Santander Brasil's Results Mask Its True Potential

As we expected, Banco Santander Brasil's (BSBR) year-end results disguise the bank's profitability potential. We still see upside for the shares, which are trading at nearly a 30% discount to our $15 fair value estimate. We are also fans of the firm's rock-solid balance sheet. In addition, the bank is putting its capital to work by expanding its loan portfolio and branch network, which will lead to wider returns on equity--currently the company's main shortcoming compared with its peers. Lastly, we think Santander Brasil's reserves for loan losses are adequate to deal with its credit problems, which makes near-term spikes in provisions unlikely, even though we expect credit quality to remain soft. Although peers Banco Bradesco (BBD) and Itau Unibanco (ITUB) are also trading below their respective fair values, Santander Brasil's upside is more alluring, in our opinion.

Covering 1.4 times its nonperforming loan balance, Santander Brasil's allowance for loan losses is sufficient, in our view. Although we anticipate credit quality will remain soft (nonperforming loans were 4.5% of the portfolio at year-end), we do not think nonperforming loans will reach 2009's high of 6.5%. This will keep provisions for loan losses elevated, but we expect there will be no need for meaningful allowance buildup, and thus no surprise spikes in provisions.

Among the top Brazilian banks, Santander Brasil is the best-capitalized institution. At year-end, its Tier 1 capital ratio was a hefty 17.5%, 5 percentage points higher than Bradesco's and Itau's ratios. Such a sturdy capital position gives Santander Brasil's balance sheet more resilience in an adverse scenario and much more dry powder to fuel its near- and medium-term loan growth.

We think Santander Brasil's profitability will improve as revenue grows and equity is put to work. The clearest deficiency Santander Brasil has relative to its peers is its scanty profitability. Under Brazilian GAAP, which calls for heavy goodwill amortizations, the company's returns on equity are very low at just under 6% (versus 20% at Itau and Bradesco). Removing this noncash charge, returns on equity nearly double. In addition, the bank's bulky equity base (Santander Brasil's equity/assets ratio is roughly double that of its competitors) depresses returns. Thus, we think that as the firm puts its capital to work, the increasing numerator and decreasing denominator will boost returns on equity, which we project will reach 18%-20% eventually.

Overall loan growth, which we project will be in the midteens, will keep Santander Brasil's top and bottom lines expanding, in our view. We think domestic demand will remain Brazil's most important economic propeller, and loans to individuals and small and medium businesses should see the most significant increases. Even though GDP growth in the next couple of years is not expected to reach 2010's 7.5% rate, its estimated 3.5%-4.5% clip is much more promising than 2009's contraction.

Forced share sales by Spain's Grupo Santander could place a temporary damper on Santander Brasil's shares. Although it seems that for the time being, Grupo Santander has met its capital requirements, it is not unlikely that it will need another boost down the line. The Spanish institution owns roughly 80% of Santander Brasil, and if it has to revamp its capital position, it may sell a portion of its stake in its Brazilian subsidiary. Even though this move will not entail dilution for Santander Brasil shareowners, the sudden increase in float could temporarily sink the stock price. Indeed, we think this may present an attractive buying opportunity, as happened with Santander Chile (SAN) when 8% of its shares were floated in late 2011.