Emerging markets brazil banking sector

Banking Sector Update Brazil M ARCH 1, 2010 Submitted by:

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Table of Contents KEY SECTOR HIGHLIGHTS.......................................................................................................................... 2 BANKING SECTOR OVERVIEW ................................................................................................................. 4 I. BANK LENDING ON A RISE DESPITE GLOBAL SLOWDOWN ........................................................................... 4 II. RETAIL LOANS OUTPACING GROWTH IN CORPORATE LOANS .................................................................... 5 III. IMPROVING OUTLOOK ON CREDIT QUALITY ............................................................................................. 5 IV. BANKS IN BRAZIL REMAIN WELL CAPITALIZED .......................................................................................... 6 V. PROFITABILITY DECREASED IN LINE WITH GLOBAL PEERS ............................................................................ 6 M&A ACTIVITY TO GAIN MOMENTUM IN 2010.................................................................................... 8 I. PLANO REAL LED THE CROSS-BORDER CONSOLIDATION DRIVE IN BRAZIL .................................................. 8 II. RECENT BANKING M&A DEALS AND OUTLOOK ....................................................................................... 8 VALUATIONS REMAIN ATTRACTIVE ...................................................................................................... 10 I. BRAZIL BANKS 窶天ALUATION ................................................................................................................... 10

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KEY SECTOR HIGHLIGHTS •

Improving economic conditions augur well for the banking sector. Brazil's GDP is expected to grow by 4.7% in 2010 after a mild contraction of 0.4% in 2009, according to the IMF estimates. Brazil's economy will benefit from improving domestic consumption, a pick-up in investment activity as well as a modest recovery in commodity prices. Unemployment levels remain stable, while wages are gradually ticking up. With more than 192 mn people, Brazil has the fifth largest population in the world. About 25% of the total population is under the age of 14, which is expected to drive domestic demand and economic growth. With Rio hosting the 2016 Olympic Games, foreign investments are likely to increase further. According to government sources FDI is likely to increase by 33% to USD 40bn in 2010. Given the strong government balance sheet and improving debt structure, Moody's upgraded Brazil's ratings from Ba1 to Baa3 and assigned a positive outlook in Sep 2009.

Chart 1: Real GDP Growth Rate (in percentage) 18 14 10 6 2 -2

2006

2007

2008

2009E

2010E

2011E

2012E

-6 -10

Brazil Mexico

Argentina Peru

China Russia

India United States

Source: IMF WEO database

•

Banking activity remains robust. Despite the economic slowdown, the banking sector in Brazil witnessed a double digit growth in loans and deposits.

Banking assets have grown over 20% p.a. in the 2005-2009 period, and is expected to grow at around 10% p.a. during the 2009-2013 period. Retail banking has grown at a CAGR of 27.6% in the 2004-2009 period. Healthy population growth and improving income levels have been primarily driving retail banking. While investments by businesses has remained subdued due to the recent economic uncertainty, stabilizing commodity prices and increasing foreign investments are likely to drive corporate banking in the near term.

•

Strong regulatory framework helped banks to weather the crisis. The banking sector in Brazil remains fundamentally strong and adequately capitalized (Capital Adequacy Ratio – 18.5% in 2009). To minimize the impact of recessionary pressures on the economy, the Central Bank injected around BRL 100bn in Sep 2008 and slashed the benchmark lending rate several times during 2009. This ensured that there were no liquidity issues in the financial

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system. With considerable improvement in the economic environment, the Central Bank may roll back some of the stimulus measures to rein inflation. We believe these are steps in the right direction and do not expect any significant downturn in lending activity. •

M&A activity likely to gain traction. The banking sector in Brazil is characterized by too many players, while a majority of the assets remain concentrated with a few banks. Given the large population, low banking penetration levels and improving economic environment, many foreign banks are planning strategic partnerships and acquisitions to gain access to this market. This in turn, is also forcing domestic players to consolidate in order to survive competitive pressures. Hence we believe M&A activity especially in the banking sector is likely to gain traction in the near term.

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BANKING SECTOR OVERVIEW The banking sector in Brazil is highly fragmented with over 170 banks which include savings banks, commercial banks, investment banks and development banks. However, the top four players, namely Banco do Brasil, Itau, Bradesco, and Santander, account for around three-fourth of the total banking assets. The banking sector in Brazil has been a facilitator and one of the prime beneficiaries of the economic growth over the past few years. While the Brazilian economy grew at a CAGR of 14% in the 2005-2009 period, the total assets of the banking sector grew at around 23% reaching over BRL 2,865bn in 2009. Banking assets in Brazil are expected to grow at a CAGR of around 10% during the 2009-2013 period.

I. Bank lending on a rise despite global slowdown Despite strong economic headwinds, credit growth for 2009 was 15% YoY. In fact, total outstanding loans increased from BRL 607bn in 2005 to around BRL 1,412bn in 2009, growing at a CAGR of around 23%. Penetration level (Credit to GDP ratio) increased from 28.1% in 2005 to about 45% in 2009. Brazilian Federation of Banks in its survey in Dec 2009 has estimated the lending activity to grow by 19.2% for 2010. However, we expect a moderate increase in lending volumes in the near term as the Central Bank is likely to initiate steps to tighten the monetary policy.

Recently the Central Bank raised banking reserve requirements on term deposits.

While the basic reserve requirements have been increased from 13% to 15%, the Central Bank has also restored additional demand requirements on cash and term deposits to 8% from 5% and 4%, respectively. These measures are expected to withhold about BRL 71bn from the economy. In January 2009, outstanding loans in Brazil grew by a modest 0.7% MoM to BRL 1.422 trillion (USD 780.5bn), representing 44.6% of GDP. Chart 2: Credit Growth and Banking Penetration 1500 1200 900

100%

92.1% 66.2%

75.1%

84.9% 80%

58.2%

60%

600 300

40%

28.1%

30.8%

34.7%

41.3%

45.0% 20%

0

0% 2005

2006 Total Credit (BRL bn)

2007 Banking Credit to GDP

2008

2009

Banking Assets to GDP

Source: Brazil Central Bank

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The drastic decrease in the provisioning to NPL ratio in 2009 was due to a very high increase in NPLs. We however expect the credit quality to improve going forward. In fact, NPL ratios were at 4.4% in December compared to 4.5% in November, a modest improvement. Loan delinquencies measured as a proportion of total loans or the average loan default rate, also edged marginally lower to 5.5% in January from 5.6% in December.

IV. Banks in Brazil remain well capitalized Banks in Brazil remain well capitalized with Capital Adequacy Ratio (CAR) well above the minimum level set by the regulatory authorities. The Central Bank of Brazil has defined the regulatory minimum CAR of 11%, which is much higher than the 8% required by Basel norms. Banks in Brazil have an average CAR of 18.5% which is much higher compared to its regional and global peers.

Table 2: Capital Adequacy Ratio (in percentage) 2004

2005

2006

2007

2008

2009

Argentina

14.0

15.3

16.8

16.9

16.8

17.6

Brazil

18.6

17.9

18.9

18.7

18.4

18.5

Chile

13.6

13.0

12.5

12.2

12.5

13.6

Costa Rica

19.1

20.6

18.8

16.1

15.1

15.4

Mexico

14.1

14.3

16.1

15.9

15.3

15.2

Peru

14.0

12.0

12.5

12.1

11.9

12.9

Australia

10.4

10.4

10.4

10.2

10.9

11.4

Canada

13.3

12.9

12.5

12.1

12.7

10.3

India

12.9

12.8

12.3

12.3

13.0

NA

Russia

17.0

16.0

14.9

15.5

16.8

18.5

US

13.2

12.9

13.0

12.8

12.8

13.5

Note: Latest available figures for 2009

Source: Global Financial Stability Report 2009

V. Profitability decreased in line with global peers Ample liquidity and healthy consumer demand for credit have placed Brazil’s commercial banks among the most solid and profitable financial institutions in Latin America. Net interest income forms the major portion of the total income followed by other income which forms around 23%. However, with an average share of around 20%, fee income also remains a major contributor of total income.

Banks in Brazil were in line with major banks globally, despite a recession driven decline in profitability. High NPLs and corresponding high provisions impacted profitability significantly. Loans to deposit ratio dropped sharply in 2008 to 78% from 85% in 2007, before increasing to 82% in 2009, which also impacted profitability. Lending spreads both on the individual and corporate loans decreased and also contributed to subdued earnings. Average spreads declined by 80 bps, to over 24% in December 2009, according to the data provided by the Central Bank. Going forward we believe the expected increase

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in interest rates to curb the rising inflation might lead to decrease in the credit growth and also tighten noose on profitability in the near-term.

Table 3: Banking Returns (in percentage) ROE 2007

ROA

2008

2009

2007

2008

Argentina 11.0 13.4 15.6 1.5 1.6 Brazil 22.7 17.9 14.8 2.4 1.8 Chile 16.2 15.2 14.7 1.1 1.2 Costa Rica 13.4 14.3 12.4 1.5 1.8 Mexico 19.9 12.5 12.7 2.7 1.2 Peru 27.9 31.1 27.8 2.5 2.6 Australia 18.1 13.7 NA 1.0 0.7 Canada 16.1 9.1 9.5 0.8 0.4 India 13.2 12.5 NA 0.9 1.0 Russia 22.7 13.3 3.6 3.0 1.8 US 7.8 0.4 2.3 0.8 0.0 Source: Global Financial Stability Report 2009, HSBC. Note: Latest available figures for 2009

2009 1.9 1.6 1.1 1.6 1.2 2.3 NA 0.5 NA 0.5 0.2

Chart 4: Income Breakup: Interest, Fee and Other Income 100% 80% 60%

27%

23%

19%

21%

21%

18%

21%

21%

21%

22%

55%

56%

60%

57%

2003

2004

2005

2006

26%

25%

22%

18%

56%

52%

57%

2007

2008

9M 09

40% 20% 0%

Net Interest Income

Fee Income

Other Income Source: HSBC, Brazil Central Bank

Table 4: Summary Financials – 2009 (in BRL mn) Banco do Brasil

ITAU

BRADESCO

Santander Brasil

Banrisul

Total Assets

708,548.8

608,273.3

506,223.0

342,323.8

29,084.1

Loans & Advances

266,483.7

221,899.1

157,458.3

121,881.9

11,956.2

Total Deposits

325,945.3

188,725.8

170,321.0

112,708.8

16,279.8

Non Performing Assets

15,237.6

12,490.0

6,858.6

7,598.2

292.4

Net Interest Income

32,740.0

49,197.4

31,335.6

22,491.6

2,446.6

Net Interest Margin

6.5%

9.7%

7.9%

9.9%

10.1%

10,147.5

10,066.6

8,012.3

1,805.9

541.1

30.7%

21.3%

21.1%

3.2%

16.7%

Net Income Return on Equity Return on Assets

1.7%

1.6%

1.7%

0.5%

2.0%

Efficiency Ratio

58.5%

44.5%

65.3%

72.4%

60.9%

Capital Adequacy Ratio

13.3%

17.0%

17.8%

28.3%

17.5%

Source: Bloomberg, Brazil Central Bank

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VALUATIONS REMAIN ATTRACTIVE The Bovespa stock index gained 83% in 2009, its best performance since 2003, as domestic demand, government stimulus plans and rising commodity prices put the economy back on track. The index is currently trading at earnings multiple (PE) of 19.7x, with forward multiples of 13.1x and 10.6x for 2010 and 2011, respectively. We believe at current levels, Bovespa’s valuation looks attractive, compared to its regional and emerging peers.

Table 6: Earnings Multiples (PE) of Stock Indices Country

Stock Exchange

2009

2010E

2011E

Brazil

BM&F Bovespa

19.7x

13.1x

10.6x

Mexico

Bolsa Mexicana de Valores

18.6x

15.8x

13.2x

India

Bombay Stock Exchange

24.6x

20.0x

15.7x

China

Shanghai Stock Exchange

32.3x

17.7x

14.8x

US

S&P 500 Index

18.8x

14.1x

11.8x Source: Bloomberg

The Brazilian financial index IFNCBV gained 79.4% in 2009, increasing from 1,888 in 2008 to 3,387 in 2009. The financial index is currently trading at a PE multiple of 13.9x, with forward multiples of 11.6x and 9.6x for 2010 and 2011 respectively.

Chart 7: Index Performance – General and Financial Index (Rebased to 100) 140 120 100 80 60 40 20 Dec-07

Mar-08

Jun-08

Sep-08

Dec-08

IBOV

Mar-09

Jun-09

Sep-09

Dec-09

IFNCBV

Source: Bloomberg

I. Brazil Banks –Valuation The Large-Cap Brazilian banks are trading at an average 2010E earnings multiple (PE) of 11.5x, 30% above the Mid-Cap banks average of 8.8x. On price to book value (P/BV), the Large-Cap banks are trading at average multiple of 2.0x on 2010E BV, 67% above the Mid-Cap bank average of 1.2x. This can be partly justified by higher profitability of large –cap banks over the mid-caps (18.3% vs.

12.7%). The valuation gap on 2011E P/BV is down to 64%, which can be partly justified by 60 bps reduction in ROE gap between the banks.

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Table 7: Brazil Banks Valuation Ticker

Price

Market Cap

(BRL)

(BRL mn)

P/E 2010E

P/B 2011E

2010E

ROE (%) 2011E

2010E

2011E

Large-Cap Banks BBDC4

31.00

96,198

11.3x

9.8x

2.1x

2.0x

20.5

21.0

Itaú Unibanco

Bradesco

ITUB4

36.01

146,926

12.6x

10.6x

2.7x

2.4x

23.4

23.2

Banco do Brasil

BBAS3

30.18

77,508

10.0x

8.9x

1.9x

1.7x

21.8

21.8

Santander Brasil

SANB11

21.35

81,139

Average

12.1x

9.4x

1.1x

1.1x

11.0

13.2

11.5x

9.7x

2.0x

1.8x

18.3

19.8

8.3x

6.7x

1.2x

1.0x

14.2

15.8

Mid-Cap Banks ABC Brasil

ABCB4

11.50

1,560

Cruzeiro do Sul

CZRS4

12.30

1,701

7.6x

7.6x

1.8x

1.6x

13.6

14.1

Daycoval

DAYC4

9.85

2,131

10.3x

9.0x

1.3x

1.2x

13.0

14.6

Paraná

PRBC4

9.85

924

7.8x

8.8x

1.1x

1.0x

11.6

12.3

Pine

PINE4

10.99

939

8.6x

6.7x

1.1x

1.0x

13.9

17.3

Sofisa

SFSA4

5.06

697

10.3x

5.3x

0.8x

0.8x

10.2

15.0

8.8x

7.3x

1.2x

1.1x

12.7

14.9

Average

Source: Bloomberg

Table 8: Regional Banks Valuation Country Banco Frances

Argentina

Price

Market Cap

(USD)

(USD mn)

2010E

2011E

2010E

2011E

2010E

2011E

BFR

6.08

1,087

11.7x

6.7x

4.3x

NA

18.7

18.9

Ticker

P/E

P/B

ROE (%)

Banco Macro

Argentina

BMA

25.96

1,514

8.6x

7.7x

NA

NA

22.5

22.5

GF Galicia

Argentina

GGAL

4.80

596

15.7x

12.1x

NA

NA

12.0

13.1

Banco de Chile

Chile

BCH

61.99

8,529

13.7x

11.7x

2.9x

2.6x

22.4

24.5

Santander Chile

Chile

SAN

64.07

11,621

14.1x

11.6x

3.8x

2.9x

26.8

26.9

Bancolombia

Colombia

CIB

46.38

9,135

15.5x

12.2x

2.3x

2.0x

18.3

20.9

Banorte

Mexico

GFNORTEO MM

3.74

7,540

13.3x

9.8x

2.1x

1.8x

15.8

18.7

Credicorp

Peru

BAP UN

78.10

6,229

11.9x

9.9x

2.4x

2.1x

21.8

21.9

13.1x

10.2x

3.0x

2.3x

19.8

20.9

Average

Source: Bloomberg

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