Pzena Investment Management, Inc. (NYSE:PZN)
Q2 2014 Earnings Conference Call
July 23, 2014 10:00 AM ET
Gary Bachman - Chief Financial Officer
Rich Pzena - CEO and Co-Chief Investment Officer
Alex Cagle - JPMorgan
John Dunn - Sidoti & Company
Good day, ladies and gentlemen, and welcome to the Q2 2014 Pzena Investment Management Earnings Conference Call. My name is Tracy and I will be your operator for today. (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 proceed, sir. Thank you.
Thank you, Tracy. Good morning and thank you for joining us on the Pzena Investment Management's second quarter 2014 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 remind you that today's call may contain forward-looking statements and projections. We ask that you refer to our most recent filing with SEC for important factors that could cause actual results to differ materially from today's comments. Please note that we do not undertake to update such information to reflect the impact of circumstances or events going forward. In addition, please be advised that due to prohibition on selected disclosures, we do not as a matter of policy, disclose material that is not public information on our conference calls.
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 $0.13 per share and $8.7 million in non-GAAP diluted net income. Revenues were $27.9 million for the quarter and our operating income was $15.5 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.
Thank you, Gary. Looking at the market so far in 2014, investors turned somewhat cautious starting in late February as tensions emerged in Ukraine. More recently the war between Israel and Hamas, the downed passenger jet over Eastern Ukraine, and the continuing Iranian nuclear negotiations has been unsettling. However, these geopolitical developments have not caused investors to abandon equities. But rather again to seek the perceived safety of defensive companies, their premium valuations notwithstanding. This investor response has perpetuated one of the bigger valuation anomalies in the markets today, namely the spread between low and high beta stocks.
Low beta stocks used to attract a boring label, but today they have acquired something of a quality pizzazz, which seems to give comfort to those paying significant premiums to invest in such companies. The quest for yield in this low interest rate environment has also sent the valuations of higher dividend yielding companies which are perceived as bond proxies to unattractive levels. The lowest beta segment of world market today is dominated by companies in the higher yielding, utility sector and defensive healthcare and consumer Staples. Due to their valuations, these sectors have little representation in our portfolios. On the other hand, the once exciting companies lie unloved in the highest beta segment of the markets which is dominated by financials, energy, consumer cyclicals and technology, all areas that trade at much cheaper valuations than the defensive. These areas are well represented in our various portfolios as we seek to exploit others flight to safety.
Since the last three years have been so good to investors in the developed market equities, we've all been hearing the refrain that a pullback must be coming. Since the 2011 market bottom in the depths of the European financial crisis, the MSCI World Index has advanced 66.8% on a cumulative basis with some of the strongest results in the U.S. where the S&P 500 Index has gained 84.1%. Although, company fundamentals have generally been supportive of an increase in valuation, some investors are concerned that stock prices may have come too far too fast, causing investors to fear downside to stocks and value stocks in particular. Some high flying growth stocks have already suffered.
The poor performance of value stocks in recent market downturn have caused many to be skeptical of values traditional role in protecting principal in down markets. In this context, we've examined the history of value stock performance when market sell-off asking the question, do value stocks protect during market corrections. For this study, we focused on the U.S. as it provides a long history with multiple cycles and allows us to clearly identify recessions and other events. It should be noted that other markets, particularly emerging markets are lagging the U.S. and at a different stage of the cycle today. We examined 54 years of monthly returns in the U.S. going back to 1960, focusing on performance of the S&P 500 Index and value stocks during market declines of 10% or greater which we termed market corrections. The data suggests that there are patterns as to when value stocks outperform and when they underperform during market corrections that are traceable to either excessive valuation, recession or financial crises.
Specifically, there were 14 market corrections since 1960 with value outperforming in nine of those periods and underperforming in five with an average out performance of 1.4%. However, four of the five periods of underperformance can be traced to financial crises. Excluding these periods, value outperformed in 9 of the 10 remaining periods by an average margin of 6.8%. Thus absent a financial crisis, value has done a particularly good job of protecting principal in market downturns. While we don't know what the cause of the next downturn will be for sure, one based on over valuation is likely to demonstrate the efficacy of a value strategy in such an environment.
From a business perspective, activity remained high for the firm during the second quarter. Assets under management ended at $27 billion with approximately $700 million of net inflows. In addition, our new business pipeline remains robust. Our opportunities are occurring in just about every region of the world which is exciting. Further, while the highest concentration of new business prospect continues to be our emerging market strategy, interest in our other strategies has grown as well. Overall, we continue to be optimistic about our prospects for positive flows, but we would continue to remind of the lumpiness of the flows.
Finally, as we previously mentioned, last quarter we launched our first three Pzena branded mutual funds. We've made an offer to an experienced professional to lead our retail efforts and have begun preliminary sales efforts for the funds. 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 AUM was $26.3 billion during the quarter, up 6.5% from last quarter and up 30.8% from the second quarter of last year. As Rich mentioned, our assets under management ended the quarter at $27 billion, up 6.3% from $25.4 billion last quarter and up 33% from the end of second quarter of last year which ended at $20.3 billion. The $1.6 billion increase from last quarter was due to a $0.9 billion in market appreciation and $0.7 billion in net inflows. The $6.7 billion increase from the second quarter of last year was driven by $5.1 billion in market appreciation and $1.6 billion in net inflows.
At June 30, 2014, our AUM consisted of $15.1 billion in institutional accounts and $11.9 billion in retail accounts. Assets in institutional accounts decreased $0.1 billion from the end of last quarter due to $0.5 billion in net outflows partially offset by $0.4 billion in market appreciation. Compared to the last quarter, retail assets were up $1.7 billion from the end of the quarter due to $1.2 billion in net inflows and $0.5 billion in market appreciation.
Revenues were $27.9 million for the second quarter of 2014, up 5.8% from last quarter and up 26.3% from the second quarter of last year. The increase from last quarter was primarily due to an increase in average assets during the second quarter of 2014.
Our weighted average fee rate was 42.5 basis points for the second quarter of 2014 compared to 42.7 basis points last quarter and 44.1 basis points for the second quarter of last year. Our weighted average fee rate for institutional accounts was 54.2 basis points for the second quarter of 2014, flat compared to last quarter but down from 55.6 basis points from the second quarter of last year. The decrease from the second quarter of last year reflects a shift in mix towards our expanded value products and larger relationships which generally carry lower fees.
Our weighted average fee rate for retail accounts was 26.7 basis points for the second quarter of 2014 compared to 25.1 basis points last quarter and 25.3 basis points for the second quarter of last year. The increase from last quarter and the second quarter of last year primarily reflects the addition of assets in our non- U.S. strategies which generally carry higher fee rates.
Our non-GAAP income statement adjusts for the recurring deferred tax, 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 $9.9 million for the quarter, down 1.5% from last quarter and up 11.1% from the second quarter of last year. The variance from last quarter reflects certain annual tax payments made during the last quarter. The increase from the second quarter of last year primarily reflects increase in salary, headcount and the discretionary bonus accrual.
G&A expenses were $2.5 million for the second quarter of 2014, up approximately $0.2 million from last quarter and $0.6 million from the second quarter of last year.
The operating margin was 55.6% this quarter compared to 53.1% last quarter and 50.9% in the second quarter of last year. Net of outside interest other income expense was income of $0.5 million this quarter relatively flat last quarter and income of $0.2 million for the second 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 5.2% this quarter compared to 5.6% last quarter and 5.9% in the second quarter of last year.
The allocation to non-public members of our operating company was approximately 81.3% of the operating company's net income for the second and first quarter of 2014 and approximately 81.1% in the second 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 41.3% this quarter compared to 44.0% last quarter and 40.5% for the second quarter of last year. The decrease in our effective rate this quarter was driven by tax benefits from option exercises that occurred during this quarter. The increase from the year ago quarter reflects the impact of the reduction in our deferred tax asset due to a change in the New York State tax law for receipts beginning at the start of the 2015 tax year. During the enactment period of this new tax law, we expect our annual corporate effective tax rate excluding any benefit associated with the share and unit investing to be between 42% and 44%. But future option exercises or investing of previously issued awards may result in tax benefits that would reduce this rate.
During the quarter through our stock buy back program, we repurchased and retired 47,633 operating company units for approximately $500,000 and 34,572 shares of Class A common stock for approximately $373,000. At June 30, there was approximately $22 million remaining in the repurchase program.
Before we turned it to questions, I would like to briefly walk through the valuation allowance and tax receivable adjustments. We recognized adjustments as a result of the revised estimates of future taxable income and our ability to utilize our deferred tax assets.
We've recognized a $0.4 million net benefit associated with changes in our valuation allowance and liability to our selling and converting shareholders. These adjustments comprised the majority of the difference between our second quarter 2014 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 our economic interest in it.
Inclusive of the effect of the valuation allowance and the tax receivable agreement amounts I just discussed, we reported GAAP basic EPS of $0.17 per share and GAAP diluted EPS of $0.13 per share for the quarter. At quarter end, our financial position remained strong. Our cash balance was $26.1 million as of June 30 and we declared a $0.03 per share quarterly dividend last night.
Thank you for joining us. We'd now be happy to take any questions you may have.
Your first question comes from the line of Ken Worthington from JPMorgan. Please proceed.
Hi, this is actually [Alex Cagle] [ph] filling in for Ken and thank you for taking my question. In regards to institutional redemptions, how seasonally would you say they are? Do redemptions generally occur in earlier in the year and then followed up by sales later in the year? And as a follow-up, as you look at your various institutional products, what would you say -- which would you say are seeing greater redemption and which are generating sales? Thanks.
I don't know whether there are seasonality to the redemptions. I can tell you that this quarter the redemptions were driven by two large accounts. One that decided that they didn't want -- at least the reason they gave us which is all that we can cite to you is that they thought the U.S. market was getting over valued and they redeemed. And the second was a client that where we had significant out performance and they rebalanced and remained a sizeable client. And the two of the -- so these kind of random things that we get I would tell you anecdotally perhaps they tend to happen earlier in the year but I can't tell you - back that up with statistical evidence. I think what happens is people review their positioning after they get yearend data and make adjustments. And normally those adjustments are -- it is easy to rebalance out but then when you decide where you are going to put the money, sometimes you go through a process that takes some time. So there tends to be some seasonality. But mostly it's just lumpiness rather than seasonality.
And which product that was the other question that you asked me. It was basically the two, one was U.S. focused value and one was global value where we have the two big net -- the two big gross outflows. Net flows for the quarter, big areas of net inflows were -- and you were asking specifically about the institutional side of the business, so was on the international -- hold on a second, it was on European focus value, large cap focus value and our global portfolio. So it's pretty mixed. If you include the retail in there we had strong flows in our -- into the mid cap value strategy that we’re sub-advising for Vanguard.
Thank you. Your next question comes from the line of John Dunn from Sidoti & Company. Please proceed.
John Dunn – Sidoti & Company
Good morning, guys. So you just talked about how -- on the advisory side what products are getting interest. Can you just give us a flavor of what those sales discussion are like? Just a flavor of how they are going?
Well, I mean I guess the process is the same process that we've always had which is -- we are identified as a potential manager by almost all the time by a consulting firm. And the consulting firm will then sort of provide a first cut list to the ultimate client. Now, I would tell you our making it to the next stage of that process, the odds are improving versus where -- I mean they are improving in two areas. One is getting recommended. So getting on the list that the consultants present to their clients and that volume of activity, that's what we grossly refer to as our pipeline which is as soon as we are told that we've been included in a search, we write it down and we keep track of it. So that is -- that's really -- it's hard to say that that conversation oriented. That is more a function of how our performance has been and the long-term relationships that we’ve had with the consultants. And I think the dialogue -- when we have constant dialogues with those consultants which are no longer overly focused on 2007 and 2008 anymore and that's why I think we’ll be included in more searches.
Then the second stage is the company whittles down the list. That list could be 20 managers and they whittle it down to 5 often without the input of us, often without talking to us. Sometimes they do, sometimes they don't. Given that we have fairly strong recent performance numbers, we are tending to get further in that process and the consultants are being supportive that we have been successful in modifying our process post the financial crisis. And then you get to the win rate, that's when we go and we make our presentation. And I got to tell you when most of the interaction, most of the dialogue you have when you get to that phase is all positive. It's generally you are making a pitch and you get a kind of question set that is fairly typical. You have discussion about it and then you leave, really not having any idea of whether you won or not. And the ability to predict whether you won after those presentations, my ability to predict is pretty low. So we don't even bother trying. I think our win rate has ticked up a little bit from where it was. But it is no long -- it's nowhere near where it was in the heydays where we won 65%-70% of those finals. Now we win I think our fair share or maybe a little bit better than our fair share. So if there are four finalists, I think we are doing better than 1 in 4 but we are not doing 3 in 4. Does that help?
John Dunn – Sidoti & Company
Right, got you, yes. It does. And then switching to the sub- advisory side can you give us a sense of what the pipeline would be for one, your -- the newer mandates that you booked in late 1Q and then 2Q and then future ones in the United States and then potential ones maybe in overseas.
Okay. I don't -- I am not aware of any future ones in the United States [inaudible] point in time. That's why we are launching our own funds in the U.S. because we have strategies that we believe offer us the opportunity to capture a market place that's a little less competitive. But existing mandates in the U.S., the big ones are the Windsor Fund for Vanguard and there are basically no net flows in that. And that's because there are no net -- really no net flows into the fund. So that -- it's a big however it's big relationship but no net flows. Other Vanguard relationship on mid-cap value which we just signed a few months ago has strong flows. And that's the market place, right. As long as mid- cap value continues to attract good flow in general, even though we are one of three sub-advisors on the account, I think we are getting most of the flows because the other two advisors are closed. The two sub-advisors are closed. So that remains strong and ahead of our expectations from when we were hired by Vanguard. And then emerging market has steady modest flows where we were the sub-advisor of Vanguard.
In the non-U.S. side, there is no -- I am trying to think if there is anything substantive of new potential mandate, nothing that’s far enough along that I would want to get us excited about. But there - the flows continue to be good and that's what’s driving the strong performance in our retail segment. Oh I did -- oh I just think of one non-U.S. sub-advisory relationship which has ongoing discussions and we are hopeful that can happen this year, but you never know on these things.
John Dunn – Sidoti & Company
Got you. And then my last question, I know you guys don't manage expenses on sort of margin, G&A margin basis but can you talk about given the build out in the mutual funds retail distribution channel, what the run rate of the G&A line might looks for the remainder of the year?
I think the G&A line is probably where it's going to run out for the rest of the year. But the salary line’s going to go up because we haven't hired the staff yet. So and we are in the market for some relatively expensive types of people that would be leading the distribution efforts and the other ancillary things that you have to do when you are in the mutual fund business including operations and compliance and market. So we do anticipate our headcount growing by another four people or so between now and end of the year. And I would also say that there is some upward pressure on investment compensation which could cause us to potentially increase our bonus accruals going forward. But we haven't figured any of that stuff out yet. So I would tell you I would expect the run rate of G&A to be flat and comp to start to tick up in the second half of the year.
Thank you. Your next question comes from the line of Ken Worthington. Please proceed.
Hi, this is Alex again filling for Ken. I think you guys have answered all my questions. I don't have any remaining ones. Thanks.
Sir, you have no questions at this time. (Operator Instructions).Thank you. There are no further questions. I would now like to turn the call over to Mr. Gary Bachman for closing remarks. Please proceed, sir. Thank you.
Thank you, operator. And thank you everyone for joining us on today's call.
Thank you for your participation in today's conference. This does conclude the presentation. And you may now disconnect.
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