Don’t Write Off Mac Bank Too Soon

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

By Greg Peel

Stock analysts have always found Macquarie Group ((MQG)) a difficult company for which to forecast earnings. Prior to the GFC, the bulk of Group earnings came from performance fees from its various listed infrastructure funds – a business which came to define the “Macquarie Model” – while the typical investment bank activities of stock-broking, M&A, capital markets and so forth performed well but took a back seat. Commercial banking operations such as funds management were also passengers.

Because the Macquarie Model was unique, at least before others began to copy it, analysts did not have much of a benchmark to work off. This even led JP Morgan's then senior bank analyst to provide two separate valuations for MQG – one as an investment bank and one as a listed fund originator/operator. But there was also another problem.

Macquarie was not known as the “Millionaires' Factory” for no good reason. The Group's success has always been built on hiring the best and brightest and then rewarding them handsomely for being the fundamental drivers of profit. Shareholders learned to accept this model despite around half the profit pool being paid out in executive bonuses each year. It was hard to argue with a soaring share price.

The problem was, however, that the actual percentage of the profit pool paid out to staff has, over the years, fluctuated between 43-53% at management's discretion, as JP Morgan's current bank analysts note. Given the extent of bonus payments to profitable executives, variations in payout translated into large variations in reported profit, yet there was never any reliable guide as to just what that payout ratio might be each year.

Throw in former CEO Alan Moss's propensity to always guide very conservatively – to the point analysts would routinely add about 10% as a rule – and Macquarie has often been somewhat of a guess and giggle from a forecasting point of view, at least in terms of getting the numbers spot on.

More qualitatively, analysts have learned over the years never to write Macquarie off. The Bank, and now Group, has built a reputation for innovation and first-mover status, initially in Australia and then in the world.

The GFC has now put paid to the Macquarie Model, or at least what one might label as the Macquarie Model of about 1992-2008. The truth is Macquarie has no one model but simply adapts to opportunities presented. Prior to the '92 recession, profit was all about the traditional investment bank activities of commissions and proprietary trading profits. With the infrastructure fund business now winding down, the focus is back on such activities.

But just when the FY10 (April-March) rally was providing analysts with an expectation that trading profits would provide the back-up for a stronger recovery in general earnings in FY11, things have slowed to a standstill. The weak markets of the June quarter – Macquarie's first quarter on an accounting basis – has led current CEO Nicholas Moore to suggest FY11 earnings may struggle to beat FY10's. This is a much weaker outlook than analysts were expecting.

Moore has landed in a tough environment having pushed hard for Alan Moss to make good on his retirement plans. Ironically, Moss's background was in typical investment banking activities while Moore was the architect of the now defunct Macquarie Model. Moore now has to work with a less familiar “Treasury” group as the significant source of income, while at the same time the GFC has forced Macquarie to upgrade its commercial banking activities to a more traditional status. One impetus was so that Macquarie depositors and cash management investors could be eligible for the government's emergency guarantees of 2008.

Nowadays the Treasury group is divided into Macquarie Securities (eg stockbroking), Macquarie Capital (eg M&A underwriting) and Fixed Income, Currencies and Commodities (which speaks for itself). It was a weaker than expected first quarter performance in all three now fundamental divisions that led Moore to suggest that FY11 might fall short of FY10, were the conditions of the first quarter to extend for the rest of FY11. Moore's guidance has led analysts to downgrade their FY11 earnings forecasts en masse.

However, Merrill Lynch points out that Moore's warning is “not necessarily a forecast but a statement of fact”. FY11 will only fall short if first quarter conditions remain for all of the next three quarters. In other words, it would require the same weakness in financial markets we saw from April highs to June lows occurring every quarter.

It is a warning worth making, given Macquarie's return on equity for FY11-13 is forecast by UBS to be 10.7%, 12.2% and 13.3% respectively compared to a cost of capital of around 13%. In other words, Macquarie is coming out of the GFC into a period of negative organic growth. But then it all depends on what happens ahead.

Whether rightly or wrongly, Macquarie's share price was trashed in 2008, forcing the Group to raise substantial capital. But once the initial panic had abated somewhat, management went to work deploying that capital by picking off the wounded from the herd in North America and the UK, purchasing stock brokerages and so forth and expanding its international footprint. The Group is still sitting on some $3bn of excess capital.

Given weak conditions, new acquisitions are yet to make an impact but RBS Australia feels the recovery that everyone was anticipating in FY11, looking ahead from FY10, has simply stumbled but not fallen. “Whilst the current operating conditions are subdued,” notes RBS, “the investment banking cycle appears to been pushed back rather than cancelled altogether”.

Merrills' assessment is that “Despite the poor earnings revision momentum we think earnings are currently depressed and it is not a foregone conclusion 1Q11 will repeat all year”.

There is general agreement among brokers that the first quarter is not necessarily a template for the future, but disagreement as to just when conditions might improve and when acquisitions might start making a difference. Whenever that may be, Credit Suisse suggests the leverage the Group enjoys to improving activity trends is simply “dead money” at the moment.

JP Morgan also notes that the staff payout ratio of 46% in FY10 – at the low end of the scale – served to offset some of the weakness in earnings results. Obviously this is a trick Moore has up his sleeve if necessary, but it creates another problem.

In the glory days, prospective trainees and executives would be prepared to walk over hot coals to get into the Millionaire's Factory. Today the attraction is not so great, and indeed aside from management quietly putting some of the longer serving executive directors out to pasture there is a groundswell of dissatisfied staff being poached to the opposition.

In 2008 I joked that Macquarie was no longer the Millionaries' Factory but the “Hundred-Thousandaires' Factory” and soon actually learned that many an executive had become technically bankrupt through the leveraged acquisition of company stock. But it seems it was no joke. UBS notes that Macquarie's executive payout per head has fallen to US$487,000 compared to a global peer average of US$1.15m. That's a big difference.

Macquarie has built its reputation and always silenced its critics by being adaptive and innovative over the decades and that has all come down to those best and brightest. Macquarie executives were always the highest paid in Australia and among the highest in the world. But not any more. It is for this reason many an analyst has warned that staff retention is an issue that cannot be underestimated in its importance.

With that caveat, analysts also agree that at 1.1x book value Macquarie is offering compelling longer term value given the optionality of acquisitions, future capital deployment and leverage to eventual recovery. Deutsche Bank can see the Group's return on equity increasing to 16-17% in a recovery and that equates to a price to book of 2.2-2.5x – a big jump from where we are now.

Again, it all comes down to just when that ultimate recovery may be. Yet it would be naïve to write off Macquarie Group and to that end six of nine brokers in the FNArena database (Macquarie does not rate itself) have Buy ratings on the stock, with Aspect Huntley upgrading from Accumulate on the day of the AGM guidance announcement and UBS upgrading from Hold subsequently when the stock price took a tumble.

The three Hold raters are those who believe the recovery will take a little more than the next quarter or two, and cannot see any immediate short term catalysts despite longer term potential. There is a big target price range, from Citi (Hold) at $40.00 to Deutsche (Buy) at $56.50. On a twelve-month basis that implies a range of 6% upside to 50% upside from today's price.

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