From Standard & Poor's Equity Research
We think that asset-management outfit Franklin Resources' (BEN
; recent price, $93) loyal following among its clients and the financial advisers who recommend and distribute its funds reflects its strong investment performance, broad product offerings, and multiple distribution channels. We expect the company to continue to gain market share aided by strong client inflows into its international and global product offerings.
We expect Franklin to benefit in fiscal 2007 (ending September) from strong net client inflows, prudent expense growth, and further appreciation in global equity markets. We believe that the company's broad product offerings, dominated by value and global investment strategies, have contributed to strong relative investment performance.
The company's investment philosophy -- which we regard as conservative -- and focus on diversification have contributed to what we view as superior investment performance. We anticipate additional market-share gains and healthy client inflows given what we see as consistently solid investment performance and excellent client service.
NOT WEIGHED DOWN. We believe Franklin's broad product line makes it easy for investors to reallocate assets among funds (which is not the case at some smaller fund companies), contributing to increased client retention, in our opinion. Finally, we see investors favoring large asset-management companies like Franklin Resources that have broad product offerings and that have generally avoided regulatory issues.
We reiterate our 5 STARS (strong buy) recommendation on the shares, based on strong growth in client assets in the March quarter and what we view as a compelling valuation. In our view, the shares should trade at a much higher multiple, based on the company's investment performance, diversified client base, and multiple distribution channels. We also view favorably its low debt, and think that increasing operating cashflows could be used to raise the dividend or repurchase additional shares.
Franklin is one of the largest U.S. money managers, with $491.6 billion in assets under management at the end of the second quarter of fiscal 2006. At the end of the second quarter, equity-based investments accounted for 60% of assets under management; fixed-income investments, 22%; hybrid/balanced funds, 17%; and money funds, 1%. Global equity and fixed income accounted for about 47% of assets under management. We estimate that about 25% of assets under management are from non-U.S. shareholders.
MORE GROWTH PRODUCTS? The company's sponsored investment products are distributed under five distinct names: Franklin, Templeton, Mutual Series, Bisset, and Fiduciary. We are impressed with Franklin's broad range of investment products, but think it lacks compelling growth equity products. It has targeted key market segments including retail (76% of assets at the end of fiscal 2005), institutional (22%), and high net worth (2%).
Although the company advertises significantly, and engages in sales promotion through media sources, fund shares are still sold primarily through a large network of independent securities dealers.
The company's mutual funds have a multi-class share structure to meet investors' varied demands. Class A shares have a traditional fee structure whereby investors pay a commission to a broker at the time of purchase. Class B shares have a declining schedule of sales charges if the investor redeems within the first six years. Class C shares are a hybrid, combining front-end sales charges, back-end sales charges, and level load pricing.
SEC SETTLEMENT. Through several acquisitions, the company has shifted its asset mix from predominantly fixed-income securities toward equity-based investments. Despite its acquisitive history, we think Franklin's management favors organic growth. We believe that the interests of management are closely aligned with those of shareholders, given that directors, director nominees, and executive officers as a group owned nearly 35% of the common shares outstanding as of Nov. 30, 2005.
We expect the company to continue to gain market share, aided by international growth. We view employee headcount growth as conservative, having risen only 7% in fiscal 2005, to 7,156.
We think client inflows could improve further given that the company reached a settlement with the Securities & Exchange Commission in fiscal 2004 that resolved the issues resulting from its investigation of market timing activity, and an agreement was reached with the State of Massachusetts concerning one instance of market timing. The company incurred a charge of $111.6 million in the fiscal 2006 second quarter for repatriating about $2 billion in earnings from foreign subsidiaries.
THINKING GLOBALLY. Despite weakness in the shares, we were very impressed with the company's March-quarter results. The company posted earnings per share from continuing operations of $1.33, up from 94 cents in the year-earlier period. Results were well above our $1.19 estimate, excluding tax and impairment charges. Much like previous quarters, we think prudent expense growth and continued net client inflows, notably into its global products, accounted for the upside.
In the second quarter of fiscal 2006, assets under management rose 19%, to $492 billion, aided by client inflows and market appreciation. We see strong demand for Franklin's global investment strategies in fiscal 2007, a competitive strength, in our view.
We also expect continued strong inflows into the company's hybrid products, notably its highly rated Income Fund. We think that a potential decline in the dollar relative to other major currencies would aid profitability, as we estimate that roughly 47% of client assets are invested in global products. We expect the company to reallocate about $2 billion in repatriated earnings in fiscal 2006 toward growth initiatives and debt repayment.
BETTER DIVIDEND? We see EPS of $5.20 in fiscal 2006 and $6.00 in fiscal 2007, including stock option expenses, driven by higher client assets, prudent expense growth, and an expected mix shift toward higher-margin equity and global funds. We expect favorable year-to-year EPS comparisons in fiscal 2006, given that results in fiscal 2005 were hurt by $33.7 million in charges, primarily for government investigations related to market-timing allegations.
In our opinion, Franklin shares deserve to trade at a much higher multiple, based on our view of the company's consistent net client inflows, strong relative investment performance, and low ratio of debt to total capitalization. We also view favorably the company's strong operating free cashflow, but would prefer that Franklin raise its dividend or repurchase additional shares given increasing cash balances.
We also factor in the significant reduction in the company's stock option grants in recent years and our view of reduced concerns over regulatory issues in our valuation of the shares. We expect that management would be opportunistic should they choose to pursue any acquisitions, given significant insider ownership at the company.
BUYING OPPORTUNITY. March-quarter results were impressive, and we view recent weakness in Franklin shares as an enhanced purchasing opportunity. The shares are virtually unchanged thus far in 2006, significantly lagging the roughly 15% gain among its peers. Franklin recently traded at about 16 times our fiscal 2007 EPS estimate, a significant discount to the company's peer group average, but somewhat above historical valuations achieved over the past decade. Our 12-month target price of $136 is equal to nearly 23 times our fiscal 2007 EPS estimate, a slight discount to peers.
We believe that Franklin's corporate-governance practices are generally sound, but think that improvements could be made. We view executive compensation as competitive, especially given what we see as generous compensation levels at certain competitors, and view favorably the company's significant reduction in stock option grants in recent years.
Also positives, in our opinion: the full board of directors is elected annually and the company does not have a poison pill.
TWEAKS NEEDED. However, we would like to see cumulative voting rights in director elections and a higher proportion of independent outside directors on the board of directors, which currently consists of a majority (over 50%) of independent outside directors.
Risks to our investment recommendation and target price, in our view, include potential stock and bond market depreciation, reduced investor confidence, and potentially increased competition. Additional risks include potentially higher-than-expected interest rates and greater regulatory scrutiny. We think that reduced demand or a potential deterioration of investment performance among the company's largest funds is also a risk.
Additionally, we believe the shift by investors toward discount brokerage firms could hurt net inflows somewhat, given that the company's funds typically have front-end sales charges.