The logic behind Profumo’s bold bet

Alessandro Profumo has been itching to get into Germany for a long time.

Alessandro Profumo has been itching to get into Germany for a long time. Four years ago the chief executive of UniCredito Italiano approached Commerzbank about a possible merger but quickly withdrew after investors punished his stock. His latest foray, an audacious E19.2 billion ($23.4 billion) bid for HVB Group, Germany’s second-largest bank, is proving much more popular.

Investors have bid up the shares of both UniCredit (as it’s now called) and HVB since the two banks announced their merger last month. The enthusiastic reaction to Europe’s biggest-ever cross-border banking deal signals that the era of pan-European banking has finally arrived, bankers and analysts say. That fact, in turn, will prompt other banks to consider similar mergers to gain scale and drive growth.

The UniCredit takeover “is going to put pressure on a lot of

European banks,” says Philippe Annamayer, a banking analyst at Fox-Pitt, Kelton in London. “It’s sending a message to investors and banks that cross-border mergers are possible.”

Cross-border deals have been done before, of course. HSBC bought Crédit Commercial de France in 2000, and last year Spain’s Grupo Santander acquired the U.K.'s Abbey National for £8.8 billion ($16.2 billion). UniCredit’s proposed acquisition of HVB, however, is far bigger than any preceding deal. It also promises to transform two banks in the heart of the euro area from second-tier players into a regional powerhouse.

The merger brings together the most profitable bank in Italy and Germany’s No. 2 bank, which is also the dominant lender in Austria thanks to its Bank Austria subsidiary. The two banks’ fast-growing networks in Central and Eastern Europe together boast more than twice the assets of their nearest competitor, Austria’s Erste Bank. The combined entity will have 28 million customers in 19 European countries. It is not mere hyperbole that UniCredit and HVB tout their merger as creating the first truly European bank.

For Profumo and HVB chief executive Dieter Rampl, who have known each other for years, the impetus for entering merger discussions was Santander’s successful purchase of Abbey National in November. Until then all the talk about building a truly pan-European bank, which flourished after the introduction of the euro, had remained just that -- talk. Bankers and their investors preferred to focus on domestic consolidation because it was easy to identify cost savings in overlapping branch networks.

Santander-Abbey offered a new paradigm. The Spanish bank promised to generate major synergies by shaking up Abbey’s management, rationalizing its bloated back-office systems and installing Santander’s state-of-the-art information technology systems. With U.K. competition rules discouraging HBOS and other domestic players from making a counterbid, investors accepted Santander’s share offer.

“The investor attitude has changed quite a lot, mainly thanks to the SantanderAbbey National deal,” Profumo tells Institutional Investor. “There is a little bit more negative view of domestic synergies and a more positive view of cross-border synergies.”

Close economic links between northern Italy, Austria and southern Germany, where the banks have the bulk of their business, create more potential for synergies between UniCredit and HVB than for other cross-border deals, the executives contend. “I was always a firm believer in consolidation of regions,” says Rampl. “You will find no other region of Europe that fits together so well.”

A recent London conference of European bank CEOs and investors sponsored by Morgan Stanley underscored this new attitude. Of some 600 fund managers and 150 bankers surveyed at the conference, 16 percent said cross-border mergers were the best way to invest surplus capital. Just last August, when Santander launched its bid for Abbey but before the deal was completed, investors knocked 3 percent off the share price of Royal Bank of Scotland after CEO Fred Goodwin remarked that the atmosphere for cross-border deals had improved, unleashing speculation that RBS was mulling an acquisition.

“A year ago investors would’ve killed” a bank for proposing a cross-border deal, says Davide Serra, Morgan Stanley’s senior European banking analyst. “Today the market is open to the idea. I see that as a sea change.”

This change in attitude comes at a time when European banks are facing more pressure than ever to fuel growth by acquisitions. The biggest spur is the emergence of a top tier of U.S. banks with the scale and earnings power to invest in new technology and to consider strategic moves anywhere in the world. The top four U.S. banks -- Citigroup, Bank of America, J.P. Morgan Chase and Wells Fargo -- all boast market capitalizations of more than $100 billion. Only Europe’s biggest bank, London-based HSBC, which is regarded by itself and investors as a global institution, enjoys a similar heft. The HVB deal will vault UniCredit from 16th place among European banks to eighth, just behind Barclays, BNP Paribas and HBOS, with a market cap of about E45 billion.

Europe’s banks also are generating capital more quickly than they can deploy it. Analysts at Keefe, Bruyette & Woods estimate that European banks have E35 billion of excess capital and that their earnings power will continue to generate surplus funds in coming years.

“Most European banks have exhausted their internal restructuring opportunities and are struggling with ways to deploy their large excess capital positions,” says Stuart Graham, a banking analyst at Merrill Lynch, which advised UniCredit on its bid. “Bigger deals offer the opportunity to take a major step forward in the franchise.”

The impact of the UniCredit-HVB merger will be felt most keenly in Germany, where the banking sector remains highly fragmented and banks have shied away from consolidation because of the political difficulties of laying off workers. Deutsche Bank is seeking to acquire banks in Germany and emerging markets and would be interested in reviving talks with Deutsche Postbank, the country’s biggest retail bank, chief executive Josef Ackermann said last month. The Free Democratic Party and the Christian Democratic Union, which are forming a coalition in the state of North RhineWestphalia after winning elections there in May, indicated last month that they were prepared to privatize WestLB, a step that could accelerate consolidation among Germany’s state-owned Landesbanken.

Commerzbank remains vulnerable to a takeover because of its modest size and weak profitability, although those factors have long deterred potential bidders. “I started at Commerzbank 17 years ago, and everybody said, ‘Don’t go there; there will be a takeover soon,’” recalls Rolf Drees, spokesman for Union Investment in Frankfurt. A Deutsche-Commerzbank merger could generate huge cost savings, but Ackermann already faces political opposition over his planned job cuts at Deutsche and could expect even more of an outcry if he took on Commerzbank.

Outside of Germany, bankers believe that ABN Amro could be vulnerable to a bid if its E7.6 billion offer to acquire Italy’s Banca Antonveneta fails. The Dutch bank has a variety of assets, including retail banking networks in Brazil and the midwestern U.S. and a European investment banking business, that could appeal to rivals like RBS and Santander or attract a bid from a U.S. bank.

The merger activity also has revived speculation of a possible deal between France’s BNP Paribas and Société Générale. A combination would generate substantial cost savings but would likely encounter political difficulties at a time when the French government is struggling to combat high unemployment. Furthermore, bankers say, a merger is hard to envisage while Daniel Bouton, who rebuffed a bid from BNP in 1999, remains in control at SocGen.

Now, says Fox-Pitt analyst Annamayer, executives at all of those European banks must be thinking a similar thought: “If deals like Santander-Abbey and UniCredit-HVB work out well, the acquirers will have a track record and be in a position for further mergers, and we’ll be in a difficult position.”

The idea that an Italian bank could acquire Germany’s second-largest bank would have been unthinkable only a few years ago. That it is happening testifies to the structural and economic weaknesses of the German banking system, which is hobbled by fragmentation, slow growth and an overhang of bad real estate loans made during the euphoria of German reunification more than a decade ago.

Rampl cut his teeth as a corporate loan officer at the former Bayerische Vereinsbank in Munich and New York in the 1970s and early 1980s, a time when German banks enjoyed tremendous clout on the global stage. He recalls his New York days as being among the most exciting of his career. Several of the banks he competed against back then have long since been amalgamated into today’s giants -- Security Pacific and Continental Illinois, for example, are now both part of Bank of America. “You will not find one single American bank that looks like it did even five years ago,” Rampl tells II.

By contrast, the inability of German banks to consolidate and gain scale has eroded their position over the past 15 years. The top banks in France, Spain and the U.K. all enjoy domestic market shares of 20 to 25 percent, Rampl notes. “If you merged Deutsche, Dresdner, our bank and Commerzbank, you would get only 20 percent,” he says.

The UniCredit-HVB deal also underscores the stunning improvements in performance that Profumo has achieved at UniCredit since taking over as chief executive in 1997.

The 48-year-old former McKinsey management consultant has transformed UniCredit from an unwieldy conglomeration of seven regional Italian lenders into an efficient and centralized bank with a single IT platform, back-office system and product factory. He also has extended his franchise into retail banking in Central Europe and global asset management, notably through the 2000 acquisition of U.S.-based Pioneer Group. Those moves have enabled UniCredit to grow earnings per share by 21 percent over the past three years despite the stagnant Italian economy.

Profumo believes he can use his domestic restructuring experience to wring big savings out of HVB. He promises to cut group costs by 7.4 percent, or E900 million, over the next four years, including cost reductions of 15 percent at HVB alone. His plan will shrink the workforces of HVB and Bank Austria by 7 percent and cut 9 percent of the banks’ combined staff in Central and Eastern Europe. He also aims to generate E85 million a year in additional revenues by applying UniCredit’s retail banking prowess at HVB and having the German bank share with UniCredit its expertise in lending to small and medium-size companies.

“We made a very conservative case because we wanted to present a proposal to the board based on cost synergies, which are the most sure,” Profumo says.

The CEO’s track record is the best argument in favor of the deal with HVB, analysts and investors say. UniCredit’s management is “outstanding,” notes Bertrand Veraghaenne, a financial sector analyst at Brussels-based Petercam Asset Management, which manages E10 billion in equities. “I would tend to give them the benefit of the doubt.”

Notwithstanding that record, it will be difficult for UniCredit to achieve its ambitious targets of 26 percent-a-year compound annual earnings growth over the next three years and an 18 percent return on equity in 2007. The prime cause for concern is HVB’s loan portfolio.

The creditworthiness of that portfolio was easily the biggest stumbling block to a merger when Profumo and Rampl began negotiations in December at a resort near Lago Maggiore in northern Italy, executives and bankers say. HVB has taken repeated write-offs for bad loans in recent years and was forced to sell a 25 percent stake in Bank Austria in a 2003 IPO to rebuild its capital base. In January, Rampl vowed to draw a line under the problem by hiving off E15 billion in underperforming real estate loans for disposal and taking a E2.5 billion write-off.

“I would have done that without the deal,” he says. “But of course, the more you clean up the balance sheet, the more poison pills you take out.”

Profumo is confident that there won’t be any more nasty surprises in HVB’s loan book, pointing out that the bank has set aside provisions amounting to 56 percent of its nonperforming loans. Some analysts and investors aren’t so sure. Petercam’s Veraghaenne says he met with HVB management last October and was told there would be no more surprises on credit quality. “They told me, ‘The books are clean,’” he recalls. But, he adds, even with the latest write-off, “I don’t believe that the books are clean.”

Looking ahead, the biggest test for UniCredit and HVB will be whether they can deliver real synergies. The sudden enthusiasm for cross-border deals notwithstanding, many investors and analysts remain skeptical that the two banks will generate significant earnings growth. Analysts at Keefe, Bruyette & Woods say cross-border bank mergers to date have added 18 percent, on average, to the acquirer’s market capitalization -- barely half the benefits of domestic mergers.

“These deals sound great, but management has to deliver,” says Union Investment’s Drees. His firm has an underweight position in both HVB and UniCredit stock.

For Santander, Abbey National remains a distinctly British business. The Spaniards hope to boost returns by applying their management skills, products and IT at Abbey, but there are few additional benefits from combining a British and a Spanish bank. With UniCredit-HVB much of the promise stems from the perceived benefits of combining banks in the contiguous markets of northern Italy, Austria and southern Germany. The three regions are wealthy, with per capita GDP that is 117 percent of the average for the 15 Western European members of the European Union. And trade among the three countries and the new EU member states in Central and Eastern Europe is thriving, at some E350 billion a year.

“There is more logic here from an industrial point of view than at SantanderAbbey National,” says Profumo. “There is a strategic fit.”

If Profumo and Rampl can deliver on that promise, they are sure to have plenty of followers.