After reflecting on 2017 actual numbers, having a fresh look at our estimates, Morningstar equity analysts are lowering their fair value estimate for Royal Bank of Scotland (RBS) to £2.90 per share from £3.
While there are signs of green shoots in RBS’ revenue generation, challenges regarding litigation and restructuring costs, as well as revenue generation, remain to be dealt with in the short term. RBS posted 2017 full-year annual net income of £752 million versus a £7 billion net loss in 2016.
While operationally somewhat better than the previous year, significantly lower litigation and conduct cost and lower restructuring costs helped RBS return to profit. Although it is rather slower than peers, it seems RBS management has found a good path to resolve outstanding issues and to operationally catch up with other banks on digitalisation.
RBS still needs to resolve its biggest litigation and conduct issues relating to U.S. Department of Justice, which remains a downside risk to profit in the short term. No timeline has been given by RBS management, which said it continues its talks with U.S. authorities. We believe resolving these two conduct charges will be a big step for the bank and remove overhang created by the uncertainty.
RBS management reiterated its target of a 50% cost/income ratio by 2020. However, it has also increased its restructuring cost target by £1.5 billion to £2.5 billion, which we have reflected in our estimates. While we find a 50% cost/income ratio by 2020 rather ambitious, under our current estimate, we have RBS reaching 60% by 2022.
RBS Has No Advantage Over Peers
We assign no moat rating to RBS, meaning we do not believe the bank has a sustainable competitive advantage over peers. We believe the bank lost its economic moat when it made the wrong management decision to acquire ABN Amro in 2007-08, and it has not returned to profitability since.
Barriers to entry in the U.K. banking sector are relatively high. In comparison with European peers, we think the U.K. banking system remains less competitive and highly concentrated. The recent CMA investigation into U.K. retail banking has revealed that, as was the case back in the late 1990s, HSBC, Barclays, Royal Bank of Scotland, and Lloyds remain the dominant players and between them hold 80% of personal accounts and 85% of business accounts.
With regards to the risks posed by Brexit, some U.K. banks under our coverage are clearly much more dependent on local economic developments, £revenue, and passporting arrangements than others. However, we believe any potential cost from the loss of passporting rights should be meagre and manageable in terms of banks’ P&Ls. In that sense, RBS and Lloyds will be less affected than Barclays when it comes to the increase in cost from the loss of passporting rights, as around 95% of their assets and banking activity are located within the U.K.
