Today the market has been up and sideways basically, perhaps a little more defensive this afternoon,...
It’s a Tough Time to Be Santander
04/13/2012 5:32 pm EST
The Spanish mega bank has kept its head above water so far, but the Euro debt crisis is turning much of its gold into lead. MoneyShow’s Jim Jubak, also of Jubak’s Picks, breaks down the bank’s quarterly report to determine whether the ship can still float.
Banco Santander (STD) 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). Its 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 provision against losses on Spanish real estate. Including that provision, a writedown on goodwill 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—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hard to do, because conditions in Spain are changing so quickly that the accounting in public documents is quickly outdated.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, read my recent post.)
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, as a result of setting aside €475 million 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 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 in March, from €30 million 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, 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, from €60.5 billion in the first quarter of 2011. But deposits in the first quarter were up by €3.2 billion 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, 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 avoid a loss for the quarter by producing €365 million 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, cash flow. Banesto’s ability to generate even €20 million 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, which 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, until 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 to all, I hope. The upside is about 38% from the $6.425 April 13 closing price in New York.
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