RBS Appears To Have Sizable Upside Given Retail Growth, Dividend Plans
Late last week, The Royal Bank of Scotland Group reported results for the second quarter of the year which were largely as expected, with revenues benefiting from an uptick in securities trading activity while the bank’s focus on growing its core retail business in the U.K. yielded strong results. Although the bottom line was hurt by the one-time legal costs linked with the bank’s settlement of its legacy U.S. mortgage lawsuit, RBS has done extremely well to keep its costs in check – something that helped its adjusted cost-to-income ratio fall to the lowest level since the downturn. We have summarized the bank’s earnings and also detailed our expectations for the rest of the year in our interactive dashboard on RBS’ Q2 earnings takeaways.
More importantly, having finally gotten rid of its nagging legal overhang, RBS is reinstating dividends after a decade, and aims to pay shareholders an interim dividend of 2 pence a share once the formalities around the mortgage settlement are completed. While the bank is likely to face sizable headwinds due to Brexit in the coming years, the effort it has put in over the years to reorganize itself as a streamlined loans-and-deposits bank will be key to creating value for investors, even under the difficult economic conditions expected to follow. Because of this, we reiterate our price estimate of $9 for RBS’s stock, which is about 30% ahead of the current market price.
Takeaways And Expectations
RBS’s Q2 results showed several signs highlighting the bank’s successful return to a growth path after nearly a decade of restructuring:
- Although RBS’s total loan portfolio decreased in size from roughly £330 billion in Q2 2017 to £324 billion, there was a noticeable increase in total loans sequentially. The year-on-year reduction can be attributed to the ongoing reduction in non-core loans under the NatWest Markets and Commercial Banking divisions. At the same time, the bank reported strong growth in its core U.K. personal and business banking loan portfolio – which grew from £160 billion at the end of Q2 2017 to £163 billion now. This is a commendable effort, especially since the ongoing Brexit talks have had a visible impact on U.K.’s economy, with the country’s banking industry reporting a decline in the demand for mortgages, auto loans and other personal loans from retail customers.
- The loan growth has not come at the expense of higher loan losses, as loan provisions were lower in Q2 2018 compared to Q2 2017 as well as Q1 2018. This makes sense, given that RBS has been cautious about the quality of loans it originates over recent years.
- The overall loan growth (coupled with an improvement in the valuation of derivatives from upbeat market conditions) helped RBS’s balance sheet grow in size for two consecutive quarters. It should be noted that the bank’s total asset base shrunk from a peak level of over £2.4 trillion in 2008 to a low of £738 billion at the end of 2017. But the figure now stands at £748 billion. Although subsequent disposal of non-core assets will weigh on the asset base going forward, we expect organic growth to more than make up for this – resulting in steady growth in RBS’s balance sheet.
- A major indicator of RBS’s leaner, more profitable business model is the fact that its two biggest operating divisions – U.K. personal and business banking, and commercial banking – reported a cost-to-income ratio well below the target level of 50%. While the U.K. PBB business reported a ratio of 47.5%, the figure was better at 42.5% for the commercial banking arm. In fact, adjusting the results for the one-time mortgage settlement, RBS’s overall cost-to-income ratio was the best since the downturn. A low-cost structure should play an important role in the bank’s remaining profitable in the face of expected headwinds in the near future.
- Finally, most of RBS’s reorganization efforts over the years have been focused on shrinking its investment banking operations, which were responsible for more than 60% of the bank’s revenues in 2007. The bank’s losses from legacy securities have fallen considerably over recent quarters, even as its debt trading desk (which is better integrated with its commercial banking business) continues to benefit from upbeat activity level in global capital markets. As seen here, investment banking revenues were roughly 6% of the top line in Q2 2018 (down from over 10% in Q1 2018). We expect these revenues to largely remain in the 5-10% range of total revenues going forward, as growth is primarily driven by traditional loans-and-deposits activities.