JMP Group LLC
Q4 2018 Earnings Call Transcript

Published: 15 Feb 2019

[Operator:]

Welcome to JMP Group's Fourth Quarter 2018 Earnings Conference Call. Please note that today's call is being recorded. [Operator Instructions] I'll now turn the call over to Andrew Palmer, the company's Head of Investor Relations.

[Andrew Palmer:]

Good morning. With me today are Joe Jolson, JMP Group's Chairman and Chief Executive Officer; and Ray Jackson, the company's Chief Financial Officer. We're joined by Carter Mack, President of JMP Group; and Mark Lehmann, President of JMP Securities. Before we begin, please note that some of this morning's comments may contain forward-looking statements about future events that are out of JMP's control. Actual results may differ materially from those indicated or implied. For a discussion of the uncertainties that could affect the company's future performance, please review the risk factors detailed in our most recent 10-K. With that, I'll turn things over to JMP's Chairman and CEO, Joe Jolson.

[Joseph Jolson:]

Thanks, Andrew. We had a better than expected fourth quarter with operating earnings of $0.12 a share. JMP Securities contributed $0.08 per share, despite the sharp selloff in the equities market, which limited capital market activity in the fourth quarter. For the full year, JMP Securities' operating earnings per share were up nearly 20% to $0.37 a share, driven by record advisory fee revenues that rose nearly 40%. As a result, JMP Securities generated an after tax return on equity of more than 30% last year. Asset management fee income and investment income combined to contribute $0.14 of operating earnings, up 8% from the fourth quarter of last year. Investment income covered our fixed corporate cost for the third consecutive quarter, and earnings of $0.12 per share produced by our untaxed pass-through entities more than covered our fourth quarter cash distributions of $0.09 a share. We also initiated an aggressive corporate simplification strategy during the fourth quarter, intended to make our business less complicated to manage and easier for investors to understand. As disclosed in January, we have elected to be taxed as a C-corp going forward, which will increase our corporate tax rate, but will eliminate scheduled K-1s for investors, removing substantial corporate cost and potentially increasing our appeal to institutional investors. The progress we made last year in our five key initiatives was substantial, and I want to take a few minutes to review some of that with you. First, in investment banking, we had a record year in our strategic advisory business, and we seem to be on track to achieve our stated objectives. Since 2013, we have been working to aggressively grow this business, and after a record year in 2016, we set a 5 year goal to once again double our annual M&A revenues and private placement fees organically to $50 million in 2021. To get there, we needed to materially increase our average fee per transaction as well as the number of transactions by selectively adding more M&A bankers to our platform. In 2018, we produced record advisory revenues of $33.5 million, closing 22 transactions with an average fee of $1.5 million compared to 18 deals at an average fee of $1.3 million in 2017. Our current advisory pipeline is strong and growing as we start the year 2019. Last year, we averaged 19 calling officers in our investment banking group, who averaged roughly $1.8 million of advisory revenue as well as $2.6 million of capital markets revenues. Since our 5 new hires last year all joined during the second half of the year, they contributed a limited amount to our advisory revenues for 2018. We are actively looking to track more senior producers to our firm with a target of 25 calling officers by year-end 2021. We are confident that our growth strategy could create compelling earnings leverage in the next few years, but as we are still ramping that up as we enter 2019, it will require us to invest some potential earnings back into our platform as we seek to attract the right people. Interestingly, we estimate that our share of U.S. M&A transactions, with enterprise values below $1 billion, jumped to nearly 2% last year, given the decrease in the number of deals for the year industry-wide, coupled with our 40% increase in advisory revenues. If we are successful in achieving our growth plan for this business, our share could approach 4% over the next 5 years. Besides offering us the advantage of a less cyclical and higher-margin business, a shift in our revenue mix towards more advisory fees could have the added benefit of improving our company's valuation, since investors apply much higher multiples to advisory boutiques than they do to capital markets firms. Our second objective was to continue to invest in our equity capital markets franchise, enhancing its value as one of the few remaining platforms of meaningful scale in the United States. Our share of all U.S. equity capital markets fees paid in our four industry verticals in 2018 was 1%, up from 96 basis points the previous year and 79 basis points in 2016. We made especially good progress in our technology vertical last year. We were a lead or co-manager of 19% of all U.S. technology IPOs priced in 2018 compared to 10% in 2014 and 8% in 2007, the peak years of the past two market cycles. During the fourth quarter of last year, we participated in fully a third of all U.S. technology IPOs, three of the nine that priced. Market volatility slowed new issuance in the fourth quarter, and subsequent to that, the month of January was severely impacted by the SEC's closure during the government shutdown. Although the equity capital markets business is cyclical in nature, it is a central part of our business model, and we believe that has material franchise value in a consolidating industry. While the recent pause in activity is worrisome, I'm confident that our focused strategy of leveraging industry expertise through senior relationships will continue to position us to gain market share over time. Looking ahead, in 2019, we anticipate that there will be windows of opportunity for good companies to access the equity markets. Similar to last year, in the second quarter, we got such a window and had our best quarter ever, generating roughly $20 million in ECM fees. We continued to gain market share in our institutional commissions business during 2018. Our net commission revenues fell less than 2% year-over-year compared to declines of more than 7% across the industry and compared to some dire predictions of a 30% plus collapse following the introduction of MiFID II in January 2018. Third, in asset management, we made a strategic decision to reposition our business to better align it with our four industry verticals and products, focusing on fund strategies that offer more synergies with the broader firm's core competencies, including VC-backed technology in healthcare and opportunistic investments in real estate and financial services and corporate credit. As part of our evaluation process, we reached an agreement to sell Harvest Small Cap Partners to its portfolio manager, a transaction that closed on December 31. While the fund contributed greatly to our company's success over many years, it was also distortive for our financial statements at times when substantial incentive fees affected our revenues and compensation ratios. As structured, the impact of the sales should be modestly accretive to JMP Group over the next few years and should simplify our financial reporting greatly. Going forward, we will work to grow assets under management in our existing fund strategies, as we look to expand our overall platform, by continuing to partner with other established fund managers that have short-term capital needs that we can address. Our most recent partnership is with Astor Investment Management, a fund manager with an asset allocation model that utilizes EPS to generate exposures. Astor has grown from $1.9 billion of AUM at the time of our investment in November 2017 to $2.2 billion at the end of last year. Our other asset management partner, Workspace Property Trust, had $1.3 billion of AUM at year-end. While unable to complete its planned IPO a year ago due to difficult market conditions for publicly traded REITs, the company continues to execute well on its business plan with above average growth in same-store NOI in 2018. In all, our sponsored assets under management, a number that includes these third-party relationships where we have an economic interest, was $5.6 billion at year-end, up from $5.1 billion the year before. Our fourth initiative was to complete the redeployment of roughly $35 million in cash that was remaining from our redemption of our first 2 CLOs in early 2017. We did complete CLO IV in June of 2017, and we were able to finally complete CLO V last July. We now manage more than $1.2 billion in corporate credit through 3 CLOs, and have a committed 3-year warehouse facility in place that should allow for several more securitizations subject to market conditions as always. Due to redeployed capital for the first 3 quarters, we have once again been able to cover our cash distributions to shareholders with earnings from our untaxed pass-through investment entities. Our fifth and final goal, to materially simplify our company, was added to the list in the second quarter of last year after the SEC lost its appeal of a lower court ruling that CLOs were not subject to risk retention rules under Dodd-Frank. While technically complicated, we now have a clear path to deconsolidating our CLO business from our financial statements, based on whether JMP Group controls the manager, which is JMP Credit Advisors and also has the ability to call each individual CLO. During 2019, we hope to attract new investor capital to JMP Credit, which would serve to fuel more rapid AUM growth for this business, but also allow for the deconsolidation of it from our financial statements. When you look at JMP Group on a deconsolidated -- consolidated basis, we are relatively simple. At the end of the year, we had $231 million of assets, mostly invested in our fund strategies, financed with $83 million of long-term debt and $84 million of tangible equity. Instead, under GAAP, our company has $1.4 billion asset balance sheet, funded with more than $1.2 billion of debt. Our operating earnings would be similar on a deconsolidated basis, but with much less variability on a quarterly basis from irregular credit cost. While hard to quantify, we strongly believe a simpler story could result in a much improved valuation for our stock. Lastly, in January, we elected to be taxed as a C-corp when we made that announcement going forward. We are hopeful that this change will attract more institutional investors that were either unwilling or unable to accept K-1 tax statements from us. Although we estimate that our reported earnings will be reduced by up to $0.08 a share as a result of our new tax status, because investment income will now be taxed at the corporate level instead of receiving pass-through treatment as it did in the past, the economic value of our earnings to our shareholders will be materially increased. Due to the negative effect of last year's changes in the tax code, we recently declared a special dividend of $0.05 a share, just to ensure that no shareholder in any state, including California and New York, high-tax states, pays more in taxes than we distributed from operating income. Put simply, the value of our partnership structure was essentially eliminated by changes in the tax law. While our earnings and dividend levels will be lower going forward, our pretax income will be much higher because of cost savings, and we will retain more of our operating income fueling faster growth of our core businesses. Our Board of Directors plans to meet in April to set a go forward quarterly dividend rate that when annualized will approximate what we think conservatively, we might -- 50% of what we think we might earn this year. As always, I want to thank our employees and our independent directors for their hard work and dedication to the company. I look forward to building on 2018 successes and to reporting on that progress throughout this year. Operator, I'm now happy to try to answer any questions there might be. Thank you.

[Operator:]

[Operator Instructions] Your first question comes from the line of Alex Paris from Barrington Research. Your line is now open.

[Alex Paris:]

Couple of questions, no order. It's just on the - the change to a C-type corporation is going to be dilutive to reported after-tax earnings of up to $0.08 as you said, pretax earnings will be enhanced due to lower costs. Can you discuss the lower cost associated with the shift to C-type corporation?

[Joseph Jolson:]

Yes, I mean, basically we -- the cost of -- to pay outside vendors to generate K-1s, it's basically accounting and legal costs. Overall, as we simplify the story and potentially go back to GAAP accounting, we hope to get even some more significant cost savings through, just for instance, I think our 10-K that we're working on now, we could eliminate maybe 20% or 30% of it, just by doing that, which of course, means a lot less hours for our outside auditors to review and time internally and everything else. So we think that those cost savings could be at least $0.03 this year after tax, maybe more next year.

[Alex Paris:]

Okay. Thank you. And then, asset management-related earnings were much better than I had...

[Joseph Jolson:]

Just to be - Alex, sorry. Just to be clear, that cost savings was included in that $0.08 -- up to $0.08 number that was - I mentioned.

[Alex Paris:]

Okay. So $0.08 was net of the cost savings?

[Joseph Jolson:]

Yes, yes. Just to be clear.

[Alex Paris:]

Okay. Appreciate that. And then the - oh, asset management. Asset management earnings in the fourth quarter were much better than I had modeled. Can you unpack, I guess, what drove, I guess, $0.14 if you put it together versus $0.13 last year on the asset management side. Were there any - was there a gain for Harvest -- the Harvest sale in that number or anything?

[Joseph Jolson:]

No. There were no unusual items. I mean, I think that credit costs were in line, maybe a little better than we expected. Under the current accounting, it can be lumpy. It usually is lumpy quarter-to-quarter, so there was no new identified problem assets or anything in the quarter. So that's good. There were some further hits that we took to existing things we had already written down, so that was a little bit better than expected. We've redeployed our capital. So we've been -- part of it is just -- the general level of net investment income is just higher than it had been before we did that, right? Our capital in our one hedge fund had a poor fourth quarter, so that hurt the results, so I guess, shouldn't be a surprise with the 20% sell-off in the market in -- towards year-end. But -- so that -- and generally, we accrue a small amount of bonuses attached to investment income that often, by the fourth quarter, we reverse out. So there's a little bit of that, I suspect, hopefully that. Now remember, going forward, that will be taxed. So that number for the fourth quarter was untaxed, and the marginal tax rate for us is around 26%, marginal. On average, it's probably going to be about 30% this year. So last year's fourth -- last year and in the previous years in the fourth quarter, that net investment income that you see in there, most of that was untaxed. There was one another positive surprise in the fourth quarter as well that I should mention, is our venture fund. Despite the sell-off in the market, the venture fund had better-than-expected results related to individual company performance.

[Alex Paris:]

Great. And then, while sticking with asset management. The sale of the Harvest Small Cap Fund, I know this is not going to have an impact really on full year EPS because a lot of that goes into compensation, it's going to eliminate some volatility in quarterly results. Question is, what was the AUM of the business unit sold. And then second - well, let's just set there.

[Joseph Jolson:]

Yes, it was about $370 million, I think. And it was a full fee hedge fund kind of thing, two and 20 hedge fund. Still is, but that's not part of our results.

[Alex Paris:]

Okay. And then, on a full year basis, what did that produce in terms of revenue, just ballparkish, because that won't be there in '19, is why I'm asking?

[Joseph Jolson:]

If you just take 2% of that number, that would be the management fee number, right? And then, there were -- it was below its high watermark for the year on incentive fees, but you had a special purpose fund separate from the regular fund that got liquidated early in the year. So if you look at the incentive fees that we had in, I think, it was Q1, and I don't know if it bled into Q2, that was also related to that. So I think going forward, you should assume much lower incentive fees in general, maybe in the $1 million to $2 million range for this year. And then, of course, that's the management fee adjustment.

[Alex Paris:]

Okay. Good. And then, I guess, my last question for now is, given your comments on deconsolidation, you now have a clear path. It's going to -- you're going to just have to do some capital raising and so on. How long of a process is the deconsolidation process. We have to deconsolidate one fund at a time basically over time. It is a couple of year, a multi-year process?

[Joseph Jolson:]

It could be. Our goal would be to make it effective immediately. But it's complicated, rules-based process. And it's possible that we may not be able to deconsolidate all 3 funds all at once. But that would be the goal. But unfortunately it's - these accounting rules, I'm not sure exactly how they create -- they're very specialized for CLOs versus other areas, so they tend to be very complicated. We can go into it off-line, if you're really interested in the details, but it's very complicated.

[Alex Paris:]

We have before. We probably should do it again. We will take it off-line though. So thanks very much and congratulations on a better than expected fourth quarter results in early tough environment.

[Joseph Jolson:]

Thank you.

[Operator:]

Your next question comes from the line of Greg Gardner [ph] from Singular Research. Your line is open.

[Unidentified Analyst:]

Thank you. A couple of questions. One about the strategic advisory. You mentioned five new hires in the second half of '18. Just trying to get a sense for how productive they might have been versus when do you think they might be fully productive. I'm just trying to get an understanding of how we're going -- you're going to ramp up to, what, doubling those revenues in strategic advisory?

[Joseph Jolson:]

Yes. I mean, last year, we had some turnover of bankers as well. So M&A revenues, just generally, when you hire someone, there's -- they are walking away from an existing pipeline from where they were previously. So generally, it takes at least six months, if not often longer for them to just get engaged on new business. And then it takes a while to process that and close it. So usually, there is almost revenue -- no M&A revenues at least in the first year, I would say. Carter is here, so he may...

[Carter Mack:]

Yes, I mean, the five people we hired, a couple of them were to replace people that departed. So kind of net three new folks, calling folks. And yes, exactly what Joe said, I view it as kind of a 12 to 18 month ramp-up period. And the good thing is the number of the people that we hired have been engaged on multiple M&A assignments, and we expect them to contribute in 2019. And feel good about their progress in their pipeline.

[Joseph Jolson:]

I think the overall productivity last year, for our calling officers, if you just take the average of 19 into investment banking revenues, was little under $5 million. That's very high productivity, especially for the smaller cap niche that we focus on. And I think that the -- it shifted. Obviously, the capital markets revenues was kind of slightly up year-over-year, where as the M&A was up almost 40%. So the mix is shifting a lot more towards M&A, and we would expect that could continue over any period of time, just given the nature of the people that [Technical Difficulty] the platform. But when we hire these people, we're hoping that they can ramp up over a couple of year period at that productivity level.

[Unidentified Analyst:]

Well, if you like that, productivity level is actually a little bit higher, if they're really not going to be as productive in their first 18 months - 12 to 18 months. And so the average productivity per producer has actually been higher. And then, if there's two more going to be coming in, there was a net three . So I guess, that would be about 25% from '17 to end of '19, so I'm just looking at...

[Joseph Jolson:]

I mean, it's kind of a -- it's a numbers game. It's a relatively simple model. If you hire people that end up being productive on your platform, and the cost is in the first year, you're backstopping them for walking away from an existing business. And so, we all get - I mean, last year's earnings were reduced by about $0.06 a share over what we would have earned have -- and we had none of those costs the previous year. So this year could be that or a little bit higher. And there's a cost. It's a pretty simple IRR model. If you hire people that are productive, it's usually accretive over a 2- or 3-year period.

[Unidentified Analyst:]

Yes, makes sense. I just wanted to get a better understand of how it's working out for you. On the simplification strategy, first of all, I personally like the idea, but it makes sense to me that the dividend policy might change. But I was surprised here you mentioned a target of 50% payout and -- because when you look at the growth initiatives and the valuation typically applied to what's most likely going to occur when you become a C-corp, it just makes me wonder there's this growth and there's this dividend payout and they're sort of competing strategies there. And -- so I just wonder what's your thought. If you can explain why would there be such a high dividend payout? Or is that just sort of, you just threw it out there as a possibility.

[Joseph Jolson:]

No, I mean, we've always paid out a high percentage of our earnings since we went public. It's been 50% to 100%. Even -- I mean, even when we were a C-corp prior to 2015. And the primary reason for that is, we're in businesses where we don't need capital to grow. So our earnings are essentially free cash flow that we can either keep and build book value and maybe make investments over time or pay off our existing long-term debt or payout. So we feel like a 50% level is reasonably balanced between growing book value, reducing debt as well as rewarding shareholders for investing in our company. I think that the -- the costs that we're talking about, fortunately, have come out of earnings that were otherwise generating to grow the M&A business. They're not coming out of capital. So we're still highly profitable. JMP Securities on about $1 of book value made $0.37 after tax last year. So that includes that $0.06 a share of cost to add the M&A bankers. So it was close to our best year ever, slightly below our best year that we ever had in 2014. So it's absorbing those costs in those numbers. And I think that it's still generating an awfully high return on capital on essentially an unleveraged basis.

[Unidentified Analyst:]

And one last question. It is more of overall economic view point, what you're seeing based on your different businesses. Just yesterday, there was a report about some car loans, the high-risk car loan default rates going up. There has been some reports about some of the junk bond side of the economy is just showing some defaults increasing. Are you seeing anything in your different business segments that are showing any signs of the tipping of the peak of the cycle where we're going to start moving to a slowdown of any kind. Just wondering what do you see along those fronts?

[Joseph Jolson:]

I think that we cover a lot of those areas with JMP Securities in terms of commercial finance, consumer finance and all that. But in terms of our business, what touch us is primarily on our credit cost for the corporate lending side. And that's normalized a couple of years ago. I had been running it at 0 losses for a number of years. And then, maybe it was two years ago, it started to kind of normalize. So I don't know, Ray, if you have the exact number for last year, I'm going to guess and see if you have it. But I think our total credit cost last year was probably somewhere around 30 basis points for last year, maybe it was a little more or less than that. But any -- of course, on a quarterly basis, it's been variable every quarter. I think in the fourth quarter, it was a bit less than that. In the first quarter last year, it was quite a bit higher than that annualized. So it does jump around. Unfortunately, it's lumpy on a quarterly basis. So we assume that those credit costs envelope could go up to around 50 basis points in our internal plans. So to the extent that they're less than that, it would be a positive variance to us, our earnings versus kind of what we would have thought at the beginning of the year. And when we do these deals in terms of the expected IRR, we assume that your annual credit costs are in that range, 50 to 60. I mean, if we had a recession type of environment, you would have a year where it would be at the high end of that or even potentially higher than that, but on average over, say, a five year period, it should be around 50 basis points, given the kind of -- we're in first lien corporate credit that isn't highly leveraged to our last dollar out. So we're at the lowest risk of the capital stack as a lender.

[Unidentified Analyst:]

Okay. All right, thanks. I appreciate it. Thanks.

[Joseph Jolson:]

Thanks for your questions.

[Unidentified Analyst:]

Sure.

[Operator:]

There are no further questions at this time. You may continue.

[Joseph Jolson:]

We appreciate the interest. And we look forward to updating everyone in a few months on our first quarter results. Thank you.

[Operator:]

Thank you for joining us today. This concludes today's conference call. You may now disconnect. Have a great day.