Barclays: Nearing The Bottom?

Aug.12.14 | About: Barclays PLC (BCS)


Adjusted H1 pre-tax profit fell 7% to £3.35 billion, beating analysts' expectations.

Investment bank continues to be a drag on earnings.

Barclays' UK Retail and Business Banking franchise and Barclaycard are highly profitable.

The bank's restructuring plan is on track.

Barclays (NYSE:BCS) reported its first half adjusted pre-tax profits had decreased by 7% to £3.35 billion ($5.62 billion), exceeding analysts' already downbeat expectations. Revenues from investment banking took a tumble as weak fixed-income, currency and commodities (FICC) trading environments persisted and the pound strengthened against the US dollar in the first half of this year. Profits before tax for the investment bank sharply fell 46% to £1.06 billion ($1.78billion). However, the bank has shown some improvement in revenues from financial advisory and equity and debt underwriting, as fee income rose 10% on the same period for the previous year. Under the recent restructuring plan, Barclays has shifted its focus from FICC and towards financial advisory and equity underwriting, which are some of the most attractive markets for investment banking in the medium term.

Profits before tax for the first half from Personal and Corporate Banking and Barclaycard rose 23% and 24%, respectively. These two divisions are highly profitable, despite an unexpected additional £900 million ($1.50 billion) PPI provision charge, as the level of customer redress remains high. The bank's Personal and Corporate Banking generated a return on equity of 12.1% in the first half of 2014. Net interest income rose 7% for Personal and Corporate Banking, as loans and advances to customers rose £5.4 billion ($9.1 billion) from a year earlier and net interest margin widened from 2.84% to 2.96%. The improvement can be attributed to improving economy, which is the cause of strong demand for mortgages and corporate loans.

Barclaycard, the bank's credit card and payments system business, is undoubtedly the crown jewel of the bank. Barclaycard earns a return on equity of 18.9% (2014 H1), which is substantially higher than all of its peers in the UK. Its huge scale, strong branding and innovation gives it a competitive advantage that its rivals envy. Growth at the business is also strong, and there is plenty of potential to expand internationally, not only in Germany and the US, but also across Europe and Africa. Barclaycard accounts for almost 23% of bank's adjusted pre-tax profit, and this business would likely be a major contributor of earnings growth in the future.

Africa Banking, which had suffered problems with high credit impairments from its loan book in South Africa, saw profits increase by 13% on a constant currency basis. Credit quality has improved significantly, particularly in the UK and with its Africa Banking mortgages, leading credit impairment charges to fall 13% to £937 million ($1.57 billion). Unfortunately, the weight of the investment bank in terms of allocated equity meant that the very substantial improvements in profitability made at the rest of the bank could not offset the decline in FICC trading income.

The bank's restructuring plans are on track, with adjusted operating expenses 9% lower for the first half of 2014. The new CEO, Anthony Jenkins, intends to put the retail and business banking business at the forefront of the business, whilst operating only in areas of investment banking where the bank can have capability, scale and competitive advantage. Barclays has planned to reduce the number of employees by 19,000 within three years, including 7,000 jobs at its investment bank. Employee headcount is already at the lowest level since 2007, as 5,000 jobs have already been cut.

Another part of its restructuring plan has been to create a non-core division to hold assets which no longer fit the bank's strategic objectives. These assets include its European retail banking business and securities and derivatives from its investment bank that have become increasingly costly to hold, given the introduction of stricter capital requirements. The bank will look to exit these lines of business by seeking potential buyers on or run-down over time. The non-core bank made an attributable loss of £464 million ($778 million), from total risk-weighted assets (RWA) of £87.5 billion ($146.8 billion).

Although largely nominal, the creation of a "bad bank" can help to improve transparency for investors and external analysts. A separate non-core division helps to express the underlying profitability at the "good" bank and shows the pace at which "bad" assets are being disposed. Internally, managers directly overseeing the "bad" assets are free from internal conflicts of interest and have only one objective in mind, which is the orderly disposal of those assets to release equity to generally more profitable areas of the bank.

Currently, Barclays trades at a price-to-book value of just 0.66, and a price-to-tangible-book value of 0.78. This is substantially lower than the valuations attributed to its peers. Lloyds Banking Group (NYSE:LYG), which is essentially a UK retail and corporate banking outfit, trades at 1.48 times tangible book value. Although Lloyds benefits from its huge scale in UK retail banking and lacks a sizeable investment bank; the valuation gap does seem excessive in light of the long term outlook for Barclays' Africa Banking and Barclaycard businesses. Litigation concerns relating to dark pool trading may help to explain some of the negative sentiment with the bank; but the potential impact of these risks should be relatively small-scaled in comparison to the recent fall in the value of the bank's shares. In the meantime, we can expect a stronger set of earnings for the second half of 2014, as the impact of lower credit impairments and cost reductions start to show up in earnings.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article. The author is long BARC.L