Description

[Note – I have used the US ticker (BCS) in the writeup summary. However the main listing is in London  - BARC LN so I have used the UK listing for prices in the writeup.]

Introduction:

Barclays is a UK based bank that we believe is coming to the end of a number of headwinds and is likely to improve its group ROTE (return on tangible equity) going forward – indeed we believe that Covid, the various headwinds and restructuring has hidden a business with very attractive underlying divisional RoTEs. Trading at 0.67x price to tangible book (share price of 178.88p on 19 May 2021 vs TNAV of 267p 31 March 2021), only small improvements in ROTE are likely to lead to significant improvements in valuation. With 14.6% CET1 (Q1 2021) it also has the ability to either deploy or return significant amounts of capital to reach its target CET1 of 13-14% (its overall capital requirement is 11.1%).

We believe a ‘normal’ year would return the bank to approximately 10% ROTE. (Q1 2021 was 14.7% but some of that reflected a reversal of 2020 items; due to quarterly volatility we believe annual numbers are probably a better assessment of the business). Our price target is £2.94 ie an upside of approximately 65% over two years (dividends / share buybacks on top). We believe the bank requires ‘only’ a ‘normal’ year – and no heroic assumptions to reach that.

Background:

Barclays is a large bank (it is in tier 3 of the Global Systemically Important Banks (G-SIBs)), operating in both retail (particularly known for its credit card operations ‘Barclaycard’), commercial and investment banking – within the UK and internationally (48% of group ‘income’ (ie revenues) is non-UK). In terms of both capital allocation and profits a lot more comes from the international business (which includes CIB) than many people might realise.

For details of the divisional breakdowns, we recommend referring to the investor relations part of the website. (Please note that all numbers are in £ (the reporting currency) - unless otherwise specified).

The key points we see are:

1. Exposure:

Barclays is particularly exposed geographically to the UK and the US. These two countries are likely to be the two major Western Countries to emerge out of Covid first due to extensive vaccination programmes. However, whilst the major US banks have re-rated we believe the move in Barclays has only really started.

Sector wise, the mix of retail, corporate and investment banking is more akin to the big US banks (eg Citigroup, JPM, MS, WFC, BofA and GS) than it is to the UK domestic banks (eg Lloyds, Natwest) that Barclays is often compared to. We believe that international investors will recognise this anomaly.

2. Self-help story / activist pressure

It is fair to say that Barclays has gone through a number of years of pain / headwinds with the loss of Bob Diamond, Libor fixing allegations, restructuring, PPI (discussed below), the need to sell the iShares business in the depth of the GFC, investigations into how it was supported by Qatar (court cases have been covered by UK press), bank corporation tax surcharge, Brexit, links of the CEO with Epstein, an inappropriate investigation into a whistleblower and an activist investor in the shape of Sherborne (Ed Bramson).

In the midst of this the present CEO (Jes Staley) and board have been under pressure to restructure the business and deliver or split it into two.

3. Dividends / Buybanks

Like many banks, Barclays ceased dividends last year due to Covid. However, it has now re-established a dividend with 1p for FY2020 (paid 25 Feb 2021). The UK market tends to have a number of institutional investors who require dividends – hence it is likely that these investors dropped Barclays last year but are likely to buy it back with the dividend re-establishment. 

It announced a £700M buyback with the Q4 2020 results. Thus, the total return (dividends plus buyback) to shareholders was the equivalent of 5p for 2020. Perhaps as important, the management has indicated that even after share options this will reduce the overall sharecount.

(For comparison: In 2019 the bank paid a final year dividend of 4p (pertaining to the previous year) and a half year dividend of 3p (pertaining to 2019). )

There are three consequences of the buyback that are slightly tangential to the investment case but interesting nevertheless:

1. It is not clear that all analysts have modelled in the sharecount reduction

2. Clearly buying back your own shares at circa 0.67x price to book is accretive

3. (Ed Bramson /) Sherborne owned their Barclays shares through various derivative instruments at one point. It is not entirely clear whether the loss of dividend impacted the ability of Sherborne to fund the financing (ie the ‘carry’) of its position. Recently Sherborne announced they have exited their holding (at peak they held approx. 6% of Barclays).

In the Q1 2021 results the company indicated an accrual of 0.75p towards a full year dividend of 3p, though it did state that this was not a forecast of future capital distributions.

4. End of PPI:

1. Payment protection insurance (PPI) compensation was imposed on all UK banks by the FCA (national regulator) due to the historic behaviour of banks (they mis-sold PPI with mortgages). The compensation scheme led to claims management companies farming claims – the total amount paid back by banks has been over £48bn with the cost to Barclays of over £9.7bn.

2. The deadline for PPI complaints was 29 August 2019.

3. This means that PPI payments by banks will start winding down. In 2019 Barclays made a £1.4bn provision for PPI – in 2020 the provision was zero. However, the administration and actual payments will take, we estimate, 2 years beyond the deadline to fully wind down.

5. Covid:

1. The bank provided payment holidays to over 680k customers and waived over £100M of UK overdraft interest and banking fees. Clearly as business reverts to normal this hit to the income statement is likely to be a one-off.

2. It also provided a £100M Covid-19 community aid package.

3. Impairments in 2020 were £4.8bn vs £1.9bn in 2019. In 2020, BUK took impairment charges of £1.5bn, whilst BI:CCP (Barclays International: Consumer, Cards and Payments) took provisions of £1.7bn, BI:CIB (Barclays International: Corporate and Investment Bank) took impairments of £1.6bn – ie a total of £4.8bn. Returning to a run rate of annual provisions of £2bn (say) should give a significant boost to profits.

4. There was also a significant impact on credit card transactions, balances and merchant acquisition – it is reasonable to expect these issues to reverse over 2021 – 2022. (The Q1 2021 results already show significant progress in this area).

6. NIM:

1. In the 2020 results presentation the bank highlighted that in BUK there was downward pressure on NIM leading to an expectation of 240bps for FY2021 (Q1 2021 results updated this to 240-250bps).

2. Clearly the yield curve expectations in the US and the UK have changed in the last few months which should improve the outlook for Barclays.

3. Indeed, in Q1 the results showed a NIM of 254bps for BUK and 392bps for BI. (Note that there was an amendment in the presentations of ‘purchased financial guarantees’ so they are not quite comparable to previous targets).

4. It is also important to note that 69% of Q1 2021 income was ‘fees, commission and other income’ ie NOT ‘net interest income’.

7. The bank’s targets:

1. The bank has a stated target of ‘>10% RoTE over time’ (‘with meaningful year on year improvement in 2021’) – we discuss this in more detail below.

2. ‘<60% cost:income ratio over time’

3. CET1 ratio between 13-14% (this implies further returns of capital via dividends / share buybacks)

4. Given the pressure management has been under from shareholders it is reasonable that there is a concrete plan to deliver these targets.

8. Taxes:

After the GFC there was a feeling in the UK that the treasury provided a backstop to banks without proper compensation to the tax payers. Hence a bank levy was introduced in 2011 and in 2016 a bank corporation tax surcharge of 8%.

In March 2021, the Chancellor (Rishi Sunak) increased UK corporate taxes from 2023 from 19% to 25%. However he also announced a review so that the combined tax burden on banks did not rise significantly (see https://www.reuters.com/article/us-health-coronavirus-britain-banks-idUSKBN2AV1ZL )

Should the review by the government conclude that banks should not be excessively taxed it will mean that the 2 year forward eps of banks will be less impacted than other UK companies by the forthcoming tax rises and hence make banks look more attractive on a relative basis.

There have been other changes over the years in the regulatory and tax regime to allow banks’ non-UK operations to not face the bank levy (see https://www.gov.uk/government/publications/bank-levy-changes-to-scope-and-administration/bank-levy-changes-to-the-scope-and-administration ) The bank levy is 0.1% of their balance sheet.

It is also important to note the general moderation of negative political sentiment towards banks that occurred immediately after the GFC.

9. Consensus:

1. In 2019 eps was 24.4p whilst in 2020 eps was 9.5p.

2. Consensus GAAP eps estimates (source: Koyfin) for 2021 are 25p and 24p for 2022, 26p for 2023. 

Why do we think Barclays can reach 10% RoTE:

1. It is already on its way to the target:

1. In Q1 2021 Barclays had an ROTE of 14.7%. This comprised an ROTE of 17.9% for CIB and 12% for BUK. CCP delivered 16.5%

2. The historic data shows the target is achievable. 

The following table shows Barclays return on tangible equity by division for the last few years:

Let us discuss each element in turn:

1. Barclays UK (BUK):

Looking at the above table it is clear that the UK business was at or near 10% ROTE for 2016 – 2018 but then went to low single digit ROTE. We believe that this has been due to the impact of provisions related to PPI and other conduct issues. We illustrate this in the table below by looking at the quarterly ROTE for the UK:

Our focus is the 2019 numbers and it can be seen that before the litigation / conduct impact the UK business was performing well. Clearly 2020 was impacted by Covid but we believe it is reasonable to anticipate that the RoTE will normalise in 2 years time; and without the PPI charges the returns should flow through to the group level.

The Barclays UK business comprises of three divisions – personal banking, business banking and Barclaycard Consumer UK. We touch on the latter within a discussion of credit cards below. The trends within personal banking and business banking are really no different from any other UK highstreet bank that has had to deal with PPI and Covid – but in particular there does not appear to be a significant deterioration that will require substantial new provisions.

2. Barclays International (BI):

If we focus on the last few years of Barclays International it is apparent that:

• The CIB business’ returns have improved significantly. In presentations the company highlights that the investment banking division has gained share against competitors. Nevertheless we acknowledge that the CIB unit will have benefitted from market volatility and fund raises / bond issuance from corporate clients during Covid

• Nonetheless it seems reasonable to assume that the unit can sustain circa 9-10% margins in a ‘normal year’

3. Credit cards

Barclays has two credit card businesses – Barclaycard Consumer UK (which is part of Barclays UK) and a separate business within CCP (consumer, cards & payments) which is part of Barclays International. Some of the following observations apply solely to CCP, whilst others also apply to the Barclaycard Consumer UK business.

CCP business seems to have averaged around 16% returns before Covid. We believe it is reasonable to assume these levels again in 2 years time – and perhaps earlier. This division includes Barclays’ international credit card business – which is mainly focussed on the US.

Barclaycard is Barclays’ branded credit card operations. Covid has led to less overall consumer activity and hence less credit card expenditure. We would expect this to rapidly rebound as the UK unlocks. Clearly international travel spending (which we expect to be a non-insignificant part of this revenue) will take longer. The Barclaycard business also profits from advances to customers and is impacted by credit impairments. In 2020 the advances fell from £14.7bn in 2019 to £9.9bn in 2020; whilst credit impairments were increased from £472m to £881m in 2020. We would anticipate both of these items reverse going forward. The 30 day arrear rate of Barclaycard consumer UK was 1.7% at the end of 2020 – the same as at the end of 2019.

CCP comprises Barclays’ US Consumer Bank, Barclays Payments, Barclaycard Germany and the Private Bank. In the US the business offers partnership credit cards via American Airlines and Wyndham Hotels & Resorts. Interestingly they have recently highlighted partnerships with GAP Inc, Emirates, AARP and point of sale financing with Amazon in Germany and the UK. They also provide finance for Apple products in the UK.

Why does the opportunity exist:

As well as the headwinds discussed above, the recent exiting of Sherborne from the share register and the temporary suspension of division has impacted the share price. Brexit uncertainty has also impacted international shareholders interest in UK stocks. Furthermore UK investors did not like the increase in costs in the investment bank in the recent quarterly results.

The risks:

UK institutional investors have, post 2008, not really believed in international or investment banking. This is perhaps reflected in their adulation of Lloyds (LLOY); and some of their ilk believed Bob Diamond was too ‘racy’. There is a clear risk that these investors will encourage the board to appoint a CEO with similar efficacy to Antony Jenkins (a previous CEO who was dismissed in 2015) and create a cult of the ‘sacred progressive dividend’.

How we obtain our price target:

The tangible net asset value per share as of 31 March 2021 was 267p. We think it will take 1 – 2 years for the market to be convinced that the bank can consistently deliver 10% ROTE. When it does we would suggest that the stock will re-value the stock at 1 - 1.2x P/B – thus giving a price target range of 267 – 320.4p and an average of 293.7p – the latter suggesting an upside of 65%.

We are likely to be significantly underestimating the upside potential. We would propose that the appropriate comparables for Barclays are Citigroup (C – 1.03x P/TB), JP Morgan (JPM – 2.53x P/TB), Morgan Stanley (MS – 2.01x P/TB), Wells Fargo (WFC – 1.48x P/TB), Bank of America (2.02x P/TB) and Goldman Sachs (GS – 1.48x P/TB). 

The reason to select this range of banks is (1) reflection of Barclays exposure to the US (2) exposure to investment and corporate banking (3) parts of Barclays are high quality franchises – similar to parts of the US banks (4) high dollar exposure in parts of the Barclays business.

(Simple average of the P/TB of the US peers is 1.76x which would reflect a price of 469p for Barclays ie an upside of 164% from the current price of 177.88p).

Conclusion:

Barclays is a globally significant bank, that is being valued at a discount to the appropriate peers due to local market attitude to international and investment banking. Within the bank there are a number of high quality franchises (particularly credit cards and UK retail). The bank has faced a number of headwinds which are now receeding.

Catalyst

The key catalyst is a consistency of ROTE over 4 - 8 quarters.