Barclays: Expect Improved Guidance for Profitability and Leverage
SEE LAST PAGE OF THIS REPORT Howard Mason
FOR IMPORTANT DISCLOSURES 203.901.1635
February 7, 2014
Barclays: Expect Improved Guidance for Profitability and Leverage
- With 2013 results and cost-cutting measures on Feb 11th, we expect Barclays to announce: (i) a 5-year target for a low-to-mid-teens return-on-equity replacing the current anemic target for a return in excess of the cost-of-equity, estimated at 11.5%, by 2016; and (ii) a reduction in leverage exposure of GBP50bn and increase in the cumulative target for mid-2014 to GBP100bn (from GBP65-80bn). These targets are consistent with a share price of 350p representing 1.2x tangible book of 295p.
- Improved guidance for leverage exposure will be enabled by derivatives compression and downsizing of the matched repo book so reducing CRDIV add-ons of GBP295bn and GBP98bn respectively. The new target cuts leverage exposure below GBP1.4bn by mid-2014 and, given pro-forma capital of GBP43bn (after the rights-issue of GBP5.8bn, GBP2bn of AT1 issuance, and GBP4.1bn of PRA capital-haircut), makes a 3% leverage ratio visibly achievable.
- Investment Bank: The swing factor to profitability at Barclays is the investment bank which absorbs ~40% of capital and has a target return-on-equity, after a 3% drag from legacy portfolios (such as the credit correlation book) of 11-12% by 2015. Given legacy-book run-off and the benefits of a business mix-shift to flow products come through (in the form, for example, of a comp-to-income ratio in the mid-30s versus the current 40%+ and asset growth materially below single-digit income growth), we expect management to confirm return-guidance for the mid-teens over a 5-year horizon.
- Barclays is structurally-advantaged in FICC (over 40% of IB revenues) because of technology investment to lower cost (through automated pricing and risk management without the need for human intervention) and increase customer value-add (through providing access to liquidity across multiple trading venues). These investments make the business scale- rather than capital-intensive creating advantage to Barclays as a top-3 player in flow rates, flow credit, and G10 currency (see Exhibit below).
- UK Branch Banking and Barclaycard: 25% of Barclays capital is deployed in businesses which are intrinsically advantaged including UK branch-banking (absorbing 15% of capital where Barclays is one of the “big-4” players in a stable oligopoly and can expect through-the-cycle low-to-mid-teen returns) and Barclaycard (absorbing 10% of capital and already generating high-teens returns).
- Corporate Bank and Europe/Africa/Wealth: The rest of Barclay’s capital is in businesses which are under-performing (15% in the corporate bank and the balance spread roughly equally between branch banking in Europe, branch banking in Africa, and wealth/investment management). At the corporate bank, for example, returns-on-equity are 7% because of a cost-to-income ratio of 55%. The bank loses ~GBP200mm/quarter in retail and branch banking in Europe, and the wealth and investment management business generates a return-on-equity of 2% with a cost-to-income ratio of 90%. We expect these businesses to be subject to aggressive expense-management.
Exhibit 1: A Scale- and Technology-Advantaged Business Model for FICC at Barclays
Having rallied towards tangible book value of 290p/share, Barclays has traded down since the middle of January on disappointing FICC results from European competitors (DB, which reported on Jan 19th, was down 31% year-on-year), a warning on Jan 29th of a GBP330bn charge for legal and regulatory issues (smaller than DB’s of EUR2.3bn but a reminder of the open-ended nature of the risks associated with alleged manipulation of the rate and currency markets), and confusion over bank plans, if any, to downsize its UK branch network (the FT reported the bank would close one-quarter of its 1,600 branches and management responded that it would not address branch closures in the earnings call on February 11th).
In practice, Barclays will continue to downsize the UK branch network (already down 8% from 1,733 is 2012 in line with the industry) as more customers migrate to mobile channels for some needs; indeed, management has commented that a combination of the cloud and smartphones opens the way to serve some customers more efficiently and small in-store branches (at ASDA, for example) are planned. We also expect the FT is correct that there will be meaningful reductions in senior investment banking jobs: the FICC revenue pool of ~EUR110bn in 2013 is down nearly one-third from its peak in 2009 and Barclays has been among the most aggressive at shifting its mix to flow business (rather than high mark-up customized product) and using technology to intermediate flow transactions. In short, whether in the institutional or retail businesses, Barclays is using technology to structurally modify the business model.
The consequence for investors of structural and firm-wide use of technology will be greater operating leverage and, in due course, higher returns. We expect CEO Antony Jenkins to update the return-target (which, at present, is anemic: above the cost-of-equity by 2016 based on achieving a CET1 ratio of 10.5% by 2015) and present a firm-wide target for the ROE of low-to-mid-teens over a 5-year horizon. This is consistent with a price-to-tangible book ratio of at least 1.2x and hence a valuation of 350p, and we would expect to raise this target price over time with improving visibility into achievement of the return-target.
Firm-wide Returns on Equity
Investors properly focus on the investment bank at Barclays which absorbs nearly 40% of equity capital and is presently targeting a 2015 return-on-equity of 11-12% after a 3% drag from legacy portfolios; we think this is too low and, on Feb 11th, expect management to confirm a longer-run target of mid-teens supported by a GBP50bn reduction in CRDIV assets and an increase in the target reduction by mid-2014 to GBP100bn from the current GBP65-80bn; as discussed below, this will address concerns about meeting a 3% leverage ratio and hence remove an important overhang on the stock.
Before looking in more detail at the investment bank, we note that one-quarter of Barclays capital is invested in highly-advantaged businesses: the UK branch bank (15% of capital) with a near-20% share of UK branches of ~8,800 is a through-the-cycle mid-teens return business in a stable oligopoly; and Barclaycard (10% of capital) which already generates high-teens returns. Other businesses are under-managed and we assume will be subject to aggressive expense-management and/or downsizing; these are corporate banking absorbing 15% of capital and three other businesses (branch-banking in Europe, branch-banking in Africa, and wealth/investment management) each absorbing ~5%. For example, wealth and investment management generates a return-on-equity of under 2% with a cost-income ratio of 90% while Barclays loses over GBP200mm/quarter in its Europe retail and branch-banking business. The corporate bank is better with a 7% return-on-equity but this is with a cost-income ratio of 55%; a cost-income ratio of 40% raises this return to 11-12%.
The Investment Bank: Leverage Ratio
Investors are concerned at the prospects for long-run profitability in investment banking in general because increased capital requirements make it less economic to offer high mark-up over-the-counter product (despite high mark-ups) and increased leverage requirements can restrict capacity for low mark-up product. It does not help that FICC is in a cyclical downturn with Central Banks taking volatility, and hence the motivation for customer activity, out of the short-end of the curve.
There is a particular concern around the leverage ratio at Barclays given a surprise haircut to capital by the PRA in Barclays and consequent GBP5.8bn rights issue announced by the bank at end-July. In practice, we believe investor concerns are overblown given the flexibility Barclays has to meet a leverage target of 3% by mid-2014 through reducing the “leverage exposure” denominator in the calculation. This denominator (see Exhibit 1), also referred to as CRDIV assets, currently comprises balance sheet or “IFRS” assets of $1,405bn together with CRDIV add-ons for derivatives (adds GBP295bn), repo transactions (net subtracts GBP105bn) and undrawn commitments (adds GBP190n) for leverage exposure of GBP1,481bn.
Exhibit 1: CRDIV Add-Ons for Leverage Exposure at Barclays
With the full-year report on Feb 11th, we expect new CFO, Tushar Morzaria, to announce a reduction in this leverage exposure of at least GBP50bn and to raise the cumulative target for mid-2014 to over GBP100bn (relative to the current target GBP65-80bn). As noted in our research call of November 10th, there is substantial flexibility to reduce the CRDIV add-ons through derivatives compression and downsizing the matched repo-book (which is likely not meeting return targets). As a result, leverage exposure will be $1.43bn and the mid-2014 leverage target clearly of 3% given projected capital of GBP43bn (after the PRA deduction – see Exhibit 2 reproduced from our Nov 10th note).
There is a theoretical risk that the PRA could move the goalposts but, as CEO Antony Jenkins properly insists, regulators signed off on the capital plan on July 30th, 2013 after Barclay’s announcement of its rights issue: “Following constructive discussions, the PRA has agreed and welcomes Barclays capital plan, announced today. We have considered all elements of the plan, including new capital issuance, planned dividends and management actions to be taken and, based on Barclays’ projections, conclude that it is a credible plan to meet a leverage ratio of 3%, after adjustments, by June 2014 without cutting back on lending to the real economy.”
Exhibit 2: Proforma PRA-adjusted CRDIV Capital at Barclays for Mid-2014
The Investment Bank: The New Model in FICC
Barclays has shifted its model in FICC, accounting for over 40% of investment banking net revenue, to flow products from structured products (see Exhibit 1 above) and invested in technology for automated pricing and risk management, without human intervention, of vanilla rate and currency flows. As a result, the business is volume-sensitive (with operating leverage over a fixed-cost technology platform) rather than capital-sensitive (with variable-cost in the form of incentive compensation to sales and trading staff). We believe the adjusted business model is capable of supporting mid-teen returns-on-equity for the investment bank because of:
- Opportunity to reduce the compensation-income ratio with 9% headcount reductions from April 2012 through April 2013 and more expected to be announced on Feb 11th so that the compensation-to-income ratio falls from the current 40% to 35%.
- A shift in competitive dynamic to: (i) scale-sensitivity where Barclays is structurally-advantaged given its top-3 position in flow-rates, flow-credit, and G10 currency businesses; and (ii) customer lock-in through technology products, such as FX Gator, which provide aggregated access to liquidity across multiple execution venues.
- A reduction in capital requirements since the model involves less risk and balance-sheet inventory.