Description

The market has left Legg Mason nearly for dead, and cheap as heck, after it suffered an almost improbable series of setbacks over the last twelve months, including significant underperformance and asset outflows across its equity and fixed income divisions, and multi-billion-dollar agreements to support SIV investments in its money market funds.  Legg Mason icon Bill Miller is down -36% over the last year, the latest act in an operatic fall from grace for “the man who beats the S&P,” to the point that a recent BusinessWeek article highlights Miller and wonders “Can value investing make a comeback?” 

 

The stock has been correspondingly punished, trading down from a high of $100 last July to a low of $27.57 during last month’s market panic.  Now trading at around $42, Legg Mason is cheap, trading at 5.1x FY2008 EBITDA and at about 0.80% TEV/assets under management, when healthy asset managers trade at multiples at least 2x of those, implying a fair value of $80+/share for a “normal” LM.  A sum-of-the-parts analysis likewise yields a value of over $100 a share for LM (ie, what it traded at in early 2007).  If investment performance is mean-reverting, and Legg Mason can at least stabilize its assets under management somewhere around current levels, then Legg Mason should be a home run from here for investors with a 1- to 2- year time horizon. 

 

Even in a realistic worst-case scenario, valuing Bill Miller’s Value Trust and related assets (>5% of AUM) as worthless and assuming that SIV losses are double LM’s estimate, and assuming reasonable further outflows from Western Asset Management, Legg Mason still trades at a big discount to its peers.  While the potential SIV exposure of as much as 5.5bb (but in reality probably less than 1bb) is one of the biggest overhangs on the stock, Legg Mason has 4.3bb of cash on its balance sheet and should generate 800-900mm of cash every year. (the SIV issue is complex and I address it at the end of the writeup)

 

Legg Mason (LM)

Stock price: $42

12-24 month price target: $80

Shares outstanding: 142mm

Market cap: 6.0bb

Enterprise value: 6.1bb (SIV charges of 873mm treated as debt)

TEV/ebitda: 5.1x

TEV/ebitda-capex: 5.4x

TEV/EBIT: 5.8x

 

Legg Mason capitalization
Description	Size		Normalized capex	80mm
SIV losses est. (LM est.) 2.5% 2015 convertible 7% 2011 mandatory convertible Term loans Short-term debt Total debt	874mm 1250mm 1150mm   573mm   500mm 4347mm			2008FY	Multiple
Cash & investments	4238mm		EBIT	1050mm	5.8x
Total equity (142mm shares)	5964mm		EBITDA-capex	1120mm	5.4x
TEV	6074mm		EBITDA	1200mm	5.1x

 

 

Edward965 wrote up Legg Mason in October of 2007 when the stock was at $83, and argued that at that price you were only paying for Legg Mason’s fixed income and fund-of-fund subsidiaries, and getting their equity operations for “free.”  What’s changed since then is that underperformance has continued, SIV losses have grown, and the stock has been cut in half.  What hasn’t changed is that Legg Mason is still a high-quality, diversifed global asset manager with multiple platforms that have in the past outperformed the market for many years, and its equity is cheap and highly leveraged to a market rebound.

 

Traditional asset management is a very good business, where earnings are tied primarily to assets under management and secondarily to performance. Historically, firms with established brand names such as Fidelity, Vanguard, etc. have been able to grow assets under management as the economy expands and as the size of global equity and debt investment grows.  There is massive operating leverage in asset management, as AUM can grow at a large multiple of the number of employees and size of operations needed to manage the funds. This is tempered somewhat by the revenue sharing agreements between Legg Mason and its subsidiaries.

 

The key risks are that Legg Mason’s asset management platforms continue to underperform the market for a sustained period, and the company suffers significant, sustained outflows of assets under management. Additionally, even if Legg Mason’s platforms perform with the market, but the market is in long-term decline, AUM and revenues will decline unless Legg Mason can increase inflows correspondingly.

 

However, I think that near-term headline and performance risks are vastly overstated. Much like Fidelity survived and prospered after Peter Lynch’s departure, and much like Janus Capital Group (JNS) survived and recovered from a far worse crisis in the early 2000s (the departure of Janus’s founder and most of its brand-name fund managers, coinciding with a nearly 50% drop in AUM), we think that Legg Mason is very likely to return to a normal valuation for a traditional asset manager.

 

Further, given the historical outperformance of Legg Mason’s most important managers (Bill Miller, Western Asset Management, and Permal) we think that the near-term underperformance of Miller and Western is likely cyclical, and that their strategies are likely to swing to outperformance or at least market performance.  Mean reversion of money managers’ performance is a well-documented phenomenon, and it applies both on the upside and the downside.

 

Legg Mason is popularly associated with Bill Miller, but is in reality Miller’s entire division only accounts for less than 5% of Legg’s assets.  Legg is in fact one of the largest independent asset managers in the world (9^th largest overall as of December 31^st 2007 according to Pensions & Investments), with over 920 billion in assets under management.

                                                                                                        

Legg Mason’s assets under management are of the following asset classes, as of March 2008 (note that AUM declined to 922bb as of June 30^th):

 

 

                                                                                       AUM                % of AUM

 

Equities	272	28.6%
Fixed income	508	53.5%
Money market / liquidity	170	17.9%
total	950

 

 

 

 

Valuation

 

Legg Mason’s operating divisions are as follows, along with a full-value and base-case sum of the parts valuations:

 

 

	Strategy	Investor base	AUM (bb)   (Mar 08)	Comp	Comp % AUM	Full upside value (bb)	Discount comp	Base case Upside Value
Western Asset	Fixed income	Institutional	631	Blackrock	2.0%	12.6	1.5%	9.5
Clearbridge	Equity all-cap	Retail	86	Traditional	2.5%	2.2	1.5%	1.3
LM Capital Mgmt	Equity mid- large-cap	Retail	44	Traditional	2.5%	1.1	1.5%	0.7
Batterymarch	Quant equity all-cap	Institutional	26	Traditional	2.5%	0.7	1.5%	0.4
Brandywine	Equity/fixed income	Retail	48	Traditional	2.5%	1.2	1.5%	0.7
Permal	Absolute return	High net worth (FoF)	39	Purchase price/AUM	5.2%	2.0bb	5.2%	2.0bb
Private Capital	Equity all-cap	Retail	10	Traditional	2.5%	0.3	1.5%	0.2
Royce Funds	Equity small cap	Retail	29	Traditional	2.5%	0.7	1.5%	0.4
Other			37	-	1.0%	0.4	1.0%	0.4

                                   Totals:                              950bb                                     21.1bb             15.5bb

 

 

The tables below show the comps used for the % of AUM metric:

 

name	primary style	TEV	AUM	% of AUM	EBITDA x	forward p/e
Traditional
Affiliated Managers	equity value & growth; quant	5.1	254	2.0%	8.4	11.6
Blackrock	fixed income, liquidity and equity	26.4	1428	1.8%	15.1	20.8
Eaton Vance	fixed income & equity	4.4	157	2.8%	10.9	17
Federated	fixed income & equity	2.9	238	1.2%	7.7	11.9
Franklin Resources	value equity	20.8	570	3.6%	8.1	13.8
Gabelli	value equity	1.3	28	4.6%	11.3	19.1
Invesco	fixed income and equity	10.8	481	2.2%	9.6	14.4
Janus	growth and quant	5.1	168	3.0%	12.1	16.6
T Rowe	growth	14.4	388	3.7%	13.6	21.2
	median	5.1	254	2.8%	10.9	16.6
Legg Mason	fixed income & equity	7.2	922	0.8%	4.9	10

 

 

As an alternative to the complicated sum-of-the-parts above, you can also just look at Affiliated Managers (AMG) and Blackrock (BLK), the two managers arguably most similar to Legg Mason,  which trade at about 1.9% of AUM and between 8x and 15x EBITDA.  At that valuation for the whole company, Legg Mason would have a TEV of about 17.5bb, which would imply a share price of around $110 (ie, what Legg Mason was trading at way back in early 2007).

 

I realize that many people may disagree with a TEV/AUM comparison of different asset management companies, as there are issues of mix of fixed income, liquidity and equity assets and their relative profitability; quality of investment management and operating management; etc.  However, it’s worth keeping in mind that idiotic or not, TEV/AUM is widely referenced in industry dealmaking, so it is “real” to some people.  Further, most traditional asset managers are more alike than unalike.  Blackrock, for example, is 38% fixed income, 25% money market, 32% equity and balanced, and 6% alternatives.  Finally, I think that the disparity in the chart above between most traditional asset managers and LM shows that LM is trading at distressed multiples – I’m saying that LM moving even anywhere near the others is a huge gain for the stock.

 

If you don’t buy TEV/AUM, ignore it and look at LM on an absolute and relative multiple of EBIT or EBITDA-capex.  On trailing EBIT multiples, Legg Mason is also extremely cheap: Legg Mason is at just 5.8x EBIT, and 5.4x EBITDA-normalized capex, the latter being a better measure as the company has had unusually high IT and infrastructure capex as it integrated the managers and assets acquired from Citibank in 2006.  Even assuming that SIV exposures are significantly higher than expected, Legg Mason is not trading at uncomfortable multiples:

 

 

SIV exposure	TEV	TEV/EBITDA-capex
874mm (LM estimate)	6.0bb	5.4x
2174mm (support agmts)	7.3bb	6.6x
3000mm (55% loss rate)	8.2bb	7.3x
5500mm (100% loss rate	10.7bb	9.6x

 

If you further assume that EBITDA at “trough” is impaired by 20% due to asset outflows and underperformance, multiples are as follows:

 

SIV exposure	TEV	TEV/ trough EBITDA-capex
874mm (LM estimate)	6.0bb	6.8x
2174mm (support agmts)	7.3bb	8.2x
3000mm (55% loss rate)	8.2bb	9.2x
5500mm (100% loss rate	10.7bb	11.9x

 

 

So on either on a cashflow multiple or on a sum-of-the-parts approach, I think Legg Mason is likely to double from current prices.  Below I discuss the three main businesses – fixed income, fund of funds and equities – in more detail, which I think helps in understanding why these businesses are robust and likely to rebound.

 

 

Western Asset Management

 

Fixed-income manager Western Asset Management is the largest component of Legg Mason.  Western Asset was founded in 1971 by a predecessor bank of Wells Fargo, and was acquired by Legg Mason in 1986.   Western Asset as of 12/31/2007 had 634bb under management, and 729 clients and 999 staff.  Those numbers reflect growth through acquisitions and organic growth, with WAM having been at 20bb in AUM 1995, with a staff of 78 and 81 clients.   The biggest acquisition which basically doubled WAM in size was the Citibank asset management acquisition of 2006.  WAM has been run since 1998 by chief investment officer Ken Leech (currently on a medical leave of absence, although still working in the office part-time).  

 

 

WAM’s clients are mutual funds, corporate and public pensions, insurance companies and endowments.  WAM strategies are mostly broad market, liquidity and fixed income, but also include a variety of other strategies.

 

 

Western Asset has a value approach to fixed income investing, and uses team management.  It tends to have more high-yield exposure than competitors, which can lead to wider ranging outperformance and underperformance versus its peers.  It has no fixed-income “star” manager like Bill Gross at competitor PIMCO.  Among the country’s largest 200 defined benefit funds, it is the most frequently used fixed income manager (next are PIMCO and BlackRock), according to Pensions and Investments.  Ranked separately from Legg Mason, WAMCO is by AUM about the 20^th largest money manager in the world (around the same size as Goldman Sachs Asset Management, Morgan Stanley Asset Management, and Prudential Financial).

 

 

The key question for WAMCO is: can they retain existing clients and attract new ones?  While recent performance of WAM’s main fixed income strategies has been subpar, the process by which institutional money managers are selected by clients such as pension funds is far less fickle than the process by which individual investors move in and out of mutual funds, which is largely performance-driven and can be executed on a daily basis.

 

 

Institutional managers are usually picked through a RFP process for a specific mandate, and usually a limited number of large managers are qualified to compete for large mandates.   Pension funds and endowments, which are run by boards of trustees overseeing operational executives, generally outsource a significant portion of the manager search process to pension fund consulting firms. 

 

The decision-makers at most pension funds and endowments (with a few exceptions such as a few universities like Yale and Harvard) are not necessarily incentivized to seek the highest possible risk-adjusted returns for their entities.  Instead they are incentivized to “not rock the boat” in many cases.  Picking a well-known, large manager to manage pension assets is generally in the best interests of pension trustees, executives and consultants, and large managers have much more influence with funds and consultants than smaller, lesser-known managers.   Reporting and disclosure requirements also place a premium on larger managers who can provide high-quality service to institutional clients.

 

 

Thus, pension funds and endowments tend to prefer large, stable, team-managed institutions with “safe” brand names, which is a limited universe of players.  And, manager selection is only partially driven by performance, as is reflected in surveys of pension funds (where “service” provided by the manager is regularly ranked no. 1, and “performance” is ranked rungs several below service.  As the head of pension consulting for Mercer put it (Mercer is a large global pension consultant that places about 100bb a year in mandates):

“[P]ast investment performance accounts for about 20 to 25 per cent of the fund manager selection process. The other factors which carry weight in the selection process include: the investment expertise and experience of the team, the investment process they follow such as how they carry out their research, its quality, thoroughness and so on. Service levels to the pension client -- ie quality reports -- and matching the required investment risk profile with the correct fund.”

Similarly, a large study of Australian pension funds found that:

 

“[V]arious performance measures, including raw, risk-adjusted, market-adjusted, and relative returns do not affect the probability of a mandate allocation.  However, pension sponsors do tend to choose managers with top-quartile five-year performance and those who are highly rated by a commercial rating agency.  The style and institutional attributes of preferred managers suggest trustees’ reputation and prudential concerns matter, particularly for the aggregate annual mandate allocations.”

 

Permal

 

Permal is one of the largest and oldest fund-of-fund alternatives managers in the world, with a thirty-year history.  Permal provides multi-manager funds across most investment classes, including global macro, long-short, long-only, commodities, event-driven and fixed-income.  Permal was acquired in 2005 by Legg Mason for a total of about 1bb, when Permal managed about 19bb; Permal has grown AUM to 39bb as of 2008.

 

Equity managers

 

Legg Mason’s original equity management team is Legg Mason Capital Management, home of Bill Miller’s team.  In addition, there are five other large managers.  LMCM, Private Capital, Royce and Brandywine are all value managers, and are responsible for about 54% of the equity AUM; Clearbridge, which was Citibank’s asset management subsidiary, is a growth-oriented firm accounting for 35% of equity AUM; and Batterymarch is a quant manager accounting for about 11% of AUM. 

 

 

SIV Exposure

 

The most risky, least transparent and difficult to value component of Legg Mason is its voluntary exposure to failed Structured Investment Vehicles (SIVs) in its money market funds.  Several of Legg Mason’s money market funds made investments in the commercial paper and senior debt of a number of SIVs (Cheyne Finance, TPG Axon, and others).  SIVs were yet another invention that borrowed short-term to buy longer-term securities such as mortgages and CDOs, and their senior paper was thought by many to be safe and liquid enough to be held in money market accounts.  However, starting in August 2007 almost all SIVs could not refinance their debt and went into liquidation.  Legg Mason made a long-term strategic decision to protect its 180bb money market business by providing support for the SIV holdings in its funds, as otherwise the funds might have “broken the buck” (fallen below $1 NAV) which is thought in the industry to be a death knell for any money market fund. 

 

The support agreements are convoluted and I can address it in follow-up posts if anyone wishes to understand the detail.  The big picture is that Legg Mason’s liquidity funds have a total exposure of 5.2bb of non-bank-supported SIVs, mostly in Western Asset-managed money market funds, for which Legg Mason has estimated an actual liability of 874mm.  This at first would seem to indicate that LM is optimistically estimating it will return about 84 cents on the dollar from these SIVs.  However, Legg Mason through its support agreements with its money market funds (2.147bb support agreements as of June 30^th) are *not* meant to “make whole” the funds’ actual SIV losses.  Rather, they are meant to keep the funds from “breaking the buck,” so LM’s support is sort of a moving business target.

 

Investors familiar with the Cheyne auction results may think that Legg Mason’s held-to-maturity marks are high.  Cheyne Finance, in a restructuring led by Goldman, sold a portion of its holdings in July at a fire-sale price of 44 cents on the dollar.  However, that sale was of a small percentage of the SIV in order to generate cash for creditors who wanted an immediate payout.  Legg and most other holders swapped their Cheyne holdings for securities in a Goldman-managed successor entity, and Legg expects to hold those securities to maturity.  Legg Mason’s SIV portfolio overall consists of about 1000 different securities on a “look-through” basis, of which 80% are AAA mortgages, and the balance are Alt-A and AA mortgages (residential and commercial).

 

To fund the potential SIV losses (and/or to finance possible purchases of the SIV assets from the funds so that the parent can hold them to maturity), LM in January raised $1.25bb in 2.5% senior convertible notes due 2015 from KKR, and in May sold $1.15bb in mandatory convertible securities, and balance sheet cash is now 4.2bb.  Combined with Legg Mason’s likely 900mm in 2008 cashflow, the company has cash sufficient to support its estimated exposure.  Further, some of the SIV losses suffered by the parent can eventually be recouped from Western Asset Management under the terms of their revenue-sharing agreement. 

 

 

Conclusion

 

Legg Mason is trading at a bargain price if you can stomach holding it through a bear market.  I think for investors with a 1-2 year time horizon it is absurdly cheap.  In a worst-case scenario, I think the equity is trading at well below breakup value (and I think that if Legg Mason tomorrow renamed itself “Western Asset Management” the stock might well trade up closer to Blackrock’s multiples).

 

Catalysts

 

1  Market acts as a weighing machine instead of a voting machine and realizes LM is incredibly cheap

 

2  SIV situation moves closer to resolution

 

3  Performance and outflows stabilize at either Western Asset or Legg Mason Capital Management

Catalyst

Improving performance and stabilization of flows at key equity and fixed income subs; resolution of SIV exposure.