- Macquarie's result weak but no shock
- Costs, staff and divs cut but is it enough?
- Stock well leveraged to market improvement
- Inexpensive but is it time to buy?


By Greg Peel

"Following the release of the European financial package," declares Goldman Sachs' equity strategy team, "we believe there is potential for the macro risks, which have been dominating investor sentiment and driving equity risk premiums higher, to diminish as we head into the end of the year".

Goldmans has backed up that belief by increasing the cyclical exposure of the strategists' model portfolio and reducing the defensive stance it has maintained up to now. Out goes the defensive toll collector Transurban ((TCL)) and in comes the cyclically exposed building products manufacturer James Hardie ((JHX)). And along with James Hardie comes Australia's battered and war-torn investment bank, Macquarie Group ((MQG)).

The "upgrade" for Macquarie from the GS top-down analysis team is at odds with the broker's own bottom-up stock analysts. They retain a Hold rating following the release of MQG's first half FY12 earnings result on Friday. While acknowledging that stock analysts limit their views mostly to a 12-month horizon, while strategists are more inclined to change views on an open-ended time scale, the disparity of opinion amongst representatives of the same broking house accurately reflects a more general market view on the company which no longer carries the tag of "The Millionaires Factory".

I last reviewed analyst opinions on MQG following the release of its full-year FY11 result in a report entitled Macquarie A Matter Of Faith. Ever since the GFC destroyed MQG's previously successful infrastructure fund model, the Group has been forced to revert to being basically a common or garden investment bank once more. Such businesses rely on market sentiment and turnover, on demand for advice, broking services and investment opportunities, and on trading profitability potential. In short, it's difficult for an investment bank to make money when markets are weak and volumes are low. Unfortunately such conditions have been the state of play ever since 2008.

It was never going to be easy to predict just when global market sentiment would "normalise" in the wake of the historically rare event that was the GFC. No one was ready for Greece to become an issue in early 2010 and again in early 2011, leading the whole European debacle to dominate the last two years of activity. All Macquarie management has been able to offer at successive six-monthly earnings updates in the interim is guidance based on the caveat of "if market activity improves". It hasn't, so management has been forced to successively downgrade earnings expectations. As Goldman Sachs stock analysts suggest, "[Friday's] result has seen a continuation of the downgrade cycle which has further delayed MQG's recovery to mid-cycle returns".

The longer market sentiment remains subdued, the longer MQG must endure weakening earnings results, and thus the longer the path back to an improved return on equity (ROE). Macquarie could boast ROEs of 20% pre-GFC but at the moment it's lucky to reach 10%. Analysts see 20% as possible again one day but are looking to at least 15% in the shorter term if markets can improve. The longer that improvement takes, the more MQG bleeds and the more it is forced to cut costs and reduce staff. The risk is that such cost-cuts are held up by management on fear the bounce will come immediately after and upside recovery potential will be crimped. It was a matter of faith, analysts then suggested, that MQG was not doing much about cost cutting at end-FY11.

Since then, the European situation has come to a head, and we've suffered two of the most difficult trading months on record in August and September. No one was expecting MQG to post anything other than another weak trading result. It would simply come down to a matter of degree. As it was, the result mostly fell short of analyst expectations which had already been trimmed in the past quarter. As Credit Suisse points out, the "miss" was related to exactly the area one would expect ? the Capital Markets division.

On the other hand, analysts note fees from funds management and other "annuity-style" activities (those which provide more predictable earnings flow largely immune to specific market movements) were solid and better than expected. BA-Merrill Lynch values that "annuity" business at $28.86. The analysts suggest that even if one were to assume zero income from Capital Markets activities, another $7-14 of value could be released for the Group. Macquarie shares closed on Friday at $25.15.

Citi is following a similar trajectory in suggesting MQG's current share price implies an ROE of only 7% by FY14. If the Capital Markets businesses can reach at least an ROE of 10% by that time, Citi believes the stock should be trading 20% higher.

Aside from missing expectations and once again watering down guidance, management made two important announcements on Friday. The first was on the subject of cost cuts and the second related to an intended share buyback. MQG may well be struggling but it is not about to go out the back door. A Basel III update at the result release was welcomed by analysts and we can't forget the big dividend due the Group shortly from the MAp Group ((MAP)) restructure.

Analysts welcome an announced dividend cut. Shareholders may not welcome this news but announced cost-cutting initiatives including a reduction of 485 staff should provide a sufficient trade-off going forward. Dividends can only be paid to MQG shareholders after bonuses have been paid to MQG staff. However, on the matter of cost cuts more than one broker questions whether they go far enough.

Citi suggests "there remains scope to go even harder on costs" and UBS believes MQG needs to "right size" the investment bank to deliver more appropriate returns across the cycle. A headcount of 15,000 is down 3% but "still appears too high for MQG's revenue potential," says UBS.

On the matter of a proposed share buyback, analysts were universally supportive as this will go some way to assisting that much needed ROE improvement. However, only an intention to buy back was announced rather than an actual buyback being confirmed. While analysts believe management will be determinedly true to its word, there is a lot to be done before a buyback can proceed. MQG needs to optimise its capital structure, exit legacy businesses, raise hybrid capital, grow retained earnings and receive APRA approval. "This may take a while," says UBS. At least 12 months by JP Morgan's reckoning.

Yet as noted, the true bottom line for MQG is quite simply whether or not market conditions can improve. Brokers were expecting a better result on profit, dividends and outlook on Friday "but these are extraordinary market conditions," notes Citi, "and the stock may continue to rally if investors are relaxing their extreme aversion to risk".

In other words, investors stand to do very well out of MQG if market conditions can just start heading back towards "normal". This would imply positive market direction and a bit more certainty than has been the case in 2011. Or 2010. If markets can't do so then MQG is in for further downgrades and an even longer path back to the ROEs it once boasted. It then comes down to whether the market has now sufficiently priced down MQG. On that, analysts remain divided.

RBS (Buy) is happy to acquire MQG stock at current levels which it calculates to be 0.9x net tangible asset valuation. Merrills (Buy) agrees, and also points out an attractive 0.7x book value. Credit Suisse (Outperform) likes the book value too as well as an implied 7.7x forward PE. Citi (Buy) is forecasting less risk aversion from markets ahead and it, too, makes note of MQG's 10% discount to net tangible assets.

Deutsche Bank (Hold) suggests it's too difficult to know just when markets will return to "normal". JP Morgan (Neutral) believes management has laid out a clear path towards ROE improvement but "it is too early to 'pay ahead' for these prospects". Goldman Sachs (Hold) suggests a ROE greater than cost of equity looks an achievable goal over the next 2-3 years, but "the risk to earnings remains high".

All brokers have trimmed their FY12 earnings forecasts. Of the seven brokers covering MQG in the FNArena database, four have a Buy or equivalent rating and three a Hold or equivalent (Goldmans is not in the database and Macquarie is not allowed to rate itself). There are no Sell ratings. The consensus price target was impacted by moves both up and down post-result, and is today at $31.00 compared to $30.61 prior to Friday. The uncertainty of whether or not markets can "normalise" from here is nevertheless reflected in the wide target range, from $27 (UBS) to $40 (Credit Suisse).