We maintain our Neutral recommendation on Legg Mason Inc. (LM) as third quarter fiscal 2011 (ended December 31) earnings fell short of the Zacks Consensus Estimate. Higher operating expenses and a decline in total assets under management (AUM) were the primary headwinds.
In January, Legg Mason reported third-quarter fiscal 2011 earnings of 41 cents per share, which fell short of the Zacks Consensus Estimate of 43 cents. Results for the reported quarter included 10 cents per share in transition-related costs and 4 cents per share related to a closed-end fund launch.
However, adjusted earnings, as reported by the company, came in at $110.3 million or 73 cents per share, up from earnings of $93.2 million or 57 cents per share in the comparable prior-year period. Results benefited partly from higher revenue.
Legg Mason enjoys a strong operating and AUM leverage due to its diversified product mix and leading investment performance in both equity as well as fixed income markets. The company has consistently produced strong organic growth and is a best-in-class retail brokerage and asset management business. With an improvement in the equity markets and fixed income business, we expect the company’s earnings to benefit. Additionally, aggressive expense control, multi-manager operating model, re-branding and restructuring product portfolio should provide downside support to margins in future.
Legg Mason has been vigorously working on improving its operating efficiencies through its key initiatives that include offering of innovative product solutions to client base, tapping sound investment capacities and expanding distribution relationships. In May 2010, Legg Mason announced an initiative to streamline its business model and cut costs. The plan, which is scheduled to be completed in fiscal 2012, projects $130-$150 million in expense reductions.
Also, Legg Mason remains committed to increasing shareholder wealth. The company is effectively deploying capital through share repurchase and has announced a $1 billion buyback authorization in May 2010. The company intends to use a portion of its available cash to purchase up to an additional $40 million of its common stock by the end of fiscal 2011 and continue repurchasing its stock in fiscal 2012. We expect such measures to instill confidence in the stock.
On the flip side, Legg Mason’s long-term funds (3–5 years) remain challenged due to decline in global asset values and volatile equity markets amid the current credit crunch. These factors significantly deteriorated the performance of Western Asset Management Company, which has an extensive business both within the U.S. and throughout the world. Further, asset outflows also remain a matter of concern for Legg Mason. The company experienced net client outflows in all asset classes in the third quarter of 2011. Considering the financial environment, which is still challenging, we believe that weakness in asset flows would remain a headwind in the near term.
The current volatility in the financial markets and the government regulations pose the risk of interest rate fluctuation for the funds business of Legg Mason. While increases in interest rates may result in reduced prices in equity markets, any significant decrease will lead to outflows in fixed income and liquidity assets, where investors seek higher yields. These effects are anticipated to affect the AUM adversely and hinder the revenue and income growth of the company.
However, we believe Legg Mason has the potential to outperform its peers in the long run, given its diversified product mix and leverage to the changing demographics in the market.
Legg Mason currently retains its Zacks #3 Rank, which translates into a short-term ‘Hold’ rating. However, Legg Mason’s closest competitor – BlackRock Inc. (BLK) retains its Zacks #1 Rank, which translates into a short-term ‘Strong Buy’ rating.
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