UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
For the quarterly period ended September 30, 2005
OR
For the transition period from to
Commission File Number 001-14818
Federated Investors, Inc.
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(IRS Employer
Identification No.)
(Registrant’s telephone number, including area code) 412-288-1900
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨.
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No ¨.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.): Yes ¨ No x.
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the last practicable date: As of October 26, 2005, the Registrant had outstanding 9,000 shares of Class A Common Stock and 107,178,148 shares of Class B Common Stock.
Table of Contents
Special Note Regarding Forward-Looking Information
Certain statements in this report, including those related to the need to make additional contingent payments pursuant to acquisition agreements; the costs associated with the internal review of mutual fund trading activities and other regulatory inquiries; legal proceedings; future cash needs; accounting for intangible assets, loss contingencies and income taxes; market risk to investments and revenue; the impact of increased regulation; and the effect of rising interest rates on money market products and other short-term duration fixed-income products 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 Investors, Inc. (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. Among other risks and uncertainties, the costs associated with the internal review of mutual fund trading activities, other regulatory inquiries, legal proceedings and future cash needs will be impacted by any additional information requests from or fines or penalties paid to governmental agencies; the cost associated with private litigation; insurance costs; and the costs to implement regulatory changes. The accounting for intangible assets and loss contingencies is based upon estimates and will be affected if actual results differ significantly. The accounting for income taxes will be affected by the ability to utilize capital loss carry forwards; investments will be impacted by fluctuations in the securities markets; and revenue will be affected by changes in market values of assets under management and the impact of rising interest rates on money market and fixed-income funds. Certain of these factors may be more likely to occur as a result of the ongoing threat of terrorism and the ongoing investigation into the mutual fund industry by federal and state regulators. As a result, 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 in the future. 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, 2004, and other reports on file with the Securities and Exchange Commission.
Part I, Item 1. Financial Statements
Consolidated Balance Sheets
(dollars in thousands)
(unaudited)
Current Assets
Cash and cash equivalents
Restricted cash equivalents
Marketable securities
Receivables – affiliates
Receivables – other, net of reserve of $84 and $52, respectively
Accrued revenue – affiliates
Accrued revenue – other
Current deferred tax asset, net
Prepaid expenses
Other current assets
Total current assets
Long-Term Assets
Goodwill
Intangible assets, net
Deferred sales commissions, net of accumulated amortization of $277,438 and $298,033, respectively
Property and equipment, net of accumulated depreciation of $32,065 and $31,402, respectively
Other long-term assets
Total long-term assets
Total assets
Current Liabilities
Cash overdraft
Current portion of long-term debt – nonrecourse
Accrued compensation and benefits
Accounts payable and accrued expenses – affiliates
Accounts payable and accrued expenses – other
Income taxes payable
Other current liabilities – affiliates
Other current liabilities – other
Total current liabilities
Long-Term Liabilities
Long-term debt – nonrecourse
Long-term deferred tax liability, net
Other long-term liabilities – affiliates
Other long-term liabilities – other
Total long-term liabilities
Total liabilities
Shareholders’ Equity
Common stock:
Class A, no par value, 20,000 shares authorized, 9,000 shares issued and outstanding
Class B, no par value, 900,000,000 shares authorized, 129,505,456 shares issued
Additional paid-in capital from treasury stock transactions
Retained earnings
Treasury stock, at cost, 22,325,308 and 22,505,641 shares Class B common stock, respectively
Employee restricted stock awards
Accumulated other comprehensive income, net of tax
Total shareholders’ equity
Total liabilities, minority interest, and shareholders’ equity
(The accompanying notes are an integral part of these Consolidated Financial Statements.)
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Consolidated Statements of Income
(dollars in thousands, except per share data)
Three Months Ended
September 30,
Nine Months Ended
Revenue
Investment advisory fees, net-affiliates
Investment advisory fees, net-other
Administrative service fees, net-affiliates
Administrative service fees, net-other
Other service fees, net-affiliates
Other service fees, net-other
Other, net
Total revenue
Operating Expenses
Marketing and distribution
Compensation and related
Advertising and promotional
Systems and communications
Office and occupancy
Travel and related
Professional service fees
Amortization of deferred sales commissions
Amortization of intangible assets
Other
Total operating expenses
Nonoperating Income (Expenses)
Interest and dividends
Gain (loss) on securities, net
Debt expense – recourse
Debt expense – nonrecourse
Total nonoperating expenses, net
Net income
Earnings per share – Basic
Income from continuing operations
(Loss) income from discontinued operations
Earnings per share – Diluted
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Consolidated Statements of Cash Flows
Nine Months Ended September 30,
Operating Activities
Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities:
Depreciation and other amortization
Minority interest
Loss (gain) on disposal of assets
Provision for deferred income taxes
Tax benefit from stock-based compensation
Deferred sales commissions paid
Net payments for trading securities
Contingent deferred sales charges received
Other changes in assets and liabilities:
(Increase) decrease in receivables, net
Increase in other assets
Increase (decrease) in accounts payable and accrued expenses
Decrease in income taxes payable
(Decrease) increase in other current liabilities
(Decrease) increase in other long-term liabilities
Net cash provided by operating activities
Investing Activities
Additions to property and equipment
Net proceeds from disposal of business, property, equipment and other assets
Cash paid for business acquisitions
Purchases of securities available for sale
Proceeds from redemptions of securities available for sale
Increase in restricted cash equivalents
Net cash used by investing activities
Financing Activities
Distributions to minority interest
Dividends paid
Proceeds from shareholders for stock-based compensation and other
Purchases of treasury stock
Proceeds from new borrowings – nonrecourse
Payments on debt – nonrecourse
Payments on debt – recourse
Payments on acquired customer relationship obligation
Net cash used by financing activities
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Notes to the Consolidated Financial Statements
(Unaudited)
(1) Summary of Significant Accounting Policies
(a) Basis of Presentation
The interim consolidated financial statements of Federated Investors, Inc. (Federated) included herein have been prepared in accordance with U.S. generally accepted accounting principles. In the opinion of management, the financial statements reflect all adjustments that are of a normal recurring nature and necessary for a fair presentation of the results for the interim periods presented.
In preparing the financial statements, management is required to make estimates and assumptions that affect the amounts reported in the Consolidated Financial Statements and accompanying notes. Actual results may differ from such estimates, and such differences may be material to the Consolidated 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, 2004. Certain items previously reported have been reclassified to conform with the current year presentation.
(b) Restricted Cash Equivalents
Restricted cash equivalents represent an investment in a third-party sponsored money market account held in escrow as required by an agreement with certain Federated-sponsored mutual funds. The restricted cash equivalents represent a return of shareholder service fees to various Federated-sponsored mutual funds resulting from an administrative delay in the implementation of contractual terms. The restricted cash equivalents are being distributed to various mutual funds over a period not to exceed 18 months, ending in January 2007 in accordance with a payment schedule established by the independent boards of directors/trustees of the mutual funds. The offsetting obligation to the mutual funds is primarily recorded as a current liability in “Accounts payable and accrued expenses – affiliates” (see Note (12)). All interest earned on the escrow account is payable to the mutual funds.
(c) Deferred Sales Commissions and Nonrecourse Debt
Federated pays upfront commissions to broker/dealers to promote the sale of certain mutual fund shares. Under various fund-related contracts, Federated is entitled to distribution and servicing fees from the mutual fund over the life of such shares. Both of these fees are calculated as a percentage of average managed assets associated with the related classes of shares. For these share classes, Federated is also entitled to receive a contingent deferred sales charge (CDSC), which is collected from certain redeeming shareholders.
For share classes that offer both a distribution fee and CDSC, excluding B-shares, Federated capitalizes all or a portion of the upfront commissions as deferred sales commissions, dependent upon expected recoverability rates. The deferred sales commission asset is amortized over the estimated period of benefit ranging from one to four years. The distribution and servicing fees are recognized in the Consolidated Statements of Income over the life of the mutual fund share class. CDSCs collected on these share classes are used to reduce the deferred sales commission asset.
For share classes that do not offer both a distribution fee and CDSC, Federated expenses the cost of the upfront commission in “Marketing and distribution” expense in the Consolidated Statements of Income as it is incurred and credits “Marketing and distribution” expense for any CDSCs collected.
Funding of the payments made by Federated of upfront commissions paid upon the sale of Class B shares of Federated-sponsored mutual funds is made through arrangements with independent third parties by selling the rights to all related future distribution fees, servicing fees and CDSCs. For financial reporting purposes, these arrangements are treated as financings. As a result, Federated capitalizes all of the upfront commissions as deferred sales commissions and recognizes B-share-related distribution fees and servicing fees in the Consolidated Statements of Income even though legal title to these fees has been transferred to the third party. In addition, Federated records nonrecourse debt equal to the proceeds received on the sale of future revenue streams. The debt does not contain a contractual maturity or stated interest rate. Interest rates are imputed based on current market conditions at the time of issuance. The deferred sales commission asset and nonrecourse debt balances are amortized over the estimated life of the B-share fund asset dependent upon the level and timing of cash flows from the sold future revenue streams, not to exceed eight years.
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Notes to the Consolidated Financial Statements (continued)
CDSCs collected on the B-share fund assets are used to reduce the deferred sales commission asset. Management accelerates the write-off of these asset and debt balances when reasonably estimable future cash flows indicate that cash flows will not be sufficient to fully amortize the remaining deferred sales commission asset and nonrecourse debt balances.
(d) Revenue Recognition
Revenue from providing investment advisory, administrative and other services (including distribution, shareholder servicing, clearing and recordkeeping) is recognized during the period in which the services are performed. Investment advisory, administrative and the majority of other service fees are based principally on the net asset value of the investment portfolios that are managed or administered by Federated. Federated may waive certain fees for competitive reasons or to meet regulatory or contractual requirements.
Federated has contractual arrangements with third parties to provide certain fund-related services. Management considers various factors to determine whether Federated’s revenue should be recorded based on the gross amount payable by the funds or net of payments to third-party service providers. Management’s analysis is based on whether Federated is acting as the principal service provider or is performing as an agent. The primary factors considered include: (1) whether the customer holds Federated or the service provider responsible for the fulfillment and acceptability of the services to be provided; (2) whether Federated has any practical latitude in negotiating the price to pay a third-party provider; (3) whether Federated or the customer selects the ultimate service provider; and (4) whether Federated has credit risk in the arrangement. Generally, the less the customer is directly involved with or participates in making decisions regarding the ultimate third-party service provider, the more supportive the facts are that Federated is acting as the principal in these transactions and should therefore report gross revenues. As a result of considering these factors, investment advisory fees, administrative service fees, distribution fees and certain other service fees are recorded gross of payments made to third parties. By contrast, management determined that in the case of shareholder services Federated acts as an agent; thus Federated records shareholder service fees net of certain third-party payments. Management reached this conclusion based largely on the fact that given the personalized nature of shareholder services, the customer, in this case the shareholder, has a direct relationship with their financial intermediary for the provision of shareholder services. Third-party payments for shareholder services recorded as an offset to revenue for the three- and nine-month periods ended September 30, 2005 were $55.0 million and $143.5 million, respectively, as compared to $40.5 million and $125.0 million, respectively, for the same periods ended September 30, 2004.
(e) Employee Stock-Based Compensation
Federated uses the fair-value-based method of accounting for stock-based awards under the provisions of Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure” (SFAS 123) for all awards granted, modified or settled in 2003 or later. Accordingly, Federated recognizes the estimated fair value of the stock-based awards as compensation expense on a straight-line or modified straight-line basis over the awards’ vesting periods, which vary in length from zero to ten years. For all employee-related stock option awards granted prior to 2003 with no subsequent modifications, Federated continues to apply the intrinsic-value method prescribed by Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” (APB 25) and related interpretations. Under APB 25, compensation expense is not recognized for stock option awards granted with an exercise price equal to or greater than the market value of Federated’s Class B common stock on the date of grant.
With respect to restricted stock awards, the fair value of the award (the difference between the market value of Federated’s Class B common stock on the date of grant and the purchase price paid by the employee) is charged to “Employee restricted stock awards” on the Consolidated Balance Sheets when the restricted stock is awarded and recognized as compensation expense on a straight-line or modified straight-line basis over the period of employee performance during which the awards vest, which ranges from three to ten years.
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Had compensation costs for all stock options and employee restricted stock been determined based upon fair values at the grant dates in accordance with SFAS 123, Federated would have experienced net income and earnings per share similar to the pro forma amounts indicated below for the three- and nine-month periods ended September 30, 2005 and 2004. As allowed by SFAS 123, Federated calculates compensation as if all instruments granted are expected to vest and recognizes the effect of actual forfeitures as they occur.
(in thousands, except per share data)
Add back: Stock-based employee compensation expense included in reported net income, net of related tax effects
Deduct: Total stock-based employee compensation expense determined under fair-value-based method for all awards1, net of related tax effects
Pro forma net income
Earnings per share:
Basic earnings per share
Pro forma basic earnings per share
Diluted earnings per share
Pro forma diluted earnings per share
(f) Marketable Securities
Marketable securities include available-for-sale and trading securities held by Federated. Federated’s available-for-sale securities are classified as current or long-term assets and are included in “Marketable securities” or “Other long-term assets,” respectively, on the Consolidated Balance Sheets based on management’s intention to sell the investment. At September 30, 2005 and December 31, 2004, Federated did not hold any available-for-sale securities that were classified as long-term assets. Federated’s trading securities held at September 30, 2005 and December 31, 2004, are classified as current and are included in “Marketable securities” on the Consolidated Balance Sheets. For more details regarding Federated’s policy for marketable securities, see Note (1)(g) to the Consolidated Financial Statements for the year ended December 31, 2004, included in Federated’s Annual Report on Form 10-K.
(g) Intangible Assets
Intangible assets, consisting primarily of goodwill, investment advisory contracts and noncompete agreements acquired in connection with various acquisitions, are recorded at fair value determined using a discounted cash flow model as of the date of acquisition. The discounted cash flow model considers various factors to project the present value of future cash flows expected to be generated from the asset. Given the investment advisory nature of Federated’s business and of the businesses acquired over the years, these factors typically include: (1) an estimated rate of change for underlying managed assets; (2) expected revenue per managed asset; (3) incremental operating expenses; (4) useful life of the acquired asset; and (5) a discount rate. Management estimates a rate of change for underlying managed assets based on a combination of an estimated rate of market appreciation or depreciation and an estimated net redemption or sales rate. Expected revenue per managed asset, incremental operating expenses and the useful life of the acquired asset are generally based on contract terms and historical experience. The discount rate is equal to Federated’s weighted-average cost of capital. After the fair value of all separately identifiable assets has been estimated, the cost of the acquisition in excess of the sum of the fair values of these assets is allocated to goodwill.
In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” Federated no longer amortizes goodwill but rather tests it for impairment at least annually or when indicators of potential impairment exist. Federated uses a two-step process to test for and measure impairment that begins with an estimation of the fair value of its reporting unit. This first step is a screen for potential impairment, and if impairment has occurred, the second step measures the amount of impairment.
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Federated amortizes separately identifiable intangible assets using a method that reflects the pattern in which the economic benefits of the intangible asset are consumed or otherwise used up. Federated uses either the straight-line or an accelerated method of amortization after considering specific characteristics of the underlying fund shareholder base to forecast the pattern in which the economic benefits will be consumed, including fund shareholder behavior, demographics and persistency levels. The assets are amortized over their estimated useful lives, which range from five to fourteen years. Management periodically evaluates the remaining useful lives and carrying values of the intangible assets to determine whether events and circumstances indicate that a change in the useful life or impairment in value may have occurred. Indicators of impairment monitored by management include a decline in the level of managed assets, changes to contractual provisions underlying certain intangible assets and reductions in operating cash flows. Should there be an indication of a change in the useful life or impairment in value, Federated compares the carrying value of the asset and its related useful life to the projected undiscounted cash flows expected to be generated from the underlying asset over its remaining useful life to determine whether impairment has occurred. If the carrying value of the asset exceeds the undiscounted cash flows, the asset is written down to its fair value determined using discounted cash flows. Federated writes off the cost and accumulated amortization balances for all fully amortized intangible assets.
(h) Loss Contingencies
In accordance with SFAS 5, “Accounting for Contingencies,” Federated accrues for estimated costs related to existing lawsuits, claims and proceedings when it is probable that a liability has been incurred and the costs can be reasonably estimated. Accruals are reviewed at least quarterly and are adjusted to reflect the impact and status of settlements, rulings, advice of counsel and other information pertinent to a particular matter. Significant differences could exist between the actual cost required to investigate, litigate and/or settle a claim or the ultimate outcome of a suit and management’s estimate. These differences could have a material impact on Federated’s results of operations, financial position or cash flows. Recoveries of losses are recognized in the Consolidated Statements of Income when receipt is deemed probable.
(i) Recent Accounting Pronouncements
SFAS 123(R) – In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS 123 (revised 2004), “Share-Based Payment,” which is a revision of SFAS 123, “Accounting for Stock-Based Compensation” (SFAS 123(R)). SFAS 123(R) supersedes APB 25, and amends SFAS 95, “Statement of Cash Flows.” Generally, the approach in SFAS 123(R) is similar to the approach described in SFAS 123, which as discussed above in Note (1)(e), Federated adopted on a prospective basis as of January 1, 2003. However, SFAS 123(R) requires all share-based payments to employees, including prior grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. The Securities and Exchange Commission (SEC) announced in April 2005 that it would require that registrants that are not small business issuers adopt SFAS 123(R) no later than the beginning of the first fiscal year beginning after June 15, 2005. Early adoption is permitted in periods in which financial statements have not yet been issued.
SFAS 123(R) permits public companies to adopt its requirements using one of two methods: (1) A “modified prospective” method in which compensation cost is recognized beginning with the effective date (a) based on the requirements of SFAS 123(R) for all share-based payments granted after the effective date and (b) based on the requirements of SFAS 123 for all awards granted to employees prior to the effective date of SFAS 123(R) that remain unvested on the effective date; or (2) a “modified retrospective” method which includes the requirements of the modified prospective method described above, but also permits entities to restate, based on the amounts previously recognized under SFAS 123 for purposes of pro forma disclosures, either (a) all prior periods presented or (b) prior interim periods of the year of adoption.
Federated plans to adopt SFAS 123(R) no later than January 1, 2006, but has not yet determined which method of adoption it will use. Federated adopted the fair-value-based method of accounting for share-based payments effective January 1, 2003 using the prospective method described in SFAS 148, “Accounting for Stock-Based Compensation – Transition and Disclosure.” Currently, Federated uses the Black-Scholes formula to estimate the value of stock options
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granted to employees and is evaluating the most appropriate valuation model to utilize (Black-Scholes or a lattice model) upon the required adoption of SFAS 123(R). Since (1) SFAS 123(R) must be applied not only to new awards but to previously granted awards that are not fully vested on the effective date, and (2) Federated adopted SFAS 123 using the prospective transition method (which applied only to awards granted, modified or settled after the adoption date), compensation costs for certain previously granted awards that were not recognized under SFAS 123 will be recognized under SFAS 123(R). Had Federated adopted SFAS 123 using the retroactive restatement method described in SFAS 148 in prior periods, the impact of that standard would have approximated the impact of SFAS 123 as described in the disclosure of pro forma net income and earnings per share in Note (1)(e). SFAS 123(R) also requires the benefits of tax deductions in excess of recognized compensation costs to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. While Federated cannot estimate what those amounts will be in the future (because they depend on, among other things, when employees exercise stock options), the amount of operating cash flows recognized for such tax deductions were $2.5 million and $37.2 million for the nine months ended September 30, 2005 and 2004, respectively.
FSP 109-2 – In December 2004, the FASB issued Staff Position No. 109-2, “Accounting and Disclosure Guidance for the Foreign Repatriation Provision within the American Jobs Creation Act of 2004” (FSP 109-2) which provides guidance with respect to reporting the potential impact of the repatriation provisions of the American Jobs Creation Act of 2004 (the Jobs Act). The Jobs Act provides conditions under which the repatriation of certain foreign earnings in either 2004 or 2005 will qualify for preferential tax treatment. If these conditions are met, a maximum 5.25% income tax rate rather than the maximum regular tax rate of 35% would apply to eligible repatriations of certain foreign earnings.
Federated has completed its evaluation of these provisions in conjunction with an analysis of its foreign earnings available for repatriation. As a result of that review, Federated has determined that it is not feasible to pay the level of dividend required to obtain this preferential tax treatment.
FSP EITF 85-24-1 – In March 2005, the FASB issued Staff Position EITF 85-24-1 “Application of EITF Issue No. 85-24, “Distribution Fees by Distributors of Mutual Funds That Do Not Have a Front-End Sales Charge,” When Cash for the Right to Future Distribution Fees for Shares Previously Sold Is Received from Third Parties” (FSP EITF 85-24-1). FSP EITF 85-24-1, which addresses when revenue should be recognized by the seller for sales of rights to future cash flows relating to certain distribution fees, was effective for reporting periods beginning after March 11, 2005. Funding of the payments made by Federated of upfront commissions paid upon the sale of Class B shares of Federated-sponsored mutual funds is made through arrangements with independent third parties by selling the rights to all related future distribution fees, servicing fees and CDSCs. Federated adopted the provisions of FSP EITF 85-24-1 effective April 1, 2005. The adoption did not have an impact on Federated’s results of operations or financial position. For financial reporting purposes, Federated continues to account for these arrangements as financings.
EITF 04-5 – In June 2005, the FASB ratified the consensus in EITF Issue No. 04-5, “Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights” (EITF 04-5). EITF 04-5 provides guidance for determining whether a general partner controls a limited partnership. The guidance broadly provides that the general partner in a limited partnership is presumed to control that limited partnership. However, that presumption can be overcome if the limited partners have either substantive kick-out rights or substantive participating rights. The effective date for applying the guidance in EITF 04-5 is June 29, 2005 for all new or recently modified limited partnerships and no later than the first reporting period in fiscal years beginning after December 15, 2005, for all other limited partnerships. During the third quarter 2005, Federated applied the provisions of EITF 04-5 to account for a wholly owned subsidiary’s general partnership interest in a newly formed limited partnership. Management will adopt the provisions of EITF 04-5 to an existing limited partnership for which a wholly owned subsidiary of Federated serves as general partner on January 1, 2006. At this time, management does not believe the adoption of this EITF will have a material impact on Federated’s financial position or results of operations.
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(2) Discontinued Operations
(a) Sale of InvestLink Technologies, Inc.
On August 25, 2005, Federated sold its interest in InvestLink Technologies, Inc., a wholly owned subsidiary (InvestLink), to an independent third party. InvestLink’s primary business was to provide software-related solutions for third-party administrators of defined contribution plans. The sale resulted in the disposal of $1.8 million in total InvestLink net assets, which consisted primarily of goodwill ($0.8 million), fixed assets ($0.7 million) and receivables/accrued revenues ($0.3 million). After taking selling costs into consideration, Federated recognized a loss on the sale of InvestLink of $1.7 million, which included tax expense of $0.3 million. This loss on sale was included in “Discontinued Operations” on the Consolidated Statements of Income.
InvestLink’s results of operations have been reflected as discontinued operations for the 2005 and 2004 periods presented in the Consolidated Statements of Income and are summarized as follows:
(in thousands)
Pretax loss
Income tax benefit
Loss from discontinued InvestLink operations, net of tax
(b) Sale of Federated’s Transfer Agency Business
On June 30, 2004, Federated completed the sale of its transfer agency (TA) business to Boston Financial Data Services. Total net assets included in the TA sale were approximately $1.1 million and consisted primarily of $0.7 million of goodwill and $0.7 million of fixed assets partially offset by $0.3 million of unamortized balances of specifically identified refurbishment allowances and deferred rent associated with the assignment of a building lease. There was no material gain or loss associated with this transaction. The results of operations of the TA business included in discontinued operations in the Consolidated Statements of Income were as follows:
Net revenue
Pretax (loss) income
Income tax (benefit) provision
(Loss) income from discontinued TA operations, net of tax
For the nine months ended September 30, 2005, Federated reported a $0.2 million loss from the discontinued TA operations, net of tax, which was primarily attributable to residual costs associated with the sold TA business.
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(3) Intangible Assets and Goodwill
Federated’s identifiable intangible assets consisted of the following:
Accumulated
Amortization
Carrying
Value
Investment advisory contracts1
Noncompete agreements2
Total identifiable intangible assets3
The increase in identifiable intangible assets relates primarily to the acquisition of the cash management business of Alliance Capital Management L.P. (Alliance Acquisition). As a result of the acquisition, Federated recorded two investment advisory contract intangible assets totaling $23.4 million. These assets are being amortized on an accelerated basis over seven- and ten-year useful lives. Federated also recorded an intangible asset of $5.0 million representing the fair value of the noncompete agreement obtained from Alliance. This asset is being amortized on a straight-line basis over a seven-year useful life. See Note (13) for a complete discussion on recent acquisitions.
Amortization expense for identifiable intangible assets for the three- and nine-month periods ended September 30, 2005 were $4.0 million and $10.0 million, respectively, and $2.7 million and $8.0 million, respectively, for the same periods of 2004. Following is a schedule of expected aggregate annual amortization expense for intangible assets in each of the five succeeding years assuming no new acquisitions or impairments:
2005
2006
2007
2008
2009
Goodwill at September 30, 2005 and December 31, 2004 was $266.2 million and $260.0 million, respectively. The increase in goodwill is primarily the result of the following transactions.
During the first quarter 2005, Federated recorded an additional $3.6 million of goodwill to account for the additional portion of the contingent purchase price earned as of March 31, 2005 in connection with the acquisition of substantially all of the business of the former advisor of the Kaufmann Fund in 2001 (Kaufmann Acquisition). Approximately 88% and 89% of the goodwill balances at September 30, 2005 and December 31, 2004, respectively, resulted from this acquisition.
During the third quarter 2005, Federated recorded goodwill of $3.2 million to account for certain contingent purchase price payments earned during the quarter as well as direct transaction costs incurred in connection with the Alliance Acquisition.
Also during the third quarter 2005, Federated sold $0.8 million in goodwill in connection with the sale of InvestLink. See Note (2)(a) for further discussion of this sale transaction.
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(4) Other Current Liabilities - Other
Federated’s “Other current liabilities – other” at December 31, 2004 included $16.5 million related to an insurance recovery for a claim submitted to cover costs associated with the internal review, government investigations and civil litigation into past mutual fund trading practices (see Note (14)(c)). The retention of this advance payment was contingent upon approval of the claim. In the event that all or a portion of the claim was denied, Federated would have been required to repay all or a portion of this advance payment. During the third quarter 2005, final approval of this claim was obtained and the proceeds were recorded as reductions to the income statement line items originally charged.
Federated’s “Other current liabilities – other” at September 30, 2005 included $5.3 million related to the purchase price and direct costs of the Alliance Acquisition. See Note (13) for additional information on this acquisition.
(5) Recourse Debt
Federated’s “Other current liabilities – other” included recourse debt balances of $44,000 and $0.5 million at September 30, 2005 and December 31, 2004, respectively, representing liabilities on capital leases. The capital leases outstanding at September 30, 2005 carry interest rates of 2.90% and 3.47% with weighted-average interest rates of 3.05% and 3.60% for capital leases outstanding at September 30, 2005 and December 31, 2004, respectively. The two capital leases outstanding at September 30, 2005 have expiration dates during the fourth quarter 2005 and the first quarter 2006.
As of September 30, 2005, Federated had no outstanding balance under its $150.0 million Second Amended and Restated Credit Agreement as amended (Credit Facility). In the third quarter 2005, Federated extended the term of its $50.0 million bank discretionary line of credit agreement to September 26, 2006. As of September 30, 2005, Federated had no outstanding balance under this discretionary line of credit.
(6) Deferred Sales Commissions and Nonrecourse Debt
Deferred sales commissions consisted of the following:
Deferred sales commissions on B-shares, net
Other deferred sales commissions, net
Deferred sales commissions, net
Current and long-term portions of nonrecourse debt consisted of the following (See Note (1)(c)):
Financings through March 1997
Financings between April 1997 and September 2000
Financings between October 2000 and December 2003
Financings between January 2004 and September 2005
Total debt – nonrecourse
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During the first quarter 2004, management determined that reasonably estimable future cash flows from revenue streams related to B shares sold through March 1997 would not be sufficient to fully amortize the respective remaining deferred sales commission asset and nonrecourse debt balances. Accordingly, Federated accelerated the write-off of the respective remaining asset and nonrecourse debt balances. As a result, in addition to the normal amortization occurring during the period based on B-share-related distribution, shareholder service and CDSC fee cash flows, the asset balances were written down by an additional $2.7 million and $5.5 million during the first nine months of 2005 and 2004, respectively, while the debt balances were written down by an additional $2.8 million and $5.6 million during the first nine months of 2005 and 2004, respectively. This acceleration of asset and nonrecourse debt write-off resulted in the recognition of a net pretax gain of $0.1 million for the nine-month periods ended September 30, 2005 and 2004, respectively.
Federated has an agreement with an independent financial institution for funding of the B-share sales commissions through December 2006.
(7) Common Stock
(a) Cash Dividends and Stock Repurchases
Cash dividends of $0.125, $0.15, and $0.15 per share or approximately $13.3 million, $16.0 million and $16.1 million were paid in the first, second and third quarters of 2005, respectively, to holders of common shares.
Federated repurchased 672,100 shares of its stock as part of its current share buyback programs during the nine months ended September 30, 2005. As of September 30, 2005, Federated can repurchase 5.0 million additional shares under the current board-approved program.
Stock repurchases and dividend payments are subject to restrictions under the Credit Facility. These restrictions limit cash payments for additional stock repurchases and dividends to 50% of net income earned during the period from January 1, 2000, to and including the payment date, less certain payments for dividends and stock repurchases. As of September 30, 2005, Federated had the ability to make additional stock repurchase and dividend payments of more than $127 million under these restrictions.
(b) Employee Stock Purchase Plan
Federated offers an Employee Stock Purchase Plan which allows employees to purchase a maximum of 750,000 shares of Class B common stock. Employees may contribute up to 10% of their salary to purchase shares of Federated’s Class B common stock on a quarterly basis at the market price. The shares purchased under the plan have been purchased in the open market. As of September 30, 2005, a total of 75,972 shares had been purchased by employees in this plan since the plan’s inception.
(c) Employee Stock-Based Compensation
During the first nine months of 2005, Federated awarded 212,796 shares of restricted Federated Class B common stock in connection with a bonus program in which certain key employees received a portion of their bonus in the form of restricted stock under the Stock Incentive Plan. This restricted stock was granted on the bonus payment date, was issued out of treasury and will vest over a three-year period. Also during the first nine months of 2005, Federated sold 462,000 shares of restricted Federated Class B common stock under the Stock Incentive Plan to certain key employees and issued 12,000 employee stock options to independent directors. During the same time period, 82,961 and 129,625 shares of restricted stock and employee stock options, respectively, were forfeited, 260,598 employee stock options were exercised by purchasing shares out of treasury, and 2,298 shares of restricted stock were sold by employees to fund their tax liabilities related to the vesting of their shares.
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(8) Income Taxes
The reconciliation between the federal statutory income tax rate and Federated’s effective income tax rate attributable to continuing operations consisted of the following for the three- and nine-month periods ended September 30:
Expected statutory rate
Increase:
State income taxes, net of federal benefit
Non-deductible expenses relating to the Settlement Charges1
Total
(9) Earnings Per Share
The following table sets forth the computation of basic and diluted earnings per share:
Numerator
Denominator
Basic weighted-average shares outstanding
Dilutive potential shares from stock-based compensation
Diluted weighted-average shares outstanding
Federated uses the treasury stock method to reflect the dilutive effect of unvested restricted stock and unexercised stock options in diluted earnings per share. For the quarters ended September 30, 2005 and 2004, options to purchase 1.0 million and 2.1 million shares of common stock, respectively, at a weighted-average exercise price per share of $33.64 and $31.90, respectively, were outstanding but not included in the computation of diluted earnings per share for each quarter due to the option exercise price being greater than the average market price of Federated Class B common stock. For the nine-month periods ended September 30, 2005 and 2004, options to purchase 1.8 million and 1.6 million shares of common stock, respectively, at a weighted-average exercise price per share of $32.25 and $32.80,
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respectively, were outstanding but not included in the computation of diluted earnings per share for each nine-month period due to the option exercise price being greater than the average market price of Federated Class B common stock. Under the treasury stock method, in the event the options become dilutive, their dilutive effect would result in the addition of a net number of shares to the weighted-average number of shares used in the calculation of diluted earnings per share.
(10) Comprehensive Income
Comprehensive income was $63.6 million and $108.2 million for the three- and nine-month periods ended September 30, 2005, respectively, and $47.1 million and $149.4 million, respectively, for the same periods of 2004.
(11) Variable Interest Entities
At September 30, 2005, Federated acted as the investment manager for two high-yield collateralized debt obligation (CDO) products pursuant to the terms of an investment management agreement between Federated and each CDO. The CDOs are alternative investment vehicles created in 1999 and 2000 for the sole purpose of issuing collateralized debt instruments that offer investors the opportunity for returns that vary with the risk level of their investment. Certain securities issued by the CDOs are subject to greater risk than traditional investment products. The notes issued by the CDOs are backed by diversified portfolios consisting primarily of structured debt and had original stated maturities of 12 years. As a result of their corporate governance, the CDOs meet the definition of a variable interest entity (VIE) under FASB Interpretation No. 46 (revised December 2003), “Consolidation of Variable Interest Entities” (FIN 46). After performing an expected cash flow analysis for each CDO, management determined that Federated is not the primary beneficiary of the CDOs as defined by FIN 46 and thus has not consolidated the financial condition and results of operations of these CDOs in Federated’s Consolidated Financial Statements. As of September 30, 2005, aggregate total assets and aggregate total obligations of the CDOs approximated $0.3 billion and $0.4 billion, respectively.
As of September 30, 2005, Federated had no remaining carrying value for the investments in these CDOs and therefore has no related risk of loss.
In addition, a number of Federated-sponsored investment products, including Irish-domiciled money market and fluctuating-value fund products, closed-end fixed-income funds and a group trust meet the definition of VIEs under FIN 46. Federated is not the primary beneficiary of these VIEs and therefore Federated has not consolidated these entities. As of September 30, 2005, total assets under management in these investment products approximated $11 billion. Federated’s investments in these products represent its maximum exposure to loss. As of September 30, 2005, Federated’s investment in these investment products was $29.0 million comprised almost entirely of investments in Irish-domiciled money market funds.
(12) Related Party Transactions
Federated has identified certain entities as affiliates in accordance with SFAS 57 “Related Party Disclosures.”
At September 30, 2005 and December 31, 2004, “Receivables—affiliates” totaled $39.2 million and $30.8 million, respectively, and “Accrued revenue—affiliates” totaled $1.8 million and $1.1 million, respectively, primarily relating to services provided to various Federated products.
At September 30, 2005 and December 31, 2004, “Accounts payable and accrued expenses—affiliates” totaled $32.6 million and $10.3 million, respectively. The balance at September 30, 2005 is primarily comprised of $27.2 million related to the internal review and Settlement Charges (see Note (14)(c)) and $1.7 million related to shareholder service fees payable to various Federated funds resulting from an administrative delay in the implementation of contractual terms (see Note (1)(b)). The balance at December 31, 2004 is primarily comprised of $3.4 million related to the internal review and Settlement Charges, $3.3 million related to shareholder service fees payable to various Federated funds resulting from an administrative delay in the implementation of contractual terms and $2.0 million related to remedial actions in connection with various fund transactions and trading.
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At December 31, 2004, “Other current liabilities—affiliates” totaled $29.5 million and represented the accrual for the contingent purchase price payment earned in 2004 related to the Kaufmann Acquisition.
At December 31, 2004, “Other long-term liabilities—affiliates” totaled $4.0 million and represented the long-term portion of management’s estimate of the costs related to the Settlement Charges (see Note (14)(c)).
(13) Business Combinations and Acquisitions
In the third quarter 2005, assets of three equity mutual funds previously advised by Investors Management Group Ltd., a wholly owned subsidiary of AMCORE Financial, Inc. totaling approximately $142.0 million were acquired by two Federated-sponsored mutual funds. As a result of the transaction, Federated recorded $1.5 million as an investment advisory contract intangible asset, which included the capitalization of transaction costs. This asset is being amortized on an accelerated basis over a seven-year useful life.
During the second quarter 2005, Federated completed the Alliance Acquisition. As a result of the acquisition, approximately $19.3 billion in assets from 22 third-party-distributed money market funds of AllianceBernstein Cash Management Services were transitioned into Federated money market funds. The cost of this acquisition paid as of September 30, 2005 was $26.4 million, which included $25.0 million in purchase price and $1.4 million in transaction costs. The purchase agreement also provides for contingent purchase price payments payable over five years. The contingent purchase price payments are calculated as 1) a percentage of revenues less certain operating expenses directly attributed to these assets over the five-year period and 2) a one-time payment payable if certain net revenue targets are met. At the current asset levels, these additional payments would approximate $68 million over the five-year period. This acquisition was accounted for using the purchase method of accounting. Accordingly, Federated began recognizing revenue and expenses related to the acquired assets in the Consolidated Statements of Income as of the acquisition date and allocated the cost of the acquisition to the acquired assets based on their estimated fair values as of the acquisition date. Federated recorded two investment advisory contract intangible assets totaling $23.4 million. These assets are being amortized on an accelerated basis over seven- and ten-year useful lives. Federated also recorded an intangible asset of $5.0 million representing the fair value of the noncompete agreement obtained from Alliance. This asset is being amortized on a straight-line basis over a seven-year useful life. Contingent purchase price payments earned through September 30, 2005 and certain transaction costs totaling $5.3 million are recorded as a liability in “Other current liabilities – other.” Goodwill of $3.2 million, which represents the costs of this acquisition recorded in excess of the fair value of the investment advisory contract and noncompete agreement intangible assets, has been recorded as of September 30, 2005 and is deductible for tax purposes.
The following table summarizes unaudited pro forma financial information assuming the Alliance Acquisition occurred at the beginning of the three-month period ended September 30, 2004 and the nine-month periods ended September 30, 2005 and 2004. This pro forma financial information is for informational purposes only and is not indicative of actual results that would have occurred had the Alliance Acquisition been completed on the assumed dates and it is not indicative of future results. In addition, the following pro forma financial information has not been adjusted to reflect any operating efficiencies that may be realized as a result of the Alliance Acquisition.
2004
Pro forma
Income from continuing operations per basic share
Income from continuing operations per diluted share
Net income per basic share
Net income per diluted share
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(14) Commitments and Contingencies
(a) Contractual
Pursuant to various acquisition agreements, Federated is required to make additional payments to the seller contingent upon the occurrence of certain events. In 2001, Federated completed the Kaufmann Acquisition. Pursuant to this acquisition agreement, Federated could pay an additional $33.1 million as contingent purchase price and $6.7 million as contingent incentive compensation between 2006 and 2007 if certain revenue targets are met. The purchase price payments are recorded as additional goodwill at such time as performance targets have been met, while the incentive compensation payments are recognized as compensation expense during the periods in which the payments are earned.
In the second quarter of 2005, Federated completed the Alliance Acquisition. The contingent purchase price payments are calculated as 1) a percentage of revenues less certain operating expenses directly attributed to these assets over a five-year period and 2) a one-time payment payable if certain net revenue targets are met. Contingent purchase price payments will be paid annually from 2006 through 2010. At the current asset levels, these additional payments would approximate $68 million over the five-year period.
Pursuant to certain other acquisition agreements, Federated is required to make contingent payments on a periodic basis calculated as a percentage of average assets under management on certain Federated fund shareholder accounts for which the seller is the named broker/dealer of record. In these cases, the payments occur monthly or quarterly and could continue through fourth quarter 2008.
(b) Guarantees and Indemnifications
In connection with the sale of InvestLink (see Note (2)(a)), the real estate lease for office space was assigned to the purchaser of InvestLink. As of September 30, 2005, Federated was the named guarantor for this lease agreement. Pursuant to the guarantee agreement, the term of which expires December 31, 2008, Federated would be required to make the scheduled lease-related payments to the landlord in the event the lessee defaults on the payment. Federated expects to be released from this guarantee agreement before the end of 2005. As of September 30, 2005, the maximum potential amount of future lease-related payments is $0.9 million. Management believes that the likelihood of making any payment under this guarantee prior to being released as guarantor is remote. After giving due regard to the remote likelihood that the lessee will default on the lease-related payments during 2005, management did not recognize a liability for the guarantee either at the inception of the guarantee or at September 30, 2005.
On an intercompany basis, various wholly owned subsidiaries of Federated guarantee certain financial obligations of Federated Investors, Inc. and Federated Investors, Inc. guarantees certain financial and performance-related obligations of various wholly owned subsidiaries. In addition, in the normal course of business, Federated has entered into contracts that provide a variety of indemnifications. Typically, obligations to indemnify third parties arise in the context of contracts entered into by Federated, under which Federated agrees to hold the other party harmless against losses arising out of the contract, provided the other party’s actions are not deemed to have breached an agreed-upon standard of care. In each of these circumstances, payment by Federated is contingent on the other party making a claim for indemnity, subject to Federated’s right to challenge the other party’s claim. Further, Federated’s obligations under these agreements may be limited in terms of time and/or amount. It is not possible to predict the maximum potential amount of future payments under these or similar agreements due to the conditional nature of Federated’s obligations and the unique facts and circumstances involved in each particular agreement. Management believes that if Federated were to incur a loss in any of these matters, such loss should not have a material effect on its business, financial position or results of operations.
(c) Internal Review of Mutual Fund Trading Activities
As previously reported, since September 2003 Federated has conducted an internal review into certain mutual fund trading activities in response to requests for information from the SEC, National Association of Securities Dealers and New York State Attorney General. Federated subsequently received inquiries relating to such trading activities from
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the U.S. Attorneys Office for the Western District of Pennsylvania, the Commodity Futures Trading Commission, the Securities Commissioner and the Attorney General of West Virginia, and the Connecticut Banking Commission. Attorneys from the law firms of Reed Smith LLP and Davis, Polk & Wardwell conducted the review at the direction of a special investigative committee of Federated’s board of directors. The special investigative committee was comprised of the current board. Attorneys from the law firm of Dickstein Shapiro Morin & Oshinsky, LLP, independent counsel for the Federated mutual funds, participated in the review and reported on its progress to the independent directors of the funds.
In February 2004, the Company announced that the special investigative committee of the Board of Directors had substantially completed its assessment of the impact of past mutual fund trading issues. Based upon the findings of the internal review and of an independent expert retained by the Federated mutual funds, Federated paid restoration of $8.0 million to compensate for the detrimental impact from the improper trading activities identified in the review. Federated has completed its review of information relating to trading activities.
Federated announced on January 24, 2005 that it was in settlement discussions with the SEC and New York State Attorney General.
The Consolidated Financial Statements for the three- and nine-month periods ended September 30, 2005 reflect a $1.7 million and $62.0 million pretax charge, respectively, as compared to $2.0 million and $11.7 million, respectively, for the same periods of 2004 for various legal, regulatory and compliance matters, including costs related to Federated’s internal review and costs incurred on behalf of the funds. In addition, the three- and nine-month periods ended September 30, 2005 include a $23.6 million insurance recovery of certain of these costs which was recorded as a reduction to the various income statement line items to which these costs were originally charged. Of the pretax charges for the nine months ended September 30, 2005, $55.6 million relates to management’s revised estimate of the Settlement Charges of $17.4 million and $7.6 million recorded during 2004 and 2003, respectively. Neither the SEC nor any state attorney general’s office has passed on the establishment or amount of these Settlement Charges. In order to estimate the accrual for expenses relating to remedying any damages to the Federated funds, management made assumptions concerning the timing and effort involved to complete the internal review and settlement negotiations. If actual experience differs from the judgments used to determine the initial estimates, the amount accrued as of September 30, 2005 would be subject to further revision, which may be significant. In addition, Federated’s management is unable to estimate the ultimate impact of any settlement proceedings, including the tax deductibility of these costs, and therefore final resolution of these matters may have a material impact on Federated’s consolidated results of operations, financial position and/or cash flows.
(d) Legal Proceedings
Since October 2003, Federated Investors, Inc. and related entities have been named as defendants in twenty-three cases filed in various federal district courts and state courts involving allegations relating to market timing, late trading and excessive fees. All of the pending cases involving allegations related to market timing and late trading have been transferred to the U.S. District Court for the District of Maryland and consolidated for pre-trial proceedings. One market timing/late trading case was voluntarily dismissed by the plaintiff without prejudice.
The seven excessive fee cases were originally filed in five different federal courts and one state court. One such case was filed on September 8, 2005 and is currently pending in the U.S. District Court for the District of Massachusetts. It was filed as a class action by a putative shareholder of the Federated Kaufmann Fund against certain Federated subsidiaries and the trustees of the Federated Kaufmann Fund. Five of the federal cases are now pending in the U.S. District Court for the Western District of Pennsylvania. The state court case was voluntarily dismissed by the plaintiff without prejudice.
All of these lawsuits seek unquantified damages, attorneys’ fees and expenses. Federated intends to defend this litigation. The potential impact of these recent lawsuits and future potential similar suits is uncertain. It is possible that an unfavorable determination will cause a material adverse impact on Federated’s financial position, results of operations and/or liquidity in the period in which the effect becomes reasonably estimable.
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In addition, Federated has other claims asserted and threatened against it in the ordinary course of business. These other claims are subject to inherent uncertainties. In the opinion of management, after consultation with counsel, it is unlikely that any adverse determination for any pending or threatened other claim will materially affect the financial position, results of operations or liquidity of Federated.
(15) Subsequent Events
On October 27, 2005, the board of directors declared a dividend of $0.15 per share to be paid on November 15, 2005, to shareholders of record as of November 8, 2005.
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Part I, Item 2. Management’s Discussion and Analysis
of Financial Condition and Results of Operations (Unaudited)
The discussion and analysis below should be read in conjunction with the consolidated financial statements appearing elsewhere in this report. We have presumed that the readers of this interim financial information have read or have access to management’s discussion and analysis of financial condition and results of operations appearing in Federated’s Annual Report on Form 10-K for the year ended December 31, 2004.
General
Federated Investors, Inc. (together with its subsidiaries, Federated) is one of the largest investment managers in the United States with $207.4 billion in managed assets as of September 30, 2005. The majority of Federated’s revenue is derived from advising and administering Federated mutual funds (the Federated Funds), separately managed accounts and other Federated-sponsored products in both domestic and international markets. Federated also derives revenue from administering mutual funds sponsored by third parties and from providing various other mutual fund-related services, including distribution, shareholder servicing, trade clearing and retirement plan recordkeeping services (collectively, Other Services).
Investment advisory fees, administrative fees and certain fees for Other Services, such as distribution and shareholder service fees, are contract-based fees that are calculated as a percentage of the net assets of the investment portfolios that are managed or administered by Federated. As such, Federated’s revenue is primarily dependent upon factors that affect the value of managed and administered assets including market conditions and the ability to attract and maintain assets. Rates for Federated’s services generally vary by asset type and investment objective and, in certain instances, decline as the average net assets of the individual portfolios exceed certain threshold levels. Generally, rates charged for advisory services provided to equity products are higher than rates charged on money market and fixed-income products. Accordingly, revenue is also dependent upon the relative composition of average assets under management. Federated pays a significant portion of its distribution and shareholder service fees to financial intermediaries that sell and service Federated-sponsored products. These payments are generally calculated as a percentage of net assets attributable to the party receiving the payment and are recorded on the Consolidated Statements of Income either as reductions to revenue as in the case of certain shareholder service fee payments or as an operating expense as in the case of certain distribution fee payments.
Federated’s remaining Other Services fees are based on fixed rates per transaction or retirement plan participant. Revenue relating to these services will vary with changes in the number of transactions and plan participants which are impacted by sales and marketing efforts, competitive fund performance, introduction and market reception of new products and acquisitions.
Federated’s most significant recurring operating expenses include marketing and distribution costs and compensation and related costs, which represent fixed and variable compensation and related employee benefits.
Business Developments
The Consolidated Financial Statements for the three- and nine-month periods ended September 30, 2005 reflect a $1.7 million and $62.0 million pretax charge, respectively, as compared to $2.0 million and $11.7 million, respectively, for the same periods of 2004 for various legal, regulatory and compliance matters, including costs related to Federated’s internal review and costs incurred on behalf of the funds. In addition, the three- and nine-month periods ended September 30, 2005 include a $23.6 million insurance recovery of certain of these costs which was recorded as a reduction to the various income statement line items to which these costs were originally charged. Of the pretax charges for the nine months ended September 30, 2005, $55.6 million relates to management’s revised estimate of the costs relating to anticipated settlements of governmental investigations concerning market timing and late trading allegations (Settlement Charges) of $17.4 million and $7.6 million recorded during 2004 and 2003, respectively. Neither the Securities and Exchange Commission (SEC) nor any state attorney general’s office has passed on the establishment or amount of these Settlement Charges. In order to estimate the accrual for expenses relating to remedying any damages to the Federated Funds, management made assumptions concerning the timing and effort involved to complete the internal review and settlement negotiations. If actual experience differs from the judgments used to determine the initial estimates, the amount accrued as of September 30, 2005 would be subject to further revision, which may be significant. In addition, Federated’s management is unable to estimate the ultimate impact of any settlement proceedings, including the tax deductibility of these costs, and therefore final resolution of these matters may have a material impact on Federated’s consolidated results of operations, financial position and/or cash flows.
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Management’s Discussion and Analysis (continued)
In the third quarter 2005, assets of three equity mutual funds previously advised by Investors Management Group Ltd., a wholly owned subsidiary of AMCORE Financial, Inc. totaling approximately $142.0 million were acquired by two Federated-sponsored mutual funds (AMCORE Acquisition). As a result of the transaction, Federated recorded $1.5 million as an investment advisory contract intangible asset, which included the capitalization of transaction costs. This asset is being amortized on an accelerated basis over a seven-year useful life.
Also in the third quarter 2005, Federated sold its interest in InvestLink Technologies, Inc., a wholly owned subsidiary (InvestLink), to an independent third party. InvestLink’s primary business was to provide software-related solutions for third-party administrators of defined contribution plans. Federated recognized a loss on the sale of InvestLink of $1.7 million, which included tax expense of $0.3 million. InvestLink’s results of operations and the loss on sale have been reflected as discontinued operations for the 2005 and 2004 periods presented in the Consolidated Statements of Income. For more information regarding the sale, see Note (2)(a) to the Consolidated Financial Statements.
During the second quarter 2005, Federated completed the acquisition of the cash management business of Alliance Capital Management L.P. (Alliance Acquisition). As a result of the acquisition, approximately $19.3 billion in assets from 22 third-party-distributed money market funds of AllianceBernstein Cash Management Services were transitioned into Federated money market funds. The cost of this acquisition paid as of September 30, 2005 was $26.4 million, which included $25.0 million in purchase price and $1.4 million in transaction costs. The purchase agreement also provides for contingent purchase price payments payable over five years. The contingent purchase price payments are calculated as 1) a percentage of revenues less certain operating expenses directly attributed to these assets over the five-year period and 2) a one-time payment payable if certain net revenue targets are met. At the current asset levels, these additional payments would approximate $68 million over the five-year period. This acquisition was accounted for using the purchase method of accounting. Accordingly, Federated began recognizing revenue and expenses related to the acquired assets in the Consolidated Statements of Income as of the acquisition date and allocated the cost of the acquisition to the acquired assets based on their estimated fair values as of the acquisition date. Federated recorded two investment advisory contract intangible assets totaling $23.4 million. These assets are being amortized on an accelerated basis over seven- and ten-year useful lives. Federated also recorded an intangible asset of $5.0 million representing the fair value of the noncompete agreement obtained from Alliance. This asset is being amortized on a straight-line basis over a seven-year useful life. Contingent purchase price payments earned through September 30, 2005 and certain transaction costs totaling $5.3 million are recorded as a liability in “Other current liabilities – other” in the Consolidated Balance Sheets. Goodwill of $3.2 million, which represents the costs of this acquisition recorded in excess of the fair value of the investment advisory contract and noncompete agreement intangible assets, has been recorded as of September 30, 2005 and is deductible for tax purposes.
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Asset Highlights
Managed Assets at Period End
Percent
Change
(in millions)
Money market
Fixed-income
Equity
Total managed assets
Mutual Funds:
Total mutual fund assets
Separate Accounts:
Total separate account assets
Average Managed Assets
Total average managed assets
Total average mutual fund assets
Total average separate account assets
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Administered Assets
Period-end assets
Average assets
Components of Changes in Equity and Fixed-Income Fund Managed Assets
Beginning assets
Sales
Redemptions
Net (redemptions) sales
Net exchanges
Acquisition related
Other1
Ending assets
Net redemptions
Changes in Federated’s average asset mix period over period have a direct impact on Federated’s total revenue due to the difference in the fees per invested dollar earned on each asset type. Equity products generally have a higher management fee rate than fixed-income or money market products. The following table presents the relative composition of average managed assets and the percent of total revenue derived from each asset type for the nine months ended September 30:
Money market assets
Equity assets
Fixed-income assets
Other activities
The September 30, 2005 period-end managed assets increased 17% compared to period-end managed assets at September 30, 2004. Average managed assets for the three-month period ended September 30, 2005 increased 14% from average managed assets for the same period last year while average managed assets for the nine-month period
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ended September 30, 2005 increased 1% compared to the same period last year. Equity assets at September 30, 2005 increased 13% compared to September 30, 2004 climbing to $29.7 billion while average equity assets for the three- and nine-month periods ended September 30, 2005 increased 15% and 10%, respectively, over the same periods in 2004 due primarily to market appreciation. Period-end money market assets at September 30, 2005 increased 23% from September 30, 2004 primarily as a result of the Alliance Acquisition. Average money market assets for the three- and nine-month periods ended September 30, 2005 increased 19% and 2%, respectively, compared to the same periods last year. Period-end fixed-income assets at September 30, 2005 declined 8% from September 30, 2004. Average fixed-income assets for the three- and nine-month periods ended September 30, 2005 decreased 8% and 11%, respectively, from the same periods of the prior year. In a rising interest-rate environment, certain institutional investors using money market funds and other short-term duration fixed-income products for cash management purposes may shift these investments to direct investments in comparable instruments in order to realize higher yields than those available in money market and other fund products holding lower-yielding instruments. In addition, rising interest rates will tend to reduce the market value of bonds held in various investment portfolios and other products.
Results of Operations
Revenue. Revenue for the three- and nine-month periods ended September 30 is set forth in the following table:
Revenue from managed assets
Revenue from sources other than managed assets
Total Revenue
Revenue from managed assets increased for the three-month period ended September 30, 2005 by $39.8 million as compared to the same period in 2004. The increased revenue primarily reflects a $12.3 million revenue increase due to a 15% increase in average equity assets under management along with $25.5 million generated from money market assets acquired in connection with the Alliance Acquisition and $6.7 million from other increases in money market products offset by declines in revenue of $3.8 million from fixed-income products as a result of an 8% decrease in fixed-income average managed assets compared to the same period of the prior year. Revenue from managed assets increased $38.1 million for the nine-month period ended September 30, 2005 as compared to the same period in 2004 resulting primarily from increased revenue from assets acquired in connection with the Alliance Acquisition of $39.4 million and a $25.7 million increase due to the 10% increase in average managed equity assets, partially offset by a $15.6 million decline due to the 11% decrease in fixed-income average managed assets and a reduction of $12.6 million from reduced average money market assets (excluding the Alliance Acquisition).
Revenue from sources other than managed assets, which represents 3% of Federated’s revenue in the third quarter 2005, decreased $2.8 million from the third quarter 2004. Approximately $2.3 million of this decrease reflects a reduction in the number of bank clients for fund administration and accounting services. For the nine-month period ended September 30, 2005, revenue from sources other than managed assets, which represents 3% of Federated’s revenue for this period, decreased $6.7 million from the same period in 2004 primarily as a result of a $6.4 million decrease in revenue from a reduction in the number of bank clients for fund administration and accounting services.
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Operating Expenses. Operating expenses for the three- and nine-month periods ended September 30 are set forth in the following table:
All other
Total Operating Expenses
As previously discussed, the Consolidated Financial Statements for the three- and nine-month periods ended September 30, 2005 reflect a $1.7 million and $62.0 million pretax charge, respectively, as compared to $2.0 million and $11.7 million, respectively, for the same periods of 2004 for various legal, regulatory and compliance matters, including costs related to Federated’s internal review and costs incurred on behalf of the funds. In addition, the three- and nine-month periods ended September 30, 2005 include a $23.6 million insurance recovery of certain of these costs which was recorded as a reduction to the various income statement line items to which these costs were originally charged. For more information, please refer to the section entitled “Business Developments.”
Total operating expenses for the three- and nine-month periods ended September 30, 2005 increased $10.5 million and $72.0 million, respectively, as compared to the same periods last year. The increase in marketing and distribution expense of $28.2 million or 76% for the three months ended September 30, 2005 as compared to the same period in 2004 relates primarily to an increase of $20.7 million due to additional expenses associated with the increase in assets under management from the Alliance Acquisition, an increase of $6.0 million related to increases to average money market assets (excluding the Alliance Acquisition) and an increase of $1.8 million related to increases to average equity assets. Compensation and related expense for the three months ended September 30, 2005, increased $4.0 million from the same period in 2004 primarily as a result of a $2.5 million increase in incentive compensation resulting principally from the accrual and payment of non-recurring bonus payments in the third quarter of 2005 and a $1.0 million increase in stock-based compensation due primarily to the 2005 issuances of restricted stock to certain key employees (see Note (7)(c) to the Consolidated Financial Statements). The change in amortization of intangible assets in the quarter ended September 30, 2005 compared to the same period of the prior year included a $1.8 million increase as a result of the Alliance Acquisition. All other expenses for the three-month period ended September 30, 2005 decreased $22.4 million principally as a result of recognizing the insurance recovery. This insurance recovery was primarily recorded as reductions to “Professional service fees” and “Office and occupancy” of $22.2 million and $1.3 million, respectively.
For the nine-month period ended September 30, 2005, the $36.8 million increase in marketing and distribution expense compared to the same period in 2004 primarily relates to $32.5 million of additional expenses associated with the increase in assets under management from the Alliance Acquisition and a $4.9 million increase due to the increase in average equity assets. The change in amortization of intangible assets in the nine-month period ended September 30, 2005 compared to the same period of the prior year included a $3.1 million increase as a result of the Alliance Acquisition. All other expenses increased $30.8 million compared to the same period in 2004 principally as a result of the net increase in the Settlement Charges of $55.6 million which were recorded in “Other” operating expenses in 2005 partially offset by the insurance recovery mentioned above.
Nonoperating Income (Expenses). Nonoperating expenses, net, decreased $2.5 million and $6.4 million for the three- and nine-month periods ended September 30, 2005 as compared to the same periods of last year. For the three-month period ended September 30, 2005, the decrease is a result of a $1.5 million increase in “Interest and dividends” primarily attributable to higher yields earned on investments as a result of rising interest rates and a $0.8 million decrease in “Debt expense – nonrecourse” attributable to a lower amount of average nonrecourse debt outstanding. For
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the nine-month period ended September 30, 2005 the decrease was a result of a $3.5 million increase in “Interest and dividends” due primarily to higher yields earned on investments as a result of rising interest rates and a $2.4 million decrease in “Debt expense – nonrecourse” attributable to a lower amount of average nonrecourse debt outstanding.
Income Taxes on Continuing Operations. The income tax provision for continuing operations for the three- and nine-month periods ended September 30, 2005 was $38.4 million and $86.1 million, respectively, as compared to $27.4 million and $84.4 million, respectively, for the same periods in 2004. The $11.0 million increase in the three-month period ended September 30, 2005 over the same period of 2004 is primarily a result of higher income from continuing operations before income taxes ($10.1 million) and increased state taxes ($1.2 million). The $1.7 million increase for the nine-month period ended September 30, 2005 over the same period of 2004 is primarily due to the estimated federal tax effect of the non-deductible portion of the current period Settlement Charges ($12.3 million) and increased state taxes ($2.6 million) partially offset by lower income from continuing operations before taxes ($12.0 million). The effective tax rate for continuing operations was 36.9% and 36.6% for the third quarter 2005 and 2004, respectively, and 43.6% and 36.4% for the first nine months of 2005 and 2004, respectively.
Income from Continuing Operations. Income from continuing operations increased $18.0 million for the three-month period and decreased $36.0 million for the nine-month period ended September 30, 2005, respectively, as compared to the same periods of 2004 as a result of the changes in revenues, expenses and income taxes discussed above.
Discontinued Operations. Discontinued operations, net of tax, reflects the sale of InvestLink in the third quarter 2005 and Federated’s transfer agency business in the second quarter 2004. The InvestLink sale resulted in a recognized loss on sale of $1.7 million inclusive of tax expense. For the three- and nine-month periods ended September 30, 2005, Federated reported a loss from discontinued operations, net of tax, of $1.8 million and $3.0 million, respectively, as compared to a loss from discontinued operations, net of tax, of $0.5 million for the three-month period ended September 30, 2004 and income from discontinued operations, net of tax of $2.0 million for the nine-month period ended September 30, 2004 (see Note (2) to the Consolidated Financial Statements).
Liquidity and Capital Resources
At September 30, 2005, liquid assets, consisting of unrestricted cash and cash equivalents, marketable securities and receivables, totaled $344.2 million as compared to $292.1 million at December 31, 2004. Federated also had a B-share funding arrangement with an independent third party and $150.0 million available for borrowings under its Second Amended and Restated Credit Agreement (Credit Facility) as of September 30, 2005.
Operating Activities. Cash provided by operating activities totaled $208.7 million for the first nine months of 2005, as compared to $201.6 million for the same period in 2004. A decrease of $34.7 million in the tax benefit from stock-based compensation resulted primarily from the vesting and employee tax realization of 1.9 million shares of restricted stock during the first quarter of 2004 ($19.4 million) and the exercise and employee tax realization of 1.7 million stock options during the third quarter 2004 ($15.9 million).
An increase of $91.7 million in the change in accounts payable and accrued expenses on the Consolidated Statements of Cash Flows for the nine months ended September 30, 2005 compared to the same period of last year is due primarily to the increases in the current portions of the Settlement Charges of $24.0 million recorded in “Accounts payable and accrued expenses – affiliates” and $35.6 million recorded in “Accounts payable and accrued expenses – other” in the first nine months of 2005 as well as the $7.0 million in restoration paid to the Federated Funds in the second quarter 2004 as part of the Settlement Charges. In addition, an increase of $10.4 million in “Accounts payable and accrued expenses – other” relates to additional distribution and service fees payable as a result of the assets acquired in the Alliance Acquisition.
Deferred sales commissions paid decreased $13.3 million for the nine months ended September 30, 2005 compared to the same period of last year primarily as a result of reduced sales of the B-share asset class.
Investing Activities. During the first nine months of 2005, Federated used $67.5 million for investing activities. Of this amount, Federated paid $61.0 million for business acquisitions consisting primarily of 1) $33.1 million in
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contingent purchase price payments related to the acquisition of substantially all of the business of the former advisor of the Kaufmann Fund in 2001 (Kaufmann Acquisition), of which $29.5 million was accrued in “Other current liabilities – affiliates” in the Consolidated Balance Sheets at December 31, 2004, 2) $26.2 million related to the Alliance Acquisition and 3) $1.4 million related to the AMCORE Acquisition. Federated used $5.0 million to provide an initial seeding for a fixed-income mutual fund product held as an available-for-sale security. In addition, Federated paid $2.1 million to acquire property and equipment, $1.8 million of which was computer related.
Financing Activities. During the first nine months of 2005, Federated used $102.4 million for financing activities. Of this amount, Federated used $21.3 million to repurchase 0.8 million shares of Class B common stock in the open market and in private transactions. As of September 30, 2005, Federated can repurchase an additional 5.0 million shares through its authorized stock repurchase program.
Federated paid dividends in the first, second and third quarters of 2005 equal to $13.3 million, $16.0 million, and $16.1 million or $0.125, $0.15, and $0.15 per share, respectively. On October 27, 2005, Federated’s board of directors declared a dividend of $0.15 per share that is payable on November 15, 2005.
Stock repurchases and dividend payments are subject to restrictions under Federated’s Credit Facility. These restrictions limit cash payments for additional stock repurchases and dividends to 50% of net income from January 1, 2000 to and including the payment date. After considering earnings through September 30, 2005, Federated, given current debt covenants, has the ability to make additional stock repurchases and dividend payments of more than $127 million.
During the first quarter 2004, management determined that reasonably estimable future cash flows from revenue streams related to B-shares sold through March 1997 would not be sufficient to fully amortize the respective remaining deferred sales commission asset and nonrecourse debt balances. Accordingly, Federated accelerated the write-off of the respective remaining asset and nonrecourse debt balances. As a result, in addition to the normal amortization occurring during the period based on B-share-related distribution, shareholder service and CDSC fee cash flows, the asset balances were written down by an additional $2.7 million and $5.5 million during the first nine months of 2005 and 2004, respectively, while the debt balances were written down by an additional $2.8 million and $5.6 million during the first nine months of 2005 and 2004, respectively. This acceleration of asset and nonrecourse debt write-off resulted in the recognition of a net pretax gain of $0.1 million for the nine-month periods ended September 30, 2005 and 2004, respectively.
Financial Position
“Accrued compensation and benefits” at September 30, 2005 decreased $7.8 million from December 31, 2004 primarily due to the payment of $44.8 million in accrued incentive compensation during the first nine months of 2005 partially offset by the accrual of $38.1 million in 2005 incentive compensation in the same period.
“Other current liabilities – other” at September 30, 2005 decreased $13.1 million from December 31, 2004 primarily as a result of recognizing the insurance recovery proceeds in the Consolidated Statements of Income during the third quarter 2005, of which $16.5 million had been received and recorded as a liability as of December 31, 2004, partially offset by $5.3 million accrued as of September 30, 2005 related to the cost of the Alliance Acquisition.
Additional significant changes in assets and liabilities are discussed elsewhere in Management’s Discussion and Analysis.
Contractual Obligations and Contingent Liabilities
Contractual. Pursuant to various acquisition agreements, Federated is required to make additional payments to the seller contingent upon the occurrence of certain events. In 2001, Federated completed the Kaufmann Acquisition. Pursuant to this acquisition agreement, Federated could pay an additional $33.1 million as contingent purchase price and $6.7 million as contingent incentive compensation between 2006 and 2007 if certain revenue targets are met. The purchase price payments are recorded as additional goodwill at such time as performance targets have been met, while the incentive compensation payments are recognized as compensation expense during the periods in which the payments are earned.
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Internal Review of Mutual Fund Trading Activities. As previously reported, since September 2003 Federated has conducted an internal review into certain mutual fund trading activities in response to requests for information from the SEC, National Association of Securities Dealers and New York State Attorney General. Federated subsequently received inquiries relating to such trading activities from the U.S. Attorneys Office for the Western District of Pennsylvania, the Commodity Futures Trading Commission, the Securities Commissioner and the Attorney General of West Virginia, and the Connecticut Banking Commission. Attorneys from the law firms of Reed Smith LLP and Davis, Polk & Wardwell conducted the review at the direction of a special investigative committee of Federated’s board of directors. The special investigative committee was comprised of the current board. Attorneys from the law firm of Dickstein Shapiro Morin & Oshinsky, LLP, independent counsel for the Federated Funds, participated in the review and reported on its progress to the independent directors of the funds.
As previously discussed, $55.6 million, $17.4 million and $7.6 million have been recorded for estimated Settlement Charges for the nine-month period ending September 30, 2005, and the full years ending December 31, 2004 and 2003, respectively.
Legal Proceedings. Since October 2003, Federated Investors, Inc. and related entities have been named as defendants in twenty-three cases filed in various federal district courts and state courts involving allegations relating to market timing, late trading and excessive fees. All of the pending cases involving allegations related to market timing and late trading have been transferred to the U.S. District Court for the District of Maryland and consolidated for pre-trial proceedings. One market timing/late trading case was voluntarily dismissed by the plaintiff without prejudice.
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Future Cash Needs. In addition to the contractual obligations and contingent liabilities described above, management expects that principal uses of cash will include paying incentive and base compensation, advancing sales commissions, seeding new products, funding marketing and promotion expenditures, repurchasing company stock, paying shareholder dividends, funding business acquisitions, and funding property and equipment acquisitions, including computer-related equipment. As a result of recently adopted regulations and frequent requests for information from regulatory authorities, management anticipates that expenditures for compliance personnel, compliance systems and related professional and consulting fees will increase. Resolution of the matters described above regarding the internal review, other regulatory inquiries and legal proceedings could result in additional accruals and payments, including fines and/or penalties which may have a significant impact on Federated’s liquidity, capital resources and/or results of operations. Management believes that Federated’s existing liquid assets, together with the expected continuing cash flow from operations, its borrowing capacity under the current Credit Facility, the current B-share funding arrangement and its ability to issue stock will be sufficient to meet its present and reasonably foreseeable cash needs.
Variable Interest Entities
At September 30, 2005, Federated acted as the investment manager for two high-yield collateralized debt obligation (CDO) products pursuant to the terms of an investment management agreement between Federated and each CDO. The CDOs are alternative investment vehicles created in 1999 and 2000 for the sole purpose of issuing collateralized debt instruments that offer investors the opportunity for returns that vary with the risk level of their investment. Certain securities issued by the CDOs are subject to greater risk than traditional investment products. The notes issued by the CDOs are backed by diversified portfolios consisting primarily of structured debt and had original stated maturities of 12 years. As a result of their corporate governance, the CDOs meet the definition of a variable interest entity (VIE) under Financial Accounting Standards Board (FASB) Interpretation No. 46 (revised December 2003), “Consolidation of Variable Interest Entities” (FIN 46). After performing an expected cash flow analysis for each CDO, management determined that Federated is not the primary beneficiary of the CDOs as defined by FIN 46 and thus has not consolidated the financial condition and results of operations of these CDOs in Federated’s Consolidated Financial Statements. As of September 30, 2005, aggregate total assets and aggregate total obligations of the CDOs approximated $0.3 billion and $0.4 billion, respectively.
Recent Accounting Pronouncements
SFAS 123(R) – In December 2004, the FASB issued Statement of Financial Accounting Standard (SFAS) 123 (revised 2004), “Share-Based Payment,” which is a revision of SFAS 123, “Accounting for Stock-Based Compensation” (SFAS 123(R)). SFAS 123(R) supersedes APB 25, and amends SFAS 95, “Statement of Cash Flows.” Generally, the approach in SFAS 123(R) is similar to the approach described in SFAS 123, which as discussed in Note (1)(e) to the
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Consolidated Financial Statements presented elsewhere in this report, Federated adopted on a prospective basis as of January 1, 2003. However, SFAS 123(R) requires all share-based payments to employees, including prior grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. The SEC announced in April 2005 that it would require that registrants that are not small business issuers adopt SFAS 123(R) no later than the beginning of the first fiscal year beginning after June 15, 2005. Early adoption is permitted in periods in which financial statements have not yet been issued.
Federated plans to adopt SFAS 123(R) no later than January 1, 2006, but has not yet determined which method of adoption it will use. Federated adopted the fair-value-based method of accounting for share-based payments effective January 1, 2003 using the prospective method described in SFAS 148, “Accounting for Stock-Based Compensation – Transition and Disclosure.” Currently, Federated uses the Black-Scholes formula to estimate the value of stock options granted to employees and is evaluating the most appropriate valuation model to utilize (Black-Scholes or a lattice model) upon the required adoption of SFAS 123(R). Since (1) SFAS 123(R) must be applied not only to new awards but to previously granted awards that are not fully vested on the effective date, and (2) Federated adopted SFAS 123 using the prospective transition method (which applied only to awards granted, modified or settled after the adoption date), compensation costs for certain previously granted awards that were not recognized under SFAS 123 will be recognized under SFAS 123(R). Had Federated adopted SFAS 123 using the retroactive restatement method described in SFAS 148 in prior periods, the impact of that standard would have approximated the impact of SFAS 123 as described in the disclosure of pro forma net income and earnings per share in Note (1)(e) to the Consolidated Financial Statements presented elsewhere in this report. SFAS 123(R) also requires the benefits of tax deductions in excess of recognized compensation costs to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. While Federated cannot estimate what those amounts will be in the future (because they depend on, among other things, when employees exercise stock options), the amount of operating cash flows recognized for such tax deductions were $2.5 million and $37.2 million for the nine months ended September 30, 2005 and 2004, respectively.
FSP EITF 85-24-1 – In March 2005, the FASB issued Staff Position EITF 85-24-1 “Application of EITF Issue No. 85-24, “Distribution Fees by Distributors of Mutual Funds That Do Not Have a Front-End Sales Charge,” When Cash for the Right to Future Distribution Fees for Shares Previously Sold Is Received from Third Parties” (FSP EITF 85-24-1). FSP EITF 85-24-1, which addresses when revenue should be recognized by the seller for sales of rights to future cash flows relating to certain distribution fees, was effective for reporting periods beginning after March 11, 2005. Funding of the payments made by Federated of upfront commissions paid upon the sale of Class B shares of Federated-sponsored
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mutual funds is made through arrangements with independent third parties by selling the rights to all related future distribution fees, servicing fees and CDSCs. Federated adopted the provisions of FSP EITF 85-24-1 effective April 1, 2005. The adoption did not have an impact on Federated’s results of operations or financial position. For financial reporting purposes, Federated continues to account for these arrangements as financings.
Critical Accounting Policies
Federated’s Consolidated Financial Statements have been prepared in accordance with U.S. generally accepted accounting principles. In preparing the financial statements, management is required to make estimates and assumptions that affect the amounts reported in the Consolidated Financial Statements and accompanying notes. Management continually evaluates the accounting policies and estimates it uses to prepare the Consolidated Financial Statements. In general, management’s estimates are based on historical experience, on information from third-party professionals and on various other assumptions that are believed to be reasonable under the facts and circumstances. Actual results may differ from those estimates made by management and those differences may be significant.
Of the significant accounting policies described in Federated’s Annual Report on Form 10-K for the year ended December 31, 2004, management believes that its policies regarding accounting for intangible assets, income taxes, stock-based employee compensation and loss contingencies involve a higher degree of judgment and complexity. See Note (1) of the Consolidated Financial Statements included in Federated’s Annual Report on Form 10-K for the year ended December 31, 2004.
Accounting for Intangible Assets. Two aspects of accounting for intangible assets require significant management estimates and judgment: (1) valuation in connection with the initial purchase price allocation and (2) ongoing evaluation for impairment. The process of allocating purchase price based on the fair value of identifiable intangible assets at the date of acquisition requires management estimates and judgment as to expectations for profit margins on the assets, asset redemption rates, growth from sales efforts and the effects of market conditions. If actual operating margins or the rate of change in assets, among other assumptions, differ significantly from the estimates and judgments used in the initial valuation for the purchase price allocation, the intangible asset amounts recorded in the financial statements could be subject to possible impairment or could require an acceleration in amortization expense that could have a material adverse effect on Federated’s consolidated financial position and/or results of operations.
The level, if any, of impairment of customer-related intangible assets, such as investment advisory contract intangible assets, is highly dependent upon the remaining level of managed assets acquired in connection with an acquisition. Approximately 52% of the carrying value of Federated’s customer-related intangible assets as of September 30, 2005 relates to a single renewable investment advisory contract with one fund. Consecutive annual declines in the managed asset balance in this particular fund in excess of 62% over its remaining useful life could have a considerable impact on the underlying value of Federated’s customer-related intangible assets. To date, the actual compound annual rate of change in the acquired assets in this fund since the acquisition in 2001 has been more favorable than the assumed rate. No changes have been made to this estimate to date.
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Accounting for Income Taxes. Significant management judgment is required in developing Federated’s provision for income taxes, including the determination of deferred tax assets and liabilities and any valuation allowances that might be required against the deferred tax assets. As of September 30, 2005, Federated had not recorded a valuation allowance on the $6.0 million deferred tax asset relating to Federated’s CDO other-than-temporary impairment losses (unrecognized for tax purposes). Federated considered the following facts in connection with its evaluation of the realizability of the $6.0 million deferred tax asset: (1) the actual amount of capital loss associated with Federated’s remaining investment in the CDOs will not be known until such time as those investments are either redeemed by the CDOs or sold by Federated; (2) the carry-forward period for capital losses is five years; and (3) Federated has historically generated capital gains in times of favorable market conditions. Based on these factors, management believes it is more likely than not that Federated will be able to utilize these losses in the future. In the event that Federated’s preliminary strategies do not materialize, Federated may be required to record a valuation allowance of as much as $6.0 million for these deferred tax assets.
Accounting for Stock-Based Employee Compensation.Federated adopted the fair-value recognition provisions of SFAS 123 for employee stock-based compensation for all stock-based awards granted, modified or settled on or after January 1, 2003. Awards granted prior to 2003 continue to be accounted for using the intrinsic-value method prescribed by Accounting Principles Board Opinion No. 25. Had compensation costs for all stock options and employee restricted stock been determined based upon fair values at the grant dates in accordance with SFAS 123, Federated would have experienced net income and earnings per share similar to the pro forma amounts disclosed in Note (1)(e) to the Consolidated Financial Statements presented elsewhere in this report.
Accounting for Loss Contingencies. In accordance with SFAS 5, “Accounting for Contingencies,” Federated accrues for estimated costs related to existing lawsuits, claims and proceedings when it is probable that a liability has been incurred and the costs can be reasonably estimated. Accruals are reviewed at least quarterly and are adjusted to reflect the impact and status of settlements, rulings, advice of counsel and other information pertinent to a particular matter. Significant differences could exist between the actual cost required to investigate, litigate and/or settle a claim or the ultimate outcome of a suit and management’s estimate. These differences could have a material impact on Federated’s results of operations, financial position and/or cash flows.
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Part I, Item 3. Quantitative and Qualitative Disclosures About Market Risk
Market Risk - Investments
In the normal course of its business, Federated is exposed to the risk of loss due to fluctuations in the securities market and general economy. Management is responsible for identifying, assessing and managing market and other risks. Federated’s securities investments are primarily money market funds that have an average portfolio maturity of less than 90 days. Federated also invests in mutual funds sponsored by Federated (initial seedings) in order to provide investable cash to the fund thereby allowing the fund to establish a performance history. Federated may use derivative financial instruments to hedge these investments. At September 30, 2005, Federated was exposed to price risk with regard to its $6.1 million of investments in fluctuating-value mutual funds. Price risk is the risk that the fair value of the investments will decline and ultimately result in the recognition of a loss for Federated. At September 30, 2005, Federated also held a $0.5 million investment in the common stock of large-cap companies which exposed it to price risk. Federated did not hold any derivative investments at September 30, 2005.
Market Risk - Revenue
It is important to note that a significant portion of Federated’s revenue is based on the market value of managed and administered assets. Declines in the market values of assets as a result of changes in the market or other conditions will therefore negatively impact revenue and net income.
Approximately 42% of Federated’s revenue in the first nine months of 2005 was from managed assets in money market products. After reaching record lows, short-term interest rates began to rise in 2004 and are expected to continue to increase. In a rising-rate environment, certain institutional investors using money market products and other short-term duration fixed-income products for cash management purposes may shift these investments to direct investments in comparable instruments in order to realize higher yields than those available in money market and other fund products holding lower-yielding instruments. In addition, rising interest rates will tend to reduce the market value of bonds held in various investment portfolios and other products. Thus, increases in interest rates could have an adverse effect on Federated’s revenue from money market portfolios and from other fixed-income products.
For further discussion of managed assets and factors that impact Federated’s revenue, see the sections entitled “General,” “Asset Highlights” and “Contractual Obligations and Contingent Liabilities” herein, as well as the sections entitled “Regulatory Matters” and “Risk Factors and Cautionary Statements” in Federated’s Annual Report on Form 10-K for the year ended December 31, 2004 on file with the Securities and Exchange Commission.
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Part I, Item 4. Controls and Procedures
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Part II,Item 1. Legal Proceedings
The information required by this Item is contained in Note (14)(d) to the Consolidated Financial Statements contained in Part I of this report and is incorporated herein by reference.
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Part II, Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
(c) The following table summarizes stock repurchases under Federated’s share repurchase program during the third quarter 2005. Stock repurchases and dividend payments are subject to the restrictions outlined in Note (7)(a) to the Consolidated Financial Statements contained in Part I of this report.
July
August2
September2
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Part II, Item 4. Submission of Matters to a Vote of Security Holders
No matters have been submitted to a vote of security holders during the period covered by this report.
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Part II, Item 6. Exhibits
The following exhibits required to be filed by Item 601 of Regulation S-K are filed herewith and incorporated by reference herein:
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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.
(Registrant)
/s/ J. Christopher Donahue
/s/ Thomas R. Donahue
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