UK Banks again: 2 bull cases and a bout of hedonic editing

This sector is fascinating. Every time I read a note, speak to an analyst or look at a model there seems to be a different view or emphasis. The variances in estimates and price targets are huge. There must be an opportunity here.

Because banks are so opaque and difficult to analyse my current focus has merely been to try and establish where the key points of contention are. Once this is done it should be a lot easier to establish whether or not there is genuine value here. As far as I can make out there are basically three areas of disagreement: pre-provision profits; total impairments; and the starting capital base.

1) Pre-provision profits: In a bull note on RBS published yesterday, a well known UK broker appears to be constructing a bull case for RBS on the basis of higher pre-provision profits than what the bears are assuming. For the 2008-11 period they have a total of £48bn of cumulative impairment, versus the uber bears who are assuming £49.6bn, slightly higher but not much difference. They key difference is the level of cumulative pre-provision profits - £35bn versus only £26bn for the uber bears. This constitues an extra £10bn of capital. Interestingly, this bull case does not rely at all on the other bull argument in the market - the assumption of lower impairments on the non-APS book versus the APS book (see 2 below). As stated explicitly in the note today: “With so few details on the composition of the assets that will be covered from APS, we do not assume any reduction in the impairment charge, once RBS has utilised the £19.5bn first loss”.

2) Impairments on the non-APS book: The other source of bullishness for the sector is the argument that the non-APS book will experience much lower provisions. Most analysts (bulls and bears) don’t assume anything for this, instead using a normalised number, although some of the bulls recognise that this could become a source of upside once more information is available. It is interesting that some analysts’ do believe that they already have sufficient information to make the assumption of lower non-APS impairments versus APS impairments. This is clearly a really important issue, and potentially one that the company's themselves may be able to provide some colour on.

3) Deductions to capital: The uber bears on the sector depress their starting capital by subtracting up front the non-amortised portion of the APS fee and the EV deduction for the life business. Others don't do this. Having considered this issue, I have concluded that the bearish view is illogical, at least as far as the APS fee is concerned. The bear arguement is that the APS fee is an intangible asset and should therefore be deducted from equity as you would goodwill. The problem with this analysis is when inferences are then made as to what the ROE should be, on the basis of the written down capital base. The APS fee represents payment for a long term insurance contract on the banks’ assets. If BP were to purchase a 7 year fire insurance contract on their head office, I would not deduct the entire cost immediately from the shareholders equity. And even if I did, I certainly wouldn’t make inferences about whether or not the resulting ROE was sustainable (the ROE would be higher because equity would be lower, but this would clearly be an accounting illusion). The APS fee should be considered as a cost of running the business and should therefore be spread over the life of the contract, ideally reflecting the timing of the losses.

That said, even if I do adjust the bear's numbers by adding back the APS fee to capital, the resulting NAVs are still some way lower than where the bulls are (especially when you get out to 2011 and 2012 when most of the fee has already been amortised). This suggests to me that a bull case on these stocks probably rests more on points 1) and 2) rather than 3). This means taking a view on how bad you think the UK economy is going to be over the next 2-3 years relative to what is already being assumed and, crucially, the extent to which LBG and RBS have managed to dump all their toxic assets into the APS. I suspect the investment case would need to rest more on the latter point rather than the former.