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, 1999 ------------------------------------------ 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 November 3, 1999, the Registrant had outstanding 6,000 shares of Class A Common Stock and 82,804,150 shares of Class B Common Stock.
Federated Investors, Inc. Form 10-Q For the Three Months and Nine Months Ended September 30, 1999 Table of Contents PAGE NO. Part I. Financial Information Item 1.Financial Statements Consolidated Balance Sheets at September 30, 1999 and December 31, 1998 3 Consolidated Statements of Income for the Three Months and Nine Months Ended September 30, 1999 and 1998 4 Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 1999 and 1998 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 Part I, Item I. Financial Statements <TABLE> <CAPTION> <S> <C> <C> FEDERATED INVESTORS, INC. CONSOLIDATED BALANCE SHEETS (dollars in thousands) (unaudited) SEPTEMBER 30, DECEMBER 31, 1999 1998 ------------------ ------------------- CURRENT ASSETS: Cash and cash equivalents $ $ 146,975 185,581 Securities available for sale 66,589 13,398 Receivables, net of reserve of $390 and $1,276, respectively 31,981 30,969 Accrued revenues 3,6665 Prepaid expenses 3,037 4,688 Other current assets 487 3,958 ------------------ ------------------- Total current assets 254,844 242,260 ------------------ ------------------- LONG-TERM ASSETS: Customer relationships, net of accumulated amortization of $11,701 and $39,571, respectively 10,713 17,743 Goodwill, net of accumulated amortization of $15,450 and $13,762, respectively 33,419 35,107 Other intangible assets, net of accumulated amortization of $106 and $3,608, respectively 84 103 Deferred sales commissions, net 292,058 258,593 Property and equipment, net of accumulated depreciation of $44,557 and $42,949, respectively 31,410 21,550 Other long-term assets 17,319 4,664 ------------------ ------------------- Total long-term assets 385,003 337,760 ------------------ ------------------- Total assets $ $ 639,847 580,020 ================== =================== CURRENT LIABILITIES: Cash overdraft $ $ 6,004 5,932 Current portion of long-term debt - recourse 254 239 Accrued expenses 51,966 51,096 Accounts payable 25,951 24,864 Income taxes payable 1,066 2,522 Other current liabilities 2,181 1,675 ------------------ ------------------- Total current liabilities 87,422 86,328 ------------------ ------------------- LONG-TERM LIABILITIES: Long-term debt - recourse 98,505 98,698 Long-term debt - nonrecourse 303,590 272,850 Deferred tax liability, net 33,065 29,949 Other long-term liabilities 6,735 2,818 ------------------ ------------------- Total long-term liabilities 441,895 404,315 ------------------ ------------------- Total liabilities 529,317 490,643 ------------------ ------------------- Minority interest 453 671 ------------------ ------------------- SHAREHOLDERS' EQUITY : Common Stock : Class A, no par value, 20,000 shares authorized, 6,000 shares issued and outstanding 189 189 Class B, no par value, 900,000,000 shares authorized, 86,337,000 shares issued 75,202 75,090 Retained earnings 92,514 14,556 Treasury stock, at cost, 3,290,950 and 138,750 shares Class B Common Stock, respectively (56,393) (23) Employee restricted stock plan (1,201) (1,512) Accumulated other comprehensive income (234) 406 ------------------ ------------------- Total shareholders' equity 110,077 88,706 ------------------ ------------------- Total liabilities, minority interest, and $ $ shareholders' equity 639,847 580,020 ================== =================== </TABLE> (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 INCOME THREE MONTHS ENDED NINE MONTHS ENDED (dollars in thousands, except per share data) SEPTEMBER 30, SEPTEMBER 30, -------------------- ------------------------ (unaudited) 1999 1998 1999 1998 --------- -------- ---------- ----------- REVENUE: Investment advisory fees, net-Federated funds $ $ $ $ 79,139 69,621 228,255 196,389 Investment advisory fees, net-other 8,147 5,485 3,025 1,834 Administrative service fees, net-Federated funds 60,150 53,682 20,178 18,723 Administrative service fees, net-other 17,080 19,230 6,025 6,347 Other service fees, net-Federated funds 91,381 73,577 31,632 25,934 Other service fees, net-other 17,109 17,741 6,032 5,749 Commission income 3,190 3,140 1,112 998 Interest and dividends 9,964 6,079 3,475 2,520 Gain (loss) on sale of securities available for 851 (169) sale 83 (210) Other income 7,516 6,723 1,496 1,552 --------- -------- ---------- ----------- Total revenue 152,197 133,068 443,643 381,877 --------- -------- ---------- ----------- OPERATING EXPENSES: Compensation and related 116,748 111,664 38,803 36,863 Advertising and promotional 40,177 33,619 14,594 12,680 Systems and communications 20,800 19,423 6,991 6,331 Office and occupancy 19,002 20,588 6,304 6,665 Professional service fees 18,463 14,730 5,650 6,023 Travel and related 10,634 9,841 3,485 3,155 Amortization of deferred sales commissions 34,341 22,926 12,456 8,219 Amortization of intangible assets 8,737 11,331 1,668 3,777 Other 4,372 7,194 2,395 1,863 --------- -------- ---------- ----------- Total operating expenses 92,346 85,576 273,274 251,316 --------- -------- ---------- ----------- Operating income 59,851 47,492 170,369 130,561 --------- -------- ---------- ----------- NONOPERATING EXPENSES: Debt expense - recourse 6,643 6,628 2,212 2,210 Debt expense - nonrecourse 17,012 13,462 5,881 4,967 --------- -------- ---------- ----------- Total nonoperating expenses 8,093 7,177 23,655 20,090 --------- -------- ---------- ----------- Income before minority interest and income taxes 51,758 40,315 146,714 110,471 Minority interest 7,628 6,485 2,588 2,277 --------- -------- ---------- ----------- Income before income taxes 49,170 38,038 139,086 103,986 Income tax provision 50,684 38,467 18,006 14,428 --------- -------- ---------- ----------- Net income $ $ $ $ 31,164 23,610 88,402 65,519 ========= ======== ========== =========== EARNINGS PER SHARE: Basic $ 0.38 $ 0.28 $ 1.05 $ 0.78 ========= ======== ========== =========== Diluted $ 0.36 $ 0.27 $ 1.02 $ 0.76 ========= ======== ========== =========== Cash dividends per share $ 0.0420 $ 0.0380 $ 0.1220 $ 0.0968 ========= ======== ========== =========== </TABLE> PER SHARE AMOUNTS HAVE BEEN RESTATED TO REFLECT THE ONE-FOR-ONE AND THE ONE-FOR-TWO STOCK DIVIDENDS PAID IN 1998. (THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS.) FEDERATED INVESTORS, INC. <TABLE> <CAPTION> <S> <C> <C> CONSOLIDATED STATEMENTS OF CASH FLOWS NINE MONTHS ENDED (dollars in thousands) SEPTEMBER 30, ------------------------------- (unaudited) 1999 1998 -------------- ---------------- OPERATING ACTIVITIES: Net $ 88,402 65,519 income ADJUSTMENTS TO RECONCILE NET INCOME TO NET CASH PROVIDED BY OPERATING ACTIVITIES: Amortization of intangible assets 8,737 11,331 Depreciation and other amortization 5,136 5,978 Amortization of deferred sales commissions 34,341 22,926 Minority interest 7,628 6,485 Gain on disposal of property and equipment (2,973) (59) Amortization of employee restricted stock and other 423 804 compensation plans Provision (benefit) for deferred income taxes 3,418 (776) Net realized (gain) loss on sale of securities available (851) 169 for sale Deferred sales commissions paid (96,104) (116,797) Contingent deferred sales charges received 28,298 16,730 Other 12 0 Other changes in assets and liabilities: Increase in receivables, net (1,012) (2,990) (Increase) decrease in accrued revenues (2,109) 585 Decrease in prepaid expenses and other current assets 5,122 312 (Increase) decrease in other long-term assets (1,190) 355 Increase in accounts payable and accrued expenses 1,957 20,008 (Decrease) increase in income taxes payable (1,456) 12,226 Increase (decrease) in other current liabilities 578 (201) Increase (decrease) in other long-term liabilities 4,416 (91) -------------- ---------------- Net cash provided by operating activities 82,773 42,514 -------------- ---------------- INVESTING ACTIVITIES: Additions to property and equipment (15,603) (3,618) Proceeds from disposal of property and equipment 4,007 0 Cash paid for acquisitions 0 (456) Investment in joint venture (1,398) 0 Purchases of securities available for sale (88,743) (6,155) Proceeds from redemptions of securities available for sale 24,459 8,992 -------------- ---------------- Net cash used by investing activities (77,278) (1,237) -------------- ---------------- FINANCING ACTIVITIES: Distributions to minority interest (7,847) (6,475) Dividends paid (10,446) (8,201) Proceeds from issuance of common stock/options 0 47,689 Purchase of treasury stock (56,370) (8) Proceeds from new borrowings - nonrecourse 93,309 111,026 Payments on debt - recourse (178) (208) Payments on debt - nonrecourse (62,569) (39,977) -------------- ---------------- Net cash (used) provided by financing activities (44,101) 103,846 -------------- ---------------- Net (decrease) increase in cash and cash equivalents (38,606) 145,123 Cash and cash equivalents, beginning of period 185,581 22,912 -------------- ---------------- Cash and cash equivalents, end of period $ 146,975 168,035 $ ============== ================ </TABLE> (THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS.) FEDERATED INVESTORS, INC. NOTES TO 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 generally accepted accounting principles. 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 will 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, 1998. Certain items previously reported have been reclassified to conform with the current year's presentation. (b) RECENT ACCOUNTING PRONOUNCEMENTS Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" (SFAS 133), requires that all derivatives, including hedges, be recorded at fair value and that all changes in the fair value or cash flow of both the hedge and the hedged item be recognized in earnings in the same period. SFAS 133 is effective for years beginning after June 15, 2000. Federated intends to adopt SFAS 133 effective January 1, 2001, and does not expect this adoption to have a significant effect on earnings or the financial position of Federated based on the current minimal use of derivatives. (2) Securitization of B Share Assets and Nonrecourse Debt Federated sells the rights to the future revenue streams associated with the 12b-1fees, shareholder service fees and contingent deferred sales charges (CDSCs) of the Class B Shares of various mutual funds it manages on a continuous basis. For accounting purposes, transactions executed under the agreement are reflected as financings and nonrecourse debt has been recorded at interest rates based on current market conditions at the time of the financings.
FEDERATED INVESTORS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued (UNAUDITED) (2) Securitization of B Share Assets and Nonrecourse Debt, Continued The following tables summarize the changes in both the deferred sales commissions and nonrecourse debt related to this agreement: Nine Months Ended September 30, 1999 -------------------- (IN THOUSANDS) Deferred B Share Sales Commissions: Financed balance at December 31, $ 249,580 1998 B Share sales commissions financed 91,081 CDSCs collected (27,298) Amortization (31,190) -------------------- Financed balance at September 30, $ 282,173 1999 ==================== Nonrecourse Debt: Balance at December 31, 1998 $ 272,850 Additional financings 93,309 Payments of nonrecourse debt (62,569) -------------------- Balance at September 30, 1999 $ 303,590 ==================== <TABLE> <CAPTION> Below is the activity of the nonrecourse debt tranches: (IN THOUSANDS) <S> <C> <C> <C> <C> <C> ---------------------------------------------------- Interest Balance Additional Balance Tranche Rate 12/31/98 Financings 9/30/99 Payments - ------------------------------- ------------- ----------- ---------- ---------- ---------- 1997-1 Class 7.44% $ 74,251 $ $ 16,293 $ 57,958 A....................................................... - 1997-1 Class 9.80% 9,700 9,700 B.................................................. - - Financings 10/97 through 6.68% - 188,899 93,309 46,276 235,932 9/99............................. 7.60% =========== ========== ========== ========== $ 272,850 $ 93,309 $ 62,569 $ 303,590 =========== ========== ========== ========== </TABLE> (3) Long-Term Debt - Recourse Federated's long-term debt - recourse consisted of the following: <TABLE> <CAPTION> <S> <C> <C> <C> Interest September 30, December 31, Rate 1999 1998 ----------- -------------- ------------- (IN THOUSANDS) Recourse Debt: Senior Secured Note Purchase 7.96% $ 98,000 $ 98,000 Agreement Capitalized leases 7.1%-8.5% 759 937 -------------- ------------- Total recourse debt 98,759 98,937 Less current portion 254 239 -------------- ============== ============= Total long-term debt - recourse $ 98,505 $ 98,698 ============== ============= </TABLE>
FEDERATED INVESTORS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued (UNAUDITED) (4) Common Stock (a) Dividends Federated'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 loss) of Federated less any stock repurchase payments 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 loss) of Federated during the period from January 1, 1996 to and including the date of payment. Cash dividends of $0.038, $0.042, and $0.042 per share or approximately $3.3 million, $3.6 million, and $3.6 million were paid in the first, second, and third quarters of 1999, respectively, to holders of common shares. Additionally, on October 19, 1999, the board of directors declared a dividend of $0.042 per share to be paid on November 15, 1999, to shareholders of record as of November 1, 1999. After the payment of the dividend on November 15, 1999, and stock repurchase payments through November 3, 1999, approximately $26.0 million is available to pay dividends under the more restrictive of the two debt covenant limitations. (b) Employee Stock Purchase Plan In July 1998, Federated established an Employee Stock Purchase Plan which allows employees to purchase a maximum of 500,000 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 September 30, 1999, 12,636 shares have been purchased by employees in this plan. (c) Stock Repurchase Program On January 26, 1999, the board of directors approved a share repurchase program authorizing Federated to purchase up to $20.0 million of Federated Class B common stock over the next 12 months in open market transactions. On July 20, 1999, a second share repurchase program was approved by the board of directors authorizing Federated to purchase an additional five million shares of Federated Class B common stock in open market and private transactions over the next 12 months. The programs authorize executive management to determine the timing and the amount of shares for each purchase. The stock will be held in treasury for employee benefit plans, potential acquisitions and other corporate activities. As of September 30, 1999, Federated had purchased 3,107,200 shares of Class B common stock for approximately $56.4 million. Of this amount, Federated has expended the total allowable amount under the first program of $20.0 million with the purchase of 1,184,653 shares of Class B common stock and has repurchased an additional 1,922,547 shares of Class B common stock for $36.4 million under the second program. From October 1, 1999, to November 3, 1999, an additional 151,900 shares of Class B common stock have been repurchased under the second program for $2.5 million.
FEDERATED INVESTORS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued (UNAUDITED) (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, ---------------------- ---------------------- 1999 1998 1999 1998 --------- --------- --------- --------- (IN THOUSANDS, EXCEPT PER SHARE DATA) Numerator: Net income $ 31,164 $ 23,610 $ 88,402 $ 65,519 ========= ========= ========= ========= Denominator: Basic weighted-average shares outstanding 83,069 85,183 84,156 83,850 Dilutive potential shares from stock-based 2,573 2,512 2,558 2,380 compensation --------- --------- --------- --------- Diluted weighted-average shares outstanding 85,642 87,695 86,714 86,230 ========= ========= ========= ========= Basic earnings per share $ 0.38 $ 0.28 $ 1.05 $ 0.78 ========= ========= ========= ========= Diluted earnings per share $ 0.36 $ 0.27 $ 1.02 $ 0.76 ========= ========= ========= ========= </TABLE> (6) Comprehensive Income Comprehensive income was $31.2 million and $23.7 million for the three-month periods ended September 30, 1999 and 1998, respectively, and $87.8 million and $65.6 million for the nine-month periods ended September 30, 1999 and 1998, respectively. Part I, Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations <TABLE> <CAPTION> HIGHLIGHTS SELECTED OPERATING DATA Three Months Ended Nine Months Ended (DOLLARS IN THOUSANDS, EXCEPT PER SHARE September 30, September 30, DATA) <S> <C> <C> <C> <C> --------------------------- -------------------------- 1999 1998 1999 1998 ----------- ----------- ---------- ---------- Revenue $ 152,197 $ 133,068 $ 443,643 $ 381,877 Operating expenses 92,346 85,576 273,274 251,316 ----------- ----------- ---------- ---------- Operating income 59,851 47,492 170,369 130,561 Nonoperating expenses and minority interest 10,681 9,454 31,283 26,575 ----------- ----------- ---------- ---------- Income before income taxes 49,170 38,038 139,086 103,986 Income tax provision 18,006 14,428 50,684 38,467 =========== =========== ========== ========== Net income $ 31,164 $ 23,610 $ 88,402 $ 65,519 =========== =========== ========== ========== Operating margin percentage 39.3% 35.7% 38.4% 34.2% Earnings per share - basic $ 0.38 $ 0.28 $ 1.05 $ 0.78 Earnings per share -diluted $ 0.36 $ 0.27 $ 1.02 $ 0.76 </TABLE> <TABLE> <CAPTION> MANAGED AND ADMINISTERED ASSETS AT PERIOD END (IN MILLIONS) September 30, % --------------------------- 1999 1998 Change ----------- ----------- -------- <S> <C> <C> <C> <C> <C> <C> Money market funds $ 77,006 $ 71,228 8.1% Equity funds 17,289 13,267 30.3% Fixed income funds 16,414 16,089 2.0% Separate accounts 4,504 2,323 93.9% =========== =========== Total Managed Assets $ 115,213 $ 102,907 12.0% =========== =========== Total Administered Assets $ 37,445 $ 54,574 -31.4% =========== =========== AVERAGE MANAGED AND ADMINISTERED ASSETS Three Months Ended Nine Months Ended (IN MILLIONS) September 30, % September 30, % --------------------------- -------------------------- 1999 1998 Change 1999 1998 Change ----------- ----------- -------- ---------- ---------- -------- Money market funds $ 77,748 $ 69,864 11.3% $ 78,526 $ 66,711 17.7% Equity funds 17,965 13,918 29.1% 17,052 13,560 25.8% Fixed income funds 16,669 15,931 4.6% 16,806 15,708 7.0% Separate accounts 4,511 2,300 96.1% 3,975 2,309 72.2% =========== =========== ========== ========== Total average Managed Assets $ 116,893 $ 102,013 14.6% $ 116,359 $ 98,288 18.4% =========== =========== ========== ========== Total average Administered $ 36,824 $ 54,772 -32.8% $ 33,616 $ 53,043 -36.6% Assets =========== =========== ========== ========== </TABLE> COMPONENTS OF CHANGES IN EQUITY AND FIXED INCOME FUND MANAGED ASSETS (IN MILLIONS) <TABLE> <CAPTION> Three Months Ended Nine Months Ended September 30, September 30, <S> <C> <C> <C> <C> --------------------------- --------------------------- EQUITY 1999 1998 1999 1998 - ------- FUNDS ---------- ----------- ----------- ---------- Beginning assets $ 18,199 $ 14,561 $ 15,503 $ 11,710 ---------- ----------- ----------- ---------- Sales 1,504 1,193 4,408 3,986 Redemptions (1,275) (932) (3,280) (2,274) ---------- ----------- ----------- ---------- 229 261 1,128 1,712 Net sales Net 17 0 96 (18) exchanges Other* (1,156) (1,555) 562 (137) ========== =========== =========== ========== Ending $ 17,289 $ 13,267 $ 17,289 $ 13,267 assets ========== =========== =========== ========== FIXED INCOME FUNDS Beginning assets $ 16,725 $ 15,816 $ 16,437 $ 15,067 ---------- ----------- ----------- ---------- Sales 1,282 1,525 4,703 4,506 Redemptions (1,456) (1,265) (4,411) (3,466) ---------- ----------- ----------- ---------- Net (174) 260 292 1,040 (redemptions)/sales Net 39 14 136 (243) exchanges Other* (176) (1) (451) 225 ========== =========== =========== ========== Ending $ 16,414 $ 16,089 $ 16,414 $ 16,089 assets ========== =========== =========== ========== </TABLE> * INCLUDES CHANGES IN THE MARKET VALUE OF SECURITIES HELD BY THE FUNDS, REINVESTED DIVIDENDS AND DISTRIBUTIONS, AND NET INVESTMENT INCOME. In preparing the discussion and analysis below, Federated has presumed that the readers of the interim financial information have read or have access to Federated's discussion and analysis of financial condition and results of operations contained in Federated's Annual Report on Form 10-K for the year ended December 31, 1998. RESULTS OF OPERATIONS - THREE MONTHS ENDED SEPTEMBER 30, 1999 COMPARED TO THE THREE MONTHS ENDED SEPTEMBER 30, 1998 NET INCOME. Net income for the three months ended September 30, 1999 was $31.2 million or $0.36 per diluted share as compared to $23.6 million or $0.27 per diluted share for the same period in 1998. This increase primarily reflects increased revenue generated from higher levels of average managed assets. REVENUE. Total revenue increased $19.1 million, or 14.4%, to $152.2 million for the third quarter 1999 from $133.1 million for the same period in 1998. Revenue from managed assets was $135.1 million for the third quarter 1999, an increase of $18.0 million, or 15.3%, over the third quarter 1998, due principally to the 14.6% increase in average managed assets. Revenue from managed assets increased at a higher rate than the rate of average managed asset growth due to the composition of assets. The increase in average managed assets from $102.0 billion for the third quarter 1998 to $116.9 billion for the third quarter 1999 included increases of 29.1%, 11.3%, 4.6%, and 96.1% in equity funds, money market funds, fixed income funds, and separate accounts, respectively, with equity funds earning the highest fees per invested dollar. The large percentage increase in separate
accounts is predominantly due to the assets associated with the newly formed joint venture in Germany and the collateralized bond obligation (CBO) transaction which Federated entered into in the second quarter 1999. Interest and dividends increased by $1.0 million or 37.9% over the prior year third quarter as a result of higher levels of invested cash resulting from cash generated from normal business activities. OPERATING EXPENSES. Total operating expenses were $92.3 million for the third quarter 1999 as compared to $85.6 million for the third quarter 1998, an increase of $6.7 million or 7.9%. More than 60% of the increase is attributable to increases in variable expenses due to continued sales and the resultant growth in assets under management. As a result, expense growth has been contained at levels substantially below the 14.4% increase in revenue and, accordingly, operating margins have improved to 39.3% for the quarter ended September 30, 1999 from 35.7% for the same period in 1998. Compensation and related expenses were $38.8 million for the third quarter 1999 as compared to $36.9 million for the same period in 1998. This increase of $1.9 million or 5.3% is due principally to salary increases for employees over the prior year and resulting increases in payroll taxes. Advertising and promotional expenses were $14.6 million for the third quarter 1999 as compared to $12.7 million for the same period in 1998. This increase of $1.9 million or 15.1% reflects higher levels of marketing allowances being paid to brokers and bank clients for retailing efforts of marketing funds. Systems and communications expenses were $7.0 million for the third quarter 1999 as compared to $6.3 million for the same period in 1998. This increase of $0.7 million or 10.4% is largely attributable to increased costs to third-party system vendors in 1999. Amortization of deferred sales commissions was $12.5 million for the third quarter 1999 as compared to $8.2 million for the same period in 1998. This increase of $4.3 million or 51.5% is due to higher levels of deferred sales commissions as a result of the continued sale of shares of funds which require Federated to advance commissions to the broker / dealers. Amortization of intangible assets was $1.7 million for the third quarter 1999 as compared to $3.8 million for the same period in 1998. This decrease of $2.1 million or 55.8% is the result of certain intangible assets reaching the end of their amortization schedules in the second quarter 1999. Other expenses were $2.4 million for the third quarter 1999 as compared to $1.9 million for the third quarter 1998. This increase of $0.5 million or 28.6% is predominantly attributable to the reduction of bad debt expense in the third quarter of 1998 as a result of improved collection of accounts receivable. NONOPERATING EXPENSES. Nonoperating expenses were $8.1 million for the third quarter 1999 as compared to $7.2 million for the same period of 1998. This increase of $0.9 million or 12.8% reflects an increase in interest expense recognized relative to the higher level of nonrecourse debt incurred as a result of the continued sales of certain B Share related future cash flows accounted for as financings. INCOME TAXES. The income tax provision for the third quarter 1999 was $18.0 million as compared to $14.4 million for the third quarter 1998. This increase of $3.6 million or 24.8% is due primarily to the increase in the level of income before income taxes from $38.0 million for the third quarter 1998 to $49.2 million for the third quarter 1999, an increase of $11.2 million or 29.3%. The effective tax rate for the third quarter 1999 and 1998 was 36.6% and 37.9%, respectively. RESULTS OF OPERATIONS - NINE MONTHS ENDED SEPTEMBER 30, 1999 COMPARED TO THE NINE MONTHS ENDED SEPTEMBER 30, 1998 NET INCOME for the first nine months of 1999 was $88.4 million or $1.02 per diluted share compared with net income of $65.5 million or $0.76 per diluted share for the same period in 1998. The increase primarily reflects increased revenues generated from higher levels of average managed assets and a non-recurring $1.9 million after-tax gain recorded on the 1999 sale of certain non-earning assets. Excluding the effect of this gain, Federated would have realized net income of $86.5 million, or $1.00 per diluted share, for the first nine months of 1999. REVENUE. Total revenue increased by $61.7 million or 16.2% to $443.6 million in the first nine months of 1999 from $381.9 million in the first nine months of 1998. Approximately $58.9 million or 95.3% of the increase in total revenue is due to increased average managed assets. Average managed assets increased $18.1 billion or 18.4% from $98.3 billion for the first nine months of 1998 to $116.4 billion for the same period in 1999, including increases of 25.8%, 17.7%, 7.0%, and 72.2% in equity funds, money market funds, fixed income funds, and separate accounts, respectively. The large percentage increase in separate accounts is predominantly due to the assets associated with the newly formed joint venture in Germany and the CBO transaction which Federated entered into in 1999. Service related revenues from sources other than managed assets decreased by approximately $2.8 million due primarily to a decrease in average administered assets. Average administered assets decreased $19.4 billion or 36.6% from $53.0 billion for the first nine months of 1998 to $33.6 billion for the same period in 1999, resulting from the termination of service contracts in the fourth quarter 1998. Interest and dividends increased by $3.9 million as a result of higher levels of invested cash from cash generated from normal business activities and the net proceeds from the initial public offering. Other income improved $0.8 million and in the first nine months of 1999 included a non-recurring $3.0 million gain from the sale of certain non-earning assets while in the first nine months of 1998 included $2.5 million of income from a servicing contract buyout of a bank-sponsored mutual fund complex. OPERATING EXPENSES. Total operating expenses increased to $273.3 million for the nine month period ended September 30, 1999 from $251.3 million for the same period in 1998, an increase of $22.0 million or 8.7%. More than 50% of the increase is attributable to increases in variable expenses due to continued sales and the resultant growth in assets under management. As a result, expense growth has been contained at levels substantially below the 16.2% increase in revenue and, accordingly, operating margins have improved to 38.4% for the first nine months of 1999 from 34.2% for the same period in 1998. Compensation and related expenses were $116.7 million for the first nine months of 1999 as compared to $111.7 million for the same period in 1998. This increase of $5.0 million or 4.6% is mainly attributable to an increase in employee salaries over the prior year and resultant increases in payroll taxes. Advertising and promotional expenses were $40.2 million for the first nine months of 1999 as compared to $33.6 million for the same period in 1998. This increase of $6.6 million or 19.5% is primarily the result of higher levels of marketing allowances being paid to brokers and bank clients for retailing efforts of marketing funds. Systems and communications expenses were $20.8 million for the first nine months of 1999 as compared to $19.4 million for the same period in 1998. This increase of $1.4 million or 7.1% is primarily due to new computer hardware leasing agreements and increased costs to third-party system vendors in 1999. Office and occupancy expenses were $19.0 million for the first nine months of 1999 as compared to $20.6 million for the first nine months of 1998. This decrease of $1.6 million or 7.7% is primarily attributable to reduced rent expense for leased office space as a result of the consolidation of certain servicing functions and the reduction in leased office space in late 1998. Professional service fees expenses were $18.5 million for the first nine months of 1999 as compared to $14.7 million for the same period in 1998. The increase of $3.8 million or 25.3% is largely the result of increased service fees related to subcontracted portfolio accounting services, as well as increased legal and consulting fees related to the German joint venture, Year 2000, and other system related projects. Amortization of deferred sales commissions was $34.3 million for the first nine months of 1999 as compared to $22.9 million for the same period in 1998. This increase of $11.4 million or 49.8% is due to higher levels of deferred sales commissions as a result of the continued sale of shares of funds which require Federated to advance commissions to the broker / dealers. Amortization of intangible assets was $8.7 million for the first nine months of 1999 as compared to $11.3 million for the same period in 1998. This decrease of $2.6 million or 22.9% is the result of certain intangible assets reaching the end of their amortization schedules in the second quarter 1999. Other expenses were $4.4 million for the first nine months of 1999 as compared to $7.2 million for the first nine months of 1998. This decrease of $2.8 million or 39.2% is primarily attributable to the rebate of certain non-income related taxes and a reduction in processing errors. NONOPERATING EXPENSES. Nonoperating expenses were $23.7 million for the first nine months of 1999 as compared to $20.1 million for the same period in 1998. This increase of $3.6 million or 17.7% is primarily due to increased interest expense attributable to higher average nonrecourse debt levels incurred for the securitization of certain B Share fund assets. MINORITY INTEREST. The minority interest increased to $7.6 million for the first nine months of 1999 from $6.5 million for the same period in 1998 as a result of higher net income for the subsidiary for which Federated 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 advised by the subsidiary. INCOME TAXES. The income tax provision for the nine month period ended September 30, 1999 was $50.7 million as compared to $38.5 million for the same period in 1998. This increase of $12.2 million or 31.8% is due primarily to the 33.8% increase in the level of income before income taxes from $104.0 million for the nine months ended September 30, 1998 to $139.1 million for the nine months ended September 30, 1999. The effective tax rate for the nine month periods ended September 30, 1999 and 1998, were 36.4% and 37.0%, respectively. CAPITAL RESOURCES AND LIQUIDITY CASH FLOW. Cash provided by operating activities totaled $82.8 million for the first nine months of 1999 as compared to $42.5 million for the first nine months of 1998. The increase is largely attributable to increased profitability. Cash flows from operating activities for the first nine months of 1999 were primarily utilized for purchases of securities available for sale, the purchase of treasury stock, purchases of property and equipment, dividend payments as well as distributions to the minority interest. Purchases of securities available for sale in the first nine months of 1999 included Federated's $11.0 million investment in subordinated notes of the CBO. Federated purchased the subordinated notes, which are classified as "Other long-term assets" in the Consolidated Balance Sheets, in the second quarter of 1999. DEFERRED SALES COMMISSIONS AND NONRECOURSE DEBT. Certain subsidiaries of Federated pay commissions to broker / dealers (deferred sales commissions) to promote investments in certain mutual funds. For mutual fund shares sold under such marketing programs, Federated retains certain distribution and servicing fees from the mutual fund over the outstanding life of such shares, subject to certain limitations. These fees consist of 12b-1 fees, shareholder service fees and contingent deferred sales charges (CDSCs). Both 12b-1 and shareholder service fees are calculated as a percentage of average 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 Federated a CDSC based on a percentage of the lower of the current market value or the original cost basis of the redeemed shares. Such percentage diminishes over a recovery schedule not to exceed six years. For non-B Share-related sales, the up-front commissions Federated pays to broker / dealers are capitalized, recorded as deferred sales commissions and amortized over the estimated benefit period not to exceed CDSC periods. The 12b-1 and shareholder service fees are recognized in the statements of income over the life of the mutual fund class share, subject to certain limitations. Any CDSCs collected are used to reduce the deferred sales commission asset. For B Share-related sales, Federated has agreed to sell, on a regular basis over a three-year contract period terminating in the fourth quarter of 2000, the rights associated with certain of the future fee revenue associated with the deferred sales commissions. For accounting purposes, the sales of the future cash flow rights are accounted for as financings and nonrecourse debt is recorded.
The following table demonstrates the effects of the B Share financing program on both the Consolidated Balance Sheets at September 30, 1999 and December 31, 1998, and the Consolidated Statements of Income for the three and nine-month periods ended September 30, 1999 and 1998: (IN THOUSANDS) 1999 1998 - ------------------------------------------------------------------------------ SEPTEMBER 30 AND DECEMBER 31, RESPECTIVELY Assets Deferred sales commissions, net* $ 282,173 $ 249,580 Receivables 7,394 6,314 Other long-term assets 2,248 2,798 Liabilities Long-term debt - nonrecourse $ 303,590 $ 272,850 Accounts payable 5,271 3,951 THREE MONTHS ENDED SEPTEMBER 30 Revenues Other service fees, net - Federated $ 18,591 $ 13,697 funds Expenses Amortization of deferred sales $ 11,272 $ 7,370 commissions Debt expense - nonrecourse 5,881 4,967 Other expenses 147 172 NINE MONTHS ENDED SEPTEMBER 30 Revenues Other service fees, net - Federated $ 52,735 $ 37,761 funds Expenses Amortization of deferred sales $ 31,189 $ 20,679 commissions Debt expense - nonrecourse 17,012 13,462 Other expenses 449 598 * EXCLUDES DEFERRED SALES COMMISSIONS RELATED TO B SHARE REVENUE STREAMS WHICH HAVE NOT BEEN FINANCED AS OF THE END OF THE PERIOD DUE TO THE TIMING OF THE SALE OF THE REVENUE STREAMS TO THE THIRD PARTY. Due to the nonrecourse nature of this financing arrangement, the $17.0 million excess of B Share-related liabilities over the related assets at September 30, 1999, will be recognized in income over the remaining life of the B Share cash flows. CAPITAL EXPENDITURES. Capital expenditures totaled $1.6 million and $15.6 million for the third quarter and first nine months of 1999, respectively, which excludes Year 2000-related project costs described below. DIVIDENDS. Federated's board of directors adopted a policy in 1998 to declare and pay cash dividends on a quarterly basis. A dividend of $0.042 per share was paid in the third quarter of 1999. On October 19, 1999, Federated's board of directors declared a dividend of $0.042 per share to be paid on November 15, 1999 to registered shareholders as of November 1, 1999. After the payment of the dividend on November 15, 1999, and stock repurchase payments through November 3, 1999, given current debt covenants, Federated has the ability to pay dividends of approximately $26.0 million. DEBT FACILITIES. Federated has the following recourse debt facilities: Senior Secured Credit Agreement and Senior Secured Note Purchase Agreement. SENIOR SECURED CREDIT AGREEMENT: At September 30, 1999, the outstanding balance under the Senior Secured Credit Agreement was zero with an amount available to borrow of $150.0 million. The Senior Secured Credit Agreement contains various financial and other covenants. Federated was in compliance with all debt covenants at September 30, 1999. SENIOR SECURED NOTE PURCHASE AGREEMENT: The Senior Secured Note Purchase Agreement debt totaled $98.0 million as of September 30, 1999. The notes are due in seven annual $14.0 million installments beginning September 27, 2000, and maturing September 27, 2006. Federated was in compliance with all debt covenants at September 30, 1999. CAPITALIZED LEASE OBLIGATIONS. At September 30, 1999, Federated had capitalized lease obligations totaling $0.8 million related to certain telephone equipment. The scheduled principal payments approximate $0.2 million per year for 1999 through 2002. SHAREHOLDERS' EQUITY. In May 1998, Federated Investors was merged with and into Federated Investors, Inc., 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 Federated Investors, Inc., 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 Federated Investors, Inc. based on their relative proportionate values immediately prior to the merger. Also in May 1998, Federated issued an additional 2,610,000 shares of Class B Common Stock in an initial public offering for net proceeds of approximately $46.2 million in cash. FUTURE CASH REQUIREMENTS. Management expects that the principal needs for cash will be to repurchase company stock, pay shareholder dividends, advance sales commissions, service debt and fund strategic business acquisitions. Management believes that Federated's existing liquid assets, together with the expected continuing cash flow from operations, its borrowing capacity under current credit facilities, its B Share financing arrangement and its ability to issue stock will be sufficient to meet its present and reasonably foreseeable cash needs. YEAR 2000 READINESS 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," or "Y2K" problem. Also, the occurrence of such problems may take place before the year 2000 if a computer system utilizes future dates during its processing. STATE OF READINESS: Computer processing is critical to Federated's business operations, and the Y2K issue poses a significant potential risk to operations. Therefore, Federated 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 Federated'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 Federated's computing environment as follows: o systems developed internally by Federated's IT division - this constitutes the majority of Federated's Y2K efforts; o mission-critical processing provided by the Federated mutual funds' service providers; o other critical aspects of systems and operations within the business units, including both commercially available computer applications and the progress of key business partners; and o embedded systems - for Federated's operations, embedded systems mainly consist of building systems and office equipment. As of September 30, 1999, Federated has completed all four phases identified above for all internally supported applications. In addition, the testing phase has consisted of several levels of testing, as appropriate for each application. Test levels have included: tests of individual system components, overall system testing, and tests of interfaces between systems. Testing was conducted using year 2000 dates in a dedicated, Y2K compliant environment. Work to be completed during the fourth quarter includes finalizing the upgrade or retirement of certain system infrastructure components and continuing to apply vendor-provided product upgrades, as they become available. Management is closely tracking our progress towards completion of the remaining work. Certain mission-critical processing is performed for Federated's mutual funds by outside service providers, including the transfer agency, portfolio accounting, and custody functions. Federated has identified these service providers, monitored the progress of these companies in addressing Y2K issues via progress reports and meetings, and worked with these service providers to test their systems, where appropriate. As of September 30, 1999, the critical service providers have reported completion of renovation and testing for their critical systems. Further, Federated has completed Y2K acceptance testing and interface testing with these firms. For business unit operations, Y2K-related upgrades for vendor-provided software are essentially complete. Federated has also received Y2K readiness assurances from critical business partners and the property managers for Federated's facilities. Additionally, Federated participated in the "industry-wide testing" coordinated by the Securities Industry Association. This testing was conducted to ensure that major broker / dealers, exchanges, clearing houses, and depositories will be able to communicate properly in the year 2000. Federated participated in initial tests for processing of mutual fund transactions in both July and October 1998. Federated also participated in the full industry-wide test conducted in March / April 1999 and encountered no Y2K-related errors. COSTS TO ADDRESS Y2K: Federated estimates its Y2K project will cost approximately $10 million. Federated has incurred approximately $9.4 million from the inception of the Y2K project through September 30, 1999, with $4.2 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 Federated'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 YEAR 2000 ISSUES: It must be realized that, as with all other companies in the financial services industry, many day-to-day functions of Federated are dependent on accurate computer processing. Further, this processing is conducted by an extensive network of systems, both internal to Federated and external, with both direct and indirect interaction. Accordingly, if not addressed, Y2K issues could result in Federated's inability to perform mission-critical functions, including the trading of securities and processing of mutual fund shareowner transactions. However, it deserves mention that, due to the extensive efforts of Federated and the financial services industry, in general, we believe the risks associated with Y2K have been greatly mitigated. A portion of Federated's business involves international investments, thereby exposing Federated to operations, custody and settlement processes outside the United States. Federated is monitoring the progress of the mutual funds' international custodians in these areas. Federated is also assessing Y2K issues for other aspects of its international operations. Y2K is a risk for many of the issuers of the specific securities in which Federated's mutual funds invest, in both the U.S. and international markets. Accordingly, Federated has incorporated assessment of Y2K risk into its investment management process. CONTINGENCY PLANS: Despite the extensive preparations of Federated and its industry, in general, disruptions at year end remain a possibility. These could occur due to internal factors or external systems and entities upon which the company relies. Federated interacts with many external entities and, like all firms, relies upon public utilities for electric, heat, water, and other services. To address the possibility of disruptions, Federated will closely manage the period surrounding the century rollover. Plans are in place to closely monitor and validate our systems at that time, have key personnel available to address any issues that arise, and be in communication with external parties, such as industry associations, regulators, and key business partners. In addition to those efforts, the company is preparing Y2K contingency plans. These plans detail the procedures and resources the company would implement to react to Y2K-related interruptions to our critical business functions. The functions for which plans are being created include portfolio management, transaction processing , shareowner servicing, and other critical business functions. However, in an operation as complex and geographically distributed as Federated's business, there are limited alternatives to certain of its mission-critical systems or public utilities. If certain mission-critical systems or public utilities are not made Year 2000 compliant or fail, there would be a material adverse impact upon Federated's business, financial condition and results of operations. Although Federated is investigating alternative solutions, it is unlikely that an adequate contingency plan can be developed to avoid such an adverse impact in the event mission-critical systems or public utilities fail to achieve compliance. SPECIAL NOTE REGARDING FORWARD-LOOKING INFORMATION. Certain statements under "Management's Discussion and Analysis of Financial Condition and Results of Operations" included in the Future Cash Requirements and Year 2000 Readiness Disclosure sections 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 Federated, 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, 1998, and other reports 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, performance, or achievements, and neither Federated 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 Federated's investments are primarily in money market and fixed income funds. Occasionally, Federated invests in new fluctuating net asset value mutual funds (performance seed) sponsored by Federated in order to provide investable cash to the fund, allowing the fund to establish a performance history. Federated may use derivative financial instruments in an attempt to hedge these investments. As of September 30, 1999, the book value of the performance seed investments and the derivative financial instruments were $16.5 million and $0.4 million, respectively. In the second quarter of 1999, Federated became the collateral manager of an approximately $361.0 million CBO consisting of high yield debt securities. At the same time, Federated purchased $11.0 million of the related subordinated notes due 2011. Payments of interest and principal on the subordinated notes will be subordinated to interest and principal payments on senior and mezzanine notes issued by the CBO as well as costs incurred by the CBO. All of Federated's debt instruments carry fixed interest rates and therefore are not subject to market risk. 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 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 10, 1999 By: /S/ J. CHRISTOPHER DONAHUE ------------------------------ --------------------------------- J. Christopher Donahue President and Chief Executive Officer Date NOVEMBER 10, 1999 By: /S/ THOMAS R. DONAHUE ------------------------------ -------------------------------- Thomas R. Donahue Chief Financial Officer and Principal Accounting Officer