Description

Summary:

Barclays plc (BARC) is a large-cap global bank that trades at a material discount to tangible book value (0.8x). Like many large European banks, BARC has been restructuring and shrinking since the financial crisis. I believe BARC is now at the end of this restructuring process and has a credible plan to earn double-digit returns on tangible equity (ROTE). In October 2017, BARC outlined targets of >9% ROTE by 2019 and >10% ROTE by 2020. Consensus is skeptical and is only forecasting a ~8.5% ROTE by 2020. However, if BARC ends up achieving a 10% ROTE in 2020 this would result in ~29p of EPS. If BARC can trade at 11x P/E and 1.1x tangible book value, this would mean 45-50% upside for the stock.

Details:

After selling off non-core businesses over the last several years, BARC now operates three main businesses: Corporate and Investment Bank (CIB), UK retail/commercial bank (BUK) and international consumer, cards and payments (CCP). After allocating Head Office capital and losses, both BUK and CCP generate 12-13% ROTEs. CIB (after Head Office allocations) only generated a ~4% ROTE in 2017. Since ~1/2 of BARC’s capital is in CIB, an improvement in CIB ROTE is a key driver of getting group ROTE to >10%.

BARC’s CIB has languished after years of neglect but appears to have new vigor after Jes Staley (former head of JPM’s investment bank) took over as CEO in December 2015. Note that prior to Staley, the CEO of BARC was from the credit card business, so I believe CIB was formerly held in relatively low regard by BARC senior management and thus suffered from underinvestment. Since Staley has taken over as CEO of BARC, he has installed a new CIB head (Tim Throsby from JPM) and replaced three of four heads on the trading desks. These CIB management changes occurred in 2017, so 2018 is the first year that the new CIB team is fully in place. In late 2017, BARC also publicly talked about committing more of its balance sheet to the trading businesses, which I believe have been capital constrained due to BARC capital concerns. Because 2017 was a transitional year for CIB management and had a weak macro backdrop (lack of volatility in market), BARC’s trading revenues were down -15% (FICC trading -18% and equities trading -9%). I believe the poor 2017 performance, new teams put in place, bigger balance sheet commitment and higher market volatility set up BARC to show improvement in trading revenues in 2018. In fact, Q4 2017 already saw BARC regain some share in FICC trading.

The BARC ROTE improvement plan isn’t only a bet on CIB revenues. I believe roughly half of the planned ROTE improvement can be attributed to “self-help” measures. Part of this comes from cost reductions, driven by reduced spending on regulatory and compliance. BARC has guided to £13.6-13.9bn of expenses in 2019e, down from £14.2bn in 2017. BARC also has the opportunity to refinance high-cost funding that was issued during the financial crisis. For example, there is a £3bn 14% junior subordinated hybrid that is callable June 2019 – this one refinance alone could save ~£300m per year which could add ~0.5% to BARC’s ROTE.

There are two ROTE tailwinds that weren’t included when BARC management gave its >10% 2020 ROTE target back in October 2017. First, the ROTE targets were developed assuming a group tax rate in low-30s, but as a result of US tax reform  BARC is now projecting a mid-20s tax rate. Second, BARC management didn’t assume interest rate increases during the plan, but UK interest rates have risen in the last 6 months. In their Q4 2017 earnings presentation (pg. 36), BARC estimated that a 100bps increase in interest rates would result in £200-450m more net interest income (NII) in year one, building to £850-1,150m of additional NII by year 3 (benefit is lagged as securities are reinvested at higher yields as they mature). Here is the rough math on how higher NII translates to ROTE: every £200m of NII is £150m after tax, so ~0.3% on £48bn of tangible equity.

A persistent concern has been BARC’s capital levels as bears have made the argument that there isn’t enough capital to deal with legal/regulatory fines and ring-fencing of US and UK subsidiaries. However, management’s February announcement that it intends to double the dividend in 2018 (3.0% yield on current price) and is looking to buy back stock (I believe 2019 is more likely than 2018) is a strong signal of confidence in the capital position of BARC. I do not think BARC management would have been able make such a strong public statement on capital returns without blessing from its regulator. A further positive development was the late-March announcement of a lower-than expected ($2bn) settlement with the US DOJ over housing bubble era RMBS issuance. I believe BARC’s capital levels are at a comfortable level. BARC had a 13.3% CET1 as of 12/31/17, which will dip under 13% with payment of the $2bn DOJ settlement but rebuild relatively quickly as BARC should generate ~100bps of capital this year from earnings (before shareholder returns).

Finally, an activist investor named Edward Bramson recently took a large stake in BARC. While I don’t have any personal knowledge of his agenda, press reports indicate that Bramson wants BARC to reduce the size of its trading operations in order to free up capital. https://www.telegraph.co.uk/business/2018/04/14/activist-investor-ed-bramson-steps-campaign-force-barclays-shake/. This would run counter to Staley’s current plans to invest more into the trading operations. Bramson has an impressive track record in past activist campaigns with his 5 successful investments averaging returns of >100% and having only one unsuccessful activist investment. (See prospectus for his Sherborne investment vehicle for more details:  http://www.sherborneinvestorsguernseyc.com/investors/introduction.php). Since BARC is a much bigger company than Bramson’s past activist investments, I don’t know if his past successes will translate to success in this BARC investment. However, the presence of a credible activist investor should increase the pressure on management to hit their promised ROTE targets, particularly when the activist is suggesting a change of course on the CIB strategy.

Catalyst

Progress towards >10% ROTE target by 2020