Pzena Investment Management, Inc.
Q2 2015 Earnings Call Transcript

Published: 23 Jul 2015

[Operator:]

Good day, ladies and gentlemen, and welcome to the Quarter Two 2015 Pzena Investment Management Earnings Conference Call. My name is Mark and I will be your operator for today. [Operator Instructions]. I would now like to turn the call over to Mr. Gary Bachman, Chief Financial Officer. Please proceed, Sir.

[Gary Bachman:]

Thank you, Mark. Good morning and thank you for joining us on the Pzena Investment Management second quarter 2015 earnings call. I’m 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 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. 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 $0.14 per share and $9.3 million in non-GAAP diluted net income. Revenues were $29.5 million for the quarter and our non-GAAP operating income was $14.7 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, and welcome to everyone who has joined us on today’s call. As we pass the midyear mark, we’re now almost eight years since the prior peak in value, a cycle that has played out differently than any other in the last 50 years. In past cycles, value stocks would be delivering sustained outperformance at this point. But the current experience has been uninspiring today. In our view, persistently low interest rates and uncertainty over the sustainability of economic growth have contributed to the unusual length of this cycle. This has been a headwind not just for us but for many active managers who have struggled to beat their benchmarks. While we have generally done okay relative to our value benchmarks, it has been more difficult to compete against broad market indices, such as the S&P 500 over the last five years. Investors have reacted by sending an avalanche of cash into passive capitalization weighted investment strategies lured by the prospect of market-like returns at low fees, convinced that most active managers don’t beat their benchmarks over the long term. We studied the assumptions underpinning this trend and published a whitepaper on our findings. The data is compelling. Passive strategies, by definition, subject the investor to perpetual underperformance due to fees and taxes. And a disciplined investment approach, and that’s almost any systematic approach, beats a capitalization weighted index over time. Fundamental weighting, volatility weighting or even equally weighting have consistently beated [ph] cap weighted indices. But the last five years have been an anomaly as cap weighting has excelled. Nevertheless, over the long run, we believe the reward accruing to the consistent application of disciplined active frameworks will endure and are well worth seeking out. A discipline such as ours has decades of academic and empirical support that, when implemented in a disciplined fashion, wins over the long term despite periods, sometimes extended, of underperformance. It appears that investor behavior has been unduly influenced by the last five years’ experience and long term data bears out the ability of active management to deliver excess returns net of fees. This reminds us that history has not been repealed and that though extended, this is still just a cycle that has a lot of life left in it. This is supported by our continuing ability to find undervalued businesses around the globe and we remain excited about the opportunity going forward. This also reminds us about the long-cycle nature of our business and the lumpiness of inflows and outflows. Our business development team has been actively discussing the value proposition of our strategy with consultants and plant sponsors over many years. And as a result, we have been awarded a number of large mandates this year, several of which that have yet to fund. While forecasting the growth of our business on a quarter-to-quarter basis is challenging, based on what we now know, we expect net flows to be positive for the year. I’m happy to report that we reached an important milestone on July 1st with the opening of our London office. We now have two fulltime business development and client service professionals in London with another moving there shortly and a fourth for which we are now recruiting. We’re thrilled to be part of the local community and we look forward to replicating the model we have found so successful in our Melbourne, Australia office. This reinforces our commitment to delivering our service at the highest possible level, no matter where our clients reside. Our business is strong and we are excited about the opportunities that lie ahead. I’d like to thank you for your continued support and I look forward to answering your questions. I will now turn the call over to our Chief Financial Officer, Gary Bachman, who will present our financial results.

[Gary Bachman:]

Thank you, Rich. As I mentioned, we reported non-GAAP earnings of $0.14 per share for the quarter, up from $0.12 last quarter and from $0.13 during the second quarter of last year. The increase from last quarter primarily reflects the increase in average assets under management and revenues, as well as a decrease in operating expenses, while the increase from last year is driven primarily by increased assets under management and revenues. Our non-GAAP income statement adjusts for certain deferred tax asset adjustments as well as the recurring valuation allowance and tax receivable agreement items. During the second and first quarter of 2015, our non-GAAP income statements also adjusted for certain non-recurring charges recognized in operating expenses. I will address the current tax related adjustments at the conclusion of my remarks, but for now, I will focus on the non-GAAP information. Our assets under management ended the quarter at $28 billion, up slightly from $27.9 billion last quarter and up 3.7% from the second quarter of last year which ended at $27 billion. In the second quarter of this year, we had market appreciation of $0.7 billion, partially offset by net outflows of $0.6 billion. The $1 billion increase from the second quarter of last year reflects $0.4 billion in net inflows and $0.6 billion in market appreciation. At June 30, 2015, our AUM consisted of $15.9 billion in institutional accounts and $12.1 billion in retail accounts. Compared to last quarter, institutional assets were flat. Assets in retail accounts increased $0.1 billion from the end of last quarter due to $0.4 billion in market appreciation, partially offset by $0.3 billion in net outflows. Our average AUM was $28.3 billion during the quarter, up 2.5% from last quarter and up 7.6% from the second quarter of last year. Revenues were $29.5 million for the second quarter of 2015, up 3% from last quarter and 5.6% from the second quarter of last year. These increases were driven by the increase in average assets over the period. We recognized $0.3 million in performance fees this quarter compared to $0.4 million last quarter and $0.2 million in the second quarter of last year. In general, our performance fees are calculated on an annualized basis over a three-year measurement period. Our weighted average fee rate was 48.8 basis points for the second quarter of 2015 compared to 41.5 basis points last quarter and 42.5 basis points for the second quarter of last year. Our weighted average fee rate for institutional accounts were 53.5 basis points for the second quarter of 2015, down slightly from 53.6 basis points last quarter and down from 54.2 basis points for the second quarter of last year. The decrease from last quarter primarily reflects a decrease in institutional performance fees recognized this quarter, partially offset by an increase in assets in certain of our non-U.S. strategies that generally carry higher fee rates. The decrease from the second quarter of last year reflects an increase in assets in our expanded value strategies which generally carry lower fee rates partially offset by the increase in non-U.S. assets. Our weighted average fee rate for retail accounts was 26.3 basis points for the second quarter of 2015 compared to 25.6 basis points last quarter and 26.7 basis points for the second quarter of last year. The increase from last quarter primarily reflects an increase in assets in certain of our non-U.S. strategies that generally carry higher fee rates, while the decrease in the second quarter of last year reflects an increase in retail performance fees recognized in the second quarter of 2015 offset by an increase in assets on our expanded value strategies which generally carry lower fee rates. Looking at operating expenses, our compensation and benefit expense was $11.8 million for the quarter, down 2.2% from $12.1 million last quarter and up 19.2% from the $9.9 million for the second quarter of last year. The decrease from last quarter reflects the timing of certain payroll taxes and benefits paid during the first quarter of 2015, while the increase from the second quarter of last year reflects increases in compensation and headcount. GAAP G&A expenses were $4.5 million for the second quarter of 2015, up approximately $0.9 million from last quarter and up $2 million from the second quarter of last year. During the second quarter of 2014, we entered into an 11-year lease agreement for our new corporate headquarters in New York City. We moved into the new space during the second quarter of 2015 and recognized approximately $1.5 million in write offs associated with the exit from our former corporate headquarters. During the first quarter of 2015, approximately $0.5 million in lease expenses associated with our new corporate headquarters is reflected in G&A expenses, as well as $0.4 million related to our former headquarters. During the second quarter of 2015, we adjusted our non-GAAP results for the non-recurring $1.5 million in write offs associated with our move. During the first quarter of 2015, we adjusted our non-GAAP results for approximately $0.4 million related to our former office space that will now recur. Excluding these onetime adjustments, G&A expense decreased $0.3 million or 7.8% from last quarter and increased $0.5 million or 19.8% from the second quarter of last year. The decrease from last quarter reflects increased operational expenses in the first quarter of 2015 that did not recur in the second quarter of 2015. While the increase from the second quarter of last year reflects an increase in professional fees and other operating expenses associated with our growth initiatives. The non-GAAP operating margin adjusting for these non-recurring expenses was 49.8% this quarter compared to 46.5% last quarter and 55.6% in the second quarter of last year. Net of outside interest, other income was $0.5 million this quarter and the second quarter of last year. These fluctuations arise generally as a result of the performance of the firm’s investments. The non-GAAP effective rate for our unincorporated business taxes was 3.8% this quarter compared to 4% last quarter and 5.2% in the second quarter of last year. The decrease in this rate from the second quarter of last year is driven by the impact of sourcing of receipts. We expect this rate to be between 4% and 5% on an ongoing basis. The non-GAAP effective tax rate for our corporate income taxes ex-UBT was 32.2% this quarter compared to 35.6% last quarter and 41.3% for the second quarter of last year. Our effective rate this quarter and last quarter reflect tax benefits from employee share and unit vesting and option exercises. The decrease from the second quarter of last year is driven by the impact of sourcing of receipts. We expect this rate excluding any share and unit vesting to be between 37% and 39% on an ongoing basis. The allocation to the non-public members of our operating company was approximately 80.5% of the operating company’s net income for the second quarter of 2015 compared to 80.4% last quarter and approximately 81.3% in the second quarter of last year. The variance in these percentages is the result of changes in our ownership interest in the operating company. During the quarter through our stock buyback program, we repurchased and retired 163,646 shares of Class A common stocks for approximately $1.5 million and 141,234 of our operating company Class B units for approximately $1.5 million. At June 30th, there was approximately $14.6 million remaining in the repurchase program. Before we turn it over to questions, I’d like to briefly walk through the non-GAAP income tax expense items. We recognized adjustment as a result of the revised estimates of future taxable income in our ability to utilize our deferred tax asset. We recognized a $0.1 million net benefit associated with changes to our deferred tax asset valuation allowance and liability to our selling and converting shareholders. These adjustments along with the adjustment for onetime operating expenses comprise the majority of the difference between our second quarter 2015 non-GAAP and GAAP net income. On a quarterly basis, we will record 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 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 tax receivable agreement amounts I just discussed, we reported GAAP basic and diluted EPS of $0.13 per share for the quarter. At quarter end, our financial position remained strong. Our cash balance was $24.4 million as of June 30th and we declared a $0.03 per share quarterly dividend last night. Thank you for joining us on the call today. We’ll now be happy to take any questions you may have.

[Operator:]

[Operator Instructions] Your first question comes from the line of Ken Worthington. Please go ahead.

[Ken Worthington:]

Hi, good morning. First, Richard, maybe can you provide us a little bit more information about the mandates that you had mentioned? Are they on the sub advice side or institutional? And I think more recently, a lot of the wins have been on the global side. Are these mandates still kind of consistent with that you had been seeing most recently?

[Rich Pzena:]

The mandates that we’ve won are predominantly on the institutional separately managed side, not on the sub advice or retail side. And there’s one that is a sub advice 401(k) platform that will wind up funding with a very small amount of assets, but we expect to grow over time. But the rest are sort of traditional lump sum funded mandates. The mix is heavily skewed towards our non-U.S. strategies. And so more than 100% of the positive flows are from the non-U.S. strategies and that’s true for the unfunded mandates as well.

[Ken Worthington:]

Okay, great. And then maybe, can you give us an update on performance? So the year-to-date numbers had looked pretty good this year after maybe a more disappointing look over the last year. The quarter seemed to have started well. How did the quarter end and maybe how has third quarter begun in terms of relative performance thus far?

[Rich Pzena:]

Yes. I mean performance for the second quarter across the board was pretty good, continuing the trend of the first quarter - when I say pretty good, it was ahead of benchmarks by modest amounts, but ahead of benchmarks and so most of our strategies are having a good year. Most of our strategies have a good one-year record. And I don’t know if I should say, all or close to all, have a good three-year record. And so right now, the 135 and year-to-date records against value benchmarks are at or slightly ahead of their benchmarks.

[Ken Worthington:]

Okay.

[Rich Pzena:]

This quarter is - I don’t know if I can make as broad of a statement, I’d say probably a little bit less exciting so far, so probably slightly lagging in July, but still generally ahead year-to-date even as of now.

[Ken Worthington:]

Okay. And then I guess last thing for me is on the outlook for sales. How are discussions going with investors both on the institutional side and the sub advice side? I assume there’s probably more excitement over the global. Is your interpretation of the value cycle kind of resonating with investors? And how are they interpreting your comments?

[Rich Pzena:]

I guess I would answer the question by saying that the good news is that our win rate has elevated to higher levels that we’ve had since pre-financial crisis. The bad news is the volume of search activity is flat. Now, it’s flat at above the levels that it was at a few years ago but it hasn’t grown any. I think that is because there is a lot of skepticism about the value cycle. There’s a lot of skepticism about active management in general. Obviously, our belief is that we just - the cycle hasn’t yet played out. But it’s a long cycle, so you need to be able to demonstrate to people that that value works. We can say we’re doing well as a value manager but for there to be a lot of search activity, I think you either have to have a pendulum swing back on this active versus passive issue and/or clear momentum happening in value stocks. I know that sounds a little backward but normally, when you’re mid-cycle, there is a lot of momentum in value stocks. And that really hasn’t happened. It’s sort of been a fledgling recovery rather than a strong one.

[Ken Worthington:]

Okay, great. Thank you. I’ll re-queue.

[Rich Pzena:]

Okay.

[Operator:]

Thank you. Your next question comes from the line of Michael Kim [ph]. Please proceed.

[Unidentified Analyst:]

Hey, guys, good morning. First, maybe just to follow up on Ken’s last question and your comments, doesn’t sound it like but just curious if you’ve seen any sort of evidence, maybe institutional demand for U.S. value strategies, is starting to pick up. And assuming that’s the case, just wondering how you think that might play out versus sort of the ongoing headwinds around rebalancing, derisking and the shift to passive more broadly.

[Rich Pzena:]

I would say we haven’t seen a broad pick-up in demand for U.S. value strategies. Most of the demand for us has been non-U.S. global emerging markets and European. I would say that’s the lion’s share of our search activity. There is an interesting pick-up in small cap value where maybe that will - but we don’t rate those as high probability at this point. We haven’t seen a big pick-up at all in the traditional large cap value - U.S. large cap value.

[Unidentified Analyst:]

Got it. And then I know you just opened the London office but just wondering how you’re sort of positioning your services or differentiating your services versus some of your peers, particularly as it relates to the kind of global and non-U.S. strategies.

[Rich Pzena:]

Well, our services are really positioned the exact same way globally no matter what the investment strategy is, that we are a concentrated, deep value, systematic manager that doesn’t deviate, that we’re very, very committed to the European market. That’s why we’re opening the office here. We are providing the vehicles by which investors can make investments but maybe somewhat different than what we had established before we had as much knowledge of the offices [ph]. Some of the investments that you’ve seen in operating expense is not only staffing but setting up the proper fund structures to be able to win over not only the traditional institutional separate accounts players in Europe but also the more continental market where the distribution is going through private banks or third parties that require different kinds of vehicles, so all of these investments are in place. Now, this doesn’t happen overnight that the assets suddenly start coming in. This is a process that literally the office opened on July 1st. We had spent the prior six months really indoctrinating our team into our program. And they are now over and fully engaged. And so we hope over the coming years this to bear fruit. But it doesn’t happen overnight.

[Unidentified Analyst:]

Understood. Okay. Thanks for taking my questions.

[Rich Pzena:]

You’re welcome.

[Operator:]

Thank you. Your next question comes from Ken Worthington. Please proceed.

[Ken Worthington:]

Hi. Thank you again. In terms of retail distribution, can you talk about the progress in building that out? So you’ve launched your own funds, you are getting those funds on platforms to be sold through different intermediaries. Where do things stand today? And is there some milestones that you would expect to reach either by the end of this year or by the end of next year?

[Rich Pzena:]

The milestones that we expect to reach by the end of this year really don’t involve AUM. They involve building the team and finishing the process of getting on the platforms. Getting on the platforms might sound like a trivial exercise. It’s really not a trivial exercise especially when you are a fledgling startup in the retail business. So we’re going through that process. And that’s happening. I would tell you that by the end of 2016, we would expect that to have some assets under management. But guessing the magnitude - I don’t even want to put a guess. But we do hope to have some wins in 2016.

[Ken Worthington:]

Okay. And this sort of drives back to the cost of the build out. As we look at compensation as well as G&A, how should we expect the investment to translate into expense growth in both areas? So you hired four, you just opened the office. There would appear to be maybe some more investment coming. What’s the outlook from I’d say the current run rate levels?

[Rich Pzena:]

Yes, I mean I would tell you that most of the investment has occurred and is being run through the operating expenses right now. There’s a little more to go. But because the people that we already hired are the expenses people and the startup of the funds are in our numbers and most are the expenses, and building out the remaining staff and adding a little bit of marketing support would be what we would do to round that out. So I guess, I would say, a small amount of growth and it’s found second half versus first half. We haven’t really set up our budgets yet for 2016. But it’s going to be nothing like the expense build of this year.

[Ken Worthington:]

Okay. Okay, great. Thank you very much.

[Operator:]

Thank you. There are no further questions at this time. I would like to now hand over the call to Gary Bachman for closing remarks. Thank you.

[Gary Bachman:]

Great. Thank you, Mark, and thank you all for joining us on the call today.

[Operator:]

Thank you, ladies and gentlemen, for your participation in today’s conference. That concludes the presentation. You may now disconnect. Have a great day.