Jay S. Sidhu, president and chief executive officer of Sovereign Bancorp, has little room for error as he takes the thrift company into New England, analysts say.
In its bold push to acquire 278 branches that are being spun off in the pending merger of Fleet Financial Group and BankBoston Corp., Sovereign would be vulnerable to "the economy weakening, credit quality declining, or earnings deteriorating," wrote Chad Yonker, a bank analyst for Fox-Pitt, Kelton in New York, in a recent report.
The deal would turn Sovereign into the third-largest financial holding company in New England by adding $11.8 billion of assets.
Once a leading advocate of thrifts' becoming more bank-like, Mr. Sidhu has made an about-face. In an interview Friday, he denied that the deal is designed mainly to expand Sovereign's commercial banking business and pointed out that 49% of the loans it is buying from Fleet Boston Corp. are housing-related.
"Shareholders are going to win big time when it is better understood what we are getting and how low the risk is," he said. Mr. Sidhu described as a "misconception" the widespread belief on Wall Street that his goal is to speed Sovereign's transformation into a commercial bank. "We will get capital in place without diluting shareholder value within 24 months of closing."
Whatever the strategy, the challenge is daunting and is the riskiest and most expensive of Mr. Sidhu's 25 deals.
It would thrust Sovereign into a new geographic area where its name is unknown and where it faces a formidable battle with entrenched competitors.
Though the deal includes a promise that Fleet Boston Corp. will not compete for the branches' existing customers, the company will compete for new customers.
Also, other banks in the area already are trying to lure away customers through hard-hitting campaigns.
"Sovereign is entering four new markets," said Laurie Havener Hunsicker, a bank analyst with Friedman, Billings, Ramsey & Co., Arlington, Va., referring to Connecticut, Rhode Island, Massachusetts, and New Hampshire.
"Already other banks are aggressively coming out with ads to take customers. Sovereign is going to have a hard time hanging onto that."
Mr. Sidhu said Sovereign would not suffer if there were significant deposit run-off because any loss would be factored into the final deal price.
Mr. Sidhu's most ardent supporters see the move as gutsy -- perhaps too much so. Edward Najarian, a bank analyst for First Union Capital Markets, who had been a strong advocate for Sovereign, turned bearish when he heard rumors about the deal.
Clearly, high among Mr. Sidhu's headaches will be financing the $1.4 billion acquisition. In its pro forma estimates, Sovereign indicated it plans to raise half the amount by issuing equity and the other half through debt. The company has not yet said what the balance would be, and Mr. Yonker said the deal may be done completely with debt.
He pointed out in a recent company analysis that if Sovereign raised all the money through debt, the holding company would have negative tangible capital. But Mr. Sidhu said Friday, "we're not doing all debt."
Raising capital by issuing more shares would be expensive for Sovereign's existing shareholders. Its stock has plunged almost 50% since April. It closed Friday at $9.5625, below the $10 assumed in the bank's projections.
The cheaper the stock, the more shares Sovereign would need to issue to raise the $700 million, increasing the dilution of shareholders. Even if the stock inches back to $10, existing shareholders would be diluted by 38%.
The deal could be looked at in "several ways and it's still dilutive," said Arthur Loomis, president of Northeast Capital & Advisory Inc., Albany.
"How much equity they choose will be the ultimate determination of the ratings and debt pricing," said John Otis, a bond analyst at Bear Stearns & Co. "However, they do it, they will have to pay."
With so little equity, raising debt is likely to be very expensive.
One analyst estimated that five-year debt issued by Sovereign, with its BBB- rating from Standard & Poor's, would yield at least 250 basis points above comparable government securities.
Its spread would be about two-and-a-half times that paid by the highly rated Fifth Third Bancorp of Cincinnati.
That spread reflects Sovereign's relatively thin capital condition and the fact that it is a thrift rather than a commercial bank. If its Standard & Poor's rating falls one more notch, its holding company bonds will be junk grade.
"Potentially we're back to a point where the capital levels could be very low," said John Bartko of Standard & Poor's. Though the deal appears attractive on the surface, "we're not comfortable with the commercial bank profile they are assuming in relation to the capital ratios they are operating with."
The day Sovereign announced the deal, another leading rating firm, Duff & Phelps Credit Rating Co., removed the bank from a list of companies whose ratings it was considering for an upgrade. Still, Moody's Investor's Service and the other agencies reaffirmed Sovereign's ratings after the deal was announced.
Despite Mr. Sidhu's denial, some analysts believe the acquisition reflects intentions to become more like a commercial bank. In 1998, Sovereign bought 95 branches from the First Union Corp. after the Charlotte, N.C. banking company acquired CoreStates Financial Corp. of Philadelphia. Analysts said the aim was to put Sovereign deeper into the commercial banking business.
A junk rating may not be critical for a thrift in which few depositors keep more than the government-insured $100,000 maximum, but it could be a deterrent to companies that keep millions of dollars in their bank accounts.
"As they become more like a bank, what would be acceptable capital ratios for a thrift are no longer applicable," said Mr. Otis of Bear Stearns.
Even if Sovereign raises half the money it needs by issuing equity, its capital structure -- by its own measurements -- would still be weak. Mr. Yonker of Fox-Pitt says that at the end of 2000, Sovereign's tangible capital ratio would stand at only 1.8% of assets, counting equity raised through a stock offering.
"In the event of an adverse economic environment, Sovereign's ability to make debt service payments could be severely strained," said Fox-Pitt's Mr. Yonker.
All depends on whether Mr. Sidhu can live up to his optimistic earnings expectations. According to the company's estimates, the new branches will earn $209 million in 2000. Mr. Loomis of Northeast Capital & Advisory said Sovereign's assumptions appear too generous. "If you analyze the deal using discounted cash flow analysis, Sovereign may be overpaying for those branches by $250 million to $400 million," he said. He estimated annual net income of the new branches at between $135 million and $140 million -- well below Sovereign's projections.
Mr. Sidhu predicts healthy capital generation, with tangible capital growing to $1.9 billion by 2003, up from $371 million in 2000. However, the company's market capitalization has fallen around 9% along with its share price since the deal was announced.
"If they complete the plan, the capital ratio generation should be strong," said Mr. Otis of Bear Stearns. "But they have to elevate their performance to a level they haven't achieved before."
Sovereign expects to generate a return on assets in the 1.2% range by 2003. Sovereign's highest annual ROA in the past five years was 0.78% in 1995, according to Keefe Bruyette & Woods Inc. In 1998, it was 0.70%.
Why would Sovereign take such a risk?
"They had to do something or they would have had to sell out at a low price," said Mr. Otis at Bear Stearns. "Sovereign has one of the lowest price earnings ratios in the industry. If they had sold out now it probably would have been without a premium. With this acquisition, Sovereign has a chance to build value for their shareholders."
The thrift executive characterized the deal as unprecedented. Fleet Boston will not be able to choose the branches it sells to Sovereign -- "we are not going to let the seller cherry pick," Mr. Sidhu said.
Fleet Boston will have to sell whole geographical segments that belonged Fleet or BankBoston, he added.
"This is a home run," Mr. Sidhu said. "This kind of opportunity does not exist. Our shareholders will win big time."
Mr. Sidhu contends that Sovereign cannot lose. "We have to earn the right to remain an independent company, which means we have to perform well,'' he said.
"If we don't perform well and somebody else makes proposals to our shareholders, we would have to take a look at it. If the price is right, it makes a lot of sense.''