Waddell & Reed Financial Inc
Q1 2015 Earnings Call Transcript

Published: 29 Apr 2015

[Operator:]

Good morning, and welcome to the Waddell & Reed Financial First Quarter 2015 Earnings Conference Call. All participants will be in listen-only mode [Operator Instructions]. After today’s presentation, there will be an opportunity to ask questions. Please note this event being is recorded. I would now like to turn the conference over to Mr. Hank Herrmann, Chairman and CEO of Waddell & Reed, please go ahead.

[Hank Herrmann:]

Thank you, Amy. Good morning. With me today are Mike Avery, President; Tom Butch, Chief Marketing Officer; Brent Bloss our Chief Financial Officer; Mike Strohm our Chief Operating Officer; Phil Sanders our Chief Investment Officer; and Nicole Russell our VP of Investor Relations. Nicole, would you read the forward-looking statement, please?

[Nicole 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 referenced in our public filing with the Securities and Exchange Commission. We assume no duty to update any forward-looking statements. Materials relevant to today's call, including a copy of today's press release as well as supplemental schedules, have been posted on our Web site at waddell.com under the corporate tab.

[Hank Herrmann:]

Thank you Nicole and good morning everyone. Earlier today we reported our first quarter results. Net income was $67.1 million, $0.30 per diluted share down 10% compared to the same quarter in 2014. When compared to the fourth quarter of 2014 net income and earnings per diluted share declined 17% and 17.5% respectively. Strong investment income and lower compensation costs helped fourth quarter results while fewer days and increases in various components of compensation cost pressured the current quarter. Operating income of a 104 million declined 10% compare to the same period last year and 12% compared to the fourth quarter of 2014. The decrease in assets accounted for most of the decline in revenues year over year and sequentially, while lower current low commissions in our advisor's channel put additional pressure on revenue sequentially. Gross rose 3% compared with the first quarter of 2014 mostly on higher salaries, incentive compensation and payroll taxes. Compared to the prior quarter cost includes 1% as higher compensation cost would likely offset by lower consulting and advertizing costs. Our operating margin was 27.1% during the quarter, down 290 basis points sequentially. Higher incentive compensation and fewer revenue days were headwinds. We generated 90 million of operating cash flow, paid 36 million in dividends and repurchased 413,000 shares including stock repurchase with taxes on April 2, pursuant to our stock incentive plan. Assets under management ended the quarter at $23 billion down 756 million compared to 124 million at year end as market appreciation largely offset outflows. Net outflows improved during the quarter from 56.4 billion in December ended quarter to 3.6 billion in the current period, as sales volume rose and redemptions moderated. Asset strategy and high income remain negative, both trends have improved materially compared to the previous two quarters. Strong sales on international core equity led to the foundry net inflows of 610 million, it’s the best quarter to date which reflects success of our ongoing efforts to broaden sales. During the quarter we saw 10 funds with sales exceeding a 100 million, obviously we still have ground to cover before return to positive flows, however overall trends are encouraging. Operator this time I would like to open the call for questions.

[Operator:]

Thank you [Operator Instructions]. Our first question comes from Michael Kim with Sandler O'Neill.

[Michael Kim:]

Hey guys. Good morning. First just any sense of quarter-to-date flow trends as we move past what is typically the strongest mutual fund flow quarter for the industry?

[Tom Butch:]

Michael, this is Tom. I would say wholesale relative to the first quarter daily sales has slowed a little bit, daily redemptions has slowed more, daily net though negative is maybe a touch better. Advisors effectively not all that different and then in institutional we have one sizeable win fund that was offset by a sizeable redemption. We have other wins that have yet to fund which in the aggregate I would say are meaningful.

[Michael Kim:]

Great, that's helpful. And then, just coming back to the international core equity fund and the strong inflows last quarter, just besides relative performance which looks very strong across time frame just wondering what some of the drivers are behind the flows. I'm sure the funds benefiting from broader demand trends favoring non-U.S. strategies. But any updates from a distribution standpoint that may be contributing to the growth as well?

[Hank Herrmann:]

Couple of things I would say. First of all, if you look at category flows in the first quarter four enlarge blend, the category in which that competes, was second and only second by a hair, among the more than 100 categories that Morningstar identifies. And so the opportunity set is great. Though, there was flows were impressive, but the category has dropped to almost $30 billion of sales. Secondly, I think as we discussed last time, this is one of our focused funds. Again, we segregate opportunity into three categories. Franchise funds has over $5 billion, funds will be consider on deck and that would be an amalgam of good performance and a category that’s working and a category that still consumes active management. And this fund fits very well. And then we have a third category of opportunistic, maybe nicher strategies that have good performance and maybe an opportunity to take to market. So, that’s just confluence of good performance, very healthy category and the category that still consumes a lot of active management.

[Michael Kim:]

Got it, and then maybe just one for Brent. Any color on the outlook for expenses and margins, particularly as it relates to sort of the trajectory for assets and flows? And then in terms of compensation, how should we be thinking about that line coming out of the first quarter just given some of the seasonality there?

[Brent Bloss:]

I’ll start with the compensation line, and we guided last quarter 49 to 51, we came in at 53.5. A lot of that was due to incentive compensation increases in the core due to our fund performance during the quarters and adjusting our accruals. The range we’re looking at for the second quarter is somewhere between 51 and 53. I’d probably say on the higher end of fund performance continues at this rate. And then overall, we guided 6% to 7% with the increased fund performance, which I’d say is still on the range of 7% to 8% annual growth in compensation. On the G&A side, we came in a little under what was guided in at the end of the year. Most of that was due to IT. Consulting getting off to a slower start than we expected and lower advertising cost during the quarter. So, for the second quarter, we look in the range of 28 to 29, as we see IT spend picking-up again in the second quarter. On the margin front, the first quarter is always depressed a bit because of the two less days in the quarter, as well as tax resets. So, keep that in mind that was probably a 100 basis points of the reduction in the operating margin. With asset levels where they’re at, we don’t see a lot of increase in that margin in the future. And so flows turnaround but we do have the ability. Based upon our 40% of our operating cost being fixed cost, we do have some flexibility in there, mainly around compensation, advertising and if we were to have to flow the IT spend.

[Operator:]

The next question comes from Robert Lee at KBW.

[Robert Lee:]

Good morning everyone. This question is for Tom. Just looking at your initial take on kind of some of the DOL proposals if we were to assume that they get put in place as kind of proposed which is unlikely, but let's just assume that happens. Can you maybe give us some idea on where your current thoughts and how that would flow through the business, mainly higher compliance cost. Any kind of tweaks to the advisor model you would think would need to be needed? Just where you think that would fall out?

[Tom Butch:]

Thanks Rob. I would start by reiterating your first comment, which is it is preliminary. And we like, I am sure all of our peers, spends and continue to spend a lot of time consuming it and interpreting it. We of course would have to wait for the final rule, and especially I think the definition of best interest. But so far our ongoing review would suggest that all that is set forth would not require any meaningful change in our business model, our operations our procedures and specially, would enable us for a specific language in the proposals to continue offering proprietary products. Changes are suggested in a number of ways, particularly entering into a contract with compliance around fiduciary standard in partial conduct, conflicts things like that. But at this time, based on this draft and our interpretations thereof, I would say we would -- we believe, we’d be able to implement it without interruption. I expect a big part of your question has to do with proprietary products which are essential to the advisor's channel and as you likely know the proposal specifically addresses that and specifically indicates that, I have the quote in front of me, the proposal permits the financial institutional with such businesses that is proprietary models that rely on the best interest contract exemption provided additional conditions are satisfied, those conditions are providing notice to clients of any limitations that exist as a result of offering principally proprietary products and also effectively affirming that we're operating in the client's best interest. And again I think in the aggregate our current interpretation of the current proposal suggests no material change for business. The other thing I say is that as you know our advisor's business has increasingly migrated to a fee based model probably two thirds of our sale, half our revenues and a third of our assets on a fee based model and those operate under a fiduciary standard already albeit a different one, it's not foreign to us to operate under one.

[Robert Lee:]

All right, great that's helpful. And maybe just a little, also on the sales. If I think of the asset strategy fund in the wholesale channel, I'm just kind of curious, I mean it looks like you had some sequential probably held by strong performance in the quarter, but some sequential improvement in gross sales from pretty tough Q4. I'm just kind of curious if you have a sense of how much of that is existing reps who sold the product in the past, took a break, kind of saw the performance come back and were willing to come back to the product versus new advisors dropping tickets on the fund. Just trying to get a sense to what degree kind of the core base of advisors who may have used the product have started coming back to the product.

[Tom Butch:]

I wish I had science behind my answer but I talk to our people in the field all the time. I would say that both of those are at work to a certain extent that existing holders who may have moved away are eyeing the fund closely and are having conversation I think the next accelerant will be people new to the fund. One of the things I would say is that for my comment about international core equity fund, part of the success of any fund is reliant on what’s happening in the category and where I talked about the fact that the international core equity category of foreign large blend was really quite fertile in the first quarter where allocation remained in outflows so there's still a little bit headwind in the category and I suspect as performance improves and the category improves that'll be our best opportunity.

[Robert Lee:]

Maybe just one last question, maybe a little bit of a modeling question. In the wholesale channel, you know, the indirect expenses, I guess over the last four quarters of kind of stepped up to it looks like kind of a new level maybe growing at least year-over-year at a pretty healthy rate. Given some of the challenging headwinds there, kind of maybe walk us through what's driving that and what we should -- how we should think about that line item going forward.

[Tom Butch:]

Yes, on the -- you're talking about the indirect line in the wholesale channel that.

[Robert Lee:]

Yes.

[Tom Butch:]

That's impacted by annual salary increases as well as we got a tax reset as well in the first quarter but yes I would say that that line where it's at today maybe a 3-4% increase in the indirect line for 2015 on an annualized basis.

[Operator:]

The next question comes from Michael Carrier at Bank of America, Merrill Lynch.

[Michael Carrier:]

Thanks, guys. Tom, I think you mentioned just on the institutional side of the business that, I think you said that the pipeline or the activity has been pretty active. Just wanted to get some color on what's driving that or where you're seeing the demand as you get in to the environment where certain things are shifting around in markets.

[Tom Butch:]

I think our principal strategy continued to drive the business and those have been and remain the core -- the domestic core equity strategy, the domestic large cap growth strategy and the domestic mid cap growth strategy. One thing I really should point out is that the asset strategy has had a couple wins in the institutional space on the insurance side, now these are small, relatively small initial win but they offer the opportunity for daily cash flow on an ongoing basis, so as we penetrate the insurance channel more deeply that's where I believe we'll have the opportunity to broaden the span of offerings beyond what is substantially enclosed the traditional institutional business the high quality growth present in the channel. Hope that's helpful.

[Michael Carrier:]

Yes, that's helpful. Fee rate this quarter ticked up and I think it is just mix if we look at it across the different buckets and then the overall UM. But just wanted to gauge if there is anything else going on driving that. Then when you think about the outlook on where some of the flow or the sales momentum is, it's like similar trends, I mean obviously the market is going to have a big impact, but just wanted to see if there is anything else in the mix.

[Brent Bloss:]

You’re right, it’s just a mix shift and with asset strategy fund and high income fund, with the outflows, that’s ticking up with higher fee product. So, those trends continue. We could see a tick up a little more. But that’s really the driver around the fee increase.

[Hank Herrmann:]

I would, this is Hank, I would just point out that seemingly to me anyway, the prejudice in the marketplace is toward growth. And I would just remind us all that if you structure on our growth products, it’s a little bit higher. And we’ll just see how it works out.

[Operator:]

The next question comes from Bill Katz, Citigroup.

[Bill Katz:]

Good morning everybody. First question Tom perhaps. I'm curious on the financial advisor accounts sequentially. It looks like it dipped down a little bit more than historically is the case. I was wondering if you could talk a little bit about the dynamics underneath and how much might be seasonal trends? The reason I ask because some of your peers have announced some very strong FA growth. And I'm trying to understand the differences between what you're experiencing versus the industry at large?

[Tom Butch:]

Bill, I wouldn’t read a whole lot into that number. We do have a touch of seasonality into it that we’ve tried to remove that in the way that we have quarterly qualification at this point. We’re working very hard on the recruiting front and we have the ambitions to grow the sales force this year. And again, I don’t think that other than any one time. I hope that’s not other than a one-time drop. But I would expect, over the course of the year, that that number should move productively.

[Bill Katz:]

And then you may provide a little bit of color, but I'm just a bit curious. What's going on in the core institutional business here? You mentioned that there's one product not due to performance, but more of reallocation. So, first product question is, where is that, where did that go, do you have any feedback from the exit view? And then when you step back and look at that, how do you sort of think about the core institutional business? Is that something you think can actually grow or is it more now just getting into the lower fee insurance side?

[Tom Butch:]

No, I don’t surrender its potential growth. The one that you’re referring to that happens sometimes, that was a sizeable piece of business and the new CIO came-in and moved from -- removed the U.S. based strategies and put in global strategies here. I think we’ve parted out a very good place in high quality U.S. growth. I would also tell you that insurance doesn’t necessarily mean lesser fee. Maybe the core fixed income general account does but the sub advisory stuff you do not have to surrender to necessarily a lower fee, and at least in our experience. And so as I said, we’ve had good success in growing the mid-cap growth strategy. We’re looking to take other strategies that are working on the retail side and institutionalizing those, even for the traditional side and the opportunities for sub advisory create a greater span of opportunity for us. I would remind you that the largest institutional account we have is in our Asset Strategy, which is by no means a traditional institutional strategy.

[Bill Katz:]

Just a couple other questions. Thanks for taking all these. Sounds like the net flows are still negatively less so. But what's your planned strategy from here to generate the growth sales? Is it just trying to better tap into the international global equity opportunity set? Or how are you sort of communicating with broker dealers? And maybe within that, where are you in terms of net adds verses subtractions on platforms at this point?

[Hank Herrmann:]

There have been no material, since we’ve last talked, there has been no net plus or minus on platforms. I think again we use the word platform pretty broadly. And I think when you’re talking about platform, you’re talking about preferred space for discretionary space and since we last were together, there was no such activity in terms of losing any slots. And in fact we’ve gained a number of slots broadly across the span of our business. The other thing I talked about is that each RIA is effectively its own platform and we had one outflow there. But we -- that's just part of the business. Relative to your first part of your question, again if you look at the first quarter category flows and it’s interesting because I think flow dynamics by category is changing more rapidly than at any time in many years. And that would just in favor changes more quickly than the three would suggest. So, if you look at the net flows in Q1, we have entries in seven of the top dozen categories. One of those is new. All the other -- and it is off to a good start. All the others are competitive to very competitive and all of those categories are still very active management driven. So the opportunity set remains very broad. As I talked about before, we stratify opportunity into three buckets, and that’s really what we’re pursuing. By way of distribution, we continue to have very good balance between three legs of a stool which is the warehouse business, the independents and the RAAs and so while our emphases shift over time by product and opportunity we're certainly, we certainly have ample merchandize to take to market and we'll just continue to do that and address the line if there's opportunity presents itself.

[Operator:]

Our next question comes from Dan Fannon at Jefferies.

[Dan Fannon:]

Thanks. I guess my question is more around capital and cash. Your cash balances continue to build. We see the buyback activity picking up more for -- in April coinciding with the share issuance. So as you think about this year inclusive of the dividend, is there a way for us to think about use of that capital towards buybacks, I know you've been opportunistic in the past, but wondering if there's some kind of gauge we can look at.

[Tom Butch:]

I'm going to let Brent answer that question.

[Brent Bloss:]

Yes, I think, we're sticking with how we've handled it in the past with share repurchases to offset our stock grants during the year as well as we'll be opportunistic where we can, like you said we did have a large repurchase at the beginning of April with our taxes, we'll continue to be opportunistic on that front as well as a dividend, we'll -- we continue to have conversations with the board each quarter, aware of our cash balance and we'll continue those discussions.

[Hank Herrmann:]

This is Hank. Just off the top of my head I guess by the time the year's out we'd target about 1.5 million shares.

[Dan Fannon:]

And is the million or so shares that were granted, is that consistent with last year or is that a step up?

[Tom Butch:]

It was a little, the share grants this year I think were a little less than last year in total when you take into account our executive grants in December and then the April grants but -- it's in the ball park year-over-year.

[Dan Fannon:]

Okay. And then on the expense side you mentioned that there are some discretionary things that could change. I guess thinking about the commentary and what you guys are -- how you're kind of characterizing the environment today is a little bit better. It seems like your outlook for this year is slightly more improved than maybe where you were when we last heard from you in the fourth quarter. But if we're in a redemption period for some time as we think about the just kind of the gross sales or redemption dynamic. Will there -- at what point do you think you'll look at, if at all, that discretionary side of the expense structure where you might pull it back?

[Hank Herrmann:]

Well, this is Hank, we've been looking at it since January 1, and various managers around the building have been trying to hold back a little bit and stretching it out a little bit, other places we had situations where that wasn't possible and actually probably hit the accelerate a little bit, but we watch it very carefully and if our view of the market were to adjust in a material way to the not so positive we would, we have places where we could take a reasonably aggressive action. So we're thinking about the same way you are, for the moment we haven't really initiated any change in process.

[Operator:]

Our next question comes from Craig Siegenthaler at Credit Suisse.

[Craig Siegenthaler:]

Thanks. Had two questions relating to the DOL rule. First one, what is the dollar amount of AUM in the advisors channel that is held in IRAs, variable annuities, and other retirement type accounts?

[Tom Butch:]

We're applying the percentage to the assets real quickly.

[Craig Siegenthaler:]

Or you can actually give it in percentage terms, that's okay.

[Hank Herrmann:]

66% of our total assets are in retirement accounts.

[Craig Siegenthaler:]

And do you know the mix there because I think that includes variable annuities and IRAs, do you know the mix between the two?

[Hank Herrmann:]

I don't have the percentage of variable annuity.

[Craig Siegenthaler:]

Is it mostly IRA though, would you guess.

[Hank Herrmann:]

Yes, it's mostly IRA, Nicole just informed me that that percentage doesn't include variable annuity asset.

[Craig Siegenthaler:]

Okay. So 66% is just IRA, no variable annuity, right?

[Hank Herrmann:]

Right.

[Craig Siegenthaler:]

Okay. And then also if you look at the advisor channel, the $46 billion of AUM I believe is only with Dale and REIT funds. How large is the advisor channel in a dollar amount basis too if you include the third party products on the platform?

[Hank Herrmann:]

Ask again just so I'm sure I understood your question.

[Craig Siegenthaler:]

Sure. So what is total assets under management on the advisors platform? Because I think the $46 billion you give us is only AUM in with Dell and REIT on the platform.

[Brent Bloss:]

It's 52.2.

[Craig Siegenthaler:]

Okay. And if I can just, let's see squeeze one more in here. What is your outlook here if I just think about sales in the assets strategy channel? You can provide commentary around RFP activity across the different platforms. I'm wondering if the frequency of recommended lists has changed. That type of commentary would be helpful, just on the asset strategy fund.

[Tom Butch:]

As I indicated in the previous answers, so no change to platform status since last we were together. And again I think it’s an amalgam of improving performance and category growth that will be determinative of the next several quarters.

[Operator:]

The next question comes from Chris Shutler at William Blair.

[Chris Shutler:]

Hey guys, good morning. If you look at the institutional channel and the larger mandate wins and losses in that channel, in both Q1 and thus far in Q2. What strategies have those been in?

[Tom Butch:]

Large cap growth, large cap core, mid-cap growth.

[Chris Shutler:]

And then Brent on expenses, I might have missed this. But for G&A I think last quarter you said G&A indirect is going to be up 3% to 4% for the year. Has that commentary changed?

[Brent Bloss:]

No, that’s still the range.

[Chris Shutler:]

And then on DOL, coming back to that topic, just curious, I know there's a lot of uncertainty. But would you expect potentially higher expenses as a result of that rule or any change to kind of how you document trade rational verses how you're doing it today?

[Brent Bloss:]

I think Tom mentioned earlier, it’s still early on in trying to work through how those impacts us. But we do a lot of that compliance work today. So, initially we don’t see any increase in our expenses at this stage.

[Chris Shutler:]

All right, thanks, Brent. Just one more quick one, thanks for taking all the questions. On the wholesale challenge, I know that at Investor Day last year you spoke about being underpenetrated at several distribution platforms. Just curious in the sales that you've been seeing since then, if you've been seeing anymore diversification in those flows.

[Tom Butch:]

The short answer is yes. I would caution that the firms where we have the greatest penetration are those obviously where we have the greatest outflow risk. And so while certain of these newer firms have shown productive and encouraging growth, it’s not in the magnitude at this point to offset the mature book of business when it is in an outflow situation. But again, I would say that if you look at the list of firms where we’re selling, there is encouragement to be found in the number of firms where historically we’ve been under penetrated. It’s just not visible in the current context.

[Operator:]

Our next question comes from Eric Berg at RBC Capital Markets.

[Eric Berg:]

Thanks and good morning to everyone. Two questions, first, going back to the earlier discussion about the Department of Labor, I understand, Tom from your earlier response that you have outlined what is essentially a safe harbor that would allow you and your colleagues at Waddell & Reed to the advisors to continue to sell proprietary products by disclosing any conflicts of interest that might be perceived or actual and by sort of acknowledging perhaps differences in compensation. Still, because for the first time in certain circumstances outside of an advisory relationship a registered reps who’re now facing a fiduciary standard will be asked to do what's best for the customer as opposed to what's just suitable. Doesn't that mean that it is likely that they're going to start selling more third-party funds than they have in the past or would you disagree with that outlook?

[Tom Butch:]

Two questions, I didn’t really outlined anything or two responses, and it’s good to talk to you. I didn’t outline anything. I was just really exciting for what was in the proposal. So it’s really not my response so much as it is a direct recitation of what’s in the proposal. And as I said, right at top, the final definition of best interest is critical here and that which was contained in the proposal does appear to not be particularly onerous and manageable from our perspective. But it’s very early days here and we’ll just have to see how it all evolves. Again, the best I can tell you is right now based on our interpretation of this proposal at this time, we don’t believe that it portents a meaningful change to our business model.

[Eric Berg:]

Thank you. My second and final question relates to the performance of Asset Strategy. Some work we've done has found that Morningstar has a -- is presenting a very different picture of the view of that funds performance than LIBOR. And as we dug in to it, we found that as best as we can tell, this difference in perspective with LIBOR having a much more positive view has to do with the two organizations using very different peer groups. Morningstar using classifying the Asset Strategy in one bucket and LIBOR in another. Is it a problem that -- how do you think of the two Morningstar verses LIBOR and in particular is it a problem for the challenge and an obstacle that needs to be overcome for the ongoing success with the future success of asset strategy for Morning Star's view to improve even though LIBOR already has a very positive, or greatly improved view of that fund.

[Hank Herrmann:]

This is Hank, I'm going to answer half the question and the other half I'll leave to Tom, but, they have pretty different ideas of what the appropriate mandate and what the appropriate universe is which leads to different conclusions. Whenever I've spoken about the relative performance on any basis on news calls or when I meet with people I always address LIBOR only to no other reason than LIBOR's been part of our methodology for calculating bonuses and for our opinion that LIBOR's pretty precise and focused on what the mandate and then tries their level best to match it up, so we’ve always felt that was a better universe to consider, however it is no question about it that Morning Star also is a source of ranking and so I'm going to let Tom address that part of it.

[Tom Butch:]

Yes Eric that's a good catch on your part because there is more considerable divergence than has been the case in the past and I don’t propose that there is a firm of record in this regard both are utilized widely and both are utilized in different circumstances, for example the annual Baron survey that evaluates fund companies vis-à-vis each other uses LIBOR, certain firms in their due diligence use LIBOR, many advisors who use the Morning Star workstation in which of course the Morning Star data is embedded use Morning Star, so it is at this point in time a divergent story and it’s important that we can tell the story in front of us as we can. But the one sort of key fit that does have our attention is how different they are and the fact the advisor workstation that Morning Star uses has that embedded in it but there's really no single source of record and in many cases we have to talk about those.

[Operator:]

This does conclude today's question and answer session, I'd like to turn the conference back to management for closing remarks.

[Hank Herrmann:]

Thank you very much for your attention we appreciate the audience so look forward to talking to you at the end of the next quarter, take care.

[Operator:]

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