Barclays: Upgraded Guidance Supports Buy Rating

seekingalpha10-27

Barclays reported a solid third quarter, with a continuation of positive trends for net interest income and operating expenses.Upgraded guidance for Barclays UK net interest income provides confidence...

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Richard Drury Introduction Barclays PLC (NYSE:BCS) reported 3Q24 results on October 24, 2024. The market responded positively to the update, with Barclays’ London Stock Exchange (‘LSE’) share price ending the October 24 trading session at 248.05p, up ~4.2% on the prior day’s close. As at the time of writing, the group’s LSE share price is up by ~10.6% since my previous Seeking Alpha note was published in early August, comfortably outperforming the FTSE 100’s rise of ~1% over the same time period. The stock has had a very strong run - investors who purchased Barclays shares during the sell-off in late October and early November 2023 are now sitting on gains of over 80%. As a holder of the stock, I’m obviously rather pleased with this outcome. But being a typical value investor, such a sharp increase in the company’s share price automatically triggers concern that the market might have become overly optimistic about Barclays’ future prospects. In this note I’ll discuss aspects of the 3Q24 result that caught my eye, and provide an updated stock rating. Barclays UK – Upgraded Net Interest Income Guidance The biggest news to come out of the 3Q24 update was management’s upgrade of guidance for FY24E Barclays UK (‘BUK’) net interest income from ~£6.3bn to the new forecast of ~£6.5bn. For readers unfamiliar with Barclays’ various divisional segments, BUK comprises the group’s UK retail and business banking activities and currently makes up ~40% of group profit before tax (based on FY24E consensus numbers). Note that management’s guidance excludes any contribution from Tesco Bank’s retail banking book, which Barclays will take ownership of with effect from November 01, 2024. The Tesco Bank acquisition is expected to add around £400m pa of net interest income. The upgrade to BUK’s FY24E net interest income guidance needs to be considered in light of the fact that it has been made with 75% of the financial year already complete. As such, the full-year guidance points to a strong 4Q24E for BUK net interest income. In Exhibit 1, I show that BUK FY24E net interest income of £6.5bn implies BUK 4Q24E net interest income of £1,688m. Annualising the expected 4Q24 number gives an implied run rate for FY25E of £6.697bn, which would be 3% above the FY24E guidance level. Exhibit 1:   Source: author’s calculations based on Barclays quarterly investor reports. Looking at the analyst consensus data that Barclays publishes on its investor relations website, the most recent consensus data (stated as at October 11, 2024) appears to have already captured some of the BUK FY25E net interest income uplift related to management’s revised guidance. Consensus BUK forecasts will include the acquired earnings from the Tesco Bank deal, and as shown in Exhibit 2, backing out the Tesco Bank contribution gives a ‘consensus FY25E ex Tesco’ net interest income of £6.739bn. Based on my analysis, on an ex Tesco Bank basis, BUK FY25E net interest income is almost exactly in line with the new FY25E run rate implied by management’s upgraded guidance (the difference is 0.6%). Exhibit 2:   Source: author’s calculations based on Barclays quarterly investor reports and the most recently available consensus data provided by Barclays Investor Relations. In Exhibit 3, I compare how FY25E consensus numbers at the total group level moved between the July and October 2024 consensus publications. The upward movement in consensus FY25E total income of £253m also points to analysts having already anticipated at least part of the BUK net interest income boost implied by management’s new FY24E guidance. Exhibit 3:   Source: author’s calculations based on Barclays quarterly investor reports and consensus data provided by Barclays Investor Relations. Based on my review of the 3Q24 results materials, there appear to have been three major drivers of the upgraded BUK net interest income guidance:  Management are now expecting the Bank of England to cut interest rates three times in 2024, whereas earlier guidance had been built upon the expectation of five interest rate cuts. The earnings drag from customers moving money out of low yielding deposit accounts into higher rate accounts (whether retained within BUK or exiting the bank) has eased more rapidly than management expected. Positive lending book mix effects due to growth in higher margin segments of the mortgage book and unsecured personal lending.  In regard to the third bullet point above, it is important to recognise that if an analyst is going to grant BUK the benefit in FY25E of the higher 4Q24E run rate for net interest income, then that analyst should also be allowing for higher normalised BUK bad debt charges. It should go without saying that higher margin lending comes with higher risk; and yet, analyst numbers often overlook this fact. In terms of earnings impact, the net interest income benefit comes through faster than the higher bad debt cost; this dynamic plays to the typical shorter-term focus of the sell-side. For investors with a longer-term perspective, I would stress that the component of BUK’s improved net interest income outlook that relates to the change in loan book mix needs to be balanced against higher future normalized bad debt charges for the division. Operating Expenses I refer readers to my Barclays note published in early March 2024 for detailed discussion of the group’s planned cost-out initiatives. In summary, Barclays is aiming to strip out a total of £2bn pa of costs through various restructuring and efficiency actions. My previous Buy ratings for Barclays have been influenced by an expectation that management will be able to execute the cost-out strategy reasonably well. A breakdown of the movement in operating costs between 3Q23 and 3Q24 is shown in Exhibit 4. The 3Q24 management speech points to solid progress having been made on cost-out to date, with CFO Anna Cross advising: We delivered a further £0.3bn of gross efficiency savings, bringing the total for the nine months to £0.7bn. These efficiencies have helped us to more than offset inflation and created capacity for investments. We remain on track to deliver £1bn for the year, and continue to expect a further £1bn of efficiency savings across 2025 and 2026. Source: Barclays 3Q24 management speech, page 12. Exhibit 4:   Source: Barclays 3Q24 presentation, slide 11. It is important to remember that there is a price to pay in order to achieve these cost-out savings. Barclays booked a restructure charge of ~£0.9bn at 4Q23, and I estimate additional restructure costs of £600m to £900m over the three years ending FY26E. A further issue to be mindful of is the risk that Barclays may cut too deep and underinvest, thus diminishing the quality of the business. Exhibit 5 sets out the future path for operating expenses based on consensus forecasts. I note that FY26E total expenses are only 2.2% higher than actual reported FY22 total expenses. If the profile of Barclays’ future operating expenses does track consensus closely, underinvestment risk is something that investors should keep in mind. Then again, perhaps CFO Anna Cross has a cunning plan to replace a bunch of overpaid, underproductive bankers with AI in the coming years; in which case, maybe the cost-out target has been lowballed. Exhibit 5:   Source: author’s calculations based on Barclays quarterly investor reports and consensus data provided by Barclays Investor Relations. UK Lending Growth - Pushing Up The Risk Curve Barclays is pushing up the risk curve to drive lending growth in BUK and the UK Corporate Bank. Exhibit 6 shows upticks in new mortgage volumes, credit card customers and balance sheet extension to corporate borrowers. The improvement in gross lending for mortgages is attributed to Barclays taking on more high loan-to-value business. Credit card acquisition trends reflect the deliberate push by Barclays to regain lost market share in personal unsecured lending. Exhibit 6:   Source: Barclays 3Q24 presentation, slide 14. It’s relatively easy for a bank to expand lending books by easing off on credit standards, and in such cases the market will often reward the bank’s share price for the higher rates of loan growth, with little consideration for the extra risk that the bank may be taking on. In the case of BUK, the decision to turn on the credit taps isn’t yet achieving the goal of loan book growth – as highlighted by Exhibit 7. Management clearly want to grow UK lending, and I am slightly concerned that risk levels may be imprudently ramped up in order to achieve this goal. Note also that the growth in higher loan-to-value mortgages and personal unsecured lending will be positive for the reported BUK net interest margin, given that these segments of the loan book tend to be higher margin. Exhibit 7:   Source: Barclays 3Q24 presentation, slide 17. Other Areas Of Interest Barclays now reports six segment results, so there is plenty of detail to work through. In the interests of brevity, I shall not attempt here to provide comments on everything that grabbed my attention. Below are a few items that I think are worth mentioning. I remain of the view that the ‘through-the-cycle’ loan loss rate guidance given by CFO Anna Cross of -50bp to -60bp is too low. Based on my analysis, a loan loss rate slightly above 65bp seems more realistic. That being said, there is no imminent sign of material credit stress in the Barclays loan book, and it would not be a surprise if the loan loss rate remained below average in FY25E. I wrote about the UK Financial Conduct Authority (‘FCA’) review of the UK motor finance market in my previous Barclays note. Barclays is currently taking legal action to block what appears to be a reasonably likely redress scheme for motor finance mis-selling. The bank is challenging a Financial Ombudsman Service decision that led to the FCA motor finance investigation. The outcome of the judicial review case could have a significant influence on any redress scheme set up by the FCA. I include an allowance in my Barclays valuation for redress costs and regulatory fines associated with motor finance, but I note that this adjustment is not material to the overall investment case. The US Consumer Bank delivered a net interest margin of 10.38%, slightly down from 10.43% in 2Q24 and well below the 10.88% reported in 3Q23. Management are sticking with the FY26 target for a US Consumer bank net interest margin of >12%, but I am doubtful that this can be achieved. At present the US Consumer Bank is 66% funded by core deposits (see Exhibit 8). In order to achieve management’s FY26 target, the US Consumer Bank will need to grow its core deposit funding base without pushing up deposit funding costs – this is a task that is easier said than done. Exhibit 8:   Source: Barclays 3Q24 presentation, slide 27. Closing Remarks and Rating On balance, I would say that the 3Q24 result for Barclays was a solid update. In this note I have deliberately chosen to focus on issues relating to future downside risks that I feel the market is not paying sufficient attention to. I could very easily have taken a different approach and focussed on a number of positives, including: robust numbers for investment banking and global markets, the strong regulatory capital position, continued simplification via further disposal of non-core businesses. My valuation for Barclays captures the downside risks that I have referenced in this note, and taking what I deem to be a cautious view, I continue to see value appeal in the stock. Based on the LSE October 25, 2024 market close price of 241.4p, Barclays is currently trading at ~68.8% of 3Q24 reported NTA (351p). This discount to NTA appears too steep given the outlook for the group’s earnings over the coming years. Whilst I regard Barclays as being less undervalued today than it has been over recent years, I still see comfortably enough share price upside potential to warrant a Buy rating.  Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. 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