Now I'd like to turn the call over to Franklin Resources' CEO, Mr. Greg Johnson.

Mr. Johnson, you may begin.

Well, thank you. Hello, and welcome to the second quarter earnings commentary.

I'm Greg Johnson, CEO; along with Ken Lewis, our CFO.

Net new flows turned positive again this quarter, driven by the increase in sales, with long-term flows positive across all investment objectives for the first time in nearly 3 years. Most importantly, long-term relative investment performance remained strong across the firm.

Net income also rebounded, and quarterly earnings per share of $2.32 reached a record high.

I'd like to now open it up for your questions.

Maybe the first question, just on the distribution revenue and expenses this quarter, and you guys mentioned a little bit on the prerecorded call some of the drivers there. But can you give a little color -- I guess, first, typically in the past when we've seen some unusual trends in those line items, it's been either some product launch or some incentive for some type of product or an initiative, but when we look across the products you mentioned, like the diversity of the flows and the sales, it seems like it was pretty much broad-based.

So it doesn't necessarily stand out. And then you also mentioned the timing of revenues and expenses sometimes being -- meaning, expenses coming in before the revenues.

So just any color on one, the issues in the quarter. And then just in terms of the outlook, what we should be expecting there.

So, Michael, I'll take that. This is Ken.

So I guess the first thing to mention in this line -- in the expense line was there's about $9 million of nonrecurring items. So going forward, I discount that.

And secondly, it really wasn't product specific, the increase in expenses, as we've been disclosing this now for a while. There's 2 components to it.

There's a component -- a smaller component that's based on the sales volumes. So that would be your upfront commission lows.

And the revenue and the expense, they tend to directionally go in sync. And then there's an asset-based component.

And that's, the asset-based component, is what we were referencing. And it's really a timing difference.

So it's the way that it's calculated and the short quarter did have an impact on it, making the expenses grow more than the revenue on the asset-based distribution items. So going forward, I think it's probably safe to say that, that line item, it either should be flat to a little bit down in the next quarter because of the nonrecurring items and this timing issue.

Okay. And then just on that, I mean, from a timing standpoint, are you saying if we just look at the number of days, the revenues versus the expenses, like there is 1 day of a delta between the 2?

Or is it not that simple?

Yes, that's right. Now well, it's -- the revenue's based on like a month-end amount and the revenue's -- and the expense is based on daily.

Okay, got it. Got it.

And then just a follow-up on the flow side. The -- I guess, on the retail side, it just seems you had broad-based inflows across all the products, which we really haven't seen across many of the other firms.

So one is what do you kind of -- what would you categorize that? Like what's the driver of that generating the diversity of the flows?

And how much of that was more seasonal versus are you seeing more traction and more interest? Not only on the fixed-income side where you guys have done well, but also on the equity side.

I wonder if Greg wants to talk.

The -- it speaks really to the mix of assets that we have in the market environment, and really, the hybrid funds that we talked about, the strength of the Franklin Income Fund. And we saw about a 35% pickup in that category.

Rising Dividends Fund, again, a conservative equity based fund with a dividend. Those are doing well.

I wouldn't say they're seasonal. I think they're very much in vogue today.

And then the third was the strength in munis. So you really saw a nice rebound in U.S.

retail. You didn't see as much of a rebound in international sales because they don't have the -- that mix to count on where you have the income fund, the munis making up for some of the drop in the global bond sales.

You had a nice pick up in Asian growth. And we also saw a nice net flow number in U.S.

Opportunities Fund in our CCAB, but really, much smaller as a percentage when you look at the net pickup that we've seen in munis and the hybrid category, which really is more U.S.-based.

Just coming back to the margin for a second, and I appreciate the seasonality of the business and some one-timers. If you back that out and you look year-on-year, and you look at the change in your operating income relative to the change in revenues, it seems like a very low incremental margin.

I'm sort of curious if you could talk to the dynamics of the margin impact from a product sales both by -- maybe by mix, I guess, at the end of the day.

Sure. Let me -- I feel like I may have misspoke in answering Michael's question.

So let me just either correct it or clarify. The revenue is based on the number of days in the quarter, and expense is accrued on a monthly basis.

So I think I might have had that backwards. So I don't know that we're seeing any significant differences even on a year-over-year basis due to the product mix or the geographical mix.

So I think all the effective fee rates are in line. Maybe this quarter, we had a slight uptick in the distribution items because there were some more equity sales.

So there is a little bit -- maybe a slight upward pressure on -- or slight upward movement on the distribution lines because the equity products have higher rates. But I wouldn't say that was significant.

So even on a year-over-year basis, I don't think there's significant change due to mix.

Okay, then sort of follow-up. As you think about the mix of the business today and the dynamics between U.S.

and non-U.S. and some of the statutory rate change going on around the world, what's your outlook for tax rate?

Yes, the -- our tax rate, we think it's going to be fairly stable, and it has been. And we don't see anything on the horizon that would change that in the short term.

First, in the prepared remarks, you mentioned on global bond, CCAB managers reducing their model portfolio allocations to global bond. It seems interesting that a number of the managers do this at the same time.

So what's going on here? Is this a global bond asset class issue or is this a Franklin global bond issue or is it something else?

Well, I think it's hard to say. I think part of it, though, we've seen a pick up in the Global Total Return Fund, which had fairly strong net inflows outside of the U.S.

where the global bond still had outflows. And it's just the nature of those type of sales are much more gatekeeper-controlled.

So I think the volatility that, that fund experienced probably, some of those gatekeepers felt like well, maybe that was more volatile than what they're comfortable with, or they just had too much exposure based on the strong sales in the past. So you tend to see big, lumpier movements when that happens when you have kind of a market shock in that somewhat of a newer category.

But overall, I don't think that's a trend that should continue as far as the reallocation by the gatekeepers. Doesn't play into it.

Yes, and it seems like you think they stayed in global bond -- the global bond category and actually within Franklin as well by going to the total return.

Right. Right, that's what we've seen.

And that's been a steady trend that the sales and the global total return continues to gain share versus the global bond.

Okay, and then for the other question. You've got a lot of cash in the balance sheet.

If the U.S. were to let the dividend tax at 15% expire at the end of the year, which I guess is what is on the table, to what extent does this influence your decision to dividend before that new tax rate goes into effect?

Like, does that influence your decision or is that kind of irrelevant to your decision?

Well, I think the after-tax return to shareholders is always a relevant input that the board considers. And in the discussions we've had, we've done a couple of specials in the last year.

And that certainly was part of the discussion.

And I think just to add, I mean, even the consideration of doing it last year, the board considered the possibility of that even happening retroactively this year. So I mean, that certainly goes into the thinking.

First, just starting on compensation expense. I was wondering if you could break out how much was from the seasonal merit increase and higher payroll?

Yes, so let's see. I think maybe somewhere in the neighborhood of in the $10 million to $12 million or something would be probably be due to those 2 items.

So if we think about the -- roughly, let's see, $323 million, if we take $10 million to $12 million out, you also have the variable component, which is also elevated versus the fourth quarter. Should we expect that variable component to stay roughly at a similar level for the next few quarters?

And given certain revenue levels, I think that's fair. At the current revenue levels, I think that's a fair comment.

Got it. But the $10 million to $12 million is something we shouldn't expect to roll in the next quarter?

Not as incremental.

Okay, got it. And just one final question.

On the international redemptions, they're a little bit higher quarter-over-quarter, but 2 of your strongest international markets, Germany, Italy, got -- even net flows got even better there. I'm wondering which international markets on a flow basis or a redemption base got a little weaker driving that.

I guess weaker is relative. I can tell you that during the quarter, some of the bigger detractors from net sales were Asia, Hong Kong and then the MENA region, the Gulf and the Eastern Mediterranean.

First, just in terms of the Global Bond Fund, is it reasonable to think flows will continue to reaccelerate, mostly a function of better trends here in the U.S., but maybe on the flip side, we likely won't see the types of inflows that you saw in prior cycles until kind of the non-U.S. investors get back on board, if you will?

Yes, I mean, I think that's right. It's still -- the global bond, both U.S.

and offshore, was still our best-selling 2 funds on a gross basis. I think the U.S.

trend is getting better, is improving. And I think that'll continue.

I think the global one is always a little harder to answer because you have so many different markets and distribution and generally newer investors that tend to have -- redemption tends to be sometimes a little bit faster, but so does the sale coming back in. So I think that's a harder one to get a handle on going forward.

But I think the trend for the U.S. investors still looks very solid.

Okay, that's helpful. And then second, can you just talk a little bit about product innovation?

What sorts of strategies are you working on? Is it still mostly focused on multi-asset class and alternative products?

And just from a seed capital standpoint, are you still sort of in a net realization mode or wouldn't you expect to be sort of more neutral going forward?

Well, I think as we've mentioned, I mean, we have started some new funds in the global tactical allocation fund. We have -- we'll continue to look at more alternatives.

I think we feel like that's a trend that's going to continue providing commodity exposure into our funds as an inflation hedge. I mean, those are all new for us, and we've just got those funds up and running.

So we're going to continue to talk about those. Another fund that's kind of interesting to me is the International Growth Fund, which just passed its 3-year record and has outstanding performance for the 1 in 3 years.

So we think that could get some traction in the category that's new for us as well.

Okay, and then just from...

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The second part of the question, as it relates to kind of seed capital investing and sort of on a net basis where you see that going forward.

In terms of -- I think we have a pretty good system of keeping the absolute amount of seed capital stable. So I think we've talked about that in the past where we look at ideas we had maybe a couple of years ago, and they're either greatly successful or not, and then we use that seed money and re-purpose it for new products.

So in terms of the balance sheet, I don't see any significant changes increasing or decreasing our amount of seed money.

So your non-U.S. cash balance was about 51% of total at the year end, at year-end 2010.

And now, it's about 62%. You acknowledged that your funding shareholder distribution is out of the U.S.

cash balance. And just very rough math, it looks like you're paying out 70%, 75% of your U.S.

free cash flow. So I'm wondering whether you view that as sustainable, and how much of a constraint it could be on your ability to reinvest in the U.S.

side of the business? And then, obviously, the cash coffer abroad is growing.

So any comments on how you plan to deploy that to generate a return?

Right. So I think we would agree that over an extended period of time, the levels of kind of share repurchases will have to -- can't be sustained at historical levels.

But that said, we are growing in the U.S. A lot of our successful products are U.S.-managed.

The Global Bond Fund is an example. So I think that we've seen some pretty good U.S.

cash flow. And there's not a lot of cash needs in the U.S.

Most of the cash needs are outside the U.S., and so that's where we plan to deploy the cash to grow the international business. You've seen that with some of the small acquisitions that we did.

And that's going to continue to be the focus.

Great. And then any comments on how you plan to deploy the non-U.S.

cash, assuming no change in the tax code?

Yes, I mean, we have a pretty, I think, innovative and -- but conservative investment strategy for offshore cash. We do use some of our own products.

We do consult with our investment professionals on the best way to do that. Obviously, we keep things relatively short and conservative.

And I think we would just continue on that path.

Did foreign currency have a big effect on the recent reported results, especially on your expense line?

I didn't get the last -- especially what?

Especially on the expense line.

It did not. It does -- because where we operate, we do tend to have offsetting currency impacts.

And on a quarter and a year-to-date basis, it was not material.

Just wondering the increase in flows in the U.S. for instance, to the income fund, do you see any of that as seasonal, so likely to slow ahead?

I don't know whether that one is particularly, for instance, 401(k) menus.

Yes, I don't think it's seasonal. I think it's -- most of those flows are coming outside of a 401(k).

I think it's just the attraction right now of the yield that it offers, and the track record is very strong. So I would expect that to continue.

Okay. And also, any color you could give just on institutional demand?

I think you mentioned that you're seeing demand for global and U.S. equity strategies.

But in terms of types of clients, are you seeing U.S. pension funds overseas?

Are you seeing sovereign funds? Where are you seeing the demand?

Are you seeing variable annuities? Any color you can give.

Yes, I mean, I think it's more of the same. I wouldn't say there's been a change away from fixed income.

It's still the big opportunity. I think our largest funding in the quarter was about a $760 million global ag with sovereign wealth.

So I think that's where the big opportunities continue to be for us, and we're seeing some in high yield as well. And then just -- we're still seeing specialized demand where in India, China things were for more regionalized management, but smaller ticket items with maybe a little bit better fees on it.

But overall, it's still really fixed income, international equity and some specialty. And we're seeing some U.S.

equity searches, but not any significant change there.

So I realized Europe is many different countries, but it seems like your flows have maybe perhaps turned a corner in the region. Any thoughts there?

Well, I think you're right. I think for the -- Europe rebounded more favorably than certainly Asia did over the last quarter.

And the 2 big markets for us, Germany and Italy, we've seen a return to decent net flows there. So I think that's going to continue for us, but I couldn't add much color around the opportunities within Europe.

Okay. And then follow-up.

Ken, it sounds like on the distribution margin that as far as you're concerned, there's no permanent change that's affecting this quarter, and some of this will reverse in the future quarters.

Yes, that's correct. So like as I mentioned, I don't really expect that line item to increase in the short term given in a stable environment like the current quarter.

Yes, I would mention a couple of things on the expense line. We do have other variable compensation.

But we have been pretty diligent on our cost management efforts in the first half of the year. And giving that we've had some success in the first half of the year, we're going to kind of loosen that up a little bit.

So you would expect to see some of the line items increasing. Expect to see a little bit more headcount in the next few quarters and some of the other line items increase, not significantly, but a little bit.

I guess, first, just on -- I think it sounded like you were saying that you've seen some investors in the Global Bond Fund moving to Global Total Return. I know you track exchange, exchange within funds analysts.

Do you have any stats on how much that's occurring?

We do track that. I don't have that in front of me between the 2.

Okay. Okay, my other somewhat unrelated question is just, can you update us on the alternatives for the -- Pelagos that you acquired a stake in?

I think you -- the commodities product you mentioned might be an outcome of that, but where you are in developing for the ag alternatives products.

Well, it's part of a new fund that we just introduced, and it's a tactical asset allocation that has a sleeve with managed futures in that. And that was really the first step for us in using Pelagos' capabilities in our fund.

So we don't anticipate a separate fund to manage futures right now. It's just really a sleeve or a portion of our asset allocation within our larger tactical fund.

I guess, Ken, just a follow-up on the last comment you made around expenses. So as we think about the second half of the year, we should see modest increases in the IT occupancy and G&A numbers from this quarter?

Yes, I think primarily, you'll see small increases in the comp line and maybe the IT line. The others should be relatively flat.

But, I mean, they do vary from period-to-period. And all of these comments exclude the impact of consolidating our VIEs and sponsored investment products, which tend to affect lines like G&A and Other.

They go through some of that -- the impact goes through that line. So excluding all of that, yes, I would expect maybe a slight increase in IT and comp.

Okay, and then on the prerecorded call, you guys mentioned a global bond retention campaign, I guess, that you guys have out. If you could kind of expand upon that and kind of I guess how that's being received.

Well, it's hard to -- I think what we're trying to do is just get as much timely information. I think we've done a pretty good job of that on what's happening in that marketplace and try to anticipate as best we can where redemptions are coming from and try to get information there quickly.

And it's a little early to tell how much success we're having with that to really measure it.

Greg, can you talk a little bit about the acquisition environment out there? Obviously, you're still sitting on a nice amount of cash.

And then maybe you can just also discuss just the capital priorities and where sort of acquisitions fit in.

Well, I don't think a whole lot has changed. I mean it's -- we're still seeing opportunities around the globe, and we'll continue to do that.

I think we -- as we've stated before, we don't have an appetite for -- or a major need for a major category that we think would fill a big gap in our lineup. But we do feel like there's going to be strategic acquisitions.

And we are firm believers that the retail market will continue as the institutional market has to look for alternatives, especially given where rates are and people looking for other options. So I think we're very much open to that.

We'll continue to look at that. And whether or not that's in the U.S.

or outside of the U.S., our appetite's are both. But I wouldn't say that M&A looks like it's picking up or there's more available than there has been.

I think it's a fairly steady state.

Just had one follow-up. On the recorded call, you mentioned on the revenues about, I think, it was $14 million of kind of nonrecurring items that depressed revenues.

And then on the expenses, you mentioned the $9 million on the distribution side. I just wanted to make sure, did those numbers include or exclude the consolidation of the VIEs or the investments?

And then...

They would exclude the VIEs. So then we show on, I guess, its Slide maybe 18 or something, the amount for that.

Okay. And then just given that it's starting the impact kind of the...

Let me have a correction. Okay, there was one exception to that.

In the other net line, there was about -- so the other net revenue line, there was maybe $9 million of the $14 million was related to the VIEs.

Okay, got it. And then just given that the consolidation is impacting kind of your core revenues and then some of the expense lines instead of it just being in a non-op area, have you guys considered doing the adjusted P&L like some of your -- some of the peers have done?

Yes. So it's obviously been a topic, not only as a result of adopting the new accounting rules, but in anticipation of them.

So we've been tracking it, and we've started pro forma-ing in. And we've been tracking it.

To date, the conclusion is, overall, it's not that material even on some of the line items like overtime, it hasn't been that material. But it's something that we continuously monitor.

And I certainly wouldn't rule out doing that in the future if we feel like it helps the investors understand the financials better.

Well, thank you, everyone, for participating on our call, and we look forward to speaking next quarter. Thank you.