RBS will be one of the last to emerge from crisis

Royal Bank of Scotland reported an attributable net loss of £1.8 billion for the third quarter on Friday, two days after it detailed its participation in the UK Asset Protection Scheme (APS) and announced a £25.5 billion share sale to the UK government and an EU mandated restructuring. Our 60p-per-share fair value had already incorporated a significant chance of another government rescue and is only modestly impacted by this announcement. We are lowering our fair value estimate slightly for the London shares to 50p and leaving it unchanged for the ADRs, as the impact is offset by the change in exchange rates. We're also leaving our uncertainty rating at the highest level. We think it is very difficult to accurately peg RBS' worth, which depends heavily on how much it is able to sell its restructured business for and how high its credit losses might be.

In August, RBS announced that it had split its businesses into core and noncore (about 32% of risk-weighted assets) and that it intended to wind down its noncore businesses. The good news for RBS this quarter was that its noncore businesses made a pretax operating profit of £1.2 billion during the quarter, although this was down 56% from the year-ago quarter on a pro forma basis. The noncore division reported a pretax operating loss of £2.7 billion. The bad news is that RBS' poor profitability in the third quarter was due to lower net interest income and, more significantly, high credit losses--two trends we don't see reversing anytime soon.

RBS' latest £25.5 billion bailout and the bank's participation in the APS have reduced the downside risk for the bank. The APS will insure £242.8 billion of RBS' worst assets, with RBS responsible for the first £60 billion of losses. We think losses are likely to be smaller than this amount and that RBS' equity base of £59 billion, plus the £25.5 billion of fresh equity it will issue to the government, will be sufficient to absorb the losses ahead of the bank. If not, the government stands ready to inject another £8 billion into RBS. At the same time, we don't see a lot of upside. RBS will be 84% owned by the British government and will almost certainly be pressured to make uneconomic business decisions. It is forbidden from paying dividends on its common or preferred shares for two years and will likely make losses through 2010. RBS' ability to pay bonuses to its bankers has been sharply limited, and it is having trouble retaining staff, especially in its most lucrative business areas. RBS has said its aim is to earn a return on equity of 15% by 2013, and we're not convinced it will even meet this modest goal.

Fair value estimate: 50p ¦ Fair value uncertainty: Extreme ¦ Economic moat: None

Thesis
(Last updated 11-11-2009)

Royal Bank of Scotland, formerly a dominant UK bank, has been undone by its global ambitions, in our opinion. It destroyed its narrow moat with its reckless acquisition of ABN Amro at the peak of the market bubble in 2007 and is suffering mightily as credit quality declines around the globe. Its fortunes now depend on its ability to prove sceptics wrong, once again, by limiting the losses of its noncore businesses as it winds them down and strengthening the core businesses it is retaining. Largely as a result of its ill-timed, overpriced acquisition of ABN Amro in 2007, RBS is one of Europe's weakest banks and has been forced to undertake several highly dilutive capital raises. Most recently, a £25.5 billion bailout to be completed in 2009 will leave the government with an 84% economic stake. We're concerned that further losses are on the horizon and that the bank may never regain its former profitability.

Investors got their first glimpse of RBS' ambitions in 2000, when RBS won a bidding war for NatWest, an ailing UK bank three times RBS' size. The acquisition was, at the time, the UK's largest hostile takeover ever. RBS confounded its critics by exceeding its cost-cutting targets and hitting milestones ahead of time, despite an economic slump--the takeover is now seen as a model of a successful acquisition.

Having got a taste of what was possible, RBS embarked on an acquisition spree, acquiring more than 20 companies between 2000 and 2006, including US-based Charter One in 2005. In 2007, it led a consortium of banks in a successful bidding war against Barclays for ABN Amro, paying a high premium for the sluggish Dutch bank in order to win ABN's wholesale and Asian banking operations. RBS now faces its biggest challenge to date, in our opinion, and so far the results don't look promising. RBS has taken tens of billions in losses on ABN's assets, and some of its fellow consortium members have been nationalised as a result of losses related to the acquisition.

Although bailouts seem to have ensured RBS' survival, we doubt its profitability will ever fully recover. Successive bailouts have left its management largely in the hands of the UK government, and the bank has announced lending programmes aimed at shoring up the UK economy. RBS will be forbidden from paying dividends for two years and has agreed to sell multiple businesses regardless of the price it receives for them. It is sharply limited in its ability to pay bonuses, and staff is leaving in droves. RBS has said that while it expects to report losses through 2010, it intends to earn a 15% return on equity by 2013, which we think will be challenging. RBS has proved critics wrong before--and may do so again--but we doubt it.

Valuation
We are lowering our fair value by 10p to 50p as we account for the effect of RBS' £25.5 billion capital raise. We assume that total assets will shrink significantly in 2009 and 2010 as the bank shrinks its trading book and sheds assets but will grow an average of 4% annually thereafter. We expect net interest margins to dip to 0.9% in 2009 as deposit pricing increases and to gradually recover to 1% though 2013. We expect charge-offs to increase to 1.5% of loans in 2009 as RBS is protected from its worst assets by the UK asset protection scheme, and to remain over 0.5% during our forecast period--somewhat above historical levels. We project that noninterest income will return to 2006 levels by around 2013. We expect the bank to report losses in 2009 and 2010 and for return on equity to remain below 10% during our forecast period, as the bank struggles to absorb credit losses and rebuild its tattered business. Using these projections, we estimate a fair value of 50p per common share.

Risk
RBS' capital raises left the government with a controlling interest in the firm, and RBS has agreed to increase lending to troubled sectors, which may result in large future losses. Under the revised terms of the Asset Protection Scheme, RBS is exposed to the first £60 billion of losses. If losses approach that amount, RBS will likely be forced to go back to the government for another bailout. The terms of RBS' bailout make it difficult to reward staff and therefore to retain employees, especially in the bank's most lucrative businesses. RBS-consortium's purchase and breakup of ABN promises to be one of the largest and most complex ever. Any further missteps could destroy what is left of shareholder value.

Management & Stewardship
RBS' management recently underwent a major shakeup as a result of its disastrous acquisition spree and its participation in the UK bank rescue plan. Its CEO since 1998, Fred Goodwin (known as "Fred the shred" for his aggressive cost-cutting), has been replaced by Stephen Hester, formerly the CEO of British Land. Chairman Tom McKillop resigned in February 2009, earlier than previously announced, and was replaced by Sir Philip Hampton, the highly respected chairman of Sainsbury supermarkets and former chairman of UK Financial Investments, the firm overseeing the UK investments in recapitalised banks. RBS and the government will work together to appoint up to three new independent board members. It is difficult to say with certainty what changes the new management will make, but we anticipate that RBS will become a smaller and more conservative institution. Historically, RBS has offered very generous management compensation packages that have not been very successful at aligning management's interests with shareholders'. Appropriately, RBS' board declined bonuses for 2008, which has been disastrous for shareholders, and any 2009 bonuses will be paid in shares.

Overview
Growth: Since 2000, RBS expanded aggressively through acquisitions. It doubled in size in 2007 as a result of the ABN Amro acquisition. We expect average growth to be negative through 2012, as RBS sells troubled assets and raises capital through sales of other assets like its stake in Bank of China, which it sold in early 2009.

Profitability: RBS' average return on equity was near 15% in 2005-07, but the bank lost a massive £24 billion in 2008. We expect losses in 2009 and 2010 and doubt RBS' profitability will return to its former levels.

Financial Health: RBS' pending participation in the Asset Protection Scheme and its latest bailout increase its pro forma core Tier 1 capital ratio to a hefty 11.1%. If losses reduce this to 5%, the government stands ready to contribute another £8 billion.

Profile: Through acquisitions, RBS has become a global bank with operations in 50 countries. RBS is primarily a business bank and is dominated by its Global Banking and Markets division, which generated 37% of operating profits in 2007, and UK Corporate Banking (19% of operating profits). The firm generates more than 65% of its profits in the UK, where it operates a sizeable retail bank. It also owns Ulster Bank in Ireland and Citizens Bank in the United States.

Strategy: RBS' strategy is aimed at cleaning up the mess left by its empire building. It is focusing on its core businesses--retail and commercial banking--and reducing the size of its investment banking operations. It also plans to sell and/or wind down noncore businesses in order to be a viable stand-alone firm, partly in response to European Union directives.

Bulls Say
1. RBS is essentially a government-run bank, and its government backing will help it to win deposits from its competitors.

2. RBS dominates the UK commercial banking market and will benefit from the shakeout of nonbank competitors caused by the ongoing financial market turmoil.

3. RBS' acquisition of ABN Amro has diversified its operations geographically.

4. RBS' participation in the Asset Protection Scheme will help protect the bank from the growing losses as its assets deteriorate.

Bears Say
1. RBS' massive losses and its ill-conceived takeover of ABN Amro has destroyed confidence in the institution. Further losses, which are likely, will mean inadequate shareholder returns for many years.

2. RBS grossly overpaid for ABN Amro at the peak of the credit bubble, destroying billions in shareholder value. It proceeded on with the acquisition even after the prize it was after--LaSalle Bank--slipped through its fingers.

3. RBS' recent government-sponsored capital raise will leave it well-capitalised but exposed to government interference--it may come under pressure to put the public's interests before shareholders'.

4. RBS' US bank, Citizens, is too small to compete as a national player and has few available options for growth. Its growing losses are likely to force RBS to infuse new capital into the bank, thereby throwing good money after bad.

5. The UK's commercial finance market is rapidly weakening. The expected increase in loan losses at RBS' large UK commercial bank could cut deeply into the bank's profitability.