Mid-size banks play hard to get

SPAIN’S BANKS LOOK as if they may be embarking on a final phase of consolidation. One deal has been done this year, there’s another on the way, and the list of potential buyers is as long as the Paseo de la Castellana snaking through the centre of Madrid. There’s just one problem, Madrid’s deadpan investment bankers assert: nobody wants to sell.

Of course, nothing supports the price of a potential acquisition like the sense that it’s the last on the shelf. That’s one of the reasons why Barclays agreed in May to pay e1.1 billion for Banco Zaragozano – approaching 20 times the Spanish bank’s earnings. And despite the eyebrow-raising price, there’s plenty more in Barclays’ coffers should the right opportunity arise, and in many other banks’ vaults besides.

Spain’s dynastic banking families may be in the game for love more than for money, but they wouldn’t have made their market so highly coveted had they not been armed with a keen sense of financial value as well. The boards of the main mid-market targets wouldn’t be doing their jobs properly if they hadn’t worked out just how much they could get for their businesses in the current climate. And Spain’s bankers are immaculately professional.

There have been rumours of activity in the mid market for years. It’s the unfinished business of a consolidation that began 15 years ago when the seven largest banks began the process of sizing up and pairing off. By the end of the 1990s this had created the two big groups that now dominate the sector – Santander Central Hispano and Banco Bilbao Vizcaya Argentaria.

Grabbing a growth market These two have 15% of the market each and Banesto, an SCH subsidiary, has another 5%. The cajas de ahorros, the local savings banks, have a 50% share between them. That leaves another 15% divided among the smaller players.

Regardless of your strategic interests, if you can grab a piece of the Spanish market it’s a nice bit of business. As Gonzalo Gortazar, executive director at Morgan Stanley in Madrid, puts it: “The Barclays/Zaragozano deal makes sense regardless of the cross-border strategy.”

The Spanish banking market is the most attractive in Europe right now. While the rest of the continent has been marking time, Spain’s economy has been growing nicely at 2% a year driven by its vigorous construction sector and boom in mortgage lending prompted by low interest rates and overseas demand for property in Spain.

“It’s an efficient, well-structured market, and is profitable for retail banks,” says Jorge Delclaux, managing director with Rothschild. “If you can establish a niche you can make good money.”

The contrast with other European markets is striking. “Lots of European financial institutions are looking for growth,” says Gortazar. “They don’t have the lift from reduced provisions that you would usually get at the end of a recession because better credit risk management meant that their asset quality did not deteriorate much in this slowdown. Therefore growth needs to come from the revenue side and that’s not so easy. That’s why the price has gone so high.”

There are plenty of foreign banks that want to get in on the action and there are lots of rich domestic banks that want a bigger share. And since the country is already home to two of the most powerful banks in Europe, the Banco de España is much more relaxed about the prospect of foreign takeovers than most other central banks.

So no-one was very surprised when Barclays announced that it was buying Banco Zaragozano. It was a good deal for both sides. Spain has been Barclays’ most successful market outside the UK. So the management team has influenced the bank’s strategy in other parts of Europe and they were in a strong situation when it came to making the case for the Zaragozano deal in London.

On the Zaragozano side, the two main shareholders had long signalled their willingness to sell for the right price. Cousins Alberto Cortina and Alberto Alcocer owned nearly 40% of Zaragozano. José Garay, president of Financial Managers, advised Zaragozano on the deal. He says there were two complications – the asking price and a continuing fraud case.

The second problem was resolved in March this year. The Albertos, as the cousins are known in Spain, were fined e24 million and sentenced to just over three years’ imprisonment (although they won’t be incarcerated unless they lose a pending appeal). This will presumably have helped bring the first problem to a conclusion too, because e24 million is a lot to find, even for financiers as ingenious as the Albertos.

At the time of the deal, Barclays was widely criticized in the UK press for lack of ambition. The bank should have bought something bigger, said the Financial Times. But that argument didn’t wash in Spain. The Spanish knew there was nothing else available, and if there had been, Barclays would have led the bidding. They had other concerns; the Spanish were worried about the price.

“This deal is all about the Spanish management team convincing headquarters to do the deal,” says one banker. “But at that price, they will have their work cut out to make it a success.”

Financial Managers’ Garay says: “There were lots of people interested. But we needed a buyer with sufficient potential synergies to be realized in the operation. Without those synergies, the price might have been difficult to reach, so there was a process of natural selection.”

Lots of foreign banks were interested, he says, but their Spanish networks were small or non-existent so the synergies weren’t there. Bancaja, the Valencia savings bank, reportedly made an offer of e9 a share. A group of four savings banks from Andalucia went to e10.50. Barclays did the deal at e12.70, paying e1.14 billion for pre-tax earnings in 2002 of e67 million. That’s 17 times.

Barclays has been working hard on that headline figure. If you do the same sums on the improved numbers for the first half of 2003 and take into account synergies, the multiple is just 11, the UK bank says. And if you then add in disposals of non-core equity holdings worth over e200 million plus the old Zaragozano headquarters then you’re down to just nine times. That looks a lot better.

Still hungry There is no suggestion that Barclays’ appetite has been sated by the Zaragozano deal. At the start of the year, Jacobo González-Robatto, CEO of Barclays in Spain, said the long-term goal was to become the fourth largest group in the market, setting its sights on Popular and Banesto. The Zaragozano deal takes Barclays up to seventh biggest.

Such ambitions are treated with scepticism by many Spanish investment bankers. “Fourth is completely impossible for Barclays,” says one. “Even with Atlántico they’ll be smaller than Sabadell.”

But it’s not just Spain’s domestic market that is under consideration. Barclays has made a point of talking up the prospect of European banking deals from London. Matthew Barrett, the CEO, says he wants to position Barclays at the head of a wave of cross-border mergers. Josef Ackermann, his counterpart at Deutsche Bank, has suggested that it will only take one deal to start that wave.

The next test in Spain is already scheduled. Before the Zaragozano deal had gone through, rumours began to circulate, not for the first time, that Banco Atlántico would be the next on the block. In August, the majority shareholder, Arab Banking Corporation, confirmed that it had received several offers for its 68.5% stake.

There have been plenty of potential takers. Top of the list were Barclays and Catalan bank Banco Sabadell. Banco Popular has also been mentioned. As have Caja Madrid, Caja de Ahorros del Mediterráneo and Bancaja from Valencia. Then there is UniCredito Italiano and Caixa Geral from Portugal. Some bankers believe that Barclays’ progress will have alerted other UK banks to the opportunities. “Barclays could prompt other English banks such as Lloyds to review their strategy in Spain,” says Financial Managers’ Garay.

Cautious foreigners The conspicuous absentees from that list, aside from the big two which have finished their Spanish shopping, are Deutsche Bank and Citigroup. Deutsche has publicly ruled out any acquisitions. Juan Carlos Garay, CEO of Deutsche Spain, told the Spanish press bluntly that Barclays had overpaid for Zaragozano and destroyed shareholder value. Financial Managers’ Garay, who is presumably well placed to follow his brother Juan Carlos’s business, added that Deutsche was focusing on developing its wholesale and investment banking businesses.

The consensus on Citi is that it might attempt something, but wouldn’t bother getting out of bed for anything smaller than Banesto.

Despite the queue of potential takers for Atlántico, however, there is some suggestion that Arab Banking Corporation might have misplayed its hand. There have been conflicting signals as to whether it intends to sell some or all of its stake that have put off some bidders. The central bank has also dampened the auction. Jaime Caruana, the bank’s governor, said at the beginning of the summer that he would not support the cajas if they sought to acquire more banks. This move will take a lot of heat out of future auctions. While the big two have concentrated on their large-scale mergers, the cajas have historically been the main buyers of the smaller banks.

One source close to the Banco de España also suggests that it has had concerns about the Arab Banking Corporation’s control of Atlántico and has encouraged BBVA to maintain its 5% participation as a stable shareholder in case the situation gets out of control.

It is understood that Arab Banking Corporation will hold a board meeting in early October at which its strategy for Atlántico will be decided. Its adviser, Deutsche Bank, refuses to confirm this.

Atlántico is a just a sideshow compared with the rest of the market, all of which – officially at least – is definitely not up for sale.

But though they might not be up for sale, the medium-size banks in Spain face big challenges over the medium term. There is a natural limit to their growth potential and competition on three fronts – from the big banks with a nationwide presence, from the cajas, and from foreign institutions. “Sooner or later the mid-sized banks will have to become hyper-specialized or they will have to sell,” says María Gracia Rubio, a partner at law firm Baker & McKenzie in Madrid.

At the moment, though, most of them are doing very well indeed, especially through mortgage lending. The real-estate boom that Spain has enjoyed over the past five years coupled with the sharp reduction in interest rates has pushed growth rates to 15% or 20%.

However, when the economic cycle turns and interest rates rise, the banks are likely to see both credit quality and lending growth decrease significantly. And that is a source of concern to the Banco de España.

“The seeds of an increasing default ratio are built into the growth rate,” says Financial Managers’ José Garay. “The smaller banks are producing good results at the moment, but they aren’t going to be able to sustain those without a significant reduction in costs. This is starting to look like a good time for them to sell.”

Mariano Colmenar, Spanish banking analyst at CSFB, expects declining credit quality to have some effect but does not see it as crucial. “It’s not in my central case,” he says. “But loan growth will slow down and asset quality should deteriorate. However, most Spanish banks embrace the whole spectrum of financial products so when the economy picks up and interest rates rise they can expect other areas of the business to benefit, especially commission incomes.”

Prudent central banking Non-performing loans have been at historical lows for four years now, at around 0.85% of the total financial system. Mortgages, which traditionally have lower default rates than other loans, have greatly increased their share of total loans from 18% 10 years ago to 35% today. The Banco de España is aware of problems that could arise and has introduced an anti-cyclical provision for banks. This provision is related to loan growth rather than asset quality and banks can call on it in the event of defaults. “The central bank has been very prudent,” says Colmenar, “and this will mitigate some of the effects when the cycle changes.”

He continues: “There will be pockets of consolidation among smaller banks but for larger-scale transactions to take place among them, their financial position would have to be in a worse shape than it currently is.”

Delclaux at Rothschild and Gortazar at Morgan Stanley are steadfastly refusing to become excited. “The only deals left to be done in Spanish banking now are leftovers,” says Delclaux. “There is no reason why they have to happen. In all likelihood some will and some won’t be done.”

Baker & McKenzie’s Rubio is inclined to take such downbeat views at face value. But Garay at Financial Managers is clearly still buoyed up by the closing of the Zaragozano deal. He suggests that large enough amounts of money can overcome most cases of intransigence among bank targets. Leon Benelbas of Atlas Capital takes a similar view. Benelbas himself closed five smaller deals in other sectors this summer and still finished work in time to spend three weeks on the beach. So perhaps there is a pattern of sorts.

The real prize in the rest of the market is Banco Popular. This was one of the biggest banks in Spain before all the other big ones got together. And despite missing out on growth through merger or acquisitions it has done well from its place on the sidelines. It’s one of the most profitable banks in Europe, making e1.3 billion, while the much bigger Banesto pulled in half that amount.

Banco Popular is an unlikely target, mainly because it is already so well run. “It would be hard to make Popular better,” says José Falgás, managing director at Deutsche Bank. “So it’s unlikely anyone will pay the premium that would be demanded.”

The bank has been run for years by its co-chairmen, the Valls brothers, who laid down its strategy of independence. For years investment bankers have been waiting for them to move over so they can get Popular on the table. Javier Valls is now 73 and his brother Luis is 77 and bankers are still waiting. They have installed a new young CEO, Angel Ron, to ensure continuity. And the younger brother still plays golf with investment bankers while he’s explaining to them that he has no need of their services. Popular is more of a shooter than a target.

That’s how Banco Sabadell would like to see itself as well. The Catalan bank doesn’t have the same prestige as Popular, but it’s still a professional operation with a young energetic chairman, José Oliu, who is more interested in growing the bank’s business than selling it.

Sabadell has been looking for an acquisition for three years and is one of the likeliest buyers for Atlántico now that the cajas are out of the picture. Furthermore, Sabadell has a low free float and BCP in Portugal has 8% of Sabadell and La Caixa has 15%, so the shareholding structure works to protect it.

If they were forced to gamble, most industry observers would have their money on Bankinter as the next to go. Bankinter is another bank in the orbit of SCH. Jaime Botín, the younger brother of SCH chairman Emilio Botín, was chairman until last year, and the Botín family is the largest single shareholder, although that holding is relatively small.

Rumours of a move for Bankinter have been fuelled by the recent appearance of Ram Bhavnani on the shareholder register. Bhavnani bought a big stake in Zaragozano before the takeover and made a killing. So he has plenty of English gold in his war chest for further adventures. Bhavnani chose to spend a big slice of that on a 5.25% stake in Bankinter and analysts are speculating that he may be hoping to repeat the Zaragozana trick.

Bhavnani, for his part, has told Spanish newspapers that he hopes to enjoy the long-term involvement with Bankinter that circumstances denied him with Zaragozano.

Bankinter shows willing? Bankinter has also recently removed the poison pill limitation from its charter. The poison pill is a classic anti-takeover measure that prevents any shareholder from controlling more than 10% of the voting rights. Its removal has been interpreted in some quarters as a willingness to consider a takeover.

Delclaux argues that a deal for Bankinter is unlikely. “It’s well run, it’s expensive at the current price, and the Botín family is unlikely to want to sell,” he says. But like Banesto, it could come into play if it became a useful bargaining chip for Santander.

“Ultimately that would be the decision of Jaime Botín,” says Benelbas. “But he has an excellent relationship with his brother. To the outside world, there is no gap between them.”

But it will still be pricey. Bankinter trades at around 13 times earnings whereas European banks average 11.5 times. “To make the deal happen, shareholders would be looking for at least 16 times,” says Mariano Colmenar. “Barclays paid more than that for Zaragozano although the latter offered more synergies.”

Some market observers insist that Banesto must be up for sale because otherwise it would have been integrated into the rest of the Santander Group. SCH owns all of Banesto, with the exception of a 12% stake which was floated last year. And Ana Paticia Botín, daughter of Emilio, is the chairman.

“But it’s like owning two cars,” says one banker, who prefers not to be named. “You can’t drive them both. They will deny that it’s for sale all day long, but it still looks as if it is.”

Baker & McKenzie ‘s Rubio predicts that both Bankinter and Banesto will eventually be absorbed into SCH. But Benelbas of Atlas Capital isn’t so sure. “Botín would sell it if some one offered the multiples that Barclays paid for Zaragozano,” he says. The likelihood of that happening, though, has been reduced since the central bank moved to neutralize the enthusiasm of the cajas. “The main doubt people would have is whether Banesto really stands alone,” says Benelbas. “In my view it does, but the perception of the market isn’t that clear.”

Benelbas doesn’t subscribe to the bargaining-chip theory. In his view money would be the only prerequisite. “The Botíns would sell to the highest bidder, I have no doubt,” he says. “They wouldn’t think strategically about who is the best buyer. Banesto doesn’t have any strategic value to Santander. They can do everything themselves. They’ve got the strength, they’ve got the capacity and they’ve got the know-how.”

The leading players in Spanish banking may have a few moves yet to play before the consolidation game is over.