Pzena Investment Management, Inc.
Q2 2017 Earnings Call Transcript

Published: 19 Jul 2017

[Operator:]

Good morning and welcome to the Pzena Investment Management Second Quarter 2017 Results Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. Please note this event is being recorded. I would now like to turn the conference over to Jessica Doran. Please go ahead.

[Jessica Doran:]

Thank you, operator. Good morning and thank you for joining us on the Pzena Investment Management’s second quarter 2017 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 projections. 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 to reflect the impact of circumstances or events going forward. In addition, please be advised that due to prohibitions on selective disclosures, we do not as a matter of policy, disclose materials that is not public information on our conference calls. In a minute, I will turn the call over to Rich, but first, I would like to review some of our financial highlights. We reported diluted EPS of $0.15 per share and $10.5 million in diluted net income. Revenues were $34.1 million for the quarter and operating income was $16.6 million. Now, let me turn the call over to Rich, who will discuss our current view of the investing environment.

[Rich Pzena:]

Thank you, Jessica. Before we get to a review of the business, I would like to share some observations from our recent travels. We meet with a lot of people, including folks who run businesses and those who invest in them. We travel to virtually every corner of the world, and in those meetings, we get a good sense of conditions on the ground and what's on people's minds. So, it's interesting to take a step back and assess what the mosaic of these conversations is telling us. First and foremost, there is an unmistakable shift in the sentiment of business leaders that tells us the underlying fundamentals of businesses are generally improving, and by the way, the data are telling us the same story. The best example is a European CEO Conference we attend every June. In past years, there was a dark cloud hanging over the proceedings as CEOs battled macro headwinds, but this year was different. The mood was upbeat and the focus was on the progress CEOs had made rationalizing their businesses and the signs of improving conditions within their companies. Order books are filling and two thirds of European reporting companies beat expectations in the first quarter. That's just one example. I can cite banks that have overcome low interest rates to restore profitability. Emerging market companies, whose governance is becoming more shareholder friendly or Japanese managements that are finally focusing on increasing shareholder returns. It truly does feel like the long shadow cast by the global financial crisis is lifting and that fundamentals are in our favor, which brings me to my second point. Investors are overly focused on the impact of the U.S. administration on equity markets, hanging on every new headline and tweet out of Washington, but our conversations always come back to the same basic point. Fundamentals started getting better before the election of Trump or McCraw and they continue to do so. Businesses adapt to whatever is thrown at them. Managements figure it out. We could spend the rest of this call listing all the examples we have found, but they're well represented in our portfolios. The evidence is also compelling that we're in a good environment for value stocks. Valuation spreads continue to be wide and there's a long list of companies whose valuations are still suffering from investor uncertainty. Historically, as economic growth revives, value stocks have done well. Initially as investors realize the economic headwinds have abated and then subsequently as unloved companies start to deliver surprisingly good earnings off generally slimmed-down cost basis. Companies have demonstrated an ability to adjust their cost structures and implement self-help measures to improve current returns and set them up for incremental earnings as top line growth reemerges. The process will take time as it always does. Investors need to overcome the doubts and uncertainties built up during the anti-value period, and there are always new things to worry about. When the world stops worrying about global deflation, they worry about the disruption from e-commerce, which is why value cycles unfold over years and not months and not in a straight lineup. Given that past pro-value cycles have lasted seven years on average, we believe there is still significant opportunity and longevity to this value psych. On the business side, we are very encouraged by the results of the first half of the year and the outlook for the remainder of the year. We ended the quarter with $33.5 billion in assets under management, the highest level of AUM in the firm's history. Net flows have been positive, reflecting inflows from a range of existing clients and new relationships and the lowest level of outflows we've experienced during the period since the global financial crisis. We continue to see an interest in our strategies across institutional investors, sub-advisory relationships, and our intermediary distribution efforts. Thank you for taking the time to attend our call and I look forward to hearing your question. I will now turn the call back over to Jessica Doran, our Chief Financial Officer, who'll provide this quarter's financial update.

[Jessica Doran:]

Thank you, Rich. As I mentioned, we reported diluted earnings of $0.15 per share for the second quarter compared to $0.12 per share last quarter and non-GAAP diluted earnings of $0.10 per share for the second quarter of last year. Our non-GAAP results for the second quarter of last year adjusts for certain valuation allowance and tax receivable agreement items. No such adjustments were made to the GAAP results during the first or second quarters of 2017 due to the release of the valuation allowance recorded against the deferred tax assets during the fourth quarter of last year. As Rich mentioned, our assets under management ended the quarter at $33.5 billion, up 4.7% from last quarter, which ended at $32 billion and 31.9% from the second quarter of last year, which ended at $25.4 billion. The increase in assets under management this quarter was driven by market appreciation of $1 billion and net inflows of $0.5 billion. The increase from the second quarter of last year reflects $7.6 billion in market appreciation and net inflows of $0.5 billion. At June 30, our assets under management consisted of $18.7 billion in institutional accounts and $14.8 billion in retail account. Compared to last quarter, institutional assets increased, reflecting $0.7 billion in market appreciation and net inflows of $0.2 billion. Assets in retail accounts also increased from the end of last quarter due to $0.3 billion in market appreciation and $0.3 billion in net inflows. Average assets under management for the second quarter of 2017 were $32.7 billion, up 4.5% from last quarter and 25.3% from the second quarter of last year. Revenues increased 6.5% from last quarter and 29% from the second quarter of last year, primarily reflecting the increase in average assets under management. Asset mix is generally 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 the quarter was 41.7 basis points compared to 41 basis points last quarter and 40.5 basis points for the second quarter of last year. Our weighted average fee rate for institutional accounts was 53 basis points for the quarter, increasing from 52.4 basis points last quarter and from 52.6 basis points for the second quarter of last year. These increases reflect an increase in assets in our non-U.S. strategies that generally carry higher fee rate. Our weighted average fee rate for retail accounts was 27.4 basis points for the quarter, increasing from 26.5 basis points last quarter and from 25.3 basis points for the second quarter of last year. These increases reflect an increase in performance fees recognized during the second quarter of 2017 as well as an increase in assets in our non-U.S. strategies that generally carry higher fees. Assets in our non-U.S. and global strategies represented 51.9% of total assets under management for the second quarter of 2017, increasing from 50% last quarter and from 43.7% for the second quarter of last year. Looking at operating expenses, our compensation and benefits expense was $14.3 million for the quarter, decreasing from $15.6 million last quarter and increasing from $11.7 million for the second quarter of last year. The decrease in compensation expense from last quarter reflects charges recognized in the first quarter of 2017, which we do not expect to recur during the year. The increase in compensation expense from the second quarter of last year reflects an increase in headcount and compensation rate. GAAP G&A expenses were $3.2 million for the second quarter of 2017 compared to $3.3 million last quarter and $3.5 million for the second quarter of last year. Operating margin was 48.7% this quarter compared to 40.9% last quarter and 42.6% in the second quarter of last year. Net of outside interests, we recorded non-operating income of $0.6 million this quarter, decreasing from $1.1 million last quarter and increasing from a non-operating expense of $0.3 million during the second quarter of last year. Non-operating income includes the gains and losses as well as other investment income recognized by the firm on its direct investment. The majority of these investments are held to satisfy obligations under our deferred compensation plan. In addition, the changes in the liability to selling and converting shareholders associated with the changes in the realizability of the deferred tax assets generated income of $0.7 million in the second quarter of 2016. No such changes were recognized during the first or second quarters of 2017 due to the release of the valuation allowance recorded against the deferred tax assets during the fourth quarter of 2016. The effective rate for our unincorporated and other business taxes was 3.9% this quarter compared to 4.4% last quarter, and 4.7% in the second quarter of last year. We expect the effective rate associated with the unincorporated and other business taxes of our operating company to be between 4% and 6% on an ongoing basis. Corporate income taxes for the second quarter of last year included $0.8 million in income tax expense, associated with an adjustment to the valuation allowance recorded against the deferred tax assets. Again, no changes in the realizability of the deferred tax asset were recorded during the first or second quarters of 2017. Excluding changes in this realizability and expected future tax benefits associated with the deferred tax asset recognized during the second quarter of 2016, the non-GAAP effective tax rate for our corporate income taxes ex-UBT and other business taxes was 37.4% this quarter compared to 32% last quarter and 37.3% for the second quarter of last year. The increase from last quarter reflects changes in estimates of future tax benefits associated with our weighted average ownership of the operating company, which were recognized during the first quarter of 2017. Excluding changes in estimates of future benefits, we expect this rate to be between 36% and 38% on an ongoing basis. The allocation to the non-public members of our operating company was approximately 74.7% of the operating company’s net income for the first and second quarters of 2017, compared to 76.5% in the second 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 buyback program, we repurchased and retired approximately 71.3000 shares of Class A common stock for $631,000. At June 30, there was approximately $6.7 million remaining in the repurchase program. At quarter end, our financial position remains strong. Our cash balance was $34.7 million at June 30, and we declared a $0.03 per share quarter end dividend last night. Thank you for joining us. We’d now be happy to take any questions.

[Operator:]

Thank you. We'll now begin the question-and-answer session. [Operator Instructions] Today's first question comes from Ken Worthington of JPMorgan. Please go ahead.

[KenWorthington:]

Good morning.

[RichPzena:]

Good morning.

[KenWorthington:]

Maybe first we saw the cycle recover for value indexes in 2016 that has reversed in '17 with what we think is bank stocks driving the market and we're definitely seeing growth benchmarks significantly outperform again. So Rich you seem to be pretty sanguine on value stocks in the value cycle. Maybe you can further flush out your comments on why you still have conviction on where we are in the value cycle? What gives you comfort for the outlook for value stocks, particularly given what we're seeing as being so good for growth rate now?

[RichPzena:]

Well I think Ken I think what we're seeing is we had this pretty unusual period post the election of Trump where the value stocks went crazy on the upside and then had given a little bit of that back in the second -- in the first half of this year. It's not unusual that these value cycles are bumpy like that. In fact, every one of them looks like this. And so, I would tell you that we got ahead of ourselves in the second half of 2016. We adjusted back in 2017, and now we're sort of more in an equilibrium position. We'll see all -- the only thing that I can really point to are valuation spreads, which remain wide and economic -- the economic environment, which remains pretty reasonable. I won't say booming, I'll just say reasonable. So, it has wide valuation spreads of booming -- of reasonable economic environment, and I think the most important thing that you have is the end of falling interest rates, which is really what gave rise to this value cycle overall. So, when you look at the market being driven by a handful of stocks that people are focused on because of structural change in the world and betting that that structural change is going to reside in the hands of five companies, seems like a pretty narrow thing to want to hang your hat on and so we're not concerned that that is undermining the value cycle.

[Ken Worthington:]

Great. I guess maybe second, active equity managers appear to be performing better this year. We're definitely seeing even more recently lower redemptions from active equity managers. How would you characterize sentiment amongst your investors in this active passive debate? Are you seeing any changes more recently in your dialogue?

[Rich Pzena:]

It doesn't really feel like there are any changes. I think that the people remain focused on making sure that if they're going to pay active management fees, they're going to get something worth paying for and that doesn't feel like it's changed. I think that dialogue is more, maybe more pronounced than just sort of the blind rush to passive on the basis that it's better. I think it's more of an intelligent discussion on whether you're getting your money's worth and the people that are losing assets are the ones where the clients are thinking they're not getting their money's worth, but they're still pressuring us on fees. It's not like that's gone away, but the dialogue has shifted and you can actually engage in this dialogue without being thrown out of the room that says let's look at net returns after fees and is our fee share reasonable or is it not reasonable.

[Ken Worthington:]

Okay. Your mutual funds have just gotten their three-year track records. I think your large-cap value business has gotten sort of five-year numbers. Any impact here to the receipt of the extended track records for these two areas and anything that you do or shift to kind of – does the marketing message change, do you refocus, do you increase investment in marketing? Any changes you're making now that you have these longer-term track records?

[Rich Pzena:]

Well, I think the answer is no. I don't think -- we're refocusing, but I don't think it's because that we've reached longer-term track records. I think we're recognizing the difficulty of getting access to the wire house distribution channel without having a significant enough asset size and that it more or less is almost a waste of time to go after that channel until you can have enough assets to be credible in their eyes in the fonts [ph]. And the idea that we're a viable institutional player and can use that as the entrée hasn't really worked. So, we've refocused -- completely refocused on the quasi institutional sale that opportunity that exists within the retail channel, which means going after the largest independent registered investment advisers who today there are hundreds of these that are actually the sizes of big institutions and seem to be receptive. And search activity -- searches tend to be similar to the way they are in institutions. So, we're actually getting in searches with that refocus and that refocus will be complete over the course of the rest of this year and next year, but that's what we're doing. And then if we can get to the critical mass in these funds, and I am going to say critical mass is a couple of hundred million dollars per font [ph] then we'll refocus on trying to have a broader distribution channel.

[Ken Worthington:]

Great. I am going to keep asking questions, I think the last couple calls there were no other follow-ups. So, I am going to be a little greedy here. I apologize if there are other questions coming after me in queue. Can you talk maybe further about investments that you're making in the business. So, you just talked about the pivoting on the distribution side. Where else are you focusing in investment resources to grow the business over the long-term?

[Rich Pzena:]

Well we've made a major investment in our European distribution. We just finished the transition to a third-party management company that will give us the access to I believe the number is 22 markets in Europe from a regulatory standpoint, which dramatically broadens our ability in Europe. We've increased the size of our European distribution team and we've increased the size of our European distribution team and the money is flowing. So, we hope that expanding the markets that we have access to will continue that process. Second is we haven't made this investment, but we are searching for someone to expand our distribution into Japan and we are participating with a partner in the big GPIF switch that's the government pension program in Japan that's in the process of moving more of the retirement fund into equities and more into non-US equities and there is a formal process for that and obviously that's a hit or miss. We don't know whether we'll win that, but if we do, we want to be positioned to be able to exploit that. So, we're making some investment there, but mostly we're trying to reap the benefits of the investments that we've made historically in our intermediary distribution. So, I would say this is not a year for big incremental investment.

[Ken Worthington:]

Just a follow-up on the GPIF, you mentioned you're working with a partner? Is that busy -- can you disclose that or is that undisclosable?

[Rich Pzena:]

I really don't know the answer to that question. So, I am not going to disclose it, but I'll find out and you can re-ask that on the next call.

[Ken Worthington:]

Okay. Fair enough.

[Rich Pzena:]

You can call us afterwards and I'll find out. I really don't know.

[Ken Worthington:]

Okay. Just two more questions. I always ask this, but talk about where you're seeing value in the market here? I know it moves very slowly and I probably ask it more often than it actually moves, but where are you seeing value in the market today?

[Rich Pzena:]

We continue to have a big exposure in financial services despite the runups. We still think the biggest banks in the world are still amongst the cheapest stocks, even though they're up 60% 70% in the last 12 months. You just have to put some perspective on where they were. You take Citibank as an example, which is probably our biggest financial holding anywhere across all portfolios and that stock bottomed in the first quarter of 2016, I think $36 a share and it's $66 a share today. But they're earning around $5.5. So, it's moved from six times earnings to 11 times earnings. The regulatory environment has improved to the point where they're able to now pay out more than 100% of their earnings and dividends and stock repurchase and the fundamentals are still improving. So, to us, we look at something like that and say okay. Despite all the sentiment that banks are maybe not the most exciting place or the most stable businesses, we actually think they're fantastically good franchises that are so much cheaper than the broad market, that how could you not want all them. We see incremental opportunities in healthcare, which we've expanded into in the first half of 2017. We continue to play the old tech, I'll call it legacy tach where you get low multiples on businesses that are actually reasonably successful at retaining their franchises in a changing world, but they don't have the multiples that would make you think they can retain their businesses. So, there are opportunities. There are other things that are hard to accept, I'll figure out, which we -- and we haven't taken on, but they screen up as cheap like retail, but for the most part, figuring that out is very difficult and so we've not expanded our exposure there.

[Ken Worthington:]

Okay. Great. And then lastly, breakdown on performance fees this quarter between the institutional and retail side, I think there was $400,000 in performance fees, but just an allocation if you guys could?

[Jessica Doran:]

So, hi Ken. It's Jessica. So, for performance fees this quarter, the performances were actually all in on the retail side. No performance fees on the institutional side in the second quarter.

[Ken Worthington:]

Okay. That makes it easy. Thank you very much. Very much appreciate how you take me -- taking all the questions.

[Rich Pzena:]

Sure.

[Operator:]

[Operator instructions]

[Operator:]

Showing no further questions, I want to conclude the question-and-answer session and this concludes today's conference call. We thank you all for attending today's presentation. You may now disconnect your lines and have a wonderful day.