M&A Pair Trading. BSIC Markets Team. The Italian Popolari banks case. March 2015

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1 BSIC Markets Team March M&A Pair Trading The Italian Popolari banks case Consolidation is one of the top agenda items for the banks management teams in this year. In fact, lower-for-longer interest rates and sluggish growth undermine the profitability of the sector, creating more pressure for mid-sized Popolari banks to consolidate. The current market conditions imply that having a relatively small size does not allow banks to deliver returns because of the profitability pressure and the raising of regulatory cost. On this basis, we think that changes in the distribution model are needed and economies of scale will play an increasing important role. The ECB/EBA comprehensive assessment (AQR) has been seen as a potential catalyst for the industry and for the consolidation in Europe as it was expected to put pressure on the weaker institution in terms of asset quality. In addition, it actually provides free due diligence on the loan book of banks (given the fact that the methods of classification of the banking loans are very unclear to analyse from an external point of view) and thus saving a lot of money (and risk) in choosing the right target. While it clearly kick started a process headed in this direction, we think that it did not provide a sufficient near term catalyst because several banks considered borderline (i.e. Banco Popolare) comfortably passed the stress test. We believe instead that the conclusion of the catalyst for the Popolari will be found in the change of governance. Indeed, the government approved an emergency decree scrapping the one-voteper-investor rule that gives shareholders equal voting rights regardless of the size of their stake. The decree affects Italy's 10 biggest Popolari banks. On the other hand, recent rumours have been speculating about the willingness of the Italian Popolari banks of their stakes in Icbpi, which seems to be valued no less than 2.5bn (meaning about 2% more on Core Tier 1 ratios on average). This would lead to a wave of incoming fresh cash-flows increasing even more the probability of a banking consolidation, given the fact that bank loans demand is lacking (TLTRO funds take up was lower than expected in both rounds). We restate the educational purpose of this work. To contact the authors of this analysis, please write to: as.investmentclub@unibocconi.it

2 MARKET SHARE ANALYSIS Before speculating on possible M&A transactions, we have gathered the single market shares of each Italian bank (we approximated the market shares by counting the number of commercial branches present in each region) in order to have an overview of the Italian banking industry and, after, look for the highest obtainable synergies through various combinations. On the back of having two very large players (Intesa and Unicredit), the concentration ratio appears similar to the large European markets. Yet, if we consider the same analysis for the top six banks the conclusion are significantly different and it is clear that the Italian market is excessively fragmented. This fragmentation emerge as the lack of a third national champion, beside the presence of a very large number of banks in the low-single-digit market share. The Italian market is characterised by two big banks (Intesa and Unicredit) that have a presence in all the territory and a market share of about 13% in the country. The other players in the industry are all below 8% market share focused on a regional presence. In fact, the third player is MPS (7.5% market share) that has a strong presence in the centre of the country with a 20% market share in Tuscany. The fourth and the fifth players are Banco Popolare (6.0%) and UBI (5.5%) with a high concentration in the north of the country. Then we have BPER (4.1%) that focuses on the south and especially in Sardinia where it has more than 50% market share in the region. There is also a small presence of foreign players, such as BNP Paribas with BNL and Credit Agricole, which control more or less 6% of the market with a strong presence in the north of the country. The other players are all small banks (less than 3% market share in Italy) that are regional champions, we can mention in this category Carige (30% market share in Liguria) and BPM (8% market share in Lombardy). 2

3 The Italian banks experience in delivering cost synergies has been mostly positive in the previous consolidation wave. We still believe that a 10% cost synergies is achievable on the back of better IT platforms and the ability to move a larger part of the customer base online with less need of a physical/branch network presence relative to the past. Hence, we believe that Popolari banks will be the focus of the consolidation in the next years due to the fragmented nature and limited geographical overlapping which will not bring antitrust issues and it is particularly important to reduce the number of branches. Moving onto the best possible M&A combinations, we opted for creating the third largest conglomerate of banks capable of competing with the Top 2 and maximizing the amount of synergies and economies of scale. Hence, the best candidates would be a merger between Banco Popolare and Banca Popolare dell Emilia Romagna or, alternatively, UBI Banca and Banca Popolare dell Emilia Romagna given their relatively larger dimensions and complementary market shares. As both BP and BPER would consolidate their position in the Centre-South regions of Italy. However, we need also to clear our mind regarding who of these 3 will act as the aggregator bank in order to elaborate a trading strategy. 3

4 FINANCIAL ANALYSIS Moving to a different point of view, another key element of the due diligence process to consider, in order to select the appropriate candidates, is the quality of the existing loan book. Indeed, when analyzing the potential targets, the acquirer needs to evaluate the amount of bad loans he is going to take on in order to not dilute excessively its own loan book after the acquisition. In the chart below, we have gathered, from the latest published financial results, the key ratios for the largest quoted banks in order to obtain a quick overview of the differences. Non-performing loans, Watchlist loans, Restructured loans and Past Due loans are the different stages of a loan when a customer is perceived to probably not repaying partly or entirely the loan. The sum of these 4 categories is called Impared loans. On the other hand, the Coverage ratio is the ratio between the amount of reserve, which the bank has already put aside given the expected loss, and the Gross amount of the loan. In addition, a ratio between Impared loans and Total loans has been calculated in order to provide a good insight of the quality of the only gross asset side. Here, we can immediately notice the large differences among the banks: from a rigorous Credem with only 6.79% of impared loans on total loans to the disastrous Banca Monte dei Paschi di Siena of 37.87% level. Hence, under the point of view of the quality of the loan book Credem seems to be a very valid candidate, but unfortunately not large enough to be considered. Regarding the 3 candidates selected above, BPE and BP enjoy pretty high Coverage ratio, however they also have on their book the highest percentage of Impared Loans (after BMPS) which make them less attractive. Conversely, UBI enjoys a really low percentage of Impared loans on its loan book, allowing sufficient margin to take on additional bad loans without putting in jeopardy the solvency of the banking group. 4

5 On the other hand, we need also to evaluate who has the financial possibility to act as a pole aggregator acquiring other banks assets. We proceeded making the following assumption. The Popolari Banks are characterized by the fact that voting power counts per head and not by the number of shares one owns. Hence, this makes the shareholders structure, even after the transformation law into normal banks, very fragmented with the majority of the shares still owned by the employees (this is because professional investors were not interested in increasing their investments since it has no change on their voting power). As a consequence, we think that a paper acquisition through stocks is highly unlikely because it would lead to an onerous and long process of acceptance. Thus, we opt for an acquisition made in cash through a public tender offer as the solution with the highest probability to happen (as Banca Popolare di Vicenza attempted to buy Banca Popolare dell Etruria e del Lazio almost one year ago). This lead us to evaluate who has the most excess capital available on their balance sheet in relation to the minimum requirements set by the ECB (with the assumption that no one will proceed with another round of capital increases to finance the acquisitions). So, we opted for the Core Tier 1 Basel III Fully Phased as the best indicator of relative excess capital as shown below. Here, we notice that Banco Popolare, UBI Banca, Banca Popolare di Milano, Credito Emiliano and Credito Valtellinese enjoy pretty good relative excess capital available. However, when combining this with their absolute dimensions, the possible candidates reduce to Banco Popolare and UBI Banca as the others are relatively small regional banks. 5

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7 CONCLUSION AND TRADING STRATEGY To sum up, combining the financial standpoint with the earlier market share analysis, we conclude that the best synergies and economies of scale would be obtained through an M&A between UBI Banca and Banca Popolare dell Emilia Romagna. In particular, we believe that the former one will act as aggregator creating the third largest bank in Italy capable of competing with the big 2 Unicredit and Intesa San Paolo. Furthermore, this will allow UBI to finally dominate its long dated rival Banco Popolare in almost every region. Today, UBI is trading at P/B, while BPE is trading at P/B. From these market prices, we can already notice that the market is pricing BPE as a potential M&A target given its worse valuation with respect to UBI. Nevertheless, we believe that, given these valuations and the assumption of an acquisition made through a public tender offer, there is still margin for an M&A arbitrage trade: long BPE and short UBI. 7

8 DISCLAIMER All the views expressed are opinions of Bocconi Students Investment Club members and can in no way be associated with Bocconi University. All the financial recommendations offered are for educational purposes only. Bocconi Students Investment Club declines any responsibility for eventual losses you may incur implementing all or part of the ideas contained in this website. The Bocconi Students Investment Club is not authorised to give investment advice. Information, opinions and estimates contained in this report reflect a judgment at its original date of publication by Bocconi Students Investment Club and are subject to change without notice. The price, value of and income from any of the securities or financial instruments mentioned in this report can fall as well as rise. Bocconi Students Investment Club does not receive compensation and has no business relationship with any mentioned company. Copyright March-15 BSIC Bocconi Students Investment Club 8