Pzena Investment Management, Inc.
Q2 2013 Earnings Call Transcript

Published: 24 Jul 2013

[Operator:]

Good day, ladies and gentlemen, and welcome to the Q2 2013 Pzena Investment Management Earnings Conference Call. My name is Alex and I will be your operator for today. At this time, all participants are in a listen-only mode. We will conduct a question-and-answer session towards the end of this conference. (Operator Instructions). As a reminder, this call is being recorded for replay purposes. And now, I would now like to hand the call over to Gary Bachman, Chief Financial Officer. Go ahead, please.

[Gary Bachman:]

Thank you, Alex. Good morning and thank you for joining us on the Pzena Investment Management second quarter 2013 earnings call. I am Gary Bachman, 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 Web site at www.pzena.com. Replays of this call will be available for the next two weeks on our Web site. Before we start, we need to reference the standard legal disclaimer. Statements made in the presentation today may contain forward-looking information about management’s plans, projections, expectations, strategic objectives, business prospects, anticipated financial results and other similar matters. A variety of factors, many of which are beyond the company’s control, affect the operations, performance, business strategy and results of the company and can cause actual results and experiences to differ materially from the expectations or objectives expressed in these statements. These factors include, but are not limited to, the factors described in the company’s reports filed with the SEC, which are available on our Web site and on the SEC’s Web site, www.sec.gov. Investors are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date on which the statements are made. The company does not undertake to update such statements to reflect the impact of circumstances or events that arise after the date these statements were made. Investors should, however, consult any further disclosures the company may make in the reports filed with the SEC. In addition, please be advised that because of the prohibitions on selective disclosure, the company, as a matter of policy, does not disclose material that is not public information on their conference calls. If one of your questions requires the disclosure of material non-public information, we will not be able to respond to it. Thank you. In a minute, I will turn the call over to Rich. But first, I’d like to review some of our financial highlights. We reported non-GAAP diluted EPS of $0.09 per share and $6.3 million in non-GAAP diluted net income. Revenues were $22.1 million for the quarter and our operating income was $11.3 million. I will discuss our financial results in greater detail in a few minutes, but let me now turn the call over to Rich, who will discuss our current view of the investing environment.

[Rich Pzena:]

Thanks, Gary. Equity markets around the world had mixed results during the second quarter of the year. The Fed’s hint that its Quantitative Easing program might start to taper sparked a rise in global bond yields and put pressure on equity markets. In the euro zone, equities ended the second quarter about where they began, although monthly performance was very mixed. In Japan, equity volatility was pronounced as the Bank of Japan announced new monetary stimulus measures in April. And the emerging markets continued their decline amidst fears of slowing growth in China. Against this backdrop, value investors are finally being paid for their patients. Since August of 2012, when the European Central Bank calmed markets, saying they would use all necessary means to backstop the European financial system, value stocks have significantly outperformed. Since then the cheapest quintile of stocks in our global universe has returned 32.4% versus 14.6% for the MSCI World Index. US has also enjoyed strong results with the cheapest quintile of the 1,000 stock universe, returning 29.9% versus 19.2% for the S&P 500. Yet, the cycle-to-date results are less rosy. Since the peak of the last value cycle in February of 2007, deep value stocks are still behind the market. By this time in the four previous value cycles dating back to the late 1960s, deep value was ahead of the broad market benchmarks. Thus investors ask the age old question, is it different this time or is deep value just too scary? We would point to four major factors that have contributed to the prolonged nature of the current cycle. First, the severity of the early part of the cycle for March of 2007 through November of 2008; second, permanent impairments suffered by value stocks during that period, particularly in financials; third, interruptions of the recovery in 2011 and 2012 by Europe’s financial and sovereign debt crisis; and finally, the normal dose of disaster myopia, or put another way, expecting the worst to happen again. This cycle’s early days were defined by a severe financial crisis with a wholesale sell-off of equities and particularly deep stress in the cheapest quintile of stocks, which was dominated by financials. During this time, investors shunned cyclical businesses and fled to the supposed safety of dividend yields, leaving behind solid business franchises with strong balance sheets and high free cash flow that are sensitive to macro-economic activity. To demonstrate this dichotomy, we analyzed earnings yields across a number of sectors as an indicator of valuation opportunity. Although, the earnings yield for the S&P 500 overall appears close to its long-term average, there is a significant skewing in the data, with “safe sectors” like utilities and REITs trading at yields well below history, while financials and technology shares offer significant premiums. The financial sector remains deeply depressed despite recent strong returns, hovering in the 93rd percentile of the sector’s valuation during the past 48 years. The technology sector should be a haven for value seekers today as well. The group embodies both the promise and threat of a shift to tablet and cloud computing, creating opportunities for investors who are able to identify strong business franchises with the scale to harvest mature technologies and the resources to reinvest for the future. Twelve-month relative price to earnings ratios are at the lowest point in 35 years, however, providing the disciplined investor an extraordinary opportunity to buy world-class franchises at considerable discounts. Many of these businesses are generating significant amounts of free cash flow and have solid balance sheets. As we mentioned last quarter, our portfolios are dominated by these most undervalued sectors, while our average value competitor continues to hold benchmark sector weights. On the business side, during the second quarter, our assets under management surpassed the $20 billion mark. This 4% increase from the first quarter was driven by market appreciation. As I mentioned last quarter and probably will repeat many times into the future, AUM flows in the institutional investment world are generally lumpy and unpredictable. Our business activity level remains flat from last quarter at a level we would describe as median as measured across our last ten years. Prospects are wondering whether deep value is right for them. This question has particular resonance to investment committees following the global financial crisis, and as I described earlier, is a likely contributor to the slower-than-average value recovery in this cycle. Our response includes a reminder of one of the key takeaways about value investing from the empirical studies like the famous one by Pharma and French. The most undervalued decile outperformed followed by the next cheapest decile, which outperformed the next cheapest decile and the next and so on and so on. In other words, deep value wins in the long run. Further, as we have discussed in the past, we conducted a study of volatility and observed that while volatility adds to a portfolio – a value portfolio’s excess return, that is only true up to a point. At the extremes, stock price volatility is likely a market signal that has showed has a negative effect on excess returns, leading us to adjust our process and limit such exposures. When we coupled the empirical evidence that deep value is a powerful strategy for the long-term, with the experience we have gained through the cycles of the last 18 years, we’re very optimistic about the future. Thank you. And I look forward to answering your questions. But first, let me turn the call over to Gary Bachman, our CFO, who will review our quarterly financial results.

[Gary Bachman:]

Thank you, Rich. I will start out by discussing our assets under management, fee rates and revenues. Our average AUM was $20.1 billion during the quarter, up 8.6% from last quarter, and up 46.7% from the last quarter – from the second quarter of last year. As Rich mentioned, we ended the quarter above $20 billion in AUM at $20.3 billion, up 4.1% from the end of last quarter, which ended at $19.5 billion and up 55% from the end of the second quarter of last year, which ended at $13.1 billion. The $0.8 billion increase from last quarter was due to $1.2 billion in market appreciation, partially offset by $0.4 billion in net outflows. The $7.2 billion increase from the second quarter of last year was driven by $4.9 billion in market appreciation and $2.3 billion in net inflows. At June 30, 2013, our AUM consisted of $12.6 billion in institutional accounts and $7.7 billion in retail accounts. Assets in institutional accounts were up $0.4 billion from the end of last quarter due to $0.7 billion in market appreciation, partially offset by $0.3 billion in net outflows. Compared to last quarter, retail assets were up $0.4 billion from the end of the quarter due to $0.5 billion in market appreciation, partially offset by $0.1 billion in net outflows. Revenues were $22.1 million for the second quarter of 2013, up 6.2% from last quarter and 20.7% from the second quarter of last year. The increase from last quarter and the second quarter of last year was primarily due to market appreciation. The increase from second quarter of last year also reflects net inflows. Our weighted average fee rate was 44.1 basis points for the second quarter of 2013 compared to 45 basis points last quarter and 53.7 basis points for the second quarter of last year. The decrease from last quarter was primarily due to the increase in average assets under management during the second quarter of 2013 as our tiered fee schedules typically charge lower rates as account sizes increase. The decrease from the second quarter of last year was also driven by the increase in weighted average assets under management primarily associated with our assignment to manage 28% of the Vanguard Windsor Fund in August of 2012. Our non-GAAP income statement adjusts for the recurring valuation allowance and tax receivable agreement items. I will address the current adjustments at the conclusion of my remarks, but for now I’ll focus on the non-GAAP information. Looking at operating expenses, our compensation and benefit expense was $8.9 million for the quarter, down 7.2% from last quarter and up 11.3% from the second quarter of last year. The decrease from last quarter reflects an expense of $0.6 million associated with severance charges recorded during the first quarter. The increase from the second quarter of last year represents an increase in our discretionary bonus accrual. G&A expenses were $1.9 million for the second quarter of 2013, up $134,000 from last quarter, but relatively flat compared to the second quarter of last year. Operating margins were 50.9% this quarter compared to 45.2% last quarter and 45.9% in the second quarter of last year. Net of outside interest, other income was $0.2 million this quarter, $0.5 million last quarter, and expense of $0.1 million for the second quarter of last year. These fluctuations arise generally as a result of the performance of the firm’s investments. The effective rate for our unincorporated business taxes was 5.9% this quarter, 0.5% last quarter, and 6.6% in the second quarter of last year. The increase in the effective tax rate from last quarter was driven by a benefit recognized in the first quarter of 2013 associated with the amendment of prior-year tax returns to change the methodology for state and local receipts. The decrease in the effective tax rate from the second quarter of last year reflects this change in methodology. We expect this rate to be between 5% and 7% on an ongoing basis. The allocation to non-public members of our operating company was approximately 81.9% of the operating company’s net income this quarter compared to approximately 82.6% last quarter and approximately 83.6% 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. The effective tax rate for our corporate income taxes ex-UBT was 40.5% this quarter compared to 42.7% last quarter and 41.9% for the second quarter of last year. The decrease in our effective rate this quarter is the result of the change on our methodology for state and local receipts. We expect our corporate effective tax rate to be between 41% and 42%. As a result, we reported basic non-GAAP EPS of $0.10 per share and diluted non-GAAP EPS of $0.09 per share for the second quarter. During the quarter, through our stock buyback program, we repurchased and retired 165,562 shares for approximately $1 million. At June 30, there was approximately $7.4 million remaining of the $10 million repurchase program authorized during April of 2012. Before we turn it over to questions, I’d like to briefly walk through the valuation allowance and tax receivable adjustments. In the second quarter of 2013, we recognized adjustments as a result of the revised estimates of future taxable income, our ability to utilize our deferred tax asset and a decrease in our corporate effective tax rate. We recognized a $0.6 million decrease in our valuation allowance and a $0.2 million increase in our liability to our selling and converting shareholders for the quarter. In the second quarter, we also recognized a $0.3 million decrease in our deferred tax asset representing the net impact of the change in the deferred tax asset and the related valuation allowance associated with the change in the corporate effective tax rate. The net effect of these adjustments comprises the majority of the difference between our second quarter 2013 non-GAAP and GAAP net income. On a quarterly basis, we reported adjustments to the valuation allowance and our liability to the maximum converting shareholders as necessary. The ultimate amount of these adjustments will depend on our estimates of the future taxable income of the operating company and the level of our economic interest in it. Inclusive of the effect of the valuation allowance and the tax receivable adjustment agreement amounts I just discussed, we reported both GAAP basic and diluted EPS of $0.10 per share for the quarter. At quarter-end, our financial position remains strong. Our cash balance was $25.7 million at June 30 and we declared at $0.03 per share quarterly dividend last night. Thank you for joining us. We’ll now be happy to take any questions.

[Operator:]

(Operator Instructions). Our first question comes from the line of Ken Worthington.

[Ken Worthington:]

Hi. Good morning. Maybe first, can you talk about the outlook for sales, it really feels like the outlook should be improving, performance is good, returns are good, the style of investing seems to be getting some attention. But maybe can you tell us a bit about what’s going on behind the scenes in terms of your conversations with both consultants and end customers and help us kind of or share with us kind of your views for the sales outlook. Maybe really over the next two quarters and maybe separately over the next 18 months, maybe those are two appropriate timelines?

[Rich Pzena:]

Sure, Ken. The level of activity for us picked up probably a year ago, from where it had been. And by the level of activity, both the quantity and the quality of the interactions that we’re having with prospective clients, with consultants and with financial intermediaries who are more on the retail side that are interested in sub-advisory type relationships. The nature of these conversations are generally that they are fairly large and chunky assets and they take a long, long time to analyze, evaluate and make decisions. So this was a quarter that just passed where we didn’t really – we didn’t benefit from any inflows even though during the quarter we won business that hasn’t yet funded and timing of these things is really, really, really difficult to call. So my answer on the next couple of quarters is that I really don’t know. We are optimistic and I’m not trying to splash any water on that optimism. We are. All the things that you suggest are accurate. By the end of 2013, we’ll have completely eliminated all of our poor performance from the five-year record. As of now, the five-year record ending June 30 has moved into the top half for most of our strategies. The one-year record is off the charts, pretty much across the board, and the three-year record is also probably median because 2011 wasn’t a great year for us, so all these things are coming into in alignment. If nothing changes from now, by the end of this year, the one, three and five all should be reasonably attractive, and those are the ones that people screen on the most. Having said that, the people that pay attention are – know all of this, this isn’t a surprise to anybody and that’s why the activity level has picked up. And so, all I can say is, one of the things that you observe and you’ve probably observed through your time studying us is the gross outflows always happen and they’re almost independent of your performance or of anything you have, but they tend to be re-balancing in nature. There is a couple of things that give rise to the outflows. One is the need for the money by the client; two is re-balancing, so that is a bigger deal when you do well. When you do well, there’s a higher risk that you’re going to have outflows because they have a specific – existing clients for a specific allocation and they rebounce, not all, but some. And then there is the inevitable corporate change that randomly happens through all times, so we’ve had a pretty consistent level of outflows and the inflows are erratic and big. And I would tell you that we’re participating in searches for a lot of big mandates. So I wish I could be more explicit in predicting one that will happen, but we remain optimistic.

[Ken Worthington:]

Okay, great. And then let’s continue with that optimism and assume things in the market continuing to be good, assets grow and earnings grow, how could you think about what you do with those incremental earnings or how you invest them? Maybe talk about the framework that you will use as you think about investing in the business, talk about maybe how you set discretionary bonuses based on revenue or earnings growth. And if we take an optimistic scenario, how much goes to employees and gets reinvested versus what’s left for shareholders, like where – how should we see this flow through margins, if I can kind of ask it that way?

[Rich Pzena:]

Sure. If we have the kind of increases in revenues that we’ve been experiencing for the last few quarters, the percentage that goes to employee compensation will decline. So we don’t set a fixed percentage target of how much of revenues go to employees. Rather what we do is fairly extensive competitive assessment and we try very hard to pay in the top quartile of what our peers are paying. So we’re more influenced by market comp levels than we are by what our revenues are, and that doesn’t mean that revenues – that comp is fixed because, obviously, there are – there are some comps that’s directly tied to revenues and the sales force and we have bonus pools that reflect that, it’s not a big percentage, but it’s there. We also, to the extent that the industry is strong, there is upward pressure on pay and comp, but we have a very strong belief that the real way that the employees participate in the upside is by equity ownership. So they have the same incentives that our outside shareholders have. And we’ve embarked on a strategy of trying to put on a fully diluted basis, 25% of the shares of the company in the hands of the next generation, and we’ve been doing this regularly. So in our comp expense, our non-cash items, which are share grants, and so to the extent that we have a good year and the share price goes up, the employees benefit from that without it flowing through the income statement. It went through the income statement on the grant date valuation. So we don’t really have to raise our salaries as much as you would if you didn’t have that kind of structure, and that also leads to cash flow exceeding net income, which is why we’re using that extra cash to buy back stock, so that the degree of dilution from these kinds of trends – programs is modest. And obviously, we pay out 80% of our earnings of our net income and dividend. So between that and the share repurchase program and the rewarding people through stock, that’s the plan.

[Ken Worthington:]

Okay. And then just maybe attacking the same question, if you get an additional dollar of revenues, how much falls to the bottom line and how much would you expect in better markets to be spent?

[Rich Pzena:]

If you look at our history, our margins peaked in the high 60s and they were in the high 60s in a period of time where the revenue were rising so rapidly that you couldn’t spend the money if you wanted to. So I would say that that’s not a reasonable target, but it is reasonable to think and this is off-the-cuff comments rather than one that I have complete confidence in the arithmetic, but probably two-thirds of the revenues flow through to the bottom line, so the incremental margins in the mid-60s.

[Ken Worthington:]

Okay, perfect. Okay. I’ll get out and re-queue. Thank you.

[Rich Pzena:]

Okay.

[Operator:]

(Operator Instructions). Our next question comes from the line of John Dunn. Go ahead, please.

[Unidentified Analyst:]

Good morning, guys.

[Rich Pzena:]

Good morning.

[Unidentified Analyst:]

Can you sort of talk – make a comparison between what you’re seeing in terms of demand for US strategies versus the international strategy?

[Rich Pzena:]

Yeah, it’s hard to make that because it’s pretty strong across the board. We have now a five year and good record in emerging markets. So even though emerging markets have suffered of late, there’s still demand and we’re still in search and we are optimistic there. Global is probably the strongest marketplace. But having said that, we still have a little room in small cap and we’re in some big searches that might fill up our small cap capacity, which we’re hopeful of, and seems to have domestic, and so when I look at it across the board, I wouldn’t tell you that there is any obvious trend that differs from our current mix of assets under management.

[Unidentified Analyst:]

Got you.

[Rich Pzena:]

Just to say maybe emerging markets probably represents a smaller percentage of our current assets under management.

[Unidentified Analyst:]

Right. And then it seems to me that the prospect of higher rates, actually it’s good for your strategies, could you just – would you characterize it that way?

[Rich Pzena:]

The prospect of a higher rate is good for our investment strategies?

[Unidentified Analyst:]

Yeah.

[Rich Pzena:]

Yeah, I would say, first of all, higher rates are generally co-incident with economic growth. And so, we have a clear pro-cyclical bent in financials and technology. But adding to that are some of the pressures that the financial stocks are under by low interest rates. And when interest rates get extremely low, the pressures on banks, life insurance companies and even property casualty insurance companies to earn yield through – to earn returns through investment yield rather than through premiums is very tough. And similarly, to the banks, to earn their net interest margin to make it up in fees, it’s particularly tough. So rising interest rates, we think will have positive earnings impact on the companies we invest and then we actually think our portfolio construction is skewed heavily in favor of the companies that did not benefit from the fall in interest rates. And so when interest rates rise, our low exposure to things like utilities and REITs and staples should benefit us in relative performance terms.

[Unidentified Analyst:]

Great. And then just lastly on distribution. Can you – specifically, on the sub-advisory conversations, can you maybe give us a little more on that? And then also what size mandates do you think are the most promising?

[Rich Pzena:]

As much as I wish that we could say we have a bunch of $3 billion Vanguard waiting in the wings, that’s not the sweet spot. The sweet spot is probably around $300 million to $500 million, that’s the kind of things that we are talking about. And so when you get a $500 million account, that makes your quarter. I wish we can get one every quarter. That’s what we would hope to be able to do, but that’s the answer to your question.

[Unidentified Analyst:]

Great. Thank you very much.

[Operator:]

And so your next question comes from the line of Ken Worthington. Go ahead please.

[Ken Worthington:]

Hi. Just a couple of follow-ups. One maybe, can you give us a little bit more information about how the break points work? I think you highlighted that the higher AUM kind of fed through to some lower fees. Just the framework that we should follow as you continue to grow.

[Rich Pzena:]

Sure. A typical fee schedule might be something like – and we can get you the actual fee schedules if you wanted to see them, so I’m going to wing this. But on our US large cap value, institutional accounts might be 70 basis points on the first $100 million and then 50 basis points on the next $200 million and then 35 basis points thereafter. That’s kind of how they work. So you’re always going to have modest fee pressure in a growing AUM environment simply because all the increment is at the marginal fee rate, which is lower than your average fee rate.

[Ken Worthington:]

Okay, perfect. And then, as we think about performance fees, again, you’ve got – the one-year numbers look good, the five-year numbers looking increasingly good. Is that going to drive these performance fees that you’ve generated in the past to kind of return or resume or is it really going to be focused on the three-year numbers?

[Rich Pzena:]

I think all of our performance fees, I believe, are on the three-year number.

[Ken Worthington:]

Okay.

[Rich Pzena:]

And our three-year numbers, we think we will generate performance fees in the second half of this year that are bigger than we’ve generated in the last two years. And that – and so if performance stays where it is and doesn’t deteriorate and, obviously, it’s always on the measurement date, so – but on the measurement date, if today were the measurement dates, we would have a pickup in performance fees in the second half.

[Ken Worthington:]

Okay. And then lastly, on the hiring front, did you hire anyone this quarter and/or do you have any plans for hiring through the rest of the year in terms of, I guess, just really new positions? And if so, in what areas or what functions are you looking?

[Rich Pzena:]

Yeah. I think we have plans really to hire one research person at an entry level kind of position, but no big ramp up plans for any of our departments really.

[Ken Worthington:]

Okay. Okay, great. Thank you very much.

[Rich Pzena:]

You are welcome.

[Operator:]

We have no further questions left in the queue. At this time, I would like to hand back to Gary Bachman for closing remarks.

[Gary Bachman:]

Great. Thank you all for joining us on the call today. If you have any questions, you can give us a call later on.

[Operator:]

Thank you, Gary. Thank you for your participation in today’s conference. This concludes your presentation. Good day.