Royal Bank of Scotland's retail businesses and ability to generate capital make it an attractive option, while the remainder of its legal liabilities are already priced in.
Erin Davis: We think that long-term investors should take a close look at Royal Bank of Scotland, which trades in both the U.S. and U.K. under the ticker RBS and is one of the biggest banks in the U.K.
RBS' downfall and rescue is one of the most notorious of the financial crisis. We think that the long shadow of its meltdown has caused investors to overlook the tremendous progress that RBS has made in turning itself around. RBS has shrunk by 64% since 2008, and its noncore assets have fallen by 98% to just 1% of assets.
We're rating the shares as 4 stars and see them as more than 20% undervalued. We think investors should focus on three key issues. The first is the attractiveness of RBS' underlying businesses. We think its retail business will be a key driver of the group's profitability and will contribute about 55% of operating profit in the medium term. We think that retail banking can earn a 30% return on equity as it benefits from its careful underwriting and footprint in concentrated markets like Scotland. Overall, we think that RBS Group can earn a 14% return on tangible equity--well above its 11% cost of capital.
Second, we think investors are overly concerned about RBS' legal liabilities. We agree that they are going to be large, but we see this as more than priced into shares already. We dug into estimating these expenses, and we think that RBS is likely to pay another net 5.1 billion pounds in legal and regulatory costs. The biggest of these are likely to be settlements with the U.S. authorities related to RBS' underwriting of U.S. mortgages. We think these settlements are likely to be just shy of $7 billion combined. They will be offset by RBS' existing 2.4 billion pounds reserved for litigation.
Finally, we think that RBS' ability to generate capital is underappreciated. It recently completed the sale of its U.S. bank, Citizens. We think that as RBS continues to shrink it will generate 20 billion pounds of excess capital by 2018. That's enough to repurchase more than 60% of the government's stake at current prices or pay a special dividend of 174 pence per share.
