Can A New Growth Cycle In Brazil Spark Growth For Itau Unibanco?

It has been an up-and-down year for Brazil’s economy and investor sentiment, so it’s no great surprise that the shares of Itau Unibanco (ITUB) have likewise bounced around. Although the ADRs haven’t really gone anywhere fast when compared to the price twelve months ago, they are up about 30% from my last update on the company on renewed optimism over Brazil’s economy and perhaps some recognition of Itau’s excellent capital and market position.

As far as the potential returns from here, though, I’m not as bullish as I was mid-year. I’m expecting double-digit earnings growth for each of the next five years (and healthy growth beyond that), and that supports a low-to-mid teens annualized return from here, which isn’t bad but not as strong as the 20%+ returns I saw before this run. Where Brazil to enter another “boom” cycle in the economy, there would certainly be upside to my numbers, but then there is also potential downside if the government’s efforts to improve the economy don’t pan out and/or if up-and-coming fintech rivals successfully disintermediate the traditional banks.

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Can A New Growth Cycle In Brazil Spark Growth For Itau Unibanco?

2018 Will Have Challenges, But Itau Unibanco Poised For A Return To Growth

This latest downturn in Brazil has been a challenging one for the banking sector, and management at Itau Unibanco (ITUB) has consistently overestimated loan growth and underestimated credit deterioration. That notwithstanding, management has steered this bank well through a tough period, and the shares have done well in 2017 as conditions in Brazil continue to improve.

2018 is likely to be a challenging year for the banking sector, as loan growth is likely to improve but not enough to offset compression to net interest margins. With likely limited options to reduce costs and cost of risk, I would expect earnings growth to be "meh" in 2018, but with a much stronger outlook for 2019 and 2020. Further complicating this outlook is the presidential election cycle in Brazil and its potential impact(s) on the cost of capital.

I think Itau Unibanco can beat the S&P 500 over the next couple of years, but I think the likely returns (low teens) are pretty well offset by the risks, so I wouldn't call this a slam-dunk buy. As a quality play on Brazil, and Brazil's return to growth, though, it's not a bad longer term holding to consider and especially on dips/pullbacks.

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2018 Will Have Challenges, But Itau Unibanco Poised For A Return To Growth

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: 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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