Franklin Resources, Inc. (NYSE:BEN)
F3Q 2014 Pre Recorded Earnings Conference Call
July 30, 2014 08:30 ET
Greg Johnson - Chief Executive Officer
Ken Lewis - Chief Financial Officer
Welcome to Franklin Resources Earnings Commentary for the quarter ended June 30, 2014. 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 pre-recorded.
Greg Johnson - Chief Executive Officer
Hello and thank you for listening to our third quarter earnings commentary. I am Greg Johnson, CEO and I am joined by Ken Lewis, our CFO. There are number of positive developments during the quarter, but most importantly, long-term relative investment performance of U.S. and cross-border funds remains strong across equity, hybrid and fixed income strategies.
Assets under management ended the quarter at over $920 billion, a new high for the company and a 13% increase from the prior year. Long-term net new flows rebounded to $2.5 billion highlighted by strong flows into hybrid strategies and a return to positive flows into fixed income. Profitability remains strong with year-to-date operating margin near 38%. Cumulative share repurchases and dividends for the trailing 12 months period was $1 billion, roughly approximating after-tax net cash flow to the U.S. parent company.
As illustrated on Slide 6, relative investment performance of our U.S. retail and cross-border funds is strong with the majority of assets in the top two Lipper or Morningstar quartiles across all standard time periods. It’s worth noting that our various hybrid funds that have been attracting strong flows continue to have exceptional long-term performance. In fact, Franklin Income Fund has top decile performance over all of these time periods and was recently awarded a five-star rating by Morningstar. The cross-border version of the fund has performed just as well. Ending and average assets under management rose again this quarter, increasing about 4% and 3% respectively. Assets under management remain well-diversified by investment objectives, sales region and client type, with the mix of assets essentially unchanged from last quarter, but we are gradually seeing a shift toward equity and hybrid products, as well as to the U.S. sales region.
Not shown in this slide is the breakdown by client type, which remains approximately three quarters retail. Our diversified asset base allows our clients to build diversified portfolios within our fund family and has historically enabled us to weather tough macro environments that caused certain strategies to temporarily fall out of paper. This quarter was no exception, as flows benefited from the diversification of our asset base, gaining further traction with various targeted, global and regional sales and marketing campaigns. Industry wide, retail and institutional sales slowed from the March quarter. Equity was the hardest hit. However, fixed income flows had a strong rebound as sales picked up and redemptions eased.
Our flows generally mirrored these trends as long-term sales decreased slightly to $47.5 billion, within the average range we have seen for the past several years. But importantly, redemptions slowed significantly to $45 billion, their lowest level in over a year. This quarter we saw traditional fixed income flows remain neutral and some relative flow weakness in equities, but the appetite for hybrid remains strong and global fixed income strategies return to positive flows. The latter two are areas of emphasis for newer campaigns that were rolled out earlier in the year. Those campaigns are intended to support financial advisors with client discussions and highlight relevant Franklin Templeton Funds. An example of this is our income for What’s Next campaign, which is a retirement focused campaign to prepare investors for income generation during retirement. Products highlighted included the Franklin Income Fund, Rising Dividends Fund, Global Bond Fund, and Federal Tax-Free Income Fund.
Moving to Slide 11, we enhanced the regional flow disclosure to provide more transparency on flow trends by retail and institutional channels within each region. Retail flows returned to positive territory this quarter following three consecutive quarters of outflows. However, international retail remained in net redemptions predominantly fueled by Europe. With that said, Europe’s retail redemptions declined by 40% and were a big contributor to our improved net new flows this quarter. In the U.S., retail flows improved resulting in its best flow quarter since March 2013. Even with muni bonds continuing to be a drag on flows.
Institutional flows improved this quarter, led by global fixed income, where we saw the most interest in our global multi-sector plus strategies. However, global equities continue to experience outflows, due primarily to a few lumpy redemptions totaling $1.5 billion. This quarter we also saw interest in our emerging market capabilities where we had notable fundings in Malaysian equity and Thai equity accounts. The pipeline of unfunded committed wins look strong for the fourth quarter, as we are seeing demand for emerging market debt and global bond plus strategies and we anticipate three larger than average $1 billion plus mandates to fund during this quarter or next.
Moving to flows by investment objective, global fixed income improved significantly over the prior quarter with $1.4 billion in net new flows. Strength in the quarter came from emerging market bond institutional demand for global multi-sector plus and strategies, managed by our local asset management teams in India, Korea and the MENA region. The cross border, Templeton Global Bond and total return funds remained in outflows, but both experienced increased sales and lower redemptions. The U.S. registered versions were essentially breakeven again, with net new flows of less than $100 million. In fact, all told, the global bond team realized essentially breakeven flows for the quarter.
Our sales and marketing teams continue to focus and educating clients on the funds, and why they are well-suited for today’s fixed income landscape. On the global equity side flows were still slightly negative, but it’s worth mentioning that we are seeing a significant recovery in our emerging markets equity products, which drove the outflows last quarter and came to close to breaking even this quarter. U.S. and cross-border versions of the Templeton Asian Growth Fund, in particular are recovering with significant declines in redemptions over the prior two quarters.
Global Equity Strategies, managed by our local asset management teams continue to be a bright spot and two of the best flowing products this quarter were cross-border funds managed by our European and Indian equity teams. In some instances we have been able to successfully export local management expertise for our cross-border funds, which is a nice way for us to build scale in those teams. As investors re-risk towards equity, we have primarily seen flows into our various hybrid strategies as we are actively promoting our balance funds as a way to diversify investors from fixed income into equity, without fully committing to an equity fund.
It’s no coincidence that Franklin Income Fund, which drew net new flows are approximately $1.4 billion was our best selling product this quarter. Over the past year, we have also seen a steady increase in demand for the cross-border version of the fund, which recorded organic growth over 90% this quarter and had over $3.6 billion of assets at June 30. It took this fund roughly 12 years to reach $1 billion, and only about three more to add an additional $2.5 billion.
We are also seeing strong traction with our Templeton Global Balance Fund for U.S. investors and the cross-border equivalent, Templeton Global Income Fund, which were both launched in 2005, and combine the expertise of our Templeton Global Equity and Global Bond Teams. These funds are top quartile performance over almost all time periods, and have combined for better than 70% pre-market organic growth year-to-date. These funds have appealed to investors looking to diversify away from global fixed income. As we have seen exchanges as well as new money coming into the funds, which have nearly tripled in AUM in the last two years to a combined $4.8 billion as of June. U.S. equity, on the other hand, had modest outflows, along with the rest of the industry. Our Franklin Small Cap Growth and Franklin Rising Dividend Funds with the top flow gainers, but a pullback for our cross-border biotech discovery and U.S. opportunities funds contributed to the variance from last quarter.
Moving on to domestic fixed income on Slide 14, flows into our municipal bonds are trending towards breakeven, with just $400 million in outflows this quarter. Despite the industry continuing to see positive net new flows since January, our focus on the longer duration investor has slowed our turnaround because investors generally remain more interested in short and intermediate term funds. While longer term we expect this recovery to fully play out ongoing headline risk around Puerto Rico may continue to affect these flows over the shorter term. With that being said several key funds within this category have turned positive, primarily those with short to intermediate duration.
U.S. taxable fixed income net new flows remained slightly positive at $200 million with inflows into high yield and floating rate products more than offsetting the outflows for more traditional fixed income strategies. We continue to execute on strategic initiatives such as international growth, and positioning ourselves to capture retirement assets. This past quarter, we held a retirement plan adviser symposium for defined contribution investment only advisers and well attended client conferences in the U.S. and Asia, which gave us the opportunity to showcase our capabilities. For example, the forum we hosted in New York was attended by a 170 institutional clients, consultants, research professionals and plan sponsors representing approximately 30% of our AUM. That event also allowed us to efficiently leverage the time of many of our senior portfolio managers and business leaders while hosting our first Investor Day, which we hope enhanced your understanding of the Franklin Templeton story.
I will now turn it over to Ken for financial results.
Ken Lewis - Chief Financial Officer
Thanks, Greg. Operating income for the quarter was $787 million, which was a slight increase from last quarter due to a number of factors, which I will go into shortly. Net income increased to $579 million, a 3% increase from last quarter due primarily to increased other income and earnings per share was $0.92 also a 3% increase. Total revenue of $2.13 billion is an all-time high and a 2% increase from last quarter. Investment management fees and the asset-based component of sales and distribution fees benefited from higher average assets under management and the additional day in the quarter.
The increase in investment management fees from last quarter was below the pace of average assets under management growth due to a slight shift in the mix towards lower fee products. The mix of assets under management has been trending towards hybrid, institutional and U.S. registered global fixed income funds and away from emerging markets, which has yielded a slightly lower effective fee rate of around 62 basis points excluding performance fees. Sales and distribution fees increased 1% as the increase in the asset-based component was partially offset by lower cross-border sales.
Shareholder servicing fees increased 2%, consistent with the increase in billable shareholder accounts. As you may recall from previous years, Canada typically purged closed billable accounts in the third quarter, but the switch to a bundled fee this year means that they are no longer charging shareholder servicing fees. The purge of closed U.S. accounts occurred in July and 1.2 million accounts were removed, which will be reflected in the financial results next quarter.
Operating expenses increased 3% with most of the increase coming from the asset-based component of sales, distribution and marketing expense, which included non-recurring items of about $12.2 million, which if excluded, would have resulted in a 1% increase, in line with the revenue increase. Compensation and benefits expense was $380.7 million, primarily reflecting increased variable compensation due to increased operating income. Also included in variable compensation is the mark-to-market of long-term mutual fund awards for investment professionals.
Information systems and technology expense was $54.3 million, an increase of 6%, as some of the typical fourth quarter seasonality was realized this quarter. Occupancy and general and administrative expenses were little changed from the previous quarter. So, looking ahead to the first quarter, we anticipate meeting the 4% to 5% of year-over-year expense growth I guided to last fall though expectations for some specific line items have changed. Our current expectations are for compensation and benefits to more or less be flat next quarter. Technology, occupancy and general and administrative expenses combined should increase somewhat.
Turning to Slide 19, on operating leverage, fiscal year-to-date operating income was almost $2.4 billion and the operating margin was 37.7%. As I stated in my comments at our Investor Day in May, we do not run the business to meet a margin goal, partly because the accounting for sales and distribution expenses can have a significant effect on GAAP margins. Our focus is on delivering operating income growth, which is tended to lead to margin expansion over time. Other income net was $96.7 million this quarter, but as you can see on Slide 19, it included substantial gains from consolidated sponsored investment products, which were offset by non-controlling interests. So therefore, better way to look at other income is net of non-controlling interests, which was $52.4 million.
The primary contributor to other income was equity method investment gains of $34 million, which was reflective of a strong global equity market this quarter. The tax rate came in lower than expectations at 28.5% for the quarter and 29.4% for the fiscal year period, but that is partly a function of pre-tax income being inflated by non-controlling interest and consolidated sponsored investment products. If not for that noise, the rate would have been in the 29.5% to 30% range we expect.
Moving on to capital management, we updated the slides this quarter to augment our discussion of capital management. During the quarter, we repurchased 2.4 million shares, continuing our track record as a net buyer of our stock, which has steadily decreased shares outstanding and added roughly 2% average accretion per year. The new chart on the bottom of Slide 22 illustrates our five year historical share repurchase activity and although the pace of repurchases did slow during last fiscal year, this was largely due to the large special dividend of $640 million we paid at the beginning of that period. We have remained consistent buyers of our stock and have accelerated the pace of repurchases when market pullbacks offer better opportunities, such as in 2011 and the September 2013 quarter.
The good news and bad news here is that there have been few if any material debts to buy over the past year or two. In fact, the S&P 500 hasn’t suffered an official correction in over 1,000 trading days and counting. The last correction occurred roughly 34 months ago, which is a long time when you consider that corrections have occurred on average about every 18 months. Slide 23, is an updated view on capital return, but rather than focus on payout ratio of net income, it focuses on actual cash distributed through dividends and share repurchases. We believe this is a better way to look at it, because the payout ratio is based on net income which is not adjusted for foreign earnings, particularly when compared to peers that have not scaled their foreign operations like we have.
That said we did include the payout ratios for dividends and repurchases on the chart for reference. Over the trailing 12 months, we distributed $1 billion, primarily through share repurchases. While feedback expressed by our fellow shareholders is pointing to a variety of preferences one common thread has been a request to distribute as much available cash flow as possible, without unnecessarily triggering tax on undistributed foreign sourced earnings. And that has actually been our practice for many years. Though the pace of distributions has been below that of a year ago, we remain committed to returning U.S. free cash flow to shareholders over the near to intermediate term.
Turning to Slide 24, we have updated the net cash and investments chart to include a breakdown of U.S. and non-U.S. net cash and investments for the prior fiscal year end periods. While we do believe in the benefits of having a strong balance sheet, the growth in net cash and investments has primarily been offshore. Total net cash and investments was $8.8 billion at the end of the quarter.
To illustrate the fact, that we have historically distributed essentially all of U.S. generated cash flow, this slide shows that net cash investments in the U.S. has averaged about $1 billion over the period shown in this chart. And the reason that we have not shown the breakdown at quarter end, even though it’s included in our filing, is that we did not want to complicate the message by discussing the seasonal adjustments required to account for intra-fiscal year cash flow timing differences. That being said, we would expect our U.S. cash investment balance to be a little higher at the end of this fiscal year, due to some large seed capital investments that we made in 2014 like in the new Franklin K2 Alternative Strategies Fund. Our goal is not to grow the balance sheet, though we are optimistic that fundamental corporate tax reform will eventually occur.
That concludes our prepared remarks and we look forward to the live call later this morning.
[No Q&A session for this event]
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