Itau Unibanco (NYSE:ITUB) – Work to be done but undervalued on prospects for recovery

of Brazil Itau Unibanco (ITUB) wasn’t one of my favorite bank stocks again in August 2020and names I prefer, like Credicorp (BAP), DBS group (OTCPK:DBSDY), and ING (ING) have all outperformed, but I have to admit I’m surprised Itau has seen only modest gains in what has been a largely global bank stock rally.

I don’t think Itau will ever be my favorite international bank, or even my favorite South American bank, but the rise of Milton Maluhy could make some changes (although as a former CFO I wouldn’t expect a big change). In particular, Itau needs to figure out how to gain more traction with its digital endeavors and offset the increasingly stiff competition from non-bank fintech companies in Brazil.

A long-term core earnings growth rate of 7% marks a significant slowdown in the long-term earnings growth rate, but still supports a fair value of $6 for the ADRs. I think work needs to be done here to maintain long-term competitiveness, but credit has held up better than I expected and I think Itau, with its leverage for a recovery in Brazil’s economy and other economies in South America, is a bit cheap appears .

Can the card business drive growth again?

While Itau’s cards business was once a key growth driver for the company, that growth has definitely stalled. Card fee revenue declined 8% in the fourth quarter, and over the past five years, the company has seen virtually no growth in net card outstandings and has seen its market share decline from a mid/high 30% to around 30%.

To be fair, this is not an Itau specific issue. Most of the big banks have only recorded stock losses bank Santander (Brazil) (BSBR) management of a small increase. However, since the cards business generates almost 10% of total revenue (mainly from interbank fees) and generates very high-margin revenues, this is not a trivial matter.

Unfortunately, I don’t see any easy solutions. Newer entrants have gained their share mainly on price or credit quality (accepting lower levels in either case), and that’s tough competition for Itau. At the same time, new payment options (such as peer-to-peer apps) continue to gain traction in Brazil, in many cases completely replacing the use of credit cards and attracting younger and wealthier customers.

FinTech needs some work

Itau launched its digital platform in 2019 and still needs some work on it. Competitors have used strategies like cash-back bonuses to lure users in, and Itau has been left so far behind that the bank’s app isn’t even in the top 10 financial apps in Brazil (according to Sensor Tower), and likes to lag behind PicPay, Nubank, caixa, Bank PANand MercadoLibre‘S (MELI) Mercado Pago by a wide margin.

It’s not too late to catch up, but it will take work and most likely additional spend – both on the IT side and on the sales and marketing side. With fintech growth outpacing overall banking growth in Brazil by a fairly healthy margin, it’s not an area where Itau can afford to lag behind, especially given the savings that can be gained by switching from one A digital model is generated from a model dominated by physical locations and employees.

Business should improve in 2021, but charges are getting worse

So far during the downturn in the credit cycle, I’ve been fairly impressed with Itau’s credit metrics — not a trivial concern for me, as I’ve felt management has been overly bullish on their credit/reserve position in past downturns.

The share of non-performing loans in loans remained fairly constant in the fourth quarter, and the prepayment rate actually improved. While the birth rate is picking up and charge-offs are expected to increase in 2021 (which is normal), the coverage ratio of over 300% seems more than reasonable. However, one area to keep an eye on is Chile, where CorpBanca is not doing particularly well.

I’m also more bullish on the underlying banking trends into 2021. Overall lending was up about 3% qoq, with growth of 4% in Brazil and growth of nearly 8% in consumer lending, including double-digit growth in card lending. Spread will still be a challenge — customer net interest margin was 7.3% this quarter, up from 10% a year ago and 7.5% in the third quarter — but demand for consumer credit is definitely recovering, and I’d expect that Enterprises and small businesses will be select throughout the year. However, I would note that management’s broad forecast range for credit growth (as well as other financial items) of 5.5% to 9.5% suggests a lot of ongoing uncertainty at the pace of the recovery.

The outlook

As I said, I don’t think Itau is my preferred option to invest in Latin American banks (I would prefer Credicorp), but despite the challenges I see, I think the valuation is relatively interesting. I expect interest rates to start rising in Brazil in 2021, and this coupled with healthy credit demand and cost leverage will lead to a more than a third improvement in core earnings and growth of over 15% over the next five years compared to 2020.

Longer-term, I see core earnings growth of 7% compared to pre-pandemic levels, and I believe ROE will return to the high teens/low 20% with ROE above 17% in 2021. That has to be seen over the long term, too Find out how Itau can improve its digital offerings and compete more effectively with fintech/payments challengers. These companies aren’t a threat to areas like corporate lending, but corporate lending isn’t as profitable, and fintech competitors are threatening some of the most profitable parts of the Itau model.

The final result

Retracing these core gains, I believe Itau shares should be trading closer to $6 than the current price around $4.50. That makes these stocks quite attractively priced and worth considering as a delayed game in terms of eventual normalization and economic recovery in Brazil.

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