Macquarie Bank’s recent Annual Report outlined a very solid headline profit result (earnings were up 22%) and impressive revenue growth (up 15%). While the 2008 results were a solid achievement given the financial turbulence of the past 12 months, incoming CEO, Nicholas Moore, dampened investor enthusiasm after noting it would be challenging for Macquarie to repeat its latest profit result. Macquarie shares have dropped more than ten percent since results were announced.
Some commentators have lavished praise on the bank and its strident risk management processes after it avoided much of the fallout from the sub-prime crisis. Of course, all Macquarie did to earn the applause was not invest in sub-prime, so such praise is akin to congratulating one’s offspring for not becoming addicted to crack cocaine.
While not opaque in the same sense as Allco or MFS, Macquarie doesn’t make it easy for investors to gauge exactly how stable their earnings are. Not only is Macquarie’s Annual Report 224 pages long (including more than 50 pages of Remuneration Report), it is reasonably difficult for investors to extract the most useful information.
To determine the intrinsic value of a company, investors try to determine a company’s future cash flows (or as a proxy, its future accounting earnings). This is tougher for complex financiers like Macquarie which earns income in vastly different means, from fund management, to traditional stock broking, to advising on transactions and, importantly, fees for managing assets.
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While Macquarie provides a segmented break-up of earnings (for example, Macquarie noted that 63% of earnings were derived by Macquarie Capital), it is extremely difficult to determine exactly how much Macquarie earns from advising outside parties (such as Wesfarmers or Rio Tinto) versus how much it earns from related parties (such as MIG or MAp). For its related party deals (and we use the term in a general, rather than a legal sense) Macquarie Bank earns money from skimming fees from assets it purchases and then sells to other Macquarie entities, as well as ongoing management and performance fees.
Income from third parties (such as providing takeover defence advice to Rio) is considered more stable and therefore, more “valuable” than origination, management or performance fees which will inevitably be weakened in the poor credit and asset environment. During 2008, Macquarie reported revenue of $4.6 billion from “fee and commission” income — however, to determine how much Macquarie creamed from associates, you need to scour all the way to page 167, where it is noted that Macquarie earned $1.52 billion in “fee and commission income” from associates and joint ventures. That is up from $967 million the previous year.
Most commentators also appear to have glossed over a substantial driver of Macquarie’s 2008 profit –a near $800 million surge in “net trading income”. Trading income represents money made by Macquarie by way of proprietary trading — that is, trading for itself rather that for clients. Prop trading is undertaken by all banks, but especially Goldman Sachs, which earned pre-tax profit of $US13.2 billion (out of $US17.04 billion) from “trading and principal investments”.
Largely as a result of Goldman’s dependence on proprietary profits, it trades on a price-earnings multiple of only 8.5, compared with 11.8 for JP Morgan or 23.3 for Morgan Stanley. Macquarie is somewhere in between, on a PE of around 9.5.While there is nothing wrong with prop trading, it is generally considered riskier than say, providing vanilla takeover advice. As Societe General and Barings found out the hard way, proprietary trading isn’t always profitable. While many, including well-regarded Jim Chanos have pointed to doubt over Macquarie’s fee income, few seemed to have picked up on its trading success.
Macquarie is the most “shorted” stock on the ASX — largely because many investors simply don’t believe Macquarie’s model is sustainable, ignoring the fact that its volatile trading operations contributed largely to the record profit. Either way, Nick Moore will certainly be working for his $25 million this year.