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Virtus Investment Partners Inc (VRTS -0.41%)
Q2 2019 Earnings Call
Jul 26, 2019, 10:00 a.m. ET
Contents:
- Prepared Remarks
- Questions and Answers
- Call Participants
Prepared Remarks:
Operator
Good morning. My name is Carmen, and I'll be your conference operator today. I would like to welcome everyone to the Virtus Investment Partners quarterly conference call. The slide presentation for this call is available in the Investor Relations section of the Virtus website, www.virtus.com. This call is being recorded and will be available for replay on the Virtus website. [Operator Instructions] I'll now turn the conference to your host, Sean Rourke.
Sean P. Rourke -- Vice President, Investor Relations
Thank you, Carmen, and good morning, everyone. On behalf of Virtus Investment Partners, I'd like to welcome you to the discussion of our operating and financial results for the second quarter of 2019. Our speakers today are George Aylward, President and CEO of Virtus; and Mike Angerthal, Chief Financial Officer. Following their prepared remarks, we will have a Q&A period.
Before we begin, I direct your attention to the important disclosures on page 2 of the slide presentation that accompanies this webcast. Certain matters discussed on this call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and as such, are subject to known and unknown risks and uncertainties, including, but not limited to, those factors set forth in today's news release and discussed in our SEC filings.
These risks and uncertainties may cause actual results to differ materially from those discussed in the statements. In addition to results presented on a GAAP basis, we use certain non-GAAP measures to evaluate our financial results. Our non-GAAP financial measures are not substitutes for GAAP financial results and should be read in conjunction with the GAAP results. Reconciliations of these non-GAAP financial measures to the applicable GAAP measures are included in today's news release, which is available on our website.
Now, I'd like to turn the call over to George. George?
George R. Aylward -- President and Chief Executive Officer
Thank you, Sean. Good morning, everyone. I'll start today with an overview of the quarter before turning it over to Mike to provide more detail on the financial results. We are pleased with our second quarter results, which included a return to positive net flows supported by net inflows at institutional, retail separate accounts and ETFs, a higher operating margin, average fee rate and continued strong free cash flow, our highest level of institutional sales in many years, investment performance that continues to be excellent, and while mutual fund flows remained negative, they improved sequentially and the negative flows were primarily due to one out-of-favor strategy.
So turning to our results for the quarter, long-term assets under management increased 3% sequentially to $103.3 billion as a result of market appreciation and modestly positive net flows. Total assets, which include liquidity strategies, ended the period at $105 billion. Total sales of $5.1 billion decreased 7% from the prior quarter, which included $0.8 billion related to a CLO issuance and initial model allocations for 2 new ETFs. Excluding those flows, sales were up 8% due to strong institutional inflows, which included the funding of a $0.9 billion global real estate mandate at Duff & Phelps, partially offset by lower sales of open-end funds.
Net flows were positive $0.1 billion, improving from the modest net outflows in the prior quarter, led by positive flows in institutional, retail separate accounts and ETFs, partially offset by the open-end fund net outflows. Institutional net flows were positive $0.5 billion in the second quarter compared with outflows of $0.2 billion in the prior quarter due to the higher levels of sales. Retail separate accounts had positive net flows of $0.3 billion from both the intermediary sold and the private client channels.
Kayne's mid-cap strategies continue to be key contributors to the net flows in the intermediary sold channel, which has now generated 14 consecutive quarters of positive net flows. Open-end fund net outflows were $0.7 billion in the quarter, primarily due to outflows in bank loan strategies, which remain out of favor. Similar to last quarter, areas of strength included domestic equity mid-cap strategies at Kayne and Ceredex as well as the international small-cap strategy at Kayne.
ETFs net flows were positive, though down from the first quarter, which included the favorable impact of the initial model allocation on 2 newly issued funds. During the quarter, we executed on several process initiatives that leverage the existing investment capabilities into new product structures. At Seix, we leveraged their loan established bank loan investment capability employed for CLOs and funds and launched a bank loan ETF. And at SGA, we implemented a series of initiatives.
First, we adopted a 5-star large-cap global growth fund managed by SGA for over 8 years. We also launched an SGA managed emerging markets growth funds. In addition, SGA was appointed as a subadvisor on one of our international developed market funds. Within one year of the partnership with SGA, we now offer each of their key institutional quality investment capabilities in mutual funds or retail separate accounts as we look to increase their scale through the retail channel. These product actions in the quarter are a demonstration of one key elements of the value proposition we offer to our affiliates.
In terms of July, we're pleased with the more favorable trend in mutual fund net flows, which we expect to end at breakeven for the month despite the ongoing negative retail sentiment in bank loans. Regarding what we're aware of so far in July for other products, we have a model win and 2 favorable model reallocations that will have a positive impact on mutual fund sales in the third quarter. And for institutional, we received notice of a few redemptions and several smaller wins that we expect to impact second half of 2019 flows. In addition, looking ahead, the pipeline remains strong with a meaningful number of finals across our affiliates.
Moving to the financial results. Operating income, as adjusted, and the related margin were $43.7 million and 36% compared with $33.5 million and 30% in the prior quarter, as first quarter results included the impact of seasonally higher employment expenses. Second quarter earnings per share, as adjusted, of $3.63 were up 33% from the prior quarter with the increase due to higher revenues, as adjusted, and the higher seasonal employment expenses last quarter. Compared with the prior year period, second quarter earnings per share, as adjusted, increased 8%. Turning to capital and the balance sheet.
We continue to maintain a balanced approach to capital management across the priorities of investing in the business, returning capital to shareholders and maintaining appropriate leverage. This quarter, we repurchased or net settled approximately 77,000 common shares or about 1% of shares outstanding. In addition, we continued our practice of consistently paying down debt on our term loan and ended the quarter with net debt to bank EBITDA of 0.7 times.
With that, I'll turn the call over to Mike. Mike?
Michael Angerthal -- President and Chief Executive Officer
Thanks, George. Good morning, everyone. Starting with our results on slide 7, assets under management. At June 30, long-term assets were $103.3 billion, up $3.4 billion or 3.3% from March 31, and $13.4 billion or 15% from the prior year quarter. The sequential increase was primarily due to $3.7 billion of market appreciation as well as modestly positive net flows of $0.1 billion. The market appreciation was reflective of strong domestic equity performance as well as an improvement in credit markets. The change in assets from the prior year primarily reflected the addition of SGA's assets of $11.3 billion and market appreciation of $7.8 billion, partially offset by net outflows of $4.3 billion, primarily in the fourth quarter. AUM continues to be well diversified by product type, asset class and channel. The relative size of mutual funds within our long-term AUM mix have declined to 40% from 49% in the prior year period. We have also continued to see strong growth in mid-cap AUM this year with assets up 36% since year-end to $9.1 billion.
Turning to slide 8. Asset flows. The $0.1 billion of positive net flows this quarter were up from modest net outflows in the first quarter with positive contributions from institutional retail separate accounts and ETFs, which were offset by net outflows in mutual funds. Total sales were $5.1 billion, a sequential decline of 7% as higher institutional sales, which included the $0.9 billion global real estate sub-advisory mandate, were more than offset by lower sales in mutual funds, structured products and ETFs. As a reminder, the first quarter included $0.8 billion of sales related to a CLO issuance and an initial model allocation into newly launched ETFs.
Looking at open-end mutual fund flows by asset class. Domestic equity funds had positive net flows of $0.1 billion, an improvement from $0.1 billion of net outflows in the prior quarter, primarily due to lower redemptions across small-, mid- and large-cap strategies. Mid-cap funds, which we offer in growth, value and core strategies, continue to generate positive net flows with $0.3 billion in the quarter, reflecting an annualized organic growth rate of 30%. This continued a strong trend for mid-cap, which has averaged 20% organic growth over the past 3 quarters.
Net flows for small-cap strategies improved sequentially, but remained modestly negative at $0.1 billion. International Equity Funds, which included both developed and emerging markets, had breakeven flows in the quarter compared with $0.1 billion of positive net flows in the prior quarter. Positive net flows of $0.2 billion in international small-cap were offset by net outflows from emerging markets. For fixed income funds, bank loan strategies were the primary driver of net outflows of $0.7 billion for the quarter. Bank loans continue to remain out of favor industry-wide for the third consecutive quarter.
Our managers continued to deliver strong relative investment performance across our many strategies. As of June 30, 26 of our funds, representing 80% of fund assets, had 4 or 5-star ratings; and 97% of fund AUM were in 3, 4, or 5-star funds. Each of our 5 largest mutual funds is a 5 or 4-star fund, representing a diverse set of strategies from 5 different managers. In addition to this very strong fund performance, 94% of institutional assets were beating their benchmarks on a 5-year basis as of June 30, and 66% of assets were exceeding the median of their peer groups on the same 5-year basis.
Turning to Slide 9. Investment management fees, as adjusted, of $116.4 million increased $8.9 million or 8% sequentially due to higher average assets under management and a higher average fee rate. I would note that neither period had meaningful performance fees. The average fee rate on long-term assets for the quarter increased to 46 basis points, up 0.4 basis points from 45.6 in the prior quarter. With respect to open-end funds, the fee rate increased to 55.4 basis points from 54.3 in the first quarter, reflecting the impact of favorable equity returns on the level of equity assets and the ongoing positive fee rate differential between sales and redemptions. This quarter, the blended fee rate on mutual fund sales was 61 basis points, up from 58 in the prior quarter, while the rate on redemptions of 51 compared to 52 in the first quarter.
Slide 10 shows the 5-quarter trend in employment expenses. Total employment expenses, as adjusted, of $57 million decreased 4% sequentially from the first quarter. The decrease largely reflects the impact of $7.5 million of seasonal employment expenses in the first quarter as well as the impact of lower commissionable sales on sales-based compensation, partially offset by higher profit-based incentive compensation in the second quarter. Employment expenses represented 47.1% of revenues in the quarter, down from 48.5% in the year-ago period. For modeling purposes, we believe an employment ratio range of 48% to 50% of revenues, as adjusted, remains appropriate. The trend in other operating expenses, as adjusted, reflects the timing of product, distribution and operational activities.
Other operating expenses, as adjusted, were $19.1 million, an increase of $0.6 million or 3% from the prior quarter. The increase reflects $0.8 million for the annual equity grants to the Board of Directors. Excluding the Board grant, other operating expenses of $18.3 million declined 1% sequentially. When looking at other operating expenses, as adjusted, over the past 4 quarters, the average has been approximately $18 million, excluding the annual director grants. All else being equal, we believe that is an appropriate expectation of other operating expenses, within the $16.5 million to $18.5 million quarterly range we had previously discussed. We will continue to evaluate the range and update you as appropriate.
Slide 12 illustrates the trend in earnings. Operating income, as adjusted, of $43.7 million increased $10.2 million or 30% sequentially, primarily due to higher revenues, as adjusted, as well as lower employment expenses compared with the seasonally elevated employment expenses in the first quarter. Compared with the prior year quarter, operating income, as adjusted, increased $6.1 million or 16%. The operating margin, as adjusted, for the quarter was 36.1%, an increase of 630 basis points sequentially and 210 basis points over the prior year period.
Net income, as adjusted, of $3.63 per diluted share increased $0.90 or 33%. Excluding the $0.65 per diluted share of first quarter seasonal expenses, the increase was 7% sequentially. Interest and dividend income, which includes income generated on seed and CLO investments, was $3.8 million or $0.34 per share, a decrease from $4.2 million or $0.37 per share last quarter, due to lower CLO interest income. While there will be variability from quarter to quarter based on market values and timing of distributions, second quarter interest and dividend income was consistent with our current expectations for an approximate annualized yield of 12% to 14% on CLO investments and 1% to 2% on total cash and seed capital, all else being equal.
The effective tax rate, as adjusted, for the quarter was 27%, relatively stable with the prior quarter and a reasonable run rate for modeling purposes. Regarding GAAP results, second quarter net income per share was $3.26 compared with $2.61 in the first quarter. Second quarter net of tax GAAP earnings per share included the following items: $0.32 of net unrealized gains on investments, $0.13 of net realized losses on investments, $0.58 of amortization of intangible assets and $0.14 of other costs, including acquisition and integration as well as restructuring and severance.
Slide 13 shows the trend of our capital position and related liquidity metrics. Working capital at June 30 of $149 million increased $11 million or 8% sequentially, primarily reflecting operating earnings, partially offset by debt repayments and return of capital to shareholders. Gross debt outstanding at June 30 was $316 million as we repaid $12.4 million of debt, representing a scheduled payment of $0.9 million and an additional principal payment of $11.5 million. The net debt-to-EBITDA ratio of 0.7 times at June 30 was down from 0.9 times at March 31, due to an increase in cash balances and debt pay down. Gross debt-to-EBITDA was 1.5 times at the end of the quarter, down from 1.6 times at March 31.
Regarding balance sheet investments. Seed capital increased to $96 million due to market appreciation and an investment in the new bank loan ETF that was launched during the quarter. CLO investments were $88 million, essentially unchanged from the prior quarter. Regarding return of capital to shareholders. Share repurchases in the quarter totaled $7.5 million or 67,709 shares of common stock, which represented approximately 1% of beginning of quarter total outstanding common shares. And as a reminder, our mandatorily convertible preferred shares will convert to common shares on February 1, 2020. One additional item of economic value to highlight, we had intangible assets that will continue to provide a cash tax benefit of approximately $10 million per year at current tax rates over the next 14 years.
With that, let me turn the call back over to George. George?
George R. Aylward -- President and Chief Executive Officer
Thanks, Mike. So, we will now take your questions. Carmen, can you open up the lines, please.
Questions and Answers:
Operator
Certainly. [Operator Instructions] Our first question is from Alex Blostein with Goldman Sachs. Your line is open.
Sheriq Sumar -- Goldman Sachs -- Analyst
Hi. This is Sheriq filling in for Alex. What are your updated thoughts around M&A for the industry? And what is -- I mean, valuation seems to have moved higher this year. And do you think that this is creating any sort of hurdles for M&A within the industry? And any color on the pipeline that you're seeing for Virtus, which asset class are you more focused on? And do you think that there are enough opportunities out there for you to consider? Thank you.
George R. Aylward -- President and Chief Executive Officer
Sure. Yeah. I mean, M&A is always going to be taking place throughout the industry, and it will be -- the volume of it is usually impacted by people's views of their own valuation and targeted valuations. As we sort of said before, while our long-term growth strategy is not predicated upon M&A, we have consistently used M&A as a successful tool for us to enhance and expand the business. And so generally, we think there is a lot of activity out there, we are very discipled about what we consider. The last transaction we closed on would have been about a year ago now, I guess, for SGA. And as we sort of look at things, like everyone, we certainly have a good cross section of the traditional asset classes. We would consider other things, but our primary focus continues to be growing our existing managers, as you noted in my earlier remarks, I highlighted the fact that our goal is to create the organic growth once you have that partner by launching them in other channels, but from the M&A perspective, we actually think we are in a very good position, being at the lower end of the leverage in the industry, having a very attractive value proposition, but we will only do it if we are very comfortable or either has strategic value and financial accretive value to our shareholders.
Sheriq Sumar -- Goldman Sachs -- Analyst
Okay. Thank you.
Operator
Thank you. Our next question comes from Michael Cyprys with Morgan Stanley. Your line is open.
Stephanie Ma -- Morgan Stanley -- Analyst
This is Stephanie filling in for Mike. Thanks for taking our question. Maybe just one on ETFs and model portfolios. Can you talk about some of the distribution initiatives around trying to increase model portfolio penetration? How much of the ETFs are in model today? And then looking ahead, what products do you think will have the greatest opportunity for potential model portfolio inclusion?
George R. Aylward -- President and Chief Executive Officer
Sure. I'll speak about model portfolios more broadly because I don't think it's limited to just ETFs. So in the first quarter, we had two newly issued ETFs, which we were very pleased received initial model allocations from an intermediary's model where they wanted exposure to certain asset classes, and we continue to see that as a good opportunity to sort of leverage very specialized ETF products into models created by some of our partners. And then in terms of the July outlook, I gave you some color around model wins and model reallocations, which actually really relate more to the mutual funds and across a number of our affiliates, actually about three. So we are very pleased with that because our goal is to provide either the building blocks or the individual pieces of a well-diversified portfolio. So we think focusing in on those models and where we can have the appropriate the product to fit to weaving that someone is looking forward to achieve for their client is a great opportunity, but I see that across ETFs, mutual funds as well as retail separate accounts. So I continue to see that as an area of great opportunity.
Stephanie Ma -- Morgan Stanley -- Analyst
Okay. Great. Thanks for taking my question.
George R. Aylward -- President and Chief Executive Officer
Thank you.
Operator
Thank you. And this concludes our Q&A session. I would like to turn the conference back to Mr. Aylward.
George R. Aylward -- President and Chief Executive Officer
Great. I just want to thank everyone today for joining us, and we obviously certainly encourage you to call us if you have any questions or any further questions. Thank you so much.
Operator
[Operator Closing Remarks]
Duration: 25 minutes
Call participants:
Sean P. Rourke -- Vice President, Investor Relations
George R. Aylward -- President and Chief Executive Officer
Michael Angerthal -- President and Chief Executive Officer
Sheriq Sumar -- Goldman Sachs -- Analyst
Stephanie Ma -- Morgan Stanley -- Analyst
