I was struggling to come up with a candidate for this week's blog post. There are a number of positions I am working on, digging up numbers, trying to better understand the business. All of them however, are rather complex and have many moving parts. I tend not to like a situation where I cannot distill the investment thesis and risk/reward into a one minute elevator pitch. Banco Santander is one such company.
I picked this idea up straight from Ken Fisher who writes the monthly portfolio strategy column at Forbes magazine. For those of you who are not familiar with Fisher, he runs Fisher Investments which is a huge asset management firm based in the US. He may not be one of the big hedge fund names, but he is pretty famous in his own right, having published quite a number of investment books. His best books in my opinion are "The Wall Street Waltz" and "The Only Three Questions That Count". I find that Ken Fisher tends to favor large-cap blue chips on his column. Not exactly my game, but occasionally there are names that perk my interest. Regardless, given that he is writing and managing money for high-net-worths, it makes total sense to his clients and Forbes' readers.
(I have tried to limit the amount of numbers in this post but unfortunately failed. The raw amount of data might be intimidating. Please be patient with me while we try to get through some of these numbers.)
Banco Santander (SAN) is a Spanish bank. If that doesn't make you freak out, you don't read enough financial news. Indeed Spain has a lot of problems - unemployment rate of at 26%, the yet to bottom falling housing prices, the anemic economy. All these spell trouble for Spanish banks. Worse, the banks are now forced to recognise the losses on their property developer loan portfolio and many will and are likely to go belly up. Now here's the catch. Historically, Banco Santander has its origins as a Spanish bank. Now, it is one of the largest bank in the Eurozone and have operations in Latin America (LatAm), the United Kingdoms, United States, and various parts of Europe. Their European operations is increasingly accounting for less and less of their net profit. Conversely, their LatAm banking business has now grown to accounting for half of profits generated, whereas Europe is just over a quarter. The main thesis here is that profits from their LatAm business will providing the cushioning for the balance sheet losses that SAN is experiencing currently.
SAN is predominantly a retail bank. 88% of revenue and 74% of total profits come from retail banking, which is basically mortgages, car loans, etc. Global wholesale banking makes up 10% of revenue but 21% of profits. Global wholesale banking includes corporate banking, investment banking, and all other treasury activities.
First of all, a quick look at the income statements and operating metrics.
The bank has done a good job of increasing net interest income year after year. Fee income, however is somewhat stagnant. Profit before tax and net attributable profit has not really follow net interest income growth because of provisioning. In 2012 alone, SAN has set aside EUR15.7bn (includes extraordinary provisions) for loan loss provisioning. This is 66% of their pre-provisioning operating income. Because of the provisioning for losses on their loan portfolio, earnings and EPS has dropped to at all time low.
While net interest margins are at a historic high, ROA and ROE has fallen to a historical low. This is again due to the provisioning. Pre-provision operating profit (PPOP) as a percentage of total assets/ total loans are surprising high for a European bank. This is because of the high profitability of their LatAm business. This is key to the investment thesis here in that, SAN can reply on profits generated from their LatAm business to plug the holes in their balance sheet in Europe.
PPOP/Assets and PPOP/Loans ratios are useful as an indication of the pre-provision profitability and the "provisioning ability" of a bank. When investing in a bank that is suffering from depressed economic conditions, it is crucial that the bank generates decent PPOP relative to the size of their loan portfolio. This ensures that as long they remain liquid in terms of short term funding (no bank runs, no freezing up of wholesale funding markets), their strong PPOP generation would allow them to clean up their balance sheet over time.
Non Performing Loan (NPL) Ratio has been creeping up slowly but is still not at a level which reflects the reality on the ground in Spain. Spanish banks are only beginning to be forced to recognize losses on their loan books, which is why NPL ratio hasn't risen as fast as one might expect. SAN has been spending 2010-2012 provisioning for losses. I expect this to continue till 2014. Given their strong Tier 1 ratio and PPOP covering >3% of their total loan portfolio, I do not think SAN will be threatened by insolvency. The group has also done well managing their liquidity. Since the peak of the crisis in 2008, Loan Deposit Ratio (LDR) has been gradually reduced to the current 113% by attracting new deposits and
A quick look at the balance sheet.
SAN has been increasing available short term liquidity by increasing cash on hand. Customer loans has not really grown in the last few years. SAN is not a growth stock (at least not in the next few years). Buying SAN is a bet that net profit margins and ROEs will return to a more normalized level after making sufficient provisions for loan losses. SAN is mostly deposit funded than wholesale funded (debt funded). Wholesale funding exposes banks to the volatility of the credit markets. When credit flow freezes up in a recession, banks will be forced to pay extravagant rates for their debt funding. The preference is almost always for banks to be funded via deposits.
Solvency
To get a sense of whether SAN faces solvency risks, we have to take a deeper look into their loan and bond portfolio.
Spanish loans account for 27% of their total loan portfolio. The more problematic mortgages, and loans to developers and construction companies account for ~13.5% of their loan portfolio. This sums up to about EUR92.8bn of loans. Bank of Spain reported in 2012 that retail mortgages have a Loan-To-Value (LTV) ratio of 62%. This means there is a 38% buffer for property prices to fall before creditors have to absorb losses on their loans. In 2012, SAN made a PPOP of EUR23.5bn. Assuming PPOP doesn't change and loan portfolios don't change, each year SAN has the ability to set aside provisions summing up to 25% of their real estate, construction and mortgage loans.
Another source of risk for SAN is their bond portfolio. Let's look at a breakdown down of what bonds they hold. The at risk component of their debt securities would be Spanish domestic debt, which sums up to EUR47.2bn at end 2011. If they were to take a 50% haircut on all their Spanish bonds, the losses can still be covered by their PPOP. This is a rather simplistic way to quickly assess the solvency of a bank. But it allows one to quickly see if profits generated by the bank can repair its balance sheet over time. The underlying assumption is that the bank has continued access to liquidity for daily operations, and there are no funding squeezes.
NPL and Coverage Ratios
Let's see where the problematic loans are, where NPL ratios are increasing. A consistently high NPL ratio for a bank is not a sign of trouble for a bank, especially in emerging market banks where the cyclical average default rates for bank loans are high. Emerging banks deal with the higher background default rates by charging high interest. Their NIM and ROEs are higher, and in exchange they have a higher background level of provisioning to deal with the losses.
The main problematic areas for SAN are SAN Branch Network (Spain), Banesto (spain), Portugal, Brazil and Chile. The first three have seen NPL ratios climb consistently since the 2008 financial crisis. NPL coverage at SAN Branch Network, Banesto and Portugal are also sorely lacking. For Brazil and Chile, NPLs climbed in response to a slow down in the economy in 2011. I expect NPLs to continue to flow in over the next 1-2 years.
Looking at quarterly GDP growth of the four relevant countries, Brazil seems to be rebounding from a trough in 2011 and Chile's quarterly GDP growth is stabilizing Spain and Portugal's economies however, continue to contract.
As at end 2012, total credit risk from the four areas mentioned above sums up to EUR305.6bn. Of this EUR305.6bn, EUR23.1bn has been classified as NPL (NPL ratio of 7.6%), and Loan Loss Reserves of EUR17.0bn has been set aside, resulting in a NPL coverage ratio of 73.6%. Again SAN's PPOP in 2012 represents 7.7% of their total credit risk from these regions. Can NPLs from the region double to 15%? Perhaps. Can SAN provision for the losses over a period 2-3 years if the situation in Europe remains under control and in order. Most likely.
I think SAN is cheap at these valuations. It has a very profitable LatAm banking franchise which should over time help SAN with provisioning with the losses in Europe. It reminds me of Bank of America (BAC) in the US, which is similarly trading at very low PB because of their high provisioning and depressed earnings. SAN like BAC sees improve mortgage loan vintages. The new mortgages loans made in 2010-2011 have much lower default rates than those made in 2008-2009. Over time, SAN should be able to resolve its balance sheet issues in Europe.
Ken Fisher estimates that SAN will be able to earn a EPS of US$1 by 2014. I think that is too optimistic. I suspect an EPS of US$0.70-US$0.80 will be more realistic.
Investment Case
(i) Strong market position in LatAm - Brazil 10% market share, Mexico 16% market share, Argentina 9% market share and Chile 20% market share.
(ii) Good vehicle to gain exposure to structural growth and rising credit penetration in LatAm,
(iii) Strong tier 1 ratio for a European Bank.
(iv) Management forecasting ROEs to return to 15% in 2014-2015 and re-provisioning for losses in Spain to finish in 2013.
(v) One of the highest PPOP/Total Asset ratio in the region - 1.93% vs an average of 0.72% for the European Bank sector in 2011.
(vi) Spanish new housing sales overtaking new housing finishes.
Risks
(i) Contraction of Net Interest Margins, especially in Brazil.
(ii) Worsening of economic conditions in the Eurozone, in particular Portugal and Spain.
(iii) Threat of a disorderly dissolution of bankrupted companies in Spain.
(iv) Worsening of economic conditions in Latin America, in particular Brazil.
(v) Breakup of the Eurozone.
I picked this idea up straight from Ken Fisher who writes the monthly portfolio strategy column at Forbes magazine. For those of you who are not familiar with Fisher, he runs Fisher Investments which is a huge asset management firm based in the US. He may not be one of the big hedge fund names, but he is pretty famous in his own right, having published quite a number of investment books. His best books in my opinion are "The Wall Street Waltz" and "The Only Three Questions That Count". I find that Ken Fisher tends to favor large-cap blue chips on his column. Not exactly my game, but occasionally there are names that perk my interest. Regardless, given that he is writing and managing money for high-net-worths, it makes total sense to his clients and Forbes' readers.
(I have tried to limit the amount of numbers in this post but unfortunately failed. The raw amount of data might be intimidating. Please be patient with me while we try to get through some of these numbers.)
Banco Santander (SAN) is a Spanish bank. If that doesn't make you freak out, you don't read enough financial news. Indeed Spain has a lot of problems - unemployment rate of at 26%, the yet to bottom falling housing prices, the anemic economy. All these spell trouble for Spanish banks. Worse, the banks are now forced to recognise the losses on their property developer loan portfolio and many will and are likely to go belly up. Now here's the catch. Historically, Banco Santander has its origins as a Spanish bank. Now, it is one of the largest bank in the Eurozone and have operations in Latin America (LatAm), the United Kingdoms, United States, and various parts of Europe. Their European operations is increasingly accounting for less and less of their net profit. Conversely, their LatAm banking business has now grown to accounting for half of profits generated, whereas Europe is just over a quarter. The main thesis here is that profits from their LatAm business will providing the cushioning for the balance sheet losses that SAN is experiencing currently.
| 2007 | 2008 | 2009 | 2010 | 2011 | 2012 | |
| Europe Profit | 53.0% | 54.0% | 46.4% | 35.0% | 31.0% | 26.8% |
| UK Profits | 15.0% | 14.0% | 16.7% | 17.9% | 12.5% | 13.7% |
| LatAm Profits | 32.0% | 32.0% | 37.1% | 43.3% | 50.8% | 50.6% |
| United States Profits | N.A. | N.A. | -0.2% | 3.8% | 5.7% | 9.4% |
SAN is predominantly a retail bank. 88% of revenue and 74% of total profits come from retail banking, which is basically mortgages, car loans, etc. Global wholesale banking makes up 10% of revenue but 21% of profits. Global wholesale banking includes corporate banking, investment banking, and all other treasury activities.
| 2007 | 2008 | 2009 | 2010 | 2011 | 2012 | |
| Retail Revenue | 86.0% | 85.0% | 85.0% | 85.0% | 87.4% | 88.0% |
| Retail Profit | 80.0% | 75.0% | 69.0% | 72.0% | 75.1% | 74.3% |
| Wholesale Revenue | 11.0% | 13.0% | 12.0% | 12.0% | 10.2% | 10.1% |
| Wholesale Profit | 16.0% | 20.5% | 27.0% | 24.0% | 20.4% | 21.2% |
| Asset Management Revenue | 3.0% | 2.7% | 2.5% | 2.4% | 2.4% | 1.9% |
| Asset Management Profit | 4.0% | 4.1% | 3.9% | 4.2% | 4.6% | 4.5% |
First of all, a quick look at the income statements and operating metrics.
| Income Statement (Eur M) | 2007 | 2008 | 2009 | 2010 | 2011 | 2012 |
| Net interest income | 14,443 | 20,945 | 26,299 | 29,224 | 30,821 | 30,147 |
| Dividends | 420 | 553 | 436 | 362 | 394 | 423 |
| Income from equity accounted method | 438 | 117 | (1) | 17 | 57 | 427 |
| Net fees | 7,869 | 9,020 | 9,080 | 9,734 | 10,471 | 10,307 |
| Gains (losses) on financial transactions | 2,981 | 2,597 | 3,423 | 2,606 | 2,500 | 2,698 |
| Other operating income/expenses | 291 | 258 | 144 | 106 | 18 | (327) |
| Gross Income | 26,442 | 33,490 | 39,381 | 42,049 | 44,261 | 43,675 |
| General admin expenses | (10,777) | (13,580) | (14,825) | (16,256) | (17,781) | (17,928) |
| Depreciation and amortization | (1,247) | (1,370) | (1,596) | (1,940) | (2,109) | (2,189) |
| Net operating Income | 14,418 | 18,540 | 22,960 | 23,853 | 24,371 | 23,558 |
| Net loan-loss provisions | (3,397) | (6,601) | (9,484) | (10,258) | (10,562) | (12,666) |
| Impairment losses on other assets | (51) | (91) | (402) | (471) | (173) | (853) |
| Other income | (263) | (426) | (1,311) | (1,072) | (2,822) | (1,593) |
| Profit before taxes | 10,707 | 11,422 | 11,763 | 12,052 | 10,814 | 8,446 |
| Tax on profits | (2,378) | (2,391) | (2,336) | (2,923) | (2,936) | (2,299) |
| Net profit from discontinued operations | 304 | 319 | 31 | (27) | (24) | (7) |
| Consolidated profit | 8,633 | 9,350 | 9,458 | 9,102 | 7,854 | 6,140 |
| Net extraordinary capital gains and provisions | 0 | 0 | 0 | 0 | (1,670) | (3,047) |
| Attributable profit to group | 8,633 | 9,350 | 9,458 | 9,102 | 6,184 | 3,093 |
| Minority Interest | 473 | 520 | 516 | 921 | 836 | 890 |
| Attributable profit to shareholders | 8,160 | 8,830 | 8,942 | 8,181 | 5,348 | 2,203 |
| No of shares | 6,802 | 7,271 | 8,554 | 8,687 | 8,892 | 8,892 |
| EPS (EUR) | 1.20 | 1.21 | 1.05 | 0.94 | 0.60 | 0.25 |
| BVPS (EUR) | 8.46 | 8.25 | 8.64 | 9.32 | 9.32 | 8.17 |
| PE | 4.4 | 4.4 | 5.1 | 5.7 | 12.0 | 29.1 |
| PB | 0.63 | 0.65 | 0.62 | 0.57 | 0.57 | 0.65 |
The bank has done a good job of increasing net interest income year after year. Fee income, however is somewhat stagnant. Profit before tax and net attributable profit has not really follow net interest income growth because of provisioning. In 2012 alone, SAN has set aside EUR15.7bn (includes extraordinary provisions) for loan loss provisioning. This is 66% of their pre-provisioning operating income. Because of the provisioning for losses on their loan portfolio, earnings and EPS has dropped to at all time low.
| 2007 | 2008 | 2009 | 2010 | 2011 | 2012 | |
| Net Interest Margin | 1.58% | 1.67% | 2.37% | 2.40% | 2.46% | N.A. |
| ROA | 1.10% | 1.00% | 0.86% | 0.76% | 0.50% | 0.24% |
| ROE | 21.9% | 17.1% | 13.9% | 11.8% | 7.1% | 2.8% |
| ROTE | 20.8% | 22.9% | 19.5% | 17.3% | 12.0% | 5.1% |
| PPOP/Assets | 1.85% | 1.89% | 2.17% | 1.96% | 1.91% | 1.86% |
| PPOP/Loans | 2.91% | 2.83% | 3.27% | 3.11% | 3.07% | 3.11% |
| NPL Ratio | 1.05% | 2.19% | 3.43% | 3.75% | 4.07% | 4.54% |
| Coverage Ratio | 150.5% | 90.6% | 75.3% | 72.7% | 61.4% | 72.6% |
| Credit Costs | N.A. | 1.16% | 1.57% | 1.56% | 1.41% | 2.21% |
| LDR Ratio | N.A. | 150.0% | 135.0% | 117.0% | 117.0% | 113.0% |
| Tier 1 Ratio | 7.7% | 9.1% | 10.1% | 10.0% | 11.0% | 11.2% |
While net interest margins are at a historic high, ROA and ROE has fallen to a historical low. This is again due to the provisioning. Pre-provision operating profit (PPOP) as a percentage of total assets/ total loans are surprising high for a European bank. This is because of the high profitability of their LatAm business. This is key to the investment thesis here in that, SAN can reply on profits generated from their LatAm business to plug the holes in their balance sheet in Europe.
PPOP/Assets and PPOP/Loans ratios are useful as an indication of the pre-provision profitability and the "provisioning ability" of a bank. When investing in a bank that is suffering from depressed economic conditions, it is crucial that the bank generates decent PPOP relative to the size of their loan portfolio. This ensures that as long they remain liquid in terms of short term funding (no bank runs, no freezing up of wholesale funding markets), their strong PPOP generation would allow them to clean up their balance sheet over time.
Non Performing Loan (NPL) Ratio has been creeping up slowly but is still not at a level which reflects the reality on the ground in Spain. Spanish banks are only beginning to be forced to recognize losses on their loan books, which is why NPL ratio hasn't risen as fast as one might expect. SAN has been spending 2010-2012 provisioning for losses. I expect this to continue till 2014. Given their strong Tier 1 ratio and PPOP covering >3% of their total loan portfolio, I do not think SAN will be threatened by insolvency. The group has also done well managing their liquidity. Since the peak of the crisis in 2008, Loan Deposit Ratio (LDR) has been gradually reduced to the current 113% by attracting new deposits and
A quick look at the balance sheet.
| Balance Sheet (Eur M) | 2007 | 2008 | 2009 | 2010 | 2011 | 2012 |
| Assets | ||||||
| Cash on hand and deposits at central bank | 31,063 | 45,781 | 34,889 | 77,785 | 96,524 | 118,488 |
| Debt securities | 102,186 | 104,097 | 144,169 | 145,989 | 141,133 | 137,884 |
| Customer loans | 571,098 | 626,888 | 682,551 | 724,153 | 750,100 | 720,482 |
| Equities | 19,906 | 12,645 | 16,579 | 15,396 | 9,768 | 10,034 |
| Trading derivatives | 46,733 | 95,815 | 59,856 | 73,069 | 102,498 | 110,319 |
| Deposits from credit institutions | 50,778 | 69,881 | 63,594 | 61,024 | 47,025 | 63,628 |
| Other (deposits at credit institutions, debt securities and equities) | 16,808 | 16,844 | 29,485 | 31,703 | 7,815 | 14,420 |
| Investments | 15,689 | 1,323 | 164 | 273 | 4,154 | 4,453 |
| Intangible assets and property and equipment | 11,661 | 10,289 | 11,774 | 14,584 | 16,840 | 17,296 |
| Goodwill | 13,831 | 18,836 | 22,865 | 24,622 | 25,089 | 24,626 |
| Others | 33,162 | 47,233 | 44,602 | 48,901 | 50,580 | 47,997 |
| Total Assets | 912,915 | 1,049,632 | 1,110,528 | 1,217,499 | 1,251,526 | 1,269,627 |
| Liabilities and Shareholder's Equity | ||||||
| Customer deposits | 355,406 | 420,229 | 506,975 | 616,376 | 632,533 | 626,639 |
| Marketable debt securities | 233,287 | 236,403 | 211,963 | 192,872 | 197,372 | 205,969 |
| Trading derivatives | 49,448 | 89,167 | 58,713 | 75,279 | 103,083 | 109,743 |
| Trading portfolio - Others | 28,867 | 38,987 | 51,559 | 53,279 | 27,214 | 24,600 |
| Due to central banks and credit institutions | 89,643 | 93,925 | 95,974 | 99,137 | 126,109 | 143,546 |
| Subordinated debt | 36,193 | 38,873 | 36,805 | 30,475 | 22,992 | 18,238 |
| Other financial liabilities | 16,683 | 17,681 | 19,300 | 19,343 | 18,221 | 19,245 |
| Insurance liabilities | 13,034 | 16,850 | 16,916 | 10,449 | 517 | 1,425 |
| Provisions | 16,571 | 17,736 | 17,533 | 15,660 | 15,571 | 12,872 |
| Other liability accounts | 16,225 | 19,777 | 20,919 | 23,717 | 25,052 | 23,026 |
| Total liabilities | 855,357 | 989,628 | 1,036,657 | 1,136,587 | 1,168,664 | 1,185,303 |
| Total Equity | 57,558 | 60,001 | 73,871 | 80,914 | 82,859 | 84,326 |
| Shareholder's Equity | 54,478 | 65,887 | 71,832 | 77,334 | 80,895 | 81,243 |
SAN has been increasing available short term liquidity by increasing cash on hand. Customer loans has not really grown in the last few years. SAN is not a growth stock (at least not in the next few years). Buying SAN is a bet that net profit margins and ROEs will return to a more normalized level after making sufficient provisions for loan losses. SAN is mostly deposit funded than wholesale funded (debt funded). Wholesale funding exposes banks to the volatility of the credit markets. When credit flow freezes up in a recession, banks will be forced to pay extravagant rates for their debt funding. The preference is almost always for banks to be funded via deposits.
Solvency
To get a sense of whether SAN faces solvency risks, we have to take a deeper look into their loan and bond portfolio.
| Loan Breakdown (Eur M) | 2007 | 2008 | 2009 | 2010 | 2011 | 2012 | 2012 (%) |
| Spanish Gov | 5,633 | 7,668 | 9,803 | 12,137 | 12,147 | 16,884 | 2.3% |
| Commercial, financial, agricultural and industrial | 45,170 | 56,290 | 70,137 | 67,940 | 65,935 | 61,527 | 8.2% |
| Real Estate and construction | 46,837 | 48,099 | 42,515 | 38,419 | 36,260 | 29,008 | 3.9% |
| Other Mortgages | 59,269 | 59,784 | 68,866 | 74,462 | 69,297 | 63,886 | 8.6% |
| Installment loans to Individuals | 21,533 | 21,506 | 20,070 | 15,985 | 12,964 | 12,775 | 1.7% |
| Lease Financing | 9,644 | 9,253 | 7,534 | 6,195 | 5,043 | 3,857 | 0.5% |
| Others | 49,995 | 37,647 | 11,420 | 12,475 | 12,912 | 12,007 | 1.6% |
| Total Loans to Borrowers in Spain. | 238,081 | 240,247 | 230,345 | 227,613 | 214,558 | 199,944 | 26.8% |
| Non-spanish Gov | 2,296 | 3,029 | 2,861 | 3,527 | 4,394 | 4,983 | 0.7% |
| Comemrcial and Industrial | 143,046 | 127,839 | 174,763 | 217,747 | 225,961 | 217,358 | 29.1% |
| Mortgage Loans | 179,164 | 201,112 | 249,065 | 269,893 | 296,330 | 290,825 | 39.0% |
| Other | 17,207 | 67,127 | 43,390 | 25,071 | 27,793 | 32,806 | 4.4% |
| Total Loans to borrowers outside of Spain | 341,713 | 399,107 | 470,079 | 516,238 | 554,478 | 545,972 | 73.2% |
| Total Loans and Leases Gross | 579,794 | 639,354 | 700,424 | 743,851 | 769,036 | 745,986 | 100.0% |
Spanish loans account for 27% of their total loan portfolio. The more problematic mortgages, and loans to developers and construction companies account for ~13.5% of their loan portfolio. This sums up to about EUR92.8bn of loans. Bank of Spain reported in 2012 that retail mortgages have a Loan-To-Value (LTV) ratio of 62%. This means there is a 38% buffer for property prices to fall before creditors have to absorb losses on their loans. In 2012, SAN made a PPOP of EUR23.5bn. Assuming PPOP doesn't change and loan portfolios don't change, each year SAN has the ability to set aside provisions summing up to 25% of their real estate, construction and mortgage loans.
| Debt Securities | 2007 | 2008 | 2009 | 2010 | 2011 | 2012 |
| Spanish Government | 14,471 | 20,268 | 37,770 | 35,110 | 37,698 | 35,380 |
| Spanish public authorities | 904 | 232 | 543 | 553 | 1,611 | 1,761 |
| Other Spanish issuer | 9,989 | 9,077 | 8,125 | 7,915 | 8,409 | 10,046 |
| Total Spanish domestic debt | 25,364 | 29,576 | 46,438 | 43,578 | 47,718 | 47,187 |
| US Treasury & Gov agencies | 1,870 | 882 | 1,184 | 1,122 | 514 | 132 |
| US States and political subdivisions | 281 | 1,260 | 1,715 | 1,743 | 1,420 | 6,941 |
| Other US debt securities | 9,718 | 6,156 | 12,965 | 11,598 | 11,115 | 7,648 |
| Other government debt | 19,466 | 20,990 | 41,108 | 60,737 | 58,619 | 60,149 |
| Other securities | 52,651 | 50,568 | 48,291 | 31,961 | 24,647 | 19,431 |
| Total Debt Securities | 109,350 | 109,431 | 151,701 | 150,739 | 144,033 | 141,488 |
Another source of risk for SAN is their bond portfolio. Let's look at a breakdown down of what bonds they hold. The at risk component of their debt securities would be Spanish domestic debt, which sums up to EUR47.2bn at end 2011. If they were to take a 50% haircut on all their Spanish bonds, the losses can still be covered by their PPOP. This is a rather simplistic way to quickly assess the solvency of a bank. But it allows one to quickly see if profits generated by the bank can repair its balance sheet over time. The underlying assumption is that the bank has continued access to liquidity for daily operations, and there are no funding squeezes.
NPL and Coverage Ratios
Let's see where the problematic loans are, where NPL ratios are increasing. A consistently high NPL ratio for a bank is not a sign of trouble for a bank, especially in emerging market banks where the cyclical average default rates for bank loans are high. Emerging banks deal with the higher background default rates by charging high interest. Their NIM and ROEs are higher, and in exchange they have a higher background level of provisioning to deal with the losses.
| NPL ratio (%) | 2007 | 2008 | 2009 | 2010 | 2011 | 2012 |
| Continental Europe | 0.90% | 2.31% | 3.64% | 4.34% | 5.18% | 6.25% |
| SAN Branch Network | 0.65% | 2.58% | 4.38% | 5.52% | 8.47% | 9.65% |
| Banesto | 0.47% | 1.64% | 2.97% | 4.11% | 5.01% | 6.28% |
| SAN Consumer Finance | 2.84% | 4.18% | 5.39% | 4.95% | 3.97% | 3.90% |
| Portugal | 1.25% | 1.72% | 2.27% | 2.90% | 4.06% | 6.56% |
| Poland | 4.89% | 4.72% | ||||
| United Kingdom (Abbey) | 0.60% | 1.04% | 1.71% | 1.76% | 1.84% | 2.05% |
| Latin America | 1.87% | 2.95% | 4.25% | 4.11% | 4.32% | 5.42% |
| Brazil | 2.74% | 3.58% | 5.27% | 4.91% | 5.38% | 6.86% |
| Mexico | 1.20% | 2.41% | 1.84% | 1.84% | 1.82% | 1.94% |
| Chile | 2.11% | 2.64% | 3.20% | 3.74% | 3.85% | 5.17% |
| Puerto Rico | 3.17% | 6.92% | 9.60% | 10.59% | 8.64% | 7.14% |
| Argentina | 1.24% | 1.83% | 2.60% | 1.69% | 1.15% | 1.71% |
| Sovereign | 5.35% | 4.61% | 2.85% | 2.29% | ||
| Santander Group | 0.94% | 2.02% | 3.21% | 3.52% | 3.87% | 4.54% |
| Coverage Ratio | 2007 | 2008 | 2009 | 2010 | 2011 | 2012 |
| Continental Europe | 188.1% | 90.0% | 76.6% | 71.4% | 55.5% | 72.5% |
| SAN Branch Network | 248.1% | 74.9% | 64.9% | 51.8% | 39.9% | 67.5% |
| Banesto | 332.9% | 106.5% | 64.1% | 54.4% | 53.1% | 71.3% |
| SAN Consumer Finance | 95.7% | 85.5% | 96.8% | 128.4% | 109.3% | 109.5% |
| Portugal | 117.4% | 77.2% | 64.6% | 60.0% | 54.9% | 53.1% |
| Poland | 65.4% | 68.2% | ||||
| United Kingdom (Abbey) | 65.8% | 68.5% | 43.8% | 45.8% | 38.1% | 45.4% |
| Latin America | 134.4% | 108.3% | 105.2% | 103.6% | 97.0% | 87.5% |
| Brazil | 101.5% | 102.4% | 99.2% | 103.5% | 95.2% | 90.2% |
| Mexico | 192.3% | 132.1% | 264.4% | 214.9% | 175.7% | 157.3% |
| Chile | 118.5% | 102.4% | 89.0% | 88.7% | 73.4% | 57.7% |
| Puerto Rico | 101.7% | 61.0% | 53.3% | 57.5% | 51.4% | 62.0% |
| Argentina | 235.9% | 178.6% | 141.0% | 149.1% | 206.9% | 143.3% |
| Sovereign | N.A. | N.A. | 62.5% | 75.4% | 96.2% | 105.9% |
| Santander Group | 150.6% | 90.6% | 75.3% | 72.7% | 61.4% | 72.6% |
The main problematic areas for SAN are SAN Branch Network (Spain), Banesto (spain), Portugal, Brazil and Chile. The first three have seen NPL ratios climb consistently since the 2008 financial crisis. NPL coverage at SAN Branch Network, Banesto and Portugal are also sorely lacking. For Brazil and Chile, NPLs climbed in response to a slow down in the economy in 2011. I expect NPLs to continue to flow in over the next 1-2 years.
| Quarterly GDP Growth (%) | 1Q2011 | 2Q2011 | 3Q2011 | 4Q2011 | 1Q2012 | 2Q2012 | 3Q2012 | 4Q2012 |
| Spain | 0.2% | 0.2% | 0.0% | -0.5% | -0.4% | -0.4% | -0.3% | -0.8% |
| Portugal | -0.9% | -0.1% | -0.5% | -1.6% | -0.1% | -1.0% | -0.9% | -1.8% |
| Brazil | 0.7% | 0.6% | 0.0% | 0.0% | 0.1% | 0.3% | 0.3% | 0.5% |
| Chile | 1.4% | 0.4% | 0.5% | 2.3% | 0.9% | 1.7% | 1.2% | 1.4% |
Looking at quarterly GDP growth of the four relevant countries, Brazil seems to be rebounding from a trough in 2011 and Chile's quarterly GDP growth is stabilizing Spain and Portugal's economies however, continue to contract.
| Credit Risk with Customer (EUR m) | 2007 | 2008 | 2009 | 2010 | 2011 | 2012 |
| Continental Europe | 358,933 | 368,512 | 366,970 | 370,673 | 364,622 | 334,028 |
| SAN Branch Network NPL | 131,676 | 135,508 | 129,099 | 126,705 | 118,060 | 111,756 |
| Banesto | 86,601 | 87,925 | 86,681 | 86,213 | 78,860 | 71,976 |
| SAN Consumer Finance | 32,178 | 56,245 | 60,245 | 67,820 | 63,093 | 59,387 |
| Portugal | 47,556 | 34,760 | 34,501 | 32,265 | 30,607 | 28,188 |
| Comercial Poloina (BZ WBK) | 9,120 | 10,601 | ||||
| United Kingdom (Abbey) | 203,225 | 217,063 | 238,215 | 244,707 | 255,735 | 255,519 |
| Latin America | 84,073 | 112,040 | 117,146 | 149,333 | 159,445 | 160,413 |
| Brazil | 26,414 | 53,764 | 65,611 | 84,440 | 91,035 | 89,142 |
| Mexico | 15,012 | 13,482 | 12,676 | 16,432 | 19,446 | 22,038 |
| Chile | 19,198 | 18,848 | 21,384 | 28,858 | 28,462 | 32,697 |
| Puerto Rico | 5,067 | 4,810 | 4,132 | 4,360 | 4,559 | 4,567 |
| Colombia | 1,464 | 1,464 | 1,719 | 2,275 | 2,568 | 5,378 |
| Argentina | 2,898 | 3,270 | 2,936 | 4,097 | 4,957 | 5,378 |
| Sovereign (USA) | 0 | 0 | 38,770 | 40,604 | 43,052 | 44,678 |
| Santander Group | 649,342 | 697,200 | 758,347 | 804,036 | 822,657 | 794,901 |
As at end 2012, total credit risk from the four areas mentioned above sums up to EUR305.6bn. Of this EUR305.6bn, EUR23.1bn has been classified as NPL (NPL ratio of 7.6%), and Loan Loss Reserves of EUR17.0bn has been set aside, resulting in a NPL coverage ratio of 73.6%. Again SAN's PPOP in 2012 represents 7.7% of their total credit risk from these regions. Can NPLs from the region double to 15%? Perhaps. Can SAN provision for the losses over a period 2-3 years if the situation in Europe remains under control and in order. Most likely.
I think SAN is cheap at these valuations. It has a very profitable LatAm banking franchise which should over time help SAN with provisioning with the losses in Europe. It reminds me of Bank of America (BAC) in the US, which is similarly trading at very low PB because of their high provisioning and depressed earnings. SAN like BAC sees improve mortgage loan vintages. The new mortgages loans made in 2010-2011 have much lower default rates than those made in 2008-2009. Over time, SAN should be able to resolve its balance sheet issues in Europe.
Ken Fisher estimates that SAN will be able to earn a EPS of US$1 by 2014. I think that is too optimistic. I suspect an EPS of US$0.70-US$0.80 will be more realistic.
Investment Case
(i) Strong market position in LatAm - Brazil 10% market share, Mexico 16% market share, Argentina 9% market share and Chile 20% market share.
(ii) Good vehicle to gain exposure to structural growth and rising credit penetration in LatAm,
(iii) Strong tier 1 ratio for a European Bank.
(iv) Management forecasting ROEs to return to 15% in 2014-2015 and re-provisioning for losses in Spain to finish in 2013.
(v) One of the highest PPOP/Total Asset ratio in the region - 1.93% vs an average of 0.72% for the European Bank sector in 2011.
(vi) Spanish new housing sales overtaking new housing finishes.
Risks
(i) Contraction of Net Interest Margins, especially in Brazil.
(ii) Worsening of economic conditions in the Eurozone, in particular Portugal and Spain.
(iii) Threat of a disorderly dissolution of bankrupted companies in Spain.
(iv) Worsening of economic conditions in Latin America, in particular Brazil.
(v) Breakup of the Eurozone.
