Pzena Investment Management, Inc. (NYSE:PZN) Q4 2017 Earnings Conference Call February 7, 2018 10:00 AM ET
Rich Pzena - Chief Executive Officer, Co-Chief Investment Officer
Jessica Doran - Chief Financial Officer
Ken Worthington - JPMorgan
Good morning and welcome to the Pzena Investment Management, Fourth Quarter and Full year 2017 Results Conference Call. All participants will be in a listen-only mode. [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, Fourth Quarter and Full Year 2017 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 projection. 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, which reflects the impacts of circumstances or events going forward. In addition, please be advised that due to the prohibition on selected disclosures, we do not as a matter of policy, disclose materials that is not public information on our conference calls.
Now let me turn the call over Rich, who will discuss our current view of the investing environment.
Thanks Jessica. New always gets people’s attention. In 1999 Michael Lewis captured the energy of the internet boom in his memorable book the “The New New Thing”. Today the New Thing is referred to as disruption. 2017 stock market returns reflect investors’ adoration of disruptors. As sentiments swung back powerfully to growth style investing.
Growth indices outperformed value in the U.S. by 17 percentage points, in emerging markets by 19, in IFA by 8% and in Europe by only 5%. Leading this disparity was the surge in the stock prices of disruptors. Many of which are in the U.S. and China, supported by the notion that these companies will displace encumbrance in a fight to the death battle.
FANG MAN stocks Facebook, Apple, Netflix, Google; Microsoft, Amazon and Nvidia were up a cap weighted 46% in 2017 representing nearly a quarter of the Russell 1000's overall gains and 13% of its market cap.
In Asia, the BATs [Baidu, Alibaba, and Tencent] rose a cap weighted 99%, accounting for 20% of the MSCI Emerging Market index’s gains and now account for 10% of its market cap. For us this period of acronym high flyers has created opportunity. Those subject to disruption have lagged opening the door to what we believe we do best, research, research, research.
Current market sentiment aside, there is nothing new about the concept of disruption. Disrupted stocks have hit our investment screens ever since we opened our doors 22 years ago. The question is, are the disrupted companies going away? Of course we don’t the answer to that question. What we do know is that disruption is difficult and it doesn’t happen very often, even though it is regularly forecast. For example, when low cost Asian manufacturers came on the scene in the last 1990s, western industrial companies were thought to be on the way to being disrupted out of business, yet they still retained their dominant positions today.
On the other hand, digital cameras completely disrupted Kodak. How does one distinguish between the two? The truth is its difficult. So, we resort to our tried-and-true approach – intensive research. If a stock is priced as if the disruption is a near-certainty, yet management has a creditable plan to retain the business, we might choose to invest. If management is right we can realize a significant upside. If management is wrong and the business erodes, well that’s what the market expected anyway.
Low initial valuation and slow decline of the existing franchise should allow an exit from the position with limited losses. We are finding opportunities among those facing the threat of disruption across several industries. Money center banks, pharmaceutical supply chain companies, technology, especially those adapting to a world driven by cloud computing, advertising companies and very selectively retailers.
Our approach to dealing with disruption can be summed up in the three words I stressed earlier; research, research, research. We seek to understand the strength of the underlying business franchise and the company’s ability to ward off potential disruptors.
Of course it’s never possible to know the eventual outcome up-front, but by skewing the risk reward profile in our favor, it is possible to expose the portfolio to investments where we see the downside case as being largely reflected in a company’s current valuation with significant upside should the business successfully adapt to disruption.
On the business front, we ended the year at $38.5 billion under management, our highest market any quarter end in our history. We now have experienced positive net flows in six of the last eight quarters and ended 2017 with $1.7 billion in net flows.
Our pipeline continues to be good and our prospects are spread across our global business and across our product line-up. Our mutual fund business crossed the $100 million market total AUM as we are beginning to see signs of interest since we refocused our efforts of the institutional portion of the retail channel about six months ago.
Thank you for taking time to attend our call today and I look forward to hearing your questions. I will now turn the call back over to Jessica Doran, who will provide this quarter’s financial update.
Thank you, Rich. Our earnings release disclosed as both GAAP and non-GAAP adjusted financial results. Our results for this quarter and the fourth quarter of last year adjusts for certain tax receivable agreement items, the release of the valuation allowance during the fourth quarter of last year and the impact of the Tax Cuts and Jobs Act enacted in the fourth quarter of this year.
We did not make any non-GAAP adjustments to our results during the third quarter of this year. I will adjust the current tax related adjustments at the conclusion of my remarks, but for now I’ll focus on the non-GAAP information.
We reported non-GAAP diluted earnings of $0.19 per share for the fourth quarter compared to $0.17 per share last quarter and non-GAAP diluted earnings of $0.15 per share for the fourth quarter of last year.
Revenues were $38.9 million for the quarter and operating income was $20.9 million. Our operating margin was 53.8% this quarter, increasing from 50.8% last quarter and 47.2% in the fourth quarter of last year. These results driven by increases in assets under management and revenue reflect the commitment to our investment process, our strong client relationship and the execution of our distribution efforts.
Taking a closer look at our assets under management, as Rich mentioned we ended the quarter at a record high of $38.5 billion, up 8.8% from last quarter which ended at $35.4 billion and 28.3% from the fourth quarter of last year which ended at $30 billion. The increase in assets under management this quarter was driven by market appreciation of $2.4 billion and net inflows of $0.7 billion. The increase from the fourth quarter of last year reflects $6.8 billion in market appreciations and some net inflows of $1.7 billion.
In December 2017 we changed the classification of our assets under management to better reflect the composition of our client base. We now group our assets under three categories; Separately Managed Accounts, Sub-Advised Accounts, and Pzena Funds. We feel these categories better illustrate the characteristics inherent in our client relationship.
At December 31, 2017 our assets under management consisted of $15 billion in separately managed accounts; $21.8 billion in sub-advised accounts; and $1.7 billion in our Pzena fund. Compared to last quarter, separately managed assets increase reflecting $0.9 billion in market appreciation, partially offset by $0.2 billion in net outflows
Sub Advised assets also increased reflecting $1.5 billion in market appreciation, $1.6 billion in net inflows. Access in Pzena funds increased from the end of last quarter due to $0.3 billion in net inflows. Average assets under management for the fourth quarter of 2017 were $36.8 billion, up 7% from last quarter and 29.1% from the fourth quarter of last year.
Moving to our fourth quarter financial results our revenues increased 7.4% from last quarter and 33.8% from the fourth quarter of last year, primarily reflecting the increase in average assets under management and the recognition of performance fees during the quarter.
Our weighted average fee rate was 42.3 basis points for the quarter compared to 42.1 basis points last quarter and 40.8 basis points for the fourth quarter of last year. 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 for separately managed account, 56 basis points for the quarter compared to 56.3 basis points last quarter and 54.9 basis points for the fourth quarter last year. The decrease from last quarter reflects the decrease in assets in our focused value strategies that generally carry higher fee rate, while the increase from the fourth quarter of last year reflects an increase in performance fees recognized.
Our weighted average fee rate for sub-advised accounts was 30.2 basis points for the quarter compared to 29.8 basis points last quarter and 28 basis points for the fourth quarter of last year. The increase from last quarter and the fourth quarter last year primarily reflects an increase in performance fees recognized.
In addition, certain accounts related to one sub-advised relationship have fulcrum fee arrangement. These fee arrangements require a reduction in the base fee or allow for our performance fee if the relevant investment strategy underperformed or out performs respectively.
The agreed upon benchmark over the contract measurement period which extends to three years. During the fourth quarter of last year a reduction in base fees related to these fee arrangements was recognized. We did not see a reduction in base fees during the fourth quarter of 2017 due to improved relative performance contributing to the year-over-year increase in weighted average fee rate. To the extent the three year performance records of these accounts fluctuate relative to their relevant benchmark, the amount of base fees recognized may vary.
Our weighted average fee rate for Pzena funds was 73.7 basis points for the quarter, increasing from 66 basis points last quarter and from 68.4 basis points for the fourth quarter of last year. The increase from the last quarter and the fourth quarter of last year reflects an increase in performance fees recognized. The increase from last quarter also reflects an increase in assets and non-U.S. strategies that generally carry higher fee rate.
Looking at operating expenses, our compensation and benefits expense was $14.2 million for the quarter, decreasing from $14.8 million last quarter and increasing from $12.4 million from the fourth quarter of last year. The decrease in compensation expense from last quarter reflects the one-time charge recognized in the third quarter of 2017, while the increase from the fourth quarter of last year reflects an increase in headcount and compensation rates.
G&A expenses were $3.7 million for the fourth quarter of 2017 compared to $3.1 million last quarter and $3 million for the fourth quarter of last year. The increases from last quarter in the year ago period primarily reflected in professional fees and travel expenses. Non-GAAP other income was $1.1 million for the quarter, driven by the performance of our investment.
Looking at taxes for the quarter, the effective rate for unincorporated and other business taxes was 3.7% this quarter compared to 3.8% last quarter and negative 1% for the fourth quarter of last year. The effective tax rate for the fourth quarter of last year includes a tax benefit associated with the reversal of uncertain tax like position liabilities due to the settlement of prior year audit. We expect the effective rate associated with the unincorporated other business taxes of our operating company to be between 3% and 5% on an ongoing basis.
Our non-GAAP effective tax rate for our corporate income taxes, ex-CVT and other business taxes was 33% this quarter compared to 36.9% last quarter and 19.8% for the fourth quarter of last year. The fluctuation in these effective rates reflects tax benefit from employee share and unit vesting, as well as option exercises. We expect this rate excluding any share and unit vesting to be between 23% and 25% on an ongoing basis, reflecting the reduction in corporate tax rate due to the enactment of the Tax Cut and Jobs Act during the fourth quarter of 2017.
Our non-GAAP other income and income tax expense for the fourth quarter of 2017 adjusted for the impact of the Tax Cuts and Jobs Act resulting in a re-measurement of the differed tax asset and associated liability to selling and converting shareholders. Income tax expense also reflects a net prior year adjustment to the differed tax asset and corresponding liability to the selling and converting shareholders, which was recognized during the fourth quarter of this year. We recognized a net expense of $4.6 million related to these adjustments which comprised the majority of the difference between 2017 and 2016 non-GAAP and GAAP net income.
The allocations to the non-public members of our operating company was approximately 74.6% of the operating company’s net income for the fourth quarter of 2017 compared to 74.8% for the third quarter of this year and 75.6% for the fourth quarter of last year. The variance in these percentages is a result of changes in our ownership interest in the operating company.
During the quarter through our stock buyback program we repurchased and retied approximately 102,000 shares of Class A common stock and class B in it for $1.1 million. At December 31 there was approximately $5.6 million remaining in the repurchase program.
On January 30, 2018 our Board of Directors determined that it intends to reduce the targeted cash dividend payout ratio from 70% to 80% of non-GAAP diluted net income to 60% to 70% of non-GAAP diluted net income.
Borrowing any changes in our financial condition, with the beneficial impact of the lower future effective tax rate, we should expect to maintain the absolute level of the dividend despite the reduction in the payout ratio. The board regularly reviews our long-term capital allocation strategy and determined that it is prudent to have additional financial flexibility to allow for investment in future business initiatives, while still returning a meaningful cash dividend to shareholders.
At quarter end our financial position remains strong with a healthy cash balance of $63.4 million at December 31. We declared a $0.42 per share year-end dividend last night.
Thank you for joining us. We’d now be happy to take any questions.
[Operator Instructions] The first question comes from Ken Worthington with JPMorgan. Please go ahead.
Hi, good morning. Maybe just first queuing up on that last point. So the board decides to reduce the allocation. It really seems like you want to invest more in the business or are planning to invest more in the business. Can you kind of flush out you know what your plans are or are plans really just not set yet and this is you know planning for the future? But what do you anticipate the best places to invest in as we look out over the next year or two with this extra cash?
Ken, the issue for us is that the funds business is more capital intensive than the businesses that we’ve historically been in, because they generally require some seed capital and to be relevant, given the size that we’ve grown to, we have to have ways to offer all of our strategies in fund form, as well as in separately managed account form and so it’s very difficult to get people to seed funds that don’t exist, so you’d have to seed them yourself and it’s not just 40 Act funds we’re talking about. It includes UCITS, includes CITS. There are so many different ways in which people want to access our services that while there are no current immediate plans to spend a substantial amount of money right now. It’s inevitable that this is going to happen.
Got it. Okay, fair enough. So that segways into this question. Maybe can you give us an update on the – your retail sort of initiative with RAs and intermediaries. To what extent were you able to add additional platforms during the quarter. A general update on how that’s proceeding.
Yeah, I mean its – remember we really just started this about six months ago, but – and it’s not geared towards additional platforms here. We’re already on all the big platforms. This is geared towards getting money into the funds, so that we have the critical mass that would be necessary to continue growing the business. To that extent we were successful in emerging markets at passing the $50 million mark, which is a critical mark.
We’re getting close in our mid-cap value, because we won a number of searches in mid-cap value, but what’s interesting is that the search process is a long process. It’s very institutional like in nature and so this is what we’re pros at, right, we just haven’t focused here and so what we’ve done is, I don’t think it’s particularly unique and that we’ve identified the largest, that the largest RIA’s are institutional like in nature, but they are sophisticated, they have staffs that evaluate managers, they are looking for differentiated product.
This is sort of what you would say of the wire houses too. They are as well – even though they are consolidating the number of funds on their platforms, they are interested in differentiated product, but we’re not relevant enough size wise to get their attention.
So we’re doing this. You know these are the search sizes that we’re talking about or like $10 million search. Hopefully they lead to flows, to incremental flows, but there is a lot of effort involved in bringing these in, kind of $10 million at a time.
So the resources are focused on calling on these people and its starting to bear fruit. Hopefully we’ll continue to see that and once we past some of these critical AUM milestones that it will get easier, but it’s a hard business and we have the fortune now that the ratings on these funds are now starting to move to four and five stars, given our relative strong performance compared to other value managers.
Obviously compared to broad market indices it was a tough year, but compared to value our one, three, five, seven year records are all pretty compelling across the board and the 10 year records are almost there. By the middle of 2018 the worst of our financial crisis performance will be out of the 10 year record, which is still – it still counts in the way that people look at you. Obviously everything counts, but people focus on 10 more than they focus on 12.
Okay, great. And then just maybe a numbers question and I don’t think you guys mentioned it. Can you give us the breakdown of the performance fees by product type?
Sorry, just one minute Ken.
We’ll get you the data, hold on.
Thank you. Maybe while you’re digging it up I’ll stick another one in. Just how is performance in the last week and a half, week – with the market kind of selling up hard and haven’t been able to dig it up yet.
Yeah, our performance has been I’d say in line with value indices during – yeah, we’re – I mean we’re a tiny bit ahead if you count the whole year. In the last week I would say we were even with the value indices.
Here’s the performance data. So performance fees for separately managed accounts were $0.4 million; for sub advised accounts $0.9 million and for fund account $0.2 million.
This concludes the Question-and-Answer Session and the conference is also now concluded. Thank you for attending today’s presentation. You may now disconnect.