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Pzena Investment (NYSE:PZN)
Q3 2018 Earnings Conference Call
Oct. 19, 2018 10:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator 

Good day and welcome to the Pzena Investment Management third-quarter 2018 earnings conference call. [Operator instructions] Please note, this event is being recorded.I would now like to turn the conference over to Jessica Doran, chief financial officer. Please go ahead.

Jessica Doran -- Chief Financial Officer

Thank you, operator. Good morning and thank you for joining us on the Pzena Investment Management third-quarter 2018 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. Replay 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 referred 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 material that is not public information on our conference calls. Now let me turn the call over to Rich, who will discuss our current view of the investing environment.

Rich Pzena -- Chief Executive Officer and Co-Chief Investment Officer

Thanks, Jessica. Being a value manager, I just felt a bit like being trapped in the movie Groundhog Day over much of the last 10 years. In the movie, day after day, the Bill Murray character expects to start a new day only to find himself trapped in a bizarre time warp where tomorrow never comes. For value managers, quarter after quarter, we expect the extreme valuations of the market darlings to decline only to watch the valuation extremes keep expanding.

This quarter, the movie continued. Growth outperformed value everywhere but in the emerging markets, where arguably the cycle follows a different pattern than in developed markets. As an illustration of the valuation extremes expanding, in just the past 12 months in the U.S., the equal weighted Russell 1000 Growth Index outperformed the equally weighted Russell 1000 Value Index by 2,200 basis points. Now the funny thing about value investors is that we see this increasingly skewed valuation environment as one that is creating and expanding set of opportunities, and it's happening all over the world.

And while the world focuses on short-term factories and obsesses about macro forces, we spend our lives considering the long-term earnings power of a business in light of the environments in which the companies operate. In the U.S., we have opportunities like Ford, a stock everyone seems to hate, selling at seven times our estimate of normal earnings and just over six times current earnings. The stock is trading around its 52-week low while business conditions at Ford actually seem pretty good. The bears are focused on the likelihood that sales may soon turn down and that the Ford is not focused on electric cars or autonomous driving technology.

Our analysis suggest that most of these factors are priced into the stock already. In Europe, we would highlight a company like Rexel, the second largest global distributor of electrical equipment. Self-infected wounds, along with fears of the Amazon effect on distribution businesses has caused a great franchise to decline 50% from its highs, selling at eight times our estimate of normal earnings and just over 10 times current earnings. In the emerging markets, we see opportunities like China Mobile, which sells for approximately 11 times our estimate of normal earnings and 12 times current.

More extraordinary though is that the company sells at just 3 times EBITDA and more than 25% of the company's enterprise value is net cash. In short, while the movie plays on, it will, of course, eventually end. And in the end, it will be good to be a value investor. On the business front, we are pleased by the reception our message is receiving in the marketplace.

Our pipeline of new business opportunities is strong and spans across all strategies, channels, and geographies. We're also encouraged by this quarter's results. We ended the quarter with $38.9 billion in assets under management and had solidly positive net flows for the trailing 12 months, driven by healthy gross inflows and a continued low rate of outflows. We saw net inflows across all AUM categories from both new and existing sub-advised and separately managed account relationships.

During the quarter, we also launched the fifth Pzena mutual fund with our international small-cap value strategy, and continued to be encouraged by the progress of our mutual fund sales efforts. We hope to expand this portion of our sales team in the coming quarters. Thank you for taking the time to attend our call today, and I look forward to hearing your questions. I'll now turn the call over to Jessica Doran, our chief financial officer, who will provide this quarter's financial update.

Jessica Doran -- Chief Financial Officer

Thank you, Rich. We recorded diluted earnings of $0.22 per share for the third quarter, compared to diluted earnings of $0.20 per share last quarter and $0.17 per share for the third quarter of last year. Revenues were $39.6 million for the quarter and operating income was $20.1 million. Our operating margin was 50.9% this quarter, compared to 51.5% last quarter and 50.8% in the third quarter of last year.

Taking a closer look at our assets under management, as Rich mentioned, we ended the quarter at $38.9 billion, up 5.4% from last quarter, which ended at $36.9 billion, and up 9.9% from the third quarter of last year, which ended at $35.4 billion. The increase in assets under management from the second quarter of this year reflects net inflows of $1.1 billion and market depreciation of $0.9 billion. The increase from the third quarter of last year was driven by $1.9 billion in market depreciation and net inflows of $1.6 billion. At September 30, 2018, our assets under management consisted of $14.6 billion in separately managed accounts, $22 billion in sub-advised accounts and $2.1 billion in our Pzena Funds.

Compared to last quarter, assets under management across all channels increased with separately managed account assets, reflecting $0.5 billion in net inflows and $0.3 billion in market appreciation; sub-advised account assets reflecting $0.5 billion in net inflows and $0.5 billion in market appreciation; and assets in Pzena Funds being $0.1 billion in net inflows and $0.1 billion in market appreciation. Average assets under management for the third quarter of 2018 were $38.3 billion, up 1.6% from last quarter and 11.3% from the third quarter of last year. Revenues increased 3.2% from last quarter and 9.2% from the third quarter of last year, primarily reflecting an increase in average assets under management. Our weighted average fee rate was 41.3 basis points for the quarter, compared to 40.7 basis points last quarter and 42.1 basis points for the third quarter of last year.

Asset mix continues to be the most significant factor in our overall weighted average fee rate, although swings in performance fees and fulcrum fees also contribute. Our weighted average fee rate for separately managed accounts was 54.7 basis points for the quarter, compared to 53.5 basis points last quarter and 56.3 basis points for the third quarter of last year. The increase from last quarter reflects an increase in assets and strategies that generally carry higher fee rates. The decrease from the third quarter of last year reflects the decrease in performance fees and an increase in large client relationships that generally carry lower fee rates.

Our weighted average fee rate for sub-advised accounts was 30.2 basis points for the quarter, compared to 30.3 basis points last quarter and 29.8 basis points for the third quarter of last year. Our weighted average fee rate for Pzena Funds was 66.8 basis points for the quarter, increasing from 62.4 basis points last quarter and from 66 basis points for the third quarter of last year. The increase from last quarter and the third quarter of last year reflects an increase in assets and strategies that generally carry higher fee rates. The increase from the third quarter of last year was partially offset by the adoption of new revenue recognition standard during the first quarter of 2018, which required expense cap reimbursements to be presented net against revenue.

Excluding the impact of this revenue recognition presentation change, the weighted average fee rate for Pzena Funds was 70.3 basis points for the quarter, increasing from 67.6 basis points last quarter and 66 basis points for the third quarter of last year.Looking at operating expenses. Our compensation and benefits expense was $16.1 million for the quarter, increasing from $15.2 million last quarter and from $14.8 million for the third quarter of last year. The increase from last quarter and the third quarter of last year reflects an increase in compensation rates and our bonus accrual. G&A expenses were $3.3 million for the third quarter of 2018, compared to $3.4 million last quarter and $3.1 million for the third quarter of last year.

Other income was $0.6 million for the quarter driven by fluctuation in performance of our investments. The effective rate for our unincorporated and other business taxes was 2.1% this quarter, compared to 4.3% last quarter and 3.8% in the third quarter of last year. This decrease primarily reflects the tax benefits associated with the reversal of uncertain tax position liability, which was recorded in the third quarter of this year due to the closure of the statute of limitations on a prior tax year. Excluding any future reserve reversals, we expect the effective rate associated with the unincorporated and other business taxes of our operating company to be between 3% and 5% on an ongoing basis.

Our effective tax rate for our corporate income taxes, ex UBT and other business taxes, was 16.9% this quarter, compared to 27.8% last quarter and 36.9% for the third quarter of last year prior to tax reform. The decrease from last quarter primarily reflects an income tax benefit recognized during the third quarter of 2018, which was associated with a onetime adjustment to our deferred tax assets. We expect this rate, excluding any adjustments or the impact of excess benefits or detriments associated with noncash compensation, to be between 23% and 25% on an ongoing basis.The allocation to the nonpublic members of our operating company was approximately 74.8% of the operating company's net income for the third quarter of 2018, compared to 74.4% last quarter and flat from 74.8% for 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 217,000 shares of Class A common stock and Class B units for $2 million. At September 30, there was approximately $28 million remaining in the repurchase program. To take advantage of higher interest rates, we made cash equivalents and short-term investments during the quarter. Although most of these cash investments have durations less than a year and are short-term in nature, those with durations over three months are classified as investments on our balance sheet.

At quarter end, our financial position remains strong with $31.9 million in cash and cash equivalents as well as $35 million in the short-term investments. We also announced a $0.03 per share dividend for the quarter. Thank you for joining us. We'd now be happy to take any question. 

Questions and Answers:

Operator

[Operator instructions] Our first question today will come from Will Cuddy of JPMorgan. Please, go ahead.

Will Cuddy -- J.P. Morgan -- Analyst

Good morning.

Rich Pzena -- Chief Executive Officer and Co-Chief Investment Officer

Good morning.

Will Cuddy -- J.P. Morgan -- Analyst

So, SMA flows showed good improvements from recent quarters. Could you elaborate on some of the drivers of the improved flows in 3Q?

Rich Pzena -- Chief Executive Officer and Co-Chief Investment Officer

Specifically on SMAs, you're asking about that one?

Will Cuddy -- J.P. Morgan -- Analyst

Yes. Yes, specifically for SMAs.

Rich Pzena -- Chief Executive Officer and Co-Chief Investment Officer

OK. We had one large new account fund in the quarter. And our -- and we had some flows in and out, but that was primarily driven by one new large account. And the outflows, the gross outflows, have remained at the low level that we've seen now for the last, say, two years, which are substantially below where they had been running for the prior five.

Will Cuddy -- J.P. Morgan -- Analyst

OK. That makes sense. Now, Jessica, what was the breakout for the performance fees by vehicle type for 3Q?

Jessica Doran -- Chief Financial Offiver

It was all in our sub-advised. So, we had -- the $0.8 million was all sub-advised.

Will Cuddy -- J.P. Morgan -- Analyst

OK. And then for you, Rich, have you noticed a change in client sentiment on U.S. value after the recent pullback in technology stocks? And relatedly, has sentiment changed for international value after the term loan in EM markets the past couple of months?

Rich Pzena -- Chief Executive Officer and Co-Chief Investment Officer

I'm going to say no. I haven't noticed any change. It started building probably 18 to 24 months ago when -- I know it sounds counterintuitive, but both institutions as well as some of the big distributors of funds that are trying to basically say we don't want all of our money in Amazon and Netflix, are looking to sort of diversify their fund holdings. And increasingly, the kinds of -- the managers that do what we do are becoming harder and harder to find, which is the same phenomenon we saw during the Internet bubble a decade ago when -- or more than a decade ago now -- when it's hard to be a value manager in the face of sustained underperformance, but that doesn't mean that every investor, particularly professional institutional investors, concludes that all of their money should be in something else.

So, as those spreads have widened, we saw our pipeline activity increase, the inquiries increased, the dialogue changed. And it feels like it's the same today as it was two quarters ago rather than substantially different.

Will Cuddy -- J.P. Morgan -- Analyst

OK. So, Rich, you mentioned a sales team expansion in your prepared remarks for the mutual fund business, like mutual fund [Inaudible] business.

Rich Pzena -- Chief Executive Officer and Co-Chief Investment Officer

Yes.

Will Cuddy -- J.P. Morgan -- Analyst

Could you elaborate on those sales team expansion plans?

Rich Pzena -- Chief Executive Officer and Co-Chief Investment Officer

Yes. We are looking to add another person in our North American intermediary team. And it's really enhancing the effort that we have geographically. And we're taking a gradual approach to this.

Remember what's going to happen this year is we hit our five-year track record in April, and that is a gating factor for many, for some it was three. And you saw that when we hit three, we got a little bit of an inflow. So, our total fund -- retail fund business in North America is around $350 million now. And we're hopeful that we can continue to grow that.

We have some pretty strong momentum in our emerging markets fund. It's highly rated by Morningstar. And we now have inbound inquires, it's not just outbound. So, we have some optimism.

We're also contemplating expanding distribution outside the United States. But my -- but the remarks I said was primarily that we've already decided to expand in the United States.

Will Cuddy -- J.P. Morgan -- Analyst

OK. Great. And then going back to performance, if I look -- for the large-cap value strategy relative to the Russell 1000 year to date and also for the global strategies year to date, could you elaborate on some of the drivers of the underperformance for your -- like those categories relative to the benchmarks?

Rich Pzena -- Chief Executive Officer and Co-Chief Investment Officer

Yes. It's -- when you do a formal performance attribution for the year to date, pretty much looks like everything that we did didn't work. And I don't mean to say that to sound as bad as it probably sounds. It was less anything that you could specifically point to and more that the environment for value was just poor.

And I know we compare ourselves to a value benchmark, but we're the -- on the deeper end of value. And if you compared us to more of a traditional deep value index like low price to book, you would have seen nothing remarkable. So, all I can say is I think this underperformance is the environment rather than any particular mistakes.

Will Cuddy -- J.P. Morgan -- Analyst

So, on that, do clients look at it that way, too? Like where they -- look at your performance and understand that it's really a benchmark with deep value? Is that something as a dialogue you have with clients when, like on a quarterly basis after you discuss performance?

Rich Pzena -- Chief Executive Officer and Co-Chief Investment Officer

Yes. I mean, look, well, the dialogue -- most of the people that our clients take a long-term view of our performance, and it's pretty rare that you'll see a one quarter or even one-year assessment. So the three- and the five-year numbers are still OK, and the inception numbers are still good. So when you have these bad quarters or even -- it's really more than a quarter because the underperformance for us started in April.

So, we've had a, call it, six-month period of kind of poor performance. It's totally explained by what's going on in the environment. And most of the time, I'm going to say more than the majority of the clients just gloss over that is because they know what we do, and they're not expecting something different than this. I won't say that there is no one that doesn't focus on quarterly performance.

But though -- and everybody will ask a question, but I don't think we're in a point where we are worried about an increase in outflows as a result of the recent performance.

Will Cuddy -- J.P. Morgan -- Analyst

OK. That makes sense. Thank you for taking my questions.

Rich Pzena -- Chief Executive Officer and Co-Chief Investment Officer

Sure.

Operator

[Operator instructions][Operator signoff]

Duration: 23 minutes

Call Participants:

Jessica Doran -- Chief Financial Officer

Rich Pzena -- Chief Executive Officer and Co-Chief Investment Officer

Will Cuddy -- J.P. Morgan -- Analyst

More PZN analysis

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