In 1999, RBS was the 39th biggest bank in the world by market capitalisation, today it ranks at fifth. Between 1999 and 2004, the bank grew its assets by 510% to $1119.5bn. Year-end figures for 2004 showed that group operating profit (after loan loss provisions but before goodwill and integration costs) was up by 18% on a constant exchange rate, and that revenues had grown by 106% over the last five years – of which 60% was due to organic growth. This year, as it has every year since 1992, RBS increased its dividend by 15%.
And yet it trades at miserable price-to-earnings (PE) multiples – hovering around the 8-9xPE mark (while HSBC trades at 13.4xPE and Barclays at 11xPE, according to data provider Thomson Financial) and its shares are trading at much the same level as they were in January 2001. The stock trails its UK peers. RBS’s share price is down about 11% over the last 27 months compared to a 8% rise at the FTSE banks group, for a total return over the same time period of -5% versus 19%, respectively.
RBS shareholders beef about the management’s remuneration packages and carp about the perceived weakness of the bank’s capital base. They accuse the CEO and his team of being M&A deal junkies, and, worse, moan that the stock hasn’t made them money.
“I would have made more money if I’d invested in any other bank stock rather than RBS. It has been the worst performer in its peer group over the last two or three years,” says one UK-based shareholder.
Mighty have fallen
It wasn’t always this way. After more than delivering on the hostile takeover of NatWest in 2000, the bank and Sir Fred, were shining stars in a dark firmament for executing a transformational deal. Plaudits were commonplace. In 2002, Forbes Global named Mr Goodwin – since knighted Sir Fred – businessman of the year for delivering a 27% rise in profits while industry profits fell by 30% in one of the market’s bleakest periods. At that time, RBS was pretty much the most expensive bank stock in its peer group.
“Then RBS stock was seen to trade at a management premium; now, despite the bank’s exemplary operating performance, it is trading at a discount. And this for perhaps the best management team in Europe,” says James Eden, bank analyst at Dresdner Kleinwort Wasserstein (DrKW).
What explains this meteoric fall from grace? How, in a few short years, and despite an unrivalled track record, has RBS gone from darling to demon in the eyes of its shareholders?
Some suggest there is a ‘disconnect’ between management and investors: while the management team is focused on optimum capital allocation and investing for long-term growth, shareholders remonstrate over lack of share performance in the near-term; while shareholders clamour for RBS to establish a share buyback programme, RBS continues to invest and acquire.
Overseas acquisitions
Most analysts agree that RBS has taken a sensible course. Two years ago it was faced with a business boasting excellent market share and a pretty high profit margin – but where was new growth going to come from? The answer lay in corporate banking and financial markets (CBFM), and in expansion outside of its home territory.
First, it has invested heavily in the cost structure of CBFM, increasing staff by 900 to 17,400 over the last 12 months (600 of those hires in the first half of this year). RBS is building the business geographically – in the US and on the European continent – and by product set, aiming to capture more debt capital markets business. The bank’s intentions are clearly now more global than regional. The strategy is paying dividends already: H1 figures this year show that CBFM profits before tax were up by 23% to £2.5bn.
RBS’s second growth option was via the $10.5bn (£5.8bn) acquisition of Charter One last year – the 25th US acquisition through its Citizens platform since Citizens itself was acquired in 1988. This latest deal extends the New England-based bank into six more US states – Vermont, New York, Ohio, Indiana, Michigan and Illinois – with the aim of replicating Citizens’ highly successful growth strategy.
Citizens’ profit before tax in the first half of this year was up by a staggering 74%. Analysis from UBS that compares 1992 figures with results annualised in the first half of this year, shows that Citizens’ net profits have increased a hundred fold, from $19m to $1.96bn. Returns on invested capital up to the Charter One acquisition averaged 15.5%. According to DrKW analysts, excluding Charter One, the internal rate of return (IRR) on invested capital generated by Citizens’ acquisitions is an admirable 18%.
So far, DrKW estimates that Charter One has generated about 11.5% return, below RBS’s own hurdle of 12% IRR for acquisitions. But if the same management team, led by Citizens CEO Larry Fish, can ultimately reproduce the same kind of growth using Charter One as a vehicle to mop up small financial firms in its geographical markets, then surely shareholders will cheer?
The problem has been that while analysts applaud RBS’s strategy and returns, the company has failed to get shareholders’ buy-in, hence the shares’ flat performance and shareholder disaffection. There has been a disconnect with what the management did and what the shareholders expected, or wanted.
“It all depends on what investors want from their bank holdings,” says Jamie Hooper, fund manager at F&C (which is also a top 10 RBS shareholder). “Slowing consumer lending and increasing competition in the retail space have led RBS to shift towards lower-margin CBFM business and to grow outside of the UK. With bad debts at a cyclical low and likely to rise, and cost cuts difficult to achieve in an already very efficient bank, its low valuation reflects the market expectation that profitability will fall and its capital is relatively thin. Its strategy has been to invest for growth rather than return capital to shareholders via improvements in the dividend payout ratio or via share buybacks. Ultimately, it’s about whether you have confidence in [RBS’s] strategy and whether you take a short-term or medium-term view.”
Communication breakdown
Communication is seen as a key problem. Shareholders protest that not enough information is given to explain the bank’s strategy and, while UK rivals such as HSBC or Barclays roll out all the divisional heads for one-on-one marketing trips on a regular basis, RBS does not. It does, of course, have investor days, but as a general rule, critics complain that there is little access to anyone other than Sir Fred or finance director, Fred Watt.
An equally unhelpful approach is often taken with the media. Though The Banker has interviewed many RBS people in the past, including Sir Fred and Johnny Cameron, when we approached RBS for participation with this feature – from Sir Fred or any of the business or product heads – we were turned down on every front. “[Our] priority is still delivering on the Charter One acquisition and more recently the deal in China, so we aren’t able to allocate time for media interviews,” said the head of press relations.
Similarly, when we asked for the transcript of a speech given by chairman Sir George Mathewson at a recent Pakistani Bankers Association dinner, we were told that “it is not the bank’s policy” to provide transcripts – even those in the public domain.
“RBS has gone from being a provincial UK bank to a global megabank, but the mindset and organisational set-up has failed to keep pace with that development,” says John Paul Crutchley, bank analyst at Merrill Lynch.
It is difficult to put one’s finger on where things went wrong, but last year’s acquisition of Charter One helped to sour relations. It was not, perhaps, Sir Fred’s smartest move to issue stock at 8xPE to buy a business at 15xPE, which RBS shareholders felt was, anyway, overpriced.
RBS has defended the issue saying that, while it was technically a share placing, stocks mainly went to existing shareholders, so it was more like a rights issue. DrKW’s Mr Eden says that although that argument has theoretical appeal, the transaction was a share placing. “There were some new shareholders, therefore the deal diluted the value of existing holdings. And it is well known that no retail shareholders had access to the deal. A rights issue would have been more acceptable to shareholders,” he says.
Silver lining
Nonetheless, the performance of Charter One may well go on to pleasantly surprise investors. If it was a bit pricey, current performance is not shameful and it provides a lot of opportunities for organic and non-organic growth.
Given Sir Fred’s acquisition track record, adds Mr Eden, success is highly likely. “When RBS acquired Churchill [Insurance] off Credit Suisse, shareholders and the market baulked at the exit multiples of 21xPE, but it now makes 2.5 times more money for Fred Goodwin than it ever made for Credit Suisse,” he says.
RBS’s Chinese investment has done little to improve already strained relations. With shareholders still pushing for share buybacks and bleating about levels of core capital, the bank went ahead as part of a consortium (with Merrill Lynch and tycoon Li Ka-Shing) to acquire a 10% stake in Bank of China (BoC), providing $1.6bn of the $3.1bn total. The deal is considered very clever by pundits: it was funded by the sale of RBS’ stake in Santander, therefore at no cost to shareholders, and includes unprecedented warranties and protections from Beijing to shield RBS’s investment from a deterioration in the BoC’s finances and other risks.
But, while other banks are seen as canny in getting their foot in the Chinese door, RBS shareholders seem, at best, relieved that their stakes were not further diluted – which brings them straight back to buybacks. “If [management] had £1.6bn to spend on China, then why not give it back to the shareholders? Anyway, it’s not a big enough stake to deliver any real benefit, certainly not in the short term,” laments one disgruntled investor.
Others argue that the financial guarantees will not be worth the paper they are written on. At a Hong Kong lunch one banker said: “Sir Fred may be able to wave his guarantees in the air if BoC begins demanding more money to cover new non-performing loans, but that will be the end of any ‘special’ relationship and the end to any joint ventures.”
However, western firms are unlikely to make any headway in such markets without local collaboration and many believe that, if anyone can deliver on a Chinese adventure, then it is Sir Fred. The key to making these deals work is business process execution, and about audit and technology infrastructure, and these are areas where RBS excels, says Mr Crutchley. “RBS can really add value here,” he says. “Where it will deliver commercially is in joint ventures such as credit cards and consumer finance initiatives like non-life insurance.”
More interestingly, why punish Sir Fred for such a deal while other banks – including Bank of America which is regarded as a far more regional (in other words, US) player than RBS – are free to take a bet? Equally, it is a small investment: only 2% of RBS’s current market cap and even less if you believe that it is trading at deeply depressed multiples.
“It’s a reasonable choice,” agrees Alastair Ryan, bank analyst at UBS Investment Bank. “There are no guarantees about how the investment will turn out, but China is one of the few areas that is able to deliver the sort of growth that a global behemoth like RBS needs.”
Fuss about nothing?
Shareholders’ concerns about low levels of core capital also seem largely overplayed. Debates over RBS’s capital position are constrained by a focus on a single point: that its equity Tier 1 capital ratio – at about 4% – is lower than its peers (HSBC says its stood at 8.7% on June 30) and therefore it is undercapitalised. Mr Crutchley thinks this is both simplistic and incorrect.
“Capital is for creditor and shareholder protection. In this the first line of defence is the P&L to absorb losses, and RBS’s coverage of provisions in pre-provisioning profit runs at 1x higher multiples, at least, than its peers. Therefore, if it has more capital in its P&L, it would need to absorb less through the balance sheet. Higher capital ratios would be an inefficient use of capital.”
Anyway, he adds, RBS is now more in harvest mode than M&A mode and the bank’s capital position will naturally improve over the next 12 months.
While he does not really worry about RBS’s capital levels per se, UBS’s Mr Ryan does question whether RBS has enough cash flow and capital to deliver on all of the growth opportunities – the American midwest, China and CBFM build up – in the near term. “RBS has perhaps bought more call options than it can afford to exercise. There’s certainly less chance of delivering than if they’d allocated their capital to one of the options,” he says.
The only explanation for RBS’s current malaise is that it is suffering from a serious perception problem. When the CEO is referred to as a megalomaniac for his so-called M&A proclivities, perhaps it has escalated into a personality clash between management and the shareholders. Sir Fred attracts gossip and apocryphal tales like a magnet does iron filings. Alleged stories of outlandish office design specifications, extravagance and control freakery have all added grist to the rumour mill. It got so out-of-hand that in November last year Sir Fred and RBS sued The Sunday Times for defamatory comments and “exposing him to ridicule”.
There are always lessons in history. Sir Fred and his team do not want to go the way of Deutsche Börse’s erstwhile CEO Werner Seifert and the Frankfurt exchange’s board members, who, despite creating a profitable global business from a small, regional exchange, were ousted by shareholders because they felt that Herr Seifert cared more about building an empire than delivering total returns to his shareholders.
Coming clean
More transparency would certainly go a long way towards sweetening relations. Revealing the assumptions underlying RBS’s IRR calculations, for example, and offering a clearer explanation of the rationale behind deals, as well as openly weighing-up any alternatives, such as share buybacks, would help the market to better understand RBS’s overall strategy. Then, maybe the bank’s share price would begin to recover.
The management is beginning to realise that action must be taken to improve communication and relations with both the shareholders and the media. For the first time ever, at the interim results conference in August, three business heads – Johnny Cameron, CBFM CEO, Larry Fish, Citizens CEO and Gordon Pell, CEO of retail banking – were wheeled out to sit alongside the three usual suspects: Sir Fred, Sir George and Mr Watt.
A PR agency has been commissioned to carry out a “media perception audit” in which questions about competitors and strategy were outweighed by those on perceptions about the firm’s approach and reputation as a communicator. Journalists have been asked: is the firm perceived as arrogant? Do you get access to senior bankers?
Placating the shareholders
Aside from going on the road to schmooze the shareholders and put a little flesh on strategy bones, analysts believe that a few simple steps would lessen shareholder ire. Mr Eden says that RBS could take a leaf out of rival HBOS’s book. In December 2004, HBOS promised to buy back 3% of outstanding stock in the following 12 months: HBOS shares went up 8% in one hour and 15% in a week. While Mr Eden acknowledges that a share buy back programme is out of the question right away, outlining a strategy to do so could get a carbon copy result.
“HBOS hasn’t fully delivered on it yet, but it was a signal; it’s about communicating to shareholders that the business is being run for their benefit. And when stock is as cheap as HBOS’s was then and RBS’s is now, it is not a bad option,” he says.
Increasing the diversity of the management team to match the diversity of the business could also go some way to pleasing shareholders. Some argue that if RBS wants to be seen as a global bank, then it must field a more international team than the almost wholly Scottish line-up it has currently. Its new chairman-in-waiting, Tom McKilloch, adds to the impression of a “Scottish Mafia” at the helm, and analysts are betting that the bank will probably miss a trick when it appoints finance director Mr Watt’s successor.
“They have a great opportunity to appoint, say, a strong American with a banking background, but what we’ll probably get is a dour, grey Scottish accountant,” says Mr Eden.
Upsetting the apple cart
Others worry that when Sir George, who was first responsible for turning a small Scottish firm into a dynamic, international bank, steps down, some of the balance will be lost. “Where is the counterpoint to Fred Goodwin’s dynamism and aggression when [Sir George] goes?” asks Mr Crutchley. “Many believe that he is the only one who is able to exert any real influence over Sir Fred.”
No one can predict when shareholder sentiment will turn. Negativity can linger for a long time and then evaporate overnight. If their displeasure with management is driven by ever-shrinking investment time horizons, then their breach with management may be difficult to mend in the near future: the battle lines will remain drawn over the merits of short-term returns of buybacks versus longer-term strategic investing for future benefit.
But surely RBS’s consistently strong profits and dividend increases must improve shareholder tempers soon? Mr Eden says: “In my view, actions speak louder than words. And if you judge RBS by what has actually been done, so far, whatever Sir Fred and his team have touched has turned to gold.”
