Macquarie’s Long Road

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– Another soggy year for Macquarie Group but signs of improvement
– Recovery in activity levels still some way off
– Buyback will offer price support
 

By Greg Peel

The “new” Macquarie Group ((MQG)) model is really just the old Macquarie model of pre-infrastructure fund days, being that which boosted the investment bank to the top of the local pile in the 1980s. It relies heavily on financial market turnover and corporate M&A activity to add revenues to more stable annuity-style funds management earnings, and unfortunately for the group such action has been lacking now for several years.

Management had been fairly optimistic of a recovery just around the corner a couple of years ago, but seems now to have resigned itself to a long period of subdued activity. Guidance at the release of the group's FY12 result (ending March) amounted simply to expectations FY13 will see “an improvement” on FY12 as long as market conditions are not any worse than they are now.

On that basis Macquarie would not be pleased to hear Credit Suisse's assessment that “market conditions at this stage remain modest and somewhat patchy, with the risk of renewed relapse”.

Macquarie's response to trying times has been to cut costs, cut staff, and use cashflow to buy back shares, thus improving return on equity (ROE). Deutsche Bank believes this is the right approach, and lays the groundwork for an eventual recovery to the ROE levels of 15-16% the group once enjoyed. However such numbers “appear some time off,” Deutsche admits. Currently Macquarie's ROE is below its cost of capital.

Macquarie's FY12 profit of $730m was 24% down on FY11 but near enough to guidance and analyst consensus. The result was “consistent with recent global investment banking results,” Credit Suisse points out. The good news is that second half profit showed a 39% improvement on the first half. The culprits for the group are those which rely on buoyant markets, being the Fixed Income, Currencies and Commodities and Securities and Capital divisions. Yet BA-Merrill Lynch notes that FICC produced its best revenue half ever (coming from a low base, and still low) and Securities and capital showed signs of bottoming. Meanwhile Funds and Asset Finance continued to deliver stable, high-returning earnings streams, Merrills notes.

UBS is not so convinced, noting a $295m one-off from the Macquarie Airports ((MAP)) distribution, $250m of FICC realisations and revaluations and $275m of credit spread benefits. Those latter two figures could just as easily turn around and go the other way were conditions to deteriorate.

Analysts are in general agreement that cost cutting over the period provided an offset to revenue weakness. JP Morgan nevertheless does not believe cost savings will be as significant going forward and believes underlying revenue growth is stalling. And revenue recovery will be muted, JPM suggests. In FY12 the group cut $420m in costs, including 1350 staff reductions.

What all analysts do agree on is that Macquarie's announced share buyback will support its share price for the time being. Management intends to buy back around 5% of the group or $500m worth dependent on market conditions and the share price, and thereafter it will apply to APRA for approval for another 5%. The first buyback is 5% accretive for FY14 earnings per share.

With the buyback in place but little sign of light at the end of the financial market tunnel, Macquarie's share price should be able to tread water in FY13, with downside limited but upside remaining largely elusive. That seems to be the consensus. As RBS puts it, “we believe the next leg up in earnings will need to be driven by revenues and in turn, an improvement in markets. This conclusion is not supported by current market conditions”.

Shareholders will thus need to take comfort in the buyback, and also in a final dividend of 75cps which was better than expected and implies a payout ratio a little higher than management's stated 50-60% range. FY12 distribution is nevertheless down 25% on FY11 in absolute terms. As any Macquarie shareholder needs to be aware, their welfare forms part of a delicate balance with the welfare – meaning the compensation packages – of staff. Compensation provides management with a rock-an-hard-place decision over paying enough to retain talent and not paying too much as to undermine shareholders.

On that front, UBS is not too impressed. During FY12, UBS notes, revenue fell 9% and staff costs fell 8%. Total staff expense to revenue remained flat at 51%. Therefore, while shareholders saw ROE fall to just 6.5% from 8.6% and their dividends down by 25%, remaining staff appear to have seen little change to their compensation. On that basis, UBS believes Macquarie's cost saving efforts have provided “limited benefit” to shareholders.

Macquarie's result has not led to any ratings changes, with the seven brokers in the FNArena database (Macquarie cannot recommend itself) maintaining two Buys and five Holds. The consensus target price has risen to $30.96 from $29.71 as analysts roll forward their valuations but offers less than 6% upside on current pricing.

JP Morgan suggests Macquarie shares will hang around the current level until the next market update, being July's AGM.
 

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