Cielo Leveraged To A Recovering Brazil, But There Are A Lot Of Moving Parts

On the surface, Cielo (OTCQX:CIOXY) would look like a good play on Brazil's eventual economic recovery. While the merchant acquiring space in Brazil is getting more competitive, Cielo's relationships with Banco do Brasil (OTCPK:BDORY) and Bradseco (NYSE:BBD) supports strong market share and Brazil's relatively low card penetration rate suggests above-average growth potential in the years to come. Go below the surface, though, and there are a lot of competitive risks to consider, as well as potential changes to the regulatory environment that would meaningfully alter the company's business mix.

I like Cielo, and I think it's one of the better-known, higher-quality plays on Brazil. I would be careful about getting a good margin of safety going in, though, and I'm not convinced that's on offer today. While my double-digit required rate of return may be too steep and my expectation of high single-digit FCF growth may be too conservative, I think Cielo is close to fair value and the added competitive and regulatory risk factors push me a little more toward the sidelines.

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Cielo Leveraged To A Recovering Brazil, But There Are A Lot Of Moving Parts

Bradesco Isn't Out Of The Woods, But The Credit Cycle May Be Bottoming

Banco Bradesco (NYSE:BBD) has had a rough time of it recently, as Brazil's weak economy has hurt demand for loans, pressured deposits, and led to greater credit losses. This isn't a unique situation, as other banks like Itau Unibanco (NYSE:ITUB), Banco do Brasil (OTCPK:BDORY), and Banco Santander Brasil (NYSE:BSBR) have seen similar pressures and stresses, but Bradesco has been the weakest of these performers over the past year (just slightly worse than Itau) and the strong rally that had pushed these shares up 50% to 100% has sharply reversed in recent days.

The good news for Bradesco is that it is at least plausible that the credit cycle has bottomed out and the company's capital position is okay. The worse news is that the recovery in Brazil could be slow and stretched out over many years - not unlike what the U.S. banking sector has seen. While I think management's inability to accurately predict worsening credit trends as the cycle dragged on is a concern, as is the indictment against the CEO, I do believe that the bank can return over time to ROEs in the high teens to 20% and generate high-single-digit to low-double-digit earnings growth, supporting a fair value above $10 for the ADRs.

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Bradesco Isn't Out Of The Woods, But The Credit Cycle May Be Bottoming

Seeking Alpha: Itau Unibanco Doing A Solid Job Of Juggling Chainsaws

I wasn't very keen on Itau Unibanco (NYSE:ITUB) back in June of 2015, as I thought there was more risk than management was acknowledging of the Brazilian economy getting worse and taking credit quality with it. While the shares have staged an impressive rebound from their January lows (up about 66%), the shares are still down about 15% from that last piece as the Brazilian economy has indeed been weaker.

I'm not taking a victory lap on that call - predicting that a Brazilian stock would be weaker over the past year or so has been about as hard as hitting the ocean with a brick. Still, I think management at Itau should be credited for managing the situation as well as they have - the company's non-performing loans are pretty well-covered, and though the next couple of years will likely be sticky, I think the company has been managing this downturn well and will emerge as a strong player in a large economy that is still under-banked.

I think Itau Unibanco's ROE could threaten the mid-teens during this downturn, but I think 20% or higher is still viable down the road. Discounting back my cash earnings estimates gives me a fair value of about $10 today, and while that doesn't look so impressive relative to a $9 price on the ADRs, I use a hefty discount rate (mid-teens) that should account for a lot of the risk.

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Itau Unibanco Doing A Solid Job Of Juggling Chainsaws

Seeking Alpha: Will Brazil's Credit Cycle Be Different This Time For Itau Unibanco?

"It's different this time" might be the most dangerous words in investing, but that's what a lot of people are saying about the credit cycle in Brazil. The country's economy is showing a lot of troubling signs that conditions are getting worse, with rising unemployment, falling wages, and weak business confidence. Bad debts and provisions are starting to tick up across the system and that is not good news for banks like Itau Unibanco (NYSE:ITUB), Banco do Brasil (OTCPK:BDORY), Banco Bradesco (NYSE:BBD), or Banco Santander Brasil (NYSE:BSBR). Maybe this cycle will indeed be different, as banks like Itau and Bradesco have been more careful with underwriting leading into this cycle, but investors should at least appreciate the risk of elevated provisioning and weaker lending on earnings.

Specific to Itau, I thought this bank looked a little undervalued a year ago, but the weakness in the Brazilian real pushed the stock down about 30% from the time of that last article. That the local shares were up about 7% is small comfort when most readers have no choice but to invest in the ADRs. In any case, these shares do still look undervalued and could perhaps get a tailwind from currency if Brazil's economy strengthens, but this is a situation with above-average risks.

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Will Brazil's Credit Cycle Be Different This Time For Itau Unibanco?

Seeking Alpha: As Brazil Has Slowed, Itau Unibanco Has Battened Down The Hatches

As Brazil's largest private sector bank, and the second-largest bank overall with about 16% of system assets, Itau Unibanco's (ITUB) ("Itau") fortunes are certainly tied to the health of the Brazilian economy. That doesn't sound like such a good thing, as Itau Unibanco and Bradesco (BBD) are both looking for sub-2% GDP growth in Brazil for the next two years and early-stage delinquencies are starting to tick up. Management runs a tight ship, though, with better efficiency and NPL ratios than its rivals, and management has been shifting toward lower-risk loan types, building up its fee-generating businesses, and expanding outside of Brazil. The shares are not hugely cheap today, but still hold some long-term appeal.

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As Brazil Has Slowed, Itau Unibanco Has Battened Down The Hatches

Investopedia: For BBVA, Does More Spain Mean More Pain?

Spain is a bigger mess than most Americans can appreciate, as the 26% unemployment rate in Spain (which was a quarter-over-quarter improvement) is higher than has ever been seen in the U.S., including during the Great Depression. Likewise, major Spanish banks like Santander (NYSE:SAN) and BBVA (Nasdaq:BBVA) continue to see bad credit levels that would be hard to imagine at major U.S. banks.

Still, U.S. banks such as Bank Of America-like (NYSE:BAC) have seen prices spike once credit costs bottom out. While BBVA is unlikely to see a BAC-type return in the next few quarters, BBVA's management of its Spanish business and the quality of its Latin American operations will ultimately lead to improved results and a better valuation.

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Investopedia: Brazil's Growing, But That May Not Help Banco Bradesco Enough

There's no question that Brazil remains a popular emerging/developing market for international and global investors. Unfortunately, it's all too common for long-term macro calls ("buy Brazil") to have only passing relevance to particular sectors or companies. In the case of Brazilian banks such as Banco Bradesco (NYSE:BBD), lower interest rates hold the potential for compressing net interest margins and bank profit/return on equity (ROE) growth just as we've seen lately in the United States. While investing money in Brazil may make sense today, Bradesco is not looking like the best means of going about it.

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Investopedia: How Much Worse Will Itau Unibanco Get Before It Gets Better?

Stop me if you've heard this one before - banks are starting to see increasing loan losses, shrinking spreads and fears of an economic slowdown are leading banks to curtail lending, while government officials would prefer to see more lending to stimulate growth. That's not the United States nor Europe that I'm talking about, but rather Brazil. With economic conditions in Brazil looking less secure, Itau Unibanco (NYSE:ITUB) could be looking at a longer stretch of compressed earnings and returns than optimists want to believe.

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Investopedia: Is Santander Worth Your Time?

Much of the European banking system seems mired in trouble and there are signs that emerging markets like Brazil are starting to show cracks as well. That is troubling news for Banco Santander (NYSE:STD), as this global bank has been counting on strong results in emerging markets like Brazil and Mexico to prop up and offset its troubled operations in Europe and the U.K.

Nothing Changing Very Fast  
Recent results from Santander were largely in line with expectations and recent trends. Operating expenses are tracking higher and there is some loan growth, but provisioning and credit losses in Europe remain a major problem. Worse still, the banking issues have spilled over into the broader economies, and it seems to be slowing business prospects overall.

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The Curious Case Of Brazil And Turkey

I do not spend all that much time talking about economics, monetary policy, and the like, but I am making an exception to talk about an interesting “compare and contrast” situation in the emerging markets. Specifically, I find it very interesting to see the unusual monetary policy being pursued by Turkey vis a vis other large emerging economies like Brazil.

High Growth, Lower Rates

Turkey is currently enjoying some of the best growth in Europe, coming in at about 8% for 2010. In most cases, that sort of growth would have policymakers nervous about inflation and looking to hike rates to cool things off. After all, that's what's going on in countries like Poland, Hungary, China, and Brazil right now.

Turkey is handling things quite a bit differently though, and lowering rates. Last week, Turkey's central bank cut rates by 25bp (to 6.25%) after cutting them 50bp back in December. At the same time, the country is raising banks' reserve requirements.

The idea here, then, is to deter yield-shoppers and limit the inflow of speculative/investment capital. Unfortunately, world markets do not usually react well to the unorthodox or the unexpected, and Turkey's actions are both – Turkey's central bank has been pretty cagey and this last rate move took the market by surprise. Moreover, a lot of economists and commentators believe that Turkey will botch this delicate balancing act and that the tougher reserve requirements won't offset the stimulation of lower rates and that this will this ramp up credit growth and stoke inflation.

What might be helping embolden Turkey's officials is the fact that inflation is very low by Turkish standards – about 6.4% in December. On the flip side, the ballooning current account deficit is a real concern, standing as it does at over 7.5% for the last period I could find data. Given that higher rates do not always produce their desired consequences, it is a credible (if very unorthodox) approach for Turkey to try.

That said, this unorthodox policy is certainly not helping Turkey's financial sector and major banks like Garanti (Nasdaq: TKGBY), Akbank (Nasdaq: AKBTY), and Yapi. All of those stocks have taken a smacking lately, as has the stock of Turkcell (NYSE: TKC). If Turkey's central bank is ultimately proven right, this could be a great buying opportunity in one of my favorite markets. If this “low rate in the face of high growth” policy backfires, though, it could take years to sort out the damage.

Brazil Going The Conventional Route

While Turkey is trying something new, Brazil is sticking to the old pattern. Brazil recently bumped its interest rate up 50bp to 11.25%, due in no small part to concerns about inflation. While Turkey has had bouts of high inflation before, it doesn't have the same history of some truly rampant hyper-inflation periods like Brazil does. Consequently, it is hard for me to imagine Brazil's central bank ever being cavalier about the risks of inflation. Unlike Turkey, Brazil also has much less to worry about in terms of its current account balance and the impact of capital inflows.

Not surprisingly, though, this round of tightening hasn't been great news for Brazilian bank stocks like Itau (Nasdaq: ITAU) or Banco Bradesco (NYSE: BBD). On the other hand, it has made virtually no difference for major exporters like Embraer (NYSE: ERJ) and Vale (Nasdaq: VALE). And then you have the broader market ETFs like the iShares Brazil Index (NYSE: EWZ) and Market Vectors Brazil Small-Cap ETF (NYSE: BRF) – with a mix of exporters and more domestically-oriented stocks, these have traded lower, but not to the same extent as the financials.

It will be interesting to see how these two countries' policies play out. Clearly there are very different circumstances for each economy – Brazil is highly leveraged to China's development and appetite for raw materials, while Turkey is keenly exposed to Europe's health and demand for lower-cost manufactured imports. Nevertheless, Brazil runs the risk of choking off growth at time when it really needs to be using the windfall of commodity exports to develop a more balanced and sustainable economy. On the other hand, Turkey is not endangering its growth, but may well be risking its future stability.

The Bottom Line

I do not want to sound too cavalier about things, but on some level I dismiss monetary movements as “rates go up, rates go down … and the markets march on”. It's not wise to ignore a country's economic conditions or present fiscal/monetary policies, but you also cannot lose the forest for the trees. Should investors buy Brazilian financial stocks in the face of higher rates or Turkey financials in the face of market disapproval and uncertainty? Maybe not. By the same token, long-term value investors know that stocks often turn before the news changes and these stocks will probably stabilize and start rebounding ahead of any official “all clear” in interest rates.

More to the point, Turkey and Brazil are two places I really want to be for the long haul.

So, how cute should an investor be? After all, banks like Itau, Garanti, and Yapi are now trading at pretty attractive valuations. Sure, there is the risk that the stocks could go down another 10-20% with investor worries about monetary policies. But tell me when, exactly, there isn't *some* risk that could push down the price of an emerging market stock by a similar amount.

All things considered, I'd probably rather own exporters, but that's not always so easily done. The most liquid stocks (and those most likely to trade as ADRs) are usually domestic-focused companies like banks, utilities, and telecoms. It's a little easier with Brazil, with stocks like Embraer, Brazil Foods (Nasdaq: BRFS), and Vale, but there are fewer options with Turkey beyond ETFs, index funds, mutual funds, and a few stocks like Anadolu Efes.

The bottom line, then, is that I'd be looking to start buying. Maybe world markets are at a near-term top and maybe we're all due for a pullback. That's just part of the risk of investing. Given the turbulence and concerns over monetary policy, though, I'd probably take a multi-stage approach – looking to buy maybe one-third of my position in the next few weeks, another third a few weeks later, and the final third in a few months.

What should investors buy? I would take a very serious look at the three banks – Akbank, Garanti, and Yapi (the first two are reasonably liquid ADRs). I would also dig deeper and look into names like Anadolu, Tofas, Koc Holdings and so on. In fact, I hope to be back in a week or so with some additional Turkish names, hopefully with available ADRs. For Brazil, I'm talking my book, but I'd seriously consider Brazil Foods, as well perhaps as Cosan (NYSE: CZZ), Vale, Itau, Petrobras (NYSE: PBR), and Hypermarcas.

Disclosure: I own shares of Turkcell and Brazil Foods

Want A Strong Bank? Think ICICI

After spending a lot of 2009 and 2010 rebounding from freak-out lows, American banks like Citigroup (NYSE:C) and Bank of America (NYSE:BAC) are choking and sputtering. Not only are investors wrapped up in the negative headlines about potentially huge mortgage documentation risks, but loan growth is stagnant and the U.S. is still over-banked.

On the flip-side, the picture for banks outside of the U.S. and Western Europe is quite a bit brighter. In India, strong credit growth and surprisingly strong credit quality is providing a healthy environment, and ICICI Bank (NYSE:IBN) is making hay while the sun shines.

The Quarter That Was
ICICI reported earnings for its fiscal second quarter that handily surpassed the analysts' targets. Bottom-line earnings rose 19% in the quarter, fueled by 8% growth in net interest income and a 40% drop in provisions. Growth was helped by margin expansion of 10 basis points, loan growth of 2%, and deposit growth of 13%, while a significant rise in expenses (10%) was a dampener. (For more, see The Bottom Line On Margins.)

Credit quality is getting better. As the 40% reduction in provisions might suggest, ICICI is feeling good about its balance sheet. Impaired loans were a bit more than 8% at the end of the quarter, continuing a multi-quarter sequential strength of improvement. As a percentage of loans, non-performing loans were 1.4% in the quarter on a net basis.

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Building A Portfolio Around Brazil's Building

The next six years are going to busy ones for Brazil. The World Cup is coming in 2014, with the Olympics following two years after. Suffice to say, like virtually every country that has hosted one of those events (let alone both in succession), Brazil has a great deal of infrastructure to build in the intervening years. Brazil is also a large country with a sizable population and a growing economy; all of which takes money to support in its own right.  


If You Build It, They Will ComeIn order to support the demands of these two major sporting events, Brazil is looking at wide-ranging projects including upgrading roads and power grids, building hotels, improving airports, and generally just adding "more" to country. Even granting that the sporting events will be concentrated in or near major cities, there will need to be infrastructure stretching into the hinterlands to bring in supplies. All told, the bill just for Rio's Olympics is looking like it will be at least $14 billion.  

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