Pzena Investment Management, Inc.
Q4 2013 Earnings Call Transcript

Published: 12 Feb 2014

[Operator:]

Good day, ladies and gentlemen, and welcome to the Fourth Quarter 2013 Pzena Investment Management Conference Call. My name is Celia and I will be your operator for today. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session. (Operator Instructions). I would now like to turn the conference over to your host for today Mr. Gary Bachman, CFO. Please proceed, sir.

[Gary Bachman:]

Thank you, operator. Good morning and thank you for joining us on the Pzena Investment Management fourth quarter and full year 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 who has dialled in remotely. Also, Bill Lipsey will be joining us, President and Head of our Marketing and Client Services. 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 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 website and on the SEC’s website, www.sec.gov. Investors are cautioned not to place undue reliance on forward-looking statements, which speak only as to 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 on the reports filed with the SEC. In addition please be advised that because of the prohibitions on selective disclosures, 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 would like to review some of our financial highlights. We reported non-GAAP diluted EPS of $0.15 per share and $10 million in non-GAAP diluted net income. Revenues were $28.7 million for the quarter and our operating income was $17.2 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 finished 2013 with a flourish especially across the developed markets. During the fourth quarter, many industries reached new all-time highs and for the full year markets experienced their strongest return since 1995 as investors who focused on long-term fundamentals were richly rewarded. Our portfolios performed very strongly for both the quarter and the full year. For the year, our U.S. strategies rose between 41% and 44%. Our global developed and international strategies rose from 34% to 40% and our emerging markets strategy rose by over 10%. Compared with the standard benchmarks for each strategy, our performance in 2013 generated from approximately 750 to 1350 basis point of excess returns. After a period of such strong performance for us and for the market, the next question is always the same

[Gary Bachman:]

Thank you, Rich. I will start out by discussing our assets under management, fee rates and revenues. Our average AUM was $23.8 billion during the quarter, up 11.2% from last quarter and up 41.7% from the fourth quarter of last year. Our assets under management ended the quarter at $25 billion, up 12.1% from $22.3 billion last quarter and up 46.2% from the end of fourth quarter of last year which ended at $17.1 billion. The $2.7 billion increase from last quarter was due to a $2.5 billion in market appreciation and $0.2 billion in net inflows. The $7.9 billion increase from the fourth quarter of last year was driven by $6.9 billion in market appreciation and $1.0 billion in net inflows. At December 31, 2013, our AUM consisted of $15.4 billion in institutional accounts and $9.6 billion in retail accounts. Assets in institutional accounts were up $1.6 billion from the end of last quarter due to $1.5 billion in market appreciation and $0.1 billion in net inflows. Compared to last quarter, retail assets were up $1.1 billion from the end of last quarter due to $1 billion in market appreciation and $0.1 billion in net inflows. Revenues were $28.7 million for the fourth quarter of 2013, up 19.6% from last quarter and 48.9% from the fourth quarter of last year. The increase from last quarter and the fourth quarter of last year was primarily due to performance fees recognized and the increase in average assets during the fourth quarter of 2013. Certain relationships pay incentive fees according to performance relative to certain agreed-upon benchmarks which results in a lower base fee but allows for us to earn higher fees if the relevant account outperforms the agreed-upon benchmark. In general, our performance fees are calculated on an annualized basis over a three-year measurement period. Approximately 65% of the performance fees recognized during this quarter represented fees calculated over a shorter measurement period. Our weighted average fee rate was 48.4 basis points for the fourth quarter of 2013 compared to 45.0 basis points last quarter and 46.1 basis points for the fourth quarter of last year. Our weighted average fee rate for institutional accounts was 62.7 basis points for the fourth quarter of 2013 compared to 57.7 basis points last quarter and 56.9 basis points for the fourth quarter of last year. The increase from last quarter and the fourth quarter of last year is primary driven by performance fees recognized during the fourth quarter of 2013, partially offset by a shift in mix towards our expanded value products and larger relationships which certainly carry lower fees. Our weighted average fee rate for retail accounts was 25.4 basis points for the fourth quarter of 2013. This compares to 24.5 basis points last quarter and 24.8 basis points for the fourth quarter of last year. The increase from last quarter is primarily driven by performance fees recognized during the fourth quarter of 2013 and the addition of assets in our emerging market value product that generally carries higher fees. The increase from the fourth quarter of last year reflects the shift in mix towards non-U.S. value strategies that generally carry higher fees and performance fees recognized during the fourth quarter of this year. Our non-GAAP income statement adjusts for recurring deferred tax, 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 $9.2 million for the quarter, up 1.1% from last quarter and up 16.7% from the fourth quarter of last year. The variance from the fourth quarter of last year reflects an increase in salary and headcount, our discretionary bonus accrual as well as the amortization of previously issued awards. G&A expenses were $2.4 million for the fourth quarter of 2013, up $0.4 million from last quarter and the fourth quarter of last year. These variances reflect an increase in business activities. Operating margins were 59.8% this quarter compared to 53.9% last quarter and 49% in the fourth quarter of last year. Net of outside interest other income was $0.5 million this quarter, $0.3 million last quarter and $0.2 million for the fourth 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 5.4% this quarter compared to 5.8% last quarter and 6.6% in the fourth quarter of last year. The decrease in the effective tax rate from the fourth quarter of last year reflects a change in the methodology for state and local receipts. 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 81.2% of the operating company’s net income this quarter, 81.9% last quarter and approximately 82.7% in the fourth 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 33.6% this quarter compared to 41.6% last quarter and 43.5% for the fourth quarter of last year. The decrease in our effective rate this quarter was driven by tax benefits from employee share and unit vesting and option exercises that occurred during the fourth quarter of this year. The majority of our employee unit grants vests annually during the fourth quarter of each year. The decrease from the fourth quarter of last year is the result of these benefits and the change in our methodology for state and local receipts implemented during the first quarter of this year. We expect our annual corporate effective tax rate, excluding these benefits, to be between 41% and 42%. Future vesting of previously issued awards or option exercises may result in tax benefits that would reduce this rate. As a result, we reported basic and diluted non-GAAP EPS of $0.17 and $0.15 per share respectively for the fourth quarter. During the quarter, through our stock buyback program we repurchased and retired 29,145 shares for approximately $0.2 million and 356843 operating company units for approximately $3.7 million. At December 31, there was approximately $2.9 million remaining of the $10 million repurchase program authorized during April of 2012. As Rich mentioned, yesterday our board announced a $20 million increase in our buyback program. Before we turn it over to questions, I'd like to briefly walk through the valuation allowance and tax receivable adjustments. In the fourth quarter of 2013 we recognized adjustments as a result of the revised estimates of future taxable income and our ability to utilize our deferred tax assets. We recognized a $0.2 million benefit associated with changes of our valuation allowance and liability to our selling and converting shareholders. These adjustments comprised the majority of the difference between our fourth quarter 2013 non-GAAP and GAAP net income. On a quarterly basis we recorded adjustments to the valuation allowance and our liability to our selling and converting 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 the tax receivable agreement amounts I’ve just discussed, we reported GAAP basic EPS of $0.19 per share and GAAP diluted EPS of $0.15 per share for the quarter. At quarter end, our financial position remained strong. Our cash balance was $33.9 million at December 31 and we declared a $0.26 per share quarterly dividend last night. Thank you for joining us. We’d now be happy to take any questions you may have.

[Operator:]

(Operator Instructions) Your first question comes from the line of Ken Worthington, JPMorgan,

[Ken Worthington:]

I respect that you are in registration. I am going to see if I can ask corporate questions that you can probably or possibly address. So launching mutual funds, how do you distribute them?

[Rich Pzena:]

We're going to be distributing them. We are going to be hiring our own team to distribute but we’re going to be distributing through a distributor that we've engaged to handle the mechanics of it. I think your question more is what we’re going to do.

[Ken Worthington:]

Yes, it’s like – would you go through like a swap, like a supermarket to sell the funds, are you ultimately trying to sell through warehouses or independent brokers?

[Rich Pzena:]

Yes, I mean the plan is – the plan for us is to do all of those things and with the recognition the market has reasonably substantially shifted over the last 10 years. As retail on the sale has actually gone and become more like an institutional sale where there are gatekeepers and the gatekeepers are very, very sophisticated investors who build model portfolios and who can recommend them to their networks, whether that be a warehouse or large registered investment advisor. And what we hope to do is call on those gatekeepers in a way similar to the way we already call on the consultants and big pension plans. In fact, many of the people are the same people. So we think that there is an opportunity for us without having a very large sales force that actually goes out to the individual broker offices.

[Ken Worthington:]

What kind of costs do you think you will incur to get the mutual fund business kind of up and running?

[Rich Pzena:]

It's going to be substantial. There is filing costs, there is the annual operating expenses that we will be subsidizing until the funds are large enough to stand on their own. And there's incremental compliance and regulatory and there’s distribution. So it’s a substantial undertaking.

[Ken Worthington:]

Any chance you could frame what substantial means?

[Rich Pzena:]

In dollar terms?

[Ken Worthington:]

Yes, if it’s a huge range.

[Rich Pzena:]

Yes, it’s a, what say, $1 million to $2 million a year.

[Ken Worthington:]

And then I am sorry I didn’t get all the funds you are launching. I’ll get that on the transcript. But how much capacity do the funds that you're launching have, and these I think you mentioned three, is that assuming that's just the first wave and if things are – go ahead.

[Rich Pzena:]

What I can do is talk about the funds but certainly the strategies and these are the same investment strategies that we offer to our institutional clients. That is going to be in fund form. And so I don't really know how much is specifically in the funds but we probably -- in the strategies combined, there's probably $15 billion of capacity.

[Ken Worthington:]

And then you chose the fund route as opposed to further expanding the sub-advice route. Do you offer like John Hancock and Vanguard the opportunity to sub-advice funds that they may not have already sub-advice before going out and doing mutual fund yourself -- are you now competing against your sub-advice relationships?

[Rich Pzena:]

We won't be competing against our sub-advice relationships because we’re not going to offer the same investment strategies in the same marketplaces under two different brands. And so our whole issue was -- we continue to like the sub-advice business and the sub-advice business is nice but it's not a business that’s under your ability to control. So when there is an opportunity for a sub-advice relationship we’re very, very interested. But if you started knocking on doors and saying we have XYZ strategy, would you like to distribute it? Can we be a sub-advisor? You are at the whim of whether the distributor has a need at the time and many distributors that use sub-advisors are more interested in picking and choosing managers one at a time rather than broad strategic relationships. So we decided that some of these funds that we’re – plan or strategies that we’re planning to offer in fund form were ones where we thought we needed retail distribution but it was an obvious how to find a partner.

[Ken Worthington:]

Last question is, what do you think breakeven is in terms of timing of these funds? Does it take you a year, two years, three years, five years, what is sort of the business plan in terms of –

[Rich Pzena:]

A year is unreasonably short. Five years would be disappointingly long. So somewhere in the hopefully two to three to four year range.

[Operator:]

The next question comes from the line of John Dunn, Sidoti & Company.

[John Dunn:]

Looking at January AUM, it looks like decrease was more cute on the institutional side. Can you just touch on what you are seeing in terms of client activity and sort of the lumpiness of flows?

[Rich Pzena:]

Yes, the flow lumpiness is the same as it always has been in the institutional business. The number of accounts are relatively small and the size are big. So you can't really judge anything from one month’s performance on flows. I would say that if you look at the trends over the last few years, outflows -- the gross outflows have fallen through the lowest level that I -- in recent history; meaning at least the last five or six years. And I don't think that will change in 2014. I hope it won’t change in 2014. And the inflows are very sporadic. So we continue to have elevated level of search activity. And so we think that there's high probability or good reasonable probability that the net positives will offset the outflows and that we will have another good year. But institutionally that’s what it's going to be on a month-to-month basis.

[John Dunn:]

And then could you touch on your early thinking about in terms of the top margin for 2014 where you think that might shake out?

[Rich Pzena:]

We never think of it in terms of a percentage margin. We really think of it in terms of what are we planning to do on comp in aggregate, and I think we are budgeting that comp is going to be up something like 10%. It depends on how fast we add staff to on these initiatives, particularly on the mutual fund distribution side. But somewhere in that range.

[John Dunn:]

Thank you for the color, or the color on the mutual fund situation. But can you talk about the progress on your international expansion plans and sort of like what you consider the benchmarks for success there?

[Rich Pzena:]

Well, the international -- if you think about it in two ways, one is our non-U.S. investment strategies, those have continued to grow and become a bigger and bigger and bigger percentage of our total assets under management. And I don't expect that those trends will change. And then if you're talking about distribution outside the United States, we haven't changed the staff or scope or size of our efforts there. They remain elevated versus where they were a couple of years ago. But we haven't made any changes additionally. We also are quite pleased with the percentage of our assets that come from outside the United States. I don’t have those numbers directly in front of me but that has become an increasing percentage of our total. So I don't have any particular benchmarks to cite other than to say we think the strategy of global expansion has really worked quite well and we hope that we look forward to continuing to work.

[Operator:]

We have a follow-up question from the line of Ken Worthington, JPMorgan.

[Ken Worthington:]

Hi, I wanted to ask about the headcount. I think you hired five in the quarter. If I saw that correctly, what roles are those people taking and then what would be your expected increase in headcount or plan for headcount for 2014?

[Rich Pzena:]

I will start with the latter. We’re going to – the plan for headcount is to be about 80 people by year-end 2014. And that would include anything that was related to our being in the mutual fund business. And the headcount in the most recent quarter, the increase over -- from the third quarter to the fourth quarter was -- to some extent some of it was replacement people. So we added two in operations and two on the client service side. And we added one on the finance side. So it's not a research expansion. Research is stable. It's really the back-office and support that is associated with both our the business growth and with our expansion plans.

[Ken Worthington:]

And then on institutions, what we were sort of hearing is that equity markets have been so strong that institutional clients have been rebalancing out of equities. Now you are small and smaller number of clients but bigger size. Like to what extent are you hearing, feeling, sensing that sort of trend as well, or because of your extreme focus, do not see that because you’re concentrated really in one particular asset class?

[Rich Pzena:]

It's hard for us to judge what people are doing in equities as a whole. I would say that we have clients who are very systematically balancers. And so when either an asset class or even an individual manager outperforms they get rebalanced out of and back to a target asset allocation. I don't have any feel that institutions are actually lowering their target asset allocation to equities more than they had done in the past. So to the extent that there's rebalancing back to target, I would say that’s business as usual. And obviously our experience and it is only on the micro level, not being a relatively niche investment strategy.

[Ken Worthington:]

And then lastly can you remind me when are the heaviest performance fee [ph] quarters for you?

[Rich Pzena:]

Fourth quarter is the predominant one.

[Ken Worthington:]

And which one is the second more –

[Rich Pzena:]

Gary, do you want to answer that?

[Gary Bachman:]

This year it will probably be in the third quarter but – I would say fourth quarter predominantly outweighs a little.

[Operator:]

The follow up question from the line of John Dunn, Sidoti & Company.

[John Dunn:]

Can you touch on your thoughts on the mix between units and shares and sort of the narrative potentially having greater public liquidity in the market?

[Rich Pzena:]

Our strategy has been all along to have a reasonable public float. The way that we achieved that with – the way that we have achieved it is obviously our initial public offering, which is now six years or so ago, six and half years ago. But we've allowed our retiring employees and our existing employees to the extent that they need funds for some purpose to exchange on a regular basis and sell those shares in the public. So our actual public float has almost doubled since the IPO through this process. Combination of retiring employees as well as exchanging employees. That's what we expect to continue. Should we ever decide to more broadly -- it's a reasonable objective of ours obviously to more broadly distribute our shares. But the decisions on how and when to do it – those kinds of things are wind up being very personal investment decisions of the individual players. And if and when the company decided that it needed capital for any reason, we would think about these issues. But this is all speculative at this point in time. But the strategy is simply to continue down the path of having annual exchanges of shares and gradually increasing the public float.

[Operator:]

(Operator Instructions) At this time with no further questions, I would like to turn the call back over to Mr. Gary Bachman for closing comments.

[Gary Bachman:]

Great. Thank you all for joining us on today’s call. Have a nice day.

[Operator:]

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