Fair Winds Now For Macquarie?

This story features MACQUARIE GROUP LIMITED, and other companies.
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The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

By Greg Peel

The biggest problem that stock analysts and the market in general has had with the Macquarie Group ((MQG)) over the years is simply what is it? Is it a bank? Is it an investment bank? Or is it some new fangled concept like “financial engineer”? While labels might seem trivial, the problem for analysts is how do you value something you can’t even confidently categorise? Do you compare price/earnings multiples with that of a Westpac, or the US Goldman Sachs? Or is Macquarie simply unique?

Obviously the company itself had decided it was something a little undefinable a couple of years ago when Macquarie Bank became Macquarie Group.

Nor did it help that former long-serving CEO Alan Moss preferred to always be rather coy about the Group’s performance. Not that disclosure was limited, just that Moss’s consistently conservative profit guidance announcements usually led to substantial outperformance – admission of which was always reserved for the interim update and the AGM. It got to the point where analysts would simply take the guidance then add about another 50% to expectations, so regularly did Macquarie blow forecasts away.

But who was complaining? Only the popular media when Macquarie decided it better disclose the vast sums afforded its staff as remuneration. Howls of protest and disdain always accompanied such revelations, but none that ever bothered Macquarie management. The large percentage of the profit pool dedicated to bonuses really just made the Group one big hedge fund with a rather stiff performance fee. Yet shareholders were happy to jump on board, all the way to a (close to) $100 share price.

When the GFC hit, Macquarie became very much an investment bank, at least in the eyes of the investment community. If Bear Stearns could go down, maybe Macquarie could too, and then Lehman went down, and made Macquarie look even more vulnerable. What’s more, the so-called “Macquarie model”, which had been copied locally and around the globe, appeared to be broken. If the much smaller Babcock & Brown could go down, what hope was there for the innovator? Financial engineers – if that’s what they were – were surely dead and buried.

Such perceptions were why Macquarie traded down to $15.00. The investment bank tag soon proved a little wayward, given the Group had no real toxic asset exposure to speak of, but there was little doubt Macquarie’s cash-cow fee generator of highly geared listed investment funds was a GFC fatality. The assumption was that if this “Macquarie model” was broken, so too was the Group.

But this Macquarie model had not always been the Macquarie model, and nor was it Macquarie’s only model. Satellite funds were just one successful part of the bank’s operation over a certain history, beginning around the early nineties. GSJB Were put it this way yesterday:

“While MQG’s business is going through a period of transformation, we believe the real Macquarie model is to discover and invest in new businesses that drive future profit growth. This model has resulted in 40% of FY09 income being generated by businesses that did not exist five years ago.”

In other words, the GFC was a set-back for Macquarie, and a rather substantial one in the context of the world-beating status it had so spectacularly garnered over the decades, but not a death sentence. With a Darwinian capacity to adapt and strive once more, Macquarie has simply said “I’ll be back”.

It took two major capital raisings at significant discounts at the bottom of the market, and a bit of help from the government deposit guarantee, but the Group survived a relentless shorting onslaught from the world’s hedge funds and is now sitting on a cash ratio of 40%. When you consider the likes of the Big Four commercial banks agonise over whether to take their tier one capital from 8% to 9%, a 40% cash balance seems almost like a capitulation. But while it may seem a conservative overreaction to the crisis, it is not untypical of Macquarie’s approach to risk which, believe it or not, has always been pretty prudent.

It simply means Macquarie is ready and able to once again exploit what GSJB Were sees as the “real” Macquarie model.

There is a growing belief among economists and stock analysts that we have now seen the worst of the GFC. The trough is in place, and lagging peaks in the likes of unemployment and bank bad debts seem now visible on the horizon. Citi, for example, yesterday upgraded all the Big Four banks to Buy on this basis. Ironically, one of the most bullish analyst teams in town has been that of Macquarie Equities, which put on the rosier-tinted glasses long before most.

Macquarie Equities’ analysts cannot nevertheless make recommendations on its parent Group’s shares, but its peers are perfectly happy to. And there is now a common theme – Macquarie has seen the worst, weathered the storm, so it’s time to stop worrying about the balance sheet and start thinking about future earnings again.

To that end, current CEO Nicholas Moore (who, having made a very public move to accept only a bowl of rice as remuneration this year instead of countless millions, has now lost his nickname of “More and Moore”) provided the Group’s first FY10 guidance at the AGM yesterday. Moore has not had much of a chance since his promotion to play the old Moss conservative profit estimate game, given 2008 was not a time to muck analysts around. It has been more heart-on-the-sleeve stuff. So when FY10 guidance did come in a little under what most analysts had presumed, there was no talk of downplaying.

What was most important for analysts was the fact Macquarie offered FY10 profit guidance at all. For that was the final trigger to reassess valuation models to the point of moving Macquarie from “critical” to “stable”, and maybe even “looking a lot healthier”. For UBS in particular, this meant increasing its target share price from $27.80 to $42.70 – a 53% increase.

Mind you, Macquarie is today trading over $44, and has posted a 193% rally from its lows to get here. UBS was the previous low marker in the FNArena broker universe and many an analyst has made some pretty significant target upgrades on Macquarie over the last month or so. JP Morgan now holds bottom place, on $33.02 (but a Neutral rating) while born-again Citi is in top place on $50.92.

That’s a 42% spread around the average (which, incidentally is $44.22 and very close to today’s share price) which just goes to show what sort of confusion the Macquarie Group offers when one tries to put a valuation on its various businesses.

Nor could Moore offer an update on the bank’s impairment charges yesterday, but then neither were upcoming entries such as the profit on the sale of the Macquarie Airports ((MAP)) management rights included. Analysts are, however, largely prepared to conclude that negatives and positives will probably net out. What’s really in question is as to whether Macquarie can actually grow its earnings once again at a rate justified by the current share price. In relation to the share price, JP Morgan asked yesterday “Are we all getting a little carried away?”

Consensus is, despite the wide variation in target prices, that Macquarie’s earnings growth will be a slow proposition from here. For starters, the Group has 40% of its balance sheet sitting in cash at the moment earning as good as nothing. Basically this reflects Weres’ “real” model. Macquarie has simply warehoused to be ready for whatever innovation opportunity the Group’s talented executives will exploit in the new dawn ahead. It is not in any hurry, and clearly is backing itself that it doesn’t need to be.

The resultant potential drag on earnings recovery was enough for Weres to downgrade to Hold this morning. That leaves an enthusiastic Citi on Buy, and everybody else on Hold. This is despite the wide target variation which might otherwise suggest a couple of Sell ratings. But eight Holds in the FNArena broker universe tie in perfectly with an average target that is very near the money at present.

So on that basis, it seems rumours of Macquarie’s death being exaggerated is now priced fairly into the shares. It will simply be a slow road from here to the sort of earnings per share one used to expect from Macquarie, and there’s also one helluva lot more shares on issue now. It remains to be seen how long it might be before the undefinable enigma can once again surprise.

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