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No prizes for stating that the UK banking sector is under intense pressure from all sides. Apart from the
immediate issue of potential CDO write-offs and the threat they pose to the capital ratios of Barclays
(Underweight TP 410p) and RBS (Overweight TP 440p), the outlook for the housing and commercial
property markets is the most uncertain it’s been for almost 20 years, and the possibility of domestic
recession can’t be discounted.
With 2008e PE multiples down in the 6-8x range how much pain are share prices discounting?
In this document we look at impairment charges, earnings, cash flows and DCF valuations under a range
of assumptions for credit losses.
We find Barclays and RBS would still be on PE multiples no higher than 10-11x even under a 1990s credit
loss scenario. Lloyds TSB (Overweight TP 470p), HBOS (Underweight TP 630p), and Alliance & Leicester
(Neutral (V) TP 620p) would end up on 13-15x, in part because this earlier period saw acute problems on
mortgage books (which may not be repeated in the current environment).
DCF valuations, which can take account of the duration of credit problems, indicate that three years of
1990s credit losses depress corporate values by 15-20%. Given the magnitude of the sector’s decline the
market may have priced most of this in. Of itself this doesn’t mean that the UK banks will outperform - the
news flow is certain to remain terrible - but it’s an argument for closing short positions.
Further, we suspect bank cash flows (and dividends) will be more stable than investors
appreciate because, although earnings tumble in a recession, banks’ capital requirements fall away too, as
WRA growth stagnates.
In this report, we lower our price targets as follows: Barclays is downgraded from 440p to 410p, HBOS
from 730p to 630p, Lloyds from 550p to 470p, RBS from 540p to 440p, Alliance & Leicester from 770p to
620p, B&B from 290p to 250p, and Standard Chartered from 1840p to 1700p. Further, Alliance & Leicester
and B&B now fall under the HSBC definition of a volatile stock, so we add a volatility indicator to our
rating for each, and we now rate both stocks Neutral (V).
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