FEDERATED HERMES, INC. annual report, FY2016

Business context and reporting period

Federated Investors, Inc. filed this Form 10-K for the fiscal year ended December 31, 2016; it is an annual report, not a standalone fourth-quarter filing. The filing describes a single-segment investment manager with $365.9 billion of assets under management (AUM). The company name in the filing is Federated Investors, Inc.; this differs from the request metadata label, Federated Hermes, Inc.

Financial and operating performance

Revenue growth was driven mainly by a $245.8 million reduction in voluntary money-market fee waivers and, to a lesser extent, higher average equity assets. The waivers reduced 2016 revenue by $87.8 million and pre-tax income by $22.0 million, versus reductions of $333.6 million and $85.9 million, respectively, in 2015. Distribution expense rose $151.2 million, largely as those waivers declined. The effective tax rate was 35.0%, down from 37.4%.

Average AUM increased 3% to $362.9 billion. Period-end AUM rose 1% to $365.9 billion: money-market assets fell 2% to $252.2 billion, equity assets rose 16% to $62.4 billion, and fixed-income assets were essentially flat at $51.3 billion. Equity and fixed-income funds and Separate Accounts recorded $4.1 billion in net sales in 2016, compared with $1.7 billion in 2015; market gains also supported ending AUM.

Fourth-quarter 2016 revenue was $289.9 million, operating income $84.8 million, net income attributable to Federated $55.8 million, and diluted EPS $0.52. Fourth-quarter voluntary yield-related waivers had a $3.4 million pre-tax impact.

Liquidity, debt and capital allocation

Cash and cash equivalents were $104.8 million at year-end, down from $172.6 million. The company reported $310.3 million of liquid assets, net of noncontrolling interests, compared with $367.4 million a year earlier. Operating cash flow was $252.8 million; investing activities used $8.2 million and financing activities used $312.4 million.

Debt totaled $191.3 million, including $25.5 million classified as short-term; the $200 million revolving facility was undrawn and available. Federated reported compliance with its covenants, with a 106-to-1 interest coverage ratio against a 4-to-1 minimum and a 0.5-to-1 leverage ratio against a 3-to-1 maximum. Management said existing liquidity, operating cash flow and borrowing capacity should meet foreseeable needs.

Federated paid $205.5 million in dividends during 2016, including a $1.00-per-share special dividend, and repurchased $83.6 million of shares. Total dividends were $2.00 per share for the year. The board declared a further $0.25-per-share dividend in January 2017.

Material changes, outlook and risks

• Money-market regulation and asset mix: Rules effective October 14, 2016, including floating NAVs for institutional prime and municipal funds and redemption fees and gates, contributed to a shift toward stable-NAV government funds. Management said these changes affected AUM, revenue and operating income. Money-market assets generated 45% of 2016 revenue.
• Fee-waiver outlook: Assuming asset levels and mix remained constant and based on then-current market conditions, management estimated a negative pre-tax waiver impact of approximately $1 million in first-quarter 2017. Management estimated that a further 25-basis-point increase in gross yields on money-market portfolio securities could nearly eliminate the waivers; actual results depend on yields, assets, expenses, product mix and intermediary arrangements.
• Customer relationship: A change effective January 27, 2017 was expected to reduce pre-tax income by approximately $1 million in first-quarter 2017 and $2 million per quarter thereafter, compared with fourth-quarter 2016.
• Regulatory uncertainty: The filing discusses the DOL fiduciary rule, proposed SEC requirements, possible U.S. deregulation, EU money-market reforms and Brexit. Compliance, product changes and uncertain customer responses may raise expenses or affect asset flows, fee rates and profitability.
• Concentration and market risks: About 15% of 2016 revenue came from the Federated Strategic Value Dividend strategy and about 15% from intermediary customer Bank of New York Mellon, including Pershing. AUM and revenue are exposed to investment performance, redemptions, interest rates, market declines, competition and intermediary relationships.
• Other items: Goodwill and intangible assets totaled $733.1 million; management reported no goodwill impairment indicators at year-end. Federated’s $37 million CCM lawsuit was granted summary judgment in Federated’s favor in February 2017; the plaintiff could appeal. The filing estimated damages at zero and considered a material loss remote.

Most important facts for investors to verify

• Whether ongoing interest-rate increases reduce fee waivers as management expected, and how waiver changes translate into net income after distribution-expense offsets.
• Subsequent money-market and other AUM flows, especially the balance between prime and government funds and the associated revenue mix.
• The realized financial effect of the January 2017 customer relationship change and any further intermediary or platform changes.
• Actual compliance costs and business effects from U.S. and European regulatory developments, including fiduciary and money-market rules.
• Cash generation, debt repayments, share repurchases and dividend sustainability relative to the company’s liquidity and capital needs.
• Any appeal or further developments in the CCM litigation, and any changes in goodwill or intangible-asset impairment assessments.