On September 27, we outlined our bullish thesis on the Royal Bank of Scotland (RBS), arguing that the bank continues to recover from the financial crisis and is restructuring itself into a simpler bank focused on retail & commercial banking. To date, the recommendation has not panned out, with the bank's ADRs down almost 8%, driven primarily by a highly negative reaction to RBS's Q3 results (RBS does not report quarterly EPS), which included the unveiling of an "internal bad bank." Though this plan will lead to a short-term decline in capital, it features several long-term benefits for RBS, and for investors with long-term time horizons, we believe that it will in fact enhance shareholder value. Our thesis on RBS was not meant to play out in several months. Rather, it is a long-term story, predicated on RBS's continued reshaping into a far simpler bank, focused on preserving and expanding its core United Kingdom franchises. We believe that with RBS's "bad bank" plans now known, its shares should be bought on further pullbacks, as the long-term thesis is fully intact. Unless otherwise noted, financial statistics used in this article will be sourced from either RBS's Q3 results presentation or its Q3 2013 interim report.
Before we delve into RBS's decision to create an internal bad bank, we believe that it is prudent to first discuss the bank's core performance in Q3. On an IFRS basis, RBS lost £634 million in Q3 2013, versus a loss of £1.364 billion in Q3 2012. However, both quarters featured a number of charges that masked RBS's core performance. The bank's Q3 2013 loss includes £496 million in charges tied to improving credit spreads on its debt, a further £250 million in provisions tied to payment protection litigation, and £99 million in other legal costs, as well as £205 million in restructuring costs. Excluding these and other more minor charges, RBS posted a net profit of £438 million, down 51.82% from a year ago. However, the vast majority of this decline is due to continued impairments at the bank's non-core asset division (much more detail on this will follow in our discussion of RBS's internal bad bank). On a core basis, RBS performed relatively well this quarter, and we present a brief overview of the bank's core results below, adjusted for various charges, with the year-over year change for each figure presented in parentheses. The non-core segment will be presented in an additional table.
RBS's Core Segment Results, Q3 2013 (in Millions of £)
Q3 2013 Revenue
Q3 2013 Expenses
Q3 2013 Impairments
Q3 2013 Segment Profit
Total Segment Results
Central Group-Level Items
RBS's Non-Core Performance (in Millions of £)
RBS's segment performance in the third quarter featured a number of notable items. We start with the bank's core UK franchises, which posted double-digit increases in operating profit in both retail and corporate banking, driven by meaningful declines in loan impairments. Revenues in the UK retail division grew by over 2% year-over-year, with RBS citing the UK government's new Help to Buy program (designed to make housing more affordable in the UK) driving an increase in mortgage lending, with application values rising by 14%. In addition, ongoing efforts to simplify RBS's various account offerings are progressing, and the bank's new debit card rewards program (the first in the UK) has signed up over 400,000 as of the end of Q3 2013. Operating profits also increased by double digits in the bank's UK corporate division, with a slight decline in revenue more than offset by large declines in impairment losses. Despite the revenue decline, RBS notes that in Q3 2013, it received more loan applications from UK businesses than in any other quarter of 2013. Given that RBS is the UK's largest corporate bank, we believe that this is a good signal for the UK economy, as loan demand from businesses is a key barometer of economic health. That being said, RBS has launched an internal review of the division, for the bank has missed its internal targets for lending to small and medium-sized businesses, with its loans-to-deposits ratio falling to 81% in Q3, down 300 basis points from a year ago. The review will be led by Sir Andrew Lange, former deputy governor of the Bank of England, and will seek to address several issues, including RBS's business loan application process and lending standards. RBS's wealth management division (Coutts) saw operating profit decline by almost 5%, as a large drop in impairment losses was not enough to offset a more than 7% drop in revenues, driven by a 9% fall in interest income due to lower spreads (as an aside, Coutts happens to be the personal bank of Queen Elizabeth II). Assets under management increased by £1 billion (3%).
Ulster Bank (covering both Ireland and Northern Ireland) improved on a year-over-year basis, with losses narrowing by over 45% year-over-year. Multiple programs designed to assist Irish borrowers have led to six months of declining mortgage arrears, and loan impairment charges as a percentage of gross loans fell to 2.6% in Q3 2013, down from 3.2% in the second quarter and 4.1% a year ago (we remind investors that Ulster Bank is the 3rd largest bank in Ireland). The bank's loans-to-deposits ratio, while still well above 100%, continues to decline, falling to 123% from 130% a year ago. The Irish economy is slowly stabilizing, and economic growth is forecast at 2.7% in 2014. Ireland exited its recession in Q2 2013, with GDP growing by 0.4%, and housing prices are recovering across the nation, both in Dublin and elsewhere. Assuming current trends continue, losses at Ulster Bank should continue to narrow in 2014, which, combined with growth in the bank's core UK operations, should lead to improvements in underlying segment profit. Operating profit within the Citizens division fell by almost 37%, as loan impairments increased by over 180% to £59 million, which exacerbated a fall in revenue tied to a decline in interest income (down 1%). We note that the year-over-year surge in impairment losses is not due to deterioration in the credit quality of Citizens' loan portfolio, but rather due to the impact of reserve releases in Q3 2012. Although loan impairment charges at Citizens rose year-over-year, they rose to just 0.4% of gross loans, versus 0.3% a year ago. Citizens' loans-to-deposits ratio rose by 100 basis points year-over-year as the bank chose to let high-cost deposits run off. Coinciding with the creation of its internal bad bank, RBS is accelerating the spinoff of Citizens; RBS now plans an IPO of Citizens in the 2nd half of 2014, versus its previous timeline of holding an IPO in 2015. Citizens will be completely divested by the end of 2016, and the IPO will help further boost RBS's Basel III capital levels (more clarity on the magnitude of the increase in capital will likely be provided in 2014 when the details of the IPO are announced). International banking, covering RBS's non-US international business, saw profit fall by over 50% as impairment losses grew, and revenues declined. We note, however, that impairment charges as a percentage of gross loans fell to 0.3% in Q3 2013, versus 0.6% a year ago. Loan income fell 15%, as RBS continues to shrink its international loan portfolio (risk weighted assets fell by £3.5 billion year-over-year to £48.4 billion), and in the long run, international banking will play a more minor role in RBS's overall revenue and profit mix. We turn now to RBS's markets division, the source of a great deal of the bank's historical woes. As we detailed in our original article on RBS, the bank is in the process of dramatically shrinking this division, with a goal of reducing risk-weighted assets to £80 billion (per Basel III standards) by the end of 2014. RBS made good progress in shrinking the markets division in Q3, cutting risk-weighted assets by £13.6 billion to £73.2 billion (per Basel 2.5 standards). Profit was further reduced by RBS's shutdown of its asset-backed products business, with a 17% cut in expenses (driven by 1,000 layoffs) helping mitigate some of this impact. Central items cover gains on the disposal of available for sale securities, investment income, and certain treasury costs, and fluctuate from quarter to quarter, potentially obscuring RBS's underlying segment performance.
RBS's non-core division continues to shed assets, with a further £8.1 billion in assets shed in Q3 2013 on a sequential basis, bringing third-party assets down to £37.3 billion. Total risk-weighted assets at the division fell to £40.9 billion, down £19.5 billion from a year ago, equivalent to a 32% fall in assets. Impairment losses increased year-over-year to higher charges against Irish commercial real estate, and the division's operating loss was also increased by lower interest income on the remaining pool of assets. RBS has come a long way in shedding non-core assets; since the division was set up, the bank has shed a total of £221 billion in non-core assets, or £89,000 every minute since January 2009 (per the bank's Q3 presentation). With third party assets now below the bank's 2013 target of £40 billion, RBS has revised the target to £35 billion by the end of 2013. But, despite the meaningful progress the bank has made, there is more work to be done, and RBS will continue to post losses in this division as long as these low quality assets remain on its balance sheet. Therefore, RBS has elected to change its approach to these assets, and it is a change that we believe will be beneficial in the long run to both the bank and its investors.
The Internal Bad Bank: Ripping of the Band-Aid
After months of debate within the UK government and financial industry, the fate of RBS has now been made clearer. The UK government has rejected the idea of fully splitting RBS in two (as we argued in our original article), and instead the government has signed off on RBS's new approach of creating an internal bad bank (hereafter referred to as the IBB). The division, which will formally be known as the RBS Capital Resolution Group, will begin operations on January 1, 2014, and is forecast to cover a total of £38.3 billion in net third-party assets. The IBB's assets will be reorganized from RBS's current non-core asset pool, and will feature approximately £16 billion in transfers from the IBB, and £17 billion in transfers of poorly performing assets from RBS's core segments. In its interim report for Q3, RBS broke down what assets will be transferred into the IBB from its core operations (based on projected values at the end of 2013). £4.1 billion will be transferred from Ulster Bank, £5.5 billion from UK Corporate, and £2.6 billion each from Markets and International Banking. The reasons for the post-results selloff in shares of RBS can be attributed to the fact that alongside the creation of the IBB, RBS will be taking £4-£4.5 billion in impairment losses in Q4 2013, which would overwhelm any core operating profit the bank would generate. Naturally, headlines that proclaim of a £4.5 billion loss at RBS are enough to unnerve many traders. However, for long-term investors, this is actually a net positive, because RBS is choosing to accelerate impairment losses that are almost certain to have happened anyway.
Though the IBB will hold £38.3 billion in assets at the end of the year, its risk-weighted asset total stands at £115.6 billion, given the poor quality of these assets. The assets within the IBB account for 5% of RBS's funded balance sheet, but consume 20% of its capital, and also are the worst performing assets in RBS's stress tests, given that they generate over 40% of the impairments that RBS creates in its stress tests. Therefore, shedding these assets as quickly as possible is of paramount importance, for it will boost RBS's long-term capital ratios, and help normalize the bank's operating profitability. Although RBS will book over £4 billion in impairment charges in Q4, these accelerated impairments will only trim the bank's Basel III Tier 1 capital ratio by 10 basis points, due to the fact that RBS will need to hold less capital for expected future losses (the capital deduction the bank will book in conjunction with this loss stands at £3.5-£4 billion). RBS is also forecasting a further £1 billion of impairment losses in 2014-2016. However, we note that of the total in over £5 billion in impairment losses that RBS will book, 50%-60% of them were forecast to be booked in 2017 and beyond. RBS is merely electing to bring forward these losses, and the incremental costs of shedding these assets at a rapid pace will cost £1.5-£2 billion, with RBS management noting that these incremental costs are already included in the bank's long-term operating forecasts (2014-2016). RBS has outlined a goal of shedding 55%-70% of the assets housed in the IBB by the end of 2015, which will drive RBS's non-performing loan ratio down to a range of 2.5%-3%, far below its current range of 9%-10%, and is expected to provide a meaningful boost to long-term capital ratios (in the range of 40-50 basis points). RBS continued to make progress on strengthening its balance sheet in Q3, with its pro forma Basel III Tier 1 ratio rising 40 basis points sequentially to 9.1%, meeting its target of 9% by the end of 2013 ahead of schedule. In total, RBS expects to see a £2 billion boost to its capital levels by the end of 2016 through the accelerated disposal of its IBB assets.
In our view, that is the key aspect that investors need to keep in mind. RBS's Q4 2013 impairment losses are not additional charges on top of its forecasted losses. Rather, the bank is bringing forward a sizeable proportion of forecasted losses to be able to more rapidly wind down its remaining non-core assets, thereby providing a more rapid boost to its capital levels, and potentially allowing the bank to more rapidly reinstate its dividend, something that investors seemed to miss when RBS released its Q3 results. In its interim report for Q3, RBS CEO Ross McEwan disclosed that the bank is in discussions with HM Treasury to repurchase the UK government's Dividend Access Share. This instrument makes it uneconomical for RBS to pay out dividends on its common stock, for it entitles the UK government to claim a dividend yield of either 7% on its stake in RBS, or a dividend that is two-and-a-half times higher than what RBS would pay to its minority investors. The price tag for buying back the Dividend Access Share is reported to be around £1-£2 billion, and any deal for it would also need the approval of the European Commission, which has supervisory authority over bank bailouts conducted by member states. Sources close to HM Treasury have said that HM Treasury itself is examining options to sell the Dividend Access Share, and there are discussions about whether or not to simply funnel the proceeds of that sale back into RBS to bolster its balance sheet. Although that would have the effect of increasing the government's stake in RBS, it would lower the average price paid for shares of RBS, and could allow UKFI to divest its stake in RBS more rapidly than it otherwise could. We expect an update on this issue in February, when RBS will report its Q4 2013 and full year results.
In our view, the markets have misinterpreted RBS's creation of an internal bad bank. Despite billions of pounds in impairment losses to be booked in Q4 2013, the impact on RBS's capital levels will be minimal, and over time, will actually be a net positive for the company's Basel III Tier 1 ratio. RBS's core UK franchises are performing well, and with the Irish economy set to recover in 2014, Ulster Bank has the potential to further stabilize in the year ahead. The markets division continues to shrink, further driving RBS towards its goal of becoming a simpler bank, with the bulk of its revenue and profit derived from its retail & commercial banking operations. With the potential for a buyback of the Divided Access Share, RBS's path to reinstating its dividend may become much clearer in 2014, which would allow for more clarity on resolving a key issue on RBS's road back to private ownership. We are buyers on this pullback, and think that the thesis for owning shares of the Royal Bank of Scotland is fully intact.