Royal Bank of Scotland's Right Royal Mess

On Aug. 8, U.K. Fool Stuart Watson -- from our sister site, fool.co.uk -- provided an interesting take on defensive stocks. We thought you'd like to read it. The article has been updated and Americanized by Todd Wenning.

Royal Bank of Scotland (NYSE:RBS) has been making headlines for all the wrong reasons this year. A few months ago, its £12 billion rights issue was the biggest in U.K. corporate history. This morning, it revealed its first loss in 40 years, which also had the distinction of becoming the second-biggest loss ever made by a U.K. bank.

As had been outlined back in April, the damage was done by writing off £5.9 billion in relation to those nasty old subprime investments. This took the Royal Bank from a profit of £5 billion for the first six months of 2007 to a loss of £691 million.

These results mean the banking hall of shame is pretty much complete. The table below summarizes the results for the first half of 2008 for the eight listed U.K. banks, plus Northern Rock, compared to the first half of 2007.

Note to U.S. investors: One British pound is roughly $1.90.

Bradford & Bingley isn’t due to report until the end of this month, but its small size is unlikely to change the overall picture. U.K. banking profits are 60% down from the pre-credit-crunch period, with only one bank, Standard Chartered, managing to record a profit increase.

The steadiness of the economy in recent years has led many investors to forget just how sensitive banking profits can be. The last six months have been an unpleasant reminder in this respect.

Yet there could be more to come. Most of the fall in profits has come from banks writing down their investments in various subprime-related investments. Their underlying profits have yet to receive any major hit from the higher level of bad debts that accompany any slowdown in the economy, either from their corporate clients or from individuals. In fact, many people have been surprised at just how well underlying profits have held up so far among the major banks. Just how bad this second hit will be is far from clear, but few people doubt that it is coming.

Royal's performance
It would be interesting to see how different Royal Bank’s share price performance would have been had it not proceeded with the joint takeover of ABN Amro last year. Many of its writedowns came from the businesses taken over, and the takeover also weakened the bank’s capital ratios, resulting in the need for the rights issue launched earlier this year.

Yet ABN could still turn out to be a good acquisition ... eventually. It cost Royal Bank around £13 billion, and revenue and cost savings are predicted to be £1.6 billion in 2010, almost four times the profits the acquired businesses achieved in 2007. The integration is also said to be ahead of schedule.

Elsewhere, the bank’s targets for capital ratios at the end of this year look like they’re being met. This has been helped by the recent disposals of Angel Trains and a 50% share of Tesco Personal Finance. Royal Bank has also been looking to sell Direct Line and Churchill, but it’s unclear whether this is still necessary to meet its capital ratio targets. Like many of the big banks, RBS looks like it has benefited from the reduced competition from the smaller players in the market in recent months, with interest margins increasing slightly.

The interim dividend will be paid in shares, at a rate that works out at just under 6 pence per share. This compares with the 10.1-pence interim dividend paid last year, although this figure has not been adjusted for the recent rights issue. Going forward, the group still hopes to pay a final dividend in cash and see dividends being paid in the mid-40% range as a percentage of its underlying earnings. This makes a total of 18 pence for this year look like a reasonable expectation.

The shares touched a low of 145 pence three weeks ago, but have since recovered strongly to 237.5 pence. Despite this recent rally, like all banks, RBS’s shares are ostensibly pretty cheap -- provided you don’t think the downturn in the economy will be longer than the one to two years most people seem to be expecting.

Royal Bank’s management team seems suitably chastened by recent events, and given their success in integrating NatWest, will almost certainly be given more time to repeat the same trick with ABN Amro. All things considered, I reckon there is a good chance that the shares will be quite a bit higher in three years’ time, but how they will make that journey is anyone’s guess.

Other top-rated foreign money center banks:

Source: Motley Fool CAPS, as of Aug. 12, 2008.