Banco do Brasil set to outperform

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By:
Rob Dwyer
Published on:

Investors have misconceptions about the scale of its retrenchment; growth and asset quality recovery likely to increase through 2018.

Banco-do-Brasil-fruit-R-600
Bearing fruit: Banco do Brasil

Banco do Brasil’s turnaround story continues to impress, but equity analysts that cover the bank say investors tend to have a misconception about the bank’s risk fundamentals.

As a state bank, it is perhaps unsurprising that Banco do Brasil sold off more than the other Brazilian banks during recent bouts of political volatility.

However, with the Brazilian economy improving and the bank’s management continuing to execute on its plan to place profitability at the heart of the bank’s strategy, some analysts believe it now offers a leveraged play on the country’s anticipated economic recovery.

UBS and JPMorgan both upgraded their expectations to Buy in the past week – or overweight in JPMorgan’s case – to join Deutsche Bank, which has Banco do Brasil as one of its top financial picks in Latin America.

Turnaround

New CEO Paulo Rogerio Caffarelli, who assumed control in May 2016, is widely acknowledged to be doing an effective job in cutting and rebuilding the bank’s capital base, seeking to sell its Argentine asset Banco Patagonia.

“Management’s focus has switched to improving efficiency and profitability, as illustrated by the completion of its 55-branch rationalization programme earlier this year, as well as by the recovery in ROE from 8.8% in 2016 to 12.2% in 2Q 2017,” according to UBS.

However, one of the main reasons for JPMorgan’s re-rating is based on the potential value driven by a lingering incorrect perception among investors about the bank’s risks that built up before Caffarelli’s arrival.

The widely held view is that the bank was used as a tool of macro-economic policy in the years of the previous Dilma Rousseff administration and that it accelerated lending as the economy shrank from 2014 – building up risky assets in the process – and that it also took longer to decelerate credit growth.

However, research by JPMorgan shows that the slowdown in lending from the beginning of 2014 is roughly comparable for all banks. The bank also highlights that Banco do Brasil’s reputation for having an elevated exposure to SMEs and large corporates.

Yet since June 2015 the bank reduced its business portfolio by 18% – virtually in line with Bradesco’s 21% reduction – including HSBC – and Itaú’s 17.5%.

“Notably Banco do Brasil reduced its small company portfolio (less than R$25 million annual revenues) by 39% in this period (now just 9% of its portfolio from 14% previously),” wrote JPMorgan in the client note accompanying the upgrade.

This is now being seen in the bank’s results, with provisions falling as asset quality improves, and NPLs appear to have reached an inflection point and are expected to stabilize in the second half of 2018 and improve next year.

The better asset quality is boosting the results from the operational improvements, which remains the key management focus.

According to Deutsche Bank’s Tito Labarta: “Management remains committed to keeping costs under control and is working on several initiatives to keep expense growth below inflation.

“Furthermore, it is working in its digital transformation, as digital clients should reach 3.3 million by year-end from 1.8 million today and mobile clients should reach 15 million from 12 million today.”

Political risk

To date, the mix of political risks and misconceptions about the bank’s credit portfolio have been weighing on the bank. Banco do Brasil is trading at much lower multiples than its peers (at 7.4x P/E, 1.0x book value and 14.2$% ROE compared with an average for the private banks of 10.7x, 1.9x book value and 18.7% ROE).

Much of this valuation discount is driven by the added political risk seen at the bank. When recordings of president Michel Temer’s conversations appeared to threaten his position, the bank’s share price fell 20%, compared with the index’s 9%.

The bank’s share price has also recovered more slowly – flat since then compared with Itaú’s rise of 8% and Bradesco’s 13% – suggesting that the perception of political risk is still an anchor on share performance.

However, the addition of improving political stability and a brighter economic outlook for the macro-economy is now mixing with the bank’s improving asset quality, improved cost control and operational strategy to create the potential for an impressive run of results.

As credit demand picks up and provisions normalize, Banco do Brasil is well placed to deliver the sharpest improvement in ROE among the Brazilian banks. Loan growth grew 37% in 2Q 2017 and has now grown for three straight quarters. This should continue if the economic forecasts are true.

UBS expects GDP growth of 3.1% in 2018 – from 0.5% this year – which is helping to ease concerns about the bank’s asset quality and capital constraints. Itaú believes successful reforms – fiscal macro reforms and a series of microeconomic reforms that focus on trade, tax and regulation – could lift potential GDP growth to 3.5%.

That’s why UBS has turned bullish on Banco do Brasil, stating: “We believe the banking sector is about to enter a new lending cycle, with loan growth accelerating and asset quality improving, [and] we view [Banco do Brasil] as the leveraged play for this cyclical turnaround.”