Pzena Investment Management, Inc.
Q3 2015 Earnings Call Transcript

Published: 21 Oct 2015

[Operator:]

Good day, ladies and gentlemen, and welcome to the Third Quarter 2015 Pzena Investment Management Earnings Conference Call. My name is Joy and I will be your operator for today. At this time, all participants are in listen-only mode. Later, we will conduct a question-and-answer session. [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, operator. Good morning and thank you for joining us on the Pzena Investment Management third quarter 2015 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 our 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 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 $0.12 per share and $1.8 million in non-GAAP diluted net income. During the quarter, the calculation of non-GAAP diluted earnings per share resulted in an increase in 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 $30.8 million for the quarter and operating income was $16.2 million. I will discuss our financial results in greater details 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:]

Thank you, Gary, and I appreciate everyone attendance on today’s call. I’d like to take a step back and spend the next few minutes providing a perspective on where we stand in the value cycle, recent volatility in the equity markets and how it has created opportunity for our portfolios and our business. It is clear that we’ve been in an anti-value cycle for almost five years. During that time, the performance of value indices has trailed their growth counterparts between 2 and 3 percentage points per year. The last 12 months have been particularly difficult with growth trouncing value by almost 9%. A factor based naive low price to book implementation of value has produced even weaker results. Although developed world economies seem to be chugging along, deterioration in emerging markets, which by the way started almost five years ago in early 2011, has led equities to act as though we are going into a recession, a period where valuation spreads widen and value typically lags. This would make the current anti-value cycle about average in length compared to previous cycles. In our view, however, this cycle is really just a continuation of the last one, which started with the global financial crises. Massive stimulus, first in the U.S. and Europe, and most recently in China delayed the cycle from fully playing out. The deterioration in emerging markets is perhaps the final phase with excesses being wrung out of those economies, profitability declining to below normal and investors punishing the stock prices of companies exposed to the downturn. Despite the pain, there’s definitely a silver lining. Valuation spreads in the U.S. are now at what we consider provocative levels. Although spreads outside the U.S. aren’t quite at these levels yet, our research team has observed an increase in the opportunity set commensurate with that in the United States. As in virtually every preceding cycle, this is likely set up for the next pro-value cycle to begin. It provides great opportunities for our portfolios which make us excited. We think the data make a strong case for increasing exposure to value. This anti-value cycle also reinforces a reality sometimes forgotten in the investment community that value investing is a philosophy not a factor, and what truly matters is that a manager has a discipline for selecting individual companies for inclusion in a client’s portfolios that has a track record of adding value. I’m pleased to report that our bottom up research driven approach to value investing has produced results that have exceeded those of a simple value factor during this value period. Our portfolios have outperformed a comparable low price to book strategy by 100 to 500 basis points per year over the last five years, and in many cases outperformed broad market indices even when value was supposedly not working. We produced these results by sticking to our discipline, a company specific research process to select our portfolio holdings. In doing so, we avoided investing in the stocks of commodities and industrial cyclicals that ultimately collapsed as emerging markets continued their long unwind from a decade long boom. Now that stock prices in these industries reflect extreme pain, our research team is combing through the wreckage to find those few good companies that we feel will put our portfolio in a position to deliver outperformance for our clients. As you know, we are investing in our business too, to be ready for what we see as an evitable and inevitable run in value equities. Our mutual fund effort is moving ahead and we are now either on or in the process of being added to all three of the major mutual fund platforms. This will give virtually the entire advisory world access to our funds, a major step forward. Our intermediary distribution team now has three full-time members focused on forming and expanding relationships in this channel. Effective July 1, our London office became officially operational. Our heads of Pzena UK and Europe are based there and we’re excited about their plans for further penetrating these markets. I’ll now turn the call over to Gary Bachman, our Chief Financial Officer, who will provide this quarter’s financial update.

[Gary Bachman:]

Thank you, Rich. As I mentioned, we reported non-GAAP earnings of $0.12 per share for the quarter, down from $0.14 last quarter and from $0.13 during the third quarter of last year. Although revenues increased, the decrease from last quarter and the year-ago period primarily reflects large investment losses associated with firm investments, which were driven by the decline in global markets towards the end of the third quarter. Our non-GAAP income statements adjust for certain deferred tax asset adjustments as well as the recurring valuation allowance and tax receivable agreement items. During the second 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 $25.5 billion, down from 8.9% from $28 billion last quarter and down 3.4% from the third quarter of last year, which ended at $26.4 billion. In the third quarter of this year, we had market depreciation of $3.3 billion partially offset by net inflows of $0.8 billion. The $0.9 billion decrease from the third quarter of last year reflects $2.1 billion in market depreciation partially offset by $1.2 billion in net inflows. At September 30, 2015, our AUM consisted of $14.9 billion in institutional accounts and $10.6 billion in retail accounts. Compared to last quarter, institutional assets decreased by $1.0 billion due to $1.9 billion in market depreciation partially offset by $0.9 billion in net inflows. Assets in retail accounts decreased by $1.5 billion from the end of last quarter due to 1.4 billion in market depreciation and $0.1 billion in net outflows. Our average AUM was $27.1 billion during the quarter, down 4.2% from last quarter and up 1.1% from the third quarter of last year. Revenues were $30.8 million for the third quarter of 2015, up 4.3% from last quarter and 3.9% from the third quarter of last year. These increases were driven by performance fees recognized during the third quarter of 2015. We’ve recognized $3.2 million in performance fees this quarter compared to $0.3 million last quarter and $2.1 million in the third 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 45.4 basis points for the third quarter of 2015 compared to 41.8 basis points last quarter and 44.2 basis points for the third quarter of last year. Our weighted average fee rate for institutional accounts was 59.6 basis points for the third quarter of 2015, up from 53.5 basis points last quarter and from 58.2 basis points for the third quarter of last year. The increase from last quarter primarily reflects the increase in performance fees recognized during the third quarter of 2015. The increase from the third quarter of last year reflects the increase in performance fees partially offset by an increase in assets in our expanded value strategies, which generally carry lower fee rates. Our weighted average fee rate for retail accounts was 26.2 basis points for the third quarter of 2015 compared to 26.3 basis points last quarter and 27.1 basis points for the third quarter of last year. While relatively flat from last quarter, the decrease from the third quarter of last year primarily reflects an increase in assets in our expanded value strategies which generally carry lower fee rates. Looking at operating expenses, our compensation and benefit expense was $11.6 million for the quarter, down 1.3% from $11.8 million last quarter and up 9.6% from $10.6 million for the third quarter of last year. The increase from the third quarter of last year reflects increases in compensation and headcount. GAAP G&A expenses were $2.9 million for the third quarter of 2015, down approximately $1.6 million from last quarter and up $0.5 million from the third quarter of last year. We moved into our new corporate headquarters during the second quarter of 2015 and recognized approximately $1.5 million in write-offs associated with the exit from 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. Excluding these one-time adjustments, G&A expense decreased $0.1 million or 3.5% from last quarter. The increase from the third 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 the non-recurring expenses during the second quarter of 2015 was 52.7% this quarter compared to 49.8% last quarter and 56.2% in the third quarter of last year. Net of outside interest, other income was an expense of $1.7 million this quarter compared to income of $0.5 million last quarter and expense of $0.4 million during the third quarter of last year. These fluctuations arise generally as a result of the performance of the firm’s investments and reflect the large drop in the market towards the end of the third quarter. The non-GAAP effective rate for our unincorporated business taxes was 4.2% this quarter compared to 3.8% last quarter and 4.3% in the third quarter of last year. 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 34.7% this quarter compared to 32.2% last quarter and 41.4% for the third 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 third 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 77.9% of the operating company’s net income for the third quarter of 2015 compared to 80.5% last quarter and approximately 80.1% in the third 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 292,762 shares of Class A common stock for approximately $2.7 million and 13,094 of our operating company Class B units for approximately $0.1 million. As of September 30, there were approximately $11.8 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 recognize 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 comprised the majority of the difference between our third 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 the 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 remains strong. Our cash balance was $33.6 million at September 30 and we declared a $0.03 per share quarterly dividend last night. Thank you for joining us on the call. We would now be happy to take any questions you may have.

[Operator:]

[Operator Instructions]. Your first question comes from Ken Worthington with JPMorgan. Please proceed.

[Ken Worthington:]

Hi. Good morning. Maybe first, Richard, when we think about growth cycles versus value cycles, are there triggers that drive cycles to go from kind of one to the next? And if so, what have been the triggers in the past between growth and value cycles?

[Rich Pzena:]

When you study these over the last 50 years, the trigger has generally been a recession. So in fact in all of the prior cycles before this one, it was a recession, all going back 50 years. I don’t know before that. So this is an interesting one because we sort of experienced the recession in '09 – I guess a little bit earlier, call it '09 and we had the kind of quasi recovery in '09, which for my best guess got delayed on a global perspective by all the stimulus that occurred. And so if you look at emerging markets as really the example of this and if you look at corporate profitability, corporate profitability went from a peak in 2011 and substantially above an all-time record high profitability in emerging markets, and it’s been steadily eroding for five years and it’s now dropped to actually slightly below normal. So the real question that we don’t even know how to answer is, is 6.9% GDP growth in China the equivalent of a recession that will stimulate the next value cycle. I don’t really know how to answer that question but at least that’s the history.

[Ken Worthington:]

Okay, thank you. And this may be equally as impossible but I’ll throw it out there anyway. Growth in value cycles are long dated. You even mentioned this one is sort of five years. Any reason to think that maybe the current growth cycle doesn’t last another two to three years, like sometimes they are that long. Are there things that you see that could be just as easy as, hey, when rates go up, that could be something that changes the investing world but not to drive to the value cycle? But anyway, any reason why it doesn’t last the current growth cycle off another two to three years?

[Rich Pzena:]

It’s a very difficult question for me to answer because this is so unlike other cycles, right. Normally, our interest rate increases would be coincident with strong economic activity. So if we’re going to speculate that we’re bottoming out in the emerging markets and then we turn back up and that would be coincident with emerging markets, I would think that that’s a possibility but I don’t have any way of guessing whether it’s another two years or three years or it’s next year. I really don’t have any way of doing it. We judge purely on the basis of valuation spreads. So if you look at the cheapest – and this is U.S. data, if you look at the cheapest stocks in the U.S., valuation relative to the average, we’ve now crossed over that one standard deviation out of bounds mark. That happened this quarter. So the only times that it’s gotten substantially – the only time in modern history that it’s gotten substantially worse than that was the Internet bubble in 1998 and 1999. So normally this is a point from a purely valuation standpoint that you would say the data is lining up to say that I should start switching the orientation of my portfolios. But I will tell you there is absolutely no sign of that in the marketplace. When we go and talk to the investment consultants around the world about activity level, they tell you there are no value searches. Nobody is looking for value measures. So to me, I take that as another good sign that how much worse can it get, but you just don’t know.

[Ken Worthington:]

Okay, perfect. That actually segues perfect into the next question, which is there’s no value searches yet you’re seeing a reasonable good number or maybe even excellent number of funding this quarter. So what is resonating with the investors that are investing into Pzena products? I guess also are you finding new investors or are these generally existing investors? And then lastly in this set, you had a very good pipeline coming into this quarter. You had what appears to be a good deal of mandates fund. How well is the pipeline reloading?

[Rich Pzena:]

Well, I suppose I should modify the answer I gave you to the last question and say that I can’t say that there is no value searches. That’s obviously not correct. There’s not a lot of activity in value. So what we’ve experienced is a lot of the funding from searches that were initiated one to two years ago with a pretty heavy orientation interestingly towards emerging markets. I think before this latest sell off, there was an idea that maybe this was the opportune in time to get into emerging markets from institutions that have lagged behind and we had had a pretty good record in emerging markets, so we got a reasonably good exposure to that. Some of that has dried up now because people start to reassess, do I really want to do this? And so our pipeline is a little bit lower than it was a year ago. So I would say it’s not completely refilled but it’s not recession like. I mean it’s not of the order of magnitude where we’d say, you know what, we’re definitely going to have net outflows next year. But it’s also not a level where we’ll say, we’re definitely going to have net inflows next year. So we kind of don’t think that we have any data to make any strong projections for the next year.

[Ken Worthington:]

All right. And are you finding new investors here or are these kind of your tried-and-true loyal investors who kind of ebb and flow and have decided, hey, now is the time to put a bunch more money with --?

[Rich Pzena:]

No, this is new investors. And actually if you look at the history, we have gross outflows and gross inflows and try and analyze it. Most of the gross inflows and gross outflows happen from existing accounts. Obviously all the gross outflows happen from existing accounts. I would say most of the gross inflows happen from existing accounts as well. But what moves you from net negative to net positive is new accounts. And so the new accounts were substantial.

[Ken Worthington:]

Got it, okay. I’ll re-queue. Thank you.

[Operator:]

Your next question comes from Michael Kim with Sandler O'Neill. Please proceed.

[Michael Kim:]

Hi, guys. Good morning. Just first, I guess one of the allocation themes that seems to be playing out across the industry more broadly is just kind of rising demand for more concentrated portfolios, but it does seem like when I look at the underlying mix of your value AUM, that seems to be skewing more in favor of your expanded value strategies across both the retail and institutional channels. So just curious to get your take on that dynamic if you will.

[Rich Pzena:]

I think you’re right on that dynamic. I’d make the observation that even our expanded products are relatively concentrated by market standards. And typically the people that have chosen expanded, they’re really more interested in the concentrated but they skew towards wanting a lower fee structure, which is significant in the decision-making process and to wanting a somewhat lower level of volatility. So it’s interesting. People say, I really want concentrated product. Very few people want to really pay for that. And the ones that do want to pay for that generally have to have a tolerance for higher short-term volatility. So I would tell you that many of our – much of our search activity starts off as focus. And in fact when we look at our pipeline today, more than half of the search activity is in focus strategy rather than expanding. Now whether it will come out that way or if the negotiation will wind up leading you to the expanded, I don’t have any way of predicting. But I think you’re observation’s correct.

[Michael Kim:]

Got it, okay, that’s helpful. And then just second, maybe to follow up on one of Ken’s questions but maybe more focused on the retail channel. It looks like outflows slowed from the prior quarter’s run rate, which seems in contrast with sort of trends that we saw across the industry more broadly last quarter. So just wondering what might be driving the sort of relative market share gains, if you will. Is it performance? Is it sort of rising demand for value to some degree? Just trying to understand that trend a bit better.

[Rich Pzena:]

Yes, Michael, I actually – I don’t know if our experience would be indicative of market trends. I think for us, earlier in the year we had one large institutional client that was invested within our mutual funds decide to reallocate out of value and that was – it was a one person decision if you look at that. So I don’t think you can draw any conclusions from our experience.

[Michael Kim:]

Got it, okay. Thanks for taking my questions.

[Operator:]

I have a follow-up question from Ken Worthington with JPMorgan. Please proceed.

[Ken Worthington:]

Hi. Okay. Thank you. I guess a couple of modeling questions. So first on share count, Gary, you ran through a little bit on share count. Share count picked up both in the publicly traded shares and the total share count as well, but you guys are buying back stock. So maybe why the unusual bump in the average shares this quarter if I’m calculating it correctly?

[Gary Bachman:]

I don’t think there was such a significant increase that we saw in regards to our total share count. I don’t know, Rich, if you have any other thoughts on that?

[Rich Pzena:]

We had a big exchange offering during the quarter is why you saw a shift, Class B to Class A. If you recall, our employees are given the right on an annual basis to exchange up to 15% of their shares from Class B to Class A. And when those exercises occur, it doesn’t necessarily mean that the employees have sold the shares but they’ve made a decision to exchange them from Bs to As. So that’s how you would see what would happen in the reallocation and that will happen – and I think under our operating agreement, it’s on at least an annual basis. We tended to do it annually. And the majority of those exchanges have occurred from either employees who have some life need like buying a house from some charitable giving that occurs where the charities wind up exchanging and selling the shares and/or from former employees who have some lockups as to how long they have to wait before they can exchange their shares. So that’s the B to A. The total share count is basically flat. So I’m not sure what you’re referring to. The number, as I look at it, this year it’s 68.1 and last year it was 67.9. So that’s kind of the growth rate – it’s a very low growth rate but it’s the growth rate that we’ve been experiencing as a result of our equity grants to employees, which we try as hard as we can to offset by share repurchase, but it doesn’t exactly offset.

[Ken Worthington:]

Okay, fair enough. I started this question with a focus on the European focus value fund, which seems to be struggling a bit, but I’ll maybe ask you more broadly. In terms of your investments, maybe talking to what’s working and what’s not working here. But I did notice that the European focus value fund seem to be struggling more versus what is used as the benchmark than some of the other funds this year?

[Rich Pzena:]

Well, I’m surprised that you picked on that one because I would have said that that is probably the single best relative performance record of any of our strategies. So let me look at what you’re looking at.

[Ken Worthington:]

I was looking at inferring [ph] it versus an MSCI European Index, but maybe that’s both the wrong thing to look at.

[Rich Pzena:]

Well --

[Ken Worthington:]

More probably what’s working and what’s not working?

[Rich Pzena:]

Okay. So I’ll give you this on a three-year perspective, okay, and let’s look at it on a three-year perspective and a one-year perspective so that you can see the data. On a three-year perspective, Europe is around 300 basis points ahead of MSCI Europe Index. On a one-year basis, it was about slightly around 100 basis points behind. On a three-year basis going down the list and we don’t have a single strategy that’s behind its benchmark on a three-year basis of the major strategies. And on a one-year basis, they’re all a little behind. So I would say especially if you’re going to use an index that’s not a value index. So if you were going to use a broad index, our global has had a bad one-year run pretty much reflecting the value cycle. Our emerging markets has a bad one-year run. Our large cap value has had a reasonably bad not as bad relative performance but bad. So they’re all bad on a one-year basis and they’re all still good on a three-year basis. So the question really becomes is this going to continue like this? I don’t really know. But when I look at our pipeline – and I guess the only product we have that looks good on any period that you chose to measure it is our small cap value. And we are seeing some activity on small cap value, which we haven’t seen in a while. So when I look at the pipeline, it’s more broadly across products than almost at any time in our history.

[Ken Worthington:]

Okay. I think that’s – one more on comp. You hired a bunch of people last quarter, I think it was four in 2Q. 3Q headcount was down I think by one. Comp was actually down this quarter. I’d say we expected it actually to be up based on some of the hiring. Was this upgrading? Is this just normal noise people leave every quarter and every year or was there some sort of focusing in terms of personnel?

[Rich Pzena:]

No, this is noise and really the down draft you saw for the quarter is the deferred comp. Remember, the markets have an impact on that because people invest their deferred comp in equities and to the extent that they lose money in those equities is their risks not our risk. So it shows up in two ways for us. It actually shows up as a loss because we’ve invested in the equities but it also shows up in a reduction of what we have to pay them and therefore there’s a reduction in comp expense. So I don’t think you’re seeing anything other than the vagaries of the stock market in that number.

[Ken Worthington:]

Okay. Thank you very much. I really appreciate it answering all the questions.

[Rich Pzena:]

Sure.

[Operator:]

[Operator Instructions]. We have no further questions. I would now like to turn the call back over to Mr. Gary Bachman for closing remarks.

[Gary Bachman:]

Thank you, operator, and thank you to everyone for joining us on our call today.

[Operator:]

Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Good day.