Here’s Why RBS Shares Are Good For $11

by Trefis Team
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Royal Bank of Scotland
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The Royal Bank of Scotland Group (NYSE:RBS) has pretty much remained in turmoil since the economic downturn of 2008, when it had to be bailed out by the U.K. government. The series of lawsuits that followed over the years combined with slowing economic conditions in Europe hit the bottom line figures hard – and continue to do so as is evident from the fact that the RBS had to set aside £570 million ($870 million) to cover PPI-related redressals and other legal costs anticipated in the near future. [1]

While the legacy issues threaten to linger, there is additional uncertainty about RBS’s future given the U.K. government’s inclination towards splitting it into a “good” bank and a “bad” bank. Stuck with an 81% stake in the global banking group, the U.K. government is keen on returning RBS to the private sector in a manner that does not put the taxpayers’ money in undue risk. And in the midst of all this, the appointment of Ross McEwan as the new CEO to take over the reins of the bank from Stephen Hester, makes it look like RBS is undergoing too much change too fast from an investor’s perspective.

But putting the uncertainty aside and on going into the operating figures for the bank, one finds that the situation is not as grim as it appears. Surely the slow economic environment is making it difficult for RBS to eke out strong operating profits. However, it must be remembered that the bank has reported very few quarterly profits since the downturn thanks to all the one-time charges and impairment losses it regularly incurred. And at this point, one can safely say that a bulk of the legacy issues that plagued the income statement have been put to rest. What really matter now is how well RBS is doing on the new path it has set off on thanks to the years of restructuring it has undergone.

The results here are encouraging with revenues remaining uptick across most business units. Stringent cost management continues with RBS reducing jobs wherever an opportunity exists. And one of the biggest source of concern – the impairment losses – seem to be stabilizing. These factors help us stick to our $11 price estimate for RBS’s stock, which is at a premium of about 15% to current market prices.

See our full analysis for RBS’s stock

Traditional Banking Operations, And Not Markets Business, Drove Results

There is no denying that one of the biggest factors behind RBS’s overall strategy in the recent past has been the pressure exerted by the U.K. government on it to make sweeping changes to its business model. In keeping with these directives, RBS has reduced its investment banking operations to a fraction of its pre-2008 size, and has shifted focus to its retail and corporate banking businesses in U.K. And this move is beginning to pay off.

Pre-impairment operating profits for the U.K. retail banking unit fell sequentially from £743 million ($1.15 billion) in Q2 2011 to £557 million ($864 million) in Q1 2013. The trend finally reversed in Q2 2013 with the figure increasing to £566 million ($877 million). RBS also announced a shake-up of its U.K. retail business this May, with the bank shedding as many as 1,400 jobs to improve profitability (see RBS Trims More Jobs To Get Into Fighting Shape) – something that will further help profitability in the future.

Impairments for the business were also lower than what has been seen over several quarters now – pointing to an improvement in overall economic conditions and presenting a better outlook for the the group’s core retail banking business.

Ulster Bank Operations Could Turn The Corner In The Near Future.

One of the biggest drags on RBS’s results since the recession of 2008 has been the impairments it recorded each quarter – especially on its Ulster Bank operations in Northern Ireland. The Ulster Bank business stuck out as a sore thumb as it piled on impairments between £200 million and £400 million every quarter since late-2009 – often representing a third of the group’s total impairments for a period while contributing to less than 5% of the group’s total revenues.

Impairments from Ulster Bank fell to the lowest level in more than three years in Q1 2013 with RBS setting aside £240 million ($371 million) for the troubled decision. Although this figure increased to £263 million ($407 million) this quarter, there has also been a 16% improvement in the top-line figure – keeping losses for the division at one of the lowest levels since the downturn.

With the revenues expected to continue to improve over coming periods even as impairments decline, the Ulster Bank operations might just end its long string of quarterly losses by the end of next year.

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Notes:
  1. Interim Results 2013, RBS Press Releases, Aug 2 2013 []
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