Federated Investors: Beneficiary of Rising Rates

12/04/2015 7:00 am EST

Focus: STOCKS

Our latest focus stock is one of the leading providers of money market funds, with $247 billion of assets under management (AUM) in money markets, notes Erik Oja of S&P Capital IQ in Standard & Poor’s The Outlook.

Federated Investors (FII) carries S&P Capital IQ’s highest investment recommendation of 5-stars or strong buy.

We expect it will benefit from rising interest rates should the Federal Reserve go ahead with a rate increase. Because interest rates have been so low, Federated has waived management fees on money markets since late 2008, when short-term rates plunged to nearly zero.

These fee waivers have been a significant headwind for the company, reducing revenue in the third quarter by $83 million (to $234 million), while trimming operating income by $22 million (to $74 million).

Indeed, in the first nine months of 2015, fee waivers reduced revenue by $262 million (to $683 million) and cut operating income by $76 million (to $202 million).

Federated’s money market AUM was—until recently—falling rapidly, with large outflows in mid-2014 and a 9% peak shrinkage rate at September 30 a year ago.

Since then, outflows have ebbed and its money market funds grew AUM by a 1% year-over-year rate at September 30, 2015. For 2016, we expect Federated’s AUM to grow in line with our industry forecast of 6.4%.

We also see Federated’s equity and fixed-income funds attracting inflows, leading to good revenue growth. The company’s other AUM was composed of $52 billion of fixed-income funds and $52 billion of equity funds.

Forty-five % of assets are managed for institutional clients and 55% are for retail clients.

Federated is aggressive about returning capital to shareholders and we project share repurchases and dividends of $125 million in 2015, about 80% of our $160 million forecast of net income.

For 2016, we project net income of $195 million, with $100 million paid out as common stock dividends, at an unchanged quarterly rate $0.25 per share, plus at least $50 million in share repurchases.

Risks to our recommendation include persistently low short-term interest rates, falling global equity and bond markets, fund underperformance, fund manager departures, and stricter regulations.

Nevertheless, our 12-month target price of $36 on the shares is based on an above-peers 20 times our forward 12-months EPS estimate of $1.81, reflecting Federated’s stable earnings and relatively high dividend.

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