Equity Research

Equity Research

June 12, 2008 Ann H. Heffron, CFA



111 North Canal Street Chicago, IL 60606

The Royal Bank of Scotland Group plc- ADR

(RBS-NYSE)

RBS: Zacks Company Report - HOLD

Current Recommendation Prior Recommendation Date of Last Change

Current Price (06/11/08) Six- Month Target Price

Hold N/A

01/15/2008

$4.30 $5.00

SUMMARY DATA

OUTLOOK

We are maintaining our Hold on The Royal Bank of Scotland Group plc (or RBS), but reducing our target price to $5. RBS completed a ?12 billion rights offering in early June. Consequently, we are slashing our 2008 EPADS estimate to $0.30 from $1.35, and initiating our 2009 estimate at $0.80. In its first quarter trading update on June 11, 2008, management stated that operating performance of many of RBS s businesses remains good, though results have been held back by the effects of continuing deterioration in the credit markets. RBS also reiterated earlier guidance: ?5.9 billion in credit market write-downs, raising capital through the rights issue and sale of assets (including RBS Insurance), and issuing a stock dividend for the interim dividend. In addition, the ?2.3 billion of ABN AMRO integration synergies are on schedule.

52-Week High 52-Week Low One-Year Return (%) Beta Average Daily Volume (ADS)

ADS Outstanding (mil) Market Capitalization ($mil) Short Interest Ratio (days) Institutional Ownership (%) Insider Ownership (%)

Annual Cash Dividend Dividend Yield (%)

5-Yr. Historical Growth Rates Sales (%) Earnings Per ADS (%) Dividend (%)

P/E using TTM EPADS P/E using 2008 Estimate P/E using 2009 Estimate

Zacks Rank

$10.94 $4.30 N/A 1.74

3,036,233

16,142 $69,411

1.16 9

N/A

$0.65 15.12

17.9 16.2 24.9

N/A 14.3

5.4

3

Risk Level

Type of Stock Industry Zacks Rank in Industry

Above Average

Large-Value Banks-Foreign

35 of 47

ZACKS ESTIMATES

Net Revenue

(in millions of $)

Q1 (Mar) 2006 2007 2008 2009

Q2 (Jun)

Q3 (Sep)

Q4 (Dec)

Year (Dec) 43,401 A 52,979 A 46,804 E 62,629 E

Earnings per ADS

(EPADS is operating earnings before nonrecurring items)

Q1

Q2

Q3

Q4

Year

(Mar)

(Jun)

(Sep)

(Dec)

(Dec)

2006

$1.28 A

2007

$1.50 A

2008

$0.30 E

2009

$0.80 E

2006 results translated at US$1 = ?0.54 2007 results translated at US$1 = ?0.50 2008 and 2009 results translated at US$1 = ?0.51 1 ADS = 1 Share Quarterly earnings and revenue figures are N/A

Zacks Projected EPADS Growth Rate - Next 5 Years % N/A

? Copyright 2008, Zacks Investment Research. All Rights Reserved.

OVERVIEW

The Royal Bank of Scotland Group plc (or RBS) is the holding company of one of the world s

2007 Revenues by B usiness Segment

largest banking and financial services groups,

with total assets of ?1.9 trillion (US $3.8 trillion) at December 31, 2007. RBS trades on the

Citizens 8%

Ulster Bank 4%

London Stock Exchange and on the New York

ABN AMRO

Stock Exchange as an American Depositary Share (ADS) since October 18, 2007. Headquartered in Edinburgh, RBS operates in

9% RBS

Corpor ate Markets

44%

the UK, US and internationally through its three principal subsidiaries, ABN AMRO, the Royal Bank, and NatWest. Both the Royal Bank and

Insurance 10%

Retail Mar kets

NatWest are major UK clearing banks whose

25%

origins go back over 275 years. ABN AMRO, a

major international banking group, was acquired

on October 17, 2007. In the US, RBS s subsidiary Citizens is ranked the eighth largest commercial

banking organization by deposits. The company has a large and diversified customer base and provides

a wide range of products and services to personal, commercial and large corporate and institutional

customers. RBS enjoys long-term credit ratings of Aa1 from Moody s, AA- from Standard & Poor s, and

AA (reduced from AA+ in April 2008) from Fitch.

RBS s activities are organized in the following business divisions: Corporate Markets (comprising Global

Banking & Markets and UK Corporate Banking), Retail Markets (consisting of Retail and Wealth

Management), RBS Insurance, ABN AMRO, Citizens, and Ulster Bank. Corporate Markets (accounting

for 44% of 2007 total revenues) is focused on providing banking, investment, and risk management

services to medium and large businesses and financial institutions in the UK and around the world. Retail

Markets (25%) was established in June 2005 to lead coordination and delivery of RBS s multi-brand retail

strategy across its product range and comprises Retail (including its direct channels businesses) and

Wealth Management. RBS Insurance (10%), the

2007 Revenues by Geograp hy

second largest general insurer in the UK, by gross written premiums, sells and underwrites retail,

Rest of

SME, and wholesale insurance over the telephone

World 7%

and internet, as well as through brokers and partnerships. ABN AMRO (9%) is a major

Europe 15%

international bank with strong positions in

United

international payments and investment banking.

Kingdom 62%

Citizens (8%) is the second largest commercial banking organization in New England and the

U nited States 16%

eighth largest commercial banking organization in the US measured by deposits. Ulster Bank Group

(4%) brings together the Ulster Bank and First

Active businesses to provide a comprehensive

range of products and services to retail and

corporate customers in the island of Ireland. Geographically, 2007 total revenues divided the United

Kingdom 62%, the United States 16%, Europe 15%, and the rest of the world 7%.

The struggle for control of ABN AMRO (ABN) between the RBS consortium, including Royal Bank of Scotland PLC (RBS), Spain's Banco Santander Central Hispano S.A. (Santander), and the Dutch-Belgian bank Fortis, N.V. (Fortis), and Barclays PLC (Barclays) has concluded. On October 5, 2007, the RBS consortium announced it had acquired 86% of outstanding ABN shares, and on October 10, announced the offer was unconditional, with the settlement of offers to occur on October 17. Following this, ABN CEO Rijkman Groenink tendered his resignation, and Mark Fisher, a member of the RBS Group Board

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and Group Executive Management Committee, was nominated as his replacement. On October 1, 2007, ABN AMRO completed the $21 billion sale of LaSalle to Bank of America.

History of ABN Takeover Battle

In April 2007, ABN became the subject of a bidding war between a consortium of banks (the RBS consortium), which includes Royal Bank of Scotland PLC (RBS), Spain's Banco Santander Central Hispano SA (Santander), and Dutch-Belgian bank Fortis NV (Fortis) and Barclays PLC (Barclays). Under the terms of the original Barclays offer, ABN AMRO shareholders would have received 3.225 shares in Barclays for each existing ABN AMRO share, or 28.75 (about US$40.50) per share. This came to a total value of roughly 53 billion (US$75 billion), and was concurrent with the sale of ABN AMRO North America Holding Company, which principally consists of the retail and commercial banking activities of LaSalle Bank Corporation (LaSalle), to Bank of America for US$21 billion in cash.

The RBS consortium originally said it would offer 30.40 cash plus 0.844 RBS share, or 36.85 (US$51.90) per share, with a total value of 68 billion (US$96 billion). While Fortis wanted ABN's operations in the Netherlands and Santander sought ABN's fast-growing Brazilian and Italian operations, RBS was interested in acquiring LaSalle, as well as the wholesale operations and international retail businesses of ABN AMRO.

In connection with the disposition of LaSalle, a lawsuit arose challenging ABN s deal with Bank of America. On May 3, 2006, the Dutch courts ruled that ABN AMRO would need to get shareholder approval to sell LaSalle. However, this ruling was appealed to the Dutch Supreme court, which issued an opinion on July 13, 2007, stating that ABN AMRO did not need shareholder approval to sell LaSalle to Bank of America.

Following this ruling, both Barclays and the RBS consortium increased their purchase offers for ABN AMRO. Barclays new offer consisted of 2.13 Barclays shares and 13.15 in cash for every ABN AMRO ordinary share, or roughly 32.15 (US$45.30) per share, with a total value of 60 billion (US$84 billion). The RBS consortium s new offer consisted of 0.296 RBS share plus 35.60 in cash or roughly 37.85 (US$53.30) per share, with a total value of 70 billion (US$99 billion). While the board of directors at ABN AMRO originally favored the Barclays bid, the board dropped its support on July 30, 2007, though it did not endorse the RBS consortium bid either.

BULL STORY

RBS has a large and prosperous banking and insurance business in the UK, having a #1 market share in UK corporate banking, a #1 or #2 market share for most products in UK retail banking markets, and a #1 or #2 share for many types of insurance products sold in the UK. Its strategy is to extend its UK franchises while enhancing productivity (and the cost-income ratio) by maintaining good cost discipline.

Furthermore, RBS continues to expand through acquisitions in markets and products it deems attractive. The most recent example is ABN AMRO acquisition, which will propel RBS into leading markets positions in many types of global wholesale products. RBS expects to apply its management model to ABN s wholesale operations and significantly improve ABN s existing cost:income ratio, which is over double that of RBS. In addition, RBS intends to leverage its product strengths through ABN s customer franchise, and eliminate duplicate IT and support functions. RBS estimates that synergies from the ABN transaction will total 2.3 billion (up from 1,800 million previously) by 2010, including net revenue benefits of 688 million (raised from 481million before) and cost savings of 1,596 million (increased from 1,237 million initially). Furthermore, the acquisition is expected to lead to a 9% increase (revised from 7%) in earnings per share by 2010.

Overall credit metrics remain strong, with improvements in both UK personal and corporate impairments. At Citizens, impairment provisioning has stepped up to a more normal level, reflecting the impact of the

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weakening US real estate market in the second half on some elements of its portfolio. Total impairment losses in 2007 fell as a percentage of average loans and advances relative to 2006.

Reflecting its improving prospects, RBS increased its 2007 final dividend by 5% to 23.1p from 22.1p and raised its 2007 interim dividend by 25% to 10.1p. This follows annual increases of 25% to 30.2p in 2006 and of 25% to 24.2p in 2005.

BEAR STORY

Our chief concern about RBS rests in the acquisition of the ABN AMRO wholesale and international operations due to the potential for negative surprises. For example, revenue and cost synergy benefits could fall short of plan, with the result that expected improvements in ABN s cost:income ratio could be less than hoped for. ABN s loan portfolio could contain more problem loans and attendant write-offs than RBS had bargained for. These and other surprises could make the ABN acquisition less attractive than expected.

We are also concerned about slowing growth in the U.K. and its consequent impact on the economy, particularly the consumer and housing markets. Furthermore, high oil prices, slowing house-price inflation, record consumer debt, sinking retail sales, and rising unemployment are contributing to a more challenging economic environment in the months ahead. This could have a negative impact on lending volumes as well as asset quality. Moreover, the company continues to face net interest margin (NIM) pressure.

Furthermore, decelerating growth in the U.S. and other major world economies could have a major impact on market-related revenues, such as capital markets fees and commissions, trading revenues in investment banking, and performance-based fees in asset management. Furthermore, volatile trading results contribute a large proportion of earnings, which the market views less favorably than more stable sources of income. The weakening of the U.S. dollar is also hurting the income statement and balance sheet through the negative impact of foreign currency translation.

Finally, the turmoil in the US subprime and other credit markets should continue to take its toll on revenues and earnings. RBS posted 2007 write-downs of roughly ?1,163 million on its exposures to US subprime mortgage markets and leveraged finance portfolio. Though these write-downs were reflected in 2007 results for ABN AMRO, they did not affect the RBS s earnings, as they were dealt with as part of the acquisition accounting adjustments. The company announced an additional ?5.9 billion (?4.3 billion net of tax) of credit market write-downs in April 2008. We expect further write-downs going forward, though the timing and magnitude are not yet quantifiable. RBS s total credit market risk exposures at December 31, 2007 were ?28,798 million.

The recent ?12 billion rights issue significantly diluted existing shareholders interests. On the positive side, the additional equity will allow the company to restore capital ratios to stronger levels, with the new Tier 1 capital ratio target at 7.5-8.5% to be achieved by the end of 2008.

RECENT NEWS

RBS completed a ?12 billion rights offering in early June. Consequently, we are slashing our 2008 EPADS estimate to $0.30 from $1.35, and initiating our 2009 estimate at $0.80. In its first quarter trading update on June 11, 2008, management stated that operating performance of many of RBS s businesses remains good, though results have been held back by the effects of continuing deterioration in the credit markets. RBS also reiterated earlier guidance: ?5.9 billion in credit market write-downs, raising capital through the rights issue and sale of assets (including RBS Insurance), and issuing a stock dividend for the first interim dividend.

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On June 9, 2008, RBS announced that it had received acceptances for 5,823, 635,440 new ordinary shares, representing approximately 95.1% of the total number of new RBS ordinary shares offered to shareholders pursuant to the 11-for-18 rights issue announced by RBS on April 22, 2008. The remaining 299,375,022 new RBS ordinary shares were sold by a consortium investment banks.

On April 22, 2008, RBS announced a rights issue to raise ?12 billion to restore capital ratios, with its new target range for Tier 1 capital at 7.5-8.5%. RBS also announced credit market write-downs of roughly ?4.3 billion net of tax, or ?5.9 billion before tax. Asset sales, including RBS Insurance, should generate ?4 billion of capital this year, almost offsetting the write-downs. Taking all of these elements together, the company expects to generate ?11.7 billion of net new capital and to have achieved its new target capital ratios by the end of 2008. As to the dividend, the company hopes to maintain a 45% payout ratio and will issue a stock dividend for the interim dividend, with the final dividend to be paid in cash. The ?2.3 billion in ABN AMRO integration synergies are on schedule.

On April 22, 2008, Fitch Ratings cut Royal Bank of Scotland Group's long-term debt rating to AA from AA+, due to expected write-downs and a weaker earnings outlook for some of the group's businesses.

On February 28, 2008, RBS reported full-year results for the period ending December 31, 2007. For the full year, net earnings from continuing operations and before nonrecurring items were ?7.2 billion, up 8% year over year and modestly above our estimate due to a lower-than-expected tax rate. (ABN AMRO has been fully consolidated since its acquisition on October 17, 2007, with interests of Fortis and Santander reported as minority interests.) Strong growth in net interest income (up 20% to ?12.7 billion) more than offset higher staff costs and a 50% drop in trading income from weak credit markets. Operating expenses rose 17%, moderately above the rate of growth in net revenues. Combined, these factors led to a 220 basis-point, year-over-year deterioration in the cost:income ratio to 54.2% in 2007 from 52.0% in 2006, by our calculation.

Operationally, most segments reported gains in full-year 2007 results, led by Ulster Bank (pretax earnings up 22% year over year), Retail Markets (up 12%), and Corporate Markets (up 2%). Citizens pretax earnings fell 16% year over year due to negative foreign exchange movements and higher credit costs and RBS Insurance slumped 9% due to severe flooding in the UK that cost the company ?274 million (operating profit would have been up 28% without the flood costs). ABN AMRO posted pretax earnings of ?128 million.

Profitability ratios deteriorated. Post-tax return on equity (ROE) fell 140 basis points to 16.4% from 17.8% from the year-ago period, while return on assets (ROA) declined 21 basis points to 0.60% from 0.81%. Asset quality measures were generally stable in full-year 2007 as the corporate loan portfolio remained strong and the retail loan book showed modest improvement following the tightening of credit standards. Nonperforming loans to total loans was 1.55% at December 31, 2007 compared to 1.55% at December 31, 2006. Reserve coverage of nonperformers fell to 60% at December 31, 2007 from 62% at the end of December 2006. On a risk-adjusted basis, capital adequacy measures remained strong the Tier 1 ratio was 7.3% at the end of December 31, 2007, near the mid-point of management s target 7.0-8.0% range, and the Total capital ratio was 11.2%, at the low end of management s 11.0-12.0% target range.

On December 6, 2007, RBS released its third quarter trading update. RBS noted that it had continued to perform well in 2007, with operating profit and earnings per share expected to be well ahead of the market consensus forecast. Impairment losses were expected to be flat compared with 2006, with improvements in both UK personal and corporate impairments offset by deterioration at Citizens. The net interest margin was expected to be slightly lower in 2007, while good expense discipline was expected to result in a further improvement in the cost:income ratio in 2007.

On October 5, 2007, the RBS consortium (Royal Bank of Scotland PLC, Spain's Banco Santander Central Hispano S.A., and the Dutch-Belgian bank Fortis, N.V.) announced it had acquired 86% of outstanding ABN shares, and on October 10, announced the offer was unconditional, with the settlement of offers to occur on October 17. Following this, ABN CEO Rijkman Groenink tendered his resignation,

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