Financial Engines' (FNGN) CEO Jeff Maggioncalda on Q2 2014 Results - Earnings Call Transcript

Aug. 3.14 | About: Financial Engines, (FNGN)

Financial Engines, Inc. (NASDAQ:FNGN)

Q2 2014 Earnings Conference Call

July 31, 2014 05:00 PM ET


Raymond Sims - EVP, Chief Financial and Risk Officer

Jeff Maggioncalda - CEO


Hugh Miller - Sidoti & Company

Bob Napoli - William Blair

Mike Grondahl - Piper Jaffray

Patrick O'Shaughnessy - Raymond James

Mayank Tandon - Needham & Company

Avishai Kantor - Cowen & Company


Good day and welcome to the Financial Engines' second quarter 2014 earnings conference call. I would now like to turn the conference over to Mr. Ray Sims, Chief Financial Officer. Mr. Sims, please go ahead sir.

Raymond Sims

Good afternoon, and thank you, all for being on today's call. Before we get started, I need to remind everyone that part of today's discussion will include forward-looking statements, such as statements regarding our operating metrics, anticipated costs and expenses, growth and growth opportunities, strategy, trends impacting our business, our competitive position, impact of new laws and regulations, enrollment rates, implementation and potential impact of enrollment enhancements and strategies, anticipated benefits, success and impact of our services, including our Income+; IRA Management, social security guidance and retirement income planning services, anticipated adoption of our products and services, anticipated benefits and impact of customer experience enhancements, long-term objectives and financial outlook for 2014.

These statements are based on what we expect as of this conference call, as well as current market and industry conditions, financial and otherwise, and we undertake no obligation to update these statements to reflect events, circumstances or changes that might arise after this call. These forward looking statements are not guarantees of future performance or plans and therefore, investors should not place undue reliance on them. We refer all of you to our SEC filings for more detailed discussions of the risks that could impact our future operating results and financial conditions which could cause actual results to differ materially from those discussed in these forward-looking statements. I also want to inform our listeners that we will make some reference to non-GAAP financial measures during today's call. You will find supplemental data in our press release which reconciles our non-GAAP measures to our GAAP results.

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

Jeff Maggioncalda

Thanks, Ray, good afternoon, everyone. Thank you for joining us today. I'm pleased to report that Financial Engines had a solid second quarter. Let's take a look at our numbers for the quarter. Revenue increased 21% to $69.8 million in Q2 compared to $57.8 million a year ago.

Non-GAAP adjusted EBITDA increased 47% to 26.2 million in Q2 compared to 17.8 million a year ago. And non-GAAP adjusted earnings per share increased 56% to $0.25 in Q2 compared to $0.16 a year ago.

In addition to our financial performance, we report quarterly on some important operating metrics including assets under management, assets under contract, total members and enrollment rates, please refer to our SEC filings for definitions of these operating metrics. We had a solid quarter against each of these metrics.

As of June 30, assets under management reached $98.4 billion, a 32% increase from $74.3 billion a year ago, assets under contract increased by 30% to $869 billion from $667 billion a year ago.

Total members enrolled in professional management grew to more than 797,000 members and enrollment rates among employer plans where services have been available for 26 months or more, averaged 13.2%.

There are a number of fundamental forces driving our growth opportunities. As we have discussed previously, demographic trends continue to drive our business. The massive generation of baby boomers is steadily moving towards retirement with the youngest of boomers turning 50 years of age in 2014.

According to the Merrill Edge report, retirement fears top the list of stress inducing situations and pressures for Americans. 61% of boomers aged 51 to 64 are frightened about the possibility of not having enough money to last them throughout their retirement.

Yet despite these fears, less than half of American workers report that they or their spouse have ever tried to calculate how much money they will need to save for retirement according to 2014 Retirement Confidence Survey issued by the Employee Benefits Research Institute.

For many Americans, planning for their retirement can be overwhelming. We believe there is a significant opportunity for financial engines to meet the needs of near retirees as they prepare and transition into retirement.

In addition to demographics, we believe another factor driving our growth is the increased reliance on defined contribution plans. Faced with rising costs and risks, over last 40 years, employers have been shifting away from traditional pension programs.

According to the Department of Labor, the number of active participants in private sector defined contribution plans increased from 11.2 million workers in 1975 to 73.6 million in 2011, an increase of over 500%.

In contrast, active participants in private defined benefit plans declined 27.2 million to 16.5 million, down 39% over the same time period. This shift towards individual accountability for retirement savings, investing and planning is a risk borne by workers today.

Financial engines also continues to benefit from legal and regulatory tailwinds. Earlier this month, the IRS finalized the first part of its lifetime income regulatory initiative with a release of final rules on longevity annuity contracts allowing for the purchase of a qualifying longevity annuity contract in a qualified defined contribution plan or IR account.

A longevity annuity is a type of income annuity with a deeply deferred payout period that usually begins at an advanced age and continues throughout the purchaser lifetime and may have no survivor benefits. Prior to the regulation, participants could not purchase the deferred annuity in their retirement accounts because it required minimum distribution regulations.

Financial Engines has been a proponent for allowing use of retirement assets in a 401(NYSE:K) or IRA to purchase longevity annuities. Delaying an annuity purchase until an advanced age provides greater flexibility to the retiree in their early years of retirement by not locking up assets in annuity and can provide a relatively inexpensive source of lifetime income starting later in retirement that will last their lifetime.

Combined with Income+ and social security guidance, we believe the longevity annuity is another tool to help participants develop a retirement income plan to maximize their household income or retirement and mitigate the risk of outliving their assets.

Establishing final longevity annuity regulations demonstrates that the government recognizes important needs and will rewrite their rules when it's the right thing to do to help Americans achieve retirement security.

We also see a trend of planned sponsors providing more help to participants in 401(k) plans and as a fiduciary to the plan, independent advice is important to them.

A recent AARP survey of employers examined a number of issues related to providing investment advice to plan participants through the planned provider. 77% of plan sponsors in the survey somewhat or strongly agreed that it is important for plan participants to receive investment advice from an independent advisor who does not make money from the plan's investments. So our growth opportunities continue to benefit from demographic trends and increasing reliance on 401(k) plans, legal and regulatory tailwinds, and demand for retirement help in the workplace.

Now, I would like to discuss our strategy to take advantage of these growth opportunities and the progress that we have been making. Let's look at our AUC and the AUM net flows in the second quarter.

I will start with assets under contract which is the value of assets in retirement plans where professional management has been made available. Assets under contract rose to $869 billion by the end of Q2, up from $824 billion at the beginning of the quarter and up 30% over the last year.

The year-over-year growth in the second quarter was driven primarily by the positive performance of financial markets over last year, new employers making their services available, and the steady contributions that participants and employers have been making into their 401(k) accounts.

Fee pressure continues to be prevalent in the industry and requires us to continue to demonstrate for plan sponsors and consultants the value delivered by professional help and guidance. Competitors including new investment advisory firms and established players alike, continued to focus on providing manage accounts to the retail and 401(k) market often at lower prices contributing to ongoing fee pressure. We will need to continue to broaden the scope of the services we offer and to improve the customer experience in order to maintaining our fees and further differentiate from target date funds and managed account competitors as we grow our AUC.

As of Q1 2014, Financial Engines' AUM was larger than all other managed account competitors combined, increasing $21.2 billion in the past year compared to $11 billion for all our competitors combined. We continue to focus our efforts on converting assets under contract into assets under management by improving enrollment. We drive new AUM primarily by offering annual print enrollment campaigns and by integrating ongoing electronic enrollment into our provider partner web site.

In Q2 2014 we added $4 billion of gross new AUM for enrollment. The growth in AUM was due to campaigns and increasing ongoing enrollment. As our installed base grows and matures, it will be important for us to develop new ways of engaging and enrolling planned participants in rollouts, annual campaigns and online through the provider websites.

In addition to the traditional print enrollment campaigns, we are pleased with the ongoing progress from our integrated enrollment efforts and continued to focus on non-campaign enrollment methods. We were actively testing and deploying rotational content with plan participants to drive higher levels of engagement and enrollment. Enrollment for employers rolled out 26 months or more, averaged 13.2% at the end of Q2.

An attractive characteristic of our business model is the built in growth that comes from ongoing contributions from 401(k) participants. Every two weeks, a part of most participant's paycheck is deducted and deposited into their 401(k) account which is usually partially matched by their employer. In addition to AUM from new enrollment, we estimate that our AUM increased by approximately $1.6 billion more in Q2 due to member and employer matching contributions which is an increase of 23% over last year.

We continue to focus on retention of professional management members. For the second quarter of 2014, our average quarterly overall cancellation rate was 2.8% which was somewhat lower than our historical cancellation rate and which we believe it is attributable mostly to favorable financial markets. We believe we can reduce cancellations over the coming years by increasing communication, personalization, flexibility and the breadth of the services that we offer.

Our AUM decreased approximately $1.2 billion due to voluntary cancellations in Q2. A current area of focus for improvement retention is with members in the first 90 days following a completed campaign where we see a larger portion of voluntary cancellations occur. Early indications from retention tests suggested more personalized and concerted outreach during the first 90 days can reduce voluntary cancellations. For example, we're testing an outbound advisor welcome program targeting members who are at high risk of cancelling in the first 90 days after enrollment. In addition to voluntary cancellations, our AUM decreased by $1.4 billion in Q2 due to involuntary cancellations. In total, net new AUM was $3 billion in Q2, including $1.4 billion from net new enrollment. In addition to net flows, our AUM increased by approximately $3.4 billion due to the positive momentum of the markets in Q2. In total, assets under management rose to $98.4 billion by the end of Q2, up from $92 billion at the beginning of the quarter and up 32% over the last year.

Our growth strategy continues to focus on enhancing our customer experience, especially for near retirees with services like Income+, a retirement income feature that provides retirees with a steady monthly paycheck from their 401(k) to a checking account that can last for life.

We are pleased to report that the U.S. Patent and Trademark Office has approved an additional patent application for Income+, titled Creating and Maintaining a Payout Ready Portfolio within an Investment Plan to Generate a Sustainable Payout Stream. This patent adds to the protection of our unique Income+ calculation methodology. The Income+ patent represents our 16 patent issued to Financial Engines.

As I have said in the past, we believe there is an opportunity to establish Income+ as the standard for retirement income in the workplace. As the demographic wave of baby boomers enters into retirement, we believe that employers will be motivated to help generate lifetime income. We believe we are establishing ourselves as the leading retirement income solution and we enjoy multiple barriers to entry and first mover advantage to prevent competitors from encroaching on this landscape.

One barrier to entry is legal protection, which we have just received in the form of the patent. Another barrier is the technological and methodological difficulties of replicating Income+, but perhaps the greatest barrier is the standards effect when a large population of plan sponsors embraces an emerging standard. We are encouraged by the market momentum that we are establishing with Income+.

The seven provider partners, who established Income+ connections, represent more than 95% of our AUC. With provider connections live and available, we believe we can more effectively sell Income+ to plan sponsors. We are pleased that sponsor adoption of Income+ continues this rapid growth. As of June 30, all signed contracts for Income+ represent 161 plan sponsors, 2.9 million participants and over $288 billion in retirement assets, an increase of 83% from $157 billion a year ago. As of June 30th, 81 plan sponsors have made Income+ available to 2 million participants representing $188 billion of assets under contract, which is an increase of 262% from $52 billion a year ago.

We expect the larger benefit of the broader retirement income planning offer, including Income+ and IRA Management to be realized over the longer term, as the demographic wave of baby boomers retiring continues over the next two decades.

With a broad adoption of Income+, we are putting in place the capabilities to provide a unique personalized retirement income planning experience for all participants, especially those nearing retirement. Income+ serves as an integral capability that helps tie together additional capabilities, like IRA management, social security guidance and income planning.

In June, to drive awareness in demand, we formally announced that we are offering integrated social security guidance and income planning services to help near retirees maximize their household income in retirement. The announcement of the launch produced significant media coverage in major national and local print, online and broadcast outlets.

Just one example, Mary Beth Franklin of InvestmentNews and an authority on Social Security, said, I think this new service could be a game changer in the retirement planning industry. The media interest in Social Security claiming strategies has continued with The Wall Street Journal recently publishing a comparison of some online social security services including ours. Our new online social security service available at no charge to all Americans received a 4 star rating and was recognized for ease of use and visual appeal. We are pleased with the media coverage today and believe the ongoing focus on Social Security claiming will allow us to drive AUC growth, engagement and enrollment, especially with new retirees, who account for two thirds of our AUC.

We are finding that participants see social security as a primary foundation of their retirement income plan, and they want help to maximize social security and supplement it with additional sources of retirement income from investments, such as 401(k)s and IRAs.

We are committed to evolving and enhancing our customer experience to meet the needs of new retirees as they transition into retirement by offering holistic retirement income planning that takes into account all of the pieces of the retirement puzzle, not only their 401(k) accounts, but also their IRA accounts, pensions, Social security, Medicare and spousal retirement accounts.

Provider partners currently are committed to supporting Income+ with social security and income planning services represent over 65% of our assets under contract. As of June 2014, the new offering is available online and through our advisor representatives to over 1.1 million participants at 34 large plan sponsors at no additional cost to participants in plans offering Income+. And in addition, the interactive social security planner is available at no charge to all Americans at

Today, the services have identified approximately $2.6 billion in additional expected social security benefits for near retirees going through the experience, based primarily on proposing delaying when the benefits are claimed and for married participants different claiming strategies than what they had anticipated.

We are seeing a favorable reaction to social security guidance and the broader income planning services from plan sponsors, participants, consultants and industry leaders. We are also seeing positive reactions from participants in terms of engagement and satisfaction. Social Security guidance are driving high levels of engagement clickthroughs among participants aged 55 and older. We are seeing high levels of satisfaction among participants who experienced the online or advisor screen sharing experience. Participants value the opportunity to see their own personalized income plan that illustrates how old the pieces fit together and provides them flexibility.

We believe that our near retiree experience with capabilities like Income+, IRA Management, social security guidance and income planning with an advisor will help to differentiate us from targeted funds and make it difficult for competitors to replicate our services.

We also believe that increasing the value of our services will help mitigate the pricing pressure prevalent in the industry. We believe that a strong near retiree experience will drive growth along many dimensions. We believe it will drive AUC growth by appealing to new plan sponsors who are interested in a retirement income planning solution. We believe it will drive engagement and enrollment in AUM, especially among the retirees, who represent about two-thirds of our AUC. We believe the offering will increase retention, by providing a solution to help near retirees to transition from their retirement savings phase, to retiring income planning phase, and allows Financial Engines to serve participants throughout their retirement.

We continue to expand the number of retirement plan sponsors that we serve. At the end of the second quarter we had 583 plan sponsors where professional management was available, representing $869 billion in assets and about 8.1 million plan participants. At the end of the second quarter, we were managing portfolios worth $98.4 billion for more than 797,000 members and half of those members had less than $56,000 in their accounts. And as June 30th, 2014 our advice is available to approximately 9.1 million participants.

In early June, Fortune reconstituted their Fortune 500 list. Based on the old list, we gained two Fortune 500 sponsors and lost none. But due to the new list changes, the number of Fortune 500 plan sponsors who have hired Financial Engines to help their employees has dropped to 144 as of the end of the second quarter.

When I look at the fundamental trends driving our growth, the breadth and strength of our relationships and the quality, scalability, uniqueness of our services I believe that Financial Engines is in an excellent position to take advantage of a growing opportunity to provide everyone with the independent, personalized retirement help that they deserve.

And now I would like to turn it over to our CFO, Ray Sims, to discuss our financial results in more detail. Ray?

Raymond Sims

Thanks Jeff. As Jeff said, total revenue increased 21% to $69.8 million in the second quarter of 2014 compared to $57.8 million in the prior year period. The increase in revenue was driven primarily by growth in Professional Management revenue which increased 25% to $60.7 million in the second quarter of 2014. Professional Management revenue growth was driven by higher AUM which reached $98.4 billion at the end of the second quarter compared to $74.3 billion ending the prior year period. This increase in AUM was the result of increased market performance, contributions, and net new enrollment for marketing campaigns and other ongoing member acquisitions.

Platform and other revenue decreased by 2% to $9.1 million for the second quarter of 2014 compared with $9.3 million for the second quarter of 2013. This decrease was due primarily to platform fee reductions as a result of a small number of sponsor conversions to sub-advisory plan providers, as well as platform fee reductions as a result of sponsors adding new asset based Professional Management services. These decreases were partially offset by an increase in platform fees due to service availability at new sponsors.

Cost of revenue exclusive of amortization of internal used software increased 21% to $27.2 million for the quarter compared to $22.5 million for the prior year period due primarily to an increase in data connectivity fees as revenue increased, and to a lesser extent to modifications to a provider relationship which extended the initial term and made other changes intended to better align the respective interests of the parties. As a percentage of revenue, cost of revenue remained constant at 39% for the comparable periods.

As most of you already know employee related costs are our largest expense and include items such as wages, cash incentive compensation, non-cash stock based compensation and benefits. The expense variance I will be talking about within each of the functional areas was driven primarily by increases in employee related wages, benefits and employer payroll taxes from growth in headcount and increased annual cash compensation, as well as increases in non-cash stock based compensation expense as a result of equity awards granted within the past year. These increases were partially offset by a decrease in cash incentive compensation expense as a result of anticipating lower cash incentive plan percentage achievement for the year-ended December 31, 2014 compared to the year-ended December 31, 2013.

Research and development expense decreased to $7 million for the quarter, down 8% from $7.6 million in the prior year period due primarily to a decrease in cash incentive compensation expense. This was partially offset by an increase in non-cash stock based compensation as well as a decrease in the amount of internally used software capitalization as more developer hours were dedicated to updating and maintaining existing core services in the current period.

As the percentage of revenue, R&D decreased from 13% in the second quarter of 2013 to 10% in the second quarter of 2014 as cash incentive compensation expense decreased and other employee related expenses grew at a slower rate than revenue.

Sales and marketing expense increased to $11.8 million for the quarter, up 8% from $10.9 million in the prior year's quarter. This increase was driven primarily by growth in wages, benefits and employer payroll taxes, as well as an increase in non-cash stock based compensation which were partially offset by a decrease in cash incentive compensation expense.

As a percentage of revenue, sales and marketing expenses decreased from 19% in the prior year period to 17% this quarter, as cash incentive compensation expense decreased and other employee related expenses grew at a slower rate than revenue.

General and Administrative expense increased to $5.6 million for the quarter, up 8% from $5.1 million in the prior year quarter due primarily to increases in non-cash stock based compensation expense as well as wages, benefits and employer payroll taxes which were partially offset by a decrease in cash incentive compensation expense.

As a percentage of revenue, General and Administrative expense was 8% in the second quarter of 2014 compared to 9% in the second quarter of 2013 as cash incentive compensation expense decreased relative to the increase in revenue.

Income from operations as a percentage of revenue increased to 24% for the second quarter of 2014 from 17% in the prior year period. The Company's effective tax rate increased to 40% in the second quarter of 2014 compared to 35% in the prior year quarter due primarily to a decrease in excess tax benefits associated with disqualifying stock dispositions.

Net income increased to $10.1 million in the second quarter of 2014 compared with net income of $6.3 million in the second quarter of 2013.

As many of you know, we look at non-GAAP adjusted EBITDA as a key measure of our financial performance. Our earnings release has a table that reconciles our GAAP net income to adjusted EBITDA.

Adjusted EBITDA in the quarter increased to $26.2 million, up 47% from $17.8 million in the second quarter of last year. Adjusted EBITDA is one of the metrics we used to determine employee cash incentive compensation.

We provide further information about the calculation of our non-GAAP adjusted EPS in today's earnings release. Non-GAAP adjusted EPS was $0.25 per share in the second quarter of 2014 compared with $0.16 per share in the second quarter of 2013.

In terms of cash resources, as of June 30th, 2014, we have total cash, cash equivalents and short term investments of $281 million compared with $216 million as of June 30th, 2013. On July 29th, 2014, Financial Engines Board of Directors declared a regular quarterly cash dividend of $0.06 per share of the Company's common stock. The cash dividend will be paid on October 6, 2014 to stockholders of record as of the close of business on September 22nd, 2014.

Now on to our outlook for 2014. Based on financial markets remaining at July 28th, 2014 levels, we estimate 2014 revenue to be in the range of $277 million and $282 million and 2014 non-GAAP adjusted EBITDA to be in the range of $98 million to $100 million.

Using only the S&P 500 Index as the benchmark for equity markets, we estimate from July 28th, 2014 market levels a sustained 1% change in the S&P 500 Index on July 28 through the end of 2014 would impact our 2014 revenue by approximately 0.33% and our 2014 non-GAAP adjusted EBITDA by approximately 0.6%, all else being equal.

While we have historically provided sensitivity based on the S&P 500 for simplicity, we encourage investors to utilize the percentage breakdown of our aggregate portfolios provided in the earnings release to run more accurate market sensitivities as international equity and bond market performance may deviate substantially from the S&P 500's performance. The recommended indices are the Russell 3000 for domestic equities, the MSCI EAFE Index for international equities and the Barclay's Capital U.S. Bond Index for bonds.

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

Question-and-Answer Session


Thank you, sir. We will now begin the question-and-answer session. (Operator Instructions). The first question we have comes from Bob Napoli of William Blair, please, go ahead. Sorry, that's going to be Hugh Miller of Sidoti.

Hugh Miller - Sidoti & Company

So I had a question just on the expense side of things. Obviously seeing a meaningful improvement in the operating margin during the quarter I was wondering if there is anything that we could consider to be non-recurring as a benefit in the quarter? Especially as we consider the updated adjusted EBITDA guidance and as we look at that metric would imply a lower rate of adjusted EBITDA per quarter in the second half of the year relative to 2Q. So I was wondering if you could talk to us about that, how we should be thinking about expenses on a go forward basis.

Raymond Sims

One of the comments we make consistently is that we strive to have our expenses grow more slowly than revenue. They grew more slowly than that in this quarter, largely driven by a lower accrual for our cash incentive plan. We expect that to be persistent for the year. We come up with those plans every year. They are aggressive. They leveraged. And based on the plan for this year, we reduced the amount we accrue. That affected each of the items of expense and we are accruing at a rate that we believe will persist for this year but probably not for next year.

Hugh Miller - Sidoti & Company

So what you are saying is that the lower rates should continue through the back half for the year, consistent with what we saw in the second quarter? Is that correct?

Raymond Sims

Yes. And our outlook both on revenue and adjusted EBITDA should reflect that.

Hugh Miller - Sidoti & Company

Okay. Because obviously barring any type of large pullback in the market or something like that, the $99 million rough midpoint of adjusted EBITDA relative to what you already accomplished in the first half wouldn’t -- would lead to a slightly lower quarterly run rate in the back half of the year compared to the second quarter. Is that just you being conservative or is there something else we should be thinking about for the margin to potentially compress from the second quarter levels in the back half of the year?

Raymond Sims

I think what we said often is that we continue to invest in areas that we expect will help us grow. And ongoing hiring and other expenses in the second half would be consistent with that objective. We were pleased and surprised at the percentage margins but given a choice we would tilt growth up a little bit and spend to achieve that.

Hugh Miller - Sidoti & Company

Okay. So there is the anticipation that you might be spending more in the back half of the year on investment opportunities?

Raymond Sims

I think a little bit of that is built in. The differences are pretty subtle, but yes.

Hugh Miller - Sidoti & Company

Okay. And can you give us an update about the utilization of best practices campaign with plan providers that have a lower penetration rate than the average? It's something I think that you guys had talked about focusing as another area for improving penetration in growth? And where do things stand on that?

Jeff Maggioncalda

So the way that we typically think about it is getting the practice in place whether that's a print campaign where we have a certain type of template that we use with certain content on it, or in the place of integrated enrollment where we built into the provider website, having a standard placement and technology that allows us to serve up dynamic content. I would say for the most part, we are pretty much standardized on most of the providers.

In terms of when we do the campaigns and when we turn on the integrated enrollment, it's pretty much best practices. The way that this works though is the deployment happens over the course of a year as more sponsors do their annual campaigns. Typically, that's one per year and as individuals log in and see this new content on the provider web site. So I'd say that our placement of best practices is pretty broad and the deployment and the actual impact of that will continue to happen gradually over the coming quarters.

Hugh Miller - Sidoti & Company

Okay. And is there any feedback that you are hearing from the campaigns that were going on in the second quarter? Just with regards to, obviously, earlier in the year you published these study about the do-it-yourself returns versus people who are getting professional help, and whether or not that's resonating with prospective users and as a possible , marketing benefit to get people more excited about using the program?

Jeff Maggioncalda

At a really high level, that report is helpful. It's definitely helpful to us. And there was recently a GAO report that came out last week on Thursday, I think, that talked about the importance of having some type of performance data. I'd say that so far for participants, having more recent numbers is helpful. They expect if they signed up that the performance would be better than if they did it themselves, and it's helpful for them to see that data and to have it more current.

Particularly though at the plan sponsor and plan consultant level, I think it's been particularly helpful whereas a fiduciary in a price sensitive environment, they want to make sure that the fees that their participants are paying are worth the services and the costs. And so having something that sells on a current and pretty broad basis, participants who sign up for these services net of fees do better than they do on their own, is pretty helpful as a fiduciary documentation at the point of sale.

Hugh Miller - Sidoti & Company

And as we think about new enrollment, if memory serves me correctly, I think that over the 2Q and 3Q, there tends to be a little bit more of a seasonal benefit as people may be more looking to do new plan enrollment with new campaigns. Any reason why the seasonal aspect was maybe a little bit less pronounced this year than in years' past?

Jeff Maggioncalda

Part of it is sort of a lumpiness effect where a couple larger sponsors will say, maybe did it in Q2 last year and are going to do it in the second half don't show up in Q2, I do think, too, that as we think about the print campaigns which produces a lot of this, as we have said before the effectiveness as you hit participants with the same print campaign each year for multiple years, the effectiveness diminishes overtime. And so continuing to revitalize the print campaigns and migrate more to a digital dynamic and more relevance based integrated enrollment strategy is going to be important which is why we continue to mention that.

Hugh Miller - Sidoti & Company

Okay. And then, the last question would be just with regards to getting back to the guidance and then on the revenue side. Can you just touch base with us again or remind us why given the strength of the market appreciation in the quarter that the increasing guidance for revenue compared to last quarter was as modest as it was?

Raymond Sims

In part because we look at what happens monthly, although we only put out the financials quarterly and we lost about $1 million just based on the monthly numbers versus what you would calculate as the ending quarterly numbers in Q2. So the increase to $277 to $282 reflects the starting point that we are at right now plus what we anticipate happening for the rest of the year. Within rounding it is consistent with market changes over the period when you average them over the shorter time frames.


Next we have Bob Napoli of William Blair.

Bob Napoli - William Blair

Just to be clear, the adjustments you made in the cash bonuses essentially was a catch up from the first quarter and the second quarter, which is why you got more of a benefit in the second quarter than it'd look like going forward, correct? I mean it was catch-up for two quarters?

Jeff Maggioncalda

It was a catch up in that we accrued less in Q2. So the total amount accrued for the first half is consistent with performance against that metric. That's right.

Bob Napoli - William Blair

Now what are the metrics that you are using to accrue? What growth in -- I mean is it an asset AUM number, is it a revenue growth number?

Jeff Maggioncalda

It's a couple of metrics that have lots of different factors involved. But they basically come down to profitability and growth. So one is on adjusted EBITDA and as Ray said, there is sort of a leverage plan where the sensitivity to performance is pretty steep.

The other one is what we call new management fee run rate. In fact, this year we call it net new managed fee run rate. So it's essentially the amount of AUM you bring in times the basis points that we get off of that AUM, minus the AUM that you lose in the quarter, times the basis points of that AUM that you lost. And that's the net new management fee run rate. So that's the growth element of it. So those are the two primary components. And they, obviously, involved pricing, gross enrollment, cancellations, sponsor terminations and all sorts of things.

Bob Napoli - William Blair

I can follow up on that. Now, the AUM that you brought in during the quarter, the $4 billion, what's little surprising to me is that the other market adjustments of $3.4 billion was far bigger than it looks like it should be with the market. But you were a little bit light on our new enrollment number. I just wondered is it getting more competitive with target date funds on the -- to bring in as many assets from new enrollment as you did? I mean you're down a little bit a year from last year.

The target date funds seem to be taking some more market share. Are you -- has it become more difficult for you to increase that penetration rate and to bring in the same amount of assets at the same pace that you had?

Jeff Maggioncalda

Yes. It's really hard to say exactly the effect of the target date funds as it relates to participant enrollment. At the sponsor level, clearly target date funds are now in the vast majority of plans. 90% of our clients have target date funds and we continue to pretty effectively demonstrate new features that target date funds don't really offer to continue to grow at the sponsor level. At the participant level, clearly, more and more of the AUC, if you will, is in target date funds. One of the things that the Help report showed is that 60% of people in target date funds are misusing them. They sprinkle their money all over the place. And when they do that, their performance is about 200 basis points lower than people who concentrate their money properly in the target date fund, but there is a lot of money.

But there is some marketing noise. It's hard to say exactly, but I imagine especially at the younger populations where people are being defaulted in the target date funds more frequently, there is a bit more noise and competition there. A big reason why we are focused on the near-retiree and income planning piece is the combination of that's where the balances largely are and that's where our services are really different, and in particular, highly relevant to people in providing services the target date funds can't really match.

Raymond Sims

Yes. I'd emphasize something Jeff mentioned earlier, this is Ray, that last year's number, which I believe was $4.8 billion of gross new had a couple of very large plans whose campaigns might have been scheduled for this quarter and the number might have been a bit larger and they are pushed into the second half of the year. So we expect that the largest single factor is probably the delay of those campaigns. And typically, we would see Q3 as our largest quarter for new AUM.

Bob Napoli - William Blair

Okay. And then just last question. You guys are -- it seems to me that you've generated a ton of cash. And it seems like that you should have a buyback in place unless you are telling me you have some other plans for that cash?

I know having a strong balance sheet is probably important. You're dealing with so many Fortune 500 companies and -- but you really don't look at M&A. When your stock is somewhat volatile and there are opportunities to buy back stock at what could be very accretive rates, and now that you've generated so much cash, continue to generate cash, project to continue, why not -- unless you're going to tell me you have other strategic reasons for that capital, why wouldn't you have some form of a buyback out there?

Raymond Sims

It used to be if you opened a bank account, you got a toaster. And I am told now that if you have $300 million in cash, you get a toaster. And so we're rapidly working for our first toaster. But no, seriously, it's obviously a Board level decision to decide what the right amount of capital and what the most sensible way to return it to shareholders is. And as you know, we introduced a modest dividend about a year-and-a-half ago. We increased it this year.

If you will, there is a very small stealthy repurchase program because when RSUs vest, we reduce the shares that employees get and pay the tax in cash to the IRS. So the net issuance is offset by the tax affected essentially repurchased, although it takes the form of a cancellation. And then we pay the tax in cash. But obviously, as the cash balance increases and given the strategic options facing the Company, the Board will from time-to-time take a look at what is the most sensible way to organize our balance sheet.


Next we have Mike Grondahl of Piper Jaffray.

Mike Grondahl - Piper Jaffray

Could you guys talk a little bit about the IRA product and the Income+ product and just how they performing against your expectations?

Jeff Maggioncalda

So with respect to Income+ and IRA, and those are related obviously. Income+ being a methodology for managing an account that allows us to produce these monthly payouts. Income+ works on 401(k) accounts if you want monthly payouts from that. It also now works on IRA accounts if you want monthly payouts from that.

I think that the way that we really see it is that Income+ is a methodology that allows us to put together this holistic income plan. With Social Security, there are annual payouts that come from you and your spouse claiming. And with you and your spouse's 401(k) and IRAs, Income+ allows you to also translate those lump sums of money into monthly payouts.

So I think that when we think about the performance of these, the way that we are thinking about it is establish Income+ as the standard methodology for retirement income and 401(k) plan, and then use it to put together this holistic retirement income view for participants. In that sense, we have found social security to be one of our most effective ways of driving engagement among people older than 50. And the income planning, particularly when you do it with an advisor, the income planning is all basically Income+. It is the experience you have when an advisor shows you when the money would show up and what accounts you would spend. It is definitely an integral part of that income planning experience.

So I would say that right now the biggest effects of Income+ and IRA is the ability to offer this holistic retirement income planning. The balances in IRA accounts are still very modest. But the idea is that when we engage people on this broader household picture of retirement income, Income+ will allow us to manage multiple accounts both, for the member and their spouse. But right now, it is mostly just being used to pull that picture together in the anticipation that we can broaden and lengthen those relationships.


The next question we have comes from Patrick O'Shaughnessy of Raymond James.

Patrick O'Shaughnessy - Raymond James

To follow up on a question about your capital return policy, are the range of options that you guys would think about, would a special dividend ever be something that you would consider as one of your potential options?

Raymond Sims

Well, as I mentioned that's a Board level decision. And I don't think the Board has either ruled anything in or anything out at this point in time. We have studied the history of companies that do special one-time dividends. They seem to be concentrated among companies with a very high ownership in one or two individuals, typically founders. So companies like Microsoft and Oracle, have declared large one-time special dividends which was mostly a tax planning exercise for Bill Gates and Larry Ellison, respectively. The stock movements of companies that have done that over the sample we looked at were not sustained over long periods of time. So while I wouldn't rule it out, I would say in those discussions it is probably the least likely of the passive balance sheet modifications we might make to the capital structure.

Patrick O'Shaughnessy - Raymond James

Next, the JPMorgan Great West tie up. Have you guys heard anything new about what implications of that merger might be for you guys?

Jeff Maggioncalda

As we look at this, obviously, the first stage is the deal negotiations. The next one, they announced it, and then there is all the integration. And then there is a client servicing and client expectations. When this was first -- even before it was actually announced as it was being put together, we viewed this as something that had uncertainty associated with it, probably had more upside than downside, and that's what we said in the early stages right after the announcement.

The way I would characterize it is as this deal progresses and the integration and planning happens, and the clients are getting ready to see what's going to be the new world under an integrated Great West Life and JPM offering, we feel at least as good as last time we talked to you guys about how this might set up for us.

So without saying definitively that it is going to turn into a win, we feel good about the way the execution's been going. We think there is a lot of ways that we can continue to serve the client bases that we do. And in addition, there are many possibilities for us to extend the offering. So you never know for sure, and any change introduces risk but we feel like this could be an opportunity.

Patrick O'Shaughnessy - Raymond James

And then last one for me. So as you're working on Income+ and your other retirement focused solutions, what sort of buy-in do you get from the plan sponsors for those? Because obviously, they don't have fiduciary responsibility for their employees once their employees have retired. So what sort of promotion efforts are you giving the sponsors to actually put behind these new products?

Jeff Maggioncalda

Yes. So it is a really good question, sort of the relevance of retirement income solutions to the plan sponsor. I would say that what makes these solutions relevant, the reason the issue comes up mostly is that plan sponsors are hearing their participants particularly, of those aged 50 and older, saying, hey, I need to start thinking about when I can retire and where the money's going to come from. And I'm worried about outliving it. And I see that you've frozen our DB plan and I'm worried about our medical costs and the retiree health benefits are going away. There is just a huge amount of angst and oftentimes disruption among those near retirees at the plan sponsor level. And the plan sponsors feel like it would be nice to do something for them. Even if after they leave us, it's not really going to be my problem, increasingly, and Cerulli says the trend will continue, people leave the Company and leave their money behind.

So it is the case that many people after they retire leave their money in the 401(k) plan where the sponsor still is the fiduciary. But the way that I see the effect going I think it plays favorably to us is that plan sponsors are trying to meet the needs of participants facing a very difficult and challenging time. And mostly what they don't want is to increase their fiduciary responsibility by putting an annuity in the plan.

They don't want to put in something that they couldn't have flexibility and change by putting an annuity in the plan. They don't want something that's very expensive. They don't want something with counterparty risk. They don't want to deal with another entity. They want to make sure it's a fiduciary. They want to make sure it conforms to current legal regulatory environment. And Income+ just checks all those boxes. So I think the receptivity of Income+ so far is it's easy, it is safe in a sense that it falls under existing and fairly clear regulatory frameworks. It doesn't cost you or your participants anything. It's just built in. The fact that we are here early with such an easy solution I think is a major reason why we are picking up a lot of market share in the retirement income space.


The next question we have comes from Mayank Tandon of Needham & Company.

Mayank Tandon - Needham & Company

Jeff, when I look at the new enrollment numbers just on an absolute basis and maybe you touched on this earlier, sorry if I missed it, could you just comment on why the numbers have been trending lower versus if we look back at 2013 and even back at 2012 on an absolute dollar basis, it would seem we would have seen better growth in the new enrollment rates. Is it just a function of the low hanging fruit has been captured and now is becoming much more competitive to win new enrollees into your service?

Jeff Maggioncalda

Yes. So I think that it's a number of things. I think that part of it is the seasonality of it. And particularly for larger sponsors, if someone goes in one quarter versus another one, it could produce a year-over-year difference that might look bigger than it is. We saw a little bit of that in Q2. There was a couple of big ones last year that did not happen in Q2 this year and we think it's going to be later in the year. There is a little bit of the low-hanging fruit and that's highly related to something I did already mention which is the diminishing impact of doing the same print campaign year-over-year. So the fact that it's print and it shows up only once per year and hasn't changed a lot is one effect.

Another one and this really gets to the need for the more integrated digital marketing, is that we need something that is there more frequently, changing more frequently and targets the individual.

Another thing that we are really interested in and working on, which is looking at the segmentation a little bit more closely, the services that we have, for the most part you need to either sign up or not sign up and that's that.

With Social Security, we are embarking on a strategy to penetrate what we think is a broader segment. People who aren't ready to quite say, you know what, here, I will hand the keys over to you. You take care of everything. I trust you. I just want to delegate this.

The people who say I am interested in this but I'm not really sure. I am close to retirement, got a lot of money here. I want to get to know you a little bit first. I want to try this a little bit. I want to make sure that I understand the nature of the services and develop a sense of familiarity with your services and your firm.

And a big part of our social security and retirement income planning that we have talked quite a bit about is the fact that it is available to all participants, even if they don't sign up for managed accounts. And even the ability to talk with an advisor and do income planning with screen sharing available to everybody even if you are not signed up for managed accounts, we think is a way to get to the next segment of folks who are not so desperate just to delegate it, but they want to get to know us a little bit more. So I think it's a combination of revitalizing the print, moving more towards digital, and creating more ways for the next segment of folks to interact with our advisors and get to know us a little bit before they sign up.

Mayank Tandon - Needham & Company

And then I will ask one more question, in terms of the IRA opportunity. When can you realistically expect that to start to contribute to revenue, and would you also consider expanding your relationships beyond the two that you currently have?

Jeff Maggioncalda

Yes. I think on the when question, it really is going to be a function of can we tie-in IRA on a relevant basis to this retirement income service. One of the things that we have found is that people often think of their 401(k) as just an employee benefit. And in order to talk about the IRA, they really want to do that more in the context of a bigger retirement income plan solution. So I think that the success of IRA will be tied to some degree on the success of providing this more holistic retirement income solution. I don't think it's going to show up -- very modest contribution in 2014, perhaps a bit in 2015, but not even significant. I think it is a little bit further out than that.

And to your question about whether we'd expand it, we could certainly see that possibility. It's more convenient for people if we can manage their accounts in place. Today, we do that at Schwab and (inaudible). People have their IRAs at other places as well. And I think to the extent that we can manage them in place without having them to move to an account if they're not at Schwab or TD, would make it more convenient, can help us build our AUM more quickly.

Mayank Tandon - Needham & Company

Okay. And then one quick one for Ray. Ray, in terms of the tax rate that has been bouncing around, I think you've guided previously to a high 30% tax rate. Is that still intact for the second half of the year?

Raymond Sims

So, let's see. There is a couple of things. We have to use our best estimate of the tax rate for the year. And at the moment we are in an environment where Congress in its flurry of inactivity has not renewed the investment tax credit. So we lose some tax benefit, although this is all book taxes. We are not a cash tax payer, probably won't be for a few years. So this is all the book tax rate.

We do lose some because we are unable to accrue the benefits of the investment tax credit. That has happened before. When it's happened before, Congress has retroactively renewed it and we get the benefit of all in one quarter, which has happened in the past.

I think one of your colleagues pointed out the stock price is a bit lower than it has been. That's a fact that's not lost on our employees, and we have a lower level of disqualifying dispositions, which mean we don't get the tax benefit from the excess stock credit that we otherwise would have which has tended to be the largest element pushing the rate up to 40% in the quarter. That's our view for the year. To the extent, either of those factors change, the rate is likely to come down.


Next we have Avishai Kantor of Cowen & Company.

Avishai Kantor - Cowen & Company

Yes. Hi. It's Avishai Kantor for Moshe Katri. Two questions, can you talk a little bit about the pricing pressure in the industry? Can you give us some color and your plans to offset that?

Jeff Maggioncalda

So obviously, pricing pressure is something that has affected the whole industry largely over the last five years or so. it preceded that a bit with rise of ETFs and index funds in the end asset management industry. We have been talking about it for a long time, largely as the price of targeted date funds has come down. I think some people have mistaken our talking about pricing pressure as we are lowering our prices. And if you look at what a lot of folks do, they look at Professional Management revenue divided by average AUM for the quarter, that's been pretty steady. It's been slightly down over the years as we've hit some of these provider break points and more of the revenue has gone to the record keeper that's been affecting our gross margins.

But overall, it's been pretty flattish. And so rather than reducing our prices, we have really been working at differentiating our offering and doing that with things that are available to more people. So we mentioned in the press release, the script, as well as when we did the big social security launch, the amount of value that is being created by the social security service, and this is available to folks at no fee, is literally over $100,000 for the typical person, in expectation for the typical person that uses the service.

Obviously, this overwhelms any fee that we would be charging on their portfolio given the fairly modest balances. And the Help report that we referenced earlier also is pretty helpful to say net of fees, having a professional manage these accounts, it pays for itself on just a performance basis, let alone talking to an advisor in Social Security and income planning and all these other things.

So I think the fact of the matter is when you really look at the data, there is a lot of evidence that says that the value that we offer overwhelms the fees, but nevertheless people talk about fees and the prices of commodity products like target date funds has been coming down. We feel like we have been doing a pretty decent job though of running that rate, adding more value and holding our fees relatively constant.

Avishai Kantor - Cowen & Company

And my next question, can you talk a little bit about R&D expenses going forward?

Raymond Sims

One of the areas where we are most actively hiring people is engineers to go into R&D. The expenses as reported are a little bit complicated because every day all the engineers come in to work and they do what they do. And based on what they do we either capitalize and amortize it as internally use software development, or we expense it as ordinary expense.

So the numbers you see in the financials each quarter are the net of the amortization of previously capitalized internal use software development, the current expense minus what we currently capitalize for internal use software development.

As we mentioned in the prepared remarks, the base compensation is up and stock related compensation is up in the R&D and is offset as each of our line items were by reductions in incentive cash compensation accruals. I would expect R&D would grow more slowly than revenue but not significantly more slowly than revenue and perhaps a bit faster than some of the other areas of expense below the gross margin line.


This will conclude our question-and-answer session and today's conference call. We would like to thank the management team for their time today. And we thank you all for attending today's presentation. At this time you may disconnect your lines. Thank you. Have a great day, everyone.

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