Santander : Upgrading our recommendation on Tier 2 notes to Buy following 2016 results in line with the strategic plan and the publication of the funding plan.

Friday 17 February 2017 - - Equity data - Reco: Neutral - Target: € 5.10 - Equity analyst: Jean Sassus - [email protected] - +33-1 44 51 83 08 - ESG analyst: XXX - Corporate governance: Opportunity (2) - / - / - - - - - Santander has released 2016 results ahead of forecasts and reiterated the targets of its 2018 strategic plan. Above all, the publication of the funding plan for the next two years finally addresses the bank's relatively large TLAC gap. In all, Santander aims to issue € 28bn-€ 35.5bn of senior non-preferred debt over the next two years. Bear in mind that on 23 November the European Commission proposed the creation of this new debt class (similar to the one created by the Sapin legislation in France) in the framework of its revision of the BRRD. This proposal is due to be implemented by July 2017 in each European country. - Santander has decided not to wait until June/July 2017, the scheduled date of the official transposition of the EC’s proposal into Spanish law. It has included in the prospectus of its first bond issue a contractual clause specifying the ranking of senior non-preferred debt, while adding that these instruments will subsequently be fully aligned with future Spanish legislation once the directive is transposed. - In view of the spread pick-up offered because of Santander's peripheral bank status and the scarcity of this paper, we reiterate our Buy recommendation on senior debt. - In the senior non-preferred segment, Santander offers a spread pick-up (SNP vs. senior) over five years of 59bp vs. 46bp for SocGen. There will be abundant supply in this market segment in the months ahead, and we advise investors to capitalise on spreads offered in the primary market. For investors who can buy subordinated paper, we are upgrading our recommendation from Reduce to Buy on Tier 2 paper, since the TLAC gap has just been addressed by the issuance of senior non-preferred debt. The bank plans to issue € 4bn of Tier 2 paper over the next two years, an amount that is unlikely to widen the spreads of existing debt. The 2.5% 2025 Santander paper trades at ASW+216bp (2.76% yield) vs. SocGen 2025 at ASW+195bp (2.50%) or ABN 2025 at ASW+142bp (2%). - Lastly, regarding AT1, we reiterate our Buy recommendation because: 1/ all monitoring indicators of these instruments are green (large ADI, comfortable distances to MDA and equity conversion triggers); and 2/ current yields on the credit are still attractive at 7.4% on 6.250% 2019 AT1 and 6.7% on 6.250% 2021 AT1 instruments. - > - Support factors - - Recurring revenue generation, based on a predominantly retail business, diversification in emerging markets and development of the consumer finance business in Europe.- RWA density is high, putting the group in a strong position for the review of calculation methodologies and ensuring a high leverage ratio. - We expect the accelerating rise in interest rates, the ongoing economic recovery in Europe and the resumption of growth in Brazil in 2017 to boost the bank's activity. - Points to watch - - The strategy to boost customer loyalty and attract new customers in Spain with the 1/2/3 product is weighing on net interest income, and this pressure may not be fully offset by growth in fee income. - A TLAC gap (excluding senior bonds) of € 30bn to € 35bn which needs to be filled by 2019. - Capital ratios are decent but require further strengthening. Earnings retention equivalent to 40bp p.a. is the bare minimum.