Pzena Investment Management, Inc. (NYSE:PZN) Q3 2016 Earnings Conference Call October 19, 2016 10:00 AM ET
Jessica Doran - Chief Financial Officer and Treasurer
Richard Pzena - Chief Executive Officer and Co-Chief Investment Officer
Kenneth Worthington - JPMorgan Chase & Co.
Good morning and welcome to the Pzena Investment Management Incorporated Third Quarter 2016 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today’s presentation there will be an opportunity to ask questions [Operator Instructions].
I would now like to turn the conference over to Jessica Doran, Chief Financial Officer. Please go ahead.
Thank you, operator. Good morning and thank you for joining us on the Pzena Investment Management’s third quarter 2016 earnings call. I am Jessica Doran, 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 do not 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 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 $0.12 per share and $8 million in non-GAAP diluted net income. Revenues were $27 million for the quarter and operating income was $12 million.
Now let me turn the call over to Rich, who will discuss our current view of the investing environment.
Thank you, Jessica. Equity investors had a lot to cheer about in the third quarter as markets reversed their June sell off and moved higher across all geographies. Although it was a mixed bag when it came to growth versus value, both posted solid returns and low price-to-book stocks handily outperformed in all regions.
Our portfolios beat their benchmarks in this environment, most by between 400 basis points and 600 basis points, the best quarter we’ve had in three years as deep value started to work. So is this the long-awaited turn in the value cycle? It’s definitely premature to make that call, but stabilizing interest rates in the U.S. and investors’ willingness to venture back into economically sensitive sectors are encouraging signs that if they continue could underpin a sustained rally in deep value stocks.
We just completed a research project on value cycles and found that the pro-value phase of these cycles is typically preceded by three events. First, uncertainties and expectations cause valuation spreads to widen. Then out-of-favor companies restructure and restore profitability, and finally the uncertainties that initially caused spreads to widen start to abate.
We experienced this during the late 1990s, as old economy stocks were left for dead, assume to be victims of Asian competition with astronomically high valuations placed on the winners, the new economy Internet stocks. Of course, old economy companies restructured and met their challenges and Internet stock valuations came back to earth, triggering one of the strongest value runs in our lifetime.
An important driver of the current cycle has been falling interest rates and sluggish global GDP growth. Investors have bid up bond proxies in their quest for yield, while shunning financials and economically sensitive businesses until there are clear signs of rate stabilization and an uptick in global growth.
As a result, valuation spreads are wide, approaching levels we last saw during the Internet bubble. Companies are addressing their issues, not waiting for a rise in rates or a pickup in growth, with tangible results. We experienced the power of narrowing spreads and a modest shift in investor expectations last quarter, but we believe that’s just the tip of the iceberg with regard to the amount of stored-up Alpha inherent in today’s undervalued stocks.
The recent rally didn’t come with any guarantees and shocks of both foreseeable and unknown nature could still set value back, but we are optimistic that the pieces are in place for value to work for an extended period.
I am pleased to report that our business has remained stable through a difficult anti-value period, ending the quarter with AUM of $27.4 billion. We are receiving a lot of interest in discussing our strategies and have won a number of new mandates from sophisticated investors that identify with the value proposition of our long-term, valuation-based investment strategy. I would like to thank all of you who took the time to attend our call today, and I look forward to answering your questions.
First, I will turn the call over to Jessica Doran, our Chief Financial Officer, who will provide this quarter’s financial update.
Thank you, Rich. As I mentioned, we reported non-GAAP diluted earnings of $0.12 per share for the third quarter compared to $0.10 per share last quarter and $0.12 per share for the third quarter of last year. Our non-GAAP income statements adjust for recurring valuation allowance and tax receivable agreement item. I will address the tax-related adjustments at the conclusion of my remarks, but for now I will focus on operating income information.
As Rich mentioned, our assets under management ended the quarter at $27.4 billion, up 7.9% from last quarter, which ended at $25.4 billion and 7.5% from the third quarter of last year, which ended at $25.5 billion. The increase in assets under management this quarter was driven by market appreciation of $2.4 billion, partially offset by net outflows of $0.4 billion. The increase from the third quarter of last year reflects $3.2 billion in market appreciation, partially offset by $1.3 billion in net outflows.
At September 30, 2016, our assets under management consisted of $15.9 billion in institutional accounts and $11.5 billion in retail accounts. Compared to last quarter, institutional assets increased, reflecting $1.4 billion in market appreciation and $0.2 billion in net inflows. Assets in retail accounts also increased from the end of last quarter due to $1 billion in market appreciation, partially offset by $0.6 billion in net outflows.
Average assets under management for the third quarter of 2016 was $26.8 billion, up 2.7% from last quarter and down 1.1% from the third quarter of last year. Revenues increased 2.1% from last quarter and decreased 12.3% from the third quarter of last year, primarily reflecting the fluctuations in average assets under management and performance fees recognized.
We did not recognize performance fee income during the third or second quarter of this year, compared to $3.2 million recognized in the third 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 in performance fees and fulcrum fees can also contribute to short-term variability. Our weighted average fee rate was 40.3 basis points for the quarter compared to 40.5 basis points last quarter and 45.4 basis points for the third quarter of last year.
Our weighted average fee rate for institutional accounts was 53.3 basis points for the quarter, up from 52.6 basis points last quarter and down from 59.6 basis points for the third quarter of last year. The increase from last quarter reflects the addition of assets in certain non-U.S. strategies that generally carry higher fees. The decrease from the third quarter of last year reflects a decrease in performance fees recognized during this quarter.
Our weighted average fee rate for retail accounts was 22.7 basis points for the quarter, decreasing from 25.3 basis points last quarter and from 26.2 basis points for the third quarter of last year. The decrease from last quarter and the third quarter of last year primarily reflects the reduction in the base fees of certain accounts related to fulcrum fee arrangements of one retail client relationship.
These fee arrangements require a reduction in the base fee if the investment strategy underperforms its relevant benchmark or allows for a performance fee if the strategy outperforms its benchmark. These fees are calculated quarterly and compared relative performance over a three-year measurement period. To the extent that three-year performance records of these accounts improve relative to their benchmarks, we will expect to earn the full base fee in the future.
Looking at operating expenses, our compensation and benefits expense was $11.8 million for the quarter, in line with $11.7 million last quarter and $11.6 million for the third quarter of last year. GAAP G&A expenses were $3.3 million for the third quarter of 2016 compared to $3.5 million last quarter and $2.9 million from the third quarter of last year. The increase from last year primarily reflects an increase in expenses related to new business initiatives.
Operating margin was 44.3% this quarter compared to 42.6% last quarter and 52.7% in the third quarter of last year. Net of outside interest, we recorded a non-operating income of $1.4 million this quarter compared to losses of $0.3 million last quarter and $1.7 million during the third 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 our unincorporated and other business taxes was 5.7% this quarter, compared to 4.7% last quarter and 4.2% in the third 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 6% on an ongoing basis.
The non-GAAP effective tax rate for our corporate income taxes, ex-UBT and other business taxes was 36.5% this quarter compared to 37.3% last quarter and 34.7% for the third quarter of last year. These effective rates reflect tax benefits from employee share and unit vesting as well as option exercises.
We expect this rate, excluding any share and 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 75.6% of the operating company’s net income for the third quarter of 2016 compared to 76.5% last quarter and approximately 77.9% in the third 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 67,000 shares of Class A common stock for $0.5 million. At September 30, there was approximately $8.7 million remaining in our 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 a result of the revised estimates of future taxable income and our ability to utilize our deferred tax assets. We recognized $0.2 million net benefit associated with changes in our deferred tax assets, valuation allowance and liability to our selling and converting shareholders. These adjustments comprise the majority of the difference between our third 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 amounts I just discussed, we recorded GAAP basic EPS of $0.13 per share and diluted EPS of $0.12 per share for the quarter. At quarter end, our financial position remains strong. Our cash balance was $31.1 million at September 30, and we declared $0.03 per share quarterly dividend last night.
Thank you for joining us. We’d now be happy to take any questions.
We will now begin the question-and-answer session. [Operator Instructions] Our first question comes from Ken Worthington with JPMorgan Chase. Please go ahead.
Hi, good morning. Maybe first on the fulcrum fees, based on how they are calculated in the funds associated with the fees, can you give us the outlook for them in the coming quarters, I guess if we assume no positive or negative alpha generated in coming quarters? We have experience with [Janison] and they seem to be very much recurring, in other words, if the performance is good, the fulcrum fees are positive and they stay positive for a number of quarters, if they are negative they tend to stay negative. So I guess what I’m asking is, should we continue to see them being negative for the next couple of quarters based on what we saw this quarter?
Yes, Ken, the fulcrum fees are based -- in our case are based on three-year rolling performance. So we roll-off the performance from three years ago and roll-on whatever we do. So if we stayed flat for the next four quarters, the penalty from going below the midpoint of the fulcrum fee will start to abate and go away, but it’s going to be negative for the next four quarters.
It shouldn’t be as negative as it was this quarter. So this is probably this quarter represents the largest deviation that is allowed under the contract, and it should probably go to about half that penalty over the next couple of quarters, and then hopefully, the performance will be good and it will turn around.
Perfect. Thank you. Okay. Second, maybe again for you, Richard, DLL broadly – what are your views? You are sub advising to a bunch of firms who are going to be directly impacted. Maybe talk about what your opinion is for how this will play out for the industry, and then if you could maybe dig in a little bit and see if there is – inform us if you think there’s any kind of opportunities or threats for Pzena specifically.
Well, you have to remember where most of our assets come from. So the biggest chunk of them is coming from Vanguard, where the fee structures are quite low, and of any of the companies that might be impacted by this that they should be on the lower end of that, and then the rest of them are from outside the United States, really.
So the only other one in the U.S. would be our relationship with John Hancock and those assets are – they are now under $2 billion. We’ve -- obviously, we’ve seen some negative flows across the Board in all of our U.S. sub-advisory relationships. But I think for us, we should probably be less impacted on average than the typical actively managed company because of who our partners are.
Understood, thank you. I’ll be greedy and I’ll try one more. Emerging markets - once again, your emerging market strategy is performing particularly well. How big can that strategy be? So if I’m going to be really optimistic, you have had a couple of really great years pretty close together.
It’s a little bit of a different strategy, a different emerging market approach that seems to work particularly well. If I’ve got a view that this fund is going to take in a lot of money, where do you start to get a little bit concerned about either the pace of positive sales or the size of the fund? Is there a lot of runway here? I just can’t tell. Thank you.
Yes. We think we can manage about $5 billion to $6 billion in emerging markets in our current strategies, and we’re just over $2 billion right now. And I don’t really think about it in terms of the pace as much as I do in terms of the level, but what we have committed to our clients and we’ve actually practiced in the past is that we will close these funds when they reach that level.
The $5 billion to $6 billion is an estimate because we try and sort of say, how much can you handle without affecting the liquidity of your ability to purchase and sell shares without impacting the market price. So it’s not a science, so we will assess it. Really it’s when the traders come to you and say, I can’t buy that anymore, that will actually take the action, but we think it’s somewhere between $5 billion and $6 billion.
Okay. Perfect. Thank you very much. I’ll re-queue if no one else has questions. Thank you.
[Operator Instructions] And we have a follow-up question from Ken Worthington with JPMorgan Chase. Please go ahead.
Okay. Thank you again. I guess the last question we had was really about the conversations that you are having with both your sub advise and your institutional investors. I think you said that you are having more conversations, I think you mentioned, with likeminded investors. Are you starting to see – I don’t know how to characterize, but I’ll call them the more fickle investors that maybe are more likely to chase what’s working? Any sense that maybe those swing investors are starting to have conversations with you, and ultimately, what I’m interested in is what are in the minds of your clients right now and how should we expect this to translate into business going forward?
Well, I mean, I don’t know exactly how to answer the questions of what’s in the mind of our investors and who is a fickle investor versus who is likeminded, but what I would say is that I’ve been out really around the world giving presentations on the value cycle, including luncheon presentations as well as one-on-ones with clients and prospects and the number of people that are attending these kinds of meetings are up sharply in the last six months. Does that mean that they are likeminded? I’m not sure.
I think what it means is, they are wrestling with the heights of the stock market overall and they all see these spread charts that people like us put out and others and are wondering, am I exposed here, particularly the ones that have followed a quality bond proxy philosophy and it’s worked beautifully.
And I think the ones that are very thoughtful are saying, maybe we have too much of a good thing, specially, as we start to see some of the enthusiasm over ever decreasing interest rates, start to wane. So I would tell you, we’ve won some new business, we did win a new sub-advisory mandate that we hope will fund soon, that might offset some of the declines that we’ve been having in the accounts of our existing relationships, but it’s not a groundswell.
So it’s still very early, right, and I think people are just starting to come to grips with this quarter when – this is kind of the way that it feels when you’re at this point in the cycle, people that have – that see these heights and they see those consumer staple stocks at 25 and 30 times earnings and they see financials at single-digit multiples and there is not substantial differential in the growth prospects for these companies and they say at some point, it’s wide enough.
And so I think people want to hear what we have to say more – and I can’t tell you, are they immediate client prospects or not, I really can’t. And the ones that turn into clients sometimes surprise you. So it’s certainly encouraging that people are attending these meetings and we are, as you know, we’ve expanded our staff, so we have more and more people hosting these meetings and they’re all getting as many appointments as they can possibly handle.
So to me, it’s encouraging, but I don’t have any incremental vision into what flows are going to be in the next 12 months than I did three months ago, I really don’t. There’s not a queue of projects – of clients in contract signing phase. There aren’t. There is the norm the level that we’ve seen, but it feels good.
Okay, excellent. I’m going to keep going here. The new sub-advisory mandate is that from an existing relationship or is that a new relationship for the Firm? What strategy is it in? You’ve kind of indicated it sounds like it’s real money but not may be as huge as some of the other sub-advisory mandates. Can you give us a flavor or sense of size?
Yes. It’s with a new client - it’s a new relationships. So it’s not one of our existing relationships. It’s in an international strategy so this is actually our first sub-advisory relationship in an international strategy in the U.S. And it’s going to be smaller than at least that initially than any of the other relationships that we currently have. And we’ll announce it when we can. The adviser that’s hiring us believes that it’s going to continue to grow and so we’re optimistic about it, but it will start off modestly.
Okay. Well, congratulations on the win, nonetheless. And that’s it for me. Thank you very much.
End of Q&A
This concludes our question-and-answer session. I would like to turn the conference back over to Jessica Doran for any closing remarks.
Thank you for joining us on today’s call.
The conference is now concluded. Thank you for attending today’s presentation. You may now disconnect.
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