Since I last wrote on Banco Santander's (SAN) independently listed Brazilian subsidiary Banco Santander Brasil (BSBR) in March this year, its share price has fallen a further 16%. In that article, I concluded that Banco Santander Brasil represented a good investment opportunity with solid growth potential, quality assets and a moderately cheap valuation. But since then it has failed to perform, and despite the bank's second quarter earnings beating expectations, I have revised my outlook because I believe it will be sometime before the bank can deliver value for investors.
Recent financial results beat expectations but still disappointing
Banco Santander Brasil is operating in one of Latin America's most competitive financial systems, which by developed economic standards is comparatively under-banked. It is the fifth largest commercial bank in Brazil and the third largest full service bank behind Brazilian banking giants Banco Bradesco (BBD) and Itau Unibanco (ITUB).
Its second quarter 2012 financial results were surprisingly good when Brazil's lackluster economic performance since the end of 2010 and current global headwinds are considered. In comparison to the previous quarter, revenue remained steady at $6.7 billion, while net income fell by 15% to $722 million. This left Banco Santander with earnings-per-share of 20 cents, which was 11% higher than the consensus forecast of 18 cents.
The fall in net income is primarily attributable to the significant increase in loan loss provisions over the period, which grew by 23% to $1.9 billion. For the same period, the bank's balance sheet weakened because despite cash and cash equivalents remaining steady at $29.4 billion, debt grew by 8% to $39.2 billion. The deterioration in the quality of the bank's assets and balance sheet is of some concern and is likely to continue for some time given the poor economic outlook for Brazil.
Asset quality and risk management
An area of Banco Santander Brasil's performance that has been particularly disappointing over the last quarter has been the deterioration in its loan quality. This has seen the bank's non-performing loan ratio (NPL), a key measure of asset quality, continue to increase, rising by a further 40bps from the last quarter to 4.9%. This as the chart shows represents an increase of almost 1% in the bank's NPL ratio since the start of 2011 and represents a worrying trend.
The loan segment that has seen the greatest deterioration since the start of 2011 is loans made to individuals, which includes the higher risk consumer finance products such as credit cards and finance leases. This segment has an NPL ratio of 7.3%, which I would consider to be uncomfortably high. Generally any loan portfolio with an NPL ratio of greater than 5% is considered to be high risk and of unacceptable quality for a commercial bank.
The chart below indicates that the individual lending segment has significantly deteriorated since the start of 2011, with its NPL ratio rising by 1.4% since then to 7.3% at the end of the second quarter. However, these loans are for lesser amounts than commercial loans, and the NPL ratio for that segment is well within acceptable parameters.
Source data: Banco Santander Brasil financial filings Q1 2011 to Q2 2012
This indicates that Banco Santander Brasil's risk management for this segment has not been of the high standard that investors have grown accustomed to at Santander Group level. It also seems to indicate a lowering of risk management standards so as to increase market share in the consumer credit segment in order to meet revenue targets.
However, as the chart below shows, Banco Santander Brasil's NPL ratio is well below the Brazil industry wide average of 7.4% and comparable to its Brazilian peers, including Brazil's largest private bank Itau Unibanco, which has an NPL ratio of 5.2%.
Banco Santander Brasil's NPL ratio is higher than the other independently listed Santander Group subsidiary Banco Santander Chile (BSAC), which has a moderately low NPL ratio of 2.9%. Furthermore, with the exception of Spain, it is also higher than the group's other geographic operating segments as the chart below illustrates as well as the group wide NPL ratio of 4.11%. Source data: Banco Santander Activity & Results First Half 2012 26 July 2012
Despite the deterioration in loan quality, Banco Santander Brasil's NPL coverage ratio is more than adequate at around 138% and has remained steady at that level since the end of 2010.
The NPL coverage ratio is also comparable to its peers and well within the acceptable range. Overall, despite some concerns regarding the bank's NPL ratio and the deterioration in asset quality, all risk indicators are within acceptable parameters and indicate that the deterioration seen to date is manageable.
Liquidity and capital adequacy are far from optimal
Another aspect of Banco Santander Brasil's position that raises some concern is the bank's liquidity and capital adequacy. Currently, the bank has a tier one capital ratio of 19.9% as shown by the chart below, and this is well above the 10% or better that investors should be seeking when investing in a bank. It is also a superior to the tier one capital ratios of its peers and the group wide ratio of 10.1%.
Source data: Banco Santander Brasil, Banco Santander Chile, Itau Unibanco Financial Filings Q1 2011 to Q2 2012
* Banco Santander Brasil includes goodwill in its tier 1 capital calculation
However, on closer inspection, it becomes clear that when calculating the tier one capital, Banco Santander Brasil has included goodwill. This is contrary to the established guidelines for calculating tier one capital, which stipulate that goodwill along with the majority of other intangible assets is to be excluded. This explains why the ratio is significantly higher than both its peers and the group wide ratio of 10.1%. It also makes it extremely difficult to determine what is the true tier one capital ratio along with making any meaningful comparison with other banks.
I am also concerned by the bank's high loan-to-deposit ratio of almost 124%, which is well outside of the optimal range of 95% to 105% and higher than the Santander group wide ratio of 117%. Of further concern is that where other banks since the start of 2011 have sought to increase their liquidity, Banco Santander Brasil, as the chart shows, has allowed its liquidity to decrease with a rising loan-to-deposit ratio. Source data: Banco Santander Brasil, Banco Santander Chile, Itau Unibanco Financial Filings Q1 2011 to Q2 2012
This high loan-to-deposit ratio indicates that the bank is more dependent on costly wholesale funding than its peers with lower ratios, making it more exposed to increased funding costs. It also leaves the bank relatively illiquid reducing its ability to effectively manage any unforeseen events that may impact on its liquidity.
Performance measures are mixed
Despite the difficult operating environment and deteriorating asset quality, Banco Santander Brasil's renewed focus on cost control and efficiency is paying dividends for the bank. Since the end of 2011, the bank's quarterly efficiency ratio, as shown by the chart below, has improved significantly falling by almost 7% to around 42%, making it more efficient than many of its peers.
Overall, this shows that Banco Santander Brasil's renewed focus on cost control is paying off with the bank more efficiently generating revenue in proportion to the resources utilized. This certainly bodes well for improved future profitability once Brazil's economy improves.
However, the bank's return on average equity tells a different story, with the chart below showing how it has deteriorated since the end of 2010, falling by almost 5% since then to now be 11.5%. This is an inferior indicator of profitability than many of its peers, including Itau Unibanco at 18% and its Latin American stable mate Banco Santander Chile at 21%.
This decline can primarily be attributed to the economic cost associated with the bank having to significantly increase its loan loss provisions as the quality if its loan portfolio deteriorates. I also don't expect to see any improvement in the bank's return on average equity until the deterioration in its loan portfolio slows and the Brazilian economy improves.
Macro environment and market outlook
The Brazilian economic outlook at this time is particularly poor. Despite the country's economy expanding by 7.5% in 2010, by the end of 2011, it had only grown by an anemic 2.73%. Since then, economic growth has continued to decline, despite the Brazilian government embarking on a particularly aggressive economic stimulus package. This stimulus program has seen the Selic rate reduced to 8%, its lowest rate in 3 years and the injection of up to $60 billion over the next 25 years into the economy through tax cuts, social programs and infrastructure spending.
For the first quarter 2012, Brazil's economic growth was reported to be 1.89% and it is expected to have slowed to 1.4% for the second quarter. Much of this slow down can be attributed to the crisis in Europe, with the European Union being Brazil's third largest export partner and the soft landing in China, which is Brazil's single largest export partner.
Furthermore, with no significant change in these circumstances expected, it has been forecast that Brazil's economy will only grow by between 1.5% and 2% for the full year. This is supported by the IGBE economic activity index, which has remained flat for the first six months of 2012 only rising by 1% over that period. The decline in economic activity has seen unemployment rise by 1.8% over the same period and average earnings remain flat. All of which has seen demand for credit fall and indicates that non-performing loans will continue to rise for at least the short-term.
Banking penetration is unlikely to significantly increase
Despite Brazil being significantly under-banked with domestic credit to the private sector representing only 61% of GDP, I do not believe that banking penetration will significantly increase in Brazil for the short to medium-term. Recent economic events have indicated that it is unlikely that the country can currently sustain a higher credit to GDP ratio for a variety of economic and demographic reasons. These include the low average income, high degrees of income inequality and significant levels of poverty. This essentially means that a substantial portion of the population has insufficient assets and income to access the formal banking system at this time. As such, I do not believe that Banco Santander Brasil will be able to significantly grow its loans and deposits to the extent typically believed and this is only exacerbated by Brazil's poor economic outlook.
All of these factors do not bode well for Banco Santander Brasil's continued growth or ability to deliver increased value for investors particularly when the economic cost of increased loan loss provisions is accounted for. Furthermore, with the official rate at its lowest point in three years and expected to fall further combined with rising funding costs, the bank will also experience margin compression, which will also detract from profitability.
There are also a number of risks associated with investing in Brazilian banks and the degree of risk associated with investing in emerging markets is higher than that associated with investing in developed markets. At this time the key risks are:
- Rising political risk, with governments across Latin America showing an increasing tendency to intervene in their economies as a means of effecting change or meeting political goals. The current Brazilian government has shown a preference for using broad-based political intervention and economic protectionism as tools for managing the Brazilian economy. To date this has been focused on natural resources, rural land holdings and manufacturing, but there are signs of increased pressure being applied to private banks in order to make credit cheaper and more accessible.
- Growing regulatory risk with a lower risk tolerance globally for aggressive growth strategies in the banking industry combined with Latin American governments becoming increasingly focused on ensuring their regulatory frameworks comply with international standards. All of which will see the regulatory burden and its associated costs increase.
- Greater economic risk as the headwinds originating from Europe and the slowing Chinese economy, continue to exert greater effects on Brazil's economy because of its close trade ties to both Europe and China.
Investing in emerging markets always brings increased risk for investors, and of late the actions of the Brazilian government have clearly underscored this risk. In which case, investors should ensure that they receive a premium for this risk that is over and above the standard equity risk premium.
Banco Santander Brasil has a generous shareholder remuneration program in place which ensures that investors receive an attractive dividend yield, which is currently around 5%. This remuneration is comprised of two parts, the regular dividend payments and share interest on capital payments. These are made in accordance with the bank's shareholder remuneration policy that currently requires it to distribute 50% of its annual net income to shareholders in the form of dividends and share interest on capital payments.
The bank has been paying a dividend consistently since listing in 2009 as shown by the chart below. The bank's last dividend and interest on capital payment totaled 13.60 cents and had a declaration date of 5th July 2012. Source data: Banco Santander Brasil Investor Relations, NASDAQ
For foreign investors in Brazilian companies there is no withholding tax levied on dividend payments made from post 2006 profits, but share interest on capital payments attract a 15% withholding tax.
Future outlook and valuation
Banco Santander Brasil is currently trading with a trailing twelve month price-to-earnings (P/E) ratio of 9, which would indicate that at its current price, it is marginally undervalued by the market. This is also in the same range of many of its Brazilian peers such as Itau Unibanco with a P/E of 10 but far lower than its stable mate Banco Santander Chile, which has a P/E of 17.
However, since listing, Banco Santander Brasil's growth record has been particularly poor as the table below shows. This poor growth can be attributed to the difficult operating environment seen over the last year and half, but it is certainly not a good indicator of the bank being able deliver future value for investors.
Furthermore, given the current economic headwinds and the negative economic outlook for Brazil over the short to medium-term, it is highly unlikely that these growth rates continue. This is especially the case when the deteriorating asset quality and economic cost associated with the rising loan loss provisions are factored in.
Banco Santander Brasil, despite promising growth indicators and delivering better than expected second quarter results, continues to disappoint. Not only has the bank failed to deliver for investors since its IPO in October 2009, but now declining asset quality and low levels of liquidity are becoming significant threats to its profitability. When these are considered in conjunction with Brazil's negative economic outlook and growing political risk, I do not believe it is a particularly appealing investment despite its generous dividend yield. I believe that investors would be better to consider other investment opportunities outside of Brazil until the Brazilian economy starts to improve and Banco Santander Brasil shows signs of its loan quality stabilizing, provisions decreasing and improvements in liquidity.
Disclosure: I am long SAN.