It's difficult being a value investor in asset manager land. Everything is often so darn expensive. Still, when Legg Mason (NYSE:LM) popped up on my radar recently, I liked what I saw. The company is suffering a wee bit of stock market indigestion, much like its star money manager, Bill Miller, who beat the S&P 500 index for 15 straight years -- until this year. The cause of Legg Mason's suffering: a mega deal acquiring Citigroup Asset Management.

Luckily, Legg Mason managers have the Tums handy and are quickly performing triage on the patient. The stock is currently cheap, as the company has not met a challenging schedule to deliver results from the merger. With successful recovery in the cards, investors should take advantage of this rare opportunity.

A few things worth noting about this company:

  • Rationalization of cost structure should continue into 2008, boosting margins gradually over time. To that end, the company recently announced a realignment of its management structure, a streamlining of mutual funds, and employee headcount reductions.
  • Company will shift from "defense" mode to "offense" mode in late 2006 and into 2007, with possible small acquisitions to further boost growth.

Did Legg Mason get a lump of coal?
With $854 billion in assets, Legg Mason is one of the world's largest pure asset managers. The company earned $434 million from continuing operations on $2.6 billion in revenues in fiscal year 2006. It earns revenues by charging fees for managing investors' assets.

Soon-to-retire CEO "Chip" Mason -- who founded the firm 44 years ago in Newport News, Va. -- is setting up one heck of a swan song. Last year, Legg Mason effectively transferred its brokerage operations, 5.3 million shares of Legg Mason, and $512 million in cash, for virtually all of Citigroup's (NYSE:C) worldwide asset management business, with assets of $409 billion. Also, the two companies signed a distribution agreement in which Citigroup will distribute the funds for three years via its 12,500-person sales network. This will help to facilitate a smooth transition period. The integration of the assets is largely complete, with much of the cost rationalization still to come.

The recently renamed global asset management division is composed of mutual funds such as Western Asset Management and separate accounts with $338 billion in assets. The international division is made up of fixed assets, with managers like Brandywine, and international equity assets that total $452 billion. Finally, at $65 billion, U.S asset management is composed of Permal assets (a hedge fund of funds asset manager) and other high-net worth assets. International assets across all divisions make up about 29% of assets managed. The company has an impressive record of collecting assets, increasing its assets under management in 56 of 57 quarters prior to the Citigroup deal.

An industry with a history of scandals (Oops! I did it again)
The money management industry is fiercely competitive, with both national and regional asset managers like BlackRock (NYSE:BLK), which recently obtained Merrill Lynch's (NYSE:MER) asset management business; Waddell and Reed (NYSE:WDR); and broker/dealers and commercial banks like Morgan Stanley (NYSE:MS).

Regulators are also a potent force, and their worries about conflicts of interests between controlling the distribution of funds and managing them gave Legg Mason a little extra incentive to do the Citigroup deal. More scandals like the 2003 market-timing affair (in which favored clients were allowed to illegally trade after the market close) certainly wouldn't help matters. Legg Mason escaped with only a $1.2 million settlement charge, and it got off easy compared with some of its peers. Still, Legg Mason has significant competitive advantages in the sheer breadth and depth of its offerings, strong industry branding both domestically and internationally, and a top-quality management team.

But it's cheap!
The stock price has dropped 9% so far this year and is about 28% off its high of $140 for the year. The current P/E ratio is 12, which looks absurdly cheap, but keep in mind that the merger created a $644 million gain after taxes last year (with the brokerage business being swapped), which skews the earnings per share quite a bit. If we consider a normalized 2007 earnings P/E of about 15, we can see that the company is trading similar to 2000 valuation levels.

Keep in mind, this is a savvy operator -- Legg Mason has more than doubled its assets under management and revenues in the 2002-2005 timeframe, before the merger that more than doubled its assets again. If we value Legg Mason based on AUM/market cap and use a conservative 2% of AUM, which is in the range of what value investor Marty Whitman likes to use, we obtain a share price of $128 a share. Furthermore, if the P/E expands back to historical levels -- above 20, versus its current 15 -- as the acquisition is successfully digested, I can see the stock being worth much more in a few years.

This is a high-quality company, and a margin of safety this size is a rare opportunity, especially in the asset management industry. As a small bonus, Legg Mason has increased its dividend every year for 26 years, although the yield currently is not particularly noteworthy, at just less than 1%.

Perhaps with good reason?
The risks that pertain to Legg Mason are greater now that it is focused solely on asset management. The primary risk has to be that any type of stock market downturn would almost certainly hurt Legg Mason's earnings power. Secondly, the Citigroup line-up of funds is largely regarded as so-so, with many equity funds underperforming the indexes, and bloated, so Legg Mason has its work cut out for itself to bring the funds up to par. To its credit, Legg Mason is taking steps to rectify the situation, including hiring former Fidelity star Brian Posner to run the Citigroup domestic equity funds.

For a CEO who disdains computer printouts and prefers to work out numbers by hand on a legal pad, absorbing the large Citigroup acquisition has been quite the challenge. The company has disappointed analysts and investors in recent quarters with slower than expected cost savings. Still, the asset losses and cannibalization (where Citigroup assets switch to Legg Mason assets) to date have been rather minimal -- both keys areas of concern for management. However, that is not to say these issues are put to rest, since the client evaluation process is expected to continue for the rest of the year.

With that in mind, CEO Chip Mason has stated that the company is in a "defense" mode now, working hard to retain assets. Understandably, this is a critical period in which the company has to execute extremely well to position itself for future growth. I have confidence that management will continue to execute this plan as we go into 2007, since historically this has been a top operator within the industry, and the earnings will start to reflect this as the successful asset-retention efforts drop to the bottom line.

A gift from Mr. Market!
Mr. Market has given us a gift in the form of a cheap, top-quality asset manager. I think the concerns regarding the merger are largely overblown and that management has been working hard to make the merger successful. While the kinks are being worked out, though, investors should be purchasing shares at current prices.

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Sources for this commentary include articles from Barron's, The Financial Times, Financial News, and Forbes, made available on Legg Mason's website.

Fool contributor Stephen Ellis does not own any shares of the companies mentioned. The Fool has a disclosure policy.