BANK ON BRAZIL´S RECOVERY WITH ITAU UNIBANCO / BARRON´S FEATURE

Feature
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SATURDAY, DECEMBER 29, 2012
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Bank on Brazil's Recovery With Itaú Unibanco

By RESHMA KAPADIA
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Brazil's largest private-sector lender has been hit hard by the nation's economic woes. But the headwinds it's been facing are about to turn into tailwinds.

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It has been a rough two years for Brazilian banks, but there may be some light at the end of the tunnel for Itaú Unibanco Holding (ticker: ITUB).


Until recently, just about everything that could have gone wrong has. The Brazilian economy has slowed sharply, ending the year with what optimists hope is 1.5% growth. The government has responded; the central bank has slashed the key interest rate by 5.25 percentage points since August 2011, and President Dilma Rousseff has pressured banks to cut fees and lower rates to spur more lending. All of that dinged Itaú's profitability at a time it was also dealing with some poor auto loans it made in 2008 and 2009.

 

 

Brazil President Dilma Rousseff has pressured banks to cut fees and lower rates to spur lending.

As a result, the stock has fallen 4% in the past two years in Brazilian real terms. The much worse 13% drop for the U.S.-listed American depositary receipt was aggravated by the steep fall in the real over the year. The ADR now trades at a recent $16.28, with a 2013 price/earnings ratio of 9.4.



Itaú, which merged with Unibanco in 2008 to create the largest private-sector lender in Brazil, with 960 billion real ($469 billion) in assets, trades at a price-to-book ratio of 1.7 times 2013 estimates. In the depths of the financial crisis, P/B hit 1.5, but it has typically averaged in the mid- to high 2s. That is mighty cheap for a company that "arguably, on every metric, is one of the best-managed banks in the world," says Paul Ehrlichman, a manager with the $2.1 billion Global Currents investment firm, who thinks Itaú's share price can increase as much as 50%, as some of the challenges facing the bank, and Brazil in general, ease.



At a time when there are concerns that U.S. and European banks don't have enough cash reserves in excess of the minimum required by international regulators, Itaú boasts a plush cushion against potential challenges, with a Tier 1 capital ratio (a gauge of financial strength) of 12% in the third quarter. The five biggest U.S. banks, by comparison, average 10.9%.



THERE'S MORE TO LIKE HERE than just a quality company that's cheap. Many of the headwinds the company has faced are going to turn into tailwinds in the next year, says Luiz Soares, head of BlackRock's global emerging-markets equity team. For starters, most economists think the Brazilian central bank has reached the end of the rate-cutting spree that has taken interest rates to record lows. As rates fell, the difference between what Itaú earns on new loans and what it brings in from deposits narrowed, eroding net interest margins. Now that those rates are unlikely to fall much further, some of the pressure on Itaú's profitability should ease.

The good news about lower interest rates is that the percentage of nonperforming loans to total loans will likely improve, since it'll be easier for borrowers to make payments. That's especially true if the economy is on its way to recovering, as many expect. In the third quarter, the ratio of nonperforming loans (overdue more than 90 days) to total loans hit 5.1%—0.1 percentage point better than the prior quarter, though worse than the 4.7% reported a year ago. While loan-loss provisions—the amount the company sets aside to cover debts that go bad—are expected to rise 32% this year from 2011, Soares expects that to improve in the coming year.


THE BIGGEST RISK TO ITAÚ has been government intervention, as it pressured state-owned banks to cut credit card and other fees, and to aggressively lend money. Since October 2008, state-owned banks' loan books have grown 147%, almost triple the 56% growth at the private-sector banks. That's much higher than the norm, and public banks' balance sheets are unlikely to stretch more, suggesting that the disparity could reverse, Soares says.

Given the lower interest-rate environment and the government intervention, Itaú's lending profitability will be harder to come by. But fund managers say expectations reflect many of those challenges. Analysts, on average, expect adjusted net income to rise 11%, to BRR15.9 billion, or BRR3.48 per share, next year, with stronger growth seen in 2014, according to FactSet. In dollars, that's $7.7 billion, or $1.68 a share. (For the ADR, the estimate is $7.8 billion, or $1.70 a share.)


Analysts say Itaú stands out for its ability to generate revenue while cutting costs aggressively. For example, it is moving back-office operations to a small town 200 miles outside of São Paulo instead of continuing to house it in one of Latin America's priciest cities.
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The Bottom Line

 

As Brazil's rate-cutting slows and its economy stabilizes, profits for Itaú Unibanco -- what some call "one of the best-managed banks in the world" -- could rise as much as 50%.

 

Itaú has learned from its overzealous auto-lending, and is shifting toward lower-risk products and clients, and can use its database to produce better credit-scoring. Secured lending, which totals about 30% of its revenue, should move to 40% to 45% in the next three to five years, says Soares, as the company offers more mortgages and loans to small- and medium-size enterprises—and as Brazilians use more financial services. Currently, mortgages represent just 6% of the country's gross domestic product—about half that of Mexico and less than one-third that of more developed emerging markets like Chile.
 


Sentiment could take a while to improve, especially if the economic recovery takes longer to materialize. But the skepticism around Brazil, matched with the company's hefty capital cushion and impressive track record, make the stock much easier for contrarians to bank on.

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