Legg Mason Down to Underperform

We have downgraded our recommendation on Legg Mason Inc. (LM - Analyst Report) to Underperform from Neutral, primarily based on the company’s ongoing managerial changes. Moreover, asset outflows remain a concern, though it improved in the last two months with aggregate net client outflows of $27.5 billion and dispositions of $23.9 billion as of June 30, 2012.

Amid ongoing economic instability, the stepping down of CEO Mark R. Fetting could be a challenge for the company. Fetting joined Legg Mason in early 2008, at the peak of the financial crisis and worked towards lessening the company's troubles. However, the performance of Legg Mason's funds has remained mixed since then and its shares did not rebound as compared with its competitors. Therefore, it could be difficult for the new CEO to help the company recover faster.

Further, challenging and volatile conditions lingered throughout the first quarter of fiscal 2013. Economic uncertainties related to the European debt crisis slowed the global economy and contributed to a sharp decline in the equity markets. Moreover, the Federal Reserve Board continued to hold the federal funds rate at 0.25%, the lowest in history. Economic challenges are expected to persist and the impact on the company’s results due to such irregularities is ambiguous.

On the flip side, Legg Mason is focused on increasing its operating efficiency. In fourth quarter fiscal 2012, Legg Mason completed the business model streamlining initiative announced in May 2010 to drive higher profitability and growth. The initiative resulted in annual cost savings of over $140 million, which will be fully realized on an annual basis during fiscal 2013. These initiatives are expected to create value for clients and shareholders.

Moreover, Legg Mason remains committed to increasing shareholder’s wealth. The company is effectively deploying capital through share repurchase and dividend payment. The company utilized its cash by announcing a 37.5% hike in dividend in April 2012.

We believe Legg Mason has the potential to outperform its peers in the long run, given its diversified product mix and leverage to the changing market demography. However, in the near term, assets outflows are expected to remain a significant headwind, though operating efficiencies are expected to improve. Moreover, the changes in management might affect the performance of the company in the near term, though it is expected to be beneficial in the long-term.

Legg Mason currently retains a Zacks #5 Rank, which translates into a short-term ‘Strong Sell rating. However, one of its peers – BlackRock Inc. (BLK - Analyst Report) retains a Zacks #2 Rank (a short-term Buy rating).