Admiring Legg Mason
Board: Legg Mason, Inc.

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By mhirschey
April 18, 2007

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On January 25, 2007, Legg Mason (LM) reported record revenues, income from continuing operations and assets under management ($945 billion) for the third quarter of fiscal 2007 ended December 31, 2006. The company continues to be a "work in progress" as it integrates the 2006 acquisition of the asset management businesses of Citigroup, a transaction that included a swap of Legg Mason's former brokerage operations.

One of the largest publicly-traded asset managers in the business, it is interesting to compare the present valuation of Legg Mason with its Baltimore-based cousin T. Rowe Price and Associates (TROW) and San Mateo California-based Franklin Resources (BEN). Both BEN and TRO are mature, growing, and well-managed operations that give some perspective on what to expect once LM is able to fully integrate the Citigroup acquisition. Keep in mind throughout that achievement of suggested LM efficiencies may take another couple of years, so the exact timing of all of this is uncertain. All we know for sure is that LM is rapidly moving in the right direction on the operating front.

Two alternative, but related, valuation metrics might be considered:

P/E ratio analysis
At today's 50.70, TROW earns a net profit margin of 29.11%, has reported 1.90 in EPS for the trailing twelve months (ttm), and is selling at P/E of 26.6. At today's 130.43, BEN earns a net profit margin of 25.98%, has reported 5.31 in EPS for the trailing twelve months (ttm), and is selling at P/E of 24.55.

At today's 99.26, LM earns a net profit margin of only 14.68%, has reported 4.32 in EPS for the trailing twelve months (ttm), and is selling at P/E of 22.92. However, these historical profit margins reflect a mix of LM high-profit asset management businesses and the now-disposed low-profit brokerage operations. Look for LM profit margins to rise. Going forward, if LM achieved profit margins of 25.98% to 29.11%, EPS would rise on its current scale of business to between 7.64 and 8.56. At a P/E between 24.55 and 26.6, LM would be presently worth 187.56 to 227.70.

Enterprise value/assets under management
Enterprise value is market cap plus total debt minus total cash and short term investments. EV is a measure of a theoretical takeover price, and is useful in comparisons against income statement line items above the interest expense/income lines such as revenue and EBITDA (earnings before interest, taxes, depreciation, and amortization). In the asset management business, it is relevant to compare EV to assets under management (AUM) because revenues and profits are directly tied to AUM. In a sense, the ratio of EV/AUM is akin to a P/E ratio in that EV measure the total net capitalization of the firm and AUM indicate earnings potential.

At present, TROW has an EV of $12.21 billion and about $334.7 billion in AUM (AUM data taken from company website). TROW's EV/AUM is presently about 3.64% (= $12.21 billion/$334.7 billion). BEN has an EV of $33.1 billion and about $511.3 billion in AUM. BEN's EV/AUM is presently about 6.47% (= $33.1 billion/$511.3 billion). By comparison, LM looks really cheap. LM has an EV of $13.26 billion and a whopping $944.8 billion in AUM. This means that LM's EV/AUM is only about 1.40% (= $13.26 billion/$944.8 billion). If LM sold at TROW's 3.64% of AUM, LM's current stock price would be 258.08. At BEN's 6.47% of AUM, LM's stock price would be 458.72.

Obviously, there is wide variation involved with estimating LM's value. However, when one considers the valuations of other industry leaders like TROW and BEN, LM looks like a compelling bargain. Over the next 3-5 year period, I look for LM to report earnings per share of 12-14, or higher. With a very reasonable P/E of 20-25, a 3-5 year stock price of 250-300, or higher, is in the cards.


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