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Morningstar | Banco de Chile Mitigates Mediocre Margins With Fee Growth, but Higher Provisions Prunes Profits

Banco de Chile had a tough first quarter as lower net interest income, higher personnel expense, and a spike in loss provisions contributed to a year-over-year earnings decline of nearly 40%. Annualized top-line growth was negligible, with operating revenue of CHP 445 billion identical to first-quarter 2018. Lower interest income in the quarter was entirely offset by a 3.5% increase in fee and commission revenue. Similar to its main competitor Banco Santander Chile, Banco de Chile has over 40% of its assets denominated in inflation-linked Unidad de Fomento. With annualized inflation in Chile in the first quarter well below the central bank’s 3% target, at just 1.83%, these inflation-indexed assets were a drag on earnings. About one third of interest-earning liabilities are denominated in UF, meaning that inflation exposure is just a fraction of the full balance sheet. Still, Banco de Chile was not as affected as Santander by lower Chilean inflation given its lower 10% exposure. Banco de Chile will need to have robust results the rest of the year to meet management’s guidance, but, given our more conservative estimates for full-year results, we don’t anticipate making a material change to our fair value estimate of $22.10 per share.

The overall loan portfolio was a tale of two segments in the first quarter. Retail banking loans were up 2.1% sequentially and 10.3% year over year, while wholesale banking loans were down 0.9% for the quarter and up 6.1% over the past year. Below-inflation wholesale banking loan growth has certainly been a disappointment for the bank. On the whole, annualized loan growth for the quarter was just 4%, below our full-year expectations. Inflation in Chile can’t go much lower than the levels experienced in the first quarter, and, given the Central Bank’s commitment to achieving its 3% inflation target, we still believe overall loan growth for the year will be in the mid- to high-single-digit range.

Personnel expenses increased about 7% annually, which contributed to a 7.8% increase in total operating expenses. Considering the strength of the Chilean economy over the past year, higher compensation was expected and wasn’t much of a surprise. Compensation growth has been very consistent over the past five years, with annual compensation growth ranging between 21% and 22.5%. While compensation growth could exceed this range in 2019, we don’t expect it to overshoot by much, and the growth of personnel expenses should remain in the low-20% range going forward. We were much more concerned by the rise in loan loss provisions this quarter. Provisions increased by 26% on a year-over-year basis, and 45% sequentially, rising by CHP 18.2 billion to CHP 89.2 billion. As a percentage of average loans, provisions increased to 1.27% from 0.9%. Higher group provisions were the main driver of this swell in provisions. The bank is expecting higher losses on consumer loans, with consumer group provisions increasing by CHP 14 billion to CHP 75 billion. Per management, about half of the higher provisions can be explained by loan growth, with the other half due to a more normalized level of provisions compared with the below-trend nonperforming loan metrics of last quarter.

In the late 1990s, Banco de Chile created a special purpose entity to repay its indebtedness to the Central Bank. In the earnings report for the quarter, the bank announced that it had repaid in full the debt to the Central Bank. Going forward, Banco de Chile will have additional flexibility from a capital management perspective given the reduction of debt liability requirements. Related to this, the effective tax rate increased to 25.2% in the first-quarter, from 16.5% in the fourth quarter. An effective tax rate greater than 20% is likely going forward given that prior debt payments had been a source of tax benefits in the past.

Annualized GDP growth in Chile in the fourth quarter was 5.2%, up from just 0.8% in the third quarter. The IMF is forecasting 2019 real GDP growth in Chile to reach 3.4%, evidence that the Chilean economy will likely continue its momentum from last year's 4% growth. The Central Bank of Chile kept interest rates at 3% following its March meeting, holding the benchmark rate stable since its 25-basis-point increase in January. In its policy statement, the bank advised that the lower level of inflation--1.7% as of February--justifies ongoing monetary stimulus and that rates will be adjusted as needed to meet the two-year inflation goal of 3%. Although a strengthening economy provides a tailwind for Banco de Chile, the Chilean economy remains highly exposed to Chinese demand for copper, commodity prices, and global economic conditions.