Banco do Brasil: Shares Remain Attractive After The Rally

seekingalpha02-15

Banco do Brasil has performed well since I opened on it with a Buy rating last October, outperforming most of its peers and Brazilian equities more generally.Q4 results capped off a solid year, with ...

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Mauricio Graiki Banco do Brasil (OTCPK:BDORY)(\"BdB\") has done well since I initiated coverage with a 'Buy' rating in October, with a circa 30% total return roughly matching the performance of peer Itaú (ITUB) and landing well ahead of Banco Bradesco (BBD), Banco Santander (Brasil) (BSBR) and indeed Brazilian equities (EWZ) more broadly. Data by YCharts The investment case for BdB was pretty straightforward a few months ago, with a clear discount to book value and a P/E of around 4x looking too cheap relative to the bank's earnings power. BdB has continued to generate healthy levels of profitability since then, with solid Q4 and 2023 results helping to send the stock's valuation closer to book value. While that leaves the investment case slightly less compelling than it was a few months ago, these shares still look moderately undervalued, notwithstanding the higher cost of equity one should build in for BdB and Brazilian banks generally. As such, I keep my Buy rating in place. Q4 Caps Off A Relatively Strong Year While Brazilian banks have faced a tricky macro backdrop in recent times, with restrictive monetary policy leading to slowing credit growth and asset quality concerns, some names have definitely fared better than others. BdB is one of them. The bank reported adjusted net income of R$9.4 billion in Q4, up around 4% year-on-year, bringing total 2023 adjusted net income to R$35.5 billion, an increase of circa 11% versus 2022. That compares well to a number of its peers, with Banco Bradesco and Banco Santander Brasil, for example, reporting declines of 21% and 29%, respectively, in net income last year. Source: Banco do Brasil Q4 2023 Results Presentation I touched on some of the drivers of this last time out. With interest rates having risen sharply in Brazil to combat inflation, demand for credit has understandably taken a hit, as has asset quality. With inflation also driving operating expenses up, that has led to a squeeze in both pre-provision and bottom-line earnings at a number of banks. Having said that, BdB's loan book skews heavily to agribusiness lending, with the agriculture sector in general proving to be a bright spot for Brazil's economy recently. This has been a nice tailwind for the bank's net interest income (\"NII\"). NII was up 20% in Q4 to R$27.5 billion, with loan growth of circa 10% year-on-year being driven by a mid-teens year-on-year increase in agribusiness lending. Source: Banco do Brasil Q4 2023 Results Presentation More generally, BdB and peers have also benefitted from improved Market NII (i.e. securities net interest income), as moderating Brazilian inflation versus 2022 led the central bank to cut rates by 200bps last year. This has eased funding costs, with BdB's Market NII continuing its trend of sequential improvement, helping to offset tighter margins in client lending. Credit Quality Not A Major Concern One seemingly weak spot in the bank's recent results was asset quality, with non-performing loans 90-plus days overdue increasing 11bps to 2.93% of total loans last quarter. That continues a trend of sequential increases, and comes despite peers like Itaú, Banco Bradesco and Banco Santander reporting more stable asset quality metrics as lower interest rates ease some of the stress on borrowers' finances. Now, BdB's overall credit quality metrics do land lower than peers on average, with a 2.93% ratio of NPL +90d still lower than the Brazilian banking industry as of Q4. This is again a function of the bank's loan book and its heavy skew to agribusiness, as these loans typically report better credit quality metrics but also come with lower margins. Source: Banco do Brasil Q4 2023 Results Presentation That said, this deteriorating credit quality trend does not concern me too much. Looking back, the NPL ratio in the agribusiness book has basically been at exceptionally low levels for quite some time now. While a 38bps increase there looks steep over the past couple of quarters, it is essentially returning to something resembling normality. Ditto for the Companies loan book (i.e. corporate, SME and public sector), where the NPL +90d ratio has also been steadily moving up. Source: Banco do Brasil Q4 2023 Results Presentation BdB's total impaired loans ratio was 8.1% as of Q4 based on the \"D-H\" classification system used in Brazil, basically flat year-on-year and implying a coverage ratio of just over 70%. That should be okay assuming credit quality doesn't deteriorate meaningfully, and I would imagine that moderating inflation and lower interest rates will provide some support there. Note that management is guiding for lower levels of provisioning this year, with R$28.5 billion at the mid-point around 7% lower than 2023 levels in absolute terms. Shares Still Offer Some Value Banco do Brasil's ADSs trade for $11.15 at the time of writing, putting them at around 4.7x 2023 EPS and a shade under book value, having re-rated since previous coverage. Data by YCharts Though the stock is more expensive than a few months ago, I still don't think the valuation here is stretched by any means. 2024 adjusted net income guidance is R$38.5 billion at the mid-point, implying another strong year in terms of ROE ahead. Now, Brazil obviously comes with some extra risks in terms of currency depreciation, regulation and so on, while BdB is also majority state-owned, all of which warrants a higher cost of equity here. On top of that, I would still prudently assume that BdB is over-earning in terms of its current 20%-plus ROE. The bank's ten-year average is much more modest at around 15%, but this is a tale of two halves, with the 2019-2023 average at circa 17.5% and 2014-2018 average much lower at 12.5%. Data Source: Banco do Brasil Annual Results BdB has been working hard on improving efficiency in that time, but regardless of whether the bank is now structurally more profitable or not the current multiple looks cheap. Baking in a 16% mid-cycle ROE, a cost of equity of around 14%, and around 4% annualized long-term growth gets me to a fair value of around 1.2x book value, or just under $14 per ADS, implying a further 25% upside to fair value. Capital returns potential looks compelling in the meantime, with management upping the payout ratio to 45% from 40% previously:  Responding to the request of many investors, we are proposing to increase the payout in 2024 to 45%. Geovanne Tobias, CFO Banco do Brasil  On 2024 net income guidance of R$38.5 billion, that would imply the equivalent of around $1.20 per ADSs for the dividend, equal to a yield of ~11% at the current price. With the stock still meaningfully undervalued and capital returns potential looking even more attractive than last time out, I maintain my Buy rating on Banco do Brasil.  Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. 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