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Legg Mason Inc. (NYSE:LM)

F3Q10 Earnings Call

January 21, 2010 8:30 am ET

Executives

Mark Fetting - Chairman & Chief Executive Officer

C.J. Daley - Chief Financial Officer

Alan Magleby - Director of Investor Relations & Communications

Analysts

Dan Fannon - Jefferies

Steven - Barclays Capital

William Katz - Buckingham

Robert Lee - KBW

Jeff Hopson - Stifel Nicolaus

Cynthia Mayer - Banc of America

Mike Carrier - Deutsche Bank

Marc Irizarry - Goldman Sachs

Roger Smith - Macquarie

Michael Hecht - JMP

Craig Siegenthaler - Credit Suisse

Operator

Good day, ladies and gentlemen and welcome to the Legg Mason quarterly conference call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. (Operator Instructions)

I’d now like to turn the conference to your host Mr. Alan Magleby. Please begin.

Alan Magleby

Thank you, Amy. On behalf of Legg Mason, I would like to welcome to you our conference call to discuss operating results for the fiscal 2010 third quarter ended December 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 statements.

For a discussion of these risks and uncertainties, please see risk factors and management 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, 2009, and in the company’s Quarterly Reports on Form 10-Q.

This morning’s call will include remarks from Mark Fetting, our Chairman and CEO; and Mr. C.J. Daley, our CFO who will discuss Legg Mason’s financial results. In addition following a review of the company’s quarter we will then open the call to Q-and-A.

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

Mark Fetting

Good morning and thank you all for joining us. In 2009 we issued a turnaround at Legg Mason and I’m pleased with most of our progress. Our balance sheet is much stronger. Investment performance is improved across virtually all key affiliates and our focus on distribution is paying some market share dividends.

2010 was kicked off here in Baltimore with all of our key sales teams and our investment managers comes together to start the New Year strong. We are ready to take advantage of opportunities this year, but to be clear; more progress needs to be made in restoring growth and improving margins.

As we look at the markets, we believe general trends should show a gradual move in assets from money market funds and taxable fixed income to equities and alternatives as the credit markets saw further, and as investors risk appetite increase. In the wake of the rally of the most beaten down stocks in ‘09 many of our equity managers in the U.S. see the most value and the greatest opportunity in high quality companies with strong balance sheets, steady earnings and high returns on capital.

Our team at western believes that a slow recovery in the economy will continue in the first half of 2010. Housing prices seem to have bottomed, unemployment shows signs of moderating and production is coming back online to meet demand. Continued challenges with some bank balance sheet issues and budget issues, and state and local governments continue to draw cautious, but by and large, western still fees value in the market.

The alternative sector went to a significant cleanup period last year and the remaining players are stronger. Investors have become more comfortable with the sector, as there is now more transparency and generally less leverage being applied. Permal our fund of hedge funds manager has seen more interest from high network in institutional clients with Asia being a particularly attractive opportunity.

Strategically, as I look forward for Legg Mason in our global asset management industry, I’m very encouraged. Particularly by the visits with clients, consultants and distribution partners I had over the last quarter across the globe, in Europe, in Asia, and throughout the Americas. I believe clients are all about more scrutiny, more do diligence, and increased appreciation for specialized skills for specialized mandates.

Yes, there is an important shift in passive and ETF, some of which I believe is cyclical coming out of the crisis and some is secular, which will have to follow and potentially participate in, but active remains the dominant choice and disposed well for our franchise firms.

Western scale and specialization, skill set, Royce expertise in small and micro-cap investing, Permal’s preeminence in fund of hedge funds, Legg Mason Capital Management and ClearBridge, and Large Cap U.S. Equities among other specializations and Batterymarch and Brandywine.

So with that as a backdrop, let’s turn to the financial highlights and to the deck that we distributed this morning. I’ll start with page two. As you can see, revenues were up 5% over last quarter to $690 million, primarily due to higher performance fees at Western and Permal, higher average assets under management and a greater percentage of equity assets in our mix.

Operating income, as adjusted was $92 million. As higher revenues were more than offset by the previously disclosed $28 million real estate lease charge for our subleasing efforts. Our operating margin as adjusted this quarter was 17.9%. The impact of the real estate lease charge on the operating margin as adjusted was 5.5%.

So excluding the effect of the accelerated charge for subleasing, all of our excess space in our headquarters, operating margin would have been up a couple of percentage points. Net income was almost $45 million or $0.28 a share, which includes $0.11 for the real estate. Cash income on an adjusted basis was $93 million, or $0.57 per diluted share. EBITDA, as adjusted was $165 million, up 20% from the prior quarter level.

Let’s take a look at assets under management as we turn to slide three. Here, as you can see and as we discussed early in December, there’s a pickup in outflows. Assets under management were $682 billion, down from the $703 billion in September. Driven by the higher outflows and partially offset by market appreciation. Equity assets are a higher percentage of the total mix at 25%. This is the highest level since September quarter of ‘08. Average AUM was up from the third quarter as compared with the previous, just over 1%.

Let’s turn to slide four, and the key issue of net flows. As we reported and discussed earlier, there was an up tick in the December quarter, driven by year end reallocation decisions made by investors. Some took advantage of the strong performance rebound across several of our affiliates to make changes.

Fixed income outflows for the quarter were approximately $24 billion, equity increased to $4 billion, and liquidity was $5 billion out. You will recall that last quarter, we had positive liquidity flows of $4 billion in a quarter where the industry had record outflows. This quarter, we were slightly better than the industry outflow trend.

In the fixed income area, some investors who earlier in the year had been assessing the risk they had in their fixed income portfolios did take advantage of a sharply stronger performance in the calendar year and made a change. In addition, Western experiences a fair amount of seasonality in the December quarter and as we’ve mentioned before, investors are moving out of the enhanced cash area in particular.

To be clear and specific, there’s a single client representing about $5 billion of that outflow in the enhanced cash area, something that we had been expecting for sometime, and that area which was over $20 billion just a bit more than a year ago is now down to $3 billion, and this is consistent with the industry experience across the board.

If you kind of acknowledge the enhanced cash situation and look at other areas, you see really individual assets allocation decisions across the globe. There was a bit of moving out of limited duration portfolios, particularly those that use spread products that were part of the process, but overall what we see is really, clearly some issues that we’ve been talking about and the expectation of some lumpiness, but at the same time, as we will discuss some good activity on the upbeat.

So let’s turn if we can to our affiliates. A reminder, this is on slide five, as we’ve done in the past, we’re listing the affiliates in the order of their contribution to earnings. So let’s focus on Western first, our largest manager, with $481 billion under management. We do see the outflows continuing to be an issue, but we do think that this quarter, because of the seasonality and some of the specific client situations may not be projectable.

Important to Western, returning to net inflows will be continued strong performance and the continued decrease of volatility in the fixed income markets. We do see an up tick in RFP activity and while there’s always a lag between activity and flows, that is encouraging. We absolutely see continued interest in the Brazilian, Australian, Pan Asian local occurrence products, their emerging market debt products, their global credit products and global TIPs.

Most importantly, clients are pleased with have the additions to the investment and risk management teams have taken place, and Western believes the changes they’ve made in their investment process are working well, and as we discussed, their performance has been strong this year.

Let’s go to Permal, where assets were slightly lower at almost $18 billion. Performance at Permal is strong across the board, with 75% of their assets subject to performance fees above their high-water mark. Permal is one of the industry players poised to serve the growing separate account market in the alternative space. Legg Mason is providing Permal with an increased level of back office support, representing a good example of how our affiliates can leverage our corporate infrastructure.

Next is ClearBridge, our largest equity affiliate who saw assets increase to $53.5 billion. ClearBridge has seen some initial interest in the strategies with family and high net worth offices and are embarking on a comprehensive road show with our wholesalers to the independent advisor channel this quarter, as they continue to see greater penetration in new channels.

In December, ClearBridge was selected by Pax World and Morningstar as a sub advisor across four asset classes in their new socially responsible offerings. Assets at Royce grew to just over $30 billion. They continue to see inflows this quarter, amid continued strong performance across the complex.

Brandywine assets were about $29 billion, with modest outflows for the quarter. Fixed income performance here rebounded nicely, and their flagship global fixed income investment grade product is ahead of its benchmark, over the one, three, five, and 10 year periods.

We continue to work with Brandywine to source new opportunities through our sales team. One institutional mandate for the large cap value equity products funded in the quarter and another one in the quarter funded last week, both of these totaling over $300 million. Brandywine is also seeking client wins in Japan, working with the LM Japan office.

Batterymarch was essentially flat at $20 million. Batterymarch’s global emerging market product is seen strong relative performance in the second half of ‘09, as the markets had moved from a rally in the most beaten down stocks to higher quality names. Interest in the product is building among consultants.

Finally, Legg Mason Capital Management assets were up slightly, to about $17 billion with continued strong performance. Four of their six mutual funds had top des aisle performance for the year and all six were top quartile according to Lipper. Legg Mason Capital Management had modest inflows into their offshore funds and important, some outflow in the U.S. funds and institutional clients are inviting them back into RFPs.

If we shift to slide six, we’ll focus on long term performance. You can see clearly the progress we have made this year with regard to performance and how that is playing into our longer term numbers. Over two-thirds of our long term fund assets are beating their benchmark over the one, three, five and 10 year periods.

You go to slide seven; you can look at a breakout between equity and fixed income. For the equity, the performance has picked up in the one year, but especially in the three and five year. On fixed income, it is even more impressive with the fixed income funds in the top quartile for the one year period. The funds are also beating the Lipper averages in the one, three, five and 10 year periods, up from extremely low levels in those same periods a year ago.

Let’s shift it if we can to distribution. Slide eight, you can see that net sales in our Americas distribution group shows improvement over a year ago period, although we did see a reversal inflow trends this quarter. As sub advisory accounts particularly variable annuity clients made some decisions to shift to other asset classes.

Gross sales, one measure of measuring our performance are up sharply in America’s distribution. Retail fund sales against the prior year are strong and it’s actually at an all time high in the very important independent advisor channel. Institutional sales were up over 40% as compared with the year ago period and as I mentioned previously, we’re seeing some share gains in certain categories of funds, muni and equity in particular.

We raised our third closed end fund with Western this quarter, raising $316 million in the global corporate fund. This was our largest closed end fund offering during ‘09, where we had several strong product introductions. The retirement channel is going to be an important market for us.

We will tap into our affiliate expertise and add to our existing income and dividend generating products. We are launching an inflation aware tactical asset allocation program in February, designed to be not highly correlated to the broader markets and we think it will be very attractive for retirement portfolio.

On slide nine, we focus on international distribution, which showed continued improvement compared with the same period a year ago and is positive for the fiscal year. This was the best quarter in the last five of our international distribution group led by Japan, where Legg Mason has been established the longest.

We also saw net positive flows in Europe, the Americas and Asia this quarter. The majority of flows outside of the U.S. continue to be centered on fixed income and Western. The bulk of our net inflows on the equity side are going into Royce, Legg Mason Capital Management, and Congruix, our Asian Equity Manager. We launched the Legg Mason Permal global absolute fund in October, and subsequently registered it in Europe and Asia.

So now I’ll give it to C.J., to cover the financial issues. C.J.

C.J. Daley

Thanks, Mark and good morning, everyone. As Mark indicated, we’re continuing to see improved trends in investment performance, which resulted in higher revenues this quarter primarily for performance fees; so in December, revenues grew 5% from the September quarter, as a result of higher average AUMs and as I mentioned a substantial pickup in performance fees.

On the expense side, we record the entire sublease charge for our headquarters of $28 million that we announced on the call last quarter. Although, we did expect that the charges would come in over several quarters we were able to complete all of the sublease transactions this quarter, so we took the entire $28 million charge that we had highlighted last quarter. That charge reduced our reported diluted earnings by $28 million or $0.11 per share.

In addition, subsequent to the end of the quarter as anticipated after the net operating loss tax law change to allow us to put tax losses back five years instead of three, and receive the tax refund in early January, of $459 million, which increased our total cash position to $1.9 billion and our excess cash to $1.5 billion.

With that excess cash, we announced today that we paid down $550 million term loan, which was scheduled to mature in October of 2010 this year. The reduction of the outstanding debt will lower our annual interest expense by approximately $15 million or $0.06 per share.

Let’s move on to the investor deck, on slide 10, our GAAP earnings per share were $0.28 per share or $45 million, and that includes the $28 million in real estate lease loss charges that we took. Cash income as adjusted was $0.57 per share or $93 million and also reflects the impact of the lease losses. Cash income was higher this quarter, but on a per share basis was slightly lower due to a higher share count this quarter related to the equity unit exchanges that we completed in August.

Our operating margin, as adjusted, was 18%, down from 21% last quarter. The lease charge impact on the operating margin was 5.5 percentage points. The margin improvement including lease loss was the result of higher revenues, particularly performance fees, with relatively flat operating expenses. Operating revenues for the quarter were $690.5 million, an increase of 5%, primarily due to the higher performance fees in western and Permal and as well as higher average assets under management in the quarter.

As we discussed in last quarter’s call, we continue to see modest increases in fee waivers, required in our money fund business, and we expect this to continue into the next several quarters. For modeling, our expectation is that any increase in waivers for the next quarter would be only a few million dollars gross or less than a penny a share.

Moving on to slide 11, we breakout our operating expenses, were up 5% with the entire increase, as you can see, driven by the lease charge. Excluding that item, total expenses were essentially flat compared to the prior quarter. Comp and benefit expenses were $288 million, in both of September and December quarter, while the increase in distribution and servicing expense was the result of successful global fixed income closed end fund launches this quarter and the related expenses of about $4.3 million.

Occupancy expense increase was driven by the real estate charge related to our headquarters building. The finalization of the subleasing of our headquarters vacant space, we have now either reserve or sublet all our excess space. Strategically we have removed aggressively on reserving and subletting our excess space and as a result beginning next year because of our headquarters sublease completion, our occupancy cost will be down approximately 800,000 per quarter or $3.2 million per year.

This is in addition to savings of 300,000 we achieve this quarter as we realized a partial quarter of the headquarters sublease benefits. All the remaining expense categories showed an improvement over the sequential quarter due to our continued focus on cost maintenance and discipline.

On slide 12, we highlighted our compensation and benefits expenses, expressed as percentage of net revenues, which our operating revenues less our distribution and servicing expenses to third parties. Our compensation ratio of 53% is slightly lower than last quarter’s level, due to higher revenues and our cost discipline. With the current revenue mix and the affiliates focus on non-comp costs we continue to expect a compensation ratio to fluctuate and around the current levels.

The compensation and benefits cost adjusted for the mark-to-market fluctuations increased 5% and is inline with our expectations given the revenue growth we experienced. We had some additional severance expenses this quarter, due to the ongoing review of our support functions and inline with our strategic priority, to continually focus on costs and improve our operating margins.

Slide 13 highlights the improvements we have made in our operating margin since our low point in the March of ‘09 quarter. Our margin this quarter was 18%, on a GAAP basis, but includes $28 million charge for the lease loss, which reduced our operating margin by 5.5 percentage points.

As Mark as stated, a strategic priority of ours is to return our margins to levels we experienced in prior years. One of our primary strategic priorities has been to improve our balance sheet and as you can see on slide 14, we have a pro forma representation of our balance sheet after the effect of the tax refund and debt repayment and we have decreased our debt levels dramatically over the past 12 months, while increasing stockholder’s equity.

So, on a pro forma basis, cash and cash equivalents which reflect the net impact of the tax refund as well as the $550 million debt reduction is $1.4 billion. We have also approximately $1 billion of excess cash that is available for strategic priorities and growth initiatives.

Page 15 updates you on our bank covenant on a pro forma basis and you will see that the reduction of debt has meaningfully improved our ratios. Our gross leverage ratio falls to 2.7 times or 3.7 times and net leverage improves to 1.2 times from 2.1 times and our interest coverage jumped to 11.2 times. So we are clearly pleased with the progress we’ve made in improving our balance sheet strength over the past six month, continuing to generate strong cash earnings that will bolster our cash position and provide us with continued financial flexibility.

With that, I will turn it back to Mark for closing comments.

Mark Fetting

Thanks, C.J. and before I open up to questions, as we’ve done in the past, just summarize our progress against our five key initiatives. In terms of balance sheet, C.J. really has covered it. We think we’ve made very strong progress paying off the term loan, applying the tax refund as part of that process, and still emerging with approximately $1 billion of excess cash to reinvest in our business. Our debt to capital ratio is now 20%.

Second, priority managing our costs, we’re going to continue to expand our focus on costs and efficiencies while we pursue growth initiatives. With revenues expanding our operating margin, excluding the lease charge, continues to improve. Third, in gauging with the affiliates on performance, risk management and other strategic initiatives, the performance has improved strongly over the year.

Our Americas and international distribution teams are working more closely with the affiliate, and I think it is a key challenge this year in particular to show some real leverage in terms of helping it shift into inflows. Clearly, this is a long term initiative in the sense that it takes time for affiliates to demonstrate to their clients the resilience of their investments story, but we can expedite that process by working more closely together. We are also working with our affiliates on other ways to enhance their overall franchise.

Fourth, quarter in terms of basic distribution focus and product innovation, you can see net sales improving. In our domestic business over year-over-year and our international long term story has been very strong in terms of long term funds year-over-year being strongly positive.

As it relates to our fifth initiative of looking tactically, it lift out and bolt-on opportunities, we have been busy this quarter and close to a couple of deal, but we did not conclude any, basically on price discipline and fit, and we’ll continue to apply those disciplines going forward.

With that, I’d like to open it up for questions. Both C.J. and I look forward to responding.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Dan Fannon - Jefferies.

Dan Fannon - Jefferies

I’d like to focus on Western here. Given the factors that you highlighted that drove the pickup in outflows. I mean how much of that should we think of should condition into 2010 or was seasonal? Just trying to get a sense of what you guys see in your backlog? What you’re seeing to start 2010 and really what we should think about in terms of the flows as we think about the first quarter here or the March quarter?

Mark Fetting

Obviously, that’s perhaps the key issue of the story this quarter, and we work closely with Jim Hirschmann and the team at Western. What we try to be is really fact based. There’s definitely been seasonality experience. We actually went back and tracked this over the last four years at Western, so there’s an element of that.

Number two is the enhanced cash story, is one that has been industry wide coming out of the crisis and there, we’ve taken something that was $20 billion, down to $3 billion and this last big slug from the one client has happened. So there’s mathematically less there to contribute to outflows.

Beyond that, it’s really kind of candidly pluses and minuses, blocking and tackling against Western, which I think has done a superb job over the last quarter in particular, getting in front of clients, reaffirming mandates that they have, making them aware of capabilities, particularly in this more specialized trend that I see, and Jim and his team sees with clients that Western can deliver on that.

Here, the pluses are meaningful. The global credit, assets that have been raised globally, the currency business that we’ve done in number of different markets. Utilizing currency from other depth I think is actually a very good development, and then the global tips area.

On the other side, you can see some things that I think are cutting across. We manage the largest bond fund in Japan and there, there has just been a shift away. It’s a global sovereign fun and the shift away from that into some other areas, some of which we’re competing for. So I think that’s it.

The two key things, the seasonality and the enhanced cash are mathematically the contributors. We don’t see that continuing and beyond that, I know its Western’s belief that they look forward to kind of removing the remaining outflows and moving in inflows over the next couple of quarters.

Dan Fannon - Jefferies

Then I guess can you talk also about the gate keepers, the consultants? It seems you mentioned a couple of times on the call that you guys are getting into more kind of bakeoffs or into more presentations, is that accelerating? I’m trying to get a sense of kind of…?

Mark Fetting

I think clearly with the RFP activity picking up, and as I had mentioned in the last call, the trend line is verifiably positive for Western, in terms of moving from being kind of put on the bench to actually being invited into some RFP’s in areas where they weren’t eligible in the past and I’ll tell you, there are two key issues going on there.

One is, the investment team being bolstered with some significant additions in both the London area, and the Pasadena area, and the risk management process being refined and some key talent added; and consultants have been particularly appreciative of that.

Operator

Your next question comes from Steven - Barclays Capital.

Steven - Barclays Capital

I was wondering if you can talk about the utilization rates with higher equities as a percentage of AUM. How we would expect the realization rate perhaps to increase a bit. Can you talk about underlying factors here?

Mark Fetting

The realization rate has moved up slightly, but not meaningfully, especially since over the last quarter. So as that percentage continues to improve, we’ll see movement in that, but to-date it just hasn’t been meaningful just mathematically.

Steven - Barclays Capital

Can you talk about any underlying reasons for that? Or is it just math?

Mark Fetting

It really is just math. I mean, we’ve seen increases at our equity affiliates, but you’re talking 50 basis points versus 20, it just hasn’t been enough to move the dial yet. I think to the extent that you see across the board, our equity managers do, I think the key will be a pickup of A, in just market appreciation, B, getting us into inflows, and then that mix being meaningful. I think it’s not unusual for that to take some time, as that shift occurs particularly with the dominance of fixed income that we’ve had, but the trend line is good.

C.J. Daley

If you think about our assets on average, you’re talking up $10 billion, which if you do the math, you can just see that it’s just not enough to move the dial.

Operator

Your next question comes from William Katz - Buckingham.

William Katz - Buckingham

Actually, one clarification and then my question, In terms of the clarification, I think you said in terms of the comp that you thought that 273 would be a flattish number. I apologize if that’s not correct. Was that an absolute number or as a percentage of net revenue?

C.J. Daley

On a GAAP basis, our expense was flat, but if you look at slide, what is it 12, on any investor deck, you will actually see that comp was up, because we had the mark-to-market adjustments, which is offset down in other income expense. So we’re actually up in comp about $12 million, which is commensurate with what we would expect given a $30 million increase in revenues.

Mark Fetting

I think the other thing Bill that you were hinting at was the expectation of things leveling was more the 53-ish range as a percent of net revenues.

William Katz - Buckingham

My bigger question is, you look at your holding company expenses, this might be a bit of a rounded number just given the quarter just transpired, was running about five, six basis points of assets under management. Just sort of wondering in prior conversations you mentioned that there is sort of a cost to support Wamco and cost to support the global distribution network.

Just curious how much more flexibility is there in that? You didn’t mention for the first time in a couple of conference calls any kind of number around annualized cost saves and I’m wondering were you sort of at the end of the opportunity from here? Or maybe quantify the opportunity from here.

Mark Fetting

Thanks for actually underscoring that issue, because this to one I’m trying to hit clearly I believe we can do more work here together well as working with the affiliates in areas where there are expenses that can overlap. We’ve made a lot of progress on that, but more progress can be done and to the extent and I think all of us in the business, while we’ve had particularly in the equity markets roughly second half of ‘09 a big pickup.

I don’t think anybody is bet in the ranch on market alone nor should you ever do that in this business so what I come into ‘10 with is a real determination around us working together, LM and the affiliates, to keep adding value in terms of some further efficiencies. We haven’t put a number on that yet, and to the extent we get to a point where we should, we will and we’ll reach out to everybody.

Operator

Your next question comes from Robert Lee - KBW.

Robert Lee - KBW

I had another question related to expenses, but Mark mentioned with Permal, working with them on some new product initiatives and what not and I’m just curious, how have you all changed how you allocate costs that you incur to the various affiliates when you work alongside of them?

My perception is that in the past, one of the issues that the holding company level may have been that you were kind of under pricing the services that you provide so to speak, lot of the affiliates, and you can make talk a little bit how what kind of changes you’ve made in that, so that as a Legg Mason shareholder, you feel like, given the revenue sharing arrangements, more of those costs are being born by the affiliates who benefit from that revenue growth.

Mark Fetting

Yes, I think it has been certainly over my tenure, a clear desire to get to essentially market based service levels and service compensation for what we do. We clearly, and if you go back to our model slide, which we don’t have this deck, but we should always have every deck to remind us, it is basically kind of affiliate investing, plus LM distribution and servicing, plus what we do in terms of capital allocation, deliver shareholder value.

We’re looking more closely with the affiliates on that distribution and that servicing piece and how we can be most efficient and effective in that and so if you just use your example on the Permal situation, we’re able to provide a service because of what we’re already doing in our fund administration area that’s advantageous for them but it is also cost effective for us, so bottom line, that should be accretive to the shareholder.

Robert Lee - KBW

If I can follow up with some questions on the money funds, just wanted to get I think there was a one of the comments was that a future fee waivers that could be less than a penny. Could you kind of bring us up to speed on what the current impact of fee waivers in the quarter just passed, and that kind of follow up to that, if I’m allowed. Can you update us on where things stand with the money fund assets you sub advice for Morgan Stanley?

C.J. Daley

Sure, I will hit the impact. The impact really is quite negligible. It is less than a couple of pennies in total, because, from the fee waiver, we share that with the third party distributor and then when you revenue share effect and tax effected, it really gets down to a negligible number, but in total, for the quarter you could be talking a penny and a half, two penny in total and so we don’t expect that to increase meaningfully in the next quarters, but we do expect it to continue.

Mark Fetting

Rob, let me pick up on the Morgan Stanley Smith Barney situation, as we talked about there, we have a very strong relationship with the leadership team there and continue to be in active engagement on a number of product interactions. They’ve made no final decisions around kind of managers that will continue and what form.

One thing to point out is the big issue here, it cuts across the industry, is the shift out of money funds, into kind of bank deposit programs and bank products, for a variety of reasons and so today, right now, just to give you kind of a fact update, we’ve got about 25 billion in retail liquidity funds with Morgan Stanley, that’s down from 37 December of ‘08.

That’s consistent with what I think others have experienced, who have suite vehicles in big broker dealers. So we’re going to want to continue to work with them. It’s less of an issue, but one that we hope can work out favorably, but as I’ve also said, it’s also dependent on pricing, which is going to be another issue I suspect as well.

Operator

Your next question comes from Jeff Hopson - Stifel Nicolaus.

Jeff Hopson - Stifel Nicolaus

Just you can give us an update on Permal in terms of the flows this quarter, and it just seems like that business is starting to turn, but what would be your thoughts as far as kind of a near term flow picture? Then maybe from a longer term standpoint, in terms of margins kind of talk about the interchange of fixed income versus equity and the influence to margins over time?

Mark Fetting

Permal and the update, the key shift that’s going on there is kind of to a certain extent, multi-manager to single manager and in the institutional channel kind of managed product to separate accounts, both of which Permal is very well positioned for because of their access to the key managers and their ability to kind of put these products together very, very effectively. Specifically, what they’ve seen is a pickup in sales in the single manager area. Not as much pickup yesterday in the multi-manager area, both of which are going to have to happen to bring the kind of space back, but they’re encouraged.

As we mentioned earlier, in Asia in particular, there’s been a quicker recovery, if you will and they’re making some real progress there. As you know, the relative performance of Permal is quite strong, and I think perhaps even more important on top of that fact is their behavior through the difficult period with distribution partners and with clients, bodes very well for them being an even stronger leader in this space going forward.

The second question around margin, and the various managers, we clearly get back to the margin in the 30s by getting more assets into the equity area, where we tend to have higher fee, higher margin situations. We clearly are directing our activities towards that and want to see that happen. Permal will also be an important contributor in that as you can see by our second largest contributor at the moment.

Jeff Hopson - Stifel Nicolaus

On the Permal though, it sounds like sales are starting to pickup. Why would there continue to be kind of dribs of outflows at this point?

Mark Fetting

The outflows, basically it’s a classic case of the outflows continue, the sales really fell off, the sales have comeback, but not enough to offset what is a reduced and what we’ve said is kind of a pre-Lehman level of redemptions. I think some of this was some year end stuff as well.

Operator

Your next question comes from Cynthia Mayer - Banc of America.

Cynthia Mayer - Banc of America

I guess just backing up on the margin question. I think in November, you said you had an operating margin goal in the 30s, and I’m wondering if that is still your goal and what are the main levers you see which will take threw? Is it the mixed shift in equity you talked about or greater contribution for Permal or cost cuts or something else? Can you order the factors in terms of the contribution you expect?

Mark Fetting

Yes, Cynthia, it’s still very much our goal and I think in light of the fact, just to put it on the table that our kind of recovery into inflows is taking a bit longer. I’m basically kind of gearing up the team, both the LM team and the affiliate team to see what more we could do to contribute to that, in addition to what we believe will come in terms of inflows, will come in terms of continued shift to equity and alternatives.

So it’s all of those things, but I think what you should hear right now is a renewed focus on what we can do separate from the revenue line, if you will.

Cynthia Mayer - Banc of America

Just as a follow up, just to clarify something, it looked like the outflows picked up in your international channel. Is that the enhanced cash or is it something else and is that a longer running trend or is that part of the seasonality?

Mark Fetting

That’s both the cash and the liquidity funds, both of which contribute to international. The enhanced cash, excuse me.

Operator

Your next question comes from Mike Carrier - Deutsche Bank.

Mike Carrier - Deutsche Bank

Just one more question on I guess the efficiencies and the expenses. When you look at how Legg Mason is organized, with the affiliates, if you look at the costs that are currently centralized, versus that’s not. I guess what area, like obviously the compensation agreements, that’s going to be tough to change, management of the affiliates, that’s going to be tough to change just given thoughts return in nature of the divisions, but when you look at whether it is trading, back office, marketing and distribution, I guess what are the areas where there maybe potential and maybe not now, but down the road, if you kind of re-examine how the operations are structured?

Mark Fetting

I think if you just go back to the progress we’ve made, I think when we first started very much as everyone in the industry did in response to the severe reduction in assets and revenues coming through the troubles, we took corporate overhead from 600 plus, to approximately 450 and we’re now at 450 on a base of roughly 700 billion of revenues, or assets.

That has not been picking up as quickly as I would like hence, we can revisit that 450 and that’s comprised of across the board distribution, shared services and the ops and technology area and HR, legal, finance, etc., but in addition to that, as was mentioned earlier, some of that is dedicated to services we provide the affiliates and we’re actively engaging with them as we have throughout this process and how to do that as efficiently we can for the shareholder while still adhering to a service level that delivers good effectiveness to the clients.

Mike Carrier - Deutsche Bank

Just the other thing, and I think you hit on this in the commentary, but just given the progress that you’ve made, on the balance sheet and the current leverage ratio and then the excess cash, you mentioned some stuff on the M&A side, just when you look at everything that you have with all of the affiliates, what are you looking at in terms of fill-ins, and obviously you can’t be too specific, but in general, where do you see gaps or where do you think you can build skill?

Mark Fetting

Well, we’ve been very consistent on the international equity area. We’ve also worked with a number of our affiliates where certain list out opportunities could very well with their existing franchise, but I have to kind of underscore some of the things that we’ve looked at and chosen not to do, is with some continued pricing discipline and a recognition that our currency right now, we believe I believe, is undervalued and so that is adds further discipline to what we should be doing.

If you just take a look at, I think we’re at kind of the low end of the peer group on a multiple of EBITDA, on the low end of the peer group on basic enterprise value, to AUM. This would all underscore there is a lot of value in what we’re doing, and that represents other options as well.

Operator

Your next question comes from Marc Irizarry - Goldman Sachs.

Marc Irizarry - Goldman Sachs

Could we just hit on performance fees a little bit? You can talk about the western, how much of your AUM is performance fee generative, and also what performance fees locked in this quarter and what should we sort of expect going forward in terms of performance fees?

Mark Fetting

I am going to let C.J. handle that but I do want to underscore the delight I have in talking about being paid performance fees by our client which underscores proof positive that our performance is picking up.

C.J. Daley

Mark, as you know, December has typically been the quarter in which we have the most opportunity to achieve performance fees. I think the good news is, is that a majority of the performance fees we did earn this quarter were quarterly, although $10 million were annual measurement points. So it was split between Western and Permal. Obviously Western had strong performance and they were delighted to earn performance fees. Permal continues to have strong performance.

After now hitting the high water mark on 75% of the assets, Permal is encouraged that they can continue to achieve some level of performance fees. So for modeling purposes, historically, we’ve been running around $10 million. We had hoped to do a little better than that and our expectation would be somewhere $10 million to $20 million a quarter, although that obviously is very dependent upon continued performance.

Marc Irizarry - Goldman Sachs

C.J. talked about just the year-to-date, what extent is there a seasonality issue in performance fee, calendar year and versus kind of calendar quarter…?

C.J. Daley

Performance fees are really client specific for the most part. As you can imagine, there’s a high number of those, so it’s really hard to give some sort of general, but the majority of at least in Permal, the majority of that 75% that’s at the high water mark are quarterly contracts.

So the good news is, is that we would expect a little less seasonality, although we could get to next December, and if performance continues to be strong, those annual performance fees could kick in, and be accretive. So because of the individual nature of the performance fees and the number of them, it really is hard to generalize.

Marc Irizarry - Goldman Sachs

Then Mark, just in terms of Western and then what’s happening in core, I think still your biggest product, what are you seeing on that front? Then we potentially heading into a period where maybe clients are going to be revisiting the way they think about core and there could be some more outflows coming out there?

Mark Fetting

I think the net of this quarter versus prior quarters relative to core and core plus is really positive that this year of strong performance, where Western is delivering to clients exactly as they should. They continued to make prudent credit bets where in prior years, that wasn’t working. They stay true to that philosophy and delivered. There are other managers where that wasn’t the case during this sea change, if you will.

So in that regard, I think Western is better positioned. Yes, there are still some clients that as we experienced we saw as a seasonal up tick took some money off the table, we see that less of an issue, but there are still some clients out there that are probably pondering, but we’re in a much better position, in responding to that situation.

On the flip side, and this I think is a definite inflection point is we are being invited into, and competing for, and actually have won some of those and so you can imagine some clients who pulled the trigger, sometime in the first half of the year, probably regretting that given the strong performance throughout the year.

Operator

Your next question comes from Roger Smith - Macquarie.

Roger Smith - Macquarie

I just wanted to make sure, I got this correct. The enhanced cash mandate that you lost is that in the liquidity number or is that in the fixed income number?

Mark Fetting

Thank you for clarifying that, Roger. That’s not in the liquidity number. It’s in the fixed income number, but as you can see, it was a significant, we believe, one off in that item.

Roger Smith - Macquarie

If we do get a lot more flows into the alternative space and the equity space, how do we think about that relative to the fixed income business itself? Like is there just an inherent headwind we face or do you think there’s additional capital that’s going to be coming into this system in general?

Mark Fetting

I think it’s all about kind of going forward. As all of us as investors are conscious of and on a go forward basis, while the money coming in to fix is probably going to be less than happened and we have suffered some opportunity costs because of Western’s challenges, there are actually better positioned to participate in what remains, which will be strong.

In addition to that, we think we got strong offerings in the equity and alternatives to capture that. So I think we’re well positioned, which goes back to my strategic enthusiasm, for our model, and our managers in particular.

Operator

Your next question comes from Michael Hecht - JMP.

Michael Hecht - JMP

So I guess just the first question is, it sounds like you guys were doing a good job managing down expense, working to leverage distribution, cleaning up the balance sheet, but the outflow number of $33 billion, I mean still running at substantial levels. So I think you guys have to be thinking outside the box in terms of what you can do to improve your top line or unlock value in some way.

So I guess the question is, are you getting any incremental pressure from some of your investors like KKR and Nelson and how given the outflow story and certain acquisitions that may accelerate your fundamental improvement or dispositions you would consider to unlock value?

Mark Fetting

Well, I think our investors, including in those two cases, Board Members, are as concerned as I about the up tick in outflows, but really probably less than your question would suggest, it’s a challenge. We shouldn’t be happy about it, but if you really look underneath it, first off, it’s still half the level of outflows year-over-year. If you really go into the fixed income situation, I think you see some non-recurring aspects to it, and that’s underneath very much improved performance.

So I think what the Board and the Management Team are focused on, now is the time to take this improved performance, unite with our distribution capabilities, and really work harder, and on that regard, we will be thinking outside of the box of how to kind of deploy our collective resources against that.

In addition, I think because we’ve made the improvements we have on balance sheet, because we’ve made improvements in margin with more to be secured for sure, it gives us optionality on other considerations, in terms of deploying capital. I would say, the clear sentiment is let’s focus on this $700 billion of assets that we have, and make that as productive as we can, and rewarding as we can to our shareholders.

Michael Hecht - JMP

Just one quick housekeeping for me, I’m sorry if I missed it, the tax rate has been pretty consistent, but expectation remains around the range it’s been last two, three quarters?

Mark Fetting

Yes, it does. That’s exactly correct.

Operator

Your final question comes from Craig Siegenthaler - Credit Suisse.

Craig Siegenthaler - Credit Suisse

I’m sorry, but I joined a little late, but wanted to ask probably the 10 question here on Western flows. What I want to do is kind of dissect sales from redemptions and management has been talking about better RFP activity now for about three quarters.

So I’m wondering, did Western non-money market sales really go up in the December quarter from the September quarter? Then on redemptions, can you quantify, maybe you did this already, but I’m sorry if I missed it, the one or two largest redemptions, and maybe qualify how unusual they are?

Mark Fetting

We covered some of this, but let me yes, sales did go up. So the net outflow story is what we believe to be particularly in the fixed income, not to be confused with the liquidity breakout that we give. A couple of one-off situations, in particular, Craig, was a $5 billion outflow of an enhanced cash client that we knew was going to be happening and has been happening across the space.

That takes that category from $20 billion, year end ‘08, down to $3 billion, and so there’s less, mathematically just less there to be happening. On the RFP activity, I think I’d have to qualify what you said a bit. We have not seen nor have we just talked about a pickup in RFP activity in areas where Western is seeing it now.

In areas of Core and Core Plus, because of their improved performance where they were on the bench, now they’re getting more active in new business opportunities and winning some of those. I think clients who did terminate them are back in discussions because of the delivery of improved performance and because of the long term relationship Western has with these clients and their consultants. So I think that’s how we would respond.

Listen, I want to wrap up by thanking everyone, I want to speak first and foremost to our clients. Our performance has improved and we’ll continue to work hard together with our affiliates to not only continue that improved performance, but also stay close to our clients through these still a bit choppy markets.

From our shareholders, we believe strongly that Legg Mason is a franchise, is undervalued. We’re going to do all that we can to improve in the areas specifically of growth and outflows, and the inflows, and improve margin. As one caller said, think outside of the box, to do that, on any and every front that could make sense. We look forward to working and delivering for our shareholders and we thank all of you who follow us for your questions. Thank you.

Operator

Ladies and gentlemen, this does conclude today’s conference. Thank you for your participation. Have a wonderful day. You may all disconnect.

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Source: Legg Mason Inc. F3Q10 (Qtr End 12/31/09) Earnings Call Transcript
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