Apr 30, 2013
Executives
Gregory Eugene Johnson - Chief Executive Officer, President, Director and Member of Special Equity Awards Committee Christopher James Molumphy - Chief Executive Officer of Investment Management and President of Investment Management Kenneth Allan Lewis - Chief Financial Officer, Principal Accounting officer and Executive Vice President
Operator
Welcome to Franklin Resources Earnings Commentary for the Quarter Ended March 31, 2013. 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 and 10-Q filings.
This commentary was prerecorded.
Gregory Eugene Johnson
Hello, and welcome to our second quarter earnings commentary. I'm Greg Johnson, CEO, and I'm joined by Ken Lewis, our CFO; and Chris Molumphy, Chief Investment Officer of the Franklin Templeton Fixed Income Group.
We're pleased to report another quarter of strong results. There are a number of positive developments in the quarter, particularly the strongly rebound in flows.
Long-term sales increased 29% due in large part to a record-setting month in January for U.S. sales, as well as a strong rebound in international sales that represented their best quarter ever.
Meanwhile, redemptions eased 9%, resulting in a significant increase in long term net new flows to $18.6 billion. Importantly, investment performance remains strong across the company with the majority of assets ranked in the top half of their peer group over all major time periods.
Equity performance also improved, particularly Templeton and Mutual Series. It was another strong quarter for operating results as well, led by new highs for operating income, net income and earnings per share.
Turning to Slide 6 of the presentation, relative investment performance of our U.S. retail fund range is strong across all time periods.
Templeton and Mutual Series equity performance had the biggest improvement in performance since last quarter, which is important given the increase in demand for global equities from investors. Tax-free fixed income was the only category that experienced a material decline in relative performance this quarter.
While certain riskier sectors in the muni bond market as a whole outperformed, particularly leveraged and high-yield bonds, our muni funds have limited exposure to these sectors. The overall strategy, which tends to be more conservative, avoids these types of assets.
Our funds do rank highly in terms of income return, which is typically what our investors are looking for. Assets under management ended the quarter at almost $824 billion, a 5% increase from last quarter and a 14% increase from the prior year.
The mix of assets under management by investment objective and sales region was unchanged from last quarter as growth was strong across most investment objectives and sales regions. As I mentioned in my opening remarks, long term net new flows improved to $18.6 billion, our strongest quarter since June of 2011, due primarily to improving U.S.
and international retail sales. Looking at Slide 11.
U.S. long-term sales increased 20%, while international increased almost 40%.
We're pleased to see the continued improvement of our international business led by Europe, where we have seen consistently improving sales over the past year. Italy, Switzerland, Germany continue to be our strongest markets, but almost every market within Europe, Middle East and Africa sales region reported positive flows in the quarter.
Due to our continued success in Italy, assets under management reached $36 billion at the end of the quarter, making it our second largest market outside of the United States. Flows in the Asia-Pacific and Latin America sales regions were also positive, and improved from a quarter ago.
While retail, which represents about 75% of assets under management, was the primary driver of flows this quarter, institutional also had a solid quarter due to strong international sales, our first large institutional K2 funding since the acquisition closed. Turning to investment objective.
Equity net new flows rebounded from last quarter's outflows. Global equity turned positive on improved sales and lower redemptions led by emerging market strategies, such as the SICAV Asian Growth Fund, which had been an outflow for the last 3 quarters, and our Frontier Markets Fund.
Templeton's Global Equity continues to win institutional mandates. However, the retail funds are still experiencing outflows despite improved performance.
U.S. equity remained an outflow as many U.S.
clients are positioning themselves in global equities after the strong 2012 for U.S. equities.
Not surprisingly, the Franklin Rising Dividends Fund was our top selling domestic equity fund and surpassed $10 billion in assets under management as of quarter end. Hybrid had a solid quarter with net new flows of $2.8 billion, about half coming from the Franklin Income Fund, also included in Hybrid are K2 assets which had about $500 million of net new flows this quarter.
Fixed income flows strengthened to $15.6 billion, with U.S. taxable and tax-free funds generating modest inflows, while Global Fixed Income had significant inflows of $15.3 billion.
Interest rate sensitive strategies such as our longer duration tax-free and U.S. government funds experienced outflows this quarter, while lower duration credit globally-oriented strategies, which have historically fared better in a rising rate environment, attracted inflows.
Demand for Global Fixed Income was particularly strong, recording its best quarter of net new flows in almost 2 years. The top-selling fund was the SICAV version of the Templeton Global Total Return Fund, which has drawn the favor of many advisors internationally over the past 18 months.
This quarter, the U.S. version of the fund, which is about 1/5 the size of the SICAV fund gained significant traction with net new flows of about $1.5 billion.
The U.S. and SICAV Global Bond Funds also had strong inflows as did the SICAV Templeton Emerging Markets Bond Fund, which invest in government and corporate debt issued from emerging markets.
In April, we launched a U.S. retail version of the emerging markets fund as well.
While we continue to pursue our equity sales and marketing campaign, we've also been engaging advisors on fixed income investing in a potential rising rate environment. With about half of our assets under management in bonds, we've also been hearing a number of questions from our shareholders.
So I asked Chris Molumphy, the Chief Investment Officer of our Fixed Income Group to join us today. Chris, with interest rates at historic lows, investors are understandably concerned with how rising rates might impact performance.
However, they might not appreciate that our portfolio is not the typical core bond portfolio either.
Christopher James Molumphy
Absolutely. Our fixed income portfolio is not typical by any means, particularly with respect to U.S.
interest rate risk. Specifically, a little over half of our fixed income assets are in global and international bond strategies, with the vast majority of these being in our flagship Global Bond Funds.
Now looking at the global bond strategy, the overall duration is roughly 1.5 years. So this is considerably lower than the traditional global indices.
Both the Global Bar Cap Agg, as well as a the WGBI have durations, to give you an idea, in excess of 6 years. Now furthermore, the global bond strategy has 0 exposure to U.S.
Treasuries. And in fact, effectively no U.S.
duration weighting at all. So with respect to rising U.S.
interest rates, the global bond assets are extremely well positioned. Now looking at our domestic fixed income assets, roughly half of these assets are in various funds, in strategies that are primarily balanced in multi-sector portfolios, with a large weighting in high-yield corporate bonds, but as well, an overweight in floating rate bank loans and adjustable rate mortgage-backed securities.
Now this combined with a significant underweight in U.S. Treasuries puts our average duration for this block of assets against significantly lower than both peer group as well asked traditional indices.
In this case, the Bar Cap Agg, to give you an idea, has an average duration of slightly over 5 years. Lastly, the remaining piece of our fixed income asset mix is made up of municipals.
Now this asset class does have U.S. interest rate exposure, given the longer maturity nature of the asset class.
Our average fund duration is a little over 5 years, and that's roughly in line with the peer group. Now it's worth noting that investors here tend to be income oriented, viewing the tax advantage nature of that income as quite important, and somewhat less total return focused.
So in summary, due to our asset mix, with a heavy skew toward global and international bonds, combined with our positioning, our exposure to U.S. interest rates is significantly less than both peer group as well as the overall market.
Gregory Eugene Johnson
Thanks for that update, Chris. Another element of the company that may be underappreciated is the diversity of our historical growth.
Slide 13 is relatively new, but it illustrates a few key points that I'd like to touch on quickly. Over the past 16-plus years, we have experienced far more once-in-a-lifetime market shocks than one might have imagined.
Over that same period, we've had cumulative net new flows of more than $200 billion and an average annual premarket organic growth rate of 3.5%, which compares favorably to the industry average. As our business has evolved and our diversification strengthened, we experienced less than a 1.5% premarket organic net asset attrition in fiscal 2008, during the depths of the global financial crisis.
You may recall, just prior to that, our AUM was 60% equity. So having a strong fixed income business, which was underappreciated by most observers up to that point, has been a key strength to our success in recent years.
Also shown on this slide are the top-selling funds each year, shaded by investment objective. As you can see, flow rotation is not a new phenomenon.
Over the years, investor preference has shifted and our diverse offerings have resonated. Whether it was our tech-oriented Small Cap Growth Fund at the turn of the millennium or our more conservative styles after the TMT bubble burst, our diversified investment options have been a key strength of the organization.
Now I'd like to turn it to Ken for operating results.
Kenneth Allan Lewis
Thanks, Greg, and good morning. Quarterly operating results continue to improve due to the strong growth in assets under management that Greg highlighted.
Operating income was $729 million, up 6% for the quarter as revenue growth outpaced expense growth despite the seasonal headwinds during the quarter. Net income increased 11% to $573 million and earnings per share was $2.69.
Now investment management fees were almost $1.3 billion, an increase of 6% from last quarter, due to the higher average assets under management, a full quarter of consolidating K2 and a positive mix shift in assets to higher fee products. That was partially offset by 2 less days in the quarter and a slightly lower performance fees of only $2 million.
Sales and distribution fees also increased 6% due to the strong global sales and the growth in assets; and similar to management fees, the shorter quarter also impacted the asset base component of these fees. Shareholder servicing fees were up 3% at $76.6 million, due to the increase in the number of billable accounts and the mix shift in open and closed accounts.
And other net revenue was $26.8 million, about $22 million was from interest and dividend income of consolidated investment products. On Slide 17, sales distribution and marketing expense was $781 million for the quarter, over half of the increase is due to the asset base expense growth, which typically outpaces revenue growth during the March quarter.
And this is due to the relationship between the revenue and expense, as revenue was primarily dependent on the number of days in the quarter, while expenses accrue on a monthly basis. More details are available in our Form 10-Q that was filed this morning.
Compensation and benefits expense increased by 6% due mostly to increased salary and wages, including a full quarter of consolidating K2, increased variable compensation such as commissions to employees for higher sales and -- as well as seasonal upticks in payroll taxes. Information systems and technology expense was $45 million and occupancy expense was $32 million.
General, administrative and other expense decreased 3% to $71.6 million. There are a number of lumpy items in this line most quarters, including expense related to consolidated investment products, which was $3.8 million this quarter.
Now expenses have been increasing along with the growth of the business, but we also expect to see some expense pressure related to increased regulations around the world and across the business. Most expense line items are in line with our forecast for the full year of 2013, except for general and administrative expenses, and we think that information systems and technology in general, and administrative expenses may trend higher in future quarters.
Turning to Slide 18, other income, net of noncontrolling interest was $72.7 million, near their higher end of the range we generally see. As always, there are a number of moving parts to this line, however, the change from last quarter is largely attributed to 3 elements: First, realized gains from available-for-sale investments decreased to $6.6 million as there was less rebalancing of our seed portfolio this quarter; second, the strengthening the U.S.
dollar during the quarter led to higher than normal unrealized gains due to the revaluation of cash and cash equivalents that are held by subsidiaries with a functional currency other than the U.S. dollar; and third was the mark-to-market gain on securities held by consolidated investment products.
Looking at Slide 19. The impact of consolidated sponsored investment products and variable interest entities on earnings is summarized.
You can see the net impact to earnings was only $8.7 million despite all of the noise. Please keep in mind that the noncontrolling interest related to the consolidation of sponsored investment products and variable interest entities offset those gains or losses that are not attributable to Franklin Resources.
I would also like to point out that because of our minimal equity in variable interest entities and the limited partnerships that we do consolidate, almost all of the gains are related to our seed portfolio. Slide 19 details the below-the-line items, including the allocation of earnings to participating non-vested stock and stock unit awards, which was about $0.02 this quarter.
This has been trending upward slowly as outstanding shares have decreased and net income has increased. The tax rate decreased to 28.3% for the fiscal year-to-date period due to a lower projected tax rate in the 28.5% to 29.5% range and discrete tax benefits that occurred in the current quarter.
That resulted in the current quarter effective tax rate of 27.2%. Moving to Slide 21.
The operating margin for the fiscal year-to-date period was 36.1%. As you can see from this slide, the operating margin has trended upward over time as the business has grown and scale benefits have been realized.
Since 2000, operating income has increased at an average annual rate of 12% compared to the 10% growth in average assets under management. Our goal is to maximize the growth and consistency of operating earnings and earnings per share.
Assets under management and GAAP margins are clearly secondary. Now several factors have contributed to the increase in earnings, particularly our success growing the international business, where 19 countries and regions now have over $3 billion in assets under management.
Geographic diversification drives the resilience and growth of our business model, as much as our asset-class brand and channel breadth. An interesting statistic, which I shared at a conference a couple of months ago was that, it took us a decade to grow our SICAV assets to $25 billion and just another decade to top $140 billion.
And part of our approach to international growth has been establishing local asset management capabilities in several countries around the world. Earlier this month, we announced an initiative to enhance our European fixed income capabilities in recognition of growing institutional and retail client demand for dedicated European fixed income strategies.
This initiative will involve adding new dedicated local management resources, on the ground in Europe, which will leverage our existing fixed income platform. We are also expanding our presence in Latin America through an agreement to join forces with independent institutional asset manager, Heyman y Asociados of Mexico City.
The investment team brings expertise in local fixed income and a deep understanding of the fast-growing and competitive Mexican market. And moving on to capital management.
Net cash and investments was unchanged at $6.5 billion. We repurchased 163,000 shares this quarter, which was below the pace of prior years, but the total payout ratio of 68% over the last 12 months is consistent with prior guidance.
So that concludes our prepared remarks. Thank you for taking the time to listen, and if you have any questions about our comments, please contact Investor Relations.