Consolidation In Financial Services

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This story features MACQUARIE GROUP LIMITED, and other companies.
For more info SHARE ANALYSIS: MQG
The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

By Greg Peel

The US subprime crisis provided a big wake-up call for not only the US financial services sector but for similar sectors across the globe. It was as if a teenager who was feeling bullet-proof had pranged the car while drunk and speeding. Once Dad was over the initial shock, he was actually pleased that the accident and subsequent licence suspension did more to knock some sense into the silly lad than he ever could achieve himself.

Australia has not escaped the worst of the global credit crisis either, and in this case there have been some definite casualties, such as RAMS Home Loans. In other cases, such as the Centro Group, it’s just a matter of when the family agrees to turn off the life support system.

For others however, and this means just about every company or fund in the financial services space, there has been collateral damage. Take Macquarie Group for example ((MQG)). Without having suffered any real signs of heavy impact the Group’s share price has fallen from an intraday high of around $99 to a low of around $42 within twelve months. Apart from a higher cost of funds and a bit of a new industry dynamic, Macquarie appears able to carry on in an almost business-as-usual sense. Hence the latest speculation is that the group, which has over $3bn sitting on the balance sheet but yesterday raised another $600m in a pref issue, might be looking to swallow up its Mini-Me.

Like Macquarie, Babcock & Brown ((BNB)) has found its shares falling from a high near $35 to lows around $10 over the period. And like Macquarie, no one has really believed the smaller investment bank was about to go down the gurgler, but sufficient fear has kept the share prices of both companies depressed at the low end of their recent ranges. In B&B’s case however, financing scares at one or two of its listed funds have helped to keep a lid on the share price.

As to whether Macquarie really wants to buy more of the same is a matter of conjecture. Could it be that new boy Nick Moore sees an opportunity to stamp his authority on the world straight up by taking out the only local competition (ACCC permitting)? Or might Macquarie not have its sights set on bigger fish somewhere in the world – something that offers even more diversity, if that were possible? Maybe one or more of the B&B listed funds might be more of an attractive proposition. B&B Power ((BBP)) comes to mind as it faces the prospect of having to sell valuable electricity assets cheaply simply because it came up $300m short on a $3bn re-fi. BBP might suit Mac Bank nicely.

But pointless conjecture aside, the financial services sectors of the world are undergoing a massive period of de-leveraging. The sector has learnt to no longer drink and speed. But as fast as the de-leveraging can occur, more immediate is the problem of settling near term refinancing obligations. Most every bank or fund is trying to reduce gearing back to manageable levels, both from a risk and a pure cost of funds point of view. In many cases, this means forced asset sales. But for those who have come off less scathed, it at least means having a closer look at the business model and deciding to ditch that which doesn’t really fit in with the rest – particularly if sundry businesses are not within a core field of expertise.

It was no doubt with this sort of risk consolidation in mind that wealth manager and financial planner AXA Asia-Pacific ((AXA)) decided to sell its annuity business to annuity specialist Challenger Group Financial ((CGF)) for $50m, and accept in return Challenger’s financial planning business, Genesys, for $150m. As far as stock analysts are concerned, the deal makes perfect sense on both sides.

If anything, Challenger has probably come out the better, but the bottom line is that AXA has a much better opportunity to make Genesys work and the earnings impact is largely immaterial. In Challenger’s case, its side of the deal reinforces the Group’s positive earnings potential going forward. There has been some earnings forecast fiddling from analysts which sees reductions in FY08 in exchange for increases in FY09-10, but strategically the deal has been well-received.

Previously, Challenger was boasting a 6/2/0 B/H/S ratio in the FNArena database, with all brokers suggesting the Group had been unfairly roped in with likes of the Allcos of the world as a major risk post-credit crunch. Shares in both have fallen spectacularly along with everyone else, but while Allco has become “speculative grade” Challenger’s balance sheet and business model are in sufficiently good shape to suggest the selling was overdone. Subsequent to this AXA swap, Citi has moved Challenger from Hold to Buy to arrive at a new B/H/S of 7/1/0. The average target has risen from $3.36 to $3.40 and the shares are still wallowing around the $2 mark.

In AXA’s case, it was always going to be tougher times ahead for a wealth manager in a period of weakness, uncertainty and volatility. The FNArena database showed a 4/4/1. But this leviathan was always going to see sunny skies again one day and half of the analysts were happy to put in a Buy given the opportunity presented to put these shares in the bottom drawer for a cheap entry price in the longer term.

With the Challenger swap announced it was once again Citi who decided to upgrade, taking the one Sell back to a Hold for AXA. Citi believes AXA can do good things with Genesys, and while the acquisition didn’t really trouble the balance sheet scorer, it underpins the opportunity the large and respected fund manager has to throw its weight around in these troubled times. AXA’s average target has fallen from $6.75 to $6.60 but the shares are down at about $5.25.

It is a fundamental tenet of any capitalist model that businesses will “pass from weak hands into strong hands” eventually, and this is never more so the case than following a boom-and-bust cycle. There have already been many examples.

One obvious example is Westpac’s attempted acquisition of St George. Of the big five banks, Westpac has suffered the least from the credit crunch while St George has been described by at least one analyst as now having a business model that is “broken”. Forget all the positive spin both camps have been putting on the merger, the reality is that St George accepted a cheap bail-out price in a heartbeat.

And it is is not just within the obvious financial services space that value will pass from weak hands to strong. There has been a lot of movement in the materials sector for example, aided by the need for overly-geared explorer/developers needing to find a sugar daddy. And another good example came today in the form of furniture retailer Fantastic ((FAN)).

You don’t need to be Warren Buffet to figure out that a furniture retailer is going to be one of the first to suffer in an economic downturn. But it took some majorly slashed FY09 guidance from the company itself to prompt a couple of broker downgrades this morning. However, at the same time Fantastic announced it was purchasing competing businesses in Adelaide and Darwin and working on acquiring another chain in WA. While sales might be slow, Fantastic still has a strong balance sheet and is making the most of it while others suffer. Macquarie, for one, noted this will put Fantastic in a great position when finally the cycle turns once more.

The trick, then, for the risk-comfortable trader, is to pre-empt just who might snap up who. But remember that these little forays do not always come off immediately, if at all.  Bank of America bought into distressed US mortgage lender Countrywide about five minutes after the credit crunch started, and has just recently been forced to buy the whole company months later just before it was about to go out the back door. BA shares are now the worst performing among US commercial banks. Citigroup’s aren’t much better, and there’s at least one Arab sovereign wealth fund realising it might have acted just a little hastily last year as well.

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