Wednesday, 19 February 2014

Oh the banks! (4) Standard Chartered PLC

The 19th century Kimberley branch, South Africa, courtesy Wikipedia
Five years have elapsed since the financial crisis and it is time to consider investing in banks again. See for the rationale behind this statement.
Standard Chartered (StanChart) was the only British bank to escape the financial crisis of 2008 and 2009 unscathed. In part this was thanks to prudent management and in part because it has always had a small presence in Europe and the USA. The company raised 3.3 billion pounds via a rights issue in 2010 to meet the higher capital requirements of Basel III.
Although domiciled in the UK, StanChart has no branches in this country. StanChart was formed in 1969 by the merger of two British banks, Standard based in South Africa, Chartered in India, Australia and China. StanChart sold the last stake in its South African bank to local investors in 1987. Today the business is weighted towards Asia, with almost half of its assets located in Hong Kong, Singapore and South Korea:
Distribution of business
By Assets %
By Loans to Customers %
By Profit Before Tax %
US $ value billions
$637 bn
$289 bn
$6.9 bn
Hong Kong, Singapore, S. Korea
Other Asia Pacific*
Middle East & Other South Asia
UK, Americas, Other Europe
Source: 2012 Annual Report *Mainly China, Malaysia, Indonesia and Taiwan
East Asia may be the centre of global growth, but it is also an area of political tension. North Korea's belligerent, possibly unhinged, new dictator does not have the institutional restraints of normal leaders. And China is confronting its neighbours - particularly Japan - over the Senkaku Islands and economic and territorial rights over the South China Sea.
Until January 2014 StanChart was organised into two businesses, consumer and wholesale banking. This is now to be integrated into one. This will enable cost savings by merging staff functions, 'strengthen its distinctive culture' (its brand), allocate resources where they can best be used and to increase cross-selling. Perhaps the growth of 'network banking', where the bank's trading customers provide revenues across countries and regions, played a part in the reorganization. Still, to an outsider, the organizational chart appears to be unusual. The Deputy CEO, responsible now for both consumer and wholesale banking, and two regional directors report to the CEO who reports to the Chairman. Overlapping responsibilities can lead to internecine hostilities.
StanChart is in the business of retail, corporate and investment banking:
Consumer (retail) banking, covering cards, personal loans, wealth management, deposits and mortgage and auto finance, is the source of 38% of the bank's $19 billion operating income.
Commercial banking, which includes income from trade, corporate cash management and custody and lending, accounts for a further 38% of operating income. StanChart claims to offer the largest number of currencies of any bank on its trading platform.
Investment banking, including corporate finance (arranging loans and equity financing) asset and liability management (the treasury function and risk management) and providing proprietary equity and mezzanine finance is the source of 24% of the bank's business. StanChart has $3.2 billion of its own funds invested in companies.
'Network banking' now accounts for over half the combined revenues of Commercial and Investment banking. The growth came mainly from China - via Hong Kong and between the China-Africa corridor - India, Africa and Korea.
StanChart has considerable strengths. Consider:
1. It claims to be the second largest bank in the world for trade and transactional finance. This is based on its large East Asian banking presence. 
2.  StanChart is a specialist in renminbi (RMB) transactions and financing. The bank reports that it is the largest issuer of RMB euro commercial paper, the largest non-Chinese RMB clearing bank and a leading advisor and agent to China's central bank. It is also the second largest bank for RMB issuance in Hong Kong and one of the largest non-Chinese bank for RMB services in the Asia Pacific region, Europe and North America.
3. The bank is targeting Africa for expansion. Its main markets are Kenya, Ghana and Nigeria and it was ranked best bank in Botswana, Gambia, Zambia and Zimbabwe by Global Finance (World's Best Banks 2013 - Africa).
4. The bank's balance sheet is very strong:
·         Solvency: With a Core Tier 1 capital ratio of 11.4% and Equity to Assets ratio of 7.0%, it easily exceeds the Basel III requirements of 6% and 4.5% respectively. Its uncovered non-performing loans at $2.6 billion are less than 6% of equity.
·         Liquidity: Its loan to deposit ratio is just 77%, well below that of any UK bank and 28% of its assets are liquid assets.
·         Standard & Poor's awards StanChart an A+ credit rating for long-term obligations.
5. The bank's efficiency ratio (cost to income) at 54%% is comparable to HSBC (54%) and Santander (50%), and far lower than other UK banks (Barclays is 71%).
6. Both earnings per share (normalised) and equity per share have increased substantially these last five years and it is one of few banks whose return on equity exceeds its cost of equity.
These strengths are reflected in StanChart's share price performance (in blue) compared to HSBC (in green). It is a constituent of the FTSE 100 (in red).

Graph courtesy Yahoo, click to enlarge
Yet, over the last two years, StanChart has underperformed both HSBC and the FTSE 100 by about 30%:

Graph courtesy Yahoo, click to enlarge
The derating of the bank's shares is partly based on a slowdown in profits and partly on a general derating of emerging markets. 2012 profits were hit with a $667 million fine by three US regulatory authorities for evading sanctions on Iran. Then in August 2013 the bank announced that it had written down goodwill on its Korean assets by $1 billion, pushing that unit into a $863 million loss in the first half of 2013. Tougher regulatory requirements, higher bad debts and a conflict with staff all reduced the bank's Korean profitability.
The bank's guidance for 2013 suggests earnings will fall short, by about 10%, from 2012's level.  Specifically, in its December 2013 pre-closing trading statement, the bank stated that:
Ø  Income would be about the same as 2012
Ø  Net margin would be slightly down
Ø  Second half impairment would be above the first half but below 2012
Ø  Core Tier 1 Capital was unchanged
Ø  The Korean operation would lose $200 million at the operating level.
Further, worries about slowing growth in emerging markets caused investors to pull funds out of those markets. And StanChart shares (in blue), which are listed in Hong Kong, move fairly closely with the Chinese Large Cap Index (in green).

Graph courtesy Yahoo, click to enlarge
At the current price of 1290p the shares are on an historical PE ratio of 11 and yield 3.9%. The bank is capitalised at 31 billion pounds, which is an 18% premium to net asset value, similar to that of HSBC.
Could this be a good moment to buy StanChart shares?
On fairly conservative assumptions, StanChart is valued at about 1480p by my model.* But banks, given their high leverage, sensitivity to market conditions and ability to manipulate earnings, are difficult to value.
*Earnings per share 10% down on 2012 and grow by 5% per annum thereafter; 54% earnings retained; return on equity 11%; equity per share growth 7% per annum; average PE ratio of 13.5; all discounted at 10.9% (3.9% SLXX + 2% operating risk + 5% margin of safety) for the 5 years 2014 to 2018.   
Management is optimistic:
"The  Group’s  income  and  balance  sheet  remain  well  diversified  by  product,  by customer  segment  and  by  geography.   We  remain  well  capitalised,  strongly funded and highly liquid.
As we highlighted at our November investor day, we are responding to near term challenges  to  ensure  we  strike  the  right  balance  between  growth  and  returns. We remain  confident  in the  strong underlying potential of our markets and of our competitive positioning as we gain market share  supporting  the  ambitions  of  our clients and customers."  Source: December 2013 pre-closing trading statement.
Investors will want to take into consideration:
1.    The bank's management, by ensuring a strong balance sheet while directing capital to markets where returns are best, has proven to be one of the best in banking. However Korea, where StanChart has made a large investment, has become a difficult market in which to secure an adequate return on capital. In its 1st half year 2013 report management explained what they are doing: "We cannot escape the realities of the Korean context, but we are determined to improve productivity and return on capital, so we are further reducing costs, simplifying the operating structure and reinforcing the balance sheet. We are tightening our focus on core clients, which means exiting unprofitable relationships. We are reconfiguring the branch network, putting greater emphasis on digital and we are reviewing options for some non-core businesses, including potential sale."
2.     Stanchart's reliance on China and its satellites for both consumer and retail banking.  China's public debt is estimated at 200% of GDP and it is still growing at a faster rate than GDP. A bursting of the bubble in China's property market would have a knock-on effect on StanChart's main markets. While the bank is expanding fast in Africa, where returns are good, this is still of small relevance when compared to China. A financial crisis in China would have major consequences for the bank.
3.     Temasek, Singapore's Sovereign Wealth Fund, with 18.2% of StanChart's shares, is the largest shareholder of the bank. Given Temasek's regional influence and cautious investment criteria, this is a stabilizing factor for the bank.
4.     StanChart is, with some other companies listed in London, a substitute for emerging markets. Just as the bank's derating coincides with the derating of emerging markets, so it is reasonable to expect its shares to recover when emerging markets do.
5.      Directors have been selling shares in the last 12 months. Between March and August 2013 directors have sold shares worth 3.3 million pounds at between 1577p and 1805p a share. Considering the current share price is 1290p, the directors sold at the right time.
Note: I will be travelling for 6 weeks, and so I will be publishing only the occasional article until 5 April.

Wednesday, 12 February 2014

Oh the banks! (3) Barclays PLC

Sheik Hamad bin Khalifa Al Thani of Qatar, saviour of Barclays, courtesy Wikipedia
Five years have elapsed since the financial crisis and it is time to consider investing in banks again. See
Barclays shareholders have had a rotten time since the financial crisis. Shares worth over six pounds in August 2007 collapsed to 47p by March 2009. Today they stand at 264p. The following graph compares Barclays' share price (in blue) to HSBC's share price (in purple) since 1988.
Graph courtesy Barclays website, click to enlarge
The main concern for investors is the quality of Barclays' management. Consider:
The ABN Amro deal that failed. Barclays agreed to buy ABN Amro in 2007 for €67.5 billion when a consortium led by RBS outbid Barclays for the Dutch bank. The collapse of RBS was largely the result of paying 49 billion pounds for ABN Amro that went on to lose billions in its US operations. Barclays would have collapsed had the deal gone through.
 Caught short of capital in 2008, Barclays has floundered to keep afloat.
·         In July 2008, Barclays attempted a rights issue, which failed.
·         In November 2008, Qatar and Abu Dhabi investors put 7.3 billion pounds into Barclays in exchange for 30% of the bank. UK authorities are looking into possible bribes paid to intermediaries and to the possibility that Barclays loaned funds to Qatar to invest in the bank.
·         In 2009, Barclays sold iShares to BlackRock for 8.4 billion pounds and raised a further 6.5 billion pounds capital by cancelling its dividend (2 billion pounds) and via another rights issue (4.5 billion pounds).
·         In 2013, Barclays raised a further 5.8 billion pounds via a rights issue as part of plan to enable it to reach the minimum capital requirements set out by the Prudential Regulation Authority. The total shortfall was 12.8 billion pounds and the bank aims to meet this requirement by June 2014.
Barclays has a reputation for unethical banking.
Like other UK banks, Barclays is paying for mis-selling payment protection insurance and for rigging LIBOR rates. But it has also been fined for failing to provide adequate investment advice to its customers, mis-selling interest rate swaps to its customers, for manipulating electricity markets in the USA, and for evading sanctions on Iran. Further, HMRC ruled that Barclays had evaded tax. The total cost of fines and compensation total 6.2 billion pounds. 
The bank that puts bonuses before shareholder returns.
Barclays has paid out 8.6 billion pounds in bonuses to staff between 2011 and 2013, when profits are declining and the bank had to go to shareholders to raise new capital.
Sliding profits and capital inadequacy, coupled with persistent signs that Barclays is unmanageable is reflected in the recent volatility of its shares (in blue) compared to HSBC (in green) and the FTSE 100 (in red) of which it is a component.
Courtesy TD Waterhouse, click to enlarge
Unlike HSBC or Santander, Barclays is both an investment bank and a retail bank. The investment bank, after the acquisition of Lehmann's core business, is centred on London and New York. Considering that Barclays reckons its cost of capital is 11.5%, neither is doing well.
By business in pounds billions for 2013
Average Equity
Return on Equity%
Retail (UK, Europe, Africa, Barclaycard)
Investment Bank
Corporate, Wealth & Investment Mgt
Head Office and Other Operations
   Total Bank
                Source: Barclays 2013 Presentation
But this is not unique to Barclays as the poor results from RBS and Lloyds show.
 Successive fund raisings have strengthened Barclays balance sheet:
 1. Core Tier 1 Capital ratio is now 13.2% and equity/total assets 4.9%, which more than meet the Basel III capital reserve requirements of a 6% minimum for Core Tier 1 Capital and 4.5% for equity/assets.
2. The Loan to Deposit Ratio, a measure of liquidity, is down from 110% in 2012 to 101% in 2013. And the Liquidity Pool exceeds wholesale debts by 45 billion pounds.
3. Standard &Poor's rates Barclays long-term credit A-.
4. Non-performing loan coverage is up from 42% in 2012 to 47%. This leaves 9.7 billion pounds of non-performing loans that are not provisioned for.
But the bank's high cost to income ratio of 71% is responsible for its poor trading performance. By comparison, Santander's cost to income ratio is 50% and HSBC's is 54%.
Other negatives are:
1. Earnings per share in the last three years average 5p, which is much below the preceding 3-year average of 56p.
2. Thanks to the rights issue, equity per share is down from 414p in 2012 to 331p in 2013.
3. The return on equity (ROE) is a miserable 1%. Even after substantial adjustments that management make*, ROE is still just 4.5%, half of the prior year's adjusted ROE. *Items excluded from the adjusted measures are: the impact of own credit; disposal of the investment in BlackRock, Inc.; the provision for Payment Protection Insurance redress payments and claims management costs (PPI redress); the provision for interest rate hedging products redress and claims management costs (interest rate hedging products redress); and goodwill impairment. Source: 2013 Barclays Results.
Barclays plans to improve profits by:
·         Reducing its cost base by 1.7 billion pounds by 2015 - 12,000 staff are to go.
·         Reducing the number of UK branches, perhaps by as much as a quarter, and promoting online banking. Barclays bought ING Direct UK in 2012, which brought it 1.5 million customers.
·         Making Barclays the 'Go-To' bank. This was explained by the new CEO, Anthony Jenkins, in the 2012 Annual Report.
 "Being the ‘Go-To’ bank means being the instinctive partner of choice for anyone looking to do banking business, whether a small business, first-time house buyer, or a large corporate undertaking a complex merger or acquisition deal. Customers and clients will benefit from being firmly in the centre of everything we do."
The CEO wants a "greater level of customer and client satisfaction" and "more business from more customers and clients." There is plenty to do. In the latest Which? survey, Barclays, together with RBS and Santander, trails other banks in customer satisfaction.
·         Reducing its operations in its main, loss-making Eurozone markets, Spain, France and Italy.
·         Integrating Absa Group Ltd, South Africa's largest bank which it bought in 2005, into its other African businesses. And expand its operations in Africa.
At 264p, Barclays shares are valued at a 20% discount to net asset value, yield 2.4% and are on a PER (adjusted earnings) of 17. If one assumes that the great bulk of nasty surprises is behind Barclays, that the adjusted earnings of the last two years is a fair base going forward, then my valuation model values the shares at around 220p.
Investors will note:
1. Barclays is essentially a mid-sized investment bank linked to a mid-sized retail bank with a good business in Barclaycard. Successive CEOs have had difficulty managing both sides of the business.
2. The present CEO is a long-term Barclays executive and he seems out of his depth. The bank has suffered from a high cost to income ratio for years, and yet the planned cost cuts will not radically change Barclays' cost structure. And the bank continues to pay out large bonuses, which exceed the planned cost cuts. So, although one key objective is to bring down compensation payments, the compensation to revenue ratio increased from 39.6% in 2012 to 43.2% in 2013 at the Investment Bank.
The CEO, who has waived his bonus for the last two years, understands that large bonuses are out of line when the bank is short of capital. But he doesn't seem to be able to implement a more rational bonus policy. Sooner or later the bank must bring in a team from outside the bank to lead it out of the morass it is in.
3. In the only large share transactions by directors in 2013, the CEO sold shares worth 2.9 million pounds at 308p a share in March, 4 months prior to the announced rights issue. The CEO took up 1.1 million pounds worth of shares at the rights issue price of 185p a share in October.
4. Barclays operates in regions with low political risk.