Barclays PLC – LON:BARC
Share Price – £1.50
Market cap – £25.35bn
Eight years on from the financial crash of 2008, the fallout across the financial sector is still being felt. No more is this evident then at Barclays PLC. After years of restructuring, CEO Jes Staley announced yet another re-organisation with the bank being stripped down to profitable core operations, while also announcing a dividend cut to raise capital. The reaction from long suffering shareholders was sharply negative to the proposed two year plan. Particular ire was directed towards the investment bankers, who endured only a 10% cut to bonuses, as opposed to shareholders who had the dividend cut by over 50%. Shares moved down to 52 week lows, with the bank now trading at share price of £1.50 as of this posting, off of tangible book value of £2.75. The market has clearly lost patience with Barclays and their turnaround. However I believe that bank now trades at a sufficient discount relative to peers even at today’s depressed valuations. I also feel that the substantial discount to tangible book value provides a margin of safety.
Even before the latest restructuring was announced, the Barclays of 2015 had already underwent significant change since the crisis. Legislation has forced Barclays to ring-fence the retail operation from investment banking, the wealth management operation was sold to raise capital, and already the first steps were made to withdraw from non-profitable Asian/European markets. The latest plan accelerates further change, focusing the company around three specific business lines, Retail and Corporate, Barclaycard, and Investment Banking. The African operation is to be sold, with remaining non-core areas to be sold or put into run-off. A sum of the parts examination however, reveals that the underlying businesses that the company are looking to focus on, are priced at a discount when compared to competitors operating even in today’s poor banking environment.
Undoubtedly the jewel in the crown of the company at the moment. While not the most profitable part of the business on an absolute level; in terms of cost ratio’s, net interest rate margin, and return on equity – Barclaycard is the best part of the business. If you were to apply Capital One’s current PE to this chunk of the business, you’d have Barclaycard being valued at £11bn just by itself.
Retail and Corporate
By far, the largest part of the Barclays business is the Personal and Corporate operation. Costs are higher, margins are lower and returns on equity are also lower than Barclaycard, but still at a level that will provide a decent return for investors. If the Lloyds valuation is anything to go by, then a multiple of 6x pre-tax/impairment earnings is a reasonable price for this business – giving a valuation of £18bn. Please note, that the combined value of Barclaycard and the Retail/Corporate operations using competitors as a comparison exceeds the current market cap by nearly 20%. In this case, you really are getting the investment banking part of the business for free.
Investment banking is currently in a cyclical decline with all competitors facing significant challenges. If it’s bad in the US, the situation is even worse in Europe where the likes of Deutsche Bank and Credit Suisse have struggled badly in the last year. If you were to value this part of the business at just 8x after-tax earnings, it gives a bargain basement valuation of £6.4bn. The optimist in me would like to think that at some point in the future, animal spirits will run free and corporate financing activities will be required again. Until then, at least we’re getting the business for free.
No longer relevant to the investment thesis as this is to be sold with management giving guidance of £3-4bn for the sale.
Currently running at negative £1-1.5bn. The vast bulk of the original £400bn of leveraged non-core assets has been reduced to £120bn and falling. By 2017 the bulk of the non-core operation run-down should be complete.
Current chairman John McFarlane has a reputation of being a ruthless turnaround expert, having re-organised Aviva, which subsequently managed to emerge after a wobble a few years back. His appointee to the CEO role is an ex-JP Morgan investment banker in Jes Staley who was given a mandate to accelerate the turnaround plan.
While investors have reacted negatively to the dividend cut, for me, the cut has shown good judgement on behalf of management. Capital requirements have to be met, and for Barclays to do so requires either assets be sold at rock bottom prices, equity to be raised (major dilution), or the dividend to be cut. A temporary dividend cut is undoubtedly the best of some bad options. Paring back to the core profitable operations also makes sense (Barclay card, UK retail and corporate are both extremely good businesses). I can see why Staley is willing to persevere with Investment Banking. The sector in Europe especially is currently in a downturn (Deutsche Bank and Credit Suisse are also feeling the pinch), and for Barclays to sell the company, or withdraw from a declining market could be selling the business at a low. I cannot say when, but at some point, demand for investing banking services will pick up. What’s not clear is the sale of the African bank – it makes little sense to me that they would sell a business that makes £1bn for between £3bn-£4bn. My worry is that we’re selling something that we know is profitable in the here and now to keep something else that only promises a return to decent profitability.
It’s understandable why Barclays has been the laggard in UK banking over the last year. When a competitor (Lloyds) are increasing dividends and reaching the end of restructuring plans, it’s not surprising that frustrated investors in Barclays have been throwing in the towel after having their dividend cut, with yet another restructuring plan put into place. A sum of the part analysis reveals that the core of Barclays operations are good businesses (worth at least £2.00) and I believe that if the patient investor is willing to wait, the shackles of the under-performing non-core business will be thrown off, allowing full value of the business to be recognised. What’s more – my valuation model also provides a free option on the investment banking side of the business. It’s impossible when/if investment banking will be turned around, but it’s not relevant to the thesis, and would be the icing on the cake.
Possible catalysts for value creation
- An increase in the dividend/share buy back. In a decent year, a striped down and restructured Barclays should be able to post about £5bn worth of earnings after tax based on 2015 figures (retail/corporate doing well, investment doing poorly). Assuming a 40% payout, investors could start expecting a dividend of 12p for the full-year of 2017, giving a yield of 8.5% based on the current share price of £1.60. Assuming that transpires, the dividend investors are likely to return to Barclays. If the Lloyds current dividend yield is anything to go by, you have a three year time-frame for the doubling of the share price.
- Splitting the retail and investment banking operations into two separate companies. The British retail side of the Barclays business has shown strong underlying strength. The investment banking arm on the other hand has generated sub-par returns on capital. Splitting the company would allow the full value of the retail operation to be realised.
- A free option on investment banking operation. Given that Barclaycard and Retail and Corporate banking are already priced at a discount. The market is giving no value to Investment banking side. I can understand why Jes Staley has decided to keep the faith with investment banking. This is understandable, as the investment banking related activity in Europe has been down sharply over the last year.
- Exceptional items have proven to be less than exceptional over the last few years (mis-selling fines, LIBOR-fixing fines, etc.).
- A downturn in the UK economy would have a very negative impact of the company as the company is now more heavily exposed to the UK.
- My model expects non-core run-off losses continue along the same lines as we’ve seen in previous years.
- Leverage ratio of the bank is 4.5%, which is higher than peers and exposes the bank to more catastrophic risk.