Federated Hermes: Look Beyond Fourth Quarter Earnings Miss (NYSE:FHI)

Elevator Pitch

Federated Hermes’ (NYSE:FHI) stock is still rated as a Buy.

With my prior October 18, 2022 write-up for Federated Hermes, I evaluated FHI’s recent M&A transaction and previewed its Q3 2022 financial results. Federated Hermes’ share price has done reasonably well since my previous update, with FHI’s shares up +18.8% (source: Seeking Alpha price data) as compared to a +8.6% increase for the S&P 500 in the same time frame.

In this latest article, my focus is on Federated Hermes’ financial and operating performance for the fourth quarter of last year. FHI’s bottom line was good, if adjusted for the non-recurring impairment loss, while its Assets Under Management or AUM growth exceeded expectations. I retain my Buy rating for FHI; investors should ignore the stock’s below-expectations headline EPS and focus their attention on the company’s positive AUM growth outlook and value creation drivers relating to capital allocation.

Fourth Quarter Earnings Miss Is Largely Attributable To Impairment Charge

FHI’s Q4 2022 top line performance was reasonably decent as highlighted in its most recent quarterly financial results media release. Federated Hermes turned around from a -11.6% YoY revenue contraction in the fourth quarter of 2021 to achieve a +16.2% YoY top line growth for the most recent quarter. FHI’s +16.2% YoY revenue expansion for Q4 2022 was also roughly on par with the company’s Q3 2022 top line increase of +16.7%.

It was Federated Hermes’ bottom line which came as a negative surprise in the recent quarter. Earnings per share or EPS for FHI decreased by -11.3% YoY from $0.71 for Q3 2022 to $0.63 in Q4 2022, which also marked a reversal from the company’s +6.8% YoY bottom line growth in Q3 2022. Furthermore, Federated Hermes’ actual fourth quarter EPS came in -16.0% below the Wall Street analysts’ consensus bottom line projection of $0.75 per share.

Notably, the market responded favorably to Federated Hermes’ Q4 2022 results release, notwithstanding its headline earnings miss. FHI’s stock price rose by +1% from $38.24 as of January 26, 2023 (Q4 results released after trading hours on this day) to $38.68 as of January 27, 2023.

In my opinion, investors appreciate the fact that FHI’s below-expectations earnings were driven by non-cash and non-recurring costs.

In the company’s Q4 2022 earnings press release, Federated Hermes disclosed that it recognized an “impairment of an intangible asset associated with the 2018 acquisition of Hermes Fund Managers Limited” that lowered its fourth quarter bottom line by -$0.27 per share. In other words, FHI should have delivered above-expectations EPS of $0.90 for Q4 2022, if not for this specific impairment charge.

FHI revealed at its recent Q4 2022 earnings call that the impairment charge relating to Hermes Fund Managers was due to the recent underperformance of “public markets” and a rising rate environment which led to a lower valuation for the specific intangible asset. Moreover, Federated Hermes disclosed at the recent quarterly results briefing that it has approximately “$4.8 billion in net institutional mandates yet to fund” and most of it relates to the Hermes Fund Managers. In other words, the Hermes Fund Managers’ acquisition is performing in line with expectations, and the one-off impairment is likely the result of broad market weakness rather than company-specific issues.

Positive Outlook Relating To AUM Growth

Federated Hermes’ AUM expanded by +7.1% QoQ from $624.4 billion as of end-September last year to $668.9 billion at the end of 2022. FHI’s actual end-Q4 2022 AUM also turned out to be +4.1% better than Morningstar’s (MORN) AUM projection of $642.4 billion.

Rising interest rates tend to drive fund inflows into money markets funds. Using history as a gauge, FHI’s money markets AUM grew by +15% during the prior rate hike cycle between end-2016 and end-2018, as per management’s comments at the recent quarterly earnings call.

FHI isn’t just growing in line with the money markets industry; it is also grabbing market share away from its rivals. Federated Hermes mentioned at the company’s Q4 2022 earnings briefing that its share of money market mutual funds increased by +30 basis points QoQ to 7.7% as of the end of Q4 2022.

In summary, FHI’s AUM growth for the recent Q4 2022 was above expectations, and there should be room for its AUM to expand further in the current rising rate environment using historical numbers as a reference.

Potential Upside From Capital Allocation

As of December 31, 2022, FHI had around $521.8 million of cash in its book which is roughly equivalent to a quarter of its total assets which amounted to $2.02 billion.

Federated Hermes can create lots of value by utilizing its huge cash pile in an optimal way.

In my earlier mid-October 2022 article for FHI, I stressed that Federated Hermes’ “shares can re-rate in the future with acquisitions being a key driver of above-expectations growth for the company.” At its recent Q4 investor call, Federated Hermes emphasized that M&A is “our first desire with the use of the money because of our returns on them.”

Separately, FHI could also allocate some of its excess capital to share buybacks. Federated Hermes currently trades at 12.0 times consensus forward next twelve months’ normalized P/E as per S&P Capital IQ data, which is -10% below its 15-year mean P/E multiple of 13.4 times. Considering that FHI’s shares are inexpensive, it makes sense for FHI to engage in share repurchases.

In a nutshell, Federated Hermes has the potential to enhance shareholder value by spending its excess cash on accretive acquisitions and buybacks going forward.

Closing Thoughts

I continue to favor Federated Hermes as an appealing investment candidate. FHI’s AUM is expected to continue expanding in the current rate environment, and there are opportunities for the company to execute on value-accretive share repurchases and M&A deals.