Federated Investors' First-Quarter Earnings Jump on Lower Taxes

Money manager Federated Investors (FHI -2.37%) reported net income of $60.3 million in the first quarter, up about 22% year over year, driven primarily by lower corporate income taxes thanks to the Tax Cuts and Jobs Act.

Wall Street wasn't pleased with its results, however, sending shares down by more than 13% as of 3:30 p.m. EDT Friday. Here's what shareholders should know now.

Federated Investors' Q1 earnings: By the numbers

Data source: Federated Investors.

What happened this quarter?

The Pittsburgh-based investment services provider generates income by managing money market, fixed income, and equity investments for clients in exchange for a fee, so how much money it manages and the average fee it collects are key drivers of profitability.

• Federated Investors ended the quarter with about $392 billion in assets under management (AUM). Assets declined in its higher-margin equity and fixed income strategies, where AUM fell 6% and 3%, respectively, quarter over quarter.
• Money market AUM was roughly flat compared to the previous period, though average AUM increased by about 7% from the prior quarter. On the conference call, management said it believed money market strategies benefited from corporate clients moving cash around following the passage of the Tax Cuts and Jobs Act. 
• Declining revenue was largely a byproduct of accounting changes rather than evidence of weakness. Federated Investors reported that total revenue declined by roughly $9.6 million (4%) year over year to $263.9 million. The decline was less severe than it appears, however, as $8.6 million of it was driven by an accounting change. Certain costs that were previously recorded as expenses are now recorded as a reduction to revenue, resulting in lower revenue this quarter. The change doesn't impact the company's bottom line, as expenses simply moved from the expense line to the revenue line.
• Investors pulled about $2.2 billion from the company's equity strategies this quarter. Its fixed-income strategies also saw outflows of roughly $1.7 billion. Market performance didn't help, either, as declining stock and bond prices resulted in a $2.3 billion decline in combined equity and fixed income AUM. Federated Investors collects a higher fee on stock and bond strategies than on money markets, so AUM fluctuations in stock and bond products have a proportionally larger impact on revenue and profit than lower-fee money market products.
• Certain expenses increased sharply. Compensation costs increased 7% year over year, due to incentive compensation primarily related to sales of equity funds. The company also recorded about $1.5 million of expenses related to its agreement to acquire 60% of Hermes Investment Management, which was announced after the end of the first quarter.

What management had to say

On the conference call, management remained upbeat about its core money market business. In response to an analyst's question, Debbie Cunningham, chief investment officer of Federated Investors' global money markets, said, "[W]e are starting to see faster growth in funds than the deposit market," noting that money market products grew at more than 6% while bank deposits grew at less than 3% in a recent one-year period.

Image source: Getty Images.

Whereas banks generally pass on a fraction of increased interest income to their depositors to boost their own bottom lines, money market funds typically pay a market yield minus a small flat fee. Thus, as rates increase, the yield differential between money market and deposit accounts may entice savers to move money away from banks and into money funds.

Looking ahead

It's one step forward, one step back for Federated Investors. After reporting inflows in all three major strategies in the fourth quarter of 2017, the company reported a decline in AUM in the two strategies that matter the most in the first quarter of 2018 -- equities and fixed income.

The money manager is looking toward acquisitions to drive growth. After the end of the first quarter, it announced a deal to acquire a 60% stake in Hermes Investment Management, a London-based asset manager that derives the bulk of its assets under management from equity and real estate strategies.

Federated will pay roughly $350 million for the stake, which it says values the company at about 12.8 times 2017 EBITDA. It believes the acquisition could bring some cross-selling opportunities, and offer a way into so-called ESG funds, which pick investments based on environmental, social, and corporate governance parameters.

The deal will weigh on earnings until the transaction closes, which is expected to happen in the third quarter of 2018. Federated Investors expects to incur about $22 million of deal-related expenses, leaving about $20.5 million in incremental expense to digest after incurring $1.5 million in transaction expenses in the first quarter.