There are more complex businesses on the ASX than Macquarie Group, but there aren’t many with more moving parts.
To start with the company is split into six divisions. Each services a different aspect of the financial markets, employing a different mix of human and financial capital, and each is therefore exposed to its own blend of inscrutable factors – currencies, commodities, interest rates, insolvencies, regulation and sentiment, to name just a few.
Management actually does a decent job at laying it all out in the various documents that accompany its final results. It’s just that there’s so much to take in that – rather like one of those Heath Robinson cartoons – by the time you get to the end, you’ve forgotten what went on at the beginning.
EPS up 24% driven by performance fees
Asset finance profit set to rise
EPS to slip in 2017
The section on the outlook, which stretches to five densely packed pages, helpfully explains some of the factors likely to affect each division over the next year, but then skewers it all with the necessary disclaimers that it’s subject to market conditions.
For once, we allow ourselves a sympathetic shrug for the brokers’ analysts that must come up with earnings forecasts for the current financial year – and even, almost laughably, for the year after that. This point is emphasised by the wide range of forecasts for 2018, with the top being a third higher than the bottom. We’d say ‘poor things’ but that wouldn’t be strictly accurate.
And that’s just the short term. If we look out to five years’ time, no-one can really say what Macquarie will even look like, let alone predict its earnings.
All of this might be enough for us to throw up our hands in despair – except we know that when others are inclined to do this is often when opportunities appear. So we examine the company cautiously, and we use three broad principles to guide us.
The first is to recognise that the one thing about Macquarie that stays the same – as the various businesses revolve around it – is the culture. Chief executive Nicholas Moore put it well in the conference call for the company’s recent final results:
‘The group evolves. And it evolves not from a top-down viewpoint, but … by people who are very close to the markets and close to the opportunities. And that evolution continues ... We don't make judgments in terms of where the world will go. We just make sure that we've got some very good teams on the ground who will be able to respond. And they are judged constantly in terms of their performance. Now that culture has remained intact, and that's the key driver, we think, in terms of where we're going.’
This culture – of employing smart people, empowering them to run their businesses and rewarding them for running them well – has stood the test of time. At the right price we’re willing to back it, but more on that in a moment.
Our second principle is to focus our efforts. The full-year result was roughly in line with the guidance and expectations that we outlined in Counting dollars at Macquarie on 10 Feb 16 (Buy – $59.72). Almost two-thirds of group profit in 2016, however, came from just two divisions – Macquarie Asset Management (MAM) and Corporate and Asset Finance (CAF). So it’s worth focusing your attention on these.
|Year to March||2016||2015|| /(–)
|Banking & FS||350||285||23|
|Commod & FM||576||835||(31)|
|Tax and other||(952)||(918)||(4)|
|Diluted EPS ($)||6.00||4.84||24|
|Final dividend||$2.40, 40% franked, ex date 17 March|
The profit contribution from MAM will ebb and flow with performance fees, which have been flowing thick and fast recently at almost $700m a year, or a quarter of MAM’s revenue. This year, however, will almost certainly see them ebb, to perhaps a third of that level: roughly where they stood in 2013 and 2014.
Increased base fees may take up some of the slack, but profits from this division are still likely to fall sharply this year, perhaps by as much as a quarter given the operational gearing in the business, due to its relatively high level of fixed costs. We’d see this as a more likely base level from which to grow in future, rather than the standout performance in 2016.
Corporate and Asset Finance (CAF), however, should continue its growth in 2017, helped by the full inclusion of the AWAS aircraft finance and Esanda dealer finance businesses and, more particularly, the absence of their integration costs. The division’s portfolio increased 37% in 2016, to almost $40bn, but its profit contribution only rose 2%, pegged back by a 23% increase in expenses (due in large part to those integration costs). If we assume that CAF’s profit makes the full step up in 2017, then it could reach around $1.5bn, making it the group’s new number one profit contributor.
Margin of safety
With its two biggest businesses largely offsetting each other, Macquarie’s group net profit looks like staying broadly flat in 2017 – all things being equal – and that, indeed, is the official guidance. Given management’s track record this is likely a conservative figure, but we’re not going to take issue with that. Earnings per share will probably fall slightly due to the increased number of shares on issue, from $6.00 to perhaps $5.80 on a fully diluted basis.
Beyond 2017, we’d expect to see gentle growth. Combining a return on equity of 15% (consistent with an average return on equity of 15–20% over the past ten years) with retained earnings of 30% a year (consistent with the target payout ratio of 60–80%) would give earnings growth of about 5% a year. That seems like a reasonable target to aim for, but note that it's only the central expectation in a wide potential range.
Alongside long-term growth of 5% the current 2017 price-earnings multiple of 13 doesn’t look expensive. However, the third principle that guides us with Macquarie is to require a fat margin of safety, and we’d rather see the PER closer to 10 before upgrading. As a cross-check, our $60 Buy price amounts to about 1.3 times tangible book value, which looks cheap for a company generating a return on equity that's well into double digits.
With many stocks, hoping for too much margin of safety will mean missing out, but history shows that Macquarie offers up excellent opportunities from time to time if you're patient. We were briefly able to upgrade when the stock fell below $60 recently (see Counting dollars at Macquarie on 10 Feb 16 (Buy – $59.72)). We also bought back the stake in our Growth Portfolio at $60.28 after selling at $80.39 a year ago, and bought a new holding in our Equity Income Portfolio. We’re hopeful of further opportunities down the track. In the meantime, 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.