December 28, 2009 - 4:52pm EST by
2009 2010
Price: 11.34 EPS NA NA
Shares Out. (in M): 64 P/E NA NA
Market Cap (in $M): 726 P/FCF NA NA
Net Debt (in $M): 0 EBIT 0 0

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Royal Bank of Scotland non-cumulative 7.25% preferred shares (US$ 25 face value, US$ 1.8125 dividend paid quarterly, NYSE: RBS-T) currently trade at $11.34 (45 cent of dollar par value). We believe the preferred shares trade at this discount due to (1) RBS dire financial situation (had to be bailed out by the UK government twice) and (2) the recent announcement to cut the dividend for two years in order to get EU approval for the second UK government bailout ("asset protection scheme"). We believe that the valuation is overly pessimistic. In the most likely scenario, RBS will resume dividend payments in 2012 and valuations of the preferred shares will be back in-line with preferred valuations of similar European banks (ex ING) Investment at current prices will yield a return of 50% to 85% within the next two to three years  with little downside risk.

Recent history

RBS grew through 90s to become one of the biggest international banks through a string of acquisitions (the last of which ABN Amro of the Netherlands). When the crisis hit with full force in 2008 RBS was one of the hardest affected banks requiring already two government capital injections. The third capital injection and loss guarantee (called "APS - asset protection scheme", injection of 25 billion pound exchange of 7% preferred stock and absorption of losses exceeding 60 billion pounds) is currently being finalized.

The UK government is already RBS biggest shareholder (70% of ordinary shares). With the APS agreement in place the UK government will inject another 25 billion pound and will detain 84 % of capital (ordinary and preferred shares).

RBS has replaced the executive team and is restructuring and downsizing RBS (separating itself into a core and non-core division, and winding down, selling off the non-core division) to become a viable operation (without government protection) within the next 3 to 4 years.

 On a cash basis RBS is making money and has continued paying dividends on its preferred shares during all the turmoil of 2008 and 2009. However, the European commission is requiring sacrifices from banks (and its shareholders and bondholders) to approve state aid to these banks. To receive approval for the asset protection scheme RBS is required to suspend dividend payments on its preferred shares for year beginning not later than April 30th 2010 (which will automatically inhibit any dividend payments on its ordinary shares).

Investment case

(1) The UK government as majority shareholder has an active interest helping RBS to get back on its feet

(2) The decision to suspend the dividends was mainly a decision to get EU approval for the APS

(3) The UK government has an interest in receiving payback (in form of dividends or share sales) from its investment and consequently not opposed in resuming the suspended dividends on the preferred capital as soon as possible

(4) When resumed in 2012 the market will value the RBS preferreds similar to how preferred shares of banks receiving state aid are being valued today. E.g. ING received state aid too and was under scrutiny of the EU commission. They had to agree to significant disposal of assets however they did not have to suspend their preferred dividends). ING preferreds (such as NYSE:IGK) currently trade around $22 (face value $25, dividend 2.125)) which implies a 9.6% discount rate.

(5) Valuation: If we apply a discount rate between 9% and 11% to the dividends in perpetuity (i.e. 1.8125/9%-1.8125/11%) to the RBS preferreds we arrive at prices between US$ 16.50 and US$ 20 which gives an annualized return of 16-25% over two and a half years (cumulative 46-76%). These discount rates do not seem unreasonable given that (1) with the resuming of dividend payments a lot of uncertainty will be removed and (2) within two years and the extended government backing there is a good chance that things improve for RBS

What might go wrong

(1) RBS goes bankrupt. We think this is very unlikely given its size and UK government ownership (to big to fail)

(2) RBS might want to preserve capital, not reinstate the dividends and convert the preferreds to common. In our view we do not think this is very likely given the relative small amount of dividend on preferred stock (6-7%) on 8 billion compared to the dividends on UK government preferred shares (7% on 25 billion of preferred) and given their dividend payments during the apex of the crisis But if this happened and the shares would be converted proportionally to book value which would mean (APS capital injection already included)

Pre conversion (UK pound billion)
Market Value          Book Value Common                    Book Value Preferreds
(@ 29.3p/share)
16.5                                48                                              36 (11  existing + 25 APS)                          

Post conversion (UK pound billion)
Market Value          Book Value Common                    Book Value Preferreds
(@ 29.3p/share)
16.5                                59                                                25

If converted at current prices preferred shares would be converted at a market to book value of 28% which implies a loss of about 37% at current share prices because the preferreds currently trade at 45% market to book value.  However, we believe losses would be smaller (or even gains) because (1) the conversion will be offered at a premium (e.g. similar to the Citi conversion) and (2)  there is a good chance that share prices will be higher (a couple of analysts have price targets in 45p and higher)


Final Remark  

There are other preferred shares issued by RBS with similar characteristics (series M, N, P, Q, R, S)


RBS preferred shares Series T prospectus:

RBS 2008 annual report:

RBS Q3 2009 results:

RBS announcement on APS:

RBS announcement on preferred shares (Oct, 20th):





Announcement of resumption of dividedn payments in 2012 (first quarter?)

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