What gives after record earnings in FY23? MQG delivered blow-out earnings in FY22 and FY23 with ROE expanding through 20%, driven by the Global Commodities & Markets (CGM) division.
CGM offers a vast array of financial services to both physical and financial customers in commodities markets. Services range from financing, hedging, inventory, storage and delivery with MQG replicating the many of the services commodity trading houses have performed. Earnings are leveraged to client activity, which in turn is leveraged to the underlying volatility in commodities. i.e. FY19 North American cold snap, FY23 Russia – Ukraine.
Investors underappreciate the capital intensity of CGM. Since FY19 CGM’s capital intensity has lifted by over $A6bn to ~$A9.5bn as client inactivity increased (35% of deployed capital). If client activity was to normalise, we would expect CGM to be able to release capital back to the Group. Whilst this would not fully replace lost earnings from CGM, it would help offset. $A3bn of capital released, deployed at 15% ROE, would add $A0.5bn of earnings MQG can generate.
Capital deployment is a catalyst over 2024. MQG has A$13bn of surplus capital. In our view the deployment of this capital is the key catalyst for the share price. A$13bn of surplus capital at 15% ROE, would generate A$2bn of earnings. MQG needs to deploy this to have any hope of filling that earnings growth hole that is likely in FY24 as the CGM business normalises.
Where could MQG deploy >$10bn of capital? Press speculation in March 2023 had MQG looking at UK listed fund manager and insurer M&G (MNG.L) with a market cap of $A9.5bn. Complementary assets/capabilities are always something that MQG is looking out for.
MQG PER 15x, PER rel in line with S&P/ASX200. Strong earnings performance of the last two years has not been capitalised into the share price. PER is in line with the MQG 10-year average, along with the PER rel. The market currently assumes FY24E earnings are 15% lower than FY23 as CGM normalises. 1Q24 earnings update expected 27 July 2023 at AGM.
Investment View
We regard MQG as one of the highest-quality large-cap companies on the ASX. A consistent track record of deploying incremental capital above its cost of capital has delivered strong compound earnings growth. Earnings growth has been in the top quartile of ASX 100 companies over the last 20 years.
A culture of strong leadership and capital discipline backed by a remuneration model which insures against the onset of hubris. We believe MQG’s competitive advantage of scale, industry expertise and adaptable business model can continue to generate strong returns on capital into the future.
Whilst visibility on MQG’s earnings drivers remains opaque, FY24E is likely to be a year of negative earnings growth (market currently assuming -15%) given the high base impacts of FY23.
Our Buy rating is premised on; 1) MQG being able to deploy surplus capital in an accretive manner over 2024/25E (something MQG has a strong track record); 2) an easing of global financial conditions as the global interest rate cycle peaks.
Risks to Investment View
The MQG share price is typically more volatile than the market. In a ‘risk off’ environment MQG will generally underperform the market. Key influences on MQG’s earnings include gains on asset sales/performance fees, client activity levels in M&A, and movements in equity and commodity markets.
Impairments and lending losses can be a drag on earnings.
Tighter than expected financial conditions would be a headwind to our Buy Rating.
We expect M&A will feature over the coming years given MQG’s strong balance sheet, which increases execution risk.
TIGHTENING FINANCIAL CONDITIONS ARE TYPICALLY ASSOCIATED WITH MQG UNDER-PERFORMING THE MARKET
MQG tends to underperform the S&P/ASX200 when global financial conditions are tightening (think higher interest rates, credit spreads, tightening lending standards, tightening measures of equity market risk). Intuitively there is some logic here.
In periods where financial conditions are very tight (think GFC or the Covid period) the ability for MQG to execute on transactions along with a general move down in asset prices combined with lower base and performance fees tends to place downward pressure on earnings. Some measures of US financial conditions look to have stabilised in 2023, Chicago Fed's National Financial Conditions Index (NFCI), being one.
Figure 1: MQG tends to underperform when financial conditions are tightening
Looking forward, the peaking of central bank cash rates (our forecast) over 3Q23 is one of the ingredients to an easing of financial conditions. If central banks can pull off a soft landing (without a wave of corporate defaults) then the outlook for MQG improves materially in our view. Equity markets across global indices are up >15% since the October 2022 low. MQG share price has performed in line with the market over that period.
CAN MQG SOLVE THE EARNINGS GROWTH HOLE IN 2024?
MQG will likely face an earnings growth headwind in FY24E. MQG gave guidance in May which flagged; 1) flat base fees in Asset Management; 2) higher transaction activity in MacCap; 3) growth in Banking and Financial Services; and 4) unforecastable conditions in CGM.
In sum, the market has interpreted that as -15% growth for FY24E, before reverting to mid-single-digit earnings growth in FY25-26E.
Figure 2: MQG’s long-term ability to grow earnings, faces a challenge in FY24. With earnings growth expected to be -15%
The critical assumption for FY24 is what level of earnings does CGM produce?
Revenues have exploded since FY19, up over x3 to just over $A6bn. Risk Management and Inventory & Trading product revenues have led the growth which has benefited from high levels of volatility in physical commodity markets, but also an expansion of services that CGM offers as well as expanded base of customers.
Figure 3: MQG’s CGM business has grown revenues >3x since FY19. This will likely create an earnings headwind for FY24E as activity will normalise at some point.
CAN >$13BN OF SURPLUS CAPTIAL BE DEPLOYED?
MQG state they have ~A$13bn of surplus capital, equivalent to ~20% of the current market cap. We chart below a stricter measure of surplus capital, removing hybrid securities (more debt-like in this context), which place MQG surplus capital at ~$7bn.
Figure 4: MQG has been able to grow surplus capital (and ROE) in recent years.
There are other sources of capital available to MQG. The CGM business has consumed close to $6bn of additional capital since FY19. Any slowdown in client activity should see a corresponding reduction in capital needed to be retained on the balance sheet.
The Australian business currently has a $A0.5bn additional capital surcharge applied by APRA (2021). There is a reasonable likelihood in our view that the regulator will ease this restriction on MQG later this year which could free up between $0.25 and 0.5bn of capital. Historically it takes around 2 years for APRA capital penalties to be unwound in banking.
Figure 5: CGM capital charge has increased by $6bn since 2019. CGM consumes 35% of Group capital
Over and above the internal sources of capital, MQG could tap equity investors to support growth initiatives.
Historically, a lift in growth expectations has outweighed the drag from additional share issuance, with the share price typically outperforming the S&P/ASX 200 after a large-scale acquisition.
Figure 6: ex GFC, major acquisitions have typically been accompanied by relative share price outperformance vs S&P/ASX 200
The motivation to deploy surplus capital can be seen in the falling ROE that the drag of surplus capital creates. The market is currently looking for reported ROE to fall from 18% in FY23 to ~14% in FY24E.
Figure 7: MQG’s surplus capital begins to drag on ROE over FY24-26E in the absence of additional earnings
WHAT COULD EARNINGS ACCRETION LOOK LIKE?
If $A6bn of capital was released, and deployed at 15% ROE, there is almost $1bn of earnings MQG can generate once fully deployed.
This would more than offset the earnings growth hole which is apparent in FY24E. We expect MQG will look towards acquisitions rather than consider share on market-buybacks, given the opportunity set available to MQG.
Press speculation in March 2023 had MQG looking at UK listed fund manager and insurer M&G (MNG.L) with a market cap of $A9.5bn. MQG has not commented on the transaction.
Complementary assets/capabilities are always something that MQG is looking out for.
“It behoves us to have capital in case there may be acquisitions, for example, in the asset manager in a Delaware-like opportunity – in terms of the correction that happened when we invested in that business,” Shemara Wikramanayake (CEO Macquarie Group) MQG Analyst Briefing February 2023
MACQUARIE GROUP VS GLOBAL COMPS
Figure 8: MQG trades at a per discount to global peers. Share price has underperformed peers CYTD
