Macquarie’s Year Ahead: Growth Or Transition?

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An extraordinary showing by the CGM (up 50% yoy), the continued shrinking of the annuity-style businesses, plus the likelihood of a sharp drop in provisioning requirements, has created a guidance predicament for Macquarie Group going forward.

-Citi detects an uncomfortable reliance on oil & gas volatility for Macquarie's FY22 outlook
-Transformation of annuity-style businesses makes near- term earnings visibility difficult
-Very little profit growth assumed in FY23
-Some brokers suggest in the absence of earnings upgrades, Macquarie's valuation looks stretched

By Mark Story

Hints that a potential capital return could be on the cards following Macquarie Group’s ((MQG)) announced 10% uplift in FY21 reported earnings of $3.02bn and final dividend boost by 86.1% to $3.35 a share may have gone some way to pleasing the market last week. Equally pleasing, the second-half net profit of $2.03bn was up 59% on a year ago.

But while the market-facing divisions did the heavy lifting (up 214% in net profit contribution for 2H21), the annuity businesses were softer (up 7%) in FY21. While Macquarie still describes market conditions as challenging, meaningful revelations on what’s in store for the investment bank were notably absent from the underlying commentary that accompanied the result.

Macquarie noted strong capital deployment opportunities across the divisions, but the group’s cautious approach on capital drove a lower payout ratio and issuance under the dividend reinvestment plan (DRP).

Despite offering little short-term guidance for the group, management noted Macquarie Asset Management’s (MAM) base fees to be broadly in line, while net other operating income to be slightly down. The group also expects Commodities & Global Markets (CGM) income be significantly down on FY21 with the positive impact of timing benefits in FY21 not likely to recur.

Meantime, first half 2022 is also expected to include the disposal of certain assets in Specialised and Asset Finance, with MacCap transaction activity expected to continue improving in FY22.

Citi notes an uncomfortable reliance on oil & gas volatility to determine how much commodities will be 'significantly down’. While Macquarie understandably declined to provide guidance during covid, Citi thinks the decision to not provide guidance at the group level is seemingly at odds with sufficiently detailed guidance provided for the operating segments.

The broker believes the recent transformation of the annuity-style businesses has made the near-term earnings visibility difficult.

Citi views the business opportunities that allowed Macquarie to invest a further $2.3bn across the divisions as one of the key highlights in 2H21.

Future growth uncertainty

Despite a lack of FY22 guidance for the overall group, Goldman Sachs believes divisional earnings guidance implies FY22 group earnings will be broadly flat on the previous corresponding period. Incorporating the latest insights into forward modeling, the broker’s forecasts assume very little profit growth in FY23, with better prospects for FY24.

While Macquarie’s balance sheet appears solid, management notes APRA’s $500m operational capital overlay will also temporarily reduce investment capacity, and so it will issue shares for the second half DRP (with a -1.5% discount) and the Macquarie Retained Employee Related Equity Plan (MEREP).

In the absence of earnings upgrades, Goldman Sachs believes Macquarie's valuation looks stretched. With the revised target price ($150.47 from $138.81) offering no upside over the next 12 months, the broker maintains a Neutral recommendation.

Driven by slightly better revenues in FY22, and supported by asset sales, with less investment income assumed in FY23 and lower staff expenses – offset by higher share count, given Macquarie will issue stock for its DRP and MEREP – Goldman Sachs’ revised FY22 and FY23 earnings per share (EPS) forecasts are up 3.0% and down -7.8% respectively.

While a faster and stronger capital markets recovery, plus more timely or higher realised performance fees (down -20% on the previous period to $660m) and/or asset realisations are key upside risks, key downside risks, notes Goldman Sachs, include prolonged capital markets weakness.

Morgan Stanley thinks Macquarie’s earnings growth can continue in FY22 and FY23 as the economy recovers, and the group deploys dry powder and plays into tailwinds in private markets, infrastructure and renewables. Having concluded that Macquarie’s outlook is decidedly conservative, Morgan Stanley’s FY22 earnings are unchanged, while FY23-24 rise 2-3%.

With CGM having already booked a $450m pretax gain in 1H22, Morgan Stanley is now looking for group-wide gains on sales to reach a new record of $2.2bn in FY22. The broker remains Overweight on the shares with the target price increasing to $175 from $172.

Having concluded the disruption from the covid pandemic was relatively short-lived, medium to long-term JP Morgan remains upbeat on Macquarie’s exposure to the key growth areas of asset management, renewable energy, technology investments; and the rapidly growing Australian mortgage business.

While JP Morgan had always anticipated FY22 would be a year of rebasing for the business, the broker believes the two notable offsets are good organic growth in the CGM franchise and the completed partial sale of the UK meters asset. The broker’s forecasts factor in 5% net profit growth in FY22, which reflects lower assumed asset impairments and loan provision.

As a result, the broker maintains an Overweight rating, with the price target rising to $170 from $165.

Inflection point

JPMorgan shares its research with Ord Minnett, hence the latter sees sufficient evidence to suggest Macquarie could more than offset the likely headwind from CGM division normalisation. Into FY22, management expects commodities income to be significantly down on FY21, and Goldman Sachs is forecasting for commodities trading income to fall by around -50% in FY22.

However, Ord Minnett points to strength within MAM’s underlying drivers and cites record fund raising and Macquarie Investment Management (MIM) net inflows, and Banking and Financial Services (BFS) as marking an inflection point with material profit growth ahead.

While MAM is guiding for base fees to be broadly in line in FY22, ex the recently completed Waddell & Reed acquisition, Morgan Stanley finds this conservative given the recovery in base fees in 2H21 in both MAM and MIRA.

Morgan Stanley bakes in 5% core base fee growth or 10% with Waddell & Reed. The broker expects integration costs to reduce MAM's profit contribution margin to 51% of revenue in FY22 versus 58% in FY21, but forecasts post-integration to rise to 58% in FY23 and 61% in FY24.

Ord Minnett regards the disruption from the covid pandemic as having been relatively short-lived, with deal activity picking up quickly and market volatility providing support to market-facing earnings. As risks from the pandemic fade, the broker expects earnings growth to pick-up, given non-recurrence of impairments and $2.7bn surplus capital deployment to the business units.

Despite the recent re-rating, Ord Minnett still sees potential upside from here, and maintains an Accumulate recommendation, while sticking with JP Morgan's target price increase to $170.00 from $165.00.

Transition mode

With the runoff of the now-defunct Corporate and Asset Finance (CAF) division having shifted the mix towards the lower returning Market-facing businesses, Citi sees Macquarie in transition, rather than growth mode. Macquarie has also made a conscious decision to shrink its annuity-business footprint with an exit of the CAF division, suggests the broker.

Citi sees the recent WDR acquisition as the first step toward reinvesting in new annuity-style business opportunities, but notes considerably more needs to be done.

Despite Macquarie having recovered back to its $3bn profit level from FY19, Citi believes growth beyond $3bn should not be expected until FY24 with excess capital continuing to keep the Return on Equity (ROE) at around 14%, down from 18% in FY19. Citi also expects the deployment of excess capital to support a rise in the long term ROE to 15% from 14.3% currently.

The broker expects the prospect of higher interest rates and higher US taxes to continue exerting earnings pressure in the medium term.

While Macquarie remains an attractive story with structural longer-term opportunities and competitive advantages in real assets and green energy, Citi agrees with Goldman Sachs that valuation and expectations appear stretched near-term, especially given the lack of earnings momentum, plus risks around interest and tax rates.

Citi has upgraded FY22 earnings forecasts by 6%, reflecting the guided gain on the sale from CGM Specialised and Asset Finance, mitigated by higher costs. But the broker has downgraded FY23 forecasts by -6%, to reflect higher group costs and lower CGM revenues.

As a result, Citi maintains a Sell rating on Macquarie with a new target price of $140 (previously $125).

Rising volatility

Citi expects the rise in the performance of the markets-facing business to exacerbate the reliance on volatility in group earnings. For example, Citi notes the dominating performance of CGM has seen its net profit contribution rise from $910m in FY18 to $2,601m in FY21, or 42% in annual growth.

With CGM having now become the largest division, Citi sees the group result becoming dependent upon a combination of weather events, market dislocation and client hedging activity in commodities markets in particular.

Also contributing to weak forward earnings visibility, adds Citi, is the volatility in assets sales. The broker cites asset sales revenue in MacCap which in the covid-affected 1H21, fell to just $123m. While conditions should improve in FY22, Citi expects the lumpy nature of these asset sales to make forecasting more difficult.

The broker notes, the reopening of the economy and the sale of key technology asset Nuix ((NXL)) enables this gain on sale revenue to recover to $998m in 2H21.

Macquarie shares are currently covered by five of the seven stockbrokers monitored daily by FNArena (UBS is absent and Macquarie does not self-analyse). The average price target (consensus) by those five brokers post FY21 results is $161.20, which remains slightly above today's share price. Prior to Friday's result, the consensus target stood at $152.38.

Price targets range from Citi's $140 to Morgan Stanley's $175. Goldman Sachs and JPMorgan are not included in the seven.

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