Barclays (NYSE:BCS) share price has tumbled in the last few trading sessions due to the collapse of Silicon Valley Bank, part of SVB Financial Group (SIVB), and Credit Suisse (CS) induced fears of systemic nature.

The share price of selected European banking stocks is noted below:

BCS is now trading at ~0.45x tangible book value even though it continues to target RoTCE > 10% and has achieved the same over the last two years.

Generally, if a bank (in a developed market) generates 10% RoTCE, it is expected to trade at around tangible book value. In other words, the generally accepted cost of capital for large banks is around ~10%.

However in Barclay’s case, Mr. Market is not ready to reward it with this valuation (and I will explain the reasons for this later in this article).

The positive side of the downward volatility in the share price is that Barclays has commenced executing its GBP500 million share buyback announced at the full-year earnings release. This is an exceptionally accretive move for shareholders and the hope is that BCS will continue to increase the share buybacks authorization in upcoming quarters.

Why Does BCS Continue To Trade At Distressed Valuations?

BCS is currently trading at a P/E of less than 5 and an earnings yield well above 20%.

The key reasons for the distressed valuation are:

1. Mr. Market is concerned that BCS earnings do not sufficiently translate to dividends and share buybacks for investors. Essentially, capital generated is not returned to investors rather it is deployed to various other purposes (e.g. fines, regulatory RWA inflation, investments)
2. Mr. Market is also concerned that the Investment Banking (“IB”) unit’s stellar performance in recent years is not sustainable as FICC trading should normalize sooner or later

In this article, I will assess whether the bear narrative is justified or not.

Where Did The Earnings Go To In 2022?

BCS earned above its 10% RoTCE target in 2022, but what happened to the earnings generated?

The below chart from the FY earnings presentation is instructive:

As per above, BCS generated 150 bps of CET1 capital and the main offsets are as per below:

Regulatory changes (80 bps): This predominantly relates to RWA inflation from the introduction of the standard approach to credit risk (“SACR”). This change to the RWA methodology has a one-off impact in 2022.

Distributions (79 bps): This relates to dividends and buybacks and BCS paid out ~50% of the capital it generated in 2022.

Pensions (39 bps): This relates to pension contributions. Note that the pension fund is currently in surplus, so no further contributions will be made in 2023.

AOCI (38 bps): This relates to unrealized losses on the assets held-for-sale (“AFS”) and is predominantly due to rapidly rising rates in 2022. This is likely to partially reverse in 2023 if the duration declines and if interest rates decline further.

RWA Growth (6 bps): this relates to business growth.

Others (22 bps): this predominantly relates to the strengthening of the USD versus the GBP.

So whilst BCS generated ~150 bps of capital, 185 bps were deployed to mostly one-off items that are unlikely to recur in 2023 and beyond.

What Headwinds Are Expected In 2023?

The currently expected capital headwinds in 2023 include IFRS 9 transition relief (13 bps) and completion of the acquisition of the Kensington mortgage business (12 bps). Given Q1 is also seasonally strong in Q1, one would expect higher temporary RWAs allocated to the trading book. Putting this all together, I expect BCS to land at a CET1 ratio of ~13.5% in Q1 which is smack in the middle of its capital target of 13% to 14%. I also expect BCS to accrete capital for the rest of the year.

So all in all, I would expect BCS to return ~120 bps of capital to shareholders in 2023 which is 50% more than in 2022. There may be additional tailwinds depending on FX and AOCI reversal especially if rates moderate. At today’s market cap, this equates to around 15% of the float.

Naturally, the capital trajectory will be impacted by items such as rates and FX (could go both ways), but the regulatory RWA inflation and pension headwinds will fall off.

FICC Normalizing?

There is no doubt that FICC trading income was stellar in 2022 and I agree with the consensus view that it is likely to normalize in 2023 and beyond. The U.S. banks have already indicated a decline of high-single digits year on year on the back of an exceptionally strong Q1 in 2022. However, for BCS there are three offsets that include an expected pickup in investment banking fees (2022 wallet was down ~50% or so), transaction banking is growing strongly (up 78% year on year) due to higher rates and the FICC financing business is much more stable and profitable in higher rates environment.

It is uncertain whether these offsets will completely compensate for the normalization of trading revenues, but should be reasonably close.

The CFO in a presentation delivered this week reiterated her confidence in BCS’s target of greater than 10% RoTCE for 2023 and beyond.

Final Thoughts

BCS valuation is currently distressed at 0.45x tangible book. Partly, it is due to the banking crisis epitomized by SIVB as well as the Credit Suisse (CS) systemic fears.

The ability to buy back shares at these levels is a great opportunity for long-term shareholders. BCS has been earning above its cost of capital for 2 straight years now and is expected to continue and grow its returns. The difference in 2023 is that most of the capital generated should be deployed in buybacks and dividends.

Buying a dollar for 45 cents is a no-brainer. I expect the management team to lean much more heavily on share buybacks throughout 2023 given its capital trajectory.

I remain very bullish.