UBI Banca : Not yet the dolce vita; Recommendation lowered to Reduce on Tier 2 on expected volatility from ECB communications on NPL and political risk

UBI Banca (UBI)’s 2017 results have been materially distorted by the impacts of the acquisition of three regional banks in April (representing around 20% of UBI’s total assets) including EUR688m of badwill, and those related to the execution of its 2019-2020 strategic plan (although the bulk was booked in 2016 UBI estimates that its “recurring” net profit for 2017 is EUR189m, meaning a c.40% increase to 2016 but a meagre 2% ROE, in our calculations. UBI has achieved significant steps in streamlining its organisation and a supportive economic environment should help improving UBI’s still modest profitability. UBI has revised its NPL ratio target to “less than 10% between 2019 and 2020, depending on market conditions” from 11.9% initially envisaged, and 13% reported at end-2017. More ambitious asset quality metrics have been a common theme to Italian banks’ 2017 results publication. They want to leverage on the better economic situation and outlook, but also meet the ECB’s expected requirements on balance sheet cleaning. The ECB has taken a seemingly tough stance on European banks’ need to tackle the NPL issue and Danièle Nouy’s motto for 2018 (“If not now, when?”) suggests potentially demanding requirements ahead. - We still see UBI’s senior debt as expensive relative to peers with higher ratings (UBIIM 10/2022 0.85%, UCGIM 03/2023 0.87%) and maintain our ‘Reduce’ recommendation. Also, we believe regulatory communications on NPLs will create pressure across the capital structure for small and medium-sized Italian banks’ debt securities, and UBI should not be spared. The pressure could be exacerbated by the (uncertain) outcome of the general elections due 4 March in Italy. While our central case is not that subordinated bondholders would contribute to any form of recapitalisation for UBI as part of solutions to tackle the NPL issue, we expected pressure on them in the short- to medium- term and thus lower our recommendation on UBI’s Tier 2 bonds to ‘Reduce’ from ‘Neutral’ on instruments that have reported a fairly good performance over the past twelve months. - >Support Factors - - Good national franchise (5%-6% market shares), with stronger presence in the wealthy Lombardy (9%).- Better economic conditions in Italy which should, under current assumptions, support gradual improvement in profitability and asset quality.Points to Watch - - Weak asset quality, although good compared to most Italian peers. Low coverage ratio (35.5%), leaving a large part of the bank’s capital exposed to unreserved NPLs (Texas ratio 103%). Tackling rather sooner than later NPL issues is a 2018 priority for the ECB and its requirements could be tough.- Satisfactory capital ratios in absolute terms, but fairly tight relative to asset quality weaknesses.- AT1 securities and MREL-eligible (SNP) debt to be issued to enhance capital structure and meet regulatory requirements.