RBS` recovery is on track, but its exposure to Ireland will continue to mean heavy loan losses.

Technology Stocks News 15

Morningstar’s credit rating of BBB+ for Royal Bank of Scotland reflects the bank’s large balance of nonperforming loans but is bolstered by the recent improvements in the bank’s operating performance. Through acquisitions, Royal Bank of Scotland 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 has historically generated about 40% of profits. In 2009, RBS formed a noncore division, holding about 10% of assets, which will be largely run off by 2014. The firm generates more than 65% of its profits in the United Kingdom and owns Ulster Bank in Ireland and Citizens Bank in the United States. In the wake of the 2008 bailout, RBS has essentially been a government-run bank, with the U.K. government holding a majority of its shares. RBS’ elevated level of nonperforming loans is mostly due to its Irish loan book, where the company has taken heavy property losses. RBS’ exposure to the sovereign debt of troubled European governments such as Greece, Italy, Ireland, Portugal, and Spain is manageable and represents less than 5% of core Tier 1 capital. In our Stress Test analysis, we assign an above-average underwriting rating for most of RBS’ loans and securities and a below-average underwriting rating for Irish loans. RBS receives a score of very good in the Stress Test, as its strong starting regulatory capital experiences controllable losses under our stress-case assumptions. RBS achieves a poor Solvency Score due to its lower reserves, recently poor earnings, and higher balance of nonperforming loans. We award RBS a fair Business Risk score, as its size and business line diversification are hindered by the lack of an economic moat. These factors lead to a rating of BBB+.

Issuer Profile
Through acquisitions, RBS became 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 has historically generated about 40% of profits. In 2009, RBS formed a noncore division, holding about 10% of assets, which largely will be run off by 2013. The firm generates more than 65% of its profits in the United Kingdom; it owns Ulster Bank in Ireland and Citizens Bank in the United States.

Financial Health
RBS’ core Tier 1 ratio was 11.1% as of the third quarter of 2012 on a Basel 2.5 basis, above the 10% level we now see as a minimum. The bank’s pro forma fully loaded Basel 3 ratio is about 9%, which puts it well ahead of peers in preparing for changing capital regulations.

Capital Structure
Thanks to the U.K. government’s 83% equity stake, RBS’ tangible equity base is among the strongest in Europe at 6.5% at the end of the third quarter, after adjusting for derivatives, by our calculations. We’re also pleased that the bank has substantially reduced its dependence on short-term borrowing by lowering its loan/deposit ratio to just over 100% (excluding repos) and increasing its long-term funding.

Enterprise Risk
While the worst is past RBS, its over GBP 60 billion of noncore assets (about 5% of its balance sheet and 90% of equity) pose significant risks for the bank. Losses could be higher than expected, and divestitures may not bring the prices RBS is anticipating. While RBS has relatively little exposure to Greece–less than GBP 1 billion–the group has about GBP 35 billion of exposure to Ireland through its Ulster subsidiary. If the sovereign debt crisis moves on to Ireland, losses there could consume a large chunk of RBS’ equity and possibly force yet another capital raise.

Thesis
Royal Bank of Scotland, formerly a dominant U.K. bank, was undone by its global ambitions, in our opinion. RBS destroyed its narrow economic moat with its reckless acquisition of ABN AMRO at the peak of the market bubble in 2007. Largely as a result of this ill-timed, overpriced acquisition, RBS became one of Europe’s weakest banks and was forced to undertake several highly dilutive capital raises. Now under new leadership and majority government ownership, RBS is narrowing its vision, turning around its core businesses, and shedding its legacy assets.

We are starting to be impressed by the improvements that RBS has made in its core division. Most notably, in our minds, is the increase in deposits and long-term funding. RBS has reduced its use of short-term wholesale funding to GBP 62 billion as of mid-2012, down from almost GBP 300 billion at its worst in 2008, and we think the bank is well on its way to achieving its 100% loan/deposit ratio goal (and already has in its core business). RBS has also significantly reduced its leverage–and therefore its riskiness–by increasing its equity base 40% since year-end 2007 (albeit with government assistance) while reducing its total assets 10%. We calculate the group’s tangible equity/tangible assets ratio is now over 6%, which is among the highest in Europe. We’re also pleased with the group’s increased transparency and its relentless focus on meeting its targets.

RBS still has a ways to go, however. It still holds about GBP 70 billion of noncore assets (equal to 97% of shareholders’ equity). Many of these assets are very unattractive, like its GBP 11 billion of property and development loans at Ulster Bank in Northern Ireland. Pretax losses in the noncore division were GBP 4.2 billion in 2011 and GBP 1.9 billion in the first nine months of 2012 due to heavy impairments, dragging the group’s results into the red. Moreover, impaired loans are continuing to rise.

In addition, we’re not fully convinced RBS will meet all of its targets in its core division over the long term. The bank is aiming to reduce its cost/income ratio to below 50% by 2013, but we think a medium-term level closer to 55% is more likely, given growing competition for investment banking talent and increasing regulation in the U.K. Moreover, even with a 50% cost/income ratio, we think it will be hard for RBS to regularly exceed its target 12% return on equity unless trading income and net interest margins improve materially–something we don’t see as likely.

Economic Moat
We assign no moat to RBS. The bank destroyed its moat in 2007 with its ill-considered acquisition of ABN AMRO. Enormous losses in 2008, largely a consequence of the merger, resulted in several rounds of government bailouts. U.K. taxpayers now own more than 80% of the group’s shares. While RBS controls a sizable share of the U.K. banking market, including 10%-15% of the mortgage market, it must also contend with government interference in lending and pricing decisions. We do not expect RBS to outearn its cost of capital in our forecast period.

Moat Trend
We see RBS’ moat trend as stable. While RBS earned attractive precrisis returns, the U.K. banking market has become more competitive as new competitors have gained footing. Despite cutting costs, RBS is not especially efficient, and we think government ownership may make it quite difficult to cut staffing levels. Moreover, we expect government-directed lending and tougher regulations will put a further damper on medium-term profitability. However, we think these trends are balanced by RBS’ good low-cost deposit base, as well as its improved management and strategy.

RBS Puts More of the Past Behind It in 2012 but Faces a Slow-Growth Future

Royal Bank of Scotland’s RBS terrible fourth quarter, which resulted in a GBP 2.6 billion loss, looks like a kitchen-sink quarter to us, with management taking big charges in an effort to start 2013 with a cleaner slate. Fourth-quarter results included GBP 1,150 million of additional redress costs related to misselling scandals, GBP 620 million of restructuring costs, and GBP 518 million of goodwill write-downs. Similarly, the full-year loss of GBP 6.0 billion included GBP 8.8 billion of special and one-time items. On a management-provided underlying basis, the no-moat bank reported an operating profit for both the fourth quarter and the full year, albeit a subpar one. For the full year, underlying return on equity was 9.8% in the core division, and the noncore division narrowed its operating loss by 32% to GBP 2.9 billion. However, we think further increases in underlying profitability will be more challenging–the bank saw a 7% sequential fall in core operating profits in the fourth quarter and an accompanying 61% increase in the noncore operating loss as the U.K. economy stagnated. Indeed, management said that it expects to see more special charges in 2013 and that it aspires to be a “clean, normal” bank in 2014. We plan to maintain our fair value estimate.

U.K. bank regulators said in late 2012 that U.K. banks collectively were GBP 20 billion-50 billion short on capital, and rumors have swirled that RBS was among the biggest offenders. We continue to see RBS as well capitalized, and management’s decision to float about 25% of Citizens in the United States in two years further assures us that RBS shareholders are unlikely to be called upon to supply fresh capital. We were glad to see that RBS’ tangible common equity ratio, as we calculate it, was once again well above 6%, at 6.4%. We were less pleased to see that its pro forma Basel III ratio is estimated at just 7.7%. We see this as one reason, among others, that shareholders are unlikely to see dividends in 2013. This poses a problem for management: It will be difficult to resume dividends until the share price rises above the government’s buy-in price, but it will be difficult to increase private demand for the shares until the prospect of a dividend increases.

RBS’ results in its core division show that near-term profit growth may be difficult to come by. The 5% year-over-year increase in operating profit was driven by a 68% increase in markets. Most other divisions saw a year-over-year drop in operating profits, such as U.K. retail (down 6%) and U.K. corporate (down 7%), as net interest margins narrowed and loan growth remained near zero. Indeed, now that RBS has reached its target 100% loan/deposit ratio, we think finding profitable loan growth will be a key challenge for the core division.

While RBS is continuing to make progress on its noncore division (funded assets fell 40% in 2012 to GBP 57 billion), we think this division will continue to pose risks for long-term shareholders for some time. Management expects to reduce noncore funded assets to GBP 40 billion in 2013, but then progress will probably slow–we think it is likely that GBP 20 billion of noncore assets (equal to 30% of shareholder’s equity) will remain on the balance sheet indefinitely.

RBS to Pay Libor Settlement of GBP 360 Million

On Wednesday, RBS RBS agreed to pay GBP 360 million ($612 million) to settle charges in the United States and United Kingdom that its traders manipulated the Libor interest rate. One of its Asian subsidiaries pleaded guilty to a criminal charge in the wake of some particularly damning emails between traders and Libor submitters. RBS said that GBP 300 million of the fine would come out of its 2012 bonus pool. The fine sits between the $450 million fine paid by Barclays BCS and the $1.5 billion fine paid by UBS UBS and reflects varying levels of misconduct at the banks. The agreed settlement is in line with our expectations and does not affect our fair value estimate and no-moat rating. We largely see this as a reflection of RBS’ historical conduct rather than its future.

Own Debt Charge Obscures Underlying Improvement at RBS in Third Quarter

RBS RBS reported a loss of GBP 1.4 billion for the third quarter, which includes a non-cash own-debt charge of GBP 1.5 billion and an additional provision of GBP 400 million against the mis-selling of payment protection insurance. While the accounting loss is unfortunate, RBS’ underlying results continued to improve. Underlying operating profits increased 61% from the trailing quarter and 46% for the first nine months of 2012 compared to the year-ago period, largely as a result of lower non-core losses. In the core division, operating results improved 8% sequentially to GBP 1,633 million as operating expenses fell 5%. Non-core operating loss fell 32% sequentially to GBP 586 million. We’re pleased to see that RBS’s non-core assets continued to fall, reaching GBP 65 billion at the end of the third quarter from GBP 72 billion as of June 30, which we think limits the probability of an uptick in non-core losses. Capital levels remained strong and stable. Core Tier 1 capital was 11.1% and we calculate the bank’s common tangible equity ratio was 6.5% at quarter-end. We expect to maintain or modestly increase our fair value estimate.

Division-by-division results show that RBS’ core U.K. franchises are performing fairly well despite the difficult economic environment, but that the group’s results continue to be dogged by Ireland. UK Retail was once again a star performer, posting a 24% return on allocated equity in the third quarter. UK Corporate earned a 12% return on equity, down from 17% in the trailing quarter, as revenues fell and impairment charges increased. US Retail and Commercial Banking (Citizens) posted a 10% return on allocated equity, flat with the trailing quarter, as lower revenues were offset by lower costs. Ulster in Ireland, however, posted a negative 20% return on allocated equity, largely flat with the trailing and year-ago quarters, as heavy loan losses continued. RBS’ Markets division reported an 8% return on allocated equity. The unit, like other investment banks, benefited from quantitative easing during the quarter but continued to suffer excessive staffing costs–the division’s cost/income ratio was 72% in the quarter.

We continue to see RBS as a best buy among U.K. banks. We’re especially fond of its 6.5% tangible common equity ratio, which gives it a large cushion against losses, if turmoil should increase in the eurozone. The bank’s earnings, however, are likely to be dragged down by losses from Ireland for some time. Irish lending fell 6% in the quarter to GBP 36 billion but dud loans increased 5% to GBP 14 billion. Provisions cover only 54% of bad loans, and we think heavy provisioning remains necessary for a few quarters. However, we doubt losses will be large enough to cause a capital raise, which would be the most material negative threat to our fair value. Even if RBS took a 100% loss on its dud Irish loans, the loss would only eat up 9% of the bank’s equity, by our estimates.

Morningstar’s Credit Methodology for Banks

Purpose

The Morningstar Corporate Credit Rating measures the ability of a firm to satisfy its debt and debt-like obligations. The higher the rating, the less likely we think the company is to default on these obligations.

The Morningstar Corporate Credit Rating builds on the modeling expertise of our securities research team. For each company, we publish:

  • Five years of detailed pro-forma financial statements
  • Annual estimates of free cash flow
  • Annual forecasts of return on invested capital
  • Scenario analyses, including upside and downside cases
  • Forecasts of leverage, coverage, and liquidity ratios for five years
  • Estimates of off balance sheet liabilities

These forecasts are key inputs into the Morningstar Corporate Credit Rating and are available to subscribers at select.morningstar.com.

Methodology

We feel it’s important to perform credit analysis through different lenses—qualitative and quantitative, as well as fundamental and market-driven. We therefore evaluate each company in four broad categories.

Business Risk

Business Risk captures the fundamental uncertainty around a firm’s business operations and the cash flow generated by those operations. Key components of the Business Risk rating include the Morningstar Economic Moat™ Rating and the Morningstar Uncertainty Rating.

Stress Test Score™

Morningstar’s Bank Stress Test Score™ evaluates a bank’s ability to handle additional losses in its loan and securities portfolios. While based on the stress tests conducted under the Supervisory Capital Assessment Program, the Stress Test Score differs in two important ways. First, it is conducted on a rolling basis each quarter. Thus, it continually measures a bank’s ability to handle additional stress beyond any already recognized losses.

Morningstar’s Credit Methodology for Banks

Second, the Bank Stress Test Score utilizes Morningstar analysts’ forecasts of future pre-tax, pre-provision earnings and expenses for individual banks. Morningstar analysts also account for differences in underwriting standards and credit quality between banks by adjusting loss rates based on their assessments. The Stress Test Score is then based on a bank’s expected capital position at the end of a twoyear period of elevated losses. As an absolute measure of capital, the average Bank Stress Test Score across our coverage universe will increase as total banking system capital increases, and will decrease when financial companies add leverage.

Bank Solvency Score™

The Morningstar Bank Solvency Score™ is a quantitative assessment of a bank’s health based on bank-specific accounting metrics. Much like the CAMELS rating utilized by bank regulators, the Bank Solvency Score measures a bank’s most recent performance in four key areas: capital adequacy, asset quality, earnings power, and liquidity.

Distance to Default

The Distance to Default rating is a quantitative, marketbased measure of a company’s current financial health. (Distance to Default serves as the basis for Morningstar’s Financial Health Grade.) The underlying model treats the equity of a firm as a call option on that firm’s assets. Based on estimates of asset volatility and the Black- Scholes option-pricing model, we can estimate the likelihood that the value of the company’s assets falls below the value of its liabilities, implying likely default.

Overall Credit Rating

The four component ratings roll up into a single preliminary credit rating. To determine the final credit rating, a credit committee of at least five senior research personnel reviews each preliminary rating.

We review credit ratings on a regular basis and as events warrant. Any change in rating must be approved by the Credit Rating Committee.

Investor Access

Morningstar Corporate Credit Ratings are available on Morningstar.com. Our credit research, including detailed cash-flow models that contain all of the components of the Morningstar Corporate Credit Rating, is available to subscribers at select.morningstar.com.

Signup for free to be the first to receive exclusive free links. Now in your mailbox!
Join over 15,000 subscribers
Send me links

Your information will not be shared to anyone