With the recent sell-off in bank stocks, I intend to take a look at whether RBS (LSE: RBS) and Santander (LSE: BNC) are compelling contrarian buys.
RBS
Shares in RBS have fallen by 22% since the start of the year, and now trade at less than two-thirds of its tangible book value. With the economy growing and loan losses declining, the bank was supposed to be firmly on its way to recovery.
Until recently, analysts had expected the bank would finally break its streak of annual losses. But instead, the bank announced its seventh straight annual loss in February, with losses totalling £1.98bn in 2015. Litigation and other legacy misconduct costs, which soared 63% to £3.57bn, were largely to blame, but there was also a more than doubling in integration and restructuring costs, as well as lower loan impairment releases.
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On the other hand, the bank has been making substantial progress in what it can control. Adjusted administrative expenses, which excludes restructuring and misconduct costs, fell by almost 9% in the year. The loan-to-deposit ratio, which used to be well over 100% until recent years, is steadily declining, and now stands at a comfortable figure of 89%. RBS’s balance sheet is also in a strong position too, with a Common Equity Tier 1 ratio of 15.5%.
However, any further unexpected losses from legacy misconduct issues, restructuring or defaults, could derail its recovery plan. The recent sell-off in the banking sector is also making it more difficult to exit from non-core assets and shrink its investment bank, undermining its efforts to ultimately focus on retail and commercial banking in the UK.
With such uncertainty continuing to surround the bank’s future earnings potential, investing in RBS shares certainty seems like a contrarian idea. Unfortunately, I’m not sure its shares offer compelling value at the moment. Shares in RBS trade at 11.0 times its expected adjusted 2016 earnings, which is significantly higher than the 8.7 multiple for the big 4 UK banks.
Santander
Santander is in much better shape, with shares in the bank up 3% since the start of the year. Profitability is trending higher too, with underlying group profits rising 12.9%, to €6.57bn in 2015.
With the steady improvement in the macroeconomic conditions in Spain, Santander’s domestic and overall group credit quality are showing clear signs of strengthening. The ratio of non-performing loans has been consistently falling year-on-year, and now stands at 4.36%.
On the downside, the bank’s balance sheet is not as strong as most UK banks. Despite a two-thirds cut in its dividend and an equity raise in 2015, its Common Equity Tier 1 ratio is just 10.05%. That’s still higher than its regulatory minimum and that of many European banks, but it does not leave a lot of room for further growth or returning more cash to shareholders.
What’s more, the bank may face a deterioration in credit quality in Brazil, where the economy is in a deep recession. Brazil accounts for nearly a fifth of Santander’s net profits, so rising loan losses there could have a serious impact on the group’s overall profitability.
However, these downside risks in Brazil are being offset by the stronger outlook in the UK, Spain and Mexico, where economic growth remains relatively robust. Overall, Santander is expected to continue to deliver earnings growth in 2016 and 2017, with shares in the bank trading at 10.0 times its expected adjusted 2016 earnings. That’s better value than RBS, but not quite a compelling value play.
