Two Brazilian Banks to Keep on Your Watch List

Amid a global crisis that stemmed from the financial sector, we see strength in two Latin American banks:  Banco Bradesco (BBD) and  Itau Unibanco (ITUB). Apart from their own structural sturdiness, we think Brazil's relatively resilient economy will help sustain these two banking giants' long-term profitability.

To find the foreign financial services firms with the best prospects among our coverage list, we set up a simple screen consisting of basic criteria using Morningstar's  Premium Stock Screener tool. Our selection for this screen focuses on profitability (giving some leeway for the most recent periods) and competitive strength, or our economic moat.  Click here to see the results.

Brazil
We think that after 15 years of progressive reforms, Brazil's economy is more mature and stable than other emerging-market economies and that social unrest is far less likely in this Southern country than in many others. Nonetheless, nobody will deny that this will be a particularly difficult year for Brazil's economy. Shrinking exports and lower spending by individuals will weigh heavily at least for the rest of the year, in our opinion. However, inflation is not shooting up through the roof as in the past, a condition that has allowed the central bank to cut interest rates to counter the downward cycle (see Chart 1).

Despite the expected short-term pain, we think Brazil's economy is diversified enough to help it withstand the global crisis better than other nations. Not only are incomes rising for its expanding middle class, which will fuel plenty of domestic demand (consumption makes up around 60% of the gross domestic product), but also exports are less than 15% of the GDP, making its output less vulnerable to a global slowdown.

Brazilian Equities
In our view, even though there have been and still are some real risks for Brazilian companies, they unnecessarily got hammered along with other equities around the globe at the onset of this crisis. It is true that lower growth prospects and decreasing margins will thwart firms' profitability for some time, so a fall in price was indeed warranted. However, we think that the wildly volatile price fluctuations were more a result of huge investment outflows from the Brazilian market as international investors pulled their money because they needed to cover liquidity constraints elsewhere and they were fearful of "risky" emerging markets, which historically have fared far worse than developed economies.

This time, it appears to be different. Net foreign investment is on the rise after nearly two years of quarterly net outflows and reached almost BRL 10 billion (see Chart 2). Between the summers of 2007 and 2008, the Bovespa market outperformed the S&P 500. But when the real's value fell precipitously in the second half of 2008, Brazilian equities were more heavily punished than other developed markets' as investors wanted to reduce their exposure to this currency. The turning point came in the first quarter of 2009. Since then, we have seen notoriously better performance on the Bovespa than on the S&P (see Chart 3).

Particularly with Brazilian banks, we think their earnings power will not be hindered as much as other global banks'. After decades of economic volatility, in the mid-1990s, the banking system was restructured, and regulation became quite conservative. Indeed, banks have stricter rules regarding capital adequacy and disclosure than in many other nations. The country's banks have very solid capital ratios, and both Itau Unibanco's and Bradesco's tangible common equity is near 7% of tangible assets. To us, this is quite hefty, when compared with the United States' largest banks' average of about 3.5%. Hence, we think these banks will not have to issue new equity at distressed prices to replenish their capital levels.

Further, as banking in Brazil has been very profitable throughout the years, management teams have had no need to pursue risky ventures in search for higher yields. Dwarfing banks in other countries, Brazilian banks' net interest margins (net interest income/average interest-earning assets) have nearly always exceeded 8%, well-above than the 3%-5% norm in the U.S. Obviously, the economic slowdown has taken its toll on margins, which will probably stay depressed for some quarters (see Chart 4).

We think interest margins are quite remarkable. Being a developing economy, one would expect astronomical loan losses tied to such wide spreads, as higher risk commands higher rates. However, subtracting loan losses from interest income and looking at adjusted net interest margins (net interest income less net charge-offs/average interest-earning assets), the panorama does not change much. During the last decade, adjusted net interest margins averaged 9.5% and 9.0% for Itau and Bradesco, respectively. In our opinion, this has greatly to do with the oligopolistic nature of banking in Brazil, where 70% of the system's loans are concentrated in only four banks which, naturally, favor high yields.

Despite their rising trend, loan losses are not likely to get out of control, in our opinion, because of the banks' sensible credit standards and management's reticence to originate loans to less creditworthy customers. At March 2009, net charge-offs stood at an annualized 3.6% and 3.9% of loans for Itau Unibanco and Bradesco, respectively. These are indeed high numbers by U.S. standards, but are not out of the banks' usual range.

 Itau Unibanco (ITUB)
After its recent merger with Unibanco, Itau became Brazil's largest bank. Although we think size by itself is not a worthy trait, we think that an expanded branch network will be quite useful in reaching Brazil's rising middle class and making banking activities pervade throughout the country.

We think this merger is potentially very beneficial for the new institution. On one hand, there's Itau, which has consistently beaten Unibanco in cost control. The latter's efficiency ratio (noninterest expense/revenues) used to be 10 percentage points, on average, above Itau's outstanding 40% ratio. This had a sizable effect on Itau's return on equity which was 3% above Unibanco's average ROE of 23.5%. On the other hand, Unibanco usually outperformed Itau in credit quality. Thus, we think Itau's focus on cost control and profitability combined with Unibanco's underwriting standards will result in one of Latin America's most powerful financial institutions.

In addition, though still incipient, Itau Unibanco also has retail operations outside of Brazil. Currently, loans in other South American countries only represent 5% of its total portfolio, but we see this as another potential growth leg.

 Bradesco (BBD)
Until recently, Bradesco was Brazil's largest non-government-controlled bank (second only to the state's Banco do Brasil). It pursues a "complete bank" model, combining banking and insurance, both contributing roughly equally to the firm's bottom line. Being able to gain more penetration in Brazil's population with a complete suite of financial solutions should maintain Bradesco's profitable long-term growth trajectory, in our view.

As Itau, its main rival, Bradesco has profitably ridden Brazil's economic growth tidal wave. Return on equity averaged 24% during the last decade. Part of it is because of the wide interest margins it enjoys and also its steady noninterest income, which makes up 50% of the bank's revenue.

We think that Bradesco will find it difficult to grow in the near future as Brazil's economy contracts, especially because 60% of its loans are to businesses. Nonetheless, it will also come back strongly because there is plenty of room for growth in the long run, and high margins should remain for several years, in our opinion.

Finally, we think that both banks will find it very useful to have such a wide distribution network. With it, they should be able to snatch from smaller competitors what near-term growth spawns. Moreover, in our opinion, sturdy reserves should give them the muscle to temporarily lower margins, if necessary, in an effort to scare away opportunistic entrants that could offer more attractive teaser rates.

Wait for the Right Price
We like these two Brazilian banks' earnings prospects and would love to own them at the right price. Yes, one can enumerate plenty of risks: lower external demand hindering businesses' revenues, potentially tighter regulation squeezing margins, high unemployment damping internal demand, rising inflation, and so on. Nonetheless, we contend that management has been conservative both at Bradesco and Itau Unibanco and that these banks have the capital necessary to weather the storm and deal with higher loan losses and reduced margins. Additionally, disciplined cost controls should provide a safety net that protects returns even when the top line becomes strained. Naturally, pain in Brazil's economy will be felt at these two institutions, and loan losses will dent profitability for some time. However, we think that the damage these firms will sustain will not be comparable with that at other global banks and that Brazil's economic blow will not be as severe, and the country should recuperate relatively faster than other nations. Another panic bout that results in deeply discounted prices might just be what the patient investor needs to buy these fine institutions.

Don't have a Premium Membership? You can still use our Premium Stock Screener by takinga free, 14-day trial.