The return of Macquarie – has it run too far?

Financial journalist
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After a difficult GFC, the turnaround on the share market by Macquarie Group Limited (MQG) – Australia’s largest homegrown investment bank – over the last two years has been very impressive.

From September 2011, when it traded at levels around $23, Macquarie has now surged to close yesterday at $47.65, near its highest point since April 2010. Over the last 12 months, the stock has put on 64%; so far in 2013, the gain is 34%.

Round numbers mean nothing on the share market, but nevertheless there would have been quiet satisfaction at 1 Martin Place, Sydney, in September when Macquarie shares touched $50 for the first time in three years.

Cash is back

The share price performance has come about because Macquarie is back to cash generation in a big way.

As recently as FY12 (Macquarie’s year ends on 31 March), the bank earned 210 cents a share, and paid a dividend of 140 cents.

For FY13, the earnings per share (EPS) was 251 cents, and the dividend was 200 cents. But for the year ending 31 March 2014, the analysts’ consensus expects EPS of 305 cents a share for Macquarie, up 21.4%, and a dividend of 237.7 cents a share in FY14, up 18.9% on FY13.

FY15 is shaping up to be even better: the consensus is looking for EPS of 367.5 cents, and a dividend of 289.4 cents a share – just over double what it paid as recently as FY12. There are not many stocks around boasting that kind of turbo-powered payout growth.

New business model

What happened is that Macquarie has completely changed its business model, such that recurring revenue streams – which it did not have only two years ago – now represent almost three-quarters of group earnings.

Macquarie is now clearly split into the three “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; and the “market-facing” businesses, Macquarie Securities, the Fixed Income, Currencies & Commodities (FICC) division and Macquarie Capital.

The non-market facing divisions generate the recurring income, with Macquarie Funds the star.

Macquarie too expensive?

The run-up in the share price has been effectively the market pricing-in a recovery in the earnings of the market-facing businesses, as global economic conditions recover and capital markets activity – mergers and acquisitions, (M&A), initial public offerings (IPOs) and secondary capital market raisings and the like – starts to surge. These are volatile businesses, but they have been subdued, and Macquarie is in a good position to leverage on improved activity. That is what the market expects, on the back of improving global economic data – even from Europe.

But – has Macquarie run too far?

The range of price targets for Macquarie from the brokers varies from CIMB Securities at the bearish end, at $39.85, to Credit Suisse at $55 and Deutsche Bank at $56.20. The latter pair are the only two brokers overtly positive on Macquarie – Credit Suisse rates it as ‘outperform,’ while Deutsche has the stock as ‘buy’ – while the rest, BA-Merrill Lynch, JP Morgan, UBS, Citi, RBS Morgans and CIMB Securities all rate MQG as ‘neutral.’ The consensus price target comes in at $47.64, pretty close to its current share price, which means that Macquarie is fully priced and yes, Macquarie has run too far.

In July, Macquarie told the market that despite write-downs (expected to come in the FICC business), the first half of FY14 would be in line with the second half of FY13 – which was a strong half. (Macquarie usually generates about 60% of its annual profit in the second half.) This implies that Macquarie should be able to deliver an interim profit of about $490 million for the half-year to September 2013.

And if the long-awaited improvement in capital markets starts to flow, then the second half of FY14 should be even stronger. For example, RBS Morgans says Macquarie stands to gain the work on six potential IPOs in the last quarter of 2013, totalling about $4.9 billion, which would boost market-facing earnings significantly. Because Macquarie generates about 63% of its earnings offshore, any earnings improvement will be augmented by a lower A$ against the US$: every 10% fall in the A$ lifts Macquarie’s full-year net profit by about 6%.

(Interestingly, RBS Morgans says Macquarie is “double blessed,” in that the technical and fundamental analysis concur: the broker says the uptrend in which MQG has been trading since September 2011 remains technically intact, with the first potential upside price target at $50.40, with a medium term possibility of $53.85.)

Yield play

While waiting for capital market recovery to strengthen, investors clearly have to bank on the US Congress striking a deal on the debt limit by October 17 and not allowing the US to default – because that would not be good at all for capital markets, given that it would probably plunge the US and the global economy into recession. Absent that happening, Macquarie is trading on decent yields – although the large proportion of offshore earnings means that 40% franking is about the best the bank will be able to do on its dividends in FY14 and FY15.

On FY15 expectations, Macquarie is trading at a 6% nominal yield, which for an SMSF in accumulation mode also represents 6%, while to an SMSF in pension mode the equivalent yield is about 7.08%. That is a healthy yield to sit on while you wait for the leverage to better global markets that Macquarie represents.

The caveat is that a major market shock that hammers market confidence and sends recent asset price rises into reverse would also hit the MQG share price. And since 2007, all investors should know that such things are always possible.

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.

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