We continue to have mixed feelings about Barclays

Barclays last week reported attributable net income of £2,730 million for the nine months ended September 30, down 19% from the year-ago period largely because of a charge of £1,298 million on fair value movements of its own debt. Excluding this and other one-time items, group profits increased significantly from the year-ago period. These results are in line with our expectations, and we're leaving our 475p-per-share fair value unchanged.

Barclays' results were negatively impacted by the £6.2 billion loan-loss provisions it posted in the first three quarters of 2009, up 65% from the year-ago period, and Barclays expects this to reach £9 billion by the end of the year and to remain elevated in 2010. (Unlike US banks, Barclays and most European banks book loan-loss expenses largely as they are incurred, rather than when they are first expected.) Higher provisions meant that income was down across most of Barclays' commercial and retail banking divisions. Barclays' investment bank, however, continued its strong performance. Trading income was up strongly from the same period last year, although down somewhat from the exceptional first half of 2009. Barclays said that although spreads had fallen, trading volumes remained robust. We were pleased to see that Barclays' capital levels were high enough for the bank to resume paying a dividend--June 30 pro forma Tier 1 capital was 11.8%--although we see the 1p per share (4p per ADR) interim dividend as a nominal gesture. Barclays said that early delinquency figures have begun to fall, and despite the bank's higher provisions this quarter, we think its results reinforce our thesis that the bank is emerging a winner as the financial crisis eases.

Fair value estimate: 475p ¦ Fair value uncertainty: High ¦ Economic moat: None

Thesis
(Last updated 11-09-2009)

Barclays is one of the three largest banks in the United Kingdom and has expanded around the world. Its large market share in its entrenched businesses--retail and business banking, credit cards, investment banking, and asset management--helped the firm to generate hefty returns during the boom years. Barclays has generated an increasing portion of its profits through the fast-growing but risky businesses like investment banking through Barclays Capital (35% of pretax profits in the first half of 2009) and International Retail and Commercial Banking. Barclays Capital acquired the remnants of Lehman Brothers in 2008 at a significant discount to book value, a transaction we think may create significant long-term value.

Like many global banks, Barclays has taken billions in write-downs since the credit crisis began in 2007 and has shored up its capital by issuing large amounts of new capital at knock-down prices. It managed to avoid turning to the UK government for support, unlike Royal Bank of Scotland and Lloyds Banking Group, but nonetheless diluted existing shareholders by nearly 50%.

Even though Barclays is emerging from the credit crisis as one of the world's strongest global banks, its shareholders have taken a beating in the process, and we're left with mixed feelings about the UK bank. On one hand, we're impressed with its profitability through the crisis, its ability to remain independent, and the tremendous deal it got by purchasing Lehman's US operations out of bankruptcy. On the other hand, the bank's bad debts are increasing and eating away at much of its investment banking profits and--more importantly--future and yet unclear regulatory changes are threatening to reduce its profitability significantly.

Despite Barclays' stated goal of earning two thirds of profits from retail and commercial banking and wealth management, we think the future of its investment bank will be key for the group. Revenues have doubled during the last year as Barclays incorporated Lehman. Reduced competition in the sector may mean that Barclays will be able to maintain and even increase its outsized investment banking profits as it builds on its strong position in businesses like commodities trading, its strong capital position, and its good reputation. However, regulators around the world, and especially in the UK, were deeply frightened by the depth of the financial crisis. They are almost certain to require banks to hold much more capital against their risky assets and force banks to reduce the financial leverage that, in part, drove their fantastic profitability during the boom years. Although we think Barclays' prospects are better than many of its peers', we think that with lower leverage, the bank's profitability will be too low to justify the large premium to book value it once garnered.

Valuation
We have raised our fair value estimate for Barclays to 475p from 375p to account for higher earnings expectations. We assume that assets will fall sharply in 2009, as Barclays reduces its trading and derivatives books, and that they will increase an average of 5% annually from 2010 to 2013. We estimate that charge-offs will increase to 1.5% of loans in 2009, from 0.7% in 2008, as loan losses increase across all categories but especially in construction and commercial lending. We expect Barclays' equity/assets ratio to increase from 1.8% in 2008 to 3.5% in 2013 as regulators raise capital requirements, which will reduce profitability. We expect trading income to rise above historical levels because of the Lehman acquisition but fall below first-half 2009 levels, as regulatory and market changes make trading less profitable. Using these assumptions we estimate a fair value of 475p per common share.

Risk
Although concerns about Barclays' viability have eased, questions about write-downs and its long-term profitability remain. Loan losses rose rapidly in the first half of 2009, more than tripling in commercial banking, and are likely to rise further and wipe out much of the bank's profits in the near term. Regulators are nearly certain to require Barclays to hold more capital in the future, which will reduce shareholder returns and may require the bank to raise even more capital. The magnitude of regulatory changes is unclear and will significantly affect the value of the bank.

Management & Stewardship
John Varley became CEO in 2004. He joined Barclays in 1982 and is married to a member of the bank's founding family. Varley is leading a cultural revolution at Barclays that is intended to increase the bank's global competitiveness, performance orientation, and entrepreneurial spirit. At least eight of Barclays' top 20 executives have joined the bank in the last 18 months. Among them is the tough, performance-driven CEO of global retail and commercial banking, Frits Seegers. Another force behind the changes at Barclays is Bob Diamond, the charismatic head of Barclays' fast-growing investment bank and asset-management businesses. He joined the bank in 1996. Although we're pleased with Barclays' emphasis on economic profit and the measures the firm has taken in the last few years to more closely link executive pay with performance, we're concerned that management's unchecked ambition has exposed the bank to excessive risk. Executive pay had been modest by US standards but increased in recent years as the bank has granted increasingly large pay packages. In late 2008, Barclays raised a large amount of capital from private investors at terms more onerous than those offered by the UK government--raising questions about whether executives are putting shareholders' interests first, or protecting their outsize compensation packages.

Overview
Growth: Total assets increased a dramatic 67% in 2008 as Barclays acquired Lehman's operations and as the accounting value of derivatives increased. We expect the derivatives book to fall substantially in 2009 and for asset growth to average 5% thereafter.

Profitability: Barclays has been very profitable historically, but we think this is unlikely to continue. Return on equity was 20% in 2007 and 15% in 2008, despite very difficult conditions. We expect ROE to fall to single digits in 2009 and to average 13.5% in 2011-13.

Financial Health: Barclays' capital raises, the pending sale of BGI, and its dividend cut materially improve the bank's capital levels, but more asset sales are possible.

Profile: Barclays is one of the largest banks in the United Kingdom and has operations around the world. Its businesses include UK banking, which serves retail and business customers in the UK; Barclays Capital, a debt-focused investment bank; international banking, which serves retail and business customers in Europe, Africa, and Asia; and Barclaycard, a large credit card issuer. The 2009 sale of Barclays Global Investors will leave the firm with a 20% stake in BlackRock.

Strategy: Barclays' short-term strategy is aimed at building up its capital to weather the downturn in the UK In the longer term, Barclays aims to earn two thirds of its income from retail and commercial banking and wealth management, thereby reducing its dependency on investment banking. Barclays' goal is to be in the top quartile of a group of peers in terms of total shareholder returns.

Bulls Say
1. Barclays has deftly sidestepped the huge write-downs taken by many other investment banks. Its strong position will allow it to gain market share at the expense of weaker rivals.

2. Prudent management practices such as bold measures to fix underperforming units and a strict adherence to generating economic profits should benefit shareholders.

3. Barclays Capital's push into emerging markets, such as China and Africa, will diversify the company's revenue stream and help stabilize profits, which will be especially valuable in the current difficult economic environment.

4. Barclays' acquisition of Lehman's operations out of bankruptcy enabled the bank to buy a very profitable business for a song while leaving behind the riskiest assets.

Bears Say
1. Barclays' aggressive growth has come back to haunt the firm in the form of dilutive capital raises, but confidence in the bank remains shaky. If confidence erodes once again and funding dries up, Barclays may have to take dramatic actions to raise capital.

2. Barclays' failed bid for ABN AMRO may not be the end of the bank's empire-building ambitions or its habit of overpaying for acquisitions.

3. Delinquencies are rising rapidly in Barclays' loan book, especially in commercial lending. Loan losses are likely to wipe out any windfall profits from investment banking.

4. Barclays makes about 60% of its loans in the UK, which is facing an ever-deepening recession. Delinquencies there could cause significant losses at the bank.

5. Barclays' trading profits are likely to decrease as regulators sharply increase capital requirements and as competition reduces spreads.