Pzena Investment Management, Inc.

Gary Bachman - CFO Rich Pzena - Chairman, CEO

Ken Worthington - JPMorgan

Thank you, operator. Good morning and thank you for joining us on the Pzena Investment Management fourth quarter 2015 earnings call.

I am Gary Bachman, 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 our 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 projections.

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 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 materials that is not public information on our conference calls. 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 non-GAAP diluted EPS of $0.12 per share and $8.3 million in non-GAAP diluted net income. Revenues were $27.7 million for the quarter and our operating income was $13 million.

I will discuss our financial results in greater details in a few minutes, but let me now turn the call over to Rich who will discuss our current view of the investing environments.

Thank you, Gary. Last five years have been a rough time for value investors.

We’ve been battling three headwinds: a move from active to passive investment strategies, a decline of defined benefit plans and the rise in defined contribution and anti-value cycle. Despite these challenges we were able to generate positive trailing 12 month net asset flows for 13 consecutive quarters until the streak was broken this past quarter.

While we don’t have good visibility into 2016, we remain optimistic that we are in the midst of a classic cycle with value poised to rebound. Our ramp-up of distribution which we started a few years ago is showing results but as we know, the full effect of these efforts takes time to pay off.

We have seen benefits from the additions to our business development team we made in North America, and we are optimistic about our investments in Europe in the intermediary space. We are seeing the first signs of tick-up in the intermediary channel, not enough to report an AUM figure but a sign that our story can resonate in that space, making us encouraged about the future.

Our view is that the shift from defined benefit to defined contribution plans is a secular trend but the flight to passive strategies in the anti-value environment are cyclical. This downturn in value as an investment style began in early 2011 as the tremendous investment boom in China began to wane.

The current fears around China reflect the continuation of a trend of slowing that is now quite advanced. That said, we are now seeing classic signs in the economic cycle that leads us to believe that the five-year anti-value period may be approaching a turning point.

The meltdown in commodities, energy, and related industrial cyclicals is a telltale sign that markets are anticipating a recession, or at best a significant slowing of the global economy. Capital spending much of which is concentrated in the energy and commodity industries has plunged over the last 18 months.

And we expect to see a bottoming of the capital expenditure cycle in 2016. Historically that has been a catalyst for the value cycle to turn as investors start to look to an eventual recovery.

Government economic bureaus often lack the market’s recognition of the bottoming which is why value often appears to work well during reported recession. But we don’t believe global GDP will turn negative.

We do believe the worst impact of the slowdown should be felt this year. Spending in the mining industries has also collapsed and in energy the process is well underway.

Sometime in 2016 we expect the spending rate to close in on the bottom. Investors are already discounting this outcome, reflected in the market’s dismal start in 2016.

As markets sold off, valuation spreads widened to what are now provocative levels, most notably in the US, we’re finding very attractive investment valuation because of the fear in the global investment community. It is likely that the negative moves in sectors like energy and financials are nearing exhaustion just because the moves in oil prices and interest rates have already been dramatic.

The key is to find businesses where this slowdown does not create financial distress. History tells us that people wait to see value work before piling in, making the ability to predict flows which is difficult, at best almost impossible.

Search activity for value is tepid but we would expect it to eventually react to a turn in the value cycle. Flows so far in 2016 have been slightly positive but we really don’t know how the rest of the year will turn out.

Our sales people are focused, working hard, doing a good job, winning mandates in a tough environment and positioning the firm well for when the cycle ultimately turns. I’d now like to turn the call over to Gary Bachman, our Chief Financial Officer who will provide this quarter’s financial update.

Thank you, Rich. As I mentioned, we reported non-GAAP diluted earnings of $0.12 per share for the quarter, flat from last quarter and down from $0.13 during the fourth quarter of last year.

Our non-GAAP income statements adjust for certain deferred tax asset adjustments as well as the recurring valuation allowance and tax receivable agreement items. During the fourth quarter of 2015, our non-GAAP income statements also adjusted for certain non-recurring charges recognized in operating expenses.

I will address the current tax related adjustments at the conclusion of my remarks but for now, I will focus on the non-GAAP information. Our assets under management ended the quarter at $26 billion, up from 2% from $25.5 billion last quarter and down 6.1% from the fourth quarter of last year, which ended at $27.7 billion.

In the fourth quarter of this year, we had market appreciation of $1.2 billion partially offset by net outflows of $0.7 billion. The $1.7 billion decrease from the fourth quarter of last year reflects $1.4 billion in market depreciation and $0.3 billion in net outflows.

At December 31, 2015, our AUM consisted of $14.9 billion in institutional accounts and $11.1 billion in retail accounts. Compared to last quarter, institutional assets were flat, reflecting $0.6 billion in market appreciation offset by $0.6 billion in net outflows.

Assets in retail accounts increased by $0.5 billion from the end of last quarter due to $0.6 billion in market depreciation partially offset by $0.1 billion in net outflows. Our average AUM was $26.4 billion during the quarter, down 2.6% from both last quarter and the fourth quarter of last year.

Revenues were $27.7 million for the fourth quarter 2015, a decrease of 10.1% from last quarter and 3.1% from the fourth quarter of last year. These decreases primarily reflect lower performance fees recognized during the fourth quarter of 2015.

We recognized $0.6 million in performance fees this quarter compared to $3.2 million last quarter and $1.2 million in the fourth quarter of last year. In general, our performance fees are calculated on an annualized basis over a three-year measurement period.

Our weighted average fee rate was 42 basis points for the fourth quarter of 2015. This compared to 45.4 basis points last quarter and 42.2 basis points for the fourth quarter of last year.

Our weighted average fee rate for institutional accounts was 53.2 basis points for the fourth quarter of 2015, down from 59.6 basis points last quarter and from 55.4 basis points for the fourth quarter of last year. The decrease from last quarter and the fourth quarter of last year primarily reflects the decrease in performance fees recognized during the fourth quarter of 2015.

Our weighted average fee rate for retail accounts was 26.6 basis points for the fourth quarter 2015. This was relatively flat from the last quarter and the fourth quarter of last year.

Looking at operating expenses, our compensation and benefit expense was $11 million for the quarter, down 5.5% from $11.6 million last quarter and up 2.9% from $10.7 million for the fourth quarter of last year. GAAP G&A expenses were $3.7 million for the fourth quarter of 2015, up approximately $0.8 million or 27% from the last quarter and up $0.6 million from the fourth quarter of last year.

During the fourth quarter of 2014, we adjusted our non-GAAP results for non-recurring write-offs of $0.4 million associated with the move to our new headquarters during 2015. Excluding these one-time adjustments, G&A expense increased $1 million or 35.4% from the fourth quarter of last year.

The non-GAAP operating margin adjusted for the non-recurring expenses was 46.9% this quarter compared to 52.7% last quarter and 53% in the fourth quarter of last year. The changes in non-GAAP operating margin during the quarter reflect a decrease in our annual bonus accrual offset by certain G&A expenses that we do not expect to recur.

Net of outside interest, other income was $0.6 million this quarter compared to an expense of $1.7 million last quarter and income of $0.1 million during the fourth quarter of last year. These fluctuations arise generally as a result of the performance of the firm’s investments.

The non-GAAP effective rate for our unincorporated business taxes was 4.1% this quarter compared to 4.2% last quarter and 4.3% in the fourth quarter of last year. We expect this rate to be between 4% and 5% on an ongoing basis.

The non-GAAP effective tax rate for our corporate income taxes ex-UBT was 34.5% this quarter compared to 34.7% last quarter and 34.2% for the fourth quarter of last year. These effective rates reflect tax benefits from employee share and unit vesting and option exercises.

We expect this rate, excluding any share and unit vesting, to be between 37% and 39% on an ongoing basis. The allocation to the non-public members of our operating company was approximately 77.4% of the operating company’s net income for the fourth quarter of 2015.

This compared to 77.9% last quarter and approximately 80% in the fourth 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 78,319 shares of Class A common stock for approximately $0.8 million and 33,690 units of our operating company’s Class B units for approximately $0.3 million. At December 31, there was approximately $10.7 million remaining in the repurchase program.

Before we turn it over to questions, I’d like to briefly walk through the non-GAAP income tax expense items. We recognize adjustment as a result of the revised estimates of future taxable income and our ability to utilize our deferred tax asset.

We recognized a $0.2 million net expense associated with changes to our deferred tax asset, valuation allowance and liability to our selling and converting shareholders. These adjustments comprised the majority of the difference between our fourth quarter 2015 non-GAAP and GAAP net income.

On a quarterly basis, we will record adjustments to the valuation allowance and our liability to our selling and converting shareholders as necessary. 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 amounts I just discussed, we reported GAAP basic and diluted EPS of $0.14 and $0.12 per share for the quarter respectively. At quarter end, our financial position remained strong.

Our cash balance was $35.4 million at December 31 and we declared a $0.32 per share year end dividend last night. Thank you for joining us on the call.

We’d now be happy to take any questions you may have.

So maybe first on the narrative on the value cycle. How is that resonating with investors right now?

Do you find that investors kind of buy into it? You obviously mentioned that investors like to see the turn before investing in it.

But to what extent is the narrative resonating?

Well, as you might expect it resonates differently with different people. There are the early adopters and we are actually having some interesting conversations with a couple that may want to be – that may want to take advantage of the valuation opportunities and are willing to do it just because the spreads are wide.

But they are not the majority. Although they can be significant.

So we are hopeful that one or two of these will actually make a significant impact in our flows for the year. But you can never be certain how you’re going to react.

Most people, early adoption is one year into the cycle. And of course, we don’t know when the cycle is going to turn.

Maybe on the expenses, AUM has started 2016 – or market has started down meaningfully. How do you think about expense flexibility and how do you think about being able to adjust to potentially lower AUM and revenue levels?

We have a bit of flexibility but we are in the middle of these initiatives. So we sort of view the range of our expenses being up 5% to up 10% for the year.

For us to actually cut expenses, we would either have to cut some of these initiatives or make some cuts that would not be consistent with the number of accounts that we are managing. We’re already pretty lean at this point.

So most of our flexibility comes in the actual level of sales comp and bonuses, and – I mean if we wound up with a really horrible year where the markets were down and flows were negative, for sure we could cut bonuses. But our planning range now is somewhere between 5% and 10% growth in expenses.

Then lastly, just give us update on the marketing of your own funds? How are things going in terms of getting your products on more of these third party platforms?

We’re pretty much now on all the major platforms. We’ve hired one additional person.

We are interviewing actively for another. And we’re just now – I mean the process of getting on the platforms takes a long time.

So the balance of the year is going to now switch focus, now that we are on the platforms to actually going out and starting to pound the pavement. With some of the big intermediaries, we’ve already had a little bit of preliminary success as I have mentioned, which gives us hope that will turn into some flows in 2016.

So if we’re successful this year with that, we will have some modest flows, and modest, I am going to say in a couple of hundred million dollars, that would be a good outcome for us. And we will see.

Non-US businesses, that was one of the areas that has been resonating with your investors over the last couple of years. Maybe talk about the performance there last year and maybe how 2016 has started.

And then given that was an area of particular interest over the last couple of years, how, if at all, is the narrative changing given how emerging markets are performing, for example, not just the non-US markets?

Yes, I would say the narrative is not very different. The performance was poor in 2015 pretty much across the board.

This was probably the worst year globally for value that you can find in a long time. And I am not – when I say that, I am not specifically referring to the indices.

People very often look at the growth and the value indices, like in the US they look at The Russell 1000 Growth and The Russell 1000 Value. If you actually look at more of the way the academics look at value, like the cheapest deciler, or the cheapest quintile versus the most expensive, the spreads everywhere in the world were completely perverse compared to long term history.

So the most expensive stocks dramatically outperform the least expensive stocks everywhere in the world. So there is no difference in the story.

It’s not like we can say, yes, it didn’t really work here in the US, but it’s working everywhere else, so we can be very excited about it. This is clearly a global phenomenon and a global investor concern.

And which – what’s interesting about it is it’s so clearly tied to the global economic cycle, and the stocks that are impacted, whether they are in US, in Europe or in China, are all of the same ilk, so it’s telling you what – the markets are basically telling you that we are afraid that the world economy is slowing down, and we don’t want to be exposed to anything that has economic sensitivity. Now our view of this is that the basic consumer segments of global economies, whether you are in the US, Europe or the emerging markets, are chugging along doing reasonably well.

It's hard anywhere to find excesses, and we don’t find excesses in consumer spending. You don’t find excesses in consumer debt levels.

You don’t find excesses in housing. You don’t really find excesses in autos although the US is a little bit above trend.

We’re hard pressed to say that that was true globally. But you don’t really find any excesses.

What you found in excess was this – crazy investment cycle in commodities to meet what was viewed as a limitless demand from China and a permanent shortage of these things that led management teams to go nuts. And so if you think of what’s gone on, if you think of a slow, steady global economic growth and superimposed on this, a bi commodity boom and then a big commodity bust, what we think is negatively affecting people’s perceptions is this big economic bust on the commodity side.

So the question is: when does that end? And if you look at the rate in the United States for example.

The rig count following from 400 rigs to 600 rigs and that has a pretty big negative impact on GDP or those industries and any industries that are surrounding it. But the question is how much lower can it go, can it go to 500 rigs, is it going to 400, maybe, but the economic impacts of that decline is much less than negative, it’s just that less than the negative that we are in the middle of experiencing right now.

And that’s true, all only in Energy. The similar things are true in mining and more metals or steel.

And so our discussions with people -- to get back to your question, our discussions with people in the world – the people that are early developers are early adapters in the US. There are early adopters in emerging markets.

There are early adopters globally. I don’t see any geographical bias to the way people are thinking about this right now.

In fact, there are people, even though the – we could look at the emerging markets and say this is pretty scary, that’s where they are calling us and that’s where they’re focused as to wanting to make a move. So I don’t think the geographic breakdown is the appropriate one.

I think it’s the global investor’s psychological makeup, that’s really what’s driving for us. End of Q&A

Great. Thank you, operator, and thank you everyone for joining us on our call today.

This commences the call.