Macquarie’s New Model

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

The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

By Greg Peel

To pick up from the comments I made on Sky Business on Friday, echoed by The Australian's John Durie, to suggest “the Macquarie Model is broken” is to not appreciate the history of Macquarie Bank, now Macquarie Group ((MQG)).

It is true that Macquarie's business of buying infrastructure assets and creating investment funds around those assets, which began in the early nineties and boomed in the early noughties, was a model for that age and has been largely killed off by the GFC. However, from the eighties through to the 1992 recession the dominant contributor to Macquarie's bottom line was proprietary trading, with fee-based services such as stockbroking being built up at the same time. When the proprietary model faded in contribution after the recession, fee-based income and ultimately infrastructure funds rose to the fore.

And so too did mortgage securitisation become a new contributor, while M&A underwriting was another area Macquarie worked hard to gain market share in. In short, there is no such thing as “the Macquarie Model”. Macquarie has simply proven an innovative force over the decades which has juggled and developed several “models” in response to prevailing market conditions. When one model is on the wane, another rises. Macquarie took a big hit in the GFC but rumours of its demise were greatly exaggerated.

It is now a new frontier once more for Macquarie and the Group is sitting on lots of new capital waiting for appropriate deployment. To date its target has been to reverse its own GFC misfortunes by picking up more traditional investment banking assets in North America while such assets are going cheap. The UK is the next target.

The Group also bounced back comfortably in 2009 given market volatility provided handsome trading and broking profits and rampant M&A activity provided plenty of fees. In the March quarter 2010 however (Macquarie's fourth quarter), volatility waned and thus so did earnings. The result was a weaker earnings result quarter-on-quarter which belied what first appeared like a flat but reasonable result. The offset was the Group's reduction in its staff compensation ratio from 45% to 43%.

If there is one Macquarie “model” at all, it is the high level of compensation paid to staff over its history. While the “greedy investment banker” tag has thus been applied in the popular press to what has always been know as the “millionaire's factory”, management makes no excuses. Shareholders also appreciate that innovation and success is all about retaining the world's best and brightest and that on average the Group has always provided solid return on equity despite its compensation bill being nearly half of distributable profits.

The GFC caused this model to wobble nevertheless, and the Group bowed to public perception as well as funding cost increases in reducing staff and compensation levels as a response. One might have thought Macquarie would by now be restoring those levels quietly but this has not been the case (albeit CEO Nicholas Moore's salary was restored from token to a more respectable $9.5m, but this is still well short of his predecessor's numbers).

Analysts suggest the surprise reduction in the compensation ratio was made in order to maintain a 60% payout ratio for shareholder dividends. While earnings were weaker this quarter, the actual staff cost to income ratio increased to 46%. Macquarie has no doubt decided perception still remains important at this stage of the recovery and that keeping shareholders happy is paramount. However, it's a tit-for-tat consideration and analysts warn the Group risks losing some of those “best and brightest” if the compensation ratio is not soon restored. As noted, lower compensation is good for shareholders on paper but not for longer term return on equity aspirations if the most productive staff all defect elsewhere.

Analysts also noted a reduction in one-off costs in this fell-year result and were pleasantly surprised by a reduction in loan impairments. While the Group still has money tied up in what are now unproductive infrastructure funds, it does have a further $4bn of capital to be deployed and offshore expansion to date is evidence of such deployment, and a reason why most analysts see the Group able to restore past return on equity levels in the medium term, from a current 10% to 20% eventually. Management is confident of an improvement in operating results ahead in FY11 but is nevertheless retaining an excess capital base pending a tightening of regulations for the sector, which still remains an unknown.

(The financial sector would not have been too thrilled to see the government is bold enough to slap a 40% resources rent tax on the mining industry as a popular political move. Bank-bashing is the electorate's favourite sport, so any strict measures applied to banks, reducing their earnings potential, would no doubt be broadly cheered on in Australian lounge rooms.)

Of the brokers in the FNArena database, none are recommending a Sell on Macquarie. Four brokers are nevertheless remaining cautious on the potential speed of solid earnings and return on equity recovery given the weaker fourth quarter earnings result and compared to the market's current pricing of MQG shares. Aspect Huntley, UBS and GSJB Were all have Hold or equivalent ratings while Citi has downgraded to Hold post-result.

Citi suggests: “There remains flexibility for the business to pursue further acquisitions. However in the interim, higher capital and elevated liquids should see returns remained subdued”.

Other brokers are nevertheless more positive, seeing excess capital not so much as a drag but an opportunity, and that recent offshore acquisitions provides faith the Group can indeed restore its ROE over time. Each of Deutsche Bank, BA-Merrill Lynch, Credit Suisse and RBS maintain Buy or equivalent recommendations. (Note that Macquarie does not analyse itself.)

There was a little bit of earnings forecast and target price fiddling post-result, substantial enough only to move the average target from $59.68 to $59.70.

Click to view our Glossary of Financial Terms