Barclays (LSE: BARC) (NYSE: BCS.US) is flying high, yet one key element must be taken into account to determine whether its stock is a hard bargain right now — return on tangible equity.
Fines Don’t Matter
“Barclays, Royal Bank of Scotland and three US banks have been fined almost £4bn over the manipulation of foreign exchange rates,” Sky News reported on Thursday.
The losses are contained, so the bank’s rally may continue based on this piece of information. Analysts are bullish on the matter, and most of them believe that at 271p — where Barclays currently trades — the shares still offer plenty of upside following a 30% surge from its one-year trough in mid-October.
While trading multiples are not very reliable, in my view, its return on tangible equity and trends for profits versus core capital point to a bank stock that looks fairly valued (although 30p-50p could be added to its valuation if Barclays trims its cost base further, it could be argued. It won’t be easy, however).
Return On Tangible Equity
In 1Q15, Barclays reported a return on average tangible equity (ROTE) — a key gauge of performance for banks — of 13.2% for its core operations, which compares with 13.2% in 1Q14, and is only one percentage point above the ROTE average for the last eight quarters.
In 1HQ14, Barclays traded between 230p and 292p a share, which suggests Barclays stock could now rise to about 300p, although the more it rises, the more painful the fall will be if bad news such as the Dark Pool lawsuit — which sank the stock in the summer of 2014 — emerges later this year.
Investors and analysts seem to believe that the bank has turned the corner, but I have doubts.
Allocated Tangible Equity
Its 1Q15 results, with profit before tax (PBT) at £2.1bn, represented the best quarterly performance since early 2013 when PBT came in at £2bn, but in 2Q13 and in 3Q13 (when it reported PBT of between £2bn and £1.6bn), ROTE stood at 16.5% and 15.1%, respectively.
This shouldn’t come as a big surprise: the average allocated tangible equity has risen by almost 40% to £38.5bn from £27.9bn over the last eight quarters, while attributable income has hovered around £1bn for most quarters, excluding Q413 and Q414, when a certain well-known item called “UK Bank Levy” diminished profits by about £400m, thus diluting returns and pushing ROTE down to 7%.
To rate Barclays as a strong buy at this level, its allocated tangible equity will have to plateau in the next few quarters, which is not a given.
Cost/Income Ratio
While there are signs that the bank may have to set aside less capital, the outlook doesn’t look rosy, however, I’d argue.
At 61% in 1Q15, the cost to income ratio for its core operations came in at the low end of the range (60-79%) for the last eight quarters, during which the stock has traded in the 208p-307p range — consider that the shares are down 7% over the period.
Efficiency has been a primary target for Barclays in recent years, and I wouldn’t be surprised if additional job cuts in investment banking (IB) will be announced, given that the IB unit promises higher returns than the reminder of its portfolio, but also absorbs a huge amount of capital and is more volatile than retail banking.
So, Barclays is faced with tough decisions at a time when there’s less fat on the bone — nonetheless, I have decided to rise my personal price target to 220p from 200p a share.
