banco de sabadell s.a. company report - run: …€¦ · · 2017-02-03€498 million in profit...

THIS REPORT WAS PREPARED BY “STUDENT’S NAME”, 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)

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MASTERS IN FINANCE

EQUITY RESEARCH

The Spanish banking sector saw in the last years a quick

accumulation of foreclosed assets and profits quickly fell with the

international financial crisis and the real estate bubble burst. This

made banks susceptible to developments in the market due to high

exposures to the real estate sector, meanly through loans. ROEs

has been falling below opportunities cost of capital driven by

deteriorations of the banks’ financial statements.

The acquisition of Banco de Sabadell, .S.A. (SAB) of TSB Banking

Group PLC (TSB) on 2015 was financed on a capital neutral basis.

SAB’s current CET 1 ratio is 11.6% and the deal funded with €0.9

billion cash and €1.5 billion shares implied a capital neutral

transaction. Synergies were one of the drivers of the acquisition.

We expect SAB to substantially change TSB’s cost base

potentially leading to higher earnings from TSB, expecting for

FY2016e synergies of €245 million.

The Discounted cash flow to equity model was performed

to value both, SAB prior the acquisition and TSB. The target value

for the FY2016e resulted from the Sum of the parts valuation. The

target price of €2.3 per share implies an upside of 39% to the

current share price of €1.6, and our recommendation is to buy.

Company description

Banco de Sabadell, SA is Spain’s fifth largest banking group and it is structured in five areas, Commercial Banking (largest Group’s business lines); Corporate Banking and Global Operations; Markets and Private Banking; BS America; and Bancassurance; as well as Other Businesses. Its shares are currently listed on three stock exchanges located in Madrid, Barcelona, Bilbao and Valencia (the “Spanish stock exchanges”) and are traded on the Sistema de Interconexión Español (SIBE), the automated quotation system of the Spanish stock exchange.

BANCO DE SABADELL, S.A. COMPANY REPORT

BANKING SECTOR 08 JANUARY 2016

STUDENT: NARYARA NARANJO BUJARDÓN [email protected]

Looking back to look ahead?

Only future matters.

Recommendation: BUY

Price Target FY16: 2.3 €

Price (as of 8-Jan-16) 1.6 €

Reuters: SAB.MC, Bloomberg: SAB SM

52-week range (€) 1.54-2.42

Market Cap (€m) 8,888

Outstanding Shares (m) 5,439

Source: Bloomberg

Source: Bloomberg

(Values in € millions) 2014 2015F 2016F

Net Interest Income 2,260 3,833 4,224

Gross Income 4,801 6,417 6,211

Net Income 372 884 726

Cost/Income 43% 49% 46%

Return on Equity 3% 7% 6%

Return on Assets 0.2% 0.5% 0.4%

NPLs ratio 12.3% 9.6% 9.8%

Risk-Weighted Assets 74,418 107,025 107,260

CET 1 Ratio 11.7% 11.6% 12.5%

Source: Company Data and Analyst’s estimates

http://www.novasbe.pt/


PAGE 2/32

Table of Contents

Executive summary 3

Company overview 4

History

Business Strategy

Shareholders structure

5

5

5

The Sector 6

European Banking Sector 6

Spanish Banking Sector 9

Funding Structure 10

Cost of Funds 12

Profitability 13

Regulatory Capital 15

Basel II 15

Basel III 15

Stress tests 17

Valuation 19

Sabadell’s Valuation 19

Sensitivity Analysis 24

TSB’s Valuation 26

Sum of the Parts Valuation 28

Multiples Valuation 29


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Executive summary

Based on nominal GDP statistics Spanish economy is in the 5th place among the

largest economies in the European Union (EU) and the 4th largest in the

Eurozone. However, any country escaped from the International Financial Crisis

of 2007-2008, the economy contracted by 1.4% in 2012 and remained in

recession until the 3Q of 2013. Situation for banks became challenging with the

crisis; high reduction in assets, declines in the mean sources of fund and large

increases in equity (driven also due tighten regulatory requirements).

But despite of that Spain has started to show improvements in the overall

economy, its nominal GDP growth rate has started to reach positive figures since

the 1Q of 2014 and unemployment has begun to decline. Moreover, Standard &

Poor’s upgraded its credit rating for Spanish public debt to BBB+ with a stable

outlook.

Under this context SAB has been able to increase in terms of scale in recent

years inside and outside Spain. With the latest acquisition of the bank TSB in the

UK, expectable growing cash flows has been forecasted from 2016 onwards and

cost savings. TSB entered to compete in a stable economy where the

unemployment rate of the active population has fallen to 5.4% and wages have

increased by nearly 3% YoY. Moreover great expectations regarding an increase

of the interest rates sooner than in the Eurozone are arising, especially after the

latest decision of the U.S Federal Reserve (Fed) to increase the interest rates by

0.25% and assured a gradual pace of increases.

SAB’s Net interest income remains resilient primarily benefit from the continued

reduction in both wholesale and retail funding costs, offsetting the negative

impacts of lower Euribor levels and pressure on loan yields, our forecasts

resulted in an increase by 3% YoY of NII from FY2016e until FY2019e.

Trading revenues remained a key driver during the last years allowing to increase

significantly the level of NPL provisioning and improving asset quality with NPL

ratio falling to 9.6% (FY2015e). Moreover, we see SAB with a solid capital

position with a CET 1 ratio of 11.6% for FY2015e and reaching a 12.5% CET 1 in

FY2016e.

Our target price for December 2016 of €2.3 per share was obtained through the

Sum of the parts valuation, which implies an upside of 39% over the current price

of €1.6 per share and our recommendation is to buy.


PAGE 4/32

Company overview

Banco de Sabadell, S.A. was established in 1881 in Sabadell, it is Spain’s fifth

largest banking group by total assets (Chart 1), and holds an important position in

the personal and business banking market.

The bank is the parent company of a corporate group and both together compose

the Banco Sabadell Group (The Group). The group is organized into 5 business

units; Commercial banking, Corporate Banking and Global Businesses, Markets

and Private Banking, Asset transformation and Sabadell America.

Commercial Banking (largest group’s business lines) which the core

function is to provide financial products and services to large and

medium-sized business, SMEs, retailers and sole proprietors,

professional groupings, entrepreneurs and personal customers. This unit

achieved €2,210 billion as of 30.09.2015 in Gross operating income and

€498 million in Profit before tax (Chart 2).

Corporate Banking and Global Businesses, which operates

internationally and inside Spain, offer products and services to large

corporate and financial institutions.

Markets and Private Banking business unit offers products and

management services related with savings accounts and investments.

The unit’s operations embrace SabadellUrquijo Private Banking;

Investment, Products and Research; Treasury and Capital Markets; and

Securities Trading and Custodian Services. Chart 3 shows that as of

30.09.2015 this business unit together with its separate area;

Investment, Products and Research, were the ones on top providing

58.6% and 116.5% ROE respectively.

Asset transformation unit is divided into two areas: Banco Sabadell

Asset transformation (manages the Bank’s real estate assets) and Solvia

(provides services for real estate asset portfolios for the Group and third

parties).

Sabadell America includes an international full branch, Sabadell United

Bank, Sabadell Securities USA, Inc., and other business units, affiliates

and representative offices (New York since 2012). All together offer

financial services in the corporate banking, private banking and

commercial banking fields in the US.

Chart 1 – Largest Spanish Banks by Total Assets as of June 30, 2015 (€ Bn)

Source: Companies’ data

Chart 2 – Sabadell’s Gross operating income per business units (€ Mn)

Source: Company data

Chart 3 – Sabadell’s ROE per business units



PAGE 5/32

History

Sabadell has undertaken an expansion policy since 1996, which in last years, its

increase in scale, has been very notable (Table I). The latest acquisition by the

Bank was done during 2015 (Appendix 4 - Sabadell’s landmark developments).

On March 19th 2015, was approved by Sabadell’s Board of Directors the tender

offer for 100% of the shares of TSB at 340 pence per share in cash. Sabadell got

control of TSB’s assets and assumed its liabilities on June 30th 2015.

Strategy

Sabadell launched in 2014 a new business plan known as ‘Plan Triple’ to put in

practice from 2014 until 2016. The key themes of the business strategy are;

transformation, profitability and internationalization (Chart 4). The strategy was

designed to leverage the strength of the bank’s balance sheet, its strong sales

platform and to recover the lending activity in the medium and long term. To

achieve that, the following targets were settled for the FY2016; €1,000 million

Income, 12% ROTE, 40% Cost to income ratio, 100% Loan-to-deposits, 1%

Lending growth CAGR 2013-2016. Our estimations if Sabadell is on track to

achieve the objectives mentioned before will be explained in the Valuation

Chapter.

Shareholders structure

The share capital of Sabadell is €679,905,624, represented by 5,439,244,992

registered shares after its latest capital increase on October 12th 2015, with a

nominal value of €0.125 each. Sabadell’s shares were listed on April 18th 2001

on the Stock Exchange and a capital increase in 2004 placed the bank in the

IBEX-35 stock market. Since 1999 the largest capital increase that Sabadell has

done was on April 27th 2015 when it issued 1.1 billion shares to perform the

acquisition of TSB.

Sabadell’s shareholders structure as of September 30th 2015 is split in 45%

institutional investors and 55% retail investors (Chart 5). During 2014 Sabadell’s

management sought to engage actively with institutional investors. The

proportion of the bank’s shareholder base represented by institutional investors

increased from 38.5% in December 2013 to 48% in December 2014. The largest

Shareholder of Sabadell is the Colombian Banker Jaime Gilinski Bacal, who is a

real estate developer and philanthropist. He holds a 5.57% shares outstanding

and the second largest shareholder is Winthrop Securities LTD, with a 3.65%

outstanding and the company is located in Spain. Most of the institutional

investors of Sabadell are Investment advisors (Chart 6); among them the first

Chart 7 – Shareholders structure by geographic

Source: Bloomberg


Table I – Sabadell’s increases in scale as of 2014

2007 2010 2014

2014/

2007

Assets (€ Mn) 76,776 97,099 163,346 2.1x

Loans and advances (€ Mn) 63,165 73,058 121,141 1.9x

Deposits (€ Mn) 34,717 49,374 94,461 2.7x

Branches in Spain 1,225 1,428 2,267 1.9x

Employees 10,234 10,777 17,529 1.7x

Chart 5 – Sabadell’s Shareholders structure



Triple

Transformation Sales

Balance sheet Production model

Profitability Leveraging greater

scale into profit

Internationalization Preparing for the Group's International expansion

Entering new markets

Chart 4 – Sabadell’s “Plan Triple” 2014 - 2016


PAGE 6/32

position by revenue is hold by the Norges Bank Investment Management from

Norway with a 1.69% shares outstanding. The second and third positions are

hold by Vanguard Group Inc and Blackrock Fund Advisors from United States,

with 1.68% and 1.47% shares outstanding respectively. The fourth and fifth

positions are hold by Dimensional Fund advisors LP 1.2 USA and Fidelity

international, Bermuda, both with 0.47% shares outstanding.

The geographic distribution of Sabadell’s shareholders have changed during the

last three years (Chart 7), most of them continued to be unknown from 2013 to

2015 and the primary known location continues to be United States, although its

representative percentage has decreased from 2013 to 2015. The second known

location is Spain, which has notably increased from 2014 to 2015 by 16.31p.p.

Moreover, in the composition of the bank’s shareholders we can see that most of

them are asset management companies. The mean objective of these

companies is to offer returns to the customers, but usually they show no intention

to hold the shares for longer periods. Given the previous analysis, it can be

concluded that Sabadell’s shares are dispersed across multiple entities, although

regarding the big size of the bank, in our opinion, it is not vulnerable for a

takeover.

The Sector

European Banking Sector

The EU banks continue facing important challenges and vulnerabilities in the

European banking sector. The levels of private and public debt still remain high

for EU countries. Chart 8 shows the aggregated values of public and private debt

compared to GDP, which range from 175% and 514%. Moreover, inflation

remains low, with expectations that will decrease from 0.6% in 2014 to 0.1% in

2015 (EU) and from 0.4% in 2014 to 0.1% (euro area). It is also expected that

the unemployment rate will fall from 10.2% in 2014 to 9.6% in 2015 (EU, 2016 –

9.2%) and from 11.6% to 11.0% (euro area, 2016 – 10.5%). The growth on

employment and the low levels of inflation rates may discourage consumers and

investors spending and slowdown the pressures on economic growth.

Some countries within the euro area, such as Greece, continue facing

geopolitical risk, economic and financial uncertainties. The risk arising from

emerging markets and the general macroeconomic uncertainty is; increasing

worries on further instability, possible effects on sovereign bond markets and

major deterioration of assets quality. The pursuit for yield in a context of low

Chart 8 – Debt of general government and private sector debt as a percentage of GDP (EU–OECD countries, USA and Japan, end of 2013)

Source: OECD statistics, EBA calculations

Chart 6 – Shareholders structure by

type

Source: Bloomberg

Chart 9 – Common equity tier 1 ratio (Until Dec-13: tier 1 excluding hybrid

instruments) – weighted average

Source: EBA KRI and EBA calculations

Table II – Tier 1 ratio, RoA, loan-to-deposit ratio – EU banks compared to US banks

2009 2010 2011 2012 2013 2014

EU

Tier 1 ratio 10.2% 11.0% 11.1% 12.5% 13.1% 13.3%

RoA 0.20% 0.30% 0.00% 0.02% 0.15% 0.21%

Loans to deposits 117.1% 117.8% 117.7% 115.7% 112.8% 108.4%

USA

Tier 1 ratio 11.4% 12.4% 12.6% 12.9% 12.7% 12.4%

RoA 0.39% 0.66% 0.65% 0.75% 0.88% 0.78%

Loans to deposits 79.5% 81.2% 74.9% 72.2% 69.9% 69.1%

Source: EBA KRI, SNL Financial and EBA calculations


PAGE 7/32

inflation and low interest rates may lead to potential asset price bubbles and also

low interest rates impose challenges for bank’s profitability.

However, banks’ capital position has being strengthened since 2011 with the

repair process of the European banking system. Chart 9 shows EU banks

weighted average common equity tier 1 (CET 1) ratio’s increase from 2011 to

2014, growing from 9.2% to 12.1%. The improvements of the capital ratios are

more related to increases in common equity than to decreases of RWAs. When

comparing EU banks with the 20 largest US banks (Table II1), it is perceivable

the improvements of the EU banks’ capital positions, which levels are above the

peers in US, since 2009 until 2014. The net capital increases, since the Lehman

Brothers crisis, have been more substantial for EU banks. However, in terms of

profitability (measured by ROA), EU banks are outperformed by US banks which

have better positions to keep moving forward a gradual growth of their capital

base by the retention of earnings.

On the asset side, the deleveraging trend has plateaued with some signs of

growth in total assets (by 5.9% - FY2014 YoY) and loan volumes (by 2.6%), at a

slower peace (Chart 10 and 11). But the constant overall deleveraging tendency

has stopped in the sector in the past years, even though banks continue

reducing their exposures to fields such as investment banking. Everything

seems to point out that banks are trying to recover their traditional business and

come back to plain vanilla products. Despite there has been a progressive

reduction of impairments on financial assets, there are still concerns around

assets quality, associated mainly with specific geographies with action needed to

move along the resolution of non-performing exposures.

Regarding funding markets and deposit bases, in the 2H 2014 and 1Q 2015,

have shown positive pictures. There has been no real shortage of market

funding, even though certain volatility in issuance volumes. The investors’

search for yield has positively influenced the increasing demand of subordinated

debt instruments (issued by banks), especially after the publication of the

quantitative easing (QE) programme by the European Central Bank (ECB). Also,

in general terms, deposits bases increased supporting the overall positive of

funding. During 2014 bonds and debt certificates’ share, as well as of client

deposits in the overall funding mix, increased. By 2014, c50% of the funding mix

was composed by customer deposits and by deposits from credit institutions

(Chart 12).

1 The EU banks (55 banks considered in the EBA KRI) and the US banks (market data for the 20 biggest banks according to their total assets) – (data no adjusted for

the difference in netting rules between US GAAP and IFRS).

Chart 10 - Total assets (€ Trillion)


Chart 13 – CoE for EU countries

Source: Bloomberg, NYU Leonard N. Stern School of Business, EBA calculation

Year end 2011 2012 2013 2014

RoE 0.0% 0.5% 2.7% 3.6%

CET1 9.2% 10.8% 11.6% 12.1%

Table III – Comparison of RoE and CET 1 ratio (weighted average, per

year‑end)

Source: EBA KRI

Chart 12 - Funding mix (weighted

average) per year end 2014

Source: EBA KRI

Chart 11 - Total loan volumes (€ Trillion)



PAGE 8/32

Regardless the improvements in funding conditions, financial markets continue

fragile and volatile in general terms. The remaining vulnerabilities are related to

funding in foreign currencies, passive cross-border interbank markets, and the

liquidity worries of the trading market. The levels of asset burden remain high, as

such the Central bank based funding, which means that trust across banks in the

single market has not been completely restored yet, and that funding markets

have not returned either to pre-crisis conditions.

In terms of profitability, the challenges remain for EU banks. It was registered on

December 2014, the highest weighted average RoE of 3.6%, since 2011. This

ratio has been constantly increasing on a year-to-year basis with similar

increases in the CET 1 ratio (Table III), although far away from the pre-crisis

levels. This modest increase has been driven mostly by the growth of the NII by

€15 billion (+5% compared to FY2013) and the sharp decline of impairments of

financial instruments (€24 billion, -20% on a year-to-year basis). The growth of

total loans and debt instruments explain the positive increase of net interest

income during 2014. Furthermore, the greater portion of loans that are funded by

deposits in conjunction with the Central banks’ funding, have reduced cost of

funding for banks and interest expenses, plus has a positive impact on net

interest margins (NIMs). On the other hand, asset quality continues to be a drag

due to the associated litigation costs that impose significant fee on banks’

profitability. The ROE remains thus subdued and not enough to cover the cost of

equity (CoE) for many banks that might lead to disproportionate risk taking or

cost cutting in an effort to increase profitability. Chart 13 shows the comparison

of the CoE in 2015 with the one in mid-2011 in order to assess its evolution. The

outcomes show that the average CoE for the EU in 2015 is 9.5% (excl. Greece),

which is lower than the 14.6% in 2011. This difference is due to the current

interest rates context that reached a peak in 2011.

There are other concerns linked to the sustainability and viability of some banks’

business models. Because it is not clear enough which are the strategies that

banks are going to follow in order to return to adequate levels of profitability,

while they walk away from official funding. Market analysts are considering that

in the short term, shadow banking2 and technological advances are tendencies

that can highly impact the EU banking sector and banks’ business models (Chart

143). The continuing tightening of banks’ regulations together with abundant

liquidity and investors’ search for yields are issues that could be boosting a

change of traditional banking activities into shadow banking. An increasing role

2 Shadow banking such as mutual funds, hedge funds, finance companies, venture capital corporations and securitisation vehicles.

3 Results obtained through Risk assessment questionnaire (RAQ): You expect that the following trends will impact European banks most in the next 6–12 months

(please do not agree with more than two options).

Chart 14 - Trends that will impact European banks

Source: EBA RAQ for analysts

Chart 15 – Spain’s nominal GDP (Index – Base 2010) and estimates

Source: Banco de España


Chart 16 – Spain’s unemployment rate from March 2002- September 2015

Source: European Central Bank

Chart 17 – Unemployment rate

estimates


PAGE 9/32

of the shadow banking and of the disintermediation of the traditionally financial

activities developed by banks, can possibly impact banks’ revenues such as fees

and commissions, as well as their ability to grow in other areas that could offset

the weakening in net interest returns.

Spanish Banking Sector

Banco de España (BDE) is Spain’s central bank and the supervisor of its banking

sector. It has established numerous measures since 2007 to increase the

resilience of the sector such as; increasing provisioning and transparency4 in

relation to the banks’ exposures to the real estate development and construction

segments, it has promoted mergers between saving banks, and set up the

SAREB5. Moreover, information regarding the results of the stress tests

conducted by the European Banking Authority (EBA), where 90% of the banking

system participated (Sabadell included), must be clearly accessible too.

Despite all the measures undertaken, the system continues having doubts about

the quality of the assets on banks’ balance sheets and also about banks' level of

solvency. Currently, BDE is managing a complex restructuring and

recapitalisation programme, the Memorandum of Understanding (MoU) which

was agreed with the European authorities in July 2012, the mean objective is to

restore confidence and stabilise the Spanish banking sector and place it on a

more secure footing for the future.

Before going deeper into the Spanish banking sector we would like to comment

first, some points in the macroeconomic context in Spain, that in past years had

major impacts in the refer banking system.

The economy in Spain was enjoying a prolonged period of expansion between

the years 2000 and 2008, growing at a CAGR of 7.1% (Chart 15). Spain’s GDP

reached its biggest increased in 2008 (€1,116 trillion), which fall by 3.3% in 2009

and continue declining afterwards as of 2014. During 2008 to 2013, there were

no indicators of growth in the economy, only in 2014 the GDP has shown some

positive results reaching €1,041 trillion and it is expected at the end of 2015 will

amount €1,078 trillion. Overall, this is a very positive indication of recovery for the

Spanish economy.

The unemployment rate is another important macroeconomic variable to take into

account (Chart 16), because it impacts directly the performance of; the Non-

Performing Loans (NPLs), the volume of loans the banks are willing to offer to its

customers and the deposits received from them as well. The refer rate has

4 Information provided by the banks to the markets. 5 Company for the Management of Assets proceeding from Restructuring of the Banking System to which non-performing real assets of banks have been transferred.

Chart 19 – Residential property prices index - Spain


Chart 18 – % of Real estate activities/GDP


Chart 20 – Spain’s number of employees


Chart 21 – Spain number of branches



PAGE 10/32

increased since 2007 in Spain until March 2013 (26.94%), and it has started to

decrease from that moment on until September 2015 to 21.18%. According to the

ECB estimations (Chart 17) the unemployment rate for FY2015 will decrease to

22.3% and continue declining for the next two years, which will translate in a

positive impact in the items mentioned before.

Despite the economic indicators mentioned before, the Real estate sector is very

relevant for the Spanish economy. Chart 18 shows that in 2008 real estate

activities accounted for 8.2% of GDP, where most of the houses were purchased

and built through loans obtained from financial institutions. Housing prices grew

at an incredible CAGR of 42% from 1995 until 1Q of 2008 (Chart 19), bring as

result the housing bubble6. This housing bubble burst in the beginning of 2008

and house prices started to fall until the 3Q of 2015 at a CAGR of 18%. Basically

the real estate activity in Spain was developing very well in the past and

Spanish’s banks were increasing their exposure to this sector in a constantly

basis. The real estate assets were used as collateral, meaning that loans were

considered safe and due to long maturities the expectations of high returns were

big. The incentive to increase mortgage loans was growing and therefore the

sources they were allocating to this type of loan. Consequently, when the real

estate crisis begun, the values of these collaterals fell considerably, the real

estate market became illiquid and banks became unable to recover the expected

returns from selling the collaterals in case of default.

During the restructuring process of the Spanish banking system, many

employees were fired, offices were closed and the smallest and weakest banks

were merged or acquired. This is part of the consolidation process this sector in

Spain is facing through, where the smaller institutions are becoming large multi-

regional banks. Charts 20, 21 and 22 show that from 2007 to 2014 the reduction;

in the number of employees in the sector from 277,311 to 208,291 (CAGR of -

4%), in the number of branches from 45,500 to 31,999 (CAGR of -5%) and in the

number of institutions from 357 to 272 (CAGR of -4%).

Funding Structure

The mean reactions in the financial markets driven by the International Financial

Crisis were; i) banks isolated themselves from each other (lending market slowed

down) and ii) central banks started to apply monetary policies to promote

economic growth and access to capital by the banks.

6 Housing bubble: Refers to the economic bubble occurred in the global real estate markets, followed by a land boom (rapid increase in valuations of real property such

as housing until they reach unsustainable levels and then decline in a bubble).

Chart 25 – Total amount of deposits by type (€’000)


Chart 22 – Spain’s number of institutions


Chart 23 – Mean Sources of funding (€'000)


Chart 24 – Total Deposits (€’000)



PAGE 11/32

Sources of funding are split in four groups (Chart 23); Total deposits, Equity,

Securities (other than shares) and Others7. Spanish banks have always relied on

deposits as their mean source of funding. The strategy has not changed in the

last times (Chart 24) especially due to the illiquid characteristics of the interbank

lending market and the restrictions imposed by central banks to credit lines. Also,

because despite financial institutions’ bonds have lower yield to maturity, they

continue being more expensive with respect to deposits. Since 2000 up to 2008,

the total amount of the mean source of funding was increasing at a CAGR of

11%, after 2008 it started to fall at a 3% CAGR up to August 2015 (consequence

of the Lehman Brothers bank’ crash).

Chart 25 shows the total amount of deposits by type, where the amount of

funding coming from the General government and the Resident sector (includes

non-financial institutions and households), both fall at a CAGR of 2% as of 2015

from 2008 in Spain. The deposits from the Resident sector hold the highest

percentage of total deposits and it is mostly composed by savings accounts and

time deposits from households. Families that were already indebted (Loans to

gross disposable income in 2017 was 130% - Chart 26), after the initiation of the

International Financial Crisis saw future income will be lower than expected, plus

the fact that banks were being more restricted when conceding credits to

customers. As a result, credits fall; families withdrawn huge amount of money

from their deposits to pay debts and started also to save less. In conclusion, the

main source of funds for banks was being in risk.

Another important source of funding for banks is the Equity, which is considered

the most expensive one. The value of Equity in the Spanish economy has seen

an increase in the last years. The outcomes of the stress in 2012 have been one

the drivers of this increase due to the major changes in regulations and

legislations related to the banking system. When looking at the increasing

tendency of the Equity held by banks in Spain from 2007 up to now (Chart 27),

we notice how severed the new regulatory capital requirements have been

implemented after the crisis in order to create a better safety cushion to support

the unexpected losses on their assets.

Regarding Spanish banks’ debt, when studying the behaviour of short-term and

long-term debt securities in the past, we see that since the beginning of 2000

until the end of 2007 these items have being growing at 38% and 34% CAGR

respectively (Chart 28). Banks, started to look for funds in the market, that were

priced at lower rates than the mortgages loans with the purpose of financing their

own growth through real estate loans. But after 2008, the interconnectivity

7 Others caption is composed by: Accrual and sundry accounts.


Chart 26 – Spanish Loans to gross disposable income

Chart 27 - Spanish Book Value of Equity (€'000)


Chart 28 – Debt securities issued by the Spanish Banks (€ Mn)


Sabadell Popular Santander BBVA

2013 BB BB- BBB BBB-

2012 BB BB BBB BBB-

2011 BBB BBB+ A+ AA-

2010 A A AA AA

2009 A A AA AA

2008 A+ AA- AA AA

2007 A+ AA AA AA-

Table IV – Long term credit ratings

(S&P)

Source: Companies’ data and Standard & Poor


PAGE 12/32

between the financial institutions in the system started to face serious problems;

the global financial system saw itself highly exposed to systemic risk. The worries

from institutions in placing their debt securities on investors increased. Banks

started to stop lending each other, also because the changes in the regulatory

requirements that obliged banks to issue more equity in order to provide such

loans because suddenly all the institutions were consider risky by the rating

agencies (Table IV).

When in 2012 it was made public the recapitalization need of the Spanish

Banking system and the Basel III accords (explained further in this report) started

to be known by banks, the banks debt’ maturities structure suffered changes

again. There was then an opportunity for banks to shift their short-term debt for a

higher quality funding to comply with the new regulatory requirements. Long-term

debt are less risky for investors (because they are more senior) and easier to

place in the market.

Cost of Funds

The banks’ interest rates paid for all type of depositors and all type of maturities

were peacefully increasing over time since 2003 and reaching its peak on October

2008 (Chart 29). However, from October 2008 to October 2015, interest rates with

maturity higher than or equal one year paid on households’ deposits in Spain fell

by 4.3.p.p. to 0.44.p.p. and in the Euro area fell by 3.7.p.p. to 0.75.p.p. For

Corporations the situation was very similar for interest rates with the same

maturity. Interest rates have fallen by 4.6.p.p. to 0.40.p.p. in Spain and the Euro

area by 4.3.p.p. to 0.63.p.p. The Euro Area and Spain’s interest rates follow a very

similar pattern.

From September 2008 the ECB’s refinancing rate has been decreasing and

reaching its historical low in September 2014 of 0.05% as of today (Chart 30). The

reasoning behind is to promote economic growth and boost Eurozone inflation

rate to reach again the desire 2% by the ECB. Moreover, the Euribor 6-months,

which is positive correlated with the ECB’s refinancing rate, has being following

the same declining trend (Chart 31). This is because the opportunity cost of

borrowing from the central bank or money market. Overall it is observed a market

decrease in the interest rates used as benchmark, which means that banks’ cost

of funds is decreasing as well.

In the stock markets the situation for banks has changed. Banks’ share prices

have become cheaper, while the return demanded by shareholders increased

due to lower expected cash flows. The main drivers of a stock price are; the

dividends per share paid by a company and growth rate of the dividends. Ever

since shareholders’ responsibility for the good performance of the company


Chart 30 – ECB’s refinancing rate

Chart 29 – Deposits' annual interest rates for households and corporations (%)


Chart 32 – Spanish bank’s deposits market share in the Sector

Source: Banco de España and company’s data

Chart 33 – Spanish bank’s loans market share in the Sector

Source: Banco de España and companies’ data

Chart 31 – Euribor 6-month evolution



PAGE 13/32

became tighter, the negative results would be supported by them. This means

that in order to issue additional capital to comply with the new capital

requirements, banks have to retain earnings and do not distribute them among its

shareholders. This increases the uncertainties around the expected dividends

that are going to be paid in financial institutions and lower the expectation for the

future cash flows.

Profitability

With the objective to analyse the Profitability of the sector we selected three

banks that, together with Sabadell, are very influent in the Spanish Banking

sector: Banco Santander S.A. (Santander), Banco Bilbao Vizcaya Argentaria

(BBVA) and Banco Popular Español (Popular) all belonging to the Ibex-35 Index.

The accumulated market shares for Deposits and Loans as of the 3Q of 2015 for

these institutions in the Spanish market were 91% and 98% respectively (Chart

32 and 33). The market share in loans held by these institutions has been

constant since 2007 up to 2013. Notable increased is perceived after 2013 in

Santander and BBVA’s case, which in 2014 and 2015 its deposits and loans

have increased considerably.

One way to measure the profitability of the sector is by applying a DuPont

analysis, being especially useful when comparing two different periods to check

for differences in underlying drivers.

To do that, we compared 9M 2015 results with FY2007 results, even if 2007 was

a peak year for banks and not an average year. Looking at Table V, we can see

that ROE decreased from 18% in 2007 to 4% in 9M2015, with negative impacts

from all components.

By far the most important driver was the very significant reduction in the Profit

Margin, from 35% to 13%. This can be traced mainly to 2 questions: i) the very

big increase in provisions in Spain and ii) the negative impact of low interest rates

on NII. The former was the most important one and was caused by the impact of

the Financial Crisis (but also the end of the Spanish real estate bubble) on banks’

credit quality, which forced a major provisioning effort to reflect the marked

deterioration on their credit books (Table VI). The later has been more important

recently, as the very low interest rate environment in Europe has been limiting

banks’ ability to earn money through their NIMs, damaging significantly their

profitability. On top of that, the economic slowdown in Spain also affected other

P&L lines like commissions, further reducing banks’ revenues and therefore their

bottom line.

Table V – DuPont analysis of the Sector

Source: Companies’ data and Analyst’s calculations

9M 2015 2007

ROE 4% 18%

Profit Margin 13% 35%

Total Asset Turnover 2% 3%

Equity Multiplier 1371% 1643%

Chart 34 – Net Income evolution of the 4 Spanish bank as of 9M 2015 (€ Mn)

Source: Companies’ data

Source: Companies’ data and analyst’s calculations

Table VI –Spanish banks financial analysis (€ Mn)

Popular Santander BBVA Sabadell

Operating Income 3,103 34,378 17,534 4,258

Net interest income 1,760 24,302 12,011 2,240

Net Fees & Com. 512 7,584 3,442 728

Trading income 687 1,702 1,558 1,152

Other income 144 790 523 138

Net Income 302 5,106 1,702 580

Provisions for NPLs 1,820- 7,797- 3,859- 1,955-

Assets 160,028 1,320,427 746,477 205,141

Equity 12,695 98,687 53,601 12,366

REO - Dupont 2% 5% 3% 5%

Operating Income 3,452 27,095 17,271 2,162

Net interest income 2,288 15,296 9,628 1,317

Net Fees & Com. 883 8,040 4,560 611

Trading income 66 2,998 1,545 95

Other income 215 761 1,538 139

Net Income 1,341 9,059 6,415 788

Provisions for NPLs 349- 3,549- 2,138- 207-

Assets 107,169 912,915 501,726 76,776

Equity 6,644 58,080 27,943 4,605

ROE - Dupont 20% 16% 23% 17%

9M 2015

2007


PAGE 14/32

The equity multiplier reduction also had a negative effect, as due to regulatory

reasons banks were forced to carry major capital increases to reduce their

previous (too) high leverage ratios. Since banks were required to have more

equity to perform the same (or less) business, it was naturally a drag on ROE

(more Equity to less Return).

Moreover, emerging currencies have been working against BBVA and Santander

which are placed within the six European banks8 that bet on growth on emerging

markets and now are facing a deteriorating profit outlook as chaos roils

economies from Asia to South America. These both Spain’s largest lenders; have

been relying on income from Latin America (LatAm) due to limits of growth at

home in a low interest rates environment. Roughly 20% of the loan book value of

Santander and BBVA is in LatAm and now are suffering a shift in sentiment.

On August 2015, China’s yuan devaluation (Chart 35 and 36), rose concerns that

the global economy is going for a slowdown, although the Fed rose interest rates

on Dec 16th 2015 showing improvements in the US economy. Moreover

currencies from Malaysia to Turkey to Brazil fell on August 2015 as well, while an

index of commodities fell to its lowest since 1999.

Santander, settled a strategy to transform its structure from a provincial lender

into the second biggest bank in Europe by market value, it has spent, under

former Chairman Emilio Botin, more than $70 billion (c€64 billion) on acquisitions

which include Banco Real in Brazil. Santander generates about a fifth of profit

from commodities-rich Brazil (Chart 37) that relies on the demand for metals of

China and is living the worst recession since 1990. It does not seem that the

political situation in Brazil is getting any better and overall the economic situation

is pretty bad shape. In conclusion the bank will start cutting types of lending in

Brazil that are most prone to losses.

On the other hand BBVA derived two-thirds of its operating income from Mexico,

South America and Turkey in the first half of 2015. Mexico’s GDP is expected to

expand 2.5% in 2015 although some economists are paring their growth

forecasts for Mexico.

In Turkey, where BBVA owns c40% of Turkiye Garanti Bankasi AS (Turkey’s

largest bank), a political impasse intensified security risks and accelerating

inflation pushed the lira to a record low against the euro (Chart 38).

Both banks tried to balance growth offered by emerging countries, especially in

Santander’s case that enjoys stability from mature economies such as the UK

and Germany. The seek to add emerging-markets revenue helped Santander

8 The six European Banks are: BBVA, Erste Bank, HSBC, Santander, Standard Chartered, and UniCredit.

Chart 35 – CNY/USD evolution from 31 Jan 2005 – 31 Jan 2016

Source: Reuters

Chart 36 – CNY/EUR evolution from 31 Jan 2005 – 31 Jan 2016

Source: Reuters

Chart 37 – How Brazil bolstered Santander earnings during Spain’s crisis


Source: Reuters

Chart 38 – TRK/EUR evolution from 31 Jan 2005 – 31 Jan 2016


PAGE 15/32

and BBVA to resist Spain’s five-year economic crash, however everything

affecting the ability to repair their balance sheets through retained earnings, will

come back to haunt them.

On the other hand, no big changes are perceived in the Asset Turnover which

decreased by only 1p.p. and this is because total assets in Santander, BBVA and

Sabadell have considerable increased as of 9M 2015 driven by the acquisitions

made inside and outside Spain.

On Charts 39 and 40 we can see the Total revenues breakdown for the four

banks as of 9M 2015 and for FY2007, respectively. NII is still the major source of

revenue as of 2015, mostly because they are Retail oriented banks and also we

can see how the Trading income has become a valuable source of revenues for

Sabadell and Popular which is not common in retail banks. Although the increase

in the item impacts positively the operating income must not be consider

recurrent for the sector as a whole, because this kind of source of revenues is not

sustainable over time because of its high volatile level.

Regulatory Capital

Basel II

Basel II was written with the objective of revising certain issues on Basel I (1988

Basel Accord) that were not able to control the new complications in the financial

instruments and activities. Basel I was primarily focused on credit risk by creating

a bank asset classification system (Table VII), but this kind of control were

staying behind with the markets globalization, deregulation and technology’s

development.

Basel II, published in June 4, was organized in three pillars: The first pillar –

Minimum capital requirement, The second pillar – Supervisory review and The

third pillar – The market discipline. Pillar I manages the maintenance of

regulatory capital that is calculated based on the three main components of risk a

bank faces: credit risk, operational risk and market risk. Pillar II aims to give

regulators better tools than the ones available in Pillar I, because it deals also

with so called residual risks9. Pillar III focuses on the disclosure of the information

that would allow market’s participants to measure the capital adequacy of an

institution.

9 Residual risk: systemic risk, pension risk, concentration risk, strategic risk, reputational risk, liquidity risk and legal risk.

Chart 39 – Income’s share over Total Revenues (9M 2015)


Table VII – Basel I classification

system

Risk Categories Bank's Assets

0%Cash, Central bank and government debt

and any OECD government debt

0%, 10%,

20% or 50%Public sector debt

20%

Development bank debt, OECD bank

debt, OECD securities firm debt, Non-

OECD bank debt (under one year

maturity) and Non-OECD public sector

debt, Cash in collection

50% Residential mortgages

100%

Private sector debt, Non-OECD bank debt

(maturity over a year), Real estate, Plant

and equipment, Capital instruments

issued at other banks

Source: Bank for International Settlements - BIS

Basel II Basel III

Capital Requirements:

Minimum Common Equity Tier 1 (CET1) 2% 4.5%

Additional Tier 1 (AT1) 2% 1.5%

Additional Capital Buffers:

Capital Conservation Buffer 2.5%

Discretionary Counter-Cyclical Buffer 2.5%

Tier 2 Capital 4% 2%

Table VIII – Regulatory requirements comparison

Source: Bank for International Settlements - BIS


Chart 40 – Income’s weight over Total Revenues (2007)


PAGE 16/32

Basel III

Basel III appeared from 2012 to fix the vulnerabilities of the exposed financial

system after the international financial crisis. It would focus primarily on the risk

of a run on the bank by requiring different levels of reserves according to the type

of bank deposits and other borrowings. Therefore, Basel III does not displace the

guidelines of Basel I and II; but it will work alongside them. The Key principles

are related to Capital requirements, Leverage ratio and Liquidity requirements.

Regarding Capital requirements (Table VIII), banks must hold from 2010 a

minimum Common Equity Tier 1 (CET 1) ratio of 4.5% (up from 2% in Basel II) of

Risk weighted assets (RWAs) and must be kept at all times by the banks.

Moreover the minimum Tier 1 capital increases from 4% in Basel II to 6% over

RWAs, applicable in 2015. This 6% is composed of 4.5% of CET 1, plus an extra

1.5% of Additional Tier 1 (AT 1).

Furthermore, Basel III has introduced two additional capital buffers: a mandatory

“capital conservation buffer” and a “discretionary counter-cyclical buffer”. The

capital conservation buffer is equal to 2.5% of RWAs and taking into account the

4.5% CET 1 capital ratio also required, banks must hold in total 7% CET 1

capital, from 2019 onwards. The discretionary counter-cyclical buffer would allow

regulators to demand up to an additional 2.5% of capital on periods of high credit

growth.

Basel III introduced as well a minimum “leverage ratio” and it is expected banks

to keep in excess a leverage ratio of 3%.

Among the Liquidity requirements it was introduced two required liquidity ratios; i)

the Liquidity Coverage Ratio which obliges a bank to hold sufficient high quality

liquid assets to cover its total net cash outflows over 30 days and ii) the Net

Stable Funding Ratio to require the available amount of stable funding to exceed

the required amount of stable funding over a one-year period of extended stress.

The Tier 2 capital ratio, considered as a supplementary capital was reduced from

4% to 2% under Basel III. All the changes introduced by this latest Accord should

be fulfilling by all the banks in 2019, forcing them to start issuing more shares.

The amount of Equity registered in the 1st of January 2005 was €148 billion, as

expected with the changes in the minimum capital requirements, a large

increased of equity in the financial and credit institutions occurred as up today.

However, by looking at Chart 41 we noticed that from the middle of 2014 until

June 2015 the amount of equity has decreased at a CAGR of 11% which means

that even though the amount of equity continues being high with respect to 10

Chart 41 – Book Value of Equity (Index – Jan/2005)


Source: Oliver Wyman-Asset quality review and

bottom up stress test. September 28, 2012

Table X – Overview of estimated capital needs at entity level under adverse scenario (€ Bn) - 2012

Financial groupProjected

Loss

Loss

Absorption

Capital

excess

(pre-tax)

Capital

excess

(post-tax)

Santander 34 59 24.4 25.3

BBVA-UNNIM 31 40 8.2 11.2

La Caixa 33 37 3.9 5.7

Kutxabank - Cajasur 7 9 1.8 2.2

Sabadell-CAM 25 26 0.6 0.9

Bankinter 3 4 0.3 0.4

Unicaja - CEISS 10 9 -0.9 0.1

BMN 9 6 -3.1 -2.2

Libercaja 16 12 -3.4 -2.1

Banco Valencia 6 2 -3.4 -3.5

Popular - Pastor 22 17 -5.5 -3.2

NCG 13 6 -6.8 -7.2

Catalunya Banc 17 7 -10.5 -10.8

BFA-Bankia 43 19 -23.7 -24.7

System 270 252 -57.3 -53.7



Financial group

Market share

(% of Spanish

assets)

Santander (incl. Banesto) 19%

BBVA (incl. UNNIM) 15%

Caixabank (incl. Banca Cívica) 12%

BFA-Bankia 12%

Banc Sabadell (incl. CAM) 6%

Popular (incl. Pastor) 6%

Libercaja (Ibercaja - Caja 3 - Liberbank) 4%

Unicaja - CEISS 3%

Kutxabank 3%

Catalunyabanc 3%

NCG Banco 3%

BMN 2%

Bankinter 2%

Banco de Valencia 1%

Table IX – Spanish domestic financial institutions in-scope



Table XI – Overview of estimated capital needs at entity level under base

scenario (€ Bn) - 2012

Financial groupExpected

Loss

Loss

Absorption

Capital

excess

(pre-tax)

Capital

excess

(post-tax)

Santander 22 43 21.3 19.2

BBVA-UNNIM 20 31 10.9 10.9

La Caixa 22 32 10.2 9.4

Sabadell-CAM 18 22 4.4 3.3

Kutxabank - Cajasur 5 8 3.4 3.1

Unicaja - CEISS 7 8 1.0 1.3

Popular - Pastor 15 16 0.5 0.7

Bankinter 2 3 0.6 0.4

Libercaja 11 11 0.4 0.5

BMN 6 6 -0.4 -0.4

Banco Valencia 4 2 -1.7 -1.8

NCG 9 6 -3.6 -4

Catalunya Banc 13 6 -6.2 -6.5

BFA-Bankia 30 17 -12.2 -13.2

System 183 212 -24.1 -25.9


PAGE 17/32

years ago, the cleanse of balance sheet from risky assets in this institutions is

being effective in general terms, which translate in less capital to be hold and

another way to increase the capital ratios and comply with them.

Stress tests

The test scenarios and methodology for the 91 European credit institutions were

developed between the Committee of European Banking Supervisor (CEBS) and

the ECB. It was defined by the CEBS a Tier 1 capital ratio of 6% to be hold in the

adverse scenario (+50% than the legally minimum required). The outcomes in

2010 revealed the capital needs in a highly stressed and unlikely scenario;

however no private bank needed more capital to reach the settled Tier 1 ratio in

both scenarios.

After two years in a row disclosing positive results, Spain’s savings banks

collapsed and required to ask for a bailout. It was required then in 2012 a top-

down stress test exercise that it was concluded on the 21st of June and after

Oliver Wyman was commissioned to perform a bottom-up stress test analysis of

the most significant financial groups in Spain (Table IX shows the 14 banks under

analysis, considering the on-going consolidation processes), covering c90% of

the Spanish banking assets.

This bottom-up exercise aimed to estimate the capital needs of the system and

individual banks in the base and adverse scenarios10. The difference between the

top-down stress test exercise and the bottom-up stress test, were that the former

analysed historical performance, the entities’ conditions at the beginning of the

stress period and assets mix at an aggregate level. While in the second one

supervisors had the chance to analyse bank’s portfolio more accurately, by

evaluating the individual risk profiles of the different banks and resulting in an

individual valuation of capital needs. The bottom-up analysis estimated first the

expected credit losses and each entity’s loss absorption capacity, embedding the

results from the concurrent portfolio and asset quality review. The process

included three key components: Projected loss forecast, Loss absorption

capacity forecast and Potential capital impact and resulting solvency position in

the two scenarios. When the estimations of the bottom-up test were finished on

June 2012, the results showed that the Spanish banking system had projected

losses of €270 billion and a loss absorption capacity of €252 billion (Table X)

under the adverse scenario. The total estimated capital needs (pre-tax) of the

sector under the same scenario were c€60 billion (€59.3 bn), expected to be

reduced to around €57.3 billion with the mergers in progress considered within

10 Base or baseline scenario reflected the consensus expectation of professional forecast in February 2009 on the depth and duration of the recession, and the adverse scenario was designed to reflect a recession that is longer and more severe than the consensus expectation.



Table XII – Macroeconomic scenarios

provided by the Steering Committee

2011 2012 2013 2014 2012 2013 2014

GDP:

Real GDP 0.7% -1.7% -0.3% 0.3% -4.1% -2.1% -0.3%

Nominal GDP 2.1% -0.7% 0.7% 1.2% -4.1% -2.8% -0.2%

Unemployment rate 21.6% 23.8% 23.5% 23.4% 25.0% 26.8% 27.2%

Price evolution:

Harmonised CPI 3.1% 1.8% 1.6% 1.4% 1.1% 0.0% 0.3%

GDP deflator 1.4% 1.0% 1.0% 0.9% 0.0% -0.7% 0.1%

Real estate prices:

Housing Prices -5.6% -5.6% -2.8% -1.5% -19.9% -4.5% -2.0%

Land prices -6.7% -25.0% -12.5% 5.0% -50.0% -16.0% -6.0%

Interest rates:

Euribor, 3 months 1.5% 0.9% 0.8% 0.8% 1.9% 1.8% 1.8%

Euribor, 12 months 2.1% 1.6% 1.5% 1.5% 2.6% 2.5% 2.5%

Spanish debt, 10 years 5.6% 6.4% 6.7% 6.7% 7.4% 7.7% 7.7%

Ex. Rate/USD 1.4% 1.3% 1.3% 1.3% 1.3% 1.3% 1.3%

Credit to other resident

sectors:

Households -1.7% -3.8% -3.1% -2.7% -6.8% -6.8% -4.0%

Non-Financial Firms -4.1% -5.3% -4.3% -2.7% -6.4% -5.3% -4.0%

Madrid Stock Exchange Index -9.7% -1.3% -0.4% 0.0% -51.3% -5.0% 0.0%

Base case Adverse case



Chart 42 – Capital needs 2012 - 14 under the base scenario (Core Tier 1=9%) and under the adverse scenario (Core Tier

1=6%) - € Bn


PAGE 18/32

the scope of the exercise. The estimated capital needs applied to 7 out of the 14

entities (Capital excess post-tax) under the adverse scenario (38% of the

exposure under consideration). The three largest institutions (SAN, BBVA, and

Caixabank – 43% of the considered exposure) had an estimated capital excess

of €37 billion in the adverse scenario. Sabadell was not one of the banks under

capital needs, actually in both scenarios, adverse and base, it was counting with

an excess capital post-tax of €0.9 billion and €3.3 billion respectively. The base

and adverse scenarios settled a CET 1 of 9% and 6% respectively and the

estimated wide pre-tax capital needs were €24 billion (base scenario) and c€57

billion (adverse scenario) (Chart 42).

The big question arising is, why the previous tests did not detect the actual

shortfalls the banks were having? The answer relies on the methodology that

was implemented to perform this test, which focused special attention on the

credit portfolio of the 14 groups, due to the increasing concerns in the markets

over the solvency and quality of the Spanish banking system. It differs mostly

from the previous stress tests performed in the greater effort applied this time in

the Spanish exercise. For example, 14 macroeconomic factors were considered

(Table XII), being the most significant factors of the Spanish economy, such as

land and housing prices, financial data of the Madrid stock exchange, etc.

Moreover, the time horizon was extended for a period of three years (from 2012

to 2014), when in most of the other tests conducted the period analysed

comprised two. This means that the economic recession would last for a longer

period of time, which translate in higher potential losses of the analysed banks,

and their potential capital needs. It was also included much more adverse

assumptions or greater deteriorations of all factors: a fall in GDP of 6.5% in the

adverse scenario over the three years while in 2010 and 2011 was considered a

fall of 2.6% and 2.2% respectively, a maximum of 5.6% increase in the

unemployment rate by the end of the time horizon (variable not considered in

2010 and 2011 stress tests), and house and land prices and the extension of

credit all fall over the three years, and more markedly so in the adverse scenario.

Last but not least, the capital ratios used in this stress test were much higher

than the ones used in the latest similar tests, such as in the European Banking

Authority (EBA) exercise where it was settled a 5% in the adverse scenario and

8% in the base scenario.

Chart 43 - Loans and Receivables by type (€ Mn)


Source: Banco de España and analyst’s estimations

Chart 44 - Sabadell's market shares over the Total Loans of Credit Int. in Spain to Customers

Source: Banco de España and analyst’s estimations

Chart 45 - Sabadell's market shares over the Total Loans of Credit Int. in

Spain to Credit Institutions (€'000)


PAGE 19/32

Valuation

The SOTP method was used to perform the valuation of Sabadell to add up TSB

divisions’ value to Sabadell’s value. It was necessary to value first; Sabadell as a

group (excl TSB) and TSB using for both the FTE method.

Sabadell’s valuation

Starting with the Commercial Activity of the bank, the Cash and balance with

Central Banks was projected under the assumption that Sabadell will aim to

keep 3% reserves over the deposits from customers. This percentage is higher

than the minimum required reserves enforced by the ECB (1%) and no changes

in the near future are expected.

One of the most important captions inside the BS of Sabadell is the Loans and

receivables (L&R) portfolio which is segmented into Customers, Credit

institutions and Debt securities (Chart 43). In general terms this item has

experienced for all the banks in Spain a slowed down after 2008, driven mostly

by the decline in loans to customers, but in Sabadell’s case this item actually has

being increasing from 2008 as of 2014 at a CAGR of 10%.

The projection for the Total amount of L&R were based on the market shares

Sabadell holds over the Total loans and advances to Customers and to

Credit Institutions over the same items in Spain. Sabadell has kept an average

of 5.1% market share in the Loans and advances to customers from 2007–2014

(increasing YoY), in 2014 the market share was 8% (Chart 44). It was projected

that Sabadell would aim to keep a market share of c8% for the FY2015 and

continue strengthen its position over the next years by keeping a constant market

share of 8%. The reasoning behind is the restabilization of the Spanish economy,

therefore families will become less indebted and able to request for more loans.

Besides, because more acquisitions are expected to be done by the bank in the

future and the purchase of mortgage loans is also within the business strategy of

the bank11.

On the other hand the Loans and advances to Credit institutions has kept an

average of market share of 1.7% from 2007-2014, in 2014 the market share was

c3% (Chart 45). For the FY2015e and FY2016e was forecasted that Sabadell

would have a market share of 2.2% in this item, and will gradually growing at

0.1.p.p. YoY. Based on the improvements in the Spanish economy, credit

institutions must tend to start trusting each other and start increasing their lending

activity again. Whilst Debt securities segment is a residual item and given the

11 Sabadell is in bid for a £13 billion portfolio of former Northern Rock mortgages from the tax payer.

Source: Company data and analyst’s estimations

Chart 46 - Available-for-sale (AFS) Financial Assets evolution (€ Mn)

Source: Company data and analyst’s

estimations

Chart 47 - Tangible and Intangible assets' evolution (€ Mn)


estimations

Chart 48 - Non-current assets held for sale evolution (€ Mn)

Source: Banco de España and analyst’s

estimations

Chart 49 - Sabadell's market shares over the Total Deposits of Credit Int. in Spain from Customers (€'000)


PAGE 20/32

historical behaviour, it only appeared in 2012, it was projected to disappear as

time goes by.

The Available-for-Sale (AFS) Financial Assets portfolio, which is the second

largest portfolio of Sabadell, has shown signs of growth over the past years

(Chart 46). The portfolio includes mostly debt securities and other equity

instruments that do not fit into the FVTPL, HTM or L&R portfolios and are held to

sell when appropriate. The debt securities included in the AFS financial assets, in

2014 amounted €20,393 million, comprising government securities of which

€10,167 million were Spanish government securities, while €8,080 million were

securities issued by foreign governments12. This shows that Sabadell has a

higher exposure to the Spanish Government, which makes it more vulnerable to

the Spanish economy. Regarding the fact that there has been a decreased to the

exposure of Credit Institutions, it seems that Sabadell is seeking for a more

conservative policy in order to avoid unnecessary risk exposure to the financial

sector (the government bonds yields were high and the probability of default

much lower than for credit institutions, especially nowadays). This portfolio is

hard to forecast in terms of evolution, because it is mostly an investment policy

choice, but an increase in the item is not expected due to the fact that it impacts

negatively the RWAs. Moreover during the last years the selling of the Spanish

Government bonds has been generating big trading profits to the bank due to the

decline in the bonds’ yields. So, it was projected for the portfolio to downsize

slowly.

One of the key themes included in Sabadell’s Triple Plan is the

Internationalization. Therefore, Tangible and Intangible assets captions were

forecasted to increase over the years (Chart 47). Although the Triple Plan will

finish in 2016 and an acquisition was already done during 2015, it is expected,

due to the improvement of the Spanish economy, that Sabadell’s tangible assets

will continue growing due to expansion in terms of branches and employees. On

the other hand, intangible assets, which include goodwill, it is expected to

increase for this matter as well and due to the needs of the banks to provide

electronic access to its users as well as the computer software required for

operations.

Certain amount of assets have been grouped in the caption Other Assets

(Appendix 1 Consolidated Balance Sheet), among them is the Non-current

assets held for sale which is composed by all the foreclosed assets of the bank.

The biggest item including in this caption is the repossessed assets, which as of

2014, amounted €3,110 million. As Chart 48 shows, non-current assets held for

12 Foreign Government Securities: Italian, US, Portuguese and Mexican governments.

Chart 53 – NII evolution (€ Mn)


estimations


Chart 50 - Revenues breakdown as a percentage of total revenues

Source: Reuters

Chart 51 – Euribor 12-month’s evolution from 1999 to 2015

Source: Reuters and analyst’s estimations

Chart 52 – Euribor 12-month’s

estimations from 2015 to 2019


PAGE 21/32

sale suffered a sharp increase from 2011 as of today, which was associated with

the deterioration in the quality of the banks’ credit portfolios in the sector. There

are still strong pressures that would imply a growth of the amount of

collateralized loans going into default. However, betting on the improvements of

the Spanish economy and on the real estate market starts being more liquid, we

believe this item will decrease over the years.

On Sabadell’s Liabilities side, all the items except Liabilities under insurance

contracts and Provisions were forecasted. The Financial Liabilities at

amortized cost (FLAC) that is mostly composed by deposits from; Central

banks, Credit Institutions and Customers it is mostly influenced by economic

growth and the national savings rate. In the current environment and near future,

it is expected an increase of income for the next years (meaning that saving rates

should be higher), however, householders are still highly indebted and an

increase in Deposits from customers might see perceivable in two or more years.

So, the Total deposits in Spain, which have being decreasing as of today, were

projected to continue falling until 2016 and start increasing at a small peace

afterwards, based on the recovery of trust from customers that Financial

Institutions in Spain are facing now.

It was applied the same reasoning of the L&R portfolio by taking into account the

market share Sabadell holds in the Total Deposits of Credit Institutions in Spain,

that on average has been c5% from 2007-2014 (Chart 49) and 7.6% in 2014. For

FY2015e it was projected Sabadell will have the same market share of 2014 and

it will aim to keep a constant 7% market share from 2016 onwards over Spain’s

Total Deposits.

The wide variety of business activities a financial institution has are grouped in the

three common types of income they generate for a bank. The NII for Sabadell

generates the highest percentage of revenues (53% of total revenues as of 2015 –

Chart 50) and in order to forecast the evolution of this item, the yields and costs of

the average balance values of the different assets and liabilities that generates

interest income and interest expenses results were forecasted. To do so, the

Euribor 12-month was used as a benchmark because is the rate used for

calculating monthly instalment payments on over 90% of mortgages in Spain. The

projection of the Euribor 12-month’s evolution was based on the latest decision of

the ECB on his last meeting on December 9th, 2015. In the meeting the ECB

announced that interest rate on the main refinancing operations (MRO), which

provide the bulk of liquidity to the banking system, will remain in its lowest level of

0.05%. It kept the marginal lending facility at the same level as well (0.30%) and

decreased the rate on deposit facility to -0.30%. We can see how much the

Euribor 12-month has declined (Chart 51) when we take a look at figures from


Chart 54 – NIM evolution (NII/ATAs)


Chart 56 – Customer loan yield and

cost of customer funds (%)


Chart 57 – Customer loan yield and cost of customer funds estimations (%)


Chart 55 – Customer spread and Margin evolution (%)


PAGE 22/32

December 2012 (0.964%) and December 2014 (0.435%), the reason why the

Euribor is falling to new lows each month is due to action taken by the ECB in the

bid to stimulate the euro zone market. While it looks like the economy in the euro

zone is improving, it doesn’t mean that the situation is likely to change any time

soon regarding interest rates and the Euribor rates are still expected to decrease

for the foreseeable future, especially due the latest ECB’s actions. Therefore our

estimations by the end of 2016 is the Euribor rate will continue reaching lower

levels (0.146% FY2016 – Chart 52) and from 2017 onwards will start increasing at

a low peace, based on that the European economy will start showing more

notable improvements that will allow the ECB to take on decisions of increasing

the key interest rates of the euro area.

The overall evolution of Sabadell’s NII has seen an increasing tendency since

2008 up to 2014 (Chart 53), the low costs funding context play an important role

on this trend and this was reflected in the forecasts made, so it is expected by the

end of 2015F a NII of €2.651 million. On the other hand Net Interest Margins

(NIMs) as a percentage of Average total assets (ATAs) has been sharply

declining from 2008 until 2014 driven mostly by the constant increases in Total

assets at a CAGR of 13% (NII – CAGR: 8%). However, since the 1Q of 2014 until

3Q of 2015 Sabadell has been able to increase NIMs in this low interest rate

environment and it is expected 1.6% NIM for FY2015e, 20bps higher than 2014

(Chart 54). This is all driven by the steady improvements in customer spreads on

the back of lower cost of funding for both wholesale and retail (Chart 56), steady

improvements that we believe will continue for the next four years under the

assumptions that interest rates will be probably start increasing from 2017

onwards (Chart 57). Moreover on Charts 58 and 59 we can see how loan

spreads from the Back and Front books are beginning to stabilise in the different

segments. This is meanly due to the fact that companies and SMEs in Spain are

been currently priced at similar levels that other countries in Europe. As we can

see on the back book the total average of loan spreads of the Sabadell has

decreased only by 2bps from 2Q to 3Q of 2015. It is also expected that liability

repricing will continue in coming years. Tables XIII and XIV shows the different

maturities of term deposits and the wholesale funding maturities, both in terms of

volume and in terms of price. We assumed that markets will maintain its current

stable conditions, so if Sabadell manages to renovate those deposits at 0.3%

cost (current one) and also the wholesale funding to 0.62% (current one), NII will

be benefit from deposit and wholesale funding re pricing of about €330 million

and €220 million, respectively. The NII has been and will continue to be under

pressure for some given years driven the on-going very low interest rate

environment in developed countries, Sabadell could generate more income from


Chart 58 - Loan spreads evolution by segment (%) - Back book


Chart 59 - Loan spreads evolution by

segment (%) - Front book

Maturities Rate Amount

4Q15 1.12% 10,550

1Q16 1.10% 6,549

2Q16 1.04% 8,359

3Q16 0.73% 6,767

4Q16 1.07% 1,138

1Q17 0.96% 495

>2Q17 0.73% 1,414

Table XIII - Maturities of term deposits: volume and average interest rate cost (€ Mn)


Maturities Rate Amount

2015 2.43% 476

2016 2.53% 4,606

2017 3.55% 3,147

2018 3.43% 1,679

2019 3.41% 924

2020 3.08% 1,547

2021 2.48% 2,585

2022 3.26% 1,144

>2022 2.18% 761

Table XIV - Wholesale funding maturities (€ Mn)



PAGE 23/32

the loans to SMEs since it is a segment that has been growing in the economy,

but due to competition and the Euribor playing against loans interest rates, NII is

being affecting. Although, we expect Sabadell’s NII to continue increasing from

FY2015e until FY2019e at a CAGR of 4% (Chart 53).

Net Fees and Commission income (F&C), the second largest source of

revenue of Sabadell has been growing in a seasonally weak 3Q 2015 (Chart 60).

The big increases are related to; i) the asset management business activity,

which are currently accounting for the largest share of F&C in Spain and they are

gaining importance, in part due to the unattractiveness of deposit’s remuneration,

and ii) all the collection and payment fees related to credit cards. Similar results

of the mentioned items are expected for the 4Q of 2015, growing the total amount

by 17% with respect to 2014. Overall, this item was forecasted to continue its

growing trend at a constant 7% growth rate YoY, especially due to the need of

the bank to continue exploring other sources of revenues different than NII.

Trading income has seen a bulk in the last two years amounting €1.5 and €1.8

billion in 2013 and 2014 respectively (Chart 61), likely to remain a key driver in

2015. In the last eight quarter trading revenues have accounted for an average

36% of Sabadell’s total revenues, which is unusually high for a pure retail bank.

Sabadell has been benefiting from the sale of Spanish government bonds that

were bought in 2011 and has seen a decline in its yield from the middle of 2012

as of today. The gains have been allocated to provisions to reinforce coverage

ratios. The bank still has unrealized trading gains in its securities portfolio in the

balance sheet in 2015, so we expect trading income to amount €1.2 billion by the

end of 2015e. For FY2016e onwards we forecast, based on the size of the

trading portfolio and the expected return on it, more normalized trading income of

€513 million for FY2016e and continue declining.

The Provisions for non-performing-loans (NPLs) and impairments were

done over the Loan portfolio. From 2007 up to 2014 Sabadell has been

provisioning on average 1.3% of the loan portfolio and for the next years we

expect the bank to provision 2% over the loan portfolio (Chart 62). We expect this

caption to decrease by the end of 2015 with respect to 2014 by 6%, regarding the

fact that Sabadell has already provisioned their problematic assets for an amount

of €1.7 billion in the first half of 2015.

In relation to Income Taxes, it was assumed that Sabadell will pay a Corporate

Income tax rate of 26% from the 4Q 2015 onwards (Chart 63). The Law 27/2014

that came into force on January 1st 2015 and stated in its article 130 that the

aforementioned deferred tax assets might be exchanged for public debt

securities after a period of 18 years from the last date of the tax period in which


Chart 60 - Net Fees and commissions income evolution per quarter (€'000) - 2015


estimations

Chart 61 - Net Gains/Losses on financial assets and liabilities evolution (€ Mn)


estimations

Chart 63 - Income tax evolution (€ Mn)


Chart 62 - Provisions for NPLs and other impairments (€ Mn) and the Provisioned percentage over the Loan portfolio


PAGE 24/32

the assets were recognised13. These means that Sabadell will be able to benefit

from tax credits for the period being analysed and according to the available

amount of Tax Assets Sabadell has on its Balance Sheet, the expected income

taxes will be deducted from it.

After deducting income taxes and the share of profit attributed to non-controlling

interests, the estimated profit attributed to the bank is €432 million for FY2015e,

representing 16% increase YoY with respect to FY2014 (€372 million).

The calculated discount rate to perform the FTE valuation for Sabadell was

obtained through the Capital Asset Pricing Model (CAPM) model (Table XV). As

a Risk free rate was used the 10 year German Government Bond (GTDEM10Y

Govt) as of January 1st, 2016. It was not used any Spanish Government bond

due to the diversified composition of investors that Sabadell has. Concerning the

beta for the bank (Chart 64), we regressed the Euro Stoxx 50 Index (SX5E)

against Sabadell’s stock using monthly data from 2011 until 2015 to measure the

risk that compares the returns of the stock to the market. It was used a

confidence interval of 95% to assess the probability that our calculated betas will

fall between the upper and lower bound estimated. An average of the last two

quarters of 2015 (where our betas get closer to the confidence interval) was

computed, resulting in a beta 1.3. The calculation of the Market risk premium

(MRP) was computed over the last year by using the Index mentioned before and

assuming that the realized return of last year is the expected excess return for

future years, the outcome was 5%. The resulted CoE was 7%.

Sensitivity Analysis

The defined growth rate to perform the valuation for the long time horizon was

2.1%. It was calculated an average of the changes over the same quarter of the

previous year since 1Q 2014 to 2Q 2015, which is the period where the Nominal

GDP in Spain has started to show positive growth rates (Chart 65). Perhaps this

growth rate can be seen as conservative, regarding the fact that in the second

quarter of 2015 the percentage change over the year before was 3.1%, however,

the reasoning behind is the current characteristics of the banking sector, which is

going through several changes not only due to the international financial crisis

and the real estate bubble, but also due to its regulatory response. The higher

capital requirements after the implementation of Basel III accords might slow

down the growth of the sector. So, worries about how banks will be actually able

to develop their business strategies and the returns they will be able to achieve

will always be present under this environment.

13 The Law 27/2014 of 27 November on Corporate Income Tax (The CIT law or “LIS”) came into force on 1 January 2015 and repeals the Revised Text of the Income Tax Law (TRLIS).

Chart 64 – Sabadell’s betas regression


Levered Beta 1.3

GTDEM10Y Govt 0.586%

Market risk premium 5%

CoE 7%

Table XV – Sabadell’s Cost of equity

Chart 65 – Spain Nominal GDP growth rate (Change over same quarter of the previous year)

Source: OECD


PAGE 25/32

It was assessed the sensitivity of the estimated target value (€1.8 per share14)

resulting from the valuation of Sabadell excluding TSB, to the changes of the

growth rate and CoE under adverse and stable scenarios. To do so different

inputs were used to analyse whether our expectations might go wrong and what

would be a fair range for uncertain variables such as the beta and the MRP. For

the nominal growth rates was used a range from -4.1% and 3.4%. The refer

series include the positive changes in the nominal GDP growth rate of the latest

six quarters in Spain and negative rates used in the Oliver Wyman Stress test in

2012, where the economy was test under a severe economic recession (adverse

scenario) with nominal GDP declines of 4.1% and 2.8% (Table XII). To assess

the changes to the CoE, different betas and benchmark MRPs were used. With

the beta varying from 1.1 to 1.4 and the MRP varying from 3% and 6%, it was

obtained a series of CoE from 4% to 9%. It was also test the price by using the

average CoE for the sector in Spain in 2011 and 2015, 18% and 11%

respectively (Chart 13).

The results on table XVI, show that in high risk scenarios in the economy in

Spain (-4.1% growth rate and 18% CoE), Sabadell’s share price can fall until

almost cero. On the upside, if the CoE is reduced to 4% and the long run growth

rate increases until 3.4%, it is perceivable a drastic and unreasonable jump in the

price per share for the bank. However, by keeping the same growth rate and a

CoE of 5%, Sabadell is likely to return to its share prices on 2007.

Table XVI:

These data suggests that the estimated share value is very sensitive to variations

of the baseline assumptions of 2.1% long-run growth rate and 7% discount rate.

Adverse variation in valuation parameters could reduce Sabadell’s share value

estimates to €0.4 per share and favourable variations could increase it to €4.6

per share.

Considering that the forecasts and valuation assumptions done are realistic, the

baseline estimated for Sabadell at the end of 2016 is €1.8 per share, meaning

that by that time the current market price of €1.6 per share of Sabadell is under-

14 The resulted Sabadell’s target value of €1.8 per share was obtained through its FTE valuation. We only refer to this value in the sensitivity analysis exercise, but the

definite target value is €2.3 per share through the SOTP valuation.

-4.1% -2.8% -1.9% -0.7% 0.7% 1.2% 1.7% 2.1% 2.7% 3.1% 3.4%

4% 1.3 1.5 1.7 2.1 3.0 3.6 4.3 5.3 7.9 11.7 18.7

5% 1.1 1.2 1.4 1.6 2.0 2.3 2.6 2.8 3.5 4.0 4.6

7% 0.9 1.0 1.1 1.2 1.5 1.6 1.7 1.8 2.0 2.2 2.4

9% 0.8 0.8 0.9 1.0 1.1 1.2 1.3 1.3 1.4 1.5 1.6

11% 0.6 0.7 0.7 0.8 0.9 0.9 1.0 1.0 1.1 1.1 1.2

18% 0.4 0.4 0.5 0.5 0.5 0.5 0.5 0.5 0.6 0.6 0.6

Growth rate

Co

st

of

eq

uit

y


PAGE 26/32

priced by about 13%. Given these estimates, it is reveal that Sabadell’s share

value has limited downside potential but substantial upside potential.

TSB’s valuation

TSB is segmented into two business units; The Franchise and The Mortgage

Enhancement15. The valuation of the Group was performed in pounds and the

outcomes were converted into euros in order to do the SOTP valuation. The

exchange interest rate used to convert the Free Cash Flows (FCF) to equity

holders were: GBPEUR 1.411 for FY2015e and GBPEUR 1.399 for FY2016e

onwards. The exchange rate for the long run was estimated using the Purchasing

Power Parity (PPP) and the inflation rates for Spain and The UK for the long run

which is 1.2% and 2.1% respectively (Chart 66)

The projection of TSB’s Loans and advances to Customer item was based on

the positive results obtained through the new Franchise’s intermediary channel16

for the first since the moment it was launched (January 2015). The Franchise

lending balances grew by £266.3 million in the first half. The success enabled

TSB to deliver positive quarterly lending growth, the total amount of this item

increased to £21,660 million in the 2Q 2015 (£21,386 million – 1Q 2015). In the

1Q and 2Q of 2015 TSB was named mortgage lender of the quarter by Mortgage

Strategy Magazine. Other attractive products were also launched during the 1H

of 2015; the Fix and Flex17 that allow customers to fix their interest rate for 10

years with flexibility to switch to a new product after 5 years and the Breathing

Space, which allows customers to make lower payments in the first year of their

mortgage. On top of this, TSB exceeded their target of winning more than 6% of

all customers opening or switching bank accounts in the UK. Overall we expect

the caption Loans and advances to customers to continue increasing over the

years (Chart 67), since through the implementation of these business strategies,

TSB has become one of the fastest growing mortgage providers in the UK.

TSB increased its Funding and Liquidity position by attracting new customers and

retaining existing deposit balances in the first half of 2015. This led to an increase

in deposit balances of 1.3%, or £313 million to £24,937 million during the first

semester. The caption Financial Liabilities it is mostly composed by Customer

deposits (98% of total financial liabilities in 2014 – Chart 68) which is made up

mostly of customer bank accounts and saving balances. The Franchise Loan to

deposit ratio as of June 2015 was 76.6% (December 31st, 2014 – 76.5%). We

expect customers’ deposits to increase by 6% in FY2015e with respect to 2014,

15 Franchise segment comprises the retail banking business which offers a broad range of retail financial services that include current accounts, savings products, personal loans, credit cards and mortgages. The Mortgage Enhancement segment comprises a separate portfolio of mortgage assets which was assigned to TSB by Lloyds Banking Group with effect from February 28th, 2014. 16 TSB launched a range of products through this channel to include house purchase, remortgaging and buy-to-let mortgages. 17 Fix and Flex product won the Innovation in Personal Finance award at the Moneyfacts 2015.

Source: Inflation.eu, European Commission, British Chambers of Commerce and Statista websites

Chart 66 – Inflation rate evolution and estimations for the long run

Source: Company data and Analyst’s estimates

Chart 67 – Loans and advances to customers evolution (£ Mn)

Source: Analyst’s estimates

Chart 68 – Financial Liabilities

breakdown (% over Total amount)


Chart 69 – Customer deposits

evolution (£ Mn)


PAGE 27/32

especially after July 2015, when Moody’s published for TSB Bank plc an

investment grade long-term debt rating of Baa2 with positive outlook and for TSB

Group plc (Baa3), which represents in our view a good independent assessment

and recognition of TSB’s strategic progress. Based on the latest performance of

this item and the overall good conditions of the UK’s economy it is believed TSB

will be able to continue increasing its mean sources of fund (Chart 69).

As expected from a retail bank, NII generates the highest percentage of income

over total revenues and in TSB’s case NII represented 84% of the Total Income

as of 2014 (Chart 70). The reasoning applied to forecast this item was based on

the scenario that in the mid of 2016 or during 2017, The Bank of England will

take on the decision of raising interest rates especially after the Fed finally raised

interest rates for the first time in almost a decade. In 2014, there was an increase

by 66.1% to £787.1 million in NII in TSB’s balance sheet, meanly due to; the

customer transfers in 2013 and the NII earned on the Mortgage Enhancement

portfolio since it was transferred to the Group on February 2014. The NIM of the

Franchise increased by 6bps in the 1H of 2015, mostly due to lower deposit

funding costs. We expect the NII arising from the two business segment of TSB

to benefit from the higher expectations around the increase in interest rates in the

UK and increase over time at a CAGR of 8% from 2015 to 2019 (Chart 71).

Operating expenses has remained stable in the 1H of 2015 because the Group

spent a huge amount in marketing during the last quarter of 2014 together with

the ongoing focus on managing costs in the current low interest rate

environment. We expect Sabadell to substantially change TSB’s cost base which

before the acquisition was dependent on a service agreement with Lloyds. As a

result, with a potentially lower cost IT system more suited to TSB, we would

expect TSB to generate higher earnings under Sabadell mandate. The item was

forecasted to continue decrease significantly YoY (Chart 72).

TSB’s Impairment losses on loans and advances to customers was projected

as a percentage of Loans and advances to customers. The caption decreased in

the 1H of 2015 by 15% with respect to 2H 2014. The absolute value of impaired

loans decreased by 12.3% and the Asset quality have been decreasing from

2013 until the 1H of 2015 reaching 0.37% (0.61% - 2013 and 0.44% - 2014)

driven by the constant favourable macroeconomic conditions in UK (particularly

due to lower unemployment). Based on the behaviour of this item is highly

influenced by general conditions of the economy, we expect it to decrease over

time (Chart 73).

Chart 71 – NII forecast (£ Mn)


Chart 73 – Impairment losses on loans and advances to customers (£ Mn)



Chart 70 – Total revenues breakdown (% over Total amount)

Chart 72 – Operating expenses evolution (£ Mn)



PAGE 28/32

The resulting estimated attributable profit for the company for FY2015e was £173

million (€245 million) and the synergies TSB will generate to Sabadell from 2015

onwards are expected to grow at CAGR of 40% (Chart 74).

The resulting CoE for TSB by using the CAPM model was 7% (Table XVII). As a

risk free rate it was used the United Kingdom 10 year Government Bond of 1.8%

as of January 4th, 2016 and a benchmark of 5% as a MRP. The continuation

growth rate for TSB is more ambitious than the long run growth rate of Sabadell,

regarding the stronger performance of the UK’s economy. The former resulted

from the computation of an average of the last quarter’s nominal GDP growth

rate (Chart 75). The latest available data for the beta of TSB on Bloomberg

against the FTSE 100 Index is significantly lower than 1 (adjusted beta of 0.333)

meaning that the volatility of TSB is significantly lower than the market volatility,

therefore it was assumed a beta equal to 1.

Sum of the parts valuation

On Appendixes are presented the consolidated figures of the financial

statements (Appendixes 1 and 3) and the resulted capital structure of Sabadell

including the acquisition of TSB (Appendix 2).

The SOTP valuation was performed from the resulted FCF to equity holders

obtained from each financial institution and the estimated Target Price for

Sabadell including the acquisition is €2.3 per share price. The expected capital

gains are 39% over the current share price of €1.6 per share, the total

shareholders’ expected return is 36% and our recommendation is to buy. On

FY2016e Sabadell is estimated a cash out of 4% that will have to be cover with a

capital increase amounting €266 million, the amount is feasible to raise due the

fact that expected income for 2016e amounts €726 million.

Table XVIII:

Regarding the objectives settled in the Triple Plan, although Sabadell won’t be

able to achieve all of them by FY2016e according to our estimations, some


Chart 74 – Net Income attributable to the company (£ Mn)

Description (Values in € Mn) 2015F 2016F 2017F 2018F 2019F

Banco Sabadell Group, S.A FTE (excl TSB) 1,911 -571 263 396 546

TSB Banking Group plc FTE 5 165 201 166 100

Sabadell (excl TSB) - Market capitalization 8,710 9,906 10,355 10,704 10,927

TSB - Market capitalization 2,484 2,463 2,428 2,426 2,489

Sabadell's Total Market capitalization 11,193 12,369 12,783 13,129 13,416

Sabadell's shares outsatnding (Mn) 5,439 5,439 5,439 5,439 5,439

Expected share price 2.1 2.3 2.4 2.4 2.5

Expected Capital Gain 39%

Shareholders' Cash in/out (per share) 0.35 -0.07 0.09 0.10 0.12

Expected "Cash" Gain -4%

Total Shareholders' Expected Return 36%

Table XVII – TSB’s Cost of Equity

Levered Beta 1

GTGBP10Y 1.8%

Market risk premium 5%

CoE 7%

Chart 75 – UK nominal GDP growth rate (Change over same quarter previous year)

Source: OECD


PAGE 29/32

improvements in the balance sheet are perceivable after the acquisition of TSB.

The expected Net Income would be below from the desired €1,000 million by

€384 million and the Cost to income ratio would be 60bps higher than the one

expected (40%). This is because the reduction in cost will return higher profits

only from 2018 onwards. In relation to the Loan to deposits ratio, Sabadell is

about to reach the 100% expected, because according to our estimations by

FY2016e it would have a 95% loan to deposits. Moreover, it has surpassed the

1% Lending growth CAGR settled from the period 2013-2016, since the

estimated CAGR would be 7% by FY2016e.

Sabadell’s Capital Structure incl. TSB shows the bank complies with the

regulatory requirements, by achieving a CET 1 ratio of 12.5% and a BIS ratio of

13.8% for the FY2016e.

Multiples Valuation

A careful multiples valuation is always very useful to measure how accurate the

forecasts and the FTE valuation were done. It was compared Sabadell with its

listed Spanish’s Peers being traded in the Ibex 35 Stock exchange; Banco Bilbao

Vizcaya Argentaria, Caixabank S.A, Banco Popular Español, Bankinter S.A,

Bankia S.A, Liberbank S.A and Banco Santader S.A. The multiples Price-to-

earnings (P/E) and the Price-to-book value (P/B) were computed due to their

common used in the industry, especially the P/E ratio that is a key multiple in the

steady-growth mid-cycle phase of economic growth. Higher ratios might suggest

that investors expect a higher growth in earnings in the future or higher expected

growth rates compared with lower ratios suggesting low-quality earnings growth

or a sector that cannot grow.

Table XIX shows the estimated results of both ratios for FY2016e (P/E -

€0.4p/shr and P/B – €1.7p/shr) are below our resulted price per share of €2.3.

One of the possible reasons to justify this difference, is that when doing multiples

valuation it can happen that the earnings estimated for the peers (in case of the

P/E ratio) are not as optimistic as the ones expected through our FTE valuation

for Sabadell or it has been adjusted for some reasons. In case of the P/B ratio,

when we look at the average resulted from the peers’ ratios we see that it is not

so high. This means that either managements are not expecting to create so

much value from their given assets or these stocks are being undervalued. In

conclusion, we keep the resulting Sabadell’s value of €2.3 per share.

Source: Bloomberg and Analyst’s estimates

Compny name Ticker FY2 P/E (x) FY2 P/B (x)

BANCO DE SABADELL SA SAB SM 11.7 0.7

BANCO BILBAO VIZCAYA ARGENTARIA BBVA SM 10.2 0.9

CAIXABANK S.A CABK SM 12.2 0.8

BANCO POPULAR ESPANOL POP SM 13.4 0.6

BANKINTER SA BKT SM 14.0 1.6

BANCO SANTANDER SA SAN SM 9.5 0.8

LIBERBANK SA LBK SM 10.9 0.6

BANKIA SA BKIA SM 12.6 1.1

Average 2016 11.8 0.9

Target Price per share € (2016) 0.4 1.7

Table XIX – Multiples valuation


PAGE 30/32

Appendixes

Appendix 1 - Consolidated Balance Sheet of Sabadell

Consolidated Balance Sheet (€ Million) 2014 2015F 2016F 2017F 2018F 2019FCash and balance (deposits) with Central Banks 1,190 8,739 8,759 9,071 9,404 9,759

Trading and derivatives portfolios and other financial assets 3,253 3,053 3,027 3,005 2,987 2,971

Available-for-sale (AFS) financial assets 21,096 24,234 23,127 22,773 22,396 21,983

Loans and receivables 117,895 149,743 146,443 148,254 150,431 152,701

Loan and advances to credit institutions 4,623 4,461 4,448 4,628 4,918 5,170

Loan and advances to other debtors 110,836 143,170 139,925 141,597 143,525 145,581

Debt Securities 2,436 2,112 2,070 2,029 1,989 1,950

Memorandum item: Loaned or advanced as collateral 772 - - - - -

Investments 513 297 297 297 297 297

Tangible assets 3,983 4,165 4,253 4,355 4,470 4,600

Intangible assets 1,591 2,019 2,120 2,239 2,377 2,539

Other assets 13,824 14,294 14,365 14,612 15,017 15,627

Held-to-maturity investments - 0 0 0 0 0

Changes in the fair value of hedged items in portfolio hedges of interest rate risk - 314 315 318 321 324

Non-current assets held for sale 2,250 2,192 2,083 2,010 1,970 1,960

Insurance contracts linked to pensions 163 170 179 190 205 225

Reinsurance assets 12 35 42 51 61 73

Tax Assets 7,128 6,831 6596 6385 6157 5910

Other assets (Inventories + Other) 4,272 4,752 5,151 5,658 6,303 7,135

Total Assets 163,346 205,818 202,377 204,605 207,379 210,477

Trading and derivatives portfolio and other financial liabilities 2,254 2,596 2,612 2,633 2,654 2,676

Financial Liabilities at amortized cost (FLAC) 145,580 185,152 181,161 183,060 185,454 188,134

Deposits from central banks 7,202 11,063 10,842 10,627 10,420 10,220

Deposits from credit institutions 16,288 15,383 15,389 15,395 15,401 15,408

Deposits from other creditors 98,208 131,975 126,145 128,129 130,283 132,574

Debt certificates including bonds 20,196 19,387 21,503 21,676 22,160 22,781

Subordinated liabilities 1,012 1,526 1,435 1,355 1,279 1,209

Other financial liabilities 2,673 5,818 5,847 5,878 5,909 5,943

Liabilities under insurance contrats 2,390 2,266 2,266 2,266 2,266 2,266

Provisions 395 402 402 402 402 402

Other liabilities 1,510 2,987 2,529 2,690 2,865 3,056

Total Liabilities 152,130 193,403 188,970 191,050 193,640 196,533

Total Equity 11,216 12,415 13,407 13,555 13,739 13,944

Total liabilities and equity 163,346 205,818 202,377 204,605 207,379 210,477

Appendix 2 Sabadell’s Capital Structure incl. TSB

Capital Structure incl TSB (€ Million) 2014 2015E 2016E 2017E 2018E 2019E

CORE CAPITAL RESOURCES (CET 1) 8,703 12,415 13,407 13,555 13,739 13,944

Core capital (CET 1) ratio 11.7% 11.6% 12.5% 12.5% 12.5% 12.5%

Tier I resources 8,703 12,415 13,407 13,555 13,739 13,944

Tier I (%) 11.7% 11.6% 12.5% 12.5% 12.5% 12.5%

Tier II resources 839 1,526 1,435 1,355 1,279 1,209

Tier II (%) 1.1% 1.4% 1.3% 1.2% 1.2% 1.1%

Capital base 9,542 13,941 14,843 14,910 15,018 15,153

Minimum capital requirement 5,953 8,562 8,581 8,675 8,793 8,924

Capital surplus 3,588 5,379 6,262 6,235 6,225 6,228

BIS ratio (%) 12.8% 13.0% 13.8% 13.7% 13.7% 13.6%

Risk Weighted Assets (RWAs) 74,418 107,025 107,260 108,441 109,911 111,553


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Appendix 3 Consolidated Income Statement of Sabadell

Income statement (€ Million) 2014 2015F 2016F 2017F 2018F 2019FNet Interest Income 2,260 3,833 4,224 4,343 4,493 4,648

Income from equity method and dividend 9 51 51 51 51 51

Other income 669 1,220 1,300 1,390 1,488 1,594

Net fees and commissions 861 963 1,031 1,103 1,180 1,263

Other operating income/expense (net) 192- 11 12 14 16 19

Gains or losses on financial assets and liabilities (net) 1,764 1,191 513 380 362 345

Foreign exchange (net) 100 123 123 123 123 123

Gross operating income 4,801 6,417 6,211 6,287 6,517 6,760

Administrative Expenses 1,773- -2,822 -2,545 -2,431 -2,350 -2,271

Depreciation & Amortization 278- -294 -308 -324 -340 -357

Pre-provision operating profit 2,749 3,302 3,358 3,532 3,827 4,132

Provisions for NPLs and other impairments 2,500- -2,455 -2,468 -2,394 -2,330 -2,264

Gains on sale of assets (Other provisions) 237 -1 41 42 43 44

Badwill - 207 0 0 0 0

Profit before tax 486 1,054 931 1,180 1,540 1,912

Income tax 110- -167 -204 -258 -343 -430

Consolidated net profit 377 886 726 922 1,197 1,482

Profit or loss from discontinued operations (net) - - - - - -

Consolidated profit or loss for the period 377 886 726 922 1,197 1,482

Minority Interest 5- -2.3 - - - -

Attributable net profit to the parent company 372 884 726 922 1,197 1,482

Appendix 4 Sabadell’s Landmark developments

A group of 127 businessmen and traders set up the Bank in the town of Sabadell to provide funding for local industry.

Acquisition of NatWest Spain Group and Banco de Asturias.

Successful bid for Banco Atlántico.

Acquisition of Banco Urquijo.

The Bank acquires BBVA's private banking business in Miami, USA. Sells 50% of its insurance interests.

The Bank launches a takeover bid for 100% of Banco Guipuzcoano.

Acquisition of Banco CAM and creation of Sabadell Urquijo BP.

The Bank begins operations in Mexico.

1881 1996 2003 2006 2008 2010 2012 201

4

1965 2001 2004 2007 2009 2011 2013 2015

Steady expansion of branch network begins.

Banco Sabadell is listed on the stock exchange. The Bank acquires Banco Herrero.

A capital increase puts the Bank in the IBEX-35 league. Integration of Banco Atlántico IT and business systems.

Acquisition of TransAtlantic Bank (Miami).

Acquisition of Mellon United National Bank.

The Bank acquires the assets and liabilities of Lydian Private Bank (Florida) and announces the takeover of Banco CAM.

Acquisition of Caixa Penedès and Banco Gallego branches and Lloyds Banking Group's Spanish operations.

TSB’s

acqui

sition

Source: Company data.


PAGE 32/32

Disclosures and Disclaimer

Research Recommendations

Buy Expected total return (including dividends) of more than 15% over a 12-month period.

Hold Expected total return (including dividends) between 0% and 15% over a 12-month period.

Sell Expected negative total return (including dividends) over a 12-month period.

This report was prepared by Naryara Naranjo, a student of the NOVA School of Business and Economics, following the Masters in Finance Equity Research – Field Lab Work Project, exclusively for academic purposes. Thus, the author, which is a Masters in Finance student, is the sole responsible for the information and estimates contained herein and for the opinions expressed, which reflect exclusively his/her own personal judgement. This report was supervised by professor Rosário André (registered with Comissão do Mercado de Valores Mobiliários as financial analyst) who revised the valuation methodology and the financial model. All opinions and estimates are subject to change without notice. NOVA SBE or its faculty accepts no responsibility whatsoever for the content of this report nor for any consequences of its use. The information contained herein has been compiled by students from public sources believed to be reliable, but NOVA SBE or the students make no representation that it is accurate or complete, and accept no liability whatsoever for any direct or indirect loss resulting from the use of this report or its content. The author hereby certifies that the views expressed in this report accurately reflect his/her personal opinion about the subject company and its securities. He/she has not received or been promised any direct or indirect compensation for expressing the opinions or recommendation included in this report. The author of this report may have a position, or otherwise be interested, in transactions in securities which are directly or indirectly the subject of this report. NOVA SBE may have received compensation from the subject company during the last 12 months related to its fund raising program. Nevertheless, no compensation eventually received by NOVA SBE is in any way related to or dependent on the opinions expressed in this report. The Nova School of Business and Economics, though registered with Comissão do Mercado de Valores Mobiliários, does not deal for or otherwise offers any investment or intermediation services to market counterparties, private or intermediate customers. This report may not be reproduced, distributed or published without the explicit previous consent of its author, unless when used by NOVA SBE for academic purposes only. At any time, NOVA SBE may decide to suspend this report reproduction or distribution without further notice.

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