Franklin Resources Is a Little-Known, Undervalued Gem

It may not be the most well-known company, but it offers a high yield and an appealing valuation

Oct 08, 2020

Franklin Resources, Inc. (BEN, Financial) may not be a well-known company. The market capitalization is only about $11 billion, but it has a long history of dividend growth and currently offers a dividend yield of around 5%. The stock also has a price-earnings ratio below 10.

In this article, we will examine the company in further detail to see why income and value investors may want to consider adding Franklin Resources to their portfolio.

Company background and historical performance

Franklin Resources has been in business since the late 1940s and has grown into a global financial services company. The company provides asset management solutions, stock-transfer services and insurance products and distributes mutual and closed-end funds. Franklin Resources has generated roughly $5.4 billion in revenues over the last year.

Franklin Resources has often used acquisitions as a method for growth. That tradition continued when the company closed on its $4.5 billion purchase of Legg Mason at the end of July. The combined entity now has approximately $1.5 trillion in assets under management and an increased global footprint. This acquisition should help continue to grow its top and bottom lines.

The declines in revenue and earnings per share for the company usually correlated with a recession in the past, but the overall trend for both revenue and EPS has generally been higher.

Revenues have climbed at a fairly steady pace of 3.8% annually over the last decade. Net profit has actually declined 1.2% over that period of time. Due to share buybacks, EPS has compounded at a rate of 1.7% from 2010 through 2019.

The lowering of trading fees on securities in recent years to near $0 will have a material impact on asset managers' bottom lines in the future. That said, Franklin Resources' most recent quarter should offer a glimmer of hope. Even though revenues declined 20% due to outflows, net income actually increased 18% and EPS was higher by 7.7% on account of higher asset prices.

The company's recent acquisition of Legg Mason should provide for growth as well. Cost synergies are expected to be $200 million within the first year.

Franklin Resources scores very well in terms of profitability, as shown in the GuruFocus chart below:

The GuruFocus system rates the company's profitability as a 7 out of 10, a solid score considering the decline in net income over the last decade. The company's return on equity and return on assets are higher than at least 82% of its peers. The operating margin, while at the low end of Franklin Resources' historical average, tops the majority of competitors. At the low end in multiple categories compared to its own performance, Franklin Resources still manages to outperform the majority of companies in the industry. I take that as a bullish sign, and it shows that Franklin Resources has room to improve.

Dividend analysis

Franklin Resources raised its dividend by 3.8% for the payment distributed Jan. 10. The company's dividend has increased with a compound annual growth rate of:

9% over the past three years.
12% over the last five years.
13% over the past 10 years.

Obviously, the dividend growth rates are in decline, with the most recent raise considerably lower than even the three-year average.

However, Franklin Resources now has 40 consecutive years of dividend growth. This is tied for the sixth longest dividend growth among companies in the financial sector and second longest among companies in the capital markets industry according to the Dividend Investing Resource Center.

The GuruFocus system gives the company solid rankings on its capital returns:

The stock's yield is in the middle of the pack for the industry, but the other dividend related rankings are higher than most peers. Franklin Resources also receives high marks for its share repurchases. The company has reduced its share count by almost 3% annually over the last decade. That reduction rate has accelerated to 3.5% over the last three years.

Franklin Resources has also distributed several special dividends over the years, the last coming in April of 2018. This special dividend was for $3.00, showing that the company isn't shy about issuing massive one-time payments.

Franklin Resources' current dividend yield of almost 5% is more than three times the stock's 10-year average yield of 1.5%:

As you can see above, Franklin Resources has only recently become more of an income play. The average annual yield has only topped 3% once since at least 2004, and that was last year. You don't achieve four decades of dividend growth without prudently managing the business and dividend, and that is just what Franklin Resources has done.

Over the long-term, the company's dividend has been well below GAAP EPS and free cash flow per share. Free clash flow cratered recently, but that is largely due to the impact of the coronavirus recession on business results.

Franklin Resources has distributed $1.08 of dividends per share over the last four quarters while producing adjusted EPS of $2.67 over that same period of time. This results in an EPS payout ratio of 40%, double the average payout ratio of 19% since 2010. The trailing 12-month payout ratio is more than double the average, but still in a range I am comfortable with.

Franklin Resources has distributed $530 million of dividends over the last year while free cash flow has totaled $563 million for a free cash flow payout ratio of 94%. The three-year average free cash flow payout ratio is even higher at 97%.

As high as these ratios are, there is a positive sign as free cash flow in the most recent quarter was nearly $494 million, substantially higher than the three previous quarters combined. If Franklin Resources can show that the most recent quarter's free cash flow is more of the trend then a one-off occurrence then this payout ratio should move lower.

Until EPS and free cash flow show improvements, dividend growth will likely be limited. The stock's yield likely compensates for the lack of dividend growth for income investors.

Recession performance

Like many financials, Franklin Resources struggled during the last recession surrounding the Financial Crisis of 2008. The company's EPS results for the years before, during and after the Great Recession are listed below:

2006 EPS: $1.85
2007 EPS: $2.37 (22% increase)
2008 EPS: $2.24 (5.5% decrease)
2009 EPS: $1.30 (42% decrease)
2010 EPS: $2.12 (63% increase)
2011 EPS: $2.89 (36% increase)

Franklin Resources' EPS suffered a severe decline of 45% from 2007 through 2009. As difficult of a period of time as this was for many companies, Franklin Resources returned to growth in 2010 and made a new high in 2011. This marked the beginning of a strong few years of growth. Though EPS did decline in 2015, 2016 and 2019, the general trend has been higher for the company.

Even while the company was reeling during the worst of the last recession, its dividends continued to grow:

2006 dividends: $0.15
2007 dividends: $0.19 (27% increase)
2008 dividends: $0.27 (42% increase)
2009 dividends: $0.28 (3.7% increase)
2010 dividends: $0.29 (3.6% increase)
2011 dividends: $0.33 (12% increase)

Franklin Resources' dividend growth was exploding leading up to the financial crisis and slowed drastically in 2009. This was the correct decision given the uncertainty of that era. Once EPS growth returned so did dividend growth. This led to steady double-digit increases every single year up until the most recent increase.

From these results, I gather that Franklin Resources will likely slow dividend growth to a crawl during the next recession until the environment is more business friendly. The dividend will continue to grow. Based on previous performance, Franklin Resources' dividend looks fairly recession-proof.

Debt

Franklin Resources' balance sheet is in pristine condition and this is reflected in the company's financial strength rating from GuruFocus:

Franklin Resources receives a solid score of 7 out of 10 for financial strength. The company ended the June quarter with almost $8 billion in current assets, including $7 billion of cash and cash equivalents. At the same time, there is zero debt due within the next year. Total debt was $1.7 billion at the end of the quarter, but Franklin Resources is assuming ~$1.5 billion of debt in the Legg Mason acquisition. Even with this, the company is well positioned to handle its debt obligations.

We will have to see next quarter how the additional debt will impact the company, but total interest expense was less than $25 million over the last four quarters. This results in a weighted average interest rate of just 1.5%. This is an incredibly low figure, one that makes it highly likely that debt will not play a role in the company's ability to continue paying and raising its dividend.

Valuation

Franklin Resources trades at $22.60 at the moment and is expected to earn $2.62 this year according to analysts surveyed by Yahoo Finance. The stock's forward price-earnings ratio is 8.6 based on these estimates. The 10-year average price-earnings ratio is 13.6.

The GuruFocus system gives the company earns a 10 out 10 rating on valuation, as its trailing and forward price-earnings ratios compare very favorably both to Franklin Resources' historical averages and the industry as a whole. The GF Value Line ranks the stock as modestly undervalued.

If you're not familiar with the GF Value Line, it is a new feature from GuruFocus that estimates the intrinsic value of a stock based on a variety of factors, including valuation ratios, past returns and future estimates of business performance.

Based on these factors, the GF Value for Franklin Resources is $29.86. This equates to a price-to-GF-Value ratio of 0.73, earning shares a rating of modestly undervalued.

Franklin Resources has struggled to grow net income and EPS over the last 10 years, but has recently made an acquisition that will double its assets under management while not impairing the balance sheet all that much. I believe a price-earnings ratio range of 10 to 12 incorporates the pluses and minuses of Franklin Resources' business.

Applying expected EPS to this valuation range results in a price target range of $26 to $31. This range would be a 15% to 37% increase from the current share price, not including dividends. The yield for this price target range would be 3.5% to 4.2%.

At a minimum, total returns for Franklin Resources could be more than 19% and as high 40% for shares of Franklin Resources.

Final thoughts

Franklin Resources scores very well in nearly every category that the GuruFocus system rates. The stock has above average scores in the areas of financial strength, profitability and valuation. The company's dividend has also survived three recessions and has four decades of growth. The stock has an extremely high yield and a valuation much lower than usual. Using a reduced price-earnings ratio range, Franklin Resources offers the potential for high double-digit total returns. This qualifies the stock as a buy in my opinion.

Author disclosure: the author is not long any stocks discussed in this article.