Legg Mason's (LM) CEO Joseph Sullivan on Q1 2015 Results - Earnings Call Transcript

 |  About: Legg Mason Inc. (LM)
by: SA Transcripts


Welcome to the Legg Mason First Fiscal Quarter 2015 Earnings Call. [Operator Instructions] Please note that this teleconference is being recorded. It is now my pleasure to introduce your host Alan Magleby, Head of Investor Relations and Corporate Communications. Thank you, Mr. Magleby, you may begin.

Alan F. Magleby

Thank you. On behalf of Legg Mason, I would like to welcome you to our conference call to discuss operating results for the fiscal 2015 first quarter ended June 30, 2014. 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's discussion and analysis of financial condition and results of operations in the company's annual report on Form 10-K for the fiscal year ended March 31, 2014, and in the company's subsequent filings with the Securities and Exchange Commission.

During the call today, we may also discuss non-GAAP financial measures. Reconciliations of the non-GAAP financial measures to the comparable GAAP financial measures can be found in the press release that we issued this morning, which is available on the Investor Relations section of our website. The company undertakes no obligation to update the information contained in this presentation to reflect subsequently occurring events or circumstances.

This morning's call will include remarks from Mr. Joe Sullivan, Legg Mason's President and CEO; and Mr. Pete Nachtwey, Legg Mason's CFO, who will discuss our financial results. In addition following a review of the company's quarter, we will then open the call to Q&A. Now I would like to turn this call over to Mr. Joe Sullivan. Joe?

Joseph A. Sullivan

Thank you, Alan, and welcome to our fiscal year 2015 first quarter earnings call. As always, we appreciate your interest in Legg Mason. As many of you know, fiscal 2014 was a year of important decisions and actions for the company. And we believe that the actions we've taken over the course of the past year were critical to enhancing our competitive position and our potential for long term growth. As we begin fiscal 2015, we will build on these actions and focus on the growth of our affiliates and Legg Mason to the benefit of our clients and shareholders. And as always, let's start with our clients.

In a more complex market environment, investors are increasingly considering different asset classes across multiple geographies to accomplish their long-term objectives. For Legg Mason, indeed for the best in our industry, being of size and scale, having a global reach and perspective, as well as being able to offer a diverse set of products and strategies are all essential in today's world to be able to help investors to achieve their objectives. So in fiscal 2014, much of our work was focused on repositioning our affiliate mix and investment capability to better reflect those client needs and leveraging our key strategic assets, most especially around our global retail distribution platform.

Underscoring this effort is the acquisition of QS Investors and the announcement of our agreement to sell Legg Mason Investment Counsel to Stifel Nicolaus. This repositioning also included the agreement to acquire Martin Currie, which will add a critically important investment capability in the fast-growing non-U.S. equity market segment. And as a result of these transactions, we will have 7 core affiliates, each with a distinctive expertise in various asset classes and focused on delivering compelling investment results for investors.

Working in tandem with all of our affiliates, our business development and product teams are leveraging the broad investment capabilities of our affiliates to create a more comprehensive menu of investment offerings that reflect evolving client demand and help solve their challenging needs. And to better serve a larger set of global clients, we are investing in our sales and client service teams to increase the effectiveness of our distribution platform while improving our client penetration and growing our market share. Certainly, we are seeing positive signs of improvement early on, but we know that we still have much more work to do to capture the market opportunity before us. Finally, our Legg Mason corporate team, which supports both our affiliates and our Global Distribution platform, is operating at a high level of efficiency and productivity and will continue to do so. Strong execution of this vision will optimize our affiliate and product mix, improve our organic assets under management growth rates, further diversify our business by client asset class and geography and generate increased long-term value creation for our shareholders. So let's walk through the quarter.

For the quarter, we reported $72 million in net income or $0.61 per share. Adjusted income was $107 million or $0.91 per share. We continue to return capital to shareholders, repurchasing 1.9 million shares for $90 million. Long-term flows for the quarter were positive at $700 million driven largely by $2.5 billion in fixed income. These flows were partially offset by equity outflows of $1.8 billion specifically with legacy Batterymarch AUM and at Royce.

We ended the quarter with $704 billion in assets under management and assets under advisement were $119 billion for the period. Over 80% of our strategy AUM exceeded benchmark for all periods. We successfully completed a debt issuance, which locked in longer maturities at lower rates and in so doing, strengthened our credit profile. We closed the QS Investors acquisition and commenced the integration process with Batterymarch and LMGAA. As I mentioned, we also announced the agreement to sell Legg Mason Investment Counsel to Stifel Nicolaus, and while not in the quarter, we announced last week the acquisition of Martin Currie based in Scotland. This transaction adds a broad investment capability and product set with solid long-term investment performance in the strategically important and currently very fast-growing international active equity space. We feel very good today about the potential breadth of investment products and strategies that we can deliver to help investors as they pursue growth and security.

On Slide 3, we've highlighted our asset and revenue diversification, which I really believe remains under-appreciated. To help you see that diversification as we do, we are further detailing revenue across geographies and by investor types. Of particular note and notwithstanding the fact that our AUM is heavily institutionally sourced, our retail business now generates over half of our total revenues despite being just 26% of AUM. Clearly, as we continue to enhance our distribution platform and in particular, as we bring QS Investors and Martin Currie online to our global distribution platform with our legacy affiliates, our retail business has room to run and it continues to demonstrate attractive profit and return potential for our shareholders. Now with virtually all of our overall affiliate repositioning behind us, we see significant opportunity to grow our market share globally in the near term and in the years ahead.

Slide 4 breaks out our AUM by affiliate. I am pleased to see momentum building across most of our 6 core affiliates with over $7 billion in unfunded wins as of June 30. Let's start at the top with Western Asset at $455 billion in assets under management. Long-term flows for the quarter were breakeven and Western's won but not yet funded mandates, total approximately $4 billion. Inflows into specialized mandates were offset by outflows from broad market and municipal strategies. The interest in Western's unconstrained and absolute return products continues with a number of these strategies now added to several platforms in the U.S. during the quarter. Western's macro op strategy, launched in 2012, reached $3 billion at the end of June. The company launched a global credit strategy which raised $1 billion in the quarter and a bank loan product that raised $400 million in the month of June. And finally, Western's REIT raised an additional $200 million in the quarter. Performance across all Western Asset strategy assets remain very strong, with 98% of their strategy AUM beating benchmarks in the 5-year period and 93% in the 3-year period. While we feel good about the continuing progress at Western, I do need to call out and provide some context around 2 redemptions that we will disclose in a few weeks with our July AUM and flows report.

We will report outflows that include approximately $5.5 billion in what is categorized as long-term fixed income but in what is actually an enhanced cash type product with mid-single digit fees. These outflows are from 2 corporate clients who, for different reasons, are bringing cash back into their companies. That said, these are clients with strong long-term relationships with Western and both of whom continue to work with Western on a variety of strategies to meet their investment objectives. I will reference these outflows when I elaborate shortly on the recently announced money market regulatory changes recently promulgated by the SEC.

Next is ClearBridge Investments, which cost $101 billion in AUM and with net inflows of approximately $300 million. In addition to the AUM, ClearBridge advises roughly $5 billion of our total assets under administration. Also we now include in ClearBridge's assets under management $5.5 billion of legacy Legg Mason capital management assets with that combination now complete. While inflows at ClearBridge were less than the previous 5 quarters, we are pleased that they did experience positive net flows in the context of the active U.S. equity universe, which was a meaningful net outflow during the quarter. Won but not funded mandates at ClearBridge closed the quarter at approximately $650 million. ClearBridge continues to diversify its business both geographically and within the IRA and independent advisor channels in the U.S. The ClearBridge team continues to see compelling opportunities in extending its high active share products, particularly given the success of Richie Freeman's Aggressive Growth projects -- products; the ongoing demand for income products; as well as the now rebranded ClearBridge Value Trust, which just last week won a $300 million institutional mandate set to fund later this year.

Next, Royce & Associates at $38 billion. Royce continues to experience redemptions albeit at a slightly reduced level. As we've mentioned in previous quarters, improving gross sales will be key to improving their flows and I just want to be clear that this will take time. Redemptions have been a function of the relative and really not so much, absolute performance and new subscriptions will take time until their numbers scream better for our distribution partners. That said, it all starts with the relative investment performance, which has meaningfully improved across a number of Royce products in the first half of this calendar year, including in this quarter. We're encouraged by that improvement and remain hopeful that it will continue. In the meantime, Royce has continued to make important enhancements to their business, including announcing the appointment of a new Head of Risk Management, rationalizing subscale products and importantly, adding incremental sales resources.

Permal closed the quarter at $20 billion in AUM. I'm very pleased to say that Permal had its best flow quarter since June of 2011 with $400 million in net inflows, split almost evenly between legacy Permal and Fauchier products. Flows were led by its managed account platform, which attracted subscriptions across geographies. Permal's won but not yet funded mandates closed the quarter just under $400 million. Permal continues to evolve its business as it has for some time, with institutional clients now accounting for 64% of Permal's total assets under management, which has helped to offset industry-wide softness in the global high network segment. Permal's relatively nascent U.S. retail business was modestly net flow positive as more products go live on U.S. retail distribution platforms. And finally Permal announced the appointment of Omar Kodmani as Chief Executive Officer as part of a long transition process that has been in the works for many years. Isaac Souede remains very actively involved at the firm as Chairman and Chief Investment Strategist.

Next, Brandywine's success continues with assets under management now at $58 billion, the highest level of AUM in the company's history. Brandywine enjoyed robust inflows of $3.1 billion which was the company's second-best net flow quarter ever and its best since December of 2005. Brandywine's flows were nicely split with $2.4 billion in fixed income and $700 million in equity inflows. Unfunded wins for Brandywine closed the quarter at approximately $1.5 billion, again underscoring continued strong investment performance across a number of their strategies and opportunities in both fixed income and equity products. We are very active with Brandywine right now in creating and launching new products in both fixed income and equities as they continue to see demand for unconstrained and absolute return strategies in both fixed income and equities in a number of regions around the world.

Finally, QS Investors, which ended the quarter with $15.2 billion in assets under management. This includes assets from both Batterymarch and LMGAA, and reflects integration-related outflows at the legacy Batterymarch entity. I must say that we are very pleased with client retention post-close of the transaction. Between LMGAA and Batterymarch, we have retained significantly more assets than we have projected and modeled. Clients from QS, Batterymarch and LMGAA are seeing significant value in the company's combined capabilities. And while we're very happy with the client response so far, we are very mindful that we have to continue to earn these mandates. Legacy QS Investor assets under management were 5.6 billion at June 30, up 1.5 billion since we announced the transaction in March which is quite encouraging. Won but not yet funded mandates at QS closed the quarter at approximately $600 million.

In addition to their institutional business, QS is enjoying a great deal of a focus from our Global Distribution platform having encouraging discussions with our retail distribution partners in the U.S. and abroad, while existing QS and Batterymarch institutional clients are considering and have added new money to existing strategies and in some cases, investing in new ones. We feel very, very good about QS, the combination with Batterymarch and LMGAA and the ongoing significant potential of the combined firm.

Slide 5 provides an overview of Martin Currie's business. As you know, a broad investment capability in various non-U.S. equity strategies has been a critically important investment and product gap for Legg Mason for some time. This transaction represents a long-term game changing opportunity for Legg Mason as we fill out our investment strategy pallet to better serve clients. As you may know, Martin Currie, based in Edinburgh, Scotland enjoys a very strong brand, dating back 130 years. I am very confident that Martin Currie is a strong fit both culturally and strategically for Legg Mason. Martin Currie offers solid long-term investment performance across a broad and differentiated set of active investment strategies and a strong client service orientation consistent with our other core investment affiliates.

Now as part of this transaction, we will combine and rebrand our $2.5 billion Australian equities business, Legg Mason Australian Equities, with Martin Currie. This combination will enhance each firm's unique and complementary strengths and combined, they will be stronger and better equipped to serve client needs in this critical market segment. The combination also affirms our commitment to our strategy of having fewer but larger affiliates centered on distinct asset classes. We find that Martin Currie's breadth of capabilities across global equity, European equity, global emerging markets, Asian equity and strategies specifically focused on Japan and China to be not only attractive but unusual for a company of its size.

We feel that we acquired Martin Currie at an opportune time as we believe that we can help accelerate the company's turnaround already underway. Martin Currie's strategies are scalable and distinctive. There exists significant capacity to grow their market share in a number of those strategies longer term through our global retail distribution platform, particularly as some promising newer strategies reach scale and maturity. Martin Currie has a strong global institutional presence, which we believe will be a strong fit for Legg Mason's equities business in Australia, which has been growing nicely but where we see meaningful opportunity to grow further. Key investments and business professionals at Martin Currie have signed long-term contracts with us and we expect to close the transaction in our third fiscal quarter.

Site 6 shows investment performance for the quarter. As I mentioned, over 80% of strategy AUM beat benchmarks over all-time periods. Performance versus Lipper is a bit more mixed reflecting the heavy weighting of our funds towards equities and is largely the result of Royce's relative underperformance in recent years.

Slide 7 shows a breakout of our Global Distribution results for the quarter, results that I'm pleased to report highlight significant progress. Global Distribution had positive net sales of $2.1 billion for the quarter, up from $1.5 billion in the previous quarter. All of the regions in which we serve clients were net sales positive and Brandywine, ClearBridge, Permal and Western, all were net sales positive across the distribution platform with Royce remaining positive internationally. Gross sales of $16.3 billion increased quarter-over-quarter. And of particular note, our redemption rates were better than industry averages in the U.S. at 18% and overall global redemption rates on the platform were 22%.

As we look forward, we are seeing significant opportunity with our clients and across our affiliates, including unconstrained strategies at Western and Brandywine, growth strategies at ClearBridge, alternative products at Permal and in customized strategies with QS now on board. While we are in the very early innings of our additional investment in our distribution platform, we expect to have most of our new U.S. hires on board by September but certainly, all by year end. Obviously, we remain quite excited about the potential of this global retail distribution platform, both this fiscal year and beyond.

And with that, let me turn it over to Pete for his review.

Peter Hamilton Nachtwey

Thanks, Joe. Turning to Slide 8, I'll start with the financial highlights. In the first quarter, we had solid P&L results with earnings of $72 million or $0.61 per share. This included integration cost related to the QS investors acquisition of $14 million, as well as $2.4 million in charges related to the sale of our Luxembourg fund administration platform, which combined to reduce earnings by $0.09. We expect that the sale of this platform, which historically operated at loss, will save us $1.7 million in annual operating expenses beginning in our fiscal second quarter.

Our revenues increased primarily due to a 2% increase in average long-term AUM, as well as 1 additional day in the quarter. QS integration costs this quarter were in line with expectations. While our anticipated investment in Global Distribution did not ramp up as quickly as planned, as the talent recruiting process has taken a bit longer than expected, hiring began in earnest this month and we do expect additional new hires before September 30.

Looking forward, we are anticipating additional cost in the second and third quarters of approximately $9 million and $13 million, respectively, related to the ongoing QS integration. While the Global Distribution initiatives will result in fiscal second quarter costs of approximately $4 million and then hit a $6 million to $7 million quarterly run rate by Q3 and beyond. Adjusted income was $107 million for the quarter or $0.91 per share, which includes the impact of the QS-related integration cost and the Luxembourg fund administration platform sale. Average long-term AUM was up 2% from the prior quarter with average equity up 3% and average fixed income up 1%. This quarter's total performance fees of $16 million were from Permal, Western and Brandywine. While impossible to predict with any precision, we estimate that next quarter's performance fees could be in the range of $5 million to $10 million subject to market movements. On the balance sheet front, this quarter we repurchased an additional 1.9 million shares for $90 million. Going forward, we continue to anticipate share repurchases of approximately $90 million per quarter, as always, subject to markets and/or investments in growth opportunities.

Moving on to Slide 9. The only things to highlight here are tax-related items, including our GAAP effective income tax rate of 36%, which is in line with expectations. And we currently expect our effective GAAP tax rate for fiscal 2015 to be approximately 36%. But most importantly as you will see on a later slide, our actual cash taxes continue to run at a substantially lower level than our GAAP rate.

Turning to Slide 10. Our assets under management were flat compared to the prior quarter despite the reclassification to assets under advisement of approximately $13 billion related to the low fee global sovereign mandate. June's AUM reflects market increases of over $18 billion, including favorable foreign currency movements of $1.6 billion. In addition, this quarter includes $5 billion in AUM as of May 31 from the QS Investors acquisition. Partially offsetting these increases was an $8.6 billion decline in liquidity AUM, reflecting the $20 billion sovereign redemption I highlighted on last quarter's earnings call. As expected, some of that AUM came back in May and June and Western expects additional amounts will come back in over the next few quarters. Also at the bottom of the slide, you will see our $119 billion of AUA, which includes assets across most of our key affiliates but particularly $101 billion at QS investors.

Long-term flows, on Slide 11, improved to $700 million from outflows last quarter. Fixed-income flows turned positive while equity flows turned negative. Fixed-income flows were solidly positive led by Brandywine. Equity outflows were $1.8 billion compared with $500 million in inflows in the prior quarter. This reflects a pickup in transaction-related outflows from the Batterymarch business combination into QS that Joe referenced earlier, as well as ongoing outflows at Royce. Brandywine on the other hand, led the way with the equity inflows for the quarter of approximately $700 million.

Slide 12 shows the advisory fee trend, with this quarter's rate up slightly primarily due to the increase in higher fee average equity AUM and a decrease in lower fee average liquidity AUM. Operating expenses on Slide 13 increased 2% to $574 million. Distribution and servicing expenses reflected the higher average AUM and 1 additional day in the quarter. Occupancy expense decreased as last quarter's results included about $4 million in real estate-related charges from efficiency initiatives. And other expenses increased as last quarter included the positive effect of the $5 million franchise tax reserve reduction.

Turning to Slide 14. Compensation and benefits increased by $8 million. The primary driver was a nearly $7 million increase in transition cost and severance related to the ongoing QS integration. The increase in benefits and payroll taxes was primarily due to seasonal benefit costs which are largely offset in salary and incentives. The compensation and benefits ratio, excluding the QS charges and the mark-to-market on deferred comp and seed investments, came in at 53% which is a bit lower than our typical range of approximately 55% to 56% and reflects a more favorable affiliate mix. We would expect the comp ratio to rise in fiscal Q2 with the addition of new sales staff in Global Distribution.

Slide 15 highlights the operating margin as adjusted, which decreased to 22% -- 22.9% from last quarter's 23.3%. The lower margin was due to the QS integration cost and other corporate initiatives in the quarter, which reduced the operating margin as adjusted by 2.5%. The prior quarter's operating margin was also negatively impacted by severance and other cost related to our efficiency initiatives, along with QS-related business integration cost. Partially offsetting these were the benefit from the franchise tax reserve reduction. These combined to reduce the operating margin as adjusted by approximately 1%.

Slide 16 is a roll forward from fiscal Q4's earnings per share of $0.58 to this quarter's $0.61 per share. Fiscal Q4 included the ongoing efficiency initiatives in QS-related integration costs, which together totaled $0.06. In addition, last quarter we had tax-related adjustments impacting not only the tax line but also interest and other expenses, reducing EPS by an additional $0.02. In fiscal Q1, increases in operating income 1 additional day in the quarter, as well as the impact of share repurchases increased earnings per share by a combined $0.04. Finally, the QS-related integration cost and the Luxembourg disposition cost reduced earnings per share by a combined $0.09.

On Slide 17, you can see that our effective tax rate for the quarter was approximately 36% in line with our forecast for the full fiscal year. But the key once again is our cash taxes, which are currently running at 6%, up slightly from prior quarters due to higher revenues at affiliates based in New York and from operations in certain European countries. We currently expect the cash tax rate to remain in the 6% range for fiscal 2015 and under 10% until we become a U.S. federal tax payer again, which we currently project to occur early in the next decade. Our very favorable cash tax rate allows for both additional investments in the business and additional return of capital to shareholders. When you translate our cash tax rate into estimated dollars saved, which are on the right side of the schedule, you see that over time we anticipate realizing a total cash savings of $1.3 billion.

Slide 18 portrays our new debt structure following our successful issuance of $650 million in new debt to retire the 5.5% coupon debt that was scheduled to mature in 2019 and was redeemed on July 23. We believe this new debt structure is optimal for Legg Mason going forward matching 550 -- $550 million of 30-year fixed rate debt against our long-term regulatory capital and seed requirements. We also have $250 million of 5-year floating rate debt for which we are basically naturally hedged against rising rates by our interest earning minimum cash balances. And finally, $250 million of 10-year debt that helps to ladder out our maturities. Once again, all 3 tranches of these new issuances were very well received in the markets, and the rates we were able to lock in take advantage of current historical lows, which should yield significant interest expense savings over the life of the debt.

We incurred an upfront cash charge in July of $98 million for a May call provision and a noncash write-down of $9 million, both of which we expect to be more than offset by future interest savings. The total charge for this debt restructuring will reduce our fiscal Q2 earnings by $0.59 per diluted share. Thanks to these historically low current rates, we project year 1 interest expense savings of approximately $15 million with approximately $55 million in savings over the next 5 years. In addition we expect significant incremental savings on our 10- and 30-year debt versus what we would likely have occurred in the refinancing had we waited for our old notes to mature in 2019.

I'll wrap up on Slide 19, which highlights how we've been returning capital to our shareholders, as well as our quarterly cash position. In the upper left, you can see that we have reduced our share count by 47 million shares or 29% since March of 2010 when we began our new share repurchase programs, and we still have $280 million of board-approved repurchase authorizations remaining as of June 30. In the upper right, we've highlighted the change in our quarterly dividend over that same time frame. We now have 5 straight years of annual dividend increases, representing a 5-fold increase in the dividend over that time frame. On the bottom left of the slide you can see our cash position net of the cash we used to retire our 2019 notes on July 23.

And our cash balance is at its annual low this quarter due to cash bonuses paid in mid-May. In summary, we have returned capital to shareholders in the form of dividends and share repurchases, while making significant investments in both organic growth and growth through acquisitions. Also since early 2012, we have significantly improved the liability side of our balance sheet with 3 debt transactions that allowed us to extend maturities and delever by a combined $450 million.

So thanks for your time and your interest in Legg Mason. And now I'll turn it back to Joe.

Joseph A. Sullivan

Thanks, Pete. As we conclude the first quarter of our new fiscal year, I am very pleased with the progress that both my corporate and affiliate colleagues have made to position Legg Mason for growth. As Slide 20 makes clear, our competitive positioning today is the result of executing against the plan that at a high level, calls for an affiliate portfolio and product mix that is better aligned with client demand. We've done this through the addition of QS Investors, whose investment expertise in outcome-oriented solutions and multi-asset class products plays into what is now hot but what we believe to be an enduring client preference for customization. We've also enhanced our position through the agreement to acquire Martin Currie, which will allow us to now bring broad global equity investment capabilities with solid performance and significant capacity to our clients around the world.

Tom Hoops and our product teams are working hard to maximize these new opportunities and I'm very excited about the potential for us to leverage our distribution platform with important new products. We continue to work with our affiliates on management equity plans. We are actively recruiting and hiring additional talent to further build out our U.S. retail business. We remain focused on identifying and implementing better business practices and efficiencies throughout our operations, and we will continue to invest and allocate capital by seeding new products, making smart and targeted acquisitions of talent and capability and returning capital to shareholders as appropriate through buybacks and dividends.

Now before we go to questions, I'd like to take just a moment to discuss the recent decisions around money market reform and how I see them impacting Western Asset and Legg Mason. The SEC's new regulations appear to be consistent with the outcome that we had expected. Clearly, there is no perfect substitute for constant NAV prime money market funds and this will certainly impact investors. How they respond to these new regulations will take time. We remain confident in Western's capability to develop alternative strategies, and obviously, they have been in constant dialogue with clients throughout this process. Fortunately, clients and Western have plenty of time to work through what best accomplishes the objectives of those clients and proceed accordingly.

From our standpoint, institutional investors in prime money market funds will have multiple options to consider. First, they may remain in those funds and accept the floating NAV and potential liquidity restrictions or gates in periods of market stress and as the fund board chooses to impose them. Alternatively, clients may move investments into government money market funds that may have lower yields but a constant NAV without gates. Additionally, clients may consider alternatives, including separate accounts and ultrashort products, which would likely also have a floating NAV but may afford the client the opportunity for greater yield and possibly a more customized approach to liquidity management.

Obviously, Western has great expertise in managing fixed-income solutions of all durations and already has created an ultrashort bond product that will be available shortly. Western will continue to work closely with clients to provide alternative solutions in this new environment. Importantly, we do not currently see these developments as having a major financial impact to either Western or Legg Mason.

Where we do believe we may see an impact longer term is that the definition of liquidity AUM may change, and this refers indirectly to the outflows in July at Western that I referenced earlier. Money market products have traditionally been used as part of a broader cash management strategy by many large institutional clients. These clients routinely move money in and out of their money market fund as the needs and strategies of their enterprise evolve. If, as new alternative products to prime funds are developed and adopted, if they remain classified as long-term AUM, we may see increased volatility in that segment around flows, both in and out which could distort the visibility on the part of an investor in Legg Mason into the higher yielding AUM within that long-term bucket. This may be a challenge in the future, and we intend to work with others in the industry to develop appropriate reporting mechanisms for these types of strategies as they develop.

And with that, we'd now like to open up the call to Q&A. Operator?

Question-and-Answer Session


[Operator Instructions] And our first question is from Bill Katz from Citi.

William R. Katz - Citigroup Inc, Research Division

Maybe the first one for Pete, I apologize, a lot of moving parts this morning, a lot of companies reporting. Can you -- and a lot of moving parts for you guys, can you just back up to what you think the core expense number was this quarter x all the noise and then layer in what you think are the unusual items and then within that, can you explain why it's such a high number on the $9 million and $13 million, those seem like relatively high numbers for those acquisitions, what's in there?

Peter Hamilton Nachtwey

Sure, Bill. Well, maybe we'll talk about this, the business initiatives that we had in the quarter, so we had QS integration total about $14 million, and $13 million of that was compensation. We also had a wind down or actually a sale of our Luxembourg fund administration operation, which resulted in a charge of about $2.4 million. $1 million of that -- or I'm sorry, $2 million of that was in nonoperating that's really a loss on the sale and about $400,000 went through the operating earnings. So those are really the 2 big things that you need to adjust. As I indicated in my comments, we also had $4 million of Global Distribution investments and we're seeing that kind of ramp up over the next several quarters to the run rate of $6 million to $7 million. So I think if you adjust for those 3 items, that will kind of get you there in terms of run rate expenses.

William R. Katz - Citigroup Inc, Research Division

Right. Okay and then just why -- the $9 million that seems like a big number relative to the asset base that's being absorbed, so is there anything unusual going on in that integration expenses?

Peter Hamilton Nachtwey

Yes, no, nothing there. I mean, keep in mind that we're winding down Batterymarch, and so a significant number of people there that are still involved in the transition but where we have exit plans and retention packages for them running through the December quarter. Once we get through Batterymarch and that will level off, but that's the combination of people cost and then an occupancy charge that we've previously talked about in the December quarter once we can abandon the space that they occupy.

William R. Katz - Citigroup Inc, Research Division

And my second question is, I'm not sure if it's for you, Joe, obviously you have the Martin Currie acquisition, your balances on cash come down a little bit but where are you now in terms of incremental priorities for capital return? You mentioned you're going to continue to buy back stock, but are there other deals out there or should we assume that you're going to house [ph] the capital or return it back to investors at this point?

Joseph A. Sullivan

Bill, it's Joe. I think that our priorities remain, although we've kind of knocked one off in terms of the non-U.S. equity capability. But we're continuing to talk to a number of potential candidates. We're going to continue to look to add capability and talent where we can, whether either incremental talent or incremental capability or better and where we can upgrade that. I did see interestingly yesterday, just a new opportunity in a segment, I don't want to get into detail about it because it's way early, but in a segment that we're not currently in. So I would say that we will -- the focus of our, sort of, talent acquisition initiatives will move more from looking at stand-alone affiliates to really -- working with our existing affiliates to strengthen and bolster their franchises through adding talent or upgrading in talent. But where there is interesting and new capability, we'll certainly look at it and potentially on a stand-alone basis. Our share buyback continues, our seed capital program continues, our investment and distribution continues and we're constantly on the prowl for and on the lookout for new and better talent to improve our organization.


Our next question is from Chris Harris from Wells Fargo.

Christopher Harris - Wells Fargo Securities, LLC, Research Division

So Martin Currie, a couple of questions here. We kind of know that they're in turnaround, just wondering if you can give us any color on what the performance inflows has been like over the last 1 year or 2.

Joseph A. Sullivan

Sure. So Chris, let me just give you some thoughts and that's a nice tee-up question because I want to really get this out. Obviously, the acquisition of Martin Currie filled a glaring gap in our investment capabilities. We've been talking about it for a long, long time. It is a game changer for us, or a potential game changer for us, particularly for Global Distribution and particularly for our international teams where they really are now going -- or soon, going to be able to add this capability to their pallet. It's a great brand as we mentioned, it's been out there for a 130 years. They have an unusually broad product set, including European equity, Asian equity, emerging-market equity and then strategies devoted to and focused on Japan and China, got a strong investment team, recently retooled about 3 years ago with the addition of John Pickard and he's really created, I think and what we believe to be a very compelling investment philosophy and process. They've got long term [ph] investment results, they're a high conviction manager. Those results can be a bit bumpy at times as we know and at times that style can be out of favor, but over the longer term their investment results are solid. They've got a great culture on their own. And I think the cultural fit with Legg Mason is exceptional. We think we acquired them at an opportune time. You mentioned that their early in their turnaround. That's exactly what we see. Certainly, they were challenged, as we were and many countries were during the crisis, but clearly their turnaround is being manifested and we are seeing that. Last year, they were in inflow to the tune of mid-$700 million. So far this year, they've been in inflow to the tune of mid-$400 million. Those flows are lumpy but 6 out of the last 8 quarters, they've been in positive net flow. And importantly, their unfunded wins are -- stand at about $500 million and on an ongoing basis their pipeline looks very solid to us. So we feel like we've been able to partner and acquire a great firm at a very opportune time.


Our next question is from Robert Lee from KBW.

Robert Lee - Keefe, Bruyette, & Woods, Inc., Research Division

So a couple of questions. I guess the first one is on the acquisition, should we expect -- I know you haven't specifically said will the terms beyond some massive accretion the first year but are there going to be any kind of incremental goodwill, tax benefits or whatnot related to this, I mean, if we want to think about this on a kind of a cash versus GAAP basis?

Peter Hamilton Nachtwey

Rob, good question. I think, yes, we'll definitely have some incremental goodwill. Keep in mind it will be primarily over in the U.K. as opposed to domestic. We do see some tax benefits. They have about $4 million of deferred tax assets on their books that will transfer over to us and we'll get the benefit of. And then we've been able to free up -- we believe, we'll be able to free up reserves just due to the incremental earnings they'll provide us in certain jurisdictions that we didn't have enough earnings projected to be able to use some of our tax attributes that were already on our balance sheet at Legg Mason and those are probably about another $1 million to $2 million or so. So as we said it's modestly accretive, particularly to GAAP earnings initially. But as Joe indicated, we're very bullish on how quickly that can ramp up, particularly with some help from the retail distribution side.

Robert Lee - Keefe, Bruyette, & Woods, Inc., Research Division

All right, great. And more so, on the acquisition, just curious, I mean I know, Joe, you guys have talked about in the past keeping or putting some equity in more of the affiliates as an incentives. And just kind of curious to know with this transaction at least on the surface why maybe it wasn't structured where there was equity being retained by the management of the affiliate.

Joseph A. Sullivan

Sure. So 2 thoughts on that. The first thing that like U.S. in many respects, we have acquired both of these at what we considered to be kind of an important time in their return to profitability. So they are not yet rev share affiliates. They're more sort of corporate affiliates that as they grow over the next 3 years and go through their earn out period at the end of 3 years both for QS and for Martin Currie, we would expect they will be full rev share affiliates. And at that time, we will put a management equity plan in place. They have, in both cases, significant incentive between now and then to build franchise value through the earn out agreements that we have with both. So and what we like about this is in both cases, in both the case of QS and of Martin Currie, is as they are and as they have been on their own going through their recovery in their turnaround, we now can bring distribution in and help accelerate that. That's exactly what QS saw as a great opportunity to partner with Legg Mason. That's exactly what Martin Currie saw which was, look, we believe we're on our own seeing our turnaround occur, but man, if we can bring in Global Distribution, we can really turbocharge that and accelerate it. And that's what we expect to do.

Peter Hamilton Nachtwey

And Rob, keep in mind the earnout, the management teams are participating in the earnout so they actually are highly incented over the next several years to grow the value of the franchise from that perspective. So we've kind of look at -- the earnout gives an amount of incentive in the next 3 years and then we look at the MEP after that.


And our next question is from Mac Sykes from Gabelli.

Macrae Sykes - G. Research, Inc.

On the outflows you noted this morning at WAMCO were they related to some of the reforms that were just announced lower yields, just trying to get a sense of that, and will they be classified as liquidity or fixed income when they come out?

Joseph A. Sullivan

Mac, good question. That's what I tried to call out a little bit. First of all, these were not related to money market form, let's be clear about that. These were simply redemptions of enhanced cash type strategies by 2 companies who are bringing some of their cash back in-house. In fact at least I believe in 1, if not both, they still have cash in the strategies. But they're bringing cash back in-house for whatever their corporate purposes are. Western has several similar short-term strategies and products already for a number of different clients, who for a variety of reasons, have chosen to move into those types of products as opposed to have money in money market funds, prime funds or otherwise. So they've -- it's not a huge business, I want to be clear about that, it's not a significant business. It is classified as long term, which is what I really tried to make the point of this morning. And that's where it's going to be challenging. If, as a result of the money market reform regulations that have been promulgated, clients move out into more of these type of strategies, we could see greater volatility in our long-term AUM, and we're going to have to find a way to call that out or classify that so that you understand. So we had $5.5 billion out with Western in July but it was a mid-single-digit fee rate. Now we could see some of that, I don't know, I'm not certain what those clients are using that cash flow. We could see some of that come back. They're not unlike money market funds in that regard. And so, we're going to have to kind of work through this a little bit to -- if in fact, longer kind of enhanced cash or short-term duration or ultrashort bond funds become more attractive to companies, we're going to have to work on that to be able to give all of you the kind of visibility around what our real long-term flows are, our higher-yielding long-term flows are.

Macrae Sykes - G. Research, Inc.

Okay. And then on the reforms going forward, does WAMCO think that this could be a competitive opportunity for them or when you think about sort of the economics from nonprime funds going forward, is this going to be not just a favorable trade-off in terms of business development on other products?

Joseph A. Sullivan

No look I think one of the things Western -- Western clearly has a strong investment capability across the yield curve. As I mentioned, they've got a number of different enhanced cash short term limited duration strategies and then obviously, they have a long-term strategies, and everything sort of in between. They use -- the money market fund business for Western, as well as some of these short-term bond strategies are used for a more holistic relationship with many of these clients. Some of these clients have relationships with Western on their retirement plans, and things like that and then they also have corporate relationships to manage corporate cash. And so that's why Western really wants to be able to be a holistic provider of investment services to many of these clients. So how it plays out, it's early yet. I mean we just don't know. But look if things continue and if clients tend to move out on the curve, we don't see that as a bad thing, we see that as Western actually having a competitive advantage by having a number of strategies already and others in development to be able to serve their clients in that way.


The next question is from Dan Fannon from Jefferies.

Daniel Thomas Fannon - Jefferies LLC, Research Division

Another question on Western. The unfunded wins if we go back several quarters has continued to be very strong, and if we exclude the couple of mandates you highlighted are leaving this coming quarter, can you talk about just the redemption trends you're seeing in their regular way [ph] business to get really the net number on a quarterly basis to improve?

Joseph A. Sullivan

Yes. I think we feel good about what Western's doing there. I think what we are continuing to see, we had a lumpy outflow in an institutional municipal strategy, that was not anything particularly performance-related as far as I know. We also see kind of chipping away at the moment in kind of the broad market strategies, which is exactly what we've experienced for some time now. On the other hand, we are continuing to see, and Western is continuing to see, sort of these specialized mandates and in particular, interest in the unconstrained and absolute return. And that's the theme just to be clear, Dan, that's across the enterprise. So that's -- Western we've seen that in fixed income and both, but we're seeing seen that across the enterprise even in equities and with both retail and institutional clients. And let's face it, in a period like we are right now of potential rising rates, this is when active management, particularly in fixed income really makes a difference. And I think that's a critically important point here is that investors are anticipating rates to go up. We are anticipating rates to go up at some point in time. Just attaching yourself to an index probably doesn't do you very well. So this is when moving into absolute or unconstrained strategies tends to really highlight the skills and talents of the investors themselves.


Our next question is from Glenn Schorr from ISI Group.

Glenn Schorr - ISI Group Inc., Research Division

A quick follow-up on the rev share agreements or I should say the deal that you did on these 2 acquisitions because they're different from the last one, so I guess my question is twofold. One is, when after a 3-year period if all goes well, do they go into a rev share agreement in line with your current book of affiliates?

Joseph A. Sullivan

Yes. So Glenn, just to be clear, good question and to clarify, in both the case of QS and of Martin Currie, because again they are at sort of a key point in their turnaround. Over the next few years, what we've done is we basically made them a corporate affiliate in the sense that we will work with them annually in a budgetary way -- in a budget process to kind of work through what the proper margin is for Legg Mason and make sure that we're continuing to support and invest in their business as appropriate. So we'll do that over the course of the next few years. And then as Pete mentioned, they are incented to build franchise value by the earnouts, both the QS and at Martin Currie. At the end of that 3-year period, we fully expect that they will become a rev share affiliate identical to the rest of our existing core affiliates. And then at that time, we will also put in place a management equity plan for the growth of the enterprise from that point forward. If you think about it, putting equity in it today, plus an earnout, kind of gives them a double dip at the growth. So we really don't want to do that. So they are highly incented to grow their platform and franchise value over the next 3 years. At that point we will then make them a rev share and then give the management equity plans.

Glenn Schorr - ISI Group Inc., Research Division

Okay I appreciate that. And it seems like positive optionality for Legg, though we can't see all the numbers, how do you go about -- how do you think about the ROI on this type of investment given some of those unknowns relative to deals of the past?

Peter Hamilton Nachtwey

Yes, as we look at ROI, we're very mindful of kind of what we're paying for capital. And these kind of deals we're looking into something that's in the double-digit range in terms of the returns over time. Again, as you said, we've structured a lot of optionality into this, so that bottom line as we only pay up if there's real growth in these businesses.


Our final question is from Michael Carrier from Bank of America.

Michael Carrier - BofA Merrill Lynch, Research Division

Just maybe 1 question, just on the new products you're launching, you guys are pretty innovative. I don't know if you can break that out in terms in the amount of flows that are going into those products versus the current tier products that are constantly are gathering flows. I just wanted to get a sense because you're obviously active, particularly at some of the affiliates and just want to know like what's the kind of the new growth opportunity versus the normal ins and outs.

Joseph A. Sullivan

We're seeing good flows in many of our traditional products. We've talked about Richie Freeman's Aggressive Growth product at ClearBridge, which has performed brilliantly and we're seeing good flows into that, into some of the other products, the income products at ClearBridge. We've actually seen more recently, some activity in Brandywine's equity product. So we're continuing to see good flows with Brandywine in terms of their global fixed income, but we're also seeing good traction with some of their equity strategies. Those tend to be a little bit more traditional strategies but they're just performing pretty well. And then with respect to fixed income again, macro ops, I mentioned in my remarks in a short period of time launched in 2012, were up to 3 billion and I believe it's one of the fastest-growing funds internationally in sort of the absolute return unconstrained space. And then it's just unique strategies. So as I mentioned, Western did about $1 billion in a global credit strategy, it's a discrete global credit strategy and then a bank loan product that had about $400 million. We are also interestingly in the market, I can't really talk about details, but we are in the market right now with a closed-end fund for our retail system. First fund we've done in a bit over a year and I'm not sure but it's one of the few, if not, the only that's been in the market. That closed-end fund market has been pretty tight. But we've got one in the market now. It's not going to be an enormous raise I don't think but we're optimistic. And again, in a more -- it's not in a traditional strategy, it's more in this new alpha strategy where you've got to go in and get somewhat uncorrelated or unconstrained absolute return type strategies.


Thank you. That concludes our question-and-answer session. I would now like to turn the floor back over to Mr. Sullivan for closing comments.

Joseph A. Sullivan

Thank you, operator. And thanks, again, to all of you for your interest in Legg Mason. As I've said, I'm quite pleased with our continued progress in reshaping the mix of our investment capabilities through the acquisition of QS and Martin Currie and the good progress that we're making to our Global Distribution platform. I'd like to thank both my colleagues at Legg Mason and with our affiliates who have worked so hard to strengthen Legg Mason and position us for growth. We do know that we've still got wood to chop, but we're confident that we are better positioned to capture the opportunity before us than we have been in a long, long time. I look forward to updating you on our continued progress next quarter. And with that, I hope you have a good day.


Thank you. This concludes today's teleconference. Thank you for participating. You may now disconnect your lines at this time.

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