Waddell & Reed Financial Inc
Q2 2008 Earnings Call Transcript

Published: 29 Jul 2008

[Operator:]

Good morning, ladies and gentlemen. Thank you for standing by. Welcome to the Waddell & Reed Second Quarter Earnings Conference Call. (Operator Instructions). This conference call is being recorded today, Tuesday, July 29th of 2008. I would now like to turn the conference over to Hank Herrmann, Chief Executive Officer of Waddell & Reed. Please go ahead, sir.

[Henry J. Herrmann:]

Thank you. Good morning. With me today are Tom Butch , our Chief Marketing Officer; Mike Strohm, our Chief Operations Officer; Dan Connealy, our Chief Financial Officer; Michael Avery, our Chief Investment Officer and Nicole McIntosh, our Director of Investor Relations. Nicole, would you read the forward-looking statements, please?

[Nicole McIntosh:]

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 referenced in our public filing with the SEC. We assume no duty to update any forward-looking statement. Material relevant to today's call including a copy of today's press release as well as supplemental schedule have been posted on our website at waddell.com under the corporate tab.

[Henry J. Herrmann:]

Thank you, Nicole. Again, good morning everyone. This morning we announced our second quarter results. I am pleased, of course, to report solid operating results in spite of a very challenging market backdrop. In my nearly 40-year career at Waddell & Reed, I cannot recall seeing such strong sales results in such a weak market environment. Earnings per share for the quarter were $0.42, which represents a 27% increase over our first quarter results and a 17% increase compared to the same period last year. Comparing the current quarter's results to those of the first quarter, operating revenues increased 8% while operating expenses increased 4%. As we noted in our release this morning, our margin improvement of 2.7 percentage points sequentially was a function of higher management fees due to a strong asset growth and a slight moderation in sales volume in the wholesale channel and a more normal level of compensation. As noted, the turbulence in the market did little to slow our sales momentum nor interfere with our ability to continue to pursue our strategic goals. Our investment management team delivered solid results demonstrating once again an ability to succeed in various market phases. Adhering to our long-established investment discipline led to superior results for our clients as weighted average returns in our funds and managed accounts outpaced the S&P index by more than 525 basis points during the quarter and over 700 basis points year-to-date. Our advisory channel continues to perform at historically strong level. Headcount sales, flows and productivity have all increased. Gross sales of $1.1 billion improved 5% compared to the previous quarter and 27% compared to the same period in 2007. Net flows were in solid positive territory for the third consecutive quarter at $243 million representing a very respectable 3% annualized organic growth rate given a period of great market volatility. Sales per advisor increased again suppressing the previous quarter high watermark at 357,000. Productivity per advisor improved 2% sequentially and 17% compared to last year's second quarter. We have made great strides in the past few years in our advisor channel and now have a strong foundation from which to grow. Our brokerage platform is up and running. This is an important step. The development will allow existing advisors to either choose to stay on the current platform or migrate to the new purging (ph 00

[Operator:]

Thank you, sir. Ladies and gentlemen, at this time, we will begin the question-and-answer session. (Operator Instructions) And our first question comes from the line of Jeff Hopson with Stifel Nicolaus. Please go ahead.

[Jeff Hopson:]

Okay, great. Thanks a lot. A few questions here, in terms of the asset fund, I know you have tried to find newer channels I guess, maybe the institutional pipeline, any thoughts on that possibility? Number two, can Michael L. Avery give an update on the strategy within the asset fund and then finally within the advisors, with the new platform, what would be reasonable expectations for recruitment and is there any income statement impact initially from bringing those potential new recruits over?

[Henry J. Herrmann:]

I will ask Tom to respond to question one and three, part A, B, C and D and I will ask Mr. Avery to comment on the outlook for the asset strategy.

[Thomas W. Butch:]

In terms of the asset strategy fund, institutional, I will send that back to Hank eventually, but the fund is widely distributed across the span of all of our broker-dealer partners and certainly has been very well accepted there. In terms of the institutional pipeline, Hank would you want to comment on that?

[Henry J. Herrmann:]

We are seeing a lot of activity particularly focused on large cap growth product, but also other things. Most of the activity is in what I recall early stage or halfway-through-the-process sort of stage and I would, speaking like an old technology analyst, I would say that the closing cycle has elongated somewhat and I suspect that is mostly because of the market backdrop, but there is quite a bit of activity at the current time and I cannot obviously do more than that. We will just have to see what closes and what doesn't. Mike?

[Michael L. Avery:]

The outlook for the asset strategy fund is good.

[Henry J. Herrmann:]

I guess the question was more of tell me a little bit what is going on there.

[Michael L. Avery:]

Consistent with the objective and the operating mandate that has been handed to us by our shareholders, we have taken the flexibility to position the fund for a market like the one that we are in. We have used the full flexibility to stabilize the principal that people have handed to use. We are extremely optimistic long-term about what we have called the emerging middle class. Those folks didn't go away with the writedown by Merrill Lynch this morning, so we are optimistic that they're still there and we are working real hard to come up with where to utilize the assets going forward. We have got a very strong team here, in addition to my two partners and I, there are 70 people behind them that help us on a day-to-day basis. So, I think the outlook is pretty good.

[Henry J. Herrmann:]

And just probably a little bit more on that, the fund is still positioned pretty cautiously. Our outlook, which I have expressed the last couple of quarters has been kind of ugh and I'd say that is still pretty much the case. We are hoping that we are getting closer to the end of stuff (ph 00

[Thomas W. Butch:]

In terms of question three, which I think related to projections for recruitment onto the purging platform, the platform is really been up just a little more than a month. We are actively out in the market. We have converted a couple folks from the outside to the platform. It would be our aspiration that over the next 12 months we bring 30 to 50 people from the outside onto the platform and continue at that rate going forward. As to income state impact, I will pass that back to Dan Connealy in a moment, but only note that substantially it will depend to the degree to which the adoption of our products takes place at a targeted rate, which we built into the model at what we believe to be a very conservative level. And so I would expect that that income state impact from the recruitment effort itself to be relatively modest over the first year.

[Daniel P. Connealy:]

As I already said, it is standard that you have some costs to bring people over. Sometimes this takes a signing bonus or a payment to assign the accounts. But it is rather modest and shouldn’t really affect the P&L that much. We would hope to start to get some production in our own products out of these people, because as we recruit them, we want to be sure that they understand the quality of the products we are offering.

[Jeff Hopson:]

Okay. Great. Thanks a lot.

[Operator:]

Thank you. Our next question comes from the line of Cynthia Mayer with Merrill Lynch. Please go ahead.

[Cynthia Mayer:]

Hi. Good morning. I just wanted to circle back quickly to your comments about demand for large cap growth. Because in the past I remember you saying that you thought the demand for large cap growth from DB was down, partly because of the migration toward, more a combination of passive and alpha. And I am wondering if you think you’re seeing some reversion in that trend, or something else. Is it just a matter of relative performance?

[Henry J. Herrmann:]

Cynthia, how are you doing? It is mostly relative performance. Consultants tell us that four out of five searches in the large cap growth area are replacement from one manager to the next. And that large cap growth in the aggregate is still down in terms of activity. So it is just mostly about performance. I still think what I said earlier about the large cap pocket being just intermediated by alternative strategies. I have noticed – in fact, you had too, that some of the alternative strategies are not quite as attractive as they were before, and hopefully that will be helpful. But as yet I have not seen much of that.

[Cynthia Mayer:]

Okay. And also, you mentioned that the sales cycle seems a little elongated in Institutional. I wondered if you could just talk about any flow patterns you’re seeing this quarter so far in Advisors.

[Henry J. Herrmann:]

So far this quarter, the net flows are still in positive territory by a very small amount. And it fluctuates from a decent amount to a small amount daily, depending on the redemptions on the other side. But we have not as of yet seen any noticeable pickup in redemptions in the Advisors channel. And we are still seeing pretty good gross sales. I have not seen much change from what we experience on average in the second quarter. And while you bring it up, I would mention the same thing is essentially true in the Wholesale channel. We are seeing a little bit of a mix shift in Wholesale because in the global natural resources there has been somewhat of a pickup in redemptions. But the flows are still the same in the aggregate net channel, it is just that other products have picked up where global natural has slowed down some. And naturally strategy is a part of that. But some of the other funds have continued to do well also. But I would say in the Wholesale channel, given the volatility, flows are better than I would have expected, being that (inaudible 00

[Cynthia Mayer:]

Okay. And as you see a pickup in redemptions in natural resources, do you have a sense of how much of that is being exchanged into other funds?

[Henry J. Herrmann:]

I do not have-

[Cynthia Mayer:]

Or is it just leaving?

[Henry J. Herrmann:]

I am looking around the room, and I do not think anybody’s looked at that yet, in part because the pickup in redemptions has been very recent. And so I do not know that anybody has an answer for you. But fair question. We will get back to you.

[Cynthia Mayer:]

Okay.

[Henry J. Herrmann:]

It is hard to trace it.

[Cynthia Mayer:]

And just a housekeeping question

[Henry J. Herrmann:]

My two financial- give us a second. We will get you something.

[Cynthia Mayer:]

Okay. Thanks.

[Henry J. Herrmann:]

We will come back to it, to you on the call.

[Cynthia Mayer:]

Thanks.

[Thomas W. Butch:]

(Inaudible 00

[Henry J. Herrmann:]

Well, we will get them up in a second.

[Operator:]

Thank you. Our next question comes from the line of Michael Kim with Sandler, O’Neill.

[Michael Kim:]

Hey, guys. Good morning.

[Henry J. Herrmann:]

Good morning, Michael.

[Michael Kim:]

The first question I have deals with distribution versus performance. Certainly you have made good progress on the distribution side of the business, really across all three channels. But going forward, how should we be thinking about balancing better positioning versus maybe a bit of a slowdown in near term investment performance, particularly at some of your bigger funds?

[Henry J. Herrmann:]

I am not quite sure how to respond to that other than the obvious- if performance is bad, flows will not be as good as they’ve been. We are a long way away from having to face up to that. God willing may that continue. I do not know if I can be more precise. Unless- we will see if Tom wants to take a crack at it.

[Thomas W. Butch:]

I guess the only thing I would say is to state the obvious, is there are a great many strategies- which, candidly, we have not gotten to cross selling, yet, although we are making good progress- that provide ample opportunity to round out what we are selling. And in fact in the second quarter, the percentage of flows going to funds other than asset strategy and global natural resources, though remaining lower than we want it over the long term, essentially doubled. And so we are having good success with funds like large cap growth, capital appreciation, international core equity, science and technology, and of course we did launch the global bond fund, which is still in a nascent period but getting good attention as well. So I think the span of things that we are able to take to market is certainly ample. That is the best way I can answer.

[Michael Kim:]

Okay. That is helpful. And then focusing now on the Advisors channel. Flows continue to accelerate with ongoing market volatility. You have always talked about the Advisors business as more of a moderate growth channel. Do you think we are entering a higher level of sustainable growth, just given the recent initiatives to build out the platform?

[Thomas W. Butch:]

You mean recent sequential results have suggested per Hank’s opening comments, we are at historically high levels of sales. And we are confident that per your comments, many of the things that we have put in place help to secure their sustainability. The Advisors channel today is quite different than it was a few years ago. Hank noted that the sales, given the kind of market environment that we are in, are unusual per our history. There are a lot of things behind that

[Michael Kim:]

Okay. And then in terms of distribution- I realize that the Wholesale channel margins remain under pressure, just given the strong level of sales. But do you have a sense of the AUM scale that you really need from a management fee perspective to offset- let’s call it normal, upfront distribution payouts, assuming the sales stay around these levels?

[Thomas W. Butch:]

Well, Michael, we are already offsetting that, because we are making a profit in that wholesale. And if you calculate a negative distribution in wholesale, you’ll see it is come down consistently. So with the assets that we have garnered thus far are important to our improving options. Operating margins. Excuse me.

[Henry J. Herrmann:]

Well you know, I find myself on conference calls or whenever I am visiting with people, saying the same thing, and time and again, and that is, if we could figure out all the moving parts and put together a model we were confident in, we would have done it already. We would love to give you a timeframe and a number. But because it is so difficult to forecast accurately how strong sales are going to be and what market action is going to be, to give more comfort than what we have been doing is just not appropriate.

[Michael Kim:]

Okay, and then just finally, any reason for any decline in the tax rate this quarter? And is that a good run rate going forward?

[Thomas W. Butch:]

In this quarter, we partially occupied some renovated space in our home office. We were required to do this by our lease. And in the state of Kansas, we got some tax credits for occupying that space. So that was about $300,000. so I wouldn’t say that we could- that won’t happen every quarter, obviously, so a good run rate is like 36.9 to 37.4 or 37.5, somewhere around there, absent these kind of tax credits. Now there are further phases of this renovation, but if you have any experience you know that we cannot even tell you when we are going to be done.

[Michael Kim:]

Okay. That is helpful. Thanks.

[Operator:]

Thank you. Your next question comes from the line of William Katz of Buckingham Research. Please go ahead.

[William Katz:]

Okay, thank you very much. Good morning. I just wanted to continue along the discussion on the margins. Sorry to stay right there. Just in the Wholesale channel you have seen some very strong improvement if you look back over the last seven or eight quarters as your AUM has scaled up. Conceptually, where can this margin go? I know, Hank, you said you do not have confidence in a particular model at this point in time, that really seems to be the biggest driver to operating profitability for the company. Is this a business that can go positive in terms of margin, or is it more just, less negative and top out some point halfway from here? I am just trying to gain a sense of direction and magnitude.

[Henry J. Herrmann:]

Well, I think when we are looking at concentrating on distribution margin, we are just talking about part of the picture. And this business, you do not make money at distribution. But you make money by keeping the assets and earning a management fee on them. This business is already positive. So the distribution business will never be positive in the wholesale area, and it is not positive for anybody else.

[William Katz:]

Right. But if you look at your- not to belabor it here- but if you look at your calculation of your distribution margin, that has improved by roughly 50 % in the last eight quarters, round numbers.

[Henry J. Herrmann:]

Right. That is simply because the expenses associated with garnering the assets have risen at a much slower rate than the asset flows coming in the door, plus we have had reasonably good market action helping us too. If that continues, the margins will be less negative. We are not building out- we made in the early days significant front end investment in getting the Wholesale channel marketing organization in place. And that was a very steep ramp. Today we are still growing it, and we expect we will continue to grow it. But the ramp’s not nearly as steep. And so we would expect that the rough relative negative margin would become less over time.

[William Katz:]

Right. Okay, that is helpful. This next question- Tom, I just was a little curious. I think you mentioned that the non global natural resources assets strategy sales are up double sequentially. What percentage of sales are actually coming away from those two types of products?

[Henry J. Herrmann:]

(Inaudible 00

[Thomas W. Butch:]

Well, I want to restate the clause in front of that, Bill, which said that although they have increased as a percent of total sales they’re not at the level we want. And they’re roughly 12 % in the second quarter.

[William Katz:]

Okay, that is helpful. And then just a couple of big picture questions. A number of your competitors have been talking about the leverage to pension plan reform, and the decay of the (inaudible 00

[Thomas W. Butch:]

Well, from two perspectives, first on the wholesale side we have a team of people that is dedicated to the DC marketplace, and in the Institutional business there are people who call on that as well. So we have a half a dozen people who work that market on investment only basis, and we have had some meaningful wins in that regard. On the advisors business, we play at the small end of the market and we have very good partners whose platforms we take to market in that regard. The larger and more compelling opportunity of those two is the investment only space.

[William Katz:]

Okay. That is terrific. Thank you very much.

[Operator:]

Thank you. Your next question comes from the line of Robert Lee with Keefe, Bruyette & Woods. Please go ahead.

[Robert Lee:]

Thanks. Good morning, everyone.

[Henry J. Herrmann:]

Hi, Rob.

[Robert Lee:]

Just a couple of quick questions on the expense front. And I noticed in the G&A for example there is a reasonable sequential pickup in expenses. Is there anything- should we think of this as the reasonable run rate? Is there anything one time there? I know you did a sales- I think you did a sales convention in the quarter. Maybe that shows up there? I am not sure.

[Dan Connealy:]

Well, we have some fluctuations and it is a little hard to predict. For instance, in this quarter we had more projects that were not capitalized by our IT folks. So, and that should have been capitalized. They were expensed. And we have some small consulting contracts that come due, and if they’re under a certain level, we just expense them. And that happened in this quarter. So there is just a little noise like that that caused it to go up. Those are just some of the minor fluctuations. I think it is a pretty decent run rate, give or take.

[Robert Lee:]

Okay.

[Nicole McIntosh:]

Rob, to go on with your question, the sales convention costs that you are alluding to would be found in the U&D expense line. More specifically, in the advisors U&D expense line.

[Robert Lee:]

Okay, great. And maybe looking at comp a little bit, I know you had some normalization of it from the prior quarter. Given the still strong relative investment performance, do you feel like you’re accruing at the right rate now, and not really any catch up that is probably going to be needed from here?

[Henry J. Herrmann:]

Well, we have to monitor this as the year goes on. We think we are about where we need to be right now but we look at that closely at every quarter and as the quarter progresses. So we do not see a major change in our comp in the third quarter, absent some unforeseen item.

[Thomas W. Butch:]

I would just say that last year it was like a 100 Year Flood in terms of relative performance. It was so exceptional. And I would say that this year, performance is still solid. But it is more normal. Last year we had good number of funds that were not only top tier but the top one or two percent of all the competitive universes; this year it is mostly not the case. And I would also say that this year the performance differentials within most different categories between the high and low groups is not that wide, maybe a couple of percentage points. And so as the year rolls on, your rankings can change quite a bit because it is a pretty narrow differential, apparently. But we have taken a couple looks at it so far this year, and we think we have got it about right.

[Robert Lee:]

Okay, great. And Hank I have maybe one follow-up question for you. I know in the past you have not expressed any particular interest in acquisitions of any particular type, but you seem to have things going pretty well, your Wholesale channel is booming along, pretty liquid balance sheet. I understand you probably do not want to do anything large. Would you at all be interested or given any thought to something where even if you could just buy assets and add them into your existing products, anything along those lines be of interest?

[Henry J. Herrmann:]

Same response as always

[Robert Lee:]

Okay, great. Thanks a lot, guys.

[Operator:]

Thank you. Ladies and gentlemen, if there are any additional questions, please press the star followed by the one at this time. (Operator instructions.) And our next question comes from the line of [Aaron Caddell with Hope Capital Advisors]. Please go ahead.

[[Aaron Caddell:]

Hi. Can you hear me okay?

[Henry J. Herrmann:]

Yes.

[[Aaron Caddell:]

Thank you for taking my question. I just have two and they are on the natural resources and assets strategy funds, respectively, given just how big they are and how important they have been to you. First, on natural resources, I wondered if, Hank, you could just give your, or the firm’s, overall investment thoughts on the commodities generally. Not just in natural resources but it seems also in other funds you have a weighting toward commodities in which you got in early on that trend, with commodity prices moving around a lot here and concerns about how global slowdown might affect them. What is your overall view, maybe not just for the managers of the fund but within the complex overall and your attitude toward commodity prices and stocks.

[Henry J. Herrmann:]

Well, in my opinion we are in a correction phase, and part of it has to do with economic activity, and the rest of it has to do with economics in the sense that if prices go up and up, you’ll find a replacement and all of a sudden instead of a shortage you have an excess. So what I have been thinking is that soft commodities, probably the easiest place to find ways to increase supply, and then metals area is probably harder and a little longer to take care of. And in the case of energy, I cannot figure out how long it is going to take, but it won’t be soon. All of that wrapped up into the idea that we have a long term prejudice toward these areas because of the impact of globalism, increasing wealth in major emerging markets and I have not had any reason to think that is changing. In the short run, however, there are lots of pressure because of concerns about speculation, government action and that sort of thing. Concerns about slowing demand because of soft economy and whatever. So we have sort of, depending on which portfolio you’re talking about, took some of the bets off the table. In the asset strategy fund, it is pretty well hedged off of most of these kinds of exposures. And then in terms of global natural resources, I think there is been some portfolio moving around and there is a little more focus on the gold and a little more focus on some parts of energy and a little less focus elsewhere.

[[Aaron Caddell:]

Okay. And then you mentioned it and it was my second question, just on asset strategy, if you just look at the performance it is which I guess on a relative basis is great, it is flattish over the past few months. In terms of their net exposure, can they be fully hedged, or even net short, or what are the net exposure guidelines for that fund?

[Henry J. Herrmann:]

I will let Mike elaborate some.

[Michael D. Strohm:]

Well, as you know, this fund can be 0 to 100 percent in each of the major asset classes- stocks, funds, cash, precious metals, we can use derivatives- in order to protect the shareholders. On the downside, our philosophy from the very beginning is to stay on the upside, to protect these from the downsides. And the fact that our performance is flattish- that is the point. We want it to be flattish in a down market, and (inaudible 00

[Henry J. Herrmann:]

In the last few years, performance has really been helped by avoiding the trouble spots more so than being the very best at picking the right stuff, although we have done a good job there. But we are still significantly underweighted in anything that I would call consumer durable related and pretty significantly under weighted in the financial services area. And that is also why most of our funds are doing pretty good even on a year to date basis. We avoided the big potholes. And if you know the firm for any period of time you know that generally speaking we do really well at missing the bumps in the road.

[[Aaron Caddell:]

Sure. So would you expect asset funds to continue to operate in a more or less hedged mode for the next quarter or two? Or is it just going to depend?

[Henry J. Herrmann:]

Well, I think it is going to operate in the mode it operates in until the day that the portfolio manager changes his mind and he will tell me and then I will tell you.

[[Aaron Caddell:]

Right. Okay. Thank you for taking my questions.

[Operator:]

Thank you. Mr. Herrmann, there are no further questions. I will turn it back to you for closing comments.

[Nicole McIntosh:]

Before we go on with the closing comments, I am going to give Cynthia the share count that she asked for, post buy-back. At the end of the quarter, we had 86.2 million shares outstanding. Post the buy-back, that brings the number down to 85.7 million.

[Henry J. Herrmann:]

Operator, I do not really have any closing remarks other than to express my appreciation to those who were on the call and I look forward to talking to you at the end of the next quarter. Take care.

[Operator:]

Thank you, sir. Ladies and Gentlemen, that will conclude today’s teleconference. We do thank you again for your participation. (Operator’s instructions.) Have a nice day.