Barclays reported attributable net income from continuing operations of £2,628 million, down 25% compared to £4,683 million in 2008. However, Barclays also earned £6,777 million on discontinued operations, including a pre-tax gain of £6,331 million on the sale of Barclays Global Investors, bringing total attributable net income to a whopping £9,393 million for the year. While Barclays only earned a recurring return on equity of 6.3% in 2009 by our calculations, we remain impressed with Barclays' performance relative to many of its peers, and we expect profitability to improve as credit costs decline. We are maintaining our 450p fair value estimate.
Barclays credit costs shot up 63% to £4.6 billion in the second half of the year compared to the first half, or 2.17% of loans on an annualised basis. Impairments rose across the board, but were especially impactful in Barclaycard's international portfolio and in Global Retail and Commercial Banking (Western Europe, Emerging Markets and South Africa). Barclays said it thinks credit losses have peaked and will slowly retreat. We tend to agree, both because of the work Barclays did early on to cut back on its riskiest lending and because global economies appear to be stabilising. We note, however, that Barclays scraped by in 2009 with very few big single-name losses, and whether it will be so lucky again in 2010 is difficult to predict.
We were glad to see that Barclays increased its core Tier 1 capital ratio to 10% and nearly tripled its holdings of cash, and we have no immediate concerns about Barclays' solvency. We think Barclays is largely done de-leveraging for the time being. While we think Barclays' lower leverage will make it a safer institution and reduce regulatory pressure on the bank, we think the bank will not be able to consistently return to its former levels of profitability at this level of leverage. We expect medium-term returns on equity to be only a few percentage points above the bank's cost of equity. In the longer term, we think new Basel regulations, when they are finalised and imposed, could force Barclays to shift some of its businesses, but we think the bank will have time to adjust in a rational manner.
Fair value estimate: 450p ¦ Uncertainty rating: High ¦ Economic moat: None
Thesis
(Last update 08/02/10)
Barclays is one of the three largest banks in the United Kingdom and has expanded around the world. Its large market share in its entrenched businesses--retail and business banking, credit cards, investment banking, and now its 20% stake in BlackRock--helped the firm to generate hefty returns during the boom years. Barclays has generated an increasing portion of its profits through the fast-growing but risky businesses like investment banking through Barclays Capital (35% of pretax profits in the first half of 2009) and International Retail and Commercial Banking. Barclays Capital acquired the remnants of Lehman Brothers in 2008 at a significant discount to book value, a transaction we think will create significant long-term value.
Like many global banks, Barclays has taken billions in write-downs since the credit crisis began in 2007 and has shored up its capital by issuing large amounts of new capital at knock-down prices. It managed to avoid turning to the UK government for support, unlike RBS and Lloyds, but nonetheless diluted existing shareholders by nearly 50%.
Even though Barclays is emerging from the credit crisis as one of the world's strongest global banks, its shareholders have taken a beating in the process, and we're left with mixed feelings about the UK bank. On one hand, we're impressed with its profitability through the crisis, its ability to remain independent, and the tremendous deal it got by purchasing Lehman's US operations out of bankruptcy. On the other hand, the bank's bad debts are increasing and eating away at its investment banking profits and--more importantly--future and yet unclear regulatory changes are threatening to reduce its profitability significantly.
Despite Barclays' stated goal of earning two thirds of profits from retail and commercial banking and wealth management, we think the future of its investment bank will be key for the group. Revenues have doubled during the last year as Barclays incorporated Lehman. Reduced competition in the sector may mean that Barclays will be able to maintain and even increase its outsized investment banking profits as it builds on its strong position in businesses like commodities trading, its strong capital position, and its good reputation. However, regulators around the world, and especially in the UK, were deeply frightened by the depth of the financial crisis. They are almost certain to require banks to hold much more capital against their risky assets and force banks to reduce the financial leverage that, in part, drove their fantastic profitability during the boom years. Although we think Barclays' prospects are better than many of its peers', we think that with lower leverage, the bank's profitability will be too low to justify the large premium to book value it once garnered.
Valuation
We are lowering our fair value slightly to 450p from 475p as we modify
our long-term assumptions. We assume that assets will fall sharply in
2009, as Barclays reduces its trading and derivatives books, and that
they will increase an average of 5% annually from 2010 to 2013. We
estimate that loan loss provisions will increase to 2% of loans in 2009,
from 1.2% in 2008, as loan losses increase across all categories but
especially in construction and commercial lending. We expect Barclays'
equity/assets ratio to increase from 1.8% in 2008 to 3.15% in 2013 as
regulators raise capital requirements, which will reduce profitability.
We expect trading income to rise above historical levels because of the
Lehman acquisition but fall below first-half 2009 levels, as regulatory
and market changes make trading less profitable. Using these assumptions
we estimate a fair value of 450p per common share.
Risk
Although concerns about Barclays' viability have eased, questions about
write-downs and its long-term profitability remain. Loan losses rose
rapidly in the first half of 2009, more than tripling in commercial
banking, and are likely to rise further and wipe out much of the bank's
profits in the near term. Regulators are nearly certain to require
Barclays to hold more capital in the future, which will reduce
shareholder returns and may require the bank to raise even more capital.
While these changes are likely to be rolled out gradually, giving
Barclays time to adjust, they could significantly affect the value of
the bank.
Management & Stewardship
John Varley became CEO in 2004. He joined Barclays in 1982 and is
married to a member of the bank's founding family. Varley is leading a
cultural revolution at Barclays that is intended to increase the bank's
global competitiveness, performance orientation, and entrepreneurial
spirit. At least eight of Barclays' top 20 executives have joined the
bank in the last 18 months. Among them is the tough, performance-driven
CEO of global retail and commercial banking, Frits Seegers. Another
force behind the changes at Barclays is Bob Diamond, the charismatic
head of Barclays' fast-growing investment bank and asset-management
businesses. He joined the bank in 1996. Although we're pleased with
Barclays' emphasis on economic profit and the measures the firm has
taken in the last few years to more closely link executive pay with
performance, we're concerned that management's unchecked ambition has
exposed the bank to excessive risk. Executive pay had been modest by US
standards but increased in recent years as the bank has granted
increasingly large pay packages.
Overview
Growth: Total assets increased a dramatic 67% in 2008 as Barclays
acquired Lehman's operations and as the accounting value of derivatives
increased. We expect the derivatives book to fall substantially in 2009
and for asset growth to average 5% thereafter.
Profitability: Barclays has been very profitable historically, but we think this is unlikely to continue. Return on equity was 20% in 2007 and 15% in 2008, despite very difficult conditions. We expect ROE to fall to single digits in 2009 but exceed its 12.5% cost of equity by 2011.
Financial Health: For now, Barclays sports a healthy Core Tier 1 ratio near 9% as of Q3. Proposed changes in global regulations may leave Barclays short of capital, but we think that Barclays will have time to adjust in ways that don't destroy too much shareholder value. Dividends will remain low, however, as Barclays hoards capital to buffer itself against the unknown.
Profile: Barclays is one of the largest banks in the United Kingdom and has operations around the world. Its businesses include UK banking, which serves retail and business customers in the UK; Barclays Capital, a debt-focused investment bank; international banking, which serves retail and business customers in Europe, Africa, and Asia; and Barclaycard, a large credit card issuer. Barclays has a 20% stake in BlackRock as a result of the 2009 sale of Barclays Global investors.
Strategy: Barclays' short-term strategy is aimed at building up its capital to weather the downturn in the UK. In the longer term, Barclays aims to earn two thirds of its income from retail and commercial banking and wealth management, thereby reducing its dependency on investment banking. Barclays' goal is to be in the top quartile of a group of peers in terms of total shareholder returns.
Bulls Say
1. Barclays has deftly sidestepped the huge write-downs taken by many other investment banks. Its strong position will allow it to gain market share at the expense of weaker rivals.
2. Prudent management practices such as bold measures to fix underperforming units and a strict adherence to generating economic profits should benefit shareholders.
3. Barclays Capital's push into emerging markets, such as China and Africa, will diversify the company's revenue stream and help stabilize profits, which will be especially valuable in the current difficult economic environment.
4. Barclays' acquisition of Lehman's operations out of bankruptcy enabled the bank to buy a very profitable business for a song while leaving behind the riskiest assets.
Bears Say
1. As currently proposed, changes in capital regulations could leave Barclays short of capital. As a result, it may need to sell valuable assets, such as its stake in BlackRock, or cut back on risk-taking in investment banking--either of which would reduce profitability.
2. Barclays escaped buying ABN Amro and avoided RBS's fate more by accident than by design. Barclays' has not left behind its empire-building ambitions and next time it may not be so lucky.
3. Delinquencies remain high in Barclays' loan book, especially in commercial lending. Loan losses are likely to dampen any windfall profits from investment banking.
4. Barclays makes about 60% of its loans in the U.K., which is facing an ever-deepening recession. Delinquencies there could cause significant losses at the bank.
5. Barclays' trading profits are likely to decrease as regulators sharply increase capital requirements and as competition reduces spreads.
