How much can Barclays afford to pay for ABN Amro?

That was the question analysts and investors were asking on Tuesday after the British bank announced it was in exclusive talks to buy the embattled Dutch lender.

Last night, the two banks outlined the structure of the combined business, but did not offer any financial details of the transaction.

However, Barclays is thought to be contemplating an offer largely in shares, though with a small cash element. The price that Barclays can afford to pay depends on several factors. The first is the level of cost savings it can extract from ABN Amro’s operations.

The second factor is the extent to which Barclays can boost revenues by distributing its investment banking and fund management products to ABN Amro’s customers in Brazil, the Netherlands, the Middle East, Asia and the US.

The third consideration is the return on investment that Barclays would have to generate in order to win the support of its own shareholders. Given that the value of Barclays’ bid depends on the performance of its shares in the next few weeks, the final factor is crucial.

Barclays has traditionally maintained strict acquisition criteria and any suggestion that its discipline was slipping would be punished.

Most analysts believe that Barclays could pay around €33 per share, which would be a premium of more than 20 per cent to ABN’s closing price of €27 last Friday, before bid talks were announced.

James Chappell, an analyst at Goldman Sachs, estimates that Barclays could cut 9 per cent of ABN’s cost base – or €1.55bn ($2.06bn) – and do a share buy-back of £2.5bn ($4.9bn) in 2009.

This includes the value of selling ABN’s stake in Italian bank Capitalia at current market value. By doing all these things, Barclays could create a valuation of €33 per share of ABN, he says.

Assuming Barclays’ cost of equity is 9.5 per cent, Goldman Sachs’ estimates that if Barclays did pay €33 per share – including around 15 per cent of the deal in cash – it could achieve a return on investment of 8.7 per cent by 2009.

In order to achieve a greater return, Barclays would need to make more cost savings, while also boosting the combined bank’s revenues. Mr Chappell estimates that the cost savings could principally come from combining the two wholesale banks – which would account for 45 per cent of total savings – and from combining the retail and commercial banking operations, which would generate a further 45 per cent.

Jon Peace, banks analyst at Fox-Pitt, Kelton, estimates that Barclays could cut £1bn, or around 10 per cent, of ABN’s cost base.

Assuming revenues synergies of 3 per cent, the deal would achieve a return on investment of 9.7 per cent by 2009 and 11.4 per cent by 2010, he estimates. But his analysis means that the deal would still dilute Barclays’ earnings per share for at least three years.

He says: “This would stretch Barclays to the limit as ABN’s low profitability and the huge paper issue required for purchase would lead to high earnings dilution in the early years for Barclays given that business overlaps are largely complementary and so cost synergies would be limited.

“A lot depends on the mix of shares and cash, how quickly they phase in the synergies and whether they sell any operations.”

Given the limited geographical overlap between the two banks, many analysts are sceptical about Barclays’ ability to significantly cut more costs.

But Barclays is expected to argue that it can lower costs not just by eliminating the overlap between the two businesses, but by running ABN Amro better than it is being managed today. Merrill Lynch argues that Barclays could save €3bn, suggesting that it could offer to pay €35 a share for ABN Amro and generate a return on investment of 12 per cent by 2009.

A final consideration is whether Barclays would consider selling any of ABN Amro’s businesses after a deal is sealed.

The issue is clearly sensitive, given that ABN Amro executives are seeking to avoid a break-up.

But some observers argue that, by selling ABN Amro’s US business and returning the cash to shareholders, Barclays would be able significantly to sweeten the deal.

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