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Morningstar | Bradesco Benefits From Lower Credit Losses in 1Q; Brazilian Economy Hinges on Bolsonaro Reform

Banco Bradesco continued its momentum from 2018 in the first quarter, with 11.4% currency-adjusted loan book growth and year-over-year recurring net income growth of 22.3%. Annualized return on average equity reached a four-year high, and the bank improved its risk-adjusted efficiency ratio, which fell from 65.2% to 64.5%. Though we continue to believe Bradesco will be challenged to achieve full-year double-digit loan book growth in 2019 due to a slowing and fragile Brazilian economy, Bradesco’s loan growth of 11.4% exceeded our expectations. This growth was mitigated by lower interest margins, as net interest income fell about 5% compared with fourth-quarter 2018. Fee and commission income were below guidance, down 4.5% in the quarter, but this decline was mainly because of seasonal effects. We expect fee income to rebound in the second quarter. While operating expenses declined 4.1% from last quarter, these costs are tracking 5.2% higher year over year because of a new collective bargaining agreement and increased variable compensation. On balance, first-quarter results were in line with our forecasts, and we still expect near 20% earnings growth for the year. We continue to believe shares are overvalued given ongoing political uncertainty with pension reform and economic risks and maintain our fair value estimate at $7.10 per ADR share.

The primary first-quarter drivers for the loan portfolio were higher corporate loans, up 5.5% for the quarter, and 5.1% growth in payroll-deductible loans. Personal loans have also been a source of growth in the past year, up 9.1% for the quarter and 23.4% year over year. While this level of growth is impressive, personal loans account for just 4% of the loan book. Card credit declined 4.3% for the quarter primarily due to fourth-quarter holiday seasonal effects. Overall loan growth is on track to reach management’s guidance of 9%-13% for the year, though we still expect annual growth to come in on the lower end of this range.

Delinquency ratios and loss allowances continued to fall in the first quarter, with delinquencies reaching two-year lows. From our calculations, annualized credit loss allowances dropped to just 2.7% in the first quarter, compared with 2.8% the previous quarter and 4.1% in fiscal 2017. In contrast, loans have increased nearly 11% during that time. In our opinion, this dichotomy is concerning, and investors should be attentive to signs of increasing losses, especially if the Brazilian economy starts to slow. We believe this historically low level of credit losses is unsustainable in the long term, and we expect normalized loss allowances to be closer to the 3.5%-4% range.

In mid-April, Bradesco announced that it will be spinning-off its digital bank Next by the end of 2019. As we’ve previously noted, about 80% of Next’s 800,000 customers were not previously customers of the Bank. While we reserve judgement on the decision to spin-off Next until terms are clarified, an independent Next could provide competition to Bradesco’s digital banking platform and could hamper Bradesco’s growth with the younger, less-affluent client base. We believe the strong growth of new accounts with Next, which averaged 60% each quarter for the past year and now total 300,000, represents a secular trend in the industry of higher demand for digital banking. The Next platform provides potential cross-selling opportunities, and a spin-off could result in a loss of these synergies.

Annualized GDP growth in Brazil for the fourth quarter was just 0.4%, down from 2% in the third quarter. The IMF is forecasting 2019 real GDP growth in Brazil to reach 2.1%, lower than the emerging market average forecast of 4.4%. Growth forecasts for Brazil have trended downward since the start of 2019 as pension reform efforts stretch into the year with increasing uncertainty. The Central Bank of Brazil kept interest rates at 6.50% following their March meeting, which also marked one year since the benchmark rate was cut by 25 basis points to its current level. In its policy statement, the Bank advised that current economic conditions continue to justify a stimulative monetary policy and that recent economic data came in below expected levels. If pension reform efforts fail and the Central Bank cuts interest rates in response to continued sluggish economic growth in the Brazilian economy, Bradesco could experience substantive revenue declines and curtailed earnings growth. Conversely, successful reform would likely stabilize the economy, leading to increased confidence and higher growth for Brazilian banks.