Business context and reporting period
Franklin Resources, Inc. (Franklin Templeton) filed this unaudited Form 10-Q for the quarter and six months ended March 31, 2013, the second quarter of its fiscal year. The global investment manager earns most revenue from investment management and distribution services, with revenue closely tied to assets under management (AUM), market performance, and investor flows.
Key financial metrics
| Metric | Quarter ended March 31, 2013 | Six months ended March 31, 2013 |
|---|---|---|
| Operating revenue | $2.014 billion, up 12% | $3.915 billion, up 12% |
| Operating income | $729.4 million, up 18% | $1.415 billion, up 13% |
| Operating margin | 36.2%, versus 34.3% | 36.1%, versus 35.7% |
| Net income attributable to Franklin Resources | $572.8 million, up 14% | $1.089 billion, up 11% |
| Diluted EPS | $2.69, versus $2.32 | $5.11, versus $4.53 |
| Operating cash flow | $771.8 million for six months, versus $478.3 million |
- Revenue and earnings drivers: Average AUM rose 14% for the quarter and 13% for six months. Investment management fees increased 13% and 12%, respectively. The annualized investment management fee rate eased to 62.8 basis points from 63.7 and 63.5 basis points for the comparable periods.
- AUM: Ending AUM was $823.7 billion, up 14% year over year and 10% from September 30, 2012. Over the six months, AUM increased $73.8 billion, including $49.3 billion of market appreciation and $18.6 billion of net new flows. In the quarter, net new flows were $18.3 billion.
- Cash flow and capital returns: Six-month investing cash flow was $98.0 million and financing cash flow was negative $1.350 billion; cash and cash equivalents decreased $495.6 million to $5.556 billion, including cash of consolidated investment products. The company paid $759.3 million of common dividends and repurchased $121.3 million of shares during the six months.
- Liquidity and debt: Management-defined liquid assets, excluding assets of consolidated sponsored products and VIEs, were $8.553 billion at March 31, compared with $8.875 billion at September 30. Corresponding debt was $1.263 billion, down from $1.566 billion. The company reported compliance with debt covenants and said it expects to meet foreseeable cash needs through liquid assets, operating cash flows and financing capacity.
- Dividends: The company declared regular dividends of $0.29 per share per quarter and a special dividend of $3.00 per share during the six-month period. Reported dividends per share for the six months were $3.58.
Material changes versus prior comparable periods
- Revenue growth reflected higher average AUM and increased sales and distribution fees; operating expenses rose 9% for the quarter and 11% for six months, slower than revenue growth.
- Quarterly operating margin improved 1.9 percentage points year over year, while the six-month margin improved 0.4 percentage points.
- Six-month net new flows improved from $10.0 billion of outflows in the prior year to $18.6 billion of inflows, led by global/international fixed-income products. The asset mix shifted toward fixed income.
- Other income was mixed: it increased in the quarter, helped by foreign-exchange gains, but declined for six months as lower market valuation gains and higher interest expense outweighed increased gains on consolidated sponsored investment products.
- Six-month financing cash outflow increased, reflecting debt payments and higher dividends, partly offset by lower share repurchases. The company redeemed $300 million face value of 2.000% notes in October 2012 for $305.4 million.
Outlook, commentary, risks and unusual items
- No quantified earnings, revenue or AUM guidance is provided. Management cited continuing market volatility and economic uncertainty, and said it would focus on investment performance, client service, expense management, strategic technology investment and employee retention. It expects regulatory developments to increase administrative and compliance costs.
- Key business risks include market declines and volatility, changes in AUM and product mix, redemptions and investment performance; fee-rate pressure; competition and dependence on third-party distribution; foreign-exchange exposure; complex and changing regulation and tax rules; cybersecurity and operational disruption; and the ability to retain key personnel.
- In November 2012, Franklin acquired approximately 69% of K2 Advisors, a fund-of-hedge-funds provider, for a $182.9 million cash investment. It agreed to acquire the remaining interests beginning in fiscal 2017; the contingent consideration liability was estimated at $90.0 million at March 31, 2013. K2 had $8.7 billion of AUM at acquisition.
- Investment and other income included volatile gains and losses from sponsored investment products, consolidated CLO fair-value changes, equity-method investees and foreign currency. Six-month consolidated CLO fair-value changes produced a net loss of $26.8 million, versus a gain of $18.3 million in the prior year.
- Management said ordinary-course litigation is not expected to materially affect the company and that an adequate accrual was recorded for probable estimable losses. The filing reported no material changes to previously disclosed risk factors or other commitments outside the ordinary course.
- Reported controls and procedures were considered effective as of March 31, 2013, with no material change in internal control over financial reporting during the quarter.
Important facts for investors to verify
- Whether AUM growth and net inflows persist, particularly in fixed income, and how market returns or redemptions may affect revenue.
- Whether the lower investment management fee rate and evolving product mix continue to pressure revenue per AUM.
- The performance of the K2 business and assumptions underlying the $90.0 million contingent consideration estimate and future payments.
- The sustainability of earnings excluding volatile investment, CLO fair-value and foreign-exchange items, and the effect of rising operating costs.
- Cash available after operating and regulatory needs, capital returns and debt obligations; note that reported consolidated product and VIE assets and liabilities are generally not available to the parent company and their debt is generally nonrecourse.
- Developments in market, regulatory, tax, cybersecurity, legal and distribution-channel risks, and any effect on AUM, costs or profitability.