Barclays Worth $11 Despite Headwinds Presented By Brexit Over Coming Years

Since the beginning of the year, Barclays (NYSE:BCS) has seen its shares lose more than 35% of their value, primarily as investors dumped shares of the U.K.-based banking giant in light of the negative impact Brexit will have on the bank’s profitability over coming years. The bank’s share price was already on a decline before the Brexit vote, as investors chose to stay away from the European banking sector in general given lukewarm economic indicators for the region, and a strengthening U.S. dollar only made things worse.

Although Barclays’ shares have seen some gains over recent weeks after the bank reported better-than-expected results for the second quarter, we believe that the shares remain grossly undervalued. After all, Brexit is only the latest in a long list of concerns investors have raised about Barclays, including its large unresolved legal burden, high costs related to restructuring and disposal of non-core assets, and low dividend payouts. But the fact that Barclays’ shares are currently trading at just 55% of their tangible book value lends support to our belief that investors’ fears about the bank’s future prospects are exaggerated.

We recently revised our price estimate for Barclays’ stock downwards from $13 to $11 to factor in the anticipated slowdown in Britain’s economy over coming quarters and also to include the sharp devaluation of the British pound with respect to the U.S. Dollar over recent months. The new figure is still roughly 30% ahead of the current market price.

See our full analysis for Barclays’ stock

A U.K. Slowdown Will Make Barclays’ Path To Recovery A More Challenging One

Barclays’ ongoing struggle to return to profitability since the downturn of 2008 is no secret to investors, as the British banking giant continues to work its way through a long list of legal charges for financial misconduct as soft economic conditions in Europe weigh on its results. It has also incurred millions in restructuring costs from the British government’s decision to ring-fence the bank’s retail banking operations from the investment banking division.

And with the U.K. unexpectedly voting in favor of leaving the European Union, earnings are likely to take a hit over the next couple of years. The impact of Brexit and the growing uncertainty around U.K.’s economy on Barclays can be summarized in terms of two core factors:

1. Lower Revenue Potential, Higher Costs

A slowdown in the U.K. will directly affect lending activity in the country, with banks witnessing a sharp decline in the demand for mortgages, auto loans and other personal loans from retail customers. Businesses will also avoid taking on additional debt – slowing the rate of growth of the banks’ commercial loan portfolios. We forecast a decline in outstanding loans for Barclays’ core personal and corporate lending division as shown in the chart below.

While a reduction in loan volumes will hurt retail banking revenues, a reduction in overall debt and equity market activity levels will also drag down investment banking revenues. This includes fees from debt origination and equity underwriting for Barclays, as well as revenues for the bank’s fixed income, currencies and commodities (FICC) and equity trading desks. Taken together, these form a sizable proportion of Barclays’ total revenues in a given quarter.

Even as Barclays continues to incur high costs to comply with the ring-fencing rule, the bank will also have to work on changes to the structure of its investment banking arm to be able to provide services to its European clients outside the U.K. This is because Brexit will make it necessary for all investment banks which use London as their de facto European headquarters to build a stronger presence in an alternate location within the EU. This will result in additional one-time costs for the investment banking division – weighing on profit margins in the near future, as we show in the chart below.

2. Decline In Asset Quality

Besides the direct impact on revenues and costs for Barclays, a slowdown in the U.K. will put pressure on the quality of its outstanding loans. Slowing economic growth and increased unemployment rates will lead to higher loan charge-off rates across the bank’s retail and commercial loan portfolio. Barclays credit card business is more susceptible to this compared to its other units because of the unsecured nature of card balances. Higher charge-off figures will force the bank to set aside more cash as loan provisions to cover these losses – in turn pressuring the bottom line. While we forecast a moderate increase to Barclays’ loan provision over the next couple of years, a steeper increase in provisions presents a sizable downside to our price estimate.

One more thing that broadly falls under the head of deteriorating asset quality is an increase in counterparty risk in the event of a slowdown. As the investment banking division takes on significant counterparty risk as a part of its day-to-day operations, the failure of major counterparties could trigger significant losses for Barclays as the value of multi-billion dollar investment securities held by the bank could drop to near-zero levels very quickly. This factor is difficult to model, but it presents a real downside risk to our price estimate.

However, There Are Several Mitigating Factors

1. British Government Is Likely To Take Steps To Stimulate Economic Growth

As the U.K. enters into a period of economic uncertainty, the British government is likely to intervene directly to ensure that the country does not slip into a full-blown recession. While it has been just over a month since the Brexit vote, the Bank of England has already cut benchmark interest rates by a further 25 basis points from the 0.5% level at which it has held them since 2008. ^[1] The rate cut came on the heels of Bank of England’s decision to reduce capital requirements for British banks by 0.5%. ^[2] Both of these moves aim to ensure that lending activity remains high in the near future. Additionally, the bank has also announced an asset purchase plan to inject more cash in the economy. This should help ease some of the pressure on net interest margins for British banks over coming quarters.

2. Barclays Generates A Sizable Share Of Its Revenues Outside The U.K.

While the U.K. is Barclays’ home market and accounts for a majority of its revenues, the bank is quite diversified geographically. According to its most recent earnings report, revenues from the U.K. constituted roughly 54% of the bank’s total revenues for the first half of the year. Of the remaining 46%, 31% was from the Americas, 10% was from continental Europe and 5% was from Asia, the Middle East and Africa.

This diversification should hedge Barclays’ earnings partially in the event of a slowdown largely contained in the U.K. (of course there is a risk that the slowdown is not contained). As the bank has a large investment banking and card presence in the U.S., a weakening British Pound against the U.S. Dollar could actually boost revenues as they are reported in GBP.

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1. Bank Rate cut and other new measures: what do they mean?, Bank of England Website, 4 Aug 2016 [↩]
2. Bank of England Frees Banks to Lend More After Brexit Vote, The Wall Street Journal, 5 Jul 2016 [↩]