Piper Sandler Companies (PIPR) Q3 2014 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen, and welcome to the Piper Jaffray Companies Conference Call to discuss the financial results of the third quarter of 2014. [Operator Instructions] The company has asked that I remind you that statements on this call are not historical or current facts, including statements about beliefs and expectations, are forward-looking statements that involve inherent risks and uncertainties. Factors that could cause actual results to differ materially from those anticipated are identified in the company's earnings release and reports on file with the SEC, which are available on the company's website at www.piperjaffray.com and on the SEC website at www.sec.gov. This call will also include statements regarding certain non-GAAP financial measures. Please refer to the company's earnings release issued today for a reconciliation of these non-GAAP financial measures to the most comparable GAAP measure. The earnings release is available on the Investor Relations page of the company's website or at the SEC website. As a reminder, this call is being recorded. And now I'd like to turn the call over to Mr. Andrew Duff. Mr. Duff, you may begin your call.

Good morning, and thank you for joining us to review our third quarter results. I will spend a few minutes discussing the market environment and the performance of our businesses, and then hand the call over to Deb, to review our financial results. The firm produced solid results for the quarter, which contributed to a 10.2% ROE for the last 12 months. The diversity of our business mix enabled us to generate these strong results in the context of markets that were generally neutral to negative for our businesses. Specifically, we took advantage of favorable M&A markets to produce record advisory revenues that drove our overall performance. In a broad sense, equity and fixed income markets in the U.S. were subject to countervailing pressures, which led to an environment void of a clear direction for markets during the quarter. Strong macroeconomic growth reported for the second quarter, together with healthier employment conditions for the current quarter, suggested accelerating U.S. growth. Concurrent with stronger growth, we would expect equity markets to perform well and interest rates to climb. However, significant geopolitical uncertainty, plus perceived weakness in the major European and Chinese economies had a dampening effect on equity markets. In addition, these factors helped to reinforce the U.S. status as a safe haven for international investors, which place downward pressure on interest rates. The equity markets demonstrated a balancing act in the context of conflicting influences. Broad indices were essentially flat for the quarter, while small cap stocks experienced a 5% to 10% decline in value. These conditions adversely impacted capital raising during the quarter, particularly in smaller growth-oriented stocks. With valuations at relatively attractive levels and generally low volatility, M&A activity was healthy. Low market volatility had a dampening effect on trading volumes as investors waited for a clearer direction in the market. Late in the quarter, we experienced some higher volatility and trading volumes, which have persisted in October. Unfortunately for the higher volumes, were associated with the decline in stock values. Touching on fixed income markets for a moment. Benchmark rates came in slightly lower during the quarter and spreads tightened as well. These conditions were unfavorable to fixed income brokerage as many investors sat on the sidelines expecting interest rate increases in the near future. Late in the quarter, similar to the equity markets, a bout of volatility hit the fixed income markets with spreads widening. We would expect periods of episodic volatility going forward as the market search for a clear rate direction. Our operating performance for the quarter largely track the markets with the exception of our M&A revenues. We continue to make great strides in this business, and this quarter, our consumer team led the charge with 3 premier transactions. We advise mix on the sale to L'Oreal. We also represented 2 high-profile restaurant change: TGI Fridays and Portillo's. The emergence of our consumer group as a market leader compliments our traditional strength in healthcare. As we have noted in the past, we have focused our efforts in resources on growing our M&A capability, and this quarter's performance is indicative of our progress. In equity capital raising, we experienced a drop-off in activity, both sequentially and year-over-year. This was primarily attributed to lower capital raising in the growth sectors in which we compete and also reflected the very robust results we produced earlier in the year. On a year-to-date basis, we are 42% ahead of the prior year. Our equity brokerage business suffered from the lower-trading volumes impacting the market. Sequentially, our trading revenues were down slightly more than the market-wide 6% decline in volume. Comparison to last year, were particularly unfavorable due to a combination of higher volumes and a significant block trade from a year ago. Strategic trading losses incurred this quarter versus trading gains last year also contributed to the unfavorable variance compared to 2013. Public finance issuance market-wide remains on track to finish the year with a 10% to 15% decline in activity. Our activity in the quarter fell off after a reasonably strong second quarter. On a year-to-date basis, we are 10% below prior year levels. While we were disappointed with the quarter, we preserved our market share gains for the past couple of years, and our performance was in line with the markets, which was also off close to 10% versus 2013. With low rates and generally tight spreads, fixed income investors have little motivation to trade, and the activity was concentrated in the short end of the curve. We experienced similar conditions last quarter, and as a result, our sequential performance was largely in line with the prior quarter. Given the influence of macroeconomic conditions on rates, we adopted a neutral stance with respect to rate movements. In addition, we felt greater certainty that spreads would widen from time to time and positioned ourselves accordingly. Late in the quarter, we experienced some episodes of increased volatility and widening spreads, which given our positioning, contributed to the sequential improvements in our results. In light of the increased volatility, we will continue to closely monitoring the markets to enable us to make timely adjustments to our exposure. Moving on to our Asset Management business. The group continues to meet our objective of generating consistent earnings for our shareholders. Our international team generated very strong performance for the quarter, and our MLP team continued to enjoy steady inflows. We finished the quarter with $12.2 billion in assets under management, which represents a 3% decline from the second quarter, primarily attributable to the market depreciation with markets for our key strategies off as much as 9% during the quarter. We continue to strengthen and add our resources to our Asset Management team to enhance their ability to serve their clients and grow their business. Now I'd like to turn the call over to Deb, to review the financial results in more detail.

Thanks, Andrew. In the third quarter of 2014, continuing operations generated net revenues on a GAAP basis of $159 million, a 24% increase compared to the year ago period and a 6% decrease compared to the sequential quarter. Net income for the quarter was $15 million or $0.90 per diluted common share, and our pretax operating margin was 16.1%. In addition to our GAAP results, we have presented non-GAAP financial measures to provide a more meaningful basis for comparison of our core operating results. The non-GAAP measures exclude revenues and expenses related to noncontrolling interests, amortization of intangible assets related to acquisition, compensation for acquisition-related agreements and restructuring and acquisition integration costs. The remainder of my remarks will be based on these non-GAAP financial measures. In the third quarter of 2014, continuing operations generated adjusted net revenues of $156 million; adjusted net income of $17 million or $1.03 per diluted common share; and our adjusted pretax operating margin was 17.3%. For the third quarter, adjusted compensation and benefits expenses were 61.5% of adjusted net revenues, compared to 62.7% in the third quarter of 2013 and 61% in the second quarter of 2014. The compensation ratio decreased compared to the year ago period due to an increased revenue base and increased 50 basis points sequentially due to lower net revenues. Adjusted noncompensation expenses were $33 million for the third quarter compared to $29 million in the year ago period and essentially flat sequentially. Noncompensation expenses increased compared to the year ago period, primarily due to onetime occupancy cost related to our office based in New York City, higher third-party marketing fees associated with our Asset Management business and higher professional fees. On a non-GAAP basis, our effective tax rate from continuing operations was 37.2% for the third quarter, consistent with our expectation of a 34% to 37% tax rate. Now I'll turn to the segment results. For the third quarter, Capital Markets generated adjusted net revenues of $136 million; adjusted pretax operating income of $20 million; and an adjusted pretax operating margin of 14.6%. The operating margin improved compared to the third quarter of 2013, driven by higher net revenues and decreased compared to the second quarter of 2014 due to lower net revenues. Adjusted net revenues increased 27% compared to the third quarter of 2013 and decreased 6% compared to the second quarter of this year. We are seeing returns from investments we made in our M&A business as the business continue its momentum from the first half of 2014 and generated record revenues of $66 million in the current quarter and $146 million in the first 9 months of 2014. We completed 22 transactions with an aggregate enterprise value of $4.7 billion in the third quarter of 2014, compared with 11 transactions and an aggregate enterprise value of $1.2 billion in the year ago period. With a modest amount of stability in the market, we should finish the year every bit as strong as we started with M&A activities similar to the first half of the year. Equity financing revenues were $14 million for the 3 months ended September 30, 2014, down 52% and 68% compared to the year ago period and the second quarter of 2014. The excess capital raising environment in the first half of 2014 slowed in the third quarter, resulting in fewer completed transactions and lower revenue per transaction compared to both periods. The low volatility in the equity markets continued to depress client trading volumes in the third quarter, which negatively impacted our equity institutional brokerage revenues. These revenues decreased 27% compared to the year ago period and 9% compared to the second quarter of this year. Turning to our fixed income businesses. Our public finance revenues from underwriting issuances increased 13%, compared to the third quarter of 2013 due to more completed transactions. However, market-wide decreases and municipal issuance volume continue to adversely impact our public finance revenues, which decreased 28% compared to the second quarter of 2014. During the third quarter of this year, we completed 85 negotiated public finance issues with a total par value of $1.8 billion, generating $14 million of revenue, compared to 112 negotiated public finance issues with a total par value of $2.4 billion in the second quarter of this year. Public finance represents a core franchise for us, and as challenging market conditions persist, we will continue to exercise vigilance in seeking market share gain. Fixed income institutional brokerage revenues were up 33% and 8% compared to the third quarter of last year, and the second quarter of 2014, respectively. The increase compared to the year ago period was driven by higher trading gains as trading volume remained relatively flat. We continued to take a neutral stance towards interest rates and are prudently managing our risk profile and inventory levels. Now I'll turn to our Asset Management segment. Asset Management generated $20 million of net revenues; $7 million of adjusted pretax operating income; and an adjusted pretax operating margin of 35.7%. Net revenues increased 11% compared to the third quarter of 2013 due to higher management fees from increased assets under management driven by market appreciation. Compared to the second quarter of 2014, net revenues decreased 9% due to lower investment income from our investments in funds that we manage, along with lower management fees from decreased assets under management in our value equity strategies. The adjusted operating margin was 35.7% in the current quarter, a decline compared to both the year ago period and sequential quarter. Operating margins decreased compared to the third quarter of 2013 due to higher noncompensation expenses, which were primarily attributable to marketing-related professional services. The decrease compared to the second quarter of 2014 is due to a decline in investment income. This concludes our formal remarks. Operator, we will now open the line for questions.

[Operator Instructions] Your first question comes from the line of Douglas Sipkin of Susquehanna.

So I wanted to just spend a little more time on the M&A. Obviously, really good number and definitely some surprise. Maybe, if you can just shed some light on some of the things you've done there in the last year or 2 years. And then maybe, how should we be thinking about the line going forward? I know it's a volatile line of in and of itself, but it clearly looks like you guys are just sort of building momentum. So I'm just trying to gauge for modeling purposes. How should we be thinking about, maybe, fourth quarter and into '15?

Okay, so I'll start with the last couple of years, where it's been a priority, and I think we spoke to it fairly frequently and have invested in it both internally and externally. From an internal perspective, more dedicated resources, specific programs to develop principles into MDs, some consistency and discipline around minimum fees and, importantly, right bankers and right sectors. From an external perspective, 2 acquisitions: Edgeview; as well as a group in San Francisco called PCG; and some additional modest hiring, but all very high-quality, very additive. And finally, what I would say is success begets success, it's a bit of a fly wheel. We're bringing to the marketplace and executing more and more attractive transactions, which enables us to deepen our relationships and get invited into more and more business. From an outward perspective, our backlog going into the fourth quarter and early 2015 is very solid. Looks more like the first half of the year then the even higher revenues of the third quarter, but it is broad and solid.

Great. That's very helpful. And then maybe shifting gears a little bit. I know you guys have been, for the most part, positioned for higher rates. And I'm wondering if -- just listening to your comments, didn't get the sense there is going to be a change. But I'm wondering, given in light of sort of the recent moves that we've seen in the bond market, if you guys were maybe reevaluating that, thinking maybe that we can stand a longer rate environment for longer and may adjust some of your positioning. Or are you still sticking with you believe rates are kind of generally moving higher into '15?

I would say it's more of a rate neutral position that we've been in. We think that the traction is relatively uncertain, while on the one hand, you've got arguably some strengthening in our domestic economy that has countervailing pressures coming from declines and the other major global economies, and again, potentially, fight to quality. So our interest rate perspective continues to be relatively neutral. Having said that, in the third quarter, we believe there were opportunity for spread increases, and we could be opportunistic, and that continues to be our outlook.

Great. And then just last question. Obviously, third quarter excluding a really strong ECM business for you guys this year. I'm just curious how the backlog looks and what will it take to sort of get a step-up again. Obviously, it's the summer, so some expectation for a slower third quarter's there. But I'm imagining the market played a little bit of a roll. So maybe some color on how it looks, the backlog, if the environment, once again, got a little more favorable.

Okay, so from -- again, from a backlog perspective, I would say we continue to have a strong and broad pipeline. In fact, have several high-quality transactions on the road as we speak. Influencing capital raising will always be the broader indices, which have been more volatile. And then volatility, in and of itself, the mix [ph] did get up and break up 30%, but it's already back down to 17%. So our outlook, barring some extreme volatility, is constructive.

Your next question comes from the line of Hugh Miller from Macquarie.

So had a question with regards to the Asset Management segment. You gave some color to the flows, but am I correct in assuming that the fees are typically generated based on the prior quarter's ending balance for the AUM?

It's really -- primarily, it varies by product. Some of it is primarily driven by the ending quarter values.

Okay, because -- as we look at that, then there would seem to be a little bit of a fee compression in the quarter. I'm wondering if that's a function of, maybe, timing or a mix between MLP and equity, but can you provide any color there?

Yes, I think it's less around fee compression. Just more around the outflows that may have happened during the quarter, or just the -- not even just the market impact during the quarter versus any real fee compression.

Okay. That may just be a function of kind of whatever assets that may price based on the actual quarter's ending balance versus the prior quarter.

Yes. Sometimes it's hard with flows in and out during the quarter, and certain clients do want a pro rata basis based on flows. It's had to do the absolute math just based on ending assets and revenues.

Okay. And as we think about kind of the gyrations in the market in kind of October so far, it didn't seem like you made any comments about it. But is there any risk to principal losses, just given position and may have been on kind of the wrong side of the trade or anything like that so far in October?

Yes. So overall, as Andrew have spoken to, really, trying to manage a very neutral position overall as there is so much uncertainty both in rates and spreads. We have really been managing our risk appetite down. Just to give you some perspective, VAR, which is value at risk, which is one measure of that. We've actually -- our VAR has declined sequentially quarter-after-quarter for the last 5 quarters. So we are really managing on a very tight basis, I guess, from our risk perspective.

Okay. And as we think about kind of the compression or the yield curve, and your ability to kind of see trading activity in generating commissions off of that. How should we think about kind of spreads on those commissions, just given kind of the compression we've seen in the yield curve over last month?

So I would say that, that continues to be a challenge and has really been, if you would, kind of in that zone for the last 4 or 5 quarters. The combination of uncertainty to rate direction has led to many investors staying in the short end of the curve, and there is very little spread there.

Okay. And what's the duration look like of your inventory portfolio now? And how does that compare to last couple of quarters?

I don't have that specifically other than to say, again, with hedging, we try to remain very neutral overall. So that impact isn't as significant.

[Operator Instructions] There are no further audio questions registered at this time.

All right. I'd like to wrap up the call and thank all my partners for their hard work and commitment that helped produced these strong results for ourselves and our shareholders. And as increased volatility reemerges in the markets, we'll continue to carefully manage our business while looking for opportunities that may arise. Thank you all very much.

Thank you, ladies and gentlemen. That does conclude today's conference. You may now disconnect.