After nearly a decade of phenomenal economic growth, Brazil's economy has faltered. This can be attributed to a variety of factors, the most salient being: falling commodities demand from China, declining global demand for Brazil's manufactured goods, structural economic inefficiencies created by excessive economic protectionism, and the government's overly interventionist approach to economic management. All of the factors have led to some market pundits to now caution investors against investing in Brazil, particularly when all of these factors are having a significant impact on the performance of companies operating in Brazil.
However, it is in these moments that contrarian and astute investors are able to uncover compelling value investment opportunities. With this in mind, over a series of articles, I have set out to uncover opportunities for investors among those Brazilian companies that are currently listed on the New York Stock Exchange (NYSE). In this the first of those articles, I have set out to analyze Brazil's third-largest bank by assets, Banco Bradesco (NYSE:BBD), in order to determine whether it presents as a value opportunity for investors.
Despite recent economic headwinds, financial performance remains strong
Unlike some of the other privately owned Brazilian banks such as Banco Santander Brasil (BSBR), which I recently covered, Banco Bradesco has continued to perform strongly relative to the difficult operating environment. This is despite the bank just missing its third quarter 2012 consensus earnings per share (EPS) of 37 cents.
For the third quarter of 2012, Banco Bradesco reported, in comparison to the second quarter (QoQ), a 9% increase in revenue to $12.8 billion. It also reported a 1% increase in net income to $1.4 billion for the same period. Another positive indicator with regard to the bank's financial performance was that its balance sheet strengthened, despite cash and cash equivalents falling 7% QoQ to $6.4 billion. This is because the bank was able to reduce its long-term debt by almost 16% QoQ to $445.6 million and loan loss provisions remained stable at around $10.3 billion. This, I believe, is a remarkable achievement given the difficult operating environment being experienced by banks in Brazil.
Asset quality remains within acceptable parameters
Despite the difficult operating environment, Banco Bradesco's asset quality has remained high. The bank's non-performing loan ratio (NPL), a key measure of asset quality, fell by 10bps QoQ to 4.1%, as the chart below illustrates.
Source data: Banco Bradesco, Itau Unibanco, Banco Santander Brasil & Citigroup Financial Statements 1Q11 to 2Q12, Banco Santander Activity and Results 1H12, Banco Central d Brasil.
* Third quarter 2012 is an estimate only based upon preliminary national financial system credit data.
Banco Bradesco's NPL ratio is well within acceptable parameters and well below the Brazilian national banking and finance industry average. It is also well below that of its major, privately owned, Brazilian peers Itau Unibanco (NYSE:ITUB) and Banco Santander Brasil, although it is almost double that of global peer Citigroup (NYSE:C).
In conjunction with the NPL ratio being within acceptable limits, Banco Bradesco has a healthy NPL coverage ratio of 179%. This is significantly higher than either Itau Unibanco or Banco Santander Brasil and it has increased significantly over the last quarter as the chart shows.Source data: Banco Bradesco, Itau Unibanco, Banco Santander Brasil & Citigroup Financial Statements 1Q11 to 2Q12, Banco Santander Activity and Results 1H12.
This substantial increase can be attributed to Banco Bradesco's non-performing loans falling and indicates that the bank may be in a position to unwind a portion of its provision during the final quarter of 2012. This will obviously boost its profitability and assist the bank with achieving full year forecast earnings.
While Banco Bradesco's asset quality, as represented by its NPL ratio, is not at the lower end of the range, it is still well within acceptable parameters and below the 5% marker. This is the level at which a bank is believed to have a high risk poor quality loan portfolio, with the potential to significantly impact its financial performance. All of which indicates that Banco Bradesco, despite the difficult operating environment and earlier high demand for credit in Brazil, has remained focused on quality and building a sustainable loan portfolio.
Liquidity and capital adequacy are within acceptable parameters
Another aspect of Banco Bradesco that is appealing is its solid capital adequacy and high liquidity. Currently, as illustrated by the chart below, the bank has a tier one capital ratio of 11.3%. This is well above the required minimum tier one capital ratio of 6% and is also higher than the minimum 10% that investors should be seeking when choosing to invest in a bank. Source data: Banco Bradesco, Itau Unibanco, Banco Santander Brasil & Citigroup Financial Statements 1Q11 to 2Q12, Banco Santander Activity and Results 1H12.
* Banco Santander Brasil factors goodwill into its tier one capital calculation.
Despite Banco Bradesco's tier one capital ratio being well within acceptable limits, it is lower than many of its Brazilian peers, including Itau Unibanco and Banco Santander Brasil.
However, there is an economic cost attached to tier one capital and it does affect profitability, which makes it important for banks to ensure they balance their need for capital adequacy with the economic cost incurred. In the case of Banco Bradesco, I believe that is being well managed, with tier one capital exceeding the minimum required and the level which is generally perceived to be the acceptable minimum. Yet the bank is not over utilizing capital to promote an unnecessary level of capital adequacy, therefore minimizing the economic cost incurred.
Disappointingly, Banco Bradesco's level of liquidity is moderate, with the bank's loan-to-deposit ratio at 114%, which is outside of what is considered to be the optimal range of 95% to 105%, as illustrated by the chart below.Source data: Banco Bradesco, Itau Unibanco, Banco Santander Brasil & Citigroup Financial Statements 1Q11 to 2Q12, Banco Santander Activity and Results 1H12.
This is considered to be the optimal range because it allows a bank to generate the maximum benefit from its deposit base, while ensuring sufficient liquidity to cope with extraordinary or unplanned events.
As the chart also shows, Banco Bradesco's loan-to-deposit ratio is also inferior to many of its peers, with only Banco Santander Brasil having a significantly lower level of liquidity. This means that Banco Bradesco is more reliant upon wholesale funding than many of its peers, leaving it exposed to movements in interest rates which have the potential to impact profitability.
Despite the current ratio being within acceptable risk tolerances, given the current global headwinds combined with Brazil's economic malaise and a lower global appetite for leverage, a lower ratio would be more desirable. Of further concern is that over the last four quarters the ratio has increased, indicating ongoing deterioration in the bank's liquidity level. This is a somewhat worrying trend, but can be expected as the Brazilian economy has continued to deteriorate over the same period, which has seen deposit growth decrease.
Operating efficiency and profitability remain high
Despite the difficult operating environment, Banco Bradesco's consistent focus on cost control is enhancing the bank's ability to efficiently grow revenue and maintain profitability. As the chart below illustrates, historically the bank has delivered an outstanding efficiency ratio, which despite marginally deteriorating QoQ is still at around 42%.Source data: Banco Bradesco, Itau Unibanco, Banco Santander Brasil & Citigroup Financial Statements 1Q11 to 2Q12, Banco Santander Activity and Results 1H12.
This efficiency ratio is one of the best among its peers and is well within the range I have come to expect for banks operating in Latin America. Generally, these banks have superior efficiency ratios to their European and U.S counterparts because they are operating in a lower cost, lower contact and service intensive environment, leading to lower operating costs.
One of the biggest pressures currently affecting the profitability of Brazilian banks is margin squeeze. This can be predominantly attributed to the substantial fall in the official interest rate, the Selic Rate. By the end of the third quarter 2012, it had dropped by 4.25% since the end of the first quarter 2011 to be 7.5%, placing considerable pressure on the net interest margin (NIM) of Brazil's banks. It is likely that this pressure will continue, with the Banco do Brasil earlier this month reducing the Selic Rate by 25 bps to 7.25% and further rate cuts are likely as Brazil's economic malaise deepens.
However, despite this pressure, Banco Bradesco, along with its Brazilian peer Itau Unibanco, continues to deliver a solid NIM. As the chart below shows, Banco Bradesco is delivering a NIM of 7.4%, which is significantly higher than many of its global peers that operate in Latin America, such as Citigroup. It is also more than double the industry wide NIM of 3.29% for similarly sized U.S commercial banks.Source data: Banco Bradesco, Itau Unibanco, Banco Santander Brasil & Citigroup Financial Statements 1Q11 to 2Q12, Banco do Brasil.
*Represents the Selic Rate that applied at the end of each quarter.
While the bank's net interest margin has declined marginally over the last quarter, along with facing renewed margin pressure from a lower official rate, I expect its NIM to remain stable. I have taken this view because Banco Bradesco has focused on improving its funding mix and reducing funding costs in order to support its margin.
However, for these same reasons, I expect to see further pressure being applied to the bank's profitability, which will place further downward pressure on the bank's exceptional double digit return-on-equity (ROE) of 19%. Source data: Banco Bradesco, Itau Unibanco, Banco Santander Brasil & Citigroup Financial Statements 1Q11 to 2Q12,
NB: Citigroup's ROE is indicative only and based on preliminary financial data.
But despite this downturn in the bank's profitability, it is still performing strongly in comparison to its peers, as evidenced by an ROE that is superior to its Brazilian peers such as Itau Unibanco and Banco Santander Brasil, and global peers like Citigroup. Furthermore, this ROE is more than double the industry average of 8.5% for U.S. commercial banks of a similar size. This indicates that Banco Bradesco is performing strongly despite the global headwinds that have affected the profitability of its global peers.
The exceptional ROE can be attributed to the bank's high asset quality, outstanding efficiency ratio and low funding costs. All of which, allows it to maximize its margins and leverage profitable returns from its lending operations.
Macro environment and market outlook
Undoubtedly the recent performance of the Brazilian economy has been extremely disappointing for investors. When this is considered in conjunction with increasing political risk in the country, it is starting to appear as a very unappealing investment location. As illustrated by the chart below, Brazil's GDP growth has slowed considerably from a high of 7.56% in the third quarter 2010 to 1.4% in the second quarter of 2012.
NB: Third quarter September 2012 GDP growth rate is an estimate only.
The chart also illustrates the clear correlations between the performance of the Brazilian economy, the demand for commodities and Chinese economic growth. It is the falling demand for commodities and China's slowing growth that have been key reasons for Brazil's declining economic performance. This indicates that it is highly unlikely that there will be a significant uplift in Brazilian economic activity until China's rate of economic growth increases.
Brazil's dependence upon the exportation of commodities as a means of growing the economy becomes even clearer when its key exports are analyzed. Almost 40% of Brazil's total exports are comprised of commodities, with iron ore being the single largest export product, making up 17% of total Brazilian exports as illustrated by the chart below. Source data: Banco Central do Brasil.
The reliance upon China becomes yet clearer when analyzing Brazil's key export partners. China, as the chart below shows, receives 18% of all exports making it the second largest export partner after the European Union.
The European financial crisis has also had a significant impact on demand for Brazilian exports and it is this, in combination with the Chinese economic slowdown, which has had a significant impact on Brazil's economy. This has seen many analysts downgrade their expectations for Brazil's economic growth, with many now estimating that full year 2012 GDP growth will be around 1.6%. This is well below the 3% GDP growth , which was originally forecast by the IMF in January 2012.
The falling demand for credit will continue to hurt growth and profitability
As a result of the slowing economy, consumer demand for credit is decreasing, putting a damper on the profitability of Brazilian banks. It was this explosive growth in consumer credit that was a driver of both economic growth and profitability within Brazil's banking sector. In addition, the economic slowdown has affected other businesses in Brazil and this has also seen the demand for corporate credit fall.
I am also expecting, over the short term, for the level of non-performing loans to rise until the economy improves, as households come under greater financial pressure. However, interestingly despite the significant slowdown in the economy, there hasn't been a significant jump in unemployment. In fact as the chart below illustrates, by the end of August 2012, Brazil had an unemployment rate of 5.3%, which is a 0.7% year-on-year (YoY) decrease and a 0.2% fall since January this year. Source data: Banco Central do Brasil.
This bodes well for the future loan default rate and indicates that the national NPL rate should stabilize over the medium term, unless there is a significant jump in unemployment. I would also expect this to further increase the likelihood of Brazil's banks being able to gradually release loan-loss provisions over the medium term as the NPL ratio stabilizes.
The consensus view is that through 2013 there will be a gradual recovery in the global economy, which will occur in conjunction with a gradual uptick in economic momentum in China resulting from its stimulus program. This bodes well for an uptick in economic growth in Brazil, particularly when the recent IMF view for Latin America is taken into account.
As part of its 2013 global economic forecast, the IMF has predicted an appreciable increase in economic activity in Brazil because of the easing of monetary policy combined with ongoing government stimulus. All of this bodes well for Banco Bradesco's ability to not only reduce its NPL ratio and improve loan quality, but also grow its loans and deposits creating further opportunities for profit growth.
Despite being under-banked, there appears to be little room for further banking sector growth
On the surface, Brazil presents as having considerable opportunity for banks to continue growing their market share because the country is still under-banked in comparison to many other emerging markets. The chart below illustrates this, showing that Brazil has a private sector credit as a percentage of GDP being only 61%, which despite being the second highest in Latin America after Chile is substantially lower than developed countries.Source data: World Bank, Banco do Brasil.
However, in my recent analysis of Banco Santander Brasil, I took the view that despite Brazil being significantly under-banked, is unable to support a higher level of banking penetration due to demographic and structural economic issues. A key requisite for a country to develop a mature banking and finance system is the need for a broad based middle-class. Despite the significant efforts made by the Brazilian government with regard to poverty alleviation, the country is still a long way off from developing such a middle-class.
By lacking this broad based middle-class and the domestic consumption driven economy that comes with it, there is a natural cap placed on loan and deposit growth for banks in the economy. Illustrated clearly by the chart below, showing how average incomes and spending power increases, as the inequality in wealth and income decreases.Source data: World Bank, International Labor Organization.
This inequality is represented by the Gini Co-efficient, which measures income and wealth inequality on a scale of 0 to 1 with 0 being the most equitable and 1 the least. As the chart shows, Brazil has a Gini Co-efficient of 0.52, which is one of the highest in Latin America. It also has an average monthly income adjusted for purchasing power parity of $709, which is lower than Chile or Argentina and considerably lower than the developed markets of the U.S. and U.K.
All of which, indicates that there are still considerable segments of the Brazilian population living near, on or below the poverty line, indicating that they would not be capable of taking advantage of the banking services available. It also indicates that Brazil is unable to support a private sector credit to GDP ratio of higher than around 60%, until there are further structural and social reforms.
There are also other constraints on economic growth emerging including significant structural economic barriers, which have emerged particularly under the presidency of Dilma Rousseff. These include increased government intervention in the economy, growing protectionism and increased bureaucracy, which are deterring investment and creating inefficiencies in the economy. With regard to banks, this includes increasing competition from state owned and financed institutions along with increasing governmental pressure to make credit more easily available and low cost as a means of stimulating economic activity.
As such I do not believe that Banco Bradesco will be able to easily grow market share and profitability over the short to medium-term. But unlike many of the other privately owned banks in Brazil, its sheer size and market share leave it well positioned to take advantage of any rebound in the Brazilian economy.
Brazilian country risk continues to grow
Alongside the economic issues currently being experienced in Brazil, there are a number of other risks that investors need to consider when making an investment in a Brazilian bank. These not only arise from the typical risks associated with investing in Latin America, but also signs of growing political risk in Brazil as the Rousseff government moves to a more interventionist agenda.
The degree of risk obviously increases for investors to a level significantly higher than that associated with investing in U.S. based companies, but for those with a strong appetite for risk, it does provide an opportunity to get in on the ground floor. The key risks, besides the economic risks that investors in Brazil need to be cognizant of are:
- Growing signs that the Rousseff government is increasingly seeing government intervention as a valid tool for managing the economy. To date this has been focused on natural resources, land and manufacturing, but there are signs of increased pressure being applied to private banks to make credit cheaper and more freely available as part of a broader effort to stimulate the economy.
- Brazil was rated in the Transparency International 2011 Corruption Perception Index at 73rd, out of a possible 182, where the higher the ranking the greater the perceived degree of corruption. I would also expect this rating to worsen in the 2012 index primarily because of the increasing political risk and governmental intervention in the economy.
- Increasing signs that the government is attempting to shift a greater portion of the financial burden of its expansive social programs from the public sector to the private sector. It is doing this through increased taxation and other punitive measures. An example of this is the ongoing royalties and taxation disputes that Vale (NYSE:VALE), Brazil's second-largest company, has become embroiled in.
- With the economy in decline, taxation revenues have also fallen and this has seen the government move to increasing the taxation burden on the private sector through interventionist measures to increase the inflow of much needed revenue. This can be attributed to the financial pressures created by the government's ambitious social programs along with the funding requirements for the World Cup and Olympic preparations.
- Brazil continues to suffer from poor infrastructure, and this is acting as direct impediment to economic growth.
- There have been increasing incidents of social unrest and strikes, which are causing significant disruption to the economy.
- Another broader based risk for banks, in general, is a lower global risk tolerance to credit and leverage. This is seeing greater regulatory pressure brought to bear on financial institutions, particularly with regard to regulation. This has seen Latin American governments become increasingly focused on ensuring their regulatory frameworks comply with international standards. All of which, adds to the regulatory burden and associated costs for banks.
As these risks highlight, investing in emerging markets always brings increased risk for investors, and of late the actions of the Brazilian government have clearly underscored this risk. Therefore, it is important that investors are not only aware of the risk but are capable of tolerating that level of risk prior to investing. This also requires investors to ensure that they receive an additional premium for this risk, over and above the standard equity risk premium.
Banco Bradesco, at the time of writing, is paying a shareholder remuneration plan with a nominal trailing-twelve-month yield of 0.70% before withholding tax. This is paid in accordance with the bank's shareholder remuneration policy, which requires it to pay out a minimum of 30% of its adjusted net income to shareholders. This yield is substantially greater than Citigroup's 0.10%, but half of Itau Unibanco's 1.4% and significantly less than Banco Santander Brasil's dividend yield of around 5%.
Banco Bradesco pays its dividend monthly and has been consistently paying a dividend since 1994, and the bank's ten-year dividend payment history is set out in the chart below. The last announced payment was on 2 October 2012, which was for just under one cent.Source date: Banco Bradesco Investor Relations.
One salient point illustrated by the chart is that Banco Bradesco has cut its dividend since the global financial crisis and given the current economic slowdown in Brazil, I wouldn't be expecting it to increase within the foreseeable future.
Investors should also be aware that the shareholder remuneration is composed of two different parts, a dividend payment and an interest payment on shareholder equity. Under Brazilian law, those shareholder remuneration payments classified as dividend payments, are withholding tax free, whereas those classified as interest on shareholder equity, are held to be interest payments and attract a withholding tax of 15%.
While the low dividend yield makes the bank in all likelihood an unsuitable investment for income investors, it does mean that the bank is reinvesting a greater portion of its earnings. The likelihood increases that the bank will be able to continue growing its business and reward investors through a higher share price.
Future outlook and valuation
Banco Bradesco, at the time of writing, is trading with a trailing twelve month (TTM) price-to-earnings (P/E) ratio of 10. This is similar to its Brazilian peer Itau Unibanco which also has a TTM P/E of 10, but lower than Banco Santander Brasil and Citigroup, which have TTM P/Es of 16 and 15, respectively.
While this indicates that Banco Bradesco is relatively cheap in comparison to its peers, I don't believe that it is possible to value a bank solely on financial ratios because they are backward looking in nature. Furthermore, they do not give a forward looking indication as to the state of the business or its future earnings potential.
Accordingly for Banco Bradesco, I have conducted two valuations, the first using an excess return model based upon Banco Bradesco's tangible book value plus retained earnings. For the second methodology, I have used the dividend discount model, which is generally the more accepted and popular model for valuing a bank. I have then used these valuations to form a view as to Banco Bradesco's indicative fair value.
Excess return valuation
In this model, I have determined Banco Bradesco's tangible book value by stripping out the value of its intangible assets and goodwill. I have then, using its payout ratio, cost of equity and a discount methodology, determined the present value of its future retained earnings over the next ten years to calculate an indicative fair value of almost $20 as shown by the chart below.
With Banco Bradesco trading at around $16 at the time of writing, this indicative valuation represents a 26% upside for investors. I have also made some relatively conservative assumptions when constructing this valuation, heavily discounting Banco Bradesco's return on equity from its historical average of 22% to 14% over the course of the valuation. I have done this in an effort to factor in the decline in revenue within the Brazilian banking sector caused by the economic slowdown and increasing government intervention.
With Banco Bradesco trading at around $16 at the time of writing, this indicative valuation represents a 26% upside for investors. However, while this is my preferred methodology for valuing a bank, the generally accepted methodology is the dividend discount model and I have also valued Banco Bradesco using this methodology below.
Dividend discount valuation
Using the dividend discount model again, coupled with the same conservative assumptions used in the retained earnings model, I have calculated an indicative fair value of around $18 for Banco Bradesco as set out in the chart below.
This indicative fair value represents a 14% upside to Banco Bradesco's share price of around $16 at the time of writing. This would appear to indicate that at this time the market has fairly valued Banco Bradesco. This discount represents the usual movement to be expected in the share price when allowing for changes in the market price because of market sentiment, liquidity and profit taking by investors.
Banco Bradesco is an impressive high performing Brazilian bank and one of the consistently strongest performing privately owned banks in Brazil. It is undeniable that its laudable efficiency ratio, solid double digit return-on-equity and solid net interest margin in combination with the bank's enviable market position give it solid growth prospects. In my view of greater importance is that all of the bank's key risk indicators show that asset quality, capital adequacy and liquidity are well within acceptable parameters.
Furthermore, its P/E ratio of 10 indicates that it is cheap in comparison to many of its peers, but it is also trading at around double its book value, which with a forward-looking indicative valuation range of $18 to $20, indicates there is only a moderate upside for investors. When this is considered in conjunction with the increasing political risk in Brazil and the country's slowing economy, I do not believe that Banco Bradesco represents a 'deep value' opportunity for investors.
In addition, its low dividend yield combined with this higher degree of risk makes it unsuitable for income seeking or low to moderate risk investors. While it is certainly a credible investment for those investors seeking exposure to Brazil's banking sector, I believe that there are superior lower risk investment opportunities for investors seeking banking exposure in Latin America.