Bank Bilbao Vizcaya Argentaria (NYSE:BBVA) will likely suffer from interest rate cuts in 2024 and higher loan losses, which is why I view its shares as overvalued at present.
As I have covered in the pastI have been has long been bullish on BBVA, particularly after its decision to sell the US business in 2021, which led to a strong capital position and very good capital return prospects. Additionally, the bank has a strong net interest income (NII) bias, making it one of the best ways to gain exposure to rising interest rates in Europe, and it additionally offers a high dividend yield that appears sustainable over the long term.
Unsurprisingly, BBVA has outperformed the European banking sector since my January 2021 “Buy” recommendation, up 159% including dividends (white line in chart), compared to 88% for the European banking sector (orange line) and only 34.5% for the S&P 500 index (yellow line) during the same period.
However, despite this good performance, I have adopted a more cautious view back in Octoberlowering my recommendation to “Hold”, and I now think it’s time for investors to take profits as the risk-reward profile of its shares is no longer attractive in my opinion.
Although I consider BBVA to be one of the most attractive banks in Europe, due to the combination of good geographical diversification and exposure to banking markets with good growth prospects, of which Mexico is the most Importantly, investors must take into account that the banking sector is a cyclical sector. activity and is highly exposed to interest rates.
The inflationary environment that followed the pandemic led to an increase in interest rates in the majority of Western economies, which strongly favored the growth of revenues and profits of the banking sector. For BBVA, the two most important markets are Mexico and Spain, which together represent 70% of the bank’s total revenues.
In Mexico, the central bank raised its key rate from 4% in mid-2021 to 11.25% in March 2023, after remaining stable at this level for the past nine months. In Europe, the European Central Bank raised its key rate from 0% to 4.5%, stable at this level since last September.
As I analyzed in previous articles, BBVA is one of the most interest rate-oriented European banks as the NII represents around 80% of the bank’s total revenues and most of its loans have variable rates. This means that BBVA benefits from higher interest rates, not only from producing new loans, but also from its existing loan portfolio.
It is no surprise that rising interest rates have strongly supported the growth of NII over the past two years, rising from €14.7 billion in 2020 to an expected value of €24.2 billion. euros in 2023, an increase of 64% in three years. and 9.5 billion euros in absolute terms.
Although costs have also increased somewhat in recent years due to the inflationary environment, cost growth has naturally been lower than revenue growth, providing a major driver of pre-provisioning profit growth over this period. .
Despite rising interest rates and the cost of living crisis over the past two years, credit quality has remained quite resilient, which has largely been a surprise to banks and analysts in general. . While an economic recession was expected in 2023, this has not happened so far, and excess savings following the pandemic have strongly supported credit quality across the banking sector, to which BBVA n was no exception.
Indeed, as the following graph shows, its cost of risk has remained relatively stable in recent years, which shows that the rise in interest rates has not constituted a major burden for households and businesses, despite the sharp rise in interest rates over the past two years. .
This combination of strong revenue growth, manageable cost growth and stable asset quality has translated into higher levels of profitability, with BBVA reporting a very significant improvement in its ratio of return on tangible equity over the last three years, to 17% over the last three years. first nine months of 2023.
Investors obviously noticed this good performance and pushed the bank’s share price upwards, which is justified by strong growth in the book value over this period (book value of €6.70 per share in 2020 compared to €8.30 in Q3 2023 – up 23%) and a higher valuation multiple. Although investor confidence in the banking sector was quite low in 2020, it has improved significantly since then, leading to much higher price-to-book multiples across the board.
For BBVA, it was trading at a P/BV floor of 0.3x at the end of 2020, while it was aggressively revalued to more than 1x book value few months ago.
Looking at the bank’s recent history, it seems there are plenty of reasons to like it and be optimistic. I think investors should not overlook the fact that banking is a cyclical business and the interest rate environment is likely to change completely in the short term. . This means that BBVA’s stock price likely peaked a month ago, given that since then its shares have fallen more than 5%, with the market increasingly betting on a drop in interest rates. interest in 2024, which could lead to a further decline.
Indeed, inflation figures in Europe and Mexico show a clear downward trend in recent quarters, and the market is already expecting rate cuts in Mexico next January. According to current estimates, the Mexican policy rate is expected to reach 9% by the end of 2024, some 225 basis points (bps) lower than its current level. In Europe, interest rate cuts are only expected in the second quarter of 2024, while the market expects the ECB’s key rate to be at 3.75% by the end of 2024, i.e. 75 basis points less than its current level.
Despite these expectations of a rate cut, the current consensus forecasts growth in the bank’s NII in 2024, to 24.6 billion euros (up 1.7% compared to 2023). This doesn’t seem to make much sense in my opinion, as I also expect interest rates to fall over the next year, so there is clearly plenty of room for a drop in estimates, which will be a headwind for BBVA’s stock price. In the coming months.
Another factor that could also lead to lower earnings and put pressure on valuation and stock prices is the cost of credit, since the cost of risk ratio increased by 20 basis points in 2023 and is highly likely to maintain an upward trajectory in 2024. While credit quality has remained strong recently, there is typically a time lag between interest rate hikes and increases in defaults (approximately eighteen months), so the negative impact of rising interest rates on the quality of the bank’s loans is likely to really start to be felt. the next quarters.
This view seems to be shared by the market, since current estimates expect a slight increase in provisions for loan losses in 2024, from 4.4 billion euros in 2023 to more than 5.2 billion euros l ‘next year. This is an increase of 18% year-on-year and will have an impact of around €800 million on BBVA’s results, putting pressure on its net profit and RoTE level.
Due to the combination of lower revenue, higher loan losses and falling RoTE, I also expect its valuation multiple to reverse towards its last five-year average, at around 0, 7x book value. Given that the current consensus expects its book value per share to remain relatively stable at €8.40 in 2024, this leads to a valuation of around €6 per share by the end of 2024, or 28% below its share price. current stock market.
A final remark on his dividend, which is also one of the main reasons why I was bullish on the bank in the past, it currently offers a dividend yield of 5.7%, up from 7-8% in the past. While this yield remains good, it is no longer much higher than the European banking sector average, which is another sign that BBVA shares are no longer undervalued and, from an income perspective, there are better alternatives within the European banking sector.
Although BBVA is a strong bank in Europe and has performed reasonably well over the past three years, the prospects of future rate cuts and increased credit losses should be significant tailwinds for its NII and earnings growth in 2024. The market has not yet ruled out this view. on its stock price, but in my opinion there is more downside risk than upside potential, and investors should therefore take profits after a very strong rally in the stock price over the last three years.