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My reference valuation for Banco Santander (SAN), or any company, is based on historical performance, trying to determine what is a logical and conservative earning per share that reflects the earnings capacity of a company on a full business cycle.

Banks tend to overstate profits on the good times, when default rates are low or non-existent, and to underestimate profits when default rates grow. Even in Spain, where there has been a practice of conservative provisioning against unknown future default rates, the depth of the crisis has dwarfed any precaution imposed by the supervisor.

Since May 2012, rules to provision for non-performing and performing real estate loans, and rules that deal with the impairment on assets transferred to the banks' balance sheet, have been extremely strengthened, impacting the whole sector in terms of bottom line profits.

On my investment approach I don't want to be influenced so much by medium term swings in EPS but by a longer more stable standardized EPS that reflects "normal business conditions".

For the 22 years I've got information in SAN average EPS has been $0.74 per share. Last 10 years EPS average has been $1.15. We can see on the chart below, the EPS evolution compared with full period and 10 years' average.

(click to enlarge)

Very long averages may not reflect the current level of the company's income capacity. In 22 years, the bank has increased its asset base at an impressive 18.7% CARG. Equity has grown in a similar fashion (18.4% CAGR), but EPS has not grown at all.

EPS for 2012 has been the same as it was in 1990, in fact a bit smaller. The distorted 2012 EPS might veil the picture, but at its peak, in 2007, growth in EPS vs. 1990 was 10.7% CARG, almost half of the growth in assets and equity. This shows that the bank has grown more by M&A than by profit retention. This can be a bad sign, but not necessarily.

A 10 year EPS average could be more representative since it covers a full business cycle and does not average in old or different business models. The problem in this case might be that the last Spanish economic cycle is hardly to be repeated, especially in the case of the financial industry, that won't be able to surf another mortgage wave as the one they were riding since 1996.

I would probably consider the last 10 year's average as a conservative EPS maximum. Therefore an EPS that reflects business capacity of the bank is anywhere between the $0.74 full period average and the $1.15 of the last 10 years.

Applying a conservative 10x PER to that range of EPS would imply a valuation of $7.4 to $11.5 per share, almost in line or above current market price of 7.91 euros per share.

We can check whether we are on the conservative side or not by using historical Return on Assets (ROA) multiplied by the lowest between current or historical leverage, to obtain another EPS reference.

Average ROA for the whole 22 year period has been 0.72% with a 27% standard deviation. That is indeed a good performance in terms of business stability. No matter the M&A activity, the bank's management has done a good job of keeping their underlying business working and on track.

I don't take the time to adjust ROA for leverage, since I am more concerned with stability and trend than on the actual true ROA figure, that would have to add tax adjusted interest cost to Net Income.

ROE, as we can see on the chart below, has indeed been more volatile because of changes in leverage. SAN has done a pretty good job to keep leverage under control since 2005 and has slowly but surely come down from the 20x level to the 15-17x range, well below many other banks in Spain and Europe.

(click to enlarge)

Average ROA of 0.72% with current leverage (Assets/Equity) of 17x times would imply a standardized ROE of 12.3%. Real average ROE for the period has been 14%.

That standardized 12.3% ROE applied to 2012 book value of $10.55 per share, would yield a standardized $1.30 EPS and a $13 per share valuation if we apply a 10x PER. Little changes if we use 10 or 5 year average, given the stability in ROA I commented before.

All of the calculations above are summarized in this table below:

(click to enlarge)

The more classic average EPS approach yields a $7.4 to $11.5 valuation. We could say we are not overstating the earnings capacity because, as we have seen, if we apply a standardized ROE measure to current book value, we get to higher earnings that would justify a valuation of up to $13 per share.

The question for Spanish banks right now is which is the real value of their equity, or if all of their junk real estate loans are marked to market, not necessarily to opportunistic buyer's price, but at least to a realistic realization value of the underlying assets.

The bank trades at 70% book value, so that accounts for some margin, even we have to be aware that a 30% margin in equity is a mere 3% haircut in all of the bank's loans (2% if we consider all of balance sheet).

I wouldn't be able to give an equity valuation without a deep analysis of the balance sheet that is very difficult not only for me, but for anybody outside the bank or the Bank of Spain after a few month's job.

Only with a new government in place at the end of 2011, hard measures were taken to make the banks' balance sheet credible.

As of today, any performing real estate loan has to be provisioned in different degrees, depending on the nature of the underlying asset. From 14% up to 52% of the loan principal with no deduction of the value of the guarantees whatsoever and, as said, no matter the loan is being paid.

This if of course because the government realized that collecting interest rates does not necessarily mean the loan is going to be paid back. So this was a way to press banks to abandon their inertia to refinance loans against recognizing losses.

Of course, non-performing real estate loans' provisions are stronger and go up to 80% of the value of the loan, without deduction of guarantees value. Therefore if the value of the guarantee is totally or partially recovered, the bank would make a profit by way of provisions reversion.

I am not a bank specialist but I see that as a conservative standard so I am much more comfortable on balance sheet values as of today than in December 2011, before these rules were in place.

Still there is the doubt in the retail mortgages, where these special rules are not applied and the traditional provision scheme is the one applicable. SAN has published a 2.8% default rate in that loan class in 2012, which is high but very manageable and lower than most of other banks in Spain.

Current multiples to Book Value are the lowest of the 22 year period. Previous 2001 and 1993 crisis periods' reference was 1,3x on both cases.

(click to enlarge)

So, to summarize this point, I think current equity might get hurt by additional unrecognized consequences from real estate underperformance, but most of the pain has been taken and on top, market is applying additional discount to that equity, in fact, the highest discount in recent history.

What can we get from SAN as an investment, assuming the principal of our investment is justified and therefore recoverable, depends on earnings. Historical average EPS is $0.74 per share which implies a 9.4% yield at current price levels ($7.91 per share) or 7.1% yield at 2012 Book Value.

That of course assumes that EPS will recovers from 2012 level $0.29 and scale back to the historic average. As of today, given the number of issued shares $0.74EPS would require $7,350MM in profits, which is slightly above the recurring net profit of the bank in 2012, $7,050MM, before extraordinary loan provisions.

Therefore a 9% yield seems quite in the pocket for the investor, once and if, extraordinary provisions begin to diminish, since the profits are already there, we just have to wait for provisions to end.

How long this could take is more difficult to say, of course, but since we would be investing at safe multiples, from an historical perspective, we can wait with some patience and comfort. I don't see the Spanish economy recovering without the banks, especially the ones surviving stronger from the crisis, taking their share of the cake.

On the table below I summarize the return that each previously calculated EPS would yield at current market price and also the safety margin of each EPS' value (10x PER) when compared to current market share price:

(click to enlarge)

I don't think that at current multiples we are paying for future growth or recovery of the Spanish economy. I think that we would be paying current business performance temporarily overshadowed by passed year's exuberance and lack of caution. Most significant effort to clean past sins has been made already so bottom line profits will converge to recurring profits sooner than later.

Improvements of the Spanish economy would enhance this recurring profit but we don't need much of an improvement to justify our valuation, so for me SAN is an interesting stock to own. If the Spanish economy improves then SAN would probably also recover its average ROE back to the 12% level which would boost investor return to an annual and very interesting 14-16%.

I have acquired SAN shares after writing this report since I think it can deliver a strong yield, close to 10% annually no matter Spanish economy does not improve significantly and can provide for very good returns if it does.

Notes: Accounting data shown in the article is based on official reports published by the company in Spain, therefore in Euros. I have passed all EUR amounts into USD at current 1.34 foreign exchange rate.

Disclosure: I acquired SAN shares after this article was written. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Investment Rationale For Banco Santander