|Shares Out. (in M):||1,095||P/E||26.0x||9.0x|
|Market Cap (in $M):||23,000||P/FCF||nm||nm|
|Net Debt (in $M):||0||EBIT||9,500||10,000|
We recommend establishing a LONG position in RBS’s Tier 1 Securities, specifically, the 5.9% Series E and 6.08% Series G. We believe there is 80-105% upside over the next 12-18 months.
They are listed under the Bloomberg ticker symbols RBS 5.9 Pfd and RBS 6.08 Pfd.
Note: these are $25.00 par securities. All price references below are shown both in actual dollar terms ($25.00) and as % of par (100). Example: $25.00 / 100.
These securities currently trade at distressed levels of ~$11.00 / 45% of par. This represents a 13.5% current yield once coupons are turned back on.
The coupons on these securities are discretionary and currently turned off. In conjunction with RBS’s agreement to accept state aid from the UK government in 2008, the European Commission required RBS to turn off all discretionary coupons on hybrid securities for a period of two years beginning April 30, 2010. Those coupons will be turned back on at the end of April 2012. However, the Series E and Series G coupons were not turned off until April 1, 2011, and as a result, will not be turned back on until April 2013. Note: the coupons are non-cumulative, so no accrual for missed payments.
We think that once RBS turns on the coupons for the initial moratorium securities, the Series E & G will trade up to $15.00-17.50 / 60-70, levels reached in May 2011. This represents 50% upside from current levels over a six month investment horizon.
We think that once the coupons for the E’s and G’s themselves are turned on in April 2013, they could trade to $20.00 / 80, representing ~80% upside over a ~15 month investment horizon. A price of $20.00 / 80 would still imply a current yield of 7.5%.
Downside supported by potential LME (liability management exercise, i.e. swaps for cash at premium to current levels but discount to par)
- If current distressed valuations persist, RBS is likely to conduct a liability management exercise to retire these securities at a premium to current trading levels and book a gain
While we believe that the UK may slide back into recession in 2012, we think that RBS is sufficiently well capitalized to weather the storm:
- Core Tier 1 Ratio of 10.0% at Sept 30, 2011 (11.3% incl the UK govt support agreement)
- Near-zero sovereign peripheral (GIIPS) exposure: £1.1bn on £50bn Core Tier 1 capital
- No need to raise additional equity capital
- Non-core Irish book has already been written down dramatically -- 40% cumulative provisions on gross loan book (again for non-core Irish assets)
- The UK Government owns ~83% of RBS equity, mitigating the risk of an impairment of junior securities in any subsequent restructuring
We believe this investment opportunity exists because the coupons have been turned off and subordinated paper of European banks is the last place most investors want to be right now.
The Royal Bank of Scotland Group is one of the four large UK banks
- Key stats:
The “Core” business consists of:
Global Transaction Services
Ulster Bank (Irish bank)
US Retail & Commercial
Global Banking & Market (investment bank)
The “Non-Core” book is RBS’s bad bank
- RBS has been shrinking this book aggressively, down to £87bn in Q3 2011 from £160bn two years ago
- ~1/3 of the loan book is property & construction
- Plans to sell this business by 2013
- UK economic slowdown
- Ireland exposure
- Eurozone break-up
- Shipping book
- Additional regulatory burdens (see below)
RBS faces a litany of new regulations that will pressure ROE; most of these however require RBS to hold more capital -- a credit positive
- Basel III
- UK Bank levy
Key Business Trends
- Key business trends are negative almost across the board
- NIM compression driven by both lower rate environment and higher funding costs
- Additional revenue pressure from deleveraging and falling loan demand
- Elevated provisions in core-book likely to persist given economic outlook inUKandEurope
- Subdued market activity affecting all trading related businesses
- More stringent regulatory environment requiring higher capital, higher liquidity reserves and higher taxes
- In spite of all these headwinds, RBS should generate greater than £2bn of net income in 2012 and pre-provision income of greater than £8bn
- Stephen Hester CEO
- Bruce van Saun CFO
Risk / Reward
- Once coupons get turned back on, we conservatively estimate these securities will trade for at least ~7.5% yield resulting in a price of $20.00 / 80
- Once coupons get turned back on for the initial moratorium securities, that should serve as a significant catalyst for these securities and could cause them to return to pre-sell off levels of $15.00-17.50 / 60-70 (50% upside)
- A par recovery via redemption is a possibility, as these securities do not qualify for Core Tier 1 capital treatment under Basel III
- On a fundamental basis, downside from current levels would occur if RBS is forced to take additional state aid, extending the moratorium on coupons for perhaps an additional two years.
- On a technical basis, if the Eurozone crisis deteriorated significantly, we would not be surprised if these securities re-traced October lows. We are long-term holders of this paper and would be buyers in that situation.
- These are perpetual securities with no maturity date and 2012 call dates (though non-callable until coupon moratorium is lifted)
- The Series E and Series G were originally issued by ABN AMRO, subsequently acquired by RBS and now exist under the RBS subsidiary RBS N.V.
- These notes do not have a guarantee from RBS parent, merely a letter of support
- Furthermore, RBS has been in the process of moving ~3/4 of the assets of this entity to RBS Plc
- Although it may appear as though RBS is stripping assets from an entity of which is does not provide a guarantee, RBS IR has explicitly told us they do not intend to leave holders of these securities in the cold
- RBS NV assets consist mostly of investment banking divisions, which are about to undergo a massive restructuring -- RBS is looking to sell or close many of these units
- Regardless of what course of action RBS takes with respect to the i-bank, we believe RBS will do right by the Series E & G holders and that any restructuring of the business could be a catalyst for a positive credit event in these securities
- Lastly, note that these are USD issues: no need to worry about hedging foreign currency
- We believe management will turn the coupons back on
- We believe RBS is sufficiently well-capitalized to withstand a further deterioration in European economic outlook
- While we are very concerned about the Eurozone sovereign crisis, we believe the monetary union will survive for the foreseeable future (with the possible exceptions of Greece and perhaps even Portugal)