WHEN BANCO ESPÍRITO Santo (BES), the banking unit of Portugals Espírito Santo Financial Group (ESFG), announced on May 18 that it expected compound annual growth of 20% a year until 2010, investors saluted its confidence and sent the shares higher BESs by 2.23% and ESFGs by 1.8% feeling justified in their valuation of the bank at a higher multiple than rivals such as Millennium BCP and Banco BPI.
Yet BES and ESFG the latter also controls non-life insurance company Tranquilidade and other businesses have hardly been an overnight success. "We have grown fairly consistently over the past 15 years but because of where we operate and our size, we are only rediscovered by analysts and investors on an intermittent basis," says Manuel Villas-Boas, director and president of the executive committee of ESFG based in London.
BES and ESFG are finding favour because the Portuguese economy, which accounts for the vast majority of their revenues, is showing signs of recovery, having been moribund for much of this decade: it grew just 0.3% in 2005 and 1.3% in 2006 and was widely expected to perform poorly in 2007. However, in the first quarter of 2007, GDP grew 2.1% year on year, according to Instituto Nacional de Estatística, the Portuguese government statistics organization.
"The big question is whether the recovery in Portugal is sustainable," says Daragh Quinn, analyst at Lehman Brothers in London. Most forecasters believe it is. In early May, the European Commission revised Portugals GDP growth estimates upwards: it now expects growth of 1.8% in 2007 compared with the 1.5% it had predicted earlier, and 2% in 2008 from 1.7% previously forecast. The Bank of Portugal, the central bank, is even more bullish: it expects GDP growth to hit 2.4% in 2008 compared with its earlier prediction of 2.1% and believes it will reach 3% in 2009.
Moreover, on May 1, Fitch Ratings revised Portugals outlook to stable from negative, noting that the economy was growing more rapidly than expected and most important that the government was making efforts to tackle its large budget deficit. Portugal is rated AA for foreign currency and local currency debt, with a short-term foreign currency rating of F1+ and a country ceiling of AAA, which is the level for eurozone members.
"Portugals public debt ratio now looks set to stabilize sooner and at a significantly lower level than previously expected, improving the credit outlook," says Chris Pryce, director in the Fitch sovereigns team in London. Portugal cut its fiscal deficit in 2006 to 3.9% of GDP from 6% in 2005 and is expected to get it below 3% the level set by the European Union as the maximum permissible in 2008.
BESs chief economist, Carlos Almeida Andrade, notes that the reduction in the deficit is improving confidence in sustained economic growth in the near future. At the same time, structural reforms such as those being applied to public administration, and new investments, such as a high-speed train network and a new international airport, indicate that the outlook for Portugal will improve.
Andrade expects GDP growth of 1.7% in 2007, 2% in 2008 and 2.5% by 2010, driven by "stronger net external demand" while "increased exposure to fast-growing economies [both inside and outside the eurozone], structural reform efforts and fiscal consolidation are expected to improve Portugals growth potential over the medium and long term".
However, as Villas-Boas points out, the recovery in Portugal is still nascent and therefore not the main driver of the groups recent impressive performance. "From a holding company perspective, the recent performance of our banking and insurance subsidiaries is all the more interesting because it was achieved during a period of economic stagnation in Portugal," he says.
A banking odyssey
When considering the current state of the Portuguese financial sector, it is important to remember that the countrys politics, society and economics have changed beyond recognition in living memory. Portugal spent four decades under a dictatorship that ended following a bloodless coup in 1974. The left-wing government that followed placed much of Portugals industry in state hands: indeed, the alleged actions of the Espírito Santo family in backing a counter-coup in 1975 hastened, according to some observers, the nationalization of the financial sector.
The Espírito Santo family was forced to flee to Spain and, although active in international banking in the 1980s founding various banks and fund management operations it was unable to re-establish the group in Portugal until the government changed in the mid-1980s and privatization of a wide variety of industries began, following amendments to the Marxist-style constitution of the 1970s.
In 1986 as Portugal joined the European Union ESFG regained its foothold in the Portuguese market by establishing Banco Internacional de Crédito with Crédit Agricole; by 1990 it had bought back its Tranquilidade insurance operation from the government; and finally, in 1991, it bought back 40% of BES from the government again with Crédit Agricoles support before taking full control in 1992.
"The legacy of privatization was remarkable," says Villas-Boas. "During the period when banking and insurance was nationalized there was a huge pent-up demand for financial products that only came to be realized when the banking and insurance sector was set free prompting significant growth."
At the same time as financial companies gained the freedom to determine their own future, they were forced to compete with international operations because privatization had been accompanied by liberalization of the market when Portugal entered the EU. Consequently, financial services companies in Portugal needed to reform themselves extremely rapidly.
"Fortunately, ESFG and some other financial companies in Portugal were able to harness the demand for financial services and the efficiencies gained through technology and new banking practices to be able to compete head on with foreign competition," says Villas-Boas. "The Portuguese banking sector worked quickly enough to prevent any foreign competitor gaining an opportunity to grow organically." Indeed, Santander Totta, which was purchased by Spains Grupo Santander in 2000, is the only sizeable international banking operation in the country.
This period of rapid growth and reform in the 1990s has left Portuguese banks with a culture of efficiency that compares favourably with the very best banks in Europe. As Fitch Ratings noted in its report on the Portuguese banking sector in April this year, the countrys leading banks had low cost/income ratios of 52.2% (Millennium BCP), 52.3% (BES) and 54.7% (CGD) in 2006. All three banks improved their cost/income ratios in 2006 and BES recently predicted that its cost/income ratio would be below 45% in 2010.
By comparison, the UKs Barclays Bank had a cost/income ratio of 59% in 2006 and Germanys Deutsche Bank 70.2% in the same period. "I wouldnt be surprised if the example of Portugal in the 1990s appears in textbooks about how to modernize a financial system in the future," says Villas-Boas. "It was a remarkable period for everyone in the industry."
Why ESFG is different
The Portuguese market is dominated by five banks: Caixa Geral de Depósitos (CGD), Millennium BCP; BES; Banco Santander Totta; and Banco BPI (in asset size order), which together have more than 85% of the banking market.
BES has a market share of about 19%, which it hopes to increase to 22% by 2010. However, although its banking unit has assets of only around two-thirds of those of CGD, ESFG believes it has the edge on its rivals by being the only fully integrated financial group in Portugal. "We dont think of ourselves as a banking group and that is the crucial difference between us and our rivals," says Villas-Boas.
BES and ESFG Stock price performance 2006-07 YTD
BES operates the most successful Portuguese investment bank in Portugal, Banco Espírito Santo de Investimento, and is also active in countries with Portuguese communities or connections such as Angola, Brazil, Macau and the US, and has a small branch network and asset management operation in Spain. Most important, through a complex web of holdings, BES and the broader ESFG group is the second-largest insurance group in Portugal, with 10% of the non-life market behind state-owned Caixa, which operates a number of brands and has around 30% and 15.3% of the life market.
ESFG is engaged in the insurance industry through its Tranquilidade company, which sells non-life agent and directly distributed products, T-Vida, a spin-off life company resulting from the purchase by Tranquilidade of its agent-originated portfolio from BES Vida; BES Vida, a life company formerly known as Tranquilidade Vida, focusing on life bancassurance; and BES Seguros, a non-life company, formerly known as Espírito Santo Seguros, focusing on non-life bancassurance.
"Strong positioning in all areas of insurance is essential for the future of ESFG because unlike banking, which underwent huge changes in terms of product range and distribution and gained substantial efficiencies in the 1990s, the insurance sector is still immature and therefore the capacity for dynamic growth is considerably higher," says Villas-Boas. "Moreover, the inter-relationship between insurance and banking is so huge and developing further that it has encouraged us to be more bold."
A new relationship with Crédit Agricole
In June 2006, ESFG and BES underwent a major reorganization aimed at simplifying shareholdings and restructuring their insurance operations. "The reorganization was a natural progression following the success of our life bancassurance operations," explains Villas-Boas. "It made sense to have the bancassurance activities directly linked to the bank."
ESFG had formerly operated bancassurance in partnership with Crédit Agricole which also had a direct stake in BES through independent sister companies called Companhia de Seguros Tranquilidade Vida (now called BES Vida) for life insurance and Espírito Santo Companhia de Seguros (now called BES Seguros) for non-life insurance. The goal of the reorganization was largely to separate the bancassurance operations of these companies from other distribution methods.
ESFG sold its 50% holding of the Vida operation to BES while Crédit Agricole maintained its 50% stake in the business and assumed management control. Similarly, Crédit Agricole acquired 15% of BES Seguros from ESFG, giving it a 50% stake and management control.
At the same time, ESFG bought Crédit Agricoles stake in and took full control of the non-life agent business Tranquilidade, which is not linked to bank distribution. By separately acquiring the non-bancassurance life portfolio of BES Vida, ESFG has now created a wholly owned non-bank distribution network for life and non-life products.
Although the need for some rationalization of the ownership structure, and the separation of bancassurance and non-bancassurance activities, makes sense, some observers initially questioned ESFGs decision to forfeit management control of its bancassurance operations. "It makes perfect sense because Crédit Agricole is without doubt one of the leading providers of bancassurance in Europe and this business is all about scale and product development," explains Villas-Boas.
Philip Smith, senior director in the financial institutions group at Fitch Ratings in London, agrees that a strengthening of the relationship with Crédit Agricole made sense. "It is now directly involved in BESs bancassurance operations, where it holds a 50% stake and management control, and these operations will benefit more fully from the expertise of Crédit Agricole, which has formidable experience in this area in France," he says.
In contrast, the agent business was less of a natural fit for Crédit Agricole but ESFG could see huge growth opportunities in what it calls assurefinance the sale by independent agents of life and non-life products in areas that might not have bank branches (direct sales channels such as the internet remain extremely small in Portugal). "These agents cant be tied but can be encouraged to sell mainly ESFG products," says Villas-Boas.
ESFG has also encouraged agents to broaden the range of products they sell, meaning that they can offer a one-stop shop for such products as mortgages and credit cards. "You might find, for example, that having taken out a mortgage through an agent there is a requirement for house contents insurance," explains Villas-Boas. "It generates its own additional business." The strategy has borne fruit: 21% of BESs new clients in 2006 came to the bank through agents while 15% of its mortgages were sold through agents.
Other than the purchase consideration of the various stakes sold between Crédit Agricole, ESFG and BES, Villas-Boas says that the costs of the reorganization which was announced in February 2006 and finished that June were limited. "It is too early to be able to ascertain the exact benefits of the reorganization given that it is so recent we envisaged it having medium-term benefits," says Villas-Boas. "The crucial thing is that it allows us to focus more closely on the needs of our clientele."
Realistic growth strategies
ESFG has pursued an organic growth strategy in its core domestic market. The rationale for the strategy is simple: when the group recovered its assets from the government at the beginning of the 1990s, it was clear that the client base of the bank, in particular, had been under-utilized. "Before nationalization, the bank had a market share of roughly 17% but when it returned to us it had a market share of 8%," explains Villas-Boas. "Clients had not abandoned the bank but they had dramatically scaled down their business with it."
"We have grown fairly consistently over the past 15 years but because of where we operate and our size, we are only rediscovered by analysts and investors on an intermittent basis"
In contrast, the strategy in international markets which is now focused on investment banking and can be divided into non-geographical and geographical markets is often based on acquisitions. "There are areas of international activity that can be pursued as discrete activities that do not divert attention away from core business and do not require the development of client bases in various markets worldwide: project finance being the most obvious example at the group, and leveraged finance being another," says Villas-Boas.
This strategy has worked most successfully in project finance, where ESFG hired the majority of a team from PricewaterhouseCoopers in 2001, creating an operation that is consistently ranked in the top 10 in Europe and has developed an expertise in infrastructure projects worldwide, including an increasing number of public-private partnership deals in Latin America and toll roads in Europe and the US. It has also recently been involved in the construction of the new Wembley stadium in London.
The geographical question
While the discrete worlds of project and leveraged finance sit well with ESFGs core Portuguese activities, the group also has a more eclectic suite of international banking activities, including operations such as Banque Espírito Santo et de la Vénétie, a Paris-based bank focused on commercial banking for French medium-sized companies, that do not easily fit into any of ESFGs many business models. "Our approach has always been to avoid a one-size-fits-all mentality," says Villas-Boas.
Where ESFG and BES see opportunities to add value, they wont hesitate to act, according to Villas-Boas. "The acquisition of a stockbroking business in Spain is a good example," he says. "We already had operations there including a small branch network and the stockbroking business allowed us to use our assets more effectively with only a limited investment. But we have no intention of trying to be everything to everybody in Spain. It would be foolish and impossible to achieve."
Outside Spain, ESFG is involved in a number of geographical markets, many of which are associated with Portugal, such as the former colonies of Angola a politically unstable but rapidly growing oil and mining economy and Macau, now part of China, with the aim of generating fees from advisory work rather than from net interest income. The group also has operations in the US, which mainly focus on private banking for Latin American clients.
On the question of ESFGs involvement in the worlds largest Portuguese-speaking economy Brazil the groups strategy is currently up in the air. ESFG has long been involved in banking in Brazil it won a licence to operate there in the late 1970s but its involvement in recent years has been cautious. In 1997, ESFG acquired a stake in wholesale and retail operator Banco Boavista InterAtlantico, which was subsequently acquired in 2000 by Bradesco now the largest Brazilian bank and largest private company in Brazil leaving ESFG with a 6% stake.
Relations continued to be cordial between the two groups for a few years. In 2002 Bradesco bought 3% of BES in a bid to cement the relationship and the two companies set up an investment banking joint venture, BES Investimento, in which BES owned 80% and Bradesco owned the remainder. However, that relationship now seems to have come to an end, following Bradescos decision to launch its own BBI investment banking operation in February 2006 without warning BES.
"Economic growth in Brazil is attractive and the country could play a more important role in ESFGs future," says Villas-Boas. "Organic growth is clearly not possible, so an acquisition would be necessary." As Euromoney was going to press, discussions between BES and German bank WestLB to acquire its 1 billion Latin American operations appear to have come to an end, with WestLB deciding to keep the operations, which are largely focussed in Brazil. "If we were to grow our presence in Brazil, it would be in investment banking only. We are not interested in retail or wholesale operations," says Villas-Boas. Rumours continue to circulate that BES is in discussions with other banking groups to develop joint ventures for investment banking in Latin America.
Certainly, ESFG sees no opportunities to be involved in retail banking in any of the international markets it operates in. This antipathy to retail banking is a relatively recent phenomenon, as is evident from its purchase of wholesale and retail operation Banco Boavista InterAtlantico in Brazil. More recently, BES was involved in a retail and commercial banking start-up in Poland, Kredyt Bank: it bought a 10% stake in 1999 and added a further 10% in 2000 before selling out to Belgiums KBC Group in 2002.
"The question the Kredyt Bank experience raised for BES was whether it makes sense to get heavily involved in markets that are peripheral to us," says Villas-Boas. "It is feasible to have ventures of that sort but it is not desirable. Gigantism does not appeal to us." Instead, ESFG has focused on what it knows best and now operates a joint venture described as nascent by Villas-Boas called Concordia Espírito Santo Investiment in Poland that focuses on project finance advisory work.
Family prevents takeover
Although the holdings and strategies of ESFG, BES and their myriad subsidiaries have been ever-changing since the group was re-established in the late 1980s, the Espírito Santo family which set the bank up in the late 19th century has always been present: Ricardo Espírito Santo Silva Salgado is chairman of the executive committee and a number of other family members sit on the management or executive board. The family, or shareholders loyal to the family, ultimately own 49.2% of ESFG and 67.4% of BES, and control both, making a takeover next to impossible.
Can such a situation continue indefinitely given the rise of shareholder activism and the constant consolidation of the financial sector? "Theres no reason why it cannot, given that the group and the bank have very clearly defined objectives," says Villas-Boas. The structure based on family ownership with Crédit Agricole as a partner has more than doubled our market share in our home market. Why would you change it?"
Villas-Boas is willing to admit that there are some markets in which scale is important. "ESFG would consider a joint venture with an international insurance company, or the acquisition of a smaller local non-life business, in order to make a real dent in the government-owned Caixas 30% market share of the non-life business," he says. "But otherwise, we are very happy continuing as we are." With ESFGs net operational consolidated profit growing 33.6% in 2006 compared with 2006 and BES increasing net income by 33% in the first quarter of 2007, the status quo is likely to be something that investors will remain comfortable with for some time.