I wrote up Pzena Investment Management (PZN) a couple of months ago where I forecasted at least a 47% upside move in the shares. The shares recently hit that target in less than four months as investors realized how undervalued the shares traded. Today, while the low-hanging fruit of that undervaluation has largely been picked, the company is still not being priced for any future growth in AUM.
The company reported full-year 2013 revenues of $95.8 million, up from $76.3 million the year before, for growth of 25.5%. Fourth-quarter revenue of $28.7 million rose 19.6% from $24 million in the sequential quarter and 49% from the year-ago period. Any way you slice it, they are growing gangbusters right now.
Underlying AUM rose to $25.0 billion, up from $22.3 billion in the sequential quarter and $17.1 billion a year earlier. Institutional accounts and retail accounts grew in similar fashion. (see chart below).
Average AUM for the fourth quarter of 2013 was $23.8 billion, an increase of 11.2% from $21.4 billion for the sequential and an increase of 41.7% from $16.8 billion for the fourth quarter of 2012. The increase was mainly from market appreciation and a small amount of inflows.
Profitability rose sharply just as my thesis stated it would. 2013 diluted net income rose 45.6% with diluted EPS jumping to $0.45 from $0.32, an increase of 40.6%. Quarterly operating margins are now approaching 60% compared to 49% in the fourth quarter a year ago.
The weighted average fee rate for institutional accounts were 0.627% for the fourth quarter, increasing from 0.577% for the third quarter and 0.569% in the year ago period. The increase in fee rate was primarily due to performance fees recognized during the fourth quarter and the addition of assets in their Emerging Markets Focused Value product that carries a higher fee rate. Fee rates for retail accounts were 0.254% for the fourth quarter, increasing from 0.245% for the third quarter of 2013 and 0.248% in the year ago quarter. In aggregate, the weighted average fee rate was 0.484% for the quarter, up from 0.45% in the third and 0.461% a year ago.
The company continues to buy back shares repurchasing and retiring 29,145 shares for $0.2 million, but they continue to be dilutive to current shareholders thanks to stock-based compensation. Total outstanding class A shares rose to 12.16 million from 11.2 million a year ago.
The firm paid out a year-end dividend of $0.26 per share, in line with their target cash dividend ratio of 70% to 80% of non-GAAP net income. The company pays out approximately 80% of its earnings in the form of a special year-end dividend and then uses the other roughly 20% to buy back shares to offset the issuance from the stock compensation program.
Performance for the PZN family of investment vehicles remains stellar with their US strategies rising between 41% to 44% compared to the Russell 2000 which rose 38% and the S&P 500's 32.4% return. The global developed and international strategies rose from 34% to 40% compared to the MSCI EAFE which rose 22.78%. Lastly, their EM product rose 10% compared to the MSCI EM which declined 2.6%.
As Pzena noted in the most recent conference call:
Compared with the standard benchmarks for each strategy, our performance in 2013 generated from approximately 750 to 1350 basis point of excess returns. After a period of such strong performance for us and for the market, the next question is always the same: is it over? And for us specifically, is the value cycle over?
The performance rebound in 2013 should draw meaningful fund flow going into 2014. Last year's performance was the company's best in nearly 10 years, on both an absolute and relative basis. With a larger sales team, they should be out pushing their products hard this year driving in fund flows.
The Call and Letter
For those who are not familiar with Richard Pzena, or his company, you are missing out on a great resource. In the conference call, Pzena commented that he believes we are in the middle of the value cycle with an average duration peak-to-peak of nearly 10 years.
In summary form, we would describe the cycles as follows: first, some sector or thematic problem dominates the market, creating significant valuation discounts. It then takes years for the companies in those sectors to address their problems. And then, it takes the market additional years to fully acknowledge the adjustments made by the companies and revalue the shares.
The current cycle is exhibiting almost identical patterns that we find in each of the prior value cycles. Consider the last value cycle connected to the Internet bubble. Value stocks had peaked by the end of 1995 and in the fourth quarter of 1997, as the market was entering the infatuation stage with tech, media, and telecom, many western industrial cyclical businesses were beset with the collapse of Asian currencies, leading to the perception that western manufacturing could never again compete on the world stage.
In the letter, he hits on the often discussed debate in equity circles today about record profit margins and whether equities are attractive given those margin levels. He counters the margin mean reversion argument by stating that ROEs are only at average levels. He notes:
Since net margins are equal to profit divided by sales, and ROE is equal to profit divided by capital, one would conclude that capital intensity (capital divided by sales) has increased. Put another way,
ROE = Net Margin x Capital Intensity
The evidence of greater capital intensity is clear. As economies mature, capital substitutes for labor and the share of GDP that is taken up by capital rises. We can see this in Figure 2 using U.S. data as an example.
He then notes that since capital is invested with the expectation of earning an adequate return, [he] would expect that margins would have to be higher on average to earn the same return than if the capital wasn't invested. He noted that financials still appear cheap along with healthcare, energy, and utilities, where today's profitability is lower than what history would suggest.
In financials, while the hype has been around higher regulatory and capital requirements for banks lowering returns on equity he counters that banks will simply shift their business model accordingly. In other words, banks will adjust their fees, global fixed income trading volumes, while figuring out how to lower costs in order to widen net interest margins. This isn't the first time banks have faced a new paradigm to operate within and it won't be the last. With consolidation and some banks exiting specific areas of the industry, Pzena believes that the industry will regain some pricing power boosting revenues and ROEs.
They are also finding value in what they call "old, cheap technology" due to the fact that investors and analysts have been overly focused on "disruptive technology" while ignoring the old guard. This has led many to shun old technology companies that still have a strong underlying franchise creating a valuation distortion.
Strong Sub-Advised Relationships
The distribution effort for Pzena has ticked up and will likely lead to stronger future flows for their investment vehicles. These assets tend to be stickier than institutional assets - although they carry a lower average fee rate. With fund flows into equity mutual funds going positive last year and accelerating throughout the back half of 2013, coupled with Pzena's strong performance giving the firm added credibility, the retail investor has reengaged to their products.
The company now sub-advises four mutual funds: John Hancock Classic Value, Vanguard Emerging Markets Select, Vanguard Windsor, and Vanguard US Fundamental Value. They were also recently chosen to manage the Pzena Europe Fund for ABN Amro. The fund is up and running and generating a small amount of sales. This may be just the first of many new funds within the relationship with ABN Amro with possible expansion to include several other Pzena products. Management has stated they remain in active dialogue with other potential sub-advised relationships.
The John Hancock fund, which they've managed since 2002, saw a massive drawdown in 2008 to which it has struggled to regain credibility with investors. Asset flows have turned positive in 2013 with market appreciation helping the fund climb to $2.9 billion in assets.
Meanwhile, since coming to the helm of the Vanguard Windsor fund in August 2012, it has turned fund flows around. If that continues, expect to see modest fund flows into the Windsor fund and beneficial performance fees return. Their other Vanguard relationships have also been in asset gathering mode albeit at a slow pace.
Future Growth Opportunities
One of the best things that has developed over the last several years is the migration of hedge fund strategies and mirrors into the '40 Act mutual fund format. Every month there are several product launches that bring more selection in the space. In the call, Pzena stated that they are still finding valuations and added this:
I will summarize our perspective as we begin 2014. We are still finding attractive valuations. Period. On the business side, 2013 was an exciting year for the firm and we're cautiously optimistic for 2014. A particular note, we're excited to announce that we filed a preliminary prospectus with the SEC to offer our emerging markets focused value, mid-cap focused value, long short value strategies in mutual fund format which we hope will be available during the second quarter of 2014.
1940 Act mutual fund vehicles that replicate great track records of hedge funds have had mixed results, usually due to leverage differences (the SEC still won't allow leveraged L/S equity as it's restricted by section 18f of the Investment Company Act of 1940). However, they have been great asset gatherers as investors and advisers alike prefer to use them over their LP brethren. For one, the mutual funds have daily liquidity and do not require a one year lock-up. Secondly, fees are known in advance as performance fees are also restricted. While fees are typically higher than traditional mutual funds, especially within the long/short strategy, they are usually lower than being in the LP.
A well-known value manager like Pzena launching a '40 Act fund is big news as most of the high-profile players have ignored the development given the increased regulations and scrutiny from the SEC. His funds are likely to draw significant assets over the next few years, especially if they are allowed to present RIAs and broker/dealers historical performance based on the LP.
This is a medium-term payoff (two to five years) as there can be substantial costs associated with the filing, compliance, custody fees, administration fees, but this will eventually pay off handsomely for the firm. The move will also bring added diversification to its distribution structure which is key to protecting revenues during downturns.
Meanwhile, their managed separate accounts business is seeing improving trends after seeing net redemptions, albeit small flow amounts, over the previous three years primarily due to poor performance during the 2008-2009 market crash. Gross redemptions have moderated to around $500-$600 million per quarter from approximately $750 million while gross sales have increased to $800 million in the third quarter of 2013 and $700 million in the fourth.
The capacity issue has subsided substantially compared to 8 years ago when they closed their core fund, Focused Large Cap Value at just under $20 billion (due to the fact they hold just 40 names in the portfolio). Capacity today is much higher and the company has a diversified product base by which to draw on. For instance, they created a fund called Expanded Value which holds approximately 80 stocks boosting capacity. The only strategy which has capacity issues would be their small cap strategy which has just $300 million left to grow.
As such, they have greatly expanded their sales force to ten, from just three, seven years ago. The current sales cycle should be better than the last with the help of recent strong performance across most of their product lines. The sales force is being aided by the Vanguard and ABN Amro wins with investors paying particular attention to their EM product which had a positive return of 1% last year compared to the benchmark's negative 3.85% return. As this strategy builds a longer track record, it should generate significant positive flows if it maintains that outperformance.
The new sub-adviser relationships have boosted their win rate in the institutional segment to approximately one-third, up from about zero a few years ago. This has been due primarily to the high volatility of their funds as institutional investors have opted for lower volatility investment strategies since the financial crisis. Some of the company's newer products contain those characteristics sought after by pension and endowment funds.
These new products are a couple of years away from containing the three-year track record typically sought by institutional and retail investors. However, the first year-plus of performance has been very strong, especially in their long/short product, a new alternative, hedge fund-like, strategy. As I mentioned above, these hedge fund replication strategies that have become in vogue for their lower volatility have been drawing significant assets since 2008.
In my prior write-up, I noted that there was the possibility of AUM approaching $30B sometime in the first half of 2014. That seems more and more likely. However, the new story is the possibility that margins approach 60% over the coming quarters. In my previous model, I used a 50% operating margin on $30B of AUM, along with a blended fee rate of 0.45%. I was very close on the fee rate and AUM but margins in the fourth quarter were 59.8%. As I noted above, there will likely be some near-term margin pressure from the new product launches and '40 Act fund introduction but that should be both minimal and transitory.
Below is my new end-of-year 2014 matrix model for EPS:
Remember, the fourth quarter operating margin came in just below 60% although it was enhanced by performance fees. I think a 55% run rate is more in line with a near-term forward looking assumption unless we see another year like we did last in terms of market appreciation. It is entirely possible though that operating margins expand out to 60% over the next several years as the leverage available in the operating model is significant. The other variable that bears watching is the fee rate. As the company launches more retail products and adds new sub-advised relationships, it is likely to drive down the blended fee rate, although this would be offset partially by positive flows into the institutional side of the business.
Even at 55%, the current intrinsic value comes in at $13.74, a 27% premium to the last trading price. But as the above matrix shows, it doesn't take much for that value to hit $16-$17. I ran through some back-of-the envelope scenarios. One that I thought likely was market appreciation of 7% in 2014 and 2015, gross flows of $1.4 billion per year, gross redemptions of $350 million per year, and a new sub-adviser relationship worth another $350 million. That would leave AUM at the end of this year at $28.2 billion and next year at $31.5 billion. Using my forward year price targeting methodology, that would equate to an end of year price target of $13 including cash.
But a second scenario that I ran is if we do see another two years of double digit returns - say 15% per annum - with similar flows and relationships. This scenario would leave AUM at $36 billion at the end of 2015. And again, operating margins would still be a key determinant but you would still see an intrinsic value somewhere between $14 (@54% margins) and $17 (@63.5%), a significant premium to the current price.
Pzena is notoriously cost conscious so I do not expect him to succumb to the typical asset manager success story where success brings a large jump in operating expenses. The industry is packed with anecdotes about asset managers who see short-term success and then spend like drunken sailors on new lavish headquarters, decorated with expensive art and office furniture, while hiring gobs of new employees on 'expected future growth', then their luck changes and revenues plummet. As such, I think they contain their operating expenses, continue to buy back shares while also funding expansion into new investment products, expanding operating margins. The big question will be what the market does. Even if Pzena outperforms the market, but the market falls 25%, they will still see a significant drop in AUM, dropping profitability significantly.
The year-end dividend is something we should consider. If the company grows the way it appears it could, we possibly will see as much as a $0.40 special at the end of this year.
Please also note that according to my valuation matrix above, the current price of approximately $10.80 is congruent with an asset base of $25 billion and operating margins of roughly 55%. That is essentially where the company is today and thus, the stock assumes no future growth in the asset base, margins or fee rate.
As I noted above, market risk is the largest single risk factor afflicting Pzena. The company cannot do much about that except to outperform on the downside 'reducing' volatility and having a downside capture of less than 100%. This is something that they didn't do the last time we had a significant market drawdown, and it led to large net redemptions and a loss of some credibility. It subsequently took several years of strong performance for institutional and retail investors to feel comfortable enough to invest with Pzena again.
- Launch of '40 Act Funds under their firm banner likely to draw significant assets
- Very strong performance likely to lead to accelerating gross inflows
- Stout cost containment allowing operating margins to run up to and possibly above 60% in the near term
- Increasing returns to shareholders in the form of special year-end dividends and share buybacks
Pzena is an emerging, high-quality investment manager that has the potential to significantly reward shareholders over the next several years if the markets cooperate. The firm has several upcoming catalysts including a large one in the launch of several Pzena-labeled '40 Act funds in areas where there are assets flowing. The stock offers investors a chance to benefit from this launch, the company's strong cost consciousnesses expanding the operating margins, and the large dividend yield. All that aside, the valuation is compelling as it assumes zero growth in the business from here.