Pzena Investment Management, Inc.
Q1 2018 Earnings Call Transcript

Published: 20 Apr 2018

[Operator:]

Good morning and welcome to the Pzena Investment Management, First Quarter 2018 Earnings Conference Call. All participants will be in a listen-only mode [Operator Instructions]. I would now like to turn the conference over to Jessica Doran, Chief Financial Officer. Please go ahead.

[Jessica Doran:]

Thank you, operator. Good morning and thank you for joining us on the Pzena Investment Management, First Quarter 2018 Earnings call. I am Jessica Doran, Chief Financial Officer. With me today is our Chief Executive Officer and co-Chief Investment Officer, Rich Pzena. Our earnings press release contains the financial tables for the periods we will be discussing. If you do not have a copy, it can be obtained in the Investor Relations Section on our website at www.pzena.com. Replays of this call will be available for the next two weeks on our website. Before we start we need to remind you that today's call may contain forward looking statements and projection. We ask that you refer to our most recent filings with the SEC for important factors that could cause actual results to differ materially from today's comments. Please note that we do not undertake to update such information, which reflects the impacts of circumstances or events going forward. In addition, please be advised that due to the prohibition on selected disclosures, we do not as a matter of policy, disclose materials that is not public information on our conference calls. Now let me turn the call over Rich, who will discuss our current view of the investing environment.

[Rich Pzena:]

Thanks, Jessica. Every investor in the world is being confronted by the same dilemma today. Markets look expensive. In the US, the S&P 500 has been up for the past nine consecutive calendar years and in all but two by double digits. Globally the trend is similar that were bit more muted. At the same time, interest rates remain relatively low, so bonds do not present the particular appealing option. These realities beg an obvious question, what should an investor do? Not surprising, most investors facing this dilemma today act just like investors have acted in similar circumstances throughout history. They keep doing what is already working. And what's working currently is a big bet on disruption. A bet that Amazon really will control all retail distribution and maybe all pharmaceutical delivery, maybe even our grocery deliveries, a bet that FinTech Software startups will replace banks, a bet that Google and Facebook will obsolete traditional advertising agencies, a bet that Tesla will dominate the auto industry because of their electric car technology. These bets have made valuation spreads wide. The valuation difference between the most expensive and the cheapest quintals of stocks is wider today and at any time during the past 50 years, except for the internet bubble period. Now, to be fair, this valuation spread today comes with absolute valuations that are nearly double what they were just a few years ago. Still, the opportunity embedded in a portfolio of deeply undervalued stocks versus one filled with trend following seems like an obvious choice to us from both a risk and return perspective. Let's consider this trend following tendency a little further. Investing in a theme of technology driven disruption is not a new phenomenon. 20 years ago during the internet bubble, the world collectively concluded that the western industrial complex was no longer necessary. Asian manufacturers, so the story went, had an unassailable cost advantage over their western counterparts and would replace them with access to market made easy via technology. What our research uncovered was that western manufacturers could eliminate their cost disadvantage by moving their plants to Asia, exploit the new technologies themselves and capitalize on their true advantage, quality, customer service and their brand reliability. The result, the existing franchises retained their business and were the true beneficiaries of technology change. Of course, real change does happen. The US textile industry as a reminder, sometimes change or disruption is permanent. That's why research is so crucial and we're so excited about the opportunities in our portfolios today. Autonomous vehicles may disrupt the way we drive our cars, but it is highly unlikely that the perfecter of the technology will be good at mass producing cars. And it's somewhat puzzling as to why they would even want to try. We think it's a better bet that Volkswagen or GM will marry the new technology with their existing capability. It's certainly a better investment thesis to buy in auto producers whose shares are priced as if they have no chance of retaining a long-term franchise and to bet on which of the multitude of startups will own the new technology. FinTech companies have figured out that to win they do not need to replace the big bank. In fact, they need those market leading banks to buy their technology. It's a hard run to be a banking franchise and instead of disrupting they're selling their technology to the big banks, which has the result of solidifying the bank's market position and raising barriers to entry. These are just a few of the many examples market's tendency to overplay what is currently working and leave behind excellent franchises with advantages that are unlikely to be replaced in the long term. We believe we're in exactly that kind of environment today. Our valuation discipline and commitment to intensive fundamental research puts us in a strong position to capitalize on the opportunities the market is presenting. Our clients, their consultants and our prospects seem to agree with our sense of opportunity. Our pipeline of new business opportunity remains strong. The strength comes primarily because we have executed the value discipline well and they fear a singular focus on investing exclusively on what's working in the market may come to haunt them tomorrow. Exposure to our research can mitigate some of that risk. We're pleased to announce the launch of three new strategies, each would see the investors, International Small Cap value, Japan Value and a Global Best Ideas portfolio. In short, our business is good, our portfolio opportunities are attractive, an encouraging combination, no doubt. Thank you for taking the time to attend our call and I look forward to hearing your questions. I'll now turn the call over to Jessica Doran, our Chief Financial Officer, who'll provide this quarter's financial update.

[Jessica Doran:]

Thank you, Rich. Our earnings press release discloses both GAAP and non-GAAP adjusted financial results. We did not make any non-GAAP adjustments to our results during the first quarter of the 2018 or 20174. However, our comparative results for the fourth quarter of last year adjusted for certain tax receivable agreement items and the impact of the Tax Cuts and Jobs Act enacted in the fourth quarter of last year. We reported diluted earnings of $0.20 per share for the first quarter, compared to non-GAAP diluted earnings of $0.19 per share last quarter and $0.12 per share for the first quarter of last year. Revenues were $39.3 million for the quarter and operating income was $19.9 million. Our operating margin was 15.8% this quarter, decreasing from 53.8% last quarter and increasing from 40.9% in the first quarter of last year. Taking a closer look at our assets under management, we ended the quarter at $37.7 billion down 2.1% from last quarter which ended at $38.5 billion and up 17.8% from the first quarter of last year which ended at $32 billion. The decrease in assets under management this quarter reflects market depreciation of $0.6 billion and net outflows of $0.2 billion. The increase from the first quarter of last year was driven by $4.6 billion in market appreciation and net inflows of $1.1 billion. At March 31, our assets under management consisted of $14.6 billion in separately managed account, $21.3 billion in sub-advised accounts and $1.8 billion in our Pzena funds. Compared to last quarter, separately managed assets decreased reflecting $0.2 billion in market depreciation and $0.2 billion in net outflow. Sub-advised assets also decreased assets also decreased reflecting $0.4 billion in market depreciation and $0.1 billion in net outflows. Assets in Pzena funds increase from the end of last quarter to $0.1 billion in net inflows. Although assets under management decreased from last quarter, market appreciation at the beginning of the quarter resulted in average assets under management of $38.8 billion up 5.4% from last quarter and 24% from the first quarter of last year. Moving to our first quarter financial results, I'd like to note that we adopted the new revenue recognition standard on January 1, 2018. The adoption did not have a material impact on our financial statements. However, I will identify any impacted areas as I discuss our financial results for the quarter. We adopted the new standard using a modified retrospective approach and that prior periods have not been restated. Revenues increased 0.9% from last quarter and 22.5% from the first quarter of last year primarily reflecting the increase in average assets under management. I weighted average fee rate was 40.5 basis points for the quarter compared to 42.3 basis points last quarter and 41 basis points for the first quarter of last year. Asset mix continues to be the most significant factor in our overall weighted average fee rate, although swings in performance fees and fulcrum fees can also contribute to short term variability. Our weighted average fee rate for separately managed account was 53.4 basis points for the quarter compared to 56 basis points last quarter and 54.9 basis points for the first quarter of last year. The decrease from last quarter and the first quarter of last year reflects the decrease in assets in our focused value strategies that generally carry higher fee rate. The decrease from last quarter also reflects a decrease in performance fees recognized. Our weighted average fee rate for sub-advised accounts was 30 basis points for the quarter compared to 30.2 basis points last quarter and 28.6 basis points for the first quarter of last year. The increase from the first quarter of last year primarily reflects an increase in performance fees recognized. Our weighted average fee rate for Pzena funds was 59.9 basis points for the quarter, decreasing from 73.7 basis points last quarter and from 66 basis points for the first quarter of last year. The decrease from last quarter and the first quarter of last year reflects management fees that we agreed to waive and expenses paid to ensure the operating expenses of certain of our funds stay below established total expense ratio. The adoption of the new revenue recognition standard requires that these expense cap reimbursement represented net accounts revenue verses G&A excessive. Excluding the impact of these revenue recognition presentation changes, the weighted average rate for Pzena funds was 66 basis points for the quarter, in line with the first quarter of last year. The decrease in the weighted average fee rate from last quarter reflects the decrease in performance fees recognized. Looking at operating expenses our compensation and benefits expense was $16.2 million for the quarter, increasing from $14.2 million last quarter and from $15.6 million for the first quarter of last year. First quarter 2018 and 2017 compensation expenses include expenses associated with tax payments and our employee profit sharing and savings plan, which generally do not recur during the year. The remainder of the increase from last quarter and the first quarter of last year reflects an increase in compensation rate. G&A expenses were $3.2 million for the first quarter of 2018, decreasing from $3.8 million last quarter and from $3.3 million for the first quarter of last year. The decrease from last quarter and the first quarter of last year reflects a change in presentation of fund expense cap reimbursement associated with the adoption of the new revenue recognition standard as well as fluctuations in other business activities. Our other income was a loss of $0.1million for the quarter driven by fluctuations in performance of our investment. The effective rate for unincorporated and other business taxes was 3.7% this quarter compared to 3.7% last quarter and 4.4% in the first quarter of last year. We expect the effective rate associated with the unincorporated and other business taxes of our operating company to be between 3% and 5% on an ongoing basis. Our effective tax rate for our corporate income taxes, ex-CVT and other business taxes was 29.4% this quarter, compared to our non-GAAP effective tax rate of 33% last quarter and 32% for the first quarter of last year. The fluctuation in these effective rates reflects tax benefits and expenses from employee share in unit issuances and investing. We expect this rate excluding any share in unit impacts to be between 23% and 25% on an ongoing basis, reflecting the reduction in corporate tax rates due to the enactment of the Tax Cuts and Jobs Act during the fourth quarter of 2017. The allocation to the nonpublic members of our operating company was approximately 73.9% of the operating company's net income for the first quarter of 2018, compared to 74.6% for the fourth quarter of last year and 74.7% for the first quarter of last year. The variance in these percentages is the result of changes in our ownership interest in the operating company. During the quarter through our stock buyback program, we repurchased and retired approximately 297,000 shares of Class A common stocks and class B units for $3.2 million. At March 31, there was approximately $2.3 million remaining in the repurchase program. On April 19, 2018, our Board of Directors approved an increase of $30 million in the aggregate amount authorized under the current program to repurchase the company's outstanding Class A common stock and Class B units. We intend to use available cash on hand with an objective of minimizing dilution from compensatory stock and unit related issuance over the next several years. At quarter end our financial position remains strong with a cash balance of $27.4 million at March 31. We declared $0.03 per share quarter end dividend last night. Before we turn the call over to questions, I like to address the question that we received this morning from a shareholder. I'll read the question and pass it over to Rich to address it. In the last quarterly meeting Rich discussed prospects of larger institutional accounts throughout the year due to ten year performance metrics surpassing the early downturn results. Can you elaborate on any developments or expectations would be of larger accounts.

[Rich Pzena:]

I wanted to clarify what I said last quarter because when I was referring to the performance I was specifically referring to mutual fund performance and in particular the John Hancock Classic Value Fund, which we are a sub advisor of. And as of today our one, three and five year records are all topped out sale, but our ten year record remains about median that ten year record will - assume being performance no different from the market for the next few months should improve pretty substantially as we roll off the last quarter of the financial crisis impact on - negative impact on our historical results. We're already starting to see some uptick in flows into John Hancock Classic Value Fund as well as into all of our other mutual funds. That fund has a three star rating and the other - all of our other Pzena branded funds are at four star ratings now. And that's translated into some improvement and you can actually see the numbers that we had inflows in the quarter into our Pzena branded funds. From an institutional perspective our business opportunities are lumpy as they always have been and the activity level and the size of the new business pipeline or opportunity pipeline continues to expand as we continue to really have decent records compared to other value managers. But that ten year cut off to date is less relevant than it is to the ratings you get from Morningstar where - which puts a large weighting on your ten year records, so I just wanted to clarify that. So now we can turn the call over to questions operator.

[Operator:]

We will now begin the question-and-answer session. [Operator Instructions] The first question comes from Will Cuddy - JP Morgan. Please go ahead. Mr. Cudddy, please go ahead, your line is open. You may have dialed in as Ken Worthington. Mr. Cuddy is your phone on mute? [Operator Instructions] The next question comes from Ken Worthington with JP Morgan. Please go ahead.

[Ken Worthington:]

Hi, good morning. Sorry we're having some phone troubles here. So first on the gross sales, they were a bit weaker for Pzena in the quarter. I kind of thought that this might be a function of the market, but the last couple of quarters we've talked about the strong pipeline, can you talk about maybe the conversion of the pipeline into funding and why we may not be seeing the gross sales a bit stronger?

[Rich Pzena:]

Yeah I mean I - the only explanation for that is the lumpiness of when these things fund, so the conversion rate appears pretty good to us. A lot of the funding that is imminent is second half of 2018 related even though we've won some of the business already. The contracting and funding times can take quite some time, so it's hard to analyze this on a quarter-by-quarter basis when you're doing - when you're looking at an institutional flow. I think the better way to do it is to look at it on a rolling twelve month basis and then you can sort of see whether there's any concerns or not so I don't think that we're going to have any issue having flows that are attractive given the pipeline, but obviously it didn't happen in the first quarter.

[Ken Worthington:]

Okay and then kind of looking at the asset build in the mutual fund specifically, you got a couple products with - just seems to us really good performance and the asset build continues to be a bit slower than - we were rooting for you, so we would hope. Is it possible to better position the funds to take advantage of the good performance and for some you've got the three year track record, the five year numbers are coming I think within the next the next twelve months, so is there anything you do to accelerate the leveraging of the good performance and just drive more sales there? Thanks.

[Rich Pzena:]

Yeah, I mean obviously this is what we're focused on. And we - if you recall we probably nine months ago decided that the strategy that we were pursuing to try and get on the platforms of the big warehouse distributors was not a successful strategy and so we refocused on our IAs and the results are encouraging, so it's slow, I accept that it's slow. Our choices are hard to either pursue this path on our own and continue to try and get to critical mass so that we can re-approach the warehouses, which is the current plan or the alternative is to pursue some sort of funded option where a distributor would adopt the funds and they would be very happy to do that given their track record and given the fact that there's not a lot of assets in them. So the dilemma that we face is that would accelerate the flows at a cost of reducing our net fee realization roughly in half. And we think about it, but as of this point we are still trying to go at your own approach.

[Ken Worthington:]

Got it, okay. And you had mentioned I think before about the funds needing to get to a critical asset level and then things become much easier. Is that more important, is the five year track record more important and I think you'd come up with $50 million or sort of that critical level, how do you feel confident at that sort of the level?

[Rich Pzena:]

I mean, I'll say to you that five year is less critical, the three year was more critical, so there was no chance really before the three year. The five year's definitely less critical but valuable. We crossed 50 million in our emerging markets portfolio and it looks like that things are accelerating and I think I would probably be more reasonable to say that a 100 million is a critical level to approach the bigger warehouses. So we're actually not engaging in those conversations until we're at a hundred. We think we'll be there in mid cap value and we think we'll be there in emerging markets value based on the way the market feels and we think we'll be there this year in both of those, but that's I think a bigger - a better number than the $50 million number.

[Ken Worthington:]

Got it, okay. And then just the performance fees, can you give us a breakdown again of where the performance fees came from?

[Jessica Doran:]

Sure, of course. Great, so the performance fees this quarter were actually primarily - actually reflected in there are separately managed accounts. I'm sorry; excuse me in our sub-advised accounts. So the point that you're hearing is also of advised [ph].

[Ken Worthington:]

Okay, great. Thank you very much, that's all for me.

[Operator:]

Showing no further questions, this concludes our question-and-answer session and the conference is also now concluded. Thank you for attending today's presentation you may now disconnect.

[Rich Pzena:]

Thanks.

[Jessica Doran:]

Thank you.