mexico the undiscovered country

See Appendix A-1 for analyst certification, important disclosures and the status of non-US analysts.

Equity Research

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Mexico: The undiscovered country

We turn more bullish on the Mexican banking sector and upgrade BBVA to Buy

In this Anchor Report, we undertake a detailed analysis of the Mexican economy�’s dynamics and their implications for the banking sector.

Following this work, we have become more positive on the outlook for profitable growth, and expect the banking sector to account for c. 35% of GDP by 2020, implying potential annual loan growth of 15-17% over the same period.

Although a key risk for BBVA remains the ongoing sovereign/economic difficulties in Spain, we upgrade the stock to Buy from Reduce (and raise our TP to EUR 7.80 from EUR 7.30), as we expect the company to generate 44% of net income from Mexico by 2014.

At the same time, we downgrade Santander to Reduce from Neutral (and cut our TP to EUR 7.10 from EUR 7.40), given greater uncertainty around the outlook for Brazil (33% of net income).

Key analyses in this report include: a review of the economy and banking sector, and the potential for

growth (including positive demographic trends); and a valuation of BBVA�’s Mexican business.

July 10, 2012

Research analysts

European Banks

Daragh Quinn �– NIplc [email protected] +44 20 7102 8333

Emerging economies

Benito Berber �– NSI [email protected] +1 212 667 9503

Industry specialist

Duncan Farr �– NIplc [email protected] +44 20 7103 1539

Mexico

GLOBAL BANKS

EQUITY RESEARCH

Anchor Report: The undiscovered countryPositive economic outlook to support banking growth

July 10, 2012

Bullish economic outlook Over the next decade, Mexico will, in our view, become LatAm’s largest economy and one of the emerging markets’ most dynamic. Given faster growth in China’s US dollar-denominated labour costs, Mexico is an increasingly attractive choice for US-destined, labour-intensive manufacturers. We believe potential GDP growth will recover to 3.5-4.5% over the next decade, supported by foreign direct investment (FDI) and structural reforms. The politics of reform The PRI party and Enrique Pena Nieto have regained the presidency and the Lower House. Unlike in previous elections, the party supports structural, pro-market, reforms. It will not have a majority in the Lower House or Senate and will most likely have to rely on the PAN party’s support. However, we could say a majority does support the reforms as the PAN party has also supported their approval, and so two of the three key parties are pro-reform. Mexican banking to come of age In relative terms, the Mexican banking sector remains one of LatAm’s smallest, particularly relative to the level of economic development. Private sector debt to GDP is barely 20% vs. an average of c. 40% for key LatAm peers and as high as almost 80% in Chile. Given our bullish economic outlook, overall lending growth of 15-17% per annum could be sustained. Hitting a demographic sweet spot This positive environment for the economy and banks is likely to be supported and even accelerated by positive demographics, hitting a sweet spot in 2020. Current projections point not only to Mexico showing one of the strongest levels of population growth among major economies, but also the greatest fall in the dependency ratio (proportion of young/old relative to the working age population). This implies a greater relative increase in resources and potentially stronger GDP growth. Some of the benefits of this demographic dividend would not be automatic, but will likely depend on appropriate policy action/reform. We believe Mexico is positive for global banks (BBVA, SAN, Citi and HSBC), we therefore upgrade BBVA Given our bullish outlook for Mexico, we upgrade BBVA to Buy from Reduce and raise our target price to EUR 7.80 from EUR 7.30). To maintain a spread in ratings, as we still have a cautious view on European banks, we lower our rating on Santander to Reduce from Neutral and lower our target price to EUR 7.10 from EUR 7.40). We estimate a potential positive impact on EPS of 1% for HSBC and of 2.0-2.5% for Citigroup. However, given the potential downgrades from capital market trends, we leave our earnings forecasts unchanged.

Research analysts

European Banks

Daragh Quinn - NIplc [email protected] +44 20 7102 8333

Prathmesh Dave [email protected] +44 20 7102 8530

Jon Peace - NIplc [email protected] +44 20 7102 4452

Domenico Santoro - NIplc [email protected] +44 20 7102 2375

Scott Sheridan - NIplc [email protected] +44 20 7102 0067

Tarik El Mejjad - NIplc [email protected] +44 20 7102 9272

Chintan Joshi - NIplc [email protected] +44 20 7102 6597

Omar Keenan - NIplc [email protected] +44 20 7102 4341

Marco Kisic - NIplc [email protected] +44 20 7102 1435

Robert Law - NIplc [email protected] +44 20 7102 2715

Emerging economies

Benito Berber - NSI [email protected] +1 212 667 9503

Industry specialist

Duncan Farr - NIplc [email protected] +44 20 7103 1539

See Appendix A-1 for analyst certification, important disclosures and the status of non-US analysts.

Nomura | Mexico July 10, 2012

2

Contents 3 Macroeconomic view: Bullish fundamentals

9 Political outlook – the PRI is back

11 Potential for sustained banking expansion

17 From where will loan growth come?

22 A closer look at the Mexican housing market

29 A demographic dividend?

32 Recent performance of the Mexican banking sector

37 The positive impact of Mexico – upgrading BBVA

44 Positive impact for global banks

45 Overview of the key Mexican banks

62 Appendix A-1

Research analysts

European Banks

Daragh Quinn - NIplc [email protected] +44 20 7102 8333

Prathmesh Dave [email protected] +44 20 7102 8530

Jon Peace - NIplc [email protected] +44 20 7102 4452

Domenico Santoro - NIplc [email protected] +44 20 7102 2375

Scott Sheridan - NIplc [email protected] +44 20 7102 0067

Tarik El Mejjad - NIplc [email protected] +44 20 7102 9272

Chintan Joshi - NIplc [email protected] +44 20 7102 6597

Omar Keenan - NIplc [email protected] +44 20 7102 4341

Marco Kisic - NIplc [email protected] +44 20 7102 1435

Tathagat Kumar [email protected] +44 20 7102 9177

Robert Law - NIplc [email protected] +44 20 7102 2715

Manish Kumar Marodia [email protected] +44 20 7102 9166

Emerging economies

Benito Berber - NSI [email protected] +1 212 667 9503

Industry specialist

Duncan Farr - NIplc [email protected] +44 20 7103 1539


3

Macroeconomic view: Bullish fundamentals Despite the opening of the economy with the signing of free trade agreements since 1994, the privatisation of several sectors and the consolidation of democracy in 2000, the Mexican economy failed to embark on a high-growth trajectory in the past decade. Mexico average economic growth rate was one of the lowest among emerging markets (EMs) at 2.6% y-o-y in 1994-2012. In addition, rising violence has threatened the investment climate, besides hurting society. However, the outlook is improving rapidly. In the next decade, Mexico is likely to become LatAm’s largest economy and one of the most dynamic among EMs.

Fig. 1: Mexico: GDP growth rate

Source: Haver Analytics, Nomura research

To understand why we have a positive outlook, it might be useful to describe the status quo of the economy: Rigidities in the labour market, a sizable informal market, high dependency of fiscal accounts on oil revenues, existing monopolistic and oligopolistic structures, and a lack of investment in the state-dominated energy sector are among the problems that have slowed Mexico’s growth in the past. The medicine, in the form of the so-called structural reforms, has proven to be elusive. Congress, which since 1997 has not been dominated by any particular party, has had difficulties in reaching consensus with respect to economic policy. Also, in the past 15 years, two out of the three main parties have opposed the key reforms.

Being linked to the US was a detriment when the US financial sector was the epicentre of the 2008-09 global crisis. However, now that the worst episode in the US appears to be over, while the worst in the eurozone seems still ahead of us, strong US links now prove very advantageous. After all, one-third of total GDP is directly linked to economic activity north of the Rio Grande.

Mexico is becoming an increasingly attractive choice for US-destined, labour-intensive manufacturers owing to rising labour costs in China. When China became a member of the World Trade Organization (WTO), there were warnings about possible repercussions for Mexico, which lost market share to China, particularly in the US. However, over the past 10 years, unit labour costs in China have grown much faster than in Mexico.

In addition to external factors behind our positive outlook, such as being tied to the only G3 country with a positive growth outlook and regained competitiveness against China, there are domestic ones: consumption lending, which was dormant for many years, is now expanding at c. 20% annually. The expansion of credit is taking place amid a sound banking system where 85% is foreign owned (in terms of assets) and from a low level of indebtedness. Furthermore, the outlook for the passage of reforms is promising. Two out of the three main parties support their approval, including the Institutional Revolutionary Party (PRI), which will govern in the 2012-18 term.

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Cheaper than China Fast-rising labour compensation in Chinese renminbi terms, on top of both real and nominal appreciation of the renminbi, has led to China’s labour costs rising sharply in US dollar terms. In sharp contrast, Mexico’ labour costs in pesos have been remarkably stable. Mexico is becoming an increasingly attractive choice for US-destined, labour-intensive manufacturers – a bullish factor over the medium term.

Over the past 10 years, unit labour costs in China have risen much faster than in Mexico. Although productivity rises quickly in China, an even quicker rise in wages has continued to push up unit labour costs, especially since 2003. The faster rate of wage increases in China than in Mexico implies that China’s cost advantage is dissipating rapidly. Chinese labour rates were 33% of Mexico’s in 1996, yet now they are fairly close or even higher than Mexico’s. Comparing the 2012 minimum wages in Mexico and China, we note that, in almost all parts of China, the legally-mandated cost of hiring has exceeded that in Mexico.

Minimum wages in both countries vary according to the level of development in various jurisdictions. Minimum wages in the most developed (Shanghai), relatively developed (Qingdao, Shandong province), and less developed (Xi’an, Shaanxi province) Chinese cities are all higher than for their Mexican counterparts in nominal US dollar terms.

Fig. 2: Mexico and China: Minimum wage (2012)

Note: assuming a 30-day month, we use average 2011 MXN exchange rate of 12.4233 and RMB exchange rate of 6.4611 to make the conversion. Source: Haver Analytics, Nomura research

Though minimum wages do not necessarily reflect the full cost of manufacturing labour, they do provide a floor for the cost of labour, which is rapidly tilting in Mexico’s favour. The latest reports from The New York Times indicate that Foxconn, a major Chinese supplier for Apple products, would raise salaries by 16-25% for many workers, to about USD 400 a month, before overtime. In Mexico, assembly-line workers at Volkswagen are paid USD 340 per month according to local newspaper Zonafranca.

On top of the labour cost differential, Mexico has always enjoyed lower transportation costs. This is especially evident in heavier, bulkier items (eg, white goods), where freight has accounted for a higher share of the total cost. Among major US trade partners, except for China, Mexico was the only country that saw its market share in the US rise.

Potential GDP growth, on the cusp of rising Potential GDP growth in Mexico (maximum economic growth that does not generate inflation pressures) has likely fallen to 3.0% currently from 4.0% in 1994 when Mexico entered the North American Free Trade Agreement (NAFTA). Potential GDP rose with the increase in capital investment following its inclusion in NAFTA. A number of factors may explain the failure of potential GDP to remain high after NAFTA: (1) rigid, non-competitive markets in key sectors (electricity, telecommunications and oil); (2) institutional arrangements that promote rent-seeking; (3) lack of enforcement of contract rights (costs are 1.5 times the OECD median); (4) rigidities in the labour market; and (5) low quality of education. However, we believe the potential output will recover to 3.5-4.5% in the coming decade owing to a sharp rise in FDI and to the passage of key structural reforms.

MXN per day USD per dayMexico City 62.33 5.02Monterrey, Nuevo Leon 60.57 4.88State of Michoacan 59.08 4.76

RMB per month USD per dayShanghai City 1450 7.48Qingdao, Shangdong 1240 6.40Xian, Shaanxi 1000 5.16

Minimum wage in Mexico (2012)

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We have discussed that rising costs in China, coupled with stable unit labour costs in Mexico, could translate into increased investment in the Mexican manufacturing sector. In addition, Mexico’s unique position of being so close to the US market and the multiple free trade agreements signed with the rest of the world (ie, the Trans-Pacific Partnership), are additional powerful factors that could trigger FDI inflows.

Fig. 3: Mexico: Recently-announced FDI projects

Source: Bloomberg, Reuters, Nomura research

There are three key structural reforms: energy (to increase private participation in the state-dominated energy sector); labour (to increase flexibility in the very rigid labour market); and fiscal (to eliminate exemptions and increase non-oil revenues). The fact that the PRI party, under the leadership of Enrique Peña Nieto (soon to be named president elect), has become a strong supporter of these reforms significantly increases the likelihood that Congress approves at least some of them.

Fiscal front, strong despite oil dependence The structural weakness of the fiscal accounts is characterised by the fact that more than a third of government revenues derive from oil. Therefore fiscal revenues are subject to price and output volatilities in the oil sector. Although oil production has now stabilised, it has decreased. Furthermore, tax revenue collection, at around 10-11% of GDP, is one of the smallest among EMs. However, these weaknesses are more than offset by a strong fiscal responsibility law, a hedging strategy for oil exports, a low debt-to-GDP ratio, reliance on the local market to finance the deficit and a fiscal stabilisation fund:

• By law, the fiscal balance of the central government has to be zero, which means that the overall public sector deficit (including state-owned companies) usually does not exceed 2.5% of GDP. In fact, Mexico’s fiscal deficit is among the lowest in major EM countries and developed economies.

• The government has been hedging its oil exports. In 2012, Mexico bought put options with a strike price of USD 85 per barrel for the Mexican oil mix. This hedge effectively shields the bulk of 2012 oil revenues against a collapse in oil prices.

• Mexico has fairly low ratios of net-debt-to-GDP at around 30%.

• The government finances itself mainly in the local market. The shift to local debt has occurred in tandem with the development of the local market. In this regard, it is important to highlight that, in 2010, Mexican local debt was included in Citi’s World Government Bond Index (WGBI), making it the first and only LatAm country to be included in such a benchmark index.

• The government’s fiscal stabilisation fund amounts to 0.43% of GDP. Although insufficient to offset a prolonged shock by itself, combined with other lines of defence it strengthens the fiscal accounts.

AnnouncedInvestment (in

$mn) Location Operational by Jobs ProductivityAudi April, 2012 2,520 Puebla 2016 N/A 150k vehicles/yrNissan Jan, 2012 2,000 Aguascalientes 2013 3000 175k vehicles/yrHonda July, 2011 800 Guanajuato 2014 3,200 200k vehicles/yrMazda June, 2011 500 Guanajuato 2013 3000 140k vehicles/yrPirelli May, 2012 400 Guanajuato 2012 1,800 400k pieces/yrUnilever July, 2011 126 Jiutepec 2012 1,000 500k pieces/yr


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Fig. 4: Mexico, Brazil, US & France: Fiscal balance (% GDP)


Fig. 5: Mexico: Gross government debt (as % of GDP)


External accounts, relentless portfolio inflows Mexico is likely to continue to have a small and manageable current account deficit that rarely surpasses 2.0% of GDP. This small deficit can be attributed to the bulk of imports being reprocessed for further export and a stable surplus in remittances. In contrast, we expect the surplus in the financial account to remain sizable. Indeed, the financial account had a surplus of USD 52.4bn (4.5% of GDP) in 2011, more than offsetting the USD 8.8bn current account deficit. Furthermore, we expect the surplus in the financial account to remain strong owing mainly to portfolio and FDI flows.

Fig. 6: Mexico: Current and financial account balances (USD bn)


Is the MXN cheap or expensive? The Mexican peso (MXN) could be among the few EM currencies that are undervalued. Although it is challenging to find the equilibrium level of the real effective exchange rate (REER), a simple comparison with past averages reveals that the MXN is undervalued. Latest Bank of Mexico (Banxico) data indicate that, as of 2Q 2012, MXN is around 5% undervalued relative to its 10-year average.

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Fig. 7: Mexico: REER deviations from long-term averages

Source: Banxico, Nomura research

Accumulating reserves a change in strategy

The rapid accumulation of reserves has limited MXN appreciation to some extent. After the 2008-09 financial crisis, the Exchange Commission (which is the body that ultimately decides on FX intervention, and is composed of three members from the Finance Ministry and three from Banxico) changed its stance substantially: it now believes reserves are pivotal for FX stability. The rapid accumulation of reserves is bearish in the short term, but could be a positive factor in the long run as it lowers the probability of a currency crisis.

Fig. 8: Mexico: FX reserve accumulation


In the past 12 months, Banxico accumulated USD 32bn in FX reserves, taking the total to USD 157bn by June. Most of the accumulation was related to oil and derivatives’ net dollar inflows from Pemex, which has to be sold to Banxico by law. The level of reserves in terms of GDP (13%) is now comparable with Brazil’s (14.7% of GDP).

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Banxico monetary policy, 4.5% until 2014 Since July 2009, the monetary policy rate has been 4.5%, a historical low in nominal terms, and we believe Banxico will delay the start of the tightening cycle to Q1 2014. The output gap (actual GDP minus potential GDP) has now closed after falling to less than -7% in the 2008-09 crisis. We project the output gap to remain around zero in the coming year and a half. Inflation is likely to stabilise to 3.5-4.5%, above the 3.0% +/-1.0% target. Under normal circumstances, Banxico would be hiking its policy rate, but with sizable risks to global growth owing to the eurozone crisis, we expect it will remain on hold.

Fig. 9: Mexico: Output gap


Fig. 10: Mexico: 12-month inflation expectations


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Political outlook – the PRI is back And the outlook for reforms

The PRI party and its candidate, Enrique Peña Nieto, regained the presidency in the 2012 general elections. This marks the return of the PRI to the executive branch after losing the presidency in 2000 to the right-leaning National Action Party (PAN) when Mexico finally transitioned to democracy. Unlike the PRI regimes of the post-revolutionary era and until the 1980s when centre-left policies were in favour, this PRI seems to be positioning itself between the centre and the moderate right of the political spectrum. It is a party that resembles the technocrats who governed with former PRI presidents Carlos Salinas and Ernesto Zedillo. The PRI is now the undisputable leading party in the country because, as well as the presidency, it will also control 22 of the 32 states. However, the PRI failed to win a majority in Congress. The left-leaning Party of the Democratic Revolution (PRD) will continue to oppose the passage of these reforms.

The final count of votes for the 2012 general election indicates that Mr. Peña Nieto won the election with 38.15% of the votes cast in an electoral process with low abstention (63.14% of the registered voters exercised their right to vote). Andres Manuel Lopez Obrador (also known as ‘AMLO’) from the left-leaning PRD party received the support of 31.64% of the votes. The party that won the presidency in the 2000-06 and 2006-12 terms, the right-leaning PAN party, finished a distant third with 25.40% of the vote.

These numbers paint an interesting picture, characterised by the following facts:

• Mr. Peña Nieto of the PRI’s has a weak mandate as 61.85% of voters did not support him.

• Since the consolidation of democracy in 1997-2000, Mexicans have once again divided their votes among the three main parties.

• The left PRD party has become the second-strongest party. Its candidate, AMLO, who in 2006 narrowly lost the election (by only 0.56% of the vote) behind President Felipe Calderon from the PAN, will remain a relevant political figure.

• Mr. Peña Nieto and the PRI, unlike in previous elections, have campaigned with the flag of supporting the passage of structural pro-market reforms. Therefore, given that the PAN has always strongly supported their approval, two out of the three main political parties now support the passage of pro-market reforms.

While the PRI will be dominant political force in both the Lower House and the Senate, it will not have a simple majority. Most likely, the PRI will have to ally itself with the PAN party and other small parties in order to pass structural reforms.

Fig. 11: Mexico: Lower House and Senate composition

Notes: (*) Coalition parties. (**) Preliminary results Source: IFE, El Universal, Nomura research

The PRI has also regained control of two states, but lost the governorship of one. Therefore, it now governs in 22 out of 32 states, and the PAN and the PRD control five states each.

2009-'12 2012-'15** 2006-'12 2012-'18**PRI* 261 240 39 61PRD* 89 134 35 28PAN 141 116 50 38PANAL 7 10 0 1Others 2 0 4 0

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Fig. 12: Mexico: Political map

Source: IFE, Nomura research

and what do the election results mean for the prospects of reform? Given that the PRI will not have a majority in Congress, it will have to rely on the PAN and the small parties (PVEM, PANAL, PT, MC) for the approval of key structural reforms (labour, energy, fiscal and political reforms).

In particular, the right-leaning PAN could impose conditions on the PRI in exchange for its support. This implies that the outlook for the passage of reforms looks binary: either the approved reforms are very ‘pro-market’ or they will not be passed at all. Indeed, the scope for watered-down reforms has decreased, which is a markedly different outlook from the situation in the past, characterised by a president from the PAN and the PRI as the kingmaker party.

In the next term (2012-18), the party proposing the reforms will be the PRI and the kingmaker party will be the PAN. This scenario means that the PAN will ask for things that the market tends to like (increased private participation in the economy, and increased transparency for unions, among others) in exchange for its vote to pass the reforms. For example, when the PRI eventually asks the PAN for its support in passing the labour and fiscal reforms, the PAN will likely insist on the inclusion of clauses to increase the transparency of monies administered by unions and state governors. Given that the unions are allies of the PRI and this party controls most of the states, the negotiations could become deadlocked.

However, we believe the labour reform will ultimately be approved because both the PRI and PAN understand the need to boost productivity. We assign a 50% likelihood to the passage of the fiscal reform, which is pivotal to funding one of Mr. Peña Nieto’s most important projects – the creation of welfare support (unemployment insurance, insurance for work hazard, minimum retirement and access to health services). We believe the likelihood of the energy reforms being approved is very small given that, after the expropriation of oil in 1938, the concept of allowing private companies into the market is still unpopular.


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Potential for sustained banking expansion From a low base, we expect to see a significant expansion in bank debt to GDP levels over the medium and long term. We believe that this is supportive of strong double-digit volume growth rates.

The banking sector remains very small relative to peers across LatAm and has never fully recovered in size following the 1994 ‘Tequila’ crisis. Although growing below potential, we believe that the continued outlook for economic, fiscal and financial stability should enable the Mexican banking sector to start recovering some lost ground. Private sector debt in Mexico barely represents 20% of GDP vs. 35% in Colombia, more than 50% in Brazil and almost 80% in Chile.

Overview Despite the growth in the Mexican economy of c. 116% in nominal terms over the past 10 years, the relative size of the banking sector remains one of LatAm’s lowest. Over the same period, real GDP growth has averaged c. 2% pa, which compares with 3.5% pa for the rest of the region. GDP per capita, in US dollar terms, ranks significantly above the average for the region; while the size of the banking sector in relative terms ranks as one of the smallest. Given our outlook for economic growth/stability and the new political environment post the recent elections, we believe the Mexican banking sector could reach c. 35% of GDP by 2020, implying potential per annum loan growth of 15-17% over the same period.

Fig. 13: Lowest level of growth over the past 10 years Average real GDP growth 2001-11, % pa

Source: IMF, Nomura research

Fig. 14: Low bank debt to GDP despite above-average GDP Private sector debt % GDP. GDP per capital PPP


We expect deposit growth in Mexico to remain strong. Inflation rates of c. 4.5% should be supportive, but the key driver will likely be continued economic growth, increased formalisation of the economy/job creation and supportive demographic trends. In terms of a regional comparison of deposits as a percentage of GDP, both Mexico and Argentina stand out as significantly below peers. This is to be expected, in our view, and is closely correlated with the low level of bank debt to GDP. However, we believe the economic and financial situation is significantly more stable in Mexico and, as a result, we are more confident that deposits will rise as a percentage of GDP in both the medium and long term.

It is also worth highlighting the relatively low loan-to-deposit ratio of Mexico, in particular in contrast to Brazil. This will likely have played a part in depressing revenues in a low interest rate environment. However, as economic growth is sustained over the coming years, we believe this relatively strong funding position should also be supportive of loan growth.

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Fig. 15: Low bank penetration also reflected in deposit levelsDeposits % GDP. 2011.

Source: Central banks, IMF, Nomura research

Fig. 16: Stronger funding capacity Loan-to-deposit ratios 2011.

Source: Central banks, Nomura research

How to expand a banking sector Private sector leverage remains low in Mexico compared with peers; however, as GDP expands, we expect to see loan growth expand at a faster pace. In fact, since 2005, the average loan growth/GDP multiplier has been 1.5x for five of the major economies in LatAm. This compares with just 1.2x for Mexico, and although growth rates in Mexico could still remain below potential, we believe the current economic outlook points to an improvement in this indicator. The scale and effectiveness of reforms from the new government could also potentially improve this outlook. We believe that there should still be sufficient capacity for strong and sustained double-digit loan growth over the next five years.

Fig. 17: Loan growth relative to GDP starting to recover Loan growth vs. nominal GDP growth


Fig. 18: Mexico lagging behind regional peers Loan growth multiplier average since 2005


Figure 19 sets out a basic premise that, as GDP increases, so will the size of the banking sector (measured here by private sector loans as a percentage of GDP). At a certain point of development, there is an exponential expansion in credit given both stronger demand and, importantly, the willingness and ability of the banking system to supply credit (capacity for funding, risk appetite). Banking and sovereign crises, such as those experienced by Mexico and Argentina, can have long-lasting effects on the development potential of the banking sector. In that regard, while the security situation in Mexico still generates a certain level of uncertainty, we believe that there are number of positive developments to highlight: the recent successful handover of power, sustained economic growth (only dipping into recession briefly in 2009), strong/stable fiscal position and sustained low inflation. All of these factors should help provide a platform for a significant increase in the Mexican banking sector over the next 10 to 15 years, in our view.

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Fig. 19: Debt to GDP increases as an economy develops 2011 data for a mix of developed and emerging economies

Source: IMF, Datastream, Nomura research

This relationship between private sector debt and GDP growth has been seen across a wide range of countries over the past 10 years. There is a strong correlation between those countries with low levels of debt to GDP and the level of growth that they have seen since 2001. Mexico’s situation in particular is worth highlighting, because despite showing reasonably strong loan growth, the overall level of debt to GDP increased by a relatively small amount vs. peers (ie, the relative size of bubble) and still remains low in relative terms.

Fig. 20: Lower debt allows for faster growth Private sector debt dynamics 2001-2009

Source: IMF, Datastream, Nomura research

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14

However, private sector debt levels will likely not be the only driver, and given the ongoing sovereign crisis in the eurozone, we believe it is worth examining the potential interaction and impact of public debt levels. Again, we believe the relative positioning of Mexico highlights the opportunity to close the gap vs. regional peers. In an empirical study, finance professors Carmen M. Reinhart and Kenneth S. Rogoff1 show that, when government debt to GDP exceeds 90% (vertical axis in Figure 21), these countries have notably lower growth rates, with the median growth rate falling by 1%, and average growth falling considerably more, in the extensive sample data set they used. Given the correlation between GDP growth and credit growth, this would imply that one should avoid banks in countries that have higher levels of government debt to GDP.

Fig. 21: Better to be in the bottom left corner Private/public sector debt dynamics and fiscal deficit forecasts


1 This Time is Different, Reinhart & Rogoff, 16 April 2008, NBER

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15

Can Mexico follow the example of Chile? What is the possible path of development that Mexico could follow over the coming decade? It is worth highlighting that the experience of other LatAm countries has been varied over the past 10 years. In addition, while most of the key economies of the region have seen an increase in the level of credit to GDP, with the exception of Argentina, it has really been a straight line up for the banking sectors. The one exception has been Chile, which has seen a much more consistent and stable development of the banking sector. Although it started with an already more developed banking sector (as measured by private sector debt to GDP), there has been a sustained gradual increase in the use of debt within the Chilean economy.

Fig. 22: How to follow in Chile’s footsteps? Private sector debt to GDP %


This growth in the Chilean banking sector is not just a reflection of economic growth, which has seen a pattern much closer to the experience of the rest of the region, but is also a reflection of other factors. The human development index (HDI) is a composite index that aggregates a series of development/economic indicators to act as an indicator of the country’s standard of living. Both the absolute levels and progression of Chile over the past 20 years potentially provides some additional insight into the sustained growth and development of the banking sector.

Fig. 23: UN Human Development Index HDI 2011

Source: UN, Nomura research

Fig. 24: Chile has maintained a gap over time HDI over time


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16

Chile consistently moved to the top right of the chart (Figure 25) over the past 16 years, with private sector debt to GDP increasing from c. 50% in 1995 to almost 80% by 2011. Those countries in the bottom right show reasonably developed economies, certainly more so than the average for the region (assuming this is correctly measured by relative GDP per capita vs. the US), but relatively small banking sectors. Previous financial crises, political instability, high inflation or volatile economic conditions will all likely play a part in this. However, given the recent economic stability in Mexico, we think conditions should enable Mexico to take advantage of continued economic growth and stability over the next 10 to 15 years.

Fig. 25: Try and move towards the top right 2011 data for all countries, except for Chile were indicated

Source: Central banks, regulators, IMF, Nomura research

Argentina

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17

From where will loan growth come? Corporate and consumer lending should dominate initial stages of loan expansion

In aggregate, we believe that loan growth of 15% to 18% y-o-y can be sustained over the next 10 to 15 years. In the short term, we expect consumer and corporate to be the main components behind this loan growth. Moreover, while mortgage lending might trail at a system level given the small level of market share (at least in number of mortgage contracts), the commercial banks should be able to grow at double-digit levels.

Corporate lending – leveraging on expanding GDP Overall corporate lending continues to remain low as a percentage of GDP. Issues regarding low usage of banking services, in particular the high usage of supplier finance by companies, has been, and is, a factor behind the low level of debt penetration. As the main banks move to internal models of expected loss for the corporate sector, this could act as an incremental spur to corporate lending growth. These models are being approved this year and will likely start to have an impact in 2013. As banks will be reluctant to lend to small and medium enterprises (SMEs) without a credit/bank history, the increased formalisation of the economy will likely be a key element of structural growth in SME.

In terms of segments, the principal sectors of the economy are services and industry, which is largely reflected in the make-up of the commercial loan book for the commercial banks. Although the corporate loan book of real estate developers is currently under pressure, it only represents a very small amount of loans, at just 3% of commercial loans and 1.7% of the total loan book.

Fig. 26: Suppliers remain a key provider of finance Sources of credit, % of companies surveyed


Fig. 27: Breakdown of GDP and commercial loans by sector % total. 2011

Source: INEGI, Banxico, Nomura research

Is funding in debt markets an option? The total amount of debt in circulation (medium/long-term debt) amounts to almost MXN 760bn, which represents an increase of c. 8% y-o-y vs. May 2011. State-controlled groups such as the oil company Pemex make up the largest component, followed by the two public sector mortgage providers, Infonavit and Fovissste. Although the size of the market continues to grow, it remains unused by most of the corporate sector or SMEs. In fact, only 3% of companies surveyed by the central bank stated that they used debt markets for funding (Q1 2012). As a result, corporate funding requirements are likely to remain serviced by suppliers and increasingly banks.

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18

Fig. 28: Sustained growth in local debt markets Stock of M/L debt and new issuance

Source: Banorte-Ixe, Nomura research

Fig. 29: Debt market dominated by Pemex and mortgage providers % distribution of debt by issuer type/sector

Source: Banorte-Ixe, Nomura research

Although growth might have slowed somewhat in H2 2012, in the run-up to elections, we believe the stable interest rate environment and GDP growth of 3-4% should sustain loan growth in double digits over the coming years. In fact, data for May 2012 are already showing signs of an improvement in credit growth, with commercial lending expanding at 14% y-o-y vs. average growth of 10% over the previous three months.

Consistent with low overall level of debt to GDP, the level of corporate debt to GDP for Mexico is one of the lowest in the region. We believe that this will be one of the key segments of growth as Mexico gradually closes the gap vs. peers.

Fig. 30: Varying degrees of corporate debt penetration across the region Corporate debt % GDP. 2011.

Source: Central banks, regulators, Nomura research

Fig. 31: Corporate lending offers further opportunities for growth 2011

Source: CNBV, Nomura research

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Bancomer Banamex Santander Banorte HSBCMarket share 21% 14% 15% 12% 9%% of group loans 37% 39% 53% 44% 55%2011 growth 6% 16% 26% 21% 24%08-11 pa growth 12% 9% 13% 13% 8%NPL ratio 3.2% 0.4% 1.2% 2.8% 2.0%


19

Consumer credit – building on employment growth Given the still underdeveloped nature of the Mexican banking sector, consumer lending is likely to form a key component of loan growth. Customer demand can remain strong, as wages and disposable income grow. For banks, this segment of loan growth is attractive given the high spreads, low maturities (ie, easier to manage funding and liquidity risk). Although loan losses can be elevated, in an expansionary phase of credit growth the profitability of this segment is high. In addition, although Mexican banks are now provisioning on an expected loss basis, we believe the combination of supportive demand and supply factors means consumer credit will remain a key component of credit growth over the coming years.

Fig. 32: Consumer loans should grow with employment/wage growth Relationship between average consumer loan and average GDP per capital per employee


At the moment, consumer credit accounts for 24% of total lending and 35% of lending growth over the past year. We see all banks looking to maintain or increase market shares in this segment, in particular in payroll credit, the key area of focus for the sector. In the last credit expansionary phase, credit cards were the key product for expansion and also the area where greater losses were incurred. The elevated levels of growth in some segments, specifically payroll lending, which is currently growing at 74% y-o-y, mean that regulators in Mexico could take an increasingly conservative stance (to avoid the mini consumer credit boom/boost of 2008/09. However, as a product it is much more intrinsically linked with the client and the credit risk profile should be lower vs. other consumer lending segments.

Fig. 33: Consumer lending continues to recover % y-o-y growth


Fig. 34: Payroll lending increasing in importance Accounts for c. 50% of personal loans within consumer lending


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20

Payroll lending is only a relatively recent addition to the information provided on lending and in Figure 33-35 we have included it in personal lending. As of Q1 2012, payroll lending reached MXN 102bn, which accounts for c. 55% of personal lending and 20% of total consumer lending. The growth rate is extremely fast at c. 74% y-o-y and the non-performing loan (NPL) ratio is 2.5%, so still well below the levels in the rest of the consumer loan book.

Fig. 35: NPL indicators stable NPL ratio % gross consumer loans


In terms of the individual banks, we expect all major banks to try grow in this segment. In terms of growth rates, HSBC and Santander could see above-average growth rates as they look to recover/rebuild this part of the portfolio post the recent credit bust. This more aggressive approach could put some pressure on the incumbents. In terms of the potential for the market to increase, sustained economic growth, nominal growth of c. 8-9% and continued job creation in the formal sector should be able to sustain growth rates above 20% y-o-y.

Fig. 36: Consumer lending a key objective for all banks 2011


Mortgage growth, but more of a slow burn Mortgage development is perhaps a more complex product to try and anticipate significant growth (in absolute terms, but also in relative size vs. the rest of the loan book). High interest rates can be a significant impediment to loan growth, as the cost in interest for the client can exceed the value of the loan/house. From a supply perspective, reforms needed to improve land ownership records and the legal process for asset recoverability can act as a constraint to banks’ willingness/ability to lend.

For the moment, mortgage growth remains concentrated in the hands of public sector providers (Infonavit and Fovisste). However, sustained economic recovery, low interest rates (and, in particular, the existence of a local interest curve), have contributed to increased supply/growth from the private sector.

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Bancomer Banamex Santander Banorte HSBCMarket share 31% 26% 10% 6% 6%% of group loans 24% 32% 16% 10% 16%2011 growth 23% 32% 22% 7% 8%08-11 pa growth 2.5% 4.5% -6.8% 2.4% -12.5%NPL ratio 3.8% 3.9% 2.5% 3.9% 4.0%


21

Fig. 37: Mortgage supply dominated by public sector Stock of mortgage debt


Fig. 38: Overall growth remains stable % y-o-y growth rates


Demographics should, however, help contribute to continued growth over the coming years. However, the continued dominance of the public sector mortgage providers and lower returns vs. other loan segments could translate into lower growth in comparison with consumer and corporate lending. It is also the one loan segment in which the relative size of the market (vs. GDP) is above most regional peers.

Fig. 39: Still room to grow in mortgages Mortgage debt % GDP


In terms of the individual banks, while a number of the banks could see significant growth rates, we expect Bancomer to retain its dominant position within the mortgage market. Overall, the issuance should continue to be dominated by the public sector providers.

Fig. 40: Potential for growth, but still dominated by public sector providers 2011. Market share data includes Infonavit and Fovissste in total

* Santander acquired the mortgage book of GE in 2011, excluding this, 2011 growth would be c. 27% y-o-y, and per annum since 2008 would have been 18% Source: CNBV, Nomura research

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Bancomer Banamex Santander* Banorte HSBCMarket share 10% 4% 5% 4% 1%% of group loans 23% 15% 20% 20% 11%2011 growth 1.2% 17% 82% 13% 1%08-11 pa growth 4.9% 18% 29% 14% 0%NPL ratio 4.3% 1.0% 3.3% 1.2% 9.2%


22

A closer look at the Mexican housing market Although some excess supply issues are still be worked through, underlying demographics and economic growth point to sustained growth in the Mexican mortgage and housing markets.

Despite the economic recovery and the continued growth in the mortgage market, the housing market continues to show signs of dealing with some excess supply inventory. While the stable economic outlook and favourable demographics should be supportive of housing demand, it could be until at least 2013 before we see a recovery in the production of new houses. Taking a more medium-term view, however, underlying demand for houses should remain strong. In fact, based on the current outlook for population growth and household formation, Mexico could see sustained demand for c. 0.3m-0.5m new houses through to 2050. Although the mortgage market is dominated by public sector providers (Infonavit and Fovissste), we expect to see continued growth in the mortgage book of commercial banks. However, growth in this loan book could remain lower vs. that of consumer and corporate lending, where we believe demand and supply can be more easily meet by the commercial banks.

Still dealing with some excess inventory following recent recession Overall levels of construction within GDP continue to shows signs of growth and the total construction sector is growing at c. 4.9% y-o-y (Q1 2012). This level of growth is effectively in line with the overall level of GDP growth. In aggregate, construction contributes 6.4% to total GDP, a contribution that has remained relatively stable since 2010. However, this is below the peak level of 7.0% reached in 2008.

Fig. 41: Construction accounts for c. 6.4% of GDP Breakdown of GDP %

Source: INEGI, Nomura research

Fig. 42: Construction remains below previous peak Construction % GDP


The level of growth from the construction sector since the 2009 recession has been relatively stable at c. 5% y-o-y of GDP. Within this, housing accounts for c. 50%, and although it saw a sharper decline during the recession, has also posted relatively stable growth rates over the past two years.

1Q 2012 Total % Growth y-o-yGDP 100% 4.6%Agriculture 3.2% 6.8%Mining 4.7% 0.6%Electricity 1.4% 2.7%Construction 6.4% 4.9%Manufacturing 17.8% 4.2%Commerce 15.8% 6.7%Transport 7.1% 5.4%Financial services 5.5% 13.0%Real estate services 10.1% 1.2%Health 2.8% 2.1%Other 25.1% 4.0%

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23

Fig. 43: Construction/housing growth stable % y-o-y growth


Fig. 44: Employment in construction % y-o-y growth


However, despite this relative stability at an aggregate GDP level, there are a number of indicators specifically within the housing market that suggest some clearing of inventory/stock is an issue. An indication that there are some oversupply issues is reflected in the sharp decline in bridge loans to real estate developers, which are currently down 15% y-o-y. This compares with the rest of the construction-related loan book, which is expanding at 24% y-o-y (data as of May 2012). The pressure that some companies in the sector are facing is also apparent in the significant deterioration in asset quality over the past 12 months. The stock of NPLs rose by 67% y-o-y, with the NPL ratio reaching 15.4%. However, it still remains a relatively small part of the loan book, accounting for 3% of commercial loans and 1.7% of the total loan book.

Fig. 45: Developers loans show sharp contraction % y-o-y growth for construction lending


Fig. 46: With a significant deterioration in asset quality % NPL ratio within construction lending


The levels of housing starts and the build-up in housing stock also points to some element of oversupply being worked through. Total housing starts are currently down 10% y-o-y, as of April 2012. In fact, growth rates have been negative for much of 2011. Annualising the data for April 2012 points to a total reduction of 16% in 2012 vs. the levels seen in 2011. However, this would see the overall stock stabilising. Despite favourable demographics and the likely continued need for additional new houses, the data suggest that 2013 could be again a relatively weak year for new house construction.

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24

Fig. 47: Stock of new housing just peaking # of housing starts/stock of new housing 000s.

Source: Conavi, Nomura research. 2012 annualised on May data

Fig. 48: New house production continues to slow % y-o-y growth in new housing starts. Monthly housing starts 000s

Source: Conavi, Nomura research

Overall house price increases have been relatively modest and, largely speaking, in line with the overall level of inflation. As of 1Q 2012, house prices have risen by c. 3.2% y-o-y. Over the past five years, there has been a cumulative rise of c. 24%, the same as the cumulative rise in general prices. When we look at the differences between new and used houses, there appears also to be little differentiation. New house prices rose by 3.3% y-o-y in Q1 2012, while used house prices rose by 3.1% y-o-y.

Fig. 49: Steady house price appreciation % y-o-y

Source: SHF, Nomura research

Fig. 50: New and old grow alike % y-o-y

Source: SHF, Nomura research

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25

Demographics and economic stability favour sustained demand for housing The total number of houses in Mexico as of 2010 was 27.3m, with a total population of 112m and 28.2m households. The Mexican authorities forecast the total population to rise by 7% to 116m in 2020. In these forecasts the population bracket between 15 and 64 would see a c. 11% rise and the number of houses would need to rise by 21% to 33m.

Fig. 51: Population growth to continue Population projection m and % y-o-y growth

Source: CONAPO, Nomura research

Fig. 52: Dependency ratio improving and to peak c. 2020 Dependency ratio = age (<15 and >64)/15-64 group * 100


The Mexican authorities expect the total number of houses to reach 33.1m in 2020 or an rise of 21%, implying the need for c. 500,000 houses per year. This would be in addition to any unmet demand over the past number of years. Although the level of construction for new houses might still be weak in 2013, population trends point to continued strong medium-term demand for houses.

Fig. 53: Growth feeds through to more houses needed Projection of growth in housing stock


Fig. 54: Growth in houses/population should sustain mortgage growth Expected demand for mortgages per annum over the next five years

Source: Infonavit, Nomura research

Overall, the level of house ownership is high, with 76% of houses being owner-occupied. As the population continues to grow, particularly in the 15-64 years old bracket, this underlying desire for house ownership should be supportive of house demand.

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Infonavit & Fovissste – public sector providers to maintain key role in mortgage supply The two largest providers of mortgage credit in Mexico are the public sector companies Infonavit (Instituto del Fondo Nacional de la Vivienda para los Trabajadores) and Fovissste (Fondo para la Vivienda del Instituto de Seguridad y Servicios Sociales para los Trabajadores del Estado). These two organisations, established in the 1970s, are charged with providing mortgages to private sector (Infonavit) and public sector (Fovissste) workers. Although both organisations were initially involved in house construction, the current focus is effectively that of providing credit facilities for house purchase or improvement. Both use securitisations as a source of financing and combined account for c .15% of the private sector debt issued in the fixed income medium-/long-term market.

Infonavit. Private sector workers contribute a percentage of their salary into an account held by Infonavit. This balance is then used as partial payment on the house. Infonavit holds this account for the life of a worker, which, if it is not used, is returned to the worker on retirement. Interest rates on the loans given depend on workers’ salary levels and mortgage payments are deducted automatically from their payroll to be paid directly from the employer into Infonavit. To be eligible, workers must be employed in the formal sector.

As of Q1 2012, Infonavit held a total mortgage portfolio of MXN 827bn. 2011 closed with total growth of c. 10% y-o-y in the loan book, with some 469,000 new credits disbursed (of which c. 28% were co-financed with other entities). There has been a slight upward trend in NPLs. The total NPL ratio has reached 6.5% in Q1 2012 vs. 6.3% in 2011, while refinanced loans have increased to 5.1% in Q1 2012 vs. 4.9% in 2011. Funding in the markets continues, and significant issuance has already taken place in 2012.

Fig. 55: Mortgages granted remains steady # of mortgages granted


Fig. 56: Partly funded by debt issuance Debt issuance per year


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Fig. 57: Maintaining volume growth at c. 10% % y-o-y growth


Fig. 58: Asset quality indicators NPL and refinanced loans % total


Fovisste. This is a very similar organisation to Infonavit, except that it offers mortgage credit facilities to public sector workers. Funding is provided by the federal government, securitisations and workers’ contributions. Fovissste underwent a significant restructuring in 2007, following the build-up of credit and functional issues over the previous decades. This successful restructuring has enabled Fovissste to start a debt issuance programme in the market from 2009, issuing c. MXN 53.8bn since then with a AAA rating. In 2011, c. 75,000 new mortgages (although this was below the initial target of 90,000) were given, with an objective to grant an additional 75,000 during 2012.

The loan book currently stands at MXN 145bn, which is an increase of 4% q-o-q, although a reduction of c. 5% y-o-y. The NPL ratio for 2011 reached 12% (an improvement vs. 14% in 2010). Fovissste’s funded mortgages account for c. 10% of the stock of mortgages in the system.

Fig. 59: Experiencing some volume contraction % y-o-y growth


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28

Improving dynamics reflected in growing mortgage loan book In terms of mortgages, the market continues to be led by the public sector providers that are particularly dominant in lower wage/mortgage segments. The number of new mortgage contracts and the amounts of new mortgages point to activity levels remaining below those reached at the peak. However, the continued demand for mortgages and the likely growth in private sector formal employment over the coming years should see sustained growth in the overall stock of mortgages. Nevertheless, volume growth in this segment is likely to remain dominated by the public sector providers and the capacity for the banks to gain market share will likely be limited relative to consumer/corporate lending.

Figure 60 shows the amount of new mortgage contracts issued each year, with Infonavit issuing the largest amount at c. 80% of the total. The overall number of new contracts still remains well below the peak levels reached in 2008. However, the amount of new business volumes is starting to stabilise, pointing to a potential improvement in growth rates in the short term (Figure 61).

Fig. 60: Number of mortgages # mortgage credits issued

Source: Infonavit, Fovisste, Conavi, SHF, Nomura research

Fig. 61: Volumes stable Volume of new issuance

Source: Infonavit, Fovisste, Conavi, SHF, Nomura research

In terms of growth in the overall stock of mortgages, this has recovered from a slowdown in 2010 to recover to c. 8.0-9.0% y-o-y. As of Q1 2012, total growth was 8.0% y-o-y, with c. 10% growth from banks and Infonavit, which was partially offset by declines in outstanding volumes at Fovissste and Sofoles/other. Banks (including development banks) currently account for 31% of the mortgage book, which continues to be dominated by the public sector providers. Infonavit and Fovissste have a 58% and 10% market share, respectively.

Fig. 62: Stock of mortgage debt continues to grow Total mortgage debt by issuer

Source: Infonavit, Fovisste, Conavi, SHF, Banxico, Nomura research

Fig. 63: Overall growth remains stable % y-o-y growth

Source: Infonavit, Fovisste, Conavi, SHF, Banxico, Nomura research

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29

A demographic dividend? Population growth and a reduction in the dependency ratio create an opportunity to improve GDP growth and longer-term potential

What is the demographic dividend? The demographic dividend is essentially the positive impact on the economy and economic growth from changes in the age profile and characteristics of age groups. As the profiles of populations change, in particular falling fertility rates, this leads gradually to a fall in the proportion of children, but before an increase in the older segments of the population. As a result, there is an improvement in the dependency ratio, freeing up resources for investment, among other things.

The second element behind the demographic dividend occurs as the increased workforce heads towards retirement; at this stage, there is an increased tendency to save/accumulate assets. This can have an important impact on aggregate savings and investment, effectively providing a strong boost to income.

Fig. 64: Population growth and declining fertility rates

Source: INEGI, Conapo, Nomura research

Fig. 65: Dependency ratio to improve until 2020 peak Dependency ratio (<15 yrs + >64 yrs)/15-64 yrs * 100

Source: Conapo, Nomura research

Figure 66 highlights some of the work done to quantify the impact of these demographic trends. This shows the potential contribution to GDP growth per effective consumer from the first and second demographic dividend. In the case of LatAm, demographic trends could have contributed 1.7% per year, although actual growth was lower than this. In contrast, the growth rates in Asia and South-East Asia have benefitted very strongly from the demographic dividend.

Fig. 66: Impact of the demographic dividend on growth %

Note : GDP/N = actual growth in GDP per effective consumer (GDP/N), 1970-2000, % y-o-y. Effective consumer is number of consumers weighted for age variation in consumption needs Source: Demographic Transition and Demographic Dividends in Developed and Developing Countries, Mason, 2005, Nomura research

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30

As shown by the regional differences, the positive impact of these population trends is not automatic, but rather opens windows of opportunity for countries. The political environment, education policies/opportunities and financial/economic stability all are factors in the benefits from demographic changes. In essence, it will be the right combination between public policy and demographic trends that will enable countries to fully exploit the demographic dividend.

Mexico is heading for a sweet spot The current outlook for population growth and trends in Mexico highlights the opportunity from the demographic dividend. On the one hand, population growth is expected to continue, and based on the UN’s current estimates should outpace other EM peers and regions. However, it is not just the level of growth in the population that is positive, but the age profile of the population. Based on current population forecasts, Mexico should see one of the largest reductions in the dependency ratio by 2025, implying a correspondingly greater freeing-up of resources and potential growth in the workforce. This increase in input into the economy, even in the absence of any productivity/ competitiveness gains, should see an improvement in GDP growth.

Fig. 67: Mexican population to increase the most? Cumulative population growth 05-50

Source: UN, US Census, Nomura research

Fig. 68: Most potential in the bottom right quadrant Reduction in dependency and population growth


In Figures 69 and 70, we look at the current population distribution by age group – the population pyramid, which shows quite a heavy skew towards a younger population, with 38% of the population under the age of 20. Based on the current projections of the Mexican authorities for 2020, this profile widens at lower middle age groups, but still remains low at the top, ie, implying a strong reduction in the dependency ratio.

Fig. 69: Large youth population 2010


Fig. 70: With positive trends expected through to 2050 2050


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Potential positive impact for banks and the economy We have concluded that Mexican demographics have the potential to be materially positive for GDP growth. As the current young population cohorts enter the workforce, the lifecycle hypothesis2 (according to which individuals borrow and then save/invest to support consumption post retirement), would point towards increased borrowing, followed by saving and finally debt repayment before retirement. Therefore, an initial impact for the banking sector would be increased demand for credit. Over time, this growing middle age work force should also be positive for aggregate saving levels, which could have a positive impact on domestic equity and bond markets. As baby-boomers age and start to save for retirement, their demand for capital increases, which in turn is supportive of asset prices. This increased level of savings could have a positive impact on the Mexican current account and also potentially put appreciation pressure on the Mexican peso.

2 F. Modigliani (1976). Life-cycle, individual thrift, and the wealth of nations, American Economic Review, 76(3), 297-313


32

Recent performance of the Mexican banking sector Recent trends remain supportive (loan growth/asset quality); credit conditions also continue to be expansive and expectations for credit demand remain positive.

Overall lending trends in 2012 remain relatively stable. Corporate lending remains the key driver behind the continued expansion in the credit book, which as of May is expanding at c. 15% y-o-y. The overall stock of NPLs remains relatively low and stable, with only one sub-segment of consumer credit showing some deterioration. The total NPL ratio stands at 2.9% vs. 2.7% at end-2011 and 2.8% in May 2011. In terms of deposits, as with loans, these continue to expand, albeit at a slower pace, growing at c. 8% y-o-y.

Lending and deposit growth After showing some initial signs of slowdown in the first few months of the year, total lending growth for May has recovered to 15.2% y-o-y, the fastest yearly growth rate for 2012. The key component of this loan growth is the corporate loan book, which accounts for c. 53% of total loans and with growth of c. 14.1% y-o-y accounted for 50% of the yearly loan growth for the system. Total consumer lending (credit cards, personal loans, and payroll loans, among others) expanded at 23.6% y-o-y, maintaining its growth following the recovery post the write-offs/asset quality issues from the 2009 recession. Although a smaller part of the private banks loan book, mortgages (at c. 20% of total loans) also maintained the +10% y-o-y growth seen so far in 2012. This compares with an average yearly growth during 2011 of c. +7.5% y-o-y.

Fig. 71: Loan growth has reached 15% % y-o-y loan growth


Fig. 72: Corporate lending the main driver Contribution to yearly lending growth and total loans (%)


The majority of the economic segments of the corporate loan book show an improvement in loan growth. The service sector, which accounts for c. 65% of GDP and 50% of the corporate loan book, is currently growing at c. 18% y-o-y vs. an average 15% during 2011. This growth accounts for nearly 60% of the growth in the corporate loan book over the past 12 months. The construction-related loan book is growing at c. 16% y-o-y and is providing c. 20% of the yearly growth. The one sector that shows a little more moderation in growth is loans related to the industrial sector (excluding construction). Although growth rates have recovered somewhat over the past two months, at c. +8.4% y-o-y, they still are significantly below the rest of the sectors.

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Fig. 73: Most sectors of the economy are expanding % y-o-y loan growth


Fig. 74: Strong contribution from the services sector Contribution to yearly lending growth and total corporate loans (%)


After being at the epicentre of credit losses during the recent recession, the consumer loan portfolio continues to show a recovery. In absolute terms, the consumer loan book has now recovered and exceeded the pre-crisis levels, although the make-up of the loan book is now different. Total consumer lending growth stands at c. 23.6% y-o-y for May, with payroll credits making the strongest contribution (included in ‘other’). Credit card lending, the source of most of the credit problems in the previous cycle, still remain an important part of the loan book (c. 45%) and with growth of c. 15% y-o-y, make a strong contribution to overall levels of growth. However, the total credit card loan book still remains some 22% below pre-crisis peak levels.

Fig. 75: Sustained growth in consumer lending % y-o-y loan growth


Fig. 76: With payroll loans a key driver (including in ‘other’) Contribution to yearly lending growth and total consumer loans (%)


Asset quality With economic conditions remaining relatively stable, overall asset quality indicators are also relatively stable. The total NPL ratio stands at 2.9% in May 2012, which compares with 2.7% in December 2011 and 2.8% in May 2011. The bulk of the NPLs are generated by consumer and corporate lending, although, in aggregate, both segments remain stable. The corporate lending NPL ratio currently stands at 2.5% vs. 2.4% in 2011. For consumer lending, the one segment showing an upward trend is ‘other personal lending’, which includes the fast-growing payroll lending segment. Here the NPL ratio stands at 4.3% in May 2011, although it is still below the NPL ratio in cards at 4.8%.

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Fig. 77: Overall NPL ratio remains relatively stable NPLs % total loans commercial banks


Fig. 78: Also stable for main loan segments NPL ratio by main loan segments


Fig. 79: Consumer lending showing a little more deterioration Contribution to yearly NPL growth and total stock of NPLs (%)


Fig. 80: Increase in payroll lending pushing up NPLs? Breakdown of consumer lending NPL ratios


1Q 2012 corporate survey supportive of continued growth The following is a quick summary of the quarterly survey conducted by the central bank on credit conditions for corporate. Overall conditions appear to remain supportive of further corporate lending growth (as indicated by use of credit and expectations for the next quarter). A significant source of corporate funding continues to be given by suppliers, although bank finance (from commercial and other banks, eg, development and foreign banks) continues to increase.

Almost 81% of companies surveyed used their suppliers as a source of funding, a level that has remained relatively stable over the past few years (see Figure 81). However, total banking funding is showing a continued rise, being used in 46.5% of corporate. This represents a significant increase vs. the c. 33% at the end of 2009. Commercial banks make up the bulk of this source of financing and in total are being used by c. 35% of corporate as a source of funding.

As of 1Q 2012, c. 45.5% of those surveyed were using bank credit; this compares with 47.6% the previous quarter and 49.9% in 2Q 2012. However, there has been an increase in the percentage of companies that expect to ask for bank credit in the next quarter, reaching 40% vs. 38.1% the previous quarter.

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Fig. 81: Suppliers remain a key source of credit Sources of credit, % of companies surveyed


Fig. 82: Expectations for 2Q 2012 increase % of companies with bank credit and those you expect to solicit next quarter


Figures 83 and 84 summarise some of the factors that are an influence on companies asking for and receiving credit. A score above 50 indicates credit is more accessible/cheaper, with a score of less than 50 indicating the contrary (ie, more restrictive credit conditions apply). Conditions regarding loan size and duration were perceived by companies as being more favourable, whereas those regarding restructurings remained more restrictive. Although collateral requirements remained marginally restrictive, at 48.9 they showed a significant improvement vs. 4Q 2011. Both interest rates and fees/other charges were perceived by companies as favourable.

Fig. 83: Loan size/duration support loan growth Access indicators


Fig. 84: Improvement in both interest rates/fees Indicators of cost


In total, some 75.6% of the companies surveyed did not receive new credit facilities during the quarter, with the bulk of this accounted for by companies that did not request any new or additional credit. Figure 86 shows some of the factors highlighted as being behind that decision. Although economic conditions featured in c. 55% of the reasons for not asking for/receiving credit, this has dropped from c. 63% of respondents in 3Q 2011.

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Fig. 86: Factors behind this decision Key factors limiting access/demand for credit


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The positive impact of Mexico – upgrading BBVA We upgrade the stock to Buy from Reduce, although events in Europe are likely to remain a key driver in the short term. We lift our target price to EUR 7.80 from EUR 7.30 and increase our EPS estimates by c. 5%

Given our bullish medium-term outlook for Mexico and the Mexican banking sector, we upgrade BBVA to Buy. We acknowledge that events in Spain and the eurozone will likely continue to remain a key driver for the stock in the short term. However, our view on BBVA is not a specific call on events and outcomes for the euro. This is reflected in our overall cautious stance on European banks (where we maintain a Neutral rating), and a preference for northern European banks vs. southern ones. However, with an improving outlook for Mexican banking, we believe there has been a significant widening in the potential value of this for BBVA relative to what is currently discounted in the group valuation.

Our willingness to take a more positive view on BBVA is based on the bank’s market-leading subsidiary in Mexico, Bancomer. Of the four international banks in Mexico, BBVA generates the largest contribution at a group level (c. 33% of pre-provision profits vs. an average of 6% for the other global banks). We estimate that, by 2014, Mexico could account for c. 40% of pre-tax profits and 15% of group loans. We believe that this could offset a prolonged period of economic weakness in Spain.

In terms of Spanish exposure and in a stressed economic scenario, we believe that additional capital demand cannot be ruled out at a group level. However, in the short term, we do not expect the upcoming bank stress tests in Spain (being conducted by Oliver Wyman) to identify any capital shortfall for BBVA. Notwithstanding this, this contrasts with management’s actual day-to-day strategy, which appears to be to strengthen capital as much as possible (non-core assets sales, scrip dividends, and liability management actions, among others). Therefore, we believe that additional dilution/share issuance cannot be ruled out.

Fig. 87: Upgrading earnings and target price based on positive outlook for Mexico Despite further downgrades to Spain

Source: Nomura estimates

Increasing contribution from Mexico Since buying out the minorities shareholders in 2003, Mexico has made a significant and growing contribution to the overall group at BBVA. Given our outlook for growth in Mexico, we believe that, by 2014, it should account for c. 40% of pre-tax profits and just over 30% of group revenues. This is in part owing to our view that profitability in Spain will continue to be depressed as the Spanish economy remains in recession in 2013, on our forecasts.

In Figure 89, we look at what the potential valuation of the Mexican business has looked like over the years relative to overall market value of the group. We have a maintained a steady valuation of 8.2x the following year’s earnings (this is the implied P/E in our current illustrative sum-of-the-parts model for BBVA – see Figure 92). This would see the Mexican subsidiary accounting for c. 30% of the value of the group pre-crisis (pre-2008). Based on BBVA’s current market value, however, the Mexican business potentially accounts for c. 63% of the total.

Old EPS New EPS Old EPS New EPS Old EPS New EPS2012 2012 2013 2013 2014 2014

BBVA 0.60 0.30 0.85 0.84 0.90 0.96

New rating Old rating New TP Old TP % changeBBVA Buy Reduce 7.8 7.3 7%


38

Fig. 88: Increasing contribution from Bancomer Mexico contribution to group level results


Fig. 89: Implying ever bigger share of market cap Implied contribution of Mexico to BBVA's market cap


In Figures 90 and 91, we highlight the recent (past two years’) relative performance of BBVA vs. the main listed Mexican bank, Banorte. Figure 90 looks just at the relative stock performance of BBVA relative to Banorte, which has seen BBVA underperform significantly over this period, particularly in the first half of this year. In Figure 91, we compare the relative earnings valuations of the two banks over the same period; this measures Banorte’s one-year forward P/E vs. that of BBVA’s. Banorte’s forward P/E of 12.8x is c. 62% above that of BBVA’s at 7.9x.

Fig. 90: Banorte share price outperformance Share price relative performance of BBVA vs. Banorte. July 2010 = 100

Source: Datastream, Nomura research

Fig. 91: Banorte trading at a significant premium Forward P/E (IBES) relative (100 implies P/E stock = P/E sector)

Source: Datastream, Nomura research

Group overview Although we value the group using the consolidated returns and equity, in Figure 92, we highlight what this implies in a potential sum-of-the-parts. The adjustment element is for the corporate centre, group equity not allocated to the divisions and consolidated goodwill at a group level. This illustrates that, in our current valuation of EUR 7.80 per share, the Mexican business is valued at EUR 16.8bn or EUR 2.8 per share, equivalent to c. 35% of our estimate of the value for the group.

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39

Fig. 92: Mexico makes the strongest single contribution to the value of the group Illustrative sum-of-the-parts, 2013, based on our current group valuation of EUR 7.80 per share

Source:, Nomura estimates

An issue for BBVA is the ongoing uncertainty in both Spain and the eurozone. We believe this uncertainty is reflected quite heavily in group’s valuation and goes beyond just what the potential earnings outlook for their Spanish business is. However, we acknowledge that, in a stressed scenario, additional capital could be required for the Spanish business. At a consolidated level, we maintain our view that BBVA can absorb Spanish losses. We expect the upcoming stress tests to confirm this.

In Figure 93, we take a look at what kind of implicit valuations BBVA’s individual subsidiaries would be worth based on the current multiples of peers. In contrast to our sum-of-the-parts exercise above, here we allocate proportionally the losses in the corporate centre to the various operating subsidiaries. We then apply the earnings multiple of peers. This implies a group value of EUR 7.50 per share, not too dissimilar to our current target price of EUR 7.80. In the final column, we take the current price (EUR 5.40 as of 6 July) and calculate the implied valuation for the Spanish business. Assuming a market valuation for other subsidiaries, the current price of BBVA implies a negative value for the Spanish business of EUR -1.1 per share.

Fig. 93: What is the market discounting for Spain?


2020 Mexican vision As part of our positive medium-term outlook for Mexico and the Mexican banking sector, and to illustrate the potential impact for BBVA, we analyse three different scenarios. The key question we ask is to what level of GDP private sector lending will rise. In a bull-case scenario, we envisage Mexico reaching debt penetration levels similar or approaching those of Chile (the most developed nation in LatAm).

In reality though, reaching the debt-to-GDP levels of Chile would take longer than just eight years. In fact, it took 16 years for Chile to go from 50% bank debt to GDP to 75%. However, we believe the mid-case scenario is plausible, where we forecast bank debt to GDP to reach 40%, similar to the LatAm region’s average. This would imply loan growth, in nominal terms, of 15-17% per annum if the target was reached by 2020. It would also see net income growth of 9% pa for Bancomer.

Net Attrib AllocatedDivision Income Equity RoE LT Growth P/NAV Cost of Implied PE

EURm EURm % capital EURm Per share %

Spain 1013 10546 9.8% 0.0% 1.0 10.0% 10377 1.7 22% 10.2Eurasia 1162 5384 22.8% 3.0% 2.5 11.0% 13340 2.2 28% 11.5Mexico 2058 7317 31.7% 3.0% 2.3 15.5% 16822 2.8 35% 8.2USA 312 3492 9.2% 0.0% 1.0 9.5% 3365 0.6 7% 10.8South America 1230 4065 32.7% 3.0% 2.4 15.5% 9673 1.6 20% 7.9Adjustment -799 -3082 -5872 -1.0 -12% 7.3Total 4977 36398 13.7% 1.3 12.0% 47705 7.8 100% 9.6

Valuation

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Valuation Valuation

2013 P/E EUR m EUR m Per share Per shareDomestic Spanish banks 10.1 644 6507 1.1 -1.1Wholesale / Asia 6.0 1076 6457 1.1 1.1Banorte 12.0 1921 23050 3.8 3.8US 9.9 238 2359 0.4 0.4LatAm Banks 7.0 1122 7855 1.3 1.3Corporate centre 5.0 -25 -125 0.0 0.0Total 4977 46103 7.5 5.4


40

Fig. 94: 2020 outlook for Bancomer Three different scenarios


From this analysis, we estimate that in a bull-case scenario Bancomer would be worth EUR 25bn, a 55% premium to the valuation we estimate in our model/target price. The mid-case scenario returns a value that is effectively in line with our current valuation. This discounts a relatively conservative outlook for Bancomer, in our view, as it assumes average earnings growth of 9% through to 2020. In our valuation for the group, we estimate that Bancomer will increase earnings by 14% pa through to 2014.

Fig. 95: Significant potential upside in valuation Bancomer equity valuations


In Figure 90, we show the results of the different scenarios for Bancomer in 2020. We also highlight the key assumptions that lead us to these outcomes. As we show in the bull-case scenario, we estimate net income growth of 15% pa over the next eight years. This compares with 3% pa net income growth in the more bearish scenario. In terms of lending growth, the scenarios vary from 7% to 27% pa.

Of all the assumptions used in the three different scenarios, the most important is that of the net interest margin. Here the range is from 4.8% in the bear case to 2.5% in the bull case. Our bull-case scenario of a margin of 2.5% is appropriate, in our view, given the margin in countries with a similar level of debt penetration and also factoring in an appropriate cost of risk (100bp in this case).

Our bull-case scenario models Mexico reaching a debt penetration of 80%, which would put it on levels close to those of Chile within LatAm. The average margins in Chile at the moment are c. 3.60%. A country in Europe with a similar level of debt penetration is Greece, where the margin for the sector is c. 3.00% (pre-crisis). As a result, we do not believe our margin assumptions in these scenarios are unrealistic.

2012Base case Bull case Mid case Bear case

Nomura Scenario 1 Scenario 2 Scenario 3"Chile" "LatAm avrg" "No change"

Loans/ GDP 20% 75% 40% 20%Loan growth (CAGR 12-20) 27% 17% 6%Asset growth (CAGR 12-20) 20% 12% 4%Net income growth, EUR (CAGR 12-20) 14.9% 8.7% 2.8%Cost-Income Ratio 38.9% 28.0% 35.3% 44.2%RoE 30.3% 22.6% 23.3% 24.3%

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Fig. 96: 2020 vision for Mexico Scenario analysis

Source: Company data, Nomura estimates

2004 2012EActual Actual Bull case Mid case Bear case

Nomura Scenario 1 Scenario 2 Scenario 3"Chile" "Brazil" "No change"

MXPm MXPm MXPm MXPm MXPmMacro inputs:Loans/GDP 12% 20% 75% 40% 20%Real GDP (% growth pa) 4.8% 2.9% 5.0% 4.0% 2.0%Inflation (CPI) 4.1% 3.5% 3.0% 3.5% 4.5%28-day Cetes (average) 7.23% 5.5% 6.0% 6.5%MXP-EUR (average) 14.04 17.29 15.59 15.59 15.59

Bancomer inputs:Average Gross Lending 154,166 657,849 4,566,124 2,346,519 1,088,738Average Securities Portfolio 285,913 415,173 750,000 550,000 450,000Average Other Assets 202,341 236,948 250,000 250,000 250,000Average Total Assets 642,420 1,309,970 5,566,124 3,146,519 1,788,738Average Deposits 449,586 685,171 3,811,791 2,204,974 1,116,059Equity/Assets 4.9% 6.3% 5.5% 6.0% 6.5%NIM 3.85% 5.25% 2.50% 3.50% 4.75%Non-Interest Income as % Revs 33.8% 23.9% 25% 28% 33%Expenses (% growth pa) 8.1% 7.3% 5.0% 5.5% 6.0%Loan Loss Charge/ Lending (bp) 189 320 90 170 300Tax Rate 29.0% 25.0% 25.0% 25.0% 25.0%

Income statement:Net Interest Income 24,733 68,773 139,153 110,128 84,965Other Revenues 12,626 21,647 46,384 42,828 41,848Total Revenues 37,359 90,420 185,537 152,956 126,813 % change pa 9.4% 6.8% 4.3%Expenses -18,031 -35,164 -51,953 -53,965 -56,045Operating Income 19,328 55,257 133,585 98,991 70,768

Net Loan Loss Charge -2,914 -21,051 -41,095 -39,891 -32,662Other Income -1,372 -700 -400 -400 -400Pre-tax Profit 15,043 33,506 92,090 58,700 37,706Tax -4,359 -8,376 -23,022 -14,675 -9,427Minorities 0 0 0Net Income (MXPm) 10,683 25,129 69,067 44,025 28,280 % change pa 13.5% 7.3% 1.5%Net Income (EURm) 761 1,453 4,429 2,823 1,814 % change pa 14.9% 8.7% 2.8%

Ratios/ growth rates:Loan growth (% pa) 15.8% 11.0% 27.4% 17.2% 6.5%Asset growth (% pa) -0.8% 7.5% 19.8% 11.6% 4.0%Loans/ Deposits 34.3% 96.0% 119.8% 106.4% 97.6%Loans/ Assets 24% 50% 82% 75% 61%Securities/ Assets 45% 32% 13% 17% 25%Cost-Income 48.3% 38.9% 28.0% 35.3% 44.2%Cost/ ATA 2.81% 2.68% 0.93% 1.72% 3.13%RoA 1.66% 1.92% 1.24% 1.40% 1.58%Leverage 20.4x 15.8x 18.2x 16.7x 15.4xROE 33.9% 30.3% 22.6% 23.3% 24.3%

2020


42

In our theoretical sum-of-the-parts model, we estimate that Bancomer is worth EUR 16.8bn. This uses a P/NAV multiple derived from a growing perpetuity formula based on a sustainable or adjusted ROE (we use 2014 as the sustainable base year). The resulting valuation is then discounted back to the present to reflect the time value of money. Using our estimates for 2014 and a perpetuity growth rate of 3%, we arrive at this valuation of EUR 16.8bn.

We can sense-check this by using comparative multiple. Banorte, a quoted Mexican bank, trades at a 2013E P/E of 12.0x (based on Bloomberg consensus – priced 6 July). Using our earnings estimates for Bancomer, this implies a valuation of EUR 24bn. However, the value of this comparative is influenced by the fact that we can use only one bank to calculate the multiple (as the bulk of the Mexican banking sector is foreign-owned).

Three scenarios

In Figure 97, we calculate a DCF-based valuation for the three scenarios. Under this methodology, we estimate that Bancomer would be worth EUR 11bn in the bear-case scenario to EUR 24bn in the bull-case scenario. The mid-case valuation is in line with the implicit valuation for Bancomer in our current valuation of BBVA.

The DCF valuation methodology is an explicit five-year period, with a terminal value at the end of this period. It also includes a deduction for the capital required to fund this growth. This deduction is included in our calculation of the net income terminal value, which we estimate using the following formula: P/NAV = (ROE – g)/(COE – g), where COE is the cost of equity and ‘g’ the growth rate in perpetuity.

The COE is a key assumption in this formula:

Present value. To calculate the present value of the cash flows and the terminal value we use a cost of equity of 13%. This includes a risk-free rate of 5%, a market risk premium of 5% and an assumed beta of 2 for Mexico. We use the beta to capture the risk for Mexico rather than the risk free rate given that our estimates are in hard currency.

Terminal value. To calculate the terminal value (TV), we have used different rates. For the bull case, we have used just 8.5%, ie, the beta falls to 1, but note that we assume a perpetuity growth rate of 0%. If Mexico delivers our ‘Chilean’ bull case and sustains five years of high GDP and lending growth, with a broadly stable currency, then we believe the perceived risk of investing in Mexico (and the uncertainty of future cash flows) will have diminished rapidly. Conversely, our ‘no change’ bear case implies precisely that – no change in people’s perception of risk. We do, however, assume a 5% perpetuity growth rate, which we regard as generous.


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Fig. 97: Valuation scenarios


Scenario 1. Bull case 2012 2013 2013 2014 2015 2016 2017 2018 2019 2020/TVEURm EURm EURm EURm EURm EURm EURm EURm EURm EURm

Cost of Equity 15.0% 10.0%Growth 2.0%Average Total Assets (EURm) 75,762 91,960 111,620 135,484 164,451 199,610 242,285 294,085 356,960 356,960Average Equity 19,633Net Income (EURm) 1,453 1,671 1,920 2,207 2,537 2,916 3,352 3,853 4,429 58,734Working Capital -1,650 -891 -1,081 -1,313 -1,593 -1,934 -2,347 -2,849 -3,458Free Cash Flow -197 780 839 895 944 983 1,005 1,004 971 58,734PV Free Cash Flow -197 678 730 677 621 562 500 434 365 19,200NPV 23,569

Scenario 2. Mid case 2012 2013 2013 2014 2015 2016 2017 2018 2019 2020/TVEURm EURm EURm EURm EURm EURm EURm EURm EURm EURm

Cost of Equity 15.0% 12.5%Growth 3.5%Average Total Assets (EURm) 75,762 85,631 96,786 109,394 123,644 139,751 157,956 178,532 201,789 201,789Average Equity 12,107Net Income (EURm) 1,453 1,579 1,716 1,864 2,026 2,201 2,391 2,598 2,823 29,377Working Capital -1,800 -592 -669 -756 -855 -966 -1,092 -1,235 -1,395Free Cash Flow -347 987 1,047 1,108 1,171 1,235 1,299 1,364 1,428 29,377PV Free Cash Flow -347 858 910 838 770 706 646 590 537 9,603NPV 15,111

Scenario 3. Bear case 2012 2013 2013 2014 2015 2016 2017 2018 2019 2020/TVEURm EURm EURm EURm EURm EURm EURm EURm EURm EURm

Cost of Equity 15.0% 15.0%Growth 5.0%Average Total Assets (EURm) 75,762 79,794 84,041 88,514 93,225 98,187 103,412 108,916 114,713 114,713Average Equity 7,456Net Income (EURm) 1,453 1,494 1,536 1,579 1,624 1,669 1,716 1,764 1,814 14,917Working Capital -1,950 -262 -276 -291 -306 -323 -340 -358 -377Free Cash Flow -497 1,232 1,260 1,288 1,317 1,347 1,376 1,406 1,437 14,917PV Free Cash Flow -497 1,071 1,096 974 866 770 684 608 540 4,876NPV 10,989


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Positive impact for global banks We upgrade BBVA to Buy from Reduce, and raise our target price to EUR 7.80 from EUR 7.30. We downgrade Santander to Reduce from Neutral, and lower out target price to EUR 7.10 from EUR 7.40.

As part of our positive outlook for the Mexican economy and banking sector, we upgrade our rating on BBVA to Buy (previously Reduce), increasing our earnings estimates at a group level by 5%, and raising our target price to EUR 7.80 from EUR 7.30. We expect Mexico to account for c. 42% of group net income by 2014. Key risks for BBVA remain the ongoing sovereign/economic risks in Spain and the eurozone, and were this situation to deteriorate, the need to strengthen capital cannot be ruled out. We continue to prefer non-eurozone banks.

We downgrade Santander to Reduce (from Neutral). In contrast, given greater uncertainty around the outlook for Brazil and the subsidiary model of SAN (which is moving towards listing all the major subsidiaries), we now have a preference for BBVA over SAN. To maintain a spread in our ratings, and in the context of remaining cautious on European banks, we downgrade our rating on Santander to Reduce from Neutral. The continued asset quality deterioration in Brazil also contributes to a further cut to our group 2014 EPS estimates by c. 4% (partially offset by an upgrade to Mexican earnings) and we lower our target price to EUR 7.10 from EUR 7.40.

Although the potential impact for HSBC and Citigroup is more moderate, we believe the current outlook for Mexico should be positive. For HSBC, we estimate that the potential lift to EPS at a group level would be in the region of c. 1%. For Citigroup, with larger relative exposure, we estimate potential uplift to group EPS of 2.0-2.5%. However, current trends in capital markets, which make a significantly higher contribution, are negative downgrades and would outweigh any positive impact from our outlook for Mexico. As a result, our earnings estimates for HSBC and Citigroup are unchanged.

Fig. 98: Summary of earnings estimates and rating changes


Exposure to Mexico While the relative difference between the absolute size of the banks’ subsidiaries is small, there is a significant difference in the relative contribution to profits at a group level. By quite a distance Mexico makes the largest contribution to BBVA at a group level, accounting for c. 10% of the loan book and c. 33% of pre-provision profits. The next largest beneficiary is Citigroup given the c. 10% contribution to pre-tax and pre-provision profits. The impact for Santander and HSBC is less relevant and unlikely to be visible at a group level. However, with Santander looking to list a 25% minority stake of its Mexican business, this could increase the markets’ attention on the Mexican banking sector and the relevance for these four global banks. Fig. 99: BBVA most exposed to Mexico 2011

Source: Company data, Nomura research HSBC 2011 pre-tax contribution adjusted for restructuring charges

Old EPS New EPS Old EPS New EPS Old EPS New EPS2012 2012 2013 2013 2014 2014

BBVA 0.60 0.30 0.85 0.84 0.90 0.96SAN 0.58 0.32 0.74 0.67 0.89 0.86

New rating Old rating New TP Old TP % changeBBVA Buy Reduce 7.8 7.3 7%SAN Reduce Neutral 7.1 7.4 -4%

Mexico % group BBVA SAN HSBC CitiRevenues 27% 5% 4% 7%Pre-provision 33% 6% 2% 10%Pre-tax 61% 10% 3% 10%Loans 10% 2% 1% 5%


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Overview of the key Mexican banks A system dominated by international subsidiaries

The five largest Mexican, which account for c. 74% market share in total lending, are dominated by the subsidiaries of international groups. BBVA’s Bancomer subsidiary is the largest bank in the country, while Santander is planning a potential IPO for a minority stake of its Mexican subsidiary. Citigroup’s subsidiary is Banamex, with HSBC closing the group. The largest ‘domestic’ owned bank is Banorte.

In Figure 100, we set out the key financial indicators and ratios to give a brief overview of the profitability of the different financial groups and key drivers behind this profitability. In aggregate, profitability for the sector remains relatively strong at c. 13%, in line with the average for the five major banks (although there are some important differences). Both Bancomer and Santander stand out for above-average returns, explained not only by cost efficiencies, but by higher revenues. In the case of Bancomer, this is particularly the case, in part a result of a greater proportion of the balance sheet used for lending activities. In the case of Santander, as with many of its subsidiaries across the world, it is a leader in cost efficiency (measured here by costs as a percentage of average total assets). For Banamex, part of the lower levels of returns are explained by a lower utilisation of the balance sheet for lending activities, while HSBC maintains a higher cost base relative to the size of assets.

Fig. 100: An overview of Mexican banks 2011, Mexican GAAP

Source: Company data, CNBV, Nomura research

BBVA Banamex Banorte HSBC Santander AverageMarket share 25.4% 16.0% 12.4% 7.6% 12.8% 74.2%Revenues:NIM (exc LLC) 5.84% 4.80% 3.51% 4.72% 4.05% 4.59%NIM (inc LLC) 4.20% 3.29% 2.84% 3.24% 3.13% 3.34%Total revenue/ATA 6.40% 5.20% 4.55% 6.32% 4.85% 5.46%Total revenue/loans+deposits 6.69% 7.53% 5.34% 6.40% 6.28% 6.45%NII/Total revenue 66% 63% 62% 51% 65% 61%Non interest income/Total revenue 34% 37% 38% 49% 35% 39%Costs:Costs/ATA 3.31% 3.47% 2.91% 5.29% 2.55% 3.51%Costs/loans+deposits 3.46% 5.01% 3.42% 5.36% 3.30% 4.11%Cost-Income Ratio (inc. LLC) 51.8% 66.6% 64.0% 83.7% 52.6% 63.7%Cost-Income Ratio (ex LLC) 26.1% 37.5% 49.1% 60.3% 33.6% 41.3%Loans+Deposits/employee (m) 34.1 32.1 30.2 25.4 48.9 34.1Profitability:Operating Income/ATA 3.09% 1.74% 1.64% 1.03% 2.30% 1.96%Effective Tax Rate 27.0% 27.9% 35.1% 21.9% 12.0% 24.8%RoA 2.27% 1.26% 1.06% 0.55% 2.63% 1.55%Leverage (RoE/RoA) 9.4x 7.4x 10.6x 9.5x 8.5x 9.1xRoE 21.4% 9.4% 11.2% 5.3% 22.4% 13.9%Credit quality:LLC/NII 28.1% 31.4% 19.3% 31.3% 22.8% 26.6%NPL ratio 3.12% 1.56% 1.94% 2.71% 1.69% 2.21%NPL Coverage 126% 284% 143% 214% 211% 196%Balance sheet:Loans/Assets 48% 33% 43% 39% 42% 41%Loans/Deposits 109% 84% 98% 64% 107% 93%Basic capital 11.3% 15.1% 15.3% 11.7% 14.5% 13.6%


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HSBC Mexico (subsidiary of HSBC covered by Chintan Joshi) – recovering lost ground HSBC’s Mexican subsidiary has a market share of c. 8% and by assets is the fifth-largest bank in the country. The bank had built up a substantial consumer credit portfolio during the credit boom of 2004-07, which suffered especially high losses as the Mexican economy entered recession in 2009. During this period, there was a significant reduction in the loan book; in fact, total loans are still 2% below the peak reached in 2007. However, given the current outlook for the economy and banking sector, management is comfortable that overall loan growth will be sustained in the 10-15% range in the near future.

Fig. 101: Distribution of loan book


Fig. 102: Market shares


Following this rebalancing of the loan book, there has also been a restructuring of the business model. Within the overall group strategy of improving efficiency, the Mexican franchise has dedicated significant efforts to remodelling the internal structure and distribution model of the business. This has seen a reduction in branches of 15% since the peak in 2007 (although total square footage of branch space has recovered to pre-crisis levels) and a 23% reduction in headcount. Although the cost/income ratio has remained stubbornly high, there has been an improvement in the cost base relative to average assets. However, HSBC continues to have a cost opportunity given the levels of efficiency seen in the other comparable Mexican banks.

Fig. 103: Trying to improve efficiency Costs % total revenues and costs % average total assets

Source: Company data, Nomura research

Fig. 104: Significant reduction in headcount/branches # of branches and employees


Following a recovery in economic conditions over the past year and a half, HSBC has again started to try and improve its growth profile. Although the bulk of the loan book remains to corporate, there is an increased focus on improving the market share in consumer finance, particularly in payroll accounts and lending.

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Growth in consumer lending currently stands at 14% y-o-y and payroll loans are growing at 74% (including other personal loans). There is a particular focus on regaining market share in this segment to at least double digits. Although this implies a more aggressive approach vs. peers, management is conscious of avoiding the pitfalls in building up a consumer portfolio. Indeed, this time around, the focus is on retaining and growing lending with the existing client base and not using third-party distribution networks.

For the rest of the loan book, HSBC will continue to leverage the capabilities of a global bank to help expand corporate and SME lending. Although management believes mortgages will continue to show sustained growth at an industry level, this is not an area of focus at the moment. In fact, it appears that HSBC is still managing some of the accumulated asset quality deterioration in the mortgage book where the NPL ratio stands at 9% vs. a system average of 3.7%.

Fig. 105: Consumer & commercial lead the way Loan growth by category % y-o-y Q1 2012


Fig. 106: Most the growth comes from commercial lending Increase in loans by segment % of total yearly increase. Q1 2012


In terms of recent results, underlying profitability has been hampered by the lower interest rate environment, which is slightly more negative for HSBC vs. peers given the larger deposit base. Although inflation over the past three years has been c. 4% per annum, HSBC has managed average cost growth of 2% y-o-y. Loan loss charges and asset quality remain stable, and we believe that the improved outlook for loan growth (particularly in higher margin business), stable interest rates and economic conditions should allow for an improvement in profitability over the coming two to three years.

Fig. 107: Still some progress to be made in efficiency Q1 2012. Growth rates y-o-y


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Q1 2012 Q1 2012NIM 4.2% RoA 1.0%Revenue growth -7.6% RoE 10.5%Cost growth -15.0% NPL ratio 2.6%Efficiency ratio 65% Loan growth 7.9%Loan loss charge bp 355 Deposit growth 16.3%Net income growth 40.1% Capital ratio 11.4%


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Fig. 108: HSBC recent full-year results Mexican GAAP, MXN m


Grupo Financiero HSBC2008A 2009A 2010A 2011A

Net interest income 25,189 21,220 21,504 21,495Fees 11,364 9,705 6,471 5,995Other 3,380 3,695 6,761 8,060Total revenues 39,933 34,620 34,736 35,550 % change -13.3% 0.3% 2.3%Costs -22,505 -21,697 -23,113 -24,121 % change -3.6% 6.5% 4.4%Pre provision profits 17,428 12,923 11,623 11,429 % change -25.8% -10.1% -1.7%Loan loss provisions -14,881 -14,472 -9,284 -6,737Other 1,329 1,683 19 -1,478Taxes & MI 234 1,420 -239 -704Net profits 4,110 1,554 2,119 2,510 % change -62.2% 36.4% 18.5%

Loans 172,938 159,952 171,421 187,638 % change -7.5% 7.2% 9.5%Deposits 238,975 233,139 249,140 292,093 % change -2.4% 6.9% 17.2%Shareholders equity 38,600 47,462 49,576 45,864 % change 23.0% 4.5% -7.5%Total assets 474,664 393,790 425,387 486,062 % change -17.0% 8.0% 14.3%

Net Interest Margin (NIM) 6.1% 4.9% 5.3% 4.7%NIM net of provisions 2.5% 1.6% 3.0% 3.2%Cost-Income Ratio 56% 63% 67% 68%Operating Costs/ATA 5.5% 5.0% 5.6% 5.3%RoA 1.0% 0.4% 0.5% 0.6%RoE 9.6% 3.6% 4.4% 5.3%Net LLP/Net Loans (bp) 798 869 560 375NPL Ratio 5.9% 5.0% 3.1% 2.7%Coverage Ratio 126% 132% 174% 214%Lending/Assets 36% 41% 40% 39%Equity as % Assets 8.1% 12.1% 11.7% 9.4%Lending/Deposits 72% 69% 69% 64%Capital ratio 10.1% 13.8% 11.2% 11.7%


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Bancomer (BBVA) – maintaining lead position Bancomer is the largest Mexican bank by assets and has the leading market share across most segments. Its position as the market leader was cemented by the acquisition of a mortgage provider (Hipotecario Nacional in 2005). The challenge for Bancomer will be to maintain its leading position in a more competitive market as the banking sector returns to stronger levels of growth. However, as some of its competitors have fully recovered following the credit cycle of 2008/09, it is very likely that some market share, particularly in consumer finance, is lost.

Fig. 109: Distribution of loan book % 2011

Source: CNBV, Company data, Nomura research

Fig. 110: Market shares 2011


As shown in Figure 110, Bancomer has a leading market share across the main banking products. Although corporate loans, at 37% of the total, are the largest within Bancomer’s loan book, consumer finance, in particular payroll lending, is likely to be an area of focus (as with all the other banks). Indeed, at the moment, it is the loan book that is showing the fastest rate of growth, +20% y-o-y as of 1Q 2012. This compares with a slight contraction in corporate lending and growth of c. 5% in mortgages. The weakness in corporate lending is driven in large part by a strong contraction in the real estate developer book (a trend seen at a sector level).

Fig. 111: Consumer lending growth leads the way % y-o-y growth Q1 2012


Fig. 112: Offsetting weakness in corporate lending Increase in lending % total yearly increase, Q1 2012


Recent results at Bancomer have been affected by the reduction in certain segments of the corporate loan book and the low interest rate environment, which has put pressure on all the Mexican banks during 2011. However, overall levels of profitability and efficiency at Bancomer continue to remain extremely strong relative to peers. The sustained growth in lending, both in corporate and consumer lending, combined with stable interest rates, should see a marked improvement in profitability over the next 12 to 18 months.

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Fig. 113: Recent results Q1 2012


Fig. 114: Bancomer recent full-year results Mexican GAAP, MXN m


Q1 2012 Q1 2012NIM 5.7% RoA 2.1%Revenue growth 6.0% RoE 20.9%Cost growth 11.5% NPL ratio 3.3%Efficiency ratio 42% Loan growth 6.9%Loan loss charge bp 306 Deposit growth 10.8%Net income growth 4.6% Capital ratio 11.0%

Bancomer2008A 2009A 2010A 2011A

Net interest income 62,775 67,240 67,053 71,264Fees 21,614 20,840 20,612 20,408Other 470 4,504 5,849 6,365Total revenues 84,859 92,584 93,514 98,037 % change 9.1% 1.0% 4.8%Costs -32,328 -35,771 -37,163 -40,383 % change 10.7% 3.9% 8.7%Pre provision profits 52,531 56,813 56,351 57,654 % change 8.2% -0.8% 2.3%Loan loss provisions -23,969 -27,251 -19,621 -20,011Other 3,699 318 311 321Taxes & MI -6,362 -8,268 -10,346 -10,254Net profits 25,899 21,612 26,695 27,710 % change -16.6% 23.5% 3.8%

Loans 518,249 524,408 579,725 629,897 % change 1.2% 10.5% 8.7%Deposits 484,024 515,491 545,661 576,119 % change 6.5% 5.9% 5.6%Shareholders equity 107,431 114,016 125,430 133,392 % change 6.1% 10.0% 6.3%Total assets 1,151,281 1,107,780 1,114,171 1,324,736 % change -3.8% 0.6% 18.9%



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Banorte – consolidating gains from recent acquisition Banorte is the largest domestic-owned Mexican bank and is listed on the local stock exchange. It has an aggregate market share of c. 14%, is the fourth-largest Mexican bank by assets and has a market cap of EUR 9bn or MXN 154bn. In 2011, it acquired a smaller competitor, Ixe Banco, which is being integrated into the group. This has increased the group’s size by 11% (gross loans) and total market share by 1%. It also significantly increased its capital markets and asset management business. In addition, Banorte hopes to generate significant synergies from the merger and deliver a ROTE of 18% to 20%.

Fig. 115: Corporate lending dominates % distribution of loan book by category. 2011


Fig. 116: Key market shares – room for growth in consumer?2011 market shares


Banorte has traditionally had substantial focus and strength in corporate and SME banking. This focus and conservative risk approach resulted in a significantly lower level of losses in 2008 and 2009. Banorte had a significantly lower risk exposure to credit cards and consumer finance during the previous credit cycle. While SME banking is likely to remain a key strength and source of growth for the bank, Banorte is looking to expand its consumer credit exposure.

Fig. 117: High loan growth driven by merger with IXe % y-o-y loan growth, Q1 2012


Fig. 118: Corporate lending remains key driver Increase in lending % total yearly lending increase


As with the other key banks in the system, Banorte is placing increased focus in capturing market share and expanding the consumer and household lending segment. The initial strategy is to try and increase penetration within the existing client base, where use of credit cards and payroll loans is relatively low. This strategy is based on the more attractive spreads and potential to improve margins. The acquisition of Ixe Banco should help improve the group’s ability to increase its consumer loan book.

The other main focus for the bank is to successfully integrate the 2011 acquisition Ixe Banco. The merger was completed in Q2 2011 and Banorte estimates that overall the group should be able to deliver a ROTE of c. 18-20%. Some of the cost synergies have already been captured and, although there are still some restructuring costs to book, underlying costs are improving. Management expects to reach a cost-income ratio of under 55% for 2012, with a medium-term target of 45%.

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Fig. 120: Banorte recent full-year results Mexican GAAP. 2011 incorporates Ixe Banco from 2Q 2011. MXN m



Banorte2008A 2009A 2010A 2011A

Net interest income 22,584 23,183 22,732 28,242Fees 7,246 6,953 7,686 8,175Other 3,385 3,096 4,009 5,592Total revenues 33,215 33,232 34,428 42,009 % change 0.1% 3.6% 22.0%Costs -15,807 -17,024 -17,691 -23,409 % change 7.7% 3.9% 32.3%Pre provision profits 17,408 16,208 16,737 18,600 % change -6.9% 3.3% 11.1%Loan loss provisions -6,896 -8,286 -6,889 -5,438Other 276 312 320 -41Taxes & MI -3,773 -2,381 -3,462 -4,604Net profits 7,015 5,854 6,705 8,517 % change -16.6% 14.5% 27.0%

Loans 245,246 245,107 270,214 357,506 % change -0.1% 10.2% 32.3%Deposits 260,769 274,908 288,837 363,337 % change 5.4% 5.1% 25.8%Shareholders equity 40,078 43,170 49,022 73,370 % change 7.7% 13.6% 49.7%Total assets 577,023 567,138 590,558 829,277 % change -1.7% 4.1% 40.4%

Net Interest Margin (NIM) 5.85% 4.04% 3.87% 3.70%NIM net of provisions 4.06% 2.59% 2.70% 2.98%Cost-Income Ratio 48% 51% 51% 56%Operating Costs/ATA 4.1% 3.0% 3.0% 3.1%RoA 1.8% 1.0% 1.1% 1.1%RoE 17.3% 13.8% 14.4% 12.9%Net LLP/Net Loans (bp) 305 342 270 169NPL Ratio 2.0% 2.5% 2.5% 1.9%Coverage Ratio 135% 122% 124% 143%Lending/Assets 43% 43% 46% 43%Equity as % Assets 6.9% 7.6% 8.3% 8.8%Lending/Deposits 94% 89% 94% 98%Capital ratio


53

Banamex (subsidiary of Citigroup covered by Glen Schorr) – looking to leverage the balance sheet Citigroup’s subsidiary, Banamex, has a total market share of loans of c. 16% and is the second-largest bank in Mexico after Bancomer. Banamex has a particularly strong franchise in consumer lending, where it has a c. 26% market share and it accounts for c. 32% of the total loan book. This is the highest proportion of consumer lending for any of the major banks.

Fig. 121: Distribution of loans 2011


Fig. 122: Market share 2011


Overall loan growth remains strong, reaching 20% in Q1 2012. The key driver behind this growth is the expansion in consumer lending, which grew at 36% y-o-y. With a loan-to-deposit ratio of 84%, Banamex should be well placed to take advantage of growth opportunities over the coming years.

Fig. 123: Consumer lending fastest growth % y-o-y loan growth


Fig. 124: Bulk of lending growth comes from consumer Increase in lending % total yearly increase


With a strong level of capital (15% basic capital ratio) we believe Banamex has a strong balance sheet to take advantage of growth opportunities in Mexico. Within the group, consumer franchise is a key area of focus for growth. The ability to increase revenues, from higher yield consumer loans, while maintaining cost control, will likely be the key to generating improving returns. The increased weight of consumer loans on the balance sheet should also see an improvement in profitability. Recent results show a further improvement in the level of loan growth, reaching 20% y-o-y as of Q1 2012. This growth is being driven by the acceleration in consumer lending, now growing at 36% y-o-y. With a stable interest rate environment, this increase in the credit portfolio is driving the increase in revenues, growing at 27% y-o-y in Q1 2012. Cost control remains a feature and in Q1 were 8% higher vs. average quarterly costs in 2011, resulting in an improvement in the efficiency ratio to 49%. Asset quality indicators remain stable and there was actually an improvement in the loan loss charges to 424bp vs. c. 490bp during 2011. As a result, overall net income increased by 83% to MXN 4.65bn or an RoE of c. 12%.

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Fig. 126: Banamex recent full-year results Mexican GAAP, MXN m


Q1 2012 Q1 2012NIM 5.5% RoA 1.6%Revenue growth 27.2% RoE 11.7%Cost growth 8.4% NPL ratio 1.6%Efficiency ratio 49% Loan growth 20.3%Loan loss charge 424 Deposit growth 5.0%Net income growth 83.0% Capital ratio 14.7%

Banamex2008A 2009A 2010A 2011A

Net interest income 52,267 54,409 56,104 56,436Fees 19,819 19,203 20,033 20,357Other 3,476 8,460 6,705 2,084Total revenues 75,562 82,072 82,842 78,877 % change 8.6% 0.9% -4.8%Costs -35,601 -37,135 -38,431 -40,700 % change 4.3% 3.5% 5.9%Pre provision profits 39,961 44,937 44,411 38,177 % change 12.5% -1.2% -14.0%Loan loss provisions -26,420 -22,680 -14,964 -17,747Other 967 1,594 280 148Taxes & MI -1,772 -5,060 -7,549 -5,749Net profits 12,736 18,791 22,178 14,829 % change 47.5% 18.0% -33.1%

Loans 276,356 350,065 332,744 394,838 % change 26.7% -4.9% 18.7%Deposits 318,850 354,949 423,774 472,838 % change 11.3% 19.4% 11.6%Shareholders equity 139,472 155,913 160,378 156,660 % change 11.8% 2.9% -2.3%Total assets 1,019,611 1,124,690 1,149,480 1,199,607 % change 10.3% 2.2% 4.4%



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Santander – getting ready for local listing Santander’s Mexican subsidiary has a total loan market share of c. 13% and is the third-largest bank in Mexico by assets. It had significant exposure to credit cards in the recession and it was only during 2011 that the contraction of this loan book stabilised. Performing consumer loans are still c. 23% below their 2007 peak. However, given that economic conditions have stabilised, Santander is retaking advantage of the growth opportunities in the sector.

Fig. 127: Distribution of loan book % total 2011


Fig. 128: Market share % 2011


As with Santander subsidiaries elsewhere, the Mexican business is characterised by high levels of efficiency and an aggressive commercial strategy. Organic (ie, ex acquisitions) loan growth is currently (Q1 2012) running at c. 18%. Santander also acquired GE’s mortgage business in 2011 to strengthen its position in that market.

Fig. 129: Growth in mortgages following acquisition %, y-o-y


Fig. 130: Sources of growth Increase in lending % total yearly increase in lending.


Santander remains committed to its current subsidiary model that promotes the listing of its subsidiaries in local markets. Brazil was listed in 2009, a listing is planned for the UK in 2013 and there are plans to increase the free float in Poland to c. 25%. A listing in Argentina was also planned, but ultimately cancelled given market conditions at the time. Santander has confirmed that it intends to list up to a 25% stake of its Mexican subsidiary.

We estimate that Santander’s Mexican business could be worth c. EUR 12bn. Based on the current multiples of Banorte, Santander Mexico could be worth EUR 18bn, although this is distorted by being the only main listed Mexican bank.

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With a return to strong growth in credit, overall profitability has improved, with net income increasing 19% y-o-y and reaching an RoE of c. 27%. As with other subsidiaries, Santander’s Mexican business is delivering strong efficiency metrics. Although the business is expanding (branches increased by 14% y-o-y), total cost growth as of 1Q 2012 stands at c. 12% y-o-y. With stronger revenue growth, there has been an improvement in the cost-income ratio (ex loan loss charges) to 36% vs. 40% in 2010.



Fig. 132: Santander recent results Mexican GAAP, MXN m



Santander2008A 2009A 2010A 2011A

Net interest income 30,659 27,252 26,289 28,806Fees 9,663 8,767 9,412 10,232Other 411 8,463 4,218 1,955Total revenues 40,733 44,482 39,919 40,993 % change 9.2% -10.3% 2.7%Costs -16,285 -15,907 -16,075 -18,111 % change -2.3% 1.1% 12.7%Pre provision profits 24,448 28,575 23,844 22,882 % change 16.9% -16.6% -4.0%Loan loss provisions -15,832 -15,320 -8,425 -6,556Other -563 -74 865 4,892Taxes & MI 473 -1,356 -2,434 -2,536Net profits 8,526 11,825 13,850 18,682 % change 38.7% 17.1% 34.9%

Loans 229,661 207,737 227,556 313,673 % change -9.5% 9.5% 37.8%Deposits 251,145 236,861 263,002 292,785 % change -5.7% 11.0% 11.3%Shareholders equity 69,770 72,416 80,004 86,813 % change 3.8% 10.5% 8.5%Total assets 656,180 582,034 681,817 739,175 % change -11.3% 17.1% 8.4%



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Fig. 133: New BBVA earnings estimates Buy (upgrade from Reduce), target price EUR 7.80 (up from EUR 7.30)


BBVA Group Recent Results and Forecasts2004 A 2005 A 2006 A 2007 A 2008 A 2009 A 2010 A 2011 E 2012 E 2013 E 2014 E

Financials: EURm EURm EURm EURm EURm EURm EURm EURm EURm EURm EURm

Net Interest Income 6,160 7,208 8,374 9,770 11,577 13,878 13,320 13,160 14,276 15,053 16,130 % change 17.0% 16.2% 16.7% 18.5% 19.9% -4.0% -1.2% 8.5% 5.4% 7.2%

Net Income Equity Method 97 122 308 242 6 0 0 0 0 0 0Fees 3,413 3,940 4,335 4,723 4,488 4,430 4,531 4,561 4,769 4,942 5,180Other income 391 487 650 729 1,407 810 1,159 1,367 1,495 1,566 1,654Trading Income 1,059 1,268 2,033 1,823 1,444 1,543 1,894 1,479 1,531 1,559 1,523Total Revenue 11,119 13,024 15,700 17,287 18,922 20,661 20,904 20,566 22,072 23,120 24,488 % change 17.1% 20.5% 10.1% 9.5% 9.2% 1.2% -1.6% 7.3% 4.7% 5.9%Net Revenues from Non-Fin Activities 126 126 131 187 8 0 0 0 0 0 0General Expenses -5,098 -5,763 -6,330 -7,053 -7,589 -7,659 -8,206 -9,104 -9,826 -10,389 -10,992Depreciation and Amortisation -449 -449 -472 -578 -699 -697 -761 -847 -888 -900 -915Other Revenues and Expenses (Net) -109 -115 -147 -146 -129 0 0 0 0 0 0Cost synergies 0 0 0 0 0 0 0 0 0 0 0Total Costs -5,530 -6,201 -6,818 -7,590 -8,409 -8,355 -8,967 -9,951 -10,714 -11,288 -11,907Operating Income 5,589 6,823 8,882 9,697 10,513 12,305 11,937 10,615 11,358 11,831 12,581 % change 22.1% 30.2% 9.2% 8.4% 17.0% -3.0% -11.1% 7.0% 4.2% 6.3%Net Loan Loss Provisions -784 -813 -1,477 -1,902 -2,912 -5,474 -4,717 -4,227 -3,861 -4,353 -4,525Other Provisions / Impairments -850 -454 -1,339 -110 -166 -4 -1,040 -2,689 -2,579 -210 19Sales of Financial Stakes 0 0 771 0 5 776 237 70 0 0 0Other 181 36 191 -11 -511 -2,345 0 0 0 0 0Pre-tax Profit 4,136 5,593 7,029 7,674 6,929 5,258 6,417 3,768 4,919 7,269 8,075Corporate Income Tax -1,029 -1,522 -2,059 -1,984 -1,543 -667 -1,425 -284 -1,009 -1,599 -1,857Net Income 3,107 4,071 4,970 5,690 5,386 4,591 4,991 3,484 3,909 5,670 6,218Minority interests -185 -265 -235 -287 -365 -384 -389 -481 -579 -654 -774Net Attributable Income (stated) 2,922 3,806 4,735 5,402 5,021 4,207 4,603 3,003 3,330 5,016 5,445 % change 30.3% 24.4% 14.1% -7.1% -16.2% 9.4% -34.8% 10.9% 50.6% 8.6%DIVISIONAL DATA - Net attributable incomeSpain 2,255 1,363 1,073 1,319 1,451South America 889 1,007 1,076 1,230 1,416Mexico 1,707 1,741 1,690 1,810 1,874 of which: Bancomer 1,397 1,426 1,453 1,560 1,609Eurasia 588 1,027 1,098 1,162 1,218 of which: Turkey 263 395 423 424USA 236 -722 330 312 304Corporate Centre -1,072 -1,413 -1,936 -819 -819Total 4,603 3,003 3,330 5,015 5,445

Number of Shares (y/e; m) 3,391 3,391 3,557 3,748 3,748 3,748 4,491 4,903 5,531 5,691 5,851EPS stated (EUR) 0.86 1.12 1.33 1.44 1.34 1.12 1.02 0.61 0.60 0.88 0.93EPS adjusted 1 - core (EUR) 0.85 1.08 1.14 1.45 1.31 0.95 1.07 0.63 0.60 0.85 0.90DPS (EUR) 0.44 0.53 0.64 0.73 0.61 0.42 0.42 0.42 0.42 0.42 0.42Net Asset Value per share (stated) 3.23 3.84 5.12 6.62 7.09 7.83 8.17 8.35 7.78 8.21 8.68Net Asset Value per share (adjusted 1) 2.99 3.23 4.20 4.42 4.84 5.90 6.43 6.58 5.92 6.38 6.88

Main Balance Sheet Measures:Shareholders' Equity 10,961 13,036 18,210 24,811 26,586 29,362 36,689 40,952 43,018 46,697 50,760Net Lending - Group 172,083 216,850 256,565 310,882 324,721 323,615 338,857 351,900 366,365 387,033 410,620 % change Group 26.0% 18.3% 21.2% 4.5% -0.3% 4.7% 3.8% 4.1% 5.6% 6.1%Gross Lending - Spain 132,061 154,928 178,307 197,524 203,117 199,165 213,281 209,622 205,430 209,538 213,729 % change European Retail 17.3% 15.1% 10.8% 2.8% -1.9% 7.1% -1.7% -2.0% 2.0% 2.0%Gross Lending - Mexico 12,464 22,398 25,225 27,907 26,463 27,373 34,626 34,544 38,344 42,178 47,240 % change Mexico (local currency) 49.6% 27.7% 24.0% 13.6% 1.8% 10.9% 8.6% 11.0% 10.0% 12.0%Risk Weighted Assets 182,683 216,890 252,373 268,491 283,320 291,026 313,327 330,771 342,728 362,063 384,128 % change 18.7% 16.4% 6.4% 5.5% 2.7% 7.7% 5.6% 3.6% 5.6% 6.1%P&L Ratios:Net Interest Margin exc Dividends 1.83% 1.92% 1.99% 2.06% 2.15% 2.57% 2.45% 2.29% 2.40% 2.48% 2.51%Net Interest Margin inc Divs - Spain 2.01% 1.95% 2.00% 2.16% 2.25% 1.90% 1.45% 1.48% 1.44% 1.44%Net Interest Margin inc Divs - Mexico 3.85% 4.82% 6.03% 6.00% 5.98% 5.29% 5.15% 5.33% 5.25% 5.25% 5.20%Cost-Income Ratio (all costs) 50.9% 48.6% 44.3% 45.0% 44.5% 40.4% 42.9% 48.4% 48.5% 48.8% 48.6%Effective Tax Rate 24.9% 27.2% 29.3% 25.9% 22.3% 12.7% 22.2% 7.5% 20.5% 22.0% 23.0%RoRWA 1.71% 2.04% 2.12% 2.18% 1.95% 1.60% 1.65% 1.05% 1.16% 1.61% 1.67%RoA 0.96% 1.13% 1.24% 1.24% 1.03% 0.85% 0.92% 0.61% 0.66% 0.93% 0.97%RoE (stated) 27.5% 31.7% 30.3% 25.1% 19.5% 15.0% 13.9% 7.7% 7.9% 11.2% 11.2%RoE (adjusted) 31.6% 34.8% 30.7% 33.6% 28.2% 17.7% 17.4% 9.6% 9.6% 13.8% 13.6%Asset Quality:Non-performing loans/Gross lending 1.25% 1.05% 0.95% 1.06% 2.54% 4.69% 4.50% 4.39% 4.39% 3.74% 3.17%Coverage of non-performing loans 208.4% 238.7% 257.0% 211.9% 87.9% 55.9% 59.9% 59.3% 57.0% 65.7% 80.2%Net LLP/Gross Loans (average) 0.47% 0.41% 0.61% 0.65% 0.90% 1.65% 1.39% 1.19% 1.05% 1.13% 1.11%Capital - Group:Core Capital Ratio (T1 ex Prefs) 5.8% 5.6% 6.2% 6.0% 6.2% 7.9% 9.4% 10.3% 10.6% 11.1% 11.5%Prefs as % Tier I 26.4% 25.4% 20.6% 22.0% 24.1% 18.3% 15.7% 5.2% 4.9% 4.4% 4.0%BIS Ratio 12.5% 12.1% 12.0% 12.1% 12.2% 13.8% 13.7% 12.9% 13.2% 13.7% 14.1%


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Fig. 134: New Santander earnings Reduce (downgrade from Neutral), target price EUR 7.10 (down from EUR 7.40)


Santander Recent Results and Forecasts2004A 2005 A 2006 A 2007 A 2008 A 2009 A 2010 A 2011 A 2012 E 2013 E 2014 EEURm EURm EURm EURm EURm EURm EURm EURm EURm EURm EURm

Financials:Net Interest Income 7,761 10,669 12,488 15,295 21,174 26,420 29,288 30,878 33,132 34,836 38,001Net Income Equity Method 450 619 427 441 97 -15 -2 5 15 15 15Fees 4,583 6,256 7,223 8,040 9,021 9,079 9,734 10,471 10,961 11,691 12,368Insurance Income 162 227 298 319 50 -64 423 407 441 450 446Trading Income 1,100 1,562 2,180 2,998 2,597 3,422 2,606 2,500 1,709 1,795 1,892Revenue synergies 0 0 0 0 0 0 0 0 11 13 16Total Revenue 14,056 19,333 22,616 27,094 32,939 38,843 42,049 44,262 46,269 48,800 52,737Net Revenues from Non-Fin Activities 140 -24 -71 -45 551 537 0 0 0 0 0General Admin Expenses -6,695 -9,382 -10,025 -10,940 -13,579 -14,825 -16,256 -17,781 -19,186 -20,697 -21,978Depreciation and Amortisation -839 -1,017 -1,151 -1,268 -1,366 -1,593 -1,940 -2,109 -2,058 -2,089 -2,052Other Revenues and Expenses (Net) 0 0 0 0 0 0 0 0 0 0 0Cost synergies 0 0 0 0 0 0 0 0 56 63 92Total Costs -7,394 -10,424 -11,247 -12,253 -14,394 -15,881 -18,196 -19,889 -21,188 -22,722 -23,938Operating Income 6,662 8,909 11,369 14,842 18,545 22,962 23,853 24,373 25,081 26,077 28,799Net Loan Loss Provisions -1,574 -1,615 -2,467 -3,470 -6,601 -9,483 -10,258 -10,562 -18,163 -14,494 -14,306Other -507 -457 548 -446 -516 -1,713 -1,543 -2,994 -1,267 -991 -762Pre-tax Profit 4,581 6,837 9,450 10,926 11,428 11,766 12,052 10,817 5,652 10,592 13,731Corporate Income Tax -596 -1,320 -1,986 -2,392 -2,391 -2,337 -2,923 -2,936 -1,616 -2,850 -3,637Net Income 3,985 5,517 7,464 8,534 9,037 9,429 9,129 7,881 4,035 7,743 10,094Discontinued Operations 11 225 354 112 319 40 -27 -24 0 0 0Minority interests -390 -530 -562 -520 -480 -526 -921 -836 -836 -925 -1,175Net Extraordinary Gains and Writedowns 0 1,008 340 934 0 0 0 -1,670 0 0 0Net Attributable Income (stated) 3,606 6,220 7,596 9,060 8,876 8,943 8,181 5,351 3,199 6,818 8,919 % change 72.5% 22.1% 19.3% -2.0% 0.7% -8.5% -34.6% -40.2% 113.1% 30.8%

DIVISIONAL DATA - Net attributable incomeEurope (European Retail pre IFRS) 2160 2979 4144 4439 4706 5030 3355 2616 2555 2344 2924 of which: Spain (SAN + BTO) 1293 1783 2765 2475 2639 2753 1265 790 758 515 978 of which: Portugal 255 345 423 527 530 531 457 174 96 70 64 of which: SCF 333 468 565 719 696 631 810 1228 1200 1305 1380UK 811 1003 1201 1247 1726 1965 1145 1074 1280 1330US -25 424 526 547 557 580Poland 232 353 428 490LatAm (LatAm Retail) 1470 1779 2287 2666 3608 3832 4728 4664 4097 4304 5689 of which: Mexico 324 376 528 654 600 495 665 939 954 1069 1505 of which: Chile 233 338 489 543 545 563 671 611 555 642 765 of which: Brazil 569 591 751 905 1768 2166 2814 2610 2136 2121 2940Corporate Centre -24 650 162 754 -685 -1620 -2292 -3833 -5427 -2094 -2094Total 3,606 6,220 7,596 9,060 8,876 8,943 8,181 5,351 3,199 6,818 8,919

EPS adjusted 1 - core (EUR) 0.73 0.83 1.16 1.22 1.05 1.03 0.93 0.57 0.32 0.67 0.86Average Number of Shares (m) 4,947 6,254 6,254 6,254 7,124 8,112 8,279 8,619 9,379 9,988 10,268DPS (EUR) 0.33 0.42 0.52 0.65 0.63 0.59 0.60 0.60 0.60 0.60 0.60Net Asset Value per share (adjusted 1) 2.72 3.78 4.40 5.7 5.3 5.4 5.7 5.9 5.7 6.0 6.4

Main Balance Sheet MeasuresShareholders' Equity (exc G/will) 17,021 23,636 27,507 38,115 44,932 47,141 50,651 55,540 56,182 60,382 66,620Net Lending - Group 369,350 435,829 484,790 533,751 611,811 672,748 715,642 730,296 759,508 808,876 861,453 % change 18.0% 11.2% 10.1% 14.6% 10.0% 6.4% 2.0% 4.0% 6.5% 6.5%Net Lending - SCH 70,018 88,659 105,476 116,798 121,466 115,582 111,372 102,643 97,510 93,610 93,610 % change 26.6% 19.0% 10.7% 4.0% -4.8% -3.6% -7.8% -5.0% -4.0% 0.0%Risk Weighted Assets 340,946 412,734 478,733 515,050 514,013 561,684 604,885 565,958 564,250 587,088 605,709P&L Ratios:Net Interest Margin exc Dividends 1.88% 1.39% 1.47% 1.70% 2.11% 2.40% 2.48% 2.46% 2.59% 2.67% 2.83%Net Interest Margin inc Divs - SCH 2.69% 2.53% 2.37% 2.52% 2.86% 3.35% 2.72% 2.95% 3.00% 2.85% 2.85%Cost-Income Ratio (inc depn and other costs 53.6% 53.8% 49.4% 45.1% 45.4% 42.3% 43.3% 44.9% 45.8% 46.6% 45.4%Effective tax rate 13.0% 19.3% 21.0% 21.9% 20.9% 19.9% 24.3% 27.1% 28.6% 26.9% 26.5%RoRWA 1.46% 1.67% 1.72% 1.76% 1.75% 1.57% 1.35% 0.71% 1.35% 1.69%RoA 1.02% 0.75% 0.91% 0.98% 0.92% 0.87% 0.78% 0.64% 0.32% 0.60% 0.76%RoE (stated) 19.7% 18.3% 20.0% 19.7% 15.3% 13.4% 11.3% 6.9% 3.9% 8.1% 10.0%RoE (adjusted) 25.0% 26.4% 28.4% 24.8% 21.4% 19.4% 16.7% 10.1% 5.7% 11.7% 14.0%Asset QualityNon-performing loans/Gross lending 1.12% 0.98% 0.94% 1.12% 2.24% 3.48% 3.94% 4.28% 4.58% 4.52% 3.92%Coverage of non-performing loans 162.7% 174.7% 177.0% 143.2% 89.2% 74.4% 69.1% 59.1% 67.7% 64.8% 68.3%Net LLP/Gross Loans (average) 0.81% 0.39% 0.53% 0.67% 1.13% 1.44% 1.45% 1.43% 2.37% 1.79% 1.66%Write-offs as % last year's NPLs 31.3% 37.3% 0.0% 0.0% 40.0% 0.0% 40.0% 30.0% 40.0% 40.0% 40.0%Capital - Group:Core Capital Ratio (T1 ex Prefs) 4.9% 6.4% 5.9% 6.2% 7.1% 8.6% 8.8% 10.0% 10.0% 10.2% 10.7%Prefs as % Tier I 31.2% 23.6% 21.1% 19.6% 19.2% 13.7% 12.1% 9.5% 9.4% 8.9% 8.3%BIS Ratio 13.0% 13.4% 12.5% 11.2% 12.2% 13.5% 13.5% 14.5% 14.6% 14.8% 15.2%


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Appendix A-1 Analyst Certification We, Daragh Quinn and Benito Berber, hereby certify (1) that the views expressed in this Research report accurately reflect our personal views about any or all of the subject securities or issuers referred to in this Research report, (2) no part of our compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this Research report and (3) no part of our compensation is tied to any specific investment banking transactions performed by Nomura Securities International, Inc., Nomura International plc or any other Nomura Group company.

Issuer Specific Regulatory Disclosures The term "Nomura Group Company" used herein refers to Nomura Holdings, Inc. or any affiliate or subsidiary of Nomura Holdings, Inc. Nomura Group Companies involved in the production of Research are detailed in the disclaimer below.

Issuer name Ticker Price Price date Stock rating Sector rating Disclosures BBVA BBVA SM EUR 5.11 09-Jul-2012 Reduce Neutral A4,A5,A6,A9 Citigroup C US USD 26.11 09-Jul-2012 Buy Not rated A22,A1,A2,A3,A4,A5,A6,A7,A9 HSBC Holdings plc HSBA LN 561p 09-Jul-2012 Buy Neutral A4,A5,A6,A9,A10 Santander SAN SM EUR 4.82 09-Jul-2012 Reduce Neutral A4,A5,A6,A9

A1 Nomura Securities International, Inc has received compensation for non-investment banking products or services from the issuer in the past 12 months.

A2 Nomura Securities International, Inc had a non-investment banking securities related services client relationship with the issuer during the past 12 months.

A3 Nomura Securities International, Inc had a non-securities related services client relationship with the issuer during the past 12 months.

A4 A Nomura Group Company had an investment banking services client relationship with the issuer during the past 12 months.

A5 A Nomura Group Company has received compensation for investment banking services from the issuer in the past 12 months.

A6 A Nomura Group Company expects to receive or intends to seek compensation for investment banking services from the issuer in the next three months.

A7 A Nomura Group Company has managed or co-managed a publicly announced or 144A offering of the issuer's securities or related derivatives in the past 12 months.

A9 Nomura Securities International Inc. makes a market in securities of the issuer.

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Previous Rating Issuer name Previous Rating Date of change BBVA Neutral 24-Mar-2011 Citigroup Not Rated 06-Oct-2010 HSBC Holdings plc Neutral 15-Sep-2011 Santander Neutral 10-Jul-2012

Rating and target price changes

Ticker Old stock rating New stock rating Old target price New target price

Santander SAN SM Neutral Reduce EUR 7.40 EUR 7.10


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Santander (SAN SM) EUR 4.82 (09-Jul-2012) Rating and target price chart (three year history)

Reduce (Sector rating: Neutral)

Date Rating Target price Closing price 27-Apr-12 7.40 4.84 13-Mar-12 7.90 6.032 03-Oct-11 8.00 5.721 13-Sep-11 8.90 5.231 28-Jul-11 9.90 7.019 29-Apr-11 10.70 8.212 29-Oct-10 11.00 8.792 04-Oct-10 NEUTRAL 8.678 30-Jul-10 12.10 9.495 10-Jun-10 12.90 7.652 20-May-10 BUY 8.03 10-Jan-10 NEUTRAL 11.392 29-Oct-09 12.70 10.811 15-Oct-09 12.30 10.954 13-Sep-09 BUY 10.154 13-Sep-09 11.90 10.154 30-Jul-09 9.20 9.534

For explanation of ratings refer to the stock rating keys located after chart(s)

Valuation Methodology Our target price is EUR 7.10. We value Santander using a normalised cost of risk to arrive at a sustainable level of profitability, which is then discounted back to reflect the time value of money (2014 ROTE discounted back two years). We adjust the stated ROE to arrive at a sustainable banking franchise or adjusted ROE primarily by stripping out goodwill and the impact of non-core equity holdings. Various nominal perpetuity growth inputs are used depending on where we are in the economic cycle. They range from 0% to a 5% maximum (we use 1.5% for Santander). The cost of equity is calculated using a common equity risk premium, a 4.5% risk-free rate and a blended beta of 1.5, driven by the different business type or if developed or emerging economies. We also adjust our target price to sustain a Tier I ratio of 9%. The benchmark index for this stock is Dow Jones STOXX® 600 Banks. Risks that may impede the achievement of the target price SAN's operating performance is affected by the Spanish/European economic environment. In addition, with about one-third of its equity allocated to LatAm, SAN is particularly vulnerable to market sentiment in respect of LatAm economic and political concerns. SAN also has significant exposure to the UK, which could see the stock price adversely affected by the economic deterioration in the UK. Other material disclosures Nomura International plc is acting as adviser to Banco Santander on the proposed tender offer for up to 100% of BZ WBK, including Allied Irish Banks' 70.36% stake in BZ WBK.

HSBC Holdings plc (HSBA LN) 561p (09-Jul-2012) Rating and target price chart (three year history)

Buy (Sector rating: Neutral)

Date Rating Target price Closing price 28-Feb-12 650.00 559.30 15-Sep-11 BUY 521.10 28-Jun-10 NEUTRAL 639.00 28-Jun-10 725.00 639.00 02-Mar-10 800.00 700.60 16-Dec-09 890.00 709.00 13-Sep-09 750.00 654.50


Valuation Methodology Our 650p target price is based on a multiple of c. 9.6x our tangible 2013 EPS estimate of 106.4 US cents. The benchmark index for this stock is Dow Jones STOXX® 600 Banks.


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Risks that may impede the achievement of the target price HSBC is a global bank with significant exposures to Asian, European and U.S. banking markets and relatively high-risk areas of banking, such as unsecured personal lending, corporate and SME lending. It is exposed to adverse events in these markets and to currency risk due to its business spread.

Citigroup (C US) USD 26.11 (09-Jul-2012) Rating and target price chart (three year history)

Buy (Sector rating: Not rated)

Date Rating Target price Closing price 01-Jun-12 41.00 25.39 02-Apr-12 47.00 36.87 01-Mar-12 41.00 34.13 17-Jan-12 34.00 28.25 19-Dec-11 36.00 24.82 17-Oct-11 38.00 27.93 03-Oct-11 41.00 23.11 06-Sep-11 44.00 27.68 27-Jun-11 50.00 39.99 11-Jan-11 55.00 49.40 06-Oct-10 Buy 41.00 06-Oct-10 50.00 41.00


Valuation Methodology Our $41 target price for Citigroup is based on 9x our 2013 EPS estimate of $4.59, below Citi's historical average, as we expect ROEs to remain below historical levels in the near term. The benchmark for this stock is the S&P 500 Financials Sector Index. Risks that may impede the achievement of the target price Risks to our price target for Citigroup include the following factors that could be below or worse than our expectations: regulatory risk, interest rate risk, general economic conditions that affect credit costs, changes in asset prices, availability of funding, credit spreads, capital market activity levels, litigation risk, and potential losses on sales of businesses in Citi Holdings.

BBVA (BBVA SM) EUR 5.11 (09-Jul-2012) Rating and target price chart (three year history)

Reduce (Sector rating: Neutral)

Date Rating Target price Closing price 26-Apr-12 7.30 5.153 13-Mar-12 7.70 6.396 27-Oct-11 8.30 6.761 13-Sep-11 8.40 5.32 29-Jul-11 9.90 7.239 06-May-11 10.00 8.312 24-Mar-11 REDUCE 8.923 24-Mar-11 10.40 8.923 03-Feb-11 11.70 8.892 12-Jan-11 12.30 7.652 28-Oct-10 12.50 8.839 29-Jul-10 14.20 9.913 20-May-10 14.00 8.008 05-Feb-10 NEUTRAL 9.152 28-Jan-10 15.00 10.386 28-Oct-09 15.50 11.526 15-Oct-09 15.10 11.734 13-Sep-09 BUY 11.573 13-Sep-09 14.60 11.573 29-Jul-09 13.00 10.343


Valuation Methodology We set a target price of EUR 7.80 for BBVA using a normalised cost of risk to arrive at a sustainable level of profitability, which is then discounted back to reflect the time value of money (currently discounted back two years). We adjust the stated ROE to arrive at a sustainable banking franchise or adjusted ROE primarily by stripping out goodwill and the impact of non-core equity holdings. Various nominal perpetuity growth inputs are used depending on where we are in the economic cycle. They range from 0% to a 5% maximum (we currently use 1.5% for BBVA). The cost of equity is calculated using a common equity risk premium, a 4.5% risk free rate and a blended beta of 1.5, driven by the different business type or if


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developed or emerging economies. We also adjust target prices to sustain a Tier I ratio of 9%. The benchmark index for this stock is Dow Jones STOXX® 600 Banks. Risks that may impede the achievement of the target price BBVA's operating performance is affected by the Spanish/European economic environment. In addition, with a significant portion of its equity allocated to LatAm, BBVA is particularly vulnerable to market sentiment in respect of LatAm economic and political concerns.


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Securities and/or companies that are labelled as 'Not rated' or shown as 'No rating' are not in regular research coverage of the Nomura entity identified in the top banner. Investors should not expect continuing or additional information from Nomura relating to such securities and/or companies. SECTORS A 'Bullish' rating means most stocks in the sector have (or the weighted average recommendation of the stocks under coverage is) a positive absolute recommendation. A 'Neutral' rating means most stocks in the sector have (or the weighted average recommendation of the stocks under coverage is) a neutral absolute recommendation. A 'Bearish' rating means most stocks in the sector have (or the weighted average recommendation of the stocks under coverage is) a negative absolute recommendation. Target Price A Target Price, if discussed, reflect in part the analyst's estimates for the company's earnings. The achievement of any target price may be impeded by general market and macroeconomic trends, and by other risks related to the company or the market, and may not occur if the company's earnings differ from estimates.


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