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Pzena Investment Management, Inc. (NYSE:PZN)

Q3 2011 Earnings Conference Call

October 26, 2011 10:00 AM ET

Executives

Gregory Martin – CFO and Treasurer

Rich Pzena – CEO and Co-Chief Investment Officer

Analysts

Alex Blostein – Goldman Sachs

Larry Hedden – Keefe, Bruyette & Woods

Ken Worthington – JPMorgan

Operator

Good morning. My name is Chelsea and I will be your conference operator today. At this time, I would like to welcome everyone to the Pzena third quarter 2011 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. (Operator instructions). Thank you. Mr. Martin, you may begin your conference.

Gregory Martin

Thank you very much, Chelsea. Good morning and thank you for joining us on the Pzena Investment Management third quarter 2011 earnings call. I am Greg Martin, 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 don’t have a copy, it can be obtained in the Investor Relations section on our Website at www.pzena.com. Replay of this call will be available for the next week on our Website.

As always, we need to reference the standard legal disclaimer before we begin. Statements made in the presentation today may contain forward-looking information about management’s plans, projections, expectations, strategic objectives, business prospects, anticipated financial results and other similar matters. A variety of factors many of which are beyond the company’s control affect the operations, performance, business strategy and results of the company and can cause actual results and experiences to differ materially from the expectations or objectives expressed in these statements.

These factors include but are not limited to the factors described in the company’s reports filed with the SEC, which are available on our Website and on the SEC’s Website www.sec.gov. Investors are cautioned not to place undue reliance on forward-looking statements which speak only as of the date on which the statements are made. The company does not undertake to update such statements to reflect the impact of circumstances or events that arise after the date these statements were made. Investors should however, consult any further disclosures that company may make and reports filed with the SEC. In addition, please be advised that because of the prohibitions on selected 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 require the disclosure of material non-public information, you will not be able to respond to it. Thank you.

I will turn the call over to Rich shortly, but first I would like to review some of our financial highlights. We reported non-GAAP EPS of $0.08 per share and $5.3 million in non-GAAP diluted net income. Revenues were $20.0 million for the quarter and our operating income was $10.3 million. Our cash balance was $36.9 million at quarter-end, and we declared a $0.03 per share of quarterly dividend last night.

I will discuss our financial results in greater depth in a few minutes. Let me first turn the call over to Rich, who will discuss our view of the investing environment and how we are positioned relative to it.

Rich Pzena

Thanks Greg. Fears over Eurozone sovereign debt and potential contagion drove financial markets lower globally during the quarter. Equities posted double-digit declines in virtually all regions of the world, with the MSCI world developed market index losing 16.6% and the MSCI emerging markets index down by 22.6% during the quarter, measured in U.S. dollars. Correlations of returns have also spiked as the Financial Times noted in their September 22nd article titled, ‘Risk-on Risk-off back with a bang’ where they discussed the extremely high correlation between equities and in particular U.S. stocks.

The International Monetary Fund compounded investors’ macro fears when they reduced their 2012 world GDP growth estimates from 4.5% to 4%, despite the fact that this is still well in excess of the 30-year average growth rate of 3.4%. Investors are tethered to the saga of the European sovereign debt crisis, producing gut-wrenching market gyrations. The threat of Greek, Spain, Italy default, European bank recapitalizations and financial contagion have driven fear and uncertainty to the extreme and cost investors globally to move and mass away from equities, highly correlated moves in Wall Street. Expecting the worst, investors have particularly penalized cyclical or high beta stocks, driving valuation spread between those and stable, i.e., low beta stocks to almost unprecedented levels.

On this basis alone, one could conclude that it is an awful time to reposition to low beta stocks as they are expensive compared to their cyclical counterparts. Even more importantly, we believe there is significant value opportunity in today’s beaten down sectors. Overtime, managements have demonstrated the ability to adapt and overcome the obstacles in front of them and to restore profitability in the wake of significant macroeconomic disruptions.

Corporations today are well-positioned to deal with near-term shocks should they arise, having deleveraged their balance sheets and realigned cost structures following the 2008 to 2009 recession. So, rather than concluding that equities and cyclical stocks in particular are in trouble, in many cases, we see a different picture, one of resilience, adaptability and solid financial footing, we see opportunity.

From a global perspective, we find convincing evidence of corporate adaptability to many types of economic environments. The return on equity for the MSCI World Index over a 37-year period, though variable over the short run has stayed within a reasonably tight band around a long-term average of 12% no matter what the economic environment. These data reinforce our on-the-ground observations of company managements taking the necessary actions to meet the challenges of the current economic environment. Most investors were surprised by how quickly corporate profits rebounded after the last recession despite only a muted recovery in GDP. We take encouragement from corporate performance in 2008 as we survey the landscape today.

The true risk of recession lies with those companies where a near-term dip in earnings could catastrophic to the equity holder due to high levels of debt and the attended risk of bankruptcy, representing real long-term capital impairment. We have studied this issue in depth and in our recently published white paper assessing risk and return determines that limiting exposure to bankruptcy risk by avoiding companies with high levels of leverage, which also tend to display the highest stock price volatility is added to long-term returns.

Today, leverage in our portfolio is extraordinarily low, with debt-to-EBITDA ratios of 0.7 times in large cap value and 0.6 times in our global value portfolios. From the start of the recovery in 2009 through mid 2011, we experienced a traditional though extremely short duration value cycle with spreads narrowing and value-based strategies outperforming. Since mid-2011, there has been a dramatic reversal leading to wider spreads as uncertainty has grown around economic growth, recession and the potential contagion from European sovereign debt lows. Though this looks like the beginning of a recessionary cycle, there is significant differences from the cycle we most recently experienced, namely the 2008/2009 recession started after the economy peaked in 2007.

So far this cycle, we have only had a partial recovery with some industries, for example, auto production and construction still at deeply depressed levels. Corporations by and large de-lever their balance sheet during the last few years significantly mitigating bankruptcy risks. Companies have cut costs and positioned themselves for an extended period of anemic growth demonstrating their ability to generate normalized levels of profits in a challenging environment, and valuations are already at highly attractive levels approaching those experienced during the ‘08/’09 market meltdown.

As a result, we are finding high quality companies with little stress, high returns on capital, strong balance sheets, and high free cash flow yields trading at deeply depressed valuations. Our cyclical exposure has increased as valuations have been driven down due to recessionary fears as has been our pattern in past cycles as these names became attractive. With respect to the fundamentals of our business, we ended the quarter at 12.2 billion in AUM, down from both last quarter and last year primarily reflecting the sharp decline in the overall market in the third quarter.

Institutional outflows were modest while retail outflows were in line with our expectations for a quarter like we just experienced. In this environment, we have maintained strong cash flows and a healthy operating margin. We are also continuing to recognize performance-based fees as our three-year track record improves. I would now like to turn the call over to Greg Martin, our CFO to review our quarterly results.

Gregory Martin

Thank you, Rich. I will start off by discussing our AUM, fee rates and revenues. Our average AUM was 14.3 billion during the quarter, down 12.3% from last quarter, but up 5.1% from the third quarter of last year. We ended the quarter with 12.2 billion of AUM, down 23% from the end of last quarter, which ended at 15.9 billion and down 15% from the third quarter of last year, which ended at 14.3 billion. The 3.7 billion decline from last quarter was primarily the result of 3.4 billion in market depreciation and a 0.3 billion in net outflows. The 2.1 billion decline from the third quarter of last year was a result of 1.2 billion in market depreciation and 0.9 billion in net outflows.

At September 30th, 2011, our AUM consisted of 10.0 billion in institutional accounts and 2.2 billion in retail accounts. Assets in institutional accounts were down 23% during the quarter primarily due to market depreciation. Retail assets declined 27% from last quarter primarily as a result of market depreciation as well.

Revenues were $20.0 million for the third quarter of 2011, down 11% from last quarter but up 8% from last year’s third quarter. The decrease from last quarter was primarily driven by a decrease in weighted average AUM, somewhat offset by an increase in performance fees recognized. The increase from third quarter last year was primarily driven by an increase in weighted average AUM and an increase in performance fees recognized.

These performance-based fees and incentive fees according to 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 56.0 basis points for the third quarter of 2011, 54.9 basis points last quarter and 54.4 basis points for the third quarter of last year. These increases were primarily due to an increased performance fees.

Turning to the remainder of the P&L, our compensation benefits expense was $7.7 million for the quarter, down 7% from last quarter and up 4% from the third quarter of last year. The fluctuations from last quarter and last year were primarily driven by changes in our discretionary bonus accruals and non-cash compensation. G&A expenses were $2.0 million for the third quarter, decreasing slightly from last quarter and up somewhat from the third quarter of last year. Both changes were primarily a result of small fluctuations in various general and administrative expense categories as well as the timing of expenses.

Operating margins were 51.5% this quarter, 54.0% last quarter and 50.3% in the third quarter of last year. Our non-GAAP income statements adjust for certain valuation allowance and tax receivable agreement items. I will address these adjustments at the conclusion of my remarks, but for now, I will focus on the non-GAAP information.

Net of outside interest, other income expense was an expense of $0.4 million this quarter, income of $0.2 million last quarter, and income of $0.3 million in the third quarter of last year. This quarter’s other expense net of outside interest consisted primarily of net realized and unrealized losses on investments in other expense offset by interest in dividend income. Other income net of outside interest from last quarter consisted primarily of net realized and unrealized gains from investments and interest in dividend income.

Net of outside interest for third quarter 2010 other income was composed primarily of net realized and unrealized gains from our investments and again interest and dividend income. The fluctuation in net realized and unrealized gains and losses from investments was primarily the result of negative performance in our mutual fund investment this quarter compared to positive performance in our mutual fund investments last quarter and during our third quarter of 2010.

The effective rate for our unincorporated business taxes was 6.0% this quarter and 5.7% for both last quarter and the third quarter of last year. The fluctuations in these effective tax rates are driven by certain expenses that are permanently non-deductible for UBT purposes. As mentioned in the past, this rate varies from period-to-period, but should generally be between 5% and 7% on an ongoing basis.

The allocation to the non-public members of our operating company was approximately 83.6% of the operating company’s net income this quarter, approximately 84.6% last quarter and approximately 85.4% in the third quarter of last year. The variance in these 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 ex-UBT was 42.9% this quarter and last quarter and 42.7% for the third quarter of last year. This is in line with our expectations of our corporate effective tax rate being between 42% and 43%. We anticipate this to be the approximate rate going forward.

As a result of the foregoing, we reported basic and diluted non-GAAP EPS of $0.08. Before we turn it over to questions, I would like to briefly walk through the valuation allowance and tax receivable adjustments.

These adjustments arise as a result of the revised estimates of future taxable income and our ability to utilize our deferred tax asset. The net effect to these adjustments is a difference between our non-GAAP and GAAP results. We recognized a 0.3 million increase in our valuation allowance and a 0.1 million increase in our liability to our selling and converting shareholders for the quarter.

On a quarterly basis, we would expect 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 and tax receivable agreement amount I just discussed, we reported GAAP basic and diluted EPS of $0.05 for the quarter. Thank you for joining us. We would now be happy to take any questions.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from Alex Blostein.

Alex Blostein – Goldman Sachs

Hi guys, good morning.

Rich Pzena

Good morning.

Alex Blostein – Goldman Sachs

Rich, can you talk a little bit about the third quarter dynamics for your investment performance? Obviously, very difficult for most of the active equity asset managers, but if you look in a relative basis, it seems like you guys are underperforming the benchmarks a little bit. What does that do to your conversations with potential investors and your current investors? Do you think that’s going to potentially bring down the pipeline a little bit, or does that create any sort of risk for your – for some near-term apples given the underperformance in the third quarter?

Rich Pzena

We actually used the third quarter as a way to illustrate to our clients, the effectiveness of the risk reductions that we took into our portfolio a little bit over a year ago. Remember, our benchmarks which people compare us to and our competitors which you will compare us to are really not good indicators of what we are hired to be. We are generally hired to be the deep value managers within an investment portfolio. And so, we look at how do we do versus a deep value index. These are obviously not public indices but we just compare our performance to buying simple low PE or low price to book stocks.

So, we have had substantial outperformance from our peak in April 30th, the peak of these indices in April 30th to the trough in September 30th. So, I think the conversations have generally been positive conversations in dealing with our clients. Plus, October is – we are almost done with October and we pretty much recovered all of that underperformance or most of it. So, we pointed out that the companies that have seen their share prices decline sharply really not experiencing any fundamental issues. In fact across the board, the companies are saying nothing happened in the third quarter and nothing happened in October. The market just panicked and recovered.

So, we use the opportunity to reposition the portfolio into more cyclical, more high beta stocks which is paying off in October, it’s exactly what our clients expect us to be doing. So, I don’t imagine this is going to have any impact on client retention, I think it has an impact on winning new business because the world is looking for lower volatility, and obviously, we are not the solution to what they are looking for right now. But we maintain and we continue to be fairly aggressive in our views that volatility is a good thing, that it’s the source of your returns and that shying away from it is in the end going to wind up being a mistake. We preach that endlessly, I think we are pretty well known that that’s our position, and those who hire us know what they are getting, and for those who want that, we remain a viable choice.

So, when we see it in business levels, we continue to get included in search activity. It doesn’t appear to be a whole lot of change in that, but we are not winning the searches, because the world is seeking lower volatility. When that’s going to change, I really have no idea. I could tell you that what we hope and what we believe is that several year from now when you look back and observe that the moves to lower volatility were mistakes, if that turns out to be the case which we expect, that will wind up being back in favor. But clearly that’s the headwind we are experiencing and the volatility of the big decline in the third quarter followed by the big growth in October doesn’t help that picture.

Alex Blostein – Goldman Sachs

Got it. That’s really helpful color, thanks. And that’s actually, your discussion on volatility is actually a decent segway to my next question. And how do you guys think about running the business with so much volatility, I guess an AUM with respect to expenses? So, you kind of have your longer-term growth sort of strategic investments that you have to balance I guess in near-term margin protection. So, with AUM having such big swings quarter-to-quarter and obviously that’s a function of the market, but how do you think about balancing that a little bit, and what else can you kind of pull in the expense front to keep the margins around like this kind of 50% range?

Rich Pzena

I will start by saying we have the luxury of beginning with a 50% margin. So, I would certainly rather begin there than begin with a 20% margin. We have a little bit of flexibility. Obviously if there is a major shift and in our revenues because the markets are really weak and stay weak, then we have to make tough decisions about what to do. But in the context of the volatility we have been experiencing to date, we are staying in the course. I mean, our opportunity is to make the choices that you just outlined. Should we invest in the long-term future and keep the expense base, or should we really worry that the quarterly earnings are going to be a little more volatile, and our conclusion is without pushing us to the extreme, we are going to keep going.

It doesn’t mean we are not going to focus on expenses, doesn’t mean that we are not constantly looking for opportunities on how to do things better, but remember, we have in this most recent period, the last six months, added substantially to our distribution capability on a global basis. And that’s within the expense structure that you have observed. So, barring any significant revenue deterioration, we are just expecting to stay the course here.

Alex Blostein – Goldman Sachs

Got you, helpful. And then, just a couple of numbers questions. Can you guys quantify how much performance is contributed to revenues this quarter?

Rich Pzena

$1 million.

Alex Blostein – Goldman Sachs

About $1 million, okay. And then lastly, on capital management, so last year, you guys did a special in the fourth quarter and it sounded like from last call that returning capital to shareholders, your dividend is probably something that you guys will continue to do. So, is that something that we should I guess expect this year and how do you sort of think about capital deployment in the near term?

Rich Pzena

Yes, our goal, our plan remains to pay out most of our earnings, most for us is 70% to 80% of our earnings. We did it in the form of a special dividend last year simply because we thought the tax rates were going to go up and we wanted to put it into the prior calendar year. The tax rates didn’t go up at that point, I don’t know when they are going up, but I think we are going to think of this on an ongoing basis instead of a special dividend basis. So, what we intend to do is to have a year-end dividend, which will be paid in February, which would be once we know what our earnings are for 2011, the February dividend will be disproportionately large and the regular dividend will stay as it is. So, we will have four dividends, not five dividends. And it will be $0.03 dividends followed by year-end dividend.

Alex Blostein – Goldman Sachs

Got you. Thanks guys.

Operator

(Operator instructions) Your next question comes from Larry Hedden.

Larry Hedden – Keefe, Bruyette & Woods

Good morning.

Rich Pzena

Good morning.

Larry Hedden – Keefe, Bruyette & Woods

I was wondering if you could just give some more color around the nature of the gross sales in the quarter, particularly in the institutional side, for example, by client type and region? Thank you.

Rich Pzena

Sure. Client type, you are meaning institutional versus retail or you mean something more specific than –?

Larry Hedden – Keefe, Bruyette & Woods

Yes, more specific within the – rather the institutional bucket.

Rich Pzena

Okay. Hold on for a second. First of all, I will do it by product. All of the gross sales were in our global and EAFE product, almost none in domestic. And by region, the biggest additions and you are asking specifically for the quarter, I believe, but –

Larry Hedden – Keefe, Bruyette & Woods

Yes.

Rich Pzena

The biggest additions were the United States and Australia invested into our non-U.S. strategies.

Larry Hedden – Keefe, Bruyette & Woods

Great.

Rich Pzena

Does that help?

Larry Hedden – Keefe, Bruyette & Woods

Yes, that’s helpful. And then, based on where I guess relative performance is currently, could you give any, I don’t know, sort of color around your expectation for performance fees in 4Q relative to 3Q?

Rich Pzena

Obviously it depends on what our performance is in 4Q, but assuming no substantive change, they should be pretty similar to the third quarter.

Larry Hedden – Keefe, Bruyette & Woods

Okay, great. And then, I know it’s very early innings, but could you give us any sense as to the size of emerging market AUM in the retail channel?

Rich Pzena

In the retail channel, it’s very small. It’s still under $10 million.

Larry Hedden – Keefe, Bruyette & Woods

Okay, great. That answers all of my questions. Thank you.

Rich Pzena

Okay.

Operator

Your next question comes from Ken Worthington.

Ken Worthington – JPMorgan

Hi, good morning. I think most of the questions have been asked and answered. I am going to try something a little different. Stocks around $4, I would assume you don’t get a lot of love from the sell side or the buy side. Are there alternatives to you being a public company, like I would guess that you are probably pretty frustrated with the stock price action over the last couple of years. Is there another way, a feasible way to exist that maybe saves you guys’ time or maybe you get something more out of being a publicly traded company, then I am giving credit for, but are there legitimate alternatives that you think would benefit your business in the current structure?

Rich Pzena

Yes, we are of course, it’s hard not to be frustrated with the share price and particularly with how volatile the share price is, but it has very little impact on our business. So, let’s talk about the pros. The answer to your question is definitely yes, there are options. We could go private again. It’s not an inconceivable thing to do. Remember, only 15% of our shares trade publicly. So, financing a deal to take us private is certainly a possibility. But let me reiterate the reasons that we are a public company and why we continue to not go down that path.

One, we did it originally to provide capital for our venture startup capital provider, but we thought that and we have gotten at least one major benefit out of it and one potential benefit. The major benefit is that we want to be able to transition this company to make this company go beyond the stewardship of the old folks [ph] like me, and to do that, you have to grant equity to the next generation, so that they have big equity stakes. And you could do that as a private company, but it’s way, way, way more difficult to do that as a private company simply because there is no current valuation and there is no liquidity for the people that are granting the shares being granted the shares. And so, they value it at a much, much lower valuation than you would as a public company. So, we have that big benefit.

Secondly, it costs us roughly $2 million a year in extra expenses to be publicly versus to be private. We view that $2 million as sort of the premium that we are paying because we think in the long run having this liquidity both for transferring ownership to the next generation and for providing liquidity for the senior people is a better opportunity for our clients than say selling the firm to another entity, which is not necessarily what our clients want and not what our team wants. So, we balance these issues all the time.

And we have been in a period since we went public really that where we have been out of favor, equities have been out of favor, and our whole business model is not the direction that the world is going. If I really believe that, that was permanent, I would think about a different structure. I just don’t. If five years from now, we are sitting here with the same kinds of issues, all have been proven to be wrong, I don’t believe that, that’s what’s going to happen. I believe the value of equities in portfolios is going to be reinforced, I believe the value of equities in portfolio is going to be reinforced and I believe the value of concentrated equities is going to be reinforced, and that’s going to lead to bigger business for us. When that happens, I don’t think our stock is going to be out of favor. And so, I don’t want to make that judgment during the period when our stock is out of favor. I don’t know if that helps or makes any sense.

Ken Worthington – JPMorgan

Yes, I know it was a lousy question to begin with, but it was very helpful to hear your response. Just maybe more traditionally, how has the – has there been any kind of turnover on the investment professional side? We have a little bit less visibility there, but how stable are you? You had been very stable for a while after I think some turnover two or three years ago, four years ago, but how does that continue, or to what extent has that continued?

Rich Pzena

Yes, I don’t think we have had a senior investment professional depart in three years. We have had a very small amount of turnover at the under two-year analyst level, but nothing that you would view as out of the norm. So, I would call our turnover excessively low.

Ken Worthington – JPMorgan

Okay, perfect. Just making sure, thank you again.

Rich Pzena

You are welcome.

Operator

There are no further questions at this time.

Gregory Martin

Great. Thank you for joining us on the call today.

Operator

This concludes today’s conference call. You may now disconnect.

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