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Morningstar | No Surprises in Macquarie Group’s 3Q19 Trading Update. FVE AUD 135 Unchanged. See Updated Analyst Note from 11 Feb 2019

There were no surprises in narrow-moat Macquarie Group’s third-quarter fiscal 2019 trading update and we retain our positive view and AUD 135 fair value estimate. Fiscal 2019 earnings guidance was reiterated with Macquarie expecting an increase in group net profit of up to 15% compared with the AUD 2.56 billion result in fiscal 2018. Guidance is subject to the usual challenges including market conditions, currency movements, and potential regulatory and tax uncertainties. Our fiscal 2019 earnings forecasts are for growth of 17% to AUD 3.0 billion, ahead of guidance and analyst consensus estimates of AUD 2.95 billion. At current prices the stock is undervalued, trading 7% below our valuation. Catalysts that could contribute to an above-guidance result include recent favourable currency movements and further asset realisations. Despite guidance, we see risk to the upside. Macquarie’s long-term commitment and investment in the renewable energy sector will accelerate and within the next decade will likely be a powerful contributor to group profits.

The update was typically brief with new CEO Shemara Wikramanayake following the customary format for trading updates. The diversified global financial services business continues to benefit from structural growth opportunities with strong performances from the two market facing businesses outweighed by softer results from the three non-market-facing businesses. Management advised the market-facing businesses of Macquarie Capital and Commodities and Global Markets delivered strong--but unspecified--December quarter profit contributions with year-to-date profits up significantly on the previous corresponding period, or pcp. Third-quarter fiscal 2019 profit contribution from the non-market-facing businesses was up on pcp, but down on year to date due to lower performance fees in Macquarie Asset Management offset by asset sales in Corporate and Asset Finance and strong continued growth in Banking and Financial Services.

As expected, balance sheet settings remain sound with surplus capital of AUD 4.0 billion up strongly from AUD 3.4 billion at Sept. 30, 2018. Macquarie Bank common equity Tier 1 ratio of 10.8%, based on Australian Prudential regulation Authority, or APRA, definitions, and 13.6% on a globally harmonised basis, exceed APRA’s January 2020 benchmark of 10.5%. Balance sheet leverage, liquidity and funding all comfortably exceeded regulatory minimums at Dec. 31, 2018. 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.

We like the globally diversified business model, low earnings volatility, high focus on risk management, strong returns on equity and quality management. Balance sheet strength, high capital ratios, diversified funding, and dividend sustainability attract. Key risks include weaker capital markets activity, lower profits on asset disposal, increased impairments and lower performance fees. 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 we particularly like the firm'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. Macquarie Asset Management and Macquarie Capital benefit from strong competitive advantages particularly in infrastructure, energy and real asset classes.

Macquarie’s three annuity-style businesses made up about 60% of group profit for first-half fiscal 2019, modestly below the longer-term trend of 70%. For fiscal 2019 we expect a contribution around the 60% level. In total, we forecast total divisional profit of approximately AUD 3.5 billion for the three annuity-style businesses in fiscal 2019 broadly flat on fiscal 2018. Collective return on equity, or ROE, for the three annuity businesses is expected to be around 19% for fiscal 2019, slightly below the 12-year historical average of approximately 20%.

Assets under management of AUD 532 billion at Dec. 31, 2018 were down modestly during the third quarter due mainly to negative market movements. During the quarter, Macquarie Infrastructure and Real Assets, or MIRA, raised AUD 8.7 billion in new equity investment capital, including AUD 7.4 billion in Europe. MIRA holds a significant AUD 24.3 billion of equity capital or “dry powder”, to deploy. Macquarie Investment Management was awarded AUD 8.4 billion in new funded institutional mandates and contributions. Macquarie Asset Management is a top 50 global asset manager, delivering strong and consistent earnings, high returns on equity and benefits from strong competitive advantages particularly in acquiring, operating and managing major critical infrastructure assets. Strong performance fees of AUD 595 million in fiscal 2018 will not repeat in fiscal 2019, with “only” AUD 282 million reported for first-half fiscal 2019. We expect only modest performance fee income in second-half fiscal 2019.

Corporate and Asset Finance’s asset and loan portfolio of AUD 22 billion at Dec. 31, 2018 was broadly in line with September 2018. The Corporate Asset Financing business is leveraged to increased economic activity and positive global growth. Banking and Financial Services continues to grow steadily with customer deposits modestly higher at AUD 51 billion, Australian mortgages of AUD 37 billion increased strongly, up 3%, during the three months since Sept. 30, 2018. Funds on investment platforms decreased 8% to AUD 83 billion due to negative market movements.

Macquarie Capital continues to report strong volumes and deal flow particularly in advisory activity in Europe, Australia and Americas with 78 transactions completed valued at AUD 155 billion in the quarter. American debt capital markets activity was down on a strong September 2018 quarter. Macquarie Capital has a long and successful track record investing in and advising on global infrastructure and real assets with increased focus on renewable energy projects. Commodities and Global Markets benefited from stronger activity in North American gas and power and increased volatility from higher levels of client hedging activity and trading results in structured foreign exchange in Europe.

In total, we forecast divisional profit of AUD 2.2 billion for the two capital market-facing businesses in fiscal 2019, up 39% on fiscal 2018. We are expecting a solid fourth quarter for the market-facing businesses, and there is upside risk to our fiscal 2019 profit forecasts for the two divisions. Collective ROE for the two market-facing businesses is expected to be around 20% for fiscal 2019, at the top end of the 12-year historical average of 15%-20%.