Even a small rate increase has paid off big for Federated in 2016. Image source: Federated Investors.
When investment manager Federated Investors Inc (FHI 0.09%) reported earnings for its second quarter on July 28, shareholders were rewarded with another strong quarter of profit growth at the halfway point of the year. Profits and revenue were both up more than 26%, due to the small bump in interest rates by the Fed to start the year, as well as steady growth in equity assets in several Federated income-focused funds.
Let's take a closer look at Federated Investors' second-quarter results
Small rate bump making a big difference
Federated Investors' second-quarter financial results look an awful lot like the first quarter:
| Metric | Q2 2016 | Q2 2015 | Change |
|---|---|---|---|
| Revenue | $286.7 | $228.1 | 26% |
| Earnings per share | $0.51 | $0.40 | 28% |
| Operating expense | $199.1 | $158.8 | 25% |
| Total managed assets | $387.2 | $349.7 | 11% |
Revenue and operating expense in millions. Total managed assets in billions. Source: Federated Investors.
Also as in Q1, the Federal Reserve's 25 basis-point increase in the overnight funds rate issued near the end of 2015 continued to work in the company's favor. The table below shows how much this small bump reduced the impact of fee waivers:
Image source: Federated Investors.
As you can see in the table above. Federated has lost a significant amount of fee income in past quarters because ultra-low interest rates have forced it to cut fees to avoid creating a negative yield. In the second quarter of 2015, the company saw fee waivers impact its pre-tax income by more than $22 million; however, the increase in the funds rate issued in December reduced that impact to just $5 million in this year's second quarter. Sequentially, it was also improved, with fee waivers costing the company $9.4 million in lost income in Q1.
On the earnings call, CFO Tom Donahue said that another 25-basis-point increase would reduce the impact of fee waivers to about $1 million per quarter, while a 50-basis-point increase would nearly eliminate them.
Federated ended the quarter with $255 billion in money-market assets, up 5% from last year, but down slightly since March.
Gains in equities help drive multiple income streams
During the past several years, Federated has taken big steps to expand its equities business. Not only has this been necessary because of the ultra-low interest-rate environment and its pressure on money markets as a revenue generator, but also because it offers the company a way to further grow and diversify the products it can offer to its clients.
Equity assets were up 13%, to $61.9 billion at the end of the quarter, and also up 10% from the start of the second quarter. On the earnings call, CEO Chris Donahue said that Federated has seen positive equity net flows in 10 out of the past 11 quarters, and ranked in the top 1% of fund managers in net fund flows in the quarter. The company is doing well with its equity products sold through its broker/dealer channel, as well, with gross fund sales up 31% last quarter.
Fixed-income assets were down 5%, to $50.3 billion, but this was largely due to a single client shifting $1.4 billion from an account, in what Chris Donahue called a "style change within their model." Combined, equity and fixed-income assets generated 53% of revenue, with 47% coming from money markets in the first half of 2016.
Looking ahead
Money-market revenue has increased significantly in recent quarters, which is more a product of higher interest rates reducing fee waivers, and not a significant change in the company's asset mix, which has become more diversified. Federated has increased its equity assets from 30.9 billion at the end of 2011, while money-market assets are down from $285 billion at that time. This transition to more equity offerings has certainly paid off, and is likely to remain a critically important part of the company's business for years to come.
At the same time, the eventual recovery of interest rates remains an important eventuality for Federated. Not only will it help drive down fee waivers even further, but it should also lead to more investor interest in money-market accounts as a source of at least some income, driving up assets at Federated as more people put money in money markets.
When this will eventuality happen, of course, remains uncertain. After the year-end rate increase in 2015, it was widely expected that the Fed would increase rates multiple times in 2016; but more than halfway through the year, rates remain unchanged. Most economists are now expecting a rate increase in December, and that would be good for money-market investors and for Federated.
It's probably going to take several more rate increases to create enough incentive for money to flow back into money markets in a meaningful way. For now, though, investors should be happy the company has grown its equity-funds business enough to pick up the slack.
