Federated Hermes, Inc. (NYSE:FHI) Q1 2024 Earnings Call Transcript

Federated Hermes, Inc. (NYSE:FHI) Q1 2024 Earnings Call Transcript April 27, 2024

Federated Hermes, Inc. isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Greetings. Welcome to the Federated Hermes, Inc. Q1 2024 Analyst Call and Webcast. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] Please note this conference is being recorded. I will now turn the conference over to your host, Ray Hanley, President of Federated Investors Management Company. You may begin.

Raymond Hanley: Good morning and welcome to our call. Leading today’s call will be Chris Donahue, CEO and President of Federated Hermes; and Tom Donahue, Chief Financial Officer. And joining us for the Q&A is Debbie Cunningham, Chief Investment Officer for the Money Markets. During today’s call, we may 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 the 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?

Christopher Donahue: Thank you, Ray. Good morning all. I will review Federated Hermes’ business performance. Tom will comment on our financial results. We ended the first quarter with record assets under management of $779 billion, driven by record money market assets of $579 billion. Looking at equities, assets increased by $866 million from year-end, reaching $80.2 billion due to market gains of $4.9 billion, partially offset by net redemptions of $3.4 billion and FX impact of about negative $567 million. The strategic value dividend domestic strategy had Q1 net redemptions of $1.3 billion when you combine it with the fund and the SMA, and the comparable number in the fourth quarter was $2.2 billion. We did see Q1 positive net sales in 12 equity fund strategies, including MDT Mid Cap Growth, MDT Large Cap Growth and US SMID Equity Fund.

The MDT strategies have shown accelerated sales and net sales in the first quarter and here the first part of the second quarter, particularly in the growth space. Looking at our equity performance at the end of the first quarter and using Morningstar data for trailing three years, 56% of the equity funds were beating peers and 36% were in the top quartile of their category. Now for the first three weeks of Q2, combined equity funds and SMAs had net redemptions of $428 million. Turning now to fixed income, assets increased by about $1.4 billion in the first quarter to $96.3 billion with fixed income separate accounts reaching a record high of $51.8 billion. The growth was driven by net sales of $1.2 billion. Fixed income funds had first quarter net sales of $565 million.

The fourth quarter was basically negative minus $988 million. Fixed income SMA for Q1 net sales had $441 million and fixed income institutional separate accounts had net positive sales of $182 million. We had 21 fixed income funds with positive net sales in the first quarter, including Total Return Bond Fund, Ultrashort Bond, Government Ultrashort Bond and Total Return Bond ETF, our new offering. Regarding performance at the end of the first quarter and using again Morningstar data for trailing three years, 40% of our fixed income funds were beating peers, 17% were in the top quartile of their category. For the first three weeks of Q2, combined fixed income and SMAs had net redemptions of $218 million. In the alternative private market category, assets decreased by $86 million in the first quarter from year end to $20.5 billion, due mainly through negative FX impact of over $200 million, partially offset by market value increases of over $100 million and net sales of $21 million.

We are in the market with Horizon 3, the third vintage of our Horizon series of Global Private Equity Funds. Horizon 3 closed on commitments of $1.05 billion through the first quarter. The Hermes Innovation II Fund, the second vintage of our pan-European Growth Equity Innovation Fund is also in the market, and we’re in the market with the first vintage of our UK Nature Impact Fund. We began the second quarter with about $1.9 billion in net institutional mandates yet to fund into both funds and separate accounts. These wins are diversified across fixed income, equity and private markets. Approximately $1.5 billion of net total wins is expected to come into private market strategies. The wins include private equity, direct lending, trade finance, outflows include some areas in absolute return credit.

On the fixed income side, we expect net additions of about $866 million with wins in ultrashort, short duration, high yield, sustainable investment grade and multi-sector. We do have some offsetting losses in high yield. For equities, we have $233 million in wins to fund, offset by about $700 million of known redemptions. Moving to money markets. In Q1, we reached another record high for money market fund assets, money market separate account assets and total money market assets as mentioned at the beginning of my remarks. Total money market assets increased by $19 billion during the first quarter from year-end. Money market strategies continue to benefit from favorable market conditions for cash as an asset class, elevated liquidity levels in the financial system and attractive yields compared to cash management alternatives like bank deposits and direct investments in money market instruments like T-bills and commercial paper.

In the long-expected upcoming period of declining short-term interest rates, we believe that market conditions for money market strategies will continue to be favorable compared to direct market rates and bank deposit rates. Our estimate of money market mutual fund market share, including sub-advised funds, was about 7.35% at the end of the first quarter, down slightly from about 7.40% at the end of 2023. Looking now at recent asset totals as of a few days ago, managed assets were approximately $775 billion, including $579 billion in money markets, $77 billion in equities, $96 billion in fixed income, $20 billion in alternative private markets and $3 billion in money — in multi-asset, money market mutual fund assets stood at $414 billion. Tom?

Thomas Donahue: Thanks, Chris. Total revenue for Q1 increased $4.9 million from the prior quarter, due mainly to higher average money market assets, increasing revenue by $13.7 million and higher average equity and fixed income assets, increasing revenue by $7.2 million, partially offset by fewer days, reducing revenue by $5.8 million and lower carried interest and performance fees, reducing revenue by $9.3 million. Total Q1 carried interest and performance fees were $400,000 compared to $9.7 million in Q4. Q1 operating expenses increased by $8.9 million from the prior quarter due mainly to higher compensation expense, primarily from incentive compensation and payroll taxes, increasing expenses by $13.7 million, partially offset by lower compensation from carried interest in consolidated vehicles of $4.6 million.

Distribution expense increased due mainly to higher average assets, partially offset by fewer days. Advertising expense decreased in Q1 due to the timing of our advertising campaigns. The effective tax rate was 27.9% in Q1, up slightly from 26.6% in Q4. We expect the tax rate to be in the 26% to 28% range throughout 2024. The tax rate incorporates a valuation allowance on certain foreign deferred tax assets. At the end of Q1, cash and investments were $559 million. Cash and investments, excluding the portion attributed to non-controlling interest was $487 million. As announced in the press release, Federated Hermes Board declared a dividend of $1.31 per share to be paid on May 15, 2024. The dividend includes a $1 per share special dividend and a $0.31 quarterly dividend.

This marks our sixth special dividend since 2008. The quarterly dividend increased by 10.7% and the dividend is considered an ordinary dividend for tax purposes. The dividend and the repurchase of 1.1 million shares in Q1 represent important additional measures intended to increase shareholder value. The special dividend is expected to reduce Q2 EPS by about $0.015 per share, due largely to the exclusion of dividends paid on unvested restricted shares from net income under the two-class method of computing earnings per share. Holly, that completes our prepared remarks and would like to open the call up now for questions.

Operator: Certainly. At this time we will be conducting a question-and-answer session. [Operator Instructions] Your first question for today is from Bill Katz with TD Cowen.

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Q&A Session

William Katz: Great. Thank you very much. Good morning, everybody.

Christopher Donahue: Good morning, Bill.

William Katz: Good morning, all. Maybe just a big picture question on capital return. Certainly appreciate your balance sheet is in very good shape and you generate a tremendous amount of cash flow. How are you thinking about just buyback in a broader sense, just given where the stock is trading versus the efficacy of the special dividend? And then how does that signal in terms of M&A and independence? Thank you.

Thomas Donahue: Yeah, Bill, it’s Tom. So we’ve looked at all three M&A, special dividends and buybacks, and we think that, as we said for a long time, our first choice is to do M&A where we find it, and because we like the returns and we like our track record on M&A. So that’s the first thing that we would like to do. As we looked at our balance sheet and looked at the stock price, we determined to obviously pay a special dividend and don’t think that paying that dividend, given our capital position and our availability under a revolver, does anything to diminish our financial flexibility. And yet we’re earning the money in our business and we don’t think that the earnings are reflected in the share price. So getting — adding value by paying a dividend to the shareholders, we think is appropriate. And we also believe in continuing to purchase the shares given where the price is and where we think the Company is going to go — grow to.

Christopher Donahue: And Bill, if I could add, we are very proud of the circle or the three things that Tom mentioned, acquisitions, dividends and share repurchases. And since you were along with going public back in ’98, that’s been over $6 billion that’s been returned to shareholders. So we have a long-term look at that. To get more current, as we mentioned on the call last time, we would love to be able to expand some of those businesses that we have at Hermes, like the real estate business in the United States. And that would attract our attention in terms of an acquisition if we could, you know, find something that was worthy. So we are convinced when we look at the cash flow that we have the continual flexibility to do whatever we want, whenever we want.

William Katz: Okay, that’s helpful. And then just a couple of housekeeping items. Can you remind me of what the comp payout rate is against both the carry-related performance revenues as well as just performance revenues? And then the clarification on your pipeline at the $1.9 billion, is that gross or net of the known outflows? Thank you.

Thomas Donahue: So Bill, there’s not a defined payout ratio. But if you look at what the portion attributed to the carried interest vehicle that is offset directly in comp has been somewhere around two-thirds of our total carry amount, and there’s no comparable number on performance fees. And then in terms of the pipeline, your question was?

Christopher Donahue: $1.9 billion is net.

Thomas Donahue: It is a net number, yes. We always report net-known wins offset by any known redemptions coming up.

William Katz: Okay. So just to clarify, there’s no comp payout against performance fees?

Christopher Donahue: Not in any formulaic way like there is with certain of the carried interest is passed directly through.

William Katz: And that’s 65%. So make sure I track that correctly. Okay. Thank you.

Thomas Donahue: It’s roughly been 65%. That can vary as well.

William Katz: Thank you.

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

Patrick Davitt: Hey, good morning, everyone.

Christopher Donahue: Hey.

Patrick Davitt: First question. For the last few quarters, you’ve talked about the money fund opportunities shifting from retail to institutional as Fed pauses and then cuts. So with $17 trillion still sitting in deposits, could you dig in on how those more institutional money fund pipelines and discussions are looking? And in that vein, what is your confidence that we should still expect the usual second half seasonal pop in those flows despite what’s already been an unusually strong start to the year? Thank you.

Christopher Donahue: I’m going to let Debbie comment in a minute. But a delay in the reduction of interest rates still keeps the money fund trade alive on the retail basis, very strong. And when you look at the, as I mentioned in my remarks, when you look at the marketplace in terms of what rates are even on commercial paper and T-bills and things like that, it’s still a decent trade. It’s not the big trade that we talked about, but that was always dependent upon when as and if the Fed actually starts to lower interest rates. And everybody guess is as good as mine. Everybody can read everything they want. In fact, I rely on Debbie’s estimate of that. Debbie?

Deborah Cunningham: Thanks, Chris. And similarly speaking, the longer rates are where they are today at 5.25% to 5.5% target rate. The better off we are from both a flow standpoint and expectation standpoint and honestly, an overall return standpoint compared to other factors in the marketplace. So it’s not a bad thing to delay it. What it does delay, however, is the broader participation in the flows from the institutional side. And again, going back to what Chris mentioned, at one point it started when the curve was fairly inverted. And even in the liquidity and the money market side of the curve, you saw, especially on the treasury side, inversions of 100 basis points in expectation that over the next year, the Fed would be cutting that amount.

That’s no longer the case. And ultimately, that means that institutional customers who have the capability of not only being in direct treasuries, but direct commercial paper, which is a positively sloped curve at this point and has never really been much negative continue to be in those direct securities. Now that will change unless something — unless history doesn’t repeat itself. And there’s always a possibility of that, but the likelihood in our estimation is very small. We think this is just a very big positive in the context of continuing the strength in the retail flow. And when you mentioned the $17 trillion that are still there from a deposit perspective, I think about 40% of that is in noninterest-bearing deposits. So that’s just fertile ground for additional converters into what we believe is the better cash management product.

Patrick Davitt: Helpful. Thanks. A quick follow-up on the capital return question. Should we think about the kind of decline from 4Q to 1Q as partially driven by the special dividend and through that lens, maybe a return to the more elevated levels once that passes in terms of the repurchase? Thank you.

Christopher Donahue: Well, Patrick, we look at it every day, run our models and determine what we’re going to buy and of course, factor in, as we talked before, the M&A and buying 1 million shares looked like a pretty decent purchase in the quarter, and we thought it made sense, where is the price going and — is it too low from our perspective, which kind of tells us and where we think the growth is going, kind of tells us to uptick from there or downtick from there. But that’s not really given you exactly what you asked for. That’s how we look at it.