Franklin's Dividend Safety Score Downgraded to "Safe" as Performance Remains Weak
Franklin (BEN) reported earnings on April 30, providing a first look into the impacts of March's market turmoil on the active fund manager.
Naturally, Franklin's investments declined in concert with markets. Assets under management (AUM) fell 17% to $580 billion, leading to a 7% decline in management fee revenue compared to the previous quarter.
More notably, a flurry of client redemptions in fiscal Q2 led to a sharp increase of $25.4 billion in net outflows from Franklin's equity and fixed income funds.
Source: Company SEC Filings
All else equal, when client redemptions exceed new account wins (i.e. negative net flows), Franklin's AUM recedes, impairing the firm's long-term earnings power.
Taking a step back, Franklin has suffered from material net outflows each year since 2014, when AUM peaked at $898 billion. Since then, AUM has declined 35%, a time during which global markets have appreciated or at least held flat.
Source: Company SEC Filings
The rise of index investing is one reason investors have pulled money out, but so is the poor performance of Franklin's flagships funds.
As we discussed in our April note on Franklin, the firm's two largest mutual funds, Franklin Income Fund and Templeton Global Bond Fund, both significantly trail their benchmarks over one-, three-, and five-year time periods.
Fund performance is often a leading indicator of future fund flows, so there's concern that more clients will leave in the year ahead.
Moreover, funds can shrink in a hurry as outflow momentum builds. No one wants to be the last investor in a fund, and as positions are sold to meet redemptions, fund performance can suffer even greater.
Franklin's struggles may be best summarized the firm's inability to grow its top and bottom line since 2014, when revenue and earnings last peaked.
Source: Simply Safe Dividends
The fund manager's soon-to-close acquisition of Legg Mason will help diversify Franklin's portfolio away from equity funds and more towards fixed income and alternative strategies, which have been less susceptible to passive investing.
However, Legg Mason saw $12.1 billion leave its funds in fiscal 2020 and is itself grappling with net outflows, though to a lesser degree than Franklin.
Despite Franklin's weak showing in recent years and question marks around the merger's potential, the dividend looks supported for now.
For one, Franklin's payout ratio before the pandemic hit financial markets was around 40%, a reasonable level for asset managers that left cushion to maintain the dividend if markets were to fall — which they did.
Analysts now forecast Franklin's payout ratio will rise to 60%, but this is not necessarily cause for concern. Asset managers' earnings are cyclical (revenue is tied in part to AUM) and usually recover as markets gain strength.
Meanwhile, Franklin has a strong A credit rating from Standard & Poor's and will assume only a modest amount of debt from Legg Mason. Post-acquisition leverage (total debt to EBITDA) is expected to be between 1x and 1.25x, well within management's goal of keeping leverage below 2x.
Franklin has also paid growing dividends for 40 years in a row, indicating a strong commitment to its payout and lowering the risk of a hasty dividend reduction while the company works to right the ship.
In fact, CFO Matthew Nicholls remarked in April's earnings call that the dividend is "a sacrament to us." Founder Rupert Johnson's family members own about 40% of shares and undoubtedly want to continue receiving their dividends.
Overall, a dividend cut appears unlikely at this stage. But pressure to retain more cash to pursue acquisitions or invest in growth opportunities (e.g. wealth management, alternative strategies) will increase if fund performance remains weak, net outflows persist, or the Legg Mason merger fails to bear fruit.
In recognition of the firm's continued fund performance challenges and the future financial pressures they could create, we are downgrading Franklin's Dividend Safety Score to Safe. We will continue to monitor Franklin's dividend safety profile and provide updates as new information arrives.
For now, our thoughts on Franklin as an investment opportunity haven't changed since our update in April:
Regardless, we prefer to invest in companies that have clearer paths to long-term profitable growth. Franklin (and other active managers) don't fit that bill due to their relatively high fees and weak performance compared to index funds, so conservative income investors may want to play elsewhere.
