VRTS (2019 - Q2)

Good morning. My name is Carmen, and I will 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. At this time, all participants are in a listen-only mode. After the speakers' remarks, there will be a question-and-answer period and instructions will follow at that time.I will now turn the conference to your host, Sean Rourke. Sean Rou

Thank you, Carmen, 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 second quarter of 2019. Our speakers today are George Aylward, President and CEO of Virtus; and Mike Angerthal, Chief Financial Officer. Following the 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 new 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 its 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 new release, which is available on our website.Now I would like to turn the call over to George. George?

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’re 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 remain negative they improved sequentially and the negative flow will primarily do, 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 modest deposit of net flows. Total assets which include liquidity strategies ended the period at a $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 allocation for two 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 mandated Duff & Phelps partially offset by lower sales of open-end funds. Net flows were positive $0.1 billion improving from the modest and 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 level of sales. Retail separate accounts had positive net flows of $0.3 billion from both the intermediary resold and private client channel. Kayne's mid-cap strategies continue to be key contributors to net flows in the intermediary resold channel which is now generated 14 consecutive quarters of positive net flows.Open-end fund net outflows were 0$.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. ETF net flows were positive though down from the first quarter which included the favorable impact of the initial model allocation on two newly issued funds.During the quarter, we executed on several product initiatives that leveraged the existing investment capability into new product structures. At site we leverage our long-established bank loan investment capability employ for CLOs and funds and launched the bank loan ETF. And at SGA we implement a series of initiatives.First, we adopted a five-star large cap global growth fund management by SGA for eight years. We also launched an SGA managed emerging market's growth fund. In addition SGA was appointed as a sub adviser on one of our international develop market fund. Within one year 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 demonstration of one of the 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 settlement and bank loans. Regarding what we are aware of so far in July for other products, we have a model win and two 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 include the impact of seasonally higher employment expenses.Second quarter earnings per share as adjusted are $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 on 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 purchased our 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 0.7x.With that I’ll turn the call over to Mike. Mike?

Thank you, 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've 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 subadvisory 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 continues the strong trend for mid-cap, which is averaged 20% organic growth over the past three 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 international small-cap were offset by net outflows from emerging markets.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 four or five-star ratings and 97% of fund AUM were in three, four or five-star funds.Each of five largest mutual funds is a five or four-star fund, representing a diverse set of strategies from five different managers. In addition to this very strong fund performance, 94% of institutional assets were beating their benchmarks on a five-year basis as of June 30, and 66% of assets were exceeding the median of their peer groups on the same five-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 five 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 and 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 four 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 have 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?

Thanks Mike. So we’ll now take your questions, Carmen, can you open the lines please.

[Operator Instructions] Our first question is from Alex Blostein with Goldman Sachs. Your line is open.

Hi this is [Sheriq] filling in for Alex. What are your update thoughts around M&A for the industry and Virtus. 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.

Sure, yes 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 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’ve consistently used M&A as a successful tool for us to enhance and expand the business.And so generally we think there's a lot of activity out there. We’re very disciplined about what we consider the last transaction we closed on would have been by 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 early remarks.I highlighted the fact that our goal is to create the organic growth once you have the partner by launching them in other channels. But from the M&A perspective we actually think we're 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’re very comfortable it either has strategic value and financial accretive value to our shareholders.

Our next question comes from Michael Cyprys with Morgan Stanley. Your line is open.

Hi this is Stephanie filling in for Mike, thanks for taking our question. Maybe just one on ETFs in model portfolios. Can you talk about some of the distribution initiatives around trying to increase model portfolios penetration and how much of the ETFs are in model today. And then looking ahead what products do you think will have the greatest opportunity or potential model portfolio inclusion?

Sure well I think about model portfolio is more broadly because I don’t think it’s limited to just ETF. So, the first quarter we had two newly issued ETFs which 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 reallocation was actually really relate more to the mutual funds, and that crossed a number of our affiliates actually about three. So we're very pleased with that because as you know, our goal is to provide either the building blocks for the individual pieces of a well-diversified portfolio, so you know we think focusing in on those models and where we can have the appropriate product to fit the waitings that someone is looking for to achieve for their client is a great opportunity, but by Ceredex plus ETFs mutual funds as well as retail separate account. So I continue to see that as an area of great opportunity.

Thank you. And this concludes our Q&A session. I would like to turn the conference back to Mr. Aylward.

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 very much.

And that concludes today's call. Thank you for participating. You may now disconnect.