Pzena Investment Management's CEO Discusses Q3 2013 Results - Earnings Call Transcript

| About: Pzena Investment (PZN)

Pzena Investment Management, Inc. (NYSE:PZN)

Q3 2013 Earnings Conference Call

October 23, 2013, 10:00 AM, ET


Gary J. Bachman – Chief Financial Officer

Richard S. Pzena – Chairman, Chief Executive Officer and Co-Chief Investment Officer


Ken Worthington - JPMorgan

John Dunn - Fidelity Brokerage Services LLC

Marc Irizarry - Goldman Sachs


Good day, ladies and gentlemen, and welcome to the Third Quarter 2013 Pzena Investment Management Earnings Conference Call. My name is Dominic and I will be your operator for today.

At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session. (Operator Instructions).

I would now like to turn the conference over to Mr. Gary Bachman, Chief Financial Officer. Please proceed sir.

Gary J. Bachman

Thank you, Dominic. Good morning and thank you for joining us on the Pzena Investment Management third 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.

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 to 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 prohibitions on selective disclosures, 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 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 would like to review some of our financial highlights. We reported non-GAAP diluted EPS of $0.11 per share and $7.3 million in non-GAAP diluted net income. Revenues were $24 million for the quarter and our operating income was $13 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.

Richard S. Pzena

Thanks, Gary. Equity markets all over the world continued their relentless upward march during the third quarter. Since the end of 2008 the MFCI World Index has nearly doubled compounding at almost 15% per year. Interestingly there's very little deviation by region with the U.S. EAFA and emerging markets all posting strong post global financial crisis returns.

Furthermore, growth indices have actually outperformed value induces during this period, an unusual occurrence in a post-recession environment. So the questions that arise are fairly straight forward. Is it over, what happened to the value cycle and what are the implications for our business. I’ll try and address each of these.

Is it over? Of course I don’t know the answer but I can offer some observations based on history. Equity risk premiums remain wide. The spread between the expected return on equities and the yield to maturity on sovereign debt ranges from about 3% in Japan to nearly 10% in Europe with the U.S. in the middle.

Clearly skepticism about equity markets remains high. For example the S&P 500 would have to rise by about 15% to restore the historical equity risk premium if interest rates remain where they are. Similarly interest rates would have to rise by about 120 basis points to around 3.8% for the 10 year to make sense of the current equity markets.

If interest rates rose to their 20 year average of nearly 5% fair value for the S&P 500 would be about 10% below current levels. Suffice it to say that we believe global equity markets offer reasonably interesting long-term returns.

What about value? Why have the growth industries outperformed. Is there something different about this cycle. I believe that the major difference about this cycle is the market’s relentless focus on volatility. We’ve all read the studies that suggest that low volatility outperforms high volatility and that has led to the wave of asset flow into alternative investments and into lower volatility strategies.

We even discovered in our own studies that avoiding the highest volatility stocks rather than facing low volatility can add long-term value. Nevertheless, the market is pricing low volatility at all time highs. In addition the dramatic fall in interest rates has clearly favored growth stocks, which by definition have a longer duration than value stock.

But now we are five years into the recovery and value stocks still have double-digit expected returns with value spreads at their long-term norms. Consequently we believe there is continued opportunity for our style and that there are exploitable investment opportunities. As for our business what a difference a year can make.

We are now almost five years since the end of the global financial crisis. Not only have investors come to the obvious realization that you can’t meet your funding objectives if you take no risk, but our own performance records have recovered to peak crisis levels. For example our focused value strategy has outperformed its benchmark by over 400 basis points per year since the end of ’08 matching the pre-crisis record we had for 11 years through 2006. Our five year record is now ahead of benchmark in many cases substantially so for all of our investment strategies.

In addition we’ve addressed the issues which led to our poor performance in 2007 and 2008 with our clients and prospects. As a result client retention has been solid and new business activity is beginning to accelerate. We had $700 million in net positive flows during the quarter. And we continue to have an active pipeline.

In addition the level of gross outflows have slowed dramatically. Accordingly we are making plans to try and exploit these opportunities and are reasonably optimistic that positive flows will continue albeit unlikely at the rate of the most recent quarter.

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.

Gary J. Bachman

Thank you, Rich. I will start out by discussing our assets under management, fee rates and revenues. Our average AUM was $21.4 billion during the quarter, up 6.5% from last quarter, and up 44.6% from the third quarter of last year. Our assets under management ended the quarter up 9.9% at $22.3 billion from $20.3 billion last year and up 32.7% from the end of the third quarter of last year which ended at $16.8 billion. The $2 billion increase from last quarter was due to $1.3 billion in market appreciation and $0.7 billion in net inflows. The $5.5 billion increase from the third quarter of last year was driven by $5.2 billion in market appreciation and $0.3 billion in net inflows.

At September 30, 2013 our AUM consisted of $14.3 billion in institutional accounts and $8 billion in retail accounts. Assets in institutional accounts were up $1.7 billion from the end of last quarter due to $1 billion in market appreciation and $0.7 in net inflows. Compared to last quarter retail assets were up $0.3 billion from the end of the quarter due to $0.3 billion in market appreciation.

Revenues were $24 million for the third quarter of 2013, up 8.6% from last quarter and 27.5% from the third quarter of last year. The increase from last quarter and the third quarter of last year was primarily due to the increase in average assets and performance fees recognized during the third quarter of 2013.

Certain relationships pay incentive fees according to the performance relative to certain agreed upon benchmarks which results in a lower base fee but allows for us to earn higher fees if the relevant account outperforms the agreed upon benchmark.

Our weighted average fee rate was 45 basis points for the third quarter of 2013 compared to 44.1 basis points last quarter and 50.8 basis points for the third quarter of last year. The increase from last quarter was primarily due to performance fees recognized during the quarter. The decrease from third quarter of last year reflects the increase in average assets under management primarily associated with the large inflow representing the company’s assignment to manage 28% of the Vanguard Windsor Fund as of the beginning of August 2012.

Our non-GAAP income statement adjusts for the recurring deferred tax, valuation allowance and tax receivable agreement items. I will address the current adjustment at the conclusion of my remarks but for now I will focus on the non-GAAP information.

Looking at operating expenses our compensation and benefit expense was $9.1 million for the quarter, up 2.1% from last quarter and up 18.4% from the third quarter of last year. The variance from last quarter represents an increase in our discretionary bonus accrual. The variance from the third quarter of last year reflects an increase in our salary and headcounts, our discretionary bonus accrual as well as the amortization of previously issued awards.

G&A expenses were $2 million for the third quarter of 2013, relatively flat compared to last quarter and up $0.2 million from the third quarter of last year. The variance from the third quarter of last year reflects an increase in business activities.

Operating margins were 53.9% this quarter compared to 50.9% last quarter and 49.9% in the third quarter of last year. Net of outside interest other income was $0.3 million this quarter, $0.2 million last quarter and $0.2 million for the third quarter of last year. These fluctuations arise generally as a result of the performance of the firm’s investments.

The effective rate of our unincorporated business taxes were 5.8% this quarter, relatively flat to 5.9% last quarter and 6.2% in the third quarter of last year. The decrease in the effective tax rate from the third quarter of last year reflects a change in the methodology for state and local receipts. We expect this range to be between 5% and 7% on an ongoing basis.

The allocation to non-public members of our operating company was approximately 81.9% of the operating company’s net income this quarter, flat compared to last quarter and approximately 83.6% in the third quarter of last year. The variance in these percentages is the result of changes in our ownership interest in the operating company.

The effective tax rate for our corporate income taxes ex-UBT was 41.6% this quarter compared to 40.5% last quarter and 42.9% for the third quarter of last year. The increase in our effective rate this quarter and decrease from the third quarter of last year is the result of the change in our methodology for state and local receipts recognized last quarter. We expect our corporate effective tax rate to be between 41% and 42%. As a result, we reported basic and diluted non-GAAP EPS of $0.11per share for the third quarter.

During the quarter, through our stock buyback program, we repurchased and retired 79,208 shares for approximately $0.5 million. At September 30 there was approximately $6.9 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 third quarter of 2013 we recognized adjustments as a result of the revised estimates of future taxable income, and our ability to utilize our deferred tax asset. We recognized a $0.8 million decrease in our valuation allowance and a $3.3 million increase in our liability to our selling and converting shareholders for the quarter.

The net effect of these adjustments comprises the majority of our difference between our third quarter 2013 non-GAAP and GAAP net income. On a quarterly basis we recorded 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 economic interest in it.

Inclusive of the effect of the valuation allowance and the tax receivable agreement amounts I’ve just discussed we reported GAAP basic EPS of $0.16 per share and GAAP diluted EPS of $0.12 per share for the quarter. At quarter-end our financial position remained strong. Our cash balance was $35 million at September 30 and we declared a $0.03 per share quarterly dividend last night.

Thank you for joining us. We’ll now be happy to take any questions you may have.

Question-and-Answer Session

(Operator Instructions) And the first question comes from the line of Ken Worthington of JPMorgan.

Ken Worthington - JPMorgan

Hi. Good morning. Just to ask the easy and obvious, very strong gross sales in the institutional business. Can you describe what happened, one big mandate or a little mandate and if we can get a sense of how long it's taking to close these sales, that’ll be helpful too?

Richard S. Pzena

Ken, let me give you a sense for the year-to-date if I can, first of all and then I guess I can probably see it for the quarter. For the year we had a total of roughly $3 billion of gross inflows. About one of that was new accounts and two were additions to existing accounts. And on the outflows about $200 million was closed accounts and the balance was withdrawals.

So you see the lion's share of the flows are still flows into and out of existing accounts. In the quarter we did have one fairly large institutional account open, that accounts for reasonable share of the gross flows during the quarter. And so there is obviously lumpiness. It accounted for, I think about half of the gross flows, inflows during the quarter. Does that help?

Ken Worthington - JPMorgan

Yes, it definitely does. And in terms of like time to actually close these, so the pipeline I can go back in the transcripts but the pipeline has been building for some time. We were seeing limited evidence in the data that probably shareholders can see but are you seeing -- obviously you had some triggers being pulled this quarter. Is the time to sales, does it seem to be improving at all and what would that be right now, is it a year and a half, a year, is it happening more slowly than even that?

Richard S. Pzena

Yeah, I mean the answer to that question is that's erratic too. It’s the long process from the time you develop a relationship with consultants to the time that they put your name in front of clients to the time that the clients start making the decision to accept, I would tell you the big inflow that we had this quarter was more of a faster track than average, faster track being less than a year, nothing happens in a month.

So I guess I would tell you the fast track ones are six to 12 months, the average is 12 to 24 months, if I had to give that kind of guess.

Ken Worthington - JPMorgan

Okay. And then on the sub-advise side you can win and lose big mandates there as well. What are you seeing in terms of either a pipeline there of new business or color about interest from either new or existing clients that sub advise to you today?

Richard S. Pzena

Sub advisory business for us has been fairly strong and we for example, we started a relationship with ABN Amro and I believe it was June. And the flows have really been quite steady and strong since that point in time. And basically our experiences have been on sub advisory that we have, that they’ve been generally net additions to our sub-advisory relationships with flow coming thereafter.

We are actually in the process of re-thinking how we report our assets between, if we have sort of categorize it institutional and retail rather than as separate accounts and sub advisory which leads us to make judgments as to where we put it or rethinking that to try and give a better feel for it. But the reality is that we have a real big opportunity now in Europe as a result of this relationship. And we think it’s going to continue to grow.

Ken Worthington - JPMorgan

Okay. Maybe I’ll just finish up on the capital side. You bought back shares this quarter. I guess in 1Q you typically have an elevated distribution, how should we think about capital policy going into next year. Any reason for changes or deviations from kind of the most recent either policy or outcomes that we’ve seen?

Richard S. Pzena

No, we are pretty happy with our policy at this point. We intend to payout approximately 80% of our earnings with the year-end distribution that would be made in the first quarter based on our, on what we wind up earning for the year. And the remaining 20% we sort of look at as available for share repurchase or anything else that we might need it for including incubating new strategies.

And we would buyback more stock if we could. Liquidity as you know is fairly light and we’re somewhat restricted in when we can be involved but the only thing that has gone a little below our expectation is the volume of our share repurchase program. I am not sure what we do about that.

Ken Worthington - JPMorgan

If you wanted advice be more than happy to talk to you offline. Thank you very much for taking the question. I will re-queue after everybody has had a chance to ask. Thank you.


(Operator Instructions). And your next question come from the line of John Dunn of Fidelity & Company.

John Dunn - Fidelity Brokerage Services LLC

Morning guys, great quarter. Can you talk about the outlook for performance fees now they seem to have gotten back into position of historic earnings?

Richard S. Pzena

Sure. The typical performance fee for us is based on a trailing three year performance record. So if you recall our performance, had a weak period in middle of 2011. And so we are now working out of that where the performance fees, our performance of those accounts on the three year basis are turning positive. So we expect there to be continued growth in performance fees and we expect the quarter, as a quarterly they are not, they are recorded based on the anniversary date on the account.

So they can be lumped quarterly and they are weighted more towards the fourth quarter. So the fourth quarter should be our best performance fee quarter barring any changes in what our performance actually is and then next year should be better than this year.

John Dunn - Fidelity Brokerage Services LLC

Great, got you. And then you talked about opportunity in Europe. But could you talk more broadly about the geographic mix of organic growth you actually have here versus Asia?

Richard S. Pzena

Yeah, I’ll start with our products and then I’ll talk about the geography of our clients because they are sort of two different issues. For the year and I’ll just use year-to-date rather than quarterly because it is kind of lumpy. So the year makes almost all of our net flows if your netting pluses and minuses came outside the U.S. and our global emerging markets Europe and EAFE strategies, and we were pretty net roughly zero flow in our U.S. strategies.

If you look at it by the domicile of our clients, the biggest growth for us has been in Europe. In fact I would say most of the growth for us has been in Europe. We have, really we have very little business in Asia. If you look at where our business is, it's you have Canada, Europe the Middle East and Australia and almost nothing from Asia. So Asia for us is a strategic imperative in the future but at this point we don’t really have any business in Asia.

John Dunn - Fidelity Brokerage Services LLC

Right, thank you.


Your next question comes from the line of Marc Irizarry of Goldman Sachs.

Marc Irizarry - Goldman Sachs

Great, thanks. Rich just wanted to ask a question on your comments around the business and re-risking and performance coming back. I am curious when you think about sort of rolling out of the '08 numbers just broadly speaking, how much has really changed in the way your clients are thinking about risk, you mentioned low val alternatives. How much can be sort of rolling off the 08 numbers, be a real sort of go-forward marketing opportunity for you guys versus just how much has really changed in the industry in terms of allocating?

Richard S. Pzena

I think a little of both of those is true. The dialogue, I don’t believe that the investment community has abandoned its views on risk. But I do believe it's way more balanced than it was even a year ago. Today the dialogue really does center around I can’t achieve my objectives if I don’t take any risk, that is really the debate. And so obviously with the expected returns in the fixed income market being so low, and clearly an inability to meet spending objectives some -- you’ve really felt that shift.

I also think and while I don't think that there is any evidence that allocations to alternatives are waning I would tell you that interest in equity is increasing. And then I would add to that a mix shift that most people would say is reasonably obvious, which is that’s a traditional defined benefit plan, which for the last 25 years we’ve been talking about becoming obsolete and being replaced by defined contribution is just now starting to have declines in the asset base because the retirees in these closed plans are dying and so the assets are actually starting to decline.

So much more of the action for firms like us has shifted into the retail world, which is why we’ve been successful in signing these sub-advisory relationships. One because there is very strong demand and two because having our kind of profile which is more higher tracking error, higher conviction, concentrated fits very nicely into multi manager programs that are being created by these institutions. And the institutions I’ll tell you have become far, far more sophisticated in constructing their own portfolios.

So for us calling on an ABN Amro today is no different than it was to call 10 years ago on a sophisticated defined benefit pension plan in the U.S. it’s a very similar sales process. And so it falls into what we think is our expertise on the sales side.

Now after that the record improvement and while ’07 and ’08 are still in our record you don’t get high from that we addressed it squarely and up-frontally in all of our conversations, it’s not something that we hide from. And the dialog is very different. Two years ago people were focusing on ’08 that was the criteria in how did you do in ’08?

Today we bring up ’08 and the response we get, shocking to me, oh don’t worry about that, everybody did badly in ’08. And so that's I would think a fairly big mentality change that’s going on. That just allows us to get in the door. Now getting in the door doesn’t guarantee success like it did when we had the same record in the mid 2000 because there is still sensitivity to volatility. And I’ll tell you that now when we lose in the final competition for selecting a manager more often than not we hear it’s because of volatility, which still is an issue for us, but a much better issue than we had four years ago which is we’re not even putting you in the final.

And so it’s a little bit more encouraging. Obviously the record, the fact that we have been able to get our five year records now back to the pre ’06 five year level so that you would look at us and say if wasn’t ’07, ’08 they would have this spectacular long-term record and it’s just a discussion of ’07, ’08 and have we done anything in our process to reassure a potential client that the likelihood of a repeat of that for us is reduced and we believe we are obviously making efforts to do that.

Marc Irizarry - Goldman Sachs

Great, thanks. Thanks appreciate the comprehensive answer.

Richard S. Pzena



You have a follow up question from the line of Ken Worthington of JPMorgan.

Ken Worthington – JPMorgan

Hi, thank you. Just in terms of expenses how should we think about 2014, maybe talk about the need for investment or plans for investment and maybe some of the costs associated with them. And then given the success that we are seeing on the performance side, the markets been good, have the gathering teams to be perking up, how should we think about how that success flows through compensation?

Richard S. Pzena

Yeah, again compensation for us is a function of the competitive marketplace that we find ourselves in and so we don't think about a percentage of revenues going to compensation. We more think about, we want to make sure we pay our people in a competitive and for the good people top quartile of what competitors are paying for similar positions.

Now that doesn’t mean that, that goes up in good markets and so we think that, there will be call it inflation in comparable pay, that’s probably 5% or more for 2014 that’s what we planned. We plan to increase fast to take advantage of some of these opportunities. So we will for sure be investing additional resources in sales and marketing and as we have success we are already running our back office as pretty much at capacity.

So there will be modest expansion in operations in legal and compliance and pretty much all of the back office. The key thing to know though is that the investment team is pretty solid and not in need of expansion and that’s where most of the highest priced employees reside. So we will use the opportunity to maybe add a person or two in research but it will be sort of for luxury purposes rather than for necessity purposes and it would be to be filling in at the lower-end of the comp scale, not at the high-end where we are more than adequately staffed. Does that help?

Ken Worthington - JPMorgan

Helps a lot. Thank you very much.


This ends today’s question-and-answer session. I would like to hand the call back over to Mr. Gary Bachman, Chief Financial Officer for closing remarks.

Gary J. Bachman

Great, thank you operator and thank you for everyone for joining us today on the call.


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

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