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