Federated Investors (FII) – BUY

Federated Investors is a good business selling at a cheap price due to regulatory overhang.  At the current price ($18.80), the stock is selling at a 6.6 EV/EBIT ratio (assuming $280 million EBIT for the year).  Catalysts for price appreciation include:

1)      An end of regulatory overhang with positive outcome for money market funds.

2)      An end of fee waivers for money market funds.

Company Overview

Federated Investors is a one stop shop asset management company with funds to meet the strategies of any client.  Asset management is a good business because it scales well and once fees from AUM is enough to cover fixed costs, the additional revenue from AUM increase and positive fund performance adds directly to the bottom line.  The largest groups of asset classes for the investment funds at Federated are Money Market (76% of total AUM and 50% of revenue), Fixed Income (12% of total AUM and 20% of revenue), and Equities (9% of total AUM and 30% of revenue).

Money market funds are mutual funds that invest in short term paper from the government and high grade corporations.  Fixed income funds invest in bonds with a longer maturity.  Equity funds invest in stocks.

Regulatory Overhang

Since 1971, when the first money market fund was established, only 3 money market funds have failed and “broke the buck”.  The most recent occurred in 2008 during the financial crisis, where the Reserve Primary Fund wrote off debt issued by Lehman Brothers and reported a NAV of 0.97.  Eventually, the investors in the money market fund recovered 99% of their investment.

After the financial crisis, the SEC imposed several regulations on money market funds to prevent future money market fund failures.  In 2012, the SEC tried to propose new regulations, but failed to reach a majority decision with a 2-3 vote.  In late 2012, the FSOC urged the SEC to consider implementing new regulations.  The outcome of the SEC decision is unknown, but the market has already moved against Federated due to the regulatory overhang.

The FSOC proposals are as followed:

1)      Maintain a 1% capital buffer and limit redemptions to 97% of assets at a given time.

2)      Maintain a 3% capital buffer

3)      Display a floating NAV instead of the standard $1.00 NAV

The effects of the proposed regulations are uncertain, but the one that is most concerning is the capital buffer.  The NAV of a money market fund already changes daily so a floating NAV that is displayed doesn’t really change the investment product, but it would create some tedious record keeping.  Redemption limits would decrease the desirability of money market funds and decrease AUM, but money market funds already have the ability to stop redemptions so the decrease in AUM may be limited.  Maintaining a capital buffer would require capital to be tied up and could either be relatively benign in a higher interest rate environment or disastrous for the money market fund industry.  There is a silver lining in that increased regulation would create even more barriers of entry for new competitors in an already oligopolistic industry.

Capital Buffers

The need for capital buffers would require a large infusion of cash either from Federated or from the shareholders of the fund.  If Federated is required to infuse capital to create the buffer, it would decrease the profitability of money market funds.  Expense fees would have to be raised in order to counteract the effects, which would make the yield for money market funds less desirable.

At a 0.25% expense fee charged to the client, the fund would take 4 years to payback a required 1% capital buffer and 12 years for a 3% capital buffer.  This is before expenses and taxes to the fund are even considered so the actual payback period would take decades.  The payback period changes based on the expenses charged and also the expenses to operate the fund.  Increases to expense fees, especially in a low interest rate environment, would make money market funds less competitive compared to alternatives.  A capital buffer funded by Federated would make the money market business unattractive not only because of the long payback period, but also because the fund sponsor would be placing a substantial amount of capital at risk without adequate compensation.  This would apply to all money market funds and would likely lead to firms exiting the business.

If the capital buffer is provided by shareholders of the fund through a small addition to the expense fee, it would also take years or decades before the capital buffer requirements are met.  This would allow money market funds to remain profitable, but would increase fees for clients and make money market funds less desirable.

Floating NAV

The underlying investments in a money market fund fluctuates and NAV doesn’t actually remain stable at $1.00.  Currently, money market funds have an exemption from the SEC to report a stable $1.00 NAV, but that is subject to change.  The impact wouldn’t change the investments in the fund, but it would impact taxes since a floating NAV would have gains and losses.  The FSOC recognizes the potential impact and is willing to propose exemptions.  In the proposed recommendations for money market funds, the FSOC states, “Because of the high volume of redemptions of shares of MMFs, however, and because of the minimal per share losses that may result from each redemption, the Council understands that the Treasury Department and the IRS will consider administrative relief for both shareholders and fund sponsors.”

Fee Waivers

Many money market funds charge around a 0.25% expense fee.  However, due to the extremely low interest rates that cause money market funds to have low yields, most funds offer fee waivers to retain customers.  Federated Investors is no exception and also offers fee waivers for their money market funds.  The waivers currently take about $80 million from EBIT in a year.  Without the fee waivers, EBIT would be around $340 million per year assuming everything else remains the same.  This would currently result in a 5.5 EV/EBIT ratio.

Fee waivers aren’t permanent and Federated Investors can decide when to implement them.  In the 3Q of 2012, the fee waiver was partially decreased to $16.6 million compared to the prior 1Q and 2Q of $40 million combined.  Going forward, the fee waiver may or may not be reduced.  The third quarter 10-Q gives a hint and states, “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.”  Regardless if fee waivers are completely removed, partially removed, or not removed at all, the stock is selling at a 5.5 EV/EBIT to 6.6 EV/EBIT multiple, which may or may not be cheap depending on your own preference and required rate of return.

Conclusion

With a low EV/EBIT ratio and in abnormally poor environment with low interest rates for the money market fund industry, there is significant upside to owning Federated Investors.  When interest rates eventually rise, fee waivers will be removed and profits will increase.  When the regulatory overhang ends, there will likely be a multiple expansion.

It wouldn’t be unlikely for the stock to trade at a 10.0 EV/EBIT multiple if regulations are favorable to money market funds.  A 10.0 EV/EBIT multiple at current low profits ($280 million EBIT) with fee waivers would imply a $28/share price.  Without fee waivers ($340 million EBIT), a 10.0 EV/EBIT multiple would imply a $34/share price.  Increases in AUM would make the value of the stock even higher.

If we assume that the money market fund business is broken and that it accounts for half of Federated’s earnings, we get $140 million EBIT for the rest of the business.  At the current price of $18.80, this would equate to a 13.2 EV/EBIT multiple.  If we bring this back down to a 10.0 EV/EBIT multiple, we get a $14/share price.  At 8.0 EV/EBIT multiple, we get an $11/share price.  At a 6.0 EV/EBIT multiple, we get an $8.50/share price.  A 6.0 EV/EBIT multiple appears low for an asset management business and the likelihood of the entire money market fund industry to be completely destroyed is remote even with new regulations.

If we assume that the fixed income and equity portion of the business remains the same, the downside is -55% with the share price at $8.50.  The upside is +80% with the share price at $34.  In my opinion, the outcome is more likely to skew towards the higher end of the spectrum and the stock is a buy at $18.80.

Disclosure – Long FII at time of writing

Disclaimer 

The content contained on this website, www.valueinwonderland.com, represents only the opinions of its author(s).  The author(s) may hold long or short positions in securities mentioned in the website and may do so before and after any particular article that mentions the securities is published.  The website and author(s) take no responsibilities to update articles and no responsibilities to provide new articles.  The website and author(s) take no responsibilities to the accuracy, completeness, or timeliness of the website.  The website and author(s) provide articles to record their own thoughts and in no way should anything on the website be considered investment advice.  Nothing from the website shall be considered an offer or solicitation for the purchase or sale of any security and should not be construed as such.