Spain’s largest bank is in trouble

Spain’s largest bank is in trouble

By Stephen Gandel, senior editor January 3, 2014: 11:38 AM ET

Santander has fallen woefully short of its chairman’s growth targets, and it’s not clear things are improving. FORTUNE — In early December, Banco Santander spent $650 million to buy an 8% stake in the Bank of Shanghai. For Santander (SAN), Spain’s largest bank, the deal looks to be another case of wrong place, wrong time.It’s also the latest example of Santander’s hard-charging chairman Emilio Botín’s long-running growth strategy. Botín has pursued acquisitions that have pushed the once-sleepy Spanish bank, which he took over from his father in 1986, well beyond its home market. That strategy has begun to sputter.

In early 2012, Botín, 79, sat down with Fortune for an interview — his first major one with an American publication. Botín predicted that in the next two years his bank’s profits would rise by 50%. He made a similar promise to analysts and investors at a meeting a few months earlier.

Nearly two years later, Botín has woefully missed his goal. Far from rising by half, Santander’s 2013 bottom line is expected to be down 13% from where it was in 2011. In all, Santander’s profits have tumbled nearly 50% since 2009, when its income reached a peak fueled by aggressive lending in Spain that has now come back to haunt the bank.

All this comes at a time when Botín has lost his longtime No. 2. In April, Santander’s veteran CEO, Alfredo Saenz, 70, was forced to quit over allegations that he made false accusations in a case that involved Banesto, a rival Spanish bank that Saenz ran until it was acquired in 1994 by Santander. Along with Botín, Saenz led the bank through its long period of expansion. Botín backed Saenz until the end.

In his place, Botín appointed a relatively inexperienced executive, Javier Marin, 47, who used to run the firm’s private bank. Some have concluded that Marin is just a placeholder for Ana Botín, 52, Emilio’s daughter, who runs the bank’s U.K. division. But it’s unclear if shareholders would back another family handover, especially at a time when the bank appears to be struggling.

An increasingly deeper profit hole

Botín’s inability to hit his target has dented his shrinking credibility with investors. The company’s shares have fallen 12% in the past three years, despite generally good equity markets. What’s more, bank analysts have mostly abandoned the stock, with more than half not recommending Santander shares.

And it’s hard to see how the bank can get back on a path to better profits. As much as Santander has tried to expand overseas, it’s still a Spanish bank. And in a world of Too Big to Fail, where large banks’ credit ratings, and borrowing rates, are closely tied to their home country, Spain’s financial problems mean that Santander can’t borrow as cheaply as Deutsche Bank (DB), or U.S. rivals, which are increasingly looking to take market share in Europe as the continent rebounds.

On top of that, Santander’s push into Brazil and elsewhere could be a liability in the near future. Rising interest rates and slowing growth are making many strategists nervous about emerging markets.

Emilio Botín declined to comment for this story. Santander CFO José Antonio Álvarez says Europe’s sovereign debt crisis and Spain’s economic problem became more of an issue than Botín and others at the bank anticipated. As a result, the bank had more losses than expected on Spanish loans. And Álvarez, like other bank executives, says low interest rates have been a drag on earnings.

Álvarez admits Santander does have to pay more to borrow than international rivals. But he also maintains that Santander is far less reliant on traditional debt than its rivals. The bank gets most of its funding from consumer deposits. What’s more, after holding back for the past few years, Spain’s receding economic problems should start to serve as a tailwind for the bank.

“Nearly every market we operate in will be better in 2014 than in 2013,” says Álvarez.

Indeed, some of Santander’s deals are paying off, particularly in the U.S. In 2006, Santander paid $636 million for Dallas-based auto lender Drive Financial. The bank sold 25% of the unit, Santander Consumer USA, in 2011 to two private equity firms, raising $1 billion. Last year, Santander filed to take Santander Consumer public. The IPO is expected to value the unit at $6 billion, making Santander’s remaining 65% stake worth $3.9 billion.

Santander has done well with U.S. retail bank Sovereign, the bulk of which it bought in 2009, during the worst of the financial crisis, for $2 billion. In the first nine months of 2013 alone, the division, which was rebranded Santander this year, earned $772 million. But loans and consumer deposits have been falling.

Still, none of that gets Botín off the hook. Europe’s debt problems were well known in late 2011 and 2012, when Botín was making his rosy growth predictions. And while lending losses are receding, those troubled loans were made under Botín’s watch and, more importantly, under the watch of Botín’s daughter and potential successor, who was in charge of Santander’s Spanish banking operations for much of the 2000s.

And Santander might hit a limit to how much it can expand based on deposits. Santander has a loan-to-deposit ratio of 108%, meaning it has lent out more money than it has in its accounts. That ratio is down significantly from five years ago, when it was 150%. But that was back when regulators were much more lenient. And it’s far higher than U.S. rivals, whose loan-to-deposit ratios are near 70%, making it easier for them to increase lending.

“But of course it was impossible to produce the type of growth Botín promised,” says Robert Tornabell, a professor of retail banking at the ESADE business school in Barcelona who has followed Botín’s career closely and has advised the bank. “He should have known.”

And while Santander’s expansion into emerging markets makes sense as a growth strategy, Botín may have misplaced his bets. Santander generates a quarter of its profits in Brazil, which is expected to experience economic growth of just over 2% this year. That’s far slower than other emerging markets and even the U.S.

Up next: misadventures in China?

Santander may be repeating its mistakes. The bank is rushing into China at a time when international rivals are selling out on fears of an economic slowdown and a possible banking crisis. Santander’s main Spanish rival, BBVA (BBVA), recently trimmed its stake in China’s CITIC Bank Corp. Goldman (GS) exited its stake in International and Commercial Bank of China (ICBC) in 2013 as well.

On top of Santander’s $650 million investment in the Bank of Shanghai, Santander has a 20% stake in Bank of Beijing’s consumer finance subsidiary. It also owns half of an auto financing company, a joint venture with Chinese car company Anhui Jianghuai Automobile.

The Santander deal values Bank of Shanghai, one of China’s business retail banks, at roughly 6.5 times the bank’s 2012 earnings, the latest available financials. That’s about the same valuation that ICBC’s shares sell for.

China’s economic growth is slowing. And a number of strategists and prominent investors have warned that its economy may be over-leveraged. Recently, China’s central bank has been pumping money into its financial system to avoid a cash crunch.

None of that seems to have stopped Santander and Botín. “He’s a risky man,” says Tornabell. “Botín likes danger.” Looks like he’s found it.