DBRS Comments on Banco Popular Español S.A. 3Q11 Earnings; Ratings Unchanged, Sr. at AA (low)

DBRS Inc. (DBRS) has today commented that its ratings of Banco Popular Español S.A. (Popular or the Group) remain unchanged after the Group’s 3Q11 results announcement. DBRS rates Popular’s Senior Unsecured Long-Term Debt & Deposit at AA (low) and Short-Term Debt & Deposit at R-1 (middle). The Group’s ratings remain Under Review with Negative Implications, where they were placed on 10 October 2011, following Popular’s announcement that it had made an offer to buy Banco Pastor, S.A. (Pastor).

Popular reported profit attributed to the controlling company (net profit) of EUR 99 million in 3Q11, down from EUR 120 million in 2Q11 and EUR 167 million in 3Q10. Despite significant margin pressures and still elevated credit costs, Popular continues to weather a challenging macro environment, particularly in its home market of Spain. DBRS views positively that the Group has remained profitable throughout the extended crisis. Popular has been able to sustain profitability by defending its margins and growing its business in key customer segments to support its revenues. On the expense side, Popular has been successful in controlling costs and preserving its relatively high level of efficiency. While the Group’s cost/income ratio is elevated from its past lows as Popular absorbs the increased cost of managing credit deterioration, it remains relatively low, resulting in a higher portion of revenues being converted into net profits and giving the Group an important advantage.

Despite elevated funding costs, the Group continues to have success in maintaining its net interest margin through wider lending spreads, thereby limiting the decline in its net interest income. Gross operating income (net revenues) was driven by solid net interest income of EUR 515 million in 3Q11, down just 2.7% QoQ, despite increased funding costs driven by competition for deposits and higher rates on wholesale funding. Popular was able to improve its yield on assets to 3.64% in 3Q11, up 9 basis points (bps) QoQ and up 29 bps YoY, which helped to offset its growing liability costs that increased to 2.05% in 3Q11, up 16 bps QoQ and up 67 bps YoY. The Group is achieving wider spreads on its loan book than its peers, mainly due to its loan mix, which contains more higher-yield lending, such as to SMEs, corporates and professionals which make up 70.6% of the Group’s loan book, rather than lower-yielding residential mortgage lending. Popular’s loan yields increased by 5 bps QoQ and 29 bps YoY to 4.29% in 3Q11, as the Group is working to reflect its higher funding costs in the pricing of its loans. By focusing on its customers, which enables the Group to tailor its offerings to its customer segments, Popular has also been able to sustain fee and commission income.

With the still weak economy in Spain, provisioning and asset impairment expense increased QoQ to EUR 282 million in 3Q11 from EUR 264 million in 2Q11, but was down significantly from EUR 693 million in 3Q10. Provisioning expense in 3Q10 included the EUR 238 million impact of the Bank of Spain’s new reserving rules. The Group increased its specific provisioning for loans and investments with increasing net entries to NPLs. Popular has also been increasing provisions for foreclosed real estate assets, held in its available for sale portfolio, ahead of the Bank of Spain’s provisioning calendar. While DBRS views positively the Group’s increased coverage, which protects against future losses, the Group’s exposure to foreclosed real estate assets adds an additional burden to the already sizeable amount of NPLs.

Indications of credit weakness are still evident with Banco Popular’s NPL ratio increasing to 5.85%, up 27 bps QoQ and up 68 bps YoY. DBRS views further asset quality deterioration as likely, given the weakness in the Spanish economy. Driving this ratio is the Group’s exposure to construction and real estate, which is 17.8% of its loan portfolio and has a NPL ratio of 18.3%. The sum of NPLs plus net acquired real estate assets of EUR 10.8 billion, or 9.1% of total risks, is a sizeable exposure that could pressure earnings if the economy deteriorates rapidly. With credit costs absorbing 73% of pre-provision profit in 3Q11, DBRS views pressure on earnings from this source as still material and will continue to monitor the evolution of credit costs.

From DBRS’s perspective, Popular continues to cope reasonably well with the stressed environment. The Group’s franchise strength is evident in its ability to gain market share and attract new customers in the midst of the restructuring and consolidation of the financial system in Spain. Popular has reduced its commercial gap to EUR 23.3 billion at 3Q11, down by EUR 1.9 billion YoY, and has reduced its loan-to-deposit ratio to 138%. With further liquidity pressures due to the continued sovereign debt crisis, Popular has appropriately built up a comfortable cushion of liquid assets that are available to pledge for central bank funding.

Maintaining solid capital levels, Popular’s core capital ratio was 9.8% at 3Q11. Last week, the EBA released new criteria for capitalisation. Included in this criteria, which requires banks to reach a 9% core capital ratio by June 2012, is the need to mark-to-market certain European sovereign debt holdings. Based on preliminary data from the Group, the EBA estimates that Popular’s potential loss on European sovereign debt holdings would be EUR 597 million, or 7.2% of equity. Additionally, the Group anticipates that its additional capital needs of EUR 2.4 billion, under the new criteria, will be covered by mandatory convertible bonds of EUR 1.2 billion and scrip dividends of EUR 508 million, combined with the management of risk-weighted assets, retained earnings and other measures.

Notes:
All figures are in Euros unless otherwise noted.

The principal applicable methodology is the Global Methodology for Rating Banks and Banking Organisations. Other methodologies used include the Enhanced Methodology for Bank Ratings – Intrinsic and Support Assessments. Both can be found on the DBRS website under Methodologies.

The sources of information used for this rating include publicly available company documents and SNL Financial. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This commentary was disclosed to the issuer and no amendments were made following that disclosure.

This credit rating has been issued outside the European Union (EU) and may be used for regulatory purposes by financial institutions in the EU.

Lead Analyst: Roger Lister
Approver: Alan G. Reid
Initial Rating Date: 21 September 2006
Most Recent Rating Update: 10 October 2011

For additional information on this rating, please refer to the linking document under Related Research.