Improving Economy Makes Counter-Cyclically Weighted Federated Investors A Sell

| About: Federated Investors (FII)
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Thesis and Overview:

A lot of the asset managers out there look pretty attractive as higher interest rates and an improving economy should help bolster asset inflows, the Fed's taper delay notwithstanding. That said, in this group, one firm stands out as clearly weaker than the rest; Federated Investors Inc. (NYSE:FII). Compared to peers like BlackRock (NYSE:BLK), T. Rowe Price (NASDAQ:TROW), and State Street (NYSE:STT), $2.9B market-cap Federated is heavily weighted towards managing money market funds and this is likely to cause problems as the economy strengthens. Yet with FII having risen 35% YTD and trading around $27.50 just shy of its 52-week high of $30.87, investors seem oblivious to this risk and are treating counter-cyclical Federated like all of the other pro-cyclical asset managers.

FII has a long history in the asset management business having started in 1955. The company's operations basically revolve around creating, marketing, and managing mutual funds and money market funds with clients ranging from high net-worth investors and foundations to pension funds and corporations. As of the end of the second quarter 2013 (June), Federated had $364 billion in assets under management of which 74% consisted of money market investments, 14% was in fixed income, 11% in equities, and the remaining 1% was in distressed securities. (Note that unlike an individual or even a mutual fund who can decide to change asset allocations shifting from equities to fixed income for example, FII does not have any ability to move money between its portfolios. If an investor puts money into an FII money market fund, they expect the money will stay in that fund, and FII does not have the right to decide to move it. The situation is analogous to an individual putting money into a checking account at a bank - the bank cannot unilaterally decide to move the money into a CD.)

Firm Headwinds

The crux of the problem for Federated is that as of the end of the second quarter, 74% of FII's assets under management (AUM) and 47% of revenues come from money market funds. Money market funds of course are those stodgy investment products that essentially serve as savings accounts for big companies and institutional investors. They are the product that people flee to when the world looks risky and other assets appear headed for a decline in value. Thus money market funds should best be viewed as a counter-cyclical product. When times are good and people are optimistic about the world, a lot of money that flowed into money market funds finds a new home in equity and fixed income assets. This is likely to become especially true in the future thanks to the proliferation of large liquid ETFs, which offer easy access to diversified investments.

Consistent with this view, FII's money market funds look set to lose at least 4.0% of AUM over the course of FY 2013 (-1.8% in Q1, and -4.0% in Q2, so even the possibility of strong seasonal increases in Q3 and Q4 won't stop the fund from shedding AUM overall for the year). This follows a 1.7% loss in FY 2012, and sets the stage for further AUM departure next year. In fact, these outflows from money market funds (and to a lesser extent fixed income funds) were so strong that despite the equity market's appreciation over the last year, FII's AUM at the end of the second quarter was down $13B compared with the end of the firm quarter.

Now, of course, money market funds do not disappear completely even when economic times are most prosperous. There is always a need for a place for companies and investors to park short-term cash and money market funds fill this role. The point though is that as the economy improves, investors are going to be a lot more interested in equities and bonds than they are in money market funds, particularly with the Fed guaranteeing that short-term rates will stay low for several years. (Money market funds are extremely safe and have just about the shortest term of any major investment class so their yield is highly correlated to short-term Fed funds rates.)

Given that nearly ¾ of Federated's AUM and 1/2 of revenues are derived from money market funds, a figure far higher than any of its peers, the company is sure to face some significant headwinds in fund flows as the economy strengthens. In contrast, the next highest level of AUM in money market funds on a percentage basis is Legg Mason (NYSE:LM) with about 21% of AUM in money market funds, followed by Invesco (NYSE:IVZ) at 11%, and BLK at 7%.

Adding to the short case here, the firm carries a 20% valuation premium versus peer forward 12-month EPS estimates. While FII's ttm P/E is about 15x, the firm's EPS levels aren't expected to improve much next year ($1.58 Est. 2013 EPS vs. $1.61 Est. 2014 EPS), and nearly all other asset manager's look set for higher earnings. Given this, FII really ought to be trading at least 20-30% lower than it is currently. This valuation premium set against a significant headwind in the form of the improving economy makes Federated a clear near term sell in my view. I don't believe the firm is in jeopardy long term, but its current valuation is unjustified and the firm is very likely to struggle for the next few years, particularly compared with peers.

Exhibit 1: The 50%+ increase in stock price for FII since the start of 2012 belies the challenges the firm faces.

In addition to the headwind the improving economy presents to money market fund operators like Federated, there is a second major risk that could easily crush FII shares by 10-20%; new SEC regulations on the money market industry. This is an old bugbear that has been hanging over the heads of the money market fund industry for a couple of years now, so I don't want to make too much out of the issue. To be clear, in my view it is very likely that we will see new SEC regulations on money market funds implemented by the end of 2014 and it's equally unlikely that these new regulations will spell disaster for the industry. (I'm not alone in this view as this recent Barron's article makes clear, though many industry groups continue to fight regulation that would damage their interests.)

Basically the two major regulations that will likely be included in some fashion in the eventual SEC regulations are called gating and floating NAVs. Gating essentially just restricts investors in a money market fund from taking out more than a set amount of money in a single period. In some proposals withdrawals over certain levels can trigger a liquidation fee. For example, the SEC might set a rule saying no more than $1 million can be withdrawn from a fund by an investor in a given day. Again the rules are in flux here and the SEC has just finished soliciting comments from the industry about this issue.

The floating NAV proposal would basically require money market funds to have a floating net asset value (NAV) versus the fixed net asset value now. Of course in reality, NAVs for money market funds already float. Money market funds invest in assets like treasuries, short-term munis, etc. These assets go up and down in value. Yet because money market funds are only investing in extremely safe assets, the (usually) minor day-to-day fluctuations in these assets were long ignored and the premise was that a dollar invested in a money market fund was always worth a dollar (not including the interest it generated of course). Put differently, money market funds, like savings accounts, have never been allowed to be money-losing investments. An investor put funds into the money market fund, and the fund wouldn't generate much in the way of a return, but it was 100% safe. A floating net asset value would fundamentally change that.

As it stands right now, it looks like the SEC will exempt retail money market funds from the floating NAV requirement, and instead only require institutional funds (and perhaps tax-exempt funds) to have a floating NAV. The details are still being ironed out on exactly what constitutes a retail vs. institutional fund, but suffice it to say that FII will have fairly significant amounts of floating NAV money market funds after the new regulations are implemented. On the last earnings call, firm management estimated that they currently have $8B of money market funds that are definitely institutional in nature, with another $47B that could go either way in terms of being institutional or retail.

The question for FII investors is how much would these new rules hurt? Would a large proportion of money market investors pull their funds if the SEC enacts the rules as it is currently considered? Unfortunately no one knows the answer to this, not even FII (or if they do, FII management isn't commenting as their last earnings call made clear). What is clear though is that if FII lost the full $55B of quasi-institutional money market funds discussed above ($8B + $47B), then this would represent a 15% of assets under management, and roughly 10% of firm revenues. Granted, the likelihood of all $55B in AUM exiting FII is very unlikely, but there is a high degree of probability that the new rules will cause a fair amount of money to exit and that in turn will pressure FII's revenues and profits. Just using conservative numbers and assuming that 33% of institutional money market assets exit the market, I estimate that FII would see a $0.20-$0.25 per share hit to profitability.

Exhibit 2: Federated Financials

Year

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

OCF/Share

1.98

1.64

2.1

2.21

2.44

2.37

2.07

1.75

1.79

1.95

EPS

1.79

1.45

1.73

1.92

2.2

2.12

1.8

1.51

1.62

1.71

Div/Share

0.96

0.96

1.98

0.96

0.93

0.81

0.69

0.58

0.41

0.3

High Price

23.89

28.57

28.14

28.31

45.01

43.35

40.17

38.11

33.79

31.9

Low Price

15.45

14.36

20.01

16.1

15.8

30.31

29.56

26.99

26.72

23.85

High P/E

13

20

16

15

20

20

22

25

21

19

Low P/E

9

10

12

8

7

14

16

18

16

14

Net Income

188

151

179

197

222

217

191

163

179

191

A lot of things can change between now and when the SEC puts out any future regulations on the money market fund industry, but the point here is that these regulations are a second significant weight on a firm that really doesn't need any more problems.

Finally, adding yet one more small headwind for the firm, FII's earnings and revenues have not been looking all that great for the last couple of quarters as the chart below shows. These issues look set to continue as FII seems to have experienced roughly $850 million in outflows from its high-fee/high-profit Kaufmann equity funds since the end of the second quarter. These outflows will likely hit Federated to the tune of about $0.05 on the bottom line in the next quarter.

Exhibit 3: Federated EPS and Revenue in Recent Quarters

Revenue

1Q

2Q

3Q

4Q

Year

2013

228

223.8

--

--

--

2012

230.3

232.1

238.5

244.8

945.7

2011

238.9

225.8

214.1

216.4

895.1

2010

233

231.5

242.2

245.3

951.9

2009

310.6

306.9

293.6

264.8

1,176

2008

305.7

310.3

305.9

301.8

1,224

EPS

1Q

2Q

3Q

4Q

Year

2013

0.41

0.39

E0.42

E0.42

E1.64

2012

0.41

0.39

0.54

0.44

1.79

2011

0.32

0.41

0.37

0.36

1.45

2010

0.38

0.46

0.42

0.45

1.73

2009

0.34

0.52

0.56

0.51

1.92

2008

0.55

0.55

0.56

0.54

2.2

Risks:

That said, there are a few risks to this outlook. First and most importantly, the market has been going up all year. Virtually every financial stock has been a winner. This could well continue, and if it does FII could get sucked up along with all the other financials. The obvious way to control this risk is to short FII while going long a basket of financials or long asset managers which are doing particularly well (BLK comes to mind for example). Remember, stocks have gone up about 11% per year on average since World War 2, so it is very important to distinguish between a stock that will underperform that market, and one that will simply crater due to impending financial ruin (the latter are often very hard to short since they are heavily shorted already of course). FII is not facing impending financial ruin, but it is extremely likely to underperform the market significantly over the next couple of years.

Beyond the basic market risk, investors in FII need to remember that since the firm is so heavily counter-cyclically weighted, any severe shocks to the economy could cause funds to flee back to the safety of money market funds. These shocks could include a costly long-term government shutdown, the default of the US government over the debt ceiling, war with Syria, or any number of other possibilities.

Finally, an increase in yields on short-term treasuries and other very safe short-term products could help FII. These rate increases would likely bring more investors back into money market (and fixed income) funds and lead to higher profits for Federated.

While these risks are possible, they are all of little concern to me. Despite the political gridlock in Washington, I don't think either party wants to see a major shock that will hurt the economy and risk throwing the country back into a recession. With midterm elections only a year away, such a strategy would likely be political suicide for the intransigent party in question. Further, if you think that I'm wrong and such an event is likely then it doesn't make sense to invest in any equities at all, as they will all see significant declines in value. Similarly, while it's conceivable that the Fed will overplay it's hand and raise rates too quickly, the delay of tapering last week and the rise of Janet Yellen as the near certain Fed Chairman-to-Be dramatically lowers the likelihood of any near-term rise in interest rates. With Larry Summers out of the picture, it certainly appears that the Fed is likely to remain quite dovish for the next few years.

Valuation:

FII looks set to earn $1.64 for 2013. At a share price of about $27.50, FII trades at a valuation of 16.8x this year's earnings. For a company that has stagnated and hasn't seen material EPS or net income growth in a decade, this valuation looks fairly rich. In contrast, peers like BlackRock and T. Rowe Price trade at P/Es of 18x and 19x this year's expected EPS and have respectively seen earnings more than quintuple and quadruple over the last decade. While analysts see 10.9% and 12.8% EPS growth for BLK and TROW next year, FII will be lucky to get 2% growth according to estimates. Given these valuations and growth rates, combined with the risks facing Federated, investors would have to be crazy to buy or even hold shares so close to their 52-week highs.

I think a much more reasonable multiple for FII would be 13.5x this year's expected EPS. That would see the stock trade at a slight discount to the S&P 500, and a share price of around $22, which is roughly 20% below current levels. Given the headwinds outlined above, and the very limited prospects for any meaningful catalysts for FII, I see upside risk limited to less than 10%. It is simply very unlikely that FII can make new highs anytime soon without a strong broad rally in the markets. Asset managers that are shedding assets as FII is, don't tend to trade at premium valuations after all.

Incidentally, as long as we are talking about analysts, and lest you think my views on Federated are too pessimistic, it's worth noting that Federated is a fairly well covered stock by sell-side analysts. Sell-side analysts of course are routinely regarded as an optimistic lot. So how does this optimistic bunch feel about FII? Of the 12 analysts covering the firm, 11 rates the company a hold (3), weak hold (5) or sell (3). Only 1 analyst rates the firm a buy at current levels. Yet despite this gloom among analysts and the obvious headwinds facing the firm, the company trades less than 10% off its 52-week high. The only conclusion I can come to here is that the market is assuming the SEC regulations will have no effect on FII and that the improving economy will help rather than hurt money market funds.

Again, let me reiterate, I do NOT believe that FII is in jeopardy long term, but I do think the improving economy, the uncertainty over the SEC's new money market regulations, and the continuing exodus of funds from FII's Kaufmann funds are all set to cause a decline in the stock price. With FII trading at valuation levels similar to the much more stable State Street, I think investors can safely short FII here.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.