Description

Summary:
Federated Investors (FII – asset play; written Jan 04). My largest position, Federated Investors (FII) currently manages 194 billion and has a number of positives, including 1) a strong balance sheet, 2) a growing dividend raised each year since the company came public in 1998, 3) a persistent share buyback plan, 4) a generally attractive options plan, with a very small grant in 2003, and 5) a very high level of free cash flow. Last year, FII generated more than $200 million in excess cash. Asset under management totals are nearly flat with last year but the mix is more heavily weighted toward stock managed assets, which enjoy higher margins. This should lead to positive earnings comparisons for at least the next three quarters given a steady stock market. The company is still embroiled in the mutual fund scandal, but the offenses appear related to lax controls verses an intentional effort to harm investors. For legal reasons, FII has halted its share buyback plan until the investigation is finalized, so cash is currently accumulating on the balance sheet. Lastly, FII has a significant family insider share presence (23.4%). There are negatives too, including 1) the company’s large money market fund managed asset base is vulnerable short-term to a spike in either short or long-term rates, 2) fixed income assets have been in slight redemption mode, and 3) stock assets are vulnerable to stock market declines. Overall, I believe the positives outweigh the negatives here, and the current price is attractive at 16x cash flow.

Description. FII is a diversified asset manager whose revenue in the most recent quarter was derived from money market funds (40% of revenue; 138 billion), equity funds (35%; 26.4b), fixed income funds (20%, 29.5b), and 5% from other products. AUM was 196b one year ago, 146b three years ago, and 115 five years ago.

Why I’m Interested in this Company

1. Strong Balance Sheet. Like most asset managers, FII has a strong balance sheet with 271m in cash and all debt is offset by a deferred commission asset. Of the 449m in shareholder’s equity, more than 60% is cash.

2. Growing Dividend. The dividend has been raised each year the company has been public but still represents a nominal amount of free cash flow.

3. A persistent Buyback Plan. FII has purchased $462m in stock in the past five years, with $120m last year.

4. A generally attractive options plan. FII has issued an average of 1.4% of options as a percentage of the ending outstanding share count in the last five years (19% forfeiture rate) but this is skewed by a large grant in 2000. In the past three years, options equaled 0.2%, 0.8%, and 0.0%. The grant in 2003 was only 6,750 shares and management plans to use restricted stock going forward.

5. A very high level of free cash flow. CapEx has equaled about 7m in each of the last three years, compared to 613m in cash plus depreciation. The market cap at $30 is currently 3.358b, so this equals a free cash flow yield of 6%.

6. High Insider Presence. The Donague family and insiders own 23.4% and effectively control the company with 100% ownership of voting A shares. The B shares are public. In several years as a public company FII has demonstrated itself as shareholder friendly with dividends, buybacks, reasonable option plans, and a very open investor relations department.

What Has to Happen for the Company to Succeed

Federated is currently trading at a below average multiple for an above average business. The company will always generate significant levels of free cash flow and thus the company’s long-term success depends on management capital allocation skills. They have a lot of choices – since CapEx is minimal, cash can be used to purchase shares (doing that), raising the dividend (three times in the last 12 months), making acquisitions (largest purchase was the group that owns the Kaufmann funds, whose assets have risen from a bit over 3b to 6.1b). Management has given every indication over the last several years that cash flow will be allocated effectively. Even if cash flow merely stays flat, FII will generate 600m in cash in the next three years, 1 billion in cash in the next five.

Pitfalls that Stand in the Company’s Path

1. Compression in Money Market Fund Assets. With healthy AUM levels in stocks and bonds the knock on FII right now, at least according to brokerage research I’ve seen, is that their money market franchise has been stagnant to down. This is mostly rate related – FII’s operates mostly in the b/d and bank/trust channels, and has some yield sensitive money market assets (estimated at 30b) that will move out of their funds as rates rise before coming back as rates stabilize or go down. I'm not denying this as a negative but it is a negative that always exists, and it doesn't relect badly on the business. Nobody is crawling over themselves to get in this business, with rates on the downside potentially eliminating any profitability in this business while a rate increase, if sustained, can lead to outflows from some participants capturing a short-term yield difference. I think this view is short-sighted - the money market asset business has grown over the past five years and represents a annuity-like source of income for the company. As the largest independent purveyor of money market funds, FII offers a wide range of choices and fee schedules appropriate for whatever market they care to target, and the companies share of this area has been growing. Any disruptions from yield changes have historically been temporary (less than 12 months of impact), and only serve to discourage others from developing a business like this. As far as I know, there aren’t any famous money market fund managers. Of course, there is always a small possibility that FII could select a poor investment for these funds, and the gigantic size of FII's asset base may preclude an investment to prevent the NAV from breaking the buck. This is highly unlikely but can't be entirely disregarded.

2. Compression in Stock and Bond Assets. This is an obvious problem with any asset manager. FII’s largest equity or bond funds are Kaufmann (6.1b), Capital Appreciation (3.1b), American Leaders (2.7b), High Income (2.2b), and Ultrashort (1.7b). Kaufmann in particular charges a high than average expense ratio (easy to justify, given performance) and could face sucession issues in the next few years. The bond funds have seen some redemptions recently but nothing overly significant. Regardless, FII has shown itself capable of increasing share in many types of markets and offers diversified products which can be sold in most market environments.

3. Inappropriate Capital Allocation. Already covered.

4. Short-term Issues. FII was wrapped into the fund scandal but my read is that the company offenses, while serious, were more related to lax controls and isolated issues as opposed to a systematic attempt to defraud investors. You can read more about this in the company’s 10K. So far, FII took a 21m charge in Q4 and another 4.2m charge in Q1 and the issue is yet to be resolved (charges included in valuation figures); there will also be a loss of revenue and some income from audit and transfer agency functions which have been reassigned. Also, FII is due to pay a contigent payment to the Kaufmann folks which was reflected in an increase in goodwill in Q1 of this year and could lead to other future payments depending on asset growth.

Final Comment
In my view this isn’t 2000 when multi-baggers abounded, or even March 2003 when quite a few names offered a reasonable 50-80% upside with little downside risk. This is year 2004, when value ideas are hard to find and those companies with earnings momentum are priced accordingly. Thus, while this idea isn’t going to strike anyone as the next tenbagger, it does offer copious free cash flow from an asset manager that gives every sign of intelligent capital allocation, all at a reasonable valuation driven by external events which the company will undoubtedly see change in the next month, quarter, or year. This is also a very liquid name. My personal rating is 6.5x, and it is my largest sigle position.

AUM History

981Q: 96
2Q: 101
3Q: 103
4Q 111
991Q 115
992Q 117
993Q 115
994Q 125
001Q 125
002Q 126
003Q 130
004Q 140
011Q 146
012Q 160
013Q 163
014Q 179
02-1Q 177
02-2Q 185
02-3Q 181
02-4Q 195
03-1Q 196
03-2Q 202
03-3Q 194
03-4Q 198
04-1Q 194

Valuation
Cap - 3.364b
PE - 17.3x
P/Cf - 15.9x
Trailing Net Income - 194m
Trailing NI + Dep - 215m (Q4 plus 3m)
Trailing CapEx - 7m (sans acquisition payments)
DY - 1.4%

Catalyst

Continued dividend increases and resumption of buybacks