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LM > SEC Filings for LM > Form 10-K on 24-May-2013All Recent SEC Filings

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Form 10-K for LEGG MASON, INC.


24-May-2013

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

EXECUTIVE OVERVIEW

Legg Mason, Inc., a holding company, with its subsidiaries (which collectively comprise "Legg Mason") is a global asset management firm. Acting through our subsidiaries, we provide investment management and related services to institutional and individual clients, company-sponsored mutual funds and other investment vehicles. We offer these products and services directly and through various financial intermediaries. We have operations principally in the United States of America ("U.S.") and the United Kingdom ("U.K.") and also have offices in Australia, Bahamas, Brazil, Canada, Chile, China, Dubai, France, Germany, Italy, Japan, Luxembourg, Poland, Singapore, Spain, Switzerland and Taiwan. All references to fiscal 2013, 2012 or 2011, refer to our fiscal year ended March 31 of that year. Terms such as "we," "us," "our," and "Company" refer to Legg Mason.

In connection with a realignment of our executive management team during fiscal 2011, we no longer manage our business in two divisions and, during fiscal 2012, eliminated the previous separation of the Americas and International divisions and combined them into one operating segment, Global Asset Management. We believe this structure allows us to function as a global organization with a single purpose. As a result of this change, we no longer present assets under management ("AUM") or revenues by division.

Our operating revenues primarily consist of investment advisory fees, from separate accounts and funds, and distribution and service fees. Investment advisory fees are generally calculated as a percentage of the assets of the investment portfolios that we manage. In addition, performance fees may be earned under certain investment advisory contracts for exceeding performance benchmarks. The largest portion of our performance fees is earned based on 12-month performance periods that end in differing quarters during the year, with a portion based on quarterly performance periods. Distribution and service fees are received for distributing investment products and services, or for providing other support services to investment portfolios, and are generally calculated as a percentage of the assets in an investment portfolio or as a percentage of new assets added to an investment portfolio. Our revenues, therefore, are dependent upon the level of our AUM and fee rates, and thus are affected by factors such as securities market conditions, our ability to attract and maintain AUM and key investment personnel, and investment performance. Our AUM primarily vary from period to period due to inflows and outflows of client assets as well as market performance. Client decisions to increase or decrease their assets under our management, and decisions by potential clients to utilize our services, may be based on one or more of a number of factors. These factors include our reputation in the marketplace, the investment performance (both absolute and relative to benchmarks or competitive products) of our products and services, the fees we charge for our investment services, the client or potential client's situation, including investment objectives, liquidity needs, investment horizon and amount of assets managed, our relationships with distributors and the external economic environment, including market conditions.

The fees that we charge for our investment services vary based upon factors such as the type of underlying investment product, the amount of assets under management, the asset management affiliate that provides the services, and the type of services (and investment objectives) that are provided. Fees charged for equity asset management services are generally higher than fees charged for fixed income and liquidity asset management services. Accordingly, our revenues and average AUM advisory revenue yields will be affected by the composition of our AUM, with changes in the relative level of equity assets more significantly impacting our revenues and average AUM advisory revenue yields. Average AUM advisory revenue yields are calculated as the ratio of annualized investment advisory fees, excluding performance fees, to average AUM. In addition, in the ordinary course of our business, we may reduce or waive investment management fees, or limit total expenses, on certain products or services for particular time periods to manage fund expenses, or for other reasons, and to help retain or increase managed assets. We have in place revenue sharing agreements with most of our asset management affiliates, under which specified percentages of the affiliates' revenues are required to be distributed to us and the balance of the revenues is retained to pay operating expenses, including compensation expenses, but excluding certain expenses and income taxes. Under these agreements, our asset management affiliates retain different percentages of revenues to cover their costs. As such, our Net Income (Loss) Attributable to Legg Mason, Inc., operating margin and compensation as a percentage of operating revenues are impacted based on which affiliates generate our revenues, and a change in AUM at one affiliate can have a dramatically different effect on our revenues and earnings than an equal change at another affiliate. In addition, from time to time we may agree to changes in revenue sharing agreements and other arrangements with our asset management personnel, which may impact our compensation expenses and profitability.


The most significant component of our cost structure is employee compensation and benefits, of which a majority is variable in nature and includes incentive compensation that is primarily based upon revenue levels, non-compensation related operating expense levels at revenue share-based affiliates, and profits. The next largest component of our cost structure is distribution and servicing expense, which are primarily fees paid to third-party distributors for selling our asset management products and services and are largely variable in nature. Certain other operating costs are quasi-fixed in nature, such as occupancy, depreciation and amortization, and fixed contract commitments for market data, communication and technology services, and usually do not decline with reduced levels of business activity or, conversely, usually do not rise proportionately with increased business activity.

Our financial position and results of operations are materially affected by the overall trends and conditions of the financial markets, particularly in the United States, but also in the other countries in which we operate. Results of any individual period should not be considered representative of future results. Our profitability is sensitive to a variety of factors, including the amount and composition of our AUM, and the volatility and general level of securities prices and interest rates, among other things. Periods of unfavorable market conditions are likely to adversely affect our profitability. In addition, the diversification of services and products offered, investment performance, access to distribution channels, reputation in the market, attracting and retaining key employees and client relations are significant factors in determining whether we are successful in attracting and retaining clients. In the last few years, the industry has seen flows into products for which we do not currently garner significant market share. In addition, the economic downturn of fiscal 2008 and 2009 contributed to a significant contraction in our business and we have not recovered to pre-downturn levels.

The financial services business in which we are engaged is extremely competitive. Our competition includes numerous global, national, regional and local asset management firms, broker-dealers and commercial banks. The industry has been impacted by continued economic uncertainty, and in prior years, by the consolidation of financial services firms through mergers and acquisitions.

The industry in which we operate is also subject to extensive regulation under federal, state, and foreign laws. Like most firms, we have been impacted by regulatory and legislative changes. Responding to these changes has required, and will continue to require, us to incur costs that continue to impact our profitability.

Our strategy is focused on four primary areas listed below. Management keeps these strategic priorities in mind when it evaluates our operating performance and financial condition. Consistent with this approach, we have also presented in the table below the most important matters on which management currently focuses in evaluating our performance and financial condition.

     Strategic
     Priorities                             Recent Initiatives
 Product             Promote revenue growth through new product development,
  expansion            leveraging the capabilities of our affiliates
                      Identify and execute strategic acquisitions to increase
                       product offerings and fill gaps in products and services

 Investment          Deliver compelling and consistent performance against both
  performance          relevant benchmarks and the products and services of our
                       competitors for 1-year, 3-year, 5-year, and 10-year periods

 Distribution        Evaluation and reallocation of resources within and to our
  focus                distribution platform to continue to build a top
                       distribution function with the capability to offer solutions
                       to relevant investment challenges

 Operating           Management of expenses
  efficiency

                      Restructuring of affiliate arrangements

Net Loss Attributable to Legg Mason, Inc. for fiscal 2013 was $353.3 million, or $2.65 per diluted share, as compared to Net Income Attributable to Legg Mason, Inc. of $220.8 million, or $1.54 per diluted share, for fiscal 2012. The current year loss is primarily attributable to $734.0 million, or $3.81 per diluted share, of non-cash impairment charges related to intangible assets and a $69.0 million, or $0.34 per diluted share, non-operating charge from the extinguishment of debt.


Average AUM, and total revenues, remained relatively flat in fiscal year 2013, as compared to fiscal year 2012. Strong overall performance and the improvement of our global distribution function contributed to a continued reduction in outflows. The modest outflows were mostly offset by increases in AUM due to market performance, an acquisition, and new product launches in fiscal 2013.

The following discussion and analysis provides additional information regarding our financial condition and results of operations.

BUSINESS ENVIRONMENT AND RESULTS OF OPERATIONS

The business environment in fiscal 2013 was marked by uneven growth and a continued heightened sensitivity to economic news. Major economic events and news of the year included uneven domestic growth, periodic developments in the ongoing European sovereign debt crisis, the fiscal cliff, sequestration, and the actions of the Federal Reserve to maintain low interest rates, including beginning a third round of quantitative easing and the continued support of the secondary mortgage market. These events led to a challenging financial environment, both globally and in the United States. However, during fiscal 2013 most U.S. indices produced positive returns, with record highs in the equity markets in March 2013. While the economic outlook has remained more positive than in recent years, the financial environment in which we operate still reflects a heightened level of sensitivity as we move into fiscal 2014.

All three major U.S. equity market indices, as well as the Barclays Capital U.S. Aggregate Bond Index and Barclays Capital Global Aggregate Bond Index, increased over the past two fiscal years, as illustrated in the table below:

                                                              % Change for the year ended
                                                                       March 31:
Indices(1)                                                        2013            2012
Dow Jones Industrial Average                                     10.34 %           7.24 %
S&P 500                                                          11.41 %           6.23 %
NASDAQ Composite Index                                            5.69 %          11.16 %
Barclays Capital U.S. Aggregate Bond Index                        3.77 %           7.71 %
Barclays Capital Global Aggregate Bond Index                      1.26 %           5.26 %

(1) Indices are trademarks of Dow Jones & Company, McGraw-Hill Companies, Inc., NASDAQ Stock Market, Inc., and Barclays Capital, respectively, which are not affiliated with Legg Mason.


The following table sets forth, for the periods indicated, amounts in the Consolidated Statements of Income (Loss) as a percentage of operating revenues and the increase (decrease) by item as a percentage of the amount for the previous period:

                                       Percentage of Operating Revenues          Period to Period Change(1)
                                                 Years Ended                        2013             2012
                                                  March 31,                       Compared         Compared
                                      2013            2012           2011         to 2012          to 2011
Operating Revenues
Investment advisory fees
Separate accounts                     28.0  %          29.1 %         29.3 %        (5.8 )%           (4.9 )%
Funds                                 55.3             56.0           53.4          (3.0 )             0.3
Performance fees                       3.8              1.9            3.5          99.1             (48.8 )
Distribution and service fees         12.6             12.8           13.6          (3.1 )           (10.1 )
Other                                  0.3              0.2            0.2          37.3             (16.0 )
Total operating revenues             100.0            100.0          100.0          (1.9 )            (4.4 )
Operating Expenses
Compensation and benefits             45.5             41.7           41.0           7.1              (2.7 )
Transition-related compensation          -              1.3            1.6          n/m              (23.1 )
  Total compensation and
benefits                              45.5             43.0           42.6           3.9              (3.5 )
Distribution and servicing            23.0             24.4           25.6          (7.6 )            (8.9 )
Communications and technology          5.7              6.2            5.8          (9.1 )             1.7
Occupancy                              6.6              5.8            5.0          11.1              12.3
Amortization of intangible
assets                                 0.5              0.7            0.8         (28.4 )           (14.6 )
Impairment of intangible assets       28.1                -              -          n/m               n/m
Other                                  7.2              7.2            6.3          (1.2 )             8.0
Total operating expenses             116.6             87.3           86.1          31.1              (3.1 )
Operating Income (Loss)              (16.6 )           12.7           13.9          n/m              (12.4 )
Other Income (Expense)
Interest income                        0.3              0.4            0.3         (33.9 )            24.2
Interest expense                      (2.4 )           (3.3 )         (3.3 )       (28.2 )            (5.0 )
Other                                 (0.7 )            0.8            2.1          n/m              (62.9 )
Other non-operating income
(expense) of consolidated
investment vehicles                   (0.1 )            0.8            0.1          n/m               n/m
Total other income (expense)          (2.9 )           (1.3 )         (0.8 )        n/m               n/m
Income (Loss) before Income Tax
Provision (Benefit)                  (19.5 )           11.4           13.1          n/m              (17.0 )
Income tax provision (benefit)        (5.7 )            2.7            4.3          n/m              (39.7 )
Net Income (Loss)                    (13.8 )            8.7            8.8          n/m               (6.0 )
Less: Net income (loss)
attributable to noncontrolling
interests                             (0.3 )            0.4           (0.3 )        n/m               n/m
Net Income (Loss) Attributable
to Legg Mason, Inc.                  (13.5 )%           8.3 %          9.1 %        n/m              (13.0 )%

n/m-not meaningful
(1) Calculated based on the change in actual amounts between fiscal years as a percentage of the prior year amount.


FISCAL 2013 COMPARED WITH FISCAL 2012

Assets Under Management

Our AUM is primarily managed across the following asset classes:
Equity                          Fixed Income                      Liquidity

   Large Cap Growth               U.S. Intermediate                U.S. Managed Cash
                                  Investment Grade
  Small Cap Core                 Global Government                U.S. Municipal Cash
  Large Cap Value                U.S. Municipal
  Equity Income                  U.S. Long Duration
  Mid Cap Core                   Global Opportunistic
                                   Fixed Income
  Global Emerging Market         U.S. Credit Aggregate
   Equity
  Global Equity                  U.S. Limited Duration
  International Equity           Global Fixed Income
                                  U.S. Government
                                   Intermediate
                                  Government/Credit

The components of the changes in our AUM (in billions) for the years ended March 31, were as follows:

                                                   2013        2012
Beginning of period                              $ 643.3     $ 677.6
Investment funds, excluding liquidity funds(1)
Subscriptions                                       44.9        46.9
Redemptions                                        (49.0 )     (51.1 )
Separate account flows, net                        (27.4 )     (35.9 )
Liquidity fund flows, net                           19.8        12.6
Net client cash flows                              (11.7 )     (27.5 )
Market performance and other (2)                    34.2        17.1
Acquisitions (dispositions), net                    (1.2 )     (23.9 )
End of period                                    $ 664.6     $ 643.3

(1) Subscriptions and redemptions reflect the gross activity in the funds and include assets transferred between funds and between share classes.
(2) Includes impact of foreign exchange, reinvestment of dividends, and other.

AUM at March 31, 2013, was $664.6 billion, an increase of $21.3 billion, or 3%, from March 31, 2012. The increase in AUM was attributable to market performance and other of $34.2 billion, including the negative impact of foreign currency exchange fluctuations of $8.3 billion, and $5.4 billion related to the acquisition of Fauchier Partners Management Limited ("Fauchier"). These increases were offset in part by net client outflows of $11.7 billion and dispositions of $6.6 billion. The dispositions were in liquidity assets which resulted from the amendment of historical Smith Barney brokerage programs providing for investment in liquidity funds that our asset managers manage. Long-term asset classes accounted for the net client outflows, with $20.4 billion and $11.0 billion in equity and fixed income outflows, respectively, partially offset by liquidity inflows of $19.7 billion. Equity outflows were primarily experienced by products managed at Batterymarch Financial Management, Inc. ("Batterymarch"), Royce & Associates ("Royce"), The Permal Group, Ltd. ("Permal"), and Legg Mason Capital Management, LLC ("LMCM"). Due in part to investment performance issues, we have experienced net annual outflows in our equity asset class since fiscal 2007. The majority of fixed income outflows were in products managed by Western Asset Management Company ("Western Asset"), including $6.4 billion in outflows from a single, low fee global sovereign mandate. We expect to continue to experience outflows from this mandate of approximately $500 million per month during fiscal 2014. Fixed income outflows were offset in part by inflows at Brandywine Global Investment Management, LLC ("Brandywine"). We have experienced outflows in our fixed income asset class in all but two quarters since the fourth quarter of fiscal 2008. We generally earn higher fees and profits on equity AUM, and outflows in the equity asset class will more negatively impact our revenues and Net Income (Loss) Attributable to Legg Mason, Inc. than would outflows in other asset classes. We experienced liquidity outflows of approximately $13 billion from a sovereign wealth


client during the month ended April 30, 2013, however, we do not expect this outflow to have a material impact on our revenues or net income.

Our investment advisory and administrative contracts are generally terminable at will or upon relatively short notice, and investors in the mutual funds that we manage may redeem their investments in the funds at any time without prior notice. Institutional and individual clients can terminate their relationships with us, reduce the aggregate amount of assets under management, or shift their funds to other types of accounts with different rate structures for any number of reasons, including investment performance, changes in prevailing interest rates, changes in our reputation in the marketplace, changes in management or control of clients or third-party distributors with whom we have relationships, loss of key investment management personnel or financial market performance.

AUM by Asset Class
AUM by asset class (in billions) for the years ended March 31 were as follows:
                           % of                % of       %
                 2013     Total      2012     Total    Change
 Equity        $ 161.8      24 %   $ 163.4      26 %    (1 )%
Fixed Income     365.1      55       356.1      55       3
Liquidity        137.7      21       123.8      19      11
Total          $ 664.6     100 %   $ 643.3     100 %     3  %

The component changes in our AUM by asset class (in billions) for the fiscal year ended March 31, 2013, were as follows:

                                                            Fixed
                                               Equity      Income      Liquidity       Total
March 31, 2012                                $ 163.4     $ 356.1     $    123.8     $ 643.3
Investment funds, excluding liquidity funds
Subscriptions                                    18.9        26.0              -        44.9
Redemptions                                     (26.4 )     (22.6 )            -       (49.0 )
Separate account flows, net                     (12.9 )     (14.4 )         (0.1 )     (27.4 )
Liquidity fund flows, net                           -           -           19.8        19.8
Net client cash flows                           (20.4 )     (11.0 )         19.7       (11.7 )
Market performance and other                     13.4        20.0            0.8        34.2
Acquisitions (dispositions), net                  5.4           -           (6.6 )      (1.2 )
March 31, 2013                                $ 161.8     $ 365.1     $    137.7     $ 664.6

Average AUM by asset class (in billions) for the years ended March 31 were as follows:

                           % of                % of       %
                 2013     Total      2012     Total    Change
Equity         $ 152.1      24 %   $ 168.4      26 %    (10 )%
Fixed Income     364.5      56       359.8      56        1
Liquidity        128.9      20       116.6      18       11
Total          $ 645.5     100 %   $ 644.8     100 %      -  %

AUM by Distribution Channel
We have two principal distribution channels, Global Distribution and Affiliate/Other, through which we sell a variety of investment products and services. Global Distribution, which consists of our centralized global distribution operations, principally sells U.S. and international mutual funds and other commingled vehicles, retail separately managed account programs, and sub-advisory accounts for insurance companies and similar clients. Affiliate/Other consists of the distribution operations within our asset managers and principally sells institutional separate accounts and liquidity (money market) funds.


The component changes in our AUM by distribution channel (in billions) for the year ended March 31, 2013, were as follows:

                                                 Global
                                              Distribution       Affiliate/Other        Total
March 31, 2012                              $         220.6     $         422.7     $      643.3
Net client cash flows, excluding
liquidity funds                                         2.2               (33.7 )          (31.5 )
Liquidity fund flows, net                                 -                19.8             19.8
Net client cash flows                                   2.2               (13.9 )          (11.7 )
Market performance and other                            9.3                24.9             34.2
         Acquisitions/(dispositions), net                 -                (1.2 )           (1.2 )
March 31, 2013                              $         232.1     $         432.5     $      664.6

For the years ended March 31, 2013 and 2012, our overall effective fee rate across all asset classes and distribution channels was 34 and 35 basis points, respectively. Fees for managing equity assets are generally higher, averaging approximately 75 basis points for each of the years ended March 31, 2013 and 2012. This compares to fees for managing fixed income assets, which averaged approximately 25 basis points for each of the years ended March 31, 2013 and 2012, and liquidity assets, which averaged under 10 basis points (reflecting the impact of current advisory fee waivers due to the low interest rate environment) for each of the years ended March 31, 2013 and 2012. Equity assets are primarily managed by ClearBridge, Royce, Batterymarch, and Permal; fixed income assets are primarily managed by Western Asset and Brandywine; and liquidity assets are primarily managed by Western Asset. Fee rates for assets distributed through Legg Mason Global Distribution, which are predominately retail in nature, averaged approximately 50 basis points for each of the years ended March 31, 2013 and 2012, while fee rates for assets distributed through the Affiliate/Other channel averaged approximately 20 basis points for each of the years ended March 31, 2013 and 2012. The decline in higher yielding equity assets has impacted our revenues, as further discussed below.

Investment Performance
Overall investment performance of our assets under management in the year ended March 31, 2013, was generally positive compared to relevant benchmarks.

For the year ended March 31, 2013, most U.S. indices produced positive returns. . . .

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