Federated Investors, Inc. (now Federated Hermes) — Q2 2018 Form 10-Q
Business context and reporting period. The filing covers the quarter and six months ended June 30, 2018. Federated provided investment management and related services and reported $379.7 billion of managed assets at quarter-end, up 5% year over year. The Hermes acquisition closed on July 2, 2018, after the reporting period.
Financial performance and position
| Metric | Q2 2018 | Q2 2017 | Six months 2018 | Six months 2017 |
|---|---|---|---|---|
| Revenue | $256.0 million | $272.8 million | $519.8 million | $546.3 million |
| Operating income | $80.8 million | $84.2 million | $160.4 million | $162.0 million |
| Net income attributable to Federated | $38.8 million | $53.5 million | $99.2 million | $103.1 million |
| Diluted EPS | $0.38 | $0.53 | $0.98 | $1.01 |
| Cash dividends per share | $0.27 | $0.25 | $0.52 | $0.50 |
- Revenue declined 6.2% in Q2 and 4.8% in the first half. Operating income fell 4.1% and 1.0%, respectively. Operating margin was approximately 31.5% in Q2 versus 30.9% a year earlier, and 30.9% for the first half versus 29.7%.
- Net income fell 27.4% in Q2 and 3.8% in the first half. Results included a $29.0 million nonoperating loss on foreign-currency forwards linked to the Hermes purchase; the lower effective tax rate partly offset the impact.
- First-half operating cash flow was $136.4 million, compared with $96.4 million a year earlier. Investing activities used $5.5 million; financing activities used $71.9 million, including $52.6 million of dividends and $20.4 million of share repurchases.
- At June 30, cash and cash equivalents were $375.2 million, total debt was $178.0 million, and $197 million remained available under the credit agreement. The company was in compliance with its debt covenants. Current assets were $484.2 million and current liabilities $135.1 million.
Material changes and management commentary
- Management attributed revenue pressure to the accounting presentation adopted under Topic 606, money-market asset mix and waivers, and a customer relationship change. Topic 606 moved customer-related reimbursements from distribution expense to a reduction of revenue; management said the accounting change itself also reduced reported expenses.
- Average managed assets rose 7% in Q2 and 8% in the first half. Fixed-income assets grew strongly, while equity assets were weaker; first-half equity and fixed-income assets together had net redemptions of $6.5 billion.
- Federated acquired a 60% interest in Hermes for £259.9 million ($343.3 million) after quarter-end. The purchase was funded with cash and an $18 million revolving-facility draw. The filing said purchase-price allocation and pro forma results were not yet available. Federated had incurred $2.8 million of transaction costs and anticipated approximately $16 million in additional costs.
- Management said existing liquid assets, expected operating cash flow and borrowing capacity should be sufficient for present and reasonably foreseeable cash needs. The board declared a further $0.27-per-share dividend, payable August 15, 2018.
Risks, contingencies and unusual items
- Investment management revenue depends on market values, asset flows and mix, fee rates, customer relationships and fee waivers. Nearly all managed assets can be withdrawn without advance notice. Money-market yields, investor preferences and ongoing regulatory changes may affect results.
- Revenue was concentrated in certain strategies and funds; one intermediary accounted for approximately 14% of first-half 2018 revenue. A significant deterioration in those relationships or assets could adversely affect revenue.
- Regulatory uncertainty includes U.S. money-market and liquidity rules, proposed broker-dealer and investment-adviser standards, and European money-market reforms. Management also noted potential Brexit effects, which could be more significant following the Hermes acquisition.
- The $29.0 million forward loss was recognized in Q2; the related contracts were due to settle August 1, 2018. The filing also disclosed an auditor-independence matter involving an EY-affiliated pension trust’s investment in a Hermes-managed fund. The investment was under irrevocable redemption notice, with redemption not available before December 26, 2018 absent a successful secondary sale. Management, the audit committee and EY concluded the matter did not impair EY’s objectivity.
- Federated disclosed approximately $9 million of future minimum compensation payments and potential incentive payments of up to an additional $31 million, subject to asset levels and performance goals. Management did not consider material losses from ordinary-course legal claims reasonably possible.
Important facts for investors to verify
- How the Hermes acquisition affects assets, earnings, integration costs, financing and the final purchase-price allocation.
- Whether revenue and asset trends improve, particularly equity flows, money-market mix, fee waivers and exposure to the significant intermediary.
- The final cash and earnings effects of the currency forwards and the acquisition-related funding needs after June 30.
- Whether the EY-affiliated investment is fully redeemed or sold and whether any subsequent auditor-independence disclosures arise.
- How regulatory developments, Brexit and ongoing compliance costs affect products, distribution, expenses and managed assets.