Royal Bank of Scotland Reports Mixed Q1 Earnings

| About: The Royal (RBS)

By: Ann Heffron, CFA

On Friday, The Royal Bank of Scotland Group plc (NYSE:RBS) posted a first quarter pretax loss of £44 million, compared to £479 million gain in the prior-year quarter, driven by a £2.2 billion increase in impairment losses to £2.9 billion on deteriorating asset quality trends. (All data presented herein is on a pro forma basis, rather than on a statutory basis, as we believe this better represents RBS’s operating trends.)

Excluding all nonrecurring items, RBS reported pretax profits of £1.97 billion, down 11% from the £2.2 billion earned a year ago.

Net revenues rose 41% year over year to £8.9 billion from £6.3 billion, largely due to the very strong trading performance (up 174%) in rates, currencies, and commodities at Global Banking and Markets (GBM).

Net interest income declined 3% to £3.4 billion as a 37 basis-point drop in the net interest margin to 1.73% more than offset a 17% gain in average interest-earning assets. The net interest margin decline reflected a decrease in the lending spread at the company’s retail and commercial banking operations, as well as higher funding costs.

Nonperforming loans increased £15.5 billion, or 189%, year over year and £4.9 billion, or 26%, sequentially to £23.7 billion at March 31, 2009. As a percentage of total loans, nonperforming loans rose to 3.50% at March 31, 2009 from 1.38% in the year-ago quarter and 2.69% at December 31, 2008.

In addition, RBS reported £2.8 billion in credit market losses, principally related to the company’s credit risk exposures to monoline insurance companies.

The company has strengthened its capital position through several equity transactions completed in April, adding £9 billion in capital. Pro forma for these transactions, the Tier 1 capital ratio would be 9.9% at March quarterend and 10.6% as of December 31, 2008.

Including the impact of the government’s Asset Protection Scheme, under which the UK government insures the bank against losses on its most toxic assets (e.g., mortgage-backed securities and property loans) in return for a small fee and an obligation by the bank to increase lending to consumers and businesses, the Tier 1 capital ratios would rise about 550 basis points.

Our recommendation on RBS is Hold. The current Zacks rank is 3, indicating no clear directional pattern in the share price over the near term. In Friday's trading, RBS shares were up over 19% from Thursday’s closing price of $12.50.

(US$1 = £0.66; 1ADS = 20 shares)