􀀗 Our recent visit to Italy yielded evidence
of even more severe deterioration in net
profit than we previously expected
􀀗 We are reducing our core EPS estimates
by 21% on average in 2009e, and expect
no recovery in 2010 (+0%)
􀀗 We downgrade Credem to Neutral and
MPS to UW (V) and upgrade UBI to
Overweight; Unicredit stays Neutral (V);
ISP is our preferred stock – OW (V)
Core revenue to fall 6% on average in 2009. We
expect lower interest rates to weaken margins as Italian banks
will probably be unable to offset reduced liability yield with
aggressive asset re-pricing. Margin pressure will worsen over
the course of 2009. We also expect fee and commission
margins to decline in all product segments.
Government capital support to dilute net profit
by 4% on average. Assuming an after-tax cost of 12%
for the government-funded instrument, we estimate an average
negative net profit impact of 4% for 2009. A cEUR9bn capital
injection would place core Tier 1 at 7% in 2008 on our
estimates and would be equivalent to 13% of market cap.
Earnings momentum negative; no triggers for
stocks to re-rate. The sector is trading at a 20% discount
to book value (ex ISP) reflecting expectations of returns below
the cost of equity. We think current prices are already
discounting most of the bad news to come. Although we argue
that some stocks are now cheap, valuation alone is not enough
to overweight the sector given currently low visibility on the
economic outlook.

Investment thesis
􀀗 Core revenue to fall 6% on average in 2009, driven by lower net
interest, and fee and commission margins; we expect this trend to
continue into 2010 affecting revenue recovery (+3% on average)
􀀗 We expect government’s capital support to cause slight net profit
dilution of 4% on average; capital shortage less of an issue in
Italy: cEUR9bn needed to push core T1 to 7% (13% of MV)
􀀗 Downgrading Credem and MPS; upgrading UBI to Overweight;
ISP remains our preferred stock

In our previous report (Italian banks – Surviving
recession, part 2 – from recession to depression?
1 December 2008) we anticipated a gloomy
outlook for Italian banks in 2009, characterised by
poor growth in net interest income, weak fees and
commissions, no recovery in trading profits and
rising provisions.
We estimated that operating profits would remain
essentially flat for our universe in 2009 – a more
resilient result than in the 1992 recession. We
were, however, more pessimistic than consensus
on credit quality.
What has changed?
Our recent visit to Italy not only supported our
thesis, but provided evidence for even more
severe net profit deterioration than we initially
expected. As the recession gains pace and
expectations of a stronger impact gather
momentum, the worsening outlook for revenue
growth is mostly driven by declining net interest
income and fees and commissions as margin
pressure grows in all product segments. Our
analysis suggests that sector revenue is set to
contract by 6% in 2009, driven by average y-o-y
declines of 5% in net interest income and 8% in
fees and commissions. We expect operating profit
to fall 10%.
Lower liability yield cannot be offset with
aggressive asset repricing. We calculate that
declining interest rates will have a detrimental
impact on margins as Italian banks will probably
be unable to offset reduced liability yield with
aggressive asset repricing. We believe margin
pressure will grow over the course of 2009. In
November the sector’s deposit spread narrowed to
86bp m-o-m (137bp y-o-y) while the lending
spread widened 74bp m-o-m (115bp y-o-y). Our
recent conversations with the management of
Italian banks suggest that this trend is set to
continue throughout 2009 as competition for
deposits accelerates; at the same time, it will be
more difficult to widen lending spreads than in
previous years given weaker credit demand and
declining rates.