When it comes to UK equities, it's often hard to look beyond the daily contortions of the Brexit psychodrama. Unsurprisingly, international investors continue to give the UK a wide berth, meaning valuations are among the cheapest in the world, assisted by the fact that many of the largest UK companies earn much of their profits outside of the UK. The c.10% depreciation of sterling against the dollar since May has been a boon to these companies. On cyclically-adjusted PE, the UK market is the second-cheapest of G10 countries after China and trades at a 30% discount to the global average.
Buying UK equities at this point does require some faith the country won't go over a cliff on a no-deal Brexit. But this outcome now seems less likely after recent events in parliament (more here). Interestingly too, the betting odds - often the most accurate indicator in situations like this - continue to point firmly to some form of negotiated exit. Paddy Power is offering odds of 3/1 on no-deal against just 1/5 on no-deal not happening (link here).
For long-term investors looking for bargains in Brexit-Britain, the banks are an obvious starting point. They are profitable, cheap, high yielding and well regulated. I wouldn't look any further than Barclays, which after a 19% share price drop since March, now trades at a 10-year share price low. P/TNAV is below 0.5x, the PE ratio just 6.4x (2019 consensus EPS) and the yield 6%.
PPI overhang removed
The timing for looking again at Barclays is particularly good as we've finally had closure this week on PPI (Payment Protection Insurance) with the company announcing it will take a final provision for PPI claims of £1.2-1.6bn in its 3Q results. This follows similar moves from most other UK banks, all of which has seen a spike in PPI claims in the run-up to the claims cut-off deadline on 29 August (more here).
PPI has been one of the most expensive mis-selling scandals in banking history, costing UK banks in excess of £50bn in compensation payments. The suspicion amongst investors (well-founded as it turns out) that a final provisioning push would be needed has hung over the share prices of UK banks in recent months. The fact of removing this significant overhang should be positive for share performance from here on.
Source: Financial Times
Aside from clarity on PPI, I see three other key arguments for buying Barclays.
Barclays stands to benefit from weaker Sterling
Due to its investment banking and US credit card businesses Barclays earns half its revenues outside the UK of which 37% in the US. This gives the company a significant positive gearing to weaker Sterling. Weaker Sterling has been the most obvious economic impact of Brexit so far with the currency weakening by 7% against the dollar from the highs it reached in March.
Barclays' geographic revenue split (2Q19)
Source: 2Q19 results presentation
Part of the benefit is offset by the fact that Barclays also has costs outside the UK but the net gearing is still positive, a point management made strongly on the 2Q earnings call:
Was sterling to remain weak, certainly, earnings per share, that's definitely a positive. And it's been quite a reasonable move and that can only be helpful for us (CFO Tushar Morzaria, 2Q19 earnings call).
Precision is difficult but my rough estimate is that every 1% decline in the value of Sterling against the dollar increases Barclays net profit by around 0.5%, implying the weakening we've seen in recent months could boost profits by 3-4%.
Market earnings expectations are probably too low
Currency could be one reason management seems so much more optimistic on the profit outlook for this year than is the market. It was significant on the 2Q earnings call that management recommitted to their key financial target for 2019, which is to achieve return on tangible equity above 9%. This would imply net profit in excess of £4bn, which was also the level that profits were annualising at in 1H.
In support of this target, management also strengthened their cost commitment for this year, promising to hold total costs below £13.6bn, the lower end of the previous guidance range. They also expressed their confidence in the profit outlook by increasing the interim dividend by 20% (from 2.5p last year to 3p this year).
Also supporting the achievability of the >9% ROTE target is the fact that the company has been above 9% in five of the last six quarters and that both 1Q19 and 2Q19 were above this level (9.6% and 9.3% respectively).
It's surprising, therefore, that market consensus still sees ROTE being only 8.1% this year and net profit being only £3.7bn, 10% below the minimum level being targeted by the company (these are underlying figures excluding the additional PPI provision, which will be classified as non-recurring).
2019 profit guidance vs consensus and annualised 1H19
Source: company data, company-compiled consensus
Management were asked about this gap on the 2Q call and responded that they think it primarily reflects a more conservative market view on the 2H revenue outlook. They themselves expect revenues to be higher in 2H than 1H, driven by a better performance in the UK retail banking business as well as the international cards business, while they also talked confidently about the deal pipeline in investment banking.
If management are correct and they do reach the 9% ROTE target then there is the possibility the share price will be driven higher by material analyst estimate upgrades.
The investment bank continues to defy its critics
A key part of the bear argument against Barclays in recent years has been the investment bank. This is an issue I explored in depth in a previous article. The accusation has been that it is sub-scale, overly dependent on low margin trading activities and dilutive to group returns. Accordingly, it has tended to be very lowly valued by investors.
However, recent performance has been improving, which holds out the prospect the market may begin to reward it with a higher valuation. ROTE in 2Q was 9.2%, similar to the level of 1Q (9.3%).
Source: company data
And the revenue performance continues to be among the best of peers with Barclays' investment bank being only one of three peers to post higher year-on-year revenues in 2Q. Across the whole of 1H19, Barclays also posted the third-best YoY revenue performance, revenues being just 1% below 1H18 levels against average declines of 7% across the industry.
Source: company data
If Barclays' investment bank continues to post returns close to 1H levels it is very hard to see how the current, discounted valuation applied by the market can persist.
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 1H19 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 (£24bn) to derive the implied valuation being ascribed to CIB.
The conclusion of this exercise is that the market is valuing CIB at around £7bn. This is extremely low in view of the fact that the business has £26bn of allocated equity and delivered £2.4bn of annualized profits in 1H19.
The implied PE multiple is just 3x and the implied P/TNAV multiple just 0.3x. Assuming CIB's cost of equity is 12% then the 1H19 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 50-60%.
I've made the point in the past that for this upside to be achieved we'd need a period of consistency where CIB delivers over several quarters. That is what is now happening.
Implied value of Barclays Investment Bank
Source: author's calculations based on company data
Share prices of UK banks and other UK companies have been held back by fears of a no-deal Brexit, making the UK among the cheapest of the major global stock markets. The risk of no-deal has receded lately while UK banks have also finally seen the end of PPI.
In Barclays' case, weaker Sterling should boost profits, earnings expectations are well below what management thinks is possible and the valuation attached to the investment bank remains extremely low despite positive recent performance.
My preferred valuation methodology for banks is ROE/COE where I derive a fair value P/TNAV multiple by comparing ROE to cost of equity and factoring in a long-term growth assumption. The calculations for Barclays are laid out below using 2020 consensus EPS numbers.
I get to a share price target of £2.2 based on consensus 2020 ROE of 8.4%, which is still well below management's target of >10% for next year. This indicates Barclays is 57% undervalued and with the share trading at a 10-year low, now looks like a time to buy.
ROTE/COE valuation model
Source: author's calculations based on company data, company-consensus data
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.