Thursday, June 20th, 2019
After extensive work in recent weeks to validate the group’s investment quality, understand the reasons for the recent lower guidance and be confident enough the growth and returns upcycle will resume in FY20, we initiated a position in Macquarie Group (MQG) in the Clime Direct Model Portfolio.
In today’s report, we describe MQG and how we think about its quality for investors and summarise our thesis.
MQG is a globally diversified financial group providing clients with asset management and finance, banking, advisory and risk and capital services across debt, equity and commodities.
How this opportunity came about
MQG shares reached a record high of $136.20 on 2 May. The subsequent selloff was initially due to disappointing FY20 guidance. MQG guided to a small decline in FY20 earnings when Bloomberg consensus was for 7% growth.
Figure 3. Disappointing FY20 guidance given with FY19 result
Figure 4. Why MQG guided slightly lower
- FY20 base and performance fees are expected to be similar to FY19
- Asset finance is expected to receive less revenue due to fewer loans
- There is downside to bank interest margins
- The trading businesses should have consistent customer flows
- Impairments are expected to decline
- Investment income is likely to decline.
If we exclude the higher gains from investment sales and the higher performance fees then there was no revenue growth from 1H19 to 2H19. This emphasises MQG’s reliance on market conditions for profit growth, a point MQG makes consistently in its outlook statements.
MQG is fairly highly leveraged, with a ratio of total assets to equity of 11.1 times on the last balance date of 31/03/19. Some of this leverage is due to ownership of Macquarie Bank. Banks are normally highly leveraged because the business model is to fund large volumes of loans with similarly large volumes of deposits and debt, with equity providing prudential capital. But bank loans were only 39% of total assets, so there is also substantial leverage across the rest of the group. This means loan and other asset impairments make proportionately large detractions from equity. For example, credit and other impairment charges totalled $552m in FY19 or 3% of equity of $18,180m at the start of the financial year.
- Strong regulatory ratios
- A strong and conservatively funded balance sheet with matched assets and liabilities, minimal reliance on short-term wholesale funding, well-diversified types of issuance and sources of funding, the ability to meet liquidity obligations during a year of constrained access to funding, and substantial surplus capital
- Growing customer deposits
Figure 5. Macquarie Bank regulatory capital ratios
Figure 6. Liabilities match assets; minimal reliance on short-term wholesale funding
Figure 7. Term funding is well-diversified
Figure 8. All entities are able to meet liquidity obligations during a year of constrained access to funding
Figure 9. Recent and long-term average ROEs are well above our modelled RR of 9.34% and the group has substantial surplus capital
Quality industrial and resources businesses have relatively low capital requirements and generate free cashflow while growing but the concept of free cashflow is not as relevant to evaluating the investment quality of a financial business. One main reason is the assets, being financial, do not typically require maintenance and growth capital expenditure; MQG’s cashflow statement does not have lines for either. Instead, the extent and use of organic capital generation versus the capital requirements of growth is more relevant. Financial businesses like MQG, which face a wide range of potential growth opportunities, need to choose ones which earn sustainable ROICs sufficiently above the cost of capital for the risks assumed, and they need to strike a dividend payout ratio which adequately rewards shareholders and leaves enough earnings behind for reinvestment in new financial assets.
MQG’s record here and on delivering genuine sustainable long-term growth is compelling. Over the last nine years MQG delivered:
- Double-digit compound growth in earnings and dividends
- and solid growth in book value
- for a negligible increase in shares on issue
- while gearing declined
- and ROE rose 693bp or by 66%.
Figure 10. Nine-year CAGRs in key shareholder value metrics
Sources: Factset, Clime Asset Management
Figure 11. Nine-year trends in gearing and ROE
The benefits of MQG’s risk management framework and culture are almost self-evident from the above record, which spans a decade of equity market rallies and falling bond yields interspersed with bouts of sharp volatility.
In summary, the thesis for initiating positions in MQG is this is a high-quality business likely to continue delivering superior growth and returns, 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.