Pzena Investment Management, Inc. (NYSE:PZN)
Q4 2011 Earnings Call
February 8, 2012; 10:00 am ET
Rich Pzena - Chief Executive Officer & Co-Chief Investment Officer
Greg Martin - Chief Financial Officer
Ken Worthington - JPMorgan
Good morning. My name is Felicia and I’ll be your conference operator today. At this time, I would like to welcome everyone to the Pzena Investment Management 2011 fourth quarter earnings 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.
I would now like to turn the conference over to Mr. Greg Martin. Sir, you may begin your conference.
Thank you very much, Felicia. Good morning and thank you for joining us on the Pzena Investment Management, fourth quarter 2011 earnings call. I’m 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. Replays 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 the 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, we will not be able to respond to it. Thank you.
I’ll turn the call over to Rich shortly, but first I’d like to review some financial highlights. Please note that we’ll be making some minor correction to two charts and resubmitting our press release this afternoon. The PDF on our website is correct.
We reported non-GAAP diluted EPS of $0.08 per share and $5.1 million in non-GAAP diluted net income. Revenues were $18.9 million for the quarter and our non-GAAP operating income was $8.9 million. Our cash balance was $35.1 million at quarter-end, and we declared a $0.19 per share quarterly dividend last night. This $0.19 dividend is our quarterly dividend, as well as the payout for 2011.
I’ll 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.
Thanks Greg. As I look back on 2011, I can’t help but feel drawn back to what it felt like in early 2000 for value investors. Back then momentum had driven Internet stocks to astounding valuations and value investing had lagged for almost five years. Investors were proclaiming the depth of value and a number of long term value investors closed shop, while others changed their strides, of course exactly at the wrong time.
Today investors are once again question whether value investing really works. Despite a strong rebound that started in November 2008 and lasted through early 2011, the market correction and value under performance during the latter half of the last year has rekindled bad memories of the financial crisis and let investors to question whether identifying good, but under valued companies still works, in a world that seems driven by global macro events rather than fundamentals. Investors have fled end mass to safety as the financial crisis in the euro zone creates massive uncertainty and fear that it’s effects will spill over and affect the global economy.
But taking a step back from the day-to-day market noise provides a useful perspective in which to assess recent market activity and possibly even identify hidden opportunities otherwise unsecured.
We studied the cycles of value investing, going back over 40 years, by measuring the performance of a naïve deep value benchmark, to find us the cheapest quintile of the 1000 largest U.S. listed companies on a price to book value basis, versus the S&P 500 index and of a number of key observations.
One, the cycles of value investing tend to be long, almost 10 years on average, with deep value outperforming for almost seven of these years.
Two, over the last four full value cycles dating back to the late 1960s, deep value has outperformed the S&P 500 by 480 basis points per year.
Three, recent experience is highly consistent with the historical ebbs and flows of the value investing cycle.
Four, the last peak in the value cycle was 58 months ago, assuming eternity in the investment world. Since then, value has under performed the S&P 500 by a cumulative 11.8 percentage points. As it turns out, this cycle to-date, relative performance versus per value versus the broad market is almost exactly the average of the last four full value cycles.
Five, the most recent period of value out performance which started in December of 2008 was interrupted in mid 2011 for six months, as investors sentiment shifted from optimism to uncertainty on concerns over sovereign debt, euro zone stability and slowing global economic growth. We experienced similar interruptions in almost all value cycles over the last 42 years and both the magnitude and duration of the mid 2011 interruption are consistent with prior cycles.
Six, history as a guide, there’s a significant pent up opportunity in the value category. A flight to safety and across the board indiscriminant selling of cyclical businesses, have left a wealth of deeply undervalue industry leading companies, with solid business franchises, high free cash flow and solid balance sheet.
Conversely, business is considered safe. For example, stable earnings or high dividend paying such as utilities and consumer staples are at record high valuations relative to cyclical businesses. Because these under valued companies have the financial strength and market precision to make it through a range of economic scenarios, share price volatility provides opportunity without outsized risk of permanent loss relative to the market.
To a large extent the macro outcomes are not knowable, so it’s prudent to place significant emphasis on balance sheets and competitive position with a conservative view of future growth. Even with these assumptions, many attractively valued opportunities exist.
As we start 2012, we acknowledge the pain investors have endured. Many investors and deep value strategies are tired and we are dealing with those issues with our clients in a constructive way. And although 2012 is off to a roaring start, we are not yet back to the prior peak of relative performance reached five years ago. Yet as disciplined value investors, we are mindful that history teaches that the real investment opportunities are often hidden among the weeds of deepest fear.
Warren Buffet’s wisdom on this point seems particularly timely. ‘Investors should remember that excitement and expenses are their enemies and if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful,’ he said.
While some investors are tired, others actually see this opportunity in the market. With the alternatives of low interest rates or highly priced yield stocks, many are realizing that the risk-off trade has to end. Consequently we have experienced a market up turn in discussions with potential clients and their consultants.
During the latter part of 2011, we won two of the largest global mandates awarded during the year, aggregating almost $1 billion, which shows that sophisticated investors believe there is long term opportunity with a manager that stays consistent with it’s deep value management style.
We believe this is also a testament to our firm stability. 17 of our 22 investment professionals have been together for five or more years and a core group of seven of these individuals have been together for 10 or more years. This stability is not only highly unusual, but we see it as a real validation of our commitment to our investment process and philosophy.
As a result, we experienced $210 million in positive institutional flows in the fourth quarter, demonstrating the ability to grow our institutional business, despite a challenging performance environment for deep value. Although flows are lumpy and unpredictable, we are encouraged by these results.
I’d now like to turn the call over to Greg Martin, our CFO to review our quarterly results.
Thank you Rich. I’ll start off by discussing our AUM, fee rates and revenues. Our average AUM was $13.2 billion during the quarter, down 7.7% from last quarter and down 10.8% from the fourth quarter of last year. For the full year of 2011, our average AUM increased to $15.0 billion, improving 5% from last year.
We ended the quarter with $13.5 billion of AUM, up 11% from the end of last quarter, which ended at $12.2 billion, but down 13% from the end of the fourth quarter last year, which ended at $15.6 billion. The $1.3 billion increase from last quarter was primarily the result of $1.4 billion market appreciation, offset by $0.1 billion in net outflows. The $2.1 billion decline from the fourth quarter of last year was a result of $1.3 billion in market depreciation and $0.8 billion in net outflows.
At December 31, 2011, our AUM consisted of $11.3 billion in institutional accounts and $2.2 billion in retail accounts. Assets in institutional accounts were up 13% during the quarter, primarily due to market appreciation. Retail assets were broadly flat from last quarter.
Revenues were $18.9 million for the fourth quarter of 2011, down 6% from last quarter and down 8% from the fourth quarter of last year. Both of these decreases were primarily driven by a decrease in weighted average AUM, somewhat offset by an increase in performance fees recognized. These performance based fees pay incentive fees according to the performance relative to certain agreed up on benchmarks, which result in a lower base fee, but allows for us to earn higher fees if the relevant account outperforms the agreed upon benchmark.
Revenues for the full year 2011 compared to the full year 2010 were up 7%, largely due to an increase in weighted average assets and increases in performance fees recognized. Our weighted average fee rate was 57.3 basis points for the fourth quarter of 2011, 56.0 basis points last quarter and 55.5 basis points for the fourth quarter of last year. For the full year 2011, our weighted average fee rate was increased about 2%. These increases were primarily due to an increase in performance fees recognized.
Our non-GAAP income statements adjust for certain one time charge of recognized and operating expense in the fourth quarter of 2011, in addition to the valuation and tax receivable agreement items. I will address these adjustments at the conclusion of my remarks, but for now I’ll focus on the non-GAAP information.
Turning to the remainder of the P&L, our compensation benefits expense was $8.0 million for the quarter, up 4% from last quarter and up 7% from the fourth 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 fourth quarter, broadly flat with last quarter and down somewhat from the fourth quarter of last year. Both changes were primarily a result of small fluctuations in various G&A expense categories, as well as the timing of some expenses.
Operating margins were 47.1% this quarter, 51.5% last quarter and 53.2% in the fourth quarter of last year. Net of outside interest, other income expense was income of $0.5 million this quarter and an expense of $0.4 million last quarter, an income of $0.2 million in the fourth quarter of last year. These fluctuations arise generally from performance of our mutual fund investments.
The effective rate for our unincorporated business taxes were 6.0% this quarter and last quarter and it was 5.8% in the fourth quarter of last year. The fluctuations and effective tax rates are driven by certain expense 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 84.5% last quarter and approximately 85.4% in the fourth 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.
Our effective tax rate for our corporate income taxes, ex-UBT, was 40.8% this quarter, 42.9% last quarter and 42.6% for the fourth quarter of last year. The decline in our effective tax rate this quarter is a result of minor prior period adjustments. Our expectations are that our corporate effective tax rate will generally be between 42% and 43%. 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’d like to briefly walk through the one-time charges and the usual valuation allowance and tax receivable adjustments. In the fourth quarter of 2011 we recognized approximately $4.8 million in one-time charges and operating expense, associated with the write-off of excess real estate and charges relating to certain employee departures.
We also recorded adjustments that rose as a result of revised estimates and future taxable income and our ability to utilize our differed tax asset. We recognize a $0.8 million increase in our valuation allowance and a $0.7 million decrease in our liability to our selling and converting shareholders for the quarter. The net effect to these adjustments is a difference between our non-GAAP and GAAP results.
On a quarterly basis, we 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 allowance and tax receivable agreement amounts I just discussed, we reported GAAP basic and diluted EPS of $0.03 for the quarter.
Thanks for joining us and we’d now be happy to take any questions.
(Operator Instructions) Your first question comes from the line of Ken Worthington.
Ken Worthington - JPMorgan
Hi, thank you for taking my question. Good morning. First, Richard you went through kind of an outlook for value investing. Maybe digging a little deeper into your views as we kind of start the New Year, where are you seeing value in the market right now and what is the kind of value relationship in what you’re seeing in the U.S. versus what you’re seeing outside the U.S.
Thanks Ken for the question. The value is really exactly where you might imagine, where the fear and uncertainty are the greatest. So we have close to half of our portfolio in the U.S. invested in financial services and housing and another 40% roughly in cyclical, in other cyclical stocks. So we are very heavily exposed to companies that are impacted or that where their share price has been negatively impacted by fears about what the future is going to look like, financials obviously being the greatest.
And I think its an interesting phenomena, because the last value cycle, when we were sitting here, as I mentioned in a little discussion, when we were sitting here at the end of 1999 and early 2000, we had roughly 50% of our portfolio in industrial cyclicals and if you remember the environment back then, the Asian currencies have just collapsed. Every newspaper article was proclaiming how western society was loosing manufacturing jobs on a steady basis to Asia.
The companies we invested all had Korean and Taiwanese competitors that were offering products at lower cost and these companies were written off as structurally being different in the past than they are in the further, and of course they all adapted to the environment as companies always do and had to restore their earnings power and they were huge home runs and lead to five years of out performance for us. At the time, most if not all of our deep value peers, gave up on those sectors and we are under exposed and that’s what led to our performance.
Today it’s the same thing in financial services. It seems intuitively obvious to everybody that the world is going to be different in the future than it is in the past and worse by the way. And so valuations are week, in spite of the fact that the franchises and pretty much all of these financial companies are in-tact and the operating performance and the financial performance is dramatically improved and yes, yet you can buy a whole host of financial companies all over the world at valuations of past of book value to book value. And so, that’s were we see value.
As you might imagine, the deepest value exists in Europe where the stresses are the greatest and then it gets less as you get into other parts of the world. The spreads that we see today between cheep stocks and the markets are wider than average, but they are not record like they were in ‘09 or back in the period prior to the collapse of the Internet bubble.
However absolute valuations, because the markets are cheep and uncertain, are amongst the lowest of our history, both in the U.S. and Europe, with really only exception and that was the March of ’09 and the environment today economically and financially and stability wise is far improved versus where it was in 2009, so a long-winded answer to your question.
(Operator Instructions) And sir, there are no further questions at this time. Excuse me, we do have a follow-up question from the line of Ken Worthington.
Ken Worthington - JPMorgan
Hi sorry, I didn’t get the second one off. In terms of the sub-advice sales, you obviously saw some very good growth sales; you mentioned the two large mandates kind of won this year. Broadly speaking, what kind of interest are you seeing from the consultants, separate from the end customers in the deep value investing and now I’ll leave it at that.
Well, I would tell you though, broadly speaking the world reflects the markets and so the consultants are faced with two competing phenomenon. One is, the clients who bought deep value strategies are disappointed and so they are calling them and saying, get me out of these things or do we make a mistake or can you re-evaluate.
Now most of the consulting world, I’m talking about the sophisticated consultants are usually pretty good at handling those issues, because they understand their cycles and they are less emotional than a board member might be when they are looking at a list of their performance and seeing a couple of mangers that are negative outliers saying why, what are we doing with these managers and they go to their consultants.
Most of the time the consultants are in the position of trying to support us or people like us, not all of the time, but most of the time and so we have that side of it. The other side of it is sort of what I mentioned, which during the prepared remarks, which is the clients are coming to them and also saying, ‘how do I meet my return objective, how do I fund my liabilities when a ten year treasury is under 2% and I’ve just made all this money and the stable high yielding stuff and the valuations look rich and I don’t see good earnings growth and I’m worried about economic activity, what do I do?’
And so obviously we support clients, consultants with a lot of the research on the cycles of value investing, they do their own research. Different consultants have different views on this, but for the most part they are trying to understand which or the mangers remain disciplined in their own strategies.
So when there is a client driven interest in deep value, we tend to get included in those searches. I’m not going to tell you that the consultants are out pounding the table, going around to their clients saying, you should higher a deep value manger today; I don’t believe that to be the case. But I do believe that the discussions about how do you position your portfolio long term are ongoing and that’s tending to at the margin lead towards incremental increases in equity exposure, relative to alternatives in fixed income.
I think there’s broadly felt disappointment with alternatives and fear that rates are low on fixed income, so they are sort of left with little choice, but they consider equities. And we stayed disciplined and we do the same thing over and over again and explain ourselves over and over again, so whenever there is a deep value search we tend to be included and that’s really the only thing that we could hope for.
Ken Worthington - JPMorgan
I’m going to be greedy here, because I’m not sure anybody else is queued up. In terms of kind of growing the business and expanding it, I think it was a couple of years ago you had won some new sub-advisory mandates. Is there opportunity to kind of continue to or to grow through those means of actually kind of wining those new mandates, kind of on the retail side? Is there a way to kind of grow the retail side or was the track record just not good enough and you need to kind of repair the track record before you can actually go out and start to even try to pitch those kind of wins.
You know, I actually think there is a real opportunity. We added someone to our staff on the business development side, specifically focused on self-advisory and defined contribution; we’ve never done that in the past. We’ve also designed products to meet the needs of that market place and the reception is quite encouraging.
So while the record – you’re absolutely right on the record and being a single manger in a sub-advised portfolio, where the only sub-advisor. There was no tougher because of the record, because it’s the only thing they have to look at, but so many of the distributors or packagers of product are combining managers and sub-advising on a multi manger basis, where our historical performance fits nicely from a risk return perspective with others, so we can get packaged with those and that’s where we seek out those kinds of relationships and as the record gets repaired this will be easier and easier.
Right now we can show a very compelling 15-year record, a very compelling three-year record and the five-year record is still tarnished for another year or so. But if you look at our results and this is what we show to our clients, our long-term performance in the 11.5 years prior to the global financial crisis, we outperformed the Russell 1000 value by 4.6% a year. Then we had a terrible 12 month period where we underperformance by 16.3% and then we’ve had 3.5 years since then when we’ve outperformed by 3.4, so back to our longer term trend.
So we are trying to make the case that we did have a bad year and we learned from those mistakes. But even with that bad year, our since inception record of our longest strategy is still over 200 basis points a year better than the market. So that doesn’t appeal to everybody, but it appeals to some and we are small enough that we don’t have to appeal to everybody; we only have to get a few to say that this makes sense.
Ken Worthington - JPMorgan
Great. I appreciate all the color. Thank you.
There are no further questions at this time.
Great. Thank you for joining us on today’s call.
Thank you for participating in today’s conference call. You may now disconnect.
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