Royal Bank Of Scotland: Time To Bail

| About: The Royal (RBS)

Summary

A long-time underperformer, RBS is performing quite poorly despite the long-term turnaround strategy.

Sluggish interest income and strong interest rate sensitivity makes the bank quite vulnerable to the possible rate cut.

Following the Brexit news announcement, RBS has underperformed the most among the European banks.

Overview

To say that the recent performance of the major banks' shares has been a disappointment would be an understatement. Low (and even negative) interest rate environment, accompanied by the global loan bubble and an increasingly bearish sentiment makes the case for picking shorts in the financial sector.

Despite staying under the radar of many value investors for years, the largest European banks have continued to move lower despite trading at increasingly attractive valuations. However, valuation-based strategies do not work too well when the companies' performance (and thus sentiment) continues to worsen.

With Credit Suisse and Deutsche Bank trading at new all-time lows, there is one strong underperformer that might be on its way to join the two.

Royal Bank of Scotland Group Plc (NYSE:RBS)

For the bulls out there, the bank is kindly providing a personally-tailored investment thesis in a separate section of its website. The slogan, which goes as "stronger, simpler, fairer" might sound rather convincing. Indeed, there have been numerous developments one should definitely be optimistic about. The question that remains is: What are the negatives?

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Source: Company's Website (2016).

By no means am I questioning the potential of the bank's long-term turnaround at this point. However, RBS might be currently viewed as a compelling short candidate given the present sentiment, lagging performance and the potential of a market correction or a bear market (since one can never be sure, I only consider shorting the securities that are expected to tank wherever the market goes short-term).

Emphasis on the turnaround

Arguably, it does not make too much sense to analyze the historical (long-term) performance of the bank given the current transformation. After the $68 billion bailout during the financial crisis, RBS is now planning to become a "a simpler bank focused on doing fewer things, and doing them well, built around a low risk UK and Irish retail and commercial bank," according to its chairman Howard Davies.

Source: Company's Presentation (2016).

Since the near-term expectations are rather pessimistic and the audit committee chairman's take on the 2016 is that it " is set to be no less challenging," it might be of value to analyze the bank's recent efforts. One of the first red flags might be expressed in the large number of adjusted measures used in the company's latest presentation.

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Source: Company's Presentation (2016).

The bank has been quite aggressive in cutting risk assets. Throughout the fiscal years 2014-2015, RBS has strongly decreased its exposure to oil and gas (-63%), mining and metals (-59%), shipping (-30%) and emerging markets (-61%).

Other notable changes include the disposal of the Citizens Financial Group and the aggressive cost-cutting happening lately. Since January, RBS has already cut more than 2,500 jobs.

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Source: company's strategic report (2016).

However, despite the bank's enthusiasm, overall operating performance has been rather disappointing of late.

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Made by the author using the exhibits from the 2015 annual report.

Interest rates

On June 16, 2016, the Bank of England has once again left the interest rate untouched at the historical low of 0.5 percent with Brexit being one of the sources of concern. From the official statement:

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Source: Financial Times (2016).

Even though the referendum will have already been finished by the time of publication of this article, the current consensus view on the U.K.'s interest policy is not suggesting rate hikes any time soon. In fact, opinions regarding the potential rate cut are not too rare as well.

Operating under challenging conditions, RBS will be quite sensitive to the future BOE's policy changes. Cost-cutting cannot compensate (and cannot continue at the same rate for a long time) for the bank's major weakness. A rate cut would be a strongly bearish signal for the stock.

Source: made by the author using the exhibits from the 2015 annual report (2016).

Numerous red flags are present, including:

1. Non-performing loans are on the rise.

There has been a rapid increase in the amount of non-performing loans in the bank's credit portfolio.

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Source: Q1 Earnings Announcement (2016).

2. Worsening trading environment.

Despite the bank's efforts to decrease risky exposure, challenging market conditions are weighing on its trading operations.

Made by the author using the data from the Q1 Earnings Announcement (2016).

3. The transformation is not free.

Made by the author using the data from the Q1 Earnings Announcement (2016).

4. Possibility of more impairment losses.

The last time RBS had those was 2 years ago. More to come?

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Made by the author using the data from the Q1 Earnings Announcement (2016).

5. Falling net interest income.

Made by the author using the data from the Q1 Earnings Announcement (2016).

6. And here comes the Brexit.

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Due to the personal schedule, I did not manage to finish this article before the Brexit has arrived. Nevertheless, the key takeaway is that the recent risk-on rally has not been backed by any fundamentals and is most probably going to dramatically reverse over the coming weeks.

2-year performance of the Royal Bank of Scotland Group plc shares traded on NYSE. Made by the author using the data from Yahoo Finance.

And here is the current performance of RBS on the London Stock Exchange:

2-year performance of the Royal Bank of Scotland Group plc shares traded on the London Stock Exchange. Made by the author using the data from Yahoo Finance.

Conclusion

The risk of holding the stock is skewed to the downside, with negative catalysts clearly outweighing the positive ones:

  • Deteriorating sentiment;
  • Challenging market conditions;
  • Increased Brexit news coverage;
  • Increasing number of NPLs;
  • Increased possibility of a rate hike due to the monetary shock from Brexit;
  • Because of the current transformation, total interest income is expected to decline any way. The total number of customer accounts and deposits, as well as that of the net loans and advancements, is declining.
  • Bad technicals.

The above-mentioned factors make a clear bearish thesis for the stock. Even though the RBS seems to cope with its long-term turnaround plans and might seem undervalued from the perspective of valuation ratios, the near-term performance is most probably going to be quite unsuccessful for the stock.

I assign RBS a Sell rating.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.