Virtus Investment Partners, Inc.
Q3 2016 Earnings Call Transcript

Published: 28 Oct 2016

[Operator:]

Good morning, my name is Clarence, and I will be the conference operator today. I would like to welcome everyone to the Virtus Investment Partners quarterly conference call. The slide presentation for this call is available in the Investor Relations section of the Virtus website, www.virtus.com. This call is also being recorded, and will be available for replay on Virtus website. At this time, all participants are in listen-only mode. After the speakers' remarks, there will be a question-and-answer period, and instructions will follow at that time. I will now turn the conference to Jeanne Hess. Ma'am you may begin.

[Jeanne Hess:]

Thank you and good morning everyone. On behalf of Virtus Investment Partners, I would like to welcome you to the discussion of our operating and financial results for the third quarter of 2016. Before we begin, I direct your attention to the important disclosures on page two of the slide presentation that accompanies this webcast. Certain matters discussed on this call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are not statements of facts or guarantees of future performance, and are subject to risks, uncertainties and other factors that may cause actual results to differ materially from those discussed in this statement. These statements may be identified by such words as expect, anticipate, believe, outlook, may, and similar terms. For a discussion of these risks and uncertainties, please see the Risk Factors in Management Discussion and Analysis sections of our periodic reports that are filed with the SEC, as well as our other recent filings, which are available in the Investor Relations section of our website, Virtus.com. We do not undertake any obligation to update forward-looking statements. In addition to results presented on a GAAP basis, Virtus uses certain non-GAAP measures to evaluate its financial results. Our non-GAAP financial measures are not substitutes for GAAP financial measures, it should be read in conjunction with GAAP results. Reconciliations of these non-GAAP financial measures to the applicable GAAP measures are included in our earnings press release, which is available on our website. For this call we have a presentation including an Appendix that is accessible with the webcast through the Investor Relations section of Virtus.com. Now, I would like to turn the call over to our President and CEO, George Aylward. George.

[George Aylward:]

Thank you, Jeanne and good morning everyone. I'll start today by discussing assets and flows followed by an overview of the financial and operating results. I’ll also comment on yesterday announcement regarding our purchase of the shares held by Bank of Montreal. Mike will then provide a more detailed discussion of the results. So let's begin with assets under management and flows. We ended the quarter with assets under management of $46.5 billion, sequential quarter increase of 3%, which includes a positive net flows of $0.5 billion that we achieved in the continued difficult environment for active managers. Total sales of $3.1 billion increased 29% sequentially and 21% over the prior year. The sequential quarter increase illustrates the strength and attractiveness of our diverse product offerings as we increase sales in all product categories. Specifically open-end funds institutional, SMAs and ETFs. Total net flows improved by $2.6 billion over the prior quarter to a positive $485 million, making at our best quarter for net flows since the third quarter of 2014. As continued positive flows in institutional, SMAs and ETFs more than offset modest outflows in open-end funds. Mutual fund sales of $1.9 billion were up 39% sequentially, due to growth in international equity, domestic equity and taxable fixed income. The increase included $0.5 billion of higher sales in the emerging market opportunity fund of which $0.3 billion or model related. Mutual fund sales were also aided by higher sales into the multi-sector short-term bond fund and small cap sustainable growth fund. Mutual fund net outflows to improved meaningfully $2.3 billion from $2.4 billion as flows in the emerging market funds aren’t positive for the quarter from net outflows of $1.6 billion sequentially. This improvement primarily related to lower model redemption, which were $0.2 billion in the quarter compared with $0.7 billion in the second quarter and $1.3 billion in the first quarter. We also saw improved net flows in domestic equity and taxable fixed income due to the higher sales in these asset classes. Our diversified with the mutual funds continues to generate strong relative performance with 19 of our rated funds representing 80% of our rated fund AUM, having four and five stars as of September 30th. Turning to our other products, we have positive flows in SMAs, Institutional, and ETFs. SMA sales increased sequentially by 16% and net flows were up more than 100% as Kayne’s equity strategies continue to gather assets. Institutional sales inflows had another strong quarter due primarily to a domestic REIT mandate Duff and Phelps have funded in September. Sales inflows in this category were up 13% and 53% respectively. Well institutional flows are hard to predict, we are pleased that flows in this category have been positive in seven of the past eight quarters. In terms of what we are seeing in October, the mutual fund flows trend remain consistent with the third quarter with flows only modestly negative. The flow composition is also similar with positive flows in emerging markets and strengthen sales same products as the third quarter. Turning to the financial results, revenues as adjusted increased 4% sequentially $65.1 million on the higher asset levels and invest management fees that included $700,000 incentives fees on the CLO. Operating expense as adjusted decrease 2% sequentially on flat deployment expenses as adjusted and lower other operating expenses as adjusted. In the quarter, we benefited from the savings and base salary and benefits as a result of staff reduction we discussed on our last call. These savings were offset by higher incentive compensation due to our higher level of sales and profits. As a result of higher revenue lower operating expenses and reduction in outstanding shares, earnings per share as adjusted increased 32% sequentially $1.64. The operating margin as adjusted was 31%, up from 27% in the prior quarter. Turning to capital cash and investments were $382.9 million or $50 on a per share basis as of September 30th. In the quarter, we returned $13.7 million of capital, which included 10 million of share repurchases. As a result of our continued repurchases, ending shares declined by 1.4% from June 30th and 12.2% from September 30, 2015. Now let me turn to our announcement from yesterday, regarding our agreements to purchase to 1.7 million shares or 22.7% of shares outstanding held by Bank of Montreal. The transaction was $93.50 per share for a total of $161.5 million. We were pleased to have the unique opportunity to repurchase this large block. Transaction is highly accretive to earnings per share and significantly reduces our share count without impacting the trading volume of our stock. After giving effect to the transaction, our balance sheet and current operating cash flow remain strong and we maintain the flexibility in our capital structure, continue to execute on our long-term growth plans. Before turning it over to Mike, I would like to thank Bank of Montreal for their partnership over the years, as well as their Board representative for their contribution and dedication. Mike.?

[Michael Angerthal:]

Thank you, George. Good morning everyone. Starting on slide eight assets under management. We ended the quarter with assets of $46.5 billion, which represents the increase of $1.3 billion or 3% from the prior quarter. The sequential increase in AUM is primarily attributable to net outflows and $0.5 billion and market appreciation of $0.9 billion. The $1.4 billion year-over-year decrease in AUM is primarily attributable to $5.4 billion of net outflows and $0.6 billion of dividend distributions, which were partially offset by $4.7 billion of market appreciation. Total AUM is diversified with 36% in domestic equity, 21% in international equity, 34% in fixed income, and 9% in alternatives and other. By product, open-end fund assets were 55% of total AUM, separately managed accounts were 17%, closed end funds were 15%, and institutional was 13%. Turning to Slide 9, Asset Flows. Total sales were $3.1 billion a sequential quarter increase of $0.7 billion or 29% reflecting higher sales in all product categories. Total sales also increased over the prior year quarter by 21% or $531 million due to higher sales and institutional SMA’s and mutual funds. Gross sales and open-end mutual funds were $1.9 billion, an increase of $0.5 billion from the second quarter, due to higher sales in the emerging markets fund. Third quarter total net outflows were positive $0.5 billion a meaningful change from the net outflows of $2.2 billion in the second quarter. Positive net flows in the quarter were attributable to continue higher levels of sales in institutional that more than offset modest outflows in mutual funds. Separately managed accounts in ETF ‘s also contributed positive net flows. Mutual fund flows by asset class were as follows. Fixed income strategies were relatively flat an improvement from net outflows of $0.2 billion in the prior quarter. This improvement was due to 15% in sales in our five star multi-sector short-term bond fund managed by Newfleet. Domestic equity fund net outflows also improved sequentially to $0.1 billion from $0.3 billion. Sales of domestic equity funds increased 7% primarily due to a 36% sales increased in the five start small caps sustainable growth fund managed by Kayne Anderson Rudnick. International Equity fund net flows were modestly negative at $41 million a significant improvement from net outflows of $1.8 billion in the second quarter. The key driver of the change was improved net flows into our emerging markets opportunities fund, which had positive net flows of $55 million for the quarter compared with $1.6 billion of net outflows in the second quarter. Sales increased by $0.5 billion or 100% sequentially while redemptions decreased by $1.2 billion or 58%. The fund had positive net flows in both August and September. As we noted previously, the funds net outflows of the first and second quarter were impacted by model redemptions. In separately managed accounts, flows were positive $334.1 million due to higher sales in Kayne’s equity strategies. We mentioned on our last earnings call that Kayne was designated as the replacement manager for a small cap SMA mandate that benefited both second and third quarter sales. ETFs had positive net flows of $47.3 million an increase of 48% over the sequential quarter. We continue to believe that ETFs present an area of future growth for our business and we remain focused on expanding our product offerings in the space, as well as refining our distribution approach. Institutional continued its recent growth trend and generated positive net flows of $360.1 million, primarily due to the new REIT mandate at funded late in the quarter. In addition, both Newfleet and Kayne Anderson continue to contribute the positive net flows in this category. These inflows more than offset of $45.2 million outflow related to the redemption of a CLO that was issued in 2006. Turning to slide 10. Investment Management fees as adjusted of $60.6 million increased 4% on a sequential quarter basis. The components of the change in Investment Management fees are average assets and fee rates. The 4% sequential increase was due to a higher net fee rate and higher average assets under management. The average fee rate increased sequentially to 51.8 basis points from 51.1 basis points, due to a higher institutional fee rate that resulted from the $700,000 incentive fee earned on the CLO that was called and redeemed in the quarter. Excluding the incentive fee, the overall and institutional fee rates were largely consistent with the prior quarter at 51.1 bps and 36.4 bps respectively. Average assets under management of $45.5 billion increased 2% sequentially due to higher average assets in all product categories. Slide 11 shows the five quarter trend in employment expenses. Total employment expenses as adjusted of $33.1 million were unchanged sequentially and down 1% from the prior year as higher variable compensation on higher sales and profits was offset by 5% or $700,000 decrease in base salary and associated benefits resulting from the staff reduction that we referenced on our second quarter call. Employment expenses as a percentage of revenues were 51%, a decrease from 53% in the prior quarter reflecting the growth in revenues. The trend in other operating expenses as adjusted reflects the timing of product distribution and operational activities. Other operating expenses as adjusted of $10.9 million decrease $1.2 million or 10% from the second quarter, which included $1.1 million of discrete items associated with the annual board grant and specific business initiatives. Other operating expenses as adjusted decrease by $388,000 or 3% from the prior year. We continue to focus on managing other operating expenses where the variability is driven by the level of distribution activity, portfolio management cost and professional fees. Slide 13 illustrates the trend of adjusted results. In the third quarter, operating income as adjusted was $20.3 million, an increase of $3.6 million, or 22% on a sequential quarter basis. The increase primarily reflects higher revenues as adjusted and lower other operating expense partially offset by higher employment expenses. Operating margin as adjusted for the third quarter increased by 460 basis points to 31% from 27% sequentially. Earnings per share as adjusted were $1.64 in the quarter, an increase of $0.40, or 32% sequentially, reflecting higher operating earnings and a 9% in average shares due to the impact of the second quarter tender offer. GAAP net income attributable to common stockholders was $15.6 million, or $0.99 per diluted share. The quarter included $4.1 million, or $0.53 per share related to unrealized gains on the Company's seed investments, partially offset by $1.9 million or $0.15 per share as severance costs. The effective tax rate of 30% includes the release of the $1.5 million valuation allowance related to marketable securities. This compares to 41% in the prior quarter and included a $0.6 million increase to the valuation allowance. Slide 14, shows the trend of our capital position and key financial metrics. During the quarter, we returned $13.7 million of capital that included $10 million of share repurchases, $3.5 million of dividends and $0.2 million of net settlements from vesting stock units. As a result of third quarter repurchases basic share is outstanding at September 30th, decline by 1.4% to $7.6 million from the prior quarter. The stock purchases agreement we announced yesterday will further reduce outstanding shares by 22.7% to $5.9 million. The repurchase which totaled $161.5 million was funded by using existing cash and investments from the balance sheet and $30 million of debt on our credit facility. This debt levels results in a leverage ratio of 0.4 times EBITDA and will bear interest at a rate of LIBOR plus a 175 basis points. In order to illustrate the impact of the transaction, we have added certain pro forma financial information to the slide. Net cash and investments of $221.4 million or $38 per share compared with $382.9 million or $50 per share as reported. Working capital of $18.9 million, or 7% of annual spend compared with a $150.4 million or 58% as reported. Seed capital investments of $179.1 million remain unchanged. For liquidity purposes our seed capital investments are generally held in mutual funds that allow for daily liquidity and we have a $120 million of unused capacity on our five year unsecured credit facility. From an earnings prospective, the repurchase is highly accretive. On a pro forma basis, third quarter earnings per share as adjusted will increase 28% to $2.10 per share from the $1.64 as reported all else being equal. For modeling purposes, given the timing of the transaction, approximately one month into the quarter, we expect fourth quarter weighted average fully diluted shares outstanding to be approximately $6.6 million reflecting the partial quarter benefit of the lower share count With that, let me turn the call back over to George.

[George Aylward:]

Thanks Mike. That concludes our prepared remarks. Now, we will some questions. Clarence, can you open up the lines, please.

[Operator:]

Thank you. [Operator Instructions] And our first question comes from Ari Ghosh from Credit Suisse. Your line is open.

[Ari Ghosh:]

Hey good morning, guys.

[George Aylward:]

Good morning.

[Michael Angerthal:]

Hey Ari.

[Ari Ghosh:]

So can you update us on your thoughts around capital deployment for Q4 and 2017. It’s just looks like you increased your funding capacity pretty significantly earlier this quarter. So I was just wondering, if you did that the buyback in mind or if you have additional plans for the excess capacity you are now, maybe even like a strategic M&A deal down the line.

[George Aylward:]

Well, I think I’ll let Mike get into some details, but fundamentally we just want make from long-term perspective that we have the flexibility to have access to what we need to execute on any of our plans. For the current facility, it was getting near to the end of its term and we certainly didn’t want to wait until that period of time to renew. So we are very pleased with results we have got in terms of the size and the terms that we receive on that deal. And again, we keep our mind open to all sorts of alternatives obviously as you know from our capital management strategy other than protecting the business, investing in the growth and returning a meaningful amount of capital as always been part of our plan. We are sure, we will talk more about the return on capital from the repurchase. But Mike, do you want to give any more color.

[Michael Angerthal:]

No, I think you said that from the credit facility perspective, we were within one year of facility expiring and importantly we moved from the secured facility to an unsecured facility and doubled the capacity, which is more in line with the size of the business and the profile of the business now. We also changed out some of the partners and lenders in the facility. So we are very pleased with that facility and we think it just continues to provide flexibility as we need it.

[Ari Ghosh:]

Got it. And then quick follow-up, if you can just talk a little bit about your net flow outlook maybe on the mutual fund side. What products they are looking at closely at the smaller funds gaining traction and then clearly the deal where rules are big issue right now. So you have ever seen - you see pressure with certain products in the mutual fund line or even issues with shelf space based or something to that effect with your platform partners as they look to consolidate. And then if you can just around that our just touching a little bit about be institutional side and it just seen sort of a pipeline build over there and maybe like demand for new products here versus like previous quarters? Thanks.

[George Aylward:]

Sure. Well certainly in interesting environment that we are all engaged in and particularly difficult for active managers. I think we have always felt, we were competitively in a pretty good position, because of the types of strategies that we offer generally are those that don’t compete head on with more index based types of passive products. So most of our strategy are the hyper quality orientation, a risk mitigation type of an approach where they are highly concentrated alpha type of portfolios. So generally we have always felt good about the offerings or products we have being differentiated enough to be less susceptible to some of those competitive pressures that absolutely we face the same competitive pressures. I think where we have seen some of the flows has really been narrowing a lot of what is going on in the market. Obviously, we did have two quarters where we had elevated outflows in our emerging market fund, but now as indicated in the prepared remarks, those outflows have pretty much gone, broken to even and that fund continues to do very well. So as we sort of pointed out, EM continues to have a good sales, multi-sector short-term bond and low duration on the fix income side, I think in this environment will be great alternatives. If you want to navigate, what could be an interesting set of experiences in each trade markets, we believe the Newfleet products are uniquely positioned to help investors navigate those markets. And we have seen great strength on the Kayne equity products and we mentioned the Duff and Phelps reach strategy which was the large inflow that we had on the institutional side. So it’s sort of feels very well positioned from the competitive standpoint in terms of performance and the types of strategies we offer. In terms of DOL and related few pressure, I think everyone in the industry is being more and more conscious of fees. We have always been conscious of fees, but it has become a little more competitive in that area. We do monitor our fees, we do have caps on about 87% of our mutual funds and at certain points we will absolutely lower some of those caps. So it’s very important to us that we remain competitive, but we sort of feel we are in a relatively good position on most of our products. But we will continue to monitor that. The terms of just shelf space that’s one of the implications of DOL. We do feel we are very well positioned, I think we have a large verity of diversified products, so firms that we sell through. I think our offering and the fact that they come from either individual boutiques that are part of Virtus or our select sub advisors. I think by partnering with us, they are actually giving their clients a much more diversified set of offerings. I would argue that we basically provide them what they would have to go to 12 individual managers to get the same diversity of. So we feel good about that and our positioning, but the implications of DOL are going to continue to create more and more challenges for the industry. And we are not immune to them, but I feel in some ways we are in a pretty strong positioning.

[Ari Ghosh:]

Great. Really appreciate the color. Thank guys. A - George Aylward Thanks Ari. A - Michael Angerthal Thanks Ari.

[Operator:]

[Operator Instructions] And our next question comes from Surinder Thind from Jefferies. . Your line is open.

[Surinder Thind:]

Good morning guts. Just a follow-up on the DOL here, there has been a lot of the industry discussion around may be the difficulties that it might be to sell kind of into the broker space or kind of managing retirement accounts without some sort of change in the industry pricing rules. Any thoughts there or if you are participating with others or collaborating with others on something like that?

[George Aylward:]

In terms of I think all of us on the asset management side are having very constructive dialogs with our distribution partners in terms of working with them to address the issues in the way that works from their prospective. So I think we are all working with our distribution partners to address that and it will manifest itself, probably in different types of share classes and different types of pricing structures. I think a lot of that will evolve over the next few months or few quarters. I thinks it’s something everyone is trying to grapple with. And I also think that people are not just focused on retirement, I think they are looking to be more holistic when they come up with an approach that even though deal well in its relationship retirement. I think our distribution partners are doing the right thing in thinking about all of their clients come out with a solutions.

[Surinder Thind:]

Fair enough. And I assume that the working assumption at this point is that at some point the SEC will come out with effectively similar rules to the deal. Well is that effectively next year sometime, is that a fair working assumption for everyone?

[George Aylward:]

I have heard many people express that view, obviously we don’t have any knowledge of that, but I have heard that frequently.

[Surinder Thind:]

Fair enough. And then just from the perspective of your all products your sales. About what percentage are and basically to brokers for in commissionable types of sales at this point?

[George Aylward:]

I mean, for A class. Are you talking about the class, the type of class that we sell or.

[Surinder Thind:]

Correct. In terms of like whether it’s A, B or C you could share classes in terms of just commissionable sales that you guys have at this point?

[George Aylward:]

Yes, I mean most of our sales now in non-commission classes like the I or A class at any day, I think 11% of our sales. Sorry 7% of our sales are in traditional A class, which is I think what you are focusing on. So it’s relatively small piece of our business at this point.

[Surinder Thind:]

Fair enough. And then maybe just move to new topics here and maybe focusing a little bit on the ETFs space. It seems like that overall ETFs space is getting much more competitive and we are not only seeing competition amongst products and the kind of race to get more and more products out there, but we are also seeing increased price competition. How are you guys thinking about that or feel that you guys are going to compete in that space, given there is a few large encumbrance and it just seems like the barriers to entry. While the actual ability to launch a product is really low, it remains fairly challenging without a first mover advantage to gain traction in products. And then you also mentioned a little bit about that you guys are refining your distribution approach, so maybe some color around that?

[George Aylward:]

Sure. Well, I mean the ETFs part the business as we mentioned. We do see that as a very important element of long-term growth, the industry is going to increasingly move through an ETF structure for some of the investment needs. So hence we have been very focused on that part of our business and have introduced several new products, we have a few that will be introduced in the near-term. So we are very excited about some of the opportunities we have there. Looking at the ETF market though, I wouldn’t necessarily look at it as one marketing right. So in terms of some of the lower cost purely passive types of products absolutely that is dominated by a lot of players and you really need that level of scale to be that competitive on the fee levels. For some of the other products, the smart data side or actively managed. Really when you think about pricing, you should really think about it relatively to, it’s alternative, right. So if someone is interested in more of an actively managed strategy, which obviously we are a big believers in smart data. They are not going to necessarily always be comparing that prices to passive alternative, but maybe to the other active alternative and say an open-end and fund or another product vehicle. So I think there is continuing to be diligence on what is the right pricing for some of those products. Again, I think where you have the ability to be competitive, it’s not competing on scale or on being the lowest cost provider. Because I think smaller players don’t have that opportunity, it’s really being innovative in terms of what types of products you are offering and then how you are making those available. So I think there are opportunities there, we saw a very small ETF business, but we have been incredibly pleased with the fact that it has been growing in that products that we have introducing, has bound some acceptance. In terms of what I’m referring to, when I say refining our distribution model, there is still work to be done throughout the industry I think. In terms of how do you truly private coordinate you ETF and you open-end mutual fund sales, because there some differences in terms of how it work with insight the distribution partners and also getting whole sellers to have the right motivations and alignments. So I think like a lot of other players, we have a open-end funds as well as ETF’s, we are continuing to work on what is the best way to maximize the right opportunities set. So that’s sort of what we are referring to there. But we see the ETF area as an opportunity for future growth and again we have a very active pipeline in some of the things including additional actively managed strategies as well as, what might be called as smart data.

[Surinder Thind:]

That’s helpful. That’s it for me, thank you.

[George Aylward:]

Okay. Thank you.

[Operator:]

And this concludes our question-and-answer session. I would like to turn the call back over to Mr. Aylward for closing remarks.

[George Aylward:]

I just wanted to thank everyone for joining us today, and obviously we certainly encourage you to call if you have any other further questions. Thank you.

[Operator:]

That concludes today’s teleconference. You may now disconnect. Everyone have a great day.