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When considering a stock's appeal, dividend investors look for attractively priced shares that offer either high and sustainable yields or weaker but fast growing ones. The Spanish economy seems to be reaching a turning point that can offer opportunities for investors willing to diversify into European stocks.

In a previous article I discussed the solid high yields of the Spanish stock exchange BME (OTCPK:BOLYY) and a second article covered the potential for growth of the niche-player and global leader Viscofan (OTC:VSCFF).

As a top yielder in the Spanish IBEX 35 Index, Banco Santander (NYSE:SAN) is another stock worth considering for income investors. The stock is traded as an ADR for the American investor

Note: $ amounts below will be based on a constant exchange rate of 1.3 €/$

Dividends

Santander is offering an admittedly juicy 10.8% yield and has kept its € 0.60 ($0.78) dividend unaltered since 2009 as the Spanish financial and real estate crisis unfolded.

Since November 2009, Santander offers its shareholders the possibility to receive dividend in cash or in newly issued shares (scrip dividend). It's worth noting that cash dividend is subject to a 21% Spanish dividend withholding tax (scrip dividend bears no withholding tax).

While scrip dividend may be a tax-efficient way to increase positions in the bank, it comes at the price of giving up cash dividends. Income investors will probably prefer cash, but on the other hand this is a dilutive choice. The key question for income investors then is whether the current high yield that SAN is offering will be sustained in the future and can continue to be paid in cash.

In my view the odds are that it will not.

Earnings per share and payout

Santander EPS have dropped every year since 2007 and reached €0.21 ($0.27) in 2012. This leaves payout at 285%, hardly a sweet spot in terms of sustainability. For 2013, consensus EPS doubles to around €0.43 ($0.56), resulting in a payout of 139% despite doubling EPS. Income investors seeking for a payout closer to 50% would need Santander EPS to move to €1.20 ($1.56), nearly a 3-fold increase from the already positive 2013 expectations and hardly achievable in the short term.

However, a closer look into both earnings and shares is needed to assess how EPS might evolve in the future.

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Source Banco Santander

Number of shares

Investors have chosen the default option for scrip dividends instead of cash in roughly 80% of the cases, which has allowed Santander to keep cash in the bank and reinforce its capital ratios.

However, quarterly inflation in number of shares is a drag on earnings per share for any company. Unless Santander can grow earnings at the pace of shares, the stock price will suffer downward pressure which in turn can reduce the returns of investors being paid in stocks (through scrip dividends).

The total number of shares has increased by an impressive 77% since 2007 and new shares will be issued in November 2013 to continue with its scrip dividend program.

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Source Banco Santander

Earnings

With new capital flowing in every quarter, Santander has been able to reinforce its solvency while growing assets at a slower pace than capital. In the period 2007-2012 assets grew by 47%, number of shares by 65% and equity by 91%.

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Source Banco Santander

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Source Banco Santander

Santander has shown it is able to keep the ratio of net operating income on its growing assets above pre-crisis levels, despite a declining trend in the last years. But on the other hand earnings on assets have suffered from the need to increase loss provisions and write-off bad loans. Given these trends, the evolution of future earnings will be very much determined by the amount of additional loss provisions the bank needs to book.

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Source Banco Santander

As for earnings per share, the inflation of shares discussed above has made each share buy less operating income for years. If scrip dividends continue to be issued each quarter, income per share will most likely keep its downward trend. This makes it harder every quarter to achieve future sustained growth in earnings per share.

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Source Banco Santander

Loss provisions

This seems the key item explaining the evolution of Santander earnings during the last years and is probably the key to advance any potentially better future prospects. Spanish banks in general have suffered from their exposure to the ailing domestic economy and real estate burst, and Santander is no exception even if it has steered well its way through the crisis.

Santander has played to its advantage the fact of being a well diversified bank, offsetting domestic credit losses with profits made abroad. However, diversification depends on the metric to be considered. As for earnings, only 15% of Santander earnings are originated in Spain, which can lead some investors to think that the exposure of Santander to Spain is limited. However, diversification looks weaker in terms of credit assets (31% in Spain) and especially in non-performing loans (47% in Spain).

If lower loss provisions are the key to a clear path to earnings, then the evolution of its Spanish business is in fact very relevant for the future earnings of Santander.

Rising NPL trends are not easily boiled down by any bank. In the case of Santander, this trend is moving strongly upward and there is little evidence that this will change in the short term. Q2'13 showed an additional increase to 5.18% total NPL. More worryingly, the trend is not exclusive of the Spanish assets, with NPL ratio growing across most geographical areas.

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Source Banco Santander

The bank has made a huge effort to increase loss provisions significantly, reaching a 66% coverage in Q2'13 and Santander also keeps NPL ratios below industry average. This no doubt makes Santander's balance sheet strong compared to peers, but unfortunately does not eliminate the drag on profits.

A second concern is Santander real estate exposure to Spain. The bank has made a tremendous effort in 2012 and exposure has been reduced from €28.5billion ($37.0 billion) to €12.5billion ($16.5 billion). However, real estate properties in Spain seem still overvalued by different metrics, so earnings may still suffer in the short term from additional price drops. The question here is whether these assets are market to market at reasonable realization prices or will cause additional losses as the bank offloads its balance sheet by selling these properties.

Conclusion

Santander will not stay forever issuing new shares every quarter under its scrip dividend program, as keeping this practice for too long would hamper earnings per share and put downward pressure on the stock price. Santander's dividend can't last, at least in its current form.

In my view, Santander will likely put an end to its scrip dividend program as soon as 2014 and no later than 2015. Whenever the bank abandons this practice, a decision will need to be made about the cash dividend to be paid to shareholders. With 2013 EPS expectations, keeping the current yield fully in cash would require a payout well above 100%, so a total dividend cut may need to be announced as the scrip dividend finishes. This would bring yield and payout somewhere closer to the industry average.

However, offering a lower yield and putting an end to scrip issues is not necessarily bad news. This would signal that the bank has fully completed its current cycle of capital reinforcement and loss provisioning, leaving the company well positioned for a new cycle of healthy growth. Santander has a remarkable track record in delivering profits while managing growth, so this would be a good moment to reconsider the stock prospects.

For the moment being, however, dividend investors looking for growing cash returns through dividends would better wait until Santander clarifies what its dividend policy will be once its scrip dividend program gets to an end.

Source: Banco Santander's Dividend Can't Last

Additional disclosure: I have no positions in SAN, and no plans to initiate any positions within the next 72 hours