UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) X QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended SEPTEMBER 30, 1998 ------------------------------ OR TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission File Number 001-14818 FEDERATED INVESTORS, INC. (Exact name of registrant as specified in its charter) PENNSYLVANIA 25-1111467 (State or other jurisdiction of (IRS Employer incorporation or organization) Identification No.) FEDERATED INVESTORS TOWER PITTSBURGH, PENNSYLVANIA 15222-3779 (Address of principal executive offices) (Zip Code) (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 the number of shares outstanding of each of the issuer's classes of common stock, as of the last practicable date: As of September 30, 1998, the Registrant had outstanding 6,000 shares of Class A Common Stock and 86,288,250 shares of Class B Common Stock.
Federated Investors, Inc. Form 10-Q For the Three Months and Nine Months Ended September 30, 1998 Index PAGE NO. Part I. Financial Information Item 1. Financial Statements Consolidated Balance Sheets at September 30, 1998 and December 31, 1997 3 Consolidated Statements of Income for the Three Months and Nine Months Ended September 30, 1998 and 1997 4 Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 1998 and 1997 5 Notes to Consolidated Financial Statements 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 10 Item 3. Quantitative and Qualitative Disclosures About Market Risk 18 Part II. Other Information Item 6. Exhibits and Reports on Form 8-K (a) Exhibits required by Item 601 of Regulation S-K 18 (b) Reports on Form 8-K 18 Signatures 19
<TABLE> <CAPTION> <S> <C> <C> <C> <C> FEDERATED INVESTORS, INC. CONSOLIDATED BALANCE SHEETS (Dollars in Thousands Except Share Data) SEPTEMBER 30, DECEMBER 31, 1998 1997 --------------- -------------- Current Assets: Cash and cash equivalents $ $ 168,035 22,912 Marketable securities 6,095 8,945 Receivables, net of reserve of $3,020 and $3,266, respectively 30,468 27,478 Accrued revenues 4,015 4,600 Prepaid expenses 2,132 2,853 Income taxes receivable - 7,519 Other current assets 2,214 1,805 --------------- -------------- Total Current Assets 212,959 76,112 --------------- -------------- Long-Term Assets: Customer relationships, net of accumulated amortization of $36,534 and $26,907, respectively 20,771 30,398 Goodwill, net of accumulated amortization of $13,198 and $11,512, respectively 35,669 37,356 Other intangible assets, net 110 126 Deferred sales commissions, net 241,764 164,623 Property and equipment, net 20,925 22,163 Other long-term assets 4,960 6,378 --------------- -------------- Total Long-Term Assets 324,199 261,044 --------------- -------------- Total Assets $ $ 537,158 337,156 =============== ============== Current Liabilities: Cash overdraft $ $ 6,975 7,680 Current portion of long-term debt - Recourse 249 280 Accrued expenses 49,672 34,939 Accounts payable 23,909 18,634 Income taxes payable 4,697 - Other current liabilities 2,569 2,520 --------------- -------------- Total Current Liabilities 88,071 64,053 --------------- -------------- Long-Term Liabilities: Long-term debt - Recourse 98,773 98,950 Long-term debt - Nonrecourse 256,437 185,388 Deferred tax liability, net 25,820 26,546 Other long-term liabilities 2,790 2,863 --------------- -------------- Total Long-Term Liabilities 383,820 313,747 --------------- -------------- Total Liabilities 471,891 377,800 --------------- -------------- Minority Interest 476 466 --------------- -------------- Shareholders' Equity : Common Stock : Class A, no par value, 20,000 shares authorized, 6,000 and 0 shares issued and outstanding, respectively 189 - Class B, no par value, 900,000,000 shares authorized, 86,337,000 and 0 shares issued, respectively 75,268 - Class A, $1.00 stated value, 99,000 shares authorized, 0 and 6,000 shares issued and outstanding, respectively - 6 Class B, $.01 stated value, 149,700,000 shares authorized, 0 and 90,093,758 shares issued, respectively - 901 Additional paid-in capital - 28,574 (Accumulated deficit) retained earnings (8,999) 55,139 Treasury stock, at cost, 48,750 and 6,666,758 shares Class B Common Stock, respectively (8) (123,373) Employee restricted stock plan (1,657) (2,266) Accumulated other comprehensive income (2) (91) --------------- -------------- Total Shareholders' Equity 64,791 (41,110) --------------- -------------- Total Liabilities, Minority $ $ Interest, and Shareholders' Equity 537,158 337,156 =============== ============== </TABLE> December 31, 1997 share amounts have been restated to reflect the one for one stock dividend paid on April 15, 1998 and the one for two stock dividend paid on April 30, 1998. (THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS.)
<TABLE> <CAPTION> <S> <C> <C> <C> <C> <C> <C> <C> FEDERATED INVESTORS, INC. CONSOLIDATED STATEMENTS OF INCOME THREE MONTHS ENDED NINE MONTHS ENDED (Dollars In Thousands Except Per Share SEPTEMBER 30, SEPTEMBER 30, Data) --------------------- --------------------- 1998 1997 1998 1997 ------- --------- --------- ------- Revenue: Investment advisory fees, $ $ $ 196,389 $ 154,905 net-Federated Funds 69,621 56,504 Investment advisory fees, net-Other 5,485 3,964 1,834 1,638 Administrative service fees, 53,682 44,249 net-Federated Funds 18,723 15,673 Administrative service fees, 15,319 17,853 net-Other 4,988 6,210 Other service fees, net-Federated 73,577 47,673 Funds 25,934 18,745 Other service fees, net-Other 21,652 15,209 7,108 5,263 Commission income-Federated Funds 3,140 1,824 998 751 Interest and dividends 6,079 2,024 2,520 721 Marketable securities (losses) gains (169) 8 (210) 16 Other income 6,723 3,936 1,552 1,039 ------- --------- --------- ------- Total Revenue 133,068 106,560 381,877 291,645 ------- --------- --------- ------- Operating Expenses: Compensation and related 111,664 102,407 36,863 35,606 Amortization of deferred sales 22,926 16,068 commissions 8,219 6,162 Office and occupancy 20,588 18,723 6,665 6,120 Systems and communications 19,423 20,094 6,331 6,652 Advertising and promotional 33,619 25,641 12,680 8,618 Travel and related 9,841 10,934 3,155 3,654 Other 21,924 12,448 7,886 3,817 Amortization of intangible assets 11,331 9,939 3,777 3,761 ------- --------- ------- --------- --------- ------- Total Operating Expenses 85,576 74,390 251,316 216,254 ------- --------- --------- ------- Operating income 47,492 32,170 130,561 75,391 ------- --------- --------- ------- Nonoperating Expenses: Interest expense 18,690 14,453 6,729 4,781 Other debt expense 1,400 754 448 245 ------- --------- --------- ------- Total Nonoperating Expenses 7,177 5,026 20,090 15,207 ------- --------- --------- ------- Income before minority interest and income taxes 40,315 27,144 110,471 60,184 Minority interest 6,485 5,610 2,277 1,928 ------- --------- --------- ------- Income before income taxes 38,038 25,216 103,986 54,574 Income tax provision 38,467 20,631 14,428 9,207 ------- --------- --------- ------- Net income $ $ $ $ 23,610 16,009 65,519 33,943 ======= ========= ========= ======= Earnings per common share: Basic $ 0.28 $ 0.19 $ 0.78 $ 0.41 ======= ========= ========= ======= Diluted $ 0.27 $ 0.19 $ 0.76 $ 0.41 ======= ========= ========= ======= Cash dividends declared and paid per $ 0.038 $ - $ 0.097 $ - common share ======= ========= ========= ======= </TABLE> Per share amounts for 1997 have been restated to reflect the one for one stock dividend paid on April 15, 1998 and the one for two stock dividend paid on April 30, 1998. (THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS.)
<TABLE> <CAPTION> <S> <C> <C> <C> <C> FEDERATED INVESTORS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS NINE MONTHS ENDED (Dollars in Thousands) SEPTEMBER 30, ------------------- 1998 1997 - ------------------------------------------------------- -------- ------- Operating Activities: Net income $ 65,519 $ 33,943 Adjustments to reconcile net income to net cash provided by operating activities: Amortization of intangible assets 11,331 9,939 Depreciation and other amortization 4,915 6,455 Amortization of deferred sales commissions 22,926 16,068 Minority interest 6,485 5,610 Disposal of property and equipment (59) (15) Amortization of employee restricted stock and 804 422 other compensation plans (Benefit) provision for deferred income taxes (776) 19,122 Net realized loss (gain) on sale of marketable 169 (8) securities Foreign currency translation (17) 3 Deferred sales commissions (116,797) (79,859) Contingent deferred sales charges received 16,730 8,818 Other changes in assets and liabilities: Increase in receivables, net (2,990) (3,204) Decrease (increase) in accrued revenues 585 (65) Decrease (increase) in prepaid expenses and 312 (452) other current assets Decrease in other long-term assets 1,418 1,247 Increase in accounts payable and accrued 20,008 7,697 expenses Increase in income taxes payable 12,226 1,200 Decrease in other current liabilities (201) (7,968) (Decrease) increase in other long-term (74) 926 liabilities -------- ------- Net Cash Provided by Operating Activities 42,514 19,879 -------- ------- Investing Activities: Proceeds from sale of property and equipment 5 - Additions to property and equipment (3,618) (1,379) Cash paid for acquisitions (456) (14,297) Purchases of marketable securities (6,155) (22,786) Proceeds from redemptions of marketable securities 8,992 26,044 -------- ------- Net Cash Used by Investing Activities (1,237) (12,413) -------- ------- Financing Activities: Distributions to minority interest (6,475) (6,096) Dividends paid (8,201) - Issuance of common stock/stock options 47,689 25 Purchase of treasury stock (77) (8) Proceeds from new borrowings - Recourse 26,324 - Proceeds from new borrowings - Nonrecourse 111,026 - Payments on debt - Recourse (208) (28,894) Payments on debt - Nonrecourse (39,977) - -------- ------- Net Cash Provided (Used) by Financing Activities 103,846 (8,718) -------- ------- Net Increase (Decrease) In Cash and Cash Equivalents 145,123 (1,252) Cash and Cash Equivalents, Beginning of Period 22,912 6,561 -------- ------- Cash and Cash Equivalents, End of Period $ 168,035 $ 5,309 ======== ======= </TABLE> (THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS.)
FEDERATED INVESTORS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) Summary of Significant Accounting Policies (a) BASIS OF PRESENTATION The interim financial statements of Federated Investors, Inc. (the "Company") included herein have been prepared in accordance with generally accepted accounting principles. In the opinion of management, the financial statements reflect all adjustments, which are of a normal recurring nature, necessary for a fair statement of the results for the interim periods presented. In preparing the unaudited consolidated interim financial statements, management is required to make estimates and assumptions that affect the amounts reported in the financial statements. Actual results will differ from such estimates and such differences may be material to the financial statements. These financial statements should be read in conjunction with the Company's audited financial statements for the year ended December 31, 1997. (b) COMPREHENSIVE INCOME In 1998, the Company adopted Statement of Financial Standards No. 130, "Reporting Comprehensive Income" ("SFAS 130"), which requires companies to report all changes in equity during a period, except those resulting from investment by owners and distribution to owners, in a financial statement for the period in which they are recognized. Comprehensive income was $23.7 million and $16.1 million for the three month periods ended September 30, 1998 and 1997, respectively and $65.6 million and $34.1 million for the nine month periods ended September 30, 1998 and 1997, respectively. (c) RECENT ACCOUNTING PRONOUNCEMENTS Statement of Financial Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information" ("SFAS 131") is effective for financial statements for periods beginning after December 15, 1997. SFAS 131 is not required to be applied to interim financial statements in the initial year of its application. Statement of Position No. 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use" ("SOP 98-1") was adopted effective January 1, 1998. SOP 98-1 requires the capitalization of certain costs incurred in connection with developing or obtaining software for internal use. Qualifying software costs are capitalized and amortized over the estimated useful life of the software. Prior to the adoption of SOP 98-1, software costs were expensed as incurred. Restatement of prior year financial statements was not required. In June 1998, the Financial Accounting Standards Board issued Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities", which is required to be adopted in years beginning after June 15, 1999. As a result of the Company's minimal use of derivatives, management does not anticipate that the adoption of the new Statement will have a significant effect on earnings or the financial position of the Company. (2) Deferred Sales Commissions and Nonrecourse Debt The Company entered into an agreement in the fourth quarter of 1997 with a third party to sell the rights to the future revenue streams associated with the 12b-1, shareholder service and CDSC fees of the Class B shares of various mutual funds it manages. This agreement includes both an initial sale of existent rights to future revenue streams as well as establishing a program to sell on a continuous basis the future rights associated with future
FEDERATED INVESTORS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued (2) Deferred Sales Commissions and Nonrecourse Debt, Continued revenue streams relating to the ongoing sale of B shares. For accounting purposes, transactions executed under the agreement are reflected as financings and nonrecourse debt has been recorded. The following tables summarize the changes in both the deferred sales commissions and nonrecourse debt related to this agreement: <TABLE> <CAPTION> <S> <C> Nine Months Ended SEPTEMBER 30, 1998 (In Thousands) Deferred Sales Commissions: Deferred B share sales commissions at December 31, 1997 $162,398 Payments to brokers/dealers 112,890 CDSC fees collected (16,080) Amortization (20,676) -------------- Deferred B share sales commissions at September 30, 1998 $238,532 ======== Nonrecourse Debt: Nonrecourse debt at December 31, 1997 $185,388 Additional financings 111,026 Payments of nonrecourse debt (39,977) -------------- Nonrecourse debt at September 30, 1998 $256,437 ========== The nonrecourse debt had a weighted average interest rate of 7.63% at September 30, 1998. </TABLE> (3) Long-Term Debt The Company's long-term debt consisted of the following: September December 30, 31, 1998 1997 ----------- ---------- (In Thousands) Recourse Debt: Senior Secured Note Purchase Agreement $98,000 $98,000 Capitalized Leases................ 1,022 1,230 ------------------------- Total Recourse Debt......... 99,022 99,230 Less Current Portion............... 249 280 ------------------------- Total Long-Term Debt - Recourse....$ 98,773 $ 98,950 ============ =========== Nonrecourse Debt...................... $ 256,437 $ 185,388 =========== ==========
FEDERATED INVESTORS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued (4) Common Stock (a) Initial Public Offering and Subsequent Merger On May 19, 1998, Federated Investors was merged with and into the Company, a wholly owned subsidiary, with the Company continuing as the surviving corporation. All outstanding Class A and Class B common shares of Federated Investors were exchanged for an equal number of shares of no par Class A and Class B common stock of the Company, respectively, with the same proportionate ownership and substantially similar rights, and all treasury stock of Federated Investors was retired. As a condition precedent to the merger described above, the Company issued an additional 2,610,000 shares of Class B common stock in an initial public offering for net proceeds of approximately $46 million in cash. At September 30, 1998, 6,000 and 86,228,250 shares of Class A and Class B Common Stock were outstanding, respectively. (b) Dividends A one for one stock dividend was paid on April 15, 1998 to stockholders of record on March 17, 1998. Also, a one for two stock dividend was paid on April 30, 1998 to stockholders of record on April 21, 1998. The 1997 per share amounts have been restated to reflect the affect of the stock dividends. The Company's Senior Secured Credit Agreement allows dividends in an amount not to exceed $20 million plus 50% of any net income (less 100% of any net loss) during the period from January 1, 1998 to and including the date of payment. The Senior Secured Note Purchase Agreement allows dividends to an amount of $5 million plus 50% of any net income (less 100% of any net loss) during the period from January 1, 1996 to and including the date of payment. Cash dividends of $0.0208, $0.038 and $0.038 per share or approximately $1.7 million, $3.2 million and $3.3 million were paid in the first, second and third quarters of 1998, respectively, to holders of common shares. Additionally, on October 15, 1998, the Board of Directors of the Company declared a dividend of $0.038 per share to be paid on November 13, 1998 to shareholders of record as of October 30, 1998. After the payment of the dividend on November 13, 1998, the Company, given current debt covenants, has the ability to pay dividends of approximately $41.3 million. (c) Employee Stock Purchase Plan In July 1998, the Company established an Employee Stock Purchase Plan which allows for employees to purchase a maximum of 500,000 shares of Class B Common Stock. The shares under the plan may be newly issued or may be shares purchased by the Company on the open market.
FEDERATED INVESTORS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued (5) Earnings Per Share The following table sets forth the computation of basic and diluted earnings per share: <TABLE> <CAPTION> <S> <C> <C> <C> <C> Three Months Ended Nine Months Ended September 30, September 30, --------------------- ---------------------- 1998 1997 1998 1997 ---------- --------- ---------- ---------- (In Thousands, Except Per Share Data) Numerator: Net income $ 23,610 $ 16,009 $ 65,519 $ 33,943 ========== ========= ========== ========== Denominator: Basic weighted-average common shares outstanding 85,183 82,275 83,850 82,263 Dilutive potential common shares from stock based compensation 2,512 881 2,380 1,029 ---------- --------- ---------- ---------- Diluted weighted-average common shares outstanding 87,695 83,156 86,230 83,292 ========== ========= ========== ========== Earnings per Basic common share $ 0.28 $ 0.19 $ 0.78 $ 0.41 ========== ========= ========== ========== Earnings per Diluted common $ 0.27 $ 0.19 $ 0.76 $ 0.41 share ========== ========= ========== ========== </TABLE>
Part I, Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations HIGHLIGHTS <TABLE> <CAPTION> Three Months Nine Months Ended Ended SELECTED OPERATING DATA (IN THOUSANDS, September 30, September 30, EXCEPT PER SHARE DATA) <S> <C> <C> <C> <C> ------------------- ------------------- 1998 1997 1998 1997 --------- -------- --------- -------- $ $ $ $ Total Revenue............................. 133,068 106,560 381,877 291,645 Operating Expenses.......................... 85,576 74,390 251,316 216,254 --------- -------- --------- -------- Operating Income.............................47,492 32,170 130,561 75,391 Nonoperating Expenses and Minority Interest.......................... 9,454 6,954 26,575 20,817 --------- -------- --------- -------- Income Before Income Taxes...................38,038 25,216 103,986 54,574 Income Tax Provision.........................14,428 9,207 38,467 20,631 --------- -------- --------- -------- Net Income................................ $23,610 $16,009 $65,519 $33,943 ========= ======== ========= ======== Operating Margin Percentage 35.7% 30.2% 34.2% 25.9% Earnings per Basic Common $ 0.28 $ 0.19 $ 0.78 $ 0.41 Share...................................... Earnings per Diluted Common Share $ 0.27 $ 0.19 $ 0.76 $ 0.41 </TABLE> MANAGED AND ADMINISTERED ASSETS (IN MILLIONS) September 30, % ------------------- 1998 1997 Change --------- -------- --------- Money Market Funds......................... $71,228 $58,235 22.3% Fixed Income Funds......................... 16,089 14,718 9.3% Equity Funds............................... 13,267 11,173 18.7% Separate Accounts.......................... 2,323 1,831 26.9% --------- -------- Total Managed $ 102,907 $85,957 19.7% Assets................... ========= ======== Total Administered Assets....... $54,574 $44,876 21.6% ========= ======== <TABLE> <CAPTION> <S> <C> <C> <C> <C> <C> <C> AVERAGE MANAGED AND Three Months Ended Nine Months Ended ADMINISTERED ASSETS (IN MILLIONS) September 30, % September 30, % -------------------- --------------------- 1998 1997 Change 1998 1997 Change --------- --------------- ---------- --------------- Money Market Funds.............$..69,864 $ 56,458 23.7% $ 66,711 $ 53,857 23.9% Fixed Income Funds................15,931 14,531 9.6% 15,708 14,212 10.5% Equity Funds......................13,918 10,557 31.8% 13,560 9,138 48.4% Separate Accounts..................2,300 1,779 29.3% 2,309 1,822 26.7% ========= Total Average Managed $ 102,013 $ 83,325 22.4% $98,288 $ 79,029 24.4% Assets ========= ========= ========== ========= Total Average $ 54,772 $ 43,989 24.5% $ 53,043 $ 41,520 27.8% Administered Assets ========= ========= ========== ========= </TABLE> COMPONENTS OF CHANGES IN EQUITY AND FIXED INCOME FUND MANAGED ASSETS (IN MILLIONS) Three Months Ended Nine Months Ended September 30, September 30, -------------------- ------------------ EQUITY FUNDS 1998 1997 1998 1997 - ------------ --------- --------- -------- -------- Beginning Assets........$ 14,561 $ 9,795 $ 11,710 $ 7,594 --------- --------- -------- -------- Sales.................. 1,193 1,092 3,986 2,897 Redemptions............. (932) (546) (2,274) (1,644) --------- --------- -------- -------- Net Sales..................261 546 1,712 1,253 Net Exchanges........... - 52 (18) 116 Acquisition Related................. - - - 353 Other*................ (1,555) 780 (137) 1,857 --------- --------- -------- -------- Ending Assets...........$ 13,267 $ 11,173 $ 13,267 $ 11,173 ========= ========= ======== ======== FIXED INCOME FUNDS Beginning Assets........$ 15,816 $ 14,286 $ 15,067 $ 14,109 -------- --------- -------- -------- Sales................ 1,525 1,134 4,506 3,329 Redemptions........... (1,265) (1,073) (3,466) (3,364) --------- --------- -------- -------- Net Sales(Redemptions). 260 61 1,040 (35) Net Exchanges............ 14 1 (243) (52) Acquisition Related.... - - - 175 Other*.................. (1) 370 225 521 --------- --------- -------- -------- Ending Assets...........$ 16,089 $ 14,718 $ 16,089 $ 14,718 ========= ========= ======== ======== * Primarily reinvested dividends and distributions, net investment income and changes in the value of securities held by the funds. RESULTS OF OPERATIONS - THREE MONTHS ENDED SEPTEMBER 30, 1998 COMPARED TO THE THREE MONTHS ENDED SEPTEMBER 30, 1997 In preparing the discussion and analysis below, Federated Investors, Inc. (the "Company") has presumed that the readers of the interim financial information have read or have access to the Company's discussion and analysis of financial condition and results of operations for the year ended December 31, 1997. NET INCOME. Net income for the three months ended September 30, 1998 was $23.6 million, or $0.27 per diluted share, a 47.5% and 42.1% increase, respectively, over the same period in 1997. Revenue growth of 24.9% from higher levels of average managed and administered assets and improvements in operating margins from 30.2% to 35.7% were the primary reasons for improved financial performance. The higher levels of average managed and administered assets occured despite the recent volatility in the stock market. REVENUE. The Company's consolidated revenue increased $26.5 million, or 24.9% to $133.1 million for the quarter ended September 30, 1998 from $106.6 million for the same period in 1997. Approximately $23.8 million, or 89.8% of this increase in revenues is due to higher levels of managed assets. Average managed assets increased 22.4% from $83.3 billion for the third quarter of 1997 to $102.0 billion for the third quarter of 1998, including increases of 31.8%, 23.7%, 9.6%, and 29.3% in equity funds, money market funds, fixed income funds, and separate accounts, respectively. Average managed equity assets, however, declined by 2.0% in the third quarter as compared to the second quarter of 1998, as declines in market values of equity fund assets more than offset net sales of their shares during the period. Average managed and administered money market assets, meanwhile, increased 6.8% in the third quarter as compared to the second quarter of 1998. Service related revenues from sources other than managed and administered assets increased by approximately $0.6 million due primarily to increased revenues within the Company's clearing and retirement plan recordkeeping services. Interest and dividends increased by $1.8 million as a result of higher levels of invested cash resulting from the B share advanced commission financing programs, net proceeds from the Company's initial public offering, and higher levels of cash generated from operations. Recently, the Company has received notice from certain clients for which it provides administrative services that those clients will end their service arrangements in the fourth quarter of 1998. Collectively, these clients had administered assets of $28.5 billion as of September 30, 1998 and represented approximately 1.4% of total revenue for the quarter ended September 30, 1998. The Company expects to receive termination payments of approximately $3.5 million for the cessation of these arrangements. OPERATING EXPENSES. Total operating expenses increased from $74.4 million for the third quarter of 1997 to $85.6 million for the third quarter of 1998, an increase of $11.2 million or 15.0%. Expense management continues to be a major focus for the Company. As a result, expense growth has been contained at levels substantially below the 24.9% increase in revenues and accordingly, operating margins have improved to 35.7% for the quarter ended September 30, 1998 from 30.2% for the same period in 1997. Compensation and related expenses increased $1.3 million or 3.5% from $35.6 million for the quarter ended September 30, 1997 to $36.9 million for the quarter ended September 30, 1998. The increase was mainly attributed to staff growth experienced within investment research and certain service areas, as well as an increase in variable based compensation and was partially offset by reductions resulting from the outsourcing of the portfolio accounting function. Amortization of deferred sales commissions increased from $6.2 million for the third quarter of 1997 to $8.2 million for the same period of 1998, an increase of $2.0 million or 33.4%. This increase was due to higher levels of deferred sales commissions as a result of the continued sale of shares of funds which require the Company to advance a commission to the broker/dealers. Office and occupancy expenses increased from $6.1 million in the third quarter of 1997 to $6.7 million for the same period in 1998, an increase of $0.6 million or 8.9%. The increase is primarily attributable to increased rent expense for leased space. Advertising and promotional expenses increased from $8.6 million for the quarter ended September 30, 1997 to $12.7 million for the quarter ended September 30, 1998, an increase of $4.1 million or 47.1%, primarily as a result of higher levels of marketing allowances being paid to brokers and bank clients for retailing efforts of marketing funds, as well as increased spending in advertising and promotional expense to further build company name and brand awareness. Travel and related expenses declined $0.5 million or 13.7%, from $3.7 million in the third quarter of 1997 to $3.2 million for the same period of 1998 as a result of continued expense management. Other expenses increased $4.1 million or 106.6% from $3.8 million for the quarter ended September 30, 1997 to $7.9 million for the quarter ended September 30, 1998. This increase is predominantly attributable to fees paid to third parties for portfolio accounting services which were performed internally throughout most of 1997. NONOPERATING EXPENSES. Nonoperating expenses increased by $2.2 million, or 42.8%, to $7.2 million for the three months ended September 30, 1998 as compared to $5.0 million for the three months ended September 30, 1997. This increase is attributable to the interest and other debt related expenses recognized relative to nonrecourse debt incurred for the securitization of certain B share fund assets. MINORITY INTEREST. The minority interest increased from $1.9 million for the third quarter of 1997 to $2.3 million for the third quarter of 1998, an increase of $0.4 million or 18.1%. This increase is a result of higher net income being recorded for the subsidiary for which the Company acts as the general partner with a majority interest of 50.5%. The increase in income is attributable to higher average managed assets of the funds which the subsidiary advises. INCOME TAXES. The income tax provision for the quarter ended September 30, 1998 was $14.4 million as compared to $9.2 million for the third quarter of 1997, an increase of $5.2 million or 56.7%. This increase was due primarily to the increase in the level of income before income taxes from $25.2 million for the three months ended September 30, 1997 to $38.0 million for the three months ended September 30, 1998, an increase of 50.9%. RESULTS OF OPERATIONS - NINE MONTHS ENDED SEPTEMBER 30, 1998 COMPARED TO THE NINE MONTHS ENDED SEPTEMBER 30, 1997 NET INCOME. Net income for the first nine months ending September 30, 1998 was $65.5 million, or $0.76 per diluted share, a 93.0% and 85.4% increase, respectively, over the same period in 1997. Revenue growth of 30.9% from higher levels of average managed and administered assets and improvements in operating margins from 25.9% to 34.2% were the primary reasons for improved financial performance. REVENUE. The Company's consolidated revenue increased $90.3 million, or 30.9% to $381.9 million for the nine month period ended September 30, 1998 from $291.6 million for the same period in 1997. Approximately $79.7 million, or 88.3% of this increase is due to revenues derived from managed assets. Average managed assets increased 24.4% from $79.0 billion for the first nine months of 1997 to $98.3 billion for the same period in 1998, including increases of 48.4%, 23.9%, 10.5%, and 26.7% in equity funds, money market funds, fixed income funds, and separate accounts, respectively. Service related revenues from other sources other than managed and administered assets increased by approximately $3.9 million due primarily to an increase in average administered assets and increased revenues within the Company's clearing and retirement plan recordkeeping services. Average administered assets increased $11.5 billion or 27.8% from $41.5 billion for the first three quarters of 1997 to $53.0 billion for the same period in 1998. Interest and dividends increased by $4.1 million as a result of higher levels of invested cash from the B share advanced commission financing programs, net proceeds from the initial public offering, and higher levels of cash generated from operations. Other income improved $2.8 million due primarily to a servicing contract buyout by a bank-sponsored mutual fund complex resulting in a payment of $2.5 million in the first quarter of 1998. This servicing contract accounted for approximately 0.4% of administrative and other service fee revenue. OPERATING EXPENSES. Total operating expenses increased from $216.3 million for the nine month period ended September 30, 1997 to $251.3 million for the same period in 1998, an increase of $35.0 million or 16.2%. Compensation and related expenses increased $9.3 million or 9.0% from $102.4 million for the first three quarters of 1997 to $111.7 million for the first three quarters of 1998. The increase was mainly attributed to staff growth experienced within investment research and certain service areas, related increases in payroll taxes and retirement plan expenses, as well as an increase in variable based compensation. The increase was partially offset by reductions resulting from the outsourcing of the portfolio accounting function. Amortization of deferred sales commissions increased from $16.1 million for the nine month period ended September 30, 1997 to $22.9 million for the same period of 1998, an increase of $6.8 million or 42.7%. This increase was due to higher levels of deferred sales commissions as a result of the continued sale of shares of funds which require the Company to advance a commission to the broker/dealers. Office and occupancy expenses increased from $18.7 million for the first nine months of 1997 to $20.6 million for the same period in 1998, an increase of $1.9 million or 10.0%. The increase is primarily attributable to increased rent expense for leased space. Advertising and promotional expenses increased from $25.6 million for the nine month period ended September 30, 1997 to $33.6 million for the nine month period ended September 30, 1998, an increase of $8.0 million or 31.1%, primarily as a result of higher levels of marketing allowances being paid to brokers and bank clients for retailing efforts of marketing funds, as well as increased spending in advertising and promotional expense to further build company name and brand awareness. Travel and related expenses declined $1.1 million, or 10.0%, from $10.9 million in the first three quarters of 1997 to $9.8 million for the same period of 1998 as a result of continued expense management. Other expenses increased $9.5 million or 76.1% from $12.4 million for the nine month period ended September 30, 1997 to $21.9 million for the nine month period ended September 30, 1998. This increase is primarily attributable to fees paid to third parties for portfolio accounting services which were performed internally throughout most of 1997. This increase was partially offset by reductions in consulting expenses as well as reduced bad debt expense as a result of improved collections of various receivables. Amortization of intangible assets increased by $1.4 million, or 14.0% from $9.9 million for the nine months ended September 30, 1997 to $11.3 million for the nine months ended September 30, 1998. The increase in the amortization of intangible assets occurred as a result of an acquisition in the second quarter of 1997. NONOPERATING EXPENSES. Nonoperating expenses increased by $4.9 million, or 32.1% to $20.1 million for the nine months ended September 30, 1998 as compared to $15.2 million for the nine months ended September 30, 1997. This increase is attributable to the interest and other debt related expenses recognized relative to nonrecourse debt incurred for the securitization of certain B share fund assets. MINORITY INTEREST. The minority interest increased $0.9 million, or 15.6% from $5.6 million for the first three quarters of 1997 to $6.5 million for the first three quarters of 1998 as a result of higher net income being recorded for the subsidiary for which the Company acts as the general partner with a majority interest of 50.5%. The increase in income is attributable to higher average managed assets of the funds which the subsidiary advises. INCOME TAXES. The income tax provision for the nine month period ended September 30, 1998 was $38.5 million as compared to $20.6 million for the same period in 1997, an increase of $17.9 million or 86.5%. This increase was due primarily to the increase in the level of income before income taxes from $54.6 million for the nine months ended September 30, 1997 to $104.0 million for the nine months ended September 30, 1998, an increase of 90.5%. DEFERRED SALES COMMISSIONS AND NONRECOURSE DEBT Certain subsidiaries of the Company pay commissions to broker/dealers (deferred sales commissions) to promote investments in certain mutual funds. For mutual fund shares sold under such marketing programs, the Company retains certain distribution and servicing fees from the mutual fund over the outstanding life of such shares. These fees consist of 12b-1, shareholder service and contingent deferred sales charge (CDSC) fees. Both 12b-1 and shareholder service fees are calculated as a percentage of average managed assets associated with the related classes of shares. If shares are redeemed before the end of a specified holding period as outlined in the related mutual fund prospectus, the mutual fund shareholder is normally required to pay the Company a CDSC fee based on a percentage of the lower of the current market value or the original cost basis of the redeemed shares, such percentage diminishing over a recovery schedule not to exceed six years. For non-B share related sales the up front commissions the Company pays to broker/dealers are capitalized and recorded as deferred sales commissions and are amortized over the estimated benefit period not to exceed CDSC periods. The 12b-1 and shareholder service fees are recognized in the income statement over the life of the mutual fund class share. Any CDSC fees collected are used to reduce deferred sales commissions. In the fourth quarter of 1997, the Company entered into an agreement to sell certain of the future fee revenue associated with its existing B shares deferred sales commissions. This agreement also provided for the Company to sell, on a regular basis, the rights associated with such future revenue streams during a three year contract period. For accounting purposes these agreements have been accounted for as financings and nonrecourse debt was recorded. The Consolidated Statements of Income reflect 12b-1 and shareholder service fees which are included in Other Service Fees, net - Federated Funds as well as interest expense associated with the nonrecourse debt and amortization of deferred sales commissions. In the first nine months of 1998, pursuant to the terms of the agreement, the Company received $111.4 million in cash in exchange for the rights to certain future revenue streams associated with B share advanced commissions with a book value of $108.8 million. As of September 30, 1998 the Company had $256.4 million of nonrecourse debt and $238.5 million in book value of deferred sales commission assets related to the B shares. CAPITAL RESOURCES AND LIQUIDITY CASH FLOW.Cash provided by operating activities totaled $42.5 million for the first three quarters of 1998. The cash flow from operating activities is primarily utilized for the purchase of equipment, dividend payments, distributions to the minority interest, as well as payments on long term debt. The deferred sales commissions paid to broker/dealers on certain shares of funds totaled $116.8 million for the first nine months of 1998. Also, in the first nine months of 1998, the Company exchanged for $111.4 million the rights to certain future revenue streams associated with the class B share advance commission assets with a book value of $108.8 million. CAPITAL EXPENDITURES. Capital expenditures totaled $3.6 million for the first nine months of 1998, with $2.0 million of capital expenditures incurred in the third quarter of 1998. Capital expenditures are not expected to exceed $10 million in 1998, exclusive of Year 2000 related project costs described below. DIVIDENDS.The Board of Directors of the Company adopted a policy to declare and pay cash dividends on a quarterly basis. In July 1998, the Company amended the Senior Secured Credit Agreement in order to allow additional dividends. Dividends of $0.0208, $0.038 and $0.038 per share were paid on January 31, 1998, April 30, 1998 and August 10, 1998, respectively. The Company's Board of Directors declared a dividend of $0.038 per share to be paid on November 13, 1998 to registered shareholders as of October 30, 1998. After the payment of the dividend on November 13, 1998, the Company, given current debt covenants, has the ability to pay dividends of approximately $41.3 million. DEBT FACILITIES. The Company has the following recourse debt facilities: Senior Secured Credit Agreement and Senior Secured Note Purchase Agreement. SENIOR SECURED CREDIT AGREEMENT. At September 30, 1998, the outstanding balance under the Senior Secured Credit Agreement was zero with an amount available to borrow of $149.1 million. The Senior Secured Credit Agreement contains various financial and other covenants. The Company was in compliance with all debt covenants at September 30, 1998. SENIOR SECURED NOTE PURCHASE AGREEMENT. The Senior Secured Note Purchase Agreement debt totaled $98.0 million as of September 30, 1998. This note is due in seven annual $14.0 million installments beginning June 27, 2000, and maturing June 27, 2006. The Senior Secured Note Purchase Agreement contains various covenants with which the Company was in compliance at September 30, 1998. CAPITALIZED LEASE OBLIGATIONS. At September 30, 1998, the Company had capitalized lease obligations totaling $1.0 million related to certain telephone equipment. The scheduled principal payments approximate $0.2 million per year for 1998 through 2002. NONRECOURSE DEBT. The Company had nonrecourse debt obligations aggregating $256.4 million at September 30, 1998. This obligation was incurred in connection with the exchange of rights to certain future revenue streams associated with the B share advance commissions. SHAREHOLDERS' EQUITY. In May 1998, Federated Investors was merged with and into the Company, its wholly owned subsidiary. All outstanding Class A and Class B common shares of Federated Investors were exchanged for an equal number of shares of no par Class A and Class B common stock of the Company, respectively, with the same proportionate ownership and substantially similar rights. All treasury stock of Federated Investors was retired and additional paid-in-capital was transferred to the no par Class A and Class B common stock of the Company based on their relative proportionate values immediately prior to the merger. Also in May 1998, the Company issued an additional 2,610,000 shares of Class B common stock in an initial public offering for net proceeds of approximately $46 million in cash. YEAR 2000 DISCLOSURE: Many existing information technology ("IT") products and systems and non-IT products and systems containing embedded processor technology were originally programmed to represent any date by using six digits (e.g., 12/31/99), as opposed to eight digits (e.g., 12/31/1999). Accordingly, such products and systems may experience miscalculations, malfunctions or disruptions when attempting to process information containing dates that fall after December 31, 1999 or when attempting to recognize the year 2000 as a leap year. These potential problems are collectively referred to as the "Year 2000" problem, or "Y2K". Also, the occurrence of such problems may take place before the year 2000 if a computer system utilizes future dates during its processing. THE COMPANY'S STATE OF READINESS: Computer processing is critical to the Company's business operations and the Y2K issue poses a significant potential risk to operations. Therefore, the Company has established an enterprise-wide project to address this issue. The project includes four phases: inventory / assessment which includes the identification of all components of the Company's computing environment and the assessment of Y2K issues for these components; remediation of the Y2K issues identified in the inventory / assessment phase; testing to ensure that remediation was successful; and implementation of the modified systems. The project scope has been divided into four segments which comprise our computing environment. These are: Systems developed internally by the Company's IT division - this constitutes the majority of the Company's Y2K efforts Mission-critical processing provided by the funds' service providers Other critical aspects of systems and operations within the business units, including both commercially available computer applications and the progress of key business partners Embedded systems - for the Company's operations, embedded systems mainly consist of building systems and office equipment The Company's goal for addressing internally-developed systems is to complete remediation and initial testing by the end of 1998. Further large scale integration and external testing will continue into 1999. The Company expects the funds' service providers to also become compliant by the end of 1998. Regarding critical systems used within the Company's various business units and embedded systems, the Company plans to complete assessment, remediation, and testing by mid-1999. As of the end of September 1998, the Company has completed the inventory / assessment of its internally-developed systems. Over 90% of remediation work is complete as well, with the remaining work on schedule. Approximately three-quarters of the applications have completed Y2K testing for the individual programs and have been returned to production. Currently, the Company is conducting more extensive integration and system testing and arranging to test with external, interfacing systems. The Company has established an isolated computer network for these testing efforts, which will continue into 1999. Certain mission critical processing is performed for the Company's funds by outside service providers, including the transfer agency, portfolio accounting, and custody functions. The Company has identified these service providers and assessed the Y2K risks associated with these relationships. The Company is monitoring the progress of these companies in addressing Y2K issues via progress reports and meetings and is working with the service providers to test the systems, as appropriate. Assessment and remediation are underway for business unit systems, key business partners, and embedded systems. The Company currently expects to meets its goals listed above for these areas. Additionally, the Company is participating in the "industry-wide testing" being coordinated by the Securities Industry Association. This testing is being conducted to ensure that major broker dealers, exchanges, clearing houses, and depositories are able to communicate properly in the year 2000. The Company participated in initial tests for processing of mutual funds transactions in both July and October 1998. The Company will also participate in the full industry-wide test slated for March 1999. COSTS TO ADDRESS Y2K: The Company estimates its Y2K project will cost at least $10 million. The Company has incurred approximately $3.9 million from the inception of the Y2K project through September 30, 1998, with $3.0 million being reflected within the current year's financial statements. Y2K costs are being funded from operating revenue and are being expensed as incurred. These cost estimates are subject to change as the project continues. The estimated total costs are not considered to have a material impact on the Company's results of operations or financial position. While certain non-time sensitive IT projects have been delayed due to Y2K efforts and costs, no strategic projects or projects for legal or regulatory requirements have been deferred or canceled. RISKS OF THE COMPANY'S YEAR 2000 ISSUES: It must be realized that, as with all other companies in the financial services industry, many day-to-day functions of the Company are dependent on accurate computer processing. Further, this processing is conducted by an extensive network of systems, both internal to the Company and external, with both direct and indirect interaction. Accordingly, if not addressed, Y2K issues could result in the Company's inability to perform mission critical functions, including the trading of securities and processing of fund shareowner transactions. A portion of the Company's business involves international investments, thereby exposing the Company to operations, custody and settlement processes outside the United States. The Company is monitoring the progress of the funds' international custodians in these areas. Further, the Company is assessing the Y2K readiness of its foreign brokers. Y2K is a risk for many of the issuers of the specific securities in which the Company's funds invest, in both the U.S. and international markets. Accordingly, the Company has incorporated assessment of Y2K risk into its investment management process. THE COMPANY'S CONTINGENCY PLANS: Because the Company's operations are reliant upon systems which are not under its direct control, the Company's Y2K plan includes the development of contingency plans to address its critical operations in the event of Y2K-related disruptions. Y2K contingency planning is planned for early 1999 as part of an update of the Company's overall contingency planning; however, no guarantee can be made that Y2K-related disruptions will not occur. SPECIAL NOTE REGARDING FORWARD-LOOKING INFORMATION. Certain statements under "Management's Discussion and Analysis of Financial Condition and Results of Operations" such as included in the Year 2000 disclosure 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, or achievements of the Company, 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 in the Company's Registration Statement on Form S-1 and quarterly reports on Form 10-Q on file with the Securities and Exchange Commission. As a result of the foregoing and other factors, no assurance can be given as to future results, levels of activity, or achievements, and neither the Company nor any other person assumes responsibility for the accuracy and completeness of such statements. Part I, Item 3. Quantitative and Qualitative Disclosures About Market Risk The Company's investments are primarily in money market funds. Occasionally, the Company invests in new fluctuating net asset value mutual funds (priming) sponsored by the Company in order to provide investable cash, allowing the fund to establish a yield history. The Company may use derivative financial instruments as an attempt to hedge these investments. As of September 30, 1998, the book value of the priming investments and the derivative financial instruments were $5.1 million and zero, respectively. In October 1998, the Company entered into a derivative instrument with an initial cost basis of $0.4 million for the purpose of hedging a $5.0 million priming investment that was initiated on September 30, 1998. All of the Company's debt instruments carry fixed interest rates and therefore are not subject to market risk. Part II, Item 5. Other Information The Board of Directors of the Company elected Michael J. Farrell and James L. Murdy as outside directors to the Board of Directors effective August 31, 1998. Part II, Item 6. Exhibits and Reports on Form 8-K (a) The following exhibits required to be filed by Item 601 of Regulation S-K are filed herewith and incorporated by reference herein: Exhibit 10. Material contracts - Federated Investors, Inc. Stock Incentive Plan, amended as of August 26, 1998 Exhibit 27. Financial Data Schedule (filed herewith) (b) Reports on Form 8-K: No reports on Form 8-K were filed during the period subject to this Quarterly Report on Form 10-Q.
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. FEDERATED INVESTORS, INC. (Registrant) Date NOVEMBER 12, 1998 By: /S/ J. CHRISTOPHER DONAHUE ------------------- ------------------------------- J. Christopher Donahue President and Chief Executive Officer Date NOVEMBER 12, 1998 By: /S/ THOMAS R. DONAHUE ------------------- ------------------------- Thomas R. Donahue Chief Financial Officer and Principal Accounting Officer