Pzena Investment Management Inc. Q2 2008 Earnings Call Transcript

| About: Pzena Investment (PZN)

Pzena Investment Management Inc. (NYSE:PZN)

Q2 2008 Earnings Call Transcript

July 30, 2008 10:00 am ET


Wayne Palladino - CFO

Rich Pzena - CEO and Co-CIO


Roger Smith - Fox-Pitt Kelton

Mike Carrier - UBS

Robert Lee - KBW

Ken Worthington - JP Morgan

Neil Stratton - Buckingham


Good morning, my name is Carli and I will be your conference operator today. At this time, I would like to welcome everyone to the Pzena Investment Management Second Quarter Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers remarks there will be a question-and-answer session. (Operator Instructions).

Thank you. Mr. Palladino, you may begin your conference.

Wayne Palladino

Okay, Carli thank you very much. I'm Wayne Palladino, Chief Financial Officer of Pzena Investment Management and I'm pleased to welcome you to our second quarter 2008 earnings conference call. I'm joined by Rich Pzena, Chief Executive Officer and Co-Chief Investment Officer of the firm.

Our second quarter 2008 earnings press release contains the financial tables for the periods we are going to discuss. If you do not 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 our website or by telephone at the number given 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 related 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 that are subject to risks and uncertainties that could cause actual performance or results to differ materially from those expressed in, or suggested by, forward-looking statements.

Such risks and certainties 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 thereof in positioning relative to the market; fluctuations in the financial markets and the competitive conditions in the mutual fund, asset management and broader financial services sector.

For a discussion concerning some of these and other risks, uncertainties and other important factors that could affect future results, please see forward-looking statements and, where applicable, risk factors in the Company's annual report on Form 10K and Form 10Q as filed with the Securities and Exchange Commission on March 31, 2008 and May 14, 2008, respectively.

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 second quarter of 2008, we reported revenue of $28.3 million, operating income of $17.0 million, net income, attributable to the publicly held shares of $0.8 million and earnings per share of $0.13.

For the six months ended June 30, 2008, we reported revenue of $58.3 million, operating income of $35 million, net income of $1.6 million and earnings per share of $0.26.

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 will discuss our view of the investing environment and how we're positioned relative to it.

Rich Pzena

Thanks, Wayne, and good morning everyone. The second quarter of the year was awful. There's no other way to describe it. Fear gripped the marketplace and sent almost all share prices lower, especially the shares of the financial services sector. We're now in territory where rational analysis has been discarded and emotion is driving securities prices.

While this is the type of market that allows traditional value investors like us to source our best opportunities, it is also the type of market that is very painful for our clients.

Let me use Wachovia Bank as an example of the emotion gripping the market. We purchased shares in Wachovia immediately after its capital raise. Our analysis concluded that there was very little likelihood of a need for further capital and, when conditions return to normal in a few years, it could earn around $5 per share.

In the panic, investors sold shares of Wachovia down by two-thirds, clearly believing the capital was inadequate and the franchise value was irrelevant. When Wachovia reported earnings last week, with what we thought was clear evidence of no need for more capital, the initial trading was down 10%. Following the conference call, the shares closed up 27%, a 37% swing in one day. Clearly, the franchise value of Wachovia didn't change by 37% during the course of the day. This is pure emotion.

During the quarter, we had moves of more than 1% in our portfolio on 52% of the trading days and moves of more than 2% on 12% of the trading days. This is a classic momentum market. No one is interested in what kind of franchise a business has or what it's worth. The only issue has been what is going to happen next? A light off, a capital raise, a dividend cut; price has become totally irrelevant to the marketplace.

Over the past 18 months, if you had simply bought a portfolio of naive momentum stocks, no research, just the stocks that did the best the prior nine months, you would have compounded at about 17% per year. And if you had simply bought cheap stocks, based on price-to-book, you'd have lost 17% a year. That kind of dramatic spread has happened at the end of every economic cycle in the past 40 years, as fear of the looming recession drives investors to lose sight of the valuation of the companies that are negatively impacted by the recession, and flee to the stocks that are working, in this case, energy and commodities.

But if history is a guide, once the session is underway and the safe haven momentum stocks turn out not to be immune from the normal rules of economics, valuation discipline should return and value stocks should outperform.

What's interesting about this cycle is that the spread in valuation between the haves and the have-nots is at an all time record high. If we examine the valuation spread between financials and commodities, it is at its highest point in 55 years. In fact, at the end of June, financials broke the previous record, in terms of pure relevant valuation set in 1990. The sector is now as cheap as it has been in recent history.

We are buying financial companies at valuations of as low as three times their normal earnings power. These stocks would have to quadruple to be fairly valued today, based on our long-term earnings estimates. There is unusually large performance potential locked up in financial stocks.

So the question is, what do you do now? Do we say, well we can't figure this kind of market out. We're just getting out. Or, do we say, this is what we're really paid to do; to react to market sentiment, to take advantage of it, particularly when it gets irrational. And it's definitely at that irrational point.

We clearly believe our job is to do the latter, react to irrational market sentiment. Our clients also expect us to do that. As you might imagine, we have had hundreds of calls with our clients over the past several months. In each case, they're checking to make sure we are sticking to our discipline and doing what they hired us to do, be value investors. As a result, our business has been quite stable. During the quarter, we actually had $700 million of net inflows.

But when will performance actually turn? Unfortunately, as value investors, we don't ever get to know the answer to that question. If we knew, it is highly unlikely the securities would be priced where they are today. Instead, let me talk about why we think financials are cheap and try to address some of the arguments against them.

The most significant case against financials is that de-leveraging and higher capital requirements will render the financial services industry incapable of generating the kinds of profits that it previously generated. Actually, we believe this thinking is backwards. Can you imagine if the entire oil industry got together and said, "We're going to withhold 10% of our volume from the market and save it for a rainy day." The price of oil would skyrocket and investors would bid up the price of oil stocks because they would understand that the future earnings power is going to be higher than the present earnings power.

Banks do essentially the same thing when they de-leverage. De-leveraging means that you don't make loans, because you're building your capital base. You withhold supply from the market. The price of loans or the spreads have already gone through the roof, yet nobody is forecasting higher profits in the future, in spite of net interest margins that are already widening in the earnings reports.

The second anti-financials argument is that, due to their high leverage, these companies are more likely to go bankrupt or suffer permanent capital destruction than other industries and so value investors should avoid them. If history is a guide, this is just wrong. We calculated the average rate of business failure for the thousand largest U.S. companies over the past two decades, a period including two recessions and credit cycles. We define failure as an 80% decline in share price over three years, sufficient evidence for permanent capital destruction.

We found that financial firms are actually half as likely to fail as other businesses. And that's in spite of the fact that there is excess leverage in financial services firms. We also looked at Moody's data over the past 40 years and found that, on a global basis, the default rate for banking and financial services is among the lowest of all industries, again, in spite of the fact that these companies are much more highly leveraged.

From what we read in the media, we would think that the capital base of the entire financial services industry has been decimated. That too is untrue. In reality, the change in book value per share for financials was actually a positive number in 2007, up about 3.5%, just as it was in the last downturn in 1990, during that banking crisis. Yet, the declines in share prices, both in 1990 and recently, were enormous.

Now let's talk about capital because this is what we hear about all the time. I'm going to use Fannie Mae and Freddie Mac as the most extreme of these examples.

The conventional wisdom is that Fannie and Freddie must raise capital. That's despite the fact that the companies say they have adequate capital. Their regulator says they have adequate capital. The Secretary of The Treasury says they have adequate capital. The Fed says they have adequate capital and every analysis that we do says they have adequate capital.

Let me walk you through that analysis. Both companies together insure an [initial] amount over $5 trillion of residential mortgage debt with about $90 billion in capital and reserves, an implied leverage ratio of over 50 times. So, the argument goes, a small downturn in the real estate market can bankrupt the company. Of course, that ignores the fact that $7.5 trillion of real estate, at current home prices, secures the debt and that Fannie and Freddie together are projected to generate over $20 billion per year in pre-tax earnings before credit costs.

So even the worst case forecast currently perceived by the market, $100 billion in losses, wouldn't eat into their capital base as it would take more than five years for those losses to fully materialize.

Furthermore, the delinquency rate would have to increase six to seven fold from current levels, even to get to $100 billion in losses.

While this is possible, it is highly unlikely. Before the capital and reserves of Fannie and Freddie are depleted, delinquencies would have to rise 12 fold. So, it's an issue of confidence. Right now, investors lack confidence because they're blinded by fear. Once they take a close look at the financial services sector, the leading companies, they'll see that there's adequate capital in most of them. Even if some of the firms do fail in some way, or their managements succumb to the pressure to raise excessive amounts of capital, the valuations are so extreme that investors in this sector could absorb the failures and still see spectacular returns.

And now, I'll turn it back over to Wayne for more details on our financial results, after which, we'll take any questions.

Wayne Palladino

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 second quarter of 2008 declined by $1.9 billion or 9.3% from $20.4 billion at March 31, 2008, to $18.5 billion at June 30, 2008. Our asset decline was comprised of $2.6 billion of negative performance of our investment strategies, offset by $700 million of net in flows, most of which were from our separately managed channel.

Year-to-date our assets have declined $5.1 billion or 21.6%, due to $4.8 billion in depreciation and $0.3 billion in net out flows. At June 30, 2008 the company managed $11.4 billion in separate accounts, and $7.1 billion sub-advised accounts. Sub-advised assets declined $0.8 billion or 10.1% during the second quarter from $7.9 billion at the end of the first quarter of 2008, due to $900 million in market depreciation, offset by $100 million in net in flows.

Assets in separately managed accounts decreased by $1.1 billion or 8.8%, to $11.4 billion at June 30, 2008, from $12.5 billion at March 31, 2008, due to $1.7 billion in market depreciation, offset by $600 million in net in flows.

Our second quarter 2008 revenues were $28.3 million, down by 23.1% from $36.8 million in the second quarter of 2007, and down by 5.7% from the first quarter of 2008, which were $30 million. The reduction in revenues was due to declines in average assets under management, offset to an extent by an increase in our weighted average fees.

For the six months ended June 30, 2008, revenues were $58.3 million, down by 19.1% from $72.1 million for the six months ended June 30, 2007. The reduction in revenues was due to declines in average assets under management.

Average assets under management were $20.4 billion for the second quarter of 2008, down 32.2% from $30.1 billion for the second quarter of 2007 and down 7.3% from $22.0 billion for the first quarter of 2008. For the six months ended June 30, 2008, average assets under management were $21.3 billion, down 26.8% from $29.1 billion for the six months ended June 30, 2007.

Our weighted average fees increased to 55.5 basis points in the second quarter of 2008, up from an average of 48.9 basis points during the second quarter of 2007, and 54.5 basis points for the first quarter of 2008. This was mainly due to the shift in asset mix toward separately managed accounts, which comprise 61.6% of our total AUM as of June 30, 2008, up from 53.9% as of June 30, 2007, and up from 61.3% as of March 31, 2008.

Weighted average fees for separately managed accounts increased to an average of 64.9 basis points during the second quarter of 2008 from an average of 63.2 basis points during the second quarter of 2007. Weighted average fees for separately managed accounts during the second quarter of 2008 remained relatively constant with those of the first quarter of 2008, which were 64.6 basis points.

Weighted average fees for sub-advised accounts increased to an average of 40.1 basis points during the second quarter of 2008 from an average of 32.3 basis points during the second quarter of 2007, and from an average of 38.9 basis points for the first quarter of 2008. For the six months ended June 30, 2008, weighted average fees increased to 54.6 basis points from 49.5 basis points for the six months ended June 30, 2007.

Compared with the second quarter of 2007, second quarter 2008 total operating expenses increased by $0.2 million, primarily as a result of the increased accounting, legal, and compliance costs associated with our status as a public company; however, compared with the first quarter of 2008, operating expenses in the second quarter of 2008 declined by $700,000 or approximately 5.8%, primarily as a result of lower variable compensation costs and decreased professional and data system costs arising from ongoing efforts to reduce overall operating expenditures. Management is continuing to analyze its cost structure to identify and implement additional potential savings.

Operating income for the second quarter of 2008 was $17 million versus $25.7 million for the second quarter of 2007. Operating income for the first quarter of 2008 was $18 million. For the six months ended June 30, 2008, operating income was $35 million compared with an operating loss of $44.9 million for the six months ended June 30, 2007. On a pro forma basis, operating income was $50 million for the six months ended June 30, 2007.

Operating margins were 60.0% for the second quarter of 2008 compared with 69.8% for the second quarter of 2007, and 60.0% for the first quarter of 2008. For the six months ended June 30, 2008, operating margins were 60.0% compared with negative 62.2% for the six months ended June 30, 2007. The pro forma operating margins for the six months ended June 30, 2007, was 69.3%.

Other income expense was an expense of $3.8 million for the second quarter of 2008, and included an expense of $3.3 million related to the negative performance of investments in the company's own products. The remaining $500,000 is comprised of interest expense on the company's term loan, offset by interest and dividend income. Other income expense declined by $5.5 million for the second quarter of 2008 from the second quarter of 2007, primarily as a result of the negative performance of the company's investments, as well as the $1.1 million in interest expense associated with the term loan entered into on July 23, 2007.

Second quarter 2008 other expense decreased by $300,000 from first quarter of 2008, primarily due to the performance of the company's investments. Other income expense declined $4.5 million for the second quarter of 2008 compared with the pro forma second quarter of 2007, primarily as a result of the performance of the company's investments.

We expect our interest expense to come down now that the swap the entered into in February has taken effect as of July 23. The fixed rate associated with the swap agreement is 4.325%, which will be in effect through July 23, 2010. We have provided supplemental income statement data on the last page of the press release to assist you in deriving our effective tax rate.

Let me take a moment to walk you through the calculation. As you will see, our effective tax rate for the second quarter of 2008 was 45.6%, this number varies slightly from quarter-to-quarter, mainly due to certain non-deductible New York City unincorporated business tax expenses, but is usually around 46%. To calculate the amount of income tax related to the publicly held shares, you must 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 approximately $654,000 of income taxes attributable to the public shares.

You then divide this number by our pre-tax income, taking our reported income before corporate taxes of $1.349 million, and add back the 9.6% of unincorporated business tax attributable to those shares, 9.6% of $887,000, or $85,000. The result is pre-tax income attributable to the public shares of $1,434,000. Thus our effective tax rate is $654,000 divided by $1,434,000 or 45.6%.

The same calculation for the second quarter of 2007, on a pro forma basis, results in an effective tax rate of 46.2% for that period. Again, you can find the information to perform these calculations on the last page of our press release.

As a result of the foregoing, we reported $0.13 and $0.26 respectively of net income per diluted share for the three and six months ended June 30, 2008.

With respect to the balance sheet, cash stands at approximately $37.2 million at June 30, 2008, a number that includes $5.7 million of cash held by our consolidated investment partnerships. As you may be aware, the covenants of our term loan agreement require us to make an amortization payment in any quarter in which AUM falls below $20 billion. We made our first $3 million amortization payment on June 30 of this year. We continue to believe that our current cash balances, coupled with our ongoing efforts to keep operating expenses in line with AUM levels, give us the financial flexibility to conform to the provisions of our term loan agreement.

And now we'd be happy to take any questions.

Question-and-Answer Session


(Operator Instructions). Your first question comes from Roger Smith with Fox-Pitt Kelton.

Roger Smith - Fox-Pitt Kelton

Great, thanks very much. I'm just curious a little bit of how the sales process is going in the separate account channel and what are you really hearing from clients, and how should we really think about potential mandates, or the pipeline in the future?

Rich Pzena

Let me address it in two different aspects, one is new prospects or clients that are prospective clients, and then existing clients. The pipeline, if you measure the pipeline as the search activity that we're included in, when we get notified that we're included in a search, remains very strong. And I think that's attributed to, basically to our reputation as a value investor. So the consulting firms that typically direct this process believe that they should expose their clients to us as one option if they're thinking about hiring a true value investor.

The process beyond the initial contact is obviously significantly weaker than it has been historically. Typically the process goes, you're exposed, there's a whittling down that can happen in a first round to maybe as many as 15 or 20 potential candidates, and then it gets whittled down to the final three or four before you make a presentation to the ultimate client. That whittling down process, we're whittled more than we used to be, because of our recent investment performance, which is not surprising.

We still make it into some finals presentations, however, and we used to win more than our fair share. Now we probably win our fair share. And so the process is clearly less robust than it used to be, but we're not shut out at this point in time, and we continue to have opportunities. The opportunities are quite erratic, and so predicting asset flows might be on a quarter-to-quarter basis is almost impossible in that channel, but that's the sales process.

As far as the existing clients go, whenever you get into a performance period like we've been in, the clients require a lot of handholding and the senior people in our firm are spending an extraordinary amount of time with our clients, to make sure they continue to understand why they hired us, what it is that we do, and why the performance has come out the way its come out, given what we do. Most people understand that and accept it, and they want to make sure that we are sticking to our guns going forward.

Obviously we have some clients who conclude that we're not appropriate for them, and they either withdraw assets or terminate us. We have other clients who are what I would call automatic re-balancers, who just send money whenever you under perform their other managers, and they take money away from you whenever you out perform the other managers. Those are the clients with the most systemic processes, and we generally appeal to those kinds of clients.

Then third we get those that are opportunistic, who think this is a good time to be adding, and that could be either existing clients or those that we've had long relationships with, but we didn't previously have a client relationship, that now seems like a really good time to enter. We have all of those things going on, and the net of them can be positive, it can be negative, but it's been modest, is they way I would describe it, compared to what it used to be when it was way better than modest.

Roger Smith - Fox-Pitt Kelton

Thanks. Then in this last quarter was any one of those three bigger than the other? Could you tell us where those flows in this quarter were coming from?

Rich Pzena

I think we had all of those factors in place this quarter. We had a number of new accounts funding, we had very few closures, and we sort of had balance between withdrawals and additions. So, I don't know even how to answer your question, other than to give you that information.

Roger Smith - Fox-Pitt Kelton

No, no, that's fair enough. And then in the sub-advised channel it looks like there were really good flows in the month of June. Is there anything going on there, on the sales effort, that we should think is going to build momentum in that channel?

Rich Pzena

We had a new sub-advisory relationship begin in June, which accounted for that. So I would tell you that the sales effort is ongoing, that we've had all along. I think new relationships in sub-advisory are erratic, so I wouldn't expect that that would happen regularly. The flows from the standard channels that you're aware of continue to be negative, although the negative numbers are significantly moderated from where they used to be.

Roger Smith - Fox-Pitt Kelton

Okay. And then the last question is on the amortization payment on the debt, is that going to be sort of at that $3 million level until we get back to $20 billion?

Rich Pzena

No, the way the agreement works is we have to get about 21.5 to stop that $3 million amortization payment.

Roger Smith - Fox-Pitt Kelton

Great, thanks very much.


Your next question comes from Mike Carrier with UBS.

Mike Carrier - UBS

Thanks guys. Just a question on the expenses, tough environment on the revenue side and you've done a lot, at least on the non-comp side. I guess just looking at the expense base going forward, at least in the next six months, is this a good base? And I know there are some things you're looking at in terms of taking out further expenses. But is there anything on the spending side that we should be looking for, or just more cost take out?

Rich Pzena

I think that the base you see right now is a good base, and we are in the process of examining whether we have any opportunity to take it down further. I don't know where we're going to come out on that, so I don't want to make any commitments at this point in time. But we are looking. Currently it's not our intention to reduce staff. So the opportunities that we would have from this point forward are somewhat modest, but we're still looking.

Mike Carrier - UBS

Okay, thanks. And then just, I understand the fee shift in terms of more of the separate accounts, in terms of where the flows are going, and the higher fee rate during the quarter. But when you look at the individual products in the separate accounts and sub-advised, what's driving that, like the incremental increase, whether it's sequential or year-over-year, in both of the segments?

Wayne Palladino

The key driver there, Mike, is the additional increase in global and international AUM and also as a percent of revenues. As you know, those carry generally a higher fee rate than our domestic strategies.

Mike Carrier - UBS

Okay, thanks then. Thanks a lot.


Your next question comes from Robert Lee with KBW.

Robert Lee - KBW

Thank you, good morning. Rich could we possibly get a little bit more color on the new sub-advised mandate, who it's with and which strategy would it be in?

Rich Pzena

Unfortunately I can't name who it's with, but I can tell you its U.S. large cap value.

Robert Lee - KBW

Is it on a mutual fund product, or is it some other type of product?

Rich Pzena

It's on a non-publicly distributed mutual fund product. So it's not something that is available, or anything that you could get access to information on, but it is a sub-advisory relationship.

Robert Lee - KBW

Okay. I also had another question on capital; I understand you've started amortizing the term loan facility. How should we be thinking about your dividend? Because I think between the amortization and your current payout, at least at current earnings rate you're probably running somewhere close to maybe a little bit below, kind of 100% kind of payout between the two. I understand you have a lot of cash on the balance sheet and what not, should be thinking that if assets stay around this low there's any concern about maintaining the distribution?

Rich Pzena

We're going to address the dividend with our board at our next meeting. I would tell you that our intention is to pay the dividend and the distribution for as long as we can. But the reality is that this depends a lot on where assets under management go. Your arithmetic is right, at current levels we're about even. If levels turn out to be significantly below where they are today, then we probably have to make an adjustment. If they move back up again then we feel like we have some breathing room, and obviously it's a fairly straightforward thought process, and we'll make that decision over the course of the next time that we have to make a dividend declaration, which is about a month away.

Robert Lee - KBW

All right great, thank you very much.


Your next question comes from Ken Worthington with JP Morgan.

Ken Worthington - JP Morgan

Hi, good morning. On the new sub-advisory mandate, are the fees in that mandate above or below the rest of your sub-advised business?

Rich Pzena

It's the same fee schedule. All of our sub-advised are on the same fee schedule.

Ken Worthington - JP Morgan

Okay, great.

Rich Pzena

So it's a function of assets under management, so it's a smaller asset base, so it would be at the higher end of the fee scale. If it grows then it will move toward -- but basically if you look at our largest sub-advised relationships, if we lose assets in those we lose them at the lowest level on that fee schedule. And when we get new assets on a smaller scale, they're at the higher level. So in reality it's actually an improvement to the average assets under management, the average weighted average fee.

Ken Worthington - JP Morgan

Okay, thank you. And then you reduced staffing very modestly during the quarter, were the cuts made among investment personnel, or elsewhere?

Rich Pzena

We made no cuts in investment personnel. Some of this was, I'd say, unintentional staff reductions. These are sort the normal process of people deciding to go somewhere else and not having the chance to replace them yet. So I wouldn't read too much into that.

Ken Worthington - JP Morgan

Okay, great. Thank you very much.


Your next question comes from Neil Stratton with Buckingham.

Neil Stratton - Buckingham

Good morning everyone. A quick question, excluding the new sub-advised mandate, can you comment on the progression of flows throughout the quarter? From sort of like a month-to-month basis? Thank you.

Rich Pzena

It's totally random, so I don't think that you could tell anything from it. I think June, I don't remember so don't hold me to this, but I think it was -- April was good, May was weak, and June was good. But that's the nature of the institutional asset management business. There's no flow pattern, so trying to predict one doesn't make a whole lot of sense.

Neil Stratton - Buckingham

Okay, thank you.


(Operator Instructions). There are no further questions at this time.

Wayne Palladino

Alright, well we'd like to thank everyone for joining us on our second quarter earnings conference call, and we'll look forward to seeing you next quarter.


This concludes today's conference call, you may now disconnect.

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