!"# Global Equity Research Spain UBS Investment Research Investment Services Spain and Portugal Strategy Equity Strategy Chart 1: Debt in Spain by group (% of GDP) and government cost of debt 450% Household debt 13% Financial institutions debt Corporate debt (ex-banks) 29 April 2010 Government debt 11% Avg. cost of debt -right axis- www.ubs.com/investmentresearch 300% 9% Bosco Ojeda Analyst [email protected] 7% +34 91 436 9050 150% Stephane Deo Economist 5% [email protected] +44-20-7568 8924 Ignacio Carvajal Cebrian 0% 3% Analyst 80's 90's 00 01 02 03 04 05 06 07 08 09 [email protected] +34-91-436 9025 Source: BDE, Tesoro Publico, UBS estimates Ignacio Sanz, CFA Analyst Contagion from Greece is painful [email protected] +34-91-436 9624 ! Spain and Portugal seem healthier…but not that much on the private side Alberto Gandolfi Our macro team published yesterday a report on Greece, Greece: What now?, in Analyst which it expects the country’s debt to be restructured. The impact on Iberia could be [email protected] material, in our view. While government debt is well below that of Greece (Spain: +44 20 7568 3975 61% of 2010E GDP, Portugal: 85%, and Greece: 125%), we believe this is an Matteo Ramenghi oversimplification since households, corporates and banks are highly leveraged. Analyst ! Leverage ratios are high; liquidity may become very expensive [email protected] +39-02-7210 0286 Households and corporates have doubled their debt in the past decade (to 89% of GDP and c150%, respectively). Aggregated debt in Spain and Portugal exceeds 350% of GDP – above that of Greece. The cost of debt in Spain was more than 8% in the 1990s with debt-servicing costs equating to c5% of GDP versus 2% at present (c6% in Greece). A 400bp increase in the cost of debt seems affordable, in our opinion. Liquidity may be scarce and expensive, but, in our view, Europe is unlikely to allow a €3 trillion-plus debt event. We believe aggressive budget cuts are required. ! We remain cautious on the banks; elsewhere, the situation is mixed The higher cost of debt is likely to compress bank margins, which up to now have reflected relatively cheap liquidity. We remain concerned about the provisioning cycle for banks, while the restructuring costs of the savings banks could be material. As a result, we retain Sell ratings on Banco Santander, BBVA, Banco Popular and Sabadell. ! Renewables cannot be immune; construction looks tough Utilities may be subject to revised regulation, though this may be in the price (we like Brisa, EDP, Iberdrola, Abertis and Abengoa). There are no pure construction stocks, while the risks seem to be on the downside for players such as FCC and ACS, in our view. Companies with relatively low exposure to Spain include: Ebro, Técnicas, NH, Gamesa, Prosegur, Grifols and OHL. This report has been prepared by UBS Limited ANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON PAGE 22. UBS does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Spain and Portugal Strategy 29 April 2010 Contents page Bosco Ojeda Analyst [email protected] Greek contagion is painful 3 +34 91 436 9050 — Can Spain weather a large credit shock? .............................................................4 Stephane Deo Still sellers of Spanish banks 10 Economist — Asset quality back to 1993?................................................................................12 [email protected] +44-20-7568 8924 — A tenth of the loan book may be under stress.....................................................13 Ignacio Carvajal Cebrian — Is Ireland a comparable?....................................................................................14 Analyst — Alco hedging or carry trade? ..............................................................................14 [email protected] +34-91-436 9025 — Banks’ valuations are full....................................................................................15 Ignacio Sanz, CFA Spanish infrastructure 17 Analyst — Diversification is working, but spending on infrastructure should shrink further...17 [email protected] Spanish exporters: Quite a few 19 +34-91-436 9624 Key Spanish stock ratings 20 Alberto Gandolfi Analyst Key Portuguese stock ratings 21 [email protected] +44 20 7568 3975 Matteo Ramenghi Analyst [email protected] +39-02-7210 0286 UBS 2 Spain and Portugal Strategy 29 April 2010 Greek contagion is painful As developments in Greece are evolving, we believe the risk of contagion to the The risk of contagion is increasing for Spanish and Portuguese debt markets is increasing. At the heart of Greece’s Spanish and Portuguese debt markets problems is the difficulty the government is experiencing in coping with significant financial gearing, a heavy budget deficit and a recessionary economy. The risk of potential debt restructuring has substantially increased, in our opinion, and yesterday our macro team has published a thorough update on this topic: Greece: What now? by Stephane Deo. A first look at the Iberian economies seems to indicate that they are in much Spain and Portugal do not look too better shape: Spanish government debt equated to 57% of GDP in 2009, while heavily indebted at first glance… Portugal is more indebted, at 77%. That said, such levels do not look too bad compared with Greece, at 113%. In reality, both economies have unprecedented levels of debt. The private sector …but both countries have has been massively increasing gearing levels, taking advantage of lower interest unprecedented levels of debt rates. For instance, families in Spain have increased leverage from 20-30% of GDP in the 1980s and 1990s to a new high of c90% in 2009. The financial burden of such high debt is tempered by the fact that interest rates today are only half of those of the 1990s. However, what happens if investors fear that the risks of default are increasing? Needless to say, investor perception of risk is now a key issue. Chart 2: Debt in Spain by group (% of GDP) and government Chart 3: US debt by category: Not too far away… cost of debt 450% Household debt 13% 350 Financial institutions debt Government Corporate debt (ex-banks) 300 Government debt 11% Nonfinancial business Avg. cost of debt -right axis- 250 Households 300% Financial Institutions 9% 200 150 7% 150% 100 5% 50 0 0% 3% 1960 1970 1980 1990 2000 2009 80's 90's 00 01 02 03 04 05 06 07 08 09 Source: BDE, Tesoro, UBS estimates Source: Fed Reserve, UBS estimates Similar to Spanish households, corporates or non-financial institutions have also increased debt to unprecedented levels, to 150% of GDP currently versus c50% in the 1980s and 1990s. However, we believe this is somewhat distorted and may not be all that bad since Spanish corporates, such as Telefonica, Iberdrola and Ferrovial, have strongly diversified into LatAm and Europe, with the result that income sources do not exactly match the GDP of Spain. When comparing aggregated data for Spanish corporates (ex-financials) with that for US or UK corporates (c80% debt/GDP and c110%, respectively), leverage is much higher in Spain, but not exactly comparable. UBS 3 Spain and Portugal Strategy 29 April 2010 To a large extent, families and corporates have grown through borrowing from The low savings ratio has prompted financial institutions. The credit to deposit ratio in Spain stands at c160%, and banks to seek external and wholesale c140% in Portugal – above that of its European peers. In addition, Spanish financing, which raises the spectre banks hold substantial positions in Spanish government bonds and have of margin compression aggressively financed the expansion of Spanish families into real estate. Typically, a bank would lend for 25-30 years at a Euribor rate (now at 1.2%) plus a small spread. These loans would be partly funded by deposits, but, given the low savings ratio, banks have notably used external and wholesale financing. This imposes risks, in our opinion, because contagion from the Greek credit crisis implies margin contraction. Banks have compensated for weaker margins by increasing their positions in government bonds, financed by short-term liquidity lines. However, while this has provided support for Spanish bonds, this impact could come to an end as the value of those portfolios is deteriorating and financing is now more expensive. Can Spain weather a large credit shock? This question cannot be answered directly, in our opinion, since market perception and government policy may not perform in a completely rational way. That said, we have conducted some sensitivity analysis that helps to put things into context: we assume, for instance, that the cost of refinancing government debt increases by 400bp from 3.5% currently to 7.5%. On the one hand, it implies significantly higher 2010-11 debt service costs for the government debt that matures, and, on the other hand, there is additional deficit to finance. We estimate the incremental financial expense from higher rates over the period 2010-11 for the government could reach a maximum of €20bn, representing c2% of GDP. Accordingly, total financial expenses for the government could increase from 2% over the period 2004-09 (see Table 1 below) to 4% in 2011. This is clearly a very tough impact, but nonetheless it would be below the peak