Earnings Mix Shifts For Macquarie Group

By Eva Brocklehurst | More Articles by Eva Brocklehurst

Macquarie Group ((MQG)) surprised the market with a strong cash profit for FY17 of $2.22bn, and a second half dividend of $2.80 also beat many expectations. The diversified financial business made record gains on sale revenues and the lowest impairment expense since 2012. This is also the third consecutive year of a falling tax rate. Macquarie Group is divesting assets and investments in prevailing conditions and reducing staff and its business footprint. FY18 guidance is for a flat outcome and a tax rate similar to FY17.

Morgans believes, given a significant drop in performance fees during the year, that 7% net profit growth was a solid effort. Divisional net profit improved in all businesses except asset management. While the result was broadly positive, the broker still believes it could be construed as compositionally weak.

While asset realisations are part of the business, aspects like the life business sale and significantly lower impairments are not sustainable items, in the broker’s opinion. Moreover, some underlying business drivers have stagnated such as funds under management in the asset management division. Morgans likes the story for the longer term, given the strong position in niche business areas and a proven management team, but believes the stock is trading close to fair value.

Citi is more bearish, noting the largest divisions all showed signs of peaking 12 months ago and, in the largest division – asset management – fees have stalled. The broker suspects a transformational acquisition will be required to kick start the next phase of growth, and finding value will be a challenge at the bottom of the interest-rate cycle. In the absence of such acquisitions, or outsized gains, the broker suspects a decline in earnings and the share price is likely.

Credit Suisse found the results quite solid, noting the dividend particularly beat estimates. The broker agrees the second half was somewhat soft, with earnings supported by costs and tax that more than offset a modest pull-back in net revenue. The broker notes the key risks looking forward are a downturn in capital markets activity and the emergence of a risk-off market environment.

Deutsche Bank suspects the bar has been set relatively high for FY18. Volatile income items contributed 15% of total operating income in FY17, well up on prior years. The underlying result appears subdued as these “other operating income” and charges have driven all the growth, the broker asserts. Deutsche Bank also believes, with the share price having anticipated a strong result, that the valuation is full.

Capital Surplus

While the group’s stated capital surplus rose to $5.5bn, the broker believes the true capital surplus is much lower than this. The business appears in a strong position for accretive acquisitions should they materialise. Failing that, once APRA’s capital requirements are finalised, Deutsche Bank suspects Macquarie Group may be in a position to conduct capital management.

Operating momentum has probably slowed, although the FY18 outlook may be underpinned by material gains on a weaker Australian dollar, a lower US tax rate and an ongoing decline in the compensation ratio, in Morgan Stanley’s belief. These factors are expected to support the share price ahead of the July trading update.

The broker believes it will be challenging to repeat the FY17 revenue outcome but upgrades FY18 estimates just the same, to reflect favourable market conditions and the life-cycle of investments. Morgan Stanley also notes the increase in Macquarie Group’s excess capital above minimum regulatory capital requirements and estimates a real surplus of $1-2bn, leaving the company well-placed to make investments and pursue growth opportunities.

Asset realisations were a key support for the earnings in FY17 and Ord Minnett expects several periods of Macquarie Group running high levels of asset realisations gains. The broker believes it makes sense at this point to realise these gains in the portfolio. This suggests the quality of earnings may appear to deteriorate but, in essence, this is part of the cycle. This may mean that the earnings outlook becomes more dependent on transactions, rather than via growth in annuity-style earnings which has been the custom in recent years.

Cost Reductions

The most pleasing aspect of the result for UBS was delivery on cost reductions. In recent years the cost base had blown out, with the broker noting this was now the same as National Australia Bank’s ((NAB)) in dollar terms. With the business mix now skewed to asset management, lending and leasing, paying staff on an investment banking framework no longer appears appropriate to the broker. Hence, UBS lauds the delivery of operating leverage, as Macquarie Group has not drawn attention to efficiency gains as a source of growth.

The group’s cost to-income ratio fell to 68.5% in the second half, continuing the down-trend from 85% in FY12. UBS envisages significant operating leverage will be forthcoming, with every 5% reduction in the cost-to-income ratio providing 16% upside to earnings per share. While this may be the case, the stock is up 53% over the last 12 months and so the broker needs ongoing evidence of cost reductions to be able to justify further share price appreciation.

Hence, UBS downgrades to Neutral from Buy. The broker believes the revenue was boosted by substantial private equity-style gains on sales over the last year and this will be difficult to replace. Revenue growth is expected to, therefore, remain subdued.

Ord Minnett also notes the operating leverage in the business, and carrying through this run rate leads to a lift in its FY18 estimates by around 10%. Going forward, the maturing of several listed funds will mean base fees stall and there are limited opportunities for performance fees. In turn, this will provide an opportunity for ongoing high levels of asset realisation gains and transaction fees to support guidance being broadly in line, the broker adds.

FNArena’s database shows six Hold ratings and one Sell (Citi). The consensus target is $88.63, suggesting -8.0% downside to the last share price. This compares with $82.82 ahead of the report. Targets range from $72 (Citi) to $100 (Credit Suisse). The dividend yield on FY18 and FY19 forecasts is 4.9% and 5.0% respectively.

Eva Brocklehurst

About Eva Brocklehurst

Eva Brocklehurst started her journalistic career in 1993 as a financial reporter with RWE Australian Business News covering money markets and economic reports. She moved to Australian Associated Press (AAP) in 1998 as a senior financial journalist to cover money markets, economic analysis, Reserve Bank and Treasury. Eva became deputy finance editor at AAP in 2003. Started working online as a reporter on ASX-listed companies for RWE Australian Business News in 2005. Eva joined FNArena in 2012 and has been covering stockbroker analysis of ASX-listed companies since, as well as writing general news stories.

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