Barclays Plc – 07 July 2014
In the 324 years since Barclays was founded as a goldsmith’s bank, on Lombard Street in London, it has grown to become the UK’s second largest financial institution with approximately £1.36 trillion in assets.
The modern day business is split across four divisions, Personal and Corporate Banking, Barclaycard, Africa and Investment Banking. The bank operates a significant retail branch network and employs 140,000 people worldwide.
|Index||FTSE 100||Ticker||BARC.L||Latest Close||216.00|
|Price Target||190.00||52 Week High||302.53||52 Week Low||209.40|
|P/E||12.9||Dividend Yield %||3||Dividend Cover||2.5|
|CEO:||Anthony Jenkins||CFO:||Tushar Morzaria|
UK Banking Shares Overview
Since the global financial crisis, banking firms have faced increasing levels of scrutiny from regulators, politicians and members of the public. The perception that activities undertaken by the sector were at least, in some part, responsible for the crisis has damaged both the brand and reputation of many global names.
In a post-crisis world, increased scrutiny of the industry has seen previously closed doors prised open, and this has led to the unveiling of many past misdeeds. Scandals surrounding payment protection insurance, interest rate swaps, LIBOR, various commodity benchmarks and most recently the FX market have each embroiled large segments of the industry – leading to record fines in some cases.
With public trust and confidence at an all time low, UK-focused institutions have each engaged in a race to become the “local” customer-centric institution that was, once upon a time, the pillar of many regional economies. Despite these efforts, a mood of caution continues to overhang banking shares as the flow of regulatory actions is yet to show signs of abating.
Barclays: Breaking the Bank and putting it Back Together Again
Of the UK institutions embroiled in the crisis and consequent scandals, one of the hardest hit has been Barclays Plc. After becoming highly over-leveraged during the run up to 2008, the weeks preceding the Lehman Brothers collapse saw Barclays forced to raise capital in the face of spiralling losses within its loan & investment portfolios.
The alternative to recapitalisation in the private sector was to accept UK government intervention and to resign the bank to the same fate as Lloyds Banking Group and Royal Bank of Scotland. The board had assessed that any such intervention (shareholding) would have been bad for existing shareholder value and the longer-term future of the bank.
Consequently, management set out to raise new equity capital from any and all possible sources. The first move by the group was to launch a rights issue for £4.5 billion, which sought to raise funding from existing shareholders and the UK public.
At the time of the deal, less than ⅕ of the shares on offer were taken up by existing investors as a result of damaged confidence and a lack of interest following multiple rights issues from other major banks.
This saw Barclays remaining under-capitalised and vulnerable to government action. Within a three-month period following the failed share offer, the bank raised nearly £12 billion from the Qatar Investment Authority and Challenger (QIAC), as well as other Middle Eastern investors.
It then used some of the funds raised to purchase the investment banking and trading operations of Lehman Brothers following its collapse. The outcome of this situation was a recapitalised bank, well positioned to expand its previously profitable investment banking and trading activities in the world’s largest market, the US.
The shares eventually bottomed close to the 50.00 pence level in early 2009 and before the end of the year had risen back to nearly 400.00 pence, recovering almost fifty percent of their earlier losses.
Barclays Shares at Weekly Intervals / Post Crisis
Barclays Shares at Weekly Intervals
Skeletons in the closet
While an initially promising recovery provided hope for investors, by late 2010 the early signs of a more serious deterioration in Europe were becoming evident. This marked the beginning of what eventually became a far more protracted crisis, with much greater consequences.
It also marked the beginning of another crisis, one that was more concentrated in both focus and consequence. Increased scrutiny of the banking sector, accompanied by regulatory changes, began to unearth a sluice of past misdeeds that by 2014, would cost the industry and its shareholders billions of pounds in fines.
In some cases, the fines paid by banking organisations in the post-crisis world have far outweighed the losses sustained, and costs incurred, by the collapse of equity markets and public confidence in 2008.
Barclays Plc specifically has been embroiled in almost every major scandal to emerge since this time, at a significant cost to both its shareholders as well as the bank’s ability to move forward.
Anthony Jenkins Eyes Go-to Bank Reputation; Transform Programme under Way
The wake of the Libor scandal in 2012/2013 saw Barclays Chief Executive Bob Diamond replaced by Anthony Jenkins, a time served retail banker. The new CEO has been at the head of design and implementation when it comes to the bank’s Transform programme, another rescue effort aimed at reviving the bank’s beleaguered reputation.
Transform Objectives; Becoming the Go-to Bank
-Turnaround – (Stabilise, Culture and Values)
-Return Acceptable Numbers (Reduce Volatility of earnings and risk-weighted capital allocation to the investment bank)
-Sustain Forward Momentum (Do not become a One-Hit Wonder)
While it is difficult to disagree with management’s objectives, the proposed strategy for reaching these does give way to certain concerns in our view. The most notable of these is the tone that has been adopted toward the group’s investment banking and securities division, the largest net contributor to earnings in Q1 2014 despite a downturn in trading volumes and revenues.
While the IB division is more than deserving of criticism given its prominence in most of the scandals to have embroiled the bank, the move toward reducing the Barclays footprint in this area bears a remarkable resemblance to the actions of an inexperienced investor in the midst of a market correction.
At a time when many competitors are heading toward the exits of various high-profile businesses, instead of seeking opportunity the new Chief Executive appears poised to follow suit with the pack by effectively selling at, or close to, the bottom.
In addition to this, much of the management speak surrounding the road ahead for Barclays tends to place the greatest level of emphasis upon becoming the “Go-to” bank for retail and corporate customers, which echoes the current strategy of many other UK-focused banks.
In a recent report on TSB Bank, we detailed our belief that “local banking” as a concept is firmly within overbought territory when it comes to UK retail consumers.
Given that new client acquisition is a notoriously slow process in the retail market and that each of the big names are making their own concerted efforts to appeal to retail and SME business, our view is that the “Go-to bank” strategy is unlikely to prove sufficient enough to reverse Barclays earnings decline, placing a question mark over the near term future of the bank.
2013 Operational and Financial Performance
Overall, revenue for Barclays fell throughout the 2013 financial year, leading to a 32% decline in post-tax profits. This was the outcome of tough trading conditions across core operations as well as regulatory and internal restructuring costs. Despite this, the bank made good progress across a number of other key metrics.
The group’s loan to deposit ratio reduced from 110% down to 101% over the period, a move that was accompanied by an improvement in capital position following a rights issue during the summer and further deleveraging across divisions.
In addition to this, new provisions for PPI and interest rate swap claims were lower when compared with the 2012 reporting year. Net interest income (NII) also increased during the period, reflecting notable growth in customer deposits.
Although BARC’s net interest margin fell in 2013, it later improved during the opening quarter of the new year, establishing a solid base for greater enhancement to NII over the coming quarters.
Despite the positives, Barclay’s ROE remains below its cost of capital and the business continues to face challenges in its external environment, most notably where regulatory actions and trading conditions are concerned.
Further from here, provisions for regulatory redress remain necessary; combined with steps to improve the group’s overall capital position, this continues to suppress earnings at abnormal levels.
The reasons for the decline in revenue within FICC are low volumes and a lack of volatility in fixed income and FX. Each of these is bad for broker dealers as they normally result in lower levels of transactions, which reduces commission income.
In addition to this, market movements are muted which makes it more difficult for proprietary trading divisions to optimise risk reward ratios and achieve returns.
So why is Volatility So Low?
In fixed income, the unprecedented involvement of central banks (Federal Reserve, Bank of England and Bank of Japan) has been the key cause behind lower volatility as record, and ongoing, purchases have in many cases led to the evolution of a buy and hold market.
With the implementation of “the taper” at the beginning of 2014, consensus expectations have been for a rise in US-T yields caused by a steady exit of participants from the market, in anticipation of the Fed’s own exit at a later date. This has reduced active trading volumes.
In addition, the same policy conditions and the advent of forward guidance have led to a similar decline in volatility within the FX market. This has further constrained trading activity and restricted the bank’s ability to generate commission income and returns from proprietary trading.
While the above conditions have been detrimental to the FICC division’s financial performance, the current horizon does offer signs of a turn for the better as interest rate expectations change. Present forecasts, supported by the current yield curve, suggest an increase in the federal funds rate sometime in the latter half of 2015. Further from here, the Bank of England is also expected to raise rates in 2015, more than likely before the Federal Reserve.
In short, the advent of a rising rate environment in developed nations would be the catalyst required for a change of paradigm, more than likely acting as a trigger for increasing levels of activity across both fixed income and FX markets, as well as in other asset classes. This would be positive for Barclays’s FICC division and could help to drive a long overdue recovery in earnings.
Balance Sheet Dividend and Valuation
As referenced earlier, throughout the 2013 financial year Barclays made good progress in improving the state of its balance sheet. The group’s loan to deposit ratio came down from 110% to 101%, while Tier 1 capital also reached 3% of assets with the aid of a rights issue in the summer of 2013. This brings the bank closer to its own 2016 internal target of 4%.
Despite the balance sheet improvement, earnings remain under pressure at just a fraction of what they were a small number of years ago.
For the full year previous, Barclays reported adjusted basic earnings per share of 16.7 pence, which places the bank on a multiple of 12.9 X 2013 earnings. This is below the FTSE average of 14.4 but at the same time, slightly higher than what would be expected for an inward looking UK financial institution.
In relation to dividends, the shareholder pay-out for 2013 remained flat (6.5p) with that of 2012. Despite the reduction in earnings, dividend cover has remained at suitable levels, which leaves the current pay-out in little danger of being reduced if all other things are held constant.
The pay-out for the year was 6.5 pence, which equates to a yield of 3% based upon today’s prices, covered 2.5 X over by 2013 earnings.
Barclays Shares at Daily Intervals
At present, the shares are well supported at 210.00 pence; however, it is not possible to know the outcome of a recent probe by US regulators into the way that the group’s “dark pool” platform has been both sold and managed.
Given the recent level of aggression toward financial firms from US regulators and government agencies, the risk that Barclays may suffer a similar fate to the French BNP Paribas is high.
Should the market perceive that any eventual financial penalty would be of a similar scale then this could lead to a further break in the shares back toward multi-year lows, in the region of 180.00 pence.
Looking further out, we see uncertainty surrounding the investment bank as having the potential to undermine Barclay’s reputation and brand in what is a highly profitable market.
This holds negative connotations for longer-term earnings performance given that the contribution from Barclays’s “growth” businesses such as Barclaycard remains small in comparison while new entrants and competition threaten the group’s retail and SME strategy in the UK.
Although we see the potential for a recovery in the shares over the quarters ahead, driven by an uptick in FICC activity during 2015, short-term regulatory risks and the clouded longer-term outlook leave us with a preference to observe price action in Barclays’s shares from a safe distance.
Our short to medium term price target for BARC.L is 190.00 pence, while we expect any near-term upside to remain capped at or around the 250.00 pence level.
The contents of this report and the Stockatonia website (https://www.stockatonia.co.uk/