Spain is a bigger mess than most Americans can appreciate, as the 26% unemployment rate in Spain (which was a quarter-over-quarter improvement) is higher than has ever been seen in the U.S., including during the Great Depression. Likewise, major Spanish banks like Santander (NYSE:SAN) and BBVA (Nasdaq:BBVA) continue to see bad credit levels that would be hard to imagine at major U.S. banks.
Still, U.S. banks such as Bank Of America-like (NYSE:BAC) have seen prices spike once credit costs bottom out. While BBVA is unlikely to see a BAC-type return in the next few quarters, BBVA's management of its Spanish business and the quality of its Latin American operations will ultimately lead to improved results and a better valuation.
For Now, Though, Things Are Still Tough
With about half of the balance sheet exposed to Spain and non-performing loans (NPLs) still increasing, BBVA's results are still under serious pressure.
Although BBVA's NPLs are in better shape than those of Santander, and the earnings quality is higher (due to lower trading and non-banking gains), the company's clean-up process has been slowed by management's view that it is “irrational” to sell assets in Spain at depressed prices. By the same token, given that the Spanish legal process makes real estate disposals a very slow process, you could argue that BBVA really isn't missing out on much.
BBVA is also still incurring relatively high costs. While many U.S. and European banks have made operating cost reduction a key priority, BBVA's costs continue to rise (up 5% yoy and 2% sequentially in the second quarter) and they stand at relatively high levels in markets like Mexico.
Latin America Weaker Now, but Well-Positioned
Both Santander and BBVA are counting on their large Latin American business to help offset the weakness in their Spanish businesses. To that end, BBVA's results are mixed at best. Although underlying results in Mexico and the rest of Latin America (including Venezuela) aren't bad, reported results have been quite weak. For the second quarter, BBVA saw Mexican profits rise just 1% sequentially, while the rest of Latin America saw profits drop 39% due in part to the devaluation in Venezuela.
I believe BBVA's Latin American business is going to go through a period of short-term pain for long-term gain. BVBA's Mexican business does have high costs and the market is seeing weak loan growth, but the company has a large branch network and strong share (22% to 28% based on whether you use metrics like branches, deposits, or loans) in a growing country that is significantly under-banked. At the same time, BBVA is relatively less-exposed to the much more competitive Brazilian market, where companies like Itau Unibanco (Nasdaq:ITUB), Bradesco (NYSE: BBD), and Santander Brasil (Nasdaq: BSBR) have been competing aggressively for share.
Can Spain Go From Pain to Gain?
With improving unemployment and PMI numbers, some analysts have tried to make the case that conditions in Spain are stabilizing. I don't consider 26% unemployment to be anything like “stable”, nor a labor force based largely on temporary workers and the construction industry.
In any case, BBVA does have some of the best capital ratios in Spain (though Spanish banks in general are among the worst in Europe by Basel 3), and its NPLs coverage is better. Moreover, funding costs are low in Spain and that could help facilitate the clean-up process.
The Bottom Line
Although BBVA has been badly hurt in the banking crisis, I do believe management here has done a relatively better job in Spain than Santander, and I likewise believe that the company has a better collection of Latin American assets. Moreover, I think BBVA is in an incrementally better capital position and should be on pace to report double-digit returns on tangible equity in the next 18 months.
If BBVA can regain a 10% return on tangible common equity, the company should have a meaningfully higher multiple to tangible book value. Likewise, I believe BBVA can regain a double-digit return on equity by 2017 (12.5%), and even with an elevated discount rate that works out to fair value above $12 today. There are ample risks to the BBVA story today, including a worsening situation in Spain and more pressure in Latin America, but at today's share price there appears to be good potential compensation for those risks.
Disclosure – As of this writing, the author has no financial positions in any companies mentioned.