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Legg Mason, Inc.
Where did the $751 Million Go?

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By hwcasey12
May 16, 2008

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5.14.2008 - LM = $55.75

Before I put up my latest DVA with the last quarters numbers, I think a few point are in order.

-EPS has dropped from 4.48 to 1.86. That will cause a drastic swing in any DVA, so we need to analyze the drop and see if it is a one time special event or a sign of things to come (which means get out!).

-If you meticulously go through the financials, as I have done, you will find two line items that attribute to the drop in EPS.

-ITEM ONE: "Impairment of management contracts"
COST: $151 million

-ITEM TWO: "Other"
COST: $600.5 million

Together the two items total over $751 million. EVERY OTHER item on the income statement is normal and within average growth numbers. If you were to add back this $751 million, EPS goes from $1.86 to $4.98 (over last years $4.48)...growth of 11.2%.

Now, I know...if and buts were candy and nuts...

But the issue now is trying to figure out what these charges were for and will they continue.

Now the frustrating part!

LM has done a poor job explaining these items, which for me is not a good sign, but I am patiently awaiting the annual report to clear things up. Here is what I have found so far in the 8-K release on May 6th...

-ITEM ONE: "Impairment of management contracts"
COST: $151 million
-"write-down of certain acquired management contracts"
-"reduction in the value of acquired management contracts held by a Wealth Management subsidiary since the time of its acquisition by Legg Mason"
-it is a non-cash charge
-completely written off in 4th quarter!

The language appears to signal that this was a one-time write-down on these management contracts, but it is not clear! Hopefully the annual report will clear that up. AND hopefully, this is not to continue.

ITEM ONE EFFECT ON EPS - $0.62

-ITEM TWO: "Other"
COST: $600.5 million
-$530.5 in the 4th quarter and $95 in the 3rd quarter (quarters 1 & 2 added $20)
-"In the quarter just ended, we continued to provide, on a proactive basis, financial support to several of our money market funds. The non-cash charges from this support led to a net loss for the quarter...Our actions on behalf of the money market funds have been dilutive to our earnings for two consecutive quarters, but we are resolute in our view that these have been prudent and proper actions to take. We will stay vigilant going forward."
-And that is about it. Will it continue? We are not sure.
-The scary part for me is in the 8-K, they say that the support for MM funds totaled $407, but wrote off $530, what was the EXTRA $123 MILLION from???
-Once again, these are non-cash charges.

ITEM TWO EFFECT ON EPS - $2.50

BOTTOM LINE - We need more information from management on the likelihood of continuing write downs on either of these items. If they are finished, the overall business does appear to be strong, even with under performance from some money managers (some areas performed very well: Western Asset, Royce Funds, Brandywine Global).

That being said...Let's see that Annual Report!

DVA

+1. Sustainable Competitive Advantage = yes
+2. Dominant in Industry = yes
+3. Decade of Dominance = yes
+4. Great Management = yes, but doubts remain
+5. Cash King Margin >10% = 17.21% INCREASE!!!
+6. Foolish Ratio <1.25 = 0.71 DROP!!!
+7. Sales >10% Annual Growth = 6.51% DROP
-8. Return on Invested Capital >11% = ???
-9. Cash > 1.5 Times Debt = 1.32 INCREASE!!!
+10. % of Stock Price that is Cash = 23.30% INCREASE!!!
+11. PE <20 = 30.24 (INCREASE, but would be near 11 without write downs)

DVA Analysis - I'm going to do 2, one with write downs and one with out.

Current EPS = 1.86
Expected EPS Growth = 12%
EPS in 5 Years = 3.28
Expected PE Ratio = 18
Stock Price in 5 Years = $59.00
Risk-Adjusted Discount Rate = 21% (bumped up 3%)
Discount Rate minus Dividend Yield = 19.30%

Intrinsic Economic Value of Stock = $24.42
DVA % of Current Stock Price = 220.78%

WITH no write-downs
Current EPS = 4.98
Expected EPS Growth = 12%
EPS in 5 Years = 8.78
Expected PE Ratio = 18
Stock Price in 5 Years = $157.98
Risk-Adjusted Discount Rate = 18% (keeping at 18%)
Discount Rate minus Dividend Yield = 16.30%

Intrinsic Economic Value of Stock = $74.25
DVA % of Current Stock Price = 72.60%


I am on HOLD until I get more information about the two current write downs that totaled $751 million...at my estimation at least 15% is unaccounted for.

My current average purchase price is basis is at $75.23.

I still see great fundamentals in the overall financials. If this was merely a blip, and the write-downs are over, it will have turned out to be an amazing buying opportunity.

Let's hope so!

Go Long!