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Legg Mason Inc. (NYSE:LM)

F1Q08 Earnings Call

July 24, 2007 8:30 am ET

Executives

Mary Athridge - Corporate Communications

Chip Mason - Chairman and CEO

Barry Bilson - SVP, Finance

Analysts

Cynthia Meyer - Merrill Lynch

Christopher Spahr - Deutsche Bank

Bill Katz - Buckingham Research

Jeff Hopson - A.G. Edwards

Prashant Bhatia - Citigroup

Robert Lee - KBW

Tom Gallagher - Credit Suisse

Matt Snowling - FBR

Marc Irizarry - Goldman Sachs

Thomas Hickson - Wachovia Securities

Presentation

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). As a reminder, this conference call is being recorded. I would now like to introduce your host for today's presentation, Ms. Mary Athridge. Ms. Athridge you may begin ma'am.

Mary Athridge

Thank you. On behalf of Legg Mason, I would like to welcome you to our conference call to discuss operating results for the fiscal 2008 first quarter ended June 30, 2007. This presentation may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

These forward-looking statements are not statements of facts or guarantees of future performance, and are subject to risks, uncertainties, and other factors that may cause actual results to differ materially from those discussed in the statement.

For a discussion of these risks and uncertainties, please see risk factors and management's discussion and analysis of financial condition and results of operation in the company's annual report on Form 10-K for the fiscal year ended March 31, 2007, and management discussion and analysis of financial conditions and results of operations in the company's quarterly report on Form 10-Q.

This morning's call will include remarks from the following speakers; Legg Mason's Chairman and CEO, Mr. Raymond A. (Chip) Mason and Mr. Barry Bilson, Senior Vice President of Finance, who will discuss Legg Mason's financial results. In addition, following a review of the company's quarter, we will open the call to Q&A.

Now, I would like to turn this call over to Mr. Chip Mason.

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Chip Mason

Good morning. Regarding Legg Mason's quarter ending June 2007, we are pleased with our operating results for the first quarter of the 2008 year, being that our year ends in March. We had record revenue of $1.2 billion and assets under management of $992 billion.

We had record net income of $191 million and earnings per share of $1.32. I should note that this excludes the one-time gain of the sale of Legg Mason Wood Walker, our broker-dealer in the December '05 quarter. In light of the equity asset under management outflow, it is especially gratifying to deliver record results that highlight the value of our diversified business model.

Cash earnings per share were also a record at $1.65, which I would like to note is 25% higher than GAAP earnings per share. Hopefully, some time the analytical world will look at our cash earnings per share, which is an important metric, considering our substantial intangible asset write-offs were booked and taxed.

For the fiscal first quarter, our net income of $191 million was up 11% from March and 22% from June a year ago. Earnings per share of $1.32 were up 11% from March, and also 22% from a year ago.

Continued operations and cash earning per share of $1.65, were up 7% from March and 17% from June a year ago, and our total cash income of $238.9 million was up 7% versus March and 17% versus June a year ago.

Our assets under management stood at $992.4 billion, which is a record. Quarterly increase by $23.9 billion, up 2.5% from last quarter in March '07 and $268.5 -- which was $268.5 billion. $23.5 billion was marked appreciation and $1.7 billion came from flows.

Flows were modestly positive for liquidity, quite respectable for fixed income, which had a few one-off outflow situations. The fixed income pipeline is at near record levels. Equity flows continue to be affected negatively by relative under-performance in several of our key equity managers.

Industry equity fund flow trend, domestic growth funds, the primary discipline of ClearBridge has had net outflows during the quarter. In calendar year 2006 and 2007, international equity fund flows have captured two to three times their relative share of the total assets. While we are very solid in the emerging market client. International equity as asset class for Legg Mason is certainly under represented.

Equity and the lack of equity flow to some of the managers is an area of focus. Performance is a key to generating flows. Improvement in performances of several funds did happen during the quarter. There are several products and managers that continue to perform well. Permal had strong performance and flow, and has doubled its size since its acquisition 20 months ago, to roughly $35 billion.

Royce has benefited from strong performance and flows consistently. Two noteworthy ClearBridge equity mutual funds, these are the important stars of the Legg Mason Partners Capital Fund with approximately $1.5 billion in assets, and the Legg Mason Partners Capital Income Fund with $3.5 billion in asset, with 4% on our ranking year-to-date in 12 month trailing.

Legg Mason opportunity trust, a four star fund with assets of $8.3 billion has outperformed the S&P over the one, three and five years since inception. For the five year inception period, it has outperformed S&P 500 by 900 basis points annually. As increasing profits in sales, the net inflows for the June quarter were $450 million.

Fixed income, generally speaking, not necessarily Legg Mason, but universally had a difficult quarter with the Lehman Brothers' aggregate down 0.52% and the Lehman Global aggregate down 0.89%. All but one of Western Asset's domestic separate account composites beat their respective benchmarks for the one, three, five and 10 years, and since inception period. Western is still challenged in the U.K.

Distribution; generally Western launched two new separately managed account products for retail investors; Core and Core Plus strategies. Portfolios were utilized, individual securities and no-fee mutual funds set up to allow portfolios to gain exposure to various securities typically accessible to retail clients. Permal’s entrance into the U.S. is gaining momentum, gaining acceptance, and shelf space in the third part retail channel.

Legg Mason Partners Funds have succeeded in being added to retail mutual fund wrap programs; the large cap growth with multi-cap growth. Separate management mandates have been added to the large distributors unified managed account platforms.

The appetite for international investment remains very high. Our assets that are managed for clients domiciled outside of the United States continues to grow. The Board has increased it's authorization to repurchase shares to five million. Our goal is to maintain and create shareholder value. We have begun servicing our debt. We are paying $50 million per quarter. All this gives us additional flexibility.

I should point out and you should realize that, our number one priority remains the purchase of an international asset manager, and our second priority would be the repurchase of stock. But, we are now increasingly focused on growing our business. We've achieved this through several avenues, delivering current products to the U.S. and international clients, through new distribution channels and new product creations, utilizing our managers individually and in combination.

What I guess I should add into this is that, while all of our efforts were focused on getting the acquisition done and getting the systems for those acquisitions done and holding on to the assets we had, there's been a distinct turn and change over the last several months on where people are and what they are doing and how their time is been spent. And it felt pre-merger when we were focused on driving assets.

We are confident that certain of our equity managers will return to their long-term levels of strong performance, and obviously from that the bottom-line would benefit. We continue to have probably a stable of some of the best known managers in the U.S. and in the world. And you do hit pockets when they do not perform as well, whether they are weaker than they should be or their category is weaker. And we've all been through those before, where we have it in value and/or in growth or whatever the area may be. As I indicated before, our diversification helps us so that we stay balanced during those periods.

I'm going to turn it over to Barry to go in to some detail.

Barry Bilson

Thanks Chip. Good morning everyone. I will try and make this expeditious. I think when balanced, this quarter probably does not surprise relative to the numerics but there may be a couple of small exceptions. Relative to normalcy, if there is such a term in this business, this is about as normal a quarter is probably which you anticipate you'd be seeing.

From a standpoint of significant variations or noise, very little; worst case, most extreme may be a couple of free cents of revenue and a couple of free cents of expense. So, in the whole scheme, don’t beat your head on the wall trying to find significant aberrations, because this really is a pretty " normal quarter".

With that said, I see one area and I'm sure but it will be recycled in the Q&A a bit, is relative to the flow side of life. Let me make a couple of quick comments in that regard, certainly we can touch on one or more later.

The fixed income flow does not appear to be exceptionally strong. The fact is if you take out a couple anomalies, it really was a good quarter, a very good quarter and very much aligned with a lot of the historical trend. For those who have a memory better than mine, there was a quarter a year ago where in fact there was re-balancing in a significant number of non-U.S. liquidity accounts, which pulled down to about $10 billion of liquidity assets.

If you go back and look at June '06, you can actually see it. Someone may I ask, go to page 10 of the release. The managed investments which is where all our mutual funds and SMA sit and all mutual funds. Once you are offshore retail and institutional, you see a net outflow in that quarter of $9.6 billion, very heavily routed. The same account goes through a re-balancing cycle pretty much annually, and last year it was at about a $10 billion level of rebalance and such was the case this year.

One other bit of an anomaly and an exception is that there were a couple of free long-term bond mandates that in fact, the client actually pulled the management in-house. Does not appear to be a trend by any stretch, and it was certainly a bit exceptional.

Moving on. In the mix of assets under management divisions, assets class, geography, virtually identical sequentially, plus or minus maybe one-half or 1% within the categories, and year-over-year within probably a percentage point, a little bit heavier on liquidity probably two percentage points and down about one percentage point each on equities and in bonds.

Realization rate, very much in line with last quarter. And what I am utilizing in realization rate just that we're all aligning our numbers, is the investment advisory fees and excluding performances fees, which actually are going to move in different directions over different times.

But, the realization rate for this quarter was at 38.9, last year it was 38.8 and last quarter it was 38.3. If you play with the math between quarters, in fact three quarters of the difference sequentially is driven by the fact that you've got an extra day in this quarter. So, with the mix substantively in line sequentially, so too was the realization rate.

All right, performance fees, I suspect that's stronger, I know it's stronger than most had modeled. Not going to be labored at the notion that that is a number that will be difficult to pay, because obviously you've got market environment and you've got underlying managers. We do have a substantial number of managers and a substantial number of products at this point that do have some element of performance fees.

There was a singular fee embedded in the $54 million this quarter that relates to an annual measurement period on one of our international accounts. There was a level last year not as large as this year, but again, we record the performance fees at the end of the measurement period. So, with that unique mandate and manager you would not see anything again until this time next year, assuming the performance warrants.

Even if you back that out, you've got a meaningful increase sequentially and very dramatic year-over-year. And that is as Chip pointed out, Permal has had an incredible run driven by flow. And with this all in the same business, performance may get slow. So, along with the strong performance they’ve also had very strong performance fees.

Everybody wants to know what a normal rate is to use. I guess in the last conversation a couple of quarters ago, I have said may be benchmarking the 30-35 range. You're going to have to vary that based upon the market environment. But, normalized kind of rate in a reasonable market probably is something around35, 37 maybe 40 would work, but there does not have an absolute stable persistency to it.

Moving on to distribution, service fee revenue and expense, I am not going to go in to the tie rates of the past six quarters. Last quarter provided guidance. Probably the best way to view that is relative to advisory fee on funds, plus distribution and service fee revenue, which is pretty much the full bundle of fund related revenue and almost with that exception that is the same days that the distribution and service expense relates to.

Next quarter, the relationship of the expense to the revenue was at 43, 9, this quarter it's 42, 3, last year it was 42, 2. I think the underlying mix of retail, institutional, etc, share classes sold can make that move, but I think if you deal with a 35 level you are going to be within a couple of million net of hitting the thing on the body, assuming you've got the revenue levels calculated correctly.

Other revenue. A bit of an increase. I would not consider this "the normal level" related to certain account fees and some commission revenue generation within one of the asset managers substantial. Little heavier than norm, probably a normalized type level there with the $4 million or $5 million, but still subject to a fair amount of potential motion.

Compensation percentage, and again the numbers that I run are may be a little different than yours. I relate most of the expenses and things like comp to the revenue that we have left to manage the business that I refer to as net revenue that in the release is presented as adjusted revenue i.e. total revenue, less distribution and servicing expense. That percentage for the quarter is at 50.4% versus 50.1% last year and 49.1% last quarter of the underlying mix of managers, performance, et cetera we will have an impact there, but pretty stable sequentially. There is also a little bit of uptick probably order of magnitude.

Sequential quarters of maybe 0.3%, with these fund-deferred compensation plans where there was additional income down from the non-operating income. All told, if you took all the income and expense that is a bottom-line watched out of the equation, probably 0.5% or 1%, but the sequential increase is about three-tenths of a percent.

The non-compensation, non-distribution expenses, $146.3 million this quarter versus $120.7 million last year and $146.6 last quarter. A little bit of increase in communications, technology, occupancy and a little bit of a decrease in intangible amortization and other operating expenses, but net, basically a copy job between the two.

The intangible amortization sitting at $15 million is your current run. Obviously, there are multiple layers of identifiable intangibles and there was really one significant piece that has hit soft amortization period.

He'd indicated that there should be some ease in some of the categories. There is opportunity over the next couple of quarters that you could see some ease in the occupancy side, the expense we had substantial advertising over really the past two quarters. So, I wouldn't go adding it back to something which could be replace it. Yeah there are actually a few million dollars in there that is very discretionary in regards to the consulting fees, etc. are still very high, and at some point those may back off a bit as well.

Another area I want touch on is the other non-operating income, which is again the category that will jump around substantially. There was a $3.5 million gain on the disposition of the joint venture that we had. There is an additional $3 million in what was already made reference to in the funded direct compensation plans, where as an equal opposite dollar amount open to comp and then other investment gains relative to seed money etc., that we have.

Tax rate was spot on to the guidance given last quarter at $37.5 and I think that's where you’re already maintaining at this point. The other thing that I think is noteworthy, and this is not the best flow quarter we've ever had by certainly a meaningful note. But despite that to have been able to hold the cost in a manageable fashion, both the fixed and variable, and still grow the revenue and expand the pretax margin. The 34.5 pretax margin one adjusted revenues again total revenue less distribution in service expense is $34.5. That is the highest level that we have attained since we did the transactions above four percentage point from last quarter.

And the only other point probably we should make and you got the reference in the release, is relative to current cash and debt level, which are substantially similar. But do keep in mind that there is a substantial portion of cash that really is not a corporate discretion either tied to compensation plans with various subsidiaries or domicile either for regulatory purposes or repatriation, restructuring outside the U.S. But within the $1.2 billion or so of cash. This is probably close to $500 is corporate that we do have some discretion certainly a level that has to be maintained for working capital purposes.

I think that's the high points, whatever I missed I am sure you would remind me and let's go ahead and open it up for questions.

Question-and-Answer Session

(Operator Instruction). Our first question or comment comes from Ms. Cynthia Meyer from Merrill Lynch, Ms. Meyer, your line is open.

Cynthia Meyer - Merrill Lynch

Hi good morning. Just a question on the interest in overseas manager, I am wondering when you say you want to buy an international asset manager are you looking for primarily somebody with assets invested in non-U.S. strategies or you most interested in distribution?

Chip Mason

Cynthia, primarily in the asset management side of non-U.S., principally we're looking for European, although global, but principally European and U.K. If we get distribution that would be great, but that is not the primary driver.

Cynthia Meyer - Merrill Lynch

And when you say that's the priority number one, how do you handle the share repurchases in the meantime? Does that mean that you are comfortable spending a certain portion of the ongoing cash flow ,or just offsetting the dilution?

Chip Mason

Well I think that our intent is that we will proceed with what the board had indicated or gave us the authorization to do on an annual, looking at it sort of on an annual basis. And if in fact we thought we were going to make or did make an acquisition my assumption is that we would stop all purchases and use that cash to do the acquisition. All right. Did that answer you?

Cynthia Meyer - Merrill Lynch

Yes. Thanks a lot.

Operator

Our next question or comment comes from Mr. Christopher Spahr from Deutsche Bank; Mr. Spahr your line is open.

Christopher Spahr - Deutsche Bank

Good morning.

Chip Mason

Good morning Chris.

Christopher Spahr - Deutsche Bank

Another quick follow-up on the realization. How much was impacted by the client rebalancing?

Chip Mason

You're talking on the fixed income side?

Christopher Spahr - Deutsche Bank

Yeah. For example, I mean obviously the revenue, advice revenue, your average revenue were up this quarter, I am just wondering how much of that do you think was impacted by the rebalancing, if any?

Barry Bilson

Very little. Barry here Chris. A little, the realization count is done off of those, off of the average assets. Actually the big chunk in the rebalancing is in the liquidity space, actually the lowest realization rate. It could have touched it, but again, once we adjust for a one day in the quarter, you are within like one of the basis points in the mid. So, yes it could have impacted but you are moving out into the, probably the second decibel place.

Christopher Spahr - Deutsche Bank

Okay. And then the follow up is on the client flows by location. Can you give us a sense of how much of these flows were coming from non-U.S. sources?

Chip Mason

It was like 70, it was close to 80 last quarter and I think it was something like 27 this quarter.

Barry Bilson

Right. In fact, if you adjust all that liquidity dynamic it actually moves up to a meaningfully higher percentage and its probably in excess of past.

Christopher Spahr - Deutsche Bank

Half quarter. Okay, thank you.

Chip Mason

And that's taken the liquidity piece out.

Christopher Spahr - Deutsche Bank

Understood. Thank you.

Operator

Our next question or comment comes from Mr. Bill Katz from Buckingham Research. Mr. Katz your line is open.

Bill Katz - Buckingham Research

Thank you and good morning. So, curious as to what you think the key is to improving the relative performance in the equity business? Is it just style, shift if you will back to domestic and growth, was it something else at play there and how does that impact your thought strategically on acquisition?

Barry Bilson

Well, probably the most correct answer is I don’t know. But, because no one knows when you get in these cycles. I remember that the value cycle in the late 90s, nobody could figure out what was causing it, but somehow this is just underperformance. It’s not necessarily out of form.

The flows are definitely in the equity side of the business gains, very effective in the United States in particular, because the international piece in all those firms that have a disproportionate amount of their assets in the equity international side are doing extremely well right now, because that's where the money is going and I've forgotten I am going to make a comment. I am not sure this is right but something like 87% of the equity flows were going in the international securities. It's a very high number whatever it is.

And many of the categories are having negative flows. I think growth has had negative flows last quarter. This is across the board. So, when you get in these trends, unless you have superior performance you’re really going to suffer and certainly we have witnessed that. Although, again the truth is the funds that are having strong performance do seem to be getting flows, may be not phenomenal. But, they do seem to be getting flows.

So, performance is still the key. How do you fix it? I don't know of anybody that knows how to fix that. Someone said to me well you need to get new managers. We've had a history over the last say 15 or 20 years of having certainly superior numbers on the equity side, and when you hit these cycles where you are underperforming, one of the concerns is do you throw the baby out with the bath water.

When you have who is perceived by almost everybody as being some of the best managers in the business, you just tend to ride out their cycles with them and hope that next week, next month, next quarter they begin performing again. I wish there were a better answer, but I sure I believe there is one.

Bill Katz - Buckingham Research

The follow-up to that, Chip, does that sort of shift your timing on acquisitions in light of that? It seems like it's going to be a gradual recovery. Which means we have to move more quickly than in maybe the last couple of quarter in terms of acquisition?

Chip Mason

Well, Bill, the answer is if I could we would have already done something there. The problem that you tend to have is that the acquisition sort of comes when it comes, and if you try and rush it, you end up making an acquisition that you may have later wished you didn't make. And you are constantly saying to yourself all things being equal or if you are in a great cycle would you do this deal? Because, once you buy it's yours. And if they do extremely well you feel smart and that I really did a good thing, and if you buy something that isn't working you are constantly either kicking yourself or trying to figure out what to do to fix it.

So, they'll come when they come. I have been spending a disproportionate piece of my time on this subject. We have certainly met with and talked to most of the companies that I think are the best in the business or that are a number of best, among the best in the business. And we will either be able to do something or not, I am not sure I can rush that.

Bill Katz - Buckingham Research

Okay. And then the follow-up, Barry, can you just quantify the unusual bond outflows this quarter?

Barry Bilson

Yeah. The indication, Bill that was in the liquidity space was a singular account with about $10 billion and then there were two or three long bond accounts with about $5 billion that pulled the management in-house.

Bill Katz - Buckingham Research

Okay, thank you.

Chip Mason

And if you take the seven plus that gives up into the 20s so…

Bill Katz - Buckingham Research

Right. Okay, thank you.

Operator

Our next question or comment comes from Mr. Jeff Hopson from A.G. Edwards. Mr. Hopson your line is open.

Jeff Hopson - A.G. Edwards

Thanks. In regard to Permal and performance fees, I think December is thought to be their strongest quarter. So, any thoughts on what we should be thinking about relative to last year there?

Chip Mason

That's a hard one. First of all we don't have a clue. We always look at the tracking number. Actually they are quarterly numbers which have been different than what we had experienced before having been tracking better than their annual number. So, and we also have some limits on the annual numbers that are substantially less on the quarterly numbers. The only answer we can give you is, we really don't know.

Jeff Hopson - A.G. Edwards

Okay. And on Western how would you say they are positioned given the weaker credit cycle that appears to be occurring?

Chip Mason

I'm not sure we know. I mean, I had a number of talks with Jim on this and with Ken Leech. Now, Western came off an extremely good year last year. Their numbers were probably the best in the business, that's again hard to say, because I can't really make a statement like that. But, they were very good numbers. And so, one of your concerns is whenever you have such a great numbers were you are getting all the benefits of those great numbers and attracting accounts and all and when you suffer if there is a change in numbers.

There is no sign of any diminution, because what you tend to watch is how many presentations are you making and the size of those presentations, and what are the basis points you're working on. Because you can't be mislead which is easy to do in the fixed income area. Where you get a whole lot of assets in one area, but you are talking about four basis points. So, it's not a very meaningful number. So, you watch all three of those things at one time.

And, factually Western appears to be pretty unchanged. There is little sign of anything that would indicate there is a slow down. There is less presentations or the size of the accounts is coming down when you are averaging say 600 million or 700 million, when your average win it's dropped down four, obviously that's a big difference.

But there is no sign of any of that. Western really isn’t, except for the liquidity business, they really are in the lower fees side, because they have tended and I am not saying this is right. We've discussed this for four or five years. They’ve tended to stay away from the low-fee large account where you get a tremendous amount of assets, but you get three basis points or something. It has typically not been their style. In fact, it has actually not been their style and that may be a mistake.

One of the issues we've always struggled with is how do you handle the favorite nations issue. But, I mean I see no change in any of this going on. So, that's a long-winded answer. But, one we have been getting questions on. Because of what's going on in the fixed income markets and it looks like long-term rates are probably on an up trend, not a down trend and because of the question as to whether fixed income will be the median that it has been going forward. I mean all the questions are reasonable and legitimate, but the fact is there is no sign of any change whatsoever. The backlogs are the same. We are still seeing the same major accounts all over the world and Western certainly has always had those accounts all over the world. So, I would say at least at this point we don’t see any change.

Jeff Hopson - A.G. Edwards

Okay. Great, thanks.

Operator

Our next question or comment comes from Prashant Bhatia from Citigroup. Mr. Bhatia your line is open.

Prashant Bhatia - Citigroup

Hi. Just on the operating expenses, I think they are up about $45 million during the quarter. Could you give us a feel for how much of that expense growth was picked up by the revenue share partners and how much was outside of the revenue share partners?

Barry Bilson

Prashant, you have to help me a little bit as to what you are including in your operating at year-over-year or sequential?

Prashant Bhatia - Citigroup

I am just taking sequential quarters. I am taking your $869 last quarter and the $914 this quarter.

Barry Bilson

Got you. Because I was going to say, the one I would slide down to is sort of the overhead side of life; the non-comp, non-distribution and those numbers are basically identical, which then takes us to two dynamics. Actually one is the distribution in servicing, which in all material respect within the $4 million softness of the copy job, which ultimately then leaves you with one number, which is your comp and bennies which broadly, you got fixed dynamics, as well as variable. But I would encourage you to take that off of sort of the percentage of revenue.

I saw when I answered your question. So ultimately, what you are looking at there is about a $42 million increase and I would have to say that relative to revenue sharing entities and also with an increase in the bottom-line some of the corporate incentive cores, I'd have to say that probably 85% to 90% of that increase and this is sort of a major gaps is variable.

Prashant Bhatia - Citigroup

Okay. So 85 to 90 came from the revenue share side?

Barry Bilson

Correct.

Prashant Bhatia - Citigroup

Okay. Also just on some of the other firms out there are participating a bit on the closed in fund side of the business, is that something that you have plans to participate in or is that something that you are you thinking about that at all?

Chip Mason

If there is an area you could criticize for that would be demand particularly with the broad diversity of mangers that we have. We certainly, in some areas haven't been quite effective. Permal probably un-bennies to most people is now on most of the major systems literally on their platform and we do have products going all over the world through them that, certainly there is a reason why their asserts are going up as much in addition to performance.

But if you look at our general managers, we really have not accepted the smash account for Western Asset, which was launched a month ago or something like that. We have been quite silent and for that we probably could be criticized and then I think legitimately but that was part of that focus that we had on bringing the assets in. We really weren’t merging theses assets remember, we were acquiring and there is a big difference. And we had to bring all of them in to our systems in a third party relationship.

So to an extent I think we did the right thing. On the other hand we did not focus in any way we probably should have on the large pools of money that are out there. Now we have talked to a number with distributors and I would hope over the next six months you would see a change in that, but it was because of our concentration on getting the deal done.

Prashant Bhatia - Citigroup

Okay thank you.

Operator

Our next question or comment comes from the line of Mr. Robert Lee from KBW. Mr. Lee, your line is open.

Robert Lee - KBW

Thank you. Good morning everyone.

Chip Mason

Good morning Rob.

Robert Lee - KBW

I just want to go back to the cash generation and share repurchase, just want to make sure I understand it correctly. The $5 million authorization from the other day, does that have a specific timeframe on it that’s sort of open ended, it's not say a one year kind of target?

Barry Bilson

That's correct.

Robert Lee - KBW

Okay. And if I look at the cash flow that you are generating of the $230 odd million, sort of cash net income this period, how much of that will actually be sort of discretionary that's not being generated outside the U.S., it does not need to be held for regulatory purposes, if I want to think of your annual cash generation what's really sort of available item that's out of the pay down that acquisitions sort of repurchase shares?

Chip Mason

We've different views on this internally. I tend to be the more conservative one and everybody else thinks I would do it, but I guess you would say that the external 10 to 15 a month is in Europe or outside the U.S. I should say, most of it.

Robert Lee - KBW

All right. So you're saying well if its you, you did what is available.

Chip Mason

Outside the US I'm talking about.

Robert Lee - KBW

Say 200.

Chip Mason

200 on an annual basis. Well that's probably 10 to 15.

Robert Lee - KBW

Okay.

Chip Mason

Roughly 200 million a year is outside. It doesn't mean we can't use it it's just much harder as you well know to use. Then it's always internal needs, contrary to what people believe, there's always internally, now you could argue with me, because we've always maintained a minimum cash balance of $300 million, which is sort of my rule, I don't want to go under $300 million in cash. Because whatever comes up or whatever we need in the subs or whatever needs to be done. So, whether we need that again when we already have it is debatable.

So, you would say I sort of think that a number overall is that we have got roughly say $700 million to $800 million that is probably free money. And with some obligations against it, because we do have a payment coming to Permal that has to be paid, $240 million I think it is later this year. And we do have some required debt repayments, which is right now $50 million a quarter so it’s not much on a relative basis.

But certainly the cash will build beginning sort of now and certainly our liquidity does not appear to be an issue. The question is, and if you look at us historically is what we have tended to do is try and clean our skirts after an acquisition and then go forward into a new acquisition somewhere in the two to three year period.

And so, the difference and rarely did we use cash by purchasing stock and most of it was used to do for acquisitions. So the question here would be what do we need for acquisition and I guess the reason I am so leery on it is the deals we do now are just big. And its because of our size and for something to be $2 billion or $3 billion, which is a horrendous amount of money relative to anything we ever thought about is not, probably going to have to be that kind of size. So, you just tend to look at it differently. We will need cash to do deals. So, I don’t know where you are going with your question, but that sort of gives you the whole answer or the full thought process.

Robert Lee - KBW

No, I mean that's fair. Is this where there will be more color on the complexion of the equity flows? I mean, are you seeing any churn, for example, a private capital management flows there stabilize where most of the outflows concentrated at ClearBridge. Just want to make sure I understood some of the complexion there.

Chip Mason

I think it's pretty even across the board. The three equity managers have shared that about equally in the past quarter. People keep putting it all in ClearBridge, which isn't fair. It is all three. Now, in fairness to private capital, they had a series of trusts outside of the United States that had been liquidated at a certain period of time, and they are in the last piece of that somewhere in here. Somewhere this summer or in the fall. And that's really been their biggest hit.

I think they and we will be glad when all that goes away. And so in their case some of the downturn in terms of outflows has been coming from this outside -- its actually the European trust that was pretty sizable. In the case of the others, Bill Miller's area it's very mixed. Certainly, outflows in the funds that have been underperforming, particularly in the value trust area in the mutual fund side. But, as we indicated to you in the opportunity trust, he has been getting net inflows. I think we told you its $450 million for the quarter.

And trust me, we are looking at this like you can't believe. Sometimes I feel we had to walk away for two or three weeks and stopping looking at it. But, there are signs that we've improved in terms of the percentage of the funds that are outperforming the benchmarks has improved, has gone up. And we are hopeful that that is a sign of the future. We will obviously tell you when it happens, because we’re waiting just for that to happen.

Robert Lee - KBW

Okay. Can you update us a little bit on your search for a successor. Where you feel you may be in the process and feel like you are making good progress in it or maybe just give us the general update?

Chip Mason

There is a four-person committee of the board that has been working pretty diligently since probably April. It has three, I think its four physical meeting and they have not set down timeframes, but they have made it pretty clear what their expectations are. And I think their progress has been certainly as good as I would have expected. I am a little bit surprised, because of the time of year that they’re as far along as they are and it would be silly for me to even try and comment in here, because it's their domain. But, I think the progress has been good, both internal and external. And I think they feel good about where they are and their progress. I can't give you a date, because they really haven't confirmed a date when they intend to be completed. But we will tell you that as soon as they are willing to. I don't want to run in front of them, I guess is what I'm saying.

Robert Lee - KBW

Fair enough. Thank you.

Operator

Our next question or comment comes from Mr. Tom Gallagher from Credit Suisse. Mr. Gallagher your line is open.

Tom Gallagher - Credit Suisse

Good morning. Just wanted to ask a couple of questions on fixed income. The $5 billion or so that you talked about being pulled in-house by some clients. Is that a trend that you had seen at all in the past and maybe how should you guess in terms of what you think is happening there?

Chip Mason

No. I think this was a one-off. I questioned Jim about that yesterday and the answer is no.

Tom Gallagher - Credit Suisse

Okay got it. So, not something you've seen in the past several quarters?

Chip Mason

No. You'll have them from time to time and it could be for various reasons. But, the answer is no. There is no indication that that's more widespread.

Tom Gallagher - Credit Suisse

Okay. Can you also talk a bit about what you are seeing domestically and internationally within fixed income? I think you mentioned a little bit about the UK having some issues. But, maybe if you could just sort of compare and contrast what you are saying?

Chip Mason

Yeah. From what I gather, Western who is, as you know, very performance oriented and that's what's really made them what they were or are. Their domestic performance is fine. Their performance in Europe is fine. Their performance in Asia is fine, maybe that’s Singapore, but everywhere other than that in Asia. But, their performance in the UK which has been very strong for years has been sort of mediocre over the last two years and/or 18 months, I don’t know about two years, certainly 18 months. So, my guess is with as many debts they've got, you are always going to have some area of the world that's not doing as well. But, for them right now it’s the UK, otherwise they are doing fine. I am talking performance here.

Tom Gallagher - Credit Suisse

Got it. And then if you just look at the kind of magnitude of flows. Have you seen any changes domestic versus international other than sort of isolating the UK situation?

Chip Mason

No, and we tried to go through that a couple of days ago to see if there was any trend. Is there anything? I got to get that from Western, because we don’t have that information. We get it more or less after the fact, when they win an account. But, we are not following all of the presentations they are making. But, the answer we got back is there is nothing that they could say that is any different. There are larger pools of money that are out there now for much lower basis points, but there is not any other trend that they are aware of that changes their numbers in any way.

Tom Gallagher - Credit Suisse

Got it. And then just one last question. Can you comment at all on plans for the U.S. roll out of Permal, kind of where that stands? Where do you think that could be substantial as it relates to net flows?

Chip Mason

I don’t know. We've tried to analyze that. It's been probably slower than we would have anticipated and that's been a good thing. Because, we are afraid that the product is more complex than the normal retail broker deals with, not that they don’t have the intelligence, but they all have the training. And so, what we are trying to do is, take smaller teams and train them on the product. So and although it continues to grow, it has not just jumped off the table.

The growth though in the other parts of the world is so strong that we are literally physically having trouble marketing-wise just keeping up with it. So, it maybe has been a good thing for that purpose too, because everybody has been so strained in terms of demands that are just very high outside the U.S.

Tom Gallagher - Credit Suisse

Got it. Thank you.

Operator

Our next comes from the line of Matt Snowling from FBR. Mr. Snowling, your line is open.

Matt Snowling - FBR

Thanks. Good morning.

Chip Mason

Good morning.

Matt Snowling - FBR

Chip, can you talk about your plans regarding the distribution partnership facility? And maybe at this point does it make more sense to open it up to outside providers?

Chip Mason

Well, it’s not really our choice per se. You probably read the article in the -- I think it was in the Journal somewhere and there has been a combination here of lower flows than would have been expected and less performance than would have been expected on the other side. So the combination has caused a question as to what would ultimately be done on the exclusive arrangement.

Matt Snowling - FBR

But don't you have an out if those flow targets are met?

Chip Mason

Yes, with some things on the side that don't make it totally clear. So, the answer is yes, but it's not a clean yes. And I guess the only way I can answer this because this is a discussion that we or I am not directly involved in, but the one other issue here is that Smith Barney, Citigroup, Smith Barney is a very key distribution partner for us and will continue to be so.

And I think we are pretty confident that this will evolve with an answer that will be to the mutual benefit of both parties going forward. I’m just not really in a position to comment more than that, I know they had there in the midst of this discussion now and I think I have probably gone as far as I can go.

Matt Snowling - FBR

All right. Fair enough.

Operator

Our next question or comment comes from the line of Mr. Marc Irizarry from Goldman Sachs. Mr. Irizarry, your line is open.

Marc Irizarry - Goldman Sachs

Great thanks. Hi everybody.

Chip Mason

Hello. Good morning.

Marc Irizarry - Goldman Sachs

My question is on the operating margin. If you look sequentially up a 120 bps or maybe there is some outsized gains and other and there they can take up, but I am just curious why your flows in equity are more negative? Your margins are up sequentially and I think you might have spoken back either last quarter or couple of quarters ago that for the operating margins to really see some leverage you need the equity flows to pick up.

I am just curious if you have at all kind of re-thought what the target operating margin on the business will be going forward or if the more normal operating margin run-rates a bit lower than where it is today? Thanks.

Chip Mason

I'll let Barry handle this because this is more in his category, but you’ve got to understand that you need to look at Permal as sort of an equity manager, because they do generate their fee basis is much more like and it will that is in many of the equity managers.

Barry Bilson

Just real quick, Marc and I see that the comments we had made even this quarter back is probably a year ago that our short term goal on the pre-tax margin, on adjusted revenue of around 35% is still our short-term goal. Actually some of the underlying business dynamics have not been as would have hoped and certainly don't need to be labored, but we're in a period where we haven't experienced a historical level of equity asset in flow.

And this quarter sits at 34.5% after we do our best to control the cost we do our best for long periods of time to clamp down with some of the discretionary spending, which quite candidly till this point we have not clamped down because we think it is in the best interest of the franchise to be doing some of these investments. If we had to during a real drought or sustain retraction of course we could, but we are not there.

I feel it’s not the greatest fourth quarter, but not the end of the world either, long way to answer. Goals beyond we certainly think in a reasonable environment where we can add some sustained growth in the AUM with some equity in there as well that we can move that up a couple of percentage points. Our long-term goal is still to move that thing in that 40 neighborhood, but again we are going to have to experience a more normalized competitive organic growth rate across the assets classes in reasonable market environment. So really the guidance hasn't altered; it just may be delayed a little bit is we built some momentum in some of the equity space in general, retail space in particular.

Marc Irizarry - Goldman Sachs

Thank you.

Operator

Our next question or comment comes from the line of [Mr. Thomas Hickson] from Wachovia. Mr. Hickson, your line is open.

Thomas Hickson - Wachovia Securities

Hello. Have you?

Operator

Mr. Hickson, you may need to un-mute your phone sir. Okay. We will put Mr. Hickson back into the queue. And our next question or comment will come from [Mr. Shaun Hayes] from [Hayes Family of Funds] your line is open. Hello Mr. Hayes. He's just removed himself from the queue as well. Our next question or comment is a follow up from Ms. Cynthia Mayer from Merrill Lynch. Ms. Mayer your line is open.

Cynthia Meyer - Merrill Lynch

Hi. Good morning. Just a quick question. Is there any chance the Royce would have to close in more products given their small CAP and have been pretty solid?

Barry Bilson

Not that we are aware of. Certainly they have had pretty solid returns and growth which you stated and certainly they have watched that closely, Chuck is not one to allow anything to interfere with how well the funds do, so but at the moment we are not aware of that, of their doing that.

Cynthia Meyer - Merrill Lynch

Okay. And actually just one more follow up. Can you give us a sense of Private Capital's year-to-date performance?

Barry Bilson

It is, I can't, but we have it. It’s a little, their one year number on a net basis is just shy of a percentage point of our benchmark and has been improving through the year.

Cynthia Meyer - Merrill Lynch

Great, thanks a lot.

Chip Mason

Cynthia, they ended up last year, it may have been excluding fees, but being the S&P I don’t know if we did, including fees or not, but they were right at the S&P. So, but looked like a really bad year early in the year last year, they made it all up.

Cynthia Meyer - Merrill Lynch

Okay. Great thanks.

Operator

(Operator Instructions). I show no additional question or comment in a queue at this time.

Chip Mason

All right. Well, thank you all for being on the call. I know that this is busy earnings period for all of you and therefore you've got a lot to do. As I indicated, I don't really see anything going on the fixed income side that would be any different than we've got over the last year or two or three years. So, there is literally no change, there are issue is flows in three of the equity managers. Brandywine and Batterymarch certainly emerging markets, which has had tremendous period, the Singapore emerging markets group just posted the best treat 47% returns for the quarter and it was the best return in Asia or something like that, now its for short period.

But, our issue is in the three equity managers in terms of their flows, after that I don't really know of issues that we have. They seem to be doing what we tough they do, the cash flow has been coming through, which of course from the Board’s standpoint they wanted to see it and they now are seeing the cash flow come through. And we do seem to be holding our own generally across the board.

The distribution side seems to be fitting closure and closure with our various entities, which is something that we hope would happen. And there is certainly in the alternative space things have been going knock on the woods very well for us Permal and some of the works that's been done it Brandywine and Batterymarch.

So, I would say that the feeling here are much more positive, much more relaxed. All the integration is over. I read these comments about the difficulty we had in integration, I am not quite sure what that was, but we literally finished every integration on or before schedule, it was incredible how accurate our projections turned out to be and these were like we did over 500 systems, changes, integrations. So, it was a pretty major undertaking by anybody's standards, but we get them all on time. We just kept our head down and got it done, which is the thing we should have done.

The only thing I want to close with is, is there any chance we can get you all to please look at our cash earning, in our case it does matter, there is a 25% differential and in some case as your willing look at them and in some as you are not willing to look at them but we would, it certainly helps our cause if you realize that when you do acquisitions you do pick up things that make your cash earnings, it creates a differential between the two. Other than that, thank you for being on the call.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may now disconnect. Everyone have a wonderful day.

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Source: Legg Mason F1Q08 (Qtr End 6/30/07) Earnings Call Transcript
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