Time to Bet on This Brazilian Bank?

As we mentioned last week, Banco Santander Brasil will put together one of the largest IPOs of the year, attempting to raise almost $7 billion. We think the offering itself is fairly valued, and worth $13 per ADR, roughly in the middle of its offer range.

At the same time, we think Santander Brasil is primed to benefit from opportunities in Brazil's lucrative banking market. With the shares set to begin trading this week, Morningstar equity analyst Maclovio Pina presents his investment thesis on the bank below:

"Santander Brasil is the smallest member of Brazil's lucrative four-bank oligopoly, which controls about 60% of the system's assets. As with  Itau Unibanco (ITUB) and  Banco Bradesco (BBD), we think Brazil's conservatively regulated and highly profitable banking system, along with the country's attractive demographics, will provide lush grounds for Santander Brasil to profitably grow in years to come despite the short-term challenges it faces.

" Banco Santander Central Hispano (STD), Spain's largest bank, remains the majority stakeholder of Santander Brasil, a trait we view as an advantage. In our opinion, the Brazilian subsidiary benefits from the well-run Spanish group's vast experience in integrations and expansions. A clear example is its massive integration with Banco Real, which was purchased from ABN AMRO in 2008. Although far from finished, it has come a long way, with improvements in efficiency already surfacing. Further, the Spanish bank's broad reach, particularly in Latin America, often makes Santander Brasil the institution of choice when Brazilian businesses need a bank to help them develop their operations beyond their native country. We think this puts Santander Brasil in a unique position to gain market share.

"Both credit and insurance penetration are relatively low in Brazil, and all banks are aggressively courting Brazil's growing middle class. In our view, Santander Brasil is especially well-positioned to take advantage of this growth, as the bank is under-leveraged with its equity base equal to a whopping 20% of its assets (roughly twice Itau Unibanco and Bradesco). In our view, it has plenty of funds to deploy through building more branches and growing its loan book without resorting to heavy future equity raises.

"While its future prospects are promising, Santander Brasil will have to successfully deal with some short-term woes. The Brazilian economy seems to have stabilized, yet we think growth in the near term will be challenging. In addition, the effects of the downturn are still being felt as non-performing loans continue to rise and are now around 8% of loans. In contrast with its peers, Santander Brasil's allowances for bad loans cover only about 80% of non-performing loans (vs. 140% and 120% at Itau Unibanco and Bradesco, respectively). We think this will result in its competitors posting higher profitability, allowing them to draw down their reserves right after loan losses peak, whereas Santander Brasil will be somewhat restrained from doing so as it rebuilds its allowance.

"All in all, we like Santander Brasil's prospects. As long as it refrains from growing for growth's sake, without safeguarding profitability or relaxing its credit standards, we think the bank will become an increasingly important player in this attractive market."

Mac uses a probability-weighted scenario analysis to arrive at his fair value estimate of $13 per ADR, explained below:

"Our base case (60% probability) projects net charge-offs continue to rise in 2009 and remain quite elevated during 2010, at 4.7% and 4.3% of loans, respectively. We expect a low asset growth rate of 6% for 2009, increasing to around 13% next year as the Brazilian economy picks up. The downside case (25% weight) has loan losses deteriorating and reaching 5.5% and 4.9% of loans in this year and the next, respectively. In this scenario, we think the bank would also find organic expansion much more difficult, and growth would amount to about half of that in the base case. Both loan losses and growth reflect a much stronger economy in our upside case (15% chance). As businesses' and households' finances regain their former health, they should be able to get current in their loan payments driving demand for credit upward. Net charge-offs would be about 4.3% and 3.9% of loans in 2009 and 2010, respectively, in our view. With loan losses on the rise, the bank will have to keep replenishing its reserves, which will put pressure on near-term profits, in our opinion. However, we think that by mid-2011, the bank should be in good shape to outearn our estimated 15% cost of equity.

"Our base, downside, and upside scenarios, respectively, yield fair values of BRL 0.24, BRL 0.10, and BRL 0.31 per Brazilian share. At 105 shares per ADR and using an exchange rate of roughly BRL 1.80 per U.S. dollar, we arrive at our $13 fair value estimate."