(LM) Legg Mason Analyst Reiterates Shares at Neutral

We maintain our Neutral recommendation on Legg Mason Inc. (LM) based on strong fourth-quarter results. However, Legg Mason experienced a decline in its assets under management (AUM) in May on a sequential basis. This was preceded by a slight decline in April, but a modest increase in March AUM.

Preliminary May-end AUM came in at $671.0 billion, down 0.1% from $672.0 billion at the end of April. Fixed income and liquidity AUM grew sequentially during the month, while equity AUM plummeted.

In May, Legg Mason reported fourth-quarter fiscal 2011 earnings of 77 cents per share, surpassing the Zacks Consensus Estimate of 45 cents. Results for the reported quarter included 7 cents in transition-related costs. Earnings beat the prior-year quarter figure by 8 cents per share. Results improved due to higher revenue, offset by higher operating expenses, coupled with a decline in total AUM.

Legg Mason has been strongly working on improving its operating efficiencies through its key initiatives that include offering of innovative product solutions to client base, tapping sound investment capacities and expanding distribution relationships. In May 2010, Legg Mason announced an initiative to streamline its business model and reduce costs. The plan, which is scheduled to be completed in fiscal 2012, projects $130-$150 million in expense reductions.

Although Legg Mason was traditionally associated with its retail securities brokerage business, it has been significantly expanding its asset management presence through acquisitions and organic growth over the past 10–15 years.

Strong investment performance in AUM, coupled with positive asset inflows, has driven investment advisory and related fees higher. Further, mix of assets is shifting toward higher-yielding equity, and in the case of fixed-income assets, a positive shift from outflows in lower-margin products to inflows in more specialized higher-margin products is also visible. Therefore, in the medium to long term, recovery in equity markets should help private client and equity capital markets businesses as well.

Moreover, Legg Mason remains committed to increase shareholder’s wealth. The company is effectively deploying capital through share repurchase. It has announced a $1 billion buyback authorization in May 2010. During fiscal 2011, the company purchased and retired 4,405 shares of its common stock for $145,067 in the open market.

The company intends to accelerate share repurchases over the upcoming fiscal year by repurchasing up to $400 million in stock during fiscal 2012, subject to market and company performance, actual cash flows and other capital needs. We expect such measures to instill investors’ confidence on the stock.

On the flip side, Legg Mason’s long-term funds (3–5 years) remain challenged due to decline in global asset values and volatile equity markets amid the current credit crunch. These factors significantly deteriorated the performance of Western Asset Management Company, which has an extensive business both within the U.S. and throughout the world.

Further, asset outflows also remain a matter of concern for Legg Mason. Due to investment performance issues, Legg Mason experienced net outflows of equity and fixed income assets under management for the last five and three fiscal years, respectively.

While the rate of outflows decreased in fiscal 2011, there can be no assurances as to when, or if, the flows will reverse. Considering the financial environment, which is still challenging, we believe that weakness in asset flows would remain a headwind in the near term.

During the March quarter, a number of events, such as the popular uprisings in the Middle East and the earthquake and tsunami in Japan, shocked the global economy. These events had an immediate impact on the global economy, both psychologically and fundamentally, including significantly higher oil and gas prices, which are slowing down the U.S. growth.

The U.S. stock market has risen to its highest levels since 2008 on the back of improved earnings in the corporate sector even with these headwinds. Although the global economic recovery is expected to pick up in 2011, it should remain gradual. Further, the current volatility in the financial markets and the government regulations pose the risk of interest rate fluctuation to the funds business of the company.

However, we believe Legg Mason has the potential to outperform its peers in the long run, given its diversified product mix and leverage to the changing demographics in the market.

Legg Mason currently retains its Zacks #4 Rank, which translates into a short-term Sell rating. However, Legg Mason’s closest competitor – BlackRock Inc. (BLK) retains a Zacks #3 Rank (a short-term Hold rating).

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