Federated Investors, Inc. (NYSE:FII)
Q2 2016 Earnings Conference Call
July 29, 2016 09:00 AM ET
Ray Hanley - President, Federated Investors Management Company
Chris Donahue - President and CEO
Tom Donahue - CFO
Justin Tarrington - Citigroup
Ken Worthington - JP Morgan
Michael Carrier - Bank of America Merrill Lynch
Surinder Thind - Jefferies Group LLC
Andrew McLaughlin - Keefe, Bruyette & Woods
Greetings, and welcome to the Second Quarter 2016 Analyst Call and Webcast. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded.
I would now like to turn the conference over to your host, Mr. Ray Hanley, President of Federated Investors Management Company. Thank you. You may begin.
Thank you. Good morning and welcome. Leading today's call will be Chris Donahue, Federated's CEO and President; and Tom Donahue, Chief Financial Officer. And joining us for the Q&A is Debbie Cunningham, our Chief Investment Officer for Money Markets.
During today's call, we may make forward-looking statements and we want to note that Federated's actual results may be materially different than the results implied by such statements.
We invite you to review the risk disclosures in our SEC filings. No assurance can be given as to future results, and Federated assumes no duty to update any of these forward-looking statements. Chris?
Thank you, Ray. Good morning. I will briefly review Federated's business performance, and then Tom will comment on our financial results. Looking first at equity. The second quarter was another solid quarter of growth for Federated with sales results that placed us near the top of the industry.
Total second quarter equity net flows were $2.8 billion, which represents an annualized organic growth rate of about 20%. We've had positive equity net flows in 10 out of the last 11 quarters. Federated ranked sixth out of nearly 700 firms in the industry for second quarter net fund flows as measured by Strategic Insight, which of course places us in the top 1%.
Net sales in the second quarter and led by our strategic value dividend strategies, both domestic and international in both funds and in SMAs. Other strategies with positive net flows include Prudent Bear and Muni Stock Advantage. Our equity business is well-positioned with a variety of strategies having produced solid performance.
Using MorningStar data for ranked funds at the end of the second quarter, six Federated funds, 23%, were in the top decile for trailing three years. We had 12 funds for 46% in the top quartile and about two-thirds in the top half for the trailing three years.
We've had solid performance results from the Federated strategic value dividend strategies. At quarter end, the fund ranked in the top 1% for the trailing quarter, one in three years, and top 2% for the trailing five years and top 10% for the trailing 10 years. Other top decile three-year equity strategies include our MDT Small Cap Core, Kaufmann, Kaufmann Small Cap, Absolute return, and Muni Stock Advantage.
Looking now at early third-quarter results, equity funds and SMAs combined are solidly positive, about $422 million, which is a slower pace than when compared to the second quarter.
Turning now to fixed income. Overall, net flows were negative due to a $1.4 billion separate account redemption from a client making a style change within their model. Fixed income fund net sales turned positive with high yield strategies leading the way. Our Total Return Bond Fund returned to positive sales in the second quarter.
At quarter end, we had nine fixed-income strategies with top quartile three-year records including high yield, total return, floating rate, mortgage backed, and ultrashort. Fixed income net sales for funds and SMAs are also solidly positive early in the third quarter and at a higher pace in the second quarter at about $418 million.
Looking now at money markets, assets decreased by about $7 billion from Q1, reflecting both tax-related seasonality and certain client specific activity. Money market assets were up about $13 billion from Q2 of 2015. Our Money Market Fund share remained at approximately 8%.
Now, we are beginning to see some client activity related to the October 2016 requirement for floating NAVs and redemption fees and gate provisions for institutional, prime, and muni funds.
We have seen increased interest in our government funds. We're also working through final regulatory approvals in order to launch a collective fund with a prime portfolio and we are pursuing a private prime fund vehicle with institutional clients. We expect activity levels to increase as we move through the third quarter and investors sort through their options.
To give you one idea of some of the movement, I'd like to compare the change in our Money Market Fund assets from the second quarter of 2015 to today and then compare them over the last quarter from year end to today.
So, from 2015 second quarter, our total is up about $8 billion led by government up $21 billion and prime is down $5 billion and tax free is down $5 billion.
Now, if you look at the change from the end of the year of 2015, we are down $5 billion, our government is up $17 billion and the prime is down $16 billion and tax free is down $5 billion. So, you can begin to see the movement from prime into govi.
Taking a look now at some of our most recent totals as of July 27, managed assets were approximately $366 billion including $252 billion in money markets, $63 billion in equity, and $51 billion in fixed income. Our mutual fund money market assets were $215 billion, and the July average has been about $216 billion.
Turning to distribution, our SMA business again reached new heights in the second quarter with record gross and net sales. Gross sales exceeded $3 billion and net sales were over $2 billion.
Total SMA assets ended the quarter at $22 billion, an increase of $3 billion in the quarter. SMA assets have more than doubled over the past three years. Federated ranked fifth in the MMI/Dover ranking of the largest SMA Managers at the end of the first quarter, which is the most recent data available.
In the broker/dealer channel, our equity fund gross sales are up 31% year-to-date 2016 compared to the same period last year. In the institutional channel, we have seen wins funding into mutual funds.
We expect a client to add about $300 million in the third quarter to our Total Return Bond Fund and another client to add $50 million to the Strategic Value Dividend Fund. RFP activity continues to be solid and diversified with interest in value and dividend strategies for equities and high yield ensure duration for fixed income.
On the international side, we continue to roll out of our new Canadian domiciled Strategic Value Dividend Fund product, which we launched in the first quarter. We saw our first new accounts and assets during the second quarter.
We've had success in Europe, Asia, and the Mid-East from a sub-advised high-yield product working with a large private bank. We are working with this client to launch a new high yield fund in the third quarter.
We are also expecting an additional $125 million in funding from a pension client in our fixed income multi-sector strategy. We continue to seek alliances and acquisitions to advance our business in Europe and in the Asia-Pac region, as well as in the U.S. and the rest of the Americas. Tom?
Thank you, Chris. Revenue was up 26% compared to Q2 of last year and 5% from the prior quarter due mainly to lower money fund yield related fee waivers. Equities contributed 37% of Q2 revenues and combined equity and fixed income revenues were 53% of the total.
Operating expenses increased 25% compared to Q2 of last year and 1% from the prior quarter due mainly higher money market fund distribution expense as a result of lower waivers.
Recognition of proceeds from an insurance claim reduced Q2 expenses by $3.5 million mostly in professional service fees line items. Comp and related decreased from prior quarter due mainly to payroll tax and benefits seasonality. An early estimate of Q3 comp and related expense is about $74 million.
The pretax impact of money fund yield related fee waivers of $5 million was down from the prior quarter and Q2 of last year. The decreases were due mainly to the higher fund gross yields.
Based on current assets and yields, we expect the impact of these waivers on pretax incomes in the third quarter to be about $4 million. An increase in yields of 25 basis points would lower this waiver impact to about $1 million per quarter and a 50 basis point increase would nearly eliminate the waivers.
As we've previously discussed, the impact of the change in one of our customer relationships may reduce pretax income by about $6 million per quarter when fully implemented in late 2016. The actual reduction may vary based on asset levels and yields at the time.
Multiple factors affect yield related waiver levels and the ability to capture related income going forward. These factors are covered in the press release and in our SEC filings and we expect these factors and their impact to vary.
Looking at our balance sheet, cash and investments totaled $352 million at quarter end, of which $320 million is available to us. Audrey, we would now like to open the call up for questions.
Thank you. At this time, we will be conducting a question-and-answer session. [Operator Instructions]
Our first question comes from the line of Bill Katz with Citi. Please state your question.
Hi, good morning. This is Justin Tarrington setting in Bill this morning. Just kind of wanted to just focus on the equity a little bit. Just kind of -- two questions, first is, seen a lot of asset management reports so far, and there has been some struggles with getting equity flows.
I'm just trying to figure out what exactly is working so well for you guys. Just right product with strategic dividends or are there some other initiatives that you're executing on that are kind of driving that momentum?
And then a second piece is within the book, we've seen a lot of flows going into SNA versus retail, can you just kind of touch on fee rate dynamics are there and how you would think about the overall fee rates in the equity book if you kind of see that same sort of core dynamic going forward?
Okay. Let's look at the first question, which relates to why the equity flow share at Federated. Obviously did strategic value dividend mandate is driving the truck. As I mentioned in my remarks, it is the largest component of the net flows of $2.8 billion.
There are other products with positive flows. We mentioned the Prudent Bear product which is obviously a shorting type product and it had positive flows. We also had positive flows in the Muni Stock Advantage Fund, which again is kind of an income-oriented yet tax-advantaged approach to the marketplace.
And a small fund that's just getting started our Equity Advantage Fund also had positive flows and this is a fund where the portfolio manager who selects the high income securities also uses the stocks the underlying common stocks of those companies for a portfolio.
And as I mentioned in the remarks, there are several of our funds that have topped decile records for three years and so we feel we have a good balance of things, but the real engine is the strategic value dividend product.
Now, on the SMAs and the fees, the fees are left in SMAs. Then they are in the regular mutual funds and Ray would you characterize that number for us.
From pure advisory fee standpoint, typically, a separate account including an SMA is about half of the level of the fund.
And so our $22 billion of SMA assets as I mentioned the remark puts us about fifth in the lineup and we have been steadily climbing in that lineup. Interestingly, one of the engines of the SMA we think is going to be the DOL situation because and SMA product in a DOL situation is very, very responsive to fiduciary concerns, to transparency, to individual ownership, and so we think that's going to be a continuing winner for us and in the industry.
Great. Thanks for taking my questions.
Our next question comes from the line of Ken Worthington with JPMorgan. Please state your question.
Hi, good morning. Maybe first on distribution, you've been investing in building up your non-U.S. distribution I think both in source and outsource. Could you update us on where non-U.S. distribution stands and what kind of sales it's generating at this point?
Yes, the distribution in -- out of the Frankfurt office has been quite good this year in terms of producing assets from large accounts. They are responsible for that high yield -- the high yield wins that I mentioned during the remarks. So, that's going along pretty well.
In terms of the London distribution, we're seeing good positive flows in the Sterling Fund and positive flows in the Money Market Funds that are headquartered in our prime rate group in London.
In terms of Canada, the numbers aren’t going to move the dial, but they are -- we are seeing movement and accounts coming in as that fund gets started. We're also looking to build every side [ph]. In Asia-Pacific area, we have some of our friends looking to try to develop new strategies out there and I can't go much further into that than to say that we're still working on it.
Ken, if you look within the fund sales in the quarter the international component of ours would've been a mid-single-digit percentage of our total sales and of course as Chris mentioned we're going to have some more activity on the separate accounts side.
Okay, great. Thank you. And then on Strategic Dividend Value, obviously awesome funds here, how big is that product through all the strategies sort of the U.S. retail, in the institutional, you got some non-U.S. too. So, how big is it all totaled, the description at least I've seen is really mid cap with large cap and small cap flexibility, but it looks like all the holdings were large cap. So, when you think capacity, when does capacity of the funds start to come into play?
If you add them all up everything together, you get to about $35 billion in the total. The fund is knocking right on the door of $15 billion. The SMAs are pretty close to $20 billion and the separate accounts have about $1 billion. So, it's $35 million, $36 billion. And because of the nature of the stocks that are in there, we're not currently looking at any capacity issues for investing the proceeds that are coming in.
Okay, great. Thanks very much.
Our next question comes from Michael Carrier with Bank of America. Please state your question.
Hi, guys. [Indiscernible] filling in for Mike. We just wanted to hear thoughts on the increasing trend of Money Market Funds pose directly with large investors and what the opportunity set or impact might be? Thanks.
Sure. We have gone down that path. There has been a huge cutback in what was the traditional supply from traditional dealers in the repo marketplace over the course of the last seven or eight years. So, we begun to look under the rocks to try to find high quality, what I call, non-traditional counterpart. So, insurers generally come to mind, what would they basically be semi-sovereign types of institutions.
And we work directly with them the same type of contractual agreements that we would have with the dealer or a bank we put in place with those entities also. And we're finding capacity along those lines. It's slow going. It's one step forward, maybe a half a step back, but we're making progress in it.
Great. Thank you.
Our next question comes from the line of Surinder Thind with Jefferies. Please state your question.
Good morning guys. I want to just kind of like to touch base on the Money Market Funds. And kind of how the conversations with Price are going at this point. In light of the upcoming deadline, is there any interest in floating rate products at this point or is everybody looking for an alternative vehicle.
In terms of discussions with customers, they vary from customer to customer. Many are still buying their time. Some are just coming to the realization that October is real and some have begun to move from prime into a govi, which is -- can be viewed as the default option because the client gets to keep daily liquidity at par and can put off a decision on what really to do with whether they want to go through systems changes et cetera, what are the spreads going to be, we don't know, how big are the spreads and I'm going to have Debbie comment to you on the spreads and what's going on that side. But we are seeing interest by people who are going to stay in a floating institutional fund. Debbie?
Sure. The more conversations we have, the more interest people have in what I call -- manning their cash at this point. So, coming up with some estimate of a cash that might be needed on an overnight to one week basis and it has a lot more to do with what would be changing cutoff times than it does actually the floating NAV aspect of it.
Because of that floating NAV aspect, the cutoff time to our prime institutional products that will be mark-to-market transaction and those products will move to 5:00 to 3:00 o'clock.
So, our government funds will stay at 5:00 o'clock in addition to our retail funds. And as such so clients that are in need of the potential to have that 5:00 o'clock trading on a regular basis, will have -- are looking to segment -- some component of their cash and keep it in that government products within the next bucket for the next liquid segment being in the floating NAV product as long as there's a total return advantage -- the total return advantage which get to the question that Chris asked about the spreads in today's environment what we're basically saying is institutional prime a spread of about 15 days at this point over government products right now.
If you look at retail prime, we're looking at a spread of about 20 basis points. If we go out to offshore products regards impacted by the regulation, we're looking at something that is probably 25 to 35 basis points over government products right now and our expectation would be that from a private and a collective fund standpoint, those will be similar types of spreads.
The reason that the institutional prime spread is lower at this point is just the conservative nature with which we're running those particular products with a huge amount in overnight and weekly liquidity to accommodate shareholders when and if they do actually needs to lead that product.
So, once we lift the calendar from October 14 till October 17, you'll see that spread on the institutional prime go out also. My expectation would be that it doesn't grow nearly as much through October 14 because of that conservative strategy.
Interesting. And very helpful. And then a different question on kind of the fee waiver dynamic. In terms of just understanding the relationship with the client and how the potential $6 million per quarter is going to be implemented towards I think it was the end of 2016.
So, is it possible to be in the scenario where you guys continue to recover -- let's say the bulk of the fee waivers and the client doesn’t relies the $6 million per quarter. Or if we were status quo now and we moved into 2016, would the client be -- what would the client be realizing in terms of the benefit from the fee waivers?
If the rates increase till we get the full 15 basis point increase, the client will get to realize the full $6 million. That's why we say in there based on rates and how things go is [Indiscernible].
So, I'm sorry is that an incremental 50 basis points or is it 25 basis points?
No, no, the rates are -- we're not waiving anymore. They're going to get the $6 million. But if we are waving, then they won't get the full $6 million. So, the rate based on rate.
I see, and if we were to just --
Hold on. We fully expect it to happen, but we also have to see.
Fair enough. And then so related to that I guess, if we were to just push forward the current situation where we're now at January 1st of 2017 and there's been no more rate hikes, what would the client be getting at this point?
Well, basically if we do the numbers, we look at it and say if it were today and everything is exactly the same, it would be around $3 million.
Okay. That's helpful.
It would be our waiver impact Surinder. So, we went down to five and we said next quarter we see our way to four and that would be running more like three if we got into next year without a rate increase, but with the new arrangement with our client.
Okay. That's helpful. Thanks a lot guys.
Our last question comes from the line of Andrew McLaughlin with KBW. Please state your question.
Hi, everyone. Thanks for taking my question. I just had a question about as the waivers go away and earnings normalize, does that change your approach to capital management or expected a dividend or maybe a special dividend?
All right. Thank you for taking my question.
There are no further questions at this time. So, I will close it back to management for closing remarks.
Okay, well that will conclude our call and we thank you for joining.
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