March 11, 2005 4:32 pm

Analyst Watch: Scot should be flying higher

When Royal Bank of Scotland reported record pre-tax profits of £8.1bn for 2004, it was at pains to reassure investors that it was not planning any big acquisitions in the near future.

Nevertheless RBS’s share price has been held back during the past two years by fears that it is gearing up for another large acquisition and will have to issue more equity.

As a result, RBS shares trade at a big discount to rivals such as HSBC on 14 times earnings. Despite In spite of the fact that RBS has outperformed the UK bank index in recent months, it trades on a modest forward price/earnings ratio of just 9.3 times.

Certainly RBS has to go some way to shed its reputation as an acquisition hungrybank. Last year it paid $10.5bn (£5.4bn) for Charter One, a US bank, which it is now integrating.

RBS has stressed that while it is integrating Charter One it does not need to do another large deal. But deals have helped transform RBS from a provincial Scottish bank into the world’s fifth largest with a market capitalisation of £56bn. What changed everything it all for RBS was the bruising £22bn takeover battle for NatWest in 2000.

NatWest was three times the size of RBS and the deal was seven times the size of the previous biggest hostile takeover.

Some in the City were sceptical that RBS would be able to integrate NatWest. But NatWest was finally integrated in November 2002 after a three-year process that entailed of cutting 18,000 jobs and stripping out duplication in areas such as back-office processing.

The cumulative benefits in cost cuts and revenue synergies realised by the end of the NatWest integration programme were £5.5bn – about £1.4bn more than its original plan.

RBS has not stood still since then. It has spent £11.25bn on 22 acquisitions in the past four years – which has included £1.4bn in the UK and £9.85bn overseas.

The deals have ranged from in-fill acquisitions in the US such as the $273m paid for Medford Bancorp, a small Massachusetts savings bank in 2002, to the $1.47bn paid for the retail bank of Mellon of the US in 2001.

Over the past decade, RBS has generated a healthy return on its cost of invested capital in every year except 1993 and 2000. However, because acquisitions easily disappear into the larger group, it can be difficult for outsiders to judge whether the group it has earned a decent return on specific deals.

Analysts were mostly positive on RBS a year ago and remain so today. Bulls point to comments made by the management of RBS about future deals as well as the bank’s strong earnings performance.

Michael Lever, analyst at CSFB, says: “The residual concerns are still there in the share price, but there is nothing more that RBS management can do to make their position clearer. Meanwhile, the shares are cheap relative to the sector for a bank which is delivering well above average earnings.”

James Eden, analyst at Dresdner Kleinwort Wasserstein, says: “RBS made comforting noises on acquisitions but investors are afraid they will be asked to cough up if RBS does another big deal. It will take two things to get the share price moving. Either investors will accept the fact there will be no large deal for at least a year or people will just accept that, even if RBS does another deal, it is still performing well. If Charter One starts delivering benefits earlier than expected that will help sentiment.”

One source of disappointment is that RBS has ruled out any share buybacks while its tier one capital ratio, a measure used by regulators to gauge the capital strength of banks, is at 7 per cent. If it goes up to 8 per cent, RBS has said it may look at doing a buyback.

James Leal, analyst at Teather Greenwood, says: “The key message of results is not to expect acquisitions or share buybacks in 2005. Potential disappointment on buybacks should be more than offset by reassurance that RBS will not go on a value-destroying spending spree.”

RBS also points out most of its profitability over the past few years has been through organic growth rather than through deals.

Sir Fred Goodwin, chief executive, said last month that, during the past five years, RBS has been one of the least acquisitive global banks making 25 acquisitions which have generated $18.9bn of value. By contrast, During the same period, Citigroup has made 63 transactions creating $72.9bn of value and Barclays has made 32 transactions which have created $11.4bn of value. Total income growth at RBS between 1999 and 2004 rose by 106 per cent to £11.7bn.

Sir Fred said that only 7 per cent of this was due to NatWest and only 33 per cent was due to acquisitions. He pointed out that organic growth was 60 per cent of the total or £7bn. “Our reputation for just buying lots of things is simply not warranted,” he said.

But until RBS can shake off its reputation as an aggressive bidder, there may not be much upside in the share price.

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