Following Royal Bank of Scotland’s (RBS) third-quarter results, Morningstar analysts have raised their fair value estimate to 300p a share, an increase of 35p, as a result of lower litigation and overall costs for 2017.
Analysts expect restructuring charges to cost the bank £3.3 billion and legal and regulatory matters to cost a further £2 billion over 2018-21. As RBS works through these issues, we think the strength of its core business will increasingly drive results. We are maintaining our revenue estimates.
There are signs of green shoots in Royal Bank of Scotland's revenue generation, sharp declines in litigation- and conduct-related costs and lower structuring costs as well as declining loan-loss. These helped RBS to post net income of £1.3 billion year to date, versus a loss of GBP £2.5 billion in 2016, which is trending better than our estimate and what consensus was expecting.
RBS reported attributable net profits of £392 million for the third quarter, marking the third successive quarter of profit, which brings year-to-date net profits to £1.3 billion. One of the items that helped RBS boost its net profit was a 21% year-over-year decline in total costs. While litigation and conduct costs are trending below our expectations, we believe both items in coming quarters have the potential to create earnings volatility for RBS.
RBS still needs to resolve its conduct issues relating to US residential mortgage-backed securities and the US Department of Justice (DoJ), which remains a downside risk to 2018 profit.
While profitability seems to be improving and restructuring is tracking as management planned, we still think in risks are on the downside for RBS in the short run, and Lloyds (LLOY) is our preferred name in UK banks. We maintain our very high uncertainty rating for RBS, driven by the risk of a DoJ fine and a slow restructuring process that causes a volatile earnings outlook.
While no timeline has been guided by RBS management over the US legal issues, we believe resolving these conduct charges will be a big step for the bank and remove overhang created by the uncertainty.
RBS's Painful Road to Recovery
We believe the bank lost its economic advantage, or moat, when it made the wrong management decision to acquire ABN Amro in 2007-08, and it has not returned to profitability since. Since 2008, the bank's cost/income ratio has deteriorated to 95% from 54% in 2007, and averaged around 90% between 2008 and 2016. RBS is almost the only bank in the UK still predominantly owned by the government, following the bailout in 2008.
While we think the government shareholding is temporary, we believe it will take several years for the government’s share to decline, given the difficult market conditions, along with RBS’ outstanding legacy issues and litigation. Changes in the shareholder structure, successful execution of the restructuring, and a strengthened position within core business segments would trigger us to revisit our moat rating.
RBS has an attractive retail banking business based in the UK, and the segment generates around 45% of group revenue. It generates return on equity of 16%; we think this has the potential to exceed 25% once the restructuring is completed and litigation costs are settled.
The cost/income ratio of personal and business banking (PBB) on a reported basis stands at 72%, and when adjusted for restructuring and litigation cost, this decreases to 50%. We believe some of the bank’s strongest brands fall under PBB, including NatWest in England and Wales, Royal Bank of Scotland in Scotland, and Ulster Bank in Ireland.
