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Santander Consumer USA Holdings (NYSE:SC) made its public debut on Thursday, January 23. Shares of the US auto-lending unit of the Spanish bank rose by 5% on their opening day.

While margins and growth are attractive, combined with a modest valuation, there are significant risks to investing in the business as well. Focused on non-prime consumers and relying upon funding from Banco Santander and asset-backed securities, the company remains vulnerable to a renewed economic setback.

The Public Offering

Santander Consumer USA is a full-service consumer finance company which focuses on vehicle financing and unsecured consumer lending. After being founded in 1995, the company has achieved good recognition in the non-prime financing space, recently focusing on the prime space as well.

The technological strong platform, extensive data and analytical tools, combined with disciplined management, allowed Santander to grow its presence in the US financing markets in recent years.

Santander USA sold 75 million shares for $24 apiece, thereby raising $1.8 billion in gross proceeds. Note that all shares being sold are being sold by selling shareholders, with none of the proceeds going to the business itself.

Initially bankers and the firm set an initial price range of $22-$24 per share. Shares sold at the high end of the preliminary public price range, as an indication of strength despite the fact that all shares have been offered by selling shareholders. Note that initially the underwriting group only targeted sales of 65.2 million shares.

Some 22% of the total shares outstanding were offered in the public offering. At Tuesday's closing price of $25.69 per share, the firm is valued at $8.9 billion.

The major banks that brought the company public were Citigroup, JPMorgan, Bank of America/Merrill Lynch, Deutsche Bank, Goldman Sachs and Santander itself, among many others.

Valuation

Santander Consumer USA operates in the US consumer finance industry with roughly $2.5 trillion in borrowings outstanding, including vehicle loans, credit card, home equity lines of credit, student loans and personal loans. With the economic recovery, demand for vehicle loans which is the company's major focus area is picking up.

Automobile loans outstanding and leases account for roughly $850 billion in outstanding credit. Through relationships, for example with Chrysler Capital, Santander aims to increase the proportion of prime loans.

The company also operates in other areas of the consumer lending markets, being credit cards, student loans and private loans, among others. Much more limited access for consumers to credit combined with an economic recovery provides these markets with an interesting opportunity according to the firm. Note that the major area of focus remains vehicle financing.

For the year of 2012, Santander USA generated revenue of $2.95 billion, up 13.6% on the year before, as the business has essentially doubled revenues since 2009. On the back of higher loan provisions, earnings fell by 6.9% to $715.0 million.

Growth continued and accelerated into 2013. For the first nine months of the year, revenues came in at $2.72 billion which is up by 26.5% on the year before. Loan loss provision rose by 85% to $1.22 billion which weighted on earnings which fell by 2% to $583.6 million.

Santander USA operates with roughly $2.5 billion in equity on a balance sheet of $25.6 billion, resulting in a simple leverage ratio of 9.8%. The majority of the balance sheet consists out of accounts receivables, totaling $21.5 billion. Given that the company is on track to generate net interest margins of $3.3 billion on just $21.2 billion in receivables, net margins surpassed 15%.

The current $8.9 billion market valuation values the company at 11 times annual earnings as earnings could approach $800 million this year.

Investment Thesis

As noted above, the offering of Santander USA has not been much of an event. The company priced the offering at $24 per share, some 4.3% above the midpoint of the preliminary offering range. Ever since, shares have inched up a little more, trading some 11.7% above the midpoint of the preliminary offering range.

Note that Santander is solidly profitable at the moment, as high net interest margins fuel earnings despite very solid provisions for bad loans. This should not come as a surprise, with 80% of the business tied to subprime lenders at the moment.

The improving economy and increased demand for cars has helped the business in recent years, yet the company remains a very much leveraged play on the state of the economy. On top of lower revenues in a weaker economy, higher bad debts and notably worsening access to securitized financing, are major concerns. Furthermore a huge portion of funding is provided by Santander (NYSE:SAN) itself, which can really hurt the business if that bank runs into troubles as well.

For now the business continues to grow nicely, fueled by the agreement made at the start of 2013 with Chrysler, to increase funding to both prime and non-prime consumers. While the current growth and fair valuation might be attractive and the company pays investors an appealing dividend of $0.15 per quarter, or 2.3% per year, there are downside risks as well.

Higher charge-offs, lower revenues and worsening access combined with the fact that sophisticated investors like KKR and Warburg Pincus are sellers, makes me worried.

I remain on the sidelines.

Source: Santander Consumer USA: Appealing Valuation For Subprime Lender, But Risks Present