Franklin Resources provides global and domestic investment management to retail, institutional and sovereign wealth clients in over 180 countries. The company offers its investment services under several brands including Franklin, Templeton, Mutual Series, Bissett, Fiduciary Trust, Darby, Balanced Equity Management and K2. As of June 2018, Franklin had c.a. $650 billion in assets under management (AUM) that were invested in the following asset classes: Equities; Fixed Income; Hybrid (includes balanced products and alternative strategies) and Cash Management. Approximately 50% of Franklin’s AUM is invested in global and international equity or fixed income strategies, while nearly 33% of assets are held by clients outside of the United States.
Investment Thesis
Since the beginning of 2015, Franklin Resources has materially under performed the S&P 500 Index. The company’s disappointing share price performance reflects a number of factors, including the continued under performance of value-oriented investment strategies, the generally poor recent performance of some of the company’s funds against peers, the ongoing flow of funds into passive investment strategies and the regulatory uncertainty. To better appreciate how negative market sentiment is against Franklin Resources, just consider that not one Wall Street analyst (a notoriously bullish group) that cover the company rate the stock a ‘buy.’
Although value stocks have been underperforming growth stocks for several years now, these periods of under performance have always proven to be cyclical rather than secular. We would not be surprised if value stocks begin outperforming in the not too distant future. We would also note that a rising interest rate environment typically is favorable for the future performance of value stocks. Because there is an obvious correlation between performance and fund flows, the prospect for future value stock outperformance is encouraging. Where we have concerns is the apparent structural shift from active to passive investment strategies, although we believe that any sustained market volatility will certainly favor active investment strategies. There have been significant inflows into passive investment strategies such as ETFs in recent years, and many of these products have not yet encountered a bear market. How these products will perform in a difficult market will be interesting to see—we doubt that they will fare well.
Asset managers have historically been great businesses that generate strong returns and cash flows. Franklin Resources is no exception. However, we believe that the market is overlooking these exceptional qualities in the current environment. Franklin generates strong and largely recurring revenues, enhanced by 35% operating margins, which in turn produce ample free cash flows thanks to the company’s minimal capital requirements—capital expenditures as a percentage of revenue have averaged 1.2% over the past three years. The company’s strong free cash generating abilities have enabled it to return a significant amount of value to shareholders over the years. Since the beginning of 2007, Franklin Resources has returned $15.1 billion to shareholders through share repurchases and dividends. For comparison purposes, consider that the company’s market capitalization today stands at $16.3 billion while the company’s enterprise value sits at $9.65 billion.
Shareholder returns will likely continue thanks to the U.S. tax law. Lower federal taxes will increase Franklin’s already strong free cash flow, while favorable repatriation tax rates will enable Franklin to deploy its outsized and growing cash hoard—almost $6 billion net of debt. The majority of this cash has been held outside of the United States. Franklin’s current cash holdings are enormous but consider that they company just distributed a $3 per share special dividend back in February 2018 to all 551,000,000 shares outstanding. The company also increased its quarterly payout to $1.04 per share on an annual basis; the current yield on BEN is 3.33%. In April, the company increased is share repurchase authorization by eighty million shares, for a total authorization of ninety-six million shares, or 18% of the company’s outstanding shares.
Franklin Resources now trades at approximately1.4% of its assets under management, representing a significant discount to industry-wide transactions that typically transpire at 2.7% of assets under management. In our view, Franklin should command a premium valuation based on its strong brands (Franklin, Templeton, Mutual Series, etc.), long-term investment performance, global breadth and depth of product offerings, and future growth opportunities. Our company fair value estimate is $51 per share. We believe that Franklin could be an attractive target for a larger financial services firm. If the company’s shares continue to underperform, we would not be surprised if the founding Johnson family tried to take the company private. The Johnson family currently owns 40% of the company.
Valuation
We assume that the dimminution of the company’s aum will halt when value returns into favor, and assets under management will increase by only 2.5% per year over the next three years, although we project revenue to increase at a slightly lower rate due to modest fee reductions.
We project that Franklin’s operating margins remain in the mid-30s percentage range though we think that this assumption could prove conservative should assets grow above our projected rate. Based on company management’s stated intentions, we project that Franklin deploys roughly $3.5 billion over the next three years toward share repurchases, buying back 85 million shares at an average price of $40 per share—a 25% premium to the current stock price level. We value Franklin at a discounted 2.5% of AUM, or an estimated fair value price of $51 per share. Based on the current stock price, we see a potential 60% return over the next three years and that does not include the dividend.
We should note that this valuation assigns no value to the company’s various real estate holdings, which covers 2.1 million square feet of office space including the Franklin’s headquarters in San Mateo, California.
Lastly, should the value versus growth or the active versus passive pendulum shift in Franklin’s favor, our intrinsic value estimate will likely prove conservative, perhaps very conservative. If Franklin’s shares continue to languish, we would not be surprised if BEN becomes the subject of a takeover or if the founding Johnson family were to make a run for the entire company. Franklin represents an attractive target for a larger financial services firm given the company’s branding power, investment track record and global distribution.
Risk to Investment
The capital and credit markets constantly experience volatility and disruption worldwide. Declines in global financial market conditions have in the past resulted in significant decreases in the company’s assets under management, revenues and income. Future declines may further negatively impact Franklin Resource’s financial results. Such declines have had and may in the future have an adverse impact on the company’s results of operations.
Fluctuations in the amount and mix of their AUM may be attributable in part to market conditions outside of their control that have had, and in the future could have, a negative impact on their revenues and income. Franklin derives substantially all of its operating revenues and net income from providing investment management and related services to investors globally through products that include investment funds and institutional, high net-worth and separately-managed accounts. The company’s revenue depends largely on the level and mix of AUM.