FEDERATED HERMES, INC. quarterly report, Q2 FY2012

Federated Investors, Inc. (now identified in the request as Federated Hermes, Inc.) — Q2 2012 Form 10-Q

Reporting period: Quarter and six months ended June 30, 2012. The filing registrant is Federated Investors, Inc.; the supplied filing does not identify it as Federated Hermes.

Business context

Federated managed $355.9 billion at quarter-end, up 2% from June 30, 2011. Its investment-management revenues depend chiefly on assets under management, asset/product mix, market performance, and fee waivers. Money-market assets generated 47% of first-half revenue.

Financial results

Margins: Calculated operating margin was about 29.7% in Q2 2012 versus 31.9% a year earlier, and 30.1% for the first half versus 27.7%. Net margin attributable to Federated was about 17.4% and 18.8% for Q2, and 17.9% and 16.3% for the respective half-year periods.

Cash flow and liquidity: First-half operating cash flow was $83.3m, compared with $74.2m. Investing activities provided $29.7m, versus $51.1m used in the prior-year period; financing used $77.0m, including $49.9m of dividends and $21.3m of debt repayments. Cash ended at $85.2m, up from $49.3m at year-end 2011. Liquid assets were $351.7m, compared with $343.8m at year-end.

Debt: Total term-loan principal was $340.0m ($42.5m current and $297.5m long-term), down from $361.3m at year-end. A $200m revolving facility was entirely undrawn. The company reported compliance with its covenants: interest coverage of 22.16x against a 4.0x minimum and leverage of 1.12x against a 2.5x maximum.

Changes versus comparable periods

• Q2 revenue rose 3%, chiefly because money-market fee waivers were $9.1m lower than a year earlier and average fixed-income assets were higher. Operating expenses rose 6%, including higher distribution costs; operating income and attributable net income consequently declined.
• First-half revenue was nearly flat, while operating expenses fell 4%. Professional-service costs were lower by $14.5m, primarily reflecting nonrecurring legal-proceeding expenses in Q1 2011; intangible-related expense also declined. First-half operating income and attributable net income increased.
• Period-end fixed-income assets rose 15% year over year and equity assets rose 6%; money-market assets were essentially flat. The revenue mix remained exposed to money markets, while higher average fixed-income assets supported growth.

Outlook, risks and unusual items

• Management expected fee waivers and related expense offsets to continue at least until late 2014. Assuming stable asset levels, it expected Q3 2012 waivers to have a net negative pretax income impact approximately similar to Q2’s $17.2m. Management estimated that 10- and 25-basis-point increases in gross money-market yields could reduce the net impact by about 40% and 70%, respectively; actual outcomes depend on multiple variables.
• Potential SEC money-market reforms under discussion included floating NAV or capital requirements combined with redemption restrictions. Management warned that such changes could harm the attractiveness of money-market funds and materially affect the business; any proposal or final rule remained uncertain.
• Business risks include prolonged low rates and fee waivers, rapid rate increases and potential investor outflows, market declines, fund performance and redemptions, regulatory changes, and concentration. One intermediary accounted for 11% of revenue; the Federated Prime Obligations Fund and Federated Kaufmann Fund accounted for 11% and 10%, respectively.
• A July 7 tentative insurance settlement of $17.3m related to legal-proceeding claims was subsequent to quarter-end. The company said it would recognize the amount as reductions to operating expenses when finalized; $10.0m previously received remained recorded as a liability at June 30. The filing did not report a finalized settlement by the reporting date.
• Management stated that existing liquid assets, operating cash flow and available borrowing capacity should cover foreseeable needs. A $0.24-per-share dividend was declared July 26 for payment August 15.
• Management did not consider ordinary-course legal claims likely to result in a material loss. It disclosed contingent acquisition payments, including estimated remaining SunTrust payments of about $16m over four years, and potential employee bonuses of up to approximately $56m over remaining contract terms.

Important facts for investors to verify

1. Whether short-term rates, money-market assets and fee-waiver levels track management’s outlook, particularly the expected duration and net earnings effect of waivers.
2. Developments and final terms, if any, of SEC or FSOC money-market regulation and the resulting effect on fund assets and revenue.
3. Asset flows, performance and concentration in the two major funds and the Bank of New York Mellon relationship.
4. Finalization and accounting recognition of the $17.3m insurance settlement, along with any repayment exposure on advance proceeds.
5. Debt amortization, covenant headroom, acquisition-related contingent payments and the use of the undrawn revolving facility.