Shares of The Royal Bank of Scotland Group (NYSE:RBS) have lost more than 15% of their value over the last two weeks, with a bulk of the decline following its worse-than-expected performance figures for last quarter and full-year 2013 which were reported on February 27.  The bank, which is majority-owned by the U.K. government, reported a loss for the sixth consecutive year, with its falling revenues and shrinking margins aggravated by continued legal and settlement-related expenses. Incidentally, the bank has lost a total of £46 billion ( around $75 billion at current exchange rates) over the last six years – the exact same figure it received from the U.K. government as a bailout at the peak of the downturn in 2008. 
The banking group has also drawn criticism from investors for setting aside millions as bonuses for employees – something that does not reflect the fact that the bank’s losses in 2013 were the highest for any year since 2008. Another point of contention remains the heavy losses RBS’s Ulster Bank operations in Northern Ireland have been piling with no improvement expected in the near future. More recently, investors also reacted negatively to the likelihood of the bank having to move its headquarters out of Edinburgh in the wake of the impending referendum for Scotland’s independence. 
Despite the series of factors that weigh against the bank, we believe that the bank’s core business model, as well as its strategy for the future, are sound enough to justify a $12 price estimate for RBS’s stock. Below, we enumerate the two most important reasons behind our model, which values the bank’s shares a good 20% ahead of its current market price.
Expect Strong Margin Improvements From The U.K. Focus
One of the biggest factors behind RBS’s overall strategy in recent quarters has been the pressure exerted on it by the U.K. government 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 the U.K. over the last two years.
The ongoing large-scale reorganization, coupled with a string of one-time settlements stemming from its missteps in the run-up to the economic downturn, has kept operating margins across the bank’s various divisions depressed over this period. But the refocused efforts in the U.K. should help cut expenses to a great extent over coming years. The bank targets a cost-to-expense ratio of 55% within three years – well below the 73% figure for 2013.  The two divisions in which marked margin improvements are expected are the U.K. consumer banking and U.K. business banking operations. Quite notably, these two divisions together account for almost 65% of RBS’s total share value, as detailed in the chart above.
The partial impact of improving operating margins on RBS’s share value can be understood by making changes to the chart below which captures the operating expenses of its U.K. retail business as a percentage of the division’s revenues.
A Solution To The Ulster Bank Problem Could Be Coming
One of the biggest drags on RBS’s results since the recession of 2008 has been the impairments recorded each quarter onits Ulster Bank operations in Northern Ireland. The Ulster Bank business stuck out as it piled on impairments of between £200 million and £400 million every quarter since late-2009 – often representing a third of the group’s total impairments in a given period, while contributing less than 5% of the group’s total revenues. And while impairments from Ulster Bank fell to the lowest level in more than three years in Q3 2013, they spiked again in Q4 2013 to the highest figure since 2008 at £1.07 billion (~$1.8 billion). This made Q4 2013 the worst quarter for the Ulster Bank division on record.
RBS has maintained that it will not be shuttering the business, but it brought in Morgan Stanley earlier this week to help explore options for the loss-making unit.  A possible option is a merger between Ulster and one of the smaller Irish banks like Permanent TSB or KBC Bank Ireland to allow the newly created entity to benefit from economies of scale in the consolidating Irish banking sector. One way or another, RBS looks keen to resolve the Ulster Bank problem as soon as possible.Notes:
- Full Year Results 2013, RBS Press Releases, Feb 27 2014 [↩]
- RBS has lost all the £46bn pumped in by the taxpayer, The Guardian, Feb 27 2014 [↩]
- Scottish independence: Mark Carney warns RBS would have to relocate headquarters if Scotland votes ‘yes’, The Independent, Mar 12 2014 [↩]
- A new direction, RBS Press Releases, Feb 27 2014 [↩]
- RBS hires Morgan Stanley to advise on Ulster Bank, Irish Times, Mar 13 2014 [↩]