The Royal Bank of Scotland Group plc (NYSE:RBS) (LON:RBS) (AMS:RBS) equity story faces two key challenges, in our view says Goldman in a new report:
- muted returns (excluding notable items, annualized core ROE was 6.2%/4.3% based on normalized/reported tax during 1Q13);
- elevated uncertainty over the medium-term path and prospects of the group (due to multiple iterations of the group’s strategy and recent management changes).
A split of Royal Bank of Scotland Group plc (NYSE:RBS) (LON:RBS) (AMS:RBS) into a good and a bad bank could potentially address both of these challenges by enabling Royal Bank of Scotland to divest low ROE / high COE operations while focusing resources on operations for which there is popular and political support (thus reducing the risk of imposed adjustments to the group’s strategy and management).
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Breaking up would be hard to do – clearing the hurdles
The challenges associated with the implementation of a good bank/bad bank split are likely to be substantial.
Notwithstanding this, we evaluate a bad bank scenario against the ‘hurdles’ set out at Mansion House on June 19, 2013, namely that a bad bank will be established only if the exercise:
- does not require additional taxpayer capital;
- supports the British economy;
- is in the interests of taxpayers;
- accelerates the return to private ownership of Royal Bank of Scotland Group plc (NYSE:RBS) (LON:RBS) (AMS:RBS).
The exact size and make-up of a potential “bad bank” is thus subject to uncertainty. However, based on the comments by HMT representatives, our analysis assumes that the asset pool would be based on:
- Non-core assets;
- Core Ulster risk elements in lending (including non-performing mortgages, commercial real estate, corporate and other loans);
- High risk core commercial real estate exposures outside Ulster REIL and Citizens.
A “bad bank” on this definition would encompass 6% of group assets (£85 bn) but 76% of risk elements in lending (£31 bn), 75% of group provisions (£16 bn) and 17% of group tangible equity (£8.5 bn).
Looking to the US to fund a ‘haircut’?
The combination of existing provisions and capital resources would allow Royal Bank of Scotland Group plc (NYSE:RBS) (LON:RBS) (AMS:RBS) to transfer the assets identified in our analysis at a 29% discount to gross notional while remaining broadly neutral from a regulatory capital ratio perspective.
To fund additional ‘haircuts’ Royal Bank of Scotland Group plc (NYSE:RBS) (LON:RBS) (AMS:RBS) would need to free up internal capital resources. While the group has various strategic options in this regard, we believe the focus would likely be on the group’s US operations, specifically Citizens Financial Group and RBS Securities Inc.
Our analysis suggests that divesting these core operations would allow Royal Bank of Scotland Group plc (NYSE:RBS) (LON:RBS) (AMS:RBS) to impose haircuts of up to 45% of notional on bad bank assets while ensuring that the remaining core operations of the group would not require an equity injection (addressing the Chancellor’s first hurdle).
The good bank: Skewed to the UK real economy
Under this scenario – which constitutes our bad bank base-line – Royal Bank of Scotland’s core operations would be meaningfully altered relative to today, encompassing core (as currently defined) excluding:
- Project Rainbow branches;
- The remaining stake in Direct Line Group;
- Ulster risk elements in lending (across mortgages, CRE, corporate, other);
- High risk commercial real estate exposures (outside of Ulster and Citizens);
- Citizens Financial Group;
- RBS Securities Inc.
Relative to current core operations, this ‘adjusted core’ would generate lower earnings (by 5%/15% relative to 2012/steady-state) but higher returns (with ROE/ROTE of 10%/12% for adjusted core versus our steady-state projections of 8%/10% for current core).
Meanwhile, the split would refocus Royal Bank of Scotland Group plc (NYSE:RBS) (LON:RBS) (AMS:RBS)’s operations on UK/real-economy activities with Markets representing <10% of earnings and the UK generating around 3/4 of income (which would arguably support the British economy – the second ‘hurdle’).
Transfer terms key to bad bank impact, but benchmarks are benign
On our analysis, a good bank / bad bank split could boost the returns and reduce the cost of capital of Royal Bank of Scotland, addressing the group’s two most fundamental challenges (i.e. muted core returns and an elevated cost of capital).
However, the overall valuation impact of a good bank/bad bank split is uncertain (given that the group’s valuation multiple would rise while EPS/BVPS would decline) with the net value impact dependent on the terms of the bad bank asset transfers and any divestment to fund associated marks.
While the terms of these transactions are uncertain, we believe the following provide meaningful downside protection for both equity and debt investors:
- stated unwillingness by HM Treasury to inject additional equity into RBS;
- the insistence from HMT that the outcome of the bad bank exercise has to be in the interests of taxpayers and accelerate the return to private ownership of RBS;
- the need to secure board sign off for any asset transfer / restructuring as being in the interests of all shareholders;
- rules governing related-party transactions.
Similar steady-state, sooner
Under our base-line assumptions, the good bank / bad bank split would be broadly value neutral to the current core in steady-state. However, importantly, a split would accelerate the process of normalization with meaningful valuation implications.
In particular, the discount factor applied to steady-state would be reduced by two years or more (increasing the value of the group’s steady-state operations today). Meanwhile, reduced tail risk (due to bad bank asset transfers) and the resulting mix shift should compress the discount rate applied to future earnings (further boosting the value today). It should also compress the gap between the group’s impairment provisions and expected losses (thus materially reducing the £6.2 bn expected loss deduction from the group’s CRD 4 CET1 capital reported at year-end 2012 and further boosting the value of the shares today).
Overall, the implied value today of Royal Bank of Scotland Group plc (NYSE:RBS) (LON:RBS) (AMS:RBS)’ shares would rise from 291p to 347p assuming a split – along the lines that we have modeled – is implemented.
In turn, this suggests that Royal Bank of Scotland would normalize sooner and be worth more following a good bank / bad bank split, addressing the last two hurdles (namely that a split should be in the interests of taxpayers and accelerate the return to the market of RBS).
Incorporating bad bank probability into price target, add to Buy List
Given that a bad bank could – on our analysis – address not only the two key challenges that we believe currently face Royal Bank of Scotland (i.e. low core returns and elevated uncertainty) but also – more importantly – the four Mansion House hurdles, we consider it more likely than not that a good bank / bad bank split is eventually implemented.
Consequently, we incorporate a probability weighting into our price target for Royal Bank of Scotland Group plc (NYSE:RBS) (LON:RBS) (AMS:RBS) of 51% for a split and 49% for no split. This implies a weighted price target of 370p, implying 28% potential upside from the current share price on a 12-month view.
The potential upside rises further, if we assume a greater probability of a bad bank split. Meanwhile, Royal Bank of Scotland shares already incorporate an elevated discount rate, which offers some downside protection – should no split be implemented – and creates an attractive risk/reward profile, in our view.
Against this backdrop, we upgrade the shares to Buy from Neutral. Key risks include no bad bank being established or unfavorable transfer terms as part of a split as well as worse-than-expected volumes, margins, trading income, credit quality, regulation, litigation, macro and market conditions.
H/T Seeking Alpha