Franklin Resources: Cautiously Optimistic (NYSE:BEN)


Franklin Resources (NYSE:BEN) has transformed as of recently, with the acquisition of Legg Mason. While experiencing declining revenues over the last six years, along with net outflows in its AUM, the company decided that adding the portfolio of Legg Mason might help change its fortunes.

With that addition, Franklin Resources now becomes one of the world’s largest asset management companies and makes it a bigger player in the field.

I am cautiously optimistic that this addition might be just what the doctor ordered for the company. Let’s take a look and see why.

Overview

Franklin Resources, Inc. is an asset management company based out of San Mateo, CA. In 1947, the company currently sported a $9.7 billion market cap and focused on equity, fixed income, and alternative market mutual funds.

The company recently reported third-quarter results, and the first part of this report will discuss those results. Unfortunately, most of the results will show downward pressures as the company is experiencing continued pressure on its revenues, margins, and earnings. All the comparisons mentioned in this section will refer to the comparable third quarter of 2019 unless otherwise mentioned.

Some financial highlights for the quarter:

  • Adjusted earnings per share – $0.70
  • Adjusted net income – $348.9 million
  • Operating revenues – $1,188.1 million
  • Operating income – $253.7 million
  • AUM at quarters end – $622.8 billion
  • GAAP P/E TTM – 7.33
  • Price to book TTM – 0.96
  • Dividend yield – 5.52%

Operating Revenues

Franklin Resources breaks up the operating revenues into four parts:

  • Investment management fees
  • Sales and distribution fees
  • Shareholder servicing fees
  • Other

And as mentioned above, all four revenue categories took a hit for the quarter.

The quarter’s investment management fees were $809.2 million, a decrease of $210.2 million, or 21%, from the previous quarter. The company states that the declines directly result from lower AUM, lower fee rates, and lower performance fees.

The AUM decreases, which we will discuss in a moment, were felt across all revenue categories.

The investment management fees declined by 53.8 basis points for the quarter and 54.6 basis points for the past six months compared to the declines of 56.4 points and 56.5 points for the previous respective periods.

Sales and distribution fees declined for the quarter by 18% from $367.5 million to $302.1 million. The declines were primarily a result of lower AUM and a 29% decrease in commissionable sales.

The majority of these segment fees go directly to the financial advisors and others that sell Franklin Resources’ products on its behalf.

Shareholder servicing fees declined $8.1 million for the quarter, a 15% decline from the comparable quarter.

Overall, the total operating revenues declined 20% from $1,476.7 million to $1,188.1 million. All of which directly relates to the continued decline in AUM.

AUM

Source: Franklin Resources third-quarter 2020 filing

Franklin Resources saw its AUM decline for the quarter, this time to the tune of 13%. The decline was primarily the result of $61.8 billion in net outflows and a decrease of $39.7 billion in net market changes.

The next several charts from the third quarter filing highlight the Franklin Resources’ continuing struggles to retain its AUM.

Source: Franklin Resources third-quarter 2020 filing

We can see the continued decline in long-term sales, long-term redemptions, and net flows.

Source: Franklin Resources third-quarter 2020 filing

We can see continued net outflows from the funds, and if it weren’t for the increase in net market changes from the second to the third quarter, there would have been a decrease in AUM for the quarter.

The improvement in the market appreciation occurred across all long-term investments, mostly showing up in the equity and multi/balance investments. The net outflows of $5.8 billion came from six global/international fixed-income funds, $0.9 billion in a global/international equity fund, and $0.6 billion from one multi-asset/balanced fund.

The long-term sales decreased for the quarter due to lower sales of global fixed income products, all of which were offset by increases in U.S. equity product sales.

Investment Performance

One of Franklin Resources’ key drivers to its success is its investment products’ long-term investment performance. The standard measure of the investment products’ performance is the AUM percentage exceeding its benchmarks and peer group medians.

On this front, Franklin has done well. The AUM’s fixed income portion across the board has outperformed both the benchmarks and peers on a 10-year basis. The U.S. equity portfolio did well on the 5-year and 10-year basis, and across the board, that portfolio has done well.

The Multi-Asset/Balanced portfolio has struggled against both the benchmark and peers, both long term and short term. Franklin Resources sees some lag on many of its portfolios’ short-term performance, especially in the one-year performance of the Multi-Asset, Tax-Free fixed income, and the taxable Global/International.

That wraps up the company’s third-quarter performance now. Let’s move onto what will drive this company forward.

Growth Story

The growth for Franklin Resources really comes down to two factors: the Legg Mason acquisition, and the dividend.

The company closed the Legg Mason acquisition as of July 2020, which more than doubled its AUM:

  • June 30, 2020 – $622.8 billion
  • July 31, 2020 – $1,428.2 billion
  • August 31, 2020 – $1,441.3 billion

The AUM’s doubling now puts Franklin Resources in the top 20 asset managers in the world; in fact, it is currently sixteenth on the list.

Benefits from the acquisition: The purchase was paid for with cash, $4.5 billion in cash, and assumed $2 billion in Legg Mason debt, and the boost to quarterly revenues. Legg Mason reported quarterly revenue of $754 million in the third quarter.

Of course, the rise in AUM should increase Franklin Resources’ annual revenues in the $8 to $9 billion range, depending on the portfolio’s performance and the slowing of outflows.

Franklin estimates additional benefits due to synergies from the combined companies. The company stated that it expects approximately $300 million in savings, and a $500 million cash tax benefit over the coming seven to ten years.

All in all, the best part of the acquisition is that it was paid for with cash, and no dilution of shares occurred.

On a portfolio basis, Legg Mason fills in where Franklin Resources was lagging, such as the fixed income space.

According to CEO Jenny Johnson:

“One interesting data point, which is that Legg Mason has six, four or five-rated funds in the top eight categories, and we have zero-rated in the four or five stars. So just bringing that combination in, this is a retail focus.”

The combining of portfolios is going to change the asset mix to approximately:

  • 46% fixed income
  • 33% equities
  • 21% mix of alternatives, multi-asset, and money market strategies

The movement towards a more fixed-income strategy makes complete sense for the Franklin Resources model, as it is heavy in mutual funds compared to index funds which carry heavier fee structures. That being said, more investors are likely to accept fees to manage bond funds as opposed to equity funds actively.

The acquisition also helps increase the mix of institutional investment compared to retail investors. Most retail investors are concentrated on performance plus managing fees, where institutional investors have different goals and trends more towards yields and stability, which the new portfolio mix of Franklin Resources will now gear up for.

With the acquisition, there has also been an increase in ETF options available to customers. The company has seen a little bit of traction in those funds recently, including the DynaTech fund. All of this bodes well for reducing the AUM net outflows, which has been the main bane of Franklin Resources.

Dividend

Franklin Resources currently pays a dividend with an annual payout of $1.08 per share and a yield of 5.31%. With a growing dividend for over 40 years, Franklin is among the group known as Dividend Aristocrats.

Seeking Alpha rates the dividend of Franklin Resources as follows:

Source: Franklin Resources Dividend Scorecard, Seeking Alpha

As a Dividend Aristocrat, safety and consistency are unsurprising, and with a payout ratio of 40.46%, you can see that the dividend is fairly safe.

If we look at the margins for the company, across the board, they are consistent, based on the 10-year median margins:

  • Gross profit – 45.8%
  • EBIT – 35.7%
  • Pre-tax income – 37.7%
  • Free Cash Flow – 24.6%

All of this supports plenty of cash flow to sustain the dividend in the future and illustrates the margin strength even with the continued pressure due to declines in AUM. Franklin Resources historically covered the dividend with free cash flow, and I have no reason to believe why that would stop now, especially with the addition of the Legg Mason portfolio to the mix.

Risks

The main risk Franklin Resources faces is the decline in revenues brought on by the outflows of AUM over the last six years. As I mentioned above, the company is seeing continued declines in both the AUM and revenues.

With the constant decline in AUM, there were fee declines. With the retail world pivoting to the low-fee index funds and ETFs, the mutual fund model that Franklin Resources has come to look sort of dinosaur-like.

The company has been slow to adapt to investor sentiment change regarding fees, such as the rise of Robinhood and other retail investors moving toward no-fee structures for their products.

Due to that adoption, Franklin Resources’ main source of income has started to come under pressure; actively managed mutual funds with higher fees.

The company’s margins are strong, and it has done a great job of controlling costs to maintain those margins, but at some point, something had to give, which is why the addition of the Legg Mason portfolio might be the cavalry to the rescue.

Another issue facing Franklin Resources is the continued lower interest rate environment. With the addition of the Legg Mason portfolio and the change of mix towards a more fixed income portfolio, those low interest rates have wreaked havoc on the fixed income market.

The Fed has recently maintained its stance on continuing low interest rates to encourage economic growth, but those decisions are on a quarterly basis as the virus continues to wreak havoc on the world.

With the continued low rates, the fixed-income strategies will struggle to maintain attractive yields, and outflows might continue in the short run.

Valuation

With the continued decline of revenues and earnings over the last six years, the company has entered an undervaluation territory.

Let’s examine Franklin Resources on a relative basis first. Seeking Alpha rates Franklin Resources as a B on value; the P/E GAAP TTM is 9.92, which is 6.49% below the sector median of 10.61. And looking at the five-year average of 15.09, the company is currently 34.27% below that average.

Moving on to the intrinsic valuation of the company, I will use an excess return model for this portion of the show. You can see the assumptions I am using for the model so you can follow along at home.

Based on the TTM numbers and the assumptions plugged into the model, I came back with a price of $32.67 compared to the current market price as of the writing of this article of $19.98. All of which gives us a margin of safety of 38.8%, approximately, which helps in the case of my assumptions being faulty.

As we can see from both examples, Franklin Resources appears to be undervalued on both a relative and intrinsic bases, and based on all that we have discussed to this point, I would agree.

Final Thoughts

Based on all the information we have discussed today, I am cautiously optimistic about Franklin Resources. I think the addition of the AUM from Legg Mason might be the catalyst that helps Franklin Resources improve its standing in the asset management space and drive revenues higher in the near and long term.

The biggest issue in the near term will be to slow the AUM outflows. If this acquisition can help slow and eventually stop the bleeding, this company will be good to go. If not, then it might be a slow bleed, as the company is well managed.

After dissecting both the acquisition and dividend safety, I think the company is worth an addition to anyone’s portfolio, and I have started a position.

Disclosure: I am/we are long BEN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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