Summary of PRICE T ROWE GROUP INC

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.
GENERAL.
Our revenues and net income are derived primarily from investment advisory services provided to individual and institutional investors in our sponsored mutual funds and other managed investment portfolios. Investment advisory clients outside the United States account for nearly 10% of our assets under management at December 31, 2008.
We manage a broad range of U.S. and international stock, bond, and money market mutual funds and other investment portfolios, which meet the varied needs and objectives of individual and institutional investors. Investment advisory revenues depend largely on the total value and composition of assets under our management. Accordingly, fluctuations in financial markets and in the composition of assets under management affect our revenues and results of operations.
Neither our clients nor we could escape the severe downturn in global financial markets during 2008. Although we have not experienced a fundamental change in our business model like many other financial services companies, the collateral damage from the global economic woes significantly reduced our assets under management, related advisory revenues, and the value of our corporate mutual fund investments in 2008. In response, we have been vigilant about our expense levels and started a series of expense-reduction initiatives, accelerating those efforts as the market dramatically declined in the fourth quarter of 2008. Ultimately, our actual 2008 expenses were well below the levels originally planned. As we continue to rein in expenses, we presently expect that our 2009 operating expenses will fall below those of 2007.
We remain debt-free with substantial liquidity and resources that are available to help us ride through the current market crises while prudently managing the firm for the long-term. Our financial stability allows us to take advantage of attractive growth opportunities, invest in key capabilities including investment professionals and technologies and, most importantly, provide our clients with strong investment management expertise and service. While we believe 2009 will be a tough year for consumers and investors alike around the world, we think the investment environment will improve as we move into the latter half of the year and efforts to get the global economy back on track gain traction.
BACKGROUND.
The aftermath of the subprime mortgage market implosion in 2007 and the continuing credit crisis have significantly affected financial markets. At the beginning of 2008, equities declined dramatically around the world. In the United States, economic growth in the first quarter was low, and the downside risks in the economic outlook increased. The Federal Reserve responded with a substantial further easing of U.S. monetary policy that reduced the federal funds rate by 225 basis points to 2% by the end of April. The Federal government also acted with a fiscal stimulus package for American households, and the Federal Reserve initiated a series of actions intended to increase liquidity, among not only the large commercial banks but also large non-bank securities dealers.
Early July saw further financial market declines as many major indexes fell 20% below their most recent highs in October 2007. As summer progressed, the continuing severe downturn in the housing sector and the restraining effect of writedowns on bank capital and in turn credit availability, further pressured the markets. In early September, the U.S. Government acted to take control of the government-sponsored mortgage enterprises, Fannie Mae and Freddie Mac, and took numerous other largely unprecedented actions to seek to stabilize the financial services industry. The investment banking industry in the U.S. was transformed almost overnight as a merger, a bankruptcy and two conversions to bank holding companies either eliminated or reorganized the four largest independent firms. Subsequently, a large unrelated institutional money market mutual fund "broke the buck" and went into liquidation. Also, mortgage and other asset quality concerns continued to weaken both larger and smaller commercial banks, some of which experienced FDIC takeovers, further government assistance and additional mergers.
In the midst of this turmoil in the U.S. markets, global equity markets declined dramatically, and banking and credit market conditions deteriorated throughout the world. In September and October, central banks and governments acted, sometimes jointly, to shore up financial institutions and markets by injecting liquidity and capital directly into the global banking system and easing monetary policy further. In the U.S., the Federal Reserve reduced the target federal funds rate to 1% by the end of October and Congress enacted an extraordinary $700 billion support package that sought to stabilize the financial system. Most of the first half of this package, authorized to be spent before year end, went to large banks in exchange for preferred shares and warrants; however, the program also extended debt and equity financing to the automotive industry and a large insurance company. At year-end, credit markets were still tight and equity markets remained volatile with significant daily swings in valuations. Fears of recession and an uncertain timeframe for economic recovery weighed on investors. Given the uncertain outlook and lower demand, energy prices had weakened, with oil falling more than $100 below its record high in July 2008. In mid-December, the Federal Reserve reduced the target funds rate to a range of 0% to .25%, the lowest in history. In doing so, it noted that "...weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time."
With the ongoing global recession now acknowledged, expectations for the economy's performance in 2009 are generally low. Markdowns in scheduled production and significant employee layoffs have been announced as businesses aggressively cut costs and households reduce spending. Financial markets remain strained, and equity prices declined further in January. In addition to the remaining $350 billion from the $700 billion fall package, the new U.S. Administration has proposed a substantial further stimulus package that would include more than $800 billion of tax cuts and federal spending to turn the economy around. We are hopeful that this package, building on the monetary and fiscal actions already taken, will eventually provide the necessary foundation for a restoration of confidence in financial markets and a resumption of economic growth.

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In the stressful and volatile financial markets of 2008, U.S. stock indexes produced significant negative results. The broad S&P 500 Index of large-cap companies in leading industries of the U.S. economy registered a 37.0% loss while the NASDAQ Composite Index, which is heavily weighted with technology companies, was down 40.5% (excluding dividends). Performance of stocks outside the United States was worse, with a strengthening U.S. dollar increasing the magnitude of losses in dollar terms. The MSCI EAFE Index, which measures the performance of mostly large-cap stocks in Europe, Australasia and the Far East, produced a 43.1% loss while the MSCI Emerging Markets Index had an even larger loss of 53.2% for 2008.
U.S. Treasury yields declined sharply across the maturity spectrum over the course of 2008, with shorter maturities experiencing the greatest movement as investors sought the safest short-term instruments and liquidity. The yield on the benchmark 10-year U.S. Treasuries was 2.25% at December 31, 2008, down 179 basis points from the end of 2007. On the shortest side of the yield curve, both the one- and three-month yields were only .11% at year-end 2008, down 265 and 325 basis points, respectively, from the beginning of the year.
The flight to credit quality amid the economic and financial turmoil of 2008 led other debt securities to record widely disparate returns with liquidity and credit quality driving the results. The Barclays Capital U.S. Aggregate Index, a broad measure of the taxable domestic investment-grade bond market, returned 5.24%. The Barclays Capital Municipal Bond Index lost 2.47% as the municipal market suffered from forced selling from leveraged investors and concerns about the condition of state finances. The Credit Suisse High Yield Index lost 26.17% as investors anticipated a wave of defaults among high-yield bonds and the asset-backed segment suffered from worries over consumer debt. Bonds from developed markets overseas enjoyed a small gain largely because of currency exchange movements over the year, and the Barclays Capital Global Aggregate Ex-U.S. Dollar Bond Index returned 4.39%.
In this unsettled environment, investors entrusted net inflows of $17.1 billion to our management in 2008. During the first half of the year, net inflows were $17.8 billion. The steep financial market downturn and extreme market volatility caused investors to be more cautious in the second half of 2008 and we experienced net outflows of $.7 billion. Total assets under our management ended 2008 at $276.3 billion, down 30.9% from the end of 2007 and up only 2.5% over the last three years from December 31, 2005. During this period, our assets under management (in billions) have changed as follows:

                                                         2006           2007            2008
Assets under management at beginning of year            $ 269.5        $ 334.7        $  400.0

Net cash inflows
Sponsored mutual funds in the U.S., including
$.8 billion in 2006 from mutual fund mergers               12.9           20.2             3.9
Other portfolios, including $.1 billion in
separate accounts acquired in 2006                         14.9           13.6            13.2

                                                           27.8           33.8            17.1
Net market gains (losses) and income                       37.9           32.4          (140.3 )
Mutual fund distributions not reinvested                    (.5 )          (.9 )           (.5 )

Increase (decrease) during year                            65.2           65.3          (123.7 )

Assets under management at end of year                  $ 334.7        $ 400.0        $  276.3

Over the last three years, our net cash inflows have been sourced most significantly from third-party financial intermediaries and from institutional investors around the world. Our relative investment performance over much of this period and brand awareness contributed significantly to attracting net inflows across each of our four distribution channels.
Assets under management at December 31, 2008, include $196.9 billion in equity and blended asset investment portfolios and $79.4 billion in fixed income investment portfolios. The investment portfolios that we manage consist of $164.4 billion in the T. Rowe Price mutual funds distributed in the United States and $111.9 billion in other investment portfolios, including separately managed accounts, sub-advised funds, and other sponsored investment funds offered to investors outside the U.S. and through variable annuity life insurance plans.
Our $513.5 million portfolio of investments in sponsored mutual funds at December 31, 2008, includes unrealized losses of $40.3 million that are considered temporary and, accordingly, are recognized in accumulated other comprehensive losses in stockholders' equity. This unrealized loss is comprised of $30.1 million attributable to investments valued at $115.9 million that have been temporarily impaired on a continuous basis from September 30, 2008, and $10.2 million arising in the fourth quarter of 2008 on fund investments valued at $79.3 million. See Item 7A, Quantitative and Qualitative Disclosures About Market Risk, in this report for further discussion about the recognition of impairments to our investments in sponsored mutual funds.
We incur significant expenditures to attract new investment advisory clients and additional investments from our existing clients. These efforts may often involve costs that precede any future revenues that we may recognize from increases to our assets under management.
RESULTS OF OPERATIONS.
2008 versus 2007. Investment advisory revenues decreased 6.3%, or $118 million, to $1.76 billion in 2008 as average assets under our management decreased $16 billion to $358.2 billion. The average annualized fee rate earned on our assets under management was 49.2 basis points in 2008, down from the 50.2 basis points earned in 2007, as lower equity market valuations resulted in a greater percentage of our assets under management being attributable to lower fee fixed income portfolios. Continuing stress on the financial markets and resulting lower equity valuations in subsequent quarters will result in lower average assets under our management, lower investment advisory fees and lower net income as compared to prior periods.

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Net revenues decreased 5%, or $112 million, to $2.12 billion. Operating expenses were $1.27 billion in 2008, up 2.9% or $36 million from 2007. Net operating income for 2008 decreased $147.9 million, or 14.8%, to $848.5 million. Higher operating expenses in 2008 and decreased market valuations during the latter half of 2008, which lowered our assets under management and advisory revenues, resulted in our 2008 operating margin declining to 40.1% from 44.7% in 2007. Non-operating investment losses in 2008 were $52.3 million as compared to investment income of $80.4 million in 2007. Investment losses in 2008 include non-cash charges of $91.3 million for the other than temporary impairment of certain of the firm's investments in sponsored mutual funds. Net income in 2008 fell 27% or nearly $180 million from 2007. Diluted earnings per share also decreased to $1.82, down $.58 or 24.2% from last year. The non-operating charge to recognize other than temporary impairments reduced diluted earnings per share by $.21 in 2008.
Investment advisory revenues earned from the T. Rowe Price mutual funds distributed in the United States decreased 8.5%, or $114.5 million, to $1.24 billion. Average mutual fund assets were $216.1 billion in 2008, down $16.7 billion from 2007. Mutual fund assets at December 31, 2008, were $164.4 billion, down $81.6 billion from the end of 2007.
Net inflows to the mutual funds during 2008 were $3.9 billion, including $1.9 billion to the money funds, $1.1 billion to the bond funds, and $.9 billion to the stock funds. The Value, Equity Index 500, and Emerging Markets stock funds combined to add $4.1 billion, while the Mid-Cap Growth and Equity Income stock funds had net redemptions of $2.2 billion. Net fund inflows of $6.2 billion originated in our target-date Retirement Funds, which in turn invest in other T. Rowe Price funds. Fund net inflow amounts in 2008 are presented net of $1.3 billion that was transferred to target-date trusts from the Retirement Funds during the year. Decreases in market valuations and income not reinvested lowered our mutual fund assets under management by $85.5 billion during 2008.
Investment advisory revenues earned on the other investment portfolios that we manage decreased $3.6 million to $522.2 million. Average assets in these portfolios were $142.1 billion during 2008, up slightly from $141.4 billion in 2007. These minor changes, each less than 1%, are attributable to the timing of declining equity market valuations and cash flows among our separate account and sub-advised portfolios. Net inflows, primarily from institutional investors, were $13.2 billion during 2008, including the $1.3 billion transferred from the Retirement Funds to target-date trusts. Decreases in market valuations, net of income, lowered our assets under management in these portfolios by $55.3 billion during 2008.
Administrative fees increased $5.8 million to $353.9 million, primarily from increased costs of servicing activities for the mutual funds and their investors. Changes in administrative fees are generally offset by similar changes in related operating expenses that are incurred to provide services to the funds and their investors.
Our largest expense, compensation and related costs, increased $18.4 million or 2.3% from 2007. This increase includes $37.2 million in salaries resulting from an 8.4% increase in our average staff count and an increase of our associates' base salaries at the beginning of the year. At December 31, 2008, we employed 5,385 associates, up 6.0% from the end of 2007, primarily to add capabilities and support increased volume-related activities and other growth over the past few years. Over the course of 2008, we slowed the growth of our associate base from earlier plans and the prior year. We do not expect the number of our associates to increase in 2009. We also reduced our annual bonuses $27.6 million versus the 2007 year in response to recent and ongoing unfavorable financial market conditions that negatively impacted our operating results. The balance of the increase is attributable to higher employee benefits and employment-related expenses, including an increase of $5.7 million in stock-based compensation. Entering 2009, we did not increase the salaries of our highest paid associates. After higher spending during the first quarter of 2008 versus 2007, investor sentiment in the uncertain and volatile market environment caused us to reduce advertising and promotion spending, which for the year was down $3.8 million from 2007. We expect to reduce these expenditures for 2009 versus 2008, and estimate that spending in the first quarter of 2009 will be down about $5 million from the fourth quarter of 2008. We vary our level of spending based on market conditions and investor demand as well as our efforts to expand our investor base in the United States and abroad.
Occupancy and facility costs together with depreciation expense increased $18 million, or 12% compared to 2007. We have been expanding and renovating our facilities to accommodate the growth in our associates to meet business demands. Other operating expenses were up $3.3 million from 2007. We increased our spending $9.8 million, primarily for professional fees and information and other third-party services. Reductions in travel and charitable contributions partially offset these increases.
Our non-operating investment activity resulted in a net loss of $52.3 million in 2008 as compared to a net gain of $80.4 million in 2007. This change of $132.7 million is primarily attributable to losses recognized in 2008 on our investments in sponsored mutual funds, which resulted from declines in financial market values during the year.

                                                        2007       2008        Change
    Capital gain distributions received                $ 22.1     $   5.6     $  (16.5 )
    Other than temporary impairments recognized           (.3 )     (91.3 )      (91.0 )
    Net gains (losses) realized on fund dispositions      5.5        (4.5 )      (10.0 )

    Net gain (loss) recognized on fund holdings        $ 27.3     $ (90.2 )   $ (117.5 )

We recognized other than temporary impairments of our investments in sponsored mutual funds because of declines in fair value below cost for an extended period. The significant declines in fair value below cost that occurred in 2008 were generally attributable to the adverse and ongoing market conditions discussed in the Background section above. See also the discussion below of Critical Accounting Policies for other than temporary impairments of available-for-sale securities.

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In addition, income from money market and bond fund holdings was $19.3 million lower than in 2007 due to the significantly lower interest rate environment of 2008. Lower interest rates also led to substantial capital appreciation on our $40 million holding of U.S. Treasury Notes that we sold in December 2008 at a $2.6 million gain.
The 2008 provision for income taxes as a percentage of pretax income is 38.4%, up from 37.7% in 2007, primarily to reflect changes in state income tax rates and regulations and certain adjustments made prospectively based on our annual income tax return filings for 2007. We currently estimate that our 2009 effective tax rate will be similar to the 2008 effective rate.
2007 versus 2006. Investment advisory revenues were up 25%, or $370.6 million, to nearly $1.9 billion as average assets under our management increased $74.5 billion to $374.2 billion. The average annualized fee rate earned on our assets under management was 50.2 basis points during 2007, virtually unchanged from the 50.3 basis points earned during 2006.
Net revenues increased 23%, or $413.3 million, to $2.2 billion. Operating expenses were $1.2 billion in 2007, up 20% or $203.8 million from 2006. Overall, net operating income for 2007 increased $209.5 million, or almost 27%, to $996.4 million. Our operating margin was 44.7% in 2007, up from 43.4% in 2006. Net income increased $141.0 million, or almost 27%, to $670.6 million for 2007, boosting diluted earnings per share more than 26% from $1.90 to $2.40. Investment advisory revenues earned from the T. Rowe Price mutual funds distributed in the United States increased 24%, or $260.2 million, to more than $1.3 billion. Average mutual fund assets were $232.8 billion in 2007, an increase of 24% over the average for 2006. Mutual fund assets increased $39.5 billion during 2007.
Net inflows to the mutual funds were $20.2 billion during 2007. Our U.S. stock and blended asset funds had net inflows of $9.9 billion, our bond funds added $4.2 billion, our international and global stock funds added $4.7 billion, and our money market funds added $1.4 billion. Seven funds each added more than $1.4 billion and, in total, account for $15.6 billion of the net inflows. The Growth Stock Fund added more than $4.8 billion, the New Income and Equity Index 500 funds together added $4.6 billion, and the Blue Chip Growth, Value, Overseas Stock, and New Asia funds together attracted net inflows of $6.2 billion. Higher market valuations and income, net of dividends not reinvested, increased fund assets by $19.3 billion. Net fund inflows of $10.7 billion originated in our target-date Retirement Funds, which in turn invest in other T. Rowe Price funds. Investment advisory revenues earned on the other investment portfolios that we manage increased $110.4 million, or almost 27%, to $525.8 million. Average assets in these portfolios were $141.4 billion in 2007, up 26% from the 2006 average. Other investment portfolio assets increased $25.8 billion during 2007, including more than $13.6 billion of net inflows from U.S. and international institutional investors and third-party financial intermediaries, and $12.2 billion from market gains and income.
Administrative fees increased $42.7 million to $348.1 million. The change in these revenues includes $10.4 million from 12b-1 distribution fees recognized on greater assets under management in the Advisor and R classes of our sponsored mutual fund shares. The balance of the increase is primarily attributable to our mutual fund servicing activities and defined contribution plan recordkeeping services for the mutual funds and their investors. Changes in administrative fees are generally offset by similar changes in related operating expenses that are incurred to distribute the Advisor and R class fund shares through third party financial intermediaries and to provide services to the funds and their investors.
Our largest expense, compensation and related costs, increased $138.8 million, or 21%, over 2006. The largest part of the increase is attributable to a $55.3 million increase in our annual bonus compensation, which is based on our operating results and considers our relative and risk-adjusted investment performance, our growth in assets under management and net investor inflows, and the high quality of our investor services. The 2007 costs also include an increase of $37.5 million in salaries, which results from a 9% increase in our average staff size coupled with an increase of our associates' base salaries at the beginning of the year. At December 31, 2007, we employed 5,081 associates, up 10.3% from the beginning of 2007 and 4.3% from the 2007 average, primarily to handle increased volume-related activities and other growth. Other employee benefits and employment expenses, including an increase of $18.8 million in non-cash stock-based compensation, account for the remainder of the change in our compensation and related costs.
Advertising and promotion expenditures increased $10.6 million from 2006 in response to greater investor interest. Occupancy and facility costs together with depreciation expense increased $16.5 million. We are expanding and renovating our facilities to accommodate additional associates to meet greater business demands.
Other operating expenses were up $37.9 million, or 26%, including $10.4 million of higher distribution expenses recognized on greater assets under management sourced from financial intermediaries that distribute our Advisor and R classes of mutual fund shares. These distribution costs are offset by an equal increase in our administrative revenues recognized from the 12b-1 fees discussed above. Additionally, consulting and professional fees, travel, information services, and other costs rose in 2007 to meet increased business demands. Our non-operating income, which includes interest income as well as the recognition of investment gains and losses, increased $9.0 million. Our larger mutual fund investments added $20.4 million in 2007, including $13.4 million of increased capital gain distributions from the funds. Additionally, 2006 included a gain of $12.2 million upon the liquidation of a sponsored collateralized bond obligation that did not recur.
The 2007 provision for income taxes as a percentage of pretax income was recognized using a rate of 37.7%, down slightly from the 38.3% rate for the year 2006 that included provisions of .6% for the anticipated settlement of prior years' taxes.

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CAPITAL RESOURCES AND LIQUIDITY.
During 2008, stockholders' equity decreased from nearly $2.8 billion to about $2.5 billion. We repurchased $.6 billion of our common stock during the year. Tangible book value is $1.8 billion at December 31, 2008, and cash and mutual fund investments exceed $1.1 billion. Given the availability of these financial resources, we do not maintain an available external source of liquidity. Operating activities during 2008 provided cash flows of nearly $742 million, down $16 million from 2007. Reconciling items include lower net income of almost $180 million that was offset by timing differences of about $59 million in the cash settlement of our operating receivables and payables. Other than temporary impairments of our sponsored mutual fund investments totaling $91 million, greater depreciation expense on our increased property and equipment of $8 million, and nearly $6 million of additional stock-based compensation account for the remainder of the difference between 2007 and 2008.
Net cash used in investing activities totaled $125 million in 2008, down $220 million from 2007. In 2007, we invested a net of $175.5 million in our sponsored mutual funds from our available cash resources. On a net basis, we added only $2.6 million to our fund holdings in 2008; however, we made $95 million of changes to the composition of our portfolio of mutual fund holdings in light of market conditions during the year. Because of an increase in savings bank deposits, we also increased our investment in debt securities held by the savings bank by $41 million in 2008. While we made other investments of $23 million in 2007, we made only $10 million of other investments in 2008. We also received proceeds of $42.6 million on the sales, and $30 million on the maturities, of our $70 million U.S. Treasury Notes portfolio.
Net cash used in financing activities was $783 million in 2008, up $382 million from 2007. Our strong cash position allowed us to increase our common stock . . .