Macquarie Group: Dead Money Or Dead Smart?

This story features MACQUARIE GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: MQG

By Greg Peel

Macquarie Group's ((MQG)) first half profit result surprised analysts by coming in around 12% above guidance, albeit down 16% on last year's first half. A bit of an accounting fiddle with the MAp Group ((MAP)) stake (which is now declared “for sale”) covered most of the surprise, but the net result still beat expectations.

While the Fixed Income, Currencies & Commodities division continued to disappoint, it was the Corporate & Asset Finance division which finally brought home some bacon. Now that Macquarie's infrastructure fund business is dead and buried, it is the traditional investment banking sector businesses of broking, advising and proprietary trading which drive the ship.

And that ship has been drifting in the doldrums since Macquarie's March year-end as financial markets have range-traded to nowhere and volumes have fallen significantly from pre-GFC, during-GFC and bouncing-out-of-GFC levels. This has led to two profit warnings from management in that time – the first, at the first quarter update, maintained FY11 guidance but “only if subsequent quarters are not as quiet as the first”. The second warning came in an unscheduled update which suggested the second quarter certainly was as quiet. Guidance was lowered.

Analysts had thus braced themselves for possibly another profit downgrade at the half-year result given little evidence things have since picked up. Hence the surprise. Most recent guidance was maintained. And the Group even maintained a constant dividend payment which tends to suggest some confidence that perhaps, just maybe, the tide is turning.

It's a little early to say. Noticeably, Macquarie's US investment bank counterparts such as Morgan Stanley have posted weak quarterly results in the recent reporting season and the big commercial banks have noted weak contributions from their investment banking divisions. Only Goldman Sachs came out smelling of roses, but then it runs the world. Local analysts had every reason to assume Mac CEO Nick Moore would be back for another round of guidance reduction last Friday.

If there is one thing brokers specifically agree on, it's that the tide will definitely turn – one day. As to when that one day is, well, that's up for debate. Deutsche Bank was bold enough yesterday to suggest “We believe the first half marks the end of the downgrade cycle, and from this point we expect the upgrade cycle to begin”. Credit Suisse, on the other hand, is not prepared to post a timetable and suggests MQG shares are “dead money” until whenever the upswing begins.

The other thing all analysts agree on is that whenever that turnaround may be, Macquarie is very well leveraged to an upswing and will enjoy a rapid return to positive numbers thereafter. Currently the Group's return on equity of around 7.5% falls short of its cost of funds, while an ROE of 15% is targeted once market activity “normalises”. The reason Macquarie is so well-levered is because of its post-GFC contrarian stance.

Warren Buffet is a good example of a contrarian investor who looks to buy when companies are undervalued by the market and divest when companies become overvalued by the market. This usually means buying when others are selling and vice versa, but Buffet's investment time horizon is a long one, uninfluenced by short term fluctuations.

A good time to buy undervalued companies is in a recession, and to that end Macquarie has been flat out picking up small “bolt-on” businesses in the investment banking areas of stock broking, commodities, advisory et cetera in North America and Europe. Macquarie was forced to raise substantial fresh capital in the GFC and this is how that capital is being deployed, along with monies collected on the closure of those Mac infrastructure funds which didn't effectively close themselves.

So put simply, the longer term view is that Macquarie's profit numbers may be suffering now, but it is taking the opportunity to cheaply buy smaller businesses which have also been suffering, and in so doing expand the Group's international footprint and earnings potential ahead of the inevitable, eventual turnaround.

This is the reason four out of the seven brokers in the FNArena database covering MQG have a Buy rating on the stock, all of which were in place prior to the first half result. (The remaining three are Hold ratings.)

But there is another element one has to consider for Macquarie, which relates to the fine tightrope listed investment banks have to walk.

Listed investment banks have to keep both shareholders and staff happy, often at odds with each other. Shareholders provide the funds to allow staff to make lots of profits, but the staff are the talent which actually make the profits. Talented staff members need to be sufficiently rewarded for their achievements or they'll go elsewhere, while shareholders have to see sufficient return on their investment or they'll sell down their holdings. It is on this basis that each year's earnings have to be delicately split between staff remuneration and bonuses on the one hand and retained earnings and dividends on the other.

Analysts were expecting 45% of earnings to be paid to staff in the half but the figure was 48%. This means the staff came out better than expected, at the expense of shareholders. But Citi notes that now that Macquarie's remuneration formula is linked to ROE it is unlikely this payout level will be maintained. Citi expects a 45% net result by year-end implying only a 42% staff payout in the second half.

That sounds more comforting for shareholders, but BA-Merrill Lynch has been arguing for a while that post the GFC Macquarie's “franchise” has been slipping. Once the Millionaires Factory, Mac Bank is now just another investment bank competing in a world where highly talented staff are both limited and completely mobile. The Macquarie aura has dimmed, and recent years have seen an exodus to other global franchises offering much better bonus opportunities.

Macquarie has responded with a lot of redundancies both immediately after the GFC and gradually in the time since. Long-serving executive directors well past the bravado of youth have been quietly offered honourable discharges and farewell dinners, thus trimming down the high end of remuneration commitments. However, with each new bolt-on acquisition the Group has inherited yet more staff to more than replace the total numbers.

Citi estimates Macquarie added around 700 staff this way in the first half FY11. “Question marks remain over the Group's high rate of headcount expansion,” says Citi, “and its ability to deliver through-cycle ROEs sufficient to satisfy investors and maintain a valuation premium”.

UBS takes the argument one step further by noting that at 15,500, Macquarie's headcount is now almost half that of the world's leading investment bank Goldman Sachs yet the Group generates only one sixth of the revenue. The point is that if market activity does not pick up soon, that aforementioned delicate balance will be sorely tested.

The high headcount is currently diluting shareholder returns but at a consistent payout ratio more staff are each getting a smaller cut of the pie. UBS estimates Macquarie staff compensation levels are around 38% below the peer average now and hence a trickle of disgruntled evacuees could lead to a flood if things don't turn around significantly very soon. Shareholders might think losing a few staff might help provide more money for shareholder returns, but losing staff also means losing profit-making ability. It is the talented ones who will be lured elsewhere.

So that's where we're left. A weak year of earnings should not be a concern for the longer term investor because Macquarie Group, through selective bolt-on acquisitions, stands ready to race back into outperformance as soon as market activity gets back to something more normal. As to when this might occur…well…Deutsche Bank seems the only broker particularly calling a turnaround sooner rather than later.

However, were the turnaround to take longer than hoped, Macquarie risks losing talented staff to the opposition and in so doing it risks losing its profit-making potential.

Analysts have written off Macquarie in the past, at their peril. That's why the FNArena database shows a 4/3/0 Buy/Hold/Sell ratio with a consensus target price set more than 15% above the current trading price. But the clock is ticking.

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