Elevator Pitch
I leave my Buy investment rating for Federated Hermes, Inc. (NYSE:FHI) stock unchanged. I previously touched on FHI’s growth drivers for the short term and long run with my April 14, 2023 update for the company.
With this latest article, I analyze the changes made to Federated Hermes’ capital allocation approach, and explain what this means for FHI’s growth outlook. In my view, I think that FHI is now more willingly to allocate a larger proportion of its free cash flow to capital investments, as it has identified relevant organic and inorganic growth opportunities. This implies that there is room for Federated Hermes’ Assets Under Management, or AUM, to expand further. Given that such positives aren’t priced into FHI’s shares yet, I rate Federated Hermes as a Buy in consideration of the potential upside for the stock.
Change In Federated Hermes’ Capital Allocation Priorities Sends A Positive Signal
There are indicators suggesting that Federated Hermes is making tweaks to the company’s capital allocation strategy, and I think these changes have positive read-throughs for FHI’s business outlook.
Historically, FHI has placed a stronger emphasis on shareholder capital return as opposed to capital investment. As disclosed in the company’s investor presentation slides, Federated Hermes has allocated 22% and 78% of its cumulative free cash flow to mergers & acquisitions (M&A) and dividends & buybacks, respectively since the company was publicly listed in 1998.
But Federated Hermes has spent a mere $7 million (source: FHI’s investor presentation) on share repurchases in this year thus far. As a comparison, FHI’s capital allocated to share buybacks amounted to $228 million and $218 million for FY 2021 and FY 2022, respectively.
At its Q1 2023 earnings call, FHI acknowledged that it hasn’t “bought as many shares” this year, even though it has a “pretty decent amount of cash.” It is worthy of note that Federated Hermes’ cash and investments of around $448 million as of end-Q1 2023 was equivalent to a significant 14% of its current market capitalization.
More importantly, Federated Hermes indicated at the company’s most recent first quarter results briefing that its “seed (money) usage may increase as we develop new products,” and it also noted that it has “M&A specialists” on the lookout for potential money market fund consolidation deals. With respect to examples of new products, FHI is introducing new nature-related fund products to leverage on the success of its Biodiversity Fund. Also, as an illustration of the size of the industry consolidation opportunity for money market fund distributors or managers, FHI estimates that about half of the players operating in this space are sub-scale.
In a nutshell, it is realistic to make the assumption that Federated Hermes has intentionally reduced the amount of share repurchases to set aside more capital for potential investments. The slowdown in Federated Hermes’ buyback activity and FHI’s management commentary imply that the company’s growth prospects are becoming much more favorable with both organic and inorganic growth opportunities emerging.
There Is Still Room For Growth In FHI’s AUM
Federated Hermes’ total AUM expanded by +11% YoY to $701.0 billion as of March 31, 2023, which is a historical high, as revealed in the company’s investor presentation.
Specifically, FHI’s money market AUM also rose by +20% YoY to set a new record of $505.8 billion at the end of the first quarter of this year. Taking into account expectations for further “rate hikes”, there should be support for money market fund inflows in the foreseeable future.
As discussed in the preceding section, Federated Hermes has the financial capacity and intention to grow its AUM further via either the launch of new product offerings or the acquisition of third-party money market assets.
Positives For Federated Hermes Have Yet To Be Priced In
The market currently values Federated Hermes at a consensus forward next twelve months’ normalized P/E multiple of 10.6 times according to valuation data sourced from S&P Capital IQ. In contrast, FHI’s historical 15-year mean normalized P/E ratio is significantly higher at 13.3 times. Similarly, FHI trades at 7.5 times consensus forward next twelve months’ EV/EBITDA now, which is below its 15-year average EV/EBITDA metric of 8.6 times.
In my opinion, FHI’s lower than expected share buybacks in 2023 year-to-date send a strong signal that the company has identified areas where it can invest its excess capital to drive future growth. With regards to organic growth, there is demand for investment products leveraged to specific themes such as nature. With respect to inorganic growth, Federated Hermes could potentially be a beneficiary of industry consolidation, as sub-scale money market fund distributors or managers put themselves up for sale and exit the market.
Notwithstanding the positive growth outlook for FHI, the stock is still trading at a meaningful discount to its long-term historical averages. As such, I view Federated Hermes’ shares as mispriced, considering that the positives for FHI haven’t been factored into its key valuation metrics.
Closing Thoughts
I remain bullish on Federated Hermes stock. I believe that the market hasn’t given sufficient credit to FHI’s good growth prospects. In that respect, I view Federated Hermes’ shares trading at below fair valuation which implies a Buy rating.
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