RBS Shares Soar After Low Impairment Costs Boost Q1 Results

Investors were pleasantly surprised late last week when The Royal Bank of Scotland Group (NYSE:RBS) reported a much better-than-expected performance for the first quarter, with one of its best earnings figures since the economic downturn of 2008 and its subsequent bailout by the British government. ^[1] While top line figures for the global banking group did not change much compared to the same period last year, RBS’s results for the quarter benefited from two factors: firstly, it was unencumbered by the multi-million dollar legal costs that have plagued it almost every quarter since 2010; and secondly, loan impairments were at their lowest level since the recession, thanks to a reversal in fortunes for the Ulster Bank operations.

As a result, RBS reported its second-best operating performance since 2008 for Q1 2014 (after Q3 2011, when exceptionally strong trading revenues carried results) – generating a little less than £1.65 billion (~$2.8 billion) in pre-tax income. This compares to a pre-tax profit of £826 million (~$1.4 billion) for the same year-ago period and a whopping £9 billion (~$15 billion) pre-tax loss for the previous quarter. The positive sentiments invoked by the results among investors is demonstrated by the fact that the bank’s shares jumped 8% over trading post results on May 2.

The marked improvement in impairment figures for the Ulster Bank division in particular, coupled with the steady reduction in operating costs for the bank, led us to revise our price estimate for RBS’s stock upwards from $12 to $13. The new price estimate is roughly 15% ahead of the current market price.

See our full analysis for RBS’s stock

Ulster Bank Operations Finally Reports A Quarterly Profit

One of the biggest drags on RBS’s results since the recession of 2008 has been the impairments recorded each quarter by its Ulster Bank operations in Northern Ireland. The business piled on impairments of between £200 million and £400 million every quarter since late-2009 – often responsible for almost 40% of the group’s total impairments in a given period, while contributing less than 5% of the group’s total revenues. The last quarter of 2013 was particularly bad, as the unit recorded its highest-ever impairment figure of £1.07 billion (~$1.8 billion) – making it the worst quarter for the Ulster Bank division on record.

The unusually high level of impairments for the previous quarter was just enough to move the division out of the red for Q1 2014, as the bank reported its first profit since the downturn. Notably, the bank did not see any marked improvement in operating performance, as revenues and operating costs were largely similar to what they have been over the last few quarters. But with RBS setting aside heavy provisions in the previous quarter, the liability was eased considerably this quarter, resulting in the token pre-tax profit of £17 million (~$28 million). The profit is, nonetheless, an important milestone because RBS is looking to get rid of the Ulster Bank business over the coming years, and a unit which churns out a profit (even if it barely manages to do so) has better prospects for a sale than a loss-making one.

Expect Strong Margin Improvements From 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. In February, the bank also announced plans to cut its cost-to-expense ratio to 55% within three years – well below the 73% figure for 2013. ^[2]

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 the last several quarters. But refocused efforts in the U.K. have begun to show improvements in expenses for the bank’s 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. In Q1 2014, the retail operations saw a cost-to-income figure of 52%, and this metric was 50% for the business banking unit. Although this is more or less around the figure for the same period last year, it must be remembered that lower interest incomes have steadily put downward pressure on the bank’s revenues. The bank has clearly done well to rope in expenses to curtail the impact of lower revenues on the bottom line.

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. business banking unit as a percentage of the division’s revenues.

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1. Q1 2014 Results Announcement, RBS Investor News, May 2 2014 [↩]
2. A new direction, RBS Press Releases, Feb 27 2014 [↩]