Macquarie Group is trading at less than a third of its peak and, to make matters worse, Citigroup has issued a sell recommendation. Morningstar has, by contrast. issued a buy, but we will come to that later. At first glance the fundamentals look OK. The forward dividend (unfranked) is 6%, the forward earnings multiple is 10.3 times and earings per share growth is forecast to be between 15% and 20% for the next couple of years. But sentiment is ugly. The “Macquarie model”: clipping the ticket as often as possible, using endless debt games and arbitraging between the equity and debt markets with dizzyingly complex accounting games came to a screaming halt when the GFC hit. In many ways, the fact that the group survived at all suggests that it was cleverer, or not as bad, as other investment banks.
Citi is pretty scathing about the company’s future:
We downgrade earnings, recommendation and TP — as deal pipeline, M&A shares, and markets all weaken. The A$ remains unsupportive of the 60% of earnings ex- Australia. We reduce cash EPS for FY12E by 10% and FY13E and FY14E by 6%. TP reduced 17% to A$30.50, following earnings downgrades and reduction in our assessment of Macquarie’s PE premium to peer group from 15% to 10%. Recommendation changed to Sell/High Risk.
- M&A pipeline slows — To the end of May announced M&A at the global level is up 29% YTD on CY10. Macquarie’s share is down from 2.2% to 0.8%, and its absolute pipeline levels are down 56% on CY10. League table positions in Australia and Asia are falling. While admittedly volatile, M&A deals announced in the first five months of this year are not supportive of our prior fee revenue expectations.
- Execution and revenue challenges in franchise expansion — means both head count and compensation will continue to grow before revenue follows. In North America the build out in equities and M&A advisory is now covering more industry sectors. In Asia, competitive pressures are squeezing league table positions.
- Concerns around compensation sustainability — While bonuses appear to be well up in FY11, lower revenue productivity versus peer group will prevent Macquarie from being fully competitive on compensation through the cycle. Equally the rising level of lock-ins and compensation deferrals could be contributing to some rising turnover of senior level staff, particularly in Asia. Bonus deferrals are now closer to the emerging European norms, than they are to its USA rivals, who remain its key competitors in most markets.
- Weak M&A, franchise build out costs and compensation pressures — is delivering an ROE below its cost of capital, and also below many of its much larger peers.
This may be overdone. The Macquarie model may be dead, but that is probably understood by the company better than anybody. They remain clever operators and they are still breathing. That is pretty much the point made in a Morningstar report:
MQG is Australia´s most successful investment bank. Strength lies in the diversity of the income stream with six individual operations contributing 10% or more to group earnings. International expansion adds another dimension to group earning capacity. The duplication of the successful Australian model offshore provides upside but only when favourable investment banking conditions exist.
Following a review of MQG we remove our Narrow economic moat rating. Following the collapse of its unique captive infrastructure related funds management business model we consider MQG has no real competitive advantages over global investment banking peers. Return on equity is unsatisfactory and we see no prospects of a near term return to historic levels.
Given the state of the equity markets and general subdued financial market conditions, we also reduce our FY12 earnings forecasts. Guidance for FY12 is for earnings to be higher than FY11, dependent on market conditions particularly for Macquarie Capital and Macquarie Securities.
During a recent visit MQG confirmed that despite signs of improvement across some businesses, overall conditions remain relatively subdued, particularly in the cash equities business. Equity market conditions are likely to remain subdued for some time and it is difficult to see any major improvement in earnings from this business. In this environment we also think it will be difficult for Macquarie Capital to achieve a major lift in earnings.
MQG is already near the end of 1Q12 and we don’t see any real evidence of more favourable market conditions. We reduce our FY12 EPS forecasts by 5% and our valuation falls from $44.74 to $43.68.
Despite the change in moat rating and downgrade to our forecasts, we retain our positive view. Earnings remain well diversified across the financial markets, geographic expansion is continuing and the group is well placed to benefit from a recovery when market conditions improve. At current prices the stock is trading well below our fair value.
Recommendation Impact (Last Updated: 07 Jun 2011)
We retain our Buy recommendation.
If the stock gets any less popular it may actually be something it has never been before — a comparatively safe investment.