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Pzena Investment Management, Inc. (NYSE:PZN)

Q3 2008 Earnings Call Transcript

October 29, 2008, 10:00 am ET

Executives

Wayne Palladino – CFO

Rich Pzena – Chairman, CEO and Co-Chief Investment Officer

Analysts

Hugh Miller – Sidoti

Marc Irizarry – Goldman Sachs

Mike Carrier – UBS

William Katz – Buckingham Research

Ken Worthington – JP Morgan

Operator

Good afternoon. My name is Heather and I will be your conference operator today. At this time, I would like to welcome everyone to the Pzena third quarter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks there will be a question-and-answer session. (Operator instructions) Thank you. Mr. Palladino, you may begin your conference.

Wayne Palladino

Heather, thank you very much. I'm Wayne Palladino, chief financial officer of Pzena Investment Management. I am pleased to welcome you to our third quarter 2008 earnings conference call. I am joined by Rich Pzena, chief executive officer and co-chief investment officer of the firm.

Our third quarter 2008 earnings press release contains the financial tables for the periods we are going to discuss. If you don't have a copy, you can find it on our website at www.pzena.com in the Investor Relations section. Replays of this call will be available for the next week at our website or by telephone at the number given in the press release.

From time to time, information or statements provided by us, including those within this conference call, may contain certain forward-looking statements related to future events, future financial performance, strategies, expectations, competitive environment, and regulations.

Forward-looking statements are based on information available at the time these statements are made and/or management's good faith belief as of that time with respect to future events and are subject to risks and uncertainties that could cause actual performance or results to differ materially from those expressed in our or suggested by the forward-looking statements.

Such risks and uncertainties include, but are not limited to loss of revenue due to contract terminations and redemptions, our ownership structure, catastrophic or unpredictable events, unavailability of third party retail distribution channels, damage to our reputation or interpretation thereof and positioning relative to market fluctuations in the financial markets and the competitive conditions in the future fund, asset management and broader financial services sectors.

For a discussion concerning some of these and other risks, uncertainties and other important factors that could affect future results, please see forward-looking statements and where applicable risk factors in the company's annual report on Form 10-K and Form 10-Q that's filed with the Securities and Exchange Commission on March 31, 2008 and August 13, 2008 respectively.

In addition, please be advised that because of prohibitions on selective disclosure, the company as a matter of policy does not disclose material that is not public information on our conference calls. If one of your questions requires the disclosure of material nonpublic information, the company will not be able to respond to it.

I would like to begin by highlighting a few items about our financial results. For the third quarter of 2008, we reported revenues of $25.1 million, operating income of $14.3 million, net loss attributable to the publicly held shares inclusive of the $9.4 million tax valuation allowance of $8.7 million, and earnings per share also inclusive of the $9.4 million valuation allowance of negative $1.42.

On a similar basis, for the nine months ended September 30, 2008, we reported revenues of $83.4 million, operating income of $49.3 million, net loss of $7.1 million, and earnings per share of negative $1.16.

On a pro forma basis, net income was $0.7 million and $2.3 million respectively for the three and nine months ended September 30, 2008. Also on a pro forma basis, earnings per sharp were $0.11 and $0.37 respectively for the three months and nine months ended September 30, 2008.

I will discuss our financial results in more detail in a few minutes. First, I would like to turn the call over to Rich Pzena, who will discuss our view of the investing environment and how we are positioned relative to it.

Rich Pzena

Thank you, Wayne, and good afternoon, everyone. To say a lot has happened since our last call would be quite an understatement. But fear and panic in the equity markets has destroyed wealth on a global basis. Wide ranging actions by governments worldwide have created a sense of flailing rather than leading and will likely have lasting effects on the mechanisms of the financial system, though it is too early to know just how.

The crisis of confidence has claimed victims that one year ago would have seemed impossible, Bear Stearns, Lehman Brothers, Merrill Lynch, AIG, Wachovia, Fortis, Fannie Mae, Freddie Mac, just to name a few.

Unfortunately, we were caught with some of these positions in our portfolios as we sought to exploit the fears rather than hide from them. In other words, to take exactly the approach value investing is supposed to take.

That approach, of exposing the portfolio to the cheapest stocks, has often protected our investors from the downside risks to the market. Yet that has not been the case for much of this cycle. That is until July, at which point our avoidance of the commodity bubble began to pay off.

During last quarter's earnings call, we noted that we were in the throes of a momentum market. Price had become totally irrelevant to the marketplace. As of June 30th, over the prior year and a half, a naive momentum strategy would have compounded at 17% a year, while a naive value strategy based on price to book ratio would have lost 17% a year.

That kind of dramatic spread has happened at the end of every economic cycle in the past 40 years, as fear of the looming recession drives investors to lose sight of the valuation of companies that are negatively impacted by the recession and flee to the stocks that are working, in this case, energy and commodities.

But as we said then, and I will quote our own words, "If history is a guide, once the recession is underway and the safe haven momentum stocks turn out not to be immune from the normal rules of economics, valuation discipline should return and value stocks should outperform".

So what happened in the third quarter? The best performing sectors in equity markets worldwide were consumer staples, healthcare, financials and consumer discretionary. The worst were energy and commodities. Since July 15th, the peak in the momentum energy market and the trough in financials consumer cyclicals through the close on September 30th, most of our strategies generated approximately 400 basis points of excess return through quarter end.

Had we moved into the markets favorite momentum sectors of the past year, we would have hugely underperformed during this period. We are not claiming victory, far from it. The pain we and our clients have endured has been extreme.

But as Warren Buffet offered a couple of weeks ago in Op-Ed piece, "A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful and most certainly, fear is now widespread, gripping even seasoned investors."

It doesn't seem like much of an observation to say that it does appear we have entered a recession. Historically, the start of the recession has been a positive inflection point for economically sensitive stocks and for value strategies in general relative to the market.

We believe that the most important point for investors should be the valuation opportunity the current crisis has created. Valuations of the cheapest stocks globally are as undervalued as we have seen in decades.

This positive perspective on the opportunity going forward comes in full recognition of the hits we have taken in our portfolios in financial holdings. We recognized the possibility of some firms failing and we mentioned this possibility in our last call.

But we also noted that valuations were so extreme that investors in financials could absorb the failures and still see attractive returns. Would it have been better in retrospect not to have owned companies that failed or were taken over, but would it have been better not to own any financials at all? We believe the answer to that will turn out to be a resounding no.

Just as exciting to us is that our deep-value research universe has broadened to include not only financial companies, but companies across a diverse set of industries and sectors. In our global universe, for instance, industrials, materials, and energy stocks are showing up in the first quintile evaluation, a stunning reversal. We are doing a lot of new work in these areas and ultimately that work should translate into investment positions.

We believe we will look back on this time as amongst the most favorable in history for new deep-value investment. In the meantime, it feels terrible to invest during times of market crisis. It is hard on us, it is hard on our clients and their consultants, and it is hard on our shareholders. But that is the nature of the investing business in general and value investing in particular.

A willingness to accept volatility is the hallmark of long-term value investing and turbulence is the necessary condition that allows our strategy to work. Our commitment remains steady as ever. We will build portfolios of deeply undervalued businesses, based on powerful historical evidence that strict valuation discipline, solid research, and a long investment horizon offer the best opportunity for long-term success.

Now, let me spend a moment on our business. Since our inception, our approach to running our firm has not wavered; focus on research and long-term investment results and the business will take care of itself. During our road show, we repeated this philosophy and reminded potential investors that we would be as disciplined about running our business as we are at managing portfolios.

Looking back, while we considered a wide range of potential business outcomes, we certainly did not expect to face a market environment as severe as the one we all find ourselves in today. Thus, as with many of our peers, we are in the process of cost cutting that will include some loss of personnel. Such cuts are never easy.

In a small firm with a culture of teamwork and shared responsibility and opportunity, it is even more difficult. Further, I am pleased to report that we have amended our loan agreement with Bank of America.

We are paying down the outstanding balance of our loan by $25 million. The remaining bank loan balance of $22 million will be secured by our receivables and we will no longer be subject to any financial covenants. The funds to pay down the loan balance consist of $9 million of cash from the firm's balance sheet and $16 million in a senior subordinated note issuance to one board member, a retired partner and my family.

Of the $16 million, my family is contributing $10 million, as I wanted to be clear to our clients, their consultants and our employees that while we are in a tough market environment, the firm's and my own commitment to our long-term success is unchanged. Wayne will review the details of this amendment in a moment.

Regarding our client relationships, we continue to be gratified by our overall client retention figures. While we had net outflows during this quarter, we have had a remarkably stable client base and are encouraged by the fact that even during the height of the market's current meltdown; we have continued to open new institutional relationships.

And now, I will turn it back over to Wayne for more details on our financial results, after which we will take any questions.

Wayne Palladino

Thank you, Rich. Certain financial results I am going to discuss are presented on a pro forma basis as we believe these adjustments and the non-GAAP measurements derived from them provide information to better analyze the company's results between periods and over time. You can see details of these pro forma adjustments in our press release.

First, let's discuss assets under management or AUM. Our assets under management during the third quarter of 2008 declined by $3 billion or 16.2% from $18.5 billion at June 30, 2008 to $15.5 billion at September 30, 2008, our asset decline was comprised of $1.3 billion of negative performance of our investment strategies and $1.7 billion of net outflows. Year-to-date our assets have declined $8.1 billion or 34.3% due to $6.1 billion in market depreciation and $2 billion in net outflows.

At September 30, 2008 the company managed $9.4 billion in separate accounts and $6.1 billion in sub-advised accounts. Sub-advised assets declined $1 billion or 14.1% during the quarter, from $7.1 billion at the end of the second quarter of 2008 due to $0.7 billion in market depreciation and $0.3 billion in net outflows. Assets in separately managed accounts decreased $2 billion or 17.5% due to $9.4 billion at September 30, 2008 from $11.4 billion at June 30, 2008, due to $0.6 billion in market depreciation and $1.4 billion in net outflows.

Our third quarter 2008 revenues were $25.1 million, down 37.6% from $40.2 million in the third quarter of 2007 and down by 11.3% from the second quarter of 2008, which was $28.3 million. The reduction in revenues was due to declines in average assets under management offset to an extent by an increase in our weighted average fees.

For the nine months ended September 30, 2008 revenues were $83.4 million, down by 25.8% from $112.4 million for the nine months ended September 30, 2007. Again this reduction in revenues was due to declines in average assets under management, partially offset by an increase in our weighted average fees.

Average assets under management were $17.6 billion for the third quarter of 2008, down 40.1% from $29.4 billion for the third quarter of 2007 and down 13.7% from $20.4 billion for the second quarter of 2008. For the nine months ended September 30, 2008 average assets under management were $20.1 billion, down 30.9% from $29.1 billion for the nine months ended September 30, 2007.

Our weighted average fee rate increased to 56.9 basis points in the third quarter of 2008, up from an average of 54.7 basis points during the third quarter of 2007 and 55.5 basis points for the second quarter of 2008. The year-over-year and sequential quarterly increase in fee rates was driven primarily by an increase in the proportion of assets in our global and international strategies in our AUM mix, which generally have higher fees than our domestic products.

Separately managed accounts comprised 60.6% of total AUM as of September 30, 2008, up from 55.4% as of September 30, 2007, but down slightly from 61.6% as of June 30, 2008. Weighted average fees for separately managed accounts increased to an average of 67.1 basis points during the third quarter of 2008 from an average of 66.3 basis points during the third quarter of 2007 and from 64.9 basis points during the second quarter of 2008.

Weighted average fees for our sub-advised accounts decreased slightly to an average of 40.6 basis points during the third quarter of 2008 from an average of 40.8 basis points during the third quarter of 2007, but increased from an average of 40.1 basis points for the second quarter of 2008.

For the nine months ended September 30, 2008 weighted average fees increased to 55.1 basis points from 51.5 basis points for the nine months ended September 30, 2007. Compared with the third quarter of 2007, third quarter 2008 total operating expenses decreased by $1 million.

Compared with the second quarter of 2008 operating expenses in the third quarter of 2008 declined by $500,000 or approximately 4.4%, for both comparative periods these decreases were generated primarily as a result of lower variable compensation costs and decreased professional and data system costs arising from our continuing efforts to reduce overall operating expenditures.

Operating income for the third quarter of 2008 was $14.3 million versus $28.5 million for the third quarter of 2007. Operating income for the second quarter of 2008 was $17 million. For the nine months ended September 30, 2008 operating income was $49.3 million compared with an operating loss of $16.4 million for the nine months ended September 30, 2007.

On a pro forma basis, which excludes the unit based compensation charges we incurred in the first quarter of 2007, operating income was $78.5 million for the nine months ended September 30, 2007. Operating margins were 57% for the third quarter of 2008 compared with 70.7% for the third quarter of 2007 and 60% for the second quarter of 2008.

For the nine months ended September 30, 2008, the operating margin was 59.1% compared with a negative 14.6% for the nine months ended September 30, 2007. Pro forma operating margin for the nine months ended September 30, 2007 was 69.9%. Other income expense was an expense of $4 million for the third quarter of 2008, which consisted primarily of charges of $4 million related to the negative performance of investments in the company's own products.

Other income expense declined $2.4 million for the third quarter of 2008 compared with the third quarter of 2007, primarily as a result of the negative performance of company investments. Third quarter 2008 other income expense declined by $200,000 from the second quarter of 2008 and $2.1 million from the pro forma third quarter of 2007, similarly due to the performance of the company's investments.

We expect total amount of our interest expense to come down in the future as the result of our loan amortization payments and the interest rate swap we entered into in the second quarter of 2008, offset by interest expense on the newly issued subordinated notes.

The provision for income taxes was $10.6 million for the third quarter of 2008 compared with $1.3 million for the third quarter of 2007 and $1.5 million for the second quarter of 2008. The sequential increase in the provision for income taxes was the result of the third quarter $9.4 million valuation allowance assessed against the deferred tax asset and associated liability to selling shareholders established as part of the company's initial public offering.

The deferred tax asset is the expected future tax benefit from amortization of the tax step-up the company received when it acquired units in our operating company from the selling shareholders at the IPO. What this means in plain English is that for accounting purposes, we are required to record the tax asset and related liability to selling shareholders at levels that are more likely than not to be realized in the future.

The accounting guidance surrounding assumptions that could be used for estimates of the realizability of deferred tax assets is very restrictive, particularly with respect to time period over which these assets can be expected to be used in uncertain economic times.

Given the recent tumultuous activity in the market and the short forward-looking period over which our analysis was required to be conducted, we felt that it was appropriate from an accounting perspective to take the net $9.4 million charge. If market conditions improve, over time we would expect that our assumptions could lead us to reduce the valuation allowance.

On a pro forma basis, excluding this valuation allowance, the provision for income taxes was $1.2 million for the third quarter of 2008 compared with $2.3 million for the third quarter of 2007. The difference was generated primarily by a reduction in taxable income of the operating company. We have provided supplemental income statement data on the last page of the press release to assist you in deriving our effective tax rate.

Let me just take a moment to walk you through the calculation. Excluding the $9.4 million valuation allowance I just discussed, our effective tax rate for the third quarter of 2008 was approximately 45%. This number varies slightly from quarter to quarter mainly due to certain non-deductible New York City unincorporated business tax expenses, but is usually between 45% and 46%.

To calculate the amount of pro forma income tax related to the publicly held shares, you take 9.6% of our unincorporated business tax, which is assessed against all of our operating company's income, and add it to the provision for corporate income taxes. The result is approximately $553,000 of income taxes attributable to the public shares. You then divide this number by our pretax income, taking a reported income before corporate taxes of $1.152 million and adding back the 9.6% of unincorporated business tax attributable to those shares. 9.6%, $766,000 or $74,000.

These results in pretax income attributable to the public shares of $1.225 million, thus our effective tax rate is $553,000 divided by $1.225 million or approximately 45%. The same calculation for the third quarter of 2007 on a pro forma basis results in the effective tax rate of 45.6% for that period.

As a result of the foregoing, we reported $1.42 net loss per diluted share for the three and nine months ended September 30, 2008. On a pro forma basis earnings per share were $0.11 and $0.37 respectively for the three and nine months ended September 30, 2008.

With respect to the balance sheet, cash stands at approximately $31.8 million at September 30, 2008, which includes $8 million of cash held by our consolidated investment partnerships. On October 28, we completed an amendment to our credit agreement with Bank of America.

While the press release goes into detail about the various provisions, importantly, we accomplished the following. We paid down the loan balance by $25 million. In exchange the bank agreed to eliminate the covenant for minimum assets under management and remove the excess cash flow sweep.

Further, we agreed to a reduction in our revolving credit facility from $3 million to approximately $1.8 million and also that future dividends would be suspended until we have repaid the debt. In addition we granted a security interest in our accounts receivable. As Rich mentioned, to fund the $25 million repayment, the company utilized $9 million of cash on the balance sheet and issued $16 million of senior subordinated notes.

These are non amortizing notes and are unsecured, have a 10-year maturity and bear interest at 6.3% per annum. In addition, the notes are subordinated to the repayment in full of the loans under the credit agreement and now, we would be happy to take any questions.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from Hugh Miller with Sidoti.

Hugh Miller – Sidoti

Good afternoon. Was wondering if you could just give a little color on the decision to eliminate the dividend instead of reducing it and what thoughts went in there.

Rich Pzena

Sure. Basically, we had a priority of eliminating the financial covenants on our debt. The financial covenants, the primary one that we had were minimum assets under management. And to eliminate that, the banks, the lenders required that we eliminate our dividend until such time as we paid the loan and we just made the decision that having the financial flexibility and not having to worry about financial covenants in our debt was the key variable and obviously we, this is highly impacted by a credit environment we find ourselves in and that you read about every single day in the newspapers.

It would be our intention that once that's credit environment changes, we would seek to either refinance or do something to ease up that covenant or that restriction. But at this point it was our judgment that not having those financial covenants was critical.

Hugh Miller – Sidoti

Okay. And it is completely tied to the agreement with Bank of America and not the subordinated debt issuance.

Rich Pzena

It is actually tied to both of them.

Hugh Miller – Sidoti

Okay. Okay. So if you were able to refinance the, the agreement with Bank of America then you still wouldn't be able to pay a dividend until you were to do something with the term loan?

Rich Pzena

That's correct.

Hugh Miller – Sidoti

Okay.

Rich Pzena

That's correct.

Hugh Miller – Sidoti

And do you now have a payment or repayment schedule for the $22 million that's remaining with the term loan and if so, what is that schedule?

Wayne Palladino

Yes, that's correct. There is an amortization schedule, Hugh, and that would be $2 million per quarter.

Hugh Miller – Sidoti

Okay and does that go away if you go above a threshold or is that just a straight amortization?

Wayne Palladino

No, that's just a straight amortization, Hugh.

Hugh Miller – Sidoti

Okay. And you guys had mentioned in your comments that you are continuing to go through some cost cutting measures, personnel reduction. Can you talk to us about how we should be looking at the competition expense line item go forward and just overall costs?

Rich Pzena

Yes. Let me answer that question. There's two issues, one is a fully loaded compensation expense, and by fully loaded, I mean the way that we would think of it, when we, we pay people, which includes a cash payment and all of the deferrals at the time that we make the payment. I think the best comparison would be a 2009 expectation versus a 2007 full-year where we expect that number to be down by over 20%.

On the other hand, the way it shows up in compensation expense is going to be a real function of how we structure year-end bonuses this year and next year, which have not yet been finalized. So, at t this point in time, the best I can say is that the compensation expense line item for 2009 will probably be only modestly down.

Hugh Miller – Sidoti

A modest reduction from the '08 levels.

Rich Pzena

Yes.

Hugh Miller – Sidoti

Okay. Can you talk to us a little bit about the, the pipeline within the separate accounts channel, I know you guys had mentioned prior to this point that you guys felt that as you were getting down to the request for proposals and pitching them, that you were winning your fair share of proposals. But, since we have seen maybe a change in the market since July, mid-July, can you talk to us about what you are seeing now and whether or not you still feel you are winning your fair share of those proposals?

Rich Pzena

I would tell you first of all that the number of proposals it has fallen sharply just in the last couple of months. And I am guessing that is a function of the market environment.

One of the things that, that we hear in the marketplace is one that, that traditional large cap public equities are the single best source of liquidity in an environment where valuations have declined, because these institutions that we do business with have cash flow obligations and they have commitments that they have made to alternatives and private equity, they have funding commitments and as well, there's less liquidity in their hedge fund portfolios.

So I think there's been generally a freezing up of, of new mandates in the public equities sector. So, while we continue to see opportunities, mostly from those consultants and clients that we've had long-term relationships with or we've been calling on for a very long time, the number of just sort of broad RFPs I would say is sharply down.

Hugh Miller – Sidoti

Okay. Great color there and if memory serves me correctly, starting next month there's the possibility of conversion from the BDA shares and if you could just touch on what we should expect to see there and whether or not there is demand to do that at these levels?

Rich Pzena

At this point we, what we committed to when we did our IPO to our employee shareholders, the class B shareholders was that employees that are active are eligible to sale up to 15% of their holdings per year, to convert up to 15% of their holdings per year. We have not at this point opened up the opportunity for conversion. We are obligated to do that at some point over the course of the next year, which we will do. I can't give you, even hazard a guess as to the size of demand for that.

My instinct is that it won't be dramatic because the people that own the biggest chunk of those shares, that is our executive committee, have stated that they don't have intention to sale their shares. So, we would be talking about the remaining employees and outside holders, which would be somewhat modest. But at this point we haven't even given anybody the option. So I don't know how to respond.

Hugh Miller – Sidoti

Okay. Thank you. That was exactly what I was looking for. I will step back in the queue and let others ask questions. Thanks.

Operator

Your next question comes from Marc Irizarry with Goldman Sachs.

Marc Irizarry – Goldman Sachs

Wayne can you just maybe expand a little bit on the margin, where it is heading here. You mentioned comp expense not budging much here, but maybe you can give us a little more of a flavor how we should think about the margin heading into '09?

Wayne Palladino

The margin is just so much a function of the AUM level and the revenue line, certainly expenses are very controllable, and you have seen us do that. So, trying to give any kind of guidance with regard to the margin is just kind of implicitly having to make some kind of a judgment call on AUM and since so much of that has been driven by performance lately, it is anyone's guess.

When you have markets moving 10% a day, it is just very difficult to try and make a call on that, Marc. But I think when you look at the operating expenses, that should at least give you good sense in terms of where we are heading with the expense lines.

Marc Irizarry – Goldman Sachs

Okay. So we should be thinking about the expenses in terms of tightening, tightening around the edges but not anything in the way of wholesale sort of big time cost cutting?

Wayne Palladino

That's correct, Mark. I think that's correct.

Marc Irizarry – Goldman Sachs

Okay. And then, Rich can you talk about some of the appetite for value strategies among institutions and maybe have you been put on some watch lists here and are there any – is there anything sort of heading into the end of the year, first quarter that we should be sort of tuned into in terms of RFP activity that you are seeing?

Rich Pzena

Yes. I would say we are on watch lists. We are on some watch lists. My sense is that a large – this a very hard to know precisely, but of the institutional outflows, a reasonable amount of that comes from the fact that we have people afraid of the equity markets in general rather than commentary on our specific performance.

Our performance recently actually has been pretty good and we had – when you look at our trailing numbers, we have a big period of underperformance in the second half of 2007. And a little bit of underperformance in the first half of 2008 and it has since started to reverse.

I am talking about relative performance, which is where we got measured. I would think that we would have heard most of the fear in our client base already and I think the biggest outflows we had certainly were in September. They have moderated somewhat in October and the phone isn't ringing as much from clients as it was three months ago, because now I think that there are a lot of things for them to worry about rather than us.

So we don't stand out anymore as being uniquely underperforming. It is hard to guess. I think the issue is more a function of our clients views on the equity markets in general.

As far as appetite for value, we have been very, very, very aggressively making the case that value strategies are where you want to be when economics cycles go negative. We have a lot of historical support for that and it does ring a bell in some of the people we deal with.

So we are actually in active discussions today for sizable amounts of money. Does that mean they're going to fund soon? I really don't know how to answer that question. I have always tried to give the sense that on the institutional side of the business, it is very sporadic and it is very, very, very hard to draw any conclusions about the direction of business from a month or a quarter's worth of net flows because they're all over the place.

We are not sitting here in a state of panic about our future flows. I would tell you that there was a lot more fear and concern in our clients of our performance before the third quarter than there is today. So, I think we will see.

You have – you have people all over the map. You have people who think this is a time to take advantage of these kinds of markets. You have people who are afraid and the net result is it is very unpredictable. I also want to – I want to expound a little bit on the answer that the question you asked about expenses.

You should understand and I think this is very critical, that maintaining a capability of research excellence and client service excellence is our primary goal. This is how we insure our long-term business viability. So, for us to be able to make dramatic reductions in our investment team doesn't make any sense at all and we really wouldn't contemplate doing that.

Marc Irizarry – Goldman Sachs

Great, thanks and then just, Wayne, one quick follow-up. Thanks, Rich, for the perspective. On the interest expense can you just give us sort of a sense of what go forward interest expense will look like now, now with all the refinancing.

Wayne Palladino

Yes, kind of if you pro forma everything, Marc, you'd come out to an annual interest expense just slightly over $2 million. So it would be about $500,000 a quarter. And that will be down from where we are today. I think this past quarter was a little over 700.

Operator

Your next question comes from Mike Carrier with UBS.

Mike Carrier – UBS

Just want to understand going forward when you said depending on what the market does. Is it more market in terms of the assumptions that would drive that or is it more related to the stock?

Wayne Palladino

No. It is related to firm profitability is what it is really tied into. So really if you – given that you have seen a decline in trend in profitability lately, obviously you have to take a very conservative view of the future under the accounting literature.

If performance itself turns around and assets start moving in the other direction, that would be positive indication that you would have greater income to take those benefits under in the future. So it is really, really driven by, by firm performance as opposed to the stock price performance.

Mike Carrier – UBS

Okay. And then just a second, one more I guess on – it's more strategic in nature. I think whenever you go through one of these downturns like a crisis, managing the expense base is always a tough thing for most asset managers, as you are still trying to think long-term about the business and, like Rich said, managing the talent and the client relationships and it is always one of those things where trying to balance the near-term pressures of shareholders versus the long-term benefits of the asset management business.

So, when you kind of look at it and you look at the different options, one option would have been the refinancing that you guys did. Just trying to think like strategically, during these periods, what are the other options?

Would you ever think of joining a bigger platform so you don't have to deal with like some of the maintenance expenses that maybe you do from being a more of a niche player? And just – just kind of thought process on more like strategic options given the pressures on the business.

Rich Pzena

Yes. Let me answer that question. I guess I would say that our business remains very profitable from a margin perspective. So, yes, with lower levels of assets under management and a relatively fixed cost base, we, our margins will be more volatile than our competition but they're still high.

So the idea that we could dramatically reduce our expenses by being part of another platform it is just not that big. Expenses that we have that we would eliminate pretty much are the expenses of being a public company, which run a couple of million dollars a year. And it is not that that is completely insignificant, but I mean our investments – I don't think there would be a whole lot of opportunity to have major reduction on our investment team if we wanted to support the clients even as part of another platform.

I will tell you that the non-investment side of the business, the expenses affiliated, associated with the back office and operations and client service, there we are very focused on controlling costs and we did today reduce our headcount by 10%, primarily outside of the investment team.

So we have the ability to, to control our costs somewhat. We have the ability to control the variable compensation, the bonuses that we paid to our investment team.

So I don't think we ever see us getting to the point of being stressed financially unless we were in a crisis significantly worse than we are in today and so the question is it in our best interest as a management team, as owners of the stock, as representatives of the shareholder, to effectively sale today at these kinds of valuations and it just doesn't make a whole lot of sense to me.

Mike Carrier – UBS

Okay. That makes sense. Thanks a lot, guys.

Operator

Your next question comes from William Katz with Buckingham Research.

William Katz – Buckingham Research

A couple of question Rich, I guess just so to your opening remarks that who would have thought a year later of all these major companies going under, but you have always pride yourself on being a style pure manager and that makes a lot of sense, but is this time a little different?

I mean, it seems like everyone has misgauged the depth of the impact here and just sort of curious if there's something a little bit more structurally different about the opportunity to grow the business on a go forward basis then maybe in prior value cycles. I guess really I am asking is there a sell discipline issue here that you are going have a very difficult time marketing into the institutional channel on a go forward basis?

Rich Pzena

I mean I don't believe so. Obviously, time will tell. We are extremely clear with our clients about what we do. And we are extremely clear with them that having a sell discipline that is based on anything other than our research judgment doesn't make sense.

If there are clients out there or prospects out there that are uncomfortable with the downside volatility associated with a pure value strategy, and I am sure there are, we do our best to try not to have those clients. And on the ones that we do have, we try to do our best to make sure we are sized appropriately within their overall portfolio.

So when you go to some of the world's largest plans and tell them does it make sense to expose a portion, even if it is only a small portion, of your overall portfolio to this kind of investment strategy, I really don't believe that we are doing anything differently.

In fact, if you compare our relative performance, our underperformance this period when we had a heavy investment in financials, with what it was last period, which happened to be the period just before we had our explosive growth, our underperformance this time is half of what our underperformance was last time and the valuation opportunities today are twice as good as they were in the last cycle.

So, I think that according to consultants, there really are very, very, very few firms that are as disciplined and focused on deep value investing as we are both in the US and globally. It doesn't mean that we are going to always win, but as far as we can tell, we are still under consideration.

Cycles always feel like this. And it felt really, really bad when we were sitting here in early 2000 after our tenth quarter of underperformance, which cumulatively was 3,000 basis points versus the Russell 1000 value and 6,000 basis points versus the S&P 500 that felt really bad. This feels really bad too, even though this feels worse to some extent even though the relative performance is half as bad. So we are very –

William Katz – Buckingham Research

I am sorry to interrupt you.

Rich Pzena

So we are very, very clear with our clients about our thought process, about what we could do to avoid some of the downturns, about why we are not going to do those, take those steps, and for the most part it actually works.

William Katz – Buckingham Research

Just on that same vain, just take that one step further, since this – I'd be curious with respect to maybe taking back to the last cycle, it just seems like this time around a lot of your investments don't have the binary opportunity to recover because they're either defaulted or been acquired at a much lower level.

So I am just sort of curious can you recoup on the other side, the same type of alpha. That's sort of one question. The other question is unrelated. Given the size of the assets and where the stock price is currently trading, are either one of those a constraint to potential new business?

Rich Pzena

The first question is we had some more issues in the last cycle where we had, we had our largest position file for bankruptcy, and it was very similar to what happened to us this time with Fannie Mae and Freddie Mac, where we wrote extensively about it. It went down, we bought more, and eventually it went out of business. And we still wound up generating the spectacular returns in the ensuing recovery.

When we look at our valuation parameters today, if you make the assumption albeit, I understand the, maybe the difficulty of making this assumption, but if you make that assumption that we are, that we have properly evaluated the remaining holdings in our portfolio, we actually believe we will recoup our alpha.

The binary outcomes, obviously we try to avoid the binary outcomes, it is not like we are seeking to employee a high risk strategy. In fact, we are seeking not to. We misjudged the extent to which the risk applied to these securities and by the time we figured it out we lost money. And yet, when we explain this to our clients, they, for the most part, get it.

So, I would tell you that it is easy enough for us to do an analysis to show you that if our securities in our portfolio today held – traded at what we thought their fair values were, our full cycle return profile would look very attractive; including the period of underperformance we just went through.

Now, I can't guarantee you that we got it right, but we can make strong arguments for why we think we have it right. Our assets under management today are they at a level at which we would struggle to be – to participate in competitive opportunities? I think it is just no. I don't think we are at the point where we are – except we are too small to be relevant.

William Katz – Buckingham Research

Okay. That's helpful. Thank you very much.

Operator

Your next question comes from Ken Worthington with JP Morgan.

Ken Worthington – JP Morgan

Thank you. My questions were asked and answered.

Rich Pzena

Okay, thanks, Ken.

Operator

At this time there are no further questions.

Wayne Palladino

We'd like to thank everyone for joining us on our third quarter 2008 earnings conference call and we look forward to speaking with you at year-end. Take care.

Operator

This concludes today's conference call. You may now disconnect.

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Source: Pzena Investment Management, Inc. Q3 2008 Earnings Call Transcript
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