AASSSTTTEEERRRSS IINNN IIINNNAAANNNCCCEEE … · Eurovida Portugal. The Non-Life business is managed by Popular Seguros. Despite the economic environment, the performance of this

THIS DOCUMENT IS NOT AN INVESTMENT RECOMMENDATION AND SHALL BE USED

EXCLUSIVELY FOR ACADEMIC PURPOSES (SEE DISCLOSURES AND DISCLAIMERS AT END OF DOCUMENT) See more information at WWW.NOVASBE.PT Page 1/32

MMMAAASSSTTTEEERRRSSS IIINNN FFFIIINNNAAANNNCCCEEE

EEEQQQUUUIIITTTYYY RRREEESSSEEEAAARRRCCCHHH

The sovereign debt crisis exposed Spanish Bank’s

weaknesses, currently being hit across the board. While the Cajas

fragilities in terms of solvency have lead them into a restructuring

process, banks are struggling to manage mounting funding costs

and sluggish economic conditions.

The cost hurdles brought upon banks by the sovereign

crisis swerved them away from wholesale debt markets towards

deposits, triggering a deposit-luring war. The main drawing was

that this has lead to higher funding costs, plummeting customer

spreads and margin erosion. POP, one of the most active deposit-

capturing banks, has seen its profits drastically reduced over the

past few years.

On the asset-side, the economic downturn lead to huge

asset-quality issues, especially after the construction bubble burst,

with NPL ratio for the sector being found at around 6% and an

astonishing 12% regarding the construction sector. POP due to its

construction exposure has been one the most heavily hit banks in

the sector, which has driven its provisioning efforts upwards and

therefore considerable hindering its profits even further.

All in all, we conclude that we are definitely facing some

structural changes in the banking sector, were profits are due to be

consistently found at diminished levels due to increased funding

costs and enhanced regulatory requirements. Despite all this our

recommendation is a hold with a 4.19€ price target.

BANCO POPULAR COMPANY REPORT

SPANISH BANKS 06 JUNE 2011

STUDENT: DUARTE LIMA [email protected]

Profit turns south

As the sovereign crisis drags on…

Recommendation: HOLD

Vs Previous Recommendation HOLD

Price Target FY11: 4.19 €

Vs Previous Price Target 4.82 €

Price (as of 6-Jun-11) 3.99 €

Reuters: POP.MC, Bloomberg: POP.SL

52-week range (€) 3.51-5.35

Market Cap (€bn) 5.53

Outstanding Shares (m) 1,390

Other (…)

Source: Analyst estimates

Source: Bloomberg

(€ million) 2010 2011E 2012E

Total Assets 130,140 129,694 127,553

Profit of the Year 590 529 616

ROA 0.45% 0.41% 0.48%

ROE 7.07% 6.28% 6.87%

LTD 121% 118% 113%

NPL Ratio 5.27% 5.82% 6.12%

Coverage Ratio 40.43% 43.00% 47.50%

Tier 1 9.67% 10.00% 11.00%

Source: Company Reports and Analysts Estimates

0%20%40%60%80%

100%120%140%

Jan

-09

Mar

-09

May

-09

Jul-

09

Sep

-09

No

v-0

9

Jan

-10

Mar

-10

May

-10

Jul-

10

Sep

-10

No

v-1

0

Jan

-11

Mar

-11

May

-11

Popular IBEX

speralta

Rectangle



EXCLUSIVELY FOR ACADEMIC PURPOSES (SEE DISCLOSURES AND DISCLAIMERS AT END OF DOCUMENT)

PAGE 2/32

Table of Contents

Company Overview…………………………………………………………………..…3

Company Description………………………………………………………..……..3

Commercial Banking………………………………………………………3

Asset Management………………………………………………………..4

Insurance…………………………………………………………………...4

Institutional and Markets Activity………………………………………...5

Shareholder Structure………………………………………………………………5

Macroeconomic Overview……………………………………………………….…….7

Spanish Banking Sector……………………………………………………………….8

Asset Side……………………………………………………………………………9

Loans and Receivables…………………………………………………...9

Construction Sector……...……………………………………….10

Deleveraging……………..……………………………………….13

Credit Quality……………………………………………………………..14

Financial Assets………………………………………………………….17

Liability Side………………………………………………………………………..18

Funding and Deposits…………………………………………………...18

Solvency……………………………………………………………………………23

Income Statement…………………………………………………………………24

DuPont Expansion……………………………………………………….24

Net Interest Income…………...………………………………….25

Credit Impairment…………………………………………………26

Net Fees and Commissions……………………………………...27

Operational Costs…………………...……………………………27

Valuation………...………………………………………………………………………28

Scenarios…………………………………………………………………………..28

Base Scenario……………………………………………………………28

Optimistic Scenario………………………………………………………28

Pessimistic Scenario………………………………………………….…29

Relative Valuation…………………………………………………………………29

Stress Test…………………………………………………………………………30




PAGE 3/32

Company overview

Company description

Banco Popular (“POP” hereafter) is the fifth largest Spanish Credit Institution and

third largest bank in terms of asset base, focusing chiefly on retail banking. By

2010YE, it had Total Assets of €130,140 million and a Net Interest Income (NII)

of €2,452 million. POP presently has operations running in Spain, Portugal and

the USA. Most of the business is conducted in Spain with Portugal accounting for

merely 6.8% of the Group’s NII and 8.6% of its Assets, with the remaining being

accounted for by Spanish operations. In Spain, the bank has 1,972 branches

alongside 12,513 employees, while in Portugal the figures are 1,439 and 237,

respectively. Operations in the USA, run through Total Bank since it was

acquired by POP in 2007 are still at an embryonic stage with 15 branches, a

headcount of 399 and $2 million in assets. Specifically, POP’s operations are

split into 4 business areas: Commercial Banking, Asset Management, Insurance

and Institutional and Markets

Commercial Banking

POP’s activities are heavily centered around its commercial business activity,

while all other units consequently end up being rather peripheral. The bank

provides financial services for both households and corporations, with a strong

emphasis on SMEs. By the end of 2010 the bank served 6,812,676 customers.

Prospects for the sector are gloomy. With the Spanish economy stagnated, credit

conceded has also come to a halt after a strong period of growth. On the other

hand the sovereign debt crisis has brought along funding hurdles, with funding

costs hitting all time-highs. All these factors have been placing downward

pressure on Commercial Banking’s Net Income, which recorded by 2010YE a

20.7% drop YoY.

In Spain, Commercial Banking is conducted through Banco Popular, a hardcore

commercial retail bank alongside three other banks: Popular Banca Privada,

dedicated to private banking, bancopopular-e, focusing on internet banking and a

0

500.000

1.000.000

1.500.000

2.000.000

2005 2006 2007 2008 2009 2010

Table 1. Total Assets Banks

Source: Company Reports

Table 2. Key Financials – Business Area Breakdown


Figure 1. Commercial Banking Profit

Before Tax (€ Thousands)


Financial Institution Total Assets €bn

Santander 1,217.5

BBVA 552.7

Caja Ahorros Madrid 328.1

La Caixa Barcelona 285.7

Banco Popular 130.1

Segmentation by Business Area

€ Thousands % € Thousands % € Thousands % € Thousands % € Thousands %

Net Interest Margin 2,161,627 88.1 10,977 0.4 38,723 1.6 241,004 9.8 2,452,331 100.0

Profit Before Tax 623,594 74.9 115,356 13.9 45,564 5.5 48,036 5.8 832,550 100.0

Total Assets 90,004,543 69.2 618,721 0.5 1,045,242 0.8 38,471,340 29.6 130,139,846 100.0

Shareholders' Funds 6,249,338 75.7 263,368 3.2 80,214 1.0 1,659,399 20.1 8,252,319 100.0

ConsolidatedCommercial Banking Asset Management Insurance Institutional and Markets




PAGE 4/32

newly-established bank jointly owned (50% stake) with Crédit Mutuel, which has

replaced Banco Popular Hipotecario. In Portugal the group is present through

Banco Popular Portugal.

The retail activities serve both Corporations and Private Individuals. Banking for

Corporations has been gradually achieving enhanced importance in this business

area due to both, its organic growth and its strong profitability, currently

accounting for 72% of the total assets and 77% of NII and fees, against 65% and

71.2% in 2009. It is noteworthy that SME’s, defined as companies with Income

and Assets ranging from €10-100 million, accounted for nearly 45% of the

Commercial Banking Income (including Fees & Commissions). Regarding

Banking for Private Individuals, its contribution to the Income suffered a decrease

in comparison to 2009 due to the shrinkage felt in mortgage loans, in spite of the

258,487 new customers captured.

Asset management

Asset management relates to investment institution management activities,

management of individual and collective pension plans and private banking. The

recent economic situation has been hindering this unit, with the widespread lack

of confidence driving sizeable funds away from asset management and in turn

towards safer fixed income securities and deposits as depicted in figure 21. The

tough macroeconomic surroundings have been having a marked negative impact

on the activities which by 2010YE accounted for 14% of the profit before tax of

the group.

The collective investment institution management services are provided by

Popular Gestión and Popular Gestión Privada in Spain, and Popular Gestão in

Portugal. Individual and collective pensions plan management is offered through

Europensiones (51% stake) and Popular Gestión de Activos, wholly-owned by

the Group. The private Banking activity is supplied through Popular Banca

Privada (60% stake).

Insurance

This unit relates to pension and insurance products comprehending life, non-life

and retirement. The Life business is conducted through Eurovida España and

Eurovida Portugal. The Non-Life business is managed by Popular Seguros.

Despite the economic environment, the performance of this area has been

1 There was a criterion change in the Asset Management Business unit from 2008 to 2009, explaining the upward movement recorded

from 2008 to 2009.

0

40.000

80.000

120.000

160.000

2005 2006 2007 2008 2009 2010

Figure 2. Asset Management Profit

Before Tax (€ thousand)


Figure 3. Insurance Profit Before Tax (€ thousands)


0

10.000

20.000

30.000

40.000

50.000

2005 2006 2007 2008 2009 2010




PAGE 5/32

13,6%

9,4%

7,1%

5,5%

100,0%

Sindicatura de Accionistas de BPE Allianz SE

Américo Amorim Unión Europea de Inversiones

Others

13,1%

9,2%

7,0%

5,4%

5,0%

60,3%

Sindicatura de Accionistas de BPE Allianz SE

Américo Amorim Unión Europea de Inversiones

Crédit Mutuel Others

satisfactory with premiums collected rising 21% YoY, and accounting for 5.5% of

Group’s profit before tax of the period.

Institutional and markets activity

The institutional activity is primarily related to issues such as funding, both in

wholesale markets and interbank markets, treasury activities related to financial

assets portfolios, held-to-maturity, held for trading and available for sale, hedging

operations and tangible and intangible asset management.

The fall in the Profit before tax of the unit can be explained by the new circular

released by the bank of Spain extending provisions to assets under the

institutional and markets area that were previously not covered by provisioning

requirements.

Shareholder Structure

By 2010YE POP had 1,472,481 shares outstanding held by 147,943

shareholders. 59.3% of the shares are held by financial investors, with the

remaining being held by foreign investors. Also noteworthy is that employees of

the group own roughly 1% of common stock. Additionally, the board of directors

by 2010YE held 579.2 million shares i.e. 42.12%, compared to 39.81% in 2009.

By 2010YE, POP’s largest shareholders were Shareholders’ Sindicate, Allianz,

one of the largest insurance groups worldwide based in Germany, Unión

Europea de Inversiones, a Spanish-based company specializing in the

acquisition, administration and management of movable and immovable

properties and goods, Américo de Amorim, the wealthiest Portuguese individual,

Figure 4. Institutional Profit Before Tax (€ Thousands)


Figure 5. Banco Popular Shareholder Structure 2010 and 2009


0

20.000

40.000

60.000

80.000

100.000

120.000

2005 2006 2007 2008 2009 2010




PAGE 6/32

and Crédit Mutuel Group, a French mutual bank resultant from the acquisition of

CIC in 1998 by Crédit Mutuel.

Following the establishment of the joint venture with Crédit Mutuel, in Nov-10,

POP undertook a capital increase of €4.2 million translated in the issuance of

41,258,539 new shares, which stood for roughly 3% of the bank’s capital to be

acquired by Crédit Mutuel. Additionally Crédit acquired an additional 2% out of

POP’s treasury stock, becoming one of the largest shareholders of the group,

holding a 5% stake. This had an impact in both the total number of shares and

voting rights, and drove to the appointment of Crédit Mutuél’s Michel Lucas as a

director at the board meeting held on December the 15th 2010. Following to the

capital increase, POP also issued €500 million in necessarily convertible bonds

maturing in 2013.

POP’s shares are listed on the four Spanish Stock Exchanges as well as in the

Lisbon stock exchange. Particularly POP’s shares are quoted on the IBEX-35

portraying a market cap of €5,530 million corresponding to a roughly 1.56%

weight in the IBEX-35. POP is listed on the IBEX-35 alongside other 4 Spanish

banks - Santander, BBVA, Bankinter and Sabadell (“SAN”, “BBVA”, “BANK” and

“SAB” hereafter). The Banking System has a 31.5% weight in the IBEX 35.

Regarding Stock prices and returns, since Jan-09 after the onset of the crisis,

POP is one of the banks that has been coping poorly with the aftermath of the

crisis, with its share price dropping 33% from 6.06€ in Jan-09 to 4.07€ in Mar-11.

Only Sabadell managed to perform worse, with its price going down 37% over

the same period. Unsurprisingly, the most diversified banks, with wider

international exposure, Santander and BBVA were the ones dealing better with

the slump with Santander recording a 24% increase in its share price and BBVA

a 4%. Two of the main issues explaining this plunge were the dramatic increase

in funding costs experienced (recall that for a period wholesale markets were in

fact closed at times), which was offset in POP’s case by an effort to capture

deposits as an alternative source of funding shrinking margins and placing

downward pressure on the Net Interest Income, which we will discuss at length

later on. Additionally POP’s exposure to the construction sector, growing NPLs

ratios and poor coverage ratios have been attaching a large degree of

uncertainty to the banks future which markets have firmly been punishing. All

these issues will be dealt with thoroughly later on.

0%

40%

80%

120%

160%

200%

Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11

POP SM Equity SAN SM Equity BBVA SM Equity

BKT SM Equity SAB SM Equity

Figure 6. Market Performance Banks

Source: Bloomberg




PAGE 7/32

Macroeconomic Overview

Europe, particularly its peripheral economies have not been cooping adequately

with the aftermath of the subprime crisis. Particularly, in Spain the huge efforts

expended in public spending and investment drove public deficits over the roof to

a peak of 11% in 2009, and are now boomeranging in form of a sovereign debt

crisis through climbing risk premiums required by holders of sovereign debt,

increasing the likelihood of a double dip. Particularly, Greece, Ireland and

Portugal more recently, have already been incorporated into IMF-European

Union joint bail-out schemes. International Markets have now turned their

attention towards the Spanish Economy, as many reckon it to be the next country

in need of rescue. Particularly in March 2010 Moody downgraded Spain’s credit

rating one notch from to Aa2 with a negative outlook as it considers its future dim

growth prospects backdrop too scant for the financial situation to improve

noticeably, while at the same time there are concerns that the Spanish

Government will in fact be able to improve its finances, despite measures made

public last September that included a 7.7% cut in Public Spending and a Public

Sector wage cut of 5%. On April 28th S&P followed the same path and

downgraded its credit rating from AA+ to AA over the same concerns. The CDS,

cost of insuring Spanish debt has been escalating, repeatedly reaching all-time

highs, despite showing some improvement since the Portuguese bailout. The

confidence crisis is so profound, with the business confidence index showing

negative values since Dec-08, that not even news about a public deficit cut to

9.1% in 2010 were able to perk markets up. One reason for such a lack of

reaction may be the fact that the reduction altogether lacks clarity, as Spain is a

decentralized economy where the autonomous regions have control over their

own finances which account for over 50% of public spending.

Notwithstanding, the Spanish GDP seems to be showing some signs of

stabilization having actually grown 0.6% QoQ in 4th of 2010, which albeit slight, is

still positive, after breaking a 7 quarter consecutive recessionary period in Sep-

10. The growth rate in unemployment also shows some signs of stability and is

currently situated near 20.6%, having only increased 0.6% since Jun-10,

contrasting to the 5% increase experienced over 2010. It is worth mentioning that

even though the unemployment rate is extremely high, it should be placed into

context, as Spain is the most elastic Eurozone economy, historically recording

among the highest unemployment rates in the Europe (around 10%). Still, the

Spanish crisis has some particular features that ought not to be overlooked. Due

-6%

-4%

-2%

0%

2%

4%

6%

-32%

-24%

-16%

-8%

0%

8%

16%

0%

4%

8%

12%

16%

20%

24%

Figure 7.Spanish Government Deficit

Source: Bloomberg

Figure 8. Business Confidence Index

Source: Bank of Spain

Figure 9. Spanish GDP growth


Figure 10. Spanish Unemployment Rate


No mesmo gráfico do Gov deficit é

para por o Public SPending

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

1995 1998 2001 2004 2007 2010




PAGE 8/32

to the high growth experienced prior to the subprime crisis it is suffering from an

overwhelming exposure to the construction and real-estate sector, which is not

likely to fade overnight and that added to all other factors does not result in a very

positive stance in terms of growth perspectives, despite the IMF forecasting a

dim recovery, announcing an expected GDP growth of 0.6% for 2011, 1.6% for

2012 and 1.8% for 2013. According to the IMF, unemployment is also to stabilize,

foretelling unemployment rates of 19.4%, 18.2% and 17.1% for 2011, 2012 and

2013 respectively.

Finally, let us stress the downside risk that Spain may be entering a two tailed

vicious cycle, because if public spending was increased to help the economy re-

taking off, the budget deficit would be readjusting through future growth. Yet, with

slim future growth perspectives and a debt crisis on hands the outcome surely

does not look sparkly.

Spanish Banking Sector

Specifically regarding the Spanish Banking Sector, after the subprime crisis, and

by the Sovereign debt crisis, it has been undergoing structural changes. The

sector accounts for €3.863 trillion in total assets, of which €2,358 trillion i.e. 61%

correspond to the 5 largest banks, while the 25 largest banks account for 84% of

the market in terms of assets-base. Consequently, one can claim that it is a

somehow fragmented market. Table 3 illustrates loan market share for the 5

largest Spanish banks (excluding Savings Banks), with Santander having the

largest share at 12% followed by BBVA with 10%. Popular comes in third holding

a 5% share. Nevertheless, much of the fragmentation is due to the fact that the

Spanish Financial System is virtually split in half between Banks and Savings

Banks (“Cajas” hereafter), as Figure 11 portrays. As we will discuss ahead, if the

two types of institutions face most of the same issues brought along by the two

Financial Crisis, i.e. Credit Sluggishness, Funding hurdles and Deteriorating

Asset Quality, Cajas, which account for nearly half of the sector, feature on top of

that a huge solvency issue, which due to the specific nature of these intuitions is

leading a comprehensive restructuring of the sector.

Specifically, the Cajas “half” of the sector has historically been even more

fragmented than Bank’s “half” of the sector, to a certain extent due to the local

profile much of these Cajas carried. Throughout the past decade, Cajas accrued

a series of limitations, which came to light once the financial crisis hit the Spanish

Financial System, namely, the excess capacity of the sector, (in light of the

Table 3. Market Share in Loans

Figure 11. Market share by type of

Financial Institution


Source: Company Reports and Bank of Spain

Institution Market Share (%)

Santander 12%

BBVA 10%

Popular 5%

Sabadell 4%

Bankinter 2%

45,7% 45,6%

8,6%

Banks Cajas Other




PAGE 9/32

forecasted evolution of the sector) and the obstacles to raise capital in a way

other than retained earnings.

The Spanish Government decided to go for a thorough restructuring of the

sector, and to that end the FROB - Fund for Orderly Restructuring of the Banking

Sector was created in 2009, whose primary goal is to conduct and oversee

integration processes between institutions and recapitalization plans. The

restructuring of the sector has been aggressive, and from the 45 Cajas in Jan-10,

Spain currently has 15. According to the Bank of Spain it is estimated that the

Capital shortfall in Cajas amounts to €14,000 million. To settle the situation,

Cajas are to present their recapitalization plans, and while to do so some will ask

for FROB capital, others are to undergo capital increases through private sector.

Despite banks not being the main target of these plans, there is a lot of

speculation surrounding the successfulness of the Cajas recapitalization plans,

due to their importance to the future of sector (and even the Spanish Economy in

what regards a possible IMF bailout).

Asset Side

Loans & Receivables

During the growth period experienced prior to the crisis, banks enlarged their

loan books dramatically, with the highly cyclical construction and real estate

sectors playing a huge role in this increase, which naturally lead to huge leaps in

both corporate and household indebtedness. Particularly, Figure 12 shows that

from Dec-04 to Dec-08 the Spanish loan book nearly doubles. In the aftermath of

the subprime crisis which has been taking a heavy toll at the Spanish Economy

due to the growth and employment the construction and real estate sector was

generating prior to the burst, and emphasized with setting off of the sovereign

crisis, the Spanish Loan Book’s expansion as come to a halt. Feeble

macroeconomic indicators, with unemployment at historically high levels and slim

GDP forecasts have driven household and corporate confidence to bottoming

levels. Moreover, on top of the lower credit demand, the sovereign crisis,

translated into lack and enhanced cost of funding, which together with the

deteriorating credit quality of borrowers, has lead banks to follow a much tighter

lending profile. Particularly as depicted in Figure 132, in order to offset lower

quality borrowers and higher funding costs banks have been trying transfer these

to consumers by re-pricing their loans books. Particularly, the picture shows that

2 From 2010 onwards we were unable to obtain data on BBVA’s loan book spreads regarding its Spanish Operation

Figure 12. Banking Sector Loan

Volumes (€ bn)


Figure 13. Loan Book Spreads

Source: Company Reports and Bloomberg

0,00%

1,00%

2,00%

3,00%

4,00%

5,00%

Mar

-07

Jun

-07

Sep

-07

De

c-0

7

Mar

-08

Jun

-08

Sep

-08

De

c 0

8

Mar

-09

Jun

-09

Sep

-09

De

c-0

9

Mar

-10

Jun

-10

Sep

-10

De

c-1

0

Jan

-11

Santander Sabadell Bankinter Popular BBVA

-2%

0%

2%

4%

6%

8%

0

400

800

1.200

1.600

2.000

Loan Volume Growth Rate




PAGE 10/32

loan book spreads against the 12 month Euribor for the 5 largest Spanish Banks

have increased considerably from Mar-07 to Mar-11.

Noteworthy that in spite of the difficult situation both in credit supply and credit

demand, the decrease in loan books is not as pronounced as one would expect,

which we lay on two factors: i) Level of household loans has not undergone a

sharp decrease as they are longer-term loans; ii) Credit extension profile many

institutions have been following in order to avoid/shape NPL’s and writeoffs.

Concerning POP, as one can gather through figure 15, its loan book followed an

identical trend to the sector’s, going from €51,500 million in 2004 to €98,213

million in 2010. Taking a more thorough look at POP’s loan book breakdown by

2010YE, one can witness that 71% of loans conceded were directed towards

corporations while the remaining towards Individuals, as shown in Figure 15.

Particularly, due to its large emphasis towards corporate loans, namely SMEs, in

comparison to other banks (as we will discuss more thoroughly later on) the

bank’s exposure to longer-term housing loans is diminished leading to a lower

maturity/duration of its loan book. In fact, credit granted for house purchase

represents around 35.9% of total loans for the sector, while it represents only

15.34% of POP’s loan book.

Regarding loan book spreads, has shown in figure 13 POP has been very

successful in managing its spreads and passing along to the customer the

increased cost of funding and deteriorating credit quality in comparison to its

peers. This is mainly due to two reasons: Firstly its loan book accounts for a

heavier weight of corporate loans which are much more profitable than home

purchasing mortgage loans and, thus naturally incorporate higher spreads.

Secondly, as the maturity of these loans is much shorter, they allow for a more

flexible and faster re-pricing. Specifically, out of POP’s €98,213m loan book by

2010YE, €38,141m were conceded during 2010, obviously leading to a faster re-

pricing.

Construction Sector

The evolution in the construction sector is of the utmost importance to the

Spanish Economy, both from Macroeconomic perspective, as well as from

financial perspective, with the sector making up a large chunk of bank’s loan

books. Hence, due to the specific weight of the sector in banks loan books we

feel it is crucial to undertake a deeper analysis of the sector. After roughly a

decade of marked growth and mounting prices, in which construction became the

main booster of the Spanish growth during that period the sector is currently

Individuals28,7%

Corporations28.1%

SMEs43.2%


51.844

66.323

77.32886.843 90.148

97.363 98.213

2004 2005 2006 2007 2008 2009 2010

Figure 14. POP’s Loan Volumes (€ m)


Figure 15. POP’s Loan Book




PAGE 11/32

undergoing a lengthy adjustment period undergoing successive quarters of

decline.

By 2010, the construction sector represented 14.4% of the Spanish GDP and

8.2% of total employment. Having reached its peak over 2007, the construction

took a long-lasting plunge thereafter, declining 5% in 2008, 11% in 2009 and an

additional 15% in 2010. The growth of the sector throughout these years much of

it was financed through bank loans, with the sector gaining an increasingly

heavier weight in banks’ loan portfolios, reaching a maximum of 17.5% of loans

conceded. Obviously, the sudden slowdown of the economy much of it attributed

to construction bubble burst has been leading to a decline of their weight in loans

outstanding, standing at 11.6% in 2010YE, as depicted in figure 17. The sudden

halt has left the sector with a heavy burden in terms of NPLs perhaps the major

hurdle the Spanish financial system is to overcome, which will be dealt with later

on. In fact the fall in loans to the construction sector would be much larger, were

it not for the credit extension profile many banks have been following in order to

mold NPL ratios and Write-offs.

Particularly, regarding POP, bank’s loans to construction and property

development amounted to over 18% of the loans outstanding, contrasting to the

11.6% average for the sector. Hence due to the huge exposure POP has to the

construction sector one can gather the importance of the future prospects of the

sector for POP. In order to evaluate the sector and its prospects, we split it into

three segments: civil engineering, residential sector, which is directly linked to the

housing market and the non-residential sector.

The civil construction sector is highly dependent on works adjudicated by the

government and hence on its public infrastructure investments budget. In 2009

€39.1bn were awarded. Still, on account of the tough situation in Spanish public

finances, and in order to achieve a 3% government deficit by 2013, the budget for

public infrastructure contemplates €14.6bn, a 33% decrease compared to the

€21.2bn in 2010 and €22.1bn in 2009. Hence, one can easily gather that the

outlook for civil engineering is bleak since public investment, the main driver of

the segment will definitely not undergo any increases over the forthcoming years.

The non-residential sector, as it encompasses buildings for distinct sectors of

activity, from industrial to commercial, educational, etc. is highly cyclical in

nature, and depends a lot upon prospects for the economy, confidence and in

credit availability. The sector has been undergoing decline, particularly a 6% in

2008 and 14% in 2009. Taking into account the current state Spanish economy,

0,0

200,0

400,0

600,0

800,0

1000,0

1200,0

De

c-0

0

Ma

y-0

1

Oc

t-0

1

Ma

r-0

2

Au

g-0

2

Jan

-03

Jun

-03

No

v-0

3

Ap

r-0

4

Se

p-0

4

Fe

b-0

5

Jul-

05

De

c-0

5

Ma

y-0

6

Oc

t-0

6

Ma

r-0

7

Au

g-0

7

Jan

-08

Jun

-08

No

v-0

8

Ap

r-0

9

Se

p-0

9

Fe

b-1

0

Jul-

10

De

c-1

0

Services

Construction

Industry

Agriculture



Figure 16. Employment in Construction

6%

7%

8%

9%

10%

11%

12%

13%

14%

Mar-

00

Ou

t-0

0

Mai-

01

De

z-0

1

Ju

l-0

2

Fe

v-0

3

Se

t-0

3

Ab

r-0

4

No

v-0

4

Ju

n-0

5

Jan

-06

Ag

o-0

6

Mar-

07

Ou

t-0

7

Mai-

08

De

z-0

8

Ju

l-0

9

Fe

v-1

0

Se

t-1

0

Figure 17. Loans Sector Breakdown (€ bn)




PAGE 12/32

leading to a situation of spare capacity and the lack of credit availability which will

be dealt with later on, the engagement on new non-residential construction does

not look promising, and we foresee a persistence in the downward trend the

sector has been experiencing, though less accentuated due to some (slight)

upturn the expected recovery of the Spanish Economy.

Regarding the housing sector, it is more sensitive for banks than the two

aforementioned sectors, as banks not only engage in financing the construction

of new houses, but are involved as well in financing home purchases. Particularly

15.34% of POP’s loan book is credit for house purchase, and additionally, on the

construction side, out of the €17.8bn it has loaned to construction industry,

€5.69bn are dedicated to house construction. If on one side demand is weak and

decreasing due to the economic situation where lower disposable income, sky-

scraping unemployment levels, tighter credit availability, interest rates’ evolution,

and thrashed consumer confidence, at the same time there is still a considerable

oversupply and thus residential construction is following a downward trend as

well. The main drawing is that housing supply/demand dynamics will only be

recouped when the absorption of oversupply is completed which we do not see

taking place before only 2013 i.e. slim demand, with still a lot of completed

houses to absorb leads to weakness in new building construction. Another factor

worthwhile to consider is that, as it is still widely regarded that prices will

experience further drops, as they have been droping for twelve consecutive

quarters as portrayed in Figure 19, house purchasing decisions may be

postponed. It is estimated by the BoS that the oversupply of houses amount to1.5

million units (which was increased in 2009). Still despite the sector showing

negative trends on the supply and demand side, the implications of these are

different. Home purchase mortgage loans, are long term loans (over 15 years)

and less profitable. The fact is that despite not having many new mortgage loans,

the new loans conceded are likely to replace the existing ones about to mature

and thus the impact on the size of the loan book is likely to be moderated, as

shown in Figure 18. The main impact is that the re-pricing of the mortgage loan

book is lengthier as spreads are fixed at the time the loan is contracted and are

valid until the maturity of the loan, and as no new loans are being captured, the

re-pricing becomes even lengthier. Figure 20 displays how spreads have been

evolving in what regards home purchasing mortgage loans, and one can observe

that despite higher funding costs, mortgage loans do not exhibit considerable

spread leaps. The importance is that at a time where Spanish bank’s funding

costs have risen, re-pricing must be done as quickly as possible in order to avoid

-5%

-1%

3%

7%

11%

15%

0

200

400

600

800

Dec-04 Nov-05 Nov-06 Nov-07 Nov-08 Nov-09 Nov-10

Total Mortgage Loans Growth Rate

-5%

-1%

3%

7%

11%

15%

1.600

1.800

2.000

2.200

Dec-05 Nov-06 Nov-07 Nov-08 Nov-09 Nov-10

Housing Prices sqm Growth Rate

Figure 18. Mortgage Loans (€ bn)

Source: Spanish Mortgage Association

Source: Spanish Mortgage Association and Bank of Spain

Source: Spanish Mortgage Association

Figure 19. Housing Prices sqm (€)

0%

1%

2%

3%

4%

5%

6%

7%

De

c-0

3

De

c-0

5

De

c-0

7

Ju

n-0

8

De

z-0

8

Ju

n-0

9

De

z-0

9

Ju

n-1

0

De

z-1

0

Fe

b-1

1

Mortgage Interest Rates Spread to 12 Month Euribor

Figure 20. Interest Rates and Spreads

on Mortgage Loans




PAGE 13/32

further profitability decrease. The fact is that with the halt of the housing market

will leave Popular with much of its circa €15bn loans to housing with unchanged

spreads driving profitability down. In terms of construction the problem is

different; first and foremost the size of its loan book will not see noticeable

additions in terms of the construction industry due to the evolution predicted.

More importantly, the existing loans for construction that have been finished but

not been acquired are leading to huge NPL ratios as we will analyze later on.

Loan Book Prospects - Deleveraging Process

We foresee a plunge in loan book values for the forthcoming years due to the

deleveraging process we expect the Spanish Economy to undergo. As previously

mentioned loans conceded by banks were an extremely important driver of the

growth the Spanish economy underwent over the past 10 years, with Spanish

Private Sector debt to GDP currently standing at 230%, having experienced an

extremely fast leveraging process, escalating from 140% in 2000 as shown in

figure 21. Comparing to other mature European economies, Spain stands as the

2nd

most leveraged mature European Economy, standing right behind Portugal,

with Germany appearing at the bottom of the list with its Private Sector Debt to

GDP standing at circa 100%.

Taking into account Spanish Economic situation, we believe this level of private

indebtedness is unbearable and we predict that over the forthcoming years, the

Spanish economy will endure a deleveraging process until it reached a

sustainable equilibrium level, which we predict to be around 175%, similar to the

levels recorded between 2004. There have been prior examples of the

deleveraging processes. Northern European Economies, Sweden, Finland and

Norway during the 1990s undertook severe deleveraging processes. These

processes usually took approximately 5-6 years.

Noteworthy, that the deleveraging process can be achieved through a reduction

in the amount of debt outstanding, as well as through (Nominal) GDP growth.

The problem is that in the Spanish case, with low current and forecasted levels of

GDP growth and inflation, most of the deleveraging will go through reducing the

amount of debt outstanding i.e. reducing loan books. Hence, using as a

Table 4. Spanish Deleveraging Process

Private Debt Nominal GDP Target Debt to GDP % Change in Private Debt

2011 2,396 1,085 221% -1.9%

2012 2,342 1,119 209% -2.3%

2013 2,288 1,157 198% -2.3%

Source: Bank of Spain, IMF and Barclays Capital

Figure 21. Private Debt to GDP

120%

140%

160%

180%

200%

220%

240%

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Source: Barclays Capital




PAGE 14/32

benchmark the Scandinavian deleveraging, aiming at reaching a 175% Private

Debt to GDP we assume a rather simplistic 5 year straight line deleveraging

process, with Private Debt to GDP dropping by 14% yearly. As portrayed in the

table, and taking into account GDP growth for Spanish Economy (according to

IMF forecasts), we see a 2% decrease in loan books in 2011 and 2.3% in 2012

and 2013 respectively. Obviously, due to their higher rotation, we believe

corporate loans will drive the adjustment (we already witness some contraction in

corporate loan books by sector of activity in figure 17, namely in construction).

Table 4 presents the results of the deleveraging process considered.

Facing a deleveraging process we feel that only healthier banks will be able to

keep their loan books flat. Banks whose funding and solvency situation is stable

will naturally be one step ahead of the others. On account of the aforementioned

reasons, we see POP being able to keep its loan book flat and hence attaining

some market share gains. The main reason is that, as we will discuss more

thoroughly further ahead, over the past couple of years we have seen POP

increasingly focused on capturing deposits and reducing its commercial gap,

which puts it rather at ease (as it reduced its dependence on debt markets) even

though it faces rather high funding costs on wholesale debt markets. On top of

that, in what regards solvency POP is the soundest bank in the system. At any

rate, we see POP trying to defend the reduction in LTD ratio it was able to grasp

during the last two years instead of being focused on increasing its loan book in

an adverse environment, albeit its comfortable equity situation. Thus, we forecast

a flat loan book for POP for 2011, 2012 and 2013. What´s more, we reckon large

Spanish Banks in general being able to keep the size of their loan books or at

least not suffer substantial reductions and we foresee the troubled Cajas as the

ones hit the hardest with the deleveraging process over the forthcoming years,

suffering loan book and market share shrinkage.

Credit Quality

Regarding Credit Quality, its evolution is critical for the sector. The extraordinary

growth experienced in the construction sector through spectacular expansions in

securitization (namely asset-backed securities and mortgage-backed securities)

and looser credit standards drove to a situation of over-exposure from the

banking sector towards construction and property development.

In fact, the burst of the subprime bubble saw NPLs starting a long-lasting

escalation, driven by huge credit deterioration, particularly in the construction

sector. Figure 22 shows the climb experienced by NPLs since Jan-08.

0%

1%

2%

3%

4%

5%

6%

7%

0

20

40

60

80

100

120

Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11

Total NPLs NPL Ratio


Figure 22. NPLs Spanish Banking

Sector (€ bn)

0%

5%

10%

15%

20%

25%

Jan-08 Jun-08 Dez-08 Jun-09 Dez-09 Jun-10 Dez-10

Unemployment Rate NPL Ratio




PAGE 15/32

Specifically, the NPL ratio for the sector rose from a meager 1% in Jan-08 to

6.2% recorded last February, which means that there were €18,400 million in

NPLs then, comparing to €112,300 million now. If we take a more detailed look at

NPL ratios by sector of activity, we can observe that these ratios tend to be

higher in the most cyclical sectors. While Agriculture and Industry show NPL

ratios of 4.3% and 4.4%, respectively, cyclical sectors such as Services and

Construction portray ratios of 8.4% and 12.1%. Amongst the two, construction

poses as the biggest problem, after the bubble burst NPLs in construction soared

due to the persistent contraction in the sector. Hence, we can witness that

despite much of the dramatic NPL situation in Spain being due to the economic

slowdown in the Spanish economy, its enhanced magnitude is certainly attributed

to the situation the construction sector is going through. Still, and even though

NPL growth has been recording increasingly smaller growth rates, we still see the

sector having to deal with forthcoming (though smaller) increases in the level of

NPL, even though the amount of NPLs will always depend on the amount of loan

write-offs. Our perspective is accounted for by 3 main reasons. First and

foremost, despite the stabilization and dim recovery which started in Jun-10 and

is expected to go on in Spanish economy (albeit the hurdles the sovereign debt

crisis may post), the evolution Construction Sector which records an 12.1% NPL

ratio and makes up 11.5% of loans conceded towards productive activities by the

sector will be crucial, and taking into consideration our previous analysis of the

sector, with a lot of oversupply yet to be absorbed we don’t see NPL ratio

undergoing any marked declines, even though we see a slowdown in net

additions to NPLs, which has already been observed in 2010, comparing to 2009.

What’s more, NPL ratio evolution also tends to be closely tied to the evolution of

unemployment rates as depicted Figure 24, and since forecasts of evolution in

unemployment do not point towards a sizeable decline in the near future we do

not expect it to exert significant downward pressure on NPLs. Finally, adding up

to the aforementioned reason, since the onset of the crisis interest rates have

been found at historically low levels, and recently the ECB seems to be bringing

rates up again, which obviously may have a negative rate on default rates,

especially in residential mortgages, which as we will see have been posting small

NPLs ratio up until now). Hence instead of falling, it is more likely that we see

default rates persisting.

Regarding POP, Credit quality is most certainly the biggest challenge the bank

has to overcome. If we take a more careful glance at the sector, looking at the

major banks, we can see POP is the most troubled bank in what regards NPLs,

0%

4%

8%

12%

16%

Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10

Agriculture Industry Construction Services

Figure 25. NPL ratio Banks


Figure 26. Coverage Ratio Banks


Figure 23. NPL ratio by activity

0%

2%

4%

6%

Banco Popular Banco Sabadell Banco Bankinter

Banco BBVA Banco Santander

30%

40%

50%

60%

70%

80%

90%

100%

110%

Banco Popular Banco Sabadell Banco Bankinter

Banco BBVA Banco Santander

Figure 24. Unemployment vs NPLs

0%

5%

10%

15%

20%

25%

Jan-08 Jun-08 Dez-08 Jun-09 Dez-09 Jun-10 Dez-10

Unemployment Rate NPL Ratio






PAGE 16/32

recording the highest ratio amongst the largest banks, at 5.4%, only to be

overtaken by Sabadell in Mar-11, at 5.5%. BBVA Spain shows an NPL rate of

5.0%, having managed to stabilize it since 2009YE, while Santander’s stands at

4.6%. Bankinter shows an above average asset quality, chiefly due to its

diminished exposure to construction and real estate, with its NPL ratio being

found at 3%.

Notwithstanding, POPs problems are not circled to its 5.4% NPL ratio.

Additionally, POP portrays the smallest coverage amongst top banks, at 41.7% in

Mar-11, which combined with one of the largest NPL ratios in the sector points

out to additional provisioning being required above its peers, placing enhanced

pressure on profits.

Plus, if POP’s exposure to the corporate sector (including construction sector)

puts it ahead of other banks in terms of speed of re-pricing and spread

profitability in comparison to other banks, much more exposed to less profitable

house purchasing mortgage loans, which is important due to increased funding

costs, on the other hand, it also makes it a much more cyclical bank as its

exposure to sectors whose performance is directly linked to the performance of

the economy is higher, and hence it is riskier in terms of macroeconomic

exposure. Particularly, as portrayed in Table 4, of the 5 largest Spanish Banks,

POP has the lowest exposure to residential housing market, making up for only

15.3% of its loan book, contrasting with Bankinter’s 60.3% exposure.

It is also noteworthy that, as expected residential mortgages show small NPL

ratios, namely 2.8% regarding POP. Contrastingly, it is worth to mention that the

increased exposure to residential mortgages explain why Bankinter has the

lowest NPL ratio among the top 5 banks.

€ Thousands Total Loans Construction Construction in % NPL Construction NPL ratio Construction

Banco Popular 98,213,000 17,840,158 18.2% 2,586,804 14.5%

Banco Sabadell 73,980,818 10,170,000 13.7% 1,544,000 15.2%

Banco Bankinter 42,410,502 2,451,811 5.8% 291,275 11.9%

Banco BBVA Spain 185,361,000 16,608,000 9.0% 3,543,000 21.3%

Banco Santander Spain 224,000,000 27,000,000 12.1% 4,590,000 17.0%


Table 6. Construction and Real Estate Loans


Table 5. House purchasing loans Banks

€ Thousands Total Loans Residential Mortgages % NPL Residential Mortgages %

Banco Popular 98,213,000 15,067,085 15.3% 415,577 2.8%

Banco Sabadell 73,980,818 14,061,000 19.0% 410,000 2.9%

Banco Bankinter 42,410,502 25,712,752 60.6% 302,278 1.2%

Banco BBVA Spain 185,361,000 80,027,000 43.2% 2,324,000 2.9%

Banco Santander Spain 224,000,000 61,000,000 27.90% 1,342,000 2.2%




PAGE 17/32

POP has €17,840 million in loans to construction and property development,

representing 18.16% of its loan book. The bank holds €2,587 million NPLs in

construction, which is translated into 14.50% NPL ratio in construction i.e. above

the 12.1% average. That is, on top of bearing an above-average exposure to

construction that represents 11.7% of total loans to the sector, its NPL ratio

regarding the sector is above average. POP’s NPLs in construction make up for

42% of the bank’s total NPLs. Furthermore, the bank also disclosed that it has

additional €2,642 million substandard loans in construction (defined by the BoS

as loans showing some weakness, associated to the fact they are to a specific

troubled group or sector, or if these weaknesses are apparent in certain

operations, even if these operations don’t classify individually for classification as

doubtful or write-off). To get a glimpse of how cyclical the bank is regarding the

sector and macroeconomic evolution, in the worst case scenario, in which all

substandard loans would turn into Non-performing, the bank would reach an

astonishing 30% NPL ratio in construction and property development.

To sum up with, POP’s future performance is much more tied to how the

economy and the construction perform, turning POP into an even-more cyclical

bank compared to its peers, and due to the picking up NPLs are forecasted to

experience, at least until construction and real estate sectors bottom out, which

we predict will happen in 2012, the bank will need to raise additional provisioning

in order to increase its coverage, and its margins will be hurt.

Final notes regarding collateral, most of the loans granted to the construction

sector are a mortgage-backed loans, which means that the value of the loan is

covered by the value of the collateral. Specifically, out of the €17,840 million POP

has to the construction sector €13,400 million are offset by the value of the

collateral. Two problems emerge here, firstly the value of the collateral is not

likely to be updated, and since property and real estate markets have been

consecutively dropping, odds are that the collateral may be worth much less

comparing to its book value, and hence the bank incurs in a loss. Furthermore, if

the bank is unable to sell the asset, it will only add up to its balance, as a non

interest earning asset, basically just sitting on the Balance Sheet until markets

improve or the bank decides what to do with it. A stress test in conducted later on

to assess the impact of collateral in a LGD situation under the assumption of

collateral devaluation. All in all, we see POP’s NPL ratio climbing from 5.27% in

2010 to 5.82% in 2011 and 6.12% in 2012 and 2013.




PAGE 18/32

65,6%

34,4%

Available for Sale Held to Maturity

Financial Assets

Regarding POP’s financial assets, including the available for sale (other portfolios

are residual so we incorporate them into the available for sale portfolio) and held-

to-maturity portfolios, the increase these have been experienced, from € 5.9 bn in

2007 to 18.3 bn in 2010 is mainly credited to acquisitions of Debt Securities,

chiefly Spanish Public Debt. Since most of the portfolios are composed by fixed

income securities (over 96% as depicted in figure 29), most of the income these

generate is either linked to a rate plus a given spread or attached to a coupon.

Consequently we see their evolution in terms of income as being related the

Euribor rate progress, rather than on how the macroeconomic backdrop plays out

(obviously, any increases in income from the trading portfolio will be offset certain

extent by supplementary expenses in marketable debt securities). Furthermore,

except for the HTM portfolio, all other financial assets are marked-to-market,

which means that depending on how rates progress, we should have either gains

or impairments on these assets, with the extent of the gain/loss linked to the

duration of the portfolios. Specifically, the held-to-maturity portfolio has a 4.05

duration, which becomes irrelevant in seeing that it is not marked-to-market. The

potential gains/losses are generated through the other portfolios. Nevertheless,

all securities in the trading portfolio whose time to maturity goes beyond 3 years

have been hedged through Interest Rate Swaps, and hence their duration is

merely 0.5 years, and therefore we do not see any relevant gains/losses taking

place owed to interest rate wobbles. Taking a deeper look at the securities

maturing, we witness that over 2011 we have € 3.7bn expiring from the Available

for Sale portfolio and € 311 expiring from the HTM portfolio. In spite of the

funding constraints we predict will persist, we consider the that the financial

assets maturing over 2011 will be “rolled over” since as we will discuss further

on, all refinancing need in terms of debt securities in 2011 have already been

carried out during the 1st quarter of the year. Hence, we see POP maintain its

investing in the acquisition public debt securities, as nowadays they make up for

an attractive investment on account of their yields. Hence, we see the Available

for Sale and HTM totaling only a slightly smaller amount by 2011YE. As for 2012

and 2013, we forecast a gradual shriveling in the portfolios for two main reasons:

1) Considering a scenario of slender recovery one expects yields on Spanish

Debt Securites to drop, becoming a less attractive investment onwards, 2) POP

has a huge amount of marketable debt securities (€ 8bn) maturing in 2012 which

will naturally thwart its investment muscle through enhanced funding needs, and,

in line with the diminished dependence on wholesale markets strategy the bank

Spanish Debt 45,4%

Foreign Public Debt7,2%

Debt Issued by Credit

Institutions 24,2%

Other Debt Securities;

19,9%

Equity Instruments

3,3%

33%

22%

44%

7%3%

89%

Up to 1 year 1-5 years Over 5 years

Figure 28. Maturity breakdown HTM and

Avaliable for Sale portfolios

Source: Company reports


Figure 29. Composition of the HTM and

Avaliable for Sale portfolios

Figure 30. Financial Assets by Allocation


5.885.676 6.443.543

15.067.456

18.266.410

2007 2008 2009 2010

Figure 27. POP’s Financial Assets (€

thousands)





PAGE 19/32

has been and intends to keep following, we disregard the possibility of re-

enlarging that same dependence in 2013. Notwithstanding the shrinkage will not

be pronounced, as over the next 5 year POP only has € 2.6 bn in financial assets

maturing (altogether), less than in 2011 alone. All in all, we see POP’s financial

assets amounting to €17.2 in 2011, €15.6 in 2012 and €15.4 in 2013.

Liability Side

Funding and Deposits

We consider funding alongside the deteriorating asset quality to be the main

hurdles the Spanish banking sector has to overcome in order to get back on track

(obviously for Cajas the situation is distinct and solvency will most definitely play

a major role). As we have previously gathered, the growth the Spanish Economy

underwent prior to the subprime crisis, entailed a huge leap in loan volumes, with

banks enlarging their loan books spectacularly. The question is the way in which

banks financed loans granted over this period. Excluding shareholders’ funds,

banks can finance themselves in three main ways: i) Money Market, ii) Deposits

and iii) Wholesale Debt Markets.

In order for us to get a glimpse of the big picture, the issue was that the growth

loan books experienced was so pronounced, that Spanish National Savings,

translated into deposits, were unable to finance new loans banks were to

concede. Hence banks resorted heavily to other funding vehicles, particularly,

wholesale debt markets, increasing their dependence on capital markets

exponentially. Particularly Figure 31 shows how the commercial gap portrayed by

the loans to deposits ratio evolved during the expansionary period from 2000 until

2007. The banking system went from a 111% ratio to a 135% ratio. The ratio is

itself a measure of liquidity as it shows how dependent (or not) banks are on

Interbank and Wholesale debt markets. 35% of loans in excess of deposits

represent funding need of over €446,000 million. The figure shows the degree to

which Spanish banks captured funds in wholesale debt markets to finance the

new loans granted. Specifically, from 2000 to 2007 there was a 731% increase in

debt securities issue throughout the sector.

Specifically, the evolution of POP’s funding gap and dependence on wholesale

debt markets until 2007 is portrayed in Figure 33. POP’s loans to deposits ratio

went from 127% in 2002 to 226% in September 2007, which stands for a funding

gap of €47,716 million. Naturally, as the figure illustrates, the funding gap was

being financed by a great deal through debt securities, that at the time amounted

120%

140%

160%

180%

200%

220%

240%

0

5.000

10.000

15.000

20.000

25.000

30.000

35.000

40.000

45.000

50.000

POP Debt Securities POP Loans to Deposits

Figure 31. LTD ratio Sector



100%

105%

110%

115%

120%

125%

130%

135%

140%

Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07

Loans to Deposits

0

50.000

100.000

150.000

200.000

250.000

300.000

350.000

400.000

450.000

500.000

Jan

-00

Ju

l-0

0

Jan

-01

Ju

l-0

1

Jan

-02

Ju

l-0

2

Jan

-03

Ju

l-0

3

Jan

-04

Ju

l-0

4

Jan

-05

Ju

l-0

5

Jan

-06

Ju

l-0

6

Jan

-07

Ju

l-0

7

Debt Securities

Figure 32. Debt Securities Sector (€ m)


Figure 33. POP’s LTD and Debt

Securities (€ m)




PAGE 20/32

to €43,739 million. Thus, we can see how the bank’s liquidity situation was

precarious with its loans to deposits ratio standing at an astonishing 226%, well

above an already liquidity-wise exposed financial system.

The problem has been that since the onset of the crisis, wholesale markets have

had trouble functioning, and never resumed the same level they did before the

crisis. The situation grew far worse when the sovereign crisis broke. Particularly,

since the Greek debt crisis in Mar-10 a contagion effect has been felt throughout

Europe’s peripheral economies, namely those recording the highest budget

deficits, and as a result wholesale markets shut down for Spanish triggering yet

another liquidity crisis. Banks unable to resort to wholesale markets, and with

huge funding gaps used ECB’s extraordinary liquidity measures, which increased

their weight in the Spanish Banking System, which has since then been slowly

drained out. Notwithstanding, by July 2010 markets reopened and Spanish

Institutions have been progressively able to issue debt, albeit at a much higher

cost than prior to the crisis.

The contagion of the Greek has already led to bail-out in Ireland and Portugal

through upward and downward spirals in sovereign CDSs and Ratings,

respectively important to stress how the banking sector’s situation is entangled in

governments CDS and ratings and issues and thus the evolution of the Spanish

situation in wholesale debt markets will be extremely dependent upon how the

sovereign debt crisis plays out.

Thus, with an enormous funding gap and a liquidity crisis in hands, Spanish

banks, kept alive through the oxygen pump, the extraordinary liquidity measure

(whose date of withdrawal continues to add further uncertainty to the banking

sector) have been driven to change their funding mix going back to the origins

i.e. reducing their wholesale funding dependence due to the cost and

difficulty/inability to issue debt and close in on their funding gaps. Naturally the

solution was to start capturing deposits as shown in figure 34. Obviously with

banks competing against one another, a deposit war broke out. Specifically,

Figures 35 and 36 show the deposit war has lead to banks engaging in negative

spreads in order capture some loans,. cutting margins and therefore placing

downward pressure on NII. So, all of the sudden, deposits that had been set

aside for so long became extremely valuable for banks and the rates offered on

them started climbing. Concretely, in a two-year period concerning household

deposits the spread plummeted from 0.49% to -1.32%, and regarding corporate

deposits, they dropped from 0.62% to -0.20% over the same period, which

-1%

0%

1%

2%

3%

POP San BBVA Sab Banki

Figure 35. Household Deposits Rate and Spread


Figure 36. Corporate Deposits Rate and Spread


0

200.000

400.000

600.000

800.000

1.000.000

1.200.000

1.400.000

1.600.000

Total Deposits

Source: Company Reports: Bank of Spain

Figure 34. Deposits for the Sector (€ m)

Figure 37. Deposit spreads vs Euribor

12 months Banks


-2%

-1%

0%

1%

2%

3%

4%

5%

De

c-0

3

De

c-0

4

De

c-0

5

De

c-0

6

De

c-0

7

Mar

-08

Jun

-08

Sep

-08

De

z-0

8

Mar

-09

Jun

-09

Sep

-09

De

z-0

9

Mar

-10

Jun

-10

Sep

-10

De

z-1

0

Jan

-11

Feb

-11

Mar

-11

Household Deposits Rate Spread VS Euribor 12m

-2%

-1%

0%

1%

2%

3%

4%

5%

De

c-0

3

De

c-0

4

De

c-0

5

De

c-0

6

De

c-0

7

Mar

-08

Jun

-08

Sep

-08

De

z-0

8

Mar

-09

Jun

-09

Sep

-09

De

z-0

9

Mar

-10

Jun

-10

Sep

-10

De

z-1

0

Jan

-11

Feb

-11

Mar

-11

Corporate Deposits Rate Spread VS Euribor 12m




PAGE 21/32

means that funding costs increased sharply, in a way representing the premium

for the desperately wished liquidity. One can easily gauge the toll that such a

leap in funding can take on margins if banks are unable to re-price quickly and

effectively.

POP, probably due to its upsetting loans to deposits ratio, was one of the banks

most actively seeking deposits, and one of the most successful too.

Although POP’s deposit hunt led to negative spreads (-0.32% in Dec-10),

increasing funding costs, and therefore hampering profits, it has almost halved its

loans to deposits ratio, which is nowadays to be found at 118% (below value

recorded in 2000). Due to the extremely positive shrinkage of the funding gap,

POP was also able to cut down its dependence on ECB funds to roughly 1.5%.

That is, in order to re-shuffle its funding mix, the bank had to give in considerable

profits. One of the main weapons POP had during the deposit war was that the

lower duration of its lending portfolio, due to smaller weight of housing

mortgages, allowed for a swifter re-pricing transferring the price to customer

much faster.

That said the slim deposit growth recorded in the Spanish banking system has

come to a halt. Nevertheless, we don’t see the level of deposits for the sector

taking a downward slide, particularly, we see that in the past when Spanish GDP

went down, savings rate went up offsetting the GDP’s drop downward pressure

leading to deposit levels to stabilize rather than fall.

Additionally, it has also been the case that in the past deposit growth has been

superior to the GDP growth for the period. However we don’t see this pattern

being translated to the current situation (in 2011), chiefly because Private and

Corporate indebtedness levels have been placing some strings in the level of

savings, which means that we only predict slight deposit growth for the sector in

2011. Furthermore, we think that POP and other well-positioned banks have

already taken full advantage of their spread management to capture deposits,

and we can even see by Figure 37 that spreads are starting to pick up again

(becoming less negative), which point out to a stabilization of the deposit war in

Spain. In fact, we do see POP achieving some deposit growth, but otherwise

through market share gains, namely at the expense of the troubled Cajas. In fact

we predict 2% deposit growth for POP in 2011 and 3.5% in 2012 and 2013

enhanced by savings levels that will start regaining some momentum by then.

The cost of funding banks incur in is directly linked to the government’s cost of

funding. In fact, it usually replicates the governments cost of funding, plus a

100%

120%

140%

160%

180%

200%

220%

0

10.000

20.000

30.000

40.000

50.000

Debt Securities POP Loans to Deposits


30.000

40.000

50.000

60.000

70.000

80.000

Figure 39. Debt Securities and LDT

POP (€ m)


Figure 38. POP Deposit Evolution (€

thousands)




PAGE 22/32

spread accounting for the bank’s specific risk. Particularly, after the Greek

Sovereign Crisis, the effect of contagion spread out to European economies with

the most fiscal imbalances, namely Portugal, Spain and Ireland (even though the

Irish situation was different with the banking system as the cause rather than a

consequence). The crisis was translated into a plunge in investor confidence in

these markets with risk premium going off the roof.

Particularly, Figure 40 shows how Credit Default Swaps for troubled countries

have evolved contrasting with Germany and France. We can see that since the

Greek bailout, CDSs for all the troubled economies have been following a

correlated upward trend, also heavily affected by sovereign downgraded applied

by credit rating agencies, which have been having a strong effect on the path

followed by CDSs. This situation has lead to a substantial increase in

government’s funding costs. In fact we can see that the spikes in the Spanish

CDS’s escalation coincide with the dates of bailout to other troubled economies,

specifically in April/May 2010 Greece, and in December 2010 Ireland of the

downgrades. This escalation so far has resulted in bailout for Ireland and more

recently Portugal, whose CDSs reached unbearable levels, leaving Spain as the

“last man standing”. Presently speculation surrounds the Spanish economy

regarding a possible bailout. The good news is that since the Portuguese bailout

the Spanish CDS evolution seems to be detaching from CDS path of other

troubled economies which means that the correlation is diminishing leaving us

optimistic.

Regarding banks, their cost of funding basically portrays the sovereign cost, plus

a spread due the bank specific risk. Specifically Figure 41 plots the CDSs of the

main Spanish Banks alongside the Sovereign CDS. The graph portrays how

close the relationship is between sovereign CDSs and bank’s CDSs. We can

also gather throughout the chronological series that POP, among the largest

Spanish banks, has one of the largest spreads, currently at 313bp, second to

Bankinter with 360bp. It is also noteworthy that Santander due to its

diversification has the lowest spread, at times below the Spanish government,

currently standing at 187bps. Additionally we can see that Sovereign

Downgrades are usually followed by downgrades on the banking system. POP’s

CDS is above the Government’s; particularly issues like credit quality are likely to

add to the uncertainty. On the other hand Santander and BBVA’s risk is standing

at the same level, probably to the diversification brought along by their presence

in fast growing markets. In terms of credit rating, POP has the lowest amongst

the largest Spanish banks (S&P ratings), with a rating of A- with a negative

0

100

200

300

400

500

600

SAN BBVA POP SAB BKT SP Gov

Source: Bloomberg

Source: Bloomberg

0

200

400

600

800

1000

1200

1400

1600

Portugal Greece Germany France Spain Ireland

Figure 40. Sovereign CDSs 5year USD (bps)

Figure 41. Spanish Banks CDSs 5 year

EUR (bps)

Source: Bloomberg

0

50

100

150

200

250

300

350

400

SP Gov SAN BBVA SAB POP BKT

Figure 42. Spanish Banks CDSs 5 year

EUR (bps) - Current




PAGE 23/32

outlook, while Bankinter and Sabadell stand at A, also with negative outlook, and

the Spanish Government, Santander and BBVA at AA with negative outlook as

well. From the Credit rating and CDS analysis, one can gather that even though

the situation is troublesome across the board, POP is one of the most seriously

hit banks, encompassing at the same time the lowest credit rating and one of the

highest CDSs (even though the two are related). We think POP’s particularly

murky outlook is chiefly attributable to the uncertain surrounding.

Recall that POP has progressively decreased its exposure to wholesale debt

markets. Nonetheless the way in which the CDS situation plays out and the

evolution of funding costs will still have a huge impact on the bank. Particularly,

these will have a huge impact once POP’s outstanding debt securities start

expiring. If in 2011 POP only has over €1,000 million expiring in debt securities

which have already been refinanced through issue of covered bonds and senior

debt over the 1st quarter of the year, in 2012 the situation is completely different

with €8,000 million in outstanding debt maturing.

The question turns to how will POP refinance these, and this will obviously

depend on how CDSs and yields will evolve. Specifically, these can either go

down to previous levels, stay at a similar level, or in the worst case scenario of

an IMF intervention go to the levels imposed by a bailout agreement. Assuming a

base scenario, where, with no miracle recovering in line we see funding costs

remaining at similar levels, we do not see POP being able to issue €8,000 million

in debt securities, as it would undoubtedly drive its profits to floor levels. Instead,

we see POP refinancing only about a portion debt outstanding, and financing the

other half through deposit growth and reductions in its financial assets portfolios.

So, we see POP’s debt securities amounting to €21.4 million in 2011, €18.2

million in 2012 and €14.698 million in 2013.

Solvency

Regarding solvency, it has been a hot topic ever since the subprime bubble burst

and banks’ fragilities emerged, with the release of the new Basel III. In Feb-11

new legislation was proved targeting the reinforcement of the financial system.

Even though the primary targets of the decree are the Spanish Cajas, already

undergoing a restructuring process through the FROB, it introduces a long

ranging reform throughout on Spanish Solvency Regulations. The Decree is

basically anticipation and strengthening of the Basel III criterion which is

expected to come into place by 2013. The legislation sets a Core Tier I Capital

Table 7. S&P rating Spanish Banks

Institution Rating Stance

Soverein AA Negative

SAN AA Negative

BBVA AA Negative

SAB A Negative

POP A- Negative

BANK A Negative

Source: S&P


67%

28%

5%

Retail Funding Wholesale Funding Official Institutions

67%

28%

5%


67%

28%

5%


Figure 43b. Funding Mix POP 2010

67%

28%

5%


67%

28%

5%



57%

41%

2%

Retail Funding Wholesale Funding Off icial Institutions

Figure 43a. Funding Mix POP 2007




PAGE 24/32

Ratio, consisting of share capital, share premium and other reserves, capital

instruments, certain outstanding instruments minus intangibles and regulatory

adjustments at 8% of RWAs. Moreover, institutions whose dependence on

wholesale debt markets is above 20% are to have a core capital ratio of 10%.

Institutions must meet these standards by September 2011, either through capital

reinforcements or through divestments.

That said, and making a clear distinction between banks and Cajas, the largest

Spanish Banks present in general comfortable capital buffers.

Specifically, the picture shows that POP has the best core capital ratio in the

Banking System at 9.93%, achieved through the 5% capital reinforcement

undertaken by Crédit Mutuél. In fact, we gather that among the largest Spanish

banks, only Bankinter still does not comply with the new legislation standing at

6.44%.

Obviously, the solid capital position of the bank makes it a “less risky” bank

translated into a decrease in the cost of equity. On the other hand the bank

become less attractive in terms of a risk-reward profile, and hence it is

straightforward that this new framework will drive the sector lower ROEs. We see

POP aiming to keep and even strengthen its solvency situation, and hence we

foresee Tier 1 levels of 10% in 2011, 11% in 2012 and 11.15% in 2013.

The Income Statement

DuPont Expansion

The aforementioned backdrop has been placing huge downwards pressure on

POP’s (and Spanish Banks in general) profits and consequently on their ROEs

as depicted in figures. Specifically, in order to obtain a better grasp of what has

Figure 44. Core Capital Banks

Source:

9,93% 9,66%9,05% 8,90%

6,44%

0%

2%

4%

6%

8%

10%

12%

POP SAN SAB BBVA BANK


0,00%

0,50%

1,00%

1,50%

ROA

Figure 45. POP’s ROA

0,00%

10,00%

20,00%

30,00%

ROE

Figure 46. POP’s ROE






PAGE 25/32

been driving POP’s profits to lower levels, as well as to forecast what will happen

in the future we undertook a DuPont expansion on ROE.

The figures above portray how, in a 3-year period, POP’s ROE has fallen from

roughly 23% to 8% while ROA went from 1.4% to 0.5%. The DuPont expansion

can help us getting insight to what the main drivers of the fall are. Taking a closer

look, we know that ROE = ROA x Assets/Equity.

The first part of the explanation is relatively straightforward, Assets/Equity, also

known as the Equity Multiplier. The crisis has called out for increased regulation,

and banks increasing their capital ratios, namely Basel III. This implies that

Assets/Equity is doomed to be consistently found at levels lower than before,

which obviously has a negative impact on bank’s ROE. Notwithstanding, this is a

generalized effect across the board, and there is nothing banks can really do

about it, so it is really a given. The interest issue is really to gnaw around the

ROA to understand what is really driving it downhill. As pictured in the table POP

shows an ROA of 0.47%. In 2007 at its peak, POP presented an ROE of 23.95%.

We replaced in the table above NII and Loan Loss Charges in 2010’s ROA

expansion (both as % of Total Assets) by 2007’s levels to see what was the

impact of their worsening in terms of ROE. Table 8 and 9 show that NII’s drop

had a negative impact of 7.14% while the Loan Loss Charges’ leap had an

astonishing negative impact of 9.42%. Hence now that we have identified the

main burdens on POP’s P&L, let us break them down even further and see what

to expect.

Net Interest Income

As we have witnessed over the past few years that banks have been consistently

underperforming markets. Even though this is partially accounted for by the

1 year 1-5 years Over 5 years

Trading Portfolio 10.1% 22.4% 44.2%

Debt Securities 19.3% 58.1% 22.6%

0,00%

0,50%

1,00%

1,50%

2,00%

2,50%

3,00%

3,50%

4,00%

Customer Spread Asset Liability Spread


0%

5%

10%

15%

20%

25%

30%

35%

40%

Sab Bank BBVA San POP

Figure 47. Spanish Bank’s ROE

Table 8. POP’s ROE and ROA decomposition (2010 % of

Total Assets)

+ NII 1.89%

+ Net Non Interest Op Income 0.78%

- Net Non Operating Expense 0.06%

- Operating Costs 0.94%

- Depreciation 0.07%

- Loan Loss Charges 0.95%

- Taxes 0.18%

= ROA 0.47%

= ROE 7.23%


2007's Loan Loss Charges 0.344%

Resulting ROE 16.65%

Negative Impact 9.42%

2007's NII 2.35%

Resulting ROE 14.37%

Negative Impact 7.14%

Table 9 and 10. Impact of NII and Loan Loss Charges

from 2007 to 2010





PAGE 26/32

slummy and uncertain macroeconomic conditions that usually hit banks harder

than most sectors, we do not see some of these trends as temporary, but rather

as structural changes on the earning and return profile of the sector. Specifically,

we can see that NII is found at levels close to those regarded in 2007, still, let us

not forget that POP has a much larger asset base nowadays than before, which

means it is generating a diminished revenue per asset unit, has we had already

depicted. This can observed in figure 49 where POPs’ Asset Liability Spread and

Customer Spreads are portrayed. It is obvious that the huge efforts POP has

engaged in order to capture deposits, which, as we have seen before have lead

to negative spreads on deposits have been placing downward pressure on

margins, reducing the bank’s profitability. That is, to a certain extent, the higher

costs of issuing debt are being offset by enhanced deposit costs. Even so, POP

has nonetheless been able to manage these positively due to the corporative

nature of its loan book that allows for a faster re-pricing, which has been acting

as a buffer. In the current market situation, where the deposit war appears to

have stabilized (we already see some recovery in customer spreads) we see

customer spreads stabilizing at around 2.60%, which despite not being even

close to the 3.50% recorded in Mar-07 is bearable, and positive. All in all, with

flat loan book we see spreads being found at similar levels for 2011-2012,

whereas in 2013 we see some slight recovery due to some pressure easing from

wholesale debt markets and improved macroeconomic scenario.

Credit Impairment

Credit deterioration POP is facing on the “bottom-half” of its income statement is,

as we have seen in our DuPont expansion in fact trimming down a large chunk of

its profits. If on one hand some of the provisioning is accounted for by

deteriorating macroeconomic conditions, namely on its available-for-sale

portfolio, the real problem is POP’s NPL ratio. As discussed before, NPL not only

has a huge exposure on its loans book to cyclical segments that have been

undergoing a huge credit deterioration process translated into NPL ratios, it also

has an above average NPL ratio in those same segments compared to its peers.

On top of that, POP has a lower-than-peers coverage ratio, In fact, the graph

presented below show the percentage increase in net additions to Credit Loss

Allowances (aka Loan Loss Reserves). It is clear that despite in steadier way

NPL ratios in fact keep their upward trend, Credit Loss Allowances on the other

hand depict a much more erratic trend where some considerable increases are

followed by some slight falls. In fact this is translated to an overall increase of

approximately € 900 million in LLP contrasting to a € 5,632 million in NPLs. This

0

200.000

400.000

600.000

800.000

Figure 47. POP’s Quarterly Net Interest Income (€ Thousands)


-20%

-10%

0%

10%

20%

30%

40%

50%

60%

Credit Allowances NPLs

321.585

1.086.359

1.738.916

1.232.133

2007 2008 2009 2010

Provisioning

Figure 50. POP’s Loan Loss Charges

vs NPL growth

Figure 51. POP’s Credit Imparities (€ thousands)



Figure 48. POP’s NII

0

200.000

400.000

600.000

800.000

0,00%

0,50%

1,00%

1,50%

2,00%

2,50%

3,00%

3,50%

4,00%

Customer Spread Asset Liability Spread

Figure 49. POP’s spreads






PAGE 27/32

has been placing QoQ downward pressure on POP’s coverage ratio. So, and

regardless of the slight recovery the Spanish economy is expected to endure, we

consider the evolution of the construction market, which is still falling and which

we predict to bottom out only in 2012 to be crucial. Until the bottoming out in

construction does not take place, we see POP having to deal with additional

NPLs, which we expect to record a value of € 6,678 million by 2011YE and

stabilize around € 7,000 million in 2012 with no further additions in 2013. For this

reason, until the construction market bottoms out, a given the LLP buffer has

been wearing down and, we foresee an additional provisioning effort from POP,

in order to maintain a buffer against loan losses of €1,292 million in 2011, €1,192

million in 2012 and finally €1,091 million in 2013, entailing a cost of risk of 1.35%,

1.25% and 1.15%, respectively. Hence we conclude that even though POP’s

provisioning effort will eventually come to a halt, it will not be a rapid adjustment,

and provisioning efforts will in fact keep hindering the bank’s profitability over the

forthcoming years.

Net Fees and Commissions

Even though Net Fees & Commissions do not have such an extensive impact on

POP’s profitability as the Net Interest Margin or Loan Loss Allowances, these are

still worth mentioning. Since the onset of the crisis Net Fee & Commissions,

these have been suffering a certain decline, despite the recent humpback in Mar-

11. Figure 52 shows the breakdown of the main components of fee &

commissions income. We can easily gather that the extended plunge that

accounts for the overall fall is related to handling services, which encompasses

collection and payment mediation and administration of customers’ securities

portfolios, both of which have undergone considerable shrinkage. We link this

shrinkage to deteriorating economic conditions, especially consumption.

Notwithstanding, given the IMF foretells a dim recovery in GDP growth and

private consumption, with GDP growing 0.6%, 1.6% and 1.8% over the next 4

years and Consumption levels growing over the same period, we see Net Fees &

Commissions in 2011 at a similar level to the one recorded in 2010, and we

anticipate a slight, yet gradual rise from 2012-2013, around 1.5% yearly where

we stress that the recovery in consumption levels are to have a positive impact.

Operational Costs

Operational costs have also been under downward pressure. Responding to

higher funding costs POP, and banks in general, have been attempting to shield

their profits through sizeable cuts, namely in Branches and Personnel, as shown


Figure 38. Composition of the Available

for Sale Portfolio

Figure 52. POP’s fees and commissions

breakdown (€ thousands)


1,048,1361,015,647

783,200 773,407

2007 2008 2009 2010

Handling Services Provision of contingent Exposures

Services in Asset Operations


15.069

12.709 12.414

2.504 2.370 2.224

2008 2009 2010

#Employees # Branches

Figure 53. POP’s employees and

branches

Source





PAGE 28/32

in the picture. Specifically, in order to buffer out the effect higher funding costs

were having on the margins, the bank has tried to keep its costs under control

through the layoff of over 2,500 employees and the shutdown of 280 branches.

Historically, POP has been one of the most efficient banks in the sector has

depicted in Figure 54. Nevertheless, its Cost-to-Income ratio has gone up from

29.9% in Mar-07 to 38.4% in Mar-11, in spite of cost-control policies carried out.

Notwithstanding POP still shows the best cost-to-income ratio among the largest

Spanish banks. Given we see funding constraints to persist, we see the bank

following its cost control policies and thus we predict operational costs to be in

line with those recorded over the past two years. Even so, these should be

somewhat lower than 2010’s because the slight increase in these over 2010 was

attributed to a sudden leap in rental expenses of branch offices sold under lease-

back agreements. All in all, we predict costs will be in line with those recorded in

2009, with subsequent 1% drops in 2012 and 2013.

VALUATION

Scenarios

Base Scenario

We valued POP’s operations altogether, without making a distinction between its

international and domestic operations. This was due to two main reasons: First

and foremost, POP’s international operations go as far as the Portuguese

Banking Sector (except for the embryonic bank in the USA), which we generally

regard as facing “similar” hurdles to those the Spanish market is facing, where

we see no substantial growth opportunities. Furthermore, POP’s market share in

Portugal is slim, accounting only for a diminutive portion of POP’s Net Profit.

Given it is a Bank valuation, where debt may be regarded as operational, as well

as financial, the approach undertaken was FTE-Flow to Equity. The Net Income

of the period was adjusted each period to meet the bank’s target Core Capital,

10% in 2010, 11% in 2012 and 11.25% in 2013, which despite being above the

8% required by the Spanish Government we believe to be the level POP will aim

at in order to maintain its comfortable solvency situation. The remaining will be

cash flow available to that it in case of need to reach the 10% core capital target,

earnings may be retained. Provisions are treated as cash out for valuation

purposes.

0%

10%

20%

30%

40%

50%

60%

70%

Mar-07 Set-07 Mar-08 Set-08 Mar-09 Set-09 Mar-10 Set-10 Mar-11

SAB BANK BBVA SAN POP

Figure 54. Operational Efficiency Banks

Table 11. FCFE Methodology

Profit of the Period

+ Amortization

- Regulatory Requirements

- Capital Increases

-Expenses on Necessarily Convertible

Subordinated Debentures

= FCF to Equityholders





PAGE 29/32

The resulting Cash Flow was discounted at the leverage cost of equity, which

was obtained using the 10 year German Bund as our risk-free rate and the

historic 6% equity premium. A 1.1 beta was obtained by regressing POP’s weekly

stock returns over the past 5 years against the Euro Stoxx 600 Index. Finally, we

added Damodaran’s country risk premium for Spanish Economy of 0.75 based

on the Adjusted Default Spread reflected in Sovereign Ratings. The resulting cost

of equity was 10.38%. We attributed this scenario a 50% probability.

Optimistic Scenario

In our Optimistic scenario we assumed a 1 notch upgrade in the Spanish

Kingdom’s sovereign rating to Aa1, alongside a 1% improvement in wholesale

funding costs. Besides the impact of the improvement in funding costs, the

upgrade in ratings will improve POP’s cost of equity as well, through a fall in

Damodaran’s country risk premium from 0.75% to 0.38%, resulting in a Cost of

Equity of 10.01%. We attributed this scenario a 20% probability.

Pessimistic Scenario

Similarly to the situation depicted in our optimistic scenario, we assumed a 1.5%

worsening in funding costs, and 2 notch downgrade to A1. In line with our

optimistic scenario, besides the impact in the cost of funding, the downgrade will

also be reflected in the Cost of Equity through an enhancement Damodaran’s risk

premium from 0.75% to 1.28% resulting in a 10.91% COE. Note that we

considered a 2 notch downgrade since the current Spanish Sovereign rating kept

is already under negative stance. We attributed this scenario a 30% probability.

Joining the 3 scenarios under consideration and their respective probabilities, the

result obtained was the following:

Relative Valuation

In order to validate our analysis, we undertook a multiple valuation through

POP’s Spanish peers.

Scenario Probability Price per Share

Base 50% 4.29 €

Optimistic 20% 4.81 €

Pessimistic 30% 3.61 €

Price Target 100% 4.19 €

Table 12. POP’s Scenario-based Valuation




PAGE 30/32

The results obtained are consistent with our valuation which lies between the

upper and lower boundary established through the multiple valuation.

A Stress Test on Construction

Due to its importance to POP and to the Spanish Banking System in general, a

stress test on the construction was carried out regarding the impact on the value

of collateral in a LGD – Loss Given Default extreme scenario. To do so, we

employed the price loss scenario undertaken by the Bank of Spain and applied it

to the collateral covering POP’s NPLs in construction.

Given a scenario in which all the NPLs default we reached a Loss of € 746,596

thousand. If we also bring into account POP’s substandard loans in construction

and assume as well that they would default, the loss would then amount to

€1,683,000. The impact on the value of the bank would be as follows:

Finished Houses 28%

Unfinished Houses 50%

Land 60%

Stress Test Assumptions (BoS) - Price Decrease

Finished Houses 53%

Unfinished Houses 11%

Land & Developed Land 36%

Construction in POP's Loan Book

P/B P/E P/B P/E P/E P/B P/E P/B

0.81 8.42 0.65 9.22 0.89 6.46 0.76 12.99

SAN SAB BBVA BANK

Average P/B Stock Price

0.78 4.37 €

Average P/E Stock Price

9.27 3.72 €

Downward Impact from NPLs 0.51 €

Total Downward Impact (NPLs and Subtandard) 1.00 €

NPLs (€ thousands) Collateral Collateral w/Stress Test

Collateral Finished Houses 945,335 680,641

Collateral Unfinished Houses 194,969 97,484

Land & Developed land 640,696 256,279

1,781,000 1,034,404

Substandard (€ thousands) Collateral Collateral w/Stress Test

Collateral Finished Houses 261,148 188,027

Collateral Unfinished Houses 847,670 423,835

Land & Developed land 293,526 117,410

1,402,344 729,272




PAGE 31/32

Appendix

Financial Statements

Balance Sheet (€ Thousands) 2008 2009 2010 2011E 2012E 2013E

Cash and Credit Institution Loans 6,764,858 11,090,610 6,737,582 8,103,984 8,064,432 8,025,494

Loans & Receivables 91,701,521 94,956,488 96,032,311 95,340,991 94,875,667 94,417,575

Financial Assets 5,466,129 15,067,456 18,266,410 17,197,681 15,616,492 15,410,108

Other Assets 6,443,543 8,175,594 9,103,543 9,050,932 8,995,945 8,943,094

Total Assets 110,376,051 129,290,148 130,139,846 129,693,588 127,552,536 126,796,271

Deposits from Credit Institutions 14,283,878 23,899,952 12,649,746 10,720,658 8,202,322 7,869,724

Customer Deposits 51,665,410 59,557,592 79,383,524 80,971,194 83,805,186 86,738,368

Marketable Debt Securities 28,591,415 30,333,821 21,850,829 21,393,572 18,236,842 14,698,649

Subordinated Liabilities 1,616,757 1,820,215 2,381,317 2,381,317 2,381,317 2,381,317

Other Liabilities 7,160,935 5,230,584 5,622,111 5,622,111 5,622,111 5,622,111

Total Liabilities 103,318,395 120,842,164 121,887,527 121,088,852 118,247,779 117,310,169

Own Capital 123,574 133,315 137,528 137,528 137,528 137,528

Own Funds 5,896,793 7,000,565 8,215,216 8,065,739 8,418,156 9,118,177

Capital Increase - 700,000 - - - -

NI 1,052,072 766,132 590,163 528,894 615,542 677,156

Dividends 307,275 199,807 167,275 176,478 -84,479 495,811

Valuation adjustments - - -572,365 - - -

Minority interests 292,492 47,779 49,052 49,052 49,052 49,052

Total Shareholders' Equity 7,057,656 8,447,984 8,252,319 8,604,736 9,304,757 9,486,103

Total Shareholders' Equity and Liabilities 110,376,051 129,290,148 130,139,846 129,693,588 127,552,536 126,796,271

Income Statement (€ Thousands) 2008 2009 2010 2011E 2012E 2013E

Interest Income 6,289,255 5,059,068 4,163,424 5,344,725 5,949,796 6,644,914

Interest Expense 3,753,994 2,236,515 1,711,093 3,053,350 3,463,241 4,190,852

Net Interest Income 2,535,261 2,822,553 2,452,331 2,291,374 2,486,555 2,454,061

Net Fees & Commissions 864,548 763,444 746,519 753,238 763,783 778,295

Personnel & Administrative costs 1,215,770 1,188,456 1,217,133 1,178,948 1,202,183 1,201,409

Other Income 300,284 468,173 263,158 133,546 135,700 138,099

Provisions -879,194 -1,688,722 1,315,995 1,292,225 1,191,762 1,091,070

Depreciation 104,086 104,086 96,330 91,721 92,332 90,194

Profit before tax 1,501,043 1,072,906 832,550 615,264 899,761 987,782

Tax 390,343 292,559 228,096 72,079 269,928 296,335

Minority Interests 58,628 14,215 14,291 14,291 14,291 14,291

Profit of the year 1,052,072 766,132 590,163 528,894 615,542 677,156

Ratios (%) 2008 2009 2010 2011E 2012E 2013E

ROA 0.70% 0.06% 0.45% 0.41% 0.48% 0.53%

ROE 10.86% 0.89% 7.07% 6.28% 6.87% 7.21%

LTD 177.49% 159.44% 120.97% 117.75% 113.21% 108.85%

NPL Ratio 2.80% 4.81% 5.27% 5.82% 6.12% 6.12%

Coverage Ratio 73.03% 50.27% 40.43% 43.00% 47.50% 54.00%

Tier 1 8.12% 9.13% 9.67% 10.00% 11.00% 11.25%




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 a Masters of Finance student, following the 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. 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 does not deal for or otherwise offers any investment or intermediation services to market counterparties, private or intermediate customers. This report is not an investment recommendation as defined by Article 12.º-A of the Código do Mercado de Valores Mobiliários. The students of NOVA School of Business and Economics are not registered with Comissão do Mercado de Valores Mobiliários as financial analysts, financial intermediaries or entities or persons offering any services of financial intermediation, to which Regulamento 3.º/2010 of CMVM would be applicable. 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.

Documents

AASSSTTTEEERRRSS IINNN IIINNNAAANNNCCCEEE … · Eurovida Portugal. The Non-Life business is managed by Popular Seguros. Despite the economic environment, the performance of this