Update Banco Santander (STD): Weighing global promise against Spanish threat

04/13/2012 5:30 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Banco Santander (SAN) is an immensely profitable global bank. It has more customers in Brazil and Mexico (34 million at the end of 2011) than in Spain and Portugal (30 million.)  It’s Brazilian subsidiary is the fifth largest bank in Brazil. In Mexico it’s No. 3. In 2011 the bank got 54% of its profits from emerging economies.

Unfortunately, Banco Santander is also a Spanish bank. It has big exposure to the Spanish economy. The bank’s overall non-performing loan ratio is a solid 3.9% but in Spain the ratio rises to 5.5%. (The average for Spain’s banking system is 7.5%.) In 2011 the bank took a 1.8 billion euro provision against losses on Spanish real estate. Including that provision, a write-down on good will in its Portuguese bank, and a regulatory charge in the United Kingdom, the bank’s 2011 return on equity was just 7.1%. That’s down from 11.8% in 2010.

The tough problem confronting any investor in Banco Santander—and the stock is a member of my Dividend Income portfolio http://jubakpicks.com/ --is how to balance the promise of the global bank with the threat of the Spanish bank. That’s especially hard to do because conditions in Spain are changing so quickly that the accounting in public documents is quickly outdated. (For more on the pain in Spain see my post http://jubakpicks.com/2012/04/13/the-spanish-debt-crisis-combines-the-worst-of-the-greek-and-irish-crises-in-a-too-big-to-fail-package/  )

In the case of Banco Santander, though, we’ve got detailed Spanish information that’s only as old as yesterday. That’s when Banesto, the publicly traded Spanish arm of Banco Santander and the fifth largest bank in Spain, reported first quarter earnings. Banesto, or to be formal Banco Espanol de Credito SA (BTO.MC in Madrid), reported a 90% drop in net profit from the first quarter of 2011 to just 20 million euros as a result of setting aside 475 million euros in provisions against bad real estate loans. Coverage of bad loans, as a consequence, rose to 50% from a previous 10%. Non-performing loans climbed to almost 5% of risk-weighted assets from 4.2% a year ago.

The bank’s most recent quarterly report is unsettling reading for Spain and its struggling economy. In 2011 the bank reduced its lending to the private sector by 9.2%. In the 12 months ended on March 31, 2011, Banesto reduced its loan book by 8.3%. It sure won’t help a Spanish economy struggling for growth if the country’s banks are cutting back on lending.

There’s also bad news for the Spanish economy in the way that Banesto has responded to new Spanish rules that force banks to increase their reserves against losses on real estate loans. One way to increase that reserve ratio, of course, is to raise capital and put it aside as reserves. That’s very expensive right now. The other way is to reduce the size of a bank’s loan book so that the reserve ratio rises without any addition to reserves. In the quarter Banesto increased its sales of real estate to 140 million euros in March from 30 million euros in January. You can imagine what the accelerated pace of selling does to housing prices.

If you’ve been wondering how far the Spanish real estate market is from a bottom as a way to judge when this crisis might end, then Banesto had bad news to deliver. The bank said it continues to foreclose on roughly the same number of properties that it is selling. In other words, the backlog of real estate on the market at distressed prices isn’t shrinking.

Okay, what answers does the Banesto quarterly report give investors in Banco Santander?

First, on deposits. The bigger the pool of deposits a bank has, the less likely it is to need to raise money in the financial markets to fund its operations. Customer deposits at Banesto were down in the first quarter to $54 billion euros from $60.5 billion in the first quarter of 2011. But deposits in the first quarter were up by 3.2 billion euros from the fourth quarter of 2011. In Spain, certainly the most troubled part of the Banco Santander global franchise, the bank isn’t seeing the kind of massive withdrawals that would endanger the bank’s capital position. Overall, Banco Santander has been able to reduce its ratio of loans to deposits—thanks to reducing the size of its loan book—to 1.17 (loans to deposits) in 2011 from a 1.35 ratio in 2009.

Second, on capital needs. How much capital a bank needs to raise is determined by the financial markets (what level gives the markets confidence), the credit rating houses (what level gives them confidence), and bank regulators. Bank regulators have, perhaps, the most influence since they get to decide that counts as capital. The evidence from Banesto’s quarterly report is that Spain’s regulators aren’t being sticklers. Banesto was able to reduce its need for capital and to avoid a loss for the quarter by producing 365 million euros of extraordinary gains from selling stakes in industrial companies and loans from its balance sheet. The attitude of regulators is a key to Banco Santander’s ability to meet its capital needs going forward by selling assets and indulging in some creative asset shifting. So far the evidence is that regulators will let this pass—if only because the alternatives are so unpalatable.

Third, on cash flow. Banesto’s ability to generate even 20 million euros in profits during the first quarter of 2012 is critical to judging Banco Santander. Right now the dividend—up to 11.17% yesterday—is crucial to the share price of Banco Santander. If the dividend goes, the stock falls hard. Already the company has resorted to voluntary payments of dividends in stock as a way to preserve cash to meet the bank’s needs to retain earnings in order to raise capital. If that goes from voluntary to mandatory, wham, the stock takes a hit. If the dividend in cash and stock falls below the 0.6-euro dividend per share level targeted by the company, then, wham, the stock takes a hit. (The record date for the next dividend was April 12.)

I know the deepening recession in Spain looks like the biggest threat to shares of Banco Santander, but my biggest worry is a slowdown in Brazil or Mexico, the two biggest sources of bank profits, that would endanger the dividend. So far that looks unlikely. Both economies are, in fact, seeing growth pick up.

Banco Santander shares are a speculative investment right now—let’s not make any bones about that. You’re taking a risk now and taking a beating now in the belief that the bank can thread its way through the current crisis to a day when the market rewards the strengths of the global franchise. Any target price I can calculate now is based on so many assumptions that, depending on how I tweak those assumptions I can get an end of 2012 target price anywhere from $12 an ADR (American Depositary Receipt) to $8.85. That a difference of about 35%.

I’m more comfortable with the assumptions behind that lower target price. The risks are pretty clear, I hope to all. The upside is about 38% from the $6.425 April 13 closing price in New York.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did own shares of Banco Santander as of the end of December. For a full list of the stocks in the fund as of the end of December see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/

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