Barclays: At the Nadir
SEE LAST PAGE OF THIS REPORT Howard Mason
FOR IMPORTANT DISCLOSURES 203.901.1635
March 12, 2014
Barclays: At the Nadir
- Barclays has lost 20% of its value since the beginning of the year as a result of two factors which will have no enduring impact: (i) a 10% increase in the 2013 bonus pool; and (ii) disappointing year-to-date results for the FICC business. We believe the bank will achieve its target for a return on equity equal to the 11.5% estimate for cost-of-equity by 2016, and see this as consistent with a 20% stock-price premium to forward tangible book value of GBP3.00 (at end-2014) rather than today’s 20% discount to current tangible book value of GBP2.83.
- FICC: Client activity is running meaningfully below normal levels as limited volatility at the short-end of the curve reduces the need to reposition portfolios, as investors rethink strategy for the intermediate and long end of the curve after the Fed’s taper announcement in December, and most recently because of geo-political risk. Even if 2013Q4 industry-wide revenues are down 15-20% (as suggested by recent comments from JPM and C), full-year revenues will likely be flat-to-up, particularly given the easy compares of 2013H2, as client activity returns. There will be further improvement in activity and results in 2015 as short rates back up and the curve steepens.
- Compensation: Barclays is not going to make its targets with the comp-income ratio for the investment bank at the 2013 level of 43%. CFO Tushar Morzaria has committed to reducing the comp-income ratio (“We are committed to bringing it down and I know we will. We have to bring comp down”) and to a broader commitment to reduce firm-wide expenses to GBP16.8bn in 2016 (“Standing up here and having credibility, I have to find GBP2billion of reduction”).
- The bigger picture is that Barclays has a portfolio of attractive businesses with 25% of capital in UK branch banking and Barclaycard (generating returns well-above the cost of equity) and over one-third of capital in the investment bank (which, given normalized FICC activity and lower comp-to-income ratio generates at least the cost of equity).
- However, normalized firm-wide returns face a 2% drag from Europe as a legacy of the firm’s pre-crisis “dash for growth” (so that Europe retail banking lost near GBP1 billion in 2013, for example), and Barclays is responding by reducing the associated balance sheet and distribution infrastructure (including, for example, halving the number of branches in Spain, Italy, and France). We expect Europe breakeven by 2015 to be an important driver of improved firm-wide returns.
Barclays is now trading as cheaply as DB at a near-20% discount to current tangible book value of GBP2.83/share (see Exhibit 1). This is despite the fact that Barclay’s balance sheet has been vetted by the UK regulators (as part of the process leading up to regulatory approval, announced last July, for an increase in the dividend payout to 40-50% from the current 30%); as a result, we see less risk of negative surprise at Barclays from UK’s “CCAR-lite” stress tests than at DB from the ECB’s asset quality review process (a 12-month process for Eurozone banks beginning November 2012). Rather than a 20% discount to current tangible book value, we believe Barclays is worth a 20% premium to forward tangible book value (estimated at GBP3.00 for end-2014) consistent with a share price of GBP3.60.
Exhibit 1: Valuation of Global Banking Plays
Note: Basel 3 CET1 ratio requirements are color-coded with red for 9.5%, blue for 9%, green for 8.5%, orange for 8% and yellow for 7% (see Appendix)
FICC: Barclays is Structurally Advantaged
The stock has lost 20% of its value since early January in part because of downward revisions to investment banking revenues, and specifically trading revenues for the FICC business as client activity falls with uncertainty over tapering and, more recently, geo-political risk. On March 3rd, C warned that FICC revenues would be down “high mid-teens” and, on Feb 25th, JPM warned year-to-date FICC revenues were down 15%. FICC is an important business to Barclays accounting for 60% of investment banking revenue which, in turn, accounts for 38% of firm-wide revenue (see Exhibit 2). Even if FICC is down by these amounts for the first quarter, full-year revenues are likely to be flat-to-up because second-half FICC compares are relatively easy (because of the impact on client activity of the Fed’s taper announcement so that 2013Q3 FICC revenue at Barclays was GBP966mm versus GBP1.4bn in the second quarter).
Exhibit 2: Revenue Components for Barclays
Some investors are concerned that the revenue-declines in FICC are as much structural as cyclical (given higher capital requirements and changing practices for execution and clearing) so that client activity levels will not improve. While the move towards swap-execution-facilities (SEFs) and clearing houses is on-going and the ultimate impact is unclear, the decline in first-quarter results almost surely has a cyclical component with Jamie Dimon, for example, dismissing it as “just the weather” (as a metaphor for the business climate). Furthermore, the structural downshift at Barclays has already largely occurred as the transition to flow products is largely completed (see Exhibit 3) and as the industry-wide impact of liquidity-mismatch is fully absorbed (with dealer bond inventories, for example, now less than US$40bn versus $235bn in 2007).
Other investors are concerned that Barclays will be disadvantaged in investment banking because it is targeting a 2019 Basel 3 CET1 ratio of 11.5-12% versus 10-11% for large competitors such as JPM. We note that CFO Tushar Morzaria has consistently directed investors towards a target, at least in the context of the investment bank, of 10.4% adding “I’m not sure I will be making decisions that far in advance based off 12%”. In practice, by 2019, capital levels by line of business will be impacted by the implementation of ring-fencing and we do not expect UK regulators to put Barclay’s investment bank at a capital-disadvantage to global competitors.
Exhibit 3: Transition to Flow Products at Barclays
Looking beyond 2014Q1 results, we see Barclays investment bank, which accounts for 36% of firm-wide capital, as generating a normalizing return of 11-12% given, in particular, that it is a top-3 player in flow rates and currency products in both the US and Europe and that returns are correlated to market share (see Exhibit 4). The other significant franchises are UK branch banking which we view as a 13-15% ROE business and accounts for 15% of firm-wide capital, and Barclaycard which is a 15%+ ROE business and accounts for 10% of firm-wide capital. In short, and after allowing for head-office allocations, nearly two-thirds of Barclay’s capital is allocated to structurally-attractive businesses where Barclays has a structural advantage; we acknowledge that our inclusion of the investment bank in this category is counter-consensus but believe that cyclical factors, and in particular depressed levels of client activity and elevated comp-to-income ratios (above 40% at Barclays, for example, versus a target of mid-30’s), are masking normalized returns.
Exhibit 4: Returns in Trading Correlated to Market Share
Source: CSFB Presentation
Restructuring Europe Businesses
For us, the risk to Barclays is not so much the normalized return in the investment bank (particularly given that CFO Tushar Morzaria was previously the CFO of the Corporate and Investment Bank at JPM and so brings to the executive suite at Barclays a complementary set of skills to CEO Antony Jenkins and a strong focus on compensation management) but the 30% of capital invested in under-performing businesses (shown in the yellow and dark blue slices of Exhibit 5). In particular, the Corporate Bank absorbs 15% of equity and generates a sub-5% ROE and the “other” businesses (comprising equal parts branch banking in Africa, branch banking in Europe, and the wealth and investment management business) absorb 13% of equity and generated a loss in 2013 of nearly GBP1bn (almost entirely due to the European branch bank).
These poor returns are a legacy of Barclay’s pre-crisis “dash for growth” in Europe which is now being restructured through the disposal of low-return, balance-sheet assets (particularly mortgages) and branch rationalization (including closing roughly half of the branches in Spain, France, and Italy); as a result, we expect breakeven for Europe as a region (across the retail corporate bank) by 2015 and this will reduce the drag on firm-wide ROE.
Exhibit 5: Deployment of Capital at Barclays
Appendix: Basel 3 G-SIFI Buffers