British Government Begins RBS Stake Sale After The Bank Posts Modest Q2 Profits

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

The British government took the first step towards returning The Royal Bank of Scotland Group (NYSE:RBS) to the private sector by selling a 5.4% stake in the banking group earlier this week. [1] The long anticipated stake sale priced RBS shares at 330 pence apiece – 33% lower than the purchase price of 500 pence at the time of the bailout in late 2008 – and reduced the British government’s stake in RBS to under 73%. The improvement in RBS’s operating performance over recent quarters – as demonstrated by the better-than-expected Q2 figures – likely played an important role in this move. ((Q2 2015 Results Announcement, RBS Investor News, Jul 30 2014))

While the strong growth in RBS’s commercial banking unit and improvement in operating efficiency are good news in terms of long term value, the bank has been forced to incur heavy costs to facilitate the restructuring process and clear its legal overhang. In fact, RBS warned investors of more legal charges this year – especially as it begins negotiating with U.S. authorities for its role in originating and selling mortgage-backed securities before 2008 (see How Much Will RBS Pay FHFA To Settle Mortgage Lawsuit?). With the bank also unlikely to begin paying dividends before early 2017, investors will have to remain patient about any payouts in the near future.

That said, RBS has put in considerable effort over the last few years to streamline its business model, and its recent push to sell off its stake in Citizens Financial Group (CFG) by the end of 2015 reinforces its commitment to improving shareholder returns. [2] As we detail in this article, improving profitability for its retail and commercial banking units in the U.K. will be key RBS’s eventual re-privatization.

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We maintain an $11.50 price estimate for RBS’s stock, which is roughly 10% ahead of the current market price.

See our full analysis for RBS’s stock

Retail Banking Costs Under Control, Revenue Pressure Likely To Remain 

One of the largest banking groups in the world before 2008, RBS has gone through the most extensive reorganization among all the global banks – reducing total jobs across its operations from 226,400 at the end of 2007 to less than 109,200 at the end of Q2 2015. While a major part of this downsizing was mandated by the European Commission (EC) as a condition for RBS’s bailout, most of the changes over the last couple of years have been driven by a strategic shift from a highly diversified business model to one focused on retail and commercial banking operations in the U.K. due to sustained pressure from the British government.

It is therefore no surprise that the U.K. retail banking business has largely remained unchanged over the years, with RBS investing considerably to improve long-term profitability. The importance of the U.K. retail business to RBS’s value is evident from the chart above, which shows that these operations account for 43% of its total value.

RBS’s U.K. Personal and Business Banking division reports five distinct revenue streams: personal advance, personal deposits, mortgages, cards, and business banking. Taken together, these units generated £1.47 billion in revenues in Q2 2015 – marginally higher than the £1.45 billion figure for Q1 2015 but a 2% decline year-on-year. Notably, RBS reported higher revenues from personal deposits as well as business banking compared to the year-ago period, but the gains were nullified by a sharp reduction in mortgage revenues – the single largest revenue stream for the division. The low interest rate environment only made things worse for the bank, as the net interest income figure remained depressed.

It wasn’t all bad news for RBS on the mortgage front, though, as improving economic conditions helped the size of its outstanding mortgage loan portfolio scale a record high of £105.4 billion ($164 billion) at the end of Q2 2015. The swelling loan portfolio will go a long way in helping the bank boost its top line once interest rates improve.

Also, the absence of any one-time charges meant that operating expenses for the division were below £800 million for the first time in three years. This helped the division’s cost-to-income ratio to fall to 54% in Q2 2015 from 78% in Q1 2015 and 64% in Q2 2014. Importantly, this is below the bank’s target of 55%, and indicates that RBS has been largely successful in reining in costs for its cornerstone retail banking division.

Commercial Banking Unit Should Help Grow The Top Line

RBS’s commercial banking division stands out with a marked year-on-year improvement in pre-tax income figures. The division, which has undergone a successful reorganization in recent years, churned out its best quarterly performance since the economic downturn with operating profits (as adjusted) reaching £476 million ($741 million). This represents a 15% improvement sequentially, and a 12% gain over the figure last year. Notably, the gains can be traced to improved net interest incomes as well as fee-based revenues which are in turn the result of strong loan growth. The division’s loan portfolio grew to £91 billion ($142 billion) at the end of Q2 2015 from £85 billion at the end of Q2 2014.

The division did incur conduct-related costs of £59 million, which had a negative impact on the final income figure. Adjusting for this and other minor restructuring costs, the division’s cost-to-income figure was an exceptionally strong 44% – the best since early 2008. As these costs are unlikely to hurt results over subsequent quarters, we expect the commercial banking division to drive revenue growth for RBS over 2015-2016.

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Notes:
  1. UKFI today announces the disposal of approximately 5.4% of The Royal Bank of Scotland Group plc, UKFI Press Releases, Aug 4 2015 []
  2. Partial Sale of Citizens Financial Group, Inc., RBS Press Releases, Jul 29 2015 []