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Legg rebounds in 2Q, beats analysts’ estimates

Legg Mason Inc. executives are fresh off a quarter marked by slight growth and — at long last — net cash inflows, but they aren’t pretending to ignore what’s really on the minds of investors and analysts.

As the search continues for a new CEO to head the Baltimore-based money manager amidst persistent questions about its future operational structure, the spotlight is on what’s in store for the company moving forward, not on the quarter that just wrapped up.

“There are couple things weighing on investors’ minds,” said Macrae Sykes, an analyst with Gabelli & Co. “There’s the potential for a new CEO, so questions are focused on that. And secondly, there’s the potential actions that could come from the expiration of [board member Nelson] Peltz’s standstill agreement.”

On Friday, Legg executives offered an assortment of rosy-sounding ideas for short- and long-term growth, but analysts don’t expect to see major developments any time soon, said Jeff Hopson, an analyst at Stifel Nicolaus & Co. Inc.

Hopson said he doubts big changes will occur before a replacement is found for former CEO Mark Fetting, who stepped down Oct. 1, or before Peltz’s standstill agreement expires Nov. 15.

Legg Mason will remain committed to the affiliate model, said Interim CEO Joseph Sullivan during a conference call on Friday about fiscal 2013 second quarter earnings. But, he said, merging or selling smaller, under-performing affiliates isn’t off the table.

Legg Mason operates nine affiliate companies, and Chief Financial Officer Peter H. Nachtwey said although executives “don’t make a big fanfare about it,” they have merged or divested under-performing affiliates. They’re willing to do so again, he said.

But analysts said even if there’s a will to sell or merge affiliates, there might not be a way — at least, a way that makes financial sense.

“If [certain affiliate companies] are not doing well, they’re probably not worth much,” Hopson said. “And any time you go through the process of putting something up for sale, that can in itself create instability because clients get worried. So you have to be very careful in any action that you take.”

Neither executives nor analysts have been shy in voicing their concerns about the company’s lagging performance. Sullivan acknowledged the lackluster results and pledged to “take a fresh look” at the firm’s business strategy. He said the primary goal is improving operating efficiency across all levels of the company, adding that “it’s got to be business better than usual.”

“Quite frankly, in an increasingly competitive environment, operating efficiency is an imperative,” Sullivan said. “So I recognize that the status quo is not an option. We are reviewing and evaluating our current business strategy with our affiliate leadership and our board, and we are prepared to modify it as appropriate.”

Those efforts haven’t gone unnoticed, but analysts are cautiously optimistic — nothing more.

“To the extent that they’re refocusing on core operating expenses, after just finishing about $140 million in restructuring, they’ve done a lot of work, and they know they have to do some more work,” Sykes said.

The company did record a few positives during the second quarter. It reported net income of $80.8 million, or 60 cents per diluted share. In the corresponding period last year, net income was $56.7 million, or 39 cents per diluted share.

Still, analysts said the company still isn’t performing at the level of its peers, in terms of both growth and profit margins.

“Our margins have not been acceptable, and I get that. We all get that,” Sullivan said Friday. “And that’s really why we have this increased focus on opportunities for efficiency.”

Unfortunately, analysts say, it can be very difficult to find the right balance between growing the company and streamlining it.

“If you cut costs to try to improve margins, then you potentially hurt your ability to sell product,” Hopson said. “Ultimately, you get higher margins from higher assets, by bringing more money in the door. That’s what it’s all about.”

Legg did make incremental strides in improving cash flow and increasing assets under management, which reached $650.7 billion, a 6 percent increase over the past year.

The company also netted client cash inflows of $200 million after struggling with steady outflows for the past several years. But the gains came from liquidity class assets, which aren’t as lucrative as fixed income and equity class assets, analysts said.

Fixed income and equity are associated with higher fees and higher interest rates, which generates more profit. Those two classes accounted for 82 percent of year-to-date revenues, but netted losses this past quarter.

“Liquidity we almost kind of ignore,” Hopson said. “Fixed income and equities are the real indicators, and both of those were still negative. Equities is especially troubling because those are higher fee, higher profit dollars. When those go out the door, that represents a considerable challenge to overcome.”

The net inflows will be especially short-lived, as executives said to expect substantial outflows in October.

“It’s a constant challenge of trying to grow — which means spending some money — and reducing expenses,” Hopson said. “So can they do it? Certainly you have to say it’s possible, but it’s going to be hard.”