What a difference a year makes (or fifteen months at any rate). When we upgraded Macquarie Group on 10 Feb 16 (Buy – $59.72) and added it to our Growth and Equity Income portfolios, it was firmly on the nose. Indeed markets were on the nose.
China’s economy was slowing, commodity prices were tumbling and interest rates were turning negative. That very day the All Ordinaries closed at its lowest for two and a half years.
As an investment bank, Macquarie Group was caught in the thick of it. At its annual operational briefing, management downgraded its forecast for earnings in its Commodities and Financial Markets business to ‘down on FY15’. With strong performance fees set to disappear in the 2017 financial year, brokers were proclaiming that we were at ‘the top of the upgrade cycle’ and that 2017 would see (horror) flat earnings (indeed that was the guidance eventually delivered with Macquarie’s full-year result in May 2016).
2017 result 7% above guidance
Due to tax and hard to repeat factors
2018 to be 'broadly in line'
Add to this the indeterminate fear of what a major market meltdown might do to the stock, and it was being priced at just ten times 2016 earnings.
As it turned out, the group delivered growth of 7% in 2017, but guidance is again for net profit to be ‘broadly in line’ for 2018. There are even reasons to suppose that management might have got its guidance right this time (or wrong, depending how you look at it).
Even so, that 7% growth – combined with a recovery in sentiment that has seen the All Ords bounce 22% – has been enough to send Macquarie shares up 56%.
Did we forsee any of this? No – not a bit of it. But we could see that Macquarie shares were being priced for a deeply pessimistic outcome. Today, however, the converse might be true.
Brokers and the financial media are telling us that Macquarie is capable of delivering ‘growth through the cycle’, and that it is a fund manager and should be rated as such. Investors have taken this to heart, and the stock is now priced at a price-earnings ratio of 15 – well ahead of global investment banks such as JP Morgan, Goldman Sachs and Citigroup (all on forward PERs of 12), slightly ahead of Aussie banks (with the exception of CBA), and only a little behind the likes of Platinum Asset Management (with a pro forma PER of 17).
MAM's the word
The trouble is that Macquarie is only one-third a fund manager and not a particularly attractive one at that. In 2017, Macquarie Asset Management contributed a third of group net profit – and it did so from assets under management (AUM) that are 40% fixed income and 30% infrastructure.
These asset classes don’t tend to show much growth in themselves, which makes Macquarie more reliant on inflows.
They also provide relatively low overall returns, which makes it tougher to scrape out a fee. In the year to March, MAM earned base fees of 0.3% of assets under management (AUM). That compares to around 0.7% for Perpetual and Magellan Financial Group and 1.2% (pro forma) for Platinum Asset Management.
|Year to March||2017||2016|| /(–)
|Net op. income ($m)||10,364||10,158||2|
|Op. expenses ($m)||7,260||7,143||2|
|Net profit ($m)||2,217||2,063||7|
|Diluted EPS ($)||6.45||6.00||8|
|*Final dividend of $2.80 per share (up 47%),
45% franked, ex date 16 May
Macquarie supplements these fees with an (arguably) higher contribution from performance fees and by making investments in its own funds – but this makes the returns more volatile and the latter requires capital.
In both 2016 and 2017 MAM made an additional margin of 0.2% of its AUM from performance fees and investment gains – but that obscures a shift of about 0.11% from performance fees (which were unusually high in 2016) to investment gains (which were unusually high in 2017). In a subdued market environment where it missed out on both performance fees and investment gains, MAM’s profits could fall by about a third (and that’s before we consider the potential impact of market falls on fund flows and AUM).
Don’t get us wrong: Macquarie is good at what it does. But what it does is not as attractive as a ‘pure’ equity fund manager and it doesn’t deserve the same kind of rating. And in any case, MAM only accounts for about a third of profits.
Lending a hand
Another quarter of profits comes from Corporate and Asset Finance, which lends money to clients to buy specialist equipment (eg aircraft, cars, mining equipment) and/or buys the equipment itself and then leases it to the client. It also buys up distressed debt in the secondary market in the hope of making a profit.
In the past five years, this division has almost doubled its asset base to $36.5bn, while its net profit contribution has risen 72% to $1.2bn. The asset base actually fell $2.9bn in the 2017 year, however, due to net repayments and realisations in the lending portfolio and the sale of nine aircraft.
This meant a 16% fall in net interest and trading income, but the net profit contribution still rose 6% thanks to a full contribution to rental income from the AWAS acquisition, a 34% fall in impairments and a gain on the sale of an interest in a US toll road – all of which will be hard to repeat.
When things are going well, this is a great business to be in. Falling interest rates keep bad debts down and drive up asset prices, but the reverse will happen in tougher conditions and we’re wary of extrapolating the recent strong performance.
The last of the ‘annuity-style’ businesses – Banking and Financial Services – was also doing little to justify its ‘annuity’ tag in 2017, with a messy result including a number of one-offs. On an underlying basis, though, profits grew about 32% thanks to a combination of lending growth and higher margins. We’re hopeful that this division can continue this strong run. Unfortunately it’s unlikely to make a lot of difference since it contributes only 10% of profit.
The two ‘capital markets facing businesses’ – Commodities and Global Markets (CGM – formerly split between Macquarie Securities and Commodities and Financial Markets) and Macquarie Capital (MC) have also not been living up to their ‘market-facing’ tag, with relatively stable profits over the past three years (a range of $844m–971m for the former and $430m–483m for the latter).
The gentle trend has been upwards, though, and in 2017 both divisions produced their best results since 2010 (for CGM) and 2008 (for MC). Impairments were down in both divisions, as were operating expenses, while in CGM income from credit, interest rate and foreign exchange markets leapt 50% thanks to market volatility triggered by Brexit and Trump’s election as US president.
So can these businesses make more? No doubt about it – and we’d even say they probably will in 2018. But they could also earn a lot less. As chief executive Nicholas Moore put it in the results presentation: ‘Their results will be very impacted by the markets they experience. Obviously, they're benign markets at the moment; they're good markets at the moment; and, at the moment, we're assuming that those markets will continue.’
Given these benign conditions, we’re reluctant to capitalise too much of their current earnings (let alone factor in much growth) by paying a high multiple for these businesses. Somewhere in the low teens would probably be fair.
Two other factors supporting the 2017 result are also worth a mention. The first is the bank’s super-strong capital position, with a tier one capital ratio of 11.1% and surplus capital of $5.5bn (on APRA’s methodology). There are question marks over how much of this capital is truly surplus to requirements, since in the past management has chosen to raise capital for acquisitions rather than use it up. Nevertheless, it’s there and it gives the company greater flexibility for when raising capital might be hard – which is often the best time to be making acquisitions.
The other factor was the lower than expected tax rate, which management had said was expected to be ‘broadly in line’ with last year’s 31%, but in fact came in at 28% due largely to a higher contribution from lower tax countries. That alone accounted for additional net profit of almost $100m and nearly half the 7% profit growth.
|Shares (diluted) (m)||356|
|Value per share ($)||84|
In the presentation, management said the business mix, and therefore the tax rate, was expected to continue at the new level (as a base assumption), but there must be a risk of it moving higher again. Added to this is the new bank levy, which we expect to add 3–4 percentage points to the overall tax rate.
Sum of the parts
Putting it all together, we don’t see much that’s different about Macquarie today than when we upgraded it 15 months ago. The only things that have really changed are the immediate macroeconomic outlook, which we attempt to ‘smooth’ in any case, and sentiment. So while the share price has risen 56%, we see little reason to increase our price guide.
As a cross-check, you can see a rough sum-of-the-parts valuation in Table 2. This comes in at about $84 a share, but that's on a fully diluted basis, is probably on the conservative side and there’s scope for positive surprises not least on account of the capital position.
We’d be happy to hold Macquarie for ‘growth through the cycle’, but there’s also a price at which we’d sell and move on. That price is getting closer, but for the time being we recommend you HOLD.
Note: The Intelligent Investor Growth and Equity Income portfolios own shares in Macquarie Group. You can find out about investing directly in Intelligent Investor and InvestSMART portfolios by clicking here.