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The long awaited public offering for Banco Santander's (NYSE:SAN) Mexican subsidiary Grupo Financiero Santander Mexico (Banco Santander Mexico) is now available. This public offering forms a part of Banco Santander's professed strategy of continuing to independently list its subsidiaries in the markets in which they operate. This sees Banco Santander Mexico following in the footsteps of Santander's Brazilian and Chilean subsidiaries to not only be listed on the local bourse but to be dual listed on the New York Stock Exchange (NYSE). But despite the group's strength and the considerable promise this offer holds for investors it hasn't been smooth sailing for Santander's Brazilian subsidiary Banco Santander Brasil (NYSE:BSBR) since it listed in 2009 as explained in my last review. This beggars the question of whether this current public offering by the Santander Group represents a value opportunity for investors.

Overview of the offer

The Mexican banking sector is relatively immature and highly concentrated, with all of the major banks being foreign owned. Banco Santander Mexico is the third largest Mexican bank by assets behind BBVA (NYSE:BBVA) owned Bancomer, which is first and CitiGroup (NYSE:C) owned Banamex, which is the second. The public offering is for up to 1,689,812,333 shares of Banco Santander Mexico, which represents almost 25% of the bank's share capital. The offer is composed of two segments; an international offering of 235,104,325 American Depositary Shares (ADS), with each representing five Series B shares, and a domestic Mexican offering of 293,880,404 Series B shares on the Bolsa Mexicana de Valores (BMV). The indicative pricing per ADS is $10.99 to $12.70 while for the series B shares in Mexico it is MXN$29 to MXN$33.5 per share.

Recent financial performance

Overall Banco Santander Mexico has performed quite well financially; while quarterly data has not been made available, unaudited half yearly data is available. This shows that for the first half of 2012 in comparison to the first half of 2011 (YoY), the bank reported a 28% increase in revenue to $2 billion and a 31% increase in net income to $702 million. However on a less positive note, for the same period loan loss provisions increased by just over 50% to $262 million.

Asset quality and risk management appear strong

A key aspect of any potential banking investment that needs to be considered is the quality of its assets, which are primarily made up of loans. The key measure for doing this is the non-performing loan (NPL) ratio.

Despite the difficult operating environment Banco Santander Mexico has remained consistently high as the chart illustrates. With an NPL ratio of 1.7% its asset quality is not only superior to its peers in the Santander Group and its competitor BBVA Bancomer, but is well within acceptable parameters.


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Source data: Banco Santander Chile, Banco Santander Brasil & BBVA Earnings Reports 1Q11 to 2Q12, Banco Santander Activity and Results 1H12.

Banco Santander Mexico's NPL ratio is also well below the Mexican national banking and finance industry average NPL ratio of 4.29%, as at the end of June 2012.

In conjunction with the exemplary NPL ratio, Banco Santander Mexico has a healthy NPL coverage ratio of 138%. This is significantly higher than the Santander Group wide coverage ratio of 65% and as the chart shows, has improved over the last three quarters


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Source data: Banco Santander Chile, Banco Santander Brasil & BBVA Earnings Reports 1Q11 to 2Q12, Banco Santander Activity and Results 1H12.

Not only is Santander Mexico's NPL coverage ratio superior to many of its peers, including BBVA Bancomer, but it is well within what would be considered an acceptable level for a bank with such high asset quality.

Liquidity and capital adequacy are far from optimal

Another aspect of Banco Santander Mexico that is appealing is its solid capital adequacy and high liquidity. Currently the bank has a tier one capital ratio of 14%, which is well above the required minimum of 6% and higher than the 10% or better that investors should be seeking when investing in a bank. It is also higher than the Santander Group wide tier one capital ratio of 11% and has remained consistently at this level for some time as the chart shows.


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Source data: Banco Santander Chile, Banco Santander Brasil & BBVA Earnings Reports 1Q11 to 2Q12, Banco Santander Activity and Results 1H12.

Based on these results it is clear that Banco Santander Mexico is well capitalized with its capital adequacy significantly exceeding the minimum acceptable standards.

Another indicator of Banco Santander Mexico's strong balance sheet is the bank's loan-to-deposit ratio (LTD) of around 85%, which indicates that the bank is predominantly funding its lending activities through its deposit base.


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Source data: Banco Santander Chile, Banco Santander Brasil & BBVA Earnings Reports 1Q11 to 2Q12, Banco Santander Activity and Results 1H12.

Furthermore, as the chart shows, it is lower that the Santander Group wide LTD of 117% and superior to many of its peers. At 85% it is outside of what is considered to be the optimal range of 95% to 105%. This range is considered to be the sweet spot where a bank is able to garner maximum utility from its deposit base while still having sufficient liquidity to cope with extraordinary or unplanned events. But a lower than optimal range is fare preferable to one that is higher.

Consistently delivering solid performance metrics

Despite the difficult operating environment, Banco Santander Mexico's consistent focus on cost control, which is something seen in all aspects of the Group's operations, is enhancing the bank's ability to efficiently grow revenue and improve profitability. The bank has historically delivered an outstanding efficiency ratio, which has continued to improve, falling by just over 6% since the end of 2011 to be 37% at the end of June as the chart illustrates.


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Source data: Banco Santander Chile, Banco Santander Brasil & BBVA Earnings Reports 1Q11 to 2Q12, Banco Santander Activity and Results 1H12.

This efficiency ratio is one the best I have seen for a Latin American bank and as the chart shows is superior to not only the Santander Group's efficiency ratio but also its Mexican competitor BBVA Bancomer.

This efficiency ratio is seeing Banco Santander Mexico maintain a healthy net interest margin of almost 5% at the end of June 2012. With such a low efficiency ratio and a solid NIM, Banco Santander Mexico is delivering a solid return-on-equity (RoE) of almost 20%, as the chart below shows. This is a particularly credible return given the difficult operating environment and the banks conservative approach to credit risk, capital adequacy and liquidity.



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Source data: Banco Santander Chile, Banco Santander Brasil & BBVA Earnings Reports 1Q11 to 2Q12, Banco Santander Activity and Results 1H12.

It is also one of the best RoE in the Santander Group as the chart shows and in the banking sector. This is well above the industry wide average of 13% for commercial banks, as well as being almost five times higher than the Santander Group wide RoE of 4.3%. It indicates that the bank is performing strongly despite the global headwinds that have affected the profitability of other banks.

The exceptional RoE can be attributed to the bank's high asset quality, outstanding efficiency ratio and low funding costs, which allow it to maximize its margins and leverage profitable returns from its lending operations.

Macro environment and market outlook

Mexico is the largest economy in Latin America after Brazil. But unlike Brazil it continues to experience moderate to strong economic growth despite the difficult global economic environment. This saw Mexico's economy expand by 4% in 2011 and continue to grow strongly through 2012 growing by 4.5% in the first quarter 2012 and 4.1% in the second. Much of this can be attributed to the strength of the Mexican trade relationship with the U.S., which accepts around 80% of Mexico's exports and the negligible export trade with China and Europe. Therefore, any uptick in economic activity in the U.S. will have a direct effect on strengthening economic growth in Mexico.

The current short to medium-term outlook for the U.S. economy is not particularly positive at this time and along with the IMF now cutting its global growth forecast, it is anticipated that Mexico's economic growth will slow to 3.6% in 2012 and 3.8% in 2013. While this is does not bode particularly positively for the Mexican economy, these rates of growth are still significant given the current global economic environment. All of this indicates that there is still substantial opportunity for Banco Santander Mexico to continue growing its business, particularly when the low degree of banking penetration in Mexico is considered.

There is still room for banking sector growth in the Mexican economy

While the Mexican banking sector is particularly concentrated with the seven largest financial Groups managing around 75% of the total financial assets, there is still considerable opportunity for growth. Currently Mexico's uptake of banking products is quite low even in comparison to the rest of Latin America and other emerging economies, with private credit to the domestic sector representing only 26% of total GDP.


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Source data: World Bank

It is quite low even in comparison to other emerging economies such as China or Thailand, and is less than a fifth of the ratios for developed economies such as Australia, the U.S. and U.K. This alone indicates that there is still considerable opportunity for the uptake of banking and financial services to increase. But this becomes even clearer when Mexico's mortgages to GDP ratio is considered, which at 9% is extremely low even in comparison to other emerging economies as illustrated by the chart below.


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Source data: Mexican National Banking and Securities Commission, Banco Central do Brasil, Banco Bradesco, Reserve Bank of Australia, Bank of England, Federal Reserve Economic Data, IMF.

Both the low private sector credit and mortgage to GDP ratios indicate there is still considerable scope for the growth of the banking sector in Mexico. This is particularly so when it is considered that Mexico has the largest economy in Latin America and has still been experiencing considerable rates of economic growth despite the global head winds. Furthermore, the IMF in a recent report on the Mexican banking system recently stated:

"Given the relatively small size of the Mexican financial system, there is significant scope for further deepening as financial inclusion progresses and capital markets develop."

For all of the reasons discussed, I believe that there are still considerable opportunities available for Banco Santander Mexico to continue growing its core lending and deposit taking business.

Risks

Investing in a Mexican bank is not risk free and despite the connotations associated with Mexico and its now violent history of narco-trafficking and corruption, the regulation of the financial system as noted by the IMF is remarkably good. However, investors would be wise to consider that in the Transparency International 2011 Corruption Perception Index Mexico was rated 100th on a scale where the higher the ranking the greater the degree of corruption. This places Mexico at 100th, which is the same score as Argentina and well behind other Latin American countries including Brazil at 73rd and Colombia at 80th.

There are also other significant risks that investors need to consider including:

  • Rising political risk, with increasing government economic intervention in the region. In the case of Mexico, this is most likely to manifest itself in government actively taking measure to boost the competitiveness of exports and attract further foreign investment.
  • Security risk, with a variety of armed criminal Groups involved in a conflict with each other and the Mexican government.
  • Growing regulatory risk with a lower risk tolerance for the activities of the banking and finance sector globally. In addition to which, Latin American governments are focused on ensuring their regulatory frameworks comply with international standards global requirements. This will add to the regulatory burden and costs for banks.
  • Investors should also recognize that Latin American governments historically have had a habit of using regulatory frameworks as political and economic levers.
  • Worsening global headwinds originating in Europe, though this will have a more muted effect on Mexico than other Latin American countries because its key trading partner is the U.S.
  • Mexico has significant dependence on the U.S. for trade and any disruptions in the U.S. economy will have a significant effect on economic growth in Mexico.

Overall the country risk environment for investors in Mexico is not as low as other Latin American countries like Brazil, Colombia or Chile and investors would do well to be mindful of this increased level of risk.

Shareholder remuneration

Banco Santander Mexico has been paying an annual dividend on its Mexican listed class B shares since 2008. The last payment was in March 2012 for a total of MXN$1.67 pesos or 13 cents per share. Based on the offer price per share this gives a dividend yield of around 5%. Banco Santander Mexico has stated that it has no intention of formally instituting a dividend policy but intends to continue paying annual dividends subject to shareholder approval.

This is quite an attractive dividend yield for a banking investment and is commensurate with the yields paid by the Group's other independently listed Latin American subsidiaries. Foreign investors should also note that another attractive aspect of investing in a Mexican bank is that there is no withholding tax payable on dividends.

Bottom line

Banco Santander Mexico's key numbers, risk indicators and performance demonstrate that it is an impressive high performing Latin American bank. I believe these numbers indicate that it is superior in many ways to what I believe is the Santander Group's best performing independently listed subsidiary Banco Santander Chile (NYSE:BSAC), which I reviewed recently. It is undeniable that its laudable efficiency ratio, solid double digit return-on-equity and high asset quality combine to give the bank solid growth prospects. But based on its offer price and recent financial performance, it does appear to be expensive in comparison to its peers with a trailing-12-month (TTM) price-to-earnings (NYSE:PE) ratio of around 14. However, for investors seeking to diversify their portfolio through the addition of a dividend paying Latin American bank with strong growth prospects, it would certainly make a first-class addition with its solid asset quality, strong financial performance and credible dividend yield.

Source: Grupo Financiero Santander México: Another High Quality Bank In The Santander Group