The effects of the European sovereign debt crisis have pushed the European banking industry into crisis with investors fleeing the sector in droves fearful of sovereign debt defaults and high risk loan portfolios. It has also had significant impact on many European economies, particularly those with high government debt leading to a eurozone wide economic slowdown, which has been most sharply felt in those countries on the periphery: Portugal, Ireland, Italy, Greece and Spain (PIIGS). This has seen the stock prices of many major European banks plunge to new lows over fears of their exposure to sovereign debt and the Spanish real estate bubble. Particularly hard hit has been Spain's largest bank and Europe's eighth largest bank by assets. Banco Santander (STD) dropped 30% in value since its 2012 high of $8.77, to be trading with a double digit dividend yield of 13% and a bargain price-to-earnings ratio of 8. All of which has aroused intense investor interest as to whether now is the time to invest in Banco Santander. All of which will depend on whether its price is being driven by market fear or an accurate appraisal of the bank's risk exposure.
Banco Santander is a full-service bank that is the 19th largest in the world by assets with almost 15,000 branches worldwide. It has a strong presence in Latin America with 41.7 million customers in the region, which is 41% of its total global customer base, and banking operations across eight Latin American countries. This includes two independently listed and highly profitable subsidiaries Banco Santander Brasil (NYSE:BSBR) and Banco Santander Chile (NYSE:BSAC).
For the fourth quarter 2011 Banco Santander reported a 56% rise in revenue to $11.8 billion and a significant 97% fall in net income to $63 million. For this period its balance sheet weakened substantially with cash and cash equivalents falling 93% to $7.2 billion, although long-term debt also fell during this period by 18% to $230.7 billion. Banco Santander for the full year 2011, reported a 1% increase in revenue to $42.2 billion and a 34% fall in net profit to $7 billion. This substantial drop in net income as well as cash and cash equivalents, can be attributed to significant loan loss provisions totaling $14.4 billion, which have been set aside due to the high volume of non-performing loans in Spain.
Yet despite this particularly poor financial performance, Banco Santander possesses some particularly compelling performance metrics that augur well for its future financial performance. These performance and valuation ratios also compare well to the performance of its main Spanish competitor and Spain's second-largest bank Banco Bilbao Vizcaya Argentaria SA (BBVA). In addition, as table 1 below shows, both of Banco Santander's independently listed Latin American subsidiaries are performing particularly strongly.
Table 1: Performance and Valuation Ratios
2012 Forward PE
Debt to Equity Ratio
Banco Santander Brasil
Banco Santander Chile
Each of the banks listed have efficiency ratios of less than 60%, which is the accepted industry standard for a healthy bank. The efficiency ratio is essentially a measure of how effectively a bank utilizes its resources to generate revenue and is reflects how many cents are required to generate one dollar of revenue. Therefore, in the case of Banco Santander with an efficiency ratio of 44.9% it is spending $0.449 for every dollar of revenue generated.
Evidently Banco Santander has quite an impressive efficiency ratio especially in comparison to other industry participants, for example in 2011 the aggregate efficiency ratio for the U.S banking industry was 68%. Furthermore, the efficiency ratios of the top four major U.S banks are substantially higher, with Wells Fargo (WFC), JPMorgan (JPM), Citigroup (C) and Bank of America (BAC)have efficiency ratios of 59%, 65%, 66% and 90% respectively. Its efficiency ratio is also substantially superior to each of the major UK banks, which during 2011 had efficiency ratios of between 54% to 71%.
Undeniably Banco Santander's return on equity is disappointing and is certainly not representative of the shareholder value it should be delivering when it has a debt to equity ratio of 3.7. However, Banco Santander's return on equity is comparable to its nearest competitor BBVA and the major U.S banks, with Wells Fargo, JPMorgan and Citigroup all having a return on equity of 12%, 10% and 6% respectively. In addition, both of Banco Santander's listed Latin American subsidiaries are delivering highly credible returns on equity, with Banco Santander Chile being a standout performer with a return on equity of 23%. This can be attributed to Chile's vigorous economic growth, which is fueling increased domestic consumption and demand for consumer finance. My article "Banco Santander Chile: Is It Another Santander Success Story For 2012?" explains this in more detail.
Banco Santander is also generating a solid double digit profit margin, which is comparable to BBVA, though it is significantly less than its subsidiary Banco Santander Chile. This certainly bodes well for its future profitability. It is also trading at a relatively cheap 2012 forward multiple of 7, which is only marginally higher than BBVA and lower than Wells Fargo, JPMorgan, Citigroup and Bank of America, which have 2012 forward price to earnings ratios of 10, 9, 8 and 13 respectively.
Banco Santander's very high debt to equity ratio of 3.7 is of some concern. It indicates the bank is reliant upon using wholesale debt and external funds to fund its lending operations. This is more costly for a bank than funding its lending through its deposit base and also leaves the bank exposed to movements in short-term interest rates that can have a direct impact on its bottom line. Banco Santander's debt-to-equity ratio is substantially higher than BBVA's, JPMorgan's and Citigroup's at 2.4, 3 and 3.2 respectively.
As a result of Banco Santander's substantial fall in price it has an exceptionally attractive dividend yield of around 13%, although this is combined with a payout ratio of 111%. As a quick and dirty measure of dividend sustainability a payout ratio of higher than 100% indicates that the dividend is not sustainable. The high payout ratio has resulted because Banco Santander has maintained its dividend payment of €0.60 or $0.79 per share despite the 34% drop in earnings per share for 2011. Due to this substantial fall in earnings per share and pressing regulatory capital requirements combined with the requirement to set aside large loan loss provisions, many within the market had expected Banco Santander to drop its dividend by up to 50%. However despite these requirements, Banco Santander's Chairman Emilio Botin's publicly vowed to maintain the bank's annual dividend.
Since that announcement he has made further public statements ruling out any cuts to the dividend. I believe this decision has been made to preserve shareholder value because any cut in the dividend, would in conjunction with the capital issues and substantial Spanish loan loss provisions, see a loss of confidence in the bank and a substantial plunge in its share price. This would potentially create a knee-jerk reaction in the market with a sell down of the bank's subordinated debt sending its borrowing costs higher. Furthermore, if Banco Santander hits the forecast 2012 consensus earnings per share of $0.93, the payout ratio will drop to a sustainable 85%.
Banco Santander has already paid a first-quarter 2012 dividend of $0.16 per share and declared a second quarter 2012 dividend of $0.29 per share with an ex-dividend date of 10 April 2012. All dividends paid by Spanish companies to foreign stockholders are subject to 21% withholding tax. However, if an investor holding Banco Santander ADRs elects to receive the dividend as additional shares rather than cash, they are not subject to paying withholding tax and are issued shares instead. This will most likely result in a marginal dilution of shareholder value.
Another compelling rationale to buy Banco Santander is that at its current trading price of around $6.30, it is trading at a 10% discount to its tangible book value of $6.90 per share as well as a 41% discount to its book value per share of $10.74. For many value investors, that discount combined with its low forward price-to-earnings ratio of 7, double-digit dividend yield and projected 22% increase in 2012 earnings per share would make Banco Santander an irresistible buy.
However, prior to making any investment investors are wise to fully understand the level and materiality of the risk associated with investing in Banco Santander. This includes understanding the quality of the bank's assets, its risk profile and its exposure to both sub-standard loans and European sovereign debt.
Each of Banco Santander's key risk ratios are set out in table 2 below and compared with its Latin American subsidiaries and its nearest Spanish competitor BBVA. I have also broken out the key risk ratios for Banco Santander's Spanish business unit due to concerns over the quality of its Spanish loan portfolio and the large loan loss provisions that have been set aside in Spain.
Table 2: Risk Indicators
Loan to Deposit Ratio
Non Performing Loan (NPL) Ratio
Core Capital Ratio
Banco Santander (Group)
Banco Santander Spain
Banco Santander Brasil
Banco Santander Chile
* Banco Santander does not breakout core capital by business unit.
**Is an approximation only as Banco Santander Brasil does not provide a core capital ratio on a BIS ratio of 19.9%.
When reviewing Banco Santander's risk ratios there are a number of red flags, which raise concerns around liquidity, funding costs and the quality of its loan portfolio. The bank has a group wide loan to deposit ratio of 117%, which is 24 percentage points higher than BBVA's 83% and is Spanish business has the highest loan to deposit ratio in the group of 124%. This indicates potential issues with liquidity should the bank face any unforeseen funding requirements such as having to set aside large and unexpected loan loss provisions because of a collapsed real estate bubble, as we are now seeing in Spain. In addition, a high loan to deposit ratio indicates that the bank's cost of funding is can be high and unpredictable because of an over reliance upon external funding for lending operations, leaving it exposed to the vagaries of short-term interest fluctuations.
Another key concern is the quality of Banco Santander's loan portfolio as the bank has a group wide non-performing loan (NPL) ratio of 3.89%, which while equivalent to BBVA's is higher than the two percent or less that is considered optimal. Furthermore, the NPL ratio for its Spanish business of 5.49% indicates that the quality of its Spanish loan portfolio is impaired and the bank is more than likely going to experience substantial loan losses or have to carry non-profitable loans from its Spanish business for some time. This can be attributed to Spain's imploding real estate bubble, which has seen many Spanish banks exposed to substantial loan losses as evidenced by the Spain's average property loan NPL ratio of 9.3%.
The bank has set aside $14.4 billion of loan loss provisions group wide of which 25% or $3.65 billion have been set aside for its Spanish business alone, yet Spain only accounts for 12% of the bank's total loan portfolio. The total provisions set aside are also more than double the bank's 2011 net profit. Of further concern is Banco Santander's lending exposure in Spain to the construction and property development markets, which has a national average NPL of 17.7% and accounts for $30.98 billion of Banco Santander's total loans, with almost half of that value totaling $14.06 billion being classified as doubtful.
However, Banco Santander has worked exceptionally hard to reduce these risks and increase its core capital to 10% from 8.8%. It also has a credible Standard and Poor's credit rating of A+, which is higher than its Latin American subsidiaries and BBVA's credit rating, as well as being equivalent to JPMorgan's. However, the bank has been placed on credit watch negative by Standard and Poor's due to the economic issues in Spain and concerns over the bank's loan exposure to the Spanish property market.
Of further concern is Banco Santander's exposure to European sovereign debt particularly with the PIIGS. As of December 2011 Banco Santander had a total exposure to European sovereign debt of $58.18 billion, broken down between European countries as set out in the table 3 below.
Table 3: European Sovereign Debt Exposure
Gross Sovereign Debt Exposure
Source: European Banking Authority
*Exchange rate €1= $1.3215 USD
The bank's total exposure to European sovereign debt exceeds its tangible book value of $61.5 billion or €46.52 billion. As the table above shows Banco Santander has a large exposure to the sovereign debt of the troubled PIIGS and in particular Portugal and Spain, totaling $68.52 billion, which exceeds Banco Santander's tangible book value of $61.5 billion.
Of obvious concern here is the likelihood of default by one or all of the PIIGS, which would leave Banco Santander with significant solvency issues. Although Banco Santander's exposure to the highest risk of the PIIGS, Greece and Portugal is low and if either were to default it would be in a position to manage such a default. The greatest concern is if Spain were to default on its sovereign debt as this would have a drastic effect on Banco Santander. The general consensus is that in Spain, stronger banks such as Banco Santander SA the country's largest lender, can manage losses from their sovereign holdings.
It is also likely that the in the event of a sovereign default either the Spanish government or the European Central Bank would assist Banco Santander. This is because the viability of Spain's top banks, Banco Santander, BBVA and La Caixa are essential to the Spanish economy as they collectively hold customer assets worth around $2.7 trillion, which is almost double the size of Spain's $1.5 trillion economy. This indicates that Banco Santander is too big to be allowed to fail and in a worst case scenario it is highly likely that either the Spanish government, the European Central bank or a combination of both would ensure the bank remained solvent.
The risk of a Spanish sovereign debt default also appears to have decreased with the recent successful Spanish bond sale and further government austerity measures. But these measures will cause greater economic distress and likely push the Spanish economy further into recession driving unemployment higher, reducing consumption and depressing economic growth. As a result it is predicted that the Spanish economy will contract with real GDP shrinking by between 1.7% and 2.7% in 2012. Obviously this doesn't bode well for the profitability of Banco Santander's Spanish operations.
However, as we can see from both Banco Santander's 2011 results and table 1 above, some of the bank's most profitable operations are in Latin America, with 51% of Banco Santander's attributable profit being derived from its Latin American operations. Furthermore, the bank's two most profitable subsidiaries are Banco Santander Brasil and Banco Santander Chile, which contributed 28% and 7% of attributable profit respectively. It is also highly likely that Banco Santander's Latin American profits will grow as the region s forecast to have strong economic growth (pdf) through 2012.
However, of some concern is Banco Santander's strategy of selling portions of its highly profitable Latin American operations to raise the capital need to fund its loan loss provisions and increase core capital. This included in December 2011, selling 7.82% of its holding in its most profitable subsidiary Banco Santander Chile for $950 million, reducing its ownership to 67%.
It has also reached an agreement to sell its Colombian business to Chilean bank CorpBanca (BCA) for $1.16 billion with the transaction becoming effective in 2012. While I believe that the sale of 7.8% stake in its Chilean subsidiary is less than optimal given the subsidiary's profitability, Banco Santander's sale of its Colombian subsidiary is a sensible move. Banco Santander Colombia is one of the smallest banking franchises in the country with only 2.7% market share and it only contributed approximately 0.5% of its 2011 group profit.
Banco Santander is certainly grappling with many problems at this time, the most significant being its exposure to the fallout from the imploded Spanish real estate bubble. It is this which has seen the bank have to set aside significant loan loss provisions for its Spanish banking business as the volume of non-performing loans has risen dramatically. In addition, the bank has found itself starved of capital to meet its regulatory capital requirements and it has a sizable exposure to European sovereign debt of which 82% is Spanish. It seems that all of these combined factors have unnerved investors causing them to irrationally sell down the stock.
Yet while its exposure to the Spanish real estate market and European sovereign debt makes it a risky investment there are a number of factors that I believe make it attractive bargain for investors:
- It has a forward 2012 price to earnings ratio of 7.
- It has a double digit dividend yield of 13%, which despite indications otherwise should be maintained on the basis of recent asset sales and the last two quarters dividend payments.
- It is trading at a 10% discount to its tangible book value.
It appears that investors have ignored Banco Santander's large and highly profitable Latin American banking franchise, which in 2011 delivered half of the bank's profits. These banking operations delivered solid profit growth in 2011 and with ongoing strong regional growth are well positioned to further grow profits. In addition, these banking operations do not have any exposure to significant loan losses or European sovereign debt and should continue to deliver strong financial results in 2012. The recent sale of a stake in its Chilean subsidiary and 95% its Colombian banking operations have also allowed Banco Santander to address its provision and capital requirements. This alone should be sufficient to invest in Banco Santander as its current price, which I believe is a result of fear rather than a rational assessment of risk.