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Morningstar | Itau Finishes 2018 With a Muted Fourth Quarter and Solid Yearly Results; Shares Remain Overvalued

No-moat Itau Unibanco released fourth-quarter earnings roughly in line with third-quarter results, exceeding our expectations for full-year 2018. Sequential recurring net income growth was up 0.4% with year-over-year growth of 3.1%. Though cost of credit increased moderately, up 4.7%, it remained stable at 2.1% as a percentage of the loan portfolio. Brazil’s 2018 GDP growth was lower than the bank had forecast, with growth in the first six months of just 0.8% annualized. Considering the economic conditions and political uncertainty, Itau posted strong yearly loan portfolio growth of 6.1%. We’re adjusting our fair value estimate down to $5.90 per share to reflect currency effects, a share split, and preliminary adjustments to our model based on management’s guidance.

While annual commissions and fee revenue came in lower than expected; fourth-quarter fee income was up 6.5%, driven by performance fees and capital market activity due to positive market conditions. Itau’s total loans grew 7.9% from the previous year and 0.4% for the quarter. The most significant changes to the loan portfolio were credit card loans (up 12.8%) and import/export financing (down 12.4%). Allowance for loan losses were down 3.5% in the quarter, and write-offs were stable at 0.8%. We reiterate our concern with the disparity between ongoing loan growth and declining credit provisions.

Itau’s financial margin with clients was up 4.7% for the year. In contrast, margin with markets was down 20.1%, primarily due to the decline in the SELIC rate. The increase in margin with clients came from changes in the loan mix, with higher-margin individual loans experiencing strong growth. From the call, it’s clear that management is highly focused on growing this segment in the coming years to improve margin. We caution investors to keep in mind that higher-margin individual loans have higher rates of default, and we intend to monitor the individual segment closely for signs of loan distress.

Along with financial results, Itau announced a total payout of 89.2%, up from 83% in 2017. This includes a minor share buyback program and translates to a 7.5% dividend yield. As of January 2019, Brazilian banks are required to follow Basel III capital requirements. Itau is mandated to keep a 13.5% Tier 1 capital ratio, which includes equity and reserves. The bank’s Tier 1 ratio was 15.9% in 2018, allowing it to make additional dividend payouts. In Brazil, firms have the option of making payouts as dividends or interest on own capital, which is calculated by applying the SELIC rate to available equity. Total dividends and interest payouts in 2018 totaled about BRL 20 billion, about 2 times from the year prior. Payouts have increased drastically in the past two years, up from 49.3% in 2016. Though the board doesn’t have specific payout targets, we expect the payout ratio to remain in the 80%-90% range for the time being.

Itau has provided guidance for 2019 GDP growth in Brazil of 2.5%, and 8%-11% growth in the bank’s loan portfolio. We’re taking these forecasts with a pinch or two of salt given the unpredictability of the economic and political environment. Brazil’s 2018 GDP growth was only 1.3%, compared with Itau’s 3.0% forecast. In addition, management stated on the conference call that its guidance assumes the Bolsonaro administration will pass pension reform this year. We believe this is more likely to occur than not; however, there is a material risk of reform efforts being unsuccessful. Lower economic growth and reduced business confidence from this result would materially impact Itau. In our view, investors should be skeptical that Itau can achieve double-digit loan growth in 2019.

The Brazilian Central Bank’s overnight SELIC rate was unchanged at 6.50% during the fourth-quarter, down from 6.75% to start the year. In the medium term, with regards to inflation factors, ongoing emerging market economic challenges will put downward pressure on inflation. This is somewhat mitigated by the uncertainty over economic reforms, as political ambiguity can push inflation upward. In the long term, we believe that the SELIC rate is likely to rise as Brazil’s economy continues its gradual recovery from the deep recession the country experienced from 2014 through 2016. The moderate likelihood of pension reform passing during Bolsonaro’s tenure as president may contribute to a higher neutral SELIC rate resulting from stronger and more stable economic growth. As Brazil continues to climb out from its recession, we expect overall long-term economic growth to have a positive effect on Itau’s future earnings.

Markets reacted favorably to far-right Social Liberal Party presidential candidate Jair Bolsonaro taking office on Jan. 1 after winning the second-round election run-off in late October, due to the expectation of pension and tax reform and potential improvements to government efficiency. There has been some indication that pension reform won’t be as robust as previously thought. To the surprise of political observers, Bolsonaro publicly mentioned minimum retirement ages lower than what has been proposed by centrist ex-president Michel Temer. While the implementation of pension reform has the potential to lead to stronger longer-term growth and budget stability, it’s unclear how successful the Bolsonaro administration will be in its overall reform endeavors. We believe Bolsonaro has the political capital to move forward on pension changes and is likely to get some version of pension reform through Brazil’s highly fragmented congress, particularly if he acts on the issue early in his term. We have some doubts about whether these changes, if they occur, will meet the market’s high expectations and ultimately drive higher growth in the country.