Treasure Chest: Macquarie Headed Back To $100?

This story features MACQUARIE GROUP LIMITED. For more info SHARE ANALYSIS: MQG

By Greg Peel

In late 2007, Macquarie Group ((MQG)) shares hit $100 intraday for all of a heartbeat. Then the wheels fell off.

In the decade leading up to the GFC, Macquarie had remodelled itself away from the traditional proprietary trading/broking and capital finance “investment bank” model it had carried into its initial stock market listing and towards a creator of utility-style infrastructure and other funds which benefitted from the cheap credit world of the time. The credit crunch and subsequent fall of Lehman rendered Macquarie’s new model “broken”, and in 2009 Macquarie shares traded under $20.

It’s been a long road back, but in the interim Macquarie has become a far more diverse global financial services organisation, sourcing 70% of its revenues from offshore. The old investment bank side of the business now represents 19% of group activities, UBS estimates, from 78% on listing. Indeed, along the way Macquarie changed its name from “Bank” to “Group”. Annuity-style businesses now generate a far greater percentage of Macquarie’s return on equity – a far cry from the proprietary trading cowboy days of the 1980s.

But despite the transition, Macquarie still, at heart, considers itself an investment bank. Or at least that’s the conclusion one is forced to draw from the long-term retention of its staff remuneration model. During its growth phase, prior to listing, Macquarie attracted the best and brightest to its fold and away from more familiar investment banking establishments by offering the potential for substantial remuneration through significant performance bonuses.

This “remuneration pool” model continued despite the group opening itself up to public ownership via listing, which comes with the responsibility of rewarding shareholders with dividends. Macquarie assumed shareholders would understand that the best and brightest had to be handsomely rewarded in order to generate the earnings that would be used to also pay dividends. And given Macquarie shares hit $100, clearly they did.

Until the wheels fell off.

Fast forward to now and we note yesterday Macquarie announced the acquisition of an aircraft leasing portfolio. The acquisition itself, while attractive, is not important. What is important is that the Group has chosen to fund the acquisition via a combination institutional placement and share purchase plan (SPP). The implication in the raising is that the $100 odd million profit the Group expects to make on the acquisition will be enjoyed by shareholders. Normally such a profit would be divvied out to the responsible executives via bonuses.

At least, this is the way UBS sees it. JP Morgan, on the other hand, sees things differently.

Close scrutiny of Macquarie’s FY13 and FY14 annual reports leads JP Morgan to believe Macquarie’s return on equity is now exceeding its cost of capital for the first time since the GFC. The bulk of this improvement has been generated by annuity-style, not investment banking, businesses. Yet the broker assumes the old investment banking-based remuneration model still in place will lead not to increased shareholder returns from increased return on equity, but to an increased staff compensation pool.

It is for that reason JP Morgan retains a Neutral rating on the stock.

UBS (Buy) doesn’t know for sure but the broker believes a clue lies in this aircraft lease acquisition. Only two days before the acquisition announcement, the UBS analysts suggested in a report that Macquarie could shift to a more efficient remuneration structure which reflects the greater level of annuity-style earnings, rather than the dusty old investment bank model which is no longer applicable. Macquarie no longer has to pay huge bonuses to stop the best and brightest – those cowboys who earn big bucks trading and dealing in the market – being poached by the competition. The whole point of annuity income is that it keeps recurring all by itself.

Under the annuity model, a staff expense-to-income ratio of 35-38% is more appropriate than the 46% still being used by the Group for the compensation pool today, UBS contends. Even if Macquarie matched remuneration of the top quartile of peer competition in each of its divisions it could still add around 32% to earnings per share. The Group’s return on equity would not only exceed the cost of capital, suggests UBS, it would revert back to the high teens for the first time since the GFC.

This would lift UBS’ valuation of Macquarie Group shares to $95 from $68.

UBS believes the aircraft deal provides an indication that the Macquarie Group board is thinking the same way. The deal-related equity raising means the majority of the benefit of the deal will be passed on to shareholders, and not on to staff as previously always been the case.

It’s a step along the path, UBS believes.

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