Pzena Investment Management, Inc.
Q3 2017 Earnings Call Transcript

Published: 18 Oct 2017

[Operator:]

Good morning and welcome to the Pzena Investment Management Reports Results for the Third Quarter 2017 Conference Call. All participants will be in a listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] 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 third 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 material that is not public information on our conference calls. Now, let me turn the call over to Rich, who will discuss our current view of the investing environment.

[Rich Pzena:]

Thank you, Jessica. As global stock markets continue to achieve record highs in 2017, investors are asking the same questions. Aren’t equities, particularly in the U.S., way overvalued? What should return expectations be going forward? While we acknowledge that stock markets are historically high levels, we don’t buy the market. We buy just a handful of undervalued businesses. In fact, since we began this firm 22 years ago, there has been a constant supply of cheap stocks that offer return opportunities far in excess of the market. Today is no different. We believe the opportunity for discerning value investors to earn double-digit returns exists in today’s market environment. That opportunity was available at the peak of the internet bubble in 2000 and it is still available to us today. What is different is which stocks we buy. In 2000, our buy list was dominated by industrial cyclicals that the market believed faced potential irrelevance due to lower cost Asian competitors and dotcom stocks that would plant [ph] their distribution channels. Today, our list is dominated by financials, energy, and healthcare stocks that face their own headwinds and long-term concerns. History teaches us that in any market environment, there are stocks whose valuations don’t look anything like the valuations in the broad market. One thing that is clear today is that the expected returns available to investors are lower than historic averages. This is particularly true for fixed income investors where the effective multiple that we pay for an income stream is higher than at any point in most of our lifetimes. The stock market also offers lower returns than at any time since the peak of the internet bubble. We calculate the expected return for the U.S. market to be about 6%. However, as I mentioned, we continue to find enough opportunities around the world to give us the chance to earn long-term double-digit returns. Is there likely to be a broad market downturn in the future? Certainly. Can we know when that will be? Probably not. But we’re comforted by the fact that in a downturn, value stocks are likely to be down less than the market, often meaningfully so, if history is a guide. With the exception of financial crises, value stocks have tended to be defensive. If we don’t have another financial crisis, we believe we can reasonably expect a similar outcome. And even if we do have a downturn, the long-term return afforded us by value stocks is ample reward for the exposure. On the business side, we ended the quarter with $35.4 billion in assets under management, a record level of AUM in the firm’s history. We have now experienced four consecutive quarters of net positive flows, reflecting inflows from a range of existing clients and new relationships as well as a low level of outflows. We continue to see growing interest in our strategies globally across institutional investors, subadvisory relationships and our intermediary distribution efforts. Thank you for taking the time to attend our call today. And I look forward to hearing your questions. I’ll now turn the call over to Jessica Doran, our Chief Financial Officer, who will provide this quarter’s financial update.

[Jessica Doran:]

Thank you, Rich. Our earnings release discloses both GAAP and non-GAAP adjusted financial results. We did not make any non-GAAP adjustments to our results during the year due to the release of the valuation allowance recorded against the deferred tax asset during the fourth quarter of last year. However, our comparative results to the third quarter of last year adjust for certain valuation allowance and tax receivable agreement items. We reported diluted earnings of $0.17 per share for the quarter, compared to $0.15 per share of last year and non-GAAP diluted earnings of $0.12 per share for the third quarter of last year. Revenues were $36.2 million for the quarter and operating income was $18.4 million. Our operating margin was 50.8%, increasing from 48.7% last quarter and 44.3% in the third quarter of last year. These results, driven by increases in assets under management and revenue, reflect the commitment to our investment process, our strong client relationships, and the execution of our distribution effort. Taking a closer look at our assets under management. We ended the quarter at a record high of $35.4 billion, up 5.7% from last quarter, which ended at $33.5 billion and 29.2% from the third quarter of last year, which ended at $27.4 billion. The increase in assets under management this quarter was driven by market appreciation of $1.7 billion and net inflows of $0.2 billion. The increase from the third quarter of last year reflects $6.9 billion in market appreciation and net inflows of $1.1 billion. At September 30, 2017, our assets under management consisted of $19.7 billion in institutional accounts and $15.7 billion in retail accounts. Compared to last quarter, institutional assets increased, reflecting $1 billion in market appreciation. Assets in retail accounts also increased from the end of last quarter due to $0.7 billion in market appreciation and $0.2 billion in net inflows. Average assets under management for the third quarter of 2017 were $34.4 billion, up 5.2% from last quarter and 28.4% from the third quarter of last year. Moving to our third quarter financial results. Our revenues increased 6.2% from last quarter and 34.2% from the third quarter of last year, primarily reflecting the increase in average assets under management and the recognition of performance fees during the quarter. Our weighted average fee rate was 42.1 basis points for the quarter compared to 41.7 basis points last quarter and 40.3 basis points for the third quarter of last year. 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 institutional accounts was 53.3 basis points for the quarter, compared to 53 basis points last quarter and 53.3 basis points for the third quarter of last year. The increase from last quarter reflects an increase in performance fees, partially offset by inflows from large client relationships that generally carry lower fee rate. Although the weighted average fee rate for institutional accounts remained flat from the third quarter of last year, the activity also reflects an increase in performance fees recognized offset by inflows from large client relationships. Our weighted average fee rate for retail accounts was 27.9 basis points for the quarter, increasing from 27.4 basis points last quarter and 22.7 basis points for the third quarter of last year. The increases from last quarter and the third quarter of last year are primarily driven by an increase in performance fees recognized. The increase from the third quarter of last year also reflects an increase in assets in non-U.S. strategies that generally carry higher fee rates. In addition, certain accounts related to one retail client relationship have fulcrum fee arrangements. These fee arrangements require a reduction in the base fee, or allow for a performance fee if the relevant investment strategy underperforms or outperforms, respectively, the agreed-upon benchmark over the contract’s measurement period, which extends to three years. During the third quarter of last year, a reduction in base fees related to these fee arrangements was recognized. We did not see a reduction in base fee during the third quarter of 2017 due to improved relative performance, which contributed to the year-over-year increase in weighted average fee rate. To the extent the three-year performance records of these accounts fluctuate relative to their relevant benchmarks, the amount of base fees recognized may vary. Looking at operating expenses, our compensation and benefits expense was $14.8 million for the quarter, increasing from $14.3 million last quarter and from $11.8 million for the third quarter of last year. The increase in compensation expense from last quarter and the third quarter of last year reflects an increase in compensation rate. The increase from the third quarter of last year also reflects an increase in headcount. GAAP G&A expenses were $3.1 million for the third quarter of 2017, compared to $3.2 million last quarter and $3.3 million for the third quarter of last year. Other income was $1.3 million for the quarter, driven by the performance of our investments. The effective rate for our unincorporated and other business taxes was 3.8% this quarter compared to 3.9% last quarter and 3.7% in the third 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 non-GAAP effective tax rate for corporate income taxes ex-UBT and other business taxes was 36.9% this quarter compared to 37.4% last quarter and 36.5% for the third quarter of last year. We expect this rate to be between 36% and 38% on an ongoing basis, excluding any changes in estimate for future benefits. The allocation to the non-public members of our operating company was approximately 74.8% of the operating company’s net income for the third of 2017, compared to 74.7% for the second quarter of this year and 76.5% for the third quarter of last year. The variance in these percentages is the result of changes in our ownership interest in the operating company. At quarter end, our financial position remains strong with the healthy cash balance of $47.9 million at September 30th. 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] Our first question comes from Ken Worthington with JP Morgan. Please go ahead.

[KenWorthington:]

Hi, good morning. So, I’m just going to go through a bigger list of questions. So, I apologize, if there is actually anybody else in queue. So, first, on the performance fees. Can you break them down between retail and institutional?

[Jessica Doran:]

Sure. This is Jessica. So for performance fees, of the -- we recognized approximately $0.9 million in performance fees during the quarter. Of that amount, I would say two thirds of it was related to our retail accounts.

[Ken Worthington:]

Okay. On the retail side of the fulcrum fees, which product or asset class are the fulcrum fees on for that one client? And what is sort of the -- I don’t know if you can discuss it, since only one client, but the maximum sort of add loss, [ph] what is the swing that can be achieved?

[Rich Pzena:]

Ken, all the vanguard relationships have fulcrum fees, they all have slightly different ones. They’re all in the -- it’s all public in the prospectus. The range is -- I don’t know if I know it off the top of my head. But it’s very…

[Ken Worthington:]

You gave me enough. We can figure it out from there. That’s really what I needed to know. In terms of performance fees related to compensation, so, to what extent does -- do performance fees kind of flow through to comp?

[Rich Pzena:]

They don’t really directly flow through to comp, because most of our variable comp goes to our sales team. And prior -- we’re in the process of rethinking our incentive compensation for sales, but the system that we have in place right now is more tied to asset levels of inflows than it is to revenues. And so, there is really not a direct linkage. The linkage more is when we set bonuses at the end of the year for the investment people? Are we influenced by the fact that we had better performance? And the answer is yes, but they’re not directly tied to performance fees.

[Ken Worthington:]

Got it, okay. Thank you. Can you talk a bit about the pipeline of new business, both on the institutional side and on the subadvise side?

[Rich Pzena:]

Sure. The pipeline is large. It’s -- given our history, as we measure these things, the pipeline is as strong as we’ve seen in our history. The mix between what we would call as retail and institutional, if you want that mix, it’s way more skewed towards the institutional than it is towards the retail.

[Ken Worthington:]

Okay. Value has underperformed quite a bit since the financial crisis. It kind of appears to us that there is relatively few value managers who have really truly stuck with their value mandate, and you appear to be one of them. How are you hearing this is impacting both your RFP activity and ultimately win rates? Like, is this something that we -- many value managers have brought growth into the mix, sort of polluting value nature, but are you seeing -- do you feel like you’re being called out for being one who is stuck with their knitting? Are you hearing this from the consultants? Do you feel like you’re getting more play from the consultants because of this? I don’t know, any background there or insights would be appreciated.

[Rich Pzena:]

I think it’s the primary reason why our search activity is up and our win rate is up. This is the exact same phenomenon that has been, post-internet bubble when our assets took off. We used to sit there as a relatively new firm wondering why are we winning all of this stuff? And I think the answer was exactly as you’ve put it. When somebody has made the decision that their portfolio has gotten too skewed towards growth or momentum and they need to do some rebalancing, and they go to their consultants and say help me select somebody, the number of players that they can recommend are far lower than they are when value is working and people are sort of following the discipline. So, I think it’s the key to our flows recently and to our search activity.

[Ken Worthington:]

Okay, thank you. In terms of sort of third-party distribution, more my words here, I kind of saw a little bit of a pivot from the wirehouse to a greater focus on the RIAs. I feel like this is young. But, any color on how, either the refocus or repositioning is going, if I’m in fact characterizing it correctly?

[Rich Pzena:]

No, that’s probably the exactly right way of characterizing it because that is what we did. We recognized that to be effective in the wirehouse. We don’t have, first of all the AUM and the funds, and second of all, the extensive ability to support that channel. And so, we refocused on RIAs, and this isn’t rocket science. We basically made a list of the largest RIAs. There’s quite a few, I mean you would measure in the hundreds that have books of business over a $1 billion and that have professional teams that pick managers. The sale is very institutional like to these RIAs. There are searches, there are RFPs, there are finals presentations. We’re winning some now. So, I think our -- there is approximate number about $70 million in our funds in aggregate. Jessica will correct me if I got it wrong? So that’s -- in percentage terms, that’s up a lot, still a small number. But there are search -- there is search activity and we’re winning searches, and it’s going into the funds. And what’s interesting is some of it -- some of this channel doesn’t go into funds. So, you call on these groups and either they have decided to set up their own commingled vehicles and we get a sleeve of that or they have larger average account size and we will take them on as separate accounts. So, it doesn’t go into the funds. But, if you actually look at -- and then, if you add on top of that the subadvisory opportunities that have come from calling on this channel, it’s paying for itself at this point.

[Ken Worthington:]

Okay, thank you. We are starting to enter into budgeting season. How are you thinking about investments and budgets for next year? It’s been a pretty good year and the broader market, less good in value, but like, it’s positive nonetheless. Like, how you think of -- where are you thinking of further investing in the business to help kind of drive growth? And then, what is that going to cost us, as we think about those investments for next year?

[Rich Pzena:]

We actually more think of it as we’ve made the investments already, and we’re hoping to reap the benefits of those investments. So, we’re not expecting any substantial change in headcount next year versus this year. The thing that probably consumes the most amount of dollars is the variety of vehicles that we need to meet the market demands. And typically, we’re not investing the money until we’re reasonably certain, we have somebody that’s going to put money into one of those vehicles. So, they don’t really -- they will show up in incremental expense, but they won’t show up as a negative to earnings.

[Ken Worthington:]

Got it. So, as I think about the increase in expenses in 2018 versus 2017 compare that to maybe some prior years, the thought that maybe less expense growth, looking forward?

[Rich Pzena:]

Yes. So, we should have substantially less expense growth than we’ve had in the last two years.

[Ken Worthington:]

You mentioned in the release -- and the comment about a larger mandate coming in at lower fees, which generally make sense. I think you are particularly aware of the capacity of your more concentrated products. Can you talk about how you’re thinking about allocating that capacity and to what extent, like where the trade off comes between bringing a large amount of assets and giving up that capacity? And does this large mandate -- larger mandate have anything to do with what I’m talking about or are they just in unconcentrated global product where you’ve got much more capacity?

[Rich Pzena:]

Yes. There is a latter. They’re in unconcentrated. I mean basically -- it’s hard to say. Our unconcentrated products are still relatively concentrated. So for us, we use the term focused strategy. So, we have focused value and focused global value. Those are our historical 30 to 50 stock portfolios where the fee rates have remained an intact. And when you get a big client, somebody that’s going to -- where you’re going to actually offer some of the discounts that we offer that are kind of a $1 billion and up client, they’re almost always going into the less concentrated product. And those are lower fees and they are getting the lowest breakpoint on those fees. But, we’ve set that fee rate. So, its consumption of capacity is identical to what we consume at the higher fee products that are more concentrated. Hopefully that explanation makes sense. But, we’re indifferent to -- from a capacity utilization standpoint of what it comes in.

[Ken Worthington:]

I think I got my questions answered. So, thank you very much.

[Rich Pzena:]

Sure.

[Jessica Doran:]

So, just to make one point, I just wanted to clarify one of the statements in my remarks around our unincorporated and other business taxes related to the comparative period and be sure that we have said that in the third quarter of this year, we saw 3.8% compared to 3.9% last quarter and 5.7% in the third quarter of last year. I just wanted to clarify. Thank you.

[Operator:]

And also, ladies and gentlemen, this concludes our formal question-and-answer session. So, Jessica, I’d like to turn it back to you for any closing remarks you may have.

[Jessica Doran:]

Thank you everyone for joining us on today’s call. We look forward to speaking with you next quarter.

[Operator:]

Thank you. This concludes today’s call. Thank you for your attendance. You may now disconnect. Take care.