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Higher interest rates have boosted profits at Spanish retail banks and attracted buyers to their shares last year. But it’s not just investors who are enthusiastic about these lenders. This also applies to other bank managers.
On Tuesday afternoon, BBVA confirmed reports that it is preparing a bid for local rival Banco Sabadell. While the industrial logic makes sense for BBVA, significant cost reductions will be required for the deal to increase pro forma consolidated earnings per share.
BBVA can expand its Spanish business, particularly in lending to smaller companies. Visible Alpha estimates that nearly three-quarters of the larger lender’s revenue comes from outside Spain, primarily Mexico and Turkey.
A previous attempt to merge the two failed in 2020. Today, the merger would create the country’s second-largest bank, valued at almost €70 billion. BBVA may have been spurred into action by rumors that Sabadell itself could replace smaller rival Unicaja.
Southern European banks were big winners in the industry this year. Slower-than-expected interest rate cuts from the European Central Bank, coupled with subdued outflows from deposit accounts, are improving the outlook for net interest income. Sabadell shares have risen more than two-thirds since the start of the year, including a 5 percent rise on Tuesday.
But the rise in Sabadell’s valuation makes it harder for BBVA to justify this combination. Assuming BBVA seeks an all-share deal to avoid reducing its capital buffers, any apparent valuation arbitrage between the two has disappeared. According to Bloomberg data, both banks now have the same valuation at just over seven times expected earnings.
Cost reduction is therefore crucial in any business. BBVA’s expected return on tangible equity this year is 15.5 percent, 4 points higher than that of Sabadell. The latter has a cost-income ratio of around 51 percent, which is significantly higher than BBVA’s 42 percent.
The regulatory authorities are likely to be supportive. Consolidation within the country should increase size and lead to greater profitability. This is due to the large overlap between the two companies’ domestic branch networks, which Barclays estimated at around 1,200 at the time of the last merger attempt. BBVA needs to achieve cost savings of 15 percent of Sabadell’s operating overhead costs, after taxes, or about 312 million euros this year.
If BBVA pays significantly more than Sabadell’s closing price on Tuesday, the deal could have a dilutive effect on profits. That explains why shareholders sold BBVA shares at a loss of 6 percent. Regardless of the logic, BBVA should carefully consider any proposed price for Sabadell.