On Tuesday, Moody's Investors Service, the ratings arm of Moody's Corp. ( MCO ), downgraded its outlook on Legg Mason Inc. ( LM ) to 'Negative' from 'Stable'. The downward revision was propelled by the fall in the company's market position due to continual outflows.
The lower market participation has negatively impacted earnings and leverage. However, the firm affirmed the Baa1 senior unsecured debt rating for Legg Mason.
Earlier this week, Legg Mason also reported a sequential decline in its assets under management (AUM) in November. Preliminary month-end AUM came in at $620.6 billion, down 1.3% from $628.7 billion at the end of October. Equity AUM and fixed income AUM also plummeted.
On a quarterly basis, as of September 30, 2011, Legg Mason's AUM was $611.8 billion, down 7.7% sequentially from $662.5 billion, driven by market depreciation, including foreign exchange and client outflows of $17.6 billion. On a year-over-year basis, AUM was down 9.2% from $673.5 billion.
Legg Mason's reduced AUM performance was also one of the factors to influence the decision taken by Moody's. On the other hand, significant deterioration in earnings, liquidity or increase in risk and leverage has unfavorably influenced its ratings.
Continuous outflows loosened investors' confidence on the company's products. According to a rating agency, it would take time before the company reverts back to positive flows on a persistent basis.
Precisely, Legg Mason's revenue growth and profitability has been stalled extensively, as AUM dropped approximately 9% over the last two years. Moreover, in the last six months, excluding streamlining charges, profit margin for Legg Mason have plummeted to 10%, way below the level of 15-25%, which the company has produced prior to 2008.
Legg Mason is working on improving its profitability. Last year, the firm has initiated a streamlining plan. The plan inculcates reduction of shared service and corporate center costs, which is anticipated to perk up profitability and growth in EBITDA (earnings before interest, tax, depreciation and amortization).
Moreover, the plan is intended to reduce operational costs while improving Legg Mason's profit margins. The 18 month plan is expected to bring profit margins closer to historical levels, assuming revenue trends to remain stable or positive.
Profitability pressures coupled with competition in the market is partly reduced through Legg Mason's strong liquidity. As of September 30, 2011, the company has consolidated cash balances of $1.1 billion, though reduced on a year-over-year basis due to share repurchases.
According to Moody's, upgrading the rating outlook to stable depends on certain factors. These factors include continued improvement in investment performance, return to positive client inflows, stronger pretax profit margins and expectation of sustained gross total debt/EBITDA below 2.5x with surplus liquidity.
However, Moody's threatened to downgrade Legg Mason's long-term rating. The company announced that if the outflows of long-term assets continue for two or more quarters, gross total Debt/EBITDA ratio will be above 3x and EBITDA/interest expense ratio below 4x for more than one quarter. Further, with significant decline in its liquidity, the company will encounter a rating downgrading action.
However, other rating agencies such as Fitch Ratings and Standard & Poor's (S&P) have not yet taken any action on Legg Mason's rating.
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 demographics in the market. However, in the near term, assets outflows will remain a significant headwind. Yet with the restructuring initiatives and cost-cutting measures, we expect operating leverage to improve, and share buybacks to continue instilling investors' confidence on the stock.
Legg Mason currently retains a Zacks #3 Rank, which translates into a short-term Hold rating. Further, considering the fundamentals, we are maintaining a long-term Neutral recommendation on the stock.