Franklin Resources, Inc.
Q2 2013 Earnings Call Transcript

Published: 30 Apr 2013

[Operator:]

Good afternoon, and welcome to Franklin Resources Earnings Conference Call for the Quarter Ended March 31, 2013. My name is John, and I'll be are conference operator today. Statements made in this conference call regarding Franklin Resources Inc. which are not historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements involve a number of known and unknown risks, uncertainties and other important factors that could cause actual results to differ materially from any future results expressed or implied by such forward-looking statements. These and other risks, uncertainties and other important factors are described in more detail in Franklin's recent filings with the Securities and Exchange Commission, including the risk factors and MD&A sections of Franklin's most recent Form 10-K and 10-Q filings. [Operator Instructions] Now I'd like to turn the call over to Franklin Resources CEO, Mr. Greg Johnson. Mr. Johnson, you may begin.

[Gregory Eugene Johnson:]

Well, thank you. Good morning, everyone, and thank you for taking time to join us today. We know it's a busy day for all of you. With me today is Ken Lewis, our CFO; as well as Chris Molumphy, the Chief Investment Officer at Franklin Templeton Fixed Income Group. I asked Chris to join us this morning in case there are any follow-up questions from his comments in the recorded commentary, which we made available this morning. To quickly recap the highlights this quarter, it was another strong quarter, highlighted by strong relative performance, significant improvement, net new flows and new highs for operating income, net income and earnings per share. I'd now like to open it up for your questions.

[Operator:]

[Operator Instructions] Our first question comes from Craig Siegenthaler from Crédit Suisse.

[Mark Deluzio:]

This is Mark Deluzio here for Craig. You mentioned that K2 had positive inflows of $500 million in the quarter. Has this momentum continued in April and is there any visibility on the pipeline of won but not yet funded business there?

[Gregory Eugene Johnson:]

Well, I think we're careful about talking about the next quarter, but there's plenty of things that they've been working on the pipeline, so it looks healthy. So we continue to be optimistic about that area.

[Mark Deluzio:]

Okay. A quick follow-up there. Has there been any traction with the 1940 Act, fund-to-funds product or any possible retail products from your alternatives business?

[Gregory Eugene Johnson:]

Well, yes, like many -- that's something we are looking at right now. It's an natural extension of what K2 does and there are funds available to put in a fund-to-funds that have liquidity and transparency for 40 Act Funds, so that's something that is in the planning stages for us.

[Operator:]

Our next question comes from Matt Kelley from Morgan Stanley.

[Matthew Kelley:]

I was just hoping to touch base with you on your Global Equity platform and just -- you had modestly positive inflows for the quarter, pretty strong performance, so I was just curious if you can kind of tease that out for us where are you seeing the strongest inflows and maybe a little bit by channel, too. Who's buying more and who's -- where the stronger redemptions are as well for the first quarter?

[Gregory Eugene Johnson:]

I think it's -- if you look at the quarter-over-quarter flows, the big switch was Asian Growth Fund and that's been a big driver. Much of that is raised in Europe through our SICAV funds and that had a very strong quarter. Another is the Frontier equity, which is, again, just an extension of the emerging markets side, which has done very well. Also, Asia small cap has done very well. The Templeton's improved but continues to be in net redemptions despite strong performance. And Mutual Discovery at Mutual rebounded the positive flows, which has -- that's been a major driver for us over the last 5 years or so. So it was good to see that one coming back. So I think just the retail tends to take the longest. We also had some decent institutional wins that funded in Global Equity as well. But really, the U.S. retail, despite good performance, it's just -- it's a longer turnaround.

[Matthew Kelley:]

And then just to follow up on that point, what are you seeing from institutional clients in terms of use of the barbell with alternatives and passives? Is that something you're seeing increase or kind of steady-state or what are you seeing there?

[Gregory Eugene Johnson:]

Well, I don't -- I'm not sure we'd seen a big shift. I mean, I think there's plenty of talk about increasing alternatives and looking for potentially more alpha and higher returns. For us, it's still relatively limited in the amount of searches that we're going to participate there, so it's not really core. We're not seeing a big switch on the passive side from international equity, from Global Equity, like we are in more of the U.S. equity business. So I think they're -- it's still a challenge with passive on Global Equity side, but not -- we're not nearly as much as on your typical, like large-cap growth in the U.S.

[Operator:]

Our next question comes from Luke Montgomery from Sanford Bernstein.

[Luke Montgomery:]

How much of your industry-leading margin do you attribute to the Global scale, the Templeton Global Bond product? And how should we think about the incremental margin and the strategy at that point? And if we were really trying to dimension the [indiscernible] -- the concentration risks, what would be the impact on the margin if you lost a significant chunk of those assets?

[Gregory Eugene Johnson:]

A couple of things. I don't -- I wouldn't necessarily attribute the overall profitability to any one product, but the scale, you're definitely right on about the scale. So we see that scale, the benefits of the scale with our international business to the extent that we're distributing the products using our SICAV umbrella and the same thing in the U.S. So I don't think that -- if you look back in our history, you can look at the margins. We've put a new slide in there this quarter. You could see, if you tracked -- and we have 2 slides in there that's new, which shows the top-selling funds over a period of time and then it shows the margins over a period of time, and you can kind of track that to see that it's not necessarily dependent on any one given product.

[Luke Montgomery:]

Okay. And then if this so-called Great Rotation thesis were to play out and the Global Bond Fund were kind of to get thrown out with the bathwater, what are the key equity or other products you'd point you that you think have strong -- would have a strong interest and good performance that would allow you to internalize a fair amount of those outflows? And in other words, what is the wholesaler strategy going to be in that environment?

[Gregory Eugene Johnson:]

Well, I think it's very important to note that one, I'm not sure what we mean by Great Rotation, because as you've seen in the first quarter, you've had a rotation into equities and fixed income, and most of that has been at the expense of money funds. And I think it's really -- it's very important to distinguish Global Bonds between typical interest rate duration-type fixed income products. And I think people position Global Bonds more like they would an alternative because they're not really correlated, it's more currency-driven. So if you have a spike up in rates, you have shorter duration on these types of funds. And they really are not as sensitive as typical fixed income. But we have Chris here to talk just to that. I think it's a question we get quite a bit for the firm in how Global Bonds are positioned versus typical fixed income. So Chris, do you want to...

[Christopher James Molumphy:]

Yes, and I would agree, Greg, and it's something we touched on a bit in the recorded remarks with respect to Global Bond. In our particular case, our Global Bond strategy, the core strategy has, in fact, no U.S. Treasury exposure and virtually negligible U.S. duration exposure. Overall, duration of the fund is 1.5 years, which is some duration, but significantly less than the broader market. And to Greg's point, it is a bit of a different asset class. It's certainly not domestic fixed income by any means, and it does sit somewhere between a traditional fixed income and perhaps alternatives as Greg alludes to. So it is a bit of a different asset class, one that's probably got some significant secular upside over the years to come.

[Luke Montgomery:]

Okay. I mean, I think we can agree that maybe it shouldn't be thrown out with the bathwater. But the question is more what is your strategy? What is your sales strategy if it does?

[Gregory Eugene Johnson:]

Well, I think our strategy -- and that's what we talked about, I mean, if you look -- we'd be sitting here talking about the Franklin Income Fund right now if -- with the same kind of issue if it wasn't the Global Bond Fund that had such significant net inflows. And for us, our goal is to always have something in the market that can drive organic growth and -- but also have a breadth of products behind it. And if you look at the category -- the quarter where we had positive flows in just about every asset class, we have plenty of funds that we think can do very well. And look at our rising dividend fund, which has done very well in this market, just crossed $10 billion, Frontier markets. There's a lot of new funds that we have introduced and a lot of equity funds like the Franklin Growth Fund that continues to get shelf space. And if that's where the world goes, we have long-term funds with strong track records in position. Our strategy hasn't changed. We've been driving home the equity message -- now Franklin has had a long history in managing equities, and that's something that we've done against -- somewhat against the market, but gotten the message out there. And I think we're well-positioned as far as shelf space with 401(k) plans when and if it does really turn back.

[Operator:]

Our next question comes from Dan Fannon from Jefferies.

[Daniel Thomas Fannon:]

I guess, Ken, just on the expense commentary from the pre-recorded call, you talked about regulatory expense and just curious as to what's different than -- if anything changed or as we think about kind of the build, is there a step function that's coming as a result of some of these changes or just kind of gradual from current levels?

[Kenneth Allan Lewis:]

Yes, I would go with the gradual. I think this was -- we did have some margin expansion this quarter. It's kind of, for us, a hard quarter to have a margin expansion just because of the seasonality of some of the expense items. So I think that was a positive. I think you could see a little bit more expansion going forward. But on the other hand, you do have some of the smaller line item expenses like G&A and occupancy and technology that were just -- we're forecasting to be a little higher. Maybe they won't be a little higher, but that was the essence of my commentary this quarter. But again, those are the smaller line items. So I think generally, margins should be in line and maybe even a little improved if the markets continue to go up.

[Daniel Thomas Fannon:]

Okay. But if I just even think about your fee rate and the improvement we saw this quarter, even a modest continuation of positive inflows, it still seems like incremental margins should be higher and you should still see decent leverage in -- going forward?

[Kenneth Allan Lewis:]

Yes, but I think a lot of the expenses are also variable with the market and you see that in the G&A line, too, so...

[Daniel Thomas Fannon:]

But even if this market flat?

[Kenneth Allan Lewis:]

Yes, it's -- like I said, I think a couple of expense line items will increase, so I wouldn't -- I think it's more of the same, slightly improved, just potential slightly improved on the margin front.

[Operator:]

Our next question comes from Bill Katz from Citi.

[Steve Fullerton:]

This is Steve Fullerton filling in for Bill. I have just one quick question. You talked on the pre-recorded call about the strong growth in Italy. Can you just go into what's striving that and how you could translate that to other regions?

[Gregory Eugene Johnson:]

Well, I mean, I think the -- Italy, it's been really on the back of the Global Bond Fund. And we've -- we are actually kicking off a big equity Roadshow throughout Italy right now. I mean, our goal, you tend to start with one popular fund, and then once you get the shelf space, you can try to diversify that mix and we try to put incentives in place for that. We also have kind of a tactical asset allocation fund that was introduced over a year ago that's done very well in Italy. But it's really through the traditional banks that we've established long-term relationships with and a way for them to diversify away from home currency risk, and that's been a big reason why the Global Bond Fund has done so well there.

[Operator:]

Our next question comes from Michael Kim from Sandler O'Neill.

[James Howley:]

This is actually James Howley filling in for Michael. I appreciate the color that you guys gave earlier about the underground capabilities in Europe and the U.S. version of the Emerging Bond Fund coming online, but what are some of the other more interesting strategies or vehicles that you're contemplating these days as it relates to product development?

[Gregory Eugene Johnson:]

Well, I think one of the areas that we touched on earlier in the call was around K2 and introducing some retail-type products there in the fund-to-fund space. We've spent a lot of time building out our solutions or tactical asset allocation, real asset return funds, funds that are positioned to have commodity exposure should rates go up. And that was probably -- I should've answered part of that to the question earlier about if you do have a rotation. We want to have funds in there that have commodity exposure and can protect capital in a rising rate environment. I think the breadth -- and that's really the area of the solutions and building out our asset allocation capabilities with -- because we really have just about every category covered from a mandate or fund perspective, so I don't think it's anything that we need to develop that's new, but really try to take what we have and package that in a different way that can be more solution-oriented.

[James Howley:]

Great. And then just turning to capital management, some peers have seemingly gotten even more focused on returning some excess capital. And I appreciate that you guys have been very consistent on the dividend and the share repurchase front over time. And I appreciate the 12 months is within the range, but how are you guys thinking about maybe getting more aggressive on returning capital, particularly if the balance sheet continues to strengthen over time?

[Gregory Eugene Johnson:]

Yes, it clearly has been a focus. It will continue to be a focus. As we've talked about, our goal is absolutely to return a high percentage of the U.S. cash flow to investors every year. And yes, the focus has been on dividends in the past. Share repurchases have been lower. The stock price has risen materially this quarter. And the other factor is that viable trading volume has declined materially. So those are factors have driven this quarter's results. It hasn't changed our strategy of being very conscious of returning earnings to shareholders.

[Operator:]

Our next question comes from Jeff Hopson from Stifel.

[J. Jeffrey Hopson:]

Can you give us the amount of institutional global fixed flows in the quarter? And then we've talked about this before, but just want an update, Vanguard has increased or actually established a global fixed ratio or percentage within their target date funds, which would seem to be, in my opinion, kind of an industry indicator perhaps. So just curious about any update on how you're doing in penetrating 401(k) with that asset class? And typically, obviously, it takes a while to build traction with a new fund, but with the emerging market in the U.S., given the track record globally and his reputation, can we assume that you will get traction in that category or that product sooner?

[Gregory Eugene Johnson:]

I don't have the first part of your question on the institutional. I'm looking at the -- some of the larger fundings over the quarter, and they're really -- the largest international fixed was $121 million. So there -- that would -- I think as far as the -- looking at flows, the majority was retail. There wasn't any big, big chunks, big separate accounts in Global fixed. And your other -- I'll take the other one, I think on just target dates in general. I think that -- I put that in the challenge category for us because the captive platforms for 401(k), they are really the ones that are in the position to benefit more from target date funds, and that makes it harder to sell individual funds as buyers move into the target date and that's how they get their exposure into equities. I mean, the good news is, they get their exposure in equities at a young age and I think that's been -- we've seen that statistic. But for the more of the independent asset manager that's not on the platform, it makes it a little bit more challenging to get flows into your traditional equity funds that are even doing well if the world moves to target date. Now we have target date, but it's hard to differentiate it enough to really get the lion's share of any one given platform that's going to go more to their own target date than they are an outside one. And in emerging markets, I hope -- we have had a long history. We've obviously been the early mover, have a strong portfolio management team. And Frontier has done extremely well for us, which is kind of the emerging story, and we hope we can continue to get flows in the core emerging markets.

[Operator:]

Our next question comes from Ken Worthington from JPMorgan.

[Kenneth B. Worthington:]

I wanted to just dig into the appetite for Global Equity. So, I'm going to try this in a couple of different pieces. So on the retail side, I'd love to hear about the momentum of interest in Global Equity products. And on the institutional side, can you talk about the pipeline of activity, how RFPs are trending and if you're seeing kind of more money moving around within the Global -- for Global mandates?

[Gregory Eugene Johnson:]

I would say it's very steady. I mean, you look at Global Equity's overall, have had positive inflows over the last year on a retail basis. I mean, clearly, more people are allocating to global equities. We have a campaign Global is the New Core. And taking the typical investor in the U.S. instead of having 50%, 60% in U.S. equities, try to think about 30%, 40% in Global equity. So that -- just the percentage of the pie has changed. That's put pressure on U.S. equity flows as well, and we continue to see that. I think for us, if I put any area that's been a little disappointing is that we haven't participated in that -- the way we should have. And part of that was the -- some of the challenges around the Templeton's value style, which, the good news that performance has turned around, but it takes time to get back into those -- the mindset of advisors and the retail investor. And that's something that has been a big priority for us to do. So I think the story is just very strong because people are much more comfortable with globalization and in investing cross-borders. The home country bias is not as strong, so that's very much in place. We have -- we participate in a lot of areas. Mutual Discovery has been a big driver within on the Mutual Series side for us and then traditionally, with Templeton as well. It's interesting, our largest mandate we won last quarter was a global growth fund, which you don't of Franklin Templeton for global growth, but we have an excellent performance in global growth, New York-based head there and that was a $0.5 billion win. So that's a category that's institutional quality for us that drives outside of the traditional Templeton value, and again, so that we can participate in just about every type of mandate on the Global Equity side. So I think institutional, it's still very strong. I mean, the pipeline, when we look at our wins every quarter, there continues to be and, whether it's Asia-specific or Global-based, we're getting in a lot of searches there. So I don't think it's been an increase, but I think it's pretty much steady straight -- steady state and still the best opportunity for us along with Global Fixed on the institutional side.

[Kenneth B. Worthington:]

Okay. Like I guess my issue is, you've got a very big franchise. The performance seems to be very good. When you flow, you flow really tiny and when you outflow, I guess maybe you're outflowing tiny as well. But if you're seeing growth, it just seems to be very modest. And you talk about gaining kind of mind share. Are there leading indicators that would show that, that momentum is improving? Or do you think this kind of blah growth run rate kind of persists for the year? Or like what kind of gets it out of this kind of range-bound, kind of really tepid growth or maybe tepid shrinkage range? It seems like you should be doing much better.

[Gregory Eugene Johnson:]

I think it's Templeton retail that is the key because we are doing very well. If you were looking at the organic growth rates in Europe or, as I mentioned earlier, Asian growth, Asian Growth Small Cap, Frontier funds, tremendous growth rates there. All of that gets somewhat lost in the net negative numbers coming out of the retail U.S., so it just takes time to turn around the mindset. The advisor moves on. You get the benefit sometimes of them still selling after you underperform for awhile. But once they -- once you are removed from -- it takes a while to get back and that has been 100% focus of our distribution groups to make sure that, that story and performance is heard. And we feel like we are making good progress there. But again, to me, it's very simple. It's getting that back on-track and then you'll see the right levels of organic growth in global equities.

[Operator:]

Our next question comes from Robert Lee from KBW.

[Robert Lee:]

Let's see, I guess, first one maybe, Greg, for you. I'd just be interested in getting an update. I know you've spoken about it in the past with the acquisition of K2 and kind of looking around the globe, you actually have a pretty fair number of alternative-type strategies, but the distribution of them maybe has been somewhat haphazard or not particularly well organized. And I know you've been making efforts to kind of streamline that and centralize it. Can you maybe first just update us on where that stands, and if that's something you think will start taking effect more this year? And maybe as we get to the end of this year, next year could start to see -- move the needle a little bit?

[Gregory Eugene Johnson:]

Well, I think it's gradual like most things we do and the -- we have dedicated senior resources to the alternative side. People that have been here with the firm a long time and really 100% of their job now is to try to make sure that we're leveraging the stories wherever we can across relationships in the firm. And so I think that's been a big step forward. I think we still debate at the actual sales client interaction level, what the right mix is. And in some cases, I think we're concluding we need more dedicated people out there. So I think that's something that we'll continue to add. And we've got the infrastructure and senior management team in place to build that out now where we didn't before. So I don't think there'll be a big change, but it's just gradually we will keep adding people on there.

[Robert Lee:]

Okay, great. And then I apologize if you had addressed this in the remarks at the start because I got on the call late. But with the capital management, the ever-present questions, I guess, but can you maybe update us if we look this quarter and out for this year, what your current expectations are for kind of the mix of cash that will be generated or you expect to be generated and available in the U.S. versus outside the U.S.? And also, if there's anything you're seeing or hearing in the recent budget negotiations and proposals that give you some, although it's always hard to hope for good outcomes, but hope to give you some optimism about maybe seeing some changes that could free up some of that non-U.S. cash to be brought back home?

[Gregory Eugene Johnson:]

All right. So I think the U.S., non-U.S. cash generations in the maybe -- it's not 50-50, it might be -- maybe 60% international. And going forward -- and I did mention as one of the questions earlier that it has been slow, some of that's been due to the viable trading volumes, as well as the run the stock has been on this quarter. We're going to stay focused on it. We're going to be pretty opportunistic going forward, and so there's no real change strategically into our policy there. But we are definitely aware that the volume was lower this quarter. Yes, and I don't -- we haven't heard anything new coming out of government. We still remain somewhat moderately optimistic that something that might happen, but it won't happen for a while. I don't know if anyone else has heard anything on that front, but -- so we're just to waiting to see on that.

[Robert Lee:]

And I guess, maybe as a follow-up to that, if you look outside the U.S., there are some jurisdictions, where -- which do have modest capital needs or regulatory needs. Do you see anything outside the U.S. that regardless of what happens here tax-wise, it means you'll just have to keep more capital or cash in certain jurisdictions than you currently do? Anything like that on the horizon?

[Gregory Eugene Johnson:]

Well, nothing material. The trend is -- with a lot of the regulatory -- as we expand globally, we get into different markets, there's different -- so there is demand to increase capital requirements in certain jurisdictions, but relative to the size of our balance sheet, it doesn't really move the needle.

[Robert Lee:]

Okay. And maybe one last capital question on seed capital. I mean, I know you guys dedicate a large chunk of capital to seeding new strategies and products and clearly recycle it. But is there any, as you continue to expand your capabilities with K2 and looking at products there, some of which can be, I guess, capital-intensive in the sense that they require higher levels of seed capital. But anything that makes you think that the amount you dedicate to that could actually start to creep upwards going forward?

[Gregory Eugene Johnson:]

I think that is the trend. I think you're right on in spotting that. As the products get more complex, we do things like introduce products with different sleeves that portfolio managers have to manage the requirements go up. Fortunately, for the capital management discussion, those needs tend to be outside the U.S., so they're not impacting the U.S. cash to an extent. We're keeping that pretty tight. And most of our product development is not in U.S. product, it's mostly in international products that we're developing products. So it's true, it's requiring more capital, but it tends to be outside the U.S.

[Operator:]

Our next question comes from Michael Carrier from Bank of America.

[Michael Carrier:]

I guess, first question just on margins and scale. So if I look at year-over-year for the first 6 months, it looks like your average assets are up 13% and you have some operating leverage. But I'm just trying to understand, obviously, there's distribution costs that are going to up with markets and assets and some comp. But if the market levels continue or they drift higher, should we assume that you can still be generating like 100 to 200 basis points on an annual basis in leverage just given the strength of the markets that you benefited from?

[Gregory Eugene Johnson:]

Yes, those are pretty big numbers and, of course, hypothetical. I think that one thing not to lose sight of in this quarter is that kind of strange anomaly with the distribution expense where we're kind of accruing the asset base component of that on a monthly basis, but the revenue was short because it's based on the number of days. So if that normalizes, just something like that, you could see some margin expansion in the short term. But over the long term, I think the variable costs will go up if the revenue goes up. And our variable compensation will, of course, go up. Performance is good, so there's pressure there. So I think all of these things lead me to believe that it's more kind of offsetting slightly better margin, but not in the range you were talking about.

[Michael Carrier:]

Okay. I mean, those nuances are helpful. And then just when I think about products versus geographies, obviously, from a scale standpoint, there are certain products you have a lot of scale in. Greg, you mentioned Italy in terms of gaining scale in that market. Are there any other -- like when you look at the international markets, are there others where you're sort of getting to, I don't know, it's probably different for each market, but whether it's $5 billion or $10 billion or whatever that level is where you feel like the operating leverage or the scale in the business starts to improve versus when you're running at a level where it's still -- relative to the overall margin it's under because you're still building up or building out?

[Gregory Eugene Johnson:]

Well, I think I would say today that most markets we're in are at scale where we're profitable, I can't even -- there's very few today that would be net negative and then still on that phase. I mean, Italy is our -- now our largest country outside of the U.S. as of this quarter, so it's certainly at scale at $36 billion. It's just a matter of the risk and diversifying and making sure you're -- while the sun's out, you're doing everything to get the message on the other funds just to help your business to be more diversified. But today, we probably have -- I think we have 19 countries or regions that we define that have assets over $3 billion in each of them, so you can see it's very broad diversification. Every one of those would be profitable, different levels of margins, but certainly profitable.

[Michael Carrier:]

Okay, that's helpful. And then just last one on the equity flows, you mentioned just in terms of seeing that improvement, the focus on Templeton retail and predominantly in the U.S., when you look at your -- like the history of Franklin, and you go through periods where there is a product, whether it was Templeton or Income Series, that did lag the industry and you saw some outflows or weak relative to the industry. Do you have any sense like how long, once -- because the performance is back, so once the performance is back, how long that traction tends to take in order to have those flows shift? Obviously, it's going to depend on the environment for overall equity flows, but just trying to gauge based on like the experience in the past, how long that tends to take?

[Gregory Eugene Johnson:]

Yes, I mean, I don't have -- I can just tell you that equity takes longer than Fixed Income. Fixed Income tends to move back a lot faster because of the attraction of that current dividend rate there, and equity is a little fuzzier so it just takes a little bit longer to get back. And the other piece that I should've mentioned, when we're talking about international flows. I'm just looking at some of the numbers too, and there tends to be some headwind just from reallocation. You get into a strong market and pension plans will rebalance based on the -- so I'm looking -- I see a lot of topping off in some large accounts that can happen over -- when you have the kind of moves that you've had and that adds up, too, and then a couple of redemptions too this quarter in Global Equity, the largest redemption was in Global Equity. So those are going to, again, mask a lot of the good that is occurring on the retail side and improvements on the retail side, and those are more one-off than the underlying flow trend. And I am looking at some numbers that the majority of the larger accounts that went out this quarter were in Global Equity.

[Operator:]

Our next question comes from Greggory Warren from Morningstar.

[Greggory Warren:]

Just trying to figure out, I know we touched on this a little bit and I don't want to really beat a dead horse here, but I'm trying to figure out what the issue really is on the Global International Equity side. Because if you look at the industry AUM flows through the first quarter, actively managed pulled in well over $35 billion. And as we roll into sort of April here, international seems to be about the only area where there's still interest. And you guys touched on there being sort of an issue on the U.S. retail side and that outside of the U.S., your flows were better. But I'm trying to get sort of a feel for, is this a matter of, on the retail side, advisors are putting the investors more into, say taxable bond and those sort of portfolios because they are a little bit more equity-like and less so on these funds because there's been some performance issues? Or I mean, what's your take on what's going on here?

[Gregory Eugene Johnson:]

Yes, I just think that we're not -- for the advisor in the U.S., they're selling other Global Equity funds than our -- selling some of ours, but not -- the only area that I think of in any significant way where we lost some share was on the retail side in Global Equities over, say the last 5 years. So that's the part that's lagging for us, that performance lagged and now it's strong, it just doesn't turn that fast. And then again, the -- if you have some significant outflows, for Global Equity accounts, some topping off, then there was one that, a large Canadian one in the quarter that went out, that's going to -- you're going to draw a lot of conclusions by looking at a big number that's a one-off number versus retail flows. So retail flows did improve for us, like most for that quarter. It's just that we had probably a little bit more in one-off kind of top -- whether it's reallocations or terminations in that category. So it's simple. I mean, we do well with just about everything else and Templeton has lagged here in the U.S. and that's also a big asset base that when it lags in gross sales, even a normal redemption rate creates fairly heavy net quarterly redemption. So we've got to get the gross sales number back up, and that's what we're trying to do.

[Greggory Warren:]

Okay, yes, that makes sense somewhat. Basically, I'm sort of looking at the January flows as being kind of a one-off, too. You got the normal reallocation that goes on there. You had a lot of money flowing out of stocks, stock fund sales and special dividends in the fourth quarter that got reallocated in the first part. But when I'm looking at your taxable bond flows here, they seem to be a lot stronger than we've seen in a long time, and I'm just wondering, do you feel that what we saw during the March quarter is going to continue at this level or sort of a tapering down as we get through the rest of the year because this is more on par with kind of the run rate we were seeing prior to the performance hiccups?

[Gregory Eugene Johnson:]

I think I don't see any reason why that shouldn't continue. I think we're still, like most of the industry, fixed income continues to be strong, so that -- we think that trend should continue. I don't -- I couldn't call anything out unusual there.

[Kenneth Allan Lewis:]

And also, Greg, you alluded to the fact, this Great Rotation. But with money funds and short rates at 0, which you believe they may well be for some time that seems as though that continues to provide a base for taxable fixed income. And then we're working fairly broad in terms of our product line both in terms of some low-duration products, some multi-sector product and then the continued search for yield. I mean, there's still a necessity for yield out there. So I don't -- I'm not a sales professional, but it seems as though a lot of those trends are here at least for the foreseeable future, one would guess.

[Gregory Eugene Johnson:]

And I think when we talk about the Great Rotation, and again, I mean, in Fixed Income and what does it mean, I think you also have to consider just the demographic shift in risk tolerance of your average investor, certainly in the states, that's getting older, closer to retirement and that baby boomer bubble there that's working its way through has less of an appetite for equities, and that has an effect as well when they're looking and getting closer to retirement.

[Greggory Warren:]

Yes, I'm right with you on there. I mean, this whole notion there will be a huge bubble popping in fixed income, I don't think it's going to be as big as people think. I mean, there will be some out draft, but we'll have to see. I still think we're caught in this kind of risk aversion cycle here, and 2013 is looking an awful lot like 2011. And all we really need is sort of a hiccup here and people start running from the doors on the equities side. Let's hope not, though.

[Gregory Eugene Johnson:]

Yes.

[Operator:]

Our next question comes from Roger Freeman from Barclays.

[Roger A. Freeman:]

I just want to come back to Global Bond Fund. As you talk about it, it kind of doesn't fit neatly into one category, and I wonder if you could just kind of talk about the sort of segmentation of the investor base, both on the institutional and retail side. Are there sort of buckets you feel like, based on whatever feedback you can get through the channels, that you can put investors in, in terms of what their invested in and for?

[Gregory Eugene Johnson:]

Yes. Again, I don't have that information, and it's just kind of guessing as far as -- I think it's generally going to be a little bit more sophisticated, a little bit maybe a little larger average ticket size just because it is something a little bit different. You're coming from 0 penetration in a traditional retail buyer. Today, we're still very small. And even for the institutional buyer, the category is still under 5%. So you've got a huge way to go. And I think -- if you think about the investor, they're kind of concerned about rates going up. They're concerned that "Gee, equity markets, I can't -- we had a tough decade and we've got all these macro headwinds that are still out there," and they're just concerned about risk. So this is not a risk-free investment by any means, but it's not correlated to a lot of the macro. You could make a lot of money with many of these macro changes that can happen with countries. So it's a different story, and it lowers the risk of a portfolio. So I think you'd still have a ways to go as far as market penetration, and it's probably starting with the more sophisticated one moving down. And I think it's the same story with pensions. It's just going to take a while to position it properly and get different fiduciaries and boards comfortable with the concept. But I do think it's an alternative that's liquid, it's transparent. It's easy to value, and it lowers the risk of a portfolio. So those -- that's a lot of checks.

[Roger A. Freeman:]

Absolutely, okay. And then the second question, just in terms of your equity marketing strategy, the global equities, new core, does -- with that being sort of your push, does that come at all, do you think, at the expense of domestically focused equity funds? Or is it the opportunity to kind of push the improved performance story in Templeton just that much better?

[Gregory Eugene Johnson:]

Well, I think it's both. I mean, it -- really, we've started and continued to push the equity story out there. The global one is newer this year. Again, I mean, I think we always talk about our wholesalers, sales team can probably give 3 good ideas in any one meeting and that's about the max, so we're careful about what those 3 are. And it's really talking about equities and whether it's Global or U.S., that story is going to fit for both. So I hope it doesn't diminish the importance of getting our domestic equity story. But we're really talking just about equities in general. That's really the start.

[Operator:]

Our next question comes from Marc Irizarry from Goldman Sachs.

[Marc S. Irizarry:]

Greg, can you talk little bit about the -- your business outside the U.S.? Are you seeing some competitors in some places maybe where there's subscale, maybe some global competitors retrenching, and is that helping you guys? And then also maybe could comment on -- I know it matters really by region, but as the local competition, are you starting to see the architecture open up a little bit and help you guys?

[Gregory Eugene Johnson:]

I think it's hard to generalize because I think every market's a little bit different with respect to some openings, some getting more difficult. I think the open architecture, generally speaking, is there in most places. And I think once the bank -- the banks control so much of what's distributed, especially as you get into the smaller countries, that's where the money is. And once the big banks went to open architecture and you have global relationships and local servicing, you can do very well there. So I don't think that's changed much one way or another, but it's there. As far as competition, you've got some disruption with the bank's own funds, so I think that's probably good for the independent and help open architecture trend. But we're not -- I don't think we're seeing a big shift on -- we see a lot of managers talking about moving into different areas and building local businesses. But I think once they look at some of the challenges and numbers and investment it takes, it's not quite that simple. And then we see the typical names that we compete with in places like Asia and Europe, but I don't think the landscape has shifted a lot.

[Marc S. Irizarry:]

Okay. And then you mentioned that Italy has grown significantly, second biggest market now, I think you mentioned. Any update or view on the financial transaction tax and what that might mean to some of your European countries in your retail business out there?

[Gregory Eugene Johnson:]

Well, I don't have an update. I mean, I hope that it doesn't happen for obvious reasons. I think those things, once people get educated on who really pays for those, that hopefully that shifts the thinking. But unfortunately, it does have momentum. And again, I don't think it's something that we can control except from somewhat of a lobbying we can try to get our message in there. But the transaction taxes have come up a lot of times before. And I think, hopefully, level heads will push back on it.

[Operator:]

Our next question comes from Chris Harris from Wells Fargo.

[Christopher Harris:]

Another follow-up here on Templeton. So performance is really strong, we've talked about it. And at this point, it's a sales issue. We're not quite certain when the timing is going to turn around. But I guess what I'm curious about is presumably, you guys are paying your people pretty well for the improved performance in that product class. And so if there is a situation where we do start to see a really big pickup in sales, all of a sudden advisors start selling the product more, is there a high degree of kind of operating leverage that would kind of really help you guys out there? Or would you kind of use that opportunity to pay your people a bit more given the better flows? So just if you can help us frame up the dynamic with how flows could potentially impact your operating leverage?

[Kenneth Allan Lewis:]

I'll take that. It's Ken. So yes, clearly, on a -- if it's a material shift to that Global Equity class, you're going to see the effective fee rate pick up. In that case, you should experience a fair amount of operating leverage. And yes, I have to agree, we do pay our people well. We will continue to do that. We talked about this a little bit in the past. It's kind of more of an art than a science. 2 things drive it, the overall company profitability, it's also the individual group's performance. And so we kind balance those 2 things and we'll continue to do that. Having said all of that, you go back and you look at our compensation ratio and investment advisory fees, it does vary. But over the long term, it's been within a pretty tight range, I would say.

[Christopher Harris:]

Yes, I mean, I would agree. I was just trying to make the point that if you guys are compensating folks for the performance that's been really good as you highlighted, it just seems like there would be a really good opportunity for the margin if we all of a sudden start getting significant amount of sales into that product, but...

[Kenneth Allan Lewis:]

I would agree. And the other dynamic is, if it is the Templeton Global Equity products and the Emerging Markets products, just keep in mind that, that also gets managed in low tax jurisdictions.

[Christopher Harris:]

Okay, perfect. It makes sense. And then real quick follow-up, I know there's been a lot of questions about the balance sheet, just curious to get your thoughts on how you guys are thinking about M&A opportunities here? And whether you think that might be a good use of the cash that's held overseas? I know a lot of it's going to be a function of really what becomes available, but I'd love your updates there.

[Kenneth Allan Lewis:]

Yes. Proactive in some markets, reactive in others. As things come up and we evaluate the product set. I think we'll continue looking at some of the smaller markets. We did that small acquisition in Mexico because we thought that's a good opportunity. But we're clearly open. I mean, we're very disciplined in the approach, which I think some of the better deals are the ones we didn't do. And so we'll continue that approach. But we feel that, that is a competitive strength -- our balance sheet that we can be able to take advantage of any opportunity when it arises.

[Operator:]

Our next question comes from Jeff Hopson from Stifel.

[J. Jeffrey Hopson:]

So just a couple of final questions, I guess. The distribution margin, to what extent is that affected by higher sales in non-U.S. markets? And then is there any overall or net FX affect to the bottom line? I know you guys have a lot of product in U.S. dollars, but you also have some not, so I'm curious about that. And then you might have commented on this, the tax rate lower, what was that reason and what -- any projection for tax rate going forward?

[Kenneth Allan Lewis:]

This is Ken. I'm just writing down your 3-part question here so I don't forget it. So the underwriting distribution margin. The first place I would suggest to look at is in the MD&A and 10-Q. We break out the revenue component into a sales base and asset base, and we break out the expense component into a sales base and asset base. And so you can see, if you match those 2 up, you can see relationships. But you're exactly right that a high degree of international sales will have a tendency to depress that margin in the short term. And the other dynamic to consider is, in the U.S., the revenue streams are kind of split between investment management, distribution, shareholder servicing. That's not necessarily the case outside the U.S. where the investment management fee is -- tends to be higher, but it also tends to -- the reason it's higher is it covers the distribution expense. So we have that little revenue expense mismatch, but we try to help you understand that more with our disclosures in the Q. On the FX side, there's a couple of areas that FX affects the business. So I think -- I'm glad you asked the question, it's probably a good opportunity to talk about that. The first is assets under management. The majority of our assets under management are in funds and accounts that are priced in U.S. dollars. The other is in cash and cash equivalents. So about 10% of the cash and cash equivalents are held by U.S. dollars -- held in U.S. dollars by entities with a different functional currency. Now those changes go to unrealized foreign -- they go to the other income line. I don't want to get like too technical, but it's just for simplicity. The translation of the U.S. dollar cash and investments into the foreign entities' functional currency is done at the month end at the spot rate, and that goes to other income and then the translation of those holdings back to U.S. dollars at the corporate level, essentially, is an offsetting transaction that goes through OCI. And then overall, because we're so global, the operations, they do tend to act as a natural hedge. And we've been tracking it for years, and it's never been material. And then the last part was for taxes. So the tax rate went down, but we did have a fair amount of discrete items in the quarter that drove the tax rate down and I think that was in the neighborhood of $12 million.

[Operator:]

We have no further questions at this time.

[Gregory Eugene Johnson:]

Well, thank you, everyone, for participating on today's call. We look forward to speaking next quarter. Thank you.

[Operator:]

Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.