We think that Brazil's economy will outperform developed nations' growth and that the Brazilian banks we cover are well positioned to take advantage of this expansion. Even with our tepid economic growth expectations, we think Brazil's growing middle class and substantial untapped credit demand will benefit Brazilian banks. Naturally, risks abound, such as growing inflation, a possible spike in unemployment and credit costs, and deceleration in the Chinese, U.S., and Western European economies. The best-run banks, such as Banco Bradesco (BBD) and Itau Unibanco (ITUB), have proved to be quite resilient in the past and would be able to navigate another crisis successfully, in our opinion. However, we think the best risk/reward profile currently belongs to Banco Santander Brasil (BSBR), which trades at a much wider discount to our fair value estimate than the others do.
Fundamentals Support Positive Outlook for Brazilian GDP
Compared with our view of other countries, we have a positive outlook on Brazil's economy. After a slow near-term recovery, we think Brazil's GDP will grow around 3.5% in the medium term. Growth in investment, combined with an expanding middle class, an acceptable unemployment rate, and controlled inflation, should keep pushing the economy forward, in our opinion. This is nowhere near the 7.5% real GDP growth achieved in 2010, and actually below the five- and ten-year trailing averages.
Brazil's economy has proved to be resilient in times of stress. In the past decade, Brazil's economy has held up relatively well. Even at the height of the crisis, Brazil's economy was not as hard-hit as others. Part of this was due to continued growth in household consumption, which held up the economy even when exports fell dramatically in 2009. Although highly dependent on commodities, Brazil's exports are not as significant a chunk of GDP as in other Latin American countries. Exports make up 12% of Brazil's GDP, whereas for Mexico and Chile, this figure is around 30% and 40%, respectively. Moreover, unlike Mexico's, Brazil's economy is not driven largely by one export partner. Eighty percent of Mexico's exports go to the United States, while Brazil's exports are more balanced among China, the U.S., and Argentina.
Credit growth will remain a tailwind. We anticipate that Brazil's growing middle class will remain a key component of long-term economic progress. However, we think that new avenues, namely investment, will become more important for the nation's GDP. Even now, the country's social mobility still shows a trend toward expansion. In less than 10 years, Brazil's middle class has grown from 42% of the population to 56%. Combined with the higher-income classes, the bankable segment grew from just over half of the population in 2003 to almost three fourths in 2011. There are a number of household consumption drivers, beginning with the fact Brazil remains home to scores of under-banked consumers. The country's loan/GDP ratio is just over 50%, compared with around 75% in Chile and India and more than 120% in China, for example. Looking more closely, we find that mortgages are just 6% of Brazil's GDP--another source of potential growth. Also, both credit and debit card use is on the rise, which is usually another way to spur growth, increase penetration, and deter tax evasion.
Of utmost importance, in our view, is that the Brazilian consumer is not yet too hampered by debt service. The debt-service burden has not increased nearly as quickly as households' leverage, thanks to lower interest rates and the gradual adoption of longer maturities, which have trended to 21 months from around 11 months between 2005 and 2012. At 45%, the Brazilian consumer's debt/income ratio is manageable, in our view, less than half that of the U.S. and the eurozone, both of which exceed 100%. In addition, nonperforming loans to individuals have remained steady, even as households' leverage has nearly doubled.
At just under 5%, unemployment remains relatively low compared with the previous decade's levels, which were well above 10% in the early 2000s. Workforce demand growth has outpaced labor force growth, which should prevent significant spikes in unemployment, in our opinion. Indeed, in the past few years, the increase in employed people has outpaced additions to the economically active population by 1% on average. Moreover, even though inflation is elevated, it is not as rampant as it was 10 years ago and remains within the Central Bank's target range. With the benchmark rate at a historic low, there is plenty of room for monetary tightening in the event of overheating, especially since much of the current inflationary pressure is demand-driven.
Investment is a priority. We think investment will play an increasingly important role. Even if household expenditures give back some share of GDP, we think capital formation is likely to pick up the slack. There are already a number of infrastructure initiatives, such as airports, highways, and railways, that combine government and private investment, reaching about $75 billion. In addition, more than $200 billion is expected to be expended toward oil-related projects. The World Cup in 2014 and the Summer Games in 2016 should spur investment as well. In the nearer term, both industry and consumer confidence surveys depict a positive economic panorama.
Brazil's Narrow-Moat Banks Are Poised to Benefit From Economic Growth
We tend to like Brazil's banking system. It is a tightly knit oligopoly where the top six players control almost 80% of the total financial system's assets. The downside is that three of the top six banks (40% of assets) are government-controlled. This means that sometimes, market dynamics may be altered (say, by offering below-market interest rates for loans) depending on the prevailing political winds. That said, we think the political impact, especially on the three largest privately controlled banks, has been more or less muted. Thanks to the healthy growth in credit demand due to increasing penetration, the non-government-controlled banks have traditionally been able to cherry-pick the most profitable clients--those with the best risk/reward profiles. As a whole, we think the Brazilian banking system has fared well, in terms of growth as well as profitability. We think this has largely kept the banks from resorting to riskier products that could come back to haunt them.
For many years, Brazilian banks have reaped handsome profits, with returns on assets and equity averaging 1.8% and 19%, respectively, during the past decade. Even at times when inflation has spiked or GDP growth has languished, profitability has remained more or less steady. While Brazil's economy took a heavy hit in 2009, profitability did not fall too much. To be sure, in contrast with previous crises in Brazil and unlike what has recently happened in other countries, Brazil's economic slowdown was not accompanied by a banking crisis.
The main reason behind the avoidance of a banking crisis in Brazil was that its banks were much better capitalized than U.S. banks. Moreover, Brazilian banks braved the crisis with stronger loan-loss reserves. Compared with the largest U.S. banks, Brazil's top firms affronted the crisis with reserves at least as high. More important, Bradesco and Santander actually increased their coverage (allowance for loan losses/nonperforming loans) between 2007 and 2011. While Itau closed 2011 with a slightly lower coverage than in 2007, it quickly strengthened its reserves in 2009 and has slowly worked them down since. Brazilian banks' resilient earnings power allowed them to juice up coverage without having to endure severe losses or capital drainage.
Brazil's Private Banks Attract the Most Profitable Customers
We like Brazil's banking landscape, especially when we look at the three banks that we cover: Itau, Bradesco, and Santander. Thanks to the country's oligopoly, these firms have had very handsome returns without having to venture into very risky products. In addition, compared with Banco do Brasil (OTCPK:BDORY), the government-controlled commercial bank, profitability is usually higher at the privately-controlled institutions.
Not being controlled by the government allows management to focus on creating shareholder wealth without having to sail in the direction in which the prevailing political winds blow. Moreover, in a country with ample room for banking penetration, having a wide branch network helps keep new customers coming through the door looking for their first banking relationships. With Brazil's robust secular growth, privately controlled banks have been able to choose those customers with the most appealing risk/reward profile. Non-government-controlled banks command higher interest rates than does Banco do Brasil (which often offers products with below-market rates). Looking at net financial income/average non-permanent assets as a measure of interest income profitability, we see that Santander, Bradesco, and Itau are well above Banco do Brasil. This trend remains when analyzing these assets on a risk-adjusted basis. Subtracting loan loss provisions from net interest income and dividing the result over non-permanent assets also shows that privately controlled banks outperform Banco do Brasil.
Itau, Bradesco, and Santander outperform their main competitor and earn solid returns. Additionally, we think that operating in an oligopoly shields these three banks from smaller competitors that could significantly erode their profits. Thus Itau, Bradesco, and Santander possess narrow economic moats, in our view.
Risks of a China Slowdown and Rising Inflation Seem Manageable
Though we think Brazil's exports do not represent an inordinate proportion of GDP and the country's export partners are diverse, serious problems could arise if outgoing foreign trade were to decelerate, in our opinion. The most salient risk revolves around China's deceleration. After years of being the number-one export partner of Brazil, the U.S. was recently superseded by China. Because of excessive investment in the past several years, it is our view that China will have a hard time reaching a consistent 7%-plus growth rate in the medium term. In addition, we think the Chinese economy must shift from an investment-centric to a consumer-centric approach. This will necessarily place downward pressure on a myriad of commodities, and we anticipate that imports of materials such as ferrous metals (Brazil's most important export product) could fall. We think the feeble recovery in the U.S. as well as the strain and uncertainty in Europe's economy will hardly help in boosting Latin American exports. Lastly, the geopolitical complexity that envelops oil prices (Brazil's second-largest export) adds another layer of risk to Brazilian exports.
Rising inflation is also a concern. Currently, the price index remains under control thanks in large part to the government's intervention. Among others, gasoline, electricity, and landline telephone rates are regulated. In addition, weather-related pressures in the prices of some food and beverage items are receding. However, a strong labor market is likely to keep service inflation lofty. All in, consensus inflation projections for the next couple of years hover between 5.5% and 6.0% per year. With this in mind, the latest Monetary Policy Committee guidelines indicate the intention to maintain the short-term benchmark Selic rate at or close to 7.25%, where it currently stands.
Near-Term Headwinds Will Not Hold Back Long-Term Prospects
Our economic expectations are not spectacular for Brazil, and we acknowledge the presence of several risks. We are not anticipating system-wide returns on assets at the pre-crisis level of 2.5%, especially since credit quality will probably remain stressed and low interest rates will prevent interest margins from widening significantly in the next couple of years. However, we do think that the country's banks--especially Bradesco, Itau, and Santander Brasil--will navigate these somewhat uncertain waters without major catastrophes.
With GDP growth less than 4%, we think increasing credit penetration will serve as the main driver of medium-term growth for banks. With total credit currently at 53% of GDP and mortgages at 6% of GDP, we think there is room to grow. Compared with other nations, Brazil's mortgage penetration is still in a fledgling phase. We do not expect to see mortgages grow to anywhere near 80% of GDP as in the U.S., but we think Brazilian mortgages can make up 10%-15% of GDP in the medium term (Thailand is at 11%, while Chile is at 19%), especially if interest rates remain depressed and the country's social mobility does not lose its momentum.
Even though we like the growth story for banks' balance sheets, we are not overly bullish with regard to credit quality. Early delinquencies (loans in arrears between 15 and 90 days) have posted some very mild improvement lately, but we would like to see a more significant turnaround before we anticipate a true amelioration in loan losses. We think an important shift in credit quality has not yet come, at least for the overall banking system. As a result, we think nonperforming loans will remain above the historical average.
If Brazil's economy were to falter, we think credit quality would naturally take a hit. Nonetheless, we think it would not be a devastating blow. In the past decade, high unemployment has not resulted in outsize dud loan balances. In our opinion, this is mainly due to the expansion of banks' loan books.
We think downward movements in interest rates are an even more threatening risk to banks' bottom lines. Since average maturities are still relatively short, credit spreads tend to depend closely on short-term rates. In 2009 and 2012 we saw sharp declines in the Selic rate, which resulted in a significant fall in credit spreads, especially in individual loans. During these periods, nonperforming loan ratios hardly moved, but the fall in banks' interest spreads did significant damage to profitability. Thus, we think that if Brazil's economy softens and the central bank lowers rates, returns on equity will take a more substantial hit than if NPLs grow. Conversely, we saw in 2010 that rising rates do help financial institutions' spreads and profits. Thus, we are not terribly worried about a slightly above-target inflation rate, because if this results in modest rate hikes, banks' spreads should widen, in our view. Presently, our base case assumes flat rates with spreads hovering at or mildly below 20%.
Bradesco Is the Best, but Santander Brasil Is the Cheapest
Among the three Brazilian banks we cover, we like Banco Bradesco's fundamentals the most. This firm has a healthy capital base, relatively good credit quality, stout reserve coverage, and a solid record of consistent profitability. In addition, it has one of the most prominent insurance operations in the country. Thanks to these advantages, Bradesco's non-interest income makes up more than half of the company's overall revenue (compared to roughly one third at Itau and Santander). This means that Bradesco's bottom line is not overly dependent on interest margin movements and profitability tends to be less lumpy.
Itau Unibanco is not far behind, in our view. Itau too has a strong record of profitability, although its credit quality, coverage, and capital position are not as good as Bradesco's. Santander Brasil's capital position is the most solid of the three. However, credit quality, coverage, and profitability are not nearly as good as its peers'. That said, when it comes to banks, we do favor those with the strongest capital footing. In addition, the reduced returns on equity are due in part to Santander's relative overcapitalization. When we compare returns on assets among these three financial institutions (and adding back Santander's forced goodwill amortization from Banco Real), profitability is actually not that different. We do anticipate that Santander will deploy more equity as opportunities become available. As a result, we project that its equity/assets ratio will gradually fall from nearly 15% (as of December 2012) to around 10%, slightly above Bradesco's and Itau's ratios.
Presently, we think Santander Brasil offers an attractive risk/reward investment profile. While Brazil's economy could fall further and Santander's credit quality and coverage are the worst of the three banks we cover, we think a downside scenario is currently priced in. Trading at just under 70% of our fair value estimate of $11 per American depositary receipt, Santander offers the most potential, in our opinion.
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