Victory Capital - Q1 2023

Transcript

Operator (participant)

Good morning, welcome to the Victory Capital first 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 (Chief of Staff and Director of Investor Relations)

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 (Chairman and CEO)

Thanks, Matt. Good morning, and welcome to Victory Capital's first 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 first 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 strong financial results to start out the 2023 year. Average AUM increased for the first time in three quarters as the markets rebounded modestly, and we achieved significant improvement in long-term net flows compared with the prior quarter. The improving net flow trajectory has also continued entering the second quarter.

In April, we had an institutional redemption from a single client that totaled approximately $1.1 billion. You will see the impact of this in our April AUM release, which is scheduled for next week. This specific redemption was invested in a purely passive strategy managed by our solutions team with a fee of less than 3 basis points, and it was consequently not making any measurable margin contribution. Absent this redemption, we've achieved relatively flat net long-term flows thus far in the second quarter as of today. Our margin stayed strong, coming in at 49.3% this quarter, which is industry-leading and demonstrates the defensibility of our margins in this challenging market environment. Our margin durability is the result of our differentiated operating platform combined with the determined daily execution by our team.

Adjusted net income with tax benefit rose to $1.08 per diluted share in the quarter, up from $1.05 per diluted share in the previous quarter. Return of capital to shareholders continued to be robust to start the year. First, we repurchased more VCTR shares this quarter versus last quarter. We spent $44 million on the share repurchases and paid out $22 million in cash dividends for a total capital return of approximately $66 million in the quarter. As a reminder, in the first quarter, the board increased the cash dividend by 28%, which is maintained in the current quarter. Our long-term margin guidance remains unchanged at 49%. Our guidance takes into account ongoing strategic investments in our business, which we continue to make.

A good example of this is last month we launched Victory Capital InVest, which is our new marketplace brokerage platform. This is an open architecture brokerage platform which provides significantly more product choice and flexibility to existing and new direct investor clients. We are also continuing to make strategic investments in other areas of the business aimed at better harnessing data and enhancing our technology capabilities, adding distribution and marketing resources, and continuing to hire new talent. All these investments will help us grow our business in the future, and all the associated costs are in our current operating margins and our guidance going forward. Turning to slide 7, the excellent investment performance we deliver on behalf of our clients was sustained during the first quarter. At quarter end, 44 of our mutual funds and ETFs had 4 or 5-star overall ratings from Morningstar.

These products with 4 or 5-stars account for two-thirds of our assets under management in mutual funds and ETFs. Additionally, approximately three-quarters of our total assets under management outperformed benchmarks for the 3, 5, and 10-year measurement periods as of 31 March. During the quarter, several of our mutual funds moved into the top quartile relative to their peer group, according to Morningstar. These included our Victory Income Fund as well as the Victory Tax Exempt Short-Term Fund. In total, 95% of fund assets under management managed by Victory Income Investors, this is the rebranded former USAA Investments franchise.Is diversified across 14 funds that have earned current overall ratings of 4 or 5-stars. Net flows into these products improved significantly in the first quarter.

With excellent investment performance, coupled with what we believe to be a better flow environment emerging for fixed income as we move through this year and into 2024, the opportunity for growth here is quite exciting. Across all asset classes, half of our mutual fund and ETF assets under management ranked in the top quartile for the trailing 12-month period. Over the 5- and 10-year periods, 65% of our fund assets under management ranked in the top quartile, with more than 20% ranked in the top decile. This excellent investment performance highlights another advantage of our differentiated operating model, which removes all non-core investment activities at the investment franchise level. By relieving our investment professionals of these, we enable them to spend a majority of their time managing client assets. We believe this enhances investment performance over longer periods of time.

Turning to slide 8, cash flow generation remained strong to start the year. We remain opportunistic with our share repurchase activity again this quarter, given the overall market and specifically our share price. We believe there is a significant amount of value that is not currently reflected in our current share price. With that in mind, we chose not to pay down any additional debt in the quarter and plan to remain flexible and nimble with our capital allocation strategy as we move through 2023. We are also continuing to conduct diligence on multiple acquisition opportunities. It is important to state that we are not deviating from our proven approach to make our company better through acquisitions. We remain patient and selective as we evaluate opportunities that can enhance shareholder value over the long-term.

I will turn it over to Mike for more details on the quarter's financials. Mike?

Michael Policarpo (President, CFO, and Chief Administrative Officer)

Thanks, Dave. Good morning, everyone. The financial results review begins on slide 10. Assets under management increased 3.7% from $153 billion at the beginning of the year to $158.6 billion at quarter end. Revenue of $201.3 million was essentially flat in the first quarter compared with the $201.5 million of revenue recorded in the fourth quarter of 2022. Average AUM in the quarter was up 2% from the fourth quarter and quarter-over-quarter fee rate was flat, there were fewer days in the first quarter compared with the fourth quarter period. GAAP operating income was $74.6 million and our adjusted EBITDA was $99.2 million.

Net income was $49.3 million, or $0.71 per diluted share on a GAAP basis, and adjusted net income with tax benefits rose to $75.2 million- $1.08 per diluted share. We returned $66 million of capital to shareholders in the first quarter, which was ahead of last year's quarterly average. Lastly, we increased our quarterly dividend last quarter to $0.32 per share, and that same rate was declared again by our board for the second quarter. That cash dividend will be payable on 26th June to shareholders of record on 12th June. On slide 11, you can see total AUM of $158.6 billion at the end of the quarter remains well-diversified from a distribution channel and client perspective.

This diversification is deliberate and designed to mitigate volatility from any particular segment of clients. Turning to slide 12, long-term gross flows were $5.8 billion in the quarter. This reflects soft industry-wide sales as investors have been hesitant to enter the market given heightened volatility, uncertainty, and holding cash has become a reasonable investment alternative to most asset classes in the current interest rate and risk environment. RX Global, Focus, and Sycamore each had positive net flows for the first quarter. We achieved positive net long-term flows in active domestic equity products, with particular strength in our U.S. mid and U.S. small cap strategies. Slide 13 illustrates our revenue by quarter. One note to make on the slide is that our fee rate held steady at 51.7 basis points in the first quarter, which is consistent with the fourth quarter of last year.

Moving forward, our consolidated fee rate will be primarily influenced by asset, client, and vehicle mix as we see general fee rates steady for our business. On slide 14, we break out our expenses for the quarter. GAAP operating expenses increased 4% or by $4.9 million-$126.8 million. This was entirely due to higher non-cash expenses associated with the change in value of consideration payable for prior acquisitions, which rose by $7.4 million quarter-over-quarter. Partially offsetting this non-cash increase were lower total compensation expenses despite the seasonally higher employment taxes and benefits that we set in the first quarter. Flat distributions and other asset-based expenses as well as lower G&A expenses. Cash compensation expense was in line with expectations.

As you can see from this graph, as a percentage of revenue, cash comp remains in a very tight range, reflecting the calibrating nature of the investment franchise revenue share component of our operating platform. It should be noted that Q1 includes the annual reset of certain employment taxes and benefits that accounted for the quarter-over-quarter increase in cash compensation as a percentage of revenue. Moving on to our non-GAAP results on slide 15. Adjusted net income rose to $65.6 million in the first quarter. The tax benefit in the quarter held steady at $9.5 million for ANI with tax benefit of $75.2 million, or $1.08 per diluted share. Our adjusted EBITDA margin remained strong at 49.3% in the quarter.

We are maintaining our long-term margin guidance of 49% for 2023, which is inclusive of our continued investments in numerous areas that support future growth. Finally, turning to slide 16. Our net leverage ratio remained at 2.4x as we did not pay down any debt in the first quarter. The average interest rate paid on our debt rose 53 basis points to 5.24% in the quarter, which resulted in our interest and other financing expense increasing $900,000 from the fourth quarter. This does factor in 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 $64.2 million in the first quarter. That concludes our prepared remarks.

I will now turn it back over to the operator for questions.

Operator (participant)

At this time, I would like to remind everyone, in order to ask a question, press star then the number one on your telephone keypad. Your first question comes from the line of Kenneth Lee from RBC Capital Markets. Your line is open.

Kenneth Lee (Managing Director, VP, and Senior Equity Research Analyst.)

Hi. Good morning, thanks for taking my question. Just one on the the positive net flows you're seeing in the US mid-cap, small cap areas. Wondering if there's anything to call out there. What are you seeing in terms of client trends there? Thanks.

David Brown (Chairman and CEO)

Thanks for the question, Ken. Good morning. As far as that asset class, we're seeing strength with a few of our franchises, Sycamore, and some others. Specifically in the institutional channel is where we've seen some nice pickup.

Kenneth Lee (Managing Director, VP, and Senior Equity Research Analyst.)

Gotcha. Very helpful there. In terms of priorities for free cash flow, you talked about being more nimble this year. Sounds like you're prioritizing share purchases a little bit more now, and there's also a new authorization. Just wondering how active could you be in terms of share repurchases potentially this year? Thanks.

David Brown (Chairman and CEO)

Yeah. Good, good question. You know, first I would say is our overall strategy around capital allocation has not changed. Our first and, highest priority is to make sure we have a flexible balance sheet to do acquisitions. With that in mind, the ancillary part of it, whether we pay down debt or whether we buy shares really is around the current facts and circumstances. The last two quarters we have purchased a lot of shares and but would remind you in 2022, we did pay down $150 million of debt, which was still a sizable portion of our cash flow. You know, as we look forward, as we said in our prepared remarks, we're gonna be nimble and opportunistic.

We do think that our stock today has a lot of value that isn't reflected in the share price. We also feel like, we have a good portion of our debt that's hedged. We'll look at the current circumstances. I wouldn't necessarily take what we've done this quarter or last quarter from a share repurchase and roll it forward. We could buy more shares, we could buy less shares. We're really gonna take it, as the market and as the opportunities evolve.

Kenneth Lee (Managing Director, VP, and Senior Equity Research Analyst.)

Gotcha. Very helpful there. Thanks again.

Operator (participant)

Your next question comes from the line of Mike Brown from KBW. Your line is open.

Mike Brown (Managing Director and Equity Research Analyst)

Hey, great. Thanks, operator. Dave, clearly a lot of money in motion right now, and I just wanted to dig into some of your flow trends here. You touched on fixed income in your, in your prepared remarks. This past quarter, we saw that you had net outflows. I noticed that your money markets, which is not as, big of a business here, but also had some outflows. It's a bit divergent from what we're seeing in the industry trends. Can you just touch on why the money markets saw some net outflows? Then specifically on the fixed income side, it looks like the gross sales haven't really picked up yet. Redemptions are still, running at a little bit of a higher pace there.

What do you think really causes those trends to improve as we progress through the year?

David Brown (Chairman and CEO)

Good morning. Thanks for the question. You know, specifically on the money markets, our money market is offered really in our captive channel in our direct business. We have not participated in some of the inflows for the industry because it's not readily available outside of our direct channel. I would say, from there, it's really an accommodation for those direct investors. Some have brought dollars to us from some of the banks, but many don't really utilize our money market in ways that other money markets are utilized in the industry. That's a little bit of a unique situation to us. As far as the fixed income side, we have spent the last few years really building the distribution pipes, with our team Victory Income Investors.

We've seen, quite a pickup in our net flows from where we were. We're not at the point now where, that has really turned a corner. We think going forward with the distribution pipes being, having been built and then new ones also being built, and then also what's happening in the market, we think as we look forward, that trajectory will change. They've got excellent investor performance, which we highlighted in our script, long-term track record, sizable amount of assets, and we think we're gonna participate, in the future with the team.

Mike Brown (Managing Director and Equity Research Analyst)

Okay. Great. Thanks for the thoughts there. Just to change gears, looks like you guys are launching a digital investing platform later this year. Can you just expand on that offering and how you expect Victory to really stand out in a crowded field? If I heard you right, it sounds like there isn't really any incremental investment. Sounds like, investment there is already baked into the expense base. Did I hear that correct or should we expect, maybe a little bit of incremental marketing expense to come through later this year?

David Brown (Chairman and CEO)

Let me take the last part of the question first. You know, our guidance going forward at 49% factors in the investment we're making and have made. It isn't that we're not making the investment, it's that the 49% is net of the investment. I think that just gives you the power of our platform and the way we're structured. We will be investing, but it is in our guidance going forward. You know, as far as our direct business, which is where we're expanding the product set, we launched, at the end of last month. We launched a new platform, really an open architecture brokerage platform. Victory Capital InVest, that's what we branded it.

That platform will continue to expand products there. We're centering around a few different points around service, around product choice. You know, it's really today will be an expansion of product choice for our existing clients, and we're just beginning to go out and market it. We expect longer term that this will be a growing part of our business. You know, we're pretty excited to really make that next step and evolution in this product offering. Down the road, we will have a digital investing platform, equivalent of what you would call a robo. You know, that's something that we're gonna, we're gonna go out and market and, see what kind of progress we can make there.

Mike Brown (Managing Director and Equity Research Analyst)

Okay. Very exciting. Thanks for sharing those thoughts.

Operator (participant)

Your next question comes from the line of Ken Worthington from JPMorgan. Your line is open.

Michael Cho (VP of Equity Research)

Hey, good morning, David and Mike. This is Michael Cho actually in for Ken. Just wanted to just touch on Sycamore again. You mentioned,, the positive flows and the slight, and I think you'd call that, you're just continuing to see strength there. I guess it's just, one, how big of a driver were those flows into Sycamore? Two, if I recall, Sycamore had been somewhat capacity constrained for some time, but, it continues to be a strong driver of the flow. At some point, do you have to,close the fund to investment or can you continue it, kind of at this pace indefinitely? Thanks.

David Brown (Chairman and CEO)

Our flows. I wouldn't say it was significant or material. It's one that we called out. And, so I wouldn't. We don't break it out franchise by franchise, but I wouldn't call it material or significant. As far as Sycamore, it is closed to new investors. It is on platforms. And then selectively with existing clients, we are accepting new dollars. But effectively, today it is closed primarily to new investment, new investors and platforms

Michael Cho (VP of Equity Research)

Okay. Understood. Thank you. Then, just to change gears just quickly. You know, you talked about the Victory Capital InVest in the marketplace and kind of expansion of product choice. I guess just curious kind of where your head is in terms of, the types of products you're kind of looking to roll out first and kind of the cadence of that going forward as well once with the new platform. Thanks.

David Brown (Chairman and CEO)

The new platform today offers all of the Victory's products. In addition to that, it offers almost all third-party ETFs and mutual funds, and then the ability to trade stocks as well, commission free. If you think about it very much looks like an open architecture brokerage platform. You could buy the VictoryShares ETFs, you could buy any Victory mutual funds. You can buy, for the most part, any third party mutual funds or any third party ETFs, and then the ability to buy and sell stocks.

Michael Cho (VP of Equity Research)

Okay. Thank you.

Operator (participant)

There are no further questions at this time. Mr. David Brown, I will turn the call back over to you for some final closing remarks.

David Brown (Chairman and CEO)

Thank you, and thank you for your interest in Victory Capital. Later this month, we will be attending the 23rd Annual B. Riley Institutional Investor Conference in L.A.. We hope to see some of you there.

Operator (participant)

This concludes today's conference call. Thank Thank you for your participation. You may now disconnect.