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Franklin Resources (NYSE:BEN)

Q1 2014 Pre Recorded Earnings Call

January 30, 2014 12:00 am ET

Executives

Gregory Eugene Johnson - Chairman, Chief Executive Officer, President and Member of Special Equity Awards Committee

Kenneth Allan Lewis - Chief Financial Officer, Principal Accounting officer and Executive Vice President

Operator

Welcome to Franklin Resources earnings commentary for the quarter ended December 31, 2013. Statements made in this commentary regarding Franklin Resources Inc., which are not historical facts, are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

These forward-looking statements involve a number of known and unknown risks, uncertainties and other important factors that could cause actual results to differ materially from any future results expressed or implied by such forward-looking statements. These and other risks, uncertainties and other important factors are described in more detail in Franklin's recent filings with the Securities and Exchange Commission, including in the Risk Factors and MD&A sections of Franklin's most recent Form 10-K and 10-Q filings.

This commentary was prerecorded.

Gregory Eugene Johnson

Hello, and thank you for taking the time to join us today. I'm Greg Johnson, CEO, and I'm joined by Ken Lewis, our CFO. Fiscal year started on a positive note for us as assets under management grew to almost $880 billion by quarter end and translated into a very strong quarter of operating results. We reached new highs for revenue, operating income and earnings per share.

Importantly, long-term investment performance remained strong across equity and fixed-income strategies, with the majority of our U.S. registered and cross-border mutual funds ranked in the top half of their respected peer groups. We continue to believe that our broad and diversified global investment capabilities position us well for the current environment, and that is evident in our flows this quarter. Equity and hybrid products had their strongest quarter of net new flows since '07, attracting $6.7 billion. This quarter also marked an important milestone for the integration of K2, as we launched our first liquid alternatives mutual fund for U.S. retail investors.

Turning to Slide 6, on investment performance. You will notice that we enhanced the disclosure to now include our cross-border mutual funds, which are sold internationally in addition to our U.S. registered mutual funds. Combined, they represent over 2/3 of assets under management and the bulk of our retail business. As you can see from this slide, long-term investment performance remained strong, and I would note that our key global equity hybrid and global fixed-income strategies continue to have outstanding performance.

Franklin Income Fund represents 14% of the total and 28% of the equity hybrid assets for the 1-year period. The fund ranked in the 51st percentile at 12/31 for the 1-year period, down from the 45th percentile at 9/30. The fund's traditional weighting in utilities, which have underperformed as of late, was a drag on relative performance.

Ending assets under management continues to increase with assets ending the quarter at an all-time high of $879 billion, an increase of 4% for the quarter and 12% for the year. Average assets under management was up 5% for the quarter at $866 billion. Our mix of AUM by investment objective continues to be well-balanced with a roughly 50-50 split between equity and fixed income, if you split hybrid assets. This diversification provides our clients with a number of attractive investment options for all market cycles. The mix of AUM by sales region was essentially unchanged over the prior quarter as AUM increased about equally across all regions with the exception of Latin America.

Moving onto flows on Slide 10. Long-term net new flows improved modestly this quarter, reflecting both slowing redemptions and increased sales over the prior year quarter. This was an improvement from the last quarter. This quarter, we saw equity and hybrid inflows offset lower fixed-income outflows. Across the industry, investor concerns over higher interest rates have been driving assets out of more traditional core fixed-income products and into income-oriented equity strategies and a variety of nontraditional and unconstrained bond funds. Our flows have generally mimicked these trends with clients rotating into less interest-rate sensitive high-yield and nontraditional fixed-income products, as well as equity and hybrid funds. In fact, much of the exchange activity we saw this quarter was consistent with that trend.

Market appreciation was $36 billion, positive across all investment objectives.

This quarter, we continued to see a shift in retail demand from traditional fixed income to equity hybrid and nontraditional fixed-income products. However, our retail business remained in outflows.

In the U.S., this was largely a result of continued outflows in the tax-free, fixed-income market. Internationally, outflows were driven by global fixed-income funds in the European sales region, where investors there are reallocating their global fixed-income holdings in favor of our European and U.S. equity strategies.

Our institutional business, on the other hand, has fared well in both the U.S. and internationally, and offset the net outflows we saw in our retail funds this quarter. Led by $1 billion local equity mandate in Australia, we saw approximately $3 billion of net sales into our institutional business this quarter. These flows were primarily in global equity and global fixed-income strategies, and the pipeline for both mandates remains strong.

We continue to expand our product range and capabilities to meet investor demand and industry trends in both retail and institutional markets. Our global reach continues to expand with a number of new regional opportunities developing. In the Philippines, we received regulatory approval to launch 2 new funds, and we continue to see demand for Islamic finance and Shariah-compliant funds. Regulatory changes in China have opened new doors for foreign asset managers who are now allowed to manage money for insurance companies.

Additionally, Hong Kong is in the final stretch of talks China on a mutual recognition initiative, which will enable cross-border sales in these countries. In response to this, we have begun the development of the Templeton Asian Income and the Templeton Global Funds, which will be domiciled in Hong Kong and sold in both countries.

Developments in Latin America this quarter include the launch of a local feeder of Franklin Mutual Global Discovery Fund in Brazil and a Mexican bank selected Franklin Templeton Mexico to manage part of their European equity strategy. This is a great example of the success of our local asset management business this quarter, which garnered $2.6 billion in net new flows led by our teams in Europe, Australia and Canada.

Although overall net new flows are essentially flat this quarter, we have begun to see significant traction on equity flows in both the U.S. and internationally. Global Equity net new flows increased to $3.1 billion due mostly to a 21% increase in sales. This was driven by increased demand internationally for European equities, and we have seen strong net inflows into our cross-border SICAV versions of the Franklin European Growth Fund and Franklin Mutual European Funds, in particular.

Given the macro environment in emerging markets, it's not surprising that we've seen outflows from key emerging markets' products. The Templeton Asian Growth Fund, for example, has suffered from a period of underperformance. We've taken action to keep clients informed about our positioning and delivered an external prospectus piece supporting portfolio management's conviction to the countries and sectors where these funds are more heavily weighted.

The global fixed-income category, as a whole, is in outflows this quarter, but the U.S. versions of the Templeton Global Bond Fund and Total Return Funds had positive flows. Although these funds are labeled as traditional global funds, they are unconstrained from a sector, geography, interest rate and currency perspective.

We tend to see international sales be more reactive to global events, like the Fed tapering, and are not surprised by the outflows of the cross-border versions of these products. On the flip side, these flows are typically quick to return when things stabilize.

We also continue to see strong flows into hybrid funds with the Franklin Income Fund remaining the top-selling fund overall this quarter. Additionally, the Templeton Global Balanced Fund, which combines global fixed income and global equity, remains popular and is proven to be an effective vehicle for global fixed income investors to reenter the global equity markets.

Moving on to U.S. equity. Long-term sales were up 11% this quarter, following strong returns in the U.S. equity markets over the past year. In the U.S., the Franklin Rising Dividends Fund remains a top-selling fund in this category as investors continue to search for income. We also saw growth in funds popular among 401(k) sponsors in the U.S., like the Franklin Growth Fund. Internationally, U.S. equity also sold well with strong flows coming into a variety of cross-border products.

Tax-free fixed income still experienced outflows. However, we are starting to see signs of this market stabilizing. Redemptions are slowing and net outflows have been on the decline. But generally, higher leaves available on municipal bonds at year end may entice more investors who've been sitting on the sidelines waiting for higher yield potential. Additionally, higher taxes can make the tax exemption of municipal bonds more appealing.

U.S. taxable fixed-income flows declined this quarter in line with the industry flow trends out of traditional fixed income that I mentioned earlier. However, nontraditional products within this category have been garnering increased net new flows.

And now ken will discuss operating results.

Kenneth Allan Lewis

Thanks, Greg. I'm happy to report a strong quarter of operating results. To begin, the fiscal year with revenue, operating income and earnings per share once again reaching new highs as a result of the growth of assets under management and our cost-conscious culture.

Operating income for the quarter was $813 million, which is up 11% over the prior quarter and 19% from the prior year, outpacing the growth in assets under management over those periods.

Net income was $604 million, a 19% increase from the prior year quarter and 17% from the prior year. And earnings per share was $0.96, up 20% since the fourth quarter and 19% from the prior year, outpacing the increase in net income due to our stock repurchase program that has steadily decreased shares outstanding over time.

Total revenue for the quarter exceeded $2.1 billion for the first time, an increase of 6% from the prior quarter. The increase in average assets under management was the primary driver of the increase in revenue. However, I would like to quickly remind everybody that last quarter's accounting adjustment obviously impacted the quarter-to-quarter comparisons as well.

Investment management fees increased 7%, due mainly to increased average assets under management as well as above-average performance fees of $26 million, with the majority of that coming from K2 products.

Sales and distribution fees were about $637 million this quarter, reflecting an increase in the asset base component, which makes up about 2/3 of this line; and increased fees from commissionable sales, which were roughly 12% of long-term sales this quarter.

Total operating expenses increased 4% this quarter, with all but the sales, distribution and marketing expense line flat, were down from the fourth quarter. Sales distribution and marketing expense increased 8%, mostly due to last quarter's accounting adjustment, but also from the increase in the related revenues.

Compensation and benefits expense was flat from last quarter, as increased salaries and wages were offset by lower variable compensation. We do expect the typical seasonal increase in this expense line next quarter as payroll taxes resume and we get the full impact of merit increases that took effect in December. In fact, last year's seasonal increase is probably a reasonable indicator of what to expect this year.

Information systems and technology decreased by a seasonal 14%, but we expect this expense to exhibit a similar pattern to last year.

Occupancy and general administration and other expenses both decreased slightly. G&A tends to be more difficult to predict due to the variability of several components, but the current level looks like a pretty good run rate going forward.

Now that implies a larger annual increase than I guided to last quarter, however, it is primarily the result of a recent pricing structure change in Canada. This change includes the bundling of investment management, servicing and administration fees together, which we believe will make our products more competitive in that market, and importantly, is not expected to have a material impact in operating income.

It will, however, change how we record the related revenues and expenses. Essentially, investment management fees will increase by about 120 basis points next quarter with shareholder servicing fees decreasing by about 2/3 of that increase in dollar terms.

General and administrative expense will increase as well to offset the remainder of the net increase in revenue.

So a few moving parts, and I know I went through that quickly, so please review the additional information contained in our quarterly filing and contact Investor Relations if you need further clarification.

Other income, net of noncontrolling interest, was $48 million this quarter. As illustrated on Slide 19, equity method investments and realized gains on the sale of available-for-sale investments contributed the most to this quarter's other income gains. Equity method investments typically follow the direction of equity markets due to the nature of the assets.

Realized gains from available-for-sale investments will result to pruning or liquidating over 30 seed investments during the quarter, as we've reallocated that capital to other products such as the K2 alternative fund launched in November.

The tax rate for the fiscal year-to-date period was 29.8%, a bit higher than we projected at the end of the fiscal year, and that was due to a mix shift in earnings toward higher tax jurisdictions and the impact of losses from noncontrolling interest on the calculated rate.

The GAAP operating margin for the quarter was 38.5%, as we benefited from some seasonally lower expenses and the growth of assets under management this quarter.

As a reminder, the March quarter tends to be a tougher quarter for margins as we have 2 fewer days to earn revenue and, generally, seasonally higher expenses.

And moving onto Capital Management on Slide 23 (sic) [Slide 22], during the quarter, we repurchased 2.5 million shares, which more than offset issuance related to long-term compensation awards, and the board increased the regular quarterly dividend by 20%.

The payout ratio for the trailing 12 months was 36% of net income, or roughly $800 million. The decrease from September was primarily due to last year's special dividend rolling off. This is below our recent historical average payout ratio, but it does not reflect a change in our approach to capital management.

We remain committed to returning available U.S. cash flow to shareholders via a combination of cash dividends and share repurchases. And I think our track record speaks for itself, as we have returned over $6 billion to shareholders over the last 5 years. Our cash dividend has continued to grow at a rapid pace for several decades now, and we have continued to systematically reduce our share count over time with regular repurchases supplemented by opportunistic accelerations of our program activity.

That concludes our commentary on first quarter results. Please see our Form 10-Q that was also filed today for additional information or contact Investor Relations if you need any clarification of our comments. Thank you.

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