Credit analyst warns against buying Sovereign solely on merger buzz

By Ronda Fears

Nashville, Nov. 3 - Kathy Shanley, senior bond analyst at Gimme Credit, said she recently recommended Sovereign Bancorp Inc. on its improving trends, but warned in a report Monday to resist buying solely on market talk that it is a takeover target of Royal Bank of Scotland.

Nonetheless Sovereign shares climbed $2.07, or 9.95%, to $22.88 on heavy volume Monday.

"Sovereign stretched the limits of its balance sheet four years ago to finance the $1.4 billion purchase of $12 billion in deposits and $8 billion in loans divested by Fleet when it bought BankBoston,"

Shanley said in the report.

"Since then it has focused on paying down debt and pursuing smaller deals like the purchase of First Essex Bancorp.

"We recently recommended purchase of Sovereign paper based on its improving trends. It is not clear Royal Bank can justify paying nearly 3.0x book value, however, so we wouldn't buy solely on the merger rumors."

The analyst noted that Sovereign reported third quarter net income of $109 million, up 17% over last year despite compression in the net interest margin. Also, commercial and consumer loans and core deposits produced healthy year-over-year growth.

Bank of America's offer to pay a 40% premium to market for FleetBoston is raising the bar for other potential acquirers looking to expand a U.S. regional bank franchise, Shanley said.

Press reports from the U.K. suggest Sovereign Bancorp (Ba1/BBB-) has been targeted by Citizens Financial Group, the U.S.-based holding company for Royal Bank of Scotland (Aa2/AA-). But Sovereign also reportedly has rebuffed the offer.

Sovereign "has been high on the list of takeover candidates since this summer when Jay Sidhu, the company's CEO, said he would consider selling out if the price were right," Shanley said.

"Reportedly, Royal Bank suggested it would pay roughly $7.5 billion ($25-$26 per share), about a 25% premium to last week's ending market close. Sovereign is said to be holding out for something approaching $30 per share, leaving the immediate prospects for a deal uncertain."

London's The Business newspaper on Sunday reported Royal Bank had approached Sovereign about making a bid around $26 per share, or $7.6 billion. The story also said Sovereign is holding out for $30 per share, or $8.8 billion.

In its home market Royal Bank has been a successful and active consolidator, the credit analyst said, emerging victorious after the bitter takeover struggle over National Westminster more than three years ago. In recent weeks, the company has announced some £2 billion in acquisitions.

"With its ability to do further big deals in the U.K. market constrained by competitive concerns, Royal Bank has made no secret of its interest in growing the size of its U.S.-based franchise," Shanley said.

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