Royal Bank of Scotland Value Play

| About: The Royal (RBS)

Although preferreds are considered a relatively safe, moderate return investment, aggressive investors may like to look at an interesting idea. Royal Bank of Scotland (NYSE:RBS) was one of the hardest hit global banks during the financial crisis, leading other European banks in total losses ($70bn) and total capital raised ($95bn). Since then, RBS has embarked on a strategic initiative of disposing non-core assets and seems to be progressing well with its restructuring plan. Despite a first quarter loss, the bank was profitable in 2010, and is regarded as making progress. Speculation has been surfacing about how, and when, Britain may start unwinding its 83% stake in the bank.

Royal Bank of Scotland Group plc (RBSG) is the main holding company. Most of the company's senior unsecured debt, however, is issued by Royal Bank of Scotland plc, which is the main operating banking subsidiary.

RBS has senior debt and subordinated debt outstanding, both ranking ahead of its preferreds: coupons must generally be paid on subordinated debt if the bank is making dividend payments on their preferreds or common shares. Barry McAlinden of UBS Wealth Management stated in a report to customers dated February 8, 2011, that he believes RBS subordinated debt will be "money good" at maturity and the risk of principal losses is low.

If that is the case, then it’s time to look down the ladder at the preferreds. Royal Bank of Scotland, RBS, has 14 different preferreds, and each has a different dividend status.
Most of the $25 par preferreds outstanding are structured as non-cumulative. Preferreds with symbols RBS pr M, N, P, Q, R, S, and T had their dividends suspended for two years on April 30, 2010, due to the European Commission's burden sharing restrictions placed on financial institutions. These securities last paid dividends on March 31, 2010.
On August 31, 2010, the European Commission ruled that starting in April 1, 2011 RBSG would not allow RBS to pay dividends for two years on RBS pr E, G, and I. (Several other series of preferreds are considered “must pay” that only allow for suspension provided that specific capital requirements and distributable profits tests are breached).
On a longer term basis, if RBS is eventually able to operate as a profitable stand-alone institution without government ownership, UBS has stated that it believes “dividends would be reinstated when their respective coupon bans are lifted in 2012 and 2013.” This means that even though dividends are non-cumulative, prices would move closer to par as the market anticipates resumption of dividend payments. (In fact, the charts below show this trend).
Consider one series: RBS prS is now trading at $17.86. If the bank resumes dividends on March 30, 2012, and if the markets anticipate it, the price will increase toward $25, generating a total return of perhaps 30% - 40%. Or, if rates stay low, the bank may consider tendering or exchanging some high coupon preferreds on or after March 30.

The risks are (1) that interest rates spike before then, making the 6.60% yield look weak to other comparable preferreds, (2) that RBS hits a bump before March 2012, or March 2013, for series E, G, I, and can’t resume payment of dividends, or (3) these dividends benefit from being taxed at the flat dividend rate of 15%, and the prices could be affected if this tax rate isn’t extended again.

(Click charts to expand)

For what it’s worth, hedge fund managers John Paulson and David Tepper like these.
If you like the outlook for the parent company, RBS, then the forecast for the price appreciation makes sense. Disclosure: We have direct and indirect positions in RBS prQ and RBS prS.