We have downgraded our recommendation on Federated Investors Inc. (FII) to Underperform from Neutral based on expected downward pressure on assets under management (AUM), flows and margins. Regulatory backdrop, waning equity markets and sluggish global economic growth are expected to keep earnings under pressure.
In April, Federated’s first-quarter 2011 earnings came in at 43 cents per share, in line with the Zacks Consensus Estimate, but better than the year-ago quarter’s earnings of 38 cents. However, this compares unfavorably with the earnings of 45 cents recorded in the prior quarter. As of March 31, 2011, total AUM was $354.9 billion, down 1% from $358.2 billion as of December 31, 2010.
Results reflected a rise in fixed income and equity assets, increased top-line growth, decrease in voluntary fee waivers and a decline in amortization of deferred sales commissions. This was partly offset by an increase in operating expenses on a year-over-year basis. Results in the first quarter of 2011 included 11 cents per share after-tax charge for non-recurring legal expenses related to the expected settlement of litigation.
Federated’s lower AUM has resulted in a negative organic growth in core business as investors are transferring cash from money market funds to higher yielding bank deposits or investments across the fixed income universe and equities.
As of March 31, 2011, approximately 49% of Federated’s total revenue was attributable to money market managed assets compared with 50% in the prior quarter. A significant reduction in money market managed assets due to changes in financial markets, including increases in interest rates over a short period of time, considerable deterioration in investor confidence, prolonged periods of historically low short-term interest rates and resulting fee waivers, could have a material adverse effect on Federated’s results of operations.
During the latter half of 2008 and early 2009, disruptions in the financial markets severely dislocated the functioning of the credit markets and damaged the availability of liquidity in the short-term debt markets. In certain money market funds, the gross yield was not sufficient to cover the funds’ normal operating expenses due to historically low short-term interest rates. Since the fourth quarter of 2008, Federated has voluntarily waived fees for certain funds to maintain positive or zero net yields. During first- quarter 2011, fee waivers totaled $63.4 million, partially offset by a related reduction in distribution expenses of $49.5 million. We expect the fee waivers and the related reduction in distribution expenses to continue into 2011 and will likely be significant.
On the flip side, Federated is one of the largest mutual fund managers in the U.S. Its business mix includes products that are found to be functional under diverse market conditions. The company has structured its investment process to meet the requirements of fiduciaries and others, who use its products to satisfy the needs of their customers. Fiduciaries typically have stringent demands regarding portfolio composition, risk and investment performance.
After the evaluation of Federated’s existing liquid assets, expected continuing cash flow from operations, and its ability to obtain additional financing arrangements and issue debt or stock, we believe that the company will have sufficient liquidity to meet its present as well as reasonably foreseeable cash needs. The company’s cash and marketable securities totaled $317 million as of March 31, 2011.
Moreover, the company has the potential for substantial growth in the long run, given its fairly healthy balance sheet, a diversified asset as well as product mix. Nevertheless, the near-term outlook remains bleak and we recommend waiting for a strong and steady rebound that will help to increase market activity and regenerate client demand.
Federated currently retains a Zacks #4 Rank, which translates into a short-term ‘Sell’ rating. The company’s peer – Franklin Resources Inc. (BEN) retains a Zacks #3 Rank (a short-term ‘Hold’ rating).
