Gary Bachman – CFO
Bill Lipsey – President, Marketing and Client Service
Rich Pzena – Chairman, CEO and Co-Chief Investment Officer
Ken Worthington – JP Morgan
Pzena Investment Management, Inc. (PZN) Q1 2013 Earnings Call April 24, 2013 10:00 AM ET
Very good day to you, ladies and gentlemen, and welcome to the Quarter One 2013 Pzena Investment Management Earnings Conference Call. My name is Mansi and I will be your operator for today. At this time, all participants are in listen-only mode. We will conduct a question and answer session towards the end of this conference. (Operator Instructions) As a reminder, this call is being recorded for replay purposes.
I would now like to turn the call over to Mr. Gary Bachman, Chief Financial Officer. Please go ahead.
Thank you, operator. Good morning, and thank you for joining us on the Pzena Investment Management first quarter 2013 earnings call. I am Gary Bachman, Chief Financial Officer. With me today is our Chief Executive Officer and Co-Chief Investment Officer, Rich Pzena, who is dialing in from a remote location and Bill Lipsey, President, Head of Marketing and Client Services.
Our earnings press release contains the financial tables for the periods we will be discussing. If you do not have a copy, it can be obtained in the Investor Relations section on our website at www.pzena.com. Replays of this call will be available for the next two weeks on our website.
Before we start, we need to reference the standard legal disclaimer. Statements made in the presentation today may contain forward-looking information about management’s plans, projections, expectations, strategic objectives, business prospects, anticipated financial results and other similar matters. A variety of factors, many of which are beyond the company’s control, affect the operations, performance, business strategy and results of the company and can cause actual results and experiences to differ materially from the expectations or objectives expressed in these statements.
These factors include, but are not limited to, the factors described in the company’s reports filed with the SEC, which are available on our website and on the SEC’s website, www.sec.gov. Investors are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date on which the statements are made. The company does not undertake to update such statements to reflect the impact of circumstances or events that arise after the date these statements were made. Investors should, however, consult any further disclosures the company may make in the reports filed with the SEC.
In addition, please be advised that because of the prohibition on selective disclosure, the company, as a matter of policy, does not disclose material that is not public information on their conference calls. If one of your questions requires the disclosure of material that is non-public information, we will not be able to respond to it. Thank you.
In a minute, I will turn the call over to Rich. But first, I’d like to review some of our financial highlights. We reported non-GAAP diluted EPS of $0.08 per share and $5.6 million in non-GAAP diluted net income. Revenues were $20.8 million for the quarter and our operating income was $9.4 million.
I will discuss our financial results in greater detail in a few minutes, but let me now turn the call over to Rich, who will discuss our current view of the investing environment.
Apparently, we’ve lost Rich. So, this is Bill Lipsey. Thanks, Gary. Markets all over...
Sorry, if you could hear me, I’m on if you can hear me.
Okay. Yes, now we hear you.
Okay. Yeah, just give me one second. I’ll be there, just give me one second.
Sorry, everybody. This is Rich Pzena. Markets all over the world continued their upward march and value strategies generally had a pretty solid quarter. And, yes in a quarter when the Japanese Central Bank declares that they too have joined the quantitative easing club, capital continued to flow into those segments generally categorized as safe, namely consumer staples, utilities and healthcare.
As a result, evaluation spread between high and low beta stocks continues to hover near 40-year record levels, making exposure to undervalued cyclical businesses appear unusually attractive. Couple that with the availability of clean balance sheets and very high levels of sustainable free cash flow and we see a very attractive investment environment for our strategies globally.
As you would expect, our portfolios continue to be dominated by the most undervalued segments in the marketplace, financials and mature technology. In fact, we still have more than half of our portfolios exposed to these sectors. Interestingly, not only does the market avoid these most attractively valued sectors, so did most of our value brethren.
We noticed the same behavior in the last value cycle during the late 1990s, when we saw other value investment managers shun the industrial cyclicals that made up over half of our portfolio and dominated the return profile during the ensuing five years. Today, we see the same phenomenon. We gather data on global and U.S. value manager portfolio holdings from eVestment Alliance one of the most commonly used investment manager database systems. For the last year, our portfolios have had an over 50% exposure to financials and technology while value managers as a group have hovered nearly 20 percentage points lower, almost exactly at the same level as the value indices.
We suspect this tendency to avoid the most controversial investment themes by value managers is just human nature. But the source of long-term out performance record of value styles is to capitalize on exactly these types of opportunities. For us, we see meaningful value in the market and recognize that our clients and consultants expect us to capitalize on these moments.
While our financial holdings are quite diverse, let me support the argument with a few comments about our holdings in universal banks. First, consider the capital level of the banks, JPMorgan, Citigroup and Barclays have core Tier 1 capital ratios of 11% to nearly 13% currently, up from levels just about half that pre-crisis and far lower at the trough.
Safety and soundness has never been stronger. The question then is will regulatory change allow these banks to earn a decent return on their increased capital base. We believe that both history and the laws of supply and demand suggest the answer to this question is yes. Demand for financial products has been escalating above nominal GDP for decades. And there is no obvious reason for that to change.
Meanwhile, the amount of capital that has been dedicated to facilitate the trading of these instruments has been curtailed. This should in theory lead to higher not lower returns. In our recent research visits, we find that bank managers have a laser-like focus on improving returns and are using all available levers to do so.
That said, our models for bank earnings are built on the assumption that they just returned to their normal long-term average ROEs. And with these banks trading at an average price-to-book value multiple today of 0.7 times, our projection of ROEs of 12% to 13% suggest fair value targets of more than double their current levels and unusually good risk reward trade-off considering book value is growing at a healthy pace.
Let me bring you up-to-date on our business as well. We mentioned last quarter that we are seeing an increase in business activity. Recall that we have been tracking activity for many years and define activity as any indication that a prospective client or consultant has one of our strategies under consideration.
That increased activity has continued into 2013 and continues across the spectrum of our strategy and is coming to us from a wide swath of geographies. We attribute some of the increased activity to the fact that our strategies have earned attractive returns since the end of 2008.
Relative to their respective benchmark, our strategies have generated from approximately 1.5% to 6.8% of excess annual return over their respective benchmarks since the global financial crisis ended returning to the pre-crisis levels that our clients have come to expect.
During the first quarter, our assets under management grew 14% driven by net inflows of approximately $500 million and $1.9 billion in market appreciation. While I would point out that in the institutional world, our flows are lumpy and unpredictable, we are encouraged by the continuing growth inflows. We believe the flows and increase in activity highlights a broad acknowledgment that both Pzena specifically and deep value investing in general have an important role to play as institutions seek to meet their long-term investment funding targets.
Last, but not least, I’m proud to announce that we were named the US Small Cap Value Equity Manager of the Year in Institutional Investor Magazine’s fourth annual US Investment Management Awards.
Thank you. And I look forward to answering your questions. But first, let me turn the call over to Gary Bachman, our CFO, who will review our quarterly financial results.
Thank you, Rich. I will start out by discussing our assets under management, fee rates and revenues. Our average assets under management were $18.5 billion during the quarter, up 10.1% from last quarter and up 29.4% from the first quarter of last year. We ended the quarter with $19.5 billion of assets under management, up 14% from the end of last quarter, which ended at $17.1 billion and up 32.7% from the end of the first quarter of last year, which ended at $14.7 billion. The $2.4 billion increase from the last quarter was due to $1.9 billion in market appreciation and $0.5 billion in net inflows.
The $4.8 billion increase from the first quarter of last year was driven by $2.7 billion in market appreciation and $2.1 billion in net inflows. At March 31, 2013, our assets under management consisted of $12.2 billion in institutional accounts and $7.3 billion in retail accounts.
Assets and institutional accounts were up $1 billion from the end of last quarter due to $1.1 billion in market appreciation, partially offset by $0.1 billion in net outflows. Compared to last quarter, retail assets were up $1.4 billion due to market appreciation up $0.8 billion and $0.6 billion in net inflows.
Revenues were $20.8 million for the first quarter of 2013, up 7.9% from last quarter and 5.4% from the first quarter of last year. The increase from last quarter and the first quarter of last year were primarily due to market appreciation and net inflows.
Our weighted average fee rate was 45 basis points for the first quarter of 2013 compared to 46.1 basis points last quarter and 55.2 basis points for the first quarter of last year. The decrease from last quarter was primarily due to the increase in average assets under management during the first quarter of 2013 as our tiered fee schedules typically charge lower rates as account sizes increase.
The decrease from the first quarter of last year was also driven by the increase in weighted average assets under management primarily associated with our assignment to manage 28% of the Vanguard Windsor Fund in August of 2012 and a decrease in performance fees recognized during the first quarter of 2013.
Our non-GAAP income statements adjust for the recurring valuation allowance and tax receivable agreement items. I will address the current adjustments at the conclusion of my remarks but for now I’ll focus on the non-GAAP information.
Looking at operating expenses, our compensation and benefit expense was $9.6 million for the quarter, up 21.9% from last quarter and up 17.6% from the first quarter of last year. The increase from last quarter and the first quarter of last year include an expense of $0.6 million associated with severance charges. The balance represents increases in our discretionary bonus accruals. G&A expenses were $1.8 million for the first quarter of 2013, down $154,000 from last quarter but up slightly from the first quarter of last year.
Operating margins were 45.2% this quarter compared to 49% last quarter and 50% in the first quarter of last year. Net of outside interest, other income was $0.5 million this quarter, $0.2 million last quarter and $0.5 million for the first quarter of last year. These fluctuations arise generally as a result of the performance of the firm’s investments.
The effective rate for our unincorporated business taxes was 0.5% this quarter, down from 6.6% last quarter and from 6.1% in the first quarter of last year. The decrease in the effective tax rate was driven by a benefit recognized in the first quarter of 2013 associated with prior period adjustments of certain tax positions. We expect this rate to be between 5% and 7% on an ongoing basis.
The allocation to non-public members of our operating company was approximately 82.6% of the operating company’s net income this quarter compared to approximately 82.7% last quarter and approximately 83.6% in the first quarter of last year. The variance in these percentages is a result of changes in our ownership interest in the operating company.
The effective tax rate for our corporate income taxes ex-UBT was 42.7% this quarter compared to 43.5% last quarter and 42.8% for the first quarter of last year. The decrease in our effective rate this quarter is the result of adjustments associated with the tax effect of non-cash compensation. Our expectations are that our corporate effective tax rate will generally be between 42% and 43%.
As a result, we reported basic non-GAAP EPS of $0.09 per share and diluted non-GAAP EPS of $0.08 per share for the first quarter. During the quarter through our stock buyback program, we were repurchased and retired 109,535 shares for approximately $666,000. At March 31, there was approximately $8.4 million remaining of the $10 million repurchase program authorized during April of 2012.
Before we turn it over to questions, I’d like to briefly walk through the valuation allowance and tax receivable adjustments. In the first quarter of 2013, we recognized adjustments that arose as a result of revised estimates of future taxable income and our ability to utilize our deferred tax assets. We recognized a $1.2 million decrease in our valuation allowance and $1 million increase in our ability to our selling and converting shareholders for the quarter.
The net effect of these adjustments comprises the majority of the difference between our first quarter 2013 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 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 amount I just discussed, we reported GAAP basic EPS of $0.10 per share and diluted EPS of $0.09 per share for the quarter.
At quarter-end, our financial position remains strong. Our cash balance was $24.5 million at March 31 and we declared a $0.03 per share quarterly dividend last night.
Thank you for joining us on the call. We’d now be happy to take any questions you may have.
Thank you. (Operator Instructions) We have a first question from the line of Ken Worthington. Please go ahead.
Ken Worthington – JP Morgan
Hi, good morning. First, if the products are performing well and there is greater interest in deep value in equities in general, it now would seem like it’s a good time to invest in kind of rebuilding the asset base. So can you talk about maybe the sales strategy for 2013?
How you’re thinking about marketing given that the year has started well and 2012 has had been a good year and maybe where you’re trying to be proactive or more proactive or different than you have been in the past in trying to build up those sales?
Sure, Ken. If you recall, over the course of the last 12 to 24 months, we had invested quite heavily in expanding our sales force. And so now we have coverage that’s dedicated to Europe and the Middle East, coverage that’s dedicated to North America and then specific coverage for the sub-advisory/defined contribution world.
These ramp ups don’t happen overnight and what we’re experiencing now is the increase in activity. So by adding these sales people into the marketplace and making a lot of calls, we’ve generated a reasonable amount of interest and that interest has now turned into what we call search activity.
Search activity is really anything that anyone indicated, yes, we’re interested in hiring you and you are now in a search. Those activity levels are growing very rapidly and primarily on the sub-advisory side of things, you’ve seen some of the benefit of that in our flows so far.
It’s interesting that as we see it and I’m not sure if this is true broadly, the interest in equities and in value in particular seemed to have spiked more rapidly on the retail side and a little more slowly on the institutional side. And I guess you’d say that’s not surprising, but the way that we experienced it was in flows into our mutual funds that we sub-advice.
They had generally been slightly negative net flows effectively the last five years ending December 31. And then, it turned into almost every day positive flows and the switch happened on January 1, the switch just happened, I can’t explain to you the logic for it. But I think it shows up in some of the mutual fund flow data as well.
Institutions have also – I’ll say the switch also turned on institutions but the action doesn’t happen as quickly. It goes through a process of soul searching, then defining objectives, then manager selection. And based on the preliminary indicators of search activity, we would hope that that would turn into flows.
We’ve been investing in this and saying this patiently and I think when you look at our data, what we see is the inflows, the net outflows have remained – the gross outflows have remained fairly constant for the last several years, but the inflows institutionally picked up in the first quarter.
And so we were very close to cash flow breakeven institutionally. So my suspicion is that it just takes longer. And remember that the period for us of the financial crisis in 2007 and 2008 was reasonably painful. So we’re just having people get over that with regard to us. So I don’t know how to answer it any better. We’re not changing our sales strategy. We think we’re on the right course with the investments that we’ve made and we’re hoping that they’ll prove to be effective with the passage of time.
Ken Worthington – JP Morgan
And can you tell us a little bit about what’s selling well for you? You’ve got a number, I’ll call new products but probably not that new anymore, they still feel new to me, kind of what selling well on a dollar basis, and then maybe separately, which products are growing most quickly?
Well, the interesting part about our – if you analyzed our flows over the last quarter, there would be no theme to them. We actually have major institutional wins and I’m including big sub-advisory in that, but major wins in U.S. large cap value, in global value in European value, and in emerging markets value and from four different regions of the world.
So it’s hard to pinpoint and answer to that question, there seem to be a general interest in our strategies and a general reevaluation of us from the institutional investment world. In terms of rate of growth, only because of starting from a much smaller base would be our emerging markets value strategies.
Ken Worthington – JP Morgan
Okay. And then lastly, you mentioned that the sales kind of turned on for the retail side January 1, and even the interest levels on the institutional side improved kind of January 1. For the industry you see seasonality in kind of a 1Q anyway, to what extent is this just a seasonal pickup versus maybe kind of issues that are esoteric in nature really specific to Pzena like – it’s a terrible question, but can you separate what’s kind of seasonality versus non-seasonality at all.
Yeah. I mean I don’t really know how to answer the question because I would tell you that when I observed seasonality from the institutional side and I’m going to answer this question non-scientifically. So because this is just the gut feel from being in this business for a long time. First quarter is usually the most difficult quarter from an outflow perspective.
That outflow perspective is generally not the best. Generally institutions sort of make their firing decisions after reviewing the year-end financial data and deciding they want to make a change and then they go through the process of hiring, where the evaluations happen in the second and third quarter and the funding in the fourth quarter.
So my experience would tell you that seasonally fourth quarter is the best quarter for net flows and first quarter is the worst quarter. But I don’t have any scientific data to back that up and even our own data is a little bit erratic, but it’s my feel that that’s how it works.
Ken Worthington – JP Morgan
So, I would not – on the retail side, I just don’t know. So I would have trouble sort of separating this into seasonal versus some fundamental shift in the way we are being perceived.
Ken Worthington – JP Morgan
Well, great. It was a good answer to a lousy question. So thank you. That’s all I have.
Thanks for your questions. We have one more question in the queue from the line of John Dunn. Please go ahead.
Good morning. I want to know, do you guys have a sense of where the industry allocation to devalue is relative to when it peaked?
I’m going to pass on that question over to my partner, Bill Lipsey to see if he has a feel for it. But I don’t personally have a feel.
Yeah. See that’s the advantage of being the Chief Executive Officer. I’ll tell you, I don’t think we have a, like Rich was saying, I don’t think we have any scientific assessment of that.
If you use the point Rich made about our – the visibility of activity rising, I would say the industry allocation to deep value is probably somewhere in the neighborhood of half what it was at the peak.
Remember the peak came five years after the trough. So it took a long time, but if you take it back to March of 2000, the peak came sometimes during 2005 when sort of the world decided the only way to make money was deep value. So I would say we’re probably half that level right now, but half that level is probably double the level it was a year ago or a year and a half ago.
Got you. Okay. And then could you give us an update on how that conversation is developing post the Windsor win. Have they been changed from your last conference call?
No. I would continue to say that the Vanguard Windsor win has created a reasonable amount of interest. It’s something that’s brought up in all of our conversations. It tends to have much more significance on the retail and the sub-advisory and the defined contribution side than it does on the institutional separate management side.
I’ll tell you on the institutional separate management account, I would view it as more – people view it as a non-issue one way or another. But on the sub-advisory side generally positive, people want to know why we were hired and I think it makes them – it’s just sort of another endorsement of our capability.
Right, makes sense. And then just could you give us an update on the pricing outlook on the sub-advisory side?
There is pricing pressure and we’ve offered a number of more expanded strategies such as what Vanguard Windsor is rather than it being a 30 to 40 stock concentrated portfolio. It’s a 50 to 80 stock portfolio that is similar, but is priced at a lower price. And we have been very religious at pricing our capacity appropriately. And so generally speaking, but I won’t say this is always the case, generally speaking the sub-advisory relationships tend to be on our expanded rather than our focused strategies. And they’re priced at a lower price point.
Got it, great. Thank you very much. Good quarter
Thank you for your questions, John. (Operator Instructions) Gary, we don’t seem to have any further questions at the moment.
Thank you, operator.
Ladies and gentlemen, I’d like to thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Have a good day.
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