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FII > SEC Filings for FII > Form 10-Q on 26-Oct-2012All Recent SEC Filings

Show all filings for FEDERATED INVESTORS INC /PA/

Form 10-Q for FEDERATED INVESTORS INC /PA/


26-Oct-2012

Quarterly Report

Part I, Item 2. Management's Discussion and Analysis

of Financial Condition and Results of Operations (Unaudited)

The discussion and analysis below should be read in conjunction with the consolidated financial statements appearing elsewhere in this report. Management has presumed that the readers of this interim financial information have read or have access to Management's Discussion and Analysis of Financial Condition and Results of Operations appearing in Federated's Annual Report on Form 10-K for the year ended December 31, 2011.

General

Federated Investors, Inc. (together with its subsidiaries, Federated) is one of the largest investment managers in the United States with $364.1 billion in managed assets as of September 30, 2012. The majority of Federated's revenue is derived from advising and administering Federated mutual funds and Separate Accounts (which include separately managed accounts, institutional accounts, sub-advised funds and other managed products) in both domestic and international markets. Federated also derives revenue from providing various other mutual fund-related services, including distribution, shareholder servicing and retirement plan recordkeeping services (collectively, Other Services).

Federated's investment products are primarily distributed in four markets. These markets and the relative percentage of managed assets at September 30, 2012 attributable to such markets are as follows: wealth management and trust (48%), broker/dealer (31%), institutional (12%) and international (6%).

Investment advisory fees, administrative fees and certain fees for Other Services, such as distribution and shareholder service fees, are contract-based fees that are generally calculated as a percentage of the net assets of the investment portfolios that are managed by Federated. As such, Federated's revenue is primarily dependent upon factors that affect the value of managed assets including market conditions and the ability to attract and retain assets. Nearly all assets under management (AUM) in Federated's investment products can be redeemed at any time with no advance notice requirement. Fee rates for Federated's services generally vary by asset type and investment objective and, in certain instances, decline as the average net assets of the individual portfolios exceed certain thresholds. Generally, management-fee rates charged for advisory services provided to equity products are higher than management-fee rates charged on money market and fixed-income products. Likewise, mutual funds typically have a higher management-fee rate than Separate Accounts. Similarly, traditional separate accounts typically have a higher management-fee rate than liquidation portfolios. Accordingly, revenue is also dependent upon the relative composition of average AUM across both asset and product types. Federated may waive certain fees for competitive reasons such as to maintain positive or zero net yields, to meet regulatory requirements or to meet contractual requirements. Since Federated's products are largely distributed and serviced through financial intermediaries, Federated pays a portion of fees earned from sponsored products to the financial intermediaries that sell these products. These payments are generally calculated as a percentage of net assets attributable to the financial intermediary selling the product and comprise the vast majority of Distribution expense on the Consolidated Statements of Income. Certain components of distribution expense can vary depending upon the asset type, distribution channel and/or the size of the customer relationship. Federated generally pays out a larger portion of revenue earned from managed assets in money market funds than revenue earned from managed assets in equity or fixed-income funds.

Federated's most significant operating expenses include compensation and related costs, which include fixed and variable compensation and related employee benefits, and distribution expenses. Certain of these expenses are dependent upon sales, product performance, levels of assets and asset mix and the willingness to continue fee waivers in order for certain money market funds to maintain positive or zero net yields.

The discussion and analysis of Federated's financial condition and results of operations are based on Federated's Consolidated Financial Statements. Federated operates in a single operating segment, the investment management


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Management's Discussion and Analysis (continued) of Financial Condition and Results of Operations (Unaudited)

business. Management evaluates Federated's performance at the consolidated level. Management analyzes all expected revenue and expenses and considers market demands in determining an overall fee structure for services provided and in evaluating the addition of new business. Federated's growth and profitability are dependent upon its ability to attract and retain AUM and, in light of the continuing adverse market conditions, are also dependent upon the profitability of those assets, which is impacted, in part, by management's decisions regarding fee waivers in order for certain money market funds to maintain positive or zero net yields. Fees for fund-related services are ultimately subject to the approval of the independent directors or trustees of the mutual funds. Management believes the most meaningful indicators of Federated's performance are AUM, total revenue and net income, both in total and per diluted share.

Business Developments

Money Market Fund Matters
For the nine-month period ended September 30, 2012, approximately 47% of Federated's total revenue was attributable to money market assets as compared to 46% for the same period in 2011. A significant change in Federated's money market business or a significant reduction in money market assets due to regulatory changes, changes in the financial markets including significant and rapid increases in interest rates over a short period of time causing certain investors to prefer direct investments in interest-bearing securities, significant deterioration in investor confidence, further persistent declines in or additional prolonged periods of historically low short-term interest rates and resulting fee waivers or other circumstances, could have a material adverse effect on Federated's results of operations.

(a) Current Regulatory Environment In January 2010, the Securities and Exchange Commission (SEC) adopted extensive amendments to Rule 2a-7 of the Investment Company Act of 1940 (Rule 2a-7) aimed at enhancing the resiliency of money market funds. These amendments included a series of enhancements including rules that require all money market funds to meet specific portfolio liquidity standards and rules that significantly enhance the public disclosure and regulatory reporting obligations of these funds. In Federated's view, the amendments of 2010 meaningfully and sufficiently strengthened money market funds. Recent experience demonstrated that the amendments of 2010 were effective in meeting heightened requests for redemptions occurring in connection with the U.S. credit rating downgrade in 2011 and the ongoing European debt crisis. In August 2012, SEC Chairman Mary Schapiro issued a public statement announcing that she did not have sufficient votes from fellow SEC commissioners to pursue certain proposed reforms relating to money market funds. In her statement, Ms. Schapiro stated that the SEC had been considering two alternative reform proposals, one which would have required a floating net asset value, and the other which would have imposed capital requirements coupled with some form of redemption restriction. In her statement, she invited other policymakers to take up the issue of reform. On September 27, 2012, Treasury Secretary Timothy Geithner sent a letter to the members of Financial Stability Oversight Council (FSOC) announcing his intent to pursue money market fund reform. His letter urged FSOC to use its authority under Section 120 of the Dodd-Frank Act to recommend that the SEC proceed with money market reform. Mr. Geithner outlined three potential options for reform in his letter and stated that he had asked his staff to begin drafting a formal recommendation for FSOC to consider at its November 2012 meeting. FSOC is required to take costs into account and solicit public comment on any proposed recommendation. If FSOC were to issue such recommendation to the SEC, the SEC would not be required to adopt such recommendation, but would be required to explain in writing why it has determined not to follow the recommendation. Federated believes the changes currently under consideration, if enacted, would significantly reduce the utility and attractiveness of money market funds to investors. Thus, rather than enhance the resiliency of money market funds, the contemplated changes would potentially severely harm the utility of money market funds for investors who, in


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Management's Discussion and Analysis (continued) of Financial Condition and Results of Operations (Unaudited)

Federated's view, value money market funds in their current form as an efficient and effective cash management investment product offering daily liquidity at par.
If ultimately enacted, some or all of these changes would be detrimental to Federated's money market fund business and could materially and adversely affect Federated's operations. The very proposal of such amendments could have an adverse impact on Federated's money market fund business and operations and could also negatively impact the short-term credit markets. Management is carefully monitoring developments in this area and plans to actively participate both individually and with industry groups in the public comment process that would accompany any rule change proposal. Federated is unable to assess the degree of any potential impact such additional reforms may have on its business and operations until such proposals are issued. Even when issued, the final version of any rule amendment could vary significantly from the form in which it is proposed.

(b) Historically Low Short-Term Interest Rates Throughout 2011 and the first nine months of 2012, the Federal Reserve left the near-zero federal funds rate unchanged and short-term interest rates continued at all-time low levels. Since the fourth quarter 2008, Federated has voluntarily waived fees in order for certain funds to maintain positive or zero net yields. These fee waivers were partially offset by related reductions in distribution expense and net income attributable to noncontrolling interests as a result of Federated's ability to share the impact of the waivers with third-party intermediaries. The impact of such fee waivers on various components of Federated's Consolidated Statements of Income was as follows for the periods presented:

                                                                      Three Months Ended

(in millions)                September 30, 2012      June 30, 2012      March 31, 2012     December 31, 2011      September 30, 2011
Investment advisory fees    $           (41.2 )     $       (43.0 )    $       (52.9 )    $           (58.8 )    $           (57.2 )
Other service fees                      (28.3 )             (27.3 )            (27.5 )                (30.2 )                (31.7 )
  Total Revenue                         (69.5 )             (70.3 )            (80.4 )                (89.0 )                (88.9 )
Distribution expense                    (52.9 )             (53.1 )            (57.5 )                (61.9 )                (63.2 )
  Operating income                      (16.6 )             (17.2 )            (22.9 )                (27.1 )                (25.7 )
Noncontrolling interest                  (0.3 )               0.0               (0.6 )                 (1.0 )                 (2.5 )
Pre-tax impact              $           (16.3 )     $       (17.2 )    $       (22.3 )    $           (26.1 )    $           (23.2 )

The negative pre-tax impact of fee waivers to maintain positive or zero net yields decreased $6.9 million for the third quarter 2012 as compared to the same quarter of 2011 primarily as a result of improved yields on instruments held by the money market funds. The negative pre-tax impact of fee waivers to maintain positive or zero net yields remained flat for the first nine months of 2012 as compared to the same period of 2011 primarily as a result of higher average yields on instruments held by the money market funds ($3.9 million) offset by higher average money market assets in the first nine months of 2012 compared to the first nine months of 2011 ($3.4 million). In terms of recent trends, the negative pre-tax impact of these fee waivers on income for the quarter ended September 30, 2012 was less than the impact in the first and second quarters of 2012 and the third and fourth quarters of 2011. The Federal Reserve Bank recently stated that it anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015. As such, fee waivers and the related reduction in distribution expense and net income attributable to noncontrolling interests could continue at least through mid-2015. Based on recent market conditions and assuming asset levels remain constant, fee waivers for the fourth quarter 2012 may result in a negative pre-tax impact on income of approximately the same amount as the third quarter 2012. While the level of fee waivers are impacted by various factors, increases in short-term interest rates that result in higher yields on securities purchased in money market fund portfolios would reduce the negative pre-tax impact of these waivers. Management estimates that an increase of 10 basis points in gross yields on securities purchased in money market fund portfolios will likely reduce the negative pre-tax impact of these waivers by approximately forty percent from the current levels and an increase of 25 basis points would reduce the impact by approximately seventy percent from the current levels. The actual amount of future fee waivers could vary


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Management's Discussion and Analysis (continued) of Financial Condition and Results of Operations (Unaudited)

significantly from management's estimates as they are contingent on a number of variables including, but not limited to, changes in assets within the money market funds, available yields on instruments held by the money market funds, actions by the Federal Reserve, the U.S. Department of the Treasury, FSOC and other governmental entities, changes in expenses of the money market funds, changes in the mix of money market customer assets, Federated's willingness to continue the fee waivers and changes in the extent to which the impact of the waivers is shared by third parties.

Global Expansion
Federated continues to explore opportunities to further expand its global footprint. In the second quarter 2012, Federated completed the acquisition of London-based Prime Rate Capital Management LLP, a cash management firm with $4.3 billion in money market AUM as of the date of acquisition. In the third quarter 2012, Federated expanded its European distribution capabilities through an agreement with Bury Street Capital, a European distribution firm based in London. Federated also expanded into the Asia-Pacific region by opening an office in Australia. The expansion into the Asia-Pacific region will result in increased operating costs that could approximate $6 million over the next twelve months. The actual increase in operating costs could vary significantly from management's estimates as further business development plans are finalized and implemented.

Insurance Proceeds
In the third quarter 2012, Federated obtained the final approval from one of its insurance carriers for $17.3 million of claims submitted over the past several years related to various legal proceedings. Accordingly, Federated recognized $17.3 million in the Consolidated Statement of Income as a reduction to Professional service fees. In a prior period, Federated had received $10.0 million as an advance from its insurance carrier related to these claims which was included in Other current liabilities on the Consolidated Balance Sheet. Federated reversed the $10.0 million liability in Other current liabilities and accrued the remaining $7.3 million related to expected insurance proceeds in Receivables, net at September 30, 2012, which was subsequently received in the fourth quarter 2012.

On October 11, 2012, Federated reached a tentative settlement with another one of its insurance carriers for $3.0 million of claims submitted over the past several years related to various legal proceedings. In the period in which the settlement is finalized, Federated will recognize $3.0 million in the Consolidated Statement of Income as a reduction to Professional service fees which were originally charged as a result of the costs incurred.

Subsequent Event - Special Cash Dividend On October 25, 2012, the board of directors declared a $1.75 per share dividend to shareholders of record as of November 8, 2012 to be paid on November 15, 2012. The dividend, which will be paid from Federated's existing cash balance, is considered an ordinary dividend for tax purposes and consists of a $0.24 quarterly dividend and a $1.51 special dividend. The special dividend is expected to decrease diluted earnings per share for fourth quarter 2012 by approximately $0.04 and for full-year 2012 by approximately $0.02 due to the application of the two-class method of calculating earnings per share.


Table of Contents
Management's Discussion and Analysis (continued) of Financial Condition and Results of Operations (Unaudited)

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