Federated Hermes, Inc. (FHI) Q2 2017 Earnings Report, Transcript and Summary

Greetings and welcome to the Federated Investors Second Quarter 2017 Analyst Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions]. I would now like to turn the conference over to your host Ray Hanley, President of Federated Investors Management Company. Thank you. You may begin.

Good morning and welcome. Leading today's call will be Chris Donahue, Federated's CEO and President; and Tom Donahue, Chief Financial Officer. During today's call, we may make forward-looking statements and 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, and good morning all. I will briefly review Federated's performance and Tom will comment on our financial results. Looking first at equities. We closed the second quarter with record high assets of over $65 billion. Total assets in the domestic and international strategy value dividend strategy increased to a record high of nearly $40 billion. The domestic strategic value fund returned 3.1% in the second quarter, which placed us in the top 8% of this what we consider not meaningful Morningstar assigned large cap value style box for the quarter and that put it in the top 7% year-to-date. Our funds objective is to provide a high and growing dividend stream from high quality companies. Its 12 months distribution yield are 3.4% ranked in the top 2% of its assigned category at quarter end. Furthermore, our find profuse a divided strategy at most funds in this category do not follow and as regularly moved between the first and fourth quartiles over history as we've discussed before. For combined domestic and international mutual funds and separate accounts, strategic value outflows decreased from 680 million in the first quarter to 40 million in the second quarter. The $14 billion domestic mutual fund had second quarter net redemptions of 336 million. Net redemptions have decreased each month in the second quarter, dropping from a 157 million in April to 114 million in May and 65 million in June. The $23 billion domestic SMA strategy return to net positive flows in the second quarter with a 147 million in net sales and institutional separate accounts added 156 million. Net sales for all equity funds and separate accounts in the second quarter were negative at 966 million, down from about 1.4 billion in the first quarter. However, funds with positive net sales in the second quarter included MDT Small Cap Growth and Small Cap Core, the Muni Stock and the Muni Stock Advantage Fund. We had six additional funds with modest flows in the second quarter. Using Morningstar data for trailing three years at the end of the second quarter, three Federated funds were in the top decile, six funds or almost 25% were in the top quartile and 42% were in the top half. Trailing one year rankings showed five funds in the top decile, nine funds in the top quartile and 17 funds almost two thirds above media. Top quartile trailing three year equity strategies at quarter end included MDT Small Cap Core top 1%, MDT Small Cap Growth top 3%, Kaufmann Small Cap top 7% and Kaufmann top 15%. Three weeks in to the third quarter, net sales of equity funds remained negative approximately 200 million, which is a lower rate than during the first quarter. Equity SMA net flows are slightly positive. In particular, the strategic value dividend fund had net redemptions of about 53 million through the first weeks of July, while the SMA had about 30 million of positive flows. We have seen early Q3 positive net sales in the MDT Small Cap Core and MDT Small Cap Growth in the Muni Stock Advantage, international strategic value dividend and international leaders. Turning now to fixed income. Overall net flows were slightly positive in the second quarter with net fund inflows of $138 million, offset by a separate account net redemption of $124 million. Net fund sales were led by the sterling plus short bond fund in the UK, the total return bond fund, high yield funds and the floating rate fund. Net redemptions for separate accounts were primarily due to a decrease of about $150 million in sub advised mandates, partially offset by the addition of a $41 million high yield account. Our fixed income business has a variety of strategies that are performing well. At quarter end using Morningstar data, the institutional high yield bond fund was top 3% for the trailing three years, top 13% for the trailing five years, and top 5% for the trailing 10 years. Our total return bond fund was top quartile for the trailing one, three, five and 10 years. In total we had seven fixed income strategies with top quartile three year records at quarter end. Fixed income next sales for funds are negative early in the third quarter at about $248 million, which includes an institutional client redemption of about $200 million from a government bond fund. Turning now to money markets. Total assets and funds and separate accounts decreased by $3 billion from Q1. Money market mutual fund assets decreased by about $2 billion from Q1 and separate accounts were down $1 billion, both reflecting seasonality around taxes. Our money market mutual fund of market share, which includes our sub advised funds at the end of the second quarter was 7.4% compared to the prior quarter of 7.5%. While money fund assets remain concentrated in government funds, we did see a slight uptick in prime asset - prime money fund assets in the second quarter. We believe investors will begin to reconsider their options overtime including our newer private prime fund and collective prime fund, which preserve the use of amortized cost accounting and do not have the burden of redemption fees and dates. We also believe that a rising rate environment will be positive for money market funds and we'll encourage investors to shift cash from bank deposits. And looking at our most recent asset totals as of July 26, managed assets were approximately $356 billion including $238 billion in money markets, $66 billion in equity and $52 billion in fixed income. Money market mutual fund assets were a $169 billion on net date and have averaged $171 billion so far in July. Looking at distributions. The second quarter was another solid sales quarter for our SMA business with $1.7 billion in growth sales and $167 million in net sales. Total SMA assets ended the quarter at an all-time high of $26 billion an increase of about $4 billion or 18% since the second quarter of 2016. Federated continued to rank fifth in the Dover Rankings of the largest SMA managers at the end of the first quarter, which is the most recent data available. In the institutional channel, we began the third quarter with about $205 million in wins yet to fund, roughly $80 million in the separate accounts and a $125 million in the project and trade finance tender fund. We also had our fixed income SMA strategies approved for one - to one of an additional major warehouse platform and anticipate sales beginning late in this year. RFP and related activity levels continue to be solid and diversified with interest in MDT and dividend income for equities and high yield in short duration for fixed income. On the international side, we are proceeding with our efforts for growth in Asia-Pac. This initiative is in its early stages. The new business development team will focus on the regional distribution of Federated investment strategies and growing strategic relationships with large financial institutions. This new effort compliments our European, UK and Canadian operations where UK assets reached an all-time high of $5.2 billion accounted in U.S. dollars. In Canada with last year's rollout of a new Canadian Domicile Strategic Value Dividend Fund, assets reached $2 billion, up from a $1.6 billion at the end of 2015. Assets overall in Europe, which we still include England in Europe are about $12 billion. We continue to seek alliances and acquisitions to advance our business in Europe and the Asia-Pac region as well as in the U.S. and the rest of the Americas. Tom?

Thank you, Chris. Revenue was down 5% compared to Q2 of last year, due to lower money market related revenues from lower assets and from the previously discussed change in a customer relationship, which occurred near the end of January. These decreases were partially offset by an increase in revenue due to lower money fund yield-related waivers and higher equity in fixed income related revenues. Revenue was down slightly from the prior quarter reflecting a full quarter of the customer relationship change and lower money market assets, offset by decrease in money fund yield-related waivers and an additional day in the quarter and higher revenue from equity assets. Equity revenues increased about $9 million in Q2 compared to Q2 2016 and $3 million compared to the prior quarter. Equities contributing 43% of Q2 revenues and combined equity and fixed income revenues were 60% of the total. Operating expenses decreased 5% compared to Q2 of last year and decreased 4% from the prior quarter. The decrease from Q2 of 2016 was driven by lower money market assets and the impact of the customer relationship change, partially offset by higher distribution expense as money fund yield-related waivers decreased. In addition, we had lower comp and related expenses reflecting lower incentive comp accruals. The decrease from the prior quarter was due mainly to the same factors as well as the seasonal decrease in payroll tax. In addition an insurance related recovery of about 618,000 drove the decrease in professional service fees from the prior quarter. An early estimate of Q3 comp and related expense is about the same as the rate in Q2. As we noted last quarter, the Q2 impact of money funds yield-related waivers was immaterial based on current and expected yields, we expect the impact of the waivers on pretax income going forward to remain immaterial. Our effective tax rate for the quarter was about 37% and we expect about the same rate for Q3. During Q2, we amended and extended our credit facility, the structure converted and amortizing term loans with $178.5 million outstanding and an unused $200 million revolver - $375 million revolver with an option to increases by two $200 million during its term. The term was also extended from 2019 to 2022 and the pricing remained the same. In addition to extending the term, the new structure gives us additional flexibility around loan draws and repayments. At quarter end, we had cash and investment of $283 million of which about $253 million is available to us. We continue to be active on the share repurchase front with 580,000 shares bought in Q2. Sherry, we would now like to open up the call for questions.

Thank you. [Operator Instructions]. Our first question is from Bill Katz from Citigroup. Please stay your questions.

Hi, good morning.

Good morning, Bill.

Thanks for taking my question. This is Ben Herbert on for Bill. Just seeing some higher spending guidance from some of your peers this quarter and wanted to get your outlook particularly against a decline in gross sales?

Well, if you notice that the distribution line came down and that's primarily because of the money fund reduction and reduction in assets and our commensurate distribution payments go out - go down if that goes down. So the main and then the compensation line, incentive compensation many times goes down if assets go down and the sales aren't as robust as they have been in the past. So those are the two main drivers of our expense line. If those go back up, the distribution and the compensation lines will follow right back up. In terms of all the rest of the line items, we company-wide have pretty diligent expense management and I expect that to continue.

Okay. Maybe taking just a step back and talking more from a strategic standpoint, where you think maybe the best opportunities are to drive gross sales going forward?

This is Chris. Overall in longer term that's one of the reasons we're going into the Asia-Pac region. Now that's not going to get you guys a quarterly number in the near term because I said it's early stages as I mentioned, but that has to be one of the first things that we go for. So when you look at where you can gather more sales, it's the ones I've mentioned in my opening remarks where you have a good handful of equity and a good handful of fixed income product that have top quartile three year records and those are the funds we have positive sales. Another interesting one which we have announced on July 24th was we did reduce the expense ratio in the Kaufmann Small Cap fund from 100.5 to 90. And we expect with this good performance in this $738 million fund to generate good sales there as well. We've also put a SMA program together for the Large Cap Kaufmann fund which again has a good record and we would expect things to be happening there as well. So what really happened in this industry strategically is as a result of the DOL, as a result of the proliferation of products over history, people are focusing more on those enterprises and those mandates and those areas of excellence that are able to offer those kinds of performance records that we're talking about and focus expenses, resources and development in those areas and that's what I think you'll see us doing and others as well.

Thanks for taking the questions.

Our next question is from Ken Worthington from JP Morgan. Please state your questions.

Hi, good morning. First, I was hoping you could talk about that the pricing of money market funds, you've mentioned in the past that there were competitors who sort of regularly were willing to cut price and try to take share and that Federated has had a strategy of remaining pretty disciplined on pricing. So what are you seeing in today's market? Are you seeing more aggressive pricing at all and if so is there a certain part of the money fund market where it's focused and maybe how intense is pricing competition today versus what it's been in recent years?

You have understood our approach to this quite crisply Ken. And overall I don't think it's any more intense than it has been before. People take turns, doing it and one firm will do it for a while, then another firm will do it for a while, some will stick to it longer. And we haven't seen ourselves lose any clients over this timeframe. We have seen the assets more or less level off. I think the decrease from during that quarter is the usual seasonality. And recall that the all of the optimization of this business means that clients like to diversify among the people, among the various people that are actually active in this field and that supplies a pretty good bottom for someone with our strategy and the strong relationships we have with the clients. There's also another thing we're working on, I've mentioned it here before and that HR 2319 which is a bill floating through Congress and you can put whatever percentage chance you want on a bill coming out of Congress. But this is a bill which would basically restore money market funds to the 2010 amendments i.e. restore prime funds with amortized cost, no fees engages, and no natural person which would enable the municipal funds to regain their once $500 billion that they had. And so that's another strategic way of getting at the same kind of question that you are looking at. Overall, in the money market fund area, the assets remain about the same where they've been, yeah, they go up and down a little bit, but you still got 2.7 trillion in that area. And so what that tells you is that the clients love the utility of the product. Yes, $1 trillion plus moved over to government but it moved over into a vehicle that retain the utility that was love so much by these clients.

Gotcha. Thank you for that. And then just turning to SMAs. Can you talk about what you're seeing in equity SMAs, maybe start by saying like what types of distribution have been the primary drivers of the growth last year when strategic value dividend was gathering so many assets there? And maybe why the flows have fallen off, I mean which distribution channels the flows have fallen off from and if so why?

Hey Ken, it's Ray. The growth there would be through all of the kind of platforms that you see, primarily broker platforms. And as we've talked about before, the SMAs work well in a Level C type of post DOL environment. So that's where most of the footings have been. In terms of the relative demand, it's really - it follow of the same overall pattern that you saw driven by strategic value dividend and - but the swings were more severe both plus and minus for the mutual fund than they were for the SMA. But they did follow a similar pattern last year after an extraordinary period of performance in the beginning of the year and then as the year went on and the market sort of shifted even though the strategy continues to do what it was supposed to do. The SMAs for us just down to where they very briefly touched negative and they're there they've been rebuilding now as we mentioned before. They're hedging back into in the solidly positive territory. So it's been driven by strategic value but we do have other strategies in there, the NDT strategies and they've had some positive flows. And I know you are coming at this from the equity side but we think that on the fixed income side, we mentioned the addition on one of the big - another one of the big warehouse platforms. And the fixed income strategy for us is a little under a $1 billion today and we look at this is a significant development to open up some meaningful new distribution toward the latter part of this year.

Great. Thank you very much.

Our next question is from Michael Carrier, Bank of America Merrill Lynch. Please state your question.

Thanks. Yeah, just had a question, you guys mentioned, I think on one of the Kaufmann funds some of the changes on the fees, just across the platform when you're you know looking at the lineup and competitively where the products you stand, how much of that have you kind of gone through, and I know it's you kind of go through from time to time, but I just wanted to get a sense on is most of that behind you or is there still some tweaks that could be done?

Well, Michael it is a constant never ending effort, and the way we look at it here is it all of those funds are like your children, and you look at them one of the time to decide what to do, there's no macro decision, oh the fee should be add or about meeting the expenses should be thus or so, those are all important touch points to analyze. But if you have a confluence of events of the capacity to sell the fund its investment record, the resources that are devoted to it, and what is the best thing to then do, and that's why I mentioned those two items the large cap Kaufmann and SMA and this the reduction in the Kaufmann small cap fund. We cannot to make big announcements about these things. We tend to just do them on the fly, and if you look over our history we're doing a few of these every year ordering the prices, changing the packaging in order to improve the presentation to the investment community.

Okay, thanks. And then just a follow up. Because both on the money market side and the fixed income has rates have risen and then on top that if we get in the second half of the year the Fed you shift in terms of the balance sheet policy. Is any your expectations on demand from products you talk to clients across either the money markets or fixed income meaning it there whether be some potential opportunities or you expect like the competitive environment to pick up become more challenging?

I will address this is at the beginning, and I think Debbie is phoned in, so she will be able to comment a little more after I finish. The first thing would be that as rates increase it was a big event to get all of the funds more or less added or above 100 basis points, and now your question is, one of the questions is, how big does a spread have to be in order to move people, and we Debbie included don't think there's going to be a rate increase until December in any event, and then there will be one, so you can tell what that's going to do to the rates in fact. So the slow inexorable increase in rates will have a positive impact on this business, but it's very difficult for us to the tech when people will switch back to prime if they don't have the utility of the product they want as against the given spread. Right now that spread is about 29 basis points or 30 basis points and in the whole history days it used to be 12 basis points to 15 points and people aren't moving back, and I think the reason is the utility of the product. Will it get higher, will they move, will they get more comfortable over time with the existing product structure that remains to be seen. I'd love to hear Debbie's comments on this, and I think you all would as well.

Sure, thanks Chris and I agree 100% that 30 basis points seems like a lot you know almost double, more than double what the history has shown as has been acceptable between prime and government, but that's when the two had a profile that were the same from a user shift standpoint and that's different now. So if 30 basis points isn't enough maybe it's 40 basis points, but what I really think is happening and what we're getting from a client feedback perspective on a day to day basis, is that they're putting a tiny bit of their cash in prime right now. So they may use to have had all of their cash in the prime factor. Now they've got let's say 80% and the government sector with a 20% that you know on new cash that's coming into their business is going into the prime factor, and because it is higher spread it's not seeing much volatility. We're not getting the seasonal flows in and out of prime that have historically been larger than what we would see in our government funds instead that day to day cash that needed on a on a daily operational basis is staying in the government space. I think the other place where we're starting to gain assets and certainly starting to gain a lot of interest specifically into the prime space is out of the bank deposit market in a rising rate environment, which as Chris mentioned, we do believe, we'll continue although with a slightly slower speed. We do think that the money funds make a whole lot more sense versus bank deposits that are kind of sticky and go up by quickly and certainly when you look at the average deposit rates both government and prime money market funds are above them substantially now from a year old and a return standpoint. So I think it's again taking time people have to have to get used to this product, but there are various reasons why it looks awfully attractive versus both the traditional government money fund product as well as other cash vehicles that are out there.

Okay, thanks a lot.

Our next question is from Kenneth Lee with RBC Capital Markets. Please state your question.

Thanks for taking my question. I just want to follow up on that on institutional prime and you mentioned that conversations with treasurer some of them are putting a portion of the money into the prime versus the government. I mean why wouldn't they put more into the - into prime because it sounds as they have the systems and accounting to handle you know the floating mass and stuff like thatjust wondering is there something else that we're missing?

I think a lot part to do…

First swing it guessing that - go ahead.

I think the lot of it has to do with the 5'o clock timing, so with the floating net asset value mark to market pricing that occurred all fund basically on the cutoff basis in the prime space of display or at 3'o clock and with many institutional clients they need capacity to transact out for 5'o clock. So I believe that a good reason why a portion of them are key thing a substantial amount of their cash in that government space.

Gotcha, gotcha.

Kenneth, one of the other features to this so, is they are going to test this, and they want to make absolutely sure that everything works? How all that four decimal place works? How the other customers in the fund work? How the fund works? And it's really hard to crawl in behind their brain to figure out, when they're going to break loose from their test mode into their all in mode.

Gotcha, gotcha. So would it be fair to characterize that the conversations from treasuries have changed somewhat that they are looking at that spread at 29 bps to 30 bps additional spread and they are trying to figure out ways to try to capture that additional spread rather than just sitting still?

Well, they are to some modest, modest extent, but you can feel them struggling with their desire to get it and being conflicted by the lack of the utility in the way the products are constructed as against the government fund and that that's their up.

I think one other fact to consider is the size of the prime fund at this point. The prime funds universe at its peak from an industry perspective was about $1.9 trillion and there were I say at least 20 products that were over $10 billion to $20 billion in size, there are currently three in the market that are of that size, so, what used to be anything an easy trade for somebody a corporate treasure that had short term cast to say what $1 billion in a single fund, now can't be done in a single fund it has to be broken up into smaller and net several funds because of the smaller nature of those products.

Gotcha. Okay, that's helpful. And just one more question in terms of the rising rates obviously some potential impact in terms of demands inflows, but wondering in a scenario of a gradual rising rate, is there any change in terms of the economics for federated either in terms of either widening margins or you know some kind of lag effect in terms of the fees versus the rates you're given to that to the clients? Thanks.

No, no.

Okay, helpful. Thanks.

Okay. And our next question is from Robert Lee with KBW. Please state your question.

Hi, thanks for taking my question, especially and go off and on to it, I just had a question about capital management you know now that earnings have come back it's been a while since you've raised your regular dividend recognizing the pace and specials are on the way, any kind of change in our policy and versus considering raising it versus continuing to kind of pay special?

So you're right. Thank you. We did pay special dividend not all that long ago and as the cash builds up you notice we still have 253 million that's available to us and looking at our needs. I think that we will have to look at that and consider what we do to see what is appropriate to give back to shareholders as we've continued in the buyback program. And the way we look at the use that cash is acquisitions that fit our criteria is kind of our first desire and that's because our criteria gives us excellent return on our acquisitions. And of course the regular dividend and then considering increases in dividends and special dividends and then the share buybacks which we continue to think are attractive. So we balance all three of those and we'll continue to look at it in a pragmatic fashion.

Great. Thank you. And if I could just follow-up on a little bit of a different topic. As distributors there's kind of been headlines and news about distributors narrowing their fund, have you felt any positive or negative impact in that?

We have felt impact from that and the way I would describe it is it forces naturally desired calling in any event. As I mentioned in answer to a previous question, when the big firms go from analyzing we're having on their platform 4,000 funds to having 2,000 funds and many of them have done exactly that. Then that causes you an impact. Now we have been very fortunate in that the funds that are big leaders for us, good flows for us, good performance for us and that we've devoted significant resources towards, all got through the grand Olympic of that change and so we came out in pretty good shape. How others did, I can't really assess that. So we have very good relationships with them and we think that our shelf space situation is really very, very good. And we also think that we'll have the ability to put new things on there as well like adding to the SMA shelf with our Large Cap Kaufmann offering. So it does have an impact and perhaps all it really does is accelerate that which the marketplace and insight business judgment would have done anyway.

Great. Thank you.

Ladies and gentlemen, we have reached the end of the question-and-answer session. I would like to turn the call back to management for closing remarks.

Well that concludes our comments for today and we thank you for joining us.