Banco de Sabadell Dogged By Weak Earnings And A Heavily Discounted Valuation

One of the most common pieces of advice you’ll find on investing is not to buy stocks on the expectation of a buyout. Personally, I’d attach an asterisk to that – it’s fine to buy a stock where a takeout is a credible part of the thesis, but make sure you can live with owning the stock on its own merits, at least for a while. That brings me to Banco de Sabadell (OTCPK:BNDSY) (SAB.MC) – a top-five bank in Spain that is struggling to deal with weak spreads, elevated loan losses, and a weak UK subsidiary.

Banco de Sabadell has been linked to both BBVA (BBVA) and Santander (SAN) as a potential merger partner, and further consolidation of the Spanish banking sector would make sense for either bank – Sabadell would expand their business lending operations and create some meaningful cost-reduction opportunities.

As I’ve said in the past, banks that sit at either end of the return on tangible common equity curve (especially high or low) can trade at distorted multiples relative to more “normal” peers, and that’s the case here. With weak growth prospects over the next few years, Sabadell trades at less than 20% of its tangible book value. I don’t love Sabadell, and I think it’s tough to generate long-term gains in banks that can’t earn their cost of equity, but I do think the valuation and capital can support a speculative play on a buyout bid.

Will One Of The Bigger Banks Bite?

There has been significant consolidation in the Spanish bank sector since the global financial crisis, as larger banks took advantage of the opportunity to acquire smaller players with crippled capital structures but worthwhile deposit and lending operations. Sabadell itself has a history here, doubling its size since 2007 through over a dozen in-market acquisitions.

Now the question is whether it’s time for Sabadell to be consolidated. With an efficiency ratio in the mid-60%’s (mid-to-high 50%’s for the core Spanish operations), Sabadell isn’t a particularly efficiently-run bank, and the company is “top-heavy” in terms of having significant corporate-level expenses. Management has started to target costs more aggressively, but it’s going to be a multiyear process before there’s improvement, and both BBVA and Santander would likely be able to cut significant costs out of the operation.

Sabadell also has a credit situation that’s far less than ideal. Elevated non-performing loan balances are the norm in Spain, but Sabadell’s adjusted NPL ratio of 5.0% is quite a bit higher than the sector average of 3.8%. Sabadell has improved its credit quality metrics significantly over the past decade, but clearly there’s still a lot of work to do.

Still, Sabadell is a meaningful player in the space. The bank has double-digit loan share in Spain and has a larger position in corporate and SME lending – acquiring Sabadell would more than double BBVA’s Spanish corporate lending book, for instance.

There are good arguments for a deal taking place, and with Sabadell having healthy reserves (around 8% of total loans) and capital, I believe the risk of surprisingly adverse losses would be manageable. Not only would Sabadell give BBVA or Santander over 20% share in Spain, the cost-cutting opportunity would almost guarantee decent-to-good accretion, and that’s all the more valuable at a time when weak rates are going to make it a real struggle for any bank to generate meaningful core growth.

What would a deal look like? Even with Sabadell’s feeble near-term return prospects, the shares should trade closer to one-third of tangible book, and a buyout based on a more normalized long-term ROTCE would probably see a 0.6x multiple of tangible book. I don’t think Sabadell is likely to see that high of a bid, but honestly anything more than 0.4x would represent significant upside to today’s price. One caveat – bank valuations are near historically low levels, and Sabadell is viable on a standalone basis, so I could see management being unwilling to accept an “opportunistic” bid (something lower than 0.5x to 0.6x TBV).

The Standalone Prospects Aren’t Great… But They’re Not This Bad

Given the extremely low rates in Europe (some bond yields were negative not all that long ago), it’s going to be a struggle for spread lenders to make much headway for the next few years, and Sabadell is overwhelmingly a spread lender (net interest income is 75% of revenue). Weak economic conditions are going to keep a lid on loan growth for a little while longer, and while management is saying the right things about reducing corporate costs, the timing on meaningful operating cost reductions is uncertain.

Non-performing loan balances remain elevated, but the bank looks well-reserved and new non-performing loan formation has been moderate. The “but” here is that I wouldn’t expect bad debt formation to be all that high yet; that could be coming in a few quarters. With a CET1 ratio of almost 12%, I think Sabadell can withstand my expected cumulative 250bp-350bp of charge-offs through the cycle.

Beyond this current challenging setup, I see mediocre prospects for Sabadell. Spanish corporate lending demand should improve from here, particularly with government assistance programs ending, and I see further credit improvement over time. That said, I struggle to see how Sabadell will ever exceed mid single-digit returns on equity without significantly higher rates than I currently expect and/or significant progress on cost reductions. Along those lines, while management has taken steps to improve the performance of its UK subsidiary TSB, this too is not a particularly good bank and the UK’s issues with Brexit have increased the near-term pressures.

The Outlook

On its own, and without substantial improvement in rates or cost efficiency, it could take the better part of a decade to regain 2019 levels of profitability, and my base-case assumptions never have the bank coming all that close to out-earning its cost of equity. Such is the negativity on the stock, though, that even if I expect core earnings to decline around 1% (annualized) over the next decade, the shares still look significantly undervalued.

The Bottom Line

To be very clear, I’m not suggesting that Sabadell is an underappreciated gem. What I’m suggesting is that the market is pricing in way too much risk relative to the bank’s long-term earnings power. Even if Sabadell’s long-term future is that of a mediocre, under-earning bank, it is worth more than this. I think the best outcome here would be a buyout, and I think there’s enough long-term “core value” to underpin the shares even if it takes a while for a bid to materialize. I’m not recommending such a speculative play, but I can see the appeal for more risk-tolerant investors.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Financial Advice

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