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Edited Transcript of PZN earnings conference call or presentation 19-Apr-17 2:00pm GMT

Thomson Reuters StreetEvents

Q1 2017 Pzena Investment Management Inc Earnings Call

New York Apr 27, 2017 (Thomson StreetEvents) -- Edited Transcript of Pzena Investment Management Inc earnings conference call or presentation Wednesday, April 19, 2017 at 2:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Jessica R. Doran

Pzena Investment Management, Inc. - CFO and Treasurer

* Richard Stanton Pzena

Pzena Investment Management, Inc. - Chairman, CEO and Co-CIO

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Conference Call Participants

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* Kenneth B. Worthington

JP Morgan Chase & Co, Research Division - Senior Analyst

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Presentation

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Operator [1]

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Good day, and welcome to the Pzena Investment Management Reports Results for the First Quarter 2017. (Operator Instructions) Please note, this event is being recorded.

I would now like to turn the conference over to Jessica Doran. Please go ahead.

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Jessica R. Doran, Pzena Investment Management, Inc. - CFO and Treasurer [2]

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Thank you, operator. Good morning, and thank you for joining us on the Pzena Investment Management First Quarter 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 2 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 comment.

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 prohibition on selective disclosures, we do not, as a matter of policy, disclose material that is not public information on our conference call.

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 diluted EPS of $0.12 per share and $8.7 million in diluted net income. Revenues were $32 million for the quarter, and operating income was $13.1 million.

Now let me turn the call over to Rich, who will discuss our current view of the investing environment.

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Richard Stanton Pzena, Pzena Investment Management, Inc. - Chairman, CEO and Co-CIO [3]

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Thank you, Jessica. This quarter, we saw a pause in the strong recovery of value as there was a slight rotation back into what had been working early last year, namely, safety and stability. Value stocks lagged in the period, and our performance was generally in line with the value indices. These pauses are common during the long run where value outperforms, and the forces that gave rise to the resurgence of value last year are still very much in place. Valuation spreads between the cheapest and most expensive quintiles remain wide across all geographies. The long decline in interest rates seems to be over, and worldwide economic conditions are stable to improving. We are reminded that past pro-value cycles have lasted 7 years on average, and we're barely a year into the current one. It takes that long for uncertainties to abate and value to be recognized, and we don't think it will be any different this time. The reason it takes so long for these cycles to play out is because long-standing invent -- investor sentiment takes time to unwind. Investors have been craving safety and predictability as they sought out substitutes for bonds whose yields had plummeted. But it is the fall in interest rates that created the great performance for the bond substitutes, not the low interest rates. It will take a period of time where rates are no longer falling for investors to realize this.

Then, the question will be, "Is it sensible to pay up for these types of investments?" To answer this question, we analyzed our stock universes and came up with a startling observation. In today's market, historical revenue growth and return on capital are not significantly different for cheap stocks versus expensive stocks. Investors who pay up for stocks in the most expensive quintiles appear to be getting shortchanged as they receive less in current earnings but don't get higher growth or profitability. We further observed that there are investments available in the cheapest quintiles evaluation, with fundamentals similar to those offered by the perceived safety and security of bond proxies, but at significantly lower valuations. Although these companies typically come with some uncertainty, they also display characteristics that we believe define a good business: high returns on capital, strong franchises and an ability to adapt to changing conditions on a path toward normal earnings. Decades of academic research and empirical evidence support the proposition that investing in the cheapest stocks provides superior investment performance over the long term. We believe that the best way to achieve this is by using a disciplined bottom-up value-based investment approach.

As we do so, moving further into 2017, we continue to see a broad set of opportunities from which to populate our portfolios. New opportunities have emerged in health care and consumer staples, which we have taken advantage of. However, our main exposures continue to be in financials, mature technology, integrated energy and cyclical businesses, as they remain among the cheapest in our investment universes. We are committed to our value discipline and remain optimistic that improving economic conditions will form the backdrop for resumed value outperformance.

We are excited about our business prospect and initiatives. We ended the quarter with $32 billion of assets under management and experienced net inflows during the quarter. Interest in our strategies is growing, with new opportunities spread across institutional investors, subadvisory relationships and our intermediary distribution efforts.

Thank you for taking the time to attend our call, and I look forward to answering your questions. I will now turn the call over to Jessica Doran, our Chief Financial Officer, who will provide this quarter's financial update.

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Jessica R. Doran, Pzena Investment Management, Inc. - CFO and Treasurer [4]

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Thank you, Rich. As I mentioned, we recorded diluted earnings of $0.12 per share for the first quarter compared to non-GAAP diluted earnings of $0.15 per share last quarter and $0.12 per share in the first quarter of last year. Our non-GAAP results for last quarter and the first quarter of last year adjust for certain valuation allowance and tax receivable agreement item. No such adjustments were made to the GAAP results during the first quarter of 2017 due to the release of the valuation allowance recorded against the deferred tax asset during the fourth quarter of last year.

As Rich mentioned, our assets under management ended the quarter at $32 billion, up 6.7% from last quarter, which ended at $30 billion, and 22.6% from the first quarter of last year, which ended at $26.1 billion. The increase in assets under management this quarter was driven by market appreciation of $1.6 billion and net inflows of $0.4 billion. The increase from the first quarter of last year reflects $6.3 billion in market appreciation, partially offset by $0.4 billion in net outflows. At March 31, 2017, our assets under management consisted of $17.8 billion in institutional account and $14.2 billion in retail account.

Compared to last quarter, institutional accounts increased, reflecting $1 billion in market appreciation, partially offset by $0.1 billion in net outflows. Assets and retail accounts also increased from the end of last quarter due to $0.6 billion in market appreciation and $0.5 billion in net inflows. Average assets under management for the first quarter of 2017 were $31.3 billion, up 9.8% from last quarter and 24.7% from the first quarter of last year. Revenues increased 10.2% from last quarter and 24% from the first quarter of last year, primarily reflecting the increase in average assets under management.

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 41 basis points for the quarter compared to 40.8 basis points last quarter and 41.1 basis points for the first quarter of last year. Our weighted average fee rate for institutional accounts was 52.4 basis points for the quarter, decreasing from 52.9 basis points last quarter and from 53.9 basis points for the first quarter of last year. The decrease from last quarter reflects a decrease in performance fees recognized. The decrease from the first quarter of last year primarily reflects the inflows from large client relationships that generally carry lower fee rate as well as a decrease in performance fees recognized during the first quarter of 2017. Our weighted average fee rate for institutional -- for retail account was 26.5 basis points for the quarter, increasing from 24.8 basis points last quarter and from 24.7 basis points for the first quarter of last year.

These increases reflect an increase in performance fees recognized during the first quarter of 2017. The increase from the first quarter of last year also reflects the increase in assets in non-U. S. strategies that generally carry higher fee rate. In addition, certain accounts related to one retail client relationship have fulcrum fee arrangements. These fee arrangements require a reduction in the base fee or allow for a performance fee if the relevant investment strategy underperforms or outperforms, respectively, the agreed upon benchmark over the contract measurement period, which extends to 3 years.

During the fourth quarter of last year, a reduction in base fees related to these fee arrangements was recognized. Although it did not reflect the full reduction in base fees of accounts with fulcrum fee arrangements. A reduction in these fees was not recognized during the first quarter of 2017 due to improved relative performance, which contributed to the increase in the weighted average fee rate. To the extent the 3-year performance records of these accounts fluctuate relative to their relevant benchmarks, the amount of base fees recognized may vary.

Looking at operating expenses. Our compensation and benefits expense was $15.6 million for the quarter, increasing from $12.4 million last quarter and $12.5 million for the first quarter of last year. Approximately half of the increase in compensation expense from the fourth and first quarters of last year reflects an increase in headcount and compensation rate. The remainder of the increase reflects other charges recognized in the first quarter of 2017, which we do not expect to recur during the year. GAAP G&A expenses was $3.3 million for the first quarter of 2017, increasing from $3 million in both fourth and first quarters of last year. The increase from last quarter and first quarter of 2016 reflects an increase in professional fees primarily associated with our recruiting effort.

Operating margin was 40.9% this quarter compared to 47.2% last quarter and 39.8% in the first quarter of last year. Net of outside interest, we recorded nonoperating income of $1.1 million this quarter compared to $1.7 million last quarter and $0.2 million during the first quarter of last year. Nonoperating income includes the gains and other investment income recognized by the firm on its direct investment. A majority of these investments are held to satisfy obligations under our deferred compensation plans. In addition, changes to the liability to selling and converting shareholders associated with changes in the realizability of the deferred tax asset generated an expense of $50.1 million and $0.9 million in the fourth quarter and first quarter of 2016, respectively.

The increase in the firm's liability to its [ selling ] and converting shareholders during the fourth quarter of 2016 resulted from the release of the valuation allowance recorded against the deferred tax asset. No such changes were recognized during the first quarter of 2017. The effective rate for our unincorporated and other business taxes was 4.4% this quarter compared to negative 1% last quarter and 4.4% in the first quarter of last year. The increase from the last quarter primarily reflects a tax benefit associated with the reversal of uncertain tax position liabilities due to the settlement of prior year audits which was recorded in the fourth quarter of 2016.

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. Corporate income taxes for the fourth quarter of last year included $60 million in income tax benefits associated with the release of the valuation allowance recorded against the deferred tax asset. Income taxes for the first quarter of 2016 included $1.1 million of such benefits. No changes in the realizability of the deferred tax asset were recorded during the first quarter of 2017.

Excluding these changes in the realizability and expected future tax benefits associated with the deferred tax asset recognized during the fourth and first quarters of 2016, the non-GAAP effective tax rates for our corporate income taxes, ex-UBT and other business taxes, was 32% this quarter compared to 19.8% last quarter and 36.2% for the fourth quarter of last year. The increase from last quarter is due to tax benefit from share and unit vesting recognized in the fourth quarter of 2016. The decrease from the first quarter of 2016 reflects changes in estimates of future tax benefits associated with our weighted average ownership in the operating company.

Excluding tax benefits from share and unit vesting and changes in estimates of future benefit, we expect this rate to be between 36% and 38% on an ongoing basis. The allocation to the nonpublic members of our operating company was approximately 74.7% of the operating company's net income for the first quarter of 2017, decreasing from approximately 75.6% in the fourth quarter of last year and from 77.4% in the first 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 11,000 shares of Class A common stock and Class B units for $109,000. At March 31, there was approximately $7.3 million remaining in the repurchase program.

At quarter end, our financial position remains strong. Our cash balance was $20.1 million at March 31, and we declared a $0.03 per share quarter end dividend last night. Thank you for joining us. We'd now be happy to take any questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) And our first question comes from Ken Worthington with JPMorgan.

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Kenneth B. Worthington, JP Morgan Chase & Co, Research Division - Senior Analyst [2]

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Some basic questions. Maybe first, in terms of the pipeline, can you discuss where you stand on both the institutional and retail businesses?

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Richard Stanton Pzena, Pzena Investment Management, Inc. - Chairman, CEO and Co-CIO [3]

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Sure. Our pipeline today is -- has moved up substantially from where it was a year ago. It's mixed. So I'm not sure that I know, off the top of my head, the difference between the retail, the subadvisory and the institutional, but I would say it's pretty even, that we have things going on, on both sides.

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Kenneth B. Worthington, JP Morgan Chase & Co, Research Division - Senior Analyst [4]

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And then -- so since it's moved up substantially, any themes, like -- it looks like the performance still really is on the international side and the emerging market side, and that's definitely where it appears the assets are growing most quickly. Is it fair to say that the pipeline may be more focused on the non-U. S. products?

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Richard Stanton Pzena, Pzena Investment Management, Inc. - Chairman, CEO and Co-CIO [5]

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Yes. That's fair. I'm just looking down the list. I would say it's actually probably 80, 20. 80 on the non-U. S. and 20 on the U.S.

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Kenneth B. Worthington, JP Morgan Chase & Co, Research Division - Senior Analyst [6]

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Okay, great. So your comments continue to be very constructive on the value cycle, where we stand on it and the outlook. To the extent that you could make a bigger splash with that outlook through increased marketing and advertising, is that something that you're considering pursuing? The G&A is up on, sort of, recruiting, and other compensation is up on recruiting. So you're definitely making investments in the business. I guess, maybe is it possible to get a bigger bang, or maybe a quicker bang, by also investing more in the marketing side as well?

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Richard Stanton Pzena, Pzena Investment Management, Inc. - Chairman, CEO and Co-CIO [7]

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Well, I mean, some of the incremental costs that you're looking at is in incremental investing in the intermediary channel. And the question is, what's the best way of doing it? I don't know that we would start advertising, as an example, because everything that we're doing is through intermediaries, and our brand in the retail channel is not the same as our brand in the institutional channel. So for us, it is a slow process. It's slower than we hoped it would be. But the partnerships that we've created over time -- and for example, we heard a comment from one of our European partners very recently, that we're becoming known as one of the key players in Europe, for example. And obviously, not as big as the big players, but when you get into the next tier -- it just takes time, I guess, is the only thing that I can say. And we're investing through people, through materials, through seminars, through discussions. We are constantly doing what you suggest in talking about the value cycle. It's a topic of great interest to people around the world, but we haven't gone to the point of advertising campaigns.

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Kenneth B. Worthington, JP Morgan Chase & Co, Research Division - Senior Analyst [8]

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That sort of segues into another question about the investments in distribution. Maybe can you give us a bit of a more granular update in terms of where you are having successes, maybe where the challenges are maybe bigger than you had anticipated? I'll just -- just start there.

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Richard Stanton Pzena, Pzena Investment Management, Inc. - Chairman, CEO and Co-CIO [9]

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I mean, I think our biggest challenge in the intermediary distribution channel was that we didn't -- we hadn't reached our 3-year track record, and we reached it on April 1st of this year. So we had hoped that the institutional reputation would give us a little bit of leeway in that, but I don't think that's the case. So we also -- it took us a long time to build up the team, and the team didn't get to full force until only the last 6 months. But you what, it happened, and this is where it probably, we don't -- you don't see it in our mutual fund flow data, but the marketing efforts by our intermediary team has led to a fairly substantial amount of assets as in subadvisory business. And so there's been some -- the marketing teams have definitely paid for themselves. You just don't see it in the retail mutual funds, but obviously, our hope is that we will, and we're continuing that effort.

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Kenneth B. Worthington, JP Morgan Chase & Co, Research Division - Senior Analyst [10]

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Okay. You mentioned Europe being considered one of the main, sort of, value players in Europe. How are you thinking about MiFID2 and sort of implementing the rules, sort of, in Europe? And how does that change the way you think about kind of research and disclosures in your U.S. business?

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Richard Stanton Pzena, Pzena Investment Management, Inc. - Chairman, CEO and Co-CIO [11]

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Yes -- I mean, look, this is a problem that we're all facing. We, as a subadvisor in Europe, are -- have less of an issue to worry about, but it doesn't mean that we don't have issues to worry about. We -- I can't tell you that I have any real conclusion yet on how we're dealing with MiFID2, but we have a task group underway in our own organization to figure this out. We are basically treating this, for the most part, as incremental disclosure rather than wholesale change to the way we operate and do business. But I'll say that's preliminary, and we're trying to think of this. If there is a fairly strong competitive response towards -- basically absorbing all the research costs in-house, then we'll have to figure out how we are going to act. But at this point, we're on the assumption that, that won't be the case.

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Kenneth B. Worthington, JP Morgan Chase & Co, Research Division - Senior Analyst [12]

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Okay. And then, I'll take a flyer here. In terms of product development, anything on the horizon?

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Richard Stanton Pzena, Pzena Investment Management, Inc. - Chairman, CEO and Co-CIO [13]

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Nothing of substance in the sense that we have anything with a track record that is ready to market. So -- we generally don't talk about the things that we're thinking about, but for sure there's nothing on immediate horizon.

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Operator [14]

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(Operator Instructions) And this concludes our question-and-answer session. The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.