Franklin Resources (BEN -0.98%), a holding company that operates the investment management firm Franklin Templeton, just acquired competitor Legg Mason in a $4.5 billion deal that now makes the combined firm one of the world's largest in assets under management. The deal suffered from bad timing, as it was agreed to right before the COVID-19 pandemic, which put the financial viability of the transaction into question. As a result, Franklin Resources may have overpaid for the acquisition. But in the long run, the deal could still work out if the company can drive improved earnings through operational efficiencies.

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Franklin Resources' acquisition of Legg Mason

Becoming one of the largest global investment funds comes at a price. The acquisition valued Legg Mason at $4.5 billion, or $50 per share, and will be funded with cash from Franklin Resources' balance sheet. Because the deal was negotiated prior to the COVID-19 pandemic, when industry valuations were higher, the market has penalized Franklin's share price. Franklin still trades below its levels from early February, when the deal was announced. The stock has also underperformed peers such as BlackRock and State Street.

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Franklin, which provides investment management and services to institutional investors and high-net-worth individuals around the world, sees Legg Mason as a catalyst for expanding its global distribution capabilities. The acquisition has made the company the sixth-largest independent asset manager in the world, behind the likes of BlackRock and the Vanguard Group. Legg Mason also provides Franklin Resources with alternative investment assets such as private equity, hedge fund, and venture capital platforms.

Expanding into additional financial products is strategically an interesting move that could help Franklin spark revenue growth. However, in the near term, the company's financial picture isn't terribly attractive.

A cloudy financial outlook

Franklin Resources has seen its revenue and operating profit decline for the past several years due to industry pressures from the shift toward passive investment products and away from actively managed mutual funds where. The hope is that by acquiring Legg Mason, Franklin Resources can diversify its revenue base so that it is less concentrated on actively managed mutual funds and drive higher profit margins through cost synergies throughout its business by eliminating duplicative corporate overhead and combining similar product teams.

However, investors were unimpressed when Franklin Resources provided the results for its most recent quarter, which ended June 30. Net income in the quarter increased by 18% compared to the prior year; however, revenue decreased 20%, mainly attributable to the market sell-off in the first quarter, which resulted in lower fees from investment portfolios.

Legg Mason also reported subpar financial figures. The company saw revenue decline by 5% although net income rose 9%. Like Franklin Templeton, Legg Mason saw its assets under management decline due to a combination of investor outflows and lower financial asset prices. Lower assets under management reduce the fee pool that asset management companies collect from.

Now that the companies have merged, Franklin Resources provides the outlook as a combined company. Unfortunately, the company wasn't able to provide much detail due to the extreme uncertainty created by the COVID-19 pandemic. Stock and bond markets have mostly recovered from the crash experienced earlier in the year, but remaining uncertainty over the economy has left investors questioning the sustainability of current asset prices and thus the sustainability of Franklin's revenue base.

In all likelihood, the results at Franklin Resources and Legg Mason would not have been much better in a "normal" economy. The long term challenges created by the shift toward lower-fee passive funds were already set in place. Although the pain may have been exacerbated by the fact that Franklin Resources paid a hefty sum to acquire Legg Mason. Driving change at Franklin Resources won't happen overnight. Investors will need to suffer through several more quarters of integration issues and business headwinds. However, given how far the company's stock price has declined relative to peers, perhaps the stock is worth holding as the company turns the ship.

Asset management industry consolidation

The asset management industry has seen a decrease in financial performance over the years. For example, Franklin Resources posted its highest revenue in 2014 and has seen those numbers steadily decrease over the years. To increase efficiency, asset management firms need to consolidate the industry through acquisition. Industry consolidation will enable firms to manage greater assets with fewer employees and reduce marketing costs due to fewer competitors. Firms will need higher profit margins as industry revenue faces more downward pressure.

There are pros and cons to every acquisition. Legg Mason's shareholders likely got the better end of the deal because they locked in a good share price right before the COVID-19 pandemic-induced market crash. As a result, Franklin Resources may have overpaid for the acquisition; however, to the extent that the combined company is able to drive a higher profit margin through efficiencies and more stable revenue growth, its shareholders stand to benefit.