Citigroup has significantly outperformed Santander over the last 5 years.
The table below shows that Citigroup and Santander are currently trading at the similar forward P/B multiples: 0.54x and 0.53x, respectively.
We expect Citigroup to outperform Santander as the current market valuation fails to reflect major structural differences between these banks, regarding: 1) earnings stability/momentum; 2) Brexit headwinds; 3) capital adequacy ratios; 4) 2016 CCAR results; 5) cost of equity.
Earnings stability: Emerging Markets and Latin America
Santander is biased on unstable and high-volatile Latin America. More than 40% of its revenues come from this region.
Source: Company data, Bloomberg
Banco Santander (Brasil) (NYSE:BSBR) generates c.60% of total SAN LA's revenues, hence, Brazil is crucial for Santander's earnings stability.
First, with Brazil facing one of its worst recessions in recorded history, we expect the worsening economic situation to be reflected in higher provisions in the coming quarters. UBS Research has recently published a stress-test analysis, suggesting provisioning risk could be higher at Santander Brazil relative to other Brazilian banks, posing a greater threat to earnings estimates:
Source: UBS Research
Although Santander Brazil's earnings forecasts have been significantly revised downwards by investors and sell-side analysts, we think that the market is still underestimating the impact of asset quality deterioration on earnings. Brazilian banks are actively using renegotiation tools and according to Brazilian Central Bank's financial stability report, the recent rise in restructured loans would add c.70 bps to NPL ratios implying a c.20% pick-up in NPL ratios.
Second, Santander Brazil has the lowest profitability among its peer group. The main reasons for the low profitability profile are: a) lower interest margins; b) higher non-interest operating expenses and c) a lower share of fee income, as the bank sold some insurance and asset management businesses.
Source: Company data
Finally, the chart below shows that Santander Brazil is one the most overvalued banking stocks in emerging markets.
Source: Bloomberg, Renaissance Research
Citigroup has a significant presence in Latin America too. The region's contribution to the group revenues is smaller though.
Source: Company data, Bloomberg
Citigroup Latin America is much more profitable than Santander Brazil, its return on assets printed at 1.25% in 1Q16 vs. 0.3% at Santander Brazil. Moreover, Citi plans to sell retail-banking and credit-card operations in Brazil, Argentina and Colombia. We believe the sale should meaningfully reduce Citi LatAm's earnings volatility and could lead to capital releases.
Earnings stability: Spain vs. North America
Revenues in Spain (13% of SAN's total revenues) are still under pressure as: a) a zero-to-negative interest rate environment weighs on margins; b) loan volumes continue to decline; and c) fee income growth is subdued. The chart below shows that, while there is limited room for decreasing deposit costs, there should be still pressure on loan yields due to Euribor repricing (spread compression almost over).
Source: Company data
Loan volumes should also have a negative impact on a NII due to mortgage deleveraging. Moreover, according to the ECB 1Q16 Lending Survey, the contribution from fixed investments fell significantly q/q in Spain.
Citigroup North America segment is in a much better position. It largely depends on the Cards business, which remains very profitable with a high-teens/low 20s RoE. Also, it is an efficient business with an expense ratio in the mid-40% range versus mid-50% for the group. Management sees this business as a key growth driver and has been investing to position the business for longer-term growth. Also, we believe the combination of ongoing business investments in North America branded Cards and upside from the Costco (NASDAQ:COST) portfolio acquisition suggest an improvement in its financial metrics.
The Brexit headwinds
Santander has grown its UK consumer credit book (including car finance) by more than 60% in two years. This is clearly very fast growth. Hence, in the event of a rise in unemployment and a decrease in real wages, as suggested by HM Treasury's severe shock scenario, Santander UK would likely see a material asset quality deterioration. UK consumer credit represents more than 40% of Santander Group's tangible equity, hence asset quality risks are significant at a group level.
Another impact on Santander from Brexit fallout is the collapse in sovereign bond yields. According to SG Research, SAN's interest income on sovereign bonds is more than EUR5bn or 80% of SAN 2016E net income.
Source: SG Research
SAN share price dynamics perfectly confirms that Santander will see a severe negative impact from declining sovereign bond yields - the chart below shows that there is a close correlation between SAN share price and German bund yields.
Capital adequacy ratios
Santander has one of the weakest capital positions amongst European banks. Its CET1 is below 2019 SREP minimum regulatory requirements.
Source: Barclays Research
In addition, Banco Popular's capital raising renewed concerns over Spanish banks' asset quality and their capital positions. On May 26, Banco Popular (OTCPK:BPESY), the fourth largest banking group in Spain, surprised the market with a EUR2.5bn rights issue and a fresh round of provisions for its troubled property portfolio. According the bank's own presentation, "some uncertainties could give rise to up to €4.7bn of additional provisions during 2016, mainly relating to credit and foreclosed assets, which could lead to accounting losses (covered, in terms of solvency, by the rights issue) and the temporary suspension of dividend payments." In our view, Banco Popular's capital raising has renewed concerns over Spanish banks' asset quality and we think the market will now focus on European banks with weak capital adequacy ratios - a negative read-across for Santander.
By contrast, Citigroup' capital base is solid with a CET1 of 12.3% and leverage ratio of 7.4%.
Source: Company data
CCAR 2016 results
Citigroup got a positive outcome. It delivered a clean CCAR approval and showed that various qualitative concerns raised in the past had been put to rest. Santander failed the CCAR 2016 exercise. Also, we do not expect good news from the Santander US unit, considering elevated cost of risk levels.
CDS markets are pricing an additional risk premium for Santander.
CDS spreads, which are often used as a proxy for a cost of equity, confirm our view that SAN is indeed much riskier than Citi. The CDS markets have been pricing an additional risk premium for Santander:
Bottom line: A very attractive pairs trade opportunity
The current market valuation fails to reflect major structural differences between the two regarding: 1) earnings stability/momentum; 2) Brexit headwinds; 3) capital adequacy ratios; 4) 2016 CCAR results; 5) cost of equity. We expect Citigroup to continue outperforming Santander, hence Citigroup on the long side and Santander on the short side look like a very attractive pairs trade opportunity.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.
Additional disclosure: I am long Citigroup and short Santander via futures contracts.