Monday, February 13, 2006

Barclays Bank PLC

  
Barron's, Vito J. Racanelli, 13 February 2006

EXIT THE TUBE STOP AT LONDON'S CANARY WHARF financial district and you can't miss the Barclays blitz. The station is plastered with huge blue-and-white ads, featuring cheeky boasts like: "Barclays people have better legs...because we run with great ideas."

On this side of the Atlantic, where it's less well-known, the 300-year-old London-based bank is also garnering attention, at least on college campuses, where its recruitment efforts appear to be attracting an increasing number of students. Investors, on the other hand, have given it a bit of the cold shoulder. But there now appear to be reasons for them to give the company a warmer reception.

Over the past year or so, Barclays' shares, which trade in London and on the New York Stock Exchange, as American depositary receipts, have suffered from U.K.-related concerns, like a housing slowdown and consumers' closing their wallets. With British annual gross domestic product growth easing last year to below 2% from 3.2% in 2004, investors are less enamored of U.K. banks in general and Barclays in particular for its reliance on the home market for a large chunk of its profit. Low customer-service scores at Barclays 2000-branch United Kingdom retail bank, combined with recent earnings weakness there, haven't helped the cause, either.

Even so, the biggest knock on the company -- and its shares -- has been the performance of its iconic Barclaycard, a credit card well-known around the globe outside the U.S.

CEO John Varley wants a bigger global footprint. A key goal: boosting the slice of pre-tax profit that Barclays generates abroad to 50% from the current 33%. "I won't let the grass grow under my feet on this ambition," he pledges.

With some 11.2 million customers in the U.K., Barclays is the biggest British card issuer by far, with a major presence in Germany and Spain, too. So last May, when it was among the first U.K. banks to warn of a "significant" rise in credit impairment, the market quickly feared the worst: a wholesale deterioration in credit quality.

"People were worried that the banks would have to increase bad-debt provisions and make a mess of earnings," says Colin Morton, a London-based portfolio manager with BWD Rensburg. In fact, in the first six months of 2005, the latest period for which results are available, impairments did indeed rise sharply, coming in 26% above the level in 2004's second half, 42% off from a year ago.

Consequently, where once Barclays stock typically outperformed the U.K. market and its European banking peers, its London-traded ordinary shares have lagged of late. The FT-SE 100 index, of which Barclay's is a member, has risen 18% in the past 13 months, while the bank's stock is up just 4%. In that same stretch, Britain's banks have risen about 8% and Continental banks have soared 32%, though most are much smaller and less diversified. (All data are in local currencies.) Barclays' New York-traded ADRs, each of which represent four ordinaries, were trading late last week in the mid-40s. That's just about where they stood a year ago.

But the cyclical gloom overshadowing the U.K. stock market is obscuring some important secular changes at Barclays that, over the long run, should give it some of the best earnings growth among its peers.

For one thing, two of the company's key units, Barclays Capital (BarCap), the investment bank, and Barclays Global Investors (BGI), the world's largest institutional investment firm, are enjoying double-digit earnings gains. And as growing global businesses, both are lowering Barclays exposure to the British Isles every day. With a price-to-earnings ratio below most of its peers', many investors believe that Barclays stock already more than discounts a worsening of U.K. impairments this year, but reflects little or none of the likely improvements.

THE BEARS MIGHT ALSO be giving up too early on the U.K. For example, the Christmas season turned out better for retailers than expected, while the cooling housing market appears to have stabilized. The British economy, expected to grow about 2.2% this year, is unlikely to fall off a cliff as many had feared last year. Moreover, despite the retail bank issues, Barclays' U.K. corporate lending business, which is bigger than the retail bank, remains quite healthy, expanding at a double-digit rate. Even with its domestic issues, Barclays consistently has maintained a return on equity comfortably over 20%, a feat few other banks can match.

So it won't take much in the way of more improved U.K. data or continued execution at BarCap and BGI to begin dispersing the gloom that has gathered around Barclay's shares. With a dividend yield of 4% on the ordinary shares, Barclays' stock could begin to make up some ground and produce a 15%-20% return over the next 12-to-18 months.

BarCap is considered by many to be the bank's gem, based on its heavy exposure to fast-growing and diversified trading areas, like credit, currency and commodity derivatives, instead of conventional equity underwritings. And BGI, the industry leader with its roughly 40% share of the world's market for exchange-traded funds (ETFs), and 50% slice of the U.S. market, should have Barclays riding high on the secular change in investment allocation wrought by ETFs for some time to come.

ETFs are increasingly popular low-cost index-tracking funds that trade like stocks. According to Morgan Stanley, the U.S.-listed ETF market soared to $305 billion and 221 funds last year, from $227 billion and 169 funds in 2004. Some 70% of Barclays $1.4 trillion in assets under management use quantitative or passively managed strategies, like the well-known iShares ETFs.

BGI and BarCap are "fantastic businesses" that can be the motor of strong earnings growth in areas where most U.K. banks don't have any exposure, says Angus Parker, the London-based head of European equities for HSBC Halbis Partners, which began buying Barclays shares last month. With exchange-traded funds, BGI is taking advantage of one of the fastest-growing secular trends in the asset-management business. "Barclays has some franchises that I back for the long term," Parker adds.

ROBERT DIAMOND, PRESIDENT of Barclays and head of both BarCap and BGI, recently reconfirmed to Barron's his view that each division should produce annual operating profit growth of 15%-20% over the next few years. Yet many in The City and on Wall Street remain skeptical, thinking that such gains can't last, observes Brad Kinkelaar, a Santa Fe, N.M.-based analyst with Thornburg Investment Management. "Not many are convinced of BarCap's improvement...Not a lot of sell-side analysts have [Diamond's numbers] in their forecasts," he says. Thornburg takes a different view; it has a significant stake in Barclays. And there are other Barclays bulls, too.

Comments UBS analyst Alastair Ryan: "The environment for capital markets businesses like BarCap is as favorable as we ever remember it." The consensus forecasts pencil in roughly half the growth that BarCap sees, he notes, but "it's looking like Bob Diamond is right, and we are wrong." Thus, Barclays probably will be more profitable than expected, says Ryan, who has a Buy 1 rating on the stock.

SUSTAINABILITY ISN'T AN ISSUE for Barclays CEO John Varley. In an interview with Barron's, he points out that BarCap has broadly diversified its array of products and expanded its geographic reach over the past five years. "It's the area where the market has consistently underestimated the performance of Barclays," Varley says.

Once, U.K. interest rates and sterling-related products dominated BarCap's business. But now commodity- and currency-related products, and clients in the U.S. and on the Continent have become major contributors to the company's performance, he says. For example, the number of clients on the Continent with whom BarCap was doing more than a million British pounds ($1.74 million) of business "in terms of flow to us," or material relationships, was 85 in 2002, 135 in 2003, 260 in 2004 "I feel unconstrained in terms of [BarCap] market share," he states. The biggest source of income contribution in the first half of 2005 was the U.S., at 40%, he adds.

International growth at both divisions, along with additions like last year's purchase of South Africa's Absa Group, have gone a long way toward making Barclays less beholden to its home market. In 2000, some 81% of pre-tax profit came from the British Isles; now, it's 67%. Varley intends to cut this to 50%. Although he's cagey about the timing -- he describes himself as "a Sphinx" on the specifics -- he says that "I won't let the grass grow under my feet on this ambition." For 2006, in any event, with Absa still being integrated, it would seem other similar-size purchases are unlikely.

In any case, there's other work to be done.

THE MAJOR AREA THAT NEEDS improvement within Barclays' empire is its United Kingdom retail-banking operation. In the first half of 2005, this unit's pre-tax profit fell 2% below the year-earlier level, to £549 million. (Without a £42-million gain in the comparable 2004 period, results in 2005's first half would have been up 6%.) "I absolutely recognize that the market is looking for a turn in the retail tide...for revenue growth...and that's exactly what I'm looking for," Varley says.

Mortgages, long-term savings and investments, and insurance are the three retail areas "where, relative to our best competitors, we are underperforming," he concedes. In insurance, where Barclays has "always been a bit of a minnow...where we don't have a back book, we are being aggressive on price among other things," the CEO says.

Long-term savings is going to be an area of massive demand growth, and here BGI will play a big role in satisfying customer needs.

In mortgages, where Barclays U.K. share is single-digit, "we need to address retention. We are all over that like a rash." Barclays recently named Deanna Oppenheimer as the retail bank's chief executive. The hope is that she can duplicate the success she had at Washington Mutual, a major player in the U.S. retail-banking market. In any event, on Feb. 21, when the bank reports second-half 2005 results, the market will be watching closely to see how well the retail banking operation did.

The concern strikes some as overblown.

HSBC's Parker says that the slower-growing retail end continues to provide steady cash flows that can be used to invest in better areas, like BarCap, BGI and the international arena.

And, says Carolyn Kedersha, a Boston-based portfolio manager at Boston Co., which owns Barclays shares, retail remains nicely profitable on other measures. For all the hand-wringing, "the U.K. retail business generated...20% of group profit before tax in the first half of 2005 but required only 15% of risk- weighted capital allocated to it. Barclays is making a lot of money out of this franchise even though people say it is a weak link. It doesn't need some huge transformational fix," she maintains.

Similarly, she adds, the Barclaycard, "is a big winner," with earnings of 15% of the [company's overall] pre-tax total in the first half of 2005, but requiring just 9% of the risk-weighted capital allocated to it." Her conclusion: The cards division appears to be suffering from a fairly typical cyclical increase in bad debt, rather than any lasting problems.

Varley declines to give a forecast for the Barclaycard operation, but he does note that impairment provisions in the U.K. credit-card industry will "likely" be higher this year than they were in 2005, when the increases began. Still, this doesn't represent a massive deterioration in the credit cycle, he contends. "What we see is not a significant increase in the number of customers who are getting behind in their interest servicing...but where that has happened, the amount has increased."

THE CYCLE IN BRITAIN typically plays out in two to three years. "You are seeing people paying down debt. That's a typical sign of a turn in the cycle, a turn in attitude. We've managed through many cycles. We know what we're doing," he adds.

None of the preliminary fourth-quarter statements from the major U.K. banks in December showed worsening bad debts, and the market has begun to conclude that things aren't getting worse, says Morgan Stanley analyst David Williams. That's helped shares of U.K. banks, including Barclays, rally a bit in recent months.

Another positive: In its 2006 report published last month, the Institute for Fiscal Studies, an independent British research outfit, said that the nation's household savings rate had moved up steadily in 2005, suggesting that the consumer is rebuilding his balance sheet. And the trend at the Bank of England is for interest rates to stabilize, or perhaps even go down. Moreover, in response to the deterioration, Barclays and other banks in the United Kingdom have tightened their underwriting stance by raising card charges, notes the Boston Co.'s Kerdersha.

"WE EXPECT DELINQUENCIES to moderate," asserts Thornburg's Kinkelaar, who expects the Barclaycard unit to have an easier time in 2006 than it had last year.

With investors so down on Barclaycard and the retail bank, many believe it won't take much in the way of good news to push up Barclay's cheaply valued stock.

Morgan Stanley's Williams argues that if, as the data suggest, the U.K. consumer is repairing his personal balance sheet and delinquency rates decline, Barclays -- the U.K.'s top card issuer -- will be pushed ahead by a tailwind, rather than being hindered by a headwind, as it was in 2005. And if investors realize that such a reversal is under way, Barclays' stock price will benefit, says Williams, who expects earnings to beat the consensus forecast when the company reports on Feb. 21.

The Bottom Line

Investors are overly concerned about Barclays' challenges and overly dismissive of its promise. The stock is inexpensive and could return 15% to 20% within 12 to 18 months.The bank's ordinary shares trade at a price-to-earnings ratio of about 10.5 times consensus estimates of 59 pence ($1.04) a share in 2006, up from an estimated 54 pence last year. That's cheaper than the average P/E of 11 for other U.K. banks, even though Barclays probably will see the best earnings-estimate upgrades among them and "has a better-quality franchise," offers HSBC's Parker. And it's cheaper than the 11-12 P/Es sported by big Continental banks, whose growth is expected to be similar to Barclays'.

Meanwhile, the U.K. market, which, as noted earlier, rose four times as much as Barclays' last year, has a P/E of about 12-13 times, with a dividend yield of about 3%, notes BWD's Morton. Yet Barclays, the only U.K.-based play on the fast-growing international capital markets, trades at a significant discount to its home market and sports a better yield on the ordinary shares, 4%, he adds.

Joshua Byrne, the Boston-based chief investment officer at Putnam Investments, where Barclays is a prominent holding, finds it strange that less diversified and smaller British banks, like Lloyds TSB and HBOS trade close to, or at a premium to, Barclays. They are more exposed to unsecured credit and have little to do with the faster-growing areas that Barclays has moved into, he notes. Investors aren't giving the bank full credit for BarCap, he asserts, and "there's a valuation opportunity for us" as the market starts to come around on BarCap and when concerns about the U.K. economy ease.

There's also an unrealized takeover option not in the stock price, though Barclays $70 billion stock-market value would be a big fish to swallow.

There have been recurrent rumors that the Bank of America is interested in Barclays, and the British concern probably has been eyed by other banks over the years, too, argues David Hendler, an analyst at CreditSights. If either wanted to get involved in Europe in a big way, Barclays would be a nice fit for BofA or Citigroup he says.

Barclays CEO Varley won't comment on the rumors, other than to say that "of course, people are going to fancy Barclays as a marriage partner."

If the bank did become available, it would fetch a nice price. "Nobody is expecting it, but if there is a bid for Barclays, it will be substantially above the current price," maintains Morton.

YET, A TAKEOVER ISN'T NECESSARY to boost the stock. With continuing growth at BarCap and as U.K. worries ease this year, it could return 15%-to-20% over the next 12 to 18 months. And the most bullish investors see the stock undervalued by as much as 30% on some valuation measures, such as its price-to-book ratio. Barclays trades at about 2.3 times book, compared with a historical average of 2.7. A lot of big banks, like UBS, trade at more than 4 times book. "There's no reason why Barclay can't be around 3 times," adds Kedersha.

Investors have found reasons to shy away from Barclays. But as 2006 unfolds and the company's continued growth answers the naysayers, the stock probably will get the kind of warm attention it hasn't seen in a good while. Bank on it.

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