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Break a Legg

In 1970, Legg & Co., a venerable brokerage firm based in Baltimore, made a momentous strategic decision. It merged with an eight-year-old local upstart, Mason & Co. and made Raymond Mason its CEO. Under Mason's leadership, the firm grew from a regional broker and investment bank into a money management powerhouse. As of year-end 2004, its assets under management were $360.5 billion, up 36 percent

In 1970, Legg & Co., a venerable brokerage firm based in Baltimore, made a momentous strategic decision. It merged with an eight-year-old local upstart, Mason & Co. and made Raymond “Chip” Mason its CEO. Under Mason's leadership, the firm grew from a regional broker and investment bank into a money management powerhouse. As of year-end 2004, its assets under management were $360.5 billion, up 36 percent from the previous year. Fund managers — like Bill Miller, who runs the $14 billion Value Trust large-cap fund — consistently beat their peers. Its shares trade at roughly 20 times its 2004 earnings, a higher multiple than Citigroup or Merrill Lynch.

Now, the firm is at another crossroads. With Mason approaching retirement age (he is 68 and has not talked about retiring), and with the company frustrated in its efforts to find suitable acquisitions to keep growing, Legg has become an oft-rumored takeover target. Throughout 2004, speculation centered on reports of talks to merge the firm into Merrill Lynch's $500 billion asset management business, Merrill Lynch Investment Managers. (Both firms declined to comment about the alleged talks, and Legg declines to comment on any potential sales or acquisitions.) Another scenario involves spinning off the retail brokerage business, which produces 31 percent of revenue and 21 percent of profits, to further concentrate on its lucrative asset management empire.

Legg Mason would be a tempting target for a number of financial firms. “Any fully integrated shop that has a regional advantage like Legg Mason is very appealing,” says Joe McCann, head of J.H. McCann & Co., a New York-based executive recruitment firm that focuses on banking. “For a number of banks, they have become a tasty little morsel.”

The list of potential buyers, according to McCann and other observers, include First Albany, William Blair & Co. and Jefferies & Co., along with a host of European and Canadian banks, including the Bank of Montreal, Royal Bank of Scotland and Royal Bank of Canada. Analysts said many of these financial institutions want to start making large purchases again and that many of these firms lack a major in-house asset management business.

Analysts who track Legg Mason, including Matt Snowling at Friedman Billings Ramsey Group, believe the triggering event will come when Mason indicates it's time to hang up his hat. He has told the board that he will give them two years' notice before he steps down. Legg Mason currently does not have a succession plan in place, but has said one will be drafted in the next year.

This “transition risk” is one of the rating agencies' biggest concerns for Legg Mason. “We always view it as a challenge when there is one particular individual so prominent in designing a successful strategy,” says Dagmar Silva, a Moody's Investors Services analyst who covers Legg Mason. “Raymond Mason has been a leading driver of the firm's strategy to build recurring fees, and while we think there is a depth of talent underneath him, the question is whether his successor will have the same vision going forward.” So far, however, this uncertainty has had no effect on Legg's A3 rating.

Timothy Scheve, president and CEO of Legg Mason Wood Walker, the firm's brokerage and investment banking subsidiary, is one of three top candidates to replace Mason. The others are Peter Bain, chief administrative officer, and Mark Fetting, head of asset management. Scheve, naturally, dismisses any succession concerns: “We absolutely have a strong bench for all of our businesses. We think it is a very strong business to build and to grow, and we are looking forward to a long and successful future.”

Clearly Legg has reasons to remain independent, not least of which is the track record for bank-brokerage deals. The company benefited enormously in the 1990s when Bankers Trust purchased its ancient Baltimore rival, Alex Brown & Co. (BT later sold out to Deutsche Bank.) “A lot of people at Alex Brown who didn't want to make the transition to BT went to Legg Mason,” McCann says.

Making a deal?

If Legg remains independent, however, it will be under pressure to make some kind of deal to keep growing. It hasn't made a major purchase since 2001. “They have been issuing stock to build up a war chest, with the understanding that they would do some deals, and I'm a bit surprised they have not pulled the trigger,” Snowling says. Most recently, Legg Mason issued 4.6 million shares of common stock to raise a total of $3.23 million and said that, as of the end of December, it had roughly $600 million in free cash.

Legg Mason has indicated that the firm would like a footprint in Europe, but declines to talk about any other possible ventures. And, says Scheve, it is not rushing into any purchases. “We will continue to grow our businesses,” Scheve says. “We are always looking to grow in a way that doesn't compete with our existing businesses.”

The problem is finding the right target. Chip Mason told analysts in a January conference call that he has been frustrated in his search: “We've felt for some time that something, somewhere, somehow, would appear, and we have looked at various situations that would have helped, but for whatever reason, and I don't think it's because we're afraid to pull the trigger … we have not found anything that really would have substantially helped us.”

Legg Mason grew to its current heft through a series of deals, starting in 1973 when it acquired New York brokerage Wood Walker. In 1986, it bought fixed-income manager Western Asset Management for what now seems a paltry $20 million (Western is one of Legg Mason's powerhouse fund managers, with $160 billion in assets under management and a 12.7 percent average return on capital over the past five years). It added Brandywine Asset Management in 1998, and in 2001, it paid $800 million for asset managers Royce & Associates and Private Capital Management. The result has been that, over the last seven years, Legg Mason's assets under management have risen to $360 billion from $71 billion — roughly 70 percent of these assets are in institutional accounts that are less affected by a bear market.

“These acquisitions have been quite successful, as Legg Mason has acquired firms that are leaders in their industry and don't compete with one another,” Moody's Silva says. Legg Mason's overall headcount, as of the end of 2004, was roughly 5,250, including about 1,480 financial advisors. It had 143 brokerage offices as of the end of 2004.

One thing that Mason has ruled out is starting a hedge fund. “It's unlikely that we would go into the direct hedge fund business,” Mason told analysts. “I'm going to say that we are not capable of managing a hedge fund. It requires skills in risk management that, at times, I question whether we have. I'm not sure anybody really has.” However, he did not rule out offering a fund of funds product.

There are a couple of shadows on the horizon for Legg Mason's asset management businesses, analysts say. For one, analysts note that in comparison to its competitors, Legg Mason has relatively few managers. “That could become a problem if one of these managers experiences reputation damage or a sharp downturn in investment performance, because it could significantly reduce the company's asset management revenue,” Silva says.

Increased regulation could also prove troublesome for Legg Mason's mutual funds businesses, as increased disclosure and more costly accounting regulations will likely eat into profit margins — a situation that all fund managers are now confronting. Last year, Legg, along with a dozen other companies, settled with the SEC, agreeing to pay $2.3 million in fines after the SEC charged the firms had failed to offer some investors discounts to which they were entitled.

“The current regulatory environment is challenging for mutual funds,” Scheve admits. “The [regulatory] focus is on leveling the playing field and increasing the amount of disclosure. Our main concern is that this regulatory environment may go too far and become burdensome and increase the cost to investors.”

What about spinning off the retail brokerage? Despite the tilt toward asset management, Scheve says, brokerage remains central to Legg Mason's future. “Retail brokerage is a strong part of our business. It is our largest business in terms of employees and private accounts,” he says. “We will continue to grow that business and provide a good margin for our shareholders.”

Indeed, Legg Mason's roots lie deep in retail brokerage. Legg & Co. started life as a brokerage firm in 1899, and Mason & Co also was mainly a brokerage. Yet, as asset management has grown, brokerage commissions have fallen from 70 percent to roughly 30 percent of revenues, and that dynamic shows no sign of changing. That's what has analysts wondering if Legg will get out of the brokerage business altogether. “Legg Mason could wind up spinning off its distribution arm — retail brokers — from its asset management business,” Snowling says. “A lot of banks would be interested in either one of the pieces.”

It's easy to see why analysts talk up the spinoff idea: Retail brokerage's profit margin is currently 18 percent, compared with the asset management business' 32.6 percent. Still, selling off its distribution arm could hinder Legg Mason's asset management business, because it would lose a critical distribution channel for its funds.

Given this fact, perhaps the best course Legg Mason could take is to hit the acquisition trail itself.

Company Profile: LEGG MASON

  • Headquarters: Baltimore
  • CEO: Raymond “Chip” Mason, 68
  • No. of Advisors: 1,480
  • Assets Under Management: $360.5 billion, up 36 percent
  • Investment Advisory Fees: $433.1 million, up 33 percent
  • Retail and Institutional Brokerage Revenues: $132.1, up 6 percent

Source: Legg Mason earnings reports for third quarter

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