RBS Shares Rally As Preliminary Reports Show Marked Recovery In 2014 Performance

RBS: Royal Bank of Scotland Group logo
RBS
Royal Bank of Scotland Group

The Royal Bank of Scotland Group (NYSE:RBS) released a preliminary report detailing its performance over the first half of the year on Friday, July 25 – a week before the scheduled Q2 results announcement date of August 1. [1] The U.K.-based banking group, which is 81%-owned by the British government, churned out its best half-year performance since its bailout in 2008, raising hopes among investors of quicker re-privatization plans. Consequently, the bank’s shares gained almost 11% over trading on Friday – jumping from $11.18 to $12.38.

Although revenues for the second quarter were lower than the figure for the previous quarter as well as the year-ago period, the bank benefited considerably from improving credit quality, which allowed it to release loan provisions for the first time since the economic downturn. RBS reported loan recoveries of £93 million (~$150 million) for Q2 2014 compared to loan impairments of £362 million (~$600 million) in Q1 2014 and £1.1 billion (~$1.7 billion) in Q2 2013. However, the impact of the loan improvement on operating profits was negated by high restructuring costs of £350 million (~$600 million) for the period as well as an additional £250 million (~$420 million) in provisions to cover PPI and interest-rate product misgivings – both of which are one-time costs and are unlikely to drag down results in subsequent quarters.

We maintain our $13 price estimate for RBS’s stock, which is roughly 5% ahead of the current market price.

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See our full analysis for RBS’s stock

Operating Margins Improved On The Back Of Cost-Cutting Efforts

This February, RBS announced plans to cut its cost-to-income ratio to 55% within three years – well below the 73% figure for 2013. [2] The banking group did well to slash its cost-to-income ratio (adjusted for one-time restructuring and litigation-related charges) to 65% for Q1 2014, and took the figure up another notch in Q2 to 62%. Adjusted operating expenses for the quarter were just above £3 billion (~$5 billion) for the quarter – a good 6.5% improvement quarter-on-quarter. A bulk of this improvement came from RBS’s U.K. Personal and Business Banking division, which saw adjusted cost-to-income drop from 60% in Q1 to 52% in Q2 – almost hitting the bank’s long-term cost-to-income ratio target of 50% for the operations. This hardly comes as a surprise, as the bank refocused its efforts in the U.K. in response to increased pressure from the British government. The importance of the bank’s retail and business banking operations in the U.K. to its overall business model is made clear by the chart above, as we estimate these operations account for roughly 70% of RBS’s total value.

The partial impact of improving cost-to-income ratios 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 banking unit as a percentage of the division’s revenues.

Ulster Bank Reports Another Profit, RBS Explores Options

RBS’s retail banking business in Northern Ireland – Ulster Bank – has without doubt been the biggest drag on the banking group’s results since the recession of 2008. The business piled on impairments 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.

But things improved earlier this year, as better economic conditions in the region helped the division report its first quarterly profit since 2008 in Q1 2014. A jump in net interest income, coupled with negligible loan provisions for Q2, made things even better with the division reporting an adjusted operating income of £58 million (~$100 million) for the period. While the sequential improvement shows that Ulster Bank’s fortunes have indeed reversed, RBS is exploring strategic options for the business. The bank was rumored to have been in talks with private equity firms to infuse capital in the business earlier this year, and a recent report by Morgan Stanley recommending a majority stake sale is expected to hasten RBS’s exit from the Northern Ireland-based retail banking operations in the near future. [3]

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Notes:
  1. Preliminary Announcement, RBS Results Center, Jul 25 2014 []
  2. A new direction, RBS Press Releases, Feb 27 2014 []
  3. RBS advised to sell majority Ulster Bank stake, Reuters, Jul 27 2014 []