Invesco Ltd (IVZ) — Q2 2020 Earnings Call Transcript

Thank you very much, and this is Marty Flanagan. Thanks for joining. Much appreciate it. What we'll do today is I'll make a few introductory comments and Allison and Loren will go through the financial results, and then we'll all be available for Q&A. Before we begin, I would like to recognize that after 15 years, this is Loren's final earnings call. He's been an incredible partner and CFO for all those years and incredibly well-regarded internally, helping us through all of our growth and some challenging times during various crises. I will say I value his trusted counsel on a daily basis, and we will continue to benefit from that as he becomes a Vice Chairman until March of next year. At that announcement, we did announce that Allison will become the CFO on August 1. Allison has been with us since mid-March and has served as Deputy CFO, working with Loren and his team. I will say the transition is going very smoothly. Let's get started, and I'm on Slide 3 if you are following along. Prior to the onset of the pandemic, we were on the path to execute our long-term strategy, which was aimed at enhancing our ability to meet client needs while returning Invesco to organic growth. Over the past decade, we've disciplined our approach to industry views ahead of key macro trends, and we think that's positioned us very well. With the onset of the pandemic, we reacted dramatically, focusing on ensuring the financial strength of the firm. During the quarter, we remained committed to helping clients and communities navigate the challenges presented by the virus. In fact, we've transformed how our employees work together. The vast majority of our employees continue to work from home, fully embedded in the virtual workspace, which helps all of us work more effectively and efficiently together. Supporting our teams while they adapt to this new normal has become a top priority. We have reshaped our client delivery model to a fully digital engagement platform, allowing us to meet our clients' diverse technology needs wherever they are in the world. These efforts, combined with strong investment performance and high-demand capabilities, led to improved fundamentals during the quarter. Long-term flows in EMEA turned positive, and we continue to see net inflows in Asia Pacific. Our institutional pipeline is at a record level, and our Solutions capability enabled over 50% of the pipeline, creating wins in customized mandates during the quarter, continuing to receive very strong feedback from our clients. Retail flows improved this quarter, but were still net outflows. Long-term flows into fixed income capabilities were strong by channel, and Loren will provide insights on flows in just a moment. During this uncertain environment, we are reallocating resources to further growth while focusing on building operating scale within the organization. Our total operating expenses were in line with guidance provided last quarter, despite the market rebound. Additionally, we strengthened our balance sheet by paying down our revolving credit facility, improving our leverage profile, and increasing our liquidity. Allison will discuss our expenses and capital management in a moment. Invesco has built a global, diversified business with the depth, breadth, and resiliency to deliver positive outcomes to clients through various market cycles. We have the foresight and discipline to invest in several macro trends shaping the future of our industry. As a result, we are now well-positioned in areas of high demand with the majority of our investment capabilities aligned with key future growth areas, a significant and growing Solutions effort, and leadership positions in alternatives, ETFs, fixed income, factors, emerging market capability, as well as the fast-growing China market. Our efforts place us in a strong position to navigate through crises while meeting client needs. The resilience of our employees, the strength of our client relationships, and the breadth of our capabilities contribute to achieving solid operating results. We remain focused on helping our clients navigate the challenging market environment by maintaining a disciplined business approach and working towards a return to organic growth. Let me conclude my introductory comments by noting that Invesco is committed to addressing long-standing racial inequalities, which became the focus of protests worldwide during the quarter. In support of the movement, we have strengthened our commitment to social justice by deepening our understanding of this topic and driving progress in our communities while expanding our diversity and inclusion efforts across the globe. As an example, we support the Metro Atlanta Chamber of Commerce efforts to pass the hate crime legislation in Georgia, which was recently signed by the governor. With that, I'll turn it over to Loren and Allison to go through the results, and then we'll get into Q&A.

Yes. Great. Thank you very much, Marty. Slide 5 summarizes our investment performance. We had 57% and 69% of actively managed funds in the top half of peers on a 5-year and a 10-year basis, reflecting strength in fixed income, global emerging markets, and Asian equities. Moving to Slide 6, we ended the quarter with $1.145 trillion in assets under management (AUM), increasing by $118 billion during the quarter, largely due to increased market values. Turning to Slide 7, long-term net outflows in the second quarter were $14.2 billion, largely reflecting market dynamics in U.S. retail. Flows in this market improved from levels experienced in Q1. Net long-term outflows in active AUM were $13.4 billion, while net outflows in passive AUM were $0.8 billion. Our ETFs experienced net outflows of $0.4 billion, primarily driven by net outflows in the S&P 500 low volatility ETF, but offset by net inflows in our EMEA physical gold exchange-traded fund and the Invesco National AMT-Free Muni Bond ETF. These ETF flows occurred against an industry backdrop of very narrow flows, where about 90% or $119 billion of total ETF flows of $131 billion went into fixed income and alternative/commodity strategies. In fact, the top 10 funds in the industry drove more than half of the total flows. Our QQQ fund saw net inflows of $6.1 billion in Q2, although we do not include these QQQ net inflows in our net long-term flows as they are non-management fee-earning flows. We saw retail net outflows improve to $14.6 billion, down from $30.3 billion in Q1. On the institutional side, our net flows were slightly positive at a net $0.4 billion for the quarter, but that was down from net inflows of $11.2 billion in Q1. I will provide further insights on these flows in the coming slides. Looking at flows by geography, you'll see positive sales outside the Americas, with EMEA excluding the UK returning to positive flows of $1.8 billion from net outflows of $1.2 billion in Q1, driven largely by strong flows into our gold exchange-traded fund. We also had positive net inflows in Asia Pacific of $2 billion, up from $0.2 billion in Q1, driven by institutional investment-grade fixed-income mandates in Japan and net inflows into balanced funds in our China joint venture. We do not show net flows by asset class on this slide, but fixed income showed strength across all channels and markets in the second quarter with net long-term inflows of $6 billion. Now let's move to Slide 8. Our institutional pipeline remains full and grew to a record level during the second quarter to $33.4 billion, up from $31.9 billion. Our pipeline is robust across both asset classes and geographies. Critically, our solutions effort enabled more than half of the pipeline, underscoring the success of the consultative approach to our sales process. Moving to Slide 9, let me add a few comments about our active U.S. retail. Long-term flows for the industry were slightly negative at $2 billion, bifurcated between fixed income, which was positive at $145 billion, and equity, which was negative at $115 billion. Industry inflows into fixed income were led by taxable funds, making up about 90% of the total inflow for the industry. You can see on the active U.S. retail slide that our ending June AUM grew 11% from the end of March. Importantly, our fee rates remained strong and consistent. Our average monthly gross sales remained at a healthy pace in Q2, similar to pre-COVID levels, up 7% from the combined results of Oppenheimer and Invesco in Q2 2019. Net flows improved 30% in Q2 versus Q1 across all asset classes but were challenged by our large exposure to equity funds, which represent about 65% of our active U.S. retail AUM, with limited exposure to taxable fixed income at only about 8% of our active U.S. retail AUM. Given the industry dynamics, this context helps explain our flows. Fixed income in the Americas shifted back into positive net long-term inflows for the quarter, led by our municipal products suite. Our heavy exposure in the five largest outflowing equity sectors in Q2 accounted for 70% of our active U.S. retail net long-term outflows. So now that we've covered flows, let me turn it over to Allison, who will discuss revenues, expense management efforts, and our capital management activities.

Thank you, Loren, and good morning. Turning to Slide 10, you'll see that our revenues decreased by $112 million from Q1, driven by lower average AUM in Q2. Average AUM in Q2 was $1.12 trillion, down 5% from $1.18 trillion in Q1. The net revenue yield excluding performance fees was 36.8 basis points, down 1.9 basis points from Q1, largely in line with guidance for the quarter. Net revenue yield was impacted by the change in the mix of our AUM due to the flight-to-liquidity experienced in March, compounded by the market recovery during the period. Given the mix shift we are seeing in our AUM, including the impact of larger, lower-fee institutional mandates, we expect a continued modest decline in our net revenue yield excluding performance fees in Q3. Our total adjusted operating expenses were $675 million in Q2. We guided in April that we expected operating expenses to be around $675 million, based on market and FX levels as of March 31. Through prudent expense management, we maintained the total operating expense level despite the market's rebound. Like many firms, we are taking hard looks at our expense base in light of the ongoing global pandemic and its impact on both markets and clients. Much of our operating expense improvement has been realized through pandemic-related restrictions on travel and other business operations. Additionally, we are thoughtfully managing hiring and tightening discretionary spending. While these measures have and will continue to benefit our operating expense base, they are temporary improvements, and we expect these expense categories to return to normalized levels when travel and in-person engagements resume. Moving to Slide 11. You'll see that nonoperating expenses negatively impacted earnings for the quarter. Adjusted EPS was $0.35, compared to $0.34 in Q1, with adjusted nonoperating expenses reducing EPS by $0.07, which included $53.2 million of net losses in equity earnings, driven by noncash market valuation adjustments primarily in our CLO holdings, which appear in our results on a one-month lag. The unrealized CLO losses do not provide tax benefits due to the jurisdiction of our holdings, contributing to an elevated tax rate for the quarter of 24.4%. For the remaining quarters of 2020, we estimate our tax rate to be between 24% and 25%, though the actual effective tax rate may differ due to nonrecurring or discrete items. Turning to Slide 12, we reduced our revolving credit facility balance by $182 million in the quarter, consistent with our commitment to improve our leverage profile. Beyond using excess cash to reduce leverage, we are focused on enhancing liquidity and financial flexibility. Our balance sheet cash position improved to $987 million in Q2 from $941 million at the end of Q1. Our goal remains to build cash to $1 billion in excess of our regulatory capital requirements. As of June 30, we were holding approximately $280 million in excess of regulatory requirements. We are focused on building financial flexibility in these uncertain times, and we believe we are making progress. We remain committed to a sustainable dividend and returning capital to our shareholders. In summary, we remain prudent and cautious in our approach to expense and capital management while reallocating resources to position us for growth. Our focus on driving greater efficiency and effectiveness into our platform, along with the work we've done over the past 15 years to build a global business with comprehensive capabilities, places Invesco in a strong position to meet client needs and grow our franchise over the long term.

Thank you, operator. Excuse me, Allison and Loren. Can we turn to questions, please?

Wanted to ask a follow-up on your comments on the retail industry and that part of the business. You obviously mentioned the positive flows for the industry in fixed income, negative in equity. And that's been going on despite pretty good equity markets overall. Obviously, this year came too with some ups and downs. So you have really strong gross sales, but redemptions are also high. So can we talk about what's within your control? How are you adapting maybe your retail servicing and platform portfolio construction? You put that all in a package of what we can do because the reason I ask, obviously, is retail and equity outflows are offsetting altogether good stuff that's going on at Invesco.

Yes, Glenn, great comments. You're right. I will say the flows this last quarter were quite large. There was a lot of fund stocking we're looking at when we have significant exposure to categories that are not performing as expected. We continue to build capabilities that will yield persistent growth over time. The engagement model with the wealth management platform continues to evolve dramatically, which is very important. It has enabled us to develop much-needed solutions capabilities. So don't think of it just as institutional; consider it as engagement with important financial advisors that exist within those platforms. This is where we started, and it truly is beginning to make a difference. Another critical evolution is developing models for these platforms and having the ability to provide solutions and our self-indexing capabilities to build models for the platforms. This requires having the right components in place for all major asset classes. We see that more and more solutions engagement, whether through buys or not necessarily a discrete model profile is essential for success. Wealth management channels increasingly look to firms like us to help them be successful with their client bases, and our consulting capabilities at Invesco have excelled at this.

Absolutely. Allison, if I could just ask one quick question, I'll move on to the next.

No, please go ahead.

Okay. Just a quick follow-up then, sorry. You mentioned the CLO mark. Could you give us a little more detail in terms of the composition and the size of CLO holdings and where you fit in that stack?

Sure. The most important thing to recognize about the CLO mark this quarter is that it reflects the valuation at the end of May. So that mark-to-market would have declined substantially from what it would have been at the end of February. During that timeframe, valuations fell about 51%. We expect our third quarter mark will be reflected by the end of August. We know CLO valuations have continued to improve through June, so we expect some modest improvement from the second quarter. It's challenging to predict, but we believe we took the bulk of the pain already. Our equity and earnings comprise our investments in CLOs and private market funds, with approximately 75% of that mark from CLOs and 25% from our private equity funds.

And Glenn, I'd just add that our co-investments are all equity, so we inhabit the lowest level in the stack. This means it can fluctuate significantly based on market valuations, and just to highlight, we had about $60 million of investment in CLO equity at the end of May.

Allison, can you provide some insight into the $675 million in expenses? It's positive given the significant market rebound since the last earnings call. Are you considering this a solid comparison for the second half on a quarterly basis? Additionally, you mentioned an evaluation of expenses; does that include streamlining products and other areas to boost organic growth by cutting non-performing products?

Thank you, Brian. Let me start with third-quarter expense guidance. Some of what we've enjoyed so far is temporary in nature, and I don't anticipate that changing in the third quarter in relation to travel or in-person engagements. We're operating in a highly consistent environment in the third quarter; like all of us, we aren't sure when that will change. I would expect marketing expenses, particularly the advertising component, might see a slight increase in third quarter. These expenses can vary quarter-to-quarter, but we are actively in the market with clients virtually, so I anticipate some increase compared to this past quarter. However, overall expenses will likely remain in line quarter-to-quarter. Concerning broader expense reviews, we aren't in a position to make any strategic decisions that may impact revenue at this time. Instead, we are considering all the typical areas for review: organizational efficiency, effectiveness, real estate optimization, technology, and third-party spends.

Okay. Great. And then maybe just the trajectory of flows moving into July in terms of how your combined salesforce is doing. Are you seeing more traction? I know it's still a tough environment, but regarding that institutional pipeline, can you comment on the timing of when some of that may fund? Looking to get a sense of the trajectory of overall flows entering Q3.

Yes, Brian. I'd say we are gaining more traction on the U.S. retail side. It's an improving yet still challenging environment. You could see flows on the ETFs steadily improving within Q2, and through mid- to late July, we've recorded $2.3 billion in positive long-term ETF flows. We believe the overall flow picture will improve relative to the first half. I've mentioned that EMEA and Asia Pac, everything outside the U.S., is currently looking nicely positive.

And can you comment on the timing of the institutional pipeline, specifically with the Solutions?

We feel positively about the timing of this pipeline funding within the next two to three quarters. There has been some slowdown in more traditional real estate funding, as that market is readjusting and we are reassessing certain property valuations. However, other elements of the pipeline, which encompass diverse capabilities such as fixed income and IQS, appear to be on track for funding this year.

One more quick follow-up on the expense guide. As we head into the third quarter against market improvement, why wouldn't we see more pressure on compensation given this market recovery? What is the extent to which there's variable compensation tied to that, or isn't there much of that relationship anymore?

No. It's important to note in our expense guidance, both for the second quarter and moving forward, that was based on market and FX levels at quarter end. If there is variability in market conditions, there will be variability in several expense line items, with compensation being the most significant driver should market improvement occur. We would anticipate those to work in tandem. However, absent any changes, all else being equal, that forms the basis of our expense guidance.

Okay. Great. That's helpful. And then more broadly, there was some chatter over the last month about a new QQQ tracker in a more traditional ETF wrapper that could actually be profitable. Can you speak to how you plan to market that alongside the existing QQQ Trust to talk about the opportunity there? The reason I ask is that current QQQ users may prioritize liquidity, making it challenging to get them to move to something else.

I can comment; would you like me to go ahead? What I can share is that Invesco has had a longstanding relationship with NASDAQ, which is our largest index partnership, overseeing 24 ETFs managed against NASDAQ indices and accounting for over $120 billion in assets. However, we aren't at liberty to delve into specifics about new offerings due to this quiet period. What I can say, though, is that the addition of new funds to the Invesco QQQ suite emphasizes how we are strengthening our relationship with NASDAQ, and more details will be shared later.

The question is on expenses compared to the margin in the second quarter. What drove the outsized decrease in expenses relative to revenues?

The improvement in expenses in Q2 versus Q1 largely stemmed from compensation expenses as average flows improved slightly but remained relatively low compared to expectations. Much of that expense reduction also derived from G&A, and the suspension of travel and in-person engagements significantly contributed to the expense reduction, which we consider temporary although we're uncertain about what 'normal' will look like anymore.

Additionally, I should mention that marketing expenses decreased significantly, from $35 million in Q1 to $16.6 million in Q2, which was a major factor.

Yes, and that includes both advertising and travel-related marketing expenses, which we expect to increase modestly in Q3.

Sorry, my question was regarding the distribution expense. What happened to the relationship between revenues and that expense? Did the net distribution margin improve quarter-over-quarter?

My apologies for not catching that; distribution fees were abnormally low this quarter due to TA waivers and reduced activity from COVID-related impacts. We expect activity and fees to rise slightly in Q3, but they were unusually low in Q2.

As Allison mentioned, while the pipeline has reached record levels, it's primarily driven by solutions efforts and some index capabilities, which typically feature lower fee structures. We have observed persistent interest in lower-fee products from both institutional and retail markets. This trend has been ongoing for years. The actual fee rates for our products remain stable, but client demand increasingly leans toward these lower-fee products.

To reiterate Loren’s point, this trend is indeed consistent with where the demand lies. We've seen outsized demand in fixed income, which naturally involves lower fee dynamics than some globally diversified offerings.

First, Invesco is a major manager of direct real estate and REITs. Can you remind us how big your real estate investment business is? What kind of exposure do you have to retail, hospitality, and other sectors affected by COVID? In your slides, you noted that 24% of your unfunded mandates were in alternatives. How many of these focus on real estate?

In terms of real estate, total AUM is approximately $80 billion. About two-thirds of that is in direct real estate, with the remainder in securities. The pipeline has a good component of real estate, but it doesn't dominate the space. It's a multibillion-dollar element within that $34 billion. The overall business is continuing to perform well through client outreach and adapting to this new environment, and we do not have an overexposure to sectors that are heavily affected by COVID. We do have some funds with greater exposure than others, but overall, we are not positioned on the edge with our exposure to these mandates.

Okay, great. As for other revenue, it’s down; you mentioned lower front-end fees.Can you clarify what drove that? Is there any offset in distribution? Or is it a 100% margin? What is the outlook for this fee component?

The decrease in front-end fees was small, approximately $4 million difference quarter-over-quarter. It's not significant. These fees still flow in but are offset by the distribution pass-through. In terms of other revenue, real estate transaction fees and commission pressures were reflected in the second quarter. We anticipate that this line item remains stable and may modestly improve in the next quarter.

Regarding capital and cash flow, you mentioned your cash level and targeted $1 billion cash reserve. Could you elaborate on your quarterly cash flow, its usages, and your cash flow priorities moving forward?

This quarter, our excess cash amounted to approximately $280 million above our regulatory and liquidity requirements, and we aim to exceed $1 billion in excess cash. We continue to pay down the revolver and build that cash position. Regarding cash flows in any given quarter, our obligations revolve around common and preferred dividends. Beyond that, we are targeting to support our growth, strengthen our balance sheet and return excess cash to shareholders. This entails working towards our $1 billion cash target, reinvesting in business seed capital, and maintaining a sustainable dividend. Right now, we’ve deemed share repurchases as a secondary priority as we aim to deleverage and improve our balance sheet. However, they remain on the table as an option for future consideration. We reduced our revolving credit balance to around $336 million after making significant progress there.

Loren, best of luck. Quick question on Direct Index. Can you provide some insights regarding the pros and cons of this business relative to your existing passive offerings? Will it present opportunities or threats to the active business as a whole?

Yes, I’ll start with a few comments, and Greg may want to add as well. We believe clients are increasingly using a combination of passive, factor-based strategies to construct portfolios. Our capabilities cover these areas and have grown significantly over the years, which is essential as clients consolidate their relationships with fewer managers. This trend is especially pronounced during the pandemic, as clients have been turning to existing relationships for more of their needs. This positioning has proven beneficial.

Building on this point, this context supports our ability to engage clients as they shift their risk budgets. They're increasingly relying on indexing and other strategies for returns, permitting us to deliver comprehensive solutions. The changing client landscape allows for holistic portfolio discussions, creating relevant interactions based on the client's shifting needs.

Wonderful. One last quick question. Just with rates falling globally and capital moving into fixed income, are you seeing any pressure on active fixed income fee rates from Invesco or the broader industry as this translates to the net yield component?

Yes. On an institutional basis, the fee landscape remains highly competitive, with threshold points where it doesn’t make sense to engage. Increasingly, we’re noticing more interest in utilizing index products, which often features lower fees. While active pressures persist, we’re in a position to articulate the advantages of both active and passive management to our clients, responding to evolving client needs.

I realize predicting this is quite challenging. However, Allison, you mentioned that you expect some continued fee rate pressure, labeling it modest. How should we contextualize this? Should we expect it to be less significant than in Q2, or is it in line with recent trends?

Yes, thanks for your question. You are correct; it would not be as significant as it was in Q2 due to the ongoing changes with mix shifts and client demand. It’s complicated to predict, so we wouldn’t want to be overly specific, but we do not foresee decline at the same magnitude as Q2, and we anticipate it to be slightly modest moving forward.

Yes, and we refer to modestly in terms of basis points, not percentages.

Understood. Changing topics a bit, I came across a headline about a portfolio manager who mistakenly botched the rebalancing in the product this quarter. It made me wonder why such a product requires a portfolio manager since it could be automated. Can you explain how that management operates?

Certainly. The title of 'Portfolio Manager' may imply different responsibilities in different contexts. Every product does indeed have a named portfolio manager. However, for automated products, their role is more operational rather than involving active selection. We take client care seriously: we swiftly corrected the fund's impact and the source of the error by moving the operations to our center of excellence for index rebalancing, which has been functioning well without issues.

We've seen positive flows in the institutional channel, but redemptions might be slightly higher than you desire. What are the main drivers for those redemptions, and how should we view the relationship between redemptions and an all-time high backlog for sales?

It's an excellent inquiry. When we look at terminations, we actually see much lower numbers compared to historical averages, indicating our reduced overall redemption rate. We're not experiencing large spikes, and redemptions have generally remained consistent with recent market dynamics. Many cancellations have been good performers, and there's not a significant pattern at work; situations often arise out of clients' financial circumstances rather than performance-related concerns.

Could you elaborate on any additional free cash flow needs over the next 12 months? This includes dividends and forward purchase liabilities that may create cash demand? Any lingering issues related to MLP calculations would also be insightful.

Sure. Our remaining obligation on forward purchases stands at about $242 million. This figure fluctuates quarterly based on stock price and will be fully settled by April next year. Regarding cash flow, we don’t expect any significant obligations related to MLP decisions until later in '21.

Okay. Again, thank you, everybody, for joining us. Thanks for your questions and the dialogue, and we'll talk with you soon. Have a good rest of the day.