Itau Unibanco Underappreciated On Its Leverage To Higher Rates And Strong Loan Demand

 

These are interesting times in the global economy, with many countries already seeing challenges to their post-pandemic recoveries even before the recent spike in oil prices. In Brazil, while sectors like construction have been fairly healthy, GDP is expected to slow from 5% growth in 2021 to 1% to 2% in 2022 and 2023, and industrial output has been shrinking for several months, with the last reading still below pre-pandemic levels.

What’s interesting for an economy is often interesting for its banks, and so too with Itau Unibanco (ITUB). Recent trends here have been quite positive, and management has not been shy about guiding for strong growth in 2022, but the market is not buying that outlook right now.

Itau has seldom been my preferred bank in Latin America, but I did like the shares back in March of last year on what I thought were underappreciated recovery prosects. The ADRs have since generated a 25%-plus return, outperforming other Brazilian banks like Banco Santander Brasil (BSBR) and Bradesco (BBD), as well as LatAm options like Banco de Chile (BCH), Bancolombia (CIB), Creditcorp (BAP). That performance does carry an asterisk, though, as the local shares haven’t been as strong, falling about 10% and lagging the BOVESPA.

At this point these shares do look undervalued, but I am concerned about the risk of revisions to management and sell-side expectations for the year. Then again, that risk is mitigated by the fact the Street really doesn’t seem to believe in those numbers now anyway.

 

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Itau Unibanco Underappreciated On Its Leverage To Higher Rates And Strong Loan Demand

Itau Unibanco - Work To Do, But Undervalued On Recovery Prospects

Brazil’s Itau Unibanco (ITUB) wasn’t among my preferred bank stocks back in August of 2020, and names I preferred like Credicorp (BAP), DBS Group (OTCPK:DBSDY), and ING (ING) have all done better, but I have to admit I’m surprised that Itau has only seen modest share price improvement in what has largely been a global bank stock rally.

I don’t think Itau will ever be my favorite international bank, or even my favorite South American bank, but the elevation of Milton Maluhy could drive some changes (though as the former CFO, I wouldn’t expect a big shift). In particular, Itau needs to figure out how to gain more traction with its digital efforts and offset increasingly fierce competition from non-bank fintech companies in Brazil.

A core long-term earnings growth rate of 7% marks a definite slowdown in the long-term earnings growth rate, but still supports a $6 fair value on the ADRs. I think there’s work that needs to be done here to maintain long-term competitiveness, but credit has held up better than I expected and I think Itau looks a little too cheap on its leverage to a recovery in Brazil’s economy and other economies in South America.

 

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Itau Unibanco - Work To Do, But Undervalued On Recovery Prospects

Itau Unibanco Refocusing On The Consumer To Drive New Growth

For a variety of reasons, including less-than-responsible competition from state-controlled banks in Brazil, increasing competition from new fintech entrants, and a management team that is consistently overly positive on the prospects for the business, Itau Unibanco (ITUB) has never been my favorite Latin American bank. With Brazil’s recovery underwhelming expectations in 2019, the shares are down more than 10% over the past year and down about 8% since my last article on the company.

Brazil’s economy needs a lot of work, and it remains to be seen if the current government has the willpower to tackle a host of thorny structural issues, including pension reform. If the recovery of Brazil’s economy accelerates, Itau can do well, but I still don’t love this bank from a fundamental standpoint and while the shares don’t look expensive, I’m not all that excited about the idea of owning these shares.

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Itau Unibanco Refocusing On The Consumer To Drive New Growth

Credicorp Arguably Not Getting Its Due As Loan Growth Accelerates

I don't want to overdo the comparisons, but given that I follow both Credicorp (BAP) and Itau Unibanco (ITUB), it's tempting to compare the evolution of these two top-notch Latin American lenders. More to the point, I see Itau in a place similar to where Credicorp was six to 12 months ago, when the company was seeing improving credit quality but sluggish loan growth as the country's economic situation was sorting itself it. At this point, though, I think Credicorp is in a pretty good place to generate attractive earnings growth, as Peru's economy is going strong, loan demand is accelerating, and the company's digital initiatives are really starting to make a difference.

As far as the stock goes, I was pretty lukewarm on Credicorp six months ago, and the shares are down a bit since then - trailing Itau, but outperforming a collection of other names like Banco de Chile (BCH) and Bancolombia (CIB). Given that I think Credicorp shares are now priced for low to mid-teen annualized returns, I think this is a name to consider again looking into 2019.

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Credicorp Arguably Not Getting Its Due As Loan Growth Accelerates

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?

PagSeguro Disrupting A Large, Previously Untapped Market

Fintech has been good to investors recently, with the markets prizing highly leverageable “toll-taker” models that can earn small, high-profit bits of revenue off of repeated transactions. One of the classic examples of this model is the merchant acquirer (think companies like Global Payments (GPN)), and PagSeguro (PAGS) is bringing a new and disruptive acquiring model to the small business market in Brazil.

No brief article can completely capture or summarize the risks of a company, so please do your own careful due diligence. In addition to the risk that comes with competing with the likes of Cielo (OTCPK:CIOXY), Itau Unibanco’s (NYSE:ITUB) acquiring operations, newer entrants like SumUp, MercadoLibre’s (MELI) Mercado Pago, and now PayPal (PYPL), there are significant regulatory risks, operating/execution risks, and macroeconomic risks.

All of that said, this is an interesting growth story, as PagSeguro has already carved out good initial market share in the “micro-merchant” niche and stands to benefit not only from ongoing merchant acquisition, but increasing transaction volume and value. Fintech valuation has often tended to exist in its own world, but PagSeguro’s growth potential could make it worth a look from aggressive investors who can accept the above-average risks.

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PagSeguro Disrupting A Large, Previously Untapped Market

Itau Unibanco In A Wobbly Recovery Cycle

With another plunge in the exchange rate, there is once again a gulf between the performance of the actual business at Itau Unibanco (ITUB) (ITUB4.SA) and the performance of the local shares and ADRs. While the local shares haven't had a great six-month run (down about 6% versus a 3% drop in the Bovespa), the ADRs have suffered far more with a roughly 17% drop.

Between an upcoming election and a recovery that has already seen some fits and starts, Brazil isn't exactly a safe market. Moreover, while Itau is arguably the best-run of the Brazilian banks and generated better than expected returns during the downturn, management has a habit of over-promising and under-delivering and needs to reinvest in the next round of growth drivers. I do believe that Itau's shares are undervalued, but there's a lot of risk and volatility that comes with this name that may overshadow the opportunity for some investors.

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Itau Unibanco In A Wobbly Recovery Cycle

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: ACE Limited Earns Its Premium, But Excess Capital Weighs On Returns

P&C insurance company ACE Limited (NYSE:ACE) is another of those examples of the sometimes-frustrating difference between a company and a stock. As a company, I think anybody who follows insurance will appreciate and admire how ACE limited runs itself. As a stock, though, the shares didn't look cheap a year ago and they still don't look all that cheap today. While ACE arguably still merits a place in a long-term portfolio and has ample capital with which to build the business, it's hard for me to work up a lot of enthusiasm for buying shares today.

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ACE Limited Earns Its Premium, But Excess Capital Weighs On Returns

Seeking Alpha: Santander Looks Pricey Relative To Its Capital And Growth Prospects

The economy in Spain has been looking a little better and that has led Spanish banking shares to do quite a lot better, with Bankia up close to 120%, CaixaBank up about 90% and the big boys BBVA (BBVA) and Santander (SAN) up around 60%. Credit recovery can be a powerful factor in bank stock appreciation and incoming bad credits in Spain are getting better for Santander. On the other hand, Santander Mexico (BSMX) hasn't been doing as well as I'd hoped, Santander Brasil (BSBR) is losing share, and the company's credit position is still quite weak relative to other large banks. These shares already seem to reflect a lot of optimism about improving interest spreads and loan growth and I don't see much value at these levels.

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Santander Looks Pricey Relative To Its Capital And Growth Prospects

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: Has Santander Made It Through The Worst?

Like so many other banks in Europe, Santander (NYSE:SAN) has been through the wringer. Its home market of Spain has seen devastating economic decline, and relatively healthier operations in faster-growing areas like Brazil and Mexico haven't made up the difference. The bank's shares have dropped more than 50% over the past five years.

Bad as things have been, investors in the U.S. have seen plenty of examples of how bank stocks can recover significantly once credit costs begin to stabilize and then improve. On one hand, then, is the possibility of a Bank of America (NYSE:BAC) or Citigroup-like (NYSE:C) rise from the ashes. But on the other hand is the truly scary state of affairs in Spain and the risk that Latin America is starting to slow to a significant degree. Although Santander shares may be a little cheap today and would certainly have significant upside if/when the market believes Spain has stabilized (and with it, Santander's credit costs), the risk/reward tradeoff does not seem appealing enough to me when considering the options available to investors in other European and Latin American banking stocks.

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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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