Barclays: The Real Investment Bank Stands Up
SEE LAST PAGE OF THIS REPORT Howard Mason
FOR IMPORTANT DISCLOSURES 203.901.1635
May 9, 2014
Barclays: The Real Investment Bank Stands Up
- Barclay’s investment bank represented ~55% of group equity but, on Thursday, management disclosed the more capital-intensive segments accounted for half of this and generated a mere 10% of investment-bank profits. With these segments consigned to a liquidating “bad bank”, the remaining “core” investment bank generated a 9-10% ROE in 2013, represents one-third of profits for new “core” Barclays, and has leadership positions in debt and equity underwriting in the key US and UK markets as well as scale- and technology-advantages in “flow” markets businesses including FICC.
- Barclay’s core investment bank, announced on Thursday, is refocused around advisory and corporate finance, the credit and equity markets activities to support the origination businesses, and those capital-lite rates/currency activities that can be migrated to an electronic platform (so short-dated, standard, and centrally-cleared products).
- After also folding in loss-making businesses such as the European retail bank and the corporate bank outside the UK, non-core businesses represent fully 30% of group equity; the remaining core “good bank” generated a 12% ROE in 2013 and has strong growth potential in UK retail and consumer banking (representing just over one-third of 2013 core profits with an ROE of 11-12%), Barclaycard and Africa banking (representing just over and just under 15% of the business respectively with ROEs of 16-17% and 8-9%) and the investment bank (representing one-third of the business with an ROE of 9-10%). Management expects to at least sustain the aggregate core ROE of 12% while growing average equity of GBP36bn in 2013 to ~GBP50bn in 2016.
- The bad-bank created a 2013 drag on the ROE of 6% in 2013 (so that the group reported 6%); this drag is expected to fall to <3% by 2016 allowing Barclays to report a group ROE of >9%.
- The bad-bank is expected to downsize risk-weighted assets from GBP115bn today to GBP50bn by end-2016 so that average non-core equity in 2016 should be ~GBP15bn and hence average group equity ~GBP65bn.
- Putting these two elements together, management is guiding to 2016 earnings of GBP5.85bn or GBX35/share.
- We believe the refocused Barclays can trade at 10x these 2016 earnings, so GBP3.50/share with the core bank valued at GBP50bn (being 1.3x estimate tangible equity of GBP38bn) and with an add-on of GBP8bn for non-core tangible capital; management expects to preserve this the sale and run-off.
- Core Valuation: Our valuation framework (see Exhibit) uses the ratio of forward 2015 earnings and current tangible capital. We expect Barclays core to generate 2015 earnings of GBP5.2bn, excluding restructuring or CTA charges; this represents a 13-14% return on current tangible equity of ~GBP38bn and corresponds to a 1.3x multiple of tangible book.
- Non-Core Add-On: The GBP8bn add-on comprises GBP14bn as the estimated tangible equity for the non-core bank less: GBP3.5bn for cumulative losses/restructuring charges; and, to avoid a double-count, GBP2bn expected to be reallocated to the core over the next two years.
Exhibit: Bank Valuation Model
- In providing guidance for the sustaining a 12% ROE in the core bank while growing equity at a 10% CAGR, management assumes the investment-bank revenue environment remains “challenging” and continues to structurally reduce costs. The firm announced 7,000 headcount reductions in the investment bank (in additional to a previously announced reduction of 7,000 across the bank as a whole) and revised down its firm-wide expense targets b GBP500mm to GBP17bn in 2014 and GBP16.3bn in 2015 (of which the core business will represent <GBP14.5bn).
Overview: Capital Reallocation from Bad Bank to Good Bank
On Thursday, Barclays announced a management (albeit not legal vehicle) split into a core “good bank” with (2013 average) equity of GBP36bn and a non-core, liquidating “bad bank” with GBP16bn of equity. The core bank – which includes (see Exhibit 1) the UK and African consumer and commercial banking business; Barclaycard; and about one-half, by risk-weighted assets, of the current investment bank generated a 12% ROE in 2013.
Exhibit 1: Core and Non-Core Activities at Barclays
Note – Numbers may not add due to rounding, particularly reported equity allocations within core bank
The core businesses are structurally attractive, and management believes it can sustain at least the 2013 ROE of 12% while growing average equity at a 10% CAGR to GBP48-50bn by 2016. Given a dividend payout of 40% through 2015, and likely 50% once the 2015 target for a CET1 ratio of 10.5% is met, this means the core businesses will need additional capital of nearly GBP5bn over the next 3 years (see Exhibit 2)
Exhibit 2: Core Businesses Need Additional Capital of Nearly $5bn Over Three Years
This capital can be generated by liquidation of the non-core businesses whose current RWA of GBP115bn (of which GBP90bn is contributed by non-core investment banking) is expected to decline to GBP50bn by end-2016. Management expects to preserve tangible book value through the sale and run-off of non-core assets, and we estimate this at GBP14bn (so 85% of total equity which implicitly assumes it is split between the core and non-core businesses in the same proportion as total equity, and pro-rates based on tangible book value/share for the firm of GBP2.84 vs. total book value of GBP3.31). Further assuming tangible capital is released in proportion to the decline in RWA, this means the gross capital released by end-2016 will be GBP8bn.
Against this, we net cumulative losses of GBP2bn (vs. the after-tax loss of GBP1bn in 2013) and restructuring or “CTA” expenses (which fall across both core and non-core businesses but are excluded from the 12% ROE assumption for the core) of GBP2.1bn (GBP1.6bn in 2014 and GBP0.5bn in 2015). The cumulative losses are after-tax and CTA expenses before tax, so that the total deduction after-tax is ~$3.5bn, and the net capital released from the liquidating non-core is GBP4.5bn – in other words, just enough within a few hundred million to fund the capital investment in the core.
If core Barclays were standalone today, it would likely be valued at GBP50bn. Our valuation model looks at the ratio of forward (2015) earnings to current tangible equity. We expect 2015 earnings for the core business to be GBP5.2bn representing a return of 13-14% on estimated current tangible equity of GBP38bn and corresponding to a tangible price-book ratio of 1.3x (see Exhibit 3). This generates a valuation of ~GBP50bn.
Exhibit 3: Bank Valuation Model
For a group valuation, we must add GBP14bn of tangible equity in the non-core businesses less ~GBP2bn that will be invested in core over the next two years (to avoid a double-count) and the deduction of GBP3.5bn for cumulative losses and CTA expenses; this generates an add-on of GBP8.5bn and a group valuation of ~GBP58bn or GBP3.50/share. This does not adjust for extraordinary items such as conduct or litigation charges, and does not take account of the likely positive earnings from the 2016 non-core business which will largely comprise (earnings-positive) long-dated derivatives and Spanish/Italian mortgages.
Barclay’s reorganization, and the effective recapitalization of the good bank by reallocation of the liquidation proceeds from the bad bank, has half an eye to future regulation. Management points out that the new “personal and corporate banking division” (which comprises the UK retail and commercial banking businesses) is a good starting point for the businesses that may be required to be ring-fenced in 2019 following the recommendations of the Vickers report in December 2013 that retail “utility” banking be separated from investment banking and corporate finance activities.
In addition, the CFO commented that, particularly with the reorganization, Barclays expects to be able to meet, by the January 2015 deadline, the requirements of the corresponding regulation in the US (under Section 165 of the Dodd-Frank Act) requiring that the US operations of foreign banks, if these operations involve more than $50bn of assets, be separately capitalized with a leverage ratio above 5%.
Finally, Barclays indicated its commitment to further de-levering by setting 2016 targets for a CET1 ratio of >11% and leverage ratio of >4% (vs. equivalent 2015 targets of 10.5% and 3.5% respectively). To illustrate the de-levering another way, we note that RWA in the core bank is expected to increase from the current GBP320bn to GBP350bn by end-2016 (with the entire GBP30bn increase outside the investment bank as RWA in the core investment bank is held flat at GBP120bn) vs. the increase in average equity from GBP26bn in 2013 to GBP48-50bn by 2016.
In providing ROE guidance for the core bank, management is not assuming a meaningful improvement in the operating environment and expects the revenue backdrop for the investment bank to remain “challenging”. The focus, therefore, is to continue to focus on costs and the CEO announced new targets for group expenses, lower by GBP500mm from the original guidance, excluding extraordinary items such as conduct charges, of GBP17bn in 2014 and GBP16.3bn in 2015 (of which <GBP14.5bn will be core).
The lower expenses are enabled by further headcount reductions of 7,000 in the investment bank (across core and non-core and on top of 7,000 reductions that had already been planned firm-wide for 2014) in part as client activities cease in non-core activities. These additional reductions will increase the restructuring or “CTA” budget by GBP800mm so that 2014 CTA charges are now projected at GBP1.6bn falling to GBP0.5bn in 2015 and vs. GBP1.2bn in 2013.
- Non-core businesses include consumer and commercial banking in Europe and EMEA and, from the investment bank, those credit and equity markets-related activities that do not support origination activity and those rates businesses involving long-dated, customized, or bilaterally-cleared product.