Barclays: 2016 ROE Target Achievable Given Competitive Strength of Investment Bank

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SEE LAST PAGE OF THIS REPORT Howard Mason

FOR IMPORTANT DISCLOSURES 203.901.1635

hmason@ssrllc.com

November 16, 2013

Barclays: 2016 ROE Target Achievable Given Competitive Strength of Investment Bank

  • Half of Barclay’s risk-weighted assets (RWA) are in businesses which do not meet the cost-of-equity (COE, estimated by management at 11.5%). We expect improving returns at the investment bank, together with a mix-shift in the portfolio so that RWA are deployed more efficiently, to allow management to meet its 2016 target for the firm-wide ROE to equal COE. Specifically:
  • Excluding legacy assets, the investment bank can achieve a 15% ROE by 2016 given its scale-advantage in flow businesses and ability to meet leverage requirements through actions, such as derivatives compression and repo-downsizing, with no meaningful revenue impact (see our note of Nov 10th entitled “Swaps Compression will Reduce Barclays Balance Sheet”).
  • With the balance of quadrant-1 “growth” business units being high-return (including units from UK RBB, and linked wealth-management units, and Barclaycard), improved profitability in the investment bank means quadrant-1 businesses as a whole can generate an ROE of 15%
  • The firm-wide ROE target is then achievable if other non-legacy businesses can generate returns equal to the COE (already true for quadrant-3 “harvest” businesses which are sources of capital and credibly-achievable for quadrant-2 “under-managed” businesses given cost-reduction plans).
  • The above analysis assumes no mix-shift in the current business portfolio. In practice, downsizing of quadrant-4 “legacy” businesses and growth of quadrant-1 businesses will add ~1.5% to firm-wide ROE (see Exhibit, left panel). This mix-shift to higher-return businesses gives Barclays leeway; for example, it can meet its firm-wide ROE target if quadrant-1 businesses generate an ROE of only 13% (see Exhibit, right panel) rather than our forecast 15%.

Exhibit: Scenarios for Return and RWA-Mix for Barclay’s Business Units by Quadrant

Investment Conclusion

We expect Barclay’s stock to trade to tangible book value of GBX295/share, from the current GBX250/share, at or before year-end when the new CFO Tushar Mozaria provides more concrete plans for how the investment bank will support compliance with a 3% leverage ratio by mid-2014 through derivatives compression and downsizing the repo book; these actions will have minimal revenue impact.

Through 2014, we expect Barclays to trade at a widening premium to tangible book value as investors gain confidence in the achievability of the 2016 target that ROE match the cost-of-equity (estimated by management at 11.5%). In particular, we expect the scale-advantaged position of the investment bank in flow rates, currency, and credit products to drive a 15% ROE excluding legacy assets (but after allocation of head-office items). Given the high-returns from other “quadrant 1” businesses including retail branch banking (RBB) and wealth management in the UK and Barclaycard, along with a portfolio mix-shift to higher-return business as legacy “quadrant 4” units are discontinued and cost-management improves returns in under-managed “quadrant 2” units, we expect improving profitability at the investment bank to drive firm-wide returns to target.

Expect 15% ROE from Investment Bank excluding Legacy Assets

Investors are paying a great deal of attention to the investment bank at Barclays given it accounts for ~50% of revenues and has a balance-sheet that is disproportionately affected by regulatory requirements and particularly the acceleration of the minimum leverage ratio of 3%, as defined by the UK’s Prudential Regulatory Authority (PRA), to mid-2014 from mid-2015; of course, this precipitated Barclays announcement in July of a GBP5.8bn rights issue and likely the subsequent under-performance of the stock which now trades at a 15% discount to tangible book value.

However, strategically, the investment bank is one of Barclay’s strongest businesses and the path to regulatory compliance is fairly straightforward: manage-down legacy assets, eliminate businesses which are not client-facing, and reduce the leverage ratio through derivatives compression and downsizing the repo book (with minimal revenue impact as discussed in our note of November 10th entitled “Swaps Compression and Central Clearing will Reduce Barclays Balance Sheet More than Expected”). We expect the new CFO, Tushar Mozaria (who has a background from JPM’s derivatives controlling function), to provide credible, concrete plans at or before year-end results and catalyze a revaluation of the stock to tangible book value/share of GBX295 from the current GBX250.

The core of Barclay’s investment banking business (accounting for ~60% of revenues) is a scale-advantaged flow business with top-3 rankings in key products (see Exhibit 1). The firm has strategically shifted the revenue mix to flow businesses (so that, for example, flow products account for 90% of rates business up from two-thirds in 2010) and invested in technology solutions providing clients with seamless access to otherwise disaggregated liquidity along with pre-trade support for price-discovery and post-trade support for portfolio and collateral management. We believe scale-advantaged “markets” businesses are comfortably capable of generating normalized return-on-equity in the mid-teens (see Exhibit 2 from Credit Suisse) and expect Barclays to achieve this in line with its 2016 target (although the reported number will likely be ~12% given a 3% drag from legacy assets).

Exhibit 1: Positioning of Barclay’s Markets Businesses

Exhibit 2: Relationship between Scale and Return for Markets-Related Businesses at CS

The Portfolio Mix-Shift in Barclay’s Businesses

Beyond improving returns from the investment bank, the firm-wide ROE at Barclays will benefit from a portfolio mix-shift. As noted by CEO Anthony Jenkins in February in announcing the “Transform” restructuring plan (see Exhibit 3), ~50% of Barclay’s risk-weighted assets (RWA) is deployed into businesses that are not currently able to generate a sustainable ROE above the cost-of-equity (estimated by management at 11.5%). Improving returns in under-managed “quadrant 2” units and discontinuing legacy “quadrant 4” units will create a favorable mix-shift in the portfolio of businesses and lift firm-wide returns by ~1.5%.

Exhibit 3: GBP154bn of Barclay’s RWA (half of total) in Low-Return Businesses

Of course, business units in the investment bank are a contributor to the under-performing “quadrants” (see Exhibit 4) and likely the driver behind management’s goal of reducing RWA in quadrant-4 by GBP50bn but other segments, particularly the wealth/investment management business and retail branch-banking businesses (RBB) in Europe and Africa and, are also well-represented (see Exhibit 4). In describing the quadrants, the CEO made the following observations:

  • Quadrant 1 (“Growth”): These are businesses where Barclays will continue to invest and grow, and targets an eventual ROE of 18%; it includes the scale-advantaged FICC businesses of the investment bank, all but one unit of the UK RBB and of Barclaycard, and most units of the wealth/investment management business.
  • Quadrant 2 (“Under-Managed”): These are businesses which Barclays expects to move into Quadrant 1 through repositioning and/or cost-management, and generate an ROE of 11.5% by 2016; it includes nearly many business units from RBB in Africa and Europe as well as some units from the corporate and investment banking businesses.
  • Quadrant 3 (“Harvest”): These are businesses, primarily in Europe or non-client activity in the investment bank, which will be sources of capital including through sale. A large portion of this is the repositioning of the Europe RBB to serve mass-affluent customers with wealth-management product rather than the current broader retail banking business.
  • Quadrant 4 (“Discontinue”): These are RWA-intensive legacy businesses which are being discontinued; expect RWA to fall by GBP50bn.

Exhibit 4: Barclays Faces a Broader Challenge in Boosting Returns than the Investment Bank Alone

An immediate observation is that if management is able to achieve an ROE of 18% for the business units in quadrant-1 then the 2016 target for a firm-wide ROE above the cost-of-equity is a sandbag. It is probably more realistic to assume the quadrant-1 businesses reach an ROE of 15% by 2016 in which case the firm-wide target is achievable with the current portfolio mix assuming no net loss from quadrant-4 and an ROE equal to the cost-of-equity for quadrants 2 and 3 (see Exhibit 5, left panel); in practice, there will be an RWA mix-shift from quadrant 4 to quadrant 1 businesses so that the firm-wide ROE target can be exceeded. Indeed, given the likely mix-shift in the portfolio, the firm-wide ROE target can be achieved even if the quadrant 1 businesses generate an ROE of only 13% (see Exhibit 5, right panel).

Exhibit 5: Scenarios for Return and RWA-Mix for Barclay’s Business Units by Quadrant

SEE LAST PAGE OF THIS REPORT Howard Mason

FOR IMPORTANT DISCLOSURES 203.901.1635

hmason@ssrllc.com

November 16, 2013

Barclays: 2016 ROE Target Achievable Given Competitive Strength of Investment Bank

  • Half of Barclay’s risk-weighted assets (RWA) are in businesses which do not meet the cost-of-equity (COE, estimated by management at 11.5%). We expect improving returns at the investment bank, together with a mix-shift in the portfolio so that RWA are deployed more efficiently, to allow management to meet its 2016 target for the firm-wide ROE to equal COE. Specifically:
  • Excluding legacy assets, the investment bank can achieve a 15% ROE by 2016 given its scale-advantage in flow businesses and ability to meet leverage requirements through actions, such as derivatives compression and repo-downsizing, with no meaningful revenue impact (see our note of Nov 10th entitled “Swaps Compression will Reduce Barclays Balance Sheet”).
  • With the balance of quadrant-1 “growth” business units being high-return (including units from UK RBB, and linked wealth-management units, and Barclaycard), improved profitability in the investment bank means quadrant-1 businesses as a whole can generate an ROE of 15%
  • The firm-wide ROE target is then achievable if other non-legacy businesses can generate returns equal to the COE (already true for quadrant-3 “harvest” businesses which are sources of capital and credibly-achievable for quadrant-2 “under-managed” businesses given cost-reduction plans).
  • The above analysis assumes no mix-shift in the current business portfolio. In practice, downsizing of quadrant-4 “legacy” businesses and growth of quadrant-1 businesses will add ~1.5% to firm-wide ROE (see Exhibit, left panel). This mix-shift to higher-return businesses gives Barclays leeway; for example, it can meet its firm-wide ROE target if quadrant-1 businesses generate an ROE of only 13% (see Exhibit, right panel) rather than our forecast 15%.

Exhibit: Scenarios for Return and RWA-Mix for Barclay’s Business Units by Quadrant

Investment Conclusion

We expect Barclay’s stock to trade to tangible book value of GBX295/share, from the current GBX250/share, at or before year-end when the new CFO Tushar Mozaria provides more concrete plans for how the investment bank will support compliance with a 3% leverage ratio by mid-2014 through derivatives compression and downsizing the repo book; these actions will have minimal revenue impact.

Through 2014, we expect Barclays to trade at a widening premium to tangible book value as investors gain confidence in the achievability of the 2016 target that ROE match the cost-of-equity (estimated by management at 11.5%). In particular, we expect the scale-advantaged position of the investment bank in flow rates, currency, and credit products to drive a 15% ROE excluding legacy assets (but after allocation of head-office items). Given the high-returns from other “quadrant 1” businesses including retail branch banking (RBB) and wealth management in the UK and Barclaycard, along with a portfolio mix-shift to higher-return business as legacy “quadrant 4” units are discontinued and cost-management improves returns in under-managed “quadrant 2” units, we expect improving profitability at the investment bank to drive firm-wide returns to target.

Expect 15% ROE from Investment Bank excluding Legacy Assets

Investors are paying a great deal of attention to the investment bank at Barclays given it accounts for ~50% of revenues and has a balance-sheet that is disproportionately affected by regulatory requirements and particularly the acceleration of the minimum leverage ratio of 3%, as defined by the UK’s Prudential Regulatory Authority (PRA), to mid-2014 from mid-2015; of course, this precipitated Barclays announcement in July of a GBP5.8bn rights issue and likely the subsequent under-performance of the stock which now trades at a 15% discount to tangible book value.

However, strategically, the investment bank is one of Barclay’s strongest businesses and the path to regulatory compliance is fairly straightforward: manage-down legacy assets, eliminate businesses which are not client-facing, and reduce the leverage ratio through derivatives compression and downsizing the repo book (with minimal revenue impact as discussed in our note of November 10th entitled “Swaps Compression and Central Clearing will Reduce Barclays Balance Sheet More than Expected”). We expect the new CFO, Tushar Mozaria (who has a background from JPM’s derivatives controlling function), to provide credible, concrete plans at or before year-end results and catalyze a revaluation of the stock to tangible book value/share of GBX295 from the current GBX250.

The core of Barclay’s investment banking business (accounting for ~60% of revenues) is a scale-advantaged flow business with top-3 rankings in key products (see Exhibit 1). The firm has strategically shifted the revenue mix to flow businesses (so that, for example, flow products account for 90% of rates business up from two-thirds in 2010) and invested in technology solutions providing clients with seamless access to otherwise disaggregated liquidity along with pre-trade support for price-discovery and post-trade support for portfolio and collateral management. We believe scale-advantaged “markets” businesses are comfortably capable of generating normalized return-on-equity in the mid-teens (see Exhibit 2 from Credit Suisse) and expect Barclays to achieve this in line with its 2016 target (although the reported number will likely be ~12% given a 3% drag from legacy assets).

Exhibit 1: Positioning of Barclay’s Markets Businesses

Exhibit 2: Relationship between Scale and Return for Markets-Related Businesses at CS

The Portfolio Mix-Shift in Barclay’s Businesses

Beyond improving returns from the investment bank, the firm-wide ROE at Barclays will benefit from a portfolio mix-shift. As noted by CEO Anthony Jenkins in February in announcing the “Transform” restructuring plan (see Exhibit 3), ~50% of Barclay’s risk-weighted assets (RWA) is deployed into businesses that are not currently able to generate a sustainable ROE above the cost-of-equity (estimated by management at 11.5%). Improving returns in under-managed “quadrant 2” units and discontinuing legacy “quadrant 4” units will create a favorable mix-shift in the portfolio of businesses and lift firm-wide returns by ~1.5%.

Exhibit 3: GBP154bn of Barclay’s RWA (half of total) in Low-Return Businesses

 

Of course, business units in the investment bank are a contributor to the under-performing “quadrants” (see Exhibit 4) and likely the driver behind management’s goal of reducing RWA in quadrant-4 by GBP50bn but other segments, particularly the wealth/investment management business and retail branch-banking businesses (RBB) in Europe and Africa and, are also well-represented (see Exhibit 4). In describing the quadrants, the CEO made the following observations:

  • Quadrant 1 (“Growth”): These are businesses where Barclays will continue to invest and grow, and targets an eventual ROE of 18%; it includes the scale-advantaged FICC businesses of the investment bank, all but one unit of the UK RBB and of Barclaycard, and most units of the wealth/investment management business.
  • Quadrant 2 (“Under-Managed”): These are businesses which Barclays expects to move into Quadrant 1 through repositioning and/or cost-management, and generate an ROE of 11.5% by 2016; it includes nearly many business units from RBB in Africa and Europe as well as some units from the corporate and investment banking businesses.
  • Quadrant 3 (“Harvest”): These are businesses, primarily in Europe or non-client activity in the investment bank, which will be sources of capital including through sale. A large portion of this is the repositioning of the Europe RBB to serve mass-affluent customers with wealth-management product rather than the current broader retail banking business.
  • Quadrant 4 (“Discontinue”): These are RWA-intensive legacy businesses which are being discontinued; expect RWA to fall by GBP50bn.

Exhibit 4: Barclays Faces a Broader Challenge in Boosting Returns than the Investment Bank Alone

An immediate observation is that if management is able to achieve an ROE of 18% for the business units in quadrant-1 then the 2016 target for a firm-wide ROE above the cost-of-equity is a sandbag. It is probably more realistic to assume the quadrant-1 businesses reach an ROE of 15% by 2016 in which case the firm-wide target is achievable with the current portfolio mix assuming no net loss from quadrant-4 and an ROE equal to the cost-of-equity for quadrants 2 and 3 (see Exhibit 5, left panel); in practice, there will be an RWA mix-shift from quadrant 4 to quadrant 1 businesses so that the firm-wide ROE target can be exceeded. Indeed, given the likely mix-shift in the portfolio, the firm-wide ROE target can be achieved even if the quadrant 1 businesses generate an ROE of only 13% (see Exhibit 5, right panel).

Exhibit 5: Scenarios for Return and RWA-Mix for Barclay’s Business Units by Quadrant

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