|Shares Out. (in M):||104||P/E||12.4x||0.0x|
|Market Cap (in $M):||2,160||P/FCF||9.6x||0.0x|
|Net Debt (in $M):||50||EBIT||295||0|
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Brief Industry Overview:
The US based Asset Management industry suffered a severe sell-off in 2011, down ~30% vs. a flat S&P500. The Asset Management industry bounced back somewhat so far in 2012, up mid-single digits, in line with the S&P 500. The sell-off in 2011 was due in part to declining revenues, and in part due to investor fear that market depreciation of an Asset Manager’s products will be magnified in an Asset Manager’s earnings. There is some basic merit to this argument, but as Mr. Market is wont to do, I believe the sell-off was over-extended. Asset Managers, including Federated, have significant resiliency in down cycles and exceptional growth profiles in positive environments. This is because Asset Managers typically have a significant amount of variable expenses in the form of distribution expenses and Principal bonuses. Revenue may decline one for one with the market, but earnings prove much more stable. Conversely, in a positive growth environment, variable expenses increase, but at a lower rate than earnings, aka, positive operating leverage. Asset Managers typically have large operating margins, healthy cash flow, low leverage and a good deal of cash on the balance sheet from retained earnings, and therefore maintain significant margin of safety. With ~30% operating margins, $225MM of FCF, $350MM of senior debt (~1.25x EBITDA) and $310MM in cash on its balance sheet, Federated is no exception.
Federated is a diversified, multi-product mutual fund Company, totaling $364 billion in AUM. Federated derives ~50%, 30% and 20% of its revenue from fees earned on its money market, equity and fixed income products. Apart from having a very diversified revenue stream (a must have in the Asset Management world), Federated represents 11% of the money market fund market share, a niche industry, that exhibits stability and high barriers to entry.
Federated trades at a slight discount (~12.4x 2012 net income) to its peers (~12.6x) but has a significant near-term event; namely, the reversal of money market fund fee waivers, that will increase earnings by ~33% sometime between now and the end of 2015, whenever the Fed begins to adjust rates upward. While it is difficult to know exactly when that will happen, Federated currently pays a 4.6% cash dividend yield, has historically purchased a substantial portion of shares each year and has issued special cash dividends; so at least you are getting paid to wait.
Stable industry. It’s very difficult to predict what type of device we’ll be using in ten years to read the morning newspaper or call home, but there will always be a need to manage cash, and there will always be government paper, for as far out as anyone can see. The only thing I can see having a major impact on the money market industry would be a regulatory change in the operating environment, which is currently being contemplated. How seriously and how drastic are both unknowable. I’ll provide some more color below.
Barriers to entry. In many ways, the turmoil in 2008, as well as the increased regulations, makes it next to impossible for new entrants into the money market business. To be profitable, you need two things. Trust and scale. Most of the major players that investors recognize and trust, (at least, sort of trust anyway), are already in the game (Fidelity, Schwab, JPM). The top 20 names control 96% of the industry and every name is a household name. To give you an idea, the 20th ranked competitor is T. Rowe Price. After what the economy just lived through, no one is going to give their cash to an unknown start-up. Secondly, you need scale. Because money market funds charge low fees, ~20-40bps, you can’t really form a business managing less than $1 billion in AUM, like you can with equities. Federated currently is tied with JPM for 2nd in market share in the industry, each with 10%, or roughly $250 billion in AUM. Only Fidelity controls more, managing approximately a 16% market share. The next five competitors, Vanguard, Schwab, Dreyfus, Blackrock and Goldman, each have 5-6% market share. I believe the industry is in its mature stage and those companies that maintain focus on gathering market share will emerge the victors, something Federated seems to be fully focused on, as I’ll explain in more detail below.
Brief history. Founded in 1955 by John Donahue, in Pittsburgh, Pa, Federated Investors helped pioneer the field of money market funds growing to $8.6B AUM in 1980, before eventually listing on the NYSE when the firm surpassed $100B in AUM in 1998. Starting in 2001, in addition to organic growth, Federated began to grow through acquisition to form a diversified, multi-product (134 to be exact), mutual fund company, totaling $364B in AUM. Today the company is run by Chris and Tom Donahue, sons of the original founder, John Donahue, who remains Chairman of the Company.
Overview. Valuing Asset Managers is a fairly straightforward task. The primary revenue driver is fees earned on the level of assets under management (“AUM”). AUM can grow/(shrink) in two ways: (i) client inflows/(outflows) and (ii) product performance.
Typically, an Asset Manager’s expense base consists of fixed costs: salaries, support staff bonuses, rent, professional costs, insurance, and other office related expenses. In addition, Asset Managers typically have a major variable cost in the form of Partner bonuses. Partners (typically made up of some assortment of founders, portfolio managers and other senior executives) often take a base salary (which falls under fixed costs) and then some discretionary bonus which represents “the Partners’ share” of the profits. Most asset managers require a relative inelastic amount of fixed expenses to run the business. The benefit of this structure is that once scale is achieved, most incremental revenue dollars fall to the bottom line.
Thus, there are typically three levers in valuing an Asset Management business: (i) product performance; (ii) client flows, which both effect revenue; and (iii) Partner bonuses – which is the major variable expense. Predicting the future with regard to these three levers is often more art than science, so it’s best to look at a variety of upside and downside scenarios and probability weight them.
One key advantage for Asset Managers is they do not necessarily have to attract new clients to achieve growth in revenue or earnings. Because they charge fees based on total AUM, simply through market appreciation of their current AUM, they can increase top line revenue and earnings. This holds true for Federated’s equity and fixed income products which represent about 50% of total revenue. Money market products, however, are a little bit different, and it might be worth a brief digression to discuss this niche area of fund management.
Brief overview of the money market business. The money market industry got its start in early 1972, growing to $80 billion by 1980, $500 billion by 1990, $1.6 trillion by 2000, peaking near $3.9 trillion in March 2009 and is currently at $2.5 trillion in total AUM of which, Federated owns 11% market share (http://www.ici.org/research/stats/).
Money market funds are designed to maintain a principal balance, or NAV, of exactly $1.00 and pay out any incremental interest earned in the form of dividends. Money market funds invest in very high quality, short-term debt securities such as US treasury bills, commercial paper, CDs and repurchase agreements issued by governments, banks and major corporations. They are designed to eek out as much yield as possible, while still nearly guaranteeing return of principal. Someone reading this will demur that nothing on Wall Street is ever guaranteed, except FDIC and SIPC, and they would be correct. Money market funds are not guaranteed and in rare cases, they have “broken the buck.” The most notable example was the Reserve Primary Fund’s money market fund dropping to a mark of 97 cents in September 2008, due to holding supposedly safe, “high-grade” Lehman Brothers paper. This caused many sensational headlines as investors panicked and journalists feasted. Investors rushed for the doors and the Reserve Primary Fund was forced to freeze redemptions, which caused more panic. Investors ultimately received 99 cents back on the $1. (Full story here at the Reserve Primary Fund’s Liquidation website: http://www.primary-yieldplus-inliquidation.com/pdf/FundUpdate-July2011.pdf)
Taking a step back, there was cause for frustration and disappointment, but hardly a panic. Investors should understand (and I think most do) that money market funds are designed to stay at a NAV of $1.00, but in extreme scenarios, like in September 2008, they might fall below. Considering this was arguably the worst financial crisis since the 1930’s and the Reserve Fund was holding some of the worst “high quality” paper, I think receiving 99 cents back for every $1 invested is fairly heroic, but too late to save the Reserve Primary Fund’s business. A little more history can be found here: (http://www.ici.org/pdf/12_mmf_history.pdf). For those speed reading, just to clarify, the Reserve Primary Fund and Federated have nothing to do with one another, other than same industry.
With that colorful background, here are the industry positives. Money markets play a critical role in the functioning of the global financial system, bringing together investors seeking low-risk, highly-liquid investments and borrowers seeking short-term funding. Governments and major corporations use money markets as the life line that allows them fund their activities on a weekly basis. In addition, money market funds are an extremely useful and necessary tool for retail and institutional investors to manage their cash reserves, as opposed to leaving cash in an uninsured (max $250k for FDIC) checking account that earns little to no interest. In fact, most checking accounts that do advertise higher than typical interest payments, sweep all excess cash into money market funds (i.e. Fidelity, Schwab, ING). Money market funds actually can act just like a checking account for companies and major institutions. In most cases, clients are permitted to deposit/invest money daily and write checks against the money market assets, all while earning a higher yield than they would if they kept their cash in a bank. Money market funds earn higher yields because they are actively managed and because, unlike banks, they don’t pay deposit insurance or have to incur the cost of jumping through regular examinations by multiple regulators.
Money market products ($275B AUM). As a veteran in the field, Federated manages 48 distinct money market products. Their largest and most successful funds are: the Prime Obligations Funds at ~$50B in AUM, the Government Obligations Fund at ~$35B in AUM, the Treasury Obligations Fund at ~$25B in AUM, the Prime Cash Obligations Fund at ~$25B in AUM, the US Treasury Cash Reserves Fund at $~$20B in AUM, the Government Reserves Fund at $12B in AUM, and the Capital Reserves Fund at $11B in AUM. As you can tell from the product names, the largest funds cover distinct strategies, but are still fairly broad within their strategies. Federated manages a number of smaller products with more specific investment strategies such as the New York Municipal Cash Trust and the Virginia Municipal Cash Trust Funds, designed to provide tax exempt returns to residents of the respective states.
Federated’s money market funds have always kept a stable $1.00 NAV since inception in 1974, and have produced positive absolute returns since inception, per their design. The funds have typically generated between 2% and 5% annual returns; the Prime Obligations Fund generating 3.76% since 1990, as an example. In recent history (2009-2011), annual returns have been fairly meager, which is to be expected, due to most high quality, short duration paper earning less than 30bps annually.
There are some legal and regulatory changes that took place post the 2008 Reserve Primary Fund debacle, as well as some currently working their way through Washington, which we’ll discuss more in the section on “Fee Waivers, Regulatory Environment and Legal Settlement.”
Equity ($34B AUM) and fixed income ($46B AUM) products. Federated operates a diversified family of 35 equity, 51 fixed income, 4 balanced and 3 alternative focused mutual funds. In the endeavor to make complex situations simpler, I’ve included some color and analysis on the top 2 equity mutual funds, and the top 2 fixed income mutual funds. These represent approximately 30-50% of total equity and fixed income AUM respectively, (including separately managed accounts “SMAs” that invest under the same strategy), and are clearly the most important individual funds to the future of Federated. The remaining 62 mutual funds (excluding money market funds, for the moment) represent an important aspect of Federated’s business in the aggregate for the following reasons; (i) they produce a stable stream of revenue; (ii) no single fund is large enough to make a major impact if it were to go away; (iii) each fund represents a call option with significant upside if suddenly investor demand for that particular product increases dramatically. However, no single fund is worth significant analysis in this write-up because its overall current impact on Federated is small.
The first equity fund worth mentioning is the Strategic Value Dividend Fund, which has a 4-star Morningstar ranking and Category 1 Lipper Ranking, and invests in high-yielding large cap value stocks, as its name suggests. They currently run $10B ($6B through the mutual fund, $4B through SMAs) and have had good performance since inception, including exceptional recent performance. They have roughly matched the S&P 500 on a 5-year trailing based and outperformed by 2% on a 3-year trailing basis, and they achieved these numbers with a 0.52 beta and a 3.1% average dividend yield. Given the low interest rate environment, dividend equity strategies are in demand. With strong performance and plenty of product capacity, I expect this strategy will continue to attract significant client inflows, and be an area of growth for Federated.
The second equity mutual fund worth mentioning is the Kaufmann Fund, which has a 2-star Morningstar ranking, and invests using mid-cap GARP (growth at a reasonable price) strategy. The Kaufmann fund runs approximately $6B, has a 25 year track record, and has been ranked 4-stars or higher on Morningstar for most of its history until hitting a rough performance patch in 2011. In addition, it was ranked #1 in its Lipper category for the 20 year period ending 12/31/2007, a very impressive accomplishment. $10,000 invested at the inception of this fund has gone up 20 fold through 2012. Therefore, likely most of the $6B in AUM has been performance growth and clients are happy. However, even loyal clients will eventually redeem should Kaufmann’s performance continue to lag. On a positive note, this strategy has significantly outperformed its benchmark year to date.
The first fixed income fund worth mentioning is the Total Return Fund, which has a 4-star Morningstar ranking and Category 2 Lipper Ranking, and invests in primarily investment grade US government and corporate debt. The strategy currently runs $9.4B, ($7.4B through the mutual fund, $2B through SMAs) and has had good performance since inception, including strong trailing 3- and 5-year performance on an absolute basis and relative to benchmark. This fund has maintained a 4- or 5-star Morningstar rating since inception in 2002, a significant accomplishment. Due to strong numbers and available capacity, I believe we’ll also see significant client inflows into this strategy.
The second fixed income fund worth mentioning is the Municipal Ultrashort Fund, which is poorly named, as it sounds like a Meredith Whitney bet. In fact, the fund invests in a portfolio of short-term highly liquid municipal securities, for a slightly higher return than a money market fund with slightly higher risk. The fund currently has a 2-star Morningstar ranking which is not an accurate representation of the fund’s performance or ranking. The benchmark that Morningstar uses to compare the Fund’s performance is the Barclays Municipal TR benchmark which includes all municipal bond funds, including those that invest in much longer duration fixed income products. Given this Fund’s indicated short duration constraint, it will underperform this benchmark in risk-on periods and outperform in risk-off periods. This phenomenon can be seen in the chart linked below showing the historical Morningstar rating. The fund was a 5-star fund in 2008 during the crisis when longer duration funds were tanking and is a 2-star fund 4 years into the “recovery,” (link below). They currently run $3.7B through the mutual fund and have had positive absolute performance since inception, exactly what you would hope for in this strategy. A comforting aspect is clients seem to understand the investment strategy of the fund and ignore the Morningstar rating, as AUM increased from $600 million 2008 to $3B in 2009, and have grown steadily through 2012.
Product summary. Coupled with running a wholesale distribution platform, which we will discuss in more detail below, Federated’s strategy is to stock its shelves with a diversified, attractive product set. Clearly Federated has strong products in its top money market funds, equity and debt products. Federated’s Strategic Dividend Fund and Total Return Bond Fund will likely be avenues for high probability growth, but what’s important to realize is that Federated also has 120 other products, many of which have strong track records, but may not be in favor at the moment, or may still be working to achieve their 3- and 5-year performance records. Once the investing environment changes, interest in the current in-demand products will wane, but more than likely a few of Federated’s other products will receive the type of attention and client flows that have come into the Strategic Dividend and Total Return Bond Funds. This multi-product platform contributes significantly to the stability of Federated’s revenues and earnings.
Part II – Client Flows:
The world of asset management involves two simple growth drivers. Performance, discussed above, and distribution. Federated is one of the world’s foremost distribution platforms. They have 134 products, many of them top notch, but their true competence is their 200 person sales team’s ability to distribute product to the 4,700 client institutions they maintain active relationships with. In Federated’s own words, they view themselves as “a wholesaler of investment products to banks, broker/dealers, registered investment advisors (RIAs), and other financial intermediaries.”
Federated’s business strategy is similar to other large distribution houses. They have built an impressive distribution network or storefront if you will, and their goal, like any other store, is to fill their distribution channels with attractive products. It can take a great deal of time and be very cumbersome to generate organic products with the requisite 3-year track records in-house, which Federated has indeed accomplished. But, in addition, to augment their own product line-up, Federated has gone out into the marketplace and purchased attractive products that lacked scale. You can think of Federated as a Williams-Sonoma. They have their own internally generated products that are very attractive, but they also sell other Company’s products that don’t have their own storefronts. The only difference is they purchase the external products’ entire company and re-market them as a joint Federated product. This type of product-distribution marriage is common strategy in the asset management marketplace. Federated’s goal would be to bring a top-performing, 4- or 5-star, $300 million small cap product in house, re-market it as a Federated product, and turn it into a $2 billion product by plugging it into their distribution networks. Everybody wins.
Considering the audience, I may be teaching fish how to swim, but I thought a few words on industry jargon might be helpful here. In the asset management world, you have retail investors and institutional investors. True retail investors are non-ultra-high-net-worth individuals who should only buy mutual funds and do so primarily through a discount broker like Charles Schwab. That’s part of Federated’s market, but not the majority. The bulk of Federated’s investors are institutional investors: pension funds, endowments, foundations, governments, etc. Most of these investors, depending on their size and level of sophistication, will invest their money (i) directly (ii) directly but with a consultant’s advice (i.e. Towers Watson, Russell, Wilshire) or (iii) through a financial intermediary such as a private bank/trust, family office, RIA or a broker/dealer.
Federated generates client flows in every category, but their competitive advantage is in the third category. Federated endeavors to have their products on every major bank and trust investment platform, and in the short list of every RIA and broker/dealers’ menu of investment options. Ever since the investment world deemed asset allocation and diversification the way to go, it greatly simplified the asset allocator’s job. 30% large cap stocks, 20% small cap stocks, 40% fixed income, 10% cash. Why not use Federated’s whole family of funds to fill every need? Want two small cap options? Federated has 4. International? Federated has 6. And so on.
In my humble opinion, Federated’s approach is the best way to run a stable public investment management business with staying power. And that’s because they are not just in the business of generating performance, they are in the business of distribution. They canvass the world for good teams and attractive products and then plug them into their already existing robust infrastructure and sales and marketing teams which touch thousands of potential clients. A good example of the opposite strategy – that is a public investment manager in the performance business – is Artio Global. They basically have 1 main product which used to represent ~90% of their AUM. Due to solid performance, Artio grew its AUM from $35B in 2005, to its peak in 2008 of $75B in AUM and $1.60 EPS. Then, due to subsequent poor performance, that product dropped from a 4-star Morningstar product to a 2-star product in mid 2011. AUM has dropped to $25B in AUM and earnings down to $0.32 per share. Clients have been redeeming steadily and AUM has dropped significantly, along with their stock price. With a diverse array of 134 products, of which several should be peaking in attractiveness at any given time, that scenario would be unlikely to occur at Federated. Clients may flow out of one of Federated’s products but will likely be flowing into another one.
Federated exhibits low levels of client concentration which means that no single client has any major impact on revenue should they leave. The only exception is Bank of New York Mellon which represents about 10% of Federated’s revenue. An important nuance is that Federated has many different touch points within the BONY Mellon organization. BONY Mellon isn’t really one client; it’s a collection of thousands of clients that are all represented by BONY Mellon. Therefore no single BONY Mellon client has any significant impact on Federated. The risk is that Federated could somehow manage to sour its entire relationship with BONY. While this is a risk, clearly Federated is aware BONY is its most important relationship, so I don’t put a high probability that Federated will lose this relationship through neglect.
Part III – Variable Costs (Principal Compensation):
Federated’s compensation approach is fairly standard compared to the industry. They have engaged the typical practices of comparing to industry peers and using compensation consulting firms (in this case Deloitte). One item worth noting is the compensation committee takes into consideration Federated’s payout ratio, in addition to revenues, earnings, EPS, ROE, investment and stock performance. Others may chime in, but I am not sure I’ve ever seen compensation tied to payout ratio which speaks to Federated’s dividend friendly approach. In addition, the compensation committee sets a performance goal at the beginning of each year, below which, no bonuses would be paid. For 2011, this goal was $65 million in operating profits (defined as earnings plus interest and D&A). Federated easily cleared this hurdle, earning $176 million in operating profits. Given the relatively low hurdle, my view is this performance goal is more there to protect against the extreme downside and to remind executive offices that their compensation is tied to the success of the business, than to actually lay out any type of operating profit goal.
Federated pays its executive and senior investment professionals a base cash salary, and a bonus, comprised of cash and equity compensation, approximately 70% cash and 30% in restricted stock that vests over 3 years. As is the case in most asset management businesses, the bonus represents the largest component of compensation and is the variable expense. In addition, employees may purchase restricted stock at significant discounts to current value during certain windows in the fiscal year. The restricted stock then vests 5% per year with a cliff vest in the tenth year. This ten-year period is notable as well in that I have seldom seen restricted stock with such a long-term, back-ended vesting schedule.
All in, Federated pays its senior executives between $3-5 million per year including stock awards valued at today’s stock prices. Chris Donahue, the CEO, receives the highest compensation at approximately $5 million for 2011. While these are certainly high levels of compensation, they are in line and actually slightly below most of Federated’s peers.
Due to a long history of paying its executives in stock, Federated’s senior management owns approximately 12% of Federated’s total shares, clearly creating alignment with shareholders (discussed in more detail below under the section “Cash Use & Stock Price”).
Corporate governance. Federated issues two types of stock, Class A and Class B. There are only 9,000 share of Class A stock and all is held by the Donahue family. Class B stock is held by everyone else and is the stock available for purchase in the public marketplace. Only the Class A stock may vote at the annual meetings with the exception of change of control situations, i.e. the sale of Federated. In that instance, all shareholders vote pro-rata to their ownership percentage.
This is admittedly an atypical structure and on the face of it, not ideal. My knee jerk reaction when I hear about a family controlling all the voting stock in a public company is not positive. However, Asset Managers are a unique business and, in this case, I am comfortable with the current arrangement. The key is to understand how trust plays a role in Asset Management businesses. Clients do not have any particular loyalty to the Federated name, clients are loyal to the management and investment team they’ve come to know and trust. Clients feel much better knowing there will be stability and continuity at the corporate level when placing their funds into Federated’s products. That’s exactly why so many investors prefer that Asset Managers stay private. As a shareholder in Federated, you may not love that you don’t participate in voting in the BOD but at least you know that clients are happy with the arrangement.
Fee Waivers, Regulatory Environment and Legal Settlement:
Now that I’ve taken you through why Federated is a stable business built for long-term success, here is why it is a very compelling buy today.
First, fee waivers. Taken from Federated’s most recent 10Q, “in certain of Federated’s money market funds, the gross yield is not sufficient to cover all of the fund’s normal operating expenses, due to historically low short-term interest rates. Since the fourth quarter 2008, Federated has voluntarily waived fees in order for certain funds to maintain positive or zero net yields. These fee waivers were partially offset by related reductions in distribution expense as a result of Federated’s ability to share the impact of the waivers with third-party intermediaries.”
In layman’s terms, Federated opted to waive approximately half of its normal money market fees so that its clients could maintain a NAV of $1.00, with some incremental return. This is not only client-friendly, but also strategic. Federated understands that clients could simply keep their money in a checking account earning 0% yield. Therefore, Federated must, at the very least, match a 0% yield; but in order to justify the remaining half of the fee not waived (~20bps), they should earn the client some return. Federated’s money market funds’ performance over the past 2 years bears out this approach. Federated cut fees from ~40bp, down to ~20bps and clients earned returns equal to 10-20bps per year in 2010 and 2011.
The reversal of such fee waivers provides the patient investor with an identifiable catalyst that will dramatically change the earnings profile of the Company.
According to Federated’s calculations, “during 2011, 2010 and 2009, fee waivers in order for certain money market funds to maintain positive or zero net yields totaled $320.7 million, $241.6 million and $120.6 million, respectively. These fee waivers were partially offset by related reductions in distribution expenses of $232.3 million, $186.6 million and $86.4 million for 2011, 2010 and 2009, respectively, such that the net negative pretax impact to Federated was $81.9 million, $54.0 million and $34.2 million for 2011, 2010 and 2009, respectively.”
In 2011, $82MM of Federated’s pre-tax income was waived, equal to approximately $52 million in after-tax income. Year to date through March 31, 2012, Federated waived $22.3 million in pre-tax income, or approximately a projected $89 million in waived pre-tax income ($56 million in after-tax income) for 2012.
There is no set timeframe at which point Federated will no longer waive fees for its money market funds but there is a catalyst: as soon as the Fed begins to raise rates. In Federated’s own words: “Based on recent Federal Reserve Bank commentary on their outlook for interest rates, management expects the fee waivers and the related reduction in distribution expense will continue at least until late 2014. Management estimates that an increase of 10 basis points in gross yields on securities purchased in money market fund portfolios will likely reduce the net pre-tax impact of these waivers by approximately forty percent from the current levels and an increase of 25 basis points would reduce the impact by approximately seventy percent from the current levels.”
Competitors to Federated are also waiving fees on money market funds to keep the $1.00 NAV. Fidelity, JPMorgan, Charles Schwab, Bank of America, and State Street have all waived fees. One article (linked below) suggested that roughly half of the fees that investors agreed to pay on their money market investments were waived in 2010, charging approximately 18bps annually compared to the normal fee of approximately 36bps. The same ballpark numbers can be assumed for 2011 and 2012. Some firms, (i.e. Schwab), have added features to their fund prospectuses that allow them to recoup waived fees at some point in the future. According to Federated’s current fund prospectuses, there is no planned recoupment of any waived fees in any future years, but each fund may change its fee periodically (approximately every year). It’s unknowable whether Charles Schwab will follow through with its plans to recapture past waived fees in future years, however, you can be sure that if they do, there will be mass exodus to those managers that are not forcing fee recoupment. In this regard, Federated is again exhibiting the type of client-first mentality that engenders long-term client loyalty.
Second, current regulatory environment. To give a little more background, the 2008 economic crisis and the breaking of the buck at the Reserve Primary Fund caused a potential run on money market funds. Panicked redemptions from money market funds caused a drop in demand for short duration commercial paper which prevented companies from rolling over their short-term debt, potentially causing a completely frozen financial system. These events forced the government to step in and prop up all money market funds. From Wikipedia:
“In response [to the run on the funds], on Friday, September 19, 2008, the US Department of Treasury announced an optional program to ‘insure the holdings of any publicly offered eligible money market mutual fund—both retail and institutional—that pays a fee to participate in the program.’ The insurance will guarantee that if a covered fund breaks the buck, it will be restored to $1.00 NAV. This program is similar to the FDIC, in that it insures deposit-like holdings and seeks to prevent runs on the bank. The guarantee is backed by assets of the Treasury Department’s Exchange Stabilization Fund, up to a maximum of $50 billion. The program immediately stabilized the system and staunched the outflows.”
Once the moment of crisis passed, the SEC began looking into ways to prevent a future run on the money market funds. In Federated’s words, the following is the SEC response in 2010:
“In January 2010, the Securities and Exchange Commission (SEC) adopted extensive amendments to Rule 2a-7 of the Investment Company Act of 1940 (Rule 2a-7) aimed at enhancing the resiliency of money market funds. These amendments included a series of enhancements including rules that require all money market funds to meet specific portfolio liquidity standards and rules that significantly enhance the public disclosure and regulatory reporting obligations of these funds. In Federated’s view, the amendments of 2010 meaningfully and sufficiently strengthened money market funds. Recent experience demonstrated that the amendments of 2010 were effective in meeting heightened requests for redemptions occurring at various times throughout 2011 in connection with the U.S. credit rating downgrade and the ongoing European debt crisis.”
The rules essentially did the following: (i) reduced the weighted average duration of the paper money market funds could hold from 90 days to 60 days, (ii) increased overnight liquidity requirements and (iii) increased holdings transparency. So far, so good. Then in 2011, the SEC announced that they were going to consider further regulations, and if they made any changes, would implement them in 2012. This taken from testimony given by Mary Schapiro on 6/21/12:
“The first option would require money market funds, like all other mutual funds, to buy and sell their shares based on the market value of the funds’ assets. That is, to use “floating” net assets values…A second option would allow money market funds to maintain a stable value as they do today, but would require the funds to maintain a capital buffer to support the funds’ stable values, possibly combined with limited restrictions or fees on redemptions. The capital buffer would not necessarily be big enough to absorb losses from all credit events. Instead, the buffer would absorb the relatively small mark-to-market losses that occur in a fund’s portfolio day to day, including when a fund is under stress. This would increase money market funds’ ability to suffer losses without breaking the buck and would permit, for example, money market funds to sell some securities at a loss to meet redemptions during a crisis….Limits on redemptions could further enhance a money market fund’s resiliency and better prepare it to handle a credit event. Restrictions on redemptions could be in several forms designed to require redeeming shareholders to bear the cost of their redemptions when liquidity is tight.”
(See full testimony here: http://www.sec.gov/news/testimony/2012/ts062112mls.htm)
Though Federated supported the first round of changes in 2010, they have spoken out defiantly against those changes currently under consideration, including threatening a lawsuit. (Chris Donahue on Bloomberg TV. http://www.federatedinvestors.com/FII/leaf/display.do?cid=87644&link=eswch)
Though Mr. Donahue’s frustration is evident, the push back from 3 out of the 5 commissions on the Senate Banking Committee during the SEC’s latest round of testimony on June 21, 2012, would seem to indicate that potential reforms that were expected to come this summer are likely to be delayed, if they happen at all. Unfortunately, knowing if and when the SEC or government may take action is impossible. What we can do is analyze and understand each reform under consideration.
First, a floating NAV, which is shorthand for: forcing money market funds to mark their underlying assets every day. This sounds scary, but actually will not have a major impact on money market marks as their true NAVs are mostly stable, at .999 - 1.001, due to the nature of the paper held. What can send ripples through the industry is that certain institutional investors currently have restrictions that only allows them to hold instruments with a stable par value. In addition, there would be capital gain tax implications that currently don’t exist, which would not cause significant tax liability, but would complicate investors’ tax reporting and accounting. Second, capital requirements. This would essentially require money market companies to set aside rainy day funds, something like 30bps of total AUM to backstop the $1.00 NAV against potential draw downs. This would be costly at first and annoying to major institutions, but likely not cause a permanent impact on the industry as the extra liquidity reserve would be a one-time use of cash. Third and final, redemption restrictions. Essentially these would be the equivalent of government imposed investor gates on money market funds, which would basically prevent investors from ever “running on the funds.” There are several nuances to this potential regulation. The whole point of money market funds is “daily liquidity at par” explains Federated and others, so this would greatly reduce the marketability of money market funds. However, money market managers already have the power to place redemption restrictions or to pay in kind in the event of a major run. It’s written right into the fund prospectuses. Therefore it’s unclear if this would have any dramatic impact on investors, other than perhaps a psychological aversion toward government intervention.
The SEC has stated they do not want to harm the industry and given the pushback from Federated and others, they clearly know they have stepped onto sacred ground in the money market industry. Most importantly, the SEC endeavors to prevent a run on money markets funds. If they put into place all the reforms in their current state, they would likely cause exactly what they are hoping to prevent.
Peter Crane, of “Crane Data” and an industry research specialist, expects that the SEC will likely want to do something eventually, but it will be a compromised set of reforms. He expects the SEC will compromise on something like a rainy day fund requirement somewhere around 10-20bps, and perhaps an 80/20 rule on redemptions; whereby, in the event of a run, investors can redeem 80% of their funds immediately, but have to wait some period for the remaining 20%, so that all redeeming investors are treated fairly.
Third, end of TAG Program – Dodd Frank extension. There also exists a very quiet catalyst that no one seems to be talking about and could potentially cause dramatic near term client inflows into the money market industry. And that is the end of the TAG program on 12/31/2012. First, I’ll let Wikipedia describe it:
“The Transaction Account Guarantee Program as described in the Interim Rule, provided for a temporary full guarantee by the FDIC for funds held at FDIC-insured depository institutions in noninterest-bearing transaction accounts above the existing deposit insurance limit. This coverage became effective on October 14, 2008, and would continue through December 31, 2009. On August 26, 2009, the FDIC extended the Transaction Account Guarantee Program for six months, through June 30, 2010. The guarantee was then extended an additional six months, through December 31, 2010. Thereafter section 343 of the Dodd-Frank Wall Street Reform and Consumer Protection Act will provide similar transaction account insurance, from December 31, 2010 through December 31, 2012.”
Basically, in response to the financial crisis, the program allowed participating banks with all noninterest-bearing transaction accounts to have unlimited coverage by the FDIC. Unlimited. It was part of the Temporary Liquidity Guarantee Program, and was designed to help calm the fears of depositors with lots of money in suspect banks. There exists an estimated $1-2 trillion in these types of FDIC guaranteed bank accounts. Once the TAG Program expires, it will be up to banks and depositors whether to keep their money in non-interest bearing accounts with no guarantees beyond the standard $250k or move them into something that earns yield. Hard to predict what will happen, but if I were depositors, my vote would be for yield.
Fourth, final settlement on Federated Kaufmann Fund case. The upshot is that Federated made a one-time final settlement in Q1 2011 equal to $17.3MM, related to a legal case involving charging excess fees charged by the Federated Kaufmann Fund. There was a wave of these types of cases in 2004-2005, which is where this case stems from as well. As one Forbes article put it, “The Federated lawsuit is one of maybe a dozen fee lawsuits filed in recent years against Invesco, Ameriprise and Janus.” The Federated Kaufmann Fund charges 1.95% annual management fee. This is admittedly a high fee, but not out of line with the market for top-performing mutual funds with a 25 year track record of making people ~12% annually. That’s 20x your money if you were in from the beginning.
I view these suits as a way for lawyers to make money by holding a publicity gun to the head of public Asset Managers. If Federated fights the case, they risk sensational headlines for months on end. If they settle, a couple articles are written and the case goes away. As the Forbes article points out, in a particularly sad display of humanity, “Coincidentally, one of the lead named plaintiffs in the Federated case just happens to be the wife of the lead plaintiff lawyer.”
The Federated Kaufmann Fund has daily liquidity. Literally any day the market is open, investors can withdraw their money and not pay the management fee any longer. Suing a Company for charging too high a management fee is the equivalent of buying a pay-as-you-go cell phone and then suing the cell phone company because you used the phone. No one is forcing people to invest their money with the Kaufmann fund. If the management fee is not worth the service, there are literally thousands of other options.
CASH USE & STOCK PRICE
Overview. Federated has historically exhibited an unusually shareholder-friendly cash policy. Since going public in 1998, total cash from operations totaled $3.1B, $1.2B to pay dividends, $992MM to repurchase shares and $850MM for acquisitions. Federated’s market cap is currently valued at ~$2.16B.
As of 12/31/98, Federated managed just over $100B in AUM, earned $522MM in revenue and made $92MM in net income. Since 12/31/98, Federated has grown to over 3.5x the AUM size, at a fairly steady year over year growth clip. Thinking in aggregate terms, you may own a company that generated $3.1B in cash over the past 14 years, and currently generates 2x the revenue and 2x the earnings than it did 14 years ago, for today’s price, equal to ~$2.16B.
Dividends and Stock Repurchases:
Dividend policy. Since initiating its dividend in 2002, Federated paid shareholders $0.22 per share in 2002 and has increased its dividend in most years, up to its current $0.96 per share. In addition, Federated paid 2 special dividends in 2008 and 2010, in part funded by small amounts of debt borrowing, but mostly funded by successful cash build-up. In 2008, Federated paid $2.76 per share and in 2010; Federated paid $1.26 per share to all shareholders. Though special dividends are a rarity in the public markets, unless there is a major one-time event, in these two cases, Federated, content with its cash position and ability to make accretive acquisitions, elected to use its remaining cash to issue a special dividend. According to senior management, the philosophy was they did not feel that Federated’s stock price reflected Federated’s strong performance and industry position and therefore wanted to reward shareholders through a cash dividend. These are the types of decisions recommended by senior management and carried out by a BOD that not only reflect a shareholder first mentality, but also stem from the fact that senior management holds ~12% of the total shares.
(See full chart of dividends here: http://www.federatedinvestors.com/FII/daf/pdf/about_federated/30635.pdf).
Share repurchase. Federated has a history of buying back shares with Company cash. Since the IPO in 1998, Federated has repurchased approximately 37 million shares. Federated consistently buys back shares every year, varying the total amount based on board appetite and the market. Federated repurchases ~1.5 million shares in 2011 and is currently authorized to buy back 2.2 million additional shares out of a 5 million share plan.
Restricted stock & stock options. Federated awarded 1,011,876 shares of restricted Federated Class B common stock under its Stock Incentive Plan to certain key employees during 2011 and issued no options. For the past 5 years, Federated has compensated employees with between 700,000 – 1,200,000 restricted shares, per year. In Federated’s own words, “The awards are generally subject to graded vesting schedules that vary in length from three to ten years with a portion of the award vesting each year, as dictated by the terms of the award. For an award with a ten-year vesting period, the restrictions on the vested portion of the award typically lapse on approximately the award’s fifth- and tenth-year anniversaries.” Federated issued very few options during the past 5 years, primarily to board directors.
Cash use summary. Because I am sensitive to a company that uses free cash flow to buy back shares, a seemingly shareholder friendly activity, only to turn around and issue all the repurchased shares to management, I went back and looked at Federated’s share repurchases vs. share compensation since the IPO in 1998. Since the IPO, Federated has granted 20.5 million share-based awards and repurchased 37 million shares. According to my rough calculations, approximately 4 million options or restricted shares have been forfeited by employees and the average exercise price for options was in the teens. Federated seems to be taking a 70/30 approach. Approximately 70% of the stock repurchases accrete to the shareholder’s benefit and the rest was paid to employees in the form of options or restricted stock. Given the high compensation practices in the asset management industry and given shareholders’ goal to incentivize management to be focused on the stock price, I believe Federated is compensating its employees appropriately, and the remainder of its stock repurchases are accretive to shareholders.
Pricing, Multiples and Free Cash Flow:
2011 results. Using Federated’s 2011 results, Federated earned $895 million in revenue, $257 million in pre-tax income, $151 million in net income and $210 million in FCF. Assuming a stock price equal to $20.73 (as of 6/27/2012), this means that Federated is trading at 8.4x 2011 pre-tax income, 14.3x 2011 net income, and 10.3x 2011 FCF.
If you add back the $320 million money market fund fee waivers ($82MM pre-tax income, $52MM in after tax earnings) and normalize Federated’s results, Federated is earning $1.22 billion in revenue, $339 million in pre-tax income, $203 million in net income and $262 million in FCF. Assuming a stock price equal to $20.73 (as of 6/27/2012), this means that Federated is trading at a normalized 6.4x 2011 pre-tax income, 10.6x 2011 net income and 8.3x 2011 FCF.
Projected 2012 numbers. Looking at projected 2012 numbers, I simply took Q1 2012 results and multiplied by 4. This way of looking at the multiples cleans up a few one-time events in 2011. For example, Federated took a one-time legal cost of $17.3MM related to a final settlement on the Federated Kaufman case, (discussed above).
Using Federated’s projected 2012 results; Federated is projected to earn $921 million in revenue, $280 million in pre-tax income, $168 million in net income and $225 million in FCF. Assuming a stock price equal to $20.73 (as of 6/27/2012), this means that Federated is trading at 7.7x 2012 pre-tax income, 12.9x 2012 net income and 9.6x 2012 FCF.
If you take money market fees waived year to date through March 31, 2012 and annualize them, you can determine what a normalized projected 2012 would look like. In this case, you would add back $322 million money market fund fee waivers ($89MM pre-tax income, $56MM in after tax earnings) and normalize Federated’s results. Federated is then making $1.24 billion in revenue, $369 million in pre-tax income and $224 million in net income and $280 million in FCF. Assuming a stock price equal to $20.73 (as of 6/27/2012), this means that Federated is trading at 5.9x normalized pre-tax income, 9.6x net income, and 7.7x FCF.
Share price history. Since the beginning of 2008, Federated share price oscillated between $14/share and $45/share and its market cap between approximately $1.5 billion and $4.6 billion. Federated’s quarterly net income, which after free cash flow is the best indication of Federated’s performance, moved between $35 million per quarter and $60 million per quarter and not surprisingly, the quarterly lows and highs in the stock price exhibit very little correlation to the quarterly lows and highs in net income.
Here’s what the market seems to be missing. If you add back all the money market fund fee waivers to Federated’s net income per quarter over the past 3 years, quarterly net income oscillates very mildly between $55 million and $60 million. It is purely due to Federated’s voluntary fee waivers that quarterly net income has dropped to ~$40 million. Federated’s stock price on the other hand has been cut by over 50% which implies a permanent impairment to the business. Federated’s business is currently negatively impacted by the historically low interest rates, but it will also certainly be positively impacted if/when the rates increase.
It’s important to remember, these are not permanent fee waivers. Nor are these fee waivers to help small funds get seeded or fee waivers to help certain funds compete within their benchmarks. These are fee waivers Federated has put in place (along with most other managers in the industry) since the beginning of 2009 – the point at which 3 and 6 month treasuries dropped to 20bps or less – to make sure that their money market funds’ NAV does not drop below $1.00 after dividends and fees. As soon as yields on short-term paper (3-month and 6-month treasuries) rise, Federated will start earning full fees again and quarterly net income should, ceteris paribus, pop directly back to $55-60 million per quarter.
Share price summary. Shares of Federated currently trade for $20.73, roughly 12.9x projected 2012 earnings and 9.6x if you normalized for fee waivers. Assuming a market multiple equal to 14x normalized 2012 earnings, Federated’s share price would be $30, a 45% premium to today’s price. When you add in a $1 of dividends in 2012, you get to a 50% premium. What I find very compelling about this idea is that you are getting a very stable business with limited downside and a healthy chance at a 1.5x MOIC (multiple on invested capital) due to a very specific, identifiable catalyst. Additionally, while you wait and sweat for the earnings bump to occur and the market to recognize it, you’re getting paid a 4.6% cash dividend by a Company with a history of share buybacks and special cash dividends.
In Q2 2011, Federated refinanced its long-term debt. Federated currently has approximately $350 million left outstanding on this facility and pays approximately 3.646% in annual interest through an interest rate swap. The Credit Agreement expires on June 10, 2016 and requires principal payments of $10.6 million per quarter for the first three years and $28.3 million per quarter for the fourth and fifth years and a final payment of $28.3 million due upon its expiration. At ~1.25x EBITDA and plenty of time to pay it down, this represents a very safe amount of leverage and primarily serves to lower Federated’s cost of capital. In addition Federated maintains a $200 million revolving credit facility, which is currently undrawn. Federated maintains this facility as a rainy day facility and presumably to smooth any timing differences between cash receipts and expenditures.
Within the past year, insiders have sold small amounts of shares. Based on the small size and timing, these are likely nothing more than shares sold to cover tax expenses.
As of 5/31/2012, short sellers had 16 million Federated shares sold short, roughly 16% of the shares outstanding and a 17 day coverage ratio. Short interest came down at 6/15/2012 to 14.9 million shares with a 14.4 day coverage ratio. Staley (The Art of Short Selling) would argue that heavy short interest indicates a company is in trouble (or in for a massive short squeeze) and at these levels, it certainly seems there is high conviction that Federated is a short. In this case, however, it’s hard to understand the thought process behind so many shorts, though I would welcome any insight from anyone on the VIC who is currently short. At 12.4x 2012 net income, Federated is hardly priced for perfection (see LNKD at ~650x P/E). In addition, there is no risk of accounting fraud or misconduct that could cause Federated to go to zero.
I believe most shorts are keyed in on the fee waivers and potential for increased regulation. As hopefully I’ve been able to lay out clearly, the fee waivers are temporary and the regulation is likely going to be compromised and commercial. As Bill Gates put it, “We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten.” Gates was talking about technology, but I believe the same applies to regulation. Many people take the contemplated SEC regulatory changes and extrapolate them to mean Armageddon is going to occur immediately. I may be proven wrong, but my money thinks that the regulatory changes, if any do occur, will be gradual and have far less impact then some people think, similar to the first round of regulatory changes in 2010.
Putting It All Together:
The best way to assure you make a good investment is to make sure you getting something for a great price. At current price levels $20.73, you are getting Federated’s core business at a great price and a number of free options in the form of near-term catalysts. The first is the cessation of fee waivers once the Fed raises rates. Unlike many catalysts, this isn’t the type of fuzzy near term catalyst like a product suddenly getting traction or a lawsuit settlement or even a pending M&A transaction (see YHOO). This is a near-term catalyst that will contribute ~33% more earnings immediately upon occurrence.
In addition, the strong performance in the Strategic Value Dividend Fund and the Total Return Bond Fund provide potential growth engines. Finally, the end of the TAG Program provides a potential for a shift in billions of dollars of AUM into the money market industry. These last two catalysts are more the fuzzy type. They may pan out and contribute significant upside to Federated, or they may pan out and not have a major impact. At least they are free.
Assuming a market multiple equal to 14x normalized 2012 earnings, Federated’s share price would be $30, a 45% premium to today’s price. When you add in a $1 of dividends in 2012, you get to a 50% premium. In the meantime, Federated pays a ~4.6% cash dividend yield, plans to repurchase an additional 2.2MM shares over the next couple years with its free cash flow and has a history of returning cash to shareholders via special cash dividends.
- Cessation of fee waivers
- End of TAG Program
- Clients flows in Strategic Value Dividend Fund and/or Total Return Bond Fund
- Market appreciation
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