Virtus Investment Partners Inc (VRTS) 2016 Q3 法說會逐字稿

Good morning. My name is Terence, and I will be the conference operator today. I would like to welcome everyone to Virtus Investment Partners' quarterly conference call.

The slide presentation for this call is available in the Investor Relations section of Virtus's website, www.virtus.com. This call is also being recorded and will be available for replay on Virtus's website. (Operator Instructions.)

I will now turn the conference to Jeanne Hess. Ma'am, you may begin.

Thank you and good morning, everyone. On behalf of Virtus Investment Partners, I would like to welcome you to the discussion of our operating and financial results for the third quarter of 2016.

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. These forward-looking statements are not statements of facts or guarantees of future performance and are subject to risks, uncertainties, and other factors that may cause actual results to differ materially from those discussed in the statements. These statements may be identified by such words as expect, anticipate, believe, outlook, may, and similar terms.

For a discussion of these risks and uncertainties, please see the risk factors and management discussion and analysis sections of our periodic reports that are filed with the SEC, as well as our other recent filings which are available in the Investor Relations section of our website, virtus.com. We do not undertake any obligation to update forward-looking statements.

In addition to results presented on a GAAP basis, Virtus uses certain non-GAAP measures to evaluate its financial results. Our non-GAAP financial measures are not substitutes for GAAP financial measures and should be read in conjunction with GAAP results. Reconciliations of these non-GAAP financial measures to the applicable GAAP measures are included in our earnings press release, which is available on our website. For this call, we have a presentation, including an appendix, that is accessible with the webcast through the Investor Relations section of virtus.com.

For this call we have a presentation, including an appendix that is accessible with the webcast through the Investor Relations section of virtus.com.

Now I would like to turn the call over to our President and CEO, George Aylward. George?

Thank you, Jeanne. Good morning, everyone. I'll start today by discussing assets and flows, followed by an overview of the financial and operating results. I'll also comment on yesterday's announcement regarding our purchase of the shares held by Bank of Montreal. Mike will then provide a more detailed discussion of the results.

So let's begin with assets under management and flows. We ended the quarter with assets under management of $46.5 billion, a sequential quarter increase of 3%, which included positive net flows of $0.5 billion that were achieved in a continued difficult environment for active managers. Total sales of $3.1 billion increased 29% sequentially and 21% over the prior year. The sequential quarter increase illustrates the strength and attractiveness of our diverse product offerings, as we increased sales in all product categories, specifically open-end funds, institutionals, SMAs, and ETFs.

Total net flows improved by $2.6 billion over the prior quarter to a positive $485 million, making it our best quarter for net flows since the third quarter of 2014, as continued positive flows in institutional, SMAs, and ETFs more than offset modest outflows in open-end funds.

Mutual fund sales of $1.9 billion were up 39% sequentially due to growth in international equity, domestic equity, and taxable fixed income. The increase included $0.5 billion of higher sales in the Emerging Markets Opportunity Fund, of which $0.3 billion were model-related. Mutual fund sales were also aided by higher sales into the Multi-sector Short-term Bond Fund and the Small Cap Sustainable Growth Fund.

Mutual fund net outflows improved meaningfully, $2.3 billion, from $2.4 billion, as flows in the Emerging Markets Fund turned positive in the quarter from net outflows of $1.6 billion sequentially. This improvement is primarily related to lower model redemptions, which were $0.2 billion in the quarter compared with $0.7 billion in the second quarter and $1.3 billion in the first quarter. We also saw improved net flows in domestic equity and taxable fixed income due to the higher sales in these asset classes.

Our diverse lineup of mutual funds continues to generate strong relative performance, with 19 of our rated funds representing 80% of our rated fund AUM having four and five stars as of September 30.

Turning to our other products, we continue to have positive flows in SMAs, institutional, and ETFs. SMA sales increased sequentially by 16%, and net flows were up more than 100% as Kayne's equity strategies continued to gather assets.

Institutional sales and flows had another strong quarter, due primarily to a domestic REIT mandate at Duff & Phelps that funded in September. Sales and flows in this category were up 13% and 53%, respectively. While institutional flows are hard to predict, we are pleased that flows in this category have been positive in seven of the past eight quarters.

In terms of what we're seeing in October, the mutual fund flows trend remains consistent with the third quarter, with flows only modestly negative. The flow composition is also similar, with positive flows in emerging markets and strengthened sales for the same products as the third quarter.

Turning to the financial results, revenues as adjusted increased 4% sequentially to $65.1 million on higher asset levels and investment management fees that included a $700,000 incentive fee on a CLO. Operating expenses as adjusted decreased 2% sequentially on flat employment expenses as adjusted and lower other operating expenses as adjusted.

In the quarter we benefited from the savings in base salary and benefits as a result of the staff reduction we discussed on our last call. These savings were offset by higher incentive compensation due to our higher level of sales and profits.

As a result of higher revenues and lower operating expenses and a reduction in the outstanding shares, earnings per share as adjusted increased 32% sequentially to $1.64. The operating margin as adjusted was 31%, up from 27% in the prior quarter.

Turning to capital, cash and investments were $382.9 million, or $50.00 on a per-share basis as of September 30. In the quarter, we returned $13.7 million of capital, which included $10 million of share repurchases. As a result of our continued repurchases, ending shares declined by 1.4% from June 30 and 12.2% from September 30 of 2015.

Now let me turn to our announcement from yesterday regarding our agreement to purchase the 1.7 million shares, or 22.7% of shares outstanding, held by Bank of Montreal. The transaction was for $93.50 per share for a total of $161.5 million. We were pleased to have the unique opportunity to repurchase this large block. The transaction is highly accretive to earnings per share and significantly reduces our share count without impacting the trading volume of our stock. After giving effect to the transaction, our balance sheet and current operating cash flow remains strong, and we maintain the flexibility in our capital structure to continue to execute on our long-term growth plans.

Before turning it over to Mike, I would like to thank Bank of Montreal for their partnership over the years as well as their board representatives for their contribution and dedication. Mike?

Thank you, George. Good morning, everyone. Starting on slide 8, assets under management, we ended the quarter with assets of $46.5 billion, which represents an increase of $1.3 billion, or 3%, from the prior quarter. The sequential increase in AUM is primarily attributable to net inflows of $0.5 billion and market appreciation of $0.9 billion. The $1.4 billion year-over-year decrease in AUM is primarily attributable to $5.4 billion of net outflows and $0.6 billion of dividend distributions, which were partially offset by $4.7 billion of market appreciation.

Total AUM is diversified, with 36% in domestic equity, 21% in international equity, 34% in fixed income, and 9% in alternatives and other. By product, open-end fund assets were 55% of total AUM, separately managed accounts were 17%, closed-end funds were 15%, and institutional was 13%.

Turning to slide 9, asset flows, total sales were $3.1 billion, a sequential quarter increase of $0.7 billion, or 29%, reflecting higher sales in all product categories. Total sales also increased over the prior-year quarter by 21%, or $531 million, due to higher sales in institutional, SMAs, and mutual funds. Gross sales in open-end mutual funds were $1.9 billion, an increase of $0.5 billion from the second quarter due to higher sales in the Emerging Markets Fund.

Third-quarter total net flows were a positive $0.5 billion, a meaningful change from net outflows of $2.2 billion in the second quarter. Positive net flows in the quarter were attributable to continued higher levels of sales in institutional that more than offset modest outflows in mutual funds. Separately managed accounts and ETFs also contributed positive net flows.

Mutual fund flows by asset class were as follows. Fixed-income strategies were relatively flat, an improvement from net outflows of $0.2 billion in the prior quarter. This improvement was due to a 15% increase in sales in our five-star Multi-sector Short-term Bond Fund managed by Newfleet. Domestic equity fund net outflows also improved sequentially to $0.1 billion from $0.3 billion. Sales of domestic equity funds increased 7%, primarily due to a 36% sales increase in the five-star Small Cap Sustainable Growth Fund managed by Kayne Anderson Rudnick.

International Equity Fund net flows were modestly negative at $41 million, a significant improvement from net outflows of $1.8 billion in the second quarter. The key driver of the change was improved net flows into our Emerging Markets Opportunities Fund, which had positive net flows of $55 million for the quarter compared with $1.6 billion of net outflows in the second quarter. Sales increased by $0.5 billion, or 100% sequentially, while redemptions decreased by $1.2 billion, or 58%. The fund had positive net flows in both August and September. As we noted previously, the fund's net outflows in the first and second quarter were impacted by model redemptions.

In separately managed accounts, flows were positive $334.1 million due to higher sales in Kayne's equity strategies. We mentioned on our last earnings call that Kayne was designated as the replacement manager for a small-cap SMA mandate that benefited both second- and third-quarter sales.

ETFs had positive net flows of $47.3 million, an increase of 48% over the sequential quarter. We continue to believe that ETFs present an area of future growth for our business, and we remain focused on expanding our product offerings in the space, as well as refining our distribution approach.

Institutional continued its recent growth trend and generated positive net flows of $360.1 million, primarily due to the new REIT mandate that funded late in the quarter. In addition, both Newfleet and Kayne Anderson continued to contribute to positive net flows in this category. These inflows more than offset a $45.2 million outflow related to the redemption of a CLO that was issued in 2006.

Turning to slide 10, investment management fees as adjusted of $60.6 million increased 4% on a sequential quarter basis. The components of the change in investment management fees were average assets and fee rates. The 4% sequential increase was due to a higher net fee rate and higher average assets under management.

The average fee rate increased sequentially to 51.8 basis points from 51.1 basis points due to a higher institutional fee rate that resulted from the $700,000 incentive fee earned on the CLO that was called and redeemed in the quarter. Excluding the incentive fee, the overall and institutional fee rates were largely consistent with the prior quarter, at 51.1 basis points and 36.4 basis points, respectively.

Average assets under management of $45.5 billion increased 2% sequentially due to higher average assets in all product categories.

Slide 11 shows the five-quarter trend in employment expenses. Total employment expenses as adjusted of $33.1 million were unchanged sequentially and down 1% from the prior year, as higher variable compensation on higher sales and profits was offset by a 5%, or $700,000, decrease in base salary and associated benefits resulting from the staff reduction that we referenced on our second-quarter call. Employment expenses as a percentage of revenues were 51%, a decrease from 53% in the prior quarter, reflecting the growth in revenues.

The trend in other operating expenses as adjusted reflects the timing of product distribution and operational activities. Other operating expenses as adjusted of $10.9 million decreased $1.2 million, or 10% from the second quarter, which included $1.1 million of discrete items associated with the annual Board grant and specific business initiatives. Other operating expenses as adjusted decreased by $388,000, or 3% from the prior year. We continue to focus on managing other operating expenses, where the variability is driven by the level of distribution activity, portfolio management costs, and professional fees.

Slide 13 illustrates the trend of adjusted results. In the third quarter operating income as adjusted was $20.3 million, an increase of $3.6 million, or 22% on a sequential quarter basis. The increase primarily reflects higher revenues as adjusted and lower other operating expenses, partially offset by higher employment expenses. The operating margin as adjusted for the third quarter increased by 460 basis points to 31%, from 27% sequentially.

Earnings per share as adjusted were $1.64 in the quarter, an increase of $0.40, or 32% sequentially, reflecting higher operating earnings and a 9% decrease in average shares due to the impact of the second-quarter tender offer.

GAAP net income attributable to common stockholders was $15.6 million, or $1.99 per diluted share. The quarter included $4.1 million, or $0.53 per share, related to unrealized gains on the Company's seed investments, partially offset by $1.9 million, or $0.15 per share, of severance costs.

The effective tax rate of 30% includes the release of a $1.5 million valuation allowance related to marketable securities. This compares to 41% in the prior quarter that included a $0.6 million increase to the valuation allowance.

Slide 14 shows the trend of our capital position and key financial metrics. During the quarter, we returned $13.7 million of capital that included $10 million of share repurchases, $3.5 million of dividends, and $0.2 million of net settlements from vesting stock units. As a result of the third-quarter repurchases, basic shares outstanding at September 30 declined by 1.4%, to $7.6 million from the prior quarter.

The stock purchase agreement we announced yesterday will further reduce outstanding shares by 22.7%, to 5.9 million. The repurchase, which totaled $161.5 million, was funded by using existing cash and investments from the balance sheet and $30 million of debt on our credit facility. This debt level results in a leverage ratio of 0.4 times EBITDA and will bear interest at a rate of LIBOR plus 175 basis points.

In order to illustrate the impact of the transaction, we have added certain pro forma financial information to this slide. Net cash and investments of $221.4 million, or $38.00 per share, compared with $382.9 million, or $50.00 per share, as reported. Working capital of $18.9 million, or 7% of annual spend, compared with $150.4 million, or 58%, as reported. Seed capital investments of $179.1 million remain unchanged.

For liquidity purposes, our seed capital investments are generally held in mutual funds that allow for daily liquidity, and we have $120 million of unused capacity on our five-year unsecured credit facility.

From an earnings perspective, the repurchase is highly accretive. On a pro forma basis, third-quarter earnings per share as adjusted would increase 28%, to $2.10 per share, from $1.64 as reported, all else being equal.

For modeling purposes, given the timing of the transaction -- approximately one month into the quarter -- we expect fourth-quarter weighted average fully diluted shares outstanding to be approximately 6.6 million, reflecting the partial quarter benefit of the lower share count.

With that, let me turn the call back over to George.

Thanks, Mike. So that concludes our prepared remarks. Now we'll take some questions. Terence, can you open up the lines, please?

Thank you. (Operator Instructions.) Ari Ghosh, Credit Suisse.

Can you update us on your thoughts around capital deployment for 4Q and 2017? It just looks like you increased your funding capacity pretty significantly earlier this quarter, so I was just wondering if you did that with the buyback in mind or if you have additional plans for the excess capacity you're now, maybe even like a strategic M&A deal down the line?

Well, I think I'll let Mike get into some details, but fundamentally, we just want to make from a long-term perspective that we have the flexibility to have access to what we need to execute on any of our plans. For the credit facility, it was getting near to the end of its term, and we certainly didn't want to wait until that period of time to renew. So we're very pleased with the results we got in terms of the size and the terms that we received on that deal.

And again, we keep our mind open to all sorts of alternatives, obviously, as you know, from our capital management strategy, other than protecting the business, investing in the growth, and returning a meaningful amount of capital has always been part of our plan. I'm sure we'll talk more about the return of capital from the repurchase. But Mike, do you want to give any more color?

No, I think you said it. From the credit facility perspective, we were within one year of the facility expiring. And importantly, we moved from a secured facility to an unsecured facility and doubled the capacity, which is more in line with the size of the business and the profile of the business now. We also changed out some of the partners and lenders in the facility, so we're very pleased with that facility, and we think it just continues to provide flexibility as we need it.

Got it. And then as a quick follow-up, if you can just talk a little bit about your net flow outlook, maybe on the mutual funds side, what products you're looking at closely. Are the smaller funds getting traction? And then clearly, the DOL rule's a big issue right now. So if you're ever seeing any fee pressure with certain products in the mutual fund line, or even issues with shelf space or something to that effect with your platform partners as they look to consolidate. And then if you can just round that out, just touching a little bit about the institutional side and if you're seeing a pipeline build over there and any, maybe, like demand for new products here versus previous quarters. Thanks.

Sure. Well, it's certainly an interesting environment that we're all engaged in, and it's particularly difficult for active managers. I think we've always felt we were competitively in a pretty good position because of the types of strategies that we offer generally are those that don't compete head-on with more index-based types of passive products. So most of our strategies either have a quality orientation, a risk mitigation type of an approach, or they're highly concentrated, alpha type of portfolios.

So generally, we've always felt good about the offerings and products we have being differentiated enough to be less susceptible to some of those competitive pressures that absolutely, we face the same competitive pressures.

I think where we've seen some of the flows has really been mirroring a lot of what's going on in the market. Obviously, we did have two quarters where we had elevated outflows in our Emerging Market Fund. But now, as I indicated in the prepared remarks, those outflows have pretty much broke into even, and that fund continues to do very well.

So as we pointed, EM continues to have good sales, Multi-sector Short-term Bond in low duration on the fixed-income side, I think, in this environment would be great alternatives. If you want to navigate what could be an interesting set of experiences in the interest rate markets, we believe the Newfleet products are uniquely positioned to help investors navigate those markets. And we've seen great strength in the Kayne equity products, and we mentioned the Duff & Phelps REIT strategy, which was the large inflow that we had on the institutional side. So we feel very well positioned from a competitive standpoint in terms of performance and the types of strategies we offer.

In terms of DOL and related fee pressures, I think everyone in the industry is being more and more conscious of fees. We've always been conscious of fees, but it has become a little more competitive in that area. We do monitor our fees. We do have caps on about 87% of our mutual funds and at certain points, we'll actually lower some of those caps. So it's very important to us that we remain competitive. But we feel we're in a relatively good position on most of our products. But we'll continue to monitor that.

In terms of just shelf space, in terms of that's one of the implications of DOL, we do feel we're very well positioned. I think we have a large variety of diversified products, so for firms that we sell through, I think our offerings and the fact that they come from either individual boutiques that are part of Virtus or are select sub-advisors, I think by partnering with us, they're actually giving their clients a much more diversified set of offerings. I would argue that we basically provide them what they would have to go to 12 individual managers to get the same diversity of.

So we feel good about that and our positioning. But the implications of DOL are going to continue to create more and more challenges for the industry, and we're not immune to them. But I feel in some ways, we have pretty strong positioning.

Great. Really appreciate the color. Thanks, guys.

(Operator Instructions.) Surinder Thind, Jefferies.

Just to follow up on the DOL here, there's been a lot of industry discussion around maybe the difficulties that it might be to sell into the broker space who are managing retirement accounts without some sort of change in the industry pricing rules. Any thoughts there, or if you're participating with others or collaborating with others on something like that?

In terms of -- I think all of us on the asset management side are having very constructive dialogues with our distribution partners in terms of working with them to address the issues in a way that works from their perspective. So I think we're all working with our distribution partners to address that. And it will manifest itself probably in different types of share classes and different types of pricing structures.

I think a lot of that will evolve over the next few months or few quarters. I think it's something everyone's trying to grapple with, and I also think that people are not just focused on retirement. I think they're looking to be more holistic when they come up with an approach, that even though the DOL and its relation to retirement, I think our distribution partners are doing the right thing and thinking about all of their clients as they come up with a solution.

Fair enough. And I assume that the working assumption at this point is that at some point, the SEC will come out with effectively similar rules to the DOL. Is that effectively next year some time? Is that a fair working assumption for everyone?

I've heard many people express that view. Obviously, we don't have any knowledge of that. But I've heard that frequently.

Fair enough. And then just from the perspective of your products, your sales, about what percentage are in basically -- to brokers and stuff -- are in commissionable types of sales at this point?

I'll give you for A class. Are you talking about the class, the type of class that we sell or -- ?

Correct, in terms of like whether it's the A, B, or C share classes in terms of just commissionable sales that you guys have at this point as opposed to different gross sales.

Yes, the traditional other class -- I mean, most of our sales now are in non-commissioned classes like the I or A class at NAB. I think 11% of our sales?

Seven percent.

Sorry, 7% of our sales are in traditional A class, which is, I think, what you're focusing on. So it's a relatively small piece of our business at this point.

Okay, fair enough. And then maybe just changing topics here and maybe focusing a little bit on the ETF space, it seems like that overall, the ETF space is getting much more competitive, and we're not only seeing competition amongst products and a race to get more and more products out there, but we're also seeing increased price competition. How are you guys thinking about that or feel that you guys are going to compete in that space, given there's a few large incumbents, and it just seems like the barriers to entry, while the actual ability to launch a product is really low, it remains fairly challenging without a first-mover advantage to gain traction in products. And then you also mentioned a little bit about that you guys are refining your distribution approach. So maybe some color around that.

Sure. The ETF part of the business, as we mentioned, we do see that as a very important element of long-term growth. The industry is going to increasingly move to an ETF structure for some of their investment needs. So hence, we have been very focused on that part of our business and have introduced several new products. We have a few that will be introduced in the near term, so very excited about some of the opportunities we have there.

Looking at the ETF market, though, I wouldn't necessarily look at it as one market. So in terms of some of the lower-cost, purely passive types of products, absolutely that is dominated by a lot of players, and you really need that level of scale to be that competitive on the fee levels.

For some of the other products, either on the smart beta side or actively managed, really, when you think about pricing, you should really think about it relative to its alternative. So if someone is interested in more of an actively managed strategy, which obviously, we're big believers in, or a smart beta, they're not going to necessarily always be comparing that price to the passive alternative, but maybe to the other active alternative in, say, an open-end fund or another product vehicle.

So I think there is continued to be diligence on what is the right pricing for some of those products. Again, I think where you have the ability to be competitive is not competing on scale or on being the lowest-cost provider, because I think smaller players don't have that opportunity. It's really being innovative in terms of what types of products you're offering and how you're making those available. So I think there are opportunities there. We still have a very small ETF business, but we've been incredibly pleased with the fact that it has been growing and that the products that we've been introducing have found some acceptance.

In terms of what I'm referring to when I say refining our distribution model, there is still work to be done throughout the industry, I think, in terms of how do you truly try to coordinate your ETF sales and your open-end mutual fund sales. Because there are some differences in terms of how it works with inside the distribution partners, and also getting wholesalers to have the right motivations and alignments.

So I think, like a lot of other players who have open-end funds as well as ETFs, we're continuing to work on what's the best way to maximize the right opportunity set? So that's what we're referring to there. But we see the ETF area as an opportunity for future growth. And again, we have a very active pipeline in some of the things, including additional actively managed strategies as well as what might be called a smart beta.

That's helpful. That's it for me. Thank you.

And this concludes our question-and-answer session. I would like to turn the call back to Mr. Aylward for closing remarks.

I just want to thank everyone for joining us today. And obviously, we certainly encourage you to call us if you have any other further questions. Thank you.

That concludes today's teleconference. You may now disconnect. Everyone have a great day.