Legg Mason: Earnings Good at First Glance, Ugly After That

On Monday, 7/20/2009, Legg Mason reported +$.35/share earnings versus an expectation of +$.22/share. LM also beat on revenue slightly with $613.1M versus and expected $612.34M. This seems good at first glance. However, when you look further things don’t seem so rosy.

First the revenue slumped 42% year over year. Operating margin slumped from 21.7% to 9.5%, although pre-tax profit margin increased to 13.2% from a loss in the previous quarter. Investors pulled a net of $34B from the company this quarter. Plus Fitch last week cut LM’s credit rating on its senior debt from A- to BBB+. It is getting closer to junk status.

Legg Mason’s assets under management were up 4% during the quarter to $656.9B from $632.4B on Mar. 31, 2009. Still net outflows were $34B. The average AUM (assets under management) was $647.2B in Q1 2010 (Apr-Jun) versus an average AUM of $657.4B in Q4 of 2009 (Jan-Mar 2009). This does not bode well for the future, especially given that the S&P500 gained almost 18% during the quarter. Next to that, the 9% market appreciation claimed by LM seems poor. Still they claim most of their mutual funds were rated four or five stars.

Overall, the performance was questionable at best. There were substantial net outflows of AUM of $34B (i.e. LM is losing customers). The Operating Margin is still too low. The general downtrend of the company has not been corrected. The AUM were 29% lower year over year. However, they were still lower on average this quarter versus last quarter, even though there was huge appreciation in the markets this quarter. LM has a non-existent P/E. It has an FPE of 19+. Its prospects are uncertain at best. They may be dismal at worst. Even GS has an FPE of only 15+, and its prospects are great. This stock is still a sell. It definitely does not deserve to sell at a premium to GS.

Disclosure: I took a small short position in LM Monday.

Comments

[Broker2:]

Unreasonable to expect that LM's investment return will track the S&P 500 since the bulk of assets it manages are fixed income.

Jul 21 10:06 AM

[Ishortyou:]

I would probably be better of covering my short..

Jul 21 11:48 AM

[David White:]

Ishortyou: If GS is not skyrocketing, you might want to stay in your short a little longer. LM is trading at approx. a 100%+ premium to GS. GS has the better reputation and the better prospects. The GS FPE is actually 9.8 (I had corrected this in an instablog comment). The GS PEG is 0.82. The LM PEG is 3.56 (yahoo finance).The LM FPE is 20.07.

GS should be trading at a premium to LM not the other way around. The current bank rally will likely only go on for a short time. Some think it only exists at all right now because of the relaxed mark to market rules. Both BAC and C only showed profits by realizing huge capital gains for the quarter. Once the bank euphoria ends, people will take a harder look at the fundamentals of each bank (or investment bank). LM should certainly be trading an no more than even value to GS. That means one or both of them have to give. The estimates for growth that I have seen on GS for the rest of this year are relatively modest (1 yr target price = $173.50 and current price = $157.91). LM is already trading above its target price. It is trading at a huge premium to the leader of its industry. Reality will almost certainly set in soon. If the market heads downward, reality will make itself known more quickly.

Jul 21 02:55 PM

[David White:]

Broker2: Good comment. However, that same reasoning may explain why they are losing customers. They did track the SPY on the way up, but they lost a lot of value on the way down. LM sold the last of its SIV's (Structured Investment Vehicles) for 25 cents on the dollar in March. That is hardly what I would call a decent return from what is supposed to be a safe investment.

Jul 21 03:01 PM

[Tack:]

I'll offer a rebuttal:

LM was decimated in the downswing, as were most fund managers with names other than Goldman Sachs. Perhaps, their negative performance was amplified because Bill Miller made some huge value bets that proved way too soon and lost big money. Lastly, LM was not an adept player in derivatives, being, at least in my view, a more conventional "investment manager," in the classical sense.

But, where are we now?

The market is returning to more normal behavior. As market and economic behavior return more to normalcy, classical investment managers will make amplified management gains that lag early on, while companies, like GS, have been making huge underwriting revenues. "Deep-value" plays are, now especially, where the action is, and that's a game at which Bill Miller, in particular, has excelled historically. In fact, his performance last quarter was near the top of all fund managers.

Cash outflows are like ocean liners. The money is still headed out, even in the early stages of recovery. No surprises there. The future will look decidedly different.

Next, the FPE analysis leads to the wrong conclusion because LM's "E" is very underestimated, with all the negativity, uncertainty and conservatism that marks the current market. In contrast, analyst-darling GS has boldly estimated earnings that, while perhaps deserved, leave little upside for major surprises. As a result, the anticipated growth rate for LM's depressed earnings is decidedly better than that expected for GS.

Lastly, LM is selling at around 20% of its three-year high, while GS is near 67% of its similar highs. Like Bill Miller, I'd be attracted to LM's still-depressed share price and better percentage-growth potential.

Jul 21 07:14 PM

[Tim Eriksen:]

I don't agree that it is an obvious short. If you use cash earnings instead of reported earnings, LM is trading around 10 to 11 times earnings.

Jul 21 10:04 PM

[David White:]

Friedman, Billings, Ramsey raised their price target on LM today to $19 from $18. Of course, the stock is trading at $26+ today. That ought to give you a clue about the likely direction of the stock. $19 is still nowhere near $26.

Jul 22 12:32 PM

[MickOlas:]

I am not a fan of LM but I think it is inaccurate to compare the company with GS. Asset management is not a capital intensive business and its ROE potential is much higher than brokers (or banks), therefore, theoretically asset managers should get a higher multiple.

By comparing GS and LM, you are also comparing a best of breed company in a different business (GS) against a company that is in a turnaround situation (LM) - so not exactly an apples to apples comparison.

Jul 23 08:48 AM

[David White:]

Amalysts are ultimately responsible for their estimates, but they are guided to a large extent by the company's estimates. If LM disagreed violently with the analysts' estimates, they would be saying so. This means the analysts' estimates are reasonable at worst.

The current analysts' estimates for 2009 EPS are $1.08. For 2010 the EPS estimate is $1.38. Yesterday's closing price was $28.75. This is a 26.6 PE for 2009 and a 20.8 PE for 2010. This is in contrast to GS's 10.3 PE for 2009 and 9.9 PE for 2010. LM is still trading at a 100% premium to GS. If anything GS is more likely to outperform its estimates. It has a history of doing that. This means that LM is even more seriously overpriced compared to GS.

The "beat" euphoria over LM's Q2 results seems to have abated today. Often this takes about a week. Now could be a good time to get into a temporary short position on LM. Logic says it should go down to being more inline with GS's PE. Since it is smaller, its results can change more easily. If you were optimistic about LM, you might allow it some premium for that. Still the analysts are expecting LM to continue to show net outflows of Assets Under Management for the next two years. This is partially due to bad recent performance, but it is also due to increased competition from ETF's. LM is not GS. It does not have GS's reputation for success. One star money manager does not make an entire company, although I am sure he helps.

LM is down today on a up day on the SPY (at least so far). This may signal the end of the Q2 results euphoria period. Now the GS to LM comparisons are likely to take LM down.

MS may be worse if anything for 2009. However, MS has a 2010 PE of less than 9. It has also just landed a lot of new business from the China Investment Corp. (essentially China's $200B sovereign-wealth fund). Blackstone was allocated $500M to manage. I am unsure what MS's exact allocation was. However, this is definitely a plus for MS.

This leaves LM trading at a 100% premium both MS and GS on a 2010 earnings basis. This bodes well for a near term short of LM. Of course, it will help if there is a tailwind from the market.

Jul 31 10:40 AM

[ozcutty:]

agree LM is still struggling. I held a significant investment in LM but lost faith in management after 5 negative quarters and conference call shpiel that didn't make sense. They had a disaster with the SIVs and had to take on a couple of billion dollars of debt to escape it. Lets face it, an asset manager should not need lots of debt.
i switched out of LM into AB, much simpler business, no debt issues or SIV's. Funnily though, since jumping to AB, they have reported better results than LM but LM has rallied much more!
It interesting that the biggest rallys have occured with the companies with the most debt and shakiest earnings, do fundamentals mean nothing to todays investors???

Aug 27 01:06 AM