If headline earnings for Federated Investors Inc. (NYSE:FII) appear a little too good to be true, it's because, in a way, they are. Federated Investors is one of a handful of financial companies whose earnings were positively impacted by a corporate tax cut put into place in December, with the passage of the Tax Cuts and Jobs Act.

The company reported GAAP (generally accepted accounting principles) net income of $131.8 million in the fourth quarter, or $1.31 per share. Backing out tax impacts, it earned $61.4 million, or $0.61 per diluted share, less than half its headline earnings figures. But that's not to downplay what was a very good quarter for the Pittsburgh-based asset manager.

$100 bills in a glass jar

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Federated Investors' fourth quarter: By the numbers

Metric

Q4 2017

Q4 2016

Year-Over-Year Change

Average assets under management

$382.0 billion

$358.3 billion

6.6%

Adjusted net income

$61.4 million

$55.8 million

10%

Adjusted earnings per share

$0.61

$0.52

17%

Data source: Federated Investors.

What happened this quarter

Admittedly, Federated Investors is a relatively sleepy asset manager, given that most of its assets under management (AUM) are derived from fixed-income and money market assets. Relative to, say, an emerging-markets manager or a private-equity shop, there aren't many opportunities to blow the doors off on an earnings report.

That said, there were some very promising developments this quarter, particularly when it came to Federated's ability to haul in AUM.

  • Let's get the boring subject of taxes out of the way first before moving into more interesting topics. Federated Investors went into the fourth quarter with a substantial deferred tax liability on its balance sheet, reflecting taxes it has accrued for GAAP purposes but hasn't yet paid to Uncle Sam. Since the Tax Cut and Jobs Act slashed corporate taxes from 35% to 21%, Federated Investors had to remeasure its deferred tax liabilities based on new tax rates, resulting in a one-time, non-cash benefit of $70.4 million. For investment purposes, the change is mostly an unimportant accounting event. What really matters is that Federated Investors estimated a full-year tax rate of 24% to 25% in 2018, down from a historical level of 35% to 37%.
  • Average AUM in all three of Federated Investors' strategies (equity, fixed income, and money markets) increased in the fourth quarter. Average equity AUM grew 2% quarter over quarter, and 7.8% year over year, to $67.5 billion. Average fixed-income AUM grew at an impressive 22.3% over the prior quarter, and by 24.9% from the year-ago period, to $64.4 billion. Finally, average money-market AUM increased 3.5% compared to the sequential quarter, and 2.5% compared to the year-ago period, to $250.2 billion.
  • Fixed income strategies were the star this quarter. Federated Investors reported that it experienced net inflows (new money coming in, less redemptions) of $11.1 billion in fixed income this quarter. Money market products took in $21.4 billion, net. Equity strategies, however, experienced $903 million more in redemptions than sales, so its AUM increases were driven by rising stock prices rather than client contributions to its lineup of equity products.
  • Total revenue was roughly flat with the sequential period, but down 4% compared to the year-ago period. However, offsetting a flat top line was a precipitous decline in operating expenses, which declined by 1% compared to the sequential quarter and by 9% compared to the same quarter last year. Federated Investors' largest expense (distribution) is variable, based on AUM, as it rewards financial advisors and other intermediaries for selling its strategies to their clients. Thus, declining management fees are often offset by a decline in distribution-related expenses.

What management had to say

In the earnings press release, J. Christopher Donahue, president and CEO of Federated Investors, said that "investors showed interest in our MDT and Kaufmann small-cap equity strategies" and that "continued investor demand for a range of quality fixed-income products helped fourth-quarter flows into high-yield and multisector bond funds."

The conference call yielded upbeat discussion on the money market business, as executives noted that rising interest rates have made money market funds more competitive with bank accounts. Cash-rich entities have more incentive to shop around for higher rates on their cash as interest rates trudge higher. Management also indicated that they continue to look overseas for acquisitions that are aligned with the company's existing lineup of funds and products.

Looking ahead

Following the financial crisis of 2008, Federated Investors had to waive fees on money markets in order to ensure its clients wouldn't lose money by investing in the money market funds and accounts it manages. Those fee waivers have since been reversed, as rates moved high enough that Federated could collect full freight for its services. Looking ahead, additional rate increases may help it win more assets from clients who have socked away excess cash in low-yielding bank accounts.

Of course, money markets, though important in terms of AUM, are a smaller contributor to the company's revenue and earnings power. Notably, money market strategies make up approximately 65% of AUM, but generate only about 30% of its revenue after distribution expenses. All else being equal, investors should cheer for inflows into its fixed-income and equity strategies, which generate substantially more fees on each dollar under its management.

Stocks are already off to a fast start in 2018, and the market anticipates more rate hikes in 2018. Federated shareholders will want to see that it can capitalize on a favorable environment, and post net inflows across all strategies over the remainder of the year.

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