Legg Mason, Inc. F1Q10 (Qtr End 6/30/00) Earnings Call Transcript

| About: Legg Mason (LM)
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Legg Mason, Inc. (NYSE:LM) F1Q10 Earnings Call July 20, 2009 5:00 PM ET


Alan Magleby - Investor Relations

Mark Fetting – Chairman, CEO

Charles "C.J." Daley – Chief Financial Officer


William Katz – Buckingham Research

Daniel Fannon - Jefferies & Co.

Mike Carrier - Deutsche Bank

Robert Lee - Keefe, Bruyette & Woods

Keith Walsh - Citi

Jeffrey Hopson - Stifel Nicolaus & Company, Inc.

Mario Gabelli - Gabelli & Co.

Craig Siegenthaler - Credit Suisse

Roger Smith - Fox-Pitt Kelton

Marc Irizarry - Goldman Sachs

Matt Snowling - FBR


Good day, ladies and gentlemen, and thank you for your patience. You've joined the Legg Mason quarterly conference call. (Operator Instructions)

I would now like to turn the call over to your host, Alan Magleby. Sir, you may begin.

Alan Magleby

Good afternoon. On behalf of Legg Mason I would like to welcome you to our conference call to discuss operating results for the fiscal 2010 first quarter ended June 30, 2009.

This presentation may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are not statements of facts or guarantees of future performance and are subject to risks, uncertainties and other factors that may cause actual results to differ materially from those discussed in the statements. For a discussion of these risks and uncertainties, please see risk factors and management'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, 2009 and in the company's quarterly reports on Form 10-Q.

This morning's call will include remarks from Mark Fetting, Legg Mason's Chairman and CEO, and C.J. Daley, our CFO, who will discuss Legg Mason's financial results. Following a review of the company's quarter we will then open the call to Q&A.

Now I would like to turn the call over to Mark Fetting.

Mark Fetting

Thank you, Alan, and good afternoon, everyone. We appreciate your interest in Legg Mason.

While our mission is not yet fully accomplished, we are pleased to have returned Legg Mason to profitability. Legg Mason generated strong cash income, reduced operating expenses and recorded sequential increases in assets under management at five of seven of our core affiliates.

Specifically, as you will see on Slide 3 of the companion deck that we put on the website, operating revenues were $613 million for the quarter, down just 1%. Net income on a GAAP basis was $50 million or $0.35 per share. Cash income as adjusted for the quarter was $87 million as it compared to a substantial loss in the prior quarter. Our pre-tax profit margin on a GAAP basis was 13%, but more importantly, as we frequently instructed, to take it on a net revenue basis it was 18%. We think this shows good progress.

This represents a good start to fiscal 2010 and reflects the sharp focus of the management team over the past year on the implementation of key strategic initiatives designed to increase our financial strength and flexibility to best position us for improved performance and growth. There is, of course, room for improvement, and today we will share more detail on our progress during the quarter and also discuss the areas that we will continue to focus on going forward.

If you turn to Slide 4, we acknowledge that the market environment, while it has been improving, does remain challenging, so we will be very focused on key strategic priorities. Specifically, we've completed a scan of both the external marketplace and our internal strengths and weaknesses. We've engaged actively with our Board and we've concluded and committed to five key priorities.

Number one, improving Legg Mason's financial strength and protect the balance sheet. As a consequence of a large tax refund, our cost savings initiatives and other measures we are implementing, we now have a cash balance of $1.6 billion, including $1.2 billion in excess cash, and we are taking additional steps to enhance our financial strength and protect the balance sheet. Last week, for example, we announced that Legg Mason is proceeding with a tender offer for $1.1 billion in equity units, which will substantially reduce debt levels on our balance sheet. This transaction will be accretive to earnings and cash earnings, excluding transaction costs, and improves our interest coverage ratios. C.J. will provide an update on that shortly.

Priority number two, effectively managing our costs. We end the first quarter having realized our run rate cost savings goal of $160 million. We have improved margins, which reflect operating leverage potential and as performance improves and revenues begin to grow we believe we'll have the opportunity to improve margins even further. Our compensation ratio for the quarter was 52.7%, just off our target of 50% to 52%, and C.J. will follow on that issue as well.

Priority three, engaging with affiliates on performance, risk management and other strategic initiatives. We think it's important to note that we did not take any blunt actions during the market turmoil over the last 18 months with regard to our investment affiliates. Now we're seeing early evidence that this was the right thing to do. Each of our affiliates who had performance issues looked hard at their processes and where they could make improvements they did, whether that was improvements in portfolio construction, risk management and/or new personnel.

It is our belief that the best way to optimize the shareholder value in our multi-manager model is to engage our affiliates strategically while respecting their investment autonomy and client accountability. Where we can invest with affiliates to enhance this process we have; several of our affiliates have seen an opportunity to add some highly regarded talent to the teams because of the dislocation in the markets and where that makes sense we've done it.

Priority four, pursue growth, distribution and business development. David Odenath, head of Americas, and Ron Dewhurst, head of International, are pursuing a multi-channel strategy for distribution and a target list of products we think are particularly compelling to investors today, filling in the gaps with new products that meet investor needs while reinforcing existing products with improved track records. Here we believe we are making progress. Our long-term fund flows are showing significant improvement over the last two quarters, with net positive flows in May and June.

And finally, our fifth priority is to continue a build-and-buy growth strategy. As we said in the past, we are looking to opportunistically add to our investment capabilities and offerings. This will include investment in lift-outs and bolt-on acquisitions for our existing affiliates.

Slide 5 shows our assets under management, with some breakout. As you see, we ended the quarter at $657 billion, up 4% from the prior quarter. Our asset mix by asset class is 56% in fixed income and 22% each in equity and liquidity. Notably, equity assets are up 13% to $144 billion under management.

Slide 6 shifts to net flows and here we're clearly making progress, but the job is far from done. We experienced a reduction in outflows in this quarter across all asset classes, a trend which has been steadily coming down each of the last two quarters. Net outflows were down 30% as compared to the March quarter and 61% when compared with the December quarter. As a percentage of total AUM, the rate has declined each of the last two quarters from approximately 9% to 6% to just under 5%. In the June quarter, total outflow of $30 billion breaks out as $22 billion in fixed, $6 billion in equity and $2 billion in liquidity.

Now, it should be noted that in the fixed income area Western's outflows decreased and approximately $5 billion of that $22 billion in fixed income relates to expected rebalancing by two large sovereign clients at Brandywine in its global fixed strategy.

Now we shift to Slide 7, which hopefully at this stage analysts are familiar with because it's one where we show AUM of our key managers in order of their contribution to earnings. Western Asset's assets were up $10.5 billion for the quarter or approximately 2% due to market appreciation. While it is still early, Western's RFP activity, unfunded wins and expected flows from many clients are all moving in the right direction, offsetting some of the outflows. More specifically, we see good growth in the global tip strategies, the muni strategies and our business in Brazil. This offsets a continued erosion in the Core/Core Plus strategies, which represents just under 25% of Western Assets. With the improved record, we're hoping that is offset.

Permal's assets ended the quarter at $17.2 billion, down from $18.5 billion. The bulk of the outflows in the quarter reflect deferrals from the March quarter. As you may recall, Permal had temporarily moved its notice period to 95 days and are now in the process of transitioning it back to a 20-day period. Redemptions at Permal have returned to pre-Lehman levels. They are also experiencing increased RFP activity, particularly in the high net worth and institutional channels.

ClearBridge was up 10% for the quarter, driven by market appreciation and slowing outflows. ClearBridge RFP pipeline has grown just over 20% quarter-over-quarter and they are seeing existing clients add money. They are also experiencing increased traction and flows in our cross-border product range, reflecting a concentrated marketing effort over the past several quarters.

Royce & Associates was up 27% to $23 billion, driven by market appreciation and inflows and continued strong record across the board.

Legg Mason Capital Management is up 14% to $13.7 billion quarter-over-quarter, driven by market appreciation. A large global investment consulting firm recently announced they have hired Legg Mason Capital Management as a sub-adviser for two Canadian multi-manager funds, which funded at approximately $100 million this month. Capital Management managed funds are also seeing net inflows quarter-on-quarter in our cross-border range.

Brandywine saw AUMs drop about 7% and, as I said, primarily from the client rebalancing previously discussed.

And finally, Batterymarch was up 15% to almost $18 billion, driven by market appreciation. Flows were essentially flat after factoring out the closing of a variable annuity fund that has long been planned. One agent strategy, a sovereign fund, funded this quarter and there are a couple of other mandates that were won but not funded and are expected to do so in the near future.

Let us now shift to the starting engine of business performance. And as you can see, we are making progress here. One a one-year basis, assets beating the Lipper category average grew from 43% to 54%, beating their category average. The three-year is 56%, up from 52%; the five-year is 58%, up from 47%; and the 10-year continues strong and even stronger at 78%, up from 75%.

Royce continues to deliver strong performance, with 93% of their assets ranked four or five stars by Morningstar. Performance across Permal products is meaningful ahead of the market year-to-date. ClearBridge Advisors continues to show strong progress, with nine of 14 strategies outperforming their Lipper benchmark year-to-date, eight of 14 over a three-year period. And for managers who had been experiencing performance challenges, performance improved in the quarter. Although one-year performance is mixed, all Western Asset funds and funds managed by Legg Mason Capital Management outperformed their benchmarks for the quarter and in many cases substantially so.

Now we shift to Slide 9 to just give an update on some key business highlights. We're gratified that our most recent closed-end fund offering, the investment-grade Opportunity Trust, was our first fund with Merrill as the lead underwriter and represented a very strong introduction to their system. We raised about $220 million. When you combine that $220 million with the previous offering of the muni fund at $240 million, Western/Legg Mason was the number one in assets raised in the closed-end market on a year-to-date basis.

A joint venture between Western and RLJ Companies was pre-approved by Treasury to be one of the PPIP managers. Though we can't say too much about this opportunity as we continue to finalize logistics with the Treasury, we believe this selection reaffirms Western's leading position among fixed-income managers and will add to our portfolio of compelling long-term investment opportunities for our clients. You can track the progress here because, as you know, we filed a REIT as part of retail offering related to this strategy, and we will also be reaching out to our institutional clients.

Permal is in the process of raising a second investment fund for discounted hedge fund positions expected to close in July, very much in response to the strong returns delivered in the first funds.

We are also seeing interest begin to grow across a broader mix of assets. Gross sales of U.S. mutual funds in the quarter are well-diversified; 61% of our gross sales in the Americas are in equity funds, 23% in municipal bond funds, and 15% in taxable bond funds. Mutual fund flows in our International distribution were positive for the quarter. In Japan alone we saw $350 million in flows to the foreign investment grade bond fund, a fund we launched in February.

Even as we made good progress in the first quarter, it's clear that we still have work ahead of us in a number of areas. I will now turn it over to C.J. to walk us through the operating results and then come back with the closing slide and then open it up for Q&A. C.J.?

Charles "C.J." Daley

Thanks, Mark.

As Mark noted, we are pleased to report that this quarter we returned to profitability. The expense control efforts that we've undertaken in the past year contributed to improved results in a quarter where revenues were flat. And as of June 30 - again, as Mark indicated - we have achieved our targeted $160 million in run rate savings which we announced last quarter.

So after a number of consecutive quarterly losses while we managed through the elimination of our SIVs and the money fund business, we have in this quarter returned to profitability while continuing to work diligently to improve the strength of our balance sheet and financial flexibility.

For those of you who are following along on the deck, I'm going to continue on to Slide 10 with operating results. Revenues were $613 million, less than a 1% decline from revenues of $617 million in the sequential March quarter. That's reflecting lower average assets under management, offset in part by performance fees at Western and Brandywine.

Average assets that we managed in the quarter were $647 billion, 2% lower than the average assets managed in the March quarter; however, our mix of assets changed slightly as the favorable equity markets drove our percentage of equity assets higher, to 22% from 20% in March.

Net income was $50.1 million or $0.35 per diluted share, and cash income as adjusted, an important measure of our earnings capabilities, was $86.8 million or $0.61 per diluted share.

As required by our accounting rule change, we effective April 1 have retroactively imputed interest expense on the $1.25 billion of convertible debt we have outstanding. And in calculating cash income this quarter, we now include the imputed interest net of tax, which is a non-cash expense, as well as the actual cash tax benefit on the related contingent convertible debt that is not realized under GAAP. The total of these two items is about a $10 million increase to cash income.

Our pre-tax margin unadjusted was 13% on revenues of $613 million and 18% on operating revenues as adjusted of $441 million. Included in the results this quarter was an $18 million gain reflecting reversal of charges taken in prior quarters from money fund support for the final outstanding support agreements we have in place. The support agreements are not related to SIVs and they were put in place in the fall of 2008 when some of our offshore money funds experienced rapid declines in assets as clients migrated to Treasury and government fund products. The current remaining support totals $27 million and the current cumulative unrealized losses on those agreements are $4 million. The support agreements are down from $35 million at June 30.

Our tax rate declined to 35% this quarter, driven by the mix of results in the U.S. and internationally, including the fund support gains which are taxed at lower rates. Based on our current business mix, going forward we expect a tax rate of approximately 36.5% to 37%, but that will fluctuate based on our mix of business between the U.S. and internationally.

Moving on to Slide 11, on a GAAP basis you'll see that expenses declined 16% to $554.8 million. The majority of that decline is attributable to two charges that we incurred in the prior quarter. The first was the intangible charge of $83 million and then the second was the lease charge of $38 million, which is in the occupancy line. Excluding those two charges and the marked-to-market and severance impact on compensation, expenses declined 4%, reflecting lower levels of expenses across all categories, including compensation, which was down 2% after adjusting for the marked-to-market impact on comp and severance.

And as I mentioned last quarter, looking forward our occupancy costs will increase in the September quarter as we relocate over the next several weeks to a new headquarters in Baltimore and the September quarter occupancy will be approximately $5 million higher due to duplicate rent we will be paying for the old and the new facilities. Thereafter on a quarterly basis the additional cost per quarter will be approximately $2 million more than we recorded in the June quarter.

In addition, when we take possession of the new building in September, we will have some vacant space which we're actively pursuing to sublet. As we execute sublease arrangements for that space, we will expect to recognize some non-cash lease charges, which will be based on the amount of space ultimately that we sublet, the timing of the sublease, and, of course, the realization rates or the sublease rates that we're able to negotiate.

Moving on to Slide 12, it highlights our compensation costs and shows the expressed as a percentage of net revenues, which are operating revenues less distribution and servicing expenses. Our goal and expectation remains to deliver a comp ratio to net revenue in the 50% to 52% range in a rising revenue environment. Key drivers to the slightly elevated comp ratio were non-compensation expense savings at revenue-sharing affiliates whereby in a revenue sharing arrangement to the extent non-compensation expenses declined compensation expenses will increase. There was also a revenue mix to lower operating margin affiliates and higher compensation will increase sales of new and existing products.

On Slide 13 we show the run rate cost savings that we've achieved. Last quarter we reported cost savings of $135 million and we announced then a target of $160 million. And, again, as of June we are pleased to report that we have achieved our $160 million run rate target savings.

Moving on to Slide 14 and the balance sheet, our balance sheet reflects our continued strengthening. Our cash position at June 30 benefited from receipt of a tax refund and cash is $1.6 billion. On July 15th we announced further action to improve our balance sheet, with a tender offer for holders to exchange substantially all of their equity units for common stock plus cash. We have highlighted the pro forma benefits of the tender offer, in which 95% of the equity units are tendered; however, the ultimate impact on our balance sheet will depend upon the percentage of holders that elected to accept the offer.

But in summary, the benefits to our balance sheet are several fold. First, as you can see in the pro forma column, it reduces debt from $3 billion down to $1.9 billion. It increases equity from $4.7 billion to $5.7 billion. And finally, tangible equity, which is now at about negative $400 million, will move to a positive $550 million.

There is some cost to the early conversion. We will use on an accelerated basis $137 million of cash that would have been paid over the remaining two years of the units, and we will tender that upon conversion. And there will be some transaction costs in the September quarter, which obviously would not recur in future quarters.

From a P&L perspective, the transaction will eliminate over $60 million of cash and GAAP interest charges and will improve our interest coverage ratios going forward, and we've highlighted that on Slide 15. Specifically, the pro forma interest coverage ratio - and this is as if the transaction had occurred at the beginning of the period or 12 months ago - improves from 4.8 times to 9.3 times. Actual results will take several quarters to bleed into these levels and we'll actually see a decline in the September quarter before we begin to see improvement in the December quarter as a result of the inducement.

So, as a result, we'll incur approximately $23 million in transaction costs this quarter and we'll eliminate about $8 million of interest expense this quarter for a negative impact in the September quarter of about $0.08 per diluted share. Going forward, however, the interest expense will be reduced by approximately $15 million per quarter, so it will be actually accretive to earnings by about $0.025 per diluted share per quarter.

While we have made significant improvements in our balance sheet over the last 12 months, we will continue to look for ways to improve our capital structure by attempting to reduce leverage back to historical levels, freeing up cash and deploy uses that will increase shareholder value. However, all of this must be accomplished within the constraints of current lower levels of cash generation, the credit covenants that we have in place, and continued volatile and uncertain market conditions.

In summary, I'm pleased with our return to profitability, noting that we have achieved the $160 million in run rate savings we announced last quarter. We've taken steps to improve and strengthen our balance sheet. But we won't stop there; we'll continue to seek ways to further improve it.

With that, I'll turn it back to Mark, who will provide some further comments before we take questions.

Mark Fetting

Thank you, C.J.

Really just to keep this piece brief, I think what you should hear loud and clear is progress achieved, but even more value being pursued.

We have five what I'll call value priorities around the initiatives that will guide us that I went through. Each and every one of those five is a continuous process. We look forward to having some Q&A now and I'll wrap it up at the end.

Questions, moderator?

Question-and-Answer Session


(Operator Instructions) Your first question comes from William Katz – Buckingham Research.

William Katz – Buckingham Research

I just want to start with the balance sheet discussion. You didn't talk about the possibility of using the tax refund to repurchase any debt, so I'm just sort of curious if the actions announced last week to recapitalize the balance sheet away from the equity takes priority and, if that's the case, is there a more subtle shift here of focus away from debt reduction to more of an expansion mode at this point?

Charles "C.J." Daley

Well, I think what you should take away from this, Bill, is that we're going to continue to stay close to the markets and take advantage of opportunities as we see them. And we will do that kind of in synch with the priorities we've always had of first and foremost making our balance sheet a strong and respected one; number two is invest in our business; number three, we see acquisition opportunities, etc., and then four and finally, if appropriate, any kind of buyback.

But implicit in that is continuing to look at our debt situation, but we want to do that in concert with growing where we see some opportunities as well.

William Katz - Buckingham Research

Okay, my second question is, just back to flows for a moment, you sort of talked about the rebalancing of Brandywine. I think in your April disclosure you could sort of deduce that you had somewhere between $15 and $20 billion of outflow - again, based on that and maybe that's true, maybe it's not true - and I'm sort of curious. Can you sort of give us a little bit of a sense of how things have progressed on a monthly basis because it seems like the second half of this calendar year seems pretty good, but then you sort of temper that with what you said about Wamco, that you're still seeing some attrition on Core and Core Plus.

So I'm just trying to find out where we stand maybe from a little bit of a trend perspective, and then within that I was wondering if you could address does PPIP accelerate this redemption/recovery story a little bit?

Mark Fetting

Yes. Relative to Wamco, I think what's going on - and this is cutting across, I believe, the entire institutional marketplace - are plan sponsors and their consultants are reevaluating the risk constraints. Some are becoming more risk averse and some are being kind of more educated about taking appropriate risk. And in that regard, Western, which has always had a credit orientation, is going to have some plusses and minuses coming out of that.

They remain very optimistic about the long term, but relative to the Core and Core Plus, the record, which has improved significantly, still has a ways to go to probably restore confidence across the board. So clients that have only a recent experience with them may not have as much upside potential as those who have enjoyed a longer relationship across multi products.

In terms of monthly, it's difficult to put any kind of real numbers to it, but I can say it's kind of improved modestly on a sequential month basis, and we see a little bit of that continuing in July. But it also cuts across what I said earlier, Bill, which is where you see the positives are in strategies like global tips, like the munis, like Brazil, and on the Core/Core Plus, which, as we point out, it really is impressive that Western has become so diversified because many people say it's just that, that's the firm, and it's really only a quarter of the business. But there it's probably going to be a little slower in terms of recovery.

Now, PPIP we are all quite excited about. We've worked together on this - Legg Mason, Western and the Johnson Company. I think we'll be out there with some degree of transparency in terms of how we're pursuing in terms of the REIT product that we have filed and the institutional marketing that we do.

I do think there is the possibility in a continued good investment environment and specifically good fixed income environment it should definitely be a net plus that would kind of help this story accelerate a bit. We probably are biased in that because you'll see others that have been kind of tempering the expectations of the PPIP program, but in the spirit of late is better than never at all, we think there's still an opportunity for a client to get good returns and some people holding this paper to kind of move it along.


Your next question comes from Daniel Fannon - Jefferies & Co.

Daniel Fannon - Jefferies & Co.

With regards to Permal, you mentioned that there's been increased RFP activity; wondering if we can get a little bit more detail there with regards to how performance has been. And then if you could talk about what the kind of feedback is from their customers and also in terms of redemptions where we stand in the backlog and what we should be thinking about over the next kind of 60 to 90 days.

Mark Fetting

The team at Permal would really kind of underscore this notion of redemptions are back to pre-Lehman levels, and so redemptions are less of an issue going forward and probably not as much of an issue going forward as are sales. And the sales piece is what's going to determine how quickly we get back.

Isaac Souede, the leader of our business there, has always said that over the decades they've been in this business - and they've gone through moments of market dislocation - it usually takes a year plus to get back the momentum that you had before, whether that was the LTCM period or other dislocations.

This one's obviously a bit more severe. At this stage we're approaching kind of nine months into it or so. I think you can definitely see a pick up of sales interest and in fact sales activity, but it's still not near the levels - we're not pre-Lehman on that front yet at all.

Daniel Fannon - Jefferies & Co.

And I guess in terms of fee discussions regarding their product and then also on the performance side how they've done kind of year-to-date?

Mark Fetting

Their performance continues to be strong across virtually all of their strategies, beating their benchmarks across the board and fairing well against the competition.

Relative to fees, we've not seen any fee pressure. There is a shift towards the institutional a bit and the institutional fees you would expect to be somewhat lower than the retail, but that wouldn't really move the dial on their numbers until the institutional base becomes more meaningful.

And I would think about that in the context of clearly alternative investing is very much of a specialized investing, so in the same that you see international specialists getting kind of higher fee levels both in retail and institutional, I would expect the alternative strategies of Permal to do the same, so it's not as much of a difference as you would see in some other categories.


Your next question comes from Mike Carrier - Deutsche Bank.

Mike Carrier - Deutsche Bank

The first question is on flows. I'm trying to dig in a little bit. First, can you just mention sort of the noise that was included in Western? I think you've mentioned that; I just missed it.

And then when you're having client conversations, particularly on the equity and the fixed income side of the business and probably more on the institutional since we can see the retail side, how are they feeling about your performance versus allocations, meaning are you seeing clients favor fixed income more than equities and do you think that's going to continue?

And then anything on the allocation in passive versus active? It's kind of been definitely talked about lately and, you know, in down markets it usually picks up on the passive side, but given performance trends it seems like it's the wrong time to sort of shift into the passive side.

So just your color on those three points.

Mark Fetting

Right. On the first question you had there, the kind of so-called noise around the fixed income, what I was trying to do is we basically laid out that the breakout of outflows was $22 billion in fixed, $6 billion in equity and $2 in liquidity. The $22 billion, an important statement that we were making there is that $5 billion of that $22 billion is tied to another manager, being Brandywine, so in fact Western's outflows decreased consistent with really the theme of the story. So we just wanted to kind of make that clear.

Within the risk appetite I think it's important that we're moving - to kind of note that on the institutional side we're moving from a kind of a pause and reflect to consideration and eventually investing, and in doing that people have gone through, as they have in any kind of cycle as severe as this, a big-time risk [inaudible]. And hence the whole notion of deleveraging, derisking, etc., is out there.

In that regard no doubt you will see some pickup in an interest in passive, which you've seen before; on the other hand, in these current markets the outperformance of active managers is about as high as it's been, so that's a plus.

What we across the firm are looking at is really to make sure clients are as aware as they can be of how we're going about investing in various strategies and when there is risk being taken making sure they're aware of what that risk is.

And it's funny. Relative to Western, they've had a lot of clients who have come back to them and said, you know, I don't want you kind of changing your philosophy or your process here. I certainly want you looking at kind of lessons to be learned on risk management and that kind of thing, but as it relates to taking risks, continue to do so. And hence they were pleased and are pleased with Western's return to strong numbers during this more recent period. There are other managers out there who kind of communicated themselves as more risk averse, but their numbers haven't really justified that, and hence there's different questions going on.

So I would say net-net what you see particularly with Western is a continued commitment to their core strategies but also continuing to stay close to clients in areas where opportunities present themselves, like a PPIP, they're going to pursue.

Mike Carrier - Deutsche Bank

Okay. And then actually, if you can, any way to sort of monitor or gauge the RFP activity sort of second quarter universe to the first quarter?

And then for C.J., just on the expense side, it seems like it came in better than expected. The other expense seems low given what we kind of expected, but did you say this is a good run rate going forward?

And then in terms of the gains, not on the seed investments but just more on the liquidity side, you gave the amount, the $27 million of support that's left. I'm just trying to understand, you also said there's like $4 million in unrealized losses, so going forward how noisy should this line item be versus the seed investments, which obviously we can kind of gauge just with the balances?

Mark Fetting

C.J., you got the lion's share of that one, but the real quick one, RFPs, RFP activity has picked up across the board, particularly more recently, so I think, as I said, there's this shift going from pause and reflect to consideration and eventually investing.

Charles "C.J." Daley

On the operating expenses I think there was a fair amount of noise last quarter; I mean, we tried to highlight that. This quarter the declines I think are really reflective of the cost savings measures that we've put into place. And so, yes, I think these are good run rates although I did highlight some occupancy increases. The $5 million actually breaks out $4 million more in occupancy and $1 million in communications and technology next quarter before dropping back to a $2 million increase between the two. So absent that one item, I think these are good run rate levels at these current revenues.

On the money fund support on our offshore funds, what we have in place as of today is $27 million in support in two funds. There is $4 million of that $27 million that's being utilized. That expense was taken in quarters prior to March and so we wouldn't expect a whole lot of noise and additional activity there, but a lot of that's based on net asset levels in the fund. But we've seen it continue to [decline] since the markets have begun to improve.


Your next question comes from Robert Lee - Keefe, Bruyette & Woods.

Robert Lee - Keefe, Bruyette & Woods

Mark, I have, I guess, a question related to as you go back and start to think about strategically whether it's lift-outs or fill-in acquisitions. Can you maybe update us on and a little more color on the types of things you're thinking about? And then I guess the flip side of that, you know, as you look at your boutique managers, the full breadth of them, are you thinking that maybe, particularly with some of the smaller ones, it's time to maybe start thinking about pruning some of the smaller ones? I don't know if they're more - even if they're profitable maybe they become more of a distraction or not quite fitting into where you're thinking strategically?

Mark Fetting

Yes, Robert, I think that part of the theme to respond to that question ultimately more specifically than I'm going to start is that this environment, as you well know, has been absent the BGI/BlackRock transaction, a tough environment for the sale of asset managers. And there are a lot of deals in the market right now that may or may not happen and if they happen are likely to happen in different formulations than were originally anticipated, hence it kind of leads one to believe probably less value than one would have originally expected - clearly, a good time to be buying as opposed to selling. And in that regard, we are very much in the pipeline of activities.

And I think what we're trying to get across, which is something we've talked about before, is historically we've thought of deploying our capital strictly in the sense of acquiring net entities. Here we want to be thinking about, because we've got what I call a franchise firm of franchise firms, significant businesses in our portfolio now who could benefit from an extension acquisition or lift-out enhancement, etc. So that's part of the equation.

As it relates to the smaller managers, we continue to work with them in building their business and I don't see any immediate change to that. At the same time, as you know, we have looked and actually done some things like Bingham Legg, Berkshire, the investment counseling business, where appropriate.

Robert Lee - Keefe, Bruyette & Woods

And maybe a follow up. You've talked a bit about the improvement in the funds business in the last couple of months and the trends there. I'm just curious, since ClearBridge had a pretty large SMA business, can you maybe update us on the trends you're seeing there? My general sense is at least for a period of time that was probably for many managers somewhat weaker even than I think many had anticipated it would be.

Mark Fetting

Yes, I think what's going on in the separate account business is a real development of going this progression from SMA to multidisciplinary account, which ClearBridge and its team were real pioneers in, to now the UMA.

And so what you see in the category, I think, clearly some shifting going on that accounts for including in the offerings things like ETS and the distributors themselves getting more involved and actually packaging those programs.

For ClearBridge that has meant adapting to a new environment as opposed to the legacy proprietary relationship they had with Smith Barney; I think that adaptation has taken place. We're now very much in most of the managers with a strong separate account lineup, usually in a kind of pre-packaged format that the distributor has done and we've got slots.

Bottom line what that's meant is that the attrition in that business is still there but it's leveled off reasonably well, and we think with the improved performance we definitely have more at bats right now. I think we signed up under David Odenath's leadership and Kim Mustin, who just joined, somewhere in the neighborhood of 70 slots over the last - let's call that a year-to-date number.

So we're trying to get more at bats with better performance; the category I think itself is still probably a bit in transition.


(Operator Instructions) Your next question comes from Keith Walsh - Citi.

Keith Walsh - Citi

Mark, just around the five strategic priorities, first off, are there any immediate priorities remaining around the balance sheet? And then in conjunction with that, specifically on point there, maybe you could give us some details around what you mean by engaging affiliates in some of the opportunities there.

Mark Fetting

Well, actually, C.J. and I together will hit the first one.

I think what you have to walk away from this with is the sense that we're going to be continuously engaged in trying to bolster the balance sheet when market opportunities present themselves. So the inducement was something that we've talked about with some advisers for some time. The stars lined up, we jumped on it and got it through in a period of a couple of weeks or so.

There are other things you would expect us to be looking at that we are, all with the goal of making the balance sheet stronger, the ratios roomier, etc.


Charles "C.J." Daley

I think that summarizes it well. We want to complete the inducement transaction and continue to investigate other ways to improve the balance sheet, but right now there isn't anything else imminent.

Mark Fetting

What we've done with the affiliates - and I want to underscore the notion of as we hopefully perfect the multi-manager model going forward, a model we deeply believe in - we believe engaging the affiliates on a strategic basis while also respecting the investment autonomy and client accountability is the right combination. That is a refinement from what we've done in the past; it's an extension.

As the affiliates have gotten bigger and we overlap more in areas of important business together we want to engage constructively together, and I think we've made a lot of progress on that front over the last six to nine months. Specifically, we've completed our first round of quarterly meetings with the affiliates, cutting across all aspects of mutual business. In areas where there have been opportunities to invest, whether it's adding talent, launching new product, seeding that product, we've worked together.

Let me just talk for a minute on the talent side. You can cut across a number of folks who have added considerably during this period. Western is probably at the top of the list, having fielded the head of the U.K. desk who will be residing in London from a major firm; a senior credit person to join on the London team. They've both promoted within and added senior talent on the risk management side. They've added in Pasadena a senior credit person from two major firms, one former chief investment officer and another one of their senior credit.

And this was all done essentially on almost a net zero basis to the cost because when they went through their headcount reduction there were reductions in some of these areas as they took a good look at things. And then they've added into it in a way that was very well done in terms of the cost and also spoke well of the reputation of Western for top talent out there. With ClearBridge we've over the past year brought in Peter Sundman, former head at Neuberger, as a CEO working closely with the investment team to build out that business and in a number of other areas we see.

So I think that's an area where we're working together not necessarily changing the economics but just working together in ways that make sense in supporting that.


Your next question comes from Jeffrey Hopson - Stifel Nicolaus & Company, Inc.

Jeffrey Hopson - Stifel Nicolaus & Company, Inc.

Just so I got the numbers right, basically you had net gains of about $15 million marked-to-market and then the recovery on the SIVs of $17 million. Is that about right?

Charles "C.J." Daley

That's about right.

Jeffrey Hopson - Stifel Nicolaus & Company, Inc.

Okay. And then you talked about the Smith Barney situation; anything new on kind of your assessment of how you're coming out with that merger situation and how you would be positioned in that firm?

Mark Fetting

I would say, based on conversations that we've had since the last call - which continue and I think hats off to James Gorman and Charlie Johnston and the team; I think they've done a terrific job of launching that combined firm on a strong basis - we're encouraged by the progress we're making, although we haven't finalized some of the important details, but we're well in the mix of that.

So I'd probably say I'm more encouraged than I was before as we work through that transition and the reason is we've got a very strong position in the legacy Smith Barney system as measured by assets under management and sales and flows, but we have a growing business on the Morgan Stanley side, and so on a combined basis, recognizing we've got to earn that business, I think we're going to be in good shape.


Your next question comes from Mario Gabelli - Gabelli & Co.

Mario Gabelli - Gabelli & Co.

Just to go back to the old story about with all the lift-outs you're doing, all the good talent out there, is private equity at all on the radar screen at this time?

Mark Fetting

As an alternative class, definitely. We have a small private equity business, Mario, that's embedded in Permal, but as a category we think that's an interesting area and continue to look at it. That's about as far as I can go right now.


Your next question comes from Craig Siegenthaler - Credit Suisse.

Craig Siegenthaler - Credit Suisse

First question, just to hit on the comp, which looked a little high - and you provided good disclosure on Slide 12 - I'm wondering if you could help us quantify the subsidies to the revenue share arrangement this quarter.

Charles "C.J." Daley

Sure. There weren't any top-offs this quarter, so the comp that you're seeing and the ratio, any perceived change, is really a reflection of some cost saves that we saw in our affiliates. And as they achieve cost saves in non-comp areas because of the way revenue share works, comp goes up as long as they keep within their allotted percentage of revenues. And then we had a bit of a mix of business, not huge, but lower margin businesses that grow, more goes into the comp line.

Mark Fetting

I think, Craig, the bottom line on that is, the operative is, nothing new there.

Charles "C.J." Daley

Yes, exactly.

Mark Fetting

Actually, you know, remember, our revenues were down, albeit modestly. If the market continues to do well and we continue to show traction, revenues go up, that ought to bode well for that comp number as we stay focused on it.


Your next question comes from Roger Smith - Fox-Pitt Kelton.

Roger Smith - Fox-Pitt Kelton

I'm just curious on the comment that you have in the press release on the long-term flows and what really happened in May and June, they were positive. If you can just give us a little bit more information there, making sure that I understand that correctly, that the long-term flows into the firm in May and June were positive, could you give us some kind of breakout on equity versus fixed income and sort of how that went in the sequential months because I'm sort of assuming that we had $28 billion then at least of net outflows in the month of April. So if there's something else you can kind of help us there because I think that's a really nice progression.

Charles "C.J." Daley

No, it is. What we do - just to make sure everybody's on the same page - is combine all of our fund families in making this calculation. So you have the Legg Mason Partners Fund, the Legg Mason funds, the Royce funds and the Western funds. And when you combine that, just looking at the stock and bonds - don't count the money funds - you should see independently from what we're saying this May and June period, from just data sources like strategic insights, etc., and that's really what we're talking about, Roger. And, as we said, we also were positive in the cross-border lineup in the month of June on our international funds.

So there is a progression here. It's not yet at a level that moves the dial, but the rate of progress is real.


Your next question comes from Marc Irizarry - Goldman Sachs.

Marc Irizarry - Goldman Sachs

Mark, just to hit on this again, can you just give a little clarity on the flow trends in May and June, maybe by type of investor and by geography as well?

Mark Fetting

Well - and I actually did touch on a little bit of July - what we've seen is a pattern of improvement. It's in aggregate continued in July, albeit on a half a month basis.

The component pieces are we look at the stock funds, the bond funds. In the stock funds, Royce's contribution is considerable. In the bond funds, the muni funds offset some of the outflows that you'll see in the taxables. And then a swing factor in total fund flows, not just stock and bond, would be liquidity, and there there's been a little bit of improvement even just recently. And that, too, you can actually track because on the money funds there are various sources that track the data there on a third-party basis. But that's how we look at it.

Any more color you're looking for, Marc?

Marc Irizarry - Goldman Sachs

That's helpful, but maybe just in terms of the flows at Western, you know, obviously there's a replacement cycle that's going on; it seems like there's some rebalancing that's happening as well. How far through the manager replacement cycle are we and are you seeing perhaps less pronounced replacement from Western than you would have expected at this point in time as other products are sort of helping offset some outflows or where do you think we are in the replacement cycle?

Mark Fetting

I think we're more than halfway done, and the good news is there's no new kind of names being added to the watch list from the negative side and there is new activity being added on the opportunity in the RFP side.

One issue that you'll always go through in this business that we should be mindful of in core categories is some investors will wait for recovery and once they've gotten kind of back to par or thereabout they may make a decision - it may seem a little contrary, particularly to us on the other side of that decision - but getting out at that point. And so you still could see some continued outflows even though you're not seeing kind of new names, but people taking action at the tail end of that cycle.

At the moment, when you aggregate all of that, I think you still remain very encouraged that with the other capabilities that Western has that they can turn this and then, as we say, things like PPIP, which a number of people in the industry are pursuing. The proof will be in the pudding.


Your final question comes from Matt Snowling - FBR.

Matt Snowling - FBR

Mark, can you give us an update on [Citi] as to where you stand in managing the cash lead products following the merger with [inaudible].

Mark Fetting

There we are engaged in discussions that, as I say, make it less clear what the outcome could be, which could be - so I'd rather not kind of speculate, but we're encouraged. I'd say we're kind of in the beginning to middle stages of dialogue, so I can't go either way on that one.

And I guess, Operator, is that - given the time, I want to be sensitive to everybody - can I close up here?


Please, sir.

Mark Fetting

Thank you.

Listen, I want to thank everyone for their interest in Legg Mason again, and I would quickly summarize by saying all members of the Legg Mason family, whether it's our affiliates and their investment teams, our corporate colleagues in distribution, in shared services, all of us are energized, enthused and determined. We've come out of a very tough period standing strong and making progress, but we are even more aware of the value we can create going forward, and that's what we're committed to.

We thank you very much and look forward to giving you an update as we go along.


Thank you, gentlemen. And thank you, ladies and gentlemen, for your participation. This does conclude your call. You may disconnect your lines at this time. Have a great day.

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