Earnings Transcript for FHN - Q4 Fiscal Year 2022

Operator: Good day, and welcome to the FHI Q4 2022 Analyst Call and Webcast. [Operator Instructions]

It is now my pleasure to turn the floor over to your host, Ray Hanley, President of Federated Investors Management Company. Sir, the floor is yours. :

Raymond Hanley: Good morning, and welcome. Leading today's call will be Chris Donahue, Federated Hermes' CEO and President; Tom Donahue, Chief Financial Officer. And joining us for the Q&A are Saker Nusseibeh who is the CEO of Federated Hermes Limited; and Debbie Cunningham, the Chief Investment Officer for Money Markets.

Today's call, we will make forward-looking statements, and we want to note that Federated Hermes' actual results may be materially different than the results implied by such statements. Please review our risk disclosures in our SEC filings. No assurance can be given as to future results, and Federated Hermes assumes no duty to update any of these forward-looking statements. Chris? :

John Donahue: Thank you, Ray, and good morning all. I will review Federated Hermes business performance, Tom will comment on our financial results. We ended 2022 with record total assets under management of $669 billion. This was driven by growth of $35.6 billion in money market assets in Q4 to reach a record high of $477 billion at year-end.

Turning to equities. Assets increased by about $7 billion to $81.5 billion due to market gains, FX impact and net positive sales in separate accounts, all of which were partially offset by net fund redemptions. :

The strategic value dividend strategy continued to produce solid net sales with nearly $1 billion in the Q4 with about 1/4 of that from the fund and almost 3/4 of that from the SMA. The U.S. strategic value dividend ETF launched in mid-November, now has $42 million in assets.:

We saw Q4 positive net sales in 16 equity fund strategies, including Asia ex Japan, International Strategic Value Dividend, MDT Large cap growth, European Alpha equity, international growth and Clover small value. Q4 equity fund net redemptions of $1.4 billion were concentrated in our growth strategies.:

Our equity fund performance at the end of 2022 compared to peers was solid. Using Morningstar data for the trailing 3 years, at the end of the year, 61% of our equity funds were beating peers and 33% were in the top quartile of their category. As we begin '23, our equity focus with clients continues to be on the strategies that have responded well in inflationary times. These include dividend income, international, emerging markets and value.:

Now for the first 3 weeks of Q1, Combined equity and SMAs had net positive sales of $328 million. We had 23 equity funds with positive net sales during this period, including strategic value dividend, global emerging markets, Asia ex Japan, MDT Small Cap Core and international leaders.:

Turning now to fixed income. Assets increased by about $1.3 billion in Q4 to $86.7 billion as assets from the CW Henderson acquisition of about $3.5 billion, and gains from market values of about $1.6 billion were partially offset by net redemptions from funds of $2.6 billion and separate accounts of $1.3 billion.:

Within our funds, our flagship Core Plus strategy, total return bond had Q4 net sales of about $652 million, benefiting from a long term performance record, and that has led to expanded distribution opportunities. Our 2 micro short bond funds combined for just under $200 million of Q4 net sales. Core plus and other multi-sector fixed income SMA strategies added $146 million of Q4 net sales.:

Within fixed income funds, Q4 net redemptions of about $1.8 billion occurred in the 3 ultrashort funds. We had 9 fixed income funds with positive net sales in the fourth quarter, including total return bond and 2 micro shorts, as already mentioned, as well as institutional high-yield bond fund and the intermediate corporate bond fund.:

Regarding performance. At the end of 2022 using Morningstar data for the trailing 3 years, 57% of our fixed income funds were beating peers and 16% were in the top quartile of their category. For the first 3 weeks of '23, fixed income funds and SMAs had net positive sales of $466 million, led by Total Return Bond and SDG engagement high-yield credit.:

During the same period, we had 18 fixed income funds with positive net sales. Some of the others include corporate bond, Sterling Cash Plus and institutional high-yield bond. In the alternative and private markets category, assets increased due to positive FX impact, partially offset by market losses and net redemptions. Pru Bear was up, MDT was up and direct lending was up. These were offset by net redemptions in absolute return credit, private equity and infrastructure.:

Now we continue marketing the fifth vintage of PEC, PEC, our co-investment private equity structure and the third vintage of the Horizon Private Equity Fund. PEC 5 has raised about $400 million through year-end, and Horizon has commitments of a little over $1 billion through year-end.:

We begin 2023 with about $4.8 billion in net institutional mandates yet to fund into both funds and separate accounts. About $3 billion of this net total is expected to come into private market strategies, including private equity, direct lending and unconstrained credit.:

Equity wins of about $1.3 billion are in Asia ex Japan, global emerging markets, global equities, Fixed income expected additions are in SDG high-yield credit, investment-grade credit and short duration.:

Moving to money markets. The Q4 asset increase reflected seasonality and favorable market conditions for cash as an asset class. Money market strategies are benefiting from higher yields, elevated liquidity levels in the financial system and favorable yields compared to bank deposits. We expect higher short-term rates will benefit money market funds over time, particularly as compared to deposit rates.:

Our money market mutual fund market share, including the sub-advised funds was about 7.7% at the end of '22, up from about 7.4% at the end of the third quarter of '22.:

Looking now at recent asset totals as of a few days ago, managed assets were approximately $674 billion, including $475 billion in money markets, $90 billion in equities, $85 billion in fixed income, $21 billion in alternative private markets and $3 billion in multi-asset. Money market mutual fund assets were $325 billion. Tom? :

Thomas Donahue: Thanks, Chris. Total revenue for Q4 decreased $7.2 million or about 2% from the prior quarter due mainly to lower average long-term assets and lower performance fees and carried interest partially offset by higher average money market assets. Q4 performance fees and carried interests were $3.3 million.

Q4 operating expenses increased $25.8 million or 9% compared to Q3, driven by the $31.5 million noncash intangible asset impairment charge, offset mainly by FX impact of $8 million from the currency forwards used to hedge certain pound exposure. The impairment charge was due to the change in fair value of one of the intangible assets from the 2018 Hermes Fund Managers Limited acquisition, representing about 6% of the total acquisition price. The lower asset valuation was driven by changes in projected cash flows and a higher discount rate compared to the prior quarter.:

In nonoperating income, investment gains after subtracting the impact attributed to the noncontrolling interest added earnings per share for the quarter of about $0.04 due to the positive impact of the market on the investments. Looking ahead to Q1, certain seasonal factors will impact results. The impact of fewer days is expected to result in about $6.4 million in lower operating income, excluding the impact of the impairment charge and with all else being equal.:

In addition, based on an early assessment, compensation and related expense could be $13 million higher than Q4 due primarily to about $9 million of seasonally higher expense for stock compensation and payroll taxes. We also expect to have higher base pay, higher incentive compensation expense. And of course, all these amounts will vary based on multiple factors.:

The effective tax rate was lower in Q4, primarily related to a onetime recognition of a capital loss for tax purposes. Nontaxable, noncontrolling interest income that's included in our pretax income but not taxable to Federated Hermes, and certain stock-based compensation where we get a higher tax deduction when our stock price at vesting exceeds the price when the shares were granted.:

We expect our effective tax rate to be in the range of 24% to 26% in 2023. At the end of 2022, cash and investments were $522 million of which about $466 million was available to us.:

Holly with that, I would now like to open the call up for questions. :

Operator: [Operator Instructions] Your first question for today is coming from Dan Fannon at Jefferies.

Unknown Analyst: This is actually Rick on for Dan. Just thinking about expenses, how should we think about the general trajectory for noncomp expenses? And also kind of double-clicking into that, I believe the other line, excluding the impairment charge was lower by approximately $5.5 million or around that range compared to the last 3 quarters and a year ago.

Just wondering, was that sort of the FX impact or FX impact in the other direction that was called out? Or is this sort of run rate of all savings? So yes. :

Thomas Donahue: Rick, I'll cover some of those Rail come in with a few more. So I mentioned the comp already. So all being equal, we expect that to go up. Distribution, we would expect that to go up. We see that as the old days a success item as we get more assets, distribution goes up. Systems and communications, professional service fees, travel related. Those all have inflation and price increases, all I expect to go up. And you want to comment on the other?

John Donahue: Yes, Rick, you're correct with the FX impact. And obviously, we saw pretty significant movement in the pound in Q3. And so we had a net expense in that line item. And then for Q4, with the pound moving the other direction, we had a net credit that was the $8 million that we mentioned.

Unknown Analyst: Got it. I appreciate that color. And then just on sort of the higher expenses that you called out, could you point to maybe a pre-pandemic sort of year or set of quarters that we can look at for general levels as a percent of revenues? Or is there a better way to think of that?

Thomas Donahue: Yes. So we don't look at it like that at all. We just don't calculate it based on that way and don't think that way. We're trying to raise assets. What's the best way to do it. And like for T&E, the sales force believes they should be out there, and you can see that trending up and it's trending up. And they're out there traveling more and it costs more to do it. But we don't calculate the way you're [indiscernible]

Unknown Analyst: Understood. Appreciate that. And if I could sneak one last question in there. In terms of long-term fee rate, just and sort of the quarter-to-date kind of flow discussion that was called out. What -- how does the exit rate for the fourth quarter kind of compared to the average? And how does that look like going into early January?

Raymond Hanley: The fee rate really is a function of the blend of changes in assets. And so you've seen, for example, in equity over the course of '22 with growth assets being down, to cite one example, that would be a case where we would have higher than the average -- higher than our average fee rates. In addition, we've had growth in -- we called out the strategic value dividend SMA. And SMAs, of course, have lower management fee rates than the mutual funds do.

So it's really a function of the blend of where the average asset growth is occurring. And looking at the first couple of weeks of '23 . I would say we're not going to see -- I wouldn't use that to forecast any material change in the fee rate. We'd want to cover some more ground before doing that.:

They're good solid wins in categories like high yield, multiple most of the equity products producing net positive flows. And of course, we've had positive market impact. So all of that goes to the good. :

Operator: Your next question for today is coming from Patrick Davitt at Autonomous Research.

M. Davitt: So my first question is on the Hermes impairment. Could you give a little bit more detail on the changes that went into the cash flow downgrades? Are there some products that are not working out as planned? And I guess, more broadly on that point, has your view on the opportunity for growth there changed in some way?

Thomas Donahue: Yes, Patrick from Autonomous. the cash flows, we have to go through, I think there's 6 different categories when we did the deal, and this is one category the public markets. And since the deal, if you look at it from a -- since 2018, the assets and particularly more recently, the asset declines. And then we have to go through and look at forecast and predicting the future. We just had to scale those back and then the discount rates, of course, rates has gone up since we did the deal.

And so when you kind of take the whole picture on a long-term basis, we had to have an impairment, just on our accounting basis, it's pretty simple. In terms of excitement with what's going on with Hermes. I think a number of things that Chris mentioned in our pipeline are pretty exciting. And I think Saker to give a comment on the exciting things that we still see happening there. :

Saker Nusseibeh: Thank you very much, Tom. So I mean, let's start just with some of the stuff that you heard from Chris. If you remember, he said that $4.8 billion of net institutional manager are yet to fund, but these are signed on near to fund. And the majority of these actually are coming in into Federal Terms Limited, which is in London, which is old Hermes business. And that gives you an idea of the strength of growth.

And of that, for example, If you talk about the equity strategies, well over EUR 1 billion, EUR 1.3 billion is in Asia ex Japan. Then you've got a further $207 million going into global emerging markets. another $117-odd million going into global equities and then some more into fixed income and high yield of around $290 million. After which you can add private equity, which is over $1.3 billion, and you have a very exciting picture based on the future positivity that we see.:

I mean, yes, One swallow does not a summer make, but it tells you the strength that here we're looking forward. Now why is that 2 reasons. One is, yes, of course, since 2018, from an accounting perspective, you've got to look at the fact that the markets went down, that was covered and there was the Ukraine war, and we have a lot of growth assets or growth equities in our public markets.:

But actually, there are much in demand. We've seen that even through the tough last year and it looks as if this is going to continue to grow for us. The proof of the pudding is within public markets is we're continuing to invest particularly in sales, we're looking at offices in other parts of Continental Europe and the ones we've got. We've talked about offices there, at least one that's going to be established this year possibly 2. And that means that we increase our capability to distribute within the mainstream European markets.:

And then if you go to private equities, which is where we -- sorry, I make private markets. That's private equities, which includes private debt. That has been very exciting with lots of flows through over the last year. Strength seeing this year with a lot of interest from our clients, an excellent environment for our kind of strategy to get our private equity, again, we're seeing lots of excitement from our clients. So that's good.:

And of course, our property is a long-term play, which continues to chug along. And for that, we're investing in -- for that, I mean, for private markets as a whole, we're investing into a dedicated sales force to work alongside our generalist sales force to help increase that. So there's a lot of exciting things happening here in London.:

And if I look at the future and the growth, I'd say that it's very much here and it will come through, notwithstanding that last year was obviously a difficult year as we all know, because of the reasons that we do know. And I'm not going to comment on accounting that storms dropped to accounting that I'm a fund manager and I look for the future. And the future, this looks exciting to me. :

M. Davitt: Helpful. Just a quick follow-up. Could you give the performance fee number for the quarter?

Thomas Donahue: $3.3 million. So that's performance fee and carried interest.

Operator: Your next question for today is coming from Mike Brown at KBW.

Michael Brown: I want to start on the -- maybe on the balance sheet here. So I guess the buybacks were lower in the quarter, but I did notice that your cash position has grown meaningfully and stands at more than 25% of assets. So how are you thinking about your cash levels and capital allocation more broadly? Could we see you return to buybacks or a special dividend here?

Thomas Donahue: Well, yes, the cash has grown. It's spectacular since we raised the long-term debt at what we view a very favorable rate. And we bought back pretty significant amount of shares. And we historically have not wanted to hold on to cash.

Now starting new products has become more expensive, i.e., more investing is needed. So that's kind of a demand for resources to have seed assets. But on a long-term basis, we have not been a group to hold on to the cash. So we will see.:

We want to do acquisitions. That's been our first desire with the use of the money because of our returns on them. And we, of course, have the regular dividend. As you know, we paid 5 special dividends and we've bought back a lot of stock. So all of those are on the table for us to figure out what to do with the cash with no time table and not trying to lead you -- so we're going to do this through this through this. :

John Donahue: One other point I'd mention here is that even though earnings are down on a kind of the impairment we still have a cash available to do a lot of the things Tom said, which I would phrase as investing for the future. And this means putting money into the platform in the private equity area over the U.K. It means $140 million worth of commitments in technology that it doesn't hit income in any one year, as you all know.

And Tom mentioned the fact that investments in seed assets, those are running at about $140 million. Again, the same number, obviously not related. And so those are where the interest of cash, but they all point to building for the future. :

Michael Brown: Great. And then if we could just switch gears to the flows. The Ultrashort fixed income flows, can you just expand on what drove the outflows there? What's some of the investor dynamics that would cause -- that caused that to happen?

And then on the money market side, it sounds like you're basically just down a little bit in totality from the 4Q EOP levels, but the mix has shifted a little bit -- any additional color you can put around that? what's kind of driving the growth of the SMAs? And is that more sticky than the fund side, which sounds like it benefited from some seasonality in 4Q? :

Deborah Cunningham: I can start to answer those questions. From an ultrashort perspective, it definitely pertains to where we are from an interest rate standpoint in the marketplace, interest rates continue to go up in the fourth by 75 basis points and then again, 50 basis points in December. The expectation is they'll continue to go up more modestly, but hold at a higher level in 2023.

And when you see that sort of increase in rates in the marketplace, generally, anything outside of liquidity products, i.e., money market products are cash. Are going to see flows going in the opposite direction. Those flows can come out of the institutional side the retail side, corporates.:

So there's, generally speaking, a broad-based exit that has slowed down as the year has progressed. And in products even like Microshort that actually got money in, that, basically, is offsetting some of what we're seeing in the sort of a little bit further out the curve of the ultra short types of products.:

From a money market fund perspective, the mix continues to be, obviously, predominantly in the government sector. However, where we experienced on a percentage basis, the most amount of growth during 2022 was in the prime and muni sectors, and that's simply a result of being above 0 at this point, and therefore, the spread between government and those other categories widening out as interest rates themselves have increased.:

When you look at it on a quarter-over-quarter basis, the fourth quarter always has a huge amount of inflows, not always, but for the most part, has a large amount of inflows in the second half of December, let's call it, it's window dressing as well as tax purpose issues that many firms are trying to do. And ultimately, this results in inflows into the government, in particular, money market funds during the second half of December. Some of which then goes out generally the first quarter of 2023 sees outflows out of those products.:

Because of increasing interest rates, however, the other categories, Prime in particular, has continued on a percentage basis to offset those flows in a pretty decided way. :

John Donahue: And Mike, just on the separate account growth into January, you mentioned some seasonality there, and that does come into play. That category of asset for us is dominated by large state cash pools that we manage. And so it has a regular pattern of increasing when tax receipts are made at year-end through the middle of the second quarter, typically.

And then that tends to go down over the latter half of the year. But it's fallen, it's reached higher highs and higher lows. We've had a lot of underlying success, both because of a favorable macro for money market yields and also some effective work that we've done with those clients to increase utilization of those pools. :

Operator: Your next question for today is a follow-up question coming from Patrick Davitt.

M. Davitt: Just on the back of that question, I asked a similar question last quarter. But you -- we keep hearing from some of your competitors that there is an expectation of a bigger surge into money fund flows from, say, deposits. And I know there's always some seasonality noise from December to january, but are you still at the view that, that big rotation is coming this year? And what milestones are you really looking for that to really pick up?

Deborah Cunningham: Sure, Patrick. Generally speaking, when interest rates are increasing because money funds have a weighted average maturity that's something greater than a day, they lag the direct market. And so for many of our institutional clients that have the capability of going into the direct market, they might do just exactly that.

Rather than go into money market funds that are increasing but are increasing with, let's call it, a 1-month lag versus the direct market where money funds generally start to excel and exceed from a growth perspective is when interest rates have kind of reached a plateau and when they start going back down the other side.:

Now the caveat to that is that they're not going to 0, that they're going from 5 to 4 to 3, somewhere in that neighborhood. And in those cases, that's when much more outsized growth generally happens from an industry and from our own experience here at FHI. Versus the deposit market at this point. Overall, deposits in the U.S. are down about $1 trillion, but the very large.:

And again, looking at the rates on deposits versus the rates on money market funds, they have increased during the first quarter. We're up to about 38% from a deposit beta perspective versus what's happening in the direct market, the Fed funds market.:

So 38% of the increase is being captured in deposits. As such, I think the average deposit rate for the fourth quarter was up to about 70 basis points. But compare that to where we are from a fund yield perspective, which is essentially all of 4% and heading towards 5%, vastly different.:

So being a trillion down in deposits is just sort of a drop in the bucket. The expectation would be that will continue to fuel outflows with that deposit beta being lower and a very natural recipient of those outflows would be money market funds. :

John Donahue: And if I can indulge this history, which I've used before, Patrick, I think it's informative. The Fed increase that was Q4 '16 to Q4 '18, we had a little pause and then the money -- our money market assets increased by 15% from about of $210 billion to $240 billion. And the industry followed a very similar pattern. They were up 11%.Naturally, we were up 15%.

Then you go to the next one, our assets went up about 22% through the third quarter of '19, and the industry at that time, did about 14%. So depending on how big people are talking about numbers that those are what happened.:

The next point I would make is that it matters a lot who your clients are. and what is their history. And we have unique clients, others have unique clients. And I can't comment on the overall situation with others clientele. And actually, we have a lot of the same ones, but it matters a lot if you have a lot of trust apartments, a lot of intermediaries and things like that. :

Operator: There appear to be no further questions in queue. I would like to hand the call back over to Ray Hanley for any closing remarks.

Raymond Hanley: Well, thank you. That concludes our call, and we appreciate you joining us.

Operator: Thank you. This concludes today's conference call. You may disconnect your phone lines at this time, and have a wonderful day. Thank you for your participation.