Australia | Oct 30 2017
This story features MACQUARIE GROUP LIMITED.
For more info SHARE ANALYSIS: MQG
The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS
Low quality items helped Macquarie Group beat forecasts in the first half but brokers suggest favourable winds continue to blow.
-Performance fees likely to remain elevated for the next few years following maturing of listed funds
-Downside risk seen mitigated by the buyback now in place
-Buyback highlights strength in capital and greater comfort around changing regulation
By Eva Brocklehurst
Macquarie Group ((MQG)) exceeded expectations with its first half result, a function of elevated performance fees and operating leverage. The beat of forecasts was largely driven by low-quality items, such as a lower tax rate and strong performance fees, rather than operating trends, but is enough to ensure brokers lift estimates for FY18.
While arguably the result could be considered low-quality, Ord Minnett believes it simply reflects the current economic and market cycle. Performance fees are expected to remain elevated following the maturing of listed funds. Ord Minnett expects the earnings outlook will become increasingly dependent on transactions, whereby Macquarie will continue to release embedded gains until such time as it can acquire new "cheaper" inventory.
The broker also highlights that, outside of the one-off items, underlying growth drivers are mixed with low or weak growth in assets under management in the corporate and asset finance books. Macquarie's infrastructure and real assets (MIRA) division continues to grow solidly and remains the most attractive business, in the broker's opinion.
Morgan Stanley believes guidance is conservative and lifts forecast by around 5% for FY18 and 4% for FY19. The broker does not consider the elevated level of performance fees in the first half as sustainable but does believe the medium-term outlook has improved, given the number of funds that are entering the realisation stage and the increase in infrastructure asset values. As a result, Morgan Stanley acknowledges these will remain above the long-run average in the next few years.
The broker forecasts MIRA performance fees of around $711m in FY18 and around $502m in FY19. Morgan Stanley also expects a period of low loan losses and write-downs, because of the ongoing improvement in the global economy. At the same time continue growth in equity investments should underpin a pipeline of gains on sale.
Citi notes Macquarie Group is taking advantage of its successful investments made several years ago and the rise in asset prices subsequently. Large performance fees and asset realisations have been lumpy from year to year but are a constant and rising contributor to recent results. The broker expects more realisations to emerge in the next half, with three key principal investments poised to cumulatively generate more than $1bn in revenue in following halves.
The broker commends Macquarie Group's skill in harvesting and realising assets and acknowledges this now offsets the challenges in the operating backdrop, but still considers the stock fully valued and the balance of risks weighted to the downside.
Performance Fees
Performance fees of $537m were near the peak reached in the first half of FY16 and were mainly due to asset realisations, fees from Macquarie Atlas Roads ((MQG)) and various other funds. Tax rates at 26% compared with 28% achieved in FY17 and were on the back of a change in geographic mix.
Deutsche Bank does not expect this level of performance fees to recur while, as other brokers also attest, the tax rate is a lower quality driver. These two features more than offset some of the weakness in other revenue streams.
That said, Deutsche Bank notes performance fees can be very lumpy and the first half outcome was unusually strong. Excluding performance fees, revenue was weak and down across most lines. Still, the broker points to the company's track record of pulling enough levers to exceed guidance and market expectations in the past, as well as the share buyback.
UBS suggests investors may be asking whether large performance fees should be considered as one-offs. Performance fees are likely to be lower in the second half yet, during FY19 and FY20, the group should begin to earn substantial performance fees as listed funds approach maturity and assets are sold. The sale of Brussels Airport is likely to crystallise performance fees for MEIF1 & MEIF3 while, in the US, MIP2 is also expected to generate fees.
Beyond this point, Macquarie Group is expected to experience more regular asset realisations. UBS believes the business can grow revenue over the next two years but will be heavily reliant on performance fees, unless markets and conditions are very buoyant.
Revenue, UBS suspects, was boosted by substantial private equity gains on sales over the last year and this is likely to be difficult to replace. The broker is also pleased with the reduction in the cost to income ratio to 68.4%, having oscillated between 70-85% for the last 20 years.
Going forward, while market valuations hold up, Morgans believes the pipeline for performance fees is likely to remain robust. Even with funds MEIF2 and MIP1 raised in elevated pre-GFC markets and the company not budgeting on fees from these vehicles, it appears that hurdle rates are likely to be achieved in the current environment.
While Macquarie continues to deliver, Morgans believes the current cycle are somewhat favourable, if skewed towards real asset classes. The broker considers the stock fair value at current levels and maintains a Hold rating.
Credit Suisse upgrades to Outperform from Neutral. Notwithstanding the narrowly-based earnings result, profitability continues to improve and the broker observes the balance sheet is being replenished. The upgrade reflects a view that there is upside to earnings in the near term, notably in relation to principal investments within Macquarie Capital.
Downside earnings risk is somewhat mitigated, in the broker's view, by the buyback that is now in place and, earnings aside, profitability is also rising, with further support from for returns on equity should the buyback be executed.
Buyback
The major item of news was the announcement of a share buyback potentially worth up to $1bn. Morgans was surprised by the announcement of the buyback, having expected Macquarie would ratchet up its dividend pay-out ratio in FY18, similar to what occurred in FY17. The buyback highlights the capital strength and greater comfort around changing regulation, in the broker's opinion, but also emphasises a lack of appropriate acquisition targets.
UBS suggests the $1bn buyback created confusion, as it comes immediately following a period when the business increased equity investments to $7.6bn. The broker believes the first priority will be to deploy capital in attractive investments but given that a lack of franking credits limits dividends (from international income), a substantial amount of excess capital is generated.
UBS assumes around half the buyback will be undertaken in the second half. The buyback can be interpreted in two ways. It could be an indication Macquarie is finding it hard to obtain attractive investments. Alternatively, it may mean Macquarie is ensuring alternatives because of a higher level of capital generation.
FNArena's database shows two Buy, four Hold and one Sell (Citi). The consensus target is $96.39, suggesting -2.4% in downside to the last share price. This compares with $89.09 ahead of the half-year result. Targets range from $77.50 (Citi) to $105.00 (UBS, Credit Suisse). The dividend yield on FY18 and FY19 forecasts is 5.0% and 5.1% respectively.
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