Federated Investors: All According To Plan

Summary

• Federated Investors has executed well this year; analysts were off-base forecasting drops for the company in 2017.
• This in spite of some weakness in the company's equity product offerings, which I believe is due to strategy bias towards value over growth.
• Look for incremental earnings accretion next year, particularly within money markets as Fed rate hikes continue.

Federated Investors (FII) has been a bit of a stubborn position for me in 2017 as far as positive price action, but one that I’ve been extremely happy with as far as management execution goes, as well as the strength of my own analysis and modeling. Readers can find the original work here on Seeking Alpha, now behind the PRO paywall. But before getting into how the company has performed over nearly the past year, it is worth highlighting the key points of what still makes this a compelling play in financials space:

• No reliance on a steepening yield curve (a concern I had going into 2017 that has materialized)
• Strong equity and fixed income asset business
• Highly stable AUM within its money markets; market underestimating the turnaround
• Great value from the company’s asset-light business model

2017 Results: Strong And Above Prior Street Consensus

Federated Investors has beaten on the bottom line all three quarters in 2017, despite some weakness on the top line. While some might be put off by the drops in revenue, this is largely due to the change in a customer relationship highlighted in my prior research: the reorganization of Edward Jones deal. Under the agreement, $19B in money market funds moved from being under Federated Investors' control to within Edward Jones', where Federated Investors is now just advising in a sub-advisor capacity. As far as company presentations go, these assets did not drop off of assets under management (“AUM”), but they are receiving less compensation as a result of the new structure. As well as the Edward Jones deal, money market AUM has fallen from $252B to $244B, which has been driven by continued investor interest in equity/fixed income products.

However, on the bright side in money market, fee waivers are no longer an issue, and were officially non-existent in Q3 2017. As a reminder, money market funds can’t “break the buck;” net asset value (“NAV”) should stay stable. Money market funds, in the ultra-low interest rate environment of the past several years, weren’t making enough money on yield of the underlying securities to pay operating expenses, much less pay out any interest on investor funds. As a result, Federated Investors implemented fee waivers; investors weren’t going to be on the hook for the company’s shortfalls. For quite some time, the company was charging investors basically nothing to manage their money market funds, waiting for the day that interest rates would rise. We’ve now seen Fed Fund rates increases in December 2016, March 2017, and June 2017, with another hike likely before we end the year. One heavy critique of my work on Federated Investors was the expectation for three rate hikes this year; that looks like the reality today. That skepticism translated over to analyst consensus heading into 2017, of which I was highly critical:

Current consensus of $1.86/share for 2017, however, seems way on the low side… It is difficult for me to reconcile the core business as being flat in 2017 [versus 2016]. Consolidated results, assuming flat results in equity and fixed income products, would drive $220M in net income. That is good enough for $2.22/share on a flat share count…

Current consensus is now for $2.12/share, which I think is still a touch low; my expectations are for a $0.03/share beat in the final quarter of the year. My estimate has come down incrementally a little bit this year primarily due to a larger-than-expected shift from prime money market into government money market funds. As a reminder, SEC changed the policy back in 2014 (implemented in October of 2016), stating that prime money market funds now mostly report floating NAV, which is off-putting to many institutional investors that are highly conservative when it comes to risk (pension plans, government entities, insurance companies, etc.). This impacts the firm because prime yields continue to be above rates on government securities, so Federated Investors earns better margins on those products.

Durable Strength In The Equity/Fixed Income Businesses, Fiduciary Rule Impact

AUM within equity and fixed income products has held up quite well, particularly equity. As a reminder, most of the equity is in so-called value and income strategies, which have been out of favor with investors. Still, trends are positive; net sales (meaning withdrawals excluding market gains/losses) were $700mm in Q3, compared to $966mm in Q2 and $1,400mm to start the year. This does reverse years of positive sales (Federated Investors had been adding billions in net sales per year), but I think this speaks more to the asset strategies involved versus real negative. Within fixed income, AUM excluding gains/losses is down just $622mm this year; far better than 2015 and 2016 run-rates, and also including one sizeable $200mm withdrawal. Overall, a solid performance considering the continued shift from active to passive investment strategies by most investing groups. Look for international expansion to potentially provide a respite for headwinds in this business. The company added a new business development team in the Asia Pacific region, with similar growth in headcount within teams in Central/South America.

Concerns have circled around the fiduciary rule – its impacts, as well as implications, on companies within the asset management space. Broadly, I don’t think asset managers are nefarious and out to get clients, but they are worried about cost of compliance and legal ramification costs for an industry already facing some pressure from client exits. Management expectation is that it will stay (despite Trump’s delay attempt in February), but that coordination on the framework needs to happen between the Securities & Exchange Commission (“SEC”) and the Department of Labor (“DOL”) so that two standards are not in play. In August, the DOL filed a document that proposed an 18-month delay for final compliance to July 2019, so asset managers are likely to get a little bit more time to comply (versus the January 2018 deadline).

Shareholder Returns, Valuation

Net cash increased from $110mm at the end of last year to $153mm at the end of Q3 2017, despite the healthy dividend ($99mm annual commitment, 3.2% yield today) and share repurchases ($44mm worth Q3). Free cash flow is roughly $250mm annually ($225mm if you include stock-based compensation), which gives the company an incredibly solid free cash flow yield, particularly once you consider balance sheet health. Instead of dividend growth, management has a preference for special dividends (large ones in 2010, 2012, 2016), which have been rather routine when the cash balance gets up towards $400mm; if we don’t see one this year, I would not be surprised to see one next year.

I see $2.26/share in earnings next year, so shares trade at roughly 14x earnings. That comps very well against the asset manager peer group (13.5-14.5x), but those peers don’t have the money market fund exposure. Equity/fixed income products, particularly among managers with active strategies like Legg Mason (LM), are going to really struggle to see y/y growth (even including investment gains), whereas money market funds are going to be highly stable. If you’re a bank owner, I still maintain the entire asset manager space looks wholely more attractive; most regional banks (Regions Financial (RF), BB&T) trade at 16x earnings, and the big banks (Bank of America (BAC), Citigroup (C)) trade at 14.5-15.5x. If you’re looking for alpha in the financials world, this name still sticks out to me.

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Analyst’s Disclosure: I am/we are long FII. 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.