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Royal Bank of Scotland Group plc (RBS) Ord GBP1

Sell: 353.80pBuy: 353.90p02.90p (0.83%)
FTSE 1000.24%
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HL comment (26 February 2015)

The Headline Numbers:
RBS has reported a full year loss of £3.5bn, which included a £4.0bn write-down on its US subsidiary Citizens. Operating profits, before the write-down, were £3.5bn, an improvement of £11.0bn from 2013. The company had a tax charge on these profits of £1.9bn, including a write-off of deferred tax assets of £1.5bn. £2.2bn of litigation and conduct provisions were also charged in 2014. Had restructuring, conduct and litigation costs been excluded, operating profits would have been £7.0bn.

Where Next?
Looking forward, RBS expects 2015 to be a year when the core UK/Irish business performs well, but with what it describes as income headwinds. The Corporate and Institutional Banking (CIB) division is set for a tough year, with income falling significantly faster than costs. RBS expects to cut its overall costs by £800m this year, but does not expect impairment write-backs in its Irish business to repeat. Restructuring costs will be "materially higher" this year.
The market has taken these results as broadly reassuring and the stock is around 2% higher in early trading.

The Detail:
RBS has progressed ahead of schedule on cost savings, with £1.1bn delivered in 2014 and capital has strengthened, with the Common Equity Tier One ratio rising from 8.6% to 11.2%. But there is still work to do, with a CET1 target of 13% yet some way off. The underlying cost/income ratio fell from 72% to 68%, but RBS's target is to achieve a ratio of under 50%.
So far, RBS has paid almost £9bn in fines and customer redress (PPI etc) costs and the bank warns that further substantial costs could be incurred in 2015. These costs have held back the achievement of capital strength targets and will continue to do so.

The underlying progress of RBS has been substantial; the CEO described the increased operating profit as a "vast improvement" and said the bank is increasingly driven by its two core divisions, Personal & Business Banking (PBB) plus the Commercial & Private Banking (CPB) arm. Citizen's has been listed in the USA and will be fully deconsolidated by 2016, whilst CIB is increasingly focused on clients in the UK and Europe.

The two core divisions, Personal & Business Banking (PBB) and Commercial & Private Banking (CPB), delivered returns on equity (ROE) of 17.5% and 11.9%, respectively. Between them, they grew income by 2.3% and costs were reduced by 2.6%. Collectively they delivered 61% of Group income, compared with just 37% in 2009, underlining the changing shape of RBS.

Capital is still below target, but RBS is ahead of schedule on the way to the target; the bank had not expected to surpass a CET1 level of 11% for another year. RBS Capital Resolution, the "Bad Bank" continues to wind-down capital-intensive, non-core assets and the group is now targeting a balance sheet with Risk-Weighted Assets below £300bn, versus a peak level in 2008 of almost £700bn. The current position is £356bn.

Key metrics Current Position Year Ago Position
Tangible Net Asset Value per share 387p 363p
Tangible Equity £44.4bn £41.1bn
Risk-Weighted Assets £356bn £429bn
Loan to Deposit Ratio 95% 94%
Short-Term Wholesale Funding £28bn £32bn

With restructuring and capital rebuilding still very much underway, there is no dividend for shareholders this year. But the bank has been able to restructure the Government's Dividend Access Share and make a £320m payment to the Treasury, bringing forward the day when ordinary shareholders can see a return to dividend payments.
Net Interest Margins in the core divisions improved, with PBB seeing an increase of 21bp to 3.42% and CPB lifting its margin by 12bp to 2.93%. Net Lending volumes were £3.9bn up in mortgages, but unsecured lending fell in the PBB division. In the Commercial and Private Banking division, lower lending to property companies offset growth in other categories, capping the division's overall net lending increase to £1bn. RBS made gross new loans of £10.3bn to Smaller and Medium Enterprises (SMEs), 10% more than targeted, but net lending within the scope of the Government's Funding for Lending Scheme declined by £2.3bn with SME lending a net minus £0.6bn.

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Our view:
RBS is still very much en route, with a fair way still to travel. But progress is pretty clear. The improvement in operating profits was immense, partly a function of one-offs dropping out of the equation, but still substantial at the underlying level. Costs are way too high, but under attack. They have to be though, because with RBS aiming to lose a further £60bn or so of Risk Weighted Assets, approaching 20% of the group total, income will still be under pressure for a while longer.
But the core of RBS is starting to look quite shiny. The PBB division is generating a great Return on Equity and CPB is catching up from behind. Both are generating returns far ahead of HSBC for instance. That's a slightly unfair comparison, because PBB and CPB have had the bad stuff extracted from them, whereas HSBC's single digit ROE is a warts and all number.

When the group gets up to a 13% CET1 ratio, it intends to resume dividend payments. We'd expect these to be modest at first, but conceivably, a 2015 final payment could be possible. The hit from writing off Citizens goodwill has already been taken, so the swing factor on capital generation is now regulatory costs. Reports of another £10bn of fines and redress costs have been coming across the newswires in recent weeks. That scale of retribution could delay the dividend restart, but it will not threaten the viability of the bank.
The stock is trading a little above tangible book value, but still making a sub-standard return overall. As the contribution from the core divisions becomes less and less clouded by restructuring costs and write-offs, and as the CIB and RCR divisions are brought to their intended long term shape, we would expect RBS shares to move to a premium to their Tangible NAV, assuming those core PBB and CPB divisions continue to earn high returns. But we are some way off that position. For now, RBS shares remain firmly in the territory of the patient and the brave.

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