RBS Earnings Takeaways: Restructuring Costs Weigh On Bottom Line

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

The Royal Bank of Scotland Group (NYSE:RBS) reported a forgettable performance for the third quarter of the year late last week, as the bank’s ongoing large-scale restructuring efforts coupled with lukewarm economic conditions weighed on profits across its core operating divisions. [1] RBS incurred restructuring as well as legal costs of just under £1 billion ($1.5 billion) in Q3 2015. Although this is well below the nearly £1.5 billion ($2.3 billion) figure for the previous quarter, the bank’s top line also shrunk by 15% quarter-on-quarter due to a reduction in revenues for each of its core divisions – resulting in a pre-tax operating loss for the fourth consecutive quarter. And things are unlikely to improve on the cost front for a few more quarters, with restructuring costs expected to remain high in the near future, and with RBS warning of higher-than-expected settlement charges for its legacy legal issues (see How Much Will RBS Pay FHFA To Settle Mortgage Lawsuit?).

We expect things to improve on the operating front next year though. Given the efforts RBS has put in over the last few years to make fundamental changes to its business model, the bank will reap the benefits in the form of stable profits from retail and commercial banking operations in the U.K. The bank has already reported considerable growth in its portfolio of mortgage and commercial loans over recent quarters. Also, with RBS completing the sale of its entire stake in Citizens Financial Group last week, it is now among the best capitalized banks in the world and has little to worry about in terms of meeting the strict capital requirement norms.

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While uncertainty over the bank’s legal overhang presents a sizable downside to its value, we maintain our $11.50 price estimate for RBS’s stock in view of the long-term improvement to profits its reorganization plan entails. This price is roughly 15% ahead of the current market price.

See our full analysis for RBS’s stock

Retail Banking Business Performs Fairly Well 

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 92,400 at the end of Q3 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 diversified business model to one focused on retail and commercial banking operations in the U.K. 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 nearly half 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 £1.46 billion in revenues in Q3 2015 – marginally lower than the £1.47 billion figure for Q2 2015 but a 5% decline year-on-year. Notably, RBS saw mortgage revenues – the single largest revenue stream for the division – increase by more than 3% compared to the previous quarter. This was primarily due to a sharp increase in the number of outstanding mortgages for the period, which reached a record high of £109.2 billion ($169 billion) at the end of Q3 2015.

Moreover, RBS also reported a sizable improvement in profits for its Ulster Bank unit in Northern Ireland. The Ulster Bank unit has drawn considerable criticism from investors for the poor quality of its loan book, as it was the single largest contributor to the bank’s loan impairment figure over 2010-2013. Although improving economic conditions have allowed RBS to release a chunk of its loan provisions for the unit in recent quarters, the loan portfolio has shrunk for every single quarter in the last four years – until Q3 2015. Improving mortgage activity helped Ulster Bank report the first increase in the size of loans outstanding in several years.

Lower Fee Income Hurts Commercial Banking Business, But Loan Base Grows

RBS’s commercial banking division is the second biggest source of value for the bank after its retail banking operations,. Although these operations saw a reduction in fee-based revenues year-on-year as well as quarter-on-quarter, the impact on the top line was mitigated to an extent from considerably higher interest incomes. RBS has reported a sharp increase in interest revenues for its commercial banking business each quarter in 2015, despite net interest margins remaining unchanged by steadily growing its loan base. The division’s loan portfolio grew to £92.4 billion ($143 billion) at the end of Q3 2015 from £86 billion at the end of Q3 2014. While pre-tax profits for the quarter were lower than the exceptionally high figure seen in the previous quarter, a reduction in operating expenses helped the division maintain a cost-to-income ratio of below 50% for a second consecutive quarter.

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Notes:
  1. Interim Management Statement, RBS Press Releases, Oct 30 2015 []