On Tuesday, asset manager Legg Mason (NYSE:LM) took its medicine early by lowering guidance ahead of its Oct. 24 third-quarter earnings announcement. The market's reaction was swift and merciless, as the company shed more than 17% of its value on Wednesday. For market participants who adopt a short time horizon, the decision to sell may be rational, but for value investors who aren't afraid to think in terms of years, rather than quarters, the sudden price cut may create opportunity.
The facts
Legg Mason said that it expects last quarter's net income to come in between $0.96-$1.02 per diluted share, compared to analysts' consensus for earnings of $1.16. The midpoint of the new range, $0.99 per diluted share, represents no growth over the prior-year quarter and an 8% decline from the second quarter. Lower expected earnings for the third quarter are attributed to two factors:
- Lower expected revenues, to the tune of 1% less than the previous quarter. This drop is partly explained by an unfavorable shift in the mix of assets under management (AUM) toward fixed-income products, which generate lower fees than equity products (see table).
- An unanticipated $12 million ($0.04-per-diluted-share) mutual fund marketing expense. This relates to the asset-management activity Legg Mason acquired from Citigroup in 2005.
Legg Mason AUM
|
Asset class |
09/30/2006 (est.) |
06/31/2006 |
|---|---|---|
|
Fixed Income |
50% |
49.2% |
|
Equity |
35% |
36.5% |
|
Liquidity |
15% |
14.3% |
|
Total AUM* |
$855 |
$855 |
It's important to note that the second item, which has surfaced as Legg Mason digests its transformational acquisition of Citigroup's (NYSE:C) asset-management business, relates to prior quarters. I think it's a fair bet that this can be considered a one-time cost with no harmful effect on future earnings. Furthermore, the company asserted that the integration of Citigroup's activity "remains on schedule."
The issue of asset mix is perhaps a greater concern. Equity assets under management appear to have suffered approximately $10 billion in net outflows during the quarter, with no growth in overall AUM. This decline is mirrored by (and linked to) superstar equity manager Bill Miller's recent "slump." His flagship fund, the $19 billion Legg Mason Value Trust, is lagging the S&P 500 by some 12 percentage points this year, after 15 consecutive years of outperformance. As a value investor, I think there is good reason to believe that Miller will recover from this difficult period (though not in time to extend his streak), which could provide the catalyst for new growth in equity assets under management. In any event, I don't believe Legg Mason's equity funds franchise is permanently impaired.
Running the numbers
So is there value here? As a rough rule of thumb, I use 2% of AUM, plus tangible book value, to value asset managers. By that measure, and by comparison with its peers (based on forward P/E and the PEG ratio), Legg Mason looks cheap. My own quick-and-dirty discounted cash flow (DCF) valuation yields a share price range of $103.40-$126.20 (implying that the closing price on 10/11 contains a margin of safety of 16%-31%), based on the following assumptions:
- Cost of equity = 10.5%;
- Growth rate = 15%;
- Excess return period = 10 years;
- Operating profit margins = 25%-30%;
Conversely, Wednesday's closing price of $87.15 implies a growth rate of 11% (keeping the other assumptions unchanged and operating margins at 27.5%).
With this profit warning, Legg Mason will have missed its earnings for three consecutive quarters. As such, its stock is now a "show me" investment for short-term investors, who will only return once they are certain that the company has all its ducks in a row. However, certainty has a price; in the meantime, I think the odds favor patient investors who take advantage of the company's temporary difficulties to acquire a good business at an attractive price.
Leg it on over to further Foolishness:
Legg Mason is an Inside Value watch list stock. Head analyst Philip Durell is always looking for good businesses trading at temporarily depressed prices. To discover his most recent recommendations, try Inside Value free for 30 days.
Fool contributor Alex Dumortier has a beneficial interest in Microsoft. He welcomes your (constructive) feedback. The Motley Fool has a strict disclosure policy .
