Wayne Palladino – CFO and Treasurer
Rich Pzena – Chairman, CEO and and Co-Chief Investment Officer
Ken Worthington – JPMorgan
Pzena Investment Management, Inc. (PZN) Q1 2008 Earnings Call Transcript April 23, 2008 11:00 AM ET
Good morning. My name is Rodney and I'll be your conference operator today. At this time, I would like to welcome everyone to the Pzena Investment Management First Quarter Earnings conference call. (Operator instructions) I would now like to turn the call over to Wayne Palladino. Sir, you may begin your conference.
Rodney, thank you very much. I'm Wayne Palladino, Chief Financial Officer of Pzena Investment Management and I'm pleased to welcome you to our first quarter 2008 earnings conference call. I'm joined by Rich Pzena, Chief Executive Officer and Co-Chief Investment Officer of the firm.
Our first quarter 2008 earnings press release contains the financial tables for the periods we are going to discuss. If you don't have a copy, you can find it on our website at www.pzena.com in the Investor Relations section. Replays of this call will be available for the next week at the website you use today or by telephone number or as detailed in the press release.
From time to time, information or statements provided by us, including those within this conference call, may contain certain forward-looking statements relating to future events, future financial performance, strategies, expectations, competitive environment and regulations.
Forward-looking statements are based on information available at the time these statements are made and/or management's good faith belief as of that time with respect to future events and are subject to risks and uncertainties that could cause actual performance or results to differ materially from those expressed in or suggested by the forward-looking statements.
Such risks and uncertainties include, but are not limited to, loss of revenues due to contract terminations and redemptions, our ownership structure, catastrophic or unpredictable events, unavailability of third party retail distribution channels, damage to our reputation or interpretation of and positioning relative to market, fluctuations in the financial markets, and the competitive conditions in the mutual fund, asset management, and broader financial services sector.
For discussion concerning some of these and other risks, uncertainties, and other important factors that could effect future results, please see forward-looking statements and where applicable risk factors in the Company's annual report on Form 10-K as filed with the Securities and Exchange Commission on March 31, 2008. In addition, please be advised that because of the prohibitions on selective disclosure, the Company as a matter of policy does not disclose material that is not public information on our conference calls. If one of your questions requires the disclosure of material non-public information, the Company will not be able to respond to it. I'd like to begin by highlighting a few items about our financial results.
For the first quarter of 2008, we reported revenue of $30 million, operating income of $18 million, net income attributable to the publically held shares with $0.8 million, and earnings per share was $0.13. I'll discuss our financial results in more detail in a few minutes. First, I'd like to turn the call over to Rich Pzena, who'll discuss our view of the investing environment and how we're positioned relative to it.
Thanks, Wayne, and good morning everyone. The first quarter of the year continued the trend of exceptional volatility for the markets in general and value investors in particular. Our large cap value portfolio moved by more than one percentage point on more than one half of the trading days during the quarter. Only a year ago such extreme moves were happening on only a few days each quarter. Our various products ended the quarter down 5% to 10%, roughly in line with the broader markets, our benchmarks, and the naïve price to book strategy.
Our cumulative negative performance from our April 2007 peak our drawdown now exceeds 25%. This is the third time in our firm's history that we've experienced a drawdown of this magnitude, and still our long-term performance record is intact. Since our inception, we are running nearly 450 basis points per year ahead of the S&P 500 including the recent drawdown in our Pzena value service strategy, which we've been managing since the firm's inception 12 years ago. And believe it or not, we are even outperforming our naïve low price to book strategy in this downdraft.
So, while this is painful in the short term, it is not unprecedented. This is what value investing feels like. This is why value investing works in the long run. This recent weakness is absolutely in line with values long-term history. A very simple strategy, buying the lowest price-to-book stocks over the past 50 years based on the cheapest quintile of the largest 1000 stocks would have resulted in a return of about 200 times the initial investment versus about 60 times for the S&P 500. But along the way, there were 8 times, you would have lost 20%.
Over the long term, of course, they are little blips. But while you are in them, they feel awful. Our clients understand this dynamic, and while they ask inevitable questions, why couldn't you just wait until they are really cheap before you bought them? They intrinsically understand that the strategy of trying to wait is extremely difficult to implement, and inevitably leads to poorer long-term performance. That's because markets like we had experienced over the last 12 months are rare and spending tremendous effort to try to avoid them are likely to cause more harm than good to the long-term record.
Further more, knowing when to jump back in is not quite as easy as it sounds. Our process of purchasing companies in the cheapest quintile of their respective universes on the basis of price to normalized earnings, identified financial stocks is being cheap a year ago. True to our discipline, we began to increase our exposure to these stocks. While in retrospect, we were early to discipline is what has led to our outstanding long-term results. Never the less, it is true in the short term holding these stocks is painful. For us and of course for our clients, no one likes losses, but in the long term, we expect the market to catch up to their true worth and reward our patience.
The volatility and wild mispricings we are seeing are the result of investor emotion running high, the very opposite of the mythical effaced market where securities are always priced according to their true vale. Investors are worried that the subprime mortgage crisis has permanently impaired the financial system, and that the leveraging up [ph] of recent years will hobble the US and perhaps the global economy for years to come.
The fact is emotion was running just as high during the bull run [ph] not too long ago as investors got into the China growth story and bid up commodities to extremes. After a 50% decline in China, we need to pay attention to not only the momentum but also to the valuation. We are hopeful that the US market is about to pay more attention to valuation. Our portfolios continue to be largely exposed to financials, consumer cyclicals and housing related stocks, where mispricing is extreme.
As we discussed on our last quarterly earnings call, a move into the recession has been the turning point for investors to refocus on valuation in each of the recessions over the last 40 years. We don't see any reason to believe why this one will be different. The current valuation in financials is very similar to the valuation we saw in 1990. And although it seems that deleveraging is unprecedented, the firs half of the 1990's was also a period of deleveraging. And during the first half of the 1990's, the economy grew and financial and consumer stocks were up sharply.
Further more, in this cycle, the excessive leverage in financial institutions is limited to the brokerage firms and hedge funds. Both bank capital ratios, and insurance company premium to surplus ratios are very strong relative to history. In fact, financial leverage among the traditional intuitions appears to be less of an issue this time. Then why are investors in a panic? This too is a classic phenomenon and we can turn to the discipline of behavioral finance to understand it.
Behavioral finance is a way of understanding what drives the sometimes very inefficient market. It was founded by two academics Daniel Kahneman and Amos Tversky. Kahneman won the Nobel Prize for his work. Tversky would have shared it had he lived long enough. Behavioral finance describes the phenomenon of trend extrapolation, the tendency of human beings to over wake the current environment believing that whatever is happening now is likely to just continue. That of course can lead to bubbles, and in a negative market to panics.
This rollercoaster effect give rise – gives rise to the two basic styles of investing, momentum and value. Momentum investors like to ride the emotion, value investors like to exploit the emotion. As I mentioned during our last call, momentum strategies tend to outperform at the end of an economic cycle, while value strategies tend to outperform once a recession has begun. We are currently in a place very similar to the last cycle, which played out from 1999 to 2003.
There too, our (inaudible) our firm suffered a 25% decline. And it was during that cycle, we made our firm's biggest investment mistake. A company called (inaudible), it ultimately went bankrupt. Interestingly as a result of excess financial leverage, and it's now safely housed in Warren Buffet's portfolio of businesses. Yet even with the 25% drawdown, and even with an investment that fared about as poorly as possible, we still had our best returns over the next few years.
Now, I would like to give you an update about our business. This quarter, assets under management in our separately managed accounts decreased primarily due to market depreciation. We did have about $200 million of net outflows largely due to one very large account, which moved a portion of their account out of our strategy and into an index strategy on the last day of the quarter. We are gratified that that client still has chosen to maintain a significant relationship with us.
Our retail sub-advised assets saw $800 million in outflows though this was half of what it was in the previous quarter. Our relationships with John Hancock and the other institutions we sub-advise for continue remain very strong. Our new financial opportunity strategy initiated to capitalize on the extraordinary opportunity in the financial sector now has $230 million in assets. We continue to be included in search activity and are very much looking forward to a turn in investor sentiment back to a value orientation.
Now, I'll turn it back over to Wayne for more details on our financial results after which we'll take any questions.
Thank you, Rich. Certain financial results I'm going to discuss for comparative 2007 periods are presented on a pro forma basis as we believe these adjustments and the non-GAAP measurements derived from them, provide information to better analyze the Company's results between periods and over time. You can see the details of these pro forma adjustments in our press release.
First, let's discuss assets under management or AUM. Our assets under management during the first quarter of 2008 declined by $3.2 billion or 13.6% from $23.6 billion at December 31, 2007 to $20.4 billion at March 31, 2008. About two-thirds of asset losses during the first quarter were $2.2 billion were due to negative performance of our investment strategies. We also lost $1 billion in assets during the quarter due to net outflows most of which were from our sub-advised channel.
At March 31, 2008, the Company managed $12.5 billion in separately-managed accounts and $7.9 billion in sub-advised accounts. Sub-advised assets declined by $1.7 billion or 17.7% during the first quarter from $9.6 billion at the end of the fourth quarter of 2007, due to $0.9 billion in market depreciation and $0.8 billion in net outflows. Assets in separately-managed accounts decreased $1.5 billion, or 10.7% to $12.5 billion at March 31, 2008 from $14.0 billion at December 31, 2007, due to $1.3 billion in market depreciation and $0.2 billion in net outflows.
Our first quarter 2008 revenues were $30 billion – $30 million down by 15% from $35.3 million in the first quarter of 2007, and by 13.8% from the fourth quarter of 2007 which were $34.8 million. The reduction in revenues was due to declines in average assets under management somewhat offset by an increase in our weighted average fees. Average assets under management were $22 billion for the first quarter of 2008 down by 21.4% from $28 billion for the first quarter of 2007, and by 16.7% from $26.4 billion for the fourth quarter of 2007.
Our weighted average fees increased to 54.5 basis points in the first quarter, up from an average of 50.5 basis points during the first quarter of 2007, and 53.0 basis points for the fourth quarter of 2007. This increase was mainly due to the shift in asset mix to separately-managed accounts to 61.3% for first quarter of 2008, up from 53.7% of our assets for the respective 2007 period, and from 59.3% of our assets for the fourth quarter of 2007.
Weighted average fees on our separately-managed accounts rose to an average of 64.6 basis points during the first quarter of 2008 from an average 63.4 basis points during the first quarter of 2007, and remain relatively constant with the fourth quarter of 2007, which was 64.9 basis points.
Compared with the first quarter of 2007, first quarter 2008 total operating expenses on a GAAP basis decreased $93.9 million. Included in first quarter 2007 operating expenses were $94.9 million of charges related to the accounting treatment for partnership units that was eliminated on March 31, 2007, and did not recur in 2008. On a pro forma basis, first quarter 2008 total operating expenses increased by 9.1% from the first quarter of 2007 primarily reflecting the increased costs incurred operating as a public company, as well as additional facility and personnel related costs associated with the increase in company headcount in 2007.
Operating expenses in the first quarter of 2008 declined approximately 13.7% compared to the GAAP results of the fourth quarter 2007, primarily is the result of the one-time professional fees associated with the Company's IPO in 2007, which were not replicated in the first quarter of 2008. On a pro forma basis, operating expenses in the first quarter of 2008 remained relatively constant compared to the fourth quarter of 2007.
We continue to anticipate 2008 total operating expenses to be slightly higher than those of 2007, due to additional legal and accounting costs of operating as a public company, as well as the full year effect of the personnel added during 2007.
Operating income for the first quarter of 2008 was $18.0 million versus a $70.6 million loss on a GAAP basis for the first quarter of 2007, and $24.3 million on a pro forma basis for the first quarter of 2007. Operating income for the fourth quarter of 2007 was $20.9 million on a GAAP basis, and $22.7 million on a pro forma basis.
Operating margins were 60.0% for the first quarter of 2008, compared with negative 200% for the first quarter of 2007, and 60.0% for the fourth quarter of 2007. Again those 2007 numbers were on a GAAP basis. Pro forma operating margins for the first and fourth quarters of 2007 were 68.9% and 65.2%, respectively. The decline in operating margins is primarily related to lower revenues over which to spread our operating expenses.
Other income/expense was an expense of $4.1 million for the first quarter of 2008, and included an expense of $3.6 million related to the negative performance of investments in the Company's own products. The remaining $0.5 million is interest expense on the Company's $60 million term loan, offset by interest and dividend income and cash balances.
Other income/expense declined by $4.3 million for the first quarter of 2008 from the first quarter of 2007, primarily as a result of the performance of Company's investments, as well as interest expense associated with the $60 million term loan entered into on July 23, 2007. Operating expense, income/expense declined $1.6 million for the first quarter of 2008 compared with the fourth quarter of 2007, primarily due to the recognition of settlement fee income in 2007 that was not replicated in 2008.
On a pro forma basis, other income/expense decreased by $3.3 million compared with pro forma first quarter 2007, and by $1.6 million from pro forma fourth quarter of 2007.
We've provided supplemental income statement data on the last page of the press release to assist you in calculating our effected tax rate. Let me just take a moment to walk you through the calculation. As you will see, our effective tax rate for the first quarter of 2008 was approximately 45.8%. To calculate the numerator or the amount of income tax related to the publicly held shares, take 9.6% of our unincorporated business tax, which is assessed against all of our operating Company's income and add it to the provision for corporate income taxes. The result is $692,000 of income taxes attributable to the public shares. Calculate the denominator or pre-tax income by taking reported income before corporate taxes of $1,422,000 and add back the 9.6% of unincorporated business tax attributable to those shares that would be 9.6% with $940,000 or $90,000.
The result is pre-tax income attributable to the public shares of $1,512,000. Thus our effective tax rate is $692,000 divided by $1,512,000 or 45.8%. The same calculation for the first quarter of 2007 on a pro forma basis results in an effective tax rate of 45% for that period. As a result of the fore doing [ph], we reported $0.13 of net income per diluted share for the first quarter of 2008. And now we would be happy to take any questions.
(Operator instructions) And your first question comes from the line of Ken Worthington of JPMorgan.
Ken Worthington – JPMorgan
Good morning. May be first for Rich. I wanted to flush [ph] out some of the comments you had in your prepared remarks about what you gained from institutional customers. In terms of RFP activity, can you tell us what that's been like and has the hit [ph] rate in your institutional finals, has that changed all because of performance or do the institutional investors still believe in the long-term Pzena story here, and you said demonstrated in RFP activity?
Well, let me explain RFP activity in a number of stages. First you get a notification that you are being considered. That activity level has not fallen off at all and continues to be very, very strong. Then there's a weeding down process where we get down from the initial RFP to make it through to finals. That weeding down process is – there's significantly more are weeding down now than they used to be, and then you go to the finals, and our win rate in – finals which I would have called in our history to be unusually high, I would say is more like normal today. So, where I would put the – most of the change is not that people aren't considering us, I think our brand remains pretty strong. I think the issue becomes – those clients that are unearthed by recent performance and little was out in that first weeding down stage. So, that was your question.
Ken Worthington – JPMorgan
That was a great answer, that's exactly what we were looking for. Second question, and again going to the prepared remarks, in terms of for lack in better phrase [ph] investment methodology, are there lessons learnt for may be the market sell off over the last three quarters and the way you've positioned the investment portfolio, and if so, are there either tweaks so like minor adjustments or anything more substantial that you are making either to the investment models or methodology? It sounded like no, but I thought I would ask anyway.
Yes. I think the answer is no. You can't go through one of these periods without questioning what you do. And as I indicated I think last quarter, and I refer to at this quarter to have been able to have perform and so was significantly different than what we had would have been to really either abandon a basic valuation strategy or modify it to incorporate momentum overlays, meaning timing overlays. And whenever we backed, actually [ph] we've done lots, and lots of it because if you make the assumption that momentum investing works on over the long term and value investing works on – over the long term, combining them together you should get even better returns. It's actually not what happens. When you combine them together, you wind up effectively reducing volatility but at the expense of long term returns. So, it's not like we've given up on this. Psychologically, you don't want to have to go through these kinds of periods, the question is, can you identify them and know when they might happen because it isn't always the case that bad news leads to bad performance. There are only certain times when that happens, and they tend to be consistent around the ends of economic cycles. The problem is you don't know when you are at the end of an economic cycle until it is. So, we are – I don't want to say that we've given up, I'm trying to improve our process but at this point, we haven't come up with anything that would have dramatically improved our recent results.
Ken Worthington – JPMorgan
Thank you. And then may be lastly for Wayne. In the release you talked about and in prepared remarks talked about the (inaudible) business to fee rate going up year over year. Just walk us through why on the metric [ph] outside the rate actually increased? Is it a function of who's dropping off or who's coming on, if you just walk us through the extra 100 or so basis points?
Yes, what you are seeing there Ken is the effect of additional assets in our international global strategies, and as we look forward as that continues to be a major emphasis of ours, and assets are gathered in that area. We would expect that to have some upward influence on the fee rates, given that those recognized, probably on the average about 10 basis points higher than our average.
Ken Worthington – JPMorgan
Okay. Perfect, thank you very much.
(Operator instructions) Mr. Palladino, there are no further questions at this time, sir.
Okay. We would like to thank everyone for joining us on our first quarter conference call, and we look forward to speaking with you next quarter.
This concludes today's conference call. You may now disconnect.
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