Bill Buhr: Hi, I'm Bill Buhr, IPO Strategist with Morningstar. While the IPO market has been in full swing here in the US, we wanted to take a step back and shift our focus to Brazil, where a gigantic offering is set to make its debut next week. Banco Santander Brazil will offer $7 billion in its IPO. Here to talk with me about the company is Morningstar Equity Analyst Mac Pina. Mac, thanks for joining me.
Maclovio Pina: It's a pleasure.
Buhr: Let's talk a little bit about Brazil's banking market. What are some of the factors that make it so lucrative?
Pina: First of all, it's an oligopoly. So, as any oligopoly, you know that you have a pretty aggressive pricing power. Four banks, only, control about 60 or 70 percent of assets and deposits of the whole system. It's in their best interest to control pricing. The slight caveat here is that there is one of those four banks, Banco do Brasil, who is pretty much government-controlled. So, as has happened in the first half of '09, you have, depending on the political winds, sometimes they'll float the market with below-market interest rates, and things like that tend to happen. But, overall, it's very lucrative because of that.
It's very well-regulated. Since the mid-1990s, several new regulations have come in place which are more conservative and provide tons of good disclosure for investors, so banks tend to pretty much be very cautious in what they do. And given that it's so profitable, you don't have managers needing to go into riskier ventures and search for higher yields, because what they're doing with the current portfolio is pretty lucrative. So, it is a nice business, definitely.
Buhr: What are some of the other positives surrounding this story?
Pina: In particular, with Santander Brazil, what you have is - one, it's part of the Grupo Santander, the Spanish conglomerate's network. Part of what their edge is, when a Brazilian business wants to expand its operations internationally and is looking for a partner, it can actually go to Santander and have access to all that worldwide network, not only Latin America, which is one of the strongest franchises, but around the world. So, that kind of gives it a good edge. Plus, Grupo Santander has plenty of experience with acquisitions and mergers throughout its history, and they have been certainly borrowing part of that with the recent merger with Banco Real. So, it's kind of a good place to be.
Buhr: What are some of the short-term hurdles that Santander Brazil will have to overcome to be successful?
Pina: In contrast with its two main peers, Itau and Bradesco, Santander Brazil's loan book is slightly under-performing. They have larger non-performing loan balances, and their reserves for those balances are lower. Which means that, going forward, as things start turning and things get better, while the other two players will start being able to draw upon their reserves and not have to impact their income statements, Santander Brazil will still have to be replenishing that allowance for loan losses and keep earnings depressed for some time. So, that's definitely one of their setbacks.
Buhr: Now, let's talk about the offering for a minute. You value the shares at about $13 per ADR. What are some of the things that go into your valuation?
Pina: There's definitely a growth story, which largely depends, obviously, on the Brazilian economy. In general, we are projecting pretty nil growth throughout '09. But, in 2010, things are going to start to pick up. Not only because the broader economy is getting better, but also along those lines, there is also better cash flow for the bank's customers, which makes them be able to pay their loans back. And then they also have more penetration, because Brazil is in the emerging markets, one of the least-penetrated markets in terms of credit and insurance. So, you also have that factored in.
However, you also have to take a step back and see, well, what would happen if the government kind of pressures Banco do Brasil to keep interest rates low. That would definitely be a huge blow. That would almost take about a third or almost a half of their fair value away. In the very worst-case scenario, you have rising expenses from the merger last year, and then you have rising loan losses, and then lower yields, which can be pretty much devastating. So, it's interesting to take a full view, but all in all.
And then, naturally, the upside case. It's kind of better growth prospects. They put their money to good use because they are under-leveraged, in our opinion, in the sense that they have much more equity than the other two players. So, they can deploy this equity in a faster pace than the others and not have to resort to capital markets to fund that growth. So, if they find good opportunities to put this money to work, and profitably, they definitely have a very interesting story going forward. And that would pretty much add about five or six dollars to the fair value.
Buhr: Well, Mac, thanks for joining me.
Pina: It's been a pleasure.
Buhr: I'm Bill Buhr with Morningstar. Thanks for watching.