March 12, 2015 Legg Mason Inc. Current Recommendation SUMMARY DATA NEUTRAL Prior Recommendation Underperform Date of Last Change 09/22/2013 Current Price (03/11/15) $55.03 Target Price $58.00 52-Week High $58.92 52-Week Low $43.36 One-Year Return (%) 20.38 Beta 1.32 Average Daily Volume (sh) 743,536 Shares Outstanding (mil) 113 Market Capitalization ($mil) $6,218 Short Interest Ratio (days) 5.18 Institutional Ownership (%) 87 Insider Ownership (%) 12 Annual Cash Dividend $0.64 Dividend Yield (%) 1.16 5-Yr. Historical Growth Rates Sales (%) 0.2 Earnings Per Share (%) 25.6 Dividend (%) 37.2 using TTM EPS 17.8 using 2015 Estimate 17.0 using 2016 Estimate 11.7 Zacks Rank *: Short Term 1 3 months outlook 3 - Hold * Definition / Disclosure on last page (LM-NYSE) SUMMARY Legg Mason s fiscal third-quarter 2015 earnings outpaced the Zacks Consensus Estimate; however it came below the prior-year quarter figure. Results were aided by higher advisory revenues and increased assets under management (AUM), partially offset by elevated expenses. The company looks ahead to reinforce its global investment products portfolio through several acquisitions. We believe that Legg Mason has the potential to outperform its peers in the long run, given its diversified product mix and leverage to the changing market demography. However, a persistent low interest rate environment, regulatory headwinds along with a volatile economy keeps us apprehensive. Risk Level * Low, Type of Stock Large-Value Industry Fin-Invest Mgmt Zacks Industry Rank * 113 out of 267 ZACKS CONSENSUS ESTIMATES Revenue Estimates (In millions of $) Q1 Q2 Q3 Q4 Year (Jun) (Sep) (Dec) (Mar) (Mar) 2013 631 A 640 A 674 A 668 A 2,613 A 2014 670 A 670 A 720 A 681 A 2,741 A 2015 694 A 704 A 719 A 706 E 2,823 E 2016 2,998 E Earnings Per Share Estimates (EPS is operating earnings before non-recurring items, but including employee stock options expenses) Q1 Q2 Q3 Q4 Year (Jun) (Sep) (Dec) (Mar) (Mar) 2013 $0.64 A $0.75 A $0.70 A $0.52 A $2.61 A 2014 $0.67 A $0.85 A $1.03 A $0.86 A $3.41 A 2015 $0.91 A $0.35 A $0.98 A $1.00 E $3.24 E 2016 $4.72 E Projected EPS Growth - Next 5 Years % 15 2015 Zacks Investment Research, All Rights reserved. www.zacks.com 10 S. Riverside Plaza, Chicago IL 60606
OVERVIEW Headquartered in Baltimore, MD, Legg Mason Inc. (LM) is a global asset management firm focused on the growth and preservation of its clients' capital through its proprietary mutual funds and separatelymanaged accounts (SMAs). It was founded in 1899 and incorporated in 1981. As a holding company, Legg Mason provides asset management, investment banking and related financial services through its various subsidiaries. The company operates in United States of America and the United Kingdom but also has offices including Australia, Bahamas, Brazil, and China. In Dec 2005, Legg Mason changed its business model to focus solely on asset management through an asset-swap transaction with an investment banking firm. Legg Mason operates through 3 primary divisions: Managed Investments, Institutional, and Wealth Management. The company markets its services to individuals and institutions through brokerage houses, insurance companies, and other thirdparty distributors. It has 2 principal revenue segments: The Investment advisory Services (accounted for 87% of total operating revenue in fiscal 2014) includes discretionary and non-discretionary management of separate investment accounts in numerous investment styles for institutional and individual investors. The Distribution and Service Fees (13%) includes fees received for distributing investment products and services or for providing other support services to investment portfolios. Legg Mason s AUM is split between fixed income, equity and liquidity investments. Equity assets are primarily managed by ClearBridge, Royce, Batterymarch, Permal and Brandywine, with fixed income assets primarily managed by Western Asset and Brandywine, and liquidity assets managed by Western Asset. As of Dec 31, 2014, Legg Mason s AUM was $709.1 billion. Of the total AUM, fixed income constituted 52%, liquidity 20% and equity 28%. On Oct 1, 2014, Legg Mason completed the acquisition of UK-based international equity specialist firm Martin Currie. On Jun 2, 2014, Legg Mason acquired New York-based private asset manager QS Investors in order to expand its global investment products portfolio. REASONS TO BUY Legg Mason has benefited from cost saving measures and improved its profitability. Notably, the completion of streamlining of business model in fiscal 2012 resulted in over $140 million of annual cost savings in fiscal 2013 and 24.2% year over year fall in operating expenses in fiscal 2014.. Notably, savings achieved from the company s corporate initiatives in the last year are being reinvested into its centralized global distribution business. As a result of these reinvestments, the company expects to incur run rate expenses of an additional $2.5 million. Though such expenses might restrict top-line expansion in the near-term, but benefits of global business expansion could be reaped over the long-term. Legg Mason exhibited successful efforts in driving inflows to the company in fiscal 2014 ($8.3 billion) after facing challenges in combating outflows in the past couple of years. We remain optimistic as the company is focused on driving overall inflows in coming years and we believe it will augur AUM growth. Driven by a sound liquidity position, Legg Mason has been able to undertake strategic acquisitions in the past couple of years. In 2014, the company acquired UK-based international equity specialist firm Martin Currie and New York based private asset manager QS Investors to Equity Research LM Page 2
REASONS TO SELL expand its global investment products portfolio. Previously, in 2013, the company and its affiliate, Permal Group, completed the acquisition of London-based fund-of-hedge-funds firm, Fauchier Partners from BNP Paribas Investment Partners. We believe the company is poised to benefit in the long run owing to these befitting acquisitions. We view Legg Mason as a sound asset for yield-seeking investors. Based on its strong cash position, the company has a steady stock repurchase program in place. Further in Jan 2015, the company approved a new share repurchase authorization worth $1 billion. Notably, the company also hiked its dividend by 23.1% in Apr 2014, continuing the trend of increasing dividends annually since 2010. We believe such measures to inspire investors confidence in the stock. We remain cautious owing to the equity AUM outflows. Including fiscal 2014, the company experienced equity outflows over the last 8 fiscal years owing to investment management performance issues. We believe an absence of credible improvement in company s investment management performance might lead to continuation of such trend. This in turn may pose a threat in achieving steady overall net inflows in the near term. In Jul 2014, the Securities and Exchange Commission (SEC) adopted a new body of regulations for the $2.6 trillion money market fund business. The new plan requires the institutional prime and municipal money market funds to maintain market-based or floating NAV (net asset value) for sales and redemptions per the prevailing market value of the securities in their portfolios. Also the rule includes imposition of liquidity fees or temporary suspension of redemptions in the event a fund s weekly liquid assets fall below a certain level. These reforms, undertaken to restrict investors from fleeing the money funds industry during a financial stress period, are expected to be detrimental to Legg Mason's money market fund business and significantly affect its business operations. Further, the current historically low interest rate environment affects the yield of money market funds, which are based on the income from the underlying securities less the operating costs of the funds. With short-term interest rates at or near zero, the operating expenses of money market funds might become greater than the income from the underlying securities. During the last 3 fiscal years including 2013, Legg Mason voluntarily waived certain fees or assumed expenses of money market funds for competitive reasons including maintenance of competitive yields. These actions have reduced investment advisory revenues by $110 million in fiscal 2014. We remain cautious as the absence of any significant turnaround in the interest rate environment might limit the company s top-line growth in the upcoming years. Currently, the asset management business is under cyclical and secular pressures, along with the ongoing margin pressures, primarily aggravated by the financial crisis. These pressures include volatile markets and new regulatory requirements. Further, the financial environment in the U.S. was volatile in the recent past, with a weakening consumer confidence. Though Legg Mason is well positioned over the long term, economic challenges are expected to persist and negatively impact the company s near-term results. Equity Research LM Page 3
RECENT NEWS Legg Mason Fiscal Q3 Earnings Beat, AUM Improves Jan 30, 2015 Legg Mason reported fiscal third-quarter 2015 adjusted earnings of $0.98 per share, slivering past the Zacks Consensus Estimate by $0.01. However, the figure compared unfavorably with the year-ago figure of $1.03 per share. Results were aided by higher distribution and service fees. Moreover, sustainable rise in AUM remained impressive. However, pressurized top line and weak expense management were the downsides. Adjusted income came in at $113.1 million, down 9% year over year. After considering certain non-recurring items, net income stood at $77.0 million, or $0.67 per share, compared with $81.7 million, or $0.67 per share in the prior-year quarter. Quarter in Detail Legg Mason s total revenue amounted to $719.0 million, almost flat year over year. Higher advisory fee revenues driven by an increase in average long-term AUM was offset by lower performance fees. The current quarter comprised incremental revenues associated with the addition of a full quarter of Martin Currie revenues, reduced by the loss of a partial quarter of Legg Mason Investment Counsel & Trust Co. (LMIC) revenues. Notably the company sold LMIC in the quarter. Revenues lagged the Zacks Consensus Estimate of $722 million. Investment advisory fees came in to $627.9 million relatively flat with the year-ago quarter figure, while Distribution and Service fees rose 2% to $90.1 million. However, other revenues plummeted 62% year over year to $1.0 million. Operating expenses increased marginally to $599.6 million on a year-over-year basis. The current quarter included costs related to the QS Investors integration and costs related to the sale of LMIC and the acquisition of Martin Currie. Adjusted operating margin stood at 21.4%, down from 24.1% in the prior-year quarter. Assets Under Management As of Dec 31, 2014, Legg Mason s AUM was $709.1 billion, up 4% year over year. AUM rose slightly on a sequential basis from $707.8 billion as of Sep 30, 2014, driven by long-term net inflows of $8.8 billion and $3.1 billion in positive market performance. These were partially offset by liquidity outflows of $10.6 billion. Of the total AUM, fixed income constituted 52%, liquidity 20% and equity 28%. The quarter experienced equity outflows of $1.1 billion and fixed income inflows were $9.9 billion. Balance Sheet As of Dec 31, 2014, Legg Mason had approximately $665 million in cash, up from $659 million in the prior quarter, while total debt was $1.1 billion at par with the prior-quarter number. Shareholders equity was $4.5 billion, compared with $4.6 billion in the prior quarter. Equity Research LM Page 4
The ratio of total debt to total capital (total equity plus total debt excluding consolidated investment vehicles) was 19%, stable with the prior quarter. Capital Deployment Update Legg Mason s board of directors approved a new share repurchase authorization for up to $1 billion of common stock. The authorization is in addition to the existing program. Also, the company declared a quarterly cash dividend of $0.16 per share. The dividend will be paid on Apr 13, 2015 to shareholders of record as of Mar 12, 2015. For the nine months ended Dec 2014, the company repurchased 5,329 shares of common stock for $266.5 million and paid $52.7 million as dividends. Outlook For fiscal fourth-quarter 2015, performance fee is expected to be the range of $10 15 million. Owing to seasonality in the fourth quarter compensation and benefits ratio is expected to trend higher from its guidance of 53 54% ratio. Adjusted operating margin is expected to rise in the fiscal fourth-quarter 2015 on account of absence of integration cost and M&A activity. However, the increase is expected to be partially offset by higher compensation cost, the incremental investments in global distribution as well as anticipated lower performance fees. Legg Mason February AUM Up; Fixed Income Inflows Recorded Mar 10, 2015 Legg Mason reported a slight rise in its AUM as of Feb 28, 2015, as compared with the prior month. Preliminary month-end AUM came in at $711 billion, up around 0.8% from the prior month. February s AUM reflected fixed income inflows of $1.0 billion, $0.2 billion equity outflows and liquidity outflows of $3.8 billion. Negative foreign exchange impact of about $0.7 billion was an unfavorable factor. Legg Mason s equity AUM as of February-end increased 5.1% over the prior month to $202.6 billion. However, fixed income AUM inched down slightly from the prior month to $374.4 billion. The rise in equity, partly offset by a fall in fixed income AUM resulted in long-term AUM of $577 billion. The figure marked a 1.6% increase from the prior month. Liquid assets, which are convertible into cash, decreased 2.9% to $134 billion. Equity Research LM Page 5
VALUATION Legg Mason s shares on a price-to earnings () basis currently trade at 17.0x the Zacks Consensus Estimate for fiscal 2015, which is at 25.9% premium to the industry average of 13.5x. On a price-to-book (P/B) basis the valuation looks attractive as the shares trade at 1.4x, which is at a 58.8% discount to the industry average of 3.4x. Legg Mason has a trailing 12-month ROE of 7.9%. Our 6-month target price of $58.00 equates to 17.9x the Zacks Consensus Estimate for fiscal 2015. Combined with a quarterly dividend of $0.16 per share, this target price implies an expected return of about 6.0% over that period. This is consistent with our long-term Neutral recommendation on the shares. Currently, Legg Mason carries a Zacks Rank #3 (Hold). Key Indicators F1 F2 Est. 5-Yr EPS Gr% P/CF 5-Yr High 5-Yr Low Legg Mason Inc. (LM) 17.0 11.7 15.0 13.5 17.8 24.0 8.7 Industry Average 13.5 12.5 12.1 20.8 19.7 91.7 12.8 S&P 500 16.3 15.2 10.7 14.6 17.9 18.4 12.0 AllianceBernstein Holding L.P. (AB) 13.6 12.3 9.3 4.8 15.1 18.3 9.1 The Carlyle Group LP (CG) 12.8 11.3 6.0 1.6 10.1 22.5 7.4 Affiliated Managers Group Inc. (AMG) 15.2 13.6 15.1 14.8 18.3 21.8 11.3 Lazard Ltd. (LAZ) 13.9 12.6 12.0 8.3 15.2 51.5 9.6 TTM is trailing 12 months; F1 is 2015 and F2 is 2016, CF is operating cash flow P/B Last Qtr. P/B P/B ROE D/E Div Yield 5-Yr High 5-Yr Low Last Qtr. Last Qtr. Legg Mason Inc. (LM) 1.4 1.4 0.6 7.9 0.2 1.1 12.1 EV/EBITDA Industry Average 3.4 3.4 3.4 19.9 0.5 4.0 10.4 S&P 500 6.2 9.8 3.2 25.4 NA 2.0 NA Equity Research LM Page 6
Earnings Surprise and Estimate Revision History Equity Research LM Page 7
DISCLOSURES & DEFINITIONS The analysts contributing to this report do not hold any shares of LM. The EPS and revenue forecasts are the Zacks Consensus estimates. Additionally, the analysts contributing to this report certify that the views expressed herein accurately reflect the analysts personal views as to the subject securities and issuers. Zacks certifies that no part of the analysts compensation was, is, or will be, directly or indirectly, related to the specific recommendation or views expressed by the analyst in the report. Additional information on the securities mentioned in this report is available upon request. This report is based on data obtained from sources we believe to be reliable, but is not guaranteed as to accuracy and does not purport to be complete. Because of individual objectives, the report should not be construed as advice designed to meet the particular investment needs of any investor. Any opinions expressed herein are subject to change. This report is not to be construed as an offer or the solicitation of an offer to buy or sell the securities herein mentioned. Zacks or its officers, employees or customers may have a position long or short in the securities mentioned and buy or sell the securities from time to time. Zacks uses the following rating system for the securities it covers. Outperform- Zacks expects that the subject company will outperform the broader U.S. equity market over the next six to twelve months. Neutral- Zacks expects that the company will perform in line with the broader U.S. equity market over the next six to twelve months. Underperform- Zacks expects the company will under perform the broader U.S. Equity market over the next six to twelve months. The current distribution of Zacks Ratings is as follows on the 1129 companies covered: Outperform - 15.5%, Neutral - 74.8%, Underperform 8.9%. Data is as of midnight on the business day immediately prior to this publication. Our recommendation for each stock is closely linked to the Zacks Rank, which results from a proprietary quantitative model using trends in earnings estimate revisions. This model is proven most effective for judging the timeliness of a stock over the next 1 to 3 months. The model assigns each stock a rank from 1 through 5. Zacks Rank 1 = Strong Buy. Zacks Rank 2 = Buy. Zacks Rank 3 = Hold. Zacks Rank 4 = Sell. Zacks Rank 5 = Strong Sell. We also provide a Zacks Industry Rank for each company which provides an idea of the near-term attractiveness of a company s industry group. We have 264 industry groups in total. Thus, the Zacks Industry Rank is a number between 1 and 264. In terms of investment attractiveness, the higher the rank the better. Historically, the top half of the industries has outperformed the general market. In determining Risk Level, we rely on a proprietary quantitative model that divides the entire universe of stocks into five groups, based on each stock s historical price volatility. The first group has stocks with the lowest values and are deemed Low Risk, while the 5 th group has the highest values and are designated High Risk. Designations of Below-Average Risk, Average Risk, and Above-Average Risk correspond to the second, third, and fourth groups of stocks, respectively. Coverage Team QCA Lead Analyst Analyst Copy Editor Content Ed. 11B Kalyan Nandy Priti Dhanuka Anindita Chaudhury Ishani Mukherjee Priti Dhanuka Equity Research LM Page 8