Legg Mason, Inc. F4Q09 (Qtr End 3/31/09) Earnings Call Transcript

May. 5.09 | About: Legg Mason (LM)

Legg Mason, Inc. (NYSE:LM)

F4Q09 Earnings Call

May 5, 2009 8:30 am ET

Executives

Mark Fetting – Chairman, CEO

Charles Daley – Chief Financial Officer

James Hirschmann – CEO Mason Investments

Analysts

William Katz – Buckingham Research

Daniel Fannon – Jefferies & Co.

Roger Smith – Fox-Pitt Kelton

Jeffrey Hopson – Stifel Nicolaus

Robert Lee – Keefe, Bruyette & Woods

[Keith Walsh – Citi]

Craig Seigenthaler – Credit Suisse

Marc Irizarry – Goldman Sachs

Cynthia Mayer – Bank of America

Operator

Welcome to the Legg Mason quarterly call. (Operator Instructions) I'd now like to turn the conference over to your host Mr. Allen Nagelby.

Allen Nagelby

Good morning. On behalf of Legg Mason I would like to welcome you to our conference call to discuss operating results for the fiscal 2009 fourth quarter and fiscal year end ended March 31, 2009.

This presentation may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are not statements of facts or guarantees of future performance and are subject to risks, uncertainties and other factors that may cause actual results to differ materially from those discussed in the statement.

For a discussion of these risks and uncertainties, please see risk factors and management's discussion and analysis of financial conditions and results of operations in the company's annual report on Form 10-K for the fiscal year ended March 31, 2008 and in the company's quarterly reports on Form 10-Q.

This morning's call will include remarks from Mr. Mark Fetting, Chairman and CEO and Mr. C. J. Daley, Chief Financial Officer who will discuss Legg Mason's results. Following a review of the company's quarter, we will then open the call to Q&A.

Now I would like to turn the call over to Mr. Mark Fetting.

Mark Fetting

Thank you Allan and let me add my official welcome to you on this your inaugural earnings call with us. I'm sure everyone on the line looks forward to meeting and working with you. I would also like to thank Barry Bilson and Mary Athridge who are our key contacts with our investors and the press.

Good morning everyone and thank you for joining us today. We have a slide presentation which reviews our fourth quarter fiscal '09 performance that we have posted to our website. So with your permission, let's begin on Slide 3.

As you've read in our press release this morning, Legg Mason's performance in the March quarter was influenced by continued volatility in the equity and credit markets and general investor uncertainty. The general economic environment in the quarter was challenging, but the credit and equity markets started to improve in mid March and this has continued through April.

Legg Mason realized significant capital losses in the quarter primarily driven by the final resolution of our SIV exposure, but we managed our balance sheet on our own terms and without external assistance. Nevertheless, our shareholders deserve better results and we are determined to provide them. Recent investment performance indicators are encouraging and we are pushing forward to pick up the pace across the board.

Because of the record levels of cash build up we see in the markets, we have started to see institutional investors show renewed interest in greater Alpha and long only strategies, albeit with a significantly renewed focus on due diligence and fundamentals.

Broadly speaking, we expect to see the global credit markets recover ahead of the equity markets which should benefit Legg Mason given our strong position in fixed income. While institutional investors are slowly but surely recovering their appetite for risk, retail investor confidence remains somewhat fragile.

For our own part, in order to manage through continuing uncertainty, we have taken several important actions to improve company performance and to realign our business. C.J. will describe the specific financial impact of these steps but let me first share with you the strategic basis for what we're doing.

First, as you can see in Slide 4, I want to say that we are not satisfied with our overall results for sure, yet we believe that our recurring core business exclusive of special charges continues to generate cash and is still profitable though not nearly at the level we expect and demand of ourselves.

We had core earnings in the quarter of $0.15 adjusted for non core items such as SIV's, impairment and real estate losses. In order to strengthen our overall performance, we are acting with urgency and purpose to grow revenue, decrease costs, improve our margins and improve our financial performance.

Our key strategies are as follows: first we are committed to improving Legg Mason's financial strength and to manage our balance sheet in a way that protects us and gives us optionality. Second, we are committed to effectively manage our cost structure in line with our lower AUM level and the reality that we need to do more with less.

Third, we are committed to enhancing investment performance across our affiliates. It begins and ends with performance and retaining and growing client assets is how we create value for our shareholders.

And finally, we are committed to strategic growth initiatives which include participating in all key market segments, accelerating new product development and expanding our multi-channel open architecture distribution strategy to access new clients and new opportunity.

I'm going to go through our financials first and then come back to the progress on these strategies, but I think it's important for you to understand what we are doing to drive better operating performance as we go through our latest results and to view our situation accordingly.

We have faced many headwinds in my first year, but we have faced these winds with confidence and determination. I'm quite proud of what we were able to accomplish this year particularly the decisive actions our team took to reduce the balance sheet overhang and the painful but necessary steps to control our expenses.

For sure, the SIV's were a big hurdle, but we put together a plan. We worked it hard. We didn't lose our nerve and we reached a final resolution that allows us to move forward. Similarly, our progress on cost savings has been strong and steady and C.J. will update you on that.

So turning to Slide 5, you can see that our revenues for the quarter were $617 million, down 14% sequentially. We reported a net loss of $325 million or $2.29 per share compared to a net loss of $1.5 billion or $10.55 per share in the prior quarter. This quarter there was a cash loss because of the realized losses on the SIV's primarily of $745 million or $5.25 per share.

The special charges in the quarter include the previously announced elimination of all SIV's from our money market funds and our balance sheet, additional impairment charges and accounting losses for certain subleases which were partially offset by certain tax benefits. Our fourth quarter core ESP excluding these charges was approximately $0.15 per share and C.J. will follow in detail on these issues.

Slide 6 shows the assets under management for the quarter at the end of March and that came in at $632 billion, down a third from the prior year and 9% sequentially. Our asset mix was 20% equity, 57% fixed income and 23% liquidity.

AUM for April is estimated to be approximately $640 billion, reflecting better market appreciation offset by continued outflows including some major items that reflect earlier client decisions.

On Slide 7 you can see our outflows for the quarter by asset class. The total outflow of $43.5 billion breaks down as $24 billion in fixed income, $10 billion in liquidity and $9 billion in equity. The key for us here is cutting the absolute number almost in half and also reducing the rate of outflows from 9% in the December quarter to 6%. We're not happy with 6% but it shows a mission of reduction and ultimate recovery.

Slide 8 breaks down our AUM by affiliate as we've done in the last couple of quarters, rank ordered top to bottom based on their contribution to earnings. Western Asset Management ended the quarter with $472 billion in assets, down roughly 8% from the prior quarter. Over the last six quarters as you know, the credit markets have not embraced risk and Western has been disproportionately impacted compared to peers as a result.

That said, performance over the last six weeks has significantly improved and outperformed the peer group. After a difficult year, core and core plus are both performing in the top decile over the past six weeks.

As credit markets stabilize, Western is well positioned to outperform. Jim Hirschmann, CEO of Western is with us today in Baltimore and is available to answer questions during our Q&A.

Let me briefly touch on our other managers. Permal ended the quarter with $18.5 billion. Withdrawals have fallen since the October/November window levels and Permal has consistently received accolades for a strong team, a robust process and leadership actions during recent stress.

ClearBridge ended the quarter with almost $43 billion in assets. While one year performance has been mixed, 13 of 14 ClearBridge strategies, equity strategies have outperformed benchmarks and 8 of 14 are beating benchmarks for the one year period. Prior 13 of 14 was for the year to date period of January through April 30.

Royce & Associates has approximately $18 billion in assets. Royce has consistently strong ratings across the micro, small and even mid cap areas with all funds beating the Russell 2000 on a one year basis and 94% of the fund assets rate four or five stars by Morningstar.

Legg Mason Capital Management ended the quarter with $12 billion. While performance over the last year has been disappointing, several key strategies have had strong performance in March and April. Special investment trusts, opportunity trust and value trusts are included in that strong performance.

Brandywine had approximately $28 billion in assets. Brandywine was recently selected to participate in the first actively managed ETF launched by Grail and American Deacon.

And finally, Batterymarch ended the quarter with more than $15 billion under management and recently won a global equity mandate for a major Asian pension fund. It's a great win.

The investment orientation of all our affiliates is to generate sustainable excess returns over the long term for their clients. So you see in Slide 9 the Lipper measurement of our long term domestic U.S. funds shows that 75% are beating their category average on a 10 year basis.

This is the benchmark we want to hit across all of our time periods so we are not satisfied with the one, three and five year performance that you see. However, as you hear my remarks earlier, while the trailing 12 months performance has been disappointing, there is a marked improvement in the relative performance of both our equity strategies and fixed income strategies over the past two months. Based on historic patterns, these strategies tend to do well as the broader markets rebound.

Now let me turn to our key strategies and touch on the progress we have made to date. It goes back to the four themes that I established at the beginning of our talk and which I've mentioned in the past.

Our final SIV actions reduced the existing overhang on our balance sheet. As announced in March, we completed several transactions selling $1.8 billion face value securities that eliminated all SIV's from our money market funds and our balance sheet. We started 18 months ago with over $10 billion in SIV exposure and today we have zero.

In addition, we also amended our bank debt covenant and paid down debt. These actions were aimed at protecting our balance sheet and giving us more optionality as we move forward.

After the receipt of a related tax refund in the next few months, Legg Mason will have approximately $1.7 billion in cash and approximately $1.1 billion in free cash after affiliate working capital of $600 million or so.

Our highest near term priority is to preserve our cash position to maintain the increased optionality we've created. This will ensure that we have the financial strength and flexibility necessary to manage through uncertainty and also to achieve our long term goals.

Yesterday, the Legg Mason Board of Directors declared a cash dividend on our common stock in the amount of $0.03 per share. To be sure, this is a significant decline from where we were but it is a necessary adjustment given both our current earnings and our desire to conserve cash at this point to invest in our business long term.

We believe that prudent cash management will allow us to manage through different macro conditions and allow us to play offense or defense as appropriate. While achieving improved financial strength is clearly a priority, aligning our cost structure to protect long term profitability remains top of mind.

To that end, as of the end of April, we have realized sustainable run rate savings of $135 million or 22% from our corporate operating budget. Last quarter we were at $108 million in run rate savings so we continue to make very good progress. We view this initiative as a key priority in improving our margins and generating more efficiency over time.

Through an ongoing and comprehensive review of our strategies in every aspect of our business, we have identified an additional $25 million of cost savings which will get us to a total of $160 million or 27% on a run rate basis which we will achieve by September 30 of this year.

Our total head count across corporate and affiliates is down 13% from September '08 levels. We have made these reductions, difficult but necessary, to eliminate certain staff support positions while largely preserving our investment team and maintaining our high service level with clients.

Now let me turn the call over to C.J. who will take you through our financials in more depth and then I'll come back for a wrap up.

Charles Daley

Good morning everyone. I plan to cover a number of areas today related to our financial performance. First, I'll review our operating results for the quarter focusing on some of the noteworthy items that affected our results and make it difficult for this quarter to assess our earnings.

I'll also review our expenses for the quarter including an update on our cost savings initiatives. Finally, I will discuss our balance sheet progress; speak to the elimination of our SIV, bank covenant amendments, as well as the adequacy of our available cash to cover our debt obligations.

As you will see on Page 12 on our slide deck, our results for the quarter were again impacted by the market turmoil in the equity and credit markets during the period. Average AELEM declined 12% to $657 billion in the March quarter and revenues followed, declining 14% to $617 million from the December quarter.

Compared to the prior year's quarter, the average AELEM declined 33% and revenues declined 42%. Our advisory fee realization rate was unchanged from December at 33 basis points and down from 37 basis points in the March quarter. The year on year change was due to lower percentage of higher fee equity assets under management.

On the expense side, there were several items that materially impacted the quarter's numbers and I will speak to those later in my discussion. Consolidated expenses which include those items were $663 million, down 63% from December and down 29% from the prior year's March quarter.

Those declines were driven by significantly lower charges for good will and intangible impairments, lower compensation and distribution costs on lower revenues and the effect of the savings we've initiated and we've announced. The offset in part to these lower expenses compared to the sequential quarter were the credits we described in the prior quarter related to recapture of incentive accruals that occurred in the December quarter which did not recur in the March quarter.

The result was a net loss of $325 million or $2.25 per diluted share compared with a loss of $1.5 billion or $10.55 per diluted share in the December quarter.

As you think about our results, it's important that we highlight a number of moving parts to help you understand our quarter. Page 13 reflects our core income which is highlighted on the top half of the schedule. The adjustments below are principally the ones we highlighted in our earnings release and when added back to our core income, reconciled to our GAAP net income and diluted earnings per share.

Let me give you some color on the items we've identified as non core. First and foremost is the final resolution of our SIV exposure which resulted in charges in the quarter of $606 million, $367 million after taxes, or $2.59 per share.

We also recorded non cash impairment charges related to acceleration of amortization primarily as a result of a change in estimated lives and separately managed account contracts acquired in the Citi Group Asset Management deal which resulted in impairment charges of $83 million on a gross basis, $51 million after tax or $0.36 per diluted share.

I realize you were not expecting this charge, but continuing outflows need separately managed accounts led to the need to revisit the remaining lives of the contracts. Outflows and market depreciation remain key risks to the valuation of our intangible assets and the possibility of further impairment charges in the future.

In addition, we incurred real estate losses reflective of expected delays in sub letting vacant space and declining sub lease rental rates, principally in New York City where commercial real estate rates nose dived since December 31. The charges total $38 million, $24 million after tax or $0.17 per diluted share.

Other items impacting this quarter totaled about $10 million, $6 million after tax or $0.04 per diluted share and were primarily fiscal year end adjustments to compensation and severance accruals and the cost for launching a closed end fund.

We also realized net tax benefits related to restructuring our Canadian business as well as fiscal year end provision adjustments of $102 million or $0.72 per share. As a result of these credits, the effective tax rate for the quarter was 53% credit. The normalized effective tax rate on income should be approximately 39% give or take half a percent either way.

I also want to point out that net interest expense for the quarter was $35 million, up from $29 million last quarter results on lower earnings on our cash balances. Net savings from our $250 million debt repayment or approximately $2 million will be more than offset by an accounting rule change effective April 1, 2009 related to our debt convertible debt securities. That will increase interest expense non cash by about $8 million per quarter beginning next quarter.

After adjusting for the items above, what we would consider our after tax core income for March would have been $21 million profit or $0.15 per diluted share.

As I mentioned previously, there were a number of items that materially impacted the quarter. It is clear on Page 14 of our slide deck that our expenses were again inflated this quarter by the impairment charge of $83 million and the real estate losses of $38 million.

I should point out that over the next several months, we will be incurring an increase in occupancy expense. There will be a period of overlapping expense for relocation of our Baltimore office. The impact will be an increase in occupancy expense of approximately a little less $1 million in the June quarter, $4 million in the September quarter and $3 million in the December quarter.

However, these additional costs will be more than offset by incremental cost savings leading into those quarters. When compared to the sequential quarter, this quarter expense appears high because of the compensation reductions that occurred in December.

The comp and expense line is up over $40 million from the sequential quarter and I will provide further detail on that line item in the next slide. You will see that our cost savings initiatives are clearly taking hold especially when you look at year on year trends. With the exception of the occupancy expense, again driven by the sub lease charges this quarter, all major expense categories are down from the March '08 quarter.

While expenses are clearly down from the prior year's quarter, comp and benefits is up from the sequential quarter. Drilling into the variance of comp and benefits on Page 15, you'll see a number of moving parts contributing to this increase.

The decline in operating revenues resulted in a $30 million reduction in comp and benefits but these were offset by a number of adjustments that flowed through in December and did not recur this quarter. For instance, mark to market changes on deferred comp and seed investments resulted in a $43 million this quarter over December.

And finally, there was a net increase due to cost reduction initiatives which resulted from credits in the December quarter including profit sharing and bonus accrual adjustments partially offset by severance and related costs for the December head count reductions.

Also in the quarter in certain cases we chose to make investments in our talent by holding compensation levels higher than would be expected given the decline in revenues.

That being said, an important component of our strategy as Mark mentioned is to manage through these turbulent markets, has been to reduce costs at an aggressive pace. We reported last quarter that we identified run rate cost reductions of $135 million, exceeding our original goal of $120 million which we've achieved.

As you can see on Page 156, run rate cost savings are in line with our target and more than half of those savings are in comp and benefits. Staffing levels as Mark mentioned are down 565 people or 13% from our September peak. We are not stopping there. We continue to look for additional opportunities to reduce costs particularly in non core technology activities and we are now targeting additional cost saves that will raise our run rate cost reductions to $160 million, most of which has already been initiated.

On Page 17 you can see that our balance sheet and capital position remains strong. The resolution of the SIV exposure while absorbing a significant amount of cash in the quarter eliminated an even large potential liability that was not reflected on a GAAP basis on our balance sheet. Accordingly, we used $1.2 billion in the quarter of cash to resolve the SIV exposure.

As a result, our cash position, while lower on an absolute basis, has been strengthened on a net basis. After receipt of tax refunds our cash position will be approximately $1.7 billion of which approximately $600 million is working capital so we'll have about $1.1 billion of cash available for repayment of debt and/or growth initiatives.

The only debt we have maturing in the next five years is a revolving credit facility of $250 million and the remaining $500 million of bank term loan both of which are due in November of 2010. So we'll have ample cash on hand to meet our short and long term debt obligations plus we have an additional six quarters of cash flow before we are required to make these payments.

The dividend reduction we announced today will reduce our cash outlay by $119 million and will have a meaningfully positive effect on retained cash.

The Slide on page 18 addresses our debt covenant and coverage. We announced at the end of the last quarter an amendment to our debt covenant. This amendment provided several benefits. First and foremost we revised the realized the SIV loss exclusion to give us the room needed to sell the SIV securities remaining on our balance sheet.

Almost as importantly, we negotiated the ability in our leverage ratio to count excess cash not needed for working capital purposes as a reduction of debt in the count. This allows for greater flexibility in paying down debt should we have covenant ratio concerns with respect to leverage.

As result, our leverage ratio you'll see which has a maximum of three times declined from 2.1 times in December to 1.8 at March 31. Our interest coverage ratio which requires a minimum of four times coverage on fixed charge interest expenses declined from 6.9 times to 6.2 times. Having said that we remain on negative outlook with the rating agencies. Two of those agencies are expected to resolve those outlooks in the near term.

While ratings are an important measure of our ability to service our debt, we have clearly evidenced our ability to repay our debt and our ratings are solidly in the investment grade range. We feel we have strengthened our financial position during the quarter, but we still face risks of a downgrade.

However, there are no rating triggers that would cause negative consequences except that our variable interest costs on our term loan and revolver do fluctuate based on the higher of our ratings from Moody's and S&P.

So in summary, I'd like to highlight we have ample cash to meet our short and long term debt obligations and our core business continues to generate cash. Also we continue to raise the borrow on cost savings and we are now targeting a run rate of $160 million by September 30.

With that, I'll turn it back to Mark who will provide some closing comments before we move on to Q&A.

Mark Fetting

I'd like to cover several important steps we recently took as a management team to run the core business and then close with an assessment of where we are today and where we're going.

First you should note in Slide 19 that we're now reporting our AUM to reflect our new organizational structure with two divisions; the Americas and International. The Americas division managed and led by David Odenath includes our U.S. fund family, the separate account business of our U.S. affiliates and our U.S. distribution team.

The International division led by Ron Dewhurst includes our large offshore fund complexes, our global distribution teams and our affiliates who are based outside the U.S. from London to Tokyo, to Hong Kong and beyond.

The new Americas and International structure aligns our products, our affiliates and our distribution efforts, provides more direct management reporting lines and allows us to service our clients and to pursue new opportunities in a more efficient way.

We also announced recently the appointment of Jeff Nattans as Head of Specialized managers including Permal, Royce, PCM, Bartlett and Legg Mason Investment Council. For the past four years, Jeff has helped manage our M&A strategy functions and he will be an excellent corporate leader for the important affiliates that have different distribution structures and capabilities.

We've also made several important hires to deepen our Americas management team and to deploy our resources in more dedicated client centric manner across the advisor sold business and the institutional/intermediary client base including insurance, retirement and private banks. We expect to generate more growth by aligning our capabilities against these discrete market segments that have unique needs and require more customized solutions.

With our deeper bench and in collaboration with our affiliates, we announced several new products in the quarter as you can see on Page 20 including a municipal term trust and an all weather asset allocation retail product managed by Permal. We have several additional new products planned this quarter including a blue chip bond fund in Europe and a series of products covering both institutional and retail markets should Western be selected as a manager for the Treasuries Public/Private Investment Fund.

Product innovation is a major growth strategy for us and it leverages the depth and breadth of investment know how that make our affiliates so distinctive. We cover the waterfront in terms of asset class, strategy and style and we can sell for virtually any kind of investment mandate.

Finally, let me note that this quarter marked my first full fiscal year as CEO of the company. As we enter the next year, our number one focus is and will always be sustained investment excellence. That's the engine that drives our business.

We have had a stretch of inconsistent performance affecting both our equity and fixed income business and while recent improvements across many of key strategies has been encouraging, we need more sustained improvement, better relative and absolute performance before we see steady inflows and asset gains.

We are working very hard on this with our affiliates. Each of these firms are taking smart steps to ensure the integrity of their investment disciplines that have served them well for decades while enhancing risk management for greater consistency.

I want to close by saying that the global growth is an enormous opportunity for Legg Mason and one that is still largely ahead of us. As markets steady themselves, our ability to execute our key strategies will put us in a position to grow. The opportunities that will emerge may look very different than they did only a few short years ago, but we are passionate in our believe that the inherent strength, diversity and global reach of our multi-manager model will be our key to success.

We recognize that we cannot cut our way to victory, but we are going to do everything prudent and proper to protect our balance sheet and to maintain a more efficient and effective operating model.

We also recognize Legg Mason represents a superb collection of franchise firms whose investment leadership requires opportunistic support where competitive advances can be secured. Thus, we are able to protect and grow our leadership positions such and number five in the institutional market place, ranked number eight in advisor sold funds, ranked number two in the retail SMA business and through Permal, ranked number four in the hedge fund to funds business.

When you put our full spectrum of investment capabilities together with our distribution and service organizations, it is a powerful combination to deliver the best of Legg Mason to clients, to grow the business and to win in the marketplace.

With that, let's open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from William Katz – Buckingham Research.

William Katz – Buckingham Research

Where I'm really struggling in is as an organization is the margin of the company. It just seems like you've been talking about the potential of this organization for quite awhile and yet quarter in and quarter out it just seems to be frustrated about one point or another and this quarter it seems to be the compensation. Can you walk through why comp was relatively sticky? I know you gave a slide and C.J. covered a little bit. I guess I'm just surprised that on the absolute level, X is deferred comp and X the seasonal factors, there wouldn't have been more progress given the announced head count reductions, given these cost savings to date.

Mark Fetting

You're absolutely right. That's probably the key issue that pops off the page and as C.J. said, in my view you peel the onion and you take a look at the deferred comp reversal and you're still down to fundamentally what we did in a couple of equity managers, we stepped in and rather than enforce a revenue share, we provided some support so that we could invest in the key professionals.

At the same time we look forward to working with Western while preserving the basic revenue share in such a way that we can support their investment and opportunities that are over there. So I think as we go through a combination of the eroding markets and the challenges that has and also the opportunities that has, we're going to make this judgment call between short term cost savings and long term investment in the business when we see who knows if it's right, but there's an inflection point here. March 9 is the inflection point we want to be positioned to build and win.

William Katz – Buckingham Research

As you think about the pace of the attrition, any sense, you gave some commentary in your recent Q about January and February and you gave us, you went into April, but any sense of what you're seeing in terms of traction in the pipeline for the institutional business, maybe quantify the attrition by month, or get some comfort that the attrition is showing even more signs of improvement.

Mark Fetting

We thought it was important as you know, I think we're unusually early on AUM for April and we just decided given we have had enough experience that we could do an approximate and the message there is clearly market appreciation is up but we do still have some outflows, a couple of which were really in the pipeline from earlier client decisions.

So on a go forward basis, there will always be a lag between investment improvement and flows but we think that we've got one moving in the right direction and hopefully the other follows.

It might be helpful now to turn to Jim Hirschmann and ask him since you talked about the intuitional business and Western is by far our largest institutional manager to just give an update and then all of us are here for follow up.

James Hirschmann

Obviously the recent market environment has not been kind to Western given our propensity to play the credit markets and as you know we've got a very diverse product line. You get down to the most granular level, well over 100 different products. Clearly we're best known for our "core to core plus" product. That accounts for about 20% of our business.

The rest of the business is pretty well diversified outside of that with maybe the exception the money fund business, the liquidity business which is about a quarter of our business.

I would tell you our RP pipeline is pretty consistent at $11.4 billion there. Our pipeline in terms of businesses won that haven't funded yet, about $5.5 billion in AUM and then in our funding pipeline, we've got about another $4 billion in AUM as well. So I would say that it's been consistent.

Clearly we would like it to be a bit better. When you look at the change in our AUM over the quarter, Mark mentioned down about 8%, the bulk of that was really due to cash flows from existing clients, market depreciation and FX impact, about 15% from lost client assets.

The other area we've seen the most challenge in terms of AUM is in the front end of the curve. That would be enhanced cash; limited duration, stock plus types of portfolios and that would not be exclusive to Western Asset. That entire market segment has been hit quite hard and will probably continue to change dramatically.

But aside from that, we continue to win business in the core plus area. We received a $1 billion plus mandate over the last quarter, looking for some large cash flows into some of our core to core plus funds over the next quarter.

We received a large mandate in the credit space from a non U.S. pension fund. It should be about $.5 billion to $1 billion and then we continue to see a lot of interest in our global tips product particularly from some sovereign oil funds around the world.

In addition to that some of our domestic products that we manage out of Brazil, Australia and Japan, have been going quite strong and over the past three years we've really worked hard at courting our products through the rest of our platform. We've seen a lot of recent interest and success particularly in Japan for products that are managed in other offices around the globe, specifically Australia and Brazil. So that's something new and it's quite heartening.

Operator

Your next question comes from Daniel Fannon – Jefferies & Co.

Daniel Fannon – Jefferies & Co.

Just to follow up on the last comp question. Should we be thinking about you providing additional support similar to what you did this quarter as we think into the June quarter and could you be specific as to which manager's you actually provided that support to?

Mark Fetting

One way to look at this, and I did some analysis around what's our comp ratio to revenues, and if you look year over year on a gross revenue basis, I think we've been somewhere in the 34% range and on a net revenue basis, net being you take out the distribution fees, you're somewhere in the 50% to 52% range.

I don't see us moving higher than that and I think the steps that we took this quarter are really kind of baked in. We're going to continue to work closely and I want folks to understand that this gives us; this market condition gives us an opportunity in terms of people who want to join some of key managers, and a necessity to retain our key managers.

You combine all that, we want on the one hand keep the pedal to the metal around cost efficiency. On the other hand, not go too far around some of those core strengths. So I think the best response I can give you is a range of net revenue and gross revenue that I use to monitor the situation.

Daniel Fannon – Jefferies & Co.

In terms of Permal, can you talk about their business? They didn't put up the gates in the December quarter. What's the redemption or the flow outlook for them and also update us on how much of their business comes from that broker dealer channel specifically at [inaudible] and what impact that consolidation of that network might have on their channel.

Mark Fetting

First off, Permal would probably want to emphasize what they did. They kind of extended the notice period as opposed to put any kind of formal paid up, but in extending it, it was helpful in enabling them to honor all redemptions. Those redemptions peaked when clients gave notice in November and December and then funded 90 days later or so, so since then there's been a definite reduction and more of a stability.

Talking with Isaac Swade, I think the issue is going to be less withdrawal and more about sales generation which they're encourage by but there's not doubt the market has taken a significant different character to it.

Relative to distribution, Permal's strong partnership with Merrill has always been on the international side which is not nearly as affected as the U.S. side with the change with Bank of America, and at the same time, Permal has diversified. Probably one of the greatest achievements they've done since they joined us was diversify their distribution into literally all of the major distributors with international presence and to some extent U.S. they've got meaningful business with.

And I think they would say they deepened that partnership through the way they conducted themselves in this process. Performance has been strong. Client service which is always strong has been stronger.

Operator

Your next question comes from Roger Smith – Fox-Pitt Kelton.

Roger Smith – Fox-Pitt Kelton

I want to go back to the Western business again and make sure I'm understanding things correctly. It sounds like what you're saying is that the gross sales levels have been consistent over the last few quarters with the discussion you just gave around the pipeline which then leads me to believe that really the redemption levels have ticked up both in the last quarter and in this quarter.

What I really want to understand is what are the clients that are leaving really talking about and do you have a chance to understand from them why after all of this time of staying with Western, they're looking to leave. Is there any specific performance metric that they focus on? And in terms of getting the new inflows or improvements there, what kind of metrics are people looking at? You say the performance is improving in March and April. Is that too short of a time frame to really get that ticking up, or how can we think about that?

Mark Fetting

Clearly the performance metrics people tend to look at would be over longer term periods, particularly three, five year periods of time. We only mentioned the shorter term time periods because given our bias towards the spread product markets and those market improving, one of the questions that people would have would be would Western see an increase in performance if these markets rebound, and we have quite handily. So we're hopeful that we can continue to move in that direction.

In terms of our cash flows, when you look at calendar year 2008 and the first quarter of this year, pretty consistent. I think when you look at last year, the calendar year 2008 about 17% of the change in AUM was due to lost accounts on a net basis, and the balance was due to cash flows from existing clients, market depreciation, about 50/50 of that remaining 83%.

You look at the first quarter of this year and about 15% of the change was due to lost accounts on a net basis. About 7% from market depreciation, about 15% is due to FX with the strengthening dollar and the balance which is about 60% to 63% from cash flows from existing clients.

So by and large the bulk of the change in our AUM has really been cash flows from existing clients. A lot of that was due to some real big moves in the money fund business with one client in particular last year, but also you had a real rebalancing initiative on the place of institutional investors in particular, particularly in the fourth quarter last year as the equity markets fell. There was a need for those institutional investors to rebalance their portfolios to keep their equity targets.

So we saw a lot of money moving out of fixed income into the equity markets and we certainly were hit quite hard by that. So most of the reason that we've been given in terms of the rebalancing either people are closing accounts to fund that reallocation of equities or they're closing accounts or taking money away to meet benefit payments.

And as I mentioned earlier, when you look at the business that we've lose, the area of our product line that has been hit the hardest has been in that product that we refer to as limited duration which again would be enhanced cash, duration of about one year, Merrill Lynch one to three portfolios and then other products where we replicate indices, typically equity indices but also commodity indexes.

We managed the underlying cash on an enhanced cash basis so given most managers who play in this space, propensity to invest in the mortgage backed, asset backed sector, that sector has been hit quite hard and across the board, not just as Western Asset, you've seen a whole reevaluation of that space and that will continue as Western and at other firms.

Roger Smith – Fox-Pitt Kelton

On the cash balances, I guess it sounds like you'll have about $1.1 billion of free cash. I'm assuming that you're talking about that once you get the tax refunds in the July time frame. And I guess at that point in time can you sort of let us know what might be your priorities for the use of that cash at that period of time? Meaning would you be willing to reinstate the dividend? Is it really that you would like to get debt payments down? Is the potential for stock buy backs, acquisitions that type of thing? What would be your priorities?

Mark Fetting

I think you're accurate on the $1.1 billion and we are assuming that's after the receipt of this approximately $500 million to $600 million tax refund. So with that $1.1 billion, we have to acknowledge that we are still in what people are calling the great recession and therefore while the markets seems to be improving a bit, the fundamental economics continue to be quite daunting.

Hence we believe it's prudent first and foremost just to have that as a buffer of optionality. Secondly, we will continue to invest in our existing affiliates, several of which have very strong ideas which they could grow share in their space as we go forward. We continue to monitor the acquisition piece, but our near term thinking is going back to my comment on the environment, there's some very interesting lists out kind of bull pen opportunities that are out there.

And then of course we will continue to work with the Board and see if beyond that as we get more stability we look at other things for shareholders including dividends, repurchase, etc.

Operator

Your next question comes from Jeffrey Hopson – Stifel Nicolaus.

Jeffrey Hopson – Stifel Nicolaus

A question in the fixed income area, there's some suggestion by consultants that the whole fixed income area is starting to broaden out in terms of categories away from core and core plus and maybe a movement away from the big three. Can you comment on that at all?

Mark Fetting

In terms of the product line broadening out I think that's been taking place for many years and will continue. The markets are dynamic and investor needs are continually changing and I think you look at our product line as an indication. Getting back to when I started, we had three basic products and today we have over 100. So I do think that will continue and clients certainly are looking for more customized sorts of solutions and I think that will continue which I think puts pressure on mangers to operate a business that again makes it more challenging from the efficiency perspective.

To that end, I think to do that, you need to have a serious amount of resources to operate and offer those sorts of solutions. So while there's some great firms out there, smaller firms that are competing now with the big three, I think the big three are still in a very strong position to compete given the resources that they have available to them and will make them very tough competitors moving forward.

Jeffrey Hopson – Stifel Nicolaus

What are the signs you're seeing initially as pension funds around the world start putting capital to work? Is it pretty much an entity by entity situation as far as whether they are going fixed income or equities or are there any broad messages at this point?

Mark Fetting

It's really been, I've travelled throughout the entire globe, all our offices around the world in the last four or five months and it really seems that there's been a bifurcation of people's risk appetites. We've had some clients that have been talking about moving to more tightly controlled portfolios, index like.

We have several clients who have been talking about taking more risk given the valuations and the opportunities in the credit markets, but to be fair, I think there's been a lot more said than done to date although we are starting to see money move off the sidelines as I mentioned before, a large non U.S. client putting $.5 billion to $1 billion in the credit space.

The other thing that we've seen which has been somewhat interesting, we saw this pick up in the fourth quarter that sort of rebalancing that many institutional clients were in was that people were reevaluating whether or not they should take money out of fixed income markets and put them back into the equity markets, and some clients and some consultants were recommending to clients that they take out that money that was supposed to go back into the equity market and put it in the credit space.

This would be investment grade corporates, bank loans or high yield; they thought offered a similar source of opportunity, but certainly a different place in the capital structure. So that was somewhat interesting and we've not quite seen that before.

To build on the bifurcated aspect, I think from our equity mangers standpoint, we had a very, the team from Capital Management went over in the Middle East and met with our major clients there and a year ago the discussion was very centered around performance and candidly the disappointment of that, and yet this time it was about how do you see things?

And I think there is this kind of pondering of what the right way to go and acknowledgement that at some point, you're going to want to step in and take some risk and you're going to want to do it with prudent managers on that side.

Operator

Your next question comes from Robert Lee – Keefe, Bruyette & Woods.

Robert Lee – Keefe, Bruyette & Woods

On your core earnings number, two questions to that. Is there any reason we shouldn't be thinking that on a cash EPS basis your earnings are actually closer to $0.46 if we just go through the normal add backs? And the second part of that would be given the change in accounting for converts which I assume creates, you have to capture some non cash interest expense, are you going to change your definition of cash earnings?

Mark Fetting

I'll give that to C.J. It's absolutely appropriate to emphasize cash earnings with our model as you know since we've been working on the convert piece as well.

Charles Daley

Were you just on the cash income, were you just adding back the net realized sale of SIV securities?

Robert Lee – Keefe, Bruyette & Woods

No. All I really do is take the core EPS of $0.15 and add back the intangible amortization and the deferred tax related to that. The $0.25 I guess is like $0.10 or $0.11 or something, whatever you have.

Charles Daley

That is one way to look at it. It's not a GAAP measure but that's one way to look at it. With respect to the second point on your question, we certainly do believe that we should focus on cash income and I think this accounting change which when we issued the convertible debentures, we were aware; we'll emphasize the fact that we ought to be focusing on cash income.

Robert Lee – Keefe, Bruyette & Woods

Maybe it's too early to tell but as Smith Barney goes through its merger into the Morgan Stanley Wealth Management business, can you update us a little bit on how you see that affecting you number one. Do you have to kind of go, any sense that you're going to have to go through any kind of re-approval process to stay on their Morgan Stanley separate account platform? The second thing is I think you had mentioned maybe on a prior call, resigning sub advisor agreement with some money funds for Smith Barney. Can you update us on that?

Mark Fetting

First off, as you point out the Smith Barney relationship that we have is very strong. It turns out that the Morgan Stanley relationship is the second oldest with the legacy business and hence our wholesalers etc. are well positioned in both systems.

Specifically as the senior team led by James Gorman and Charlie Johnston have made appointments, we are encouraged that essentially the product team coming out of Smith Barney has been declared, the group wide product team and it looks like their research analysts would be the ones that would make the decisions going forward and we've had a good relationship there across the board.

I don't want to having said that, underestimate everyone as you can imagine wanting to get their oar in the water with this very strong distribution partner and we've been spending considerable time on that.

Relative to the money fund, it's just too soon to tell. We have some discussions under way. It's really a function of making sure from their standpoint that they get all of the higher priorities nailed down and then we're working on that as kind of a next year issue with them.

Robert Lee – Keefe, Bruyette & Woods

You mentioned that you have a lot of the lost clients or offloads were related to products at the short end of the curve and that's obviously the very short end of the curve as we had the biggest problems with SIV exposure. Is there in your mind a connection between the two and do you think the resolution of the SIV problem will help that or maybe talk about what kind of changes you made to eliminate that problem going forward?

James Hirschmann

The company I spoke of is managed out of Pasadena which is separate and distinct from our effort in New York which focuses purely on the money funds and certainly the SIV issue did impact our money fund business, but I would tell you that over the period on average, our business there actually grew.

We do think and are hopeful that with the funds being SIV free now it will enable us to have a more aggressive marketing campaign moving forward, but I wouldn't say at all that that issue impacted the challenges we've had in our limited duration area that's managed out of Pasadena.

Operator

Your next question comes from [Keith Walsh – Citi]

[Keith Walsh – Citi]

First question is around flows. Just looking at the numbers it looks like they were pretty much the worst in the group in the quarter despite performance that was in line with the group especially on the equity side. How much of this do you attribute to outflows at I believe you said earlier in the call the city separate managed account business, and if you could put some numbers behind that and how much would you attribute to headline risk around the company still?

Mark Fetting

I think relative to flows you're hitting a good issue and you're also kind of reinforcing my challenge to our distribution teams that while we've had some periods of underperformance now we're actually getting some period of performance, it's time for us to kick in and deliver.

And in that regard, I do think you typically see a lag. And that lag has to be factored in and that's what we're seeing a bit as we try to give you this early insight on April. We've clearly continued to have outflows but the big numbers were things that have been baked in a couple of months before from some institutional allocations.

So I think that should be an encouraging thing. The more the markets continue to come back toward promoting risk, that's an equity or credit, the more we should be performing well. The more we perform well, the more I believe we have a team that can deliver share gains offsetting the ones that we've lost over the last couple of years.

Operator

Your next question comes from Craig Seigenthaler – Credit Suisse.

Craig Seigenthaler – Credit Suisse

Just strategically speaking, maybe Mark and C.J. can provide some of the reasons around making the decision to cut the dividend payout. I kind of view capital levels as much stronger now and to delay to fund that expense is stronger now than it was a year ago so I'm just wondering why the lag and why now?

Mark Fetting

I think the lag is really one of as we got through the SIV situation, we could then look with more clarity about what our earnings capacity is now and equate that to what has been a historic connection, and I think just good fiscal discipline brings that back.

In addition, in this environment, we'd kind of like to be more conservative than not just because of the uncertainty in the markets not necessarily any uncertainty that we have in our shop right now. And so the thinking was that we were candidly going to have to take a significant decline, why not kind of do it right and have a better expectation going forward? That was certainly reflective in the Board's discussion.

Craig Seigenthaler – Credit Suisse

I understand all those details, but I thought those details could still be used in that argument maybe a year ago and I thought the comments were even more constructive now versus where they were a year ago with your large cash bump up especially from the IRS payment.

Mark Fetting

Remember how we deploy capital. We deploy capital with a priority around a strong balance sheet and I think in the midst of this severity, here again the economic fundamentals are more severe. The market may be that leading indicator and it may or may not be a bear market bounce or whatever, but we want to be solid across the board and preserving this cash for that I think is actually the right thing for the long term interest of the shareholders.

It could be if we were pleasantly surprised that we have an opportunity to revisit and take a look at other ways we could bring the capital back to the shareholders.

Craig Seigenthaler – Credit Suisse

I had one question on your expenses. I'm still a little confused with the occupancy expenses because it used to trend in the low 70's and I think you got it down on the last conference call to the mid 30's but we had that one time expense which kind of bumped it up to the 70's. I think C.J.; you said it was actually going to grow over the next two quarters. Is that from the low 70 level now or is that actually from the mid 30 levels where you had it before and will it actually ever get back down to the mid 30's?

Charles Daley

If you look on Slide 14, you'll actually see that the December quarter after adjusting for lease impairment charges was 35. This quarter it's 33. So from the 33 it should grow because of our relocations of our Baltimore office, but in total expense wise, it will be offset in some other line by some additional costs.

Mark Fetting

I think C.J. was property being kind of full disclosure in the sense that he's anticipating that when we shift buildings here in Baltimore, there will be a modest increase that on a net basis is certainly going to keep us in that 30 range.

Craig Seigenthaler – Credit Suisse

But the point is it's going to be in the 30 range. It won't be in the 70 range.

Charles Daley

Right. There are lease impairment charges in both quarters.

Operator

Your next question comes from Marc Irizarry – Goldman Sachs.

Marc Irizarry – Goldman Sachs

A couple of questions around the revenue shares. Can you talk about how big the subsidies were and which affiliates and also does the operating leverage flex back in those revenue shares if the market comes back? And also on the revenue share if you think about the tension between different affiliates when you're going through those decisions, does that factor into changing revenue shares more broadly?

Mark Fetting

C.J. can give you a little more detail but let me frame it if I can. Clearbridge is as I think everyone knows, not a revenue share entity and as revenues decline because of the market decline, really more so even than the outflows, we had long intended to protect a certain level relative to the investment team there.

PCM we've talked before that we made some adjustments there, and then in Capital Management, we really didn't change anything just because of the level of AUM decline. We reverted as was previously in place before we had grown, and in that regard, adhered to what was the historic pattern.

The bottom line which you should know, C.J. can give you.

Charles Daley

For the quarter which is really a fiscal year catch up because it was really for the entire year was about $14 million. There is always, as revenue grow, there's always opportunity to restore those levels and we've done this in the past with affiliates during periods of difficulties and in the long term it works out well for us to keep those investment teams in place and to be able to work through these difficult times.

Marc Irizarry – Goldman Sachs

What percent of the mix is high net worth Europe?

Charles Daley

The vast majority. The institutional business that they're pursuing. In the U.S. they've had some recent wins over the last year or so and the one change in that high net worth that is shifting is in serving predominantly high net worth customer base or client base, they are doing where appropriate more on a separate account approach than in the co-mingled fund approach. That is actually a shift that's going on in the industry that should favor Permal because of it's access to the key mangers.

Marc Irizarry – Goldman Sachs

For Permal, when do redemptions for the first quarter post in the AUM? Is that as of the end of March we see first quarter redemptions or is that something that comes out in the April AUM?

Mark Fetting

What you see in the numbers we're reporting right now takes you through settlements in March but that window actually was done in December. So it will be in the next quarter that you see the real reduction that's been baked in and we know it, but it's not in the numbers yet.

We anticipate at the moment that it's somewhere in the approximately $2.5 billion range which is well below the prior period.

Operator

Your next question comes from Cynthia Mayer – Bank of America.

Cynthia Mayer – Bank of America

In terms of the additional $25 million in expense reductions, can you let us know what those are from and are they going to show up gradually? I think you mentioned September. Should we just assume that they gradually in the course of the two quarters?

Charles Daley

A good portion, the vast majority has been head count reduction which have already been announced both in April and we'll see people transition out over the next several months. And so on a fully realized basis, you'll see the majority of that by September 39.

Cynthia Mayer – Bank of America

Circling back to the question of comp really quick, the $14 million you mentioned is that something that you would recover later and also I think in previous quarters Western gave up some comp related to the SIV issues. Should we assume that's over and they're receiving their full revenue share again?

Charles Daley

As revenues increase in these affiliates, we certainly would look to revert back to pre-existing revenue share arrangements. Historically these have been on a temporary basis.

Mark Fetting

On the Western, it's really during this quarter for the past couple of years that we've established the agreement for the then fiscal year and we're still working through that with Western. On the one hand there's definitely continued commitment to work through summer payment. At the same time, we're looking across the board at expenses they're incurring relative to their business and investment opportunities that we want to work together on. So Jim and I will work together on that over the next couple of weeks.

James Hirschmann

One of the silver linings in this otherwise dark cloud that we've all been under for the past couple of years is that there's really an incredible amount of talent available in the marketplace right now. So we are taking advantage of that. We've added investment professionals in London, New York, in Pasadena and are planning on bringing a few more on board in field offices around the globe. So we're quite excited about that.

Cynthia Mayer – Bank of America

On interest expense, you mentioned a couple of moving parts including potential downgrades. What would be the maximum interest expense you would have if those downgrades came through?

Charles Daley

A downgrade, a single notch downgrade would be a little less than $2 million, a little over $1.5 million a year.

Mark Fetting

I think that will wrap up. I'd like to close with three points. First and foremost, we are making progress and we did it this quarter by incurring significant capital losses without any external assistance and in so doing we have no, I repeat, no SIV exposure.

Secondly our shareholders deserve better returns. This quarter as the conversation that we just went through included some frustration which we understand around comp expenses and certain things. We're going to continue to make the right judgment call around cost saving and investment building.

The one thing I can commit to incrementally is that I will work with Allen and Barry to communicate more with our investors in a way that kind of removes some of those gaps and expectations versus delivery.

And finally, we believe strongly that while we have a significant challenge on a number of fronts we have a hell of an opportunity and the combination of investment excellence, world class distribution and superb service that that Legg Mason can uniquely deliver is the combination that we are in intent on delivering.

I want to thank our affiliates and my colleagues across Legg Mason and thank you all for your interest today.

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