Earnings Risks Heightened For Macquarie Group

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Brokers suspect Macquarie Group's earnings are peaking as the diversified financial business has increased the levels of asset sales in its first half.

-Realising gains on asset sales making sense to brokers as valuations become vulnerable to rising global rates
-Citi believes profits and share price will not hold up indefinitely
-UBS expects upside still exists from improvements in operating efficiency

By Eva Brocklehurst

Is Macquarie Group ((MQG)) becoming more conservative in its outlook? This is the question brokers are asking in the wake of the first half results. The results beat most estimates, driven by significant gains on asset sales, mainly from the disposal of the Macquarie Life business to Zurich Australia, as well as co-investment assets.

Macquarie Group posted first half FY17 cash earnings of $1.05 billion, slightly above recent guidance. Guidance for FY17 to be broadly in line with FY16 was retained. Ord Minnett expects the first half is one of several upcoming periods where the bank will run higher levels of asset realisations. Given the current valuations of real assets in which Macquarie is co-invested, and the vulnerability of valuations as interest rates rise globally, this strategy makes sense to the broker.

This could also mean the so-called “quality” in earnings appears to deteriorate as earnings are supported by a higher proportion of gains on asset realisations. The broker calculates the contribution to FY17 estimates from asset sales shifts to a 6.5% tailwind from a 6.5% headwind. The retention of flat year-on-year guidance also suggests a corresponding reduction in the contribution from underlying operations.

Ord Minnett attributes this to weakness in corporate and asset finance and a higher compensation ratio. Accordingly, the broker assumes a higher run rate of asset realisations to fill the gap left by the weak first half. Despite the term “lower quality” being applied to gains from asset recycling, Ord Minnett is not overly concerned, believing this is an inherent part of Macquarie Group's business model.

Macquarie has significant amounts of co-invested capital in assets that have unrealised embedded gains, as asset values have risen globally in the low rate environment. Nonetheless, the broker interprets this to mean that the earnings outlook will be more dependent on transactions, until such time that Macquarie can acquire new assets at cheaper valuations.

Citi observes the extent of revenue from asset sales is a classic signal of the end of the cycle and earnings at this juncture are probably as good as they will get. Profits and the share price may hold up for a while but the broker suspects this will not be indefinite and retains a Sell rating.

UBS considers Macquarie a leveraged play on market movements and activity, the potential for further reductions in tax rates and a lower Australian dollar and believes, at a time when earnings growth is increasingly difficult, the bank can still pull levers which are not available to most. The broker also expects material upside from improvements in operating efficiency and believes the market is not fully pricing in this upside, retaining a Buy rating.

While Macquarie has invested significantly over a number of years and has a relatively conservative balance sheet, management still envisages opportunities across its businesses where growth may be delivered. With that observation, UBS acknowledges there are signs that that Macquarie is becoming more cautious, unusual for an organisation which is particularly optimistic about the outlook.

During the first half Macquarie generated $855m in gains on sales, almost twice as high as any period since the financial crisis, and the broker agrees the group may have decided to harvest embedded gains on a number of investments it has made over the last few years.

Credit Suisse makes some compositional changes to its FY17 estimates and downgrades to Neutral from Outperform to reflect the fact the stock price is approaching the target and earnings growth is peaking. This broker also points to an historically high level of realised embedded gains in the first half but suspects this might be overstated, in that the first half included the life insurance business gain which does not sit in the principal investment portfolio.

Morgan Stanley also suggests underlying revenue trends were weaker and that earnings will peak this year. Still, the broker flags the prospect for upgrades in the second half and notes the diversified business mix, a strong balance sheet and 5.5% dividend yield underpin the stock. The dividend was up 19% to $1.90 and the pay-out ratio was 62%, which is at the bottom end of the target range of 60-80%.

The broker does not expect quite the same split as in prior years because the seasonality of the group has been reduced and the first half was boosted by gains on sale. Nevertheless, Morgan Stanley raises its FY17 dividend forecast by 10% to $4.40, which equates to a 71% pay-out ratio.

Deutsche Bank suggests the strong run in the share price over the last six months appears to have priced in the group's strengths and believes there is cause for concern with the prospect of rising global rates and removal of stimulus by central banks. The prospect of the US Federal Reserve raising rates at its December meeting is casting a shadow over equity market and, perhaps, the broker muses, over asset values generally.

ASX-listed utilities and infrastructure stocks have already sold off in anticipation, Deutsche Bank notes, and as the number one manager of these types of assets globally this could present headwinds for Macquarie's infrastructure and real asset portfolio. In this context the valuation appears only fair and the broker downgrades to Hold.

Morgans observes some softness in underlying revenue trends in certain divisions in the first half such as corporate and asset finance, where net operating income was down 3% from lower loan volumes. Also, in asset management, where the increase in base fees was less than 1% despite funds under management being 3% higher. Commodities and financial market net interest income was down 16% on lower commodities trading activity.

Additionally, the Macquarie securities business, which experienced a 3% decrease in profit to $18m on weaker Asian trading activity, continues to struggle in the broker's view. Morgans likes the stock longer term but believes it is now trading closer to fair value and agrees earnings risks are heightened, given an uncertain global macro backdrop.

There is one Buy rating on FNArena's database (UBS), five Hold and one Sell (Citi). The consensus target is $78.21, which signals 1.9% in downside to the last share price. This compares with $76.69 ahead of the results. Targets range from $75.00 (Morgan Stanley) to $85.00 (Credit Suisse). The dividend yield on FY17 and FY18 forecasts is 5.2% and 5.6% respectively.
 

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