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High conviction picks and upgrade for Macquarie Group

Key points

  • The key themes of US dollar leverage, major banks, non-bank dividend growth and inbound tourism remain.
  • Macquarie Group, along with Westfield Corporation (WFD), Servcorp (SRV), CSL (CSL), Resmed (RMD), Brambles (BXB), Platinum Asset Management (PTM), and Magellan Financial Group (MFG), are leveraged to the US dollar.
  • Macquarie Group’s earnings per share (EPS) is only set to grow, which means it deserves a new 12-month target of $70.

 

In terms of Australian equity strategy, I am attempting to position for globally-driven yield compression meeting domestically-driven yield compression as the Reserve Bank (RBA) cuts the cash rate. I have a feeling we are all going to be surprised by how much money attempts to move down a reasonable narrow street and that is why my entire focus this year has been on dividend growth stocks (and currency-translated winners).

In an Australian context, these global growth downgrades mean ASX200 earnings growth will be harder to find. That is why I am looking for industrial ideas that can most likely grind out 6% EPS growth and generate a 6% plus pre-tax dividend yield. A 12% pre-tax total return may well look extremely attractive by the end of 2015 if bond yields are to be believed. That is why I recently upgraded Telstra and the big four banks.

High conviction ideas

I have attempted to move quickly at the Australian equity strategy level in three ways. Firstly, upgrading Telstra ($7.00 target) and the major banks (5% fully franked FY15 yield targets), secondly, reaffirming high conviction non-bank yield growth ideas, and thirdly, reiterating US dollar leverage and inbound tourism exposures as the Australian dollar heads towards 75 US cents. I have tried to get the message across in the big liquid stuff first. My high conviction ideas are listed below.

• Major banks

ANZ (ANZ), National Australia Bank (NAB), Westpac (WBC)

• Non-bank dividend growth

AMP (AMP), APA Group (APA), Challenger (CGF), Goodman Group (GMG), GPT (GPT), IAG (IAG), Transurban (TCL), Sydney Airport (SYD), Suncorp (SUN), Tabcorp (TAH), Telstra (TLS) Wesfarmers (WES) and Spark New Zealand (SPK).

• US dollar leverage

Westfield Corporation (WFD), Servcorp (SRV), CSL (CSL), Resmed (RMD), Brambles (BXB), Macquarie Group (MQG), Platinum Asset Management (PTM), and Magellan Financial Group (MFG). In the banks, ANZ (ANZ) generates the greatest proportion of USD earnings.

• Inbound tourism

Crown Resorts (CWN), Sydney Airport (SYD), Auckland Airport (AIA), Qantas (QAN), Air New Zealand (AIR.NZ), Village Roadshow (VRL), Ardent Leisure Group (AAD) and Sealink Travel Group (SLK). For the highly risk tolerant, Virgin Australia (VAH) is arguably worth a punt.

Macquarie Bank

I have consistently written, “currency translated EPS growth is EPS growth” and that key “US dollar earning stocks were cum consensus upgrades”. We got evidence of that earlier last week when Macquarie Group (MQG), who generates 65% of revenue outside of Australia, revised up their earnings guidance.

Macquarie Group is a member of my key high conviction US dollar earning ideas list alongside Westfield Corporation (WFD), Servcorp (SRV), CSL (CSL), Resmed (RMD), Brambles (BXB), Platinum Asset Management (PTM), and Magellan Financial Group (MFG). In the banks, ANZ (ANZ) generates the greatest proportion of USD earnings.

Macquarie Bank (MQG)

[1]

Source: Yahoo!7 Finance, 29 January 2015

Macquarie Group is now more of a fund manager than investment bank. I tend to think comparisons to US investment banks, and their cyclical profitability, are out of date. Macquarie has a lot more in terms of better quality, higher return on equity (ROE), and lower volatility income than its US-based peers.

With 62% of operating income now generated from “annuity-style” businesses that generate an ROE of 24%, and as I said above, 65% of revenue generated from offshore, I suspect Macquarie’s price to earnings ratio (P/E) is about to rise a few points to reflect the greater forecastability of EPS and dividend per share (DPS).

Macquarie didn’t give details of the drivers of the profit guidance upgrade but it’s fair to assume currency and advisory fees played a role. I also keep hearing market rumours they had a big win in oil trading, but that is yet to be confirmed.

Either way, I’m not too interested in the minutia, more that Macquarie has confirmed they have earnings leverage to our key macro theme: the US dollar.

The numbers

I have upgraded my FY15 net profit after tax (NPAT) estimate to $1,455 million and I now forecast MQG to generate 20% EPS growth in FY15 and 16% DPS growth.

Despite the share price bounce from recent lows, Macquarie remains a cheap US dollar leverage stock with the ability to deliver total returns above most ASX200 members. Again, that should lead to P/E expansion as growth becomes harder to find.

Based off a MQG share price of $60.00, below are my forecasts and multiples.

[2]

The only slight negative with Macquarie is that dividends are only 40% franked. However, this is the trade-off. If you want earnings growth driven via offshore revenue exposure, you are going to have to tolerate a lower level of franking.

Interestingly though, and this is a positive, shareholders are now getting a greater share of the growing revenue pie with the “compensation ratio” down to 43% in FY15 from 45% in FY14.

Macquarie remains a high conviction buy. The EPS/DPS forecasts are in an upgrade cycle. That cycle will be underestimated if I am right about my 75 US cents Aussie dollar target.

New target

By the time we get to the end of FY16 (March 2016) I expect Macquarie consensus EPS to be 500 cents. I expect the market will pay 14 times for that 500 cents EPS and therefore set a 12-month price target for Macquarie at $70.00.

That would equate to a 16.6% capital gain and 5.03% yield, taking potential total 12-month return above 20% even from today’s $60.00 share price.

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