Pzena Investment Management's CEO Discusses Q1 2012 Results - Earnings Call Transcript

| About: Pzena Investment (PZN)

Pzena Investment Management, Inc. (NYSE:PZN)

Q1 2012 Earnings Call

April 25, 2012 10:00 AM ET


Rich Pzena – Chairman, Chief Executive Officer & Co-Chief Investment Officer

Greg Martin – Chief Financial Officer & Treasurer


Ken Worthington – JP Morgan


Good day, ladies and gentlemen, and welcome to the first quarter Pzena Investment Management earnings conference call. My name is Ann, and I will be your coordinator for today’s call. At this time, all participants are in listen-only mode. (Operator instructions)

We will be facilitating a question-and-answer session following the presentation. I would now like to turn the presentation over to Mr. Greg Martin. Please proceed sir.

Gregory Martin

Thank you very much, Ann. Good morning and thank you for joining us on the Pzena Investment Management first quarter 2012 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 two 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 these statements are made. The company does not undertake to update such statements to reflect the impact of circumstances or events that arise after the date these statements were made. Investors should however consult any further disclosures the company may make in the reports filed with the SEC.

In addition, please be advised that because of the prohibitions on 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 requires the disclosure of material non-public information, we will not be able to respond to it. Thank you.

As always I’ll turn the call over to Rich, but first I’d like to review some of our financial highlights. We reported non-GAAP diluted EPS of $0.09 per share and $5.6 million in non-GAAP diluted net income. Revenues were $19.8 million for the quarter and our non-GAAP operating income was $9.9 million.

I’ll discuss our financial results in greater depth in a few minutes. Let me now turn the call over to Rich, who will discuss our view of the investing environment.

Rich Pzena

Thanks Greg. The year started out well on the performance side of the ledger, both for global markets and for our portfolios. The MSCI all country world index was up 11.9% in US dollar terms during the quarter, and has advanced almost 20% since last October. This is the flipside of the risk of behavior that dominated the April to September period last year.

During those six months, stable earnings and high dividend paying stocks were the big winners, as the fears of a euro zone meltdown caused a flight to safety among investors. This in turn drove down the valuation of economically sensitive sectors, with financials paying the highest price. As fears started to lift, we experienced a strong rebound in those sectors, with financials, housing related businesses, tack [ph], and other cyclicals posting the largest gains.

This helped our portfolios outperform their benchmarks by approximately 300 to 500 basis points during the first quarter of 2012, and to generate returns of 20% to 30% over the last six months. But despite this recovery, the five-year track record for most of our portfolios, and for deep value, in general, still lags benchmarks and the broad market. As we discussed with you last quarter, this fits in with the history of value investing.

During the last four value cycles spanning a 40 year period on average, five years after a prior value cycle peak, a naïve deep value benchmark worse still almost 12 percentage points behind the S&P 500, yet ended up posting a 500 basis point per annum advantage over the S&P 500 over the entire length of the cycles, which lasted an average of 10 years.

This included in average almost seven years of value out performance during these cycles. Today, we’re exactly 5 years past the peak of the last value cycle, and not surprisingly deep value is 12% behind the S&P 500, completely consistent with the last four value cycles. We have been actively engaging our clients in this discussion, emphasizing the length and power of value cycles.

Although there seems to be a growing recognition that equity markets are an attractive investment option, investors are having a tough time pulling the trigger to take advantage of them. For every conversation about adding incremental risk to the portfolio, there is another one about reducing volatility and derisking. We see this in our institutional asset flows, where despite being flat on a net basis over the last three years; quarterly flows have been chunky and erratic.

Just think about the current environment. CIOs, consultants and investment committees are faced with a very thorny issue, yields are low and liability is up. Get investments with some of the attractive valuations that may help close this growing gap are in sectors that brought the economy to the brink less than four years ago. This includes financials with some of the cheapest valuations in the equity markets today, as well as other industries yet to stage a strong recovery, such as those linked to residential housing.

Although we cannot deny the pain incurred both broadly and in our portfolios as a result of the collapse in the housing activity and the ensuing global financial crisis, we stress that it is equally important to remain disciplined and objective, and not overlook opportunity. Significant progress has been made by financial institutions in the US, UK and Switzerland ensuring up balance sheets and liquidity, while underlying profit drivers are strengthening.

Although not all uncertainties are resolved, or can they ever be, it is very possible that the worst is behind us and we’re staring opportunity squarely in the face. It is still difficult for most investors to seize the opportunity, the pain is too fresh, the trauma was too deep. Conventional wisdom is to wait for further improvement and stay hunkered down in the meantime.

This behavior is common. We have seen it before, and it has been studied for decades by psychologists and behavioral economists. They have coined a term to describe it, disaster myopia. Subsequent to a low-frequency but high loss catastrophe, humans tend to overestimate the probability of recurrence shortly after the initial event. With the passage of time, investors lower their subjective probability and eventually people become comfortable once again.

We believe this behavior creates opportunity, and underlies the cycle of value investing we discussed last quarter. And as we dug further into the data underlying value cycles over the last 40 plus year, we found clear evidence of disaster myopia in each of the last four value cycles, as well as the current one. Our client service and business development focus is to provide data to help investors see beyond their disaster myopia and recognize the opportunity.

Now let me spend a few minutes addressing that opportunity. Despite the recovery over the last two quarters, economically sensitive businesses are still priced at a wide discount to perceived safe stocks, continuing to provide us outsized opportunity. In fact, there are three features of current equity markets that we find particularly striking, high dividend paying shares are historically rich valuations. This is likely a reflection of the fact that in many markets shall yield more than long-term government bonds, and investors feel the need to pursue income producing alternatives.

High yielding shares have generally been regarded as safe by the market, further increasing demand and valuation. The valuation spread between low beta defensive stocks, utilities, health care, consumer staples and telecom, and high beta stocks, economically sensitive names as well as financials, continues to be wide. Investors have sought a safe haven of defensive names leaving high beta stocks behind.

Finally many companies with very high cash flow yields are being overlooked in an environment, where dividends attract a premium. Today many of the non-financial names in our portfolio trade at free cash flow yields of 10% or more, providing an unusually attractive opportunity. The recent recovery in equities has certainly not been on a scale to eliminate the value opportunity. Although the valuation gap between cyclicals and defensive names has narrowed somewhat during the recent rally, the undervaluation of certain companies and sectors in the market remains compelling.

This is an exciting environment for our research team, which continues to identify solid deep value opportunities for our client portfolios. Our expanded sales team is actively getting this message out and we’re seeing traction in the form of increased search activity around the world. The ongoing focus on macro events and the continued risk on risk of behavior pattern may continue to make this a bumpy ride.

We in turn will stick to our investment discipline as we always have in each and every year since our inception, and concentrate on creating portfolios of the most attractively valued opportunities to help our clients meet their long term objectives. Our feeling is that if the past investment cycles are in any way a guide to the evolution of the current cycle, we are likely still in the foothills of this value cycle.

And now I would like to turn it over to Greg Martin, our Chief Financial Officer, who will review our results.

Gregory Martin

Thanks Rich. I’ll start off by discussing our AUM, fee rates and revenues. Our average AUM was $14.3 billion during the quarter, up 8.3% from last quarter and down 11.7% from the first quarter of last year.

We ended the quarter with $14.7 billion of AUM, up 9% from the end of last quarter, which ended at $13.5 billion, but down 10% from the end of the first quarter of last year, which ended at $16.3 billion. The $1.2 billion increase from last quarter was primarily a result of $2 billion in market appreciation, partially offset by $0.8 billion in net outflows. The $1.6 billion decline from the first quarter of last year was a result of $0.2 billion in market depreciation and $1.4 billion in net outflows.

At March 31, 2012, our AUM consisted of $12.2 billion in institutional accounts and $2.5 billion in retail accounts. Assets in institutional accounts were up 8% during the quarter, due to market appreciation, but offset by net outflows. Retail assets were up from last quarter thanks to market appreciation and minimal net outflows.

Revenues were $19.8 million for the first quarter of 2012, up 5% from last quarter, but down 9% from the first quarter of last year. The year-over-year decrease was primarily the result of lower weighted average assets. The increase from the fourth quarter of last year was driven by highly weighted average assets, offset somewhat by a reduction in performance fees recognized. These performance based fees pay incentive fees according to the performance relative to certain agreed up on 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 55.2 basis points for the first quarter of 2012, 57.3 basis points last quarter, and 53.9 basis points for the first quarter of last year. The increase from the first quarter of 2011 was attributable to a higher mix of assets in the company’s institutional channel and its retail emerging market strategy, which carry higher fee rates. The decrease from the fourth quarter was primarily due to a reduction in performance fees recognized in 2012 as compared with 2011.

Our non-GAAP income statements adjust for the recurring valuation allowance and tax receivable agreement items. Our first quarter 2011, non-GAAP income statements also adjust for certain one-time real estate and employee related costs, which we discussed during last quarter’s earnings call. I will adjust the current adjustments at the conclusion of our remarks, but for now I will focus on the non-GAAP information.

Looking at operating expenses, our compensation benefits expense was $8.2 million for the quarter, up 3% from last quarter, and down 2% from the first 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 $1.7 million for the first quarter of 2012, down over 10% from last quarter and last year. Both changes were primarily driven by reductions in real estate expenses associated with the sub lease of excess office space in the fourth quarter of last year, as well as the timing of expenses.

Operating margins were 50.0% this quarter, 47.1% last quarter and 52.8% in the first quarter of last year. Net of outside interest, other income was $0.5 million this quarter and last quarter, and $0.2 million in the first quarter of last year. These fluctuations arise generally from performance of our firm investments.

The effective rate for our unincorporated business taxes was 6.1% this quarter, relatively flat with last quarter, and down from 6.6% in the first quarter of last year. The fluctuations in these effective tax rates are driven by certain expenses that are permanently non-deductible for UBT purposes. We expect this rate to 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 83.6% last quarter and approximately 85.4% in the first quarter of last year. The variance in these percentages is the result of changes in the ownership interests of the public entity in the operating company.

The effective rate for our corporate income taxes, ex-UBT, was 42.8% this quarter, 40.8% last quarter and 42.8% for the first quarter of last year. The decline in our effective tax rate from last quarter is a result of minor prior period adjustments. Our expectations are that our corporate effective rate will generally be between 42% and 43%. As a result, we reported basic and diluted non-GAAP EPS of $0.09 for the first quarter.

Before we turn it over to questions, I’d like to briefly walk through the usual valuation allowance and tax receivable adjustments. In the first quarter of 2012, we recognized adjustments that arose as a result of revised estimates of future taxable income and our ability to utilize our deferred tax asset.

We recognized a $1.1 million decrease in our valuation allowance and a $1.0 million increase in our liability to our selling and converting shareholders for the quarter. The net effect to these adjustments comprises the difference between our first quarter 2012 non-GAAP and GAAP net income.

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 amount I just discussed, we reported GAAP basic EPS of $0.10 and diluted EPS of $0.09 for the quarter.

At quarter-end, our financial position remained strong. Our cash balance was 27.8 million at March 31, and we declared a $0.03 per share quarterly dividend last night. Our board also approved a $10 million share and unit repurchase program to be used to mitigate the dilutive effect of annual stock, unit, and option grant to our employees. We anticipate that this program will be implemented over the next several years.

Thank you for joining us and we’d now be happy to take any questions.

Question-and-Answer Session


(Operator instructions) And our first question comes from the line of Ken Worthington with JP Morgan. Please proceed.

Ken Worthington – JP Morgan

Hi, good morning. I guess first on the performance fee side, performance in 1Q was actually pretty good, can you talk about the dynamics of why performance fees would be down if what you are adding to the performance base has been quite good. Was it good on a relative basis, but bad versus the benchmark, or I didn’t actually dig into what was rolling off, maybe there was something outstanding rolling off, but just a little information on why the decline in performance fees?

Rich Pzena

Yes. I mean -- if it is none of those issues, the only issue is the anniversary date on which we calculate the performance fee, and they are not distributed evenly across the quarters. But the way our performance fees work is there are three rolling performance fees, almost all of them, and they have a specific date that we measure. And we measure our performance on that date if we earn the performance fee on that date that is when we book it. We don’t really accrue anything.

Ken Worthington – JP Morgan

Got it. And when you -- is this -- are they -- so when you book it, it is booked for the three-year period on a specific date, it can be 1Q, 2Q, 3Q or 4Q, is that…

Rich Pzena

Right. It is just on the anniversary of when the account opened.

Ken Worthington – JP Morgan

Okay. In terms of kind of the -- to say this, what is the seasonality there, do you have a lot more accounts with anniversary dates in 1Q, is it weighted to 2Q, 3Q, 4Q, evenly split and is -- as we look forward-based on the three year numbers on the products where you have these performance fees, are performance fees going to bounce back, are they going to fall further, what would you expect?

Rich Pzena

They are very heavily weighted to the fourth quarter. So most of our accounts earn performance fees in the fourth quarter.

Ken Worthington – JP Morgan

Okay. Two far away to kind of probably dig into what they look like.

Rich Pzena

Yes. I mean, our -- and they are 3 year numbers generally. So our 3 year numbers are at their peak right now, because 3 years ago is when we had our best quarter. So they won’t be as good. If we have no relative performance change between now and the end of the quarter, they will roll downward.

Ken Worthington – JP Morgan

Okay. And then you announced I think in the press release a buyback, in terms of that, the stock is very thin anyway, you are kind of a small microcap company, and I think you highlighted how dividend paying stocks are being highly valued, so in your consideration of ultimately the flow, but also on the dividend as well why not a decision for the dividend, why go for the buyback?

Rich Pzena

Well, as you know, I think we pay out 80% of our earnings already in the dividend. And we just view this very simply as wanting to effectively keep the shares outstanding flat over time, rather than saying we are actively going to buy back a lot of stock. We’re not using a lot of resources for this. This is mostly to say, look, we issue some shares and options every year. Our share count has crept up; I will call it marginally, because it really hasn’t been that much.

But we decided, you know, that we would use a little bit of the 20% that we don’t pay out to effectively keep the share count flat.

Ken Worthington – JP Morgan

Okay. And I will ask one more and if there is still other questions, I will just jump back and ask the rest of them. But you mentioned that your sales force is going out with a message and getting traction on that message. And you know, you are seeing more interest from customers. Is there anything to kind of quantify the increase in interest, I know that we’re probably talking kind of small numbers to begin with, but more flavor there would be of interest?

Rich Pzena

Well, you know, we measure search activity. The problem is that search activity means that somebody called you up, and said, we are thinking of hiring a value manager, and we are including you in that search. Okay, and we track that. So we see how that -- now that could be that you’re imminently in serious discussions with somebody, or it could mean that you are one of 300 people that they are considering.

So I don’t know how much faith to put in these numbers. We view them as an indication, and that number has gone up quite dramatically just in the last, you know, six months. Now at the same time we had this pause in performance in this value cycle, we were marching along really for four years with an interruption for six months in the middle of 2011 really from April to September, where the momentum of these things got somewhat derailed.

And now that we’re back marching upward, the momentum is a bit re-established. So how you figure out how this goes from search activity to flows, I don’t even know how to answer the question. But I do think that we can trace the fact that we have expanded our sales team and they are out enthusiastically making calls to a response that says we are now considering you for a possible mandate. And I don’t know how much more flavor I can give than that.

Ken Worthington – JP Morgan

Just maybe one little flavor component, where are you seeing more activity in certain products than others, because you had launched some new products on the kind of the International global side, is it for kind of the core, or the global, or everything?

Rich Pzena

You know, I don’t really know the question. More recently it has been regional rather than global, but over the last few years it has been more global than regional. So I can’t tell you whether that is a trend or just what we have seen in the last few months.

Ken Worthington – JP Morgan

Okay, good. I will pause there and re-queue if there are other questions. Thank you.

Rich Pzena

All right. Thanks Ken.


(Operator instructions) Mr. Morgan. Please continue.

Ken Worthington – JP Morgan

Hi, okay. So, it is -- I think that is me again.

Rich Pzena

Yes, Ken. Keeping going.

Ken Worthington – JP Morgan

Yes. Head count was down, I guess down by a couple, it is two, are you going to replace them, I don’t know, it could have been?

Rich Pzena

Yes. There were administrative more than investment people, and the answer is yes.

Ken Worthington – JP Morgan

Okay. Let us see, can you go through the institutional side, you gave some flavor on the call, the sales were, gross sales just modest, the gross redemptions picked up quite a bit. And you know, customers don’t necessarily have to give you a reason, but your performance again was very good in the quarter. Obviously people will have a much longer term perspective, and these decisions are made over much longer periods of time. The fear I would have is that things are looking up for you, and you know the clients have kind of given up and are using the improvement as kind of their opportunity to exit. So any additional color I guess, on either side, either the kind of lack of the sales side, or the pick up on the gross rate redemption side in the institutional accounts.

Rich Pzena

Yes, I would say the pick up on the gross redemption side is non-significant. It is average roughly the same level for the last, I don’t know six, seven, eight quarters. I mean, it doesn’t -- so it tends to be early year weighted. I mean, having observed non-scientifically for the last 15 years that we have been in business, it tends to get hired in the first quarter, and hired in the second half.

And the data supports that. So I would guess it is just the pattern of investment committees making their decisions. They make decisions based on year-end data, and besides work managers they don’t want to employ any more. And then they redeploy it more towards the end of the year.

Now if that is really true, I don’t know. I think it is true and the data indicates that. I would tell you that that mostly where we have had redemptions has been from derisking, and been from people who have said that we are moving the portfolio to more of a bond kind of portfolio, or a less risky, less volatile equity portfolio. It is -- I know those are painful decisions because the yields on fixed income instruments are very low.

But I think that that is mostly what we experienced. There is some of what you mentioned, right, that is five years now, and your five-year record is still pretty poor. But, you know, for us it has been erratic and chunky, and it is really hard to generalize. We are not worried if that is your question that there is some trend here of clients giving up on value right at the worst time.

It actually feels like most of that is done and more of what we are experiencing is we are now 40 years into a value up cycle. Maybe I am missing something. This feels to us almost exactly like the first quarter of 2000, which was the bottom of the last value cycle. I mean, it was five years into an anti-value cycle. People were giving up redemptions, to reach their maximum point right at around the peak, or the trough, I will say it in the value cycle, right when five-year numbers were sort of miserable, and people couldn’t take it anymore.

And then the market turned. Now will that happen? It is happening in our performance that the investment is turning, and it is happening, the conversations are becoming about hiring us are becoming more intense. But you know, we didn’t have any inflows in the first quarter. So it was more an absence of inflows than it was a pickup of outflows that drove this. So I, if you saw that continuing quarter after quarter, you should be concerned. I don’t think that we feel like that is a risk at this point.

Ken Worthington – JP Morgan

Okay, great. That is it from me. Thank you very much.


Ladies and gentlemen, with no further questions, this concludes today’s question-and-answer session. I would now like to turn the call back over to Mr. Greg Martin for closing remarks.

Gregory Martin

Thank you for joining us on today’s call.


Ladies and gentlemen, this concludes today’s presentation, and you may now disconnect. Have a good day.

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