Guido Mieth
Elevator Pitch
I continue to assign a Buy investment rating to Federated Hermes’ (NYSE:FHI) shares.
I evaluated Federated Hermes’ financial performance for the second quarter of this year in my earlier update for FHI written on August 4, 2022. The focus of the current article is FHI’s recently completed acquisition and the preview of the company’s upcoming third-quarter earnings release.
My bet is on Federated Hermes announcing above-expectations earnings next week. Also, I am of the view that FHI should continue to execute on more M&A deals going forward, which should be positive for the company’s intermediate term growth prospects. Considering these factors, I keep my Buy rating for Federated Hermes unchanged.
Recent M&A Deal
In the early part of this month, Federated Hermes disclosed that the company has concluded the “acquisition of C.W. Henderson & Associates, Inc., a specialist in municipal-bond SMA (Separately Managed Accounts) products.”
Specifically, the takeover of C.W. Henderson increased FHI’s municipal bond AUM (Assets Under Management) by +26% to $16.8 billion. This M&A transaction also helped to grow Federated Hermes’ SMA assets by +9% to $29.0 billion.
Federated Hermes’ decision to acquire a company focused on municipal bonds seems to be a sound one based on a review of some of FHI’s most recent quarterly metrics.
Notably, FHI highlighted at its Q2 2022 results briefing that its “Municipal High Yield Advantage Fund” and “Conservative Municipal Micro Short” Fund were among “fixed income funds with positive net sales” for the recent quarter, even though “most categories of bond funds had net redemptions.” As such, it makes sense for Federated Hermes to expand its municipal bond AUM by acquiring C.W. Henderson.
On a broader level, this recent M&A deal could mark an inflection point for FHI’s inorganic growth strategy and prospects.
Federated Hermes’ organic growth track record has been disappointing, which implies that inorganic growth or M&A is a key driver for the company going forward. As a reference, FHI’s five-year mean organic AUM annualized growth was a mere +0.2%, according to Morningstar research.
At the company’s second-quarter investor call, Federated Hermes emphasized that there are a “lot of opportunities” and stressed that it is “still active and out there” when asked about the potential for future acquisitions. In my opinion, FHI can surprise the market in a positive way with better-than-expected future growth driven by M&A.
Q3 2022 Earnings Preview For FHI
In an announcement issued on October 6, 2022, FHI noted that it will reveal its third-quarter financial results on October 27, 2022.
Federated Hermes had delivered below-expectations earnings per share or EPS for the past two quarters. The company’s actual Q1 2022 and Q2 2022 normalized EPS fell short of market expectations by -9.3% and -9.1%, respectively. Therefore, it is natural to be concerned whether FHI’s upcoming Q3 earnings release will meet the Wall Street analysts’ expectations.
But analysts have become more conservative with regards to their financial forecasts for FHI, as the company’s bottom line has disappointed the market in the prior two quarters. The market’s consensus Q3 2022 normalized EPS projection for Federated Hermes was reduced by -7.9% in the past three months.
Based on S&P Capital IQ’s financial data, the sell-side estimates that FHI achieved a normalized EPS of $0.70 for the third quarter of 2022. This is equivalent to a -4.0% YoY bottom line contraction for the company.
The key differentiating factor for Federated Hermes as an asset manager is its focus on money market assets, which accounted for about 70% of its AUM as of end-June 2022. As such, FHI’s near-term performance should be reasonably good in the current environment of rising rates. At its Q2 2022 results call, Federated Hermes mentioned that “higher short-term rates will benefit money market funds.” Coupled with the fact that expectations for FHI’s Q3 2022 earnings aren’t that high as seen with consensus numbers, I see a good chance of FHI delivering an earnings beat next week.
Valuations And Buybacks
Federated Hermes’ current valuations are undemanding and the company plans to continue with share repurchases. FHI’s share price downside should be limited by these two key factors.
FHI is currently valued by the market at 11.7 times consensus forward next twelve months’ normalized P/E, and this is lower than the stock’s 10-year average forward P/E multiple of 13.7 times. In a scenario where Federated Hermes’ P/E multiple reverts to the long-term historical mean with no change in expected forward earnings, FHI’s share price could potentially rise by +17%.
Furthermore, Federated Hermes has indicated that the company will still buy back its own shares in the foreseeable future, which should provide support for its stock price. FHI noted at its most recent quarterly earnings call that the company “will remain active” with the “5 million (number of shares rather than in dollar terms) share program that is approved and available to us.”
Concluding Thoughts
FHI continues to be rated as a Buy. Federated Hermes’ valuations are inexpensive, and I think that the shares can re-rate in the future with acquisitions being a key driver of above-expectations growth for the company.
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