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Legg Mason, Hawkins and Heinz - The Case for Legg Mason

February 20, 2013 | About:
Mason Hawkins probably understands the business of asset management better than most. After all, he's been running Southeastern Asset Management for decades. He's now buying the stock of one of his competitors.

Business

Legg Mason provides investment management services. The company owns multiple investment units, including fixed-income kingpin Western Asset Management. Other units include the $57 billion equity shop ClearBridge Investments, $35 billion small-cap specialist Royce and $16 billion hedge-fund-of-funds operator Permal.

Western is by far the company’s largest unit with roughly $450 billion of assets under management.

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At the holding level, Legg Mason receives a percentage (30% to 60%) of each unit's revenue, while the unit remains responsible for costs. Competition comes from the likes of Alliance Bernstein, BlackRock, Eaton Vance, GAMCO, Invesco and T. Rowe Price.

History


In 1962, Raymond A. “Chip” Mason founds a highly successful brokerage firm, Mason & Co. The company merges with Legg & Co. in 1980 and moves its headquarters to Baltimore, Md.

Chip Mason becomes chairman and CEO of the combined company in 1975.

Legg Mason becomes publicly traded in 1983. Chip Mason proceeds to expand the asset-management side of the business by acquiring Western Asset Management in 1986 and the Royce family of funds in 2001. Permal Group Ltd. is acquired in 2005.

Also in 2005, Chip Mason swaps the company’s original brokerage business in with Citigroup for that company’s asset management business. Citigroup’s bond and money funds are folded into Western Asset management. Legg Mason forks over an additional $3.7 billion to Citigroup and became the world’s fifth largest asset manager.

2008: Mark Fetting takes over as CEO after the funds acquired from Citigroup suffer huge losses on mortgage-related investments. The funds owned as much as $10 billion in structured investment vehicles that plunged as investors shunned mortgage-related debt.

Western Asset Management requires a multi-billion-dollar bailout from its parent to cover for redemptions.

The firm announces that it has increased its capital base by $1.25 billion through the sale of 2.5% convertible senior notes to an affiliate of Kohlberg Kravis Roberts & Co. In connection with this transaction, KKR Member Scott C. Nuttall joins the board of directors.

2012: The company repurchases the $1.25 billion convertible senior notes held by Kohlberg Kravis Roberts & Co. The terms of the repurchase include repayment at par and the issuance of new warrants that provide for the purchase of approximately 14.2 million shares of common stock at $88 per share. The warrants expire in 2017 and can be settled, at the election of the company, in either shares of common stock or cash.

2012: Mark Fetting steps down. Joseph A. Sullivan, head of global distribution, becomes interim CEO.

Last Wednesday, Legg Mason concluded its five-month search for a CEO. They picked Sullivan.

Value and price

Legg Mason has 128 million shares outstanding. At $28, Mr. Market offers us the company for $3.5 billion. The company's balance sheet is solid. Interest expense is less than $100 million and FCF is consistently in excess of $400 million. The company has roughly $1 billion in cold cash. That's about as much as its long-term debt.

Simple valuation

$3.5 billion is about half of one percent of assets under management. Charlie Munger says invert. Could you somehow extract $3.5 billion worth of future owner earnings if you were in charge of managing a collection of funds worth $650 billion?

Normalised earnings power

In 2005, prior to the Citigroup acquisition, Legg Mason was managing roughly $350 billion. They earned $400 million. This shows what the business can generate on half its current asset base under the right conditions.

Yield on run-rate owner earnings

I define owner earnings as cash that you can take home or use to retire debt after paying all your bills and paying for the maintenance of your business. In four years, Legg Mason has spent about $2 billion retiring debt and buying back shares. That's a yield of 14% under some pretty tough conditions.

Fair market value

This week, Orix paid $2.5 billion for a 90% stake in Robeco. Robeco has roughly $200 billion in assets under management. This data point indicates Legg Mason is worth at least $8 billion.

Specific risk

1) Market (headline) risk - Though Bill Miller receives disproportionate media coverage, Legg Mason Capital Management manages less than $12 billion.

2) Regulatory - Many governments (especially in Europe) are considering a “transaction tax" on all financial products. Of course, the UK has had that for many years and Legg Mason makes money there. Nevertheless, earnings could take a short-term hit.

3) Mix of the assets under management - Since fixed income funds generate less fees, the mix has an impact on profitability.

Catalysts

1) Western's bond funds have been performing well in recent years. The dismal results from 2007 to 2008 are rolling off from five-year measures. The company is finally seeing some fund inflows.35024_136138844777WA.png

2) The company has been actively repurchasing shares and the board has authorized $1.0 billion of additional share repurchases.

3) Nelson Peltz joined the board in 2009 under an agreement that prohibited him from forcing a sale or merger of affiliates. That agreement has now ended.

4) Valuation on cash earnings versus GAAP earnings. Once the plethora of one-time costs are no longer part of the financials, cash flow will become clearer.

5) Rising interest rates. There's little value in shoveling around bonds yielding next to nothing. The trading costs are higher than a years worth of interest. With higher bond yields, Western should be able to earn higher fees.

Management

Former CEO Mark Fetting laid the foundations for recovery by paying back a pile of sub-prime debt following the bailout of struggling money market funds in 2008. He raised $1.25 billion through the issue of convertible loan stock bought by Kohlberg Kravis Roberts. It was convertible into equity at $88 a share. He deserves a lot of credit for a phenomenal job leading the company through the crisis. The cost structure for the company was designed to handle over $1 trillion and had been built up through the numerous acquisitions. Under Fetting’s leadership, overhead was cut by about $160 million. On $2.5 billion in revenues, this represents 6% of margin improvement. Fetting also used excess cash to buy back a lot of shares. He saved the company from bankruptcy. As one of his last acts, he redeemed the convertibles.

Since Fetting’s resignation, Joseph A. Sullivan has lead the company. Sullivan has the support of some key affiliate managers. They like his decisiveness and the introduction of an equity incentive plan.

Sullivan worked at Legg Mason from 1994 to 2005 when, to his disappointment, he and his unit were swapped for Citigroup's asset management business. Three years later, Chip Mason invited Sullivan to lunch. Mason had already retired as CEO but with Fetting's approval, he asked Sullivan to join the executive team. Sullivan subsequently, served as head of global distribution which works with brokers and financial advisers to market and sell Legg's funds to individuals.

Nelson Peltz, sits on the board and owns almost 10% of the equity. Peltz is a highly regarded investor who helped spur Cadbury Plc’s 2008 spinoff of Dr Pepper Snapple Group. He’s also on the board of Heinz and Wendy’s.

On the board, you’ll also find former Pepsi operations chief John Cahill, Robert Angelica, who used to be chairman at AT&T Investment Management and Allen Reed, who used to run GM Asset Management.

That’s a pretty savvy and respectable group of people in charge of a $3.5 billion dollar company.

Legg Mason has managed to retain quality individuals, not just at board level, but also within its affiliates. Chuck Royce has remained loyal in good times and bad, while Isaac Souede continued as chief executive at Permal after its purchase in 2005.

Insiders have been buying stock hand over fist for years.

Why Is This cheap?

1) GAAP earnings materially understate cash earnings.

2) Bill Miller - Legg Mason Capital Management has underperformed for years, but there is little room for further declines given its small contribution to earnings.

3) Outflows - Western suffered a well-publicized run on its money market funds and required a costly bailout from its parent. Compounding this, star manager Bill Miller suffered the worst performance of his career.

This too shall pass.

Read more:

Recent 10-q.

Chip Mason talks about Sullivan.

Nelson Pelz at Heinz

Legg Mason buys back the KKR notes



Disclosure
This is not a recommendation to buy or sell anything. At the time of writing, I had no position in any of the stocks mentioned.

Any and all questions welcome as usual.

About the author:

batbeer2
I define intrinsic value as the price I would gladly pay to own the business outright. With current management in place. For most stocks, that value is 0. As of September 2012, I'm the author of the monthly Buffett-Munger Best Bargains Newsletter. I can be reached at fvandenbroek AT gurufocus DOT com

Visit batbeer2's Website


Rating: 3.8/5 (8 votes)

Comments

vgm
Vgm - 1 year ago
Batbeer,

Interesting piece, lots of fascinating and solid background. Thanks.

Mario Gabelli has been banging the table for LM for quite some time, as you probably know.

In the latest Southeastern annual report, just issued, they give a brief rationale for their LM purchase:

"Legg Mason has multiple strong brands including small cap specialist Royce and bond manager Western Asset, for which we paid less than ten times adjusted free cash flow. We began purchasing the stock when the CEO stepped down, knowing that the search for a replacement is being led by large shareholder Trian Partners, and the new leader should be able to meaningfully raise margins closer to industry average."
buynhold
Buynhold - 1 year ago
Nice article, as always, batbeer!

I wonder why someone like Mason Hawkins, who must know at lot about Legg Mason, would wait until now to buy Legg Mason. He could have easily bought it in the spring of 2009 at $10, instead of keeping stocks like Telephone & Data Systems, Walgreens and Nipponkoa Insurance - it'd have been a really good portfolio upgrade at the time.
batbeer2
Batbeer2 premium member - 1 year ago
Yes,

I wondered about that too.

Maybe...

- they've been selling CX and some other housing/infrsatructure stocks that ran up a lot last year. Not to mention Olympus. This may be their best idea now.

- they like it more after the issue with the KKR convertibles has been put to rest.

- we take their word for it and assume they think new management will extract higher margins.

- they have some information that the managers of the units were unhappy with Fetting at the helm (they all suffered because Fetting bailed out Western). The whole point of this business model is to isolate problems.

- they are seeing inflows in their own funds which makes them wonder who else is going to benefit.


I don't know, just some thoughts.
kfh227
Kfh227 premium member - 1 year ago
Limit order in at $26.
batbeer2
Batbeer2 premium member - 3 weeks ago

At $56 I think Legg Mason is still far from expensive but no longer absurdly cheap. The company is spitting out about $450 million per annum of excess cash and they've been spending most of that buying back shares.

It is possible that their bond funds will earn higher fees if interests go up but it is also possible that a market downturn will cause assets under management to decline. My crystal ball is a bit cloudy.

What is clear though is that we have roughly $450 million of owner earnings on a market cap of $6.4 billion; a 7% yield.

LM is flying off my radar.

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