Is Santander Worth Your Time?

By Stephen D. Simpson, CFA | February 23, 2012 AAA

Much of the European banking system seems mired in trouble and there are signs that emerging markets like Brazil are starting to show cracks as well. That is troubling news for Banco Santander (NYSE:STD), as this global bank has been counting on strong results in emerging markets like Brazil and Mexico to prop up and offset its troubled operations in Europe and the U.K.

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Nothing Changing Very Fast
Recent results from Santander were largely in line with expectations and recent trends. Operating expenses are tracking higher and there is some loan growth, but provisioning and credit losses in Europe remain a major problem. Worse still, the banking issues have spilled over into the broader economies, and it seems to be slowing business prospects overall.

Not surprisingly, results in Europe are soft. Spain is struggling to recover in the aftermath of its real estate bubble, and fiscal austerity is likely to lead to prolonged elevated unemployment. While the situations in markets like Poland and the U.K. are better, they're not good enough to really make a difference. (For related reading, see The Unemployment Rate: Get Real.)

Brazil is still a relative area of strength for Santander. Loan demand has remained solid, but credit losses are starting to tick up. Fearing that non-performing loan ratios may start moving up, Brazilian banks have been hiking their reserves - to the tune of 20% or more, recently. Although this does reduce near-term profitability, it would seem that perhaps Santander, Banco Bilbao Vizcaya Argentaria (NYSE:BBVA), Itau (NYSE:ITAU) and Banco Bradesco (NYSE:BBD) have learned from the meltdowns in Europe and the U.S.

Spain Still Sorting Itself out
Santander has built itself into a much diversified bank, with about one-third of its business in the U.K. and over 20% in Latin American markets like Brazil, Chile and Mexico. That said, Spain is still a major market and business segment for this company, and the situation in Spain is still evolving.

It looks like authorities are getting more aggressive and realistic about provisioning requirements. Although many (if not most) banks refused to mark down the value of real estate on their books beyond a 30% haircut, actual on-the-ground sales were showing value declines of 50 to 70%.

New rules aren't going to fully close that gap, but they are going to force Spanish banks to increase reserves. For Santander, that could put more than 10% of 2012 profits at risk, and the high unemployment and low growth environment in Spain today suggests no quick recovery.

On the more positive side, Santander and BBVA may get stronger through a process of elimination. These new requirements in Spain are likely to force banks to raise capital and many will be unable to do so - likely leading to a wave of mergers that will shrink the market fairly significantly.

The Bottom Line
There's a fair chance that Santander will get through this mess without further significant dilutive capital raises. There's little point in assuming best-case scenarios, but if things do not get radically worse Santander should be able to get by with internal profits and careful capital management (including lower dividend payouts). Remember, though, that Santander is limited in the extent to which it can move capital around between its operating units, so relative stability in Latin America or the U.S. has only limited impact on the situation in Spain.

With one of its largest markets (Spain) in a rut, the U.K. not exactly growing at a blistering pace, and Brazil possibly in for a slowdown, it seems prudent to take a more conservative stance on Santander's profitability improvement. To that end, a 10% return on equity (ROE) in 2015-2016 seems reasonable and through an excess returns model, that suggests a fair value of around $9 per share. Boost that targeted ROE to 12% and the target jumps to about $11. (For related reading, see How Return On Equity Can Help You Find Profitable Stocks.)

Investors have a tough decision with Santander. This is a fairly attractive franchise, even with the troubles in Spain, but the valuation is not so tremendously compelling. At this point, I'd be more inclined to be a watcher of Santander than a buyer.

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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.

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