correct. We feel like at this point there is really a leveling off of assets that there is likely expectation going forward, not only from our perspective but from an industry perspective. If you look at where some of those assets went, they went into some bank deposit-type instruments that would be increased, and the yield curve that we've seen over the last quarter has made funds competitive with those products again. And that's why you've seen sort of a leveling off of those asset flows. And the expectation would be that, that will be maintained.

Having said that, anytime you go into a rising rate environment, although we are pushing that out into the 2011 time period, the fact of the matter is we hit no lower from here. So we expect that to occur at some point in the fairly near future. Rising rate environments are definitely companies on a cyclical basis with a decline in assets from money fund perspective because of the lag in the funds versus the direct market. Having said that, we think the good portion of that has already played itself out, and the 3.9 to 2, that's a more than $1 trillion that's gone out from an industry perspective already.

A good portion of what was in there also at its peak, what I will call non-traditional money market investment. They fled the markets during a time period in 2008 and in early 2009, when they were looking just for Safe Harbor, and I would certainly the biggest portion of those are those types of investors are gone at this point.

Craig Siegenthaler - Credit Suisse

So, it sounds like from your thinking we have probably modest downside less and when rates decide to start going up, at that point it could be a little different in prior cycle shift because we are not used to rates being this low. So you may even see a more favorable impact on the flows from rising rates than historical precedent?

Debbie Cunningham

Correct. Money funds are definitely the vehicle of choice from an ease and usage perspective. And to the extent that they are even with or even close to what's happening from a direct market perspective. I think they'll win the game in that regard.

Operator

Thank you. Our next question is from Marc Irizarry with Goldman Sachs. Please proceed with your question.

Marc Irizarry - Goldman Sachs

Just a question on the waivers. Obviously, you are not expecting as much of a change in the impact and I guess a part of that is related to rates, but can you just discuss a little bit about what your AUM outlook is that's embedded in the fee waiver guidance and it's less of the change going forward? And then also, can you talk about the willingness to extend the fee waivers. How should we think about your willingness to extend the fee waiver?

Tom Donahue

I'll take the last one which is the willingness to extend the fee waivers, because what this gets to is a long-term commitment to a business. We are in the middle of our fourth decade of doing the money market fund business, and one of the reasons that we were willing to do the waivers in the beginning was for a commitment for the long-haul, and we think this is still an important thing. And so, as long as the math works, as I'm about to describe which it is, we are okay with doing the waivers and that is that the short term interest rate cover the core expenses of the fund, and this is just an average kind of a number, but basically that means the three basis points roughly of third party expenses and the 7 basis points of administration in order to keep the functions of the funds alive and well. So, if the growth yield and the fund is ten, and those third parties expenses are ten and that is covered, then we are still quite happy to be proceeding with waivers, and that's what happened. We got close to some of those points in early January when the Fed funds rates and repo rates were low single digits. But it didn't last long enough to affect the entire yield on the fund.

So now when we have rates that are periodically in the 20s and mostly in the 18s, you can see that those core expenses are covered. So our attitude is such that given this scenario, we would continue to waive and further from our clients, we get the comment that even if funds are at zero or we've really been having to increasing yields here recently as Debby mentioned, but even at zero the clients prefer to have the funds open evidencing the fact that they're utilized as part of a cash management service.

Tom Donahue

The guidance there $11 million to $12 million is based on assets as they are today.

Marc Irizarry - Goldman Sachs

Now can you just comment on some of the SEC rules on the money market fund industry? Are we expecting a second round or second set of rules coming? What's your view on directionally on the business as it stands today and what's going to be mandated or proposed?

Chris Donahue

The President's Working Group has been studying in conjunction with the SEC various things, but they have not come up. We thought that that would come out as part of the financial reform regulation, but it hasn't. So this is still another effort. The first blush of the President's Working Group was very precise on money funds saying that they were going to do things to quote, enhance the resiliency of money fund, and they are going to keep studying all sorts of different ideas, some of which we of course don't like, like variable net asset value and things like that.

But we believe that overall what they did with the 2a-7 rules was an excellent job of putting best practice and enhancing the resiliency of money fund. Point two, we think that it has worked well in the market place, and that this fact will be very helpful in the next round, and we don't know exactly what the SEC or the President's Working Group may have in store for the next round.

We know that we have been working on this idea, we discussed this the last call which is the liquidity bank, which is a very good private effort, non-governmental effort in order to enhance the resiliency of money fund. But now I will let Debbie talk about the package of rules and how she and we believe that that has impacted the funds and what might be in store there.

Debbie Cunningham

From a standpoint of what's already been enacted or been brought forth to the market, but maybe not put into place yet from a timeframe perspective. If you look at the various sectors of funds, the government money market funds are most affected by the interest rate risk reductions that were put through specifically the weighted average life calculation and this has to do with the longer dated floating rate securities from Fannie and Freddie that were historically a large portion of those products.

If you look at prime money market funds, prime money market funds are also affected by the same weighted average life calculation, but to a larger degree the prime funds are affected by the 10% and 30% overnight and weekly calculations that are required for liquidity purposes. Lastly for the muni sector, the muni-money market sector, it's the credit quality changes, the reduction, the amount of second tier paper that can be used within those products that will cost the most amount of obtained or yield loss in the product going forward.

In the current environment, where you are still working in an interest-rate scenario that maybe 20 to 80 basis points in range at this point, a very little change in overall product yield based on any of these issues that I just mentioned or risk mitigation items that have been have been required by the SEC.

Having said that if you get back into a more normalized sort of environment, the 2% to 3% area, what we are thinking is the result of all of these changes across the board in the various products. It's somewhere in the neighborhood of three to 8 basis point. Any yes, that's a hit when you are looking at something that may have a one or two or 3% yield, but it's not the end of the world. It's something that still allow these products to remain competitive in their market place. Yes, it has gone a long way in reducing the overall risk of the product because of these changes..

Operator

Our next question is from Will Katz with Citigroup.

Will Katz - Citigroup

A couple of your competitors, actually quite a few of your competitors, are increasingly focused on the markets outside the United States and have stepped up their investment spending. Just wondering if you can talk about strategically where you stand in terms of leveraging the non-US opportunity set and how you might go about increasing that opportunity?

Chris Donahue

As we mentioned, we have an investigative team that has been traveling around the world looking for opportunities, and we are able to talk to lots of different people about things. We are not at a point where we can say that we have something lined up, but we do see some excellent opportunities and we remain enthusiastic about doing it. So it's really hard to give a more accurate timing analysis on that other bill, then we remain committed to it and are enthusiastic about it.

Tom Donahue

And so the other thing I'd add is that we've had increased calling effort with clients and potential clients overseas and we've had some success there. That was reflected in the second quarter, we referenced in the growth, but particularly that happened after April. So, we continue the ongoing marketing efforts with our offshore products and we've had some success there lately.

Will Katz - Citigroup

Second question for me, ties into the first part of the answer to that, Chris. Looking at your balance sheet, it doesn't seem like there is a lot of flexibility given where the net deposition is. If an acquisition were to come along and maybe as I said it before, I mean I've heard correctly. How should we think about potential financing of the transaction at this point in time? Is there enough balance sheet capacity to add on debt or would you have use the equity to get something done at this point?

Chris Donahue

Well, I would respectfully demure from your view about the flexibility of our balance sheet. I think we have an extraordinary flexible balance sheet and that whatever deal we would decide to do would have its own ability to finance itself, and then add to our financials. And I will let Tom comment further.

Tom Donahue

Well, I agree with you. We borrowed the money, the $425 million in order to basically keep a lot of it here for deal. Now, what we've done in the interim is invested in our own fund, and as I said before the bank group in there absolutely would increase it on our own if we wanted to and add in the cash flow from what we would buy. And I have great confidence that we would able to borrow to complete an acquisition. We got into some acquisition that was a merger of equal type of thing or huge thing. We would start thinking about stock type of transactions there; at least that will be our first thought process on it.

Chris Donahue

And Bill, just one another thought, and if you look at it from a, typically if you look at typically borrowing capacity and ratios, our debt to EBITDA would be fairly over one time. Our interest coverage is very high interest coverage. So, from the way lenders would locate our balance sheet, they would look at us as having a lot of capacity as well.

Will Katz - Citigroup

And just one final, and comment to make sure I heard you correctly. You mentioned that Q3 comp is $64 million and if so why the sequential increase over the normalized second quarter?

Chris Donahue

Yes, let's do that. Just going back so I don't miss anything on it.

Will Katz - Citigroup

In fact you already covered this. I'll just take a note just quickly.

Chris Donahue

We had lower incentive cost, that was the big thing. We had seasonality in payroll and benefits and we had credits from the insurance recovery, and also Q1 had a previously accrued incentive cost reversal in it. So there is a lot of moving parts there, Bill. The biggest part is that we reduced the accrual for bonuses.

Operator

Thank you. Our next question is from Roger Freeman with Barclays Capital. Please proceed with your question.

Roger Freeman - Barclays Capital

I just had a couple of clean-ups from for some of the other questions, just getting back to rates on where Ken was asking about LIBOR. If we think about prioritizing the short-term sort of rate, measures that are most impactable, can you maybe run through those, I'm trying to figure out where the LIBOR factors in, because Chris, when you were talking about rates, you were talking about teens which I guess its really more like repo rates and short-term treasury rates, et cetera, et cetera and the rates as opposed to LIBOR. What's the interplay there?

Debbie Cunningham

The largest portion of our money market assets has some credit relevance associated with them. This would be our government agency portfolios, our prime portfolios and our tax free portfolios, all of which have some tie back to that LIBOR curve. The portion of our assets that sort of goes in the other direction often times, if it's a credit related event that's causing the spread widening in the LIBOR curve would be our treasury assets, our treasury repo and our treasury non-repo products. Those are a smaller portion of the larger part of assets. The biggest portion of our assets would be reflective and responsive to changes in that LIBOR curve.

Tom Donahue

And just to put it in percentage terms, if you look at the asset base at the beginning of the month, the treasuries would have been about 15% of our assets. So 85% would be in the credit category.

Roger Freeman - Barclays Capital

Following up on Cynthia's question, around other money market managers, banks, et cetera, considering exiting those businesses and that being sort of a drawn out process, with the rate hike expectations being pushed out broadly, does that in any way, do you think, on their part, accelerate any thinking they've got around getting out sooner than later?

Chris Donahue

I don't think it helps, hurts or does much at all. That point is just not a meaningful factor in their decision process.

Roger Freeman - Barclays Capital

And then on the point about a second round of regulations that Marc was asking about, do you think at all that any of that maybe takes a back seat now? I'm wondering at this point with all of the rule writing that the SEC and other regulatory agencies have to do out of the financial reform legislation, there's just simply not enough staff resources to work on anything else.

Chris Donahue

I enthusiastically embrace your observation.

Roger Freeman - Barclays Capital

And then the MDT, when you gave those numbers on sizing that business, what was the base of the equity SMA?

Chris Donahue

It was $6.7 billion at its start.

Roger Freeman - Barclays Capital

Up to $10.5 billion.

Chris Donahue

No, the $10.5 billion was the total size of our business which included Strategic Value, SMAs as well. That was the peak of our total business. So I was reflecting, our total business in SMAs have been cut in half and the lion share of that came out of the movement from MDT from $6.7 billion to $2.0 billion now.

Roger Freeman - Barclays Capital

The deal, the debt that you raised, the $425 million, you said you put that into your funds. I guess that, that's part of your flows for the quarter? Is that right? Does that show up in mutual fund flows?

Tom Donahue

Yes, any purchase or redemption in there would show up in the numbers and just to go back on the MDT numbers, the MDT in total is over $3 billion, the SMA part is down to $2 billion, it was a little over to $6 billion at the time that we did the acquisition, but MDT in total is lower to $3 billion.

Roger Freeman - Barclays Capital

On the quarter-to-date, July flows, it seems like very much a continuation of late second quarter, i.e., money market flows up, ultra short bond up, Prudent Bear up, all the risk aversion flows still favoring you as they were at the end of last quarter, right?

Tom Donahue

I think that's fair. We said growth on the strategic value dividend funds, we had a decent map over from one of the large brokers and that product continues to do well. You still see demand for income-oriented products, even in the equity front.

Operator

Thank you our next question is from Robert Lee with Keefe, Bruyette & Woods. Please proceed with your question.

Robert Lee - Keefe, Bruyette & Woods

Two quick really, frankly, just modeling questions. Just curious, non-controlling interest came in a lot lower than where it's been running for a while. Is there any one-time items that there skewed that downwards?

Tom Donahue

Yes Rob, right above the trading securities, we have a product that we consolidate and we have to consolidate it because of the accounting rules. We don't own it, and so we take a loss in the trading security because it's consolidated and then we back it right back up in the parts that we don't own and then on controlling interest side of things. So to say that one time, if it continues going up, we will have the opposite reaction.

Chris Donahue

That's just the mark.

Robert Lee - Keefe, Bruyette & Woods

And I guess the other part of the mark was reflected partially in the $1.6 million loss in investment income?

Tom Donahue

Right.

Robert Lee - Keefe, Bruyette & Woods

And real quickly, tax rate, has been running a little over 38%, is that a reasonable expectation balance for the year?

Tom Donahue

It's 37.8 as counted on the income statement here and we expect it to continue to stay right around there, 37.5 to 38.

Operator

Thank you. Mr. Hanley, there are no further questions at this time. I would like to turn the floor back over to you for closing comments.

Raymond Hanley

Okay. Well, thank you. That concludes our call and we appreciate you joining us today.

Operator

Thank you, this concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.

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Source: Federated Investors, Inc. Q2 2010 Earnings Call Transcript

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