Barclays: Normalized Forward Dividend Yield of 4%
SEE LAST PAGE OF THIS REPORT Howard Mason
FOR IMPORTANT DISCLOSURES 203.901.1635
February 17, 2014
Barclays: Normalized Forward Dividend Yield of 4%
- The negative sentiment around Barclays, and cyclical component of the downturn in investment banking, creates a buy opportunity. It is not without risk given the potential legal/regulatory costs associated with alleged manipulation of the libor/currency markets, but investors are offered a large margin of safety; at 253p, Barclays is trading at a 10% discount to current tangible book value (“TBV”) which is likely to increase through 2014.
- Our estimate for end-2014 TBV/share is over 300p based on in-line EPS of 25p and a 40% dividend payout ratio translating to 10p/share (and 4% yield on the current share price). We expect the increase in the dividend from the current 6.5p/share to be announced at the 2014 AGM in April. Both dividend and TBV are at risk to legal/regulatory costs but these would need to reach GBP5bn for there to be both no dividend raise and for TBV to decline.
- We understand investor concerns on cost, particularly given the 10% increase in the 2013 bonus pool, but expect management to meet its expense target (of GBP16.8bn in 2015 down GBP1.4bn from 2013) through re-engineering. Meantime, Barclays cannot afford to lose good people in the investment bank, and we are concerned the compensation debate may be overly influenced by optics over economics (see Exhibit). Assuming management can pay competitively and notwithstanding increased capital intensity, the investment bank (absorbing ~40% of firm-wide equity) is an attractive business with a normalized ROE in the low-to-mid teens:
- Barclays is gaining share in equity capital markets and has a top-ranked FICC flow-derivatives business in both Western Europe and North America. In addition, we are confident CFO Tushar Morzaria (as former CFO of the Corporate and Investment Bank at JPM) will reduce the comp-to-income towards management’s target of the mid-30s from the current 43%.
- While Barclay’s target for a CET1 ratio of 11.5-12% is currently higher than targets for competitors (e.g. “above 10%” at HSBC and 10-10.5% at JPM), the gap will likely close. HSBC, for example, has acknowledged it could get guided to a higher point, and we expect the Fed’s “advanced approach” and CCAR testing to raise capital requirements for US banks. Ultimately, we do not expect UK regulators to impose disadvantaged end-state capital requirements on Barclays relative to large, global competitors.
- If we are wrong about a level playing field, Barclays will shrink or exit businesses rather than erode book value. While there will be exit costs, these are more than offset by businesses (see below) which generate returns materially above the cost of capital and so are worth more than book. This makes firm-wide tangible book value of 283p/share (albeit subject to currency swings) a very conservative measure of floor valuation.
- Looking beyond the investment bank, one-quarter of Barclay’s GBP52bn of common equity is absorbed by structurally attractive businesses including the UK retail branch bank (~15% of equity) with returns in the low-to-mid teens and Barclaycard (~10% of equity) with a high-teens return. Our concern is not with the investment bank but with the ~30% of Barclays capital deployed in under-managed businesses including the corporate bank (~15% equity and ROE<5%) and three equally-sized businesses (retail banking in Europe and Africa, and wealth management) which, between them, absorb ~12% of equity and, largely because of Europe, generated a 2013 loss of GBP1bn. We assume fixing these businesses is a CEO-level priority.
Exhibit: The Comparison of Barclay’s Bonuses to Dividends made it to the FT
Source: Financial Times, Feb 11th, 2014
At a 10% discount to tangible book value, and with book value likely to increase in 2014 notwithstanding the potential for substantial legal/regulatory costs associated with alleged manipulation of the libor/currency markets, Barclays offers investors a large margin-of-safety. The balance sheet is sound with management meeting the regulatory requirements for the leverage ratio (of 3% as calculated by the UK regulator) six months ahead of schedule and having a credible plan to raise the ratio the Tier 1 common-equity (“CET1”) ratio to 10.5% from the current 9.3% by 2015; this is above the regulatory requirement of 10.4% for 2019, and Barclays expects to continue to build capital for a CET1 ratio of 11.5-12% by then.
Barclays may face a higher minimum CET1 requirement than competitors because of “Pillar 2” requirements even though its Pillar 1 requirements (see Exhibit 1) are below those of JPM, C, DB, and HSBC with 2.5% G-SIB buffers; Barclays has a 2% G-SIB buffer versus 1.5% for BAC, GS, and MS . To support Pillar 2A requirements, the UK regulator is requiring that Barclays hold additional CET1 of 1.4% of risk-weighted assets. The Pillar 2 requirements for many competitors remains uncertain; for example, HSBC has set a total CET1 target “above 10%” but acknowledged in the November earnings call that “as the UK implements CRD4 we could get guided to a higher point”. We expect some resolution in the US with the results of the CCAR tests to be announced in March and note in the meantime that JPM is targeting an end-state CET1 ratio of 10-10.5%.
Regardless of short-term differences, we do not expect UK regulators to impose capital requirements on Barclays that place it at a meaningful disadvantage to large, global competitors in investment banking and other businesses. Based on this assumption, and given the portfolio of other businesses, we expect a normalized firm-wide return-on-equity for Barclays is low-to-mid-teens and this is consistent with a valuation at a 20% premium to forward tangible book, or ~350p/share. If we are wrong about UK regulatory policy, CEO Antony Jenkins has been adamant that he will not accept businesses that return below their cost of capital and so, by implication, will shrink or exit businesses rather than erode book value.
While there may be some businesses where there are exit costs (which must be deducted from current tangible book value), these are more than offset by businesses, such as branch banking in the UK and Barclaycard (together accounting for 25% of Barclay’s equity compared with ~40% for the investment bank), which generate returns materially above the cost of capital and are plainly worth more than tangible book. This makes firm-wide tangible book value of 283p/share (albeit subject to currency swings) a conservative measure of floor valuation even under adverse regulatory scenarios so that investors buying at the current price of 253p have a large margin of safety.
Exhibit 1: Minimum Required Pillar 1 CET1 Capital Requirements
Source: Global Banking and Capital Markets Sector, Ernst & Young, August 2013
At 253p, Barclays is trading at a 10% discount to current tangible book value of 283p and a 17% discount to estimated end-2014 tangible book value of 305p (see Appendix for Barclays Model). Investors apparently believe one or more of the following: that there is a hole in the balance sheet, that there is a need for an additional capital raise (above and beyond contingent convertibles), or that Barclays will earn less than its cost of equity.
Hole in the Balance Sheet
We do not believe there is a hole in Barclay’s balance sheet particularly given the regulatory approval last August for Barclays to increase its dividend payout to 40-50% (albeit after agreement on a GBP5.8bn rights issue). There may well be further legal and regulatory fines, particularly associated with alleged manipulation of currency and libor markets, which could reduce forward tangible book value below our estimate of 305p/share but, given the earnings power of Barclays businesses, they are unlikely to reduce it below current levels.
Additional Capital Raise
Basel 3 requires banks to have minimum “Pillar 1” common-equity tier 1 (“CET1”) captial of 7% of risk-weighted assets (comprising a base CET1 requirement of 4.5% plus 2.5% as a capital conservation buffer); in addition, as a global, systemically-important bank (“G-SIB”), Barclays must hold an additional 2% bringing the total CET1 requirement to 9%. Barclays risk-weighted assets are GBP436bn and its CET1 is GBP40.4bn putting its CET1 ratio at 9.3%. The UK regulator requires Barclays to supplement its Pillar 1 capital with Pillar 2 capital raising the practical minimum regulatory requirement for the CET1 ratio to 10.4%. Barclays expects to achieve this by mid-2015 and continue to build capital so that the ratio reaches 11.5-12% by 2019.
Banks also face requirements for broader Tier 1 capital which includes, beyond common-equity, additional tier 1 (“AT1”) capital. Contingent convertible securities, or “coco’s,” can qualify as AT1 capital provided they are perpetual and have low-enough conversion triggers. Barclays has issued GBP2.3bn of AT1 securities over the last 6 months so that its total T1 capital is GBP42.7bn allowing it to meet a minimum regulatory requirement of 3% for the leverage ratio (which uses “leverage exposure” rather than “risk-weighted assets” in the denominator); Barclays leverage exposure stands at GBP1,377bn.
The capital picture is complicated because implementation of the Basel 3 framework varies by regulatory jurisdiction. The European Union implements the framework through Capital Regulatory Directives with the current legislative package referred to as “CRD4”. In the UK, implementation is in the hands of the UK regulator, the Prudential Regulatory Authority or “PRA”, which has followed CRD4 with some important exceptions so that Barclays reports both CRD4 and “PRA-adjusted” measures of capital and leverage. For example, the above results are on a CRD4 basis but the PRA disallows GBP2.2bn of Barclays CET1 capital (so that the PRA-adjusted capital is GBP40.5bn versus the CRD4 figure of GBP42.7bn) and computes the leverage exposure as GBP1,363bn not the CRD4 figure of GBP1,377bn. These nuances aside, the bottom-line is that Barclays already meets future minimum regulatory requirements (see Exhibit 2).
Exhibit 2: Barclays Meets Future Regulatory Minimum Requirements
Investors are concerned that Barclays will not be able to meet its target for a return-on-equity above the cost-of-equity (pegged at 11.5% by management) in 2016 or beyond because FICC revenues are not coming back, expenses will not fall by GBP1.4bn to management’s target of GBP16.8bn in 2015, and regulators will move the goal posts so that the investment banking business that the increase in capital intensity surprises to the upside.
FICC Revenues: We see FICC revenues as being cyclically depressed. At the industry-level, the business is going through an important structural mix-shift from high mark-up, customized “structured” derivatives products to low mark-up, standardized (and increasingly centrally-cleared) “flow” products. Barclays is ahead of peers in completing this transition so that ~90% of its rates business is flow versus ~two-thirds in 2010 (see Exhibit 3) so that we do not expect a material headwind from this structural factor.
Exhibit 3: Transition to Flow Products Largely Completed at Barclays
Separately, there are cyclical factors: zero-interest rate policy (“ZIRP”) has reduced the incentive for clients to trade at the short-end and, over the last 6-months, this has been exacerbated by taper talk caused clients to step away in the intermediate and long curves. In short, FICC revenues are below-normal because of the monetary policy and rate environment and will first re-normalize. More generally, after allowing for a step-down associated with regulatory restrictions on structured derivative product, capital markets revenues will then resume long-run growth driven by the growth in global financial stock which ran at a CAGR of ~7% from 1990 to 2010 (with McKinsey, for example, estimating that the global stock of debt and equity outstanding increased from $54tn to $212tn including a 13% decline fall from a peak of $202tn in 2007 to $175tn in 2008 as stock market capitalization nearly halved to $34tn).
Expense Management: The new CFO at Barclays, Tushar Morzaria, has had his job for just over two months. During that time his primary focus has been managing the balance sheet to meet leverage ratio requirements; he delivered a reduction in leverage exposure of GBP140bn (excluding currency effects) and promised a further GBP60bn over the next six months versus initial management guidance for GBP65-80bn in total.
He is now “rotating” focus to expense management and has re-committed to the target for core operating expenses of GBP16.8bn in 2016 (albeit indicating some flexibility on the interim target of GBP17.5bn for 2014). Critically, Mr. Morzaria – as the former CFO for the Corporate and Investment Bank at JPM – brings compensation-management skills to the investment bank and so complements CEO Antony Jenkin’s more branch-banking background. We would be surprised if he does not deliver on management’s target for the compensation-to-income ratio to fall to the mid-30’s from the level of 43% in 2013, and this will be important for Barclays to generate operating leverage and to meet its firm-wide expense target.
Return-on-Equity: Barclays frames its return guidance for 2016 unusually: that the return-on-equity (ROE) will exceed the cost-of-equity (COE). This seems sensible enough although the notion of a cost-of-equity can be challenged as illustrated by the discussion in Exhibit 4 involving Charlie Munger.
Exhibit 4: Exchange Between Charlie Munger and Professor William Bratton, 1996
The issue is that the cost-of-equity is not directly observable (or even reasonably calculable) so that Barclays management simply asserts it – at 11.5% in mid-2013. On the Q4 conference call, the CFO responded to a question around whether COE had fallen because of delevering (given the GBP5.8bn rights issue and GBP2.1bn AT1 issuance) with words to the effect that he was glad investors might feel the COE had fallen, but Barclays had not updated its estimates; we take this to mean the target return-on-equity remains at 11.5%. (Technically, one could make a case that the COE, on a marginal basis at least, is 7% since this is current yield on recently issued AT1 securities which convert into equity if the CET1 ratio falls below a trigger – coincidentally 7% of risk-weighted assets).
Of course, current returns are meaningfully lower than this (5% for the firm and 11% for the investment bank – see Exhibit 5). Furthermore, the investment bank is running with equity equal to 8.5% of risk-weighted assets (“RWA”) of GBP222bn; if we delever so that total common equity is 12% of RWA, the ROE falls below 8%; of course, the actual impact of setting the CET1 ratio to management’s long-run firmwide target of 12% would be more severe since not all common equity counts as Tier 1. In practice, this “static” analysis is misleading since Barclays will not delever in isolation. Other investment banks will also be delevering changing industry pricing, and Barclays will at the same time be cutting cost.
However, it is likely that some of the investment banking businesses will be exited or downsized and, indeed, management has already given an example of this with the repo book being shifted from fixed-income to equity securities. The impact, then, of rising capital intensity (both in absolute terms and potentially relative to competitors) will not be that management at Barclays destroys value by earning inadequate returns but that the investment bank grows more slowly than it otherwise would (again both in absolute terms and potentially relative to competitors).
In practice, we do not believe Barclays will ultimately be leverage-disadvantaged relative to global investment banking competitors but, if we are wrong, it argues for a lower premium-to-tangible-book value than the 20% implied by our target price of 350p not a discount to tangible-book-value or even (given that 25% of Barclays equity is deployed in structurally attractive businesses such as branch banking in the UK and Barclaycard) merely tangible book value.
Exhibit 5: Barclays Return-on-Equity by Business
Appendix: Barclays Model
- In 2012, Barclays reached a non-prosecution agreement with the US Department of Justice in relation to allegations of Libor manipulation but it is conditioned on the bank not committing any US crime between 2012 and June 2014. It follows that, if Barclays is found to have criminally manipulated the currency markets, it will open up the prospect of legal and regulatory costs related to activity in both the rate and currency markets
- The European Union has implemented the Basel 3 framework through Capital Requirements Directives with the current legislative package referred to as “CRD4”; in the UK, implementation is in the hands of the Prudential Regulatory Authority or PRA which follows CRD4 with some important exceptions (so that Barclays, for example, reports both CRD4 and “PRA-adjusted” measures of capital adequacy and leverage).
- The CET1 ratio is the ratio calculated with a numerator equal to Common Equity qualifying as Tier 1 under regulatory capital rules, and a denominator equal to risk-weighted assets.
- Under the Basel 3, “Pillar 1” capital requirements are the minimum to meet the standards of the framework. In the case of CET1, they include a base requirement of 4.5% of risk-weighted assets along with, for institutions returning capital to shareholders through dividends or share buyback, a “capital conservation buffer” of 2.5%; in addition, global, systemically important banks must post an additional “G-SIB” buffer varying from 1-2.5%. Separately, the framework provides for national regulators to impose “Pillar 2” capital requirements, above and beyond the Pillar 1 minimums, based on on-going supervisory processes and stress-testing; the former are Pillar 2A requirements and the latter Pillar 2B.
- We know CAPM but question whether long-term investment decisions should be based on how much a stock bounces around day-to-day relative to others.