Legg Mason Inc. posted positive earnings surprise of 8.6% for second-quarter fiscal 2017 (ended Sep 30). Earnings per share of 63 cents outpaced the Zacks Consensus Estimate of 58 cents. Moreover, the bottom line exhibited an 8.6% increase from the year-ago quarter.

Increased revenues and higher assets under management (AUM) were the primary drivers. Rise in operating expenses was on the downside.

Shares of Legg Mason declined more than 3% in the beginning of the trading session today, reflecting investors’ concern on higher expenses. However, the price reaction during full trading session will give a better idea.

Including one-time items, Legg Mason reported net income of $66.4 million, up 3.3% from the prior-year quarter.

Notably, Legg Mason recorded non-recurring items, including acquisition and transition-related costs of $13.2 million or 9 cents per share, along with a credit of $7 million or 5 cents per share. The results also included a tax benefit of $6.3 million or 6 cents per share, resulting from a reduction in U.K. corporate tax rate.

Revenues & Expenses Rise

Legg Mason’s total operating revenue were $748.4 million, up 11.2% year over year. The rise was mainly due to incremental revenues associated with the addition of Clarion and EnTrust, as well as performance fees from Clarion that were passed as compensation as per the acquisition deal terms. However, revenues lagged the Zacks Consensus Estimate of $752 million.

Investment advisory fees totaled to $652.4 million, up 13.9% year over year. Further, other revenues increased significantly to $1.4 million compared with nearly $0.6 million in the year-ago quarter. However, distribution and service fees were down 5.1% year over year to $94.5 million.

Operating expenses came in at $620.7 million, up nearly 15% year over year. The rise was chiefly due to acquisition and transition-related costs incurred during the reported quarter, as well as incremental expenses associated with addition of Clarion and EnTrust. Moreover, compensation and benefits escalated nearly 30% year over year to $368.3 million.

Adjusted operating margin was 22.7%, down from 24% in the prior-year quarter. The contraction was mainly due to acquisition and transition-related costs in the reported quarter.

Asset Position Improves

As of Sep 30, 2016, Legg Mason’s AUM was $732.9 billion, up 9% year over year. Of the total AUM, fixed income constituted 54%, equity 23%, liquidity 13% and alternatives represented 10%.

AUM decreased 1.2% sequentially from $741.9 billion as of Jun 30, 2016, driven by liquidity outflows of $25.4 billion and long-term outflows of $0.3 billion.  This was partially mitigated by positive market performance of $15.7 billion and $1.0 billion positive foreign exchange.

Notably, long-term net outflows of $0.3 billion included equity outflows of $1.5 billion and alternative outflows of $1.6 billion, partially offset by fixed income inflows of $2.8 billion.

Additionally, average AUM was $742.1 billion, compared with $709.1 billion in the prior quarter and $687.2 billion in the prior-year quarter.

Balance Sheet Remains Stable

As of Sep 30, 2016, Legg Mason had $571 million in cash, up from $491 million at the end of the prior quarter.

Further, total debt was $2.2 billion and shareholders’ equity was $4.1 billion, in line with the previous quarter. The ratio of total debt to total capital (total equity plus total debt excluding consolidated investment vehicles) was 36%, in line with the prior quarter.

Legg Mason repurchased 2.7 million shares during the quarter.

Our Viewpoint

We believe that Legg Mason has the potential to outperform its peers over the long run, given its diversified product mix and leverage in the changing market demography. Further, with strategic acquisitions and restructuring initiatives, we anticipate operating efficiencies to improve. Also, persistent steady capital deployment activities continue to boost investors’ confidence in the stock.

However, escalating expenses remain the primary concern.

Legg Mason currently carries a Zacks Rank #3 (Hold). You can see the complete list of today’s Zacks #1 (Strong Buy) Rank stocks here.

Competitive Landscape

Franklin Resources, Inc. (BEN Quick QuoteBEN - Free Report) reported earnings per share of 82 cents, handily beating the Zacks Consensus Estimate of 69 cents. Moreover, results compared favorably with the prior-year quarter earnings of 59 cents per share.

Results were aided by decline in expenses, partially offset by reduced revenues. Notably, the quarter recorded decline in assets under management (AUM) and recorded net outflows.

SEI Investments Co. (SEIC Quick QuoteSEIC - Free Report) reported earnings per share of 53 cents that outpaced the Zacks Consensus Estimate by 4 cents. Moreover, the bottom line improved 13% from the prior-year quarter tally of 47 cents.

Higher revenues and income from operations, along with improvement in asset position, aided the better-than-expected results. On the down side, the quarter witnessed an increase in expenses.

Janus Capital Group, Inc.’s reported adjusted earnings per share of 24 cents, beating the Zacks Consensus Estimate by a penny. Moreover, the bottom line improved 9.1% from the prior-year quarter.

Though the company outperformed the Zacks Consensus Estimate for earnings, we remain apprehensive due to declining revenues. However, the decline in operating expenses is a consequence of prudent expense management. Moreover, increase in AUM was another positive.

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