MACQUARIE GROUP – Risk controlled evolution --TOP 10 holding

MQG FY24

Understandable business

My first interaction with senior MQG executives was in 1992. At that stage, it was an unlisted, very private company and the C-suite was very friendly and professional but it was clear that any details of actually how they made their money were not for full disclosure. At the time the company was mainly a corporate advisory firm with an average broker, that enabled trading, ECM and M&A activity. Much has changed since then.

Two themes have sustained the investment case over the decades. One is a strict risk protocol. We have heard the stories about big hitters being shown the door for risk limit breaches and the importance placed on risk is perhaps the main reason MQG has never been on life support like many of their investment bank competitors.

The second is an innovative culture, a willingness to identify and resource capabilities into new and growing areas of potential returns, the building of the infrastructure business, the digital bank, the energy trading business and the latest green investment as well as many smaller ones are examples of the ability to start and grow successful businesses. There has also been ruthless action to cut underperformers. The capital allocation over time has been excellent, IMO. At one result around 2000, the then CEO stated that there was a significant amount of profits derived from businesses that didn’t exist five years ago (20% as I recall). Although that result would be difficult to replicate nowadays, given the larger base, it indicates a culture of innovation and the ability to execute.

MQG disclosed the ROE returns for its annuity businesses (MAM and BFS, the fund manager and the bank) as an ROE of 12% compared to an 18-year average of 22%, indicating potential underearning, what's happening? The market-facing divisions, Commodities/Global markets (CAGM-commodity and derivate market making and trading among other activities), together with Mac Cap (the traditional IB) reported an ROE of 16% compared to the 17% 18y average. That means MAM is seriously under-earning. Management is quite transparent with the strategy with MAM. Mam has always been a specialist fund manager concentrating upon their specialties in unlisted assets or infrastructure not only publicly trade FI and equities, the traditional area of fund managers, although they have those as well.

MAM is carrying significant green assets for a new fund MGECO that is forming. The assets are not fully developed and are generating losses and are carried by MAM on the balance sheet. Ultimately they will be sold into the fund crystallising a modest cost of capital type gain. The development gains that accrue over time will form part of future performance fees for MQG. The success of the strategy is dependent on MQG amassing attractive assets in an attractive asset class. The green energy assets are still well sought but success does depend on clients being convinced of the quality and price that MQG can provide, being regarded as a leader in the area is critical, built upon a decade of investment in the industry, in expertise and assets. There is risk but MQG ability to establish a new fund should not be underestimated. The time frame is probably 2-3 years for full establishment. That will see a ratcheting upward in the group ROE. The size is larger than some of the other strategies undertaken by MQG so progress should be watched.

The bank, BFS, appears to be chugging along fine, being a lower cost operator, being a digital bank compared to the large incumbents, counter positioning themselves to win share or pressure the incumbents into lower returns.

The other area that should be monitored is the growing exposure to the private credit market. The attractiveness of the segment has been identified and commented on by many and MQG mainly through MCap but also funds in MAM are involved. That exposure is both on the balance sheet and off-balance sheet. MCap has exposure to about $21b ($55/share). Large. The success of this strategy and against peers will be decided by relationships and understanding of the risks involved for each exposure. MQG appear well placed given its tentacles in knowing various industries and players. The main exposures here are software 28%, finance and insurance 19%, and Health 16%. The average exposure time frame is about 2-3 years.

The guide is for significant profit improvement in MCap and MAM and little improvement for BFS as it sheds its car loans biz (4% of loans) and for CAGM being flat, although CAGM has large exposure to commodity volatility in a positive way and profitability can increase quite quickly with these volatile events, eg price spikes.

Operating History

The interesting aspect of the EPS graph below is the steady improvement up to C19, which saw the impact of poor markets, then strong markets and now the lack of asset realisations. The conclusion is that MQG is underearning on the last numbers. The volatility is a bit of a concern as I prefer steady and forecastable growth and must be addressed in the forecasts for accurate valuation.

The recent volatility in earnings makes analysis interesting for instance the 5 and 10-year EPS growth numbers ending fy23 and fy24 are as follows, 13% and 1% and 18% and 9%. Indicating the difficulty with point-to-point analysis for MQG.

ROE has averaged 13.6% for the last 5 and 10 years, equity has grown by 11%pa over the last 10 years. The numbers show a solid ability to grow the equity base and earn above the cost of capital.

The volatility in performance fees (PF) is something to monitor as are asset realisations. The PF history is that PFs have averaged 16% of PBT over the last 10 years and in FY24 it was 13%, therefore a bit under average, indicating potential underearning. Several years ago MQG stopped specifically disclosing profit on asset realisation, I believe, due to wishing to avoid pressure from the buyers of those assets. We have a proxy however, in the MAM accounts there is an item “investment-related and other income” which includes profit on asset realisations as, I believe, the vast majority of the profits. Over the last 6 years this number has averaged 16% (wow big) of PBT and was 3% in FY24, indicating significant under-earning. Of course, the size of the investment book and embedded unrealised profits in that book would be great to know but I suspect (and assume) the book of investments rises with the asset growth. That is, the tank is not empty here. Ongoing investment has occurred and the implicit assumption is that they will be as profitable as previous investments.

Management

The senior management of the bank has a track record amongst the best in the domestic market and amongst the best of their peer group. The industry and the MQG team are well incented with SBC (share-based comp)(p/tax) being 24% of after-tax profits while SBC was 15% last year with the bumper earnings. Peers numbers are GS 24% and MS 19%, so it is an industry that rewards the staff well. The peculiar aspect of MQG is that although the rewards are very large vesting is usually long-dated encouraging long tenure, of which there are many examples.

I struggle to think of a large disastrous investment for MQG, that almost every other investment bank has made at least once in their history.

Balance Sheet

As with most financials, I usually look at TA/E leverage ratios and excess capital. The leverage ratios have averaged 11.8X and are currently 11.9X. excess capital is disclosed as $10.7B ($28ps), on APRA Basel III 10.5% capital adequacy measure. Average to conservatively geared.

Other

Note the reversal of impairments, mainly in Mcap on equities written down in the pcp. These were significant for MCap, and can be taken as conservative accounting or profit smoothing. I've observed the group long enough to think some profit smoothing may exist but it is not large or ongoing. The interesting aspect is that MCap is forecast to grow significantly from these levels even though impairments have already been reversed. Speaks to an expected pick up in ECM, M&A activity.

The market is concerned about the longevity of green investments, and whether the transition will test the resolve of participants and reduce investment in the area. MQG has invested a significant amount of resources into building a large, leading franchise in this area and there is a possibility of disappointment. There is a bet the green trend will continue.

The build-up in private credit is another area to watch. Traditionally, MQG does not take on vanilla credit risk, unless there is a big payoff. Investors are relying on management’s ability to be selective with risk exposures in this area. MQG commented at the result that loss rates are 30bp LT and are tracking to expectations (seems low to me, but they can be low for a long time until they aren’t, exposure 2-3 years, so have the option to unwind in that timeframe).

Conclusion-Valuation

Investment banking is a tough industry, the ability to reward shareholders as well as staff in a sustainable model, while keeping risk under control is incredibly difficult. That is why I hardly investigate IB’s as investment propositions and only look at them for general knowledge and entertainment value. MQG stands out as being able to sustain good returns in a difficult industry over the long term. MQG could well be the only IB I would contemplate owning.

My valuation framework for MQG is quite simple. Firstly it is based around the business's growth prospects and the ability to generate an ROE target. The ROE target is based on the business mix and likely normalising in the business environment so higher if we are in a bear market for asset realisation and the inverse for bull markets. The only other numeric assumption is the level of equity which we can see growing 11%pa for the last 10 years and I assume 6% for the next five. That generates an EPS number and I put that to a lens of PE assumptions based on previous ranges to generate a target valuation I am comfortable with. From the last reported EPS, a 5-year eps growth of 13% is forecast, with a target exit PE of 13x plus dividends. At $188 a 7% pa return is generated, at $165 it generates a 10% return and is my buy price.

Please note the disclaimer.