The World's Cheapest Large Bank?

07/04/2013 7:00 am EST

Focus: GLOBAL

When assessing this Madrid-based bank, investors shouldn't be deterred by the economic problems in Spain, notes Brian Hicks of The Wealth Advisory.

Here's a news flash for you: Spain is a mess. Unemployment in Spain is the highest in the European Union.

Spain's debt remains rated just above junk status. And Spain's banks have an appalling number of bad loans. So it may seem like an odd time to recommend a Spanish bank.

Banco Santander (SAN) is headquartered in Madrid. And it has suffered with the Spanish economy. But as you'll see, this bank is Spanish in name only.

For all of 2010, it traded between $10 and $14 a share. By late 2012, it fell briefly below $5. Now, as the price hovers around $6.50, we see value and a good deal of upside.

There are a few reasons for this. Banco Santander has reduced its exposure to the Spanish economy. There is significant earnings growth ahead. Loan loss reserves and Tier 1 capital have improved dramatically. And the large dividend appears safe. Let's take these in order:

In its most recent quarterly earnings report, Spain accounted for just 11% of profits. And the bank has only 20% of its assets in Spain.

The bank has extensive operations across the lucrative areas of Latin America, and emerging markets account for half of profits in the latest quarter. By country, Brazil accounted for 26% of total profit, with Mexico providing 13% and Chile 5%. The US and UK account for 12% of profits each.

Still, profits across all regions are lower. Continental Europe and Britain saw profits decline 27% and 23%, respectively. Even in the US, profits fell 2% to €233 million.

However, earnings are expected to jump 113% this year—and another 21% in 2014. We do not expect the rise in earnings to lead to a dividend hike just yet...but it will push the shares higher.

Santander has done an excellent job of adding to loan-loss reserves and boosting its Tier 1 capital. It has set aside over €60 billion for bad loans, and added €20 billion in capital.

Santander cut its dividend in 2009, but has maintained it since. And with the expected jump in earnings, the 60 cents a share it pays will be safe.

With a price-to-book ratio of 0.77, Banco Santander is among the cheapest large banks in the world. There's no reason to think that, in a few years, Banco Santander couldn't trade for 1.5 times book value. And the forward P/E of 9 is also attractive.

Before the financial crisis, the stock traded between $18 and $22. While we don't expect a return to those levels anytime soon, a move to $9.50 a share over the next 12 months is reasonable. We rate Banco Santander a strong buy under $6.75 a share.

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