Pzena Investment Management, Inc. (NYSE:PZN)
Q2 2016 Earnings Conference Call
July 20, 2016 10:00 AM ET
Gary Bachman - Chief Operating Officer
Richard Pzena - Chief Executive Officer and Co-Chief Investment Officer
Jessica Doran - Chief Financial Officer and Treasurer
William Cuddy - JPMorgan Chase & Co.
Good day, ladies and gentlemen, and welcome to Pzena Investment Management 2016 Second Quarter Management Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time [Operator Instructions].
I would like to introduce your host for today’s conference Chief Operating Officer, Gary Bachman. Sir, you may begin.
Thank you, operator. Good morning and thank you for joining us on the Pzena Investment Management’s second quarter 2016 earnings call. I am Gary Bachman, Chief Operating Officer. With me today is our Chief Executive Officer and Co-Chief Investment Officer, Rich Pzena; and I would like to introduce Jessica Doran our newly appointed Chief Financial Officer who will be walking you through our financial results for the quarter.
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. Replay 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 filings with the 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 prohibitions on selective disclosures, we do not, as a matter of policy, disclose materials 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 $0.10 per share and $6.6 million in non-GAAP diluted net income. Revenues were $26.4 million for the quarter and operating income was $11.3 million.
Now let me turn the call over to Rich, who will discuss our current view of the investing environment.
Thank you, Gary. I would like to take this opportunity to introduce Jessica Doran as our new Chief Financial Officer and say once again how thrilled we are to have her step into our role. I would also like to thank Gary Bachman for his work as CFO over these last four years and we look forward to his continued contribution as our Chief Operating Officer.
Jessica is going to review the firm’s results in a few minutes. But first I would like to offer some observations on the value cycle, how continued investor uncertainty has resulted in a massive spread between cheap and expensive stocks and why this is critical to the value investor.
Although, equity markets appear to have mostly [sloughed] off the challenges of a China slowdown and Brexit, it has mainly been the continued flight to safety and flight to yield that has propelled equities. As investors found refuge in stable earners and bond proxies in the midst of uncertainty and low yields they pushed the valuations of those stocks ever higher while cheap stocks dominated by financials and cyclicals became even cheaper. This has left investors with a paradox. Markets are high and cheap stocks are very cheap.
Although unusual, the situation is not without precedent. We had exactly the same experience during the Internet bubble when the valuation of new economy stocks rose to unsustainable heights with old economy stocks left for dead. We all know how that ended and spreads today between cheap and expensive stocks are approaching Internet bubble levels.
Periods of spread widening are painful for the value investor, but they also set up the preconditions for value to work over the entire cycle. History has shown that there are three necessary ingredients that set up future value outperformance. Wide spreads, corrective action by companies negatively impacted and abatement of the negative forces that initially drove down the valuation of the cheap stocks.
Today it’s the financials that have been crushed especially in the wake of Brexit, forming the core of deeply undervalued stocks in the developed world where valuations are cheap, trading at deep discounts to book value last seen in the euro crisis of 2011. In addition, managements have dramatically improved capitalization, liquidity and returns on equity in the face of massive headwinds. However, the final criteria in this case low interest rates are still with us.
Rising interest rates are not necessary for these investments to work however. Rising dividends and stock buybacks should provide tangible visibility to the underlying profitability and stability of these businesses. We also expect managements to continue to restructure to drive up profitability which should ultimately be rewarded once the environment stabilizes.
We recently completed a study examining the performance of value strategies when spreads are wide across the developed world. Out of 14 periods, a classic value approach provided positive alpha in 13 of those observations over the ensuing three-year period ranging from 7.6 to 12.6 percentage points per annum of alpha. Five-year relative performance was similar with positive alpha over 11 of 12 periods. We believe these numbers are extraordinarily compelling and wide spreads across all developed world regions today make us bullish on the outlook for value.
We are encouraged about our business prospects and initiatives. During the quarter, we launched our fourth mutual fund, small cap value and our intermediary distribution team is starting to gain traction. Combined with our sales team in the U.S., Europe, and Australia we are winning mandates even in the face of a risk-off environment.
We know there are periods when being a value investors trying and we appreciate your continued confidence and support, but these periods are exactly why value investing work. Most people give up when the pain seems worst which history shows us is when investors should be investing in value. We are committed to our value discipline, so our clients can win in the long run.
I’ll now turn the call over to Jessica Doran, our Chief Financial Officer who will provide this quarter's financial update.
Thank you, Rich. As Gary mentioned, we reported non-GAAP diluted earnings of $0.10 per share for the second quarter compared to $0.09 per share last quarter and $0.14 per share for the second quarter of last year.
Our non-GAAP income statements adjust for recurring valuation allowance and tax receivable agreement item. During the second quarter of 2015, our non-GAAP income statements also adjusted for certain non-recurring charges recognized in operating expenses. I will address the tax related adjustments at the conclusion of my remarks, but for now I will focus on the non-GAAP operating income information.
Our assets under management ended the quarter at $25.4 billion, down 2.7% from last quarter, which ended at $26.1 billion and down 9.3% from the second quarter of last year, which ended at $28 billion. The decrease in assets under management this quarter was driven by net outflows of $0.4 billion and market depreciation of $0.3 billion. The decrease from the second quarter of last year reflects $2.6 billion in market depreciation and flat net flows.
At June 30, 2016, our assets under management consisted of $14.3 billion in institutional accounts and $11.1 billion in retail accounts. Compared to last quarter, institutional assets decreased reflecting $0.3 billion in market depreciation partially offset by $0.1 billion in net inflows. Assets in retail accounts also decreased from the end of last quarter due to $0.5 billion in net outflows.
While assets under management ended the second quarter at $25.4 billion down from last quarter, the market depreciation occurred primarily towards the end of the quarter resulting in average asset of $26.1 billion, up 4% from last quarter and down 7.8% from the second quarter of last year.
Revenues increased 2.3% from last quarter and decreased 10.4% from the second quarter of last year, primarily reflecting the fluctuations in average assets under management. We do not recognized performance fee income during the second quarter compared to $0.1 million last quarter and $0.3 million in the second quarter of last year.
In general, our performance fees are calculated on an annualized basis over a three-year measurement period. Asset mix continues to be the most significant factor in our overall weighted average fee rate. Although, swings and performance fees can also contribute to short-term variability.
Our weighted average fee rate was 40.5 basis points for the quarter compared to 41.1 basis points last quarter and 41.8 basis points for the second quarter of last year. Our weighted average fee rate for institutional accounts was 52.6 basis points for the quarter, down from 53.9 basis points last quarter and 53.5 basis points for the second quarter of last year.
The decrease from last quarter and the second quarter of last year reflects the shift in mix of assets toward our Expanded Value strategies that generally carry lower fee rates. Partially offset by the addition of assets in certain non-U.S. strategies that generally carry higher fee rates.
Our weighted average fee rate for retail accounts was 25.3 basis points for the quarter, increasing from 24.7 basis points last quarter and decreasing from 26.3 basis points for the second quarter of last year. The increase from last quarter is driven by an increase in assets in certain strategies that generally carry higher fee rates, while the decrease from the second quarter of last year primarily reflects the decrease in retail performance fees.
Looking at operating expenses, our compensation and benefit expense was $11.7 million for the quarter, down 6.4% from $12.5 million last quarter and down 0.9% from $11.8 million for the second quarter of last year. This decrease primarily reflects a decrease in bonus accruals for 2016. GAAP G&A expense were $3.5 million for the second quarter of 2016.
During the second quarter of 2015, we adjusted our non-GAAP results for non-recurring expenses of $1.5 million associated with our former headquarters. Excluding these one-time adjustments, G&A expense increased $0.4 million from last year and $0.5 million from the second quarter of last year.
The non-GAAP operating margin adjusting for the non-recurring expenses was 42.6% this quarter, compared to 39.8% last quarter and 49.8% in the second quarter of last year. Net of outside interest, we recorded a non-operating loss of $0.3 million this quarter compared to income of $0.2 million last quarter and $0.5 million during the second quarter of last year. These fluctuations arise generally as a result of the performance of the firm’s investments.
The non-GAAP effective rate for unincorporated and other business taxes was 4.7% this quarter compared to 4.4% last quarter and 3.8% in the second quarter of last year. We expect the effective rate associated with the unincorporated and other business taxes of our operating company to be between 4% and 5% on an ongoing basis.
The non-GAAP effective tax rate for our corporate income taxes, ex-UBT and other business taxes was 37.3% this quarter compared to 36.2% last quarter and 32.2% for the second quarter of last year. These effective rates reflect tax benefits from employee share and unit vesting and option exercises.
We expect this rate excluding any share in unit vesting to be between 36% and 38% on an ongoing basis. The allocation to the non-public members of our operating company was approximately 76.5% of the operating companies’ net income for the second quarter of 2016 compared to 77.4% last quarter and approximately 88.5% 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. During the quarter through our stock buyback program, we repurchased and retired approximately 90,000 shares of Class A common stock for $0.8 million and approximately 6,000 of our operating company Class B units for less than $0.1 million. At June 30, there was approximately $9.2 million remaining in the repurchase program.
Before we turn it over to questions, I'd like to briefly walk through the non-GAAP income tax expense items. We recognized adjustments as the result of the revised estimates of future taxable income and our ability to utilize our deferred tax asset. We recognized a $0.1 million net expense associated with changes to our deferred tax asset, valuation allowance and liability to our selling and converting shareholders. These adjustments comprise the majority of the difference between our second quarter 2016 non-GAAP and GAAP net income.
On a quarterly basis, we will record 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 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 $0.9 per share for the quarter. At quarter-end, our financial position remained strong. Our cash balance was $24.8 million at June 30 and we declared a $0.03 per share quarterly dividend last night.
Thank you for joining us, we would now be happy to take any questions.
Thank you. [Operator Instructions] And our first question comes from the line of Ken Worthington from JPMorgan. Your line is now open.
Good morning. This is Will Cuddy filling in for Ken. First, congratulations guys on the new roles. You had mentioned an increasing shift to Expanded Value strategies driving down institutional fee rate? Why are Expanded Value strategies growing more quickly than the Focused Value strategies, the performance fees?
Yes. I mean I think it's probably not performance; it's probably fees and channel. The fee rates are lower and they're more diversified. So they appeal to a different kind of client base. But where there are sub-advisory kind of relationships where there is an intermediary involved and the fee sensitivity is greater, they've tended to gravitate towards these types of strategies and we've had a lot of success in attracting assets in that channel. So I think that's the primary explanation.
Okay. Great thank you. How does the sales pipeline look moving forward?
It's been pretty flat over a couple of years now. I guess the way I would describe it is – it's stable, there is a lot of interest and talk about the value cycle, a lot of hand-wringing about whether you should pull the trigger, and not a lot of uptick in the actual pipeline. On the other hand, there's not really a down tick in the actual pipeline either, so we're continuing to find prospects.
We have had a pretty decent year of net flows and I am calling decent slightly negative, considering the environment that we are in which is substantially anti-value, anti-active, anti-risk. But we have a lot of large prospects in the pipeline and the win rate has been pretty good, actually, once things go to final, so I would say the outlook is stable, not improving, not falling apart.
Great. And can you add headcount? Where are you at – the count from year-over-year and quarter-over-quarter? Where are you adding headcount?
In headcount, we’re at 93, we’re at 90 at the end of the first quarter and we were at 89 a year ago.
I'm sorry. And where are those distribution roles for mutual funds?
We added three people in research in the second quarter?
Got it. Thanks.
Everything else was stable. For the rest of the year, we're still planning to add one more in research, two more in sales, and two more in administration.
Okay. I’ll re-queue.
[Operator Instructions] And the next question comes from the line of Ken Worthington from JP Morgan.
Hey, I’m back. I have a couple more questions.
Feel free to just keep asking your questions.
Okay, great. So EM Focused Value performance looks quite good so far this year? Can you talk about the performance of your other strategies?
Performance, really EM is probably the only really bright spot that we have compared to the traditional valuation benchmarks. So everything else is running as of the end of the second quarter more like 400 or 500 basis points behind benchmark and this is primarily due to our relatively large exposure to financial services in the developed market, which have been hard-hit as a result of Brexit.
And we actually see financials as probably having the best risk-reward trade-off of any sector in the market today. So as the Brexit environment unfolded and remember we are measuring on June 30, which is probably at the worst measurement point that we possibly could have picked given when Brexit occurred. Reduce the opportunity to top up and increase our purchases in financial services to maintain our weights in those sectors.
And by the way just to reinforce that not an issue in Emerging Markets where we have a very different perspective on financials then we do in the developed world.
Okay. So the mix of assets between institutional and retail again both those segments between U.S. global and international investment regions? Has that mix been shifting I think we saw a little bit between the – dispersion between returns this past quarter institutional and retail? How has that been changing?
Yes, I think we had more of an outflow this quarter in retail than we've had in a while. Some of that is performance related, so the John Hancock strategy was probably half of our outflows during the quarter. And I think what Vanguard Windsor had some small net liquidation and maybe – but call it a retail phenomenon driven primarily by John Hancock clients.
Great. That actually all I had. Thank you very much for taking our questions.
End of Q&A
At this time, I'm showing no further questions. I would like to turn the call back over to Ms. Jessica Doran for closing remarks.
Thank you, operator and thank you for joining us on today’s call.
Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may now disconnect.
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