Federated Hermes - 10-Q quarterly report FY

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

Federated Investors, Inc.

(Exact name of registrant as specified in its charter)

(Registrant’s telephone number, including area code) 412-288-1900

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes     X     . No            .

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes     X    No        .

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the last practicable date: As of May 9, 2003, the Registrant had outstanding 9,000 shares of Class A Common Stock and 109,025,521 shares of Class B Common Stock.

Table of Contents

Table of Contents

Special Note Regarding Forward-Looking Information

Certain statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in “Liquidity and Capital Resources” and elsewhere in this report, constitute forward-looking statements, which involve known and unknown risks, uncertainties, and other factors that may cause the actual results, levels of activity, performance, achievements, or industry results, to be materially different from any future results, levels of activity, performance or achievements expressed or implied by such forward-looking statements. For a discussion of such risk factors, see the section titled Risk Factors and Cautionary Statements in Federated’s Annual Report on Form 10-K for the year ended December 31, 2002, and other reports on file with the Securities and Exchange Commission. Many of these factors may be more likely to occur as a result of the ongoing threat of terrorism. As a result of the foregoing and other factors, no assurance can be given as to future results, levels of activity, performance or achievements, and neither we nor any other person assumes responsibility for the accuracy and completeness of such statements.

Table of Contents

Part I, Item I. Financial Statements

Consolidated Balance Sheets

(dollars in thousands)

(unaudited)

(The accompanying notes are an integral part of these consolidated financial statements.)

3

Table of Contents

Consolidated Statements of Income

(dollars in thousands, except per share data)

(unaudited)

(The accompanying notes are an integral part of these consolidated financial statements.)

4

Table of Contents

Consolidated Statements of Cash Flows

(dollars in thousands)

(unaudited)

(The accompanying notes are an integral part of these consolidated financial statements.)

5

Table of Contents

Notes to the Consolidated Financial Statements

(Unaudited)

(1)    Summary of Significant Accounting Policies

(a)    Basis of Presentation

The interim consolidated financial statements of Federated Investors, Inc. (Federated) included herein have been prepared in accordance with accounting principles generally accepted in the United States. In the opinion of management, the financial statements reflect all adjustments which are of a normal recurring nature and necessary for a fair statement of the results for the interim periods presented.

In preparing the unaudited interim consolidated financial statements, management is required to make estimates and assumptions that affect the amounts reported in the financial statements. Actual results may differ from such estimates and such differences may be material to the financial statements.

These financial statements should be read in conjunction with Federated’s Annual Report on Form 10-K for the year ended December 31, 2002. Certain items previously reported have been reclassified to conform with the current year’s presentation.

(b)    Revenue Recognition

Revenue from providing investment advisory, administrative and other services (including distribution, shareholder servicing and accounting) is recognized during the period in which the services are performed. Investment advisory, administrative and the majority of other service fees are based on the net asset value of the investment portfolios that are managed or administered by Federated. Federated may waive certain fees for services for competitive reasons or to meet regulatory requirements. Certain revenue is recorded net of third-party distribution and service costs. Investment advisory fees, administrative service fees and other service fees, primarily distribution and shareholder service fees, are net of third-party payments of $16.0 million, $1.0 million and $49.8 million, respectively, for the three months ended March 31, 2003 and $16.4 million, $1.1 million and $54.0 million, respectively, for the three months ended March 31, 2002.

(c)    Employee Stock-Based Compensation

During the first quarter 2003, Federated issued 40,000 shares of restricted Federated Class B common stock under the Stock Incentive Plan. During the first quarter 2003, 36,900 employee stock options were exercised and 52,800 employee stock options were forfeited.

As allowed under the provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (SFAS 123), Federated applied Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations in accounting for its stock-based awards granted through March 31, 2003. Had compensation costs for stock options and employee restricted stock been determined based upon fair values at the grant dates in accordance with SFAS 123, Federated would have experienced net income and earnings per share similar to the pro forma amounts indicated below for the three month periods ended March 31. For purposes

6

Table of Contents

Notes to the Consolidated Financial Statements (continued)

(Unaudited)

of pro forma results, the estimated fair values of the options and restricted stock are recognized as expense on a straight-line basis over the awards’ vesting periods.

(d)    Recent Accounting Pronouncements

In December 2002, the FASB issued Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure,” (SFAS 148). This statement provides alternative methods of transition for a voluntary change to the fair-value-based method of accounting for stock-based employee compensation and amends the disclosure requirements of SFAS 123 to require prominent annual and interim disclosures about the method used to account for stock-based compensation. This statement is effective for financial statements for fiscal years ending after December 15, 2002. Management is deliberating whether to adopt the expense recognition provisions of recording the fair value of stock-based compensation under the guidance of SFAS 123 and intends to reach a final decision in 2003.

In January 2003, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities,” (FIN 46). The objective of FIN 46 is to provide guidance on how to identify a variable interest entity (VIE) and determine when the assets, liabilities, noncontrolling interests and results of operations of a VIE need to be included in a company’s consolidated financial statements. A company that holds variable interests in an entity will need to consolidate the entity if the company’s interest in the VIE is such that the company will absorb a majority of the VIE’s expected losses and/or receive a majority of the VIE’s expected residual returns, if they occur. FIN 46 also requires additional disclosures by primary beneficiaries and other significant variable interest holders. The provisions of this interpretation are currently effective upon issuance for all new VIEs and for interim and annual periods beginning after June 15, 2003, for all VIEs that existed at the date of its issuance. Management is assessing the impact FIN 46 may have on Federated’s results of operations and financial position as it applies to Federated’s role in the collateralized bond obligations (CBOs) for which it acts as investment manager as well as other aspects of Federated’s business. Management is exploring all of its options relating to its relationship with the CBOs in the event that application of FIN 46 requires consolidation of one or more of the CBOs.

7

Table of Contents

Notes to the Consolidated Financial Statements (continued)

(Unaudited)

(2)    Intangible Assets

Federated’s identifiable intangible assets consisted of the following at March 31, 2003 and December 31, 2002:

Amortization expense for identifiable intangible assets for the three-month periods ended March 31, 2003 and 2002, was $2.6 million and $3.1 million, respectively. Following is a schedule of expected aggregate annual amortization expense for intangible assets in each of the five succeeding years assuming no new acquisitions or impairments:

(3)    Long-Term Debt—Recourse

Federated’s total recourse debt balance of $2.4 million and $2.3 million at March 31, 2003 and December 31, 2002, respectively, represented liabilities on capital leases. The capital leases carry interest rates ranging from 2.90% to 4.55% with weighted-average interest rates of 3.79% and 3.92% at March 31, 2003 and December 31, 2002, respectively. The four capital leases outstanding at March 31, 2003, have expiration dates that range from the first quarter 2005 to first quarter 2006.

(4)    B-Share Programs and Long-Term Debt – Nonrecourse

Federated sells its rights to future cash flow streams associated with B-share deferred sales commissions (distribution and servicing fees as well as contingent deferred sales charges (CDSCs)) to an independent third party. For accounting purposes, sales of distribution fees and CDSCs are accounted for as sales and the related gains are included in “Other service fees, net – affiliates” in the Consolidated Statements of Income. Sales of Federated’s rights to future servicing fees are accounted for as financings due to Federated’s ongoing involvement in performing shareholder-servicing activities. Accordingly, various tranches of nonrecourse debt have been recorded. Total nonrecourse debt at March 31, 2003, and December 31, 2002, was $58.7 million and $57.9 million, respectively. The tranches carry interest rates ranging from 5.80% to 8.60% with weighted-average interest rates of 7.25% and 7.36% at March 31, 2003 and December 31, 2002, respectively. The current B-share program allows Federated to finance deferred sales commissions through December 2003.

(5)    Common Stock

(a)    Cash Dividends and Stock Repurchases

Cash dividends of $0.057 per share or approximately $6.4 million were paid in the first quarter of 2003 to holders of common shares. (See Note (10) Subsequent Events for details regarding the dividend declared in April 2003.)

8

Table of Contents

Notes to the Consolidated Financial Statements (continued)

(Unaudited)

As of March 31, 2003, under Federated’s current share buyback programs, Federated can repurchase approximately 1.4 million additional shares subject to the cash payment limit imposed by Federated’s Second Amended and Restated Credit Agreement, as amended, (Credit Facility). (See Note (10) Subsequent Events for details regarding the extension of this buyback program.)

Federated’s Credit Facility contains restrictions on payments of dividends and purchases of treasury stock. The Credit Facility limits cash payments for additional stock repurchases and dividends to 50% of net income earned during the period from January 1, 2000, to and including the payment date, less certain payments for dividends and stock repurchases. As of March 31, 2003, more than $208 million was available to repurchase stock or pay dividends under this restriction.

(b)    Employee Stock Purchase Plan

Federated offers an Employee Stock Purchase Plan which allows employees to purchase a maximum of 750,000 shares of Class B common stock. Employees may contribute up to 10% of their salary to purchase shares of Federated’s Class B common stock on a quarterly basis at the market price. The shares under the plan may be newly issued shares, treasury shares or shares purchased on the open market. As of March 31, 2003, a total of 59,149 shares had been purchased by employees in this plan.

(6)    Earnings Per Share

The following table sets forth the computation of basic and diluted earnings per share:

Federated uses the treasury stock method to reflect the dilutive effect of unvested restricted stock and unexercised stock options in diluted earnings per share. At March 31, 2003, options to purchase 3.4 million shares of common stock at an average exercise price of $30.49 per share were outstanding but not included in the computation of diluted earnings per share because the option exercise price was greater than the average market price of Federated Class B common stock. Under the treasury stock method, if the average market price of Federated common stock increases above the option’s exercise price, the proceeds that would be assumed to be realized from the exercise of the option would be assumed to be used to acquire outstanding shares of Federated common stock. As such, the dilutive effect of the 3.4 million shares of options would result in the addition of a net number of shares to the weighted-average number of shares used in the calculation of diluted earnings per share.

(7)    Comprehensive Income

Comprehensive income was $48.8 million and $52.4 million for the three-month periods ended March 31, 2003 and 2002, respectively.

9

Table of Contents

Notes to the Consolidated Financial Statements (continued)

(Unaudited)

(8)    Contingent Consideration

Pursuant to various acquisition agreements entered into by Federated in 2001 and 2002, Federated may be required to make additional payments to the seller in each acquisition contingent upon the occurrence of certain events. In 2001, Federated acquired substantially all of the business of Edgemont Asset Management Corporation, the former adviser of the Kaufmann Fund. In addition to the upfront purchase price paid at the date of the acquisition, the acquisition agreement provides for additional purchase price payments based upon the achievement of specified revenue growth through 2007. Pursuant to this agreement, Federated does not expect to pay any contingent purchase price in 2003 based on the level of revenue earned during the twelve-month period ended April 2003. Federated could pay an additional $132.3 million as contingent purchase price between 2004 and 2007 with as much as $66.2 million payable in the second quarter 2004 if revenue targets are met.

In 2001, Federated signed an agreement with Lincoln Investment Planning, Inc. and Rightime Econometrics, Inc. (Rightime Acquisition) and in 2002, Federated signed an agreement with FirstMerit Advisors, Inc. and FirstMerit Corporation (FirstMerit Acquisition). As a result of these agreements, assets previously managed by Rightime Econometrics, Inc. and FirstMerit Advisors, Inc. were merged into various Federated funds. Pursuant to both agreements, Federated is required to make contingent payments on a periodic basis calculated as a percentage of average assets under management in any Federated fund shareholder account for which the seller is the named broker/dealer of record. In the case of the Rightime Acquisition, the payments occur quarterly and could continue through first quarter 2007. Contingent payments relating to the FirstMerit Acquisition occur on a monthly basis through third quarter 2005. As of March 31, 2003, Federated had recorded a liability of $0.5 million representing the present value of expected future contingent purchase price payments relating to the assets under management originally acquired in connection with these acquisitions.

(9)    Variable Interest Entities

Federated acts as the investment manager for two high-yield collateralized bond obligation (CBO) products and a mortgage-backed CBO product pursuant to the terms of an investment management agreement between Federated and each CBO. The CBOs are alternative investment products that were structured using special-purpose entities. As of March 31, 2003, aggregate total assets and aggregate total obligations of the CBOs approximated $1 billion, respectively.

The financial condition and results of operations of these CBOs are not included in Federated’s Consolidated Financial Statements as of and for the three-month period ended March 31, 2003, or for any prior period. In each case, there exists a majority owner(s) that is an independent third party from Federated owning at least three percent equity in the CBO. Federated has not guaranteed nor has any recourse related to any of the notes issued by the CBOs. As of March 31, 2003, the remaining $0.6 million carrying value of Federated’s investments in the CBOs represents Federated’s maximum exposure to loss as a result of its involvement with the CBOs.

(10)    Subsequent Events

After the close of trading on April 15, 2003, Federated was added to the S&P 500 Index.

On April 23, 2003, the board of directors declared a dividend of $0.07 per share to be paid on May 15, 2003, to shareholders of record as of May 7, 2003. The board also approved an extension of Federated’s existing share repurchase program authorizing management to purchase up to five million shares of Federated Class B common stock in addition to the 1.4 million shares remaining eligible for purchase as of March 31, 2003.

10

Table of Contents

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. We have 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, 2002.

General

Federated Investors, Inc. (together with its subsidiaries, “Federated”) is one of the largest investment management companies in the United States with $196 billion in managed assets as of March 31, 2003. The majority of Federated’s revenue is derived from advising and administrating Federated mutual funds, separately managed accounts and other Federated-sponsored products, in both domestic and international markets. Federated also derives revenue from administrating mutual funds sponsored by third parties and from providing various other mutual fund-related services, including distribution, shareholder, transfer agency, fund accounting, trade execution and clearing and retirement plan recordkeeping services (collectively, “Other Services”).

Investment advisory, administrative and certain Other Services fees, such as distribution and shareholder service fees, are contract-based fees that are calculated as a percentage of the net assets of the investment portfolios that are managed or administered by Federated. As such, Federated’s revenue is primarily dependent upon factors that affect the value of managed and administered assets including market conditions and the ability to attract and maintain assets. 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 threshold levels. Generally, rates charged for services provided to equity products are higher than rates charged on money market and fixed-income products. Accordingly, revenue is also dependent upon the relative composition of average assets under management or administration. Federated pays a significant portion of its distribution and shareholder service fees to financial intermediaries who sell Federated-sponsored products to the public on its behalf. These payments are generally calculated as a percentage of net assets attributable to the party receiving the payment and are recorded as reductions to revenue earned by Federated on the Consolidated Statements of Income.

Federated’s remaining Other Services fees are based on fixed rates per fund, account, transaction or retirement plan participant. Revenue relating to these services will vary with changes in the number of mutual funds, accounts, transactions and plan participants which are impacted by sales and marketing efforts, competitive fund performance, introduction and market reception of new products and acquisitions.

Federated’s most significant operating expenses include compensation and related costs, which represent fixed and variable compensation and related employee benefits, and marketing and promotional costs.

11

Table of Contents

Management’s Discussion and Analysis (continued)

of Financial Condition and Results of Operations (Unaudited)

Asset Highlights

Managed Assets at Period End

Average Managed Assets

12

Table of Contents

Management’s Discussion and Analysis (continued)

of Financial Condition and Results of Operations (Unaudited)

Administered Assets

Components of Changes in Equity and Fixed-Income Fund Managed Assets

Changes in Federated’s average asset mix period over period have a direct impact on Federated’s total revenue due to the difference in the fees per invested dollar earned on each asset type. Equity products generally have a higher management fee rate than fixed-income or money market products. The following table presents the relative composition of average managed assets and the percent of total revenue derived from each asset type for the three months ended March 31:

The March 31, 2003, period-end managed assets increased 10% over period-end managed assets at March 31, 2002. Average managed assets for the three months ended March 31, 2003, grew 9% over average managed assets for the three months ended March 31, 2002. These increases in total and average assets primarily reflect strong fixed-income and money market asset sales in 2002 and the first quarter 2003 including the addition of $13.2 billion in money market assets for TexPool, Texas’ local government investment pool, in the second quarter 2002. Despite positive net

13

Table of Contents

Management’s Discussion and Analysis (continued)

of Financial Condition and Results of Operations (Unaudited)

equity sales in 2002 and first quarter 2003, average equity assets declined in the first quarter 2003 as compared to first quarter 2002 primarily as a result of market depreciation.

Results of Operations

Net Income. Federated reported net income of $48.7 million or $0.43 per diluted share for the three-month period ended March 31, 2003, as compared to net income of $52.3 million or $0.44 per diluted share for the same period last year. The decrease in net income of 7% reflects decreased revenue from managed assets despite net asset growth, partially offset by a reduction in operating expenses. The decrease in diluted earnings per share for the first quarter 2003 as compared to the same period of 2002 is the result of decreased net income partially offset by reduced weighted-average diluted shares outstanding due to stock repurchases in 2002 and the first quarter 2003.

Revenue. Revenue for the three-month periods ended March 31, are set forth in the following table:

Revenue for the first quarter 2003 decreased $11.6 million as compared to the same period of 2002 primarily as a result of decreased revenue from managed assets, which includes investment advisory, administrative and other service fees and commission income earned in connection with investment portfolios managed by Federated. The 6% decrease in revenue from managed assets is primarily attributable to the impact of equity market depreciation in 2002 and 2003 and the ensuing decline in average equity assets under management since the first quarter 2002. The decrease in revenue resulting from declines in average equity assets was tempered by the effect of Federated’s continued growth in money market and fixed-income average assets.

Revenue from sources other than managed assets, which represents 6% of Federated’s revenue in the first quarter 2003, decreased $1.4 million for the first quarter 2003 as compared to the same period last year. This decrease is mainly due to certain bank customers internalizing administrative services previously provided by Federated.

Operating Expenses. Operating expenses for the three-month periods ended March 31, are set forth in the following table:

Total operating expenses for the first quarter 2003 decreased $4.7 million as compared to the same period last year. Compensation and related expense for the three months ended March 31, 2003, decreased over first quarter 2002 primarily as a result of the impact of negative equity market returns in 2002 and 2003 on variable-based compensation and the outsourcing of substantially all of the day-to-day operations of Federated’s legal department in the fourth quarter 2002. Compensation and related expense in 2003 included a $2.4 million downward adjustment of accrued incentive compensation as a result of actual equity market performance differing from performance estimated as of December 31, 2002. The decrease in marketing and promotional expense primarily reflects a planned decrease in spending on Federated’s advertising campaign. Amortization expense for deferred sales commissions and intangible assets both decreased in 2003 over first quarter 2002 primarily as a result of the full amortization of certain assets during 2002. All other expenses increased 13% over the same period last year primarily as a result of increased professional service fees due to the outsourcing of substantially all of the day-to-day operations of Federated’s legal department in the fourth quarter 2002, increased hardware and software depreciation due, in part, to four new capital

14

Table of Contents

Management’s Discussion and Analysis (continued)

of Financial Condition and Results of Operations (Unaudited)

lease arrangements entered into in 2002 and first quarter 2003 and setup expenses incurred in connection with the launch of Federated’s two closed-end funds.

Nonoperating Income (Expenses). Nonoperating expenses, net for the first quarter 2003 as compared to the same period last year remained flat at $0.7 million.

Income Taxes. The income tax provision for the three-month period ended March 31, 2003 was $26.9 million as compared to $30.0 million for the same period in 2002. The effective tax rate was 35.6% and 36.4% for the first quarter 2003 and 2002, respectively.

Liquidity and Capital Resources

At March 31, 2003, liquid assets, consisting of cash and cash equivalents, marketable securities and receivables, totaled $148.0 million as compared to $182.1 million at December 31, 2002.

Operating Activities. Cash provided by operating activities totaled $50.6 million for the three-month period ended March 31, 2003, as compared to $38.0 million for the same period in 2002. The increase is primarily attributable to the effects of certain cash payments made in the first quarter 2002 including taxes paid on the sale of Federated’s retained interest in the residual cash flows associated with Class B shares of Federated-sponsored mutual funds.

Investing Activities. During the first quarter 2003, Federated paid $0.8 million to acquire property and equipment.

Financing Activities. During the first quarter 2003, Federated used $81.7 million for financing activities. Of this amount, Federated used $73.5 million to repurchase 2.9 million shares of Class B common stock in the open market under the stock repurchase program. As of March 31, 2003, Federated can repurchase an additional 1.4 million shares through its authorized programs. On April 23, 2003, Federated’s board of directors approved an extension of the current repurchase program to add five million shares to the 1.4 million eligible for repurchase at March 31, 2003.

Federated paid dividends in the first quarter 2003 equal to $6.4 million or $0.057 per share. On April 23, 2003, Federated’s board of directors declared a dividend of $0.07 per share that is payable on May 15, 2003.

Stock repurchases and dividend payments are subject to restrictions under the Second Amended and Restated Credit Agreement, as amended. These restrictions limit cash payments for additional stock repurchases and dividends to 50% of net income from January 1, 2000 to and including the payment date. After considering earnings through March 31, 2003, Federated, given current debt covenants, has the ability to make additional stock repurchases or dividend payments of more than $208 million.

Contractual Obligations, Contingent Liabilities and Future Cash Needs.

Federated is a party to various service contracts pursuant to which it receives certain support services and is a party to various acquisition agreements, the terms of which may require Federated to make additional payments to the seller in each acquisition contingent upon the occurrence of certain events. See Federated’s Annual Report on Form 10-K for the year ended December 31, 2002, for a discussion of these contractual obligations and contingent liabilities.

In 2001, Federated acquired substantially all the business of Edgemont Asset Management Corporation, the former advisor of the Kaufmann Fund. In addition to the upfront purchase price paid at the date of the acquisition, the acquisition agreement provides for additional purchase price payments based upon the achievement of specified revenue growth through 2007. Pursuant to this agreement, Federated does not expect to pay any contingent purchase price in 2003 based on the level of revenue earned during the twelve-month period ended in April 2003. Federated could pay an additional $132.3 million as contingent purchase price between 2004 and 2007 with as much as $66.2 million payable in the second quarter 2004 if revenue targets are met.

Management expects that the principal uses of cash will be to advance sales commissions, fund marketing allowances and other payments to intermediaries, repurchase company stock, fund new strategic business acquisitions, pay incentive and base compensation, pay shareholder dividends, fund property and equipment acquisitions and seed new

15

Table of Contents

Management’s Discussion and Analysis (continued)

of Financial Condition and Results of Operations (Unaudited)

products. Federated has experienced increases in the cost of insurance and management expects these increases, including the assumption of additional risk, to be significant going forward. Management believes that Federated’s existing liquid assets, together with the expected continuing cash flow from operations, its borrowing capacity under the current credit facility, the current B-share sales program and its ability to issue stock will be sufficient to meet its present and reasonably foreseeable cash needs.

Alternative Products

Federated acts as the investment manager for two high-yield collateralized bond obligation (CBO) products and a mortgage-backed CBO product pursuant to the terms of an investment management agreement between Federated and each CBO. The CBOs are alternative investment products that were structured using special-purpose entities. As of March 31, 2003, aggregate total assets and aggregate total obligations of the CBOs approximated $1 billion, respectively.

The financial condition and results of operations of these CBOs are not included in Federated’s Consolidated Financial Statements as of and for the three-month period ended March 31, 2003, or for any prior period. In each case, there exists a majority owner(s) that is an independent third party from Federated owning at least three percent equity in the CBO. Federated has not guaranteed nor has any recourse related to any of the notes issued by the CBOs. As of March 31, 2003, the remaining $0.6 million carrying value of Federated’s investments in the CBOs represents Federated’s maximum exposure to loss as a result of its involvement with the CBOs.

In January 2003, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities,” (FIN 46). The objective of FIN 46 is to provide guidance on how to identify a variable interest entity (VIE) and determine when the assets, liabilities, noncontrolling interests, and results of operations of a VIE need to be included in a company’s consolidated financial statements. A company that holds variable interests in an entity will need to consolidate the entity if the company’s interest in the VIE is such that the company will absorb a majority of the VIE’s expected losses and/or receive a majority of the VIE’s expected residual returns, if they occur. FIN 46 also requires additional disclosures by primary beneficiaries and other significant variable interest holders. The provisions of this interpretation are currently effective upon issuance for all new VIEs and for interim and annual periods beginning after June 15, 2003 for all VIEs that existed at the date of its issuance. Management is assessing the impact FIN 46 may have on Federated’s results of operations and financial position as it applies to Federated’s role in the CBOs as well as other aspects of Federated’s business. Management is exploring all of its options relating to its relationship with the CBOs in the event that application of FIN 46 requires consolidation of one or more of the CBOs.

Recent Accounting Pronouncements

In December 2002, the FASB issued Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure,” (SFAS 148). This statement provides alternative methods of transition for a voluntary change to the fair-value-based method of accounting for stock-based employee compensation and amends the disclosure requirements of SFAS 123 to require prominent annual and interim disclosures about the method used to account for stock-based compensation. This statement is effective for financial statements for fiscal years ending after December 15, 2002. Management is currently deliberating whether to adopt the expense recognition provisions of recording the fair value of stock-based compensation under the guidance of SFAS 123 and intends to reach a final decision in 2003.

Critical Accounting Policies

Federated’s Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States. In preparing the financial statements, management is required to make estimates and assumptions that affect the amounts reported in the Consolidated Financial Statements and accompanying notes. Management continually evaluates the accounting policies and estimates it uses to prepare the Consolidated Financial Statements. In general, management’s estimates are based on historical experience, on information from third-party professionals and on various other assumptions that are believed to be reasonable under the facts and circumstances. Actual results may differ from those estimates made by management and those differences may be significant.

16

Table of Contents

Management’s Discussion and Analysis (continued)

of Financial Condition and Results of Operations (Unaudited)

Of the significant accounting policies described in Federated’s Annual Report on Form 10-K for the year ended December 31, 2002, management believes that its policies regarding accounting for intangible assets and income taxes involve a higher degree of judgment and complexity (see Note (1) of the Consolidated Financial Statements included in Federated’s Annual Report on Form 10-K for the year ended December 31, 2002).

Accounting for intangible assets. Two aspects of accounting for intangible assets require significant management estimates and judgment: (1) valuation in connection with the initial purchase price allocation and (2) ongoing evaluation for impairment. The process of allocating purchase price based on the fair value of identifiable intangible assets at the date of acquisition requires management estimates and judgment as to expectations for profit margins on the assets, asset redemption rates, growth from sales efforts and the effects of market conditions. If actual operating margins or the rate of changes in assets, among other assumptions, differ significantly from the estimates and judgments used in the initial valuation for the purchase price allocation, the intangible asset amounts recorded in the financial statements could be subject to possible impairment or could require an acceleration in amortization expense which could have a material adverse effect on Federated’s consolidated financial position and results of operations.

The level, if any, of impairment of customer-related intangible assets, such as advisory contract intangible assets, is highly dependent upon the level of managed assets acquired in connection with a business combination. Over 80% of the carrying value of Federated’s customer-related intangible assets as of March 31, 2003 relates to a single renewable investment advisory contract with one fund. A decline in the managed asset balance in this particular fund in excess of the estimated rate of change in the acquired assets could have a considerable impact on the underlying value of Federated’s customer-related intangible assets.

Accounting for income taxes. Significant management judgment is required in developing Federated’s provision for income taxes, including the determination of deferred tax assets and liabilities and any valuation allowances that might be required against the deferred tax assets. At March 31, 2003, Federated had capital loss carry-forwards of $2.8 million generated by losses recognized on the sale of certain performance seed investments. $2.6 million of this capital loss deferred tax asset will expire in 2006 and the remaining $0.2 million will expire in 2007. As of March 31, 2003, a $2.3 million valuation allowance had been recorded on a portion of this deferred tax asset due to management’s uncertainty of realizing the benefit of these capital loss carry-forwards. As of March 31, 2003, Federated had not recorded a valuation allowance on $6.6 million of deferred tax assets relating to Federated’s CBO other-than-temporary impairment losses. Federated considered the following facts in connection with its evaluation of the realizability of the deferred tax asset: (1) the impairment losses do not represent capital losses for tax purposes until the losses are realized, (2) the actual amount of capital loss associated with Federated’s investment in the CBOs will not be known until such time as Federated’s investments are either redeemed by the CBOs or sold by Federated, (3) the carry-forward period for capital losses is five years, and (4) Federated has historically generated capital gains in times of favorable market conditions. Based on these factors, management believes it is more likely than not that Federated will be able to utilize the capital loss carry-forwards in the future. In the event that Federated’s preliminary strategies do not materialize, Federated may be required to record a valuation allowance of as much as $6.6 million for these deferred tax assets.

17

Table of Contents

Part I, Item 3. Quantitative and Qualitative Disclosures About Market Risk

(Unaudited)

Market Risk—Investments

In the normal course of our business, Federated is exposed to the risk of loss due to fluctuations in the securities market and general economy. Management is responsible for identifying, assessing and managing market and other risks. Federated’s investments are primarily money market funds and mutual funds with investments which have a duration of two years or less. Federated also invests in mutual funds it sponsors (performance seeds) in order to provide investable cash to the fund allowing the fund to establish a performance history. Federated may use derivative financial instruments to hedge these investments. At March 31, 2003, Federated was exposed to price risk with regard to its $0.4 million of investments in fluctuating-value mutual funds. Price risk is the risk that the fair value of the investments will decline and ultimately result in the recognition of a loss for Federated. Federated did not hold any derivative investments to hedge its performance seeds at March 31, 2003.

At March 31, 2003, Federated’s investment in its mortgage-backed CBO product totaled $0.6 million. This investment is subject to interest rate risk due to it being recorded at fair value using a discount rate that may increase over time.

Market Risk—Revenue

It is important to note that a significant portion of Federated’s revenue is based on the market value of managed and administered assets. Declines in the market values of assets as a result of changes in market or other conditions will therefore negatively impact revenue and net income.

Approximately 48% of Federated’s revenue in the first quarter 2003 was from managed assets in money market products. As a result of Federal Reserve Bank interest rate easings, interest rates reached historic lows in late 2002. Further decreases in interest rates from levels at March 31, 2003 could also have an adverse effect on Federated’s revenue from certain retail money market funds distributed largely through the broker/dealer market. Lower interest rates on the investments in these funds could cause Federated and other service providers to the funds to waive some or all of their fees in order to maintain positive yields. Management estimates that a decrease of 0.50% or more in interest rates on money market investments could cause an adverse effect on Federated’s revenue from these retail money market funds.

For further discussion of managed assets and factors that impact Federated’s revenue see the sections entitled “General” and “Asset Highlights” herein as well as the section entitled “Risk Factors and Cautionary Statements” in Federated’s Annual Report on Form 10-K for the year ended December 31, 2002 on file with the Securities and Exchange Commission.

18

Table of Contents

Part I, Item 4. Controls and Procedures

(Unaudited)

19

Table of Contents

Part II, Item 4. Submission of Matters to a Vote of Security Holders

(Unaudited)

20

Table of Contents

Part II, Item 6. Exhibits and Reports on Form 8-K

(Unaudited)

Exhibit 99.1—Certification pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

(1) Form 8-K dated April 10, 2003, reporting preliminary first quarter 2003 results; and

(2) Form 8-K dated April 23, 2003, reporting first quarter 2003 results.

21

Table of Contents

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

22

Table of Contents

CERTIFICATIONS

I, J. Christopher Donahue, certify that:

23

Table of Contents

CERTIFICATIONS

I, Thomas R. Donahue, certify that:

24