A good weekend read if you get bored: analysis of Itau Unibanco by HSBC.
Summary
1. We believe that Itaú Unibanco has the right mix of growth potential and balance sheet strength to deliver healthy ROEs
2. Higher credit charges will be some offset from low growing opex

3. We believe that premium returns have been deferred and not destroyed at Itaú Unibanco

Premiums deferred. Even though we believe concerns on Itaú Unibanco’s credit quality are justified, we do not believe that the higher credit charge will wipe out its premium ROE prospects but rather erode some of this premium in 2011 and 2012. On PE multiples of 9.4x for 2011, 7.8x for 2012 and 6.8x for 2013, we see Itaú Unibanco’s de-rating as a buying opportunity. Our target price of BRL44 is equivalent to an ADR target price of USD29, based on the Implied PE valuation methodology. We estimate that Itaú Unibanco trades on PBV ratios of 2x for 2011e and 1.7x for 2012e and 1.5x for 2013e, which are historically low multiples for high quality returns.

2Q11: credit charges above expectations. The main highlight in the quarter was the higherthan- expected provisions (+9% versus HSBC estimate). Recurring net income was down 8.8% q/q, and 9.4% below our estimate and consensus. Annualized ROE of 22.3% was below our estimate of 22.9%. Loan growth was fractionally ahead our expectations at 21.9% y-o-y, driven by growth in personal loans (+34.7% y-o-y), SME loans (+26.2%) and mortgage (+73.2%). Net interest income was inline with our expectations. Opex, excluding depreciation, came in 2% better than our expectations due to lower staff costs, and it rose just 4% on a y-on-y basis. Although the headline NPL ratio was better than we expected, the 90 days corporate NPL ratio rose 40bps over previous quarter to 3.5%, driven by SMEs, driving higher provisions.


Outlook. In 2H11, we expect some deterioration in asset quality (+30bps in 2H11) especially in the small corporate segment, which should drive higher credit charges. However, we believe higher charges should be partly offset by slower growing opex. We are optimistic on the execution of cost containment as Itaú Unibanco benefits from its investments in IT migration and integration, which are to be concluded during 2H 2011. We believe that there will be some ROE erosion from higher credit charges but we do not believe that the higher provisioning level of 2Q 2011 is the new norm. One reason for this is the limited uptick in NPL formation, which we believe has been helped by the limited deterioration in the consumer credit portfolio. In terms of the renegotiated credits (+22% q/q in 2Q11), and concerns that this might negatively impact the credit charge going forward, we believe, the level of re-negotiations as a percentage of total loans, does not seem to correlate much with the credit charge; a better forward indicator of the credit charge, would be the chart below with early delinquencies.

Valuation, rating and risks. We applied our core valuation methodology of implied PE, as we believe this best captures both growth potential and return on capital. The implied – or target – PE multiple is ROE less long-term growth (ROE-g) divided ROE multiplied by the cost of capital less long-term growth (ROE* (k-g)). We assume ROE of 22.3% for 2012e and cost of capital of 12.12%, with an assumed stock beta of 1.04, medium-term (2010- 2013e) EPS growth of 15.1% pa, and long-term (2014e-2017e) EPS growth of 6%. Based on an implied PE of 12x for 2012, we arrive at our 12- month target price of BRL44 for Itaú Unibanco shares equivalent to USD29per ADR. Under our research model, for stocks without a volatility indicator, the Neutral band is 5 percentage points above and below our hurdle rate for Brazilian stocks of 11.5%, or 6.5-16.5% around the current share price. Our 12-month target price of BRL44 implied a potential return above the Neutral band when we set our target; therefore, we rated the stock Overweight. Risks to the downside for Itaú Unibanco, in our view, include poorer-than-expected GDP growth, resulting in slower-than-expected asset quality deterioration and thus greater charges for loan losses against earnings; synergy gains and economic of scale, both in terms of banking and insurance businesses, falling short of expectations; and the bank’s net interest margins and spreads coming under greater pressure than expected.

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