An additional concern is that while the planned rights issue will leave the group’s CET1 ratio largely unchanged, it will result in the CET1 ratio of the group ex TSB falling 100bp to c10.5%. We understand Sabadell’s desire for international diversification this transaction dilutes Sabadell’s attraction as a relatively pure play on a Spanish recovery, increasing Sabadell’s overseas assets from 5% to 22% of the group.
From a TSB perspective, receiving cash equivalent to 1.0x tangible book looks attractive against our expectation of a 7% RoTE in 2018 but at the expense of significant longer term upside.
20% cost savings almost exclusively from IT platform: Sabadell targets £160m of cost synergies to be achieved in the 3rd full year post acquisition (2018), with savings phased through to then. These are almost entirely savings in IT as it migrates TSB off Lloyds’ platform and onto its own, Protea, platform. The £160m target is 20% of TSB’s cost base but there is little detail on why Sabadell can do this 20% cheaper. The key challenges will be accommodating the UK’s regulatory framework and product design into what is so far a domestic Spanish platform. While Sabadell has successfully integrated Spanish acquisitions in a short space of time, the complexities of cross-border integration have yet to be truly tested. Only limited headcount reduction is planned and that’s associated with TSB no longer being a public company. There are no plans to change the branch network at this stage. Helpfully, the £450m contribution from Lloyds should at least offset integration costs and will be booked as the costs are incurred.
Largely sticking with TSB growth strategy: TSB already targets 40-50% growth in its franchise loans over 5 years to 2019, mainly organically but supplemented with loan portfolio acquisitions where there is opportunity. The £2.8bn mortgage enhancement portfolio that gives TSB the economic benefit of Lloyds mortgages is not removed with the transaction but will roll off with residual balances reverting to Lloyds in 2018 as is the case with TSB standalone. Management has some hope that Sabadell can help to accelerate TSB’s franchise growth but we would expect this to be fairly limited in the near to medium term. SME lending is currently 1% of TSB’s loans so even if Sabadell is able to help grow this fast, we doubt that it’s going to be a meaningful part of the mix for quite some time.
TSB’s capital stays as is, weakening Sabadell in Spain, in our view: TSB has a 19.7% pro forma CET1 ratio which is at a high level to fund future growth but also reflecting the UK regulator’s concern around operational risk given TSB’s current reliance on Lloyds. While this reliance will be removed and management wouldn’t comment on the regulator’s views, they also mentioned that they do not plan to upstream either capital or funding from TSB, which in our view suggests that TSB will still run with higher capital levels. Although the CET1 ratio for the group should nudge up from 11.5% to 11.6%, the capitalisation of the group ex TSB should fall 100bp to a 10.5% CET1 ratio as the €2.4bn cash consideration is only partially offset by the €1.6bn planned rights issue.
Near-term EPS neutrality target requires cost savings to start soon, in our view: Our current TSB forecasts suggest that it would increase Sabadell’s earnings by about 16% in 2016 and around 11% in 2017 as Sabadell’s earnings grow but TSB’s to fall due to the step-up in costs related to the service agreement with Lloyds. However, if the planned €1.6bn Sabadell rights issue is done at a 15% discount to the current share price then we estimate that the share count would go up by approx 19%, resulting in c3% and c7% earnings dilution in 2016 and 2017, respectively, before any synergies. In our view, making this EPS neutral, as Sabadell targets, would need TSB’s earnings to increase around 22% in 2016 and 80% in 2017. If this were all to come from costs then synergies would need to be 3% and 9% of the cost base in 2016 and 2017, suggesting that almost half of the planned synergies could be delivered in the first two full years post acquisition. Sabadell expects the transaction to be EPS accretive in the medium term.
Stock Rating/Industry View: Overweight/Neutral
Price Target: EUR 2.60
Price (19-Mar-2015): EUR 2.21
Potential Upside/Downside: 18%
Tickers: SAB SQ / SABE.MC
Stock Rating/Industry View: Equal Weight/Neutral
Price Target: GBp 270.0
Price (19-Mar-2015): GBp 327.0
Potential Upside/Downside: -17%
Tickers: TSB LN / TSB.L