SAN - Rethinking Santander: A Decade-Long Journey Of High Hopes And Hard Lessons

2024-01-17 07:58:15 ET

Summary

• My initial thesis on Santander was based on undervaluation and the expectation of improved earnings.
• Santander's strategic advantage under Botín's leadership weakened after his departure, and the bank struggled to grow net interest income compared to American banks.
• Santander's recent financial performance has shown improvement, but it still lags behind its peers in several metrics.

In 2014, my first investment analysis was published on Seeking Alpha, it was about Santander ( SAN ), marking the beginning of my engagement in the site. The investment rationale centered on the post-crisis valuation of European banks, emerging from the subprime and European sovereign debt crises. The key metric underpinning this thesis was Assets per Share, suggesting a notable undervaluation in the sector.

A comparative analysis with a range of banks, including JPMorgan ( JPM ), was conducted, focusing on the Assets per Share metric. This comparison highlighted Santander's relative positioning in the industry. A specific observation was made regarding Santander's loan loss provisions, which appeared disproportionately high. It was anticipated that a normalization of these provisions would significantly enhance earnings and positively impact the stock price.

The investment in Santander was eventually liquidated post the 2017 French Election , yielding a profit. However, it's important to note that the returns did not fully compensate for the time, patience, and risk involved in this investment.

Flawed Thesis

My original investment thesis on Santander contained several flaws. Initially, I recognized the bank's strategic advantage under Botín's leadership, notably in executing opportunistic acquisitions . However, this approach was largely attributable to Botín's individual leadership style, and with his departure, Santander's deal-making prowess weakened.

Moreover, Santander, akin to other European banks, had overextended in credit offerings. This, coupled with a less favorable macroeconomic environment for European banks compared to their US counterparts, impacted performance. In the U.S., regulators were more proactive in ensuring banks maintained adequate capital to avoid stagnation.

A key oversight in the initial analysis was the ongoing issue of dilution. Santander's approach to dividends, particularly the script dividend paid in shares, contributed to an increase in share count. The situation was further exacerbated by a substantial capital raise of EUR7.5 billion in 2015. This development should have prompted a reassessment of my investment rationale.

As it became apparent that Santander was not progressing as expected, it necessitated a reevaluation of the investment thesis, particularly questioning the assets per share metric, which was no longer a reliable indicator.

Santander was also having a hard time growing net interest income, while JPMorgan and Wells Fargo ( WFC ) were steadily moving up.

The disparity in return on assets (ROA) between American and European banks was a critical indicator. American banks consistently demonstrated superior ROA ratios, underscoring their competitive edge over European counterparts, including Santander.

By early 2017, the evidence was clear: Santander's growth and profitability prospects were limited. Concurrently, the French presidential election was influencing European bank stocks, primarily due to the market's preference for political stability and the perceived advantage of candidate Emmanuel Macron. This situation created a strategic window for divestment.

Capitalizing on the market movements associated with the French election, I executed the sale of Santander stock. This decision marked a definitive end to my investment in the company, closing a chapter that, despite its initial promise, ultimately did not align with the evolving realities of the banking sector.

Has Something Changed?

Reflecting on the initial assessment of the banking industry, it becomes evident that JPMorgan and Bank of America ( BAC ) were superior choices for investment. This realization stems from the broad peer comparison analysis, which highlighted JPMorgan's robust dynamics, consistent performance, and strong management team poised for future success.

Regrettably, my investment decision veered towards Santander, a classic example of a value trap. While this decision did yield some profits, it also incurred significant opportunity costs by missing out on the potential gains from investing in a more dynamic and well-positioned bank like JPMorgan.

In retrospect, this experience underscores the importance of thorough industry analysis and the pitfalls of value traps in investment decisions. It also offers a valuable perspective on the current state of the banking industry and its ongoing evolution, emphasizing the need for continual reassessment of investment strategies in a dynamic market environment.

Looking back over the past decade, a distinct trend in the banking sector has emerged, particularly when examining the growth of the asset base per share. JPMorgan and Bank of America are standout performers in this regard, consistently accruing value and expanding their asset bases. In stark contrast, Santander experienced a 10% decline in this key metric during the same period, indicating a lack of similar growth or value accrual.

This pattern is also evident in the net interest income ((NII)) metrics. JPMorgan and Bank of America have dominated this area, reflecting their effective management and strong market positions. Conversely, Santander's performance in terms of NII has been stagnant, failing to show any significant progress over the last decade.

These comparisons highlight the divergent paths taken by these institutions. While JPMorgan and Bank of America have successfully capitalized on opportunities and enhanced their financial positions, Santander's strategies have not yielded the same level of growth or profitability, reflecting a missed opportunity for investors who focused on the latter.

Finally, when we look at the stock price performance, it is JPMorgan and BofA that clearly lead the pack, with UBS ( UBS ) there in the middle. Even BBVA ( BBVA ) performed better than Santander over the period.

Now looking at more recent trends within the banking industry, it's noteworthy that Santander has shown improvement in its Return on Assets (ROA). Lower-performing banks, including Santander, may be improving their ROA, likely due to their starting point from a relatively weaker position.

Conversely, for more established and consistently high-performing banks like JPMorgan and Bank of America, enhancing ROA is a more challenging task. These banks already operate at a high level of efficiency and profitability, leaving less scope for significant improvements in ROA.

Overall, while Santander's recent improvement in ROA is a positive sign, but it needs to be viewed in the context of the industry's overall performance.

The same goes for assets per share, where Santander has also made some progress.

This broader analysis of the banking industry, while simplified, brings to light a crucial point: the significance of approaching investment analysis without preconceived notions. In hindsight, a more open and data-driven evaluation could have allowed me to correctly identify the emerging winners in the industry, such as JPMorgan and Bank of America, rather than assuming the undervaluation of European banks like Santander.

To gain a more nuanced understanding of Santander's future prospects, it is essential to delve deeper into its operational and strategic changes and recent developments.

Financials

Santander's financial performance in the third quarter of 2023 reflects a notable turnaround and significant improvement in its operations. The bank reported a record quarterly profit of €2.9 billion ($3.16 billion), marking a substantial 20% increase from the same period in the previous year, and a 26% rise in constant euros. This performance is part of a broader positive trend, with a 13% increase in profit to €8.1 billion ($8.8 billion) for the first nine months of the fiscal year, adjusted for constant euros. The Return on Tangible Equity ((ROTE)) also saw an impressive rise, increasing by 126 basis points year-on-year to nearly 15%.

Several key factors contributed to this robust performance. Revenue growth was strong across all global businesses and regions, attributed to substantial growth in customer revenue. The addition of 9 million new customers over the last 12 months, bringing the total to 166 million, played a significant role in this revenue increase.

The profit growth was driven by a combination of factors: a strong top-line performance with revenue growth, improved efficiency with costs increasing at a slower rate than revenue, and double-digit growth in net operating income, which exceeded €24 billion ($26.1 billion). Additionally, there has been a normalization in loan loss provisions.

Financial stability indicators are also positive. The Common Equity Tier 1 (CET1) ratio, a key measure of financial resilience, is improving. Furthermore, the RoTE, an important metric for shareholder returns, is now close to 15%. The bank's commitment to shareholder returns is further evidenced by its decision to pay a cash dividend of €0.081 per share in November, a 39% increase from the previous year, and the ongoing share buyback program of up to €1.3 billion.

Strategic Transformation

Santander's strategic transformation, as detailed in their 3Q23 earnings call, is a comprehensive effort focused on operational standardization across different geographies, which is expected to bring about significant cost reductions. A key component of this strategy is the adoption of a common platform, which minimizes the need for multiple, region-specific systems and processes. This consolidation leads to lower maintenance costs and reduces the necessity for specialized personnel, while also achieving economies of scale.

Another significant aspect of Santander's transformation is the streamlining of its processes. By moving towards a unified operating platform, the bank aims to reduce redundancies and automate many functions. This initiative not only increases operational efficiency but also accelerates service delivery, thereby reducing operational bottlenecks.

Furthermore, the unified system enhances data integration across different regions and business units. This integrated approach to data management enables advanced analytics, fostering more informed decision-making.

The early results of this transformation are already visible. The bank reported a reduction in its product offerings by 8% in 2023, which translates to around 800 fewer products. Additionally, the shift towards digital channels has led to a 16% reduction in the use of contact centers.

Santander has also successfully implemented a new fully digital onboarding process in Mexico, which takes only six minutes and has resulted in the opening of 36,000 new accounts since its launch in July. The bank's collaborative efforts between its Private Banking, Corporate Investment Banking ((CIB)), and corporate divisions have also borne fruit, generating over €160 million ($174 million) in revenue, marking a 13% increase.

Lastly, Santander's payment solution, Getnet, is currently operational in five countries and has expansion plans for Chile and the U.K. in the near future. These developments highlight Santander's commitment to a more streamlined, efficient, and technologically advanced banking operation.

Valuation & Risks

Santander's financial performance in 2023 has been notably strong, with revenues growing at double digits. This growth trajectory indicates that the net income and diluted Earnings Per Share ((EPS)) are on track to be the highest they have been in the past decade, signaling positive developments for the company. However, our peer analysis reveals some ongoing challenges.

Despite these promising signs, Santander's return on assets (ROA) continues to lag behind its peers, suggesting that the bank's balance sheet efficiency is not as robust when compared to other players in the industry. This aspect is crucial as ROA is a key indicator.

Furthermore, there are macroeconomic factors that contribute to the generally lower Price-to-Earnings ((PE)) ratios of European banks compared to their American counterparts. The European economy is grappling with issues such as weak demand, an energy crisis, and challenges in the German industry. These factors inevitably impact banks like Santander, which, despite its geographic diversification, still relies significantly on Spain for its profits. The decline in loan growth in Spain, which is more pronounced than the sector's overall decline, further exacerbates this situation.

In valuing Santander, applying a PE ratio of 10 seems reasonable under the assumption that the bank can close the valuation gap with its peers. If the bank ends 2023 with a diluted EPS of $0.64, it suggests a valuation of $6.4 per share, equating to a potential return of 55%. However, this investment thesis, based on closing the valuation gap, has been a recurring yet unfulfilled expectation over the past decade. This historical context raises doubts about the feasibility of this thesis moving forward.

In my opinion, while the potential 55% return appears attractive, it does not sufficiently compensate for the risks involved, especially when considering the availability of better investment opportunities in American banks. The structural and macroeconomic challenges that have historically hindered Santander's performance appear to remain unresolved. Therefore, from an investment perspective, it seems prudent to consider other options in the banking sector, particularly in the more robust American market, where banks demonstrate stronger financials and face a more favorable economic environment.

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