Australia | Sep 07 2010
By Greg Peel
At the risk of repeating a metaphor I have used previously, the best way to sum up the recent predicament of the once all-powerful Macquarie Group is to suggest “Suppose they threw a party and nobody came”. That's the way the Mac Bankers are feeling at present, as they stare at the uneaten party pies and watch a solitary couple drift around the dance floor.
The Global Financial Crisis forced Macquarie into two significant actions. One was the abandonment of its “financial engineer” infrastructure fund model and the other was to raise significant levels of fresh capital. But in so doing Macquarie also moved to seize opportunities. This required a re-focus back to its earlier model (pre-1992) in which the bulk of profits were provided by “investment bank” activities, specifically financial market broking commissions, advisory fees and proprietary trading profits.
Macquarie quickly moved to use its now strong balance sheet to acquire smaller firms engaged in such activity, with an emphasis on expanding the Group's international footprint. There was never any suggestion the Group would thus bounce back immediately, but a base was certainly being built upon which an eventual bounce-back in global activity could be exploited.
It was all looking quite good in Macquarie's FY10 (April-March) given the strong stock market rally and associated financial activity, most of which can be accredited to global fiscal and monetary stimulus. But in FY11, the wheels have fallen off. Not because Macquarie has made or is making mistakes, but because its predominant earnings divisions are now Macquarie Capital, Macquarie Securities, and Fixed Income, Currencies & Commodities. To provide earnings opportunities, these three financial market divisions simply need two elements – turnover and volatility.
The following graphs show the movement of the Australian ASX 200 stock index and the US S&P 500 stock index over the past six months. We'll take these as proxies for general financial market activity locally and internationally over the period:
Note that Macquarie's first quarter on a financial year basis is April-May-June. Note that it was this period in which the European financial crisis turned the 2009-10 market recovery on its head. It was a volatile period, and while turnover volumes were down on previous years, they were still reasonable. Brokers and proprietary traders prefer that markets go up, but it doesn't mean they can't also make good money when markets go down.
Nevertheless, while June saw the market rebound, it soon became clear many market participants had simply been scared off. Volumes dwindled. All went quiet.
It was at this point that Macquarie CEO Nicholas Moore provided a first quarter update and warned that there was a risk the Group would not be able to grow earnings in FY11 over FY10 levels if subsequent quarters failed to see any return to more robust market activity. It was also thus at this point that stock analysts cut their earnings forecasts and lowered their price targets.
But all stock analysts qualified their changes, noting that Moore's guidance was applicable only if there was no rebound in activity in subsequent quarters. It was a preemptive, not a retrospective, warning. So while analysts acknowledged that Macquarie was now doing it tough, the general expectation was that market activity would begin to return to more normal levels by the second half FY11 (in Macquarie's case, the December and March quarters). The analysts were split only on timing and degree. But all agreed that whenever the markets were to rebound, Macquarie would benefit handsomely, particularly given its acquisitions.
Hence the agreement was that Macquarie remained a compelling longer term investment, and that a book value of close to 1.0x meant it was simply cheap. The timing factor meant three of nine brokers in the FNArena database kept the Group on a Hold rating, while the other six maintained Buy. (See Don't Write Off Mac Bank To Soon).
But now returning to out graphs, it is graphically evident that both markets have achieved nothing other than to go sideways from June to September. There's been the odd spate of significant interday volatility, but market participants have been staying away in droves. Volumes have been alarmingly low. Volumes on the NYSE, for example, were 30% down in August compared to the prior August.
Which brings us back to our party analogy. You just can't make money as an investment bank when there's no one there to make money from.
This time Nicholas Moore did not wait for the second quarter (July-August-September) to be completed. Yesterday he simply cut earnings guidance by 25%.
This understandably came as a shock to the market, despite the warning Moore had already articulated in July. However, Moore's fresh guidance suggested that first half FY11 earnings would be 25% lower than first half FY10 earnings, not that full-year FY11 would be 25% lower than full-year FY10. Indeed, he reiterated that management still expected the FY11 result to be flat on FY10. In other words, Moore is betting on a second half rebound.
In July, Moore wasn't betting on anything. He was just stating the case that earnings would be flat if things didn't improve. It was the stock analysts who were assuming a second half rebound, and thus suggesting Macquarie would likely produce better than flat earnings growth. But now the case is one of a second half rebound being necessary for Macquarie even to achieve flat earnings growth.
Indeed, RBS Australia points out that the Group's first half FY10 earnings result actually contained various profitable “one-offs”. So on that basis a 25% earnings downgrade in the first half FY11 actually equates to a 40% downgrade on an apples-to-apples basis. According to the RBS analysts' calculations, a flat FY11 result will now require “second half FY11 sequential net profit after tax growth of 90%”, which the analysts believe will “prove a stretch”. This is despite RBS also assuming a rebound in activity in the second half.
JP Morgan is in agreement, suggesting “given ongoing uncertainty we are yet to see sufficient evidence that markets activity will rebound to the degree required to translate into meaningful earnings upside relative to a re-basing of first half FY11 earnings”.
UBS raises another issue, and that is the small matter of Macquarie's significant staff costs and bonus pool. The problem is, notes UBS, that Macquarie is “suffering from asymmetric earnings leverage”. In other words, staff fixed costs are high and solid bonuses can be paid in the busy times, but if bonuses are cut and salaries reduced in the quiet times, staff will be lost. So in cutting or losing staff, Macquarie has to be wary of the fact its staff are its earnings generation machine.
Think of it in comparison to a retailer which has a number of stores but is forced to close several in a recession. When the good times return, there are fewer stores and thus less potential to return to previous earnings levels.
Such considerations aside, the fact remains that stock analysts have not changed their underlying collective view, being that Macquarie offers significant longer term upside potential and at these levels is cheap on that basis. The problem for investors, of course, is that analysts also thought Macquarie was cheap several dollars above today's trading price. It might mean a loss of faith in stock analysis, but let's just say the attitude is that if Macquarie was a Buy before, it must really be a Buy now.
Indeed, five out of nine brokers in the FNArena database believe so. But that's one less than in July. This morning BA-Merrill Lynch decided it was time to pull back to join the three other brokers on Hold. Those three were previously on Hold because they didn't see any meaningful bounce in activity occurring in the short term. Again – a matter of timing.
But Merrills sums its reasons up succinctly:
“Persistent lack of conviction amongst corporate and trading clients has hurt and we don't see that changing soon”.
Speaking of conviction, Merrills' downgrade from Buy to Hold (Neutral) is more significant given Macquarie was previously on the analysts' “conviction list” which in theory elevates a Buy rating to Buy (with your ears pinned back). One might call it a double downgrade.
More notably, analysts have really taken an axe to their target prices this time around, dropping consensus from $49.61 to $43.13 (13%). But we also note that this twelve-month consensus target is 25% above today's trading price.
We also note that target distribution remains extensive. JP Morgan bit the bullet today and downgraded its target by 28% to $33.20 to become the low-marker, well below top-marker Credit Suisse on $50.00. That means the brokers range from expecting MQG to either fall 4% on the one hand, or rally 45% on the other.
The investor, or prospective investor, has every right to be bemused. But realistically the story is simple. If market activity can rebound to more “normal” levels, then Macquarie will clean up. The longer market activity remains subdued, the longer Macquarie quietly bleeds. An investor simply has to weigh that up.
