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Sovereign Bancorp: The Good, The Bad, The Ugly


Sovereign reported earnings last's a look.


The Good:

  • The Sovereign (SOV) headline beat on EPS, but there were a lot of one-time and unsustainable items. Indeed, I would expect that analysts' 07 EPS expectations start coming in.
  • Management announced a material balance sheet restructuring and expense reduction initiative, which long-term should benefit the franchise.
  • This action, however, does bring into question the likelihood of a sale-there are quicker ways to gussy up a company to make it more attractive.

The Bad:

  • Stripping out one-time and non-sustainable items, SOV reported EPS of around 0.32, around a penny short of consensus.
  • SOV reported an extremely high provision to replenish its reserves, after the sale of its wholesale home equity book.
    • It partially offset this with increased reserves, a lower tax rate and above trend capital market revenues.
  • SOV had been benefiting from above average credit performance, but there is evidence that credit trends are normalizing, which should increase credit costs.
  • Commercial and commercial real estate loans primarily drove the deterioration.
  • Losses increased almost two-fold from last quarter.
  • Mitigating factor: It was off a very, very low base.

The Ugly:

  • Underlying lending trends:
    • Core deposits declined 6% vs. 3Q (most of SOV's peers showed increases).
    • Declines were despite a 15-20 bp increase in deposit rates (more than the increases at its peers).
  • Loan growth fell 2%.
    • Management has indicated that it is reluctant to chase loan growth.
    • Compared to peers, SOV should have lower loan growth for the quarter.
    • This is possibly a prudent strategy in a downturn, but then it becomes hard to justify the premium this bank trades to its peers.
  • SOV's margins were down 3bps sequentially.

SOV has been bid up on takeover speculation and investor belief that Santander (SBP), which recently bought a 20% stake at $27, will buy the rest of the bank at a similar price or greater. My thinking is that this thesis is wrong. Here's why:

1) A sale is less likely with a permanent CEO: Joe Campanelli, the interim CEO, was named permanent CEO earlier this week. The board has charged Campanelli with turning around the bank. Indeed, the massive balance sheet restructuring announced during the earnings report is not the type of thing that a bank does right before it is getting sold (generally depresses earnings for a short period as charges are taken-short-term pain versus long-term gain, which is wise. Unfortunately, sales prices are based on run-rate earnings, which measures like this usually hurt).

2) Even if a deal does occur, I'm not sure where the upside is: Santander's $27 per share price was probably not the best bit of bargain hunting I have ever seen and SOV's fundamentals have deteriorated significantly since then. A $27 purchase price would translate into some record-breaking multiples. My quick and dirty analysis suggests that even $25 would be really optimistic.

3) Lousy risk/reward: Optimistic takeout scenarios suggest $25 (heck I will even give the company $27 for argument's sake). Real fundamentals (peer comparisons on P/E, P/B basis), however, suggest to me that the bank is worth $14-$18.

Editor's Note: Steve Zausner of Vicis Capital also contributed to this article.

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Position in SOV

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