Victory Capital Holdings, Inc. (NASDAQ:VCTR) Q3 2023 Earnings Call Transcript

Victory Capital Holdings, Inc. (NASDAQ:VCTR) Q3 2023 Earnings Call Transcript November 5, 2023

Operator: Good morning and welcome to the Victory Capital Third 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’ll now turn the call over to Mr. Matthew Dennis, Chief of Staff and Director of Investor Relations. Please go ahead.

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 disclosed 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’s 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 Third 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, Director of Investor Relations. I’ll start today by providing an overview of the third 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 five. We reported strong financial results for the third quarter. Revenue, including adjusted EBITDA earnings and margin, net income, and earnings per diluted share all rose sequentially from the second quarter and we achieved the highest levels for each of those metrics thus far in calendar year 2023.

Our margins remain robust with adjusted EBITDA margin coming in at 51.1% this quarter, which underscores the strength of our operating platform in all market environments. This was the 13th quarter in a row that we achieved margins above our long-term guidance of 49%, and it was the ninth quarter over that period that we reported margins of 50% or higher. Adjusted net income with tax benefit rose to $1.18 per diluted share in the quarter, a 6% increase over the $1.11 per diluted share that we reported last quarter. Long-term net flows improved from the second quarter, with outflows declining to $1.7 billion in the third quarter. I would also note that our gross redemptions are the lowest that they have been in the past eight quarters. Although we are in an environment where many investors have chosen to either invest in cash and cash equivalents or to pause allocations, we are seeing some significant green shoots with several of our investment franchises.

One franchise I would like to call out is WestEnd Advisors, which continues to see positive net flows and significant distribution expansion from a platform and advisor perspective. We made the decision to build up cash during the quarter to enhance our financial flexibility and ensure we have the means to execute on our capital allocation strategy, specifically the inorganic aspect of it. As announced in our latest AUM press release in September, we consolidated the former fixed income franchise, INCORE, under the Victory Income Investors brand, which is also a fixed income franchise. In conjunction with this consolidation, we sold a number of unique accounts totaling approximately $1.3 billion that were not scalable on our platform. We did retain a majority of the investment strategies and all the investment professionals associated with the management of the strategies that transferred under the Victory Income Investors franchise.

Lastly, as we stated in our earnings release, there will not be any material financial impact from these actions. Consistent with our ongoing growth initiatives, we continue to strategically invest in our platform in several areas. These include product development, enhancing capabilities for our direct investor channel, technology, automation, artificial intelligence, digital marketing, as well as our use of data to make our platform even more competitive and efficient. Turning to slide seven, you can see that our investment performance remains very strong. At quarter end, 40 of our mutual funds and ETFs had four or five star overall ratings from Morningstar. These products account for more than two-thirds of our AUM in mutual funds and ETFs. Additionally, more than 80% of our total AUM outperformed benchmarks for the five-year measurement period ended September 30th.

One standout in the quarter was our WestEnd Advisors Investment Franchise. Through quarter end, 98% of WestEnd’s AUM was outperforming respective benchmarks over the five-year period. This bodes well for accelerating the already positive net flow momentum at WestEnd that I mentioned earlier. With the trillions of dollars that is currently invested in cash and cash equivalents, we are exceptionally well positioned in anticipation of investors eventually re-risking portfolios when there is more visibility around the direction of interest rates, as well as economic and geopolitical conditions, given the investment performance in our fixed income products and our distribution positioning. Moreover, our suite of equity offerings continues to perform very well, and our distribution positioning within our different channels is as strong as ever.

Turning to slide eight, we continue to generate robust to excess free cash flow in the third quarter. Subsequent to quarter end, we also monetized our floating to fixed swap that generated $43 million in cash and produced the gain that is now locked in. Converting the swap into cash only adds to our financial flexibility, and we see real benefit to flexibility at this point in the cycle. We are continuing to have numerous discussions around inorganic opportunities. As I have said many times, exact timing is difficult to predict, but I do believe that the opportunities that are presenting themselves in this environment are quite attractive, becoming more plentiful and executable. With that in mind, we remain patient, disciplined, and selective as we evaluate opportunities with the end goal of enhancing long-term shareholder value.

With that, I will turn the call over to Mike to go through the quarter’s financial results in greater detail.

Michael Policarpo: Thanks, Dave, and good morning, everyone. The financial results review begins on slide 10. Assets under management at quarter end were $153.5 billion. Average assets under management rose 2.4% in the third quarter compared with the second quarter. Our fee rate was steady at 51.6 basis points. Revenue of $209.7 million in the third quarter was up 2.7% compared to the second quarter. The higher revenue benefited from the higher average AUM as well as one extra day in the quarter. GAAP operating income was $80 million, and our adjusted EBITDA rose to $107.2 million, as adjusted EBITDA margin expanded 20 basis points to 51.1% in the third quarter. Quarterly net income was $52 million or $0.77 per diluted share on a GAAP basis.

And adjusted net income and tax benefit rose quarter-over-quarter to $79.8 million or $1.18 per diluted share, up 6% from the second quarter. Dave already covered accumulating cash to enhance our flexibility and strengthen the balance sheet during the quarter. This accumulation resulted in cash increasing to $108 million at quarter end. Further to this point, in October, we monetized our floating to fixed interest rate swap locking in the gains from that arrangement, which generated $43 million in cash. From an accounting standpoint, the gain will be realized on a straight-line basis as a decrease in interest expense through the end of the swaps term in July of 2026. Our net debt to adjusted EBITDA ratio improved to 2.1 times at the end of September, reflecting the growth in adjusted EBITDA and our lower net debt.

We returned $21 million to shareholders in the quarter in the form of cash dividends and another $7 million with share repurchases. Our Board of Directors declared another quarterly cash dividend of $0.32 per share. This next dividend will be payable on December 22nd to shareholders of record on December 11. On slide 11, you can see the steady increase in the total AUM in the first half reversed in the third quarter. This was driven primarily by negative market action, which reduced AUM by $4.9 billion in the period. Our AUM remains well diversified from a distribution channel and from a client perspective within each channel. We’re also becoming more diversified from a vehicle perspective with ETFs and separately managed accounts, including model delivery, now representing more than one-third of our total AUM.

Turning to slide 12. Long-term gross flows were $5.3 billion in the quarter and net long-term flows were negative $1.7 billion. Gross redemptions improved to their lowest level in two years. We are not immune to the current industry landscape with muted gross sales, reflecting investors being content to hold cash in this environment, as they delay allocations to longer term and higher risk asset classes. Several franchises had positive net flows in the third quarter, including New Energy Capital, RS Global, Trivalent, and WestEnd. WestEnd’s investment and business performance has been very strong, and we are beginning to realize the vision of growth for the platform we had when we made the acquisition. Another franchise worth noting is RS Global, which has been net flow positive for 10 consecutive quarters.

The overall Five Star rated RS Global Fund, ticker RSGGX, ranked in the top decile according to Morningstar for the choice one, five and 10-year periods as of September 30th and has outperformed benchmarks as well over those same periods. Slide 13 illustrates revenue by quarter. You can see the close correlation between revenues and average assets under management, which resulted in the highest level of quarterly revenue achieved in the past year. Our fee rate decreased slightly in the third quarter. As you may recall, the fee rate realization recorded in the second quarter was the highest in the year. In general, our investment management fees have remained steady and asset class client and vehicle mix are the primary drivers of quarterly fee rate variations.

On slide 14, we break out our expenses for the quarter. GAAP operating expenses rose in the quarter, primarily due to a significant increase in quarter-over-quarter noncash charge related to the net present value of contingent consideration for prior acquisitions. This rose to $10.3 million, up from $1.5 million in the second quarter. Additionally, some of the increase is related to our variable cost structure and was due to the higher average AUM and revenue reflected in higher asset-based expenses, such as broker-dealer and platform fees, fund administration, and middle office expenses. Cash compensation as a percentage of revenue held constant at 23.7% for the third quarter. Finally, G&A expenses rose slightly due to the timing of our ongoing investments to support growth.

Moving on to our non-GAAP results on slide 15. Adjusted net income rose to $70.3 million in the quarter, which was the highest level in the past four quarters. The cash tax benefit in the quarter was unchanged at $9.5 million, resulting in ANI with tax benefit growing to $79.8 million or $1.18 per diluted share. Our adjusted EBITDA margin expanded 20 basis points to 51.1% in the third quarter. We achieved steady growth in adjusted earnings per share over the past year, which including our cash tax benefit rose 12% from the level achieved in the final quarter of 2022. Looking forward, we are maintaining our long-term margin guidance of 49%, which is inclusive of the continued investments in numerous areas to support our future growth. Finally, turning to slide 16.

We did not pay down any debt in the first three quarters of this year. However, our net leverage ratio improved to 2.1 times at the end of September, reflecting the higher cash balance on our balance sheet and higher earnings. The average interest rate paid on our debt increased 18 basis points to 5.6% in the quarter. This was the smallest quarter-over-quarter interest rate increase in the past 1.5 years. Our $100 million revolver remains undrawn and GAAP operating cash flow was $91.6 million in the third 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: Thank you. [Operator Instructions] Your first question comes from the line of Craig Siegenthaler of Bank of America. Your line is open.

Craig Siegenthaler: Good morning, Dave, Mike. I hope everyone is doing well. My first one is on M&A. So with $140 million of cash on hand today after the floating to fixed swap monetization, can you update us on the M&A pipeline? And are you holding more meetings with Prospects today than six months ago? And any commentary on valuation multiples would be helpful, though? Thank you.

David Brown: Good morning, Craig. First, let me start off on the pipeline. The pipeline for the last year or so has been pretty full. And we’ve been having lots of meetings. I wouldn’t say that the meetings have increased. What I would say is, and I said this in our prepared remarks, that I feel like the ability to execute has gotten a lot better and really us monetizing our hedge and us building cash is a reflection of where we think we are in the cycle and how close we are to potentially doing a transaction. That being said, nothing is imminent, and we also look at our capital strategy very opportunistically. And so we had historically, at least this year, bought a lot of shares back and continue to pay a dividend. I wouldn’t say that we wouldn’t be buying shares back going forward, but we want to make sure that we have a balance sheet that’s flexible to execute in a really timely manner.

Craig Siegenthaler: Thanks, Dave. Just as my follow-up on the SMA and other flows of $440 million in the quarter. Within the $440 million, I was wondering if you have the mix or could provide some color between trust, wraps, UMA, UCITS, any other vehicles that I may be missing because that’s been a nice growth engine for you guys. And then within those sort of sub-buckets, which one do you expect to be the biggest flow contributor in 2024?

David Brown: It’s all primarily WestEnd, the WestEnd Advisors franchise. And really, that is when we bought — we purchased that business, our thesis really was — is that we thought the model business within the large platforms in the industry, that was going to increase and that they were well positioned, and that’s happened. And so primarily, where we think going forward is we think it’s all going to be on the model side.

Craig Siegenthaler: Dave, thank you.

Operator: Your next question comes from the line of Etienne Ricard of BMO Capital Markets. Your line is open.

Etienne Ricard: Thank you and good morning. So lots of discussion on the potential to return to positive net flows in fixed income across the industry. So in this environment, how do you think about promoting your fixed income strategies, both across the direct and retail channels?

David Brown: So over the last few years, we have really spent the time to build out our distribution channels for the Victory Income Investors franchise. And where we’ve spent the time from a marketing, from gaining access to different platforms and really shoring up the platform. And as we said in our prepared remarks, we did consolidate the INCORE franchise into at least from a brand perspective into the Victory Income Investors franchise. And we think having one brand, the scalability of that brand and really consolidating all of our efforts under that brand will really help us when some of these investors come off the sidelines and get out of cash or decide to allocate back to traditional fixed income. I’d also add, one of the best ways to prepare for it is to have really, really good investment performance.

And if you were to look at the Victory Income Investors franchise and look at our performance, it’s excellent across the board. And I think that’s really the best preparation for it.

Etienne Ricard: Okay. And just to circle back on M&A, can you give us a sense of the potential size of transactions you’re looking at? And would you be willing to maybe close multiple transactions in a relatively short period of time? Or would you prefer to stick to your historical one transaction per year track record?

David Brown: We really have — if you go back and look historically, we have done large transactions, I’d say, medium size and small. And we’ve always said that because we’ve built such a great platform, we have the benefit of looking at multiple sized transactions, and that’s how we look at it, where the transactions have really impacted us have been on the larger side and also on the smaller side. Historically, if you go back years ago, the beginning of our ETF business was a very small acquisition, which has grown nicely over the last eight years. From how many, we have had where we’ve done three, I think at the end of 2021 into 2022, we closed 3.25 or at least in the back half of the year. And then we’ve had situations where we have done one and then it’s been a few years in between. I’m not in a position to say how quickly, what the size would be and how many in a year, we’re really looking at it on an opportunistic basis.

Etienne Ricard: Great. Thank you very much.

Operator: Your next question comes from the line of Adam Beatty of UBS. Your line is open.

Adam Beatty: Thank you and good morning. Just a follow-up on M&A, not to harp on it too much, but Dave used the word executable a couple of times. And potential interpretation of that is maybe tighter sort of bid-ask spread, sellers kind of getting more realistic on valuation. But those are my words. So I’m just curious, probably no one out there executes M&A in the asset management space as well as Victory. So just curious what you meant by more executable at this stage in the cycle? Thanks.

David Brown: I think you summed it up nicely. I do think that the bid and the ask spread has tightened. And I think buyers and sellers are much more realistic of what valuation is and potentially being open to structuring. And so my word of executable is really in reference to that.

Adam Beatty: Excellent. Thank you. I appreciate it. And then just turning to small and mid-cap equities. You guys have significant scale there, a good view on the market. Just wondering how you see the climate right now for small and mid-cap investing and the outlook given some of the recent Fed moves or non-moves? Thanks.

David Brown: So generally speaking, there is a lot of investor dollars sitting in cash and cash equivalents. I think there’s over $7 trillion in money markets. And so a lot of investors have decided at least at this point in the cycle to go to cash, to get the higher return. I do believe going forward that a lot of those dollars will leave the money market asset class and b) either put into fixed income or into higher-risk type assets, including US small cap, including US Midcap. I also think that if you go and look at the small and mid-cap indices, they have not performed up to where the overall market has. So I think that they look like very good potential investments with good returns. We happen to have multiple franchises in US small cap and mid-cap and really feel like we’re well positioned there.