02/26/14 08:12 AM EST

LEGG MASON (LM): ADDING TO BEST IDEAS

ON THE LONG SIDE

Takeaway: Institutional de-risking from stocks and into fixed income is our Theme of the Year which benefits LM's

largely institutional client base

We are adding Legg Mason (LM) to our Best Ideas list as a long position over the intermediate to long

term predicated on the fundamental changes in the institutional pension fund market, including

incremental adoption of liability-driven investing and automatic glide path asset allocation, creating an

investable tailwind for the largely institutional, fixed income assets at Legg Mason.

With institutional de-risking set to accelerate in the intermediate term, we estimate that $500 billion will

flow into leading fixed income managers and conversely $1 trillion will be reallocated out of straight

equity products. The institutional reallocation into fixed income has already started with early signs

from leading institutional bond segments showing improvement.

With interest rates coming off of historical lows, we think the appetite to invest at higher rates by

institutions is substantial. While a back up in rates will hurt the retail fixed income mutual fund market,

these bond losses will be softened by institutional money streaming into the market to capture improved

re-investment rates. With the institutional nature of Legg's assets and also a substantial money market

fund business, LM stock has actually had a positive linear correlation to higher interest rates.

The company recently went to market and successfully placed 30 year term debt which will enable it to

get more aggressive with up to $1 billion in excess capital to pursue an acquisition. Historically, Legg

Mason shares have outperformed the S&P 500 by over 900 bps on both a 6 month and 12 month time

period following acquisitions and the creation of new affiliates.

The style factor set up and cash flow dynamics at Legg are the most favorable in the asset management

sector, yet Legg Mason stock is still not widely recommended on the Street. Currently, only 16% of sell

side ratings on LM are "buy" making it the least-recommended name in the group. Further, the stock

has substantial short interest at 11% of its float (2nd highest in the group). This aggressively bearish

sentiment seems at odds with the fact that Legg will benefit the most from institutional de-risking.

We continue to outline the "tale of two tapes" in the asset management industry with retail investors allocating

out of fixed income mutual funds and into equity products. However the opposite dynamic is occurring on the

institutional side of the business with equity allocations being whittled down in favor of incremental

allocations into fixed income and alternatives.

We first outlined this trend following our call with leading pension fund consultant Towers Watson at the end

of last year and it is now clear to us that this will be an emerging theme of 2014. Legg Mason is a key

beneficiary of shifts within the pension fund market with largely an institutional client base and a substantial

amount of fixed income assets.

Legg Mason has the highest percentage of institutional assets in the asset manager group with the largest

percentage of fixed income:

Institutional Survey Projects a Strong Backdrop for Legg:

The $18 trillion U.S. pension fund market is undergoing a shift away from equities and into fixed income and

alternatives. This adjustment is being assisted by the ongoing adoption of two institutional processes, liability

driven investing (LDI) and glide path investing. This theme was emphasized in the results of Towers Watson

survey work conducted in 2013 on a substantial amount of client assets ($32 trillion in global assets or roughly

15% of the global finance stock of over $200 billion in outstanding stock and bonds).

The most important themes in the TW survey centered around de-risking with demonstrable evidence of a shift

away from equities and into fixed income. In a broad general questionaire on asset allocation with 6 responses

as to potential action, the majority of the respondents in the TW survey came back that they will be reducing

equity exposure through 2015 (58% of respondents to be exact) with a resounding 80% of responses focused

on increasing or considering increases to fixed income (see specific survey outline below). In addition, in a

binary question of investment objectives between "seeking higher returns" or "focusing on managing risk", an

overwhelming 78% of responses were returned that "managing risk" was the main objective from U.S. defined

benefit plans over the next 2-3 year period.

Equity exposure is indicated as being reduced in the TW survey:

WIth an overwhelming response that fixed income will be the beneficiary:

With "managing risk" over "seeking higher returns" being the most common response in the Towers survey:

The institutional reallocation out of equities and into fixed income is being set in motion by the continued

adoption of liability driven investing (LDI) and also glide path processes. In LDI, the institution seeks to match

its asset allocation to its rate sensitive liabilities. While only half of TW respondents were operating with LDI

strategies prior to 2013, an incremental 19% are moving towards implementation in 2014 and by 2015, 71% of

defined benefit respondents will be operating within an LDI framework.

Glide path investing, which in essence is an automatic re-balancing between asset classes depending on their

recent appreciation levels stands to reduce institutional exposure to stocks as the bull market in equities

continues. According to TW by 2015, glide path percentages within defined benefit plans stand to almost

double from 37% coming into 2013, to finish at 61% in several years.

$500 Billion to Flow into Institutional Fixed Income with $1 Trillion out of Equities:

With institutional de-risking set to accelerate in the intermediate term, we estimate that $500 billion could flow

to leading institutional fixed income managers over the coming 24 months and conversely $1 trillion will be

reallocated out of straight equity products. The $18 trillion pension fund market currently breaks out to asset

allocation of 57% to equities, 22% to fixed income, and 21% to Other (mainly Alternatives). With the effect of

LDI and glide path adoption as outlined above however, the pie to set to shift. Assuming that an incremental

19% of TW survey respondents will have adopted a LDI framework and an additional 24% of institutions will

have glide path processes in place by 2015, we are using this general 20%+ rate as what will be the

incremental institutional adoption of fixed income market share. Being that LDI and glide path processes are

mainly applicable on only defined benefit assets which are just under half of the U.S. pension system (the other

half being defined contribution assets), we estimate the overall institutional fixed income pie will then shift by

10% over the next several years. Thus, this will move the overall pension market from a 22% fixed income

allocation to a 24% share which will create net new inflow of over $500 billion for bonds. Conversely, the

counter shift and reduction in equity allocation will result in $1 trillion being withdrawn from institutional

equity allocation with the balance being picked up in Other categories including Alternatives and cash. We

have assumed 2% market apprecation for fixed income and 8% apprecation for equities into 2015. Overall, we

estimate the pension system will settle into an asset allocation of 53% to equities, 24% to fixed income, and

23% to Alternatives and other. Due to the substantial size of the U.S. pension market, even subtle market share

changes are substantial absolute investor sums.

The institutional reallocation into fixed income has already started in our view with early signs from leading

institutional bond segments showing improvement. Using BlackRock's active fixed income segment from their

quarterly earnings reports and Legg Mason's overall fixed income business (again LM is largely an

institutional franchise overall), displays the substantial progress and upward trajectory of institutional bond

flows.

But What About Higher Rates and a Fed Coming Out of the Bond Market?

With interest rates coming off of historical lows (the 10 year yield bottomed at 1.6% in May of last year), we

think the appetite to invest at high rates by institutions is substantial. While a back up in rates will hurt the

retail fixed income mutual fund market as losses are created on existing paper, these bond losses will be

softened by institutional money streaming into the market to capture improved re-investment rates. With the

institutional nature of Legg's assets and also a substantial money market fund business, LM stock has actually

had a positive linear correlation to higher interest rates. This positive historical correlation to rates is driven by

improved institutional bond flows as rates rise (to capture higher re-investment rates) and a better fee

environment for Legg's substantial money market business.

Finally getting Back to Affiliate Building with Recent Amend & Extend 30 Year Term Loan?

Legg Mason has been a successful roll up of various asset management properties over the past 20 years with

the successful integration of investment managers employing everything from quantitative strategies to

domestic small cap equities to European hedge funds. With the recent refinancing of the company's long term

debt, and the successful placing of $400 million of term debt not maturing until 2044 (struck at 5.7% interest

cost), Legg may now be more apt to invest some of its excess cash to acquire a new manager being that its long

term funding is now set.

We calculate that LM has over $1 billion in excess cash (which has been validated by management), being that

only half of its current $805 million in cash on its balance sheet is needed to run the business (i.e. regulatory

capital needed on hand as well as working capital for 1 year of operations). In addition, the company has a

$750 million revolving credit facility it can pull down for general corporate purposes including for use in an

acquisition. We believe that the main product hole that the company may look to fill is the lack of a dedicated

European equity manager, and the potential $1 billion in capital would allow the company to acquire anywhere

between $30-50 billion in assets-under-management (under an assumed purchase price of between 2-3% of

client assets).

We believe that one of Legg Mason's acquisition mandates is for potential deals to be immediately accretive

(in conversations with their management team) which could render a forthcoming transaction as being an

immediate positive for the stock. Historically, LM stock has reacted quite favorably to its roll-up strategy with

substantial outperformance against the market after employing M&A. In analyzing the acquisitions of the main

affiliates that still surivive under the LM umbrella (Batterymarch, Brandywine, Royce, etc), Legg stock has

outperformed the S&P 500 by 900 basis points on average in the 6 and 12 month time periods after deal

announcements. Thus if the recent amend and extend within Legg's long term capital structure does allow the

company more financial flexibility coincides with what we believe is management's threshold to only do an

immediately accretive deal, LM may soon finally pull a new affiliate under its umbrella which has been

historically positive.

LM stock price reaction in 3, 6, and 12 month periods after announcement:

Still a Non Consensus Idea Trading at a Discount:

The style factor setup on Legg Mason is still quite favorable with LM stock the lowest rated stock of the major

public asset managers with the stock also having the second highest percentage of short interest within the

sector. Only 3 traditional brokerages in total coverage by 19 brokers are recommending investors buy LM

stock, the worst percentage of the major public asset managers. In addition, Legg stock has 11.1% short

interest on its float, the second largest percentage in the group, only behind the 13.7% short balance on Janus'

stock. This dynamic is inefficient in our view considering Legg has the highest free cash flow yield in the

sector at 9.7% (200 bps ahead of Janus with a 7.7% free cash flow yield) with the potential for a more stable

cash flow profile considering the ongoing positive developments in the pension fund market as outlined above.

In addition, Legg Mason continues to trade at a historical discount to the asset management group on a P/E

basis when adjusting for the company's significant amortization schedules as a result of its past roll up

acquisition strategy (Bloomberg earnings estimates adjust for the non GAAP add back on Legg's results

because of their roll up strategy to create an apples-to-apples comparison to the rest of the asset management

group. This add back essentially eliminates the amortization expense the company experiences from its past

acquisitions as the expense is non cash and the number of acquired asset management properties is quite

unique to Legg).

The Street still doesn't like Legg stock:

With the potential for a short squeeze higher if positive institutional trends take hold:

...despite the strongest cash flow yield in the group:

With a discount to the group on a P/E basis:

Jonathan Casteleyn, CFA, CMT

203-562-6500

jcasteleyn@hedgeye.com