Here’s an unconventional way of looking at nine major banks and their earnings in the past 10 years. Based on the following table, Santander (SAN) seems to be one of the most punished large banks in the world. From 2003 to 2012, the bank had combined net income of almost $82 billion, yet it is currently selling at $72.76 billion. Essentially, the market is saying that Santander’s earning power is not close to the largest U.S. banks or HSBC, whose premiums range from 46% to 154%. In the meantime, Mr. Market tells us SAN deserves an 11% discount on the total net earnings of the last 10 years.
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I know this is an unorthodox approach to valuation but stay with me. If I saved $100,000 (after taxes) each year from 2003 to 2012, I would have accumulated $1,000,000 in my bank account — let’s not worry about dividends for the argument’s sake. Most banks pay various dividends and I’m trying to compare banks and their premiums. If I then decided to withdraw the full amount to pay for a house, can the bank tell me that my million is only worth $890,000 (-11%) and therefore that’s the amount I can withdraw now? Maybe the bank thinks that the extra $110,000 should stay in the account as a safety net for the upcoming decade where I’m expected to be a net drain on the checking account.
I realize that the market provides feedback in real time and the fundamentals could have deteriorated rapidly for Santander, eroding its business model. Historically, the company may have been excellent, but now it could be a dud. We can imply from Mr. Market’s valuation that Europe and Spain in particular are expected to be a drag on Santander’s ability to generate a decent profit in the next decade. And that 55% of revenues derived from emerging markets (table 2), 13% from the UK and 10% from the U.S. are not sustainable, at least not without higher operating costs or non-performing loan increases.
|Table2: SAN operation REGIONS:|
|Rest of Europe||6%|
The average market price premium to 10-year net income of the nine banks in table 1 is 49%, led by the four large American banks (BAC, C, JPM, WFC) and HSBC, which does 50% of its business in Asia. If Santander was valued at this average 49% premium, it would be worth approximately $122 billion – a 67.58% upside to the Thursday price of approximately $72.76 billion. It’s not all roses, however. Santander’s SCRIP dividend – essentially a stock dividend – is dilutive to the shareholders and offers no real value because it’s not paid from retained earnings, but rather is a rights issue to convert to newly minted shares created out of thin air.
|market cap||current||avg prem||potential||upside|
Note that I’m not convinced by Morningstar’s assessment of fair value for Santander because it doesn’t get to the bottom of earnings. It weighs book value ($10 per share) by three different multiples: 1.3 - 50% of base case without a crisis, .65 - a 20% probability of a downside scenario with some write-downs, and .5 - 30% case of deeper sovereign debt crisis requiring equity dilution. That model yields a $9 ADR price, a 28% premium to $7 current price.
I am more interested in the profit level of the company over the next 10 years and some questions need to be answered to project earnings potential of Santander in that time period.
1) Is the euro going to exist as a currency?
2) Will Spain be able to recover and grow from what seems to be a perpetual recession? And can Santander decouple its brand from Spain if the answer is negative?
3) Can Europe as a whole grow at an acceptable rate (the UK specifically)?
4) How, if at all, will the banks be restricted and regulated in the future to prevent financial systemic pandemics in the European Union?
5) Will Brazil and Mexico be able to grow in the next 10 years without increasing risk of non-performing loans?
6) How can the U.S. contribute to SAN's bottom line?
I will split this paper into 2 parts. The first part will cover basic banking and some Santander facts (not much math). The second part will focus on the macroeconomic environment in Santander’s geographical operations, addressing the questions above.
Overview of Banking
Banks perform the necessary role of maturity transformation by gathering short-term deposits with immediate liquidity for the lender/customer and lending out long term loans with potentially fixed rates to reduce uncertainty for the borrower. The banks then hedge the risks by using various financial market products and transferring this risk to investors.
Banking can be boiled down to interest risk and credit risk management. Interest risk depends on short-term vs. long-term interest rate imbalances and the yield curve changes, while credit risk measures the ability of borrowers to repay loans. Banks can make money in three ways:
1. Income from net interest margin (banks borrow money through bond offerings and deposits, then loan it out. The spread is the conventional income. Banks use leverage to loan out anywhere from $10 to $30 for every $1 in equity.)
2. Income from service and banking fees (such as trading transactions, underwriting, investment management fees, bank account fees, credit card transactions, insurance operation, etc.)
3. Expense efficiencies from operations and non-performing loans. Cost to income ratio demonstrates a bank’s operational efficiency, which leads to higher profits. It’s defined as operating expenses/ operating income. Anything under 50% is considered outstanding in the industry as most players fluctuate between 60-80%.
|2012||SAN||BBVA||HSBC||LYG||BCS (barklays)||BNPQY (Paribas)||CS||JPM||Citi||BAC|
To start, gross income is derived from net interest income (interest income- interest expense) and non-interest income, the first two underlined items above. Then operating expenses such as SG&A and depreciation are deducted leading to net operating income. After that any non-performing loan expenses (NPLs) are subtracted, along with taxes and other expenses arriving at net profits. The two main areas of expenditure are operating expenses and NPL provisions. If a bank is going to be profitable, it must have effective cost-controls and lending practices. A strong brand value enhances the bank’s earning power by signaling confidence to customers, leading to increased deposits.
Santander is the third-largest bank in the world in terms of pre-provision profit – 23.56 billion euros (2012). In 2012 the bank’s net earnings were 2.2b euros, 59% lower than in 2011. The bank earns 88% of revenue from retail banking – traditional loans and services provided to the general public. This means that Santander is less difficult to understand than a bank like Lloyds with its insurance operations and operational complexity. Santander’s profitability depends on interest risk and credit risk analyses, coupled with operational efficiency.
Santander’s Spain risk
A large part of the 59% net profit decrease in 2012 was due to the increased provision of EUR 6.14B for Spanish real estate exposure. According to SAN’s annual report, this provision completes the coverage of all real estate in Spain - the bank reduced real estate exposure net of provisions to EUR 12.5 billion. It sold 33,500 properties belonging to the Santander group. Volume of foreclosed properties decreased by 8% during the year and by 2014, SAN can expect to sell most of the property portfolio. Exposure to property in Spain represents 1.7% of total loan portfolio. This is a manageable risk.
A note about non-performing loans (NPL)
According to the International Monetary Fund (IMF), 2011 median non-performing loans (NPLs) were at 6% in EU-27 countries. NPLs before the 2008 crisis in the US were averaging .83%. During the Asian Crisis in late 90’s, the Asian banks had ratios above 12% and European countries had ratios above 8% during that time. Santander's 2012 NPL ratios in Europe (excluding the UK) are consistent with the average ~6%, but Spain is among the worst performers at 9.65%. The UK is 2.05% and Latin America is 5.42%. USA weighs in at 2.29% for the total SAN group average of 4.54%. Roughly, if a bank can keep NPLs between 2% and 4% with prudent operating expense management, it should be able to make a decent profit.
According to Emilio Botin, the bank has a comfortable debt maturity structure and in 2012 it issued EUR 31 billion in debt worldwide and another EUR 9 billion in Spain. SAN returned EUR 24 billion of liquidity to ECB. The company maintains the strategy goal of publicly listed subsidiary banks worldwide. It publicly placed 25% of Santander Mexico in 2012. The overall goal is to gain market share in loans and deposits. The loan to deposit ratio was 113% in 2012, and 117% in 2011. In 2011 the ratio was around 115% for the EU-27 banks, demonstrating a reduction of lending versus deposit funds in the real economy from 2004 ratio of 127%.
Santander consolidated Banesto and Banif under the Santander flag. Strategically, the brand is stronger together rather than a wealthy client option vs. the basic operating branches. The bank has 14,400 branches and more than 100 million customers worldwide. The branch network is the largest in the world.
Cost-to-income ratio was 46.1% in 2012. The company assigned more than EUR 61 billion in provisions in the last four years and core capital increased by $25 billion. Santander’s ROE is cyclically depressed in the past few years around 9% from 20% in good years. The trend will shift toward 15% in the next few years based on the decreased provisions, margin expansion and market share gains in emerging markets/mature markets.
The brand value of Santander cannot be underestimated. Banking is a confidence enterprise and in economically distressed regions, a brand name is necessary for a feeling a safe haven. In Spain, Santander is gaining market share from competitors as more people shift deposits to the bank.
- A drop in the euro directly affects Santander’s underlying fair value without touching any of its fundamentals.
- Spanish economic corrosion may have a contagion effect on the euro and the company. Deteriorating confidence may drive customers to withdraw deposits which will force loan reduction to temper risk.
- SCRIP issues are not real dividends. A SCRIP issue is a stock dividend with a right to sell the share on the open market and receive cash. It increases the number of shares outstanding without increasing the value of the company, effectively diluting existing shares with no net effect on total company equity. This scrip dividend accomplishes several goals for Santander. First, it placates income investors and shareholders since they “feel” wealthier. And second, it boosts perception of a significant dividend yield, and it doesn’t use net earnings for the payout (like regular cash dividends). Through inertia, 80% of the shareholders received stock dividends, reducing EPS and diluting equity with no benefit until share price appreciation. 20% of the shareholders curtailed their ownership of the company by choosing to sell scrip shares on the market and receiving cash. The company will pay a 0.60 euro dividend in 2013. Its total shareholder remuneration in 2012 was 6.086 billion euros, 4 billion more than profit.
End of part 1.
Part 2 to come: Is Europe, specifically Spain, killing Santander?