Macquarie A Matter Of Faith

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

– Macquarie's FY11 result was roughly in line
– Quality was arguable
– Faith plays a large part in forecasts
– Valuation undemanding for the long term
 

By Greg Peel

“Management appear to be waiting for 'operating leverage' to arrive with no specific plans to reallocate capital or costs among underperforming divisions,” suggests BA-Merrill Lynch, “We still view the path to a materially higher ROE [return on equity] too uncertain and too far into the future”.

The path of the merchant bank Hill Samuel Australia to become Macquarie Bank, to obtain a commercial banking licence and then to be listed on the stock exchange was predicated on investment banking activities reliant upon solid financial market demand and turnover. The 1990s recession brought with it a swift slowdown in activity in equity, capital and advisory markets, but the investment bank morphed into a unique structure dominated by the infrastructure fund model. That model carried what became the Macquarie Group ((MQG)) into the new century, before it “broke” in 2008.

For Macquarie, the last three years have been all about a return of focus to that which set the original merchant bank on a path to greatness in the first place – financial market fees, commissions and trading profits. But the group has not returned such focus because that's now where the riches once more lay. It has done so because of the amount of capital the remaining business has invested in such activities. Unfortunately it is the markets themselves which have not been playing along. 

For the past three years since the GFC, Macquarie's return on equity (ROE) has been at or below 10%, notes UBS. Both management and the market would like to see a return to ROE's of 15-20%. If everything falls into place, that may be possible in the longer term. But right now a strong element of hope is involved.

The group's FY11 profit of $956m was roughly in line with analysts forecasts and recently downgraded guidance. The result was a lot “cleaner” than FY10's because it contained less one-off adjustments and was not supported by a low tax burden affected by excessive bad debt write-offs. In this case, paying more tax is seen as a good thing in the wider scheme. However, in terms of actual result “quality”, analysts are split. While, for example, RBS has called the result quality “reasonable”, JP Morgan, for example, begs to differ.

JPM's analysts note a miss in expectation in the group's higher PE-generating fee and commission result. The balance is made up from higher than expected but lower PE-generating asset realisation gains, meaning booked from on ditching unwanted assets. MQG is now an operation for which fee and commission income is paramount, yet the accounts show management is withholding a reserve of around $400m in equity representing assets “Available For Sale”. This substantial figure cannot be ignored, so the JPM analysts have been forced to include potential asset realisations in its forecast earnings when normally they wouldn't given inherent uncertainty. Hence even their own forecasts now imply a “lower quality”.

The other problem with FY11 earnings was one of currency. By financial year-end, 64% of Macquarie's profits were being sourced offshore. While the ongoing internationalisation of the business has growth and diversification merit, the strong Aussie dollar has decimated profits on conversion back into the local currency, and a similar drag is expected in FY12 with little end to currency strength in sight.

Management has guided for an FY12 result ahead of FY11, but subject to improving market conditions in the Securities and Capital divisions. These divisions have borne the brunt of the loss of investor interest since the GFC. Low volumes and demand still dominate this space, but analysts, and clearly management, are assuming that activity must “normalise” eventually. It's just a matter of how long an investor in MQG shares is prepared to wait.

Indeed, if one takes a five-year average of profits earned across each division, FY07-11, management's guidance looks quite conservative, more than one analyst notes. The question must be, however, one of whether five-year averages are an accurate guide when this particular period is one in which a once-in-a-lifetime event dominates. Management has also guided to 16% profit growth in FY12 by simply doubling the result of the second half of FY11. In this case, analysts believe guidance is really quite conservative indeed, given consensus growth of some 35% was expected in FY12 prior to the result release.

On that basis, Citi has stuck its neck out and suggested that it is consensus forecasts which are ambitious rather than management's. Not only would market conditions have to pick up, but Macquarie's growth rate would have to be “notably faster” than consensus forecasts are suggesting for international peers. And as Merrills notes, “given current market share trends we are not confident past levels can be easily recaptured”.

All analysts note that at 1.0x book value, MQG does offer more upside than downside. Merrills nevertheless fears the “franchise may be slipping” and Citi can't see any signs of a reduction in headcount or expenses flagged in order to boost returns. At least the deal pipeline is in better shape than it was 12 months ago.

Aside from these naysayers, the general response to the MQG result from analysts was one of gradual signs of recovery. Amongst the broker reports were headlines of “small steps”, “turnaround evident”, “getting ready for the good times”, and “encouraging signs…keeping the faith”.

It seems faith is playing an important part, particularly given the extent of crossed fingers with respect to a pick-up in trading activity. For the most part nevertheless, the story is one of a long road back and at an undemanding valuation it becomes a matter of investor patience.

There were no ratings changes in the FNArena broker database emanating from the result, meaning the Buy/Hold/Sell ratio remains at 3/4/0 (note Macquarie can't rate itself). Goldman Sachs is also on Hold and Morgan Stanley on Equal-weight. The consensus target has fallen only slightly, to $40.98 from $41.35, suggesting 13.4% upside at current levels.

 

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