Goodwin’s turning point

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By Ian Fraser

Published: Sunday Herald

Date: 27 November 2005

BANK CONSOLIDATION: ACQUISITION DRIVE FALTERS

Sir Fred Goodwin turned the Royal Bank of Scotland into a global institution with an aggressive takeover policy matched by a strident rationalisation strategy . . . he bought big and cut deep. Now, with British banking out of favour with the markets, he may have to retrench to save it all

SIR Fred Goodwin does not have many reasons to be cheerful at the moment. The Royal Bank of Scotland, the global institution he has built up through a series of deals over the past half-decade is out of favour in the City.

Its current low share price and stretched capital ratios mean Goodwin has limited room for manoeuvre. The bank also needs to find a new finance director very soon, and needs to persuade investors that it is capable of displaying greater capital discipline and even making share buybacks.

Essentially Goodwin has had to do a strategic U-turn since the summer, promising investors he will not make any further big deals for the foreseeable future and thus limit himself to an organic growth strategy.

To add insult to injury, some investors are pushing for a break-up of the group that Goodwin has assembled over the past five years, as a means of boosting shareholder value. Despite doubling profits over the past three years, their peerless reputation for integrating acquisitions and their multi-brand approach, Goodwin and his RBS team have, since summer 2002, been learning to live with a flaccid share price.

RBS shares have gained just 2.6 per cent in the past three years, compared with Barclays’s 30.7 per cent and HBOS’s 27.1 per cent. For many – including Goodwin and his pugnacious chairman Sir George Mathewson – this has not come too easily. Longer-term holders of the shares, however, have less cause for complaint given that the share price nearly trebled between February 2000 and May 2002.

But every investor who has bought in since then is concerned Goodwin has failed to deliver the hoped-for returns on the string of acquisitions made since RBS acquired NatWest in 2000. Shareholders are increasingly fretting that the bank’s capital ratios are looking over-stretched.

“Some of the funding of acquisitions needs to be borne by the company as well as by shareholders,” says Neil Tong, a fund manager at Dundee-based Alliance Trust, a big investor in RBS. “The balance sheet isn’t strong enough to meet with [his] international expansion plans. The plans may have good long-term growth merits but the returns we’re actually receiving are too low. The payout ratio – of earnings to dividends – is the lowest in the banking sector. Growth is great, but we’d like to see some returns on the capital we’ve invested in the company. I’d rather see a more balanced approach to expansion.”

At the moment RBS’s critical equity tier-one capital ratio is just 4 per cent, compared with around 7 per cent to 8 per cent at most of its UK peers. “Because Goodwin is very much the architect of the entire strategy, he gets the blame when things go wrong,” says Richard Staite, analyst at SG Securities.

Some investors are said to be pushing for a break-up of RBS – with the most popular routes being a demerger of its US Citizens Financial arm, or of its UK general insurance arm, which includes Direct Line and Churchill, or both. Such deals would have parallels to ScottishPower’s sale of PacifiCorp, and could raise at least £20 billion very quickly – enabling RBS to put some much-needed oomph into its share price.

But such a move would be anathema to Goodwin as it would mean tearing up his legacy. It may, however, prove more attractive to incoming chairman Sir Tom McKillop who is expected to succeed Mathewson in May.

James Hamilton, analyst at WestLB, believes RBS’s board will have asked Goodwin to “look at a possibility of such a break-up.” However he adds: “I think Goodwin would resign if he was asked to do that. It would destroy the bank he has created.” Hamilton compares RBS to a Savile Row suit that happens to be out of fashion at the moment. “That doesn’t mean you should cut off the arms and the legs.”

Staite says: “To break up the group would mean they had effectively given up on their entire strategy.”

Tong, however, is less hostile to the concept of a break up. He said: “It may be that would create value in the shorter term, and we do think the shares are undervalued at current levels. But I would have some reservations. The medium to long-term potential would be undermined by such a break-up.”

Some of the frustration about RBS’s share price – which closed on Friday at £16.97, about the same level as in July 2002 – bubbled to the surface last week with reports that Goodwin was close to throwing in the towel. The Independent On Sunday claimed he was poised to resign because he “is understood to be unhappy about the bank’s relationship with investors” and “believes the rating of RBS shares has led the group to miss opportunities to expand abroad”.

THE company has since suggested Goodwin has no plans to go, with Mathewson saying the reports are “well wide of the mark”. However most followers of RBS believe Goodwin is, at the very least, frustrated. One bank analyst said: “The amount of investor interest in UK banks this year has been zero. It’s not just Goodwin; every UK bank chief executive is frustrated by their share price and by their ability to do anything. They’re looking with envy at the multiples at which European banks are trading compared to their own.”

A senior figure at a rival bank says: “Fred is despondent. But I’d be gobsmacked if he were to leave now. They have a lame-duck chairman, and a finance director [Fred Watt] who is on the way out.”

Staite at SG Securities believes that there are better ways to inject some dynamism into the RBS share price than through a painful U-turn. “One easier route would be to give shareholders better access to senior management. Most of RBS’s peers are happy for divisional heads to meet shareholders but RBS has always resisted . . . They also need to make their financial disclosure a bit less opaque.”

Tong agrees. “I think we would appreciate seeing some of the key operational people as well.” He says he is disappointed he has never had meetings with either Johnny Cameron or Benny Higgins, divisional heads of RBS’s corporate banking and retail arms respectively. Tong also said that the replacement for Watt needs to be a strong individual. “We want a good quality finance director, and part of being a good quality finance director is the strength and ability to have your own mind and speak your own mind.”

The current state of affairs is particularly hard for Goodwin given that RBS was a stock market darling for about two-and-half years after it sealed its £21bn takeover of NatWest in 2000, a deal which propelled it from regional player to global contender. In that period Goodwin was lionised in the City and allowed almost free rein to try to apply the NatWest treatment (rationalising acquired businesses through ruthless job cuts and efficiency savings) on as many overseas banks as he could handle.

But, by about mid-2002, the mood in the City had turned, as part of a broader trend that saw investors tire of UK banks. The investors feared the sector was too exposed to a UK housing market crash, as well increasing bad debts at home and overseas. RBS investors were concerned that Goodwin showed few signs of changing his approach to suit the changed conditions. Instead he ploughed ahead with further deals.

The fear that he would issue further preference shares to fund overseas deals caused RBS shares to underperform the sector throughout 2003. Talk centred on the risk Goodwin would pay about $8bn for Pennsylvania’s Sovereign Bancorp, a deal that would have required a further dilution of shareholder equity and jeopardised RBS’s capital ratios.

Although the deal never happened, some investors were dismayed when RBS made a £2.5bn share-placing to fund the $10.5bn acquisition of Ohio-based Charter One in May 2004. The deal weighed on RBS’s share price, as investors feared he would make a bigger cash call to buy a sizeable stake in a Chinese bank. Relations with the City grew fraught, and Goodwin is believed to have watered down his approach to taking a stake in Bank of China, a deal which finally happened in August, as a result.

Goodwin’s expansionist rhetoric has since evaporated as he has sought to reassure investors that no further major deals are on the cards. At Merrill Lynch’s bank conference last month he said he “sees no strategic need for further acquisitions” and that the priorities over the next five years are “to grow income, improve efficiency and improve return on equity”.

So at least he appeared to be listening to the City. He added that he believes the next five years will be “rich in opportunity” for RBS, with capital returns improving and no further calls on capital. But the revised approach is going to be harder graft than the previous strategy of the past five years – which was all about diversifying the earnings base through acquisitions.

WestLB’s Hamilton does not think there is much Goodwin can really do to boost RBS’s flagging share price, believing that investors are wrong to undervalue UK banks. “Ultimately, his job is to run the business and maximise profit. It’s up to the market to appraise the value. The trouble is the market very often gets it very wrong; just look at the valuations given to dotcom stocks between 1996 and 2001.”

John-Paul Crutchley, analyst at Merrill Lynch, believes that fears that RBS is under-capitalised are overdone. Despite a 5 per cent discount for perceived acquisition risk, he says its shares have a fair value of £20.30 – still below their May 2002 peak.

He says: “Our buy rating is predicated upon the fact that RBS’s more diverse business mix provides protection from the anaemic business trends expected in its core UK retail banking business over the next 12-18 months. It has the most significant upside among major UK banks.”


NEED TO KNOW

BACKGROUND: Last weekend it was reported that RBS chief executive Sir Fred Goodwin might consider resigning because the bank’s low share price has limited his room for manoeuvre.

THE FACTS: RBS’s share price has serially underperformed that of UK rivals since 2002. While HBOS shares have risen by 27% since November 2002, HSBC by 23% and Barclays by 30.7%, RBS has risen by just 2.6%. This has been caused by fears that Goodwin is too keen to pursue overseas expansion irrespective of the short-term returns to shareholders.

RBS was a relative minnow when the Monopolies & Mergers Commission blocked takeovers by HSBC and Standard Chartered in 1982, but has since become a global player through a series of deals. Most transformational was the £21bn acquisition of NatWest in 2000, and US arm Citizens Financial has been bulked up by a string of 27 other deals. RBS has also this decade acquired UK insurer Churchill, Irish mortgage player First Active and a 5% stake in Bank of China. But it has unwound a cross-shareholding with old ally Banco Santander.

NEED TO KNOW MORE?
www.investors.rbs.com For financial reports section for full details of RBS results.

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