Royal Bank of Scotland Group (NYSE:RBS) is slowly recovering from the collapse in 2008 (£24bn loss for a then-largest bank in the world) followed by a governmental bailout. It hasn't reported profit in the last 7 years but the situation should improve in near term after non-core assets are divested and regulatory supervision is eased. Some serious risks (outlined below) are present and we believe that after Brexit RBS was oversold on Friday, June 24 th, 2016 and look like an attractive entry opportunity. However, to justify that attractiveness and to generate handsome capital gain, it might take years for RBS due to the weaknesses it possesses.
Government control ensures support for RBS (although it would be very negatively received by the public if happens). Her Majesty's Treasury (HMT) still holds 72.6% of RBS' equity and reducing this share can be difficult given currently depressed stock prices but HMT indicated that it would divest its share in RBS even at a loss (stock were purchased at 5.02p, almost twice the current price) and had already sold first portion in the beginning of 2016. RBS is expected to become privately-owned again by 2020. Under governmental "Capital Resolution" program RBS faces various restrictions i.e. it should decrease portion of its problem legacy businesses (26% of risk-weighted assets at end-FY2015) more than 2 times by the end of 2016.
Operating environment is negative for RBS. Although most of RBS' business is concentrated in the UK (88% of income in FY2015 and RBS plans to increase focus in domestic activities raising its share to 90%) it could face significant problems after almost imminent UK economy slowdown following the Brexit. The UK gross-domestic product (NYSEMKT:GDP) growth was already slow at just +0.4% in 1Q16 (compared to +0.6% in 1Q15). Various studies forecast up to 8-10% decline in GDP after separation with the EU and financial services should be among industries most adversely affected - potential problem sources include legal restrictions to capital flow, limiting employment of EU citizens and as a result - shift of Europe's financial center from London to Frankfurt or somewhere else in continental Europe and reduced market share for UK-based banks.
Wholesale banking is under pressure as the UK dominates this business in the EU. RBS has mostly low-risk exposure with modest share of depressed industries (oil & gas, metals & mining, shipping) and emerging markets (4.4% of loan portfolio) but further decline in core portfolio quality is likely given anticipated economical slowdown. Reducing worldwide exposure also contributes to RBS' losses - i.e. selling Russian-based subsidiary lately resulted in £27mln loss (sold at roughly 0.5 P/B).
NPLs have been improving lately but are still high at 3.6% (down from 3.9% at end-FY2015, above average 2.5% for the UK). NPL coverage declined to just 57% but this is manageable given Tier 1 capital ratio is high at 15.4%. Full provisioning of problem loans would decrease this to still solid 13.3% not threatening solvency. In our opinion, situation with problem loans is more likely to worsen in near term - restructuring old bad debt should be more than offset by problem borrowers from depressed industries (production, construction and manufacturing outputs are still below 2008 level and service sector is the only one demonstrating growth).
The positive factor in loan portfolio is that RBS' earnings stability is underpinned by solid mortgage share (44.2% of total income and 87.5% in loan portfolio in the most important UK Personal & Business Banking segment, roughly half in total loan portfolio). Mortgage rates are higher than market-average (2.05% vs 1.85%). RBS strives to improve its market share in mortgage lending by introducing various promotional programs as well as by increasing number of sale partners ("mortgage advisors").
Low efficiency with Cost / Income at 79% (significantly improved from 129% in FY2015) and is under pressure by heavy restructuring costs. The management indicates long-term Cost / Income target for 2019 at less than 50%. To achieve that RBS plans to further reduce operating costs by £0.8bn in 2016 which should improve the ratio to 72%. Weak operating performance is further indicated by net interest margin of just 2.15% (up from 2.12% for FY2015) and low share of noninterest income (29.6% in 1Q16, down from 32.2% in FY2015). Interest margin is depressed by low interest rate environment and Bank of England might be forced to lower its base rate to 0.25% (currently 0.50%) to boost economical growth. RBS is negatively aligned towards possible rate decrease - this should lead to £96mln decrease in net interest income (negligible 1.1% of total net interest income).
RBS currently focuses on improving its core businesses and doesn't have any specific plans to increase share of noninterest income. Growth in online payments and various FinTech products can contribute to increasing earnings stability but that's not the key issue for the bank at the moment.
Litigation and conduct costs are high for RBS. The bank was found involved in various questionable practices like LIBOR rigging and "RMBS fraud". At end-FY2015 RBS accumulated £6.1bn provision related to these cases, £4.0bn attributable to RMBS claims. The management indicates that "further substantial provisioning may be required".
RBS hasn't paid any dividends since 2008 due to legal restrictions. In March 2016 it repaid £1.2bn under so-called 'Dividend Access Share' program which effectively removes government restrictions to distribute profit to shareholders. RBS hopes to resume dividend payments in early 2017 after Bank of England affirms its capital strength at end-2016. This could be somewhat delayed by the fact that RBS is expected to generate losses in 2016 and possibly in 2017 due to high restructuring costs. Divestment process is very slow for the government in comparison with Lloyds Bank (was also rescued by HTM in 2008) which is already allowed to resume dividend payments.
To sum up, at this moment we do not see any obvious factors which can positively affect RBS' stock price in near term - even the core mortgage market is experiencing difficulties. Slow improvement in performance is likely in long-term with organic earnings growth but it's threatened by all the other points we've outlined before. While RBS is definitely going through hard times it shouldn't be considered a suitable investment for those seeking stable income due to very high price volatility and still uncertain dividend payments (resume is somewhat likely to happen only in 2017 given favorable financials and operating environment). Such weak position is confirmed by low trading multiples in comparison with the peers - RBS is currently trading at roughly 0.4 P/B after June 24th price drop by 17.5% on Brexit result and 50% decline YTD. As a comparison, Lloyds Bank that had completed government instructions and pays dividends is now traded almost twice as high as RBS (at 0.8 P/B).
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.