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Morningstar | Macquarie Upgrades Earnings Guidance Again. FVE Increased 4% to AUD 135

Narrow-moat-rated Macquarie Group continues to demonstrate the strength of its diversified, yet interconnected business units with the strong first-half fiscal 2019 performance and a second earnings upgrade in two weeks. Macquarie’s two market-facing business (Macquarie Capital and Commodities and Global Markets) are benefiting handsomely from stronger capital markets activity and confidence complementing a slightly softer performance from the three non-market-facing businesses. Following our post result management catch up, we are more convinced the global leader in infrastructure asset management and renewable energy is well placed to generate impressive earnings growth. Based on the stronger earnings outlook, we increase our fair value estimate 4% to AUD 135 per share with our fiscal 2019 forecast profit increasing to AUD 3.0 billion from AUD 2.7 billion previously.

We forecast the dividend increasing to AUD 6.20 per share in fiscal 2019, 45% franked, based on a 70% payout, in the middle of the 60%-80% target range. At current prices, the stock is undervalued, trading 11% below our upgraded valuation. We continue to see strong structural growth opportunities across most of Macquarie’s business units. Following the Australian Competition and Consumer Commission’s approval for the sale of Quadrant Energy to Santos, Macquarie provided a brief upgrade to fiscal 2019 earnings guidance to reflect the AUD 130 million post-tax profit from the sale of its 21.8% stake in Quadrant. Updated guidance is now targeting an increase in fiscal 2019 earnings of up to 15% compared with previous guidance of an approximate 10% increase in profit. Previous guidance was issued on Nov. 2, 2018 with the release of first-half fiscal 2019 results. Macquarie reported earnings of AUD 2.56 billion in fiscal 2018, therefore, based on updated guidance fiscal 2019, earnings should be at least AUD 2.94 billion subject to normal qualifications and allowances.

The stellar performance of the two market-facing businesses (Macquarie Capital and Commodities and Global Markets) was significantly ahead of expectations, contributing 43% of group business unit contribution in first-half fiscal 2019 up from a multiyear average contribution around 30%. We like management’s confidence in the second half particularly around the timing of asset sales. We now forecast fiscal 2019 profit will be 17% higher than fiscal 2018.

Despite the strong first-half group profit, a higher share count resulted in a modestly lower, but still impressive annualised return on equity of 16.3%. Increased investment in organic business opportunities is slowly absorbing excess capital resulting in the cancellation of the previously announced, but unutilised AUD 1.0 billion on market share buyback. The recent dip in return on equity seems temporary with a higher ROE expected when recent new investments reach maturity.

Our positive long-term view is intact with EPS forecast to grow an average of 8% per year for the next five years. Macquarie continues to benefit from an earnings upgrade cycle and there is upside risk to our earnings forecasts. We particularly like Macquarie’s long-term commitment and investment in the global renewable energy sector with accelerated investment expected during the next decade, which in our view will boost group profits and shareholder returns.

We like the strong increase in equity under management, up a very healthy 23% to AUD 106 billion during the six months to Sept. 30, 2018 due to acquisitions and new equity raised. Importantly, base management fees are generated on the equity under management and we expect a corresponding increase in management fees in second-half 2019.
Macquarie has long been known for its strong and shrewd leadership, particularly its stable senior management team. Even though there will shortly be a change in CEO, we see no risk in a change of strategy when CEO designate Shemara Wikramanayake takes over from Nicholas Moore on Dec. 1, 2018.

Key downside risks include a slowdown in the global economic growth, weaker capital markets, lower profits or losses on asset disposals, increased impairments, nonrepeat of performance fees, and reputational damage from potential management mis-steps. The group continues to benefit from robust global investment market conditions and strong demand for infrastructure and energy assets, but a reversal of these tailwinds would likely drive Macquarie’s profits and dividend lower with the share price likely to suffer.

Higher forecast profits and the retail investor-friendly dividend payout underpin our attractive forecast yield of 5.2% for fiscal 2019 and 5.5% for fiscal 2020. Across the group, approximately 67% of net operating income is sourced offshore and a 10% average movement in the Australian dollar against all major currencies is estimated to increase/decrease full-year net profit by approximately 7%.

We believe there is more to come in the earnings upgrade cycle and retain our positive view on the international-focused asset manager and investment banking group. As expected, Macquarie continues to benefit from improved trading conditions, a lower Australian dollar and underlying business growth.

The key to Macquarie’s long-term success is its strong balance sheet, surplus capital, robust liquidity and funding positions and conservative approach to risk management, and importantly we do not see any of these factors changing any time soon. Fiscal 2019 guidance is subject to the completion of investment transactions, market conditions, the impact of foreign exchange movements, potential regulatory changes, and tax uncertainties. Despite these uncertainties, we are increasingly confident the firm can achieve our medium-term earnings forecasts. We retain our medium uncertainty rating and narrow moat rating.