Waddell & Reed Financial Inc
Q2 2017 Earnings Call Transcript

Published: 1 Aug 2017

[Operator:]

Good morning, and welcome to Waddell & Reed's Second Quarter 2017 Earnings Conference Call. All participants will be in listen-only mode. After today's presentation, there will be an opportunity to ask questions. Please note, this event is being recorded. I'd now like to turn the call over to Phil Sanders, Chief Executive Officer. Please go ahead, sir.

[Philip James Sanders:]

Good morning, everyone. With me today are Tom Butch, our Chief Marketing Officer; Brent Bloss, our Chief Financial Officer; and Nicole Russell, our Head of Investor Relations. Nicole, would you please read the forward-looking statement?

[Nicole McIntosh-Russell:]

During this call, some of our comments and responses will include forward-looking statements. While we believe these statements to be reasonable based on information that is currently available to us, actual results could materially differ from those expressed or implied due to a number of factors including, but not limited to, those we reference in our public filing with the Securities and Exchange Commission. We assume no duty to update any forward-looking statements. Materials that are relevant to today's call, including a copy of today's press release as well as supplemental schedules, have been posted on our Investor Relations section of our website at ir.waddell.com under the Investor Information tab.

[Philip James Sanders:]

Okay. Thanks, Nicole. Good morning, again. We have two purposes for today's call. The first is to review our quarterly earnings, and the second is to provide an update on the corporate initiatives we first outlined about a year ago. Starting with second quarter results, this morning, we reported net income of $23 million or $0.28 per share compared to net income of $33 million or $0.39 per share in the previous quarter. As Brent mentioned in our last earnings call, an accounting standard change in the January of this year had a meaningful impact on our second quarter's tax expense. As a result of this change, we recorded an additional $9 million in tax expense or $0.11 per share. Brent will provide more details on our financial results later. Gross sales of $3.3 billion during the quarter increased 13% compared to the prior quarter, and 17% compared to the second quarter of 2016. It is also worth noting that sales in each retail channel reached a multi-quarter high. Net outflows of $2.5 billion during the quarter also saw marked improvement, reflecting progress not only in sales, but also abatement in redemption pressure. While much work remains to be done, early indications are encouraging. Preliminary assets under management at the end of July were $81.0 billion. We will begin reporting month-end assets under management on a monthly basis beginning with July asset levels next week. Let me now turn it over to Tom for a review of the quarter's sales results. Tom?

[Thomas W. Butch:]

Thanks, Phil. Beginning with retail unaffiliated sales, results continued on their encouraging trend. Net outflows at $571 million were approximately one-third of the prior quarter's amount, and were at their lowest level since the second quarter of 2014. This resulted both from the continuing slowdown in redemptions and a third consecutive quarter of growth in gross sales. Thus far, in July, gross sales are roughly consistent with second quarter levels, and redemptions continue to decline. During the quarter, gross and net sales were led by our International Core Equity and Emerging Markets Equity strategies. Outside these products, importantly, redemptions and net outflows decreased among all our other largest AUM strategies, Asset Strategy balanced, high income, mid-cap growth and science and technology. In the broker-dealer channel, proprietary net outflows at $911 million; decreased by 19% from the prior quarter as gross sales ticked up slightly and redemptions slowed. July redemptions were in line with those in the second quarter; sales levels were softer. On May 22nd, we launched our MAP Navigator Advisory program, inclusive of funds from four unaffiliated asset managers. As you'll recall, the $43 billion in proprietary assets in the broker-dealer channel comprises $28 billion in commissionable assets, and $15 billion in advisory programs, principally our proprietary MAP program. So far, the run rate of assets transferring to other fund families in MAP Navigator from the combination of either MAP or commission assets in the channel, is within the $1 billion to $3 billion range over 12 to 18 months that we set forth in prior calls. That said, we're just 10 weeks into this program, and advisor interest is still accelerating, so we're cautious about drawing definitive conclusions from so preliminary, a data set. There are, however, two other things worth noting. First, there's been no appreciable shift with our proprietary commission assets away from proprietary funds to commissionable funds of other fund families. And second, the new SPA, or Strategic Portfolio Allocation program, which is a home office discretionary program that is run by Wilshire, and comprises proprietary funds only, just launched on July 10th, eight weeks after MAP Navigator. Interest in this program, which again comprises proprietary funds only, is solid, but as anticipated and discussed on last quarter's call, not at the rate of the Navigator uptake; only in future quarters will we have any real insight into its adoption. AUA at quarter-end in the broker-dealer was $54.1 billion compared with $53.6 billion at March 31. The institutional channel remained subdued as certain strategies central to that channel continued to experience performance challenges. Post quarter-end, the client redeemed an account with AUM of about $450 million. The institutional pipeline remains soft with a span of primarily early-stage opportunities. Now, let me turn it over to Brent for more financial detail on the quarter. Brent?

[Brent K. Bloss:]

Thanks, Tom. As Phil noted earlier, the current quarter included almost $9 million in additional tax expense related to an accounting standard change that requires tax benefits or shortfalls from vesting of restricted stock to be recorded to the income statement. Prior accounting guidance allowed tax deduction differences between the grant date pricing of awards and their ultimate vesting prices to be recorded through equity. Since restricted stock awards vesting in the second quarter had a grant date stock price in excess of their vesting price, we incurred a tax shortfall requiring an increase to tax expense. Operating revenues increased slightly during the quarter, reversing a downward trend that started in the third quarter of 2015. Lower average assets under management in the quarter were offset by an additional day of management fees. Operating cost increased $1.8 million or less than 1% sequentially. In the quarter, we had several expenses not expected to continue in our future run rate, including fund proxy and start-up expenses of $900,000 related to fund additions and upcoming mergers. Tom will talk about the competitive and business significance of these mergers later. I would like to touch on the financial impact of the funds' merger activity. Merger documentation was filed yesterday to merge nine Waddell & Reed Advisor Funds into Ivy Funds counterparts; these mergers are expected to close in October. We intend to recommend that the Mutual Fund Board of Trustees approved the merger of the remaining advisor funds into Ivy Funds in the coming months. After the mergers are complete, we anticipate the combined AUM level of the newly-merged funds will result in the reaching additional breakpoints. As a result, we anticipate annual management fee revenues for the nine merged funds to decline by approximately $400,000 in 2017. Assuming board and regulatory approval of mergers of all remaining advisor funds into Ivy Funds, we expect the 2018 impact of all mergers to revenues to range between $10 million and $11 million. Other cost in the quarter not expected in our ongoing run rate include legal expenses of $2.2 million; fund start-up and merger cost of $900,000, which I mentioned earlier; and a technology license true-up of $600,000. Cost for implementation of Project E totaled $1.2 million in the quarter, while DOL costs came in at $800,000. Total cost for these initiatives were down $1.5 million compared to the prior quarter, and are running slightly under budget year-to-date. Finally, we recorded an impairment charge of $900,000 related to a sub-advisory intangible during the quarter. Following this write-down, the intangible has a remaining value of $1.2 million. On the capital return front, our cash and investment balances totaled $870 million at the end of June, excluding non-controlling interest and unsettled investment activity. During the quarter, we began to put in place a laddered investment portfolio to optimize the return on our cash. Our strong balance sheet continues to give us flexibility as we look to reposition the company for future growth. At the current time, we are comfortable in our ability to pay the dividend, and repurchase shares to offset dilution from our restricted stock grants. That said, the management team and the board continue to monitor our financial outlook, growth and investment opportunities to ensure we are managing our capital return policy appropriately. Now, let me turn it back to, Phil.

[Philip James Sanders:]

Thank you, Brent. As I indicated at the call's outset, in addition to our discussion of the quarter today, we want to give you greater insight into our specific plans for the business in the near and intermediate terms. The current management team has been in place for about a year now. During that time, we have focused on several key initiatives, including

[Thomas W. Butch:]

Thanks, Phil. Phil obviously laid out our corporate plan very well. I'd add just a few comments on the product and sales strategy, and the broker-dealer strategy. By way of sales, we have, as I indicated earlier, made continuous progress sequentially in reducing net outflows. This is substantially the sales progress we've made in our International Core Equity and Emerging Markets Equity products, as well as some others. Were you to go back a few years, neither of those two would have been essential to our sales mix, but today, they are its leaders. I make that point, because we continue to work very hard to broaden and adapt the product line to what may be the next opportunity set. We believe that the future for active lies increasingly in distinctive high-performing and cost-competitive product. Directionally, this has been our focus, and we expect more of this going forward. In that vein, we are reviewing existing products for their long-term efficacy, and we'll replace, refine or merge those for which there is not an identifiable path forward. By way of efficiency and brand uniformity, as previously noted, we have filed to merge nine of our Waddell & Reed Advisors Funds into our Ivy Funds, and expect those mergers to close in October. We also intend to recommend to the Mutual Fund Board of Trustees that all remaining Waddell & Reed Advisors Funds be merged into the Ivy Funds. Assuming regulatory and board approval, we would expect those mergers to close in the first quarter of 2018. This $26 billion in advisor fund assets will increase the Ivy Funds family total AUM by almost 70%. This obviously provides greater brand leverage and for fund shareholders cost efficiency. Brent discussed the revenue impact earlier. The other sales note I would make is that in September we will launch a new CRM capability that will provide a new framework for utilizing business intelligence to identify opportunity and drive sales. Data availability has grown exponentially in recent years that enables more targeted and efficient selling. As for the broker-dealer, Phil lined out the changes pretty comprehensively, and Brent will go over the financial impacts. A couple of additional things are worth noting. We expect that our proprietary products will remain central to Waddell & Reed Advisors. This is a huge part of what binds us culturally. We're opening our architecture gradually even as other broker-dealers are shrinking theirs. The industry destination point is probably somewhere in the middle. And whatever evolves, we believe the asset manager remains a valued partner to the broker-dealer. That said, the level of proprietary assets will reduce over time. It will be our goal to partly replace those less associated revenues through greater AUAs and new broker-dealer revenue streams. Two of the key changes we are making in the broker-dealer are to increase our advisor payout grid to more competitive industry standard and over time to increase minimum revenue requirements for advisors. The shift in the manner we offer services to advisors allows us the flexibility to increase the dollars we are able to add to the enhanced payout grid. The result is a grid that looks far more industry standard, which allays confusion among advisors and recruitment prospects. As to minimums, they will be graded in over multiple years. So while the minimums will result in advisor attrition, we believe many advisors will rise to the new minimums where others are likely to join teams. And those who do neither may sell their books to other existing Waddell & Reed Advisors. As a result, we'd expect asset attrition relating to the changes in advisor minimums to be manageable. As we move forward, we expect to maintain the most distinguishing features of the broker/dealer, the offering of valued field leadership, a competitive span of individualized service and that long-standing linkage with our asset manager, while taking steps to be fully competitive within the emerging independent broker/dealer world. With that, let me turn it to Brent to add financial dimension to the strategy discussion. Brent?

[Brent K. Bloss:]

Thanks, Tom. The final leg of our strategy focuses on corporate efficiency. This includes making thoughtful investments in our business and in our people to support the evolution of our model. While the plan calls for investments in growth, we are mindful of the dynamic environment for our business and the need to be diligent and focused on containing costs. We are undergoing a complete review of our compensation and benefits package to ensure it's competitive in the market. Earlier this year, we hired a Chief Human Resources Officer with deep experience in transformational change to guide us through these challenging yet necessary changes. We recognize the evolution underway in the retirement benefit market and announced yesterday that we will freeze our defined benefit pension plan at the end of September. To assist in this transition, we will provide eligible employees with a one-time transition contribution to their 401(k) accounts at year-end. The net one-time impact of these changes will result in elevated compensation expenses of $3 million in the second half of 2017. However, we anticipate annual savings of $12 million from freezing the pension plans to be fully realized in 2018. Finally, we continue to make more efficient use of our corporate resources. This includes aligning our cost structure to the new operating model by continuously monitoring home office and field support staff and G&A costs. We estimate the run rate of our plan to add $30 million to $40 million to pre-tax income over the next 18 to 24 months. Given the many challenges in the environment for our core business, this vigilance around expense management is and will remain especially important. We take seriously the critical importance of controlling that which we can and our focus on doing so will be visible in our plan and evident on our results going forward. Now let me turn it back to Phil for closing comments.

[Philip James Sanders:]

We are undergoing a period of unprecedented change and recognize that in order to prosper as an organization we must evolve our business model, become more efficient and make significant changes in how we analyze and approach opportunities. Last year, we identified four key priorities, which have evolved into an actionable plan that will touch every part of our organization. Our employees are eager to succeed and collectively are committed to executing these critical strategies. Operator, we would now like to open up the call to questions.

[Operator:]

Yes. Thank you. We now will begin the question-and-answer session. And our first question comes from Glenn Schorr with Evercore ISI.

[Glenn Schorr:]

Hi. Thanks very much. I wonder if you could help break down a little bit of – I'm trying to -- I know there's a lot of moving parts, particularly what's new and not. The $30 million to $40 million of additional pre-tax income in the next 18 month to 24 months, are we talking that specifically from your efficiency efforts? And the $10 million or $11 million that you talked about on the revenue hit from merging the funds, should we, in our minds, be netting those two out when we think about the go-forward from today's run rate? I just want to make sure that we don't miss anything or double count.

[Brent K. Bloss:]

Yes, Glenn, let me set this up a little bit. So as I've communicated in the past, we were targeting run rate second half of 2016 on our fixed cost to be fairly steady with that run rate. That's still our expectation. So what the $30 million to $40 million that we've talked about here is incremental to the cost savings that we put in place in the past. So just to set that straight. On your second question around the $10 million in revenue, that is netted against the $30 million to $40 million.

[Glenn Schorr:]

Okay. So if I was – when you say netted, I just want to make sure. So it's $20 million to $30 million net to the bottom, to the pre-tax line, if I include both?

[Brent K. Bloss:]

No. What I meant to say is that, in the $30 million, the $30 million is an actual savings considering the revenue loss.

[Glenn Schorr:]

Got it. Okay. Perfect. I appreciate that. And then maybe one line in between. I think, in the release, you said talking about spending money on the DOL implementation. And I'm just curious on is there a magic point where that actually starts to fall off. In other words, how much of it is implementation and getting systems in place versus ongoing cost?

[Brent K. Bloss:]

Yes, so for the DOL and Project E, we believe as we approach year-end those will fall off, and we won't have additional onetime implementation cost necessarily going forward or not to a large magnitude. So I've guided in the past on those DOL and Project E costs. We look to position ourselves around probably $9 million total for the year on DOL. So an additional $4 million it looks like in the next couple of quarters.

[Glenn Schorr:]

All right. That's excellent. Thank you. Appreciate it.

[Operator:]

Thank you. And the next question comes from Robert Lee with KBW.

[Robert Lee:]

Thanks. Thanks for taking my questions. Sorry to go back to this, but it's still, for me, needs a little clarification. So the $30 million to $40 million, is that including the $12 million of pension savings you expect each year? So that's a part of it? So there is $10 million less revenues, but there's an offset because you also have $12 million of cost savings. Those are included in the $30 million to $40 million of your pre-tax goal? And is that $30 million to $40 million an annual number? Or is that a cumulative number over the course of those two years?

[Brent K. Bloss:]

That's a run rate number, so a cumulative number, but the $12 million is -- the $12 million for the pension savings is included in that $30 million net savings number. And Rob, we don't have -- besides the reductions in the revenue, just to clarify on the fund mergers, we don't have anything baked into our models for any incremental revenue as a result of that. We put that in the $30 million to $40 million just because of the fund merger. So the rest of it, the benefits from our pension, a couple of other banks, we can highlight here. We expect to pay down that first tranche of our debt in early January of 2018, which results in at lower interest expense of about $5.5 million. And then as I mentioned in our opening comments, we've moved some of our excess cash to a laddered bond portfolio, and we expect to pick up some increased income from that. The rest of the savings, as Tom mentioned, we're moving to complexing in our broker/dealer, our retail broker/dealer, which shrinking that footprint, a lot of real estate cost. And then as we take that on a glide path over time and resize the field, we'll look to services both in the field and in the home office as potential savings.

[Robert Lee:]

Okay. That's very helpful. I appreciate that incremental color. And then maybe just, Tom, a quick question. You gave the July AUM and some color, but do you have a specific flow number for July, just as a starting point?

[Thomas W. Butch:]

No, we don't really have -- we don't have flow numbers for July. I can tell you sort of on a trend basis that the wholesale channel continued to see the abatement in redemptions that it's experienced, and that July on a net flow basis was constructive relative to the prior quarter. And then in the advisors channel, there's a piece that sort of missing in that one relative to the transfer activity that can move that a little bit because, as you know, as advisors leave and reposition -- if advisors leave the firm and repositions their book, that number can move. But as I did say, the redemption picture in that channel was constructive relative to or was in line with the prior quarter and the flows -- and the gross sales were a little bit softer. I think there was some seasonality in the sales. And I think, given the changing dynamic in that channel that the redemption figure is the one that probably merits your attention.

[Robert Lee:]

Great. Thanks for taking my question.

[Operator:]

Thank you. And the next question comes from Bill Katz with Citigroup.

[William Raymond Katz:]

Okay. Thanks very much. I just want to come back to expenses as well, I'm still trying to box the numbers a little bit in my head, so I apologize. Can you break it down a little bit further? So it sounds like there's $12 million coming off the comp line, I guess, related to the pension. So I was sort of curious as to where the other savings are going to feed into. And is it all savings? Or is there an opportunity here to increase revenues as part of that net number?

[Brent K. Bloss:]

So Bill, the $12 million, it would be partially in the comp line and partially in the indirect U&D line. So I'm not going to give specific guidance on the line items because there's a lot of moving parts here. But you'd be correct that that would hit compensation in indirect and the compensation line. And Bill, tell me again what was the second part?

[William Raymond Katz:]

Right. I'm just trying to get to -- I understand the price reduction. I understand the benefit savings by shifting to defined contribution from DV. (32

[Brent K. Bloss:]

Yes, the savings really come from the indirect line, the compensation line and the channel and administration line. Like I said before, we haven't built any enhancements into the revenue line, so it's pretty much status quo based upon our model. So we haven't built in any incremental revenue. Again, the fund mergers are a part of that $30 million to $40 million; without those, our savings would be $40 million to $50 million.

[William Raymond Katz:]

And my follow-up question, Phil, I'm just curious, your feedback, here. One of the key themes coming off the second quarter earnings season from many of your larger peers is a pretty significant step-up of spend, whether it'd be technology, distribution, compliance, what have you. And appreciate; you guys have been sort of studying your business now for the last year or so since you took over leadership. But these savings sort of seem to come at a time when the industry itself is spending. Can you talk a little bit about how you think the revenues play out from here? I guess I'm trying to understand what the top line leakage might be as you go through this sort of reshaping of the business model?

[Philip James Sanders:]

Well, I might start, and others can jump in. I think we have a lot of things that we've been focusing on. Obviously, we had – we started this, and we had significant performance challenges in key products. And so, that became kind of job one. So we've tried to focus efforts on improving that. I think we've made pretty decent progress. Obviously, there's a lot more work to do, but the flows are the single biggest thing that can change our story, obviously, and our growth trajectory. So that's going to be a challenge for us. So we've made progress, but we still have some flow headwinds. We also know that – we knew the next 18 months to 24 months are going to be a little bit of a challenge as we gradually open up the architecture in the broker-dealer, so we're going to have to overcome that. In the long run, I think that will be a positive for us as we have enhanced value propositions for our clients and advisors, and hopefully grow our AUA over time. The turnaround in the retail unaffiliated or wholesale part of our business is a big part of our strategy going forward. And we've got some key products that are flowing positively here, that can help us in that dynamic. You're right, though, that in terms of – that's a headwind. We also know, facing the industry, there's a lot of fee pressures that we have to deal with. It's all in the background of us being a little bit unique in this industry in the sense that we own a broker-dealer that its heritage has been primarily proprietary. So we've had to evolve our business model. We've got a lot of moving parts here. I'm sure you can appreciate that challenge. But I think we're making good progress on many fronts. And while we know we need to grow revenues over time to grow the earnings power – I might let Tom or Brent to add anything there to see. The one final thing I would just mention, before I let them touch in is, we've put a lot of, I think, a fair amount of investment in kind of what we need to do in terms of grow, and that's whether it's people or technology or the resources and so forth. So it's really getting the model to a position where we can then execute upon it, and grow over time. So I'll let Tom and Brent add anything there if they want.

[Thomas W. Butch:]

I just have a couple of quickies. We focused most of the conversation about the evolution of the broker-dealer around its potential effect on proprietary assets, which, of course, is critically important. At the same time, because we grew up as a substantially proprietary broker-dealer revenue sources attaching to broker-dealers weren't things that we had. So if you look at potential revenue lift as the broker-dealer becomes more self-sustaining, and we take on more product partners, the revenue streams coming from them to the broker-dealer is something that is substantially new to us. Reviewing all products and programs as we are for their competitiveness from a pricing perspective in the industry, and the breadth we have to look at pricing is another thing. So those are two potential sources of revenue lift. And as Phil pointed out, obviously, the most powerful thing is to broaden the span of products that are selling or getting closer by the quarter to sort of flattening out net sales, and hopefully getting back on a growth trajectory. And we're not far away from doing that; presuming we (37

[William Raymond Katz:]

Thank you.

[Operator:]

Thank you. And the next question comes from Craig Siegenthaler with Credit Suisse. Craig Siegenthaler - Credit Suisse Securities (USA) LLC Thanks. Good morning, everyone. Phil, if we take a step back on the $30 million to $40 million profit objective, what type of operating margin are you targeting in really one to two years after the expense cuts have flowed through and one-time items you normalize?

[Brent K. Bloss:]

Yeah, I think, they will – based on what Phil just said, we're going to face some headwinds here in the next 18 to 24 months. And so, Craig, I'd expect those to settle in the low-20s after we embark on these initiatives, and make these cuts. Craig Siegenthaler - Credit Suisse Securities (USA) LLC Got it. And then also, in the retail broker-dealer channel, there's a pretty sharp rotation out of equities into bonds. I know we're seeing that in a lot of places, but it looked a little more significant in your results this quarter. Do you know what drove this?

[Thomas W. Butch:]

It's principally decision-making by advisors relative to their asset allocation, the overwhelming amount of sales in that channel, about two-thirds, is driven by advisory sales, wherein advisors are making asset allocation decisions. It's certainly possible, too, that, within that channel, the rotation was driven partly by the fact that, as you'll recall, we hired Wilshire to assume management of the Advisors Asset Strategy Fund. And just the reallocation of that, which was principally in equities into a broader span of products, that's a fund of funds, probably drove a piece of that as well. Craig Siegenthaler - Credit Suisse Securities (USA) LLC Got it. Thanks, Tom.

[Operator:]

Thank you. And the next question comes from Dan Fannon with Jefferies & Company (sic) [Jefferies LLC].

[Daniel Thomas Fannon:]

Thanks. So, a couple more questions here on the expenses. So I guess, what are the factors that would potentially drive you to be at the low-end of the $30 million or the high-end of the $40 million in terms of the savings? And then, in terms of revenue impact on those assumptions, there's no revenue synergies or either revenue impact associated with outside of what you called out on the management fees? Just want to clarify that.

[Brent K. Bloss:]

No, there's no revenue impacts other than the fund mergers. In terms of the delta between the $30 million and $40 million, and what might impact that, again, we're on a glide path here, as Tom mentioned, with the footprint in the field. So depending on how quickly that comes, we can restructure in the field that will impact it. Also, we're looking at all of our expenses internally here in the home office, and looking for efficiencies; we have several initiatives already underway and looking at things. And so, that will take some time to get those really up to speed and running. But we expect, on the fourth – third quarter to have more details on the specifics of the initiatives we have, but it will depend on how we can pull efficiencies out between that delta, between the $30 million and $40 million, in the home office, primarily.

[Daniel Thomas Fannon:]

Okay. And then, Tom, just a follow-up on the broker-dealer. You mentioned a gradual rollout of the open architecture. So maybe update us on kind of what that means until you – where you are, I guess, in that process? And then, in terms of the overall, kind of, productivity, we've seen the advisor head count go down. Are we going to – should we continue to see that as a trend in terms of kind of the calling of the lower productive brokers?

[Thomas W. Butch:]

Sure. When I say gradual opening of architecture, I would point out that, on the commissionable side of our business, though it is very heavily weighted to proprietary products we have for many, many years, had selling agreements with roughly a hundred fund companies. So the principal change, as discussed in prior calls, was the implementation of a new advisory program, which for the first time, included four unaffiliated fund families, sort of household name fund families; that launched on May 22nd. So the discussion of opening the architecture has to deal with that, which is on the classic side, the largest side of our broker-dealer. There's another side, Choice, it is pretty much an open – a fully open architecture broker-dealer. That program, as I said, launched in mid-May. And the uptake has been substantial, I think, relative to the time it's been in the marketplace. And we are the most adopted of the fund families in it, though lower than the range of adoption we thought for our products. On the other hand, adoption generally has been, though, I think, fertile. At the same time, it's well within the bounds of what we had considered. So if you take those two factors, overall adoption and the degree to which asset allocation moves away from our products, we're still comfortably within the range that we set forth on the last call. So that's what I'd say relative to the architecture. It's really moving it into the advisory part of the classic business, which is the largest part of our sales mix in the broker-dealer, goes to advisory, as is true with other broker-dealers. Relative to head count, your other question, yes, I do think you can expect it to continue to decline sequentially. As I said, we've put in new – we will put in new minimum production requirements beginning next year. Those will get us closer over time, gradually and thoughtfully to a more industry-level of minimum production. It is our hope that as many advisors as possible, obviously reach those new thresholds or join teams. So we'll see how that goes. But I don't think there's ambiguity around the fact that the head count will over time sequentially decrease.

[Daniel Thomas Fannon:]

Great. Thank you.

[Operator:]

Thank you. And the next question comes from Patrick Davitt with Autonomous Research.

[Patrick Davitt:]

Hey, good morning. Thanks for taking my question. One more on the $30 million to $40 million, does that account for any increased compensation related to the increased payout grid that you mentioned?

[Brent K. Bloss:]

Yes, there's really no incremental cost of increasing that payout grid. What we've tried to do is, as Tom outlined in his opening comments, we have taken services that we've in the past included in the grid, which drove it down and pulled those out, and advisors have more of an à la carte type situation now, where they can purchase services. So there's no real incremental cost in the grid. There might be – there's – I should say, there's a small investment in that grid, but nothing material.

[Patrick Davitt:]

Okay. Thank you. And then, on the flow trajectory, I guess, it looks like, there's been a pretty significant pivot since May from a positive trend to a negative trend, at least from what's implied by the AUM number you gave in July. Do you think that's mostly the opening of the architecture on May 22nd? And if so, what is the kind of trajectory for that playing out you think in your mind? I guess, this shift in the second derivative.

[Brent K. Bloss:]

Okay, okay. Well, what I'd say is that – you're talking – I want to reset the question. I'm sorry; you're talking specifically about the advisor channel?

[Patrick Davitt:]

No. Broadly, the monthly flow trajectory because you gave us April and May at the beginning of June. And it looks like June was worse than May, and then July is even worse than that.

[Brent K. Bloss:]

Yeah.

[Patrick Davitt:]

I suspect, that's at least partly driven by this new platform, and since we're kind of in the early stages of it, how long do you see that kind of reversal of the positive second derivative trend playing out with this new platform?

[Thomas W. Butch:]

Yeah. So what I'd point out is that, that trend, I think that you're discussing was true in the advisors channel. I'm not sure that it played out in the wholesale channel in the way that you are mentioning. Yeah, the advisor channel, I think the July results would suggest a leveling of the net flow experience or the net sales experience. As I said, we don't have the net flow number. Again, redemptions in the month of July were south of the prior month, and sales were also south. So I'd – answering your question more broadly, I think, the trends in the wholesale business seem to be sustaining, and on a net flow basis improving. And that is on a monthly basis, inclusive of the months you talked about. And I think in the broker-dealer channel, there's a little bit more ambiguity, because we'll have to wait and see the effect of the Navigator, the Navigator program, and the degree to which that in any way reduces the flow into proprietary products. But so far, as I said, I don't think there's a discernible trend that says that is resulting in material changes to the net sales and net flow experience. Finally, I'm wondering if the institutional outflow that we discussed, that took place first quarter is something that factors into what you've seen. So that's a long answer. But I don't think that the trends are materially reversed in any sense, certainly, not in wholesale. On the retail side, we've seen perhaps some of the impact of the Navigator launch on proprietary flows, but again, that appears to be in a range of reasonableness so far.

[Patrick Davitt:]

Okay. That's helpful. Thank you.

[Operator:]

Thank you. And the next question comes from Mike Carrier with Bank of America Merrill Lynch.

[Michael Carrier:]

Hi. Thanks, guys. Tom, you mentioned some of the products that are kind of taking a lead at this point. I think, you mentioned internationally, but just any sense, maybe in terms of platforms that you're seeing the momentum versus one that could be added on; just trying to get some sense on some of these newer products?

[Thomas W. Butch:]

Yeah, if you look at the flows beyond those couple of products, our small-cap suite is in positive sales. And even some of our core products like mid-cap, for example, in the month of July, had a really constructive month. But as you point out, we are in the process of having a lot of activity on the research pipeline at the broker-dealers. So the process of getting funds listed is much more complex than it was in the past. And as you know, there are multiple levels. One is, getting a fund up and running; and two is, getting it research covered and/or in a preferred situation. So what I'd say is, those couple of funds that we have talked about is really driving the bus are capturing the attention of research teams at the broker-dealer, and hopefully will have some placements beyond just being on platforms. And separately, there's a great deal of activity relative to the placement of many of the funds that we've launched in the recent past, which, as you know, have been somewhat plentiful as we've had a pretty aggressive product development agenda. Sort of taking your question to the next level, I do think that, if you look at where retail flows are going, obviously, what would really help us is, breaking through in a couple of the large bucket categories on the fixed income side that are material recipients of active flow, which most still are, and working very hard to make that happen as well. And we have some products we think will be very competitive to help. So I hope, that's responsive to your question. The short story is, we have a couple of things that are working really well. We have a subset that's working, but needs to increase its momentum. And we have some things on deck that if we make them work should continue to move the story forward.

[Michael Carrier:]

All right. That's helpful. And then just maybe a follow-up, Brent, just on the kind of the strategic guidance. if I look at the fund mergers, the revenue loss there, and then the pension, that's mostly a wash, maybe $2 million (52

[Brent K. Bloss:]

Yeah. So Michael, in terms of – you had it right in netting those fund mergers and the savings from the defined benefit freeze. So you pick up a couple of million there. Then, the $5.5 million from the interest of paying down those private placement notes. And then, we have modeled in somewhere around $5 million, I think, of pickup and investment income from redeploying our cash on a run rate basis. And then, the rest of the activity relates primarily to – centered around the broker-dealer, which, as we've talked about, we have to move that to a more profitable standing, and that gradually opening this architecture puts us in a different place than we've been in the past. We could rely on the management fees of selling primarily proprietary products, and as that changes over time, Tom has mentioned the movement of $1 billion to $3 billion in assets in our advisory programs, and we're on track to do that. But again, we're looking to decrease that footprint in the field. We've already started with some complexing of our field offices and look to shrink that footprint over time. So there's some – the cost savings from those restructurings, not only in the field, but the services that we provide in the home office around running that broker-dealer, should be able to be decreased over time; so the real delta is there. And then, on top of that, we're – as we've laid out in our plan here, we're just looking for efficiencies internally as well. We took $40 million out in the prior year. We think, there's still some opportunities. And we will get more specific, as I said, in subsequent quarters as these initiatives get underway. And we do have targeted areas that we're looking at for efficiencies. And as those – as we get more details around that, we'll share it. But we feel pretty confident in the $30 million – at least the $30 million, and hopeful to get to $40 million.

[Michael Carrier:]

Okay. Thanks a lot.

[Operator:]

Thank you. And the next question comes from Kenneth Lee with RBC Capital Markets.

[Kenneth S. Lee:]

Focus on the broker-dealer unit. In terms of the advisor payout changes, fair to say that, most of it's being driven by the potential loss of fee revenues, given the DOL fiduciary rule; or is it more of a just a general improvement of profitability?

[Thomas W. Butch:]

It's driven substantially by the fact that we were sort of anomalous in the way that we did our payout, in that we had a package of services we provided to our advisors. It was effectively put into the grid and, therefore, effectively netted against it, and it led to optically a grid which did not appear to be in line with other independent broker-dealers. So what we've done is, we've taken the money attaching to those services, pushed it back into the grid and pushed the services outside the grid, which has the two-fold purpose of elevating the grid to a place where it's more comparable to those of other independent broker-dealers, which as I said in my remarks, allays confusion relative to our advisors and prospective advisors joining our firm. And also, does not tether our advisors to a specific span of services that enables them to purchase those which are more relevant to their practice, so that was the principal motivation.

[Kenneth S. Lee:]

Got you. Okay. So it sounds like more of a migration towards like a franchisee model that we've seen in some other platforms?

[Thomas W. Butch:]

No, it's an independent broker-dealer model.

[Kenneth S. Lee:]

Got you. And just one follow-up question; in terms of the specialty products, there was mention of the expansion of specialty products. What sort of factors would influence the decision to either acquire or utilize like a sub-advisory relationship when introducing new products?

[Philip James Sanders:]

Yes, this is Phil. I think we consider a lot of factors. Obviously, we'd probably be more interested in things that are outside of our core capabilities. In the recent past, we've explored sub-advisory relationships in kind of the real estate, alternative credit, emerging market debt; and we have some excellent partners there. But whether it's a sub-advisory relationship, or as we indicated, a lift-out of particular team or something that brings us specialty or a unique ability that we don't have internally, we're open-minded to that. I think, we understand that we're good at a lot of things, but there are other things that we don't have a deep expertise in. So I think, as the industry has evolved, our clients want more options, more choices. And we need to be able to deliver that. So just a wide range of considerations, but I think we're open-minded, and each opportunity needs to be evaluated on its own merits.

[Kenneth S. Lee:]

Great. Thank you very much.

[Operator:]

Thank you. And the next question comes from Richard Tattersall with Heathbridge Capital Management.

[Richard Michael Tattersall:]

Hi, given your ancient history back as part of insurance company, are you selling any of your funds through insurance brokers or insurance companies? And indeed, have any insurance companies approached about becoming owners of Waddell & Reed?

[Thomas W. Butch:]

I will answer the first question, and that is, yes, we have a variable insurance portfolio product line that's about $12.5 billion. And it is distributed both through our proprietary broker and many unaffiliated broker-dealers as part of their variable insurance shelves.

[Philip James Sanders:]

And this is Phil, I guess, with respect to the second part of your question. Obviously, we're not going to comment on speculation or – in the marketplace with respect to that. We're just really focused on running the best company we can; got a lot going on here, and that's where our focus is today.

[Richard Michael Tattersall:]

Thanks.

[Operator:]

Thank you. And the next question comes from Mac Sykes with Gabelli.

[Macrae Sykes:]

Good morning, gentlemen. Can we talk about the transformation of Waddell & Reed in your core competencies? When you think about your strategy five years out, will the firm look more like a wealth manager supported by an investment team as opposed to the current asset manager that acquired Ivy to diversify distribution?

[Philip James Sanders:]

Well, that's a good question. I don't know. I think, it's hard to say. I think, we've got a long heritage. I think, at our core, we're an investment manager, and an asset manager. We've invested heavily over the past decades in developing that expertise, and we have a lot going on here. I think we will continue to evolve the product line and develop, and always have a deep investment expertise and a commitment to that. The broker-dealer side of the business is something that we're in the early stages of evolution here. We've all kind of mentioned this periodically, but the last decades have been built on a broker-dealer that sold primarily proprietary funds. So I envision, that's clearly going to evolve over time and is in the process of changing today as we speak. So it's unclear where that eventually settles out, but it's something that we've got to adapt and adjust the operating model of that part of our business to make it a more of a standalone profitable entity. And because, the rules of the world have changed in that side of the business, and so, we're adapting and evolving our business on that side. So I think, it's a tough question to ask at this time, but – and I again, too, I would just say, as we think about our balance sheet, and where we have our capital allocation over time, as we see opportunities, we have a lot of flexibility, and what opportunities come our way, that obviously could have a significant impact on the trajectory and direction as the company evolves. But I think, asset management will always be at the core of our business.

[Macrae Sykes:]

Thank you.

[Operator:]

Thank you. And the next question is a follow-up from Robert Lee of KBW.

[Robert Lee:]

Thanks. Thanks for taking my follow-up. Just going back to all the initiatives, I know, one of the things you've talked about as part of the $30 million to $40 million is improving efficiency in the BD channel, and maybe make some changes to the real estate footprint there. Should we be thinking that as you start to look to put in place some of these things that we could along the way have various quarter-to-quarter different types of real estate charges or things like that? So when we think of the $30 million to $40 million, is that excluding – I'm assuming, that's excluding any kind of incremental short-term charge that could come about as you've put in place some changes?

[Brent K. Bloss:]

Yes, Rob, that's correct. So I think, putting these initiatives in place, what we have currently, and one of the initiatives we talked about was the complexing of our field offices. So we have projected – and for the rest of 2017, around $4 million in severance. So that would be a cost to execute this plan. And then also, on top of that, we mentioned earlier the one-time contribution to the 401(k) plan, the transitional contribution would amount to about $6 million, and that would be spread fairly evenly over the next two quarters.

[Robert Lee:]

Right. Thank you.

[Operator:]

Thank you. And the next question is a follow-up from Bill Katz with Citigroup.

[William Raymond Katz:]

Okay. Just a couple; and thanks for your patience this morning. Within the AUM you gave for the end of July, does that include or exclude the institutional mandate that's pending that you had called out?

[Brent K. Bloss:]

It's inclusive of that.

[William Raymond Katz:]

Okay. And then just, you had mentioned that you're going to be merging a bunch of funds, and that you didn't assume any revenue synergies. What's been the experience in the past when you've merged funds together? Has there been any leakage in terms of related AUM there, as a guidepost we could use, as a possible risk? Or does the $10 million or $11 million of foregone revenue include both pricing and volume?

[Thomas W. Butch:]

We would not anticipate material leakage. These mergers are perhaps different than others, where you're merging disparate strategies together. These are myriad strategies. So the clients of the merged fund is going have the exact same portfolio at what likely would be a modestly lesser cost as a result of economies of scale. So leakage should not be at issue here.

[William Raymond Katz:]

Okay. And just one more from me, thanks. Thanks again for taking all those questions, today. In terms of the new pricing, as you get into next year, one of it seems to be that, you need to have good performance in sort of lowest quartile expense structures just to gain flow. When you sort of reset your pricing, where do you think you fall in that grid in terms of that, that sort of quartile of expense structure? Are you now amongst the lowest within your respective categories? Or how should we think about that?

[Thomas W. Butch:]

Well, I'll take a crack at it; others might want to. I think, it varies somewhat by product, by strategy and by asset class. And so it's really hard to give an aggregated answer. Of course, we have a Section 15(c) process with the board, that we'll go through later this summer to ensure that we're competitive from a fiduciary perspective. But we're very focused on the competitive construct, and look very closely to make sure that, where we have the opportunity to gather assets that we're competitive against those in the marketplace that are doing so. So I don't think there's sort of an aggregated answer. It varies product-by-product in terms of looking at the competition that is winning in the marketplace.

[William Raymond Katz:]

Okay. All right, thank you very much.

[Operator:]

Thank you. And that's all the time we have for questions for the present time (01

[Philip James Sanders:]

Okay. Thanks, everybody, for joining us on the call. We had a lot to go over today, and I appreciate the attention and looking forward to catching up with you soon. Thank you.

[Operator:]

Thank you. The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.