RBS deserves its day in the sun but heed CEO s caution

Royal Bank of Scotland delivered a temporary boost to a sleepy UK market on Friday morning (25th July) when it pushed out first-half results that were ahead of schedule and mostly, much better than expected.

RBS’s stock jumped as much as 14% higher when it published results, which were scheduled to come out a week later, showing pre-tax profits for the six months to the end of June were £2.65bn against £1.37bn in H1 2013.

RBS said operating profit was set to leap to £2.6bn versus £780m in the same period a year ago.

In another move that cheered analysts, the bank reduced the level of reserves it keeps back to cover bad debts. It said it would be able to reduce provisions for bad loans because it was pushing ahead with plans to shed assets in a strategic refocus on to the UK economy.

Provisions would be reduced by £258m, the bank said, and as a consequence there would be a net release of £93m into quarterly results. RBS said it was likely to achieve £1bn in cost reductions.

These powerful signs that the bank – which is still 80% owned by the UK government – had finally turned a corner eclipsed the few negative points in the earnings release, chiefly that net profit was in fact lower, on a quarterly basis.

Q2 net profit came in at £230m from £1.2bn in the quarter a year earlier, dented by charges. The bank booked a £130m goodwill writedown, a common method of accounting for assets which were purchased and had subsequently depreciated. RBS also shifted £190m-worth of credit adjustments on to the negative side of the ledger.

A note of caution from the CEO

RBS’s writedowns were one visible sign of the note of caution overlaying the strong results, sounded quite strongly by the bank’s CEO, Ross McEwan. “I am very pleased to have had two good quarters,” McEwan said. “But no one should get ahead of themselves.” Having highlighted “progress on all of our key priorities,” he added that the bank was “actively managing down a slate of significant legacy issues. This includes significant conduct and litigation issues that will likely hit our profits going forward…there are bumps in the road ahead of us.”

McEwan is almost certainly correct to call for a delay in excessive celebrations.

Apart from the well-trailed ‘conduct and litigation issues’ the bank has yet to resolve, it also faces challenges which are a consequence of its ownership structure: the bank remains prone to political sensitivities. At worst, it goes through bouts of serving as a political football.

An example of this was seen just two days before the surprise results release when the chairman of the UK Parliaments’ Treasury select committee called RBS “wilfully obtuse”. The bank was in effect forced to admit its global restructuring group was indeed a “profit centre” only weeks after denying the operations were in effect just that.

“If this is how RBS deals with a parliamentary committee, how much can customers and regulators rely on it to be straightforward with them?” asked Andrew Tyrie, the committee chairman.

He was referring to the bank’s GRG unit, a vehicle intended to take care of distressed loans to small businesses. A number of UK officials, including a member of UK Treasury Secretary Vince Cable’s staff, accused the unit of attempting to benefit from small businesses in financial distress, something which the bank denied. However a report commissioned by the Treasury Committee concluded that it had a “potential conflict of interest” because it was a “profit centre”. RBS later said that it would not disagree with the use of the term.

‘Interest’ in Ulster Bank, but no fixed timetable for a disposal

Perhaps more seriously, a further headwind faced by the group is execution risk inherent in the process of disposing of assets which have been targeted as non-core. A notable example of this is Ulster Bank.

Ulster Bank impairments fell £44m in H1 to £57m, helping it book a £55m profit on an operating basis, but the subsidiary has cost the group £15bn over the last five years.

Options for Ulster Bank include an outright sale or a private equity investment, RBS said. “It is interesting how many people want to buy into Ireland,” said CEO McEwan. However, continuing with his cautious undertone he stressed there was “no fixed timetable” for Ulster, with the situation perhaps likely to be clearer in two-three months.

Investors wishing to make a balanced assessment of RBS after these promising results need to take heed of these cautions just as much as they should also recognise a further signal measure of improvement in RBS’s strengthened common equity.

This is a strictly regulated measure of a financial institution’s ability to withstand economic shocks.

RBS’ tier 1 capital ratio at 10.1% compared with 8.6% at the end of 2013. That’s well above the threshold required by most major regulators, including the European Central Bank, which will publish results of ‘stress tests’ in its region in the autumn.

With capital ratio, restructuring, balance sheet and the bottom line going in the right direction, RBS might well begin to attract the attention of investors who had hitherto looked askance. Even so, it’s worth remembering the bank targeting tangible net asset value to be flat for this year and for 2015, a sign that the factors management warned of are likely to have a significant effect on net profit in coming years.

Shares have yet to regain best levels, likely to ease in the near term

As for the share price, recall it has bumped along near its bottom since its calamitous collapse between the second quarter of 2007 to the first of 2008. Since then it has remained roughly within an 170p range – between 200p and 370p.

Granted RBS stock has opened up a sizeable gap on Friday to as high 378p versus the closing price on Thursday at 328.8p. However the stock is now butting up against levels around 387p. These are prices around which the stock has faltered each of the four times it has approached the area since late 2012.

Looking at Moving Average Convergence Divergence (MACD) we can see that the stock is not guaranteed to build upon today’s spike in the near term. MACD is used by technical chart analysts as a means of judging the current strength of a given price move. The technique comprises the MACD itself and a ‘signal’ line, an exponential moving average. Analysts take the MACD crossing above the signal as a potential sign of strength on the upside and as vice versa when MACD crosses below the signal. Whilst RBS’s MACD is above the signal line, the fact that the signal itself is in the red and that MACD is at 1.77 against a maximum of 10 is an ambivalent short-term picture for the shares.