Brazilian Bank Investors Grow Skeptical of Record Profitability

August 27, 2015

For Brazil’s two biggest banks by market value, good news on profitability isn’t translating into higher share prices.

Itau Unibanco Holding SA has tumbled 14 percent since the start of trading on Aug. 4, when it reported the best return on equity in seven years. Banco Bradesco SA is down 17 percent since posting its highest ROE since 2011.

“The market is skeptical and concerned that those results won’t be sustainable,” Tito Labarta, an analyst at Deutsche Bank AG, said in a phone interview from New York. “You will see a weaker macro environment and further asset quality deterioration.”

Brazil’s economy will probably contract this year and next, the first two-year streak since the Great Depression, analysts surveyed by the central bank predicted. Yet bank profitability is holding at multi-year highs, bolstered by rising fee income, higher net interest margins and gains from proprietary trading, as well as lower costs and tax payments.

Warning signs are flashing: Almost half the companies in Brazil, or about 3.9 million firms, aren’t paying at least part of their debts on time, as higher interest rates boost costs and revenue declines because of the economic contraction, according to credit-data provider Serasa Experian.

In just one example, PDG Realty SA Empreendimentos e Participacoes, a real estate developer, said earlier this month it hired Rothschild to restructure its 5 billion reais ($1.4 billion) of debt.


Late Payments

Rising unemployment is having the same effect on individuals, with the jobless rate in July climbing to a five-year high of 7.5 percent. Itau said in its earnings release that debt overdue more than 90 days increased for the first time since the third quarter of 2012 and bad-loan provisions climbed.

Marcelo Kopel, Itau’s director of investor relations, said the bank, as a publicly traded company, can’t release guidance for return on equity.

“Our focus is to generate more value for shareholders by strengthening our strategy of managing lower-risk assets and providing service, while keeping our discipline on expenses,” Kopel said in an e-mailed statement.

Itau’s return on equity was 24.8 percent in the second quarter, up from 24.5 percent in first three months of 2015 and the highest in seven years, according to Deutsche Bank calculations, which exclude one-time items.


Proprietary Trading

Higher spreads on loans and bigger gains on proprietary trading were the main contributors, according to Max Bohm, an analyst at Sao Paulo-based consulting firm Empiricus Research.

Yet the positive results aren’t showing up in the share price, which is down six percentage points more than the benchmark Ibovespa index since the start of the year. At Bradesco, the gap is 10 percentage points.

Bradesco, which gets about 30 percent of revenue from its insurance business, has also been posting gains from credit-card fees and asset management, according to Bohm. Its ROE rose to 22.7 percent in the second quarter from 22.3 percent in the first. Excluding one-time items, the Osasco-based bank had a 21.1 percent return on equity last quarter, the highest in four years, according to Deutsche Bank’s calculations.

“Bradesco and Itau have been expanding credit only in lower-risk areas, so they’ve been able to keep asset quality under control with only some modest deterioration for Itau,” Labarta said. “Fee-based income has been growing at a high-single-digit, low-double-digit pace, and expenses also have been under control.”


HSBC Purchase

Also weighing on profitability prospects for Bradesco is its acquisition of HSBC Holdings Plc’s money-losing Brazil unit for $5.2 billion in cash, according to Labarta.

“At the price paid, which seems high, the bank will really have to deliver significant synergy gains to increase earnings per share by 2017,” Labarta said. “It’s always challenging integrating banks. There will be some overlap in people and branches during a period of time, the economy is in recession, banks are not growing — that adds to the challenge.”

An official at Bradesco declined to comment.

State-owned Banco do Brasil SA, Latin America’s largest bank by assets, has been more aggressive in making loans in recent years, and the national recession is taking a bigger toll on profitability. ROE at the Brasilia-based bank fell to 14.1 percent in the second quarter from 16.1 percent a year earlier as it increased money set aside for bad loans 21 percent, to 5.53 billion reais.

An official at Banco do Brasil declined to comment.

“There is a huge increase in non-payment rates all over the economy, and no doubt that will have a bigger and bigger impact on banks’ balance sheets, reducing their profitability,” Bohm at Empiricus Research said.

Brazilian Bank Investors Grow Skeptical of Record Profitability