UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2005 or [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _________ to________ Commission File Number: 001-09318 FRANKLIN RESOURCES, INC. (Exact name of registrant as specified in its charter) Delaware 13-2670991 (State or other jurisdiction (IRS Employer of incorporation or organization) Identification No.) One Franklin Parkway, San Mateo, CA 94403 (Address of principal executive offices) (Zip Code) (650) 312-3000 (Registrant's telephone number, including area code) (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. [ X ] YES [___] NO Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). [ X ] YES [___] NO APPLICABLE ONLY TO CORPORATE ISSUERS: Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Outstanding: 251,615,588 shares of common stock, par value $.10 per share, of Franklin Resources, Inc. as of July 29, 2005
PART I - FINANCIAL INFORMATION ITEM 1. CONDENSED FINANCIAL STATEMENTS. <TABLE> <CAPTION> FRANKLIN RESOURCES, INC. CONDENSED CONSOLIDATED STATEMENTS OF INCOME UNAUDITED THREE MONTHS ENDED NINE MONTHS ENDED JUNE 30, JUNE 30, (in thousands, except per share data) 2005 2004 2005 2004 - ---------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> OPERATING REVENUES Investment management fees $642,034 $505,409 $1,801,191 $1,459,512 Underwriting and distribution fees 386,950 282,852 1,104,669 857,458 Shareholder servicing fees 64,609 60,582 192,088 183,644 Consolidated sponsored investment products income, net 1,306 1,136 3,282 2,645 Other, net 14,835 17,836 45,707 53,217 - ---------------------------------------------------------------------------------------------------------------------------- Total operating revenues 1,109,734 867,815 3,146,937 2,556,476 - ---------------------------------------------------------------------------------------------------------------------------- OPERATING EXPENSES Underwriting and distribution 359,657 252,250 1,018,455 769,035 Compensation and benefits 232,971 193,532 662,387 579,875 Information systems, technology and occupancy 73,253 67,464 209,866 205,525 Advertising and promotion 36,845 31,139 94,061 84,306 Amortization of deferred sales commissions 29,361 24,688 91,356 72,133 Amortization of intangible assets 4,348 4,398 13,108 13,201 Provision for governmental investigations, proceedings and actions, net of recoveries (8,385) 21,500 33,658 81,500 September 11, 2001 recovery, net -- -- -- (30,277) Other 35,205 31,858 104,202 92,122 - ---------------------------------------------------------------------------------------------------------------------------- Total operating expenses 763,255 626,829 2,227,093 1,867,420 - ---------------------------------------------------------------------------------------------------------------------------- Operating income 346,479 240,986 919,844 689,056 OTHER INCOME (EXPENSES) Consolidated sponsored investment products gains/ (losses), net 4,402 (3,463) 19,013 6,356 Investment and other income, net 21,849 14,300 87,814 59,437 Interest expense (9,017) (7,832) (25,245) (22,742) - ---------------------------------------------------------------------------------------------------------------------------- Other income, net 17,234 3,005 81,582 43,051 - ---------------------------------------------------------------------------------------------------------------------------- Income before taxes on income and cumulative effect of an accounting change 363,713 243,991 1,001,426 732,107 Taxes on income 101,840 70,095 278,290 217,903 - ---------------------------------------------------------------------------------------------------------------------------- Income before cumulative effect of an accounting change, net of tax 261,873 173,896 723,136 514,204 Cumulative effect of an accounting change, net of tax -- -- -- 4,779 - ---------------------------------------------------------------------------------------------------------------------------- NET INCOME $261,873 $173,896 $723,136 $518,983 - ---------------------------------------------------------------------------------------------------------------------------- BASIC EARNINGS PER SHARE Income before cumulative effect of an accounting change $1.04 $0.70 $2.89 $2.06 Cumulative effect of an accounting change -- -- -- 0.02 - ---------------------------------------------------------------------------------------------------------------------------- NET INCOME $1.04 $0.70 $2.89 $2.08 - ---------------------------------------------------------------------------------------------------------------------------- DILUTED EARNINGS PER SHARE Income before cumulative effect of an accounting change $1.00 $0.67 $2.78 $2.00 Cumulative effect of an accounting change -- -- -- 0.02 - ---------------------------------------------------------------------------------------------------------------------------- NET INCOME $1.00 $0.67 $2.78 $2.02 - ---------------------------------------------------------------------------------------------------------------------------- DIVIDENDS PER SHARE $0.100 $0.085 $0.300 $0.255 SPECIAL CASH DIVIDEND -- -- 2.000 -- See accompanying notes to the condensed consolidated financial statements. </TABLE> 2 - --------------------------------------------------------------------------------
<TABLE> <CAPTION> FRANKLIN RESOURCES, INC. CONDENSED CONSOLIDATED BALANCE SHEETS UNAUDITED JUNE 30, SEPTEMBER 30, (in thousands) 2005 2004 - -------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> ASSETS CURRENT ASSETS Cash and cash equivalents $2,811,114 $2,814,184 Receivables 496,386 406,247 Investment securities, trading 263,968 257,329 Investment securities, available-for-sale 582,158 432,665 Deferred taxes and other 131,522 133,420 - -------------------------------------------------------------------------------------------------------------------------- Total current assets 4,285,148 4,043,845 - -------------------------------------------------------------------------------------------------------------------------- BANKING/FINANCE ASSETS Cash and cash equivalents 141,332 103,004 Loans held for sale, net 198,796 82,481 Loans receivable, net 268,417 334,676 Investment securities, available-for-sale 260,132 265,870 Other 36,861 39,813 - -------------------------------------------------------------------------------------------------------------------------- Total banking/finance assets 905,538 825,844 - -------------------------------------------------------------------------------------------------------------------------- NON-CURRENT ASSETS Investments, other 429,366 388,819 Deferred sales commissions 314,468 299,069 Property and equipment, net 487,005 470,578 Goodwill 1,386,855 1,381,757 Other intangible assets, net 659,848 671,500 Receivable from banking/finance group -- 37,784 Other 60,335 108,572 - -------------------------------------------------------------------------------------------------------------------------- Total non-current assets 3,337,877 3,358,079 - -------------------------------------------------------------------------------------------------------------------------- TOTAL ASSETS $8,528,563 $8,227,768 - -------------------------------------------------------------------------------------------------------------------------- See accompanying notes to the condensed consolidated financial statements. </TABLE> 3 - --------------------------------------------------------------------------------
<TABLE> <CAPTION> FRANKLIN RESOURCES, INC. CONDENSED CONSOLIDATED BALANCE SHEETS UNAUDITED JUNE 30, SEPTEMBER 30, (in thousands, except share data) 2005 2004 - -------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES Compensation and benefits $263,274 $284,483 Commercial paper 169,418 169,633 Accounts payable and accrued expenses 246,032 249,789 Commissions 165,753 128,341 Income taxes 22,690 76,862 Other 19,522 11,640 - -------------------------------------------------------------------------------------------------------------------------- Total current liabilities 886,689 920,748 - -------------------------------------------------------------------------------------------------------------------------- BANKING/FINANCE LIABILITIES Deposits 533,987 555,746 Payable to parent -- 37,784 Variable funding note 145,874 -- Other 72,939 65,187 - -------------------------------------------------------------------------------------------------------------------------- Total banking/finance liabilities 752,800 658,717 - -------------------------------------------------------------------------------------------------------------------------- NON-CURRENT LIABILITIES Long-term debt 1,215,490 1,196,409 Deferred taxes 248,705 236,126 Other 33,157 32,895 - -------------------------------------------------------------------------------------------------------------------------- Total non-current liabilities 1,497,352 1,465,430 - -------------------------------------------------------------------------------------------------------------------------- - -------------------------------------------------------------------------------------------------------------------------- Total liabilities 3,136,841 3,044,895 - -------------------------------------------------------------------------------------------------------------------------- MINORITY INTEREST 90,184 76,089 COMMITMENTS AND CONTINGENCIES (NOTE 13) STOCKHOLDERS' EQUITY Preferred stock, $1.00 par value, 1,000,000 shares authorized; none issued -- -- Common stock, $0.10 par value, 1,000,000,000 shares authorized; 251,388,854 and 249,680,498 shares issued and outstanding, for June 30, 2005 and September 30, 2004 25,139 24,968 Capital in excess of par value 314,372 255,137 Retained earnings 4,897,264 4,751,504 Deferred compensation (24,131) -- Accumulated other comprehensive income 88,894 75,175 - -------------------------------------------------------------------------------------------------------------------------- Total stockholders' equity 5,301,538 5,106,784 - -------------------------------------------------------------------------------------------------------------------------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $8,528,563 $8,227,768 - -------------------------------------------------------------------------------------------------------------------------- See accompanying notes to the condensed consolidated financial statements. </TABLE> 4 - --------------------------------------------------------------------------------
<TABLE> <CAPTION> FRANKLIN RESOURCES, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS UNAUDITED NINE MONTHS ENDED JUNE 30, (in thousands) 2005 2004 - -------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> NET INCOME $723,136 $518,983 Adjustments to reconcile net income to net cash provided by operating activities: (Increase) decrease in receivables, prepaid expenses and other (39,585) (68,703) Advances of deferred sales commissions (106,755) (143,577) Increase in current liabilities and other 205,246 50,237 Increase in provision for governmental investigations, proceedings and actions 13,334 76,946 (Decrease) increase in deferred income taxes and taxes payable (20,600) 43,169 Increase in commissions payable 37,413 22,769 Increase in accrued compensation and benefits 37,437 67,991 Originations of loans held for sale, net (354,881) (270,078) Proceeds from securitization of loans held for sale 238,565 52,896 Net change in trading securities (6,639) (231,875) Equity in net income of affiliated companies (21,278) (13,023) Depreciation and amortization 146,724 137,455 Net gains on disposal of assets (2,476) (18,586) - -------------------------------------------------------------------------------------------------------------------------- Net cash provided by operating activities 849,641 224,604 - -------------------------------------------------------------------------------------------------------------------------- Purchase of investments (921,841) (1,591,013) Liquidation of investments 725,063 2,669,373 Purchase of banking/finance investments (106,692) (31,512) Liquidation of banking/finance investments 117,278 77,972 Net proceeds from securitization of loans receivable -- 179,965 Net origination of loans receivable 67,279 (48,484) Net additions of property and equipment (57,873) (11,935) Acquisition of subsidiaries, net of cash acquired (37) (68,255) Insurance proceeds related to September 11, 2001 event -- 32,487 - -------------------------------------------------------------------------------------------------------------------------- Net cash (used in) provided by investing activities (176,823) 1,208,598 - -------------------------------------------------------------------------------------------------------------------------- (Decrease) in bank deposits (21,759) (74,994) Exercise of common stock options 95,292 117,083 Dividends paid on common stock (573,369) (60,847) Purchase of common stock (149,257) (50,431) Increase in debt 40,588 84,157 Payments on debt (29,055) (21,449) - -------------------------------------------------------------------------------------------------------------------------- Net cash (used in) financing activities (637,560) (6,481) - -------------------------------------------------------------------------------------------------------------------------- Increase in cash and cash equivalents 35,258 1,426,721 Cash and cash equivalents, beginning of period 2,917,188 1,053,695 - -------------------------------------------------------------------------------------------------------------------------- CASH AND CASH EQUIVALENTS, END OF PERIOD $2,952,446 $2,480,416 - -------------------------------------------------------------------------------------------------------------------------- [Table continued on next page] </TABLE> 5 - --------------------------------------------------------------------------------
<TABLE> [Table continued from previous page] <CAPTION> FRANKLIN RESOURCES, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS UNAUDITED NINE MONTHS ENDED JUNE 30, (in thousands) 2005 2004 - -------------------------------------------------------------------------------------------------------------------------- <S><C> <C> <C> SUPPLEMENTAL DISCLOSURE OF NON-CASH INFORMATION Value of common stock issued, principally restricted stock $82,777 $48,059 Total assets related to the consolidation of certain sponsored investment products and a lessor trust, net of deconsolidated assets (37,508) 201,714 Total liabilities related to the consolidation of certain sponsored investment products and a lessor trust, net of deconsolidated liabilities 6,659 61,834 Fair value of subsidiary assets acquired -- 37,690 Fair value of subsidiary liabilities assumed -- 6,345 - -------------------------------------------------------------------------------------------------------------------------- See accompanying notes to the condensed consolidated financial statements. </TABLE> 6 - --------------------------------------------------------------------------------
FRANKLIN RESOURCES, INC. Notes to Condensed Consolidated Financial Statements June 30, 2005 (Unaudited) 1. BASIS OF PRESENTATION --------------------- We have prepared these unaudited interim financial statements of Franklin Resources, Inc. (the "Company") and its consolidated subsidiaries in accordance with the instructions to Form 10-Q and the rules and regulations of the U.S. Securities and Exchange Commission (the "SEC"). Under these rules and regulations, we have shortened or omitted some information and footnote disclosures normally included in financial statements prepared under generally accepted accounting principles. We believe that we have made all adjustments necessary for a fair statement of the financial position and the results of operations for the periods shown. All adjustments are normal and recurring. You should read these financial statements together with our audited financial statements included in our Annual Report on Form 10-K for the fiscal year ended September 30, 2004. Certain amounts for the comparative prior fiscal year periods have been reclassified to conform to the financial presentation for and at the period ended June 30, 2005. 2. NEW ACCOUNTING STANDARDS ------------------------ In December 2004, the Financial Accounting Standards Board (the "FASB") issued Statement of Financial Accounting Standards No. 123 (revised 2004), "Share-Based Payment" ("SFAS 123R"). SFAS 123R addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for equity instruments of the enterprise. It also addresses transactions in which an entity incurs liabilities in exchange for goods and services that are based on the fair value of the enterprise's equity instruments or that may be settled by the issuance of such equity instruments. SFAS 123R requires an entity to recognize the grant-date fair-value of stock options and other equity-based compensation issued to employees in the income statement. The revised statement generally requires that an entity account for those transactions using the fair-value-based method, and eliminates the intrinsic value method of accounting in Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees". SFAS 123R also requires entities to disclose information about the nature of the share-based payment transactions, the method used to estimate fair value of goods and services received or the value of the equity instruments granted, and the effects of those transactions on the financial statements. On April 14, 2005, the SEC announced that SFAS 123R is to be effective for fiscal years beginning after June 15, 2005 for entities other than small business issuers, and applies to all awards granted after the required effective date and to awards modified, repurchased, or cancelled after that date. For entities that currently apply the fair-value-based method for either recognition or disclosure under the original pronouncement, Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation", the revised statement also applies to the portion of outstanding awards for which the requisite service has not yet been rendered based on the grant-date value of these awards. Retrospective application is permitted. We have not completed our evaluation of the impact of adoption of SFAS 123R on our financial position and results of operation. In October 2004, the Emerging Issues Task Force Issue No. 04-8, "The Effect of Contingently Convertible Debt on Diluted Earnings per Share" ("EITF 04-8"), was ratified. EITF 04-8 was effective for reporting periods ending after December 15, 2004 and required the restatement of diluted earnings per share for comparative prior year periods. EITF 04-8 required us to include the potential conversion into common stock of our Liquid Yield Option Notes due 2031 (Zero Coupon-Senior) (see Note 11) in the calculation of diluted earnings per share, even if the conditions that must be satisfied to allow conversion have not been met. Its adoption resulted in a decrease in diluted earnings per share of $0.03 and $0.06 for the three and nine months ended June 30, 2005 and $0.02 and $0.04 for the three and nine months ended June 30, 2004 (See Note 5). In December 2004, the FASB issued Staff Position No. 109-2, "Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004" ("FSP FAS 109-2"). The American Jobs Creation Act of 2004 (the "Act") was signed into law on October 22, 2004. Under a provision of the Act, we may elect to repatriate certain earnings of our foreign-based subsidiaries at a reduced U.S. federal tax rate in either of our fiscal years ending September 30, 2005 or September 30, 2006. FSP FAS 109-2 provides guidance on when an enterprise should recognize in its financial statements the effects of the one-time tax benefit of repatriation of foreign earnings under the Act, and specifies 7 - --------------------------------------------------------------------------------
interim disclosure requirements. We are currently evaluating the effect of this repatriation provision; however, we do not expect to complete this evaluation until the issuance of additional guidance regarding this provision. The range of possible amounts we are considering for repatriation is between zero and $1.9 billion, and the potential range of income tax associated with these amounts, which are subject to a reduced tax rate, is between zero and $117.0 million. 3. ACQUISITIONS ------------ On October 1, 2003, we acquired the remaining 87.3% interest in Darby Overseas Investments, Ltd. and Darby Overseas Partners, L.P. (collectively "Darby") that we did not own, for an additional cash investment of approximately $75.9 million. The acquisition cost was allocated to tangible net assets acquired ($31.3 million), definite-lived intangible assets ($3.4 million) and goodwill ($41.2 million). The definite-lived intangible assets relate to management contracts and are being amortized over the remaining contractual life of the sponsored investment products, ranging from one to eight years, as of the date of purchase. At September 30, 2003, Darby had approximately $0.9 billion in assets under management relating to private equity, mezzanine and emerging markets fixed-income products. 4. COMPREHENSIVE INCOME -------------------- The following table computes comprehensive income. <TABLE> THREE MONTHS ENDED NINE MONTHS ENDED JUNE 30, JUNE 30, (in thousands) 2005 2004 2005 2004 ---------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Net income $261,873 $173,896 $723,136 $518,983 Net unrealized (loss) gain on investments, net of tax (2,851) (8,206) 6,205 10,765 Currency translation adjustments (10,574) (9,840) 7,514 6,979 Minimum pension liability adjustment -- -- -- (683) ---------------------------------------------------------------------------------------------------------------------- COMPREHENSIVE INCOME $248,448 $155,850 $736,855 $536,044 ---------------------------------------------------------------------------------------------------------------------- </TABLE> 5. EARNINGS PER SHARE ------------------ We computed earnings per share as follows: <TABLE> THREE MONTHS ENDED NINE MONTHS ENDED JUNE 30, JUNE 30, (in thousands, except per share data) 2005 2004 2005 2004 ---------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Net income $261,873 $173,896 $723,136 $518,983 Adjusted net income in accordance with EITF 04-8 264,100 176,092 729,783 525,473 ---------------------------------------------------------------------------------------------------------------------- Weighted-average shares outstanding - basic 250,730 249,802 250,417 249,032 Incremental shares from assumed conversions: Common stock options and restricted performance shares 4,236 3,314 4,036 3,212 Zero coupon convertible senior notes 8,209 8,209 8,209 8,209 ---------------------------------------------------------------------------------------------------------------------- Weighted-average shares outstanding - diluted 263,175 261,325 262,662 260,453 ---------------------------------------------------------------------------------------------------------------------- BASIC EARNINGS PER SHARE Income before cumulative effect of an accounting change $1.04 $0.70 $2.89 $2.06 Cumulative effect of an accounting change -- -- -- 0.02 ---------------------------------------------------------------------------------------------------------------------- Net income $1.04 $0.70 $2.89 $2.08 ---------------------------------------------------------------------------------------------------------------------- </TABLE> 8 - --------------------------------------------------------------------------------
<TABLE> THREE MONTHS ENDED NINE MONTHS ENDED JUNE 30, JUNE 30, (in thousands, except per share data) 2005 2004 2005 2004 ---------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> DILUTED EARNINGS PER SHARE Income before cumulative effect of an accounting change $1.00 $0.67 $2.78 $2.00 Cumulative effect of an accounting change -- -- -- 0.02 ---------------------------------------------------------------------------------------------------------------------- Net income $1.00 $0.67 $2.78 $2.02 ---------------------------------------------------------------------------------------------------------------------- </TABLE> 6. EMPLOYEE STOCK OPTION AND INVESTMENT PLANS ------------------------------------------ We may award stock options to certain employees under our 2002 Universal Stock Incentive Plan (the "USIP"). In addition, we have a qualified, non-compensatory employee stock investment plan (the "ESIP") allowing eligible participants to buy our common stock at 90% of its market value on defined dates and to receive a 50% match of the shares purchased, provided the employee, among other conditions, holds the purchased shares for a defined period. We account for stock options awarded and the ESIP using the intrinsic value method under Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees", and related interpretations. Accordingly, no compensation costs are recognized with respect to stock options granted that have an exercise price equal to the market value of the underlying stock at the date of grant, or with respect to shares purchased at a discount under the ESIP. Matching grants provided to ESIP participants, however, are recognized as expenses during the required holding period. If we had determined compensation costs for stock options granted under the USIP and the discount available on our ESIP based upon fair values at the grant dates in accordance with the provisions of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation", our net income and earnings per share would have been reduced to the pro forma amounts indicated below. For pro forma purposes, the estimated fair value of options was calculated using the Black-Scholes option-pricing model and is amortized over the options' vesting periods. <TABLE> THREE MONTHS ENDED NINE MONTHS ENDED JUNE 30, JUNE 30, (in thousands, except per share data) 2005 2004 2005 2004 ---------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Net income, as reported $261,873 $173,896 $723,136 $518,983 Less: stock-based compensation expense determined under the fair value method, net of tax (6,314) (12,949) (20,447) (35,941) ---------------------------------------------------------------------------------------------------------------------- PRO FORMA NET INCOME $255,559 $160,947 $702,689 $483,042 ---------------------------------------------------------------------------------------------------------------------- BASIC EARNINGS PER SHARE As reported $1.04 $0.70 $2.89 $2.08 Pro forma 1.02 0.64 2.81 1.94 ---------------------------------------------------------------------------------------------------------------------- Adjusted net income in accordance with EITF 04-8, as reported $264,100 $176,092 $729,783 $525,473 Less: stock-based compensation expense determined under the fair value method, net of tax (6,314) (12,949) (20,447) (35,941) ---------------------------------------------------------------------------------------------------------------------- PRO FORMA NET INCOME $257,786 $163,143 $709,336 $489,532 ---------------------------------------------------------------------------------------------------------------------- DILUTED EARNINGS PER SHARE As reported $1.00 $0.67 $2.78 $2.02 Pro forma 0.98 0.62 2.70 1.88 ---------------------------------------------------------------------------------------------------------------------- </TABLE> 9 - --------------------------------------------------------------------------------
7. CONSOLIDATED SPONSORED INVESTMENT PRODUCTS ------------------------------------------ The following tables present the effect on our consolidated results of operations and financial position of consolidating sponsored investment products under FASB Financial Accounting Standards No. 94, "Consolidation of All Majority-owned Subsidiaries", and FASB Interpretation No. 46, "Consolidation of Variable Interest Entities (revised December 2003)" ("FIN 46-R"). <TABLE> THREE MONTHS ENDED JUNE 30, 2005 ------------------------------------------------------ SPONSORED BEFORE INVESTMENT (in thousands) CONSOLIDATION PRODUCTS CONSOLIDATED --------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> OPERATING REVENUES Investment management fees $642,782 $(748) $642,034 Underwriting and distribution fees 387,146 (196) 386,950 Shareholder servicing fees 64,632 (23) 64,609 Consolidated sponsored investment products income, net -- 1,306 1,306 Other, net 14,835 -- 14,835 --------------------------------------------------------------------------------------------------------------------- Total operating revenues 1,109,395 339 1,109,734 --------------------------------------------------------------------------------------------------------------------- OPERATING EXPENSES 763,255 -- 763,255 --------------------------------------------------------------------------------------------------------------------- Operating income 346,140 339 346,479 --------------------------------------------------------------------------------------------------------------------- OTHER INCOME (EXPENSES) Consolidated sponsored investment products (losses) gains, net -- 4,402 4,402 Investment and other income, net 27,335 (5,486) 21,849 Interest expense (9,017) -- (9,017) --------------------------------------------------------------------------------------------------------------------- Other income, net 18,318 (1,084) 17,234 --------------------------------------------------------------------------------------------------------------------- Income before taxes on income 364,458 (745) 363,713 Taxes on income 102,048 (208) 101,840 --------------------------------------------------------------------------------------------------------------------- NET INCOME $262,410 $(537) $261,873 --------------------------------------------------------------------------------------------------------------------- </TABLE> <TABLE> NINE MONTHS ENDED JUNE 30, 2005 ------------------------------------------------------ SPONSORED BEFORE INVESTMENT (in thousands) CONSOLIDATION PRODUCTS CONSOLIDATED --------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> OPERATING REVENUES Investment management fees $1,804,116 $(2,925) $1,801,191 Underwriting and distribution fees 1,105,202 (533) 1,104,669 Shareholder servicing fees 192,147 (59) 192,088 Consolidated sponsored investment products income, net -- 3,282 3,282 Other, net 45,707 -- 45,707 --------------------------------------------------------------------------------------------------------------------- Total operating revenues 3,147,172 (235) 3,146,937 --------------------------------------------------------------------------------------------------------------------- OPERATING EXPENSES 2,227,093 -- 2,227,093 --------------------------------------------------------------------------------------------------------------------- Operating income 920,079 (235) 919,844 --------------------------------------------------------------------------------------------------------------------- OTHER INCOME (EXPENSES) Consolidated sponsored investment products gains, net -- 19,013 19,013 Investment and other income, net 96,188 (8,374) 87,814 Interest expense (25,245) -- (25,245) --------------------------------------------------------------------------------------------------------------------- Other income, net 70,943 10,639 81,582 --------------------------------------------------------------------------------------------------------------------- Income before taxes on income 991,022 10,404 1,001,426 Taxes on income 275,322 2,968 278,290 --------------------------------------------------------------------------------------------------------------------- NET INCOME $715,700 $7,436 $723,136 --------------------------------------------------------------------------------------------------------------------- </TABLE> 10 - --------------------------------------------------------------------------------
<TABLE> AS OF JUNE 30, 2005 ------------------------------------------------------ SPONSORED BEFORE INVESTMENT (in thousands) CONSOLIDATION PRODUCTS CONSOLIDATED --------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> ASSETS Current assets $4,166,640 $118,508 $4,285,148 Banking/finance assets 905,538 -- 905,538 Non-current assets 3,368,163 (30,286) 3,337,877 --------------------------------------------------------------------------------------------------------------------- TOTAL ASSETS $8,440,341 $88,222 $8,528,563 --------------------------------------------------------------------------------------------------------------------- LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities $868,397 $18,292 $886,689 Banking/finance liabilities 752,800 -- 752,800 Non-current liabilities 1,497,352 -- 1,497,352 --------------------------------------------------------------------------------------------------------------------- TOTAL LIABILITIES 3,118,549 18,292 3,136,841 Minority interest 18,702 71,482 90,184 Total stockholders' equity 5,303,090 (1,552) 5,301,538 --------------------------------------------------------------------------------------------------------------------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $8,440,341 $88,222 $8,528,563 --------------------------------------------------------------------------------------------------------------------- </TABLE> 8. CASH AND CASH EQUIVALENTS ------------------------- Cash and cash equivalents consist of the following: <TABLE> JUNE 30, SEPTEMBER 30, (in thousands) 2005 2004 ------------------------------------------------------------------------------- ------------------- ----------------- <S> <C> <C> Cash and due from banks $336,555 $341,891 Federal funds sold and securities purchased under agreements to resell 97,121 64,029 Money market funds, time deposits and other 2,518,770 2,511,268 ------------------------------------------------------------------------------- ------------------- ----------------- TOTAL $2,952,446 $2,917,188 ------------------------------------------------------------------------------- ------------------- ----------------- </TABLE> Federal Reserve Board regulations require reserve balances on deposits to be maintained with the Federal Reserve Banks by banking subsidiaries. Required reserve balances totaled $2.1 million at June 30, 2005 and $1.9 million at September 30, 2004. 9. SECURITIZATION OF LOANS RECEIVABLE ---------------------------------- From time to time, we enter into auto loan securitization transactions with qualified special purpose entities and record these transactions as sales. The following table shows details of auto loan securitization transactions. <TABLE> THREE MONTHS ENDED NINE MONTHS ENDED JUNE 30, JUNE 30, (in thousands) 2005 2004 2005 2004 ---------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Gross sale proceeds $-- $-- $231,570 $223,403 Less: net carrying amount of loans held for sale -- -- 230,581 217,685 ---------------------------------------------------------------------------------------------------------------------- PRE-TAX GAIN $-- $-- $989 $5,718 ---------------------------------------------------------------------------------------------------------------------- </TABLE> When we sell auto loans in a securitization transaction, we record an interest-only strip receivable. The interest-only strip receivable represents our contractual right to receive interest from the pool of securitized loans after the payment of required amounts to holders of the securities and certain other costs associated with the securitization. 11 - --------------------------------------------------------------------------------
We generally estimate fair value based on the present value of future expected cash flows. The key assumptions used in the present value calculations of our securitization transactions at the date of securitization were as follows: <TABLE> THREE MONTHS ENDED NINE MONTHS ENDED JUNE 30, JUNE 30, 2005 2004 2005 2004 ---------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Excess cash flow discount rate (annual rate) -- -- 12.0% 12.0% Cumulative life loss rate -- -- 3.6% 3.4% Pre-payment speed assumption (average monthly rate) -- -- 1.5% 1.8% ---------------------------------------------------------------------------------------------------------------------- </TABLE> We determined these assumptions using data from comparable transactions, historical information and management's estimate. Interest-only strip receivables are generally restricted assets and subject to limited recourse provisions. We generally estimate the fair value of the interest-only strip receivables at each period-end based on the present value of future expected cash flows, consistent with the methodology used at the date of securitization. The following table shows the carrying value and the sensitivity of the interest-only strip receivables to hypothetical adverse changes in the key economic assumptions used to measure fair value: <TABLE> JUNE 30, SEPTEMBER 30, (dollar amounts in thousands) 2005 2004 ------------------------------------------------------------------------------ ------------------ -------------------- <S> <C> <C> CARRYING AMOUNT/FAIR VALUE OF INTEREST-ONLY STRIP RECEIVABLE $23,123 $31,808 ------------------------------------------------------------ EXCESS CASH FLOW DISCOUNT RATE (ANNUAL RATE) 12.0% 12.0% -------------------------------------------- Impact on fair value of 10% adverse change $(278) $(240) Impact on fair value of 20% adverse change (549) (476) CUMULATIVE LIFE LOSS RATE 3.6% 3.9% ------------------------- Impact on fair value of 10% adverse change $(2,130) $(2,677) Impact on fair value of 20% adverse change (4,259) (5,354) PRE-PAYMENT SPEED ASSUMPTION (AVERAGE MONTHLY RATE) 1.8% 1.8% --------------------------------------------------- Impact on fair value of 10% adverse change $(2,502) $(3,479) Impact on fair value of 20% adverse change (4,935) (6,894) ---------------------------------------------------------------------------------------------------------------------- </TABLE> Actual future market conditions may differ materially. Accordingly, this sensitivity analysis should not be considered our projection of future events or losses. We receive annual servicing fees ranging from 1% to 2% of the loans securitized for services we provide to the securitization trusts. The following table is a summary of cash flows received from and paid to securitization trusts. <TABLE> THREE MONTHS ENDED NINE MONTHS ENDED JUNE 30, JUNE 30, (in thousands) 2005 2004 2005 2004 ---------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Servicing fees received $3,589 $3,047 $10,838 $9,844 Other cash flows received 5,599 8,021 17,312 18,726 Purchase of loans from trusts -- -- (12,333) (11,837) ---------------------------------------------------------------------------------------------------------------------- </TABLE> Amounts payable to the trustee related to loan principal and interest collected on behalf of the trusts of $41.5 million at June 30, 2005 and $40.6 million at September 30, 2004, are included in other banking/finance liabilities. 12 - --------------------------------------------------------------------------------
The securitized loan portfolio that we manage and the related delinquencies were as follows: <TABLE> JUNE 30, SEPTEMBER 30, (in thousands) 2005 2004 ---------------------------------------------------------------------------------------------- <S> <C> <C> Securitized loans held by securitization trusts $678,762 $768,936 Delinquencies 15,006 13,301 ---------------------------------------------------------------------------------------------- </TABLE> Net charge-offs on the securitized loan portfolio were $2.6 million and $9.2 million for the three and nine months ended June 30, 2005 and $2.8 million and $11.6 million for the three and nine months ended June 30, 2004. 10. GOODWILL AND OTHER INTANGIBLE ASSETS ------------------------------------ Goodwill and indefinite-lived intangible assets, including those acquired before initial application of Statements of Financial Accounting Standards No. 141, "Business Combinations", and No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142"), are not amortized but are tested for impairment at least annually. All of our goodwill and intangible assets, including those arising from the purchase of Fiduciary Trust Company International ("Fiduciary Trust") in April 2001, relate to our investment management operating segment. Non-amortized intangible assets represent the value of management contracts related to certain of our sponsored investment products that are indefinite-lived. During the quarter ended March 31, 2005, we completed our annual impairment testing of goodwill and indefinite-lived intangible assets under the guidance set out in SFAS 142 and we determined that there was no impairment in the value of these assets as of October 1, 2004. Intangible assets, other than goodwill were as follows: <TABLE> GROSS CARRYING ACCUMULATED NET CARRYING (in thousands) AMOUNT AMORTIZATION AMOUNT --------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> BALANCE, JUNE 30, 2005 Amortized intangible assets Customer base $233,388 $(66,449) $166,939 Other 34,933 (23,165) 11,768 --------------------------------------------------------------------------------------------------------------------- 268,321 (89,614) 178,707 Non-amortized intangible assets Management contracts 481,141 -- 481,141 --------------------------------------------------------------------------------------------------------------------- TOTAL $749,462 $(89,614) $659,848 --------------------------------------------------------------------------------------------------------------------- BALANCE, SEPTEMBER 30, 2004 Amortized intangible assets Customer base $233,205 $(54,716) $178,489 Other 34,933 (21,730) 13,203 --------------------------------------------------------------------------------------------------------------------- 268,138 (76,446) 191,692 Non-amortized intangible assets Management contracts 479,808 -- 479,808 --------------------------------------------------------------------------------------------------------------------- TOTAL $747,946 $(76,446) $671,500 --------------------------------------------------------------------------------------------------------------------- </TABLE> 13 - --------------------------------------------------------------------------------
Estimated amortization expense for each of the next 5 fiscal years is as follows: (in thousands) FOR THE FISCAL YEARS ENDING SEPTEMBER 30, -------------------------- ------------------------------------------------ 2005 $17,030 2006 17,030 2007 17,030 2008 17,030 2009 17,030 -------------------------- ------------------------------------------------ The change in the carrying value of goodwill was as follows: (in thousands) --------------------------------------------------------------------------- Goodwill as of September 30, 2004 $1,381,757 Foreign currency movements 5,098 --------------------------------------------------------------------------- GOODWILL AS OF JUNE 30, 2005 $1,386,855 --------------------------------------------------------------------------- 11. DEBT ---- Outstanding debt consisted of the following: <TABLE> JUNE 30, SEPTEMBER 30, (in thousands) 2005 2004 --------------------------------------------------------------------------------------------------------------------- <S> <C> <C> CURRENT Federal Home Loan Bank advances $11,000 $6,000 Variable funding note 145,874 -- Commercial paper 169,418 169,633 ------------------------------------------------------------------------------- ------------------- ----------------- 326,292 175,633 NON-CURRENT Convertible Notes (including accrued interest) 537,581 530,120 Medium Term Notes 420,000 420,000 Other 257,909 246,289 ------------------------------------------------------------------------------- ------------------- ----------------- 1,215,490 1,196,409 ------------------------------------------------------------------------------- ------------------- ----------------- TOTAL DEBT $1,541,782 $1,372,042 ------------------------------------------------------------------------------- ------------------- ----------------- </TABLE> Federal funds purchased are included in deposits and Federal Home Loan Bank advances are included in other liabilities of the banking/finance operating segment. On December 31, 2003, we recognized a $164.9 million five-year note facility that was used to finance the construction of our corporate headquarters campus under the guidance of FIN 46-R, as a current liability in our Condensed Consolidated Balance Sheet. In September 2004, we purchased the headquarters campus from the lessor trust that held these assets, and we issued $170.0 million of commercial paper to finance the transaction. In May 2001, we received approximately $490.0 million in net proceeds from the sale of $877.0 million principal amount at maturity of Liquid Yield Option Notes due 2031 (Zero Coupon-Senior) (the "Convertible Notes"). The issue price of the Convertible Notes, which were offered to qualified institutional buyers only, represented a yield to maturity of 1.875% per annum excluding any contingent interest. Each of the $1,000 (principal amount at maturity) Convertible Notes will become convertible prior to maturity into 9.3604 shares of our common stock (subject to adjustment) following the occurrence of certain specified triggering events. In particular, the Convertible Notes will become convertible if, during any calendar quarter, the closing sale price of our common stock for at least 20 trading days in a period of 30 consecutive trading days ending on the last trading day of the preceding calendar quarter is more than a specified percentage (initially 120% as of the third quarter of fiscal 2001 and declining 0.084% each 14 - --------------------------------------------------------------------------------
quarter thereafter) of the accreted conversion price per share of our common stock on the last trading day of the preceding calendar quarter. Based on this formula, the Convertible Notes are not convertible during the quarter ending September 30, 2005. However, holders may convert their Convertible Notes during the quarter ending December 31, 2005 if, during the quarter ending September 30, 2005, the closing sale price of our common stock for at least 20 trading days in a period of 30 consecutive trading days ending on the last trading day of the quarter is more than $78.34 (118.57% of $66.07, which is the accreted conversion price per share of our common stock on the last trading day of the quarter), assuming no events have occurred that would require an adjustment to the conversion rate. The Convertible Notes also will become convertible prior to maturity if: (i) the assigned credit rating by Moody's or Standard and Poor's of the Convertible Notes is at or below Baa2 or BBB, respectively; (ii) the Convertible Notes are called for redemption; or (iii) certain specified corporate transactions have occurred. Separately, we will pay contingent interest to the holders of Convertible Notes during any six-month period commencing May 12, 2006 if the average market price of a Convertible Note for a measurement period preceding such six-month period equals 120% or more of the sum of the issue price and accrued original issue discount. To date, we have repurchased Convertible Notes with a face value of $5.9 million principal amount at maturity, for their accreted value of $3.5 million, in cash. We may redeem the remaining Convertible Notes for cash on or after May 11, 2006 or, at the option of the holders, we may be required to make additional repurchases on May 11 in each of 2006, 2011, 2016, 2021 and 2026. In this event, we may choose to pay the accreted value of the Convertible Notes in cash or shares of our common stock. The amount that the holders may redeem in the future will depend on, among other factors, the performance of our common stock. In April 2003, we completed the sale of 3.700% Senior Notes due 2008 totaling $420.0 million (the "Medium Term Notes"). The Medium Term Notes, which were offered to qualified institutional buyers only, carry an interest rate of 3.7% and are not redeemable prior to maturity on April 15, 2008 by either us or the note holders. Interest payments are due semi-annually. Other long-term debt consists primarily of deferred commission liabilities recognized in relation to U.S. deferred commission assets financed by Lightning Finance Company Limited ("LFL") that were not sold by LFL in a securitization transaction as of June 30, 2005 and September 30, 2004. In March 2005, Franklin Capital Corporation, a subsidiary of the Company, which engages in the purchase, securitization and servicing of retail installment sales contracts, entered into definitive agreements to create a new one-year revolving $250 million variable funding note warehouse credit facility. Under these agreements, and through a special purpose statutory trust (the "Trust"), we issued a variable funding note ("Variable Funding Note") payable to certain administered conduits in the amount of up to $250 million. Security for the repayment of the Variable Funding Note consists of cash and/or a pool of automobile loans that meet certain eligibility requirements. Credit enhancement for the Variable Funding Note consists of over-collateralization and a reserve account. In addition, the Company provides a payment provider commitment in an amount not to exceed 4.66% of the pool balance. The Trust and the Company also entered into interest rate swap agreements to mitigate the interest rate risk between the fixed interest rate on the pool of automobile loans and the floating interest rate being paid on the Variable Funding Note. 12. PENSIONS AND OTHER POST-RETIREMENT BENEFITS ------------------------------------------- Fiduciary Trust has a noncontributory retirement plan (the "Retirement Plan") covering substantially all its employees hired before we acquired it. Fiduciary Trust also maintains a nonqualified supplementary executive retirement plan ("SERP") to pay defined benefits in excess of limits imposed by U.S. federal tax law to participants in the Retirement Plan who attain age 55 and ten years of service as of the plan termination date. In April 2003, the Board of Directors of Fiduciary Trust approved a resolution to terminate both the Retirement Plan and the SERP as of June 30, 2003. In February 2005, Fiduciary Trust received approval from the Internal Revenue Service to terminate the Retirement Plan. We recorded our estimated settlement obligation in relation to the Retirement Plan and the SERP in accordance with Statement of Financial Accounting Standards No. 88, "Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits", during the period ended June 30, 2005. In addition to these pension plans, Fiduciary Trust sponsors a defined benefit healthcare plan that provides post-retirement medical benefits to full-time employees who have worked ten years and attained age 55 15 - --------------------------------------------------------------------------------
while in the service of Fiduciary Trust, or have met alternate eligibility criteria. The defined benefit healthcare plan was closed to new entrants in April 2003. The following table summarizes the components of net periodic benefit cost for the Retirement Plan and the SERP, under pension benefits, and for the defined healthcare plan, under other benefits. <TABLE> PENSION BENEFITS OTHER BENEFITS ------------------------------------------------------------------ THREE MONTHS ENDED THREE MONTHS ENDED JUNE 30, JUNE 30, (in thousands) 2005 2004 2005 2004 ---------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Service cost $-- $-- $13 $12 Interest cost -- 391 91 101 Expected return on plan assets -- (226) -- -- Amortization of prior service costs -- -- 64 64 Amortization of net loss 528 67 -- 17 ---------------------------------------------------------------------------------------------------------------------- NET PERIODIC BENEFIT COST $528 $232 $168 $194 ---------------------------------------------------------------------------------------------------------------------- </TABLE> <TABLE> PENSION BENEFITS OTHER BENEFITS ------------------------------------------------------------------ NINE MONTHS ENDED NINE MONTHS ENDED JUNE 30, JUNE 30, (in thousands) 2005 2004 2005 2004 ---------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Service cost $-- $-- $39 $36 Interest cost 746 1,173 273 303 Expected return on plan assets (330) (678) -- -- Amortization of prior service costs -- -- 192 192 Amortization of net loss 3,182 201 -- 51 ---------------------------------------------------------------------------------------------------------------------- NET PERIODIC BENEFIT COST $3,598 $696 $504 $582 ---------------------------------------------------------------------------------------------------------------------- </TABLE> 13. COMMITMENTS AND CONTINGENCIES ----------------------------- GUARANTEES Under Financial Accounting Standards Board Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others", we are required to recognize in our financial statements a liability for the fair value of any guarantees issued or modified after December 31, 2002 as well as make additional disclosures about existing guarantees. In relation to the auto loan securitization transactions that we have entered into with a number of qualified special purpose entities, we are obligated to cover shortfalls in amounts due to the holders of the notes up to certain levels as specified under the related agreements. As of June 30, 2005, the maximum potential amount of future payments related to these obligations was $31 million. In addition, our Condensed Consolidated Balance Sheet at June 30, 2005 included a $0.2 million liability to reflect the fair value of certain additional obligations arising from auto securitization transactions. At June 30, 2005, our banking/finance operating segment had issued financial standby letters of credit totaling $2.7 million on which beneficiaries would be able to draw upon in the event of non-performance by our customers, primarily in relation to lease and lien obligations of these banking customers. These standby letters of credit, issued prior to January 1, 2003, were secured by marketable securities with a fair value of $3.3 million as of June 30, 2005 and commercial real estate. 16 - --------------------------------------------------------------------------------
LEGAL PROCEEDINGS On April 12, 2005, the Attorney General of West Virginia filed a complaint in the Circuit Court of Marshall County, West Virginia (Case No. 05-C-81) against a number of companies engaged in the mutual fund industry, including the Company and its subsidiary, Franklin Advisers, Inc., and certain other parties, alleging violations of the West Virginia Consumer Credit and Protection Act and seeking, among other things, civil penalties and attorneys' fees and costs. Defendants have since removed the action to the United States District Court for the Northern District of West Virginia (Case No. 5:05-cv-78). To the extent applicable to the Company, the complaint arises from activity that occurred in 2001 and duplicates, in whole or in part, the allegations asserted in the February 4, 2004 Massachusetts Administrative Complaint concerning one instance of market timing (the "Administrative Complaint") and the SEC's findings regarding market timing in its August 2, 2004 Order (the "SEC Order"), both of which matters were previously reported. As also previously reported, the Company and certain of the Franklin Templeton mutual funds ("Funds"), current and former officers, employees, and directors have been named in multiple lawsuits in different federal courts in Nevada, California, Illinois, New York, and Florida, alleging violations of various federal securities and state laws and seeking, among other relief, monetary damages, restitution, removal of Fund trustees, directors, advisers, administrators, and distributors, rescission of management contracts and 12b-1 plans, and/or attorneys' fees and costs. Specifically, the lawsuits claim breach of duty with respect to alleged arrangements to permit market timing and/or late trading activity, or breach of duty with respect to the valuation of the portfolio securities of certain Templeton Funds managed by the Company's subsidiaries, allegedly resulting in market timing activity. The majority of these lawsuits duplicate, in whole or in part, the allegations asserted in the Administrative Complaint and the SEC's findings regarding market timing in the SEC Order. The lawsuits are styled as class actions, or derivative actions on behalf of either the named Funds or the Company. To date, more than 400 similar lawsuits against at least 19 different mutual fund companies have been filed in federal district courts throughout the country. Because these cases involve common questions of fact, the Judicial Panel on Multidistrict Litigation (the "Judicial Panel") ordered the creation of a multidistrict litigation in the United States District Court for the District of Maryland, entitled "In re Mutual Funds Investment Litigation" (the "MDL"). The Judicial Panel then transferred similar cases from different districts to the MDL for coordinated or consolidated pretrial proceedings. As of August 8, 2005, the following federal market timing lawsuits are pending against the Company (and in some instances, name certain officers, directors and/or Funds) and have been transferred to the MDL: Kenerley v. Templeton Funds, Inc., et al., Case No. 03-770 GPM, filed on November 19, 2003 in the United States District Court for the Southern District of Illinois; Cullen v. Templeton Growth Fund, Inc., et al., Case No. 03-859 MJR, filed on December 16, 2003 in the United States District Court for the Southern District of Illinois and transferred to the United States District Court for the Southern District of Florida on March 29, 2004; Jaffe v. Franklin AGE High Income Fund, et al., Case No. CV-S-04-0146-PMP-RJJ, filed on February 6, 2004 in the United States District Court for the District of Nevada; Lum v. Franklin Resources, Inc., et al., Case No. C 04 0583 JSW, filed on February 11, 2004 in the United States District Court for the Northern District of California; Fischbein v. Franklin AGE High Income Fund, et al., Case No. C 04 0584 JSW, filed on February 11, 2004 in the United States District Court for the Northern District of California; Beer v. Franklin AGE High Income Fund, et al., Case No. 8:04-CV-249-T-26 MAP, filed on February 11, 2004 in the United States District Court for the Middle District of Florida; Bennett v. Franklin Resources, Inc., et al., Case No. CV-S-04-0154-HDM-RJJ, filed on February 12, 2004 in the United States District Court for the District of Nevada; Dukes v. Franklin AGE High Income Fund, et al., Case No. C 04 0598 MJJ, filed on February 12, 2004, in the United States District Court for the Northern District of California; McAlvey v. Franklin Resources, Inc., et al., Case No. C 04 0628 PJH, filed on February 13, 2004 in the United States District Court for the Northern District of California; Alexander v. Franklin AGE High Income Fund, et al., Case No. C 04 0639 SC, filed on February 17, 2004 in the United States District Court for the Northern District of California; Hugh Sharkey IRA/RO v. Franklin Resources, Inc., et al., Case No. 04 CV 1330, filed on February 18, 2004 in the United States District Court for the Southern District of New York; D'Alliessi v. Franklin AGE High Income Fund, et al., Case No. C 04 0865 SC, filed on March 3, 2004 in the United States District Court for the Northern District of California; Marcus v. 17 - --------------------------------------------------------------------------------
Franklin Resources, Inc., et al., Case No. C 04 0901 JL, filed on March 5, 2004 in the United States District Court for the Northern District of California; Banner v. Franklin Resources, Inc., et al., Case No. C 04 0902 JL, filed on March 5, 2004 in the United States District Court for the Northern District of California; Denenberg v. Franklin Resources, Inc., et al., Case No. C 04 0984 EMC, filed on March 10, 2004 in the United States District Court for the Northern District of California; Hertz v. Burns, et al., Case No. 04 CV 02489, filed on March 30, 2004 in the United States District Court for the Southern District of New York. Plaintiffs in the MDL filed consolidated amended complaints on September 29, 2004. On February 25, 2005, defendants filed motions to dismiss, which are currently under submission with the court. As previously reported, various subsidiaries of the Company, as well as certain Templeton Fund registrants, have also been named in multiple class action lawsuits originally filed in state courts in Illinois, alleging breach of duty with respect to the valuation of the portfolio securities of certain Templeton Funds managed by such subsidiaries, and seeking, among other relief, monetary damages and attorneys' fees and costs, as follows: Bradfisch v. Templeton Funds, Inc., et al., Case No. 2003 L 001361, filed on October 3, 2003 in the Circuit Court of the Third Judicial Circuit, Madison County, Illinois; Woodbury v. Templeton Global Smaller Companies Fund, Inc., et al., Case No. 2003 L 001362, filed on October 3, 2003 in the Circuit Court of the Third Judicial Circuit, Madison County, Illinois; Kwiatkowski v. Templeton Growth Fund, Inc., et al., Case No. 03 L 785, filed on December 17, 2003 in the Circuit Court of the Twentieth Judicial Circuit, St. Clair County, Illinois; Parise v. Templeton Funds, Inc., et al., Case No. 2003 L 002049, filed on December 22, 2003 in the Circuit Court of the Third Judicial Circuit, Madison County, Illinois. In April 2005, defendants removed these lawsuits to the United States District Court for the Southern District of Illinois (Bradfisch v. Templeton Funds, Inc., et al., Case No. 3:05-cv-00298-MJR; Woodbury v. Templeton Global Smaller Companies Fund, Inc., et al., Case No. 3:05-cv-00301-GPM; Kwiatkowski v. Templeton Growth Fund, Inc., et al., Case No. 3:05-cv-00299-GPM; Parise v. Templeton Funds, Inc., et al., Case No. 3:05-cv-0300-GPM). On July 12, 2005, the court dismissed one of these lawsuits, Bradfisch v. Templeton Funds, Inc., et al., on the ground of preemption. Defendants' motions to dismiss the remaining three lawsuits on the same ground are pending. In addition, Franklin Templeton Investments Corp., a subsidiary of the Company and the investment manager of Franklin Templeton's Canadian mutual funds, has been named in two class action market timing lawsuits in Canada, seeking, among other relief, monetary damages, an order barring any increase in management fees for a period of two years following judgment, and/or attorneys' fees and costs, as follows: Huneault v. AGF Funds, Inc., et al., Case No. 500-06-000256-046, filed on October 25, 2004 in the Superior Court for the Province of Quebec, District of Montreal, and Heinrichs, et al. v. CI Mutual Funds, Inc., et al., Case No. 04-CV-29700, filed on December 17, 2004 in the Ontario Superior Court of Justice. As previously reported, the Company, as well as certain current and former officers, employees, and directors, have been named in multiple lawsuits alleging violations of various securities laws and pendent state law claims relating to the disclosure of marketing support payments and/or payment of allegedly excessive commissions, and/or advisory or distribution fees, and seeking, among other relief, monetary damages, restitution, rescission of advisory contracts, including recovery of all fees paid pursuant to those contracts, an accounting of all monies paid to the named advisers, declaratory relief, injunctive relief, and/or attorneys' fees and costs. These lawsuits are styled as class actions or derivative actions brought on behalf of certain Funds, and are as follows: Stephen Alexander IRA v. Franklin Resources, Inc., et al., Case No. 04-982 JLL, filed on March 2, 2004 in the United States District Court for the District of New Jersey; Strigliabotti v. Franklin Resources, Inc., et al., Case No. C 04 0883 SI, filed on March 4, 2004 in the United States District Court for the Northern District of California; Tricarico v. Franklin Resources, Inc., et al., Case No. CV-04-1052 JAP, filed on March 4, 2004 in the United States District Court for the District of New Jersey; Wilcox v. Franklin Resources, Inc., et al., Case No. 04-2258 WHW, filed on May 12, 2004 in the United States District Court for the District of New Jersey; Bahe, Custodian CGM Roth Conversion IRA v. Franklin/Templeton Distributors, Inc., et al., Case No. 04-11195 PBS, filed on June 3, 2004 in the United States District Court for the District of Massachusetts. 18 - --------------------------------------------------------------------------------
The United States District Court for the District of New Jersey consolidated for pretrial purposes three of the above lawsuits (Stephen Alexander IRA, Tricarico, and Wilcox) into a single action entitled "In re Franklin Mutual Funds Fee Litigation" (Case No. 04-cv-982 (WJM)(RJH)). Plaintiffs in those three lawsuits filed a consolidated amended complaint (the "Complaint") on October 4, 2004. Defendants filed a motion to dismiss the Complaint on November 19, 2004. It is anticipated that the matter will be heard in the coming months. Management strongly believes that the claims made in each of the lawsuits identified above are without merit and intends to defend against them vigorously. The Company cannot predict with certainty, however, the eventual outcome of these lawsuits, nor whether they will have a material negative impact on the Company. Public trust and confidence are critical to the Company's business and any material loss of investor and/or client confidence could result in a significant decline in assets under management by the Company, which would have an adverse effect on future financial results. If the Company finds that it bears responsibility for any unlawful or inappropriate conduct that caused losses to the Funds, it is committed to making the Funds or their shareholders whole, as appropriate. The Company is committed to taking all appropriate actions to protect the interests of its Funds' shareholders. The Company is involved from time to time in litigation relating to claims arising in the normal course of business. Management is of the opinion that the ultimate resolution of such claims will not materially affect the Company's business or financial position. In addition, pending regulatory and legislative actions and reforms affecting the mutual fund industry may significantly increase the Company's costs of doing business and/or negatively impact its revenues, either of which could have a material negative impact on the Company's financial results. OTHER COMMITMENTS AND CONTINGENCIES We have reviewed our interest in LFL, a company incorporated in Ireland whose sole business purpose is to finance our deferred commission assets, for consolidation under FIN 46-R. Based on our analysis, we determined that we hold a significant interest in LFL but we are not the primary beneficiary of LFL because we do not hold a majority of the risks and rewards of ownership. On June 1, 2005, the majority shareholder of LFL paid the subordinated debt of $41.0 million due to the Company. As of June 30, 2005, LFL had approximately $558.2 million in total assets and our exposure to loss related to LFL was limited to the carrying value of our investment in LFL, interest and fees receivable from LFL totaling approximately $19.8 million. We have also reviewed our sponsored investment products for consolidation under FIN 46-R and have consolidated one variable interest entity in our financial statements as of June 30, 2005. We have also determined that in relation to certain other of these products, we hold a significant interest but are not the primary beneficiary, because we do not hold a majority of the risks and rewards of ownership. As of June 30, 2005, total assets in sponsored investment products in which we held a significant interest were approximately $2,147.1 million and our exposure to loss as a result of our interest in these products was $281.0 million. These amounts represent our maximum exposure to loss and do not reflect our estimate of the actual losses that could result from adverse changes. In July 2003, we renegotiated an agreement to outsource management of our data center and distributed server operations, originally signed in February 2001. We may terminate the amended agreement any time after July 1, 2006 by incurring a termination charge. The maximum termination charge payable will depend on the termination date of the amended agreement, the service levels before our termination of the agreement, costs incurred by our service provider to wind-down the services and costs associated with assuming equipment leases. As of June 30, 2005, we estimate that the termination fee payable in July 2006, not including costs associated with assuming equipment leases, would approximate $13.5 million and would decrease each month for the subsequent two years, reaching a payment of approximately $2.2 million in July 2008. At June 30, 2005, our banking/finance operating segment had commitments to extend credit aggregating $224.5 million, primarily under credit card lines. We lease office space and equipment under long-term operating leases. As of June 30, 2005, there were no material changes in leasing arrangements that would have a significant effect on future minimum lease payments reported in our Annual Report on Form 10-K for the fiscal year ended September 30, 2004. 19 - --------------------------------------------------------------------------------
14. COMMON STOCK REPURCHASES ------------------------ During the three months ended June 30, 2005, we repurchased 0.4 million shares of our common stock at a cost of $23.1 million. During the nine months ended June 30, 2005, we repurchased 2.2 million shares of our common stock at a cost of $149.3 million. At June 30, 2005, approximately 11.0 million shares remained available for repurchase under our Board of Directors authorizations. During the three and nine months ended June 30, 2004, we repurchased 0.7 and 1.0 million shares of our common stock at a cost of $35.7 and $50.4 million, respectively. 15. SEGMENT INFORMATION ------------------- We have two operating segments: investment management and banking/finance. We based our operating segment selection process primarily on services offered. The investment management segment derives substantially all its revenues and net income from providing investment advisory, administration, distribution and related services to the Franklin, Templeton, Mutual Series, Bissett, Fiduciary Trust and Darby Overseas sponsored investment products. The banking/finance segment offers selected retail-banking services to high net-worth individuals, foundations and institutions, and consumer lending services. Our consumer lending activities include automotive lending related to the purchase, securitization, and servicing of retail installment sales contracts originated by independent automobile dealerships, consumer credit and debit cards, real estate equity lines, and home equity/mortgage lending. Financial information for our two operating segments is presented in the table below. Operating revenues of the banking/finance segment are reported net of interest expense and the provision for probable loan losses. <TABLE> THREE MONTHS ENDED NINE MONTHS ENDED JUNE 30, JUNE 30, (in thousands) 2005 2004 2005 2004 --------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> OPERATING REVENUES Investment management $1,097,717 $853,069 $3,109,932 $2,512,653 Banking/finance 12,017 14,746 37,005 43,823 --------------------------------------------------------------------------------------------------------------------- TOTAL $1,109,734 $867,815 $3,146,937 $2,556,476 --------------------------------------------------------------------------------------------------------------------- INCOME BEFORE TAXES ON INCOME AND CUMULATIVE EFFECT OF AN ACCOUNTING CHANGE Investment management $358,762 $237,986 $983,689 $710,755 Banking/finance 4,951 6,005 17,737 21,352 --------------------------------------------------------------------------------------------------------------------- TOTAL $363,713 $243,991 $1,001,426 $732,107 --------------------------------------------------------------------------------------------------------------------- </TABLE> Operating segment assets were as follows: <TABLE> (in thousands) JUNE 30, SEPTEMBER 30, 2005 2004 --------------------------------------------------------------------------------------------------------------------- <S> <C> <C> Investment management $7,623,025 $7,401,924 Banking/finance 905,538 825,844 --------------------------------------------------------------------------------------------------------------------- TOTAL $8,528,563 $8,227,768 --------------------------------------------------------------------------------------------------------------------- </TABLE> 20 - --------------------------------------------------------------------------------
Operating revenues of the banking/finance segment included above were as follows: <TABLE> THREE MONTHS ENDED NINE MONTHS ENDED JUNE 30, JUNE 30, (in thousands) 2005 2004 2005 2004 --------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Interest on loans $8,275 $8,431 $20,619 $22,199 Interest and dividends on investment securities 2,961 2,612 7,687 8,679 --------------------------------------------------------------------------------------------------------------------- Total interest income 11,236 11,043 28,306 30,878 Interest on deposits (2,043) (969) (5,165) (3,218) Interest on short-term debt (1,938) (50) (2,107) (156) Interest expense - inter-segment -- (573) (409) (1,286) --------------------------------------------------------------------------------------------------------------------- Total interest expense (3,981) (1,592) (7,681) (4,660) Net interest income 7,255 9,451 20,625 26,218 Other income 5,003 5,286 17,185 22,471 Provision for probable loan losses (241) 9 (805) (4,866) --------------------------------------------------------------------------------------------------------------------- TOTAL OPERATING REVENUES $12,017 $14,746 $37,005 $43,823 --------------------------------------------------------------------------------------------------------------------- </TABLE> Inter-segment interest payments from the banking/finance segment to the investment management segment are based on market rates prevailing at the inception of each loan. Inter-segment interest income and expense are not eliminated in our Condensed Consolidated Statements of Income. 16. BANKING REGULATORY RATIOS ------------------------- Following the acquisition of Fiduciary Trust in April 2001, we became a bank holding company and a financial holding company subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can result in certain mandatory, and possibly additional, discretionary actions by regulators that, if undertaken, could have a direct material adverse effect on our financial statements. We must meet specific capital adequacy guidelines that involve quantitative measures of our assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. Our capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Quantitative measures established by regulation to ensure capital adequacy require us to maintain a minimum Tier 1 capital and Tier 1 leverage ratio (as defined in the regulations), as well as minimum Tier 1 and Total risk-based capital ratios (as defined in the regulations). Based on our calculations, at June 30, 2005, and September 30, 2004, we exceeded the capital adequacy requirements applicable to us as listed below. <TABLE> JUNE 30, SEPTEMBER 30, OUR CAPITAL ADEQUACY (dollar amounts in thousands) 2005 2004 MINIMUM ------------------------------------------------ -------------------- --------------------- ------------------------- <S> <C> <C> <C> Tier 1 capital $3,339,035 $3,144,919 N/A Total risk-based capital 3,341,712 3,148,617 N/A Tier 1 leverage ratio 51% 50% 4% Tier 1 risk-based capital ratio 84% 76% 4% Total risk-based capital ratio 84% 76% 8% ------------------------------------------------ -------------------- --------------------- ------------------------- </TABLE> 21 - --------------------------------------------------------------------------------
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The Quarterly Report on Form 10-Q includes trademarks and registered trademarks of Franklin Resources Inc. (the "Company") and its direct and indirect subsidiaries. FORWARD-LOOKING STATEMENTS In this section we discuss and analyze our results of operations and our financial condition. In addition to historical information, we also make statements relating to the future, called "forward-looking" statements, which are provided under the "safe harbor" protection of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are generally written in the future tense and/or are preceded by words such as "will", "may", "should", "could", "expect", "suggest", "believe", "anticipate", "intend", "plan", or other similar words. These forward-looking statements involve a number of known and unknown risks, uncertainties and other important factors that could cause the actual results and outcomes to differ materially from any future results or outcomes expressed or implied by such forward-looking statements. You should carefully review the "Risk Factors" section set forth below and in our recent filings with the U. S. Securities and Exchange Commission (the "SEC"), which describes these risks, uncertainties and other important factors in more detail. We undertake no obligation to update any forward-looking statements in order to reflect events or circumstances that may arise after the date of this Quarterly Report on Form 10-Q. OVERVIEW Many of our key performance measures including net income and earnings per share continued to improve in the three and nine months ended June 30, 2005, as compared to the same periods last year. In part, we can attribute these improvements to our continued focus on broadening our client base geographically. This expansion, along with the overall increases in many foreign equity markets, has led to increases in our assets under management driven from both market appreciation and positive cash flows into our sponsored investment products. We continually evaluate our business from the standpoint of profitability, product performance and client service, among other things, in light of our long-term strategies under varying market and competitive conditions. The strategies of expanding our assets under management and related operations internationally, continually seeking positive investment performance, protecting and furthering our brand recognition, developing and maintaining broker/dealer and client loyalties, providing a high level of customer service and closely monitoring costs, while also developing our "human capital" base and our systems and technology, and growing our investment management and other revenues all continue as objectives in the context of an uncertain U.S. market environment. GENERAL We derive the majority of our operating revenues, operating expenses and net income from providing investment advisory and related services to retail mutual funds, institutional accounts, high net-worth clients, private accounts and other investment products. This is our primary business activity and operating segment. The mutual funds and other products that we advise, collectively called our sponsored investment products, are distributed to the public globally under six distinct names: * Franklin * Templeton * Mutual Series * Bissett * Fiduciary Trust * Darby Overseas Our sponsored investment products include a broad range of global/international equity, domestic (U.S.) equity, hybrid, fixed-income and money market mutual funds, and other investment products that meet a wide variety of specific investment needs of individuals and institutions. The level of our revenues depends largely on the level and relative mix of assets under management. To a lesser degree, our revenues also depend on the level of mutual fund sales and the number of mutual fund shareholder accounts. The fees charged for our services are based on contracts with our sponsored investment products or our clients. These arrangements could change in the future. 22 - --------------------------------------------------------------------------------
Our secondary business and operating segment is banking/finance. Our banking/finance group offers selected retail-banking services to high net-worth individuals, foundations and institutions, and consumer lending services. Our consumer lending activities include automotive lending related to the purchase, securitization, and servicing of retail installment sales contracts originated by independent automobile dealerships, consumer credit and debit cards, real estate equity lines, and home equity/mortgage lending. <TABLE> <CAPTION> RESULTS OF OPERATIONS THREE MONTHS ENDED NINE MONTHS ENDED JUNE 30, PERCENT JUNE 30, PERCENT (in millions except per share data) 2005 2004 CHANGE 2005 2004 CHANGE - -------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> NET INCOME $261.9 $173.9 51% $723.1 $519.0 39% EARNINGS PER COMMON SHARE Basic $1.04 $0.70 49% $2.89 $2.08 39% Diluted 1.00 0.67 49% 2.78 2.02 38% OPERATING MARGIN 31% 28% 11% 29% 27% 7% - -------------------------------------------------------------------------------------------------------------------------- </TABLE> Net income increased 51% and 39% for the three and nine months ended June 30, 2005, as compared to the same periods last year, due primarily to higher investment management and underwriting and distribution fees reflecting a 20% and 19% increase in simple monthly average assets under management for the three and nine months ended June 30, 2005, as compared to the same periods last year, and a 28% and 23% increase in gross sales for the three and nine months ended June 30, 2005 over the same periods last year. The increase was partly offset by higher operating expenses including underwriting and distribution and compensation and benefits expenses. <TABLE> <CAPTION> ASSETS UNDER MANAGEMENT (in billions) JUNE 30, 2005 JUNE 30, 2004 - -------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> EQUITY Global/international $168.0 $128.6 Domestic (U.S.) 74.5 66.3 - -------------------------------------------------------------------------------------------------------------------------- Total equity 242.5 194.9 - -------------------------------------------------------------------------------------------------------------------------- HYBRID 73.3 55.9 FIXED-INCOME Tax-free 53.5 49.9 Taxable Domestic (U.S.) 32.8 30.1 Global/international 17.6 13.6 - -------------------------------------------------------------------------------------------------------------------------- Total fixed-income 103.9 93.6 - -------------------------------------------------------------------------------------------------------------------------- MONEY MARKET 5.7 6.4 - -------------------------------------------------------------------------------------------------------------------------- TOTAL $425.4 $350.8 - -------------------------------------------------------------------------------------------------------------------------- SIMPLE MONTHLY AVERAGE FOR THE THREE-MONTH PERIOD (1) $416.0 $347.8 - -------------------------------------------------------------------------------------------------------------------------- SIMPLE MONTHLY AVERAGE FOR THE NINE-MONTH PERIOD (1) $400.3 $336.1 - -------------------------------------------------------------------------------------------------------------------------- (1) Investment management fees from approximately 38% of our assets under management at June 30, 2005 were calculated using a daily average. </TABLE> Our assets under management at June 30, 2005 were $425.4 billion, 21% higher than they were at this time last year, primarily due to excess sales over redemptions of $34.6 billion and market appreciation of $42.4 billion. Simple monthly average assets, which are generally more indicative of investment management fee trends than the year over year change in ending assets under management, increased 20% and 19% for the three and nine months ended June 30, 2005 over the same periods a year ago. 23 - --------------------------------------------------------------------------------
The simple monthly average mix of assets under management is shown below. NINE MONTHS ENDED JUNE 30, 2005 2004 - -------------------------------------------------------------------------------- Equity 56% 54% Hybrid 17% 15% Fixed-income 25% 29% Money market 2% 2% - -------------------------------------------------------------------------------- TOTAL 100% 100% - -------------------------------------------------------------------------------- For the nine months ended June 30, 2005, our effective investment management fee rate (investment management fees divided by simple monthly average assets under management) increased to 0.600% from 0.579% in the same period last year. The change in the mix of assets under management, resulting from higher relative excess sales over redemptions, appreciation of equity as compared to fixed-income products, and an increase in performance fees, led to an increase in our effective investment management fee rate. Generally, management fees earned on equity products are higher than fees earned on fixed-income products. Assets under management by sales office location were as follows: <TABLE> JUNE 30, SEPTEMBER 30, (in billions) 2005 % OF TOTAL 2004 % OF TOTAL - ------------------------------------------------------- --------------- --------------- ------------------- --------------- <S> <C> <C> <C> <C> United States $305.4 72% $265.3 73% Canada 30.5 7% 25.8 7% Europe 42.2 10% 29.5 8% Asia/Pacific and other /1 47.3 11% 41.3 12% - ------------------------------------------------------- --------------- --------------- ------------------- --------------- TOTAL $425.4 100% $361.9 100% - ------------------------------------------------------- --------------- --------------- ------------------- --------------- /1 Includes multi-jurisdictional assets under management. </TABLE> Components of the change in our assets under management were as follows: <TABLE> THREE MONTHS ENDED NINE MONTHS ENDED JUNE 30, PERCENT JUNE 30, PERCENT (in billions) 2005 2004 CHANGE 2005 2004 CHANGE - --------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> Beginning assets under management $412.1 $351.6 17% $361.9 $301.9 20% Sales 29.7 23.8 25% 91.0 73.5 24% Reinvested distributions 1.9 1.2 58% 7.3 4.0 83% Redemptions (22.0) (21.8) 1% (63.0) (57.6) 9% Distributions (2.4) (1.7) 41% (9.3) (5.8) 60% Acquisitions -- -- -- 0.1 0.9 (89%) (Depreciation)/appreciation 6.1 (2.3) N/A 37.4 33.9 10% - --------------------------------------------------------------------------------------------------------------------------- ENDING ASSETS UNDER MANAGEMENT $425.4 $350.8 21% $425.4 $350.8 21% - --------------------------------------------------------------------------------------------------------------------------- </TABLE> For the three and nine months ended June 30, 2005, excess sales over redemptions were $7.7 billion and $28.0 billion, as compared to $2.0 billion and $15.9 billion in the same periods last year. Market (depreciation)/appreciation of $6.1 billion and $37.4 billion for the three and nine months ended June 30, 2005 related primarily to our equity and hybrid products, as compared to market (depreciation)/appreciation of $(2.3) billion and $33.9 billion for the same periods last year. 24 - --------------------------------------------------------------------------------
<TABLE> <CAPTION> OPERATING REVENUES THREE MONTHS ENDED NINE MONTHS ENDED JUNE 30, PERCENT JUNE 30, PERCENT (in millions) 2005 2004 CHANGE 2005 2004 CHANGE - -------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> Investment management fees $642.0 $505.4 27% $1,801.2 $1,459.5 23% Underwriting and distribution fees 387.0 282.9 37% 1,104.7 857.5 29% Shareholder servicing fees 64.6 60.6 7% 192.1 183.7 5% Consolidated sponsored investment products income, net 1.3 1.1 18% 3.2 2.6 23% Other, net 14.8 17.8 (17%) 45.7 53.2 (14%) - -------------------------------------------------------------------------------------------------------------------------- TOTAL OPERATING REVENUES $1,109.7 $867.8 28% $3,146.9 $2,556.5 23% - -------------------------------------------------------------------------------------------------------------------------- </TABLE> INVESTMENT MANAGEMENT FEES Investment management fees, accounting for 58% and 57% of our operating revenues for the three and nine months ended June 30, 2005, consistent with the same periods for the prior fiscal year, include both investment advisory and administration fees. These fees are generally calculated under contractual arrangements with our sponsored investment products as a percentage of the market value of assets under management. Annual rates vary by investment objective and type of services provided. Investment management fees increased 27% and 23% for the three and nine months ended June 30, 2005, as compared to the same periods last year, consistent with a 20% and 19% increase in simple monthly average assets under management and an increase in our effective investment management fee rate resulting from a shift in asset mix toward equity products, which generally carry a higher management fee than fixed-income products. UNDERWRITING AND DISTRIBUTION FEES We earn underwriting fees from the sale of certain classes of sponsored investment products on which investors pay a sales commission at the time of purchase. Sales commissions are reduced or eliminated on some share classes and for sales to shareholders or intermediaries that exceed specified minimum amounts. Therefore, underwriting fees will change with the overall level of gross sales, the size of individual transactions, and the relative mix of sales between different share classes. Many of our sponsored investment products pay distribution fees in return for sales, marketing and distribution efforts on their behalf. While other contractual arrangements exist in international jurisdictions, in the United States, distribution fees include "12b-1 fees". These fees are subject to maximum payout levels based on a percentage of the assets in each fund and other regulatory limitations. We pay a significant portion of underwriting and distribution fees to the financial advisers and other intermediaries who sell our sponsored investment products to the public on our behalf. See the description of underwriting and distribution expenses below. Underwriting and distribution fees increased 37% and 29% for the three and nine months ended June 30, 2005, as compared to the same periods last year. For the three and nine months ended June 30, 2005, commission revenues increased 37%, as compared to the same periods last year consistent with a 28% and 23% increase in gross sales, partially offset by the discontinuation of front-end sales charges on Class C shares sold in the United States effective January 1, 2004. Distribution fees increased 31% for both the three and nine months ended June 30, 2005 over the same periods last year consistent with a 20% and 19% increase in simple monthly average assets under management and a shift in the asset and share class mix. SHAREHOLDER SERVICING FEES Shareholder servicing fees are generally fixed charges per shareholder account that vary with the particular type of fund and the service being rendered. In some instances, sponsored investment products are charged these fees based on the level of assets under management. We receive fees as compensation for providing transfer agency services, including providing customer statements, transaction processing, customer service and tax reporting. In the United States, transfer agency service agreements provide that accounts closed in a calendar 25 - --------------------------------------------------------------------------------
year generally remain billable at a reduced rate through the second quarter of the following calendar year. In Canada, such agreements provide that accounts closed in the calendar year remain billable for four months after the end of the calendar year. Accordingly, the level of fees will vary with the growth in new accounts and the level of closed accounts that remain billable. In the coming quarter, we anticipate that approximately 1,203,000 accounts closed in the U.S. during calendar 2004 will no longer be billable effective July 1, 2005. Shareholder servicing fees increased 7% and 5% for the three and nine months ended June 30, 2005, as compared to the same periods for the prior fiscal year. These increases are consistent with billable shareholders accounts increasing to 17.4 million accounts on June 30, 2005, an increase of 2% and 14% during the three and nine months ended June 30, 2005. CONSOLIDATED SPONSORED INVESTMENT PRODUCTS INCOME, NET Consolidated sponsored investment products income, net reflects the net operating income of majority-owned sponsored investment products, including dividends received. The 18% and 23% increase for the three and nine months ended June 30, 2005, as compared to the same periods last year reflect the fluctuation in timing and amounts of income earned by the sponsored investment products, as well as an increase in the number of products that have been consolidated in our results of operations. OTHER, NET Other, net consists primarily of revenues from the banking/finance operating segment as well as income from custody services. Revenues from the banking/finance operating segment include interest income on loans, servicing income, and investment income on banking/finance investment securities, and are reduced by interest expense and the provision for probable loan losses. Other, net decreased 17% and 14% for the three and nine months ended June 30, 2005, as compared to the same periods last year, due to lower realized gains on sales of automotive loans, lower interest income on Treasury Bills held for sale, and lower realized gains from investments, partially offset by an increase in interest on demand deposits and federal funds held and a decline in provision for probable loan losses primarily related to our automotive portfolio. <TABLE> <CAPTION> OPERATING EXPENSES THREE MONTHS ENDED NINE MONTHS ENDED JUNE 30, PERCENT JUNE 30, PERCENT (in millions) 2005 2004 CHANGE 2005 2004 CHANGE - -------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> Underwriting and distribution $359.7 $252.3 43% $1,018.5 $769.1 32% Compensation and benefits 233.0 193.6 20% 662.4 579.9 14% Information systems, technology and occupancy 73.3 67.4 9% 209.9 205.5 2% Advertising and promotion 36.8 31.1 18% 94.0 84.3 12% Amortization of deferred sales commissions 29.4 24.7 19% 91.4 72.1 27% Amortization of intangible assets 4.3 4.4 (2%) 13.1 13.2 (1%) Provision for governmental investigations, proceedings and actions, net of recoveries (8.4) 21.5 N/A 33.6 81.5 (59%) September 11, 2001 recovery, net -- -- -- -- (30.3) (100%) Other 35.2 31.8 11% 104.2 92.1 13% - -------------------------------------------------------------------------------------------------------------------------- TOTAL OPERATING EXPENSES $763.3 $626.8 22% $2,227.1 $1,867.4 19% - -------------------------------------------------------------------------------------------------------------------------- </TABLE> UNDERWRITING AND DISTRIBUTION Underwriting and distribution includes amounts payable to brokers and other third parties for selling, distributing and providing ongoing services to investors in our sponsored investment products. Underwriting and distribution expense increased 43% and 32% for the three and nine months ended June 30, 2005 over the same periods last year consistent with similar trends in underwriting and distribution revenue. 26 - --------------------------------------------------------------------------------
COMPENSATION AND BENEFITS Compensation and benefits expense increased 20% and 14% for the three and nine months ended June 30, 2005, as compared to the same periods last year. The increase resulted primarily from an increase in employees and from additional bonus expense under cash and stock bonus plans that are based, in part, on our performance. In addition, we experienced increases related to annual merit salary adjustments effective in October 2004 and to other employee benefits. We employed approximately 7,000 people at June 30, 2005, as compared to about 6,600 at June 30, 2004. INFORMATION SYSTEMS, TECHNOLOGY AND OCCUPANCY Information systems, technology and occupancy costs increased 9% and 2% during the three and nine months ended June 30, 2005, as compared to the same periods last year. The increase in the three months ended June 30, 2005 was primarily due to an increase for market data services and an increase in building costs related to global expansion. Details of capitalized information systems and technology costs, excluding occupancy costs, were as follows: <TABLE> THREE MONTHS ENDED NINE MONTHS ENDED JUNE 30, JUNE 30, (in millions) 2005 2004 2005 2004 - --------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Net carrying amount at beginning of period $44.3 $64.8 $51.3 $79.1 Additions during period, net of disposals and other adjustments 5.1 0.2 13.7 10.6 Net assets added through acquisitions -- 0.3 -- 0.3 Amortization during period (7.5) (10.5) (23.1) (35.2) - --------------------------------------------------------------------------------------------------------------------------- NET CARRYING AMOUNT AT END OF PERIOD $41.9 $54.8 $41.9 $54.8 - --------------------------------------------------------------------------------------------------------------------------- </TABLE> ADVERTISING AND PROMOTION Advertising and promotion expense increased 18% and 12% for the three and nine months ended June 30, 2005, as compared to the same periods last year. Overall, the increase in the nine months ended June 30, 2005 was due to higher expenditures on direct advertising campaigns and marketing efforts. For example, we completed a series of television commercials in December 2004 that began to air this quarter and will continue for the remainder of fiscal 2005. We are committed to investing in advertising and promotion in response to changing business conditions and in order to advance our products where we see continued or potential new growth opportunities, which means that the level of advertising and promotion expenditures may increase more rapidly or decrease more slowly than our revenues. AMORTIZATION OF DEFERRED SALES COMMISSIONS Certain fund share classes, including Class B, are sold without a front-end sales charge to shareholders, although our distribution subsidiaries pay a commission on the sale. Furthermore, in the United States, Class A shares are sold without a front-end sales charge to shareholders when minimum investment criteria are met and Class C shares have been sold without a front-end sales charge since January 1, 2004. However, our U.S. distribution subsidiary pays a commission on these sales. We defer and amortize all up-front commissions paid by our distribution subsidiaries and amortize them over 12 months to 8 years depending on share class or financing arrangements. Class B and certain of our Class C deferred commission assets ("DCA") arising from our U.S., Canadian and European operations are financed through Lightning Finance Company Limited ("LFL"), a company in which we have a 49% ownership interest. LFL has entered into a financing agreement with our U.S. distribution subsidiary and we maintain a continuing interest in the DCA transferred to LFL until resold by LFL. As a result, we retain DCA sold to LFL under the U.S. agreement in our financial statements and amortize them over an 8-year period, or until sold by LFL to third parties. In contrast to the U.S. arrangement, LFL has entered into direct agreements with our Canadian and European sponsored investment products, and, as a result, we do not record DCA from these sources in our financial statements. The U.S. funds that had offered Class B shares ceased offering Class B shares to new investors and existing shareholders effective during the three months 27 - --------------------------------------------------------------------------------
ended March 31, 2005. Existing Class B shareholders may continue to exchange shares into Class B shares of different funds. Existing Class B shareholders may also continue to reinvest dividends in additional Class B shares. The cessation of purchases of Class B shares by new investors and existing shareholders may have a negative effect on the overall sales of the funds' shares and cause a decrease in the levels of deferred commission amortization. Amortization of deferred sales commissions increased 19% and 27% for the three and nine months ended June 30, 2005, as compared to the same periods last year principally due to a 25% and 24% increase in gross product sales for the three and nine months ended June 30, 2005, and because LFL has not sold U.S. DCA in a securitization transaction since fiscal 2002. PROVISION FOR GOVERNMENTAL INVESTIGATIONS, PROCEEDINGS AND ACTIONS, NET OF RECOVERIES In the three months ended June 30, 2005, we received $8.4 million from our insurance provider for certain legal costs we incurred associated with previously disclosed governmental investigations and litigation. During the quarter ended March 31, 2005, we recognized a charge to income of $42.0 million ($26.5 million, net of taxes) related to the Ontario Securities Commission's investigation of frequent trading practices in Canada. OTHER INCOME (EXPENSES) Other income (expenses) includes net realized and unrealized investment gains (losses) of consolidated sponsored investment products, investment and other income, net and interest expense. Investment and other income, net is comprised primarily of income related to our investments, including dividends, interest income, realized gains and losses and income from investments accounted for using the equity method of accounting, as well as minority interest in less than wholly-owned subsidiaries and investments and foreign currency exchange gains and losses. Other income (expenses) increased 474% and 90% during the three and nine months ended June 30, 2005, as compared to the same periods last year primarily due to higher realized and unrealized net gains from our consolidated sponsored investment products, net of related minority interest in less than wholly-owned subsidiaries and investments, gain from the disposition of fixed assets, higher interest income from term deposits and debt securities and higher equity method income from our investments. TAXES ON INCOME As a multi-national corporation, we provide investment management services to a wide range of international sponsored investment products, often managed from locations outside the United States. Some of these jurisdictions have lower tax rates than the United States. The mix of pre-tax income (primarily from our investment management business) subject to these lower rates, when aggregated with income originating in the United States, produces a lower overall effective tax rate than existing U.S. federal and state tax rates. Our effective income tax rate for the three and nine months ended June 30, 2005 was 28% and has decreased from the 29% and 30% for the three and nine month periods ended June 30, 2004. The effective tax rate will continue to reflect the relative contributions of foreign earnings that are subject to reduced tax rates and that are not currently included in U.S. taxable income, as well as other factors. 28 - --------------------------------------------------------------------------------
LIQUIDITY AND CAPITAL RESOURCES The following table summarizes certain key financial data relating to our liquidity, and sources and uses of capital. <TABLE> JUNE 30, SEPTEMBER 30, (in millions) 2005 2004 - --------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> BALANCE SHEET DATA Assets Liquid assets $4,555.1 $4,279.3 Cash and cash equivalents 2,952.4 2,917.2 Liabilities Federal funds purchased and Federal Home Loan Bank advances $11.0 $6.0 Commercial paper 169.4 169.6 Variable funding note 145.9 -- Convertible Notes 537.6 530.1 Medium Term Notes 420.0 420.0 Other long-term debt 257.9 246.3 - --------------------------------------------------------------------------------------------------------------------------- Total debt $1,541.8 $1,372.0 - --------------------------------------------------------------------------------------------------------------------------- </TABLE> <TABLE> NINE MONTHS ENDED JUNE 30, (in millions) 2005 2004 - -------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> CASH FLOW DATA Operating cash flows $850.0 $224.6 Investing cash flows (176.8) 1,208.6 Financing cash flows (637.9) (6.5) - -------------------------------------------------------------------------------------------------------------------------- </TABLE> Liquid assets, which consist of cash and cash equivalents, investments (trading and available-for-sale) and current receivables, increased from September 30, 2004, primarily due to cash provided by operating activities. Cash and cash equivalents include cash, debt instruments with maturities of three months or less at the purchase date and other highly liquid investments that are readily convertible into cash, including money market funds. Cash and cash equivalents increased from September 30, 2004 as we invested operating cash flows in debt instruments, including term deposits, U.S. T-bills and other interest-bearing deposits, with maturities of three months or less from the purchase date. The increase in total debt outstanding from September 30, 2004 relates primarily to the issuance of a variable funding note ("Variable Funding Note") payable under a new one-year revolving $250 million variable funding note warehouse credit facility secured by cash and/or automobile loans, and the increase in the long-term financing liability recognized in relation to U.S. DCA financed by LFL. We experienced higher operating cash flows for the nine months ended June 30, 2005, as compared to the same period last year, due to higher net income and net proceeds from the securitization of loans held for sale. The decline in investing cash flows for the nine months ended June 30, 2005, as compared to the same period last year related primarily to excess purchases of investments over liquidations. Net cash provided by financing activities in the nine months ended June 30, 2005 declined as compared to the same period last year principally due to a special cash dividend that was declared on March 15, 2005 and paid on April 15, 2005 to holders of record of our common stock on March 31, 2005. The $2.00 per share special cash dividend returned $502.1 million to investors. Cash provided by financing activities also decreased as a result of repurchases of our common stock. In the nine months ended June 30, 2005, we repurchased 2.2 million shares of our common stock at a cost of $149.3 million. At June 30, 2005, approximately 11.0 million shares remained available for repurchase under our existing stock repurchase program. We repurchased 1.0 million shares of our common stock at a cost of $50.4 million during the nine months ended June 30, 2004. 29 - --------------------------------------------------------------------------------
CAPITAL RESOURCES We believe that we can meet our present and reasonably foreseeable operating cash needs and future commitments through existing liquid assets, continuing cash flows from operations, borrowing capacity under our current credit facility, the ability to issue debt or equity securities, and mutual fund sales commission financing arrangements. In particular, we expect to finance future investment in our banking/finance activities through operating cash flows, debt, increased deposit base, and through the securitization of a portion of the receivables from consumer lending activities. As of June 30, 2005, we had $300.0 million of debt and equity securities available to be issued under a shelf registration statement filed with the SEC and $330.0 million of additional commercial paper available for issuance. On June 10, 2005, we entered into a $420 million Five Year Facility Credit Agreement with certain banks and financial institutions. The Five Year Facility Credit Agreement replaces our $210 million 364-day revolving credit facility, which matured by its terms on June 2, 2005, and our $210 million five-year revolving credit facility, which was terminated on June 10, 2005, prior to its scheduled expiration date of June 6, 2007. We desired to replace both the former 364-day and five-year credit facilities with a single $420 million five-year credit facility. There were no amounts outstanding under either the former 364-day or the five-year credit facilities on the respective dates of termination and no early termination penalties were incurred by us. The Five Year Facility Credit Agreement is currently undrawn and available. In addition, at June 30, 2005, our banking/finance operating segment had $345.0 million in available uncommitted short-term bank lines under the Federal Reserve Funds system, the Federal Reserve Bank discount window, and Federal Home Loan Bank short-term borrowing capacity. Our ability to access the financial and capital markets in a timely manner depends on a number of factors including our credit rating, the condition of the global economy, investors' willingness to purchase our securities, interest rates, credit spreads and the valuation levels of equity markets. Depending upon circumstances, we might not be able to access these financial markets readily. Our investment management segment finances Class B and certain Class C DCA arising from our U.S., Canadian and European operations through LFL, a company in which we have a 49% ownership interest. Class B and C sales commissions that we have financed globally through LFL during the three and nine months ended June 30, 2005 were approximately $20.3 million and $98.0 million, as compared to $38.2 million and $128.4 million during the three and nine months ended June 30, 2004. LFL's ability to access credit facilities and the securitization market will directly affect our existing financing arrangements. Our banking/finance operating segment finances its automotive lending activities through operational cash flows, inter-segment loans and by selling its auto loans in securitization transactions with qualified special purpose entities, which then issue asset-backed securities to private investors. Beginning March 2005, automotive lending activities were also financed by issuing approximately $145.9 million under a Variable Funding Note, and as a result, inter-segment lending activities have decreased. Gross sale proceeds from auto loan securitization transactions were $0 million and $231.6 million for the three and nine months ended June 30, 2005, as compared to $0 million and $223.4 million in the three and nine months ended June 30, 2004. Our ability to access the securitization market will directly affect our plans to finance the auto loan portfolio in the future. USES OF CAPITAL We expect that the main uses of cash will be to expand our core business, make strategic acquisitions, acquire shares of our common stock, fund property and equipment purchases, pay operating expenses of the business, enhance technology infrastructure and business processes, pay stockholder dividends and repay and service debt. On June 23, 2005, our Board of Directors declared a regular quarterly cash dividend of $0.10 per share payable on July 15, 2005 to stockholders of record on July 5, 2005. In May 2001, we received approximately $490.0 million in net proceeds from the sale of $877.0 million principal amount at maturity of Liquid Yield Option Notes due 2031 (Zero Coupon-Senior) (the "Convertible Notes"). The issue price of the Convertible Notes, which were offered to qualified institutional buyers only, represented a yield to maturity of 1.875% per annum excluding any contingent interest. Each of the $1,000 (principal amount at maturity) Convertible Notes will become convertible prior to maturity into 9.3604 shares of our common stock (subject to adjustment) following the occurrence of certain specified triggering events. In particular, the Convertible Notes will become convertible if, during any calendar quarter, the closing sale price 30 - --------------------------------------------------------------------------------
of our common stock for at least 20 trading days in a period of 30 consecutive trading days ending on the last trading day of the preceding calendar quarter is more than a specified percentage (initially 120% as of the third quarter of fiscal 2001 and declining 0.084% each quarter thereafter) of the accreted conversion price per share of our common stock on the last trading day of the preceding calendar quarter. Based on this formula, the Convertible Notes are not convertible during the quarter ending September 30, 2005. However, holders may convert their Convertible Notes during the quarter ending December 31, 2005 if, during the quarter ending September 30, 2005, the closing sale price of our common stock for at least 20 trading days in a period of 30 consecutive trading days ending on the last trading day of the quarter is more than $78.34 (118.57% of $66.07, which is the accreted conversion price per share of our common stock on the last trading day of the quarter), assuming no events have occurred that would require an adjustment to the conversion rate. The Convertible Notes also will become convertible prior to maturity if: (i) the assigned credit rating by Moody's or Standard and Poor's of the Convertible Notes is at or below Baa2 or BBB, respectively; (ii) the Convertible Notes are called for redemption; or (iii) certain specified corporate transactions have occurred. Separately, we will pay contingent interest to the holders of Convertible Notes during any six-month period commencing May 12, 2006 if the average market price of a Convertible Note for a measurement period preceding such six-month period equals 120% or more of the sum of the issue price and accrued original issue discount. To date, we have repurchased Convertible Notes with a face value of $5.9 million principal amount at maturity, for their accreted value of $3.5 million, in cash. We may redeem the remaining Convertible Notes for cash on or after May 11, 2006 or, at the option of the holders, we may be required to make additional repurchases on May 11 in each of 2006, 2011, 2016, 2021 and 2026. In this event, we may choose to pay the accreted value of the Convertible Notes in cash or shares of our common stock. The amount that the holders may redeem in the future will depend on, among other factors, the performance of our common stock. CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS Our contractual obligations are summarized in our Annual Report on Form 10-K for the fiscal year ended September 30, 2004. As of June 30, 2005, there had been no material changes outside the ordinary course in our contractual obligations from September 30, 2004. In relation to the auto loan securitization transactions that we have entered into with a number of qualified special purpose entities, we are obligated to cover shortfalls in amounts due to the holders of the notes up to certain levels as specified under the related agreements. As of June 30, 2005, the maximum potential amount of future payments related to these obligations was $31.0 million. In addition, our Condensed Consolidated Balance Sheet at June 30, 2005 included a $0.2 million liability to reflect the fair value of certain additional obligations arising from auto securitization transactions. At June 30, 2005, the banking/finance operating segment had commitments to extend credit aggregating $224.5 million, primarily under its credit card lines, and had issued financial standby letters of credit totaling $2.7 million on which beneficiaries would be able to draw upon in the event of non-performance by our customers, primarily in relation to lease and lien obligations of these banking customers. These standby letters of credit, issued prior to January 1, 2003, were secured by marketable securities with a fair value of $3.3 million as of June 30, 2005 and commercial real estate. OFF-BALANCE SHEET ARRANGEMENTS As discussed above, we obtain financing for sales commissions that we pay to broker/dealers on Class B and certain Class C shares of our sponsored investment products through LFL, a company established in Ireland to provide DCA financing. We hold a 49% ownership interest in LFL and we account for this ownership interest using the equity method of accounting. Our exposure to loss related to our investment in LFL is limited to the carrying value of our investment, interest and fees receivable from LFL. At June 30, 2005, those amounts approximated $19.8 million. During the three and nine months ended June 30, 2005, we recognized pre-tax income of approximately $2.3 million and $7.7 million for our share of its net income over these periods. As discussed above, our banking/finance operating segment periodically enters into auto loan securitization transactions with qualified special purpose entities, which then issue asset-backed securities to private investors. Our main objective in entering in securitization transactions is to obtain financing for auto loan activities. Securitized loans held by the securitization trusts totaled $678.8 million at June 30, 2005 and $768.9 million at September 30, 2004. 31 - --------------------------------------------------------------------------------
CRITICAL ACCOUNTING POLICIES Our financial statements and accompanying notes are prepared in accordance with generally accepted accounting principles in the United States. The preparation of these financial statements requires us to make estimates and assumptions that impact our financial position and results of operations. These estimates and assumptions are affected by our application of accounting policies. Below we describe certain critical accounting policies that we believe are important to understanding our results of operations and financial position. For additional information about our accounting policies, please refer to Note 1 to the financial statements contained in our Annual Report on Form 10-K for the fiscal year ended September 30, 2004. GOODWILL AND OTHER INTANGIBLE ASSETS We make significant estimates and assumptions when valuing goodwill and other intangibles in connection with the initial purchase price allocation of an acquired entity, as well as when evaluating impairment of intangibles on an ongoing basis. Under Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142"), we are required to test the fair value of goodwill and indefinite-lived intangibles when there is an indication of impairment, or at least once a year. Goodwill impairment is indicated when the carrying amount of a reporting unit exceeds its implied fair value, calculated based on anticipated discounted cash flows. In estimating the fair value of the reporting unit, we use valuation techniques based on discounted cash flows similar to models employed in analyzing the purchase price of an acquisition target. Intangible assets subject to amortization are reviewed for impairment on the basis of the expected future undiscounted operating cash flows, without interest charges, to be derived from these assets. We review definite-lived intangible assets for impairment when there is an indication of impairment, or at least once a year. During the quarter ended March 31, 2005, we completed our annual impairment testing of goodwill and indefinite-lived intangible assets under the guidance set out in SFAS 142 and we determined that there was no impairment in the value of these assets as of October 1, 2004. In performing our analysis, we used certain assumptions and estimates including those related to discount rates and the expected future period of cash flows to be derived from the assets, based on, among other factors, historical trends and the characteristics of the assets. While we believe that our testing was appropriate, if these estimates and assumptions change in the future, we may be required to record impairment charges or otherwise increase amortization expense. INCOME TAXES As a multinational corporation, we operate in various locations outside the United States. As of June 30, 2005, and based on tax laws in effect as of this date, it is our intention to continue to indefinitely reinvest the undistributed earnings of foreign subsidiaries. As a result, we have not made a provision for U.S. taxes and have not recorded a deferred tax liability on $2.8 billion of cumulative undistributed earnings recorded by foreign subsidiaries as of June 30, 2005. Changes to our policy of reinvesting foreign earnings may have a significant effect on our financial condition and results of operation. In December 2004, the Financial Accounting Standards Board ("FASB") issued Staff Position No. 109-2, "Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004" ("FSP FAS 109-2"). The American Jobs Creation Act of 2004 (the "Act") was signed into law on October 22, 2004. Under a provision of the Act, we may elect to repatriate certain earnings of our foreign-based subsidiaries at a reduced U.S. federal tax rate in either of our fiscal years ending September 30, 2005 or September 30, 2006. FSP FAS 109-2 provides guidance on when an enterprise should recognize in its financial statements the effects of the one-time tax benefit of repatriation of foreign earnings under the Act, and specifies interim disclosure requirements. We are currently evaluating the effect of this repatriation provision; however, we do not expect to complete this evaluation until the issuance of additional guidance regarding this provision. The range of possible amounts we are considering for repatriation is between zero and $1.9 billion, and the potential range of income tax associated with these amounts, which are subject to a reduced tax rate, is between zero and $117.0 million. 32 - --------------------------------------------------------------------------------
VALUATION OF INVESTMENTS We record substantially all investments in our financial statements at fair value or amounts that approximate fair value. Where available, we use prices from independent sources such as listed market prices or broker or dealer price quotations. For investments in illiquid and privately held securities that do not have readily determinable fair values, we estimate the value of the securities based upon available information. However, even where the value of a security is derived from an independent market price or broker or dealer quote, some assumptions may be required to determine the fair value. For example, we generally assume that the size of positions in securities that we hold would not be large enough to affect the quoted price of the securities when sold, and that any such sale would happen in an orderly manner. However, these assumptions may be incorrect and the actual value realized on sale could differ from the current carrying value. We evaluate our investments for other-than-temporary decline in value on a periodic basis. This may exist when the fair value of an investment security has been below the current value for an extended period of time. As most of our investments are carried at fair value, if an other-than-temporary decline in value is determined to exist, the unrealized investment loss recorded net of tax in accumulated other comprehensive income is realized as a charge to net income, in the period in which the other-than-temporary decline in value is determined. We classify securities as trading when it is management's intent at the time of purchase to sell the security within a short period of time. Accordingly, we record unrealized gains and losses on these securities in our consolidated income. While we believe that we have accurately estimated the amount of other-than-temporary decline in value in our portfolio, different assumptions could result in changes to the recorded amounts in our financial statements. LOSS CONTINGENCIES We are involved in various lawsuits and claims encountered in the normal course of business. When such a matter arises and periodically thereafter, we consult with our legal counsel and evaluate the merits of the claim based on the facts available at that time. In management's opinion, an adequate accrual has been made as of June 30, 2005 to provide for any probable losses that may arise from these matters for which we could reasonably estimate an amount. See also Note 13 to our Notes to Condensed Consolidated Financial Statements included in Part I, Item 1 of this report and "Legal Proceedings" included in Part II, Item 1 of this report. VARIABLE INTEREST ENTITIES Under FASB Interpretation No. 46, "Consolidation of Variable Interest Entities (revised December 2003)" ("FIN 46-R"), a variable interest entity ("VIE") is an entity in which the equity investment holders have not contributed sufficient capital to finance its activities or the equity investment holders do not have defined rights and obligations normally associated with an equity investment. FIN 46-R requires consolidation of a VIE by the enterprise that has the majority of the risks and rewards of ownership, referred to as the primary beneficiary. Evaluating whether related entities are VIEs, and determining if we qualify as the primary beneficiary of these VIEs, is highly complex and involves the use of estimates and assumptions. To determine our interest in the expected losses or residual returns of each VIE, we performed an expected cash flow analysis using certain discount rate and volatility assumptions based on available historical information and management's estimates. Based on our analysis, we consolidated one VIE into our financial statements as of June 30, 2005. While we believe that our testing and approach were appropriate, future changes in estimates and assumptions may affect our decision and lead to the consolidation of other VIEs in our financial statements. IMPACT OF INFLATION Our Condensed Consolidated Financial Statements and related Notes are presented in historical dollars without considering the effect of inflation. Since a significant portion of our assets is liquid in nature, the potential effect of inflation is mitigated. In addition, the majority of our revenues and related expenses are denominated in U.S. dollars, a currency that has not been significantly affected by the impact of changes in prices in recent years. To the extent that a potential rise in inflation may affect the securities and the consumer lending markets, it may adversely affect our financial position and results of operation in the future. 33 - --------------------------------------------------------------------------------
RISK FACTORS WE ARE SUBJECT TO EXTENSIVE AND OFTEN COMPLEX, OVERLAPPING AND FREQUENTLY CHANGING REGULATION DOMESTICALLY AND ABROAD. Our investment management business and other businesses are subject to extensive and often complex, overlapping and frequently changing regulation in the United States and abroad, including, among others, securities, banking, accounting and tax laws and regulations. Non-compliance with applicable laws or rules or regulations, either in the United States or abroad, or our inability to keep up with or adapt to an often ever changing, complex regulatory environment could result in sanctions against us, including fines and censures, injunctive relief, suspension or expulsion from a certain jurisdiction or market or the revocation of licenses, any of which could also adversely affect our reputation, prospects, revenues, and earnings. We are subject to federal securities laws, state laws regarding securities fraud, other federal and state laws and rules and regulations of certain regulatory and self regulatory organizations, including those rules and regulations promulgated by, among others, the SEC, the National Association of Securities Dealers, the New York Stock Exchange and the Pacific Exchange, Inc., and to the extent operations or trading in our securities take place outside the United States, by foreign regulations and regulators, such as the UK Listing Authority. Certain of our subsidiaries are registered with the SEC under the Investment Advisers Act of 1940, as amended, and many of our funds are registered with the SEC under the Investment Company Act of 1940, as amended, both of which impose numerous obligations, as well as detailed operational requirements, on our subsidiaries which are investment advisers to registered investment companies. Our subsidiaries, both in the United States and abroad, must comply with a myriad of complex and often changing U.S. and/or foreign regulations, some of which may conflict, including complex U.S. and non-U.S. tax regimes. Additionally, as we expand our operations into non-U.S. jurisdictions, the rules and regulations of these non-U.S. jurisdictions become applicable and add further regulatory complexity to our on-going compliance operations. In addition, we are a bank holding company and a financial holding company subject to the supervision and regulation of the Federal Reserve Board (the "FRB"), and are subject to the restrictions, limitations, or prohibitions of the Bank Holding Company Act of 1956 and the Gramm-Leach-Bliley Act. The FRB may impose additional limitations or restrictions on our activities, including if the FRB believes that we do not have the appropriate financial and managerial resources to commence or conduct an activity or make an acquisition. REGULATORY AND LEGISLATIVE ACTIONS AND REFORMS, PARTICULARLY THOSE SPECIFICALLY FOCUSED ON THE MUTUAL FUND INDUSTRY, ARE MAKING THE REGULATORY ENVIRONMENT IN WHICH WE OPERATE MORE COSTLY AND FUTURE ACTIONS AND REFORMS COULD ADVERSELY IMPACT OUR ASSETS UNDER MANAGEMENT, INCREASE COSTS AND NEGATIVELY IMPACT OUR PROFITABILITY AND FUTURE FINANCIAL RESULTS. During the past five years, the federal securities laws have been augmented substantially and made significantly more complex by, among other measures, the Sarbanes-Oxley Act of 2002 and the USA Patriot Act of 2001. Moreover, changes in the interpretation or enforcement of existing laws or regulations have directly affected our business. With new laws and changes in interpretation and enforcement of existing requirements, the associated time we must dedicate to, and related costs we must incur in, meeting the regulatory complexities of our business have increased and these outlays have also increased as we expand our business into various non-U.S. jurisdictions. For example, in the past few years following the enactment of the Sarbanes-Oxley Act of 2002, new rules of the SEC, the New York Stock Exchange, the Pacific Exchange, Inc. and the National Association of Securities Dealers were promulgated and other rules revised. Among other things, these new laws, rules and regulations have necessitated us to make changes to our corporate governance and public disclosure policies, procedures and practices and our registered investment companies and investment advisers have been required to make similar changes. Compliance activities to meet these new requirements have required us to expend additional time and resources, including without limitation substantial efforts to conduct evaluations required to ensure compliance with the management certification and attestation requirements under the Sarbanes-Oxley Act of 2002, and, consequently, we are incurring increased costs of doing business, which potentially negatively impacts our profitability and future financial results. Moreover, current and pending regulatory and legislative actions and reforms affecting the mutual fund industry, including compliance initiatives, may negatively impact revenues by increasing our costs of accessing or dealing in the financial markets. STRONG COMPETITION FROM NUMEROUS AND SOMETIMES LARGER COMPANIES WITH COMPETING OFFERINGS AND PRODUCTS COULD LIMIT OR REDUCE SALES OF OUR PRODUCTS, POTENTIALLY RESULTING IN A DECLINE IN OUR MARKET SHARE, REVENUES AND NET INCOME. We compete with numerous investment management companies, mutual fund, stock brokerage and investment banking firms, insurance companies, banks, savings and loan associations and other financial institutions. Over the past decade, a significant number of new asset management firms and mutual funds have been established, increasing competition. At the same time, consolidation in the financial services industry has 34 - --------------------------------------------------------------------------------
created stronger competitors with greater financial resources and broader distribution channels than our own. Competition is based on various factors, including, among others, business reputation, investment performance, product offerings, service quality, distribution relationships, and fees charged. Additionally, competing securities broker/dealers whom we rely upon to distribute our mutual funds also sell their own proprietary funds and investment products, which could limit the distribution of our investment products. To the extent that existing or potential customers, including securities broker/dealers, decide to invest in or distribute the products of our competitors, the sales of our products as well as our market share, revenues and net income could decline. Our ability to attract and retain assets under our management is also dependent on the relative investment performance of our funds and other managed investment portfolios and our ability to maintain our investment management and administrative fees at competitive levels. CHANGES IN THE DISTRIBUTION CHANNELS ON WHICH WE DEPEND COULD REDUCE OUR REVENUES AND HINDER OUR GROWTH. We derive nearly all of our fund sales through broker/dealers and other similar investment advisers. Increasing competition for these distribution channels and recent regulatory initiatives have caused our distribution costs to rise and could cause further increases in the future or could otherwise negatively impact the distribution of our products. Higher distribution costs lower our net revenues and earnings. Additionally, if one or more of the major financial advisers who distribute our products were to cease operations or limit or otherwise end the distribution of our products, it could have a significant adverse impact on our revenues and earnings. There is no assurance we will continue to have access to the third-party broker/dealers and similar investment advisers that currently distribute our products, or continue to have the opportunity to offer all or some of our existing products through them. A failure to maintain strong business relationships with the major investment advisers who currently distribute our products may also impair our distribution and sales operations. Because we use broker/dealers and other similar investment advisers to sell our products, we do not control the ultimate investment recommendations given to clients. Any inability to access and successfully sell our products to clients through third-party distribution channels could have a negative effect on our level of assets under management, related revenues and overall business and financial condition. THE AMOUNT OR MIX OF OUR ASSETS UNDER MANAGEMENT ARE SUBJECT TO SIGNIFICANT FLUCTUATIONS AND COULD NEGATIVELY IMPACT OUR REVENUES AND INCOME. We have become subject to an increased risk of asset volatility from changes in the domestic and global financial and equity markets. Individual financial and equity markets may be adversely affected by political, financial or other instabilities that are particular to the country or regions in which a market is located, including without limitation local acts of terrorism, economic crises or other business, social or political crises. Declines in these markets have caused in the past, and would cause in the future, a decline in our revenues and income. Global economic conditions, exacerbated by war or terrorism or financial crises, changes in the equity market place, currency exchange rates, interest rates, inflation rates, the yield curve and other factors that are difficult to predict affect the mix, market values and levels of our assets under management. Our investment management revenues are derived primarily from fees based on a percentage of the value of assets under management and vary with the nature of the account or product managed. A decline in the price of stocks or bonds, or in particular market segments, or in the securities market generally, could cause the value and returns on our assets under management to decline, resulting in a decline in our revenues and income. Moreover, changing market conditions may cause a shift in our asset mix between international and U.S. assets, potentially resulting in a decline in our revenue and income depending upon the nature of our assets under management and the level of management fees we earn based on them. Additionally, changing market conditions may cause a shift in our asset mix towards fixed-income products and a related decline in our revenue and income, as we generally derive higher fee revenues and income from equity assets than from fixed-income products we manage. On the other hand, increases in interest rates, in particular if rapid, or high interest rates, as well as any uncertainty in the future direction of interest rates, may impact negatively on our fixed-income products as rising interest rates or interest rate uncertainty typically decrease the total return on many bond investments due to lower market valuations of existing bonds. Any decrease in the level of assets under management resulting from price declines, interest rate volatility or uncertainty or other factors could negatively impact our revenues and income. OUR INCREASING FOCUS ON INTERNATIONAL MARKETS AS A SOURCE OF INVESTMENTS AND SALES OF INVESTMENT PRODUCTS SUBJECT US TO INCREASED EXCHANGE RATE AND OTHER RISKS IN CONNECTION WITH EARNINGS AND INCOME GENERATED OVERSEAS. While we operate primarily in the United States, we also provide services and earn revenues in Canada, the Bahamas, Europe, Asia, South America, Africa and Australia. As a result, we are subject to foreign exchange risk through our foreign operations. While we have taken steps to reduce our exposure to foreign exchange risk, for example, by denominating a significant amount of our transactions in U.S. dollars, 35 - --------------------------------------------------------------------------------
the situation may change in the future as our business continues to grow outside the United States. Stabilization or appreciation of the U.S. dollar could moderate revenues from sales of investment products internationally. Separately, management fees that we earn tend to be higher in connection with international assets under management than with U.S. assets under management. Consequently, a downturn in international markets could have a significant effect on our revenues and income. POOR INVESTMENT PERFORMANCE OF OUR PRODUCTS COULD AFFECT OUR SALES OR REDUCE THE LEVEL OF ASSETS UNDER MANAGEMENT, POTENTIALLY NEGATIVELY IMPACTING OUR REVENUES AND INCOME. Our investment performance, along with achieving and maintaining superior distribution and client services, is critical to the success of our investment management business. Strong investment performance often stimulates sales of our investment products. Poor investment performance as compared to third-party benchmarks or competitive products could lead to a decrease in sales of investment products we manage and stimulate redemptions from existing products, generally lowering the overall level of assets under management and reducing the investment management fees we earn. We cannot assure you that past or present investment performance in the investment products we manage will be indicative of future performance. Any poor future performance may negatively impact our revenues and income. WE COULD SUFFER LOSSES IN EARNINGS OR REVENUE IF OUR REPUTATION IS HARMED. Our reputation is important to the success of our business. The Franklin Templeton Investments brand has been, and continues to be, extremely well received both in our industry and with our clients, reflecting the fact that our brand, like our business, is based in part on trust and confidence. If our reputation is harmed, existing clients may reduce amounts held in, or withdraw entirely from, funds that we advise or funds may terminate their investment management agreements with us, which could reduce the amount of assets under management and cause us to suffer a corresponding loss in earnings or revenue. Moreover, reputational harm may cause us to lose current employees and we may be unable to continue to attract new ones with similar qualifications, motivations or skills. If we fail to address, or appear to fail to address, successfully and promptly the underlying causes of any reputational harm, we may be unsuccessful in repairing any existing harm to our reputation and our future business prospects would likely be affected. OUR FUTURE RESULTS ARE DEPENDENT UPON MAINTAINING AN APPROPRIATE LEVEL OF EXPENSES, WHICH ARE SUBJECT TO FLUCTUATION. The level of our expenses are subject to fluctuation and may increase for the following or other reasons: changes in the level and scope of our advertising expenses in response to market conditions; variations in the level of total compensation expense due to, among other things, bonuses, changes in our employee count and mix, and competitive factors; changes in expenses and capital costs, including costs incurred to maintain and enhance our administrative and operating services infrastructure; and an increase in insurance expenses including through the assumption of higher deductibles and/or co-insurance liability. WE FACE RISKS, AND CORRESPONDING POTENTIAL COSTS AND EXPENSES, ASSOCIATED WITH CONDUCTING OPERATIONS AND GROWING OUR BUSINESS IN NUMEROUS FOREIGN COUNTRIES. We sell mutual funds and offer investment advisory and related services in many different regulatory jurisdictions around the world, and intend to continue to expand our operations internationally. As we do so, we will continue to face various on-going challenges to ensure that we have sufficient resources, procedures and controls in place to address and ensure that our operations abroad operate consistently and effectively. Notwithstanding potential long-term cost savings by increasing certain operations, such as transfer agent and other back-office operations, in countries or regions of the world with lower operating costs, growth of our international operations may involve near-term increases in expenses as well as additional capital costs, such as information, systems and technology costs and costs related to compliance with particular regulatory or other local requirements or needs. Regulators in non-U.S. jurisdictions could also change their policies or laws in a manner that might restrict or otherwise impede our ability to distribute or register investment products in their respective markets. Any of these local requirements, activities or needs could increase the costs and expenses we incur in a specific jurisdiction without any corresponding increase in revenues and income from operating in the jurisdiction. OUR ABILITY TO SUCCESSFULLY INTEGRATE WIDELY VARIED BUSINESS LINES CAN BE IMPEDED BY SYSTEMS AND OTHER TECHNOLOGICAL LIMITATIONS. Our continued success in effectively managing and growing our business, both domestically and abroad, depends on our ability to integrate the varied accounting, financial, information and operational systems of our various businesses on a global basis. Moreover, adapting or developing our existing technology systems to meet our internal needs, as well as client needs, industry demands and new regulatory requirements, is also critical for our business. The constant introduction of new technologies presents new challenges to us. We have an ongoing need to continually upgrade and improve our various technology 36 - --------------------------------------------------------------------------------
systems, including our data processing, financial, accounting and trading systems. This need could present operational issues or require, from time to time, significant capital spending. It also may require us to reevaluate the current value and/or expected useful lives of our technology systems, which could negatively impact our results of operations. ANY SIGNIFICANT LIMITATION OR FAILURE OF OUR SOFTWARE APPLICATIONS AND OTHER TECHNOLOGY SYSTEMS THAT ARE CRITICAL TO OUR OPERATIONS COULD CONSTRAIN OUR OPERATIONS. We are highly dependent upon the use of various proprietary and third-party software applications and other technology systems to operate our business. We use our technology to, among other things, obtain securities pricing information, process client transactions and provide reports and other customer services to the clients of the funds we manage. Any inaccuracies, delays or systems failures in these and other processes could subject us to client dissatisfaction and losses. Although we take protective measures, our technology systems may be vulnerable to unauthorized access, computer viruses or other events that have a security impact, such as an authorized employee or vendor inadvertently causing us to release confidential information, which could materially damage our operations or cause the disclosure or modification of sensitive or confidential information. Most of the software applications that we use in our business are licensed from, and supported, upgraded and maintained by, third-party vendors. A suspension or termination of certain of these licenses or the related support, upgrades and maintenance could cause temporary system delays or interruption. In addition, we have outsourced to a single vendor management of our data center and distributed server operations, and this vendor also is responsible for our disaster recovery systems. A failure by this vendor to continue to manage our data center or support our servers and our disaster recovery systems adequately in the future could have a material adverse impact on our business. Moreover, although we have in place certain disaster recovery plans, we may experience system delays and interruptions as a result of natural disasters, power failures, acts of war, and third party failures. Potential system failures or breaches and the cost necessary to correct them could result in material financial loss, regulatory actions, breach of client contracts, reputational harm or legal claims and liability, which in turn could negatively impact our revenues and income. OUR INABILITY TO SUCCESSFULLY RECOVER SHOULD WE EXPERIENCE A DISASTER OR OTHER BUSINESS CONTINUITY PROBLEM COULD CAUSE MATERIAL FINANCIAL LOSS, LOSS OF HUMAN CAPITAL, REGULATORY ACTIONS, REPUTATIONAL HARM OR LEGAL LIABILITY. Should we experience a local or regional disaster or other business continuity problem, our continued success will depend, in part, on the availability of our personnel, our office facilities and the proper functioning of our computer, telecommunication and other related systems and operations. While our operational size, the diversity of locations from which we operate, and our redundant back-up systems provide us with a strong advantage should we experience a local or regional disaster or other business continuity event, we could still experience near-term operational challenges, in particular depending upon how a local or regional event may affect our human capital across our operations or with regard to particular segments of our operations, such as key executive officers or personnel in our technology group. We are constantly assessing and taking steps to improve upon our existing business continuity plans and key management succession. However, a disaster on a significant scale or affecting certain of our key operating areas across regions, or our inability to successfully recover should we experience a disaster or other business continuity problem, could materially interrupt our business operations and cause material financial loss, loss of human capital, regulatory actions, reputational harm or legal liability. OUR ABILITY TO MEET CASH NEEDS DEPENDS UPON CERTAIN FACTORS, INCLUDING OUR ASSET VALUE, CREDIT WORTHINESS AND THE MARKET VALUE OF OUR STOCK. Our ability to meet anticipated cash needs depends upon factors including our asset value, our creditworthiness as perceived by lenders and the market value of our stock. Similarly, our ability to securitize and hedge future loan portfolios and credit card receivables, and to obtain continued financing for certain Class C shares, is also subject to the market's perception of those assets, finance rates offered by competitors, and the general market for private debt. If we are unable to obtain these funds and financing, we may be forced to incur unanticipated costs or revise our business plans. CERTAIN OF THE PORTFOLIOS WE MANAGE, INCLUDING OUR EMERGING MARKET PORTFOLIOS, ARE VULNERABLE TO MARKET-SPECIFIC POLITICAL, ECONOMIC OR OTHER RISKS, ANY OF WHICH MAY NEGATIVELY IMPACT OUR REVENUES AND INCOME. Our emerging market portfolios and revenues derived from managing these portfolios are subject to significant risks of loss from political and diplomatic developments, currency fluctuations, social instability, changes in governmental polices, expropriation, nationalization, asset confiscation and changes in legislation related to foreign ownership. Foreign trading markets, particularly in some emerging market countries, are often smaller, less liquid, less regulated and significantly more volatile than the U.S. and other established markets. 37 - --------------------------------------------------------------------------------
OUR REVENUES, EARNINGS AND INCOME COULD BE ADVERSELY AFFECTED IF THE TERMS OF OUR INVESTMENT MANAGEMENT AGREEMENTS ARE SIGNIFICANTLY ALTERED OR THESE AGREEMENTS ARE TERMINATED BY THE FUNDS WE ADVISE. Our revenues are dependent on fees earned under investment management or related administrative agreements that we have with the funds we advise. These revenues could be adversely affected if these agreements are altered significantly or terminated. The decline in revenue that might result from alteration or termination of our investment management or selected administration agreements could have a material adverse impact on our earnings or income. DIVERSE AND STRONG COMPETITION LIMITS THE INTEREST RATES THAT WE CAN CHARGE ON CONSUMER LOANS. We compete with many types of institutions for consumer loans, which can provide loans at significantly below-market interest rates in connection with automobile sales or in some cases zero interest rates. Our inability to compete effectively against these companies or to maintain our relationships with the various automobile dealers through whom we offer consumer loans could limit the growth of our consumer loan business. Economic and credit market downturns could reduce the ability of our customers to repay loans, which could cause losses to our consumer loan portfolio. FUTURE SALES OF OUR COMMON STOCK IN THE PUBLIC MARKET COULD ADVERSELY AFFECT OUR STOCK PRICE. We cannot predict the effect, if any, that future sales of shares of our common stock or the availability for future sale of shares of our common stock or securities convertible into or exercisable for our common stock will have on the market price of our common stock prevailing from time to time. For example, in connection with our May 2001 offering of Convertible Notes, we filed a registration statement on Form S-3 with the Securities and Exchange Commission, which was subsequently declared effective, to register, among other things, approximately 8.2 million shares of our common stock issuable upon conversion of the Convertible Notes. Holders may convert their Convertible Notes prior to maturity into 9.3604 shares of our common stock per $1,000 principal amount at maturity of the Convertible Notes, subject to adjustment, following the occurrence of certain specified triggering events, including if, during any calendar quarter, the closing sale price of our common stock for at least 20 trading days in a period of 30 consecutive trading days ending on the last trading day of the preceding calendar quarter is more than a specified percentage, initially 120% as of the third quarter of fiscal 2001 and declining 0.084% each quarter thereafter, of the accreted conversion price per share of our common stock on the last trading day of the preceding calendar quarter. Based on this formula, the Convertible Notes are not convertible during the quarter ending September 30, 2005. However, holders may convert their Convertible Notes during the quarter ending December 31, 2005 if, during the quarter ending September 30, 2005, the closing sale price of our common stock for at least 20 trading days in a period of 30 consecutive trading days ending on the last trading day of the quarter is more than $78.34 (118.57% of $66.07, which is the accreted conversion price per share of our common stock on the last trading day of the quarter), assuming no events have occurred that would require an adjustment to the conversion rate. Sale, or the availability for sale, of substantial amounts of common stock by our existing stockholders pursuant to an effective registration statement or under Rule 144, through the issuance of shares of common stock upon the exercise of stock options or the conversion of convertible securities, such as our Convertible Notes, or the perception that such sales or issuances could occur, could adversely affect prevailing market prices for our common stock. CIVIL LITIGATION ARISING OUT OF OR RELATING TO PREVIOUSLY SETTLED GOVERNMENTAL INVESTIGATIONS OR OTHER MATTERS, GOVERNMENTAL OR REGULATORY INVESTIGATIONS AND/OR EXAMINATIONS AND THE LEGAL RISKS ASSOCIATED WITH OUR BUSINESS COULD ADVERSELY IMPACT OUR ASSETS UNDER MANAGEMENT, INCREASE COSTS AND NEGATIVELY IMPACT OUR PROFITABILITY AND/OR OUR FUTURE FINANCIAL RESULTS. We have been named in shareholder class action and other lawsuits, many of which arise out of or relate to previously settled governmental investigations. While management believes that the claims made in these lawsuits are without merit, and while we intend to vigorously defend against them, litigation typically is an expensive process. Risks associated with legal liability often are difficult to assess or quantify and their existence and magnitude can remain unknown for significant periods of time. Moreover, settlements or judgments against us have the potential of being substantial if we are unsuccessful in settling or otherwise resolving matters early in the process and/or on favorable terms. It is also possible that we may be named in additional civil or governmental actions similar to those already instituted. From time to time we may receive requests for documents or other information from governmental authorities or regulatory bodies or we also may become the subject of governmental or regulatory investigations and/or examinations. Moreover, governmental or regulatory investigations or examinations that have been inactive could become active. We may be obligated or may choose to indemnify directors, officers or employees against liabilities and expenses they may incur in connection with such matters to the extent permitted under applicable law. Eventual exposures from and expenses incurred relating to current and future litigation, investigations, examinations and 38 - --------------------------------------------------------------------------------
settlements could adversely impact our assets under management, increase costs and negatively impact our profitability and/or our future financial results. Judgments or findings of wrongdoing by regulatory or governmental authorities or in civil litigation against us could affect our reputation, increase our costs of doing business and/or negatively impact our revenues, any of which could have a material negative impact on our financial results. WE DEPEND ON KEY PERSONNEL AND OUR FINANCIAL PERFORMANCE COULD BE NEGATIVELY AFFECTED BY THE LOSS OF THEIR SERVICES. The success of our business will continue to depend upon our key personnel, including our portfolio and fund managers, investment analysts, investment advisers, sales and management personnel and other professionals as well as our executive officers and business unit heads. Competition for qualified, motivated and highly skilled executives, professional and other key personnel in the investment management and banking/finance industries remains significant. Our success depends to a substantial degree upon our ability to attract, retain and motivate qualified individuals and upon the continued contributions of these people. As our business grows, we are likely to need to increase correspondingly the overall number of individuals that we employ. Moreover, in order to retain certain key personnel, we may be required to increase compensation to such individuals, resulting in additional expense without a corresponding increase in potential revenue. We cannot assure you that we will be successful in attracting and retaining qualified individuals, and departure of key investment personnel, in particular, if not replaced, could cause us to lose clients, which could have a material adverse effect on our financial condition, results of operations and business prospects. Moreover, our employees may voluntarily terminate their employment with us at any time. The loss of the services of key personnel or our failure to attract replacement or additional qualified personnel could negatively affect our financial performance. 39 - --------------------------------------------------------------------------------
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. In the normal course of business, our financial position is subject to market risk: the potential loss due to changes in the value of investments including those resulting from adverse changes in interest rates, foreign exchange and/or equity prices. Management is responsible for managing this risk. Our Enterprise Risk Management Committee is responsible for providing a framework to assist management to identify, assess and manage market and other risks. Our banking/finance operating segment is exposed to interest rate fluctuations on its loans receivable, debt securities held, and deposit liabilities. In our banking/finance operating segment, we monitor the net interest rate margin and the average maturity of interest earning assets, as well as funding sources. In addition, as of June 30, 2005, we have considered the potential impact of the effect on the banking/finance operating segment balances, individually and collectively, of a 100 basis point (1%) movement in market interest rates. Based on our analysis, we do not expect that this change would have a material impact on our operating revenues or results of operations in either scenario. Our investment management operating segment is exposed to changes in interest rates through its investment in debt securities and its outstanding debt. We minimize the impact of interest rate fluctuations related to our investments in debt securities by managing the maturities of these securities, and through diversification. Our exposure to interest rate changes related to our debt issuances is not material since a significant percentage of our outstanding debt is at fixed interest rates. We are subject to foreign exchange risk through our foreign operations. We operate primarily in the United States, but also provide services and earn revenues in Canada, the Bahamas, Europe, Asia, South America, Africa and Australia. Our exposure to foreign exchange risk is minimized since a significant portion of these revenues and associated expenses are denominated in U.S. dollars. This situation may change in the future as our business continues to grow outside the United States. We are exposed to equity price fluctuations through securities we hold that are carried at fair value and through investments held by majority-owned sponsored investment products that we consolidate. To mitigate this risk, we maintain a diversified investment portfolio. Our exposure to equity price fluctuations is also minimized as we sponsor a broad range of investment products in various global jurisdictions. ITEM 4. CONTROLS AND PROCEDURES. The Company's management evaluated, with the participation of the Company's principal executive and principal financial officers, the effectiveness of the Company's disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act")) as of June 30, 2005. Based on their evaluation, the Company's principal executive and principal financial officers concluded that the Company's disclosure controls and procedures were effective as of June 30, 2005. There has been no change in the Company's internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the Company's fiscal quarter ended June 30, 2005, that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. 40 - --------------------------------------------------------------------------------
PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS. As previously reported, various subsidiaries of the Company, as well as certain Templeton Fund registrants, have been named in multiple class action lawsuits originally filed in state courts in Illinois, alleging breach of duty with respect to the valuation of the portfolio securities of certain Templeton Funds managed by such subsidiaries, and seeking, among other relief, monetary damages and attorneys' fees and costs, as follows: Bradfisch v. Templeton Funds, Inc., et al., Case No. 2003 L 001361, filed on October 3, 2003 in the Circuit Court of the Third Judicial Circuit, Madison County, Illinois; Woodbury v. Templeton Global Smaller Companies Fund, Inc., et al., Case No. 2003 L 001362, filed on October 3, 2003 in the Circuit Court of the Third Judicial Circuit, Madison County, Illinois; Kwiatkowski v. Templeton Growth Fund, Inc., et al., Case No. 03 L 785, filed on December 17, 2003 in the Circuit Court of the Twentieth Judicial Circuit, St. Clair County, Illinois; Parise v. Templeton Funds, Inc., et al., Case No. 2003 L 002049, filed on December 22, 2003 in the Circuit Court of the Third Judicial Circuit, Madison County, Illinois. In April 2005, defendants removed these lawsuits to the United States District Court for the Southern District of Illinois (Bradfisch v. Templeton Funds, Inc., et al., Case No. 3:05-cv-00298-MJR; Woodbury v. Templeton Global Smaller Companies Fund, Inc., et al., Case No. 3:05-cv-00301-GPM; Kwiatkowski v. Templeton Growth Fund, Inc., et al., Case No. 3:05-cv-00299-GPM; Parise v. Templeton Funds, Inc., et al., Case No. 3:05-cv-0300-GPM). On July 12, 2005, the court dismissed one of these lawsuits, Bradfisch v. Templeton Funds, Inc., et al., on the ground of preemption. Defendants' motions to dismiss the remaining three lawsuits on the same ground are pending. Also as previously reported, on April 12, 2005, the Attorney General of West Virginia filed a complaint in the Circuit Court of Marshall County, West Virginia (Case No. 05-C-81) against a number of companies engaged in the mutual fund industry, including the Company and a subsidiary of the Company, and certain other parties, alleging violations of the West Virginia Consumer Credit and Protection Act and seeking, among other things, civil penalties and attorneys' fees and costs. Defendants have since removed this action to the United States District Court for the Northern District of West Virginia (Case No. 5:05-cv-78). ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS. The following table provides information with respect to the shares of common stock we repurchased during the three months ended June 30, 2005. <TABLE> (C) TOTAL NUMBER OF SHARES (D) MAXIMUM PURCHASED AS NUMBER OF SHARES PART OF THAT MAY YET BE (A) TOTAL (B) AVERAGE PUBLICLY PURCHASED UNDER NUMBER OF PRICE PAID PER ANNOUNCED PLANS THE PLANS OR PERIOD SHARES PURCHASED SHARE OR PROGRAMS PROGRAMS - ----------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> April 1, 2005 through April 30, 2005 352,475 $65.65 352,475 10,991,594 May 1, 2005 through May 31, 2005 49 $67.58 49 10,991,545 June 1, 2005 through June 30, 2005 -- -- -- 10,991,545 - ----------------------------------------------------------------------------------------------------- TOTAL 352,524 $65.60 352,524 10,991,545 - ----------------------------------------------------------------------------------------------------- </TABLE> Under our stock repurchase program, we can repurchase shares of our common stock from time to time in the open market and in private transactions in accordance with applicable securities laws. From time to time we have announced the existence of the Company's continuing policy of purchasing shares of its common stock, including announcements in March 2000, August 2002, May 2003, and August 2003. From 2002 through the current date, our Board of Directors has authorized and approved the repurchase of up to 30.0 million shares 41 - --------------------------------------------------------------------------------
under our stock repurchase program, of which, approximately 19.0 million shares had been repurchased and approximately 11.0 million shares remained available for repurchase as of June 30, 2005. Our stock repurchase program is not subject to an expiration date. 42 - --------------------------------------------------------------------------------
ITEM 6. EXHIBITS. EXHIBIT NO. DESCRIPTION ----------- ----------- Exhibit 3(i)(a) Registrant's Certificate of Incorporation, as filed November 28, 1969, incorporated by reference to Exhibit (3)(i) to the Registrant's Annual Report on Form 10-K for the fiscal year ended September 30, 1994 (File No. 001-09318) (the "1994 Annual Report"). Exhibit 3(i)(b) Registrant's Certificate of Amendment of Certificate of Incorporation, as filed on March 1, 1985, incorporated by reference to Exhibit (3)(ii) to the 1994 Annual Report. Exhibit 3(i)(c) Registrant's Certificate of Amendment of Certificate of Incorporation, as filed on April 1, 1987, incorporated by reference to Exhibit (3)(iii) to the 1994 Annual Report. Exhibit 3(i)(d) Registrant's Certificate of Amendment of Certificate of Incorporation, as filed on February 2, 1994, incorporated by reference to Exhibit (3)(iv) to the 1994 Annual Report. Exhibit 3(i)(e) Registrant's Certificate of Amendment of Certificate of Incorporation, as filed on February 4, 2005, incorporated by reference to Exhibit (3)(i)(e) to the Registrant's Quarterly Report on Form 10-Q for the period ended December 31, 2004 (File No. 001-09318). Exhibit 3(ii) Registrant's Amended and Restated By-Laws incorporated by reference to Exhibit 3.1 to the Registrant's Form 8-K filed with the SEC on June 29, 2005 (File No. 001-09318). Exhibit 10.1 Five Year Facility Credit Agreement dated as of June 10, 2005 among Franklin Resources, Inc., the Banks parties thereto, Bank of America, N.A. and The Bank of New York, as Co-Syndication Agents, Citibank, N.A. and BNP Paribas, as Co-Documentation Agents, and JPMorgan Chase Bank, N.A., as Administrative Agent, incorporated by reference to Exhibit 10.1 to the Registrant's Form 8-K filed with the SEC on June 16, 2005 (File No. 001-09318). Exhibit 12 Computations of ratios of earnings to fixed charges. Exhibit 31.1 Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith). Exhibit 31.2 Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith). Exhibit 32.1 Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (furnished herewith). Exhibit 32.2 Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (furnished herewith). 43 - --------------------------------------------------------------------------------
SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. FRANKLIN RESOURCES, INC. (Registrant) Date: August 8, 2005 By: /S/ JAMES R. BAIO ------------------ James R. Baio Senior Vice President and Chief Financial Officer (Duly Authorized Officer and Principal Financial Officer) 44 - --------------------------------------------------------------------------------
EXHIBIT INDEX ------------- EXHIBIT NO. DESCRIPTION ----------- ----------- Exhibit 3(i)(a) Registrant's Certificate of Incorporation, as filed November 28, 1969, incorporated by reference to Exhibit (3)(i) to the Registrant's Annual Report on Form 10-K for the fiscal year ended September 30, 1994 (File No. 001-09318) (the "1994 Annual Report"). Exhibit 3(i)(b) Registrant's Certificate of Amendment of Certificate of Incorporation, as filed on March 1, 1985, incorporated by reference to Exhibit (3)(ii) to the 1994 Annual Report. Exhibit 3(i)(c) Registrant's Certificate of Amendment of Certificate of Incorporation, as filed on April 1, 1987, incorporated by reference to Exhibit (3)(iii) to the 1994 Annual Report. Exhibit 3(i)(d) Registrant's Certificate of Amendment of Certificate of Incorporation, as filed on February 2, 1994, incorporated by reference to Exhibit (3)(iv) to the 1994 Annual Report. Exhibit 3(i)(e) Registrant's Certificate of Amendment of Certificate of Incorporation, as filed on February 4, 2005, incorporated by reference to Exhibit (3)(i)(e) to the Registrant's Quarterly Report on Form 10-Q for the period ended December 31, 2004 (File No. 001-09318). Exhibit 3(ii) Registrant's Amended and Restated By-Laws incorporated by reference to Exhibit 3.1 to the Registrant's Form 8-K filed with the SEC on June 29, 2005 (File No. 001-09318). Exhibit 10.1 Five Year Facility Credit Agreement dated as of June 10, 2005 among Franklin Resources, Inc., the Banks parties thereto, Bank of America, N.A. and The Bank of New York, as Co-Syndication Agents, Citibank, N.A. and BNP Paribas, as Co-Documentation Agents, and JPMorgan Chase Bank, N.A., as Administrative Agent, incorporated by reference to Exhibit 10.1 to the Registrant's Form 8-K filed with the SEC on June 16, 2005 (File No. 001-09318). Exhibit 12 Computations of ratios of earnings to fixed charges. Exhibit 31.1 Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith). Exhibit 31.2 Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith). Exhibit 32.1 Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (furnished herewith). Exhibit 32.2 Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (furnished herewith). 45 - --------------------------------------------------------------------------------