Thursday, 24 September 2015

Franklin Resources - Modelling EPV Using Different Sensitivities

I've continued to run a screen for new 52 week lows on a daily basis. Commencing mid July 2015, I began screening on a weekly basis (using the Friday close), but as I got better at focusing my screening to weed out non-viable candidates (i.e., garbage), I figured that making the leap from weekly to nightly wouldn't be too difficult. And so far, it hasn't.

Here's what I've been looking for:
  1. Reasonable to (preferably) no leverage
  2. Sufficiently high pretax cap rate (EBIT / EV)

These two criteria become the starting point for additional research (I further stratify consideration by looking at a history of consistent ROIC, revenue growth, operating income, gross margins, and EBIT margins).

It hasn't been difficult weeding out the nonsense this way.  Despite the proliferation of 52 week lows on almost a daily basis, I've managed to focus my consideration on candidates that meet both the initial two considerations above, and a pretax cap rate in excess of 10%.  And guess what?  I'm not finding much in terms of cheap even despite the drop in the market over the last few months.

A few candidates keep showing up consistently in the Asset Management sector, and one of these candidates is Franklin Resources (BEN).

On initial screen, it has a pretax cap rate (rolling last 4Q EBIT / EV) close to 22%, and a very reasonable leverage profile (Mkt Cap of $23B, and EV of $14B, i.e., almost 40% of current market cap is cash and securities).  So I began researching it.

The first thing to note is that the Asset Management business is highly competitive and not without its challenges for "legacy" asset managers like Franklin Resources (think Fidelity).  The industry seems to be under pressure to compete with minimal management fee ETF companies like Blackrock or Vanguard. BEN's foothold in the industry of charging (and maintaining) high enough management fees sort of reminds me of American Express vs. Visa and/or Mastercard.

I think that overall, in order to compete with the likes of Blackrock or Vanguard, Franklin will be under pressure to shave management fees.

The next thing to note (and this is a subset of fees) is that Assets Under Management (AUM) are mobile.  There is no reason why investors won't pull AUM over time if they are convinced that they can improve their returns being doing it yourselfers, or in the face of prolonged weakness in the market.  Fidelity is therefore, highly dependent on strong equity markets, and competitive fee structure.

Building the EPV - First Attempt: 

I've done this a number of times in previous posts, so I will spare the details of how I get to my valuation matrix.  I will jump straight to end result, but list my assumptions in getting there:

  • My starting point is last four quarter's rolling Revenue (per gurufocus)
  • I took the average EBIT over the last 10 years as a % of revenue of 34% in order to determine normalized EBIT.  2014 EBIT was actually higher as a % of revenue at 38%, but I want to be conservative in my valuation efforts as September 30, 2014 was just about the peak of the current market cycle.  By using 34%, I'm normalizing for reduced EBIT due to down cycles
  • I added back 25% of SG&A as Franklin Resources incurs a significant amount of SG&A as a % of sales each year as a function of marketing and retention of staff.  Per Greenwald, some of this expense should theoretically be capitalized if it leads to future goodwill (client retention, etc.)
Using today's closing price of $37.27, my valuation matrix is as follows:

Cost of capital rates:EPVAdj for Debt & Excess CashAdj EPVO/S sharesEPV / shareBVPS / shareExcess EPVCurrent pricePrice / EPVPrem/Discount vs EPV
Upper bound - VC15%14,175.46979823,973.46614.239.0321.841.7937.270.95-4.51%
Arbitrary 2 <10% - 12 %>10.00%21,263.19979831,061.19614.250.5721.842.3237.270.74-26.30%
Combined NI & Div growth9.46%22,471.10979832,269.10614.252.5421.842.4137.270.71-29.06%
Arbitrary 17.50%28,350.92979838,148.92614.262.1121.842.8437.270.60-40.00%
Per GF6.45%32,966.18979842,764.18614.269.6321.843.1937.270.54-46.47%

Looks pretty good initially.  At WACC's of between 7.5% and 10%, BEN appears to have a margin of safety of between 46% and 26%.

And then something dawned on me.  My model is too static!

While it doesn't take future growth into consideration (conservative), it also doesn't take future diminishing returns into consideration either (aggressive).  It assumes that revenue will stay flat and grow from here, which, thinking about it, is likely incorrect.

How to Fix EPV to Account for Declining Growth

I started thinking about the overall business, and it's is pretty straightforward.  Franklin's future success is a function of AUM x fee margin (above the line), and controlling SG&A in response to decreasing AUM’s below the line.

I shouldn't really care that it appears that there is a margin of safety today at current prices.  What I should care about is what my EPV tells me under the worst case scenario.  And the worst case scenario is both a decrease in both fees, and a decrease in AUM's a la 08/09.

Analysis of Fee Margin

I took the last 10 years of revenues and the average AUM's per the 10K's, and I came up with the following:

You can see a gradual reduction in Fees / Avg AUM since 2006 from 1.05% to .91% currently.  I think this is symptomatic of competitive pressure.

You can also see the effect on AUM's of the 08/09 crisis.  

AUM ($1b's)9/30/20069/30/20079/30/20089/30/20099/30/20109/30/20119/30/20129/30/20139/30/20149/30/2015
Yr/yr change26.40%-21.46%3.17%23.21%2.34%13.64%12.67%6.27%-3.51%
Yr/yr change20.75%3.93%-26.90%29.15%21.52%1.73%14.45%9.90%-0.11%
Fees ($1m's)
Total fees5,0516,2066,0324,1945,8537,1407,1027,9858,4918,100
Fees / Avg AUM1.05%1.07%1.00%0.95%1.02%1.03%1.01%0.99%0.96%0.91%

Next I performed a sensitivity analysis under the following states:
  1. Fee margins at .91%, .85%, and .80% (allowing for further pricing pressure on fees)
  2.  A reduction in AUM’s of between 20% to 30% from ending AUM’s as at June 30, 2015 (encompassing a repeat of 08/09)
I then modelled my after tax adjusted EBIT and resulting EPV using the average outcome of the three fee states, .91%, .85%, and .80% across the different drawdown states, -30%, -25%, and -20%.

Here is my three state outcome matrix:

Sensitivity Analysis
Fee marginFee marginFee margin
08/09 drawdown in AUM = 26%0.910.850.8
Ending AUM thru June 2015867
Drawdown in AUM = 30%30%606.55606.55606.55
Fee margin5,519.615,155.684,852.40
Drawdown in AUM = 25%25%649.88649.88649.88
Fee margin5,913.865,523.945,199.00
Drawdown in AUM = 20%20%693.20693.20693.20
Fee margin6,308.125,892.205,545.60
AT EBIT Margin25.84%1,527.921,427.181,343.22

Here are the results at the current price of $37.27 per share:

Cost of capital rates:EPVAdj for Debt & Excess CashAdj EPVO/S sharesEPV / shareBVPS / shareExcess EPVCurrent pricePrice / EPVPrem/Discount vs EPV
Upper bound - VC15%9,551.81979819,349.81614.231.5021.841.4437.271.1818.30%
Arbitrary 2 <10% - 12 %>10.00%14,327.72979824,125.72614.239.2821.841.8037.270.95-5.12%
Combined NI & Div growth9.46%15,141.64979824,939.64614.240.6121.841.8637.270.92-8.21%
Arbitrary 17.50%19,103.63979828,901.63614.247.0621.842.1537.270.79-20.80%
Per GF6.45%22,213.52979832,011.52614.252.1221.842.3937.270.72-28.49%

Here are the results at $25 per share:

Cost of capital rates:EPVAdj for Debt & Excess CashAdj EPVO/S sharesEPV / shareBVPS / shareExcess EPVCurrent pricePrice / EPVPrem/Discount vs EPV
Upper bound - VC15%9,551.81979819,349.81614.231.5021.841.44250.79-20.65%
Arbitrary 2 <10% - 12 %>10.00%14,327.72979824,125.72614.239.2821.841.80250.64-36.35%
Combined NI & Div growth9.46%15,141.64979824,939.64614.240.6121.841.86250.62-38.43%
Arbitrary 17.50%19,103.63979828,901.63614.247.0621.842.15250.53-46.87%
Per GF6.45%22,213.52979832,011.52614.252.1221.842.39250.48-52.03%

Here are the results at $20 per share:

Cost of capital rates:EPVAdj for Debt & Excess CashAdj EPVO/S sharesEPV / shareBVPS / shareExcess EPVCurrent pricePrice / EPVPrem/Discount vs EPV
Upper bound - VC15%9,551.81979819,349.81614.231.5021.841.44200.63-36.52%
Arbitrary 2 <10% - 12 %>10.00%14,327.72979824,125.72614.239.2821.841.80200.51-49.08%
Combined NI & Div growth9.46%15,141.64979824,939.64614.240.6121.841.86200.49-50.75%
Arbitrary 17.50%19,103.63979828,901.63614.247.0621.842.15200.43-57.50%
Per GF6.45%22,213.52979832,011.52614.252.1221.842.39200.38-61.63%

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