BBVA's superiority and optionality

BBVA is Spanish only by name. It is a global commercial-banking-oriented group, present in more than 30 countries, and which aspires to become the world’s best universal bank. The group is the third largest Bank player in Spain with market shares comfortably above 10%. However, over the past three decades, the group has largely diversified its geographical footprint targeting Spanish-speaking customers.

Hence, it is the largest financial institution in Mexico, which was until recently complemented by an extended presence in the the US Sunbelt region, unexpectedly sold to PNC last November. BBVA has also developed a strong presence in South America through leading franchises. At last, the group has bet on Turkey with the acquisition of a large but minority stake (49.9%) in Garanti Bank, the country’s second largest player.

As a result, if Spain is the group’s historical market, it accounts for less than a quarter of the group’s normalised profits (temporarily down to 15% in 2020 depressed by the COVID-19 outbreak). The Americas (Mexico + the US) account for more than half of the profits. Following the disposal of Chile in 2018, the contribution of LatAm has fallen to around 10% of profits, while that of Turkey increased to around 15%.

BBVA is an impressive achievement that begs to be better recognised. We abide by our Strong Buy recommendation with a 31% upside potential. Below are the need-to-knows about how BBVA differs.

Superior and highly stable capital generation power

Such a geographical diversification provides superior long-term growth potential and reduces earnings volatility. Coupled with a proven risk management expertise, this has enabled BBVA to pass through the great financial crisis relatively unscathed. This was again the case in 2020, during which the group frontloaded provisions ahead of the expected credit risk impact of the pandemic. In spite of this provisioning effort, the group managed to post a 9% adjusted RoTE, broadly in line with its cost of capital.

The group’s superior profitability profile was already evidenced by its strong performance in the EBA’s stress tests. We expect BBVA to continue to rank well in the pending stress tests due to be released in July. On the other hand, the group’s geographical diversification translates into a strong exposure to foreign currencies which has considerably weighed on the equity generation and, consequently, on the share price appreciation over the past years.

Accelerated geographical repositioning

BBVA began to rebalance its geographical exposure in 2010 when it invested in Turkey. This was followed in 2017 by the disposal of the Chilean operations and accelerated recently with the disposals of the US operations (announced in November 2020) and of BBVA Paraguay (January 2021).

However, BBVA’s management reckoned that the disposal of the US retail operations (the group will retain its capital markets and private equity investment activities) to the Pittsburgh (Alabama) headquartered PNC, was not planned. However, management did not resist PNC’s offer (a €10bn all-cash consideration), which valued the US operations around €6bn above the consensus valuation, corresponding to a value creation the group would not have been able to meet by its own means.

The deal (expected to be completed within six months) will release an equivalent of €8.5bn capital (the CET1 will increase by around 300bp), largely driven by reduced capital consumption (+237bp). Management does not rule using the excess capital for acquisitions, but we understand that this should be marginal. The released capital will be used to fund organic growth and to a large extent will be returned to shareholders through share buy-backs once restrictions are lifted, potentially in September.

Sabadell (temporarily) failed discussions? 

A few days after the announcement of the sale of the US operations, BBVA disclosed that it was in talks with Sabadell, the troubled fourth largest Spanish player. However, the discussions were short-lived, officially closed on a price issue. This did not come as a surprise to us as we never believed that both operations were linked together as BBVA could acquire Sabadell without having to raise cash, although the proceeds of the US sale were not expected for several months. Indeed, a Sabadell deal would generate a huge badwill which would largely cover restructuring charges as well as the balance sheet clean-up/repositioning if needed.

Also, we suspected a likely disagreement on the price. On the one hand, Sabadell’s management, who announced further restructuring in Spain on top of TSB’s already engaged restructuring, had stated that it considered that a standalone strategy was a viable route for the group whose business mix is skewed towards higher-margin SME loans. As a result, we expected that it would not accept the merger at any price. On the other hand, BBVA’s management, like many other large banks’ management, stated that domestic consolidation was not vital, thus confirming that acquisitions can only be opportunistic and made at attractive valuation levels.

It remains that such a merger could make sense from a strategic angle and it is true that BBVA is well-advanced in its digital transformation, meaning that management is in a better position to allocate time to a merger. In this context, we do not rule out the reactivation of talks enabled by the appointment of a new CEO at Sabadell. However, we continue to believe that the merger would require BBVA to secure the disposal of TSB. Indeed, we always considered that Sabadell’s UK operations (TSB) represented a “poison pill” for BBVA as they do not meet the group’s criteria, namely critical size and accessorily Spanish-speaking customers. At first sight, we estimated that cost synergies (excluding TSB) could amount to €700m before tax. Net of restructuring charges, they could be valued at around €3.5bn or €0.6 per share. If one assumes that they are equally shared between BBVA’s and Sabadell’s shareholders, we believe that BBVA could be ready to pay Sabadell up to €0.6 per share.

Wrong Turkish bet?

Like UCG, BBVA wrongly bet on Turkey’s entry into Europe through a large but minority stake (progressively increased to 49.9%) in Garanti Bank. The country accounts for 15% of RWAs and profits. If asset quality has proven more resilient than expected, the Turkish exposure pollutes the group’s fundamental profile in our view and, with an 8-9% return on capital, weighs on the group’s overall profitability. In the wake of UCG’s 2019 decision to exit the country, a divestment cannot be ruled out even if it cannot be officially on any agenda. However, the stake’s current valuation (€2.2bn) stands significantly below the net carrying amount (€5.5bn), which would significantly limit the capital release potential.

A first digital mover

Like its direct competitor Santander, the group intends to lead the pack in terms of digital transformation. BBVA has undertaken the task of rebuilding its technology platform from scratch in 2006, entirely transforming its technology function so that it could at one and the same time keep existing systems in full operation and develop new systems in line with the latest technological advances. As regards achievements, on top of creating and developing new models in-house (Nimble, API_Market and Elenko), BBVA has built strategic alliances and partnerships (Dwolla, Distributed Ledger Group), and acquired stakes in start-ups directly (Simple, 29.5% of Atom, etc.) or through venture capital investments. Generally speaking, BBVA is considered as one of the most advance digital players in Europe which makes it a potential winner of the ongoing digital transformation of financial services.

Weak governance score

The group states that it has reshaped its organisation to support its digital transformation. It does seem to be the case when it comes to its governance as illustrated by a below-average score. The Board’s domestic density looks particularly elevated for such a geographically diversified group. The average age of the members is also relatively high whereas the Board’s feminisation remains particularly limited. At last, the proportion of truly independent directors (according to our own criteria) is very low. 

Reassuring fourth quarter results

The group’s fourth-quarter results were broadly in line with expectations, translating into strong equity generation based on very resilient profitability. The profits came in at €1.0bn, corresponding to a very decent 10% RoTE as the bottom line was depressed by the annual contribution to the deposit guarantee fund. The tangible book value per share increased by almost 4% qoq and the fully-loaded CET1 ratio by 20bp before factoring in the announced divestments.

Importantly, management reiterated its guidance of a lower cost of risk this year pointing to a potential 20bp decrease, in line with our projections. In this context, it remained committed to resuming dividend payments on a 35-40% payout ratio as soon as this year, complemented with share buy-backs.

Another 31% left

All our valuation approaches point to an upside potential as shown in the table below. As mentioned in our post-release comments, we expect to make limited changes to our forecasts. However, the addition of 2023 to our forecasts is  likely to boost the result of some of our valuation approaches, notably the intrinsic value which currently weighs on the overall target price.

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