Victory Capital Holdings, Inc. (NASDAQ:VCTR) Q2 2023 Earnings Call Transcript

Victory Capital Holdings, Inc. (NASDAQ:VCTR) Q2 2023 Earnings Call Transcript August 4, 2023

Operator: Good morning, and welcome to the Victory Capital Second Quarter 2023 Earnings Conference Call. All callers are in a listen-only mode. Following the company’s prepared remarks there will be a question-and-answer session. I will now turn the call over to Mr. Matthew Dennis, Chief of Staff and Director of Investor Relations. Please go ahead, Mr. Dennis.

Matthew Dennis: Thank you. Before I turn the call over to David Brown, I would like to remind you that during today’s conference call, we may make a number of forward-looking statements. Please note that Victory Capital’s actual results may differ materially from these statements. Please refer to our SEC filings for a list of some of the risk factors that may cause actual results to differ materially from those expressed on today’s call. Victory Capital assumes no duty and does not undertake any obligation to update any forward-looking statements. Our press release that was issued after the market closed yesterday, disclose both GAAP and non-GAAP financial results. We believe the non-GAAP measures enhance the understanding of our business and our performance.

Reconciliations between these non-GAAP measures and the most comparable GAAP measures are included in tables that can be found in our earnings press release and in the slide presentation accompanying this call, both of which are available on the Investor Relations portion of our website at ir.vcm.com. It is now my pleasure to turn the call over to David Brown, Chairman and CEO. David?

David Brown: Thanks, Matt. Good morning, and welcome to Victory Capital’s second quarter 2023 earnings conference call. I’m joined today by Michael Policarpo, our President, Chief Financial and Administrative Officer; as well as Matt Dennis, our Chief of Staff and Director of Investor Relations. I’ll start today by providing an overview of the second quarter. After that, I will turn the call over to Mike to review the financial results in detail. Following our prepared remarks, Mike, Matt and I will be available to take your questions. The quarterly business overview begins on Slide 5. We generated another quarter of strong revenue, earnings and margins to close out the first half of the year. Long-term net flows improved for the second consecutive quarter with outflows of $1 billion compared with the $1.2 billion of outflows recorded in the first quarter.

This excludes the 3 basis points passive mandate redemption in April, which is previously disclosed in our April AUM release. Average AUM was essentially flat quarter-over-quarter, and our average fee realization rose to 52.1 basis points, which contributed to higher revenue compared with the first quarter of the year. Our margins remained exceptional coming in at 50.9% this quarter, which highlights the differentiated nature of our operating platform and its highly variable expense structure. This is the 12th quarter in a row that we achieved margins above our long-term guidance of 49%. And this is the eighth quarter over that period where our margin surpassed 50%. Our long-term margin guidance remains unchanged at 49%. And keep in mind, this does factor in ongoing strategic investments that will help us grow our business in the future.

Adjusted net income or tax benefit rose to $1.11 per diluted share in the quarter, up from $1.08 in the previous quarter. Substantial capital return to shareholders continued through the first half of 2023. We repurchased a record 1.5 million of our shares this quarter versus 1.4 million in the first quarter. We allocated $47 million to share repurchases and paid out $21 million in cash dividends for a total capital return of $68 million for the quarter. On a year-to-date basis, we’ve repurchased 2.9 million shares for $92 million and paid cash dividends of $43 million for a total return of capital in the first half of $135 million. We continue to invest in our business in a number of different areas. We launched our new brokerage platform in April and rebranded the direct channel at the same time.

Additionally, we continue to allocate resources to data and technology and are embarking on a few new marketing and distribution initiatives as well. Turning to Slide 7. Investment performance remains excellent and consistent. At quarter end, 42 of our mutual funds and ETFs had four or five star overall ratings from Morningstar. These four and five star products account for nearly two-thirds of our AUM in mutual funds and ETFs. Additionally, approximately three quarters of our total AUM outperformed benchmarks for the three, five and 10-year measurement periods ended June 30. A number of our products rose into the top quartile according to Morningstar’s trailing three year rankings. These include the Victory Income Investors Tax-Exempt Intermediate Term Bond Fund, Victory RS Global Fund, Victory RS Partners Fund and the Victory RS Investors Fund as well as the Victory Munder MidCap Fund and our emerging markets value momentum ETF.

In total, approximately 43% of our mutual funds to ETF AUM is ranked in the top quartile as of June 30th. Focusing specifically on the 16 fixed income products managed by our Victory Income Investors franchise that are rated by Morningstar, 14 of those 16 products representing 95% of that AUM ended the quarter with four or five star overall ratings. Given this investment performance, the trillions of dollars presently invested in money market funds, and the distribution we have built out for this franchise over the last few years, we believe we are nicely positioned to capture inflows into these products as the Fed’s tightening cycle subsides, investors begin to migrate their holdings into longer-duration fixed income strategies. Turning to Slide 8.

We continue to generate robust excess free cash flow in the second quarter. Once again, we remain opportunistic with our share repurchase activity this quarter, given where our shares were trading during the period. While we intend to remain flexible with our capital allocation, it is important to state that we are not deviating from our proven approach of making our company better through acquisitions. Over the long run, we believe that the best use of our excess free cash flow is to invest in both organic growth initiatives and strategic acquisitions to create shareholder value. On the organic side, in addition to what I mentioned a few slides back, we are also investing in new product development. One recent example is our VictoryShares Free Cash Flow ETF, ticker VFLO that we launched in June.

On the inorganic side, we are spending quite a bit of time conducting diligence on multiple inorganic opportunities. Although timing and getting to a transaction close cannot be guaranteed, we are generally optimistic with what we are seeing and how things are going. That being said, we remain patient, disciplined and selective as we evaluate opportunities aimed at enhancing shareholder value over the long term. Before I turn the call over to Mike, I want to take a moment to highlight a significant company milestone. On Monday, we celebrated our 10th anniversary of being an independent company. In 2013, when we executed on our management buyout, employees contributed about third of the required equity and the balance of the equity was funded by Crestview Partners.

Our other private equity investor, Reverence Capital Partners began their investment in the fourth quarter of 2014. Crestview and Reverence have been long-term investors and neither firm sold any shares leaving up to or during our initial public offering in February of 2018. For calendar year 2018, we ended the year with $53 billion of AUM, generated revenue of $413 million and adjusted EBITDA of $160 million with an adjusted EBITDA margin of 38.7% and adjusted net income with tax benefit per diluted share of $1.64. Since then, we have more than tripled our AUM and increased our run rate revenue and earnings by more than twofold. But of most importance is we made our company better and more durable by significantly diversifying our business across investment products, asset classes, broadening distribution and adding size and scale with substantially increased efficiency and has allowed us to expand our margins by well over 1,000 basis points during our time of being a public company.

It wasn’t until November of 2021 that our private equity holders executed on their first sale of VCTR shares in a secondary offering. Since then, they’ve either sold or distributed more than 23 million shares taking their combined ownership stake down from approximately 67% at the time of the IPO to approximately 32% today. The relationship with our private equity holders has been a textbook case of a genuine win-win over the past decade. We are very proud of our track record on executing on our differentiated strategy and the ability to producing an attractive return for the shareholders, who understood our strategy and believed in our vision from the very beginning. While they remain shareholders today, given the nature of their business model, we anticipate monetization of their investments will continue moving forward.

Although we anticipated the decision to monetize and the exact timing of that monetization are at the sole discretion of their respective organizations. With that, I will turn the call over to Mike to go through the quarter’s financial results in greater detail. Mike?

Michael Policarpo: Thanks, Dave, and good morning, everyone. The financial results review begins on Slide 11. Assets under management increased nearly 2% from $158.6 billion at the end of March to $161.6 billion by the end of June. While the point-to-point variance was higher, our average AUM was slightly lower than in the first quarter due to intra-quarter market volatility. The higher ending point of AUM in June gives us a nice jump-off point to start the third quarter from a revenue perspective. Revenue of $204.2 million was up in the second quarter compared with the $201.3 million of revenue in the first quarter. The higher revenue on the lower average AUM was a result of a higher quarter-over-quarter fee rate realization and one additional day in the period.

GAAP operating income was $87.5 million in the quarter and our adjusted EBITDA was $104 million, both up from the previous quarter. Second quarter net income was $56.7 million or $0.83 per diluted share on a GAAP basis, resulting in GAAP EPS increasing by 17% from the prior quarter. And adjusted net income or tax benefit rose quarter-over-quarter to $75.9 million or $1.11 per diluted share. The quarterly cash dividend of $0.32 per share will be payable on September 25 to shareholders of record on September 11. On Slide 12, you can see a steady increase in total AUM over the trailing 12-month period, reaching $161.6 billion at the end of the second quarter. Our AUM remains well diversified from a distribution channel and client perspective. We are also well diversified from a vehicle perspective with ETFs and separately managed accounts, including model delivery, representing more than a third of our total AUM.

Turning to Slide 13. Long-term gross flows were $5.6 billion in the quarter. Industry-wide softness in gross sales has persisted with investors remaining hesitant to enter the market given heightened volatility and uncertainty and holding cash has become an attractive risk-adjusted option for many investors. Five franchises, including Integrity, New Energy Capital, RS Global, Sycamore and WestEnd each had positive net flows for the second quarter. In fact, WestEnd has been net flow positive since the acquisition closed at the end of 2021 for the full calendar year 2022 and to date in 2023. This is a result of not only their excellent investment performance, but also enhanced distribution reach and winning new platform placements since the acquisition.

Moreover, strong industry tailwinds, such as an increasing adoption of model portfolios by financial advisers and the shift to fee-based revenue models in the industry have reinforced our original thesis regarding the attractive growth profile of WestEnd. We also achieved positive net flows in our active ETF products during the quarter, which we believe is a very attractive vehicle wrapper with excellent growth prospects going forward. Slide 14 illustrates our revenue by quarter. Our fee rate increased 0.4 basis points in the second quarter, which is the highest fee rate realization we have recorded in the past four quarters. In general, fees have remained steady and asset class, client and vehicle mix are the primary drivers of quarterly fee rate variations.

On Slide 15, we break out our expenses for the quarter. Total expenses declined by $9.9 million or 7% to $129.6 million from the first quarter, driven by lower operating expenses. GAAP operating expenses were down $10.1 million or 8% in the quarter. This reflected lower compensation expense and lower noncash expenses, including depreciation and amortization, as well as expenses associated with the change in value of consideration payable for acquisitions. Cash compensation expense was in line with expectations and as you can see from the graphic on this slide as a percentage of revenue, cash compensation remains in a very narrow range. Moving on to our non-GAAP results on Slide 16. Adjusted net income rose to $66.4 million in the second quarter.

The tax benefit in the quarter held steady at $9.5 million resulting in ANI with tax benefit increasing to $75.9 million or $1.11 per diluted share. Our adjusted EBITDA margin expanded to 50.9% in the quarter. We are maintaining our long-term margin guidance of 49%, which is inclusive of continued investments in numerous areas to support our future growth. Finally, turning to Slide 17. While we did not pay down any debt in the first half of this year, our net leverage ratio improved to 2.3 times at the end of June due to our growth in earnings during the quarter and slightly higher cash position. The average interest rate paid on our debt increased just 19 basis points to 5.43% in the quarter. This was the smallest quarter-over-quarter interest rate increase in the past five quarters and takes into account the $450 million hedge portion of our debt, which is fixed at 3.15%.

Our $100 million revolver remains undrawn and GAAP operating cash flow from operations was $77.4 million in the second quarter. That concludes our prepared remarks. I will now turn it back over to the operator for questions.

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Q&A Session

Operator: [Operator Instructions] And your first question comes from the line of Etienne Ricard from BMO Capital Markets. Your line is open.

Etienne Ricard: Thank you and good morning. To circle back on the launch of brokerage capabilities in your direct channel, how do you think about the opportunity to cross-sell your strategies? And what improvement are you expecting as it relates to the number of products held for customer?

David Brown: Good morning. The launch of our brokerage platform, I’d start off by saying we’re in the early stages. We launched it at the end of April of this year. And we’re making really, really good progress on it. There will be a great opportunity to be able to cross-sell — to take your term, to cross-sell our investment strategies to our current clients to new clients. But I think the real opportunity is to get closer to our clients there, so to offer them more product choice to be able to work with them with their financial future and to really be able to see what we can do to be a bigger part of their financial life through more product choice. So part of that is going to be more of our own products. But another part of that is going to be other firms products sitting on our brokerage platform. And that’s the real goal is to really help our clients and to get closer to our clients and then ultimately to get new clients.

Etienne Ricard: Okay. Understood. Switching gears a little bit on New Energy Capital. Could you please remind us of the potential for scale in that business as well as how investor interest is holding up in this macro backdrop? And lastly, the time line for future fundraising.

David Brown: So New Energy was our first entrance into really private markets. And the business is smaller relative to our overall business. Think of it as $1 billion or sub-$1 billion platform. The opportunity there is to go out and to launch new funds. We were net flow positive for this quarter with them. And it’s really just the beginning of New Energy, and that’s also the beginning for us in the private market part of the industry.

Etienne Ricard: Thank you very much.

Operator: And your next question comes from the line of Craig Siegenthaler from Bank of America. Your line is open.

Craig Siegenthaler: Hey, good morning, Dave, Michael, hope you’re both doing well.

David Brown : Good morning.

Michael Policarpo: Good morning.

Craig Siegenthaler: So fixed income continues to be a net flow headwind for Victory despite pretty good and best performance, but I wanted your perspective over — into the second half, into 2024. Are you expecting a large pickup in industry fixed income flows kind of really after the Fed pauses and how do you think your bond business is positioned for this migration?

David Brown: So we — as we said in the script, we think the second half of this year and then going into next year, we do think that investors are going to pivot really from money market or very, very short-term fixed income investments to more longer duration. And from our perspective, and we articulated this in the script, we have a number of products that have really good performance, long track records, high ratings from a Morningstar perspective. And we’ve expanded out the distribution over the years. So we think we’re really well positioned. Some of the softness, if you go back to the first half of the year for us has really been in some of the noncore fixed income products that we have, some floating rate, high yield and other noncore fixed income products that really we’ve seen those investors go into a money market type investment.

So when those investors feel comfortable — I think, as we talked about with the industry, feel comfortable getting out of a money market type investment, we think we’re really well positioned, and we’re really excited about that. And we think that, that’s going to be a big driver going forward of our organic growth opportunities.

Craig Siegenthaler: Great. For my follow-up, I want to circle back on M&A, just given the rebounding markets here. I wanted to see what that’s changed. Has there been any change in valuation multiples over the last six months. The financing side looked a little more challenged last year, is that starting to ease a little bit, too?

David Brown: I think sellers have come down in their expectations. So I would say that there’s probably a lot more conversations happening that potentially can get to a conclusion. We have seen some activity from Victory’s perspective, we’re really encouraged. We’re working hard and part of our growth over the last decade has been through acquisitions. And I would anticipate that going forward and I’d also anticipate, and I’ve said this before, that coming out of some of these challenging periods, you see a lot of M&A activity in this industry, and I don’t think it’s going to be any different this time. And if you assume we’re coming out of a challenging period through this year and into next year, I think the M&A activity is going to happen, and I think there’s going to be a lot of it, and we’re going to participate in it.