Banco Santander: Cautious In The Short-Term, Bullish In The Long-Term
Summary
- H1 2021 12.6% RoTE driven by North (31% of group underlying profits) & South America (again a 31% contribution to underlying profits).
- Valuation at 78.5% of tangible book and CET1 ratio of 12.11% should limit short-term upside.
- Long-term prospects are bright, with key risk being South America (20% of year-end 2020 Risk-weighted assets) currency exposure.
- Selling options premium looks appealing given Banco Santander's prospects, valuation, capital position, and broader market environment.
Orbon Alija/iStock Unreleased via Getty Images
Investment thesis
So far this year, I have covered several European banks, each with its unique set of circumstances, challenges, and opportunities, ranging from a restructuring/rerating story at Commerzbank (OTCPK:CRZBF) (OTCPK:CRZBY) here, an end of restructuring/normalized operations story at Deutsche Bank (NYSE:DB) here, a capital return story at ING (NYSE:ING) here, a sum of the parts/normalized operations story at Societe Generale (OTCPK:SCGLF) (OTCPK:SCGLY) here, as well as a capital return story/end of restructuring at ABNAMRO (OTCPK:AAVMY) here.
In today's article, I will have a look Banco Santander (NYSE:SAN) which I think presents an excellent opportunity to generate current income via covered calls/cash secured puts after the recent uptick in yields and the associated uplift in most bank shares. While there is no reason to be pessimistic long-term about Banco Santander, I think that the recent run-up of bank shares, coupled with Banco Santander currently trading at around 78.5% of its 3.98 EUR/share tangible book value, and a CET1 ratio of just 12.11%, make for a cautious outlook over the near term. I think that selling option premium presents an acceptable risk and may boost returns over the medium term. The two main risks I see to such a strategy are that yields increase much faster than expected, which could boost bank shares higher, in which case the strategy would lose out as compared to a pure buy-and-hold approach. Alternatively, a flight to safety may push Latin American currencies lower, hitting overseas operations, a key contributor to the very decent 12.6% underlying RoTE (return on tangible equity) in H1 2021.
Operational overview
I view Banco Santander primarily as a play on American growth, given that some 62% of profits came from North & South America in H1 2021:
Santander H1 2021 Profit By Regions
I think the company is likely to focus on overseas markets in the future, given that they are delivering double-digit RoTE rates:
KPIs & RoTE by region in H1 2021
As you can see above, Y/Y customer loans are growing the fastest in South America at 10%. Pertinent in this regard is what CEO Jose Antonio Alvarez had to say on capital use:
If I look at how we're going to deploy the capital we generate to the business, I will look for a kind of risk-weighted asset growth. This is a growth story, particularly we're going to grow double digits in Latin America, yes, naturally maybe some currency depreciation. But well, we are aiming for double-digit growth in Latin America, also significant growth in our consumer business in the U.S. While in Europe, we see a more kind of flattish evolution of the risk-weighted assets.
Source: Banco Santander H1 2021 Conferance Call
Looking at the capital allocation by region, if we take risk-weighted assets (RWA) as a proxy for capital at risk, we see that the European market accounted for 59% of RWA at the end of 2020:
Risk-weighted assets by region, end 2020
Taking all of the above into account, Europe is clearly a drag on performance, taking over 50% of RWA capital but delivering less than 30% of underlying profits, with the caveat that Digital consumer bank segment has customers in Europe as well which blurs the picture a bit. In this regard, you can view Banco Santander as a carry trade on higher-yielding North & South American markets, with the associated risks and benefits, chief of which is a flight to safety and a rapid depreciation of emerging market currencies against the Euro.
Capital Position
Banco Santander ended Q2 with a CET1 ratio of 12.11%, slightly above management's 11-12% target range:
CET1 Capital Position and Tangible BV per share Source: Santander H1 2021 Financial Report 
While comfortably above the 8.86% CET1 requirement, the 12.11% is on the low side as far as big European peers are concerned. Coupled with the fact that the stock is trading at around 78.5% of its tangible book value of 3.98 EUR, again higher than most European peers, I remain a bit cautious. Take for example, Societe Generale (which has emerging market exposure in Eastern Europe and Africa) - they ended Q2 with a CET1 of 13.4%, a Maximum Distributable Amount (MDA) buffer of 430 basis points, and are currently trading at around 48% of tangible book. That said, management seems confident in the outlook and its capital position and announced an interim shareholder remuneration from H1 2021 earnings of around €1.7 billion in cash dividend and share buyback, equivalent to 40% of its H1 2021 underlying profits. The announcement also laid out plans for the rest of 2021:
The bank will announce a further and final distribution from 2021 earnings in the first quarter of 2022, subject to the appropriate corporate and regulatory approvals. Should the trend in the bank’s performance for the first half of the year continue, it would result in a total cash dividend for 2021 that is in line with the cash dividend paid in 2019 (before regulatory restrictions were applied), and a total buyback equivalent to c.3% of the outstanding share capital.
Source: Banco Santander Press Release, 28th September 2021
Solid long-term potential
I think one good differentiating factor for Banco Santander is that its home market of Spain is still a long way away from a full recovery, thus providing significant upside for operational performance in the country. Take a look at Spanish unemployment over the last 10 years, which, while recovering from the all-time high of 26.1% reached in 2013, is still well above the average for Northern European countries:
Unemployment rate in Spain, Last 10 Years www.sdw.ecb.europa.eu
With Banco Santander being primarily a retail bank, I think the demographic prospects of its key North and South America markets are far superior to those of Europe, with a population decrease expected in Europe, flatlining in South America, and growth in North America:
2100 population forecast by continent Source: Statista forecast of the world population in 2019 and 2100, by continent 
Population in Central America is also expected to increase somewhat going into 2100.
How to position in the shares
Taking account of all moving parts - Banco Santander specifics, bank shares valuation, economic prospects, and general market levels, I think that selling options premium is an acceptable strategy. Personally, I recently rolled options on some bank positions I hold. While rising yields are bullish for bank shares, they do drag down interest rate-sensitive sectors, such as REITs. Take for example Vonovia (OTCPK:VNNVF) (OTCPK:VONOY), which I covered here - it is down 7% in the past month:
Past Month Performance of Vonovia Source: Seeking Alpha
When the whole market starts struggling with rising rates, and bargains start appearing in the hardest-hit sectors, investors may actually shun bank shares despite good long-term prospects. After all, rising rates take time to appear in bank bottom lines. The counterargument is that it is a fool's game to time the markets, and if you believe in the prospects of the company, you should hold the shares outright, without selling the upside.
There is also one more argument against selling options premium which is especially pertinent as far as Banco Santander is concerned - you retain all of the downside, which may materialize if there is a capital exodus away from Latin America, hitting currencies in the region. In essence, you may say that selling options premium is like picking pennies in front of a steamroller. In this regard, a picture is worth a thousand words - take a look at the exchange rate of the Brazilian real against the Euro over the past 10 years:
BRL to EUR Exchange Rate, Last 10 Years Source: www.xe.com
Investor takeaway
I remain optimistic on bank shares and Banco Santander in particular. However, the recent rise in interest rates has started to hit broader market sentiment and interest rate-sensitive sectors, drawing investors' attention away from banks. I think that Banco Santander's elevated tangible book valuation and smaller capital buffer will limit upside potential in the short term, providing an excellent opportunity to sell options premium. Over the medium to long term, significant upside remains in the Spanish market still suffering from double-digit unemployment. In my opinion, a key risk is that robust North and South America performance can be offset by exchange rate fluctuations. Alternatively, politicians may target bank profits if they are deemed excessive. Personally, I will continue to monitor the shares and may initiate a position on weakness in the next couple of months.
Thank you for reading.
This article was written by
Analyst’s Disclosure: I/we have a beneficial long position in the shares of DB, SCGLF, CRZBF either through stock ownership, options, or other derivatives. 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.
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