UBI Banca : The acquisition of three small banks makes strategic sense and is well structured; Recommendation raised to ‘Neutral’ on Tier 2 notes

The Bank of Italy has accepted UBI Banca’s offer to acquire the good banks stemming from the resolution late 2015 of three small regional lenders. Their total assets are relatively modest (around EUR20bn, or about 20% of UBI's balance sheet at end-3Q016), but this should allow UBI to raise its market share in loans and deposits by around 1pp to c.6% and expand its footprint in regions where it had little presence. - Thanks to the strict conditions set by UBI Banca for asset quality and restructuring provisions, it will acquire for 1 euro relatively healthy institutions whose integration and turnaround should not be excessively changelling in our view. The badwill generated and the activation of the deferred tax assets inherited from the acquired banks will support the return on this investment. Lastly, the EUR400m capital increase (required, or at least welcomed, by the ECB) will limit the immediate impact of this transaction on UBI's capital ratios. By 2020 (the timeframe of the business plan presented last June), the CET1 ratio should reach 13.5% vs. a previous target of 12.8% (and 11.3% reported at end-3Q16, fully-loaded). - By responding to strategic uncertainties and the question of UBI's role in the consolidation of the Italian banking sector, this deal alleviates concerns about M&A risk. The measures announced by the Italian government to support struggling banks also reduce contingent risks for healthy banks and improve the outlook for the sector. - As such, we are revising our credit opinion from ‘Negative’ to ‘Stable’. We are maintaining our ‘Reduce’ recommendation on senior notes, which appear relatively expensive, but raising our recommendation from ‘Reduce’ to ‘Neutral’ on subordinated Tier 2 notes, whose yield (YTC 4.14% for the 2026/21) seems fair now that risks on this credit have reduced in our view. - >Support factors - UBI will strengthen already adequate market shares, generating organic growth that may be rounded out by small bolt-on acquisitions. Pro forma the acquisition of these three small banks, UBI ranks fourth to fifth-largest Italian bank by loans and deposits.The conditions of the acquisition and capital increase, together with the measures of the 2019/2020 plan, are set to have a positive impact on the bank's already satisfactory capital ratios, and on its modest profitability.Points to watch - - Although it compares favourably in an Italian context, asset quality remains weak (pro forma NPL ratio estimated at 15.2%) and the amount of non-performing loans not covered by provisions represents a large share of the bank's capital (around 100% on our calculations).- Pressure on the banking sector has eased following the measures taken by the government, but the operating environment remains tough, marked by sluggish growth.