Eaton Vance Corp. (NYSE:EV)
F4Q11 and Full Year 2011 Earnings Call
November 22, 2011 11:00 am ET
Tom Faust – Chairman and Chief Executive Officer
Bob Whelan – Chief Financial Officer
Laurie Hylton – Chief Accounting Officer
Dan Cataldo – Manager of Financial Planning and Analysis
Roger Freeman – Barclays Capital
Jeff Hobson – Stifel Nicolaus
Ken Worthington – JP Morgan Chase
Michael Kim – Sandler O’Neill
Bill Katz – Citigroup
Jerry O’Hara – Jefferies & Company
Cynthia Mayer – Bank of America
Marc Irizarry – Goldman Sachs
Douglas Sipkin – Ticonderoga Securities
Greetings, and welcome to the Eaton Vance FQ4 2011 Earnings Release. (Operator instructions.) As a reminder, this conference is being recorded. It is now my pleasure to introduce your host Dan Cataldo. Thank you, Mr. Cataldo, you may begin.
Good morning, and welcome to our FQ4 2011 earnings call and webcast. Here this morning are Tom Faust, Chairman and CEO of Eaton Vance; Bob Whelan, our CFO; and Laurie Hylton, our Chief Accounting Officer. Tom and Bob will comment on the quarter and then we will take your questions.
The full earnings release is available on our website at www.eatonvance.com under the heading “Press Releases.” Please also refer to the charts available on that website as we make our comments this morning as they will provide additional color on the quarter.
Please be aware that today’s presentation contains forward-looking statements about our business and financial results. The actual results may differ materially from those projected due to risks and uncertainties in our operations and business including but not limited to those discussed in our SEC filings. These filings, including our 2010 Annual Report and Form 10(k) are available on our website or on request to the company at no charge.
I’d now like to turn it over to Tom.
Good morning and thanks, everyone, for joining us. October 31st marked the end of our FQ4 and full F2011. While the first nine months of the fiscal year was a time of relative tranquility in the financial markets, FQ4 was anything but smooth sailing. Over the course of August and September, Treasury yields fell sharply, credit spreads widened significantly, and market volatility spiked in response to the dual US government budget and Eurozone crises. Reflecting higher market risk levels and moderated growth expectations, the S&P 500 fell approximately 15% from the beginning of the quarter to the market bottom on October 3rd, erasing the entire previous year’s gains. And then quite remarkably the markets reversed course, with the S&P 500 closing October as one of its best months in recent decades.
While rollercoaster rides can be entertaining at the amusement park, in the financial markets they present difficulties for asset managers like Ethan Vance. Those of you who have heard our presentation at the Bank of America Merrill Lynch Financial Services Conference last week know that I characterized F2011 as a year of achievement amid challenges. The past fiscal year certainly did have its challenges, particularly in FQ4, but it was also a year of significant achievement for Ethan Vance. We reached new highs in terms of gross sales, revenues, and most importantly net income and earnings per share. It took a while but we finally surpassed our previous peak earnings levels reached prior to the 2008-2009 bear market, but the year ended with more of a whimper than a bang as volatile markets took their toll on our business results in FQ4 – more on that in a few moments.
For F2011 we had adjusted earnings per diluted share of $2.00, an increase of 28% over the $1.56 of adjusted diluted EPS in F2010. Adjusted diluted EPS was $0.47 in FQ4 of both F2011 and F2010. Reporting adjusted earnings per diluted share is a new practice for Eaton Vance that is designed to help investors understand the true current earnings power of our business. The major difference between our GAAP earnings and adjusted earnings is that adjusted earnings add back the markups or markdowns in the estimated value of non-controlling interests in our majority-owned subsidiaries that we are required under GAAP to include in current earnings.
In addition to backing out non-controlling interests value adjustments, our adjusted earnings calculation deviates from GAAP through other items that management deems nonrecurring or non-operating in nature. Please refer to the table we have included in the press release for further detail on our adjusted earnings.
Our managed assets of $188.2 billion at October 31st, while down from our mid-year peak of $203 billion, were $3 billion higher than managed assets at the end of F2010. We had our best year ever in terms of gross inflows with$54.9 billion in new sales and other inflows up 4% from F2010. We did however see a declining trend of sales results as the fiscal year progressed, with FQ4 gross sales of $11.1 billion down 19% sequentially, and down 21% year-over-year, reflecting the challenging market environment in FQ4. A highlight of FQ4 from a flows perspective was the strength of our institutional business, largely driven by demand from our floating rate bank loan and pair metric-structured emerging market strategies. Combined, we raised $2.2 billion in institutional separate accounts and comingled funds in these two disciplines in the quarter.
Net flows for the full fiscal year were $3.9 billion, which represents a 2% organic growth rate. While in line with average industry growth rates, these results fall well short of our internal 10% organic growth target and our 11% average annual internal growth rate for the preceding decade. Net flows for FQ4 were a negative $2.7 billion as redemptions and other outflows of $13.8 billion exceeded quarterly gross inflows. In the category of “all good things must come to an end,” this marks the conclusion of our streak of 22 consecutive quarters of positive net inflows. We attribute the disappointing quarterly net flows primarily to the difficult markets and high investor anxiety that prevailed through FQ4. Consistent with the external environment, we saw improvement over the course of the quarter: negative $2 billion of flows in August, negative $700 million of flows in September, and flat flows in October – certainly a trend that we hope to build on in F2012.
I know the question on many investors’ minds is when will we be able to get our organic growth back on track and running closer to our historic levels? Although that remains uncertain we do see an abating of many of the challenges we faced in F2011 and a rising of new opportunities. Let me give you some examples. At the beginning of F2011 the municipal bond market was under significant pressure caused by what we and others with long experience there believed to be misguided speculation of an eminent collapse in municipal credit around the country. The projected wave of defaults did not materialize but the vocal conjecture had a big impact on investors, leading to large-scale muni fund redemptions, portfolio liquidations, and bond price declines.
Today, the storm seems largely behind us. State and local governments continue to face long-term financial challenges but have demonstrated an ability to increase revenues, cut spending, and defer new financing beyond what the naysayers could envision. Municipal bonds have been one of the top-performing domestic asset classes of 2011.
The strong performance year combined with an attractive after-tax yield and the prospect of higher tax rates sets this asset class out to be a positive contributor to our flows in F2012, a significant turnaround from the $2.6 billion of net withdrawals we saw from muni’s in F2011. With two distinct Eaton Vance municipal teams – one here in Boston and the [TAS] Group in New York – a broad lineup of income and return-oriented fund and separate account offerings, and a new capability managing ladder muni portfolios, we believe that we are well-positioned to build on our leadership position in muni bond investing in F2012.
Another area where we expect to see improved flows in F2012 is in absolute return funds. You undoubtedly know that much of the growth we experienced in F2010 was the result of the phenomenal success of our global macro asset return strategy. This was one of the best-selling funds in the industry in 2010 as assets grew from under $400 million at the end of our F2009 to nearly $7.5 billion a year later. To ensure that the fund’s rapid growth did not begin to detract from performance, we closed the global macro absolute return fund in the US to new investors on October 1, 2010.
As a result of investments in our infrastructure and the further development of the markets in which this fund invests, we were able to reopen the fund last month. This should allow not only resumed growth of the fund but help us reclaim mindshare with financial advisors in the asset return space. Within the LIPOR asset return fund category we are the market leader with 38% market share as of October 31st. We think the demand for asset return investment strategies is here to stay.
Investors and intermediaries are increasingly looking outside of the Morningstar-style boxes for strategies that provide downside protection and lower risk. We now have a stable of five absolute return funds that we offer to retail investors in the US, and a version of the global macro strategy that we sell to fund investors outside the United States. While we do not currently have an absolute return offerings for the institutional market, this is an area that we believe has significant potential. We expect to roll out our first absolute return strategy for the institutional market in 2012.
Floating rate bank loans are an area of Eaton Vance market leadership that was a big contributor to our net flows in the first three quarters of F2011. The bank loan flows were negative in FQ4 as retail investors turned cautious on credit and the Fed announced intentions to keep interest rates low. We believe that floating rates should be a strong performer for us in 2012. The credit fundamentals of the asset class remain strong, yields are attractive and there remains significant appreciation potential in the wake of the summer selloff; and performance across our line of bank loan funds continues to be outstanding.
High yield is another credit-related income strategy that we believe will contribute strongly in F2012. This is a well-established discipline at Eaton Vance with over $5 billion in managed assets and an excellent performance record for us as primarily a single big credit manager. In a world that continues to be starved for income, high yield offers a compelling combination of strong credit fundamentals, high current yields, and a favorable risk/reward history compared to equities. We see opportunities for significant growth in both our retail and institutional high yield businesses in F2012.
In equities our Parametric and Atlanta Capital subsidiaries are performing at high levels, both in terms of business results and investment results. Parametric has established itself as a leader in applying a structured, active approach to managing emerging market equities and has recently rolled out structured, active strategies in international, global, and core emerging market equities; commodities, currencies and absolute return. Across all product categories, Parametric saw net inflows of $5.8 billion for the fiscal year and ended the period with managed assets of approximately $39 billion.
Atlanta Capital also had an outstanding F2011, further establishing itself as a leader in high-quality US core and growth equity investing. For the fiscal year, Atlanta Capital has over $2.3 billion in net inflows to bring their managed assets to almost $14 billion. On an overall basis, our investment performance remains solid across a broad range of strategies. As of the end of October we offered 27 funds that had at least one share class with overall Morningstar ratings of four or five stars.
If there is a significant internal uncertainty we face going into 2012 it is our large cap value strategy which stands today as a $24 billion franchise. Our large cap value strategy composite largely outperformed its benchmark in both Q2 and Q3 2011, certainly a positive trend, but remains below the benchmark for one-year and three-year performance. Although five-year, seven-year, ten-year and life of manager results continue to compare favorably, particularly on a risk-adjusted basis, the near-term performance shortfall and general weakness in large cap US equity flows caused the strategy to move into net redemptions in F2011.
With $2.1 billion on net outflows for FQ4 and $4.7 billion for F2011 as a whole, a key challenge for us has been that a large a portion of our client base is relatively new to the strategy and did not fully participate in the stronger long-term performance record. We continue to invest significantly in both working to improve the strategy’s performance and maintaining our outreach to clients so that they understand the distinctive qualities of our equity approach and our organization that we believe position us for continued long-term investment success.
We enter our F2012 with unusual uncertainty about the broader economic and market environment and our own near-term business prospects. Can the economy maintain a growth trajectory amid the continuing European debt and US government deficit challenges? Will the political leadership in Brussels and Washington be able to devise workable solutions to today’s seemingly intractable problems? How will the markets respond in 2012? Will we be able to capitalize on the growth opportunities we see for Eaton Vance in the income and alternatives space? Can subsidiaries Parametric and Atlanta Capital maintain their business momentum? What happens with our large cap value performance and flows?
These are the questions the answers to which will likely determine what kind of year we have in 2012. Although I don’t have a crystal ball I believe Eaton Vance continues to be well-positioned for success. We have a broad array of investment capabilities and leading positions in a number of investment categories with high growth potential. We have a solid financial foundation, one of the strongest retail distribution organizations in the industry, and a growing position in institutional and international markets. We have a stable leadership team, an exceptionally dedicated and capable group of employees, and a commitment in investment performance and client service.
For many years we have been a leading innovator among asset managers, bringing to market creative solutions to help investors meet their evolving needs. Will that be a formula for success going forward? Can we revert back to above industry growth rates in 2012? I don’t know for sure but I certainly like our chances.
That covers my prepared remarks. I’ll now turn the call over to Bob to review the FQ4 and year-end financial results in more detail.
Thank you and good morning. As Tom as outlined, 2011 was a record year on many fronts, but also a year where we face a number of challenges given the market volatility and related impact on our asset levels and flows, most notably in FQ4. Notwithstanding some continued headwinds we are optimistic for our business prospects in F2012 and beyond.
We are reporting adjusted earnings of $0.47 per diluted share for FQ4 2011 versus $0.47 in F2010 and $0.55 in this past FQ3. Not surprisingly, this quarter’s earnings as compared to FQ3 results were impacted by the decline in average AUM, which fell from $201.2 billion to $188.2 billion, or 6.4%. This quarter’s earnings were also adversely impacted by losses on investments of approximately $0.02 and benefited by approximately $0.04 because of reduced compensation expense as we paid out less in bonus given the AUM and related earnings decline.
On a full-year basis we are reporting adjusted earnings per diluted share of $2.00 compared to $1.56 per diluted share for F2010, an increase of 28%. This is our highest recorded adjusted earnings ever and surpasses the prior high set in 2007 of $1.63 per share. Our adjusted earnings were driven by record average AUM levels and revenues and continued margin improvement year-over-year.
Our financial condition is extremely sound, which allowed us to increase our dividend, continue to buy back shares, and commit seed capital to new investment ideas. We have used our balance sheet and strong cash flow to position the company for growth in 2012 and beyond. I’ll first highlight our FQ4 results both on a year-over-year and sequential basis and then discuss the full-year financials, concluding with a further discussion on capital planning.
Ending assets under management of $188.2 billion were 2% higher as compared to FQ4 2010 while average AUMs were 6% higher year-over-year. Investment advisory fees were up 4.1% from one year ago, largely in line with the period changes in average AUM offset somewhat by a lower effective management fee rate which dropped one basis point to 51 basis points from 52 basis points in last year’s FQ4. Distribution revenues continued to be impacted by a shift in our fund business away from share classes with higher distribution fees to those with lower or no distribution fees. Other revenue in this quarter was reduced by net losses in our investments in consolidated funds of $2.7 million compared to a $4.8 million gain in FQ4 2010.
Total operating expenses were down 2% year-over-year from $197.5 million to $192.7 million. The decline was largely driven by lower compensation expenses partially offset by higher fund expenses and higher IT costs. Compensation this quarter was down due to lower operating income-based bonus accruals and lower sales incentives given lower sales volumes from one year ago. Amortization of deferred sales commissions declined as a result of fewer Class-D and C-share sales. On a GAAP basis, our operating margin remained steady at approximately 35% over this period.
On a sequential or linked quarter basis, assets under management in the quarter declined 5% to $188.2 billion from FQ3 ending AUM of $199 billion. The drop was driven by market declines of $7.9 billion and net outflows in the quarter of $2.7 billion. Average assets were down 6% from the sequential quarter. Investment advisory fees were down 8.5% as the drop in AUM also impacted the effective fee rate which declined sequentially from 52 to 51 as the market declines were largely in equities that overall command a higher fee rate.
Distribution revenues continued to be impacted by a shift in our business as discussed earlier. Other revenues in this fiscal quarter were lower because of the $2.7 million of net losses on investments in consolidated funds, which compares to a slight gain in FQ3. Operating expenses dropped 9% sequentially from $211.6 million to $192.7 million driven largely by a decline in compensation expense due to lower operating income-based bonus accruals in the quarter as well as lower sales incentive payments in line with lower sales as mentioned earlier.
Our operating margin continued steady at essentially 35% as it was in FQ3 2011. Our ending headcount for Eaton Vance and all of our affiliates was 1159 employees at the end of FQ4 as compared to 1176 employees last quarter, and 1098 the last year FQ4. The decline sequentially relates to a decline in temporary employment due to our summer intern program ending in late August. Our effective tax rate for FQ4 was 45.5%, 38.7% last quarter and 38% in FQ4 2010. Our tax rate in the quarter was impacted by the consolidation of a CLO entity as the losses associated with the CLO are not tax-affected. Excluding the CLO impact, our effective tax rate this quarter would be 40%.
Let me now summarize some key points for the full fiscal year. We are reporting full-year adjusted EPS for F2011 of $2.00 per diluted share compared to $1.56 per share in F2010. As mentioned, we delivered record gross flows in F2011. We began F2011 with assets under management of $185.2 billion, added $3.9 billion of net sales, lost just under $1 billion due to market declines, bringing our ending assets to just over $188 billion. Average assets under management for F2011 were $192.4 billion compared with average AUM for F2010 of $169 billion. We recorded record revenues for the full year of $1.26 billion, an increase of 12.3% from F2010 revenues of $1.122 billion and in line with the increase in average AUM.
We were successful at keeping our administrative and advisory-effected fee rates steady at 51.8 basis points in F2011 versus 51.3 basis points in F2010, and saw a slight decline in our total effected fee rate from 65.8 basis points to 64.6 basis points this fiscal year. Total operating expenses increased 7% in F2011 to $822 million from $768 million. With revenues growing at 12% and expenses at 7% year-over-year, we realized very strong operating leverage with adjusted net income attributable to Eaton Vance shareholders growing at 26% and adjusted diluted EPS at 28% year-over-year. Our GAAP operating margin increased to 34.7% for the full fiscal year compared to 31.5% in F2010.
Now some quick comments on our balance sheet and capital planning results. Our financial condition, both in terms of balance sheet strength, cash flow generation, credit availability, liquidity, and access to capital markets continues to be extremely sound at this time. We have financial flexibilities to pursue various growth opportunities. We have a cash position of $511 million, ending equity of $562 million, a $200 million untapped line of credit, debt not due until 2017, and very strong credit ratings, and importantly, ready access to the capital markets.
We provided some direction to you last earnings call that we would increase our share repurchase efforts in this quarter and we did. We purchased approximately 3.5 million shares for approximately $80 million in share repurchases at an average price of $23.06. Consistent with our philosophy of returning cash to shareholders, we increased our dividend from $0.18 to $0.19, or 5.6% - our 31st consecutive year of an increase. In F2011 like F2010 we were able to use our balance sheet to invest in the business, specifically committing excess cash to new product innovations and to bring new products to scale so that they can be placed on our distribution partners’ platforms. Our long-term investments of approximately $288 million are largely made up of various seed capital investments and strategies.
In F2010, we had net seeded activity of approximately $180 million reflecting seed investments of $280 million and redemptions of approximately $100 million, the redemptions representing success at growing those new products to scale to allow us to take back our original investment. This year we were able to reduce our seed portfolio by approximately $45 million as our investments of $145 million in new product ideas were offset by strong traction in previously-seeded products, allowing redemptions of $190 million. The seed program has had a meaningful impact on our flows and our new product development.
We anticipate further strength in our cash flow generating ability over the course of F2012 and a likely build in cash balances. We will continually evaluate various capital planning activities and maintain financial flexibility for various growth opportunities as they arise.
Now, we’d like to take your questions.
Thank you. We’ll now be conducting the question-and-answer session. (Operator instructions.) Thank you. Our first question is from the line of Roger Freeman of Barclays Capital. Please proceed with your question.
Roger Freeman – Barclays Capital
Hi, good morning. I guess in terms of your comments on the global macro fund, I missed part of what you said. I think you said part of the reason that you were able to reopen it is sort of a change in the market dynamics. What was the other piece and can you just elaborate on the market dynamics piece?
Yeah, two things: one, we talked about internal changes and that’s I would say the more important reason for the reopening. We reopened I believe on October 19th so just over a year when we were out of the market at least with respect to taking new investors. During that time we added significant staff – I believe the number of people in the department supporting that product went from something like, I want to say… I don’t know if you have these numbers, Dan, but I want to say low twenties to 33 people from the middle of F2010 to where we are now. But significant staffing, mostly infrastructure-related people this would be – traders, trading assistants. We also upgraded our systems over the course of that year, so that was one. We have a bigger, more robust department.
The other thing is certainly one of the challenges we faced in 2010 was not so much the size of our business but the scale of our growth. We were at the peak adding about $1 billion a month, and so we went from, in the space of twelve months in the strategy from under $1 billion to something approaching $9 billion; and we just needed a pause to give ourselves, our infrastructure, our trading capability at the time to catch up with that.
In terms of changes in the market, it’s a little hard to be specific there – that’s a comment that comes from our investment teams about their ability to access liquidity, and some of that is a reflection. Maybe it’s more a commentary on the investments that we’ve made that give us access to deeper liquidity and perhaps it’s also a function of the markets themselves. But we certainly feel like that we’re in a position where for the foreseeable future we can continue to offer this product. The capacity is not unlimited but we see a fairly significant running room from where we are today.
Roger Freeman – Barclays Capital
Okay. So from the time you closed it, it sounds like you had plans to sort of catch up on the backend to be able to reopen it, because I don’t recall that that was the strategy that you had talked about. It sounded like it was more of a market issue in terms of your ability to continue to…
Well, there I would say we’ve had net withdrawals in the strategy over the year approaching $1 billion, so the strategy shrunk. We didn’t know what was going to happen. We were allowing continuing investment in the US by existing investors. We also never closed the offshore version of the same strategy for reasons that frankly we didn’t anticipate and for reasons we don’t really understand. We didn’t see a lot of growth in the offshore version and we certainly saw more net redemptions, not huge but we lost about $1 billion in business from existing investors, even though we were open for new business there.
So we shrank by about $1 billion. We didn’t see the potential growth that we had hoped to see internationally. Those things plus the changes in the team and more confidence in our ability to access liquidity were the reasons for the decision to reopen. And that decision, by the way, was made by the investment team ultimately. Certainly there were people on the marketing side that were cheering that decision but it was clearly a decision that Mark [Finetzia] who runs that group and the rest of the portfolio team, ultimately they’re the ones that made the call that we’re confident today that we can invest with the liquidity that we desire, and that we can continue, the team felt, to add value through securities selection and implementation of that.
Roger Freeman – Barclays Capital
(Operator instructions.) Our next question is coming from the line of Jeff Hobson with Stifel Nicolaus. Please proceed with your question.
Jeff Hobson – Stifel Nicolaus
Okay, thank you. So on the global macro, I know it’s been just a few weeks but any initial response on that? And then my other question was Morgan Stanley I guess recently announced some fee increases, so my question is are they catching up? Is this a new direction that you would expect from others and any sense of what type of impact it would have on you?
I guess first on the global macro, we have seen an improvement in our flow trend. The numbers aren’t as of about a week ago, which is the last time I really looked at this closely, we had seen an improvement of I think about $4 billion, $5 billion a day in net flows. We had been trending at a rate of modest outflows on that order of magnitude to being about flat in terms of flows for that product, and that’s really without fully reengaging our marketing effort. And I’m not sure that we’re actually up and running on all the various platforms where the fund is available.
So the early results, and it’s been just about four weeks – our early results is that it is having an improvement, one that will be noticeable over the course of a year. But certainly there’s nothing that indicates that we’re on the verge of going back to the type of growth that we saw in 2009. We don’t expect that and frankly I’m not sure that we really want that because we do have, somewhere out there, there is a capacity limit; and we’d rather continue to grow our assets in a measured pace there as opposed to seeing the types of growth that really strained our capabilities back a little over a year ago.
And then in terms of the question about the Morgan Stanley revenue sharing deal – I did see the article in Ignite this morning. From everything we know, that article was accurate in terms of certainly the general direction and the specifics of the action there. It should be understood that the change there only affects – and this was pointed out in the article – only affects the brokerage part of their business which is maybe a quarter or a third and a shrinking piece of the pie.
This will not be the most expensive revenue sharing deal; it would be certainly on the more expensive side. Ultimately the relationship between providers, asset managers and distributors is evolving. There are benefits to some of the changes for established players like us to offset in part the cost, but we certainly don’t see this as the last step in increasing the cost of retail distribution. It’s not something we have bought, it’s not something we frankly look for but we view it as a manageable change for us.
Thank you. Our next question is from the line of Ken Worthington of JP Morgan Chase. Please proceed with your question.
Ken Worthington – JP Morgan Chase
Hi, good morning. Maybe first on the institutional side of the business, it continues to solve quite well. It seems to be an ongoing continued area of growth for you. Can you give us a greater sense of what’s selling there? I know your outlook was for better high yield but what’s selling well there now? You have an LDI Team – are they continuing to get traction? We haven’t heard about them for a while; and what is your outlook for LDI over the next couple years? Is that still an opportunity for Eaton Vance? Thanks.
The two areas of broadest interest and most significant flows for us have been Parametric’s structured emerging market which is doing quite well and attracting flows, both North American institutional and also offshore – it’s very much a focused product for our offshore marketing team based in London. The other one that is a leading product for us in institutional is floating rate bank loans, so those two are really the primary areas of current focus. High yield is an area that we’ve been active in in the institutional market for a long time. We do think that there is a good opportunity, and it’s not today a major source of flows but we certainly feel that it has the potential to be that in F2012.
We have a team that’s been around, I guess it was probably early, I’d say mid-‘80s when we got into the high yield business, and Mike [Walheimer] who runs that team has been in charge of the group since I would say the early ‘90s. So he’s been at the help for a very long time and we have an exceptionally good track record over the full course of his tenure as well as in recent periods.
One period when we did not perform particularly well was FQ4 2008 and we will over the course of the next few weeks see those results roll out of our three-year numbers; and from the first of January we will have really quite outstanding numbers on a one-year basis, three-year basis, five-year basis, ten-year basis and over the full life of Mike’s tenure of running that team. So we think it’s a compelling story for Eaton Vance as a player in the high yield market and we also think that high yield is a very interesting asset class today given the combination of current yields and attractive risk/reward characteristics, particularly versus equities.
I’m sorry, the other part of your question…
Ken Worthington – JP Morgan Chase
Sorry, so LDI: we hired a team, I guess it would be about five and a half years ago that we focused on the LDI opportunity. They continue to spend some of their attention on that but for the most part they have morphed their primary attention. We actually renamed the group to the Customized Solutions Group and they are the managers of our multi-strategy absolute return fund and also a multi-strategy all-market fund which was just launched in the last couple months. That has been an area for us of real significant growth. So it’s not LDI but it’s that same team.
In the LDI space, I guess the frustration we had – and this is covering the period of 2005 to 2008 or ’09 – was that most clients responded to the drive for liability-driven investing primarily by shifting the strategies they employed with existing managers. There was a relatively small amount of money that was moved in response to the increased acceptance of LDI, at least in the US. And so we were frustrated with our ability to win new business there and that prompted the shift in focus, which occurred over time for this group but principally about two years ago really was the renaming of the group.
And we’re very excited about what they’re doing and very pleased with the business growth they have. They have effectively become our in-house asset allocation group across a range of risk and volatility levels encompassing absolute return-type products as well as going further out the risk and volatility spectrum.
Thank you. Our next question is coming from the line of Michael Kim from Sandler O’Neill. Please proceed with your question.
Michael Kim – Sandler O’Neill
Hey guys, good afternoon. First, just kind of given the period of underperformance for large cap value, at what point do you maybe start to think about making some changes to either the way the fund is positioned or how it’s being managed?
The thing we’ve done, and we measure closely not only the overall performance of the fund but the contribution to performance from various factors, both external things like style factors as well as internal effects, like specific recommendations made by individual analysts. And we’ve clearly determined that the performance of our large cap value team has been effective primarily by style factors; that it’s been a couple of years now of headwinds for quality, a couple of years of headwinds for large cap. And within the competitive universe of large cap value funds, we are certainly larger cap in our focus than many of our competitors, and we are certainly larger cap more quality-oriented than many of our competitors.
We have a disciplined consistent investment style which we believe works over periods of time but does not work necessarily in all market environments. So accepting that, we know we’re going to have periods when we’re going to underperform, but at the same time we look at the individual underlying drivers of performance and we also recognize that there’s been some disappointment in terms of our stock selection. And the way that works at Eaton Vance, there’s an element of that that’s influenced by the portfolio team but there’s also a significant element that resides with the analyst team; and we have made some changes in both our equity investment process, and around the margins have made some small changes in our team.
And so our approach to fixing the performance problem is really twofold: one is at the portfolio level sticking to our knitting, investing in a way that we know makes sense over time, proven over market cycles that this is an effective way to invest; but also looking to enhance the team, looking to upgrade the quality of the team and have made some changes on the analysts team in support of that.
Michael Kim – Sandler O’Neill
Okay, that’s helpful, and then maybe a question for Bob. Any areas where you might look to kind of slow your reinvestment spending just given the environment? And then more specifically on comp, can you just maybe give us an outlook as we look into next year?
Sure, let me take the compensation question first. Sequentially our compensation declined from $95 million to $81 million FQ3 to FQ4, a $14 million decline. All of that decline came in our incentive areas that relate to either sales or earnings. We saw a $3 million decline in our sales incentives because of lower sales volumes. Of the $11 million remaining, $3 million of that related to lower earnings based on our historical targeted amount. The other $8 million relates to us dropping the target in FQ4 to pay out less based on how the year ended in terms of AUM and earnings.
That $8 million becomes important because when you think about FQ1, that $8 million will come back as we target at the historic levels. You’ll also see in FQ1 the typical stock-based compensation increase of $3 million to $4 million, and you’ll also see another $1 million increase in base and benefits and FICA. So you’re going from an $81 million number to probably a $93 million to $95 million number in FQ1, so that’s the compensation question.
I think in terms of areas that we’re looking at, I mean the things that we focus on mostly is managing compensation because it is such a big component of our total operating expenses – roughly 40%. So we will keep a close eye on headcount additions. Also the other area we’ll look at and it’s related is the overall cost of sales which you folks asked a question on earlier, and that has to do with revenue sharing, managing that, managing our marketing expenses which relates, and managing all of those point of sale costs in terms of getting assets on the books. So combined between compensation and cost of sales those are the big key areas.
You didn’t see a big increase in a lot of the discretionary expenses year-over-year. We did put in a new SAP system. We saw some increases in IT expenses that won’t reoccur, but the goal here is to manage all discretionary expenses prudently and to keep a close eye on headcount which tends to be the biggest expense category.
Thank you. Our next question is from the line of Bill Katz with Citigroup. Please state your question.
Bill Katz – Citigroup
Good morning, just a couple questions. The first one: just in terms of looking at the distribution revenues and expenses, I know you mentioned slower sales were impacting that. But how are you thinking about that relationship on a go-forward basis? I’m trying to just understand the best way to model that dichotomy.
Bill, this is Dan. So the distribution revenues are largely driven by the, well in total driven by the mutual funds’ distribution revenues collected on the A-, B-, and C-shares, primarily B and C. We’ve seen it decline in that business and we expect we probably will continue to see it decline in B- and C-share business as brokers migrate to our I-share which is a no-load class and low-load waved A-share class. So that’s largely what you saw in this quarter combined with the fact that these are assets-based revenues and assets were down due to the market.
We would expect to see declines in the expenses associated with those line items. Amortization expense goes down; asset base distribution expenses go down – those are on the C-shares. And in addition you should see a corresponding reduction in service fee expense along with the reduction in assets and the reduction of A-shares as a percent of our total mutual fund assets. So it’s a dynamic. You tend to see more of an immediate effect on the distribution revenue side, and then a little bit of a trailing effect on the expense side, but we would generally expect those to move in tandem.
Bill Katz – Citigroup
That’s helpful. And then the second question is, Bob, you mentioned before the strong strategic position of the balance sheet but then I thought I heard that you looked as though to maybe boost liquidity on the balance sheet. Can you sort of highlight how you’re thinking about free cash flow usage into F2012?
Sure. The capital planning strategy has been very consistent. We do hold a fair amount of cash for financial flexibility. You know we increased the dividend. Our share repurchases year-over-year essentially doubled. I would say going into F2012 the share repurchase activity will be closer to what it was in F2011 than what it was in F2010 and we may not be buying at the same rate we did in FQ4 but you’ll see a comparable level in F2012 as we saw in F2011.
Thanks. Our next question is from the line of Daniel Fanon with Jefferies & Company. Please state your question.
Jerry O’Hara – Jefferies & Company
Good morning, this is actually Jerry O’Hara sitting in for Dan this morning. I just wanted to get any additional color if there was any available for potential new fund launches coming in the pipeline. It sounded like you mentioned something on the institutional front with global macro. I don’t know if there’s any timing that you might be able to share there but anything would be helpful in that respect. And also as a follow-up, if you have any color on flow trends as we are early still in FQ1 2012. Thank you.
Yeah, first on the institutional global macro, that’s a private fund so we’re limited on what we can say about that. In terms of the public funds where we can talk more openly, we’ve had a fairly active season in terms of new product introductions in the last few months, and actually have a couple more planned by the end of the year. Our subsidiary Parametric is the manager of three new funds: they have a structured currency fund, they have a structured commodity fund, they have a structured absolute return fund and we’re on the verge of launching a structured emerging market core country fund – that is limiting investments in frontier markets.
And we are in the midst of a concerted effort to move the positioning of Parametric from at least in their structured active business from what has historically been a focus on emerging market equity. They have roughly $11 billion or so in structured active emerging market equities. They’re in the process of building out a broader family of products, taking advantage of the same investment approach but applying it to a broader range of asset classes. We rolled out a structured international equity product last year in addition to the ones this year.
So one of the things we have going on is our subsidiary Parametric is substantially broadening its range of funds, and the timeframe over which that becomes commercially significant to us is a little bit unclear but over time we believe that this structured approach to investing, which is on the continuum between market cap-weighted index to traditional fundamental active investing is closer to, I guess you’d say somewhere in the middle of the road compared to one end of the spectrum or the other one.
Another new product we have introduced lately: we have an affiliation with Richard Bernstein, a former Merrill Lynch strategist. We launched in October of last year the Eaton Vance Richard Bernstein Equity Strategy Fund, and we recently complemented that by launching the Eaton Vance Richard Bernstein All Asset Strategy Fund. So it’s not just an equity product but has the capability to go across equity, income, commodities and other asset classes. We also have a new Atlanta Capital Fund that we filed and expect to launch at the end of the year, and have as I mentioned earlier a new multi-strategy all-market fund run by our Custom Solutions Team here.
So if you looked at all those in total I think I got everything that’s new over the last few months or planned at the moment. A few key things: the two products there you could probably categorize as asset allocation funds – that’s the Bernstein and the multi-strategy product. There’s an addition to the family of products managed by Atlanta Capital. We today have three funds in Eaton Vance family run by Atlanta Capital – that moves to four and that’s reflective of the good performance and the strong growth they’ve had. And then finally it’s the expansion, the build out of the Parametric lineup of structured, active products. So that’s the list.
We have not seen a huge contribution to growth from, I’ll call it the “class of 2011” funds. They’ve been relatively slow in their uptake but the class of 2010, when we rolled out nine new funds here in the US, nine new open-end funds in the US, continue to be very significant contributors; and in fact, in total were quite significant contributors to our results currently.
Jerry O’Hara – Jefferies & Company
Our next question is from the line of Cynthia Mayer with Bank of America. Please proceed with your question.
Cynthia Mayer – Bank of America
Hi, good morning. Just maybe a couple of quick Morningstar questions. One is do you know when GMAR is going to get its five-year ranking, because it looks like its early years actually had a really good performance? And then what impact do you think the new Morningstar system might have in terms of people, financial advisors using it to screen for funds? Thanks.
The mutual fund Golden Macro Absolute Return Fund was launched I want to say June 27th or some date in late June of 2007, so we’ll have five-year numbers at the end of June next year. The strategy predates that and for some purposes we can use the long-term record of the strategy but Morningstar does not for star purposes recognize that prior record. So it’ll be the middle of next year.
One change for global macro in terms of Morningstar is that the fund was previously categorized with world income funds, which was never a very good fit because we have a much lower volatility than most world income funds and much lower durations, so in time periods when interest rates are generally declining we suffered in terms of our relative performer versus a traditional bond fund. Our duration is well inside a year; other funds we might be compared against would have a duration of often five years plus.
Morningstar recently created a non-traditional bond category that’s not a perfect fit but it’s at least a subset of that that would have I would say a broader representation of a product similar to ours. It’s again, still not a perfect fit but we’re hopeful that as our record develops and that category matures we’ll see more support from Morningstar stars than we’ve seen historically for that global macro strategy.
The new Morningstar analysts’ ratings where, as I understand it they have a gold, silver, and bronze, and I think neutral and negative in addition to that – I think it’ll take a while frankly before that has much impact. It’s a subjective, forward-looking ratings system as I understand it. My guess is people will need some time to get comfortable with that and likely will want to see some evidence that it’s a reasonable predictor of future performance before that has much impact on the market. So I wouldn’t expect it’s going to make much difference for the next six to twelve months.
Over time it’s certainly possible that that does start to influence the directions of flows but it’s a little harder task they’re now taking on. The old Morningstar system, the star system is very much backward-looking, quantitative and people accepted it for what it was. The new system is intentionally forward-looking and that’s a trickier thing to get right on a consistent basis; and unless it does that I think people will place little value on that new service.
Thank you. Our next question is from Douglas Sipkin of Ticonderoga Securities. Please proceed with your question. Ladies and gentlemen, it appears we’ve lost Mr. Sipkin’s line. Our next questioner is Marc Irizarry with Goldman Sachs. Please proceed with your question.
Marc Irizarry – Goldman Sachs
Great, thanks. Tom, if you could talk a little bit about the fee m ix of the new products that are coming on versus those coming off – how should we think about that balance? And then maybe this is a question for you as well, Bob – if you look at the economics of what appears to be maybe becoming a little bit more costly to get on some of these platforms, how are you thinking about the sales incentive-based comp going forward? Is there any sort of plan to maybe address the economics as there’s a little bit more pressure dealing with the distribution channel?
The new funds we have rolling out, I would say, are probably in the midrange of our fee realization rates for the most part. So they’re mostly in mutual funds as opposed to separate accounts; because of the administrative complexity that comes with running mutual funds, they tend to be on average higher-fee products than a standalone separate account, and that’s certainly true here as well.
One new product that maybe we’re spending just a couple minutes on that is a low-fee product that we hope to make some significant progress with in F2012 is our ladder municipal bond portfolios. There’s a large universe of muni’s that historically have been held on the books of financial advisors where increasingly they recognize that they may not have the full complement of research capability and trading skill and access to inventory that allows them to effectively manage those portfolios themselves – where they’re increasingly interested in outsourcing those at a relatively low fee rate to outside advisors.
So this is a laddered portfolio where you put together a portfolio of muni’s of different maturities and then you monitor the credit, but most of your trading activity is related to just replacing bonds as they roll off assuming that there aren’t adverse credit events. So that’s a business that is a low-fee business that we hope to make into quite a significant opportunity for Eaton Vance. If that succeeds that would have an adverse effect on our adverse fee realization rate. But it could be certainly many billions of dollars in assets. We’re still at a pretty early stage there so that won’t be a huge impact on F2012, but longer-term if it’s successful it could start to pull down fees.
Other than that, of new products that are in focus for us, I would say all of them are at least average fee rates. Dan or Bob, did you want to comment on the other part of the question?
It’s a little bit repetitive of what I talked about earlier in terms of the cost of distribution pressures. The three components that we are focused on, one is obviously revenue sharing where hopefully we cement our relationship with our intermediaries; they ask for something and we ask for something in return. Compensation: I think we’re smarter in terms of managing compensation so that we can draw our attention to some of these new seed products and different focus products to drive sales – that’s certainly a component. So those are the things that we’re focused on in terms of managing those pressures that we see in terms of distribution expenses.
I would just add a little to that, Bob, in that when we enter into these negotiations with the intermediaries we don’t just look at what the proposal is in a vacuum. We look at the product mix of the intermediary; we look at the asset retention of the intermediary. We look at the cost of the sales force servicing that channel, the channel in which the intermediary participates in. We look at the cost of the sales incentive paid to our internal sales force. So there are a lot of factors that go into the negotiation and they all weigh in on what we ultimately decide on, so that’s all I would add to that.
Thank you. Our next question is from the line of Douglas Sipkin of Ticonderoga Securities. Please go ahead with your question, sir.
Douglas Sipkin – Ticonderoga Securities
Thank you and good morning. Maybe just a longer-term question about some of the longer-term growth initiatives, specifically the active ETF rollout. I’m just sort of thinking through what you guys are currently largely an active open-end mutual fund company, and I know that is all about sort of active ETFs. I’m just wondering how do you plan on managing that potential channel conflict down the road? I know you guys have talked about mimicking the open-end mutual funds with active ETFs when that thing eventually gets launched. How do you manage that conflict both with your existing investors and distributors?
Yeah, thanks for the question about our initiative and the Exchange-Traded Managed Funds, which is our term for the active ETFs that we’re working on. Just a little background for those not familiar with this – just over a year ago we acquired a patent portfolio in the area of active ETFs, specifically net asset value trading of ETFs in what we’re calling Exchange-Traded Managed Funds. We don’t really see much of a channel conflict. Our goal here is I would say analogous to what’s happened in our mutual fund business over the last few years. When I started my career in the mid-‘80s, our business in the mutual funds area was almost 100% of what we’d call A-shares: a frontend load product.
That evolved into largely B-shares, and then increasingly C-shares and then I-shares. In recent years, the movement from A and B and C has been primarily to I-shares which are today about 60% of our mutual fund sales. I-shares are the lowest-cost form of distribution. They do not have embedded distribution costs – so no 12-B1 fees, no service fees. Our goal with Exchange-Traded Managed Funds is to continue that evolution into an incrementally lower-cost version that as you point out would, as we envision it, be offered alongside of mutual funds but would have lower costs – not lower management fees but lower costs.
And those lower costs come in two areas. One is transfer agent costs which average a little over 20 basis points for an average mutual fund versus less than half a basis point for the average ETF, so we would look to take advantage of the efficiencies of that ETF structure to drive down transfer agent costs. That’s number one. And the second area of cost savings with ETMFs is in the area of cost that the mutual fund incurs to accommodate inflows and outflows. So those don’t show up in the expense ratio but academic research has shown across a broad range of strategies that those can be as much as 50 basis points to 75 basis points on assets per year.
We think across a broad range of strategies, if you add together those two things – the lower cost of flow, and these are costs that don’t exist with ETFs because they create and redeem primarily in kind, so taking baskets of securities as opposed to taking in [cash] – that if we can mimic that in a traditional active strategy and capture the advantages of the lower transfer agent costs by utilizing the ETF structure that we can, across a broad range of strategies, save an incremental 50 basis points or more in costs – both explicit expense ratio costs as well as underlying trade-in costs.
And if we can do that this structure has the potential to be the next step in the evolution of mutual funds, and quite frankly as we view it, put active strategies again on a posture where we can compete on an equal basis versus passive, because passive strategies today are increasingly delivered in this super-efficient ETF structure which really isn’t available to active strategies today unless the manager is willing to disclose full portfolio holdings on a real time basis. We and most other managers don’t want to do that so today’s active investment opportunity in the ETF structure is extremely limited.
So what’s needed is an innovation that allows for non-transparency of current portfolio trading positions. We believe our patented portfolio approach is the best answer for how to do that. It’s not going to affect our FQ1 2012; it may not be in place anytime in F2012. But we certainly believe from a longer-term perspective this has the potential to be a quite significant development, not only for Eaton Vance but for the whole universe of active managers. Our business plan is to commercialize this in two parts, and one is by developing an Eaton Vance family of ETMFs and secondly by licensing the underlying technology to other active managers and earning royalty fees on that.
So not about to happen but we think a very exciting development.
Thank you. Ladies and gentlemen, we have exceeded our allotted time for the question-and-answer session. I will now turn the floor back to Mr. Cataldo for any closing comments.
Well thank you for joining us this morning. We wish you all a happy and safe Thanksgiving and look forward to talking to you in 2012.
This concludes today’s teleconference. You may disconnect your lines at this time and thank you for your participation.
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