Pzena Investment Management CEO Discusses Q3 2010 Results – Earnings Call Transcript

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 |  About: Pzena Investment Management, Inc. (PZN)
by: SA Transcripts

Pzena Investment Management, Inc. (NYSE:PZN)

Q3 2010 Earnings Call

October 28, 2010; 10:00 am ET

Management

Greg Martin -- Chief Financial Officer

Rich Pzena -- Chief Executive Officer & Co-Chief Investment Officer

Analysts

Alex Blostein – Goldman Sachs

Larry Hedden – KBW

Ken Worthington – JPMorgan

Operator

Good morning. My name is Ginger 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 remark, there will be a question-and-answer session. (Operator Instructions) Thank you. Mr. Greg Martin, Chief Financial Officer. Sir, you may begin your conference.

Greg Martin

Ginger, thank you very much. Good morning, I’m Greg Martin, Chief Financial Officer of Pzena Investment Management. And I’d like to take this opportunity to welcome you all and thank you for joining us on our third quarter 2010 earnings conference call. With me on the call is our Chief Executive Officer and Co-Chief Investment Officer, Rich Pzena.

Our earnings press release contains the financial tables for the periods to be discussed. If you don’t have a copy, it can be obtained in our website at www.pzena.com in the Investor Relations section. Replay of this call will be available for the next week on our website.

Before we begin, I would like to reference the standard legal disclaimer. Statements made in the presentation today may contain forward-looking information about management 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 SECs website www.sec.gov. Investors are cautioned not to place undue reliance on forward-looking statements, which speaks only as the date on which these 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 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 non-public information, we will not be able to respond to it.

Thank you. For the third quarter of 2010, we reported revenues of $18.5 million, operating income of $9.3 million, non-GAAP diluted net income of $5.2 million and non-GAAP diluted net income per share of $0.08. We also declared a quarterly dividend of$0.03 per share. At quarter end, our total cash was 26.8 million and we are debt free.

I’ll review our financial results in greater detail in a few minutes. First, I’d like to turn the call over to Rich Pzena, who will discuss our view of the investing environment and how we’re positioned relative to it.

Rich Pzena

Thanks, Greg. We experienced an entire year in the third quarter as sentiments swung wildly from peer of a double-dip recession to cautious optimism propelling markets to double digit gains. The MSCI world index was up 13.8% in the quarter with most of that earned in September. Despite the gains, we are still finding good values in high quality companies in a range of industries.

I will touch on our investment outlook a bit more in a minute, but first I want to update you on our business. I am very happy to report that as of today the trailing three-year returns for many of our investment strategies are now in positive territory relative to their respective benchmarks and the others are rapidly approaching parity. We are hopeful that as the significant underperformance we experienced in the fourth quarter of 2007 rolls off by year end, these records will look even better.

The business implications of this improvement are clear. Managers trailing three-year relative returns are weighed heavily by consultants in their manager selection process along with the managers’ long-term track record. Although, our long-term track record has been excellent, our US value and small cap value products have nearly 15 years of history and have generated 270 and 450 basis points of extra return for annum since inception.

We have been living with the challenged three-year record due to the underperformance we experienced during the financial crisis in the last half of 2007 and the first half of 2008. We are already beginning to see signs that the passage of time has begun to heal some of the wounds in that underperformance. Search activity which bottomed in the middle of 2009 and had shown signs of improvement early this year until the mid year market collection cooled things off had begun to tick back up again.

Our trailing 12-month new search activity is at the highest level since 2008, albeit, significantly below the peak level of prior years. We attribute the improvement to one, our improving performance; two, a flicker of institutional interest in equities and three, relatively strong demand for global and emerging market strategies. Searches entered into over the last six to 12 months are now bearing fruit. Gross institutional inflows during the quarter were $628 million up from the prior two quarters.

Although there is lumpiness to institutional flows, some moderating of the outflows has occurred as well. As a percentage of beginning of period AUM, institutional outflows are back to pre-financial crisis levels. Based on the tick up in search activity and normalization of institutional outflows, we are hopeful that subject to the usual quarter-to-quarter lumpiness we will see positive net institutional flows in the future.

We have expanded our sales force, first by adding a dedicated sales client service individual in Australia earlier this year. We also recently named a Director of North American Business Development and are in the process of searching for another dedicated client professional, which will help beef up our coverage in Europe and the Middle East. In addition, we added two analysts this quarter bringing our investment team up to 24 strong as, we successfully launched our emerging market strategy with our initial institutional client.

Now, let’s take a moment to discuss the investing environment. Investors’ obsession with all things macro continue to drive equity markets during the quarter. In July, markets recovered from the jitters associated with the European debt crisis only to run into concerns about a double-dip recession in August. Ironically, some of the European data releases for August were much less down deep than was feared including Euro region second quarter GDP, German exports and industrial production. By early September, however, these fears began to lift as data releases came in somewhat better than the gloomier fears engendered earlier moving the MSCI World Index and the S&P 500 up 13.8% and 11.2% respectively during the quarter.

With their attention on macro, industries are overlooking the fact that despite near-term economic uncertainties, company results are extraordinarily strong. Managements around the world reacted quickly and almost in unison to the economic downturn and corporate margins with the exception of the financial services and energy sectors have in many cases been restored to pre-recession levels primarily through cost cutting.

Even financial companies are showing signs that credit loses have peaked and some of the major US, European and Asian banks have posted lower impairment provisions and reserve recoveries in the latest round of reporting.

The expected return of equities versus bonds present a picture of significant opportunity for equities broadly, as well as for a deep value portfolio. Our expected return in many global markets are double digit versus risk-free rates below 3% based in part on the assumption that companies will continue to maintain profitability at long-term norms despite an environment of depressed revenue growth. These trends are exceedingly attractive and per our analysis a deep value portfolio offers expected returns in excess of market returns.

So as investors continue to seek out safer investment alternatives with low single-digit expected returns, we find ourselves with a rare opportunity, quality companies with strong balance sheets and solid performance are available at substantial discounts. As a result, our portfolios continue to be among the cheapest in our history, yet contain a wide variety of high-quality businesses with leading global franchises.

I would now like to turn the discussion back over to Greg Martin, who will review our third quarter results in more detail.

Greg Martin

Thank you, Rich. I would like to start out by discussing our assets under management or AUM, our fee rates and revenues. Our total AUM during the third quarter of 2010 increased 9.2% from the second quarter of 2010 to $14.3 billion. This $1.2 billion increase was primarily attributable to $1.5 billion in market appreciation offset by some small net outflows. At December 30, 2010, the company’s $14.3 billion in AUM consisted of $11.3 billion in institutional accounts and $3.0 billion in retail accounts.

During the third quarter of 2010, assets in institutional accounts grew 13.1% due primarily to market appreciation and some small net inflows. Retail assets decreased 3.2% due mainly to net outflows partially offset by market appreciation. Our third quarter 2010 revenues were $18.5 million, slightly down from last quarter and up 10.1% from last year. The year-over-year increase in revenues was due to an increase in average AUM partially offset by a decline in weighted average fee rates.

Average AUM was $13.6 billion for the third quarter of 2010, down 6.2% from last quarter and up 11.5% from last year. Our weighted average fee rate was 54.4 basis points in the third quarter of 2010, up from 53.3 basis points last quarter and down from 55.0 basis point last year. The sequential increase was mainly due to the timing of asset flows in our retail accounts and the full quarter effect of the exploration of the temporary voluntary partial fee waiver on the John Hancock Classic Value Fund, which ended in May.

As noted before, the year-over-year decrease was due in part to the large institutional inflows in our newly launched EAFE Diversified Value and Global Diversified Value strategies that occurred at the end of 2009.

Again, we typically offer reduced fee rates to initial clients on our new product offerings. The year-over-year weighted average fee rate also decreased in part due to increase in the average size of the company’s institutional accounts. The company’s tiered fee schedules typically charge lower rates as account size increases.

Institutional accounts comprise 77.2% of total assets under management as of September 30, 2010, increasing from 76.3% as of June 30, 2010 and from 73.4% as of September 30, 2009.

The weighted average fee rate for institutional accounts was 58.9 basis points for the third quarter of 2010, remaining about equal to the weighted average fee rate for the second quarter of 2010 and declining from 63.0 basis points last year. The year-over-year decline in the institutional weighted average fee rate arose as a result of the institutional inflows and our EAFE Diversified Value and Global Diversified Value strategies and higher institutional average account size mentioned early.

The weighted average fee rate for retail accounts increased to 38.9 basis points for the third quarter of 2010 from 37.1 basis point last quarter and from 34.6 basis point last year. The sequential and year-over-year increases were due to the timing of asset flows in our retail accounts and the expiration of the temporary fee waiver on the John Hancock Classic Value Fund discussed earlier.

Now, let’s look at the remainder of the P&L. Our third quarter compensation expense was $7.4 million, up slightly from last quarter and up 19.4% from the third quarter of 2009. The year-over-year increase in compensation expense was driven primarily by increases in our employee headcount and discretionary bonus accruals.

General and administrative expenses were $1.8 million for the third quarter of 2010, down 18.2% from last quarter and remaining relatively flat from last year. The sequential decrease in general and administrative expenses arose primarily as a result of somewhat higher travel expenses last quarter.

Operating margins were 50.3% for the third quarter of 2010, 51.5% last quarter and 51.8% for the third quarter of 2009. Our non-GAAP income statement adjusts for certain valuation allowance and tax receivable agreement items. I will briefly discuss the adjustments at the conclusion of the financial discussion. I will focus my remaining remarks on the non-GAAP information.

Other income expense, net of outside interests was income of $0.3 million for the third quarter of 2010 and consisted primarily of net realized and unrealized gains from investments as well as interests and dividend income. Other income expense net of outside interest was an expense of $0.6 million last quarter and income of $1.2 million in the third quarter of last year. The sequential increase was primarily attributable to better performance of our investments compared to last quarter.

The year-over-year decrease in other income arose in part due to the fact that we had fewer firm assets and investments as well as slightly lower performance. This was partially offset by the decrease in interest expense associated with retirement of our debt. The effective rate for our unincorporated business taxes was 5.7% for the third quarter of 2010, 6.6% last quarter and 5.2% for last year. The fluctuations in these effective tax rates are driven by certain expenses that are permanently nondeductible for UBT purposes. This rate varies from period-to-period, but should generally be between 5% and 7% on an ongoing basis.

The allocations to the non-public members of our operating company represented 85.4% of the operating company’s net income for the third quarter and second quarter of 2010. This allocation was approximately 86.5% of the operating company’s net income for the third quarter of 2009. The variance in the allocation percentages is the result of changes in the ownership interest of the public entity in the operating company.

The effective tax rate for our corporate income taxes not including UBT was 42.7% for the third quarter and second quarter of 2010, as well as the third quarter of 2009. We generally anticipate our corporate effective tax rate to be between 42% and 43% in the future. As a result of the foregoing, we reported $0.08 of basic and diluted non-GAAP net income per share for the third quarter of 2010.

Now, I would like to briefly walk through the valuation allowance and tax receivable adjustments, the net effect of which comprises the difference between our non-GAAP and GAAP results.

For the third quarter of 2010, the company recognized a $2.2 million decrease in its valuation allowance and a $1.7 million increase in its liability to selling and converting shareholders, due to revised estimates of future taxable income.

We would expect on a quarterly basis to record adjustments to the valuation allowance and our liability to our selling and converting shareholders as we extend our projections out in future quarters. The ultimate amount of these adjustments will depend on our estimates of the 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 tax receivable agreement amount I just discussed, we reported $0.13 of GAAP basic and diluted net income per share for the third quarter of 2010. And now, we would be happy to take any questions.

Question-and-Answer Session

Operator

(Operator Instructions) Okay, your first question comes from the line of Alex Blostein from Goldman Sachs.

Alex Blostein – Goldman Sachs

Hi, good morning guys.

Rich Pzena

Good morning.

Greg Martin

Good morning

Alex Blostein – Goldman Sachs

Rich, first question on the institutional pipeline you talked about a flicker of interest from institutional investors, I guess into equities. Can you just give a little more color on what type of institutions are you guys seeing a pickup in interest from and then with respect to your own pipeline, how it looks today versus let’s say a quarter ago?

Rich Pzena

Yeah, when I say flicker, it really is a flicker. I would tell you that what’s going on is really almost instantaneous reaction to where the market is going. So, when we were sitting here in the middle of 2009 after a pretty depressing period, almost every institutional conversation was volatility reduction, reallocations towards fixed income and equity strategies being hedged rather than long on life.

Then we started to -- when the market rebounded in ’09, we started to see that moderate, meaning not boom but going back to kind of a little bit more willingness to talk about equities. Then that disappeared again in the summer this year with the markets decline and now it’s reemerged. So I can’t tell you that. We track monthly search activity, which is a new search activity, which is a highly, highly volatile number. So we look at it over a trailing period of time.

So if I wanted to tell you where is the trailing 12-month number today versus where the trailing 12-month number was a quarter ago, it’s up but it’s not up more than single digit, less than 10%. So this is a flicker, and it’s, I can’t tell you that it’s specific on type of institutional account. It tends to be more focused on non-US investment strategies and non-US clients, but there is no type of client that I would say is more likely to be suddenly appearing on the list [Inaudible] be able to flavor.

Alex Blostein – Goldman Sachs

Yeah, certainly. And then with respect to the current quarter, it looks like retail outflows picked up a little bit, it might be just a reflection of the industry, summer was a pretty tough month frankly than what was in general, but any specific big outflows that could have been maybe one time, that’s other than just the environment, and on a flipside a pick-up in gross sales and institutional, is there any relative size from any sort of mandates coming into, maybe a little big bigger than your standard?

Rich Pzena

On the gross, on the retail side, there was a little bit of distortion, because one of the big holders of the fund reallocated the way that they held their accounts in the fund. So there was an equal inflow and outflow number, which grossed up the outflows, and maybe outflows look bigger this quarter than last quarter, which they really weren’t.

The real issue is that the inflows are still quite low and the inflows are low because of the conditions in retail that you mentioned, which is that institutional flow -- I mean retail flows to equity, funds are not good and retail flows to the US equity funds are even worse and then retail flows to funds that have a two-star Morningstar rating which we do or even worse than that. So, we see mostly more so a decline in inflows than a pick-up in outflows even though it seems to be reported a little differently than that.

Alex Blostein – Goldman Sachs

Got you, thanks for the color. And then a couple of just numbers questions, the quarter Greg. If I look at G&A, I guess this quarter over last quarter, you mentioned last quarter had a little bit of a pick-up in traveling expense, but given the fact that you expanded your distribution a little bit and hired a few more people and presumably institutional activity picks up a little bit more so from here on, should we think about that line item in general kind of creeping up a little bit over the next couple of quarters or do you think 1.8, 1.9 kind of like a good run rate?

Greg Martin

I would expect, the problem with the travel expense is that they come in half hazardously, so I think we experienced quite a bit of travel in the second quarter, and a little bit less than the third quarter, but over the course of the year I would expect the one-point number to pick up slightly as flatten now, the effect of the lumpiness of our G&A reporting.

Alex Blostein – Goldman Sachs

Got you, alright. Thanks guys.

Operator

And your next question is from Larry Hedden from KBW.

Larry Hedden – KBW

Good morning.

Greg Martin

Good morning.

Rich Pzena

Good morning.

Larry Hedden – KBW

Could you comment on the composition of flows in the quarter in terms of product or and client side?

Rich Pzena

Yeah, here with me and so I can put the number right in front of me. The biggest flows in the quarter were in global value, I am talking about institutional flows right now, which had more than a 100% of the net flows. And the outflows that offset that were basically US equities. So we had some slightly net positives on the inflow side, slightly on the global side, slightly net outflows on the US side. And when you say by type of quant end, are you talking about, you mean pension versus endowment or did you have some other?

Larry Hedden – KBW

Yes, I mean it’s really any sort of additional color that you can give outside of retail institutional?

Rich Pzena

Yes, I guess I would say we had probably more net flows from existing clients this quarter than new client. So there were a lot of flows from clients that we’ve done business with for many, many years who have either reallocated more to us or experienced positive flows in their own business and allocated some to us.

I don’t know that there is anything more than that I could say. It wasn’t one big lumpy client, it was actually quite a few number of inflows this quarter that were more, as I said more existing clients, but we had some new clients. There is nothing that particularly stands out other than that the activity seems to have picked up in line with the pick-up in search activity and the relationship between the search activity and the flows, then that the gross inflows seems kind of the way it where it’s been for the last couple of years.

Larry Hedden – KBW

Okay, that’s helpful. You mentioned that you funded a large client for the emerging market strategy. Is that something that hit in the quarter or is that going to fund in the next quarter, and can you size?

Rich Pzena

It funded in the fourth quarter of $50 million.

Larry Hedden – KBW

Okay, great. Could you comment on, I don’t know, the discussions that you are having and feedback that you are giving from consultants and some of your clients at this point, just in terms of, I don’t know, the environment, the improvements and relative performance or just the demand for other types of product?

Rich Pzena

Yes, I guess I would say that you don’t precisely get into discussions about the improvement and performance. What tends to happen is you get off the negative watch lists that you are on with clients and consultants, because you’ve had some tough period of bad performance and so the discussions of why we did so poorly in ‘07 and ‘08 don’t tap in all that much anymore, mostly that’s history.

I would say that there the topic of volatility, quality and risk reduction and macro are the primary topics of conversation. So we have a pretty intensive discussion about what it is that we do to exploit the volatilities in the marketplace, and not get ourselves overly exposed from a risk standpoint, but without trying to shy away from taking the investments that devalue managers really like to take.

And I think that those conversations have been very productive. They demonstrate to our clients and consultants that philosophically we are remaining a deep value investor. And we get into a great deal of conversation about the benefits of volatility versus the cost, so they are very interesting. We try to point out that volatility in and of itself is not an objective to be reduced.

And a year ago, you couldn’t have had those conversations because the only thing that people were interested in doing was reducing volatility. So from a product standpoint, there is a great deal of interest in emerging markets, and having a value offering in emerging markets sets us up slightly differently than most of the emerging market offerings out there. We had lots and lots of compelling evidence, why emerging market is effective, using a value strategy, getting a launch client was big.

And so now we can, I’ll call it roll it out, still a long process, doesn’t mean it’s going to be instantaneous flows. But having that first client makes a big, big difference and so we are actually out actively promoting that amongst our clients. I don’t know, did I give you some flavor?

Larry Hedden – KBW

Yes, it was very helpful. And that does answer my questions. Thank you.

Rich Pzena

Okay.

Greg Martin

Are there any further questions?

Operator

Yes and your next question is from Ken Worthington from JPMorgan.

Ken Worthington – JPMorgan

Hi, good morning. Just turning back to margins, maybe on the compensation side first, can you talk about the competitive landscape for a pay and what that means for compensation, looking forward? And then based on the non-comp side, based on the improving three-year numbers, are you going to ramp up marketing around those numbers and if so, can you talk about timing and magnitude of the ramp?

Rich Pzena

Yes, compensation, we focus on one survey data that we get from third party consultants on compensation. It’s a little bit behind the times. So we just in the summer get competitive data on 2009 compensation, and broadly speaking in the investment side of things. Compensation in 2009 was below 2008, so pressures are downward. In 2010, our guess, and this is a guess, just through the pipeline is that it’s another year of negative compensation pressure on an individual position-by-position basis.

Although we are planning more like flat rather than down, 2011 it’s guessing at this point in time, probably guessing that we will probably be flat to slightly up. But they are still, the bottom line is there is not a lot of wage pressure. We fear there might be some going into this year and we don’t feel like that’s happened.

As far as marketing, ramping up marketing, yes, we are adding staff. As you know, we opened an office, a representative office in Australia, which adds a little bit of expense that’s been in our numbers already. And we are looking to add staff in distribution as well. Now most of distribution expenses are variable, because they are tied to the flows of assets, but there are some fixed costs.

So I would tell you that over the course, more likely into the first part of 2011 than any real big ramp up in the end of 2010, you will see modest numbers, but we’re talking, we’re not talking about millions of dollars, we are talking about hundreds of thousands of dollars.

Ken Worthington – JPMorgan

Okay, thank you. And then on the launch client for the emerging market product, are the sales from that launch client already incorporated into numbers that we’ve seen or are those sales yet to be reported and recorded?

Rich Pzena

They are yet to be reported and recorded. So there’s been no revenue yet and nothing in the AUM either.

Ken Worthington – JPMorgan

Okay. How big is the size of the commitment from the launch client, I don’t know if that’s something you can share or not but?

Rich Pzena

$50 million.

Ken Worthington – JPMorgan

Okay. Great, thank you very much.

Rich Pzena

You’re welcome.

Operator

And at this time, there are no further questions

Greg Martin

Okay. Thank you all for joining us in today’s call.

Operator

Ladies and gentlemen, thank you for participating in today’s conference call. At this time, you may now disconnect.

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Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

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