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Macquarie – how the mighty have changed

Australia’s home-grown investment bank, Macquarie Group, has had an interesting life on the stock market.

Joining the ASX in 1996 at $6, the shares rocketed to nearly $100 in 2007. But the bank was hit hard by the GFC, and sank as low as $17 by February 2009. Macquarie has since recovered to trade just below $45.

The history

In those far-off pre-GFC days, the flagship investment banking and securities trading division did the big corporate deals, cementing Macquarie as the dominant player in the local mergers and acquisitions (M&A) space.

Meanwhile, the “Macquarie Model” came to drive earnings: the bank would buy an asset, gear it up, revalue it, sell it into a listed satellite infrastructure fund and sit back to enjoy the returning flow of cash in the form of management, performance and transaction fees. The “Macquarie Model” was so successful, many investors began to wonder why they should invest in the funds when they could invest in the headstock, which was where the flow of cash seemed to end.

That all changed during the credit crisis, when the market suddenly developed a dislike for complex and opaque structures, marking down the satellites. Instead of supplying cash to the parent, all of a sudden they became a cash drain on the parent.

Post-GFC, Macquarie has changed its business model. The highly profitable satellite-fund business has gone: the funds were either restructured or brought back within the fold. While that revenue has not been replaced, the group has been busy buying asset-management businesses around the world, looking for more predictable income.

As recently as two years ago, Macquarie was not considered to have anything in the way of a recurring revenue stream, but it does now. The non-market facing divisions now contribute 73% of pre-tax earnings and much of it is recurring income.

Meanwhile, the businesses exposed to market fluctuations have been cut back in staff and capital to pay their way.

The present

Group profit slipped to an eight-year low in FY12, but Macquarie is now virtually unrecognisable from the pre-GFC days.

Analysts say the business now has to be assessed on the basis of the so-called “market-facing” businesses – Macquarie Securities, the Fixed Income, Currencies & Commodities (FICC) division and Macquarie Capital – and the non-market facing divisions, which are Corporate & Asset Finance (CAF), the lending and asset-finance business, Macquarie Funds (the funds management business) and the banking and financial services (BFS) business.

Macquarie’s re-orientation of its business model can be seen most starkly in the recent performance of the Macquarie Funds business. This division has increased its assets under management from $100 billion in 2005 to $334 billion.

The change in Macquarie’s business means it needs to be considered in a different light.

A very interesting – and bullish – report on Macquarie from its fellow investment bank Deutsche Bank came out last week. Deutsche has noted and is impressed by the new Macquarie, saying that the flow of annuity-style income from these businesses is the key to the group’s profitability.

With the share price at  just below $45, Deutsche argued that this was the value that could be attributed to Macquarie’s non-market-facing business units – Macquarie Funds, Corporate & Asset Finance and Banking & Financial Services. It said these businesses generate pre-performance fee income worth up to $7.4 billion a year.

The bonus business

The corollary to that belief was that the market-facing businesses – the investment banking divisions of Macquarie Capital, Macquarie Securities and the FICC business – were being valued at nothing. Investors buying the stock at the current price were getting those businesses thrown in for free.

It is not often on the share market – when it is functioning normally – that parts of a company’s business are handed to investors for free. It was common at the worst of the GFC, circa the first quarter of 2009 – when shot-to-bits valuations were everywhere – but the dilemma for investors at the time was that they felt they could not buy with any confidence. There were many wonderful bargains on offer, but one needed nerves of steel to take advantage of them.

Now, with Macquarie, it does not so much take nerves of steel, but a conviction in the way that Deutsche Bank sees Macquarie, as being “significantly under-valued” by the market. Deutsche thinks MQG is worth $56 a share – implying 25% growth in the price from here.

It has to be said that Deutsche Bank is an outlier in its view. The consensus target price on the FN Arena database is $43.93 – below the current share price. Credit Suisse is the only other broker with a positive view on Macquarie, rating it as ‘outperform,’ but the other five ratings on Macquarie from its investment bank peers are ‘neutral.’

Macquarie is certainly on the improve as a business. Net profit for the year to 31 March was $851 million, up 17% on FY12. The result was well ahead of Macquarie’s guidance in February, when it told the market to expect 10% growth, and the market consensus forecast. Announcing the FY13 result, the group said it expected its FY14 profit to be higher again, provided market conditions are no worse than those experienced in 2012-13.

If Deutsche Bank is right, the businesses that investors are picking up virtually for nothing now are a free option on a recovery in global capital markets and M&A activity. That would be a bonus on top of the annuity-style revenue, which is nowhere near as volatile as the transactional revenue of the market-facing businesses.

The dividend bonus

Macquarie is trading on a consensus FY14 forecast yield of 5.2%, increasing to 6.4% on FY15 expectations.

Macquarie sprang a surprise earlier in the year, paying a final dividend of $1.25 a share (up from 75 cents a year earlier), 40% franked. Not only did the bumped-up final push total dividends for the year to $2 a share, up 43% from the $1.40 in FY12, franking returned to Macquarie dividends for the first time since FY09.

If the 40% franking is retained for the full-year dividend in FY14, the nominal dividend yield of 5.2% will stay pretty close to 5.2% for an SMSF in accumulation phase, but increase to 6.1% for a fund paying a pension.

For FY15, the equivalent yields for an SMSF are 6.4% for an SMSF in accumulation phase, and 7.5% for a fund paying a pension. While waiting for a free option to kick in, that’s not a bad return.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

James Dunn

Published on: Wednesday, July 17, 2013

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