Federated Investors Inc (NYSE:FII) is up 36 percent this year causing pain for short sellers notes Brendan Conway of Barrons. He notes that the stock has down well as of late as Federated Investors Inc (NYSE:FII) stock could benefit from expectations of higher interest rates. Citigroup’s William Katz predicts further pain for short sellers. Below we have the math behind Citi’s explanation and why they predict further increases for the stock.
Why The Shorts Should Be Concerned
We see two issues for the bear thesis. First, reform is evolving, and likely to only partially affect Federated Investors Inc (NYSE:FII). By contrast, short interest – at 18% versus a 2% median for Traditionals – has remained elevated, even as the risks of reform have softened. We do not expect capital buffers or mandatory redemption/gates to be included in the SEC’s proposal, further reducing the key risks. As highlighted above, the vast majority of the “Street” is cautious on FII, even as the likelihood for “Franchise Armageddon” is no longer likely. To be sure, we doubt FII will need to raise capital, and as detailed below, we could paint a scenario whereby estimates go up, not down for Federated Investors Inc (NYSE:FII).. Second, our scenario analysis suggests the real EPS risks may not be so bad.
Federated Investors Analysis
Working Through The Scenarios
In scenario #1, we work through the potential dilution assuming a high percentage of Federated Investors Inc (NYSE:FII).’s Prime money market business were to attrite owing to the shift in reform. Of FII’s ~$280B in money market AUM, roughly $100B are “Prime”. In turn, we array run off from 25% to 75% of these AUM. Importantly, there is a large, but not yet fully quantifiable percentage of retail oriented Prime money market funds, which may not be impacted by reform. In speaking with management, they too are not sure on the size, but likely a large percentage given much of the volume comes from retail B/D and bank trust channels.
For this analysis, we assume 80% incremental margins, as we suspect management may not be able to shed much costs. In turn, we arrive at $0.17 to $0.52 potential EPS loss (Figure 6). However, this analysis is in a vacuum, and assumes no offsetting rotation impact or fee waiver recovery.
In Scenario #2, we assume 50% of foregone AUM rotate into other Federated Investors Inc (NYSE:FII). money markets, such as Agency or Treasury funds. Given the lower for longer rate backdrop, we believe much of the AUM with FII are less rate sensitive, and more liquidity driven. As such, we suspect some of the flows would stay “in house”. In turn, “dilution” essentially halves to a more manageable $0.09 to $0.26 range (Figure 7). And, should their be a long phase in period, ultimate attrition might be less, particularly as FII is among the more scaled of the money market managers.
In scenario #3, we start with scenario #1, and simply adjust for fee waiver recovery. While we recognize some timing mismatch depending on absolute level of rates and timing of regulatory implementation, the EPS impact improves to a worst case scenario of $0.15 dilution to $0.20 accretion (Figure 8). Note, we assume only 75% of fee waivers are added back, or those related to Treasury-only money markets.
In scenario #4, which we believe could be how it ultimately plays out for Federated Investors Inc (NYSE:FII)., we start with scenario #2, and work through the same fee waiver recapture. Here, we see a range of $0.11 to $0.29 accretion (Figure 9).
Net, net, the likelihood for material EPS dilution, only hinges on nearly 100% of the Prime business attriting, and based on what we expect the SEC will propose, such an outcome is a low probability outlier. We do see some slippage in repo rates, but believe much of that is seasonal, and should rise over the coming months.