Barclays remains in the doldrums
Shareholders in Barclays (NYSE: BCS) have had a pretty lackluster year so far, with the share price rebounding by only 5% from its December lows over a period where UK peers like Lloyds (NYSE: LYG) and RBS (NYSE: RBS) are up 10-20%. Many of its continental peers have also outperformed substantially, with Credit Suisse (NYSE: CS) being +20% year-to-date and BNP Paribas (OTCQX: OTCQX:BNPQF) +15%.
Barclays has underperformed its peers so far in 2019
Source: FT markets data
In addition, Barclays' share price rating is low, in fact it is among the lowest in Europe with price to net assets currently being below 0.6x and PE below 8x on expected 2019 earnings. Amongst large-cap European banking peers only Deutsche Bank (NYSE: DB), Unicredit (OTCPK: OTCPK:UNCFF) and Societe Generale (OTCPK:OTCPK:SCGLF) are cheaper on price to net assets.
Source: company accounts, Thomson Reuters consensus 2019 data
The investment bank dominates the debate
Discussion about Barclays invariably ends up at the investment bank (NYSE:CIB). The focus on this unit has intensified in the recent period with the emergence of Edward Bramson and his activist campaign to have the business culled. Even if his bid to win a board seat failed at the AGM (more here from the FT) he has given voice to reservations many investors still hold about the wisdom of Barclays' commitment to CIB, which now consumes more than 50% of group equity.
But are things really as bad as the share performance and valuation rating suggest?
The Bramson critique of CIB is a good place to start as it resonates with the views of many other shareholders. He essentially argues that the business is flawed on several counts:
- It is sub-scale with a total balance sheet smaller than peers, especially US peers. Barclays' CIB assets total ~$1.1tn against Citigroup, for example, with $1.8tn
- It is overly dependent on low margin trading activities which make the business inherently volatile. Bramson cites CIB's revenue yield of 1.2% as evidence of this, compared, say, to advisory-led franchises like Morgan Stanley, which typically have revenue yields above 2%.
- It is dilutive to group returns, 2018 return on tangible equity being only 7.1% compared to Barclays' UK retail business at 16.7% (underlying) and the international cards and payments unit at 17.3% (underlying).
The table below shows some of the key financial metrics used by Bramson in support of his case.
CIB key financial metrics as per Edward Bramson letter to shareholders
The case for the defense
However, there are some important counter-arguments that can be made in defense of CIB.
My view is that CIB is never likely to be a great business but that it can become an adequate business that can cover its cost of capital. And this really is all that is required for there to the major upside to the Barclays share price since the valuation ascribed to the business by the market seems to be extremely low, appearing to assume that things can never get better.
I'll discuss this valuation point later but first the financial case in defense of CIB:
- Returns are on an upward path: most investors would probably put CIB's cost of capital at least at 10% and probably higher. From this perspective 1Q19 return on tangible equity of 9.3% is still too low. But the important point is that it is improving, unlike the returns of most of its European peers. ROTE was only 7.1% in 2018 and 2.2% in 2017. It remains to be seen if the 1Q19 level can be maintained through the remainder of this year but it's worth noting that management sounded confident that revenues at least into 2Q will strengthen. This is a point that has been echoed by other investment banks in view of generally difficult 1Q market conditions and subdued underwriting and advisory volumes. Barclays' management have also talked positively about the scope for further cost improvement to support returns.
I do think our Investment Banking fee number for the first quarter was a little bit low, and I think that's the calendar effect. We think we picked up market share at least according to the dealogic surveys, and I would expect Q2 fees to be certainly higher than Q1, and pipeline looks pretty strong. (CFO Tushar Morzaria, 1Q19 earnings call)
Source: company data
In addition, CIB's revenue performance has been better than peers lately, a sign the business is winning market share, especially in FICC and Equity trading. Overall CIB revenues were down 11% in 1Q19 compared to 1Q18. To iron out different seasonal patterns for individual banks it probably makes more sense to compare annualized 1Q19 revenues against full-year 2018 level (here I assume 1Q accounts for 30% of the full year outcome). On this basis Barclays' CIB revenues were 14% lower in 1Q19 than the rate of the prior year, giving it the best performance of peers bar BNP.
Source: company data *assumes 1Q19 is 30% of full-year 2019 outcome
- Barclays investment bank looks a lot more sensible than European peers. It may not be saying much to be best of a bad bunch but I think it's a flaw of the Bramson analysis that almost all the peer bench-marking is against US investment banks, which enjoy home advantage in the extremely high margin US IPO, advisory and equity underwriting markets. Looked at from the perspective of the European peer group, Barclays is doing a lot better. The next chart shows CIB profits going back to 2016 (indexed to 100). It highlights that Barclays is one of only two European banks to report higher annualized 1Q19 profits compared to 2016 (+4%). Deutsche Bank, Societe Generale, UBS and BNP have all seen sharp falls in profits over the period, ranging from 30% to 100%.
Source: company data
Barclays is also the most profitable of the European peer group, with 1Q19 return on tangible equity of 9.3% being more than 2% higher than the next best competitor (BNP Paribas on 7.1%).
Barclays is the top investment banking performer in Europe
Source: company report & accounts
The European comparison is important since the poor performance of peers is forcing some to retrench, notably Deutsche Bank and Societe Generale. To the extent this reduces capacity it should be good news for the returns of other banks like Barclays who are staying the course and may benefit from a redistribution of the European fee pool.
- The scale and revenue margin arguments against CIB do not stand up to scrutiny. Two of the key criticisms of CIB are that it is sub-scale relative to US peers and that it is too exposed to low margin business segments like FICC and Fx trading. I don't find either argument particularly convincing.
First, scale and profitability are not well correlated for investment banks. Some of the most profitable IB's are boutiques that have very small market shares but focus on businesses they are extremely good at. Among the larger European players, the most profitable investment bank of recent years is UBS (average return on equity of over 12% since 2016) but it achieves its returns with the smallest balance sheet ($75bn in risk weighted assets as of 1Q19 compared to Deutsche Bank with closer to $200bn). If anything, the next chart suggests that size and profitability are inversely correlated.
Size is not everything in investment banking
Source: company report & accounts *Risk weighted assets
Investment banking is more about being good at executing and keeping a lid on costs (especially compensation) than it is about size per se.
This feeds into the second issue of revenue margins. Whilst it is true that CIB's revenue margins are lower than peers this is not, on its own, an impediment to profitability. What is critical is that the cost base is sized appropriately for the margins that are being earned. In the case of Barclays it largely is sized appropriately: cost:income at 65% in 1Q19 is by far the lowest of European peers. This compensates for the fact that revenue margins of 5.6% (revenues as % risk weighted assets) are also the lowest of the group.
Of course, Barclays can always be better on costs and 65% is still too high to generate the level of ROTE the company desires. But the required improvement is fairly incremental, certainly when put alongside a competitor like Deutsche Bank, which has a similar revenue margin but a whopping 102% cost:income ratio.
It interesting also to note also that Barclays' revenue margin is not dissimilar to that of JP Morgan (6.0%). JP Morgan still earns a return on equity of 16% from this low-ish revenue margin. Why? Because it operates its investment bank on a 55% cost:income ratio.
Source: company report & accounts
CIB is priced to fail
The final important point about CIB that investors need to think about is the valuation the market current ascribes to it. It may not be a great business but if that is already reflected in Barclays' share price then it's not a reason to sell the shares. Indeed if the pessimism is overdone it might be a reason to buy the shares. This is more where my thinking is currently at on the issue.
I've sketched out below a basic calculation of the implied value of CIB within Barclays at Barclays' current share price. To do this I've taken the annualized 1Q19 profit level for the other business segments (Barclays UK, Consumer, Cards & Payments and Head Office) and applied a reasonable PE multiple (basically the current Lloyds multiple for BUK and the current JPM multiple for CCP). I've then backed their valuations out of Barclays' current market value (£27bn) to derive the implied valuation being ascribed to CIB.
The conclusion of this exercise is that the market is valuing CIB at around £10bn. This is extremely low in view of the fact that the business has £25bn of allocated equity and delivered £2.3bn of annualized profits in 1Q19.
The implied PE multiple is just 4x and the implied P/TNAV multiple just 0.4x. For comparison, Morgan Stanley and Goldman Sachs trade on roughly double the PE and P/TNAV multiples. Yes they are more profitable, but the gap to CIB is still huge.
Assuming CIB's cost of equity is 12% then the 1Q19 level of profitability (9.3%) would suggest a fair value price to net asset multiple of 0.7-0.8x. If Barclays could achieve this level of re-rating for CIB, the upside to the group share price would be around 40%. To do this we will need a period of consistency where CIB delivers over several quarters.
The market seems to value CIB at only £10bn putting implied PE at 4x and implied P/TNAV at 0.4x
Source: calculations based on company data
If you had a blank sheet of paper and were to redesign Barclays from scratch you probably would not include a business like CIB. It has many faults, including a track record of underperformance, volatile earnings and the fact that it operates in an intensely competitive global marketplace.
However, shareholders don't have the luxury of a blank sheet of paper and the question is whether it makes more sense to persevere with the business in the hope it can deliver adequate returns over time, or to radically restructure with all the associated risks and upheaval. The experience of Deutsche Bank should be an instructive lesson on how hard it is to successfully downsize a bulge bracket investment banking franchise, an exercise often compared to decommissioning a nuclear reactor: slow, risky and extraordinarily expensive.
I'm for the first course of action. CIB is not broken. It is improving, albeit from a low base and it appears to have a realistic shot at attaining at least cost of equity returns, benefiting from the fact that a number of European competitors are vacating the space and putting market share up for grabs. It was the most profitable European investment bank in the first quarter and has the second best profit growth record of the European peer group since 2016.
Most importantly for the future of Barclays' share price, it is priced to fail, meaning any positive surprises are likely to be richly rewarded by the market. At Barclays' current share price CIB appears to be valued at only c.0.4x P/TNAV and only 4x earnings. A doubling of these multiples would be justified if CIB could maintain its 1Q19 profitability level. This could potentially add 40% to Barclays' share price.
Coming quarters will be crucial and consistency of returns is key. But with an activist shareholder breathing down their necks, management have more incentive than ever to make CIB work and to unlock the share price upside that I currently see buried within the stock.
Disclosure: I am/we are long BNPQF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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