Philip O'Sullivan's Market Musings

Financial analysis from Dublin, Ireland

Royal Bank of Scotland (RBS.L) – Turning the Corner

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(This is the fourteenth installment in my series of case studies on the shares that make up my portfolio. To see the other thirteen articles, on Marston’s, France TelecomRyanairPetroNeftIrish Continental GroupIndependent News & MediaTotal ProduceAbbeyGlanbiaIrish Life & PermanentDatalexTrinity Mirror and Datong, click on the company names)


Following speculation that he would step down earlier this year in a row over bonus payments, Royal Bank of Scotland CEO Stephen Hester vowed to stay on in order to finish defusing “the biggest time bomb in history.”


Few would argue that the task Hester took on when he grabbed the helm in November 2008 was anything but formidable. Shortly after his appointment the group unveiled losses of £24.1 billion for 2008—the biggest corporate loss in UK history.


Hester’s objectives were to stabilize the group, clean up the balance sheet, dispose of noncore assets, take costs out and improve ROE.


In addition to these, he has to help wean the group off its substantial government support—the UK government has an 83% economic ownership of RBS following the injection of £45.5 billion into the group—and keep within the terms of the restructuring plan agreed with the European Commission.


Despite the challenging macroeconomic backdrop, the group has made impressive progress toward meeting these objectives. RBS’ balance sheet has shrunk (relatively speaking) from £2.4 trillion at the end of 2008 to £1.4 trillion at the end of March of this year.

Over the same period, noncore assets have declined from £343 billion to £92 billion. Management has sold assets ranging from a 4.26% stake in Bank of China, sold for £1.6 billion , to its Sempra metals, oil and European energy business, sold for $1.6 billion , all the way across to pub and hotel assets.


This year will see further asset sales, with management reaffirming in the recent first-quarter results that the group aims to IPO its insurance business later this year, subject to market conditions. This unit achieved profits of £454 million in 2011 and has been valued at up to £4 billion.


In terms of the operating performance, the group has exceeded its own targets to date . The RBS Restructuring Plan targeted 2009-2011 cumulative operating profits of £18.3 billion in the core business and -£28.4 billion in the noncore business. In the event, these came in at £22.0 billion and -£24.3 billion, respectively. Over 15% of the legacy cost base had been taken out by the end of 2011.


One legacy that has been harder to escape from is reflected in the near-£40 billion of impairment charges booked in the past four years. These have been on an improving trend, however. In 2009 they came in at £13.9 billion, in 2010 £9.3 billion and last year they came to £8.7 billion. In the group’s recent first-quarter release , impairment losses came to £1.3 billion, down 22% sequentially and 33% below year earlier levels, “with improvements across all divisions except Ulster Bank [RBS’ Irish operation]”.


This improvement is being reflected in the bottom line. In the first-quarter of 2012 operating profit came in at £1.2 billion, +4% year-on-year and ahead of consensus of £917 million. For this year as a whole, consensus pretax profit forecasts stand at £2.9 billion , a big turnaround from the £766 million pretax loss booked last year.


It appears that 2012 will contain a number of milestones for RBS. The group looks set to post an annual net profit this year for the first time in five years, it has just repaid the last of the emergency liquidity support it received from the UK and US governments during the financial crisis and it is to resume paying coupons on its hybrid capital instruments, a step Hester describes as: “one of the steps to rehabilitating [RBS] with investors.”


Might 2012 see a shake-up in the share register as well? Earlier this year, media reports speculated that Middle Eastern investors might buy some of the British government’s stake in the group. Hester played down the prospects of this happening in the immediate future following RBS’ recent first-quarter results. As things stand, RBS’ share price (which closed at 23.05p yesterday) is considerably offside the British government’s break-even price of 50.2p a share.


Leaving aside that speculation, how should investors look at RBS here?


The bull case is that: (i) The group has turned the corner and the coming years look set to deliver significant improvements in profitability as impairments move toward more normal levels; (ii) the valuation is very undemanding, at 8.4x 2013 earnings and less than 0.5x P/B; and (iii) the resumption of dividend payments on hybrid capital instruments could prove a precursor to the restarting of dividend payments on RBS’ ordinary shares over the next 12 to 18 months— consensus forecasts show RBS shares yielding 1.5% next year.


A bear case is almost as easy to craft, however. Namely: (i) Ongoing macroeconomic uncertainty poses risks to banks’ earnings; (ii) were the British government to signal a willingness to sell shares at this level it could create a significant overhang in the shares; and (iii) political and regulatory risk for the majority State-owned bank should not be overlooked.


Given the above, it is perhaps not surprising to see that, of the 29 brokers who follow the company, 13 rate RBS a buy, 10 are neutral and six are on sell.


From my own perspective, while the near-term headwinds for markets generally are a concern, I see material, long-term upside for RBS, specifically as the benefits of the restructuring really start to flow through.


Were RBS’ share price to rise to meet its end-first-quarter 2012 TNAV of 48.8 pence per share , this would deliver upside of circa 100% from current levels. Considering that consensus forecasts are for the group, which is capitalised at £13.5 billion, (based on the number of ‘A’ shares in issue , adding the nonvoting ‘B’ shares gives a ‘fully diluted’ market cap of circa £25 billion) to deliver cumulative pretax profits of £8 billion in 2012-13, I think it isn’t unreasonable to imagine that sort of share price appreciation over the medium term.


Of course, the elephant in the room is the ongoing troubles in Europe. I should point out that the steps taken by RBS to de-risk its balance sheet do give some comfort where the problems in the periphery are concerned–at the end of the first quarter of 2012, the group’s exposure to the PIIGS’ sovereign debt was only £0.3 billion , while excluding the Irish unit, which has a predominantly domestically funded balance sheet, its lending exposure to the peripheral Eurozone countries amounts to only 1.9% of the group’s loan book.


Granted, it may well take a resolution (of sorts!) of the euro-zone crisis before a significant re-rating of RBS’ shares takes place, but given the steps taken by management to de-risk the group, I think investors looking at RBS have the relative luxury of being able to look at it on a longer-term view.


In this regard, the undemanding multiple RBS trades on offers an attractive entry level for what is a clear recovery story (now that the balance sheet is substantially cleaned up and earnings are set to take off as impairments normalise), while the high probability of a return to dividends for ordinary shareholders in the next 12-18 months means that investors are likely to be compensated for their patience until markets recover.


Note: This is an edited version of an article that I wrote for Marketwatch yesterday

Written by Philip O'Sullivan

May 11, 2012 at 7:26 am

Posted in Sector Focus

Tagged with ,

8 Responses

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  1. […] supports our prior conclusions and not weight so heavily information which disagrees with them. Philip O'Sullivan last week published a piece called 'Turning the Corner' with a pretty strong case for holding the […]

  2. […] of case studies on the shares that make up my portfolio. To see the other fourteen articles, on RBS, Marston’s, France Telecom, Ryanair, PetroNeft, Irish Continental Group, Independent News […]

  3. […] case studies on the shares that make up my portfolio. To see the other fifteen articles, on AIB, RBS, Marston’s, France Telecom, Ryanair, PetroNeft, Irish Continental Group, Independent News […]

  4. […] differ from Cormac on is RBS, given that while he is correct to flag its large exposure to Ireland, as I’ve outlined before RBS’ Irish unit (Ulster Bank) has a largely domestically funded balance sheet which mitigates […]

  5. […] share price below £2 for the first time since the 1-for-10 reverse share consolidation. I’m still positive on the stock on a longer-term perspective, and am monitoring its current difficulties closely with a view to gauging if the risk/reward […]

  6. […] the shares that make up my portfolio. To see the other sixteen articles, on Bank of Ireland, AIB, RBS, Marston’s, France Telecom, Ryanair, PetroNeft, Irish Continental Group, Independent News […]

  7. […] my portfolio. To see the other seventeen articles, on Smurfit Kappa Group, Bank of Ireland, AIB, RBS, Marston’s, France Telecom, Ryanair, PetroNeft, Irish Continental Group, Independent News […]

  8. […] In terms of my own response to all of this, I have been stepping up my exposure to financials, trebling my stake in Bank of Ireland and significantly increasing my exposure to RBS (which is now my third-largest portfolio position). The recent surge in the value of Irish government bonds prompted my Bank of Ireland move, given that BKIR held €5,945m worth of them at the end of June (up to €1.5bn of which were acquired following the LTRO earlier this year). As the notes to BKIR’s interim results show (see page 99), the vast majority of these are in the books on a ‘Level 1′ fair value basis, i.e. “valued using quoted market prices in active markets”. Given the recent lift in Irish bond prices, this should have a positive impact on Bank of Ireland’s NAV, given that ”any change in fair value is treated as a movement in the [available for sale] reserve in Stockholder’s equity”. Elsewhere, in the case of RBS, the IPO of its Direct Line business and recent moves towards agreeing financial settlements for Libor and IT issues indicate that the narrative around the group may be about to radically shift, as I noted in a recent blog post. […]

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