Pzena Investment Management, Inc.
Q3 2014 Earnings Call Transcript

Published: 22 Oct 2014

[Operator:]

Good day, ladies and gentlemen, and welcome to the third quarter 2014 Pzena Investment Management earnings conference call. My name is Jackie and I will be your coordinator for today. At this time, all participants are in a listen-only mode and we will be facilitating a question-and-answer session towards the end of the presentation. (Operator Instructions) I would now like to turn the conference over to Mr. Gary Bachman, Chief Financial Officer. Please proceed, sir.

[Gary Bachman:]

Thank you, Operator. Good morning and thank you for joining us on the Pzena Investment Management third quarter 2014 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 period we will be discussing. If you do not have a copy, it can be obtained in the investor relation’s 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 selected disclosures, we do not, as a matter of policy, disclose material 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 non-GAAP basic EPS of $0.13 per share and $1.7 million in non-GAAP basic net income. During the quarter, the calculation of non-GAAP diluted earnings per share resulted in an increase of earnings per share. Therefore, diluted net income and diluted earnings per share are assumed to be equal to basic net income and basic earnings per share for the reporting period. Revenues were $29.6 million for the quarter and our operating income was $16.6 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. Performance of equity markets in the quarter was characterized by the broad weakness in September as investors reacted to slowing economies in Europe, Japan and the emerging markets. Even the US markets stalled after reaching new highs earlier in the period. The MSCI all country world index ended the quarter down 2.3% with the decline extending into October. As the US continues its slow, steady recovery, the Euro zone’s economy has had a difficult time generating steam, hampered by high levels of unemployment and government deficits and, in Japan, a large sales tax increase earlier in the year has had a negative impact. In this environment, our portfolios performed generally in line to slightly behind their respective benchmarks during the quarter. In a very real sense, market sentiment continues to waiver between risk on and risk off as it has since the financial crisis. And while some investors continue to try to play the technical game, we remain focused on exposing our client portfolios to the deepest segment of the value universe. We have taken full advantage of this environment with our largest developed market exposures in the financial, mature technology, integrated energy and industrial sectors. In addition, (technical difficulty) and emerging markets offer the lowest valuations. We own a number of leading global companies in our portfolios, particularly those with European headquarters where results did not necessarily reflect the performance of their local economies. From a business perspective, our AUM closed the quarter at $26.4 billion. Search activity has remained strong with new opportunities spread throughout the world and the highest concentration of new business prospects are in our emerging markets and European strategies. We have had success growing our business in Europe and we’re planning to open an office there in mid-2015 to support both our business development and client service efforts in that region. I look forward to answering your questions, but first let me turn the call over to Gary 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 $26.8 billion during the quarter, up 1.9% from last quarter and up 25.2% from the third quarter of last year. As Rich mentioned, our assets under management ended the quarter at $26.4 billion, down 2.2% from $27 billion last quarter and up 18.4% from the third quarter of last year, which ended at $22.3 billion. The $0.6 billion decrease from last quarter was due to $0.5 billion in market depreciation and $0.1 billion in net outflows. The $4.1 billion increase from the third quarter of last year was driven by $3.3 billion in market appreciation and $0.8 billion in net inflows. At September 30, 2014, our AUM consisted of $14.3 billion in institutional accounts and $12.1 billion in retail accounts. Assets in institutional accounts decreased $0.8 billion from the end of last quarter due to $0.4 billion in net outflows and $0.4 billion in market depreciation. Compared to last quarter retail assets were up $0.2 billion due to $0.3 billion in net inflows, partially offset by $0.1 billion in market depreciation. Revenues were $29.6 million for the third quarter of 2014, up 5.9% from last quarter and 23.1% from the third quarter of last year. The increase from last quarter was primarily due to an increase in performance fees recognized during the third quarter of 2014. We recognized $2.1 million in performance fees during the third quarter of 2014 compared to $0.2 million in the second quarter and $0.7 million in the third quarter of last year. Our weighted average fee rate was 44.2 basis points for the third quarter of 2014 compared to 42.5 basis points last quarter and 45 basis points for the third quarter of last year. Our weighted average fee rate for institutional accounts was 58.2 basis points for the third quarter of 2014, up from 54.2 basis points last quarter and from 57.7 basis points from the third quarter of last year. The increase from last quarter and the third quarter of last year primarily reflects the performance fees recognized this quarter. The increase from the third quarter of last year was partially offset by a shifted mix toward larger relationships and our expanded value strategies that generally carry lower fee rates. Our weighted average fee rate for retail accounts was 27.1 basis points for the third quarter of 2014 compared to 26.7 basis points last quarter and 24.5 basis points for the third quarter of last year. The increase from last quarter and the third quarter of last year primarily reflects the addition of assets in our non-US strategies, which generally carry higher fee rates. Our non-GAAP income statements adjust for certain deferred tax asset adjustments as well as the recurring valuation allowance and tax receivable agreement items. I will address the recurring adjustments at the conclusion of my remarks but for now, I will focus on the non-GAAP information. Looking at operating expenses, our compensation and benefit expense was $10.6 million for the quarter, up 7.3% from last quarter and 16.7% from the third quarter of last year. The increase from last quarter primarily reflects an increase in the discretionary bonus accrual. The increase from the third quarter of last year reflects an increase in salary, headcount and the discretionary bonus accrual. G&A expenses were $2.4 million for the third quarter of 2014, down approximately $0.1 million from last quarter but up $0.4 million from the third quarter of last year. During the second quarter of 2014 we entered into an 11-year lease agreement for a new corporate headquarters in New York City. We took possession of the space in October of 2014 and plan to occupy it during the second quarter of 2015. We expect an incremental quarterly increase in rent expense of $0.2 million and an increase in quarterly depreciation expense with furniture and leasehold improvements of approximately $0.2 million which will begin when we occupy the new space. The operating margin was 56.2% this quarter compared to 55.6% last quarter and 53.9% in the third quarter of last year. Net of outside interests, other income expense was an expense of $0.4 million this quarter, an income of $0.5 million last quarter and $0.3 million for the third quarter of last year. These fluctuations arise generally as a result of the performance of the firm’s investments. The effective rate for unincorporated business taxes was 4.3% this quarter (technical difficulty) last quarter and 5.8% in the third quarter of last year. The decrease in this rate is driven by the impact of tax sourcing of receipts and we expect this rate to be between 4% and 5% on an ongoing basis. The effective tax rate for our corporate income taxes, ex-UBT was 41.4% this quarter compared to 41.3% last quarter and 41.6% for the third quarter of last year. In March of 2014, New York State changed its tax law for receipts beginning at the start of the 2015 tax year. During the enactment period of this new tax law, we expect our annual corporate effective tax rate, excluding any benefits associated with share and unit vesting to be between 40% and 42% but future option exercises or vesting of previously issued awards may result in tax benefits that would reduce this rate. Once this tax law is effective, we expect our annual corporate tax rate, excluding any share and unit vesting, to be between 37% and 39%. The allocation to non-public members of our operating company was approximately 80.1% of the operating company’s net income for the third quarter of 2014 compared to 81.3% for the second quarter of 2014 and approximately 81% in the third quarter of last year. The variance in these percentages is the result in changes of our ownership interest in the operating company. During the quarter, through our stock buyback program, we repurchased and retired 61,647 shares of Class A common stock for approximately $605,000. At September 30th, there was approximately $21.4 million remaining in the repurchase program. Before we turn it over to question, I’d like to briefly walk through the valuation allowance and tax receivable adjustments. We recognize adjustments as a result of the revised estimates of future taxable income and our ability to utilize our deferred tax asset as well as an adjustment to our deferred tax asset associated with expected decrease in the effective tax rate. We recognized $0.3 million net benefit associated with changes to our deferred tax asset valuation allowance and liability to our selling (encumbered) shareholders. These adjustments comprise the majority of the (difference per share) third quarter 2014 non-GAAP and GAAP net income. During the quarter we also recognized $0.3 million expense associated with the net impact of expected decrease in the effective tax rate and expected future tax benefits. On a quarterly basis, we will record adjustments of the valuation allowance and our liability to our selling (encumbered) shareholders as necessary. The ultimate amount of these adjustments will depend on our estimates of 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 tax receivable agreement amounts I just discussed, we reported GAAP basis EPS of $0.16 per share and GAAP diluted EPS of $0.14 per share for the quarter. At quarter-end, our financial position remains strong. Our cash balance was $37.2 million at September 30th and we declared a $0.03 per share quarterly dividend last night. Thank you for joining us on the call. We’d now be happy to take any questions you may have.

[Operator:]

(Operator Instructions) Your first question comes from the line of Mr. Ken Worthington with JP Morgan. Please proceed.

[Ken Worthington:]

Hi, good morning. First, on the institutional side, the gross redemptions still are… seem somewhat elevated like kind of consistent with what we’ve seen over the last couple of quarters. Can you talk about the nature of the ongoing redemptions and anything you can on an outlook or a pipeline of what you would expect on the redemption side?

[Rich Pzena:]

Well, the nature is similar to the nature that we’ve been talking about before. In this quarter, Ken, we had two large account closings. One was a client that decided to go passive and one was the result of a merger amongst our client with another and we weren’t selected as the surviving manager. And that… those are the big numbers and we’ve had those kinds of things, as you point out, for the last few quarters. Unfortunately, we have no visibility and in both of those cases we’re basically notified the day of the closing and in many cases we’re not even aware that a review is ongoing from the client. So it’s very, very hard to predict. The flows, the inflows in the near term are a little easier to predict because you win an account and then there’s a process of negotiating the contract and funding so you have a little more visibility into the inflows than you do into the outflows, but only for maybe a couple of months forward.

[Ken Worthington:]

Okay. And then turning to the gross sales there, how are the conversations going with clients? You had been seeing more interest in the international products than the domestic products. Is that continuing and, I don’t know, can you give us some more flavor on the gross inflows side as you just did on the redemption side?

[Rich Pzena:]

Yes, we’re pretty… we continue to be encouraged. We continue to participate in searches where our win rates have ticked up a little bit and we actually expect the inflows to tick up a little bit versus the rates that you’ve seen in the last few quarters on the institutional side.

[Ken Worthington:]

And I assume it’s still coming… the interest is on the non-US side of the business or is there…

[Rich Pzena:]

Predominately.

[Ken Worthington:]

Okay. And then lastly on your newer Pzena branded retail fund, can you talk about what platforms you’re on, if there are any new platforms that you would expect to come on in the next, I don’t know, call it six months or so? And then talk about any color you can give us on the sales effort behind those products.

[Rich Pzena:]

Yes. I mean, we, as of now, have still now found somebody to lead this effort for us. We’ve been in… for us, making sure that we find the right person has been way more critical than just getting it filled. And we’ve had some close calls but, as of yet, haven’t found somebody to lead that effort and so we haven’t ramped up our sales effort. We’re gradually putting ourselves on the platforms but there is no material flows that we can talk about. I would tell you that I’m hopeful that we get this position filled sooner rather than later and then that person will spearhead the effort of getting on platforms. We’re on them but getting on them doesn’t do you any good if there’s nobody selling behind that. And so we’re not… we’re behind where we would like to have been on that aspect of this.

[Ken Worthington:]

Okay. Okay, thank you very much.

[Operator:]

(Operator Instructions) And your next question comes from the line of Mr. John Dunn with Sidoti & Company. Please proceed.

[John Dunn:]

Good morning.

[Rich Pzena:]

Good morning.

[John Dunn:]

Sort of like the third leg of the distribution channel, could you give us an update on these… the newer sub advisory relationships that you booked earlier in the year and how they might be bearing fruit?

[Rich Pzena:]

Yes, well the biggest sub advisory… the biggest set of inflows that we have come from the Vanguard Select Value fund, which is a mid-cap value. And those assets now exceed $1 billion from… yes, I mean, that’s pretty much all in the last 12 months. And the flows we think are continuing. So those continue to bear fruit and that’s what’s driven our net flows on the retail side.

[John Dunn:]

Got you. And just more generally, could you… I mean, you talked about where people’s interests are internationally versus the US. But could you orient us as to where we might be in the devalue cycle just giving shifting views on when interest rates might move or whether they’ve gotten pushed out?

[Rich Pzena:]

Yes. I mean, I don’t really have a good answer for that question, so I wish I had the crystal ball to tell you. The value cycle has sort of stagnated mid cycle here. This is not a typical cycle. The recoveries globally have been relatively sluggish and so when you look at the sectors that are cheap, there’s still some pretty sizeable discounts that are available. So on a valuation perspective, we’re still in the sweet spot of the value cycle. When it might happen is anybody’s guess. Obviously I think you’re probably aware that our portfolios are positioned to benefit from rising interest rates and from (relatively) stronger economic activity. And some of the sort of choppiness and weakness that we’ve seen in the last month or so has actually given us the opportunity to more broaden our portfolios to include some more industrial cyclicals that haven’t been as cheap. So the value base is still good. It’s reasonably maybe even slightly more expanded sectorally that it was and we still continue to believe the value cycle’s going to play out. But timing… the crystal ball of timing has never been my skill set.

[John Dunn:]

Got you. Thank you very much.

[Rich Pzena:]

You’re welcome.

[Operator:]

And now we have a follow-up of Mr. Ken Worthington with JP Morgan. Please proceed.

[Ken Worthington:]

Hi. Gary, turning to you, in terms of the expense outlook, so I think you and Richard mentioned a number of things, need new head of sales, new office, new lease. You defined the (technical difficulty) I think you mentioned the cost of the new office. What are the kind of expected and foreseeable additional costs that you see for 2015 right now? And I assume the $0.2 million of G&A and the $0.2 million of new lease, was that… I assume that was a quarterly run rate or was that annual? I’m sorry I didn’t catch that.

[Gary Bachman:]

That’s fine. That was quarterly.

[Ken Worthington:]

Okay.

[Gary Bachman:]

To answer your question, I would think given the initiatives that Rich spoke to and the build out, we would expect our expenses next year to be somewhere between 10% to 15% higher than we’re running right now.

[Ken Worthington:]

Okay. That makes it easy. Okay. Okay, great. Thank you very much. Actually, one more for Rich. On the performance, I think you mentioned in your prepared remarks that you were, for the quarter, at or below benchmark for most of your products. The way we were tracking them, it looked like maybe performance was a little bit weaker than you had indicated after having an obviously fabulous year last year. Can you talk about maybe what is working for you and what is not working for you in terms of investments that you’re making and in terms of which products are performing better than others right now on a, I’d say like a one-year basis? The three-year numbers I think we were pretty confident in.

[Rich Pzena:]

Yes, yes. The quarter isn’t particularly indicative and the quarter was, for the most part, within a percentage point of benchmark across the board for all of our products. The year-to-date, the relative performance year-to-date for us is running somewhere around, on average, 200 basis points behind our benchmarks and I think most of this reflects a bit of the risk off where some of the things that are… some of the sectors that make up our benchmarks that perform particularly well were things like utilities, real estate investment trusts, staples, we’re basically completely absent from those sectors across the board. And that’s the primary cause of our relative underperformance. These are sectors that the interest rate’s coming back off again and economic fears coming back into vogue that being absent from those has triggered the relative underperformance. And of course, whenever you look at any of the strategies, there are individual companies where things go right and things go wrong but trying to express it in the broadest of themes across a wide product base, that’s how I would describe it.

[Ken Worthington:]

Okay, okay. Great, thank you very much.

[Operator:]

And at this time we have no question. I would like to hand the call back to Mr. Gary Bachman for closing remarks.

[Gary Bachman:]

Great. Thank you, Operator, and thank you, everyone, for joining us on today’s call.

[Operator:]

Ladies and gentlemen, that concludes today’s conference. Thank you for your participation. You may now disconnect and have a great day.