Pzena Investment Management's CEO Discusses Q3 2012 Results - Earnings Call Transcript

| About: Pzena Investment (PZN)
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Pzena Investment Management, Inc. (NYSE:PZN) Q3 2012 Earnings Call October 24, 2012 10:00 AM ET


Gary Bachman – CFO

Richard S. Pzena – Chairman, CEO and Co-Chief Investment Officer


Ken Worthington – J.P. Morgan

Marc Irizarry – Goldman Sachs Group, Inc.



Good day ladies and gentlemen and welcome to the third quarter 2010 Pzena Investment Management Earnings Conference Call. My name is Tony and I will be your coordinator for today. At this time all participants are in listen-only mode. We will be facilitating a question answer session towards the end of this conference. (Operator Instructions)

I would now like to turn the presentation over to your host for today’s call, Mr. Gary Bachman, CFO. Please proceed sir.

Gary Bachman

Thank you operator. Good morning and thank you for joining us on the Pzena Investment and Management Third Quarter 2012 Earnings Call. I’m Gary Bachman, Chief Financing Officer. With me today is our Chief Executive Officer and Co-Chief Investment Officer, Richard S. Pzena. Our earnings press release contains the financial tables for the periods we will be discussing. We don’t 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 reference the standard legal disclaimer. Data made in the presentation today may contain forward-looking information about management’s plans, projections, expectations, strategic objectives, business prospects and anticipated financial results and other similar matters.

A variety of factors, many of which are beyond the company’s control affect the operations, performance, business strategy and results of the company. And can cause actual results and experiences differ materially from the expectations or objectives expressed in these statements. These factors include but are not limited to the factors described in the company’s reports filed with the SEC which are available on our website and on the SEC’s website at www.sec.gov.

Investors are cautioned not to place unduly reliance and forward-looking statements which speak only as of the date on which the statements are made. The company does not undertake to update such statements to reflect the impact or circumstances or events that arise after the day these statements were made.

Investors should however consult any further disclosures the company may make and the reports filed with the SEC. In addition, please be advised that because of the provisions on selected disclosures, the company as a matter of policy does not disclose a material that is not public information on their conference calls. If one of your questions requires disclosure of material of non-republic information we will not be able to respond to it, thank you. In a minute I will turn the call over to Rich, but first I’d like to review some of our financial highlights.

We reported non-GAAP diluted EPS at $0.08 per share and $5.2 million in non-GAAP diluted net income. Revenues were $18.9 million for the quarter and our operating income was $9.4 million. I will discuss our financial results in greater detail in a few minutes but now let me turn the call over to Rich, who will discuss our view of the investing environment.

Richard Pzena

Thank you Gary, as this is your first earnings call since becoming our new CFO in August I could like to take the opportunity to say once again how thrilled we are that you are part of our team.

It was an exciting quarter for us, on August 2, we were appointed by Vanguard to sub-advice approximately 28% of the Windsor fund. This is a watershed event for us and a highlight of our year. We now oversee nearly $3.5 billion dollars of one of the flagship funds of the Vanguard Group.

This appointment expands our partnership with Vanguard, a relationship that extends back over seven years. In addition to the Windsor Fund, Pzena is also co-sub-adviser to the Vanguard emerging market select stock fund and actively managed emerging markets equity funds launched in June 2011. As well as the sole sub-adviser to the Vanguard fundamental valued funds which is available to non U.S. investors.

Without question, Vanguard is one of the world’s premier investment organizations and the Windsor Fund launched in 1958 is one of their largest equity funds. We attribute the depth of our resources a long tenure res investment team, a strong long-term record and an outstanding client service and the fact that we are unwavering in our commitment to value investing as the reasons for our selection.

As it happened in past cycles, many firms who describe themselves as value managers avoid the deepest value opportunities when the environment is tough as a compromise to near-term business pressures. Our clients know that we will not deviate from true value investing and that such commitment is necessary to achieve long-term investment success.

Today’s environment provides a good example, the deepest valuation opportunities lie in mature technology companies and financials. As true value investors we have not shied away from these opportunities and reflecting the deeply discounted nature of large exposures in our portfolio. This is in contrast to many other managers labeled value whose portfolios closely mimic the benchmark. To strain the point 46% of our global value portfolio, is invested in technology and financial services companies compared to 28% across the value peer group and 31% in the MSCI World Index.

The difference is even more pronounced in our U.S. large GAAP value strategy where 55% of our portfolio is exposed to these two sectors as opposed to 32% among the value peer group and 33% for the Russell 1000 Value benchmark. Meanwhile those same peers have invested in the more overvalued factors including utilities and staples and we have avoided these sectors. We believe it is the willingness to expose our portfolio to the deepest areas of undervaluation that offers the opportunity for long-term outperformance.

The Vanguard Windsor Mandate also appears to have helped stimulate interest in our firm from prospects who may be taking a second look at both devalue and at for Pzena. Although this has not yet translated into asset flows, we’re encouraged by the additional interest in our firms and investment philosophy. I am pleased to report that the firm continues to be solidly profitable and that the directors approved at $0.03per share quarterly dividend.

Now let me take a few minutes to review the investment environment and how we’re positioning our portfolios to take advantage of what we consider to be compelling value opportunities around the globe.

Central bank intervention helped push investors into a risk on mode during the quarter, propelling the MSCI All-Country World Index to a 6.8% advance in U.S. dollar terms. Energy and financials lead the rally while consumers, staples and utilities trailed. Yet despite this risk on mini-rally, a massive valuation gap persists between inexpensive high beta economically sensible names and highly valued high payout low beta of stocks reflecting continued investor scepticism about the trajectory of the global economy and Eurozone woes.

Arguably, as investors are chased out of fixed income securities by low or negative real returns, they’re seeking the next best alternative. Dividend paying stocks and perceived stable earners pushing their relative valuations to historical highs. This has resulted in one of the most notable and exploitable valuation disparities in the global equity markets today. And as committed value investors we’re taking full advantage.

Our approach to exploiting this opportunity is as it has always been. We use a research-driven bottom-up process to identify the most compelling value opportunities in our investment universe and to understand the strength of the business franchise, long-term profitability and valuation opportunity.

This approach has produced valuations in many of our strategies that are among the cheapest in our history and are dominated by leading franchises with high free cash flows and solid balance sheets. Despite its strong rebound this quarter, Europe continues to present the most attractive valuation opportunities with a good selection of leading multi-national companies selling at discounts primarily due to domicile. In the U.S. value opportunities are skewing more toward our large cap universe yet we are finding solid investments for our mid and small cap portfolios albeit at somewhat higher valuations.

The emerging markets have become interesting and are getting better. Our efforts continue to be directed at identifying and thoroughly researching the most undervalued opportunities in our universes. We were then excited by the depth and graph of the value opportunities that are bound today and to which our portfolios are exposed.

High free cash flow, strong balance sheets, leading business franchises and attractive valuations continue to characterize our portfolio, holding putting the opportunity for significant output performance as uncertainties dissipate. I would now like to turn the call over to Gary who will review our quarterly financial results.

Gary Bachman

Thank you, Rich. I’ll start out by discussing our assets under management, fee rates and revenues, our average assets under management worth $14.8 billion during the quarter of 8% from last quarter, and up 4% from the Third Quarter of last year. We ended the quarter with $16.8 billion of AUM, up 28% from the end of the last quarter which ended at $13.1 billion. Now 38% from the end of the Third Quarter of last year which ended at $12.2 billion, the $3.7 billion increase from last quarter was due to $1.1 billion in market appreciation and $2.6 billion in net inflows. The $4.6 billion increase from the third quarter of last year was driven by $3.4 billion in market appreciation and $1.2 billion in net inflows.

On September 30, 2012 our AUM consisted of $11.2 billion in institutional accounts and $5.6 billion in retail accounts. Assets in the institutional account were up 3% during the quarter primarily due to market appreciation, partially offset by net outflows. Compared to last quarter retail assets have more than doubled primarily due to our employment as advisor to 28% of the Vanguard Windsor Fund in the beginning of August. Revenues were $18.9 million for the quarter of 2012 up 3% from the last quarter but down 6% from the third quarter of last year.

The increase from last quarter was primarily due to higher rated weighted average assets driven by the Vanguard Mandate. The decrease from the third quarter of last year was due primarily to the lack of performance fees recognized during this quarter. Our weighted average fee rate was 50.8 basis points for the third quarter of 2012 compared to 53.7 basis points last quarter and 56 basis points for the quarter of last year.

The decrease from last quarter and from the third quarter of last year was due to the impact of two amounts of advisory fee associated with the Vanguard Mandate carries over fees. The decrease from the Third Quarter of last year is also attributed to the lack of performance fees to recognize this quarter.

Our non-GAAP income statement adjusts for the recurring valuation allowance in tax receivable agreement items. I will address the current adjustments at the conclusion of my remarks, but for now I’m focused on the non-GAAP information.

Looking at operating expenses, our compensation and benefit expense was $7.7 million for the quarter, down 4% from last quarter and relatively flat from the third quarter of last year. The decrease from last quarter is primarily driven by changes in our discretionary bonus accrual. GNA expense was $1.8 million for the third quarter of 2012, down 8% from the last quarter and down 10% from the third quarter of last year.

The decrease from last quarter was primarily due to timing, while the decrease from last year was driven by reduction in real estate expenses associated with the sub-lease of excess office space in the fourth quarter of last year. Operating margins were 49.9% this quarter compared to 45.9% last quarter and 51.4% in the third quarter of last year.

Net and outside interest, other income and expense was income of $0.2 million this quarter and expense of $0.1 million last quarter and expense of $0.4 million in the third quarter of last year. These fluctuations arise certainly as the result of the performance of firm investment.

The effective rate for unincorporated business taxes was 6.2% this quarter, down from 6.6% last quarter and up slightly from 6% in the third quarter if last year. The fluctuation in these effective tax rates are driven by certain expenses that are primarily nondeductible for UBT purposes.

We expect this rate to be between 5% and 7% on an ongoing basis. The allocation to the non-public members of operating company was approximately 83.4% of the company’s net income this quarter compared to approximately 83.7% last quarter and approximately 84.5% in the third quarter of last year. The advantage in these percentages is the result of changes in ownership interest in the operating company.

The effective tax rate for our corporate income taxes ex-UBT was 42.9% this quarter and the third quarter of last year and 41.9% last quarter. Our expectations are that our corporate effective tax rate will generally be between 42% and 43%. As a result we reported basic and diluted non-GAAP EPS of $0.08 per share for the third quarter. During the quarter, through our stock buyback the program we were purchasing and retired 27,797 share and units were approaching $143,000. At September 30 there was approximately $9.7 million remaining of the $10 million of the purchase program authorized during April of this year.

Before we turn it over to the questions, I’d like to briefly walk through the valuation allowance in tax receivable adjustments.

In the third quarter of 2012 we recognized adjustments that arose as a result or revised estimates of future taxable income and our ability to utilize their different tax assets. We recognize the $2.1 million decrease in our valuation allowance, and a $1.7 million increase in our liability towards selling and converting shareholders for the quarter.

The net effect of these adjustments comprise of the difference between our third quarter 2012 non-GAAP and GAAP net income. On a quarterly basis we will quarter adjustments to the valuation allowance and our liability to our selling and converting shareholders as we extend our projections out in future quarters.

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 the tax receivable agreement amount I just discussed, we reported GAAP basic EPS of $0.12 per share and a loaded EPS of $0.09 per share for the quarter.

At quarter end our financial position remains strong. Our cash balance was $38.1 million at September 30 and we declared a three stand per share quarterly dividend last night.

Thank you for joining us. We’ll now be happy to take any questions you may have.

Question-and-Answer Session

(Operator instructions). Your first question comes from the line of Ken Worthington. Please proceed.

Ken Worthington – J.P. Morgan

Hi, good morning. Rich, I wanted to just maybe flesh out your comment on the Vanguard, when you said that the inquiries had increased. Is it possible just to give us more flavor there? Because it seems like that that concept is pretty interesting. So like how much has it increased? Has it increased a lot? Has the customer type or some flavor of the customer changed as well? Do these customers have big money to invest? Are they little investors? And then if you could, I have no idea how to do this, but like gauge the seriousness. Is this something like Vanguard is so high profile you get a bunch of investors out of the way to work, but you kind of know they are really not serious? Or is there any way to gage the seriousness of these enquiries?

Richard Pzena

The level of activity in terms of how busy our client, our sales people are is, it is – I don’t know how to describe it rather than say it’s massively more busy. We have more people and the meetings per person have gone up dramatically. The quality of the people that we are meeting and the requests that we are being asked to participate in, the searches that we are being asked to participate is all over the map. So there are some that we look at and say there is very, very low probability of actually this becoming a new business.

So I don’t know that I would read a whole lot into the activity increase in terms of near term flows, but there is something interesting about the nature of the type of client that’s making the request. There is a big, big increase in the large sized sub advisory mandates, not the size of a Vanguard, but the $100 million plus potential relationship that where I gauge the interest as being quite serious. And we are actually hoping that some of that actually turns into business in the reasonable near term and reasonable means six to 12 months. So it’s very hard to answer because the announcement is two months old and the process still remains a painstakingly slow process to go through the education, qualification and negotiation of these things.

So all I can say is that it’s encouraging, but I don’t know that I can say you should change your outlook for what our flows are in the next six months as a result of that. Does that help?

Ken Worthington – J.P. Morgan

Yeah, it did. It was a little bit of a fishing expedition for me. And then just secondly on performance, I don’t know, we still kind of question when we track engage your relative performance, but I’ll call it a flood process, but it seems like performance is not as good as it had been. The mix of your investment seemed to be good. Now I was just wondering if you could maybe talk about your evaluation of the performance. Let’s say like year-to-date, so not just fiscal but year-to-date and then attribution. Is it – how is security selection doing versus asset allocation because it seems like asset allocation will be pretty good and would result in better numbers than I would have expected you to put up. So comments there will be helpful.

Richard Pzena

Yeah. If you look, you have to be product specific here because year-to-date we’re outperforming our benchmarks in all but our US large GAAP value and by fairly significant magnitude. So I presume your question is on US large GAAP value.

Ken Worthington – J.P. Morgan

It’s the easiest thing to say, but I…

Richard Pzena

So what’s driven our performance globally – let me start with the good stuff, has been a strong exposure to Europe, with Europe being the best performing market in the world in 2012. And so we had significant overlaid there and our security selection was good. In the US, we had – the reason why it didn’t translate in the US is one, the cap-way that benchmarks are more skewed by including the value benchmarks are more skewed by the companies that are more stable and are higher yielding.

And while that wasn’t true in the last couple of months, the typical value managers are having a tough time this year against the roughly 1,000 value. I think very, very few of them are beating that benchmark. If you look at a pure deep value benchmark which we do internally, very few other people do this, but we look at just comparing our performance to naïve low-priced book portfolio.

We’re doing about – we’re average performers on there. We’re neither stand-out positive nor stand-out negative. So the real issue is a handful of stocks in our portfolio, in our US large GAAP portfolio where earnings or revenues have turned negative and the market has really, really punished their valuations. And they already started from deeply undervalued, but they’ve continued to deteriorate. The biggest negative performance in the portfolio year-to-date is Hewlett Packard for us. And so we’ve gotten to the point where today that company sells for a four current PD. And there’s really very little historical precedence for that valuation for any company that’s not in financial distress, which they’re clearly not. So we’ve stuck with it, but if I was going to say that there was a theme in valuation outside of financials it would be companies that don’t have growth prospects. So, companies with flattish revenue profiles for the next few years. We’re heavily exposed outside of financials in those. When the market gets nervous, these things sell off big time. And so we were exposed

Ken Worthington – J.P. Morgan

Okay. Great, thank you very much.

Richard Pzena



(Operator instructions). Your next question comes from the line of Marc Irizarry. Please proceed.

Marc Irizarry – Goldman Sachs Group, Inc.

Thanks. Marc Irizarry, Goldman Sachs. Rich, could you talk about the consultants and what they’re saying on the institutional side of the business? And then an unrelated question, just in terms of fees, I’d appreciate any perspective you can give in terms of when you’re out there competing for some of these sub advice mandates. What’s happening on the fee side? Then I guess institutionally as well? Any comment on fees it would be great. Thanks.

Richard Pzena

Yeah, Mark. There isn’t a lot of change in the consultants perspective of the world. They remain still focused on risk reduction, volatility reduction. They’re responding to their clients I think more than leading their clients. And so there is no obvious shift of re-emergence of equity mandates or re-emergence of more volatile strategies. So I would tell you that allocation still remained towards lower volatile managers within equities themselves, towards lower volatile and passive. So we don’t see a whole lot of change. It’s not a robust market institutionally from, driven by the consultants. Fee pressure is probably stronger today than at any time that I’ve been involved in this. So for the last, fees have been talked about for a long, long time and mostly it was my sense that institutions just wanted to make sure that they were getting a fair price and not paying higher than others.

I think fees play more of the role today as defined contributions markets get to become a bigger and bigger component of the overall market. It’s not a new trend, but some of the institutions that are successful in the self-advisory, in the defined contribution business and are looking for self-advisors, have their own pressures, profit pleasures. And so by necessity they have to be more fee conscious than historically institutions have had to be. And we’re spending a lot of time from a strategic standpoint trying to figure out how to address that, but it’s definitely there.

Marc Irizarry – Goldman Sachs Group, Inc.

Okay. So then any color on how we should think about the institutional fee rate going forward, any sort of performance related fees if any? And then also the rail. It looks like it bounces around somewhat. Is that just sort of mix related or is there money that’s sort of running off that’s lower fee institutional money?

Richard Pzena

There is no price changes on comparable products. So it’s all issues of timing of cash flows, inflows and outflows, which account opens and closes, which product gets more money. So there’s nothing – I don’t think the decisions that our clients are making on where to add money or take money away is fee related. So I think the outcome that you are seeing is just the randomness of the flows. Performance fees obviously play an impact and if you look at our – since most of our performance fees are three year rolling performance fees, we had a spectacular year in 2009 and then we’ve been just moving up and down with no clear direction since then. So we’ve had no out performance and there’s no significant under performance, but it just looks like a great year followed by three mediocre years. And so we don’t get performance fees when mediocre is the outcome and so the performance fees that basically are none in our numbers in 2012, certainly in this current quarter. So that describes the volatility, but there is no big pricing changes that where our clients have come to us and said if you don’t lower the fees we’re leaving and therefore we lower them. There have been actually none of that.

Marc Irizarry – Goldman Sachs Group, Inc.

So it’s just more a function of mix in the internals if you will. Just one question on the dividend and as we think about your use of your cash flow and dividends special or ordinary, just in terms of how you plan to use your cash flow going forward.

Richard Pzena

Yeah. Well, we set a policy of paying out 70% to 80% of our earnings in dividends through the special dividend declared after the end of the year and we are not changing that. So we would expect to do that again, declare year-end dividend and it depends what our earnings wind up being in the fourth quarter, but we’ll be in that range. And we’ve been trying to buy back some stock, but the volume is very low in our shares. And so when you are trying to be 5% or 10% or 15% of the volume and there’s not very much volume, you don’t buy back a lot of stock. But we would like to continue that program.

Marc Irizarry – Goldman Sachs Group, Inc.

Okay, great. Thanks.


There are no further questions from the listening audience. I would now like to turn the conference over to your host, Mr. Gary Bachman for closing remarks. Thank you.

Gary Bachman

Great. Just want to thank everyone for joining us on today’s call. Have a great day.


Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect and have a great week.

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