Thursday, February 18, 2010

Bought LM

If you are a first timer, please read the following pieces first. It will provide you with important background information.
1. Why I created this blog?
2. How am I going to operate this blog?

I bought 200 shares of LM at $26.26 on Feb 03 2010 paying a commission of $4.95.

I owned 400 shares of LM before this purchase.

Legg Mason, one of the world largest asset managers, is trading at less than 10x trough earnings. Currently LM has approximately $700Bn under management, with 55% invested in fixed income products, 22% in money market, and the remainder in equity. LM is structured in an affiliate model: this means that it operates as a holding company and owns a number of relatively independent money managers. The affiliates keep a percentage of their revenue generation with the rest going to LM Corporate. This percentage varies, but most believe approximately 30% is kept by the affiliates' employees. The holding company provides certain shared services as well as retail and international distribution.

The shares had been traded around $100 before the crisis. Here is what happened:

The Company's largest affiliate, Western Asset Management, needed to be bailed out due to its exposure to structured investment vehicles. Because of the reduced liquidity for these products, Western suffered a run on its money market funds and required a costly bailout from its parent, Legg Mason. Compounding this, LM's all-star manager Bill Miller suffered the worst performance of his career. Miller saw significant outflows as a result and was ridiculed for calling the bottom of the market on multiple occasions. Legg Mason's total outflows were $225Bn from 2007 to Sept 2009, representing 22% of AUM at Sept 2007. Further, the market didn't help matters driving AUM down a further $190Bn. At its bottom, AUM had gone from over $1T to $630Bn. All this occurred under watch of a new management team that stepped in just as the markets were collapsing. More recently, Trian Investments, headed by Nelson Peltz, has taken a 4% stake in LM. As part of a standstill agreement, Trian is required to buy up to 8% of the outstanding shares and has been awarded a board seat.

A private equity heavyweight, KKR was involved too. Nelson Peltz is a very savvy investor and now has a board seat. Moreover, Peltz has agreed to buy more shares through his standstill contract. He is required to own 8% of the company by April of next year.

While a downturn in the market would be a negative, LM has a number of levers they can pull to help offset the decline in earnings. Hypothetically, if AUM's were to fall to $500Bn, or a 30% decline from where they are today, LM will generate, at worst, cash EPS of $1.50/sh (which implies an 80% incremental margin). At this point, it would be apparent that their distribution group was not fulfilling its duty, and this unit could be cut lose, saving an additional $1.20/sh. This alone helps to justify the current valuation in a downside case. However, as a little extra incentive, this decline in AUM would bring about added pressure from Peltz and may accelerate a sale or spin-off of one of the affiliates.

Giving further comfort to the downside, LM earned $1.80 cash EPS in 2005 on an apples to apples basis (stripping out performance fees and adjusting for the share count - this was also prior to the tax shield which has been excluded from the above EPS). 2005 was the year prior to the CAM acquisition, and while times were very different, LM was operating with an average AUM of $330Bn. Again, times are different, but this is prior to the distribution group joining and shows what the business can generate if such a scenario presents itself.

The bottom line is fund management companies are able to achieve reasonable size and also enjoy reasonable persistence in terms of AUM. And I am buying a fund management at very attractive valuation.

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