Headwinds could trigger earnings downgrade for Macquarie Group

Thanks in part to its annuity-style businesses, Macquarie Group Ltd (ASX: MQG) posted a record net profit of $2.063 billion on revenues of $10.35 billion for the full year ending 31 March 2016, up 29% and 9% respectively over the previous corresponding year.

The contribution of Macquarie's annuity-style businesses – Macquarie Asset Management (MAM); Corporate and Asset Finance (CAF); and Banking and Financial Services (BFS) – was up by $277 million, or 10% on 2014-15.

While the group's capital markets-facing businesses – Macquarie Securities Group (MSG); Macquarie Capital; and Commodities and Financial Markets (CFM) – saw their combined net profit contribution decrease by $34 million or 3%, Macquarie's annuity-style businesses, Macquarie Asset Management (MAM) continue to perform reasonably well against comparative periods and benefited from strong performance fees.

However, recent headwinds, have led one analyst to speculate whether Macquarie Group's return to pre-GFC performances might be short lived.

Due largely to rising US interest rates, currency wars, China's slowdown, lower equity trading volumes, and challenges around repeating the 2016 outcome for commodity-related revenue, there are major doubts surfacing over the investment bank's ability to repeat the performance, especially without the help of a declining A$.

This has led one broker's analyst to cut their 2017 earnings estimate to $1.96 billion, and a corresponding downgrade has left the investment bank trading close to a revised target price of $68.00.

At an operational briefing back in February, Macquarie revealed some sobering figures that help put currency in context for its Macquarie Asset Management (MAM) which – remains Macquarie's main earnings driver.

 

Since 2011, Macquarie Asset Management (MAM) has increased assets under management (AUM) by 10% a year, to $487 billion, and base fees by 12% a year, while Macquarie Investment Management (MIM), has increased its AUM by almost 12% a year, from $205 billion to $345 billion, with base fees have rising slightly more, by around 13% a year.

It's understood that 56% of  Macquarie Investment Management (MIM) assets under management (AUM) growth from 2011 to 2015 can be attributed to the lower A$ – with 81% of assets denominated in other currencies – while a further 30% is the result of rising markets.

 

That means that only 14% ($21 million) can be attributed to fund inflows – which grew in line with the overall industry at just over 1.9% annually.

Based on these numbers, it is easy to see just how vulnerable Macquarie is to a 'perfect storm' of falling markets and a rising dollar.

MIM does expect some growth in asset value over the cycle, but it's also worthy of note that only around a third of its AUM is in equities, with the bulk of the remainder in bonds which are unlikely to grow over the cycle.

While Macquarie's share price is now trading 24% below its 12 month high of $85.15 mid-July last year, recent headwinds suggest that the mismatch we wrote about back in March now looks less likely to correct, and could widen in the short term.

Meantime, future acquisitions are likely to keep its Corporate and Asset Finance (CAF) division ticking along in the high single-digits. Following the recent purchase of the AWAS aircraft leasing business and the Esanda dealer finance portfolio from ANZ, last month Macquarie along with bid partner contractor Maeda Corp was also named as a shortlisted party for a Japanese toll road deal.

However, the continued growth from its corporate finance business, Macquarie Capital, which typically contributes around10% of the group total profit, looks less bankable with market sentiment in decline.

While the impact of future market conditions makes forecasting difficult, the headwinds confronting will make it hard for the group to deliver a net profit for 2017 in line with the 2016 result.

It's unlikely that the dollar will provide as much of a gift to all of Macquarie's businesses that it did during the last financial year.

The stock now seems to be trading on a fairly unchallenging forward price to earnings (P/E) of 10.5x earnings and a very modest premium of 5.55% on its intrinsic value (IV) for good reason.

While EPS has been excellent over the last five years, it is expected to soften; with EPS of $5.84 in 2016 jumping to $6.78 in 2019, while return on equity (ROE) of 12.69% in 2016 is only expected to jump to 14.02% by 2019.