Description

Situation Overview

Value is dead!  At least it is according to the incremental sellers of Pzena Investment Management, Inc. (“Pzena” or “PZN”).  Shares of PZN cratered along with the rest of the non-SAAS world in February and March and have remained down 40% below their “before times” valuation of $8.50-$9.00.  At current levels, the shares are meaningfully undervalued and offer a number of different ways to win with limited downside absent a complete disintegration of the business.

I don’t need to tell this board who Rich Pzena is, but I’ll just mention that PZN focuses on long-term deep value investments, often in names you’ve likely heard of, and frequently at single-digit earnings multiples.  As you might guess, PZN has had a bit of a tough time beating the indexes of late and is likely not the kind of “hot idea” that the average investor is seeking out.

PZN as a stock suffers from (i) heavy weighting toward deep value names (affecting PZN’s investment performance as well as investor sentiment toward PZN stock), which have suffered greatly from not being SAAS companies (ii) relatively thin trading volume, (iii) lack of attention from the investment community as demonstrated by the one or zero questions that they get on their earnings calls, (iv) a convoluted corporate and ownership structure that became further convoluted at the end of 2019, and possibly (v) a significant one-time charge in Q419 related to a new compensation system that caused a 43% increase in GAAP compensation expense (making it appear to screens as though annual operating income declined by over 40%).

This is not a complicated story, and this isn’t a writeup about how PZN is sure to deliver massive asset and earnings growth and get rerated as the most premiums of names.  This stock is oversold to the point that flat performance from here (implying no recovery in PZN’s AUM and permanently depressed margins) results in downside of only 20%, while a recovery in AUM with no improvement in multiple will yield a return of over 50%.  If the company also grows AUM at 10% annually for three years (lower rate than its cagr from 2015-2010), the stock is a double.

In the meantime, the stock paid out $0.55 in dividends last year which represents a 10% yield on the current price of $5.29.

Company Overview

As of June 30, 2020, PZN managed $13.0 billion through separately managed accounts, $16.4 billion through sub-advised accounts (including their well-known John Hancock funds), and $2.1 billion through the Pzena funds for a total AUM of $31.5 billion.

PZN earns management fees, performance-based fees, and in some cases “fulcrum fees” (fee arrangement that can result in a performance fee for outperformance of a benchmark or a reduction in the base fee for underperformance of benchmark).  In 2019 the company earned 60bps on its separately managed accounts, 31bps on its sub-advised accounts, and 78bps on the Pzena funds.  Performance fees over the last five years have totaled 1.8% of revenue (range of 0.2% to 3.9% in any given year), meaning that that vast majority of fee income is from management fees, i.e. AUM is the key determinant of revenue.

PZN’s operating results reflect a strong five -year trajectory through 2019 followed by a Q120 giveback driven by market depreciation of AUM (despite a small net inflow) and a further recovery in AUM in Q220.  For the most part, the business “is working” despite taking a step backwards in 2020.  The 40% stock price decline is an overreaction.

---- AUM grew from $26 billion in December of 2015 to $41 billion in December of 2019 (58% cumulative or 12% annualized growth).  The AUM decline to $31.5 billion from December 2019 to June 2020 was driven almost entirely by depreciation in PZN’s portfolio values (Q120 saw a slight net inflow, and Q2 saw a small outflow of $400 million).

---- Similar to AUM, revenue increased by 29% cumulative from 2015 to 2019 (~6.5% annualized) and Q220 annualized revenue reflects a 20% decrease from 2019 (because of the lag in management fee calculation, Q220 revenue reflected the Q120 AUM trough).  While average blended fee rate has bounced around a bit from 40bps to 47 bps over the five-year period based on investment performance and product mix, there has not been a consistent trend in this figure, implying again that asset growth and stability are the major determinants of revenue.

---- As mentioned above, TTM operating profit is heavily distorted by a significant Q419 one-time compensation charge stemming from a new compensation scheme.  EBIT margins have historically ranged from 44% to 50%.  Due to growth investments the company has been making, the reversal in revenue has resulted in depressed EBIT margins of 36% in Q220.  Rich noted on the Q220 earnings call that there was plenty of flexibility in the cost structure and it’s worth remembering that in 2015 the company delivered EBIT margins of nearly 50% with only $26 billion of AUM.

Valuation backdrop

I’d like to point out a few things that figure into my valuation cases:

(i) Although if investment performance improves there is some upside available from performance fees and improved fulcrum arrangements, in general (and given the relatively stable historical relationship between AUM and revenue) I treat revenue as moving with AUM.

(ii) Given the above, retaining and/or growing customer/partner relationships is key for the company.  At Q120, only four of PZN’s twelve strategies were outperforming the relevant indexes on a since-inception basis (as you can guess, Morningstar ratings are low), and zero outperformed over five years (I note that they use “style” rather than “pure style” indexes in several cases, which is a contributing factor given PZN’s heavy value orientation).  This figure is of course endpoint sensitive.  At the same time however, the company has generated net inflows of $1.4 billion over the last 10 quarters, implying patient investors and continuing interest in the strategy.  For what it’s worth, Rich has said on earnings calls that partner relationships (relevant to sub-advised accounts) are strong, that tough value environments help them because it shakes out competitors, and that they have a number of further relationships and accounts that they are pushing toward the finish line.  Earlier this month Pzena announced that it had won a new mandate to manage half of St James’s Place PLC’s Global Value Fund.

(iii) The convoluted corporate structure is annoying but not a disaster.  The public vehicle is a holding company that owns units in PZN’s operating subsidiary.  The operating subsidiary also has units held by Rich Pzena, employees, and others (the B units).  In addition, the operating subsidiary has B-1 “upside participation” units that are held by PZN employees in order to align interests for a broader group than just Rich, cofounders, etc.  I could write several pages on how this all works but instead the important parts are:

(iiia) The way to think about share count is 17.2mm public A shares, 54.3mm B units, 1.9mm of options, restricted stock, etc., and 6.0mm shares representing the upside participation units.  This means valuing consolidated earnings, and then using a fully diluted share count of 79.3mm.  You could get a little more granular than this (for example the upside participation units only have a right to “future income and distributions of the operating company” rather than an “economic interest”) but it doesn’t make a material difference, and more importantly I doubt you can count on whoever you’ll eventually sell your shares to being aware of it.

(iiib) Because the operating subsidiary is an LLC, it is possible to overestimate cash flow because cash from operations only includes the cash tax burden on the A shares (~23% of shares).  The company has agreed to cover the income tax burden for holders of the B units, and this cash flow is deducted in cash from financing (and, confusingly, combined with dividends paid to the B units).  Because the relevant tax rate for the B units is based on federal+state+local rate for the individual holders, it results in a tax rate of about 50% (for a top bracket NYC resident).  This means you can’t put a 10x EBIT multiple on PZN and CNS and call it the same thing.  In addition, because the operating subsidiary is an LLC, it is subject to unincorporated business taxes of ~4%.  The all-in result is a blended average tax rate of 48% vs 24% for a more typical corporation.  Because the doubled effective tax rate would result in 30% lower after-tax cash flow (and the company has no debt), I’ve reflected this by putting a 30% haircut on any multiple I use that’s above the income tax line.  It’s not perfect but I think it makes sense in terms of getting to an apples to apples valuation for multiples typical of investment managers.  Happy to hear feedback from people that disagree.

Corp governance

A few things to note here, all with the caveat that if you don’t trust Rich to take decent care of the public shareholders you’re not going to make this investment anyway.  First, the B units have super voting rights so all of the A shares together have less than 10% of the voting power.  Secondly, the tax arrangement mentioned above is obviously favorable to B unit holders.  Third, the B-1 upside participation units were created in Q419 (they were the cause of the non-recurring charge in operating income).  It was similar to 6mm shares being created instantly.  To the extent that it increases stability and motivation of the organization to perform, that’s great but the fact remains that it came out of everyone else’s pocket.  Despite these negatives, I feel fine about being in bed with Rich.  I do feel like he considers this company something to take care of, and value has flowed to the A shareholders through dividends and repurchases and these appear likely to continue.

Valuation

My downside case says that AUM stays flat to Q220 through offsetting performance and flows (no significant view here other than flows continue to avoid significant declines), and the company somehow doesn’t cut costs, leaving it with 36% EBIT margins vs its historical 50%.  This results in $47mm of annual EBIT.  In general I assume 10-15x EBIT for an investment manager based on quality.  In this scenario I reflect PZN’s weakness buy using an 8.5x multiple which, when cut by 30% for the reason discussed above, becomes a 6x multiple resulting in an EV of $278mm plus $62mm of cash and investments.  I don’t value their “other” income relating to equity investments and changes in security value.  Using the 79.4mm diluted share count from above I get an A-share value of $4.30 or 19% down from the current level.

A more realistic downside scenario assumes the same flat AUM but a return to 50% EBIT margins through cost cuts (recall that the company already achieved this in 2015 on lower AUM) resulting in $64.3mm of EBIT.  A 10x EBIT multiple (reduced to 7x) results in a stock price of $6.46 or 22% higher than the current level.

For an additional downside scenario I use Marty Whitman’s “NBV + 2% of AUM” approach but reduce 2% to 1.4% for the same tax reasons noted above.  This results in a stock price of $6.41 or 21% above the current level.

When applying the Whitman methodology to PZN’s Q419 AUM of $41.2 billion (recall that this could be achieved just by improvement in pricing of PZN’s portfolio to prior levels, and doesn’t require any net inflows), the resulting stock price is $8.12 or 54% above the current level.  Similarly, if PZN returns its EBIT to the 2018 level of $79mm, the resulting stock price is $8.36 (58% improvement) without any multiple expansion.  This is my base case.

Finally it’s worth at least mentioning that if PZN returns to 2019 AUM through portfolio recovery and then grows AUM by 10% annually for three years (vs a 12% CAGR for 2015 through 2019).  The stock will be a double and is likely to collect a couple dollars in dividends along the way.

Risks

The biggest risk is that the world gives up on value investing and/or on PZN.  This could either be investors fleeing Pzena funds or partners shutting down sub-advising relationships.  I don’t think this will happen, despite what the last several quarters have felt like (if I did I’d be posting on a different board) and I feel that the Pzena team are competent jockeys with whom to express that view.  I do think that PZN would be able to absorb some AUM losses by cutting costs, but it would be ridiculous, especially in the current environment, not to acknowledge the death of value as a possible loss-causer.  Rich has stated that existing clients have rebalanced toward them and that the pipeline is meaningful.

The second biggest risk is shareholder-unfriendly behavior.  While Rich and team don’t appear to be trying to maximize their extraction of value from the public shareholders (and they’ve had over a decade to do so), there’s nothing I can hang my hat on that says another tranche of 6mm B-1 units is impossible (though they did call the plan “one-time” when they announced it).

With further weak performance there is a possibility of a dividend cut.  This I think may be priced in economically (40% stock price decline vs my estimate of a possible 25% dividend cut if the company makes zero progress), but as always these can cause short-term volatility.  If you believe in the long-term outlook for the company, it might be a cheaper buying opportunity.

Finally, as with many asset management firms, the assets walk out the door every evening.  We’ve already eaten some of this risk in the form of the B-1 issuance but any investment team can potentially lose its way and/or fall apart.

Catalyst

No hard, precisely-timeable catalysts but a number of ways to win including:

AUM improvement through portfolio appreciation

Continued progress in flows including new partner relationships

Margin improvement driven by cost reductions

Continued stock repurchases

Market confidence in dividend stability returns stock to prior ~6% dividend yield from current 10% yield