Today I am looking at why shares in Royal Bank of Scotland (LSE: RBS) (NYSE: RBS.US) are likely to suffer from continued downsizing at the core, an issue that is likely to continue to whack earnings potential.
Alarming reduction in contribution from the core
Royal Bank of Scotland’s half-yearly report published in July revealed that its ambitious cost-cutting programme continues to make hay. Group operating profit moved 5% higher in the initial six months of 2013, the release showed, to £1.68bn. This was prompted by a colossal 42% drop in non-core operating losses, to £786m.
Although continued progress in the firm’s transformation should, of course, be applauded, the results also showed that core operating profit dropped 17% in the first half to £2.46bn.
This was mainly due to a weaker performance from its Markets division, which has been battered by severe downsizing as part of the company’s wider cost-stripping drive. More specifically, revenues here slipped 21% in April-June, to £800m, from the prior three-months, while pre-tax profit dropped a massive 66% to £200m during the period.
Investec expects pre-tax profit from Markets to come in at £483m in 2013, down markedly from £1.5bn last year and an incredible £5.8bn back in 2009. Although a gradual recovery in this division has been pencilled in, further weakness in this critical area — particularly if signs of wider geo-financial slowdown escalate — could severely hamper the company’s earnings potential.
Significant share price strength has left Royal Bank of Scotland trading on a P/E rating of 20.8 for 2013, based on current City earnings projections. This represents a hefty premium to industry rivals Barclays and HSBC, which change hands on forward readings of 10.5 and 10.8 respectively and are in far better shape to deliver solid earnings growth than their part-nationalised rival.
Indeed, shares have ascended to their highest in more than two years above 370p in recent days, and have advanced more than 38% alone during the past three months. But in my opinion, the threat of reduced earnings potential from its core operations leaves it in danger of a severe price correction, and I would like to see signs of recovery from this area before parking my cash.
