Macquarie Cooking With Gas

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

– MQG upgrades FY14 guidance
– Energy trading key driver
– FY15 a more critical period
– Brokers cite full valuation

By Greg Peel

In the late eighties your humble correspondent was a young proprietary trading trainee with Macquarie Bank and was sent to a global energy trading conference in Singapore with a senior colleague to write a paper on the state of the market. Providing hedging opportunities for major energy producers and consumers was, back then, a new frontier.

Jump ahead over 25 years and the now Macquarie Group ((MQG)) was yesterday able to tighten its FY14 profit guidance to an approximate 40-45% increase over FY13 and drilling down (sorry) into the numbers shows a big boost in energy trading profits as a primary driver.

I’m not actually taking the credit.

Macquarie’s fiscal year ends this month, so analysts are prepared to take yesterday’s update as almost a profit pre-release. Management included the usual caveats but has a history of being broad and conservative on guidance rather than specific and ambitious. Adding 40-45% to the FY13 result gives us a range of $1190-1235m and market consensus had been sitting at the low end of the range. Hence the update is not a shock but rather confirmation of broker expectations with some added upside. Brokers have mostly upgraded their forecasts slightly.

The only definitive factor provided as the reason for a more positive result was a change in guidance for Macquarie’s Fixed Income, Currencies & Commodities division. Previously management had expected FICC’s result to be “down on FY13, with the potential to be broadly in line with FY13,” but yesterday that was upgraded to “broadly in line with or slightly up on FY13”. Global investment banking peers have mostly delivered subdued FICC guidance of late, which means Macquarie has outperformed. Brokers agree outperformance is due to Macquarie’s 75/25% skew in commodities/fixed income as opposed to a typical industry balance closer to 50/50.

While commodities include metals and agriculture as well as energy, all brokers cite 2014 volatility in US energy markets as offering the hedging and trading opportunities that provide the difference. The severe winter in North America has, for example, seen the domestic natural gas price shoot from below US$4/mmbtu to above US$6/mmbtu and back again within weeks. The good news is such price volatility provides a greater potential for profit from proprietary trading activities. The bad news is not every winter is as likely to be as severe as this one.

In other words, analysts are not prepared to reset forecasts for FY15-16 and beyond to include a repeat performance. Morgan Stanley, for example, suggests that while the improvement in FICC profits is consistent with an improving cycle, “we’re reluctant to capitalise this pick-up given volatility in FICC revenues”. UBS suggests that “given the volatile trading nature of these businesses it is risky to extrapolate this good performance to future periods”.

But that is not to suggest Macquarie’s FY14 result is destined to be a flash in the pan. US gas volatility might have been a gift but the underlying trend for the investment bank has been improving over the past twelve months, as it has for all investment banks. As the ghosts of the GFC fade, global growth improves and markets re-rate, investment banks can only be a beneficiary. Indeed, the MQG share price has run from under $35 a year ago to over $55 today.

The market pushed MQG shares up 3% yesterday to adjust to this tighter, slightly more positive guidance update, but has the market already priced in any further upside from improving conditions?

Brokers agree that while the update has provided comfort around what they had been expecting anyway, Macquarie is really an FY15 story. Cyclical improvement in metals, energy and agriculture provide potential upside and these are key areas of expertise, as UBS notes, but can clearly be volatile profit sources. JP Morgan suggests attention now turns to the extent to which performance fees from Macquarie Infrastructure & Real Estate unlisted funds, increased deal activity and strong growth in domestic mortgages can potentially provide positive earnings revisions and a further re-rating to the MQG share price.

“We still think that future share price outperformance will be driven by earnings, not trading multiple expansion,” says Morgan Stanley in agreement.

UBS acknowledges an improving investment bank cycle but notes MQG is trading on a 1.5x multiple to book value and a 16.4x price/earnings at around 10% return on equity (ROE). “In our view,” says UBS, “further earnings upgrades and mid-teen ROEs are required to justify further price appreciation”. Goldman Sachs suggests the current multiple implies Macquarie can sustainably deliver an ROE of 13.4%. Given the first half of FY14 provided 8%, a good deal of improvement is already accounted for.

Four FNArena database brokers thus have MQG on a Hold or equivalent rating, as do Morgan Stanley and Goldman Sachs. Given Macquarie’s history of publishing final results that vary from earlier guidance, Credit Suisse sees upside risk to the final FY14 result despite books close being Monday. CS thus retains Outperform, joining BA-Merrill Lynch (Buy).

Merrills suggests that while MQG is trading near the top of its 10-year trading band in forward PE terms, this is justified given the group’s strong earnings growth prospects and greater mix of annuity-style earnings than in the past. And given that many cyclical divisions, such as Securities (eq equities broking) and Capital (M&A) are arguably still near trough levels, further improvements in these divisions can provide catalysts for further upgrades.

The FNArena database shows a consensus target price of $56.34 suggesting a mere 0.4% upside, but on a range from $50.46 (JP Morgan) to $62.15 (Merrills). In yield terms, MQG is offering, on forward consensus, 4.7% in FY14 and 5.6% in FY15 of which less than half is franked given the extent of offshore businesses.

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