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Eaton Vance Corp. (NYSE:EV)

F2Q 2012 Earnings Conference Call

May 23, 2012 11:00 ET

Executives

Dan Cataldo – Treasurer

Tom Faust – Chairman and Chief Executive Officer

Laurie Hylton – Chief Financial Officer

Analysts

James Howley – Sandler O’Neill

Bill Katz – Citigroup

Jerry O’Hara – Jefferies & Company

Ken Worthington – JPMorgan

Cynthia Mayer – Bank of America/Merrill Lynch

Roger Freeman – Barclays Capital

Operator

Greetings and welcome to the Eaton Vance Corp’s Second Quarter Fiscal Year 2012 Earnings Release. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. (Operator Instructions) As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Dan Cataldo, Treasurer of Eaton Vance Corp. Thank you, sir. You may begin.

Dan Cataldo

Thank you and welcome to our second quarter fiscal 2012 earnings call and webcast. Here this morning are Tom Faust, Chairman and CEO; Laurie Hylton, our CFO; and we will first comment on the quarter and then we will take your questions.

The full earnings release and charts we will refer to during the call are available on our website, eatonvance.com under the heading Press Releases. 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 2011 Annual Report and Form 10-K are available on our website or on request at no charge.

I’d now like to turn the call over to Tom.

Tom Faust

Good morning and thank you for joining us. I am happy to report that our second fiscal quarter marked the return to positive organic growth for Eaton Vance with $567 million of net inflows into long-term funds and separate accounts during the quarter.

Our second quarter net flow results showed sequentially improvement across all categories of investments, equities, fixed and floating rate income, and alternatives, and among funds and separately managed accounts of all flavors, institutional, high net worth and retail. We achieved positive net flows primarily on the strength of net sales into Parametric’s structured emerging market equities, our tax managed bond and high yield income strategies, Global Macro Absolute Return, Parametric’s index tracking and overlay products.

We reported $0.45 of adjusted earnings per diluted share in the second quarter, which compares to adjusted diluted EPS of $0.47 in the prior quarter and $0.52 in the year ago quarter. As noted in the press release, earnings per diluted share were increased $0.01 and $0.03 in the prior and year ago quarter respectively by gains recognized on the 2011 sale of our interest in Hong Kong-based equity manager, Lloyd George Management.

And as Laurie will address in a few minutes, earnings in the first quarter of this fiscal year also benefited from $0.02 of other investment gains that did not recur in the second quarter. If there was a theme for our second quarter, I would say, it is improvement. In the quarter, we saw improved gross and net flows, improved investment performance, improved financial strength, and most importantly, improving opportunities. As I comment further on the results for the quarter and our prospects going forward, please refer to the PowerPoint slides on our website. We ended the second quarter with managed assets of $197.5 billion, 3% ahead of where we finished the first quarter and within 3% of our peak AUM reached 12 months ago.

Gross sales and other inflows in the quarter were $13.2 billion, up 15% from the first quarter. The increase was driven largely by 26% higher income product sales and strong flows into Parametric’s emerging market and index tracking strategies. Redemption and other outflows of $12.7 billion were flat versus the first quarter. The $567 million of net inflows for the second quarter translates into organic growth of just over 1%, not where we want it to be, but a decided improvement after two quarters of negative flows.

We have seen an improving investment performance trend for our strategies in a number of asset classes. We now have 31 funds with at least one share class with an overall Morningstar rating of 4 or 5 stars, up from 25 such funds a year ago. The improving performance of our family of municipal bond fund is coming at an opportune time as the prospect of higher federal income taxes in 2013 moves ever closer.

Floating rate bank loans continued to be a top performing and top selling franchise for us with significant growth potential. The combination of attractive current yields, solid underlying credit fundamentals, and a little to no exposure to potential loss of principal value due to rising interest rates creates a compelling investment opportunity. Industry – industry flow data provided by the Investment Company Institute continues to show a general reluctant among U.S. retail investors to invest in domestic equities instead of favoring international equities, taxable income, and tax free income.

We have competitive products in each of these categories as shown on the slide listing our four and five star ranked funds. Funds managed by our Atlanta Capital and Parametric affiliates remain an important part of our performance story. Within U.S. equities, large cap value strategy appears to be turning the corner in terms of its relative performance.

Following two months of strong relative returns, the Class A shares of Eaton Vance large cap value fund is now ranked in the top half of its Lipper peer group for a year-to-date, 1-year and 5-year performance and in the top quartile over 10 years. Performance over three years continue to lag most peer funds reflecting our funds more competitive positioning coming out of the market bottom in early 2009. We were optimistic that large cap value fund is now positioned for prolonged period of good performance.

Our strategy favoring large cap franchise companies trading at discount valuation is no longer encountering the style headwinds that hurt our relative returns in the early stages of the market rally and the investments in our equity research team and the enhancements we have made to our equity research process appear to be paying off and improved stock selection. Net withdrawals from our large cap value disciplined totaled $3.2 billion in the quarter, reducing net assets in the strategy to just over $20 billion or about 10% of our total managed assets.

Although, net outflows from large cap value continue, we are confident that the improved relative performance we are announcing is the same will lead to better flow results. There is nothing we can do in the short run that will better enhance our growth prospects than stemming large cap value withdrawals through better investment performance. On the new product front during the quarter, we launched Eaton Vance Global Natural Resources Fund a new mutual fund in the U.S. was advised by AGF Management, a leading Canadian fund company with a long heritage of successful natural resource stock investing.

Also during the quarter, AGF introduced one of Canada’s first Floating Rate Income Fund managed by Eaton Vance’s bank-owned investment team. We are pleased to be collaborating with AGF on these new fund launches. In May, we went live with a new global macro fund designed for institutional investors with return expectations and volatility tolerances that are above those reflected in our retail global macro products.

We have also started to gain traction with the traditional version of our global macro strategy in the variable annuity of some advisory channel. We have had one major win and believe we are closed to a second in the phase with funding to occur over the balance of the year. Institutional demand we are starting to see for our global macro strategy is consistent with broader trends in the institutional marketplace to reduce the allocations to equities and favorable alternatives that don’t have significant exposures to market risk.

As these trends further develop, we believe our many of asset return and other alternative strategies appealed for broader range of institutional investors. Outside the United States, we continue to develop business opportunities in Australia specifically around Parametric’s tax managed investing and portfolio overlay capabilities. Focused on the large superannuation fund to market and private banks serving high network of Australian investors, this is the first significant business opportunity for Parametric’s industry leading tax management capability that we have pursued outside the U.S.

Although this is in many ways a missionary sales effort, we are optimistic that we will see initial funding in Australia over the next several months. A new product that we have talked about in recent earnings calls is, I mean, municipal bond ladder strategy, which was developed to meet demand for institutional and supervise municipal bond separate account for high network investors moving from traditional brokerage relationships to fee-based advisory relationships.

Since launching the strategy last August, we have grown assets in managed muni ladders to nearly $300 million. Sales in the second quarter were up almost 90% from first quarter sales levels. While relatively low fee, we believe the ladder of muni assets will prove to be quite long-lived with well below average redemption rates and the market opportunity is clearly very large.

Including the Parametric Australian tax management and global macro opportunities just mentioned; our institutional pipeline for the remainder of the year looks quite solid. We also see continued strong interest in Parametric’s structured emerging markets and our bank loan strategy and recently had a couple of nice wins in large cap growth. As you know, institutional flows are lumpy and their timing can be unpredictable. Nonetheless, we remain optimistic that the channel will be an important contributor to Eaton Vance’s full year results. Looking more broadly, we believe our net flow performance over the balance of the year will be driven largely by the timing and size of new institutional wins as just described, how we do in large cap value and how our strategies are positioned for the investment environment as it develops over the next six months.

I would now like to turn the call over to Laurie to discuss the second quarter’s financial performance in more detail.

Laurie Hylton

Thank you and good morning. In our press release this morning, we reported adjusted earnings per diluted share of $0.45 for our second fiscal quarter, compared to $0.47 in the first quarter fiscal 2012 and $0.52 in the second quarter of fiscal 2011. As Tom mentioned, results for the first quarter of fiscal 2012 and the second quarter of fiscal 2011 included gains of $0.01 and $0.03 respectively related to the sale of the company’s equity interest in Lloyd George Management in the second quarter of fiscal 2011.

Other investment gains on our seed portfolio net of gains attributed to non-controlling interest holders in our consolidated funds did not make a meaningful contribution to earnings in either the second quarter of fiscal 2012 or 2011, but did contribute an additional $0.02 earnings in the first quarter of fiscal 2012. As we noted in the release the calculation of adjusted earnings per diluted share differs from the calculation of GAAP earnings per diluted share and that it reflects the add back of quarterly adjustments related to the estimated redemption value of non-controlling interest in our affiliates for the redeemable at others than fair value.

As you can see in slide 17, which reconciles our GAAP earnings to adjusted earnings, these adjustments totaled $0.01 in the second quarter, $0.07 in the first quarter and $0.02 in the second quarter of last year. As Tom noted, we reported assets under management of $197.5 billion on April 30, up 3% from managed assets of $191.7 billion on January 31 and down 3% from year earlier record managed assets of $203 billion. Average assets under management were $195.6 billion in the second quarter up 4% in the first quarter and down 1% from the $197.3 billion reported in the second quarter of last year.

Operating income was $98.8 million in the second quarter up 6% from $92.8 million in the prior quarter and down 7% from $106.8 million in the second quarter of last year. Our operating margin was 32% in the second quarter, 31% in the first quarter and 34% in the second quarter of last year. Revenue increased 3% to $304.8 million in the second quarter from $295.6 million in the first quarter, but decreased 3% from the $315.6 million reported in the second quarter of last year.

Changes in investment advisory and administrative fee revenue were consistent with changes in average managed assets as effective investment advisory and administrative fee rates were stable at approximately 51 basis points for each of the compared period. We saw 13% year-over-year decline in distribution and service fees related to revenue reflecting lower managed assets in fund share classes that are subject to those fees. Consistent with industry trends, our fund business continues to evolve from Class B and C shares with distribution and service fees generally totaling 100 basis points. To Class I shares with no distribution and service fees and Class A shares with distribution and service fees generally totaling 25 basis points. Although, the share class trend has no adverse effect on revenue, the profit impact is much smaller due to offsetting declines in distribution, service and deferred sales commission amortization expense.

Operating expenses of $206 million were up 2% from $202.8 million in this year’s first quarter and down 1% from $208.8 million in last year’s second quarter. Compensation expense was up 1% to $97.6 million in the second quarter from $96.7 million in the first quarter, reflecting increases in sales and operating income-based incentives and severance expense, partially offset by a $3.4 million decrease in stock-based compensation.

Gross sales and other inflows which drive sales-based incentives were up 15% in the second quarter compared to the first, while pre-bonus adjusted operating income, which drives our operating income-based incentives, was up 3% for the same period. As we noted on the first quarter call there is seasonality in our stock-based compensation expense that derives from the recognition on Class B of the full accounting cost of stock options awarded to retirement eligible employees. As a result, we see elevated stock-based compensation expense in the first quarter of each fiscal year as new grants are made. We then see a leveling in stock-based compensation expense in the second quarter that sets the pace for the rest of the fiscal year.

Compensation expense was substantially unchanged in the second quarter of fiscal 2012 compared to the second quarter of last year. With increases in base, benefit and severance largely offset by decreases in sales and operating income-based incentives. The increase in base and benefits can be largely attributed to 5% increase in headcount year-over-year, reflecting extended coverage in our retail distribution channel and additional new hires to support investment and administrative functions here in Boston and at Parametric in Seattle. The decrease in incentive compensation year-over-year is consistent with the decreases noted in both gross sales and pre-bonus adjusted operating income in our year-over-year comparisons.

Distribution expense increased 2% in the second quarter from the first quarter, reflecting an increase in intermediary marketing support payment, driven by growth in sales and managed assets as well as terms of certain marketing support arrangements, partly offset by decrease in discretionary marketing and promotional expenses. The decline in distribution expense in the second quarter of fiscal 2012 in comparison with the same quarter a year ago can be attributed to a decrease in discretionary marketing and promotional expenses and a decrease in intermediary marketing support payments driven by the decrease in program sales and managed assets year-over-year. The decrease in service fees, both sequentially and year-over-year is consistent with the decrease in service fee income, reflecting the ongoing shift to low or no service fee share classes.

The impact of this shift is also seen in the decrease in the amortization of deferred sales commission, which declined 5% sequentially and 43% year-over-year. Ending unamortized deferred sales commission assets on our balance sheet dropped to $22 million on April 30 from $24.4 million on January 31 and $38.1 million on April 30 of last year.

Fund expenses, which were substantially unchanged in comparison with the first quarter of fiscal 2012, increased to $6.6 million in the second quarter from $5 million in the second quarter of last year, primarily reflecting the conversion of Lloyd George Management from an advisor to a sub-advisor of certain funds sponsored by the company. Other expenses were up 8%, both sequentially and year-over-year, reflecting ongoing investments in systems and legal expenses related to various corporate initiatives.

Non-operating income for the quarter reflects net investment gains and other investment income of $2.8 million compared to $8.2 million in the first quarter of fiscal 2012 and $12.5 million in the second quarter of last year. A substantial portion of the decrease can be attributed to gains recognized on the sale of the company’s equity interest in Lloyd George Management, which totaled $2.4 million in the first quarter of fiscal 2012 and $5.5 million in the second quarter of fiscal 2011. As seen on slide 16, $1.2 million, $1.1 million and $3.3 million of net investment income was allocated to non-controlling interest holders in our consolidated funds in the second quarter fiscal 2012, the first quarter of fiscal 2012, and the second quarter fiscal 2011 respectively.

Non-operating income also include other income associated with the company’s consolidated CLO entity of $4.8 million in the second quarter of fiscal 2012 and $6 million in the first quarter of fiscal 2012 of which $3.9 million and $5 million, respectively was attributed to other beneficial interest holders as seen on slide 16. Second quarter fiscal 2011 the CLO entity reported total other expense of $17 million and a loss of $18 million was attributed to other beneficial interest holders. The residual contribution to earnings of approximately $1 million each period represents the combination of the company’s collateral management fee and net investment returns on its $2.2 million investment in the CLO entity.

Equity in net income of affiliates, which contributed $1.5 million net of tax in the first quarter of fiscal 2012 and $1.2 million in the second quarter of fiscal 2011 did not contribute to earnings in the current fiscal quarter. Reflecting a decrease in reported investment earnings of a private equity partnership in which the company invests, a decrease in non-consolidated investments in sponsored funds, and the sale of our equity interest in Lloyd George Management in the second quarter of fiscal 2011. As seen in slide 16, fluctuations in non-controlling interest have been largely driven by the performance of our consolidated CLO entity and the non-controlling interest value adjustments related to our subsidiaries. These non-controlling interests are redeemable at other than fair value.

Non-controlling interest value adjustments in the second quarters of fiscal 2012 and 2011 related primarily to adjustments through redemption value of the non-controlling interest in Parametric Risk Advisors based on an April 30 measurement date. The non-controlling interest value adjustment made in the first quarter of fiscal 2012 relates to an adjustment to redemption value of the non-controlling interest impairments of Portfolio Associates, which is based each year on a December 31 measurement date. Our effective tax rate was 35.9% in the second quarter of fiscal 2012 substantially unchanged from 35.7% reported in the first quarter and down from the 44% reported in the second quarter of last year.

Excluding the effective consolidated CLO entity earnings and losses, which are substantially allocated to other beneficial interest holders and therefore not subject to tax rate calculation of our provision. Our effective tax rate for both the first and second quarters of fiscal 2012 would have been approximately 37.5%. We currently anticipate that our effective tax rate, adjusted for CLO earnings and losses will hold steady somewhere between 37.5% and 38% for the remainder of the fiscal year.

At this point, I would like to turn the call over to Dan to provide some commentary on our balance sheet and liquidity.

Dan Cataldo

Thanks. I will be brief. We finished the quarter with just over $500 million in cash and $296 million in investments on our balance sheet. Excluding $47 million of investments in consolidated funds held by outside investors and other long-term investments of $17 million, we held approximately $240 million in our seed portfolio investments at quarter end. This is down from approximately $285 million at the end of last quarter as we were able to reduce our investment in a number of strategies that are talking outside investor interest. As Laurie mentioned net gains and other investment income made only a modest contribution to earnings in the second quarter as seed portfolio gains were substantially offset by hedges we carry against those investments.

Non-controlling interest holders of Parametric exercised to put in May requiring has to purchase $17 million of the total $51 million in estimated redemption value included in temporary equity at the end of our second quarter. The remaining non-controlling interest in Parametric is subject to put and call at a multiple to operating cash flow for the calendar year 2012. We expect to close strongly on a new $300 million corporate revolving credit facility to replace the existing $200 million facility that expires this summer.

We used $52 million to buyback approximately $2 million of our shares in the first six months of this fiscal year, repurchases did fall to approximately 600,000 shares in the second quarter from 1.4 million shares in the first quarter reflecting higher average prices of repurchase shares, and our desire to conserve cash for other corporate purposes. We have 5.9 million shares still remaining on our current repurchased authorization. With a strong credit ratings available line of credit, $500 million in cash, and $240 million in relatively liquid seed portfolio assets. We have ample resources in the financial flexibility to meet, anticipate, and need enact on opportunity that they arise.

This concludes our prepared comments. Operator, I would now like to open the call to question.

Question-and-Answer Session

Operator

Thank you. We will now be conducting a question-and-answer session. (Operator Instructions) Thank you. Our first question is from Michael Kim with Sandler O’Neill. Please proceed with your question.

James Howley – Sandler O’Neill

Good morning guys. This is actually James Howley filling in for Michael this morning. Just as you look across your retail franchise, which strategy you think are going to drive organic growth over the next 12 months or so whether it be munis, bank loans, high yield, absolute returns and then just assuming that at some point, retail investors do begin to re-risk, how do you think your asset mix setup for that type of environment? Thank you.

Tom Faust

If I heard that that was focused on retail, correct?

James Howley – Sandler O’Neill

Yes, it’s correct.

Tom Faust

I guess one thing, I would say and just to start is that I think most of the listeners are probably aware. We have a significant business in both municipal income and tax managed equities that is quite sensitive to the tax environment, and although, fund is not getting a lot of play. We think that over the next several quarters we will see increased focus on the issue of federal tax rates in the U.S. and therefore increased focus on tax efficient invest. We are certainly aware that as that environment unfolds that we could be in a position where input in our tax managed and tax sensitive products goes up.

We are in a position and I am speaking particularly around the muni side where our performance has gotten significantly better. We have a broad range of products and feel like if there is a significant surge in interest in either muni investing or tax efficient equity investing that we are positioned to be a significant beneficiary of that. So, depending on how things fall, that could be a significant driver of our growth over the next several quarters. Beyond that, much depends on what kind of environment we are facing.

We’ve got an array of products that span a broad range of risk categories; risk-on, risk-off across the broad range of things we are certainly covered. On the low risk side, we are best positioned in the absolute return space, where our Global Macro Absolute Return Fund is one of the flagship products in that category. You may recall that we closed that to new investors in October of 2010 and reopened that in October of 2011.

We feel like we are now pretty well back with that product now being in front of investors who would pull away from it, because we weren’t making available to new investors. So, certainly if we are going into an environment or continuing environment, where caution about the economy, caution about equities, I think our absolute return strategies and particularly Global Macro Absolute Return are well-positioned for that.

Similarly, I would say that, if there is concern about interest rates or the possibility of rates going up, our floating rate products, our floating rate fund, Floating-Rate Advantage, Floating-Rate & High Income Fund and institutional strategies that follow similar mandates, I think all are exceptionally well-positioned for an environment of rising rates. If it looks like and this doesn’t seem to be occurring today at the moment, but if it looks like enthusiasm for equities is growing based on better economic outlook and what look like pretty good valuations for equities. We’ve certainly got a broad range of products there.

I mentioned that our large cap value strategy has seen a notable pickup in performance over the last couple of months and now is at least above average in its category for a year-to-date 1, 5 and 10-year performance, and in fact top quartile for 10 years. Certainly one of the best sources of incremental net flows for us is a slowing in redemptions from large value. We think if we are entering a more cautious and equity environment, which seems to be the case, that this has historically been the kind of environment in which large value has performed relatively well given our focus on risk management and downside protection. And we would be hopeful, haven’t seen it yet, but we’d be hopeful that we’ll see an improvement in our net flows not from increased sales, but reduced redemptions and outflows from that strategy, which we commented were over $3 billion in the second quarter. So, a better outlook for large value even if it doesn’t involve significant sales growth would likely lead to better net flows just based on the likelihood of reduced redemptions.

James Howley – Sandler O’Neill

Great, thanks. It’s helpful. And then maybe just one for either Laurie or Dan, if you could just give some forward guidance on how should we think about the other expense line? Does that IT spend come up again? And then as you could just disclose the interest income portion of the gains and losses on other investments? I noticed you guys didn’t give that this quarter.

Laurie Hylton

Yeah, I’ve got the – at least the interest and other income, which is it’s about 1 point – just shy of $2 million for the quarter.

Dan Cataldo

Okay, great. In terms of other expenses, I mean I would think of it as modest upward pressure. I mean, we continue to feel pressures on investing in systems to support the various investment disciplines around the company. We did go through a big SAP installation over the past couple of years in 2009 call it through 2011, that is over, but we do expect that we will continue to have to increase investments in IT for our investment infrastructure.

James Howley – Sandler O’Neill

Okay, great. Thanks for taking my question.

Operator

Our next question comes from the line of Bill Katz with Citigroup. Please proceed with your question.

Bill Katz – Citigroup

Okay, thanks very much. I just want to start with capital management discussion. You mentioned that slowdown a function of both price and other uses. Can you comment a little bit on another uses at this point in time particularly since your stock price is coming relative to larger buyback last quarter?

Tom Faust

Yeah. We’ll remember that the stock is coming and mostly since the turn of the quarter. So, we were looking at over the course of our second quarter generally higher average stock prices than during the first quarter, so that’s the one point I would make. The second point, I guess relates to your observation about our comment about other opportunities and there are both opportunities that we see offensively and perhaps some defensively. Just maybe covering the defensive first, probably isn’t lost on people that we’ve seen some significant – starting to be significant retraction in the market in recent weeks and months and that to us is generally a good environment to be cautious and conservative and how we use our cash.

We found out in 2008, 2009 the great business benefit that can be derived from a generally conservative financial posture, so that’s the defensive side. On the offensive side, we have said publicly that we are interested in acquisitions and there have been certainly some properties that have been – I’ve talked about publicly that we’ve had some interest in, can’t obviously comment specifically on plans there, but if it proves to be an opportune time for attracting for – transacting in attractive properties, we certainly want to have the finance or whatever relative to consider that. And we think keeping a little more powder dry in terms of slightly reduced share repurchases makes sense at this time. We can reverse that at anytime. We are aware of the fact that the stock is down at the moment, but over the course of the second quarter, you’re right that we did take the foot off the pedal a little bit in terms of our stock repurchases.

Bill Katz – Citigroup

Okay, it’s helpful. And then my second question for you guys. Just so, Tom, you mentioned that you’re very close win for your peak level AUM, I was just sort of looking back at where both your earnings and your margins were then versus where they are today, and appreciate the volatility of the AUMs subsequent to those 12 months. But as you look at the business today at the end of the incremental business, is it equally profitable, particularly listening to Dan talk of IT expense a little bit or margin is sort of still trending lower?

Tom Faust

It’s a little hard to say, one of the things that when you talk about profitability, it’s important to think about, I guess maybe in two or – at least two and maybe even in three dimensions. One is profitability per dollar of revenue, which is what you will normally think about in terms of margins. Second is profitability per dollar of asset managed, and then the third if you want to think about that way might be value of asset managed. It not only looks at profitability, but also the longevity of assets that we’re bringing on to the books.

One of the things we did comment on in the quarter is that we are seeing a pretty significant run-off in our – in B and C share assets and therefore the mix of our assets is shifting more towards products that have known that distribution or service fees or have very low levels and that’s not a new trend but it seems to be if anything accelerating both within our fund business moving more to A and I share but also just at the moment the faster growth we’re seeing in our non-fund business versus fund. Those things are driving down realization rates on an overall basis per dollar of managed assets, but they do also have a positive effect on margins because the embedded service and distribution revenues are offset largely by associated expenses.

So one of the things that’s happening is as our business changes we’re seeing some upward pressure on margins, maybe somewhat perversely as we move from B and C share business to A and I share business. I would note though that doesn’t necessarily mean its better business. Profitability per dollar of asset is likely down a little bit as a result of that because we have made some – were generally small but have made some profit on those incremental revenues we’ve gotten in connection with distribution and service.

So it depends a little bit on how you look at it whether you’re looking at it on margin per dollar of asset – margin per dollar of revenue. In terms of the third dimension I referred to the stickiness of the assets, I think that’s one of the great frustrations I and others that try and run asset management businesses have at the moment, is that based on changes in and share classes and maybe even more so based on changes in technology. The value of the assets that we raise and this is probably more through retail than institutional, but somewhat through there as well. The value of those assets is going down because the assets don’t stay on the books as long, there is a faster churn rate of assets, its easier for financial advisors to move from fund A to fund B.

The switching costs to the investor that’s doing that are close to zero, if not zero. So we’re seeing a lot more – a lot higher velocity of money. Funds like our large cap value fund, that go through a period of underperformance when their style is out of sync with what the market is doing for over a period of couple of years get punished more in terms of outflows than I think would have been the case five or 10 years ago. So, there’s a real cross current of things. If you trying get underneath, is our business is a new business, we’re bringing on somehow better or worse than what it’s replacing. I think I have a hard time answering that in aggregate.

One of the things I guess I would point to is, as we talk about this muni ladder business which is low fee, we said 120 basis points for that business, so small, only about $300 million, so just a drop in the bucket, but brand new business that we’re excited about; think that we can grow. Low fee, low profitability per dollar of managed assets. We think it will be relatively high margin because we can manage these assets pretty efficiently, but also we think there are attractive assets because we think they’ll be on the books for potentially many, many years. So, how do I think about that business? I look at the total value of those assets that we’re raising. What is the cost of bringing the assets in, what are they worth to which is a function of revenue realizations, cost to manage the assets and how long we expect those assets to remain on the book.

So maybe a longer answer than you’re looking for, but there are a lot of things that drive our margins up and down on a secular basis. I am not sure I could really prognosticate whether on an overall basis margins go up or down on a percentage of revenues. But certainly there are many competitive pressures on our business, and second, on an overall basis, this is very big picture how company like Eaton Vance it grows margins, it’s generally by growing scale. There remain significant economies of scale in our business and incremental $1 billion or $5 billion added to the assets of an establish investment team that tends to be pretty profitable if we’re out creating new strategies and building new teams or have existing strategies or teams that are not at their full potential in terms of assets, those are going to be less profitable.

So, if we can grow deeper and stronger in areas of core expertise I see no reason why we can’t see upward pressure on margins. If we’re unable to do that I think there’s a pretty good chance that we’ll see pressure on margins because this is a very competitive business. If you stand still in this business your prices are going to go down, your costs are going to go up squeezing margin. So, I feel like growth is imperative, innovation is imperative, performance excellence is imperative to maintain and improve upon margins.

Bill Katz – Citigroup

Okay, that’s very helpful. Thanks on the detailed answer.

Operator

Our next question comes from the line of Dan Fannon with Jefferies & Company. Please proceed with a question.

Jerry O’Hara – Jefferies & Company

Good morning. This is actually Jerry O’Hara sitting in for Dan this morning. I was wondering if you might be able to just discuss a little bit of flow trends month-to-date and specifically a large cap value if at all possible. We are seeing a little bit of it at least on an estimate sense from some of our data providers. It looked like there may have been an acceleration of how close that compared to some of the months prior?

Tom Faust

Yeah, I don’t have at my fingertip a good sense of your kind of month-to-date for May. Is that what you are looking at?

Jerry O’Hara – Jefferies & Company

Yeah, and in a broad sense and then if possible anything on a granular level as well?

Tom Faust

Yeah, whether what we are facing in, I won’t comment specifically on the three weeks or so period. And one of the – but may be more generally on large cap value. We have been in this mode where in the period mostly 2006 to 2009, we won a lot of platform sponsorships within the broker dealer world within independent financial advisors were essential, they are keeping growth awarded a lot of large cap value business to Eaton Vance.

In periods when you have seen lumpy outflows out of our large cap value funds, generally what is that reflects is that the same gatekeepers have allocated away from us on basis generally of disappointing three-year performance. I guided that our year-to-date one, five, and 10-year performance numbers are ahead of average. But the three-year numbers are depending on the day and depending on what you have got – what you are looking at are either fourth or fifth quintile. So, certainly not what people are looking for?

So, that’s – we know that’s how it works. We got the business three or four years ago because we had competitive performance. We can argue that firing us and hiring somebody else at this time may well be exactly the wrong thing to do. We think this is the kind of environment that we are in today where quality is in favor with value makes sense for large cap companies and their greater financial wherewithal are perhaps more attractive for a more difficult economic environment where we have seen an improvement in short-term performance.

All these things may say a sensible decision is buy in the large cap value as opposed to sell. But we understand that very often those gatekeepers rely quite heavily on their views of recent performance trends. But that’s the world we live in. Outlook for the third quarter flows beyond large cap value and more generally, I would say, it’s certainly mix and we are a bit more cautious than we would have been three months ago because it’s a bit of a scary world at the moment and what is that imply for fund flows generally, what is that imply for equity flows. I think we are pretty well-positioned with a nice anchor to win word in our alternatives business and our floating rate business. But on an overall basis given what the market has been doing over the last several weeks, it’s hard to be real optimistic that particularly that equity flows will be strong industry wide.

Jerry O’Hara – Jefferies & Company

Great, that’s very helpful. Thank you.

Operator

(Operator Instructions) Our next question comes from the line of Ken Worthington with JPMorgan. Please proceed with your question.

Ken Worthington – JPMorgan

Hi, good morning. First on the muni business, it seems like the industry has been seeing pretty good sales into muni funds. Eaton Vance seems more a lackluster, and I think that flagship funds is in pretty – pretty regular, like small, but still regular redemptions. So, what do you think is going on here and I think you mentioned in the prepared remarks maybe to an earlier question that you thought that the muni franchise should be a beneficiary as we start to think more about federal taxes changing and so on. So, what gives you kind of the conviction that if retail investors and the brokers are starting to focus more munis? They are going to focus more on your munis and not someone else’s muni products? Thanks.

Tom Faust

Good question. We have – I would say we probably have as broad, if not a broader menu of muni strategies as really any provider. We have a muni team here in Boston. We have a muni team in New York with quite distinctive styles. We have national. We have state specific funds. We have national. We have state specific retail managed account products. We’ve got this new muni ladder product that I mentioned.

What – but despite all that we have one product that has been and continues to be our flagship, which is Eaton Vance National Municipal Income Fund. You may recall that in the period of 2008 – late 2008 in particular, we had a pretty significant downturn in relative performance. Thankfully that’s now moved out of our three-year performance numbers. So, we have using Lipper or Morningstar data, we’ve got for our national muni bonds, really very good total return performance on a 1-year, a 3-year, and a 10-year basis, though our 5-year numbers are still well below the category average, because they include that period of weakness in late 2008 and to some degree another period of weakness in late 2010. So, we have been a somewhat more volatile manager than we’ve been the longer duration. We are higher yielding and there are times when that’s appealing broadly to the marketplace, there are times when that’s not exactly what muni investors are looking for.

I can’t really comment on why I think we are going to do better than others? We’ve got good products. We’ve got competitive yields. We’ve got strong performance. We’ve got a diversified asset base. So, I think it will be who is more effective in first investing, producing investment results, and second, positioning their strategies with the gatekeepers and the individual financial advisors that choose among the, I don’t know, half dozen or so major muni providers, but you are right, we’ve been a little bit disappointed with our retail fund flows. So, to some degree that masks the overall strength of our muni effort. Our TABS retail managed account effort is in strong positive flow position as is the new ladder of muni portfolios that are managed by TABS.

Ken Worthington – JPMorgan

Perfect, that’s helpful. And then in terms of gross sales, so looking at sales in the gross basis as opposed to net, it seemed to pickup in the quarter, you changed exposure, so I can’t really see how the trend was doing. But I guess the question is how do the gross sales look today versus a year ago, two years ago, are you seeing kind of a little bit of a pickup here and to what extent on the gross side, is the sales force getting more traction or is it generally unchanged?

Tom Faust

Well, if you look at the slide, slide 6 is a pretty good measurement. This is on a semi-annual basis, but you can see that – semi-annual basis, but you can see that our sales run rate – this is our gross sales. Our sales run rate in the first half of last year was at about $60 billion a year clip that we didn’t do that for the whole year, because the second half of the year we only sold roughly $25 million. So, where we – and which is about where we are now. So, in the first half of last year, and this is all on slide 6, we sold $30.2 million, the second half of last year we sold $24.7 million. The first half of this year we sold $24.7 million.

So, we have a pretty big falloff in our gross sales in the last quarter of fiscal 2011. We have seen a partial recovery in the first quarter, a partial recovery in the second quarter, but that puts us in total for the first half right equal with where we were in the first half – in the second half of last year and well down roughly from $30 million down to $25 million. So, we’ve got some work to do to recover our gross sales momentum back to where we were in the first half of last year.

And that was a peak level. We’ve never in any individual year had over $55 billion of gross sales. We are trending at about $50 billion today, so we’re running a little bit below where we were on an annual basis last year; so down significantly where we were from the first half of last year. What fixes that? A couple of things, one is I guess better product which is mostly a reflection of performance and we see an improving trend of performance across a range of products. I think generally there are some exceptions to this, but many more of our strategies do better on a relative basis during periods of market weakness than they during periods of market strength on an overall basis I would characterize this as relatively defensive investor, so again there is some exceptions to that.

So, we think the market environment is moving more in our favor compared to where we were in the first couple of months of the year when markets were moving up sharply. The other thing is we’ve made significant investments in our distribution team. We’ve added a number of – I think we have roughly half a dozen new retail sales people in the field today that we didn’t have 12 months ago. So, between better product performance and more sales people and more resources devoted to marketing and product support for them, I feel like we’ve got the ingredients in place for a higher level of sales than we’ve seen for continued growth there, but a lot is going to depend on what the market does.

Dan Cataldo

Ken, I would just add if you look at the quarterly gross sales, if you see a trend and it started back in Q3 of 2011 where sales dropped off with the pace that they were on in Q2. But let me just give you the quarterly numbers and you’ll see where we bottomed and now we are kind of coming up out of bottom. So, in Q3 2011, our quarterly gross sales were $13.7 billion; Q4 was $11.1 billion; Q1 2012 $11.5 billion; Q2, $13.2 billion. So, we have come up off the bottom and are showing some momentum.

Ken Worthington – JPMorgan

Great thank you very much.

Operator

Our next question comes from the line of Cynthia Mayer with Bank of America/Merrill Lynch. Please proceed with your question.

Cynthia Mayer – Bank of America/Merrill Lynch

Hi thank you. Maybe just following – excuse me, drilling down a little bit on that. It seems like the flows in high net worth and SMA improved a lot this quarter and I was just wondering what’s driving that and how much of that is at Parametric, is that fixed income and what’s the fee trend in those products?

Dan Cataldo

So, Cynthia you’re right, we did see some strong flows in high net worth $800 million to be precise, and that was largely driven – almost entirely driven by success at Parametric which is largely through the tax managed core products. So, that business tends to be lumpy and we certainly saw some nice positive close this quarter. It is a lower fee business probably 25 basis points plus or minus, but certainly very profitable business that we’re happy to bring it.

Cynthia Mayer – Bank of America/Merrill Lynch

Okay. And maybe just following up on the discussion you had on the margins in the business, a two-part question if it’s okay, which is if the business is becoming higher velocity it seems like maybe that’s at odds with the long-term practice in the business of paying sales incentives based on gross sales, and is there any move to copy more on retained assets or net sales or in some other way trying to incentivize sales to sell the stickier assets. And then secondly, if scale is really what’s key to improving margins would you be more inclined to do an acquisition for scale sake as opposed to just doing a – or not just doing, but as opposed to strategic considerations being really key, the scale important to you now in terms acquisitions?

Tom Faust

Just – the two things, one is on the gross versus net and how we compensate the sales force and the other on scale. So, first on the sales force compensation, I personally would love to go to the model where we pay the sales force on net flows. I don’t think we figure out how it would work for in net outflows, would they actually pay out for that. We haven’t suggested that, but my guess is it would not go over terribly well. So, we have not moved to paying on net sales. We still pay primarily on the basis of growth.

However, we do have a growing percentage of the compensation of our sales force that – that’s bonus as opposed to just gross sales that tends to be reflective of a number of factors is certainly one of the them is net sales success and overall both for the – both for the company as a whole as well as for the individual territory. But that’s one is that increasing bonus component that’s there. The other thing I would say is that we do have a quite differentiated sale payment.

We don’t pay the same for everything. We recognize it – that some assets are significantly more valuable to us than others will look at and determining less those. So, in some cases we pay more than twice as much per dollar asset for one fund as we do for another. What goes into that is things that, I am sure you would guess, strategic importance to us of building two scale in that particular product or investment mandate fee rates expected longevity of the assets etcetera.

So, we are – we have not – we are not a leader, I don’t believe in going to paying on net sales. Some have tried it, I think it works pretty well if you can keep the net positive. But it gets awkward as the net is a negative. It also puts the sales person and I think a bit of an unfair position because typically it’s – while there is a lot that goes into a sale that the wholesaler is not in a position to influence there. I think, significantly more that the wholesaler is not in a position to influence relating to redemption so, it has that problem as well.

Regarding the question about, do we think scale derived from an acquisition is likely to produce higher margins? I guess it could be, but it depends a lot on what you pay for the acquisition and can you bring out cost. That really wasn’t what I had in mind. If you have one investment team and they’re running twice as much assets that tends to be pretty straightforward that you get economies of scale. You get – some of those economies are shared with investors through break points and fee concessions. But a fair bit of that flows to the bottom line of the investment manager.

If you have one investment team and then you acquire a second investment team and each of them is doing their own things, I don’t see how one plus one necessarily comes to more than two. Now if you can consolidate those two teams into one or you can consolidate admin functions or executive functions or sales management functions, marketing functions, you can make one and one produce more than two so, we are open. We have looked at in acquisitions.

We have never done a type of acquisition that is I guess what you might think of as a merger of equals, at least going back to late 70s when Eaton Vance was created and what was more or less a merger of equals. That is a review as a purely high-risk acquisition strategy. If it works, you can bring out significant scale economies as long as you don’t overpay. If it doesn’t work potentially, you put your whole business at risk. So, we have been consistent with our cautious nature generally, we have been cautious about the company type acquisitions as well.

Cynthia Mayer – Bank of America/Merrill Lynch

Thank you.

Operator

Thank you. Our next question comes from the line of Roger Freeman with Barclays Capital. Please proceed with your question.

Roger Freeman – Barclays Capital

Hi, good morning. Just two questions on things that were asked. The comments about the gatekeepers reallocating away and large cap value’s underperformance, I’m just curious how that process works, when the performance improves on a product like that that they know well, is it mainly just a function of when you get back to the three year numbers, and fairly quickly do you come back or did you have to sell that to them again and what kind of lag could there be, they want to see some consistency?

Tom Faust

What I would say our numbers are better. The numbers are not good enough at least in most places to win new platform assignments. How we improve our net flow situation, we may have some of that and I would welcome that, but for the most part the way we look at it is, it’s not that we’re winning new, it’s that we’re getting fired less. And generally to win new business you got to be well above average and I would to be fired, normally you need to be well below average. So, our numbers have moved into a range that I’m hopeful we’re less likely to be fired as opposed to moving into a range where I think we’re going to be consistently more successful in getting hired.

Roger Freeman – Barclays Capital

Okay. But again, if you’ve been fired, is it like a new sales process all over again or is?

Tom Faust

I think worse than a new sales process. I think once you’ve been fired they’re probably not going to hire you next week, regardless of what happens with your performance over the course of that week. I would think you go, but not to the back of the line, probably near the back of the line once you get booted.

Roger Freeman – Barclays Capital

Okay. And then just parsing part of the comments about gross flows quarterly, you may have actually answered this, but on large cap value, net flows were picked up 1Q to 2Q. So is that a function of gross sales actually being less versus your overall trend or was it higher again?

Tom Faust

Yeah. So, net flows went from – for large cap value, the whole strategy went from minus $2.1 billion in the first quarter to minus $3.2 billion in the second quarter. Somebody’s looking at whether the – I’m guessing that sales were down.

Dan Cataldo

Gross sales were down to just. This is somewhat across the franchise, but they were $1.6 billion in Q1 versus $1 billion in Q2.

Tom Faust

Of the $1.1 billion decline in net, about half of that was due to lower gross sales and other half was due to a pick-up in redemptions.

Dan Cataldo

That’s right.

Tom Faust

Alright, yeah.

Roger Freeman – Barclays Capital

Okay, great. Thanks for the clarification.

Operator

Mr. Cataldo, we have no further questions at this time. I would now like to turn the floor back over to you for closing comments.

Dan Cataldo

Thank you. And thank you all for joining us this morning and we look forward to talking to you in August and hope you all enjoy the Memorial Day weekend coming up. Thank you.

Operator

Ladies and gentlemen, this does conclude today’s teleconference. You may disconnect your lines at this time. Thank you for your participation and have a wonderful day.

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