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Creative Options Use Makes Federated Investors a Winning Play

September 11, 2009 | About:
Federated Investors [NYSE:FII] Sep. 11, 2009 - $25.78

52-week range: $15.80 (Dec. 29, 2008) - $36.63 (Sep. 19, 2008)

Dividend = $0.24 quarterly = 3.72% current yield


Federated provides investment-management services to institutions and individuals. The company offers 158 funds as well as management of separate accounts. Of the company's managed funds, 50 are money market funds, 51 are fixed-income funds, and 57 are equity funds. Its money market and fixed-income funds represent about 87% and 6% of its managed assets respectively. Equity mutual funds were about 7% of assets with its largest equity fund, the Federated Kaufmann Fund, generating about 13% of Federated’s revenues in 2008.

Because Federated focuses on money market funds it fared better than most asset management companies in 2008’s bear market. Earnings per share actually hit a new record of $2.20 versus $2.12 before dipping a bit in 2009’s first half. Zacks sees EPS of $1.90 and $2.05 for 2009 and 2010 respectively. Those numbers are similar to expectations from Value Line and other sources.

Federated is healthy. Standard and Poors and Value Line each rate FII’s financial strength as ‘A’ and Value Line notes Federated’s ‘earnings predictability’ as being in the top 1% of all 1700 companies in their research universe.

Today’s well-covered dividend rate provides a very nice 3.72% current yield in a world where bank CDs and Treasury notes pay much lower rates. The payout has been increased in each of the past eleven years.

Here are the per share numbers from continuing operations as reported by Value Line:

[Dividend data excludes 2008’s special dividend of $2.76 /share]

Year ........ Sales ........ C/F ......... EPS .......... Div. ....... Avg. P/E

2002 ....... 6.32 ........ 1.98 ........ 1.74 ........ 0.22 ........ 17.3x

2003 ....... 7.58 ........ 2.07 ........ 1.83 ........ 0.30 ........ 15.0x

2004 ....... 7.92 ........ 2.03 ........ 1.77 ........ 0.41 ........ 17.0x

2005 ....... 8.49 ........ 2.08 ........ 1.84 ........ 0.58 ........ 17.0x

2006 ....... 9.42 ........ 2.07 ........ 1.80 ........ 0.69 ........ 19.3x

2007 ...... 11.08 ....... 2.39 ........ 2.12 ........ 0.81 ........ 17.8x

2008 ...... 11.97 ....... 2.41 ........ 2.20 ........ 0.93 ........ 14.8x

At today’s quote of $25.78 these shares are offered at 13.6x this year’s and 12.6x 2010 estimates. Those are the lowest valuations on FII shares since 1999. Buyers of Federated shares back then saw their investment rocket from a (split-adjusted) $10 /share to $32.80 within two years.

I think a return to at least a fifteen multiple is a good bet based on all historical precedents. That would put FII’s target price above $30 again. Is that a reasonable expectation? Sure. These shares peaked at $31.70 - $45.00 at some point during each calendar year from 2000 right through 2008. Sales and dividends are higher now than in all previous years and EPS are not far off their peak levels from past periods.

Morningstar sees ‘Fair Value’ as $30/share. Standard and Poors now carries a 12-month target of $29 /share.

Here’s my buy/write combination play with Federated to make an excellent total return with less risk than outright purchase of the shares.

................................................................ Cash Outlay .............. Cash Inflow

Buy 1000 FII @ $25.78 /share ....................... $25,780

Sell 10 FII April $25 Calls @ $3.10 /share .......................................... $3,100

Sell 10 FII April $30 Puts @ $5.70 /share .......................................... $5,700

Net Cash Out-of-Pocket ................................ $16,980


Here’s the break-down on this trade under two different scenarios:

If FII shares rise to at least $30 (+ 16.4%) by April 16, 2010:

• The $25 calls will be exercised.

• You will sell your shares for $25,000.

• The $30 puts will expire worthless.

• You will likely have collected $480 in dividends.

• You will have no further option obligations.

• You will end up with no shares and $25,480 in cash.

This best-case scenario would represent a net profit of $8,500/$16,980 = 50%

achieved in less than 7.5 months on shares that only needed to go up by 16.4% or better.


If FII shares finish exactly unchanged at $25.78 on April 16, 2010:

• The $25 calls will be exercised.

• You will sell your original shares for $25,000.

• The $30 puts will be exercised.

• You will be forced to buy another 1000 FII shares.

• You will need to lay out an additional $30,000 in cash.

• You will likely have collected $480 in dividends.

• You will have no further option obligations.

• You will end up with 1000 shares of FII and $480 in cash.

What’s the risk?

Break-even on this trade would be figured as follows…

On the original 1000 shares it’s their $25.78 purchase price less

the $3.10 /share call premium = $22.68 /share.

On the ‘put’ shares it’s the $30 strike price less the

$5.70 /share put premium = $24.30 /share.

Your break-even would be the average of $22.68+$24.30/2 = $23.49 /share

(excluding dividends) and $23.01 /share (including yield).

Federated shares could drop by up to $2.77 /share or (-10.7%) without

causing a loss on this trade.



Summary:

Federated Investors is a profitable, financially strong company with a nice yield and a bargain valuation. It could easily rebound to $30 or better before next April 16th. That 16.4% (or greater) move up would translate to a 50% total [cash-on-cash] return.

If Federated shares merely stay unchanged from today’s price of $25.78 you would still see a nice profit. You would end up with the same 1000 share quantity you started with and have $480 in dividend payments from two quarterly payouts of $0.24 /share.

Your net cash flow would have looked like this:

.......................................................... Cash Outlay ............. Cash Inflow

Buy 1000 FII @ $25.78 /share ................. $25,780

Sell 10 $25 calls @ $3.10 /share .............................................. $3,100

Sell 10 $30 puts @ $5.70 /share ............................................. $5,700

Collect Dividends (2 X $240) .................................................... $480

Buy 1000 ‘put’ shares @ $30 /share ......... $30,000

Sell 1000 ‘called’ shares @ $25 /share ..................................... $25,000

Net Cash Out-of-Pocket ......................... $21,500


You would end up owning 1000 Federated shares worth $25,780 (at the unchanged price) for your net outlay of $21,500 (over the full course of the 7.5 month trade).

That would be a $4,280 net profit from start to finish on shares that did not go up!

You would have had a margin of safety of 10.7% (from trade inception) as any price above $23.01 /share on the April 16, 2010 expiration date would allow for liquidating your 1000 shares at a profit.


Disclosure: Author is long Federated shares and short Federated options.

About the author:

Dr. Paul Price
http://www.RealMoneyPro.com
http://www.TalkMarkets.com
http://www.MutualFunds.com

Visit Dr. Paul Price's Website


Rating: 3.3/5 (3 votes)

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