E CONOMICS, EXCLUSIVELY FOR ACADEMIC PURPOSES.T HIS REPORT WAS SUPERVISED BY

(1)

THIS REPORT WAS PREPARED BY PATRÍCIA OVÍDIO, A MASTERS IN FINANCE STUDENT OF THE NOVA SCHOOL OF BUSINESS AND ECONOMICS, EXCLUSIVELY FOR ACADEMIC PURPOSES.THIS REPORT WAS SUPERVISED BY ROSÁRIO ANDRÉ WHO REVIEWED THE

VALUATION METHODOLOGY AND THE FINANCIAL MODEL. (SEE DISCLOSURES AND DISCLAIMERS AT END OF DOCUMENT)

See more information at WWW.NOVASBE.PT Page 1/36

M

ASTERS IN

F

INANCE

M

ASTERS IN

F

INANCE

E

QUITY

R

ESEARCH

§ Banco Santander’s operations are diversified between developed economies and emerging markets. Yet, with tighter global and local regulations in the horizon, problems may arise.

§ Notwithstanding, the European operations, which took a major dive in profits following the crisis (namely in Spain with high provisions on property having to be made), are now starting to recover. With interest rates at historical lows in Europe, the net interest income is expected to start returning to pre-crisis levels. All in all, Continental Europe’s operations were valued at EUR 3.20 and the UK’s at EUR 1.72.

§ In Latin America, despite the cost reduction efforts, inflation is still quite high and is offsetting them (Brazil especially). Also, given the recent history of defaults in the region, the implications of a sovereign bankruptcy in Santander’s price were taken into account. Overall, the operations in Brazil were valued at EUR 0.88, in Mexico at EUR 0.46, in Chile at EUR 0.31 and in the rest of LATAM at 0.48.

§ The YE15 target price is based on the sum-of-the-parts valuation. The discounted cash flow to equity method was used to value Santander’s Continental Europe, UK, Brazil, Mexico, Chile, rest of LATAM, USA, and Corporate Activities’ operations. The EUR 6.92 target price, allied with a EUR 0.61 dividend, implies an expected return of 14.01%, hence our recommendation to hold.

Company description

Banco Santander is a Spain-based commercial bank founded in 1857. The Bank operates mainly in Spain, the United Kingdom, Portugal, Germany, Poland, the Latin American countries (Brazil, Mexico, Chile, and Argentina) and the United States. Its business comprises retail banking, wholesale banking, asset management, and insurance, among others. Regardless, it is mainly a retail focus bank.

B

ANCO

S

ANTANDER

C

OMPANY

R

EPORT

B

ANKING

6 J

ANUARY

2015

S

TUDENT

:

P

ATRÍCIA

O

VÍDIO

patricia.ovidio.2013@novasbe.pt

Leaving the European crisis behind

But facing uncertainty in Latin America

Recommendation: HOLD

Price Target FY15: 6.92 €

Price (as of 6-Jan-15) 6.60 €

Reuters: SAN.MC, Bloomberg: SAN.SM

52-week range (€) 6.2010-7.9600 Market Cap (€m) 84,328.16 Outstanding Shares (m) 12,584.41 Source Bloomberg:

Source: Bloomberg

(2)

BANCO SANTANDER COMPANY REPORT

PAGE 2/36

Company Overview

Banco Santander is the largest bank in Europe and 11th worldwide with a market capitalization of EUR 84,328.16 million, and weighing 18.67% on the IBEX 35. Santander has ten main markets (Fig. 1) and operates in Retail Banking, Global Wholesale Banking, Private Banking, Asset Management, and Insurance. The bank employees 183,534 people and has 13,067 branches worldwide. Santander’s business model lays on six fundamental pillars: focus on retail, capital discipline and financial strength, prudence in risk, geographical diversification and subsidiaries model, the Santander brand, and efficiency.

History

On May 15th, 1857, Queen Isabel II of Spain signed a royal decree authorizing the creation of Banco Santander. Its international outlook was present from the start, with the bank being initially associated to trade between the port of Santander and Latin America. In the beginning of the 20th century Santander experience major growth and, in 1920, Emilio Botín y López was appointed as the first full-time chairman. In the 1930s, Santander began its expansion throughout Spain with the acquisition of a several local banks, but it was not until 1942 that it reached Madrid with the acquisition of Banco Ávila (Fig. 2). The first international offices were set up in 1947 in Havana (Cuba) followed by Argentina, Mexico, Venezuela and London. In 1960 was the beginning of several international acquisitions that eventually lead to Santander’s strong presence in Latin America and Europe (Fig. 3).

In 1986, following his grandfather and father’s shoes, Emilio Botín Sanz de Sautuola y García de los Ríos, who was then vice-chairman and CEO, is chosen as chairman. He was determined to embrace innovation and expansion as the future of Santander. The first was evident in 1989 with the launch of “Supercuenta Santander”, a current account with high remuneration that shook-up the Spanish banking system. With this move, Santander profited by increasing its number of clients and the domiciliation of bills as well as with a light and efficient account cost structure, it increased in size and shattered the competition. The 1990s saw Santander become the leader in Spain with the acquisition of Banco Español de Crédito and engage on a second wave of investment in Latin America. With the turn of the century came the euro and Santander’s merger with Banco Central Hispano.

In recent years the bank has set up Santander Consumer (2003), bought the sixth largest bank in the UK, made its first investment in the USA, arrived in

Fig. 1 Distribution of Ordinary Attributable Profit by Operating Geographic Segments (9M’14)

Source: Company data.

Fig. 3 International Acquisitions

1960 Banco del Hogar

Argentino

1976 First National Bank of

Puerto Rico

1982 Banco Español – Chile

Late 1980s

CC – Bank Banco de Comércio e

Indústria

1999

Banco Totta e Açores

Crédito Predial Português 2000 Banespa Grupo Serfín Banco Santiago

2004 Abbey

2005 Sovereign Bancorp

2007 Banco Real

2008

Alliance & Leicester

Bradford & Bingley

2010 Sovereign

2011

Scandinavian SEB Group Bank Zachodni WBK

Fig. 2 Domestic Acquisitions

1942 Banco de Ávila

1946 Banco Mercantil

1994 Banco Español de Crédito

2013 Banesto

(4)

PAGE 4/36

Poland and took a leap forward in Germany. In 2006, Santander made record profits of EUR 7,596 million, the largest of any Spanish Company. On the domestic front, Banesto and Banif merged with Santander in 2013, and Ana Patricia Botín as been unanimously appointed as the executive chairman following her father’s death on September 9th, 2014.

Santander’s shares are listed in the Madrid, New York, London, Lisbon, Mexico, São Paulo, Buenos Aires, Milan, and, recently, Warsaw stock exchanges, and are in 63 different stock exchange indices. Comparing Santander’s shares performance against the IBEX 35 and the EURO STOXX 50 (Fig. 4), there is a strong positive correlation with the Spanish index (0.83) and a little less so with the European one (0.70). Furthermore, it is also possible to see that Santander’s shares tend to move more than the market, although in the same direction as it (beta greater than 1). This is expected as banks are strongly influenced by the general health of the economy. Finally, Santander’s share had been on an upward trend since its listing but were severely affected with the 2007-2009 financial crisis (Fig. 5).

Shareholder Structure

Santander presents a dispersed shareholder structure where no shareholder held significant interests (of more than 3% of the share capital or interests that would permit a significant influence on the bank). By 2013YE, the interests held by State Street Bank & Trust (9.33%), Chase Nominees (7.05%), The Bank of New York Mellon (5.35%), EC Nominees Ltd. (4.57%), Clearstream Banking (3.49%) and Guaranty Nominees (3.29%), the ones in excess of 3%, were held on behalf of their customers. Overall, institutional investors hold most of Santander’s capital (Fig. 6), the capital is mainly concentrated in Europe (Fig. 7) and is mainly concentrated in the hands of some investors that hold over 400,000 shares (Fig. 8).

Regarding the latest capital increases that Santander has developed, they mainly concern the “Santander Scrip Dividend” programme (Fig. 9). In this, shareholders can choose between one of three options to receive the dividend. First option, they can receive new shares; second, they can sell their shares rights to the market; and third, they can sell the rights to the bank at an established price. The first two options do not require tax retention. Furthermore, on November 5th, Santander issued 370,937,066 shares as part of the offer to buy Banco Santander Brazil shares.

On February 2006, certain shareholders signed an agreement regarding the Fig. 6 Distribution of Ownership of Capital

(September 30th 2014)

Fig. 5 Santander’s Shares Total Return (EUR)

Source: Bloomberg.

Fig. 4 Total Return (%)

Source: Bloomberg.

Fig. 7 Distribution of Capital by Continent (September 30th 2014)

Fig. 8 Distribution of Capital by Tranches (September 30th 2014)

Share Holdings Shareholders _CapitalShare

1 – 200 1,646,972 1.27%

201 – 1,000 787,511 3.21%

1,001 – 3,000 482,363 7.41%

3,001 – 30,000 288,141 19.77%

30,001 – 400,000 23,888 13.41%

Over 400,000 797 54.93%

(5)

PAGE 5/36

exercise of voting rights and imposing the parties to limitations on the transferability of the shares. The purpose of the syndication pact is to guarantee that the representation of the members of the Syndicate as shareholders of the Bank is undertaken at all times in a coordinated fashion, with the goal of implementing a long-lasting and stable common policy and an unified representation in the Santander’s corporate bodies. At year-end 2013, the syndication included a total of 0.7% of the bank’s share capital (Fig. 10), with a 29% and a 19% increase in Ana Patricia Botín and in Emilio Botín O’Shea’s shares, and a total alienation of PUENTEPUMAR’s shares.

The chairman of the group, who is the highest-ranking officer of the bank, is chosen amongst the members of the board of directors. The chairman’s appointment shall require the favorable vote of no less than two-thirds of the members of the board of directors. On September 10th, 2014, Ana Patricia Botín was unanimously appointed chairman. The appointments and remuneration committee considered her to be “the most appropriate person, given her personal and professional qualities, experience, track record in the Group and her unanimous recognition both in Spain and internationally”. She will be the fourth generation of the Botín family to lead the bank, and, despite all the cons for family dynasties in banking, she has been in Santander for many years and her record on the UK is quite good. Nonetheless, following her appointment, share price fell 1.2 per cent although recovering afterwards (Fig. 11).

Macroeconomic Context

Europe

The European advanced economies have begun to recover, although in a slow and uncertain pace. Overall, in the second quarter of 2014, the Euro Area

stagnated, with investment lower than expected in various large economies. Financial markets have remained strong, with spreads at pre-crisis lows and lower bank funding costs. Nonetheless, the scarce demand, high debt, and unemployment that the crisis brought still challenge Europe’s ability to grow in a robust and sustain way.

Output and investment are still far from the pre-crisis levels, and growth is weak and uneven across countries. Inflation, which is quite below the European Central Bank’s (ECB) target, is universal reflecting persistent slack and inflation expectations have decreased. Balance sheets continue to be weakened, partly due to high debt and unemployment. Also, financial fragmentation persists, and companies in stressed economies face borrowing limitations. The ECB’s Fig. 11 Santander’s Share Price (EUR)

Source: Bloomberg.

Fig. 10 Shares Included in the Syndication

Signatories to the shareholders’ agreement

Number of Shares

Emilio Botín-Sanz de S. y G. de los Ríos 6,464,149 Ana Patricia Botín-Sanz de S. O’Shea 17,082,380 Emilio Botín-Sanz de Sautuola O’Shea 16,873,709 Francisco J. Botín-Sanz de S. O’Shea 16,203,429 Paloma Botín-Sanz de S. O’Shea 7,830,897 Carmen Botín-Sanz de S O’Shea 8,633,998 PUENTEPUMAR, S.L. 0 LATIMER INVERSIONES, S.L. 553,508 CRONJE, S.L., Unipersonal 4,024,136 NUEVA AZIL, S.L. 5,575,279

TOTAL 79,297,349

Fig. 9 Capital Transactions in 2014 Date Shares Issued Reason 31-Jan 227,646,659 Dividend 30-Apr 217,013,477 Dividend 31-Jul 210,010,506 Dividend 5-Nov 370,937,066 Santander Brazil 6-Nov 225,386,463 Dividend Source: Company data.

Fig. 12 Sovereign CDS Spreads

(6)

PAGE 6/36

comprehensive assessment encouraged banks to strengthen balance sheets, however this has not yet been achieved. Productivity and competitiveness still face major obstacles. Furthermore, the adjustment of relative prices and external imbalances has been asymmetric – credit countries’ current accounts surplus persists.

The World Economic Outlook (WEO)1 of October 2014 estimates a modest recovery and low inflation. Growth is expected to average 0.8 percent in 2014 and 1.3 percent on 2015. In the medium term, growth is projected to be around 1.5 percent. However, within this weak outlook, forecasts are uneven across countries. Inflation is expected to average around 0.5 percent in 2014, and given its persistent slack, it is foreseeable that it will remain below the ECB’s target in the medium-term.

In the United Kingdom, according to the ECB’s preliminary estimates2, real GDP growth slowed to 0.7 percent QoQ in the third quarter of 2014 from 0.9 percent in the second quarter. Growth was particularly strong in the transport and communications sectors and the business services sector. In the first half of the year growth was driven by private consumption and housing investment. The labor market continued to strengthen, and the unemployment rate fell to a five-year low of 6.0 percent in the three months to August. Furthermore, and even though employment is growing rapidly, the labor market is still slacking and labor productivity growth has been low. Inflation continues to be below the 2 percent target despite the 10 percent increase in house prices across the country. Overall, inflationary pressures are expected to remain subdued owing to moderate wage growth and the effects of the appreciation of the pound sterling. Household debt remains high at 140 percent of gross disposable income. In the Euro Area, the risk of an extended slow growth period and of persistently low inflation is high. If this risk materializes, its effects would echo across Europe. There are also risks concerning reform fatigue and larger than expected bank recapitalization needs. The UK faces financial stability risks from the housing and mortgage markets. For Europe as a whole, negative external developments in the region such as lower growth in trading partners, a sudden tightening of global financial conditions, and economic disruptions and sharply higher oil prices for geopolitical reasons, are an extra major source of risk.

In emerging and developing European economies, the economic recovery has remained uneven, with growth continuing steady or even accelerating in Hungary, Poland, and Turkey in 2013 and into the first half of 2014, but slowing

1

IMF World Economic Outlook (WEO); Legacies, Clouds, Uncertainties; October 2014. 2

European Central Bank; Monthly Bulletin, November 2014.

Fig. 13 Selected Measures for the Euro Area

Source: IMF.

Fig. 14 WEO Projections for GDP Growth (%)

Source: IMF.

Fig. 15 Selected Measures for the UK

(7)

PAGE 7/36

in south-eastern Europe. Financial market developments, although also mixed, are overall encouraging. The WEO projects a 3.2 percent growth in Poland in 2014 supported by rising investment and decreasing unemployment. In 2015, growth will average 3.3 percent in Poland.

The main risk to this outlook continues to be a return of market turbulence and a weaker Euro Area recovery. Taken into account the large stock of external private debt in many countries, along with significant foreign-exchange-linked domestic debt in some, the region is also vulnerable to other adverse shocks. Nonetheless, these risk are to some extent mitigated by ECB’s recent policy to ease monetary conditions even more, which might raise confidence and domestic demand more than what is currently expected.

The Americas

The first quarter of 2014 in the United States economy was market by an unusual harsh winter and a sharp correction to an earlier inventory build-up, which set the economy temporarily back. In the second quarter, these constraints were surpassed and growth reached an annualized 4.6 percent. Improving housing activity, stronger non-residential investment, and steady payroll gains suggest that the rebound is getting more sustainable. In August, the unemployment rate was 6.1 percent and the labor participation rate was 62.8 percent.

Nonetheless, price pressures remain controlled, with the consumer price index inflation and the core personal consumption expenditure inflation at 1.7 percent and 1.5 percent, respectively, in August. Although on a monthly basis inflation was mostly supported by an increase in the food and shelter indices, energy prices posted their third consecutive monthly decline, in line with recent developments in oil prices. Inflation is expected to increase only slowly, driven by a gradually diminishing amount of slack in the labor market, which has kept real wages flat, while recent oil price declines and the appreciation of the U.S. dollar will exert downward pressure.

With growth projected at about 3 percent, it is expected that it will remain above the potential for the rest of the year and into 2015. The strength is supported by an improving labor market, better household balance sheets, favorable financial conditions, a healthier housing market, higher non-residential investment as firms upgrade aging capital stock, and a smaller fiscal drag. Yet, medium-term prospects are overall low. Considering the current policies, potential growth was estimated at only approximately 2 per cent. This is a consequence of population aging and lower productivity growth compared to the previous decades.

Fig. 16 US Real GDP Growth Rate

Source: US Bureau of Economic Analysis.

Fig. 17 US CPI % Change from Year Ago

Source: FRED (St. Louis Fed).

Fig. 18 US Unemployment Rate

(8)

PAGE 8/36

The outlook risks are rather balanced. On the one hand, on the downside, an unexpected rise in inflation due to an unexpected lowed economic slack could increase interest rates more sharply than expected today. Another option is that there could be a disorganized relaxing of the recent compression of volatility and term premiums in financial markets. Uncertainty regarding fiscal policy and the related political strategy could return in early 2015. There are also external risks such as a sharper slowdown in emerging markets, namely China, and sharply higher oil prices due to geopolitical tensions. On the other hand, on the upside, the increasing improvement in private investment could continue, leading to higher confidence levels regarding future economic prospects and raising growth. More developments in mortgage credit availability for relatively lower-rated borrowers could lead to a faster housing market recovery.

As for Latin America, growth remained slow in early 2014, and even weaker than expected with both external and domestic factors playing a role. As for the first, exports fell short of expectations in early 2014, and the terms of trade worsened for some countries. For the latter, supply bottlenecks and policy uncertainty held back business confidence and investment. This has had an impact on consumer spending despite signs that labor markets are beginning to soften. All in all, financial conditions are still encouraging, the continued gains in equity prices and a reduction of sovereign spreads since the beginning of the year have helped to turn around most of the financial market losses suffered after the mid-2013 turbulence. Furthermore, even though domestic interest rates have eased since April, credit growth has remained slow, namely in Brazil.

According to the WEO, growth in the region is expected to average 1.3 percent for 2014, the lowest since 2009. Still, in 2015 it is expected to pick up to 2.2 percent due to improving exports and recovery in investment. Specifically, on going supply-side reforms in some countries, Mexico for instances, should begin to pay off with higher capital spending.

• In Brazil, output decreased in the first half of 2014, with the full year growth projected at 0.3 percent. Investment has been constrained by weak competitiveness, low business confidence, and tighter financial conditions, and consumption has been held down by continued moderation in employment and credit growth. In 2015, activity is expected to pick up slightly, with growth at 1.4 percent, as the effects of this year’s presidential election fade away. Inflation is expected to remain higher than the target, reflecting its persistence, binding supply constraints, and restrained pressure from administered prices.

Fig. 19 WEO US Projections (in percent)

Source: IMF.

Fig. 20 WEO GDP Growth Projections (%)

(9)

PAGE 9/36

• Mexico, even though the economy is gathering pace, it still has not been able to fully offset the weak start of the year caused by lower external demand and slower-than-expected construction activity. Growth is expected to average 2.4 percent in 2014 and 3.5 percent in 2015, due to a firmer U.S. recovery, a bounce back in domestic construction activity, and with the result of the on-going reform of the energy and telecommunications sectors.

• Chile has been affected by a sluggish growth in investment and in durables consumption, which lead to an unexpected slowdown. Notwithstanding, the recent monetary and fiscal easing and a weaker exchange rate should support a modest rebound.

Regarding the outlook’s risks, activity in the region’s commodity exporters might be weakened by negative external demand shocks like a sharper-than-expected investment slowdown in China. A sudden rise in US interest rates could lead to a repeat of the mid-2013 financial turmoil, resulting in tighter financial conditions and depressing confidence further. A sharp increase in oil prices, although benefiting a small number of net exporters (Bolivia, Colombia, Ecuador and Venezuela), would have an overall negative effect on the region’s growth. It could also intensify inflation or budgetary pressures. In the medium-term, another important risk for some of LATAM’s economies is a potential continuation of weak investment if underlying competitiveness and structural issues are not adequately dealt with. The effects on growth would be compounded by an extended stagnation in advanced economies.

Banking Sector

Overall, following the global financial crisis of 2007-2009 and the consequent European sovereign debt crisis, the financial system in Europe has not been in a great shape. If, on the one hand, a strong financial system can support economic growth, on the other hand, when the sector is in trouble, the economic downturn tends to be amplified.

(10)

PAGE 10/36

Retail Banking Trends

Four major global trends that will impact retail banking can be pointed out:

regulation reshaping, technology developments, demographic

transformations, and social and behavioral change.3,4

First, regarding regulation, and still in the aftermath of the global financial crisis, states are looking to increase their control in the financial systems and the institutions operating in their country as there has been seen that, despite a bank being global, in a crisis, it is the local government that is called to take action. Also, with a greater influence in the financial system governments can promote policies such as increase lending in certain sectors and support the housing markets. These trends are thought to impact the industry in a number of ways. (1) In the event of an increase in local regulatory constraints, global banks might loose their economies of scale advantages. (2) More markets can close off to foreign banks, as has been the case of China, thus the need for regional trade pacts that can create opportunities for global financial institutions to emerge in certain markets. (3) Furthermore, given the stronger capital requirements aimed at reducing some of the “sovereign risk”, shadow banking is likely to grow and hence putting pressure in regulated banks in markets avid for credit. (4) Moreover, the size of a nation will more likely correlated to the size of the banking sector, that means that by 2020 large banks in small countries will shrink through asset reduction efforts, business sales and subsidiarisation. (5) Finally, regulatory compliance will be more proactive as banks assimilate to a greater extent the goals of governments and regulators.

Second, technology has been evolving and the banking sector is not immune to its developments. Presently, it is being used to optimize the current products and services, but with the increase and improvement in data collection and treatment, banks will be able to better target costumer’s needs and improve their servicing. Improvements in security will allow for further online banking, and mobile banking will also change the way banking services are provided, thus changing the distribution models. Likewise, changing banks will become easier; hence more banks will be able to have a complete profile of each customer. Given the continuous and still accelerated pace of innovation, banks will have to enable or leverage it, leading them to a customer-centric information and risk-management business. Such trends are expected to impact the banking sector in some of the following ways. (1) In developed markets especially, large branch networks will continue to shrink. Traditional branches, which are expensive, will have to become

3

PWC; Retail Banking 2020: or Revolution?

4

KPMG; Evolving Banking Regulation EMA Edition: Is the end in sight?; February 2014.

Increase in local banking regulation will make it harder for global banks…

Technology reduces the need to have a large branch

(11)

PAGE 11/36

more efficient or less costly, and their concepts will also change (kiosks with specialists, financial advisory services, etc.). In emerging markets, given some of the delay in access to some of the technology, physical branches will still be key. (2) Marketing will grow in importance as technology eliminates some barriers to entry (there is no longer the need to have a major branch footprint). Therefore, regional banks will be able to go national, and new competitors can come in with strong branding and take market share. (3) Banks will have to be low-cost producers with most products profitable by themselves, as changing banks will be easier and new entrants will rely on digital formats. (4) Smartphones will become a major payment device, alongside cards, and biometrics will become a common method of authentication. (5) Lastly, with the need to have more efficient cost structures, banks will likely outsource processing and payments infrastructures or partner with each other to have achieve scale.

Third, concerning demographic transformations, population in developed markets is aging, hence the banking demand being of savings and investments rather than of credit and consumption. Conversely, in emerging markets with a younger population, the eagerness for consumer credit is growing. Also, with the increase in life expectancy worldwide, retirements are now longer, thus the need to restructure both public and private pensions. Furthermore, the global middle class will grow and, manly in Asia and Africa, people will move into the cities, hence increasing the demand for financial services in such locations. These demographic trends are probably going to affect the sector in several forms. (1) Given the increased need for a retirement plan, wealth management will be one of the pillars of retail banking. (2) On the same token, in developed markets, a longer working time means more savings and less debt taking (or more repayment of such), therefore fees will be a greater proportion of the total and interest income a smaller one. (3) Finally, an exodus from the countryside to the cities will increase the number of bank customers.

Fourth and final, with respect to social and behavioral changes, customers are comparing their interactions with the banks to those with other industries and increasingly expect the same high quality service all-around. Also, given the easiness to communicate, the slightest complaint in the corner of the world can echo everywhere impacting from reputation to purchasing decisions. Moreover, customers are distrusting of banks and want them to be more socially responsible. Security and privacy is a concern as well as the increase of personal and financial available being migrated to online platforms. The trends above are expected to influence the banking sector in some ways. (1) Customers will be at the center of the way banks organize their business and not products, that is, offers will be

Demographics will change the weights of the main sources of revenues…

Strong branding and high efficiency will be key…

(12)

PAGE 12/36

tailored to the specificities of each customer. (2) Social media will become the tool banks will use to reach, engage and inform their clients, and in which customers will be able to compare offerings, thus the need for banks to master this instrument. (3) Customer trust will return with some banks participating in the public debate to inform and educate customers on banking and its benefits, and also on the different products it offers. (4) Lastly, and so to rebuild trust, cyber security is extremely important and banks will have to invest in this area.

Balance Sheet

After the crisis the size of the banking system did not shrink. Analyzing the aggregate balance sheets of European banks, there is no overall deleveraging trend in Europe (Fig. 21). However, there is a large disparity, with some countries, namely those hit harder by the crisis, showing a major decline in the past years. On a bank-by-bank analysis, the story is somewhat different. Between 2008 and 2012, individual bank assets have been quite volatile (for example, Barclays decrease 15%, whilst Standard Chartered increased 55%), with several European banks, such as Barclays, Standard Chartered, or Bankia, receiving state aid.5

Deposits

Santander’s customer deposits in 2013 were of EUR 607,837 million and accounted for 49% of the bank’s funding structure. Regarding its geographic distribution, Spain is clearly the single market with the largest share of the group’s deposits (31%) being that the rest of Europe accounts for 43%. Latin America’s deposits weight 19% on the group’s total and the U.S. and Puerto Rico’s 7%. As for the type of deposits, the biggest proportion correspond to fixed-term deposits (37%), followed by current accounts (28%) and by savings accounts (27%). Comparing to some of its peers (Fig. 22), Santander is one of the European banks with a higher amount of deposits.

Liquidity Ratios

A commonly used measure to assess a bank’s liquidity is the Loan-to-Deposit (LTD) ratio. On the one hand, if this is too high, the bank might not have sufficient liquidity to cover any unexpected fund requirements; on the other hand, a LTD ratio too low, may mean that the bank is not earning as much as it could be. Santander has engaged in a strategy to decrease its LTD ratio. The downward trend started in 2008 and has been a result of the group’s ability to generate

5

Dirk Schoenmaker and Toon Peek; The State of the Banking Sector in Europe; OECD Economics Department Working Papers No. 1102; January 2014.

Fig. 21 Euro Area MFIs excluding ESCB reporting Aggregated Total Assets (M EUR)

Source: ECB.

Fig. 22 Evolution of Total Deposits (M EUR)

(13)

PAGE 13/36

liquidity and to attract deposits partially due to the restructuring of some Spanish banks (Fig. 23). In the 3Q’14, the group reported a LTD ratio of 112%, with Santander Consumer Finance (192%), the U.K. (122%), Chile (136%), and the US (144%) as the main drivers of such.

As for some of Santander’s peers (Fig. 24), BBVA, BNP Paribas and Societe Generale have a slightly higher LTD, whereas Bank of America, Citigroup and JP Morgan’s LTD is quite lower. Regarding the latter, which are some of the largest American banks, although the Fed had near-record low interest rates in 2013 designed to boost the economy, consumers and companies were still reluctant to take on risk until they see more signs that business is improving. Moreover, banks, on the aftermath of the global financial crisis and given new federal rules and capital requirements, have been less willingly to borrow funds.

Another liquidity measure is the Liquidity Coverage Ratio (LCR). This is one of the Basel Committee’s major reforms to strengthen global capital and liquidity regulations in order to promote a more resilient banking sector. The LCR is constructed so to improve resilience to short-term liquidity shocks through encouraging banks to hold high-quality liquid assets that can be converted into cash easily and immediately in private markets to meet its liquidity needs for a 30 calendar day liquidity stress scenario. The LCR will be introduced on 1 January 2015 with a minimum requirement of 60% that will increase until the full implementation threshold of 100% (Fig. 25).6

At the end of 2013, both Santander as a whole and its individual subsidiaries had LCR levels of more than 100%. As for its European peers, the European Banking Authority (EBA) has analyzed 357 banks (2/3 of total banking assets in the EU) and has seen that EU banks already show an average LCR of 115%.7 In the US, the rule has been of 80% to 100% from January 2015 to 2017, and, given that several large banks already meet the ratio’s requirements or are close to, it is perceived to be achievable.8

Funding Structure

Funding structures are important for financial stability since a healthy funding structure decreases the chance a bank will fall into distress. Proper capital buffers reduce the probability of default and, ceteris paribus, improve the odds of depositors and debt-holders to be paid back. Bank’s funding structures can be

6

Bank for International Settlements (BIS); Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring tools; January 2013

7

European Banking Authority (EBA); Report on impact assessment for liquidity measure; December 2013. 8

PWC; First take: Liquidity coverage ratio – Less stress, but no real relief; September 2014.

Fig. 24 Evolution of LTD

Source: Company data, Bloomberg. Fig. 23 Evolution of Santander’s LTD

Fig. 25 Minimum LCR Requirement Evolution 2015 2016 2017 2018 2019

60% 70% 80% 90% 100%

(14)

PAGE 14/36

classified by investor type, instrument type, and priority (Fig. 26). Taking the investor type of classification as a start point we have:

(1) Customer deposits: main source of funding in banks whose business model focuses of traditional deposit taking and loan making. The more stable deposits, even though may sound contradictory, are those payable at par and at the customer’s demand. These carry the most liquidity risk because of the duration mismatch with long-term loans. Nonetheless, covering deposits with a credible guarantee scheme can reduce this risk. Less stable deposits include uninsured deposits, foreign currency deposits, and money market funds, among others.

(2) Wholesale funds: are regularly used for investments in financial assets, namely those used in the bank’s proprietary trading. Short-term (ST) secured funds include repos, swaps and asset-backed commercial paper (CP) (suffered in the early stages of the crisis). ST unsecured funds include interbank loans, CP, and wholesale certificate of deposits, and can be volatile in times of distress. Finally, long-term (LT) funds include bonds and several forms of securitization and are less likely to originate abrupt funding difficulties. LT raise less refinancing issues but are quite difficult to refinance in an unstable financial environment.

(3) Regulatory capital: is set to absorb losses before any other creditor. It includes common equity and certain types of subordinated debt.

A bank’s funding structure is determined by several factors. First, even though the historical structure and bank-specific factors matter, regulation has been found9 to play a role. On average, higher-regulation is associated with banks with more deposits and less debt funding (higher deposit-to-asset ratios and lower LTD ratios) (Fig. 27).Second, capital structures change at a very slow pace, with equity funding adjusting faster than debt and deposit funding. Third, larger banks tend to take on more debt and use less equity and deposits to fund themselves. This can perhaps be because investors are more familiar with larger financial institutions. Fourth and final, more traditional and safer banks with more securities and tangible assets and that pay dividends depend less on wholesale funding (lower LTD ratios).

An example of a bank that used wholesale funding is Northern Rock (Fig. 28). On June 2007, retail funds and deposits constituted only 21% of the financial structure and equity just 3%. Northern Rock’s (NR) case was a prime example of how wholesale funding can be challenging in times of crisis. Even though by 2007 is was seen as well capitalized and with good quality mortgage, in the

9

IMF World Economic and Financial Surveys; Global Financial Stability Report – Transition Challenges to Stability; October 2013.

Fig. 26 Types of Bank Funding

By Investor

Type By Instrument By Priority Customer deposits Stable deposits Secured debt Less stable deposits Wholes sale funding S T Unsecured Senior unsecured debt Secured L T Unsecured Secured Regulatory capital (retail/wholesale) Subordinated debt Junior debt Common equity Equity Source: IMF World Economic and Financial Surveys (October 2013)

Fig. 27 Customer Deposits to Total (Non-interbank) Loans Ratio (2013 Q4)

Denmark Finland 29,01 53,38 Portugal 79,38 Germany Spain 84,54 84,85 Brazil 118,46 Argentina 134,22 Lebanon Afghanistan 286,89 403,19

Source: IMF Data.

Fig. 28 Northern Rock Balance Sheet growth and liability structure (M GBP)

(15)

PAGE 15/36

summer of 2007 with the sub-prime crisis, NR was facing the possibility of not being able to tap the securitization and covered bonds markets and be difficult to secure new money market funding or rolling over existing market borrowing. By mid-September, NR had no longer access to long-term finance.10

Fig. 29 Santander’s Funding Structure Evolution

Source: Company Data

Santander’s funding structure, on the other hand, reflects its traditional and safe deposit taking and loan making business model (Fig. 29). The main funding source is, and has been sine 2008 at least, customer deposits, which have actually been increasing its weight in the funding structure. Also, Santander, with a major part of its business in an advanced economy, and, despite all, being a Spanish bank, is subject to high disclosure requirements.

Comparing Santander’s funding structure with that of some of its peers (Fig. 30), US banks rely more on deposits to fund themselves than Santander and the rest of its peers. It is also noteworthy that big European banks like Barclays, BNP Paribas, and Societe Generale are using very few deposits and equity financing, relying mostly on debt. The funding structures of some banks, namely of those in distress, has not improved much since the crisis and they remain vulnerable.

Loans

According to BIS data (Fig. 31), credit growth to the non-financial sector has been weak in many advanced economies, namely in the Euro Area and in the US. In Brazil and Mexico credit growth has been stronger, nonetheless, it has also been more volatile.

Access to credit has been relatively constraint, especially after the global financial crisis, due to both constraints on the collateral and the debt overhang. Regarding the first, the decline of asset prices (Fig. 32), leads to a decrease in

10

Bank of England; Financial Stability Report; October 2007; Issue No 22.

Fig. 30 Funding Structures (2013)

Source: Company data, Bloomberg.

Fig. 31 Credit to non-financial sector Growth

(16)

PAGE 16/36

the value of the collateral and hence the amount that one can borrow. This also has implications in the interbank markets as lower collateral prices lower the amounts banks will lend each other and, thus, once again tightening credit supply. As for the latter, highly in debt firms may choose to focus on their current loans or banks may not want to grant them more loans. Companies in this position often see themselves not being able to pursue profitable businesses. As for highly leveraged banks, they may struggle to obtain funding, thus not have the liquidity to make more loans, leading to a contraction of the credit supply.

Fig. 33 Santander’s Loans Breakdown

by Geography (2013) Fig. 34 Santander’s Loans Breakdown by Activity (2013)

Santander’s credit portfolio is concentrated mainly in Europe (25% in Spain and 47% in the rest of the EU) with Latin America also being a considerable region (19%) (Fig. 33). Most loans granted were to households (59%) of which 43%, of the total loans, were to residential, 14% to consumer loans and 2% to other purposes. Loans for non-financial companies are the next large proportion with 3% to construction and property developments, 1% to civil engineering constructions, 19% to large companies and 11% to SMEs and individual traders (Fig. 34). Loans to the public sector and to other financial institutions correspond to 3% and 4%, respectively.

Santander’s Non-Performing Loans (NPL) (Fig. 35) and the corresponding NPL ratio (Fig. 36) have been increasing due to a number of factors. Besides the countrywide recession, on June 2013, Spain carried out a reclassification of substandard loans. In Portugal, lending dropped due to deleveraging throughout the banking system. In Poland, the NPL ratio was affected by the integration of Kredyt Bank’s businesses. And finally, in Mexico, there was an extraordinary reclassification of loans to the social housing sector.

The adverse macroeconomic conditions felt worldwide led to a deterioration of the NPLs. In figure 35 it is possible to see that all banks saw an increase in the NPL from 2008 to 2009. Nonetheless, some regions have been able to bounce back quicker than others. In the US, according to the Q3 2014 Bank Lending and Default Report by Chandan Economics, banks are seeing default rates declining Fig. 32 Euro Area Residential Property

Prices (2007=100)

Source: ECB.

Fig. 35 Non-Performing Loans (Million EUR)

Source: Company data, Bloomberg. Fig. 36 Non-Performing Loan Ratio

(17)

PAGE 17/36

reflecting the shrinking legacy of distress and new production. Conversely, in Europe, the effect of the crisis in the financial system was more severe and recovery has been slower.

Income Statement

Fig. 37 Net Interest Income (Million EUR) Fig. 38 Net Interest Margin

In the past 3 years, Santander’s Net Interest Income has been decreasing slightly (Fig. 37) due to reduced spreads aligned with an environment of interest rates at record lows in mature markets and the change of mix toward lower risk products in some markets. Still, in the UK, there was a favorable evolution of the net interest income; in Spain, mainly due to deleveraging, mortgage re-pricing and the higher cost of funds, it has dropped; and, in the Latin American countries, the decrease was driven by Brazil. Comparing to its peers, Santander has the highest Net Interest Margin standing out particularly from its European competitors (Fig. 38)

Santander has the lowest efficiency ratio (cost/revenues) among its peers (Fig. 39). Improving efficiency has been one of the group’s management drivers with the global plan to create synergies up to 2016. Regarding the ROA and the ROE, once again the American banks stand out (Fig. 40).

Regulatory Capital

Capital Requirements

The European Banking Authority’s (EBA) 2014 stress tests reflected the recapitalization effort following the 2011 results (Fig. 41). The tests assumed a pessimist scenario in which the EU economy would go into a two-year recession, shrinking 0.7% and 1.5% in 2014 and 2015 respectively, and growing slightly in 2016. With unemployment hitting record values, house and stock prices collapsing, and interests rates on government and corporate debt spiking. Banks would pass if they had a core capital buffer of 8% for the base scenario and of 5.5% for the adverse one. All in all, 24 of the 123 banks failed the test.11

11

Results of 2014 EU-wide stress test – Aggregated results; European Banking Authority; 26 October 2014.

Fig. 40 ROA and ROE (2013)

Source: Company data, Bloomberg. Fig. 39 Efficiency Ratio

Fig. 41 Evolution of Core Tier 1 ratios for major EU banks

(18)

PAGE 18/36

Overall, both Santander and the selected European peers passed the stress test (Fig. 42). From this sample, Santander is the bank generating most capital in the baseline scenario (160 b.p), followed by HSBC (120 b.p). Societe General, on the contrary, would have an impact on the CET1 ratio in the base scenario (-10 b.p). In the adverse scenario, the lowest impact would be the one of Santander and of BBVA (-150 b.p) and the highest would belong to Societe Generale (-260 b.p.).

Basel III

Basel III capital regulations (Fig. 43) foster higher levels of minimum equity capital and improve its quality, making any debt safer and cheaper. Despite setting the minimum total capital requirement at the same level as Basel II (8%), the quality of the capital is now higher, demanding a CET1 of 4.5% - percentage of risk weighted assets (RWA) that has to be of higher quality capital. Furthermore, Basel III is stricter on the criteria to set what qualifies as CET1, additional Tier 1 capital, and Tier 2 capital, and adds several buffers. With no changes in assets, higher capital buffers ought to decrease the probability of default, and thus reducing the costs of debt independently of the rest of the funding structure and also the cost of equity as the equity beta should decrease with lower leverage. Global systemically important banks, given its role in financial stability, are subject to extra conditions.

In the aftermath of the financial crisis, regulators set out to align the investors incentives with bank’s low risk taking and to increase the private sector contribution in resolving failed banks, and thus reducing the fiscal costs. Therefore, Basel III raised the loss-absorbing capacity of debt that qualifies as additional Tier 1 and Tier 2 capital, enhancing protection on senior debt. Namely, authority ought to have power to write off or convert these other instruments to common equity if the bank is deemed nonviable.

Tier 1 Capital Ratios (Fig. 44) are above the minimum regulatory requirement, nonetheless, as the full implementation of the Basel III standards is going to raise both the quantity and the quality of capital that banks have to meet, in 2013, some banks saw their ratios decrease. Comparing the Tier 1 ratios with simple leverage ratios (Fig. 24), there seems to be conflicting signals regarding balance sheet strength. In part, this is due to differences in business models and regulatory environments. European banks’ model (Universal Banking) will unsurprisingly lead to larger balance sheets, whereas the North American banks’ model (Originate-to-Distribute) leads to smaller ones. This duality is combated with supplementing leverage ratios as proposed by Basel III.

Fig. 42 Stress test results

Source: EBA.

Fig. 43 Basel III Phase-in Arrangements Phases 2013 2019 Minimum Common Equity

Capital Ratio 3.5% 4.5%

Capital Conservation Buffer --- 2.5%

Minimum common equity plus capital conservation bufffer

3.5% 7.0%

Phase-in of deductions

from CET1 --- 100%

Minimum Tier 1 Capital 4.5% 6.0%

Minimum Total Capital --- 8.0%

Minimum Total Capital plus

conservation buffer --- 10.5%

Source: BIS.

Fig. 44 Tier 1 Captial Ratio

(19)

PAGE 19/36

Valuation

The EUR 6.92 target price was derived from the sum-of-the parts valuation using a discounted cash flow to equity model to model the Continental Europe, UK, Brazil, Mexico, Chile, rest of LATAM, US, and Corporate Activities operations. Such method was used because separating the financing and the investing decisions from the operating decisions of a bank would not make sense. The cash flows are projected individually for each geographic segment and in the local currency.

Cost of Equity

The Capital Asset Pricing Model (CAPM) was used to determine Santander’s cost of equity. The market risk premium applied was of 5.5% and the risk free rate was of 0.89% (10 year German bunds). As for the beta, we regressed Santander’s excess return to the MSCI World Index excess return (using monthly data for the past 5 years). The beta yielded 1.18, thus a cost of equity in EUR of 7.38%. The cost of equity in each remaining country reflects the differential in the expected inflation rates from Europe to the several countries (Fig. 45).

Scenarios

In order to minimize the risks of making inaccurate assumptions when valuing Santander, the final target price incorporates the following four scenarios.

Base Scenario

The base scenario incorporates the International Monetary Fund’s (IMF) forecasts for the GDP growth rate and for the inflation rate for each geographical segment (Fig. 46 and 47). The ECB has been decreasing interest rates, with the deposit facility at -0.20% annum effective from the 10th of September, the Net Interest Income (NII) margin is expected to increase, namely in Continental Europe, thus helping the top line. The cost savings program is expected to continue, although, given that Brazil is a major part in this, it will be somewhat offset by high inflation. Santander’s overall liquidity ratio (LTD) is expected to continue to decrease and the CET1 ratio is forecasted to reach 11.75% in 2015. The base scenario yields an overall share price of EUR 6.94, with the following breakdown: Continental Europe EUR 3.23, the UK EUR 1.73, the rest of LATAM EUR 0.49, Brazil EUR 0.91, Mexico EUR 0.45, Chile EUR 0.29, USA EUR 0.77, and Corporate Activities EUR -0.91.

Fig. 45 Cost of Equity

Currency Cost of Equity

EUR 7.38% GBP 8.54% BRL 13.51% MXN 10.96% CLP 11.50% USD 8.91% Source: Analyst’s estimates.

Fig. 46 GDP Growth Rate

Source: IMF

Fig. 47 Inflation Rate

(20)

PAGE 20/36

Pessimistic Scenario

In the pessimistic scenario a clear distinction was made between developed economies and developing ones. In Continental Europe, the UK, and the US, it was built a scenario in which GDP growth would be lower than the IMF’s projections and inflation higher. This would be an economic environment with higher unemployment, thus banks would have to rise provisions and NII would be lower has loan restructurings would take place. The share price for Continental Europe would then be EUR 2.23, for the UK EUR 1.12, and for the US EUR 0.31. Regarding the Latin American countries, it is examined a harsher scenario that mimics some of the banking system’s difficulties during the 2001-02 crisis in Argentina. First, an analysis of the linkage between country and bank risk will be performed followed by the application of the Argentinian example to Santander’s operations in LATAM.

Usually, sovereign defaults are connected with severe economic downturns (most past sovereign defaults have been followed by economic recessions). They also typically lead to a loss of investor confidence and capital outflows, often culminating in a systemic banking crisis and a foreign exchange crisis.12 For banks in particular, sovereign risks are transmitted through (1) a bank’s holdings of government securities or exposure to related public sector entities, (2) a bank’s dependence on ongoing market access for funding, and (3) the macroeconomic environment that originates the bank’s performance13. This transmission of risks was quite evident during the European sovereign debt crisis, namely in Greece (Greek banks were fairly well going into the crisis into 2008, but with the country’s debt crisis they were deemed insolvent).

Firstly, regarding sovereign exposures, domestic banks are important creditors to the government. Even more so in emerging markets where local regulation tends to favor domestic sovereign debt and in which there is limited access to high rating and liquid debt instruments in the domestic currency. Therefore, in the event of a sovereign default, the losses are directly transferred to the banks’ balance sheets. Secondly, for banks that rely heavily on market funding, a sovereign debt crisis can cut one of their main funding sources. This happens because concerns regarding a bank’s holdings of sovereign debt arise, leading to a negative market sentiment and thus an increase in the cost of funding or even a shutting of the interbank and wholesale funding markets. Thirdly, sovereign distress periods are characterized by falling demand, high inflation, high interest rates, capital outflows, and exchange rate depreciation. This results in a

12

How Sovereign Credit Quality May Affect Other Ratings; Moody’s Investors Service; February 13, 2012.

13

Banks and Sovereigns: Risk Correlations Constrain Standalone Bank Credit Assessments; Moody’s Investors Service;

(21)

PAGE 21/36

decrease of bank’s asset quality and increase of non-performing loans (businesses and individuals are no longer able to meet their payments), there is a risk of a deposit run (confidence in the banking system is shaken), and the capacity to pay for foreign-currency debt obligations is reduced (income is in rapidly depreciating local currency). Regardless, given that Santander is a foreign bank in LATAM, this may serve as a buffer to some country risk.

In the Argentinian crisis example, in 2002, GDP had decreased 10.90% and inflation was at 25.90% (Fig. 48). As for the banking sector, not all banks were equally affected14. Between January 1995 and December 2001, the loan to assets ratio fell from 68.8% to 45.8% in foreign banks (65.7% to 49.0% in the overall banking system) and the LTD ratio fell from 118.7% to 85.1% (119.9% to 86.7% in the overall banking system) (Fig. 49). After the shock of the crisis, the banking activity was hindered. Although deposits started recording positive growth in annual terms in September 2002, credit to the private sector only reached a positive YoY growth in July 2004 and private banks just returning to profits in 2003.

All in all, in this scenario, the share price for Brazil is EUR 0.24, for Mexico EUR 0.20, for Chile EUR 0.03 and for the rest of LATAM EUR 0.12. Therefore yielding an overall price of the pessimistic scenario of EUR 3.39 (EUR -0.86 for Corporate Activities).

On a final note on this scenario, although the triggers for crisis have had many forms, some of the symptoms have been common among countries in distress. Some of these are too much borrowing mainly lent by foreigners and in a foreign currency, a current account deficit, weak or declining growth prospects, and high or uncontrolled inflation. In the Argentine case, the overvalued fixed exchange rate and with too much foreign debt were the two main causes.15

Optimistic Scenario

In the optimistic scenario the economic conditions are expected to be better than the IMF projections. The overall share price is thus EUR 7.92, with the following breakdown: Continental Europe EUR 3.67, the UK EUR 2.07, the rest of LATAM EUR 0.54, Brazil EUR 0.93, Mexico EUR 0.52, Chile EUR 0.37, USA EUR 0.84, and Corporate Activities EUR -1.01.

14

Adolfo Barajas, Emiliano Basco, V. Hugo Juan-Ramón, and Carlos Quarrancino; Banks During the Argentine Crisis:

Were They All Hurt Equally? Did They All Behave Equally?; IMF Staff Papers Vol. 54 No. 4 pp. 621-662; 2007

International Monetary Fund. 15

Martin Feldstein; Argentina’s Fall – Lessons from the Latest Financial Crisis; Foreign Affairs Vol. 81 No.2 pp. 8-14; March/April 2002.

Fig. 48 Argentine Crisis

Source: IMF

Fig. 49 Argentine Banking Data (M ARS)

(22)

PAGE 22/36

Regulatory Change Scenario

In this scenario it is examined how Santander would be impacted if the regulator were to impose higher capital requirements. Assuming that the Modigliani-Miller’s theorem16 does not hold, thus assuming that changes in a bank’s capital structure affect its funding costs, an increase in the capital requirements imposed by the regulator would increase a bank’s funding costs. However, Schanz et all17

have found that the suitable capital requirements ought to be between 10-15% of RWA as, within this range, the average cost of funding of a bank is not substantially affected in the steady state. Furthermore, and regarding on how an increase in the capital requirements affects a bank, Bridges et all18 have found that an increase in the capital requirements actively affects a bank and is not simply absorbed by the capital buffer that was held above the regulatory minimum. That is, banks tend to restore their capital buffer following an increase in the requirements. They have estimated that in the year following a one percentage point increase in the capital requirement, banks increase their ratio by 0.4pp, after 3 years by 0.9pp, and in the fourth year the initial buffer is reestablished. Furthermore, this change also leads banks to reduce the lending activity, although loan growth mainly recovers after 3 years.

Nonetheless, both studies mentioned above were conducted using data from UK banks. Hence, the impact of a change in regulatory requirements can be somewhat different if it is done for all banks at once. In this case banks might not all restore their capital requirements at the same rhythm.

To build up this scenario the above was taken into account, thus the scenario is of an increase in the CET1 to 10% (increase of 4pp). Also, it is assumed that a regulator would only increase capital requirements if the economy were somewhat healthy, that is, in our base and optimistic scenario. Hence, we have that in the event of a regulatory change in whilst in the conditions of the base scenario the overall share price is thus EUR 5.50, with the following breakdown: Continental Europe EUR 2.38, the UK EUR 1.48, the rest of LATAM EUR 0.42, Brazil EUR 0.79, Mexico EUR 0.40, Chile EUR 0.25, USA EUR 0.68, and Corporate Activities EUR -0.90. In the conditions of the optimistic scenario the overall share price is thus EUR 7.24, with the following breakdown: Continental Europe EUR 3.37, the UK EUR 1.99, the rest of LATAM EUR 0.49, Brazil EUR

16

Franco Modigliani and Merton H. Miller; The Cost of Capital, Corporation Finance and the Theory of Investment; The American Economic Review Vol. 48 No.3 pp. 261-297; June 1958.

17

Jochen Schanz, David Aikman, Paul Collazos, Marc Farag, David Gregory, and Sujit Kapadia; The long-term economic

inmpact of higher capital levels; BIS Papers No. 60 pp. 73-81; December 2011.

18

Jonathan Bridges, David Gregory, Mette Nielsen, Silvia Pezzini, Amar Radia and Marco Splatro; The impact of capital

(23)

PAGE 23/36

0.85, Mexico EUR 0.49, Chile EUR 0.34, USA EUR 0.78, and Corporate Activities EUR -1.08.

Perpetuity Analysis

Given the large weight the perpetuity has on the valuation (Fig. 50), we will analyze further with the help of sensitivity analysis and of a Dupont analysis. The perpetuity component of the valuation is projected using the last estimated ROE, the equity value of the last estimated year, the dividend payout ratio and the cost of equity. Each scenario yields a different ROE and dividend payout ratio (Fig 51), as each assumes different conditions in which Santander will be. However, it is important to see how the share price would change if the expected profitability of Santander and the banking sector would change (Fig 52).

Fig. 52 Sensitivity Analysis of the Share Price (EUR) to the ROE

Scenario Return on Equity

4% 5% 6% 7% 8% 9% 10% 11% 12%

Pessimistic 3.09 3.93 4.76 5.56 6.35 7.13 7.89 8.65 9.39

Base 5.05 5.90 6.72 7.52 8.29 9.04 9.76 10.46 11.15

Optimistic 5.39 6.28 7.14 7.98 8.81 9.61 10.40 11.17 11.93

Base with Regulation 4.19 5.16 6.11 7.03 7.94 8.82 9.69 10.54 11.37

Optimistic with Regulation 4.74 5.84 6.93 8.02 9.09 10.16 11.23 12.29 13.35

Source: Analyst’s estimates.

Overall, each additional increase in the ROE has an increasingly smaller relevance on the share price. Also, a Dupont analysis was conducted on the last FCFE, from which the perpetuity is derived, and for each scenario (Fig. 53).

Fig. 53 Composition of 2021E ROE using the Dupont Analysis

Scenarios Pessimistic Base Optimistic Base with Regulation

Optimistic with Regulation

All EU Banks a

Large EU Banks a Return on Equity (ROE) 4.35% 6.27% 6.93% 5.35% 6.28% 2.19% 2.92%

ROE is the

of:

ROA 0.48% 0.70% 0.78% 0.64% 0.78% 0.13% 0.16%

Equity Multiplier 9.02 8.91 8.87 8.33 8.04 16.84 18.25

ROA is the of:

Net Interest Income %

Assets 2.39% 2.41% 2.47% 2.39% 2.47% 1.29% 1.23%

Net Non-NII Operating

Income % Assets 1.05% 1.14% 1.14% 1.12% 1.14% 0.94% 0.95%

Net Non-Operating Income

% Assets -0.22% -0.23% -0.23% -0.23% -0.23% NA NA

Operating Costs % Assets -1.79% -1.65% -1.62% -1.68% -1.62% -1.45% -1.43% Loan Loss Charges %

Assets -0.77% -0.69% -0.69% -0.70% -0.69% NA NA

Group Tax % Assets -0.17% -0.27% -0.30% -0.25% -0.30% NA NA

NII % A is the

of:

Net Interest Margin 3.09% 3.15% 3.23% 3.17% 3.23% 2.34%b 2.09%b

Earning Asset Ratio 77.33% 76.51% 76.52% 75.60% 76.52% 55.13%c 58.85%c Source: Analyst estimates, ECB.

a

Data for the year 2013 from the Statistics on Consolidated Banking Data.

b _{Not given explicitly by the ECB. Calculated using only Loans and Trading Assets as the interest bearing assets, thus it is likely to be}

overestimated.

c

Calculated with the NII % Assets and the NIM.

Fig. 50 Breakdown of the Equity Value

Source: Analyst estimates.

Fig. 51 ROE and Dividend Payout

Scenario ROE Dividend

Payout

Pessimistic 4.35% 105% Base 6.27% 111% Optimistic 6.93% 107% Base with

Regulation 5.35% 107% Optimistic with

(24)

PAGE 24/36

Analyzing the table above and comparing Santander’s ratios with the consolidated data for all EU banks and for large EU banks enables us to:

• Establish that Santander’s estimated ROE comes from having a high ROA and not from having a high balance sheet leverage (determined by the equity multiplier, or the assets % equity ratio). Regardless, this is not a clear indicator of balance sheet risk as different assets have different levels of risk. Hence, the need to look at CET1 ratio, which are weighted on RWA, to establish balance sheet risk.

• Determine that Santander’s ROA are mainly driven by NII. This is a sign of good earnings quality as a higher proportion of earnings is derived from NII rather than from a more volatile non-operating income or from low loan loss charges points towards better asset quality. The NII is able to offset the high operating costs and loan loss charges. One of the major key drivers of such is the high lending margins Santander enjoys in Brazil (as discussed in the “Retail Banking Trends” chapter, for developed economies the NII will tend to decrease in importance).

E CONOMICS, EXCLUSIVELY FOR ACADEMIC PURPOSES.T HIS REPORT WAS SUPERVISED BY

M

ASTERS IN

F

INANCE

M

ASTERS IN

F

INANCE

E

QUITY

R

ESEARCH

B

ANCO

S

ANTANDER

C

OMPANY

R

EPORT

B

ANKING

6

J

2015

S

TUDENT

:

P

ATRÍCIA

O

VÍDIO

patricia.ovidio.2013@novasbe.pt

Leaving the European crisis behind

But facing uncertainty in Latin America

Table of Contents

COMPANY OVERVIEW ... 3

MACROECONOMIC CONTEXT ... 5

BANKING SECTOR ... 9

VALUATION ... 19

APPENDIX ... 26

Company Overview

History

Shareholder Structure

Macroeconomic Context

Europe

The Americas

Banking Sector

Retail Banking Trends

Balance Sheet

Deposits

Liquidity Ratios

Funding Structure

Loans

Income Statement

Regulatory Capital

Capital Requirements

Basel III

Valuation

Cost of Equity

Scenarios

Base Scenario

Pessimistic Scenario

Optimistic Scenario

Regulatory Change Scenario

Perpetuity Analysis