UK Banking—33%

Barclay’s UK banking operations are performing well, with earnings up 11% over the past year. 52% of earnings come from corporate banking while 48% came from retail/small business, presenting an ideal balance. Barclay’s relative exposure to mortgage/housing is much less than its peers. In general, the UK banking market is highly consolidated (top 10 players control vast majority of market share) vs. the U.S. which is far more fragmented. Barclays’ is in the process of successfully turning around its retail operations, which showed 12% YOY profit growth.

Credit Card—8%

Barclay’s credit card operations have been a huge drag on earnings over the past couple of years. Barclaycard used to be one of the fastest growth, most respected brands in the financial services world, but like many other credit card companies (Capital One, MBNA), saw earnings and balance growth slow significantly after the housing boom started and consumers began tapping home equity en masse. More recently, the earnings have been hurt because of higher delinquencies and charge-offs. (Several reports have tried to pinpoint the cause, but in general there is no one specific culprit, rather just a general but still fairly modest deterioration across the board after a very benign credit environment.) However, at only 8% of earnings, Barclaycard is becoming irrelevant. Additionally, management commented that they have started to see some signs of delinquencies stabilizing (page 10 of August press release). They have also been spending/investing a lot of money on their expansion into the U.S. (they bought Juniper, a small credit card operation, in 2004.) The stabilization of losses and reduction of investment/expansion expense in the U.S. could provide a significant positive delta to the earnings in 2007. (For reference, Barclaycard will likely earn around 600M pounds in 2006 vs. 704M in 2005 and 843M in 2004. If loss rates improve and the lagged effect of rate increases prove effective (to restore profitability, all the major credit card lenders have increased rates), it is not inconceivable that this business could earn over 1B in 2008. Revenue and credit card balances have been growing rapidly, up 14% and 10%, respectively over the last year. Barclaycard, is the biggest player in a consolidated and relatively rational UK credit card market. It seems likely that they will work things out.

International Banking—14%

This consists of a network of offices throughout the more developed parts of Africa along with some exposure to fast growing Spain, where many Britons travel for Holiday. In 2005, Barclays acquired a majority stake in South African based Absa, one of the four dominant banks. The deal has already been significantly accretive and gives Barclay’s exposure to the raw materials/natural resources boom that is driving strong growth in South Africa. Because of the limited competition and good growth, the South African banking industry posts very solid mid-20% ROEs. Excluding Absa, which now makes up about 60% of the international banking operations, profit was up an impressive 28% in the first half of 2006. The central bank in South Africa recently raised rates to cool down a very hot economy and property market (GDP growth near 5% last year), but growth should stay relatively strong going forward. The South African Rand also traded off with the emerging markets and commodities sell-off, falling about 26% since early May. (BCS’s H1/2006 results captured about 16% of the 26 % decline.) More recently, Barclays has started pursuing a bite-size acquisition policy in India. I like Barclays’ international angle here—there is relatively little competition in Africa, and the small deal sizes prevent big blow-ups and allow for BCS to quietly become expert in the local markets. The resulting revenue and profit growth has validated such a strategy.

Barclays Capital (BarCap)—33%

BarCap is a highly regarded investment bank that primarily serves the derivatives, foreign exchange, and interest rate markets. The earnings are definitely opaque (what is prop trading vs. client execution?) and they don’t deserve a high multiple. But just like Goldman Sachs and Lehman Brothers, the revenue and profits have soared recently (+66% YOY). Growth in global commerce and the accompanying increase in demand for capital markets expertise, which is the fundamental driver of growth in derivatives markets,  looks likely to continue. (GFIG, an NYC credit derivatives broker that trade at a forward PE of 20, estimates the notional value of the credit derivates market can easily quadruple to $100 trillion within a few years—it was up 50% in 2005 to $26T.) As BarCap President Bob Diamond (who has an outstanding reputation and gets paid for it) noted on the call, “the best days are ahead.” Barclays has also aggressively spent money and invested in BarCap. In fact, it has probably “over-invested” (investors in CBH should be familiar with Vernon Hill’s similar description of his own company), meaning that they can dial back expenses fairly quickly if revenue growth slows down. A 9.5 PE multiple on the business seems reasonable, particularly with Goldman at 9.7, Morgan Stanley at 10.8, and Lehman at 10.5.

Barclay’s Global Investors (BGI)—10%

Based in San Francisco, BGI is one of the world’s pre-eminent money managers with over $1.6 trillion in assets managed in a combination of actively managed funds, index funds, and most recently, the market-share leading ishares ETFs—one of the fastest growing areas in the asset management business. Profits were up an impressive 51% YOY, easily blowing past the 29% YOY growth of current darling T. Rowe Price, who currently trades at a 22 forward PE. State Street, which also has a strong ETF business trades at 16.6 times 2007 EPS (their multiple has been hampered by severe net interest margin compression in this inverted yield curve environment). I am willing to admit that no one would ever give BGI a full valuation, but I think a PE of 15 is very reasonable. Incidentally, Congress’ new pension bill should provide tailwinds for all asset managers, including BGI.

Wealth Management—3%

This is too small to matter and should be included in the UK banking operations, but earnings were up 31% YOY and most wealth managers trade near 15 times forward earnings. It is another business that is executing well.

Overseas Earnings and Minimal Acquisition Risk

Last May, some of the sell-side became antsy because CEO John Varley said he wanted at least half of Barclays earnings to come from overseas within a few years. The analysts immediately assumed that this would require a big acquisition. Because BGI, BarCap and Absa have grown so fast, along with a reclassification of some UK corporate banking earnings into BarCap, Barclays achieved that goal in the first  half of 2006. They made a point of mentioning this in the press release on page 6. Barclays has actually been very quiet on the acquisition front. By far, Absa is the largest deal they have done in the last 5 years and it constituted only 5% of earnings at the time and has proven to be a home-run. Barclays’ current organic growth is so strong that they do not need to do any deals. I find the risk of a large acquisition to be very small, but small bolt-on/tactical acquisitions clearly can add significant value. In general, the sell-side analysts are obsessed with Barclays doing some big deal. It is as if they can think of nothing else. I think a big deal is far more likely for a bank with limited organic growth—i.e. ABN Amro ( big Dutch banking conglomerate), which is busy trying to consolidate Italy.

Barclays as a Take-out Candidate?

Bank of America CEO Ken Lewis has recently started making comments about doing a transformational deal. Barclays, with its low valuation, high growth, and high profitability, has been rumored to be one of the targets. While I don’t put much credence in the rumors, BAC’s most recent acquisition of MBNA has proven to be successful and the company is riding high and likely feeling confident (stock is up 25% in the past year and now trades at a more respectable 10.8 forward PE multiple).

Basics of the UK economy:

The UK economy is dynamic and open. GDP growth was near 3% in 2003 and 2004, then dropped to 2% for most of 2005 (following the rate increases by the Bank of England) and recently has started to rise, coming in at 2.6% in Q2/06. Population growth is positive (+0.3% for 2006 vs. declines in much of mainland Europe) and immigration is robust, particularly to London, one of the major financial centers in the world. The Bank of England was the first developed country to begin raising rates after the 2001-2002 recession. Starting in mid-2003, it raised rates from 3.5% to 4.75% and then cut rates to 4.50% last August. Much of the housing/lending market is based on short term rates set by the BoE, unlike in the U.S. where rates used to be more long term oriented, but have gradually become shorter in the last five years (i.e. option ARMs and 3-year hybrids).

Barclays vs. other British banks

Barclays is unique among the British banks in that its organic growth is very high. Sure, HSBC, might be bigger and have exposure to China, but it is definitely more deal-dependent and is currently spending a lot of money by trying to break into traditional M&A advisory in the U.S, a questionable strategy. It also bought Household in 2001, which was hugely accretive to earnings, but exposes HSBC to a potential slow-down/credit cycle with the US consumer. Standard Chartered is the other British bank with a significant presence in Asia. It is really an Asian bank with over 80% of earnings coming from there. Royal Bank of Scotland (RBS) is inexpensive at 8.2 times forward EPS, but it is not growing nearly as fast, has significant exposure to U.S. commercial banking (it owns Rhode Island-based Citizens, which is the 6^th largest bank in the U.S.) and has had a more active deal history—most recently Ohio-based Charter One, which most analysts heavily criticized. RBS also does not have any world class brands such as BGI or BarCap, lacks any real catalysts, and just reported decent, but not blow-out results. Most of the other large British banks such as HBOS and Northern Rock are almost purely domestic and heavily geared to residential mortgages—very unexciting currently.

Valuation

Based on my above PE sum of the parts analysis, I think Barclays should be trading on at least a 9.8 PE given its strong earnings momentum, diversification, and world class brands in BGI, BarCap, and Barclaycard. The PE based on current consensus is 8.7 and that is based on growth of only 10% over 2006, even though there a variety of reasons to believe that growth will be substantially higher (current trough earnings in Barclaycard, 15%+ growth in most of its core businesses). With a 4% dividend yield (and rising), BCS rewards us well while waiting for the Street to recognize the value of the company. I think the ADRs trade to $60 within a year, providing a low risk 20%+ total return.

Finally, while the large cap vs. small cap rally remains somewhat elusive, it seems to be common sense that if there is a large cap rally, the stocks that will first trade up will be the ones that have a track record of strong earnings growth and a platform to continue executing, both of which Barclays has.

Incidentally, the ADRs trade at a 1-to-4 ratio and the current exchange rate is 1.9 to 1. The GBP is up against the USD about 8% in the last year and about 25% in the last 5 years.

Risks

-The biggest risk is some sort of blow-up in BarCap. While the business is currently executing well and earnings come from a wide variety of customers, geographies, and products, Barclays could definitely be exposed to some contagious global derivatives blow-up. But BarCap only constitutes 33% of earnings, meaning the company could almost certainly get through any sort of capital markets stress. By the way, much of the sell-side analysis is simply incomprehensible or misguided. Citi’s most recent report (40 pages) concluding that Barcap’s returns are sub-par flies in the face of its outstanding performance and fails to admit that if BarCap is not as profitable is commonly thought, then Barclays’ other businesses are far more profitable than assumed. The report is indicative of an overly scientific and myopic approach to analyzing a company that is better thought of on a big picture scale.

-Others will tell you that acquisition is a risk. This is not true. Absa has been the only deal of any substance in the last 5 years and this constituted less than 5% of Barclays earnings at the time, has added heft to their pre-existing African operations, and has been a home-run so far. Additionally, Barclays has such great organic growth opportunities that its senior management should feel no pressure to do a big deal. See my comments above.

Catalyst