Federated Hermes, Inc. — Q2 2023 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2023. Amounts below are in U.S. dollars; financial statement figures are in millions unless otherwise noted.
Business context
Federated Hermes provides investment management, administrative, distribution, stewardship and related services. Revenue is primarily linked to managed assets and their mix. Assets under management (AUM) were $704.0 billion at June 30, up 11% year over year. Money market assets increased 16% to $509.0 billion; long-term assets increased 1% to $194.9 billion.
Key financial results
| Metric | Q2 2023 | Q2 2022 | Six months 2023 | Six months 2022 |
|---|---|---|---|---|
| Revenue | $433.2 | $366.0 | $815.4 | $690.8 |
| Operating income | $98.4 | $92.3 | $183.6 | $176.3 |
| Net income attributable to Federated Hermes | $72.2 | $57.7 | $141.8 | $113.5 |
| Diluted EPS | $0.81 | $0.64 | $1.59 | $1.24 |
| Operating margin | 22.7% | 25.2% | 22.5% | 25.5% |
Q2 revenue rose 18%, while operating income rose 7%; margin declined as operating expenses grew faster than revenue. For the first half, revenue rose 18% and operating income rose 4%. Revenue gains reflected higher money market revenue and carried interest, and the absence of voluntary yield-related fee waivers that reduced revenue in 2022. Higher compensation and distribution costs partly offset these gains. Q2 net income also benefited from a much smaller securities loss than in 2022.
Cash flow and liquidity: First-half operating cash flow was $76.6 million, versus $79.5 million. Investing activities provided $7.2 million and financing activities used $83.3 million. Cash and cash equivalents were $342.8 million at June 30. Management reported $577.2 million of liquid assets, net of noncontrolling interests, compared with $559.5 million at year-end 2022.
Debt and capital returns: Long-term debt was $347.7 million, net of issuance costs, consisting of $350 million of senior notes due in 2032 at a fixed 3.29% rate. The $350 million revolving credit facility was undrawn, with an additional $200 million optional accordion. The company was in compliance with its debt covenants; reported leverage was 0.8x against a maximum of 3.0x, and interest coverage was 36x against a minimum of 4x. First-half dividends paid were $49.3 million; treasury-stock purchases used $47.9 million. The board declared a further $0.28-per-share dividend payable August 15, 2023.
Material changes versus prior-year period
- Average money market assets increased 22% in Q2 and 17% in the first half; average long-term assets declined 3% and 6%, respectively.
- Money market revenue increased with higher average assets and the end of voluntary yield-related fee waivers. No such voluntary waivers were recorded in the first half of 2023; the first half of 2022 had $85.3 million of waivers, partly offset by lower distribution expense.
- First-half securities gains were $5.5 million, compared with losses of $32.6 million in 2022; investment income also increased as yields rose.
- Operating expenses increased 22% in Q2 and 23% in the first half, including higher distribution and compensation costs. Compensation expense was affected by consolidation of carried-interest vehicles.
Outlook, commentary, risks and unusual items
- Outlook: The filing provides no specific earnings or revenue guidance. Management expects sufficient liquidity for short- and reasonably foreseeable long-term cash needs, based on liquid assets, operating cash flow and available borrowing capacity.
- Money market regulation: The SEC adopted additional money market fund reforms on July 12, 2023, including higher liquidity minimums and liquidity-fee requirements. Management is assessing the impact and is concerned that mandatory fees could adversely affect institutional prime and tax-exempt funds. The potential business and financial effects are uncertain.
- Regulatory and market risks: Management cites extensive and evolving U.S. and international regulation, possible compliance-cost increases, changing investor preferences and market conditions, and sensitivity of revenue to AUM, asset mix and fee waivers. Revenue concentration includes the Government Obligations Fund (14% of first-half revenue) and one intermediary (11% of first-half revenue).
- Carried interest and fund restructuring: Q2 included $39.3 million of carried-interest revenue from two fund-related transactions, with $26.3 million of associated compensation expense. A separate $9.8 million purchase of rights to future carried interest was recorded in other operating expense; related costs were not tax-deductible.
- Administrative error and insurance claim: A share-registration error led to an estimated $18.9 million cost. A $17.9 million shareholder settlement was paid in Q2; the company recorded a $16.4 million insurance receivable it considers probable, but the claim is being litigated with two insurers. The ultimate recovery and resulting expense could differ materially from the estimate.
- Other watch items: The fair value of the FHL right-to-manage intangible asset exceeded its carrying value by less than 5% at June 30, following a $31.5 million impairment in 2022; management says further impairment is possible if assumptions worsen. The CWH acquisition’s customer-relationship valuation remains preliminary and could be adjusted.
Important facts for investors to verify
- Whether money market AUM, fee income and fund flows remain resilient as SEC reforms are implemented, particularly for institutional prime and tax-exempt products.
- How much of earnings growth is sustained operating performance versus carried-interest transactions, securities valuation changes and the prior-year comparison from fee waivers.
- Whether the insurance recovery is ultimately realized and how the registration-error matter affects reported expenses.
- Future AUM and net flows by asset class, given growth in money market assets alongside lower average long-term assets.
- Potential impairment exposure in the FHL intangible asset and any final purchase-accounting adjustments for CWH.