Legg Mason February 2008 Research Report Price: $70

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1 Legg Mason February 2008 Research Report Price: $70 Legg Mason is the world s fifth-largest publicly-traded investment manager with about $1 trillion in assets under management. 84% of revenues come from investment advisory fees; the rest from distribution and service fees. The firm has posted strong long-term results. Its earnings per share have grown at an average annual rate of 14% over the last 15 years. The Business $6.00 $5.00 $4.00 $3.00 $2.00 Legg Mason's GAAP EPS The money-management business has some unique qualities which often enable firms to generate high returns over time. Assetsunder-management (and therefore revenues) tend to grow naturally because of the compounding nature of the investment business. If a firm generates reasonable returns, its earnings will move higher with its assets. Furthermore, money management has great economies of scale. As assets under management increase, revenues tend to increase more than do expenses. Therefore profit margins naturally rise. There are other positive attributes that separate this industry from most others. Assetmanagement firms have no inventory and do not have to deal with accounts receivable or bad debt expense. They have no patents or R&D costs. On the other hand, investment managers have some acute risks. If returns significantly trail market indices, firms face the double whammy of lower assets under management (or at least lost Composition of Managed Assets compounding) as well as client withdrawals. A long period of Fixed Income Equity Other Money Market underperformance can devastate a company s managed assets. 16% Legg Mason has purchased several investment firms, including Western Asset Management, one of the world s leading bond managers. 52% of Legg s assets under management are in the fixed-income category. As the graph at right shows, equity investments account for only 28% of Legg s total. Equity 4% 28% 52% 1

2 products usually generate much higher fees than do fixed income and money market funds. However, equities are also more volatile. Legg Mason is interested in making more acquisitions, particularly in the international category. The firm has made great strides at attracting foreign assets. 34% of Legg s client assets reside outside the U.S. It has investment centers in nine countries and sells its products in 25 more. Nonetheless the firm lags many of its peers in offering investment products with international exposure, and it seeks to remedy that at some point. Citigroup Deal In December 2005 Legg Mason completed an asset-swap with Citigroup. In that deal Legg Mason traded its capital markets and retail brokerage business to Citigroup and received Citigroup s $437 billion asset management arm in return. As part of the deal, Legg Mason paid Citigroup $1.5 billion in stock and $550 million cash. The deal virtually doubled Legg s assets under management and transformed it into a pure-play investment manager. On the day of the announcement Legg stock rose from $85 to $98. Two months later the stock hit $140. The view at that time was that Legg Mason had received Citigroup s unit on the cheap, and that as the unit was integrated Legg s income would soar. Earnings per share rose 31% in fiscal 2006 and 34% in fiscal [Legg Mason s fiscal year ends on March 31, so the fiscal year is three quarters ahead of the calendar year]. However, the integration of Citigroup s division proved difficult. Integration costs and severance costs caused the operating margin to fall from 31.1% in 2005 to 25.7% in 2006 and 23.7% in Thus, despite the sizeable advances in earnings per share Operating Margin Wall Street was disappointed 35.0% that results weren t stronger still. 30.0% Margins began to rebound in the first two quarters of fiscal 2008, 25.0% as the company put much of the merger costs behind it. The 20.0% company finished the process of converting or replacing % different systems and relocating numerous offices. Legg estimates that it has realized cost savings of $140M per year. However, starting in the third quarter of fiscal 2008, Legg encountered several new problems * Op. Margin 26.7% 28.3% 31.1% 25.7% 23.7% 25.6% 2

3 Recent Issues In recent months Legg Mason has faced several different issues. One relates to the credit crunch. Unfortunately for the company, it inherited some money market funds in the 2005 Citigroup deal which were partially invested in SIVs (structured investment vehicles). Some of these funds had as much as 60% of their assets in SIVs. These SIVs contained asset-backed securities which came under stress during the credit crunch. Citigroup had made these higherrisk investments in an effort to goose the performance of its money market funds. After the acquisition, Legg began reducing its exposure to the SIV assets. When the credit crunch started, however, some funds still had as much as 10%-20% of their assets invested in SIVs. Overall, as of 10/31/07, 6.4% of Legg s money market funds were backed by SIVs. In a portfolio of $160 billion, this amounted to about $10 billion. The falling value of these investments forced the company to bail out $1.1 billion of its money market funds, resulting in a $23M ($.16/share) hit to earnings in the third quarter of fiscal By doing this the company ensured the safety of its money markets for investors. SIV exposure (ABS) has now been greatly reduced. As of 1/26/08, SIV assets totaled just $4B, or 2.6% of money market funds. Taking the SIVs onto its balance sheet weakened Legg Mason financially. Moody s and Fitch credit-rating agencies changed their ratings outlook for Legg to negative in November To strengthen the balance sheet the firm recently raised $1.25B through sale of 2.5% convertible preferred bonds to Kohlberg Kravis Roberts. The conversion price is $88/share, and the bonds come due in Legg is using $250 million of this to repurchase and retire preferred shares from Citigroup. The remaining $1 billion may eventually be used to fund acquisitions or share repurchases, but its immediate use is simply to shore up the balance sheet and assuage market fears about the company s finances. Although terms of this preferred issue are fairly positive, with a below-market interest rate and a conversion price 25% above Legg s current stock price, it is disappointing that the company was forced to take this action. Ultimately these preferred shares will convert into common stock and probably reduce shareholder value by diluting the share base. Another major issue dogging the firm is the underperformance of some of its equity funds. The firm s largest fund has an enviable long-term track record, but stumbled badly in 2006 and This underperformance has caused many clients to redeem shares. The company has struggled with net withdrawals from its equity funds over the past few quarters. Exacerbating this is the weakness of the U.S. stock market overall. Since fees are based assets under management, there is a direct correlation between a stock market decline and a reduction in revenues. Assets under management were down 1% ($13B) in the December quarter. $4B of this was due to market depreciation; while $9.1B was due to client outflow ($10.6B was withdrawn from the firm s equity programs). Many other firms have also experienced negative asset flows recently, but the effect has been more pronounced at Legg Mason because its equity offerings are highly concentrated in U.S. markets. 3

4 Jun-05 Sep-05 Dec-05 Mar-06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 These two issues have hurt the company s growth and short-term outlook. It is possible that Legg may have to take additional write downs due to its SIV exposure. It is hard to say when the firm s equity portfolios will regain steam. As the graph to the right shows, quarterly EPS moved from roughly per quarter in 2006 to about $1.20 in 2007, peaking at $1.32 in June The last two quarters results have been impacted by the aforementioned problems, including the SIV charge (noted in red on the graph) in the December 2007 quarter. $1.40 $1.20 $0.80 $0.60 $0.40 $0.20 Recent Quarterly EPS One final issue is that founder and long-time CEO Raymond Mason recently stepped down. Although his departure might draw scrutiny due to some of the company s current problems, Mason has been planning to leave for over two years. The new CEO is Mark Fettig, who had been a senior executive vice president with the firm. In the first few days of his tenure Fettig bought $1 million of Legg stock in the open market. Financial Metrics Legg Mason s financial metrics have suffered since the Citigroup acquisition. The net profit margin is still high at 16%. However, the firm s reported return on equity is just 10% because of the large increase in intangible assets and shareholder s equity that accompanied the Citigroup deal. Fortunately, Legg s reported earnings don t tell the whole story. Legg Mason s cashflow is significantly greater than its reported earnings. In fact, the differential is so great that Quarterly EPS Dec Sep Dec 2006 management breaks GAAP Basis $1.23* $1.23 $1.21 out cash earnings Cash Basis $1.58 $1.60 $1.58 separately in each * Excludes $.16 for SIV charge earnings release. GAAP income was $3.62 in GAAP vs. Cash Earnings Per Share the first three quarters of fiscal $ , but cash income was $6.00 $4.68. This is a 29% $5.00 difference, and demonstrates $4.00 that measuring Legg Mason $3.00 on GAAP earnings alone significantly understates the $2.00 firm s true earnings power. Cash Income is calculated by adding the amortization and deferred taxes that are related * GAAP Cash 4

5 to intangible assets back to net income. The firm does not add back amortization or depreciation on fixed assets because those assets will likely have to be replaced at some point, which is not true of the intangible assets. Because of the Citigroup deal and other acquisitions these noncash charges are significant. The table and graph on page 4 both show that cash income exceeds reported income by a wide margin. Valuation Despite problems with the Citigroup integration, SIV assets, the stock market s negative returns and client withdrawals, Legg s earnings have been reasonably solid. Its EPS over the past four quarters is $4.81 (including the SIV charge), giving it a P/E ratio of But the company s cash earnings over the past year total $6.26, so the cash P/E just This translates into a cash earnings yield of 8.9%, a very solid return even without factoring in future growth. With a long-term outlook, there is even more reason to be optimistic. The current problems should eventually pass and Legg s managedasset base will trend higher over time. Also, the company s margins will likely move toward their pre-acquisition levels, which would raise profits considerably. $140 $120 $100 $80 $60 $40 $20 $0 As the graph at right shows, Legg Mason stock has tumbled since the post-acquisition euphoria. Investors now seem as pessimistic about Legg s prospects as they were optimistic two years ago. It is likely that the optimism and the pessimism are both overdone. Price 16 times Earnings Per Share *The Company Profiles are for informational purposes only and are not an offer to sell or a solicitation to buy. They are not personal recommendations for any particular investor and do not take into account the financial circumstances of any individual investor. Check Capital, or one of its officers, may have a position in the securities discussed and may purchase or sell such securities from time to time. The Company Profiles utilize third-party data in the creation of the reports. While Check Capital believes such third-party information is reliable, we do not guarantee its accuracy, timeliness or completeness Primary Sources: Value Line, Zacks Investment Research; Legg Mason 10K, 10Q, company presentations and financial releases; SeekingAlpha.com 5