IntesaBCI. Passera s to do list BUY

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1 3 Se tember 2002 Equity Research IntesaBCI BIN.MI Passera s to do list New industrial plan to be presented on 9 September Short term: likely to give confidence to the market Long term: focus on revenues Valuation: upside potential even accounting for clean-up Industrial plan: New group CEO Passera is due to present the new industrial plan on 9 September, together with the group s first-half results. This will be his first appearance in front of the financial community. In this report, we discuss the industrial plan s likely messages and how they could affect the valuation of the group. Short-term to do list: We expect Mr Passera to tackle most of the issues that have concerned investors in the last few months: asset quality, Latam, the BCI put warrant and the capital structure. The conversion of savings shares and final outstanding gaps in the management team might not be addressed until a later date. Long-term to do list: The main strategic guidelines have already been indicated: an exit from Latin American banking, a reduction in international lending and a focus on domestic retail banking. In our view, the two key issues to consider are the costs of exiting and solving international banking issues and the way of bringing profitability into line with the group s best peers. We see valuation as compelling even after a potential 2.3bn potential clean-up: We reiterate our current fair valuation of 3.6 per share. We calculate that a clean-up process could erode up to 10% of the group s fair value (down to 3.2), still leaving fundamental upside potential of around 30%, on our estimates. Investment case: We believe half of the discount to our fair value could be closed by eliminating the short-term issues. The remaining upside potential would probably take more time to fulfil as investors are likely to demand a consistent improvement in quarterly results, which we do not expect until mid IntesaBCI is the largest bank in Italy, active across the whole range of financial services. research team Fabio Candeli, CFA fabio.candeli@csfb.com Investors should assume that CSFB is seeking or will seek investment banking or other business from the covered companies. Recommendation BUY Price (30 Aug 02) 2.50 (eu) Target price (12 months) 3.60 (eu) Market cap. (eu m) 16, Enterprise value (eu m) 16, Region/country European/Italy Sector Regional Banks Date 3 September Price/pricerelative Sep-00 Jan-01 May-01 Sep-01 Jan-02 May-02 Price Price relative The price relative chart measures performance against the eur_djeu index. On 30/08/02 the eur_djeu index closed at On 30/08/02 the spot exchange rate was eu1.02 /US$1.. Performance over 1mth 3mths 12mths Absolute (%) Relative (%) Year 12/00A 12/01A 12/02E 12/03E PCC Operating profit 3, , , ,245.4 Net income (eu m) 1, , ,810.7 EPS stated (eu) CSFB adj. EPS (eu) CSFB adj. BVPS (eu) CSFB adj. ROE (%) P/E (adj., x) P/E rel (%) P/BVPS (adj., x) Dividend 2002E (eu) Free float (%) Dividend yield (%) Number of shares (m) 2.9 5, CSFB adj. equity (12/02E, eu) Current cost of equity (12/02E, 16, Net int margin (12/02E, %) Tier 1 ratio (12/02E, %) Cost/income (12/02E, %) 52-wk range (eu) Source: FTI, Company data, Datastream, CSFB (EUROPE) LTD estimates

2 Table of contents Investment summary...3 Valuation...8 1) Asset quality ) Put warrant solution ) Savings shares debate ) Capital structure ) Management and communication...30 IntesaBCI s Business Plan presentation will be held on Monday, 9 September at 4pm CET in Via Romagnosi, 6 Milano. The presentation will be webcasted live through IntesaBCI s website under Investor Relations, home page. Banco de Investimentos Credit Suisse First Boston S.A. is acting as financial adviser to Banco Itau in relation to the potential acquisition of Banco Sudameris Brasil from IntesaBCI. 2

3 Investment summary On 9 September, Mr Passera is due to announce the main guidelines of IntesaBCI s new industrial plan. This will be the first time the new CEO, appointed in May, has addressed the financial community. The stock bounced on the back of the announcement of his appointment, outperforming the sector by 11% in a month. Since then, however, it has lost most of this ground, and is back to levels reached before Mr Passera joined IntesaBCI. Worries over Brazil, large corporates concerns, capital issues and the interest-rate environment have undermined the potential goodwill brought in by new management, in our view. Figure 1: IntesaBCI: One-year relative performance INTESA BCI 2/9/02 Worldcom, Vivendi Brazil Passera appointment S O N D J F M A M J J A PRICE PRICE REL. TO DJ STOXX BANK - PRICE INDEX HIGH /4/02, LOW /8/02, LAST /8/02 Source: DATASTREAM Source: Datastream, CSFB research We will try here to anticipate the industrial plan s messages, and discuss how they could affect the valuation of the group. Short-term versus longterm issues Passera s short-term to do list We believe Mr Passera has some short-term issues to tackle as soon as possible in order to calm likely investor concerns. Once these issues have been addressed, he will need to assuage investors longer-term concerns, which are much less visible and more difficult to assess. These mainly relate to the group s strategic positioning and revenue growth potential, something on which investors have not had the chance to focus until now. We believe that solving the short-term issues is within the new management team s reach, while achieving credibility on the delivery of a consistent level of earnings will take more time. Following in the footprints of Marc Rubinstein s research on Deutsche, Ackermann s to do list, dated 12 October 2001, we provide here what we think should appear in Mr Passera s short-term to do list: 1) Asset quality: resolving past issues; 3

4 2) Put warrant solution: what to do with 8% of the company; 3) Savings shares debate: to convert or not to convert; 4) Capital structure: active capital management is more than enough; 5) Management restructuring: the appointment of the final key management team member; and 6) Communication with the market: building a new relationship. We believe tackling this list should serve to calm recent market concerns, thereby allowing management to focus on longer-term targets. Furthermore, solving this list in combination with fully integrated risk management should help the company avoid making large losses as frequently as in the last few years. This could involve a second considerable kitchen sinking process as was seen in the fourth quarter of However, we believe paving the way for a positive progression in earnings delivery would be more beneficial than diluting the clean-up process over the next few quarters. Therefore, we would not be surprised to see high provisioning levels in the quarter. In this report, we analyse each of these issues in detail. What we leave out of the list We do not think Mr Passera will need to change current trends considerably on the costs side and Latin American (Latam) positioning, both of which issues have represented recent major concerns for investors. 1) Costs cutting on track: Despite investors perception, we believe the cost restructuring has been already partly achieved and is well on track to reach its target. Although group ratios could be misleading, Intesa on average showed betterthan-market improvements in most cost ratios in the last two years (see Figure 2). Figure 2: Large Italian banks: Cost ratio trends, %, unless otherwise stated IntesaBCI 1999A 2001A Change (*p.p.) Ranking Staff costs/total costs Cost income (ex-goodwill) Operating costs/ta UCI Staff costs/total costs Cost income (ex-goodwill) Operating costs/ta SPI Staff costs/total costs Cost income (ex-goodwill) Operating costs/ta Source: Company data, CSFB research 2) Exiting Latam operations: The previous management team had already said that Latam no longer constitutes a strategic focus for the group. We can divide Latam into two areas: Brazil and the rest. IntesaBCI is currently in negotiations to sell Sudameris Brazil to Banco Itau. (The first deadline for ending due diligence should be 10 September.) CSFB is advising Banco Itau, and we are currently restricted on 4

5 Sudameris Brazil. The rest of the exposure, mainly Argentina and Peru, investments already covered in 2001, should be sold whenever possible, in our view. More details are provided in the section on Asset quality. In both instances, we believe Mr Passera will need to communicate figures and timing and convince investors of the results achieved rather than change direction. Passera s longer-term to do list Apart from the short-term market concerns, the real issue for Mr Passera will be to start growing revenues in the domestic operations. This is a much less visible, more difficult to assess issue, in our view. Over the last couple of years, we believe investors have paid relatively little attention to the expected potential profitability of Intesa, focusing instead on shorter-term issues. In the future, we expect this attitude to change in favour of a more sustainable valuation of the IntesaBCI franchise. We believe the key long-term challenges for Intesa are as follows: 1) Delivery of strategic restructuring: In a recent interview, Mr Passera indicated his intention to exit Latam and reduce the international operations, with the aim being to focus entirely on the core business of domestic retail banking. Exiting these unprofitable businesses, where the group has neither critical mass nor competitive advantage, would represent a key step towards achieving stability of earnings. Looking at recent market concerns Argentina, Brazil, large corporates and the BCI put warrant almost none have related to the group s domestic operations. Only the loss of market share in mutual funds related to the Italian market. However, we believe most of these outflows did not really concern the core franchise, but related to institutional contracts and networks previously sold. In the year to date, IntesaBCI has lost 1.8bn of mutual funds, less than the 3.3bn and 2.0bn lost by Sanpaolo IMI and UniCredit, respectively. 2) Revenue growth: In our view, the main differences between IntesaBCI and its highest-quality peers relate neither to cost efficiency nor to provisioning needs. The key factor is revenue generation. We believe IntesaBCI has delivered low revenue growth for two key reasons: the lack of a commercial effort and sub-market pricing. From a commercial point of view, we believe the slow and painful integration process has undermined commercial initiatives and the sales force s morale. The new head of retail banking will have to tackle this as soon as possible to avoid losses in the franchise and a fall in the sales force s motivation, in our view. From a pricing point of view, IntesaBCI s historical strategy has involved discounting prices in order to keep customers over the long term, resulting in a loss of current revenues. We believe IntesaBCI needs increase its focus on short-term profitability as opposed to long-term volume growth. We will assess these issues in more detail in a follow-up report after the presentation. Reasons for being optimistic In our view, both the group s short- and long-terms targets are within reach. In particular, we see the following: Asset quality: With the credit cycle likely to have bottomed and the clean-up exercise carried out in the fourth quarter of 2001, Mr Passera should be in a position to solve past issues with some degree of serenity. A further kitchen sinking process, which 5

6 we are not completely ruling out, could destroy value by 10%, which we believe is more than discounted in the current price. Put warrant solution: The new corporate governance, which is increasing the weighting of top management versus the board, should help solve the risk of stock overhang in a quicker, more effective way than has been experienced in similar cases in the past. Savings shares debate: The conversion would bring two key advantages in terms of a simpler share structure and a cash inflow. Capital structure: We still do not believe the company needs a rights issue, even in a worst-case scenario involving a large clean-up process. Mr Passera has already stated this, but he will need to confirm it with some initiatives. Management restructuring: The appointment of the final key figure in the top management team has yet to come, but the names chosen so far have proved Mr Passera s ability to hire free from any pressure from the board or core shareholders, and we believe a high-profile person will join the team shortly. Delivery of strategic restructuring: Reducing non-core businesses such as international corporate lending and selling Latam assets should not undermine the core franchise, and in terms of valuation, these divisions are probably valued at less than zero in the current market cap. Revenue growth: We still believe that the franchise in Italy is safe (despite limited management of the franchise over the last few months) and that the group has the critical mass and geographical mix to turn it into a profitable entity in line with its highest-quality peers. Mr Passera s track record at the post office (particularly the banking subsidiary) represents a good start, in our view. Valuation IntesaBCI trades at 9.0 times our forecast 2003 adjusted earnings and 1.1 times forecast 2002 book value, representing a considerable discount to both the European (10.8 and 1.9, respectively) and the Italian (10.5 and 1.4, respectively) sectors. We reiterate our fair value of 3.6, offering 45% fundamental upside potential. In our sum-of-the-parts valuation based on a DCF and simplified EVA calculation, we factor in a higher growth in earnings than the sector between 2003 and 2005, but this is mostly based on cost improvement rather than higher revenue growth. We therefore believe the following: In a negative scenario, under which Mr Passera had to instigate a further clean-up process amounting to an estimated 2.3bn pre-tax write-off, the valuation would still be compelling. After tax, the impact would be only 6% of our fair value, lowering the potential upside from 45% to 35%. In a blue sky scenario, under which IntesaBCI generated higher revenue, we believe the stock would offer considerable further upside potential. The quality of the franchise, the business mix and geographical distribution should deliver sustainable profitability at least in line with the best domestic peers, in our view. (Our 2005 ROE estimate for UniCredit is 38% above our current estimate for IntesaBCI.) Ahead of the results, we would feel more comfortable taking into account a further 10% risk of value decrease from lower earnings expectations. As for the rest of the 6

7 Italian banking sector, we believe our estimates and those of the consensus are still too optimistic, as they do not fully take into account the lack of equity market recovery and expectations of further delays in interest rate rises. On this basis, we believe IntesaBCI offers an interesting valuation case, combined with a clear catalyst for outperformance in the short term. (We expect the new management team to roadshow the industrial plan in September.) Even in the kitchen sinking valuation, the considerable upside potential should allow a better absorption of the negative macro environment affecting Italian banks. IntesaBCI remains our top pick in the Italian banking sector (which we rate as neutral within the European banking sector). 7

8 Valuation Based on our sum-of-the-parts valuation, we value IntesaBCI at 3.6 per share. This values the stock at 1.6 times our forecast 2002 book value and 13.6 times forecast 2003 adjusted earnings. Our fair value represents potential fundamental upside of 45%. As for the to do list, we could split IntesaBCI s potential upside into two parts: in the short term, we would expect the stock to close part of the valuation discount caused by current likely investor concerns; and in the medium term, we would expect a rerating of the market fair multiples in relation to an improving track record of earnings and newsflow. Figure 3: IntesaBCI: Sum-of-the-parts valuation eu in millions, unless otherwise stated Value of asset management business Value of excess/deficit of capital Value of banking without excess capital Average FuM, 2003E 142,877 Optimal Tier 1 (%) 6.0 Net profit banking, 2003E 1,455 Net margin, 2003E (%) E fully diluted Tier 1 (%) 6.7 Average equity banking, 2003E 15,255 Net profit asset management, 2003E 286 ROE on excess equity (%) 4.4 ROE, 2003E (%) 9.5 Growth, (%) 5.0 Probability of capital optimisation (%) 100 Peak ROE, 2005E (%) 13.0 Growth post-2013 (%) 2.0 Reinvestment rate in banking (%) 5.5 Value asset management 2003E 4,707 Excess/deficit of capital 1,742 Value banking, 2003E 19,088 P/E, 2003E (x) 16.5 P/BV, 2003E (x) 1.00 P/E, 2003E (x) 13.1 P/average FuM 2003E (%) 3.3 P/BV, 2003E (x) 1.25 Source: Company data, CSFB estimates Figure 4: Italian banks: Summary sum-of-the-parts valuation eu in millions, unless otherwise stated Sum-of-the-parts valuation IntesaBCI UCI SPI MPS BNL BPVN Asset management 4,707 5,965 3,661 1,872 1,015 1,011 Excess/deficit of capital 1,742 3,860 1, (456) 1,173 Traditional banking 19,088 21,567 9,973 9,857 4,418 4,498 Total value, 2003E 25,537 31,392 15,002 12,332 4,977 6,682 Asset management (%) Excess/deficit of capital (%) (9) 18 Traditional banking (%) Total value, 2002E 23,712 29,566 14,269 11,636 4,537 6,316 Premium/discount (%) Adjustments 0 0 2,772 (2,027) 0 (632) Total value, 2002E (adjusted) 23,712 29,566 17,041 9,609 4,537 5,684 Target price, 2002E Current price Upside/downside (%) E P/E adj (target price, x) E P/BV (target price, x) E ROE adj (%) E ROE (%) Source: Company data, CSFB estimates 8

9 In Figure 5, we consider the likely impact of an extraordinary clean-up of the various concerns shown by investors. Details of the figures included are given in the various sections of the report. We also include a bold 1.0bn in generic provisions to take into account any hidden skeletons Mr Passera might uncover in his review of the group. The total value destruction (amounting to 2.3bn pre-tax) could account for 6% of our fair value after tax, bringing it down to 3.4 per share. This still represents 35% potential upside. Figure 5: IntesaBCI: Potential floor valuation accounting for various write-offs eu in millions, unless otherwise stated Pre-tax impact Post-tax impact Large corporate provisions (p. 16) Latam provisions (p. 17) Credit derivatives provisions (p. 20) Others ( hidden skeletons ) 1, Total 2,320 1,485 Fair value 23,672 23,672 Floor fair value 21,352 22,187 Value destruction (%) Floor fair value per share Potential upside (%) Source: Company data, CSFB estimates For this valuation sensitivity to be realistic, we must consider whether the group would be able to absorb the impact without needing to go to the market. The need for a rights issue would clearly dilute the valuation further. All the main details are included in the section Capital structure, of which a synthetic representation follows in Figure 6. Figure 6: IntesaBCI: Clean-up impact on Tier 1 ratio eu in millions, unless otherwise stated Tier 1 capital RWA T1 ratio (%) Core T1 ratio (%) YE 2001A 14, , Organic elements Retained earnings/organic growth 788-9,845 Goodwill amortisation Conversions and others YE 2002E pre one-off factors 15, , One-off factors Exercise of put warrant -1,338-9,513 Sale of Sudameris Brazil 300-3,900 Conversion of savings shares* Placement of treasury shares* YE 2002E pre-cleaning process 16, , Clean-up process after-tax Large corporate provisions Credit derivatives provisions Latam provisions Others ( hidden skeletons ) YE 2002E post-cleaning process 14, , * Although included here, both these initiatives are more likely to happen in Source: Company data, CSFB estimates 9

10 Figure 7: Italian banks: Multiples Reuters Price Shares Mkt cap EPS st. (eu) BVPS st. (eu) ticker (eu) (m) (eu m) 01A 02E 03E 04E 01A 02E IntesaBCI (mkt cap) BIN.MI ,849 16, UniCredit CRDI.MI ,288 24, Sanpaolo IMI SPI.MI ,836 15, Monte Paschi Siena BMPS.MI ,599 7, BNL BANI.MI ,147 3, B.Pop.Verona Novara PVR.MI , Fideuram FIBK.MI , Rec ROE st. (%) P/E st. (x) P/BV st. (x) 01A 02E 03E 01A 02E 03E 04E 01A 02E IntesaBCI (mkt cap) Buy UniCredit Hold Sanpaolo IMI Hold Monte Paschi Siena Buy BNL Buy B.Pop.Verona Novara Buy Weighted average Fideuram Hold DPS (eu) Yield (%) EPS adj. (eu) BVPS adj. (eu) 02A 03E 02A 03E 01A 02E 03E 04E 01A 02E IntesaBCI (mkt cap) UniCredit Sanpaolo IMI Monte Paschi Siena BNL B.Pop.Verona Novara Fideuram Tier 1 (%) ROE adj. (%) P/E adj. (x) P/BV adj. (x) 02E 01A 02E 03E 01A 02E 03E 04E 01A 02E IntesaBCI (mkt cap) UniCredit Sanpaolo IMI Monte Paschi Siena BNL B.Pop.Verona Novara Weighted average Fideuram n/m Source: Company data, CSFB estimates 10

11 Figure 8: European banks Summary valuations eu, unless otherwise stated Priced at 30/08/2002 Fair Stated EPS P/E stated (x) P/BV (x) ROE (%) P/E adj. (x) P/NAV (x) RONAV (%) Yield (%) Rel DJ Banks (%) Bank Rec Price value 2002E 2003E 2002E 2003E 2002E 2002E 2002E 2003E 2002E 2002E 2002E 1W 1M Benelux ABN Amro B France BNP Paribas B Credit Lyonnais H Soc Gen B Germany Deutsche H HVB H Ireland AIB H Bk Ireland B Italy B.P.Verona Novara B Banca Fideuram H BNL B IntesaBCI (ord) B MPS B San Paolo-IMI H UniCredito H UK A&L H Abbey National H Barclays B Bradford & Bingley H HBOS B HSBC H Lloyds TSB B Northern Rock B Royal Bk of Scot B Stnd Chart B Portugal BCP H BES H BPI H Scandinavia Danske H DNB B Handelsbanken H Nordea R SEB H Swedbank H Spain Banco Popular B Bankinter H BBVA H SAN (BSCH) B Switzerland UBS H Euro Universe average Retail banks Corporate banks Multinational banks Specialty finance Source: Company data, CSFB estimates 11

12 1) Asset quality We believe investors are concerned about IntesaBCI s asset quality on three different grounds: 1) higher domestic NPLs than its peers; 2) international large corporate lending; and 3) emerging-market exposure. Investors have also been sceptical about the reasons for and the size of IntesaBCI s exposure to the credit derivatives markets. Overall, we believe the main causes of the lower asset quality are now under control. The almost completed integration of risk control systems should eliminate further large losses. We think Mr Passera should indicate the potential cost of exiting the Latam operations, state how much is needed to bring the coverage on international lending to acceptable levels, and provide the market with a timeframe for all this. Finally, the company s disclosure should move towards total counterparty exposure rather than simply loans, in line with the best of its European peers, in our view. IntesaBCI shows a higher level of gross NPLs than its two main peers: at 7.1% of gross loans versus 3.3% on average for UniCredit and Sanpaolo IMI, and similar specific coverage (63%). Although there is no official breakdown of asset quality by region or client, we believe domestic asset quality remains the biggest cause of difference versus its peers, followed by international large corporates and Latin American subsidiaries. Figure 9: Italian banks: An asset quality comparison eu in millions, unless otherwise stated IntesaBCI UniCredit SPI MPS BNL Capitalia BPVN Total Gross NPLs 13,124 4,350 4,236 1,695 3,739 9, ,144 Watch list 4,515 2,185 1,618 1,212 1,350 3, ,698 Restructured 1, ,783 Total gross problem loans 19,317 6,867 6,183 2,959 5,258 14,421 1,594 58,625 Write-downs on NPLs 8,218 2,570 2, ,491 4, ,935 Provisions for credit risks General write-downs on good loans 1, ,221 Total provisions for NPLs 9,603 3,657 3,804 1,393 1,755 4, ,052 Write-downs on watch list ,373 Write-downs on restructured Total provisions 10,814 4,244 4,305 1,660 2,208 5, ,134 Ratios (%) Coverage ratio NPLs (specific only) Coverage ratio good loans Coverage ratio NPLs Coverage ratio watchlist Coverage ratio restructured Coverage ratio total problem loans Gross NPLs/total loans Gross total problem loans/total loans Net NPLs/total loans Net NPLs/fully diluted total equity Net total pr. loans/f.d. total equity Note: The total also includes figures from B. Pop. Bergamo and B. Pop. Milano. Source: Company data, CSFB estimates 12

13 Domestic loans Of the various reasons for lower domestic asset quality, a key one to highlight is the non-performing loans of Carime, the southern Italian subsidiary sold in December 2000 to BPCI. As Intesa runs on a bad loan company system, all Carime s NPLs were transferred to Intesa Gestione Crediti prior to sale, and so remained within the group. Moreover, for most commercial and retail mortgages, the life of NPLs in banks books is much longer in Italy than the rest of Europe. In Italy, banks on average take seven to nine years before getting the money back or writing off the loan. This compares with a two- to four-year average in Europe. The difference is mostly related to the long timing of court decisions and the excessive protection of debtors in Italian legislation. The vast majority of IntesaBCI s bad loans (including those of Carime) originated in the mid- 1990s, when NPLs for both Intesa and BCI were growing at double-digit rates (around 15% in ). We believe IntesaBCI will continue to see a decrease in old domestic NPLs over the next few years. Figure 10: Italian NPLs: Yearly and monthly growth rate % Figure 11: Italian NPLs: Absolute value eu in billions 40% % 20% 7-9years % 0% Large securitisations -10% -20% -30% Jan-93 Apr-93 Jul-93 Oct-93 Jan-94 Apr-94 Jul-94 Oct-94 Jan-95 Apr-95 Jul-95 Oct-95 Jan-96 Apr-96 Jul-96 Oct-96 Jan-97 Apr-97 Jul-97 Oct-97 Jan-98 Apr-98 Jul-98 Oct-98 Change YoY (%) Change QoQ (%) Source: Banca d Italia, CSFB research Intesa has a similar geographical distribution to UniCredit Jan-99 Apr-99 Jul-99 Oct-99 Jan-00 Apr-00 Jul-00 Oct-00 Jan-01 Apr-01 Jul-01 Oct-01 Jan-02 Apr Dec-91 Apr-92 Aug-92 Dec-92 Apr-93 Aug-93 Dec-93 Apr-94 Aug-94 Dec-94 Apr-95 Aug-95 Dec-95 Apr-96 Aug-96 Dec-96 Apr-97 Source: Banca d Italia, CSFB research NPLs ( bn) Aug-97 Dec-97 Apr-98 Aug-98 Dec-98 Apr-99 Aug-99 Dec-99 Apr-00 Aug-00 Dec-00 Apr-01 Aug-01 Dec-01 Apr-02 Gauging the quality of an Italian bank s loan book is a difficult task. However, we believe two main macro differentiating factors can help us achieve this: 1) geography (the more northern the better); and 2) business segment (the more retail mortgages and large corporates the better). In terms of geography, the main differentiating factor is clearly related to the two macro areas, north versus south, where gross NPLs are 3.5% and 15.7% of loans, respectively (2001A). Following the sale of Carime, IntesaBCI has a very similar geographical exposure to UniCredit, with northern regions accounting for 69% of branches versus 74% at UniCredit. In contrast, following the acquisition of B.Napoli, Sanpaolo IMI has considerably increased its exposure to southern regions, now at 31% of total branches versus 7% and 5% for IntesaBCI and UniCredit, respectively. 13

14 Figure 12: Italian banks: Branch distribution Italy IntesaBCI UniCredit SPI-Cardine No. %oftot. No. % Mkt share (%) No. % Mkt share (%) No. % Mkt share (%) North-west 9, , o/w Lombardy 5, North-east 7, , Centre 5, South and Islands 6, Total 29,245 3, , , Source: Banca d Italia, company data Moreover, almost half IntesaBCI s domestic lending exposure is to Lombardy, one of the richest areas in Europe, with a gross NPL ratio of only 3.7%. Lending exposure to the centre and the south is now 26%, in line with 23% at UniCredit. Figure 13: Italian banks: Loans distribution and NPL ratios by macro area % Loan NPL adj. Italy Loan distribution distribution distribution NPLs/loans Intesa UniCredit Sanpaolo North-west n/a o/w Lombardy n/a North-east n/a Centre n/a South and Islands n/a Total 6.3 Source: Banca d Italia, company data In terms of business segment, retail mortgages and large corporates are normally considered less risky and therefore require lower provisioning across the cycle than small and medium-sized corporates loans. Once again, figures here are quite scattered, but we believe the exposure to the risky segments is lower for Intesa than its two peers, as shown in Figure 19. International large corporates During 2001 and mid-2002, IntesaBCI was caught in almost all the main bankruptcies in both the US and Europe. Of itself, this did not make IntesaBCI look much worse than other global wholesale banks, such as Chase, Citicorp, Deutsche and BNP Paribas. The only difference was that IntesaBCI was not perceived as a global wholesale bank: investors apparently reacted with surprise at its exposure, having considered it mostly a regional retail bank. We think it is fair to say that IntesaBCI hardly has enough critical mass, franchise and probably interest to play the global corporate bank. This large exposure to global corporates may well result from the two-ceo structure of Mr Benassi, in charge of International and CIB divisions, was exclusively interested in expanding in those areas, including large corporate lending. During those two years, Intesa s balance sheet grew at a CAGR of 20% (by 55bn) versus 13% for the domestic sector. We believe some of the difference was related to international lending expansion. 14

15 As previously mentioned, Mr Passera has already indicated his intention to decrease the large corporate lending business. In September, he will need to provide investors with enough figures about exposure and risks in order to assess further provisioning needs, in our view. We try now to estimate the potential impact of a clean-up process. In April, Intesa disclosed part of its international loan portfolio broken down by ratings. This segment comprises 200 large clients, representing a total 26bn of loans, or the vast majority of Intesa s total exposure, which we estimate to be just around 30bn (or 17% of the book). Figure 14: IntesaBCI: Loan breakdown by rating, 2001 Figure 15: IntesaBCI: Loan breakdown by geography, 2001 Non investm. grade 5% Unrated 14% America others 2% Asia - Australia 3% UE 44% Lower investm. grade 26% Upper investm. grade 55% US 44% Europe others 7% Source: Company data Source: Company data We assume that half of the non-investment grade and one-fifth of the unrated loans could become non-performing, and that the company would take a 50% cut in them. We believe these assumptions have to be considered bearish (although not necessarily a worst-case scenario), based on the following observations: According to most recent research, the peak in large corporate bankruptcies was reached in the first half of 2002 and the picture is likely to improve. Loans to unrated companies are normally supported by a higher level of collaterals than loans to rated companies. Banks normally require more guarantees from companies that fall into non-investment grade categories (as we believe happened with most of IntesaBCI s 5% exposure). Based on the above assumptions, IntesaBCI could write off 0.7bn, or 2.7% of its international loan portfolio. This would represent less than 5% of the group s 2001 Tier 1 capital. In Figure 16, we also include a B scenario, in which we assume that all the noninvestment grade and one-third of the non-rated loans become non-performing. In this case, IntesaBCI would write off 1.25bn, or 5% of its international large corporate book. 15

16 Figure 16: IntesaBCI: Kitchen sinking analysis on international large corporate loans eu in billions, unless otherwise stated eu bn % Case A Case B Upper investm. Grade Lower investm. Grade Non investm. Grade Unrated Total int. large corporate loans Coverage at 50% % of 2001A ILC loans % of 2001A total loans % of 2002E pre-tax profit % of 2001A tier 1 capital Case A: 50% of non-investment grade and 20% of non-rated loans to become NPLs, 50% covered. Case B: 100% of non-investment grade and 33% of non-rated loans to become NPLs, 50% covered. Source: Company data, CSFB estimates As international large corporate lending represents just 15 17% of IntesaBCI s total loan book, the write-off would only represent 0.4% of group loans. Clearly, making the same assumptions for some European wholesale banks would give a different picture. Deutsche Bank, in particular, would look particularly penalised by such a scenario in which around 5% of total loans would be written off. Figure 17: European banks: Sensitivity analysis on wholesale loan book eu in millions, unless otherwise stated UBS Deutsche ABN Amro % Case A Case B % Case A Case B % Case A Case B Investment grade Non-investment grade Unrated Total wholesale loans Coverage at 50% % of wholesale loans % of total loans % of 2001 tier 1 capital Source: Company data, CSFB estimates Emerging markets Emerging-market exposure for the group is highlighted in Figure 18. Excluding Brazil, it now accounts for around 6% of loans and 8% of revenues. Argentinian exposure has been covered during 2001 in terms of 100% of equity and subordinated loans, 100% of intragroup loans and 40% of cross-border loans. Equally, the company covered total equity in Peru, which is not running into the same systemic problems but is characterised by a high level of non-performing loans and a difficult overall operating environment. As in the previous instances, we attempt to calculate a clean-up process on top of what the company has already done. We assume IntesaBCI raises the coverage on non- 16

17 performing Latam loans from the current 42% to 70%. A further 330m of provisions would be needed the same amount that has already been indicated by the company as the minimum capital gain expected from the sale of Sudameris Brazil. 17

18 18 Figure 18: IntesaBCI: Summary financials of International operations eu in millions, unless otherwise stated Argentina Peru Sudameris (ex-br) Hungary Croatia Slovakia Total international Brazil 2001A 2000A 2001A 2000A 2001A 2000A 2001A 2000A 2001A 2000A 2001A 2000A 2001A 2000A 2001A 2000A Total revenues ,031 1, Operating costs n/d n/d n/d n/d n/d n/d n/d n/d Operating income n/d n/d n/d n/d n/d n/d n/d n/d Goodwill amortisation n/d n/d n/d n/d n/d n/d n/d n/d Total operating costs , Operating income Ordinary income Net income Customer loans 1,211 1,339 2,430 2,427 6,098 5,937 1,832 1,411 1,797 1, ,677 9,410 3,765 3,659 Customer deposits 1,327 1,895 3,120 2,914 7,134 7,245 1,768 1,333 3,241 2,287 3,360 2,857 15,503 13,722 3,261 4,275 Total assets 2,001 2,580 4,452 4,767 10,429 11,247 2,691 2,196 4,296 3,115 4,089 3,748 21,505 20,306 8,808 8,165 Shareholders equity (1) n/a n/a n/a n/a Ratios (%) Customer spread n/d n/d n/d n/d n/d 4.62 n/d n/d n/d n/d Total spread n/d n/d n/d n/d n/d 3.25 n/d n/d n/d n/d Cost/income (ex goodwill) n/d n/d n/d n/d n/d n/d n/d n/d Cost/income ROE n/a n/a n/a n/a Asset quality Gross NPLs Net NPLs % coverage Gross: NPLs/loans (%) Net: NPLs/loans (%) Employees 1,309 1,384 2,198 2,457 4,847 5,215 1, ,622 3,790 5,393 5,809 15,029 15,794 6,303 6,554 Branches Market shares - Loans (%) Ranking n/d n/d n/d 12 - Deposits (%) Ranking n/d n/d n/d 8 Source: Company data, CSFB estimates IntesaBCI 3 September 2002

19 Over-the-cycle provisioning needs We now look at the total loan portfolio to take into account the different business mix. We hit each segment of the loan book with a different loan-loss rate to take into account the various risk profiles. Based on this analysis, we believe that over the cycle IntesaBCI should provide far less than the last three years average provision of 1.0% of loans and not more than UniCredit. This is because IntesaBCI has a lower weighting than UniCredit in SMEs and mid-corporate segments. As a result, it requires a similar blended provisioning rate. The expected change in focus out of large corporates would in this case be more than compensated for by the likely exit from emerging markets. Figure 19: IntesaBCI and UniCredit: Blended loan loss rate based on business mix, 2002E eu in millions, unless otherwise stated BIN %oftot. UCI %oftot. PLL Families o/w Mortgages o/w Consumer lending Family-run business Mid corporates Total domestic (ex-large corp.) Large corporates (total) International branches & others Emerging markets Total Blended PLL (%) Average PLL, E (%) Difference (%) Source: Company data, CSFB estimates This leaves considerable potential for upside versus our estimates. We still factor in average provisions of 0.76% of loans in the next three years, which we believe could be overly pessimistic. A better disclosure of the group s asset mix and expected changes in the new industrial plan could help this to flow into market estimates. Credit derivatives IntesaBCI was probably the largest foreign player on the US credit derivatives market in 2001, with a total notional amount of 85bn. With a small team, the group has been highly profitable over the last five years ( ), accounting for almost 400m of total profitability. Considering the small size of team and the positive results, top management probably underestimated the potential risks involved in this business during the last few years. Since 2001, management, under the Head of Risk Control, Mr Conti, assessed the operations completely within the more comprehensive project on risk control. The sound quality of the credit derivatives portfolio was then confirmed by independent analysis. 19

20 Figure 20: IntesaBCI: Credit derivatives portfolio (notional amount 85bn, duration 2.5 years) Open positions Supersenior 11% Other open positions 11% o/w 94% Investment grade 57% expiring by YE 2003 Protection bought 10% Fully hedged 68% Source: Company data As of the end of 2001, the open positions amounted to 9.6bn, of which 94% has investment grade counterparts, the rest being non-rated (4%) or non-investment grade (2%). Assuming that half of these latter two could be lost if more credit events were to happen, this would represent a potential write-off of around 300m, or 2% of the market cap and 2% of 2001 Tier 1 capital. 20

21 2) Put warrant solution We believe investors have consistently worried about the put warrant, as this represents: 1) a considerable destroyer of value; 2) a reason for capital concerns; and 3) a risk of stock overhang. Although there is little we can say about the evident value destruction (the strike price is some 130% above the market price, resulting in absolute destruction potential of 1.4bn), we will try to tackle the other two issues. We believe Mr Passera s main objective in September will be to convince investors that the buyback will not result in a stock overhang. Origins of the put warrant The put warrant was created in 1998 in combination with the first bid for BCI. As part of the agreement, Intesa was to accept only 70% of the BCI shares in order to leave enough free float to have BCI shares traded on the stock market. Intesa received 88% of BCI shares, and for the surplus 18%, it gave back the shares plus a warrant for each. The put warrants allowed investors to sell back the shares to Intesa in November 2003 at 7.8 per BCI share. In 2000, IntesaBCI bought out the 30% of minority shares still trading and the put warrant was transferred from BCI to IntesaBCI shares at the same merger ratio (1.45 Intesa shares for each BCI share). As a result, in November 2002, the group is due to buy back 479m shares (or 350m put warrants times 1.45) at a strike price of 5.38 (or 7.8/1.45), unless the stock price is above that level. Figure 21: IntesaBCI: Put warrant details eu, unless otherwise stated Number of warrants (m) Strike price per warrant 7.8 Expiry date 1 15 Nov 2002 Exchange ratio (IntesaBCI shares per BCI share) 1.45 No. of IntesaBCI share equivalent (m) 479 % of ordinary shares 8.1 % of total shares 7.0 Strike price per share 5.38 Difference from current (%) 132 Source: Company data Impact on capital ratios We believe the net impact of the exercising of the put warrant should be a fall of 0.40% in the Tier 1 ratio (at current market prices) since March Although significant, the impact is probably less substantial than investors might have been expecting. In order to assess the impact on the solvency ratio, we need to consider three different elements: 1) RWA; 2) cash outflow; and 3) fiscal benefits. In a counter-intuitive manner, the lower IntesaBCI s stock price in November, the lower the impact on the Tier 1 ratio. The sole reason for this behaviour is linked to the fiscal impact of a realised loss. Below, we detail the impact, starting from the latest actual figures as of March 2002 and assuming that IntesaBCI s stock price at expiration will be the same as the current one. 21

22 RWA (+0.20%): The put warrant is included in the RWA within the market risks. As of March 2002, the put absorbed 715m of capital. As a result, it accounts for some 8.9bn of RWA (capital absorbed divided by the required 8%). With the exercising of the put in November, the positive impact on the Tier 1 ratio from lower RWA should be around 0.20%. Cash outflow (-0.66%): The total investments to cover the exercising of the put will be 2.57bn, or 5.38 times the 479m IntesaBCI share equivalents. However, the company has marked to market the put warrant on a quarterly basis. As of March 2002, total provisions amounted to 975m, leaving the remaining investment at 1.6bn, representing a 0.66% hit on the Tier 1 ratio. This outcome is fixed whatever IntesaBCI s price (unless it goes above the strike price of 5.4). Fiscal benefit (+0.07%): The third crucial element is the taxes saved according to the sizeoftherealisedloss.thedifferencebetweenthestrikepriceoftheputandthe market price will represent a deductible loss in November. As the provisions have already enjoyed fiscal advantages, we only have to consider the fiscal benefit on the remaining provisions to be made up to November. Assuming the share price stays constant at current levels, the remaining provisions of 400m would account for a further fiscal advantage of 150m, or 0.07% of the Tier 1 ratio. Full details of the impact on the Tier 1 ratio can be found in Figure 27. Figure 22: IntesaBCI: Put warrant investment eu in millions, unless otherwise stated Since inception Formula Comment 1 Total investment exercise 2, strike price per share times 479m shares 2 Value of buyback 1, market price per share times 479m shares 3 Total value destruction 1, Equivalent to final market cap of warrant 4 Fiscal benefits 479 3x36% 5 Total after-tax investment 2, Since March Existing provisions 974 A 7 Remaining provisions Mark to market of put existing provisions 8 Remaining tax benefits 146 7x36% Provisions taxed at 36% 9 Remaining investment pre-tax 1, % of T1 ratio 10 Remaining investment after-tax 1, % of T1 ratio Source: Company data This counterintuitive impact on the Tier 1 ratio (the lower the stock price, the better the ratio) is only valid if the shares are cancelled or kept on the books. Clearly, should the company place the shares bought back, the higher the stock price, the better the ratio (as it would generate a higher cash inflow). Moreover, the fiscal benefit would be reversed, as a higher IntesaBCI price versus November would account for a capital gains tax. As shown below, the likelihood of cancelling shares or keeping them on the books is very low. As a result, we believe investors should not perceive the fiscal benefit as an incentive to keep the stock price low until November. 22