September 13, 2011 - 2:17pm EST by
2011 2012
Price: 26.23 EPS $1.51 $2.09
Shares Out. (in M): 152 P/E 17.4x 12.5x
Market Cap (in $M): 3,989 P/FCF 9.5x 7.1x
Net Debt (in $M): -171 EBIT 406 482
TEV ($): 3,818 TEV/EBIT 9.4x 7.9x

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Legg Mason is one of the largest global asset management firms, characterized by an attractive business model that includes ownership of several high quality franchises. We believe LM represents a compelling investment opportunity given its unusually attractive valuation, which is driven by widely held misperceptions about the Company, including: 1) the nature of the company's business (diversified portfolio of independently operated asset managers), 2) cash generation (GAAP earnings materially understate cash earnings), and 3) profit growth independent of market levels (material expense reduction underway). As the Company completes the final stages of its streamlining program, we believe the stock should be worth $50 or more (~14x free cash flow for the fiscal year ending in March 2013), representing over 100% upside from current levels within the next 12-18 months.


Investment Thesis

High Quality, Diversified, Franchisor-Like Business Model

In total, Legg Mason manages $663B of assets under management (AUM).  As of 6/30/11, 78% of LM's marketed composite AUM (representing 89% of total AUM) was beating benchmark over the critical 3-year time period favored by many institutional investment consultants, and 87% of marketed composite AUM was beating benchmark over a 10-year time period.

Bill Miller receives disproportionate media coverage, but Legg Mason Capital Management manages less than $12B of AUM and represents less than 2% of Legg Mason, Inc.'s revenue. Instead, most of LM's profits come from its ownership of Western Asset Management, Permal, Royce, Clearbridge, and other independent asset management firms with expertise in their respective areas of specialization. Western Asset Management is one of the world's largest global fixed income managers, with approximately $447B of AUM (~67% of LM AUM). Permal, one of the world's largest global hedge fund-of-funds, is a respected manager of alternative investments, with approximately $21B of AUM (~15% of LM revenue). Royce & Associates (~$43B AUM) is the largest active manager of small-cap equities in the U.S., and Clearbridge Advisors manages ~$57B of U.S. Equities.

Many analysts and investors do not appreciate the favorable aspects of Legg Mason's business model. LM is essentially a holding company of autonomous investment management firms ("affiliates"). The company owns 100% of each affiliate, which operate independently with the exception of leveraging LM's retail distribution and strategic capital. LM generally receives a % of each affiliate's gross revenues (~40%-60%), while affiliates are responsible for their own costs. This arrangement produces a corporate financial profile that is relatively stable, with very high margins and low capital intensity. This favorable dynamic is masked by reported financials that consolidate results due to accounting requirements. For example, the company reports Adjusted EBIT margins of just over 20%, but we estimate true Adjusted EBIT margins (Corporate Pre-Tax Cash Flow / Corporate % Share of Affiliate Revenue) for the corporate parent company closer to 50-60%.

Through its portfolio of affiliates, LM's business mix (AUM) is well-diversified across asset classes (55% Fixed Income, 27% Equity and Alternative, 18% Liquidity), client types (65% institutional, 35% retail), and geographies (35% non-U.S.). Alternatives and Equity assets have higher fee rates (about 4x higher than those for Fixed Income and Liquidity), so Fixed Income and Liquidity assets contribute less than 50% of revenues. Liquidity fees are currently depressed due to money-market-fund fee waivers.

A key point that we believe many analysts and investors misunderstand is the changing mix of assets and its impact on earnings.  A focus on aggregate AUM declines over the past few years fails to capture the important fact that most of the AUM decline has come in lower fee-generating asset classes such as money market and fixed income and are offset by positive flows and appreciation in the much higher fee asset categories of equities and alternatives.  Consequently, the average fee load of assets has grown and the absolute earnings level has also grown.


Attractive Valuation

At the current stock price of $26, LM has a market cap of $4.0B and TEV of $3.8B.  In FY2012 (ending March) it should generate $1.51 of GAAP EPS, plus non-cash expenses of $1.25 per share results in $2.76 of Cash EPS, and remaining net cost savings of $0.82 per share gets to $3.58 of Pro Forma Cash EPS (additional details in section below).  Thus, the company trades for 7.3x PF Adjusted EPS, over a 13% yield -- this for a fairly recurring, and growing fee stream, with minimal operating or financial leverage. We also believe the company's $1.25B of convertible debt should actually be considered an asset due to its low cost (2.5% coupon, effective conversion price of $107.46 far out-of-the-money).

Traditional asset managers (AMG, Alliance Bernstein, Blackrock, Cohen & Steers, Eaton Vance, Federated Investors, Franklin Resources, GAMCO Investors, Invesco, Janus, T. Rowe Price, Waddell & Reed) trade on average at ~15x trailing P/E and ~12x forward P/E.  While we believe a slight discount is warranted given lower growth, LM's effective discount to its closest comparables is excessive, and caused in meaningful part by inappropriate use of GAAP EPS and insufficient credit given for its almost completed streamlining initiatives.   A multiple of 15x trailing cash earnings results in a price target of $55/share by March 2013 (18 months).

Importantly, the company has been actively repurchasing shares ($400M targeted for FY2012). We think this is a smart way to allocate capital given current prices. The company also pays a modest dividend. In 2012 and beyond, we expect higher margins, lower share count, and an improved growth profile, all of which should enhance cash earnings and the probability of a multiple re-rating.


Misperception #1: GAAP vs. Cash Earnings

GAAP EPS materially understates cash earnings due to misleading non-cash charges including amortization expense from historical acquisitions, imputed convertible debt interest expense (de minimis economic impact since conversion price so far out of the money), and most importantly, GAAP tax expense that does not reflect the company's advantageous deferred income tax position (effectively not a cash taxpayer this decade). Similarly, GAAP EBIT includes various non-cash charges. Please note that the EBIT figures at the top of this write-up are based on Adjusted EBIT (although even that metric does not reflect the company's tax benefits).

Many research reports from reputable Wall Street firms indicate P/E multiples of as high as 18x for LM based on the use of GAAP EPS. However, we estimate that the current price represents a multiple of 9.5x fiscal 2012 Cash EPS (ending 3/12), and 7.3x if you incorporate the benefits of already implemented cost-reduction initiatives.


Misperception #2: Profitability

Legg Mason's profit margins have historically lagged those of its competitors. The company had previously maintained highly inefficient and duplicative facilities, personnel, and systems. For example, this type of expensive central infrastructure was maintained even though many of its affiliates were already handling their own operations and thus incurring similar costs. However, in 2010 the company embarked on a transformative streamlining program with $130-150M of projected savings by March 2012.

To provide a sense of magnitude, LM reported Adjusted Operating Margin of 21% in its quarter ended June 30, 2011. Assuming $140M of annualized cost savings, and $9M of savings realized to-date, there remains an incremental ~500bps of margin improvement upon completion of the streamlining by next year, or an incremental $0.68 of cash EPS (an increase of 23% from current level). Current year profitability will be further understated due to transition costs associated with the streamlining, but the transition costs are non-recurring. 


Misperception #3: Business Performance

We believe many analysts and investors do not view LM as exciting given AUM declines over the past few years. However, the company's results need to be examined by individual business / affiliate, which suggests a healthy profile over the long term due to diversification, mix shifts, asset appreciation, and improved fund performance figures (particularly at Western Asset Management, LM's largest affiliate). Bill Miller doesn't really matter -- Legg Mason Capital Management has underperformed now for years, but there is little room for further declines given its small contribution to earnings. Additionally, while most of the fund outflows over the past several quarters have been concentrated in Western Asset Management, the outflows do not appear to be permanent and were mostly in lower yielding mandates.  Western Asset Management fund performances suffered in 2007-2008, but soared in 2009, and did well in 2010 and 2011YTD. The dismal results from 2007-2008 are now rolling off from 3-year measures, and this past quarter the company achieved positive fixed income fund flows for the first time since 2007. We are not assuming any dramatic recovery in fund flows, but find such improvements encouraging.  Most of the outflows have been in lower margin fixed income and liquidity products, and offset by growth in higher yielding business (equities and alternatives).



LM is a leading global asset management firm, providing ownership of a diversified set of high-quality, independently-operated investment management franchises. Cash earnings are much higher than reported GAAP earnings, profit margins are poised to improve substantially as streamlining initiatives progress, active share repurchases continue at depressed valuations, and various operating trends have shown signs of improvement.  With a current valuation of 7x cash earnings for the fiscal year ending March 2013, we believe the stock could double over the next 12-18 months.


Completion of restructuring program, expected by March 2012, with full impact of cost savings reflected in subsequent financials

Share buybacks

Possible strategic or financial M&A event involving subsidiaries or entire company

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