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.