Waddell & Reed Financial (WDR) Henry John Herrmann on Q4 2015 Results - Earnings Call Transcript

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Waddell & Reed Financial, Inc. (NYSE:WDR)

Q4 2015 Earnings Call

February 02, 2016 10:00 am ET

Executives

Henry John Herrmann - Chairman & Chief Executive Officer

Nicole McIntosh-Russell - Vice President-Investor Relations

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

Brent K. Bloss - Chief Financial Officer, Treasurer & Senior VP

Michael L. Avery - President and Portfolio Manager

Analysts

Glenn Paul Schorr - Evercore ISI

Chris C. Shutler - William Blair & Co. LLC

Michael S. Kim - Sandler O'Neill & Partners LP

Michael Roger Carrier - Bank of America Merrill Lynch

Robert Lee - Keefe, Bruyette & Woods, Inc.

Daniel Thomas Fannon - Jefferies LLC

Michael J. Cyprys - Morgan Stanley & Co. LLC

William Raymond Katz - Citigroup Global Markets, Inc. (Broker)

Macrae Sykes - Gabelli & Company, Inc.

Eric Berg - RBC Capital Markets LLC

Operator

Good morning, everyone, and welcome to the Waddell & Reed Fourth Quarter 2015 Earnings Conference Call. All participants will be in a listen-only mode. After today's presentation, there will be an opportunity to ask questions. Please note that today's conference is being recorded.

At this time, I'd like to turn the conference call over to Mr. Hank Herrmann, Chairman and Chief Executive Officer. Sir, please go ahead.

Henry John Herrmann - Chairman & Chief Executive Officer

Thank you. Good morning. With me today are Mike Avery, President; Tom Butch, our Chief Marketing Officer; Brent Bloss, our Chief Financial Officer; Phil Sanders, our Chief Investment Officer; and Nicole Russell, our VP of Investor Relations. Nicole, would you read the forward-looking statement, please?

Nicole McIntosh-Russell - Vice President-Investor Relations

During this call, some of our comments and responses will include forward-looking statements. While we believe these statements to be reasonable based on information that is currently available to us, actual results could materially differ from those expressed or implied due to a number of factors, including, but not limited to, those referenced in our public filing with the SEC. We assume no duty to update any forward-looking statements.

Henry John Herrmann - Chairman & Chief Executive Officer

Thank you, Nicole, and good morning, everyone. The fourth quarter marked the end of one of the most challenging years for our company. Flows are under pressure due to weak performance in some of our funds, simultaneous with softening demand broadening these asset classes exacerbating the problem.

There are two important and seemingly competing realities in our business right now: the need to rationalize our cost to reflect the decline in the assets under management from the June 2014 peak of $136 billion; and the need to make strategic investments necessary to adapt to a fast-changing period in our industry. Throughout 2016, we will seek to do both. If we execute well and we're committing to doing so, not only will these efforts prove not to compete with each other. They will carry us forward with efficiency focus and ability to remain an important competitor in our lines of business.

Strategically, we'll make investments to modernize and strengthen our Advisors channel. We will intensify our efforts to broaden our Wholesale product line. And we will join our UCITS and Institutional efforts outside the United States to begin to broaden our footprint beyond domestic markets.

These investments are not without costs. In light of our diminished asset base, to fund these priorities, we have challenged every level of our organization to aggressively manage expenses. This is an important balancing act. We must be vigilant in managing costs while funding initiatives we believe critical to our future.

To expand on strategic initiatives underway in our distribution channels, let me turn it over to Tom.

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

Thank you, Hank. In our Advisors channel, we're undertaking an ambitious modernization of our brokerage and product platform that will include the restructuring of our share classes. Our new platform will move us from a paper-based, labor intensive environment to a paperless state-of-the-art brokerage platform, which also will include significant enhancements to our investment advisory programs, our financial planning capabilities and client experience.

This new platform should enhance both Advisor and back-office efficiency. And we believe this in turn supports productivity, retention, and recruiting. As part of this effort, we intend to convert load waived Class A shares into the more widely used Class I shares as the exclusive share class in our advisory programs. This step is consistent within the three trends and will allow us to compete more effectively for investment advisory assets.

The share class conversion is expected to occur in June and the platform launch likely in the third quarter. This portfolio of initiatives, referred to internally as Project E, positions the Advisors channel for long-term competitiveness. The Wholesale channel recently has been a challenge for us as it has for many, if not most, active managers. Investor preference for passive products, especially in core categories, and rapid changes in active categories that are in favor have provided for an unfamiliar distribution landscape for active managers.

We, of course, believe in active management and its capacity to reassert itself versus passive. And we have a number of strategies such as International Core Equity, Balanced, Emerging Markets Equity, Energy and others, where we have very good performance in categories which in the recent past have sourced considerable active flows. And other of our funds enjoy recommended list placements at large distributors.

These opportunities are in addition to franchise products in Asset Strategy, High Income, Science and Technology and Mid Cap Growth. Still it's important to note we've not rested on all of these products. Over the last three years, our effort to build out our product line with globally recognized managers in the respective asset classes has, we believe, added an important next layer to our product suite, taking us into non-traditional asset classes with subadvisors, Pictet, LaSalle and Apollo.

Though newer, we believe these products will continue to gain traction this year, supporting a distribution strategy that now includes a more comprehensive overall product profile in both traditional and non-traditional asset classes. In all, we expect to continue the trajectory of overall sales into products other than Asset Strategy and High Income. Such funds represented approximately two-thirds of sales last year and had net inflows of $1.6 billion.

Currently, we project that Asset Strategy and High Income will remain in net outflow, but that overall redemptions in both funds will taper in 2016. Also in Wholesale, we continue to push forward in our effort to offer exchange-traded managed funds or ETMFs and expect to launch our first of these in the third quarter. While no large distributor has yet adopted this product, we will be ready when they do. One more important note. Despite recent performance challenges, Ivy Funds retained its favorable relationships with all major distributors, including preferred and/or approved list placements at all of them.

Lastly, our Institutional channel faces challenges in 2016 with expected substantial slowing of sales into subadvised accounts. We announced on our last call that our largest such account with approximately $2.2 billion in assets will be lost in May. And we since have been advised of additional subadvisory account loss, this one unrelated to performance, and in a third account the reallocation of a portion of our assets to another manager. These changes amount to approximately an additional $850 million in subadvised assets, bringing the total second quarter asset loss in subadvisory assets to approximately $3 billion.

In an effort to globalize our Distribution, our Institutional and Wholesale groups will work together to establish a foothold in London by mid-year. We now have eight UCITS funds that mirror many of our most successful domestic products and over time expect to add more of them. The opportunity for our largest Institutional Strategies, which we believe remains fertile in the U.S., also should be enhanced by an offshore presence. While the year has just begun and much, of course, can change, we would expect that across all distribution channels we will remain in net outflows in 2016, though at a lesser rate than in 2015.

I'll now turn it over to Brent, who will walk you through the impact of all these moving parts. Brent?

Brent K. Bloss - Chief Financial Officer, Treasurer & Senior VP

Thank you, Tom. Our challenge as an organization is to balance costs with making the right strategic investments for the future. As a result of the share conversion, we will no longer collect 12b-1 fees on approximately $17.6 billion in assets under management.

This, along with other one-time and ongoing costs associated with all of our strategic investments, will lower 2016 operating income by approximately $30 million. To offset, we will undertake significant cost reduction efforts intended to reduce fixed cost by approximately 10% or a $40 million reduction on our annual run rate of expenses over the next 12 months to 18 months with a goal to realize most of the reduction in 2016.

We have recently posted a supplementary slide deck on our website that I'll be referring to as I walk you through the financial impact of Project E and lower level of assets under management. You can find the slides under the presentation tab of the Investor Relations section on our website.

So if you go to the presentation on page three of that presentation, we will outline the Project E impacts on our income statement for 2016. Referring to the revenue line on that sheet, the underwriting and distribution fee revenues will be reduced by $19 million. This relates to lost 12b-1 fees from moving from load waived A shares to I shares, which do not have a 12b-1 fee.

Also these numbers, I want to remark, are based on our assets in our fee-based accounts as of the end of December of 2015. These numbers could fluctuate based on market action. But the $17.6 billion includes both proprietary and non-proprietary mutual fund assets.

Moving on to shareholder service fee, there will also be an impact of reduced revenues on shareholder service fees. Today, we receive an account-based fee on Class A shares, which ranges from $18 to $20. With an I share, we will receive an asset-based fee of 15 basis points.

Given that the balance in the shareholder accounts are fairly small relative to the industry, the 15 basis points will therefore result in a loss in revenues. So a total of $27 million is estimated based on the asset base today. Moving down to operating expenses, we will also see a reduction in payouts due to the elimination of the 12b-1 fees on a $11 million benefit to expenses based on the elimination of 12b-1 fees.

On the platform related fees, the $8 million that we've noted there relates to the build-out of the platform that Tom mentioned in the Advisor channel, which includes implementing Docupace and Envestnet (13:29), new technologies to put our wrap funds on. That cost relates to integration costs as well as consulting costs that will be resources used to build out that platform over the next three quarters.

And then in terms of general and administrative expenses, the impact there is an estimate of assets moving from our current platform to a new Envestnet platform. We will have to employee a brokerage capability because of the enhanced products set which will – we will have to share our networking fees with a brokerage provider. So net is about a $30 million operating loss impact, of which $8 million of that we consider to be a one-time build out of the platform. So adjusted operating income would be about $20 million or $0.15 related to the Project E initiative.

Moving on to page (14:51), we realize that we're under a new reality with the reset in our asset base, which has gone from $136 million at its peak in 2014 to reporting $104 billion in December. So, as a result of these lower AUMs and reductions in net revenue, it requires us to adjust our expense base. So, today, we're reporting that we have a cost reduction plan underway to reduce $40 million in our current run rate of fixed operating expenses over the next 12 months to 18 months. This expense reduction represents approximately 10% of our fixed operating expenses today.

You'll recall approximately 60% of our operating expenses – they're variable in nature and around 40% are fixed. The reductions we will be targeting will be in our general and administrative expenses, our field structure and support, selective incentive compensation adjustments and a hiring freeze other than for strategic hires. We've had an ongoing limit to our hiring throughout 2015. We've just added a handful of people, mainly due to strategic initiatives. So this is an ongoing effort that we've had in place for some time.

And then this imitative will also include selective workforce reductions as we reallocate resources to adjust to our new base of AUM. Our goal is to realize two-thirds of the impact of the $40 million reduction in 2016, which equates to approximately $0.20 per share.

With that, I will turn it back over to Hank for final comments here.

Henry John Herrmann - Chairman & Chief Executive Officer

Thank you, Brent. As I've often said, our dividend is the top priority. Our model shows that we generate sufficient free cash to fund operations, maintain our dividend and offset the dilution from our annual equity grants. We will continue to be opportunistic with share buybacks.

It is our hope and belief that 2016 will be a launching point toward recapturing the growth we enjoyed historically. We can't control the markets or investment sentiment, but we can and will aggressively manage our business to efficiently capture the many opportunities available to us. We look forward to updating you as the year progresses.

Now let me take you briefly through the quarter. This morning, we reported fourth quarter net income of $63 million or $0.76 per diluted share, 31% sequential improvement and a decline of 22% compared to last year's fourth quarter. Operating income was $91 million during the quarter, declining 16% compared to the previous quarter, pressured by a 5% decline in average assets under management.

Assets under management were $104 billion at quarter-end, declining 2% sequentially. Net outflows of $5 billion were largely concentrated in our Wholesale channel as redemptions rose during the quarter and sales pulled back somewhat. Our Advisors channel remained stable with minor outflows and our Institutional channel were flat.

Finally, as was announced this morning, Mike Avery will retire at the end of June. I would like to say thank you to Mike for his 35 years of outstanding service. He leaves behind an important legacy and a strong team to manage the Asset Strategy Fund. While the Asset Strategy Fund requires a vast majority of Mike's time and focus, he also held the title of President, the duties of which will be assigned to other executives.

With this announcement, we understand many investors will wonder about succession. The board regularly discusses succession, and Mike's departure does not affect the process.

Operator, at this time, I would like to open the call for questions.

Question-and-Answer Session

Operator

Ladies and gentlemen, at this time, we'll begin the question-and-answer session. Our first question today comes from Glenn Schorr from Evercore ISI. Please go ahead with your question.

Glenn Paul Schorr - Evercore ISI

Hi. Thanks very much. Curious to the behind the scenes on what brought about Project E in terms of the switching up of the asset classes and – share classes, sorry. And curious if the coming DOL rules have any influence on that thought process.

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

Hi, Glenn. It's Tom. I'll take a whack at that. What I would tell you is that Project E was underway before the DOL proposal really came forward. But certainly a more modernized platform and product structure could prove responsive to what we believe to be the intent of the proposal. But it was not a motivating factor. The motivating factors were the needs of our Advisors and the competitive environment. Relative to the DOL, we believe our Advisors always seek to act in the best interest of their clients. And, certainly, these steps can only buttress that perspective on our part.

Relative to the share classes, when we were constructing the new platform, obviously, we felt it important to align share classes to what has become or at least is becoming industry standard relative to share classes in advisory programs, which is an institutional 912b-1 share class. So, I would say that the sequencing of the project and the more rapid adoption in the industry of the I share model pushed the share class conversion in front of our landing the new platform.

In other words, we wanted to effect the share class conversion from a project management and implementation perspective prior to trying to land the new technology and platform. So, that's kind of a long answer, but the I share is an industry-driven phenomenon and much of Project E is the same. It's really a competitive response to our Advisors and their clients' needs in the competitive frame in which we're operating.

Glenn Paul Schorr - Evercore ISI

I definitely appreciate all that. Historically, your Advisor network has had – and still has much better redemption rates than the industry and versus your Wholesale channel. Is there any reason that changes in the new world?

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

I don't think so.

Glenn Paul Schorr - Evercore ISI

Okay. And then just one quick follow-up. In the net distribution cost analysis that you provide us, there was an actual net distribution cost in the Advisors channel the first time that I remember. What was the swing in the fourth quarter that brought that to an actual cost as opposed to net distribution effort? (23:37)

Brent K. Bloss - Chief Financial Officer, Treasurer & Senior VP

Glenn, this is Brent. There was about $4 million of non-recurring items included in that indirect line for the Advisors in the fourth quarter. Much of it related to increased health claims experienced during the last half of the year and then also some restructuring that they got underway in the fourth quarter related to the channel as well as some costs related to Project E. That was about a $0.5 million that was included in the build out of the platform in the fourth quarter.

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

And, Glenn, this is Tom. I want to make sure I was responsive to your question. The retention rate of our assets is, as you pointed out, fractional to the industry that is in the Advisor channel. We expect that the overall retention of client assets will be undiminished by the platform changes we are making. That said, the opening of the platform to a certain extent likely will result in some flow away from our products. So, if that was the intent of your question, we have modeled that in to all of the analysis that we have done. But the overall client relationship and the assets attaching thereto we expect will be unchanged. And I also would say that our Advisors belief in an attachment to our investment management capability as a significant part of the culture. And we have every reason to believe that will be undiminished during these changes.

Glenn Paul Schorr - Evercore ISI

Thank you. That's super helpful. I appreciate it.

Operator

Our next question comes from Chris Shutler from William Blair. Please go ahead with your question.

Chris C. Shutler - William Blair & Co. LLC

Hey, guys. First, maybe could you just talk about the timing of Mike's departure later this year and how long has that kind of been in the works? And to what extent over the last year has it been Chace and Cynthia that have been meeting with investors and distribution partners as opposed to Mike?

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

I can take the last part and then certainly Hank or someone else can talk about the first. What I would say is one of the hallmarks of the Asset Strategy team always has been the accessibility they provide to the distribution partners and the financial advisors who use their products. So Mike has, I think, been very focused on getting the team out in the marketplace as have our National Accounts relationship management people. And at this juncture, the entirety of the team is well known. And we will continue to reinforce that over time.

Henry John Herrmann - Chairman & Chief Executive Officer

It was your second part of the question or the first part. Can you ask me again?

Chris C. Shutler - William Blair & Co. LLC

No. I think that answers. I was really just wondering to what extent the timing of it – how long it have been in the works and just if Chace and Cynthia have been out in front of a lot of investors to-date.

Henry John Herrmann - Chairman & Chief Executive Officer

I don't know. I don't look that carefully at their calendar but they certainly have been exposed to our distribution partners one way or another. They've been involved with the portfolio now for 18 months or so. So, that's part of the answer. And the conversation amongst Mike's retirement has been in discussion between us for a couple months.

Chris C. Shutler - William Blair & Co. LLC

Okay. Thanks. And then just one more on the new Advisor platform. Can you just reiterate when it's going to go live? I think you said Q3, but could you confirm that? And then, how should we think about the ongoing cost of that platform once it is up and running?

Brent K. Bloss - Chief Financial Officer, Treasurer & Senior VP

So the platform, as Tom mentioned, will likely light up in the third quarter of this year. Ongoing cost of the platform, we would expect to be covered by platform related fees. So I didn't lay that out in here. But the fees that we will pay to Envestnet, the Docupace (28:12) should be covered by a platform related fee which is typical in the industry and is amount taken off the top of the advisory fee that the advisor earns before you pay out commission. So, we expect that that revenue will offset the cost of the platform.

Chris C. Shutler - William Blair & Co. LLC

All right. Thank you.

Operator

Our next question comes from Michael Kim from Sandler O'Neill. Please go ahead with your question.

Michael S. Kim - Sandler O'Neill & Partners LP

Hey, guys. God morning. First, Tom, you mentioned the $3 billion of subadvisory losses expected in the second quarter. So, just wondering how that sort of fits or aligns within the $4 billion of total institutional AUM for Asset Strategy as of, I think, December 31.

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

That doesn't sound like an accurate number to me, but the largest such Asset Strategy account is about $2.2 billion. The other two are not Asset Strategy. One was a Fixed Income Strategy, which – the company for which we are subadvising it decided to internalize. And I said the other is another Equity Strategy where they're adding another manager an apportioning certain of the assets to them.

Michael S. Kim - Sandler O'Neill & Partners LP

Okay. No, that's helpful. That answers my question. And then, I don't think I saw it in the release, but can you isolate the level of outflows in the fourth quarter that related to un-reinvested distributions, if you will, and then just any sense of quarter-to-date flow trends thus far?

Brent K. Bloss - Chief Financial Officer, Treasurer & Senior VP

Yeah. The dividends that were not reinvested were about $200 million.

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

And, Mike, what flow trends were you interested in precisely for January?

Michael S. Kim - Sandler O'Neill & Partners LP

As much as you want to offer, I mean, total, in aggregate or by channel or a strategy?

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

Boy, was that a leading question. I guess, what I would say is that, in sum, the overall gross is a little softer than January in the context of the market environment – pardon me, in January, then in December, in the context of the market environment. I don't find that particularly surprising. But the net flows, though, again negative, have improved on a month-to-month basis. That really would be across all channels. If you look at the largest funds, I think that same logic would kind of carry through. Asset Strategies, January sales are in keeping, maybe a little better than the months of the fourth quarter and redemptions are tamped fairly significantly from that period.

High Income redemptions are down from December, but flows are a little softer. International Core Equity is better both in terms of – well, certainly better in terms of its gross flows. And the redemption characteristics are still good. And so those are sort of the lead horse funds. But, in the aggregate, what I would say is that, in the Wholesale channel, flows are a couple million a day softer but the net experience is improved on a month-to-month basis from December.

Michael S. Kim - Sandler O'Neill & Partners LP

Got it. That's very helpful. Thanks for taking my questions.

Operator

Our next question comes from Michael Carrier from Bank of America Merrill Lynch. Please go ahead with your question.

Michael Roger Carrier - Bank of America Merrill Lynch

All right. Thanks, guys. Brent, maybe just on the expenses. When you think about 2016 through each of the quarters, just wanted to get a sense. Are there certain quarters where you'd expect more of the investment needed to come online and then on the flipside more of the cost reductions needed to be taken out?

Brent K. Bloss - Chief Financial Officer, Treasurer & Senior VP

Yeah. Michael, in terms of the platform related expenses, I mean, I think those would be fairly smooth across the next three quarters. In terms of the cost reduction, we're in the process of finalizing a plan which hopefully will be done here in a few weeks. And I would expect that from the outcome of that – we said we wanted to get a two-thirds of the $40 million run rate in 2016. So I would expect most of that run rate to start in the second quarter, if that's helpful.

Michael Roger Carrier - Bank of America Merrill Lynch

Yeah. That's good. And then, Tom, maybe one for you. Just given what you guys have been managing, particularly with Asset Strategy over the past, one year to two years, given Mike's announcement, what's kind of the plan that you've put in place in terms of talking to the distribution channels and getting them comfortable with this process? And then, you mentioned a little bit of when you look at the kind of the net flow your outlook for 2016 and what the trends – that what you would expect. And I know a lot of things can change. So not holding you go ahead, but just when you think about maybe like a reduction in the outflows, based on this event, what are maybe some of the offsets, products where you're seeing some traction that can generate some offsetting inflows?

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

Okay. The first thing I would tell you relative to your first question, Mike, and thank you for it, is, as we're speaking, our Advisors are out in the market talking to their – pardon me, our Wholesalers to their Advisor clients. Our relationship managers are at this moment in touch with the distribution partners. And, as I said, again, one of the hallmarks of the Asset Strategy team under Mike's leadership has been openness, transparency and availability, not just of himself, but of the entire team. So Chace and Cynthia are not unknown quantities. Mike's going to be here and be supportive of the transition period and visible in supporting that. So the plan, if you will, is kind of more of the same and making sure that the strategy is well known and the investment approach is well known and making both home offices and Advisors comfortable with both.

Relative to the products that we think can be helpful this year, there's not a shortage of them, which is the good news. I mentioned certain of them in my remarks. And that included the Balanced Fund, Emerging Markets Equity Fund, International Core Equity and Energy. As I said in the past, and as you all know, today, opportunity has multiple dimensions. It's not just having good performance. It's having good performance in a category that's growing and has a meaningful percentage of its flows going to active versus passive and has an opportunity for rec list or approved placements at firms. And it's consistent with the firms positioning on the markets. It's myriad factors that hopefully co-join into opportunity.

And so when we think of those opportunities, the ones I mentioned, each of those fulfills some or if not all of those. We have additional opportunities in some of our newer products, our joint products with Apollo. We're seeded with – in October with just $125 million and the asset base and them has more than doubled with very thin distribution at this point. It takes some time to get products on platforms. On a net basis, we're seeing again modest, but net flows into things like our LaSalle Global Risk-Managed Real Estate product, which just got added to a major broker/dealers' recommended list.

The Energy product, which is a bit of a contrarian opportunity at the moment, it too just gotten added to a major broker/dealers' recommended list. So, I guess, the point I would make is that underneath the largest funds, which have had a period of outflow – and we have not really baked in any material assumption to that changing due to performance or market sentiment – there's a lot of good things percolating. The rest of the product line, as I mentioned, was in positive net flow last year and many of the products have good opportunities, based on those criteria that I discussed.

The other thing is that we're going to be very focused in our sales activities this year. The way we've constructed our activities and the reward structure in our Wholesale business really will have us laser-focused on substantially tactical opportunities within the strategic context by which we go to market. So, we just had our wholesaler meeting last week. Our Advisors channel management team is meeting right now and listening to this call. And there's a great deal of enthusiasm about all the opportunity in front of us. We're not pollyannic. We have challenges ahead. Everybody is very committed to rolling up their sleeves and taking all these good messages to market.

Michael Roger Carrier - Bank of America Merrill Lynch

Okay. Thanks a lot.

Operator

Our next question comes from Robert Lee from KBW. Please go ahead with your question.

Robert Lee - Keefe, Bruyette & Woods, Inc.

Thanks. Good morning, guys. I guess, my first question is how should we be thinking about all things going on this year with the expense spend and the savings initiatives, kind of, any guidance or help on how we should think about the timing of this kind of rolling through the P&L? I mean, the expense saves to offset some of the spend, does that going to be pretty much back-end loaded? I mean, I'm just trying to get a sense to have, at least from a modeling perspective or earnings perspective we should kind of think of the progression in kind of different line items.

Brent K. Bloss - Chief Financial Officer, Treasurer & Senior VP

Hey, Rob. It's Brent. In terms of the platform related costs, I would just smooth those over the first three quarters of the year. In terms of the cost cutting initiatives, the $40 million which we announced a target of two-thirds of those expenses to be realized in 2016, until we get our plans finalized here, we look to start recognizing that $26 million to $30 million over the course of the second quarter through to fourth quarter.

Robert Lee - Keefe, Bruyette & Woods, Inc.

Okay. Great. Thank you. And then maybe a question for Hank. Understanding that protecting the dividend is the priority, I mean, given still some very substantial amount of liquidity on the balance sheet and still at a reduced level though still generating pretty good cash, I guess I was expecting that given the stock action maybe a more aggressive repurchase during the quarter. So can maybe just update us a little bit on kind of your thoughts around that and maybe how we should be thinking about it kind of at least over the next couple of quarters?

Henry John Herrmann - Chairman & Chief Executive Officer

Well, I don't have a number. But I think I've historically said we will continue to be opportunistic. I would define opportunistic as the present time. How's that sound?

Robert Lee - Keefe, Bruyette & Woods, Inc.

Sounds good. Thanks. Appreciate taking my questions.

Henry John Herrmann - Chairman & Chief Executive Officer

Thanks.

Operator

Our next question comes from Dan Fannon from Jefferies & Company. Please go ahead with your question.

Daniel Thomas Fannon - Jefferies LLC

Thanks. Tom, you mentioned the buildout of the non-U.S. distribution. Can you talk about what the opportunities that you see? What level of investment in terms of people and staff that might involve? And is it institutional? Is it the kind of retail opportunity or how are you thinking about that?

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

It's kind of an amalgam of the two, I think. And what we're doing is -- stepping back: a couple years ago, we acquired – I guess, 18 months ago, we acquired three UCITS funds and the substructure of them that we were subadvisor for. And they now are our products and we've now supplemented that with five additional funds. So we have eight UCITS funds. And we had a location in New York, which we also inherited, from which we serve principally the non-resident citizen opportunity in the United States with – which effectively is the largest wire-house broker/dealers dealing with clients who want to transact in the United States and must transact in the United States, but cannot use 1940 Act product for tax and other reasons or who just want the stability of transacting in the United States.

That is a small part of the opportunity. And so we've decided to really refocus that opportunity in London with some of our – with an institutional leader who already is here, someone who came to us through that transaction. And in the first instance, it will be the two of them, one there full-time and one there part-time and a couple other people whom we will hire in market. We believe there to be two prongs to that opportunity: platform business on a pan-European basis, the due diligence for which is centered in London; and then a pure institutional business coat-tailing on consultant relationships that we have here and other relationships that we will seek to uncover over there.

I don't want to overstate nor do I want to understate this opportunity. We've examined with great care the markets where we think we have an opportunity to win and the channels where we think we have an opportunity to win. We've replicated in the UCITS structure our most successful strategies here and our most successful institutional strategies, which are domestic Large Cap Growth and domestic Large Cap Core, already have some salients but that'll be enhanced by being there and taking that into the due diligence environments. What we won't do is seek to build a wholesaling pure retail capability, because we don't think that that's really necessary, nor is it something which at this juncture we want to sign up for. But we spend a lot of time understanding the environments. People who are going into them understand them well and will add to local talent incrementally to help us in that venture.

Daniel Thomas Fannon - Jefferies LLC

Great. Thanks. And then I guess to follow up on Asset Strategy. First, Tom, I just want to clarify. You're not assuming redemption rates change, I think, in terms of your comments. I guess, assuming with Mike's departure announcement, isn't it reasonable to assume some level of heightened redemption as a result? And then, I guess, Mike, if you could please talk about the positioning of the fund today and kind of your outlook at this point in time.

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

I'll take part one. It would be our hope that through the good work that has already been done to acquaint the marketplace with the managers who joined the fund 18 months ago and brought more than 50 years of investment experience to it that this won't be a materially disruptive event relative to the flows into the product. I think it's also important to understand that the underperformance and reaction to it by broker/dealers in the past year or so has really emptied substantially the model portfolio placements of the funds such that that risk is not anywhere near what it used to be. It's still on a couple model portfolios of some substance. But yes, the fund will be scrutinized, but we believe it'll stand up to that scrutiny, and the pockets of the greatest vulnerability relative to model portfolios or home office directed portfolios is, I think, behind us. Mike?

Michael L. Avery - President and Portfolio Manager

Yeah. With regard to your question about how the Asset Strategy Funds and related funds are currently positioned, we have – in view of the market that's in front of us, have taken a fairly defensive posture, based on our market outlook. We have about 25% of the funds in short-term duration securities. We have about 8% of the fund in longer duration, sovereigns, 4% is in gold bullion, so about 37% of the fund is in very liquid securities. In addition, we've taken opportunities with the team to put in place hedges, so that if we have a further reduction in the market from here, that our equity exposure would be reduced via the futures contracts, the options that we have in place.

Our equity exposure is about 59%. This morning, our net exposure with derivatives is about 51%. And, again, we have derivatives in place, so that if the market would take a further reduction, the derivatives are structured in a way to reduce our net exposure to equities.

Our view of the market is that – and it has been for some time as long-term listeners to this call will recognize – that we believe that we're in a very difficult environment that is hard to manage with just monetary policy. Since the point of the global financial crisis, the markets have reacted well to monetary stimulus, but the extent to which monetary stimulus can have the desired impact of faster economic growth is perhaps met the limit of its efficacy.

We think that, in the days ahead, there will be more emphasis focused on fiscal stimulus, but that probably is within the purview of the next legislative executive cycle. In the meantime, we're probably in for a difficult period. I don't think there's any different way to say that. The Asset Strategy Fund, as you pointed out by your underlying question, has the flexibility to mitigate the downside of volatile markets and hopefully participate in rising markets. As Tom and Hank has alluded to, going forward, the team that we have in place is very good, the best it's ever been. The two people that I've had the pleasure to work with on the Asset Strategy product will be in the seat for two years come June. Both of them respectably have a lot of experience in volatile markets, different asset classes. And so, I'm very confident that they are well suited to manage our clients' money going forward.

In addition to Cynthia and Chace, we have three people that work very closely with them with the titles Assistant Portfolio Manager. One is focused on risk management. Second one is focused on security selection and multiple asset class allocation. And the third spends much of his time on illiquid securities that we have in the portfolio and is also focused on the financial service sector. And with the benefit of having a person as a client portfolio manager, who can act as a liaison between the team and our clients, I think, that the team is well positioned.

In addition, at this time, the investment management division under Phil's leadership as Chief Investment Officer is the strongest it's ever been. He's put together a team under him, the focus on equity and fixed income research, global fixed income securities with a very strong process under Hank's leadership for a long period of time is still very strong and is still very solid. So I am very comfortable that even though we're headed into the continuation of a volatile period as the world adjust to the shift of unconventional monetary policy becoming less of the focus and fiscal stimulus becoming more of the focus that this team is more than prepared to handle the challenges in the days ahead.

Daniel Thomas Fannon - Jefferies LLC

Thank you.

Operator

Our next question comes from Michael Cyprys from Morgan Stanley. Please go ahead with your question.

Michael J. Cyprys - Morgan Stanley & Co. LLC

Hi. Good morning. Thanks for taking the question. Just on Project E, it sounds like – correct me if I'm wrong here, but it sounds like you're moving clients in the Advisors channel, more into Wrap Fee Programs, if you could just talk a little bit about that. And then if you could just also update us on your current Wrap Fee Program just in terms of client assets and revenue that you have in there, some of the trends that you're seeing and then also the opportunity for revenue share from having third-party products on the platform.

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

Those are all great questions. So, I wouldn't say that we're going to be moving clients more aggressively into advisory accounts, because that has been in-flight for some time. In the fourth quarter, for example, roughly two-thirds of our sales were into fee-based accounts. And at this point, we're fast approaching half of our revenues being in fee-based accounts. So, as you know, this has emerged as the preferred way for clients and advisors to engage one another in the business.

This is not a Waddell & Reed centric phenomenon, but an industry-wide phenomenon for all the reasons that we all appreciate. And so, again, I don't think that this is any sort of attempt to accelerate the flow into those accounts because that already is in-flight. Relative to the potential for revenue sharing from third-parties, we'll see certainly the ability to engage our financial advisors ought to be an opportunity that a certain of them find attractive, but it's early days on that.

Michael J. Cyprys - Morgan Stanley & Co. LLC

Okay. Great. Thank you. And then just – if you could just update us on your latest thoughts, Hank, maybe on succession planning given Mike's departure. Just how you're thinking about that now?

Henry John Herrmann - Chairman & Chief Executive Officer

I didn't hear the question. I'm sorry, I distracted. Ask me again.

Michael J. Cyprys - Morgan Stanley & Co. LLC

Just a question around the succession planning, given Mike's departure. Just how you're thinking about succession planning at this point?

Henry John Herrmann - Chairman & Chief Executive Officer

Well, the comment I made in my opening remarks is for the moment, there's nothing really more to add to that and to that. And what I said it was a standard process around here. And I mean the board will continue to reflect on things. And my standard comment about – up to my two-year commitment last June and for the moment that's where we stand.

Michael J. Cyprys - Morgan Stanley & Co. LLC

Okay. Thanks.

Operator

Our next question comes from William Katz from Citigroup. Please go ahead with your question.

William Raymond Katz - Citigroup Global Markets, Inc. (Broker)

Okay. Thanks. Good morning, everyone. Thanks for taking my questions. I've got a number of them this morning. Just looking at the slide deck you guys provided, so maybe more of a clarification. When I read footnote number one, it shows that it's based on a July 1 conversion date. So is the $19 million a full year revenue loss? Should I think about it that way? Because I'm still wondering if it's deeper operating income loss in 2016, but it sort of balances out in 2017, when you get the fully phased in cost synergies.

Brent K. Bloss - Chief Financial Officer, Treasurer & Senior VP

Bill, that's a good question. Of course, these numbers are based on AUMs at this time. But that is a six-month look at the revenue loss if we're able to get the conversion in place at the beginning of July. So the annualized impact would be around $40 million if the asset base stays similar as it is today, which we would hope it would grow given the new technology, of course. So now the revenue is baked in for increased sales at this point.

William Raymond Katz - Citigroup Global Markets, Inc. (Broker)

Okay -

Brent K. Bloss - Chief Financial Officer, Treasurer & Senior VP

That is just really a look at the cost.

William Raymond Katz - Citigroup Global Markets, Inc. (Broker)

I understand. Okay. Thank you for that. In the strategic decision to shift from 12b-1 to the I Class, where is Waddell relative to the industry? So the question is, are you guys just playing catch-up to where the industry already is or is there some type of fundamental shift in the business model that will affect everyone on a go-forward basis?

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

No. I think what I said earlier is that this has become the share class of Choice, if you will, in the broker/dealer environment. This shift has been in play for a while. And to be fully competitive, we felt that as we were undertaking this major evolution of our broker/dealer that this was an important component. That really is the most important part relative to the timing.

William Raymond Katz - Citigroup Global Markets, Inc. (Broker)

Got you. And what gives you guys the confidence that the redemption pressure – obviously you gave guidance for each channel this year being an outflow mode. When I step back and I think about the performance, the portfolio manager turnover, the migration to potentially more of an open architecture dynamic on the advisory model, why wouldn't there be a structural risk to the flows on the advisory sides? So, what gives you confidence that redemptions here may have peaked or trend sustained on a lower basis? I'm just trying to understand your thinking there.

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

A couple things. I would say that we – as I indicated, it's likely that certain of the assets will in a new environment go to other providers. But there's two things I would point out in that regard. We do have past experience in that as certain of our advisors have chosen to go from our classic channel, which is the channel that we are most attaching this modernization effort to, to the Choice channel where they have a platform, which, though different from this, is substantively the same relative to product selection or substantially the same relative to product selection. And so, yes, some of the assets go to other providers, but the overwhelming majority have stayed with our investment management capabilities because most of these people have grown up with understand, respect and attach themselves to that capability.

The second piece of it is that we would expect, as also happened with many of our advisors who have made that transition, that the ability to grow their practices through this new platform and the new products will be enhanced and that the overall growth in total sales will mitigate substantially the sales that flow to other than our products. So, if somebody can grow their practice and the percentage is say 75% or 80% versus the maybe 90% that it may have been prior, the growth in that practice will offset that diminution of sales into our products. And so, that's the ability to scale the broker/dealer in the context of a more scalable platform is a key component of that. And so it is important that we're able to recruit and grow the business such that any diminution of sales into our products is substantially offset by that. The prior question had to do with other revenue streams that may come into the broker/dealer and that too is something that's possible.

William Raymond Katz - Citigroup Global Markets, Inc. (Broker)

And thanks for taking my questions, a couple more. How you think about the long-term margin now in the advisory business? And, Hank, maybe the broader question associated with this is can manufacturing and distribution work under the same house?

Brent K. Bloss - Chief Financial Officer, Treasurer & Senior VP

Bill, I'll take the first one. I think the margin, as we roll out Project E over the next few quarters, will have some impact on the margin because of those one-time costs for the build out. But I think over time with platform fee revenues and other revenues entering into the equation that our projections show that that direct margin doesn't change much into the future.

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

As to your question of can manufacturing and distribution exist in the same house, we believe that the two, if operated in a way where they co-join as appropriate, but have the right separability relative to issues where that is an issue, that they absolutely can. And so, this model, I would say, is an evolution of whom we are and not a revolution that suggests that we are in any sense repudiating the model. But we are updating it. We're modernizing it. And we are making it one that we think is scalable and also responsive to our advisors and their clients' needs.

William Raymond Katz - Citigroup Global Markets, Inc. (Broker)

Okay. And just one final one. Is there any change in these long-term trajectory of about a 50% payout of earnings for the dividend?

Henry John Herrmann - Chairman & Chief Executive Officer

I'm not sure. Repeat the question for me, please.

William Raymond Katz - Citigroup Global Markets, Inc. (Broker)

Hank, you've historically paid out roughly 50% of earnings plus or minus a little bit in the form of a dividend. And you mentioned earlier that you'll need to be tactical to buy back right here right now. But just longer term, given where the earnings probably has gone, are you still committed to that 50% payout ratio? Would you allow that to be a bit higher pending a recovery of earnings power?

Henry John Herrmann - Chairman & Chief Executive Officer

Well, I understand your question. Given the structure of our balance sheet, our cash flow, and our present projections, I think it will result in the payout ratio being somewhat higher than it has been historically. As you know, this is, broadly speaking, in a normal environment, whatever that is, just investment advisory kind of business generates plenty of free cash flow. We're a little out of sync with that because of the program, but it's not going to last that long. And just as a reminder, we have a very substantial cash position.

So, the best answer I can give you right now is that I expect that the payout ratio for some time in the next maybe even two years will exceed the 50% ratio. And I would hope that you would keep in mind that making a presumption on normal market action, which, as Mike Avery said earlier in his own way, that's debatable, I think everyone on the call realizes that it's somewhat of an unusual situation. But, again, I think you need to keep focused on the fact that our very limited debt and a strong cash position, I think, someone else talked about, I've forgotten what the number was in terms of cash, it's $550 million or something like that, another $200 million somewhat invested in various portfolios. So, that's a pretty significant cushion.

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

Right.

William Raymond Katz - Citigroup Global Markets, Inc. (Broker)

Okay. Thanks for the patience on all my questions today.

Operator

Our next question comes from Mac Sykes from Gabelli & Company. Please go ahead with your question.

Macrae Sykes - Gabelli & Company, Inc.

Good morning. I guess, with Mike's departure, will the fund operate differently in terms of allocation to certain asset classes or different market vehicles?

Henry John Herrmann - Chairman & Chief Executive Officer

No. I don't think so. The team has been together for quite a while, as we already said. The product is well know internally. We'll still try to figure out where the right places are to emphasize and deemphasize. I think you have to appreciate you've got, I don't know, 80 analysts or so forth committed to all sorts of different mandates -- fixed, equities, domestic, international, big caps, small cap, et cetera, et cetera, et cetera. And as a result of that breadth of capability, we have historically done a pretty good job of identifying where the big opportunities are. I know that if you think about the performance over the last two years, you might say posh or something to that effect. But the reality is, since late 1990s, we've been able to execute new allocations very successfully.

As Mike pointed out in his comments about where the fund stands currently, we've had a pretty important defensive position in place since the fall. And I think most people would recognize that that's worked pretty well. And, of course, portfolio's position isn't modest. So we have a long history of putting our money where our mouth is or so to speak. And I expect that that will continue.

In the case of the two co-PM, managers, Cynthia and Chace, they've been in our process for many years, Cynthia for over 30 years, Chace for 20 years, I think, pretty close to that. And they've been involved in, what I would call tactical asset allocation for a long time as well.

Macrae Sykes - Gabelli & Company, Inc.

Okay. And then my follow-up was you mentioned the ETMF initiative in the third quarter. What are your expectations for ramp-up with that product maybe this year and next?

Henry John Herrmann - Chairman & Chief Executive Officer

I'll let Tom answer that one. I may have a rejoinder.

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

Our expectation since we have become part of the consortium, if you will, that has signed on for the product is that it ultimately will be adopted. We certainly are supportive of that. But our partner, Eaton Vance, really is leading that process. And they remain confident and, as a result, so do we that the product will be broadly adopted over time. It's on a couple platforms now but, as I said in my comments, has yet to be adopted by a large distributor.

Our belief is that, when it is, we want to be there because, again, the product sort of fuses the best parts of the ETF and the mutual fund into an actively managed product. It goes to market at lesser cost and without the tax implications embedded in 1940 Act funds. That certainly ought to be an attractive proposition to advisors and their clients. And I know that negotiations and conversations with the large distribution firms are still very much afoot and in plate [sic]. We're in constant contact with Eaton Vance on this, and we remain confident that it can be an important product over time and help us to reassert active management in the context it provides.

Macrae Sykes - Gabelli & Company, Inc.

Thank you.

Operator

And our next question comes from Eric Berg from RBC Capital Markets.

Eric Berg - RBC Capital Markets LLC

Thanks very much and good morning. Thanks for taking my questions. First, Tom, because the Choice platform has been available for some time and is in effect an open architecture system, what do we mean by building out the platform and, in particular, what will the new system do and bring to the advisors the Choice does not?

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

Great question. And certain advisors are – many of our advisors, particularly those who have grown up in the classic architecture, are substantially comfortable in that environment that have been desirous of a new operating backbone that eliminates paper and a new more robust brokerage capability. Many of them would prefer not to leap the fence over to Choice, but rather just have this accommodated within classic.

There are certain requirements when an advisor moves to Choice relative to repapering their client's book which can be clunky and time consuming. And so, what we're trying to do is effectively develop a continuum of advisory products, which provide a new and updated under-structure for the classic side and gives flexibility on fees, funds and models to our advisors, while preserving the advisory products that are on the Choice side. It would be our anticipation, Eric, that over time, these distinctions of classic and Choice would disappear. And you'd have one continuum of advisory products from very basic to all-encompassing and having all asset classes. And it would be entitlement-driven, based on length of service at the firm and revenue characteristics of the advisor's practice.

And so, what this does is it responds in the near-term to the advisor's desire to have a effectively updated version of what they have and over time gives us the opportunity to have substantially what I believe will be one of the most robust advisory program architectures in the business with four or five flavors along the way.

Eric Berg - RBC Capital Markets LLC

Now, you mentioned too, Tom, that – I believe you said that roughly half of the broker/dealers' revenue at this point is not of a – is advisory related and fee-based, and the other half is, I guess, transaction-based. And if I have that right, with respect to the one half of your revenue base that is not advisory, that continues to be traditional transaction-based business, how will they be affected by this Project E?

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

This is real. They'll be substantially unaffected other than through the straight-through processing and the fact that – I shouldn't have said they'll be – let me start my answer over. The principal effect for that group of people will be the straight-through processing in the absence of paper. So straight-through processing environment that I talked about doesn't attach only to the advisory piece of the business, but to the totality of what we do.

And so really if you think of two separate prongs of the needs that our advisors have expressed to this, one has been less paper, more efficiency, give me a workstation where I can conduct all my business, simplify forms, put in place electronic processes that reduce my error rate and make my administrative help more efficient, give me more time in the marketplace. That transcends whether it's advisory or transactional. Most of our advisors, I would tell you, aren't fish nor fowl. They do both. And so, the effect uniformly is the increased efficiency via all the things we're doing to effect straight-through-processing and then particularly for the advisory programs greater flexibility and everywhere.

Eric Berg - RBC Capital Markets LLC

One last quick one, very quickly. On flows, if you're expecting your business away from Asset Strategy and High Income to continue to gain momentum in all the areas that you've said, your positive flow last year, you expect this momentum to continue this year, why do you nonetheless expect – given that, why, Tom, do you expect your best sense is that flows in each of the three channels will be negative this year?

Thomas W. Butch - Chief Marketing Officer & Executive Vice President

Because we have yet to find equilibrium is what I would tell you. The magnitude of increase on the standard products that are producing net flows is not yet at the moment where it eclipses the outflows in some of the franchise products. It's really that simple. We're working on it and hopefully we have some breakouts that get us a little bit closer. But as we look out, that's the lens through which we see it.

Eric Berg - RBC Capital Markets LLC

Thanks very much.

Operator

And, ladies and gentlemen, at this time, we've reached the end of today's question-and-answer session. I'd like to turn the conference call back over to Mr. Herrmann for any closing remarks.

Henry John Herrmann - Chairman & Chief Executive Officer

I express my appreciation for everybody on the call. Hopefully, we addressed the majority of your questions. Anything needs further flushing out, I'm sure, Nicole will get hooked up with you. We look forward to speaking to you next quarter. Thanks for your time. Take care.

Operator

Ladies and gentlemen that does conclude today's conference call. We do thank you for attending. You may now disconnect your telephone lines. Thank you.

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