Itaú Group: An Opportunity In Brazilian Banking

| About: Itau Unibanco (ITUB)

Summary

Itaú Group posted another set of strong results, especially when considering the circumstances involving Brazil.

Challenges ahead relate mostly to the ability to prevent asset quality deterioration in light of challenging economic conditions and implement the integration of ongoing transactions successfully.

The acquisition strategy of the group brought shareholder value and geographic diversification, which should continue to reinforce its competitive position in Latin America.

Itaú Group (NYSE:ITUB) posted another set of strong results, especially when considering the circumstances involving Brazil. The spotlight of these results was the strong credit metrics presented, probably a dual effect of prudent risk management and international diversification of the business.

Credit grew 3.5% in 2015, but when excluding the foreign exchange effect, it would have fallen around 3%. Despite the adverse environment, non-performing loans as a proportion of total loans (measured by loans in arrears for more than 90 days) rose only slightly to 3.5% in 4Q15 from 3.3% in 3Q15 and 3.1% in 4Q14. On a longer-term comparison, they present a downward trend and stand well below the 4.5% registered in March 2013, when the economic environment was much more favorable. Provisioning levels covered a comfortable 209% of non-performing loans.

Lending to individuals has seen an increase in the weight of less risky loans like mortgage loans and loans directly debited to the pay-check, with a focus on civil servants both retired and active. This was achieved through organic growth and through the acquisition of a local player specialized in the segment back in 2012. There is also a decreasing trend in lending to more risky small- and medium-size companies.

Itau's credit portfolio is well diversified by sector and by debtor, with the largest individual exposure representing only 0.9% of total loans, a conservative positioning most welcome in more challenging times like the current ones.

In the future, deterioration of the quality of the credit portfolio is expected, on the back of adverse economic environment and rising interest rates, but Itaú seems well provisioned to go through more difficult times. It also seems well capitalized, with Basel III solvability ratio at 17.8% and Core Tier 1 ratio at 13.3% in the end of 2015.

Itaú's profitability metrics are sound with recurrent ROE reaching 22.3% in 4Q15, a good level despite the downward trajectory of the metric.

The asset base has been expanding in the last years on the back of organic growth and acquisitions in Brazil and other countries in Latin America. 2015 was no exception although with a slightly changed mix.

Total assets grew 12.5% to 348.5 bn USD, but the contribution from lending to asset growth was lower than previously. The expansion of investments in securities and open market deposits gained importance. With an eroding deposits base (-0.7% YOY), deposit-based funding has been replaced by open market and securities funding. These trends led the Group to a more leveraged position as seen in the proportion of loans to deposits, which reached 150%, a level that cannot be called conservative and which shows a consistent upward trajectory throughout the years.

Despite rising interest rates, higher funding costs had a negative impact on financial margins which were not compensated by rising securities income, even if net interest margin associated with pure lending business remained rather stable. Growth from fee income and insurance were not enough to prevent the operational result deterioration. Net income rose 15% in 2015 on the back of deferred taxes, and reached 6 bn USD.

When looking on a QoQ basis, one can see some volatility in the securities lines of the income statement, which suggests some relevance of trading and available for sale securities activities in the bank's portfolio.

Itau's business evolution throughout the years has been guided by very prudent lending policies but also more openness and successful track record in securities trading and M&A activity. The recent acquisition of BTG's Recovery adds to evidence of the sense of opportunity of the group, by buying a leading company in non-performing credit portfolio management (and recovery), from a bank currently in a difficult condition, most probably at a good price.

Also, this positioning allowed the group to conclude good deals that brought shareholder value and geographic diversification. International operations accounted for slightly over 30% of Itau Group operating income and 19% of net income. The merger of Itau operations with Corpbanca, one of the largest commercial banks in Chile with assets amounting to 30 bn USD, should add further diversification benefits to the Group and a reinforced competitive position in Latin America.

What is more, despite also challenging environment in several Latin American countries, even if to a lesser extent than Brazil, Itau group's more expressive operations in terms of size are all profitable, which on top of Chile, include regions like Argentina, Uruguay and Paraguay. Itaú also opened a broker in Mexico, which started operations in December 2015, an investment banking operation in Colombia, and a representative office in Peru.

International diversification also brings risks both in terms of operations control and foreign currency management. This is somewhat evidenced when looking at 9.6 bn BRL foreign exchange effect on cash items, which stands for 41% of net income.

Itau posted P/E of 6.8, dividend yield of 4.1, net pay-out of 31.3%, and is trading at 10-year low levels. Being the financial sector somewhat neutral in terms of cyclicality when compared to alternatives, this could be a good opportunity to gain exposure to the Brazilian banking sector.

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