Only capital can fix Santander's discount

It's not easy being Ana Botin. The Banco Santander executive chair is pushing through a heavy restructuring programme, and delivering robust results, particularly in Latin America. Still, until the Spanish lender bolsters a capital ratio which languishes well below her peers' average, she will struggle to revive its lowly valuation.

Santander's full-year results, released on Wednesday, look worse than they really are. The 60 billion euro bank delivered a 9.3 percent return on equity, a decline from last year's 11.7 percent. But restructuring charges - predominantly in Europe - made up most of 1.7 billion euros of one-off costs, compared to 250 million euros in 2018.

Strip out those hits, and Santander's pre-tax profit actually grew by 1 percent year-on-year to 14.9 billion euros. With the exception of the UK, which is struggling with the country's exit from the European Union, underlying profit rose in every major market, powered by double-digit growth in Brazil and Mexico, its two biggest Latin American subsidiaries. The underlying return on tangible equity was an impressive 12 percent. Botin hopes to crank this up to between 13 percent and 15 percent over the medium term.

Yet shareholders don't seem convinced. Assuming a 10 percent cost of equity, the lender's underlying 12 percent ROTE implies that its shares should trade at a premium to tangible book, rather than a 15 percent discount. The reason for investor scepticism is probably capital.

True, Santander is steadily getting stronger. Its common equity Tier 1 capital ratio rose to 11.65 percent last year, drawing closer to Botin's target of 12 percent. Assuming the bank produces another net 35 basis point of capital, as it did in 2019, it should fulfil that aim this year.

Even then, Santander's capital ratio would look lightweight compared to a European average CET1 capital ratio of 14.6 percent. That leaves little cushion if the global economy were to suffer a sharp downturn. Moreover, a capital hit of 62 basis points last year due to regulatory "headwinds" may not be the last, given looming stricter requirements, such as higher risk-weightings on some banks' trading assets.

The 3 percent share price jump on Wednesday suggests Botin is at least heading in the right direction. Still, at the current rate, closing the capital gap with European peers could take years. If Botin can assuage investors' anxiety more quickly, the bank's valuation discount will close.

Banco Santander on Jan. 29 reported a 11.7 percent year-on-year fall in pre-tax profit for 2019 to 12.5 billion euros, in part due to higher restructuring costs. Revenue rose by 1.7 percent to 49.2 billion euros.

Spain's largest lender said its cost-to-income ratio of 47 percent was unchanged year-on-year. Its common equity Tier 1 capital ratio rose to 11.65 percent from 11.3 percent.

The Madrid-based bank reported a return on tangible equity of 9.3 percent for the year, compared to 11.7 percent a year earlier. Excluding one-off costs, the lender said its underlying ROTE was 11.8 percent, compared to 12 percent in 2018. Santander targets a ROTE of between 13 percent and 15 percent in the medium term, and said it planned to maintain a CET1 capital ratio of between 11 percent and 12 percent.