BBVA: Should You Buy This 6.7% Yielder?

| About: Banco Bilbao (BBVA)
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Summary

BBVA is one of the largest European banks and has better long-term growth prospects than most of its peers due to its large exposure to emerging markets.

However, the bank faces several issues in the short term like strong competition in Spain, economic headwinds on several emerging markets and a relatively weak capitalization.

BBVA is trading at a discount to the European banking sector, but this seems to be justified by the many issues it currently faces, making it a value trap.

BBVA (NYSE:BBVA) is a Spanish bank with large exposure to high growth markets of Latin America and Turkey and historically has an above-average profitability compared to its closest European peers, leading to premium valuation compared to its peers. However, due to a cyclical downturn in emerging markets due to the commodities drop, the bank has de-rated and now trades at a discount to the European banking sector. While some could see this as a value play, BBVA's valuation appears to be justified by its structural woes and is more likely a value trap than a good long-term investment proposition.

History & Description

BBVA is one of the largest European banks and has a diversified geographical presence, with significant exposure to emerging markets. It is a globally systemically important financial institution (G-SIB) with a buffer of 1%. Its two largest country units are Spain and Mexico, with the latest being currently the most profitable one. It has a customer-centric retail business model, providing a range of financial and non-financial products and services.

The bank is Spain's second-largest publicly traded bank by assets after Santander (NYSE:SAN) and was created in 1999 through the merger of Banco Bilbao Vizcaya and Argentaria. The bank trades on the New York Stock Exchange and has a market capitalization of about $42 billion.

One of its key differentiated factors is its geographical diversification that enables it to smooth weakness in some units without jeopardizing group earnings, justifying its relatively good profitability history during the past decade. Within the European banking sector, BBVA is one of the banks with higher geographical diversification, contrary to many European banks that operate mainly domestically, like its Spanish peer Caixabank (OTCPK:CAIXY), Italy-centered Intesa Sanpaolo (OTCPK:ISNPY) or U.K.-focused Lloyds Banking Group (NYSE:LYG).

Emerging Markets

BBVA has operations in many countries beyond Spain that contribute significantly to its revenue and earnings base. Indeed, around 57% of its revenues are generated in Emerging Markets while the rest comes from Spain and other developed markets. In 2015, the division that contributed most of its revenue was Mexico, even though BBVA is usually seen as a Spanish bank.

Internationally, beyond Mexico it has also sizable operations in the U.S., Turkey and throughout several Latin American countries. This makes its business profile different from most of its European peers, being Santander, BNP Paribas (OTC:BNPZY), Unicredit (OTC:UNCFY) and Societe Generale,(OTCPK:SCGLY) its closest peers due to higher than average exposure to emerging markets. More recently, the bank has sold its stake in Chinese bank Citic (OTCPK:CTPCY) and invested in Turkish bank Turkiye Garanti (OTCQX:TKGBY), increasing its stake to 40% and becoming the leading shareholder in the bank.

Due to its high exposure to emerging markets, BBVA's growth profile is stronger than for most European banks. BBVA has experienced significant growth in its Latin America division over the past decade, as this division quintupled its earnings during this period and continues to have above-average growth prospects. Another pocket of growth is Mexico, where BBVA has a market share of close to 30% in a country with low banking penetration and high level of concentration, therefore, offering high levels of sustainable profitability for most established players.

On the other hand, BBVA's geographical mix in Latin America implies higher expropriation risks than for other banks, namely for Santander which has exposure mainly to Brazil. BBVA has larger operations in unstable countries, such as Argentina and Venezuela, where foreign companies have been expropriated in the past. Additionally, it also has higher exposure to currency devaluation in these two countries, something that has already hurt its earnings in 2015 due to currency depreciation in Venezuela.

Moreover, its exposure to emerging countries also led to some exposure to energy, about $18 billion or 3.3% of group loans. Of this exposure, about $4 billion of exposure is in the U.S. with a higher risk profile than at group level given that it has a much higher share of upstream loans. Non-performing loans are still low within the group and even though its total exposure does not seem to be a big issue, it may imply higher provisions over the next few quarters if oil remains at the current low price and possibly represent a headwind for BBVA's earnings growth.

Financial Overview

Regarding its financial performance over the past few years, BBVA has delivered relatively good results taking into account the difficult environment, it has faced both domestically and abroad since the global financial crisis of 2008-09. The bank was negatively affected by the real estate collapse in Spain and more recently by low interest rates in Europe, the slowdown in emerging markets and the fall in commodity prices. Despite this weak operating environment, BBVA was able to report profits every year during this period showing the resilience of its business model and the positive benefit of a diversified operating base.

More recently, BBVA has shown good growth in 2013 and 2014 but this has slowed in the past year due to pressure on net interest margins in Spain, slower growth in Mexico and adverse currency effects. Despite the low interest rate environment in Europe, in 2015 the bank's net interest income increased by more than 8% to $18.7 billion, driven mainly by higher revenues in Mexico where BBVA is experiencing higher loan growth than elsewhere.

In Spain, the deleveraging process following the country's real estate collapse continues to weigh negatively on loan growth and banks have become much more competitive to grab new loans. This has led to lower margins on new loan production, putting pressure on net interest income for all Spanish banks. This impact is to some extent smoothed by lower funding costs from time deposits, but as interest rates approach zero this offsetting effect is near its end thus revenues should continue to be constrained in the medium term given that interest rates in Europe are expected to remain low for a long period of time.

Given its weak prospects for revenue growth over the next few quarters, cost efficiency is an important factor for BBVA to grow its earnings. Over the past few years, its cost-to-income ratio has been relatively stable at around 52%, which is better than its peer group, but considerably above the most efficient banks in Europe and its closest peer Santander that have a C/I ratio at around 45%. This means BBVA still has room for further optimization, namely through branch reduction and pushing forward to digital transformation that could mean lower costs for the group in the medium to long term. BBVA is one of the European banks that has invested more on digitalization recently and expects to generate annual savings of $200 million from 2016 onwards. This should not represent a major uplift to its earnings, but is important at least to offset revenue headwinds.

Another area that has been quite important for BBVA's earnings is the improved asset quality that is leading to much lower non-performing loans (NPLs) and loan losses. Its cost of risk has decreased from 160 basis points (bps) in 2013 to 110 bps last year, which means lower losses and higher profits on its P&L account. If macroeconomic conditions on its most relevant markets remain supportive this good trend should continue over the next few quarters, given that BBVA's cost of risk is still higher than compared to most of its peers.

Also reflecting improving economic conditions, namely in Spain, BBVA should also report lower losses on its real estate exposure. Despite the earnings contribution from Spain to group's earnings is nowadays much lower than before the global financial crisis, BBVA's balance sheet is still about half exposed to its domestic market. This happens because it still has a large loan book of real estate assets. Even though losses from real estate assets are now manageable compared to a few years ago, this is still a drag for its profitability and in 2015 about 30% of its cost of risk came from Spain plus real estate assets. Nevertheless, lower losses should lead to higher earnings in Spain and its net profit in the domestic division should be much higher than in 2015 during the next two years.

Regarding emerging markets, BBVA's prospects are for some growth but lower than in recent years due to the commodity downturn and currency headwinds. This is valid both for Latin America and Turkey, making its exposure to emerging markets somewhat weak in the current environment. Additionally, reversal of investment flows over the past couple of years creates downside risks to economic growth in the medium term and thus bank asset quality. Even in Mexico, which has been a growth driver for BBVA, the outlook is challenging owing to margin stabilization, lower loan growth and increasing cost of risk expected in the next few quarters.

Capitalization & Dividends

Regarding its capitalization, BBVA's capital position is weak relative to peers and needs to grow over the coming quarters. Like its closest peer Santander, it has one of the lowest fully loaded equity tier one (CET1) ratio among European banks, at only 10.3% as of end-2015. This is below its own target of about 11% in the medium term and even though its capital deficit is not large, it may take some time to be achieved given that historically its organic capital generation has been below 30 bps per year.

Even though BBVA's capital position seems acceptable so far, despite being at the bottom of its peer group as higher earnings should lead to higher capitalization in the near future, taking into account several regulatory uncertainties that still persist its capitalization could become weaker. The impact of new regulatory measures which may materialize over the coming months, such as the fundamental review of the trading book, the introduction of capital floors, review of standardized credit risk-weighted assets, beyond other reviews, may affect BBVA's capital position negatively and possibly leading to a shortfall.

However, this does not mean BBVA will have to raise capital, but most likely it will reduce risky assets and deleverage its balance sheet, impacting loan growth, revenues and profits which will be another headwind for its operational performance. Given that it already faces several operational headwinds, BBVA clearly needs to be more ambitious regarding its capital levels and reduce the gap compared to its better capitalized peers.

This relatively weak capitalization may also represent a constraint on BBVA's shareholder remuneration. Its dividend history is not impressive given that it remained flat for several years until it was cut in 2013. Additionally, its scrip option (shareholders can choose between new shares or cash) has represented further shareholder dilution for those who have chosen to receive cash. Its dividend related to 2015 earnings will be the same as the previous year at $0.42 per share, representing a dividend yield of 6.7% at its current share price. This yield is clearly attractive and BBVA makes quarterly payments like U.S. companies.

BBVA has the intention to replace gradually the current shareholder remuneration with another one, with payments fully in cash and linked to the group's earnings. Its target is to pay between 35% and 40% of earnings to shareholders, a level that is below the sector's average and way lower than its Swedish peers that pay about 70% of earnings to shareholders. In the past four years its dividend payout ratio has been above 100%, clearly showing that its dividend is not sustainable unless its earnings increase significantly over the next years.

Conclusion

BBVA is one of the European banks that is more attractive to U.S. investors due to its geographically diversified business, namely its vast exposure to emerging markets. This feature has enabled the bank to achieve relatively good returns over the past years despite the challenges it had to face, namely the global financial crisis and the Spanish real estate collapse. This justifies why historically it has traded at a premium to the European banking sector.

BBVA has de-rated recently and is now trading at a discount to the sector's average. Currently, it trades at only 8.6x its forward earnings and 0.73x book value, a small discount to the European banks that trade on average at 0.79x book value. Additionally, it offers an attractive dividend yield and some investors may see BBVA as offering good value.

However, given the many issues it faces, namely margin pressure in Spain, exposure to oil, a relatively weak outlook in emerging markets and a weak capitalization, BBVA is a value trap and investors should avoid its stock until macroeconomic conditions improve and the bank reaches a capitalization level more in line with its peer group.

Disclosure: I am/we are long ISNPY.

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.