Federated Investors Inc (NYSE:FII) has been known for its money market investments for many years. But the incredibly low interest-rate environment since the financial crisis has driven yields to near zero, and made this business a hard go. Luckily for Federated shareholders, the company undertook a major effort a few years back to diversify its investing business and increase its fixed-income and equity portfolio.

Those moves have helped the company continue to operate profitably in recent years, and the just-reported third quarter of FY2015 was no exception. 

The numbers 

 Q3 2015Q3 2014Change
EPS $0.42 $0.36 17%
Revenue $158.9MM $141.1MM 13%
Operating expenses $160.1MM $156.1MM 3%
Total managed assets $351BB $352BB -0.4%

The numbers above only tell part of the story. One of the big drivers of the increase in revenue and earnings was the benefit of slightly improved interest rates in the quarter. The table below helps show this:

With some of Federated's money market funds, the company has waived fees during the past several year in order for those funds to maintain positive or net-zero yields, and that, of course, has a negative impact on the company's profits. But as you can see in the table above, yield waivers declined last quarter, and the net result was a pre-tax benefit of $10 million compared to last year's third quarter. This was a $1.9 million net reduction from the second quarter of 2015, as well. 

What happened in the quarter 

  • Despite the weak interest-rate environment, the majority of Federated's managed assets remain in money market funds. Of the $355 billion in total assets on October 21, $249 billion was in money market funds, $54 billion in equities, and $52 billion in fixed-income investments. 
  • The majority of revenue, 67%, was derived from equity and fixed-income assets. These assets are likely to remain the primary drivers of revenue and profits for at least the foreseeable future. 
  • Operating expenses increased 3% in the quarter, well below the increase in revenue, and partly up because there was one more business day in the quarter versus last year. 
  • The balance sheet remains relatively strong: Cash increased $24.5 million to $321.7 million. Long-term debt decreased $19 million, to $216.8 million. 

What management had to say 
The interest-rate environment has made it tough going for Federated and its competitors during the past half-decade, and recent regulatory challenges threatened to derail the entire industry before concerns were allayed. But CEO Chris Donahue pointed out that there will always be challenges:

Every time you turn around there is another gang of regulations. So we have been through redo the whole thing on Money Market funds, which to the people working on it is truly water boarding as we were told by one of the commissioners it would be. We are now dealing with the liquidity rule. We are now dealing with a fiduciary rule and the SEC has said they are going to come out with a derivatives rule before year end. Well even though these challenges are greater, there are other things going on. 

CFO Tom Donahue gave some color on the potential benefit of a small increase in interest rates on reducing money market yield waivers:

Looking forward, we estimate that gaining 10 basis points in gross yields from beginning Q3 levels would likely reduce the impact of yield waivers by about 45%, and a 25 basis point increase would reduce the impact by about 65%. We expect to capture about two-thirds of the pre-tax income related to the remaining money fund yield waivers. 

Looking ahead 
Federated management continues to increase the company's fixed-income and equity asset fund selection in order to further diversify the business and to grow income. However, money market funds will remain a core part of the business. While equity and fixed-income growth is important and necessary, a major driver for Federated as a long-term investment remains an eventual recovery of short-term interest rates. 

When this happens, it will lead to big profit growth for Federated; but it's not going to happen overnight. For now, it looks like management is focusing on improving the business where it can.