MacBank smoke and mirrors
November 18, 2008
Sydney Morning Herald (Australia)
In the circumstances, this is quite a neat result from Macquarie, although it remains to grapple with more formidable matters: debt, smoke and mirrors.
We will deal with the accounting chipmunkery later.
First up, the headline number - a half-year profit of $604 million - came in just a tad below consensus estimates as both the operating income of $2.97 billion and the write-downs of $1.1 billion exceeded expectations.
Costs were commendably smashed 33% lower and, incredibly, performance fees were up.
The dividend payout ratio was ratcheted higher to keep the punters happy and earnings guidance was for more of the same in the present half for a full-year profit of $1.2 billion.These numbers are largely irrelevant, however, to the fate of Australia's most impressive financier. This stock is trading on a price/earnings ratio of five times for a reason.Headline claims that Macquarie has "conservative gearing'' are patently ridiculous. The debt load lies in the assets beneath. True, much of this $150 billion-odd in obligations is non-recourse to the mothership and sits in the assets controlled by the satellites but this is money that will have to be repaid, refinanced or extinguished somehow, and at some point.Just meeting the interest payments while deal-flow and cash-flow are under such intense pressure from the credit crisis is challenging enough.
We can leave the detailed results analysis to the experts and focus on another area which will prove tricky (more on the interim figures later).Now that the gloss has come off the "Macquarie model'' - don't mention Brisbane! - some real scrutiny will be brought to bear on the group's expedient accounting practices; and of course the various assumptions deployed in its valuations such as the "discount rate'' on its infrastructure assets.
This is critical to a complex beast such as Macquarie, which books profits, not only from cash earnings (fees and so forth) but from the uplift in valuations on the assets under its control.Fruit-salad accounting
Too much is taken as read by the market. When it comes to accounting, the company takes a fruit-salad approach, using whatever method is best to achieve an outcome. This is the case throughout. It will come back to bite.
While Macquarie has diversified brilliantly and the importance of its original infrastructure plays to the overall result have diminished it is worth looking at the stalwart Macquarie Infrastructure Group (MIG) as a case in point.
Where does MIG feature in the MacBank results?In its 2008 report, the group notes, "Specialist Funds - Macquarie is a manager of specialist funds which own assets in infrastructure and related sectors (toll roads, airports, communications infrastructure, utilities and other asset classes)''.MIG MIA
But where does MIG sit in this structure?There is no mention of toll roads in Macquarie Capital, which appear to be MIG's advisers. It's not in Equity Markets Group. There is no mention in Treasury and Commodities Group, nor in Real Estate Group.Financial Services Group
is wealth advisory and it's not in Banking and Securitisation.
Perhaps it's in Funds Management
- yet none of the descriptions there mention toll roads or infrastructure.'Mark-to-myth'
Macquarie claw fees out of the valuation uplift. Presumably, the MIG fees form part of the $4.645 billion "fee and commission income'' recorded in the full-year numbers ($2.2 billion for the half released today).
MIG's June accounts show the satellite owns only one toll road, which is the M6 road in the British Midlands. This is accounted for as an intangible asset and amortised over its useful life - all above board.
All the other roads are owned between 22.5% to 50%. In a normal treatment these would be equity accounted. Not by MIG though. The units are treated as financial assets "at fair value through profit or loss'', that is, they are "marked to market'' with value uplifts recorded as revenue and flowing to profit.Unfortunately, most of these units are not listed and MIG must use a valuation model to determine the fair values. This is what Warren Buffett dubs "mark-to-myth''.Moreover, this information won't be unearthed in the financial statements per se but in the separate Management Information Report.
That MIG is a triple-stapled security does not ease the burden of analysis.
Here MIG deploys DCF methodology (discounted cash-flow). This is all hunky-dory and signed off by the group's excellent auditors, PricewaterhouseCoopers.
The risk-free rate is the yield on 10-year government bonds in the relevant jurisdictions, plus a risk premium.Risk premiums
These figures are all laid out in the notes to the MIG report. Risk premiums range from 4% up to 9.5%.Given the recent toll road experience - counter to cherished beliefs it was found this year that toll revenues worldwide are in fact elastic when it comes to toll and fuel prices - one would be compelled to ask whether these risk premiums were actually appropriate.
Further, the year-to-date growth figures are provided in the MIG Management information Report for 2008. There are a lot of minus signs here
, an indication perhaps that higher risk premiums are required.
The Westlink M7 asset has a risk premium of 5%. Is this realistic for outer Sydney? PWC?
The Financial Accounting Standards Board (FASB) guidance on fair value estimation using company-generated figures suggests raising 15% risk premiums up to 25%. It would seem 5% is decidedly skinny.
For those who have not had the pleasure of getting acquainted with the beauties of the discount rate, it is a powerful little variable. The lower the discount rate (risk premium), the greater the fair value and the greater the fee - in this case to MIG and Macquarie.
Moving along, treating its investments as financial assets at fair value through the P&L (profit and loss) means that no debt is consolidated, that is, no debt materialises on the balance sheet from these infrastructure investments.Were you to employ equity accounting, you would book the investments at cost - which is broadly equivalent to net assets (after deducting the debt, that is) - and add in your share of profits each year.The road tollIn the early years of toll roads, the roads make losses because of high early depreciation, slow traffic build-up and start-up costs. This means that you don't show the share of debt. By treating them as financial assets at fair value through profit or loss, you mark to your own self-made market and don't bring in your share of early losses.
Linking this to the famous MacBank remuneration, it would be fair to say that if the group had not "upfronted'' its profits by this convenient "fair value'' treatment, its executives would have had to wait a lot longer to pull out their $30 million salaries.In fact, if profits were about cashflow rather than imaginative accounting, there would never have been a $30 million salary. Too late now: that cash is gone.
In 2007, MIG sold Sydney toll roads Eastern Distributor, M5 and M4 - via the spin-off of Sydney Roads Group - to Transurban. It is worthwhile pondering why Macquarie reduced its Australian holdings.Smoke and mirrorsResponding to questions over the accounting at today's presentation, Nick Moore avoided canvassing the magical reclassifications which had allowed the group to avoid taking a large hit on MIG and Macquarie Airports.
On the way up the bank happily booked big profits out of capital in MIG and MAP then took fees as a proportion of their heady market value. Now, on the way down, the fees are still coming in but neither the asset values in the satellites nor the plunging value of the satellites themselves have been recognised in the mothership's accounts.Then there is the accounting in the satellites themselves.
According to MIG: ''MIG ... (has) designated (its) non-controlling investments in toll road assets as financial assets at fair value through profit or loss.''
Under AASB 139, you can use that reclassification if the units were bought for ''trading'' (or because they are classified as such).
AASB 2008-10, released on October 24, provided a one-off chance to reclassify ''trading'' financial assets at fair value through profit or loss back to being a loan or receivable (or even as a held-to-maturity financial asset).
In that case, you would adopt amortised cost as the basis of accounting. You took fair value as at 1 July 2008 - before it all went pear shaped - and called that your cost basis. The amortised cost refers to amortising any difference between that ''new'' cost basis and the amount you will receive at maturity over the life of the asset.In other words, Macquarie and PWC apparently took a dog that had plummeted, and were able to go back to July 1 before the global meltdown. They could then reclassify it and make their calculations as if the market meltdown had not happened. There are words for this kind of treatment but they ought not to appear in print.These instruments whose fair value had gone through the floor are shown at a virtually unchanged value as at July 1, 2008.
The reclassification had to occur before November 1, or else Macquarie would have been forced to adopt fair value as at that date, that is, post the market disaster.
The MIG accounts say these units were ''designated''. If they were ''designated'' as such under AASB 139, reclassification was not an option. Hardly true, hardly fair.The good and the bad
Back to the half-year result. The good points are that operational income beat analysts' estimates.
The stock should therefore rally for a while. (Shares, in fact, spiked 26% at one point.)
That the writedowns were also higher than expected will instil confidence that the group is being frank with the market and taking the pain on the chin. If the market misses the accounting stuff that is.
Further, the adept management of costs - staff costs were cut by 48% with a big hit to the bonus pool - will bring optimism that Macquarie will survive the tumult. The personal cost to the ambitious army of bankers who signed up with $30 million bonuses deep on the radar and now find themselves lucky to have a base salary amid the global fall-out is another story.
The impressive flexibility of this company was on display once again when it came to meeting the need for lower costs. The cuts were primarily made in staff however. The cost-to-income ratio still rose.Outlook for jobs
Pursuant to a story here the other day about mass job cuts, Macquarie actually added to its headcount in the past six months. However, new boss Nick Moore batted away questions at the analyst briefing today as to how many would go.
It was a ''business by business'' decision, was the line.
On the face of it the Macquarie mothership's capital position seems comfortable, though a moving feast. In any perspective on this company the parent and its satellites should be analysed as separate entities (debt is higher in the latter) although it should never be forgotten that they are also intertwined.The trust structures enable the mother to adopt the fall-back position that they she has no legal obligations or liabilities when it comes to solvency. Still, fees flow from the trusts to the head-stock so they are linked financially and reputationally.The Brisbane connection
The contribution from Treasury and Commodities rose modestly, proving the group can make money in a volatile market. Likewise Macquarie Securities which did well in difficult conditions.
The negatives include the fact the result was bolstered once again by a low tax rate at 11%. The rise in performance fees was also a worry as satellite investors lost a lot of money. The question looms as to how sustainable are these performance fees.As evinced by the disaster of its BrisConnections infrastructure float, which is now offered at 0.01 cent, the retail satellite model is dead. Whether the wholesale fund model can take up the slack remains to be seen in a deadly environment for both asset values and growth in cashflow.A large element of the unknown presides. A few months ago nobody had heard of an Italian mortgage business.
Suddenly it counted for $200 million in writedowns. Now the analysts are wising up to other exposures such as the potential for a hit on Macquarie's Spirit Finance operation - a US real estate sale and leaseback business.
What else is in there is anybody's guess, in terms of potential for losses. In the meantime, there is trading revenue and a reasonable short- to medium-term capital buffer in the parent. This should buoy confidence for a time.The sort of accounting and disclosure issues canvassed above, however, will come back to haunt the Millionaires Factory.
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