Millionaires Factory flicks the on-switch

Despite its full-year result being weaker than last year, Macquarie Group's second half showed strength, with an increase in employment expenses an indicator the sleeping giant is waking.

Could the Millionaires Factory be starting to get back into business?

There is an interesting line in today’s Macquarie Group earnings presentation that might suggest that it is just starting to operate again, albeit not at its pre-crisis levels.

As the group’s earnings developed momentum through the year, with a 36 per cent rise in March-half earnings relative to the September half, so did its employment expenses, which grew from $1.54 billion in the first half to $1.74 billion.

While that’s a lower proportion of Macquarie’s net income (47.8 per cent compared to 50 per cent in the September half), after years of cost-cutting and headcount reductions as Macquarie adjusted painfully to the impact of subdued capital markets on its market-facing businesses – which between them saw more than a billion dollars a year of earnings evaporate – it is a perversely positive signal that the group’s fortunes are improving, albeit off a low base.

The fact that Nicholas Moore’s compensation increased nearly 13 per cent, to $8.8 million, might provide an even stronger signal.

The sharemarket’s response to the result – an immediate spike of more than 10 per cent in Macquarie’s share price – suggests the market, too, is convinced that the group is now on an improving trend. The increase in dividend, from the $1.40 paid last year to $2 a share, 40 per cent franked, may also have contributed to the market’s enthusiasm.

The underlying improvement in both external conditions and in its internal condition is reflected in Macquarie’s top line.

Over the full year, Macquarie generated $263 million less income than it did in 2011-12. In the second half, however, it lifted its income by more than $600 million relative to the September half. As global market activity, while still subdued, began to improve the impact on Macquarie was immediate and marked.

Investment bank compensation is driven by returns on capital. Macquarie’s remains modest, with a return on equity of 7.8 per cent for the year compared with 6.8 per cent in 2011-12. In the second half, however, it was 8.9 per cent and Nicholas Moore has foreshadowed further improvement, provided markets don’t again deteriorate.

While still well short of the kinds of returns investment banking groups target, and well short of what even the new Macquarie (with a much smaller exposure to traditional investment banking than it once had) might aspire to, there does appear to be strong momentum within the group.

The repositioning of Macquarie over recent years and an extremely aggressive attack on its cost base has provided the foundations for the lift in profitability.

Over the past two years Macquarie has slashed about $1 billion, or 17 per cent, from its operating costs. The most savage reductions have occurred within its two market-facing businesses, Macquarie Securities and Macquarie Capital, where costs were reduced by 26 per cent and 18 per cent respectively in the past year.

While Macquarie Securities lost $50 million in the year (a big improvement on the $194 million it lost the previous year) it actually made a profit of $14 million in the second half. Macquarie Capital’s profit rose 76 per cent to $150 million for the year. The fixed income, currencies and commodities division, which has been more stable, produced a 4 per cent profit increase.

Relative to what they used to contribute and could still contribute in a more active environment, the two most troubled businesses are still under-performing but they are now far more leveraged to an improvement in markets-related activity and aren’t anywhere near as significant a drag on the rest of the group as they were even a year ago.

While there was a four per cent drop in Macquarie’s full-year operating income, the re-setting of the group’s cost base and the staunching of the bleeding within the markets-facing operations created the ability to produce the 17 per cent increase in full-year earnings.

Moore has presided over a major re-orientation of the group away from those volatile businesses towards annuity-style operations.

Macquarie Funds in particular has been grown aggressively and now has assets under management of $343.5 billion. Its earnings were up 17 per cent to $755 million. Banking and financial services generated a 22 per cent increase in earnings. Corporate and asset finance’s contribution was down one per cent to $694 million.

Within the detail of the result was an indication that Macquarie’s fledgling expansion into the major banks’ stronghold is starting to develop some momentum of its own. Within its loan portfolio Australian mortgages grew from $3 billion a year ago to $6.8 billion.

Macquarie has begun using the relatively cheap deposits it generates from its wealth management platforms to have a serious crack at the home loan market, both directly and through third-party channels, including the relationship it has built with Mark Bouris’ Yellow Brick Road.

With the majors’ pricing dictated by an average cost of funding that includes expensive wholesale money raised four or five years ago, Macquarie can under-cut them and still make handsome profits and very attractive returns on capital.

The majors are known, despite the current small presence Macquarie has at this point in the mortgage market, to be worried about its potential to eventually dictate their home loan pricing because of its funding cost advantage. They have seen in the past how quickly an independent force can emerge and have real influence in that market.

It is a measure of Moore’s cautious optimism that (with the usual caveats about market conditions) he expects another improvement this year despite signalling relative flat performances from his annuity-style businesses, which he says are expected to produce earnings broadly in line with their 2012-13 contributions.

It is the market-facing businesses – Macquarie Securities, Macquarie Capital and the fixed income, currencies and commodities unit – from which the bulk of the improvement is expected to come.

There will be a lot of investment bankers, and not just Macquarie’s, who will be hoping that he is right and that the re-booting of the Millionaires Factory continues.

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