Macquarie mending slowly

Macquarie Group’s annual meetings no longer feature a heavenly display of cream-filled desserts, but the company has delivered a 100% total return since it was upgraded to Strong Buy in Chaos amid the storm: The upgrades on 5 Aug 11 (Strong Buy – $22.97).

Back then the investment case was simple. The stock was trading at a 24% discount to net tangible assets and a 33% discount to book value, and you were being paid a 7% unfranked yield to wait for the gap to close.

The share price has increased 86% since then and it now represents a 16% premium to book value and a yield of 4.7%. But, on the evidence of Macquarie’s recent annual meeting and first-quarter trading results, it's still only operating on three of its six cylinders despite an improved economic outlook in the US.

Overall the results for the three months to 30 June (Macquarie has a 31 March year end) were ahead of the previous quarter and last year's first quarter, but let's run through each division’s performance, outlook and value.

Funds Management

Assets under management increased 10% to $379bn in the three months to 30 June, chiefly due to the lower Aussie dollar vis-à-vis the US dollar. Since the company’s listed satellite fund model crashed from orbit during the global financial crisis it has invested heavily in funds management, and it recently added another $24bn of funds by acquiring ING Investment Management Korea from ING.

Global financial institutions have been leaving South Korea due to increased competition and poor returns, but Macquarie’s decision to expand its funds management business has provided stable profits to support its dividend. Despite asset management fees being crunched around the world and low returns from the fixed income funds that form a large part of Macquarie’s portfolio, this business produced $800m of pre-tax earnings in 2013 and could easily be worth more than our estimate of $8.0bn-$10.4bn using a multiple of 10-13.

Corporate and Asset Finance

The asset and loan portfolio increased 8% to $24bn during the quarter, again chiefly due to favourable currency movements. Growth is coming from financing cars, equipment and mining equipment, which is somewhat surprising given the raft of downgrades across the mining services sector in Australia and another profit downgrade from Caterpillar in the US.

With car sales in Australia setting new records and the US motor vehicle industry improving, Macquarie is currently reaping the rewards from shrewdly increasing its exposure to motor vehicle financing as lenders fled the sector during the GFC due to bad loans and tight credit. Despite regulations forcing investment banks to hold more capital, Macquarie’s strong balance sheet should allow this division to grow relatively steadily over time. Using virtually the same multiples as for funds management, this division also gets a value of $8.0bn-$10.4bn.

Banking and financial services

Although Macquarie is Australia’s number one full service stockbroker, trading volumes, commissions and margins remain under intense pressure. Some brokers are reducing their stock coverage universe and finding new ways to earn income, such as publishing trading and stock newsletters. Share prices among listed brokers confirm the pain, with Wilson HTM managing director Andrew Coppin considering taking the securities part of the company private.

Still, the division’s $32bn of retail deposits provide a relatively sticky source of funding, and Wrap assets under management have increased 32% to $33bn during the quarter, chiefly due to managing the administration of clients of Perpetual Private. This relatively small division is potentially worth at least $2bn-$3bn.

Market-facing divisions

These three divisions boast recurring revenue and are potentially worth $18bn-$24bn or more. Given Macquarie’s current market value of $15bn, that implies Mr Market is valuing the market-facing divisions – Fixed income, commodities & currencies (FICC), Macquarie Securities and Macquarie Capital – at $1bn-$7bn after capitalising $1bn of corporate costs using a multiple of 10.

In 2013 this trio produced pre-tax earnings of $750m, with FICC making $600m alone. That suggests the other two divisions, which produced a colossal $3.4bn profit in 2008, are potentially being valued at less than nothing. Unfortunately the 2008 performance is highly unlikely ever to be repeated, but if corporate activity improves from today’s depressed levels then they could be worth much more than the value Mr Market is currently attributing to them.

Currently on tour in Australia, Goldman Sachs chief executive Lloyd Blankfein recently said that despite signs of life in the global economy, companies were still averse to risk because mistakes were drawing the ire of an unforgiving public.

‘In the US right now, we've come off a very big trauma and so the political environment is very negative. The consequences of making a mistake are very, very high. If you look at the amount of activism that goes on, the lack of forgiveness, and I think that it gets reflected in a lot of the negative attentions that all institutions get. People are very loathe to come to decisions because they worry about it.’

Reasons to hang on

Despite sitting on record levels of cash, building confidence in the corporate sector will clearly take time. Though Macquarie Group is no longer dirt-cheap as investors have regained their senses since the panic in late 2011, there are reasons to hang on.

First, Macquarie provides international diversification as 63% of income is earned overseas. Second, regulation is restricting growth but it will favour larger institutions over smaller ones (the annual shareholder letter from US listed bank M&T explains why). Third, the company’s balance sheet is in good shape and it has turned a profit every year since it was founded in 1969. Macquarie Group is a lower return business than it used to be, but it is also less leveraged.

If Macquarie has become a large part of your portfolio you might consider taking some chips off the table, which would give you the opportunity to buy more if China’s economy stumbles, for example. But we’re comfortable with the 5% position in the model Growth Portfolio and, with the share price down slightly since 3 May 13 (Hold – $43.17), we’re sticking with HOLD.

Note: The model Growth Portfolio owns shares in Macquarie Group.