We maintain our Neutral recommendation on Legg Mason Inc. (LM) as minimal increase was recorded in total assets under management (AUM) as of March 2011. Moreover, third quarter of fiscal 2011 (ended December 31) earnings fell short of the Zacks Consensus Estimate. Higher operating expenses and a decline in total AUM were the primary headwinds.
In January, Legg Mason reported third-quarter fiscal 2011 earnings of 41 cents per share, lagging two cents behind the Zacks Consensus Estimate. Results for the reported quarter included 10 cents in transition-related costs and 4 cents 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 has been strongly 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 reduce costs. The plan, which is scheduled to be completed in fiscal 2012, projects $130-$150 million in expense reductions.
Legg Mason enjoys a strong operating and AUM leverage attributed to its diversified product mix and leading investment performance in both fixed income as well as equity markets. The company has constantly produced solid 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 in the long run. Additionally, aggressive expense control, multi-manager operating model, re-branding and restructuring product portfolio is expected to provide downside support to margins in the upcoming quarters.
Moreover, Legg Mason remains committed to increase shareholder’s wealth. The company is effectively deploying capital through share repurchase. It 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 encourage the investors.
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.
Estimate Revision Trends
Legg Mason is expected to release its fiscal fourth-quarter 2011 earnings on May 3, 2011. Over the last 7 days, 1 of the 15 analysts covering Legg Mason has decreased their estimates for the fourth quarter, while no upward revision was witnessed. Furthermore, for fiscal 2011, none of the 15 analysts has decreased their estimates, while one moved north over the last 7 days.
Currently, the Zacks Consensus Estimate for the fourth quarter is operating earnings of 45 cents per share, a surge of 16.07% from the year-ago quarter. Furthermore, over the last 7 days, operating earnings estimate for the fourth quarter and fiscal 2011 remained stable.
Legg Mason currently retains its Zacks #3 Rank, which translates into a short-term ‘Hold’ rating. Also, Legg Mason’s closest competitor – BlackRock Inc. (BLK) retains a Zacks #3 Rank (a short-term ‘Hold’ rating).
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