Piper Sandler Companies

NYSE:PIPR

Earnings Call Transcript 2018-Q2

[Operator]

Good morning and welcome to the Piper Jaffray Companies’ conference call to discuss the financial results for the second quarter of 2018. During the question-and-answer session, securities industry professionals may ask questions of management.

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. The non-GAAP measures should be considered in addition to and not a substitute for measures of financial performance prepared in accordance with GAAP. 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. Chad Abraham. Mr. Abraham, you may begin your call.

[Chad Abraham, Chief Executive Officer]

Good morning, everyone. I’m here with Deb Schoneman, our President; and Tim Carter, our CFO. And we would like to thank you for joining the call to discuss Piper Jaffray’s results for the second quarter of 2018.

I’ll first provide some overall comments and then an overview of our advisory and equity capital markets businesses, before handing the call over to Deb to discuss the rest of our business lines. Tim will finish with the review of the financials and an update on capital deployment. We will then open up the call for questions.

Revenues for the quarter were up modestly compared to the first quarter. We continue to gain momentum in both of our banking businesses, and we expect revenues on a full-year basis to be back-half weighted. As we disclosed in our earnings release, Q3 is off to a solid start as we expect July will be our strongest month of revenues so far this year. Market conditions remain strong for investment banking and are improving in public finance, while our brokerage and asset management businesses continue to face challenging market conditions.

Given our strong advisory pipeline and assuming no major market disruptions, we estimate our second half revenues to be up meaningfully from the first half. We remain committed to providing bottom-line results for our shareholders. We took actions in the quarter to reduce costs in our brokerage and asset management businesses as we adapt to market headwinds and a changing business model. These headcount reductions, while difficult, are necessary to maintain appropriate margins.

Now, I’ll provide more color on our advisory and equity capital markets business lines. Our advisory business was up modestly from Q1 and down year-over-year. Market transaction values are at record levels. However, the number of completed deals, which is typically a better indicator of middle market activity, is down on a sequential and year-over-year basis. For context on our performance, year-to-date advisory revenues were down 18% compared to the first half of 2017, which seems consistent with the number of completed deals market-wide.

As we have noted in the past, advisory activity can be uneven from quarter-to-quarter depending on the size and timing of transactions. We believe market conditions remain constructive, and our pipeline is robust with several significant transactions setting up for a strong second half of the year. As an example of our strong pipeline, we served as the exclusive financial adviser to have access in Q1 on its announced sale to Zoetis for approximately $2 billion, a transaction that has not yet closed. This is one of the largest diagnostics and animal health M&A transactions in 2018, and reflects the type of deal activity from our market-leading healthcare team.

On an LTM basis, advisory revenues of $410 million are up significantly compared to prior years, driven by investments we have made in the business. As our advisory platform has grown in size, it has grown in diversity and durability. For example, over the last three quarters, different industry teams have led our performance. This quarter was driven by our industrials team, as they completed several significant transactions, including the sale of our majority stake in True Value, one of the largest wholesale distributors to independent hardware retailers.

We’ve invested in the industrials vertical, hiring several bankers and have grown revenues. Relative to the overall market, we are still underpenetrated in this sector, and we continue to look for opportunities to further grow in this space. Another large fee pool that we are targeting is the leverage loan market. In the first quarter, we announced the formation of Piper Jaffray Finance, which specializes in providing loans to middle market companies. The introduction of this debt financing capability expands our value proposition to clients and is synergistic with our advisory business.

We’re very encouraged by the client reception we’ve received. We started marketing the clients in February and have already won several mandates and closed on our first two transactions this quarter. We increasingly believe this new product will be a substantial revenue growth driver and a differentiator for us in the marketplace. Another important initiative is to build out other subsectors in our market-leading franchises. In July, Simmons added one MD to further expand into the upstream E&P sector. Our healthcare franchise also added a new Managing Director in the healthcare services vertical to grow our capabilities serving payers and providers.

Turning to our Equity Capital Markets business. We generated $30 million of revenue in the second quarter, which was down from a strong Q1, but up meaningfully on a year-over-year basis. We believe that we’re on pace to have a strong year as the equity underwriting market is active, and the strength and breadth of our platform is increasing our market share. In the sub $2 billion market cap fee pool, our revenue was up 32% year-to-date, while the market fee pool was up 4%. We believe there is significant organic growth opportunity to increase our equity underwriting mandate by leveraging our reputation and relationships.

Now, I will turn the call over to Deb to discuss the rest of our businesses.

[Deb Schoneman, President]

Thanks, Chad. As Chad noted at the outset of the call, both our equity and fixed income brokerage businesses have been facing market headwinds, albeit for different reasons. First, I will address changes to the equity brokerage business and actions we’ve taken to maintain appropriate margins. Then I will discuss the market dynamics impacting our public finance and fixed income businesses. Our equity brokerage business generated revenues of $19 million for the quarter, which was up 6% from Q1, but down 7% year-over-year.

MiFID II European regulations governing how market participants pay for execution and research services went into effect on January 1. Although a European regulation, this indirectly impacts the U.S. equity markets as many global asset managers adapt to consistent MiFID II compliant regime across all geographies.

Increasingly, market participants are executing trades through low-touch providers and paying separately for research services. The equity brokerage fee pool has been contracting for several years, and the increased transparency of unbundling research from trading execution will likely exacerbate this trend.

Our response to these market changes have been twofold. First, a high- quality research team is imperative to demonstrate value to our clients and complement our equity banking franchise. We continue to invest in research talent, and client feedback has been positive as demonstrated by our progression up to vote ranks with our buy-side clients. We further expanded our biopharma research coverage with the recent hiring of two senior analysts in biotech. We now have one of the broadest biopharma platforms on TheStreet with six research teams and the capacity to cover over 125 stocks.

We’ve also taken cost out of the business to maintain appropriate margins and focus resources on the best talent and opportunities. This quarter, we reduced headcount, including the closing of our Switzerland office, as we are able to more efficiently service our Swiss clients with our Kepler Cheuvreux partnership.

Turning to our public finance and fixed income brokerage businesses. Public finance generated $17 million of revenue in the second quarter as issuance volume increased in the municipal market. As we discussed on the first quarter call, this market was significantly impacted by tax reform enacted at the end of 2017. During the second quarter of 2018, municipal volumes began to rebound, with close to $100 billion of issuance, which is more in line with historical levels. Our public finance pipeline is strong and we expect to drive increased revenues in the second half of the year.

However, we expect overall issuance to be down 20% to 25% from the prior year. Investing in this business has been a priority for us as we look to add high-quality talent. In the second quarter, we hired a team in Phoenix to strengthen our state and local government practice in the southwest region. Market conditions in our fixed income brokerage business remain challenging as low interest rates and a flattening yield curve depress volumes, trading spreads and carry-on inventories. With this market dynamic, we are focused on reducing cost and capital to optimize returns.

Our fixed income brokerage headcount was reduced as we right sized our cost structure this quarter. We also reduced our inventories to coincide with the current market environment, where trading activity is low. Given this dynamic, we expect our revenues in this business to be down about 20% on a full-year basis. This business provides critical distribution for our public finance platforms and also provides important execution services and liquidity for our clients.

I’ll finish up with asset management. Net asset flows were positive for the period as investors see the value proposition in the MLP space. AUM also increased due to market gains as MLPs rallied in the second quarter, erasing their Q1 decline. Revenue was essentially flat sequentially and down year-over-year due to the outflows we experienced in 2017. We continue to focus on improving our margins, given the difficult conditions faced by active managers.

I will now turn the call over to Tim to go through our financial results.

[Tim Carter, Chief Financial Officer]

Thanks, Deb. My comments will be based on our adjusted non-GAAP financial results. Our revenues for the quarter of $174 million were up compared to the first quarter of 2018, but down compared to the year-ago period. As Chad discussed, we expect revenues in the second half of the year to be significantly better than the first half. Our diluted EPS was $0.92 for the quarter, lower on both the sequential and year-over-year basis. The sequential decline of $0.46 was due to three items: a restructuring charge, timing of non-compensation expenses, and a lower tax benefit related to stock vesting.

I’ll discuss each of these items in more detail later in my remarks. EPS was lower compared to the year-ago period, driven by an 11% decline in our revenues due to lower decline in our revenues due to lower advisory activity as well as the restructuring charge.

Turning to our operating performance. The comp ratio for the quarter was 62.2%, consistent with the previous quarter and within our target range of 62% to 63%. The decline compared to the second quarter of 2017 reflects the impact of the new revenue recognition standard adopted this year, under which client-reimbursed deal expenses are no longer netted within revenue. Despite lower revenues on a year-over-year basis, our comp ratio was consistent with the year-ago period after adjusting for the impact of deal expenses, demonstrating the variable nature of our model.

This quarter, we incurred $3.8 million of restructuring cost, primarily related to headcount reductions of approximately 50 people across our sales and trading, and asset management businesses. We undertook these actions in response to challenging market conditions in order to reduce fixed cost and maintain an appropriate level of returns. This charge reduced our EPS in the quarter by $0.19 per share.

Non-comp expenses, excluding the restructuring cost, were $45 million and at the high end of our $43 million to $45 million per quarter range. This was due to higher deal expenses and also the timing of expenses. In the first quarter, non-comp expenses were below $43 million. So on average for the year, we are still within our per-quarter range. As we remain diligent in managing cost, we expect that our non-comp expenses will continue to be in our target range.

Tax expense this quarter was favorably impacted by a $1.4 million tax benefit related to restricted stock vesting at prices greater than their grant date price. In the first quarter, this tax benefit was $5 million. The tax impact is more pronounced in the first half of the year when the majority of our equity award vestings occur. Excluding this benefit, our adjusted tax rate for the quarter of 26.5% was slightly above our estimated range, but on a year-to-date basis, our tax rate of 24.3% was at the low end. We recognize that our tax rate can fluctuate quarter-to-quarter, but on an annual basis, we continue to estimate the tax rate of 24% to 26%, excluding the impact of stock vestings.

Finishing up on capital, as Deb mentioned, we have reduced inventories and fixed income. Our inventory balance was just over $800 million at quarter-end, down approximately 40% from $1.4 billion at the end of the year. We’re taking out of this business in response to market conditions and slow trading activity. We believe these inventory levels are in line with market conditions and opportunities.

We continue to return capital to shareholders through cash dividends. On a year-to-date basis, we have returned an aggregate of $36 million or $2.37 per share. This includes the special cash dividend of $1.62 per share that was paid out in the first quarter. In addition, today we declared quarterly dividend of $0.375 per share to be paid on September 14 to shareholders of record as of the close of business on August 24th.

Finally, given our strong capital position, earnings power and market position, a wide range of capital deployment options are available to us to drive growth, including corporate development opportunities. As we explore the opportunities that present themselves, we will continue to be strategic and selective in our use of capital. We can now open up the call for questions.

[Operator]

[Operator Instructions]. Your first question comes from Devin Ryan of JMP Securities.

[Devin Ryan, JMP Securities]

Thanks. Good morning, guys. How are you?

[Chad Abraham, Chief Executive Officer]

Hi, Devin.

[Tim Carter, Chief Financial Officer]

Hi, Devin.

[Deb Schoneman, President]

Good morning.

[Devin Ryan, JMP Securities]

I guess first question – thanks for the update on the Piper Jaffray Finance initiative. Sounds like it’s going well. I think you guys have highlighted the kind of longer-term potential here in revenues could be $50 million or more. So, I’m just trying to think about some of the early success you’re seeing and maybe now that it’s already kind of launched here, how long you think that it might take to kind of get it to kind of that run rate or kind of fully scale? Like how many deals would that be? Just trying to think about a little more as it matures from here.

[Chad Abraham, Chief Executive Officer]

Yeah. Sure, Devin. I’ll take that one. I think it’s basically tracking light – right as we expected. We knew it would have a financial impact sort of in the back half of this year, but nowhere near the full potential as it just takes a while to ramp – train all the bankers, make sure all our sponsored clients understand the product. I think we were pleased. We got a couple transactions done in the quarter. Those were both related to deals around acquisition financed, which we’re obviously seeing. Good opportunities. Clearly, we continue to think the revenues from that product will grow every quarter. And I think I would just say what I said when we launched this. It probably takes us close to three years to be at that run rate, but we expect we’ll be – we expect we’ll sort of be growing that every quarter.

[Devin Ryan, JMP Securities]

Got it, okay. Thanks for the update there. And then appreciate the advisory commentary as well. And the fact that it will be a nice step-up into the back half of the year. As we just think about kind of the way this year has progressed, where first half’s been little softer than we had modeled and it sounds like the back half could be quite strong. Is that just the normal ebb and flow of that business, just timing of specific events and when they close? Or was there some period where actually there was a little bit of an air pocket and so we’ve kind of now reaccelerated?

And I guess, that’s one question. I’m just trying to get a little bit of the sense just since it is pretty big step-up or seems like it could be. And then kind of bigger picture just on the environment right now, we’re not hearing much about trade tensions impacting activity or anything that’s kind of a negative. So I’m just curious if there’s anything that you would point to good or bad, that’s kind of changed the trajectory of kind of new announcements that are coming into the pipeline recently.

[Chad Abraham, Chief Executive Officer]

Yes, Devin. I would say, just – if you look at, relative to lumpiness, I think over a longer-term period, especially for the advisory business, we tend to do better in the back half than the first half. That certainly was true last year. The last two quarters were certainly better than the first two quarters. It might be a little more magnified this year. But for this year, that’s mostly just related to – each year, we have a handful of pretty large feeds and it just so happens that most or all of those large feeds this year are weighted towards the back half.

So that kind of is what drives the – also just the PE sort of sponsor deal timing. They start a lot of deals in the – after year-end, after they have financials in the spring, and we close a lot in the back half. Relative to overall market conditions, I would agree, I mean, we don’t see any sort of major macro changes sort of affecting the current pipeline or pace of deals, and for us, I think, the feeling coming out of Q2 versus Q1, we now on, some of our more notable transactions, have quite a bit more visibility because we’re three months closer than we were, and we’ve already had some of those things closed in July. So we’ve got pretty good visibility into the back half of year.

[Devin Ryan, JMP Securities]

Great, okay. Thank you. And then just last one here, Chad for you as well on the asset management business and strategy now you had a little more time, I’m sure, to kind of think about that. What are the considerations that at least you’re thinking about today around kind of what the direction of this business is within Piper Jaffray? And is it status quo? Do you need to do something one way or another? But as you’ve had some more time here to think about, I’m just curious kind of what those considerations are today?

[Chad Abraham, Chief Executive Officer]

Got it. I can take that and then Deb can follow-up. I think that’s sort of been consistent for us. I mean, we got into the asset management business because we loved the sort of the continuous nature of earnings versus deal by deal. I would say we still love the potential margin profile. We still love some of the opportunities synergistically. I think, like I’ve said to you in the past, it’s pretty clear though we’re not going to be $7 billion and sort of just run it at that size. So, while I think we’re encouraged by the fact that we started to see some inflows and we’ve sort of stabilized around the products we want to be in, and we – you’re not seeing the outflows like we were. I think we’re still very focused.

Okay, now from here, we know what we have, how can we grow it. I think we’ve got a very focused strategy around a few areas. And I think we will continue to look opportunistically if there are areas that are really aligned with what we’re good at and the rest of the firm that we could add to that. But we’re very conscious that if we’re in this business in the right way, in a few years, it’s going to be much bigger.

[Devin Ryan, JMP Securities]

Okay, great. Thanks very much.

[Operator]

[Operator Instructions]. Our next question comes from Ann Dai of KBW.

[Ann Dai, KBW]

Hi, good morning. Thanks for taking my question. So, I wanted to start with…

[Chad Abraham, Chief Executive Officer]

Good morning, Ann.

[Ann Dai, KBW]

Good morning. I wanted to start with public finance. So it does feel like the recovery that you’ve – or the rebound, I guess, I’ll call it, you’ve had year – quarter-over-quarter, has been a little bit better than what we’ve seen in industry volumes. So I was just curious to getting your perspective on that. Are you picking up market share in certain places? Or are you more biased towards certain areas of the market that are rebounding a bit faster?

[Deb Schoneman, President]

Yes. I would say actually, our volumes are more in line with what’s happening in the marketplace holistically, at least, that’s how we look at it. Our pipeline does continue to build. I mean, you saw that in the second quarter versus the first. And we see that continuing throughout the year, especially as we have some of our specialty sectors with strong pipelines, and those just tend to be some higher spread products. So I guess, we see ourselves be more in line with market in the first half of the year here.

[Chad Abraham, Chief Executive Officer]

Yeah. And Ann, I would just add to that. I think part of it is, we were probably down more in Q1 than most of the market. So our – obviously, our improvement in Q2 looks good, but I would say it’s very consistent with what we’ve been saying the last three or four months. We certainly expect Q3 to be even better for public finance and it’s really driven on some of the specialty areas Deb mentioned.

[Ann Dai, KBW]

Okay, great. Yeah, maybe, next on institutional equities. You spoke a little bit about ongoing headwinds. Obviously, you know second quarter is better than first and so now year-to-date, kind of looking at trending down high single digits, do you feel like that’s a decent run rate for where the rest of the year might be? And kind of what are the ins and outs of what might move that?

[Deb Schoneman, President]

Yes. I think the business is performing similar to how we had expected when we had talked about at the start of the year. Obviously, there’s a lot of moving pieces which netted out there and a lot of conversations with clients and it’s very clear to us that high-quality research and it is very important to this business. One of the things that we stated in last quarter was that overall we’d expect these revenues to be down about 10%. Again, year-over-year basis right now, down about 8.5%. So I would say that general trend we do expect to continue for the year.

[Ann Dai, KBW]

Okay. Thanks, Deb. Next on the restructuring. So sounds like it’s more heavily biased towards the fixed income side of things. I guess, I’m just curious whether that’s the right characterization of that? Or if there was some decent contribution from the equity side as well? And then it does sound like it was mostly headcount-based and so there’s not really a non-comp impact. But please let me know if I’m kind of misinterpreting that?

[Tim Carter, Chief Financial Officer]

Yes, Ann. I’ll take that. It’s really across both of our brokerage businesses. So I would say it’s more evenly split across those businesses. You’re right, it’s primarily headcount related in nature. So not a lot of change from a non-comp perspective. I think as we think about it and trying to maintain sort of the appropriate returns and margins, the – so the guidance we’ve given in terms of comp and non-comp ratios don’t really change related to this.

[Ann Dai, KBW]

Thanks, Tim. Actually, that was my next question on comp was given that we’re kind of trending on the lower end of the comp range that you gave and now there is some of this restructuring in some of the businesses, on a full year basis, does it feel like that’s reasonable, that maybe we’ll end up kind of on the lower end?

[Tim Carter, Chief Financial Officer]

Yes. I think that’s possible. But it’s dependent on sort of the mix of the business. And I still think that sort of 62% to 63% is overall the right range. I mean, some of that can also be dependent on what we’re trying to do to grow the business and sort of reinvest in the business. So that can impact it as well.

[Ann Dai, KBW]

Great. That’s it from me. Thanks.

[Deb Schoneman, President]

Thanks, Ann.

[Operator]

Your next question comes from Bill Dezellem of Tieton Capital Management.

[Bill Dezellem, Tieton Capital Management]

That’s Tieton Capital Management. A couple of questions. In the press release, you referenced the expanded range of debt solutions. Presumably, that’s your leverage loan business. Is that correct?

[Chad Abraham, Chief Executive Officer]

Yeah. That’s what we’re talking about Piper Jaffray Finance.

[Bill Dezellem, Tieton Capital Management]

Great, thank you. And then secondarily, what are the capital requirements of that business versus your other businesses.

[Chad Abraham, Chief Executive Officer]

Yes. So, when we launched that, we talked quite a bit about it, but it’s not a high capital usage from Piper. We partnered with large middle market capital providers to provide and backstop most of the financing on many of the transactions we are going to commit capital, but it’s a much, much smaller percentage than our partners. And so it – while it will take some capital relative to the opportunity, it should be a high return.

[Bill Dezellem, Tieton Capital Management]

Thank you.

[Operator]

[Operator Instructions]. And we have no other questions in queue.

[Chad Abraham, Chief Executive Officer]

Okay. Thanks everybody, for joining the call. We look forward to talking to you after Q3, and hope everybody has a good day.

[Operator]

This concludes today’s conference call. You may now disconnect.