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After my last article on Banco Santander (STD), Spain's largest bank and one of the largest global banking groups, there has been a succession of events revealing a crippled Spanish economy and banking system on the brink of insolvency, which has again brought into question the survival of the euro-zone. All of this has had a significant impact on the share price of Banco Santander and has seen the bank's ADRs plunge further in value.

However, I have taken a contrarian view of Banco Santander because I believe that investors have fundamentally misunderstood the bank's business model and its operational structure, including its risk management methodology. All of which significantly limits its exposure to the Spanish economic crisis and the European sovereign debt crisis.

Financial Performance

Overall, Banco Santander's first quarter 2012 financial results in comparison to the same period in 2011 (YoY) were disappointing, despite the bank reporting an 8% increase in revenue to $14.9 billion. This is because of increased provisions being set aside for its non-performing loan exposure in Spain, the U.K and Brazil, which contributed to net income falling by 24% to $2 billion. In comparison to fourth quarter 2011 (QoQ), the first quarter 2012 financial results were extremely pleasing, with revenue rising by 3.8% and net income rising by a massive 3,310%.

Furthermore and most importantly, Banco Santander's balance sheet strengthened during the first quarter 2012, with cash and cash equivalents rising by 30.2% YoY and 16% QoQ, to $146.7 billion. However, for the same period it did increase its loan loss provisions by 0.5% YoY and 1.6% QoQ to $25 billion.

Overall, despite the poor result on a YoY basis, Banco Santander has reported improved financial results - most importantly a stronger balance sheet, with a substantial increase in the amount of cash available. This bodes well for the bank's continued capacity to meet any further contingencies that may arise in Spain as well as being able to maintain its current dividend payment.

Dividend Payments

Despite the fall in net income for both the full year ending 2011 and now in the first quarter 2012, Banco Santander has reiterated that it will maintain its dividend. The Chairman Emilio Botin has publicly promised that the dividend payment of €0.60 or $0.79 per share will remain unchanged despite the fall in net income primarily attributable to increasing loan loss provisions being established.

For the year to date Banco Santander has honored that commitment, making a final quarterly dividend payment for 2011 of $0.16 per share, which went ex-dividend on 11 January 2012. Its first dividend payment for 2012 was $0.29 per share and this went ex-dividend on 10 April 2012. This payment represents 37% of the promised annual dividend, with the balance to be paid after each of the three remaining quarters.

Investors have the choice of taking the dividend as either scrip or cash. The advantage for ADR holders in taking the scrip dividend is that it allows them to avoid payment of Spanish withholding tax of 21% on the value of the dividend. By maintaining the dividend the payout ratio has lifted well above the bank's historical payout ratio of around 50% to an unsustainable ratio of over 100%. However, this is only for the short-term as it is forecast that over the long-term Banco Santander will continue to grow profits and eventually be able to release a portion of its provisions, which will net income rise and the payout ratio fall.

By issuing scrip existing shares will be diluted though this dilution should be minimal and not sufficient to constrain future growth in the share price. Nor is it a mechanism for the bank to be able to maintain its dividend payout ratio above a sustainable level because the decision to accept dividends as either cash or scrip rests with the individual shareholder and not the bank.

Obviously there are those who believe the dividend would be cut and there were analysts predicting that this cut would be up to 50%. But based on the bank's public commitment and payments to date it is my view that any cut is extremely unlikely. As a result, Banco Santander now has an incredible dividend yield of around 16%, which is unheard of for a banking stock and if it continues to be maintained promises a solid return for investors.

Performance and Efficiency Measures

For the first quarter 2012 Banco Santander maintained its outstanding efficiency ratio, with it remaining steady at 44.7%. Evidently, despite the need to increase loan loss provisions and increasingly negative customer perceptions relating to the security of the bank, management has not dropped the ball and kept a firm control of costs while continuing to build business and generate revenues. This is also reflected by Banco Santander's profit margin marginally increasing during the first quarter being up 2% QoQ to 19%.

Disappointingly, both the outstanding efficiency ratio and strong profit margin are not translating into a credible return on equity with Banco Santander's return on equity remaining unchanged at 8%. This is even more disconcerting when the bank's degree of leverage, with a debt to equity ratio of 3.7, is considered. However, this can be attributed to the increased loan loss provisions set aside due to the worsening outlook of its Spanish loan portfolio and the difficulties of the current operating and economic environment.

Risks

Currently, we are seeing an almost perfect financial storm that is again threatening to tear apart the euro-zone, overwhelm Spain's banking system and push Spain deeper into economic crisis. For Spain and many Spanish banks it is the collapse of the real estate and property development bubble that has brought them to the brink of insolvency. But as I will demonstrate, Banco Santander's exposure is significantly lower than many of its Spanish peers by virtue of its operational structure and strong risk management practices, making its limited exposure manageable.

European Sovereign Debt Exposure

In total, Banco Santander has $76.17 billion in European sovereign debt according to the European Banking Authority, as set out in table 1 below. Of this the bank has a total of $67.94 billion exposed to the PIIGS and $144 million with the country that is believed to be the most likely to default, Greece.

Table 1: European Sovereign Debt Exposure

Country

Gross Long Sovereign Debt Exposure

€Euros

$USD*

France

€1.90 billion

$2.49 billion

Germany

€1.88 billion

$2.46 billion

Greece

€110 million

$144 million

Italy

€1.40 billion

$1.83 billion

Poland

€2.50 billion

$3.28 billion

Portugal

€2.46 billion

$3.22 billion

Spain

€47.88 billion

$62.75 billion

Total

€58.13 billion

$76.17 billion

Source: European Banking Authority

*Exchange rate $1.3105 USD = €1

While this exposure seems quite large as a percentage of total assets Banco Santander's European sovereign debt exposure is not extreme at 4.5% of its total assets. Furthermore, its exposure to the PIIGS as a percentage of total assets is only 4% and to Greece as a percentage of total assets is less than 0.1%.

Despite no clear end to the sovereign debt crisis in sight, it has appeared until recently that except for Greece the likelihood of a default among the PIIGS was decreasing. However, the latest news concerning Spain's deepening economic crisis and the health of its banking system is concerning. There are claims of increasing signs that external intervention in Spain maybe required, which increases the risk associated with the Spanish sovereign debt held by Banco Santander. However, there are no clear signs that Spain would default on this debt and it is unlikely that they would given the lengths the Spanish government is going to in order to bailout insolvent or deeply troubled Spanish banks.

Regardless, I still believe that the risk of defaults and their potential impacts upon Banco Santander are being driven predominantly by sentiment and anxiety. This becomes apparent when it is considered that the European Union and the European Central Bank have established a rescue package and bailout fund to further minimize the risk of default and mitigate the impact if a default were to occur.

Accordingly, for these reasons, I believe that investor concerns regarding Banco Santander's sovereign debt exposure are overblown and driven more by sentiment than real risk. In addition, in the event of a default I agree with the consensus view that Banco Santander is well positioned to manage losses from its sovereign holdings, especially when it is considered it would receive some assistance from the European Central Bank.

Credit Risk

Another key catalyst for Banco Santander's plunge in share price has been the growing economic crisis in Spain, which was triggered by a massive real estate bubble bursting, leaving many of Spain's banks heavily leveraged and over-exposed to non-performing loans. However, Banco Santander is a truly global bank and only 28% of its gross customer loans are in Spain, with the remainder across its other European, U.S and Latin American businesses.

Source: Banco Santander Financial Report First Quarter 2012

Despite the ongoing problems in Spain and investors sentiment seeming to indicate that Banco Santander would be facing an implosion of the quality of its loan portfolio, the total group wide value of impaired loans only grew moderately during the first quarter 2012, increasing by 14.3% YoY and 1.6% QoQ to $41.7 billion. Banco Santander's total non-performing loans are only 2.5% of total assets, which indicates that if all of those loans were totally unrecoverable Banco Santander could comfortably absorb those losses. In addition, the total value of the bank's group wide loan loss provisions during the same period only increased by 0.5% YoY and 1.6% QoQ to $25.21 billion.

Furthermore, Banco Santander's non-performing loan ratio increased only slightly by 0.37% YoY and 0.11% QoQ to 3.98%. While Banco Santander's non-performing loan ratio is higher than I would ideally prefer to see it is certainly well within the accepted parameters of indicating a low risk loan book. As a point of comparison, it compares favorably with its Spanish peers, including both CaixaBank's and BBVA's (NYSE:BBVA), which are higher at 4.9% and 4.4% respectively. But they all three banks have a non-performing loan ratio which is lower than the Spanish industry average non-performing loan ratio of 7.91%.

Banco Santander's non-performing loan ratio is also superior to its U.S peers such as Bank of America (NYSE:BAC) and Citigroup (NYSE:C), which for the same period reported non-performing loan ratios of 4.88% and 4.5% respectively. Furthermore, it is lower than the U.S banking industry wide non-performing loan ratio, which at the end of 2011 was 4.17%. Banco Santander also has a solid non-performing coverage ratio at the end of the first quarter 2012 of 62%, which is a 9% improvement YoY and 1% QoQ. It is also substantially higher than the Spanish industry average of 58%.

Loans, Real Estate and Pain in Spain

The Spanish loan portfolio's total value is $281.76 billion, which is 28% of Banco Santander's gross loans. In addition, over the last 2 years Banco Santander has sought to decrease its loan exposure to the more troubled European economies as it de-leverages its balance sheet, improves the quality of its loan book and increases liquidity. As a result its Spanish loan portfolio has dropped in value by 6.5% since 2010 and 1.8% since the end of 2011.

Source: Banco Santander Financial Report First Quarter 2012

As the breakdown of Banco Santander's Spanish loan book illustrates the majority of the loans are commercial loans for non-real estate purposes, while the bank's exposure to the high risk construction and property development industries represents only 22% of its gross loan in Spain. In addition, when the bank's exposure to household mortgages is considered, there are a number of factors that indicate this segment is low risk.

These factors include firstly, that the segment is predominantly composed of first residence mortgages with a large concentration of loans in the lowest tranches of loan-to value (87% with an LTV lower than 80%), which means in the event of default by a borrower the bank's ability to recoup the full value of the loan through the sale of secured assets is high. Secondly, the quality of this segment of the Spanish loan book appears to be quite high having a low non-performing loan ratio of 2.6%.

Finally, despite Banco Santander's Spanish non-performing loan ratio of 5.7% being just over 1.6% higher than the group wide non-performing loan ratio, it is still lower than Spain's industry average non-performing loan ratio of 7.91% and the industry wide property only non-performing loan ratio of 9.3%.

It is clear that the Spanish banking system is experiencing a solvency crisis because of high exposure to sub-quality loans made predominantly to property development and construction companies during the real estate bubble. Most recently the Spanish government has approved a bailout package totaling $24.9 million for Bankia, which had previously disclosed a substantially lower exposure to non-performing loans. This has obviously further spooked investors who are now concerned about whether Spain's banks are reporting the true extent of their exposure. However, for all of the reasons discussed above I believe that Banco Santander's credit risk is within acceptable levels.

Furthermore, by virtue of only 28% of Banco Santander's total loan book being exposed to Spain it acts as a default barrier that effectively curtails potential losses. Investors should also consider that unlike many of its U.S peers at the time of the sub-prime crisis, Banco Santander is not subject to lawsuits relating to predatory lending practices, the misleading sale of mortgage backed securities and derivatives or significant regulatory investigations.

Liquidity and Capital Ratios

I believe that while Banco Santander's loan to deposit ratio is not optimal, as I would in the current circumstances prefer to see it below 100%, it is not reaching the an extremely unhealthy level. Furthermore, the bank has been working hard over the last four years to significantly reduce it and bring it down to a healthy level. The importance of a bank's loan deposit ratio as a measure of liquidity and financial stability can't be emphasized more.

At its most basic level it represents the ratio of funds loaned in proportion to funds taken as deposits and therefore is indicative of how much of a bank's loan portfolio is funded through wholesale or short-term loans, which leave a bank's costs base vulnerable to movements in interest rates. A healthy loan deposit ratio is generally considered to be 95% to 105% and as the chart below shows Banco Santander's loan to deposit ratio is over this at 115%.

Source: Banco Santander Financial Report First Quarter 2012

However, as the chart also illustrates the bank has been working hard to improve its loan to deposit ratio to a healthy level with it dropping by 35% since 2008 and reporting a drop of 2% QoQ and 9% YoY to 115%.

This is a remarkable feat given the current operating environment, that has seen many customers withdraw their deposits or hold their savings in a different institution due to concerns surrounding the safety of Spanish banks. An example of this is Banco Santander U.K saw a recent run on its deposits with anxious investors withdrawing $316 million in deposits, when Banco Santander's credit rating was downgraded. However, this should not have a significant effect on the bank's liquidity as it only represents around 0.2% of Banco Santander U.K's total deposits.

As part of increasing its liquidity Banco Santander has also been steadily increasing its tier one capital and by the end of the first quarter 2012 had a tier one capital ratio of 11.05%. This was unchanged on a QoQ basis and almost unchanged on a YoY basis. It is also well capitalized in comparison to its peers having a higher tier 1 capital ratio than Spanish peers, CaxiaBank and BBVA with 10.4% and 10.7% respectively. Its tier one capital ratio is also superior to Bank of America's 9.9%, but lower than Citigroup's 14.2%. If anything this further supports my view that Banco Santander is well capitalized and able to absorb the impaired loans currently on its books.

Spanish Economic Risk and Currency Risk

A key catalyst that is driving Banco Santander's share price lower is the increasing concern that the Spanish banking sector is insolvent and that many banks have higher exposures to bad loans than previously reported. The Spanish government has committed to bailing out insolvent banks but this is putting significant pressure on a government already managing its own economic crisis.

The Spanish economy is in a deep recession with unemployment reported at 24.4% for the first quarter 2012. This has placed a significant cap on the funds that the Spanish government has available to bailout other Spanish banks. This may require the government to tap bond markets for further funds or even seek an external bailout if the Bankia bailout is representative of the funds required to ensure the solvency of other Spanish banks.

However, because Banco Santander's overall exposure to Spain is considerably less than any other Spanish bank, any further deepening of the Spanish crisis will only have a limited effect on the bank. This has been recognized by the credit rating agency Standard and Poor's.

While the credit ratings awarded by ratings agencies such as Standard and Poor's are little more than lagging high level indicators as to the financial robustness of a company they are a useful indicative measure of how that company rates in comparison to the rest of its industry. In the case of Banco Santander it still has an investment quality Stand and Poor's credit rating of A-, and when confirming this rating Standard and Poor's stated;

In our view, Santander benefits from a very strong business profile, which places it in a good position to withstand the challenges posed by an adverse operating environment, as demonstrated in the recent past. As the result of an intensive expansion strategy over the past two decades Santander is today viewed as one of the most geographically diversified banks in the world, enjoying strong market positions in most of the markets where it operates.

Spain's deepening economic crisis combined with a renewed European sovereign debt crisis has also caused the euro to fall further in value. This has not assisted the value of Banco Santander's U.S dollar denominated ADRs because overall a depreciating euro is bad for stock prices denominated in U.S dollars. This has also seen the value of Banco Santander's non-dollar denominated assets fall in value as well as increasing the costs of its U.S dollar denominated debt.

Banco Santander's Growth Catalysts

It seems to me that among investors there is a strong belief that Banco Santander is a Spanish bank and anything that is increases the pain in Spain can only further ratchet up the risk associated with Banco Santander. However, as the analysis of the bank's credit exposure has illustrated and as the following analysis of its assets and income will confirm, Banco Santander is a global bank. As a result it has a significant geographic diversification of assets and income, which effectively mitigates investment risk associated with investing in any single market or economy.

Portfolio Diversification

Banco Santander as a global bank only derives 12% of its attributable profit from Spain and holds 26% of its assets in Spain. The majority of Banco Santander's profit is derived from Latin America, which accounts for 52% of the bank's total profit. The single largest contributor in Latin America is Brazil at 27%, as set out in table 2 below.

Table 2: Banco Santander Profit by Geographic Segment

Country

Profit

Percentage

Europe

Spain

$369 million

12%

Germany

$155 million

5%

Poland

$124 million

4%

Other Europe

$93 million

43%

United Kingdom

$401 million

13%

Latin America

Brazil

$848 million

27%

Mexico

$388 million

13%

Chile

$174 million

6%

Other Latin America

$152 million

6%

World Other

USA

$315 million

10%

Total

$3 billion

100%

*Exchange rate $1.3105 USD = €1

Besides Banco Santander's profits being geographically diversified its total asset holdings are as well with only 26% of all assets held in Spain.

Source: Banco Santander Financial Report First Quarter 2012

This geographical diversification immediately mitigates risk for investors as it would require a global economic contagion off a significant scale for all of the bank's major markets to be affected.

Latin America Banco Santander's Growth Engine

Despite the economic slowdown being experienced in Brazil, both it and Latin America as a whole are a key growth engine for Banco Santander. This is for two reasons, firstly the majority of the economies across Latin America are still growing rapidly particularly in comparison to Europe and the U.S, and will continue to do so for some time. Over the last decade the region has experienced an average annual GDP growth rate of almost 4%.

Secondly, the region remains under-banked and there is a relatively low take-up of consumer banking products in comparison to the population. When this is considered in conjunction with the explosive expansion of the middle-class there is a greater demand for consumer banking products including credit, investment and insurances. In a region with a young and growing population in excess of 550 million this can only bode well for strong future growth even if there is a prolonged Brazilian economic slowdown.

Already this can be seen with the growing profitability of Banco Santander's independently listed subsidiaries Banco Santander Brasil (NYSE:BSBR) and Banco Santander Chile (NYSE:BSAC). Both subsidiaries have experienced phenomenal revenue and profit growth, with very healthy profit margins and returns on equity. In order to enhance growth in the region and unlock capital in its highly profitable Mexican banking business Banco Santander has elected to list the business later in 2012. This should realize around $3.5 billion when it offers 25% of the business to the market and further enhance its capital levels.

There have also been reports of Banco Santander coming under increasing pressure to sell down a portion of Banco Santander Brasil, which is of some concern as it is the greater contributor to attributable profit of any single business for the group. However, these reports do not appear credible, with Banco Santander denying the sale, the reported buyers denying any involvement and the Brazilian newspaper concerned being unable to substantiate the claims.

Final Outlook

Banco Santander is a geographically diversified bank that is well positioned to continue growing from its Latin American businesses alone. Any exposure to Spain and increasing risk created by the deepening of the Spanish economic crisis is clearly mitigated by its geographic diversity and the fact that it derives 78% of its net profit from markets outside of Spain. Furthermore, the bank continues to exhibit strong risk management practices, through reducing loan exposure to troublesome markets, de-leveraging its balance sheet and taking measures to increases liquidity. Even with the further deepening of the Spanish economic crisis its credit risk indicators are still healthy and within acceptable parameters.

I believe that the stock has been oversold on sentiment due to the bank's association with Spain and the failure of investors to truly understand the diverse geographical nature of the bank's operations. However, the full extent of the Spanish economic crisis and a feasible solution to it needs to be presented to markets before Banco Santander's share price can recover significantly. At this time I would expect the share price to continue to fall as the euro weakens and sentiment based selling continues. But, over the long-term Banco Santander can only continue to grow in value because it has manageable and limited exposure to the Spanish economic crisis while having a considerable presence one of the fastest growing regional banking markets, Latin America.

Source: Banco Santander: Paying The Price For Its Association With Spain