Legg Mason (NYSE:LM) dropped 17% last Wednesday, losing about $2.5 billion in market capitalization. It seems like this ought to trigger some value “snooping” if not concerted buying, but let’s look at a few fundamentals.
LM transformed itself completely in June of 2005 with a deal with Citicorp that closed in December of last year. Legg became a pure asset manager; in fact, the fifth largest money manager in the States, one of the largest fund-of-fund hedge fund managers, and the largest fixed income manager.
The firm became the #1 supplier of separately managed accounts in the States. The deal extendeded the reach of the firm globally with operations in Japan, Hong Kong, Latin America and Australia. All good things! In fact, enthusiasm for the deal and for the broadened distribution capabilities of the business brought the stock to $140 at its peak.
Now, reality is setting in. Bill Miller will not beat the S&P this year and is 1168 basis points behind as of last Wednesday. Yes, the great record has a tiny blemish, but hardly a disconcerting negative to long term investors. It appears that the performance of the former Citicorp Asset Management funds have also been somewhat disappointing. Western, the institutional fixed income management business is doing much better than most of the equity businesses.
Consequently, LM finds itself gaining assets in lower margin fixed income and money market areas rather than the higher margin equity products.
The pre-release of earnings that caused last week's drop suggests that the equity flows are probably of the order of about $5 billion in the most recent quarter. Not horrific, but I wonder about redemption issues for Bill Miller’s Value Trust potentially accelerating as headlines loom about the disruption in the record. Believe me, I think redeeming this fund after one bad year is an incredibly stupid idea. I hope investors hang in but who can predict the likely behavior?
Do the rest of us buy the stock? Legg Mason is currently trading at only 1.3% of assets under management, well below the industry which is trading at about 3%. As of the June quarter, equities represented about 37% of the assets with fixed income and “liquidity” meaning money market representing the balance. Contrast this with Federated Investors (NYSE:FII) which as the most heavily fixed income oriented public money manager (with only 14% equities) trading at 1.7% of assets under management.
Integration issues remain and the earnings accretion that was anticipated when the deal was first announced has not been as readily attained. Operating margins should be much higher than the current 24.5% over time.
Looking at ROIC, the company can do much better than its current 9% as well. The benefits of scale, of diversification, and what historically has been a very well run organization I believe will once again come to the fore. With an EV/EBIT of 17 times, the stock is not exactly a bargain at first brush, but more normalized levels of profitability likely, I think the stock at least deserves to be on the radar screen.
How significant is the Bill Miller risk? Not very...the massive Value Trust represents about $19.4 billion of total equities of $311 billion or 6.2%. Compared to total managed assets of $855 billion, the Value Trust is about 2.3%. The chances of a mass redemption seem small given the tremendous goodwill and performance that Bill Miller has attained.
Historically, this quiet, somewhat understated management team has under-promised and over-delivered. Near term integration issues have disappointed the Street, have hurt profitability, but have created an opportunity in my view. There is always market risk in asset management companies both from equity risk and interest rate risk.
The company has an excellent record of integrating its previous acquisitions which have included names such as Brandywine and Royce. Existing management teams persevere and thrive under the new regime. Contrast that with some of the horror stories of the brokerage industry. How many Advest brokers have stayed with Merrill?
Bottom line, many analysts are disappointed but many estimates remain somewhat high. However, last week's move took the stock down to the bottom of the valuation pile as far as assets under management. It does not deserve to be there in my view.
LM 1-yr chart:
Disclaimer: Neither I, my family, or clients have a current position in Legg Mason or any of the other securities mentioned in this post except I, and some clients have a current position in Federated Investors.