Wednesday, July 3rd, 2019
On 14 June we added to our newly initiated Macquarie Group position in the Clime Direct Model Portfolio.
In our last report, we explained the investment quality we see in MQG. Today we summarise our thesis below.
In summary, the thesis for initiating positions in MQG is this is a high-quality business likely to continue delivering superior growth and returns over several years, and the guidance disappointment at the 1H19 result combined with the current correction on equity markets have created a medium-term buying opportunity because the stock is inexpensive.
MQG has a thorough and properly developed approach to its governance, which covers the organisation’s goals and values, the allocation of responsibilities between directors and management, risk governance, risk culture, director independence, board structure, qualifications for being a board director, board performance and renewal, how the board gains information on the state of the business, remuneration, financial reporting, ethics and responsible decision making, conflicts and continuous disclosure. The corporate governance statement is not a replica of an external template, for example the ASX corporate governance standards, but stands out as unique to MQG and internally and organically developed.
Guidance likely conservative
For the first time since May 2009 management has guided to an earnings decline in the year ahead (at the recent FY19 result). Given MQG tends to issue conservative initial guidance, then upgrade through the year and has not missed its guidance since 2012, the question now is whether the latest guidance is indicative of this typical conservatism or if management is concerned about its ability to repeat the FY19 result, which was boosted by record gains on sale (~A$2.1bn) and “strong market conditions” in commodities.
Figure 1. MQG’s record of earnings guidance and results since 2011
Source: Morgan Stanley
Our base case is a small decline in FY20 earnings but not with 100% probability. Incremental earnings growth is still possible. Operating momentum is positive across most of MQG’s businesses and the group can absorb lower gains on sale and commodities revenue while still meeting or beating guidance. Post-FY20 MQG should remain in an earnings and ROE growth cycle given structural tailwinds, unrealised gains in several operating businesses, favourable operating conditions for some of its businesses, and the ability to flex its remuneration ratio. Given this, we see limited downside risk to consensus estimates near-term unless equity markets enter a sustained correction of 5-10% from current levels.
In FY19 Macquarie Infrastructure and Real Assets invested $10.9bn and on 31 March 2019 it had $25.5bn of equity to deploy. This should also support delivery of the ‘slightly lower’ earnings guidance or a modest increase in profit from FY19 to FY20.
The large gains on asset sales in FY19 were accompanied by a $400m increase in impairment charges from 1H19 to 2H19. Also, “miscellaneous expenses” rose $297m. Should the additional impairments not be needed in future years and be written back they could boost earnings growth then. If the additional expenses don’t recur in FY20, earnings growth that year should be inflated by recovery from FY19’s lower base.
Increasing proportion of annuity-style earnings
Figure 2. The proportion of annuity-style earnings has trended higher
Over time the market should price this into the shares in the form of less volatility (a lower beta) and less of a multiple discount to the market. We think MQG shares should trade at a premium to the market now for the group’s quality described above.
Structural growth in alternative asset management, and potential for higher performance fees
Traditional equities asset managers face a trend away from traditional active management to passive investing, with associated fee compression. Alternative asset management, in contrast, enjoys structural growth as governments and local authorities turn to private finance of infrastructure and investors seek growth and higher returns in this space. MQG operates one of the world’s largest global alternative asset managers: Macquarie Infrastructure and Real Assets (MIRA), which manages ~US$129bn of assets globally in infrastructure, real estate, agriculture and energy across over 70 funds and vehicles. MIRA is the world’s largest infrastructure manager.
Infrastructure businesses like transport, water and energy utilities, and waste management, provide essential, widely used services. They are often difficult to replace or replicate due to size, scale or location, which creates a natural barrier to new market entrants. Usually they operate under regulatory or long-term contractual frameworks designed to protect consumers while ensuring ongoing investment and service quality. These frameworks often set prices and revenue through links to inflation or capital expenditure. The businesses typically have stable operating cost bases. So infrastructure tends to deliver defensive and predictable cashflows supporting steady long-term yields with less risk and low correlations with traditional asset classes. This package of risk and returns is attractive to pension funds, sovereign wealth funds, insurance companies and other investors.
Most likely MIRA will continue to grow equity under management (EUM) and revenue as investor demand for this newer asset class continues to grow. We have seen forecasts for 9% growth in MIRA net inflows over FY19-21 and a 6% compound average growth in base fee revenues over the same period. These are high-quality revenues from 10-year closed-ended funds.
MIRA’s performance fees tend to increase when its funds mature. A$25bn of EUM across ~15 funds could mature in coming years as continued growth in inflows and the increase in infrastructure asset values over the last five years underpin a pipeline of gains on sale of A$3.5bn.
MIRA can exceed the ~8% return performance fee hurdle for maturing fund vintages, for several reasons. The first is the conservative accounting treatment for the majority of its equity investments. Some 70% of the book is held at cost or lower. Conservative valuations make gains on sale – and associated performance fees – more likely while supporting group revenue. In FY19 gains on sale were 81% of lumpy revenue of $2,642m and 18% of total group revenue. We have seen estimates of uncrystallised gains of ~$3.5bn at the end of 2H19. The result is potential performance fees of $3.8-9.8bn across six large MIRA funds at a 12% IRR. FY19 reported performance fees were $859m, implying scope for sustained average performance fees around this level over coming years.
Flexibility on remuneration ratio
MQG undertook significant discretionary investment in FY19 and the group cost-to-income ratio rose 1.5 percentage points despite 17% growth in revenue. This means there is room to reduce expenses. Morgan Stanley estimates a ~1% cut in the remuneration ratio adds ~3% to earnings.
MQG generates two thirds of its venue outside Australia, which exposes it to more growth options than a group of its size could probably find in today’s slow-growing Australian economy.
The depreciation of AUD in recent years increases the A$ value of offshore earnings.
Not only a beta play on financial markets
MQG is also leveraged to the real economy, not only financial markets. ~40% of revenues are driven by the real economy, for example banking, Corporate & Asset Finance and MIRA’s real asset management, while ~35% of revenues are geared to financial markets.