Equity Research Report on Legg Mason

By: Raution Jaiswal

1. Introduction

Over the past two decades, world has experienced an exponential growth in financial assets and

debt market. Innovation and competition has fueled the growth and thus the participants in the

financial industry have soared. This growth provides a platform for efficient use and distribution

of capital and for better risk management. Developments in the financial industry have thus

contributed to stronger and more stable economic global growth over the past decades. Technical

development has reduced the cost of communication, computation, cost of processing, and

storing. This has lead to a transparent system to restore faith in the system. Financial market has

expanded and become deeper. The broader involvement has permitted risk to be widely spread

across borders. Borrowing has been voluminous and cheap from different parts of the world, to

invest in different financial instruments that fit into the needs and cater to different profile of risk

and return. Market seems to deliver what people are expecting from the market but when we dig

deep into it we will find a different pictures amid recent development and crisis. Evaluation of

recent changes in the financial landscape will help us to draw the right picture about the growth

in financial sector and related industries.

2. Recent developments in the industry:

Developments in the financial services industry is a mix bag as it present new challenges for

financial institutions coupled with untapped potential to grow and expand globally. These

changes are being driven by economic influence, financial modernization, privacy concerns,

industry consolidation, the emergence of new institutions, new trends in borrowing and lending,

globalization, and emerging technology. Overall, the future of the industry is bullish. Markets

will recover to find directions, and investor confidence will be restored with gradual upturn.

There will be a move back from cash and money market instruments into equity-related assets

management. Demand for asset management will remain strong as the population becomes older

and lives longer and as more individuals rely on defined contribution plans and individual

retirement accounts. With social security systems under strain in the United States and many

other countries, there may be international opportunities for asset management companies.

A. Scale and size of the market:

Factors promoting consolidation in the asset management industry is relevant even for the

smallest asset managers, namely the need to spread the cost of technological and administrative

overhead and the desire to maintain earnings growth. There has been a spate in the mergers and

acquisitions in the asset management industry. These mergers and acquisitions is an attempt to

capture the benefits of scope through the expansion in international market, developing

distribution relationship or alternative business rather than mere scaling asset under management.

Instead of seeking to dominate in every segment and territory in which they operate, many

institutions will temper their ambitions, looking to expand regionally instead of globally or

focusing on particular customer segments. Size will still be important to institutions, not least as

a means of deterring potential predators, but there will be an emphasis on simplification, both of

processes and platforms inside the organization and of the service offering to the customer. The

consequence will be the rise of competency-led enterprises, institutions that develop and excel in

particular areas. Economies of scale will help in the reduction of operating cost, use of broader

channel for distribution, spreading of the risk, and strategic growth of the organization. Big

players are getting considerably bigger: just 5 years ago, an average top-ten player managed

about $500 billion in assets; today, their asset under management has doubled and the figure is

closer to $1 trillion1. Even though the industry as a whole is performing better, there is a profit

and performance gap between the performers and the laggards of the industry, irrespective of

their size and the customer segment they serve, this gap continues to widen. Although the rise in

the recent volatility in the financial market has resulted in outflows from stock mutual funds and

equities in 2007, the asset management industry continues to be strong enough to cope with the

turmoil. Overall mutual fund asset under management (AUM) continues to increase and totaled

about $11.9 trillion in September compared to $10.6 trillion in February, according to data from

trade group Investment Company Institute (ICI). Exchange-traded-funds (ETF) have also been a

high growth business for the asset management industry in the past few years. As of September

2007, the combined assets of the nation's exchange-traded funds (ETFs) were $551.10, compared

to just $300 billion at the end of 2005 according to ICI.

1 www.mckinsey.com

Source: Investment Company Institute (ICI), Note: 2007 data is till September 2007

B. Cross-border activity:

Expansion in asset management industry has not been confined to United States rather it has

been a cross border expansion. This has scaled the operational capabilities and integrated the

operations globally. This cross-border activity has contributed to increased competition among

international and domestic players, a wider range of options for operators operating

internationally and the sharing of expertise across organization. With operations from several

geographical markets, the financial system is also less vulnerable to cyclical developments in any

one country. Growth stories in emerging markets requires expertise from the matured markets as

risk assessment is more demanding. A consequence of cross-border institutions may also be that

turbulence in financial markets in one country can more easily spill over to other countries.

Moreover, a crisis may be more complicated to resolve in an internationally active institution

than in a national institution. This has helped asset management companies to spread risk and

gain from emerging markets.

C. Tough pricing Environment:

Increase in competition and slowdown of economic growth has put downward pressure on the

pricing of the financial products. It has been found that there has been a 50% reduction in the

total shareholder cost. ICI figures show that in 1980, the buyers of equity funds incurred an

average cost which was 2.26% of their initial investment. That cost declined to 1.13% by the end

of 2005. These recent price declines of the actively managed products are likely to continue.

Asset management industry which has enjoyed a steady asset growth and consistent annual fees

increase for most part of the last decade seems to diminish and the implication seems to be

profound. Expense ratio has declined due to shift in the focus from load funds to non-load funds

due to its low cost structure. It is also experienced that as the funds grow in size and reap the

advantages of economies of scale, it reduces the expense ratio due to fees reduction. This has

forced organizations to be more creative and look forward to alternative capabilities. Over the

past several years a number of traditional managers have developed alternative capabilities in the

form of hedge funds, private equity arms, or fund-of-funds vehicles. Alternatives have become

an important asset class for revenue generation. For many players these changes required them to

revisit their business model. This has forced far more complex organizational structure and

processes, design to effectively manage a broader range of products.

D. Economic turmoil:

The performance of the economy at the national level directly affects the business strategies of

individual financial institutions and the industry's overall performance. Changes in the business

cycle of sectors such as commercial, real estate, agriculture, interest rates, inflation, energy, and

unemployment, influence the lending and funding strategies of insured depository institutions.

Adverse economic or financial conditions abroad did spill over and had impacts on the national

and regional economies. An economic slowdown has adversely impacted the financial services

industry, resulting in slower asset growth, increased loan losses, and diminished profitability.

Looking forward to the economic trends and growth indexes, financial services industry can

expect leaner time over the medium term. Economic forecaster expects the next few years to be

characterized by a gradual slow down of output, demand growth and economy as a whole.

Financial industry will be affected as the industry is an important contributor to overall economic

activity and employment in the United States. It is a noteworthy contributor to the overall gross

domestic product. With the downturn in the economy and the accompanying declines in stock

market values, the industry has been hit hard. Growth will still be robust by historic standards but

financial institutions will have to overcome a number of challenges to make money over the next

few years. This will lead to the search for markets that is under-utilized. But the challenges of

successful and sustainable entry into emerging markets, from emergent domestic competition to

the regulatory and compliance issues of operating in multiple territories, will encourage most

institutions to adopt an incremental approach to geographic expansion.

E. Subprime effect:Subprime mortgage defaults continue to make their mark on the economy and financial market

since their emergence in late 2006. There are several factors that collectively account for the

occurrence of subprime event, such as creative loan practices, loose lending standards by lenders,

under-educated borrowers and lack of governmental oversight. All these events have led to a

record number of Americans facing foreclosures as real estate values have leveled out. At its

peak, subprime loans accounted for one out of every five total loan originations in 2006. The

combination of these scenarios has resulted in a domino effect, distressing a variety of

homeowners and investors. As the valuation of these mortgaged houses began to tumble,

adjustable rate mortgages (ARM) were reset to higher rates and as the result more and more

subprime borrowers defaulted. To worsen the case, most lenders have now started tightening

their loan standards, making it extremely difficult for borrowers to refinance and find

alternatives, which eventually lead to more foreclosures. It had catastrophic effects on financial

companies. Most of the financial companies fall prey to the luring high income growth of

subprime mortgage and many financial institutions have built up their subprime origination and

securitization business over the past few years. As a result all major firms such as Bear Stearns

Cos, Morgan Stanley, Merrill Lynch & Cos, Goldman Sachs Group Inc, and others all have

exposure to subprime market. Several companies with high subprime exposure have reported

negative earnings results and some of them which cannot bear the losses, simply filed for

bankruptcy. It was anticipated that market will react severely to the event but the timing was

unsure. It happened late this year in July and August as a result other markets reacted as well.

Credit market dried up, volumes of mergers and acquisitions slowed down, and financial services

firms considered their next move as some of them planned to exit the subprime business thus

reducing considerable number of related jobs. Washington mutual responded by increasing its

loan-loss reserves by $500 million to as much as $2.2 billion to cover its mortgage exposure.

Five of the world’s largest financial service firms were forced a collective write down $ 17

billion worth of their securities, including $5 billion at Merrill Lynch; $3.4 billion at UBS; $3.3

billion at Citigroup; $3.1 billion at Deutsche Bank; and $2.4 billion at Morgan Stanley. Subprime

effect was not limited to US corporations; some of the international firms felt the burnt as well.

European financial institutions like IKB, Northern Rock, WestLB Mellon Asset Management,

and Carlyle Capital Corp. were among those who have to write down their securities worth in

millions.

Major Write-downs

Third-quarter write-downs on fixed-

income assets

$ billions

Merrill Lynch....................................................$5.0

UBS..................................................................$3.4

Citigroup...........................................................$3.3

Deutsche Bank..................................................$3.1

Morgan Stanley.................................................$2.4

Goldman Sachs.................................................$1.5

Sources: Corporate earnings releases

Financial situations were closely watched by fed and eventually they had their roles to play. Fed

followed up by a series of rate cut. Reaction to fed was short lived as the market was still not in a

position to gauge the effect of these collateral debts backed by subprime mortgages. Public

traded asset managers had their stock with high volatility with market whirl. Even small news

from the sector was severely attacked and related stocks were brutally punished. Biggest impact

was felt by hedge funds and private equity. Under performance by hedge funds made them loose

billions and the industry as a whole had its worst performance since 2000.

F. Regulatory changes:

Recent development in regards to the implementation of FASB 157 and its impact on financial

institution will be worth to watch. It will force financial institutions to recognize much larger

losses and price radioactive toxic waste (CDO, leveraged loans, RMBS, etc.) at market value.

Financial institutions as a whole have already written down around $50 billion but estimates are

that the figures could be $100-$400 billion. It will definitely have a ripple effect thus affecting

the whole economy. Based on these scenarios FASB has decided to delay the implementation of

FASB 157 for non-financial assets and liabilities that are not accounted for at fair value on a

recurring basis. “Asset impairments and the valuation of assets and liabilities acquired in

business combinations are the most common situations that would be affected,” Mr. Stevens

said. This will help financial firms to buy extra time to comply with the standard.

Reforms in the Pension Protection Act of 2006 by US congress are positive signs for the

financial institutions as it will help accelerate the inflows into the mutual fund. The new

legislation encourages companies to automatically enroll 401(k)-eligible employees and to

automatically increase worker contributions every year. It also allows the plan provider chosen

by the employer to offer investment advice to workers. Automatic enrollment is expected to

boost the participation rate in 401(k) plans. The bill makes permanent the saver's tax credit to

encourage low-income workers to save for retirement2. These saving are infused to mutual funds

and to other venues where these funds can be safely parked and raising billions of additional

dollar mutual funds and other plans which tends to be the prime saving vehicle for these plans.

G. Distribution channel:

Most of the asset management firms are expanding globally with the preview that it will allow

them to market their product internationally. The importance of the distribution channel is

increasingly being acknowledged as critical to success in the asset management industry. In past

two decades there has been a dramatic change in how mutual funds and other investment

products are sold to the investing individuals or institutions. Basically there were two main ways;

as no-load funds which are in the lines of retail, sold directly to the public and load funds which

is marketed through brokerage firms or other commissioned sales agent. Lately another form of

2 http://money.cnn.com/2006/08/17/pf/retirement/pension_signing/index.htm

distribution channel has emerged – the mutual fund supermarket. The supermarket channel is

made up of discount brokers that offer mutual funds from a large number of fund sponsors. It

brings a host of mutual funds from several fund managers together under one roof. It offers more

choices that fit into the needs of individuals or institutions. Many of the fund offerings are

subject to no transaction charges or sales loads. This allows them to switch between funds

without a sales charge and with reduced paper work. This has provided investing public with

wide array of choices, consolidating their broker option and they are offered products that meet

their requirements.

H. Impact of technology:

“Innovation has already transformed the financial services (FS) industry. Thanks to their ability

to harness the power of innovative technology. Who predicted that technology would enable

outsourcing and offshore contracting of core financial processes in low-cost countries such as

India? The business environment continues to change today, and the financial services sector

needs to confront many issues to remain competitive. In particular, technology and innovation

are board level issues; they create opportunities and pose threats. Although the industry is

relatively buoyant, it is facing competition from several quarters. Especially important is the

continued creation of ever larger and more powerful players. Financial services industry will

continue to employ technology to improve operational efficiency. As financial institutions

leverage new technology, risk-management oversight issues will become more complex for

both the institutions and their regulators. For example, emerging technology is introducing new

ways for asset management firms to deliver and manage traditional products and services and,

in some instances, to develop innovative offerings. In addition, new worldwide industry

standards are being developed that could allow financial data to be exchanged more accurately

and timely at less cost.

3. Growth:

Asset management is interchangeably use for investment management. The term asset

management is basically used to refer to the management of all the investment collectively in

various securities like shares, bonds, mutual funds etc. However, the term is broadly used as

nearly every type of financial institutions engage in some form of asset management activities. In

spite of high volatility and subprime turmoil, there has been a steady inflow in the equity funds.

Asset under management in fixed income group and mutual funds have also witnessed a steady

inflow of funds. The combined assets of the nation's mutual funds increased by $406.20 billion,

or 3.5 percent, to $11.906 trillion in September, according to the Investment Company Institute's

official survey of the mutual fund industry. Total Asset under management is up from $ 1.28

billion in 1945 and $1.07 trillion in 1990 to $11.906 trillion in 2007.

There has been a phenomenal growth in the Exchange-traded fund (ETFs) in the past few years.

In the past 12 months 252 new exchange-traded funds were launched worldwide and ETF assets

increased globally by 46%. Assets in domestic equity ETFs increased $105.79 billion since

September 2006, and global equity ETFs assets raised $73.12 billion during this period

according to ICI. The combined assets of the nation's exchange-traded funds (ETFs) were

$551.10 billion in September, as compared to $ 300 billion at the end of 2005. A fairly

synchronized global bull market since late 2002 provided nice fuel. A similar pattern in growth

Close competitors Market Cap

($ billions)

Legg Mason 1,012

Franklin Resources 617

Blackrock, Inc. 1,154

Allianz SE 82,113

AXA Group 630

JP Morgan Asset management 1,108

Mellon Financial corp. 4,811

Source: Individual company’s annual report.

can be found at the other end of the investment spectrum: hedge funds. The ongoing strength in

the global equity market, rise in the client inflow and increased performance fees continues to

benefit the bottom line of Asset under management industry. Assets under management of the

hedge fund industry totaled $1.225 trillion at the end of the second quarter of 2006. This was up

19% on the previous year and nearly twice the total three years earlier. Because hedge funds

typically use leverage/gearing or debt to invest, the positions they can take in the financial

markets are larger than their assets under management. The number of hedge funds increased

10% during the past year to reach around 9,000. Recently there have been issues in the money

market but that has not stopped institutions from playing safe. Thus volatile market has spurred

inflows in the less profitable fixed income funds as investors prefer to avoid volatility thus fixed

income has become more attractive recently.

4. Industry forecast:

In days to come distinction between financial service providers will continue to sublime and will

mean less as organizations, will focus to position themselves in niche that cuts across sectors,

from the value of proprietary branch network to a expertise in a set of exclusive services. The

financial service industry of tomorrow will arranged more intricately with focus on sectors,

functions, and institutions interlocking more and overlapping less than it happens today.

A. Seize retirement opportunity:

Most of the organization will position themselves to meet the demand of long term savings

products and for the life-cycle wealth management services. This will lead to next generation

mutual fund products and other investment vehicle that address the income generation and risk

management needs of consumers. These products will find certain investors, not the least of

which include the impending retirement of some 76 million baby boomers – are already making

their presence known. Merely amplify an even more fundamental change to the consumer risk

profile. As millions of baby boomers move headlong into retirement, they will be forced to bear

a whole array of financial risks that previous generations didn't even have to consider. A key

reason, of course, is the continuing decline among today's workforce of defined benefit pensions

and retiree healthcare. Research indicates that consumers are now actively interested in

purchasing financial products that will not only limit their exposure to market risk, but also to

inflation, taxation, health care and other risks. Bolstered by the assets of retiring baby-boomers,

net new inflows into the IRA market are forecasted to grow at a compound annual rate of 5

percent through 2010. Over the next 5 years alone, rollovers from defined contribution plans to

IRAs will generate approximately $1.5 trillion in new assets flows.

B. Alternative Asset class:

Recently we have found that there is a surge in the alternative asset class and a wall of money is

flowing into hedge funds and private equity (PE) and thus shifting the center of gravity in the

asset management industry. Market predicts that in future major players will draw as much as

30% of their revenue from the asset classes that they don’t offer today. Some evidence of this

shift is already reflected in the alternative arena. This trend will only accelerate, due primarily to

the increasing appetite among investors (particularly institutional) for such strategies.

Alternatives will shift from being a "special case" for many traditional managers to becoming a

core asset class. Some of these products will be based on traditional strategies with "overlays"

added to provide different risk management characteristics. Others will be entirely new products

that incorporate different capabilities (insurance, for instance) either by means of internal

expertise or external partnerships. We will also see new compensation models that give firms

much more flexibility to reward a wide range of talent and capabilities, while retaining the

existing culture. Taken together, these changes will result in firms that look different not only

from a financial perspective, but also in terms of organizational fabric.

C. Emerging markets:

As the emerging markets mature, it offers tremendous opportunities to western financial

institutions. But success is no means guaranteed. China and India are most obvious destination in

regards to growth opportunities. Both countries have enormous population with growing middle

classes and steady rising income. In the emerging economies, firms are likely to be dealing with

much larger number of customers-most of who are less wealthy. This will require a creation of a

different operating model. Expanding the business to the farthest corner is certainly attractive but

it also has its down sides like integrating business globally, business alignment, business models

and dis-economies of scale.

______________________________________________________________________________

Legg Mason Inc.

Ticker: LM

Recommendation: Buy

Price: $ 68.48

Target price: $ 92.57

Entry and Exit price : $75-$98

Profile:

Legg Mason, Inc., an asset management company, provides investment management and related

services to institutional and individual clients, company-sponsored mutual funds, and other

investment vehicles worldwide. It operates in three divisions: Managed Investments ($411

billion), Institutional ($ 530 billion), and Wealth Management ($ 70 billion). The Managed

Investments division manages domestic and international equity, fixed income, money market

mutual funds, closed-end funds and other proprietary funds. The Institutional division provides

asset management services to institutional clients and the institutional businesses. This division

also manages a range of domestic, international and global equity, fixed income, and cash

management portfolios for domestic and international institutional clients, including pension and

other retirement plans, corporations, insurance companies, endowments and foundations, and

governments. The Wealth Management division provides customized discretionary investment

management services and products to high net worth individuals and families, endowments,

foundations, and institutions. Legg Mason offers its products and services directly and through

various financial intermediaries. Legg Mason offers equity (34%), fixed income (50%), and

liquidity (16%).

Asset under management by division and asset class

Bulls Say3:

Legg has a diverse group of products and investment channels that provide protection

against a market downturn in any particular asset class.

The Permal acquisition has been smooth sailing so far, with Permal doubling assets under

management since its purchase in November 2005 and providing larger-than-expected

performance fees.

The Citi transaction, while not fully living up to expectations, still made good strategic

sense, allowing Legg to concentrate on its abilities in asset management.

3 Source: Google.com, Yahoo.com, Morningstar.com and financial blogs.

Legg has a very strong stable of brands, from Batterymarch in quantitative investing to

Western in fixed income, that are each well known in their domain and very capable of

attracting new investments.

Bears Say:

Star manager Bill Miller has suffered from subpar performance recently along with most

of Legg's equity offerings. While these funds should rebound on the basis of their

historical record, this setback makes Legg's marketing more difficult in the meantime.

Attempting to build the brand of the central firm could hurt the individual subsidiaries,

either through brand dilution or culture clashes with central management.

Even after the recent deals, Legg's asset base is still concentrated in less profitable fixed-

income and liquidity strategies.

Legg has not seen the expected distribution benefits from the Citi deal. The renegotiation,

while improving Legg's prospects, is also an admission the transaction did not go as well

as planned.

Company financials:

Market Data Balance SheetTarget Price $98.42 cash (m) $1,184 52-Week range $ 68.35-$ 110.17 Total Assets $9,604 Market capitalization (B) $12.60 Debt $1,108 Assets (B) $9.50 Total Revenue $4,344 AUM (B) $1,012 Shares (m) $133

2002 2003 2004 2005 2006

2007

Net income 152962 190850 290470 408398 435000 646145

Total Assets 5939614 6067450 7262981 8219472 2645212 4343675Debt 779463 786753 794138 811164 1166077 1107507

Revenue 1578612 1615382 2004267 2489552 9302490 9604488Pre-Tax Earning 253249 308321 472309 658707 715462 1043854

Investment thesis:

Legg Mason, Inc. is one of the largest independent asset management firms in the world. At the

end of third quarter of FY 2008, it had $1.012 trillion of assets under management, of which

$336 billion was managed on behalf of clients domiciled outside the United States. It is expected

that the company with it strong relative fund performance, broader product offerings, and diverse

distribution channels will outperform industry benchmark. I think that growth of the AUM and

global presence of Legg Mason is positioning it into a new value network that is going to have to

adjust before it can continue to march the new highs. The shift in its strategic focus to

concentrate on asset management seems to be the right ploy. LM has been very aggressive, in its

approach in acquiring other asset management companies. Its recent under-performance is due to

market slump and acquisition. Prior acquisitions of Legg Mason were of smaller magnitude,

however, the Citi deal departed from those deals in two critical ways. First, Mason swapped his

1,400 strong brokerage force to Citi, thus ceding a powerful sales boost. And, no one could call

Citi’s money management record anything better than mixed. The stock is currently cheap as the

company has not anticipated the challenges related to acquiring Citigroup Asset Management. I

would consider it mere pain of growing and be optimistic to take advantage of this rare

opportunity. Legg Mason has significant competitive advantage in the breadth and depth of its

offerings, strong industry branding both domestically and internationally and a top quality

management team. It helps us to believe that the company will recover soon from its recent

turmoil and is a good investment for a short term as well as long term.

Company overview:

In mid of such high volatile market it is tough to gauge the value of financial institution specially

effected by subprime effect. However, Legg Mason is one of those companies which seem to be

on sale with strong fundamentals which promises to deliver in recent future. The company did

suffer from stock market downturn much like its star performer Bill Miller, who has been on top

of S&P 500 for the past 15 years. Recent downturn is due to mediocre performance of its top

performers and transformational acquisition of Citigroup’s asset management business.

However, the strong factors to consider about the company are its management and leadership.

Raymond Mason has been managing the company since the company’s founding in1981 and it

has been an impressive two decades for Mason and the company. The markets have rewarded

Mason's arithmetic. Legg Mason's stock has outstripped just about every other investment bank,

commercial bank, and asset manager, big and small4. Company has performed well to tap growth

in international ambience. It has worked to consolidate and rationalize its international funds.

These funds are sold throughout Europe, Asia, Middle East and America. It has growing

presence in distribution in Hong Kong, Singapore and Taiwan. Legg Mason has investors from

180 countries investing in Legg Mason’s proprietary cross border funds and currently one-third

of total asset under management, or $ 336 billion, are managed on behalf of clients domiciled

outside the United States in more than 180 countries.

Bill Miller:

Recently it has been witnesses that Bill Miller has become the face of the company and his slack

performance is considered to be an under-performance of the company as whole. Miller’s

performance to beat S&P index for 15 consecutive years has set high expectations for his

investors and it was certain to conclude sooner or later. It is an important event in the history of

the company; however, it will make more sense to know the rationale behind his

underperformance. Two major factors that led to his under-performance are attributed to energy

and housing stocks. Miller’s fund seems to lack exposure to energy stocks which rallied due to

economic and geo-political reasons. Second, it got into the train of house building stocks a bit

too early and the stock has tanked due to subprime effect. Now the question is how significant is

Bill Miller’s underperformance for the company as a whole. He manages around $20 billion of

total equities more than $300 billion or 6% or around 2% of total asset under management of

Legg Mason. However, chances of mass redemption seem lean given his goodwill and past

performance. Miller is an old campaigner and I am optimistic that he will bounce back soon.

4 http://money.cnn.com/magazines/fortune

Risk:

Legg Mason is facing the risk of keeping up the pace of buyouts. But I believe that integration

with Citigroup is nearing the end and cost synergies will be reflected soon. Factors that may

affect the proposed target price in relation to the reduction of asset under management and

revenue are market depreciation, under-performance of the company and regulatory issues.

Investment in diverse asset class makes it tough for the company to isolate itself from any

significant downswing in the market and in all likelihood would hurt earning power.

Financials:

In last twelve months the stock prices have fallen more than 28%. It is interesting to think of the

reasons that caused the stock price to tank, whether it was due to the under-performance of the

company or more as a function of the overall market? As it has investments in diverse asset

classes even a smaller deviation takes a toll on the asset under management due to investment

losses. Another concern is about its integration with Citigroup. LM is integrating the $400 billion

of fund assets it acquired from Citigroup in exchange for its retail brokerage services. According

to Legg Mason management, the integration has not gone as quickly as planned. Despite recent

turmoil the numbers were very strong with revenues at $ 4.3 billion in fiscal year 2007 from $2.6

billion in year 2006; acquisition had a major impact on that growth. There has been a steady

growth in the Assets under management (AUM) to $1.012 trillion and all three categories of

assets (Managed Investments, Institutional, and Wealth Management) contributed to the increase

in AUM. Company has witnessed strong equity performance in small cap and emerging market

categories.

Source: Legg Mason annual report 2007 & interim report 2008. 2008 data is till September 2007.

Legg Mason has addressed the issues in regards to the cost structure and has been able to reduce

it considerably. Distribution expense has reduced in financial year 2008 to about 40% and this

rationalization of cost structure is expected to continue further into 2008, boosting margins

gradually over time. It is also considering realignment of its management structure, a

streamlining of mutual funds, and employee head count reduction. Company has an impressive

record of collecting assets, increasing its assets under management and deriving the benefits of

scale. Most of the company’s revenues are generated from its investment advisory business in

the form of investment management fees and underwriting and distribution fees.

Valuation:

I have considered valuating Legg Mason based on its historical operating performance,

company’s growth strategy and overall economic impact on financial sector. If we value Legg

Mason based on asset under management/market capitalization and use a conservative 2% of

AUM, which is an industry standard widely used by value investor Marty Whitman, we will

obtain a much higher stock price. However, following my numbers to analyze real stock price, I

expect the operating margin to settle around 27%. It is a bit higher than its operating margin of

24% since its merger with Citigroup. I anticipate that post-merger will have greater efficiency as

the funds will be integrated with existing operations. Cost reduction and distribution benefits

have just started to materialize, so I expect a reduction of net distribution expense ratio. Asset

managers like Permal has phenomenal results which will result in higher management fees rates,

thus boosting up the revenue once the growing pain eases out in short run.

Running numbers:

Cost of equity= 11%

Growth rate = 15%

Operating profit margins = 27%

Debt = $1107 million

Current market price= $ 73.60

Target price= $92.57

It seems to be a critical growth phase of the company in which they did face few challenges,

however, their efforts to execute their strategy seems to work well in tough market conditions to

position themselves for future growth. I have confidence that management will continue to

execute this plan as it progress further into the year. Time and again company has beaten market

expectation and has been a top performer within the industry. Future earning will reflect this as

successful asset retention efforts.

References:

http://www.leggmason.com/

http://faculty.chicagogsb.edu/raghuram.rajan/research/finrisk.pdf

http://seekingalpha.com/

http://www.wikinvest.com/

http://richard-wilson.blogspot.com/

http://www.fool.com/

http://morningstar.com

http://finance.google.com/finance

http://www.informationarbitrage.com/

http://www.michaelcovel.com/archives/cat_economics.html