Description

Business Mix

Barclays PLC (heretofore Barclays) is a universal bank whose primary business sectors include: a domestic UK retail and commercial banking franchise, a global investment bank, a Continental European banking franchise, a growing emerging market bank footprint (with concentrated exposure to South Africa), and a US & UK credit card lending portfolio.  The closest comps in terms of business mix and footprint would be the universal banks in the US such as Bank of America, JP Morgan, and Citigroup, although Barclays' international retail & commercial banking presence is most similar to C's.  Barclays also holds a 19.9% economic interest in BlackRock after selling its Barclays Global Investors (BGI) asset management arm to raise capital in early June.  

Management: Recent Capital Allocation Decisions were savvy

John Varley is the CEO of Barclays Group.  He has served as the CEO since 2004 and has been with the firm in various roles since 1982. Bob Diamond is the President of Barclays Group and is the Head of Corporate and Investment Banking (CIB) and Wealth Management.  Diamond has been with Barclays since 1996. 

Management is savvy as evidenced by a few of their recent capital allocation decisions. Barclays was able to purchase Lehman Brothers' North American trading and investment banking operations for $1.75b ($250m in cash legacy assets and liabilities; $1.5b for the headquarters).  The acquisition was transformational for BarCap (investment bank) because it strengthened Barclays fixed income offering (particularly in mortgages and credit) while also providing an equities and M&A business, two areas in which BarCap previously had no presence.  Furthermore, Barclays was able to avoid a bailout/ownership by the UK government through two different capital actions.  First the bank was able to sell shares to two Middle East sovereign wealth managers, the Qatar Investment Authority and to a lesser extent the Abu Dhabi Investment Authority (holders of warrants). While this capital raise was dilutive to existing shareholders it avoided government ownership, unlike UK competitors Lloyds or Royal Bank of Scotland.  Secondly, Barclays was able to monetize its BGI asset management business. The sale of the business generated generated a net gain of $9.7b (£6.2b) and added 185bps of Core Tier 1 capital, while also providing Barclays with an economic stake in the future upside of the business (19.9% holding of Blackrock, the acquirer). 

Thesis

• The acquisition of Lehman Brothers made Barclays a dominant global player in Fixed Income, Currency and Commodities (rounding out legacy BarCap), while also providing an entry into North American equities and M&A.
• The robust capital markets trading activity in 2009 has allowed the company to absorb mark-to-market losses in the investment bank, elevated impairments, and higher loan loss provisions. The company has been able to absorb losses & build reserves all while not impairing tangible book or core capital levels.
• The company is now well-capitalized with proforma Core Tier 1 capital of 9.7% (fully diluted for warrants) and given the fact that the company has positive earnings it is generating organic capital. Thus, the likelihood of an additional capital raise and further dilution appears de minimus.
• I also see the opportunity for market share gains and favorable lending spreads in Barclays UK banking franchise because large competitors are running off portions of their books (LLOY and RBS commercial real estate) and focusing on capital preservation, which limits competitors' ability to lend and improves pricing dynamics.
• I estimate year-end 2009 tangible book value in a range of 315-320p. Given that the firm isn't impairing tangible book and doesn't need to raise capital tangible book should provide a risk support level. Thus, given that the stock is trading near 2009 year-end TBV, valuation and risk-reward look compelling (1.0x tangible NAV; less than 6x normalized earnings).

Earnings Sensitivity/Normalized Earnings

• Headwind from Risk Asset Marks should Abate: Risk asset costs through the P&L in BarCap were £4.4b in the 1H09. While there are still legacy exposures the incremental writedowns appear manageable. Legacy exposures include £8.2b of CRE, including £4.2b of US CRE exposure marked at 67c. The company has also sold the majority of its monoline exposure to an off balance sheet entity, which does leave the overhang of longer-term exposure through accrual accounting (as potential non-payments occur), but reduces the tail risk associated with a monoline filing for bankruptcy protection or credit downgrades.
• We believe impairments have also peaked: company guidance for the year was for impairments in a range of £9.0-£9.6b. On the 3Q09 interim trading update management indicated that the low-end of the range was definitely more realistic, and in subsequent meetings seemed to indicate below £9b was achievable. Consensus estimates for next year are for flattish impairments (again around £9b); however, given Barclays limited whole loan commercial exposure, the positive trend in home prices, and lower unemployment growth in the UK, I think impairments have peaked.
• Tailwind from Barcap revenue synergies & moderating costs in outer years: Barcap cost/net income ratio in 2H09 will be around 81%. Long-term management guidance is for a range of 70-75%. The elevated levels are owing to the buildout of the European & Asian equity and M&A platforms. Longer-term Barcap is targeting £5b of revenue synergies from these buildouts (although we remain conservative and only include £2.5b in our normalized #'s). Also, the abatement of risk assets marks shouldn't be met with concurrent costs (bankers won't be fully paid for risk assets no longer being written down), which should help reduce cost-income ratio.
• Normalized Earnings (putting it all together): I estimate that on a normalized basis Barclays can earn approximately 55-60p. Base case assumptions include a long-term cost-income ratio at BarCap of 72%, £2.5b of revenue synergies from the European and Asian platform buildouts, modest NIM expansion driven by better liability spreads once rates rise, and 90-100bps of impairments on the loan book. As a sanity check we estimate 2011 year-end tangible book of roughly 375p and book of ~440p. The company has guided for over-the-cycle ROE of 15-20%. As a sanity check 55p of normalized earnings on 440p of book value only implies 12.5% ROE, which seems reasonable.
• Impairment sensitivity: I believe impairments have peaked in 2009 and could surprise to the upside (lower impairments) in 2010. Consensus still appears to be around £9b for impairments. However, every £500m less of impairments equates to roughly +3p of earnings upside (all else equal), which is roughly 10% upside to current 2010 consensus of 30p. It should also be noted that our normalized impairment range is ~£4.5-£5.0b, which implies a 21-24p tailwind to annual earnings from impairment normalization.
• BarCap revenue sensitivity: there is a great deal of debate about the sustainability of Barcap's top line income excluding asset marks and own credit losses. We estimate roughly £17.8b in 2009 (£3.6b in 4Q09). Now assuming a -15% revenue decline is normalized, because of the difficulty to replicate record FICC business in 2009, and assuming a 72.5% cost to income ratio would imply a -4p headwind to EPS. In fact every -5% variability in Barcap revenue equals +/- 1.5p in eps. However, it should be noted that while FICC spreads on plain vanilla products are definitely narrower there are some tailwinds: 1) 2009 activity was still during an economic slowdown and activity should increase as economic growth increases; 2) highest interest rate volatility (as central bank policy becomes less certain) and large government obligations (and thus issuance) should provide structural drivers for the rates business; 3) M&A volume is still paltry but should increase as economic growth rebounds, particularly given that anemic revenue growth and excess capacity should drive strategic M&A.

Valuation & Risk/Reward:

• Valuation: stock is currently trading at roughly 1.0x 2009E tangible book value and ~0.9x 2010 year-end tangible book. On a P/E basis the company is trading at 10.5x '10E consensus, but more importantly slightly less than 6x our normalized earnings range of 55-60p.
• Risk/Reward: While I acknowledge that the stock recently traded as low as .84x year-end tangible book, I think that the risk-case should be around 1x a burn-down tangible book. The burn-down would include a $5b pretax (roughly £3b) litigation settlement with the Lehman estate, which coincides with the stated grievance filed by the estate. This would imply a -17p hit to tangible book value. Thus, the risk price is near 295p. For reward, I take the 55p normalized earnings estimate and apply a 10x multiple. I then discount back by a 12% cost of capital for 2 years. This equates to a reward price of 435p. Risk-reward at current levels is -25p down and +115p upside or roughly 4.6:1x.

Overhangs: why is the stock cheap vs. peers?

• LLOY rights offering: Investors were overweight BARC and used it as a source of funds in 4Q09 to fund the LLOYs £13.5b rights offering
• Sovereign debt concerns in Europe: although Barclays direct exposure to Dubai is limited, Barclays was hindered in 4Q by concerns over sovereign default risk (Dubai, Greece).
• Basel III Capital requirements: while the recommendation by Basel Committee for higher capital thresholds, the disallowance of minority interests and DTAs, and higher risk weighted calculations from equity stakes and securitzations all hindered BARC, we feel that the bank has time to organically grow capital before the regulations are fully implemented in 2012 and that the actual recommendations could be less onerous after the comment period (expires April 2010).
• 4Q09 capital market downward revenue revisions: trading revenue and activity slowed earlier than expected in November and then December was characterized by light volume. However, we believe this is largely known and discounted by the market.
• Lehman litigation: aforementioned litigation with the Lehman creditors, which we already have factored into our downside risk assumptions.
• Hedge funds delevered into year-end and Barclays was an overowned name.

Catalysts

• Better than expected '10 impairment guidance: company will exceed prior guidance on 2H09 impairments and perhaps guide impairments below consensus estimates for 2010.
• Positive trading commentary for Jan '10: while 4Q09 Barcap topline results will almost certainly be disappointing we think that is widely known and believe the company will be able to make positive comments about January activity and client engagement. Historically 1Q has experienced a 30-40% seasonal sequential increase vs. 4Q.

Catalyst

Catalysts

• Better than expected '10 impairment guidance: company will exceed prior guidance on 2H09 impairments and perhaps guide impairments below consensus estimates for 2010.
• Positive trading commentary for Jan '10: while 4Q09 Barcap topline results will almost certainly be disappointing we think that is widely known and believe the company will be able to make positive comments about January activity and client engagement. Historically 1Q has experienced a 30-40% seasonal sequential increase vs. 4Q.