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The secret to contrarian value investing is identifying companies that have been oversold by the market, yet have sound financial and operational fundamentals. Instances where these types of companies can be identified include those where particular industries fall out of favor with investors, such as banking and financial services post the global financial crisis (GFC), or where economic and/or political risk has been perceived to be unacceptably high by investors, as was recently seen with the financial crisis in Spain. This triggered a savage sentiment based sell down of Spain's major banks including the country's largest and second largest banks Banco Santander (NYSE:SAN) and BBVA (NYSE:BBVA).

We are now seeing a similar example of this with Brazil which, because of rising political, regulatory and economic risk combined with a significant decline in economic growth, has seen it fall into disfavor with investors. As a result, I have started digging through all of Brazil's major New York Stock Exchange (NYSE) listed companies in an attempt to identify value investment opportunities. In the first article of this series, I popped the hood on Brazil's third largest bank by assets, Banco Bradesco (NYSE:BBD), and while it did represent some value for investors, it certainly didn't represent a solid value investment opportunity. In this article, I am going to take a closer look Banco Bradesco's peer, the world's eighth largest bank by market value and Brazil's second largest by assets, Itau Unibanco (NYSE:ITUB).

Despite recent economic headwinds, financial performance remains strong

Like Banco Bradesco, Itau Unibanco has continued to perform strongly despite the current economic headwinds. While it just missed its forecast third quarter 2012 consensus earnings per share (EPS) of 37 cents, it still delivered impressive financial results. For the third quarter 2012, in comparison to the second quarter (QoQ), Itau Unibanco disappointingly reported a 7% fall in revenue to $11.9 billion.

However, the bank reported a 2% increase in net income to $1.7 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 with 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 5.1%, as the chart below illustrates.

Source data: Banco Bradesco, Itau Unibanco, Banco Santander Brasil, Bank of America & 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.

However, Itau Unibanco's NPL ratio is marginally above what I regard to be a comfortable maximum of 5%. This indicates that there are some issues regarding the bank's asset quality, but the NPL ratio is well below the Brazilian national banking and finance industry average.

It is also the same as Banco Santander Brasil, which, as a result of its poor third quarter results and declining asset quality, has recently seen its share price plunge. However, as this analysis will demonstrate, Itau Unibanco is in a far stronger position with regard to financial performance and liquidity than Banco Santander Brasil, which explains why its share price has not been as badly affected by its relatively high NPL ratio. Investors should also be cognizant of the fact that the majority of the non-performing loans are within Itau Unibanco's consumer lending portfolio. The higher degree of risk in this portfolio is symptomatic of the bank's aggressive expansion into consumer lending and leases for credit cards and consumer durables.

It is these product lines that experienced the greatest consumer demand, with Brazil's strong economic growth fueling the expansion of the country's middle-class and boosting domestic consumption. These lines do not presents the same risks to the bank's solvency and asset quality as commercial loans and mortgages, because they are for lower sums and have a higher margin.

Furthermore, the overall quality of Itau Unibanco's loan portfolio has improved significantly over the last quarter. The number of low risk high quality loans, that is those rated as AA, increased by 1.4% to make up 42.2% of the total portfolio as the chart below illustrates.Source: Itau Unibanco Financial Report September 30, 2012.

As the chart also illustrates, the overall quality of the portfolio has improved with the number of loans rated as being low risk, which is grades AA to C, improving by 10bps to make up 91.1% of the total portfolio.

In conjunction with the NPL ratio being within acceptable limits, Itau Unibanco has a healthy NPL coverage ratio of 149%. While this is inferior to Banco Bradesco's 179% and Citigroup's 203%, it is superior to both Banco Santander Brasil's 136% and Bank of America's (NYSE:BAC) 112% as the chart shows.

Source data: Banco Bradesco, Itau Unibanco, Banco Santander Brasil, Bank of America & Citigroup Financial Statements 1Q11 to 2Q12, Banco Santander Activity and Results 1H12.

Furthermore, with the overall quality of the loan portfolio improving, there is no need for Itau Unibanco to have a high coverage ratio. By maintaining a lower coverage ratio, the economic cost associated with the loan loss provisions is reduced, and this increases the bank's profitability. Although unlike Banco Bradesco, I do not expect Itau Unibanco to be in a position to unwind a significant portion of its provisions during the next quarter because of its lower coverage ratio and higher NPL ratio.

While Itau Unibanco's asset quality, as represented by its NPL ratio, is not at the lower end of the range, it is close to being within acceptable parameters and 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 this indicates that Itau Unibanco is focused on reducing the level of risk in its loan portfolio and improving the overall quality of these assets. While this will be a lengthy process, it is certainly a move in the right direction and should give investors renewed confidence in the bank's asset quality.

Liquidity and capital adequacy are within acceptable parameters

Itau Unibanco is well capitalized with a tier one capital ratio of 12.2%, which is well above the required minimum of 6% and the minimum 10% that investors should be seeking when choosing to invest in a bank. Furthermore, as the chart below illustrates, Itau Unibanco's tier one capital ratio is superior to its Brazilian peer Banco Bradesco but it is lower than many of the major U.S. banks such as Citigroup (NYSE:C) and Bank of America.

Source data: Banco Bradesco, Itau Unibanco, Banco Santander Brasil, Bank of America & Citigroup Financial Statements 1Q11 to 2Q12, Banco Santander Activity and Results 1H12.

* Banco Santander Brasil factors goodwill into its tier one capital calculation.

When considering tier one capital ratios, investors need to be cognizant that this capital, while a good indicator of a bank's capital adequacy, carries with it an economic cost. This cost not only relates to the accounting cost of carrying the capital on the balance sheet, but also the lost opportunity from not being able to use that capital for revenue generating purposes. Therefore, it is important for banks to ensure that they retain sufficient capital to meet their capital adequacy requirements, while reducing the economic cost by ensuring there isn't excessive capital allocated.

In the case of Itau Unibanco, I believe that its tier one capital is being well managed, with it exceeding the minimum required, as well as being above the minimum desirable level for investors. Yet the bank is not over utilizing capital to promote an unnecessary level of capital adequacy, therefore minimizing the economic cost incurred.

Another aspect of Itau Unibanco that I like is its solid level of liquidity as measured by its loan-to-deposit ratio which, at almost 94%, is almost within what is perceived to be the optimal range of 95% to 105% as the chart below shows.

Source data: Banco Bradesco, Itau Unibanco, Banco Santander Brasil, Bank of America & Citigroup Financial Statements 1Q11 to 2Q12, Banco Santander Activity and Results 1H12.

Generally, 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. In addition, any loan-to-deposit ratio that is less than 100% shows that the bank is less reliant upon wholesale funding. This essentially means that Itau Unibanco is less exposed to the vagaries of short-term credit markets and interest rate movements, which have the potential to impact its profitability.

For all of these reasons in comparison to its peers, Itau Unibanco's loan-to-deposit ratio is particularly good and indicates that it has superior liquidity to its Brazilian peers, such as Banco Bradesco and Banco Santander Brasil with ratios of 114% and 134% respectively.

Operating efficiency and profitability remain high

The efficiency ratio is a measure of a bank's profitability; it essentially measures how efficiently a bank is able to generate revenue for every dollar of expenses incurred. Generally, the lower the ratio, the more cost-efficient and productive a bank is at generating revenue, with a ratio of 50% or better seen as being optimal.

However, investors also need to be aware that a bank may have a poor efficiency ratio because it has established a higher cost strategy to expand its business or maximize margins. Furthermore, typically, Latin American banks in comparison to their U.S., U.K., or Canadian counterparts have significantly better efficiency ratios because they operate in a lower cost operating environment, particularly with regard to labor costs.

As the chart below illustrates, Itau Unibanco has an efficiency ratio of almost 46%, which is below the 50% mark, placing it in the generally accepted optimal range. But it is not operating as efficiently as its Brazilian peers Banco Bradesco or Banco Santander Brasil, with ratios of 42% and 45% respectively. It is also well under the efficiency ratio of its U.S. peers such as Citigroup and Bank of America.

Source data: Banco Bradesco, Itau Unibanco, Banco Santander Brasil, Bank of America & Citigroup Financial Statements 1Q11 to 2Q12, Banco Santander Activity and Results 1H12.

Itau Unibanco's focus on costs has also been paying off, with its efficiency ratio falling by around 3% since the end of 2011. Combined with a focus on improving asset quality, this should see the bank's profitability improve over the short to medium-term, meaning that the bank will be able to deliver better value for investors. This will assist the bank in delivering a credible return-on-equity (ROE) for shareholders but this will also depend on Itau Unibanco being able to maintain a solid net interest margin (NIM).

In fact, at this time, one of the biggest pressures affecting profitability for Brazilian banks is margin squeeze. Basically, this can be attributed to the official interest rate, the Selic Rate, tumbling to a low of 7.25% in early October 2012, with it more than likely to fall further as Brazil's economy fails to be stimulated by easing monetary policy and further stimulus measures.

But despite this pressure, Itau Unibanco, like its Brazilian peer Banco Bradesco, is continuing to deliver a solid NIM of around 7%. This as the chart below illustrates is more than double many of its U.S. peers as well as being 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, Bank of America & Citigroup Financial Statements 1Q11 to 2Q12, Banco Santander Activity and Results 1H12.

*Represents the Selic Rate that applied at the end of each quarter.

Of some concern, though, is that Itau Unibanco's NIM has declined by almost a full percentage point since the end of 2011 and it is likely to decline further in the fourth quarter given the recent cut in the Selic to 7.25%.

At the end of the third quarter, Itau Unibanco was delivering an impressive double digit ROE of almost 18%. But this represents an almost four full percentage point decline in its ROE since the end of 2011, and this can be attributed to pressure on its NIM as discussed.

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 financials.

Itau Unibanco, along with its Brazilian peers, despite declining profitability caused by margin pressure, is still delivering a ROE that is superior to many of their U.S. peers, such as Citigroup and Bank of America. Their ROE is also superior to the U.S. national average ROE of 8.5% for similar size U.S. domiciled banks.

Despite the decline in Itau Unibanco's ROE, I expect it to stabilize with the bank's increased focus on costs and improving the quality of its loan portfolio, which should increase efficiency and profitability.

The macro environment, market outlook and country risk remains poor for the foreseeable future

In my Bradesco article, I discussed the outlook for Brazil's economy in some depth and I don't believe there is any need to duplicate that discussion here. Suffice to say, that over the short term, operating conditions in Brazil will remain difficult as the economy continues to slow despite the government easing monetary policy and implementing a broad range of stimulus measures. Much of this can be attributed to Brazil's dependence on China and the European Union as key export markets along with structural economic and demographic issues. Obviously, this will affect the profitability of Brazil's banks for the short to medium-term until the economy starts to grow strongly.

I also discussed growth opportunities for banks in Brazil, and concluded that despite Brazil still being significantly under-banked particularly in comparison to Chile and other more mature emerging markets, there is very little opportunity for expansion due to structural economic and demographic issues. In addition to the economic and investment risks associated with Brazil and the country's banks, the degree of political risk in the country has increased significantly. These risks were again covered in the article on Banco Bradesco (see here for that discussion) but in summary primarily relate to:

  1. growing government intervention in the economy;
  2. a conscious effort by the government to shift a significant portion of the cost of its populist social programs to the private sector through taxation;
  3. poor infrastructure, which is acting as an economic choke point;
  4. growing social unrest, which is increasing the cost of doing business and increasing the socialist populism of the Rousseff government;
  5. increasing pressure on banks to reduce lending standards and margins in an effort to make credit more obtainable, as a means of boosting the money supply; and
  6. growing currency risk with the real weakening considerably against the US dollar as the Brazilian economy slows and interest rates fall.

Each of these points highlight the type of risks that investors must be aware of when choosing to invest in an emerging market and particularly in Latin America, which has a long history of economic nationalism. For further detail of the risks faced by investors in Brazil, I have provided a deeper analysis in an article I published earlier this year The Return of Economic Nationalism and Rising Investment Risk in Brazil. But in summary, it is essential that investors understand the risk reward tradeoff and seeking quality investments with a higher than standard equity risk premium.

Shareholder remuneration

At the time of writing, Itau Unibanco's shareholder remuneration plan, based on paid and planned dividend payments for 2012, comes to a yield of around 1.4% before withholding tax. This is paid in accordance with the bank's shareholder remuneration policy, which requires it to pay out a minimum of 25% of its net income to shareholders. This is not a spectacular yield for a bank, but it is superior to its Brazilian peer Banco Bradesco and U.S. domiciled peers Citigroup and Bank of America, with yields of 0.10% and 0.40% respectively. However, it is significantly less than Banco Santander Brasil's dividend yield of around 5%.

Itau Unibanco, like Banco Bradesco, pays its dividend monthly, and has been consistently paying a dividend since 1997. The bank's ten year dividend payment history is set out in the chart below. The last announced payment was on 28 September 2012 and was for $0.007 net of withholding tax.
Source date: Itau Unibanco Investor Relations

The chart shows that Itau Banco has increased its dividend over the last ten years, but for 2012, at this time, it would appear that the dividend is lower than what has been paid historically. This may change with the bank deciding to make additional interest on shareholder equity (or capital) payments or bonus dividend payments after full year results have been reported. The dividend payment is composed of two parts, firstly a dividend payment, which under Brazilian law is withholding tax exempt and an interest payment on shareholder equity (or capital), which is subject to 15% withholding tax.

While the low dividend yield makes the bank an unsuitable investment for income investors, it does mean that the bank is reinvesting a greater portion of its earnings. This should see the share price grow as the bank's value grows from expanding its business.

Future outlook and valuation

At the time of writing Itau Unibanco is trading with a trailing twelve month (TTM) price-to-earnings (P/E) ratio of around 9, which is similar to Banco Bradesco with a TTM P/E of just under 10. This makes it appear more expensive than Banco Santander Brasil with a P/E of 8 but cheaper than Citigroup with a P/E of 11 and significantly cheaper than Bank of America, which has a P/E of 26.

However, Itau Unibanco is trading at a 116% premium to its tangible book value per share, whereas Banco Bradesco is trading at a 123% premium and Banco Santander Brasil is trading roughly on par with its tangible book value per share. However, both Citigroup and Bank of America are trading at significant discounts to their tangible book value, 30% and 446% respectively. But investors need to be reminded that Citigroup and especially Bank of America are still dealing with significant liabilities and operational issues arising from the subprime lending crisis.

While this indicates that Itau Unibanco 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. Therefore, I have valued the bank using two valuation models, firstly an excess return model, using Itau Unibanco's tangible book value plus retained earnings over a ten year period. The second model used is the dividend discount model, which is generally the more accepted and popular model for valuing a bank. From these models I have attempted to determine a fair value for Itau Unibanco.

Excess return valuation

In this model I have determined Itau Unibanco's tangible book value by stripping out the value of its intangible assets and goodwill. I have then, using its payout ratio, projected return on equity, cost of equity and future growth prospects, applied a discount methodology to determine the present value of its future retained earnings over the next ten years. This has then allowed me to calculate an indicative fair value of almost $21 as shown by the chart below.I have determined this valuation using some relatively conservative assumptions. These include discounting Itau Unibanco's return-on-equity from its seven quarter historical average of 21% to 15% over the course of the valuation and using a cost of equity of 10%.

I have also applied a discount rate that equals the weighted average cost of capital for Brazilian banks of around 7% and allows for a moderate rate of annual economic growth of 4%. I have done this in an effort to factor in the decline in revenue within the Brazilian banking sector and falling profitability caused by the economic slowdown, falling margins and increasing government intervention.

With Itau Unibanco trading at around $15 at the time of writing this indicative valuation represents a 40% upside for investors. However, while this is my preferred methodology for valuing a bank, the generally accepted methodology is the dividend discount model, which is set out 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 $19 for Itau Unibanco as set out in the chart below.This indicative fair value represents a 27% upside to Itau Unibanco's share price of around $15 at the time of writing. While this upside is not as high as that indicated by the excess return valuation, it does demonstrate that there is considerable upside for long-term value investors.

Bottom line

It is clear that despite some issues relating to asset quality, Itau Unibanco is well capitalized, with a high degree of liquidity, and continues to operate very efficiently and deliver solid profitability. When it is considered that the bank is focused on reducing the degree of risk in its lending portfolio combined with its strong financial performance in a difficult operating environment, it presents a compelling investment opportunity.

Furthermore, despite trading at a premium (116%) to its tangible book value per share, it is trading with a P/E of around 9, which does make it look cheap in comparison to its peers. When this is considered in conjunction with the forward looking indicative valuation range of $19 to $21, which gives investors a potential upside of between 27% and 40%, Itau Unibanco presents a compelling value investment.

I also believe that this thesis still holds, even when the heightened political and economic risk in Brazil is taken into account, as it gives investors the opportunity to generate solid upside while still having a solid safety margin. Accordingly, for those risk-tolerant investors seeking exposure to the banking sector of Latin America's largest and the world's fifth largest economy, Itau Unibanco presents a credible opportunity.

Source: Seeking Contrarian Value In Brazil: Itau Unibanco Shows Potential Despite Rising Risk In Brazil