Intesa Sanpaolo : Neutral credit impact of the Veneto banks acquisition; ‘Buy’ recommendation maintained on AT1, lowered to ‘Neutral’ on Tier 2

The acquisition of certain assets and liabilities of Veneto Banca and Banca Popolare di Vicenza (VB/BPVi) is a small-sized and strategically relevant deal, concluded at very conditions, and thus without substantial impact on Intesa Sanpaolo (IntesaSP)’s credit profile. The decree ruling the transaction must be approved by the Italian Parliament by the end of the summer. - Despite a complex operating environment in Italy (fragile political situation, low economic growth, high NPL volumes) which accounts for 85% of IntesaSP's loan book, the group has reported a resilient performance and maintained solid solvency ratios and good liquidity. Asset quality is still weak by international standards but is expected to improve if economic forecasts envisaging a speed up in the GDP growth materialise, and owing to a plan to reduce NPLs put in place by the bank. - We keep our ‘Buy’ recommendation on the AT1 securities that still offer an attractive risk/return, supported by wide distances to coupon omission/loss-absorption triggers. We lower our recommendation on Tier 2 securities to 'Neutral' because of their strong performance since the beginning of the year (in line with the debt class) and as they now price at levels which we do not so see as attractive any longer, especially relative to the risks carried by the debt segment as the Banco Popular events reminded. The position of the senior bondholders (and in particular on retail bonds) appears much more comfortable to us and underpins the revision of our recommendation to ‘Buy’ from ‘Neutral’ on the senior benchmarks. - >Support Factors - - The group enjoys a strong and diversified franchise in Italy, with leading positions in retail banking (strengthened by the VB/BPVi deal), and strong positions in asset management, insurance and private banking and CIB. These provide the group with resilient revenues and the ability to attract business volumes, among other customer savings.- The significant proportion of fees and commissions in the income mix is positive in an adverse interest rate environment, resulting in pressure on the sector's interest margins. Group's profitability is supported by a stringent cost control (cost/income ratio or around 50%).- IntesaSP has solid capital ratios, both under weighted (fully loaded CET1 ratio of 12.9% at end-march 2017) and and unweighted measures (fully loaded leverage ratio of 6.1%). The distance between the CET1 ratio and the SREP 2017 is large at 525bp at end March 2017.Points to watch - - IntesaSP financial performance is dependent on that of the Italian economy; any increase in the perceived political risk in Italy ahead of upcoming uncertain general elections would lead to a potentially substantial spread widening on IntesaSP’s debt securities.- Although it should continue to improve, asset quality remains weak (NPL ratio of 14.4% at end-March 2017, 13.4% pro forma of the VB / BPVi transaction) compared with European banks (average ratio of NPL of 4.8% at end-March 2017).