Royal Bank of Scotland Is a Diamond in the Rough

While many investors are familiar with the broad strokes of this story, RBS' recovery from the financial crisis has been obscured by headlines dominated by losses and regulatory settlements. Few investors, therefore, appreciate the significance of its transformation or the strength of its remaining businesses. While we anticipate that statutory losses are likely to continue through 2016, we believe the shares will rise ahead of reported profitability improvements. Specifically, we think the shares are likely to rerate materially over the next 6-18 months as major points of uncertainty, like the size of legal settlements related to the underwriting of U.S. mortgage-backed securities and the restructuring of the investment bank, are resolved.

Place in U.K. System Offers Platform for Stability but Limits Excess Returns Royal Bank of Scotland, headquartered in Edinburgh, participates in the U.K. banking system, which we rate as fair under our global assessment of banking systems. RBS has said that it would relocate its headquarters to London if Scotland were to secede from the United Kingdom.

The unchecked growth of RBS and its subsequent fall are an excellent example of the importance of the banking systems in which banks operate, as well as the delicate balance regulators must strike between stability and competitiveness. We rate the U.K. banking system as fair from a regulatory standpoint, one notch above poor, the lowest rating a system can receive. The deregulation of U.K. banking began in the mid-1980s in response to the perception that London had fallen behind other global banking centers because of excessive regulation. It continued in 1997 when the Financial Services Authority was created to consolidate bank regulation. The FSA lauded its light-touch regulation and encouraged banks to expand by leveraging up their balance sheets. The FSA was criticized for being too slow to act and too beholden to the firms it was regulating, and we view its light-touch regulation as largely responsible for the size of the U.K.'s involvement in the global financial crisis.

The U.K. has significantly improved its bank regulation. Plans to abolish the FSA were announced in 2010, and its responsibilities are now split among the Bank of England, the Financial Conduct Authority, and the Prudential Regulation Authority. Capital and conduct standards have strengthened significantly, and the U.K. banks are subject to annual stress tests by the Bank of England.

The primary drivers of our current fair rating are the country's good macroeconomic environment, good competitive environment, and very good political environment, which are partially offset by its fair regulatory environment. We think that much in the U.K. banking system supports RBS' ability to earn long-run returns in excess of its cost of capital--the U.K.'s macro stability means little threat of spillover from doubts about sovereign credit quality, high banking market concentration (the top five banks control 80% of retail banking) means muted competition, and its long history of political stability means little risk of government asset seizures (whether outright or through excess inflation). However, we note the difficult regulatory environment in the U.K., which is characterized by strong anti-bank and ever-increasing regulation, which we think will make sizable excess returns more difficult to achieve and sustain. We highlight the U.K. bank levy, which is peaking at 0.21% of certain liabilities and which cost banks GBP 2.2 billion in 2014, and the new 8% bank income tax on U.K. profits. This will partially replace the bank levy as it is gradually reduced from 0.21% to 0.1% in 2010; RBS is expecting its levy to be reduced from GBP 250 million in 2014 to GBP 150 million in 2019. The U.K. government initially estimated that the tax will raise GBP 5.3 billion over the next five years. The actual amounts raised will vary with banks' income and changes in exempted income and will be partially offset by ongoing cuts in the U.K. corporate tax rate.

2009: The Long Recovery Begins With its 2008 annual results, RBS announced the first of many restructurings aimed at returning the bank to its roots as a strong and conservative U.K. retail and business bank. It has gone through round after round of cuts and a revolving door in the executive suite, including two new CEOs and two new chairmen.

At the end of 2007, RBS' business mix was heavily tilted toward its global investment banking activities, which consumed nearly one third of risk-weighted assets. (This weight would be much higher under current capital rules, which sharply increased the risk weights of assets typically associated with investment banks by 20% or more.) Much of the heavy lifting has already been done. In corporate and investment banking, risk-weighted assets shrank 44% between the end of 2012 and mid-2014. Noncore assets have shrunk 91% since the end of 2011, to just GBP 6.5 billion as of Sept. 30. In October, RBS sold its remaining stake in Citizens, its U.S. retail bank. The exit cut total assets by approximately GBP 90 billion (11%) and boosted RBS' common equity Tier 1 ratio by about 350 basis points. Ulster, in Northern Ireland, has returned to a nominal profit. Loan losses at Ulster, which peaked at GBP 1.2 billion in 2010 (3.1% of loans) have subsided to the point that RBS has been able to release some of its provisions. RBS is selling its international wealth management operations, which no longer fit with its U.K. focus, with the sale expected to be completed in 2016. The sale cost RBS a GBP 200 million write-down of goodwill but is expected to provide a modest boost to capital.

In a few years, RBS will look entirely different than it did in 2008: It will be a highly profitable, U.K.-focused institution. RBS' attractive retail and business bank will generate about half of profits, its dominant U.K. commercial bank will generate another 35%, and the U.K.-focused investment bank will generate about 10% and consume less than one fifth of risk-weighted assets.

U.K. Personal and Business Banking Business Will Be a Powerful Profit Engine As measured by risk-weighted assets, RBS' U.K. retail operations, called personal and business banking, will be about half the size of U.K. corporate banking--23% of group risk-weighted assets in 2019 compared with 47%. However, the division's attractive profitability means that it will generate 45% of revenue and 55% of operating profit in 2019.

The U.K.'s retail banking market is particularly attractive, and RBS' projected profits aren't unusual. Lloyds Banking Group LYG, for example, earned a 33% underlying post-tax underlying return on equity in the first nine months of 2015, by our calculations. We credit this in large part to the concentrated market, in which the top five firms control 80% of the market, and high switching costs relative to benefits, in a market where nominally free checking accounts are commonplace. And that's for the U.K. as a whole; RBS tends to compete in particularly concentrated markets, like retail banking in Scotland and banking for small and midsize enterprises. As a result, its cost/income ratio in retail banking tends to be especially low. It has averaged 55% on an operating basis in the first nine months of 2015, and we think it will fall to 51% by 2019 as higher revenue leads to operating leverage. This will help offset a rise in loan losses, which we currently see as being below midcycle levels.

We don't see 2015's results as a blip and argue that RBS' 2014 results clearly demonstrate that our high expectations are achievable; we calculate that the bank earned an operating 33% post-tax return on equity in 2014. Reported returns on equity have been lower at 20% in 2014 and in the single digits in 2012-13 as the division absorbed high litigation and misconduct costs. We think reported results will be ugly again in 2016 as the bank absorbs GBP 1.8 billion of restructuring costs related to the planned initial public offering of the retail bank Williams & Glyn. This will also cause an 11% drop in loans and a 9% drop in revenue in 2016, according to our estimates. However, we think 2017-19 will be much better. We're anticipating that the operating cost/income ratio will fall to 50% (from 55% in 2014) and net interest margin will rise modestly to 3.60% (from 3.51% in 2014). We expect these positive factors to be somewhat offset by the normalization of loan losses, which we expect to rise from 10 basis points in 2015 (21 basis points in 2014) to a midcycle level of 40 basis points. Altogether, we project that RBS' retail and commercial banking segment can generate a 35%-plus post-tax return on equity.

Commercial Banking Business Poised to Earn 12% ROEs It is also critical to understand the earnings power of RBS' U.K. commercial banking operations, as we think it will be nearly half of RBS' business by 2019, as measured by risk-weighted assets. The division serves large and midsize corporate clients and is the U.K.'s largest corporate bank, with 12,000 commercial customers (annual gross sales GBP 25 million and up) and 67,000 commercial customers (annual gross sales of GBP 2 million-5 million). While we currently assign no moat to RBS, we think scale is one of the most important factors in building cost-based competitive advantages in banking, and we think RBS clearly has the potential to do so here.

We anticipate that the segment will report fairly rapid growth in 2016-17, as in 2015, as RBS shifts some of the business currently allocated to its corporate and institutional segment to U.K. commercial banking, and 4% organically in the medium term, just below the International Monetary Fund's forecasts for U.K. nominal economic growth, which anticipate 2.15% real growth and 2.0% inflation in 2019. As a result of this and of modest net interest margin expansion as U.K. interest rates rise, we expect preprovision revenue to grow at a 6.8% cumulative average rate through 2019. We see this as a conservative estimate, as it assumes little to no market share gains. Thanks to the operating leverage inherent in commercial banking as well as the roll-off of litigation and restructuring charges (projected to be GBP 130 million in 2015), we expect the division's cost/income ratio to fall from 57.4% (51.1% excluding litigation and restructuring) to 48% in the medium term. This is somewhat above the 40% we see as best in class for this business because we expect technology spending to remain fairly high as RBS upgrades its creaking legacy systems. We expect cost improvements to be partially offset by normalizing credit costs. Years of conservative underwriting and a fairly benign credit environment have allowed RBS to lower its commercial banking loan impairments to around 10 basis points of loans in 2014-15, and we expect this to normalize around 50 basis points in the medium term.

As a result, we calculate that RBS can earn a post-tax 12% return on equity in this business, comfortably above its 11% cost of equity. We're particularly reassured by RBS' commercial banking results in 2014--we calculate that the bank earned a 13.5% operating basis ROE--although we expect this to moderate as credit losses normalize. RBS aims to earn a 15% return on equity in this business, which we think is possible if management is able to reduce operating costs to 40% of revenue, but we're not including this in our valuation.

Investment Bank Will Become Much Smaller and More Profitable RBS has sharpened its knives and continues to make deep cuts in its corporate and investment banking segment, which we think are necessary to support the group's solvency and profitability. We think the division is necessary to support RBS' position as the U.K.'s largest corporate bank, but that it has spectacularly proved that it has no moat by losing billions since 2008.

We think the go-forward investment bank will be modest by industry standards--we expect post-tax returns on equity of 10%, a hair below the group's 11% cost of equity--but we think the smaller and more focused division will cease to be a threat to the group's overall performance in the medium term. We project that risk-weighted assets will be cut by three fourths from 2014 levels to just under 20% of group risk-weighted assets, as about GBP 9 billion of risk-weighted assets are transferred to commercial banking and the remaining operations are downsized. We expect returns to be much less volatile as the division focuses on providing debt-financing and risk-management products (rates and currencies products, for example) to its corporate customers. We think the smaller investment bank offers RBS an opportunity to regain its narrow moat rating, as its low profitability will be a smaller offset to the higher profits earned by the rest of the group.

Still, we think results through 2016 are likely to be painful. We anticipate the division will continue to report losses as it absorbs GBP 2.6 billion of additional litigation and restructuring costs and GBP 1.5 billion of disposal costs. In the medium term, we think costs will consume about 70% of income, above management's 60% target. We have significant uncertainty around even this estimate, given the scale of the necessary transformation, but we take comfort in the relatively small scale of the go-forward division. If RBS were unable to get investment banking costs below 80% of revenue, we estimate this would cut only about GBX 10 from our fair value estimate.

Regulatory and Litigation Costs Significant, but Not Enough to Break the Bank It is for good reason that future legal and regulatory expenses scare off many potential investors in RBS--the headline settlements of other global banks have been enormous, like Bank of America's BAC $16.7 billion settlement in August 2014, JPMorgan's JPM $13 billion settlement in November 2013, and Citigroup's C $7 billion settlement in July 2014. While RBS was not a significant originator of retail mortgages or issuer of subprime bonds in the years leading up to the financial crisis (though it did own the retail bank Citizens, through which it issued retail mortgages), it grew to become an extremely active underwriter of residential mortgage-backed securities. In 2005-06, it was the second-largest underwriter of RMBS after Lehman Brothers. We think there are two important takeaways here. First, RBS, though a U.K. bank, was an important underwriter of mortgage-backed securities and is therefore likely to face substantial monetary penalties. Second, RBS was not involved in as many aspects of the mortgage market such as underwriting, MBS issuance, and subprime servicing as were many U.S. banks (or their predecessors), and it is therefore unlikely to face comparable fines.

We anticipate that RBS' additional legal liabilities will be GBP 5.1 billion ($7.9 billion) over the next several years, or about 11% of tangible equity at the end of the third quarter. These additional costs include a $3.9 billion settlement with the Federal Housing Finance Agency, the conservator of Fannie Mae and Freddie Mac; $3.0 billion of additional mortgage-backed securities settlements, dominated by a U.S. Department of Justice civil fine; and GBP 2.0 billion in miscellaneous other regulatory expenses. These will be offset by the bank's GBP 5.6 billion of total provisions (GBP 2.4 billion of provisions for mortgage-related litigation). We base these estimates on RBS' volume in the years leading up to the crisis and triangulate potential outcomes based on settlements by other banks.

In the years leading up to the financial crisis, the business of packing residential mortgages and selling them as securities exploded. The U.S. government-sponsored enterprises Fannie Mae and Freddie Mac bought the bulk of the "conforming" loans--loans of less than a certain value ($417,000 for a single-family home in 2006), with a minimum down payment of 5%-20% and the borrower having a credit score of 620 or above. In 2008, losses driven by the deteriorating mortgage market compelled the U.S. government to provide a $200 billion backstop for Fannie and Freddie and the FHFA to place them into conservatorship. As conservator, it is the FHFA's duty to preserve the assets of Fannie and Freddie on behalf of U.S. taxpayers, and in September 2011 it filed claims against 17 financial institutions (including RBS) seeking damages and civil penalties, alleging that the banks knowingly misrepresented the quality of the securities. So far, 10 of these suits have been settled for a total of $20.1 billion, or a weighted average of 13% of contested mortgage-backed securities. We use these data to estimate that RBS will pay $3.9 billion (GBP 2.5 billion) to settle FHFA claims, or 13% of the $30.4 billion in contested residential mortgage-backed securities bought by the FHFA. We see this as a reasonable and conservative estimate and note that a simple average would imply a $3.3 billion settlement.

Banks have also faced a litany of lawsuits by the U.S. Department of Justice, U.S. states, the FDIC, and other entities. Headline settlements have been huge--$16.7 billion for Bank of America, $13 billion for JPMorgan, and $7.0 billion for Citigroup. These headline numbers obscure the nuances of the settlements and significantly overstate the penalties RBS is likely to face, in our opinion.

We're broken apart the primary components of seven large-bank settlements into their various components, while also considering each firm's participation (including predecessor firm activity) in various states of issuing mortgage-backed securities. Bank of America's headline $16.7 billion settlement from August 2014, for example, includes a $5 billion civil penalty from the DOJ and $7.0 billion in consumer relief, which includes promises of new lending that has at least the potential to be profitable.

We think two things are important to realize here. First, the Department of Justice's civil fines are significantly smaller than the headline figures suggest and have ranged from $2 billion at JPMorgan to $5 billion at Bank of America. Second, firms that have been required to set aside significant consumer relief funds, and especially Bank of America, participated significantly in consumer-facing aspects of the mortgage business, like origination (Bank of America, via Countrywide, was number four), and servicing (number one). We think consumer relief is unlikely to be a significant component of RBS' settlement.

We estimate that RBS will settle the Department of Justice's claims for $3 billion, or just over 3% of 2005-06 mortgage-backed securities underwritten, which compares with 3.5% for Bank of America and 3.3% for JPMorgan. Citigroup was not a significant MBS underwriter.

While civil fraud penalties can be more difficult to predict than damages, we think the data support this as a reasonable estimate. Our estimate is below the $4 billion-$6 billion fines paid by Bank of America and Citigroup, but we think those firms' involvement in the industry misconduct leading up to the financial crisis was much greater than that of RBS, given the two each had (or inherited from predecessor firms) a 10%-plus share of subprime mortgage originations and around a 10% share of mortgage servicing. Our $3 billion estimate is at the top end of $2 billion-$3 billion range leaked to The Wall Street Journal in June, which we think is appropriate, given RBS' role as a major underwriter of mortgage-backed securities during peak years.

Like all major banks, RBS faces a litany of litigation. While the outcome of any one of these matters is difficult to predict, we estimate RBS' net additional liabilities (excluding MBS litigation discussed previously) at GBP 2 billion.

Perhaps the most important of these is the U.K. class-action lawsuit related to RBS' April 2008 capital raising. The claimants allege that RBS knowingly misled them into participating in the bank's GBP 12 billion capital raising, which came only seven months before the bank's first government bailout, in November 2008. They are seeking GBP 4 billion in damages, and the start of the trial has been delayed until December 2016. We think RBS will face significant legal expenses related to this matter and may even settle certain claims, but we think a blanket judgment against RBS is unlikely, given precedent in other cases. For example, in the wake of the 1991 collapse of Luxembourg-based Bank of Credit and Commerce International, the bank's liquidator, Deloitte, sued the Bank of England for GBP 1 billion of damages, alleging that the Bank of England failed to protect investors. In 2006, U.K. courts ruled in favor of the Bank of England and awarded it GBP 74 million in legal expenses. In a separate example, the mutual insurer Equitable Life sued Ernst & Young after the insurer came close to collapse in 2000, alleging that the accounting firm had failed to properly inform the insurer of the potential size of its liabilities. The case collapsed in 2005 when Equitable Life abandoned its claim.

Don't Wait for Uncertainty to Be Resolved to Buy In Investors may question whether they should wait until RBS' legal uncertainties are resolved before buying shares. We point to the experience of another beleaguered U.K. bank, Lloyds Banking Group, to demonstrate the potential cost of waiting. Through Dec. 10, Lloyds has outperformed the FTSE 100 by 17% relative to the beginning of 2010. Going into 2012, just as Lloyds' shares were about to take off, we identified the shares as 38% undervalued. Essentially all of Lloyds' outperformance occurred before two of its biggest issues were resolved: the overhang of government ownership and the cost of the payment protection insurance mis-selling scandal.

RBS' share price performance underscores our position that the market has failed to appreciate how far the bank's turnaround has come. The shares have fallen by one fourth since the beginning of 2015 compared with drops of 5% and 10% at its two large U.K.-focused competitors, Lloyds and Barclays BCS.

We also would not to wait for RBS' reported profits to improve before investing, as we think the share price is likely to appreciate well before the bottom line moves up. We note that Lloyds' price/book ratio improved from 0.45 in mid-2012 to 0.80 at the end of 2012, with no improvement in reported returns on equity. Instead, the share price followed improvement in underlying earnings--but even then, shares appreciated in anticipation of improved results.

Investors eager for capital return will have to wait until RBS' mortgage litigation is resolved but should be rewarded for their patience--we estimate that by the end of 2017, RBS could have around GBP 20 billion in excess capital. Through 2017, the bulk of this will be generated by cuts in risk-weighted assets. We assume RBS will maintain its 13% common equity Tier 1 ratio target, plus a 100-basis-point buffer, and note that the 13% target is in line with those of some of the most conservative European banks, such as UBS UBS. For the time being, we expect RBS to hold on to this capital in order to pay its legal liabilities. By 2018 we anticipate that earnings will become the primary contributor and that the impact of cuts to risk-weighted assets will reverse as RBS' core business grows organically. RBS' excess capital would be enough to pay out a special dividend of GBX 150 per share or to rebuy more than 60% of the government's stake at current prices.

We think that declining government ownership is likely to prove beneficial to shareholders, as there has been strong evidence in the past that the government has pushed RBS into uneconomic decisions. In fact, government majority ownership is the primary reason behind our Poor stewardship rating. We point to the accelerated sale of Citizens and the government's interference in management's compensation, which has made it more difficult for the bank to attract top talent. While buybacks are less common in the U.K. than in the United States, we think RBS is likely to use its excess capital to buy government shares until the government's shareholding is materially reduced.