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We have upgraded our recommendation on Legg Mason Inc. (LM - Analyst Report) to Neutral from Underperform attributable to the recent acquisition of Fauchier Partners. Moreover, the company reported strong fiscal second quarter 2013 earnings, which significantly outpaced the Zacks Consensus Estimate.

Legg Mason’s second quarter 2013 adjusted earnings of 75 cents per share were up from the Zacks Consensus Estimate by 19 cents. Moreover, earnings were well above the prior-quarter figure of 64 cents per share. Better-than-expected results reflected higher top-line growth, aided primarily by improved investment advisory fees and other revenues. Yet, elevated operating expenses acted as a dampener.

The company also reported a slight rise in its assets under management (AUM) for the month of November 2012, compared with the prior month. Preliminary quarter-end AUM came in at $648.3 billion, up 0.4% compared with the prior month. Equity AUM and Fixed Income AUM were down, though liquidity AUM advanced.

With the aim of expanding globally and to provide exceptional services to its clients, Legg Mason and its affiliate, Permal Group, announced the acquisition of London-based fund-of-hedge-funds firm - Fauchier Partners from BNP Paribas Investment Partners in December 2012. Moreover, the acquisition is anticipated to be accretive to Legg Mason's earnings in the first year, reflecting management’s continuing assurance to create shareholder value.

While the financial environment in the United States remained uncertain during the first half of fiscal 2013, positive news related to increased consumer confidence, decline in unemployment, and growth in manufacturing indicated towards a rebound in the economy, though at a slow rate. However, during the reported quarter, the Federal Reserve Board continued to hold the federal funds rate at 0.25%, the lowest in history. Therefore, economic challenges are expected to persist and the impact on the company’s results due to such uncertainties is ambiguous.

We believe that the risk-reward profile of Legg Mason is currently balanced and hence, we upgraded our recommendation to Neutral. Moreover, 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. Though, in the near term, assets outflows remain a significant headwind, the restructuring initiatives, the recent acquisition and cost-cutting measures are expected to improve operating efficiencies.

Legg Mason currently retains a Zacks #3 Rank, which translates into a short-term Hold rating. BlackRock Inc. (BLK - Analyst Report) is another Zacks #3 Rank in the same industry.

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