Santander Diversity Brings Earnings Stability, but Has Historically Limited Profitability

Equity Analyst

Johann Scholtz

Santander generates around 45% of its earnings from its highly profitable Latin American operations. The subscale returns Santander has historically recorded in Europe and the U.S. have obscured the high-double-digit/early-20s returns on equity Santander generates from its Latin American operations. Santander is confident that it can significantly improve the profitability of its European and U.S. businesses, supported by higher interest rates. We wonder if Santander could boost its profitability, release capital, and rerate its valuation by trimming its portfolio, so that it operates only in areas where it has a clear competitive advantage. 

Santander is one of the market leaders in Brazil, Mexico, and Chile. Santander's strong competitive position in these consolidated, oligopolistic markets protects its high profitability. Its profitability has suffered from low interest rates, especially in its European operations. The return to a more normalized monetary policy environment has supported a profitability improvement in Santander's European and U.S. operations.

We believe investors have typically discounted too much risk in their valuation of Santander. We agree that Santander's emerging-market exposure comes with greater risk. However, Santander's earnings have been remarkably stable compared with most of its European peers. While diversification plays a role, its low exposure to investment banking and relatively low exposure to home loans also contributed. Investment banking earnings tend to be volatile, while the long duration and inferior margins of home-loan books tend to lead to significant write-downs relative to earnings during downturns in the credit cycle.

Santander is looking to its investment banking, wealth management, vehicle finance, and payment businesses to drive growth ahead of its peers. These areas could present low-hanging fruit where Santander operates below its natural market share. Santander's intention to grow its investment banking business does puzzle us somewhat; many of its European peers have struggled to generate adequate profitability in the highly capital-intensive and volatile investment banking segment.

Business Strategy & Outlook

We base our narrow economic moat rating for Santander on its cost advantage and high switching costs. Santander attracts cheap deposit funding via an almost unparalleled global network of 9,000 branches. It has a good record of managing operational costs and its presence in uncorrelated geographies creates a diversification benefit that reduces the volatility of credit costs.

We believe that access to cheap deposit funding is one of the critical cost advantages that a bank can enjoy. Santander's top-five deposit market share in 10 countries (including Spain, Brazil, Mexico, Chile, Argentina, Poland, and the U.K.) precisely provides that. 

Santander has an attractive funding structure and funds itself primarily via customer deposits with a limited need for institutional funding. Demand deposits (current and call accounts) make up 50% of its deposits. Demand deposits are the cheapest source of funding and also the stickiest. A strong position in current or call accounts comes with added benefits. Being a client's primary banker positions Santander well to cross-sell other products to the client. Also, loans to a primary banked client tend to be of higher credit quality, as Santander has direct insight into the client's financial health. 

Santander's cost/income ratio is one of the lowest in Europe. We attribute this to the economies of scale and scope that Santander's multinational and multiproduct business model generates. Simply put, Santander can sell products it develops centrally to clients in different countries using the same back-office infrastructure and processes.

During the global financial crisis and European sovereign debt crisis, Santander's credit losses were more stable than its European peers, despite its exposure to the weak Spanish housing market. We do not necessarily believe this is due to superior local underwriting; the credit losses for the Spanish operations actually tracked those of its Spanish peers. However, on a consolidated basis, Santander's diverse lending book, with exposure to markets that are not necessarily correlated, provides it with downside protection during downturns in the credit cycle of a region or asset class. Consequently, Santander's earnings have shown the least volatility of all the large European universal banks over the past two decades. We highlight that Santander's absolute credit costs and nonperforming loans are higher than its European peers. However, we believe this is not necessarily a sign of higher risk. Santander's book includes a large portion of emerging-market loans with higher credit costs. Still, Santander earns a higher yield on these emerging-market books to compensate for higher credit costs. 

Under our banking moat framework, a moat from switching costs arises where banks have strong relationships with their clients and limited competition exists between banks. 

Santander's retail banking product range is commoditized, but it involves cross-selling various lending, savings, and transactional products to the same client with opaque, intertwined pricing. This makes it difficult for clients to switch banks. We like the small and medium-size companies/midcorporate bias in Santander's business mix, as we view these as moaty businesses, where strong client relationships and the provision of bespoke lending products based on knowledge of the client's business are key differentiators. 

Santander operates in markets that are either already highly consolidated and oligopolistic or markets that are moving in that direction. In Brazil, state-owned banks account for 40% of deposits and private banks 60%. Itau, Bradesco, and Santander control 70% of publicly owned banks' deposits. The diminished importance of the politically controlled cajas lead to increased consolidation in Santander's Spanish home market, where the top-five banks now control 66% of deposits. The U.K. has always been a concentrated market, where the five major clearing banks have current account market share of close to 90%.

Narrow

Economic Moat

Banco Santander

Banco Santander purchased GE Money Bank, GE Money Bank, GE Capital's consumer finance business in Sweden, Norway and Denmark, for 700 million euros ($950 million) in 2014.

GE Money Bank

Banco Santander SA is a banking services company, which engages in the provision of banking services to individuals, companies, and institutions. It operates through the following segments: Europe, North America, South America, and Digital Consumer Bank. The Europe segment comprises business activities carried out in the region. The North America segment includes business activities in Mexico and the United States. The South America segment involves financial activities of the Group through its banks and subsidiary banks in the region. The Digital Consumer Bank segment includes Santander Consumer Finance, which incorporates the entire consumer finance business in Europe, Openbank, and ODS. The company was founded on March 21, 1857 and is headquartered in Madrid, Spain.

Earnings data Q1 2024

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Banco Santander, S.A. (SAN) Q3 2023 Earnings Call Transcript

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