Italy

Italian banks

Sector report January 2007

Mid-sized banks: consolidation vs. restructuring
We confirm our positive stance on Capitalia (2/Outperform, target upgraded to EUR8 from EUR7.6), on both valuation and consolidation grounds. We stand by our 3/Underperform rating for MPS, due to the demanding valuation and higher execution risk (target price moved to EUR5 from EUR4.7).
We prefer Capitalia based on its speculative appeal and lower execution risk. In 2007, we forecast 7% revenue growth, driven by rising commission income. NPL recoveries remain buoyant and the declining cost of funding and lower tax rate should underpin 20% EPS growth. Consolidation appeal stems from the unstable shareholding structure and a strategic investor's (ABN Amro) willingness to pursue growth in Italy at the expense of its operations in the Americas.
We keep a cautious stance on MPS, despite the improvement seen in 2006. It is entering a major year of transition, which kicked off with the bancassurance JV. In turn, this spurred the search for a new business model to better re-allocate capital. However, the execution risk for this crowded pipeline is high and restructuring appears to be partially priced in, based on multiples. Finally, Capitalia is more appealing prey than MPS in this consolidation scenario.
Key date for Capitalia: 19 January. If the main opponent of consolidation, Mr. Geronzi is not confirmed as Chairman at the AGM, the real season of M&A activity will begin for the bank.

Carlo TOMMASELLI Research Analyst [email protected] (39) 02 80 62 83 44

www.cheuvreux.com

CHEUVREUX

ITALY

CONTENTS I—

Capitalia: Business plan on track ..................................................................... Page 05 Company visit ......................................................................................................................................................................................... P.05 Banca di Roma: The new deal ...................................................................................................................................................... P.05

II— MPS: A restructuring story ................................................................................... Page 09 Company visit ......................................................................................................................................................................................... P.09 MPVita deal .............................................................................................................................................................................................. P.09 MPS: Key success factors .............................................................................................................................................................. P.11 Capital allocation................................................................................................................................................................................... P.12 Business plan targets ......................................................................................................................................................................... P.12

III— Company profiles ....................................................................................................... Page 13 Capitalia ......................................................................................................................................................................................................P. 15 MPS............................................................................................................................................................................................................... P.19

CHEUVREUX'S BANKS TEAM Cyril Meilland Rodney Alfvén Fredrik Gutenbrant Jaap Meijer Joachim Müller Francisco Riquel Benjamin Schultz Christian Stark Carlo Tommaselli

Italian banks

(coord.)

France

+33 1 41 89 73 11

[email protected]

Nordic

+46 8 723 5172

[email protected]

Nordic

+46 87 235 173

[email protected]

Benelux

+31 20 573 06 35

[email protected]

Germany

+49 69 47 89 79 60

[email protected]

Spain

+34 914 327 550

[email protected]

Germany

+49 69 47 897 523

[email protected]

Switzerland

+41 1 218 17 02

[email protected]

Italy

+39 02 80 62 83 44

[email protected]

2

CHEUVREUX

ITALY

INVESTMENT RECOMMENDATION After visiting both companies, we still prefer Capitalia to MPS, on valuation and consolidation grounds. Despite the recent outperformance, we confirm our positive stance on Capitalia, which should go through a major phase of transition in 2007, due to potential changes in the shareholding structure. On a stand-alone basis, the expected revenue delivery (we expect 7%) should attract most attention from the market, along with the new business plan at the end of 2007. For MPS, 2007 should be a milestone, as the bank will finally set up the long-awaited bancassurance JV with a foreign partner, which could boost the guidance for the future (beyond the one-off capital gain on the sale of the 50% stake in MPVita). −

We confirm our bullish stance on Capitalia (2/Outperform, new target price of EUR8, with 11% upside) based on the: 1) visible revenue delivery in 2007 (+7% expected), stemming from the fee income recovery; 2) the Delta 2 project which should generate additional revenues, that were not forecasted in the original business plan; 3) the ongoing NPL outperformance, on the back of the buoyant bad loan recovery trend of the last two years; 4) potential changes in the shareholding structure in the near future, as the main strategic shareholder, ABN Amro, seems interested in expanding its presence in Europe via new acquisitions (in Italy?), at the expense of the Americas; 5) potential interest of SCH, as an alternative proprietary branch network to SPI; 6) at end-2007, the bank should roll out its new 2007-09 business plan, which will be a key event in the news-flow pipeline; 8) the unjustified 4% discount to Italian peers (7% premium to EU) based on multiples, factoring in an 2006-08E EPS CAGR of 20.4%.

−

We maintain a cautious stance on MPS (3/Underperform, new target price of EUR5) due to: 1) the demanding valuation, at a 1.7% premium to Italian peers (13.6% to EU); 2) restructuring potential which is partly priced in at this high price level (11.7x PE08E) and the 2006-08E EPS CAGR of 16.7%, already partly reflected in the multiple valuation; 3) the market's misperception of MPS' real role in the consolidation process (the bank is seen as a target, but actually the Foundation is willing to partly reduce its stake in the bank and retain control). 1) MPS has more room for cost restructuring than Capitalia (with a cost to income ratio of 60% vs. 58%), as the planned reduction of headquarter staff is not up and running yet: 2) lower pro-capita productivity ratio than Capitalia, the front to back office ratio being equal (EUR383k vs. EUR393k, assuming 50% FO/BO ratio); 3) the stock is in few institutional investors' portfolios, hence there is a limited chance of marginal selling. The acceleration of the equity portfolio disposal and sale of non-core real estate assets could be good news, as capital re-allocation would improve the return on the capital. But in 2007, there is a lot in the pipeline and the execution risk is high, backing our cautious stance.

For Capitalia, we see some execution risk for revenue delivery. For MPS, the execution risk is higher, considering the numerous restructuring initiatives in the pipeline for 2007, from the rationalization of the equity investment portfolio and non-core real estate asset to cost-cutting to the changes in the business model (JV in several areas with foreign partner). As Capitalia and MPS could both make acquisitions, bidding risk weighs on both banks.

MPS & Capitalia: Multiples, ROE and Growth (x, %) PE 08E PTBV 08E ROE 08E EPS Growth 08/06

MPS

Capitalia

11.7 2.0 16.02 16.7%

11.0 2.1 18.23 20.4% Source: Cheuvreux

Italian banks

3

CHEUVREUX

ITALY

Market share

PBV and ROE 2007E OKPM

NRKMB

NTKM

OKOR

NMKMB

NSKM

OKOM

RKMB

OKNR

MKMB

OKNM

kçêíÜ

`ÉåíêÉ

pçìíÜ

NRKM NQKM

OKMR

qçí~ä

NPKM

OKMM jmp

jmp

`^m

m_s

PE07E and growth 07/06

OMKMB NRKMB NMKMB RKMB MKMB `^m

dêçïíÜ

olb

SRI Issues

NPKTM NPKSM NPKRM NPKQM NPKPM NPKOM NPKNM NPKMM

ORKMB

jmp

`^m

−

Capitalia has 4 independent members on the BoD out of 20.

−

MPS and Capitalia all observe a code of ethics.

−

MPS issues environmental and social annual reports.

−

Capitalia issues environmental and social annual reports.

mbMTb

Italian banks: Multiples comparison (x, %) UC SPIntesa CAP MPS BPVN-BPI BPU-BL BPM Credem ITALY EUROPE

Rating 2 NR 2 3 3 2 1 2

PE

PTBV

ROE

Yield

07E

08E

07E

08E

07E

08E

07E

08E

11.96 15.22 13.27 13.63 13.61 11.51 14.71 12.31 13.76 11.30

10.49 12.03 11.02 11.69 10.88 10.13 12.78 11.53 11.53 10.30

2.93 2.24 2.27 2.11 1.46 1.97 1.74 2.26 2.08 2.39

2.74 2.09 2.06 1.97 1.46 1.76 1.62 2.05 1.94 2.14

24.70 14.74 16.75 14.38 10.69 19.64 11.70 18.38 15.59 22.80

26.21 17.36 18.23 16.02 13.40 19.93 12.59 17.78 16.98 22.70

3.96% 4.55% 3.68% 4.64% 3.61% 3.85% 3.14% 4.11% 4.1% 4.0%

4.69% 5.39% 4.43% 4.74% 3.90% 4.40% 3.73% 4.29% 4.6% 4.4%

Source: Cheuvreux

Capitalia-MPS: Business plan targets and CAGR comparison (%) Revenue Cost GOP/NOP EPS CIR ROE

Capitalia - CAGR04-07 / Targets 2007

MPS - CAGR05-09 / Targets 2009

6.0 0.0 15.0 50.0 54.0 16.0

6.5 1.0 18.0 17.0 51.0 18.0 Source: Cheuvreux

Italian banks

4

CHEUVREUX

ITALY

I— CAPITALIA: BUSINESS PLAN ON TRACK Company visit

Revenue delivery is key in 2007

Growth targets confirmed

At a recent meeting with investors, Banca di Roma's top management discussed the organic and external growth outlook for the company. Key points: 1) in 2007, commission income should fuel revenues and BdR (60% of Capitalia's assets and revenues) keeping pace with Capitalia (+15% y-o-y). 2) Management is trying to reduce the churn rate by leveraging on internal staff, by promoting and offering performance-based incentives and by splitting the bank into divisions (retail and mid-corporate). 3) The Delta 2 project (lunch and Saturday opening hours and other non-banking services) is starting to deliver results (though the visibility on the revenue contribution is limited). 4) The Bersani decree will have a negligible impact on closing fees (EUR2m for BdR per quarter in our estimates). 5) The sharp mutual fund outflow was due to the market downturn in May and the switchover to unit-linked products, while in 2007, commission income will sharply benefit from the third party bonds (~EUR2bn volume) to be sold at ~200bps more than the captive bonds. Growth targets were confirmed, but in our view, despite the stretched and aggressive targets, Capitalia has room for an EPS upgrade, as Delta 2's revenues were not announced, adding flexibility to the targets (already revised upward). Key drivers are: 1) rising penetration rates; 2) work on the client dynamic; 3) recovery of mid-corporates; 4) product and pricing opportunities.

Comparison of growth rates CAGR 04-07 (%) Revenue Cost GOP EPS

Capitalia

Cheuvreux

6.0% 0.0% 15.0% 58.0%*

6.0% 0.0% 15.0% 56.5%

*after the June 2006 update

Source: Cheuvreux

In our view, Capitalia's management has a clear vision and commitment to restructuring. BdR could gain clients following the recent wave of consolidation. The company is in no hurry to pursue external growth. In Northern Italy good opportunities might arise if cooperative ("Popolari") bank rules change (e.g. BPM). Capitalia has one year to make a move, as competition is intensifying and scale is essential. Revenue delivery and consolidation appeal should attract investors for the next 6 months. The stock trades at 11 x PE08E at a 4% discount to Italian peers.

Banca di Roma: The new deal The divisional model

Founded through merger of statecontrolled banks

Italian banks

Banca di Roma was the result of a merger of 3 state-owned Rome-based banks (Cassa di Risparmio di Roma, Banco di Santo Spirito and Banco di Roma), meaning that the company culture was very different from that of a fully profit-driven bank. Credit quality has improved sharply and the bank has been concentrating on recovering NPLs. The riskiest portion of the portfolio halved from 2003 to June 2006. After deeply restructuring its loan book and streamlining costs, Capitalia shifted its focus to revenues. One of the first steps was the reorganisation of the group's most important subsidiary: Banca di Roma (>60% contribution to the group's total income).

5

CHEUVREUX

Divisions reorganized to enhance revenue

Restructuring process

Loss of clients and measures to win them back

ITALY

The bank is now organised into a few key functions and business units, while central functions are grouped at the holding level. Over the last 12 months, the bank was split into divisions. Corporate and retail segments have been better separated to achieve a tighter focus on client segments and to improve the commercial performance. Two deputy general managers have been placed in charge of a segment. The distribution network has been split into corporate and retail units, thereby streamlining the organisation and reducing the layers of management. The restructuring targeted three main areas: 1) personnel; 2) processes; 3) marketing. Five area managers were named, four of them brand new (appointed less than 12 months ago) and all of them promoted from within the bank. For the top management, setting up the divisional network and the restructuring process provided the opportunity to reshuffle middle management: 18% of the branch managers were replaced, along with 50% of the district managers. The bank has also been focusing on IT systems, jointly with Capitalia. The IT system for the branches has been completely revamped. Marketing was the last area targeted, where the bank still has a lot to do. Before 2005, Banca di Roma posted market share and client losses (>50K a year). 2005 was the turnaround point, when the Delta 2 project was initiated to reduce the churn rate and staff training was increased in September 2005. Now, net new clients have been streaming into the bank over the last few months. The bank is trying to increase client fidelity. In Italy, clients are changing bank due to the service quality, then the price. Therefore, BdR is concentrating mainly on those factors. Banca di Roma is made up of 1,100 branches, but the top 300 branches account for the bulk of its sales. A fundamental part of the project was to turn the branches into small enterprises and branch managers into entrepreneurs. Branches started to open on Saturdays and at lunch time (Delta 2). The bank is now trying to improve its product range, including pricing, because it will be crucial to drive client/revenue growth. BdR has worked hard on technology and CRM to improve its client relationships.

Impact of the Bersani decree This decree abolished closing fees and now obliges banks to announce changes in their conditions 30 days in advance. This will fundamentally change the way banks deal with their customers and 2-3 years from now, this decree will be a key issue. Recently, the bank has had to cope with a high churn rate, which has had a negative impact of ~EUR2m per quarter, according to our estimates.

Large outflow for Capitalia AM: why?

Weak mutual fund performance

Italian banks

The reasons for the sharp mutual fund outflows from Capitalia's asset management arm are tied to: 1) the market downturn in May; 2) its commercial policy. EUR450m in funds were diverted into unit-linked, life insurance and structured bonds. Relations between the retail network and the product factory have been poor due to: (i) the weak performance, which has failed to reach the top quartile, (ii) clients (mass market) were more attracted by life insurance (market down 15%, BdR up 16% for life insurance). From a margin standpoint, the upfront fee on index funds is well above the unit-linked upfront fees. There is a cost for this leap in quality, and the bank is pushing more unit-linked products. The NPV and sustainability of client revenues is better thanks to this policy.

6

CHEUVREUX

ITALY

Is open architecture a good strategic approach? Capitalia's Asset Management division aims to improve the mutual fund performance and revamp its in-house product offer. On the other hand, the network is working on new product based on the so-called “best of breed” multi-manager funds, that will be launched in the coming months. It no longer plans to use “closed architecture”, and it should gradually shift to open architecture. Its value proposition is key: the clients must receive good solutions to manage their wealth and the bank's products must perform well. In the end, it must propose other products if it cannot manufacture them in-house.

Commercial trends are catching up

Mortgage and credit cards

Although economic trends are still lagging, commercial trends have been steadily improving, boosting Banca di Roma's net interest income (at end-September 2006, it was up 4% y-o-y). For commission income, the subsidiary still has significant room to grow: net fees declined by 1% at end-September 2006. Commercially, growth rates have rebounded: credit cards have been growing at a triple digit rate recently, with mortgages at +41% (vs. 15% for the market). Before, Capitalia did not sell any creditrelated insurance, now it represents 33% of the mortgage transactions (according to the latest statistics for mid-November). BdR has a lot of opportunities (e.g. 20% penetration rate in credit cards vs. 40% at UC, according to our estimates). On the corporate side, outstanding SME loans have declined, and SME loans have recently grown by 18%, meaning that segmentation is starting to pay off. Retail loans soared by +54%. The quality of the brand has dramatically improved: from below average in the Rome area to the top quartile and it has risen every quarter. The recent wave of consolidation helped Banca di Roma to gain clients, but now the trend is slowing down.

Competition and external growth strategy

The market environment

Capitalia's attitude to external growth

The preferred route

Italian banks

Most stocks in the Italian banking system are listed, contrary to Germany, where more than 50% of the market is not listed. So competition is fierce among Italian banks to keep profitability high (all are profit-driven). Today, more than 30% of all Italian advertising campaigns are launched by financial institutions, far outstripping the publicity rates of the past. Pricing pressure is also more evident: some banks have launched zero-commission current accounts. One year from now, the landscape will have changed completely, however, thanks to Antitrust efforts, the market will not be an oligopoly. Capitalia’s management thinks that doing nothing at all is not an option, but rushing into a deal is not feasible either. In our view, there are still opportunities, in particular in the world of cooperative banks (a new reform for "Popolari" should be announced soon). It is not interested in BP Milano for the moment: it has an extensive network, so an acquisition would make sense, but a deal would not be cheap, and it would be hard to take it over, with the current Popolari bank regulations. An amendment of the law would change the landscape, and would also attract the interest of foreign players. Geographically, Unicredito is well-diversified, like other major European banks, and represents a benchmark for Italy, in our view. The only major bank that is not diversified is SPI-Intesa, which is based solely in Italy. There is a gap between the large European and Italian banks. Capitalia's primary goal is to consolidate in Italy, then expand in Europe.

7

CHEUVREUX

Banca di Roma's business plan targets…

…for 2007 are mostly in line with our estimates

ITALY

BdR's targets are consistent with Capitalia’s business plan. Qualitatively, growth should stem from: 1) better client dynamics; 2) under-penetration of the corporate segment; 3) better pricing, thanks to the recently launched bundled products (mortgages+insurance). The bank is revamping its whole product range. Delta 2 is obviously helping: opening on Saturdays is generating traffic and has become a distinctive trait of the bank. The bank is also making its staff aware of what it means to lose, or gain a client. As a result, the company culture is undergoing profound changes. G&A costs have been broadly stable (excluding personnel costs and depreciation) and cost growth has been limited to specific activities (advertising, promotions, etc.). In Q4-05, costs were very high due to the launch of Delta 2, but Q406 will be more consistent with previous quarters of 2006. Personnel cost growth will be dependent upon the performance and this is a major improvement for BdR. Capitalia’s upfront revenues represent 3% of the revenue base vs. 11% for Unicredito. But the bank has been front loading costs and the return on these investments (Delta 2) is 18 months on average (for branch openings, a range of 300k-600k fixed costs per branch) and 12 months when they are efficient. Capitalia expects to achieve the following upgraded targets in 2007: EUR5.9bn total income, EUR3.2bn operating expenses, EUR2.7bn gross operating profit and EUR1.4bn net income. Our revenue and cost estimates are bang in line with Capitalia's guidance, but our net income estimate is slightly lower than the target (by 2.5%). Another difference is the revenue mix, as we expect 6% commission income growth vs. Capitalia's 15% target. The original business plan, rolled out in July 2005, had the following targets: Capitalia: Original business plan targets (%) Revenue Cost Gross operating profit EPS CIR ROE Core Tier 1

CAGR 04-07 / Targets 2007 6.0 0.0 15.0 50.0 54.0 16.0 7.0 Source: Capitalia

Following H1-06 results, Capitalia raised its 2007 guidance, lifting the original EPS target from EUR0.51 to EUR0.55 to account for: 1) the improving macroeconomic environment (GDP estimates upgraded, interest rates spread to widen as opposed to the original business plan assumption); 2) the cheaper cost of funding, following the credit agencies' ratings upgrade (excluded from the plan); 3) conservative provisions and higher write-backs (EUR554m write-backs in 2005, vs. avg. EUR200m budgeted; EUR334m write-backs at end-September 2006 vs. avg. EUR200m annual budget); 4) lower tax rate (the company is now targeting 37%, 1% below the plan guidance of 38%); 5) revenue from Delta2 project (not included in the original plan forecast). In terms of the contribution to the 2007E EPS target, EUR0.02 should stem from the revised revenue target and EUR0.02 from provisions, write-backs and the tax rate. As we noted earlier, the announced targets are achievable in our view, therefore we recently raised our 2007E EPS (following H1-06 results) nearly aligning it with the company target of EUR0.55.

Italian banks

8

CHEUVREUX

ITALY

II— MPS: A RESTRUCTURING STORY Company visit

New bancassurance deal

Capital allocation

Many projects in the pipeline

At our meeting with Banca Monte dei Paschi di Siena's (MPS) Chairman, Mr. Mussari and General Manager, Mr. Vigni, we were informed that the board has approved a short list of candidates (seven insurers who were not officially identified) to buy 50% of MPS Vita, paving the way for a 50-50 JV. Eventually, the partnership could be extended to asset management and might allow MPS to expand abroad, leveraging on the same distribution platform. As a result of the joint venture, the bank's strategy is likely to shift to the pension and life market, which should unlock capital and generate a EUR550-600m capital gain according to our preliminary calculations. This excess capital could be used to finance both organic growth and external growth (to double its market share from 6% to 12%). At the moment, MPS is focusing on cost savings and aims to complete the restructuring process in 2007, in order to improve its revenue and value proposition. Capital is the other big issue for the bank: it must decide whether to sell or try to raise the return on its ~EUR2bn equity portfolio by 2007. EUR300m of non-core real estate assets will be sold. In addition, the bank plans to increase the number of branch openings from 200 to 300 by 2009. Management is also planning a joint venture in dynamic NPL management. Clearly, there are many initiatives in the pipeline. The key issues are revenue delivery and more efficient use of capital. The bank is shifting to a brand new business model. There is great scope for improvement in many areas, which could give MPS the opportunity to grow: 1) low penetration of corporate fees; 2) still high costs for both personnel and G&A; 3) above average tax rate; 4) a top line cleaned from upfront fees and ready to grow. However, all of this growth potential already seems to be priced in. MPS is a restructuring story with several gaps to fill, but the multiples already imply a premium stemming from consolidation appeal. However, the bank seems to be more a bidder than prey. We maintain a cautious stance, as the stock trades at 11.7 x PE08E, at a slight premium to Italian peers.

MPVita deal 7 candidates for MPVita

Capital release

According to the press, in late November the Board of Directors approved a short list of 7 institutions to form a life insurance partnership (MPS Vita, EUR800m in embedded value at end-2005). Apparently, all the major European insurers and bancassurers are on the list (which was not disclosed). According to the press, the candidates are Axa, Aegon, CNP, Talanx (German insurer not listed), Fortis, Predica (Credit Agricole) and Zurich. The partner (to be selected in a few weeks) will hold a 50% stake in the company and will have management control. For MPS, the industrial rationale is fundamental: on top of creating a powerful new bancassurer in Italy, MPS will book a nice capital gain and free up capital (with a view to Basel II). Through the JV, MPS will unlock capital (50% of the economic capital of MPS Vita) and its unit-linked policies will consume far less capital as well. Moreover, the capital gain will reinforce the capital base. The joint venture could also pave the way for expansion in other countries, where the new partner is already present. This is the last chance for a foreigner to enter the attractive Italian bancassurance market and MPS intends to make the most of the deal.

Italian banks

9

CHEUVREUX

The Italian bancassurance market

ITALY

Italy is the fourth largest bancassurance market in Europe and the sixth largest in the world. The insurance and pension markets in Italy will grow fast. MPS started this business in a JV with Crédit Agricole’s Prédica in 1994, but re-gained control five years later and set up MPS Vita. Now, it has 10% market share, above MPS' natural market share of 6% as MPS was an early mover and a pioneer in this market. The key issues in this business, apart from distribution, are product quality (which must be well-designed to meet clients’ specifications) and risk-management, and the new partner should be able to provide just that.

Potential business models in bancassurance and AM

New opportunities

Two business models could be employed to manage the bancassurance business: 1) open architecture; or 2) JV in asset management and life insurance. The problems stem from the products: they do not adequately meet clients' needs (particularly the traditional and unit-linked policies). Clients tend to prefer guaranteed products or short term products at the moment. However, the demand for long term saving instruments is rising, but there is no appropriate product on offer. MPS thinks that there is an appealing opportunity there. Moreover, management feel that attractive opportunities could arise in the SME market (pension products for staff) as well as in P&C.

Outlook for the Tuscan economy

Finally a recovery

After a slowdown that lasted for several years, the region is recovering from zero growth to positive growth. MPS has a positive stance for the next 2-3 years on the economy of the area. More than 1/3 of MPS' business is based in Tuscany, 1/3 in the north and a bit less than 1/3 in the south. In Tuscany, some sectors are still undergoing what looks like successful restructuring, in particular the steel and textile industries. There is also a lot of M&A activity in the SME universe. Competition from China has been dealt with successfully and exports are on the rise again. Two years ago, the bank acknowledged that the situation was poor, but was still optimistic that things would move in the right direction. Now, things are turning around. Corporate margins are under competitive pressure and declining, but MPS must recover market share in this segment, where it is still lagging compared to retail. So new initiatives will be implemented:

Restructuring actions and new initiatives Management has several projects in the pipeline for 2007-09. The most important are capital re-allocation from the under-performing equity stakes into other areas and the turnaround of several subsidiaries and business units. It plans to change the territorial organisation (fewer regional centres), invest in new products and improve distribution. It will focus its restructuring efforts on Banca Toscana, MPS Leasing and Factoring and the headquarters, as the front/back office ratio is still very low. Banca Agricola Mantovana has a ROE of 14%, but Banca Toscana, with less than 10%, is definitely lagging behind. MPS L&F is now only one company, whereas this business was run by 4 companies a few years ago.

Corporate banking

Italian banks

In corporate banking, the merger of Banca per l’Impresa with MPS Finance, will enable the company to propose a wider range of products from long term financing to investment banking and capital markets. In the last few quarters, credit spreads went down, but margins held up due to rising rates. As a result, MPS had to compensate by raising volumes, and there are signals that market share is on the rise: the number of corporate clients increased (+47,000 clients). The corporate segment shows considerable potential, as the penetration of commission-based products is still very low: 95% of the revenues in the corporate segment comes from NII.

10

CHEUVREUX

Distribution network reorganisation

ITALY

As for the distribution network reorganisation, MPS has changed its strategy for the size of the new branches: previously it opened branches with 2-3 people, however this renders it more difficult to make the units profitable, now the average headcount is 4-5 people. The network has achieved better deposits and assets per capita, and also a better operating profit per capita. The key issue is not branches, but the headoffice, which is overstaffed. The restructuring of the territorial organisation was aimed at cutting Regional Head office and back office functions: since November 2006, BMPS Bank has reduced its commercial districts from 22 to 9, including 2 in Tuscany (from 5) and only one in the north (from 3). The geographical target is where MPS is below 5% market share, as the group realized, by benchmarking branches and penetration/profitability/products, that achieving more than 6% in a certain area significantly increases the profitability of all the branches in the area. The focus is therefore the north, east (Adriatic, Marche) and south of Italy. All banks are following the same path: over the first nine months, the Italian banking system has opened 1,000 branches and closed 260.

Tax rate higher than the system

From a fiscal standpoint, MPS could see some improvement, as it the Italian bank with the highest tax rate (40%). High personnel costs and high provision charges, which are not entirely deductible, are responsible for this. The group will improve this in the years ahead, even though it will not reach the 35% that Intesa and Unicredito achieve as it does not have the same tax-saving opportunities

MPS: Key success factors Franchise to combat competition

Banks are experiencing a sharp increase in competition for retail business, just like the rest of Europe. MPS is responding to this by broadening its product range and cutting costs. For example, MPS is beefing up its consumer finance business; it now has more than 7% market share in mortgages and its P&C business is developing very well. MPS' key strengths are mostly tied to its franchise: −

First, it has very low churn rate (one of the lowest in the Italian banking industry), thanks to strong bank/client relationships and its strong geographical footprint.

−

The high quality of personnel at the distribution network is also a major plus.

Products on the other hand, show room for improvement.

Market share in asset management

In asset management, its market share is too low, at only 4.5%. The business is performing well, but it is too small to offer the best products, so the best way forward is to implement open architecture and proceed with the new JV in life insurance. Overall, MPS' top line is cleaner than most other Italian banks, as it charges upfront fees for structured bonds, but only for the less popular indexed funds. MPS considers its distribution network to be the best in Italy, but it needs to improve cost efficiency: the plan targets a decline in the cost/income ratio (C/I) from 60% today to the best in class, i.e. ~50%. The ratio of front to back office staff has improved by 6pp (from 42% to 36%) over the last few years. Now, it also needs to improve the quality of its product range.

Capital allocation

RAROC problems

Italian banks

MPS' capital allocation is not optimal, the group has a problem with the RAROC of certain businesses, i.e. MPS L&F must and will reach 15% thanks to the restructuring that is underway. Banca Toscana will undergo heavy restructuring under a new, younger management team.

11

CHEUVREUX

ITALY

MPS has also a problem with its large equity holdings (~EUR2bn) and real estate portfolios (EUR1.5bn), which together represent 16% of the net equity and yield –6%.

Equity stakes

Part of its equity portfolio will be sold: Finsoe, Hopa, Generali, Santorini. On 15 December, MPS sold the 1.6% stake in Generali, but will retain its voting rights for three years. The forward private agreement will take place at EUR32.86 per share at a 4.3% discount to the market price. The buyer is Mediobanca. MPS will make a gross capital gain of EUR220m. This is good news, indicating that MPS is finally addressing the capital allocation issue, by reducing its equity stakes, which absorb 16% of the capital (~EUR2bn). The re-deployment of the capital in other more profitable ways will help the bank to meet its business plan targets. However, the Generali stake was not a problem, given the good yield: the key stakes to be addressed are the Hopa, Santorini and Finsoe stakes. We estimate that those stakes will likely be sold in 2007, unlocking another ~EUR1.4bn of capital. The Generali stake disposal will also free up considerable capital (EUR663m). The Tier 1 impact is limited to 10 bp, whilst the net capital gain should have a ~14% impact on 2006 stated net profit. The non-core real estate (that is not used for the banking business) will be sold as well, i.e. EUR0.3bn out of the EUR1.5bn. The tax collection business was handed over to the Ministry of Finance, reducing the workforce by 2,000 employees (and improving the C/I ratio by 1pp).

Foundation and voting rights The removal of the cap on Foundations’ voting rights, would have a negligible impact on MPS. It is more a question of principle, asserting the Foundations' right to take full advantage of their holdings. Moreover, the cap appears unfair and anti-capitalistic. Note that at the AGMs, MPS Foundation has always applied a limit to its voting rights equal to the number of shares held by the other shareholders present at the AGM minus one. So decisions required the approval of other shareholders to be passed.

Business plan targets The 2005-2009 plan

In June 2006, MPS rolled out its new 2007-09 business plan targeting: 1) reduction of capital allocated for its equity portfolio (~EUR1.5bn ex-Generali) 2) better risk management (cost of credit below 40 bps) and agreements with third parties to recover bad loans; 3) a more effective commercial model, driven by the renewal of the products on offer and to the new business model (JV in key segments as bancassurance – 50% MPVita currently up for sale); 4) restructuring (10% headcount reduction (including tax collection); 5) increased penetration, thanks to new branch openings (200) and new clients; 6) alignment of the underperforming areas with the group's best practice standard (i.e. Banca Toscana, the Corporate banking division, MPS Leasing & Factoring). Financial targets for 2009 are: a 51.2% cost to income ratio (from 64.8% in 2005) and 18.1% ROE (from 12.9%), which implies ~EUR1.5bn net profit, not far off our EUR1.419m estimate (due to a slightly slower revenue trend). MPS: Business plan targets (%) Revenue Cost Net operating income EPS CIR ROE Core Tier 1

CAGR 05-09/Targets 2009 6.5 1.0 18.0 17.0 51.0 18.0 ~7.0 Source: BMPS

Italian banks

12

CHEUVREUX

ITALY

Company profiles

Capitalia MPS

Italian banks

13

CHEUVREUX

ITALY

Intentionally blank

Italian banks

14

CHEUVREUX

ITALY

Capitalia (EUR7.17)

Banks - 5 January 2007

Rating: 2/Outperform - Target price: +11.7% EUR8 (from EUR7.6) To 31/12 (EUR) Revenues (m) Cost/Income ratio (%) Bad debt charge (%) Op. profit (m) Net attrib. profit (m) Clean EPS P/E (x) Core capital ratio (%) Core ROE (%) Tangible BVPS P/TBVPS (x) Net dividend Yield (%) Payout ratio (%)

Market capitalisation No. of shares, adjusted Daily volume

2005E 5 173 60.5 0.66 1 454 1 028

2006E 5 536 58.1 0.58 1 795 1 265

2007E 5 926 54.6 0.54 2 180 1 369

2008E 6 450 50.7 0.57 2 610 1 638

0.38 12.8 6.1 14.9 2.66

0.45 16.0 6.4 16.9 2.91

0.54 13.3 6.7 16.7 3.17

0.65 11.0 7.1 18.2 3.49

5

1.8

2.5

2.3

2.1

1

0.2 4.1 50.0

0.2 3.4 50.0

0.3 3.7 50.0

0.3 4.4 50.0

EUR18 521m 2 584.9m EUR118.41m

S&P/MIB Reuters Bloomberg

Carlo Tommaselli

9 8 7 6

4 3 2 01/01

09/01

06/02

03/03

mêáÅÉ

41 597 CPTA.MI CAP IM

Absolute perf. Relative perf.

12/03

09/04

06/05

03/06

01/07

mêáÅÉLpCmLjf_

1 month

3 months

12 months

5.4% 2.4%

6.7% 0.0%

44.0% 24.9%

Shareholders: ABN Amro 8.6%, Fondazione Cassa di Risparmio di Roma 5.0%, Fondazione Manodori 4.0%, Fondiaria-SAI 3.5%, Regione Siciliana 2.8%, Fond. Banco di Sicilia 2.7%, Libyan Arab Foreign Bank 2.6%, Generali 2.3%, Free Float 66%

At the centre of the consolidation process Q3-06 results were in line at the operating income level. Revenues were 2% higher than we expected, thanks to trading income, which benefited from the disposal of 12m FIAT shares (EUR56m capital gain). Interest income was 1.7% better than expected, thanks to higher customer loans (+3.6% vs. Q2) and to a 2 bp improvement in the customer spread. The liability spread was the main growth driver. Commission income was 3% below our forecast, due to a slowdown in asset management and the placement of captive bonds, which will keep the cost of funding low, unless the credit agencies raise Capitalia's rating. If that occurs, Capitalia will benefit from lower financing costs and can place third party bonds to secure ~2.5% fees, rather than the current 0.5% return on the captive bonds. Operating costs for the Delta2 project (non-recurring) and for advertising were higher than expected. The cost/income ratio rose from 59% in previous quarters to 61%. Asset quality remained stable, as did the coverage ratio at ~68%. Including the rising lending volumes, LLP remained broadly in line with previous quarters, at 12.3 bps vs. 14.6 bps in Q2-06. Write-backs are at an all-time high. The tax rate was higher than expected, rising to 41.5% in Q3-06, due to the lack of extraordinary items, but it is expected to normalise at ~37% in Q4-06. In July 2005, Capitalia rolled out its 2005-07 business plan. After H1-06 results, management raised the 2007 guidance, lifting the original EPS target from EUR0.51 to EUR0.55. The reasons for this revision were: 1) the improving macroeconomic environment (GDP estimates upgraded, interest rates spread to widen vs. business plan assumption); 2) cheaper cost of funding, following the credit agencies' ratings upgrade (excluded from the original plan); 3) conservative provisions and write-backs (EUR554m write-backs in 2005 vs. EUR200m avg. budgeted; EUR334m write-backs at end-Sept 2006 vs. avg. EUR200m budgeted); 4) a lower tax rate (Capitalia now has a 37%, target, 1% below the 38% plan guidance); 5) revenues from the Delta2 project (previously excluded from the business plan). In terms of the contribution to the 2007E EPS target, the revision should carry EUR0.02 from revenues and EUR0.02 from provisions, write-backs and the tax rate. In our view, the new targets are achievable and we recently revised our 2007E EPS (after H1-06 results) broadly aligning them with the company target of EUR0.55. We would not rule out the eventual sale of part of the on-balance-sheet NPLs to unlock capital and raise profitability, thanks to a further improvement in Capitalia's risk profile. In terms of capital allocation, the bank recently set up Capitalia Partecipazioni SpA, where it has concentrated its equity portfolio, with the dual goal of rationalisation and value optimization. Capitalia's core equity portfolio comprises: 9.4% of Mediobanca, 2.4% of Generali (to serve the convertible bond), 1.85% of FIAT, 5.22% of Parmalat and 1.98% of RCS Media Group, for a total mark-to-market of EUR3bn. Its equity investments are currently performing well, but we do not rule out a reallocation of capital to other activities, which would lead to major capital gains on the P&L (the current revaluation is carried out at equity). In the current consolidation scenario, Capitalia is rumoured to be a target either for SCH (after the disappointing outcome of the SPI-Intesa deal) or for ABN Amro, for which corporate action on Capitalia would be the most reasonable defensive tactic.

Italian banks

15

CHEUVREUX

ITALY

Company profile

Valuation

Capitalia is ranked 4th in Italy, with a banking franchise consisting of 1,948 branches: 492 are based in Lazio (19.2% market share), 454 in Sicily (26.2%% market share), 141 in Emilia Romagna (4.2% market share) and 230 in Lombardy (3.8% market share). Capitalia has an overall market share of 3.3% in northern Italy, 8.7% in central Italy and 11.1% in the south.

Our SOP-based valuation delivers a fair value of EUR6.7 for Capitalia, implying ~6.5% downside vs. the current market price.

Capitalia is vertically integrated, with 100% of its wealth management (Capitalia AM) and corporate banking products (MCC) produced in-house. It outsourced bancassurance to CNP, after selling its majority stake in Fineco Vita at end-2005 (it currently owns a 38.8% stake in CNP-Capitalia Vita). Customer loans totalled EUR93bn at end-September 2006, with EUR90bn of customer deposits and EUR125bn of indirect deposits, of which AuM accounted for EUR50bn. Capitalia holds 5.1% domestic market share in mutual funds.

We based our valuation on a 9.4% cost of equity and 2.5% long term growth rate. In our 2007E SOP, the retail banking business weighs for 35% of Capitalia's net profit and 25% of capital (39% of the fair value). Corporate banking represents 13% of the net income and 29% of the capital (10% of the fair value). The Investment banking division generates 23% of the net profit, while absorbing 21% of the capital and represents 20% of the fair value. The other businesses account for the remaining 12% of the capital (including the corporate centre, i.e. the equity stakes) and 27% of the total value. Including the dividend, the 2007E SOP yields a total fair value of EUR17.2bn, or 12.3x 2007E PE. We factored in a new consolidation premium of 20% to the fair value (from the previous 14%), which lifts the target price to EUR8 from EUR7.6.

Investment case

SWOT analysis

Our positive stance on Capitalia is based on: 1) visible revenue delivery in 2007, supported by the expected commission recovery; 2) the promising Delta 2 project, whose costs were front-loaded (but not revenues); 3) conservative write-backs at budget, as in the last two years the actual result was actually double the forecasted figure; 4) the cheaper cost of funding expected, following the credit agencies' recent upgrade; 5) instability of the shareholder structure: the strategic shareholder (ABN Amro) appears willing to refocus its strategy on Europe rather than the Americas, through Capitalia. In addition, SCH is also apparently interested in Capitalia as an alternative to the disappointing SPIIntesa deal. Capitalia's syndicated pact expires in July 2008, but it would be possible to launch a takeover, with the unanimous approval of all pact members. 6) News flow on the new business plan (2007-09) is expected in 2007 (presumably toward the end of the year).

Strengths 1 - Management's strong track record for turnarounds 2 - Achievements in NPL management and recovery 3 - Tight control of the cost base 4 - Pioneer in Italy in launching lunch and Saturday opening hours

Capitalia trades at 11.02 x PE08E, at an unjustified 4% discount to Italian peers. In terms of EPS growth, we forecast a 2006-08E CAGR of 20.4%, among the highest in Europe. In our view, Capitalia is the safest way to play the current wave of consolidation in Europe in the short term, based on its appealing valuation, visible targets and reliable management.

Italian banks

Weaknesses 1 - Unsound asset quality 2 - Product range in asset management and bancassurance 3 - Market share in mutual funds below the natural market share 4 - Disappointing commission income trend Opportunities 1 - Rationalisation of equity stakes 2 - NPL disposal might unlock capital and improve the risk profile 3 - Delta 2 project revenues could be underestimated 4 - Further room for LLP decline and higher writebacks Threats 1 - Failure to deliver revenues (commission income) 2 - Asset margin pressure 3 - Execution risk in managing bad loans 4 - Bidding risk

16

CHEUVREUX

ITALY

EPS & ROE

Profit & Loss account (%)

2.0

20.0 15.0

7 000 6 000 5 000 4 000

10.0 5.0

0.0

3 000 2 000 1 000

0.0 -5.0 -2.0

0 99

-1 000

-10.0 99

00

01

02

03

bmp

04

05

06

07

01

02

03

04

05

06

07

08

kÉí=Ä~åâáåÖ=áåÅçãÉ léÉê~íáåÖ=ÅçëíëHiç~å=äçëëÉëH^ëëçÅá~íÉë mêÉJí~ñ=éêçÑáí=ÉñÅäK=ÉñÅÉéK

08

olb=EBFI=EêÜëF

PE after and before goodwill 96 92 88 84 80 76 72 68 64 60 56 52 48 44 40 36 32 28 24 20 16 12 8 4 0

00

-2 000

Price to book value and RoE

(x)

(x)

2.5

(%)

20.0 15.0

2.0

10.0

1.5

5.0 1.0

0.0

0.5

-5.0

0.0

-10.0 99

99

00

01

02

03

mLb

mLb=ÄÉÑ=dt

04

05

06

07

(%)

80.0 75.0

3 500

70.0

3 000

65.0

2 500

60.0

2 000

55.0

1 500

50.0 45.0

1 000

40.0

500

35.0 30.0

0 00

01

02

léÉê~íáåÖ=Åçëíë

Italian banks

03

04

02

03

04

mL_s

(m)

99

01

05

06

07

05

06

07

08

08

Operating costs and Cost to income ratio

4 000

00

08

`çëíLfåÅçãÉI=EêÜëF

olbI=EêÜëF

Average risk-weighted assets and Loan loss ratio (% of RWA) 120

(bn)

(%)

100

2.50 2.00

80

1.50

60 1.00

40

0.50

20 0

0.00 99

00

01

02

^îÉê~ÖÉ=ot^

03

04

05

06

07

08

iç~å=äçëë=ê~íáç=EB=çÑ=ot^FI=EêÜëF

17

CHEUVREUX

ITALY

Capitalia FY to 31/12 (Euro m)

2000

2001

2002

2003

2004

2005E

2006E

2007E

2008E

4 189

3 964

4 452

4 801

4 899

5 173

5 536

5 926

6 450

6.5

-5.4

12.3

7.8

2.0

5.6

7.0

7.0

8.8

(2 742)

(2 608)

(3 365)

(3 221)

(3 140)

(3 130)

(3 216)

(3 238)

(3 272)

P&L and cash flow statement Total income % Change Operating costs % Change Pre provision operating profit % Change

0.6

4.9

-29.0

4.3

2.5

0.3

-2.7

-0.7

-1.1

1 447

1 356

1 087

1 580

1 759

2 043

2 320

2 688

3 178

23

(6)

(20)

45

11

16

14

16

18

(755)

(903)

(2 330)

(1 563)

(1 450)

(589)

(525)

(508)

(568)

582

453

(1 243)

17

309

1 454

1 795

2 180

2 610

-

-22.2

-

101.4

-

-

23.5

21.4

19.7

Associates [contribution]

(110)

0

0

0

0

0

0

0

0

Other exceptional items

135

261

1 044

243

439

41

140

0

0

Pre-Tax Profit

607

714

(199)

260

748

1 495

1 935

2 180

2 610

Bad debt charge Profit bef tax, exceptionals and GW [B] % Change

% Change

12.2

17.6

-

-

187.7

99.9

29.4

12.7

19.7

Tax

(382)

(428)

(67)

(89)

(140)

(461)

(665)

(806)

(965)

Goodwill amortisation

(59)

(120)

(121)

(120)

0

0

0

0

0

Minorities

(34)

(63)

58

(20)

(277)

(6)

(5)

(5)

(7)

Net attributable profit [loss] [B]

242

103

(329)

31

331

1 028

1 265

1 369

1 638

NAP [Loss], restated after goodwill

206

101

(33)

(53)

353

990

1 160

1 399

1 669

% Change

-8.8

-51.0

-

-60.6

-

180.5

17.2

20.6

19.3

ROE [%]

4.3

1.8

(4.8)

0.5

5.1

12.5

14.3

14.3

15.8

Core ROE [%]

5.8

4.0

(3.2)

2.4

5.3

14.9

16.9

16.7

18.2

65.5

65.8

75.6

67.1

64.1

60.5

58.1

54.6

50.7

(0.77)

(0.85)

(2.28)

(1.66)

(1.64)

(0.66)

(0.58)

(0.54)

(0.57)

Financial Ratios

Cost income ratio [%] Bad debt charge [% av. RWA] Per Share Data EPS before goodwill

0.20

0.10

0.04

0.03

0.14

0.38

0.45

0.54

0.65

% Change

-8.0

-49.0

-60.0

-35.0

-

179.6

17.2

20.5

19.4

Dividend per share

0.05

0.00

0.00

0.02

0.08

0.20

0.25

0.26

0.32

Book value per share

4.2

2.6

3.0

2.5

2.5

3.2

3.4

3.7

4.0

Tangible book value per share

3.8

2.5

2.9

2.5

2.4

2.7

2.9

3.2

3.5

Latest price

4.62

2.23

1.21

2.33

3.37

4.89

7.17

7.17

7.17

High

6.30

5.30

3.21

2.94

3.39

5.05

7.40

7.29

0.00

Low

4.28

1.79

0.75

0.94

1.92

3.25

4.85

7.16

0.00

Average price

4.89

3.70

1.97

1.72

2.58

4.31

6.49

7.21

0.00

Market capitalisation (Euro m)

25 239

4 943

2 691

6 015

8 691

12 640

18 534

18 521

18 521

Detailed N° of shares (m)

5 463.000

2 216.600

2 216.600

2 584.900

2 584.900

2 584.900

2 584.900

2 584.900

2 584.900

Av. number of shares, adjusted (m)

1 352.000

2 216.600

2 216.600

2 584.900

2 584.900

2 584.900

2 584.900

2 584.900

2 584.900

23.6

22.4

30.6

90.0

24.7

12.8

16.0

13.2

11.1

1.1

0.0

0.0

0.9

2.4

4.1

3.4

3.7

4.4

Payout ratio [%]

28.9

0.0

0.0

166.8

62.3

50.0

50.0

50.0

50.0

P/BV

1.10

0.85

0.40

0.92

1.34

1.53

2.09

1.94

1.79

Valuation multiples and ratios P/E before goodwill Yield [%]

Balance sheet Customer credits & leases Total assets Customer deposits [excl repos] Minority interests Pref shares and hybrid capital Shareholders' equity [group share] Customer deposits/Customer loans Risk weighted assets [end of period] % Change Total Tier 1 capital Tier 1 ratio [%] Core eco capital, group share

Italian banks

72 837

74 452

80 094

75 227

76 418

82 389

91 785

103 316

116 704

133 586

133 114

140 943

126 982

131 801

136 375

141 160

154 304

169 344

38 927

41 220

52 114

46 076

50 624

62 140

68 354

73 822

78 990

634

654

450

485

735

226

226

226

226

0

0

0

0

0

0

0

0

0

5 836

5 850

6 726

6 620

6 690

8 755

9 509

10 242

11 195

53.4

55.4

65.1

61.2

66.2

75.4

74.5

71.5

67.7

103 001

106 000

98 525

89 375

87 367

90 687

91 045

96 437

102 449

9.9

2.9

-7.1

-9.3

-2.2

3.8

0.4

5.9

6.2

5 877

5 260

5 809

6 126

6 166

5 784

6 028

6 701

7 510

5.3

5.3

6.2

6.9

7.3

6.4

6.6

6.9

7.3

5 243

3 340

4 231

4 111

4 709

4 794

5 018

5 670

6 458

18

CHEUVREUX

ITALY

Banca MPS (EUR4.91)

Banks - 5 January 2007

Rating: 3/Underperform - Target price: +1.9% EUR5 (from EUR4.7) To 31/12 (EUR) Revenues (m) Cost/Income ratio (%) Bad debt charge (%) Op. profit (m) Net attrib. profit (m)

2005 4 728 63.3 0.59 1 198 790

2006E 5 073 59.8 0.45 1 610 1 102

2007E 5 339 57.8 0.45 1 797 1 443

2008E 5 741 54.7 0.45 2 127 1 281

Clean EPS P/E (x) Core capital ratio (%) Core ROE (%) Tangible BVPS

0.29 13.8 7.2 13.4 2.03

0.30 16.6 7.3 13.8 2.21

0.36 13.6 7.5 14.8 2.47

0.42 11.7 8.1 15.8 2.66

1.9

2.2

2.1

2.0

0.1 3.3 49.8

0.2 3.7 49.7

0.2 4.6 46.9

0.2 4.7 55.0

P/TBVPS (x) Net dividend Yield (%) Payout ratio (%)

Market capitalisation No. of shares, adjusted Daily volume

EUR14 841m 3 023.9 m EUR36.32m

S&P/MIB Reuters Bloomberg

Carlo Tommaselli

6 5 5 4 4 3 3 2 2 01/01

10/01

07/02

04/03

mêáÅÉ

41 597 BMPS.MI BMPS IM

Absolute perf. Relative perf.

01/04

10/04

07/05

04/06

12/06

mêáÅÉLpCmLjf_

1 month

3 months

12 months

2.2% -0.7%

2.3% -4.2%

24.0% 7.6%

Shareholders: Fondazione Mps 49.0%, Caltagirone Francesco 3.8%, Premafin 2.6%, Free Float 44.6%

Restructuring appeal at a high price In Q3-06, interest income rose by 1.3% q-o-q, due to 3% loan growth. The commercial spread remained resilient, rising by only 4 bps on Q2-06, but there was some asset margin pressure, especially in corporate banking. Investment banking reported poor interest income, down 35% y-o-y (just as it did in 2005), due to some one-off items. Commission income came in 2% below estimates. Aside from the seasonal weakness, MPS is trying to reduce the contribution of non-recurring items on up-front fees. The contribution of the insurance company improved in Q3-06 thanks to the recovery of the bond portfolio. Operating costs exceeded our expectations by 1.2%, mainly due to oneoff costs for early retirement (EUR18m in Q3-06). Gross operating profit was up 8.2% y-o-y, in line with Q-06, slightly ahead of our estimates. Asset quality is improving on an annual basis. The net NPL ratio remained steady at 1.9%, along with the coverage ratio at 52.8% q-o-q. Annualised LLP fell slightly from 51 bps to 49 bps. The tax rate was 40.5%, in line with our estimates. The bank should close the year with roughly EUR969m net profit. Management is confident that it will benefit from a declining cost trend in 2007. LLP could further decline. The spread is under pressure, along with fee income, because the focus is shifting to structural revenues. For 2006 and 2007, we have raised our stated net profit forecasts by 13.7% and 33.4% respectively (with a negligible impact on the core earnings) to include the impact of the capital gains on the disposal of the Generali stake (~EUR220m) and 50% of MPVita (EUR600m). The impact on the fair value is EUR0.3 per share, stemming from the higher excess capital. In June 2006, MPS rolled out its new 2007-09 business plan, which is based on: 1) a reduction of capital allocated to equity investments (~EUR1.5bn ex-Generali); 2) better risk management (cost of credit below 40 bps) and agreement with third parties to recover bad loans; 3) higher commercial efficiency, thanks to the renewal/updating of products offered and to the new business model (JV in key segments like bancassurance – 50% MPVita currently up for sale); 4) restructuring (10% reduction in the group's headcount (including tax collection); 5) increased penetration, thanks to new branch openings (200) and new clients; 6) alignment of the underperforming areas with the group's best practice standard (i.e. Banca Toscana, Corporate banking division, MPS Leasing & Factoring). For 2009, financial targets include: a 51.2% cost/income ratio (from 64.8% in 2005) and 18.1% ROE (from 12.9%), which implies ~EUR1.5bn net profit, not very far off our EUR1.419m estimate (due to a slightly slower revenue trend). Recently, the bank made a forward sale agreement with Mediobanca to sell its Generali stake, for a ~EUR700m cash-in and EUR220m capital gain, which is a sign that the capital re-allocation process has finally begun. The key issues are revenue delivery and more efficient use of capital. In our view, the bank is shifting to a brand new business model. There is great scope for improvement in many areas, which could give MPS the opportunity to grow: 1) low penetration of corporate fees; 2) still high costs for both personnel and G&A; 3) above average tax rate; 4) a top line cleaned from upfront fees and ready to grow. MPS is an appealing restructuring story, with some major gaps to fill. However, its multiples already factor in a premium for consolidation appeal, despite the fact that it seems more likely to be a bidder than a prey.

Italian banks

19

CHEUVREUX

ITALY

Company profile

Valuation

MPS is ranked 5th in Italy, with a banking franchise consisting of 1,884 branches: 583 are based in the appealing Tuscan region (25% market share), 285 in Lombardy (4.7%% market share) and 148 in Lazio (5.8% market share). MPS has an overall market share of 3.0% in northern Italy, 12.7% in Central Italy and 6.4% in southern Italy. The group serves 4.15m retail customers and 350k corporate clients.

Our SOP-based valuation delivers a valuation of EUR5 for MPS, implying ~1% upside vs. the current market level.

MPS is vertically integrated, with 100% of its wealth management and investment banking products produced in-house. The bank is modifying its strategy, to focus on a bancassurance JV and NPL recovery.

We based our valuation on a 10.1% cost of equity and 3% long term growth rate. In our 2007E SOP, the retail banking business weighs for 37% of MPS' net profit and 18% of its capital (40% of the fair value). Corporate banking represents 25% of the net income and 48% of the capital (30% of the fair value). The other businesses account for the remaining 34% of the capital (including the corporate centre – i.e. the equity stakes) and 30% of the total value.

Customer loans totalled EUR89bn at end-September 2006, with EUR86bn of customer deposits and EUR108bn of indirect deposits, of which AuM accounted for EUR48bn. MPS holds 3.6% market share in mutual funds.

Including the dividend, the 2007E SOP yields a total fair value of EUR15.1bn, or 13.9 x 2007E PE. We have raised our target price from EUR4.7 to EUR5 to account for the increased excess capital due to capital gains on the disposal of the Generali and MPVita stakes. The key issue is the cost of capital, which is still high on the back of the execution risk weighting on the plan.

Investment case

SWOT analysis

MPS is transforming itself from a traditional commercial bank into a financial conglomerate. It plans to offer a wider range of products, thanks to JVs with foreign partners and an open architecture model. Our cautious stance is based on the: 1) demanding valuation; 2) restructuring process, which is partially priced in; 3) the market's misperception of MPS' real role in the consolidation process. The stock is in a few institutional investors' portfolios, hence there is little chance of marginal selling. At the core operating level, interest income is rising. Mortgage loans (with real estate as collateral) make up the bulk of the loan book. As for asset quality, MPS reported a 1.9% net NPL ratio in Q3-06 and 53% coverage at end-Sept 2006. Commission income is one of the weakest points at the top line level, as mutual funds are posting outflows and the switch to more profitable unit-linked products has not offset declining asset management fees. MPS is slashing the weight of up-front fees, to reduce the prevalence of one-off revenues and improve quality. On the cost front, MPS will be one of the few banks in Italy to post declining staff expenses in 2007. The Italian financier, Mr. Zaleski recently joined the shareholding structure with a