Federated Investors (NYSE:FII) reported that first-quarter net income grew to $49.6 million, a 9% increase from the year-ago period. Higher interest rates buoyed management fees it earned on money market assets it manages on behalf of its clients.

With the easy money for the Pittsburgh, P.A.-based asset manager in the past, the company will have to move beyond its legacy money market business to generate meaningful earnings growth. 

Federated Investors' first quarter by the numbers

Metric

Q1 2017

Q1 2016

Year-Over-Year Change

Assets under management (AUM)

$361.7 billion

$369.7 billion

 -2%

Net income

$49.6 million

$45.3 million

 9%

Earnings per share

$0.49

$0.44

 11%

Data source: Federated Investors investor relations.

What happened this quarter

  • Federated Investors' legacy money market business contains the bulk of its managed assets, but it continues to slowly bleed fee-earning AUM. It managed $245 billion of client capital in money market strategies at the end of the first quarter, down approximately 3% from the sequential quarter, and 6% from the year-ago period.
  • AUM in stock and bond strategies grew 2.5% during the quarter, but investors are pulling money faster than new investments are flowing in. AUM growth here is driven by rising stock and bond prices rather than new investments. While AUM is the lifeblood of any asset manager (more is always better), Federated shareholders would prefer to see the company grow by bringing in new investors rather than grow by riding a rising tide in the markets.
  • A shift in the mix of its managed assets is weighing on its average fee rate. AUM in its funds, which carry higher fees, declined by roughly 10%, or $29.5 billion during the quarter. Its separately managed account (SMA) assets grew by about 30%, or $25.3 billion. All else equal, fund assets generate more fees, and profit, than SMA assets. 
  • For years following the financial crisis, Federated waived fees to keep its clients' money market returns in positive territory. Those waivers have since been reversed. Fee waivers negatively impacted pre-tax operating income by $0.8 million in the first quarter vs. $9.4 million in the year-ago period. To put that in perspective, fee waivers were a mere rounding error, negatively affecting its operating income by about 1% this quarter. 
Photo of change jar

Image source: Getty Images.

What management had to say, plus a look ahead

Management called out its Strategic Value Dividend stock strategies as a high-quality driver of asset and fee growth. In prepared remarks on the company's post-earnings conference call, Federated Investors CEO J. Christopher Donahue noted that

Total assets in the domestic and international strategic value dividend strategies increased 4% in the first quarter to reach a record high of $38.9 billion. The strategic value dividend funds investment performance was solid in the first quarter returning 5.3%. This ranks it in the top 9% of funds in the Morningstar category which it has been assigned, namely large cap value.

It's no surprise that company management is excited about record stock assets. As the table below shows, stock and bond assets generate more revenue per dollar of AUM than its legacy money market business.

Asset Type

Percentage of Average AUM

Percentage of Total Revenue

Money market

68%

42%

Stock

18%

41%

Bonds

14%

17%

Data source: Federated Investors 10-Q.

In the future, growing revenue and profit won't be as easy as simply riding the tailwinds of rising interest rates. As this growth driver falls off, Federated will have to grow AUM while stemming a negative shift in its mix toward lower fee structures. 

Case in point: More than $25 billion of money market assets moved from higher-fee funds to lower-fee SMAs in the past year. On the conference call, management indicated that these SMAs generally carry fees of 0.04% of assets vs. the average net fee of 0.10% it collects from money market funds. 

To move the needle on profits, Federated Investors will have to convince its clients that it's more than just a money market manager, and that it can effectively manage more profitable assets, too. 

Jordan Wathen has no position in any stocks mentioned. The Motley Fool recommends Federated Investors. The Motley Fool has a disclosure policy.