Australia | Nov 04 2013
-Sydney Airport sale welcomed
-Return on equity to improve
-UBS questions change to constitution
-Share price upside likely
By Eva Brocklehurst
Macquarie Group ((MQG)) will offload its 17% stake in Sydney Airport ((SYD)) via an in-specie distribution to shareholders. The investment banker confirmed the widely suspected decision at its half-yearly profit release. Brokers largely welcomed the decision to sell but some found the means a little curious.
Morgan Stanley has thought for some time that the more than $5 billion in equity investments were a drag on group returns on equity (ROE) and, therefore, this transaction makes sense. Moreover, a decision to make such a distribution to its own shareholders suggests Macquarie has no compelling alternative uses for the excess capital. The timing also suggestsSydney Airport is considered fully valued.
Citi has upgraded forward earnings on the anticipation of additional profit from the sale and expects the profit impact to be in the $80-100m range. The broker also notes the bank's capital strength remains intact after the transaction and Macquarie retains considerable capacity to acquire, or continue with, further capital management initiatives as other legacy investments, although much smaller, are also unwound.
The distribution in specie achieves several objectives. It crystallises a profit and distributes part of the capital surplus via a partially franked dividend and a capital return at a time when there is likely to be significant demand internationally for Sydney Airport stock once the restructure, that will be voted on this month, lifts the foreign ownership limit. This should support Sydney's stock price in the face of any selling pressure from Macquarie shareholders. Citi's return on equity for FY15 estimates is lifted by 50 basis points to 11% as a result of the reduced capital.
In scrutinising the proposal, JP Morgan notes one stapled security in Sydney Airport for each Macquarie ordinary share will trigger $380m revenue recognition through Macquarie's profit & loss in the second half, pre-tax and pre-bonus. Using a 45% compensation ratio and 30% tax rate, this would deliver an equivalent cash earnings benefit of $145m. The net capital return from the distribution, in addition to other initiatives, would translate into a net $250m capital return for shareholders, thereby resulting in cancellation of the current buy-back. While largely earnings neutral, the transaction will improve Macquarie's ROE, and demonstrate to shareholders Macquarie is seeking to improve returns.
Such a sale structure is not common among investment banks. UBS observes that investment banks usually balance the value attribution between staff and shareholders and utilise various forms of bonus pool or profit share arrangements. Directors of Macquarie have chosen to distribute the Sydney Airport stake on a one-for-one basis, subject to a shareholder vote. While in specie distributions are not unusual, UBS has concerns around the leaking of value. Given Macquarie's profit share arrangement, the staff bonus pool takes $200m, while $60m tax is crystallised. Thus, it appears costly for shareholders to gain access to assets they already indirectly own, in UBS opinion. One of the bank's core strengths is very large and strong distribution channels across retail, institutional and unlisted customers. This proposed transaction, if approved, adds another – shareholders.
Macquarie has stated that the shareholder meeting to approve this distribution will include a change to the constitution to undertake this proposal and future flexibility in distribution payments. As a result, Macquarie is asking shareholders to change its constitution to enable similar distributions in the future. UBS questions whether this is a good precedent. The bank may argue that Sydney is a unique asset but, should the environment change in the future, other transactions of this nature can be undertaken.
Sydney Airport stock is desirable and trades in a liquid market. Given this is the case, UBS asks why didn't Macquarie simply undertake a book build and sell into the market via Macquarie Securities. The broker sees the choice as a complex structure requiring meetings of shareholders and changes to the constitution. Macquarie still holds around $5.5bn of equity investments on the balance sheet. It is likely that many of these assets are less desirable than Sydney Airport. If in the future Macquarie is unable to distribute these assets via its retail, institutional or unlisted channels, there is nothing stopping a distribution to shareholders, at what Macquarie perceives to be the fair value. Will shareholders be happy the next time around?
Credit Suisse liked the proposal as it deals decisively with a sizable and long-standing non-core asset. The broker has been of the view that the relatively subdued returns have been primarily a function of capital allocation. Sydney Airport's strong share price, prudential regulatory rule changes and pending QE tapering are seen underpinning the timing of this decision. Credit Suisse would like to see further such capital management initiatives, but this may be unlikely until greater regulatory capital certainty emerges and/or rising asset prices facilitate the deploying of capital surpluses. Culturally, the broker suspects that Macquarie prefers deploying capital surpluses to the business rather than conducting buy-backs.
What of Macquarie's half year result? Solid was how most brokers viewed it. First half profit of $501m was up 39%. The interim distribution of $1.00 was short on Credit Suisse's expectations of $1.16 but this is compensated by the proposed distribution of the Sydney Airports security. Citi notes impairments were still significant, with $177m in investment impairment charges mainly from the resources sector. JP Morgan is maintaining FY14 and FY15 earnings estimates.
The strong share price in recent months in the absence of positive earnings revisions is a likely reflection of the growing expectations for deals as equity markets improve. This should return the market-facing divisions such as Macquarie Capital a Macquarie Securities to profitability. Transactions should flow too, as unlisted funds begin to wind down and this gives JP Morgan more confidence over fee streams. The stock is expensive relative to the broker's valuation but the Sydney distribution, and the absence of negative catalysts, could see it stay that way for some time and a Neutral rating is preferred.
Citi expects liquidity and the cycle will take the share price higher from here, assisted by continued upgrades in earnings and dividend estimates. This could lift the share price well beyond fair value. The broker expects cycle leverage is much reduced these days, and sees a peak cycle return of 16% compared with the mid to high 20% area in prior cycles. All up it leads Citi to maintain a Neutral rating.
Macquarie has a $48.68 consensus price target which signals 10.1% downside to the last share price. The target has moved up from $48.35 ahead of the report. The dividend yield is 4.4% on FY14 forecasts and 5.2% on FY15 forecasts. There are two Buy ratings (Credit Suisse and Deutsche Bank) and five Hold ratings.
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