Strong All-Around Performance Helps RBS Beat Earnings Expectations

The Royal Bank of Scotland Group (NYSE:RBS) reported a much better-than-expected performance for the third quarter of the year on Friday, October 31, with the U.K.-based banking group witnessing a notable increase in operating profits for its U.K. retail banking, global commercial banking as well as Ulster Bank divisions both year-on-year as well as quarter-on-quarter. ((Interim Management Statement, RBS Earnings Release, Oct 31 2014)) Investor expectations for the bank, which is 81%-owned by the British government, were already high since late September when it announced plans to release £800 million ($1.3 billion) in provisions  for the period (see Q3 Results At RBS To Benefit From $1.3 Billion Provision Release). But the strong operating performance for Q3 2014 allowed RBS to trounce these high expectations despite having to set aside £780 million ($1.25 billion) in additional legal reserves to cover the ongoing foreign exchange settlement talks. Notably, this is the first time RBS has reported three consecutive quarterly profits since the economic downturn of 2008 – indicative of the fact that the bank has finally been able to put its operational woes behind it.

RBS also made progress on several fronts over Q3, including the successful divestment of a 28.75% stake in Citizens Financial Group (see RBS Announces An IPO To Divest 25% Stake In Citizens), a reduction in the size of its non-core RBS Capital Resolution (RCR) unit to under $50 billion, as well as the substantial increase in Common Equity Tier 1 (CET1) ratio to 10.7%. Also, the bank is well-poised to achieve its target of slashing £1 billion ($1.6 billion) in recurring costs by the end of this year.

We maintain our $13 price estimate for RBS’s stock, which is roughly 10% ahead of the current market price.

See our full analysis for RBS’s stock

Personal and Business Banking (PBB) Unit Grows Revenues While Cutting Down On Expenses

Since early 2012, RBS has refocused its operations in the U.K. in response to increased pressure from the British government. The banking group provides retail and business banking services to customers in U.K. under the RBS and Natwest brand names, and these operations contribute roughly 35% of the bank’s total value according to our estimates. The overhaul of these operations has allowed the bank to witness a steady improvement in revenues, even as the large-scale cost cutting initiatives limit corresponding expenses. An uptick in revenues from mortgages, deposits as well as business banking saw revenues for PBB cross £1.5 billion ($2.5 billion) for the first time since the bank adopted its current reporting structure – a 3% improvement compared to Q3 2013 as well as Q2 2014.

This February, RBS announced plans to cut its cost-to-income ratio to 55% within three years – well below the 73% figure for 2013. ^[1] A bulk of this improvement was expected to come from the PBB division, with the bank targeting a long-term cost-to-income ratio of 50% for the operations. RBS almost achieved this target in Q3 2014, as the adjusted cost-to-income figure fell to 51% for the period. With the bank looking to shutter as many as 154 branches by the end of the year, we expect the division to hit the target in the fourth quarter. ^[2]

Ulster Bank Shines In Q3, Prompting RBS To Keep The Unit

RBS’s retail banking business in Northern Ireland – Ulster Bank – has without a 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 began improving this year, as better economic conditions in the region helped the division report its first quarterly profit since 2008 in Q1 2014. A steady increase in income, a notable reduction in operating costs and a release of loan reserves (a first for the unit since 2008) to the tune of £318 million ($500 million) in Q3 made this the best quarter for Ulster Bank since the downturn. The reversal of fortunes also helped RBS drop plans to get rid of the unit.

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1. A new direction, RBS Press Releases, Feb 27 2014 [↩]
2. Royal Bank of Scotland earmarks 5% of branches for closure, The Guardian, Oct 31 2014 [↩]