Franklin: Global Footprint Favorable but Regulation Could Mar Growth, Raise Costs

Jul. 7.11 | About: Franklin Resources (BEN)

We have downgraded our recommendation on Franklin Resources Inc. (NYSE:BEN) to Neutral from Outperform apprehending costly regulatory issues in a volatile economic environment.

However, Franklin’s second-quarter 2011 earnings of $2.25 per share outpaced the Zacks Consensus Estimate of $2.00 per share. Results reflected robust growth in revenue and higher AUM, partially offset by increased operating expenses. Moreover, the results were ahead of earnings of $1.55 per share in the prior-year quarter and $2.23 per share in the prior quarter.

Earlier in June, Franklin reported preliminary AUM of $735.8 billion at its subsidiaries for May. Results were up 0.4% from $733.1 billion as of April 30, 2011 and 28.5% from $572.7 billion as of May 31, 2010.

Franklin’s closest competitor - Invesco Ltd. (NYSE:IVZ) reported preliminary AUM of $661.4 billion for May 2011, slipping 1.1% from $668.6 billion in April 2011. The decrease in AUM was mainly attributable to net outflows principally in the PowerShares QQQ exchange traded funds (ETFs), negative foreign exchange and negative market returns.

During the first half of fiscal 2011, market returns improved as the global economy continued to proceed toward recovery. Global markets showed signs of stabilization and the recovery in the markets appreciably benefited Franklin’s AUM, fee revenue and non-operating income. We expect the company to continue to benefit from the economic recovery.

Franklin is growing strategically and expanding its foothold. During the first half of fiscal 2011, the company entered into a new strategic relationship with (Telegis) Capital Management, acquiring a 20% equity stake. This company’s experience in commodities, managed futures and hedge fund replication ideally balances the existing alternative offerings of Franklin.

Furthermore, Franklin completed the acquisition of Rensburg Fund Management, a U.K. equity specialist, with approximately $1.5 billion in AUM in January 2011. The Rensburg acquisition allows the company to diversify product offerings in key markets. Moreover, Franklin’s planned acquisition of Balanced Equity Management in June 2011 aims to mark its presence in the Australian market by providing best investment options for satisfying local investors' needs. Therefore, we expect Franklin to benefit from the growth potential of these transactions.

Franklinstands strong from a balance sheet perspective. The company has been able to generate positive cash flow even in an increasingly difficult operating environment. The company remains in compliance with the requirements of regulatory ratios. For the past six years, it has been increasing its dividend. The company enhanced shareholders’ value by returning over $5 billion to shareholders through dividends and repurchases in the past four years, including $1.5 billion in 2010.

On the flip side, Franklin is increasing focus on international markets for investment products has led to increased exchange rate and other risks in connection with earnings and income generated overseas. Moreover, Franklin’s investment management and related services are subject to wide and intricate, overlapping and frequently changing rules, regulations and legal interpretations in the countries in which it operates. Although the financial markets continued to improve during the first half of fiscal 2011, the business and regulatory environments remain uncertain and subject to change.

However, consolidation in the financial services industry has created stronger competitors for the company, who possess better-quality financial resources and broader distribution channels. New product offerings from tough competitors could decrease sales of products, potentially resulting in market share decline, revenue and net income.

Therefore, Franklin invests in advertising and promotion due to address changing business conditions for developing products and potential new growth opportunities. As a result of potential changes in strategic marketing campaigns, the level of advertising and promotion expenditures may increase more rapidly than revenue.

Overall, Franklin's global footprint is an exceptionally favorable strategic attribute, since its AUM is well diversified. Moreover, a strong balance sheet and recently completed acquisitions are expected to strengthen the financials of the company. However, the regulatory restrictions could mar the AUM growth and increase its costs.

Franklin currently retains a Zacks #3 Rank, which translates into a short-term ‘Hold’ rating.