Opportunity Now in Franklin Templeton

Franklin Templeton (BEN) has given back a lot of ground in recent months. Naturally asset managers decline when the overall market falls. But BEN has significantly lagged T. Rowe Price (TROW) and Blackrock (BLK). These two peers are up slightly over the last 12 months, while BEN is down over 30%. And the disparity in valuations is likewise wide, with BEN at 13.1X FY 2008, compared to 22X for TROW and 19.8X for BLK.

The immediate cause of the sell off in BEN was disappointing earnings last quarter. Yet in looking at the details, the quarter was not a disaster. Operating profit rose 4%, and the decline in eps was driven to a large extent by a tough comp on the investment income line. Average assets under management [AUM] rose 8%, and period end AUM was up 3%, to just under $600 billion. Net asset flows (sales minus redemptions) were slightly negative, but only by $6 billion. The mix of AUM deteriorated somewhat, from 60% equities last year to 56% at 3/31/08. Still, BEN has a well diversified product mix which should lend stability to operations.

The asset management industry has become a business of scale. Small niche boutiques can do extremely well, thanks to the power of technology which enables a small shop to use outside sources for operations and custody. A few very large firms define the mega sized enterprises which have the resources to spend large sums on marketing, client service and technology.

BEN is in that group, along with non-public entities such as Fidelity, Vanguard and the like. The worst place to be is stuck in the middle. Midsized asset managers are unlikely to prosper or survive over time. They are too small to compete with the giants, and too large to have the entrepreneurial quickness of the boutiques.

In thinking about why BEN might be selling at such a relatively low valuation, here are some pluses and minuses which might affect the outlook over the next few years.

Some positive things which could happen:

• BEN could gain market share. That will occur only if performance is reasonably competitive. At the end of March, BEN's equity products were mixed on a 1-year basis, but fine for longer periods, while fixed income performance was excellent both long and short term. Thus, the burden falls on marketing to grow the asset base.
• BEN could maintain share of an expanding pie of financial assets. That would occur as equities grow with global economic progress, and fixed income grows in nominal terms with credit markets and client demand for income.
• BEN can enter new markets and/or offer expanded/new products and services.

And negative things to balance out the picture:

• A prolonged bear market in financial assets would shrink AUM to the detriment of earnings unless the cost structure is adjusted.
• BEN could execute poorly and lose market share.
• Baby boomers could withdraw assets in copious amounts for retirement needs, not offset by new asset inflow.

Regarding the macro risk of bear markets in both bonds and stocks, we are still left with the question of why BLK and TROW sell at such a hefty premium to BEN. They will be affected the same way if such a scenario plays out. So either BEN has some valuation attraction at these levels, or the peer companies have some significant downside risk notwithstanding the fact they are both very well managed and excellent franchises.

To put some more light on BEN's valuation: the company generates a ton of free cash flow [FCF], and is using it in ways friendly to shareholders. Over the past 12 months, FCF was $1.2 billion, and BEN spent a total of $1.7 billion for cash dividends and share repurchase while still ending the period with a cash hoard of almost $3.7 billion, or $15.49 per share. I calculate the current run rate on FCF/share at just over $8, which translates to an FCF yield of about 9%. This is attractive given the quality of the company and the fact that asset managers provide a highly predictable recurring revenue stream.

One thing to think about is comparison to the 10 year Treasury yields, now around 3.8%. The Treasury is arguably richly priced in here, given the flight to quality trade and accelerating inflation. So BEN with a yield of 9%, well over 2X the Treasury, and with a chance to grow over time, seems very interesting.

Another way to look at the stock is to back out the cash on the balance sheet. On that basis, it is selling at only 10.6X the current Street estimate for FY '08 of $7.08 per share. The Street consensus, by the way, is pretty subdued and expects a flat year in '08 and only 8.5% growth in fiscal '09. I am not arguing the numbers are too low, but just that expectations seem unheroic which lessens the chance of a major miss.

In general, I am not positive on stocks in the financial sector. The credit problems are well known but still unfolding. Second quarter earnings reports from the banks/brokers are going to be bad, the only question is how bad and will managements be able to provide transparency/visibility, or will it be another quarter of postponing the final reckoning? The Fed is aware of the cataclysmic over hanging risk in the derivatives and mortgage markets, but seems to be struggling to find a solution within its toolbox of remedies.

Thus, I believe we will not exit the mortgage crisis without a super agency created to hold, collect and dispose of these assets. Similarly, on the insurance industry side we have the unhappy combination of flood losses impacting Q2 earnings, weak pricing on new business, and hurricane season underway. So while BEN lacks the sizzle of the hot commodity plays (which have cooled off a lot in the last 2 weeks!), it is worthy of a look and further investigation on the basis of its excellent profitability, strong free cash flow, and very reasonable price earnings multiple.

Disclosure: Long.

Comments

[Riga:]

Two things to bear in mind are as follows:

A. The asset management business is attractive but if you look deep in Franklin's financials you will find that they have also been in the business of securitizing car loans. However much of a sideline, I imagine that this gives the market pause at times like this.

B. I would maintain that TROW has a higher valuation NOT, as everyone assumes, because their AUM is heavy equity but rather because they have a strong presence in the defined contribution pension (401 K) market which provides more assured cash flows at times like these. Franklin is comparatively weak in that area. Where are the Franklin-Templeton target date funds? Meanwhile the place where Franklin is quite strong happens to be overseas and particularly Europe --speaking in terms of not only invested AUM but more the sourcing of the AUM (i.e. the country where the client is domiciled). Everyone sees "overseas" as sexy but Europeans are notoriously fickle about their mutual fund or "investment trust" holdings. They dump their shares at the slightest sign of a downturn and are far, far less inclined than Americans to buy and hold. This is why so-called structured investment products are so popular in Europe. In any event, the point is that TROW's domestic DC plan strength looks good at the moment while BEN's asset gathering in foreign lands looks like a source of weakness at the moment.

Thanks for your thoughtful piece.

2008 Jul 11 10:49 AM

[SouthShore:]

David,

Well said regarding TROW. I consider buying their shares a better long-term buy than any of their funds. TROW's fees are based on a growing AUM for 401k's, which should continue to grow as pensions are replaced. Also, TROW is building out branches in high net worth locations, which suggests expansion into new business lines. Stable growing dividend. Waiting.

Cheers,

2008 Jul 15 10:12 PM