Description

Legg Mason, one of the world largest asset managers, is trading at 10x trough earnings.  With a modest rise in AUM, the operating leverage for LM will drive EPS and LM shares could double in the next 2 years.  In an extreme downside case (where AUM's fall 30% from today, and no actions are taken, i.e. the sale of a division or closing the distribution group), LM still generates $1.50/sh in cash EPS, resulting in a 15x multiple of today's share price. 

Business Description:

Legg Mason ("LM" or "the Company") has been written up several times on VIC, so I will be brief in terms of a business description.  Currently LM has approximately $700Bn under management, with 55% invested in fixed income products, 22% in money market, and the remainder in equity.  LM is structured in an affiliate model: this means that it operates as a holding company and owns a number of relatively independent money managers.  The affiliates keep a percentage of their revenue generation with the rest going to LM Corporate.  This percentage varies, but most believe approximately 30% is kept by the affiliates' employees.  The holding company provides certain shared services as well as retail and international distribution. 

Recent events:

2008 and 2009 were particularly difficult for LM.  The Company's largest affiliate, Western Asset Management, needed to be bailed out due to its exposure to structured investment vehicles.  Because of the reduced liquidity for these products, Western suffered a run on its money market funds and required a costly bailout from its parent, Legg Mason.  Compounding this, LM's all-star manager Bill Miller suffered the worst performance of his career.  Miller saw significant outflows as a result and was ridiculed for calling the bottom of the market on multiple occasions.  Legg Mason's total outflows were $225Bn from 2007 to Sept 2009, representing 22% of AUM at Sept 2007.  Further, the market didn't help matters driving AUM down a further $190Bn.  At its bottom, AUM had gone from over $1T to $630Bn.  All this occurred under watch of a new management team that stepped in just as the markets were collapsing.  More recently, Trian Investments, headed by Nelson Peltz, has taken a 4% stake in LM.  As part of a standstill agreement, Trian is required to buy up to 8% of the outstanding shares and has been awarded a board seat. 

New Management: 

In 2008, Chip Mason stepped down from running the organization.  He handed the reins to Mark Fetting who was greeted by one of the worst financial environments his company or the country has ever seen.  Because of this, he was forced to save the organization as opposed to cleaning it up.  While the headlines were about bailouts of Western, Fetting and his team quietly started to right the ship to take advantage of the organizations operating leverage. 

• First on his agenda was fixing the balance sheet. Through several initiatives, including issuing equity, paying down debt, tax refunds, and the cash flow from the business, LM's current balance sheet is clean with over $1.9Bn in cash and another $400mm in investments (they have about $2Bn in debt including the KKR convert which is very much out of the money). According to the Management, they only need about $500mm in cash to run the business, leaving the Company with dry powder for an acquisition or other shareholder friendly actions.
• Second up was distribution. When LM bought Citigroup Asset Management ("CAM") it inherited a wholesale distribution group (previously all funds had been sold through a proprietary network of advisors). When things were rosy, no one really paid attention to this business. However, it was costing LM money and not adding value. In late 2008, Dave Odenath was put in charge of the domestic and international distribution. He is the former head of Prudential's variable annuity business, and while the financials don't show it, he and his newly structured group have been able to slow the outflows and add value to the organization. In their presentations, LM shows that international distribution has generated net inflows for the year, versus outflows for last year - International has brought in between $1.5Bn to $2Bn versus an outflow of about $4Bn YTD 2009 vs 2008. The same can't be said for the domestic distribution, but the trends show vast improvement (outflows of about $8Bn versus $20Bn YTD this year versus last year.) The newly revamped distribution group has helped to stabilize the flows and will help to gather assets.
• Third, the cost structure for LM was designed to handle over $1T in AUM and had been built up through the numerous acquisitions. Fetting cleaned up the organization and this overhead was cut by about $160mm on an annual run rate. On $2.5Bn in revenues, this represents 600 BPS of margin improvement alone. With the current cost base, LM management believes that they can handle significantly higher AUM without significant additional costs.

Thesis: 

Now that the business has stabilized somewhat, we can look ahead to what the organization can generate.  For the year ended fiscal March 2010, I believe the Company will earn $1.44 in GAAP EPS, and $2.69 in cash EPS.  At 15x (midpoint of where comps are trading), this implies 45% upside from where the stock is trading today.  Further, I believe LM can grow AUM from the current $700Bn to $875Bn in 2 years.  With the operating leverage, this translates to over $4.00 cash EPS.  At the same 15x multiple, this implies a $60 share price, or double where we are today. 

• Cash EPS is a term that the company has introduced and Wall Street has ignored. Given the acquisitions the Company has made as well as the most recent losses, the Company reports a cash EPS as well as a GAAP EPS (See below for the Sept and June quarters). Even with the most recent $450mm tax refund, the Company has the ability to shield over $3Bn in net income, meaning they won't be a federal taxpayer for many years down the road.
  • To illustrate just how significant the difference is, one analyst has LM generating $1.47 in GAAP income this year, but $2.47 in cash EPS (see below for my forecast). Given the long-term nature of the adjustments, it is clear that cash EPS is a better operating metric.
  • Of the three differences, one stands out. This is the amortization of goodwill for tax purposes. While GAAP has eliminated this amortization, the IRS has not. On a few rare occasions, a Company is allowed to deduct this amortization for tax purposes - LM is one of those occasions. This amortization will last 10 years+, providing a nice cash stream for investors. Of the other two, the amortization of intangibles is self explanatory. The convertible interest is because of a recent accounting change - Companies need to recognize the imbedded warrant on the convert in equity, with the difference being accounted for as a discounted bond.

                  
Quarter Ended                                  Sep-09         Jun-09

Net Income GAAP                            $45,774        $50,054
Plus:
 Amort of intangibles                           5,664          5,628
 Deferred taxes on intangibles            34,023         35,297
 Imputed interest on converts               8,587          8,364

Cash Income                                   $94,048        $99,343

• Most don't believe there is operating leverage in the organization. Given that the affiliates take a % of the revenues that they generate, this implies that there is no way that margins will expand when AUM return. This is not entirely true. While the revenue share does preclude some leverage, LM is able to leverage its distribution network, its central costs, real-estate, etc. In the Sept quarter, operating margins were approximately 22% with AUM at $700Bn. Management has stated that a 30% operating margin at $850Bn is achievable.
  • On the way down, LM had an incremental operating margin of 60%+. Based on the 30 to 40% revenue share, this seems to make sense. Going forward, I have assumed this 60% operating margin holds true because of the cost cutting the company has undertaken as well as the leveraging of the distribution and central cost base. The Company targeted a cost structure to handle $850Bn in AUM, so the only increase in costs would be this revenue share.
• Growing AUM's from 700Bn to 875Bn may seem like a lot, but this is not insurmountable.
  • First, hopefully the market helps out. To get to the $875Bn in AUM, I am assuming an equity return of 12%, fixed income of 6% and liquidity of 2%.
  • Second, this still requires outflows to stop and reverse. There are several reasons why I think this will occur:
    • Most consultants will tell you that performance is only a small part of the decision to hire or fire a manager. The biggest factors are deviation from investment mandates, turnover in the organization, investment process and other qualitative factors. I won't go into the reason for this other than to say in the short term poor performance is forgiven, as long as it doesn't become a trend.
    • While LM's performance wasn't great, most of its affiliates stayed true to their investment process. Because of this, consultants I have spoken with suggest that LM will be able to grow its AUM once things settle down in with the markets. Q1 appears to be the earliest this could happen, as this is the normal rebalancing period for most institutional investors. Janus's is a decent example of how an asset manager can come back - they were effectively committing fraud, yet their equity funds returned to 10%+ annual inflows. LM's didn't suffer fraud, and actually stepped up to the plate to bail out Western funds. Because of this I feel that LM should begin to see inflows in short order.
    • The $875Bn in AUM assumes an annual 3 to 4% inflow rate for the next two years. When Janus recovered, it saw inflows of 3% on a quarterly basis. Further, during its heyday, LM saw inflows of over 20% on an annual basis. Given that Pensions and Endowments need to make up losses, moving out of cash and into riskier assets, and historical precedent, this 3% annual rate is probably conservative.
• Based on a 28% margin at $875Bn AUM, I come out with cash EPS of $4.07. Using a 15x multiple, this implies that LM is worth $60/sh, or more than double where they are today. This gives no credit to any accretive transactions or actions by Nelson Peltz and assumes that the mix between equity and fixed income stays flat. If equity were to outgrow fixed income, margins would expand further as this product is higher fee generating.
• o $4.07 may prove to be conservative. In the 4^th quarter of 2006, AUM was $860Bn (the most comparable period I could find) - adjusting for the change in share count and stripping out the impact of performance fees, LM earned an annualized cash EPS of $4.80/sh. Further, looking at FY 07, making the same adjustments, LM earned $4.85 cash EPS on an average AUM of approximately 900Bn.

 Year ended March 31                         2008      2009     2010E    2011E    2012E  

AUM (in billions)                                $950      $632      $717     $786     $878

Revenues (ex distribution)               $3,942   $2,882   $2,266   $2,592   $2,913
EBITA (ex distribution)                       1,840    1,170        749    1,004     1,220
 Net distribution                                  (582)    (495)      (335)    (361)     (399)
EBITA                                              1,258       675         414      643       820
 % Margin                                          31.9       23.4         18.3     24.8       28.2
Net Income                                        268    (1,948)       225      354       467
Cash Net Income ex 1-timers             $961      $565       $419     $551    $666

Cash EPS                                       $6.69       $4.01     $2.69    $3.37    $4.07

Downside protection:

• While a downturn in the market would be a negative, LM has a number of levers they can pull to help offset the decline in earnings.  Hypothetically, if AUM's were to fall to $500Bn, or a 30% decline from where they are today, I estimate that LM will generate, at worst, cash EPS of $1.50/sh (which implies an 80% incremental margin).  At this point, it would be apparent that their distribution group was not fulfilling its duty, and this unit could be cut lose, saving an additional $1.20/sh.  This alone helps to justify the current valuation in a downside case.  However, as a little extra incentive, this decline in AUM would bring about added pressure from Peltz and may accelerate a sale or spin-off of one of the affiliates. 
• Giving further comfort to the downside, LM earned $1.80 cash EPS in 2005 on an apples to apples basis (stripping out performance fees and adjusting for the share count - this was also prior to the tax shield which has been excluded from the above EPS).  2005 was the year prior to the CAM acquisition, and while times were very different, LM was operating with an average AUM of $330Bn.  Again, times are different, but this is prior to the distribution group joining and shows what the business can generate if such a scenario presents itself. 

Risks:

• The market - while the business can be very accretive when the markets go up, it can hammer results on the way down.  I view a return to the volatile markets of 2008/09 as a key risk to Legg Mason.
• Poor acquisitions - with the excess cash earning very little, most acquisitions would be accretive.  With Peltz and KKR on the board, I highly doubt they would allow LM to undertake a risky acquisition, but this still remains a key risk.

Catalysts:

• Nelson Peltz and KKR both are involved.  Nelson Peltz is a very savvy investor and now has a board seat.  Moreover, Peltz has agreed to buy more shares through his standstill contract.  He is required to own 8% of the company by April of next year (versus less than 5% currently). 
  • While I won't speculate as to what Peltz sees under the hood, I feel fairly comfortable that he won't allow the current war chest to be wasted on a senseless acquisition.  Further, given his board membership, he may still push for changes that could add value.  Some of these changes could mean a spin or sale of one of their affiliates, providing a nice catalyst for the shares.
• Clean reporting.  With its issues now in the past, LM will begin to report financial information with less noise.
• Valuation on cash EPS versus GAAP EPS.  While this may take time, it is difficult to ignore the cash flow of the business.  Once severance costs and other one-time costs are no longer part of the financials, cash flow will become clearer. 

Catalyst