Santander's capital

Santander's capital is one of the most important topic when covering the group.

The long term dividend sustainability is a challenge. There are currently 11.78bi shares. At least the next 3 dividend distributions will be as scrips (600mi new shares) and the Santander brasil operation is done by issuing new shares (660mi new shares). Switching to an all cash dividend with a 50% payout requires net earnings of €15.6bi. Clearly restoring the return on existing business is not enough to reach that level of earnings: Growth is needed.

Growth both organic or by M&A requires capital. Historically Santander has secured the needed capital for acquisitions by making ad hoc capital increases. For example in 2004 Santander issued 1.5bi new shares (nearly 30% of the outstanding shares at that time) to acquire Abbey in the UK and in 2008, 1.6bi new shares (25% of the outstanding shares) for the ABN Amro operation.

However, my opinion is that current market conditions are bad for making market capital increases because (1) shares are under valuated and (2) will suffer significant discount (as an example DB's recent capital increase was with 30% discount).

Organic growth is active in UK, Mexico, US. By end of 2014, it should also clearly appear in Spain.
Recent M&A growth (in the commercial bank core activity) is currently active in Consumer finance (Cortes Ingles in Spain, PSA in Europe, GE money in Scandinavia, two 2013 deals in China). Additionally there has been the GetNet acquisition in Brazil, and Bank of Shangai in China.

On the other hand, by end of 2014, we have the ECB stress tests/EZ banking union together with the 1st year of BIS III load. This should provide significant M&A activity mainly in Europe based banks. To participate as a buyer Santander must have the excess capital available.

Regulatory capital ratios

Securing capital for growth is made more complex by the increase in the regulatory capital needs and exclusion of amounts from capital both coming from BIS III as shown below
2013 (end): 4.5% tier I capital, 8% total (tier I+II)
2014 (end): 5.5% tier I capital, 8% total, 20% of exclusions
2019 (end): 6.0% tier I, +2.5% of tier I for the conservation capital buffer, 11.5% total (includes the 1% surcharge as being low risk G-SIFI), 100% of exclusions

Current capital ratio situation 

In June 2014, Santander published Fixed Income Investor Presentation Q1 2014 that has 3 slides linked to the capital situation:

Slide 32: current ratios

Slide 33: Current situation solid?

The information comes from Oliver Wyman (end of) 2012 stress tests. These tests were done as part of the €41bi Spanish bank rescue operation. They are considered tougher than the coming ECB stress tests.
In the adverse scenario, Santander has in 2014 €25.3bi capital surplus.

Future capital ratio (slide 35)

This slide 35 is a rarity in communications coming from Santander:

• That is the first time (I remember) that there are the words "vision" and "ambition"
• It has been clearly massively worked from original internal data: In column "Group total ratio", the ">3%" comes from nowhere.
  CORRECTION: regulatory capital requirements end of 2019 for Santander (including the 1% as low risk G-SIFI) are 11.5%. >3% (14.5%-11.5%) means the excess capital end of 2019!
• Long term 5 years means 2019, at BIS III full load date!

How can it be done?

">11%" CET1 and ">14.5%" total are impressive, and much higher than the regulatory fully loaded capital requirements (300bpp more than required). How can Santander reach these numbers (without making new share issues in the markets).

There are many elements, and these will make clear how irrelevant it is for Santander to provide in 2014 fully loaded capital ratio.

These elements are:

1. Dividend scrips
2. DTA
3. Issuing additional capital in the form of convertible covered bonds
4. Change in RWA calculation rules
5. EPS
6. Excess provisions in Spain

1. Dividend scrips

Dividend as scrips taken at 87% (2013 average) as new shares means that every 3 months, Santander increases capital by about €1.5bi. The bulk comes from retained earnings, but as currently EPS are lower than dividend, some reserves are also converted to capital. A milestone will be when EPS reach €0.15 per quarter. This should occur beginning of 2015. 

Since Q4 2011, Santander has carried out 12 dividend scrips, issuing 2.56bi new shares (30.7% of the outstanding shares at the start of the process), and increasing capital by more than €10bi.

The scrips have many advantages and one potential disadvantage

+ Increase capital whilst shares are under valuated

+ Go around the 21% Spanish dividend tax

+ No discount

+ Still allow shareholders to get cash, by selling the new shares, whilst maintaining their existing shares

- Dilution

I consider dilution as a potential disadvantage, because dilution only matters in case capital increases are not done to capitalize growth. In fact I hope that in future, even long term, Santander will use scrips to raise the capital needed for growth.

2. DTA

Deferred Tax Asset together with BIS III regulations is a negative factor. Some expenses are not immediately tax deductible and the not received tax benefits parked in the balance sheet as DTA till allowed to be recognized. 

In BIS II they are considered as capital. However BIS III excludes the DTA from capital in the case they are not guaranteed to be utilizable (bankruptcy,...). The exclusion happens between 2014 and 2019 at a rate of 20% per loading year. Santander has around €16bi of DTA. The main amounts are €10bi in Spain, €4bi in Brazil, and €1bi in the USA. Should the whole amount be excluded from capital, then capital ratio will go down by 240bpp. Should Santander win the Catalunya bank privatization this year, the DTA amount in Spain will increase by €3.5bi.

DTA in Spain are of different nature than in Brazil and in the USA. In the case of Spain they come from pension provisions, 2012 real estate provisions and previous FY losses. In Brazil and the USA they come from non deductible provisions to be made when a new loan is granted and still performing.

In 2013, Brazil changed the regulation in such a way that the €4bi stay in capital. I never checked the USA rules, but would be stunned it is not the case in that country as well .

In 2013 Spain changed legislation is a more complex way. My understanding is that the pension related DTA can stay in capital whilst the other categories cannot.

As such future earnings in Spain and cleaning of the real estate situation is key to lower the effects on capital. Santander guidance for 2014 Spanish net earnings is €1.1bi in 2014, €3bi starting 2016, means that the DTA linked to previous FY losses will be eaten quickly. For the (companies with) real estate DTA, please read point 6.

3. Issuing additional capital in the form of convertible bonds

Slide 35 makes clear that Santander intends to increase capital significantly through the use of convertible bonds. When these bonds are unconditionally converted to additional shares when capital situation passes a lower level, they are added to normal capital to compute some ratio.
In 2014, Santander made 2 such issues: in March, €1.5bi, 6.25% coupon. In Mai, $1.5bi, 6.375% coupon.

4 Change in RWA calculation rules

The capital and what can be considered as tier I capital is the numerator for computing capital ratio. The denominator is RWA. Currently, the rules for computing RWA from the assets are regulated by each national regulator, and differ per EZ countries. However the EZ banking union that starts in Nov 2014 will uniformize the rules for the 128 biggest European banks. Four big Spanish banks, including Santander, asked to Oliver Wyman to make a comparative analysis between EZ countries plus UK about the subject. The result published in April 2013 can be found here Oliver Wyman report. The conclusion related to Santander is the following:
In case the ECB rules are aligned to the most conservative rules among existing EZ regulators, Santander core capital ratio will increase 0bpp-35bpp. In case the less conservative rules are imposed by ECB, the increase will be between 85bpp-145bpp. Both cases have low probability and let’s take the middle way to estimate the effect:
The ECB taking over the regulation of the main EZ banks will provide a level playing field and increase Santander core capital between 40bpp and 90bpp.

5. EPS

As soon as EPS goes above the €0.15 quarterly dividend, capital increases through retained earnings, and this in addition to the new scrip shares.
In Q1 2014, EPS were €0.113.
Santander does not provide guidance. However in the Sep 2013 BAML presentation, Santander provided 2016 target ROE per main unit. It is complex effort that includes €1.5bi cost cutting effort (€750mi by 2014, then €500mi in 2015, and €250mi in 2016). It also includes redeployment of capital between and within units to concentrate on segment with higher ROE. The figures are detailed in the "Guidance" tab. At current business perimeter, it gives net earnings in 2016 between €8.8bi and €9.4bi. This shows how critical growth is to be able to sustain the dividend at long term.
Santander only provides one kind of financial results: GAAP. I find that incredibly better than the cases where companies put emphasis to No-GAAP figures, even when the exceptionals are recurring (e.g. JPM fines). When Santander has exceptionals, the credit part is applied to the debit part (example restructuring costs). Excess credit is parked in the balance sheet. In Q1 2014, Santander parked €1.135bi of exceptional gains.
A US based company would have reported Q1 2014 net earnings of €2.4bi (EPS of €0.211 for the quarter), and put emphasis on no-GAAP figures in the quarter report

6. Excess provisions in Spain

My opinion is that there is a significant excess of provisions in Spain. The 2016 €3bi net earnings target in Spain alone does not include provisions release.
If 2008 is 100, new NPL entries in Q1 2014 is:

• 51 for mortgages to individuals
• 23 for individual cards and customer loans
• 155 for companies w/o real estate purpose
• non measurable for companies with real estate purpose (because incredibly bad)

There are significant excess provisions in 2 cases:

- For companies with real estate purpose, NPL are around 50%. In 2012, the Guindos II decree forced the Spanish banks to provision everything. So the current situation is that even the performing loans of that category are provisioned at 30%. Santander has transferred the whole activity to an internal bad bank. Strong effort to clean it, with impact on the corresponding DTA, as Guindos II provisions were not tax deductible.

- For companies without real estate purpose, there is a significant effort under way, with test drive for 4 medium sized companies currently under way (the full scope is 20,000 companies). It consists to restructure part of the non performing loans as capital. After this recapitalization and debt shrinking is completed, non performing and provisioned loan saldo becomes performing and related provisions can be released immediately. There are more details in a past separate post

Conclusion

Santander's capital situation is much better than (usually) estimated. Management has quietly amassed significant capital surplus to cover organic growth together with being able to make significant purchases without having to issue new rights in the market. This is typical of management very long term approach.

Spanish banks to provide €150bi new capital to non financial companies?

Today appeared this headline in cincodias.es "Banks will save 4 companies, before summer, with a pilot capital-for-debt fund" (ES), also (ES)

We know NPL in Spain for real estate companies are awful. They are also bad for other kinds of non financial companies. However in many cases, the companies are economically viable as far as excess debt problems are cleaned and new capital made available. There are 20,000 such companies in Spain.

The country plan is at the basis simple: Get the banks convert part of the debt into capital, for an amount like €150bi.

That plan became visible in March 2014, with the government taking some measures to make the operation possible. In short all demands of the banks are being answered, and situation has reached the point that 4 big companies have been chosen to validate the process with as target date "before summer". Full scope is 20,000 companies.

Here are some example of the measures (Overview - ES):

• New rules to make a minority of creditors unable to block a restructuring
• In case a restructuring occurs, the provisions linked to the debt (not converted into capital) can be released immediately. 
• In case of bankruptcy, rules for the banks to keep precedence for the new capital at what it was.
• Systematic dispense for the obligation to offer to buy the whole company when reaching 30% shares
• Work around to the way BIS III handles non financial participations in RWA calculations (1250% weight).

What the be the effect for the banks, and Santander in particular (should the operation be fully applied)?

• Banks will become major shareholders of many companies, placed in equity funds, kind of bad bank for private companies capital. This bad bank will take time to sell assets, to the further frustration of vulture funds.
• Part of the non performing loans will end as equity in the funds. The rest will stay as loans but by default will become performing. Major cleaning of the company related NPL.
• Indirect economic effects with many companies out of financial distress.

New section: News - Rating agencies

I have created a new section "News-Rating agencies". 

In "News-Group" I want only the most important group notices. I have cleaned that section (News-Group) from rating agencies changes.

In my opinion rating agencies news are not important for long term investments, because they have too many links with the financial industry.

As a matter of fact, fundamentals's situation in Spain did not change since July 2012, in the sense that all elements to forecast an improvement were available in July 2012. In particular the structural changes were implemented at that time.

So recent Spain (and Santander) ratings upgrades are simply too late, too slow, should they be based on objective data.

This period (July 2012) was so interesting as investor because a lot of money movers were convinced they could break Spain and the EZ. In fact the internal EU politics were complex (at that time and now) and as a consequence perceived as impotent and slow, but I never had any doubt, that should it really be needed, they would act. Please remark I don't consider UK as part of the EU at political level. They are in to control it and twist to own interest, including block.

Draghi's speech in London. That speech is remembered as "ECB is ready to do whatever it takes..." That is not that part I remember: It was done in London in front of the financial community. After saying "ECB is ready to do...", Draghi stopped reading his speech. He took off his glasses, looked at the audience and said "and believe me it will be enough". (even the City knows you don't anger an Italian).

As the most symbolic example of behind the scene activity, at that time, the German constitution was changed, to authorize the German army deployment in Germany itself. (huge for historical reasons. Officially to handle terrorist threads. Real reason: In case Greece leave EZ, and as a consequence occurs a bank run, Germany police would be unable to secure borders and bank branches).
And around same time Shenghen treaty was changed in a way to allow to reactivate borders controls in such a situation.

All this to say that I consider country ratings are irrelevant for long term investment. Rating agencies try to build virginity through this activity (sovereign ratings), whilst their commercial activity is deeply tainted by their customer interests (give good ratings to have future business).

Since Jul-2012, including the dividends, Santander went up 100%+. There is still room to go. Personal target prices are €8 for 2014, €10 2015, €12 2016 (all around year end).
At the basis for this is the opinion SAN will be able to keep its dividend at €0.6 even when all cash and 5% DY is nice (4% net).
The complex way to justify this is in tab "Guidance". This information only covers existing business. "Capital" tab is key to see if there are growth possibilities. "Acquisition" tab is proof that Santander is now bigger than in 2008, having made significant acquisitions in Poland, UK, US and China that more than compensate the sales in Colombia, AM and insurance. However the regulation changes requiring more capital lowers these growth effects.
Another way is: Should €0.6 be unsustainable then management would have reduced it already. In 2 years time of daily news reading about Santander keeping its €0.6 dividend for 5 years, long term sustainability is my best explanation. The only other explanation I read is that Botin wants to proof he has balls (literally, it was in Anglo-saxon economic press and within the English text they used the Spanish word "cojones" for obvious reasons)
Botin is brilliant. Keeping a high dividend in the form of scrip allows Santander to raise €1.5bi capital every quarter, without discount, to use for organics growth and acquisitions starting end of 2014

Keeping a €0.6 dividend when all cash with a 50% payout is a challenge: need net earnings north of €15bi by 2016. Focus on ROE is one part of the effort, with significant operations in Brazil and Mexico. There is the €1.5bi cost cutting effort, including Spanish and Polish restructuring (merge). Organic growth is also very active in UK, Mexico and US. Spain is coming with the raise in deposit market share to translate into more loans. My hope is that Santander will announce a major M&A operation, to use the excess capital they have, starting end 2014, preferably in Germany, but could be also in Austria or any US region other than North-East. All the M&A operations end 2013 to 2014 are not significant: they are small (China, Spain) or capital neutral (China), or capitalized with new share issues (especially the 25% share purchase in Brazil). PSA deal is possibly more significant but will be completed in 2015 only. In case no major M&A possible, then Botin should fall back to a share repurchase program, but this is not in his character.

2016 target (€12), including the dividend gives an additional 100% gain to that date.
However my intention is to start unload 50% of my SAN exposure in the next 4 years (selling same amount each month)
That is a long period, but that slow rate allows me to keep the capital gains tax free.
Also I would not do it without the possibility to reinvest in situations similar to Spain Jul-2012.

The good thing with the current financial world is that there are always similar situation.