FORM 10-Q SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 (Mark One) [X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For Quarterly Period Ended March 31, 2003 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 No. 1-9318 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) 312-2000 (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. YES X NO ----- ----- Indicate by check mark whether the registrant is an accelerated filer (as described in Rule 12b-2 of the Exchange Act). YES X 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: 253,468,709 shares, common stock, par value $.10 per share at April 30, 2003. - -------------------------------------------------------------------------------- PART I - FINANCIAL INFORMATION ITEM 1. CONDENSED FINANCIAL STATEMENTS FRANKLIN RESOURCES, INC. CONSOLIDATED STATEMENTS OF INCOME UNAUDITED THREE MONTHS ENDED SIX MONTHS ENDED MARCH 31 MARCH 31 (in thousands, except per share data) 2003 2002 2003 2002 - --------------------------------------------------------------------------------------------- OPERATING REVENUES: Investment management fees $347,897 $365,778 $699,309 $722,576 Underwriting and distribution fees 194,158 197,537 380,095 389,544 Shareholder servicing fees 55,315 48,024 103,366 95,365 Other, net 15,765 14,629 35,816 36,690 - --------------------------------------------------------------------------------------------- TOTAL OPERATING REVENUES 613,135 625,968 1,218,586 1,244,175 - --------------------------------------------------------------------------------------------- OPERATING EXPENSES: Underwriting and distribution 173,068 177,327 341,915 349,594 Compensation and benefits 160,809 159,764 319,927 319,907 Information systems, technology and occupancy 71,404 73,197 143,999 147,791 Advertising and promotion 24,226 25,481 46,870 51,906 Amortization of deferred sales commissions 17,040 17,047 33,085 33,790 Amortization of intangible assets 4,238 4,258 8,472 8,633 Other 22,644 20,875 45,157 41,670 - --------------------------------------------------------------------------------------------- TOTAL OPERATING EXPENSES 473,429 477,949 939,425 953,291 - --------------------------------------------------------------------------------------------- Operating income 139,706 148,019 279,161 290,884 OTHER INCOME/(EXPENSES): Investment and other income 15,558 14,782 27,861 33,111 Interest expense (3,037) (2,808) (6,069) (5,976) - --------------------------------------------------------------------------------------------- Other income, net 12,521 11,974 21,792 27,135 - --------------------------------------------------------------------------------------------- Income before taxes on income 152,227 159,993 300,953 318,019 Taxes on income 42,624 39,997 81,590 79,504 - --------------------------------------------------------------------------------------------- NET INCOME $109,603 $119,996 $219,363 $238,515 - --------------------------------------------------------------------------------------------- Earnings per share: Basic $0.43 $0.46 $0.85 $0.91 Diluted $0.43 $0.46 $0.85 $0.91 Dividends per share $0.075 $0.070 $0.150 $0.140 See accompanying notes to the consolidated financial statements. 2 - -------------------------------------------------------------------------------- FRANKLIN RESOURCES, INC. CONSOLIDATED BALANCE SHEETS UNAUDITED MARCH 31 SEPTEMBER 30 (in thousands) 2003 2002 - ------------------------------------------------------------------------------------------------ ASSETS Current assets: Cash and cash equivalents $701,020 $829,237 Receivables 286,594 292,325 Investment securities, available-for-sale 1,286,326 1,103,463 Prepaid expenses and other 95,559 97,783 - ------------------------------------------------------------------------------------------------ Total current assets 2,369,499 2,322,808 - ------------------------------------------------------------------------------------------------ Banking/finance assets: Cash and cash equivalents 123,866 151,367 Loans receivable, net 516,679 444,338 Investment securities, available-for-sale 474,194 449,629 Other 39,769 45,889 - ------------------------------------------------------------------------------------------------ Total banking/finance assets 1,154,508 1,091,223 - ------------------------------------------------------------------------------------------------ Non-current assets: Investments, other 258,346 263,927 Deferred sales commissions 162,670 130,617 Property and equipment, net 379,571 394,172 Intangible assets, net 690,479 697,246 Goodwill 1,327,582 1,321,939 Receivable from banking/finance group 183,200 100,705 Other 80,450 100,101 - ------------------------------------------------------------------------------------------------ Total non-current assets 3,082,298 3,008,707 - ------------------------------------------------------------------------------------------------ TOTAL ASSETs $6,606,305 $6,422,738 - ------------------------------------------------------------------------------------------------ See accompanying notes to the consolidated financial statements. 3 - -------------------------------------------------------------------------------- FRANKLIN RESOURCES, INC. CONSOLIDATED BALANCE SHEETS UNAUDITED MARCH 31 SEPTEMBER 30 (in thousands except share data) 2003 2002 - ------------------------------------------------------------------------------------------------ LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Compensation and benefits $171,848 $228,093 Current maturities of long-term debt 4,216 7,830 Accounts payable and accrued expenses 125,510 117,246 Commissions 81,408 81,033 Income taxes 14,166 12,510 Other 8,363 8,307 - ------------------------------------------------------------------------------------------------ Total current liabilities 405,511 455,019 - ------------------------------------------------------------------------------------------------ Banking/finance liabilities: Deposits 720,188 733,571 Payable to Parent 183,200 100,705 Other 59,769 49,660 - ------------------------------------------------------------------------------------------------ Total banking/finance liabilities 963,157 883,936 - ------------------------------------------------------------------------------------------------ Non-current liabilities: Long-term debt 636,086 595,148 Deferred taxes 187,466 175,176 Other 45,598 46,513 - ------------------------------------------------------------------------------------------------ Total non-current liabilities 869,150 816,837 - ------------------------------------------------------------------------------------------------ - ------------------------------------------------------------------------------------------------ Total liabilities 2,237,818 2,155,792 - ------------------------------------------------------------------------------------------------ Commitments and contingencies (Note 10) Stockholders' equity: Preferred stock, $1.00 par value, 1,000,000 shares authorized; none - - issued Common stock, $0.10 par value, 500,000,000 shares authorized; 25,546 25,856 255,463,878 and 258,555,285 shares issued and outstanding, for March and September Capital in excess of par value 504,810 598,196 Retained earnings 3,883,497 3,702,636 Accumulated other comprehensive loss (45,366) (59,742) - ------------------------------------------------------------------------------------------------ Total stockholders' equity 4,368,487 4,266,946 - ------------------------------------------------------------------------------------------------ TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $6,606,305 $6,422,738 - ------------------------------------------------------------------------------------------------ See accompanying notes to the consolidated financial statements. 4 - -------------------------------------------------------------------------------- FRANKLIN RESOURCES, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS UNAUDITED SIX MONTHS ENDED MARCH 31 (in thousands) 2003 2002 - ------------------------------------------------------------------------------------------------ NET INCOME $219,363 $238,515 Adjustments to reconcile net income to net cash provided by operating activities: Decrease in receivables, prepaid expenses and other 29,863 133,644 Net advances of deferred sales commissions (65,381) (76,118) Increase in other current liabilities 2,290 64,925 Increase in income taxes payable 1,656 7,468 Increase in commissions payable 374 2,249 Decrease in accrued compensation and benefits (27,870) (38,756) Depreciation and amortization 87,926 91,134 Losses/(gains) on disposal of assets 2,240 (5,433) - ------------------------------------------------------------------------------------------------ Net cash provided by operating activities 250,461 417,628 - ------------------------------------------------------------------------------------------------ Purchase of investments (1,114,217) (787,795) Liquidation of investments 897,620 981,974 Purchase of banking/finance investments (108,547) (84,780) Liquidation of banking/finance investments 168,596 143,115 Net proceeds from securitization of loans receivable 124,989 299,980 Net origination of loans receivable (198,589) (239,147) Additions of property and equipment (32,052) (27,992) Proceeds from sale of property 143 9,534 - ------------------------------------------------------------------------------------------------ Net cash (used in)/provided by investing activities (262,057) 294,889 - ------------------------------------------------------------------------------------------------ (Decrease)/increase in bank deposits (13,382) 72,362 Exercise of common stock options 729 12,010 Net put option premiums and settlements 2,862 895 Dividends paid on common stock (37,404) (35,129) Purchase of stock (133,322) (8,070) Increase in debt 42,686 43,799 Payments on debt (6,291) (4,146) - ------------------------------------------------------------------------------------------------ Net cash (used in)/provided by financing activities (144,122) 81,721 - ------------------------------------------------------------------------------------------------ (Decrease)/increase in cash and cash equivalents (155,718) 794,238 Cash and cash equivalents, beginning of period 980,604 622,775 - ------------------------------------------------------------------------------------------------ Cash and cash equivalents, end of period $824,886 $1,417,013 - ------------------------------------------------------------------------------------------------ SUPPLEMENTAL DISCLOSURE OF NON-CASH INFORMATION: Value of common stock issued, principally restricted stock $28,376 $28,151 See accompanying notes to the consolidated financial statements. 5 - -------------------------------------------------------------------------------- FRANKLIN RESOURCES, INC. Notes to Consolidated Financial Statements March 31, 2003 (Unaudited) 1. Basis of Presentation --------------------- We have prepared these unaudited interim financial statements of Franklin Resources, Inc. and its consolidated subsidiaries in accordance with the instructions to Form 10-Q and the rules and regulations of the Securities and Exchange Commission. 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 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 year ended September 30, 2002. Certain amounts for the comparative prior year periods have been reclassified to conform to the financial presentation for and at the periods ended March 31, 2003. 2. Comprehensive Income -------------------- The following table shows comprehensive income for the three and six months ended March 31, 2003 and 2002. THREE MONTHS ENDED SIX MONTHS ENDED MARCH 31 MARCH 31 (in thousands) 2003 2002 2003 2002 --------------------------------------------------------------------------------------------- Net income $109,603 $119,996 $219,363 $238,515 Net unrealized (loss)/gain on available-for-sale securities, net of tax (4,629) 3,610 3,155 6,181 Foreign currency translation adjustments 3,464 (2,217) 11,221 (8,852) --------------------------------------------------------------------------------------------- Comprehensive income $108,438 $121,389 $233,739 $235,844 --------------------------------------------------------------------------------------------- 6 - -------------------------------------------------------------------------------- 3. Earnings per Share ------------------ We computed earnings per share as follows: THREE MONTHS ENDED SIX MONTHS ENDED MARCH 31 MARCH 31 (in thousands except per share amounts) 2003 2002 2003 2002 ---------------------------------------------------------------------------------------- Net income $109,603 $119,996 $219,363 $238,515 ---------------------------------------------------------------------------------------- Weighted-average shares outstanding - basic 257,023 261,596 257,315 261,284 Incremental shares from assumed conversions 631 515 603 697 ---------------------------------------------------------------------------------------- Weighted-average shares outstanding - diluted 257,654 262,111 257,918 261,981 ---------------------------------------------------------------------------------------- Earnings per share: Basic and diluted $0.43 $0.46 $0.85 $0.91 ---------------------------------------------------------------------------------------- 4. Employee Stock Option and Investment Plans ------------------------------------------ Under our stock option plan, we may award options to some employees. In addition, we have a qualified, non-compensatory Employee Stock Investment Plan ("ESIP"), which allows participants who meet certain eligibility criteria to buy shares of common stock at 90% of their market value on defined dates. We account for these plans 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 issued under the ESIP. If we had determined compensation costs for our stock option plans and 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. 7 - -------------------------------------------------------------------------------- THREE MONTHS ENDED SIX MONTHS ENDED MARCH 31 MARCH 31 (in thousands) 2003 2002 2003 2002 --------------------------------------------------------------------------------------- Net Income, as reported $109,603 $119,996 $219,363 $238,515 Less: additional stock-based compensation expense determined under the fair value method, net of tax 17,414 15,012 33,949 28,056 --------------------------------------------------------------------------------------- PRO FORMA NET INCOME $92,189 $104,984 $185,414 $210,459 --------------------------------------------------------------------------------------- BASIC EARNINGS PER SHARE As reported $0.43 $0.46 $0.85 $0.91 Pro forma $0.36 $0.40 $0.72 $0.81 DILUTED EARNINGS PER SHARE As reported $0.43 $0.46 $0.85 $0.91 Pro forma $0.36 $0.40 $0.72 $0.80 --------------------------------------------------------------------------------------- 5. Cash and Cash Equivalents ------------------------- Cash and cash equivalents at March 31, 2003 and September 30, 2002 consisted of the following: MARCH 31, SEPTEMBER 30, (in thousands) 2003 2002 ----------------------------------------------- -------------------- ------------------- Cash and due from banks $245,970 $224,214 Federal funds sold and securities purchased under agreements to resell 50,445 82,150 Other 528,471 674,240 ----------------------------------------------- -------------------- ------------------- Total $824,886 $980,604 ----------------------------------------------- -------------------- ------------------- Cash and cash equivalents - other includes money market mutual fund investments and U.S. Treasury bills. Federal Reserve Board regulations require reserve balances on deposits to be maintained with the Federal Reserve Banks by banking subsidiaries. The required reserve balance was $2.4 million as of March 31, 2003 and $5.3 million as of September 30, 2002. 6. 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 for the three and six months ended March 31, 2003 and 2002: 8 - -------------------------------------------------------------------------------- THREE MONTHS ENDED SIX MONTHS ENDED MARCH 31 MARCH 31 (in thousands) 2003 2002 2003 2002 --------------------------------------------------------------------------------------- Gross sale proceeds $- $- $131,620 $319,616 Net carrying amount of loans sold - - 126,104 306,260 --------------------------------------------------------------------------------------- Pre-tax gain $- $- $5,516 $13,356 --------------------------------------------------------------------------------------- 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. Gross sales proceeds include the fair value of the interest-only strips. 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: THREE MONTHS SIX MONTHS ENDED ENDED MARCH 31 MARCH 31 2003 2002 2003 2002 -------------------------------------------------------------------------------------- Excess cash flow discount rate (annual rate) - - 12% 12% Cumulative life loss rate - - 4.27% 3.75% Pre-payment speed assumption (average monthly rate) - - 1.76% 1.50% -------------------------------------------------------------------------------------- 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 strips 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 shows the carrying value and the sensitivity of the interest-only strip receivables at March 31, 2003 and September 30, 2002 to adverse changes in the key economic assumptions used to measure fair value, which are hypothetical: 9 - -------------------------------------------------------------------------------- MARCH 31, SEPTEMBER 30, (in thousands) 2003 2002 --------------------------------------------------------------------------------------- Carrying amount/fair value of interest-only strips $27,146 $29,088 --------------------------------------------------- Excess cash flow discount rate (annual rate) 12% 12% -------------------------------------------- Impact on fair value of 10% adverse change $(388) $(400) Impact on fair value of 20% adverse change $(765) $(789) Cumulative life loss rate 3.95% 3.63% ------------------------- Impact on fair value of 10% adverse change $(1,827) $(1,787) Impact on fair value of 20% adverse change $(3,651) $(3,579) Pre-payment speed assumption (average monthly rate) 1.70% 1.73% -------------------------------------------------- Impact on fair value of 10% adverse change $(2,896) $(2,632) Impact on fair value of 20% adverse change $(5,461) $(5,155) --------------------------------------------------------------------------------------- This sensitivity analysis shows the hypothetical effect of a change in the assumptions used to determine the fair value of the interest-only strip receivable. Actual future market conditions may differ materially and accordingly, this sensitivity analysis should not be considered our projections of future events or losses. With respect to retained servicing responsibilities relating to the securitization trusts, we receive annual servicing fees ranging from 1% to 2% of the loans securitized. We also receive the rights to future cash flows, if any, arising after the investors in the securitization trust have received their contracted return. The following is a summary of cash flows received from and paid to securitization trusts. THREE MONTHS ENDED SIX MONTHS ENDED MARCH 31 MARCH 31 (in thousands) 2003 2002 2003 2002 --------------------------------------------------------------------------------------- Servicing fees received $2,696 $2,092 $5,069 $3,397 Other cash flows received 4,266 4,603 9,132 5,922 Purchase of loans from trusts 10,363 7,964 10,363 8,380 --------------------------------------------------------------------------------------- Amounts payable to the trustee for servicing income collected on behalf of the trusts of $26.5 million at March 31, 2003 and $24.9 million at September 30, 2002 are included in other banking/finance liabilities. The securitized loan portfolio that we manage and the related delinquencies as of March 31, 2003 and September 30, 2002 were as follows: 10 - -------------------------------------------------------------------------------- March 31, September 30, (in thousands) 2003 2002 --------------------------------------------------------------------------------------- Securitized loans held by securitization trusts $521,560 $530,896 Delinquencies 10,991 9,317 --------------------------------------------------------------------------------------- Net charge-offs on the securitized loan portfolio were $3.0 million and $1.6 million during the three months ended March 31, 2003 and 2002 and $6.0 million and $2.7 million during the six months ended March 31, 2003 and 2002. 7. Intangible Assets and Goodwill ------------------------------ Intangible assets at March 31, 2003 and September 30, 2002 were as follows: GROSS CARRYING ACCUMULATED NET CARRYING (in thousands) AMOUNT AMORTIZATION AMOUNT --------------------------------------------------------------------------------------- AS OF MARCH 31, 2003 Amortized intangible assets: Customer base $232,321 $(31,182) $201,139 Other 31,546 (18,917) 12,629 --------------------------------------------------------------------------------------- 263,867 (50,099) 213,768 Non-amortized intangible assets: Management contracts 476,711 - 476,711 --------------------------------------------------------------------------------------- Total $740,578 $(50,099) $690,479 --------------------------------------------------------------------------------------- AS OF SEPTEMBER 30, 2002 Amortized intangible assets: Customer base $231,935 $(23,358) $208,577 Other 31,546 (18,181) 13,365 --------------------------------------------------------------------------------------- 263,481 (41,539) 221,942 Non-amortized intangible assets: Management contracts 475,304 - 475,304 --------------------------------------------------------------------------------------- Total $738,785 $(41,539) $697,246 --------------------------------------------------------------------------------------- Estimated amortization expense for each of the next 5 fiscal years is as follows: FOR THE FISCAL YEARS ENDING (in thousands) SEPTEMBER 30, ---------------------------------------- ----------------------------- 2003 $16,959 2004 16,959 2005 16,959 2006 16,959 2007 16,959 ---------------------------------------- ----------------------------- 11 - -------------------------------------------------------------------------------- The change in the carrying value of goodwill was as follows: (in thousands) ---------------------------------------------------------------------- Goodwill as of September 30, 2002 $1,321,939 Foreign currency movements 5,643 ---------------------------------------------------------------------- Goodwill as of March 31, 2003 $1,327,582 ---------------------------------------------------------------------- We adopted Statement of Financial Accounting Standards No. 142 "Goodwill and Other Intangible Assets" ("SFAS 142") on October 1, 2001. SFAS 142 addresses the initial recognition and measurement of intangible assets acquired outside a business combination and the recognition and measurement of goodwill and other intangible assets after acquisition. Under the new standard, all goodwill and indefinite-lived intangible assets, including those acquired before initial application of the standard, are not amortized but are tested for impairment at least annually. Accordingly, on October 1, 2001, we ceased to amortize goodwill and indefinite-lived assets. All of our goodwill and intangible assets relate to our investment management operating segment. Indefinite-lived intangible assets represent the value of management contracts related to our mutual funds and other investment products. As of March 31, 2003, we completed the 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 goodwill and indefinite-lived assets recorded in our books and records as of October 1, 2002. 8. 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, Fiduciary Trust and Bissett funds, and institutional, high net-worth and private accounts and other investment products. The banking/finance segment offers consumer lending and selected retail-banking services to individuals. Financial information for our two operating segments for the three and six months ended March 31, 2003 and 2002 is presented in the table below. Operating revenues of the banking/finance segment are reported net of interest expense and provision for loan losses. 12 - -------------------------------------------------------------------------------- THREE MONTHS ENDED SIX MONTHS ENDED MARCH 31 MARCH 31 (in thousands) 2003 2002 2003 2002 --------------------------------------------------------------------------------------- OPERATING REVENUES Investment management $600,787 $617,794 $1,190,082 $1,216,753 Banking/finance 12,348 8,174 28,504 27,422 --------------------------------------------------------------------------------------- Total $613,135 $625,968 $1,218,586 $1,244,175 --------------------------------------------------------------------------------------- INCOME BEFORE TAXES Investment management $146,777 $156,700 $285,712 $299,381 Banking/finance 5,450 3,293 15,241 18,638 --------------------------------------------------------------------------------------- Total $152,227 $159,993 $300,953 $318,019 --------------------------------------------------------------------------------------- Operating segment assets were as follows: MARCH 31, SEPTEMBER 30, (in thousands) 2003 2002 --------------------------------------------------------------------------------------- Investment management $5,451,797 $5,331,515 Banking/finance 1,154,508 1,091,223 --------------------------------------------------------------------------------------- Total $6,606,305 $6,422,738 --------------------------------------------------------------------------------------- Operating revenues of the banking/finance segment included above were as follows: THREE MONTHS ENDED SIX MONTHS ENDED MARCH 31 MARCH 31 (in thousands) 2003 2002 2003 2002 ------------------------------------------------------------------------------------------ Interest and loan fees $8,101 $6,608 $15,964 $17,923 Interest and dividends on investment securities 5,852 4,112 10,862 9,507 ----------------------------------------------------------------------------------------- Total interest income 13,953 10,720 26,826 27,430 Interest on deposits (1,791) (2,340) (3,380) (5,077) Interest on short-term debt (110) (57) (198) (275) Interest expense - inter-segment (605) (1,341) (1,409) (3,486) ----------------------------------------------------------------------------------------- Total interest expense (2,506) (3,738) (4,987) (8,838) Net interest income 11,447 6,982 21,839 18,592 Other income 4,234 4,351 13,215 19,162 Provision for loan losses (3,333) (3,159) (6,550) (10,332) ----------------------------------------------------------------------------------------- Total operating revenues $12,348 $8,174 $28,504 $27,422 ----------------------------------------------------------------------------------------- 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 Consolidated Statements of Income. 13 - -------------------------------------------------------------------------------- 9. Debt ---- In May 2001, we received approximately $490 million in net proceeds from the sale of $877 million principal amount at maturity of zero-coupon convertible senior notes due 2031 (the "Convertible Notes"). At March 31, 2003, long-term debt included $501.0 million in principal and $18.0 million of accrued interest related to the Convertible Notes. The Convertible Notes, which were offered to qualified institutional buyers only, carry an interest rate of 1.875% per annum, with an initial conversion premium of 43%. Each of the $1,000 (principal amount at maturity) Convertible Notes is convertible into 9.3604 shares of our common stock. We may redeem the Convertible Notes for cash on or after May 11, 2006 at their accreted value. We may have to repurchase the Convertible Notes at their accreted value, at the option of the holders, on May 11 of 2003, 2004, 2006, 2011, 2016, 2021 and 2026. In this event, we may choose to pay the purchase price in cash or shares of our common stock. The amount of Convertible Notes that will be redeemed depends on, among other factors, the performance of our common stock. On April 9, 2003, we notified holders that we would redeem the Convertible Notes for cash at their accreted value on May 11, 2003. If we had to repurchase all of the Convertible Notes on this date, the total payment would be approximately $520.1 million. We did not have any commercial paper outstanding or medium term notes issued at March 31, 2003 and at September 30, 2002. See Note 13 for additional disclosures about subsequent events. 10. 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, on a prospective basis, 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 (see Note 14). The following are guarantees issued as of March 31, 2003. At March 31, 2003, there was no liability recognized in our consolidated balance sheet for guaranteed amounts as existing transactions as of this date were entered into before the effective date of the fair value provision of the interpretation. We lease our corporate headquarters in San Mateo, California from a lessor trust under an operating lease that expires in fiscal 2005, with additional renewal options for a further period of up to 10 years. In connection with this lease, we are contingently liable for approximately $145 million in residual guarantees, representing approximately 85% of the total construction costs of $170 million. We would become liable under the residual guarantee of $145 million if we were unable or unwilling to exercise our renewal option to extend the lease term or buy the corporate headquarter buildings, or if we were unable to arrange for the sale of the building for more than $145 million. We are also contingently liable to purchase the corporate headquarter buildings for an amount equal to the final construction costs of $170 million if an event of default occurs under the agreement. An event of default includes, but is not limited to, failure to make lease payments when due and failure to maintain required insurance. Management considers the possibility of default under the provisions of the agreement to be remote. The lease is treated as an operating 14 - -------------------------------------------------------------------------------- lease as none of the capitalization criteria under Statement of Financial Accounting Standards No. 13, "Accounting for Leases" was met at the inception of the lease. We provide investment management services to, and have made investments in, a number of collateralized debt obligation entities ("CDOs") that, using debt financing, invest in debt instruments. These entities subsequently issue notes and preferred shares to investors. As of March 31, 2003, in relation to one of these entities, and in the event that the CDO is terminated prior to the issuance of securities to investors, we have a contingent obligation in the maximum amount of approximately $107 million. 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 March 31, 2003, the maximum potential amount of future payments was $9.6 million. At March 31, 2003, our banking/finance operating segment had issued financial standby letters of credit totaling $9.7 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 customers. These standby letters of credit were secured by marketable securities with a fair value of $20.3 million as of March 31, 2003 and commercial real estate and have various expiration dates through March 2004. From time to time, we sell put options giving the purchaser the right to sell shares of our common stock to us at a specified price upon exercise of the options on the designated expiration dates if certain conditions are met. These put options are treated as equity instruments and the related premium received is recorded in Stockholders' Equity as Capital in excess of par value. The likelihood that we will have to purchase our stock and the purchase price is contingent on the market value of our stock when the put option contract becomes exercisable. At March 31, 2003, there were 4.4 million put options outstanding with various expiration dates from May 2003 through January 2004. OTHER COMMITMENTS AND CONTINGENCIES In February 2001, we signed an agreement to outsource management of our data center and distributed server operations. Under the agreement, we may end the agreement any time beginning on March 1, 2004 by incurring a termination charge. The maximum termination charge payable depends on the termination date, the service levels before our termination of the agreement, and costs incurred to wind down the services. Based on March 31, 2003 service levels, the termination fee payable on March 1, 2004 would approximate $37.2 million and would decrease on each one-year anniversary for the following three years. We are involved in various claims and legal proceedings that are considered normal in our business. While it is not feasible to predict or determine the final outcome of these proceedings, we do not believe that they should have a material adverse effect on our financial position, results of operations or liquidity. At March 31, 2003, our banking/finance operating segment had commitments to extend credit aggregating $292.7 million, mainly under credit card lines. We lease office space and equipment under long-term operating leases. Future minimum lease payments under non-cancelable leases are not material. 15 - -------------------------------------------------------------------------------- 11. Transactions with Variable Interest Entities -------------------------------------------- Variable interest entities ("VIEs") consist of corporations, trusts, partnerships and other entities where the equity investment holders have not contributed sufficient capital to finance the activities of the VIEs or the equity investment holders do not have defined rights and obligations normally associated with equity investments (see Note 14). At March 31, 2003, we were engaged in financial transactions with the following VIEs. LESSOR TRUST. We lease our corporate headquarters in San Mateo, California from a lessor trust under an operating lease as described in Note 10. Our maximum exposure arising from this arrangement is approximately $170 million at March 31, 2003. At this time, we believe that it is probable that we will have to consolidate the lessor trust in our annual financial statements as of September 30, 2003. COLLATERALIZED DEBT OBLIGATION ENTITIES. We provide investment management services to, and have made investments in, a number of CDOs as described in Note 10. Our equity ownership interest in the CDOs is currently not sufficient to meet consolidation requirements and they are reported at fair value. We earn investment management fees, including subordinated management fees in some cases, for managing the CDOs, as well as incentive fees that are contingent on certain performance conditions. At March 31, 2003, the combined market value of assets in these CDOs was approximately $1.7 billion, and our maximum exposure to loss as a result of these investments was approximately $19.6 million. At this time, we believe that it is reasonably possible that we will have to either make additional disclosures about or consolidate one or more of these entities in our annual financial statements as of September 30, 2003. 12. Banking Regulatory Ratios ------------------------- Following the acquisition of Fiduciary Trust Company International 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 initiate certain mandatory, and possibly additional, discretionary actions by regulators that, if undertaken, could have a direct material 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 as of March 31, 2003, we exceeded the capital adequacy requirements applicable to us as listed below. 16 - -------------------------------------------------------------------------------- THREE MONTHS ENDED MINIMUM FOR OUR CAPITAL (in thousands) MARCH 31, 2003 ADEQUACY PURPOSES ------------------------------------- --------------------- --------------------------- Tier 1 capital $2,244,324 N/A Total risk-based capital $2,255,816 N/A Tier 1 leverage ratio 47% 4% Tier 1 risk-based capital ratio 65% 4% Total risk-based capital ratio 66% 8% ------------------------------------- --------------------- --------------------------- 13. Subsequent Events ----------------- In April 2003, we completed the sale of five-year senior notes due April 15, 2008 and totaling $420 million. The senior notes, which were offered to qualified institutional buyers only, carry an interest rate of 3.7%. During April 2003, we purchased approximately 2.0 million shares of our common stock at a cost of approximately $68.6 million. 14. New Accounting Standards ------------------------ In November 2002, Financial Accounting Standards Board Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others" ("FIN 45"), was issued. FIN 45 addresses financial accounting and reporting for companies that issue certain guarantees. Under FIN 45, a company must recognize a liability at fair value for all guarantees entered into or modified after December 31, 2002, even when the likelihood of making any payments under the guarantee is remote. FIN 45 also requires enhanced disclosures for guarantees existing at December 31, 2002. The adoption of FIN 45 did not have a material effect on our consolidated operating results and financial position. See Note 10 for additional disclosures. In December 2002, Statement of Financial Accounting Standards No. 148, "Accounting for Stock-Based Compensation--Transition and Disclosure" ("SFAS 148"), was issued. SFAS 148 amends Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation", to provide alternative methods of transition to the fair value method of accounting for stock-based compensation when companies elect to expense stock options at fair value at the time of grant. SFAS 148 also requires additional interim disclosure for all companies with stock-based employee compensation. As we adopted the intrinsic value method described in APB Opinion No. 25, "Accounting for Stock Issued to Employees", the transition provision of SFAS 148 will not apply to us. The disclosure requirements are effective for interim periods starting after December 15, 2002. The adoption of SFAS 148 did not have a material effect on our consolidated operating results and financial position and we have provided the necessary disclosures in Note 4. In January 2003, Financial Accounting Standards Board Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46"), was issued. FIN 46 addresses reporting and disclosure requirements for VIEs. It defines a VIE as a corporation, trust, partnership or other entity where the equity investment holders have not contributed sufficient capital to finance the activities of 17 - -------------------------------------------------------------------------------- the VIE or the equity investment holders do not have defined rights and obligations normally associated with an equity investment. FIN 46 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. It also requires additional disclosures for an enterprise that holds a significant variable interest in a VIE, but is not the primary beneficiary. The consolidation and disclosure provisions of FIN 46 are effective immediately for VIEs created after January 31, 2003, and for interim or annual reporting periods beginning after June 15, 2003 for VIEs created before February 1, 2003. FIN 46 also requires interim disclosures in all financial statements issued after January 31, 2003, regardless of the date on which the VIE was created, if it reasonably possible that an enterprise will consolidate or disclose information about a VIE when FIN 46 becomes effective. We are currently evaluating the impact that the adoption of FIN 46 will have on our results of operations and financial condition. See Note 11 for interim disclosures under FIN 46. 18 - -------------------------------------------------------------------------------- ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FORWARD-LOOKING STATEMENTS In addition to historical information, we also make some statements relating to the future, which are called "forward-looking" statements. These forward-looking statements involve a number of risks, uncertainties and other important factors that could cause our actual results and outcomes to differ materially from any future results or outcomes expressed or implied by such forward-looking statements. Forward-looking statements are our best prediction at the time they are made, and for this reason, you should not rely too heavily on them and review the "Risk Factors" section set forth below and in our recent filings with the U.S. Securities and Exchange Commission, which describes these risks, uncertainties and other important factors in more detail. 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, high net-worth, private accounts and other investment products. This is our main 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 via five distinct names: * Franklin * Templeton * Mutual Series * Fiduciary Trust * Bissett Our sponsored investment products include a broad range of domestic and global/international equity, balanced/hybrid, fixed-income and money market mutual funds, as well as 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. Our secondary business and operating segment is banking/finance. Our banking/finance group offers consumer lending and selected retail-banking services to high net-worth individuals, foundations and institutions. 19 - -------------------------------------------------------------------------------- RESULTS OF OPERATIONS THREE MONTHS ENDED SIX MONTHS ENDED (in millions except per share MARCH 31 PERCENT MARCH 31 PERCENT amounts) 2003 2002 CHANGE 2003 2002 CHANGE - ----------------------------------------------------------------------------------------------- NET INCOME $109.6 $120.0 (9%) $219.4 $238.5 (8%) EARNINGS PER COMMON SHARE Basic and diluted $0.43 $0.46 (7%) $0.85 $0.91 (7%) OPERATING MARGIN 23% 24% - 23% 23% - - ----------------------------------------------------------------------------------------------- Net income decreased 9% and 8% during the three and six months ended March 31, 2003 compared to the same periods last year. These decreases were mainly due to lower investment management fees consistent with a decline in simple monthly average assets under management, partially offset by higher shareholder servicing fees mainly due to an increase in billable shareholder accounts. ASSETS UNDER MANAGEMENT March 31 March 31 (in billions) 2003 2002 - ----------------------------------------------------------------------------------------------- Equity: Global/international $75.7 $93.9 Domestic (U.S.) 42.7 53.2 - ----------------------------------------------------------------------------------------------- Total equity 118.4 147.1 - ----------------------------------------------------------------------------------------------- Balanced/hybrid 37.4 40.8 Fixed-income: Tax-free 52.3 48.7 Taxable Domestic 29.4 24.6 Global/international 9.4 7.7 - ----------------------------------------------------------------------------------------------- Total fixed-income 91.1 81.0 - ----------------------------------------------------------------------------------------------- Money market 5.5 5.6 - ----------------------------------------------------------------------------------------------- Total $252.4 $274.5 - ----------------------------------------------------------------------------------------------- Simple monthly average for the three-month period (1) $255.1 $267.9 Simple monthly average for the six-month period (1) $254.6 $261.6 - ----------------------------------------------------------------------------------------------- (1) Investment management fees from approximately 50% of our assets under management at March 31, 2003 are calculated using a daily average. Our assets under management at March 31, 2003 were $252.4 billion, 8% lower than they were a year ago, mainly due to market depreciation in the latter half of fiscal 2002 and in the quarter ended March 31, 2003. Simple monthly average assets decreased 5% and 3% during the three and six months ended March 31, 2003 over the same periods a year ago. The simple monthly average mix of assets under management is shown below. 20 - -------------------------------------------------------------------------------- SIX MONTHS ENDED MARCH 31 2003 2002 - ----------------------------------------------------------------------------------------------- PERCENTAGE OF TOTAL ASSETS UNDER MANAGEMENT Equity 48% 52% Fixed-income 35% 31% Balanced/hybrid 15% 15% Money market 2% 2% - ----------------------------------------------------------------------------------------------- Simple monthly average for the six-month period 100% 100% - ----------------------------------------------------------------------------------------------- The change in the composition of assets under management resulted from market depreciation in equity assets in the latter half of fiscal 2002 and in the quarter ended March 31, 2003. This shift in asset mix led to slight decrease in our effective investment management fee rate (investment management fees divided by simple monthly average assets under management). For the six months ended March 31, 2003, the effective investment management fee rate declined slightly to 0.549% as compared to 0.552% over the same period last year. Assets under management by shareholder location were as follows: AS OF MARCH 31, (in billions) 2003 2002 - ------------------------------------------------------------------------ ----------- ---------- United States $211.5 $232.1 Canada 16.9 22.0 Europe 10.6 10.8 Asia/Pacific and other 13.4 9.6 - ------------------------------------------------------------------------ ----------- ---------- Total $252.4 $274.5 - ------------------------------------------------------------------------ ----------- ---------- Components of the change in our assets under management were as follows: THREE MONTHS ENDED SIX MONTHS ENDED MARCH 31 PERCENT MARCH 31 PERCENT (in billions) 2003 2002 CHANGE 2003 2002 CHANGE - ---------------------------------------------------------------------------------------------- Beginning assets under management $257.7 $266.3 (3%) $247.8 $246.4 1% Sales 17.6 18.8 (6%) 34.8 37.7 (8%) Reinvested distributions 0.6 0.5 20% 2.0 3.1 (35%) Redemptions (15.1) (14.3) 6% (31.3) (29.8) 5% Distributions (1.1) (1.1) - (3.2) (4.8) (33%) (Depreciation)/appreciation (7.3) 4.3 N/A 2.3 21.9 (89%) - ---------------------------------------------------------------------------------------------- Ending assets under management $252.4 $274.5 (8%) $252.4 $274.5 (8%) - ---------------------------------------------------------------------------------------------- For the three and six months ended March 31, 2003, sales exceeded redemptions complex-wide ("net inflows") by $2.5 billion and $3.5 billion, compared to inflows of $4.5 billion and $7.9 billion in the same periods last year. Market appreciation of $2.3 billion in the six months ended March 31, 2003 related mainly to our fixed-income category. 21 - -------------------------------------------------------------------------------- OPERATING REVENUES THREE MONTHS ENDED SIX MONTHS ENDED MARCH 31 PERCENT MARCH 31 PERCENT (in millions) 2003 2002 CHANGE 2003 2002 CHANGE - --------------------------------------------------------------------------------------------- Investment management fees $347.8 $365.8 (5%) $699.3 $722.6 (3%) Underwriting and distribution fees 194.2 197.6 (2%) 380.1 389.5 (2%) Shareholder servicing fees 55.3 48.0 15% 103.4 95.4 8% Other, net 15.8 14.6 8% 35.8 36.7 (2%) - --------------------------------------------------------------------------------------------- Total operating revenues $613.1 $626.0 (2%) $1,218.6 $1,244.2 (2%) - --------------------------------------------------------------------------------------------- SUMMARY Total operating revenues decreased 2% for both the three and six months ended March 31, 2003 compared to the same periods last year primarily due to lower investment management related to a decline in simple monthly average assets under management, and lower underwriting and distribution fees resulting from lower sales. The decreases were partly offset by higher shareholder service fees. INVESTMENT MANAGEMENT FEES Investment management fees account for 57% of our operating revenues in the quarter ended March 31, 2003. 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. In return for these fees, we provide a combination of investment advisory, administrative and other management services. Investment management fees decreased 5% and 3% during the three and six months ended March 31, 2003 over the same periods last year consistent with the 5% and 3% decrease in simple monthly average assets under management over the same periods. UNDERWRITING AND DISTRIBUTION FEES We earn underwriting fees from the sale of some classes of sponsored investment products on which investors pay a sales commission at the time of purchase. Sales at reduced or zero commissions are offered on some classes of shares and for sales to shareholders or intermediaries that exceed specified minimum amounts. Therefore, underwriting fees will change with the overall level of gross sales and the relative mix of sales between different share classes. 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. We pay a significant portion of underwriting and distribution fees to the financial advisors 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 decreased 2% during both the three and six months ended March 31, 2003 over the same periods last year. During the three and six months ended March 31, 2003, 22 - -------------------------------------------------------------------------------- commission revenues decreased 7% and 5% over the same periods last year mainly due to a 6% and 8% decrease in product sales. Distribution fees increased 2% during the three months ended March 31, 2003 and decreased 1% during the six months ended March 31, 2003 over same periods last year. The overall decline during the six months ended March 31, 2003 over the same period in the prior year was related to a 3% decline in simple monthly average assets under management over the same period. 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, which include 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 year remain billable through the second quarter of the following calendar year at a reduced rate. 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. Shareholder servicing fees increased 15% and 8% during the three and six months ended March 31, 2003 over the same periods last year. The increase reflects an increase in billable shareholder accounts due to revised shareholder service fee agreements effective on January 1, 2003 and 0.7 million shareholder accounts added in the acquisition of Pioneer ITI AMC Limited ("Pioneer"), in July 2002. Prior to January 2003, the U.S. transfer agent did not assess a fee for certain partially serviced shareholder accounts. As of March 31, 2003, billable accounts included approximately 3.9 million additional partial service accounts now billable under the revised U.S. shareholder agreements. This increase in billable accounts was partially offset by lower rates on closed accounts under the new agreements. OTHER, NET Other, net consists mainly 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, which are offset by interest expense and the provision for anticipated loan losses. Other, net increased 8% during the three months ended March 31, 2003 over the same period last year. This increase was mainly due higher interest on auto loans and a decline in interest expense. Other, net decreased 2% during the six months ended March 31, 2003 from the same period last year consistent with a decrease in realized gains from auto loan securitizations to $5.5 million in the six months ended March 31, 2003 from $13.4 million during the same period in the prior year, partially offset by a decline in interest expense. 23 - -------------------------------------------------------------------------------- OPERATING EXPENSES THREE MONTHS ENDED SIX MONTHS ENDED MARCH 31 PERCENT MARCH 31 PERCENT (in millions) 2003 2002 CHANGE 2003 2002 CHANGE - --------------------------------------------------------------------------------------------- Underwriting and distribution $173.1 $177.3 (2%) $341.9 $349.6 (2%) Compensation and benefits 160.8 159.8 1% 319.9 320.0 - Information systems, technology and occupancy 71.4 73.2 (2%) 144.0 147.8 (3%) Advertising and promotion 24.2 25.5 (5%) 46.9 51.9 (10%) Amortization of deferred sales commissions 17.0 17.0 - 33.1 33.8 (2%) Amortization of intangible assets 4.2 4.2 - 8.5 8.6 (1%) Other 22.7 20.9 9% 45.1 41.6 8% - --------------------------------------------------------------------------------------------- Total operating expenses $473.4 $477.9 (1%) $939.4 $953.3 (1%) - --------------------------------------------------------------------------------------------- SUMMARY Operating expenses decreased 1% during both the three and six months ended March 31, 2003 over the same periods last year. This decrease was primarily due to a decrease in underwriting and distribution, information systems, technology and occupancy and advertising and promotion expenses, partially offset by an increase in other expenses. UNDERWRITING AND DISTRIBUTION Underwriting and distribution includes sales commissions and distribution fees paid to brokers and other third parties for selling, distributing and providing ongoing services to investors in our sponsored investment products. Underwriting and distribution expense decreased 2% during both the three and six months ended March 31, 2003 over the same periods last year consistent with the decrease in underwriting and distribution revenues. COMPENSATION AND BENEFITS Compensation and benefits expense increased 1% during the three months ended March 31, 2003 and remained constant during the six months ended March 31, 2003 over the same periods last year. Although our compensation structure has remained relatively constant as compared to the prior year, we have experienced increases in employee insurance and other benefits costs in the current fiscal year. We employed approximately 6,600 at March 31, 2003 as compared to about 6,400 at the same time last year. Our acquisition of Pioneer, in July 2002, added approximately 180 employees. In order to hire and retain key employees, we are committed to keeping our salaries and benefit packages competitive, which means that the level of compensation and benefits may increase more quickly or decrease more slowly than our revenues. INFORMATION SYSTEMS, TECHNOLOGY AND OCCUPANCY Information systems, technology and occupancy costs decreased 2% and 3% during the three and six months ended March 31, 2003 over the same periods last year. While continuing work on new technology initiatives and investment in our technology infrastructure, expenditures have declined from 24 - -------------------------------------------------------------------------------- the prior year as we slowed down a number of initiatives and delayed the start of other technology projects given the current economic slowdown and our focus on cost control and management. Details of capitalized information systems and technology costs were as follows: THREE MONTHS ENDED SIX MONTHS ENDED MARCH 31 MARCH 31 (in thousands) 2003 2002 2003 2002 - ----------------------------------------------------------------------------------------------- Net book value at beginning of period $110,045 $151,321 $121,486 $162,857 Additions during period, net of disposals and other adjustments 8,414 14,906 15,331 22,432 Amortization during period (18,365) (19,361) (36,723) (38,423) - ----------------------------------------------------------------------------------------------- Net book value at end of period $100,094 $146,866 $100,094 $146,866 - ----------------------------------------------------------------------------------------------- ADVERTISING AND PROMOTION Advertising and promotion expense decreased 5% and 10% during the three and six months ended March 31, 2003 over the same periods last year. During the three and six months ended March 2002, we incurred increased promotion expense to assist in educating the sales channels and the investing public about the strong relative investment performance of our sponsored investment products. We are committed to invest in advertising and promotion in response to changing business conditions, 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, while at the same time, our distribution subsidiaries pay a commission on the sale. In the United States, class A shares are sold without a front-end sales charge to shareholders when minimum investment criteria are met while our U.S. distribution subsidiary pays a commission on these sales. Class C shares are sold with a front-end sales charge that is lower than the commission paid by the U.S. distributor. We defer and amortize all up-front commissions paid by our distribution subsidiaries. We have arranged to finance some of these deferred commission assets ("DCA") arising from our U.S., Canadian and European operations through Lightning Finance Company Limited ("LFL"), a company in which we have an ownership interest. In the United States, LFL has entered into a financing agreement with our U.S. distribution subsidiary and we maintain a continuing interest in the assets 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 resold by LFL in a securitization, which generally occurs at least once annually. LFL did not sell any U.S. DCA in securitization transactions in either the 6 months ended March 31, 2003 or the 6 months ended March 31, 2002. In contrast to the U.S. arrangement, LFL has entered into direct agreements with the Canadian and European sponsored investment products, and, as a result, we do not record DCA from these sources in our financial statements. Amortization of deferred sales commissions remained constant and decreased 2% during the three and six months ended March 31, 2003 over the same periods last year. 25 - -------------------------------------------------------------------------------- OTHER INCOME (EXPENSE) Other income (expense) includes investment and other income and interest expense. Investment and other income is comprised mainly of the following: * dividends from investments * interest income from investments in government securities and other fixed-income investments * realized gains and losses on investments * foreign currency exchange gains and losses * miscellaneous income, including gain or loss on disposal of property. Other income (expense) increased 5% during the three months ended March 31, 2003 over the same period last year. Other income (expense) decreased 20% during the six months ended March 31, 2003 over the same period last year due to lower realized investment gains and interest income, partially offset by higher foreign exchange gains from our non-U.S. operations. TAXES ON INCOME As a multi-national corporation, we provide investment management services to a wide range of international 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 income (mainly investment management fees) 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 in the quarter ended March 31, 2003 increased to 28% compared to 25% in the same period last year. 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. MATERIAL CHANGES IN FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES At March 31, 2003, we had $824.9 million in cash and cash equivalents, as compared to $980.6 million at September 30, 2002. Cash and cash equivalents include cash, U.S. Treasury bills and other debt instruments with original maturities of three months or less and other highly liquid investments that are readily convertible into cash, including money market funds. The mix of short-term instruments and, in particular, the maturity schedules of some debt instruments, affect the level reported in cash and cash equivalents and in investment securities, available-for-sale in any given period. Liquid assets, which consist of cash and cash equivalents, investments available-for-sale and current receivables increased to $2,872.0 million at March 31, 2003 from $2,826.0 million at September 30, 2002. Outstanding debt increased to $640.3 million at March 31, 2003 compared to $603.0 million at September 30, 2002. As of March 31, 2003, outstanding debt consists of $519.0 million in principal and accrued interest related to outstanding convertible notes that we issued in May 2001 and $121.3 million of other long-term debt. As of September 30, 2002, outstanding debt included $514.2 million related to the convertible notes and $88.8 million of other long-term debt. Other long-term debt consists mainly of deferred commission liability recognized in relation to the U.S. DCA financed by LFL that has not yet been sold by LFL in a securitization transaction. The increase in outstanding debt from September 30, 2002 is due to U.S. DCA financed by LFL and the accretion of interest on the convertible notes. 26 - -------------------------------------------------------------------------------- Each of the $1,000 (principal amount at maturity) convertible notes is convertible into 9.3604 shares of our common stock. We may redeem the convertible notes for cash on or after May 11, 2006 at their accreted value. We may have to repurchase the convertible notes at their accreted value, at the option of the holders, on May 11 of 2003, 2004, 2006, 2011, 2016, 2021 and 2026. In this event, we may choose to pay the purchase price in cash or shares of our common stock. The amount of convertible notes that will be redeemed depends on, among other factors, the performance of our common stock. Redemption of the convertible notes may require us to obtain alternative financing, which may increase future interest expense. On April 9, 2003 we notified holders that we would redeem the convertible notes for cash at their accreted value on May 11, 2003. If we had to repurchase all of the convertible notes on this date, the total payment would be approximately $520.1 million. As of March 31, 2003, we had $500 million of commercial paper, $350 million of medium term notes and $300 million of debt and equity securities available to be issued under shelf registration statements filed with the Securities and Exchange Commission. Our committed revolving credit facilities at March 31, 2003 totaled $420 million, of which, $210 million was under a 364-day facility. The remaining $210 million facility is under a five-year facility that will expire in June 2007. As of March 31, 2003, our Fiduciary subsidiary had $350 million available in uncommitted bank lines under the Federal Reserve Funds system. On April 3, 2003, we amended the $350 million medium term note shelf registration filed with the Securities and Exchange Commission to permit the issuance of an additional $70 million in medium term notes. On April 8, 2003, we completed the sale of $420 million in five-year senior notes due April 15, 2008. The senior notes, which were offered to qualified institutional buyers only, carry an interest rate of 3.7%. We expect to use the net proceeds from the offering for general corporate purposes, which may include repayment of existing debt. Our ability to access the 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. In extreme circumstances, we might not be able to access this liquidity readily. We have arranged with LFL for non-recourse financing of sales commissions advanced on sales of our B and C shares globally. The sales commissions that we have financed through LFL during the three and six months ended March 31, 2003 were approximately $36.2 million and $68.3 million compared to $36.0 and $65.4 million over the same periods last year. LFL's ability to access credit facilities and the securitization market will directly affect our existing financing arrangements. 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. The outstanding loan balances held by these special purpose entities were $521.6 million as of March 31, 2003 and $530.9 million as of September 30, 2002. Our ability to access the securitization market will directly affect our plans to finance the auto loan portfolio in the future. At March 31, 2003, the banking/finance operating segment had commitments to extend credit aggregating $292.7 million, mainly under its credit card lines, and had issued financial standby letters of credit totaling $9.7 million that expire through March 2004. The standby letters of credit are secured by marketable securities and commercial real estate. During the three and six months ended March 2003, we purchased approximately 2.7 million and 4.3 million shares of our common stock at a cost of $90.5 million and $136.8 million, including 1 million 27 - -------------------------------------------------------------------------------- shares repurchased under put option contracts. In January 2003, we increased the number of shares of our common stock authorized for purchase by 10 million shares. During April 2003, we purchased 2.0 million shares of our common stock at a cost of approximately $68.6 million. During the quarter ended March 2003, we sold put options giving the purchaser the right to sell 1.4 million shares of our common stock to us at a specified price upon exercise of the options on the designated expiration dates if certain conditions are met. At March 31, 2003, there were 4.4 million put options outstanding with various expiration dates from May 2003 through January 2004. 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 our technology infrastructure * improve our business processes * pay shareholder dividends * repay and service debt. We believe that we can meet our present and reasonably foreseeable operating cash needs and future commitments through the following: * our existing liquid assets * the continuing cash flow from operations * our borrowing capacity under current credit facilities * our ability to issue debt or equity securities * our mutual fund sales commission financing arrangement. In particular, we expect to finance future investment in our banking/finance activities through operating cash flows, debt, increased deposit base, or through the securitization of a portion of the receivables from consumer lending activities. 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. In addition, 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, 2002 for further discussion of our accounting policies. Estimates, by their nature, are based on judgment and available information. Differences between actual results and these estimates could have a material impact on our financial statements. 28 - -------------------------------------------------------------------------------- INTANGIBLE ASSETS AND GOODWILL Intangible assets and goodwill as of March 31, 2003 were as follows: (in thousands) NET CARRYING AMOUNT - ------------------------------------------------------- ------------------------ Goodwill $1,327,582 Intangible assets - definite-lived 213,768 Intangible assets - indefinite-lived 476,711 - ------------------------------------------------------- ------------------------ Total $2,018,061 - ------------------------------------------------------- ------------------------ Under Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets", we are required to test the fair value of goodwill and indefinite-lived intangibles for impairment at least once a year. As of March 31, 2003, we completed our annual impairment test of goodwill and indefinite-lived intangible assets and we determined that there was no impairment to the goodwill and indefinite-lived assets recorded in our books and records as of October 1, 2002. While we believe that our testing was appropriate, it involved the use of estimates and assumptions. We are also required to consider if any impairment has occurred to definite-lived intangible assets. Based on our review and evaluation, we do not believe any impairment has occurred. INCOME TAXES As a multinational corporation, we operate in various locations outside the United States. We have not made a provision for U.S. taxes on the cumulative undistributed earnings of foreign subsidiaries as those earnings are intended to be reinvested for an indefinite period of time. These earnings approximated $2.1 billion at March 31, 2003. Changes to our policy of reinvesting foreign earnings may have a significant effect on our financial condition and results of operation. 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. During fiscal 2002, we recognized $60.1 million for an other-than-temporary decline in the value of certain investments. While we believe that we have accurately 29 - -------------------------------------------------------------------------------- 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 March 31, 2003 to provide for any losses that may arise from these matters. VARIABLE INTEREST ENTITIES In the United States, the Financial Accounting Standards Board ("FASB") has recently issued Interpretation No. 46 "Consolidation of Variable Interest Entities" (see Note 14 to the financial statements). This interpretation requires consolidation of a variable interest entity ("VIE") by the enterprise that has the majority of the risks and rewards of ownership, referred to as the primary beneficiary. It also requires additional disclosures for an enterprise that holds a significant variable interest in a VIE, but is not the primary beneficiary. We are currently evaluating the impact of this interpretation on our investments in existence as of January 31, 2003. This evaluation requires us to make certain assumptions and estimates in calculating the extent of our interest in such entities, which may impact our treatment of a lessor trust and certain collateralized debt obligation entities described below. LESSOR TRUST. We lease our corporate headquarters in San Mateo, California from a lessor trust under an operating lease that expires in fiscal 2005, with additional renewal options for a further period of up to 10 years (see Note 11 to the financial statements). At this time, we believe that it is probable that we will have to consolidate the lessor trust in our annual financial statements as of September 30, 2003. COLLATERALIZED DEBT OBLIGATION ENTITIES. We provide investment management services to, and have made investments in, a number of collateralized debt obligation entities (see Note 11 to the financial statements). At this time, we believe that it is reasonably possible that we will have to either make additional disclosures about or consolidate one or more of these entities in our annual financial statements as of September 30, 2003. 30 - -------------------------------------------------------------------------------- RISK FACTORS WE FACE STRONG COMPETITION FROM NUMEROUS AND SOMETIMES LARGER COMPANIES. We compete with numerous investment management companies, stock brokerage and investment banking firms, insurance companies, banks, savings and loan associations and other financial institutions. Continuing consolidation in the financial services industry has created stronger competitors with greater financial resources and broader distribution channels than our own. Additionally, competing securities 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 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. 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 advisors. Increasing competition for these distribution channels has caused our distribution costs to rise and could cause further increases in the future. Higher distribution costs lower our net revenues and earnings. Additionally, if one of the major financial advisors who distribute our products were to cease their operations, it could have a significant adverse impact on our revenues and earnings. Moreover, our failure to maintain strong business relationships with these advisors would impair our ability to distribute and sell our products, which would have a negative effect on our level of assets under management, related revenues and overall business and financial condition. WE HAVE BECOME SUBJECT TO AN INCREASED RISK OF ASSET VOLATILITY FROM CHANGES IN THE GLOBAL EQUITY MARKETS. We have become subject to an increased risk of asset volatility from changes in the domestic and global financial and equity markets due to the continuing threat of terrorism and the recent reports of accounting irregularities at certain public companies. Declines in these markets have caused in the past, and would cause in the future, a decline in our revenue and income. THE LEVELS OF OUR ASSETS UNDER MANAGEMENT, WHICH IN TURN IMPACT REVENUES, ARE SUBJECT TO SIGNIFICANT FLUCTUATIONS. Global economic conditions, changes in the equity market place, 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. Changing market conditions may cause a shift in our asset mix towards fixed-income products and a related decline in our revenue and income, since we generally derive higher fee revenues and income from equity assets than from fixed-income products we manage. Similarly, our securitized consumer receivables business is subject to marketplace fluctuation. WE FACE RISKS ASSOCIATED WITH CONDUCTING OPERATIONS 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. Regulators in these jurisdictions could 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. OUR ABILITY TO SUCCESSFULLY INTEGRATE THE WIDELY VARIED SEGMENTS OF OUR BUSINESS CAN BE IMPEDED BY SYSTEMS AND OTHER TECHNOLOGICAL LIMITATIONS. Our continued success in effectively managing and growing our business globally depends on our ability to integrate the varied accounting, financial and operational systems of our international business with that of our domestic business. 31 - -------------------------------------------------------------------------------- OUR INABILITY TO MEET CASH NEEDS COULD HAVE A NEGATIVE EFFECT ON OUR FINANCIAL CONDITION AND BUSINESS OPERATIONS. 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 Class B and 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. OUR EMERGING MARKET PORTFOLIOS AND RELATED REVENUES ARE VULNERABLE TO MARKET-SPECIFIC POLITICAL AND ECONOMIC RISKS. 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. 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 our consumer loan portfolio losses to increase. THE SEPTEMBER 11, 2001 WORLD TRADE CENTER TRAGEDY MAY ADVERSELY AFFECT OUR ABILITY TO ACHIEVE THE BENEFITS WE EXPECT FROM THE ACQUISITION OF FIDUCIARY TRUST COMPANY INTERNATIONAL. The September 11, 2001 tragedy at the World Trade Center resulted in the destruction of our Fiduciary headquarters, loss of 87 of our employees, additional operating expenses to re-establish and relocate our operations, and asset write-offs, all of which could adversely affect or delay our ability to achieve the anticipated benefits from the acquisition. Our insurance coverage may not cover all losses on claims for property, damage, extra expenses and business interruptions arising out of the destruction of the World Trade Center. For the next several years, insurance costs are likely to increase materially and we may not be able to obtain the same types or amounts of coverage. WE ARE SUBJECT TO FEDERAL RESERVE BOARD REGULATION. Upon completion of our acquisition of Fiduciary in April 2001, we became a bank holding company and a financial holding company subject to the supervision and regulation of the Federal Reserve Board. We are subject to the restrictions, limitations, or prohibitions of the Bank Holding Company Act of 1956 and the Gramm-Leach Bliley Act. The Federal Reserve Board may impose additional limitations or restrictions on our activities, including if the Federal Reserve Board believes that we do not have the appropriate financial and managerial resources to commence or conduct an activity or make an acquisition. The Federal Reserve Board may also take actions as appropriate to enforce applicable federal law. TECHNOLOGY AND OPERATING RISK COULD CONSTRAIN OUR OPERATIONS. We are highly dependent on the integrity of our technology, operating systems and premises. 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, which could negatively impact our operations. 32 - -------------------------------------------------------------------------------- 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 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. We are exposed to changes in interest rates mainly through our debt transactions and portfolio debt holdings available-for-sale, which are carried at fair value in our financial statements. As of March 31, 2003, a significant percentage of our outstanding debt is at fixed interest rates. 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 March 31, 2003, we have considered the potential impact of the effect on the banking/finance operating segment, our outstanding debt and portfolio debt holdings, individually and collectively, of a 100 basis point (1%) movement in market interest rates. We do not expect this change would have a material impact on our operating revenues or results of operations in either scenario. We are also exposed to equity price fluctuations through securities we hold that are carried at fair value. To mitigate this risk, we maintain a diversified investment portfolio. We operate mainly in the United States, but also provide services and earn revenues in Canada, the Bahamas, Europe, Asia, South America, Africa and Australia. A significant portion of these revenues and associated expenses, however, are denominated in U.S. dollars. Therefore, our exposure to foreign currency fluctuations in our revenues and expenses is not material at this time. This situation may change in the future as our business continues to grow outside the United States. ITEM 4. CONTROLS AND PROCEDURES (a) EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES. The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company's filings under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the periods specified in the rules and forms of the Securities and Exchange Commission. Such information is accumulated and communicated to the Company's management, including its principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure. The Company's management, including the principal executive officer and the principal financial officer, recognizes that any set of controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. Within 90 days prior to the filing date of this Quarterly Report on Form 10-Q, the Company has carried out an evaluation, under the supervision and with the participation of the Company's management, including the Company's principal executive officer and the Company's principal financial officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures. Based on such evaluation, the Company's principal executive officer and principal financial officer concluded that the Company's disclosure controls and procedures are effective. (b) CHANGES IN INTERNAL CONTROLS. There have been no significant changes in the Company's internal controls or in other factors that could significantly affect the internal controls subsequent to the date of their evaluation in connection with the preparation of this Quarterly Report on Form 10-Q. 33 - -------------------------------------------------------------------------------- PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS There have been no material developments in the litigation previously reported in our Quarterly Report on Form 10-Q for the period ended December 31, 2002 as filed with the Securities and Exchange Commission on February 13, 2003. We are 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 our business or financial position. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS (a) The Annual Meeting of Stockholders of Franklin Resources, Inc. was held at 10:00 a.m., Pacific Standard Time, on January 30, 2003 at the principal offices of the Company located at One Franklin Parkway, San Mateo, California. The three proposals presented at the meeting were: 1. The election of eleven (11) directors to hold office until the next Annual Meeting of Stockholders or until their successors are elected and shall qualify. 2. The ratification of the appointment of PricewaterhouseCoopers LLP as the Company's independent accountants for the fiscal year ending September 30, 2003. 3. The approval of the adoption of the 2002 Universal Stock Incentive Plan. (b) Each of the eleven nominees for director was elected and received the number of votes set forth below: Name Votes For Votes Withheld ---- --------- -------------- Harmon E. Burns 208,811,524 3,179,372 Charles Crocker 208,850,777 3,140,119 Robert D. Joffe 208,799,419 3,191,477 Charles B. Johnson 207,748,540 4,242,356 Rupert H. Johnson, Jr. 208,812,563 3,178,333 Thomas H. Kean 208,773,239 3,217,657 James A. McCarthy 203,680,603 8,310,293 Chutta Ratnathicam 207,831,590 4,159,306 Peter A. Sacerdote 203,522,289 8,468,607 Anne M. Tatlock 208,681,169 3,309,727 Louis E. Woodworth 203,668,229 8,322,667 (c) The ratification of the appointment of PricewaterhouseCoopers LLP as the Company's independent accountants for the fiscal year ending September 30, 2003, was approved by a vote of 200,588,811 shares in favor, 9,973,248 shares against, and 1,428,837 shares abstaining. (d) The approval of the adoption of the 2002 Universal Stock Incentive Plan was approved by a vote of 190,683,381 shares in favor, 19,516,716 shares against, and 1,790,799 shares abstaining. 34 - -------------------------------------------------------------------------------- ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits: see Exhibit Index on page 41 to page 42. (b) Reports on Form 8-K: (i) Form 8-K filed on January 23, 2003 reporting under Item 5 "Other Events" an earnings press release, dated January 23, 2003, and including said press release as an Exhibit under Item 7 "Financial Statements and Exhibits" 35 - -------------------------------------------------------------------------------- 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: May 12, 2003 By: /s/ Martin L. Flanagan ---------------------- Martin L. Flanagan President and Chief Financial Officer 36 - -------------------------------------------------------------------------------- CERTIFICATIONS I, Charles B. Johnson, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Franklin Resources, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have: a. designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b. evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c. presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a. all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b. any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 37 - -------------------------------------------------------------------------------- 6. The registrant's other certifying officers and I have indicated in this quarterly report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: May 12, 2003 /s/ Charles B. Johnson ---------------------- Charles B. Johnson Chief Executive Officer 38 - -------------------------------------------------------------------------------- I, Martin L. Flanagan, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Franklin Resources, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have: a. designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b. evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c. presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a. all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b. any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 39 - -------------------------------------------------------------------------------- 6. The registrant's other certifying officers and I have indicated in this quarterly report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: May 12, 2003 /s/ Martin L. Flanagan ---------------------- Martin L. Flanagan Chief Financial Officer 40 - -------------------------------------------------------------------------------- EXHIBIT INDEX Exhibit 3(i)(a) Registrant's Certificate of Incorporation, as filed November 28, 1969, incorporated by reference to Exhibit (3)(i) to the Company's Annual Report on Form 10-K for the fiscal year ended September 30, 1994 (the "1994 Annual Report") Exhibit 3(i)(b) Registrant's Certificate of Amendment of Certificate of Incorporation, as filed 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 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 February 2, 1994, incorporated by reference to Exhibit (3)(iv) to the 1994 Annual Report Exhibit 3(ii) Registrant's Amended and Restated By-Laws incorporated by reference to Exhibit 3(ii) to the Company's Annual Report on Form 10-K for the fiscal year ended September 30, 2002 Exhibit 4.1 Indenture between Franklin Resources, Inc. and The Chase Manhattan Bank (formerly Chemical Bank), as trustee, dated as of May 19, 1994, incorporated by reference to the Company's Registration Statement on Form S-3, filed on April 14, 1994 Exhibit 4.2 Indenture between Franklin Resources, Inc. and The Bank of New York dated May 11, 2001 incorporated by reference to Exhibit 4.2 to the Registrant's Registration Statement on Form S-3, filed on August 6, 2001 Exhibit 4.3 Form of Liquid Yield Option Note due 2031 (Zero Coupon- Senior) (included in Exhibit 4.2 hereto) Exhibit 4.4 Registration Rights Agreement between Franklin Resources, Inc. and Merrill Lynch, Pierce, Fenner & Smith Incorporated ("Merrill Lynch") dated May 11, 2001, incorporated by reference to the Registrant's Registration Statement on Form S-3, filed on August 6, 2001 Exhibit 4.5 Form of 3.7% Senior Notes due 2008 Exhibit 10.69 Amendment to the Managed Operations Service Agreement dated February 6, 2001, June 10, 2002 and February 3, 2003 between Franklin Templeton Companies, LLC and International Business Machines Corporation Exhibit 10.70 Representative Form of Franklin Templeton Investor Services, LLC Transfer Agent and Shareholder Services Agreement Exhibit 12 Computations of ratios of earnings to fixed charges 41 - -------------------------------------------------------------------------------- Exhibit 99.1 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 Exhibit 99.2 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 42 - --------------------------------------------------------------------------------