Beware Barclays

Barclays (NYSE:BCS) has had some tough years since 2012, impacted by several issues that led to very weak results despite several restructuring plans being implemented during the past four years. Without much progress being made, Barclays’ management was changed in 2015 and the bank has recently shown more progress to fix its structural problems. Nevertheless, things are improving slowly and until it delivers sustainable improvement of its fundamentals, its low valuation seems to be justified and Barclays is a value trap.

Company Overview

Barclays is a U.K.-based banking group that operates globally, providing retail banking, credit cards, corporate and investment banking and wealth management services. Its focus has shifted recently to be a consumer, corporate and investment bank, with a focus on its two home markets of the U.K and the U.S. It has also a strong presence in Africa, through ownership of Barclays Africa Group which is listed in Johannesburg. It aims to achieve regulatory deconsolidation in the next few years of its African business and has already sold a part of its stake, reducing it to 50.1%.

Due to its large size, Barclays is a Globally Systemically Important Bank (G-SIB) with a buffer of 2%. It has a market capitalization of about $35 billion and is listed in the U.S. on the New York Stock Exchange. Its main competitors are other U.K. retail banks like Lloyds (NYSE:LYG) or RBS (NYSE:RBS), but also global banks with significant investment banking operations like Citigroup (NYSE:C) or JP Morgan (NYSE:JPM).

The bank recently changed its business structure following several years of weak financial results and restructuring of its operations, being now split only in two major operating units, namely Barclays U.K. and Barclays Corporate & International.

This structure already reflects regulatory demands in the U.K., aiming to separate retail operations from investment banking activities. Barclays U.K. is the division that will become the group’s U.K. ring-fenced bank by 2019. Within its Barclays Corporate & International business unit is concentrated its corporate and investment banking operations, consumer, cards and payments, Barclaycard and wealth international.

Additionally, Barclays has Non-Core operations which are not focused on non-performing loans (NPLs), like some of its European peers, but has a focus on Investment Banking assets that are no longer strategic or do not generate attractive returns under the new regulatory paradigm. This is expected to run-down over time but still is a major drag for its earnings.

The division that generated more income in 2015 was Personal and Commercial Banking with a weight of 49%, followed by Investment Banking (26%), Barclaycard (22%) and Africa (15.5%). Non-Core operations reported losses and should continue to do so in the foreseeable future. Geographically, the bank generates about 48% of its revenue in the U.K., while Americas are responsible for more than 21%. Africa is also a large market, generating 16% of its revenues, followed by the rest of Europe with a weight of 11% and Asia with a smaller weight of 3%.

Financial Overview, Capital & Dividends

Regarding its financial performance, Barclays has had very weak results since 2012, reporting very low profits or even losses throughout this past few years. Its profitability has dropped considerably from the high levels achieved prior to the global financial crisis of 2008-09, when the return on equity (ROE) was above 20%, to near zero. The bank has been hurt by external factors, like the low interest rate environment in Europe or weak revenues in capital market activities, but also from one-off effects, such as huge litigation costs and provisions for bad conduct in the past, and from structural issues with some of its business units, especially within its investment bank arm and non-core operations.

Investment Banking has been a huge drag on the group’s profits, even though its size has been reduced compared to a few years ago. Its relatively high reliance on fixed income trading has been very bad for its performance, an issue that is similar for its peers Deutsche Bank (NYSE:DB) and Credit Suisse (NYSE:CS). Nevertheless, investment banking is still quite large within the group and should continue to have weaker profitability levels than other units in the next few years.

Another significant drag on Barclays’ earnings has been its Non-Core operations, which had more than more than $140 billion in risk-weighted assets (RWA) at the end of 2013, but were reduced to $61 billion at the end of 2015. Within Non-Core operations, Barclays was able to sell the Spanish, Portuguese and Italian retail networks, reduce assets and capital allocated to Non-Core operations. Nevertheless, during the past year Non-Core consumed around 20% of group capital and made a negative return of 26%. Therefore, Barclays’ ability to run-down more rapidly Non-Core operations is critical for its earnings turnaround. Its goal is to reduce RWAs to about $25 billion by 2017, which should lead to less capital consumption and a lower drag in profits. Its guidance is for losses of around $3 billion in the coming year, but this number should fall in the next few years as its size is reduced.

Litigation has also been a significant issue over the past few years, mainly related to payment protection insurance in the U.K., interest rate hedging products and forex rigging. Cumulatively, Barclays has taken more than $10 billion in costs over the years and is almost impossible to know if that amount is enough to cover all litigation issues. Therefore, future litigation costs have the potential to create short-term volatility in its earnings and push back its turnaround program.

Taking into account this poor track record of the past few years, it is no surprise that Barclays’ CEO has changed in 2015. The new management is now under the leadership of CEO Jes Staley, which has taken some steps to turnaround the bank. Further cost-cutting, business structure simplification, accelerating Non-Core run-down and selling Africa were the main decisions implemented to improve Barclays’ prospects in the future.

During the first six months of 2016, Barclays has shown some progress on its restructuring program reporting lower costs, shrinking Non-Core activities and improving capitalization. Its core operations showed good performance with a return on tangible equity of 11% (RoTE). In Non-Core operations the bank reduced RWAs by more than $4 billion, but losses increased from the same period of the last year. Its efficiency ratio improved in the last quarter to 65%, on track to be below 60% in the next couple of years. Despite this, its group RoTE was below 5% in the first semester of the year, a weak level of profitability, showing that Barclays still has a long road to turnaround successfully its business.

Despite these improvements, a new issue that may affect Barclays’ earnings going forward is Brexit. U.K. banks will likely face several headwinds both from a deteriorating domestic economy and higher economic and political risk, due to less predictability in the next few years. Also, concerns over the ability of U.K. banks to passport services into the European Union may lead to higher costs if banks have to relocate operations outside the U.K. This does not bode well for a bank that is trying to reshape itself but its full impact may take a few years to be visible.

Regarding capitalization, Barclays is one of the lowest capitalized banks compared to its closest peers, both whether considering its core equity tier 1 ratio or on a leverage basis. Its fully loaded core equity tier 1 (FL CET1) ratio was 11.6% at the end of the second quarter of 2016 and its leverage ratio was 4.2%. These ratios are much better than a few years ago and its capital deficit is now lower, but Barclays’ capitalization seems to be relatively weak compared to its closest peers and still needs some improvement.

The bank’s management acknowledges that and its aim is to improve capitalization over the next few years, targeting a FL CET1 ratio of about 12-13% in the medium-term and leverage ratio above regulatory requirements (currently about 4%), expecting to grow the leverage ratio further over time. To achieve these targets, it plans to sell more of its stake in the African business, accelerate run down of Non-Core assets and retain cash in the next few years.

Regarding its dividend, Barclays’ history is relatively good given that over the past few years its dividend was stable, despite its earnings volatility and reported losses. This was obviously not sustainable and the bank has already signaled that its dividend for the next two years will be suspended. Thus, for income investors Barclays may take some time to become attractive again, given that to resume dividend payments its financial prospects have to improve a lot, something that is not easily achievable taking into account the many issues it still has to fix.

Conclusion

Barclays is a global bank with a large size that has had poor results over the past few years, and its previous restructuring were not bold enough to change the bank’s course. Its current valuation seems cheap trading at only 0.47x book value, but this is more than justified by its poor performance. Some of its closest peers that are also restructuring stories, like Deutsche Bank, Credit Suisse or Standard Chartered (OTCPK:SCBFF), are trading close or below Barclays’ valuation, thus this book value multiple seems to be appropriate right now.

Under its new leadership that took control last year, it appears that Barclays’ issues are being addressed more decisively and some decisions to change its business profile are being made, like the sale of its African stake. However, there is a lot of things to fix and profitability may take some time to recover, thus until Barclays shows clear improvements that change its earnings power over the long-term it seems to be more of a value trap than an opportunity for value investors.

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 Unique Finance). I have no business relationship with any company whose stock is mentioned in this article.