Pzena Investment Management, Inc. (NYSE:PZN) Q4 2016 Earnings Conference Call February 8, 2017 10:00 AM ET
Jessica Doran - CFO
Rich Pzena - CEO and Co-CIO
Ken Worthington - JPMorgan
Good morning and welcome to the Pzena Investment Management Reports Results for the Fourth Quarter and Full-Year 2016 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] Please note this event is being recorded.
I would now like to turn the conference over to Jessica Doran. Please go ahead.
Thank you, operator. Good morning and thank you for joining us on the Pzena Investment Management’s fourth 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 $0.15 per share and $10.5 million in non-GAAP diluted net income. Revenues were $29.1 million for the quarter and operating income was $13.7 million.
Now let me turn the call over to Rich, who will discuss our current view of the investing environment.
Thank you, Jessica. Just a few short months ago, investors had accepted the paradigm of low interest rates and sluggish economic growth forever. That has been turned on its head with expectations of fiscal stimulus and higher interest rates in the US driving asset prices. The rotation out of bond proxies and stable earners into banks and economically sensitive stocks coincided with the rise in interest rates in early 2016 and accelerated in the third and fourth quarters particularly after the US Election. Our portfolios were well positioned to benefit with most of our strategies beating their benchmarks by between 400 and 700 basis points for the year. [indiscernible] turn in the value cycle, it appears that the cycle in the US turned up in February of 2016 with deep value stocks outperforming the broader market by almost 20% since then. Deep value also outperformed outside of the US during the second half of the year. While it is too soon to say definitively if the value cycle has turned in those regions, we believe the widespreads we are seeing in markets outside the US are similar to what we have seen in the US which is starkly preceded extended periods of deep value outperformance.
Now investors are asking did we miss the cycle is it over. Our view is a resoundingly no, only hindsight will tell us the ultimate length and magnitude of the current value cycle but we believe there is much further to go. In order to understand how this value cycle might unfold let's focus on what created it and look at historical data to see how prior value cycles have played out. This current cycle has been very long in the making with years of declining interest rates leaving investors seeking yield and earning stability to the detriment of financial services and other economically sensitive businesses. As a result, valuation spreads widened to levels approaching those we last saw during the Internet bubble beginning to contract only recently on the dramatic shift in investor sentiment. However over the last 50 years, history over the last 50 years has shown that pro-value cycles are typically far longer in duration and greater in cumulative outperformance than the current cycle to-date. Pro-value cycles in the US have lasted 72 on average and generated a 162% cumulative excess returns versus our current cycles of 11 months and 20% cumulative excess return.
We believe there is still significant opportunity and longevity to this value cycle. Valuation spreads remain wide throughout the world leaving us with portfolios that are generally characterized by deeply discounted cyclical businesses with sustainable business franchises, strong balance sheets and a demonstrated ability to adapt to a wide range of economic scenarios. More than ever, 2016 demonstrated the importance of being exposed to deeply undervalued securities before the turn in a value cycle. On the business side, 2016 was an exciting year for the firm and we're very encouraged with our business outlook for 2017. Our AUM ended the year at 30 billion. Net flows in the quarter were approximately $300 million but we estimate that gross outflows were inflated somewhat due to client rebalancing resulting from our recent strong investment performance. Still our win rates continue to be high with recent wins ranging across our product suite and large assignments won in the fourth quarter in international ex-US, emerging markets and US large cap. Almost all of our strategies have outperformed their benchmarks over trailing one, three and five year periods. Given that performance historically proceeds fund flows, we are encouraged as we continue to see an increase in interest in our strategies with new opportunities spread throughout the world and across institutional investors, sub advisory relationships, and our intermediary distribution efforts.
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. I'll now turn the call over the 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 $0.15 per share for the fourth quarter compared to $0.12 per share both last quarter and the fourth quarter of last year. Our non-GAAP income statements adjust for certain valuation allowance and tax receivable agreement item. I'll 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 $30 billion, up 9.5% from last quarter which ended at $27.4 billion and 15.4% from the fourth quarter of last year which ended at $26 billion. The increase in assets under management this quarter was driven by market appreciation [ph] [00:08:27] of $2.5 billion and net inflows of $0.1 billion. The increase from the fourth quarter of last year reflects $4.5 billion in market appreciation partially offset by $0.5 billion in net outflows. At December 31, 2016, our assets under management consisted of $16.9 billion in institutional accounts and $13.1 billion in retail account compared to last quarter institutional assets increased reflecting $1.2 billion in market appreciation partially offset by $2 billion in net outflows.
Assets in retail accounts also increased from the end of last quarter due to $1.3 billion in market appreciation and $0.3 billion in net inflows. Average assets under management for the fourth quarter of 2016 were $28.5 billion, up 6.3% from last quarter and 8% from the fourth quarter of last year. Revenues increased 7.7% from last quarter and 5.1% from the fourth quarter of last year primarily reflecting the increases in average assets under management. We also recognized reductions in certain base fees associated with fulcrum fee arrangements in the third and fourth quarter of this year which contributed to revenue fluctuation. We recognized $0.1 million in performance fee income during the fourth quarter of this year compared to $0.6 million in the fourth quarter of last year. We did not recognize performance fee income during the third quarter of this year. In general, our performance fees are calculated on an annualized basis over a three-year measurement period. Asset mix is generally 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 40.8 basis points for the quarter compared to 40.3 basis points last quarter and 42 basis points for the fourth quarter of last year. Our weighted average fee rate for institutional account was 52.9 basis points for the quarter compared to 53.3 basis points last quarter and 53.2 basis points for the fourth quarter of last year. Our weighted average fee rate for retail account was 24.8 basis points for the quarter, increasing from 22.7 basis points last quarter and decreasing from 26.6 basis points for the fourth quarter of last year. The increase from last quarter reflects the addition of assets in certain non-US strategies that generally carry higher fees. The decrease from the fourth quarter of last year primarily reflects a decrease in performance fees partially offset by a shift in mix towards strategies that generally carry higher fees.
In addition, certain accounts related to one retail client relationship have fulcrum fee arrangements. These fee arrangements require a reduction in the base fee if the investment strategy underperforms its relevant benchmark or allow for our performance fee if the strategy outperforms its benchmark. These fees are calculated quarterly and compare relative performance over a three-year measurement period. A reduction in base fee is related to these fee arrangements contributed to the decrease in the weighted average fee rates for retail accounts from the fourth quarter of last year. Conversely the increase in weighted average fee rate from last quarter reflects improved relative performance and an increase in the level of base fee recognized, although it does not reflect the full base fees of accounts with fulcrum fee arrangements. To the extent that three-year performance records of these accounts fluctuate relative to their benchmarks, the amount of base fees recognized may vary.
Looking at operating expenses, our compensation and benefits expense was $12.4 million for the quarter, increasing from $11.8 million last quarter and $11 million for the fourth quarter of last year. The increase from last quarter reflects increased headcount as well as an increase in obligations under the company's deferred compensation plan, driven by an increase in the performance of the strategies in which employees elect to invest deferred compensation. The increase from the fourth quarter of last year primarily reflects an increase in compensation and headcount. GAAP G&A expenses were $3 million for the fourth quarter of 2016 compared to $3.3 million last quarter and $3.7 million for the fourth quarter of last year. The decrease from the fourth quarter of last year is due to expenses in the fourth quarter of 2015 that did not recur in 2016. Operating margin was 47.2% this quarter compared to 44.3% last quarter and 46.9% in the fourth quarter of last year.
Net of outside interests, we recorded non-operating income of $1.7 million this quarter, increasing from $1.4 million last quarter and $0.6 million during the fourth quarter of last year. These increases arise generally as a result of the performance of the firm’s investment. The majority of these investments are held to satisfy obligations under our deferred compensation plans. The non-GAAP effective rate for our unincorporated and other business taxes was negative 1% this quarter, decreasing from 5.7% last quarter and 4.1% in the fourth quarter of last year. This decrease primarily reflects a tax benefit associated with the reversal of uncertain tax position liabilities due to the settlement of prior year audit, which was recorded in the fourth quarter of this year.
We expect the effective rate associated with 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-CBT and other business taxes was 19.8% this quarter compared to 36.5% last quarter and 34.5% for the fourth quarter of last year. The fluctuations in these effective rates primarily reflect tax benefits from employee share and unit vesting, option exercises as well as the impact of the reversal of the UBT reserve on corporate taxes during the fourth quarter. Executing these items, we expect this rate 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 both third and fourth quarter of 2016, compared to approximately 76.9% in the fourth 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 programs, we purchased and retired approximately 146,000 shares of Class A common stock and Class B units for a total of $1.4 million. At December 31st, there was approximately $7.3 million remaining in the repurchase program.
Before we turn it over to questions, I'd like to briefly walk through the non-GAAP income tax expense items. During the fourth quarter, we recognized adjustments related to the release of the valuation allowance recorded against our deferred tax asset. The release resulted from increased levels of AUM and the associated future taxable income. We concluded it is more likely than not that we will generate sufficient taxable income in the future to realize the deferred tax asset. We recognized an $8 million net benefit associated with the changes to our deferred tax asset, valuation allowance and the liability to our selling and converting shareholder. These adjustments comprise the majority of the difference between our fourth quarter 2016 non-GAAP and GAAP net income. Inclusive of the effective the release of the valuation allowance and tax receivable agreement amount I just discussed, we reported GAAP basic EPS of $0.67 per share and diluted EPS of $0.27 per share for the quarter.
At quarter end, our financial position remains strong. Our cash balance was $43.5 million at December 31st, up from $35.4 million last year, primarily due to the timing of year-end bonus payments and we declared a $0.28 per share year end dividends last night.
Thank you for joining us. We’d now be happy to take any questions.
[Operator Instructions] Our first question comes from Ken Worthington of JPMorgan. Please go ahead.
Hi. Good morning. Maybe first, can you talk about maybe more fully your conversations with your institutional investors? I think, Rich, you said you saw this quarter some money was taken out, given our performance and I'd say that's sort of the logical initial reaction, but to what extent are you seeing institutional investors kind of buying into or is the pitch resonating with them that it's still very early in the cycle. And I guess in terms of the sub-advise, are you seeing any new interest emerge, given how maybe the deep value cycle appears to have turned?
So the conversations, first of all, the conversations with existing clients who have already been invested with us for some time, pretty straightforward, they're very happy with our performance and we would get, we pretty much, you’d get an e-mail the last week of the year saying, please send us 8% of the account. So, the conversations -- usually very little conversation around that. Of course, we call whenever we get one of those and they say they're just rebalancing, because we are out of whack with our asset allocation -- with our strategic asset allocation. A good example of that would be we’re a sub advisor to a closed end fund called the Liberty All-Star fund and we were the best performing manager in that fund. I believe there are five managers in the fund and we're supposed to all be equally weighted.
And at the end of the year, they just redistribute it, so we're all equally weighted. And that is how they’ve operated, so we benefit from that, if you want to call it that, when we're underperforming. And we donate when we're outperforming and it tends to be sharper when you've had periods of sharp relative performance. And so there were fairly wide differences amongst managers’ performance during 2016, which I think made this an unusually large number. It's hard to quantify exactly because you don't really know how much is rebalancing and how much is adjusting in the underlying fund size, so you can't come up with a precise number.
But that's the conversation that we've had with existing clients, with clients that have been thinking about this for the last 18 months, we've been going around the world pounding the table on this and so the only thing I can observe is we try it, we track the size of search activity that we're involved in and that has picked up fairly significantly during 2016 and that does not guarantee that you're getting the business. And although, we've had some pretty decent win rate, this is why we're optimistic. But for sure, people are wringing their hands and saying, well, with this just a Trump bounce and I have to worry about it going away. So did I miss it? Conversations are real.
I mean they're agonizing that anybody would go through when they're making shifts to their portfolio, but I think broadly speaking, because so much of the dialog in the last few years has been moved towards passive and lower volatility and safe and quality that I think people are finding themselves, I don't know, if I want to use the word significantly, but under allocated to the kinds of things we do. So while there's no guarantees in life, I think things look good. On sub-advisory, we funded a fairly decent sub-advisory new relationship in the fourth quarter and it continues to have the daily flows that we've seen in the first year or two of other sub-advisory contracts. So we hope that that continues and we are in conversations for one sizable sub-advisory relationship. But there's no guarantee how that will turn out either.
Okay, great. You had mentioned some larger account wins across some various mandates in 4Q, did those happen the funding 4Q or are we still waiting for those for that money to come in ’17?
The ones that I mentioned funded in 4Q, we do always have an inventory of funded, one but not funded, which we did have at 12/31, and a lot of that funded in January. So for the most part, I think you're seeing most of that already in the January AUM.
Okay. Great. And then you had been finding value in a number of sectors, including banks and energy. Is your opinion that you're still seeing still good value in those areas or are your thoughts evolving as to what areas actually may provide the most value from here as we look out the next couple of years?
Well, the biggest change has been the addition of healthcare into the value universe. We've had some pretty sizable contractions in share prices in healthcare as a result of -- really as a result of the election I guess you would say, because of fears that there might be some pressure on drug pricing. So, the generic drug manufacturers, the branded drug manufacturers, the drug distributors have all started to screen up and we're beginning to make some investments in those. Financials still remain the cheapest sector globally in spite of their big run. We still think the risk reward trade-offs are pretty favorable in financials. So we haven't really reduced any of our exposure in financials and we're excited to have another area to be focused on.
[Operator Instructions] There are no additional questions at this time. This concludes our question-and-answer session. The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.
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