Franklin Resources (NYSE:BEN) is one of Wall Street's largest asset managers. The company manages investment funds that have more than $742 billion of assets between them, generating a lucrative stream of income from management fees each year.
That treasure trove of client money has made Franklin Resources one of the market's best performing high-yield stocks over its history, affording 36 years of consecutive dividend increases and a spot on the list of so-called Dividend Aristocrats. But though the dividend may be safe, its status as a dividend growth stock is in question.
Franklin can easily afford its current dividend
Franklin Resources should be able to pay out its current dividend for a very long time to come, thanks in no small part to two insulating factors: its cash-rich balance sheet and a low payout ratio.
- A rock-solid balance sheet. Franklin Resources is only paying out about $445 million a year in annual dividends, and its balance sheet reflects $12.2 billion of cash and investments against only $1.4 billion of long-term debt. Although much of the company's excess cash is held overseas, and bringing it home would subject it to U.S. corporate taxation, Franklin Resources can easily borrow domestically to fund its cash dividend if the need arises.
- A relatively low payout ratio. Even though Franklin Resources' earnings power has been in decline, the company has paid out only about 25% of its earnings as a dividend in the most recent 12-month period. The company returns much more capital with stock buybacks, which can be turned off at any time, giving it capacity to maintain its dividend for some time to come.
Of course, both of these safety nets provide a backstop for the dividend as it stands today. Franklin Resources' earnings over the last 12 months, along with its balance sheet today, suggest the dividend is safe. But what does the future hold, particularly as investors turn away from the actively managed funds that make up Franklin Resources' core business?
Can the dividend grow if the business is shrinking?
It's important to understand how Franklin Resources became one of the largest asset managers on the market. The company has historically grown by rewarding financial advisors handsomely for selling its mutual funds to retail investors. To illustrate the model simplistically, Franklin Resources adds 0.25% surcharge on fund assets known as a 12b-1 fee and passes on the bulk of the cash to an army of financial advisors who make the sale.
To find evidence of this "old school" business model, one only need to look to its income statement. In the first nine months of fiscal 2017, the company generated nearly $1.3 billion of sales and distribution fees -- charged to its clients -- and had sales and distribution expenses of approximately $1.6 billion -- largely paid to financial advisors.
The pay-for-distribution model worked well under the regulatory regime of years gone by, but the model may soon change for the worse for asset managers who rely on it. Under a series of proposals referred to as the fiduciary rule, financial advisors may face increased pressure to sell what's best for their clients rather than what's best for the advisor. As for what the fiduciary rule will ultimately require, no one knows exactly, but it's a clear sign that the Labor Department and other regulators and bureaucracies have financial advisors' conflicts in their sights.
As government takes aim at the distribution method, retail investors are increasingly satisfied with low-cost index funds and exchange-traded funds, which charge a mere fraction of the fees assessed on actively managed funds. This isn't a Franklin Resources-only phenomenon. New money coming into the financial markets is primarily coming in by way of passive funds and ETFs, while mutual funds and other active products are bleeding assets.
In each of the past five quarters, Franklin Resources has bled $7.3 billion to $15 billion of assets under management. Since 2008, active U.S. funds have shed $976 billion of assets on a combined basis, while passive funds have added $1.1 trillion, according to Morgan Stanley research published by Financial Times. The trend is very, very clear: Active is out and passive is in.
It doesn't help that Franklin Resources' active focus and retail-distribution scheme make its funds relatively expensive for investors. Adding up Franklin Resources' management, sales and distribution, and servicing revenue and dividing by its assets under management, I arrive at an average annual fee load of 0.80% on Franklin's fleet of funds, based on its most recent filings. While that may not seem nominally high, consider that roughly 58% of its clients' assets are invested in strategies with lower expected returns (bonds, blended funds, and multi-asset strategies). A 0.80% all-in management fee weighs far more heavily on a bond fund than a stock fund, all else being equal.
In exchange for these costly fees, investors have received tepid returns. With the exception of its global and international taxable bond products, which make up less than a quarter of its fee-earning assets, fewer than 50% of its assets under management in any of its strategies have beaten their benchmark over the most-recent 10-year period, according to the company's own disclosures in its quarterly filings.
For how long will its clients continue to pay above-average fees for below-average performance?
Management has incentives to do the right thing
For what it's worth, Franklin Resources' founding family remains its largest shareholder, as two family members control about two-fifths of all shares outstanding. Theoretically, businesses where founders have substantial share ownership also have the capacity to make decisions with the long run in mind. Franklin Resources doesn't have to share Wall Street's obsession with quarterly numbers, since the founding family calls the shots.
Of course, the opposing view is that the incentives, no matter how substantial, matter very little when a business is facing fundamental disruption. To be sure, the past looks far better for most asset managers than the future. As fees decline across the industry and financial advisors face pressure to actually sell the best funds rather than the funds with the highest commissions, one wonders if Franklin Resources can convince investors to pick its funds among a sea of other active funds, given their less-than-exceptional performance.
Paying financial advisors to sell costly funds with less-than-stellar records is easy. Convincing investors to buy its funds without a commission-based salesforce is much harder to do. Franklin Resources' past performance and dividend growth was a by-product of a business model that appears increasingly outdated. Investors shouldn't blindly extrapolate its historical success into the future.