MQG FH26 result -- Still waiting

 

MACQUARIE GROUP FH26 RESULT—I see the red tape, but where’s the Innovation?

Main Points

NPAT up a lacklustre 3% and revenues up 6%, so operational deleveraging. As can be seen in the numbers below, this was a disappointing result. The outlook, which is traditionally conservative, was quite muted as well.

MQG is a composition of operational income combined with performance fees (PF) and asset sales realisations, which can significantly swing results.

MQG do not disclose asset sale realisations, but they are included in the MAM “Investment related and other Income” section, which I take as a proxy. For this period, PFs were 31% of PBT (compared to a 13-year average of 16%) while asset realisations were 8% of PBT (compared to a 7-year average of 14%). Combining these two gave a PBT tailwind of 9%, a significant number and pointing to issues with the base business.

The ROE was 9.6%, below the 15-year average of 12.4%. MQG also disclose operational ROE for the two groups, being the annuity businesses, MAM and BFS and the more transactional businesses, being CGM and MCap. The 19-year ROE averages for the annuity-style businesses are 21% compared to 20% in the last half, and 17% for the transactional businesses compared to 12% for the last half. Excess capital continues to weigh on ROE calculations. Looking at these numbers gives us a framework to see what went on.

As for excess capital, the group continues to buy back stock and has bought A$1b at $190 per share. This is good progress and also indicates where management views value in the stock.

Below, we see Net income growth over the last 12 years. This is analogous to sales growth and is before expenses. We can see a steady decline in the rate of growth, although it has been very volatile due to the timing of the PF and asset sales. My conclusion to this is that it is due to either the base effect or innovative regeneration becoming less effective over time, or both.

 

For many years, MQG has provided a segmental report that discloses capital allocated to each of the four divisions, ROE for the two annuity-style businesses and market-facing businesses, and capital allocated to corporate and surplus capital.

Below is the 5.5-year growth rate in capital allocated between the segments. Some interesting numbers here.

Mac Asset Mgt	11%
Banking & Finance	11%
Commodities GM	13%
Mac cap	8%
Corporate	36%
Surplus	1%
TOTAL	10%

 

Of interest to me is that surplus has hardly moved, meaning that MQG is drawing down excess capital as a %, so it’s a drag but less so. Secondly, the corporate segment is growing a lot. The Corporate segment is a mix of various operations. Group services such as risk, technology, compliance and work out assets that need special attention. Therefore, it is not an area that investors want to see growing. On the operating businesses, we see growth across the board with CGM leading and MCap lagging, which I would guess means that capital follows returns.  Current total capital is allocated as below.

Mac Asset Mgt 12% Banking & Finance 19% Commodities GM 28% Mac cap 15% Corporate 8% Surplus 19%

 

 

 

The graph below is the ROEs for the two annuity businesses, being MAM and BFS, the two market-facing businesses, CGM and MCap and the total group ROE including Corporate costs and surplus capital.

Hard not to conclude that CGM is the largest driver of ROE. Surplus capital is a drag, but a constant drag; corporate is also a negative to be monitored. BFS has steady growth and returns, MAM fluctuates with PF, and MCap is a lower-returning business with some volatility. Some of these conclusions are educated guesses. The decline in ROE is mainly driven by the decline in CGM after some spectacularly good years.

SEGMENTS

 

Keeping the above in mind, we move on to the segments.

 

MAM very much saved the result with a huge PF. MAM competes in the specialised alternative asset management business, so it competes with sourcing, raising and operating funds with the likes of KKR and Apollo. Several comments were made about the underwhelming size of raisings and the issues with the green assets on the balance sheet and the realisable values. MAM has gone big into green assets, and that also involves development risks. A couple of assets have been moved to corporate to work out, offshore wind and solar, while MAM focuses on building the third-party business. MAM is a core of the group, is a specialist alternative manager, which is a good area but is up against solid competition, and Green energy assets have their issues, although the long-term appears sound. MAM is selling its NA/Europe public assets, which I think is a good move, no competitive advantage. AUM was fairly flat in the period, up 2% in the last 6 months. Besides the green energy transition theme, mention was made of growing into adjacencies such as real estate, agriculture, reinsurance and private credit. Green energy has hit a bit of a bump; it is to be seen how long that lasts.

 

BFS is the poster child at the moment. The group has spent huge amounts on the technological platform to position it as the digital, low-cost bank and is expanding its share here against the major Australian Banks. BFS has 6.5% of the home loan market and is growing strongly in home loans and deposits. The business bank is much smaller, and the wealth/platform business is growing, but at much lower rates than HUB and NWL. The expectation is that MQG continues to gain share in home lending and deposit taking. Margin pressure persists as it is a competitive market.

 

CGM is made of the commodity trading, which includes physical assets as well as dealing, third-party party and principal positions. Derivatives and leasing were higher, but core commodity profits were flat. There was a large increase in costs in the division. Note that the division has recently undergone a management change. Costs are a grab bag of technology spend, regulatory and licensing spending, remediation and one-off transactions. MQG commented that investing in the platform was holding profits back. CGM is building a scalable and global platform and mentioned the success of BFS as a template. Management commented that the client base was still growing and is accretive; the weaker USD and stronger gold price had caused increases in working capital and increased anticipatory provisioning. The business has large exposures to the gold trade, with clients less desperate, I suspect, given the bullion price and a large exposure to US oil and gas, which has been subdued. There have also been murmurings that competition is increasing in these areas, which did not help with the weaker results.

 

MCap is a traditional merchant bank with ECM/IPO capabilities, but the main focus has been growing the private credit (PC) book, which now stands at $26B.  The book was held steady in the last half. I believe that PC is going through the well-worn innovators, imitators, and idiots cycle, with us most likely being in the last phase. MQG appear quite aware of this and offered up the following. The book is now mature and performing within expectations. MQG have been in the business for over 10 years and, importantly, sources their own deals. They looked at 800 deals in the last period and took on 40. The book has moved geographically, with European business now being the largest, not the US. Provisions of 2-3% are held against the book. MQG mentioned IRRs of over 20% and the breakdown of the book was given with software being a large part. On the PC industry as a whole, MQG said that PC is still a small portion of the total TAM of small/mid-sized lending, but that it had not been tested with a credit cycle.

MQG would like to build a PC fiduciary duty business through MAM, with Europe being a focus and carefully building a good record over the next few years.

 

Corporate. The work out assets were described as being ¾ solar and ¼ offshore wind. Offshore wind valuations are much more problematic, and provisions have been taken. It will take a couple of years to work these out. Technological and regulatory costs continue to grow, with regulatory 5-year spend around an 8% cagr and technology around 11% cagr. These costs have clearly blunted operating leverage over the last few years.

                                                                                                                                                          

SUMMARY and VALUATION

Is MQG still a good business? Certainly, returns have decreased over time, and management admits that better is required. Some of the lower returns are due to excess capital, but more to subdued revenue growth and increasing costs. Investors have been waiting for returns on these costs for a while now.   

What has struck me listening to the last few years' calls is how small things seem to have gotten in the group. Under the new CEO, it appears more of an optimisation and consolidation phase with steady conservative growth instead of the dynamic self-regeneration we saw under the previous two CEO’s. What has made MQG different from other investment banks has been its risk culture, which I think still exists; secondly, the ability to identify and grow into new lucrative businesses. That seems to have slowed, imo, and that's what concerns me most with the group.            

My valuation approach has been consistent and simple over a number of years. Given the volatility in individual results, I don’t try and predict any individual result. I look at equity growth and the ROE on that equity over the next five years, so I get a normalised value based on equity deployed, hopefully growing, and returns on that equity, hopefully high. That gives me an NPAt to which I attach a reasonable PE. Then just add dividends.

Comparisons are not that useful, but see Australian banks at PEs from 17-28X, GS/MS at 16-17X and Apollo and KKR at 16X and 23X. Using 16X multiple for MQG has been historically reasonable, and if anything appears conservative with the various comps, IMO.

My basic assumptions are 8% growth in equity; historically, growth has been 10% for both 5 and 10 years. For ROE, I run a few scenarios: a no-change bear case, a return to normal returns and a bullish scenario, with bear ROEs of 10.6%, a base case ROE of 12.5% assuming tougher conditions described above and thirdly a bull case with ROEs back to 5 and 10 year historical averages of 14.5%. Then put these earnings on 15 and 16X Pes. That gives and range of prices to buy that would generate 10% cagr returns. (got all that- I do this for most stocks, it’s not as hard as my description).

Buy prices under the bear case, PE 15x and 16X, and 8% eps growth, would be $155 and $160.

Under the base case of 11% eps growth, and PE of 15x and 16x would generate buy prices at $170 and $180.

Under the bull case would be buy prices at $200 and $210 for 15x and 16X.

That leaves me at $175 buy price. In terms of position sizing, MQG used to be a top 10 holding for me, but the business is now pretty good instead of great, and it is a mid-sized holding. That said, I would be prepared to increase it significantly at the right price.