Is it Safe to Invest in Royal Bank of Scotland Again?

RBS had a great first quarter, and shares leapt 11.5% following the good news. Reasonable, or premature?

May 10, 2014 at 9:00AM

Source: RBS.

Royal Bank of Scotland (NYSE:RBS) reported an enormous jump in first-quarter profits last Friday to about $2 billion, a huge improvement over the first quarter of 2013.

Overall, the bank's news sounded great. Costs were reduced 6% year-over-year, net interest margins are up, the bank's Irish subsidiary, Ulster Bank, turned a profit for the first time in five years, and impairments are down 65% from a year ago. The bank's core Tier 1 ratio is up 80 basis points to 9.4%, and its leverage ratio has risen to 3.7%.

So should we be jumping for joy and buying RBS? 

Not so fast
As the bank's executives said themselves, don't read too much into one quarter. Impairments were low in the first quarter -- 114 million pounds -- but are expected to total about 1.5 billion pounds for 2014. This means that this was a light quarter for the bank and not indicative of a new trend. As described on the earnings call, there is still the possibility for volatility ahead.

Similarly, The bank's restructuring costs are expected to climb throughout the year. RBS expects the costs to rise in the second quarter and through the second half of the year, and executives are sticking with their initial guidance that restructuring costs are expected to total about 5 billion pounds over the coming few years.

Of course, RBS intends to get a good return on the restructuring activity starting in the second half of 2014. One quarter of data isn't enough to make any real assessments of how well it's going, though.

The executive team also cautioned that some gains look better because of a low starting point. For example, their markets division had a tough first quarter in 2013, so this year's first quarter looks a lot better by comparison. This is especially true when taking into account once-off additions from deleveraging activities. In reality, the bank's markets division is in the same boat as everyone else's trading divisions: that is to say, down.

Finally, it's possible that RBS could face about $8.4 billion in litigation claims stemming from a 2008 rights issuance. The bank has promised to fight the charges rather than settle, but it could add significantly to the costs facing the bank in 2014.

It's also worth noting that the British public is still about GBP 14 billion underwater on its investment in RBS (the UK government owns 81% of the bank.)

Still, it's not all bad
RBS intends to become a "simpler, smaller, and smarter bank," according to its CEO Ross McEwan. It seems to be going boldly in that direction. The bank has revamped its operations from seven divisions to three, and has already had success in reducing the number of commercial and retail banking products (expected to be cut by half by the end of 2014.)

The bank improved costs by about 6% year over year, including a 10% decline in staff costs with a 6,000 strong fall in headcount. RBS' Citizens Bank in the U.S. has cut costs by 4% from last year.

The smaller and smart strategy might be working. Just five years ago, the investment bank was responsible for 82% of the bank's profits. That number dropped to 20% in 2013, and is expected to keep falling as the bank's restructuring continues.

What next?
In the words of McEwan, there are still a lot of headwinds facing RBS. However, there do appear to be some positive trends at work. Provided that the bank can stick with its strategy, avoid further scandals such as the immense headaches of forex and Libor, and benefit from an expanding British economy, perhaps we will see RBS rise again. 

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Anna Wroblewska has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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