Like so many other banks in Europe, Santander (NYSE:SAN) has been through the wringer. Its home market of Spain has seen devastating economic decline, and relatively healthier operations in faster-growing areas like Brazil and Mexico haven't made up the difference. The bank's shares have dropped more than 50% over the past five years.
Bad as things have been, investors in the U.S. have seen plenty of examples of how bank stocks can recover significantly once credit costs begin to stabilize and then improve. On one hand, then, is the possibility of a Bank of America (NYSE:BAC) or Citigroup-like (NYSE:C) rise from the ashes. But on the other hand is the truly scary state of affairs in Spain and the risk that Latin America is starting to slow to a significant degree. Although Santander shares may be a little cheap today and would certainly have significant upside if/when the market believes Spain has stabilized (and with it, Santander's credit costs), the risk/reward tradeoff does not seem appealing enough to me when considering the options available to investors in other European and Latin American banking stocks.
Spain – A Small Part of Profits, but Still a Big Risk
Although Spain only accounts for a small part of Santander's profits (less than 10% in the last quarter), it still makes up about 15% of the bank's labor force, over 30% of its branch network and deposits, and about 25% of its loans.
That's a big problem, as Spain continues to struggle to an extent that Americans may find hard to believe. Spain's first quarter unemployment rate was a whopping 27% and unemployment among the youth (age 25 or younger) was close to 60%. While the second quarter unemployment rate fell to 26%, it appears that the decline had more to do with emigration and workers giving up their search for work.
Not surprisingly, it's difficult to make progress against that backdrop. While banks in the U.S. like BB&T (NYSE:BBT) had the option to deal relatively aggressively with their problem credits (writing down properties and loans and moving them off the balance sheet), that has proven to be more challenging for Spanish banks like Santander and BBVA (Nasdaq:BBVA) as the only prices at which they can sell weaken their credit more than just hanging on and hoping for improvements.
Consequently, there's something of a deja vu case here with the “zombie banks” that weighed on Japan's economy for so long. With only about 50% coverage of Santander's NPLs, I believe credit and capital risks are still relevant here.
Can Latin America Save the Day?
Both BBVA and Santander can look outside of their borders to healthier banking markets in Latin America, or at least that was the hope. Unfortunately, Latin American profits came in about 5% below expectations in the second quarter the major markets of both Brazil and Mexico are showing signs of weakness.
While Brazil's results did show better credit quality, major consumer-facing companies like Wal-Mart (NYSE:WMT) and Arcos Dorados (Nasdaq:ARCO) have talked of growing economic pressures on consumers. Though I'm not predicting any sort of banking collapse in Latin America, it's worth noting that major Latin American banks like Itau Unibanco (Nasdaq:ITUB), Bradesco (NYSE:BBD), Creditcorp (NYSE:BAP), and Santander's own Mexican subsidiary Santander Mexico (Nasdaq:BSMX) are all well off their highs on weaker loan growth and rising rates.
The Bottom Line
Although I've seen some analysts argue that Spain is stabilizing and that conditions in Latin America are just temporary, I'm more cautious on those topics with respect to Santander. With the bank's NPLs up for multiple quarters in a row and tangible equity per share declining, I just don't believe that Santander has the “wiggle room” for things to get any worse.
Moreover, neither a return on equity model nor a TBV/RoTCE model suggest major upside from today's price (5% to 15%) despite relatively optimistic assumptions. Now, there are certainly plenty of examples from the U.S. banking sector that show how well a bank stock can respond once credit costs have bottomed and started to improve, I'd be cautious about assuming that Santander is poised to see that same sort of rebound in the remainder of 2013.
Disclosure – As of this writing, the author owns shares of BB&T.