Oh the banks! (2) - Banco Santander

Santander branch in Rio de Janeiro, courtesy Wikipedia

 

Five years have elapsed since the financial crisis and it is time to consider investing in banks again. For a further discussion and a review of HSBC see http://thejoyfulinvestor.blogspot.co.uk/2014/01/ohthe-banks-1-andhsbc-holdings-plc.html

When a bank has sidestepped the traps that brought many to the edge of default, its shares yield 7.7% net of withholding taxes and it sells at an 18% discount to net asset value, it is worth a look.

Emilio Botín, the 79-year old Chairman of Banco Santander, is one of the very few senior bankers who have survived the financial crisis with their reputation intact. The Madrid based bank managed to profit hugely from its stake in ABN Amro that sank both its partners in the acquisition, the Royal Bank of Scotland (RBS) and Fortis Bank. Throughout the financial crisis, Santander continued to be profitable. Thanks to the Bank of Spain, which prohibited off-balance sheet items and advised the banks not to hold subprime mortgages, Santander did not have undeclared liabilities or subprimes to provide for. And it is one of the few large, international banks that have not suffered major fines and damages for unethical practices. (It did provide 538 million pounds for PPI miss selling from the Abbey National and Alliance and Leicester banks which it subsequently acquired.)

Today Santander has a market capitalisation of 60 billion pounds, making it the largest European bank after HSBC.

It has helped that Santander has concentrated on retail and wholesale banking for 96% of its net revenue. If it was tempted by the profits bonanza of investment banking leading up to the financial crisis, it resisted it. Fund management and insurance make up the remaining 4% of its revenues.

But it is Santander's acquisition of ABN Amro that illustrates the quality of its management. Santander sold on the Italian bank it had acquired from ABN Amro, Banco Antonvenate, to Monte de Paschi di Siena for €9 billion. The price was agreed only one month after the takeover. This realised an implied 36% profit of €2.4 billion for Santander. Santander merged the other main unit of ABN Amro it acquired, Brazil's Banco Real, into Banco Santander Brazil to create the third largest bank in that country. Brazil is now the largest single profit centre in the Santander group.

Although the bank is controlled from a 600-acre site called Santander Group City, just outside Madrid, Santander is far from dependent on its Spanish operations. And Santander's operations are in politically stable countries. Its main emerging market risk is concentrated in the three most stable large Latin American states (Brazil, Mexico and Chile), while the remainder is concentrated in the European Union and the USA.

Business by region %	By Attributable Profits	By Total Assets	By Customer Loans
Brazil, Mexico, Chile	39%	19%	17%
UK	17%	29%	35%
Spain	7%	25%	24%
Other Europe*	19%	15%	16%
USA	10%	5%	6%
Other	8%	7%	2%

                *Mainly Germany and Poland - source 2013 4th quarter report of Santander

Yet its Spanish domicile and operation have dogged the bank. Credit agencies award Santander the same long-term credit rating as its sovereign. So the bank's credit rating has declined with the sovereign from AA in 2008 to BBB today (S&P). Returns from its large banking presence in Spain - it has the largest share of the Spanish market - have been meagre, and it has had to absorb large non-performing loans from its Spanish portfolio.

The London listing of Santander's shares (in blue) tends to move closely with the Ibex 35 Index of leading Spanish companies (in green), where most of its shares are held. The divergence with the FTSE 100 (in red) is particularly marked since the mid 2010 bailout of Greece with the concomitant Euro crisis.

Graph courtesy of Yahoo, click to enlarge

Since Santander's €7.2 billion rights issue in 2008, the bank has improved its balance sheet without further capital fund raising. This has been achieved by selling shares in its Brazilian and Mexican ventures, by shrinking its assets in Spain and by retaining earnings. The result is that the balance sheet is much stronger than it was at the end of 2008. Consider:

1.  The loan to deposit (LTD) ratio is down from 150% to 109%.This makes the bank much less dependent on external financing. In its problematic Spanish market its LTD ratio is down to 96%.

2.  The bank's Core Tier 1 Capital ratio has increased from 7.6% to 11.7% and equity as a percent of assets is up from 5.5% to 6.4%. Both ratios are far superior to the Basel III capital reserve requirements  of a 6% minimum for Core Tier 1 Capital and 4.5% for equity/assets.

3.  The Spanish problem property book is shrinking and now accounts for 1.2% of net assets.

4. An area of concern is falling non-performing loan (NPL) coverage, now 62% of NPLs compared to 91% in 2008. At December 2013, €42 billion of NPLs were covered by €26 billion of provisions leaving €16 billion not provided for. While €6 billion of unprovisioned NPLs are covered by property (land and buildings), this still leaves a possible hole of €10 billion. 

At the present price of 512p, shares in Santander are on an historical PE ratio of 15 and yield 7.7% net of the 21% withholding tax in Spain. Fifteen percent is recoverable from the UK-Spain Tax Treaty and the remaining 6% can be recouped via Spain's tax form 210, which can be done through Banco Santander, though shareholders must prove UK residence. The shares sell at an 18% discount to net asset value, which puts Santander on a 30% discount relative to HSBC.

 

As with many other banks, the challenge for Santander is to regain profitability and a suitable return on assets. Since 2008 its efficiency ratio (costs/net revenues) has declined from 42% to 50%, though it is still among the best. Return on equity has declined from 17.5% in 2008 to 5.4% today.

The Chairman, Emilio Botín, perhaps to be expected, is upbeat:

 "Our shareholders can expect from Banco Santander the performance of a bank with a comfortable capital base, a solid balance sheet, recurring revenues, 187,000 professional employees, the best in international banking, and considerable potential to increase profits as the global economic situation returns to normal." (From the 2012 Annual Report)

 

And on the benefits of the financial crisis (Interview with The Banker, January 2013):

 

"One advantage for us is that a lot of banks have disappeared during the crisis and there will be fewer competitors. We used to have some 60 banks in Spain, including savings banks. At the end of the crisis we may have about 10. There will still be a lot of competition but not as much as there was."

 

Sr Botín, in his presentation of the 2013 results of 30 January 2014, affirms that the bank will continue with its high dividend payout and expects improved results for 2014. Concerns that its high dividend is unaffordable are countered by the chairman, who notes that 89% of shareholders opt for the scrip dividend in lieu of cash.

 

Santander expects to realise cost savings of €1.5 billion by 2015 from its merger of Banesto's operations into Santander's in Spain. But the key to a recovery in profits will be the recovery of its major developed markets - Spain in particular - and a return to growth in Brazil.

 

Taking a conservative view of Santander, my valuation model values Santander shares at about the current price of 512p. This is based on the average earnings per share for the last 5 years with no increase in earnings, equity per share or return on equity for the 2014-2018 period, all discounted at 10.9% (3.9% SLXX + 2% operating risk + 5% margin of safety).

 

Investors may take the view that they can sit on the shares and wait for an improvement in Santander's markets while reaping a net dividend of 7.7%. And they will note that the bank's share price (in blue) is low compared to the past and compared to HSBC (in green):

 

Graph courtesy Yahoo, click to enlarge

 

There are further considerations:

 

1. Succession. Sr Botín is 79 and he has been chairman for 26 years, overseeing the bank's growth from a regional Spanish bank to a major international bank. Both his father and grandfather were chairmen of Santander. His likely replacement is his daughter, Ana Patricia Botín, who is head of Santander UK. She has the right background in banking and the work ethic of her father (both rise at 6 am). But this is a big role to fill.

 

2. Shareholdings. Successive share issues have left the Botín family with less than 2% of the bank's equity. However, their confidence in the bank is backed by share purchases worth 90 million Euros in recent years.

 

3. Spain's economy. While it appears that Spain is beginning to grow again (the OECD forecasts a weak recovery for 2014 and 2015), non-performing loans continue to hit Santander's profits. There is the risk that another shock in the Eurozone could increase the default rate.

 

4. The dividend, which is 150% of 2014's earnings. While the chairman seems determined to continue with the 60 cent dividend, this could change either by force of circumstances or by a less committed (or stubborn) successor. However, a cut in dividend might reassure investors who are concerned about continuing loan losses in Spain.