Gregory Johnson - Chief Executive Officer, President, and Director
Kenneth Lewis - Chief Financial Officer and Executive Vice President
Franklin Resources (BEN) Q3 2011 Earnings Call August 2, 2011 8:30 AM ET
Welcome to the Franklin Resources Inc. Third Quarter Earnings Commentary. This recording will be available until September 1, 2011, 11:59 p.m. Pacific Time [Operator Instructions].
Welcome to Franklin Resources earnings commentary for the quarter ended June 30, 2011. 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 filing. This commentary was pre-recorded.
Hello, and welcome to the third quarter earnings commentary. I'm Greg Johnson, CEO; along with Ken Lewis, our CFO. We're pleased to be reporting another very strong quarter of operating results amidst what remains a volatile macroeconomic environment. Most importantly, long-term investment performance remains strong across equity and fixed-income strategies, and areas that have been underperforming in the short term have improved.
Performance, coupled with the depth and breadth of our global advisor relationships, translated into another quarter of record net flows led by the continued strength of our global fixed income franchise. We continue to execute on our long-term strategy of investing in those areas that are complementary to our existing business and strengthen our capabilities in key markets.
During the quarter, we announced the acquisition of Balanced Equity Management, a well-respected institutional manager in Australia. The acquisition closed in early July and is consistent with our strategy to address home country investing buys with local asset management capabilities in key international markets.
Assets under management ended the quarter at $734 billion, slightly below May's reported high due to the June pullback in equity markets. Average AUM increased almost 6% to $727 billion. The strength of fixed income flows combined with the pullback in equity markets in June caused a slight mix shift in AUM by investment objective, away from equities towards fixed income. The overall attribution of AUM by sales region was essentially unchanged from March, but Europe and Asia continue to be the fastest-growing regions for us, thanks to continued success in countries such as Italy, Switzerland and Taiwan.
Turning to Slide 8. Net new flows outpaced market appreciation for the second time in the last 5 quarters. Long-term sales reached a new high as well this quarter, but the decrease in redemptions was the key driver of improved net new flows. Redemptions had been running higher the past 2 quarters due to some larger-than-normal institutional redemption activity that we've discussed on previous calls.
Long-term sales were strong in both the U.S. and internationally. While the Templeton Global Bond Fund remains our best-selling fund in the U.S. and abroad, our global total return fund continues to gain momentum with over $5 billion of net new flows this quarter from the U.S. and SICAV funds. In addition, this quarter we saw further diversification of global fixed income flows from emerging markets debt in Asian bond funds, attracting a combined $1 billion of net new flows.
In the U.S., redemptions from our municipal bond funds slowed throughout the quarter. Net new outflows totaled $900 million compared to a peak of $3.5 billion in the prior quarter, with a few funds returning to positive flows. We continue to actively communicate our perspective on the muni market to financial advisors to help them allay investor concerns, and our straight-talk, client-used muni brain chart has been one of our most viewed ever.
Our U.S. institutional business continued the trend of net positive new flows with several new fundings in global equity mandates. More recently, the team is focused on promoting alternative strategies with roadshows highlighting private equity strategies managed by the global fixed income and emerging markets equity team, as well as hosting a well-received emerging markets real estate roundtable in Chicago.
Our international business continues to generate impressive growth and our SICAV range of funds approached $150 billion in AUM at quarter end. As I mentioned earlier, we continue to have success across Europe and Asia and believe that our global presence will continue to be a key driver of future growth.
One of those success stories has been Malaysia, with $2 billion in AUM, and almost 1/3 of that coming from Shariah investments for Islamic investors. It's been one of our fastest-growing countries, nearly tripling in the past year. We plan to add 3 Shariah funds to our SICAV range in the near future and will register some of our SICAV funds in Malaysia, where the retail market has recently been opened to foreign asset managers.
Turning to Slide 10. Overall equity outflows slowed during the quarter. However, flows were positive in April and May before reversing course in June, as the market pulled back and the industry experienced increased redemptions. Long-term sales of both global and U.S. equity funds declined due to market volatility, but redemptions from global equity had a much more significant decrease from last quarter, when we had a spike in institutional redemptions from sovereign wealth clients of near $5 billion.
In addition, the profit taking we saw last quarter from the Asian Growth Fund reversed and that funded strong positive net new flows for this quarter. U.S. equity funds saw a modest increase in redemption activity, but funds that have been attracting flows such as the Franklin growth, rising dividends and U.S. opportunities remained in inflows, although at a slower pace.
We continue to promote the value of long-term investment and equity funds to financial advisors through the GLOBAL - THE NEW CORE theme, which is an extension of our 2020 Vision campaign. Hybrid net new flows were $1.6 billion, a bit of a decrease from last quarter as we did see a slowing of flows to the Franklin Income Fund that attracted $800 million in net new flows between the U.S. and SICAV funds.
In April, we launched a new balance strategy to leverage the strengths of our global fixed income and emerging market teams. The Templeton Emerging Markets balanced fund was added to our SICAV lineup and is co-managed by Dr. Michael Hassenstub and Dr. Mark Mobius. Core fixed income flows continue to be very strong with net new flows of $20 billion, as I already explained.
Overall, relative investment performance remains strong, and we saw improvement in the percent of assets in the top 2 quartiles across all the periods. The most significant change from the last quarter was the relative performance of the 5-year period, due mostly to Templeton growth and mutual shares performance improvements. Short-term performance from mutual series in our muni funds remain under pressure. However, both have experienced improving performance in recent months.
I'll now turn it over to Ken for operating results.
Thank you, Greg. The strength of the company continues to be reflected in operating results this quarter. Operating income for the quarter was $683 million, which was an 8% increase from the second quarter and a 31% increase from the prior year. Net income for the quarter was flat from quarter 2 at $503 million, but earnings per share increased slightly to $2.26. And our share repurchase program continues to enhance our earnings growth on a per share basis by driving the share count down over time.
Investment management fees increased 6% this quarter, slightly more than the increase in average assets under management due to 1 more day and $1.7 million of additional performance fees. This was partially offset by slightly lower effective fee rate that was due to 2 factors: The first was a slight mix shift to fixed income and no change in sales region mix this quarter that Greg highlighted earlier; and the second was that daily average assets under management, which most of our fees are calculated on, was a bit lower than the simple monthly average assets under management for the quarter.
Looking forward, I want to remind everybody that we did close on Balance Equity Management acquisition in early July, and their assets under management do have a materially lower effective fee rate than the mix we've reported today due to the size and nature of their client accounts. And that acquisition will have a small impact on the reported effective fee rate going forward.
Additionally in July, Darby's emerging market fund sold its most successful private equity investments to date, returning more than 15x its original investment. And in conjunction with this sale, we now expect to earn about $48 million in carried interest, which will be split between Franklin and the team, which is consistent with industry practices, and that will drive both performance fees and compensation and general and administrative expenses higher next quarter.
Sales and distribution fees increased 6%, consistent with the increase in average assets under management and with sales. The asset base fee that comprises 69% of this line item increased almost 7% due to increased average assets under management and the one additional day in the quarter. Sales component increased 4.5% due to the increase in commissionable gross sales that made up 11% of total sales.
Shareholder servicing fees were $77.5 million, an increase of 2%, which is less than the increase in billable accounts. Two things contribute to that: First, with the normal mix shift between open and closed accounts that we experienced throughout the year; and second is what we've experienced a number of conversions to omnibus accounts that earn lower fees. During the quarter, we purchased 272,000 Canadian closed accounts and in July, we purchased 2.2 million U.S. accounts that will be reflected in the fourth quarter results.
Other net revenue increased $2.4 million this quarter due mostly to increased investment income from consolidated sponsored investment products. Operating expenses increased 4%, which is less than the 6% increase in revenue. Sales, distribution and marketing expense increased 6%, about 70% of this expense is driven by changes in assets under management, with just over half coming from outside the United States. The asset base component increased 7% to $505 million, and the sales base component also increased 7% to $177 million. The amortization of deferred sales commission decreased 7% to about $38 million.
Compensation and benefits was $314 million, a slight decrease from the prior quarter, as increased salaries and incentive compensation were more than offset by lower payroll taxes and employee benefit's expenses. Looking forward to the fourth quarter, we expect this line to increase about 3% to 4%, reflecting increased headcount that's up 4% since March. And in addition to that, about 1/2 of the expense associated with splitting carried interest with the Darby team will run through compensation and benefits, while the other 1/2 will run through other expenses.
Information systems and technology and occupancy expenses were both relatively flat compared with last quarter, but we do expect technology expense to increase to a level similar to what we saw last September, as projects get completed and are expensed in the fourth quarter.
General, administrative and other expenses normalized as expected following the large insurance recovery in the prior quarter. Other income was $4.4 million this quarter, a $45 million decrease from last quarter. But as you can see from the chart on Slide 17, the impact of consolidated variable interest entities cause this line to be lower than I'm sure most of you expecting. Please keep in mind that those losses are reversed in the noncontrolling interest line. Otherwise, the biggest difference from last quarter was about $17 million less of gains from available-for-sale investments.
Realized gains and losses on the sale of available-for-sale investments have been running higher than normal in recent quarters and that's due to a blend of reallocating SICAV investment and the rebalancing of some of our corporate investments. Interest expense was a little higher this month due to a modest increase in our tax reserve.
Turning to Slide 18. The effective tax rate for the quarter came in higher than expected due to an increase in the fiscal year-to-date rate to 29.1%. The rate's been fairly consistent for the past 4 years. We do experience quarterly volatility as foreign service earnings fluctuate.
The operating margin for the quarter was 36.8%. Cash and investments was $8.7 billion at June 30, including about $1 billion from variable interest entities. And we repurchased another 1.6 million shares this quarter, decreasing shares outstanding to $220.4 million. Payout ratio for the quarter was 51%, and we remain committed to returning substantial portion of free cash flow to shareholders over time. However, a substantial portion of cash and investments is invested offshore and is used to see new products and is not currently available for repurchase or dividends.
Well, that concludes our commentary on the third quarter results. As always, if you have any questions, please contact Investor Relations or Corporate Communications. Their contact information is located in the presentation and in the press release.
Thank you for participating in this program. You may now disconnect.
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