Summary
All the attention has been on LBG, but it seems the situation at RBS has developed into a rather complicated one as well. While details remain sketchy, our reading of the “new” plan for RBS is fairly valuation neutral, but with increased execution risk and raising further questions about the quality of its balance sheet.

The negative impact of the changes
We see three main negative impacts. First, a £40bn first-loss piece would render payments to RBS very unlikely, in our view. At the moment, we assume a pre-tax APS payout of £5bn over the next 5 years and this would, therefore, disappear. What worries us more is the potential message given by such a big FLP. Previous media reports have suggested that the EC wants the FLP set inline with expected losses – if these are £40bn then our loss assumption on these assets over the next 5 years might be £15bn too low. After tax, that’s around 10p per share. It might also lead the Government to inject the £6bn of B shares commited in February in addition to the £19.5bn we already have in the models. This would add 12bn to the share count, lifting it to 107bn, on our estimates.

Second, and on the same subject, the tier 1 supervisory deduction associated with a £40bn FLP would not fall away as quickly as previously assumed. While the day 1 deduction shouldn’t change very much – the regulatory rules require the lower of 50% of the FLP and 4% of the RWA relief, or £6bn, to be deducted – the FLP is unlikely to zero during our forecast horizon. In other words, we would expect some level of tier 1 deduction until the bank dropped out of APS.

Third, the divestments would obviously damage underlying earnings, with net profits potentially falling by £1-1.5bn depending on the extent of required disposals, on our numbers. This is net of the interest generated on any cash consideration. Whereabouts in that range depends in large part on whether the bank has to sell Citizens and the extent of sales in the “core” investment bank.

On the new pay-as-you go plan, it seems reasonable to assume that RBS would pay around £3.5bn per annum in cash directly to HMT. To simplify the numbers, we also assume that the deferred tax asset element of the plan is removed completely. Then, if RBS came out of the scheme at the end of 2011 for example, it would have saved itself £7bn (£5bn after tax) versus the previous plan.

Pulling it all together
The detail will be key to drawing any conclusion. However, we have attached a summary spreadsheet based on the above, and which assumes a sale of the insurance company, 20% of core GBM and 300 branches at the end of this year for simplicity (although clearly it will have longer). We then note the following outputs.

1. The equity tier 1 ratio would rise to 14.6% at June 2009 versus 10.6% on the previous plan;
2. The equity tier 1 ratio would settle at 10.9% at December 2013 (8.5% previously);
3. The TNAV would be 57p at June 2009 and trough at 40p in 2011 (48p and 35p previously);
4. Normalised EPS would be 4.3p in 2013E and 5.3p excluding non-core (5.2p and 6.3p previously);
5. Resulting Government ownership would be 84%

But what the plan really changes, in our view, is the gearing of the company to an improvement or deterioration in the economy. With a pay-as-you-go APS, the option to withdraw early could prove lucrative if things improve markedly, but with such a high FLP, the company is exposed to far more losses in the event of a downturn. This naturally increases the cost of equity, without a commensurate increase in the expected return – which must be valuation negative in our view. Furthermore, we view the very high first loss-piece as the second message in three months that losses could be bigger at RBS than currently forecast – we worried at the interim results about the £9-11bn of estimated deferred tax assets, implying future pre-tax group losses of £10-15bn. It begs the question what it is in the book that really concerns those that have scrutinised it closely?

The shares are currently trading on 11 times the present value of 2013E “core” EPS, and 1.4 times the present value of 2013E TNAV for a company we expect to generate a normalised ROE of about 13-14%. This seems at best fairly valued, and given the huge uncertainty, as well as the 84% Government ownership, arguably overvalued relative to many other banks, on our numbers. Clearly any one of the above assumptions could have a marked impact on the outcome but for now we remain on Underperform. Barclays remains the lowest risk, cheapest bank of the three UK domestic groups in our view.

RBS continues to look demandingly valued to us. At the Friday closing price, the market capitalisation is discounting PBT of at least £10bn in our view. The company’s peak profitability in 2007 was £10.4bn. Annualising the first half pre impairment PBT and normalising credit impairment would suggest PBT of £11.5bn. However, cutting the GBM contribution by one third would reduce this to £9bn. Furthermore, weekend press coverage suggests that the group is likely to have to make sizable disposals, including insurance and branches. If this is extended to Citizens (still under consideration apparently and c5% of normalised PBT) and GBM (the core of the group and two thirds of normalised PBT) also potentially to be scaled back, there is potential for significant dilution. At the same time, the first loss piece from the APS may be substantially increased, requiring higher capital raising and dilution. Remain negative on RBS.

RBS Likely to have to sell it insurance businesses, 300 or so branches and also scale back GBM. There are still question marks over whether it will be allowed to keep Citizens. If disposals are limited to insurance and a number of branches, then we would regard this as limited in impact; under 10% of PBT-nevertheless, it would still threaten some dilution. However, bigger disposals would be more serious. Citizens could ultimately generate 5% of group profits and GBM is the group’s largest profit generator, making some two thirds of our estimate of normalised profits.

At a market capitalisation of £38bn, we would argue Lloyds is discounting normalised PBT of c£8bn. The combination achieved this in 2007, ex HBoS private equity gains. Cost gains of £1.5bn are targeted from the merger. However, disposals and the dilution from the contingent capital raise have the potential to reduce earnings. At the same time, the group faces strategic challenges from its high loans/deposits ratio. These moving parts make the valuation of the group relatively uncertain. However, we do not regard the shares as clearly demanding as at RBS. We would view them as near fair value to moderately attractive and we would use any significant weakness in the capital raise period as a potential buying opportunity.

Press coverage suggests some £14bn in share issuance, of which £2bn would be from swapping existing non equity capital into a mandatory convertible, plus £7bn in contingent capital, again from a debt swap. At the closing price on Friday, this would result in a group market capitalisation of £38bn. The rights issue would be priced at 50p.

Disposals are likely to include C&G, IF and elements of the Scottish branch network. These are estimated to be some 5% of its current account market share of c25%. Pro rating this share, we would estimate that the disposals would relate to businesses with normalised PBT of some £400m-500m, or roughly 5% of the group total. This would be consistent with the indication the company gave in its statement last week that disposals related to EU remedies were unlikely to have a material effect on the group.

The cost of the contingent capital could also be high enough to incur dilution to profits, depending on the terms of the swap.

The implication behind the coverage is that much tougher sanctions would have been applied if the group had not exited the APS, further incentives for shareholders to back the deal. It is also consistent with the tougher measures apparently under consideration at RBS.

Ahold (€8.8, BUY, TP €11). We believe the Ahold shares offer
considerable upside towards our €11 TP. The shares are cheap on all metrics,
the group’s performance is resilient, and there are plenty of catalysts on the
horizon. A persistent market undervaluation could trigger takeover interest.

Today’s announcement confirms the strength of our position:- a strategic investor with significant industry connections; support from institutional investors; finance facilities and banking support; and highly experienced new Board members with oil company backgrounds.

We will shift our geographic focus to areas with much greater potential for major hydrocarbon discoveries and we expect to complement our prospects in Australia with other similar sized opportunities in such diverse areas as Asia, Africa and Europe. Our strengthened Board and Management capabilities will enable us to move quickly on any opportunities, and our new cash position will ensure we are able to add further resources wherever needed, whilst eliminating our net debt position.

Evil Knievil recently highlighted Earthport (EPO) on www.t1ps.com and his diarist recommended selling them at around 30p. Having had a look at the company I have to agree with him and have sold short at 23p – where the market cap is still £19 million..

Earthport “owns provides and hosts an international money movement platform called the Universal Payments Network”. It has been going for ten years and invested around £70 million in the business. To date as far as I am aware the company has not turned a profit.

Part of the reason for this was the non appearance of £2 million receipt heralded in an announcement of January 7th this year from a mysterious, unnamed Middle East “partner”. The money was due within six months and its non receipt was announced nine months later, which seems a little late.

The company has long been a private client favourite and the constant object of bid speculation. Indeed it was until recently in a formal offer period having announced a strategic review that included the sale of the company. Unsuprisingly no bid was forthcoming.

Given Earthport’s turnover it does not look like their product is gaining much traction amongst financial institutions and I would be surprised to see the majors doing business with a company with such a precarious balance sheet.

There must be a real chance that Earthport’s days are numbered without a dramatic upturn in their business and I am happy to be short even at these levels.